The Untested Waters of Default in Islamic Finance

The Cayman Islands has developed a reputation as a jurisdiction of choice for Islamic finance structures, including sukuk. However, the rights held by the investors in the event of default under such structures are largely untested.

Shariah principles must be applied when structuring Shariah-compliant financial products, including sukuk. These principles include the avoidance of riba, gharar (uncertainty or speculation in contracts), unjust enrichment and prohibited activities or investments (such as gambling- and alcohol-related investments).

Undoubtedly, the Islamic finance term that is most commonly referred to in the financial newspapers of western countries is sukuk. The majority of recent sukuk structures have been sukuk ijarah, where the originator seeking financing transfers certain of its assets to a special purpose vehicle (SPV) that is often incorporated as an offshore company. SPVs become the issuers/trustees of sukuk ijarah. The SPV is typically owned by a charitable or a purpose trust (such as a Cayman STAR trust).

The SPV will issue sukuk or trust certificates to investors (the certificate holders) and invest the proceeds in assets. Trust arrangements are typically governed by English law. The SPV holds the assets in trust for the benefit of the sukuk holders pursuant to a declaration of trust using the income from the assets to make payments to the sukuk holders. There is typically a requirement that on maturity of the sukuk or upon an event of default, the originator has a purchase obligation to repurchase the assets, enabling the SPV to redeem the outstanding certificates and repay the sukuk holders.

In this regard, the rights of sukuk holders in the event of default will vary, depending on whether the sukuk structure is an asset-based or an asset-backed structure. This is important since we recognise that if the originator is in default of its obligations to make payments to the trustee for use of the assets under a sukuk ijarah, he may not be able to honour the purchase undertaking. Consequently, the SPV may not be in a position to repay the principal of the sukuk on maturity or default.

In an asset-based sukuk, the originator transfers only the beneficial ownership or equitable interest in the assets to the SPV issuer; therefore, there is no true sale. To maintain Shariah compliance, there must be a transfer of assets; since investors have no recourse to the assets, the transaction does not focus on asset risk but rather on the creditworthiness of the sponsors of the sukuk. If the originator fails to pay any amount payable pursuant to the transaction documents, the certificate holders normally have no recourse against the originator or the issuer/trustee.

These types of sukuk do not grant the certificate holders the right to cause the sale or other disposition of any of the trust assets on default. Typically, they can cause the trustee to call a meeting of the certificate holders and exercise their rights under the transaction documents, including issuing a notice to the originator pursuant to its undertaking to repurchase the assets on maturity or default of the sukuk.

In structuring the sukuk, additional security could also be granted by the originator, including share charges, mortgages and guarantees provided by related parties in the originator group. Alternatively, upon a default, the parties may agree to restructure the debt and related obligations, including an agreement to reduce the principal sums outstanding or granting standstills on exercising any rights under the transaction documents. Ultimately, asset-based sukuk are based upon the credit of the issuer, guarantor or other co-obligors.

Alternatively, in an asset-backed sukuk, the legal title to the underlying assets will typically pass by way of a true sale from the originator to the issuer SPV. On default by the borrower, sukuk holders are able to exercise certain rights of ownership and control over such assets. The elements of true sale, fundamental to a securitisation, must be present in an asset-backed sukuk. An asset-backed sukuk is similar to a securitisation in that it is a non-recourse obligation and credit risk performance is determined solely by the underlying asset.

To date, many sukuk issuers have been established as Cayman-exempted companies. As a result, issues may well arise under Cayman Islands law as to how investors in a sukuk will be treated and what recourse they may have in the event of a default or in the course of a restructuring. The difficulty in this regard stems from the fact that investors and the courts may well struggle to make legal sense of finance structures that are designed primarily to comply with Shariah. Moreover, the questions of governing law, jurisdiction and enforcement authority may be entangled.

As mentioned above, although a sukuk issuer is often incorporated as a Cayman Islands-exempted company, the transaction documents, including the declaration of trust, are typically governed by English law and the courts of England will normally have exclusive jurisdiction to settle disputes under such documents. Since the underlying sukuk assets may be located outside of the Cayman Islands or the UK (in the Middle East, for example), conflict of law issues arise.

Some foreign courts, for example, tend to guard their jurisdiction over a matter jealously and view the retention of jurisdiction as a matter of public policy. As a result, clauses purporting to grant exclusive jurisdiction to a Cayman Islands or UK court may be deemed to be contrary to public policy and not upheld. Furthermore, where there are no bilateral treaties for reciprocal enforcement of judgments between the Cayman Islands or the UK and the foreign jurisdictions where the assets are located, even if judgment is obtained in the Cayman Islands or the UK against the borrower, there may be additional hurdles to be overcome to have those judgments enforced in those foreign jurisdictions.

A great deal of attention focused on the East Cameron Gas asset-backed US$165.6 million, 13-year sukuk issued in 2006. In October 2008, East Cameron Gas filed for bankruptcy protection under Chapter 11 in the US Bankruptcy Court for the Western District of Louisiana after its offshore Louisiana oil and gas wells failed to yield the expected returns, partly because of hurricane damage.

The ultimate question facing the court in the East Cameron case was whether the sukuk holders actually own a portion of the company’s oil and gas royalties. The company argued that there had been no transfer of ownership of royalties into the Cayman SPV formed to issue the sukuk. It submitted that the transaction was really a loan secured on those royalties, suggesting that sukuk holders would have to share the royalties with other creditors in the event of liquidation.

The bankruptcy court appeared to have rejected East Cameron’s secured loan argument when it said that “holders invested in the sukuk certificates in reliance on the characterisation of the transfer of the royalty interest as a true sale.” If East Cameron cannot advance additional arguments in support of its case, the sukuk holders’ rights will obviously be strengthened and they may be entitled to the stream of royalties.

According to a recent Moody’s report, most sukuk structures to date have been asset-based (rather than asset-backed), which equates them to conventional unsecured bonds. It should be noted that the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) recently approved new guidelines that will require investors to become the legal, rather than nominal, owners of sukuk assets. AAOIFI’s new guidelines have resulted in heightened investor awareness of sukuk structures that will likely result in increased investor preference for asset-backed sukuk.

However, although asset-backed sukuk are more consistent with the ideal of granting the investor an ownership share of the asset, asset-based sukuk may be more suitable where assets cannot be legally owned by investors (such as where there are restrictions on foreign ownership of certain asset classes such as real property). In addition, asset-backed sukuk may not be adequate in circumstances where the enforceability against the assets may be challenging (such as sovereign-related or owned assets).

Where sukuk are asset-backed or are structured as securitisations of a stream of revenue, the status of the transfer or sale to the issuer SPV is critical. As with other securitisations, if structured legally as a true sale, the sukuk holders will be better positioned to recover their investment through execution on the assets.

A true sale will also be fundamental in determining that the assets of the issuer will not be consolidated with the assets of the originator in the event of the bankruptcy of the latter. Where a Cayman Islands issuer is used, investors will have a right to the assets of a Cayman Islands company and Cayman Islands legal issues regarding security arise depending on the sukuk structure.

The Cayman Islands has no general system of registration of security interests to perfect or obtain priority. There are, however, registration systems in place for ships and aircraft registered in the Cayman Islands. Cayman Islands companies are required to keep an internal (private) register of mortgages and charges, but failure to make the appropriate entries does not, of itself, affect the creation of the security interest or its perfection or priority.

The law that governs the creation of the security interest, its perfection and the priority of the secured party depends upon the application of conflict of laws principles. In general, these principles require application of the laws governing the security agreement and the laws constituting the asset over which the security has been taken or the laws of the place where the asset, subject to the security interest, is situated. Hence, for sukuk, because of the interplay between different governing laws and assets typically located in a jurisdiction outside of the Cayman Islands, a myriad of complex legal issues will arise.

The continuing success of Islamic finance will depend on structuring Islamic debt financing that strikes a balance between creditor and borrower rights while maintaining Shariah compliance. The Cayman Islands has been a beneficiary of the emergence of sukuk as a burgeoning source of business finance. The restructuring of sukuk will pose new challenges for the Islamic finance market, including Islamic scholars and both onshore and Cayman Islands lawyers.

This article is not intended to be a substitute for legal advice or a legal opinion. It deals in broad terms only and is intended to merely provide a brief overview and give general information.

This article first appeared in Islamic Finance News (Vol. 7, Issue 3, 20 January 2010 issue). For more information, please visit