The current global crisis has allowed the Islamic finance industry some time for reflection, and as such, when considering the future of the Sukuk market, we explore in detail the issue of substance over form. Most Islamic market participants are aware that Sukuk, sometimes known as Islamic bonds, should grant the investor a share of an asset or business venture along with the cash flow and risk commensurate with such ownership. However, while this is indeed the Shariah ideal, most current structures have more in common with conventional fixed income or 'debt' instruments from a risk / return perspective. The assets in the structure of Sukuk are commonly for Shariah compliance only, and ultimately have little or no bearing on the risk or performance of the Sukuk itself. In this paper, I will be discussing the overview of Islamic finance industry, the Shariah requirements in Islamic economy, and subsequently turn into the main part of this paper, the discussion about the Sukuk: introduction to Sukuk, its features, brief differences between it and the conventional bond, the issues pertaining it, and some recommendations highlighted to curb the issues.
Objectives of the research:
The purposes of this research are mainly to
Fulfill the partial requirement of paper SH1002 - Shariah Aspects of Business and Finance for CIFP
Understand the Islamic financial institutions, their roles and contributions to the Islamic economy.
Enhance to knowledge on the Islamic products introduced by the Islamic financial institutions.
Understand the nature and structures of Islamic products, and assessing the fulfillment on the Shariah requirements for those products.
Investigate the role of standard-setting bodies for authority in Islamic finance.
Key terms of the research
1. Islamic finance 2. Shariah 3. Form and substance 4. Sukuk 5. Islamic financial instruments 6. AAOIFI standards
1.0 Introduction
Islamic finance is a rapidly growing part of the financial sector in the world. Indeed, it is not restricted to Islamic countries and is spreading wherever there is a sizable Muslim community. More recently, it has caught the attention of conventional financial markets as well. There are about more than 250 financial institutions in over 45 countries practice some form of Islamic finance, and the industry has been growing at a rate of more than 15 percent annually for the past five years (Hennie & Zamil, 2007).
Over some 30 years, a variety of financial institutions have developed sophisticated methods to advance capital to both the private and public sector in a manner compatible with Shariah. However, it is only recently that tradable Shariah-compliant financial investment instruments have come to market in substantial amounts. In this respect, the development of an Islamic bond market has been the primary area of growth, providing an avenue for the short and medium-term placement of funds by investors. The growth of this market has not only been fuelled by the desire of corporates to raise Shariah compliant funds but also by investor demand for Shariah compliant products.
2.0 Shariah
Islam is a system of belief that encompasses not only man's relationship with God, but also provides Muslims with code that regulates their entire way of life: with self, other people and the community. The Qur'an sets out notions of equity, justice, fairness, morality and many other values which underpin the entire Islamic system (Lovells, 2004).
The Qur'an states that God created, and owns everything. Man, therefore, holds wealth on trust for God and must carry out his duties as trustee in the manner prescribed by God. These duties are found in the Islamic Law (Shariah).
Shariah is derived from the Qur'an. However, it is not a codified body of law. It is, by virtue of its derivatives, capable of development and interpretation. When a new issue arises on which the position of Shariah is unknown, it may be necessary to seek a legal opinion, or fatwa, from a religious scholar (Mufti). The opinion of different Muftis may differ on the same issues depending on the major Islamic juristic schools which they belong to and according to their individual interpretation of the Shariah.
An Islamic financial institution will have a committee consists of senior officers and religious scholars which evaluate whether certain transactions conform to Shariah. Each Shariah committee will form its own view as to the acceptability of a particular transaction. Consequently, a transaction may be found by the Shariah committee of one Islamic financial institution to be permitted but may be considered prohibited by the Shariah committee of another Islamic financial institution or even by potential investors in the financial instruments.
3.0 Islamic finance
Islamic financing is not tied up to any particular jurisdiction, but can take place anywhere in the world where there are Muslims who wish to engage in financing transactions in a manner consistent with their faith. Even now, due to the unique products introduced by Islamic financial institutions, there are a number of non-Muslims who are also interested with these Islamic products.
Various Shariah compliant financing and investment structures have been developed. The most commonly used structures are
Murabaha (Sale at an agreed profit margin),
2. Mudarabah (participation financing) and Musharaka (Equity participation),
3. Ijara (Leasing),
4. Sukuk (Islamic bond).
One of the fundamental principles governing Islamic financing is that the receipt of interest is prohibited. This is categorically stated in the Qur'an:
"Those who devour Riba (interest) will not stand except as stands one whom the devil hath driven to madness by (his) touch" (11:275).
In particular, Shariah prohibits transactions in which some or all of the following elements are present:
Uncertainty (gharar) in contract - there is a prohibition on the sale of items whose existence or characteristics are not certain, and upon contractual terms that are ambiguous or unclear. This may mean that criteria contracts containing obligations to insure another person or to grant an option to purchase an asset may be unacceptable.
Gambling (maisir) - may apply to dealings in futures and options to the extent that they are speculative.
Prohibited (haram) commodities and activities - his involves a blanket prohibition on involvement in activities relating to the provision of pork, alcohol and gambling services, among others. Nevertheless, different views exist on borderline cases such as hotels or aircraft in which, for example, alcohol may be served.
4.0 The Form and the Substance: A study of Sukuk
According to Gassner in website www.islamicfinance, the form over substance can be interpreted as an expression in jurisprudence, when the legal form is considered fully valid but the substance is totally different. In the context of Islamic finance, certain techniques exist to find a way around a prohibition, which can be acceptable (a different case avoiding the prohibited) or unacceptable (a pure circumvention with bad intention). The discussion regarding such techniques remains a day to day topic, as many financial techniques used nowadays are from an Islamic perspective on the borderline between the disliked and the prohibited and the opinions differ on which side they belong.
The current state of the Islamic finance industry revolves around "inventing" (also known as structuring) ways and legal structures that comply with Shariah in form, but not entirely in substance. At this point, it is fair to differentiate Islamic finance (the broader industry) from Islamic banks. Unfortunately, most Islamic banks have adopted a debt-based model, which in its form, is completely Shariah compliant, but the essence of Shariah compliancy is missing. This, among others, remains the primary reason that Islamic banking is labeled as "smoke-and-mirrors" by some experts and purists alike.
In this paper, I will be focusing on Sukuk financing instruments; its structure, its roles in the Islamic financial institution, the comparison between Sukuk and the conventional bond, the issues arising from Sukuk and its implication, as well as some recommendations to overcome these issues.
4.1 The Sukuk: What is Sukuk?
According to Wikipedia, Sukuk is the Arabic name for financial certificates, but commonly refers to the Islamic equivalent of bonds. Since fixed income, interest bearing bonds are not permissible in Islam, Sukuk securities are structured to comply with the Islamic law and its investment principles, which prohibits the charging, or paying of interest.
The AAOIFI [1] defines 'Sukuk' as:
"....certificates of equal value representing, after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity. [2]
Sukuk can have many types depending upon the type of Islamic modes of financing and trades used in its structuring. The most common used are Sukuk Murabaha (asset-based Sukuk), Sukuk Al Ijara (project-based Sukuk), Sukuk Al Musharaka (business-based Sukuk), and Sukuk Al Istithmar (investment-based Sukuk). The other types of eligible Sukuk as identified by the AAOIFI includes Mudaraba Sukuk, Salam Sukuk, Istisna Sukuk, Hybrid Sukuk, Al Musaqa Sukuk, Ijarah Thumma Bai' Sukuk, and Wakalah Sukuk.
4.2 The roles of Sukuk in Islamic financial institution
The Sukuk plays crucial roles in the development of Islamic finance industry, and this can be seen through increasingly high demand of Sukuk in the market. Among the roles of Sukuk are the following:
Sukuk are among the best ways of financing large enterprises that are beyond the ability of a single party to finance.
Sukuk provide an ideal means for investors seeking to deploy streams of capital and who require, at the same time, the ability to liquidate their positions with ease whenever the need should arise. This is because it is envisioned that a secondary market for the trading of Sukuk will develop. Thus, whenever investors require cash from their investments, or from a part of the same, it will be possible for them to sell their Sukuk holdings, or a part thereof, and receive their value from their original investment plus earnings, if the enterprise is profitable, in cash.
Sukuk represent an excellent way of managing liquidity for banks and Islamic financial institutions. When these are in need of disposing of excess liquidity they may purchase Sukuk; and when they are in need of liquidity, they may sell their Sukuk into the secondary market.
Sukuk are a means for the equitable distribution of wealth as they allow all investors to benefit from the true profits resulting from the enterprise in equal shares. In this way, wealth may circulate on a broad scale without remaining the exclusive domain of a handful of wealthy persons. This is clearly among the most important of all the higher purposes sought by an Islamic economic system.
4.3 Sukuk and conventional bond: A brief comparison
On the earlier point, I have mentioned that Sukuk is an Islamic equivalent to bond. More or less, some of the features of Sukuk are same as the conventional bond, even though it is treated and called using different term and names. On one hand, Sukuk have certain attributes that make them comparable to a conventional bond.
First, from an economic perspective, the substance of a Sukuk is similar as its issuance permits a party in need of funds to finance them from another party. Second, an arrangement involving periodic distributions by the special purpose vehicle (SPV) to the certificate-holders is comparable to an arrangement involving the distribution of the regular coupon payments by the issuer to the investors in a conventional bond. Third, like a conventional bond, a Sukuk is a standardised and marketable security, with its face value representing par value. Fourth, in the event of default, the certificate holders would not be able to exit their investments by way of disposal of the underlying assets but rather must rely on the originator's ability to honour its undertaking purchase the assets back from the SPV in certain cases (including a case of default), which indicates that the certificate-holders would ultimately depend on the originator's credit to recoup their original investments. For this reason, as in the case of the conventional bond where the credit rating of the bond mirrors that of the issuer, the credit rating of the Sukuk mirrors that of the originator
Despite the above-mentioned similarities, Sukuk are distinguishable from conventional bonds as they are asset-based. Unlike conventional bonds, which merely represent a contractual claim, Sukuk represent an undivided pro rata ownership of the underlying assets. This fundamental difference makes it difficult to reach a conclusion about whether Sukuk are comparable to conventional bonds,
4.4 Issues of Sukuk and its implication on the Islamic financial institutions
Sukuk are widely regarded as among the most controversial Islamic financial instrument nowadays due to its substance that are comparable to conventional bonds. As such, a few issues revolving the structures of Sukuk will be discussed further in this section, as follows:
Sukuk holders' ownership to enterprise asset.
In fact, Sukuk are Shariah-compliant trust certificate and tradable financial instruments which reflect the value of particular assets or assets. It represents ownership of shares in assets that generate profits or return to Sukuk holder. Hence, from the Shariah perspective, it is essential that Sukuk are backed by a specific, tangible asset throughout its entire tenure and Sukuk holder must have a proprietary interest in the assets which are being financed.
In order to affect an actual transfer of assets, the Shariah Board of AAOIFI further ruled that the manager issuing Sukuk must certify the transfer of ownership of such assets in its books and must not keep them as his own assets. There must be an agreement that is evidence of a binding sale transaction from the originator to the Sukuk investors. Such contract should be legal, valid, binding and enforceable on all parties and the laws of the country which the assets and the company are based.
However, this Shariah requirement is merely complied with by a few Sukuk issued to date, such as Tamweel and Sorouh PJSC, both UAE transactions where the underlying assets were sold to the investors and registered in favour of the investors. In most cases, the originator would actually intend to legally retain the asset, and the Sukuk do not actually involve the transfer of ownership of the underlying assets to the Sukuk holders. Moody's notes that this result in a "requirement for tangibility" which has "significant - and problematic - effect" (Howladar, 2009). Sukuk originators seemed to have solved the problem of asset backing and tangibility by including an asset somewhere in the Sukuk structure. This results in "sometimes hundreds of pages" of Sukuk documentation, which makes it difficult to assess the actual source of risk of the profit and principal / capital payments (Howladar, 2009). From Moody's point of view, however, at the end of the analysis, most asset-based Sukuk structures replicate the risk and return characteristics of a fixed income bond (Howladar, 2009). In some Sukuk issuance, the assets concerned may be shares of companies which do not confer real ownership, although it offers a right to returns to Sukuk holders. Such arrangements would render the Sukuk not lawful in the eyes of Shariah.
Thus, in these turbulent times, the recommendations of ownership of the assets is transferred to the Sukuk holder by AAOIFI would certainly benefit them in the long run as they would have recourse over the assets in the event of insolvency of the originator. On the other hand, it is to be noted that if the recommendations of the AAOIFI are followed by market players, Sukuk holders must also be prepared to take true asset risk as the ownership transfer will entail in the transfer of control and risk in such assets. If the assets do not perform, Sukuk holders must be prepared to incur the ensuing losses.
The prohibition of selling receivables or debts.
The second point raised by AAOIFI was that Sukuk must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally. This recommendation is related to the first point raised by AAOIFI above where Sukuk holders should stand in the line of owners of underlying assets and not in the line of creditors.
As such, in order to be tradable, Sukuk should not be backed purely by receivables. In Sukuk securitisation [3] the underlying assets should be sold to the investors. If the originator were to become insolvent, the legal ownership of the properties would reside with the investors, thus providing the necessary protection to them.
Stipulation of incentive for manager & stipulation of loans to investors.
As pointed by Taqi Usmani [4] , most Sukuk issued are similar to conventional bonds in relation to the distribution of profits from their enterprises at fixed percentages based on interest rate (LIBOR) (Taqi Usmani, n.d.). There is usually a clause in the relevant contract stating that if the actual profits from the enterprise exceed the percentage based on interest rates, the entire excess amount shall be paid to the manager (whether a mudarib, or a partner, or an investment agent) as an incentive for good management. If the actual profits are less than the prescribed percentage based on interest rates, the manager may take it upon himself to pay out the difference to Sukuk holders, as an interest free loan to them. The loan will be recovered by the manager either from the amounts in excess of the interest rate during subsequent periods or from lowering the cost of repurchasing assets upon redeeming the Sukuk. With regard to the stipulation of an incentive for the manager, if the fees of the manager is not specified in the contract (save for the incentive), such arrangement is considered as makruh (undesirable) by the majority jurists, other than Hanbali scholars as it will lead to uncertainty. In this relation, the Standard for Mudarabah as approved by the Shariah Council of AAOIFI reads as follows:-
"If one of the two parties should stipulate for itself a specific amount (of profit), the Mudarabah will be void. This prohibition, however, is not inclusive of an agreement by the two parties that if the profits exceed a certain percentage then one of those parties will receive the excess exclusively such that the distribution will be according to what the two have agreed." [5]
However, in practice, such an incentive has been operated on the basis of interest rates or with a view to maintain the status quo of the conventional, riba-based market. The prescribed percentage in some Sukuk is not linked to the expected profits from the enterprise, but to the cost of financing or to the prevalent rates of interest in the market. There is no connection between prevailing interest rates and the actual profit / returns from an enterprise. Hence, it has been commented by Taqi Usmani that the so-called "incentive" in these Sukuk "is not truly an incentive but rather a method for marketing these Sukuk on the basis of interest rates." As such, it has been recommended that Sukuk should be free of such "incentives" or it should be based on the enterprise's expected profits.
In relation to the stipulation of loans when profits fall below the prescribed percentages, the Shariah Board of AAOIFI has disallowed such practice as it is not justifiable from the Shariah perspective. According to Taqi Usmani, such arrangement would amount to a sale with a credit, which is prohibited by the Prophet and the entire community of Shariah scholars. However, the Shariah Board of AAOIFI permits the setting up of a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus.
Manager's promise to repurchase assets at face value.
The rule under the Shariah quoted that the return of investors' capital cannot be guaranteed as reward that always follows the risk. However, most Sukuk issued today contain a guarantee of Sukuk holders' principal by indirect means, where the manager undertakes to purchase Sukuk assets at par value upon maturity, regardless of their true value on that day. Such arrangement is rather similar to conventional bonds - if the enterprise is making a loss, such losses will be borne by the manager; if it is profitable, and the profits will accrue to the manager, regardless of the amount. The Sukuk investors have no right other than the return of their principal.
This practice is departure from the Shariah principles which prohibit any guarantee of capital to Sukuk investors. Instead, Sukuk holders should have a right to the true value of the Sukuk assets, whether their value exceeds that of their face value or otherwise. The manager of Sukuk may act in the capacity of a mudarib (investment manager), a sharik (partner) or a wakil (investment agent) for the investors.
(a) Where the manager acts as a mudarib (investment manager)
If the manager makes the commitment to the investors in the capacity of a mudarib, such commitment is void. According to the Standard on Mudarabah approved by the Shariah Council of AAOIFI, if the loss is greater than the earnings, the losses should be deducted from the capital provided that there is no negligence or mala fides on the part of the manager. If the costs are equal to the earnings, the investors will receive their capital back and the manager will earn nothing. If there is profit, it will be distributed among the investors and the manager according to the pre-agreed ratio. [6]
(b) Where the manager acts as a sharik (partner)
In the case where the manager acts as a partner of the Sukuk holders, it is also unlawful for him to guarantee the return of capital to the Sukuk holders as it would interrupt the partnership in the event of losses / in the sharing of profits. [7] Whilst it is not permissible for a partner to issue a binding promise to purchase the assets at face value (as it amounts to a capital guarantee), it is lawful for him to promise to purchase the assets of the partnership during the period of partnership or at the time of dissolution at market value or at an agreed price at the time of purchase. [8]
(c) Where the manager acts as a wakil (investment agent)
In the case where the manager acts as an investment agent, it is also unlawful for him to make such a commitment because agency or wakalah is a contract of trust and there can be no guarantees except in cases of negligence or mala fides. This is because the stipulation of a guarantee by an investment agent will transform the operation into a loan with ribawi interest. [9]
In view of the foregoing, the Shariah Board of AAOIFI disallows managers of Sukuk to undertake [now] to repurchase the assets from Sukuk holders for its nominal value when the Sukuk are redeemed at the end of its maturity. However, it is permissible for the manager to undertake to purchase on the basis of the net value of the assets, its market value, fair value or a price to be agreed, at the time of actual purchase in future. The guarantee of capital only occurs in the case of negligence or omission on the part of Sukuk manager, or his non-compliance with the investors' conditions.
The role of Shariah Supervisory Board
Islamic banks and financial institutions have been set up with an aim to achieve the objectives of an Islamic economic system and to move away from interest-based banking system. In this relation, the Shariah Supervisory Boards have given permission to the Islamic banks to introduce Shariah compliant products to the investors with the hope that the banks will gradually distance themselves from interest-based enterprises, thereby creating a Shariah-compliant investment environment for the investors.
However, the operations of the majority Islamic financial institutions show that many institutions have moved backwards to interest-based system through the introduction of products which are not Shariah complaint, in the strive to compete with conventional banks and financial institutions.
As such, the AAOIFI has resolved that the Shariah Supervisory Boards should go beyond the role of advising and approving the structures. In this relation, it is believed that Shariah scholars and the Shariah Supervisory Boards have a more significant role to play. They should structure, assist in the drafting of, review and approve the documentation for Shariah-compliant transactions in order to ensure the adequacy of compliance and to enhance the certainty, consistency and transparency of enforcement of such transactions. The relevant Shariah provisions should be precisely and adequately incorporated in the relevant contracts so that such contracts may be enforceable in a purely secular jurisdiction. Further, Shariah Supervisory Boards should continue to oversee the implementation and operation of the relevant product so as to ensure that it complies with all respects of the Shariah principles up to its maturity.
4.5 Recommendations to curb the issues of Sukuk
Despite the controversies of Sukuk that were discussed above, several recommendations are highlighted in order to put back the Sukuk fully in line with the Shariah requirement; not 'Shariah-compliant in the view of form' only. Such recommendations are as follows:
Sukuk holders must have complete ownership in the real assets throughout the tenure, which is evidenced by proper book entries and the relevant documents. This is to give reasonable assurance to investors that they will be able to recover major part of their investment if the issuer defaults. Eventually, Islamic capital market is to move away from the bulk of unsecured structures towards secured, assets-backed Sukuk;
The returns of enterprises should accrue to Sukuk holders after deducting all relevant expenses, such as the managers' fees, or the share of the mudharib in profits. If there is to be incentives for a manager, then let it be based on the profits expected from the enterprise and not on the basis of an interest rate.
If the actual profits are less than expected, it is unlawful for the manager to offer loan to Sukuk holders. .
It is unlawful for a Sukuk manager whether a mudharib, partner or an agent, to commit to repurchase of asset at face value. Instead, the repurchase must be carried out on the basis of the net value of the assets, or at price agreed upon by the parties at the time of purchase.
Shariah Supervisory Boards of the Islamic financial institutions to play a more pro-active role in ensuring that Sukuk products adhere to the Shariah principles. Apart from reviewing the relevant contract and documents related to the actual transactions, the Shariah Supervisory board should oversee the actual means of interpretation and make sure that the operation complies with Shariah principles and requirements at all stages.
5.0 Conclusion
As seen above, the problems faced by the Sukuk industry include the legal constraints under the existing legal framework of certain jurisdictions, the issue of enforceability of the contracts, cross-border issues, lack of well-structured and well-regulated secondary market for Sukuk etc. Further, in order to compete with conventional bond market, most Sukuk offered partial or total guarantees of repayment of capital and/or periodical distributions. This is contrary to the Shariah principle that parties to a financial transaction must share in the risks and rewards attached to it. Hence, Sukuk structure needs to be revised and this would require the joint efforts of the states, market providers, market players, investors, regulators, legal expertise as well as the Shariah scholars. This is an on-going process which may take years or even decades to achieve.
Thus, it is high time that we move the Islamic finance industry towards a direction where equal emphasis is given to both form and substance of a transaction. This will require much needed efforts on educating the general public, who currently rely solely on the fatwas issued by the Shariah Boards of the Islamic financial institutions. Until the general public de-couples itself from the current conventional financial system and is willing to put "faith" in a riba-free financial system, we will continue to see Islamic financial institutions replicating the conventional riba-based products and we will continue to accept them as "innovation".
