Wednesday, January 12, 2011



In the world of securitization or sukuk issuance, SPV (Special Purpose Vehicle) is normally established based on the common law distinction between legal and equitable right/ownership where the trustee i.e. the SPV is considered to assume legal ownership (right as recognized by court of law) of the underlying asset used in sukuk or securitization for the benefit of the beneficiary (whose interest or right is recognized by the court of equity), and as such a split is thereby caused to the concept of ownership as a result of which the beneficiary is not empowered to take or assumed all rights as an established owner of the asset as is required by Shariah law if he is truly to be considered as a true owner as per the Shariah provisions that will give him several rights that include right of free disposal and possession without restriction.
It can be argued that having what is called beneficial interest in the underlying asset as described above is not enough to give the respective holders of the sukuk a full right of ownership as envisaged under the Shariah as all their rights are exercisable only through the trustee/SPV. The purpose to have this structure involving SPVs is to achieve what is said to be bankruptcy remoteness meaning that whatever happens to the originator will not make the asset in the custody (legal ownership) of the SPV vulnerable to any action by possible creditors of the originator thank to the fact that it is transferred to the legal ownership of the trustee; the fact that will insulate the same from any possible recovery action by other potential creditors of the originator.
This above effect will however only arise if the SPV is truly an independent entity that has no connection with the originator, and such an entity is known as orphan SPV rather than a subsidiary of the originator. What actually happens is that it is normally the potential originator (the party seeking the funding) that will make effort to establish the SPV, and this SPV is not supposed to hold any asset other than the underlying asset to be transferred to it upon the issuance of the sukuk. The SPV also will normally have a very minimum share capital and staff, and in fact it is a mere tool to facilitate the transfer and issuance of the sukuk/bond, and as such is not supposed to conduct any real business activities or trading for the benefit of the sukuk holder notwithstanding the fact that in the case of sukuk al-ijarah for example, the asset will be rented back to the originator and the resulting rental streams from the originator will be used to pay the sukuk holders on periodic basis as a form of profit or income.
Unless and until true/full ownership is duly transferred to the sukuk holders in its fullest sense, it is difficult to treat the structure using SPVs as truly truthful to the concept of ownership as envisaged under the Shariah. Additionally if at the end of the tenure, the originator is obliged to redeem (repurchase) the asset, then this is another indication that what is intended is no more than lending and borrowing arrangement between the originator and the sukuk holders where the SPV will in real sense effectively act as the trustee appointed to hold the underlying asset as collateral.
In contrast, under a traditional mudarabah structure, the mudarib/manager of the mudarabah investment fund is in fact a trading agent to the capital providers/investors and as such assumes the role of a “trustee” from Islamic law perspective. However this mudarib cum “trustee” is not supposed to be a non-active party as far as business or trading activities are concerned unlike the trustee in the context of the structure using the SPV. The mudarib is supposed to conduct trading for the benefit of the investor with a view to create profit that is to be shared based on an agreed ratio. At the end of the mudarabah tenure, all trading assets that are still under the custody of the mudarib, if any, need to sold in an open market to turn them into cash again to know whether there is any profit (or loss) out of the trading activities conducted during the duration. In the case of many sukuk however, the underlying asset is normally to be repurchased by the originator at the end of the tenure as part of an undertaking or binding promise to repurchase at nominal value. If the reason and motivation for the establishment of the SPV, as it seems from this interpretation, is just to create an element of collateral for the benefit of the sukuk/bond holder (especially in the case where there has been no true sale affected between the originator and the SPV or where there is an undertaking (or binding promise) to redeem or repurchase the sukuk/asset) i.e. when the underlying asset under the control of the trustee (SPV) is more in essence of a collateral rather than the one truly belongs to the sukuk holders in the true Shariah sense then the Shariah compliance aspect of the sukuk as investment certificates will be compromised. Therefore it is very important to ensure that true ownership with all its risk and return implications including all rights accorded to a true owner as granted by Shariah are assumed by the sukuk holders, otherwise their entitlement to the income streams will remain doubtful. In this connection sukuk investors need to be warned and be truthfully told about the basic different between investing in sukuk and purchasing conventional bonds where, in the case of bonds, without doubt the SPV is a party who holds the underlying asset as collateral for the borrowing.

Monday, January 10, 2011



The guideline on Islamic REITS issued by the Malaysian Securities Commissions several years ago is a step in a direction to further develop Islamic finance, and such an initiative should be viewed as part of continuing efforts undertaken by the regulatory body in line with the vision to make Malaysia a leading player in Islamic finance. In essence, the Guideline seeks to address important issues surrounding asset classification with regard to investment in real estate to ensure Shariah compliance. It provides for criteria according to which a certain real estate or property is considered permissible for an investor to acquire with other investors as co-owners who are also holders of the investment trust fund.

Generally these criteria deal with the way the estates are utilized rather than their physical aspects; if they are utilized for purposes not repugnant to Shariah then they are considered permissible. Of course permissibility of an asset is also in the first place decided on the basis of whether it is halal asset or otherwise. Halalness of an asset is an issue which is entirely different from the way it is used or utilized in actual fact. Halal assets may be used both in Shariah and non-Shariah compliance ways. However, as it is clearly stated in the guideline, if the non-halal usage exceeds a certain benchmark, than the investors need to be advised by their relevant Shariah advisors to sell off their holding in the unit trust.

An example given in the FAQ section of the Guideline is a clear indication that the utility aspect of an asset is given prominence in deciding the Shariah compliant status of the relevant investment.

Any Islamic REIT as it is envisaged under the current scenario is still governed by another Guideline issue earlier by the SC in respect of normal REITs. In one aspect, the introduced Guideline on Islamic REITs can be considered as a supplement to the mentioned conventional Guideline which in itself is of general application governing all aspects of investment in REITs in Malaysia. Basically REITS are unit trusts where investors purchase units which form part of a larger pool of fund contributed by all investors who purchase units offered for sale by any unit trust or investment management companies. In every unit trust scheme there must be a trustee appointed to ensure that the fund management company functions in accordance with the duties as listed in the prospectus and also in accordance with the trust deed. Returns or income in REITs can come in two ways, firstly through dividends payout if the investors still keep their investment or any increased value of the units if sold by the investors.

From Islamic perspective the act of buying a unit in a unit trust fund/REIT may be said to constitute a financial or capital contribution or investment in a mudarabah scheme whereby such a contribution is handed over to the management company so that the later can purchase some assets to be used for income generation purpose. If these assets are rented out based on ijarah contract, an income stream is expected to flow throughout the duration of the investment period. This model or process is said to be governed by both mudarabah and Ijarah principles. The first principle governs the relationship between the investor and the asset or investment management company whereas the second as between the management company and the tenants. In short what is meant here is an investment scheme structures based on Mudarabah for the purpose of an acquisition of a certain piece of tangible asset so that it can be rented to third parties in a way that profitable returns or proceeds be made for the interest of the investor.

Notwithstanding this characteristic, one major different between Mudarabah and Islamic REITs investment scheme run as described above is that in Mudarabah the manager is to share profit based on a ratio agreed with the investor/owner of capital at the outset. In REITs however, the manager will not share any profit in the above manner but to be paid management fees as per the terms as normally expressed in the Prospectus. This fact makes Islamic REITs is said to be outside the scope of the normal mudarabah structure where there is going to be profit sharing between the manager and the investors as the first will not be paid any fee whatsoever for the management effort he is to be involved throughout the duration of the investment. When fees are collected by the manager, the structure may be said to have changed into a form of a fee-based agency relationship between the parties, and as such must follow all the established Shariah rules governing the same. Among others, management fees need to be fully specified so does the duration of the contract to avoid potential disputes, and more importantly it has to be made clear that as a paid agent the manager is to conduct the management in the best possible manner failing which a breach of an agency contract would occur.

As an interesting comparison, there are many similarities between Islamic REITS and sukuk al-ijarah as both schemes envisage acquisition of tangible assets that are to be rented out to third parties for an income stream payable to the investor during the relevant period he keeps his investment in the fund or sukuk. In the case of Islamic REITs there is an involvement of 3 other parties apart from the investor; the unit trust management company, the trustee and the third party tenant of the asset. In the case of sukuk al-Ijarah, according the way they have been structured all these while, instead of having a unit trust management and a trustee company in between, there is an SPV company specially established to issue the sukuk and another trustee/management company which function is similar to the scenario as applicable in the unit trust scheme as previously stated to manage the real estates. What will happen here is that the SPV will invite subscription from the potential investors to purchase sukuks for which certificates are issued to them in acknowledgement of their contribution or purchase. It may be said again that what the investors do is no other than providing money capital to the SPV in the context of mudarabah so that the later can use the fund or pool of fund contributed by all sukuk buyers to purchase certain real tangible assets to be employed for income stream generation in order to pay the investor periodically as agreed in the sukuk document or contract.

In both instances as describe above, income or return to sukuk investors/holders of unit trust will come from the projected income stream generated through the utilization of the relevant assets and also from capital gain, if any, if the sukuk are sold back to or redeemed by the issuer (based on market value which is more that nominal value) or in the case of unit trusts when the holders dispose of their units in the market (ETF) at any given time or have them be repurchased by the unit trust management company at the current purchase price which is calculated on the basis of the NAV of the unit less management fees or charges.

The only issue that may be asked here relates to the Shariah position with regard to the fees as paid to the management company in the case of unit trusts including Islamic REITs in the context of our discussion. In classical mudarabah, return or income to the mudarib (the manager) is payable from a share of profit of the scheme if it turns out to be profitable, based on an agreed ratio say 40:60 for example. In the case of unit trust however the managers received their income from the fees charged to the fund irrespective of whether the scheme is profitable or not. Thus this scheme is not a straight forward mudarabah, but rather it can be classified as al-wakalah bi'l ujur meaning hiring someone to act as an agent with fee.

In the context of sukuk al-ijarah, this is not an issue given the fact that in many cases as it has been practiced, these sukuk are issued by companies or governments to fund infrastructure projects whereby certain assets are sold by the originators (public or private) to the SPVs (the issuers) which will purchase them with the use of the fund collected through sukuk subscription, and then the originators will rent the assets from the SPVs for a certain period of time commensurate with the lifespan of the sukuk by making periodic rental payments to the investors through the SPVs. Normally these SPVs are formed by the originators specifically for the purpose of facilitating the whole securitization as these SPVs are there to ensure that the pool of investment of the sukuk holders are utilized to purchase the assets that are to be rented out to generate incomes in the form of a rental stream that will subsequently be passed on to them at the relevant intervals. In the normal Mudarabah structure, the Mudarib/manager is to engage in trading/renting activities with truly third parties or the market at large and not with the providers of capital as seen in the context of the originators as described above. So as far as this aspect is concerned, it seems that the REITs is closure to the original spirit of the Mudarabah ( except for the issue related to fees collected by the REIT manager) where assets are rented out to true third parties to generate income streams. It the case of sukuk al-ijarah, the major Shariah issue is whether there is a true sale between the originator and the SPV (at the start of the process) as to warrant a transfer of true ownership to the investors through the SPV given the fact that the SPV is established by the originator or sometimes its subsidiary. Secondly there is an issue of redemption of the sukuk by the originator at the end of the tenure of the sukuk; whether it is again a true sale as between the parties (based on market value) or a redemption of a collateral by an assumed borrower (the originator) if such a sale/resale is based on a nominal value in which case the true ownership by sukuk holders are not correctly reflected.

In the Middle-east particularly in the past 20-25 years, there used to be another method to achieve similar objectives that seems to be well within the framework of a true Mudarabah. There were many so-called Islamic investment companies that established and managed special real estate funds on the basis of Mudarabah. The general public were invited to contribute to these funds that would be used specifically for real estate investment both in local and oversea markets. Interestingly, in many instances one of the clauses of the mudarabah agreement employed for this purpose would say " whatever will be bestowed upon us by Allah as a result of this scheme will be shared between us in the ratio of so and so…". This is a typical mudarabah scheme whereby the manager is to be remunerated when there are actual profits generated by the venture.

In conclusion, whether potential investors would prefer to buy sukuk al-ijrah, Islamic REITs or to take part in the traditional mudarabah scheme with less Shariah compliance issues as explained, the underlying Islamic rule is that by buying such sukuk or Islamic REIT units or to participate in traditional mudarabah funds, they in fact need to be ensured to acquire the ownership in the relevant assets or real estates which justify their entitlement to the associated returns or incomes. However as owners they should never forget the fact that according to the Shariah law, they also bear the ownership risk (daman al-milk) in respect of the underlying assets or real estates that they own, as Islam dictates that income or return is in exchange for ownership risk assumed ( al-Ghunm bi'l ghurm). Notwithstanding what has been previously stated, investment in real tangible assets and the employment of the ijarah principles relating to the utilization of these assets to create income streams are held to be valid (if done correctly) according to almost all Muslim jurists in contrast to the investment in debts securities which is not generally or globally accepted especially when these securities are not structured, negotiated or sold/purchased in a manner that is consistent with the generally accepted view on money exchange and debt trading in Islamic law.