SUKUK, SPV AND BORROWING WITH COLLATERAL??

SUKUK, SPV AND BORROWING BACKED BY COLLATERAL??

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.

SUKUK: BASIC INFO

WHAT MAKES SUKUK GLOBALLY SHARIAH COMPLIANT?

Sukuk have gained acceptance as viable instruments for both investment and project financing purposes. Investors worldwide have readily accepted these certificates in diversifying their portfolio such that for quite sometime demand over strips supply given that whoever buy them will keep the papers until maturity. For the purpose of funding, more and more relevant parties have resorted to sukuk as a method of raising funds needed for business and infrastructure projects. As such demand for sukuk is anticipated to grow further especially if we take into account the surplus liquidity currently present in the market as a result of the high oil revenues kept by many oil exporting countries especially in the Middle East.

But why in the first place an investor would buy sukuk rather than normal conventional bonds? The answer lies, putting Islamic motive aside, partly because investment in sukuk gives some sort of relief to investors when it is said that sukuk are less volatile as compared to conventional bonds since they are basically asset-backed and not just a mere securitization of future cash flow in the form of debts payable in future as practiced in conventional securitization.

In sukuk, when an investor purchases the certificates, he in fact purchases an undivided share or interest in the underlying assets which back the sukuk issuance. In order to comply with Shariah requirements these assets must be essentially tangible assets, and the position of the investor must be one of a full owner throughout the tenure of the sukuk. Ownership in this contact must means full ownership as understood in Shariah law that confers all rights and privileges to the relevant owner who, on his part, is entitled to receive whatever income that can be generated by the asset including possible rise in its value.

However a pertinent issue would arise if sukuk structure does not take Shariah guideline seriously for example when sukuk are structured based on methods used in conventional securization which is typically a lending by investors to the seekers of fund in the capital market. Sukuk are not debt instruments simply because they are essentially backed by real tangible assets as opposed to debts or receivable as is the case with conventional bonds. This major difference leads to a different outcome; since sukuk are not based on debts, returns of investment to the relevant investors can not be viewed in the context of fixed incomes because what the investors would received depends largely on the real performance of the underlying asset. Therefore to talk of sukuk as fixed income instruments is both misleading and inaccurate.

Even in the context of Sukuk al-Ijarah where the anticipated returns to investors are likely to flow from rental streams, investors can not be guaranteed of fixed incomes based on such streams that in themselves can not assured. It may happen that the relevant underlying tenancies or leasing contracts need to be terminated earlier due to some misfortune or natural calamities or the asset may be lost or destroyed due to faults of no one. Under these kinds of circumstances, the right of the investors to the payment of the stipulated returns or income could not be continued and nothing could be done in term of the manager’s liability. In fact the contract itself will become frustrated due to the reasons. Furthermore, a future income stream as previously described can not under the Shariah law be securitized in the first place as it constitutes a non-established liability on the part of the tenants. It will become established only when the tenants have utilized the period of leasing, but have yet to pay the necessary rental to the owner of the assets.

Given the fact that sukuk are basically financial instruments used for investment purposes, the issue of risk for return is central to the operation of the sukuk. Investors who buy them are expected, as owners of the underlying assets, to be ready to face risk of loss or diminution of their capital or value of the purchased assets. In line with this, the issuer is not duty bound to guarantee any payment of fixed income to the investors be it in the form of regular dividend or capital gain emanating from any possible increase in the value of the underlying assets. What the issuer must do however is to provide an undertaking to exercise his level best to manage the investment so that it is profitable, in which case the parties will share the realized profit based on an agreed ratio. Any form of guarantee that covers capital protection or payment of certain fixed rate return or dividend runs counter to the Islamic theory or notion of risk for return principle.

One issue that has been recently raised is related to the way sukuk were structured in the past few years when it was discovered that in many cases, the issuers normally made non-revocable undertaking to repurchase the sukuk at certain prices fixed in advance in case of default or non-adherence to the term of the issuance. This kind of undertaking that creates an obligation on the part of the issuer when the triggering events do take place will undoubtedly lead to a guarantee of capital that is not in line with the Shariah requirement.

However this point needs further clarification to clear the doubt that has been lingering around about the shariah compliance aspect of these sukuk. Any undertaking to repurchase made on the basis of possible breach or wrongdoing or negligence on the part of the issuer, who is possibly a fund or project manager (sukuk Mudarabah) or even a partner in an Islamic partnership (sukuk Musharakah), will not violate any shariah principle because as per the Shariah, the manager is to be held liable for any loss resulting from either his negligence or wrongdoing or both.

In other words, the insertion of such an undertaking is just to reemphasize a shariah rule pertaining to the possible liability of the manager/issuer in case of negligence or wrongdoing. If however, the undertaking seeks to cover the investor more that what he is entitled to under the Shariah law i.e to cover for the manager’s liability even though there is no fault on his part, then this will trigger a Shariah compliance issue.

In the context of obligation to repurchase in the event of default as is commonly provided in Sukuk documents, if default here means inability to pay returns or dividend as agreed, this condition/undertaking needs to be further clarified to refer only to cases where such inability is due to the issuer’s negligence or wrongdoing. From Shariah perspective once negligence or wrongdoing is committed, the issuer or manager by that account has changed his Shariah status from that of a trustee (whose liability is based on fault) to one of a wrongdoer who by thus is under the duty to repay the investors their investment capital. In order to discharge this duty, the relevant assets must be liquidated or sold for value, and the money be paid back to the investors.

Whatever the outcome of the present discourse on the Shariah compliance aspect of sukuk, one thing that must be understood by all is that the notion of risk for return or no pain no gain is there in the Shariah to be implemented in practice and not just be treated as a mere theory repeated time after time. Furthermore if Islamic finance is to be conducted truly on the basis of Shariah guidance, then it is incumbent on all parties involved to subscribe sincerely to the relevant rule both in form and substance.