Part 1: Features of the Sukuk
In Part 1, Hani Abbas Helmy, Head of Sharia Review, for Dubai Islamic Bank, explores & focuses on certain generic features that are building blocks of a Sukuk issuance under the Sukuk framework.
Sukuk Features are (1) predominantly features that the Sharia Reviewer does not find in a normal bilateral transaction at an IFI; however, they are needed to make the Sukuk issuance more viable and defensible to a potential Sukukholder, and (2) features mapping or channeling an existing aspect of the Underlying Sukuk Transaction that the Sharia Reviewer finds in a normal bilateral transaction at an Islamic Finance Institution (IFI) (using different terminologies comparatively). It is therefore important to establish the relationship that exists between the Sukuk Features and the basic aspects of a bilateral transaction at an IFI.
The Sukuk Features stands independent of the Underlying Sukuk Transaction’s structure, although it may have an impact. This impact is considered under the Sharia Review of the Underlying Sukuk Transaction as it extends to cover the structure’s ramifications in relation to the relevant Sukuk Features.
The Sukuk Features are as follows:
(1) The Sharia Governance. The DFM Sukuk Standard stipulates that: “For every sukuk issuance there must be a Shari’a Committee comprising three members …” Then it goes on to explicitly document the Sharia Committee’s responsibilities, namely the Sharia Review (endorsement) and monitoring of the use of proceeds, trading, profit distribution and redemption process, throughout the life of the Sukuk up to maturity. It further sets the obligation of reporting any Sharia violations to the securities commission. The AAOIFI Sukuk Sharia standard sufficed to say “The prospectus must explicitly mention the obligation to abide by the rules and principles of the Shari’ah, and that there is a Shari’ah Supervisory Board that approves the procedures of the issues and monitors the implementation of the project throughout its duration.”
(2) The Basic Parties. The DFM Sukuk standard stipulates that: “Sukuk are issued by an authorized entity or by a special purpose vehicle (SPV)that is independent in its legal entity and financial liability. The SPV receives the subscription proceeds and acts as the sukuk holders’ trustee in holding title of the sukuk assets, and as their agent in investing and utilizing the same in what the sukuk were issued for, in addition to distributing their proceeds and redemption value.” This really sums up the major roles of the Issuer of the Sukuk. As it acts, it is basically acting solely on behalf of the group of the Sukukholders and for their benefit, so it is as if the Issuer/SPV is the Sukukholder dealing with the counterparty/originator/Obligor throughout the cycle of the Sukuk.
This simplifies the Sharia Review task. The Sharia Reviewer now looks at the core structure of the Underlying Sukuk Transaction as if he is looking at any bilateral deal in any IFI! Hence, if it is an Ijara Sukuk, the Sharia Reviewer would be looking at the issuance as if he is reviewing an Ijara Muntahiya Bittamleek transaction with a customer, except that the names are different here. The customer (Lessee) here is the Obligor and the IFI/Islamic Bank (Lessor) is the Issuer/Sukukholders, and so forth based on the relevant Underlying Sukuk Transaction’s structure.
(3) Sealing the Sukuk Deal (the Sukuk Offer and Acceptance). The Sukukholders look at the Underlying Sukuk Transaction of the Sukuk (the Underlying Sukuk Transaction) as a proposition that the Issuer is willing to execute on their behalf in accordance with a pre-declared business plan. The Sukukholders and Issuer exchange an offer and acceptance to agree on appointing the SPV/Issuer to carry out the Underlying Sukuk Transaction, as an agent with one of the following approaches from a Sharia perspective:
(A) The issuer issues the Prospectus as the Offer for carrying out the Underlying Sukuk Transaction on behalf of the Sukukholders and the Sukukholders accepts pursuant to the submission of the Subscription Application Form; or
(B) The Prospectus, is considered an invitation to treat (willingness of negotiation), and the Sukukholder’s duly filled Subscription Application Form is considered the Offer, where the Issuer’ approval thereto is the Acceptance. The Issuer accepts this offer at discretion and reflect the same by notification and/or issuance of Sukuk certificates upon concluding the allotment process.
The prospectus is made public during the subscription period, whereas other Transaction documents are made available on request. The trust relationship is established pursuant to a declaration of trust, or embedded within another (agency) agreement.
The Prospectus further documents the Service Providers who are performing certain tasks on behalf of the Issuer – in effect, on behalf of the Sukukholders.
(4) Equal Rights. Each Sukukholder should have equal rights in relation to each Sukuk certificate as compared to any other Sukuk certificates issued under the same issuance or a single series.
(5) The Expected Return. The Prospectus expresses the expected returns of the Sukuk issuance. This may be a flat rate, or tagged with a benchmark or an index’s performance. A Sharia compliant Sukuk prospectus does not state an absolute return, even if it is debt type Sukuk (Murabaha, for instance).
(6) The Sukuk Assets. The underlying Sukuk Assets are the property of the Sukukholders, initially being the Sukuk proceeds at subscription, later converting to other assets and may change various times throughout the Sukuk term depending on the Sukuk type.
(7) Periodic Distributions. This covers channeling the profit generated from the underlying Sukuk Assets to the Sukukholders on a pro rata basis, periodically.
(8) The Profit Reserve. Where the return of a relevant Underlying Sukuk Transaction may fluctuate across periodic profit distribution periods, the Sukuk issuance’s design provides for a Profit Reserve. Excess profit earned by the Sukukholders in a distribution period, exceeding the expected profit may be kept in the Profit Reserve. This may continue till it reaches a specific threshold or cap. The balance in the Profit Reserve would be used throughout the life of the Sukuk to boost profit distributions in a relevant profit distribution period where the actual return in that period is below expectations. This helps maintaining an equal profit distribution rate with less volatility period-to-period or even across the whole Sukuk term. The prospectus also stipulates treatment at maturity, i.e. whether the remaining balance therein is distributed to Sukukholders or is given to the issuer, as a performance incentive. This feature is well covered in the DFM Sukuk standard and not covered in the AAOIFI Sukuk standard.
(9) Transfer Restrictions. This predominantly relates to selling restrictions due to law provisions and/or tax implications.
(10) Listing. This indicates the financial market through which the Sukukholder can trade his Sukuk. The Sharia Reviewer considers the impact of the Underlying Sukuk Transaction on this feature from a tradability perspective.
(11) Redemption. This covers channeling the principal amounts of the Underlying Transaction to the Sukukholders on a pro rata basis. This could be scheduled at maturity of the Sukuk, during the Sukuk term or pursuant to a Put or Call Option.
11.1 Scheduled Dissolution. Usually refers to the redemption at maturity or periodically in accordance with a partial redemption schedule, if any. This maps with an IFI regaining its capital (principal) in any bilateral transaction, except here it matches the capital regain of the Underlying Sukuk Transaction.
11.2 Put Option. This gives the Sukukholders the right to redeem their Sukuk Certificates, upon the occurrence of certain pre-prescribed events such as: (1) a default of the Obligor, (2) an adverse change of control or ownership of the Obligor (as this can affect the credibility of the Underlying Sukuk Transaction), (3) delisting, (4) a merger of the Obligor and/or (5) a spin-off by the Obligor (A spinoff is the creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent company). A Put Option early redemption right may be discretionary for the Sukukholders provided it is redeemed at market value of the underlying asset(s).
11.3 Call Option (Optional Dissolution – early settlement). This gives the Obligor the right to redeem the Sukuk. This may take place partially or fully as called for by the Issuer with the consent/request of the Obligor, giving him a (partial or full) early settlement option. This may be available throughout the life of the Sukuk or after a block period, of two years, for example.
11.4 Early Dissolution (for Tax implications). This may take place in response to adverse tax implications on the Issuer, as a result of a change in law or regulations of a relevant jurisdiction, which may arise during the Sukuk term for which the Issuer may call all the outstanding Sukuk for redemption, acting in the best interest of the Sukukholders, to which extent it may be perceived as a Put Option.
All these options are in principle exercised at market value. These may be exercised for face value in cases that qualify, as default, gross negligence and/or breach of contract. Otherwise the same is reported to the Sharia Board for their guidance, bearing in mind the nature of the Underlying Sukuk Transaction.
(12) Convertibility. The Sukuk may be converted at maturity or after a block period at the option of the Sukukholders or the Obligor to stock shares of the Obligor. This would usually be at a market value to market value, i.e. the market value of the Sukuk to the market value of the Shares being converted to, deviations are reported to the Sharia Board for their guidance.
(13) Ranking (parity). This refers to the ranking of the Obligor’s financial liabilities arising out of the Underlying Sukuk Transaction against his other financial obligations. Sukuk usually rank pari passu (at par) in nature and ahead of the Obligor’s share capital repayment in case of bankruptcy, as the case is for debt type Sukuk. The Sukuk may be ranked ahead of the Obligor’s debts or in isolation thereof if the Underlying Sukuk Transaction is of an investment type in a specific project or deal in isolation of the overall business of the Obligor. However if it was an investment type Sukuk being commingled with the Obligor’s funds, then it ranks below the general debts of the Obligor. Deviations are reported to the Sharia Board for their guidance.
(14) Limited Recourse. This may apply both ways. (A) For the benefit of the Issuer, the Sukukholders have no recourse against the SPV/Issuer, except in the case of default or negligence, which would still be limited to its nominal capital! The SPV usually stipulates that it has no financial sources except the revenue and proceeds derived from the Sukuk Assets for the benefit of the Sukukholders. (B) For the benefit of the Sukukholders, they would not lose beyond their Subscription capital to the Sukuk (the face value of the Sukuk certificate)!
(15) Meeting of Sukukholders. Covering how to convene their meetings, the quorum, proxies and representations, amending documents, the business plan and matters to consider.
(16) Rating. This indicates the credit worthiness of the Sukuk issuance.
The Sharia Reviewer being familiar with these Sukuk Features, is now well equipped in reviewing the Sukuk documentation overall, knowing what to expect and how this may or may not have an impact on the Sharia compliance of the Sukuk issuance at hand. Later on, after a few encounters he builds a targeted Sharia Review approach focusing on the major areas of concern, based on the Underlying Sukuk Transaction at hand.