This paper is about a Shariah compliant version of the conventional securitization model — Real Asset Benefits (RAB) Realization or Real Economic Asset Vitalization (Revitalization) model — replacing financial receivables with real assets. This leads to an out-of-the-box approach to arrive at what should be a natural model instead of the conventional framework.
Why not to adopt conventional securitization?
In securitization, an originator sells booked receivables or future receivables to a special purpose vehicle (SPV) to raise long-term funds. The essence of this mechanism is the monetary asset that renders it non-Shariah compliant. The SPV mobilizes the funds for acquiring the receivables by floating a fixed income bond (fixed or floating rate coupon). The profit and principal payment to the investors of the bond are made from the receivables.
The core of the securitization is the receivables, whether present or future, which are unsecured in nature and have no claim on any tangible assets of the originator or the debtor of the originator. So, in the event of a non-recovery of securitized receivables, no recourse is available to the SPV or to its investors, although some cash waterfall mechanism is usually included in the structure to ensure timely payment to investors, but that again is mainly dependent on the cash flow health of the receivables.
Therefore, the investors of the fixed income bond (packaged from the financial receivables) bet on the best-case scenario of receivables collection and cash flow realization from them. By the same token, the bond is traded in the capital market and the investor holding it is only entitled to make a claim on the underlying financial receivables.
This situation can be likened to parents (the underlying tangible assets) disowning their children (resulting financial receivables) to fulfill a key requirement of the securitization structure. It gives rise to a possibility that an nth investor may not be able to track the parent assets that originally generated the financial receivables. In case of a default, the investor has no real asset backing his claim as the rightful owner/beneficiary.
Can there be an alternative model? This paper seeks to explore a possible model using Islamic finance principles.
Is the alternative RAB Realization or Asset Revitalization?
These can be described as a commercial transaction where an investor or a group of investors purchases a real economic asset or assets by forming an SPV to offer usufruct or economic benefits in return for rentals, toll manufacturing/services fee or a share of the profit over a period, with or without transferring ownership risk and rewards, along with the title to the asset user.
How it works and what it requires
Sale/purchase of an asset
a) Unlock cash flows by selling an existing asset in an outright sale and purchase transaction. It has to be a real productive asset complying with Shariah injunctions and not a financial asset. Therefore, solely receivables cannot be a qualifying asset for sale. The asset sale must meet the following criteria:
• It must be an outright sale where the seller will forego all risk and reward of ownership.
• Post sale, the seller should have no ownership rights or obligations attached to the sale.
• The SPV should be the absolute and legal owner of the asset.
• The asset should be properly recorded on the books of the SPV.
b) The SPV can also procure an asset from the market or direct from the manufacturer to make it available for use by the intended user. This will help to boost real economic activities by mobilizing fresh capital.
The SPV – keeping intact the parent-child relationship
To establish clear ownership by the purchaser and the ensuing risk and rewards, a SPV should be set up. This will, firstly, ensure that the real assets remain associated with the cash flow complete with all the risk and reward characteristics. This will allow for the following dimensions of RAB Realization or Asset Revitalization to be realized:
• Absolute legal ownership in favor of the investors of the SPV.
• Proper recording of the asset on the books of the SPV, thus nullifying any risk, however remote, of being involved in any bankruptcy move.
• The ownership rights and privileges, including risks and rewards, automatically go to the SPV and its investors.
• No accounting or any other complexities will be involved as far as the real ownership criteria is concerned.
• Benefits will be directly associated with the identified asset.
The SPV can be set up under a trust structure or as a legal corporate entity to finance and offer certain assets for use in the business in return for expected economic benefits.
The SPV management or the board would be a pro-active unit in terms of supervision and decisions in the same style and spirit as an active investment or asset management company. This should not be underrated in terms of authority and management powers vis-à-vis any trustee appointed on behalf of the minority investors under the RAB Realization or Asset Revitalization.
Mohammad Aamir is an investment banker with more than 12 years experience in accounting firms in Pakistan.