In previous articles IdealRatings have presented the fundamentals of Sukuk Shariah screening and the challenges facing it today. In this article, GHADA ESSAM presents a few more controversial issues in Sukuk structuring that remain outstanding, unclear and elusive to many Sukuk market practitioners.
What once was unclear and debatable can be resolved after many rounds of discussion, justification and proofing. However, another set of more sophisticated structural issues then evolves to replace the prior set. This process is continuous and will always be so as long as there is innovation in Islamic finance.
The first issue we present in this article is the combining of purchase and sale undertaking in Sukuk contracts. The purchase undertaking is, by definition, the originator’s promise to Sukukholders to buy back the underlying assets any time at their discretion, whereas the sale undertaking is the promise by Sukukholders to sell the assets back to the originator anytime at his discretion. So eventually, via either undertakings, the outcome is the same: which is the return of ownership of the assets back to the originator (original owner).
In screening Sukuk compliance, we have found many controversies and a dozen of opinions over the discussed issue. Some fully disagree, as in their view it would incur Inah. Others drift from the Inah perspective to a concern over combining binding contracts and hence their emphasis is rather on whether or not the undertakings are bilateral binding. Are both undertakings signed by both the promisor and promisee? Or does each of them sign only the contract they are bound to?
A middle view allows the combination of the undertakings provided they utilize different trigger events. That is, the enforceability of both undertakings is not tied to the same conditions such as dissolution date, tax event, early redemption and change of control. It is worth mentioning, however, that using total loss as a condition of enforcement is refuted by all scholars without exception, since it would then become an explicit unconditioned guarantee of the assets.
Empirically, very few Sukuk structures do not use any undertaking and have structured other mechanisms for liquidation such as Sukuk Tasnee and Sukuk Al-Marai. On the other hand, the majority of Sukuk utilize at least one undertaking, or use both with different trigger events: such as issuances from the government of Dubai, Qatar Islamic Bank and Saudi Electricity’s global Sukuk. A very limited number of Sukuk utilize intersecting trigger events — such as Dana Gas, Emaar Sukuk 2016 and Turkiye Finans 2018 — and despite the consensus on the impermissibility of enforcing any of the undertakings in a case of total loss, there also remain a few Sukuk with such condition.
The second controversy to discuss is the ‘asset substitution undertaking clause’, sometimes called an ‘in kind’ exchange of assets. By definition this is a promise by which Sukukholders are bound to exchange with the originator the underlying assets with other assets that are at least of the same value and also Shariah compliant. In other words, the asset substitution undertaking is an asset-exchange option at the full discretion of the originator throughout the tenure of the Sukuk.
The first challenge that IdealRatings team met in screening this clause was that it is not commonly recognized by market practitioners, nor it is among any of the standards of AAOIFI, the Securities Commission Malaysia or the IFSB. The IdealRatings Sukuk team decided to take the issue to prominent Shariah scholars and experts in Saudi Arabia, the GCC and Malaysia and have reverted back with varying opinions: including an absolute refutation, an approval and a conditioned approval, with significant supporting proofings for each.
Having applied the varying scholars’ opinions, our analysis has shown that 18 international Sukuk issuances from prominent GCC originators would disqualify it from the investment universe, when adopting the refusing view. In other words, the asset substitution undertaking clause is the sole reason these Sukuk are disqualified from the investment universe of the largest two Islamic wealth management institutions in Saudi Arabia whose Shariah boards have refuted the clause completely.
Scholars from Malaysia and the GCC, on the other hand, have accepted the use of the asset substitution undertaking clause provided the assets are in a state of economic use (not in total loss), as illustrated and justified in the Shariah pronouncement of global Sukuk Wakalah.
In fact, some scholars have argued further that is it necessary to utilize such mechanisms in Sukuk structuring to be able to validate the Sukuk portfolio throughout the tenure of the Sukuk, particularly Sukuk with underlying assets such as equities, leases and mortgage contracts.
Their argument is that only through such an option/mechanism can Sukuk managers exchange non-compliant equities with a compliant portfolio, and exchange maturing lease or mortgage contracts with other new contracts to keep the outstanding value of the Sukuk portfolio constant throughout its tenor. The empirical analysis of these varying opinions shows that the number of disqualifying Sukuk by the total loss condition is very few compared to disqualification by absolute refutation, standing at five and 18 respectively.
Another argument rises on the guarantee of insurance payments, when a Sukuk manager, whether a lessee or a Wakeel, guarantees the full re-instatement value of the assets should the insurance operator for any reason evade or delay payment. This is a practice refused by most scholars, who instead insist that the guarantee should be conditioned by negligence of the Sukuk manager in performing his duties. While that sounds reasonable in theory, it is in practice almost impossible to assess the negligence of the Sukuk manager.
Similar to previous issues, through screening hundreds of Sukuk, the IdealRatings Sukuk team concluded three models for this issue. Some Sukuk issuances do condition the guarantee of insurance payments to a proved case of negligence by the manager, and apart from that, the manager is deemed not liable.
Another model phrases the guarantee unconditionally, while in the third model the matter of insurance payments and insurance shortfalls is not covered (disclosed) in the offering circular. Typically the permissibility of each of the three models is subject to the mandate of each Shariah board.
More issues are still in the queue, and so as long as Islamic finance exists and is in demand, more issues will evolve; as practioners, regulators and arrangers innovate new Islamic financial instruments and new structures to elude prohibitions. These innovations on the other hand are challenged by the universe of specialized scholars, which is not only broadening but also deepening its expertise every day. Eventually, it is the duty of the regulators and scholars to exert significant efforts and genuinely cooperate to shorten the gap between compliance and innovative structuring.
Ghada Essam is the Sukuk product manager at IdealRatings. She can be contacted at
[email protected]
.