Having explained the issuance and normal running of a Sukuk transaction, I would now like to channel the discussion on what happens when a Sukuk transaction experiences a default situation, and could such a situation be redressed without the need for the Sukuk transaction to be wound up? While doing so, I will try as much as possible to avoid using the technical jargon for the sake of easy understanding.
As a standard practice, the Sukuk documentation contains a list of probable default situations so as to safeguard investors’ interest on one hand and to keep the obligor disciplined and agile on the other. Some of the defaults may be easy to redress and the others could prove to be lethal and a deal breaker.
So what are these situations in general, how does the default occur and what measures are taken to ensure Sukukholders remain protected from financial loss as much as possible?
To start with, let me provide you with a list of situations where a Sukuk transaction could be jeopardized. These are enumerated in the Islamic financing documents under a schedule called ‘events of default’. The financing documents in terms of a Sukuk Ijarah transaction which is currently under our discussion are the lease agreement and the servicing agency agreement where such a schedule should appear.
Similarly, for the other sale-based Sukuk transactions, the schedule shall be attached to the Murabahah, Istisnah or Salam contract. As for investment Sukuk, it shall be part of the Mudarabah, Wakalah or Musharakah agreement. There could also be a hybrid-structured Sukuk transaction in which case the schedule shall be part of all Shariah contracts constituting the transaction.
There could be a management agreement between the Sukukholders (represented by the trustee shell company) and the obligor (originator of Sukuk) irrespective of whether the financing contract is of a sale or investment nature. Such a management agreement carries a certain defined mandate for the manager (the obligor) and the events of default may also include breaching any of the mandated responsibilities.
Before I share with you the main events of default, I would like to clarify that these events should not be mixed or confused with the conditions precedent (or CPs).
In a financial contract, the CPs are happenings or events that must occur before the financier releases the funds to the obligor. There are several examples of CPs, such as the assignment of comprehensive Takaful or insurance over plant and machinery or real estate assets to the financier.
Another illustration could be for the obligor to furnish the latest unqualified audited financials or deposit the obligor’s contribution in the bank account prior to the Islamic bank releasing its part toward the joint acquisition of an asset in terms of Sukuk Musharakah.
Generally, the legal counsel or the mandated arranger bank appointed for the Sukuk transaction, or both, will severally or jointly ensure that all the CPs have been complied with and that it will now be in order to proceed for drawdown of the Sukuk amount.
Then there are financial covenants to be adhered to by the obligor in all circumstances if it would like to continue with the Sukuk transaction in the normal course. The financial covenants are defined as the financial ratios that must be maintained, with the most important one being the leverage ratio which is defined as the threshold of total debt to the assets.
There could also be a non-financial covenant such as the obligor under a Sukuk Mudarabah transaction must ensure that a certain number of key personnel holding the requisite expertise to successfully run the business must remain in its employment at all times during the Sukuk tenor.
The covenants are further classified into positive or negative covenants. In short, a positive or affirmative covenant is the one which the obligor is required to attain and maintain whereas a negative covenant falls under a prohibited area. I have provided you above with the examples of both types. Some of the covenants can also be made part of the events of default.
Coming back to the events of default, the most glaring default a Sukuk transaction may endure is the non-payment of the periodic profit distribution by the obligor to the trustee shell company (managed through a delegate bank called the paying agent) for onward distribution to Sukukholders. Normally, a grace period of three to seven days is granted before crystalizing the default in order to factor in the differences in time and weekends, given that the Sukuk may have investors from different parts of the world.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Next week: Discussion on the events of default in a Sukuk transaction shall continue.