Redefining Sukuk As An

Equity Instrument, Not A Debt One

Dhafer Salih Alqahtani

Executive principal Rusmal Consult Manama, Kingdom of Bahrain.

dhaferq@gmail.com

As 2013 unfold and we begin to look towards a better new year, global investors are waiting

anxiously for nerve-racking volatility and uncertainty in the world economy to settle at an

acceptable and tolerable level, once again restoring confidence in the financial sector. In Europe, investors are hoping for a resolution to the European sovereign debt crisis that will avoid

escalating and propagating the woes of the western European economy. In addition, the U.S.

economy’s path to recovery has been dominated by the contrary aims of bickering politicians. Unfortunately, it all adds up to a bigger fear—that the goal of reaching workable long term

solutions to those crises on both sides of the Atlantic is not getting serious and timely attention

thus reducing the options for solutions and escalating further the global economic deterioration. Austerity measures are spreading like fire all over the globe, and their implications are

profoundly negative. And if that was not enough, ratings agencies are rushing into downgrading

sovereign debts and financial institutions, adding insult to injury. The irony of this bleak picture

is the fact that sovereign debt was created specifically to solve economic problems and stimulate the market economy. Instead, and in due course, the solution itself became the problem.

Accordingly, we now have two major problems— troubled economies and bad debts—which raises the question of whether so-called capitalism (particularly the Western version) is in denial

about what it promised to deliver through its interest-based system. We are left with over-

leveraged economies and over-borrowed countries, not to mention the over distressed individuals who are struggling to make ends meet, and the situation will not get any better even after

countries enforce their super-national lender’s austerity plans and belt-tightening measures. At the

same time, funding resources are drying out and funding has become more expensive, thus

forcing governments, banks, and corporations alike to seek alternatives outside the interest-based (i.e., asset-based) system. One alternative that has received wide attention is Islamic finance and

its crown jewel—Sukuk. In fact, the demand for Sukuk is outstripping the supply. And why not,

in light of the unprecedented growth in the Islamic banking sector, averaging 15%–20% annually for the past decade, even during the financial crisis. Most of that growth took place in the Gulf

Cooperation Council (GCC) region and some parts of Asia that happen to be the least affected by

the financial crisis.

The Islamic finance area also enjoys surplus liquidity, particularly in oil-rich countries (i.e., GCC

countries). Accordingly, in their quest for surplus liquidity, the rest of the world’s countries and

financial institutions— facing liquidity squeezes, debt crises, holding extremely risky assets, rating downgrades, and increasing unemployment—are looking toward Islamic instruments to do

business. Meanwhile, with the financial crisis tremors being felt in the background, the Arab

Spring revolutions swept across the Middle East and North Africa (MENA) region. Some countries are yet to recover from the aftermath of the Arab Spring revolutions, which is continues

to harvest tyrants and install Islamists who promise to embrace democracy after decades of

dictatorship. After decades of suppression and rejection, Islamic banking is starting to flourish in

some of these countries, starting with Tunisia, Egypt, Libya, Morocco, Yemen, and soon Syria,

thus adding new markets and a new players as well new challenges. The majority of these countries and their newly elected governments, however, inherited huge deficits and

infrastructures in shambles with great need for liquidity as well as huge unemployment rates.

Resolving these issues in the current troubled macroeconomics times will require serious

navigation. Logically, because Islamists hold the majorities on these newly elected governments, Sukuk will be a favorite tool to tackle these issues. Also unfolding in the gulf region, other

countries acted ahead of the unrest in the streets and forged ahead with their infrastructure

development and social programs by expanding their budget spending and thus, with minimal confrontation, met most of the demands of the protesters and the social media campaigns. Those

measures did stimulate the economy in the gulf region.

Islamic finance and its institutions are an intricate part of this unsympathetic economic cycle and

unstable political atmosphere. Hence, they are not isolated from its impacts and progressions.

Accordingly, Islamic finance should take advantage of this turmoil and come forward as the

solution provider for the crisis, not just as a safe harbor for excess liquidity that seeks a better yield. In order to do so, it will need to rapidly adapt to a myriad of ongoing changes in the

markets. Islamic finance has already demonstrated its resiliency and sustainability, so it should be

able to see and capture opportunities in the crisis while reserving and defending the authenticity and genuineness of Shari’ah-based products.

No dialogue or scholarly discussion about Islamic finance and banking as a whole would be complete without addressing one of the cornerstones of Shari’ah-compliant investments

instruments— Sukuk. Sukuk as an instrument are less than two decades old, and recently, since

2007, they have been under intensive scrutiny about whether they are workable, real Islamic

financial instruments. The conflict between the Sukuk documents and the governing law of Shari’ah, especially cross-border Sukuk, arises from the differences between asset-backed and

asset-based Sukuk. In a true Sukuk, an asset-backed one, the Sukuk holders have recourse in case

of default through the transfer of the underlying assets through a trust—this is known as an “equity Sukuk.” In so-called “complaint” or asset-based Sukuk, also known as “debt sukuk”

where no true sale or real ownership take place between the originator and the issuer i.e., (trust

SPV), hence sukuk units holders have recourse to originator, contrary to true sale in asset-backed

sukuk, where recourse is to the Sukuk’s SPV that represents the Sukuk units holders ownership of the underlying assets and no recourse to originator in case of default. Such concerns as this or

others that have been raised by Shari’ah standards setting bodies (e.g., Accounting and Auditing

Organizations for Islamic Finance, or AAOIFI) are needed to further refine and tune Sukuk structures without violating the principals of risk and profit sharing on which Sukuk should be

based. The rapid growth and mounting global interest in Sukuk will bring with it new and

innovative structures designed to serve specific needs and demands, consequently giving rise to new challenges and concerns. Unfortunately, the core issue remains unsolved and untackled, at

least by the scholars who are suppose to be the “gatekeepers”—that is, the shift toward asset-

backed Sukuk instead of debt sukuk, (Asset-based sukuk), it’s a case of “substance over form”.

Indicators are pointing in the right direction for a change, signaling a possible recovery on the horizon, thus the time is ripe for the sukuk to move to the next level of its development and

advancement, as well as carving a place for true sukuk in the global financial market while

correcting the way sukuk are being issued, structured, and administered.

With that said, and out of fear and concern for where the sukuk industry might be headed, I would

like to contribute and share my views and suggestions as a practitioner and a veteran of the industry. Thus, I have few pointers on how we can possibly make sukuk more genuine and

appealing (i.e., investment sukuk) while holding their creditability and conformity with shari’ah,

also preventing reputational risk in the new world order of the global financial market as well as

our direct markets.

1. We start with the most important component of any sukuk development—the Shari’ah

Supervisory Board (SSB) and shari’ah scholars—“The Gatekeepers.” Their duties and mandates

should go beyond issuing a signed and sealed fatwa for Sukuk or any product for that matter, the SSB must be fully responsible and accountable in addition to being proactive, from the concept

level of structuring and the Fatwa process to implementation and execution and, eventually, the

attainment of maturity for the instrument or security, as well as a possible default. These Gatekeepers should serve in this role for all related Shari’ah-complaint structures, securities, and

products as well as Halal businesses. The Shari’ah compliance and/or audit officer should

spearhead such crucial functions under a direct mandate from the SSB.

2. All SSBs, separately or collectively, should encourage if not require asset-backed Sukuk

(equity Sukuk or investment Sukuk) with clear and well-defined recourse for investors while

discouraging asset-based Sukuk (debt Sukuk) with the objective of eventually minimizing if not eradicating debt Sukuk. Such a task is only possible and feasible through the institutionalization

of an SSB process.

3. Introduce Sukuk at the retail level (distribution of wealth) by allocating sizeable tranches to the

retail segment, thus expanding the trading platform of Sukuk to augment accessibility,

consequently expanding the secondary markets. At the same time, this adds another attractive and viable asset class for investors (i.e., Sukuk) in addition to traditional equity and real estate.

(Moreover, real estate as an asset class is illiquid in nature, and it is becoming too expensive to

acquire by the regular investor, which gives all the more reason to push for Sukuk as an

alternative asset class that is liquid for Muslim and non-Muslim investors alike who may have limited choices.)

4. Contribute to the expansion of the secondary market by issuing larger Sukuk to address the volume concerns, which will enhance their liquidity and marketability.

5. Increase the number of long-term Sukuk (10 years), which will increase both the diversity and the attractiveness of Sukuk, particularly for long-term investors (e.g., asset managers, sovereign

wealth funds, pension funds, and takaful companies).

6. Advance and encourage issuance of Sukuk for short and medium terms to expand the

breadth and depth of secondary markets as well as the numbers and diversity of Sukuk.

7. Governments issuances should promote Sukuk as a saving instrument option for individuals,

allowing them to participate in major issuances at the retail level by creating retail portions for

private individuals.

8. Sukuk issuance cost should be driven down, thus allowing cash-starved medium-capitalization

businesses to become issuers to finance expansion and growth and fulfill one of their vital roles in the economy—jobs creation. This could come mainly through more standardization in terms of

Sukuk generic structures and types by AAOIFI and other standards-setting bodies for Islamic

finance (e.g., Islamic Financial Services Board or IFSB; International Islamic Financial Market or

IIFM).

9. Infrastructure development and mega-project originators and issuers, both governments and

quasi-governments, should utilize Sukuk for financing their needs instead of using their surpluses.

This would expand the volume of the Sukuk market while directing those surpluses to more

pressing issues at the social level, such as education and health care.

10. Explore and encourage innovative features and structures that are hybrid in nature, beyond the

14 Sukuk types of AAOIF (especially, the well-known Sukuk alijarah or leasing) structure),to

enhance versatility and adaptability in meeting the increasingly complex needs and situations faced by issuers.

11. Encourage new asset classes as the underlying asset other than the traditional assets (i.e., real estate and Islamic financial institutions), such as infrastructure, railroads, airports, manufacturing,

power generation, education, and health care sectors, thus widening diversity as well as the risk

profile for Sukuk. Similarly, encourage more issuances in local currencies other than the dollar.

12. One of the major misconceptions in the Islamic finance industry is calling a Sukuk an

“Islamic bond.” Islamic finance does not have any structure that can be called a bond. Similarly, a

bond as we know it is contrary to Islamic finance principals. Thus, a bond cannot be called Islamic, and it’s not a Sukuk, as Sukuk are an investment instrument. Accordingly, there is no

such thing as Islamic bond, and a Sukuk is not any kind of bond. Those issuances that are being

called Islamic bonds are only debt instruments that are being forced to be Shari’ah-complaint while mimicking many features of the conventional bond—so, calling those issuances “Islamic

bonds” is not far from the truth, even though there is no such thing as an Islamic bond. But

calling them Sukuk is major distortion to the substance and a misrepresentation of the form of Sukuk as a major Islamic investment product that derives its uniqueness and functionality from

the equity side. Sukuk is an investment instrument, in which the Sukuk units represent a partial

ownership of the underlying assets, with direct claim to those assets and profits in distribution or

liquidation.

13. Significantly improve the disclosure and transparency of Sukuk structures and unit holder

rights and obligations to the underlying assets, including the case of default, market risk, pricing, fees, charges, and uses of the funds. Similarly, risk and return prevailing conditions with their

essential dynamics should be embedded in the transparency and disclosure process, both

quantitative and qualitative.

14. Educational institutions that cover Islamic finance and economics in their degree programs,

but who have been invisible until now while claiming they have Islamic finance research centers,

should go beyond their curriculum guidelines and textbooks for Islamic finance and constructively challenge, analyze, and criticize the industry practices and products through

research and development. Their findings, criticisms, recommendations, and analyses should be

made public, sharing it with the concerned regulators, standards-setting bodies, and Islamic financial institutions.

15. Islamic finance standard-setting bodies (e.g., AAOIFI, IFSB) should move beyond their

present mandate by being vocal in enforcing their regulations and raising the red f lags publicly whenever needed and by introducing newer regulations and guidelines. At the same time, they

must be proactive in terms of being ahead of the industry’s needs and requirements.

Considering these pointers and recommendations, which largely address the creation of a vibrant

secondary investment Sukuk market as well as accessibility, will enhance growth and reinforce

confidence in Sukuk and attract a sizeable share of the liquidity surplus by opening a new window for private individuals’ savings, an area that yet to be developed. By the same token,

following these recommendations will give more choices and flexibility to asset managers for

better asset allocations by developing more innovative products in the fixed-income industry,

with different tenors, returns, and risk profiles involving investment Sukuk. This will bring more investors to structured Sukuk funds, in particular, which have been battling to gain market share

in the mutual and fixed-income funds sector. They have encountered difficulties in attracting

investors due to the lack of breadth and depth caused by the shortage in diversity and volume in

the Sukuk issuance as well as the low variety of sectors in relation to the underlying assets in Sukuk issuance, and a lack of variety in the currencies mix. Fortunately, Sukuk funds can be now

re-energized on the basis of the Sukuk issuances record for 2011, 2012 and its high prospects for

2013 and beyond.

On the issuance side, governments through central banks will have a stable instrument to manage

the money supply as well as the fiscal and monetary budget. In the larger picture, governments of Islamic countries should also foster the growth of Shari’ah-compliant products by utilizing

Islamic finance instruments (i.e., investment Sukuk) to finance major infrastructure

developments, power grids, bridges, transportation projects, housing, and mining projects. At the

same time, the government issuances will enable citizens at the individual level (retail segment) to become Sukuk unit holders (wealth distribution) with clear recourse to the underlying assets,

thus investing in financing those projects through those Sukuk while getting reasonable returns on

their participation alongside having the comfort from knowing that they are investing in genuine Sukuk. In addition, those citizens will feel pride in knowing that they are owners of a mega

project in their country for their benefit. Allowing individual participation in Sukuk will

eventually create products for preserving wealth and encouraging savings for citizens, while gradually developing a vibrant secondary market and slowly moving away from concentration of

wealth.

The unprecedented growth of the Sukuk has raised many red f lags and requires all of the parties involved to step back and take the time to evaluate, analyze, and examine its merits and virtues,

its impact on the industry as a whole—in particular, its integrity, reputation, creditability, and its

authenticity. It’s the responsibility of all of us practitioners, lawyers, and regulators, with a particular focus on scholars; this responsibility and accountability should go beyond the race to

introduce another debt Sukuk while blinded by the fees to be earned from those issuances to the

market, as that debt Sukuk undoubtedly will backfire on the industry. In short, debt Sukuk is an

“accident is waiting to happen,” thus let us prevent it from happening and be vigilant of such a trend.

The rush of many sovereign and conventional financial institutions, investment and commercial banks, as well as international regulators, to Sukuk issuance is mainly driven by the drying

fountain and high cost of conventional debt. They are also lured by the surplus liquidity in the

Arabian Gulf region and some parts of Asia; this was demonstrated most recently by the announcement that South Africa, Japan, Hong Kong, Ireland, Kazakhstan, Bermuda, France,

China, India, and Australia, among others, are joining the issuers league, or contemplating the

idea. This coincides with the fact that a large sum of the gulf region’s liquidity is starved and in

most cases constrained to Shari’ah-compliant instruments and securities. Such a new paradigm of debt demand and supply—jointly with the wrong intentions and purposes (camouflaged greed or

needs)—can be a recipe for disaster. Thus, although the sprouting interest motives and aims in

Sukuk should be welcomed, it must also be challenged and scrutinized, especially by the Gatekeepers (i.e., Shari’ah scholars) as well the standards setting bodies (e.g., AAOIFI, IFSB),

until the establishment of a universal regulatory body to supervise and scrutinize Sukuk to

guarantee the conformity and adherence to Shari’ah guidelines at all times. This scrutiny and supervision will prevent any threats to the authenticity and integrity of Sukuk and the Islamic

finance alike, while serving the essence of Islamic economy in term of fairness, distribution of

wealth, and equality as opposed to concentration of wealth. At the same time, the balanced

growth of the industry will progress without any major setbacks while carrying out best practice in terms of transparency and governance.

A P P E N D I X

GLOSSARY Accounting and Auditing Organization for Islamic Financial Institutions. AAOIFI is an Islamic

international, autonomous, non-profit corporate body that prepares accounting, auditing, governance, ethics, and Shari’ah standards for Islamic financial institutions and the industry. Professional qualification

programs (notably CIPA, the Shari’ah Adviser and Auditor or “CSAA,” and the corporate compliance

program) are presented by AAOIFI in its efforts to enhance the industry’s human resources base and

governance structures. AAOIFI was established as an independent international organization in accordance

with the Agreement of Association, this was signed by Islamic financial institutions on February 26, 1990,

in Algiers. It was registered on March 27, 1991, in the Kingdom of Bahrain. AAOIFI is supported by

institutional members (200 members from 45 countries, so far) including central banks, Islamic financial

institutions, and other participants from the international Islamic banking and finance

industry, worldwide. (www.aaoifi.com)

Fatwa. Under Islamic teachings, in Arabic “fatwa” is a religious opinion concerning Islamic law issued by

an Islamic scholar in Arabic, an “alim” or “ulama” for plural. Ulama is a body of recognized Muslim clergy who have completed several years of training, research, and study of Islamic sciences.

GCC. The Arabian Gulf Cooperation Council was established on May 25, 1981. The GCC is a political and

economic union of the Arab states bordering the Arabian Gulf and constituting the Arabian Peninsula,

namely Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and United Arab Emirates. The unified economic

agreement between the countries of the Gulf Cooperation Council was signed on November 11, 1981, in

Abu Dhabi. These countries are often referred to as the GCC States. (www.gcc-sg.org)

International Islamic Financial Market. IIFM is the global standardization body for the Islamic capital and

money market segment of the Islamic financial services industry (IFSI). Its primary focus lies in the

standardization of Islamic financial products, documentation, and related processes. IIFM was founded with the collective efforts of the Central Bank of Bahrain, Bank Indonesia, Central Bank of Sudan, Labuan

Financial Services Authority (Malaysia), Autoriti Monetari Brunei Darussalam, and the Islamic

Development Bank-IDB (Saudi Arabia). IIFM is supported by its permanent member State Bank of

Pakistan. Dubai International Financial Centre Authority (DIFCA), ABC Islamic Bank, Bank Islam

Malaysia Berhad, Crédit Agricole CIB, European Islamic Investment Bank, Kuwait Finance House,

National Bank of Kuwait, Standard Chartered Saadiq. (www.iifm.net)

Islamic Economic System. An economic system that identifies and promotes an economic order that

conforms to Islamic scripture and traditions that evolved around creating a real economy that is ethical and

socially responsible, where money is always in circulation and equitable while sharing risk and reward,

with an interest-free financial system as guided by Shari’ah law through Islamic economic jurisprudence.

Islamic financial institution. An IFI is a bank or investment house or financing entity or takaful (co-

operative insurance) or re-takaful that fully adheres and conforms to Shari’ah rules and guidelines as

stipulated and enforced by the firm’s Shari’ah supervisory board (SSB) as well as its articles of

incorporation.

Islamic Financial Services Board. The IFSB is based in Kuala Lumpur, Malaysia, and was officially

inaugurated on November 3, 2002, and started operations on March 10, 2003. It serves as an international

standards-setting body of regulatory and supervisory agencies that have vested interest in ensuring the

soundness and stability of the Islamic financial services industry, which is defined broadly to include

banking, capital market, and insurance. In advancing this mission, the IFSB promotes the development of a

prudent and transparent Islamic financial services industry through introducing new or adapting existing

international standards consistent with Shari’ah principles and recommending them for adoption. The IFSB

also conducts research and coordinates initiatives on industry-related issues, as well as organizing

roundtables, seminars, and conferences for regulators and industry stakeholders. IFSB works complement

the Basel Committee on Banking Supervision, International Organization of Securities Commissions, and

the International Association of Insurance Supervisors. IFSB has 191 member; 54 are regulatory and supervisory authorities, 7 international inter-governmental organizations, and 130 market players,

professional firms, and industry associations operating in 43jurisdictions. (www.ifsb.org)

MENA. Middle East and North Africa

Shari’ah (Islamic Law). A set of rules and guidelines derived from two primary sources of Shari’ah. First,

the divine revelations set forth in the Qur’an (the holy book of Muslims and the main religious text);

second, the Hadith, the sayings and example set by the Islamic Prophet Muhammad in the Sunnah (Arabic

word that means habit or usual practice; the Muslim usage of this term refers to the sayings and living

habits of the prophet Muhammad). Fiqh (“jurisprudence”) interprets and extends the application of

Shari’ah to questions not directly addressed in the primary sources by including secondary sources. These

secondary sources usually include Ijma (the consensus of the religious scholars) and analogy from the Qur’an and Sunnah through Qiyas (the analogical reasoning). In relation to this article, the Islamic law for

investment and finance calls for all financial transactions to be free of interest/usury (riba), speculation

(maisir), uncertainty (gharar), while sharing risk beside profit and loss sharing, and to not invest in

businesses that provide goods or services considered forbidden and prohibited (haram). Prohibited business

activities can relate to food (production and sales of alcoholic beverages, including pubs and restaurants;

pork products; tobacco), gambling (casinos; online gambling; betting; lottery schemes), adult oriented

(video; magazines; on-line material; strip clubs), dubious or immoral, and illicit trades (online dating;

prostitution; drugs), weapons production and manufacturing, insurance, and reinsurance. In general,

Shari’ah is not dissimilar to socially responsible investing (SRI); also, because speculation and gambling is

forbidden in any form, derivatives, forwards, options, and futures can be considered prohibited. Other

forbidden practices include short selling, margin, day, and scalping trading.

Shari’ah Supervisory Board. An SSB is an executive body of few Islamic scholars (ulama) retained under a

mandate by Islamic financial institutions to ensure compliance and adherence to Shari’ah as well issue

fatwa for the products and transactions within Islamic financial institutions.

Sukuk. Arabic, plural of sakk, means “legal instrument, deed, check,” and is the Arabic name for Shari’ah-

compliant financial certificates. It is often mistakenly referred to as the Islamic equivalent of bonds, which

it is not. Sukuk is similar to an obligation backed by asset securities but is not in any way a bond, because it

is not based on debt with interest. It can be regarded as a commercial paper/certificate that gives the

investor a share of ownership in the underlying asset or a pool of assets. The issuer must identify the

asset(s) to be sold to investors by transferring it to undivided beneficial ownership in the underlying

asset(s). Investors enjoy the usufruct of the assets in proportion to their investment and bear the credit risk of the issuer. Sukuk are traded and rated financial instruments. The AAOIFI defines Sukuk as, “Certificates

of equal value representing after closing subscription, receipt of the value of the certificates and putting it

to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a

given project or equity of a special investment activity.”