Sukuk Innovations by: Wan A Rahim Kamil ICM Consultant, Securities Commission Malaysia

Sukuk Innovationsby:

Wan A Rahim KamilICM Consultant, Securities Commission Malaysia

Capital Market: Products & Instruments

CERT 22-23 May 2007 2

Sukuk as a consequent of Islamic securitisation

• Also known as Islamic bonds - but better described as “Trust Certificates” or “Participation Securities”• “ Grant investor a share of an asset along with the

cashflows and risk commensurate with such ownership”

• Prescribed as “securities” under the Islamic Securities Guidelines to give wider definition

• Can be consistent with conventional asset-backed securities (ABS) or conventional unsecured lending – depending on the structures


CERT 22-23 May 2007 3

Issuance of Sukuk must be supported by an underlying asset

• From Shariah perspective, Islamic financing should only be raised for trading in specified and identified Shariah compliant assets

• In general, trading of indebtedness is prohibited, unless it is traded at par• Middle East and some other jurisdictions only allow

debt trading at par• Malaysia – trading of indebtedness is permissible at

any value provided the underlying contract is Shariah e.g. Bai’ Bithaman Ajil / Bai’ Dayn

• Return for investment in sukuk in most cases are linked to cash flows and performance of underlying assets


CERT 22-23 May 2007 4

Possible Contracts for Project Funding Needs

• Consider a rental of the asset instead of a sale:• Project rents it from outsourced party;

• Actually investors purchased the asset and rents it to the project, thus:

• Objective of use of asset achieved;• Investors subject to similar cash-flow risk if

it had gone into a murabahah contract;• At end of period, project company could opt

to purchase the asset, considering that it would have already paid in full.


CERT 22-23 May 2007 5

• Best achieved through an Asset Backed Securitisation (“ABS”) exercise:• What qualifies as assets?

• Investment entries through Participatory Contracts;• Need to comply with guidelines or regulations on

ABS.


CERT 22-23 May 2007 6

Definition of Assets

• Under the shari’ah the assets must meet the necessary conditions:• Must exist physically (land, building, machinery)• Must be pure;• Must have use (however restricted to halal use

and not for example for operations of casino or alcohol sales outlet);

• Must be owned by the seller;• Must be free from encumbrances;• Must be known by specifications, descriptions,

location, etc.


CERT 22-23 May 2007 7

What are Participatory Contracts? Such as …

Participatory Contracts

(risk participation)

Mudharabah or Trust Loan-Investments:

Contract between fund owner and entrepreneur whereby returns are pre-agreed based on profit achievements but losses borne just by capital provider. Entrepreneur only provides management expertise.

Musharakah or Joint Participations:

Pooling of capital resources among several parties based on pre-agreed proportions of profit distributions and losses borne according to equity contributions.


CERT 22-23 May 2007 8

Applications

• These are extensions to equity-related instruments.• Musharakah is close to joint participations;• Mudharabah is a semi-equity semi-debt

instrument.• Can be applied to needs normally raised under

subordinated debt structures.


CERT 22-23 May 2007 9

Participatory Contracts

Participatory Contracts of:1. Musharakah or general partnership under

profit-loss sharing formula. Partners:Share profits in accordance with pre-agreed proportions and not necessarily based on capital investment;Bear losses in proportion to capital contribution.Partners might forgo rights to management to other partners.

Managing partner liable for losses due to mismanagement or wrong business judgments.


CERT 22-23 May 2007 10

2. MudharabahTrustee investment contract that is semi-equity

and semi-debt in nature.• Marriage between capital and entrepreneurship;• Profit sharing contract whereby:

• one party, the capital provider or rabb al mal provides the necessary capital for the venture,

• The other party, the mudharib, provides the expertise for the venture.

• Profit sharing not based on capital but based on pre-agreed proportion of achieved profits.

• Genuine business losses borne in entirety by rabb al mal.


CERT 22-23 May 2007 11

• Asset Backed Securitisations:• Create new opportunities to popularise

mudharaba or qirad, and/or musharkah contracts,

• Ability to ring-fenced risks with more secured contracts such as ijarah, murabaha, salam or other compounded contracts of exchanges, whereby

• Risks mitigated through secured cash-flow streams and with lesser operational and credit risks,

• More shari’ah compliant due to Special Purpose Vehicle involved in direct investments or business activities – avoidance of Bai’ al Dayn issues.


CERT 22-23 May 2007 12

Special Purpose Vehicle(“SPV”)(Mudharib)

Mudharaba or Musharakah

Certificates

Pool of Investors(Rabb al Mal or Musharkah

Partners)

Subscription for Certificates

($)

Direct Investments through ijarah,

murabahah or otherreal estate businesses or

trading activities

Cash-flow stream ($)

Profit Distribution

Expenses for m

eeting operational requirem

ents

1

2

3

4

5

6

7

3


CERT 22-23 May 2007 13

Asset Backed Securitisation

1. Sale of asset to the SPV – True Sale

2. SPV issues asset-backed securities to investors

3. Proceeds from the sale of ABS go to the Originator

4. (Interest) & principal repayments to Investors

SPV Investors

1.

2.

3.

Originator

3a.

4.


CERT 22-23 May 2007 14

Islamic Asset-Backed Sukuk adds a new dimension to ICM products

• True sale – legally belong to SPV• Non-recourse sukuk / ABS - credit risk performance is

determined solely by underlying asset• SPV – bankruptcy remote (independent)• Correspondence of income streams with actual income

and value of the assets• Ratings are primarily dependent on a risk analysis of

the assets or performance of assets• Unilateral purchase undertaking (if any) – at market

value


CERT 22-23 May 2007 15

AmbangSentosa

Originator

Investor

2.Investor purchase asset (gift)

4. Sale of asset on deferred payment (BBA)

5. ASSB issue BAIDS to investor

3. Cash

Identified Asset:Rights, title and interest over the

balance sales proceeds of two development projects

1. Hibah (Gift) Aqad Asset

Proceeds from BBA transaction used to purchase Identified asset

Ambang Sentosa BBA (ABS) –domestic version of Islamic securitisation

Underlying assets to execute BBA are assets awarded by 3rd party – need tangible assets to avoid debt-for-debt transactions which is prohibited both in Msia and international

Cash flow is still based on receivables


CERT 22-23 May 2007 16

Cagamas Sukuk Musyarakah (RMBS) - does it comply with international Shariah standards ?

Cagamas(Transaction

Administrator & Administrator)

Cagamas MBS

GOM(Originator &

Servicer)

Sale of GSHFs

Purchaseconsideratio

n

Investors

Sukuk issued

to investors

Proceeds from sukuk

Trustee

Represent Sukukholders

Sale of Islamic house financing receivables

Debt trading – sold at discount not at par

Although investors formed as musyarakah venture


CERT 22-23 May 2007 17

Golden Crop Sukuk Ijarah (ABS) – compliance with international Shariah standards

Share Trustee

Golden Crop Returns(Issuer)

Sukukholders

Boustead Group

(Originators)Trustee

LTATSukuk Ijarah

Originator sell the plantation asset

to the Issuer

Issuer leases back the plantation asset

to the Originator

Subordinated Musyarakah facility with LTAT


CERT 22-23 May 2007 18

Islamic Asset Backed Securities issued in Malaysia

Issuer FacilityIssue Size

RM (million)

SC Approve

d

Ambang Sentosa Sdn Bhd

BBA986.00 29-May-03

Musyarakah One Capital Berhad

Sukuk Musyarakah 2,500.00 7-Mar-05

Cagamas MBS Berhad Sukuk Musyarakah 2,500.00 6-Jul-05

Golden Crop Returns Bhd Sukuk Ijarah * 442.00 27-Oct-05

ABS Logistics Bhd Sukuk Ijarah * 300.00 6-Jul-06

Nepline SPV Sdn Bhd Sukuk Ijarah * 170.00 21-Jul-06

Total Islamic ABS 6,898.00 * International Shariah compatible structure


CERT 22-23 May 2007 19

Majority of sukuk has been on simple “ijarah” structure – unsecured financing / asset-based

• Originator seeking financing “sells” the assets to SPV for a value equal to financing required and lease it back

• SPV – subsidiary of originator;

• Lease payments provide fixed income stream which may be benchmarked to an index / LIBOR +;

• Conducted on non true-sale basis so repayment and risk/performance is not asset backed but originator based;

• Purchase undertaking of asset at maturity with pre-determined value;


CERT 22-23 May 2007 20

• Ratings are primarily dependent on the riskness of the borrower / sponsor / originator / lessee;

• Assets only used to facilitate Shari’ah compliance.


CERT 22-23 May 2007 21

Sukuk Al-Ijarah - Asset Based Transaction

SPV

Sukuk

Originator

Sukuk Sukuk

Sukuk

Sale of asset

Sukuk proceeds

Lease & repurchase payments for assets

Sukuk proceeds

Asset repurchase

Periodic payments:

Lease flows and principal (via amortisation/repurchase)

Non-true sale – condition to repurchase at maturity

Payment of rental / profit can be derived from ijarah or other sources


CERT 22-23 May 2007 22

Sukuk Al Ijarah – Asset Backed

• There are also structures of sukuk al ijarah under an Asset Backed Scenario.• True sale, though• The ownership of the SPV is transferred to the originator or

the lessor at end of lease. Original underlying sale has been true sale.


CERT 22-23 May 2007 23

SPV

Certificates of Investments

Investors

1.Offer for Sale

of securities

2.

Asset Provider

3. Sale & Purchaseof Asset (payment ofasset acquisitionCost US$) Asset

4. Transfer of Ownership of

Asset to SPV

1st Transaction: SPV and Asset Provider1st Relationship: SPV and Investors

Step 1

$

Creation of Sukuk al Ijarah


CERT 22-23 May 2007 24

SPV Project Owner1. Execution of al

ijarah contract

ASSETASSET

2. Rental of Asset on fixed term and fixed rental basis

Ijarah Rental ObligationCertificates

(evidence of obligations)3. Issuance of ijarah rental Obligations Promissory Notes to

SPV implying cash flow stream on asset.

Step 2


CERT 22-23 May 2007 25

SPV Project Owner

1.Regular Ijarah Rental Payments

Asset

5. Asset transferred to Project Owner

Investment Certificates

Holders2. Scheduled Distributions of Coupon Payments to Holders Of Investment Certificates issued by SPV

3. Final Repayment Representing Total Settlement equal to Initial Purchase PriceOf Asset by SPV

4. Payment of Final Amount being final settlement of Obligations under Ijarah Contract


CERT 22-23 May 2007 26

• Assets purchased by the SPV are funded by the issuance of floating rate Trust Certificates, representing beneficial ownership in the assets and having beneficial rights on the lease;

• Upon maturity of the lease, SPV sells asset to the Project Owner at the original price. Proceeds from this sale will be utilised to meet the final payment to investors.


CERT 22-23 May 2007 27

• Sukuk al Ijarah can be:• short term facility instruments i.e. as per

structure of sukuks issued by the Bank Negara and/or Government of Malaysia to replace T-Bills; or

• Medium to long term facilities but with rental settings made every scheduled periods of say 3 or 6 months each year.

CERT 22-23 May 2007 28Capital Market: Products & Instruments

PROJECTCo.

Ijarah SPV

Rental of Equipment

6. Ijarah contract

Musharakah Investors2. Musharakah Investment Agreement

3. $ for Working Capital Needs $ Income Stream

7. $ Ijarah RentalPayments

7. $ Profit Payments & Repurchase or Redemption of MPS

Ordinary Equity

SukukMudharabah

Financial Investors

5. $ ParticipationInto Mudharabah

1.

4.

8. $ Mudharabah ProfitPayments Project Funding through

COMBINATION OFPARTICIPATORY AND

IJARAH CONTRACTS

9.$

Dividends

MUSHARAKAH PREFERENCE

SHARES (‘MPS’)


CERT 22-23 May 2007 29

Khazanah Exchangeable Sukuk(Asset Swap)

Khazanah & Other Sellers

Issuer Rafflesia

Khazanah

SPV II Sukuk

Sukuk

Proceed ($)

Sale of

Equity Pool

Sale Price

(Principal)

($)

Sale Price

(Principal) ($)

Sale of

Equity Pool

Cash Settlement

Purchase Right DeedDefault / Maturity

Purchase

Undertaking Deed

Investors

$


CERT 22-23 May 2007 30

Some notable Sukuk issued in the global markets


USD(mil)Manager

Nakheel Development Convertible Sukuk Ijarah 3,520.00Barclays

Capital, DIB

ADIB Sukuk Co Sukuk Ijarah 800.00 HSBC

Rafflesia CapitalExchangeable Sukuk

Musyarakah750.00

CIMB, HSBC Amanah, UBS

Aabar SukukExchangeable Sukuk Mudarabah

460.00 Deutsche


CERT 22-23 May 2007 31

Tabreed 06 Financing Corp

Sukuk Istisna’ 200.00

CIMB, HSBC, Dreer

Kleinwort Wassertein

East Cameron Gas Co Asset backed Sukuk 168.00Merrill Lynch International


USD(mil)Manager


CERT 22-23 May 2007 32

Asset-Based Sukuk vs Asset Backed Sukuk

Asset based Sukuk Asset backed Sukuk

Feature Using Shariah compliant assets/business ventures to facilitate issuance of Sukuk

Asset backing Shariah compliant assets/business ventures which form PRIMARY source of income /return to investor. Issued in various Shariah principles

Key Accounting Concept/ treatment

ON balance sheet (for originator/obligor)

OFF balance sheet (for originator)True sale criterion: legal & off balance sheet accounting


CERT 22-23 May 2007 33

Funding Cost Market driven mainly depending on originator/issuer credit rating/standing

Mainly based on the strength of the asset cash flow

Rating Corporate rating of issuer/obligor

Strength of cash flow

Asset based Sukuk Asset backed Sukuk


CERT 22-23 May 2007 34

END

Thank You

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Documents

Sukuk Innovations by: Wan A Rahim Kamil ICM Consultant, Securities Commission Malaysia