What is Sukuk

8/3/2019 What is Sukuk

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Centre of Islamic Banking & Economics

Sukuk an Islamic Bond Sukuk Market over View.Recent innovations in Islamic finance have changed the dynamics of the Islamic finance

industry. Especially in the area of bonds and securities the use of Sukuk or Islamicsecurities has become increasingly popular in the last few years, both as a means of raising government finance through sovereign issues, and as a way of companiesobtaining funding through the offer of corporate Sukuk. Beginning modestly in 2000 withtotal three Sukuk worth $336 millions the total number Sukuk by the end of 2006 hasreached to 77 with over US$ 27 billion funds under management. By the end of 2007the total figure is expected to exceed US$35 billion. Sukuk has developed as one of themost significant mechanisms for raising finance in the international capital marketsthrough islamically acceptable structures. Multinational corporations, sovereign bodies,state corporations and financial institutions use international Sukuk issuance as analternative to syndicated financing.

Basics of SukukSukuk (plural of word Sukk) were extensively used by Muslims in the middle Ages aspapers representing financial obligations originating from trade and other commercialactivities. However, the present structure of Sukuk are different from the Sukukoriginally used and are akin to the conventional concept of securitization, a process inwhich ownership of the underlying assets is transferred to a large number of investorsthrough certificates representing proportionate value of the relevant assets. Sukuk ispopularly known as an Islamic or Sharia¶h compliant µBond¶ whilst in actual fact and it isan asset-backed trust certificate. In its simplest form Sukuk is a certificate evidencingownership of an asset or its usufruct. The Sukuk structures rely on the creation of aSpecial Purpose Vehicle (SPV).SPV would issue Sukuk certificates which represent for

example the ownership of an asset, entitlement to a debt or to rental incomes or evenaccumulation of returns from various Sukuk (a hybrid Sukuk). The return provided toSukuk holders therefore come in the form of profit from a sale, rental or a combinationof both. Sukuk could be based on Mudaraba, Musharaka, Murabaha, Salam, Istisna,Ijara or hybrid of these.

Definition of Sukuk Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) definesSukuk as being:Centre of Islamic Banking & Economics

³Certificates 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 intangible assets, usufructs and services, or equity of a given project or equity of a specialinvestment activity´.

Benefits and Features1) Tradable Sharia¶h-compliant capital market product providing medium to long-termfixed or variable rates of return. Assessed and rated by international rating agencies,which investors use as a guideline to assess risk/return parameters of a Sukuk issue.



2) Regular periodic income streams during the investment period with easy and efficientsettlement and a possibility of capital appreciation of the Sukuk.3) Liquid instruments, tradable in secondary market.

Difference between conventional bond and SukukA bond is a contractual debt obligation whereby the issuer is contractually obliged to pay tobondholders, on certain specified dates, interest and principal.

In Sukuk structure the Sukuk holders each hold an undivided beneficial ownership intheunderlying assets. Consequently, Sukuk holders are entitled to share in the revenuesgenerated bythe Sukuk assets as well as being unrestricted to share in the proceeds of therealization of theSukuk assets. Sukuk in general may be understood as a Sharia¶h compliant µBond¶. Theclaimembodied in Sukuk is not simply a claim to cash flow but an ownership claim. This alsodifferentiates Sukuk from conventional bonds as the latter proceed over interest bearingsecurities, whereas Sukuk are basically investment certificates consisting of ownershipclaims ina pool of assets.

Similarities between conventional bond and Sukuk1) Marketability: Sukuk are floated in real assets that are liquid , easily transferred andtraded in the financial markets2) Ratability: Sukuk can be easily rated3) Enhance ability : Different Sukuk structures may allow for credit enhancements4) Versatility: The variety of Sukuk structures (as many as over 27 possibilities)

Steps of Issuance of Sukuka) Preparing a detailed feasibility study (stating clear objectives to be achieved from the

proposed Sharia¶h-compliant business) and setting up of general framework andorganizational structure to support the issuance process.b) Working out an appropriate Sharia¶h structure to achieve the set objectives incompliancewith Sharia¶h.c) Arranging lead manager (s) to underwrite the Sukuk issue.Centre of Islamic Banking & Economics

d) Arranging legal documentation around the agreed Sharia¶h structures (both from theIssuer¶s as well as arranger¶s perspective).e) Setting up the SPV to represent the investors (Sukuk holders) andputting the Sukuk into circulation.

Parties Involved in Sukuka) Originator: he is the initiator and owner of asset which will be used to issue Sukuk.b) SPV: Special purpose vehicle or company is the intermediary company that worksbetween the Sukuk holder and Originator. This company receives the amount forminvestors and pays to the originator of Sukuk and buy the ownership of that asset andit transform to Sukuk holders and also make a checkup on both parties and assetmaintenance etc.c) Investors: there are two types of investor that invest in Sukuk as primary and



secondary market. They also are actual owner of specific portion of assets and free tosell it at any time in secondary market. And enjoy the profit in term of rent or profit atthe end of month quarter, semi yearly or yearly basis.d) Banks perform as Receiving and paying agent and provide security to both parties.

Role of Sharia¶h Advisors in Sukuk Issuance

a) Sharia¶h advisor (Sharia¶h scholars or Sharia¶h advisory firms with recourse toSharia¶h scholars) have a significant role to play. Amongst others, following may belisted as examples:b) Advising on proposed Sukuk structure and suggest a Sharia¶h structure whichotherwise fulfils the set economic aims;c) Working closely with legal counsel of the issuer to ensure that the legal documentsare in line with Sharia¶h Principles.

Sharia¶h Requirements.a) Working closely with legal counsel of the arranger to ensure that the legal documentsare in line with Sharia¶h requirements.b) Issuing Fatwa on the whole Sukuk deal before the same can be put into circulation.

Uses of Sukuk FundsThe most common uses of Sukuk can be named as project specific, asset-specific, andbalancesheet specific.Centre of Islamic Banking & Economics

1) Project-Specific SukukUnder this category money is raised through Sukuk for specific project. For example,WAPDAissue its first Sukuk in Pakistan in 2006 worth of Rs.8, 000 million to raise fund toupgrading theMangla Dam for 7 years .the structure of this Sukuk was on Ijarah Base and annual rate

of profitwas decided KIBOR + 35 bps.There were following key objectives to issue the Sukuk.a) To raise financing in ab) cost efficient manner c) Strengthen its presence in the local financial marketsd) Diversify and cultivate WAPDA¶s investor basee) Undertake a landmark transaction which will catalyze the promotion of IslamicFinancialinstruments and lead the way for other public sector entities2) Assets-Specific Sukuk.

Under this arrangement, the resources are mobilize by selling the beneficiary right of the assetsto the investors. For example, the Government of Malaysia raised US$ 600 millionthroughIjarah Sukuk Trust Certificates (TCs) in 2002. Under this arrangement, the beneficiaryright of the land parcels has been sold by the government of Malaysia to an SPV, which wasthen re-sold



to investors for five years. The SPV kept the beneficiary rights of the properties in trustandissued floating rate Sukuk to investors.

Another example of Asset-specific Sukuk is US$250 million five-year Ijarah Sukukissued to

fund the extension of the airport in Bahrain. In this case the underlying asset was theairport landsold to an SPV.3) Balance Sheet-specific Sukuk

An example of the balance sheet specific use of Sukuk funds is the IslamicDevelopment Bank(IDB) Sukuk issued in August 2003. The IDB mobilized these funds to finance variousprojectsof the member countries. The IDB made its debut resource mobilization from theinternationalcapital market by issuing US$ 400 million five-year Sukuk due for maturity in 2008.Centre of Islamic Banking & Economics

Types of SukukThere is lot of type of Sukuk but according to Accounting and Auditing Organization for IslamicFinancial Institutions (AAOIFI) Recommend the 14 models of Sukuk with Sharia¶hcompliance.These types depend upon the type of Islamic modes of financing and trades used in itsstructuring. However, the most important and common among those are Mudaraba,IjarahMusharaka, Salam and Istisna.

1. Mudaraba SukukThese are investment Sukuk that represent ownership of units of equal value in the

Mudarabaequity and are registered in the names of holders on the basis of undivided ownershipof sharesin the Mudaraba equity and its returns according to the percentage of ownership of share. Theowners of such Sukuk are the rabbul-mal. (AAOIFI). Mudaraba Sukuk is used for enhancingpublic participation in big investment projects.

Salient Features:Following are the salient features of Mudaraba Sukuk:I. Mudaraba Sukuk (MS) represent common ownership and entitle their holders share inthespecific projects against which the MS has been issued.II. The MS contract is based on the official notice of the issue of the prospectus whichmustprovide all information required by Sharia¶h for the Qirad contract such as the nature of capital,the ratio for profit distribution and other conditions related to the issue, which must becompatible with Sharia¶h.



III. The MS holder is given the right to transfer the ownership by selling the deeds in thesecurities market at his discretion. The sale of MS must follow the rules listed below.a) If the Mudaraba capital, before the operations of the project, is still in the form of money, the trading of MS would be like exchange of money for money. In that case therules of bay al-sarf would be applied.

b) If Mudaraba capital is in the form of debt then it must satisfy the principles of debttrading in Islam.c) If capital is in the form of combination of cash, receivables, goods, real assets andbenefits, trade must be based on market price evolved by mutual consent.IV. The Manager/SPV who receives the fund collected from the subscribers to MS canalsoinvest his own fund. He will get profit for his capital contribution in addition to his sharein theprofit as mudarib.Centre of Islamic Banking & Economics

V. Neither prospectus nor MS should contain a guarantee, from the issuer or themanager for thefund, for the capital or a fixed profit, or a profit based on any percentage of the capital.

Accordingly,a) The prospectus or the MS issued pursuant to it, may not stipulate payment of aspecificamount to the MS holder,b) The profit is to be divided, as determined by applying rules of Sharia¶h that is, anamountaccess of the capital, and not the revenue or the yield.c) Profit and Loss account of the project must be published and disseminated to MSholders.VI. It is permissible to create reserves for contingencies, such as loss of capital, by

deductingfrom the profit.VII. The prospectus can also contain a promise made by a third party, totally un-relatedto theparties to the contract, in terms of legal entity or financial status, to donate a specificsum,without any counter benefit, to meet losses in the give project, provided suchcommitment isindependent of the Mudaraba contract.On the expiry of the specified time period of the subscription, the Sukuk holders aregiven the

right to transfer the ownership by sale or trade in the securities market at his discretion. Steps involved in the Structure:a) Mudarib enters into an agreement with project owner for construction/ commissioningof project.

b) SPV issues Sukuk to raise funds.



c) Mudarib collects regular profit payments and final capital proceeds from projectactivityfor onward distribution to investors.

d) Upon completion, Mudarib hands over the finished project to the owner.Project Owner

ProjectSecondary MarketSVP as Mudarib Primary1. Agreement Subscriber 4. Project handed over upon completion2. Sukuk issue andSukuk proceeds3. Capital proceedsand profits collection3. Capital proceeds andprofits distributionCentre of Islamic Banking & Economics

Mudaraba Sukuk in practiceShamil Bank of Bahrain raised 360 million Saudi Riyal investment capital through the AlEhsa Special Realty Mudaraba, representing an investment participation in a landdevelopment transaction with a real estate development company in the Kingdom of Saudi

Arabia. The investment objective of the Mudaraba is to provide investors with annualreturnsarising from participation in the funding of a land financing transaction Profits due toinvestors will be accrued on the basis of returns attained from investing thesubscriptions.

2. Musharaka Sukuk

These are investment Sukuk that represent ownership of Musharaka equity. It does notdiffer from the Mudaraba Sukuk except in the organization of the relationship between thepartyissuing such Sukuk and holders of these Sukuk, whereby the party issuing Sukuk formsacommittee from the holders of the Sukuk who can be referred to in investment decisions(AAOIFI).Musharaka Sukuk are used for mobilizing the funds for establishing a new project or developingan existing one or financing a business activity on the basis of partnership contracts.

Thecertificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiableinstruments and canbe bought and sold in the secondary market.³These are certificates of equal value issued with the aim of using the mobilized fundsfor



establishing a new project, developing an existing project or financing a businessactivity on thebasis of any partnership contracts so that the certificate holders become the owners of the projector assets of the activity as per their respective shares, with the Musharaka certificates

beingmanaged on the basis of participation or Mudaraba or an investment agency.´ (AAOIFIStandard17, 3/6)

Steps involved in the structure:Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangementfor afixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buyMusharakashares of the SPV on a periodic basis.a) Corporate (as Musharik) contributes land or other physical assets to the Musharaka

b) a & b. SPV (as Musharik) contributes cash i.e. the issue Proceeds received from theinvestors to the Musharakac) The Musharaka appoints the Corporate as an agent to develop the land (or other physicalassets) with the cash injected into the Musharaka and sell/lease the developed assetsonbehalf of the Musharaka.Centre of Islamic Banking & Economics

d) In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variableincentive fee payable.e) The profits are distributed to the Sukuk holders.f) The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharakasharesof the SPV on say semi-annual basis and at the end of the fixed period the SPV wouldnolonger have any shares in the Musharaka.

Musharaka Sukuk in PracticeUS$550 million Sukuk transaction for Emirates airline, the seven-year deal was astructured on aMusharaka contract. The Musharaka or joint venture was set up to develop a newengineeringcentre and a new headquarters building on land situated near Dubai's airport which willultimately be leased to Emirates. Profit, in the form of lease rentals, generated from theMusharaka venture will be used to pay the periodic distribution on the trust certificates.Sitara Chemical Industries Ltd, a public limited company, made a public issue of profit-and-losssharing based term finance certificates (TFC¶s) worth Rs 360 million which weresubscribed inJune 2002. The TFC¶s had a fixed life tenor of five years and profit and loss sharing waslinked



to the operating profit or loss of the Chemical Division of the company.MusharkaOriginator SVPInvestors1. Physical AssetContribution3b.Periodic Profits+Incentive Fees2b. SukukProceeds2a. SukukProceeds3a: PeriodicProfits4. Periodic Distribution of Profits5. Musharka Agreement +Undertaking to Buy MusharkaShares of SPV on a periodic BaisCentre of Islamic Banking & Economics

Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al MuthannaInvestment Company (MIC), the mandated lead arrangers launched US$ 125 millionLagoonCity Musharaka Sukuk to support the Lagoon City residential and commercial realestatedevelopment as part of Kheiran Pearl City project.

3. Ijarah SukukThese are Sukuk that represent ownership of equal shares in a rented real estate or theusufruct of the real estate. These Sukuk give their owners the right to own the real estate, receivethe rent

and dispose of their Sukuk in a manner that does not affect the right of the lessee, i.e.they aretradable. The holders of such Sukuk bear all cost of maintenance of and damage to therealestate. (AAOIFI)Ijarah Sukuk are the securities representing ownership of well defined existing andknown assetstied up to a lease contract, rental of which is the return payable to Sukuk holders.Payment of Ijarah rentals can be unrelated to the period of taking usufruct by the lessee. It can bemade

before beginning of the lease period, during the period or after the period as the partiesmaymutually decide. This flexibility can be used to evolve different forms of contract andSukuk thatmay serve different purposes of issuers and the holders.

Features of Ijarah Sukuk



I. It is necessary for an Ijarah contract that the assets being leased and the amount of rentboth are clearly known to the parties at the time of the contract and if both of these areknown, Ijarah can be contracted on an asset or a building that is yet to be constructed,as

long as it is fully described in the contract provided that the lessor should normally beable to acquire, construct or buy the asset being leased by the time set for its delivery tothe lessee (AAOIFI, 2003: 140-157). The lessor can sell the leased asset provided itdoesnot hinder the lessee to take benefit from the asset. The new owner would be entitled toreceive the rentals.II. Rental in Ijarah must be stipulated in clear terms for the firs term of lease, and for futurerenewable terms, it could be constant, increasing or decreasing by benchmarking or relating it to any well-known variable.III. As per Sharia¶h rules, expenses related to the corpus or basic characteristics of the

assetsare the responsibility of the owner, while maintenance expenses related to its operationare to be borne by the lessee.IV. As regards procedure for issuance of Ijarah Sukuk, an SPV is created to purchasetheasset(s) that issues Sukuk to the investor, enabling it to make payment for purchasingtheasset. The asset is then leased to third party for its use. The lessee makes periodicrentalpayments t the SPV that in turn distributes the same to the Sukuk holders.V. Ijara Sukuk are completely negotiable and can be traded in the secondary markets.

VI. Ijara Sukuk offer a high degree of flexibility from the point of view of their issuancemanagement and marketability. The central government, municipalities, awqaf or anyCentre of Islamic Banking & Economics

other asset users, private or public can issue these Sukuk. Additionally, they can beissued by financial intermediaries or directly by users of the leased assets.

Steps involved in Ijarah Sukuk structurea) The obligator sells certain assets to the SPV at an agreed pre-determined purchaseprice.b) The SPV raises financing by issuing Sukuk certificates in an amount equal to thepurchase price.c) This is passed on to the obligator (as seller).d) A lease agreement is signed between SPV and the obligator for a fixed period of time, where the obligator leases back the assets as lessee.e) SPV receives periodic rentals from the obligator.f) These are distributed among the investors i.e. the Sukuk holders.g) At maturity, or on a dissolution event, the SPV sells the assets back to the seller ata predetermined value. That value should be equal to any amounts still owedunder the terms of the Ijarah Sukuk.

Ijarah Sukuk in Practice



In December 2000, Kumpulan Guthrie Berhad (Guthrie) was granted a RM1.5 billion(US$400million) Al-Ijara Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facilitywasraised to re-finance Guthrie¶s acquisition of a palm oil plantation in the Republic of

Indonesia.The consortium was then invited to participate as the underwriter/primary subscriber of theSukuk Transaction.Obligator AsSeller Obligator Leasies Back asLesseeSVPIssuer/Lessor Sukuk Holders3. Lease Agreement

4. PeriodicRentals andcapital amountDistribution2. SukukProceeds2a. SukukProceeds1. Title to Asset4. Periodic Rentals andcapital amount paymentsCentre of Islamic Banking & Economics

US$350 million Sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI)

SarawakEconomic Development Corporation (SEDC) raised financing amounting to US$350million byway of issuance of series of trust certificates issued on the principle of Ijara Sukuk. Thecertificates were issued with a maturity of 5 years and under the proposed structure, theproceedswill be used by the issuer to purchase certain assets from 1st Silicon (Malaysia) SdnBhd.Thereafter, the issuer will lease assets procured from 1st Silicon to SEDC for an agreedrentalprice for an agreed lease period of 5 years.

4. Murabaha SukukIn this case the issuer of the certificate is the seller of the Murabaha commodity, thesubscribersare the buyers of that commodity, and the realized funds are the purchasing cost of thecommodity. The certificate holders own the Murabaha commodity and are entitled to itsfinalsale price upon the re-sale of the Commodity. The possibility of having legallyacceptable



Murabaha-based Sukuk is only feasible in the primary market. The negotiability of theseSukukor their trading at the secondary market is not permitted by Sharia¶h, as the certificatesrepresenta debt owing from the subsequent buyer of the Commodity to the certificate-holders and

suchtrading amounts to trading in debt on a deferred basis, which will result in riba.Despite being debt instruments, the Murabaha Sukuk could be negotiable if they are thesmaller part of a package or a portfolio, the larger part of which is constituted of negotiableinstrumentssuch as Mudaraba, Musharaka, or Ijarah Sukuk. Murabaha Sukuk is popular inMalaysian marketdue to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt(bai-aldayn)at a negotiated price.

Steps involved in the structure:a) A master agreement is signed between the SPV and the borrower b) SPV issues Sukuk to the investors and receive Sukuk proceeds.c) SPV buys commodity on spot basis from the commodity supplier.d) SPV sells the commodity to the borrower at the spot price plus a profit margin,payableon installments over an agreed period of timee) The borrower sells the commodity to the Commodity buyer on spot basis.f) The investors receive the final sale price and profits.Centre of Islamic Banking & Economics

Murabaha Sukuk in Practice

Arcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-undVereinsbank AG (³HVB´), Standard Bank Plc (³SB´) and WestLB AG, London Branch(³WestLB´) (together the ³Mandated Lead Arrangers´), to arrange a Five Year Multicurrency(US$, ¼ and £) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity andproposed pricing three month LIBOR +175bps.

5. Salam SukukSalam Sukuk are certificates of equal value issued for the purpose of mobilizing Salamcapital sothat the goods to be delivered on the basis of Salam come to the ownership of thecertificate

holders. The issuer of the certificates is a seller of the goods of Salam; the subscribersare thebuyers of the goods, while the funds realized from subscription are the purchase price(Salamcapital) of the goods. The holders of Salam certificates are the owners of the Salamgoods andare entitled to the sale price of the certificates or the sale price of the Salam goods soldthrough a



parallel Salam, if any.Salam-based securities may be created and sold by an SPV under which the fundsmobilizedfrom investors are paid as an advance to the company SPV in return for a promise todeliver a

commodity at a future date. SPV can also appoint an agent to market the promisedquantity at thetime of delivery perhaps at a higher price. The difference between the purchase priceand the saleprice is the profit to the SPV and hence to the holders of the Sukuk.

All standard Sharia¶h requirements that apply to Salam also apply to Salam Sukuk, suchas, fullpayment by the buyer at the time of affecting the sale, standardized nature of underlyingasset,clear enumeration of quantity, quality, date and place of delivery of the asset and thelike.InvestorsIssuer SPVCommodityBorrower Buyer CommoditySupplier 1. Master

Agreement4. Project handed over upon completion4. MurabahaCommodity6. Sale Price + Profit 2. Sukuk issues and SukukProceeds

4. DeferredPayment5. Commodity5. Spot Payment3. Commodity3. Spot PaymentCentre of Islamic Banking & Economics

One of the Sharia¶h conditions relating to Salam, as well as for creation of Salam Sukuk,is therequirement that the purchased goods are not re-sold before actual possession atmaturity. Suchtransactions amount to selling of debt. This constraint renders the Salam instrument

illiquid andhence somewhat less attractive to investors. Thus, an investor will buy a Salamcertificate if heexpects prices of the underlying commodity to be higher on the maturity date.

Steps involved in Salam Sukuk Structurea) SPV signs an undertaking with an obligator to source both commodities and buyers.Theobligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then



to sell it for the profit of the Sukuk holders.b) Salam certificates are issued to investors and SPV receives Sukuk proceeds.c) The Salam proceeds are passed onto the obligator who sells commodity on forwardbasisd) SPV receives the commodities from the obligator

e) Obligator, on behalf of Sukuk holders, sells the commodities for a profit.f) Sukuk holders receive the commodity sale proceeds.

Salam Sukuk in Practice Aluminum has been designated as the underlying asset of the Bahrain Government alSalamcontract, where by it promises to sell aluminum to the buyer at a specified future date inreturn of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated torepresent the other banks wishing to participate in the Al Salam contract. BIB has beendelegatedto sign the contracts and all other necessary documents on behalf of the other banks in

thesyndicate. At the same time, the buyer appoints the Government of Bahrain as an agentto marketthe appropriate quantity at the time of delivery through its channels of distribution. TheGovernment of Bahrain provides an additional undertaking to the representative (BIB) tomarketthe aluminum at a price, which will provide a return to al Salam security holder¶sequivalent tothose available through other conventional short-term money market instruments.InvestorsIssuer SPV CommodityBuyer

Borrower 2 a. Sukuk Proceeds1. under Taking4b. Commodity SaleProceed2b. Salam Proceed3. CommodityCentre of Islamic Banking & Economics

6. Istisna SukukIstisna Sukuk are certificates that carry equal value and are issued with the aim of mobilising thefunds required for producing products that are owned by the certificate holders. The

issuer of these certificates is the manufacturer (supplier/seller), the subscribers are the buyers of theintended product, while the funds realised from subscription are the cost of the product.Thecertificate holders own the product and are entitled to the sale price of the certificates or the sale



price of the product sold on the basis of a parallel Istisna, if any. Istisna Sukuk are quiteusefulfor financing large infrastructure projects. The suitability of Istisna for financialintermediation isbased on the permissibility for the contractor in Istisna to enter into a parallel Istisna

contractwith a subcontractor. Thus, a financial institution may undertake the construction of afacility for a deferred price, and sub contract the actual construction to a specialised firm.Sharia¶h prohibits the sale of these debt certificates to a third party at any price other than their face value. Clearly such certificates cannot be traded in the secondary market.

Steps involved in the structure:a) SPV issues Sukuk certificates to raise funds for the project.

b) Sukuk issue proceeds are used to pay the contractor/builder to build and deliver thefuture project.

c) Title to assets is transferred to the SPVd) Property/project is leased or sold to the end buyer. The end buyer pays monthlyinstallments to the SPV.

e) The returns are distributed among the Sukuk holders.

Istisna Sukuk in PracticeTabreed¶s five-year global corporate Sukuk (on behalf of the National Central CoolingCompany, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisnaand IjaraSukuk HoldersContractor/Builder SPV End Buyer 2. Sukuk Proceeds4. Title to Asset

4. Monthly Payments3. Distribution of Return4. Title to Asset2. PaymentsCentre of Islamic Banking & Economics

Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raisefunds toretire some existing debt, which totals around US$136 million, as well as to financeexpansion.The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of abroader US$ 1 billion world class residential and leisure destination known as 'Durrat Al

Bahrain',currently the Kingdom of Bahrain's largest residential development project. The returnon theSukuk is 125 basis points over 3 months LIBOR payable quarterly, with the Sukukhaving anoverall tenor of 5 years and an option for early redemption. The proceeds of the issue(cash) will



be used by the Issuer to finance the reclamation of the land and the development of BaseInfrastructure through multiple project finance (Istisna) agreements. As the workscarried outunder each Istisna are completed by the Contractor and delivered to the Issuer, the

Issuer willgive notice to the Project Company under the Master Ijara Agreement and will leasesuch BaseInfrastructure on the basis of a lease to own transaction.

7. Hybrid SukukConsidering the fact that Sukuk issuance and trading are important means of investment andtaking intoaccount the various demands of investors, a more diversified Sukuk - hybrid or mixed assetSukuk -emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna,Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of differentclasses allows

for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot betraded onsecondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukukmustcomprise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabahaand Istisnareceivables are part of the pool, the return on these certificates can only be a predeterminedfixed rate of return.

Steps involved in the structure:a) Islamic finance originator transfers tangible assets as well as Murabaha deals to theSPV.

b) SPV issues certificates of participation to the Sukuk holders and receive funds. Thefundsare used by the Islamic finance originator.c) Islamic finance originator purchases these assets from the SPV over an agreedperiod of time.d) Investors receive fixed payment of return on the assets.Centre of Islamic Banking & Economics

Hybrid Sukuk in practiceIslamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8%Sukuk al-

Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuancerequired theIDB¶s guarantee in order to secure a rating and international marketability. The $ 400millionIslamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a specialpurposecompany incorporated in Jersey Channel Islands. The Islamic Corporation for theDevelopment



of Private Sector (ICD) played an intermediary role by purchasing the asset from IDBand sellingit to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.

ConclusionThe market for Sukuk is now maturing and there is an increasing momentum in the

wake of interest from issuers and investors. Sukuk have confirmed their viability as analternative meansto mobilize medium to long-term savings and investments from a huge investor base.Different Sukuk structures have been emerging over the years but most of the Sukukissuance todate has been Ijara Sukuk, since they are based on the undivided pro-rata ownership of theunderlying leased asset, it is freely tradable at par, premium or discount. Tradability of the Sukukin the secondary market makes them more attractive. Although less common than Ijara

Sukuk,other types of Sukuk are also playing significant role in emerging markets to helpissuers andinvestors alike to participate in major projects, including airports, bridges, power plantsetc. Thesovereign Sukuk issues, following Malaysia¶s lead, are enjoying widespread andpositiveacclaim among Islamic investors and global institutional investors alike.Originator SPVInvestors1. Transfer of

Tangibles assets,Mudaraba Deal4. Fix Payment of theReturn on the Asset3. Purchase of asset (Ijarah, Mudaraba , IstisnaContacts )2. Sukuk Proceeds2. DirectResourceCentre of Islamic Banking & Economics

8. Classic Sukuk structureOver the last few years there has been a dramatic growth in the use of Islamicfinancetechniques in raising capital that complies with the requirements of Sharia¶h law.

According to recent reports assets invested in an Islamic, Sharia¶h compliant, manner are nowestimated to exceed US$250 billion with the pool of money held by Muslim investorsestimatedat US$1.5 trillion (and growing rapidly with high oil prices).



The growth of the Sukuk market, which only opened in 2002 with the MalaysiangovernmentUS$600 million Sukuk issue, is a prime indicator of this trend. By 2004, US$6.7 billion of capital was raised through the issue of Sukuk and in the first six months of 2005 thetotal raised

reached US$6.2 billion.Under the Holy Qoran, interest (riba) earned on money (for example, a loan) isforbidden, butmany other types of finance are allowed. The basic principle behind the Sukuk is thatthe holder has an undivided ownership interest in a particular asset and is therefore entitled to thereturngenerated by that asset. The classic Sukuk structure involves an acquisition of aproperty asset bya special purpose company (SPC) established in a tax neutral jurisdiction. The companyfunds

itself by the issue of Sukuk, declaring a trust in favor of the Sukuk holders. The Sukukholdersreceive a return based on the rental income of the asset, taking the credit risk of theunderlyinglessee (see box "Classic structure").

Increasing interestThe growth in the Sukuk market is due to the confluence of a number of factors rangingfrom thegeopolitical impact of the 9/11 atrocities to a more general interest in developingSharia¶hcompliant products and structures. The fundamental drivers behind the Sukuk market

are thesame as those for the conventional securities market as it aims to:a) Broaden the pool of investors.b) Spread risk away from financial institutions.c) Disintermediate the link between investors and borrowers.

Although the market is relatively small, the excess liquidity currently being pumped intoGulf economies means that another pool of investment funds is becoming available tocorporatetreasurers. As the market is developing rapidly and the jurisprudence from the Islamicscholars is

becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP(TrustCertificate Issuance Program) established by the Islamic Development Bank (IDB) inMay 2005marks a further step in the development of the Sukuk market with the IDB able to usesome of the financial assets on its balance sheet to underpin Sukuk issues under a medium termnote



(MTN) like program structure. The TCIP structure is similar to that outlined above withtheCentre of Islamic Banking & Economics

underlying assets being a mixture of Ijara (lease), Murabaha (installment sale) andIstisna(conditional sale) contracts.

Eligible assetsThe main stumbling block for accessing the Sukuk market is the availability of underlying assetsthat generate a Sharia¶h compliant income stream. An interest-derived income streamwill not beeligible for inclusion in a Sukuk, but a rental-based income stream (whether from realestate or movable property) is ideal. The most popular asset class to date is real estate whererentalincome can be generated to provide cash flow returns to holders and repurchaseobligations canbe entered into to ensure principal repayments on the scheduled maturity dates. Other eligibleassets have included aircraft, car fleets, pipelines and large air conditioning units.

EnforceabilityBefore being brought to market any Sukuk will need a declaration or opinion fromSharia¶hscholars that the relevant transaction complies with Sharia¶h law. There has been adegree of confusion as to the interplay between compliance with Sharia¶h law and with theenforceability

of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v BeximcoPharmaceuticalsLtd & Ors, the Court of Appeal held that an Islamic financing agreement which wasexpressed tobe governed by both English and Sharia¶h law was governed by English law. The courtheld thatthe question of whether or not a contract was Sharia¶h compliant does not have abearing on itsenforceability. This confusion can of course be minimized by clear drafting.

Model of Classic SukukContractor/Builder SPV End Buyer Sale of AssetsFor Example BuildingProfit Earned on Asset3. Issue of SukukRent, Able to vary for example by reference toKIBORRepurchase of Asseton Maturity dateRedemption of Sukuk



on Maturity date

Classic SukukStructureCentre of Islamic Banking & Economics

The future of SukukInvestors worldwide have readily accepted these certificates in diversifying their portfoliosuchthat for quite sometime demand over strips supply given that whoever buy them willkeep thepapers until maturity. For the purpose of funding, more and more relevant parties haveresortedto Sukuk as a method of raising funds needed for business and infrastructure projects.

As suchdemand for Sukuk is anticipated to grow further especially if we take into account thesurplusliquidity currently present in the market as a result of the high oil revenues kept by manyoilexporting countries especially in the Middle East.But why in the first place an investor would buy Sukuk rather than normal conventionalbonds?The answer lies, putting Islamic motive aside, partly because investment in Sukuk givessomesort of relief to investors when it is said that Sukuk are less volatile as compared toconventionalbonds since they are basically asset-backed and not just a mere securitization of futurecash flowin the form of debts payable in future as practiced in conventional securitization.In Sukuk, when an investor purchases the certificates, he in fact purchases an

undivided share or interest in the underlying assets which back the Sukuk issuance. In order to comply withSharia¶hrequirements these assets must be essentially tangible assets, and the position of theinvestor must be one of a full owner throughout the tenure of the Sukuk. Ownership in thiscontact mustmeans full ownership as understood in Sharia¶h law that confers all rights and privilegesto therelevant owner who, on his part, is entitled to receive whatever income that can begenerated by

the asset including possible rise in its value.However a pertinent issue would arise if Sukuk structure does not take Sharia¶hguidelineseriously for example when Sukuk are structured based on methods used inconventionalmercerization which is typically a lending by investors to the seekers of fund in thecapital



market. Sukuk are not debt instruments simply because they are essentially backed byrealtangible assets as opposed to debts or receivable as is the case with conventionalbonds. Thismajor difference leads to a different outcome; since Sukuk are not based on debts,

returns of investment to the relevant investors can not be viewed in the context of fixed incomesbecausewhat the investors would received depends largely on the real performance of theunderlyingasset. Therefore to talk of Sukuk as fixed income instruments is both misleading andinaccurate.Even in the context of Sukuk al-Ijarah where the anticipated returns to investors arelikely toflow from rental streams, investors can not be guaranteed of fixed incomes based onsuch streams that in themselves can not assured. It may be happen that the relevant

underlyingtenancies or leasing contracts need to be terminated earlier due to some misfortune or naturalcalamities or the asset may be lost or destroyed due to faults of no one. Under thesekinds of circumstances, the right of the investors to the payment of the stipulated returns or income couldnot be continued and nothing could be done in term of the manager¶s liability. In fact thecontractitself will become frustrated due to the reasons. Furthermore, a future income stream aspreviously described can not under the Sharia¶h law be securitized in the first place as itconstitutes a non-established liability on the part of the tenants. It will becomeestablished onlyCentre of Islamic Banking & Economics

when the tenants have utilized the period of leasing, but have yet to pay the necessaryrental tothe owner of the assets.Given the fact that Sukuk are basically financial instruments used for investmentpurposes, theissue of risk for return is central to the operation of the Sukuk. Investors who buy themareexpected, as owners of the underlying assets, to be ready to face risk of loss or diminution of

their capital or value of the purchased assets. In line with this, the issuer is not dutybound toguarantee any payment of fixed income to the investors be it in the form of regular dividend or capital gain emanating from any possible increase in the value of the underlying assets.What theissuer must do however is to provide an undertaking to exercise his level best tomanage the



investment so that it is profitable, in which case the parties will share the realized profitbased onan agreed ratio. Any form of guarantee that covers capital protection or payment of certain fixedrate return or dividend runs counter to the Islamic theory or notion of risk for return

principle.One issue that has been recently raised is related to the way Sukuk were structured inthe pastfew years when it was discovered that in many cases, the issuers normally made non-revocableundertaking to repurchase the Sukuk at certain prices fixed in advance in case of default or nonadherenceto the term of the issuance. This kind of undertaking that creates an obligation on thepart of the issuer when the triggering events do take place will undoubtedly lead to aguaranteeof capital that is not in line with the Sharia¶h requirement.

However this point needs further clarification to clear the doubt that has been lingeringaroundabout the Sharia¶h compliance aspect of these Sukuk. Any undertaking to repurchasemade onthe basis of possible breach or wrongdoing or negligence on the part of the issuer, whoispossibly a fund or project manager (Sukuk Mudaraba) or even a partner in an Islamicpartnership(Sukuk Musharaka), will not violate any Sharia¶h principle because as per the Sharia¶h,themanager is to be held liable for any loss resulting from either his negligence or wrongdoing or both.In other words, the insertion of such an undertaking is just to reemphasize a Sharia¶hrulepertaining to the possible liability of the manager/issuer in case of negligence or wrongdoing. If however, the undertaking seeks to cover the investor more that what he is entitled tounder theSharia¶h law i.e to cover for the manager¶s liability even though there is no fault on hispart, thenthis will trigger a Sharia¶h compliance issue.In the context of obligation to repurchase in the event of default as is commonlyprovided inSukuk documents, if default here means inability to pay returns or dividend as agreed,thiscondition/undertaking needs to be further clarified to refer only to cases where suchinability isdue to the issuer¶s negligence or wrongdoing. From Sharia¶h perspective oncenegligence or



wrongdoing is committed, the issuer or manager by that account has changed hisSharia¶h statusfrom that of a trustee (whose liability is based on fault) to one of a wrongdoer who bythus isunder the duty to repay the investors their investment capital. In order to discharge this

duty, therelevant assets must be liquidated or sold for value, and the money be paid back to theinvestors.Centre of Islamic Banking & Economics

Whatever the outcome of the present discourse on the Sharia¶h compliance aspect of Sukuk, onething that must be understood by all is that the notion of risk for return or no pain nogain is therein the Sharia¶h to be implemented in practice and not just be treated as a mere theoryrepeatedtime after time. Furthermore if Islamic finance is to be conducted truly on the basis of Sharia¶hguidance, then it is incumbent on all parties involved to subscribe sincerely to therelevant ruleboth in form and substance.

Documents

What is Sukuk