By Usman Hayat
Dubai World is presenting creditors with a restructuring plan for $26bn of debt. Questions remain about how Islamic financial structures will fare in financial distress. Usman Hayat discusses the role of sukuk after recent defaults.
Sukuk are a nascent segment of capital market instruments that comply with sharia (Islamic law). The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Bahrain-based Islamic financial standard setter, defines sukuk as “certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”.
The Central Bank of Bahrain issued the first sovereign sukuk in 2001. According to the London-based International Financial Services Limited, sukuk accounted for 10 per cent of the estimated $951bn (£626bn, €711bn) in global Islamic financial assets under management in 2008. Sukuk are often portrayed as one of the most promising instruments in Islamic finance.
What is the primary difference between sukuk and conventional bonds?
Sukuk represent ownership of real assets, whereas conventional bondholders own debt. In Islamic teachings, “money now for more money later” is widely held to fall within the scope of riba (the giving or receiving of interest), which is forbidden to Muslims. Between money and return should stand an asset and/or an enterprise—hence, the emphasis on ownership of assets in sukuk. Thus, in principle, sukuk should not be referred to as “Islamic bonds”.
- What is the form vs substance debate regarding sukuk?
From an economic perspective, the ongoing form versus substance debate in Islamic finance generally refers to the view that some modern debt-based structures appear to be the trading or leasing of assets but are actually financing with an embedded cost of financing. In the case of sukuk, the debate often pertains to whether the structure is asset-based or asset-backed.
- What is the difference between asset-backed and asset-based sukuk?
The key difference is the concept of true sale. In asset-backed sukuk, there is a true sale between the originator and the special purpose vehicle (SPV) that issues the sukuk and sukuk holders do not have recourse to the originator. Assets are owned by the SPV, returns are derived from assets, and asset prices may vary over time. The majority of sukuk issues, however, are not asset backed.
- Are sukuk closer to equity or to debt?
Sukuk can be structured in a variety of ways. In terms of risk/return profile, asset-backed sukuk are arguably closer to an equity position because sukuk holders own the underlying asset and have no recourse to the originator in the event of a payment shortfall. Asset-based sukuk are closer to debt because sukuk holders have recourse to the originator if there is a shortfall in payments.
- Are sukuk holders treated differently from conventional bondholders in the event of default?
Defaults pertaining to sukuk are a recent phenomenon, and how the underlying legal structures would fare in a court of law vis-à-vis conventional bonds is uncertain. Although sukuk must comply with Islamic law, they are governed as well by the secular law under which they are issued, like bonds. In the case of Dubai World, a last-minute bail-out by Abu Dhabi has obviated the need to address this question directly.
Legal precedents that would provide more legal certainty will take time.
- Are there global sharia standards to help investors determine whether a sukuk structure is sharia compliant?
Currently, there are no global sharia standards. Those issued by AAOIFI have broad appeal, but differences in interpretation remain. The need for global standards was highlighted when AAOIFI issued a statement on sukuk in February 2008 amid criticism that the majority of sukuk were structured such that they were not in strict compliance with Islamic teachings. Because risk/reward sharing fits well with Islamic teachings, equity-like structures in socially responsible businesses are likely to be seen as compliant.
- What issues have arisen following recent defaults in sukuk?
One of the most critical issues is whether the SPV—and thus sukuk holders—completely owns the underlying assets. In addition, the role and efficacy of sharia governance arrangements and due diligence for sharia compliance have attracted attention. Given the relatively nascent stage of development of sukuk in particular and of Islamic finance in general, sukuk are likely to continue to evolve.
-- Usman Hayat is director of Islamic finance and ESG at CFA Institute