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POST GRADUATE DIPLOMA IN ISLAMIC BANKING & FINANCE

SUKUK, ISLAMIC FUND & INVESTMENTS

IB&F: 411: Types and Structure of Sukuk

AlHuda CIBE

TYPES & STRUCTUREOF SUKUK (ISLAMIC BOND)

IB&F: 411

“Malaysia has a robust Islamic liquidity management system that work simultaneously form product varieties, payments systems, market players and most importantly comprehensive regularity frameworks that govern Islamic financial practices”

Hijah Arifa Othman, Managing Dir. & CEO Hong Leong Islamic Bank

C O N T E N T S

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l· Types of Sukukl· Classic Sukuk Structurel· Sukuk & Their Contemporary Applicationsl· Summaryl· Discussion Questionsl· Supplement Material

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TYPES OF SUKUK

There are many types of Sukuk, but Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) recommend the 14 models of Sukuk with Shari'ah compliance. These types depend upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are Mudaraba, Ijarah, Musharaka, Salam and Istisna.

Mudaraba Sukuk

These are investment Sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such Sukuk are the Rabbul-mal (AAOIFI). Mudaraba Sukuk is used for enhancing public participation in big investment projects.

Following are the salient features of Mudaraba Sukuk:

n Mudaraba Sukuk (MS) represent common ownership and entitle their holders share in the specific projects against which the MS has been issued.

n The MS contract is based on the official notice of the issue of the prospectus which must provide all information required by Shari'ah for the Qirad contract such as the nature of capital, the ratio for profit distribution and other conditions related to the issue, which must be compatible with Shari'ah.


Mudaraba Sukuk is

used for enhancing

public participation

in big investment

projects.

TIP

Keep In Mind

The Sukuk structures rely on the creation of a Special 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 even

accumulation of returns from various Sukuk (a hybrid Sukuk).

n The MS holder is given the right to transfer the ownership by selling the deeds in the securities market at his discretion. The sale of MS must follow the rules listed below.

o 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 the rules of bai al-Sarfwould be applied.

o If Mudaraba capital is in the form of debt then it must satisfy the principles of debt trading in Islam.

o If capital is in the form of combination of cash, receivables, goods, real assets and benefits, trade must be based on market price evolved by mutual consent.

n The Manager/SPV who receives the fund collected from the subscribers to MS can also invest his own fund. He will get profit for his capital contribution in addition to his share in the profit as Mudarib.

n Neither prospectus nor MS should contain a guarantee, from the issuer or the manager for the fund, for the capital or a fixed profit, or a profit based on any percentage of the capital. Accordingly,

o The prospectus or the MS issued pursuant to it, may not stipulate payment of a specific amount to the MS holder,

o The profit is to be divided, as determined by applying rules of Sharia'h that is, an amount access of the capital, and not the revenue or the yield.

o Profit and Loss account of the project must be published and disseminated to MS holders.

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Glossary:

Bai Al-Sarf: Basically, in pre-Islamic times it was exchange of gold for gold, silver for silver and gold for silver or vice versa. In Islamic law such exchange is regarded as 'sale of price for price and each price is consideration of the other. It also means sale of monetary value for monetary value – currency exchange.


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n It is permissible to create reserves for contingencies, such as loss of capital, by deducting from the profit.

n The prospectus can also contain a promise made by a third party, totally un-related to the parties to the contract, in terms of legal entity or financial status, to donate a specific sum, without any counter benefit, to meet losses in the given project, provided such commitment is independent of the Mudaraba contract.

On the expiry of the specified time period of the subscription, the Sukuk holders are given the right to transfer the ownership by sale or trade in the securities market at their discretion.

Steps Involved in the Structure

The steps involved in the Mudaraba Sukuk structure are as follows:

n Mudarib enters into an agreement with project owner for construction/ commissioning of project.

n SPV issues Sukuk to raise funds.n Mudarib collects regular profit payments and final capital proceeds

from project activity for onward distribution to investors.n Upon completion, Mudarib hands over the finished project to the

owner.

It is permissible to

create reserves for

contingencies, such

as loss of capital, by

deducting from the

profit.

TIP


Mudaraba Sukuk in Practice

Shamil Bank of Bahrain raised 360 million Saudi Riyal Investment Capital through the Al Ehsa Special Realty Mudaraba, representing an investment participation in a land development transaction with a real estate development company in the Kingdom of Saudi Arabia. The investment objective of the Mudaraba is to provide investors with annual returns arising from participation in the funding of a land financing transaction Profits due to investors will be accrued on the basis of returns attained from investing the subscriptions.

Musharaka Sukuk

These are investment Sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba Sukuk except in the organization of the relationship between the party issuing such Sukuk and holders of these Sukuk, whereby the party issuing Sukuk forms a committee from the holders of the Sukuk who can be referred to in investment decisions (AAOIFI).

Musharaka Sukuk is used for mobilizing the funds for establishing a new project or developing an existing one or financing a business activity on the basis of partnership contracts. The certificate 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 negotiable instruments and can be bought and sold in the secondary market.

“These are certificates of equal value issued with the aim of using the mobilized funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate holders become the owners of the project or assets of the activity as per their respective shares, with the Musharaka certificates being managed on the basis of participation or Mudaraba or an investment agency.” (AAOIFI Standard 17, 3/6)

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Musharaka

Certificate Holders

become the owners

of the project or the

assets of the activity

as per their

respective shares.

TIP



Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangement for a fixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buy Musharaka shares of the SPV on a periodic basis.

n Corporate (as Musharik) contributes land or other physical assets to the Musharaka.

n SPV (as Musharik) contributes cash i.e. the issue Proceeds received from the investors to the Musharaka.

n The Musharaka appoints the Corporate as an agent to develop the land (or other physical assets) with the cash injected into the Musharaka and sell/lease the developed assets on behalf of the Musharaka.

n In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentive fee payable.

n The profits are distributed to the Sukuk holders.n The Corporate irrevocably undertakes to buy at a pre-agreed price

the Musharaka shares of the SPV on say semi-annual basis and at the end of the fixed period the SPV would no longer have any shares in the Musharaka.

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Keep In Mind

Musharaka Sukuk is used for mobilizing the funds for establishing a new

project or developing an existing one or financing a business activity on the

basis of partnership contracts. The certificate 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 negotiable instruments and can

be bought and sold in the secondary market.

Corporate and the

Special Purpose

Vehicle (SPV) enter

into a Musharaka

Arrangement for a

fixed period and an

agreed profit-

sharing ratio.

TIP


Musharaka Sukuk in Practice

Sitara Chemical Industries Ltd, a public limited company, made a public issue of profit-and-loss sharing based term finance certificates (TFC's) worth Rs 360 million which were subscribed in June 2002. The TFC's had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company.

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

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Ijarah Sukuk

These are Sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These Sukuk give their owners the right to own the real estate, receive the rent and dispose of their Sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such Sukuk bear all cost of maintenance of and damage to the real estate. (AAOIFI)

Ijarah Sukuk is the securities representing ownership of well defined existing and known assets tied 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 be made before beginning of the lease period, during the period or after the period as the parties may mutually decide. This flexibility can be used to evolve different forms of contract and Sukuk that may serve different purposes of issuers and the holders.

Features of Ijarah Sukuk

Features of Ijarah Sukuk are as follows:

n It is necessary for an Ijarah contract that the assets being leased and the amount of rent both are clearly known to the parties at the time of the contract and if both of these are known, 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 be able to acquire, construct or buy the asset being leased by the time set for its delivery to the lessee (AAOIFI, 2003: 140-157). The lessor can sell

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Ijarah Sukuk

represents

ownership of equal

shares in a rented

real estate or the

usufruct of the real

estate.

TIP

Keep In Mind

Ijarah Sukuk is the securities representing ownership of well defined

existing and known assets tied 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 be made before

beginning of the lease period, during the period or after the period as the

parties may mutually decide.


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the leased asset provided it does not hinder the lessee to take benefit from the asset. The new owner would be entitled to receive the rentals.

n Rental in Ijarah must be stipulated in clear terms for the firs term of lease, and for future renewable terms, it could be constant, increasing or decreasing by benchmarking or relating it to any well-known variable.

n As per Shari'ah rules, expenses related to the corpus or basic characteristics of the assets are the responsibility of the owner, while maintenance expenses related to its operation are to be borne by the lessee.

n As regards procedure for issuance of Ijarah Sukuk, an SPV is created to purchase the asset(s) that issues Sukuk to the investor, enabling it to make payment for purchasing the asset. The asset is then leased to third party for its use. The lessee makes periodic rental payments t the SPV that in turn distributes the same to the Sukuk holders.

n Ijarah Sukuk is completely negotiable and can be traded in the secondary markets.

n Ijarah Sukuk offers a high degree of flexibility from the point of view of their issuance management and marketability. The central government, municipalities, awqaf or any other asset users, private or public can issue these Sukuk. Additionally, they can be issued by financial intermediaries or directly by users of the leased assets.

Steps Involved in Ijarah Sukuk Structure

The steps involved in the structure of Ijarah Sukuk are as follows:

n The obligator sells certain assets to the SPV at an agreed pre-determined purchase price.

n The SPV raises financing by issuing Sukuk certificates in an amount equal to the purchase price.

Ijarah Sukuk offers

a high degree of

flexibility from the

point of view of their

issuance

management and

marketability.

TIP


n This is passed on to the obligator (as seller).n 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.

n SPV receives periodic rentals from the obligator.n These are distributed among the investors i.e. the Sukuk holders.n At maturity, or on a dissolution event, the SPV sells the assets back to

the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijarah Sukuk.

Ijarah Sukuk in Practice

In December 2000, Kumpulan Guthrie Berhad (Guthrie) was granted a RM1.5 billion (US$400 million) Al-Ijarah Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facility was raised 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 the Sukuk Transaction.

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Murabaha Sukuk

In this case the issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realized funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the Commodity. The possibility of having legally acceptable Murabaha-based Sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by Shari'ah, as the certificates represent a debt owing from the subsequent buyer of the Commodity to the certificate-holders and such trading 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 the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or Ijarah Sukuk. Murabaha Sukuk is popular in Malaysian market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.

Steps involved in the Structure

The steps involved in the structure of Murabaha Sukuk are as follows:

n A master agreement is signed between the SPV and the borrowern SPV issues Sukuk to the investors and receive Sukuk proceeds.n SPV buys commodity on spot basis from the commodity supplier.n SPV sells the commodity to the borrower at the spot price plus a

profit margin, payable on installments over an agreed period of timen The borrower sells the commodity to the Commodity buyer on spot

basis.n The investors receive the final sale price and profits.


A GLANCE AT THE GLOBAL SUKUK MARKET

The Islamic bond has recorded an enormous growth in last five years as compared to traditional bond issuance. The Sukuk market has grown from $11bn issued in 2005 to $50bn in 2010, according to the Deutsche Bank Global Markets Research report on Islamic Finance.

However, the contribution of Sukuk market remains tiny compared with the conventional debt market, hovering around 1.4 percent of the total market in terms of volumes.

Given this low base, the report suggests that the Sukuk industry could continue to grow with pace for some time, providing significant upside to fee income growth for Islamic Financial Institutions involved in this market segment. Moreover, it has been witnessed that major corporate has also jumped into the untapped market to diversify their funding structure. The Islamic credit market represents a more feasible and shorter-term reality for the corporate sector.

During last five years, several blue chip companies outside the Middle East and Southeast Asia have already tapped the Sukuk market to issue paper. One of the most visible issuers has been General Electric (GE), which issued $500 million Sukuk in late 2009, listed in Malaysia. Goldman Sachs also recently announced the creation of $2 billion Islamic funding program, although has not yet come to market.

According to the report, the ongoing deleveraging by major companies after the global financial turmoil would prompt other corporate houses to explore other alternatives to their traditional funding avenues.

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Salam Sukuk is

certificates of equal

value issued for the

purpose of

mobilizing Salam

capital

TIP


lam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in return for a promise to deliver a commodity at a future date. SPV can also appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The difference between the purchase price and the sale price is the profit to the SPV and hence to the holders of the Sukuk.

All standard Shari'ah requirements that apply to Salam also apply to Salam Sukuk, such as, full payment by the buyer at the time of affecting the sale, standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like.

One of the Shari'ah conditions relating to Salam, as well as for creation of Salam Sukuk, is the requirement that the purchased goods are not re-sold before actual possession at maturity. Such transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence somewhat less attractive to investors. Thus, an investor will buy a Salam certificate if he expects prices of the underlying commodity to be higher on the maturity date.Steps involved in Salam Sukuk Structure

The steps involved in the structure of Salam Sukuk are as follows:

n SPV signs an undertaking with an obligator to source both commodities and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.

n Salam certificates are issued to investors and SPV receives Sukuk proceeds.

n The Salam proceeds are passed onto the obligator who sells commodity on forward basis

n SPV receives the commodities from the obligatorn Obligator, on behalf of Sukuk holders, sells the commodities for a

profit.n Sukuk holders receive the commodity sale proceeds.

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The difference

between the

purchase price and

the sale price is the

profit to the SPV and

hence to the holders

of the Sukuk.

TIP


Salam Sukuk in Practice

Aluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, where by it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to al Salam security holder's equivalent to those available through other conventional short-term money market instruments.

Istisna Sukuk

Istisna Sukuk are certificates that carry equal value and are issued with the aim of mobilizing the funds 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 the intended product, while the funds realized from subscription are the cost of the product. The certificate holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on

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the basis of a parallel Istisna, if any. Istisna Sukuk is quite useful for financing large infrastructure projects. The suitability of Istisna for financial intermediation is based on the permissibility for the contractor in Istisna to enter into a parallel Istisna contract with a subcontractor. Thus, a financial institution may undertake the construction of a facility for a deferred price, and sub contract the actual construction to a specialized firm.Shari'ah 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.


The steps involved in the structure of Istisna Sukuk are as follows:

n SPV issues Sukuk certificates to raise funds for the project.n Sukuk issue proceeds are used to pay the contractor/builder to build

and deliver the future project.n Title to assets is transferred to the SPVn Property/project is leased or sold to the end buyer. The end buyer

pays monthly installments to the SPV.n The returns are distributed among the Sukuk holders.

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Istisna Sukuk are

certificates that

carry equal value

and are issued with

the aim of

mobilizing the funds

required for

producing products

that are owned by

the certificate

holders.

TIP


Hybrid Sukuk

Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk - hybrid or mixed asset Sukuk - emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijarah. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijarah Sukuk. Due to the fact the Murabaha and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return.


The steps involved in the structure of Hybrid Sukuk are as follow:

n Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.

n SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are used by the Islamic finance originator.

n Islamic finance originator purchases these assets from the SPV over an agreed period of time.

n Investors receive fixed payment of return on the assets.

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In a hybrid Sukuk,

the underlying pool

of assets can

comprise of Istisna,

Murabaha

receivables as well

as Ijarah.

TIP


Hybrid Sukuk in Practice

Islamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijarah, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance required the IDB's guarantee in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the Development of Private Sector (ICD) played an intermediary role by purchasing the asset from IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.

Conclusion

The 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 an alternative means to 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 Sukuk issuance to date has been Ijarah Sukuk, since they are based on the undivided pro-rata ownership of the underlying leased asset, it is freely tradable at par, premium or discount.

Tradability of the Sukuk in the secondary market makes them more attractive. Although less common than Ijarah Sukuk, other types of Sukuk are also playing significant role in emerging markets to help issuers and investors alike to participate in major projects, including airports, bridges, power plants etc. The sovereign Sukuk issues, following Malaysia's lead, are enjoying widespread and positive acclaim among Islamic investors and global institutional investors alike.

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Since Sukuk is based

on the undivided

pro-rata ownership

of the underlying

leased asset, it is

freely tradable at

par, premium or

discount.

TIP


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Classic Sukuk Structure

Over the last few years there has been a dramatic growth in the use of Islamic finance techniques in raising capital that complies with the requirements of Shari'ah law.

The Islamic bond has recorded an enormous growth in last five years as compared to traditional bond issuance. The Sukuk market has grown from $11bn issued in 2005 to $50bn in 2010, according to the Deutsche Bank Global Markets Research report on Islamic Finance.

However, the contribution of Sukuk market remains tiny compared with the conventional debt market, hovering around 1.4 percent of the total market in terms of volumes.

Under the Holy Quran, interest (Riba) earned on money (for example, a loan) is forbidden, but many other types of finance are allowed. The basic principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a special purpose company (SPC) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favor of the Sukuk holders. The Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee.

Increasing Interest

The growth in the Sukuk market is due to the confluence of a number of factors ranging from the geopolitical impact of the 9/11 atrocities to a more general interest in developing Shari'ah compliant products and structures. The fundamental drivers behind the Sukuk market are the same as those for the conventional securities market as it aims to:

n Broaden the pool of investors.n Spread risk away from financial institutions.n Disintermediate the link between investors and borrowers.


Although the market is relatively small, the excess liquidity currently being pumped into Gulf economies means that another pool of investment funds is becoming available to corporate treasurers. As the market is developing rapidly and the jurisprudence from the Islamic scholars is becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP (Trust Certificate Issuance Program) established by the Islamic Development Bank (IDB) in May 2005 marks a further step in the development of the Sukuk market with the IDB able to use some of the financial assets on its balance sheet to underpin Sukuk issues under a medium term note (MTN) like program structure. The TCIP structure is similar to that outlined above with the underlying assets being a mixture of Ijarah (lease), Murabaha (installment sale) and Istisna (conditional sale) contracts.

Eligible Assets

The main stumbling block for accessing the Sukuk market is the availability of underlying assets that generate a Shari'ah compliant income stream. An interest-derived income stream will not be eligible for inclusion in a Sukuk, but a rental-based income stream (whether from real estate or movable property) is ideal. The most popular asset class to date is real estate where rental income can be generated to provide cash flow returns to holders and repurchase obligations can be entered into to ensure principal repayments on the scheduled maturity dates. Other eligible assets have included aircraft, car fleets, pipelines and large air conditioning units.

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As the Sukuk

market is developing

rapidly and the

jurisprudence from

the Islamic scholars

is becoming more

settled, the issue

costs for a Sukuk

structure continue to

fall.

TIP

Keep In Mind

The most popular asset class to date is real estate where rental income can

be generated to provide cash flow returns to holders and repurchase

obligations can be entered into to ensure principal repayments on the

scheduled maturity dates.


Enforceability

Before being brought to market any Sukuk will need a declaration or opinion from Shari'ah scholars that the relevant transaction complies with Shari'ah law. There has been a degree of confusion as to the interplay between compliance with Shari'ah law and with the enforceability of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd & Ors, the Court of Appeal held that an Islamic financing agreement which was expressed to be governed by both English and Shari'ah law was governed by English law. The court held that the question of whether or not a contract was Shari'ah compliant does not have a bearing on its enforceability. This confusion can of course be minimized by clear drafting.

Model of Classic Sukuk

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Before being

brought to market

any Sukuk will need

a declaration or

opinion from

Shari’ah scholars

that the relevant

transaction complies

with Shari’ah law.

TIP


THE FUTURE OF SUKUK

Investors worldwide have readily accepted these certificates in diversifying their portfolio such that for quite sometime demand over strips supply given that whoever buy them will keep the papers until maturity. For the purpose of funding, more and more relevant parties have resorted to Sukuk as a method of raising funds needed for business and infrastructure projects. As such demand for Sukuk is anticipated to grow further especially if we take into account the surplus liquidity currently present in the market as a result of the high oil revenues kept by many oil exporting countries especially in the Middle East.

But why in the first place an investor would buy Sukuk rather than normal conventional bonds? The answer lies, putting Islamic motive aside, partly because investment in Sukuk gives some sort of relief to investors when it is said that Sukuk are less volatile as compared to conventional bonds since they are basically asset-backed and not just a mere securitization of future cash flow in 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 with Shari'ah requirements these assets must be essentially tangible assets, and the position of the investor must be one of a full owner throughout the tenure of the Sukuk. Ownership in this contact must means full ownership as understood in Shari'ah law that confers all rights and privileges to the relevant owner who, on his part, is entitled to receive whatever income that can be generated by the asset including possible rise in its value.

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Investment in Sukuk

gives some sort of

relief to investors

when it is said that

Sukuk are less

volatile as compared

to conventional

bonds.

TIP

Keep In Mind

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 with Shari’ah requirements these assets

must be essentially tangible assets, and the position of the investor must be

one of a full owner throughout the tenure of the Sukuk.


However a pertinent issue would arise if Sukuk structure does not take Shari'ah guideline seriously for example when Sukuk are structured based on methods used in conventional mercerization which is typically a lending by investors to the seekers of fund in the capital market. Sukuk are not debt instruments simply because they are essentially backed by real tangible assets as opposed to debts or receivable as is the case with conventional bonds. This major 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 incomes because what the investors would received depends largely on the real performance of the underlying asset. Therefore to talk of Sukuk as fixed income instruments is both misleading and inaccurate.

Even in the context of Sukuk al-Ijarah where the anticipated returns to investors are likely to flow from rental streams, investors can not be guaranteed of fixed incomes based on such streams that in themselves can not assured. It may be happen that the relevant underlying tenancies or leasing contracts need to be terminated earlier due to some misfortune or natural calamities or the asset may be lost or destroyed due to faults of no one. Under these kinds of circumstances, the right of the investors to the payment of the stipulated returns or income could not be continued and nothing could be done in term of the manager's liability. In fact the contract itself will become frustrated due to the reasons. Furthermore, a future income stream as previously described can not under the Shari'ah law be securitized in the first place as it constitutes a non-established liability on the part of the tenants. It will become established only when the tenants have utilized the period of leasing, but have yet to pay the necessary rental to the owner of the assets.

21

Sukuk are not based

on debts, returns of

investment to the

relevant investors

can not be viewed in

the context of fixed

incomes

TIP

Keep In Mind

Sukuk are not based on debts, returns of investment to the relevant

investors can not be viewed in the context of fixed incomes because what

the investors would received depends largely on the real performance of

the underlying asset. Therefore to talk of Sukuk as fixed income instruments

is both misleading and inaccurate.


22

Given the fact that Sukuk are basically financial instruments used for investment purposes, the issue of risk for return is central to the operation of the Sukuk. Investors who buy them are expected, 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 duty bound to guarantee 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 the issuer must do however is to provide an undertaking to exercise his level best to manage the investment so that it is profitable, in which case the parties will share the realized profit based on an agreed ratio. Any form of guarantee that covers capital protection or payment of certain fixed rate 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 in the past few years when it was discovered that in many cases, the issuers normally made non-revocable undertaking to repurchase the Sukuk at certain prices fixed in advance in case of default or non-adherence to the term of the issuance. This kind of undertaking that creates an obligation on the part of the issuer when the triggering events do take place will undoubtedly lead to a guarantee of capital that is not in line with the Shari'ah requirement.

However this point needs further clarification to clear the doubt that has been lingering around about the Shari'ah compliance aspect of these Sukuk. Any undertaking to repurchase made on the basis of possible breach or wrongdoing or negligence on the part of the issuer, who is possibly a fund or project manager (Sukuk Mudaraba) or even a partner in an Islamic partnership (Sukuk Musharaka), will not violate any Shari'ah

Sukuk are basically

financial

instruments used for

investment

purposes, the issue

of risk for return is

central to the

operation of the

Sukuk.

TIP

Keep In Mind

The issuer is not duty bound to guarantee 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.


principle because as per the Shari'ah, the manager 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 Shari'ah rule pertaining 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 to under the Shari'ah law i.e. to cover for the manager's liability even though there is no fault on his part, then this will trigger a Shari'ah compliance issue.

In the context of obligation to repurchase in the event of default as is commonly provided in Sukuk documents, if default here means inability to pay returns or dividend as agreed, this condition/undertaking needs to be further clarified to refer only to cases where such inability is due to the issuer's negligence or wrongdoing. From Shari'ah perspective once negligence or wrongdoing is committed, the issuer or manager by that account has changed his Shari'ah status from that of a trustee (whose liability is based on fault) to one of a wrongdoer who by thus is under the duty to repay the investors their investment capital. In order to discharge this duty, the relevant assets must be liquidated or sold for value, and the money be paid back to the investors. Whatever the outcome of the present discourse on the Shari'ah compliance aspect of Sukuk, one thing that must be understood by all is that the notion of risk for return or no pain no gain is there in the Shari'ah to be implemented in practice and not just be treated as a mere theory repeated time after time. Furthermore if Islamic finance is to be conducted truly on the basis of Shari'ah guidance, then it is incumbent on

23

Keep In Mind

Any undertaking to repurchase made on the basis of possible breach or

wrongdoing or negligence on the part of the issuer, who is possibly a fund

or project manager (Sukuk Mud araba) or even a partner in an Islamic

partnership (Sukuk Musharaka), will not violate any Shari’ah principle

because as per the Shari’ah, the manager is to be held liable for any loss

resulting from either his negligence or wrongdoing or both.


all parties involved to subscribe sincerely to the relevant rule both in form and substance.

SUKUK AND THEIR CONTEMPORARY APPLICATIONS

The issuance of Sukuk on the basis of the rules of the Shining Shari'ah of Islam is among the objectives of Islamic banking, and is also one of the greatest means of establishing Islamic economies in society. This, however, is on condition that the tools used to develop and structure Sukuk are in consonance with the fundamental principles which distinguish Islamic economic systems from others.

The interest-based system prevalent in the world today regularly issues bonds that yield interest from capital-intensive enterprises that bring great profits and regular revenues. Yet, the holders of such certificates are no more than lenders to the sponsors of such enterprises; and their earnings come from the interest on their loans in a percentage that accords with the price of interest in the marketplace. The profits of these enterprises after costs, including interest payments, return exclusively to the sponsors. The basic concept behind issuing Islamic Sukuk, however, is for the holders of the Sukuk to share in the profits of large enterprises or in their revenues. If Sukuk are issued on this basis they will play a major role in the development of the Islamic banking business and thereby contribute significantly to the achievement of the noble objectives sought by the Shari'ah.

24

IB&F: 410: Sukuk

Keep In Mind

The basic concept behind issuing Islamic Sukuk, however, is for the holders

of the Sukuk to share in the profits of large enterprises or in their revenues.

If Sukuk are issued on this basis they will play a major role in the

development of the Islamic banking business and thereby contribute

significantly to the achievement of the noble objectives sought by the

Shari’ah.

Article Reference:

The article “Sukuk and their Contemporary Applications” is written by Muhammad

Taqi Usmani.


Among the benefits of Sukuk are the following:

n Sukuk are among the best ways of financing large enterprises that are beyond the ability of a single party to finance.

n Sukuk provide an ideal means for investors seeking to deploy streams of capital and who require, at the same time, the ability to liquidate their positions with ease whenever the need should arise. This is because it is envisioned that a secondary market for the trading of Sukuk will develop. Thus, whenever investors require cash from their investments, or from a part of the same, it will be possible for them to sell their Sukuk holdings, or a part thereof, and receive their value from their original investment plus earnings, if the enterprise is profitable, in cash.

n Sukuk represent an excellent way of managing liquidity for banks and Islamic financial institutions. When these are in need of disposing of excess liquidity they may purchase Sukuk; and when they are in need of liquidity, they may sell their Sukuk into the secondary market.

n Sukuk are a means for the equitable distribution of wealth as they allow all investors to benefit from the true profits resulting from the enterprise in equal shares. In this way, wealth may circulate on a broad scale without remaining the exclusive domain of a handful of wealthy persons. This is clearly among the most important of all the higher purposes sought by an Islamic economic system.

25

Sukuk represent an

excellent way of

managing liquidity

for banks and

Islamic financial

institutions.

TIP

Keep In Mind

Whenever investors require cash from their investments, or from a part of

the same, it will be possible for them to sel l their Sukuk holdings, or a part

thereof, and receive their value from their original investment plus

earnings, if the enterprise is profitable, in cash.


26

Today, there are many Sukuk in the market, all claiming to be Islamic Sukuk. In this brief study, I mean to shed light on the mechanisms they use and on the extent to which these comply with the precepts of Islamic jurisprudence, and its principles, and its higher purposes. The issuers of these Sukuk have expended a great deal of effort to make them competitive with the conventional bonds prevalent in today's capital markets. By endowing these Sukuk with the same characteristics of bonds, they have attempted to facilitate their acceptance in both Islamic and conventional markets.

The most prominent characteristics of conventional bonds may be summarized as follows:

n Bonds do not represent ownership on the part of the bond holders in the commercial or industrial enterprises for which the bonds were issued. Rather, they document the interest-bearing debt owed to the holders of the bonds by the issuer, the owner of the enterprise.

n Regular interest payments are made to the bond holders. The amount of interest is determined as a percentage of the capital and not as a percentage of actual profits. Sometimes the interest is fixed, while oftentimes in bonds with longer tenors the rate of interest is allowed to float.

n Bonds guarantee the return of principal when redeemed at maturity, regardless of whether the enterprise was profitable or otherwise.

Keep In Mind

The most prominent chara cteristics of conventional bonds include that

Bonds do not represent ownership on the part of the bond holders in the

commercial or industrial enterprises for which the bonds were issued.

Rather, they document the interest-bearing debt owed to the holders of the

bonds by the issuer, the owner of the enterprise . Regular interest payments

are made to the shareholders and Bonds guarantee the return of principal

when redeemed at maturity.


27

The issuer of such bonds is not required to return more than the principal and the agreed amount of interest. Whatever profits may have been earned by the enterprise accrue entirely and exclusively to the issuer. So the bond holders have no right to seek a share in the profits beyond the interest.

These characteristics are not to be found in Islamic Sukuk, at least not directly. Even so, the issuers of Islamic Sukuk today have attempted to distinguish their Sukuk, however indirectly, with many of these same characteristics. For this reason they have developed a variety of mechanisms. Let us now study these mechanisms in the light of the following three points.

Bond Holders' Ownership of Enterprise Assets

The first point, or the bond owners' ownership of enterprise assets, is that the majority of Sukuk are clearly different in this respect from interest-based bonds. Generally, Sukuk represent ownership shares in assets that bring profits or revenues, like leased assets, or commercial or industrial enterprises, or investment vehicles that may include a number of projects. This is the one characteristic that distinguishes Sukuk from conventional bonds.

However, quite recently, the market has witnessed a number of Sukuk in which there is doubt regarding their representation of ownership. For example, the assets in the Sukuk may be shares of companies that do not confer true ownership but which merely offer Sukuk holders a right to returns. Such Sukuk are no more than the purchase of returns from shares; and this is not lawful from a Shari'ah perspective. Likewise, there has been a proliferation of certain Sukuk that are based on a mix of Ijarah, Istisna' and Murabaha contracts undertaken by Islamic banks or institutions such that these are packaged and sold to Sukuk holders who hope to obtain the returns from these operations. The inclusion of Murabaha contracts into such Sukuk, however, cannot but bring into question the issue of the sale of debt, even if the percentage of the Murabaha contracts may be considerably less than that of the Ijarah, Musharaka and Istisna' contracts. All of this requires careful review.

Sukuk represent

ownership shares in

assets that bring

profits or revenues

TIP

Generally speaking,

the sale of debt is

prohibited by

Shari’ah Law.

TIP


28

Regular Distributions to Sukuk Holders

In reference to the second point, most of the Sukuk that have been issued are identical to conventional bonds with regard to the distribution of profits from their enterprises at fixed percentages based on interest rates (LIBOR). In order to justify this practice, the issuers include a paragraph in the contract which states that if the actual profits from the enterprise exceed the percentage based on interest rates, then that amount of excess shall be paid in its entirety to the enterprise manager (whether a Mudarib, or a partner, or an investment agent) as an incentive for the manager to manage effectively. I have even seen in the structure of certain Sukuk that they do not state that such excess will become the right of the manager as an incentive but, instead, they state no more than that the holders of the Sukuk will be entitled to a fixed percentage based upon the rate of interest at the time of regular distributions (as if the excess as an incentive was established by estimation or by exigency). If the actual profits are less than the prescribed percentage based on interest rates, then the manager may take it upon himself to pay out the difference (between the actual profits and the prescribed percentage) to the Sukuk holders, as an interest free loan to the Sukuk holders. Then, that loan will be recovered by the lending manager either from the amounts in excess of the interest rate during subsequent periods, or from lowering the cost of repurchasing assets at the time the Sukuk are redeemed as will be explained in detail in the third point, below, Allah willing.

Keep In Mind

If the actual profits are less than the prescribed percentage based on

interest rates, then the manager may take it upon himself to pay out the

difference (between the actual profits and the prescribed percentage) to

the Sukuk holders, as an interest free loan to the Sukuk holders.


29

Guaranteeing the Return of Principal

As to the third point, virtually all of the Sukuk issued today guarantee the return of principal to the Sukuk holders at maturity, in exactly the same way as conventional bonds. This is accomplished by means of a binding promise from either the issuer or the manager to repurchase the assets represented by the Sukuk at the stated price at which these were originally purchased by the Sukuk holders at the beginning of the process, regardless of their true or market value at maturity.

Then, by these complex mechanisms, Sukuk are able to take on the same characteristics as conventional, interest-bearing bonds since they do not return to investors more than a fixed percentage of the principal, based on interest rates, while guaranteeing the return of investors' principal at maturity.

We will now speak about these mechanisms firstly from the perspective of Islamic jurisprudence and secondly from the perspective of the higher purposes of Islamic finance and economics.From the Shari'ah perspective, there are three questions:First: Stipulating the amount in excess of the price of interest for the manager of the enterprise under the pretense that this is an incentive for good management.

Second: The manager's commitment, if the actual profits are less than the yield from the fixed rate of interest during any of the times for distribution, to lend the amount of the shortfall to the holders of the Sukuk. Thereafter the amounts of such loans will be recovered either through the actual profits of the enterprise at the times of following distributions or through the sale of the enterprise's assets at maturity.

Third: The binding promise by the manager that he will purchase the assets represented by the Sukuk at their face value, and not at their market value on the day they are redeemed.


30

One: Stipulating an Incentive for the Manager

With regard to the stipulation of an incentive for the manager of the enterprise, its justification may be found in what certain jurists have mentioned in regard to the lawfulness of offering incentives in contracts of wakalah or in brokerage. Al-Imam al-Bukhari mentioned the same on the authority of the Companion Ibn ̀ Abbas and Ibn Sirin:

Said Ibn ̀ Abbas:"There is no impediment to one's saying, 'Sell this cloth and

whatever is in excess of this or that will be yours.'" Said Ibn Sirin: "When someone says, 'Sell it for this much and whatever profits are realized beyond that will be yours, or will be shared between us,' then there is no problem with that.”

This opinion was adopted by the Hanbali School of jurisprudence. In Al-Kafi by Ibn Qudama it is written:

If someone says, "Sell this for ten, and whatever you receive in excess will be yours," then that excess will be lawful for the seller because Ibn Àbbas did not see any impediment to doing so.

This opinion is recorded by Ibn Abi Shaybah in his Al-Musannaf from Ibn Àbbas, Ibn Sirin, Shurayh, Àmir al-Sha`bi, al-Zuhri, and al-Hakam. Àbd al-Razzaq added Qatada and Ayyub to those who agreed. The arrangement, however, was considered makruh (undesirable) by Ibrahim al-Nakhaì and Hammad, as related by ̀ Abd al-Razzaq, and by al-Hasan al-Basri and Tawus

6ibn Kaysan as related by Ibn Abi Shaybah. This is the opinion of the majority, other than the Hanbali scholars. Al-Hafidh Ibn Hajr commented on the opinion of Ibn ̀ Abbas mentioned by al-Bukhari:

7This, too, refers to the wages of a broker. But, as these are unknown , the majority of jurists have not allowed the arrangement, saying if the broker sells the item for the owner on this basis, he will be entitled to no more than the fee customarily awarded for similar sales. Some jurists have interpreted the statement by Ibn ̀ Abbas to mean that he saw the situation as analogous to that of a partnership. The same interpretation was given by Ahmad ibn Hanbal and Ishaq. Ibn al-Tin recorded that some jurists stipulated, for its acceptance as lawful, that people at the time understand the price of the goods to equal more than what was stated;


31

but his opinion was challenged on the grounds that ignorance of the actual amount of the fee still remains.

Badr al-Din al-Àyni wrote:

As to the opinion of Ibn Àbbas and Ibn Sirin, well, the majority of scholars do not allow such a sale. Among those who disliked it are Sufyan al-Thawri and the jurists from Kufa. Likewise, al-Shafiì and Malik did not allow it. If someone sells on this basis he will be entitled to a fee equal to what is Customary for such a sale. Ahmad and Ishaq, however, have allowed the sale, saying, "This is actually a partnership, for at times a partner will not profit.”

Of course, all of this is said in relation to the fees of a broker if other than the excess over the stated original price of the sale is not specified. However, if the broker's fee is stated as a determined amount, and then the broker is told, 'If you sell this for more than this, the excess will be yours in addition to your predetermined fee,' then it should be clear that the majority will not oppose it.

This is because the ignorance with regard to the fee is lifted when it is determined in advance. Then, if the broker sells the item for more than a certain amount, the excess will be his as an incentive for better management.

If the broker sells

the item for more

than a certain

amount, the excess

will be his as an

incentive for better

management.

TIP

Keep In Mind

if the broker's fee is stated as a determined amount, and then the broker is

told, 'If you sell this for more than this, the excess will be yours in addition

to your predetermined fee,' then it should be clear that the majority will not

oppose it. This is because the ignorance with regard to the fee is lifted when

it is determined in advance.


32

On this basis, the Standard for Mudaraba approved by the Shari'ah Council reads as follows:

“If one of the two parties should stipulate for itself a specific amount (of profit), the Mudaraba will be void. This prohibition, however, is not inclusive of an agreement by the two parties that if the profits exceed a certain percentage then one of those two parties will receive the excess exclusively such that the distribution will be according to what the two have agreed.”

The operations manager in a Sukuk will manage on the basis either of its being a wage-earning employee (Ajir) or an investment agent (Wakil), thus resembling a broker, or on the basis of its being an investment manager (Mudarib), or a working partner (Sharik `amil). All of these possibilities are covered by the Standard.

However, when the jurists gave permission for this arrangement, they did not consider that it would be used to carry out operations on the basis of interest rates or to maintain the status quo of the conventional, Riba-based market. The right of the manager to an amount in excess of the prescribed percentage has been called an incentive for better management of the assets. Such an incentive, however, may only be understood as an incentive if it is linked to what exceeds the minimum amount of expected profits from the commercial or industrial enterprise for which the Sukuk were issued. For example: if the minimum amount of expected profits is 15%, then it may be said that the actual profits in excess of that percentage may be paid to the manager as an incentive.

The Operations

Manager in a Sukuk

will manage on the

basis either of its

being a wage-

earning employee

(Ajir) or an

investment agent

(Wakil)

TIP

Keep In Mind

The right of the manager to an amount in excess of the prescribed

percentage has been called an incentive for better management of the

assets. Such an incentive, however, may only be understood as an i ncentive

if it is linked to what exceeds the minimum amount of expected profits from

the commercial or industrial enterprise for which the Sukuk were issued.


33

This is because that excess amount may logically be ascribed to good management. The problem is that the prescribed percentage in these Sukuk is not linked to the expected profits from the enterprise, but to the costs of financing or to the prevalent rates of interest in the market; rates that vary every day, or every hour of the day. Obviously, there is no connection between these and the profitability of the commercial or industrial enterprise. Oftentimes, this rate will be considerably lower than the expected rate of return from the enterprise. Thus, for example, if the expected rate of return from the enterprise is 15%, the interest rate at the same time may be no more than 5%. If, owing to poor management, the actual rate of return from the enterprise falls to 10%, then how may what is in excess of 5% be given to the manager as a reward for "good

management"? How can this be, even when poor management resulted in profits dipping from [an expected] 15% to only 10%? It should therefore be clear that what is being called an "incentive" in these Sukuk is not truly an incentive but rather a method for marketing these Sukuk on the basis of interest rates. It should also be clear that this aspect is not free of legal repugnance (Karahah), even if we do not declare it prohibited (haram) outright.

The foregoing is from the perspective of Islamic jurisprudence only. From the perspective of the higher purposes of Islamic economics, such "incentives" in today's Sukuk actually defeat the purpose of an Islamic economic system in which wealth is equitably distributed among investors. Sukuk that are based on such "incentives" distribute profits to investors on the basis of prevalent interest rates, and not on the basis of actual returns from an enterprise.

Excess amount may

logically be ascribed

to good

management.

TIP

Keep In Mind

From the perspective o f the higher purposes of Islamic economics, such

"incentives" in today's Sukuk actually defeat the purpose of an Islamic

economic system in which wealth is equitably distributed among investors.

Sukuk that are based on such "incentives" distribute profits to investors on

the basis of prevalent interest rates, and not on the basis of actual returns

from an enterprise.


34

If Shari'ah supervisory boards have tolerated such irregularities when Sukuk began to be issued, and at a time when Islamic financial institutions were few in number, the time has now come to revisit the matter… and to rid Sukuk from now on from such blemishes. Either Sukuk should be free of all such "incentives" or these should be based the enterprise's expected profits. These should certainly not be based on prevalent interest rates. This will then become a truly distinguishing characteristic of Islamic financial institutions, and one that sets them apart from their conventional, interest-based counterparts.

Two: Stipulating Loans when Profits Fall Below Prescribed Percentages

There is absolutely nothing in the Shari'ah to justify a loan when actual profits are less than the prescribed percentages. The one undertaking the loan is the operations manager, and the manager is the one that sells the assets to the Sukuk holders at the beginning of operations. If it is then stipulated that the manager will make loans to the Sukuk holders at times (for distribution) when actual returns fall below the (promised) rate of return, the transaction will come under the heading of a sale with a credit. It is well known that the Prophet, upon him be peace, prohibited sales linked to credits. The same was related by Malik in his al-Muwatta on the authority of trusted narrators (Balaghan), and by Abu Dawud and al-Tirmidhi whose version reads, "A sale and a credit are not lawful." Al-Tirmidhi added, "This is a good and a sound Hadith." In his commentary on this narration, Ibn ̀ Abd al-Barr wrote:

“This hadith is recorded on the authority of Àmr ibn Shuàyb, from his father, from his grandfather, from the Prophet, upon him be peace. It is a sound hadith that has been related by many reliable narrators on the authority of Àmr ibn Shuàyb; and Àmr ibn Shuàyb is a reliable narrator (i.e., his narrations are reliable) when those who relate his narrations are themselves reliable.”

The entire community of scholars is agreed on this (prohibition) and no one is known to have held a dissenting opinion. Ibn Qudamah wrote:

If someone sells on condition that the purchaser give credit (to the seller), or advance him a loan, or if the buyer stipulates the same, that will be unlawful and the sale will be void. This is the opinion of Malik and al-Shafiì, and I know of no dissenting opinion.

Sukuk should be

free of all such

"incentives" or these

should be based the

enterprise's

expected profits.

TIP


35

At another place, he wrote:

If he stipulates that he lease his house to him at a rate lower than the market rate, or that he take a lease on the lender's house at a rate higher than the market rate, then this will be even more unlawful.

With regard to the mechanism used in the Sukuk, the manager is not willing to offer the loan unless he receives more than his due share of the actual profits by means of the "incentive" which is stipulated for him when the percentage of actual profits exceeds the percentage based on the prevalent interest rate of interest. Therefore, such a loan, in view of the opinion voiced by Ibn Qudamah, is emphatically all the more unlawful.

At times, the manager who undertakes the loan may be a partner in the enterprise, or a Mudarib. Such an undertaking [on his part], too, is in opposition to the requirements of the contract and falls under the same prohibition as that against a sale linked to a credit (or a loan) in exactly the same way. Thus, it is not lawful.

Three: The Manager's Promise to Repurchase Assets at Face Value

The third issue is that in true commercial enterprises, where the Shari'ah is concerned, the return of investors' capital cannot be guaranteed. In Shari'ah compliant dealings, reward always follows after risk. The legal presumption with regard to Sukuk is that there can be no guarantee that capital will be returned to investors. Instead, they have a right to the true value of the [Sukuk] assets, regardless of whether their value exceeds that of their face value or not. All of today's Sukuk, however, guarantee by indirect means Sukuk holders' principal.

At times, the

manager who

undertakes the loan

may be a partner in

the enterprise, or a

Mudarib.

TIP

The legal

presumption with

regard to Sukuk is

that there can be no

guarantee that

capital will be

returned to

investors.

TIP

Keep In Mind

The legal presumption with regard to Suk uk is that there can be no

guarantee that capital will be returned to investors. Instead, they have a

right to the true value of the [Sukuk] assets, regardless of whether their

value exceeds that of their face value or not. All of today's Sukuk, however,

guarantee by indirect means Sukuk holders' principal.


36

The manager pledges to the Sukuk holders that he will purchase Sukuk assets at face value upon maturity, regardless of their true value on that day. What this means is that the principal paid originally by the Sukuk holders will be returned to them at maturity. There is no other significance to such a commitment. If the enterprise is not profitable, the losses will be borne by the manager. If it is profitable, however, the profits will accrue to the manager, regardless of how great the amount. The Sukuk holders have no right to other than the return of their principal, as is the case in conventional bonds.

In considering the lawfulness of this commitment, we note that the manager of the Sukuk may act in his capacity as an investment manager, Mudarib, for the Sukuk holders, or as a partner, Sharik, or as an investment agent, Wakil, for them.

A Commitment by a Mudarib

That such a commitment to investors on the part of a Mudarib is void should be obvious because it is a capital guarantee by the Mudarib to the investors, and no jurist has ever averred that such an arrangement is lawful. The Standard on Mudarabah approved by the Shari'ah Council states:

If the loss at the time of closing operations is greater than the earnings, the losses will be deducted from the capital and the manager, in his capacity as a trust holder (ameen), will not bear any of the loss as long as there is no negligence or mala fides on his part. If the costs are equal to the earnings, the investors will receive their capital back, and the Mudarib will earn nothing. When profits are earned, these will be distributed among the two parties (investor and manager) in accordance with what the two have decided.

Thus, I can see no possible justification for such a commitment by a Mudarib. It is, however, mentioned in some Sukuk that the manager does not make this commitment in his capacity as a Mudarib, but in another capacity. This is clearly illogical because the Mudarib has no other capacity in this deal.

If the loss at the

time of closing

operations is

greater than the

earnings, the losses

will be deducted

from the capital

TIP


37

A Commitment by a Sharik

The manager may also act as the partner of the Sukuk holders. Then, in the same way that it is unlawful for a Mudarib to guarantee the return of capital to investors, it is also unlawful for one partner to guarantee the return of capital to the other partner or partners. This is because to do so would effectively interrupt the partnership in the event of losses; and that is something that no jurist has ever allowed.

The Standard on Musharaka approved by the Shari'ah Council states:“It is unlawful for the conditions of partnership or for the basis of profit distribution to include any text or condition that leads to the possibility that the sharing of profits will be interrupted. If this happens, the partnership will be void.”

The Standard specifically mentions the unlawfulness of such a commitment in one of the following paragraphs, where it states:

“It is lawful for one of the parties to the partnership to issue a binding promise to purchase the assets of the partnership during the period of partnership or at the time of dissolution at market value or at an agreed price at the time of purchase. A promise to purchase the assets at face value, however, is unlawful.”

In the Basis for Conclusions for the Standard it is stated:The justification for the ruling of "unlawful" with regard to the binding promise by one of the partners to purchase the assets of the partnership at face value is that this is the same as a capital guarantee, which is unlawful. The justification for a ruling of "lawful" for repurchase at

The manager may

also act as the

partner of the Sukuk

holders.

TIP

Keep In Mind

The manager may also act as the partner of the Sukuk holders. Then, in the

same way that it is unlawful for a Mudarib to guarantee the return of

capital to investors, it is also unlawful for one partner to guarantee the

return of capital to the other partner or partners. This is because to do so

would effectively interrupt the partnership in the event of losses; and that is

something that no jurist has ever allowed.


38

market value comes from the fact that there is nothing in this arrangement that guarantees anything to the partners.

Certain contemporary scholars have attempted to justify a commitment that implies a capital guarantee by saying that while it may be prohibited in a partnership of contract, Shirkah ̀ Aqd, it is not prohibited in a partnership of property, Shirkah milk. They then claim that the sort of partnership that occurs in Sukuk (especially Sukuk with leased assets) is a partnership of property and not a partnership of contract. However, when we consider the reality of these two types of partnership, it is clear that the type of partnership that occurs in Sukuk is a partnership of contract and not a partnership of property. This is because the purpose of the partnership [in these Sukuk] is not merely to own physical assets for the purpose of consumption or personal benefit but for the purpose of joint investment. This is the fundamental difference between a partnership of property and a partnership of contract.

To be more specific, when we consider what the classical jurists have mentioned regarding the reality of a partnership of contract, it should be clear to us that a partnership of contract may be distinguished from a partnership of property in three ways:

n The purpose of the partnership of contract is to jointly seek profits; whereas the purpose of the partnership of property is no more than to have possession of something and make use of it.

n A partnership of contract makes each partner the agent of the other in investment enterprises, whereas partners in a partnership of property are entitled to dispose of their own share [of the jointly owned property] as they wish; while they are

Keep In Mind

Certain contemporary scholars have attempted to justify a commi tment

that implies a capital guarantee by claiming that the sort of partnership

that occurs in Sukuk is a partnership of property and not a partnership of

contract. However, when we consider the reality of these two types of

partnership, it is clear that t he type of partnership that occurs in Sukuk is a

partnership of contract and not a partnership of property.


39

absolute strangers with regard to the shares of the other partner or partners.

n The partners in a partnership of contract are free to distribute profits among themselves in whatever proportion they agree among themselves. A partnership of property is different. In it, each partner is entitled only to the profits earned by his own share. So, when each partner puts his share to work separately, each partner will profit solely from the returns earned by his own share.

Each of the characteristics [of a partnership of contract] described above is to be found in Sukuk. Shaykh Mustafa al-Zarqa', May Allah bless him, wrote clearly and concisely of the difference between the two types of partnership in what follows:

Joint ownership always occurs in things that are shared. Such a partnership, if it occurs in physical wealth only, with no agreement as to its investment by means of a collective effort, will be called a partnership of property. This is countered by the partnership of contract in which two or more persons contract among themselves to invest wealth or labor and then to share the profits, as occurs in commercial and industrial partnerships.

Keep In Mind

Shaykh Mustafa al -Zarqa' describes the difference between the two types

of partnership in the following way: Joint ownership always occurs in things

that are shared. Such a partnership, if it occurs in physical wealth only, with

no agreement as to its investment by means of a collective effort, will be

called a partnership of property. This is countered by the partnership of

contract in which two or more persons contract among themselves to invest

wealth or labor and then to share the profits, as occurs in commercial and

industrial partnerships.


40

At another place, the Shaykh spoke of the difference between the two types:

The partnership of contract: This is a contract between two parties or more to cooperate on a profitable activity and to share in its profits. Partnership, in its essence, can be either a partnership of property shared between a number of persons as a result of some natural reason, such as inheritance, or it can be a partnership of contract in which a group agrees to undertake an investment activity in which they assist one another with capital or labor and then share in the results of the same. Thus, a partnership of property is a sort of joint ownership rather than anything contractual, even if the reason for the partnership may be traced back to a contract; as in the case of two people who purchase something together, so that they share its ownership. This is a partnership of property (joint ownership). There is no contract between the owners, however, to put the property to use, or to invest it through commerce or leasing or by any other means of earning profits. A partnership of contract, on the other hand, has investment and the earning of profits as its objective. This is the partnership that it intended here, and this is the partnership that is numbered among the nominate contracts, al- ̀ Uqud al-Musammah.

Thus, the Shaykh explained that whenever the purpose of a partnership is investment or earning, regardless of whether that is to take place by means of commerce, or by means of leasing, the partnership will be a partnership of contract. Since it is obvious that the purpose of Sukuk is investment or earning by means of leasing assets, it is impossible to call Sukuk a partnership of property. Therefore, it is not lawful for one partner to guarantee the capital of another partner either directly or indirectly.

The partnership of

contract is a

contract between

two parties or more

to cooperate on a

profitable activity

and to share in its

profits.

TIP

A partnership of

property is a sort of

joint ownership

rather than anything

contractual, even if

the reason for the

partnership may be

traced back to a

contract

TIP

Keep In Mind

It is obvious that the purpose of Sukuk is investment or earning by means of

leasing assets, it is impossible to call Sukuk a partnership of property.

Therefore, it is not lawful for one partner to guarantee the capital of

another partner either directly or indirectly.


41

In fact, that it is unlawful for a partner or a Mudarib to make such a commitment is a matter that requires very little in the way of justification because it is an established fact of Islamic jurisprudence that has been emphasized by fiqh academies, and at specialized seminars, and by the Shari'ah Council itself. If we were to open this door, the managers of Islamic banks would then be able to guarantee the capital of depositors by committing to purchase shares in investment accounts at their face value; thus negating the single difference between conventional deposits and deposits in Islamic banks.

A Commitment by an Investment Agent

In some Sukuk, the manager is neither a Mudarib nor a partner but an agent for the Sukuk holders whose function is to invest the assets represented by the Sukuk. Then, is it lawful [for the agent/manager] to promise the Sukuk holders that he will purchase the assets at maturity for their face value? The answer is that such a commitment by an investment agent, even if it is less egregious than a commitment by a partner or a Mudarib, it too is unlawful. This is because agency, Wakalah, is a contract of trust, Amanah; and there can be no guarantees except as regards negligence or mala fides. The aforementioned commitment is tantamount to a guarantee and is therefore unlawful. This point is mentioned in para 1/2/2 of the Standard for Guarantees, issued by the Shariah Council, as follows:

It is not lawful to stipulate a guarantee from a Mudarib, or an investment agent, or a partner among partners, regardless of whether the guarantee is for the principal or for the profits. Likewise, an operation may not be marketed on the basis that investor capital is guaranteed.In the following Para it is written:

It is unlawful to combine agency with a guarantee in a single transaction because to do so is contrary to the requirements of both. This is because to stipulate a guarantee by an investment agent transforms the operation into a loan with Ribawi interest, guaranteeing [the return of] principal while offering returns from the investment.

In some Sukuk, the

manager is neither

a Mudarib nor a

partner but an

agent for the Sukuk

holders whose

function is to invest

the assets

represented by the

Sukuk.

TIP

It is unlawful to

combine agency

with a guarantee in

a single transaction

because to do so is

contrary to the

requirements of

both.

TIP


42

It might, however, be imagined possible to justify such a commitment from an investment agent on the basis of an issue that was established by the Standard in the same Para, where it is stated:

However, if the agency is not encumbered by a stipulation of guarantee [or surety], and a guarantee for the agent was given in a separate agreement by another, the agent will be a guarantor, but not in his capacity as agent, such that if the agency were withdrawn he would remain a guarantor.

Then it might be said that the investment agent, though not originally a guarantor, became a guarantor as a result of the commitment which is conducted separate from the contract of agency.

The answer to this is that the proposed analogy contains a false comparison because the agent described in the Standard acts as a guarantor under a separate agreement for a debtor in the enterprise, such that the agent will not be responsible [as guarantor] unless the debtor fails to make a required payment. The agent therefore does not guarantee for the seller that his sale will be profitable under all circumstances. In the case of the Sukuk, the investment agent does not guarantee for a specific debtor, but rather against the failure of the enterprise, such that his guarantee remains valid even after every debtor has performed its obligations and the enterprise suffers losses as a result of falling prices in the market, or for any other reason. So, how can the first instance be compared to this?

In the case of the

Sukuk, the

investment agent

does not guarantee

for a specific debtor,

but rather against

the failure of the

enterprise

TIP

Keep In Mind

It is unlawful to combine agency with a guarantee in a single transaction

because to do so is contrary to the requirements of both. This is because to

stipulate a guarantee by an investment agent transforms the operation into

a loan with Ribawi interest, guaranteeing [the return of] principal while

offering returns from the investment.


43

Then, adding to the confusion in regard to this commitment is that the manager is the seller of the assets to the Sukuk holders, as is the case in most Sukuk, so that the commitment leads to a sale of ̀ inah. This is because he commits to buy what those to whom he has committed are selling; unless the `inah is negated by means of the conditions which are well known in Islamic jurisprudence.

The Higher Purposes of Islamic Economics

To this point, this entire study has been conducted from the perspective of Islamic jurisprudence. However, if we consider the matter from the perspective of the higher purposes of Islamic law or the objectives of Islamic economics, then Sukuk in which are to be found nearly all of the characteristics of conventional bonds are inimical in every way to these higher purposes and objectives. The noble objective for which Riba was prohibited is the equitable distribution among partners of revenues from commercial and industrial enterprises.

The mechanisms used in Sukuk today, however, strike at the foundations of these objectives and render the Sukuk exactly the same as conventional bonds in terms of their economic results. Islamic banks were not established so that they could offer the same products, and engage in the same operations, as conventional banks in the prevalent interest-based banking system. Instead, the purpose was to gradually open up new horizons for business, commerce, and banking that would be guided by social justice in accordance with the principles established by the Shari'ah of Islam.

Undoubtedly, such an ambitious undertaking requires a gradual approach; and a gradual approach may be imagined with a careful and detailed plan that outlines all of its various stages. Likewise, if the undertaking is to advance it will require continual follow up throughout each of its stages. A gradual approach does not mean that its progress will depend on a single step for an undetermined period of time.

A gradual approach

does not mean that

its progress will

depend on a single

step for an

undetermined

period of time.

TIP


44

Undoubtedly, Shari'ah supervisory boards, academic councils, and legal seminars have given permission to Islamic banks to carry out certain operations that more closely resemble stratagems than actual transactions. Such permission, however, was granted in order to facilitate, under difficult circumstances, the figurative turning of the wheels for those institutions when they were few in number [and short of capital and human resources].It was expected that Islamic banks would progress in time to genuine operations based on the objectives of an Islamic economic system and that they would distance themselves, even step by step, from what resembled interest-based enterprises. What is happening at the present time, however, is the opposite. Islamic financial institutions have now begun competing to present themselves with all of the same characteristics of the conventional, interest-based marketplace, and to offer new products that march backwards towards interest-based enterprises rather than away from these. Oftentimes these products are rushed to market using ploys that sound minds reject and bring laughter to enemies.

In order to promote Sukuk, the justification given is that international ratings agencies will not grant the desired, investor-grade ratings unless these mechanisms are used to guarantee the return of principal to investors, and to distribute profits from capital at specified rates.

Islamic Financial

Institutions have

now begun

competing to

present themselves

with all of the same

characteristics of the

conventional,

interest-based

marketplace

TIP

Keep In Mind

The mechanisms used in Sukuk today, however, strike at the foundations of

these objective s and render the Sukuk exactly the same as conventional

bonds in terms of their economic results. Islamic banks were not established

so that they could offer the same products, and engage in the same

operations, as conventional banks in the prevalent inter est-based banking

system. Instead, the purpose was to gradually open up new horizons for

business, commerce, and banking that would be guided by social justice in

accordance with the principles established by the Shari’ah of Islam.


45

Without these mechanisms, so they say, it will not be possible to market Sukuk widely. The answer to this objection is that if we are to continue to run behind the international ratings agencies, agencies that do not distinguish between halal and haram, it will never be possible for us to move forward with authentic Islamic products which actually serve the purposes of Islamic economics. This is because these agencies have matured in an interest-based atmosphere that is unable to acknowledge the quality of an investment unless its capital is guaranteed and its returns are distributed on the basis of interest. At the same time, the quality of a product from a Shari'ah perspective depends upon the sharing of risk and the equitable distribution of profits between investors. Thus, the Islamic mentality is diametrically opposed to the mentality of those institutions.

As a result, Islamic Sukuk were introduced for Islamic banks and financial institutions which aim to move beyond Riba. Therefore, Sukuk should be circulated among these banks on that basis. For the same reason, Sukuk should be acceptable between them so that they have no need of conventional ratings. Recently, an Islamic ratings agency was established. Islamic banks and financial institutions should strive to support that agency so that they no longer have a need for conventional ratings agencies.

Actually, the number of Islamic banks and financial institutions today is not to be overlooked, and thank God! The numbers increase day after day; and the growth of Islamic banks in many countries is greater than that of conventional banks. It is now incumbent upon these Islamic banks and financial institutions to cooperate among themselves for the purpose of developing authentic products that are far removed from empty stratagems, free from all association with Riba, and that aim to serve the

Islamic Sukuk were

introduced for

Islamic banks and

financial institutions

which aim to move

beyond Riba

TIP Keep In Mind

The quality of an investment unless its capital is guaranteed and its returns

are distributed on the basis of interest. At the same time, the quality of a

product from a Shari’ah perspective depends upon the sharing of risk and

the equitable distribution of profits between investors. Thus, the I slamic

mentality is diametrically opposed to the mentality of those institutions.


46

higher purposes of Islamic law in the spheres of economics, development, and social justice. None of this will come about without the guidance and encouragement of Shari'ah supervisory boards.

If these boards continue with their present policies, however, Islamic banks will stumble on the road, and there is a danger, God forbid that this virtuous movement will fail. It is time for Shari'ah supervisory boards to review their policies, and to moderate the license [they have granted] until now to benefit Islamic financial institutions. Instead, the Shari'ah supervisory boards need to apply themselves to upholding the Shari'ah Standards issued by the Shari'ah Council, standards which are not insensitive to the real needs of these institutions. Personally, I am certain that if Shari'ah supervisory boards uphold these Standards, the exceptional professional qualifications found in today's Islamic financial institutions will have no difficulty in developing viable alternatives to these dubious products. Allah willing,

Summary and Recommendations

n Sukuk should be issued for new commercial and industrial ventures. If they are issued for established businesses, then the Sukuk must ensure that Sukuk holders have complete ownership in real assets.

n The returns of enterprises should be returned to Sukuk holders regardless of what amounts they reach after costs, including the manager's fees, or the share of the Mudarib in profits. If there is to be an incentive for a manager, then let it be based on the profits expected from the enterprise and not on the basis of an interest rate.

n It is unlawful for a manager to lend money when actual profits are less than expected.

n It is unlawful for a manager, whether a Mudarib or a partner or an agent, to commit to repurchase of assets at face value. Instead, their resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase.

n Shari'ah supervisory boards must abide by the Shari'ah Standards issued by the Shari'ah Council.

It is unlawful for a

manager, whether a

Mudarib or a

partner or an agent,

to commit to

repurchase of assets

at face value.

TIP


n

n

n

n

There are many types of Sukuk, but Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) recommend the 14 models of Sukuk with Shari'ah compliance. These types depend upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are Mudaraba, Ijarah, Musharaka, Salam and Istisna. Mudaraba Sukuk are investment Sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share.Musharaka Sukuk are investment Sukuk that represent ownership of Musharaka equity. It does not differ from the M u d a ra b a S u ku k exc e pt i n t h e organization of the relationship between the party issuing such Sukuk and holders of these Sukuk, whereby the party issuing Sukuk forms a committee from the holders of the Sukuk who can be referred to in investment decisions (AAOIFI).Ijarah Sukuk are Sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real

44

Summary n estate. These Sukuk give their owners

the right to own the real estate, receive the rent and dispose of their Sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such Sukuk bear all cost of maintenance of and damage to the real estate. (AAOIFI)

n Salam Sukuk is certificates of equal value issued for the purpose of mobilizing Salam capital so that the goods to be delivered on the basis of Salam come to the ownership of the certificate holders. The issuer of the certificates is a seller of the goods of Salam; the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam capital) of the goods.

n The mechanisms used in Sukuk today, however, strike at the foundations of these objectives and render the Sukuk exactly the same as conventional bonds in terms of their economic results. Islamic banks were not established so that they could offer the same products, and engage in the same operations, as conventional banks in the prevalent interest-based banking system.


n

n

n

n

n

n

n

n

E-Library:

n

n

n

n

What are the types of Sukuk? Explain in detailExplain the classic Sukuk structure in your own word?Write a brief note on contemporary applications of Sukuk?

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Managing Financial Risk of Sukuk by Ali Arsalan Tariq

Overview of the Sukuk Market by Professor Rodney Wilson

Managing Financial Risk of Sukuk Market by Professor Rodney Wilson

Malaysian Debt security & Sukuk Market by bank Negara and Securities Commission

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Overview of the Sukuk market by Professor Rodney Wilson

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