'Market, not methodology', drives sukuk defaults

Problems associated with restructuring linked to sukuk's inherent complexity. Islamic investors advised to remain better prepared for a higher degree of risk

The occurrence of sukuk defaults is driven by credit risk and has nothing to do with the validity of the sukuk methodology. But the problems associated with restructuring have something to do with sukuk's inherent complexity, experts said.

Currently, the three major defaulters are East Cameron Partners in the US, which was behind the issuance of the US's first and only sukuk; Saudi Arabia's Saad group; and Kuwait's The Investment Dar. The list is not expected to stop there as new surprises in the business world keep showing up. "This is not a Shariah issue. This is an issue to do with credit and security," Muneer Khan, Partner and Head of Islamic Finance at international law firm Simmons & Simmons, told Emirates Business.

"All defaults and potential defaults have been driven by market and credit risks. These deals would have gone wrong even if they were conventionally financed," said Neil Miller, Global Head of Islamic Finance, Norton Rose, a company that offers services on business-related legalities. "What makes sukuk different is its complexity and this complexity makes sukuk harder to restructure."

One of the complexities is the issue on whether a sukuk is asset-based or asset-backed. Some have presumed that Islamic finance instruments are always backed by assets and so they can recover a part of their investments from the proceeds of the asset sale, should there be a default on the side of the issuer.

Basically, the difference between being asset-based and asset-backed lies in ownership and sale of assets. Asset-based sukuk allow the inclusion of assets that may not be legally recognised as being owned by the investors. The assets fulfil Shariah compliance in form, but they may not ensure that investors can recover capital, through sale of the asset, for example, in case of originator bankruptcy.

Asset-backed sukuk, on the other hand, stick more closely to the ideal of granting the investor a share in a concrete asset or business venture, and a share of the risk commensurate with such ownership. In this case, sukuk securitisation is structured around investors' rights, or legal ownership, of a plot of land, building or any other asset.

"I think investors do need more education... sukuk are complex structures," said Khalid Ferous Howladar, Vice-President, Senior Credit Officer Structured and Islamic Finance, Moody's Investors Service.

"Sometimes, it may be difficult for the investor to understand them. That's why I do not prefer the terminology asset-backed or asset-based, it sounds very similar," he said.

Peter Casey, Director, Policy, DFSA, said it is unlikely that any investors have been deceived into buying asset-based sukuk believing them to be asset-backed. "I'm not convinced that people who are mostly [running] large funds were deceived," he said, adding that these pools of investors are usually sophisticated.

Miller said a "vast majority" of the sukuk in the market are asset-based and in legal terms, there is no ambiguity on how it is defined. "The lawyers know what this means. It's just that people didn't read the documents," he said.

These sophisticated investors, Khan said, have legal or financial advice to distinguish between a secured and non-secured deal.

"I think some of the claims have been a bit disingenuous," he said. "They claimed they didn't know what these products represented, but the issue of whether a product is secured or unsecured is a fundamental aspect. Sophisticated investors should know what they are getting into."

In addition, two more issues need to be considered. One is whether those assets could be accessed by the sukuk holders if they wanted to make that claim and second, would they want to, even if they could.

Casey said assets often include real estate, whose worth is likely to have dived and they may be in jurisdiction where sukuk holders may have difficulty in having access.

"Do we hold and run the asset or do we sell the asset? What do we do with the asset? Those are some of the questions in restructuring that will be discussed." Khan said. "Majority of the sukuk holders might actually think that even though they're only getting to have recovery of 50 per cent, they may as well take that now rather than wait for five years to wait for the value of the assets to rise."


Restructuring process

Before questions are asked about recovering value, the issue of restructuring needs to be settled first. And this is a process that usually takes a long time, again due to the complexities of sukuk.

"The types of certificate holders, as we have found in these structures, are very different from banks," Miller said, adding that the number of votes needed to pass a resolution varies from one sukuk to another. The reason this creates tension is because the decision-making process requires sukuk holders to make extraordinary resolutions. "That process, in itself, is quite cumbersome. Canvassing opinions can be quite difficult," Miller said.

The restructuring process usually starts with a downturn in the market, which results in drastic devaluation of assets, such as properties, which often underpin sukuk offerings. This impinges on the sukuk's ability to generate sufficient returns from such assets to service the periodic payments against an already tight debt market.

Law firm Vinson & Elkins said the issuer is left with one of two options – either to attempt to work with certificate holders and trustees to restructure their obligations or be in default – neither of which is in the hands of the issuer to ultimately decide.

Sukuk certificate holders have various rights that they can exercise and in certain circumstances they can compel the trustee to call a meeting of the certificate holders and potentially exercise its rights under the transaction documents, including the purchase undertaking.

If a restructuring plan is to be put in place, it will be imperative for the certificate holders to work among themselves to establish a viable plan in a private forum outside of the scope of the formal meetings. Once a plan has been finalised, this can be presented to the formal certificate holders' meeting for approval. The alternative method sometimes available is to hold the formal meeting at the outset and empower a steering committee with the ability to undertake the restructuring on behalf of all the certificate holders.


Reality check

However, the question of whether rights under the purchase undertaking are taken or revised payment plans or restructurings are considered in a certificate holder meeting should be driven by commercial realities, a paper from Vinson & Elkins said.

If the issuer is facing difficulties in making a periodic distribution payment, the reality of repaying the remaining debt becomes more unlikely. Thus certificate holders may prefer to delay exercising such rights in an attempt to restructure the debt and payment obligations rather than force the trustees' hands.

In theory, once the purchase of the units by the issuer has occurred, the certificates can be redeemed and the trust can be dissolved. If the issuer is unable to make payment to purchase the units, a claim in favour of the trustee will arise.

The International Islamic Financial Market (IIFM), however, criticised sukuks in that investors in the defaulted sukuk found themselves "without recourse to the so-called trust assets under the governing law and, therefore, are being treated just like subordinated creditors, even though under Shariah guidelines, they must have had full recourse to the trust assets and should have had the right to investments".

Another factor contributing to the uncertainty surrounding post-default sukuk is that many are subject to partially or wholly non-Shariah based regimes, Ayman Abdel Khaleq and Todd Crosby, partner and associate, respectively of Vinson & Elkins, wrote in the Collaborative Sukuk report. For instance, the legal documents governing sukuk or the Islamic structures underlying sukuk are often subject to different legal regimes. "Certainty with regard to the post-default process in sukuk transaction is necessary because the potential for a default exists in all types of transactions," they said. "Even the most prudently structured products can fail due to circumstances outside investors' control. Consequently, risk is inherent in any transaction, whether Islamic or conventional, although an argument can be made that an Islamic investor should be better prepared to assume a higher degree of risk than a conventional investor."

No global standards for Islamic finance

A global standard for Islamic finance is unlikely to be established in the near future. Rather, further improvements in the interpretation of Islam in applications to finance will fuel the growth of the industry, said the chief of Islamic Development Bank (IDB).

Ishtihad, which connotes consensus, is an important Islamic concept that allows for flexibility in interpreting its laws. "I don't think you will have a unified institution. There are some attempts that you can have one Shariah body to provide standards to all industry but I don't think this can be achieved in the near future," Dr Ahmad Mohamed Ali, President of IDB Group and the Chairman of the Islamic Corporation for Insurance of Investments and Export Credits, told Emirates Business.

"Most likely, we'll continue to have different views of the Shariah committee," he added. However, ishtihad – the effort to develop new interpretation – will continue. This is one of the strengths of the Islamic jurisprudence," he said.

Standardisation, a long-standing issue in Islamic finance, should be addressed properly to avoid damage to consumer confidence in the retail sector and to avoid confusion in the corporate sector.

According to Islamic finance analysts, while Islamic business is growing by the day, the growth is hurdled by the lack of standardisation and homogeneity. Because there is no single interpretation of Islamic law, each financial institution has a board of religious scholars who determine which products are Islamic, and what one bank considers Shariah-compliant may be unacceptable for another.

Industry players speaking to this newspaper said there are some existing standards, but due to the nature of Islamic finance, establishing a body to set global standards is not only difficult to attain, but in fact almost impossible.

Dr Mohamad Akram Laldin, CEO and Executive Director of International Shariah Research Academy for Islamic Finance (ISRA), said there is still a "long way to go" as far as implementation is concerned. "We have a Shariah parameter and that's the AAOIFI, but not many jurisdictions are subscribing to it," he told this newspaper in an earlier interview.

Ten guiding principles of Islamic finance

- The doctrine of maximising human welfare: Securing of the objectives of Shariah rather than maximisation of happiness as seen by human beings

- The doctrine of general permissibili ty: In the Islamic theory of contracts, parties are free to agree on any terms as long as known Islamic rules and principles are not violated.

- Prohibition of riba (interest)

- Prohibition of gharar: This refers to acts and conditions in contracts, the full implications of which are not clearly known to the parties. In eco nomic parlance, it is very close to 'asymmetric information'.

- Prohibition of gambling: Gambling involves transfer of wealth without any value added. It involves that kind of risk that is self-created, is zero-sum game and does not add any value to the national wealth.

- Prohibition of selling without having possession and two deals in one: The terms are similar to No8

- No pain no gain (Al-Kharaju Bil-Daman): Every financial transaction must involve a level of risk to justify profits.

- Permissibility of hybrid contracts: There are certain rules that govern 'combining of contracts'. First, the combination must not contradict an explicit text. Second, a product structured on the basis of a combina tion of contracts should not be in tended to circumvent impermissible transactions. Third, the combination must not involve contradictory contracts/conditions.

- Principle of relief (istihsan): This refers to departure from the applica tion of a ruling on an exceptional basis by taking a lenient view of an act that may otherwise cause unfair ness or distress.

- The Doctrine of necessity: In excep tional circumstances, application of a particular command may be tem- porarily suspended. For example, eating carrion is prohibited, but if someone is facing certain death due to hunger and they have nothing but carrion to eat, the objective of 'pre serving life' dictates that eat carrion, but only as much as is necessary to live.

Source: Prof Dr Munawar Iqbal, Former Chief of Research, Islamic Banking and Finance, IRTI, Islamic Development Bank Group


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