Sukuk Securities: Definitions, Classification, and Pricing Issues

The foundation principles for sukuk certificates have developed in conformity with Islamic legal principles based on the Quran's commandments and elaborated in Shari'ah through 14 centuries of development. The word sukuk is not found in the Quran; it emerged as a development in the application of the Quran's principles to the real human act of debt funding.

The practice of borrowing and lending with asset backing (or assets that would be created from such debt) for specific production activities was widely known in the pre-Islamic Middle East and Mediterranean regions. Such debt transactions were practiced as risk-shared and profit-shared loans to be liquidated over mostly finite periods. The shorter the production process—for example, working capital loans (istisna) taken by producers of goods—the shorter the duration of lending. These practices were adapted by scholars who applied doctrinal provisions of Islam and refined them as Islamic debt instruments to make funding possible for economic activities.

By the late 19th century, which also coincided with the demise of Islamic empires in most parts of the world, the use of sukuk slowly waned, being replaced with modern banking practices and the introduction of modern financial instruments based on no risk sharing and prenegotiated interest payments. After about four decades, during which profit-sharing and risk-sharing banking was reintroduced, the Islamic debt instrument of sukuk appeared in the late 1990s in a number of countries.

The foundation principles are quite comprehensive as a guide to the parties in a contract. Examples of this are fairness in risk sharing, thus earning a permissible increase (commenda), and equity and full information provision (no asymmetric information, so both parties have the same information). Financial contracts are provided in a written form so they can be formally witnessed. In this chapter, we restrict our discussion of fundamental principles to those that affect sukuk securities.

FUNDAMENTAL PRINCIPLES

The word sukuk is plural for a certificate (sakk) of ownership of a given class of assets that a borrower gives to a lender as proof of ownership.[1] Therefore, sukuk securities are debt instruments that require the creation of assets in a separate entity, these assets being owned proportionally by the lenders, the fund providers. Full asset-backed lending is a fundamental principle of sukuk contracting.

In a sense, it suggests that without the lender being able to create an arm's length asset backing to a debt-funding arrangement to which the borrower has transferred income-producing assets, there cannot be any lending contract in an ethical financial transaction. This suggests that all sukuk securities have to have this safety net, so that from the start of the contract, the lenders have asset backing for their funding.

This makes sukuk security safer than conventional bonds because the lender in a conventional debt contract would need the permission of a court to obtain the right of ownership. That permission is given only if the issue is contested at the time of an actual default of the promised payoff.

A sukuk contract may thus be defined simply as a debt-funding arrangement agreed to between a party providing the funds (the investor) and the counterparty (a government or a firm, since individuals rarely issue sukuk) that is borrowing the funds to engage in permissible economic activities of production or service. Funding arrangements may vary, including an ownership and control basis, sharing-type securities, pure borrowing-type securities, and leasing-type securities. Because of this, it is inaccurate to describe sukuk as solely an Islamic debt instrument, as is the widespread practice of finance mass media.

Unlike in most sukuk issues, in sharing-type (musharakah) sukuk securities issued to investors, the fund providers get rewards only in the form of a portion of the profits based on a prenegotiated profit ratio. If the ownership is assigned to all the assets of the borrower, whether the ownership entails control or absence of control of the enterprise, this too is musharakah sukuk, a sharing-type funding arrangement for a finite period (an uncommon concept in modern finance).

It is very useful to get subordinated common stock with voting rights for a finite period. This type does not exist presently and may be thought of as a common share in a specific project with a finite period of life to produce an item for the fund to be paid back with profits. In conventional share funding, if another restriction were imposed to limit the use of such funds to produce permitted products or services, the result would be an Islamic common stock, which is the musharakah contract. If these were also issued for a finite period, this would be a new type of share unknown to date. All contracts with an infinite period and shared ownership and control of assets of the total enterprise are pure musharakah contracts.

A more common practice is for a borrower to set aside a portion of income-producing assets previously under the control of a producer into a special purpose company (SPC) and immediately make those assets available as owned by the investors in proportion to the funding ratio; this is a basic asset-backed sukuk contract. A simple sukuk security would be a funding arrangement for a finite period with the provision of ownership of part of the borrower's assets set aside as owned by an SPC, which would service the investors during the contract period using incomes produced by the SPC and, in cases of likely default, through the sale of assets.

Hence, one should consider a finite-period funding arrangement for debt as a characteristic of sukuk funding. Another characteristic is the removal of part of the borrower's assets into an SPC to be owned by the fund providers starting from the contract issue date. In recent years, a novel practice has somewhat altered asset-backing to asset-based contracting—instead of real assets, usufructs that produce incomes are accepted as assets.

Some scholars and regulatory regimes oppose this practice as a deviation, since there is no real asset in asset-based SPC. Asset backing is not the case with conventional bond-type lending, since the lenders have to contest in court only if nonpayment of prenegotiated interest payments occurs; the court has the discretion to permit creditors to access ownership of assets of the total firm. Not so in sukuk contracts. This makes Islamic funding arrangements a lot safer and prevents borrowers from borrowing without assets to back the funding.

Asset backing can be considered a fundamental principle. If there are no assets to back a loan made to a producer, there is no funding. This places quantity limits on excessive borrowing. Heavy reliance on borrowed funds has been associated with financial fragility in the economic policy literature, which concludes that excessive debt has been the root cause of many bankruptcies over the centuries as well as during crisis periods and business downturns.

New Zealand's central bank pioneered a new regulation in 2013 under which a bank will lose its license if more than 10 percent of its loans exceed 80 percent loan to asset backing. This rule is meant to slowly bring down the debt overload of governments, firms, and households.

A recent example of financial fragility is the global financial crisis, which developed from the nonrecourse to fund providers of real assets of major banks and financial firms. Had there been an ownership factor, there would not have been the credit bulge in 1994-2006, which has been blamed for the start of the global crisis. Debt gauging under sukuk would not exceed 100 percent of a debtor's assets, so there would be no question of debt overload if these principles were strictly followed.

Another characteristic is the use of profit ratio in the contract to determine the rewards to investors. Since profit or loss is known only after a span of time in which the borrowed fund has been applied to an economic activity, this introduces the very significant characteristic of Islamic fund providers sharing in the risk of a project before a reward can be mandated and decided on. One can see this quite clearly when a firm decides to pay dividends, in the case of common shares. Dividends are paid at quarterly periods in the United States and at half yearly periods in other countries. If there is no profit in a period (e.g., if there has been a fire that reduced the value of the real assets of an SPC), then there is no reward or just part reward for that period.

To the extent that the payment of reward is conditional on profits occurring, the nature of the payment is not fixed, so aggregate economic activities are relieved somewhat by producers and financiers sharing in the risk. Thus, to treat the rewards promised as fixed and apply a fixed-coupon-paying bond valuation model to value a sukuk security is not justifiable unless it is meant only as an approximate indicator of theoretical value.

There are specific sukuk contracts that require the amount of payoff to be fixed and paid periodically or that permit the payoff to grow at a constant rate. That payoff is fixed, but the incomes of the SPC may be higher or lower. There are two sukuk contracts that are exceptions to the general rule of payoffs being not fixed. These special arrangements are ijarah (lease-type) sukuk funding, with payoffs of a fixed rental-type arrangement; and bat bithaman ajjal sukuk (constant-growth profit sharing that starts with a fixed ratio), which provides for the payoff to increase by a constant factor in each subsequent periodic payment. The latter is a popular issue in Malaysia. It may be an arrangement in which the rental of the assets held by the SPC increases by a constant factor after the first ordinary annuity payment is made. There are four other types of sukuk securities that do not share this fixed or constant rate of growth characteristic, which will be described in a later section.

Another characteristic of sukuk funding is that when there is only an initial funding and no periodic rewards paid over the entire period of contract, the payoff is intended at the terminal period. Such contracts have different modes of design. Some are designed with a predetermined end-period payment formula, whereas others are designed with the end-period value based on the market value of the SPC assets at the terminal period. An example is a debtor's buyback arrangement at a price, to reduce the risk of the market price being volatile.

The conventional bond design does not permit this level of sophistication because the lender is treated as an outsider to the firm with no ownership of any part of the borrower's assets. To the extent there is ownership in sukuk contracting, though only to that portion of income-producing assets in the removed SPC, it is possible that there will be a market value (less or more, depending on the depreciation and replacement value of assets in the SPC). The important point is that the value of the payoffs could be in excess of the original funding to provide a return that is unspecified. Thus the payoff is stochastic (random), depending on the market value of assets in the SPC at a future date, unless a buyback arrangement limits this. That is, for valuation purposes, the final repayment is indeterminate and is not fixed (except in buyback contracting), and this introduces a new element in the valuation of such assets.

Finally, as in all Islamic financing contracts, the projects to which funding is supplied must be consonant with legally permitted, or halal, economic products and services. For example, there are doctrinal restrictions to funding firms engaged in gambling, the production of intoxicants for human consumption, prostitution, or the production of pork for human consumption. Sukuk financing will not be extended to such economic activities; this is an ethical principle very dear to most moral societies. Some conventional ethical mutual funds do not hold stocks of companies that produce intoxicants, weapons, or environmental degradation, for instance.

There are few other restrictions, one of which is that funding is made unavailable to firms engaging in usurious interest-based activities. We are not going to delve into other characteristics now but will discuss them in a later chapter. Figure 2.1 provides a comparison of the fundamental principles underlying the contract specifications of sukuk funding to conventional debt funding contracts as a summary of discussion to this point.

There are six main differences between Islamic sukuk funding arrangements and conventional bond-based or bank-lending arrangements. First, the pricing of the bond is based on how much of the profit share the borrower is willing to give, which, of course, depends on the riskiness of the project to which the fund is applied.

A letter of credit to import $1 million worth of wood product into a country may be less risky than to fund a project to build a toll road. Hence the profit ratio would be lower in the former case (in reality, it is a small fee) and higher in the latter case. In a conventional lending contract, be it a prenegotiated fixed or variable payoff (or fee-based) loan, the payoff

Fundamental Principles of Sukuk Security Compared to Conventional Debt Security

FIGURE 2.1 Fundamental Principles of Sukuk Security Compared to Conventional Debt Security

is lower in the former case and higher in the latter case. There is a subtle difference. The fund provider in sukuk agrees to take no rewards if in a particular year there is no profit, unless there is proof that the borrower has behaved fraudulently. That means that there is participation in the risk of the project. Even worse, the project may fail out of willful neglect of the entrepreneur, in which case the commercial court would adjudicate how the matter is settled.

These two favorable aspects, profit sharing and risk sharing, may make sukuk securities have a higher risk than is the case in prefixing a payoff in lower interest-based securities where there is no ownership of any assets until the project fails.

The second and third ways in which sukuk differs from a conventional contract are that a reward is given only if profits are earned, and if the project fails with no proof of willful negligence, the principal is lost to the extent of the market value of the assets in the SPC, which is owned by the fund providers. Having access to ownership of income-producing assets from day one of the contract limits the loss of the entire principal fund. In conventional bond-type lending, the reduction of debt settlement is applied to the entire firm's assets and not just the assets transferred to the SPC. The litigation costs charged by lawyers and accountants are huge in such cases. After almost 10 years, the lenders to the failed WorldCom Corporation have incurred a share of the court award—4 percent of the judgment amount, as reported in August 2013 in the financial press.

Hence, during crises, sukuk contracts tend to take away or waste fewer assets than would be the case in conventional funding. The firm could resume normal action with the assets not assigned to the SPC and avoid the expensive litigation costs.

The fourth characteristic is that for a sukuk funder, only the assets in the SPC are accessible for sale, not all the firm's assets. This provides a metaphorical halfway house before bankruptcy, whereas under conventional funding, bankruptcy is the only course under civil law in most countries. Even in the case of Chapter 11 protection (in which a firm can apply to continue to operate while all assets are being taken away by lenders), under bankruptcy laws the unavailability of this limited-damage recourse to settle dispute saves assets not transferred to the sukuk holders through the SPC.

Hence, at the aggregate level of the economy, there is no need to throw away large amounts of assets each time a crisis or recession occurs, because under sukuk contracting part of the loss is borne by the sukuk funders, and most assets are under the control of the owner of the firm. The extent to which debt settlement is reduced, known in the market as a haircut, is limited.

The fifth characteristic is that sukuk provides special structures to match the special needs of the project cash flow. For example, in a working capital sukuk (istisna), the customer who wants to produce an item over a finite period may provide funds for that period for production of an item by an entrepreneur even before the item is produced; this encourages entrepreneurship. The asset backing in this case is the revealed information about the future existence of the item to be produced as specified by the entrepreneur, who risks his or her labor, and the financier, who risks his or her working capital. But the contract must specify the exact nature of the product so that the future existence of that product could serve with reasonable probability as the value for the purpose of working capital funding.

There are other more exotic designs, such as that the original sum funding a project will be repaid both as profit sharing and as part principal repayment in what is called diminishing musharakah sukuk contracts. Complexity of product design is a desirable characteristic in finance, and the specificity of projects means that the firm cannot deploy funds to other than the approved purposes.

Finally, the doctrinal restrictions on the application of the funds to prosocial (i.e., halal) activities constitute the sixth distinguishing feature of Islamic finance in general. As noted earlier, religious doctrine dictates that gambling, prostitution, the production of intoxicants, and the production of pork for human consumption are not permitted. Therefore, no sukuk funding will be made available if the intended use of the fund is to produce those items or activities. This aspect introduces an embargo on financing antisocial production, even though an individual may use his or her own money to engage in such activities so that public funding is not made available.

This discussion then introduces a high moral purpose to debt contracting (as well as equity financing). This aspect is meant to starve the growth of antisocial activities by denying investments in prohibited economic activities. If one uses one's own funds to carry out these activities, then it is a different matter of taking personal responsibility for breaking the doctrine relating to prohibited activities. This is not an area for compromise under Islamic doctrine-based fundamental principles.

A brief examination suggests that sukuk are not bond like funding contracts or bank lending based on the following: (1) prefixed or variable interest rates, (2) profit sharing, (3) non-risk-sharing contracting, or (4) a principal guaranteed to be returned at the terminal period. In addition, basic conventional funding is not easy to structure in complex ways because of the lack of an SPC, and there are no provisions under modern debt contracts for restricting antisocial economic activities.

  • [1] Historical references suggest that the word sukuk was used both as a singular term and as the plural form of sakk. In addition to its use in borrowing and lending, this mode of issuing certificates was practiced a millennium ago in Damascus as a form of check writing to pay for purchases. In this book, we use the term sukuk as both singular and plural, as the context indicates.
 
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