Contract Design and the Structure of Common Sukuk Securities Issued to Date

This chapter and the next two are connected. This chapter reviews the financial and legal structures of the six major types of existing sukuk securities: mudarabah (partnership), musharakah (profit sharing), murabahah (markup), ijarah (leasing), salam (futures), and istisna (working capital). The next chapter describes the structures of the contracts that are widely available in different markets.

The cash-flow pattern of each type of structure and its variations are discussed in this chapter. There are a variety of sukuk types, based on their funding purposes, contractual specifications, payback schemes, and issues such as conversion. The details, characteristics, and specifications of them are elaborated in the following sections. Chapter 6 describes those that have not yet been issued.

MUDARABAH (PARTNERSHIP)

A mudarabah sukuk is based on mudarabah contract terms. Mudarabah, or partnership in profit, is one of the premier financing methods, with roots going back to the pre-Islamic era. The Prophet Muhammad (570-632 ce) used mudarabah with Khadijah bint Khuwaylid (555-619), a rich woman from Mecca who became his first wife, about 15 years before he began his prophetic mission.

Mudarabah is defined in jurisprudence as a mode of financing through which a financier provides capital for the venture of an entrepreneur. The financier is known as the rab-al-mal, and the entrepreneur is called the mudarib. The rab-al-mal may be an individual investor, an investment company, or a bank.

At the maturity of the contract or at some predetermined time, the profits generated from the venture are shared by the contracting parties according to a prenegotiated ratio. In case of a loss, each party bears the loss of his or her contribution to the contract. In other words, the financier bears all financial losses and the entrepreneur bears the operating losses such as time and effort. In the case of negligence or misconduct by the entrepreneur, he or she alone is liable to cover it.

The rab-al-mal is not allowed to have a management role in the mudarabab venture contract. Thus, the mudarib becomes a trustee as well as an agent of the business. As a trustee, the mudarib is responsible for losses stemming from willful negligence. As an agent, the mudarib is required to use and manage the capital in ways that generate the maximum profit.

Furthermore, similar to equity holders in modern finance, mudarabab investors have a profit that is proportionate to the performance of the firm. Such a contract has features of both equity and debt. However, mudarabab investors do not benefit from all the aspects of shareholders, like capital gains, and they do not have rights such as attending or voting at the annual general meeting. In the case of bankruptcy, sukuk holders are in a higher position than equity shareholders with residual claims—a position akin to the modern conventional bond or loan contracts.

Although mudarabab may be applied in various economic activities, the majority of Islamic jurists and scholars hold the view that mudarabab contracts are most suitable for commercial activities. In practice, however, the nature of a mudarabab contract is limited because of operational difficulties and business ethics constraints. In Muslim countries, an inefficient tax system, a high rate of illiteracy, low accounting standards, and the practice of keeping a double set of accounts by the majority of small businesses are major issues hindering the practical implementation of a system of profit and loss sharing.

In order to issue a mudarabab sukuk, a special purpose company (SPC) is set up. This SPC acts as the rab-al-mal, and the originator acts as the mudarib. The proceeds of the issue collected by the SPC from the sukuk investors are applied as the capital of the mudarabab, which the mudarib manages for a fee and a share in the profits. The profit-sharing ratio is specified at the outset.

Although there should not be a predetermined rate of return in a mudarabab contract, the sukuk issued until early 2008 were designed to ensure that sukuk holders receive the so-called indicative rate of return announced at the inception of the issue. This was achieved by including clauses in the mudarabab agreement that specified a maximum rate of return. Any profit to be generated above that rate of return was directed to a reserve account, which could be used to cover any shortfall in future years.

In case of insufficient profits as well as insufficient funds in the reserve account, the issuing company is required to provide Shari'ah-compliant funding to meet the shortfall and make it up to the indicative rate of return, in effect guaranteeing the rate of return independent of the actual profit generated. Muhammad Taqi Usmani, the chairman of the AAOIFI Shari'ah council, ruled against the practice of guaranteeing the indicative rate of return.

As mentioned before, mudarabah sukuk are pure debt. They are mere cases of borrowing money; thus, they are not tradable. However, some scholars have pointed out that in practice the mudarabah sukuk are structured in a way to be tradable. Mudarabah sukuk are tradable and negotiable if the mudarabah assets are not entirely composed of the sukuk proceeds (in which case they would be liquid assets and could not be traded). In most mudarabah sukuk, there is a combination of tangible assets and sukuk proceeds, and the mudarib is allowed to mingle his or her own assets with those of the mudarabah. Such an arrangement mostly meets the Shari'ah requirement of having more than 51 percent of the assets in tangible form for tradability and negotiability.

The International Islamic Financial Market (IIFM) surveyed the sukuk market in 2010 and reported on international mudarabah sukuk contracts. Before 2011, there were more than US$8.7 billion international mudarabah sukuk issues in the market (excluding domestic issues), ranging from US$200 million to US$2.5 billion each. The UAE had issued most of the international mudarabah sukuk contracts. Moreover, the data show that all the international mudarabah sukuk were issued in 2007; there was no issuance before that.