Contract Design and the Structure of Sukuk Securities Yet Issued
This chapter reviews the financial and legal structures of sukuk that have not yet been issued but have already been structured: wakalab (agency), manfaah (usufruct), muzarah (farmland leasing), musaqa (orchard leasing), and muqarasah (tree leasing).
Wakalah is an agency contract in which one party entrusts another party to act on his or her behalf. The principal (the investor) appoints the agent (the wakeel) to invest a certain amount of funds on behalf of the principal in a pool of investments or assets. The agent charges the principal a predetermined fee for his or her expertise and management skills. The wakalah agreement governs this relationship by setting the scope of services, responsibilities, and fees payable to the agent. This is for a specific purpose.
Wakalah sukuk are based on the wakalah contract and are of interest when there is no particular tangible underlying asset. Wakalah sukuk can be used when the underlying asset is a pool of investments or assets to be collected. Then, using his or her expertise, the agent selects and manages the portfolio of assets to ensure the generation of the principal's expected rate of return.
Wakalah sukuk may resemble some features of mudarabah sukuk; however, the main difference is that in mudarabah, the agent receives a portion of the profit, whereas in wakalah, the investors receive the prenegotiated profit share, while the balance of any profits is paid to the agent as a performance bonus.
Wakalah sukuk has some features that may be attractive to originators. The agent is free to choose the investment portfolio on the condition that the investment is made only in Shari'ah-compliant assets (e.g., equities, sukuk, derivatives). Hence, the portfolio can include a wide range of assets, unlike in conventional mutual funds. In addition, the originator may build his or her balance sheet by acquiring assets to be included in the portfolio and using them as the underlying assets of the wakalah sukuk.
Moreover, the originator may include some nontradable assets (such as mudarabah sukuk, which implies a debt) in the portfolio to the extent that they constitute only a portion of the underlying assets of the investment wakalah sukuk portfolio. (The maximum allowed is different under different Shari'ah jurisdictions.) In a sense, the fund is leveraged.
Manfaah, a usufruct contract, is used when a party sells its existing right, or usufruct, in some particular service or profit of a durable asset to another party. Manfaah's use ranges widely, since the underlying services can differ case by case. However, since the right of usufruct is transferred to the other party, it can generate profit based on it. The manfaah sukuk may be structured based on different types of underlying rights and would be named accordingly. For instance, if the underlying asset is the right to use a lease property based on an ijarah contract, then the sukuk might be termed a manfaah ijarah sukuk or a manfaah ijarah mowsufa bithimn sukuk.
MUZARAH (FARMLAND LEASING)
Muzarah contracts govern the lease of a farm or arable land for agricultural purposes. Under such a contract, one party (the landlord) permits the other party (the farmer) to use the arable land for a certain period for agricultural purposes and, in return, receives a portion of the harvest.
Consequently, muzarah sukuk is the sukuk structure based on this form of contract. Similar to other structures, muzarah does not promise a fixed return to the investor, but only a predetermined portion of the profit (the harvest). The risks are borne by the sukuk holders unless there is proof of negligence.
Muzarah sukuk may be structured similar to the ijarah so that the agricultural company (the originator), which already owned the land, sells its ownership title to the sukuk holders through the SPC proxy. Then the originator uses the proceeds from the sukuk issuance and conducts agricultural
activity on that particular land. At harvest time, the revenue is distributed between both parties based on the predetermined ratio. If the sukuk tenure is more than a cultivation year, then the same profit-sharing process repeats until maturity.
MUSAQAH (ORCHARD LEASING)
A musaqah contract is applied when an owner leases his or her orchard to a farmer for a period and, in return, receives part of the harvest. This contract is very similar to the muzarah contract, but in muzarah the leased property is a piece of land (mostly for the cultivation of grains), whereas in musaqah it is an orchard (for the cultivation of fruit-bearing trees).
Musaqah sukuk can be structured when the proceeds are used to purchase a garden. Hence, the sukuk holders collectively act as landlord, and the originator acts as a horticulturist who works in this particular orchard for a certain period. The harvested fruits from this garden are distributed proportionally, based on a predetermined agreement. The risks are borne by the sukuk holders unless there is proof of negligence.
MUQARASAH (TREE LEASING)
Muqarasah is a contract between a landlord and another party to plant and maintain trees. Muqarasah sukuk securities are based on this contract, which is similar to muzarah and musaqah except for the particular proceeds.
This chapter concludes the description of the sukuk contracts currently being used, as well as potential contracts that are likely to be issued as the market expands in the future. Some commentators have dubbed sukuk as project-funding arrangement. In a broad sense it is correct, because funding is sought for specific projects that are common production activities of humans.
It may also be called targeted funding, because sukuk contracts offer targeted financing that is tailored to the needs of a particular economic activity. Whereas working capital financing (istisna) provides cash for producing a clearly defined product before the product is made, three separate contracts provide financing to put agricultural land and crops (farmland, orchards, and trees) under a profit-sharing arrangement.
The latter three contracts have the attractive feature of avoiding the indebtedness of farming communities to a bank by cutting out the middleman. This is an attractive feature for economic activities that depend on seasonal features such as rain and that therefore risk recurrent crop failures. Rural indebtedness can be avoided if such instruments are used to allow tenant farmers to share the profits and the risk with the owners of the land.
In Pakistan, for example, and in many Latin American countries, the landowners live luxuriously and make the peasants bear the burden of crop failure. As a result, poverty prevails in the rural areas. Farming indebtedness is a major issue in both developed and developing economies. Putting profit- and loss-sharing contracts in place not only releases the farmer from penury in times of drought and crop failure but also spurs a mutual interest in increasing farming productivity.