Executive Summary
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Sukuk issuance utilizes a number of different shariah structures but all make use of the purchase undertaking.
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The purchase undertaking is the key credit document in sukuk issuance. It provides for the return on an investment at maturity and under any early redemption right, whether arising as the result of a default event or otherwise.
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Purchase undertakings have come under great scrutiny from shariah scholars, who feel that they have been developing into an instrument guaranteeing a return on certain types of sukuk that should be subject to the investment risk associated with an equity investment.
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AAOIFI has sought to move sukuk away from classification as a pure debt instrument toward reclassification as an equity instrument, in order to better reflect the position of sukuk in the Islamic finance sphere.
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An evolution in market perception will need to occur to move transaction risk disclosure, and therefore investor focus, away from focusing solely on the obligor under the purchase undertaking toward greater focus on the creditworthiness of the sukuk assets as well.
Introduction
As is the case with most Islamic finance instruments, the typical approach to sukuk is to take the equivalent instrument in conventional finance and to attempt to replicate it in a way that is shariah-compliant. In the case of sukuk, consideration is given to the important commercial features (such as rate of periodic return, return at maturity, and financial covenants), together with key legal considerations (such as transaction risk disclosure, events of default, and representations and warranties). The market has tended to place sukuk in the same asset class as a conventional bond and has thus identified sukuk as debt capital market instruments. However, this view is at odds with Islamic jurisprudence, which, though differing on certain issues of interpretation in relation to detail, has almost universally agreed that sukuk should be viewed as equity investments, thereby exposing the investor to ownership risk in relation to the assets they have purchased through their investment in sukuk. This issue came to a head in February 2008, with the announcement by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)1 that in its view the majority of sukuk in the market at that time were not in compliance with the precepts of shariah. The concerns of the scholars centered around the use and application of the purchase undertaking in sukuk transactions, and particularly the methodology used to determine the exercise price (or purchase price) for the sukuk assets upon an exercise by the issuer/trustee of its right to require the obligor to purchase those sukuk assets pursuant to the terms of the purchase undertaking.
What Structures are Used in Sukuk Issuances
In any issuance of a sakk (the singular form of sukuk) there are three main parties:
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the sukuk-holders (or investors);
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the issuer/trustee (normally a special purpose vehicle (SPV));
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the obligor (the company that ultimately wishes to benefit from the proceeds of the sakk).
In a sakk, irrespective of the structure, the sukuk-holders will purchase the sukuk (or trust certificates) from the issuer/trustee at the issue price—for example, US$100 million. The issuer/trustee will then use the proceeds of the issue to purchase certain assets from the obligor. These assets will need to be shariah-compliant income-generating assets. In an ijarah sakk, the issue proceeds will be used to purchase certain “hard” assets (for example, machinery, automobiles, or aircraft). Those assets will then be leased to the obligor against payment of rental on a periodic basis to the issuer/trustee (acting in the capacity of lessor) under the terms of an ijarah (lease) agreement. The proceeds from that ijarah agreement will be used by the issuer/trustee to make payment of the profit amount due from it to the sukukholders under the terms of the sakk.
A slight variation on this structure is the istisna’a/ijarah structure, pursuant to which the issuer/trustee will use the issue proceeds in two ways: (i) a portion will be used to fund the purchase price payable in respect of certain hard or already existing assets; and (ii) a portion will be used to fund the construction of certain other assets. According to shariah principles, the assets purchased under (i) must be equal to at least 33% of the principal amount of the sakk and must not be allowed to drop below this ratio at any time during the life of the sakk. As each asset under (ii) is constructed, it will be delivered to the issuer/trustee and will become subject to the ijarah agreement. Further, shariah requires that by the maturity date of the sakk, the value of the hard assets subject to the ijarah agreement is equal to the outstanding face value of the sakk, i.e., that no assets remain to be constructed under the istisna’a agreement.
Musharakah, mudarabah, and wakalah structures differ from the structures described above in that they are sukuk that involve investment in certain assets. A musharakah is an equity participation arrangement between the issuer/trustee and the obligor under which each party contributes capital to a project and shares in its risks and rewards. While profits may be apportioned according to any previously agreed ratio, losses must be borne according to the ratio of capital contributed. A mudarabah involves the issuer/trustee (as investor) appointing the mudarib (investment manager) to invest its funds in certain shariah-compliant assets. Profits from those investments are shared according to a previously agreed formula, but losses in respect of the assets are borne wholly by the investor (the mudarib bears the loss of its time and effort). A wakalah structure involves the issuer/trustee as muwakkil (investor) appointing the obligor as wakeel (agent) to invest in certain pre-identified assets. Similar to a mudarabah, the muwakkil bears the loss in relation to the assets, while the wakeel bears the risk of loss of its time and effort.
What Role Does the Purchase Undertaking Play in a Sakk Issuance?
A purchase undertaking is a unilateral undertaking or promise given by the obligor to the issuer/trustee that it will purchase the sakk assets at a future date or on the occurrence of certain events. The purchase price for those assets is determined in accordance with a pre-agreed valuation mechanic. This usually takes the form of a formula, but it can also be a price set by an independent third party (usually an industry expert), at a time on, or prior to, the date of purchase.
The purchase undertaking is the key credit document in any sakk transaction as it is the means by which investors receive the return on their investment at maturity and is also the means by which sukuk investments may be terminated early should an event of default or certain other pre-agreed trigger events occur. As such, when an investor comes to look at the documentation used in a sakk transaction, the documents to which they will turn first are the terms and conditions of the sakk and the purchase undertaking.
In What Circumstances Will a Purchase Undertaking Become Operative?
As mentioned above, the purchase undertaking is the key credit document in a sakk as it deals with the means by which investors will receive the repayment of principal at maturity or upon the occurrence of an event of default.
The purchase undertaking may also become operative upon the occurrence of nondefault based events, such as the exercise of an early redemption right (in conventional terms, a put right) by the sukuk-holders. However, the most common nondefault-based exercise of rights under a purchase undertaking is the exercise upon maturity of the sakk.
A purchase undertaking will set out all the circumstances in which the rights under it may be exercised. Typically, a purchase undertaking also sets out in detail the events of default and the terms of any nondefault-based early redemption rights. Such rights will mirror any sakk-holder put right or other early redemption provisions as may be applicable under the terms and conditions of the sakk.
How is a Purchase Undertaking Exercised?
Shariah requires that any sale and purchase of assets takes place on a spot basis. This is why a purchase undertaking, rather than a forward sale and purchase agreement, is used in sukuk transactions. Shariah prohibits a sale agreement being entered into if there is uncertainty as to the date on which such sale and purchase will actually take place. This is particularly applicable to early redemption rights (whether arising as a result of an event of default or otherwise). To address this requirement, an undertaking is used. However, shariah also requires that contracts arising out of the purchase undertaking be entered into correctly, through offer and acceptance leading to the conclusion of a formal sale agreement. In order to achieve this, and to ensure that negotiation is not required at the time at which the sale is entered into, the necessary documentation required for the issuer/trustee to exercise the rights under the purchase undertaking will be scheduled to that document. The schedules will usually include a form of exercise notice and a form of sale and purchase agreement. In order to exercise its rights under the purchase undertaking, the issuer/trustee is required to deliver an exercise notice to the obligor (declaring its intention to require the obligor to purchase the sakk assets from it) together with the sale and purchase agreement signed by it. The obligor indicates its acceptance by returning a copy of the sale and purchase agreement duly countersigned by it. Having promised under the purchase undertaking that it would do so, any failure by the obligor to return the original sale agreement within a stated period of time will constitute an event of default. Payment of the exercise price to the issuer/trustee and the transfer to the obligor of the sakk assets will occur shortly thereafter.
How Are the Rights of the Issuer/Trustee Exercised in a Default or Early Redemption Scenario?
While the exercise of rights on the maturity date of a sakk is a straightforward matter, the exercise of the rights of the trustee (on behalf of sukuk-holders) under a purchase undertaking in an early redemption scenario (whether fault-based or not) presents more complications.
The purchase undertaking acts as a mirror of the rights of the sukuk-holders under the terms and conditions. As with any finance special purpose vehicle (SPV), the issuer/trustee will appoint an administrator to perform its day-to-day functions—for example, issuing notices through the clearing systems (if any), liaising with sukuk-holders, and acting on the instructions of the sukuk-holders under the terms and conditions of the sakk. Neither the issuer/trustee nor the transactions administrator will wish to prejudice the rights of the sukuk-holders as to whether to not to exercise the early redemption right, and as such will only act on the instructions of the sukuk-holders. The means for providing such instructions will be set out in the terms and conditions and the trust deed and will broadly follow the terms relating to such instructions found in conventional documentation.
What Alternative Forms of Consideration May be Used to Satisfy the Exercise Price Payable Under a Purchase Undertaking?
Although a purchase undertaking will typically use cash to settle the exercise price payable in respect of the sakk assets, other forms of consideration can be used. The most obvious example of this is in the convertible or exchangeable sukuk market. In order to achieve conversion or exchange, the clauses dealing with payment of the exercise price will be amended to state that the obligation to pay the exercise price will be satisfied through the delivery of a certain number of shares in the obligor (for a convertible) or in another entity (for an exchangeable). The number of shares to be delivered will be calculated in the same manner as under a conventional convertible or exchangeable investment.
Shariah Issues with the Calculation of the Exercise Price under Purchase Undertakings
Purchase undertakings are typically drafted such that the exercise price (and thus the value) of the sakk assets is calculated by reference to a formula resulting in an amount equal to the principal amount of the sakk plus any accrued but unpaid profit amounts. This formula may easily be adopted in relation to physical assets in an ijarah or istisna’a/ijarah structure, owing to the fact that there is no partnership or investment management relationship between the parties with an agreement to share in the losses associated with the sakk assets. The assets in an ijarah-based sakk are hard assets. As such they are not subject to shariah concerns about investment risk and, provided that they have not been destroyed, can be purchased at a price agreed between the parties.2
The shariah view is that this formula may not be used in relation to the valuation of the sukuk assets in musharakah, mudarabah, and wakalah structures because such structures are used in relation to intangible investment-type assets. In a number of cases the assets to be invested in are broadly identified according to certain criteria. Such assets are inherently more unstable than, for example, movable equipment, and as such are subject to fluctuations in market price. As a result of this, shariah scholars are uncomfortable with the idea that an asset such as a shariah-compliant equity instrument could be ascribed a value five years in advance of its purchase date, thereby providing an implicit guarantee of the value of those assets. This formulation of the exercise price would run counter to the shariah principle that the investor should share appropriately in (for example, in a musharakah) or should absorb wholly (as in a mudarabah or wakalah) the losses associated with the sakk assets. These concerns were formally voiced in February 2008 when the AAOIFI handed down its guidance to Islamic finance institutions on the issuance of sukuk.3
The February 2008 announcement by the AAOIFI and its effect on the determination of the exercise price under a purchase undertaking appeared to end the market in musharakah, mudarabah, and wakalah sukuk. While this may have been the initial reaction of the market, it is also clear that financial institutions and other corporations in the market that do not possess a large inventory of hard assets will still require funding in a shariah-compliant manner in the future. How then can sukuk be used to fund such operations? The simple, albeit somewhat unsatisfactory, answer is that a more sophisticated valuation methodology needs to be applied in the sukuk market in order to accurately price the underlying assets in a purchase undertaking, for the purposes of returning principal to investors in a manner that meets the requirements of both potential investors and shariah scholars.
A Shift from Debt to Equity?
It would appear from the above that the general spirit of the February 2008 AAOIFI guidelines is to shift the focus of the sukuk market away from a purely debt-based model toward an equity-based one. Given the global economic events of the past two years, it has become clear to investors that the ultimate credit in a sakk transaction is not, in fact, the obligor, but rather the assets that form the sakk assets. It is the ownership interest that sukuk-holders have in these assets that should determine the credit of a sakk and thus drive the decision to invest. As a result, there will need to be a shift in the focus of transaction risk disclosure in offering documents from the obligor to the sakk assets. Financial disclosure on the obligor will remain an important aspect of sukuk given the fact that the creditworthiness of the obligor will have a direct impact on its ability to meet its obligations under the purchase undertaking but, in the event that the obligor is unable to meet such obligations or otherwise defaults under the sakk, the sukuk-holders will be left with the sakk assets.
Case Study
Dubai Bank’s US$5 billion Trust Certificate Issuance Program4
One example of a more sophisticated methodology for calculating the exercise price is that used in Dubai Bank’s sukuk program listed in September 2008. Dubai Bank utilized its shariah-compliant mortgage portfolio as the underlying asset in a wakalah-based sakk. The fact that a shariah-compliant mortgage is by its very nature a depreciating asset gave rise to complications regarding the most effective way to calculate the exercise price. To address the concerns described in this article, the purchase undertaking is drafted so that the exercise price payable in respect of the sukuk assets at maturity is calculated by valuing the outstanding principal amount of the underlying assets at that time (i.e. the aggregate outstanding principal amount under each mortgage). This is coupled with an obligation on the wakeel to ensure that the sukuk assets always comprise mortgages with an outstanding aggregate principal amount at least equal to the outstanding face value of the sukuk. Such methodology allows sukuk investors to share in the risk associated with the mortgages (default, etc.), but also provides comfort as to the return on their investment at maturity.
Accounting Treatment of Sukuk Assets
The February 2008 AAOIFI guidelines also had implications for the accounting treatment of sukuk assets in their attempt to move the classification of sukuk from a debt capital markets instrument to an equity-style instrument. The AAOIFI stated that the assets in a sakk must be transferred to the sukuk-holders in full and that “the manager issuing the sukuk must certify the transfer of ownership of such assets in its (sukuk) books, and must not keep them as his own assets,”5—i.e. sukuk must move toward the “true sale” securitization model.
Given the fact that an obligor will repurchase the underlying assets in the future, there is great difficulty from a purely accounting perspective in meeting the AAOIFI requirement to remove such assets from its books. International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) usually preclude accounting firms from leaving sukuk assets off the balance sheet of the obligor as the long-term risk associated with the sukuk assets will reside with it by virtue of its obligations under the purchase undertaking. Given the current economic climate, accountants are likely to take a cautious approach in relation to such treatment. However, a solution may be found where the relevant scholars are given comfort that the sukuk assets will be segregated in the books of the issuer and clearly identified as having been sold to the sukuk-holders subject to the terms of the purchase undertaking.
Conclusion
The challenge for the sukuk market going forward will be to develop valuation methodologies in respect of the exercise price that meet the shariah requirement that sukuk operate as equity-style instruments. Such methodologies will also have to address sukuk-holder demand for clarity on the return at maturity, as investors will not wish to invest in products that do not generate acceptable levels of return. More important, however, will be the education of the market (in particular, investors) as to what it is that is being purchased under a sakk. Investors will still need to look to the purchase undertaking as the key credit document (and therefore as an assurance of the creditworthiness of the obligor) in their decision whether or not to invest in a sakk, but the emphasis of disclosure—and therefore the basis on which an investor makes its investment decision—will need to evolve so that greater focus is given to the sakk assets as opposed to the obligor alone.
Such focus is likely to become ever more prevalent in the sukuk market as investors, chastened by recent developments, and in view of the 2008 AAOIFI announcement, begin to focus their attention on the assets underpinning a sakk, the creditworthiness thereof, and the revenue flows associated therewith, and not on the credit of the relevant obligor. This is not to say that the creditworthiness of the obligor is not a key factor in relation to the operation of the purchase undertaking; it will and always should remain a key consideration when deciding whether or not to invest in a sakk. However, in a market that has witnessed a spate of distressed sukuk, experience is likely to lead to a shift in focus from the obligor to the actual assets underlying a sakk.
Notes
1 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) shari’a board statement. Bahrain, February 13 and 14, 2008. Online at: www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf
2 AAOIFI shari’a board statement, fifth guidance note.
3 AAOIFI shari’a board statement, fourth guidance note.
4 The DB Sukuk Company Limited US$5 billion Trust Certificate Issuance Program was admitted to the Official List of the London Stock Exchange on September 25, 2008.
5 AAOIFI shari’a board statement, first guidance note.
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