Executive Summary
This article examines the following:
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Understanding the particular appeal sukuk has to investors.
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Notable defaults and near-defaults of sukuk and the effects on the market.
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Case study: Nakheel sukuk—a lesson to learn for Islamic finance.
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Issues of enforceability in light of sukuk defaults.
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Jurisdictional response to legal issues surrounding sukuk.
Introduction
According to the Kuala Lumpur-based Islamic Financial Services Board, a standards body for the Islamic finance industry, the Islamic finance industry is a roughly US$1 trillion asset that may almost triple to US$2.8 trillion by 2015. Arguably, sukuk is the catalyst that has put the Islamic finance industry on the global capital market map. Despite being the flagship product of the burgeoning Islamic finance industry, the sukuk market has not been immune to the economic downturn. Marketed often as a safer alternative than conventional bonds, the subsequent near and actual sukuk defaults have raised questions about sukuk-holders’ rights, how they will be treated, and what sukuk entails. A closer examination is required of the structural deficiencies of some sukuk structures that may result in nullifying the recourse of investors and the enforceability of sukuk contracts. Based on the above, we discuss bankruptcy resolution and investor protection in sukuk markets.
Sukuk by Any Other Name
Although a rose by any other name may well be a rose, a sukuk by any other name is not a sukuk. A commonly held description of sukuk, both within and outside the Islamic space, is one of an Islamic bond. Although many sukuk structures are designed to replicate the economic function of conventional bonds, their legal structures are different. “Any references to sukuk as being Islamic bonds are oxymoronic and misleading to investors who may believe they have certain bond-like remedies that, ultimately, may not be enforceable in some Islamic jurisdictions.”1 The Accounting and Auditing Organization for Islamic Financial Institutions’ (AAOIFI) shariah Standard no. 17 on investment sukuk carefully distinguishes sukuk from equity, notes, and bonds. It emphasizes that sukuk are not debts of the issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects, or investment activities. Sukuk may not be issued on a pool of receivables. Nevertheless, the importation of provisions and conventional contractual risk transfer covenants into the overall sukuk structure is the primary link between sukuk and bonds.
Given the standardized nature of conventional bond transaction in terms of (a) the relative rights and remedies of the parties, (b) the terms of many financial and commercial risk allocations, and (c) the legal documentation, one begins to understand the rationale for embedding the conventional provisions and covenant within sukuk structures. Shariah-compliant transactions of this type have not yet obtained an equivalent degree of standardization or concomitant certainty, consistency, predictability, or transparency, especially as to enforcement of the shariah, hence the importance of the work of the International Islamic Financial Market (IIFM) in its development of standardized Islamic financial transaction agreements. As long as the Islamic finance industry continues to play catch-up in term of contractual standardization, the sukuk investor may be left with cosmetically comforting structured Islamic notes that may lack the same legal safeguards and risk profile as the conventional bond to which they are often compared. Therefore, there is all the more reason to understand the sukuk structures, and in the event of default to know what, if any, recourse an investor would have under those structures.
Importance of Understanding the Fine Print in Sukuk Structures
Standard & Poor’s has grouped the various sukuk structures into three categories:
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Sukuk with full credit-enhancement mechanisms. These are sukuk that receive an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral. The guarantor provides shariah-compliant shortfall amounts in case the issuing vehicle (usually a special-purpose entity) cannot make payment.2
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Sukuk with no credit-enhancement mechanisms. This structure resembles an asset-backed security. The pool of underlying assets is the sole basis for the coupon and principal payment.3
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Sukuk with partial credit-enhancement mechanisms. This combines the first two categories, with a third-party guarantee absorbing a limited shortfall from an asset-backed transaction.
According to a report by Moody’s, many of the sukuk structures applied have been effectively reduced to a form that is identical to conventional unsecured bonds. Most asset-based sukuk may have the form of asset-backed sukuk, but not the substance.4 In other words, although most sukuk have assets in their structures, they were only considered as asset-backed or asset-secured if key securitization elements were present to ensure that holders enjoy beneficial title and realizable security over the assets and associated cash flows.
Although terminologically similar, asset-based and asset-backed have unique differences in credit risk with respect to a potential investor in a sukuk. This can be seen in the case of Tamweel PJSC, where two types of sukuk had been issued. In the Tamweel asset-backed sukuk, the freehold titles to the properties were transferred to the sukuk-holders along with the associated ijarah cash flows. The property or land titles are registered in the name of the investors. Any losses on those cash flows (that arise from the sale of distressed property) are passed on to sukuk-holders, who are exposed to the asset risk. Nevertheless, upon the insolvency of Tamweel, the assets continue to pay the sukuk investors. As for the unsecured or asset-based sukuk issued by Tamweel, the sukuk does not survive the insolvency of Tamweel. Investors in these two sets of sukuk are taking very different risks.
Investor Protection in Notable Sukuk Defaults
East Cameron Gas Sukuk
The first ever sukuk to originate from the United States was launched in 2006 to raise US$165.67 million. The US energy firm East Cameron’s sukuk defaulted in 2008, and it subsequently filed for bankruptcy protection after its offshore Louisiana oil and gas wells failed to yield the expected returns. Interestingly, although most sukuk are Reg-S, the East Cameron sukuk was the first US 144A regulation sukuk, meaning that it was on a par with a bond in terms of disclosure and transparency. The issue in this case was whether the sukuk-holders actually owned a portion of the company’s oil and gas. In this relation, East Cameron argued that there had been no real transfer of ownership of production revenues, known as royalties, into a special purpose vehicle formed to issue the sukuk. Instead, the company claimed that the transaction was merely a loan secured on those royalties, implying that sukuk-holders would have to share the royalties with other creditors in the event of liquidation.
The bankruptcy judge rejected the company’s contention and ruled that the sukuk-holders “invested in the sukuk certificates in reliance of the characterization of the transfer of the royalty interest as a true sale.”5 Nevertheless, the judge then gave East Cameron leave to find further arguments to support its case, raising questions about whether holders own the assets underpinning the issue when the security sours.
The Investment Dar Sukuk
The Investment Dar was the first Gulf company to default on a sukuk. Investment Dar defaulted on a US$100 million sukuk when it failed to pay a periodic distribution, when due, to holders of an issue maturing in 2010. The irony is that the issuance took place, presumably offshore, despite the fact that Kuwait has no sukuk or trust laws in place.
Golden Belt 1 Sukuk
Citicorp Trustee Co. Ltd, trustee for a US$650 million Islamic bond sold by a unit of Saudi Arabia’s Saad Trading, Contracting and Financial Services Co., said that investors agreed to dissolve the trust after the unit defaulted on the debt. The dissolution may allow investors to claim assets used to back the Islamic securities sold in 2007 by Saad Group’s Golden Belt 1 Sukuk Co. BSC.
Issues of Enforceability
Nakheel
The near-default of the dollar-denominated sukuk from Dubai property developer Nakheel shattered perceptions that Islamic financing instruments were a safer alternative to conventional bonds. It is important to note that it was evident in the prospectus that Nakheel sukuk did not enjoy any government guarantee. Yet, the circumstances surrounding the Nakheel/Dubai World debacle and the events that followed highlight issues regarding the potential enforceability against sukuk assets or issuers. If Nakheel did default on its sukuk, the idea that the sukuk investors have any legal recourse to those assets is by no means clear. Not least, it is uncertain whether Western law, which typically allows for recourse, is more relevant and enforceable than shariah law in the United Arab Emirates (UAE), which implies a degree of burden-sharing for creditors. Yet, the issue of enforceability of sukuk contracts in the UAE also applies to conventional financing that Nakheel/ Dubai World has obtained. Conventional investors would have had the same issue in securing any of Dubai World’s assets in the UAE. The bankruptcy laws in the UAE, as well as the rest of the Gulf Cooperation Council (GCC) countries, have still to be developed; there is very little precedent.
The following illustrative sukuk transactions will help sharpen understanding of issues pertaining to enforceability of shariah in different jurisdictions. Assume the following: a sukuk issuance that is a securitization of assets located in a shariah-incorporated jurisdiction; the asset originator is located in that same jurisdiction; the special purpose vehicle (SPV) sukuk issuer is located in a purely secular jurisdiction that allows for the choice of applicable law for financial transactions; and the sukuk is sold to both Muslim and non-Muslim investors throughout the world. The applicable laws will include those of the shariah-incorporated jurisdiction and of where the originator and the assets are located, particularly with respect to whether there has been a true sale of the assets by the originator to the special purpose issuer. The bankruptcy laws of both the jurisdiction where the originator and the assets are located and of the jurisdiction in which the issuer is located will be applicable to the transaction. Further, it is likely that the securities laws of the issuer’s jurisdiction, as well as those of the various jurisdictions of the purchasers of the sukuk, will be applicable in certain circumstances.
Subsequent Jurisdictional Responses
UAE
The law does not have a specific definition of bankruptcy, but merely highlights the situations in which a trader will be regarded as bankrupt. The meaning may be inferred from Article 645 of the law, which provides that “a trader who ceases to pay his debts can apply to the court for his adjudication as bankrupt.” Dubai’s government recently announced the new bankruptcy reorganization law in 2009 as part of the package to rescue Dubai World that included a US$10 billion bailout from Abu Dhabi.
Kuala Lumpur
Lawyers, bankers, and shariah scholars in Malaysia, which has the world’s largest sukuk market, have begun looking into civil law provisions that may conflict with shariah law and impede the use of Islamic finance. “We are producing Islamic products in conventional surroundings. The other laws that are applicable—land law, contract law, all other laws—are conventional laws,” said a former Malaysian chief judge who is heading the expert body.6
Case Study: Nakheel Sukuk—A Lesson for Islamic Finance
Background
Nakheel sukuk is chosen as a case study despite the fact that this sukuk never defaulted. Nevertheless, this near-default of the sukuk has left an indelible mark on the Islamic financial market, ushering in the Dubai Debt Crisis. On November 25, 2009, the financial world was shocked when Dubai World requested a restructuring of US$26 billion in debts. The main concern was the delay in the repayment of the US$4 billion sukuk, or Islamic bond, of Dubai World’s developer Nakheel, which was especially known for construction of the Dubai Palm Islands.
The massive implication of the Nakheel sukuk default scenario to the financial world, particularly Islamic finance, has created a broad discussion among experts on the course of events and how to provide better protection to investors against bankruptcy in sukuk investment in the future.
Nakheel sukuk were originated by Nakheel Holdings 1 LLC, one of three Nakheel World LLC subsidiaries (along with Nakheel Holdings 2 LLC and Nakheel Holding 3 LLC, these three companies together acting as co-guarantor of the sukuk) which are 100% owned by Dubai World, a 100% stated-owned company under the Government of Dubai. All three Nakheel Holdings companies had a subsidiary, Nakheel PJSC, which was operating in the real estate sector in Dubai. Below is the company ownership structure and the interlinking, to give a better background of the case.
The Transaction Structure—Issuance
Nakheel sukuk was set up as an ijarah sukuk based on two properties (and any buildings on the land), DWF South and Crescent Lands, both in the Dubai Waterfront development. This parcel of properties was initially valued at US$4.22 billion, based on the developments that were to be constructed on it. The sukuk was issued by SPV, Nakheel Development Limited (Nakheel SPV), a newly incorporated free-zone company with limited liability in the Jebel Ali Free Zone. Nakheel SPV acted as agent and trustee for and on behalf of the sukuk-holders, in accordance with an agency declaration and a declaration of trust.
The originator, Nakheel Holding 1 LLC, sold the leasehold right on the properties of 50 years to the SPV, which in turn issued sukuk to finance the transaction. The funds raised of US$3.52 billion were used to pay the leasehold right from Nakheel Holding 1 LLC. The amount was injected into Nakheel Co. PJSC. Next, Nakheel SPV, as lessor, leased the sukuk assets to Nakheel Holdings 2 LLC, as lessee, for a period of three years to end on December 14, 2009, in concurrence with the maturity of the sukuk. The lease comprised six consecutive periods of six months each. The rental payments of the lease periods matched the periodic distribution payments on the sukuk. Half of the lease amount was paid to sukuk-holders through the SPV and half was deferred until maturity.
On December 14, 2009, the lessee had to purchase the sukuk assets from the lessor in accordance with a purchase undertaking at a certain exercise price. This is when the deferred lease payment would be made. This exercise price was equal to the redemption amount of the sukuk and would be used to pay back the principal amount to the sukuk-holders. In this way the sukuk were redeemed.
The Issues over Nakheel Sukuk
The issues over Nakheel sukuk comprise two sources—the sukuk structure and the legal concern. The sukuk in itself is a complicated financial product, and the laws of Dubai do not provide a clear precedent as to how investors in the sukuk will be treated and what recourse is provided. The sukuk was structured under a sale and leaseback transaction, which from an Islamic perspective is referred to as an ijarah structure. The sale and leaseback structure in ijarah sukuk does not provide for a real transfer of assets from the originator to a SPV; it merely provides a leasehold interest over the tangible underlying asset for a period of, in this case, 50 years. The issue is that leasehold right is not seen as a real right or property right under UAE law as applicable in Dubai, which limits investors’ claims and law enforcement.
Nevertheless, the Nakheel sukuk was backed by a few additional guarantees that may provide sukuk investors with some recourse. As such, these guarantees gave investors the confidence to invest in the sukuk. A guarantee from the state-owned parent company, which implicitly provides a government guarantee for the sukuk (despite the fact that the prospectus clearly stated otherwise), had reassured investors. This misplaced assumption misled investors in their risk–return decision on the investment. A similar scenario occurred for the holders of equity in Fannie Mae and Freddie Mac in the United States. The issue, however, does not end there; the complications worsened when the parent company that acted as guarantor found itself in a situation that made it no better placed than Nakheel to repay the sukuk. Dubai World is also just a holding company for a number of other companies beside Nakheel Holding 1 LLC. However, all of Dubai World’s subsidiaries have their own creditors and their own debts to service, and the important thing for Nakheel sukuk-holders is that the creditors of Dubai World, through the guarantee, are subordinated to the creditors of the subsidiaries of Dubai World.
The sukuk-holders were also granted a mortgage over the two properties that formed the basis for the sukuk through a security agent. Nevertheless, this is subject to the ability of investors to pursue claims on assets that are mainly located in the UAE, as there is a general lack of precedent in how the laws will be applied. Investors are not able to touch government assets, pursuant to Law no. 10 of 2005 amending Government Lawsuit Code no. 3 of 1996 (as amended by Law no. 4 of 1997), which provides that a government establishment may be sued, but that no debt or obligation of such establishment may be recovered by way of an attachment on its properties or assets. In addition, the structure of the sukuk transaction (the issuance) itself could limit investors’ ability to enforce the mortgage. The sukuk is structured under English law in which the concept of trust and beneficial interest is applied. These concepts are not recognized in Dubai.
In addition to the guarantee above, Nakheel sukuk-holders were granted a share pledge of 18.89% of the outstanding equity in Nakheel at the time the sukuk was originated. The aggregate value of the share pledge was capped at 25% of the sukuk issue amount (US$3.52 billion). However, this guarantee would probably be worthless should Nakheel be unable to restructure or repay the outstanding sukuk due on December 14 (and the Nakheel 2 and 3 sukuk that also become due on December 2010 and January 2011 for another US$2 billion).
The Way Forward
In order to increase protection of all parties in the sukuk transaction, some essential measures must be put in place.
The IIFM and other relevant international bodies such as the AAOIFI and the Organization of the Islamic Conference (OIC) Fiqh Academy should lead the Islamic capital market industry with an initiative to converge prevailing differences in sukuk. Note that some differences may not be converged, for example matters that relate to different shariah rulings might not be compromised. Nevertheless, there are many other matters for which the respective bodies could meet to find a solution. The industry could agree on a few standard structures that cover specific legal and shariah jurisdiction—for instance, standard structures for sukuk issuance in the GCC region and in South East Asia. This option is suggested with consideration for the fact that a particular region tends to have similar legal and shariah rulings; thus, relative convergence can be achieved to provide recourse for investors.
The issuer must be aware that sukuk in its pure form has different characteristics from bonds; as such, sukuk must be structured according to the standards of the sukuk structure and should not merely resemble a bond. A provision to purchase at face value instead of market value, for instance, has effectively shifted sukuk from equity-based securities to debt-based securities. Therefore, the risk–return and legal consequences of sukuk do not reflect equity, which would eventually mislead the market. If sukuk were structured in such a way as to retain their equity status, disputes when bankruptcy occurred would be much less severe. This is because investors would adjust their anticipated risk–return and legal claim to reflect equity investment. Furthermore, issuers must provide a clear and definitive provision in their prospectus and agreement. For instance, the near-default Nakheel sukuk contains ambiguous provisions in its prospectus, basically saying that where the agreement states that English law is applicable, it is not certain that the Dubai courts would actually apply English law as opposed to local law. Second, the prospectus indicated that once an English court had given judgment, executing it in Dubai might be difficult because it is not possible to enforce measures on property owned by the government or the ruling family.
Governments—and not just those that issue sovereign sukuk—should put in place comprehensive and clear provisions on their regulation and a legal framework to govern sukuk issuance. Something that may not seem important when everything goes smoothly, but which is absolutely critical if they do not, is the enforceability of such provisions, especially with regard to claims over government interest/property. The Nakheel and Investment Dar sukuk are good examples in this regard.
Investors need greater education on sukuk, which basically have more complex structures than bonds. Investors, whether sophisticated or not, should be able to understand clearly what a prospectus is saying and not need to make their own, potentially misleading, interpretations. For instance, in the Nakheel sukuk, despite the disclaimer in the prospectus that “the Government of Dubai does not guarantee any indebtedness or any other liability of Dubai World,” investors perceived the sukuk to be implicitly guaranteed by the government, whereas in fact the government declared itself to have no liability in respect of the sukuk. This perception led to mistaken investment decisions with regard to the anticipated risk–return and contingency claim in the event of default.
In order to reduce the severity of disputes, sukuk documentation should contain clear and comprehensive provisions concerning transactions in terms of the governing law, legal jurisdiction, shariah rulings, and legal enforcement. For instance, a sukuk issuance may have transactions governed by UAE law, but with an exclusive jurisdiction clause for the High Court in London, or for an arbitration panel in another location, such as Geneva, Switzerland. Such a move would bring more objectivity where uncertain questions of law arise. Different contracts in different parts of the transaction may have different jurisdiction clauses. On top of that, legal enforceability is an important factor to consider before a decision is made to invest in sukuk. With reference to the Dubai World case, there is still a question of the local enforceability of any judgment made elsewhere. Although the ruler of Dubai and the government are subject to court orders just like anyone else, their assets cannot be seized and sold by public auction. The UAE courts will order all to pay their debts, as everyone including the ruler and government are equal under the law. Nevertheless, as in many countries, when it comes to government debt the attachment of government assets and their sale at public auction is not allowed.
Some jurisdictions in the Islamic economic area will not enforce foreign judgments and arbitral awards. Some enforce foreign arbitral awards, but not foreign judgments. In some jurisdictions the extent and degree of enforceability of foreign judgments and awards is not entirely clear. To ensure to all the benefits of integrating the Islamic financial sphere with the Western financial sphere in a globalized economy, there must be shariah-compliant transactions in purely secular jurisdictions, in which the governing law will take cognizance of shariah as a matter of substantive and procedural law. Enforceability of shariah can be achieved by incorporating it into the law of the land, and then choosing the law of the shariah-incorporated jurisdiction as the governing law of the relevant transaction. Furthermore, to ensure recourse for investors, true ownership should pass to the individual sukuk-holders.
Notes
1 Ali Agha, Oliver, and Claire Grainger. “Sukuk: Default or no default?” Credit (January 2010).
2 Hassoune, Anouar. “Standard & Poor’s approach to rating sukuk.” S&P RatingsDirect, September 17, 2007.
3 Ibid.
4 Howladar, 2009.
5 Fidler, 2009.
6 Jakarta Globe. “Experts seeks to clear legal snarls in shariah finance.” July 30, 2010.
7 Raza, Kashif. “Nakheel pre IPO sukuk issue—A case study.” Millenium Capital, April 25, 2007.
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