ISLAMIC CAPITAL MARKETS�SUKUK VALUATION, SUKUK DEFAULT, �AND SUKUK RESTRUCTURING

Lecturer Team

• Role of the Trustee/Agent
• The preferred legal mechanism to effect sukuk ownership is through a trust; thus in legal form (e.g. under English law), sukuk are called trust certificates. Trusts, however, may not be available in all jurisdictions as most civil law jurisdictions do not allow for trusts easily; in which case an agency mechanism may be used, as both agency and trusts are possible in most common law jurisdictions. The trust mechanism is preferred because it is considered able to avoid certain complications of agency (e.g., the discretionary powers of an agent, bankruptcy protection for the principal).
• Under an agency arrangement, typically, the SPV purchases the assets as agent for the holders who are the principal and the sukuk represent an investment agency certificate of ownership of the sukuk assets.
• Under the preferred trust arrangement, the SPV purchases the assets as trustee, and the SPV, being the trustee declares a trust over the sukuk assets in favour of the beneficiaries, being the holders. The trust assets hence represent the entire sukuk assets, comprising the underlying assets as well as the rights and obligations under the whole sukuk structure. Another advantage of establishing a trust is that trust certificates are used in many forms of structured financing and debt capital markets, including securitisation; hence conventional investors and issuers are familiar with this mechanism.
• Role of the Security Trustee/Agent
• Usually, if the sukuk are intended to be collateralised or covered/backed by some assets, a security trustee/agent will be used to take possession of these underlying assets to ensure they are separate from the assets of any other party (e.g., the issuer under a winding up) so that the holders may dispose of these underlying assets according to the commercial arrangements pre-agreed in the sukuk documentation.

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ROLE OF THE SPECIAL PURPOSE VEHICLE�

Various sukuk structures involve different parties, and a structure typically uses a legal entity called an SPV. Synonymous terms for an SPV include SPC (special purpose company) or SPE (special purpose entity).

An SPV typically has the following characteristics:

• Orphan: i.e. it has no parent or owner. In many offshore jurisdictions, companies can be established that are not owned by anyone except a professional nominee or a charitable trust. Their affairs will be handled by a professional corporate secretary that typically deals with a large number of such SPVs.   
• Single-purpose: i.e. the SPV is ‘clean’ or ‘new’ and has never undertaken any activity and will never undertake any activity except as stipulated in the sukuk documents. Typically, this is achieved by it having professional nominee directors who are instructed not to permit the SPV to enter into any arrangements except those detailed in the sukuk documentation. In this way, the SPV is also intended to be bankruptcy remote.
• Taxation- and regulation-light: i.e., given it is an entity established for the sole purpose of sukuk issuance, consideration is given to the tax, legal, accounting, reporting obligations and costs. The aim for the SPV is to minimise taxation and regulation costs. Thus, popular offshore jurisdictions compete to provide cost-efficient locations for international sukuk to host SPVs, e.g. Labuan and the Cayman Islands.

Given that sukuk are based on a form of undivided asset ownership, the usual legal method to affect this is not for the SPV to own the sukuk assets and issue sukuk to the holders, but for the SPV to own the sukuk as either and agent or trustee on behalf of the holders. As such, the assets will not appear on the balance sheet of the SPV, as it is merely acting on behalf of another party

ASSET-BASED VS ASSET-BACKED

Sukuk Type

Recourse to Asset

Recourse to Original Seller if Asset is Insufficient?

Asset-Based

Covered

Asset-Backed

NO

YES

YES

NO

SUKUK VALUATION

SUKUK VALUATION

• Valuation of financial instruments is carried out to determine the fair value of each financial instrument:
• Fair value reflects the fundamental condition of the financial instrument, which is influenced by various related factors.
• As a comparison with the market value, whether it is undervalued or overvalued.
• Different financial instruments have different valuation methods, depending on:
• The cash flow pattern of each financial instrument in the future.
• The risk level of the financial instrument.
• The structure and scheme of the financial instrument.
• Although it is a certificate of ownership, sukuk is considered similar to bonds and is included in the fixed income securities group:
• Provides fixed cash flows periodically.
• The pattern and size of cash flows are easy to predict, especially for sukuk ijarah.
• Has a certain time limit.

SUKUK VALUATION

SUKUK VALUATION

• Characteristics of sukuk cash flows:
• Coupon value can be fixed or variable, depending on the contract used.
• Some types of sukuk do not provide a coupon (zero-coupon sukuk).
• Usually paid periodically and regularly - every 3 months, 6 months, or one year.
• At the end of maturity, the issuer repays the principal amount of the sukuk.
• If the sukuk term is less than 1 year, payment is made in advance (discount).
• Formula for sukuk valuation:

SUKUK VALUATION

• The r component in the sukuk valuation formula is a proxy for the investor's opportunity cost:
• It is usually calculated using YTM (yield to maturity), which is the expected rate of return that an investor would expect if they hold the sukuk until maturity.
• The largest component of YTM is the market interest rate, along with other factors.
• In sukuk valuation, the interest rate is used as a benchmark for the r component, and not as a determinant of the value of the sukuk cash flows.
• From the sukuk valuation formula, sukuk risk can be identified:
• The pattern of sukuk cash flows, which depends on the underlying asset/project and the contract used.
• Some types of contracts provide uncertain cash flow patterns because they depend on the performance of the asset, such as mudharabah and musharakah.
• The longer the term, the higher the risk of sukuk, as market interest rates fluctuate and can affect the market price of sukuk.

SUKUK VALUATION

• The relationship between the value of sukuk and the discount factor (YTM):
• The value of sukuk has a negative relationship with the discount factor.
• If the YTM increases, the value of sukuk decreases, and vice versa.
• If the coupon rate > YTM, the value of sukuk > par value.
• If the coupon rate < YTM, the value of sukuk < par value.
• If the coupon rate = YTM, the value of sukuk = par value.
• Therefore, in the analysis of fixed income securities (including sukuk), the relationship between fair value (price) and interest rates is the focus of the analysis:
• How sensitive the price or value of sukuk is to changes in market interest rates.
• The more sensitive, the riskier.
• From the formula for calculating the fair value of sukuk, two measures can be derived that can connect between fair value and interest rates:
• Duration
• Convexity

EXAMPLE

EXAMPLE

EXAMPLE: ILLUSTRATION

You are offered a Senadat Mudarabah Cagamas with a face value of RM30 million. The details of the SMC are:

• Issuance date: July 9, 2010
• Maturity: July 9, 2012
• Transaction date: November 22, 2010
• Next coupon date: July 9, 2011
• Indicative coupon: 6% (annual coupon)
• Yield to maturity: 8%
• What is the appropriate value of this SMC?

EXAMPLE: ILLUSTRATION

P = Price per RM100 face value

C = Indicative coupon for current coupon period

E = Number of days in current coupon period

T = Number of days from transaction date to next coupon payment day

r = Yield to maturity

t = Number of days from last coupon payment date to the value date

NV = Nominal value of SMC transaction

ISSUES & CHALLENGES: SUKUK DEFAULT

ISSUES & CHALLENGES: SUKUK DEFAULT

• Theoretically, default is difficult to occur in sukuk:
• It is not a debt instrument.
• It has underlying real assets.
• The SPV or issuer acts as an agent/manager/representative of sukuk holders in managing assets, so it does not have the obligation to pay interest or repay the principal of the sukuk.
• Penalties or fines are possible when the issuer or SPV acts outside of the agreement.
• However, in practice, sukuk is a financial instrument that is used as a substitute for bonds:
• Its characteristics are similar to bonds: limited tenor, interest in the form of coupons, periodic coupon payments.
• Thus, default risk is also inherent in sukuk. The issuer's ability to provide returns depends on the originator's ability to pay rent or profit sharing.

ISSUES & CHALLENGES: SUKUK DEFAULT

• Sukuk can face a default under two conditions:
1. A scheduled payment (profit distribution) and/or the face value have not been made by the sukuk issuer (which is directly linked to the default of the obligor)
2. A clause in the sukuk contract is violated 🡪 covenant on sukuk
• Related parties in sukuk default:
• Obligor or originator
• Underlying asset
• Structure
• Legal and regulatory framework
• Governance

EXAMPLE OF SUKUK DEFAULT CASES

• Sukuk US and Gulf Cooperation Council (GCC)
• Sukuk Investment Dar (Kuwait Islamic Investment Company)
• Sukuk Saad Group (Saudi Arabia)
• Sukuk Nakheel Dubai
• Sukuk Berlian Laju Tanker (Indonesia)

EXAMPLE OF SUKUK DEFAULT CASES: NAKHEEL

• The Nakheel sukuk was Dubai-based, high profile and the largest ever. It was issued on December, 14 2006 for a period 3 year to raise USD 3.5 billion
• Listed on the Dubai International Financial Exchange
• Objective: to finance a property development project of one of public sector enterprises of Dubai, Nakheel Co.PJSC.
• SPV: Nakheel Development Limited and have high ratings from Moody’s (A1) and S&P (A+)
• Akad: Ijarah Manfaa
• Sukuk holder via SPV by the leasehold interest of the primary assets without transferring the title of the asset to them
• Therefore, sukuk holder only had rights on the stream of income generated by the assets and not on the assets themselves

EXAMPLE OF SUKUK DEFAULT CASES: NAKHEEL

1. SPV issue sukuk to raise USD 3.5 billion to purchase the leasehold in certain land, building and property at the Dubai Waterfront,
2. SPV transfers the proceeds of the sukuk to Nakheel Holding 1
3. SPV as a trustee of sukuk holder, leases the underlying sukuk asset to Nakheel Holding 2 for period 3 year. Half of the lease amount is paid to sukuk holder via the SPV and other half is deferred till maturity of the sukuk
4. The lessee, Nakheel Holding 2, also makes a unilateral undertaking to purchase the leasehold rights from the SPV

EXAMPLE OF SUKUK DEFAULT CASES: NAKHEEL

• A misunderstanding occurred between sukuk holders and the originator:
• Sukuk holders believed that the Dubai government fully guaranteed Nakheel Holding 1 and Dubai World, which served as the originator, if they defaulted.
• However, the prospectus clearly stated that the government did not guarantee at all.
• Sukuk holders are subordinated to other creditors.
• However, the rating agency gave a high rating (A+)
• The absence of guarantees should have resulted in a lower sukuk rating.
• Causes of default:
• At the macro level, it was caused by the global financial crisis of 2007-2008.
• Dubai World, the parent company, had high leverage.
• It had high short-term borrowings, falling oil prices, bubble real estate prices due to oversupply, and liquidity mismatch.

EXAMPLE OF SUKUK DEFAULT CASES: EAST CAMERON

• In July 2006, East Cameron Partners (ECP) issued sukuk of USD 165.67 million with a maturity of 13 years. The sukuk was rated by Standard & Poor's and was the first of its type to be issued by a company based in the United States.
• The structure utilises musharakah as the underlying contract, in which the sukuk investors were sold the overriding royalty interest (ORRI) in two gas properties through an SPV acting as the trustee for sukuk investors.
• Incorporated in the Cayman Islands, the SPV was named East Cameron Gas Company.
• According to the nature of the musharakah contract, the originator, ECP which was incorporated in Houston, Texas as a private oil and gas exploration company, also contributed to the funds and, consequently, the musharakah venture was co-owned by the originator and the sukuk holders.

EXAMPLE OF SUKUK DEFAULT CASES: EAST CAMERON

EXAMPLE OF SUKUK DEFAULT CASES: EAST CAMERON

The steps involved in the structure are as follows:

• Sukuk worth USD 165.7 million were issued by the issuer SPV. The proceeds were to be used for purchasing ORRI from the purchaser SPV according to a funding agreement for USD 113.8 million while the balance was to be used for a reserve account, development plan and purchase of put option for natural gas as a hedge instrument against the risk of falling gas prices.
• The share of musharakah capital from the originator came in the form of a contribution through a transfer of ORRI into the purchaser SPV.
• Holding ORRI in the properties, the purchaser SPV would be entitled to about 90% of the net revenue of ECP's gas production.
• With Merrill Lynch as a backup off-taker, the production would be sold to two of-takers.
• The proceeds from the oil and gas sale, after being transferred to an allocation account, were distributed as follows: 20% was to be paid to the government and private ORRI; the balance was to be transferred to the purchaser SPV; the purchaser SPV was to allocate 10% for the originator and the remnant for payment expenses, redemption amount and periodic sukük returns; any excess amount would go to the originator and early sukk redemption equally.
• At the maturity date, all sukk would be redeemed by the issuer SPV against the amount left to be transferred to the sukuk holders.

EXAMPLE OF SUKUK DEFAULT CASES: EAST CAMERON

• Depending upon the production and sale of hydrocarbons to the purchasers, it was scheduled that the sukuk holders would be paid an expected annual rate of return of 11.25% on a quarterly basis. As a credit enhancement, a reserve account was maintained for the purpose of filling any shortfall in return with the amount reserved in this account. Additionally, the right to sell the oil and gas at a strike price was acquired by way of buying put options which provided a hedge against a decrease in gas prices below a certain level (strike price).

EXAMPLE OF SUKUK DEFAULT CASES: EAST CAMERON

• Unfortunately, the production from the gas field was falling continuously after the issuance of the sukuk which made ECP default on its periodic payments. The major reason for this default was the financial problems of ECP caused by a shortfall in oil and gas production which was triggered by a hurricane in that area in September 2008.
• Consequently, the originator, ECP, filed a petition for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court in Louisiana to restructure their debts and operations.
• ECP also filed adversary proceedings requesting the court that the primary sukuk transaction with the purchaser SPV should be considered a secured loan and not a true sale of the assets. The implication of this would be that the assets were to be shared between sukuk holders and other creditors in the case of liquidation if the transaction is considered a secured loan. However, the court did not accept this argument stating that the '[sukuk] holders invested in the sukuk certificates in reliance on the characterization of the transfer of the royalty interest as a true sale'. This stance is important because it recognized the true sale nature of this asset-backed sukuk which was based on the musharakah concept, at least on US soil.
• Although ECP filed another lawsuit after making revisions, the stakeholders agreed to settle the case through negotiations. As a result, the sukuk assets were transferred to the issuer but for the benefit of the sukuk holders. As per the terms of the sale, the sukuk holders were sold the assets of ECP. However, a subordinated ORRI on the future production was given to the originator which would carry some value after the sukuk holders have been repaid their principal amount. To sum up, the rights of the sukuk holders were protected in the US due to the recognition of all the contracts by the courts of law and a well-established legal system of collateral

Sources: Stephen (2009); Graham (2011); Hawkamah (2011); Van Wijnbergen & Zaheer (2013)

SUKUK DEFAULT: FACTORS TO CONSIDER

• Is sukuk a bond or something different? 🡪 asset-based vs asset-backed
• What are the applicable laws for Islamic financial transactions and what are their sources? 🡪 legal system within the country
• How an Islamic bankruptcy law might develop, and who would use it?
• What tribunals are appropriate for the resolution of bankruptcy cases when the company has either issued Islamic instruments or purports to operate according to notions of Islamic law?

THE POSITION OF ISLAMIC LAW ON DEFAULT/INSOLVENCY

The establishment of modern corporation affects the default/insolvency

Foundational principles of the Shari’ah apply:

• Leniency to debtors is the founding recommendation by Islamic law (Qur’an 2: 280)
• Leniency to debtors is balanced by asking the debtor to pay his debt if he is solvent, which is both a legal obligation and a sin if not adhered to
• Islamic law also addresses the root cause of the problem of insolvency which is excessive debt. The law exhorts believers to avoid excessive debt and leverage
• Due to the prohibition of riba in all its forms, delay in payment by the debtor cannot lead to increased benefit to creditor. Therefore, issues such as interest on interest, packaging interest-based instruments in the form of CDOs and CDSs are not allowed and therefore, the bubble created through this chain of transaction is eliminated
• Any attempt to devise a viable Islamic insolvency law regime should be guided by the Islamic principles of justice and equity that are paramount in the objectives of Shari’ah
• The debtor who is unable to repay his debt constitutes a part of the eight beneficiaries of zakah (alms) and this fact must be a part of the Islamic insolvency model even if the institution of zakah is not currently efficient. A debtor being the recipient of zakah is thus a post-default measure

THE POSITION OF ISLAMIC LAW ON DEFAULT/INSOLVENCY

Debtor

• Compulsory payment of debt based on the Quranic obligation to fulfill covenants
• Avoid procrastination in paying debt
• Seek the creditor’s support to extend time if in difficulty

Creditor

• Remember that the debt was originated due to his social responsibility
• Receive his debt from the debtor as he has the full right to
• Ease the debtor through a time extension in case the debtor is in distress

SUKUK RESTRUCTURING

• Restructuring is less expensive than bankruptcy which is costly for both creditors and debtors on whom legal expenses are levied
• Restructuring also saves the entity from formal insolvency and it can continue its operations thereafter
• Restructuring also prevents the ‘fire sale’ of a debtor’s assets that may happen if it were to liquidate its assets
• A default event may trigger other automatic defaults by the defaulting party, thus damaging its credibility as well as the value of its assets
• Generally, restructuring follows default and therefore referred to as post-default restructuring. However, several pre-emptive debt restructuring have been taking place recently where outstanding debt instruments are exchanged before the debtor misses any payment

ISLAMIC LAW AND DEBT RESTRUCTURING

• Generally speaking, experts seem to agree that debt restructuring in the case of default and/or distress is acceptable under Islamic law
• However, they have different opinions regarding the mechanism to be used for debt restructuring
• The objective of restructuring by a debtor is twofold:
• To ensure the fair treatment of its creditors
• To ensure that the obligor can continue to operate as a going concern
• Although restructuring of debt is generally permissible under Islamic law, scholars disagree as to how debt can be restructured

POSSIBLE DEBT & SUKUK RESTRUCTURING MECHANISM: MATURITY EXTENSION

• This mechanism allows the debtor an extended period to pay his debt
• There are two types of maturity extension: (i) without any additional payment and (ii) with additional payment
• The first type is simpler and immediately available in the case of a debtor’s distress; aligned with QS 2: 280
• The second type, if extended without entering into a new contract, is prohibited as it is tantamount to riba due to additional increments of payment
• Creditors will generally opt for maturity extension when they view the financial prospects of the debtor as strong and expect to be paid in full
• In the context of sukuk, the investors agree to extend the maturity of the sukuk and hence get the full payment at a later period without entering into a new contract or changing the terms of payment, i.e. without getting extra payment. However, in practice, such delays are unlikely to happen

POSSIBLE DEBT & SUKUK RESTRUCTURING MECHANISM: HAIRCUTS

• The creditors waive part of their right to the debt, hence a portion of the debt is written off. The debtor’s liabilities are reduced, and the creditor bears the loss. There are two types of haircut:
• Haircut without an acceleration of the remaining debt
• Haircut with an acceleration of the remaining debt

POSSIBLE DEBT & SUKUK RESTRUCTURING MECHANISM: �NEW MURABAHAH CONTRACT TO SETTLE THE EXISTING DEBT

• Shari’ah scholars have divergent opinions on this arrangement. While Maliki and some Shafii jurists prohibit it except in the case of necessity
• Hambali and some Shafii scholars allow qalb al-dayn provided that both creditor and debtor enjoy the benefits of such arrangement, and more benefits go to the debtor
• Some contemporary scholars allow qalb al dayn for the solvent debtor only, whereas some disallow it regardless of the status of the debtor, solvent or insolvent
• Nonetheless, in the case of rescheduling which only involves an extension of time without an increase in the debt obligation, a supplementary agreement to effect the changes would be sufficient, provided that all the contracting parties agree to the revision

SUKUK RESTRUCTURING: TYPES OF SUKUK

SUKUK RESTRUCTURING

Disagreement

A Shari’ah arbitration tribunal

Award enforceable in court

Bankruptcy proceedings

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