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Sukuk Shariah Compliance Challenge

Aug 4th, 2011

Zia Ahmed Investment Banker, Islamic Banker

The existing regulatory legislation simply requires that the activities of the institutions be Sharia compliant, and the only requirement for assurance of such compliance is that it should be approved by a Sharia Supervisory Board to be established by each institution that is itself introducing the product, for
THE ISSUES AND CHALLENGES OF SHARIAH COMPLIANCE APPLICABLE TO SUKUK PART I: Practical Problems A. Introduction The evolution of Islamic finance is based on the concept of developing new financing techniques and instruments which are compatible with market acceptable banking and securities products. In doing so, the central idea is to ensure that newly developed products are in compliance with Sharia. Therefore it is extremely difficult to determine whether a product is Sharia compliant or not, under the multiple schools of thought.
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B. Practical Aspects Before I elaborate further on the challenges facing lawyers in addressing the big question, I will just mention certain examples of problems facing the construction of Sukuk, in particular Ijara Sukuk, being the most common instrument that is used for medium and long term financing. The technique of Ijara Sukuk, in a simplified description, is based on four major steps/transactions: 1. Issuing Ijara Sukuk by the SPV to raise funds to purchase the asset from the corporate seeking finance ("Project Company"). 2. Purchase of the asset by the SPV from the project company. 3. Lease of the asset by the SPV to the project company. 4. Finally, sale back of the asset to the project company at the end of the Ijara
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term by the SPV. These steps/transactions must meet certain conditions to qualify as being Sharia compliant, according to the widely respected bodies such as Fiqh Academy of the OIC. However the engineering of Sukuk to meet these requirements faces practical problems, and the market has developed certain approaches to overcome such hurdles that can vary from case to case, or jurisdiction to jurisdiction. 1. Sequence One of the conditions is that the issue of the Sukuk must take place before the lease agreement by and between the SPV and the project company is entered into. The practical techniques developed to overcome these conditions include: a) The purchase of the assets as well as its lease agreement is dated on the same closing date as the issue of Sukuk. b) Furthermore, for transactions that cannot take place on the closing date, for example the sales back agreement; the parties rely on promise from the SPV to sell the asset back at the end of the Ijara term, dated for the closing date. 2. No Guarantee

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Another condition is that the issuer of Sukuk (often an SPV), or the arranger may not guarantee the return on the Sukuk. This condition is surmounted by the arranger issuing the "Confidential Offering Circular" to potential underwriters, by relying on the Engagement Letter executed beforehand by the project company in favor of the arranger, and promises by the project company, inter alia, to: a) Sell the asset to the issuer (SPV) upon receipt of the agreed sale price from the Sukuk proceeds. b) Take on lease the asset for the agreed period and the agreed lease rental. c) Obtain a rating for the Sukuk by internationally recognized rating agencies. d) Sometimes, obtain a bank guarantee from a conventional bank, securing the Ijara rental payments. Such assurances can be viewed as an implied guarantee. 3. Independent Entities At times the Islamic scholars require that the SPV and the project company must be independent entities. To circumvent this condition, the SPV that is formed in practice is totally or partially owned by the project company, but this raises concerns about piercing of the corporate veil in event of a dispute. 4. Residual Value of the Asset A major feature of the Sukuk is that the asset needs to be returned to the project company. To realize this end, various mechanisms are applied: a) The title of the asset may be returned to the project company as a gift without consideration. b) The project company is required to pay fair market value of the asset at the end of the lease period, which is established by an expert selected in advance. c) The lessee acquires the asset against a nominal residual amount that is agreed in advance. 5. Valid Acquisition of the Asset The technique of Sukuk relies heavily on the SPV having acquired ownership of the asset to be leased to the project company, through a valid and enforceable sales agreement. However such sales face two problems in practice, especially when the asset is real estate: a) Registration Requirement: According to UAE laws the sale of real estate is not a consensual agreement, but rather a formal one that requires registration before the Land Department. b) Foreign Ownership: UAE law imposes restrictions on foreign ownership of real estate, and whereas most of the SPVs are established as offshore companies in foreign jurisdiction (mainly to protect the asset from claims by creditors or liquidators by the project company). Even if the SPV is registered in UAE and has full UAE citizenship, still the parties are reluctant to go through the registration process due to the high cost of registration for the initial sale, and then the sale back. 6. Default and Security Since transfer of the title pursuant to the sales agreement is questionable, the chances of realizing such a security in the event of default are also questionable.

C. Prime Concern: Sham Agreement These are some examples of the many practical issues facing structuring Sukuk that can be generally grouped into one prime concern: The risk that the various layers of transaction utilized in Sukuk may be viewed as a faade or a sham aimed at disguising the conventional asset backed bond, which is prohibited under Sharia principles. As you might be aware, UAE courts in dealing with such a transaction have the right and the duty to examine features of the transaction through discovering the intention of the parties on the basis of documentation used, and thus may recharacterize the transaction into a legal form they find most appropriate, regardless of the title of the agreement, or language used by the parties. Furthermore, given the nascent nature of Islamic finance, the products have not been tested sufficiently before the courts of law, and the current economic boom gives rise to few disputes arising out of Islamic finance products. Therefore there is little basis to predict how the UAE courts will treat disputes arising from Sukuk transactions. While some may view these concerns as theoretical, and an attempt by the lawyer to unnecessarily complicate the issues, but any adverse trends in the markets will bring these problems to the forefront. PART II: Challenges A lawyer may not be able to address all these issues in a clear cut manner due to the various challenges he

would face in finding an answer, which can be summarized as follows: A. Major Challenges 1. Legal Vacuum One of the major challenges in addressing these issues is the lack of national legislation, as mentioned earlier Sharia is not a codified body of law, but rather a set of practices based on various interpretations. It may be noted that the first attempt to codify the Sharia into a binding legislation was by the Ottoman Empire in the (known as Majalah Al Ahkam Al Adlia), and to a great extent civil laws in most of the GCC countries are influenced by this first code. Although the countries in the region do have certain legislation governing Islamic financial institutions, for example in UAE's case: - Federal Law No. 6 for 1985 concerning Islamic Financial Institution; - Emirates Securities and Commodities Authorities ("ESCA") Resolution No. 93/2005 concerning listing of Islamic Sukuk; and - DIFC Law No. 13 for 2003 Regulating Islamic Financial Business. However, these laws are more regulatory in nature, and do not deal with the substance of the product introduced by the Islamic financial institution, leaving a legal vacuum. 2. Lack of Precedents Although UAE legal system can be classified as a civil law system, but court precedents still play a major role by supplementing the legislation, and help plug the gaps left by codified law. Issues relating to Islamic finance, however, present an unusual problem because there is neither specific legislation regulating it, nor is there sufficient relevant case law to address these issues. Under this context, we would like to mention the ruling of the English Court of Appeal in the famous case of Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd. et al. (2004). To those who are not already aware of this case, we can briefly mention that Beximco entered into a Murahaba arrangement with Shamil Bank and defaulted in its obligation, where Beximco challenged that the transaction was not Sharia compliant as the agreement stipulated that the transaction was subject to the principles of Glorious Sharia" and was to be construed in accordance with the laws of England. However, if the issue arises before a court in one of the Muslim countries, particularly those countries which consider Sharia a main source of their legislation, the reasoning of English court may not be applicable, as courts in such countries are under obligation to review the contract to ensure that it is Sharia compliant, as the matter will be a public order issue. 3. Standardization Although there are certain organizations that enjoy a great deal of recognition in the region, such as Fiqh Academy of the Organization of Islamic Countries, based in Jeddah and the International Islamic Financial Markets ("IIFM") in Bahrain, or the Accounting and Auditing Organization for Islamic Financial Institute ("AAOIFI") also in Bahrain, that lay down certain guidelines about the requirement of Sharia for the various products, and issue an explanatory note, that can be viewed as setters of standards. These guidelines however have not been officially adopted as national laws in the region. In this context we can mention an advanced attempt by International Swap & Derivatives Association ("ISDA") to develop a "Master Agreement for Islamic Derivatives" for consideration by IIFM for adoption.

B. Other Challenges In addition to the difficulties mentioned above, other factors contribute to the uncertainty surrounding Sukuk transactions: 1. Absence of Centralized Sharia Compliance Board Unlike some countries, such as Malaysia, the UAE does not have a central sharia compliance board. The existing regulatory legislation simply requires that the activities of the institutions be Sharia compliant, and the only requirement for assurance of such compliance is that it should be approved by a Sharia Supervisory Board to be established by each institution that is itself introducing the product, for instance: Article 6 of Federal Law No. 6 of 1985 requires each Islamic financial institution to have their own Sharia Supervisory Board, and the Articles of Association of the financial institution itself will regulate the formation of this board, their function and their competence. Nonetheless, the names of the members of the board should be approved by the Central Sharia Compliance Board to be formed pursuant to a UAE Cabinet resolution. However to the best of our knowledge, such a governmental body has not been set up yet. However, under this regulation the approval by financial institution's Sharia Supervisory Board is only binding on the institution itself, and is not binding on others. 2. Lack of Models

In spite of the fact that the Sukuk has experienced tremendous growth over the last few years in UAE, the majority of these transactions relate to infrastructure development projects launched by government itself or government backed companies, and have their own unique structure that cannot be considered as a model for the private sector. For example, one of the major Sukuk issues in UAE was for the second phase of expansion of Dubai International Airport which involved building Terminal 2 for the Dubai Aviation Department, and was arranged by Dubai Islamic Bank for USD 750,000,000.00. For this particular issue, a specific law, Law No. 8/2004, was passed by the Ruler of Dubai Emirate by virtue of which Dubai Civil Aviation Department, the party seeking financing for this project, was allowed to secure the financing through Islamic products, and establish a company in Dubai Airport Free Zone, majority of which was owned by Dubai government, to act as the SPV where Dubai Civil Aviation was authorized to enter with the said SPV into all necessary agreements to secure the financing. 3. Multiple Jurisdictions The structure of Sukuk involves various transactions that might take place in different transactions, especially in cross border transactions which are quite common. For example, the engagement letter to be issued by the project company in favor of the arranger may be subject to a jurisdiction, while the sale of the asset and its lease may take place in another jurisdiction. Such a circumstance will just aggravate the above mentioned problems. Conclusion In conclusion, I believe that the future of Islamic finance depend very much on the core fundamentals of Shariah compliance and new product development. Customers will demand from the institutions more choices of products, better returns and Shariah compatibility. To meet their customers needs, Shariah Boards will have to play a more active role in product development and work in close partnership with management. And because of the increasingly complex role that they have to play, Shariah Boards should be staffed by scholars who are trained in both modern finance and Shariah law. On its part, Muis will continue to develop such scholars. We are also committed to contribute to the development of new and innovative products, just like what we had innovated five years ago. We hope that the other players in the industry will also do likewise. With such efforts, we will see a more exciting future ahead for the Islamic finance industry. Let me conclude by reiterating my view that to enable the Islamic capital market to develop further and to tap the tremendous opportunities world-wide, we must move beyond trying to merely cater to the investment needs of Muslim investors to introducing products that are acceptable to all in the global financial arena. Hence our efforts must not be focussed merely on ensuring Shariah compliance but also in ensuring international compatibility and acceptability. Negative differentials, whether in the form of different legal, tax or accounting framework must be removed to ensure that Islamic capital market products and services are competitive with the best in the conventional market. At the end of the day, the pursuit of value is a common denominator amongst all investors and therefore the value proposition that Islamic capital market products and services can offer will make all the difference. From a practicing lawyers point of view, we feel there is a serious and pressing need to enact legislation regulating the various Islamic financial products, in order to maintain the growth and stability in the market, and there is no harm if such legislation would adopt the most liberal views of the various schools to structure new financing techniques and instruments which are compatible with the market acceptable banking and securities products. Preferably, passing of national legislation adopting the standards issued by widely respected organizations such as the Fiqh Academy and IIFM, will help in creating a unified international standard for determining Sharia compliance of Islamic financing products.
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