A Synthesis

of SharÔÑah Issues
and Market Challenges
in the Application of WaÑd in
Equity-based ØukÕk

Shabnam Mokhtar∗

The ÎukËk market is a fairly new development in the Islamic financial

system. Shell MDS (Malaysia) issued ÎukËk in 1990, but there were
no active issuances by other players or countries until the year 2001 in
which a number of institutions issued ÎukËk, including Majlis Ugama
Islam Singapura (MUIS), the Government of Bahrain and the first
global corporate ÎukËk by Guthrie Malaysia. This was the beginning
of an active ÎukËk market. Total ÎukËk issued as at 5th August 2009
amounted to US$133 billion.1 In the year 2007, equity-based ÎukËk
(i.e. ÎukËk mushÉrakah, ÎukËk muÌÉrabah and ÎukËk wakÉlah) was
the most popular type of ÎukËk issued. It represented 75% of ÎukËk
issued in 2007 but dropped to only 36% of ÎukËk issued in 2008. The
main motivation of this study was sparked by a pronouncement made
by AAOIFI in February 2008 on ÎukËk which among others, does not
permit the Obligor to give a pre-determined purchase undertaking at
par.
The main question that this research is attempting to answer is
whether the purchase undertaking (at par) guarantees principal in
the equity-based ÎukËk. To answer the main research question, we
embarked on detailed case studies of 11 pre-AAOIFI cases and four
post AAOIFI cases. These provide empirical evidence on the role of
purchase undertakings in equity-based ÎukËk.

* Shabnam Mokhtar is an Associate Researcher at ISRA. She can be contacted at

shabnam@isra.my.
1 Based on IFIS database assessed on 5th August 2009.

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 A Synthesis of SharÊÑah Issues and Market Challenges in the Application of WaÑd in Equity-based ØukËk

The specific objectives of this research are as follows:

i. To identify why waÑd (undertaking) is needed in the
securities market;
ii. To examine the application of waÑd (undertaking) in equity-
based ÎukËk and the SharÊÑah position on this;
iii. To analyse the SharÊÑah underpinning behind AAOIFI’s
pronouncement on ÎukËk;
iv. To discover how the market is currently coping with the
issue of purchase undertakings in equity-based ÎukËk; and
v. To explore alternative solutions to the issue of purchase
undertakings in equity-based ÎukËk.

As the Islamic finance market is heavily saturated with debt-based

products, this study aims to provide clarity to the market when
SharÊÑah requirements and market requirements collide in these
equity-based instruments. It hopes to provide suggestions on how a
reconciliation of both may be chartered.

SUMMARY OF MAIN FINDINGS:

Is Purchase Undertaking at Par a Form of Guarantee?

An analysis of selected term sheets indicates that the purchase

undertaking in asset-based equity ÎukËk provides assurance that in
certain circumstances the Obligor will have to repay not only the
principal but also the accrued but unpaid profit. This is because
the exercise price of the purchase undertaking is made at this price
(outstanding principal + accrued but unpaid profit). Although
sometimes there is a formula instead of a straight-forward equation,
a deeper diagnosis of the term sheet provides evidence that the
formula can be substituted with an absolute equation.
For example, in the Gold ØukËk DMCC issued in May 2005,
the following were the functions and prices of the purchase
undertaking:

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 Shabnam Mokhtar

When What was Detail of purchase undertaking price

bought

Exercise Price = {U + (P – X)}

Periodic 10% of = Principal amortised + unpaid Periodic

distribution Issuer’s Distribution Profit Amount accrued
date unit = US$20 m + {[(6m
LIBOR+0.6%)*Outstanding principal*
n/360] – profit paid}

Exercise Price = Aggregate principal amount

outstanding + unpaid Periodic Distribution
Dissolution All of Profit Amount accrued
event Issuer’s
unit = Outstanding principal + {[(6m
LIBOR+0.6%)*Outstanding principal*
n/360] – profit paid}

Furthermore, the sole right of the ÎukËk holders in a dissolution

event is to invoke the purchase undertaking. They are not allowed
to dispose of the asset. The purchase undertaking now becomes
a very important tool and it promises principal and unpaid profit
redemption. Simply put, it provides recourse to the Obligor and
not the underlying asset and this is a form of guarantee, because
regardless of the venture’s performance the ÎukËk holders will
obtain their expected return and principal.

Independence of Purchase Undertaking Provider?

The IDB SharÊÑah Board in the second IDB ØukËk Al-Istismar

issued in June 2005 clearly indicated that purchase undertaking
is a guarantee of payment. However they allowed it in ØukËk
muÌÉrabah (as indicated in the SharÊÑah pronouncement) because
IDB was considered an independent party. The issuer was an
offshore SPV, thus the SharÊÑah Board viewed IDB as being
independent from the issuer. Nonetheless, SPVs are usually shell
entities (thinly capitalised and do not have employees nor make
any decisions). That is why there will be a trustee appointed to act
on behalf of the ÎukËk holders. Besides the factors identified in
the accounting standards on control and significant influence, the
rating bodies have another important test of independence - credit

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 A Synthesis of SharÊÑah Issues and Market Challenges in the Application of WaÑd in Equity-based ØukËk

independence between the SPV and the Obligor. If the trust asset
does not provide enough cash flow, does the SPV have recourse
against the issuer? If yes, then the SPV is credit-linked to the
Obligor. In this case, the rating bodies will not consider the SPV as
an independent entity and they will pierce through the SPV’s veil
and look at who is behind it. A purchase undertaking provides this
credit-linking and allows the ÎukËk holders to have recourse against
the Originator and not the trust asset.

Status of ØukËk Holders – Owner vs Secured Creditor vs

Unsecured Creditor?

Asset-based ÎukËk holders are usually considered as unsecured

creditors because they do not have the right to dispose of the
underlying ÎukËk asset. Furthermore, in an asset-based ÎukËk it is
very common to find that no detailed due diligence was conducted
on the asset. Let us look at an example:

No investigation or enquiry will be made and no due diligence will be

conducted in respect of any Sukuk Assets. Only limited representations will
be obtained from IDB in respect of the Sukuk Assets of any Series of Trust
Certificates. In particular, the precise terms of the Sukuk Assets or the
nature of the assets leased or sold will not be known (including whether
there are any restrictions on transfer or any further obligations required
to be performed by IDB to give effect to the transfer of the relevant Sukuk
Assets). No steps will be taken to perfect any transfer of the relevant
Sukuk Assets or otherwise give notice of the transfer to any lessee or
obligor in respect thereof. Obligors and lessees may have rights of set off or
counterclaim against IDB in respect of such Sukuk Assets.

IDB ØukËk 2005: No due diligence on asset

(Source: Risk Factors, p69-70 of the IDB 2005 Offering Circular)

In addition, the intention of the documents (in asset-based ÎukËk)

indicates that from the English law perspective (the governing law
for the main transaction documents) the ÎukËk holders do not have
interest in the asset. Let us look at DP World for example:

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 Shabnam Mokhtar

Pursuant to the Declaration of Trust, the Issuer will declare a trust, inter
alia, of its interest under Shari’a in the Mudaraba Assets and certain of its
rights, benefits and entitlements, present and future, under each of the
Transaction Documents. On any Redemption Date, pursuant to the Purchase
Undertaking or the Sale Undertaking, the Obligor will be obliged to purchase
all (or in the case of a Change of Control Put Date, the relevant pro-rata
part) of the Trustee’s interest under Shari’a in the Mudaraba Assets. Each
of the Mudaraba Agreement, the Purchase Undertaking and the Sale
Undertaking are governed by English law under which the interest under
Shari’a in the Mudaraba Assets of either the Issuer and/or the Trustee may not
be recognised. Neither the Issuer nor the Trustee has any interest in the
Mudaraba assets under English law.

Intention of document not to have interest in trust asset

(Source: Risk Factor relating to Mudaraba Asset, p22 of the DP
World Offering Circular)

This phenomenon of no due diligence raises important SharÊÑah

issues because basically the ÎukËk holders are not sure whether they
can buy the asset or not. They do not focus as much on this because
in the event of default, they rely on the purchase undertaking and
not the asset. WaÑd now shifts the focus of the investor from the
asset to the Obligors by way of assurance provided in the waÑd.

How is the Market Coping with the Issue of Purchase

Undertaking (PU) at Par?

• In asset-backed securities it is normal not to have PU at all.

The ÎukËk holders would have the right to dispose of the asset.
There are about 11 Islamic asset-backed ÎukËk that have been
issued in the market. There was no problem with rating.
• There is no PU but there is expected redemption. Redemption
will only take place if there is money in the pot. This was the
Villamar structure.
• In Sorouh, an asset-backed ÎukËk issuance, there was PU given
at par, however the issuer had the right to defer payment if it
did not have enough cash flow in the trust asset. In other words
this was a limited PU; limited to the actual performance of the
venture. So they relied fully on performance of the underlying
project/asset rather than Sorouh.

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 A Synthesis of SharÊÑah Issues and Market Challenges in the Application of WaÑd in Equity-based ØukËk

• PU at market value. This has been applied for a long time in

the Asset-backed ØukËk Ijarah, so it is not something alien.
Malaysian asset-backed ØukËk Ijarah that went for the true-
sale securitisation structure had the promise to sell at market
value. There were still investors and the deals still obtained
good ratings.
• PU at value to be agreed in future. The PLSA ØukËk MuÌÉrabah
applied this approach and there was no pre-determined price of
PU. They managed to find investors.
• Third party guarantee – Bin Ladin ØukËk MuÌÉrabah issued in
Saudi utilised a guarantee from its parent. Again the issue of
independence would come up.
• If it is too cumbersome to achieve true sale and bankruptcy
remoteness, the Islamic market can explore the covered bond-
like ÎukËk, where a pool of assets that continue to sit on the
balance sheet of the Obligor will be ring-fenced for the bond
holders. This was basically tried in the PG Municipal ØukËk
MuÌÉrabah issued in Malaysia in 2004. The covered bond is a
well established instrument in the European market.

Conclusion

If we analyse waÑd as a stand-alone component in equity-based ÎukËk,

it fulfills the SharÊÑah requirement. However, when we look at the
combined effect of waÑd and its price, it plays the role of guarantee
because it provides the investors with recourse to the Obligor,
regardless of the performance of the venture. The requirement to have
tangible assets in order to issue the ÎukËk is taken away in equity-
based ÎukËk, thus making it a very “asset-light” structure. In these
asset-light structures, the anchor in the form of the tangible assets
requirement was lifted and this was replaced with a different anchor
(loss sharing). However, with the application of waÑd at par, even this
anchor (loss sharing) has vanished.

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 Shabnam Mokhtar

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