UK: London: The New Souk For Sukuk

Islamic finance is now the Buzz Topic in the City of London. While the Middle East’s economies thrive and prosper, the enormous funds generated are seeking the best opportunities for investment the markets can offer. The Chancellor, Gordon Brown - perhaps the next Prime Minister- has been key to the debate; last month, he announced in his budget that Sukuk were to be given equivalent tax treatment to traditional interest-bearing bonds. The intention is that the City should eventually compete with Dubai and Kuala Lumpur in the development of new financial instruments which comply with Shariah law.

Although Shariah law prohibits certain activities, including the earning of interest, speculation, contracts which have an element of uncertainty and transactions which are overly advantageous to one party at the expense of another, the Islamic finance industry has developed various structures in order to meet the financing needs of businesses and investors who wish to comply with Shariah. Incidentally, these arrangements may have a broader appeal to those interested in investing ‘ethically’. These structures can deliver the same results that conventional financing transactions are able to achieve. Among these financing instruments is the Sukuk.

What is a Sukuk?

The Accounting and Auditing Organisation for Islamic Financial Institutions ("AAOIFI") - the regulatory and accounting standards body for Islamic finance - defines Sukuk as being:

Popularly referred to as an ‘Islamic Bond’, the Sukuk is, in fact, an asset-backed, trust certificate showing evidence of ownership of an asset or its usufruct (earnings or fruits). The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. The closest instrument comparable to them in the conventional financial system would be a bond such as those issued in relation to a securitisation. A Sukuk confers a beneficial interest to the holder in terms of holding a proportional ownership of the underlying asset as well as the income that it generates. The Sukuk holder also assumes all rights and obligations for the maintenance of the asset.

Their use in the world of Islamic finance has become increasingly popular in the last few years, both because they provide the means to raise government finance through sovereign issues, and as a way of companies obtaining funding through the offer of corporate Sukuk.

• Sukuk holders claim an undivided beneficial ownership in the underlying assets, whereas since the bond is a contractual debt obligation, the issuer is contractually obliged to pay bond holders, on certain specified dates, interest and principal. Consequently, Sukuk holders are entitled both to share in the revenues generated by the Sukuk assets and to share in the proceeds of the realization of the Sukuk assets.
• Sukuk holders have the right to profits but are also under an obligation to bear losses, whereas the holders of securities are not similarly bound.
• A unique feature of a Sukuk is that in instances where the certificate represents a debt to the holder, the certificate will not be tradable on the secondary market and instead is held until maturity or sold at par.

Characteristics of Sukuk:

• Sukuk are based on an investment process which involves investors mixing their profits with other investors in order to make profits.
• They are a tradable Shariah-compliant capital market product providing medium to long-term fixed or variable rates of return.
• They are assessed and rated by international rating agencies.
• They provide regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation.

The primary condition for issuance of Sukuk is the existence of assets on the balance sheet of the issuing entity. The identification of sufficient assets is the most important step before the issue of the Sukuk certificate. The model of Sukuk security is derived from the conventional securitization process in which a special purpose vehicle ("SPV") is set up to acquire assets and to issue financial claims on the assets. These financial assets claims represent a proportionate beneficial ownership to the Sukuk holders.

Types of Sukuk:

Islamic markets offer different instruments to satisfy both providers and users of funds in a variety of ways. The AAOIFI has issued standards for 14 different types of Sukuk, where some of these Sukuk are classified as tradable and others are classified as non-tradable based on the type and characteristics of the issued Sukuk. The most important and common among those are:

• Mudaraba Sukuk

These are investment Sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders. Sukuk holders are considered to be owners of common shares in the Mudaraba capital and all benefits and returns are related to the investor’s percentage of ownership in the capital. Mudaraba Sukuk are used for enhancing public participation in big investment projects. Mudaraba basically means an agreement between two parties according to which one of the two parties provides the capital (capital provider) for the other (Mudarib) to work with on the condition that the profit is to be shared between them according to a pre-agreed ratio.

The issuer of these certificates is the Mudarib, the subscribers are the capital providers, and the realised funds are the Mudaraba capital. A Mudaraba Sukuk gives its owner the right to receive his capital at the time the Sukuk are surrendered, and an annual proportion of the realised profits as agreed. Mudaraba Sukuk neither yield interest nor entitle owners to make claims for any definite annual interest. Mudaraba Sukuk must represent a common ownership and entitle their holder to shares in a specific project for which the Sukuk have been issued to fund. On the expiry of the specified time period of the subscription, the Sukuk holders are given the right to transfer the ownership by sale or trade in the securities market at their discretion.

Musharaka Sukuk

Musharaka means a relationship established under a contract by the mutual consent of the parties for the sharing of profits and losses in the joint business - akin to a joint venture agreement. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by every partner strictly in proportion to respective capital contributions. These are investment Sukuk that represent ownership of Musharaka equity.

Musharaka Sukuk are used for mobilizing funds for establishing a new project or developing an existing one or financing a business activity on the basis of any partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market.

Ijara Sukuk

The Ijara Sukuk are title deeds of equal shares in a leasing project, usually equipment or real estate. These Sukuk give their holders the right to own shares, receive rental fees and dispose of their Sukuk in a manner that does not affect the right of the lessee. The holders of such Sukuk bear all the cost of maintenance of and damage to the real estate. The duration of the rental and the fee are agreed in advance and ownership of the asset remains with the lessor. Ijara Sukuk are tradable at market prices on any stock exchange and are listed in the same way as conventional bonds.

Sukuk al-Ijara are subject to risks related to the ability and desirability of the lessee to pay the rental instalments. Moreover, these Sukuk are also subject to real market risks arising from potential changes in asset-pricing and in maintenance and insurance costs. The expected net return on some forms of Sukuk al-Ijara may not be completely fixed and determined in advance, since some maintenance and insurance expenses may only occur subsequently.

Sukuk al-Ijara offer a high degree of flexibility from the point of view of their issuance management and marketability. Sukuk al-Ijara holders, as owners, bear full responsibility for what happens to their property. They are also required to maintain it in such a manner that the lessee may derive as much usufruct from it as possible. The Ijara Sukuk provides an efficient medium-to-long term mode of financing. These instruments have been used in a variety of cross-border applications for an increasing range of asset classes including ships, aircraft, telecommunications equipment and power station turbines.

Murabaha Sukuk

Murabaha is basically the sale of goods at a price comprising the purchase price plus a margin of profit agreed upon by both parties concerned. Sukuk al-Murabaha are certificates of equal value issued for the purpose of financing the purchase of goods through Murabaha so that the certificate holders become owners of the Murabaha commodity. The issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realised funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the commodity. The potential for having legally acceptable Murabaha-based Sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by Shariah, as the certificates represent a debt owing from the subsequent buyer of the commodity to the certificate-holders and such trading amounts to trading in debt on a deferred basis, which will result in the earning of interest (Riba). Despite being debt instruments, the Murabaha Sukuk could be negotiable if they are the smaller part of a package or portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or Ijara Sukuk.

Salam Sukuk

The main concept of Salam Sukuk is that it is a financial instrument linked to a commodity sale, whereby the seller undertakes to supply a specific commodity to the buyer at a future date in return for an advanced price paid in full on the spot. The price is paid in cash but the supply of the purchased goods is deferred. As a form of financing, the purchaser is able to acquire the assets by advance payment at a discounted price and subsequently sells the assets upon delivery. The Salam contract is the sale of goods or assets delivered on time and paid for in advance. The Salam process is not suitable for the issuance of tradable Sukuk since they represent debts. At maturity, the Sukuk holders receive their proceeds in addition to the margin paid by the underwriting entity. These Sukuk are short-term Sukuk and are held until maturity. The Salam Sukuk is different from Istisn’a Sukuk in that the purchase price for the assets under Salam Sukuk must be paid in full and the date of delivery must be fixed.

Istisn’a Sukuk

The Istisn’a contract is similar to project finance contracts in conventional finance. Istisn’a is a sale where a commodity, either an asset or project, is transacted before its completion or in its development phase. The contract involves investors who agree to buy the commodity before its manufacture is completed. Investors are not obliged to pay all the investment in advance, but to pay gradually before the beginning of each stage of the manufacturing process of the commodity. It is necessary for the Shariah’s validity of Istisn’a, that the price of the commodity is fixed with the consent of the parties, and that the necessary specification of the commodity intended to be manufactured is fully settled between them. The Islamic financial institution funds the manufacturer or the contractor during the construction of the asset, acquires title to that asset and upon completion, either immediately passes title to the developer on agreed deferred payment terms or, possibly, leases the asset to the developer under an Ijara Sukuk. However, it should be noted that, if the Sukuk are listed during the Istisn’a period, the Sukuk should be traded only at par as the underlying assets do not yet exist.

Emergence and Growth of Sukuk:

The emergence and growth of Sukuk instruments have revolutionised the Shariah-compliant debt securities sector. They have not only given momentum to the Islamic financial industry, but have also provided opportunities for the development of secondary markets, which in the long-term will match the well-established conventional debt markets. The overall Sukuk market size was estimated to be close to US$70 billion globally as at the end of 2006. These include those issued from Malaysia, Pakistan and the Middle East. This is expected to reach US$100 billion according to the more conservative forecasts within the next five years.¹

As to the rapid growth of Sukuk instruments, AAOIFI issued a Shariah standard: "Investment Sukuk" in May 2003, which became effective from 1st January 2004. It states that Sukuk represents a common share in the ownership of the assets made available for investment, whether these are non-monetary assets, usufructs, services or a mixture of all these plus intangible rights, debts and monetary assets. The wide application parameters of the product can be seen from the fact that Sukuk may be issued both on existing as well as specific assets that may become available at a future date.

Sukuk as a financial instrument may be expected to meet all of the economic objectives of conventional fixed-income securities without breaching the fundamental principles of the Shariah. The market potential is far from being realised and there is general agreement that the total value of Sukuk issues made so far represents only a fraction of the market demand.

The London-based International Capital Market Association ("ICMA") and Bahrain-based International Islamic Financial Market ("IIFM") signed a Memorandum of Understanding which will focus on the Sukuk market, and is increasingly attracting non-Islamic financial institutions and firms. Another sign of the growing importance of the Sukuk market is that several Islamic issuers from outside the Middle East are now entering the market. Those issuers include Asian Development Bank, Nestle and the Federal state of Saxony-Anhalt - the first public European issuers to do so. Traditional issuers of Sukuk in 2005 included Emirates Airlines, with a $550 million Sukuk, the first of its kind to be issued by an airline company and Dubai Metals & Commodities Center, which issued a gold-linked bond allowing investors to receive payment in gold bullion or US dollars.²

In 2006, $7 billion worth of Sukuk were issued, a 78% increase on 2005. Sukuk worth $20 billion are still outstanding.³ In conclusion it would seem that the Sukuk has developed as one of the most significant mechanisms within Islamic finance for raising capital in the international markets today.

Islamic Bonds in UK:

Traders estimate the number of Sukuk trades in the London market rose from a trickle before November 2006 to about $2 billion in January 2007, spurred on by the world’s largest Sukuk bond issue: a $3.52 billion issue in November 2006 from the Nakheel Group, the Dubai property developer.⁴

London has already seen the issue of Islamic bonds of huge value. The two latest deals from UAE property giant, Aldar Properties and the Dubai Islamic Bank, will help propel the amount of outstanding Sukuk in the world past the $70 billion mark. Aldar Properties issued a mighty $2.5 billion Sukuk on the London Stock Exchange. The Dubai Islamic Bank bond, which is yet to be priced and will be of benchmark size, suggesting more than $1 billion, is likely to list in London soon after a road show. It will also list on the Dubai exchange⁵.

Ford Motor recently agreed to sell Aston Martin for £479 million to a leveraged buy-out ("LBO") consortium organised out of London by motor-racing entrepreneur Dave Richards.⁶ The consortium will finance the purchase according to strict Islamic principles. The Islamic financial focus has arisen partly because two key financiers behind the LBO, Kuwaiti Groups Investment Dar and Adeem Investment Company, only make investments that are Shariah-compliant. The control of the luxury performance carmaker has moved from the USA to Kuwait after the two Middle East investment firms promised to generate the major portion of the funding for the acquisition of the business from Ford.

According to the Financial Times, West LB, the German Bank, has been appointed to arrange £225m of quasi-debt finance to back the LBO of Aston which, following the requirements of the Koran, will be free of any elements of interest or speculation. An executive director at West LB believes that this may be the first time that Islamic finance has been used for an LBO in the UK and possibly in the Western world.

Impact of the March 2007 Budget on Islamic Bonds:

Sukuk are certificates which entitle the holder to the economic return arising from a portfolio of assets held by the issuer. The assets, and the arrangements relating to their holding and disposal, are such that the returns received by Sukuk holders are equivalent to the returns which they would receive on an interest-bearing debt security. The main tax problem with such arrangements at the present time is that the issuer, if UK resident, will be taxable on the profits received in respect of the assets but will not be entitled to any deduction for payments which it makes to the Sukuk holders in respect of those profits.

Under the proposals laid out in the Budget, Sukuk will in the future, be taxed in the same way as conventional bond transactions and it will therefore be possible to issue, hold and trade such Sukuk in the UK on that basis. And if companies that issue Sukuk meet the necessary conditions, they will also be able to qualify for the special tax regime that applies to securitisation companies. Before this proposed change, there was much uncertainty as to how capital gains tax, income tax and capital allowances would apply to Islamic Bonds.

As outlined by the Chancellor, Gordon Brown, income payments will be treated as if they were interest payments, so that the issuer will get a deduction in computing the tax liability. In addition, there are provisions which equate Sukuk to traditional debt securities for other tax purposes such as the ‘qualifying corporate bond’ regime and the tax treatment of discounts. By treating Sukuk in the same way as corporate securitisations, a level playing field is being created, which will facilitate the issuance and trading of Sukuk in the UK. This will widen the choice of products for all investors, including those businesses which want to diversify their investor base and tap into the immense pool of Islamic funds in the Middle East.

However, there is a concern, almost certainly justified, that these proposals may open the door to tax avoidance schemes. A number of conditions will have to be met for such arrangements to fall within the scheme. These include:

• the payments made to the Sukuk holders must not exceed a reasonable commercial return on the amounts subscribed;
• the arrangements must legitimately be treated as a financial liability of the issuer under International Accounting Standards; and
• the Sukuk must be listed on a recognised Stock Exchange.

The market for Sukuk is growing and their attraction as an alternative means to conventional methods of saving and investment has an appeal to a growing investor base. Although different Sukuk structures have emerged, most of the Sukuk issuance to date have tended to be Ijara Sukuk; since they are based on the undivided pro-rata ownership of the underlying leased asset, they are freely tradable at par, premium or discount.

According to Standard & Poor’s Rating Services, Dubai has been the most active trading centre for Sukuk notes so far. However London clearly has a head start in the race to become the Islamic financial centre of the West. This is partly because of its geographical location and time zone, which give it an advantage over New York and partly because the government and banks in the UK have been more willing to promote Islamic finance than the US. However, it is the recently proposed amendment to the tax laws in the UK which may really boost London’s chances as a credible rival. So, can London be the new Souk for Sukuk? A share of a market with a predicted value of $ 100 billion certainly seems worth playing for.

Footnotes

The content of this paper does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

© B.J. Macfarlane & Co.