Islamic Finance: Issues in Sukuk and Proposals for Reform: Issues in Sukuk and Proposals for Reform 9780860375784, 9780860375517

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his collection of essays brings together leading scholars and practitioners to discuss contemporary issues in the rapidly-expanding sukuk market, and debates the challenges facing it since the 2008 financial crisis and a number of high profile sukuk defaults. It looks in particular at issues of Shari[ah compliance, the issue of replication in Islamic finance, the need to have a true sale in the asset securitization process, and the issue of sukuk defaults. It is highly recommended for practitioners, scholars and students of Islamic finance. The contributors are Abdul Karim Abdullah, Mohammed Imad Ali, Muhammad Al-Bashir Muhammad Al-Amineo, Rafe Haneef, Mohammad Hashim Kamali, Nermin Klopic, Raja Teh Maimunah, Faizal Ahmad Manjoo, Abbas Mirakhor, Sirajulhaq Hilal Yasini, and Sheila Ainon Yussof. Professor Mohammad Hashim Kamali is the founding chairman and CEO of the International Institute of Advanced Islamic Studies (IAIS) in Malaysia, and is a leading authority in Islamic jurisprudence, Islamic finance and human rights in Islamic law. A. K. Abdullah is Research Fellow at the IAIS. He previously lectured at several private institutions of higher learning both in Canada and in Malaysia, and also at the University Sains Islam Malaysia (USIM).

In a relatively short period of time the sukuk industry has become the most vibrant chapter of Islamic banking and finance. Rapid progress has, however, given rise to very many questions. This book provides insightful responses to topical questions that the students and scholars of Shari[ah would find refreshing and relevant. Sheikh Nizam Yaquby, Shari[ah scholar and advisor to numerous Islamic financial and institutions worldwide The papers in this volume contributed by scholars and practitioners demonstrate that Shari[ah compliance in sukuk structuring remains a challenge. They also remind us of the need to resolve the issue of overlapping jurisdictions that govern sukuk under the common law and the Shari[ah. This book will be of interest to members of the legal profession, especially in the corporate sector, and in Islamic banking and finance. Tun Abdul Hamid Mohamad, former Chief Justice of Malaysia

THE ISLAMIC FOUNDATION United Kingdom www.islamic-foundation.com

Islamic Finance Issues in Sukuk and Proposals for Reform

Tan Sri Zarinah Anwar, former Chairperson, Securities Commission Malaysia

Islamic Studies | Islamic Finance | Economics

Kamali and Abdullah

This is a valuable book that addresses current issues regarding the sukuk, both from the Shari[ah as well as the legal and regulatory perspectives and offers important insights and observations in response. The extensive analysis of the issues will help facilitate greater understanding of the challenges and contribute towards meaningful discussions on solutions.

Islamic Finance

Issues in Sukuk

and Proposals for Reform

isbn 978-0-86037-551-7 | US$24.95

Editors Mohammad Hashim Kamali and A.K. Abdullah www.iais.org.my

In the midst of continued turmoil in the financial markets, a search for credible alternatives is gaining pace. This book is engaged in a crucial discussion about the best Shari[ah-compliant ways of addressing the challenge of developing structures for sound investment, and, at the heart of this debate, is the assessment of ‘asset-based’ versus ‘assetbacked’ sukuks, which has come out well in this book. Dr. Mansoor Durrani, Senior Vice President, Head of Project Finance, National Commercial Bank, Jeddah, Saudi Arabia

Islamic Finance Issues in S ụ ku‾k and Proposals for Reform

Editors Mohammad Hashim Kamali Abdul Karim Abdullah

International Institute of Advanced Islamic Studies, Kuala Lumpur, Malaysia

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Islamic Foundation, Markfield, United Kingdom

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Islamic Finance: Issues in Ṣukūk and Proposals for Reform Published in the United Kingdom By the International Institute of Advanced Islamic Studies and the Islamic Foundation International Institute of Advanced Islamic Studies Jalan Elmu, Off Jalan Universiti, 59100 Kuala Lumpur, MALAYSIA Tel: +60 3 7956 9188 Fax: +60 3 7956 2188 Email: [email protected] Copyright © International Institute of Advanced Islamic Studies 2014/1435 AH, in Malaysia Distributed in Malaysia by International Institute of Advanced Islamic Studies The Islamic Foundation Markfield Conference Centre Ratby Lane, Markfield, Leicestershire LE67 9SY, UNITED KINGDOM Email: [email protected] Website: www.islamic-foundation.com Qur’an House, PO Box 30611, Nairobi, KENYA PMB 3193, Kano, NIGERIA Distributed worldwide except for Malaysia by: KUBE PUBLISHING LTD. Tel: +44 (0)1530 249230 Fax: +44 (0)1530 249656 Email: [email protected] Copyright © The Islamic Foundation 2014/1435 AH, all territories outside of Malaysia The right of the named contributors to be identified as the Authors of this work is hereby asserted in accordance with the Copyright, Design and Patents Act 1988. A CIP record is available from the British Library. ISBN: 978-0-86037-556-2 casebound ISBN: 978-0-86037-551-7 paperback ISBN: 978-0-86037-583-8 ebook Printed in Turkey by IMAK Ofset.

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CONTENTS Preface

v

Introduction

1

1. The ‘Ping-Pong’ of the Asset-Backed/Asset-Based Ṣukūk Debate and the Way Forward Faizal Ahmad Manjoo

11

2. Unresolved Sharīʿah Issues in Ṣukūk Structuring Muhammad Al-Bashir Muhammad Al-Amine

29

3. Ṣukūk: Perception, Innovation and Challenges Mohammed Imad Ali

57

4. Ṣukūk and Bonds: A Comparison Abdul Karim Abdullah

69

5. Measuring Sharīʿah Compliance in Ṣukūk Ratings: A Survey of Existing Methodologies Sheila Ainon Yussof

96

6. Concession Rights as Underlying Assets for Ṣukūk Sirajulhaq Hilal Yasini and Nermin Klopic

113

7. The Case for Receivables-Based Ṣukūk: A Convergence between Malaysian and Global Sharīʿah Standards on Bayʿ al-Dayn? Rafe Haneef

144

Interviews 1. Abbas Mirakhor – ‘Ṣukūk: Issues & Reforms’ by Sheila Ainon Yussof

162

2. Raja Teh Maimunah – ‘Issues in the Prevailing Financial Architecture with Special Reference to Ṣukūk’ by Zarina Nalla

167

Contributors’ Biographies

177

Transliteration Table

181

Glossary

182

Index

192

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Preface The collection of essays in this volume by scholars and practitioners of Islamic finance on the subject of ṣukūk could hardly have come at a more pertinent time. Since the global financial crisis started in 2008, Islamic finance has come under the spotlight. Questions are being asked regarding Islamic ṣukūk, in particular about some recent – and unprecedented – ṣukūk defaults. Questions are not confined merely to the causes of the defaults – concerns have surfaced about deeper issues of Sharīʿah compliance in ṣukūk structuring, including whether a lack of compliance at key stages of the securitisation process may have played a role in the defaults. It seems that the challenge of how to structure ṣukūk in ways that at once satisfy the requirements of Sharīʿah, the diverse expectations of the stakeholders, as well as the needs of the Muslim community, remains as relevant as ever. Sharīʿah compliance requires first and foremost the avoidance of interest (ribā), which has been categorically prohibited in the Qur’an, even as trade (bayʿ) has been permitted. Ensuring income is earned in the form of profit rather than interest, therefore, is of paramount importance. A good grasp of the difference between profit and interest (and by implication between trading and lending) is a sine qua non for issuing or investing in Sharīʿahcompliant securities. Whether income is earned in the form of profit rather than interest depends on whether the income-generating transaction is a loan or a sale. Profits are earned in the course of trading but interest is earned through lending. In order to ensure that income is earned in the form of profit rather than interest, income needs to be earned in the context of trading or investment, rather than as rental charge on money. In an interest-based loan, money is exchanged for (more) money. In a sale, by contrast, money is exchanged for an asset or service. Trading requires the counterparties to take risk and responsibility for the outcome of a trade or investment. Sellers face the risk of being unable to find buyers for their products or that the market price may be too low. Buyers face the risk that the products they buy may turn out to be of lower quality than expected or that their price may be too high. Investors in a business enterprise face the risk of incurring losses, and even of losing their entire investment. In interest-based lending, in particular collateralised lending, in contrast, contracts between creditors and debtors are structured in such a way that the risks of business enterprise are faced by one counter-party alone: the

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borrower. This means that risks are not shared by creditors. Ensuring that business risks remain with borrowers is achieved by requiring the latter to provide legally binding (interest) income and capital guarantees. In other words, lenders as a rule take no responsibility for the outcome of the business enterprises they help to finance. In some transactions, in particular in asset sales that fall short of being ‘true sales’, it becomes hard to tell the difference between sales and loans. This has been true in particular of the asset-based ṣukūk, where sale of underlying assets by originators to investors (ṣukūk holders) were not subject to a true sale. The ṣukūk contracts that resulted from these transactions, while formally appearing to have the character of sales, in substance came closer to loans. This was due not only to the lack of a true sale of the underlying assets to investors but also on account of the presence of income and capital guarantees in the ṣukūk structures, the hallmarks of conventional bonds. As a matter of fact, most ṣukūk have been structured as debt instruments, rather than as risk-sharing securities. However, when put to a test in trying times ­– as in the 2008-2009 financial crisis – ṣukūk structured to replicate conventional bonds failed to live up to expectations and instead brought unpleasant and costly surprises, as the ensuing defaults and near defaults have shown with abundant clarity. Apart from failing to reflect risk sharing – a sine qua non for earning income in the form of profit rather than interest – debt-like ṣukūk came with a risk that remains largely unfamiliar to investors in risk-sharing securities, namely, the risk of default. This type of risk is not found among the risks that face investors in profit-and-loss-sharing securities. The risk of default is a risk that specifically faces lenders. Default or the failure to repay a loan takes place within the context of lending, rather than investing. To make matters worse, debt-like ṣukūk raised the spectre of rising levels of debt, private as well as sovereign, with all its negative implications, in particular for taxpayers. In light of the current Eurozone debt crisis – which has been moving from the periphery to centre stage and has now engulfed the large economies of Italy and France, with the US debt crisis still looming large – this is not to be taken lightly, especially in cases of sovereign debt. The embedded debt-aversion traits of Islamic finance, together with its equally inherent risk-sharing principle, provide solid foundations for financial stability that merit the earnest attention of all concerned. If anything has become clear from the 2009 ṣukūk defaults and near defaults it is that, contrary to current practice, substance needs to be prioritised over form, not only to ensure Sharīʿah compliance but also to vi

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retain the credibility of Islamic finance and enhance investor protection. Ṣukūk – in particular participatory ṣukūk that proceed over the idea of risk sharing as a foundational principle – need to be structured so as to enable genuine profit-and-loss-sharing, rather than lending or quasi-lending presented as leasing. Structuring ṣukūk as risk-sharing instruments will ensure that the income generated by the underlying assets will take the form of profit. The fact is that risk sharing still remains in short supply in the Islamic finance industry. Islamic banking and finance institutions have yet to make risk sharing a significant feature of their activities. It is clear that financial innovation needs to go beyond replication of conventional structures. If Islamic finance continues merely to replicate conventional models, then Muslim societies will remain unable to realise the full benefits of financing on a risk-sharing basis, including the avoidance of debt, the need to service it, as well as a more even distribution of wealth. According to Muslim scholars, Sharīʿah allows exceptions on grounds of necessity (ḍarūrah) in order to overcome difficulties presented by special cases. One difficulty in Islamic securitisation was presented by the need to have a true sale – the only kind of sale recognised in Sharīʿah – of the underlying, profit or rent-generating assets to investors. In a true sale, all rights to an asset, including the right to sell the asset to a third party, are transferred by sellers to buyers. However, a true sale of the assets to investors would, in the case of sovereign issues, necessitate the sale of national assets to foreign interests. Politically, this might prove less than palatable. In addition, asset owners keen to generate liquidity on the basis of their assets have shown reluctance to sell them. This is why some Sharīʿah advisers have recognised a special type of sale: one that does not require sellers to transfer legal ownership of the assets to buyers. Such a sale falls short of a true sale. In a sale of this type, only some rights to an asset, such as the right to use an asset or obtain revenues from it, are transferred to buyers. Legal ownership of the asset remains with the sellers. As this type of sale is not recognised in Sharīʿah – or in most other legal systems for that matter – it had to be ‘imported’ from common law, or, more precisely, from trust law. In common law, such a sale proceeds over the idea of transferring ‘beneficial ownership’, hence falling short of the idea of a true sale. This ‘import’ of the common law notion of ownership into Sharīʿah, however, stretched the notion of ḍarūrah to its farthest reaches. It is clearly not a case of the classical notion of ḍarūrah but a convenient addition to the Sharīʿah notion of ownership. Sharīʿah scholars, clearly, have to look for better solutions. vii

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Another reason why asset owners, and the Islamic finance industry, have readily accepted the common law notion of beneficial ownership is that transfer of real ownership title involves detailed, often protracted legal proceedings that were deemed to be less than conducive to the fast-moving ṣukūk transactions. Additional incentives for arranging sales that fall short of true sales include the avoidance of sales taxes, capital gains taxes, and stamp duties, depending on the type of asset involved. These are avoided through opting for beneficial ownership. However, the application of a notion of sale imported from the common law of a type of sale not recognised in the Sharīʿah as a valid sale raised other issues. One of these is the question of how a departure from Sharīʿah in the process of structuring ṣukūk can reasonably be expected to produce ­a Sharīʿah-compliant security. How does one depart from Sharīʿah at key stages in the securitisation process and still produce ṣukūk that are Sharīʿah compliant? Can ṣukūk, whose essential characteristics have been altered by departing from key Sharīʿah principles (such as the notion of a true sale), remain Sharīʿah compliant? One of the consequences of borrowing from the common law has been a proliferation of a large number of ṣukūk – the so-called ‘asset-based’ ṣukūk – that bear a striking resemblance to conventional, unsecured bonds. It appears that, in at least some cases, investors in asset-based ṣukūk were under the impression that they were the legal and not just beneficial owners of the underlying securitised assets. One perceives a certain lack of transparency on the part of ṣukūk originators and the so-called ‘special purpose vehicle’ operators regarding the real status of the underlying assets, as well as other weaknesses, in the proposed ṣukūk structures. It is clear that at least some asset owners feared a collapse and even potential bankruptcy down the line as a result of the ṣukūk deals they entered into. Rating agencies for their part did not distinguish themselves with assiduous scrutiny, providing instead window dressing of sorts to their clients while ignoring deeper problems in their exuberance at the prospect of lucrative revenues. Apart from the issue of Sharīʿah compliance, beneficial ownership turned out to be also problematic for other reasons. Since it does not bestow legal ownership of underlying assets on investors, it does not allow them to recover their investments by selling the underlying assets at a time of distress, when originators may be facing bankruptcy and possibly default on their obligations. Investors are not in a position to sell the assets for the simple reason that they do not own them. From a legal perspective, they rank pari passu with unsecured creditors. This puts investors who are merely beneficial owners of the underlying assets in a vulnerable position. viii

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In hindsight, despite higher costs of issuance due to the need to pay taxes and stamp duties, it would have been better for all parties concerned to structure ṣukūk as asset-backed securities. Structuring ṣukūk as assetbacked could have been accomplished by ensuring that a true sale of the underlying assets by originators to investors took place. This would have solved several issues simultaneously. First, on account of a true sale of the underlying assets by originators to investors, the issue of whether the sale is compliant with Sharīʿah would not have arisen. Second, a true sale in the securitisation process would also have prevented the question as to whether beneficial ownership is acceptable under the Sharīʿah from arising. Third, a true sale would have provided stronger investor protection, as investors would have become legal owners of the assets. Finally, the principle of risk sharing would have been realised, as investors in asset-backed ṣukūk would have faced asset risk rather than originator risk. In light of the close resemblance of the vast majority of asset-based (bond-like) ṣukūk to unsecured bonds, one may wonder if the avowed ‘flexibility’ of Sharīʿah has not been taken a step too far. If common law can supplant Sharīʿah at one stage of the securitisation process, then why not at other stages further down the line? In light of the applications of the common law notions of sale and ownership in Islamic securitisation, one wonders whether the Islamic basis of ṣukūk has been eroded excessively to suit market convenience. Questions arise as to what can be done to restore the credibility of Islamic finance and avoid repetition of past failures. The chapters in this volume address these as well as other issues, and chart the way forward. It is to be hoped that Islamic finance will find its bearings and once again serve the purposes for which it was originally intended, namely genuine risk sharing, financial stability, and social justice. This may be accomplished by utilising risk-sharing partnership contracts, namely the muḍārabah and the mushārakah. In order to reflect genuine risk sharing, however, these contracts need to be structured without income and capital guarantees, as such guarantees effectively disable the principle of risk sharing in Islamic securitisation, and thereby transform bona fide ṣukūk into mere replicas of conventional bonds. Mohammad Hashim Kamali Abdul Karim Abdullah International Institute of Advanced Islamic Studies (IAIS) Malaysia December 2013

ix

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Introduction Mohammad Hashim Kamali and Abdul Karim Abdullah This introduction consists of three parts: an overview of the ṣukūk industry; an introduction to the articles; and an introduction to the interviews.

Overview of the S ̣uku‾k Industry The ṣukūk industry is still in its early stages of development yet has already experienced turbulent times. The recent financial crisis brought in its wake the defaults of a number of ṣukūk for the first time. Other ṣukūk – including quasi-sovereign issues – nearly defaulted. No major issuing region has been spared. This new – and unexpected – development came as an unwelcome surprise to those who expected ṣukūk to perform better than conventional bonds, in particular the collateralised debt obligations (tranches of debt securities with varying risk/return profiles) that were at the heart of the crisis in conventional banking and finance. To make matters worse, the issuance of debt instruments also resulted in debts for issuers, in some cases of a substantial size. By all indications, this debt will take a long time to repay. Unlike risk sharing instruments, debtlike ṣukūk require originators to pay ‘fixed returns’ to ‘investors’ regardless of the profitability of the enterprises financed by the ṣukūk proceeds. This means that originators, unlike issuers of risk sharing securities, need to maintain payments of dividends to investors even when the underlying assets may be experiencing losses. The resemblance between the ṣukūk defaults and the defaults by issuers of conventional bonds has given the impression that Islamic ṣukūk may not – in substance – be much different from conventional bonds. As a result, the authenticity, if not also the credibility of Islamic finance, has been questioned. Has the development of the ṣukūk market taken a wrong turn at some point? If so, how did this come about? What can be done to set this important instrument of Islamic finance back on track? It is time to do a post mortem, ascertain what went wrong and propose how whatever ails Islamic finance can be remedied. This was the main reason why the International Institute of Advanced Islamic Studies (IAIS) Malaysia took the initiative to solicit the views of a number of leading figures in the industry, and which brought about the compilation of this volume of essays. 1

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The ṣukūk defaulted not only because the earnings of originators fell below expectations or turned into losses due to the contagion effect produced by the financial crisis. Other issuers were exposed to the fallout from the crisis, yet they did not default. A major reason why some ṣukūk defaulted – and others nearly defaulted – is that, for all intents and purposes, they were structured as debt instruments. Default, it cannot be overemphasised, is an event that takes place within the context of lending. Few informed observers doubt that even participatory ṣukūk, such as ṣukūk mushārakah, were structured as debt instruments. Lenders face the risk of default for the simple reason that – unlike funds raised on the basis of risk sharing – debt requires repayment. Default takes place when a debtor is unable to repay the principal amount of a loan, or to make a periodic payment on time. That the majority of ṣukūk have been structured as debt instruments is confirmed by the fact that ṣukūk are commonly referred to as ‘Islamic bonds’ or the ‘Islamic alternative to conventional bonds’. Even from the legal perspective, ṣukūk are treated as debt instruments. The ‘dividend’ yields on ṣukūk are routinely expressed as a percentage of the total amount ‘invested’ by ṣukūk holders – the same way as interest yields are indicated on bonds – rather than as a number of dollars per certificate out of the total profit earned by underlying assets. What is more, ṣukūk ‘dividends’ are routinely linked to interest rates such as LIBOR in a process known as benchmarking. The effect of this practice is that the earnings on benchmarked ṣukūk replicate interest earnings on conventional bonds. Benchmarking makes possible easy comparisons of dividend yields on ṣukūk with interest yields on conventional bonds, but raises the question as to in precisely what way do payments of such interest-like dividends differ from interest payments. Furthermore, in what way can a debt instrument be said to pay dividends, as normally dividends refer to payments of profits to holders of profit-and-loss-sharing securities such as ordinary shares. It appears that the process of structuring ṣukūk to replicate conventional bonds, while at least maintaining formal compliance with Sharīʿah, also replicated the major risks inherent in debt instruments. The greatest of these is the risk that the originator will fail to make a promised (legally obligatory) payment or payments, commonly known as the risk of default. Default is the inability of a borrower to pay back to a creditor a specified sum of money at a time agreed upon in advance, according to the terms of a given loan. It is a risk that faces all lenders. The ṣukūk defaults demonstrated that, while issuers of debt instruments may perform well under stable market conditions, a very different scenario could emerge at a time of crisis. Revenues may fall below levels necessary to service the fixed obligations that debt instruments invariably require 2

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their issuers to maintain regardless of prevailing economic conditions. Under such conditions, the possibility of default becomes real. As a result of a dramatic decline in revenues, due to adverse economic conditions, a number of issuers of debt-like ṣukūk were not able to maintain periodic payments or redeem the ṣukūk they issued. The point to be noted is that this would not, and could not, have happened had the ṣukūk been structured as profit-and-loss-sharing instruments, as such instruments do not require issuers to commit themselves to making legally-binding periodic dividend payments, or to refund to investors the principal sums invested on specified dates in future. In any case, the defaults made it abundantly clear that debt structures are risky not only for investors but also for originators. Profit-and-loss-sharing securities have significant advantages over debt instruments. Unlike debt structures, they do not come with income and capital guarantees. Profit-and-loss-sharing instruments require both issuers and investors to share the risks, rewards, as well as losses, if any. Profitand-loss-sharing instruments do not require originators to go into debt. The possibility of default, therefore, does not arise in the first place. Issuers of debt-like ṣukūk, however, are not in a position to capitalise on the advantages of profit-and-loss sharing, as all debt-like structures expose issuers to the risk of default. They do this primarily by incorporating income and capital guarantees into the ṣukūk structures, which effectively render the principle of profit-and-loss-sharing inoperative. In other words, structuring ṣukūk as debt instruments effectively transformed the ṣukūk, which are first and foremost profit-and-loss-sharing instruments, into replicas of conventional bonds. It should thus hardly come as a surprise that a number of debtlike ṣukūk shared the fate of their counterparts in conventional finance, conventional bonds, and either defaulted or nearly defaulted. A number of questions arise from the debacle. Is the conventionalisation of Islamic finance the right direction in which the development of ṣukūk should proceed? In what meaningful sense can replication of conventional bonds be viewed as financial innovation? Can the benefits of risk sharing be realised by replicating conventional instruments? Can debt structures be replicated without at the same time replicating the risks inherent in debt instruments, in particular the risk of default? Are income and capital guarantees, widely utilised in ṣukūk issuance, compliant with Sharīʿah? Is it in the interest of the originators to structure ṣukūk as instruments that burden them with debts and in addition expose them to the possibility of default? In the case of sovereign ṣukūk, is it in the public interest (maṣlaḥah) to incur debts that eventually have to be repaid using tax revenues? Is it fair to burden future generations with having to repay substantial portions of this debt? Is it wise, especially at a time when a number of sovereigns 3

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are teetering on the brink of default, to add to sovereign debt by additional borrowing? These are some of the questions that arise out of the ṣukūk defaults, and that the articles collected in this book, written by a number of well-informed scholars and industry practitioners, address and attempt to resolve. The articles identify and analyse issues and make practical proposals for reform. Problems appear to stem from the fact that ṣukūk origination, trading, and dispute settlement take place in different jurisdictions. Ṣukūk are commonly arranged and traded in places such as London. Yet securitised assets are normally located in Muslim lands. The problem of overlapping jurisdictions becomes acute in cases of disputes when the need for arbitration arises. If an obligor defaults, will the dispute be settled by reference to the common law or Sharīʿah? Significant differences exist between these two legal systems, rooted in different worldviews that, despite having much in common, are clearly not identical. The differences are real and no amount of financial engineering or innovation can paper over them. Some practices, for example the earning of interest, are permitted in one system but emphatically prohibited in another. It is difficult to see how convergence can take place on a key issue such as this without compromising in a fundamental way the basic identity of one system or the other. Another difference between the two systems is found in the notion of a sale. Common law recognises a sale that falls short of a ‘true sale’. In this type of sale the ‘buyer’ becomes entitled only to use the asset ‘purchased’, without, however, becoming its legal owner. Legal ownership remains with the seller. This means that the buyer cannot sell the asset he purchased. Yet a concept of a sale that falls short of being a true sale is conspicuously absent from Sharīʿah, where every sale has to be a true sale. Under Islamic law, buyers must be able to dispose of the purchased assets, including being able to sell the assets to third parties. Important implications for investor protection follow from the fact that the underlying assets are sold to investors by means of a sale that falls short of a true sale. Different types of sale result in different types of ownership. Where the sale of the asset falls short of a true sale, investors obtain merely ‘beneficial’ ownership of the underlying assets. This means that investors can use the asset, or obtain revenues generated by the asset, but they cannot sell the asset. They cannot sell the asset because they do not legally own it. Ṣukūk where investors have merely beneficial ownership of the underlying assets are known as asset-based. The great majority of ṣukūk issued are asset-based. Yet asset-based ṣukūk face numerous difficulties, as the chapters in this volume demonstrate. 4

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Where the sale of an asset is ‘true’, by contrast, investors become full legal owners of the asset. This means they can dispose of the asset in any way permitted by the law. Ṣukūk structured on the basis of true sales are known as asset-backed. After selling the assets by way of a true sale, originators no longer have any claims over the assets. This means that, in the case of a bankruptcy of the originator, the originator cannot claim any of the securitised assets from the investors for the purpose of selling them to third parties in order to pay off creditors. Different types of ownership provide different degrees of protection to investors. Full legal owners of the underlying assets (holders of assetbacked ṣukūk) are protected by the fact that, as legal owners of the assets, their profits come from the securitised assets rather than from the general revenues of the originator. This means that, in case the originator goes bankrupt, the dividend payments to investors continue uninterrupted, as the underlying assets are independent of the originator. In other words, investors in asset-backed ṣukūk face asset risk rather than originator risk. The securitised assets will have been sold by way of a true sale to a bankruptcy-remote special purpose vehicle (SPV) that acts as a trustee on behalf of the ṣukūk holders. The case is different with holders of asset-based ṣukūk. They enjoy little protection in case the originator defaults and is unable to maintain payments, because the dividends of the holders of asset-based ṣukūk come from the general revenues of the originators rather than from profits generated by securitised assets. Holders of asset-based ṣukūk thus face originator risk rather than asset risk. In case of bankruptcy of the originator, holders of asset-based ṣukūk have merely the status of unsecured creditors, with no prior claims to the securitised assets. Such investors are thus not in a position to recover their investments at a time of distress by selling the underlying assets because they do not legally own them. The protection such investors have, apart from insurance or guarantees provided by third parties where applicable, is the obligation by the originator to ‘repurchase’ the underlying assets in case he defaults on the payments. One problem with this ‘protection’, however, is that originators who have been unable to make a periodic payment (defaulted) are hardly in a position to have sufficient funds to make a much larger payment that would be required for repurchasing the underlying assets. Hence, protection in the form of the obligation to repurchase the underlying assets ‘upon default’ does not go very far. In the absence of a renegotiation of the agreement (restructuring), insurance or guarantees provided by third parties, investors in asset-based ṣukūk might thus face potentially catastrophic losses. 5

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Articles Faizal Ahmad Manjoo, in ‘The ‘Ping-pong’ of the Asset-backed/Assetbased Ṣukūk Debate and the Way Forward’, identifies two factors as the main causes of the problems besetting the ṣukūk industry: the absence of a true sale when underlying assets are sold to investors by originators; and the requirement to repurchase the securitised assets by originators from investors at par value when the ṣukūk mature. Sharīʿah, he points out, endorses neither practice. Problems arise in part from the fact that originators and investors have different goals. Originators want to raise money in the capital markets without, however, giving up (selling) any assets. Investors, on the other hand, wish to make profits without, however, putting their capital at risk. The objective of the originators was achieved by arranging a sale that fell short of a true sale. This enabled originators to retain legal ownership of the securitised assets even after ‘selling’ them to investors. The objective of the investors, on the other hand, was achieved by incorporating income and capital guarantees into the ṣukūk contracts. These enhancements produced what are known as asset-based ṣukūk. The problem with asset-based ṣukūk, however, is that income and capital guarantees run counter to the principle of profit-and-loss sharing. Moreover, due to the absence of a true sale, no transfer of legal ownership from originators to investors – as required by Sharīʿah – takes place when securitised assets are sold by originators to investors. Thus, if investors do not wish to be exposed to the credit risk of the originator – that is, if they do not wish to invest in ṣukūk that give them merely the status of unsecured creditors of the originator, it is better to take a risk on the assets rather than on originators. This can be achieved by investing in asset-backed rather than asset-based ṣukūk. In an assetbacked structure, the investor has, in case of a bankruptcy of the originator, recourse to the asset. Manjoo, accordingly, recommends asset-backed securitisation as the current asset-based structures fall short of meeting Sharīʿah requirements. Muhammad Al-Bashir Muhammad Al-Amine, in ‘Unresolved Sharīʿah Issues in Ṣukūk Structuring’, addresses the issues of sale, ownership and investor protection. These issues came under the spotlight after the defaults of some high-profile ṣukūk, which demonstrated the need to protect the rights of ṣukūk holders. Specifically, he argues, it is necessary to determine what rights investors have over the assets in the event of a default, and asks are these rights legally enforceable? At the heart of the problem is the question of whether or not there is a 6

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true sale of the securitised assets by originators to investors. This question is central to all other Sharīʿah issues. While recognised in common law, a sale that falls short of a true sale is not recognised as a valid sale in Sharīʿah. Under a Sharīʿah-compliant sale-and-purchase contract, the buyer has the right to keep the goods purchased or to resell them to a third party as and when he wishes. In other words, in order to maintain Sharīʿah compliance, there must be a transfer of legal ownership of the securitised assets from originators to investors (ṣukūk holders). Despite the urgency of these issues, the market appears slow in addressing them. As the asset-based structure normally results in debt creation, Al-Amine recommends asset-backed securitisation rather than maintaining the current practice of producing debt-based conventional bond-like structures. Mohammed Imad Ali, in ‘Ṣukūk: Perception, Innovation and Challenges’, observes that investors, rating agencies, and lead arrangers perceive ṣukūk as ‘Sharīʿah-compliant bonds’. Scholars, on the other hand, view ṣukūk in terms of whether they are asset-based or asset-backed. While some scholars are willing to endorse ṣukūk that are ‘akin to bonds’, others insist that ṣukūk need to enable genuine profit-and-loss sharing. Despite a diversity of views, many scholars agree that risks and rewards of the underlying ṣukūk assets need to be shared by the ṣukūk holders. The reason is that it is risk sharing that justifies the returns to investors on their investment. There has to be a clear ownership link between the ṣukūk holder and the underlying ṣukūk assets. Yet, instead of sharing the risks and rewards with the ṣukūk holders as required by the Sharīʿah, the current ṣukūk structures create a debt. The recent financial crisis showed, however, that no matter how innovative a debt structure is, it is still vulnerable to default because it is a debt structure. Accordingly, Ali recommends the utilisation of asset-backed structures. He concludes that merely structuring ṣukūk to replicate conventional bonds will not benefit the industry in the long run, either from a Sharīʿah or a commercial perspective. On the other hand, if the risks and rewards of the underlying ṣukūk assets are shared between the ṣukūk holders and the originators, then ṣukūk will have a bright future. Abdul Karim Abdullah, in ‘Ṣukūk and Bonds: A Comparison’, contrasts Islamic ṣukūk and conventional bonds. He notes that, apart from being free of ribā, ṣukūk structured as profit-and-loss-sharing instruments have other advantages over conventional bonds. Prominent among these is the fact that ṣukūk, as profit-and-loss-sharing instruments, do not require issuers to go into debt and therefore protect them from default, especially at times of stress. 7

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Sheila Ainon Yussof, in ‘Measuring Sharīʿah Compliance in Ṣukūk Ratings: A Survey of Existing Methodologies’, explores the possibility of a Sharīʿah-compliance rating methodology, where it is recommended that rating agencies factor in Sharīʿah credibility risks in their rating analysis frameworks. A survey of existing rating methodologies of ṣukūk by both international and domestic rating agencies indicates bias towards assessment of credit risks or creditworthiness of originator/issuer, and not Sharīʿah compliancy per se. This could be due to a lack of mandate or avoiding a conflict with Sharīʿah advisers whose role is to certify Sharīʿah compliance. It is recommended that the rating spectrum be multidimensional to include Sharīʿah determinants/parameters that measure the quality of underlying assets, integrity of scholars and their fatāwā and the robustness and effectiveness of Sharīʿah governance framework within rating agencies. This integrated approach will give full disclosures to investors on the quality of their investments and whether their rights are protected when a default occurs. The International Islamic Rating Agency (IIRA) has the potential to create an Islamic rating methodology for ṣukūk but more collaborations and acceptance are required from Islamic financial institutions to mandate this regional agency with the responsibility of developing an Islamic model. Sirajulhaq Hilal Yasini and Nermin Klopic, in their chapter on ‘Concession Rights as Underlying Assets for Ṣukūk’, explore the viability and permissibility of using intangible assets such as concession rights or concession contracts as underlying assets in the securitisation process. After surveying the relevant Sharīʿah literature, they conclude that the use of concession rights as underlying assets will be helpful to issuers who may otherwise lack sufficient tangible assets for the purpose of securitisation. They provide two case studies of successful securitisation using concession rights as underlying assets: the Saudi Electricity Company and the Saudi Basic Industries Corporation sukuk issues of 2007. Rafe Haneef, in ‘The Case for Receivables-based Sukūk: A Convergence between the Malaysian and Global SharīʿAh Standards on Bayʿ al-Dayn?’ attempts to bridge the current divide between Middle Eastern scholars and their Malaysian counterparts on the issue of the sale of ṣukūk in which some assets comprise receivables (debts). Currently, Middle Eastern scholars hold that, in order to qualify for secondary trading, at least 51% or 33% (as the case may be) of ṣukūk assets must be in the form of physical assets, in order to prevent ribā. On the basis of an analysis of relevant aḥādīth, he argues that wakālah ṣukūk consisting of mixed assets, physical as well as cash/receivables could, conceivably, be traded at less than the thresholds of 33% or 51% physical assets, as long as the price at which 8

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they are traded is equal to or greater than the value of the cash (and/or receivable) component of the portfolio of underlying assets. This would satisfy the requirement that debt could not be sold at less than par value. He suggests that it is preferable to rely on the principles of mudd al-ʿajwah of aḥādīth rather than on the maxim ‘ruling of the majority shall apply’.

Interviews This section features interviews with two prominent observers, Raja Teh Maimunah and Professor Abbas Mirakhor. The former interview is the more extensive of the two. In addition, there is a comment from Faiz Azmi. Raja Teh Maimunah, interviewed by Zarina Nalla, points out that Islamic finance differs from its conventional counterpart in that it funds the real economy. She disagrees that ṣukūk need to be asset-backed in order to comply with Sharīʿah and provide genuine protection to investors. Scholars, she feels, are unable to explain, from a practitioner’s point of view, how structuring ṣukūk as asset-backed would benefit the industry. She feels that a suitable legal framework can ensure investors’ protection. Once the issue of investor protection is settled, the difference between asset-backed ṣukūk and asset-based ṣukūk will become irrelevant. She feels that common law provides adequate protection to investors in asset-based ṣukūk, even if they do not legally own the underlying assets. Under trust law, she insists, investors have full rights over the assets. The originators are just the legal owners of the assets. Since the rights of the investors are not diluted at all, it is unnecessary for the investor to become a registered owner of the underlying assets. She insists that the recent ṣukūk defaults should not be regarded as a failure of the instrument but a myriad of things typical of any credit issue. She points out that structuring ṣukūk in the form of asset-backed securities would raise the costs of issuance. Issuers would have to pay sales taxes and stamp duties each time they were to sell the underlying assets – via a true sale – to investors. They would have to pay the same taxes and duties a second time when repurchasing the assets upon maturity. If the cost of issuance becomes too high for originators, they would be unlikely to opt for Islamic structures. Hence, insisting on a transfer of ownership of the assets from originators to investors acts as a deterrent to the growth of ṣukūk. Abbas Mirakhor, interviewed by Sheila Ainon Yussof, highlights the fact that, while ṣukūk need to be compliant with Sharīʿah, they are issued in places such as London, where they are governed by common law. While common law permits sales that fall short of true sales, Sharīʿah requires all 9

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sales, including the sales of underlying assets by originators to investors, to be true sales. In other words, investors need to become legal owners of the assets. The major lesson of the few ṣukūk defaults or near defaults has been the need to ensure the legal strength of the true sales in contracts. Muslim scholars have long criticised provisions of ṣukūk contracts that did not enable the complete transfer of property rights claims in cases of default. A legal transfer of ownership, as Dr Mirakhor emphasises, is a basic requirement of Sharīʿah-based finance. In economic terms it is understood as a transfer of all property rights claims resulting from the contract of albayʿ. This is the same as a true sale. Dr Mirakhor adds that, in so far as they provide guarantees to investors that their capital will be returned to them in full, repurchase undertakings are inconsistent with profit-and-loss sharing. Instead of debt-like instruments, he advises utilising profit-and-loss-sharing structures. He notes, however, that to encourage the growth of bona fide profit-and-loss-sharing ṣukūk, it will first be necessary to create a level playing field between debt and equity. Currently, bias in favour of the interest rate mechanism permeates the economy, macro-economic policies, commercial laws, administrative procedures, and even accounting rules. This has to change. On behalf of IAIS Malaysia, the editorial team records their profound appreciation and gratitude to each and every one of the contributors in both the articles and interviews. We believe that the insights, critique and reform proposals offered go a long way to address many of the yet unresolved hurdles facing ṣukūk, an undoubtedly burgeoning instrument of Islamic finance. The selected research input is richly endowed both in Sharīʿah analysis of issues as well as industry experience and expertise. That said, the IAIS editorial committee wishes to add that not all the views and suggestions held by the contributors represent IAIS’ own positions.

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1 The ‘Ping-Pong’ of the Asset-Backed/Asset-Based S ụ ku‾k Debate and the Way Forward Faizal Ahmad Manjoo

Introduction This article explores the underlying debate that is taking place posed by the fiqhī issue as to whether ṣukūk should be asset-backed or asset-based. In both instances there have been shock waves in the industry and the need to settle this issue is of paramount importance. Criticism has been levelled against issuers and investors alike. The reality is that we are dealing with a new mindset of the homo Islamicus compared to the homo economicus, in the words of Muslim economists. It would seem that the root of the problem is that ‘Islamic’ finance participants want to operate the industry with a ‘conventional’ mind. This research reveals that there is a need to adopt the asset-backed ṣukūk. However, despite the Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI) pronouncement against asset-based ṣukūk in 2008, it is difficult to reverse the trend. Data have been collected to ascertain the various types of ṣukūk issuance. In addition, a qualitative analysis has been carried out to understand the underlying problems of a true sale and ‘purchase undertaking’, which are causing this jurisprudential havoc. It is hoped that this discourse will shed some light on the fiqh and legal aspects of the issues so that the ṣukūk industry can become more cautious, despite the cry for standardisation of contracts and products. When the first ṣukūk was issued by Shell MDS in 1990 following the OIC resolution of 1988 approving the concept of ṣukūk,1 the ṣukūk industry was still slumbering. Many sceptics did not realise its potential in the Islamic capital market and that ṣukūk would be viewed as a panacea for overcoming challenges in liquidity management. Various reasons explain why the ṣukūk market developed at a tortoise-walking rate. Primarily it was due to the intricacies linked to asset-backed securitisation, as discussed below. The market developed fairly slowly until September 2001, when Bahrain issued its first sovereign ṣukūk, which gave a boost to the ṣukūk market and other successful issuances followed. Subsequently the market was quick to realise that ṣukūk could be used to forecast various trends in Islamic finance in general. Industry players discovered the potential for a relatively stable return compared with the share market. Ṣukūk filled a gap 11

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in the Islamic capital market by providing mid- and long-term investment vehicles that could be readily traded on the secondary market. Presently, the ṣukūk market stands at $100 billion, according to a report from the Saudi Gazette.2 This achievement has been realised within 10 years of its existence and projections indicate exponential growth in the coming years. As the need to lay down Sharīʿah and regulatory standards was felt, the AAOIFI issued further consolidated standards on ṣukūk in 2008. The Islamic Financial Services Board (IFSB) issued its Standard 7 in 2009, which differed from the AAOIFI Standard as it endorsed asset-based ṣukūk. The AAOIFI’s original Sharīʿah standard was not really heeded by the industry and most of the ṣukūk tended to be asset-based until 2007, when Sheikh Taqi Usmani, Chairman of the AAOIFI, blew the whistle by stating that the practice was not in line with Sharīʿah.3 The market responded immediately by coming to a near standstill. At the same time many wondered what went wrong. The debate was inflamed when investors took cognisance from the fact that the AAOIFI’s strong insistence on asset-backed ṣukūk was to bring some sanity into the market, especially after some big blows being inflicted on the market by cases such as Nakheel, Dar Investment and East Cameron Gas. In the interim, the market, which was mainly driven by Islamic institutions who wanted a pseudo-bond product, realised that ṣukūk were not bonds and that the problems had been created by two main issues: 1. The lack for the true sale of the underlying assets. 2. The purchase undertaking by the obligator. We analyse these issues in the following sections.

Assessment of the Market’s Psyche The fact that the market is driven by two forces – investors and the ṣukūk originators/obligators – creates a dichotomy. The originators want to raise money by replicating the conventional bond and to tap a different source of funds. They wish to raise money by issuing ṣukūk but retain ownership of their assets at the same time. This mindset was, and is often, inherent within bond issuers, as echoed in the East Cameron Gas case in the USA, where the originator refused to accept that the ṣukūk holders had ownership of the royalty in the exploitation of natural resources. The investors, on the other hand, are interested in the guarantee or protection of their capital investment and a fixed return. They do not really want to take the risk in the assets. So the asset-based ṣukūk seemed to be the ideal solution whereby the issuer keeps the ownership of his assets by not doing a true sale and camouflages the whole transaction with trust law, mainly English trust law, where there 12

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is a bifurcation of ownership into legal and beneficial ownership. In most cases the originator transfers only the beneficial ownership of the assets to the SPV issuer.4 Accordingly, while the originators own the assets legally, investors have only a beneficial interest in (the ownership of) the assets. In addition, the originator in this structure would make a promise to repurchase the assets at the original price, which technically stands as a form of guarantee for capital invested. In order to understand whether the purchase undertaking at par value guarantees the principal amount in the asset-based ṣukūk, it is important to look at the actual application of waʿd in such ṣukūk by perusing available databases, such as that of the Islamic Finance Information Service (IFIS). This exercise was conducted by analysing selected case studies involving such ṣukūk – both pre-AAOIFI and post-AAOIFI pronouncement via the IFIS database. The criteria for selection of the ṣukūk were based on whether a purchase undertaking was explicitly used or not. This is critical for the research, as it differentiates clearly between asset-based ṣukūk that used the purchase undertaking and those that did not. In the pre-AAOIFI period, some of the ṣukūk used purchase undertakings and some did not, as can be seen below:5 • IDB Ṣukūk Istithmār, which was issued in July 2003, did use a purchase undertaking at par. • Caravan 1 Hanco Ṣukūk Istithmār, which was issued in February 2004, did not use a purchase undertaking. • Pasir Gudang Municipal Ṣukūk Muḍārabah, issued in February 2005, did not use a purchase undertaking. • Gold Ṣukūk DMCC Ṣukūk Mushārakah, issued in May 2005, did use a purchase undertaking at par. • IDB Ṣukūk Istithmār, issued in June 2005, did use a purchase undertaking at par. • PCFC Ṣukūk Mushārakah, issued in January 2006, did use a purchase undertaking at par. • Rantau Abang Ṣukūk Mushārakah, issued in March 2006, did use a purchase undertaking at par. • East Cameron Gas Ṣukūk, issued in June 2006, did not use a purchase undertaking. • ADIB Ṣukūk Mushārakah, issued in December 2006, did use a purchase undertaking at par. • KL Sentral Ṣukūk Mushārakah, issued in April 2007, did use a purchase undertaking at par. • DP World Ṣukūk Muḍārabah, issued in July 2007, did use a purchase undertaking at par. 13

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In the post-AAOIFI period, use of purchase undertaking at par dropped considerably, as can be seen below:6 • Villamar Ṣukūk Mushārakah, issued in May 2008, did not use a purchase undertaking. • Sorouh Ṣukūk Muḍārabah, issued in August 2008, did use a purchase undertaking at par. • PLSA Ṣukūk Muḍārabah, issued in October 2008, did use a purchase undertaking at market value or value to be agreed in future. • Bin Ladin Ṣukūk Muḍārabah, issued in September 2008, did not use a purchase undertaking but instead used a third-party guarantee. The above case studies show clearly that, prior to the AAOIFI pronouncement, eight out of eleven ṣukūk used waʿd, while the remaining three did not as they were asset-backed ṣukūk. This was not the case with the post-AAOIFI pronouncement, which indicates that inappropriate usage of waʿd has declined. Future data would help to show whether this is merely a temporary measure.7 Despite an order dated 31 March 2010, in which a US judge issued a decision vindicating the ṣukūk structure of the East Cameron Gas case, most ṣukūk issuance today has reverted to the assetbased structure. This was the first legal case proving that the asset-backed structure can protect ṣukūk holders once a default event is triggered, and the judgment effectively viewed the ṣukūk as asset-backed, as advocated by the AAOIFI.8 These data reveal clearly the mindset prevailing in the market and that most investors and originators alike prefer asset-based structures. Most ṣukūk issued today are still asset based and this situation persists despite the concerns raised by the AAOIFI in 2007/8. Ravalia9 has identified some of the reasons for the delay in changing this market physiognomy: 1. Asset-backed transactions, both conventional and Islamic, seem to be more difficult and costly for companies when undertaken in the Gulf. 2. There are tougher legal and analytical requirements imposed by rating agencies and many companies in the region lack sufficient robust internal systems to service and report on the assets to investors and agencies. 3. There is a shortage of suitable underlying assets for issuers to use in asset-backed transactions, although in a few instances third parties are leasing assets to issuers for this purpose. 4. Many markets, especially those in the Gulf Cooperation Council, do not currently have a legal structure that can support a securitisation market. 14

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5. Property rights, trust law, insolvency law and other laws are often rudimentary or non-existent. 6. Enforceability of contracts in these and other emerging markets may be uncertain and untested. 7. Investors demand products that mirror conventional debt structures in terms of risk and economic substance. 8. Issuers will only issue ṣukūk if it makes economic sense to them.

The Fiqhī Issues The two main fiqhī issues that are of concern are, firstly, whether, with an asset-based ṣukūk issuance, there is a true sale, and secondly, whether the purchase undertaking by the originator to guarantee the investors' capital is effective. True sale issue in asset-based ṣukūk In an asset-based transaction, the ṣukūk holder, technically, pays money to receive money without a real asset changing hands between the counterparties. In an asset-backed transaction, by contrast, the deal is premised on an underlying asset itself, which generates the cash flow to investors. The asset-based and asset-backed true sale debate has deep fiqhī repercussions. It echoes the unresolved debate about form over substance. Many institutional investors in ṣukūk are conventional financial institutions.10 On top of that, ṣukūk are regularly structured as restricted or wholesale securities, which are not offered or sold to retail investors.11 These big institutions have been operating with a bond market mindset but at the same time wish to have an Islamic product purely because they are Islamic financial institutions, in terms of windows or fully licensed. Because of this, they turn out to be the market drivers. They are reluctant to deal with an asset that has its own risk and would rather opt for instruments that ensure that their investment brings in appropriate return, so that: 1. Their money does not depreciate due to inflation. 2. They meet their liabilities vis-à-vis their clients. 3. They can make some profit for their shareholders. They do not want to take a risk, as required from an Islamic law perspective.12 The originators/obligators, on the other hand, want to tap into a new market to raise money but do not want to give up ownership of their assets, especially in the case of sovereign and quasi-sovereign ṣukūk. So the trust mechanism as developed in English law is used, and ṣukūk are issued via a trustee in the form of a special purpose vehicle (SPV). 15

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The result is that originator keeps legal ownership of the underlying assets while the issuing SPV holds beneficial ownership of the assets on behalf of the ṣukūk holders. Consequently, there is no transfer of legal ownership. This is a prima facie problem, in that it creates a precarious situation for investors due to this ownership risk in case of default, both in equity and non-equity ṣukūk structures. From a legal point of view, the originator owns the underlying asset (due to the structure of the SPV using trust law), and not the ṣukūk holders, who have a weaker stake in the underlying assets. Hence, in case of bankruptcy, the ṣukūk holders will be at pari passu with other creditors and they might not enjoy their rights.13 To appreciate the whole debate about the true sale and who carries the risk of ownership, one has to understand the Islamic normative theory of profit,14 which explains why Sharīʿah endorses profit and proscribes interest. When entering a bilateral commercial transaction, there should be a countervalue from both contractual parties. The seller is entitled to his profit on the basis of this countervalue. The countervalue (ʿiwaḍ) explains from an economic and fairness perspective why Islam allows profit and prohibits interest. There are three elements that justify the countervalue in a transaction as compared to interest, from the perspective of economic justice: ḍamān, ghurm and kasb. The first is premised on the famous hadith ‘al-kharāj bi al-ḍamān’, meaning that when a person enters a commercial deal he should bear some liability, such as giving the option of defects (khiyār al-ʿayb) to a buyer when selling something. The second is ‘al-ghurm bi al-ghurm’, meaning that one is entitled to his profit provided that he burdens himself with some risk. The issue of kasb entails that the seller should put in some effort prior to claiming a profit. In the case of the asset-based ṣukūk, one wonders where the risk lies. If the ṣukūk holders or originators do not want to bear the risk, then this is not in line with the theory of profit. The underpinning principles of the Islamic normative theory of profit provide an Islamic justification for the seller to make a profit and the buyer to be entitled to the subject matter of the contract. In lending at interest, on the other hand, there is no real countervalue except that the money is lent for a period of time. Should the lender invest his capital somewhere else, he could make a profit or a loss. By contrast, interest is a legally guaranteed return with its capital also guaranteed at the expense of someone else’s labour. This is the Islamic reason that legitimises profit, which is justified compared to earning interest, as no exploitation takes place in so far as each party receives a countervalue. If the same idea is applied to the asset-based ṣukūk sale, then it would 16

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seem that a departure from the Islamic ethos has taken place. The investor wants not only his money but also his fixed return to be guaranteed. He does not want to take any risk in the asset. These requirements characterise the conventional bond market. One of the main reasons for this situation is, as has been highlighted earlier, that the ṣukūk market does not really operate at the retail level but is focused on financial institutions, such as takāful companies and Islamic banks, who have fiduciary and regulatory duties as they work with the public’s money. They are the big ṣukūk holders and they work with a mindset to mitigate investment risks.15 This implies that the transfer of securitised assets from the entity raising funds to the trustee or SPV is on a beneficial basis; actual proprietorship does not pass to the SPV. Such transfer of beneficial ownership is not acknowledged as a true transfer of ownership or proprietary rights under English law, which governs the majority of such ṣukūk.16 Hence the AAOIFI ruled out this discrepancy between Sharīʿah and governing law by insisting that the underlying assets must be legally transferred to the ṣukūk holders. They must also be taken off the balance sheet of the original seller so that the ṣukūk holders have binding legal rights on the trust assets. This is preferred in cases where investors do not wish to be exposed to the credit risk of the originator – that is, they do not wish the ṣukūk to constitute (from an economic perspective) unsecured obligations of the originator.17 When the tsunami of defaulting ṣukūk hit the Gulf area in the aftermath of the 2008 crisis, investors became more conscious about the warning given by the AAOIFI. The reality is that standards for asset-backed ṣukūk existed even before 2008 but nobody was paying attention due to the aspirations of the market drivers. They were homo economicus trying to satisfy their own human economic interest instead of being a homo Islamicus, i.e. the Muslim investor who operates within the Islamic ethos. Consequently this fiqhī issue became clear to investors. Ṣukūk are not bonds where issuers ensure that investors can claim interest and get their capital back. Investors have to take risks. If one argues that ṣukūk originates from the classical concept of ṣakk, then it is to be linked to the ownership of some asset and not represent beneficial interest alone. The legal transplant in the form of trust law resulting in beneficial ownership sent ripples across the Islamic finance world. It is well known that there are few fundamental prohibitions in Sharīʿah, including ribā, gharar, maysir and sale of debt, but these can have drastic economic consequences if not well observed. Should ṣukūk structures be asset-backed, this would imply that the investors share a concrete asset or business venture and bear a share of risk commensurate with such ownership. Chapra18 argues that, when investors take risk rather than accept a fixed and guaranteed return, 17

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they tend to keep the financial intermediaries, in this case the SPV trustees, on their toes to ensure maximum return. In the absence of such a mindset, the usurious approach tends to create a laxity as both capital and return are guaranteed, which is against the spirit of Islamic profit and loss sharing. By contrast, in an asset-backed ṣukūk, each investor owns an undivided interest in the underlying tangible asset. The ṣukūk can even be structured to give a fixed-income economic return in a Sharīʿah-compliant manner. The ṣukūk certificate evidences this ownership interest, but it is not a debt or bond in the ‘IOU’ sense.19 This is why the purchase undertaking was developed to provide extra security. In the case of asset-based ṣukūk, it is the rating of the originator that becomes the focus and not the asset, whereas in an asset-backed structure, the credit rating is of the asset itself. In case of default the investors can have recourse to the underlying assets because they legally own them. In a conventional true-sale securitisation transaction, a pool of assets is typically sold and ownership legally transferred to investors; a true sale to a special-purpose vehicle takes place. Unfortunately, even in the case of asset-backed structures, despite the fact that the ṣukūk issued signify ownership, in practice the title to the underlying assets may not be legally transferred. The ownership is likely to be an indirect title only. Essentially the underlying assets are viewed as receivables on their own Sharīʿah principles, considered as debts (as they are rights to receive money) rather than assets. If, therefore, one owns an asset that generates a receivable, one has the right to the receivable and is thus exploiting the asset rather than trading in debt. The recourse of the investors is limited to recourse against the special purpose vehicle and its assets, i.e., there will generally be no direct recourse against the originator.20 This, therefore, is an area that needs improvement so that the AAOIFI Standard can be implemented. In other words we still need to develop proper asset-backed securitisation. The AAOIFI has defined ṣukūk as: Certificates of equal value representing, after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity.21

This definition echoes the asset-backed approach needed. The conventional capital market enjoys a blend of debt and equity instruments, namely bonds and shares. According to Mokhtar22 because of its fixed interest return and principal guarantee, a bond is classified as a fixed income security. Hence, it violates the Sharīʿah’s prohibition of ribā. 18

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Table 1

Comparison between conventional bonds and ṣukūk

Bonds

Ṣukūk No loan contract due to prohibition of riba.

Primary level

Loan contract to create indebtedness

Return to investors

Interest charges known as coupons

Rental/profit

Secondary level

Trading of bonds amounts to trading of debts, normally with discounting.

Tradability of sukuk depends on the nature of the asset underlying the Islamic securities (only for GCC).

Use a variety of contracts to create financial obligations such as sale, lease, partnership etc.

Source: Securities Commission Malaysia, The Islamic Securities (Sukuk) Market, (Securities Commission Malaysia, Selangor: LexisNexis Series, 2009), p. 13

According to Usmani,23 the lack of transfer of ownership to bondholders of any commercial or industrial enterprises that the bonds were issued to finance is among the main features of bonds. In fact, the objective is to create a debt to the bondholders. Secondly, interest payments on the debt are expressed as a percentage of the capital, not of actual profits. Thirdly, the capital is guaranteed at maturity, irrespective of the profitability of the enterprise. It is important to analyse whether the last characteristic of bonds is being adopted in asset-based ṣukūk by recourse to waʿd. Use of waʿd in asset-based ṣukūk McMillen,24 Mokhtar25 and Lotter and Howladar26 argue that the features of bonds are generally expected to be absent from ṣukūk but, in order to compete in the conventional market and to obtain the required rating, a number of mechanisms have been developed so that ṣukūk can resemble bonds. Al-Masri27 points out that the AAOIFI recommendations were issued to bring the ṣukūk practices back in line with Sharīʿah. Al-Amine28 and Haneef29 have mapped the developments in ṣukūk structures in order to appreciate where issues arise. They state that ṣukūk have evolved from an asset-backed structure, where ṣukūk holders have ownership rights over the underlying assets and rely on the assets of the ṣukūk issuer for security. Ṣukūk have evolved from the asset-backed structure to an asset-based structure. Here ṣukūk holders rely on the originator for the repayment of the principal and return and rank pari passu with unsecured creditors in cases where the obligor may default, as they have no legal recourse to the underlying assets. Lotter and Howladar30 argue that, subsequently, ṣukūk have evolved from the asset-based structure of pre-AAOIFI standards, where the requirement of having tangible assets seems to be almost non-existent, back to the asset-backed structure of postAAOIFI standards. The table below from Moody’s shows a comparison 19

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between the two most prominent structures whereby waʿd is being used in the first category: Table 2

Differences between asset-backed and asset-based ṣukūk

Ṣukūk category

Analytical characteristics

Unsecured asset-based ṣukūk

The issuance principal is effectively ‘guaranteed’, in most cases by the originator, via a purchase undertaking agreement, i.e. a commitment to buy back the underlying assets of the ṣukūk at maturity at original or pre-agreed price. The coupons (periodic distribution amounts) are protected by a liquidity provision, i.e. the commitment of the originator/guarantor to provide sufficient liquidity to make up for any shortfall between asset returns and periodic distribution amounts.

Secured asset-backed ṣukūk (Islamic securitisation)

Neither the principal nor the coupons are subject to formal guarantees. Ṣukūk performance is asset driven and the effective legal transfer of assets to investors (true sale) is critical.

Source: ‘Moody’s special comment 15: Islamic banks and ṣukūk: Growing fast but still fragmented’, Moody’s (15 April 2008), , retrieved 20 March 2011.

Moini31 writes that: Purchase undertaking is the operative document that transfers the credit risk to the obligator, as it provides an irrevocable undertaking to buy the assets on the trustee’s exercise of the put that has been granted under the agreement. The exercise price payable by the obligator is equivalent to the redemption amount of the sukuk inclusive of any outstanding periodic distribution and principal. The exercise of the purchase undertaking transfers all rights and interest of the trustee to the obligator and creates a payment obligation for the obligator. Therefore having exercised the put, sukuk holders’ claims are regarded as pari passu or equivalent to those of other unsecured creditors of the obligator. The purchase undertaking is usually governed by English law on account of its creditor friendliness.

The undertaking is an irrevocable promise to buy the trust assets from the SPV at the time of the redemption of certificates (whether at maturity or prior to maturity). The undertaking pre-specifies the price at which the assets would be bought, which is ordinarily equal to the face value of the certificates, in effect guaranteeing the return of principal as under a conventional bond. Though acceptable for ijārah-based structures, they are not admissible for participatory types of ṣukūk. Usmani32 argues that one of the key issues is the use of waʿd in asset20

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based ṣukūk to repurchase the assets at par value from the ṣukuk holders. He states that it is not permissible for the investment manager (sharīk), partner (muḍārib) or investment agent (wakīl) to agree by way of a waʿd to repurchase the assets at par value at maturity or upon an early dissolution of the ṣukūk. However, he asserts that it is permissible to agree to repurchase the assets at their net or market value, or for a price agreed at the time of the repurchase, in accordance with the rules of Sharīʿah. Other critics endorse these arguments as well. Abdel-Khaleq and Crosby33 raise similar arguments specifically in relation to mushārakah-based ṣukūk. Kapetanovic and Becic34 echo such contentions specifically in relation to muḍārabah-based ṣukūk and Naim and Hussain35 specifically in relation to wakālah-based ṣukūk. As for ijārah-based ṣukūk, Mokhtar and Thomas36 contend that it is permissible to agree via waʿd to repurchase the leased assets at maturity or upon an early termination of the lease at par value, provided the lessee is not also a sharīk, muḍārib or wakīl of the lessor. The arguments in relation to the use of waʿd in participatory ṣukūk are reiterated in various AAOIFI Sharīʿah standards. AAOIFI Standard 17 states that where the manager acts as a sharīk (or a muḍārib) with the ṣukūk holders, it is unlawful for him to guarantee the return of capital to them, as this would invalidate the partnership in the event of losses or in the sharing of profits.37 However, AAOIFI Standard 12 states that it is lawful to promise to repurchase the assets at market value or at an agreed price at the time of repurchase.38 AAOIFI standards justify the legitimacy of these promises on the basis ‘that there is nothing in this arrangement that guarantees anything to the partners’.39 Usmani argues that the use of waʿd by a sharīk in the above manner cannot be supported by distinguishing between a partnership of contract (shirkah al-ʿaqd) and a partnership of property (shirkah al-milk). He asserts that it is baseless to argue that this arrangement is only prohibited in partnerships of contract, whereas ṣukūk are examples of partnerships of property. He argues that, in reality, all characteristics of the former are also present in ṣukūk. He substantiates his assertion by stating that the purpose of the former is to seek profits jointly, to make each partner the agent of the other in investment enterprises and to freely distribute profits to partners in whatever proportion they may agree.40 Muṣṭafā al-Zarqā’41 also argues that whenever the purpose of a partnership is investment or earning rent, regardless of whether that is to take place by means of commerce or leasing, the partnership will be one of contract. Referring to al-Zarqā’, Usmani42 concludes that since it is obvious that the purpose of ṣukūk is investment or earning income by means of leasing assets, it is impossible to call ṣukūk a partnership of property. The usage of waʿd is, therefore, unacceptable. 21

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According to Usmani43, where the manager acts as a muḍārib for the ṣukūk holders, the use of waʿd in the said manner is unlawful and void. He argues that no jurist has averred that such an arrangement is lawful. AAOIFI Standard 13 provides the reasoning by stating that if the loss is greater than earnings, the losses ought to be deducted from the capital, provided that there is no negligence or mala fide on the part of the manager.44 The Standard continues that if the costs are equal to the earnings, the ṣukūk holders will receive their capital back and the manager will earn nothing.45 Conversely if there is profit, it will be distributed among the ṣukūk holders and the manager in accordance with the pre-agreed ratio.46 Usmani, therefore, concludes that no such undertaking is acceptable. He also refutes the argument that in some ṣukūk the manager actually gives such an undertaking in another capacity. He states that this is clearly illogical because the muḍārib has no other capacity in such a venture. Usmani states further that, where the manager acts a wakīl for the ṣukūk holders, such a promise is again unlawful and void. He contends that wakālah is a contract of trust and there can be no guarantee except in the event of negligence or mala fide. AAOIFI Standard 5 provides the reasoning by stating that this is because the stipulation of ‘a guarantee by an investment agent will transform the operation into a loan with ribawī interest, guaranteeing [the return of] principal while offering returns from the investment’.47 Usmani48 argues that the commitment by way of a waʿd may lead to a sale of ʿīnah. This is because the manager, who sold the assets to the ṣukūk holders, now commits himself by way of a promise to repurchase the same assets from the ṣukūk holders, unless the sale of ʿīnah is negated by means of the conditions which are well known in Islamic jurisprudence. According to Haneef,49 who presents the Malaysian perspective, it is impossible to issue an asset-based ṣukūk without a purchase undertaking. The Islamic Financial Services Board, in its Guidelines No. 2 (IFSB 2), issued in 2005, defines asset-based ṣukūk as ‘ṣukūk where the underlying assets offer fairly predictable returns to the ṣukuk holders, such as in the case of salam, istiṣnāʿ and ijārah’. However, according to Dusuki and Mokhtar,50 the IFSB 2 criteria are, in reality, not complied with, arguing that most asset-based ṣukūk structures in the market do not reflect true ownership by the ṣukūk holders of the underlying asset. An additional standard, IFSB 7, therefore, was issued in 2009. Dusuki and Mokhtar assert that the standard elaborates on two types of asset-based ṣukūk: the first category is of those that utilise a purchase undertaking from the originator, and the second is of those with a guarantee from the issuer in case the originator defaults. 22

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Khan argues that according to English common law waʿd will not be entertained except on ground of deed, forbearance and tortious liability.51 However, there is great similarity to promissory estoppel. So, should these Islamic products be heard in an English court, problems might arise, as we do not have any precedent yet. There are differences of opinion among Muslim scholars regarding the enforceability of waʿd. The more appropriate view is that if the waʿd creates a tort, then it can be legally enforced, which is one of the OIC resolutions. This is similar to promissory estoppel – hence it can be enforced in an English court, and this can happen in case of default by the originator. But what is the remedy if it is not the originator’s fault? The law in the UK, under the Alternative Financial Investment Bonds, would expect the originator to guarantee payment but, from the Islamic perspective, who should take the risk if the venture collapses? Because of all the complications with the purchase undertaking, it is submitted that proper asset-backed securitisation should take place. The Sun Finance and Gulf Holding Company ṣukūk are living examples of proper securitisation. If they survive, there is hope that more certainty and Sharīʿah compliance will emerge in the market. However, there are still risks due to differences of opinion among not only Sharīʿah scholars but also legal engineers. There is, therefore, a push towards standardisation of legal documents and products. The following advantages may result from standardisation: 1. Maintenance of growth of the Islamic capital market. 2. Certainty in transaction methods. 3. Decrease in transaction costs. 4. Sharīʿah principles will be clearer to investors and practitioners. 5. Time can be saved in obtaining fatwās, which ‘document out’ legal risk. The counter argument against standardisation is that it is: A hankering for conventional or interest-based financing which requires homogeneity to churn out renting money transactions – commoditising documents is undesirable in the context of the Islamic finance industry, which is developing the implementation of its principles in regulation that is geared towards conventional or ‘IOU’ banking.52

Another important drawback is that standardisation may lead to what Imām Mālik wanted to avoid when asked to standardise Islamic law by the authorities: he wanted to let all views of the mujtahid prevail, as this is what brings dynamism to Islamic law as compared with étatism (where 23

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the state monopolises legislation). This legacy might be lost. However, one has to take into account also the fact that the era of Imām Mālik was that of ijtihād by the al-mujtahid al-muṭlaq and this trend could not be stopped at that time. Secondly, the concept of ijmāʿ also endorses the idea of standardisation. It is up to the Muslim scholars to draw the limits within which to standardise. Complete standardisation is not a solution. In fact, Clifford Chance LLP, a leading global law firm, in its Client Briefing of March 2010 following the Blom case judgment, advised the following practical steps prior to entering an Islamic financial transaction with an institution: • request that they provide a copy of the fatwā (or other relevant certificate/ approval document) confirming their detailed consideration of the structure and documents and that the transactions contemplated thereby are Sharīʿah compliant; • documents should include detailed representations regarding Sharīʿah compliance and no conflict with constitutional and other authorisation documents; and • documents should include an express waiver of any Sharīʿah-related defences. Though the bona fide intention of the advice given is to avoid unnecessary Sharīʿah risk in court, the advice of this kind betrays a strong trend towards standardisation of Islamic finance based on secular rather than Islamic law. This is an indication as to what will be the status of Islamic finance law in the near future.

Conclusion This article has drawn a picture about the debate surrounding assetbacked and asset-based ṣukūk structure and the legal uncertainties surrounding them. It explained the need to move towards proper assetbacked securitisation, as neither the present asset-backed nor the assetbased structures satisfy the ethos of Sharīʿah. However, while there is a movement towards standardisation to stabilise the market, this should be done cautiously so that any legal transplants from English (common) law do not disfigure the form or substance of Islamic law.

Bibliography Abdel-Khaleq, A., and Crosby, T., ‘Mushārakah ṣukūk: Structure, legal framework and opportunities’, in A. Thomas (ed.), Ṣukūk (Selangor: Sweet & Maxwell Asia, 2009, pp. 187-222). 24

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Abdullah, N., ‘The status of promise (wa’ad) and its implications in contemporary Islamic banking’, paper presented at ISRA Islamic Finance Seminar (IIFS), Kuala Lumpur, 11 November 2008. Abū Ghuddah, A.S., Buḥūth fī al-Muʿāmalāt wa al-Asālīb al-Maṣrifiyyah alIslāmiyyah (Research Paper on Islamic Banking Transactions and Ways), Vol. 8 (Jeddah: Dallah al-Barakah, 2007). Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sharīʿah Standards for Islamic Financial Institutions (Bahrain: AAOIFI, 2010). Al-Amine, M.A., ‘Islamic bonds market: Possibilities and challenges’, International Journal of Islamic Financial Services, Vol.1, No. 3, (2001), , retrieved 21 January 2013. Al-Ḥaṭṭāb, M.B.M., Mawāhib al-Jalīl li-Sharḥ Mukhtaṣar Khalīl (Libya: Maktabat Al-Najah, n.d.). Al-Masri, R.Y., ‘The binding unilateral promise (waʿd) in Islamic banking operations: Is it permissible for a unilateral promise (waʿd) to be binding as an alternative to a proscribed contract’, Journal of King Abdulaziz (Islamic Economics), Vol. 15 (2002), pp. 29-33. Al-Qarḍāwī, Y., Bayʿ al-Murābaḥah li-al-Āmir bi-al-Shirā’ (Murābaḥah Sales in the Light of Order Purchases) (Cairo: Maktabah Wahbah, 1987). Al-Zarqā’, M.A., Al-Madkhal al-Fiqhī al-ʿĀmm (Introduction to General Islamic Law) (Beirut: Dār al-Fikr, n.d.). Ali, R. and Kamal, M., ‘Ṣukūk: Standardisation and regulation’, in R. Ali (ed.), Ṣukūk and Islamic Capital Markets (London: Globe Law and Business, 2011), pp. 81-9. Belmontes, M. and Jawed, T., ‘The role of the SPV issuer’, in R. Ali (ed.), Ṣukūk and Islamic Capital Markets (London: Globe Law and Business, 2011), pp. 57-70. Chapra, U., ‘Prohibition of interest: Does it make sense?’ International Institute of Islamic Business and Finance (IIIBF) , retrieved 3 June 2011. Clifford Chance, ‘Islamic finance: When will an English court consider Shariah compliance?’ Client Briefing (2010), , retrieved 8 June 2011. Dey, D. and Ure, S., ‘Islamic securitisation’, in R. Ali (ed.), Ṣukūk and Islamic Capital Markets (London: Globe Law and Business, 2011), pp. 145-56. Dusuki, A.W. and Mokhtar, S., Critical Appraisal of Sharīʿah Issues on Ownership in Asset-Based Ṣukūk as Implemented in the Islamic Debt Market, ISRA Research Paper 8 (Kuala Lumpur: International Shariah Research Academy for Islamic Finance, 2010). Elmaki, F. and Ryan, D., ‘Ṣukūk – an evolution’, Conyers, Dill and Pearlman, January 2010 , retrieved 5 June 2011. Fankhauser, R., ‘Listing Ṣukūk’, in R. Ali (ed.), Ṣukūk and Islamic Capital Markets (London: Globe Law and Business, 2011), pp. 91-101. Haneef, R., ‘From “asset-backed” to “asset-light” structures: The intricate history of ṣukūk’, ISRA International Journal of Islamic Finance, 1/1 25

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(2009), pp. 103-26. International Islamic Financial Market (IIFM), Ṣukūk Report, 1st edn. (Bahrain: IIFM, 2010). Islamic Financial Services Board, Capital Adequacy Requirements for Ṣukūk, Securitisations and Real Estate Investment, IFSB Standard 7 (Kuala Lumpur: Islamic Financial Services Board, 2009). Islamic Fiqh Academy, ‘Resolutions and recommendations of the Council of the Islamic Fiqh Academy (1985-2000), Scribd.com, , retrieved 3 June 2011. Kapetanovic, H. and Becic, M., ‘Muḍārabah Ṣukūk: Essential Islamic contract, applications and ways forward’, in A. Thomas (ed.), Ṣukūk (Selangor: Sweet & Maxwell Asia, 2009), pp. 223-247. Khan, B., A Critical Legal Analysis of Waʿd Products under Sharīʿah Law and English Common Law: A Case for Sukuk and Derivatives. Unpublished MA dissertation (Markfield: Markfield Institute of Higher Education, 2011). Khnifer, M., ‘Lex Islamicus – when ṣukūk default – asset priority of certificateholders vis-à- vis creditors’, Opalesque Islamic Finance Intelligence (31 August 2010) , retrieved 2 September 2010. Laldin, A., The Concept of Promise and Bilateral Promise in Financial Contracts: A Fiqhī Perspective. ISRA Research Paper 4 (Kuala Lumpur: International Shariah Research Academy for Islamic Finance, 2009). Lotter, P. and Howladar, K., ‘Understanding Moody’s approach to unsecured corporate sukuk’, Moody’s Investors Service (Dubai) (August 2007) , retrieved 24 March, 2011. McMillen, M., ‘Asset securitisation, ṣukūk and Islamic capital markets: Structural issues in these formative years’ (8 May 2008), , accessed 2 February 2012. Minas, Q., ‘Prospects for ṣukūk market brighter’, The Saudi Gazette (24 December 2010), , retrieved 12 June 2011. Moini, Y. ‘Comparison and differences bwetween sukuk and conventional products’ in R. Ali (ed.), Ṣukūk and Islamic Capital Markets (London: Globe Law and Business, 2011), pp. 35-49. Mokhtar, S., ‘A diagnosis of tranching in light of Sharīʿah principles’, ISRA International Journal of Islamic Finance, Vol. 2, No. 1, (June 2010), pp. 161-170. Mokhtar, S., ‘A synthesis of Sharīʿah issues and market challenges in the application of waʿd in equity-based ṣukūk’, ISRA International Journal of Islamic Finance, Vol. 1, No. 1, (December 2009), pp. 139-45. Mokhtar, S., Application of Wa’ad in Equity Based Sukuk: Empirical Evidence, Research Paper 20 (Kuala Lumpar: International Shariah Research Academy for Islamic Finance, 2011). Mokhtar, S. and Thomas, A., ‘Ijārah ṣukūk’, in A. Thomas (ed.), Ṣukūk (Selangor: Sweet & Maxwell Asia, 2009), pp. 145-59. Mokhtar, S. et al., ‘Ṣukūk and the capital markets’, in A. Thomas (ed.), Ṣukūk 26

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(Selangor: Sweet & Maxwell Asia, 2009, pp. 17-40. Naim, F. and Hussain, A., ‘Wakālah ṣukūk’, in A. Thomas (ed.), Ṣukūk (Selangor: Sweet & Maxwell Asia, 2009), pp. 249-69. Ravalia, A. ‘Ṣukūk market at a crossroads’, CPI Financial (n.d.) , accessed 2 June 2011. Rosly, S., Critical Issues on Islamic Banking and Financial Markets (Kuala Lumpur: Dinamas Publishing, 2005). Usmani, T., An Introduction to Islamic Finance (Karachi: Idaratul Ma’arif, 2000). Usmani, T., ‘Ṣukūk and their contemporary applications’, Mufti Muhammad Taqi Usmani (n.d.) , retrieved 3 March 2013. Usmani, T., ‘What Sharīʿah experts say: Futures, options and swaps’, International Journal of Islamic Financial Services, 1/1 (1999), pp. 36-8. Zahraa, M. and Mahmor, S., ‘The validity of contracts when the goods are not yet in existence in the Islamic law of sale of goods’, Arab Law Quarterly, 7/4 (2002), pp. 379-97.

Notes International Islamic Financial Market, Sukuk Report. Q. Minas, ‘Prospects for ṣukūk market brighter’. D. Dey and S. Ure, ‘Islamic securitisation’, pp. 143, 145. F. Elmaki, and D. Ryan, ‘Ṣukūk – an evolution’. S. Mokhtar, Application, pp. 8-14. Ibid. B. Khan, A Critical Legal Analysis of Wa’ad Products. M. Khnifer, ‘Lex Islamicus - when ṣukūk default - asset priority of certificate-holders vis-à- vis creditors’. 9. A. Ravalia, ‘Ṣukūk market at a crossroads’. 10. International Islamic Financial Market, Ṣukūk Report. 11. Fankhauser, R., ‘Listing ṣukūk’. 12. T. Usmani, ‘What Sharīʿah experts say: Futures, options and swaps’; T. Usmani, An Introduction to Islamic Finance. 13. Khnifer, ‘Lex Islamicus’. 14. S. Rosly, Critical Issues on Islamic Banking and Financial Markets. 15. Dey and Ure, ‘Islamic securitisation’. 16. Elmaki and Ryan, ‘Ṣukūk – an evolution’. 17. M. Belmontes and T. Jawed, ‘The role of the SPV issuer’. 18. U. Chapra, ‘Prohibition of interest: Does it make sense?’. 19. Dey and Ure, ‘Islamic securitisation’. 20. Ibid. 21. Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards for Islamic Financial Institutions, Standard 17. 22. S. Mokhtar, ‘A diagnosis of tranching in light of Sharīʿah principles’. 23. T. Usmani, ‘Ṣukūk and their contemporary applications’. 24. M. McMillen, ‘Asset securitisation, sukuk and Islamic capital markets’. 25. S. Mokhtar, ‘A synthesis of Sharīʿah issues and market challenges in the 1. 2. 3. 4. 5. 6. 7. 8.

27

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application of waʿd in equity-based ṣukūk’. 26. P. Lotter and K. Howladar, ‘Understanding Moody’s approach to unsecured corporate ṣukūk’. 27. R.Y. Al-Masri, ‘The binding unilateral promise (waʿd) in Islamic banking operations’. 28. M.A. Al-Amine, ‘Islamic bonds market: Possibilities and challenges’. 29. R. Haneef, ‘From “asset-backed” to “asset-light” structures: The intricate history of ṣukūk’. 30. Lotter and Howladar, ‘Understanding Moody’s approach’. 31. Y. Moini, ‘Comparison and differences between ṣukūk and conventional products’. 32. Usmani, ‘Ṣukūk and their contemporary applications’. 33. Abdel-Khaleq, A., and Crosby, T., ‘Mushārakah ṣukūk: Structure, legal framework and opportunities’. 34. H. Kapetanovic and M. Becic, ‘Muḍārabah ṣukūk: Essential Islamic contract, applications and ways forward’. 35. F. Naim and A. Hussain, ‘Wakālah ṣukūk’. 36. S. Mokhtar and A. Thomas, ‘Ijārah ṣukūk’. 37. Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards for Islamic Financial Institutions, Standard 17, Para. 3.1.5.7. 38. Ibid., Standard 13, Para. 3.1.6.2. 39. Ibid., p. 230. 40. Uthmani, ‘Ṣukūk and their contemporary applications’. 41. M.A. Al-Zarqā’, Al-Madkhal al-Fiqhī al-ʿĀmm. 42. Usmani, ‘Ṣukūk and their contemporary applications’. 43. Usmani, Ibid. 44. Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards for Islamic Financial Institutions, Standard 17, Para. 7.8. 45. Ibid. 46. Ibid. 47. Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards for Islamic Financial Institutions, Standard 5, Paras 1-3. 48. Usmani, ‘Ṣukūk and their contemporary applications’. 49. Haneef, ‘From “asset-backed” to “asset-light” structures: The intricate history of ṣukūk’. 50. A.W. Dusuki, and S. Mokhtar, Critical Appraisal of Sharīʿah Issues on Ownership in Asset-Based Ṣukūk as Implemented in the Islamic Debt Market. 51. Khan, Critical Legal Analysis. Technically, this view of Khan needs to be qualified because legal documents such as Letters of Credit do not function as a normal contract, hence there might be a unilateral promise to pay by a bank. 52. R. Ali, and M. Kamal, ‘Sukuk: Standardisation and regulation’, p. 83.

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2 Unresolved Sharīʿah Issues in S ụ ku‾k Structuring Muhammad Al-Bashir Muhammad Al-Amine

Introduction Islamic finance has become the fastest-growing segment in the international financial system and the internationalisation of the industry has accelerated in recent years. This is evidenced by the greater presence of Islamic financial institutions in new jurisdictions, increased international participation in Islamic financial markets and increased cross-border flows of Sharīʿahcompliant funds and securities. The ṣukūk market in particular has evolved as a major contributing factor driving the internationalisation of Islamic finance, becoming an important avenue for international fund raising and investment activities.1 Indeed the ṣukūk market is not just the fastestgrowing part of Islamic finance but one of the fastest-growing sectors in the global financial market.2 It is widely acknowledged that innovation is one feature of modern ijtihād in Islamic law and jurisprudence. The structuring of ṣukūk is not just the implementation of contracts and mechanisms that existed in the writings of early Muslim scholars, but an adaptation of these contracts to the necessary changes in modern business realities and transactions. It is an endeavour that involves a number of parties, agreements and contracts. Ensuring that all parties, agreements and contracts work in harmony without contravening Sharīʿah principles is in itself a form of ijtihād. However, in every creative and new human endeavour mistakes are inevitable. Striving for continuous improvement and perfection is an unremitting process. The quest for continuous improvement demands collective effort that often consists of building on others’ efforts and striving for excellence. This paper addresses a number of unresolved Sharīʿah issues in ṣukūk structuring and their implications on the development of the ṣukūk market in particular and Islamic finance in general. These issues have varying levels of importance. On the one hand, we have the controversial issue of the sale of debt and the difference of opinion relating to it between Malaysia and the Gulf Cooperation Council (GCC), while on the other hand we have the broader issues of global concern about ṣukūk structures. The present paper is more concerned with the latter issues, which are affecting the development of the ṣukūk market internationally. The paper divides the contentious Sharīʿah issues into three categories: 29

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• The core issues that need immediate attention. • The intermediate issues that can be overcome if the broader issues are adequately addressed. • The methodological and procedural issues that could be the source of confusion if not wisely addressed. The core issues that can have a negative impact on the industry include the issue of ownership, in particular whether or not there is a true sale and the implications of such a sale on protecting the right of the ṣukūk holders in case of default. There is a need to establish whether or not beneficial ownership in ṣukūk structures complies with the basic requirements of a valid sale contract in Islamic law. Another question is whether the condition of preventing the purchaser from selling or disposing of the purchased assets violates any Sharīʿah principle of a valid sale contract, and whether or not the lack of due diligence or even inquiry regarding the purchased commodity amount to jahālah and gharar. The second core issue is the purchase undertaking in mushārakah, muḍārabah and wakālah ṣukūk and the possible implications of such an undertaking even in ṣukūk ijārah. The third issue in this category deals with the concern of subjecting ṣukūk transactions to conventional courts, in particular English courts, to settle disputes arising out of ṣukūk transactions. The second category of unresolved issues includes the practice of providing loans by obligors to investors in case of a shortfall of the actual returns to make the promised payments, and the issue of linking the return on ṣukūk to Libor or using it as a benchmark. The third category addresses the methodological and procedural approaches adopted by some scholars involved in ṣukūk structuring and their implications on market confidence and transparency. Although controversial Sharīʿah issues in ṣukūk structuring have been discussed among practitioners and academics for some time, these issues have taken centre stage following the well-publicised statement by Sheikh Taqi Usmani in 2007 that 85 per cent of the ṣukūk in the market are not Sharīʿah compliant.3 This was followed by deliberations on the issues raised in the paper he submitted to the Islamic Fiqh Academy.4 The polemic has been brought under control to some extent following the well-received Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI) resolution in 2008 on ṣukūk that has drawn the ‘road map’ for the future of ṣukūk structuring. The resolution reiterated and explained some of the basic principles that need to be observed by industry players. However, these controversial issues came under the spotlight again after the defaults of some ṣukūk when it became clear that there was a need to protect the rights of ṣukūk holders in such cases. This was very evident 30

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following the TID Ṣukūk default, the Cameron Ṣukūk default and in particular the controversy that surrounded the much-publicised possible default by Nakheel on its ṣukūk towards the end of 2009. Addressing the above Sharīʿah issues will require pointing out other issues affecting ṣukūk structuring and harmonising Sharīʿah requirements with business priorities, political considerations and the relevant legal framework. This paper argues that, in future, ṣukūk issuance will need to adopt a modified asset-backed securitisation model rather than continue with the current practice of replicating debt-based conventional bond structures. This means there is a genuine need for a shift in terms of structures, risks, markets and even the type of investors if the ultimate objective is to uphold Sharīʿah principles.

Definition of S ̣uku‾k A number of definitions have been proposed depending on the institution concerned and its understanding of the concept of ṣukūk. Thus, a definition of ṣukūk can be a detailed one, such as that provided by the AAOIFI or a broader and less detailed one, as it is the case with the definition given by the Securities Commission of Malaysia (SCM). The AAOIFI defines ṣukūk as: […] certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services (in the ownership of) the assets of particular projects or special investment activity…5

The Islamic Financial Services Board (IFSB), on the other hand, provides the following definition: Ṣukūk (plural of ṣakk), frequently referred to as ‘Islamic bonds’, are certificates with each ṣakk representing a proportional undivided ownership right in tangible assets, or a pool of predominantly tangible assets, or a business venture. These assets may be in a specific project or investment activity in accordance with Sharīʿah rules and principles.6

The SCM defines ṣukūk as: Certificates of equal value, which evidence undivided ownership or investment in the assets using Sharīʿah principles and concepts approved by the SAC.7

Through analysis of the above definitions it has been observed that the definition of the Bahrain-based AAOIFI gives a clear list of tangible assets, usufructs, services, particular projects, and assets of special investment 31

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activity for the structuring of ṣukūk, whereas the Malaysia-based IFSB provides a broader definition of tangible assets, pool of predominantly tangible assets or business venture. It should be noted that, although the IFSB put forward a broad definition, it did not elaborate much on the structural Sharīʿah issues in ṣukūk, perhaps due to the fact that the standard defining ṣukūk is primarily concerned with issues of capital adequacy requirements rather than Sharīʿah issues. The SAC’s definition, on the other hand, is more general, intended perhaps to accommodate all ṣukūk issued in the Malaysian capital market pursuant to any Sharīʿah principles.8 It leaves room for the introduction of financial assets such as receivables and debts into the pool of underlying assets. Based on the AAOIFI standard on ṣukūk, financial assets and debts are not acceptable as possible underlying assets. The 2008 AAOIFI resolution is explicit on the issue, stating that ‘ṣukūk, to be tradable, must not represent receivables or debts’.9 However, within the Malaysian jurisdiction, receivables are considered to be a permissible asset class for securitisation according to the SCM’s Shariah Advisory Council (SAC).10 Thus, structures such as the murābaḥah-tradable ṣukūk or the sale and buy back ṣukūk based on bayʿ al-ʿinah are commonly incorporated and widely used in the Malaysian capital market. The Sharīʿah Advisory Council of Bank Negara Malaysia and the Securities Commission of Malaysia permitted such transactions and structures based on their interpretation and application of Sharīʿah principles.11 It is also clear from the AAOIFI definition that ṣukūk does not create indebtedness and the certificate is not a proof of investor’s loan to the ṣukūk holders, as is the case with conventional bonds. On the contrary, the ṣukūk certificates constitute evidence of ownership of underlying assets, usufruct or services. Ṣukūk, therefore, facilitate investment, not lending.12 Ṣukūk must represent co-ownership of an asset or business venture13 and should grant investors a share of the cash flows and risk commensurate with such ownership. Some ṣukūk structures in the market do not comply with the above definition. According to the international rating agency Moody’s, while the AAOIFI definition is the Sharīʿah ‘ideal’, from a risk/return perspective most structures have more in common with conventional fixed income or ‘debt’ instruments. Commonly, the assets in the structure are there only for Sharīʿah compliance, and ultimately have little or no bearing on the risk or performance of the ṣukūk.14 This observation forms the basis of the questioning of the Sharīʿah compliance of at least some ṣukūk structures in the market and calls for a thorough assessment and analysis. 32

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S ̣uku‾k Market Growth and Development Although the issuance of ṣukūk started in the 1990s, global ṣukūk were inaugurated by Malaysia in 2002. From that day until the recent financial crisis, the market has witnessed exceptional double-digit growth. The ṣukūk market, as is the case within the Islamic finance industry generally, was less affected by the financial crisis than its conventional counterpart, though it was not completely immune from its consequences. The industry faced difficult times during the financial meltdown, as reflected in the reduction of ṣukūk issuances over the last few years, dropping by 54.9% in 2008 to US$15.5 billion compared with US$34.3 billion issued in 2007. However, the market emerged from the worst of the financial crisis more rapidly than expected.15 In 2010 ṣukūk issuances hit a record of US$47.78 billion. The market in 2010 managed to surpass the 2007 peak level by around 50%. This was a clear sign of increasing confidence in the global markets. According to Dow Jones Islamic Markets Indices December 2010 Commentary, the DJIM Citigroup Ṣukūk Index gained 9.1% in 2010, finishing at 125.32 points.16 Standard & Poor’s posted a marginally higher figure for the 2010 issuances that reached a record high of US$51.2 billion in 2010 – including those issued and maturing the same year – beating the previous peak in 2007 by 34%.17 This positive development continued through the first half of 2011. In terms of geographical breakdown, Malaysia continued to dominate the market, with over 62% of ṣukūk issued, followed by Qatar with 20.6%. It should be noted that it is the first time Qatar surpassed the UAE as the main issuer of ṣukūk from the GCC. Jordan issued its first corporate ṣukūk before its first sovereign ṣukūk, while Yemen issued its first small ṣukūk just before the eruption of unrest and HSBC Bank Middle East issued its first ṣukūk ever under a wakālah-muḍārabah structure. On a regulatory and legislative level, the Egyptian Financial Services Authority approved the proposal for rules governing issuing and trading in ṣukūk, a step that could finally bring a long-awaited giant to the ṣukūk market. Thus, despite mixed sentiments, big announcements, major delays and a wave of political unrest in the Middle East and North Africa (MENA) region, the first half of 2011 witnessed the issuance of US$43.8 billion in ṣukuk globally, according to data compiled by Zawya Sukuk Monitor. This represents more than double the amount issued during the same period in 2010.18 However, if the ṣukūk market was quick to reverse the slowdown in terms of growth due to the financial crisis, the market has been sluggish in addressing the controversial Sharīʿah issues that tainted the market following Sheikh Taqi Usmani’s statement and the polemic that followed 33

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the ṣukūk defaults. The market has been slow in abiding by the 2008 AAOIFI statement that was intended to help the market regain confidence in terms of Sharīʿah compliance. This general neglect of the AAOIFI statement is evident in the non-compliance of many ṣukūk in the market with a number of principles highlighted in that statement, in particular the first point of the statement regarding the issue of true sale and the necessity to move the asset sold from the balance sheet of the seller.

True Sale in S ụ ku‾k Structuring By a true sale we mean a sale that complies with Sharīʿah principles and observes AAOIFI standards and resolutions on ṣukūk. The main requirements of such a sale are: 1. A legal transfer of ownership of the assets sold from the buyer to the purchaser. 2. The assets sold are transferred from the balance sheet of the seller to that of the purchaser. 3. There is no condition or clause that prevents the purchaser from exercising his rights to sell the asset or dispose of it. 4. The ṣukūk returns are based on the actual performance of the asset underlying the ṣukūk. 5. The purchaser has direct recourse to the asset in case of default. The true sale issue is one of the first steps in structuring a ṣukūk transaction. It is not limited to ijārah, murābaḥah, mushārakah and wakālah ṣukūk. Its importance is based on the fact that if the first step is wrong, then all the following steps will follow suit. If the sale and purchase of the asset underlying the ṣukūk structure do not reflect a Sharīʿah-compliant true sale, then the assets in the structure will not fulfil their real purpose. As a consequence, the profit or returns will not be based on the actual performance of the assets but on the creditworthiness of the originator. Moreover, if the presence of the asset in the ṣukūk structure is not real, then the transaction will be akin to mere credit transaction, and, therefore, a repurchase undertaking of the assets at a nominal price will be necessary to guarantee repayment of the capital to ṣukūk holders at maturity. Furthermore, if the transfer of the asset is not legally enforceable, it could be a source of dispute in case of default. The same will apply to other Sharīʿah issues that might affect ṣukūk structuring. Thus, the issue of true sale in the sale and purchase agreement of ṣukūk structuring is central to all other Sharīʿah issues.

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In addressing the issue of true sale and the controversy surrounding asset-backed and asset-based ṣukūk, the AAOIFI 2008 resolution is very clear, stating: Ṣukūk, to be tradable, must be owned by ṣukūk holders, with all rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally as well as in accordance with the rules of Sharīʿah, in accordance with Articles (2)1 and (5/1/2)2 of the AAOIFI Sharīʿah Standard (17) on Investment Ṣukūk. The manager issuing sukūk must certify the transfer of ownership of such assets in its (ṣukūk) books, and must not keep them as his own assets.19

One important classification of ṣukūk that has dominated discussion recently is the division of ṣukūk into asset-backed and asset-based. The classification is intended to replicate the conventional division into assetbacked securities and debt-based bonds, or simply secured and unsecured securities. Once again, the main feature that distinguishes the two types of ṣukūk from each other is whether a ‘true sale’ of the asset has taken place. The ṣukūk structure is asset backed when there is a true sale, while it is asset based when mere beneficial ownership has been transferred to investors. In most ṣukūk structures, despite the presence of an asset in the sale and purchase agreement, the transfer of ownership in such a sale/ purchase agreement between the issuer and the originator would be only beneficial ownership and would not involve full legal title. AAOIFI’s recent ruling, as quoted above, clearly disapproves of this practice. However, the practice is acceptable in English law. The AAOIFI resolution rules that any transaction transferring mere beneficial title would be non-compliant with Sharīʿah. Accordingly, it is universally acknowledged that if only beneficial ownership is transferred to ṣukūk holders, the transaction does not represent a ‘true sale’. As a result, when the sale is not a true sale, originators keep the asset on their balance sheet, while in a true sale transaction such assets would be taken off the originator’s balance sheet, representing a transfer of legal ownership. Moreover, in a true sale, resulting in a genuine transfer of ownership, the new owners or the ṣukūk holders should have full rights of disposal over the assets without any recourse to the originator.20 In order to maintain Sharīʿah compliance there must be a legal transfer of assets. However, currently, many ṣukūk investors have no recourse to the assets, so rating agencies do not focus on asset risk, but on the credit worthiness of the sponsors of the ṣukūk. These types of ṣukūk do not grant the certificate holders the right to cause the sale or any other disposal of any of the trust assets upon default of the issuer. They can only cause the trustee to call a meeting of the certificate holders and exercise their 35

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rights under the transaction documents, including issuing a notice to the originator pursuant to its undertaking to repurchase the assets on maturity or default of the ṣukūk. Ultimately, asset-based ṣukūk are based upon the credit of the issuer, guarantor or other co-obligors.21 Under a well-structured asset-backed ṣukūk, legal title to the underlying assets will typically pass by way of a ‘true sale’ from the originator to the issuer or special purpose vehicle (SPV). On default by the issuer, ṣukūk holders would be able to exercise full ownership rights and control over the assets. Thus, if the underlying assets are performing well while the originator is facing bankruptcy, the ṣukūk holders’ payment will not be interrupted. However, if the underlying assets are not performing, the ṣukūk holders must bear the risk of the non-performance as the real owners of the assets. The ṣukūk holders have to recognise from the beginning that they will be exposed to market and credit risk of the assets.22 It is clear from the above that asset-backed ṣukūk are closer to an equity position because ṣukūk holders own the underlying asset and have no recourse to the originator in the event of a payment shortfall. Assetbased ṣukūk, on the other hand, are closer to debt instruments because ṣukūk holders only have recourse to the originator if there is a shortfall in payments.23 To reiterate, the key difference is the concept of true sale. In asset-backed ṣukūk, there is a ‘true sale’ between the originator and the SPV that issues the ṣukūk. Assets are owned by the SPV, returns are derived from assets, and asset prices may vary over time.24 On the other hand, the asset-based structure normally results in debt creation. The debt that is created represents the receivables that will be distributed to the entitled parties. In asset-based ṣukūk structures, the debt comprises the coupon plus principal investment via a right in the obligor’s cash flow.25 In assetbacked ṣukūk (ABS) on the other hand, ṣukūk holders are actually buying undivided shares of the underlying assets that will take effect by way of a transfer of the legal title. They have full ownership rights over the assets and are therefore entitled to revenues generated by them. At the same time, investors will share the risks that come with ownership, such as loss or damage to the underlying asset.26 Thus, it is widely observed that in most ṣukūk: Issuers are trying to avoid a common law ‘true sale’ and instead enter into what appeared to be a sale, but was not a perfect sale at all. The issuer was able to transfer only the ‘beneficial ownership’ of the asset or business venture to a common law trust-SPV.27

It is also widely acknowledged that the assets in the vast majority of assetbased ṣukūk are there merely for the purpose of formal Sharīʿah compliance, 36

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rather than to serve as the source of profit and capital payments. Credit risk assessment, therefore, will typically be directed towards the entity with the obligation to redeem the ṣukūk28 while from a legal perspective the originator owns the underlying assets and not the certificate holders.29 Sometimes the certificate holders purchasing the ṣukūk assets will not perform any due diligence or even enquire regarding the asset. Sometimes they do not even have the right to do so, as stated in the following offering circular: No investigation or enquiry will be made and no due diligence will be conducted in respect of any of the constituent assets comprised in the Portfolio. The constituent assets in the portfolio shall be selected by the IDB and the certificate holders shall have no ability to influence this selection… In particular, the precise terms of any of the constituent assets comprised in the portfolio will not be known…30

In another offering circular the following was stated: No investigation or enquiry will be made and no due diligence will be conducted in respect of any portfolio asset… In particular, the precise terms of the portfolio assets sold will not be known… No steps will be taken to perfect any transfer of such interest and rights or otherwise give notice to any lessee or obligor in respect thereof.31

It is also stated that: No investigation will be made to determine if the purchase agreement will have the effect of transferring any beneficial interest and rights in and to the assets described therein. No investigation has been or will be made as to whether any interest and rights in and to any of the Portfolio Assets may be transferred as a matter of the law governing the contracts, the law of the jurisdiction where such assets are located.32

However, questions arise as to why investors should not be asking for due diligence about the assets, whether or not the assets are legally transferred, and whether they really have the value they are paying for them in the form of the price or consideration. More importantly, why are they not asking if the assets would continue having a value in case of default in order to protect their rights? The answer seems to be clear. Investors in such structures can only rely upon the purchase undertaking to get their capital back and they have no right to dispose of the assets. Thus, there is no need for legal or financial due diligence over the asset. A Sharīʿah question that will arise over the absence of due diligence and even right to inquiry about the asset purchased is whether these restrictions result in a type of jahālah and gharar that will affect the Sharīʿah compliance of the sale. 37

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Based on Sharīʿah principles, the ṣukūk holders should be able to deal freely with the assets and the seller should not have any claim over the assets after selling them. This means that the ṣukūk holders should be having a prior claim over the assets if there is default and the right to sell them or place them as a security. They are the real owners of the assets and should have full control over them. However, the reality is that the ṣukūk holders cannot dispose of the assets and can only enforce the purchase undertaking. They have to rank pari passu with unsecured creditors of the obligor. Moreover, the transfer of ownership would not take place and the assets utilised in the ṣukūk will remain on the balance sheet of the obligor. The purchase undertaking is the sole right arising upon occurrence of dissolution. Based on the above, it has been rightly asked if such a contract is a genuine sale and purchase from a Sharīʿah perspective.33 If the buyer cannot pledge or resell the asset, then the seller is deemed to maintain control, and then the whole arrangement could be easily classified as a kind of loan-based financing, not sale of an asset.34 Thus, it is clearly stated in some of the offering circulars that: Taking enforcement action in the name of the Trustee against the obligor for all amounts due to be paid or shares to be delivered under the Purchase undertaking provided always that, for the avoidance of doubt, such enforcement action shall not include the right to sell muḍārabah assets.35

In another offering circular the following was stated: Under no circumstances shall any certificate holder, the trustee or the delegate have any right to cause the sale or other disposition of any of the trust assets except pursuant to the transaction documents…36 In any such case the dissolution amount will be funded by requiring the obligor to purchase the relevant muḍārabah assets and pay the relevant price to or to the order of the issuer (pursuant to the terms of the purchase undertaking and the sale undertaking).37

It is also added that: The certificate holders will not have any rights of enforcement as against the portfolio assets and their rights are limited to enforcement against Kuveyt Türk of its obligation to purchase the trustee’s interest and rights in and to the portfolio assets pursuant to the terms of the purchase undertaking.38

The above seems to be the common position of all ṣukūk structured as assetbased, whereby ṣukūk holders have no real ownership over the asset and therefore, have no right to sell the asset to a third party or dispose of it otherwise: 38

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Under no circumstances shall the delegate or any certificate holder cause the sale or other disposition of any of the relevant wakālah ṣukūk assets otherwise than to the Government of Malaysia in accordance with the terms of the transaction documents…39

Based on the analysis of similar documentations by rating agencies it is concluded that without evidence of a legal true sale, there is little or no benefit to the assets in an ‘asset-based’ ṣukūk. This is based on the fact that the ‘form’ of the risk and return may appear to be that of assets but the ‘substance’ is purely that of the corporate or bank originating the ṣukūk and not that of asset risk. Importantly, in most cases, this is exactly what the borrowers and investors want. Many, with full knowledge and understanding, are content to transact on this basis.40 However, the question from the perspective of Islamic law is, if the purchaser has no right to dispose or to sell the assets does he have full ownership? If the buyer is not given full access to the goods purchased without restriction based on the principle of takhliyah and taṣarruf, does the contract continue to be valid? What if the buyer does not undertake any effort to see whether legal title of the purchased goods is transferred to him? Is the contract really intended to be a sale contract? Making it a condition that the purchaser cannot sell the assets he purchased, dispose of them or even place them as security is generally discussed by early Muslim scholars under the conditions that are incompatible with the objective of the sale contract (al-shurūṭ allatī tunāfī muqtadā alʿaqd). The conclusion of the jurists’ discussion regarding the issue is that such conditions would render the contract null and void according to some, while another group maintains that the contract is still valid but the condition is void and therefore should be dropped automatically.41 The main argument is that a sale contract by definition entitles the purchaser to have free hand and full control over the purchased asset, but the type of conditions we have reviewed restrict it and go against its spirit (yunāfī wa yunāqiḍu maqṣūd al-ʿaqd). It is pertinent here to explain to Sharīʿah scholars advising on ṣukūk that the problem in moving from legal ownership to beneficial ownership is merely an issue of registration. Registration of ownership transfer in the Land Register, for instance, is not a pre-condition for the compliance and validity of a sale and purchase contract under Islamic law. A sale-andpurchase contract is valid through offer and acceptance and there is no Sharīʿah requirement that this must be registered. Registration is just a modern legal formality. Thus, a sale-and-purchase contract is valid even without registration. However, what has been misunderstood here is that, in Islamic law, the legal ownership is automatically transferred by the sale 39

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contract itself and the formality will be whether or not this legal title should be registered. In addition, under a Sharīʿah-compliant sale-and-purchase contract, the buyer has the right to keep the goods purchased or to resell them to a third party as and when he wishes. However, what needs to be explained to Sharīʿah scholars is that in the current beneficial ownership structures, the purchaser cannot sell the assets or dispose of them; he cannot perform any due diligence in relation to the assets or even inquire about them. Moreover, the revenues of the ṣukūk holders will not depend on the performance of the assets and the purchasers will not have a right of recourse to the assets in case of default. Thus, portraying the difference between a legal transfer and beneficial transfer of ownership in ṣukūk structure as just an issue of registration is misleading. The use of the concept of beneficial ownership started with the first Malaysian global ṣukūk that securitised US$600 million worth of sovereign tangible assets. To structure the ṣukūk as asset backed, the Federation of Malaysia, as the originator of the ṣukūk, faced a major legal constraint. Malaysia had previously issued international bonds and some of them were still unredeemed. It should be noted it is a market practice that all international bonds have a standard negative pledge that restrains the bond issuers from issuing any bond not pari passu with existing unredeemed unsecured bonds. Given the fact that the existing Malaysian international bonds were unsecured, this would constitute a direct breach of the negative pledge clause agreed upon by Malaysia in its international bond issues if the proposed asset-backed ṣukūk are structured as asset-backed securities. This is because the ṣukūk would be backed by the ownership of the underlying assets and become effectively secured bonds and therefore would be given priority over all unsecured bonds of the Federation of Malaysia.42 Based on the recommendation of legal firms advising on the transaction and the approval of some Sharīʿah scholars, a short-term solution was found and a new structure designed. Based on this new structure, the ṣukūk holders would have beneficial ownership of the assets held through the ṣukūk trustee during the ṣukūk’s life. However, in the event of default by the Federation of Malaysia, the ṣukūk trustee’s sole recourse would be to dispose of the assets only to the Federation of Malaysia and seek payment. The ṣukūk trustee would not have the power to retain or sell the assets to any third party. Once the ṣukūk trustee had disposed of the assets to the Federation of Malaysia, the ṣukūk holders would in law be treated as unsecured creditors. Thus, the new ṣukūk structure was no longer asset-backed but rather asset-based. As a result, although the ṣukūk had underlying assets, the ṣukūk holders would only be able to dispose of the assets to the lessee and not to any other party.43 The construction was achieved on the basis of a nuance between 40

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the Sharīʿah and the UK/New York legal systems that appears to have allowed them to meet in the definition of a ‘sale’. This was combined with a willingness from some scholars to accept beneficial ownership as a sufficient Sharīʿah basis in sales contracts in order to avoid a number of encumbrances that otherwise would have had to be dealt with. These encumbrances could result from tax, legal or rating requirements. However, while this was intended to be a temporary ‘way out’, it has now become the norm. Some of the obstacles in structuring appear to have been resolved and ṣukūk were issued, favourably rated, well priced, oversubscribed and safely placed. So everybody was happy – or were they?44 It should be highlighted that the asset based-ṣukūk form of many existing unsecured ṣukūk is a deliberate construction. Many sovereigns and companies do not want to ‘sell’ their quality assets to investors. At the same time, many investors do not actually want asset risk but the equivalent of conventional bonds. Through widespread structuring approaches companies acquire the desired debt funding in ṣukūk form and investors are happy with this for the most part.45 Asset-based ṣukūk are popular among market players as they allow the obligor to raise unsecured funding – they don’t have to part with their assets to get money – and they can use the money raised for any purpose they want. The proceeds from ṣukūk do not necessarily go into any specific project. At the same time, some investors do not want asset risk – they want to be like bondholders and have purely credit risk.46 Thus, it has been observed that, although AAOIFI guidelines are clear, market participants can and will make their own decisions based on the priority given to Sharīʿah compliance in their own agendas and economic objectives – where the need for financing may be the key driver.47 The non-compliance by the resolution has led some to conclude that, ‘many of the current ṣukūk types adhere to AAOIFI in form, but not in substance’.48 Another controversial issue in ṣukūk structuring is the purchase undertaking. It is widely associated with the mushārakah, muḍārabah and wakālah ṣukūk structures. A deeper analysis shows that such a purchase undertaking will be an issue even in a ṣukūk ijārah if the transfer of ownership in the ṣukūk assets is not based on true sale.

Purchase Undertaking The 2008 AAOIFI guidance on ṣukūk is explicit on the issue of purchase undertaking, with particular reference to mushārakah, muḍārabah and wakālah ṣukūk: It is not permissible for the muḍārib (investment manager), sharīk (partner), or wakīl (agent) to undertake (now) to re-purchase the assets from ṣukūk holders or from one who holds them, for its nominal 41

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value, when the ṣukūk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase… It is known that a ṣukūk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or his non-compliance with the investor’s conditions…49

The AAOIFI statement stipulates that the purchase undertaking should not be based on the exercise price, which is calculated by reference to the face value of the sukūk at maturity or upon the earlier dissolution of ṣukūk. Instead, any repurchase undertaking may be based on the net asset value, market value, cash equivalent value or any price agreed upon at the time of purchase. The ṣukūk manager can only guarantee to repay the capital to ṣukūk holders at face value in cases of negligence or violation. Ṣukūk holders in a muḍārabah- or mushārakah-based structure, therefore, need to understand that they must have some risk in these structures. Generally, under most muḍārabah and mushārakah ṣukūk, the provider of the purchase undertaking is also the investment agent. The role of the investment agent under a muḍārabah ṣukūk is ultimately to use his or her best efforts to make a profit for the ṣukūk holders, for which the investment agent is entitled to be paid an agreed proportion of the profit. It is not the role of the investment agent to guarantee the capital repayment of the ṣukūk in the form of a purchase undertaking or otherwise. Similarly, the nature of a mushārakah partnership is that the partners agree to maintain the assets of the joint venture on a trust basis. Except for cases of wilful default, negligence or breach of contract, it is not permissible to stipulate that a partner under a mushārakah, muḍārabah or wakālah agreement will guarantee the capital of another partner in the same contract.50 The AAOIFI resolution had some impact on the use of purchase undertaking in the profit-and-loss sharing ṣukūk structures based on wakālah, muḍārabah and mushārakah, by reducing the number of ṣukūk based on these contracts in favour of ṣukūk ijārah. It should be noted, however, that this shift is based on a move to address the root causes of the problem by developing ṣukūk structures that reflect genuine investment, whereby investors obtain genuine ownership of the underlying assets and where the profit is linked directly to their performance. Unfortunately this seems not to be the case. In a recent ṣukūk based on muḍārabah and wakālah issued by First Gulf Bank it is clear that not much has changed. The problem that the AAOIFI statement seeks to avoid by declaring the purchase undertaking non-permissible in mushārakah, muḍārabah and wakālah ṣukūk is still present. In its rating of the above 42

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ṣukūk Moody’s stated the following: The (P) A2 rating assigned to the trust certificates is at the same level as the long-term local-currency and foreign-currency deposit ratings of First Gulf Bank (FGB), as the ṣukūk certificate holders will effectively be exposed to FGB’s senior credit risk; (ii) will not be exposed to the risk of performance of the ṣukūk assets relating to the certificates; (iii) have no preferential claim or recourse over the trust assets, or rights to cause any sale or disposition of the trust assets except as expressly provided under the transaction documents; and (iv) only have rights against FGB, ranking pari passu with other unsecured obligations as provided in the Transaction Documents.51

Purchase Undertaking in Ijārah S ̣uku‾k The 2008 AAOIFI resolution states the following: It is permissible for a lessee in a Ṣukūk al-Ijārah to undertake to purchase the leased assets when the ṣukūk are extinguished for its nominal value, provided he (lessee) is not also a partner, muḍārib, or investment agent.52

It is clear from the above statement that a purchase undertaking in which the exercise price is calculated by reference to the face value of the underlying assets is permissible under ṣukūk ijārah. This is because, under an ijārah contract, the originator usually ‘sells’ the asset to the SPV and then leases it back from the SPV for the ṣukūk term. The purchaser bears the risk of the asset throughout the life of the ṣukūk and he has the option but not the obligation to sell it. It is, therefore, permissible for the originator to undertake to purchase the tangible asset at face value on maturity date. During the life of the ṣukūk, the ṣukūk holders would still bear the risk of the asset. If the asset is destroyed in some way during this period the originator will not be under an obligation to buy the asset.53 The ṣukūk holders should have full control over the ṣukūk assets and there is nothing in the sale and purchase agreement that restricts their ownership or curtails their rights. However, given the fact that in many ṣukūk ijārah structures the assets underlying the ṣukūk are unlikely to have been the subject of a legal sale initially, it is submitted that the main purpose of the contract has changed to create a payment obligation on the originator. Thus, in the event of the corporate going bankrupt, this claim can be ‘accelerated’ and hence investors should have a claim to this amount. From an investor perspective, such claim should rank at the same level as other unsecured creditors, both conventional and Islamic. Ṣukūk investors here have no prior claim over 43

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the ṣukūk assets.54 Thus, one may argue that even the purchase undertaking in ṣukūk ijārah is not immune from criticisms if there is no true sale of the assets at the outset.

Loans in Mushārakah, Mud ̣ārabah and Wakālah S ụ ku‾k Before the recent criticisms concerning a number of Sharīʿah issues involving ṣukūk structures, it was common practice in mushārakah, muḍārabah and wakālah ṣukūk that the investment agent would undertake to provide a loan in order to cover any shortfall in the specified return in the ṣukūk vis-à-vis the actual return generated from the performance of the underlying assets. This has been criticised by the 2008 AAOIFI resolution as follows: It is not permissible for the manager of ṣukūk, whether the manager acts as muḍārib (investment manager), or sharīk (partner), or wakīl (agent) for investment, to undertake to offer loans to ṣukūk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus. It is not objectionable to distribute expected earnings, on account…55

There has been some improvement over the issue following the above statement. In many ṣukūk structures, there is no undertaking from the investment agent to provide such a loan. Provided that a loan is not an obligation but an option, the investment agent can provide a loan based on his own discretion. Thus it is stated: In the case where there is a shortfall in the Periodic Distribution Amounts payable to the ṣukūk holders and the reserve amounts are not sufficient to cover such shortfall, the managing agent may provide Sharīʿah-compliant liquidity facility to ensure that the ṣukūk holders receive the full amount of the periodic distribution amounts payable. The liquidity facility is repayable by the issuer to the managing agent.56

It should be noted that the above represents a step in the right direction but is yet to be observed by all ṣukūk structures and market operators.

S ụ ku‾k Returns and the Use of LIBOR Using LIBOR as a benchmark for Islamic finance transactions, including ṣukūk, is commonly practised. It is widely acknowledged by Sharīʿah scholars and many economists that use of LIBOR is not prohibited as long as it is simply a benchmark for determining the rate of return.57 However, a contentious Sharīʿah issue to be noted is whether or not the return on ṣukūk 44

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is really generated by the performance of the asset. Once again we are back to the issue of true sale, asset-backed and asset-based ṣukūk. In asset-backed ṣukūk the return is generated directly by the asset and therefore can vary from time to time based on the actual performance of the asset and does not need to have any direct correlation with the prevailing interest rate. In contrast, in asset-based ṣukūk, the return is not based on the performance of the asset, and therefore the Sharīʿah concern will be: if the return is not really related to the performance of the asset, then how has it been determined? This ambiguity is obvious in one of the recent mega-ṣukūk structures. The proceeds of the ṣukūk are used in three different ways: 26 per cent to purchase a lease generating asset; 26 per cent to purchase some shares; and the remaining 48 per cent to enter into a commodity murābaḥah. The total of the three represents the total assets of the wakālah ṣukūk. The periodic distribution amount to the certificate holders, however, depends entirely on the lease rental. Thus, it is stated in the offering circular that, on each periodic distribution date, the certificate holders will receive a periodic distribution amount: A periodic distribution amount representing a defined share of the rental paid by the lessee to the lessor pursuant to the lease agreement in respect of the lease assets. The certificates will be distributed by the trustee to the certificate holders in accordance with these conditions.58

A simple question is, if the 26% of the wakālah proceeds can generate the specified return to the ṣukūk holders, what would be the return if the whole amount were used to invest in similar assets? Perhaps these investors are naïve or not very sophisticated and therefore are willing to accept the specified return, not looking for a better return. Another explanation may be that it is irrelevant as to what assets comprise the asset portfolio as, from a credit perspective, investors are relying entirely on the credit risk of the Malaysian government. The presence of the assets is merely to satisfy Sharīʿah scholars that the ṣukūk are in fact based on assets. Thus, while many Sharīʿah scholars approving such ṣukūk structures, as well as some participating investors, are of the belief that the assets in the ṣukūk are owned by investors and that the return of the certificates is based on the performance of the assets, the documentation of many ṣukūk structures does not reflect this assumption. This leads us to another important issue, namely, what will be the court’s position in case of default and litigation? Will the court side with the scholar’s position or the legal documentation of the ṣukūk? What complicates the litigation issue is the fact that the condition of not selling the assets or disposing of them is considered by Muslim jurists to render the contract null and void according to one 45

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opinion, but even if the contract is considered to be valid, the condition is definitely void. What, then, will be the position of the English court on this? Moreover, what will be the status of the court’s verdict if the court is an English court that does not recognise Sharīʿah as a legal system, but merely a collection of moral principles?59

S ụ ku‾k Litigation and the English Courts Although there is still no clear precedent in addressing the above issues and concerns, recent ṣukūk defaults have highlighted the need to address the rights of ṣukūk holders. Legal uncertainty surrounding creditor rights in the event of ṣukūk defaults or restructuring has come to the fore. What rights would investors have over assets in the event of default, and would those rights be legally enforceable? As highlighted above, the difficulty in this regard stems from the fact that investors and the courts are trying to make legal sense out of financial structures designed primarily to comply with Sharīʿah principles. For instance, difficulties are sure to arise when transaction documentation and their embedded remedies are at odds with Sharīʿah and investors take the position that they must comply with Sharīʿah, irrespective of the contractual terms agreed between the parties.60 The challenge of the courts will be to determine the rights of investors in ‘asset-based’ structures. In particular, the courts will need to resolve the on-going legal debate on these rights under transaction documents that incorporate a structure akin to that of a conventional bond that may not be consistent with Sharīʿah principles.61 As is clearly stated by Badlisyah Abdul Ghani, Chief Executive of CIMB Islamic, a Malaysia-based Islamic investment bank and a leading player in the ṣukūk market: People have to remember that most sukūk are unsecured investment instruments… Those assets are there to facilitate a financial obligation of the issuers. They are not there to provide security to the investors.62

Upon default, considering the fact that they have no right of recourse to the underlying assets, ṣukūk holders will rank pari passu with other creditors. The parties to the transaction, namely the issuer, originator and ṣukūk holders, may agree to restructure the debt and related obligations of the issuer and originator, inclusive of a possibility of having an agreement to reduce the principal sums outstanding or granting standstills on exercising any rights under the transaction documents. Although there are not many established precedents and cases on the issue, if, from a theoretical point of view, and the viewpoint particularly of a 46

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credit rating agency, the analysis validates the presence of asset ownership or security, then the ṣukūk risk/profit is driven more by the value and cash flows of the underlying asset. Even if the originator were to default and go bankrupt, the ṣukūk investors should be in a good position to recover much of their investment, obviously depending on asset quality. If, for example, a building or land was truly sold to the ṣukūk holders, then it would be the value of the building or land that determines how much the ṣukūk investors will recover.63 However, if the rating agencies come to a conclusion that such contracts are not binding or that they are voided in a bankruptcy court situation, then they would assign only a limited value to the assets in the structure, and the risk and rating analysis would be focused on the issuing party, whether a sovereign, corporate or bank.64 The foregoing theoretical position is well supported by one precedent, namely the East Cameron Gas Ṣukūk case, whereby investors were granted rights over the ṣukūk assets after the default of the issuer. The East Cameron Gas Sukuk case provides a clear example of how ṣukūk holders can be protected and how such a structure could be judged by courts. The East Cameron Gas Ṣukūk was issued as a ṣukūk mushārakah in 2006 for US$165.67 million. The mushārakah was between an onshore SPV and the issuer, East Cameron Partners. The SPV used the ṣukūk proceeds to purchase an overriding royalty interest (ORRI) from the issuer who contributed an additional ORRI to the mushārakah. The issuer’s expenses resulting from the need to repair hurricane damage to its facilities caused by Hurricanes Katrina and Rita, which swept through the Gulf of Mexico in 2005 were among the risks to the ṣukūk. In October 2008, East Cameron Gas filed for bankruptcy protection after its offshore Louisiana oil and gas wells failed to yield the expected returns, partly because of hurricane damage. The issue in Islamic financial circles was whether or not the ṣukūk holders actually own a portion of the company’s oil and gas. The company argued that there had been no real transfer of ownership of production revenues, known as royalties, to an SPV formed to issue the ṣukūk. They claimed that the transaction was really a loan secured on those royalties, meaning the ṣukūk holders would have to share the royalties with other creditors in the event of liquidation. Fortunately, the bankruptcy judge, Robert Summerhays, rejected this contention. He ruled that, according to court records, ‘holders invested in the ṣukūk certificates in reliance of the characterization of the transfer of the royalty interest as a true sale.’ However, the judge gave East Cameron Gas leave to find further arguments to support its case, but if the judge in this case were to maintain his position, the ṣukūk holders’ rights will be strengthened.65 47

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The first issue that the bankruptcy court was forced to consider was whether the transfer of ownership in the ORRI under the ṣukūk constituted a true sale, and whether the intent of the parties was to transfer actual ownership to the SPV. The ṣukūk documents included a legal opinion that characterised the sale as a true sale and the courts upheld this view. In an order dated 31 March 2010, the judge in the case ordered approval of an asset purchase and sale agreement between East Cameron Partners and EC Offshore Properties, owned by the certificate holders. The asset purchase agreement transfers the title over both leases (East Cameron block 71/72) to the ṣukūk certificate holders.66 Based on the above precedent and taking into consideration that many ṣukūk structures especially those organised as asset-based ṣukūk, are the focus of criticism from Sharīʿah perspectives, a better alternative of Islamic securitisation could be developed by utilising only the positive aspects of conventional securitisation and avoiding any shortcoming not compatible with Sharīʿah. Adopting and adapting asset-backed securitisation will help in resolving the issues of true sale, which is a precondition for any legal securitisation from a conventional perspective. Moreover, the returns of ṣukūk will be based on the performance of the underlying assets and not on the credit worthiness of the originator, which means that in case of default the ṣukūk holders will be granted direct recourse to the ṣukūk assets. However, for conventional securitisation to be adopted in Islamic finance, we have to avoid all features that fall short of complying with Sharīʿah, and prepare the ground through adequate rules and legislation and, more importantly, a supportive political environment.

Islamic Securitisation as the Way Forward In both mechanisms, namely in conventional securitisation and assetbacked ṣukūk or Islamic securitisation, there is no recourse back to the originators. The risk of principal/capital repayment depends on asset performance, not on a purchase undertaking from the corporate at nominal value. Moreover, the risk of profit payments depends on the performance of the assets, not that of originator’s creditworthiness. If the assets perform badly, investors may lose profit as well as the principal. If they do well, they are paid the expected profit or even the lease returns, as the case may be, are renegotiated upward if the rate of return is a floating one. Even if the corporate defaults, the ṣukūk holders retain the assets and the cash flows should continue.67 Securitisation transactions are relatively new in the Middle East, but Sharīʿah could become a key positive driver of such transactions, if ṣukūk issuance in accordance with the AAOIFI guidelines is favoured by investors.68 48

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Obstacles to securitisation: 1. The regulatory framework for securitisation is not yet developed. 2. There are restrictions on foreign ownership of certain assets in the GCC. 3. Even in countries with securitisation laws such as Malaysia, which has clear guidelines on a true sale, asset-backed securitisation has not taken off. 4. Insolvency law is still underdeveloped. It should be clear that adapting securitisation procedures to the principles of Islamic finance will solve only some of the fundamental issues raised against the ṣukūk market, namely the issue of true sale. Securitisation is beset with issues that need careful study so that they are further distanced from any non-compliance with Sharīʿah. The use of receivables as assets, the classification of certificates into different categories or classes that give preferential rights to some investors over others under the concept of tranching, and the issue of over collateralisation are among noticeable concerns with conventional securitisation from the Sharīʿah perspective. These controversial issues will need collective ijtihād.69 At the same time the adoption of a modified Islamic securitisation requires some legislative changes, which in turn requires political will. Among regulatory requirements, in particular in the GCC region, there is a need for a sound and comprehensive securitisation framework addressing the legal, regulatory, accounting and tax issues. There is a need for specific laws, including a modern securities law, a modern insolvency law, a securitisation law, a comprehensive law relating to the foreign ownership of assets and effective land property rights legislation.70 For effective Islamic securitisation to take place, overcoming these legal obstacles requires genuine political support. For instance, in Malaysia, some of the legal components of a successful securitisation are already in place, but little interest has been shown in full-scale Islamic securitisation.71 It is, therefore, believed that political will to push for genuine changes is needed.

Sharīʿah Methodology in S ̣uku‾k Issuances The last point in this paper is concerned with the methodology and procedure adopted by Sharīʿah scholars involved in the structuring of ṣukūk. Sheikh Taqi Usmani summarised this methodology as follows: Undoubtedly, Sharīʿah supervisory boards, academic councils, and legal seminars have given permission to Islamic banks to carry out certain operations that more closely resemble stratagems than actual transactions. Such permission, however, was granted in order to facilitate, under difficult circumstances, the figurative turning of the wheels for those institutions when they were few in number.72 49

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Reading carefully this statement any independent observer can see that early ṣukūk structures were designed on shaky foundations. At the same time, if the above methodology is correct, it could be argued that it is still valid on the basis that the early conditions are still present, difficult circumstances are still prevalent and the number of Islamic financial institutions is not sufficient to allow the development of a capital or ṣukūk market. However, if the methodology is questionable from the outset, then the present Sharīʿah problems in the ṣukūk market would be the natural outcomes.73 There is a need for greater transparency. Do all parties in the ṣukūk market need to know the extent to which a specific issue is compliant with Sharīʿah principles? Are all ṣukūk in the market at the same level in terms of Sharīʿah compliance? Is the present stage the culmination in terms of Sharīʿah perfection or is there possibility for new drastic changes and controversies? This will lead us to the necessity of a Sharīʿah rating of ṣukūk and the International Islamic Rating Agency (IIRA) needs to take this dimension as a priority, especially when conventional rating agencies concern themselves directly with the Sharīʿah compliance dimension.

Conclusion Despite the huge success of the ṣukūk market so far, there is room for improvement in the different aspects of the industry, in particular in the Sharīʿah aspects of ṣukūk structuring. There is a need to address the shortcomings of the industry and work to be done towards the full realisation of the main features of Islamic finance and industry. As mentioned above, adopting and adapting securitisation will be one of the possible solutions towards developing fully Sharīʿah-compliant ṣukūk. However, towards that end, some bold steps need to be taken by all players, including politicians, regulators, lawyers, financial institutions and Sharīʿah scholars and board members. It is almost impossible to move forward without full government support. Four decades of the industry have shown that wherever there is political support the industry will flourish even if Muslims are a minority and that the growth of Islamic finance can be slowed down and hindered even in countries where Muslims are majorities. Thus, it is believed that countries such as Malaysia and some GCC countries can play a leading role towards that end. Malaysia in particular not only has the legal and regulatory requirements of an Islamic mode of securitisation already in place but has been a leader in Islamic finance and the ṣukūk market in particular. Given the political will of the Malaysian government, therefore, Islamic securitisation should progress without much difficulty. Some 50

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sovereign countries are reluctant to sell their country’s assets to foreigners and therefore avoid Islamic securitisation. To address this issue it is suggested that the government should designate one of its departments as one of the ṣukūk holders subscribing to the ṣukūk. More importantly the documentation of the transaction should have clear provisions and clauses on the right of shufʿah or the right of pre-emption whereby the government department will make it a condition based on the right of shufʿah that no investor can sell his undivided ownership right in the underlying assets of the ṣukūk to another party at maturity before giving their counterparties, including the government department, the right to buy these undivided ownership rights first. Thus, although the certificate holders have the right to sell their undivided rights on the underlying assets to whom they want at maturity, they would, through the new arrangement based on the principle of shufʿah, not be able to sell these assets to a third party as long as the government department is ready to buy them. Through this arrangement the government will make sure that national assets are not in the hands of foreigners at maturity. The concept of shufʿah as suggested above is also recognised under the English legal system as ‘the right of first refusal’. This recognition of the concept under both systems, namely Islamic and English law will help in the documentation. On the regulatory and legislative aspects of securitisation, there is a need for key legislation to be in place even in countries that are currently active in the ṣukūk market but could face some difficulties in entering the Islamic securitisation market. Key legislation includes, among others, a modern securities law, a modern insolvency law, a securitisation law, comprehensive laws relating to the foreign ownership of assets in these countries and effective land property rights legislation. Financial institutions, especially international banks active in the ṣukūk market in terms of arrangement, structuring, distribution and management, such as HSBC, Citibank and Standard Chartered, have a bigger responsibility in helping to overcome structural problems of a possible Islamic securitisation based on their expertise and knowledge of the market. They can also help with distribution issues, as the market has to move from situations where investors only look at the risk prospects of originators to investors looking for the risk of assets or assets enhanced by the creditworthiness of the originators. There is also a need for better collaboration between Sharīʿah scholars and lawyers documenting ṣukūk transactions. They need to work out the details together and analyse the implications of each concept. Moreover, Sharīʿah boards need to work collaboratively and not by delegating these huge responsibilities to just one of the members. 51

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Bibliography Accounting and Auditing Organization for Islamic Financial Institutions ‘AAOIFI’s Shari’a Board resolutions on ṣukūk’, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) (February 2008), Bahrain,, retrieved 12 March 2010. Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sharīʿah Standards n. 17 Investment Ṣukūk (Bahrain: AAOIFI, 2008). Al-Buhūtī, Kashshāf al-Qināʿ ʿan Matn al-Iqnāʿ (Beirut: Dār al-Fikr, 1982). Al-Ḥaṭṭāb, Mawāhib al-Jalīl li-Sharḥ Mukhtaṣar al-Khalīl (Beirut: Dār alFikr, 1978). Al-Kāsānī, A.B.M., Badā’iʿ al-Ṣanā’iʿ fī Tartīb al-Sharā’iʿ, 2nd edn. (Beirut: Dār al-Kutub al-ʿIlmiyyah). Al-Mirdāwī, Al-Inṣāf (Beirut: Dār al-Kutub al-ʿIlmiyyah, 1997). Al-Shādhilī, H.A., Naẓariyyah al-Sharṭ fī al-Fiqh al-Islāmī, (Theory of Conditions in Islamic Law) 1st edn, (Riyadh: Dār Kunūz Ishbiliyyah, 2009). Al-Yamānī, M., Al-Sharʿ al-Jazā’ī wa-Atharuhu fī al-ʿUqūd al-Muʿāṣirah (The Clause of Liquidated Damages in Modern Contracts) (Al-Riyāḍ: Dār Kunūz Ishbīlyā li al-Nashr wa al-Tawzīʿ, 2007). Aziz, Z.A., ‘Financial stability – regional and global cooperation’, speech by the Governor of the Central Bank of Malaysia, at the 8th Islamic Financial Services Board Summit, Luxembourg, 12 May 2011. ‘Beximco Pharmaceuticals Ltd & Ors v Shamil Bank of Bahrain EC [2004] EWCA Civ 19’, British and Irish Legal Information Institute, 29 January 2004, http://www.bailii.org/ew/cases/EWC/Civ/2004/19.html, retrieved 1 June 2013. Bi, F., ‘AAOIFI statement on ṣukūk and its implications’. Norton Rose (September 2008), , retrieved 1 March 2011. Chapra, U., ‘Islamic banking and finance: The dream and reality’, Hamdard Islamicus, Karachi, Pakistan, Vol. XXII, no.4, p. 74. CIMB, Citi, HSBC and Maybank, Preliminary Offering Memorandum of Wakālah Global Ṣukūk Berhad, (CIMB, Citi, HSBC and Maybank: no place: 2011). Deutsche Bank AG Abu Dhabi Commercial Bank, Offering Circular, Aabar Ṣukūk Limited due 2010, (Abu Dhabi: Deutsche Bank AG Abu Dhabi Commerical Bank, 22 June 2006). Dusuki, A.W. and Mokhtar, S., Critical Appraisal of Shariah Issues on Ownership in Asset-Based Sukuk as Implemented in the Islamic Debt Market, ISRA Research Paper 8 (International Sharīʿah Research Academy for Islamic Finance (ISRA), Kuala Lumpur, Malaysia, 2010). Elmalki, F. and Ryan, D. ‘Ṣukūk: An evolution’, Conyers, Dill and Pearman (January 2010), , retrieved 1 December 2010. Ferry, J., ‘Scuppered by ṣukūk’, Risk.net (17 February 2010), , retrieved 3 March 2011. Fidler, S., ‘Defaults pose latest snag in Islamic bond market’, Wall Street Journal (16 June 2009), , retrieved 10 March 52

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2010. Goud, B., ‘Courting disaster’, Islamic Business and Finance, 52 (April 2010), pp. 23-4.   Greaves, A., ‘Governing law clauses in murābaḥah and ijārah agreements: The Court of Appeal’s decision in Shamil Bank of Bahrain EC v. Beximco Pharmaceuticals Limited and Others [2004] EWCA Civ. 19’, Steptoe & Johnson, , retrieved 1 December 2006. Halawi, A., ‘Ṣukūk mondiale’, Zawya, (5 July 2011), retrieved 23 November 2011. Hamoud, S., ‘Progress of Islamic banking: The aspirations and the realities’, Islamic Economic Studies, Vol. 2, No. 1 (June 1994), pp. 125-6. Haneef, R., ‘From “asset-backed” to “asset-light” structures: The intricate history of ṣukūk’, ISRA International Journal of Islamic Finance, Vol. 1, No. 1 (2009), pp. 103-26. Hayat, U. ‘Islamic finance’s ṣukūk explained’, Financial Times (11 April 2010), , retrieved 2 May 2010. Howladar, K., ‘The future of ṣukūk: Substance over form?’, Moody’s Investors Service (6 May 2009). HSBC Amanah Central Shariah Committee, Pronouncement on the Trust Certificate Issuance Programme (the ‘Programme’) established by First Gulf Bank P.J.S.C. (the ‘FGB’), 7 July 2011. Ibn ʿAbidīn, Radd al-Muḥtār ʿalā Durr al-Mukhtār (Beirut: Dār al-Fikir, 1966). IDB Trust Services Limited, US$3,500,000,000 Trust Certificate Issuance Programme Base Prospectus, 2010, , retrieved 1 January 2011. Islamic Financial Information Service, IFIS Global Ṣukūk Market H2-2010 Report, , retrieved January 1, 2011. Islamic Financial Services Board, Capital Adequacy Requirements for Ṣukūk Securitisations and Real Estate Investment, Standard 7 (IFSB: n.p., January 2009). Khalaf, R., ‘Islamic bonds hit by religious concerns’, Financial Times, 6 February 2008, , retrieved 2 March 2011. Khnifer, M., ‘When ṣukūk default – asset priority of certificate-holders vis-àvis creditors’, Opalesque Islamic Financial Intelligence, 11 (August 2010), pp. 9-14. KT Turkey Ṣukūk Limited, Offering Circular US$100,000,000 Trust Certificates due 2013 (19 August 2010), , retrieved 1 January 2011. Kuwait Finance House, Ṣukūk ‘Back on Track’, 20 July 2010 (Malaysia Islamic Financial Center MIFC, KFH Research Ltd , Kuala-Lumpur, Malaysia). Laldin, A., ‘Shariah and legal issues in ṣukūk,’ paper presented at the International Conference on Islamic Business and Finance, National Institute of Banking and Finance (NIBAF), Islamabad, Pakistan, 8-9 February 2011. Moody’s Investors Services, ‘Moody’s assigns (P)A2 to First Gulf Bank’s ṣukūk: outlook negative’ (18 July 2011), , retrieved 1 November 2011. Muhammad Al-Amine, M.B., Global Ṣukūk and Islamic Securitization Market: Financial Engineering and Product Innovation (Leiden/Boston: Brill Academic Publishers, 2011). 53

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NIG Limited, Offering Circular NIG Limited US$1,500,000,000 Trust Certificates Program, , retrieved 1 January 2011. Pruvost, P-H., ‘Global standards to give breadth and depth to the global ṣukūk market’, Standard & Poor’s (1 March 2011), retrieved 5 October 2011. Ryan, D. and Elmalki, F., ‘The evolution of ṣukūk’, The Briefing (Asian Council) (February 2010), pp. 4-5. Securities Commission Malaysia, Islamic Securities Guidelines (Ṣukūk Guidelines) Revised (12 July 2011), , retrieved 15 November 2011. Usmani, T., ‘Ṣukūk and their contemporary applications’, Paper presented to the AAOIFI Shariah Board and subsequently to the Islamic Fiqh Academy’s nineteen sessions, Sharja United Arab Emirates, 26-30 April 2009. Woodruff, J. et al., ‘Demystifying corporate ṣukūk’, Fitch Ratings (5 March 2007), , retrieved 23 January 2009. Wouters, P., ‘Asset-backed ṣukūk – Islamic finance going its own way’, Islamic Finance News, 8/12 (March 2011), pp. 22-4. Wouters, P., ‘“Ṣukūk! Ṣukūk! My kingdom for a ṣukūk!” – a brief introduction in ṣukūk concepts’, Singapore Law Gazette, May 2011, , pp.1-3, retrieved 2 November 2011.

Notes 1. 2. 3. 4. 5.

Z. A. Aziz, ‘Financial stability – regional and global cooperation’. J. Woodruff et al., ‘Demystifying corporate ṣukūk’. R. Khalaf, ‘Islamic bonds hit by religious concerns’. T. Usmani, ‘Ṣukūk and their contemporary applications’. Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sharīʿah Standards n. 17 Investment Ṣukūk (Bahrain: AAOIFI, 2008), p. 345. 6. IFSB, Capital Adequacy Requirements for Ṣukūk Securitisations and Real Estate Investment, Standard 7, p. 3. 7. Securities Commission Malaysia, Islamic Securities Guidelines (Ṣukūk Guidelines) Revised (2011). 8. P. Wouters, ‘Ṣukūk! Ṣukūk! My kingdom for a ṣukūk! A brief introduction in ṣukūk concepts’. 9. Accounting and Auditing Organization for Islamic Financial Institutions ‘AAOIFI’s Shari’a Board resolutions on ṣukūk’. 10. Kuwait Finance House, Ṣukūk: Back on Track. 11. Ibid. 12. A. Laldin, ‘Shariah and legal issues in Ṣukūk’, p. 1. 13. P. Wouters, ‘Asset-backed ṣukūk – Islamic finance going its own way’, pp. 22-24. 14. K. Howladar, The future of ṣukūk: Substance over form?’. 15. Kuwait Finance House, Ṣukūk: Back on Track. 16. Islamic Financial Information Service, IFIS Global Ṣukūk Market H22010 Report, , retrieved January 1, 2011. 17. P-H. Pruvost, ‘Global standards to give breadth and depth to the global ṣukūk market’. 54

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18. A. Halawi, ‘Ṣukūk mondiale’. 19. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), ‘AAOIFI’s Shari’a Board resolutions on ṣukūk’. 20. Kuwait Finance House, Ṣukūk: Back on Track. 21. F. Elmalki and D. Ryan, ‘Ṣukūk: An evolution’. 22. A.W. Dusuki and S. Mokhtar, Critical Appraisal of Shariah Issues on Ownership in Asset-Based Ṣukūk as Implemented in the Islamic Debt Market. 23. U. Hayat, ‘Islamic finance’s ṣukūk explained’. 24. Ibid. 25. Kuwait Finance House, Ṣukūk: Back on Track. 26. Ibid. 27. Wouters, ‘Asset-backed ṣukūk’. 28. Dusuki and Mokhtar, Critical Appraisal. 29. M. Khnifer, ‘When ṣukūk default asset priority of certificates holder visà-vis creditors’. 30. IDB Trust Services Limited, US$3,500,000,000 Trust Certificate Issuance Programme Base Prospectus. 31. KT Turkey Ṣukūk Limited, US$100,000,000 Trust Certificates due 2013. 32. Ibid. 33. Dusuki and Mokhtar, Critical Appraisal. 34. Ibid. 35. Deutsche Bank AG Abu Dhabi Commercial Bank, Offering Circular, Aabar Ṣukūk Limited due 2010, (Abu Dhabi: Deutsche Bank AG Abu Dhabi Commerical Bank, 22 June 2006), p. 47. 36. NIG Limited, Offering Circular NIG Limited US$1,500,000,000 Trust Certificates Programme, p. 12. 37. Ibid, p. 17. 38. Offering Circular, KT Turkey Ṣukūk Limited, US$100,000,000 Trust Certificates due 2013. 39. CIMB, Citi, HSBC and Maybank, Preliminary Offering Memorandum of Wakālah Global Ṣukūk Berhad, (CIMB, Citi, HSBC and Maybank: no place: 2011), pp. 27, 50-51, 64. 40. Howladar, ‘The future of ṣukūk’ . 41. Al-Buhūtī, Kashshāf al-Qināʿ, Vol. 3, pp. 193-4; Al-Ḥaṭṭāb, Mawāhib alJalīl, Vol. 4, p. 373; Ibn ʿAbidīn, Radd al-Muḥtār ʿalā Durr al-Mukhtār, Vol. 4, p.121; A.B.M. Al-Kāsānī, Badā’iʿ al-Ṣanā’iʿ, p. 165; Al-Mirdāwī, Al-Inṣāf, Vol. 11, p. 233; H.A. Al-Shādhilī, Naẓariyyah al-Sharṭ, pp. 2302, 266-9, 300-3, 384-5, 487-97, 624-6; M. Al-Yamānī, Al-Sharʿ al-Jazā’ī, pp. 86-105. 42. R. Haneef, ‘From “asset-backed” to “asset-light” structures’. 43. Ibid. 44. Wouters, ‘Asset-backed ṣukūk’. 45. Howladar, ‘The future of ṣukūk’. 46. Dusuki and Mokhtar, Critical Appraisal. 47. Howladar, ‘The future of ṣukūk’. 48. Ibid. 49. Accounting and Auditing Organization for Islamic Financial Institutions, ‘AAOIFI’s Shari’a Board resolutions on ṣukūk’. 55

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50. F. Bi, ‘AAOIFI statement on ṣukūk and its implications’. 51. Moody’s Investors Services, ‘Moody’s assigns (P)A2 to First Gulf Bank’s Ṣukūk; outlook negative’. 52. CIMB, Citi, HSBC and Maybank, Preliminary Offering. 53. Bi, ‘AAOIFI statement’. 54. Howladar, ‘The future of Ṣukūk’. 55. Accounting and Auditing Organization for Islamic Financial Institutions, ‘AAOIFI’s Shari’a Board resolutions on ṣukūk’. 56. See Pronouncement of the HSBC Amanah Central Shariah Committee on trust certificate issuance programme (the “Programme”) established by First Gulf Bank P.J.S.C (the “FGB”). 57. See U. Chapra, ‘Islamic banking and finance’, p. 74; S. Hamoud, ‘Progress of Islamic banking’, pp. 125-6. 58. Government of Malaysia Wakālah Global Ṣukūk Berhad Offering Circular p. 56. 59. See A. Greaves, ‘Governing law clauses in murābaḥah and ijārah agreements’; ‘Beximco Pharmaceuticals Ltd & Ors v Shamil Bank of Bahrain EC [2004] EWCA Civ 19’. 60. D. Ryan & F. Elmalki, ‘The evolution of ṣukūk’, pp. 4-5. 61. Ibid. 62. J. Ferry, ‘Scuppered by ṣukūk’. 63. Howladar, ‘The future of ṣukūk’. 64. Ibid. 65. S. Fidler, ‘Defaults pose latest snag in Islamic bond market’. 66. B. Goud, ‘Courting disaster’, pp. 23-4 67. Howladar, ‘The future of ṣukūk’. 68. Ibid. 69. M.B. Muhammad Al-Amine, Global Ṣukūk and Islamic Securitisation Market: Financial Engineering and Product Innovation (Brill Academic Publishers, 2011). 70. Ibid. 71. Dusuki and Mokhtar, Critical Appraisal. 72. See Usmani, ‘Ṣukūk and their contemporary applications’. 73. See Al-Amine, Global Ṣukūk and Islamic Securitisation Market.

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3 S ̣uku‾k: Perception, Innovation and Challenges Mohammed Imad Ali

Introduction Sharīʿah scholars, lawyers, bankers, rating agents, regulators, originators and investors active in the structuring of ṣukūk all have their own views about ṣukūk. For the effective growth of ṣukūk it is important that there be a consensus amongst all the parties participating in their structuring. The ṣukūk market has shown phenomenal growth in the past decade and is showing a promising future going forward. The basic difference between ṣukūk and conventional bonds is that ṣukūk are asset linked, where specific underlying assets generate the income to ṣukūk holders. In contrast, conventional bonds are not linked to any asset that serves as a source of non-interest income to bondholders. At the same time, it is important to note that ṣukūk display some features of conventional bonds as well as of conventional asset-backed or asset-based securities. Investors, rating agencies and lead arrangers perceive ṣukūk as Sharīʿahcompliant bonds but most Sharīʿah scholars and academicians perceive them as either asset-based or asset-backed securities. Harmonisation of these two approaches has been an arduous task for the industry. Even amongst the Sharīʿah scholars, some insist that ṣukūk need to reflect profit and loss sharing while others are of the view that ṣukūk are akin to bonds, the only difference being that in the case of ṣukūk dividends are paid from the profits generated by the underlying ṣukūk assets and the principal is refunded via the purchase undertaking. Nevertheless, a clear consensus exists amongst the Sharīʿah scholars that the risks and rewards in the underlying ṣukūk assets need to be shared by the ṣukūk holders and that only this sharing justifies the return to the ṣukūk holders on their investment. The issues of whether the transfer of ownership of the underlying ṣukūk assets is off or on balance sheet, or if the transfer of the ownership is a transfer of title or merely of beneficial ownership, or if the transfer is registered or not registered, are mainly procedural or legal issues, according to a commonly held view. The majority of the Sharīʿah scholars hold the view that, provided a legally recognised ownership interest is created between the underlying ṣukūk assets and the ṣukūk holders, and the risk and rewards of the ṣukūk assets are shared by the ṣukūk holders, then the ṣukūk structure is acceptable. 57

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Growth Phenomenon The growth of the ṣukūk industry has been driven by the need to develop infrastructure in the Middle East and South East Asia. Over the years, the ṣukūk market has grown by 10% to 15% annually to reach approximately US$135 billion in 2010, contributing approximately 11.3% of the global Islamic finance assets. In 2011, ṣukūk issuances reached US$32 billion and, in the last three quarters of 2012, it has already reached US$36 billion of ṣukūk issuances.1 The recent (2011) Malaysian sovereign ṣukūk was oversubscribed and reinforced the belief that, if any sovereign is wishing to raise funds in a Sharīʿah-compliant manner, then ṣukūk are the right vehicle on which to capitalise and receive participation from global investors. The below chart shows ṣukūk performance:2 Chart 1

Global Sukuk Volume by Quarter

Types of S ụ ku‾k Structures Ijārah (Lease) Structure Ṣukūk derive their value from the fact that they certify ownership of profit-generating underlying assets. Initially, ṣukūk were based on the ijārah (lease) structure wherein the value of the assets matched the ṣukūk issuance amount. The originator sells selected assets to a special purpose vehicle (SPV) and then leases them back from it. The SPV issues the ṣukūk certificates and sells them to investors (ṣukūk holders). It then uses the proceeds from the ṣukūk holders to purchase the underlying assets and leases them back to their original owners (originators) for the benefit of the ṣukūk holders. The rentals from the originator are passed to the ṣukūk holders. At default or maturity of the ṣukūk, the originator undertakes to 58

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purchase the underlying leased assets at a pre-agreed price based on a formula. Currently this is the most preferred structure as it addresses both Sharīʿah requirements as well as business expectations. Generally, in the Middle East, there are legal restrictions on sales of fixed assets (e.g., land) to foreign entities. In countries such as Saudi Arabia and Qatar it is both socially and legally unacceptable for fixed assets (e.g., land) to be sold to foreign entities via issuance of ṣukūk. This limitation curtails the usage of this structure in the Middle Eastern region. As of late, ṣukūk structures based on musāṭaḥah3 have become common in the United Arab Emirates. In musāṭaḥah structures the musāṭaḥah right is sold and then leased for a shorter period. The other structure, which is also becoming common in jurisdictions where the sale of fixed assets to foreign owners is difficult, is the head lease and sublease structure. In this the head lease will be on a long-term basis and will be considered as a sale from the Sharīʿah perspective, while the sublease will take place for the term of the ṣukūk. Mushārakah Structure The mushārakah4 (joint enterprise) structure is used when there are not enough assets to match the ṣukūk issuance amount. In the mushārakah structure the assets are co-owned by the ṣukūk holders and the originator. Co-ownership of the underlying ṣukūk assets between the issuer and the originator is vital from the Sharīʿah perspective as that will allow one partner (originator) to purchase the co-ownership interest of the issuer in the underlying ṣukūk assets, at a pre-agreed price on default or maturity of the ṣukūk. The proceeds from the sale of the assets via the issuance of the ṣukūk are passed to the originator. The originator manages the assets and the revenues generated from the assets are passed back to the ṣukūk holders. The application of this structure has decreased significantly after 2008. Wakālah Structure In a wakālah (agency) structure, the originator sells the beneficial interest in its portfolio of assets – e.g., underlying assets in lease contracts, or murābaḥah or istiṣnāʿ5 contracts, real estate, exclusive rights, shares (listed, non-listed) to the ṣukūk holders and then in the capacity of agent manages the portfolio and provides returns to the ṣukūk holders. In a combination of such a portfolio it is a Sharīʿah requirement that at least one third of the portfolio should consist of fixed tangible assets or real estate underlying ijarāh (lease) contracts. This structure has been widely used by financial institutions that wish to use their existing portfolio for the purpose of raising funds via ṣukūk. The concern raised by Sharīʿah scholars is that the agent should not be obligated to maintain the value of 59

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the underlying portfolio equivalent to the face value of the ṣukūk but that his role is limited to making the best effort to maintain its value. Muḍārabah Structure In cases where the originator does not have any assets, the muḍārabah6 structure is used. In a muḍārabah structure the proceeds raised from the ṣukūk holders are passed on to the originator to invest in a Sharīʿah compliant pre-agreed business plan and then pass the returns from such a business to the ṣukūk holders. The originator who is appointed as manager undertakes to buy the underlying assets of the muḍārabah sukūk on default or maturity. This structure has also been used by financial institutions to structure ṣukūk on their existing Sharīʿah-compliant portfolios. The point to be noted here is that there cannot be any obligation on the muḍārib to maintain the value of the underlying ṣukūk assets in the portfolio equivalent to the face value of the ṣukūk. There should not be any kind of guarantee provided by the muḍārib in this structure in case of devaluation of assets or default on repayments. Murābaḥah Structure Murābaḥah can be a deferred sale. In the murābaḥah ṣukūk the murābaḥah receivables are securitised. These ṣukūk structures are available in Malaysia but not in the Middle East. The Sharīʿah scholars in the Middle East do not approve the murābaḥah ṣukūk structures in cases where the ṣukūk portfolio is made up of murābaḥah receivables and secondary trading is present. A few murābaḥah ṣukūk that were permitted in the Middle East did not have the provision of secondary trading. The Sharīʿah scholars in the Middle East do not permit trading of debt at a premium or discount. By contrast, in Malaysia, the murābaḥah ṣukūk are popular and Malaysian Sharīʿah scholars have approved sale of debt (bayʿ al-dayn) at a negotiated price. In the Middle East, ṣukūk with a murābaḥah component are being structured as of late, and to address the Sharīʿah concern of tradability, at least one third of the ṣukūk assets need to be tangible in nature (e.g., lease assets).

Innovation To address the requirements of the originators, law and Sharīʿah, innovation had become a pivotal requirement in the ṣukūk structuring process. Innovation was also the need of the hour, as the ṣukūk structuring process has not yet reached a degree of maturity comparable to that of conventional bonds. SABIC Ṣukūk An innovative ṣukūk was conceptualised and structured on 29 July 2006 60

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when SABIC7 issued a US$800 million ṣukūk. In these ṣukūk, the underlying assets were the ‘marketing rights’ of SABIC. Intangible assets were used because SABIC did not have enough tangible assets that would match the face value of the issuance amount, and in addition, the law was not clear on whether ownership of intangible assets can be sold to international investors via a subscription of the ṣukūk. This ṣukūk by its third issuance raised a combined capital of US$2.7 billion for SABIC. Khazanah8 Ṣukūk Innovation has also been a striking feature in the Malaysian ṣukūk market. Malaysia has a very well-developed regulatory capital market environment for the structuring and marketing of ṣukūk. On 27 September 2006, Khazanah issued US$750 million worth of Sharīʿah-compliant Islamic bonds. The ṣukūk are exchangeable into the shares of Telekom Malaysia. This transaction marked the first-ever Sharīʿah-compliant exchangeable bond transaction and the largest equity-linked issue in Malaysia. Saudi Electricity Company Ṣukūk Saudi Electricity Company (SEC), a government-owned entity, issued another innovative ṣukūk. The underlying ṣukūk assets in the first SEC ṣukūk issued in 2006 were the rights that SEC derived from the distribution licence it has from the Saudi Arabia government to provide ‘metering services’. The size of the first SEC ṣukūk issue was US$1.3 billion. The second SEC ṣukūk, issued in 2007, was oversubscribed three times and closed at US$1.9 billion. In the second issue, the rights to provide ‘electrical service connection services’ were used as the underlying assets of the ṣukūk. Etisalat Ṣukūk Etisalat9 established a US$1 billion ṣukūk programme in 2010. It had two series: one was a regular ijarāh (lease) and the other required the sale of airtime for the purpose of securitisation. These once again were innovative ṣukūk in which the ṣukūk proceeds were used to purchase a specified quantity of minutes of airtime from Etisalat, equivalent to the issue size. Subsequently, Etisalat was appointed as distributor to sell the minutes at a pre-agreed minimum selling price. Etisalat, as distributor, sells minutes of airtime to end-customers at a base value (principal) amount plus profit and collects the revenue for each period. Any excess would be kept in reserve to be used in case of shortfall. In case the reserve was not sufficient to address the shortfall, Etisalat, pursuant to a purchase undertaking, would purchase any unsold minutes of airtime to meet the shortfall. 61

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Challenges In 2008, the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)10 came up with a statement that emphasised that in mushārakah, wakālah (investment agency) and muḍārabah ṣukūk structures the originator cannot give a pre-agreed face value undertaking to purchase the assets at maturity or default as this type of undertaking violates the basic nature of these structures. After the AAOIFI resolution was released, the ṣukūk market is again returning to the ijārah structures where it is permissible for the originator to provide a purchase undertaking to acquire the underlying assets at a pre-agreed price. This pre-agreed purchase undertaking makes it easier for the rating agencies to rate the ṣukūk ijārah, as they end up rating the ṣukūk based on the purchase undertaking. The agency and muḍārabah structures are being used by financial institutions, which have sufficient Sharīʿah-compliant assets in their portfolios. Corporations that do not have sufficient tangible assets but own unlisted and listed shares are attempting to design capital and profit guaranteeing structures that would use shares as underlying ṣukūk assets. Guarantee Undertakings that would be given by a third party, be it an insurance company or a sovereign entity, are among the options that can be used to provide acceptable guarantees. This will surely address both Sharīʿah and rating agency requirements, but on the pricing side it may have a negative impact as third-party guarantees come with a cost. The other option is to build a guarantee into the structure and let the directors of the originator’s company provide the guarantee in their individual capacity for the amount of the ṣukūk. Some Sharīʿah scholars hold the opinion that ṣukūk have the elements of both debt and equity. Equity comes into the picture when the ownership link is created between the ṣukūk holders and the underlying ṣukūk asset, whilst debt comes into the picture by the purchase undertaking given by the originator to purchase the underlying ṣukūk assets at default or maturity. Equity Vs Debt The existing ṣukūk structures create a debt cycle. The recent financial meltdown made it clear that no matter how big, esoteric or niche a debt structure is, it still has the potential to default. Quasi debt-cum-equity and purely equity ṣukūk structures, therefore, can be utilised. The advantage of this would be that these structures would create profit-and-loss-sharing instruments, which has always been encouraged by the major proponents of Islamic finance. On the other side, the ṣukūk holders may not have the comfort that they will be receiving a fixed return on their investments 62

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but who would have thought that AAA-rated fixed-return bonds would default as happened recently on a global scale? If the titans of the industry can wither away in the storm of debt then why not take a chance with an umbrella of equity? One strongly held view is that the market will not easily adapt to equity structures for ṣukūk when debt is cheaper and the originator can get tax deductions for payment of rental for ṣukūk. So unless the debt is made more expensive by taking away the tax benefits and other incentives, the market will not move away from debt-based securities. A great deal of construction of infrastructure is taking place in the Middle East, and this will go on for quite some time. Project finance ṣukūk could be a good medium to raise financing for infrastructure development. Exchangeable or convertible ṣukūk are an option but with a battered equity market, that is showing few signs of recovery in the Middle East, these options are being treated with caution. The writer is of the opinion that debt brings in a feeling of self-alienation with respect to the borrower. To the borrower, other parties always provide the ṣukūk proceeds. Even though the funds need to be returned at some point, borrowers maybe more willing to spend borrowed funds than their own funds. This is reflected in the spending behaviour of the borrowers. This may mean that the debtor does not always make the right spending choices and in the end wrong investments can be made and defaults are there to be seen. There is also a lot of evidence that consumers spend more money when paying with credit cards than when they spend cash.11 The writer is of the view that this analogy can also be applied to corporations and sovereigns. They view ṣukūk as debt instruments and feel that no matter what assets are used for the purpose of structuring the ṣukūk, the assets will always remain with them, even in case of default, and that the ṣukūk holders will be perceived only as senior unsecured creditors. Branding Vs Income Ṣukūk-lead-arranging institutions have to weigh the profile and income earned by lead-arranging ṣukūk cautiously. Undoubtedly, the brand name of any financial institution is enhanced with every ṣukūk it lead-arranges, but there also has to be a commercial justification for them to participate in this exercise. The lead arranging banks on ṣukūk transactions have many roles to fulfil. These include conducting road shows, assuring investors of Sharīʿah compatibility, as well as pricing of the ṣukūk and the rating of the originator. The approach is simple: the weaker the originator from the rating perspective, the higher the income for the lead-arranging institution. 63

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Asset-Based Vs Asset-Backed The terminology of asset-based and asset-backed is not present in the AAOIFI standards. To put it in simple language, with asset-based ṣukūk the investor (ṣukūk holder) is not interested in owning the underlying ṣukūk asset. From a legal perspective the investor is considered a senior unsecured creditor. In case of default by the originator, the investor (ṣukūk holder) will not have recourse to the underlying ṣukūk assets but will have to be grouped with the other, senior unsecured creditors of the originator. The ṣukūk assets are in the structure to justify the payment of funds by the ṣukūk holder to the originator and the incremental return flowing back from the originator to the ṣukūk holder. This is precisely also the reason why rating agencies do not rate the underlying ṣukūk assets. If this has been an acceptable approach to the market at large, including Sharīʿah scholars, then the writer is of the opinion that the definition of ṣukūk should incorporate this element for clarity in the industry. The bulk of the ṣukūk that are being structured today are asset-based; hence it becomes important that this be made clear. Even the bankruptcy judge, Robert Summerhays J., in the East Cameroon ṣukūk default case rejected the company’s contention that there had been no real transfer of ownership of production revenues, known as royalties, into a special purpose vehicle formed to issue the ṣukūk. Instead, the company claimed that the transaction was merely a loan secured by those royalties, implying that ṣukūk holders would have to share the royalties with other creditors in the event of liquidation. The judge clearly ruled that the ṣukūk holders ‘invested in the ṣukūk ṣukūks in reliance of the characterization of the transfer of the royalty interest as a true sale.’12 The critics of ṣukūk are concerned about why the ṣukūk holders, who have an ownership interest in the ṣukūk assets, cannot have recourse to the ṣukūk assets. The answer normally given to this is: what is the purpose of the recourse? If the rationale is to liquidate the assets and return capital to investors, then the purchase undertaking is already providing that kind of obligation and fulfilling the same need in another way. Few Sharīʿah scholars propose that in case providing recourse to the ṣukūk assets is not possible, then at least recourse should be available to the proceeds of the ṣukūk assets when insolvency occurs. But this does not mean that the ṣukūk holders have to benefit from the ownership of the ṣukūk assets and treated as other than senior unsecured creditors, along with other senior unsecured creditors of the client. The recourse to the ṣukūk assets by the ṣukūk holders in case of default is still a pertinent issue and needs to be addressed, as currently in most of the ṣukūk structures the ṣukūk holders do not have the right to sell the ṣukūk assets to third party purchasers in case of default by the originator. 64

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While we have highlighted that Sharīʿah principles require a transfer of control and risk (as well as reward) in relation to an asset from the seller of the asset to the investors, to date the actual analysis as to whether a transfer of the asset is perfected and immune from the bankruptcy of the seller (a typical feature of conventional asset-backed securitisation) has not been not been carried out in the case of most ṣukūk.13 The question to address here is: what is stopping the perfection of sale and providing recourse to the ṣukūk holders and investors to the underlying ṣukūk assets? Is it the registration costs, market practice, investor’s preference, originator’s preference or a combination of these? Other market practices convey a different message. A good example of asset-backed ṣukūk is the Sun Finance Limited securitisation launched in 2008. This represented a novel securitisation of proceeds derived from the sale of land by Sorouh Real Estate PJSC in Abu Dhabi. The securitisation confirmed the fact that methods currently exist to structure ṣukūk by way of an Islamic true sale. This transaction broke new ground in the Islamic capital markets as the largest Sharīʿah-compliant securitisation to date, while ṣukūk issued by Sun Finance Limited (a special purpose vehicle incorporated in Jersey and the issuer of the ṣukūk) represented (at the time of issue) the highest-rated non-sovereign instruments issued in the Middle East and North Africa region.14 Sharīʿah Monitoring The AAOIFI guidelines in this regard are quite clear that there has to be ongoing Sharīʿah monitoring by a Sharīʿah board with reference to the ṣukūk. The following clarifies this provision: The prospectus must explicitly mention the obligation to abide by the rules and principles of the Islamic Sharīʿah, and that there is a Sharīʿah board that approves the procedures of the issues and monitors the implementation of the project throughout its duration.15 In certain ṣukūk structures, where there needs to be regular active management of the ṣukūk portfolio, Sharīʿah monitoring would become even more beneficial. Sharīʿah Rating The other proposed idea by industry experts is the provision of having a Sharīʿah rating of each ṣukūk. The rating could encompass and analyse many features of ṣukūk and rate them accordingly. Regulatory Challenges For the effective growth of ṣukūk, it is very important that specific regulations are implemented so as to provide a level playing field to the 65

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institutions that intend to structure ṣukūk. It is a requirement for ṣukūk that an ownership link be created between the ṣukūk holders and the underlying ṣukūk assets. Hence, it is vital that there be exemptions from having to pay the registration fee in the sale of the underlying ṣukūk assets. In regions where there are legal restrictions on selling tangible assets (e.g., land) to international investors, some other non-tangible assets have to be recognised to facilitate the structuring of ṣukūk. Saudi Arabia’s GDP is twice that of Malaysia but, in terms of ṣukūk volume issuance, it is almost equal to Malaysia. This could be an indicator that political will and a clear regulatory environment play a vital role in the growth of any financial instrument.

Conclusion The main approach until now has been, to a great extent, to transform bonds into Sharīʿah-compliant ṣukūk. In this process the sale and purchase of the assets have been appended to the structure. Although a few ṣukūk structures were done with proper securitisation, they are not many in number. The sovereigns have to take a serious note of the fact that their support in providing an amiable regulatory environment will surely enhance the growth of ṣukūk. The investment rationale of the ṣukūk holders to a great extent is generally derived from the credit rating of the originator and not the asset quality of the underlying ṣukūk assets. The challenge is how to change the perception of the investor and make it clear that no matter how strong the credit (e.g., Lehman or Greece) of an originator is, the possibility of default still exists. Hence the focus of rating should also include the evaluation of underlying ṣukūk assets. Generally, rating agencies rate the originator and not the underlying ṣukūk assets. This approach can change. A dual evaluation from the rating agencies could be sought, that is, one for the originator and another one for the assets, in order to enable prospective investors to make better investment decisions. In this vein, recourse to the assets would be an added advantage, as international investors do not have such an option with conventional bonds. The final recommendation is that a clear and strong ownership link has to be created between the ṣukūk holder and the underlying ṣukūk assets, as this ownership link is the lifeline of the whole ṣukūk structure from the Sharīʿah perspective. The weakening of the ownership interest of the ṣukūk holders means that the ṣukūk holders will not have the following rights: sell the ṣukūk assets, have title to the assets and have recourse to the ṣukūk assets in case of default by originators. Ethics and justice constitute the 66

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foundations of Islamic finance, and keeping these as a foundation will help ensure an enterprising financial environment where the financier and the originator come together to share risk and reward in a Sharīʿah-compliant manner. This writer feels that merely structuring ṣukūk to replicate conventional bonds and bringing the transfer of beneficial ownership of ṣukūk assets into the structure will not benefit the industry much in the long run, either from the Sharīʿah or commercial perspective. But if the spirit of Islamic finance is upheld and the risk and rewards of the underlying ṣukūk assets are shared between the ṣukūk holders and the originators, then surely ṣukūk will have a flourishing future.

Bibliography Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards For Islamic Financial Institutions, 1432H – 2010 (AAOIFI: Manama, Bahrain, 2010). Dey, D., and S. Ure, ‘Islamic securitisation’, in R. Ali (ed.), Ṣukūk and Islamic Capital Markets, A Practical Guide (London: Globe Business Publishing, 2011). Fidler, S., ‘Defaults pose latest snag in Islamic bond market’, Wall Street Journal (16 June 2009) , retrieved 6 December 2012. Islamic Finance News Newsletter, 5th December, Vol. 9, No. 48 (Kuala Lumpur: Red Money Publication, 2012). Markman, A., ‘Ulterior motives. How goals, both seen and unseen, drive behaviour’, Psychology Today ,, retrieved 6 December 2012.

Notes 1. Islamic Finance News Newsletter, 5th December. 2. Ibid. 3. Musāṭaḥah is a legal right to build on and retain the building on another person’s land for a fixed term of years. 4. Mushārakah is a joint enterprise or partnership structure with profit-andloss-sharing implications. It allows each party involved in a business to share in the profits and risks. The financier will achieve a return in the form of a portion of the actual profits earned, according to a pre-determined ratio. 5. Istiṣnāʿ is a contract of exchange with deferred delivery, applied to specified made-to-order items. This is generally used as a manufacturing contract. 6. Muḍārabah is a mode of financing through which the financier provides capital finance for a specific venture desired by the client. The financier is the owner of the capital and the customer, called a muḍārib (manager), is 67

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responsible for the management of the business and provides professional, managerial and technical expertise for starting and operating the business enterprise or project. Profit is shared according to a pre-agreed ratio and loss is only borne by the financier. 7. One of the world’s leading manufacturers of chemicals, fertilisers, plastics and metals. 8. Khazanah Nasional is the investment holding arm of the Government of Malaysia and is empowered as the government’s strategic investor in new industries and markets. 9. One of the largest telecommunications companies in the world and the leading operator in the Middle East and Africa, headquartered in the UAE. 10. A Bahrain-based Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, and Sharīʿah standards for Islamic financial institutions and the industry. 11. A. Markman, ‘Ulterior motives. How goals, both seen and unseen, drive behaviour’. 12. S. Fidler, ‘Defaults pose latest snag in Islamic bond market’. 13. D. Dey and S. Ure, ‘Islamic securitisation’, p. 148. 14. Ibid. 15. Accounting and Auditing Organisation for Islamic Financial Institutions, Sharīʿah Standards, Standard 17, guideline 5/1/8/4, p. 313.

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4 S ̣uku‾k and Bonds: A Comparison Abdul Karim Abdullah

Introduction On account of the prohibition of interest (ribā), Islamic finance is generally considered – not only by Muslims – as more stable and equitable than its conventional counterpart.1 At the very least, financing on the basis of profit-and-loss sharing ensures that, unlike in conventional finance, no mismatch develops between the assets and liabilities of a financial institution as a result of poor performance or non-performance of any of its investments. The stability of the financial institution is assured because both sides of the balance sheet rise or fall in tandem. Any losses on the asset (investment) side of the balance sheet will be matched by an equal decrease in the liabilities (investors’ shares) of the financial institution. An additional advantage of financing on the basis of profit-and-loss sharing is that losses, if any, remain private. Unlike in conventional financing, there is no need in Islamic finance for costly bailouts using public (taxpayer) funds. This helps avoid adding to sovereign debt. There are other benefits. The prohibition of interest in Islamic finance rules out making interest-based loans as well as trading in interest-yielding securities (bonds). The prohibition of interest protects people from having to pay back (in some cases much) more than what they initially borrowed as a result of increases in debt due to interest charges. The prohibition of trading in debt (bonds) reduces unproductive speculation financed by interest-based debt significantly. Financing on the basis of interest-based debt brings many disadvantages. Speculation in the financial markets only redistributes existing wealth and contributes little to the generation of new wealth. The elimination of excessive speculation in the financial sector, implied by the prohibition of interest-based loans, will free resources for utilisation in the real sector. Higher investment in the real sector means more jobs, stronger economic growth, a reduction in the pressure on prices to increase and a higher standard of living. Interest-based debt adversely affects the real sector in other ways. Spending financed by debt adds to inflation, which erodes the purchasing power of currency. Inflation also increases the cost of living as well as of doing business. Spending financed by interest-based debt contributes to 69

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asset bubbles in the property, commodity and stock markets. Debt-financed growth takes place unevenly, in the form of boom and bust cycles. The attendant social and personal costs of interest-based financing include large levels of indebtedness, enormous burdens in the form of the need to service large debts, both personal as well as national, bankruptcies, and an uneven distribution of wealth. Deeply indebted businesses and households risk insolvency whenever expenses exceed income. The inability to pay debts on time necessitates debt restructurings and the repossessions of assets. A number of developed countries are experiencing difficulties paying off sovereign or quasi-sovereign debt. It may well be worth to forego some of the (uneven) growth in return for greater stability, less debt and a more equitable distribution of income. A substantial decrease in speculation will lessen the swings of the boom-andbust cycles, thereby enhancing overall stability. Interest-based debt financing periodically results in a massive misallocation of resources. The most recent evidence of this can be seen in the large surplus of empty houses in the US, a legacy of the construction boom financed by sub-prime mortgages. Many of these houses are now being torn down as a result of having become dilapidated due to being unoccupied for an extended period of time. Utilising alternative methods of financing, in particular profit and loss sharing, can restrain overinvestment, provide more affordable financing, and reduce waste. The need for ‘hedging’, used widely to justify speculation in the financial markets, merely transforms risks that institutions face individually into a collective or systemic risk facing all participants, in particular the taxpayers. The latter are invariably called upon to bailout overleveraged and poorly managed financial institutions unable to meet their obligations. This is due to excessively risky ‘investments’ made with depositors’ savings. The reduction of overleveraging for the purpose of speculation, implied by the prohibition of trading in debt, can be expected to contribute significantly to greater systemic stability. During the recent economic and financial crisis, financial institutions borrowed heavily at low rates and purchased risky debt that offered – at least for a time – higher returns. This resulted in high debt-to-equity ratios for many institutions. The collateralised debt obligations (CDOs), purchased with borrowed funds were assigned AAA (investment grade) ratings, despite the fact that much of the ‘collateral’ backing a substantial portion of the CDOs consisted of subprime mortgages, an uncertain source of income under any conditions. Dramatic rises in interest rates in the years leading up to 2007 caused widespread defaults in the adjustable rate subprime mortgages sector. 70

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Due to impaired cash flows from borrowers to creditors, rating agencies downgraded the CDOs. The downgrades triggered dramatic declines in their prices. Financial institutions were unable to sell the CDOs at prices that would enable them to repay the money they borrowed to buy them in the first place. In retrospect, the higher yields initially paid to the buyers of CDOs were dwarfed by the massive losses that resulted from the dramatic decline in their market values. Investment banks such as Lehman Brothers went bankrupt, while others nearly went bankrupt. The prospect of a systemic collapse became real. Only massive infusions of funds (bailouts) by central banks averted a domino-like financial collapse of institutions that have been allowed to become ‘too big to fail’ due to poor or non-existent regulatory oversight. The progressively larger rescues of private institutions using public funds,2 however, by way of massive injections of liquidity to support institutions teetering on the brink of collapse under the weight of debt, sow the seeds of the next round of inflation and the next, even bigger bubble, in a familiar cycle of boom and bust. The most recent financial crisis (2007) inflicted less damage on Islamic finance than on its conventional counterpart, where losses by insolvent companies (and costs to the taxpayers including future generations) have been estimated in the trillions of US dollars.3 However, in light of some ṣukūk defaults and near defaults, there is now a significant ‘public scepticism concerning ṣukūk and the extent of the differences with conventional bonds’.4 Some observers are concerned that the ‘conventionalisation’ of Islamic finance is gradually and imperceptibly eroding its distinctive character by assimilating it to, and making it more and more indistinguishable from, its conventional counterpart. This process is sometimes referred to as the ‘convergence’ of Islamic and conventional finance. One may ask, however, what is the point of having Islamic finance in the first place, if it is merely going to replicate its conventional counterpart, along with all the problems (including indebtedness and instability) that the latter brings in its wake? While noting similarities between ṣukūk and bonds, this paper focuses on the differences between ṣukūk and conventional bonds. Contrary to some perceptions, important differences exist between the two. These differences arise out of the fact that (secured or risk-free) lending at interest differs in fundamental ways from investment that requires the entrepreneur to take risk in order to earn profit. The significance of the differences between ṣukūk and bonds goes beyond the structure of each instrument. The ways in which ṣukūk and bonds enable issuers to raise funds, and the ways in which 71

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the providers of these funds are rewarded for their respective contributions, have far reaching implications on society in general, and on how members of a given community will relate to one another, in particular.

A Brief History of S ̣uku‾k Early forms of ṣukūk were used as far back in Islamic history as the time of the caliph Omar. These ṣukūk entitled the bearer (typically a soldier) to collect a specified quantity of food (such as grain) at designated centres of distribution. The ṣukūk were marketable and were commonly traded at discounts. They were directly exchangeable into a specific and intrinsically valuable asset, and they derived their value from the asset backing the ṣukūk, normally a specified quantity of a given commodity. When a person bought an asset-backed certificate of this type, he purchased not only the certificate, but also the underlying asset backing the certificate. If the ṣukūk were not exchangeable into the asset backing them, they would lose their value. These were the earliest examples of what we would today call ‘asset-backed’ ṣukūk. The issuance of ṣukūk was spurred over the last few decades by the need to finance large infrastructure development in Muslim countries, including the construction of highways, ports, airports, universities, hospitals, power generating stations, distribution grids, telecommunication networks, railroads, housing, clean water supply as well as drainage facilities. The need to tap Islamic funds generated by the sales of oil in the Middle Eastern and other resource-rich Muslim countries contributed to the growth of the ṣukūk market.5 As Muslims are not permitted to issue, buy or sell interestbearing securities, there was a need to find a way of raising and investing funds in the capital markets that would dispense with the need to pay or earn interest. This need was met by ṣukūk.6 In Malaysia, ṣukūk made their first appearance in the early 1990s. They were known as Islamic Debt Securities (IDS). These included the murābaḥah ṣukūk in the form of the BBA (al-bayʿ bithaman ājil or deferred payment sales).7 Additional types of ṣukūk appeared after 2000. These included istiṣnāʿ, salam, ijārah, and intifāʿ.8 The IDS remained the most common type of ṣukūk up until 2004, when the market saw the emergence of participatory sukūk such as the muḍārabah and mushārakah, as well as ṣukūk exchangeable or convertible into common shares. By 1996, the total ṣukūk issued in Malaysia amounted to RM2.3 billion. This rose to RM5.2 billion in 1997. There was a slowdown in the issuance of ṣukūk in 1998 and 1999 due to the Asian financial crisis. In 2000, the total ṣukūk issued rose to RM7.6 billion, rising to RM13.2 billion in 2001. By 2003, the total amount of ṣukūk issued in Malaysia was RM 70 billion. 72

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By 2006, the total amount of ṣukūk outstanding grew to RM105.2 billion. By 2007 it stood at RM135.8 billion. As of September 2008, just before the recent financial crisis, the total outstanding ṣukūk stood at RM146 billion.9 In 2009, total ṣukūk issuance in Malaysia was RM32 billion. In 2010, ṣukūk issuance in Malaysia fell 30% from 2009 to RM22.4 billion.10 By the end of September 2011, sales of ṣukūk in Malaysia totalled RM19.3 billion.11 ‘Bursa Malaysia’s total ṣukūk listings amount to US$27.6 billion, comprising 19 ṣukūk listed by 17 issuers, three of which are foreign issuers.’13 Global ṣukūk issuance increased from slightly more than US$5 billion in 2001 to a record of US$32 billion in 2007.14 In 2008, issuance declined to US$14.9 billion.15 It rose again to US$24.7 billion in 2009.16 In 2010, global ṣukūk sales amounted to US$15.3 billion.17 By the end of July 2011, they reached US$18 billion.18 Most of the issues were sovereign (government) or quasi-sovereign (government-linked). The total amount of ṣukūk outstanding globally by the end of September 2011 was US$130 billion, of which 60% has been issued by Malaysia.19 In 2002, Malaysia launched the world’s first US-dollar denominated sovereign issue of ṣukūk ijārah, worth US$600 million, with a five-year tenor.20 In 2003, Qatar followed with ṣukūk ijārah worth US$700 million. In the same year the Islamic Development Bank issued US$400 million worth of ṣukūk istithmār. In 2004, Dubai Civil Aviation issued US$1 billion of ṣukūk ijārah. 2005 saw the Emirates Airlines issue US$550 million of ṣukūk mushārakah. In the same year Pakistan issued US$600 million worth of ṣukūk ijārah. In 2006, Khazanah Nasional of Malaysia issued the first tranche of US$750 million exchangeable ṣukūk mushārakah. In the same year, the Ports Customs and Free Zone Corporation (PCFC) and Nakheel issued US$3.5 and US$3.52 billion of ṣukūk mushārakah and ṣukūk ijārah, respectively. In 2007, Al Daar Properties issued US$2.35 billion of muḍārabah-convertible ṣukūk. In the same year, Daar International issued US$600 million of ṣukūk ijārah. Khazanah Nasional of Malaysia issued its second tranche of mushārakah-exchangeable ṣukūk of US$750 million in 2007. In the same year, Malayan Banking issued US$300 million worth of ṣukūk.21 In 2009, Petronas of Malaysia issued US$1.5 billion of ṣukūk ijārah.22 In 2010, after a hiatus of eight years, Malaysia issued US$1.25 billion sovereign ṣukūk ijārah with a five-year maturity period. The ṣukūk yield 3.928% returns per annum.23 In 2011, notable issues included the RM600 million issue, the first tranche of a RM3.5 billion programme that ends in 2016, by Kuwait-based Gulf Investment Council (GIC). The ṣukūk were structured to yield 5.25% per annum.24 In the same year, Malaysia issued two tranches of wakālah ṣukūk. The first was a US$1.2 billion five73

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year tranche yielding 2.99% per annum, and a US$800 million ten-year tranche yielding 4.65% per annum.25 Top originators currently include Nakheel, PCFC, Aldar Properties, DP World from UAE, SABIC from the Kingdom of Saudi Arabia, and Nucleus from Malaysia. Together these originators have issued about 31% of total world ṣukūk.26

Conventional Financing Financing is the process of raising funds to pay for a given asset or an investment. The need for financing is experienced in all sectors of the economy. Few governments, businesses, or households have the funds to finance expenditures as and when necessary. At any point in time, some parties possess surplus capital, while others experience a deficit. Those with excess (surplus) savings are generally willing – for a reward – to make those funds available to parties in need of financing. The transfer of capital from those with a surplus of funds to those facing a shortage takes place by means of securities. A ‘security’ is similar to a receipt with various terms and conditions attached. It is a legally enforceable contract that stipulates the rights and obligations of the counterparties. Parties in need of funds issue (sell) securities, while parties with surplus funds buy (subscribe to) them. Some securities are used for raising funds, while others are used for hedging (risk reduction) purposes. The former include shares, ṣukūk and bonds. The latter comprise futures, options, warrants, as well as interest-rate and credit default swaps. Conventional finance utilises two types of securities for raising funds: common (ordinary) shares and bonds. Shares enable issuers to raise capital in the form of equity, while bonds enable issuers to raise capital in the form of loans (debt). Shares and bonds come in a number of different forms, depending on the specific features incorporated into a particular structure.27 Shares and bonds are traded in the share and bond markets respectively. Trading of shares represents the trading of companies, while the trading of bonds represents the trading of debt. Prices of securities fluctuate according to market conditions.28 Because they are convertible into cash, shares and bonds are ‘liquid’ securities.29 Currently, the size of the global bond market is US$82 trillion. By contrast, the size of the global share (stock) markets stands at US$44 trillion: ‘the world bond market exceeds the world stock market in size by a factor of nearly 2 to 1.’30 While shares and bonds facilitate the channelling of surplus funds (savings) to those parties that experience a shortage of capital, they do so in fundamentally different ways. The different ways in which they do so in turn have different social implications. 74

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Shares Companies raise funds in the share market by inviting parties with excess savings to become shareholders in the issuing company. The ‘invitation’ takes the form of an initial public offer (IPO) of shares, described in a prospectus (business plan).31 In exchange for share capital, investors become part owners of the company. As owners of the company, shareholders become responsible (liable) for its actions. This liability is limited to the amount that they have invested in the company. They bear the risks, on a proportionate basis, of their company’s activities. As such, they become eligible for a proportionate share of the profits, when profits are earned. They also become responsible for bearing losses, if any. The rewards or losses, if any, of the shareholders depend on how well they can manage their company. Good management generally brings profits; poor management generally results in losses. Thus, participating in business activity by investing in common shares maintains the link between responsibility and reward. Each share certificate entitles a shareholder to one share of the total profits in the course of a given accounting period. In case of a bankruptcy of the company, the ownership of each share entitles the shareholder to one share of the net assets of the company (shareholders’ equity or the difference between total assets and total liabilities). As owners of the company, shareholders are responsible for overall management. Shareholders elect representatives – members of the board of directors – at shareholder meetings. The board of directors in turn appoints the executive officers (day-to-day management). The management reports to the board of directors and the board of directors reports to shareholders. It is common for senior executive officers, as well as large shareholders, to be on the board of directors. This facilitates communication between the shareholders and the management of the company. In order to earn profits, shareholders are required to share risk with other owners of the company. It is a basic characteristic of business activity that neither profits nor investors’ capital are guaranteed. All shareholders face the risk that the company may fail to earn profits, or that they may lose their investments in toto. Risks of losses, however, are balanced by the possibility – and in the case of well-managed enterprises the probability – of earning profits. This is in keeping with the principle, ‘The earning of gain is justified by taking risk.’ Profits are expressed as an x number of dollars and cents per share, not as an x number of per cent out of the total amount invested. The risk of losses provides a strong incentive to investors to exercise due diligence before and after committing funds. Once funds are committed, 75

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investors need to participate on an on-going basis in their company. The exposure of the investors’ capital to risk helps to ensure that only promising business plans will secure funding. This contributes to a more efficient allocation of resources and a reduction of waste. Efficiency – in the sense of supplying the required quantity and quality of products and services – is rewarded with profits. Inefficiency – providing products or services in excess of what is demanded by the market – is likely to result in losses.32 Investors share profits and losses on a proportional basis. Those who invest more become entitled to a greater share of the profit than those who invest less. Sometimes a part of the profits is retained for future investment. Shareholders do not lose if a company does not distribute dividends. Retained profits strengthen share prices and shareholders benefit from capital gain.33 The possibility of capital gain provides an additional incentive to investors to invest in shares. Ordinary shares, unlike bonds or loans, do not come with income and capital guarantees. In particular, they do not come with ‘maturity’ dates. They do not require issuers to refund to investors their capital on a date specified in advance. This means that issuers of shares, unlike those of bonds, are not under pressure to ensure that they have enough money return to investors their capital on the specified date. If investors wish to liquidate their investments, they can do so by selling their shares in the secondary market. The prices investors may obtain in the secondary market may be higher or lower than what they originally paid for the shares, depending on how well or poorly the company has performed. If the company performed well – and no significant market failure (such as insider trading or share price manipulation) influenced share prices – it is likely that shareholders will obtain higher prices than what they initially paid. If the company performed poorly, it is unlikely that shareholders would obtain more than what they originally paid. In order for investors to buy shares, they need to have the confidence that their investments are well managed. This requires good corporate governance, transparency, a sound regulatory regime and a level playing field. Tax laws that allow companies to treat interest payments as expenses, for example, put issuers of equity (shares) and equity-type instruments at disadvantage vis-à-vis issuers of bonds.34 Such laws provide an incentive to companies to raise capital in the form of debt, rather than equity. When tax laws are amended to create a level playing field between debt and equity, the issuance of equities and equity-like instruments can be expected to increase. 76

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High ethical standards are required of all stakeholders to maintain interest in, and the credibility of, equity financing. This requires transparency and accountability in all corporate and regulatory matters. Shareholders may shy away from equities when they see the value of their shares diluted on account of insider trading, fraud, violation of minority shareholders’ rights, misalignment of the interests of executives and shareholders, conflicts of interest or opaque transactions.

Bonds When issuing shares does not appear to be a viable option, conventional businesses borrow. Businesses borrow to finance expansion, pay off debts, or raise working capital. They can borrow either by taking out bank loans or by issuing bonds. A bond is an IOU (I owe you) or a written promise (contract), issued by a borrower to a lender. The IOU is issued in exchange for a sum of money (loan). The borrower promises to pay back the principal amount of the loan, along with an extra amount (interest), on a specified date in future (maturity). The extra amount constitutes the incentive for parties with excess savings to make their funds available to those who experience a shortage. The exact amount of interest, the magnitude of each repayment and the date on which the principal needs to be repaid are all specified in advance. Unlike shareholders, bondholders know beforehand how much they are going to receive, when they are going to receive it, and when the principal amount of the loan will be returned to them. Unlike shareholders, bondholders receive rewards that have been determined and agreed upon in advance. Therefore, they are not exposed to the uncertainties (risks) of business enterprise. The fact that rewards paid to creditors are determined without any reference to the performance of the business they help to finance means that they are shielded from the risks facing those businesses. In other words, creditors do not share the risks faced by the enterprises they finance. It is for this reason that interest-based (collateralised) bonds are ‘risk-transferring’ rather than ‘risk-sharing’ contracts. The terms of the interest-based loan contract ensure that all risks remain with the borrower. The fact that creditors are paid rewards that are determined independently of the performance of the businesses they finance means that there is no link between the magnitude of the interest payments paid to creditors and the efficiency of the businesses they finance. For this reason, interest-based financing, unlike equity financing, is at odds with a fundamental principle of the free enterprise (capitalist) economy, which is that reward needs to be linked to performance (efficiency). 77

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As a result of having both their income as well as capital guaranteed, bondholders face little uncertainty (risk) compared to buyers of common shares. Unlike shareholders, bondholders neither play an active role in, nor take responsibility for, how the funds they provide in the form of loans are utilised. The responsibility for the use of the funds (with the corresponding risk) rests squarely on the shoulders of the borrowers. Lenders earn (interest) income solely for the service of providing a given amount of capital over a given period of time. Unlike shareholders, bondholders make their capital available to entrepreneurs on a temporary basis. The latter are legally obliged to return capital to creditors on a date or dates specified in advance. The amount of interest is expressed as a fraction (percentage) of the total amount borrowed. Interest is paid on a periodic basis: annually, semi-annually, monthly, or daily, depending on the terms of a particular agreement. The difference between ‘nominal’ and ‘real’ interest rates is due to inflation. If, for example, the inflation rate is 5% per annum, and the nominal rate of interest is 8%, the real interest rate is 3% (8 – 5 = 3%). Historically, real interest rate have been relatively constant at about 3%. Businesses issue bonds with the help of ‘underwriters’ or investment banks. Underwriting institutions arrange the bond issues for their clients and assist them with marketing the bonds to parties interested in ‘fixed-income’ instruments such as pension funds, insurance companies, and individuals. Banks retain bonds they are unable to sell on their own books. Privately placed bonds are sold directly to buyers without the assistance of financial intermediaries. Private placements are cheaper, because borrowers save on fees to investment banks for arranging and underwriting services. Bonds are issued (sold) in primary markets and traded in secondary markets. A limited number of bonds, mostly those issued by corporations, are listed on exchanges. Most bonds are traded over the counter (in a decentralised manner), directly between broker-dealers and financial institutions. Participants in the bond markets include investment banks, hedge funds, insurance companies and pension funds. Buyers may be local or foreign. Bonds are classified according to maturity, risk, liquidity, and whether they are secured or not. Bonds issued by corporations are known as ‘notes’ or (commercial) ‘paper’. Bonds can be of a long-term, medium term, or short-term nature. Long-term bonds range from 12 to 30 years, medium term bonds (notes) are issued for a period of 1 to 12 years, while short-term bonds, known as ‘bills’ or ‘money market instruments’ mature in less than one year.35 78

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.

Bond prices vary inversely with interest rates. When interest rates fall, bond prices rise. When interest rates rise, bond prices fall. This is known as ‘bond market volatility’. When bonds are traded at above their nominal (par) value, it is said that they are traded at a premium. When they are traded below their nominal value, it is said that they are trading at a discount. The market price of a bond in a secondary market is the present value of the future payments by the issuer to the bondholder, calculated at the current interest rate.36 Returns on bonds are directly related to risk. The main risk facing bondholders is the risk of default. As risk rises, so does the yield. High-risk (and high-yielding) bonds are known as ‘junk bonds’.37 The risk of default can be mitigated by requiring borrowers to post collateral or security. Creditors can also mitigate the risk of default by purchasing credit default swaps, a form of ‘insurance’ on debt.

Shares and Bonds A major difference between fixed-income securities such as bonds and risksharing securities such as shares is that bonds come with legally binding income and capital guarantees while risk sharing securities such as shares do not. In other words, the possibility of default simply does not arise in the context of risk sharing. Issuers of common shares are under no legal obligation to ‘guarantee’ either profits or investors’ capital. The amount of profit paid to shareholders or partners by issuers of shares or equity-like instruments is at the discretion of the issuers. No such discretion is available to issuers of debt or debt-like instruments. They have no choice in how much they will have to pay to creditors during any particular accounting period, as these amounts (as well as repayment dates) are commonly specified and contractually agreed upon by both parties in advance. Raising funds in the form of conventional loans effectively obliges borrowers to promise contractual certainty on the basis of operational uncertainty. Parties that raise funds in the form of debt rather than equity are obliged to make specified payments at agreed upon times regardless of the profitability of the assets that they invested in using the borrowed funds, and regardless of the market conditions prevailing at any particular time. This means that borrowers are legally obliged to keep up interest and principal repayments even when the productive assets invested in using the borrowed funds experience losses. The need to guarantee both interest as well as principal means that should borrowers fail to make a promised payment on time, they will be in default. This may result in legal action against borrowers by creditors. The failure of a borrower to make a payment on time entitles lenders to seize whatever 79

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assets may have been pledged as collateral and possibly force borrowers into bankruptcy. The need to maintain predetermined loan repayments puts borrowers under much pressure to ensure that their enterprises will earn sufficient profits to service the loans at all times, both good and bad.38 For this reason it is hardly surprising that businesses that borrow have a higher rate of failure than businesses that obtain financing by issuing profit and loss sharing instruments: ‘the probability of bankruptcy and financial distress are increased when debt-based financing is used’.39 This is in sharp contrast to issuers of common shares, who are under no legal obligation to pay profits to shareholders (dividends) when no profits have been earned.40 Thus, financing with the help of profit-and-loss sharing instruments, such as common shares, is more conducive to the success of the firm in the longer term. Such financing does not require issuers to pay investors dividends when their businesses experience losses.

Interest and Profit The Arabic term ribā, translated into English as interest or usury, literally means ‘increase’ or an ‘addition’. Interest is an additional amount of money, paid by borrowers to creditors in addition to the repayment of the principal amount of a loan. Ribā or interest is prohibited in the Qur’an: Those who swallow usury cannot rise up save as he ariseth whom the devil hath prostrated by (his) touch. That is because they say: Trade is just like usury; whereas Allah permitteth trading and forbiddeth usury.41

In a conventional loan, a given amount of money is exchanged for another, larger amount. The larger amount is invariably delivered (paid) in future. In other words, an interest-based loan is a sale of a given amount of money for more money. The difference between the two amounts is interest (and a specified period of time). Since the total amount of interest paid by a borrower to a creditor over the lifetime of some loans (e.g., those extended to finance the purchase of houses) can be several times higher than the principal amount of the loan, the two amounts of money exchanged (counter-values) can be radically unequal. One can hardly help wondering about the fundamental justice or fairness of a transaction in which one party gives up so much and the other so little. Under normal conditions no one would willingly give up something of much greater value for something of much lesser value. Entering a contract with terms skewed so dramatically in favour of creditors hardly appears to be in the interest of borrowers. The ribā prohibited in the Qur’an is known as ribā al-nasī’ah. Ribā mentioned in the prophetic traditions is known as ribā al-faḍl. The latter 80

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is the excess (extra) value obtained by one party in a trade where assets (rather than money) of significantly unequal value are exchanged. The transaction can take place on the spot or on a deferred basis. The party receiving the greater value in a transaction gives up a lesser countervalue (ʿiwaḍ) than the counterparty. The fact that two considerably unequal values are exchanged once again raises questions about the justice of this type of exchange. The Prophet (peace be upon him) stated that, ‘hardship shall be alleviated’. Interest-based lending, however, does not alleviate hardship. On the contrary, it increases it. Borrowing at interest forces debtors unable to maintain repayments deeper into debt, sometimes resulting in the wholesale indebtedness of families, communities and even nations. Compound interest, or interest on interest, increases the magnitude of debt at an exponential (accelerating) rate. It can multiply the original amount of the loan to the point where the debtor may be unable to repay it. This is no doubt one reason why the believers are admonished to avoid lending at interest: ‘O ye who believe! Devour not usury, doubling and quadrupling (the sum lent).’42 Great financial burdens have caused much harm, and continue to cause harm, to families, various institutions, as well as entire nations. The Qur’an states that people in difficulty should be given more time to settle their obligations. Indeed, the Qur’an recommends foregoing even the principal amount by way of charity: ‘If a debtor is in want, give him time until his circumstances improve; but if you forego (the debt) as charity, that will be to your good, if you really understand.’43 The difference between interest and profit arises from the fact that they are earned in different ways. Interest is gained in the context of lending while profit is earned in the context of trading. Profit is earned by taking risk, while interest in (collateralised) lending is obtained in a risk-free (guaranteed) manner. Normally, only parties able to post sufficient collateral qualify to obtain interest-based loans. In other words, those who need help more than most – the poor – do not qualify for loans due to their inability to post collateral. ‘The current collateral based system for financing business effectively locks the poor out of participation…’44 The value of the collateral is typically equal to or greater than the amount of the loan. In the event that a borrower obtains a loan and is unable to pay it back, the creditor is legally entitled to take possession of the asset pledged as collateral. By selling the collateral, the creditor is able recover the value of the loan. In this way, the need to post collateral eliminates the risk of non-repayment to the creditor. 81

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Those unable to post collateral will remain ineligible for loans.45 ‘Potentially very good investments would be passed up if the investor does not have enough collateral to guarantee repayment in case of an unfavourable outcome.’46 Start-up businesses may find it difficult to obtain bank financing due to their limited ability to post collateral. By withholding funding from start-up businesses due to inability to post collateral, financing by way of interest-based lending hinders rather than fosters innovation in business enterprise. The (secured) lender takes little risk in making his capital available for a period of time to a borrower. His contribution does not extend beyond providing capital, such as providing management expertise to ensure the success of the business he finances. It has been argued that ‘reward should only be given for productive behaviour’.47 In what sense, however, does risk-free (collateralised) lending of money at interest, which does not require the lender to take any responsibility for the outcome of the business enterprise he finances, qualify as productive behaviour that merits being rewarded? The entrepreneur, in contrast to a lender, has to take risk to earn profit. He needs to take full responsibility for the on-going management of the business enterprise. The entrepreneur has no guarantee that he will earn a profit, or even that he will be able to recover his capital. There is a direct correlation between the effort he makes and the reward he earns. Entrepreneurs who qualify for loans can maintain loan repayments only as long as their businesses generate profits at least equal to, or greater than, the payments they need to make to repay their loans (interest plus loan). When profits fall below the level necessary to service loans, businesses may fail due to default on loan repayments. Creditors may force such businesses into bankruptcy. This can happen despite the fact that the business is still making profits, albeit insufficient to cover loan repayments. In other words, financing by borrowing at interest can force even profitable businesses into bankruptcy. By contrast, this cannot happen to businesses financed by means of profit-and-loss sharing. They should be able to survive periods of low profits as long as contributing partners have the commitment to see their business through difficult times. This means that, on the whole, the prospects of success and long-term viability of enterprises financed on a profit-and-loss sharing basis are better than those financed by debt. In collateralised lending the lender’s main concerns include timely repayments and capital protection. This is why borrowers are invariably required to provide capital and interest guarantees. Once borrowers commit themselves to guarantees, missing a payment constitutes ‘default.’ From a legal point of view, default constitutes a breach of contract. The creditor 82

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becomes entitled to claim the collateral pledged and even force the debtor into bankruptcy. While the main objective of lenders is capital protection, the main objective of entrepreneurs is the success (profitability) of the project being financed. The interests of lenders and entrepreneurs are thus not fully aligned. Secured lenders have little incentive, for example, to share information with their clients. The clients (borrowers) thus benefit little from the knowledge and expertise of bank officials: Under conventional interest-based financing backed up with collateral, the bank has no real incentive to share its information – it is guaranteed a fixed return in any case. In the Islamic system, the return to the bank depends on the return to the investor and hence the bank will have great incentive to ensure that the new investor has the best possible information for planning.48

Thus, the interests of investors on a profit-and-loss sharing basis and the entrepreneurs utilising the investors’ funds are closely aligned. The counterparties share a common interest: to see to it that their (jointly owned) business becomes and remains profitable.

Social Implications The way of life of a community imparts to it much of its character. A community, much like an individual, is made better by lawful activities and worse by illegal ones. Lawful activities generate legitimate income, while illegal activities produce unlawful income. The Qur’an bids the believers to pursue only permitted (ḥalāl) activities and to abstain from forbidden (ḥarām) activities. Trading (bayʿ) is permitted but lending at interest (ribā) is prohibited. Trading requires channelling resources into the provision of useful goods and services. Lending at interest rewards unproductive activity. By requiring people to pursue only lawful activities, Islam strengthens the community and helps to protect it from disintegration. The way in which people earn their sustenance introduces – as well as reinforces – different relationships among the members of their community. This applies no less to the earning of interest from lending, and to the earning of profit from trading. In business, profit depends on the skill and diligence of the trader. There is a link between effort expended and reward earned. In lending, by contrast, no meaningful link exists between effort expended and reward gained. For this reason, interest-based lending is inconsistent not only with the teaching of Islam, but also with a fundamental principle of the free market economy, which requires that reward depend on, and indeed be proportionate to, exertion (or productivity). 83

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Islam encourages sharing. This includes the sharing of risks as well as rewards. The form of business enterprise best suited to enable risk sharing is the partnership. Trading and investment carried out by partnerships have many advantages. Partners can pool their resources and in this way increase the amount of capital at their disposal. They can also benefit from each other’s knowledge. Partners have a common objective, the success of their business enterprise. Because profit and loss sharing contracts require the sharing of profit, they contribute to a more equitable distribution of wealth.49 For this reason, partnerships are better suited for the realisation of the social objectives of Islam, in particular the alleviation of poverty and a higher quality of life: Islamic finance is constructed upon the principle of brotherhood and cooperation, which stands for a system of equity-sharing, risk-sharing, and stake-taking. It promotes such sharing and cooperation between the provider of funds (investor) and the user of funds (entrepreneur).50

By contrast, sharing is conspicuously absent from relationships between creditors and debtors. Creditors remain generally aloof from the challenges (including risks) facing debtors, and are more concerned with timely repayments of loans and the preservation of their capital than with the success of the business enterprises they help to finance. The interests of the counterparties in a creditor/debtor relationship only partly coincide. There are some exceptions, however. European and Japanese banks, unlike their UK and US counterparts, often take equity interest in the enterprises they finance.51 The practice of the former is more in line with the Islamic worldview than that of the latter, as the banks take some risk by becoming shareholders of the businesses they finance. By doing so, financial institutions acquire an interest in ensuring that the enterprises they finance (their clients) become successful. Thus, the interests of banks and the businesses they finance are more closely aligned. Conventional financial institutions generally lend on condition that borrowers provide income and capital guarantees to lenders. While they protect lenders, income and capital guarantees ensure that wealth remains, and indeed over time increases, among the well-to-do.52 Income and capital guarantees ensure that net income (in the form of interest) always flows in the one and the same direction: from the poor (borrowers) to the wealthy (creditors). In this way, interest-based lending widens the gap between the rich and poor, and undermines the attainment of the social objectives of Islam, in particular an equitable distribution of wealth. Making loans at interest is characteristic of a society where man is seen 84

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as an individual with few, if any responsibilities to his fellow man or to the larger community. Such a society is characterised by individualism. Each person pursues his self-interest. A member of such a society is or becomes fundamentally indifferent to the fate of the ‘other’. He views life as a ‘war of all against all’ in which any party can win only if another loses. There is little that members of such a community have in common. Islam, by contrast, envisions a society with a common vision and even a common destiny. It envisions an inclusive social order in which no one lives outside the community. It is for this reason, among others, that the Sharīʿah supports partnerships, rather than creditor/debtor relationships. Partnerships unify communities; creditor/debtor relationships divide them. Borrowing establishes a different relationship between counterparties than a partnership. Debt is a legally enforceable contract between one party (debtor) and another (creditor). Going into debt requires the borrower to become beholden to the creditor. Debt effectively places the debtor in a position of service to the creditor, for as long as the debtor needs to service the loan. Thus, going into debt entails entering – at least for a time – a form of servitude. The need to repay debt reduces the borrower’s disposable income and his standard of living. It also limits his ability to participate in other activities, at least until the debt is repaid. With high interest rates this can take a long time. Being in debt can be demoralising. A heavy burden of debt can reduce an indebted person’s confidence. A reduction in confidence in turn may make it difficult for the indebted person to succeed. Paying off debt entails additional hardship when compound interest (interest on interest) is added to the loan. If the debtor is unable to pay the full amount of interest, he or she will slide deeper into debt. Such debt may become impossible to repay. The person may fall into and remain in a debt trap. Going into debt entails risking one’s reputation. In case the debtor fails to repay a debt or to repay it on time, he would have broken his word. The failure to keep one’s promise brings disgrace. It may expose the defaulter to ridicule, contempt, blacklisting and other types of social ostracism.53 Islam, while placing a high value on keeping one’s promises, also places a high value on dignity.54 It requires Muslims to protect their dignity and to refrain from violating that of others.55 A relationship among partners requires more trust (amānah) than a relationship between creditors and debtors. The insistence on income and capital guarantees betrays a lack of trust by creditors in borrowers. Guarantees protect creditors from a possible failure by borrowers to repay their debts as promised. Partners, by contrast, have confidence in one another – and may even become friends – something that rarely takes place 85

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in creditor/debtor relationships. Indeed, many a friendship has come to an end when a debtor failed to repay to a creditor. Friendship among partners, by contrast, need not terminate when partners suffer a loss, as they suffer it together. Indeed, friendship among partners may even grow stronger as a result of a loss because the loss is shared. Thus, a partnership is more in keeping with the spirit of brotherhood than a relationship that prevails among creditors and debtors. Relationships between creditors and debtors tend to be adversarial; those among partners tend to be co-operative. Lending at interest destroys the spirit of brotherhood; profit-and loss sharing strengthens it. The Qur’an states that, ‘Verily, this brotherhood of yours is a single brotherhood…’56 Going into debt imposes a burden on current as well as future generations. This may be unfair to future generations, as they may not benefit as much as the present generation from current spending financed by debt. Borrowings ultimately have to be repaid using tax revenue. Higher taxes may become necessary later to repay debts. Higher taxes, however, will reduce private spending, and thereby impede economic growth. Excessive borrowing also restricts the government’s ability to maintain existing social programs and finance new ones. For these reasons it is in the public interest (maṣlaḥah) to avoid indebtedness. Profit-and-loss-sharing (PLS) instruments do not create debt. For this reason, financing by way of profit and loss sharing is clearly in the public interest. Savings generated by avoiding indebtedness can be used for the development of the community. They can be used to increase spending on education, research and development as well as for building infrastructure. This kind of social investment can generate valuable productivity gains, especially over the longer term.

S ụ ku‾k In Islam, ‘all loans must be interest-free’.57 Thus, lending at interest and the issuance of conventional interest-based bonds is not permitted. The interest-free loan is known as al-qarḍ al-ḥasan (good loan). Not everyone, however, may be willing to lend a given sum of money without getting something tangible in return. Accordingly, an incentive other than interest is required to reward people for making their surplus funds available to those in need of investment capital. This alternative incentive is profit. While Muslims cannot make or obtain loans at interest, they are permitted – indeed encouraged – to earn profit. One way to earn profit is by investing in ṣukūk. Ṣukūk are ‘certificates of investment’.58 They are issued by parties that need funds to invest in a productive enterprise or credit for the purpose of trading. 86

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Ṣukūk are purchased by parties willing to provide investment funds or credit. They signify ownership of assets59 known as the ‘underlying assets’.60 These assets generate the returns (profits) to investors. In other words, issuers of ṣukūk obtain financing or credit without the payment of interest. Ṣukūk can broadly be categorised into sale-based and participatory. Sale-based ṣukūk are used to finance trade, while participatory ṣukūk are issued to finance investment.61 Sale-based ṣukūk enable the issuer to obtain interest-free credit in contracts of exchange (ʿuqūd al-muʿāwadāt), while participatory ṣukūk enable issuers to obtain interest-free financing in contracts of participation (ʿuqūd al-ishtirāk).62 Participatory (i.e., profit-andloss sharing) ṣukūk are similar to ordinary shares.63 While both sale-based as well as participatory ṣukūk are risk-sharing instruments, only participatory ṣukūk are – strictly speaking – profit and loss sharing instruments. The amount of profit paid to ṣukūk holders (or investors) in contracts of exchange (or trade) is determined differently than in contracts of participation. In the former, a mark-up is fixed in advance. With participatory ṣukūk the profit is not specified in advance. Holders of participatory ṣukūk become entitled to a proportionate ‘share’ of the total profit earned by the underlying pool of assets they own. Due to the uncertainties of business enterprise, this profit cannot be known in advance. It can at best be ‘projected’ or estimated. However, some issuers have found ways to assure investors of predictable returns. One such method is the use of equalisation payment accounts. Such accounts are used to top up investors’ profits at times of adversity by using surpluses accumulated during times of prosperity. The use of such accounts, however, has the effect of making the payments of profits resemble the payments of interest by conventional bond issuers to their creditors. The type of ṣukūk a trader issues depends on the type of contract he or she intends to finance. Ṣukūk issued to finance trade enable issuers (or traders) to make payments (to sellers) or deliveries (to buyers) on a deferred basis.64 Trade-based ṣukūk include ṣukūk murābaḥah, salam, istiṣnāʿ and ijārah. In so far as they represent promises to deliver goods rather than funds on a future date, sukūk salam and istiṣnāʿ are also known as ‘non-monetary debt securities’.65 The most popular trade-based instruments are ṣukūk murābaḥah. The expression murābaḥah comes from ribḥ, meaning gain or profit. A murābaḥah is a sale in which an asset is sold at a price that includes its cost and a mark up. The cost price of the item sold is made known to the buyer in advance.66 The price can be paid on the spot or on a deferred date or dates. When the price is paid on a later dates or dates, buyers of the asset issue sukūk murābaḥah to evidence their debt to the sellers. 87

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Ṣukūk salam is a prepaid (or forward) sale, where payment is made on the spot and the assets (usually commodities) are delivered in future. The seller of the commodity issues ṣukūk salam to the buyer of the commodity in exchange for cash paid on the spot. The ṣukūk certificates evidence the obligation of the seller to deliver the receivables (commodities rather than cash) to the buyer on a specified future date. The price, quantity, quality and delivery date are all agreed upon in advance. Buyers of the commodities realise a profit by reselling them for a higher price to third parties. Ṣukūk istiṣnāʿ is a manufacturing contract. A financial institution will buy an asset (not yet constructed) from a manufacturer for a cash price paid on the spot. The manufacturer will use the proceeds to construct the asset according to specifications. The financial institution will then sell the completed project back to the manufacturer for a higher (and deferred) price, to be paid in instalments. The manufacturer will issue ṣukūk istiṣnāʿ to the financial institution (investor) to evidence its obligation to make the promised payments over the course of the payment period. The manufacturer will subsequently sell the completed assets on the open market for a price higher than what it paid for it. Ṣukūk ijārah is a sale and leaseback contract over a period of time. The originator (or party seeking to raise funds) sells eligible assets to a special purpose vehicle (SPV) that acts as a trustee on behalf of investors (or ṣukūk holders). The assets can include land, buildings, an aircraft, ships, or any other rental-generating asset. The buyers of the assets (lessors/investors) then lease the assets back to the seller (or lessee/originator) for a specified period of time at an agreed upon rental payment. After an agreed period of time, the lessor (or investor) sells the asset back to the originator. Profit-and-loss-sharing ṣukūk are known as ‘participatory’ ṣukūk. They enable investors to ‘participate’ in a given project or business enterprise. By selling participatory ṣukūk, issuers make interested investors partners in their business venture. Like ṣukūk issued to finance trade, participatory ṣukūk reward investors (or ṣukūk holders/partners) with profit rather than interest. Profit is earned in exchange for taking risk in the course of funding and participating in a specific business enterprise. The ratio at which profit is shared among partners is determined beforehand. The total amount of profit earned, however, is not determined in advance. Neither party knows how much profit may be generated by a given investment. Profitability depends on many factors. Prominent among these are the efficiency of the assets purchased using the raised funds, the quality of the management, the nature of the regulatory environment, as well as the prevailing economic conditions. 88

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Participation in a business partnership can take different forms, depending on the role investors (buyers of ṣukūk or ṣukūk holders) wish to play. In the case of the muḍārabah, a professional manager (muḍārib), who can also be a partner, is hired to manage the enterprise. The party financing the investment (buyer of the ṣukūk or investor) is the rabb al-māl (capital provider). The owner of the capital and the muḍārib share profits according to a pre-agreed ratio. Losses are borne exclusively by the rabb al-māl, unless the muḍārib is also a partner. Where the muḍārib functions only as a professional manager, he is responsible for losses only in cases of wilful negligence or fraud.67 The muḍārib cannot guarantee profits to ṣukūk investors: It should be noted that it is not permissible to guarantee the capital or profit in a muḍārabah ṣukūk transaction. The muḍārib is considered as the manager and trustee (amīn) of the muḍārabah fund and its project. Thus, the muḍārib is not to be made responsible for losses unless due to negligence, mismanagement and dishonesty leading to losses.68

If investors wish to participate more directly in the management of the business and have a say in how the business is run, they can invest in a mushārakah. Partners share both profits and losses, as the case may be.69 Profits are shared – as in a muḍārabah – according to a pre-agreed ratio. Losses, however, are shared on a proportional basis (according to the amounts invested by each partner).70 As in a muḍārabah, neither profits nor capital are guaranteed.71 The advantage of participatory ṣukūk is that they enable profit-and-loss sharing. The sharing of rewards as well as losses is more in agreement with justice than an arrangement where the party providing financing shares only the profits but not the losses of the enterprise being financed. Conclusions and Recommendations

Ṣukūk facilitate the financing of trading and investment in Sharīʿahcompliant ways. Investors earn profit (or rent), rather than interest. The difference between bonds and ṣukūk corresponds to the difference between lending (at interest) and trading or investing (for profit). In order to earn profit, investors (or ṣukūk holders) need to take responsibility for the outcome of an investment, which requires taking risk. Neither profit nor capital is guaranteed. Taking responsibility (risk) justifies the earning of profit. Holders of ṣukūk become owners not merely of securities, but also of the underlying assets backing those securities. It is the underlying assets that generate the returns to ṣukuk holders. There is a direct link between the productivity (or efficiency) of the underlying assets, and the dividends paid to investors. 89

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By contrast, a sale of conventional bonds (or borrowing) does not require any assets to be sold to investors. Only the bond, representing debt, is sold to investors. The fact that interest payments as well as the principal amount are guaranteed means that buyers of collateralised bonds take little or no risk. If issuers fail to pay any part of the agreed upon payments or the principal amount of the loan on time, they will be in default. Creditors will become legally entitled to repossess any collateral pledged to secure the loans. For this reason, collateralised lending at interest is fundamentally risk-free. While default is not a crime in most countries, it entitles creditors to take legal action to recover any outstanding amount of a loan. They may commence to take action to repossess any assets pledged by debtors. A default cannot happen in contracts structured to share profits and losses, such as ṣukūk mushārakah or muḍārabah, as they are not loans but profitand-loss-sharing contracts. Issuers of profit-and-loss-sharing ṣukūk, unlike issuers of conventional bonds, have no legal obligation to pay dividends to investors when no profits have been earned. This means that investors will not receive dividends when losses are incurred. Investors may earn dividends when the underlying assets become profitable again. • It is necessary to maintain the distinction between ṣukūk and bonds, both in theory and in practice – in particular in the way ṣukūk are structured as compliance with the Sharīʿah hinges on whether the income paid by issuers of financial securities takes the form of profit or interest. • In order to maintain compliance with Sharīʿah, ṣukūk need to be structured as profit-and-loss-sharing instruments. Only this can guarantee that investors will earn bona fide profit, rather than forbidden ribā. • In order to ensure that ṣukūk reflect genuine risk-sharing, they need to be structured without income and capital guarantees, as such guarantees effectively render the principle of risk sharing in the ṣukūk structures inoperative.

Bibliography ‘10-year sukuk for Malaysia’, Zawya Sukuk Monitor (29 May 2011) , retrieved 27 September 2011. Ahmed, H., ‘Islamic financial system and economic growth: An assessment’, in M. Iqbal and A. Ahmad (eds.), Islamic Finance and Economic Development (New York: Palgrave Macmillan, 2005), pp. 29-48. 90

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AJP Worldwide, ‘Global Sukuk Markets’, Sukuk.me (18 January 2011) , retrieved 28 September 2011. AJP Worldwide, ‘Malaysia’s Islamic capital market on road to recovery’, Sukuk.me (7 September 2009) , retrieved 28 September 2011. Alsayyed, N., ‘Sukukisation: Risk factors in Shariah view’, ISRA Bulletin, No. 5 (2010), p. 8. Anwar, Z., ‘The emerging Islamic capital market’, in A. Thomas (ed.), Sukuk (Selangor: Sweet & Maxwell Asia, 2009), pp. 1-15. Brenner, Albert J., ‘World stock and bond markets and portfolio diversity’, Asset Allocation Advisor (15 November 2009), , retrieved 15 June 2011. Chew, E., ‘Malaysian Islamic banking assets rise 15 Percent to $123 billion’, Bloomberg (7 October 2011) , retrieved 10 October 2011. Dusuki, A. W., ‘Commodity murabahah programme (CMP): An innovative approach to liquidity management’, in M.D Bakar and E.R.A. Engku Ali (eds.), Essential Readings in Islamic Finance (Kuala Lumpur: CERT Publications, 2008), pp. 169-92. Engku Ali, E.R.A., ‘Issues in Islamic debt securitisation’, in M.D. Bakar and E.R.A. Engku Ali (eds.), Essential Readings in Islamic Finance (Kuala Lumpur: CERT Publications, 2008), pp. 443-493. Fintan, N.G., ‘Record-breaking RM6bil sukuk sold’, The Star Online (Malaysia) (30 June 2011), http://biz.thestar.com.my/news/story. asp?file=/2011/6/30/business/8997934&sec=business>, retrieved 27 September 2011. ‘GIC launches RM600m sukuk in Malaysia’, MyShare2u, Bursa Malaysia News Blog Archive (3 March 2011) , retrieved 27 September 2011. Haneef, R., ‘From ‘asset-backed’ to ‘asset-light’ structures: The intricate history of sukuk’, ISRA International Journal of Islamic Finance, 1/1 (2009), pp. 103-26. ‘IDB’s USD500 million sukuk accorded EMAS status’, ‘Epicentre: The MIFC eNewsletter’, Malaysia International Islamic Financial Centre (MIFC) (December 2010) , retrieved 6 October 2011. ‘Importance of Islamic sukuk market’, Islamic Financial Industry News Centre, General Council For Islamic Banks And Financial Institutions (CIBAFI) (4 January 2011) , retrieved 12 January 2011. Jamaluddin, J., ‘Exclusive interview with Jamela Jamaluddin’, ISRA Bulletin, 5 (2010), p. 13. Kamali, M.H., ‘A Sharīʿah analysis of issues in Islamic leasing, Journal of King Abdul Aziz University, 20/1 (2007), pp. 3-22. 91

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Kamali, M.H., Islamic Commercial Law: An Analysis of Futures and Options (Selangor: Ilmiah Publishers, 2002). Kuwait Finance House, ‘Introduction’, in A. Thomas (ed.), Sukuk (Selangor: Sweet & Maxwell Asia, 2009), pp. liii-lxvii. McConnell, P., ‘Regulatory madness in the banking world’, The Drum Opinion (21 December 2010), , retrieved 3 May 2011. Mokhtar, S. et al., ‘Sukuk and the capital markets’, in A. Thomas (ed.), Sukuk (Selangor: Sweet & Maxwell Asia, 2009), pp. 17-39. Ng, F., ‘Record-breaking RM6bil sukuk sold’, The Star Online (Malaysia) (30 June 2011), , retrieved 27 September 2011. Parker, M., ‘Huge potential for sukuk in Saudi and Gulf Market: Al-Jasser’, Arab News (21 February 2011), , retrieved 15 March 2011. Permatasari, S., ‘Malaysian sukuk may rebound in 2011 on $444 billion plan: Islamic finance’, Bloomberg (6 October 2010), , retrieved 6 October 2011. Permatasari, S. and Yong, D., ‘Malaysia sukuk funds see a rebound as returns tumble 40%: Islamic finance’, Bloomberg (16 December 2010), , retrieved 10 October 2011. Permatasari, S. and Omar, S., ‘Sukuk beats emerging-market debt for 2nd month: Islamic finance’, Bloomberg (24 December 2010) , 10 October 2011. Pettifor, A., The Coming First World Debt Crisis (Basingstoke: Palgrave Macmillan, 2006). Securities Commission Malaysia, Introduction to Islamic Capital Market (Selangor: LexisNexis Malaysia, 2009). Securities Commission Malaysia, The Islamic Securities (Sukuk) Market (Selangor: LexisNexis Malaysia, 2009). Sultan, S.A.M., ‘Islamic banking: Trend, development and challenges’, in M.D. Bakar and E.R.A. Engku Ali (eds.), Essential Readings in Islamic Finance (Kuala Lumpur: CERT Publications, 2008), pp. 89-110. Wan Abdullah, T.S.W.A.A., ‘Malaysia’s global sukuk issue a huge RM4bil success’, The Star Online (Malaysia) (28 June 2010), , retrieved 10 October 2011. Wilson, R. ‘How expansive are the frontiers’, in A. Thomas (ed.), Sukuk (Selangor: Sweet & Maxwell Asia, 2009), pp. 335-56. ‘World stock and bond markets and portfolio diversity’, Asset Allocation Advisor (15 November 2009), , retrieved 10 October 2011. Zaman, A. and Zaman, A., ‘Interest and the modern economy’, Islamic Economic Studies, 8/2 (April 2001), pp. 61-74.

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Notes 1. A.W. Dusuki, ‘Commodity murabahah programme (CMP)’, p. 175. 2. This process is known as the ‘socialisation of losses’, as distinguished from the ‘privatisation of profits’. 3. According to the US Congressional Service, the cost of the bailout resulting from the 2007 global financial crisis amounted to US$8.1 trillion, measured in today’s prices. This exceeded the combined costs of all economic crises in US history. These included the following, in descending order: World War II at US$4.1 trillion, Vietnam War at US$686 billion, Iraq War at US$648 billion and counting, the New Deal at US$500 billion, Korean War at US$320 billion, World War I at US$253 billion, War on Terror at US$ 171 billion and counting, and Marshall Plan at US$115 billion. See P. McConnell, ‘Regulatory madness in the banking world’. 4. R. Wilson, ‘How expansive are the frontiers’, p. 336. 5. M. Parker, ‘Huge potential for sukuk in Saudi and Gulf Market: Al-Jasser’. 6. According to one view, ‘sukuk started as the Islamic alternative to bonds or debt securities’, see Securities Commission Malaysia, The Islamic Securities (Sukuk) Market, p. 16. 7. Kuwait Finance House, ‘Introduction’, p. liii. 8. A forward variant of the ijārah contract. 9. Securities Commission Malaysia, Islamic Securities (Sukuk) Market, p. 18. 10. S. Permatasari and D. Yong, ‘Malaysia sukuk funds see a rebound as returns tumble 40%: Islamic finance’. 11. S. Permatasari, ‘Malaysian sukuk may rebound in 2011 on $444 billion plan: Islamic finance’. 12. E. Chew, ‘Malaysian Islamic banking assets rise 15 Percent to $123 billion’. 13. ‘IDB’s USD500 million sukuk accorded EMAS status’. 14. Securities Commission Malaysia, Islamic Securities (Sukuk) Market, p. 22. Another source places this amount somewhat higher at US$ 34.4 billion. See Kuwait Finance House, ‘Introduction’, p. lv. 15. Kuwait Finance House, ‘Introduction’, Ibid. 16. ‘Importance of Islamic sukuk market’. 17. S. Permatasari and S. Omar, ‘Sukuk beats emerging-market debt for 2nd month: Islamic finance’. 18. Chew, ‘Malaysian Islamic banking assets rise’. 19. Permatasari, ‘Malaysian sukuk may rebound’. 20. The lead arranger was HSBC Amanah. See Z. Anwar, ‘The emerging Islamic capital market’, p. 3. 21. Securities Commission Malaysia, Islamic Securities (Sukuk) Market, p. 22. 22. AJP Worldwide, ‘Malaysia’s Islamic capital market on road to recovery’. 23. The arrangers for the issue were HSBC Amanah, CIMB Islamic and Barclays Capital, see T.S.W.A.A. Wan Abdullah, ‘Malaysia’s global sukuk issue a huge RM4bil success’; ‘10-Year sukuk for Malaysia’. 24. The Royal Bank of Scotland Bhd (RBS) was the principal advisor and arranger of this issue, its third in Malaysia, see ‘GIC launches RM600m sukuk in Malaysia’. 25. N.G. Fintan, ‘Record-breaking RM6bil sukuk sold’. 93

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26. AJP Worldwide, ‘Global sukuk markets’. 27. Preference or preferred shares constitute a hybrid between bonds and shares. Preference shares pay fixed returns, characteristic of bonds, out of profits, a source of dividend payments to ordinary shareholders. 28. Share markets are also known as ‘stock’ or ‘equity’ markets, while bond markets are also known as ‘credit’ or ‘fixed-income securities’ markets. 29. The share (or stock) market is a market for the buying and selling of companies; the bond market is the market for capital. 30. Albert J. Brenner, ‘World stock and bond markets and portfolio diversity’. 31. Shares can also be placed (or sold) privately (or over the counter), without going public to the share market. 32. Providing goods and service that are in demand by society is macroeconomic (or social) efficiency. The micro-economic business meaning of efficiency is producing a product or service with the least amount of input at the lowest possible unit cost, without sacrificing quality. 33. This assumes that share prices reflect company performance accurately, which need not always be the case. 34. Treating interest payments as expenses reduces the taxable income of companies that raise capital in the form of loans. Such laws discourage companies from raising capital in the form of equity. 35. S. Mokhtar et al., ‘Sukuk and the capital markets’, pp. 18-19. 36. The concept of present value can be understood by asking: how much investment would one need to make in order to obtain all the future payments paid by a bond issuer, given the prevailing (or equilibrium) rate of interest? Suppose the face value of a bond that matures in one year is $1,000.00, and assume that the prevailing market interest rate is 8%, then the present value of this bond would be x = 1,000/1.08, which is equal to $925.92. Thus, the present value of a $1,000.00 bond that matures in a year, given that the market interest rate for bonds with comparable risk profiles is 8%, is $925.92. This means that an ‘investment’ of $925.92 will bring returns equal to $1,000 – 925.92 = $74.07. The latter amount ($74.07) represents 8% of $925.92. 37. For this reason investors should beware of ‘high-yielding’ portfolios, as these are as a rule produced only by high-risk issues, where the risk of default on the repayment of the principal amount is high. 38. Some recent examples of well-known insolvencies include Enron, WorldCom, Global Crossing, Barings, Drexel Burnham Lambert, Long Term Capital Management and General Motors, whose debt of US$453 billion was downgraded to junk status in 2005. See A. Pettifor, The Coming First World Debt Crisis, pp. 10-13. Other companies that had to be bailed out, bought over or went into bankruptcy following the 2007 financial crisis included Fannie Mae, Freddie Mac, Countrywide Financial, Lehman Brothers, Merrill Lynch, Bear Stearns, Northern Rock and AIG. 39. A. Zaman and A. Zaman, ‘Interest and the modern economy’, p. 65. 40. Ibid.: ‘In bad times, interest payments must continue at the same rate, while equity-based payments are reduced.’ 41. Qur’an 2:275, M.M. Pickthall translation. 42. Qur’an 3:130, M.M. Pickthall translation. 43. Qur’an 2:280, A.Y. Ali translation. 44. Zaman and Zaman, ‘Interest and the modern economy’, p. 71. 45. In consumer finance, the collateral is usually provided by the very item 94

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that is purchased using the borrowed funds, in most cases, a house or an automobile. 46. Zaman and Zaman, ‘Interest and the modern economy’. 47. Ibid., p. 72. 48. Ibid. 49. H. Ahmed, ‘Islamic financial system and economic growth: An assessment’, p. 18. 50. Securities Commission Malaysia, Introduction to Islamic Capital Markets, p. 28. 51. Ahmed, ‘Islamic financial system’, pp. 7-8. 52. Cf. Qur’an 7:59, A.Y. Ali translation. 53. It may also result in a damaged credit rating, or in being blacklisted. 54. Qur’an 17:70 and 5:1 respectively. 55. The protection of one’s dignity is one of the objectives of Shariah (maqasid al shariah). 56. Qur’an 21:92, A.Y. Ali translation. 57. M.H. Kamali, Islamic Commercial Law: An Analysis of Futures and Options (Selangor: Ilmiah Publishers, 2002), p. 211. 58. The singular form of ṣukūk is ṣakk. 59. J. Jamaluddin, ‘Exclusive interview with Jamela Jamaluddin’, p. 13. 60. What properly constitutes an ‘asset’ remains a subject of discussion, see, for example, E.R.A. Engku Ali, pp. 460-78. 61. ‘Ṣukūk may be divided into two types: ṣukūk that yield pre-determined returns, and ṣukūk based on profit-and-loss sharing’; see M.H. Kamali, ‘A Sharīʿah analysis of issues in Islamic leasing’, p. 13. 62. N. Alsayyed, ‘Sukukisation: Risk factors in Shariah view’, p. 8. 63. Mokhtar et al., ‘Sukuk and the capital markets’, p. 22. 64. An issuer (or obligor) of sukūk issued to finance trade is ‘a buyer in a sale contract with the subscribers’, see Securities Commission Malaysia, Islamic Securities (Sukuk) Market, p.12. 65. Ibid., p. 25. 66. The mark-up is sometimes referred to as ‘profit’ to the seller, but is more accurately viewed as a source of profit, as the trader still has to pay expenses before he can realise profit from the mark-up. 67. Securities Commission Malaysia, Islamic Securities (Sukuk) Market, pp. 72-5. 68. Ibid., p. 73. 69. S.A.M. Sultan, ‘Islamic banking: Trend, development and challenges’, p. 93. 70. R. Haneef, ‘From ‘asset-backed’ to ‘asset-light’ structures: The intricate history of sukuk’, p. 118. 71. Securities Commission Malaysia, Islamic Securities (Sukuk) Market, p. 76.

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5 Measuring Sharīʿah Compliance in S ụ ku‾k Ratings: A Survey of Existing Methodologies Sheila Ainon Yussof

Introduction This article analyses stakeholders’1 views on the proposed development of a Sharīʿah-compliance rating methodology for ṣukūk. From a legal perspective, a dual rating of ṣukūk may be a necessity as Islamic securities must satisfy two legal regimes – the applicable commercial law as well as Sharīʿah law – in order to make ṣukūk legally acceptable. In a rating of ṣukūk, investors rely on such ratings to evaluate the risk aspects of the ṣukūk, whilst originators depend on a good or balanced rating to ensure a well-priced and viable ṣukūk is placed on the capital market. The Sharīʿah-conscious investor is concerned not only with the enforceability of an obligation strictly from the standpoint of contract and commercial law but also with its compliance from the Sharīʿah perspective. Ṣukūk investors have the right to know what can be disposed of in distressed or default situations, and it is the role of the rating agencies to give a complete assessment of the total variations in value of ṣukūk. This should include any threatened breaches of religious prohibitions (or the risk of Sharīʿah non-compliance). Currently, ṣukūk rating replicates conventional securities rating methodology, where the main focus is on credit-rating of the instrument but lesser or no consideration is given to the value of the physical assets in terms of Sharīʿah credibility – that is, whether the underlying assets meet Sharīʿah requirements in form and substance under Islamic securitisation. Ṣukūk structures must not only comply with the contractual form of Islamic contacts and securitisation process; it must ensure that Sharīʿah objectives of justice, equity and fair play are also achieved. It is proposed in this research that rating agencies should factor in two dimensions for a balanced rating of ṣukūk – the returns on investment (profitability) and Sharīʿah requirements (compliance) – in its analytical framework or ṣukūk rating methodology. For instance, in a credit rating of ṣukūk as currently applied, investors are given disclosures on the creditworthiness of the issuer; however, there is no rating on the quality of the underlying assets on which the ṣukūk is structured. 96

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Based on library and online research, a comparison is made of existing rating methodologies and rating agencies’ approach towards inclusion of Sharīʿah parameters in their ṣukūk rating analysis framework. The factors analysed to be conducive to the development of a more integrated and holistic Sharīʿah-compliant rating of ṣukūk is as follows. Firstly, the experiences of Dubai and the Gulf States on inadequate or ill-advised structuring of ṣukūk have provided the industry with much evidence on the danger of non-disclosures of Sharīʿah non-compliance risks. Default cases in those regions also showed the rampant practice of form over substance compliance, where in the case of a ṣukūk issuance in Dubai (Nakheel ṣukūk), legal devices were used to conceal the true nature of the underlying assets, only to be discovered later that much of the land backing the USD1.03 billion ṣukūk is unreclaimed seabed which may be valueless without the reclamation/construction efforts of Nakheel. This overvaluation of the land eventually restricted investors’ rights to have recourse to tangible assets to recoup their investments. Rating agencies should use this as an opportunity to provide a scale of rating on Sharīʿah compliance to give full information to investors on the Sharīʿah quality of their ṣukūk investments. Secondly, international investors may not be fully aware of the inherent risks embedded in ṣukūk structures when religious and ethical considerations are not observed. Rating agencies need to give an independent opinion on the existence of a potential Sharīʿah non-compliance risk that can transform the ṣukūk into an unsecured investment to the detriment of investors. Thirdly, having learnt from past cases of ṣukūk defaults, investors are now demanding full disclosures on their ṣukūk investments: they want to know more about the ṣukūk, the assets in the ṣukūk structure, whether they are asset-based or asset-backed, and the possibility to recoup their investments in case of default. Fourthly, defaulting and near-defaulting ṣukūk have shown that threats to recouping their investments do not only come in the form of credit risks but also in the form of Sharīʿah non-compliance risks. This was evidenced by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)’s ruling in 2008, which had pronounced that ṣukūk will be invalidated if they are structured without any transfer of collateral (which consists of the bundle of assets used in the securitisation).2 Players who understood this costly breach of Islamic law now want full and independent assessment of all risks to protect their investments, including Sharīʿah credibility or non-compliance risks. However there are contrary opinions to the rating of ṣukūk based on religious dictates, where ‘risk has no religion’ is the prevailing dogma of their jurisdiction. The first opinion is that rating a ṣukūk on its compliance with Sharīʿah is not a major consideration as it does not bear any effect on 97

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the issue’s finances: the only time that religious rulings did add monetary risk to a ṣukūk was in 2008 when AAOIFI issued its rulings to highlight the dangers of non-compliance to Sharīʿah requirements. Secondly, there is general concern about the reliability and certainty of ṣukūk ratings when measured in accordance with a pluralistic religious standard. There is much confusion in the Western market now on the diversity of interpretations from the four schools of Islamic jurisprudence. To Muslims, diversity is a blessing as it opens the door to ijtihād or collective reasoning, to bring forth newer ways of solving problems, but to the West diversity is construed as a difficulty in defining and managing the risks and in pricing the ṣukūk. Thirdly, there must also be an external and independent evaluation of those institutions or products on the extent of their adherence and respect of Sharīʿah legitimacy. This would necessitate the establishing of a regulatory architecture to rate the rating agencies and the logistics involved. Fourthly, many ṣukūk transactions are governed by English or US law due to their ‘creditor-friendly’ nature and doubts were raised on whether Sharīʿah law can be recognized and accepted globally as a governing law due to the perceived lack of certainty and predictability in its implementation. Lastly, there is yet another group which clings to the belief that the ṣukūk market can only evolve if it imitates the conventional bond market, as the latter has been tried and tested with decades of market leadership, standards, know-how, and tradition, whilst ṣukūk issues are viewed to be structured for small, captive audiences. The perception that the ṣukūk market is insular and insignificant needs to be re-examined. The recent introduction of the world’s first Islamic arbitration rules by Kuala Lumpur Regional Centre for Arbitration (KLRCA) in 20123 will certainly pave the way for internationalisation of Islamic finance, which covers the ṣukūk market under the Malaysian Financial Sector plan. From a dispute resolution perspective (for stakeholders’ assurance on enforceability of contracts), parties to a dispute are now weighing the cost of protracted and costly litigation through courts and migrating towards a more just and expeditious alternative dispute resolution mechanism such as arbitration. With these new Islamic arbitration rules, the relevant parties to a dispute could have a complete Sharīʿah-compliant process, from the formation of the Islamic products right to the dispute resolution process. Ṣukūk investors will be assured of certainty in the implementation of Sharīʿah law through progressive removal of Sharīʿah non-compliance risks. As the Islamic finance industry in Malaysia is government-driven with regulators adopting a proactive approach, consistent guidance and directives from supervisory and standard-setting bodies will improve standards (in ratings, internal auditing and arbitration) and increase transparency, standardisation 98

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and uniformity in practices. What is required now is to ensure that a ṣukūk rating methodology will have an infusion of religious and ethical values from the Islamic perspective, and when combined with best practices of conventional systems, ṣukūk can be a powerful economic tool to transform world economies.

Unique Selling Point of S ̣uku‾k One of the unique features of ṣukūk is that it can be created or structured from innovative applications of a myriad of Islamic financial contracts ranging from ‘contracts of participation’ of muḍārabah and mushārakah, and ‘contracts of exchanges’ of Sharīʿah-compliant assets of al-bayʿ bithaman ājil, murābaḥah, salam, istiṣnāʿ and ijārah.4 The downside to this is that ṣukūk structuring may be too complex for the investors to understand or be aware of any protection (if any) of their interests in the complicated bundle of asset-securitization.5 In a conventional bond, it is a straightforward and simple process of the issuer raising capital with a promise to pay back the principal and interest. As interest is prohibited in Islam, the primary condition for issuance of ṣukūk is the existence of assets on the balance sheet of the issuing entity that wants to mobilise its financial resources. Thus, unlike conventional structures, ṣukūk need to have an underlying tangible asset transaction to make it Islamically permissible, either in ownership, where the ṣukūk investor purchases a proportional ownership of the asset, or a beneficial interest, as in a master lease agreement where the ṣukūk investor earns profit off the leasing arrangement. According to the market’s leading Sharīʿah compliance and standard setting body, the AAOIFI, 14 kinds of ṣukūk exist, which are structured not only on tangible assets, but also on debts, businesses, and investments. The types of Islamic security or ṣukūk that are offered in the market are either asset-backed securities, (which are equity- or ijārah-based) or debt-based securities (which are usually murābaḥah-based securities) and other variations such as convertible and exchangeable ṣukūk. The basic or standard model of ṣukūk security is derived from the conventional securitisation process in which a special purpose vehicle (SPV) is established to acquire assets, and to issue financial claims on the assets, representing a proportionate beneficial ownership to the ṣukūk holders. For instance, in a ṣukūk ijārah structure, it is illustrated that: • The SPV acts as trustee on behalf of ṣukūk-holders and also as issuer of ṣukūk on behalf of originator. • The SPV collects the price of the ṣukūk and transfers it to the originator. It receives periodic rentals and transfers these to ṣukūk holders. 99

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• At maturity, the SPV transfers the principal amount of ṣukūk to ṣukūkholders whilst the ṣukūk assets are transferred to the originator by the SPV. Thus ṣukūk in the form of a commercial paper provides an investor with ownership in an underlying asset with a stream of stable income (the periodic fixed rentals in ṣukūk ijārah) and evidenced by Sharīʿah-compatible trust certificates. The identification of a suitable asset is hence the first and most important step in the process of issuing ṣukūk certificate. Investors’ appetite is yet another crucial determinant: ṣukūk is purchased not only for religious reasons, but also ṣukūk is a relatively less risky investment than equities or real estate, and is more lucrative as seen in its consistently buoyant growth over the years.6 Due to the familiarity in structures (where ṣukūk resemble debt-like fixed income instruments), traditional bond investors switch over to ṣukūk to diversify their portfolio of investments, whilst Muslim investors choose ṣukūk because they offer a Sharīʿah-compliant alternative to bonds.

Risks Underlying S ụ ku‾k Structure and Issuance Ṣukūk are investment instruments that are intended to promote risk-andreward sharing in the performance of the underlying asset(s), project or venture in which ṣukūk holders have invested. The ṣukūk deal is structured in such a way that investors are exposed to business risk and rewarded according to the amount of risk they take on. However, due to the availability of two types of ṣukūk, rating agencies need to divide the ṣukūk market according to the two types of structures: asset-backed ṣukūk (where tangible asset forms the basis of the issue as required by Sharīʿah and ṣukūk limits the amount of debt to the value of the assets held in the Special Purpose Vehicle (SPV)7; and asset-based ṣukūk (which is structured on the ‘expected profit’ of an asset, or the worth of the issuer, rather than a tangible asset itself). Thus in determining the riskiness of ṣukūk, rating agencies will have to look at who is issuing the ṣukūk and the type of asset on which it is based. Assets will only be taken into account by the rating agency if they are in place as underlying assets of the ṣukūk, otherwise the rating will be based on the borrower’s portfolio or issuer’s ability to pay. Most ṣukūk issuances, however, have been wholly asset-based, which makes ṣukūk behave more or less like conventional fixed income instruments, rather than as asset-backed ones. It is shown in a default case of Tamweel Sukuk Limited (TSL) that asset-based ṣukūk can compromise the security of ṣukūk transactions. In this case, ṣukūk holders were granted rights on a portion of the cash flows, but with no direct links to physical assets. By linking ṣukūk to the creditworthiness of the originator and not 100

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to physical assets, a higher ṣukūk rating may be assured. As the transaction was not backed by assets, in case of default, investors will bear the risk of having no recourse to the assets in order to liquidate and recoup their investments.

Benefits of Rating and Challenges Ratings generally provide a basis for informed judgement by investors. It is a comparison with established benchmarks to match investors’ risk appetite with the risk profile of entities and available instruments. Ratings also enhance and encourage fuller disclosure of information and better governance procedure. The role of rating agencies is to give an external and independent opinion on ṣukūk for investors to make a well-informed decision on whether to invest in the particular type of ṣukūk offered. By making investors more aware of their investment risks, ratings ascertain gharar and thereby increase transparency of transactions or investments. In the conventional bond market, credit ratings assist in determining an issue’s price and benchmarking creditworthiness, but the rating is biased towards the financial capabilities (or creditworthiness) dimension with no necessity to focus on religious and ethical requirements. International rating agencies such as Fitch, Moody’s, Standard & Poor’s (S&P), and domestic rating agencies such as Malaysian Rating Corporation (MARC) and RAM Rating Services give an external and independent opinion on whether ṣukūk issuances comply with international commercial standards. A cautious approach is however adopted towards rating of ṣukūk based on Sharīʿah criteria. They cling on to a belief that current rating methodologies and rating scales are adequate to accommodate ṣukūk and Islamic banks, despite the differences being consistently highlighted between conventional bonds and Islamic ṣukūk on the structure and substance.8 Regional Rating Agencies The Islamic International Rating Agency (IIRA) was set up to overcome the lack of focus in the rating of Islamic financial institutions and instruments. IIRA currently services financial institutions in Bahrain but they have also received very positive responses from the Middle East and North Africa (MENA) region and the Far East. It also offers its services to all entities operating in any Muslim and non-Muslim country. In their advertising brochure and website, they have stated their challenging role in the region and claimed that people prefer them over conventional products, to avoid what is forbidden by Sharīʿah, for the following reasons:9 1. It is the specialist Islamic rating agency that was set up to be the legitimate alternative to international rating agencies. 101

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2. It is also the sole rating agency established to provide capital markets and the banking sector in predominantly Islamic countries with a rating spectrum that encompasses the full array of capital instruments and specialty Islamic financial products. 3. It provides impartial, independent and reliable ratings to regional investors and stakeholders for both the Islamic as well as conventional financial institutions by making an assessment of the risk profile of entities and instruments, which can be used as a basis for investment decisions. 4. The IIRA’s array of services include Sharīʿah quality rating, credit rating, corporate governance rating, and sovereign rating, which appears comprehensive.

IIRA’s Sharīʿah Quality Rating10 The Sharīʿah Quality Rating (SQR) is aimed at providing information and independent assessment of Sharīʿah compliance by Islamic financial institutions (IFIs) or institutions that offer Islamic banking or financial services, as well as Islamic financial products. • While doing the SQR, IIRA’s Sharīʿah Rating Committee examines a number of factors before arriving at a rating assessment. These factors include the fatāwā issued by the Sharīʿah Committee of the institution, the mechanism within the institution to comply with the Sharīʿah fatwā, and the opinions of the Sharīʿah Committee of the institution, as well as any dissenting opinion thereon. • IIRA’s Sharīʿah Committee also assesses the detailed structure of assets and liabilities and selected executed agreements and documents to evaluate the degree of compliance with the approved scheme or product. • IIRA also looks at the strength of the internal control and audit systems and the procedures and safeguards against commingling of funds (in the case of Islamic windows in conventional banks). The level and quality of disclosure of information to clients, investors and other stakeholders is considered. • IIRA assigns importance to the presence (or lack) of a code of ethics and its understanding and implementation among all the tiers of management and employees. Each of the above aspects is assessed separately to arrive at an overall Sharīʿah Quality Rating. • It is IIRA’s standard practice that the initial ratings assigned by IIRA are first discussed with the management of the institution so that the management has the opportunity to present any new information or 102

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data that could have an impact on the rating. This exercise completes the rating process. However, the rating is an independent opinion of IIRA and the Rating Committee issues the final rating according to its own judgment.

IIRA’s Credit and other Ratings11 The credit-rating services cover both Islamic and conventional banks, financial institutions and their products, such as ṣukūk, bonds and commercial paper. Corporate governance rating assesses the governance system of banks, corporate and financial institutions against international best practices and local regulatory requirements, thus providing guidance for improving governance systems. Sovereign rating assesses the creditworthiness of the government of a country, that is, its ability and willingness to service fully its financial obligations on time.

Comparative Rating Methods or Approaches The rating agencies referred to in this study is Moody’s, S&P, MARC and RAM Rating Services. All rating agencies exercise due diligence before the rating is given. Rating agencies, especially international rating agencies, are generally cautious about making an assessment on Sharīʿah compliance as they want to avoid coming into conflict with bodies or organisations that are mandated to certify Sharīʿah compliance of products and processes, or are restricted by their company’s conservative rating policies. Although rating methods may differ from one rating agency to another, there is a common focus on credit risk assessment. Credit risk assessment rating simply means a rating on the issuer’s ability to deliver. This credit risk bias is to satisfy the ordinary investor where he/she wants to know whether the issuer is able to deliver the deliverables as promised in the ṣukūk prospectus. The rating agencies concur on one rating aspect: that their ratings are an opinion about the ability and willingness of the originator to meet financial obligations in a timely manner, without commenting on Sharīʿah compliance.12 Although these reasons are used to justify the nonfactoring of Sharīʿah credibility risk in their profiling of risks, it should not stop international rating agencies from collaborating with domestic rating agencies to develop a ṣukūk rating framework that fulfils the Sharīʿah requirement of greater transparency and full disclosures. Ṣukūk investors who are conscious of their religious obligations do want their investments to be safeguarded by a reliable and religio-ethical rating methodology. According to Moody’s, the industry’s descriptions of ṣukūk on whether they are ‘asset-backed’ or ‘asset-based’ are not semantically dissimilar; only that they mask significant differences in the credit risk.13 Thus from 103

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a credit-risk perspective, asset-based ṣukūk are generally considered as unsecured investments, meaning that such ṣukūk are not underlined with assets that can be valued; and so they do not and cannot provide investors with the financial recourse to recoup lost investments. At Moody’s, a key element is the default rate of the assets and the corresponding recovery levels following a default. Moody’s ratings address credit risk; and not legal compliance of an instrument with Sharīʿah or English or New York law for that matter. Moody’s quantitative analysis is based on the following framework or methodology: 1. The rating is based on a quantitative analysis of a combination of data which allows them to model the cash flows generated by the asset pool. (Any other material factors such as currency risk, hedge agreements and taxes will also be modelled). The final result is a complete ‘set’ of asset pool loss scenarios, each with the probability of their occurrence. 2. Moody’s will then process these cash flows through a model that replicates the waterfall of payments and any structural enhancements (interest coverage triggers, reserve funds and so on) specified in the documentation. (It was stressed here that such analysis becomes irrelevant if the legal structure does not support the ṣukūk holder’s rights to the underlying assets and their cash flows). 3. In some scenarios, a high default rate on the underlying assets will result in impairment to the ṣukūk and a loss to the amount due to its holders. Each scenario will have a loss rate (0-100%); the research house then takes the loss and multiplies it by the probability of its likelihood. 4. By summing up all these probability weighted losses, the expected loss for the ṣukūk is obtained, which is then mapped to a Moody’s rating. International rating agency Standard & Poor’s (S&P) is consistent with its tradition of being conservative and due to their familiarity with conventional standards it addresses only the credit aspects of the transactions, to ensure transaction security without factoring in Sharīʿah compliance into its ratings. Furthermore in S&P’s effort to maintain neutrality, it has held out that a rating does not constitute a recommendation to buy, sell, or hold a particular security and neither does it comment on the suitability of an investment for a particular investor. Thus their ratings are based on an assessment of the issuer’s ability and willingness to meet financial obligations in a timely manner, without commenting on Sharīʿah compliance. Their main concern is on the bond’s legal enforceability, the 104

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likelihood of scheduled payments according to the terms of the bond, and the compliance of any transaction to applicable commercial law. Sharīʿah compliance is not featured in any of the S&P’s rating analysis. S&P does not review the role or composition of the Sharīʿah board nor does it form an opinion on the validity of the Sharīʿah board’s recommendations and decisions. In short, S&P does not pronounce on the suitability of a particular obligation from the perspective of Sharīʿah compliance, except in jurisdictions where ṣukūk is governed solely by Sharīʿah.14 S&P is of the view that in practice Islamic investors appear to be more concerned about whether the obligation could, for Sharīʿah purposes, be seen to transgress a crucial Sharīʿah prohibition on charging interest. S&P has categorised the security of ṣukūk into three groups depending on the type of collateral and transaction structure. • Ṣukūk with full credit-enhancement mechanisms: This structure resembles asset-based ṣukūk. Under this structure, the ṣukūk receives an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral. The guarantor provides Sharīʿahcompliant shortfall amounts in case the SPV cannot make payment. • The ratings on this type of ṣukūk largely depend on the creditworthiness of the guarantor/entity providing the credit enhancement mechanisms, as well as the ranking of the ṣukūk (usually senior unsecured), among other financial obligations of the guarantor. • Ṣukūk with no credit-enhancement mechanisms: This structure resembles asset-backed securities (ABS) in a securitisation. The pool of underlying assets is the sole basis for coupon and principal payment. • The ratings on these ṣukūk are largely based on the ability of the underlying assets to generate sufficient cash in a timely manner, to meet the SPV’s obligations. • For this type of ṣukūk, S&P’s ratings are based on the performance of the underlying assets under different stress scenarios. • Ṣukūk with partial credit-enhancement mechanisms: This structure combines the first two categories with a third-party guarantee absorbing limited shortfalls from an otherwise asset-backed transaction. • S&P’s ratings approach depends on its estimate of the capacity of the underlying assets to meet the SPV’s financial obligations as well as the terms of the guarantee and the creditworthiness of the guarantor. 105

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On the other hand, RAM Rating Services and MARC, perhaps due to their role as domestic rating agencies, have been seen to embrace Sharīʿah compliance requirements in their rating approaches to comply with domestic regulatory requirements.15 At MARC,16 a conscious attempt is at least made to distinguish conventional bond ratings from Islamic ṣukūk ratings by having a different set of rating definitions for ṣukūk and non-ṣukūk Islamic debt instruments.17 MARC is the first rating agency to introduce a specific set of rating symbols and definitions for the ratings of Islamic capital market instruments.18 MARC has also appointed its own Sharīʿah Advisory Panel to advise on Sharīʿah aspects of Islamic financial instruments, and review new or variations to Islamic rating products and rating definitions to ensure that they comply with Sharīʿah requirements. MARC holds the opinion that Sharīʿah compliance is, in general, adequately addressed by the appointed Sharīʿah panel of the issuer’s lead arranger(s) and financial advisors. RAM Rating Services19 declare in a measured way that an assessment of Sharīʿah will form an ‘added assessment factor’ to its analytical framework of ṣukūk. Whilst it is left to the Sharīʿah scholars to certify on Islamic aspects, RAM’s rating methodology incorporates the distinguishing features of the Islamic securities as succinctly echoed by its Chief Operating Officer for Islamic ratings: In this regard, our analytical task includes an examination of Sharīʿah-related issues, to the extent that it is necessary to appreciate the contractual terms, operations and mechanism of the underlying contract(s) supporting the ṣukūk transaction to be rated, and also to identify Sharīʿah-related matters that may have a credit impact or a bearing on the risk profile of the ṣukūk.20

A declaration from Sharīʿah scholars is still sought by RAM before the final rating for a certification on Sharīʿah compliance of the transaction. RAM’s Rating Services’ approach for ṣukūk transactions may be classified into the following broad analytical framework:21 • Asset-backed or structured-finance rating methodology: This is used if the ṣukūk transaction encompasses essential securitisation elements, which establish that the credit risk profile is determined solely by the performance of the underlying asset and that ṣukūk investors have ownership and realisable security over the assets. • Asset-based rating methodology: If the ṣukūk investors do not possess realisable security over the assets, or where the asset is present for the purpose of Sharīʿah fulfillment, rather than to serve as a source of profit and capital payments, then the credit risk assessment will be 106

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directed towards the entity with the obligation to redeem the ṣukūk; typically, this will be the issuer (borrower). In this instance, where an analysis of the asset is of no consequence but rather the credit quality of the obligor which determines credit quality and rating of ṣukūk, RAM Rating Services would apply the corporate rating methodology. • Corporate rating methodology: The credit quality of the corporate obligor will be the key driver affecting the credit risk of the ṣukūk, with the final rating assigned depending on the ranking of the ṣukūk vis-à-vis other existing senior unsecured obligations of the issuer. To illustrate the difference in rating analysis between asset-backed and asset-based ṣukūk, RAM’s Rating Services’ analytical framework will be used as an example to show that details of the analytical process may vary according to the class of asset being securitised. This article will not go into the detailed definition of the parameters used for both analytical frameworks. Diagram 1 Asset Risk Assessment*

Asset-Backed Rating Methodology: Analytical Framework Payment Structure Assessment

Legal and Tax Assessment

Servicer and Trustee Review

*On the robustness of underlying assets in generating sufficient funds to meet the issuer’s periodic financial obligations, and an assessment of the expected realisable values of the assets upon maturity.

Diagram 2

Asset-Based Rating Methodology using ‘Corporate Rating Methodology’:22 Analytical Framework

Industry Analysis

Business Analysis

Financial Analysis

Management Analysis

*Growth potential

*Market position

*Earning

*Track record

*Industry vulnerability

*Business diversity

*Cashflow analysis

*Operating efficiency

*Capital structure

*Capacity to overcome adversity

*Barriers to entry *Threats of substitutes

*Liquidity position

*Cost Structure

*Financial flexibility *Financial policy

*Level of competition

*Risk appetite *Succession plans *Goals, philosophy and strategies

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The table below summarises the rating approaches of both international and domestic rating agencies referred to in this study. Table 1

Summary of Ratings Agencies

Standard & Poor’s

MARC

RAM Rating Services

Default rate is key

It’s about meeting obligations

Use of in-house Shariah Panel

Shariah an added assessment factor

Moody’s believes that Shariah is more a matter of expert opinion and not objective fact.

Standard & Poor’s has openly declared that it does not factor Shariah compliance into its ratings.

MARC holds the opinion that Shariah compliance is generally adequately addressed by the appointed Shariah Panel of the issuer’s lead arranger(s) and financial advisors.

Whilst it is left to the Shariah scholars to certify on Islamic aspects, RAM Rating Services’ rating methodology incorporates the distinguishing features of the Islamic securities.

Moody’s

It can be deduced here that due to the lack of mandate given to rating agencies to rate ṣukūk on Sharīʿah compliance per se23 and/or reluctance on the part of some rating agencies to factor Sharīʿah compliance into their ratings, ṣukūk has been rated on commercial factors such as default rates, creditworthiness, issuer’s ability to meet financial obligations or the likelihood of timely repayment, stability rating, legal and commercial enforceability. There is a need to factor in the Sharīʿah in determining risks to ṣukūk issuance and trading so that investors can be given a comprehensive picture of the risk profile before exercising their informed choice.

Conclusion and Recommendations Rating agencies in their rating of ṣukūk tend to focus on credit risk or default risks, rather than examining the quality of investment (or the Sharīʿah quality of physical assets). The concept of default as defined under the conventional regime also uses credit ratings as the core determinant for rating bond and ṣukūk. This is inadequate and requires redefining as ṣukūk efficiency and credibility are also based on fulfilment of religious factors and ethical criteria. Non-compliance to Sharīʿah, or any deviations thereof, should be treated as a threat, or a potential defaulting event. If religious considerations or Sharīʿah credibility risks are not factored in to rate ṣukūk, it could result in a substantial loss of Muslim investors due to loss of confidence, and will 108

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in turn affect the liquidity of the ṣukūk issued. The challenge faced by the industry is to get the rating agencies assess the Sharīʿah quality of assets and investment to complement credit quality and default risks rating, or a 360 degree profiling of risks for any ṣukūk issuances. It is unfortunate that, as recent cases have shown, the majority of defaulting ṣukūk on the market is asset-based and this trend should be changed to asset-backing where there is a greater compliance with Sharīʿah requirements with all the benefits of enhancing security of investments. Rating agencies (domestic and international) need to invest in research to understand and appreciate Islamic finance principles and transactions in order to develop an industry benchmark based on Islamic issues for ṣukūk issuances. The Securities Commission of Malaysia has provided a clear and comprehensive framework for ṣukūk in 2004, where ratings have been made mandatory to achieve a consistent, benchmarked and risk-based pricing. A similar framework can be designed by the collaborative efforts of rating professionals to come up with a common methodology in the profiling of risks, to include Sharīʿah non-compliance risks for new ṣukūk issuances, which will lay the groundwork for the creation of an industry benchmark or a uniform rating of ṣukūk. IIRA has taken the initiative in 2011 by entering into a technical agreement with MARC to augment its technical expertise and support, and to broaden its ratings coverage of the region’s Islamic capital markets and Sharīʿah-compliant financial institutions. If rating agencies can work together on a common platform the following objectives can be fulfilled: 1. Development of a new Islamic rating methodology and products for the Islamic financial services sector. 2. Enhanced quality of rating services in light of their eroding credibility, especially after the global financial crisis. 3. Promotion of best practices (to include incorporating conventional standards) to meet the requirements of Islamic financial industry. It is hoped that IIRA’s initiatives can spearhead the development of a uniform Islamic rating methodology for ṣukūk and other Islamic financial instruments. As ṣukūk cross geographical borders, investors have the right to know and are demanding full disclosure on their ṣukūk investments pertaining to enforceability of obligations, transaction liquidity, and the legal and regulatory restrictions to ṣukūk in the host jurisdiction. Given that there are two types of investors in the ṣukūk universe – Muslim and conventional investors – rating agencies need to weigh what is of real value to a growing breed of investors, who are ethically conscious, and who want a safer or more secured alternative investment. 109

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It is recommended that a rating methodology be scientifically developed to give a comprehensive rating to ṣukūk on its compliance to two criteria: financial performance and Sharīʿah compliance. The rating analysis should take into account credit ratings and Sharīʿah compliance ratings. The rating spectrum should be more inclusive not only to assess creditworthiness of the originator but also Sharīʿah determinants, such as quality of assets, Sharīʿah integrity, the quality of Sharīʿah scholars, integrity of fatāwā and end-to-end Sharīʿah governance architecture. This will ensure an integrated and holistic approach towards rating and assure investors of legal enforceability and security of transactions. With a balanced rating methodology all potential risks on ṣukūk can be anticipated before determining an issue’s price and for any benchmarking prospects.

Bibliography Alqahtani, D.S., ‘Shariah Finance: An alternative in the Making’, Halal Tamweel (6 November 2011), , retrieved 18 November 2011. ‘Could Ratings Help Boost Transparency in the Trillion-Dollar Islamic Finance Market?’, Arabic Knowledge@Wharton (6 April 2010), , retrieved 4 July 2011. Dhesi, A.D., ‘Introduction of the World’s first Islamic Arbitration rules will grow Islamic finance assets’, The Star (22 October 2012), Malaysia, , retrieved 26 October 2012. Hales, A., ‘Tapping surplus liquidity’, Risk – Islamic Finance (Autumn 2006), pp.4-6; , retrieved 7 November 2012. Khnifer, M. ‘Lex Islamicus: When sukuk default – Asset priority of CertificateHolders vis-a-vis Creditors’, Opalesque Islamic Financial Intelligence (2 September 2010), , retrieved 17 November 2011. Malaysian Rating Corporation Berhad, Clarity & Integrity, 2010 Annual Report (Kuala Lumpur: MARC, 2010), , retrieved 22 December 2011. Noor, L.M., ‘Sukuk Rating - General Approach, Criteria and Methodology’ in RAM Rating Services Berhad et al, Malaysian Sukuk Market Handbook – Your Guide to the Malaysian Islamic Capital Market (Kuala Lumpur: RAM Rating Services Berhad, 2008), pp. 147-61. RAM Rating Services Berhad et al, Malaysian Sukuk Market Handbook – Your Guide to the Malaysian Islamic Capital Market (Kuala Lumpur: RAM Rating Services Berhad, 2008). ‘Ratings: How Do They Do It?’, Islamic Finance Asia (August-September 2008), , retrieved 17 November 2011. 110

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Securities Commission Malaysia, Capital Market Masterplan 2 (Kuala Lumpur: Securities Commission Malaysia, 2011). Securities Commission Malaysia, The Islamic Securities (Sukuk) Market, Islamic Capital Market Series (Kuala Lumpur: Lexis Nexis, 2009). Standard & Poors, Two Aspects Of Rating Sukuk: Sharia Compliance And Transaction Security, Commentary Report (New York: Standard & Poor’s, 2006). Sundhram, A., R.S. Shaharuddin and B. Shanmugam, ‘A Holistic Rating Methodology for IFIs: Introducing a Unified Rating Framework’, Sixth International Islamic Finance Conference, Kuala Lumpur, 13-14 October 2008. Yussof, S.A., and Y. Soualhi, ‘Islamic Securitisation in Malaysia: Issues and Prospects of Cross-border Ṣukūk’ in C. Marcinkowski, C. Chevallier-Govers and R. Harun (eds.), Malaysia and the European Union. Perspectives for the Twenty-First Century, Frieburg Studies in Social Anthropology (Berlin/ Zurich: Lit Verlag: Berlin, 2011), pp. 111-32.

Notes 1. The stakeholders to ṣukūk are investors, originators, issuers, arrangers and market makers, regulators, standard setting organisations, Sharīʿah boards, rating agencies and law firms. 2. In late 2007, Chairman of the AAOIFI Board of Scholars, Sheikh Mohammed Taqi Usmani, declared that some 85% of outstanding ṣukūk had failed the Sharīʿah compliance test on the basis that they were assetbased, rather than asset-backed due to the guaranteed return of the face value of the ṣukūk on maturity and in the absence of a transfer in asset ownership to ṣukūk holders to make it a true sale and bankruptcy remote transfer. 3. A.D. Dhesi, ‘Introduction of the World’s first Islamic Arbitration rules will grow Islamic finance assets’. 4. S.A. Yussof and Y. Soualhi, ‘Islamic securitisation in Malaysia: Issues and Prospects of Cross-border ṣukūk’. 5. Ibid. 6. M. Khnifer ‘Lex Islamicus’. 7. Hales, A., ‘Tapping surplus liquidity’. 8. For further details see Fitch’s website, . 9. For further information see the Islamic International Rating Agency’s website, . 10. Ibid. 11. Ibid. 12. Khnifer ‘Lex Islamicus’. 13. ‘Could Ratings Help Boost Transparency in the Trillion-Dollar Islamic Finance Market?’: Arabic Knowledge@Wharton 2010 (http://knowledge. wharton.upenn.edu/arabic/article.cfm?articleid=2432) 14. This is seen in a situation where ṣukūk is governed solely by Sharīʿah and are subject to the jurisdiction of Sharīʿah courts; a declaration by such courts that the ṣukūk do not comply with Islamic law could render the ṣukūk unenforceable. 111

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15. The regulatory framework for issuance of Islamic securities in Malaysia requires the appointment of Sharīʿah advisers to advise on all aspects of Islamic securities and to ensure compliance with applicable Sharīʿah principles and relevant resolutions and rulings made by the Malaysia Securities Commission’s Shariah Advisory Council. 16. MARC is a domestic credit rating institution in Malaysia. It has served the Malaysian capital markets for 15 years, rating financial institutions and capital market obligations, with a substantial part of its ratings relating to Sharīʿah-compliant institutions and ringgit ṣukūk issuances. Since MARC started operations in 1996, it has made significant inroads into the Malaysian corporate bond market, especially in the rating of Islamic debt securities. It is the first rating agency to introduce a specific set of rating symbols and definitions for the rating of Islamic capital market instruments. It also has its own Sharīʿah Advisory Panel to advise on Islamic rating products and rating definitions. 17. This differs from the practice of global credit rating agencies. They do not take into consideration the prohibitions against ribā-based financing and the same set of rating definitions are employed for both conventional and Islamic financial instruments. 18. The Islamic Capital Market Instrument Ratings assess the likelihood of timely repayment of the instruments issued under the various Islamic financing contracts. New products include Islamic ṣukūk, asset-backed instruments, Islamic non-fixed income instruments, investment quality ratings, and ṣukūk ijārah. 19. RAM Ratings Services is a public limited company and is wholly owned by RAM Holdings Berhad. Its ultimate shareholders comprise major financial institutions in Malaysia, Asian Development Bank and Fitch Ratings. It is the country’s leading credit-rating agency. As an external rating agency for ṣukūk transactions, it evaluates the financial strengths of obligor institutions with underlying ṣukūk structures, as approved by Sharīʿah scholars and thus involves both quantitative and qualitative analysis. It was voted as the top domestic rating agency in the Asia-Pacific by ADB and was named the most influential rating agency in the region. In 2006, RAM Ratings was designated the world’s second best Islamic rating agency as part of the Islamic Finance News Awards. 20. L.M. Noor, ‘Sukuk rating: General Approach, Criteria and Methodology’. 21. ‘Ratings: How Do They Do It?’ 22. Corporate credit ratings are a measure of a corporate’s intrinsic ability and overall capacity for timely repayment of its financial obligations. These are voluntary ratings that may be sought by companies to enhance corporate governance and transparency. These ratings are useful for benchmarking a company against its peers, enhancing investors’ confidence, market profiling, reduction in time taken for future debt ratings, enhancing a company’s standing for counterparty risk purposes, and facilitating evaluation for bank borrowings and bank lines. 23. The Sharīʿah compliance of the issuer is usually left to experts such as Sharīʿah advisors or Sharīʿah committee to determine; conversely, rating agencies do not have the mandate to give certification on Sharīʿah compliance or are restricted by their own policies. 112

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6 Concession Rights as Underlying Assets for S ụ ku‾k Sirajulhaq Hilal Yasini and Nermin Klopic

Introduction When an issuer intends to raise funds by means of the issuance of ṣukūk, having sufficient assets for backing the ṣakk’s issuance may be one of the most important elements. A key challenge for the fund raisers can be having sufficient tangible assets to back the issuance of their ṣukūk. The nature of ṣukūk assets may differ from issuance to issuance depending on the Sharīʿah concepts employed – such as ijārah, wakālah, istiṣnāʿ, muḍārabah, mushārakah, for instance. One type of asset used for a limited number of ṣukūk issuances until now is the ‘concession rights’ (ḥuqūq al-imtiyāz), which are intangible assets. Having the alternative to use intangible assets, which do not represent cash, debt, and receivables, as an underlying asset for ṣukūk not only helps the fund raisers overcome the asset constraints but will also help them develop the ṣukūk market further. This chapter aims to examine the Sharīʿah stand on concession rights, looking at various juristic opinions and key Sharīʿah requirements for its usability as an underlying asset for the issuance of ṣukūk; additionally, it will also analyse relevant case studies. Meaning and Background of ‘Concession’ Concession means ‘a grant’.1 As a technical term, the concept of concession means a right or privilege with preferential treatment granted by a government to a corporation or a private-sector company.2 The concept of concession has evolved from a simple ‘prioritisation’ and was used in legal jurisprudence with a variety of historical applications. For example, the Roman legal system granted ‘priority’ to some debtors over others, while the Napoleonic French code adopted the same concept and further recognised the ‘prioritisation’ of rights over specific types of land, and the Ottoman legal system granted judicial ‘immunity’ in 1536 to the citizens of France residing in Ottoman territory.3 However, the modern employment of concession was adopted by European legal systems in the late nineteenth century, a precedent that many Muslim countries absorbed into their legal 113

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systems. The notion of granting concession was then developed later to cover a wider area, including contracts granting rights related to public utilities and similar projects. The concept of ‘public utility’ was not known until the late nineteenth century when the railway industry was developed and electricity and gas distribution had begun. The concept of concession was further expanded to include contracts granting commercial concessions such as marketing rights.4 French law today defines the concession contract as ‘a contract according to which the state as a sovereign entity grants to a party the possibility to invest in a public utility or a public organisation that exists for public benefit.’5 The concession being essentially a legal concept remains a relatively new concept for Muslim jurists. The modern term of ‘concession’ translates the Arabic term imtiyāz,6 derived from verbal root māza/yamizu ‘to distinguish between two things’.7 The Qur’an states that ‘Allah will not leave the believers in the state in which you are now, until He separates (yamiza) what is evil from what is good.’8 The term imtiyāz is also used in Arabic to denote tafḍīl (preference), rifʿah (high rank, superiority), and infirād (singly, standing alone).9 At an early stage, the Muslim jurists had not known the concept of concession rights ḥuqūq al-imtiyāz in its modern context. However, they had known the concept of ‘prioritisation of rights’. The Prophet (peace be upon him) stated that ‘He who cultivates (barren) land not belonging to anyone, has more right (to its possession).’10 The second caliph ʿUmar (may God be well-pleased with him) implemented this principle by delivering such a judgment during his caliphate (13–23H/634–644CE).11 Similarly, the Prophet (peace be upon him) stated: ‘If a man finds his wealth assigned to a man gone bankrupt, he has more right to take it back than anyone else.’12 Muslim jurists also recognised the concept of prioritisation in rahn (pledge or lien), iqṭāʿ (temporary or permanent grant of land by the state), ḥimā (protected land for grazing), and taḥjīr (to put a stone and other things on the boundaries of land, so that other persons may not lay hands on it). 13 The Sharīʿah recognises the right of ḥimā. Ḥimā is a piece of land taken by the imām (the head of state) from unclaimed land that is reserved exclusively for grazing livestock. The Prophet (peace be upon him) protected al-Naqīʿ (an eight square mile area, 80 miles from Madīnah) for the livestock of his defending Companions. Al-Ṣaʿb ibn Jaththāmah narrated that the Prophet (peace be upon him) stated: ‘No ḥimā except for Allah and His Prophet.’ Al-Ṣaʿb states that, ‘We have been told that Allah’s Prophet made a place called al-Naqīʿ as ḥimā, and (the second caliph) ʿUmar made al114

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Sharaf (a place near Makkah) and al-Rabadhah (a place between Makkah and Madīnah) ḥimā (for grazing the animals of zakāh).’14 This is a sort of imtiyāz or concession over land granted by the state for grazing livestock of charity. Given no ḥimā can be made except for Allah and his Prophet as per the above evidence from the Sunnah,15 Imām Shāfiʿī argues that ḥimā can be made by the Prophet or one who takes his place in the Muslim state, such as the caliph and governor.16 The above text gives evidence for the general authority of the Islamic state to grant concessions. We will mention iqṭāʿ below but will bypass the historical evolution of the concept of concession in Islamic jurisprudence, and instead discuss its contemporary usage. The most recent recognition of the modern use of concession rights is in the concession contracts’ Sharīʿah standard issued by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The standard defines the concession as ‘the act of an authorised party granting another party the right of utilising, establishing, or managing a project for an agreed upon consideration.’17 The AAOIFI limits the scope of its Sharīʿah standard to three types of rights granted by the state only, thereby ruling out the rights related to licensing and franchises: istighlāl (utilisation or development); inshā’ (originating or constructing); and idārah (administering or management of projects).’ Our study will examine these three types of concession rights in turn. It will also explore the possibility of employing other types of concession rights for the issuance of ṣukūk by both the state and the private sector with case studies of ṣukūk transactions using concession rights as underlying assets for ṣukūk.

Types of Concession and Their Juridical Conditions Concessions may be classified in accordance to the position of the right granted by the state into four main types: the utilisation concession; originating concession; management concession; and franchise and licence concession. There are other types of rights that may come under ḥuqūq al-imtiyāz, such as intellectual property, trademark, trade name, marketing rights, contracts of supply, and rights of exclusive production and services. These rights are modern concepts and have value in today’s customs. The Sharīʿah basis of juridical conditions (al-takyīf al-fiqhī) for concession contracts depends on and differs according to the subject matter of the contract (the activity of the underlying pursued project).18 We provide a brief explanation of each type here. Utilisation Concession The utilisation concession contract (istighlāl) is an agreement between 115

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the state and a natural or legal person (institution), according to which the latter becomes the sole owner of the right of extracting and producing the minerals, water or any other object in question against a specific remuneration. The holder of a utilisation concession is entitled to undertake all activities required for utilisation, such as establishing refineries and treatment laboratories, acquiring transportation devices and facilities. The holder becomes the sole owner of such rights throughout the period of the concession licence thereof.19 The utilisation concession requires exploration, which entails an unknown amount of effort and work needed. The remuneration to which the holder of such concession is entitled, on the other hand, is stipulated either as fixed amount or a portion of the production. ‘The Sharīʿah classifies such contracts as a form of compensation or wage termed juʿālah, where the state initiates the provision of juʿālah, the licensee institution is the hire party, and the specific amount to be received by the latter is the compensation amount.’20 This Sharīʿah perspective is in line with what was stated by classical scholars concerning juʿālah. For example, when defining juʿālah, Ibn Rushd stated that, ‘The wage (al-juʿl) is leasing of usufructs which are assumed to result.’21 Ibn Qudāmah provided a more detailed explanation by stating that: Juʿālah is (a contract) wherein one party offers a specified compensation to anyone who achieves a determined result, such as returning a fugitive individual or a stray animal or constructing (a structure) or tailoring (clothes), and other types of work and services where leasing is permissible.22

These two citations show that the amount and kind of work in juʿālah is unknown on account of the services required for returning a fugitive individual or recovering a stray animal which cannot be determined in advance. Accordingly, the utilisation concession takes the form of juʿālah in the case of necessary work undertaken for exploration of, for instance, oil and water being indeterminate until actually undertaken for a specific consideration. The Mālikīs also allow contracting on the exploration of mines for a portion of its production 23 and further allow a case where the state grants the concession for a known amount (ujrah) to be paid by the concessionaire (the holder of a concession contract) to the state and the concessionaire keeps whatever it explores. Ḥanbalīs do not allow the latter case due to the lack of knowledge (jahālah) about the subject matter as it is not clear how much the concessionaire will explore. Mālikīs also do not deny the jahālah in this case, but say this is akin to gift (hibah) and hibah is allowed with jahālah.24 116

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Origination Concession The originating concession (inshā’) contract is an agreement ‘between the state and another party, according to which the latter constructs a specifically defined project usually related to public utilities’.25 The right to use the constructed project for a specific period before handing it over to the state represents the return of the concession holder, and therefore one is entitled to the collection of fees or remunerations for providing services to the public. This is similar to the Build Operate and Transfer (BOT) contract, an ‘arrangement in which the private sector builds an infrastructure project, operates it and eventually transfers ownership of the project to the government’.26 In some BOT arrangements, the government assumes ownership after an agreed timeline and in others the government does not assume ownership of the project. In the latter case, the concessionaire continues running the project facility and the government may act as both the concession grantor and regulator. An origination or construction concession may be categorised into three sub-varieties as follows: The first is ijārah (leasing): ‘In case the concessionaire hires the land from the state with the aim of constructing the project thereon and presenting the project back to the state based on al-ijārah al-muntahiyah bi al-tamlīk (rental culminating in ownership).’27 Waleed Bin Hadi sees a concern in this form if the land is leased to the concessionaire for a deferred rental because the manfaʿah (usufruct) might be unknown at the time of contracting.28 This concern, however, can be addressed by specifying the usufruct of the land and the purpose of its use and the rental can be deferred as long as it is specified and known, as Waleed also agrees. The second sub-variety is istiṣnāʿ (commissioned production): if the concessionaire contracts for establishing a construction providing building materials, then the contracts take the form of istiṣnāʿ (commissioned production). Operating the project by concessionaire after its completion and benefiting from its revenues is a consideration for construction of the project. Constructing a structure as well as providing needed materials are the main characteristics of istiṣnāʿ – as pointed out by the Ḥanafī jurist Kāsānī, who wrote: The procedure of istiṣnāʿ is for the person to make a request of a maker – of shoes or vessels, etc. – by saying, ‘make for me shoes or vessels from your leather or copper, for this price’, while showing and describing the type and amount and manner of the object needed. So the manufacturer agrees to it.29

Kāsānī’s words ‘make for me … from your leather or copper’ refer to the raw material provided by the manufacturer. The consideration can be a 117

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monetary amount as well as the manfaʿah of the constructed project item according to the majority of jurists, other than Ḥanafīs. Ḥanafīs are of the view that this may lead to a dispute because the consideration is unknown.30 Mohammad Daud Bakar, a contemporary scholar, allows agreement on a specific return for concessionaire during the operation of the project after being built with an undertaking from the concession provider to cover any shortfall in the agreed return from the operation of the project. This will address the concern of a possible dispute that may arise if the consideration is not specified. The consideration can be linked to a benchmark as is acceptable in al-ijārah al-muntahiyah bi al-tamlīk.31 Sheikh Muhammed Taqi Usmani, however, disagrees with this analogy and says the manfaʿah (which is a consideration in this example) does not exist when istiṣnāʿ is entered into, unlike al-ijārah al-muntahiyah bi al-tamlīk where the manfaʿah is available at the time of entering into the contract. Waleed Bin Hadi believes the existence of the manfaʿah is not necessary at the time of entering into istiṣnāʿ, because istiṣnāʿ is the sale of a non-existent and its consideration can be non-existent, too, unlike ijārah, which is the sale of available usufruct and, therefore, the consideration shall also exist.32 The third sub-variety is mushārakah (partnership). It can be diminishing mushārakah, where ‘the institution contributes a share in the required capital, while undertaking that the institution or party, which executes the concession license, shall sell its share in the project gradually to the state’, or it can be on a fixed mushārakah basis, where ‘the institution contributes a share in the required capital besides the State or the party that executes the concession licence, the mushārakah continuing up to the end of the contract period.’33 Management Concession The management concession (idārah) contract is an agreement ‘between the state and other parties according to which the right of managing public utilities and providing services to the public is given against a specific price.’34 The management concession may take one of two forms. The first is when the price for offering the management concession is determined as a lump sum of money or as a percentage of total income, then the contract between the state and the concessionaire is that of ijārah.35 Muslim jurists have stated that one of the conditions for validity of ijārah is determination of the return or compensation (al-ʿiwaḍ),36 and thus the determination of the price with a fixed amount or percentage of total income for management services to be provided by the concessionaire – in the form of ijārah or leasing.

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Secondly, ‘if the price of the management concession is a percentage of the profit [i.e., net income after expenses and allocations], then the contract between the state and the concessionaire becomes one of muḍārabah (commenda partnership), wherein the capital is the original facility or the project itself.’37 This is supported by what is mentioned by scholars in defining muḍārabah, when they state that: Muḍārabah consists of giving property to another individual in order to trade with it, while the profit will be shared between them. […] The validity of muḍārabah is conditional upon determining the entrepreneur’s share in net profit on a percentage basis, just as the Prophet Muḥammad (peace be upon him) concluded an agreement with the people of Khaybar by sharing equally with them the yield (of agricultural production), which is parallel to the case of muḍārabah.38

Franchise and Licence Franchise is a ‘special privilege to do certain things conferred by government on individual or corporation, and which does not belong to citizens generally of common rights’.39 It can also be a licence from the state permitting the licensee to benefit from the granted privilege for a consideration or fee. This type of concession can be granted to produce certain products (medicine for instance) or a product line such as agriculture products exclusively. It can also entail granting concession to provide certain services such as telecommunication, electricity, hospitality services, post, railway, airline landing rights, exclusive air, rail, and sea terminals, pipelines, etc. It can also take the form of marketing rights exclusively granted to a party or a contract of supply. Iqṭāʿ is a well-known concept in the Sharīʿah. It means the state (imām or head of state as mentioned in books of jurisprudence) has the right to grant the usufruct or ownership of an undeveloped land to some citizens.40 The Prophet (peace be upon him) has granted land to al-Zubayr ibn alʿAwwām from the undeveloped land of al-Naqīʿ in Madīnah. Al-Shawkānī says that the Prophet (peace be upon him) granted the mines and land capable of being cultivated for agricultural purposes to Bilāl ibn al-Ḥārith al-Māzanī.41 Al-Shawkānī also narrates from ʿAyyāḍ that iqṭāʿ means a grant by the imām from the wealth-property (māl) of Allah, to those whom he deems eligible, and is mostly used in lands and what is extracted from the land: ‘The grant is either by giving him ownership or granting him usufruct for a specific time period.’ 42 Accordingly, if the state is permitted to grant the māl of Allah to the deserved ones, it can grant the franchise and licence of objects and commercial activities to individuals and corporate entities. This helps the state to fulfil its duty of developing the necessary infrastructure and to serve the people as part of its obligations. 119

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The contract of granting franchise and licence becomes a gift (hibah) if granted free of charge and becomes juʿālah if granted for a fee paid to the concessionaire by the state. The contract between the state and the concessionaire can be one of muḍārabah if profit ratios are specified, wherein the capital is the franchise or licence itself. This is supported by what is mentioned by scholars in defining muḍārabah, for instance, ‘Muḍārabah consists of giving property to another individual in order to trade with it, while the profit will be shared between them.’43 Private Sector’s Ḥuqūq al-Imtiyāz There are rights owned by the private sector that can be tantamount to the level of concession granted by the state as they both are intangible rights capable of being granted to others by the owners of these rights for a consideration. Some of these rights are as follows: Intellectual property: various forums of Islamic jurists, including the Islamic Fiqh Academy of the Organisation of the Islamic Cooperation and the Islamic Fiqh Academy of the Muslim World League, have recognised the entitlement of an author and inventor to the ‘right’ of their intellectual property and inventions, and ruled that it is ‘owned by them according to Sharīʿah’ and that others cannot take them without their permission.44 Trademark and trade name have also been recognised as rights that should be protected. Their owners have concession or imtiyāz over them. They can be transferred for a consideration as long as they are Sharīʿah-compliant and the transaction is free of gharar (deceptive ambiguity), jahālah (lack of knowledge), tadlīs (hiding defects), ghish (deception and fraud), and other prohibitions in Sharīʿah.45 The trademark and trade name include the private sector’s franchise and licence right that is [a] ‘licence from owner of a trademark or trade name permitting another to sell a product or service under that name or mark on terms and conditions mutually agreed upon’.46 Marketing rights: These can originate from a contract or contracts that a company may sign with other companies granting them certain marketing rights. These rights have a value as the company will generate revenues from the distribution of products for example. The concessionaire can transfer these rights to others in a sale contract for a consideration or may enter into juʿālah or into mushārakah and muḍārabah using its rights as a contribution in such partnerships. Sharīʿah Ruling of Concession Based on the above Sharīʿah conditions, we may conclude that the basic ruling regarding concession contracts is that they are permissible due to the fact that the above-stated forms do not depart from financial transactions 120

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that are valid according to the main sources of Islamic law. For reasons of space, we can only briefly elaborate on the Sharīʿah rationale for each of those contracts. The validity of juʿālah (offering a reward to an unspecified worker) is evident from both the Qur’an and Sunnah. As for the Qur’an, the evidence is in the story of the Prophet Yūsuf (peace be upon him) and his brother after the announcement of the loss of the King’s great beaker: ‘For him who brings it is the (reward of) a camel-load; I will stand surety for it’ (Yūsuf 12:72). With regard to the Prophetic Sunnah, the evidence is in the ḥadīth from Abū Saʿīd al-Khudrī concerning the stipulation of reward if the chief of the tribe was cured through him and the Prophet Muḥammad (peace be upon him) approved it by stating ‘you do not know it is a ruqyah (magical incantation); take your reward and also give me one part from it.’47 Ibn Qudāmah has stated, within the context of establishing the validity of juʿālah, that: Given that there is a need to recover stray animals and the like, juʿālah is valid as a type of ijārah or leasing. Nevertheless, Islamic law allows compensation to an undetermined worker or service provider and for anonymous work. For example one says: ‘Whoever brings back my lost animal will be rewarded with such and such a reward.’ The Sharīʿah foundation for this transaction is based on the Qur’anic verse in Yūsuf 12:72, and means it is required although the work is unknown. For this reason, it is deemed permissible, just as with muḍārabah. Yet, the consideration shall be determined upfront as it is an exchange contract, and the price in every exchange contract must be known since it is a case of ijārah leasing. Consequently, offering an uncharted price in juʿālah invalidates it, while the worker will be entitled to a service fee according to custom because this is a transaction where a predetermined upfront amount is to be paid provided the contract is valid – or otherwise a customarily known fee for similar work in case the contract is invalid, as in ijārah.48

We may mention that the validity of juʿālah is accepted by the Mālikī,49 Shāfiʿī50 and Ḥanbalī51 schools of law, whilst the legality of ijārah leasing is unanimously agreed among all four schools of law,52 based on varied and combined evidence in the Qur’an and Sunnah. Several examples are found in Qur’an, such as al-Ṭalāq (65:6): ‘then if they give suck to children for you, give them their due payment...’. Elsewhere, it is stated: ‘said one of them, “O my father, Hire him! Verily, the best of men for you to hire is the strong, the trustworthy.” He said: “I intend to wed one of these two daughters of mine to you, on condition that you serve me for eight years...”’ (e.g., al-Qaṣaṣ 28:26–7). 121

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Furthermore, in al-Kahf (18:77), it is stated that Then they both proceeded until, when they came to the people of a town they asked them for food, but they refused to entertain them. Then they found therein a wall about to collapse and he [al-Khidr] set it up straight. (Moses) said: ‘If you had wished, surely, you could have taken wages for it!’

All these verses indicate the permissibility of taking a fee for services provided and work done. With regard to proof texts from the Sunnah, the authority for legitimacy of ijārah is taken from the following statement of the Prophet (peace be upon him): ‘Whoever hires a worker shall inform him of his wages.’53 Furthermore, during the Prophet’s migration with Abū Bakr from Makkah to Madīnah, an experienced guide from the Banū al-Dīl was hired.54 The authority for legitimacy of muḍārabah is based on the Qur’an and the consensus (ijmāʿ).55 The Qur’an states: ‘… and others who may travel through the land, seeking Allah’s bounty’ (al-Muzammil 73:20). The term muḍārib may also connote traveling for the purpose of trading and seeking permissible income in order to provide for oneself and one’s family. Elsewhere the Qur’an states: ‘Then when the ṣalāh [Friday prayer] is ended, you may disperse through the land and seek the Bounty of Allah (by pursuing livelihood), and remember God much, that you may prosper’ (al-Jumuʿah 62:10). Another verse mentions: ‘There is no sin on you if you seek the Bounty of your Lord (during pilgrimage by trading)’ (alBaqarah 2:198). The consensus is narrated from a group of Companions (may God be well pleased with them) that they had invested the wealth of orphans through muḍārabah. This is reported from the caliphs ʿUmar, ʿUthmān and ʿAlī, as well as from ʿAbdullāh ibn Masʿūd, ʿAbdullāh ibn ʿUmar, ʿUbaydullāh ibn ʿUmar, and the Prophet’s wife ʿA’ishah (may God be well pleased with them all). At the same time, no report conveys an objection by any of their peers. Hence, this issue is deemed to satisfy the parameters of the consensus of the Companions.56 Finally, istiṣnāʿ is also deemed permissible as an established contract. In this context, the leading Ḥanafī jurist al-Kāsānī stated this when declaring its permissibility:57 With regard to the validity of istiṣnāʿ: as for analogical deduction (qiyās),58 this would indicate its invalidity, since it involves the sale of what is not possessed (by the seller) – and it is different from the case of salam (forward sale), as in salam only one of the two countervalues is non-existent.59 The Prophet (peace be upon him) prohibited selling what the seller does not possess, whereas he approved the forward sale of salam. 122

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So istiṣnāʿ is validated by means of istiḥsān (juristic preference),60 and by the consensus of people since they are implementing istiṣnāʿ without anyone having denied its validity. For the Prophet has stated, ‘Whatever is deemed acceptable by all Muslims is also acceptable to God, and whatever is considered unacceptable by all Muslims, it is also unacceptable to God.’ Thus, analogy is ignored because consensus is unanimously preferred. For this reason, the validity of qiyās is also upheld in the case of charging a fee for using a public toilet, although the period of time and amount of water used may be unclear. Qiyās is also upheld for determining the amount of water drunk, or the sale of plants (e.g., onions) whose yield is hidden in the soil. Istiṣnāʿ is also validated in order to meet people’s need for socks, slippers or sandals, for instance, made from particular materials with specific characteristics. Due to the need for such products to be made or manufactured, the prohibition of ‘commissioned production’ would cause harm. This answers the objection that the specified items in istiṣnāʿ do not yet exist, since the non-existent receives the ruling of existent items according to need. Likewise, in the salam or rendering of a security deposit, although the item does not yet exist during the contracting session, it is not included in the prohibition of selling something not possessed by the seller. Furthermore, istiṣnāʿ is valid, since it embraces the meaning of two permissible contracts – namely, salam and ijārah – by virtue that the notyet existent item in salam is sold on a description basis, and the validity of hiring producers is conditional upon labour. Hence, whichever transaction embodies two permissible contracts is itself also permissible. Finally, we note that istiṣnāʿ was discussed and approved in the Second Meeting of the OIC Fiqh Academy.61

Tas ̣kīk (Securitisation) Taṣkīk is an Arabic term for ‘securitisation’– the infinitive noun of the second verbal form – while its root form is the verb ṣakka/yaṣukku. This meaning for taṣkīk is a neologism not attested to in classical juridical sources. The verb ṣakka denotes ‘striking a thing hard with something else’, or ‘slapping someone with one’s hand’,62 while its infinitive noun is ṣakkun – with plurals ṣikāk, aṣkūk and ṣukūk (often now transcribed in English as sukuk, and sometimes employed as a generic singular).63 In classical Arabic legal usage, the noun ṣakkun signifies a document recording and certifying a financial or commercial transaction or the like.64 Ṣakk has been originally defined to denote ‘a written acknowledgement of a debt of money or property, or of some other thing; and a written statement of a commercial transaction, purchase or sale, transfer, bargain, contract, or the like.’65 123

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In commercial usage today, ṣukūk are technically defined as: Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct or services, or (in ownership of) the assets of particular projects or specific investment activity; this applies after acquisition of the value of the ṣukūk and the closing of subscription, beginning with the employment of funds received for such purpose for which the ṣukūk were issued. Ṣukūk meeting this definition are known as ‘investment ṣukūk’ (al-ṣukūk al-istithmārīyah), in distinction from shares and conventional bonds.66

More specifically, taṣkīk (in the meaning of securitisation) is defined as ‘the registration and transfer of assets recorded in papers, certificates, and commercial papers, which are characterised by the attributes of liquidity, tradability, and (their) cash value.’67 This definition reveals that the most important feature of ṣukūk is representation of undivided shares of the underlying assets or usufruct. In other words, ṣukūk is merely a veil for an asset, and therefore purchasing ṣukūk equals buying an item or asset. The term taṣkīk is used in this context throughout this chapter. At this point, the following question is raised: which types of existing items may be thus securitised? To answer this we may classify those assets and benefits eligible for securitisation into the following four groups: 1. Tangible Assets (al-aʿyān): this includes two types – real asset and capital goods that include immoveable and moveable assets; and nonfinancial traded assets. With regard to the former, immoveable assets cover building premises, land or movables such as cars, appliances and machinery intended for use by the business entity. Non-financial traded assets that cover goods intended for trade such as agricultural produce, industrial products, medical equipment, for instance. 2. Usufructs (al-manāfiʿ): including usufruct (i.e., authorised use of another’s property or holdings for one’s own advantage) and services. 3. Intangible rights (al-ḥuqūq al-mujarradah): such as concession, franchise, license, trade mark, trade name, intellectual property, marketing rights and contracts of supply. This type of underlying asset shall be elaborated upon in more detail in this study. 4. Cash and debt.68 Cash is usually not securitised in Sharīʿah-compliant transactions as this is only done in conventional bonds that promise the payment of interest over the funds raised from the bond holders. Debt, however, can be securitised in the form of securitising receivables, murābaḥah-deferred payments, price paid for goods in salam and istiṣnāʿ. Thus in terms of representing assets and debts, ṣukūk may generally be 124

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divided into two major groups: asset ṣukūk; and debt ṣukūk. Asset ṣukūk represent ownership of tangible assets, usufructs or services. They are tradable in the secondary market and thus can be purchased for premium or discount because: 1. Ṣukūk al-muḍārabah represent interest in projects or activities that generate profit on the basis of muḍārabah. The manager (muḍārib) and ṣukūk holder (rabb al-māl), i.e., capital owner, are entitled to a proportional share from the net income. 2. Ṣukūk al-mushārakah represent interest in projects or activities that generate profit on the basis of mushārakah. The partners (the managing partner and ṣukūk holders) both contribute to the partnership and are entitled to a proportional share from the net income. 3. Ṣukūk ijārah represent interest in the usufruct of leased assets, or assets promised eventual possession of through being leased. Ṣukūk holders are entitled to rentals for the length of the lease period. The more frequent practice are rentals promised to conclude in ownership by the lessee (al-ijārah al-muntahiyah bi al-tamlīk). 4. Usufruct ṣukūk (al-manāfiʿ) represent authorised use of another’s asset for one’s own benefit or advantage. Usufructs are similar to ṣukūk ijārah from the perspective of legal rulings. The only difference is that here the ṣukūk holders take possession of the usufruct or profit of an asset, but not of the asset itself. In ṣukūk ijārah, in contrast, the holders of the ṣukūk ultimately come into possession of the leased asset itself. 5. Service ṣukūk (al-khidamāt) represent interest in well-described services to be provided as a future obligation, or a specific purpose, for example, ṣukūk representing teaching duties at a university. Here, the service provider will be paid out of the funds received from the ṣukūk holder. Once the ṣukūk holders own the services, they are then entitled to sell them for a profit. Debt ṣukūk refer to investments in which the funds raised through ṣukūk issuance end with debt. As long as ṣukūk represent a debt, according to majority jurists, they cannot be traded in the secondary market.69 Instances of this group are: 1. Ṣukūk al-murābaḥah (via resale with an advance) represent investments whereby funds received through ṣukūk issuance are then used for purchasing an asset; in other words, the asset is sold on a deferred payment basis and the ṣukūk holders become entitled to the deferred sale price (receivables) of murābaḥah. Therefore, it cannot be traded for a premium or discount. 125

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2. Ṣukūk al-salam represent the capital goods of salam that will eventually be owned through ṣukūk issuance, by the ṣukūk holders when produced. Once the deposit for securing the asset in such a salam transaction is paid, the ṣukūk will then represent a debt until a reasonable part of ṣukūk proceeds are transferred to illiquid assets, i.e., a reasonable portion of salam assets is produced. 3. Ṣukūk al-istiṣnāʿ represents capital raised through ṣukūk issuance through securitisation of the products of istiṣnāʿ consisting of a commissioned production transaction. Similar to the ṣukūk al-salam, once the payment of price is made, the ṣukūk then represents a debt until a reasonable part of the ṣukūk proceeds are transferred to illiquid assets, i.e., a reasonable portion of istiṣnāʿ assets are manufactured.70

Tas ̣kīk of Concession Having elaborated upon the Sharīʿah rulings of concession and certain basics of taṣkīk, we have now established a platform to support the main focus of our study – namely, the Sharīʿah ruling on securitisation of concession rights (taṣkīk ḥuqūq al-imtiyāz). These rights can be the subject of taṣkīk in two forms: • taṣkīk of rights directly by source originally owns these rights such as the issuance of ṣukūk by a state directly granting a concession to ṣukūk holders; • and taṣkīk of concession by the concessionaire after receiving the concession from the grantor. In both scenarios, the concession needs to be transferred to ṣukūk holders as part of the taṣkīk arrangement. 71 A distinction between the taṣkīk of Sharīʿah contracts such as juʿālah, ijārah, istiṣnāʿ, mushārakah, and muḍārabah and the taṣkīk of associated rights shall be made. In the context of taṣkīk, the intention is to securitise the underlying rights and benefits with or without the associated assets that may come with the original concession. A Sharīʿah contract itself is the description of the arrangement between the concession grantor and the concessionaire and when the rights are transferred by concessionaire to someone else, the latter may or may not replace the concessionaire in the initial relationship with the grantor. The search for a ruling on taṣkīk of concession leads one to the issue of the legitimacy of transferring intangible rights for consideration. Generally, permissibility or impermissibility of this issue is based on: the proper Sharīʿah perspective on these rights – whether they can be regarded as wealth-property or not; and the possibility of stipulating their characteristics with the aim of eliminating ignorance and gharar. Before 126

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entering the discussion of this topic, we will examine the classification of rights in terms of its underlying assets, and afterward, we shall address the Sharīʿah perspectives on these rights, deriving their ruling from rulings on parallel examples that were studied by the classical jurists. Intangible rights (al-ḥuqūq al-mujarradah) are those rights not fixed in place, meaning that no established effect ensues from the relation of such a right to its underlying position, which would vanish if the right is waived. This right arises solely from its possessor and his will – he will exercise the right provided it is beneficial for him, otherwise he will waive it, without his waiving causing any change in the authority of his position. For example, the right of pre-emption is in reality a type of authority belonging to one who exercises pre-emption – e.g., whether to possess an immovable asset before it is possessed by a purchaser. Ownership of this asset by the bearer of the right to pre-emption before waiving his right to pre-emption is exactly the same as before the possessor’s waiving it. Accordingly, this right is not related to the underlying position except through this type of relation. The possessor of the right of pre-emption cannot restrict disposing or using of the asset by the owner or a prospective purchaser. Hence, it is exactly the same before and after the waiving. The same applies to the right of traversing with regard to a road, or the right of custody of wealth in regard to wealth. Tangible rights (al-ḥuqūq al-ghayr mujarradah) are rights having a fixed relation to their underlying position with an established effect which would vanish if that right is waived. For example, the right of retribution (qiṣāṣ) is related to the person of the killer and his next of kin. Given this relation, the killer will be subjected to punishment before the waiving of the right of pre-emption by the aggrieved party or his relatives, whereas the opposite would be true after their waiving that right.72 There are several classifications of rights, including: financial and nonfinancial rights; personal and property rights; and tangible and intangible rights. We shall focus on the latter classification, since it is most relevant for this study. Now, the utility of this twofold classification of rights is evident in what follows: The ‘tangible right’ may be waived in exchange for monetary payment, such as the right of retribution, and the wife’s right (in divorce) – it is valid for the guardian of the slain one, or for the husband, to be compensated for waiving of their rights through reconciliation (bi al-sulḥ); whereas such monetary compensation (for waiving rights) is impermissible for ‘intangible rights’ as in the case of the right of authority over someone’s life or wealth-property, or the right of pre127

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emption. This is the view of the Ḥanafī law school, whilst the other three (Sunnī) schools deem it permissible.73

One reason behind this ruling by the Ḥanafī school is they do not consider these rights to be māl (wealth-property). Accordingly, they have explicitly prohibited selling certain kinds of rights, such as the right of raising high (a building) or the right of flowing of a water course. In such contexts, alKāsānī opined that, ‘If the lower and upper floors (of a structure) collapsed, it is impermissible for the owner of the upper floor to sell his/her elevated space since air and altitude are not deemed to be wealth-property – because wealth-property must be capable of being possessed.’74 Other Ḥanafī scholars, however, have held a differing view. For example, in the classic legal manual al-Hidāyah it is stated that the ‘sale and donation of a pathway or passage is permissible, while the sale and donation of the watercourse flow is invalid.’75 This statement shows that some Ḥanafī scholars distinguished between the right of passage and the right of water flow. Clarifying the reasoning behind this important distinction, Shams al-Dīn al-Siwāsī stated that: There are two probabilities in terms of this issue: the sale of tangible assets, in this case a passage and watercourse flow; or the sale of the use of the passageway for passing, and right of using the flow for watering. If the first possibility is meant, the difference is that characteristics of a passage or road may be determined like length and width, whereas this cannot be stipulated in terms of water flow as one cannot know how much water will pass through the watercourse or channel. In respect to the second possibility, there are two reported opinions regarding the right of passage. According to one of them, the difference between right of passage and right of flow is that right of passing may be determined in relation to a known site or location, which may be the road. With regard to water flow over the roof, it is similar to the right of altitude (transacting of which is impermissible); while water flowing over the ground is unknown due to the fact that the amount of ground to be covered with water cannot be specified. Nonetheless, the difference between right of passage and right of altitude, based on one report, is that the right of altitude is related to a tangible object, namely the building, and is therefore comparable with usufructs. On the other hand, right of passage is related to a continuously existing object, namely the ground, and is therefore identical with tangible assets.76

From this citation we may conclude that the main concern of this Ḥanafī scholar was the indetermination of characteristics of the right of water flow. In other words, since their features cannot be clearly stipulated it may 128

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lead to violation of the Sharīʿah objectives of preserving harmony between people and the avoidance of a dispute. Hence, the underlying cause of prohibiting the right of water flow is uncertainty of its characteristics. Concerning the right to sell irrigation water, there are also opposing views reported from classical Ḥanafī scholars. Discussing this matter, alSarkhasī said that: Sale of irrigation water is invalid, as it is like selling descriptive features of an item, and such features may not be transacted. Furthermore, it is unknown in itself and cannot be easily delivered, owing to the inability of the seller to know whether the water would flow or not; for one is usually not able to influence this flow.77

However, al-Sarkhasī also stated that there are some Ḥanafī scholars who approved of this transaction, commenting that: Some later generations among our scholars have approved the sale of irrigation water, even when one does not possess land, basing this ruling on the explicit custom in some countries. This is a well-known custom in Nasaf [Transoxiana]. They opined: istiṣnāʿ leasing is licit based on the customary dealings of people, although it is inconsistent with qiyās, likewise for sale of irrigation water without possession of the land.78

From this quotation, we may deduce that the inability to safeguard the right of sale of irrigation water was seen as another underlying factor. In sum, the two derived underlying causes are: uncertainty over qualifying the characteristics of an intangible right; and the inability to deliver it – both of which are the main components of gharar. In contrast to the Ḥanafī legal school, the majority of jurists have adopted the permissibility of transacting usufruct forever and of selling intangible rights, except when such transactions embrace certain Sharīʿah impediments. Scholars of the Mālikī, Shāfiʿī and Ḥanbalī juridical schools have explicitly stated the legitimacy of selling some types of intangible rights. In the following paragraphs some instances are provided of their views. The prominent Mālikī scholar al-Dardīr once stated that: It is permissible to sell the upright air measured in mudd [a dry measure] – that is, the space lying above the air – if one says to the owner of a piece of land: ‘sell me ten arms-length of what grows upon your land,’ and providing clarification by saying: ‘the lowest, or the highest’, or by determination through customary practice. It is lawful due to the absence of ignorance and of gharar. The seller will own the entire air space above the building, but he is not allowed to build on 129

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air space which covers some object attached to the building unless one gets permission of their owners. It is permissible to transact to build inside a pillar. This includes both building a pillar into a wall through leasing or selling, and to build in an onyx (pillar).79

Further, in the large Mālikī collection Mudawwanah of Saḥnūn, it is stated: With regard to rulings on selling a right, such as the right to sell irrigation water, is that permissible? Mālik b. Anas said: ‘Yes it is permissible. If I sell you that right, then I am selling the basis of watering.’ If I possess only one day out of twelve [i.e., access to the water flow], is that lawful according to Mālik? He answered: ‘Yes.’ I [Saḥnūn] said, in the case of my not buying its basis, but only the right to watering – that is, on that day the irrigation right belongs to me, and I sell (that right) to somebody – is that permissible by Mālik? He answered: ‘Yes.’80

Moreover, the Shāfiʿī scholar Sharbīnī when defining sales agreement, declared that ‘some define a certain financial transaction as possessing ‘forever’ an intangible asset or usufruct. Usufruct embraces sale of the right of passage and the like, whereas leasing is excluded by the word ‘forever’.’81 His words ‘right of passage and the like’ indicate permissibility, for, in the Shāfiʿī legal school, abstract or intangible rights are regarded as wealth property, and thus it is valid to transact them. Similarly, in the definition of financial transaction in Ḥanbalī jurisprudence it is stated that: Sale is exchanging of wealth-property, even when if only by description, concluded orally or silently. Wealth-property is every object with permissible usufructs, but not only in case of need, or permissible usufruct in abstractum, like the right of passing through a house or somewhere else. The wealth-property or usufruct in the sale agreement is exchanged for either the wealth-property or the usufructs.82

Al-Bahūtī, in his Kashshāf, stated: It is valid to buy a passage-right owned by another individual, regardless as to whether it is in a house or something else; or to buy a portion of a wall in order to build in a door; or to buy a piece of land to excavate a well, provided it is permissible. By virtue of that targeted benefit, it is valid for it to be transacted like sale of a house. It is also permissible to buy the upper part of a house to build on it a determined structure, or to place on it determined pillars, because (the upper part with its space) belongs to the seller. When we say ‘determined’ that means well depicted and known. A similar ruling applies if the house of the purchased upper part is not yet constructed, provided the upper or lower part is well determined and described. This transaction is 130

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permissible as the subject matter is possessed by its owner, and hence he has the right to be compensated for it. Therefore, it is lawful to own a passage that lies (within property) possessed by somebody else, or a piece of a wall in order to build in a door, or a piece of land in order to dig in a well, or the upper part of a house in order to build (a higher structure) upon it, or to erect upon it pillars forever–all of which cases are a sale in reality. Should the building or pillars be removed (by someone), the purchaser has the right to replace them because he deserves this right in exchange for the price he paid. This ruling applies regardless as to whether the pillars, or the house, or the wall, fall down or are destroyed. The owner of the house has the right to negotiate and seek to reconcile with another to remove the upper part from the house, or to reconcile with him not to replace the pillars after they fall down, regardless as to whether the amount he offers for reconciling is more, similar or less than the amount paid to him by the owner of that right–as this compensation is deserved usufruct by the owner and thus is permissible for whatever they mutually agree upon.83

To conclude, there is disagreement between the juridical schools over the terms of transacting abstract or intangible rights. The majority of scholars, including Mālikī, Shāfiʿī, Ḥanbalī and certain Ḥanafī scholars, approve of it on the authority that these rights are considered as wealth property and hence they may be bought and sold. By contrast, the Ḥanafī legal school disagrees with the majority by claiming that sale of these rights involves prohibited elements in financial transaction including ignorance and gharar. Looking at the reasoning offered for both views, we may conclude that the preferred view is that of the majority for the following reasons. The fundamental ruling in financial transactions is permissibility. The Qur’an (al-Anʿām 6:119) states: ‘while He has already explained to you in detail what is forbidden unto you....’ Commenting on this verse, ʿAbd al-Raḥmān Saʿdī states that: This noble verse indicates that the basic ruling in all existing things and foodstuffs is that they are lawful. Also, the verse implies that whatever is not prohibited by the Sharīʿah, remains in its basic ruling of lawfulness. For this reason, things about which the Sharīʿah is silent are deemed permissible since Allah has detailed and clarified each and every prohibition. Accordingly, things not included in these prohibitions are indeed permissible.84

The verse indicates that the basic ruling in all things, including financial transactions, is lawfulness. Once this basic ruling is identified in a particular issue, it is obligatory to observe it until evidence bearing similar weight is identified, which therefore indicates a different ruling, given that certainty cannot be removed by doubt. The great legal thinker al-Shāṭibī observed: 131

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The enduring principle for distinguishing between worship and interpersonal relations is that the basic regulation for acts of worship is to serve God, without regard to their effective benefit or significance. For the basic regulation consists of not undertaking any ritual except by leave of the Lawgiver since the human mind is not allowed to create rituals, and likewise those conditions connected to it. By contrast, in regulation related to interpersonal human relations, it is sufficient for its lawfulness not to be prohibited, since it is based on taking its meaning into account and not the mere worshiping. Thus, the basic ruling in these relations is license until Sharīʿah evidence indicates the opposite.85

Absence of any evidence in the Qur’an, Sunnah, consensus or disciplined qiyās that show the impermissibility of transacting abstract or intangible rights is a clear indication that the lawgiver did not prohibit it. The second reason is that the Companion Abū Dardā’ recorded the Prophet (peace be upon him) saying: ‘Whatever God has allowed, it is permissible; and whatever God has forbidden, it is impermissible. And whatever God remained silent about (in His revelation), it is excused.’86 Commenting on this tradition, Ibn Taymiyyah observed: This is an explicit statement that whatever issue the Sharīʿah is silent about, it is a matter for forgiveness. Calling it ‘forgiven’, and God knows best, as permission is allowing something by a specific (revealed) text, whereas prohibition is forbidding something by a specific text. By contrast, being silent on an issue is neither permission nor prohibition by a specific text. Hence, there is no punishment save only after a revealed message, and whatever does not expose one to punishment is permissible.87

Accordingly, since the Lawgiver is silent in regard to transacting of intangible rights, we conclude that silence implies permissibility of this transaction. Abstract or intangible rights have become a valuable usufruct in people’s custom and practice. In addition, abstract rights such as licensing and concession are well determined and portrayed in a detailed way, which removes any prohibited ignorance or gharar. As we saw above, the Sharīʿah concerns of Ḥanafī jurists in selling abstract rights may represent ignorance and gharar. Certain scholars have even explicitly stated that the prohibition of the sale of abstract rights is due to ignorance, and not because it is not wealth-property. This is exemplified in the following statement from the ʿInāyah: ‘Sale of irrigation water is deemed impermissible by our scholars due to ignorance, and not because it is not accounted as wealthproperty.’88 Accordingly, we may conclude that, if ignorance is removed, 132

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then the prohibition will also be removed, as the proper ruling would follow its underlying cause in both a positive and negative sense. Based on that insight, transacting of abstract rights is permissible provided that the Sharīʿah impediments arising from gharar and ignorance are eliminated. In short, concession rights do not involve any Sharīʿah impediments in regarding them as legitimate financial transactions, and they resemble valuable and permissible usufruct. Whatever combines these two features is allowed to be sold. In this context, Ibn Qudāmah stated that ‘It is permissible to sell everything that can be possessed, and this embraces permissible usufruct.’89 This position is also taken by many contemporary scholars. Nazīh Ḥammād requires three elements in māl: it has an intended benefit (manfaʿah) by having a legitimate and correct purpose either to fulfil an advantage (maṣlaḥah) or to prevent an evil (mafsadah); it has a valued benefit that is valued in the custom of people; and its benefit is permissible in Sharīʿah.90 Abdul Karim Zaidan and Ali Khafif define māl (wealth-property) as ‘anything that can be usually owned and benefited from’.91 As the concession right is intended to benefit both the grantor and concessionaire, its benefit has value in the custom of our modern days, and is granted for a Sharīʿah-compliant purpose, it is submitted that it shall be considered wealth property and as such its owner may dispose of it through selling, mortgaging, partnership or securitisation according to Sharīʿah rulings, as well as according to the conditions imposed by the licensor.92

Conclusion The Sharīʿah ruling on the taṣkīk of concession rights is dependent on judging whether or not transacting abstract/intangible rights is allowed by the Sharīʿah. Our study reveals that the officially adopted view of the Ḥanafī school on the taṣkīk of concession as a stand alone intangible right (without the tangible asset such as land, infrastructure, mines etc. that might be associated with it) is impermissible, for the sole reason that the sale of intangible rights may involve ignorance and gharar. These concerns were triggered owing to an inability to determine the main features of the subject matter in transacting intangible rights. On the other hand, the majority of legal scholars including those from the Mālikī, Shāfiʿī and Ḥanbalī schools – as well as some Ḥanafī jurists – do allow the sale of abstract rights. Mālikī scholars explicitly licensed transactions of certain, abstract rights, including the rights of sale of irrigation water and of altitude (above ground space), whilst Shāfiʿī and Ḥanbalī scholars were even more explicit with their inclusion of selling of intangible rights in their definition of sale agreement. Their reasoning behind 133

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this view is that it is permissible to sell whatever includes: permissible usufruct, which may be possessed. Both of these characteristics exist in the rights of concession. Moreover, there is nothing in the Qur’an, Sunnah, consensus or qiyās that implies prohibition of selling abstract rights. With regard to the concerns raised by the Ḥanafī school, their general claim of inability to determine features of abstract right should not be accepted, since there is nothing that prevents: adequate measurement and defined stipulation of a determined area of road or passage through a house or a property; accurate determination of usufruct, such as that of a passage; and the purpose for which the passage will be used, such as for the passing of humans or animals. In today’s world, the advance of technology may provide even more detailed measurements that facilitate the determination of the various types of rights. Moreover, in terms of contemporary concession practices, they are well identified and protected by the competent authorities. The taṣkīk of concession rights, therefore, is permissible. Many contemporary scholars (including many from the Ḥanafī school) and scholarship forums, such as AAOIFI, the Islamic Fiqh Academy of Organisation of the Islamic Conference and the Islamic Fiqh Academy of the Muslim World League, approve the taṣkīk of concession. ʿAbd al-Sattār Abū Ghuddah, from the contemporary Ḥanafī school, is of the view that the manfaʿah of real estate and imtiyāz al-idārah (management concession) are correlated.93 He also concludes that: The usufruct right is not a debt; it is an asset that can be the subject of taṣkīk like any other tangible assets. It is allowed to issue ṣukūk backed by manfaʿah (usufruct) for the entire tenure of the right or for a lesser period. And the return from the use of the right is the profit of ṣukūk.94

We provide case studies of two such enterprises established in the Kingdom of Saudi Arabia below (see Appendix). The first case study is an example of the taṣkīk of concession granted by the state to one of its own public sector companies, while the second case study is an example of the taṣkīk of concession originated from transactions between the private sector companies. After looking at the various aspects of imtiyāz, ṣukūk, and the taṣkīk of imtiyāz, we conclude the following: 1. Sharīʿah has known imtiyāz in different forms since inception as ‘prioritisation’ in rahn (pledge or lien), iqṭāʿ (a temporary or permanent grant of land by the state), ḥimā (protected land for grazing), and taḥjīr (to put a stone and other things on the boundaries of land, so that other persons may not lay hands on it). 134

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2. Imtiyāz or concession has a wider meaning than iqṭāʿ, ḥimā, and the contemporary legal definition of concession in some jurisdictions that only limits concession to ‘grants by the State’. Imtiyāz in Sharīʿah includes iqṭāʿ, ḥimā, contemporary concessions, and concessions originating in the private sector from transactions among individuals, among companies, and from transactions with each other. 3. Imtiyāz, therefore, is not limited to the three types of concessions mentioned in the AAOIFI Sharīʿah standard; it includes, furthermore, other intangible rights such as franchise, licensing, intellectual property, trademark, trade name, marketing rights, and contracts of supply. 4. Ṣukūk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct or services, intangible rights or in ownership of the assets of particular projects or specific investment activity. 5. Wealth-property eligible for taṣkīk are tangible assets (al-aʿyān), usufructs (al-manāfiʿ), intangible rights (al-ḥuqūq al-mujarradah), and debt. Ṣukūk are asset-based if they represent interest in tangible assets, usufruct of tangible assets, or intangible rights. Asset-based ṣukūk can be listed for tradability in secondary market for trading at a premium or discount. Ṣukūk are debt based if represent interest in debt, receivables (including murābaḥah deferred sale price), salam, and istiṣnāʿ. Debtbased ṣukūk cannot be traded at a premium or discount. They can only be purchased for the actual price of the debt it represents. Salam and istiṣnāʿ ṣukūk can be traded after sufficient salam assets are produced or sufficient istiṣnāʿ assets are manufactured. 6. Taṣkīk of concession associated with tangible assets such as land, building, machinery, equipment and infrastructure, is permissible. There is no difference of opinion among jurists on its permissibility. Taṣkīk in this case will be the taṣkīk of assets and associated rights. 7. Imtiyāz as an intangible right (not associated with tangible assets) can be securitised for this being a valid wealth property according to the views of majority jurists and contemporary approvals and practice. As a stand alone intangible right, it can be exchanged or transferred for consideration. It can be granted to the concessionaire and the concessionaire can use the same concession for its onward transactions (e.g., selling it to ṣukūk holders or contributing it as its share in muḍārabah and mushārakah arrangements with ṣukūk holders, or by way of juʿālah). 8. The concessionaire shall abide by the terms and conditions of the concession agreement signed with the grantor. Transfer of concession to ṣukūk holders will be invalid if the concession agreement prohibits the concessionaire from doing so. 135

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9. It is not required to transfer concession to ṣukūk holders on the same Sharīʿah grounds/concepts as were granted to the concessionaire unless stipulated in the concession agreement or if the arrangement between concessionaire and ṣukūk holders violates the terms and conditions of the concession agreement. For example, if grantors’ contracts with the concessionaire on the basis of juʿālah and stipulates the concessionaire can only grant the concession to others on the basis of juʿālah, the concessionaire shall abide by such conditions. 10. The concession agreement between the grantor and the concessionaire as well as its taṣkīk shall be free of gharar, jahālah, tadlīs, ghish and other prohibitions in Sharīʿah. 11. Ṣukūk comprise a set of Sharīʿah contracts that are financially engineered (ʿuqūd murakkabah) in a hybrid manner and include more than a Sharīʿah concept to achieve the intended commercial terms and benefits. Nazīh Ḥammād names this as a combined financial engineering of Sharīʿah contracts. He says: Combined financial engineering is a set of new contracts (in Sharīʿah) that under one agreement contains a group of contracts and binding promises. They are correlated, sequential, and aim to fulfil a specific duty in accordance to terms governing this set as a single unbreakable and non-restructurable transaction. The parties agree from inception to execute this set in a certain sequence and organised system so it leads to the achievement of the aim intended by the parties.

It is allowed to combine more than one contract in a transaction if the contracts are permissible individually. The combination of contracts shall not fall in a Sharīʿah prohibition such as a sale with loan or a conditional sale, it shall not be a ḥīlah (trick) or leading to ribā (interest), and the set of contracts shall not contain contradicting contracts containing contradicting conditions.95 The taṣkīk of concession shall abide by these conditions of combined financial engineering and respective ṣukūk contracts shall fulfil the relevant Sharīʿah required elements of those contracts. 12. Lack of suitable tangible assets can be a constraint for raising funds via the issuance of ṣukūk. Taṣkīk of intangible rights such as concessions by governments, government entities and private sector can help in overcoming this constraint and help in the development of the ṣukūk market further.

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Appendix: S ụ ku‾k Case Studies The Saudi Electricity Company (SEC) and the Saudi Basic Industries Corporation (SABIC) issued ṣukūk in 2007 using concession rights. The proceeds they raised were allowed to be used for their general corporate purposes, including meeting working capital requirements. While both structures are of a similar nature, the concession rights used were different. Saudi Electricity Company Ṣukūk96 SEC, a company incorporated in the Kingdom of Saudi Arabia, issued ṣukūk in 2007 using the concession rights granted to it exclusively by a royal decree. The concession rights are a distribution license for distributing electricity service connections for which SEC charged a tariff to its customers. Ṣukūk holders purchased beneficial interest in a percentage of the rights equal to 28 years from the SEC through their appointed agent. These rights included specified rights and entitlements to collect electricity service connection tariff. The tariffs charged by SEC to its customers for providing electrical service connections are determined by the Kingdom’s government bodies regulating electricity services. SEC is appointed as the ṣukūk holders’ trustee. The trustee manages the revenue generated from the ṣukūk assets for and on behalf of the ṣukūk holders. The revenues generated from the ṣukūk assets are passed to the ṣukūk holders as periodic distribution amounts equal to an expected rate of return. Any excess is kept as a reserve to be used for covering any shortfall in future revenues to facilitate the timely payment of the expected rate of return. Under a purchase undertaking given by SEC, SEC has undertaken unilaterally to purchase the concession rights from the ṣukūk holders at the end of Year 5 for 90% of initial ṣukūk value (or face amount), at the end of Year 10 for 60% of initial ṣukūk face value, and at the end of year 15 for 30% of the initial ṣukūk face amount. This ṣukūk is an example of securitising concession provided by the state to one of its affiliated companies that used it for onward transaction with ṣukūk holders. Saudi Basic Industries Corporation Ṣukūk97 SABIC is a company incorporated in the Kingdom of Saudi Arabia, which issued ṣukūk in 2007 using the marketing rights it gained from 13 marketing agreements signed with its subsidiaries and affiliates. SABIC’s obligation under each agreement is to provide marketing and sales services for certain 137

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products. These services include contacting customers and understanding their requirements, negotiating and executing sales contracts, processing orders, credit information and risks, invoicing, collecting payments, investigating claims and complaints, technical sales services, advertising, promotion, as well as distributing specification sheets and sales brochures relating to the relevant products. The products delivered to SABIC by each counterparty are marketed and sold by SABIC at agreed upon prices between SABIC and the purchasers of these products. SABIC is entitled to deduct certain costs, expenses and a fee from such product prices. SABIC transfers these marketing rights to a special purpose vehicle (SPV), 100% owned and managed as a subsidiary of SABIC. This SPV (SABIC Sukuk LLC) enters into the assets transfer agreement with the agent of ṣukūk holders by selling these rights to the ṣukūk holders for 20 years. SABIC is appointed by ṣukūk holders as the trustee and manager in order to manage the ṣukūk assets and to collect the revenues from its use of the marketing rights. The trustee manages the revenue generated from the use and distribution of the marketing rights, for and on behalf of the ṣukūk holders. The revenues generated from the ṣukūk assets are then passed to the ṣukūk holders as periodic distribution amounts equal to an expected rate of return. Any excess is kept as a reserve to be used for future needs in case of shortfall. While the marketing rights are sold to ṣukūk holders for 20 years, SABIC unilaterally undertakes to purchase the remaining marketing rights from the ṣukūk holders at the end of every five years. It will purchase the remaining rights after five years at 90% of the ṣukūk initial price (face value); at the end of Year 10 for 60% of the initial ṣukūk face value; and at the end of Year 15 for 30% of the initial ṣukūk face value. The concessions rights in this case are marketing rights, and are not granted by the state, as was in the case of SEC above. These concessions are originated due to the 13 agreements that SABIC entered into with its subsidiaries and affiliates.

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Notes 1. Joseph R. Nolan and Jacqueline M. Nolan-Haley, Black’s Law Dictionary, p. 289. 2. ‘Concession agreement definition’. 3. Nolan and Nolan-Haley, pp. 27-8. 4. Z. Yakan, Al-Qaḍā’ al-Idārī, Vol. 3, p. 722. 5. Translated from the Arabic in I.S.I. Al-Tanam, Al-Imtiyāz fī al-Muʿāmalāt, p. 59 – citing Ghassan Rabbah. 6. M. Henni, A Dictionary of Economic and Financial Terms, p. 85. 7. M. M. Manzūr, Lisān al-ʿArab, Vol. 6, p. 4307. 8. Qur’an, Āl ʿImrān, 3:179. 9. Al-Tanam, Al-Imtiyāz fī al-Muʿāmalāt, p. 54. 10. Narrated from ʿĀ’ishah (may God be well pleased with her), see M. I. AlBukhārī, Ṣaḥīḥ al-Bukhārī (Summary), Vol. 8, p. 508. 11. Ibid. 12. Al-Bukhārī, Ṣaḥīḥ al-Bukhārī, ‘The Book of Loans, Payment of Loans, Freezing of Property, Bankruptcy’, Vol. 3, Book 41, No. 587. 13. The Mejelle, p. 166, No.1052. 14. A. A. H. al-ʿAsqalānī, Fatḥ al-Bārī, No. 2241. 15. Sunnah is defined as ‘the sayings, doings, and practices approved of Prophet Muḥammad (peace be upon him)’, see M. R. Qalʿahjī, Muʿjam Lughat al Fuqahā’, p. 224. 16. Al-ʿAsqalānī, Fatḥ al-Bārī, No. 2241. 17. Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sharīʿah Standards, p. 397. 18. The resolution of the Albarakah Conference for Islamic Economy, Jeddah, 15-16 January 1997 on Concession Contract and Its Juridical Condition. 19. AAOIFI, Sharīʿah Standards, pp. 397-9. 20. Ibid., p. 398; see also W. Bin Hadi, Uṣūl Ḍabṭ, p. 97. 21. A.W. Ibn Rushd, Bidāyat al-Mujtahid, p. 616. 22. M. D. Ibn Qudāmah, Al- Kāfī, p. 440. 23. Bin Hadi, Uṣūl Ḍabṭ, p. 98. 24. I.S. al-Tanam, Al-Imtiyāz fī al-Muʿāmalāt, pp. 421-3. 25. M.D. Ibn Qudāmah, Al-Kāfī, p. 400. 26. ‘Definition of “Build-Operate-Transfer Contract”’, Investopedia, , retrieved 26 December 2011. 27. AAOIFI, Sharīʿah Standards, p. 402. 28. Bin Hadi, Uṣūl Ḍabṭ, p. 100. 29. al-Kāsānī, Badā’iʿ al-Sanā’iʿ, Vol. 6, p. 95. 30. Bin Hadi, Uṣūl Ḍabṭ, p. 98. 31. M.D. Bakar, ‘Istisna of Projects under BOT’. 141

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32. Bin Hadi, Uṣūl Ḍabṭ, p. 99. 33. AAOIFI, Sharīʿah Standards, p. 402. 34. Ibid. 35. Ibid., p. 403. 36. M.Y. al-Bahūtī, Rawḍ al-Murabbaʿ, p. 256. 37. AAOIFI, Sharīʿah Standards, p. 403. 38. Ibn Qudāmah, Al-Kāfī, p. 428. 39. Nolan and Nolan-Haley, Black’s Law Dictionary, p. 658. 40. M.A.R. ʿAbd al-Munʿim, Muʿjam, Vol. 1, p. 269. 41. M.A. Al-Shawkānī, Nayl al-Awṭār, Vol. 5, p. 370. 42. A. M. al-Māwardī, Al-Aḥkām al-Sulṭāniyyah, p. 239. 43. Ibn Qudāmah, Al-Kāfī, p. 428. 44. Islamic Fiqh Academy of the Muslim World League, The Fourth Resolution. 45. Islamic Fiqh Academy of the Organisation of the Islamic Conference, Resolutions and Recommendations, p. 84; the Fifth Session held in Kuwait, 10 December 1988. 46. Nolan and Nolan-Haley, Black’s Law Dictionary, p. 658. 47. Namely, muttafaq ʿalayh. 48. Ibn Qudāmah, Al-Kāfī, p. 440. 49. A.Q.M. al-Kalbī, Al-Qawānīn al-Fiqhiyah, p. 205. 50. A.Z. al-Nawawī, Rawḍat al-Ṭālibīn, Vol. 4, p. 330. 51. A.D. al-Mardāwī, Al-Inṣāf, Vol. 6, p. 368. 52. Al-Kāsānī, Badā’iʿ, Vol. 5, p. 513; Ibn Qudāmah, Al-Kāfī, p. 443; al-Kalbī, Al-Qawānīn, p. 205; al-Nawawī, Rawḍat, Vol. 4, p. 247. 53. Sunan Ibn Mājah, No. 1653; only Ibn Mājah among the six canonical ḥadīth references cites this ḥadīth, which contains in its isnād the weak transmitter Maslamah ibn ʿAlī. 54. Al-Bukhārī, Ṣaḥīḥ al-Bukhārī, ‘The migration of the Prophet (peace be upon him) and his Companions’, Vol. 4, Book No. 61, p. 490, No. 3615. 55. Ijmāʿ is defined as ‘the unanimous agreement of the mujtahidūn (scholars capable of deducing the law from its sources) of the Muslim community of any period following the demise of the Prophet Muḥammad on any matter’, see M.H. Kamali, Principles of Islamic Jurisprudence, 2nd revised edn. (Selangor: Ilmiah Publishers, 2007), p. 169. 56. Al-Kāsānī, Badā’iʿ, Vol. 8, p. 7; Ibn Qudāmah, Al-Kāfī, p. 428; al-Kalbī, Al-Qawānīn, p. 211; al-Nawawī, Rawḍat, Vol. 4, p. 198. 57. Al-Kāsānī, Badā’iʿ, Vol. 6, p. 95. 58. Qiyās is defined as ‘the extension of a Sharīʿah value from an original case to a new case because the latter has the same effective cause as the former’, see Kamali, Islamic Jurisprudence, p. 197. 59. Namely, an advance deposit to secure the purchase of a not yet existing asset. For salam as a legal instrument of purchase through depositing an advance security to reserve the item, see S. Abū Jayb, Al-Qāmūs al-Fiqhī, p. 182. 60. Istiḥsān is technically defined as: ‘leaving explicit analogy for something that is more effective and beneficial’, see S. Kayadibi, Istihsan, p. 193. 61. Organisation of the Islamic Conference Fiqh Academy, Qirārāt wa Tawṣiyāt, p. 144. 62. A. Ibn Fāris, Muʿjam, Vol. 3, p. 276; also cf. Ibn Manzūr, Lisān, Vol. 10, 142

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p. 456. 63. N. Ḥammād, Muʿjam, p. 280. 64. I. Muṣṭafā, Al-Muʿjam, Vol. 1, p. 519. 65. E. W. Lane, Arabic–English Lexicon, s.v.: ṣ - k - k. This term was further applied to ‘the signed and sealed statement of a judicial decision [wherein the sentence recorded by the judge was written]’; as well as to ‘a written order for payment of a stipend, salary or pension’. 66. AAOIFI, Sharīʿah Standards, p. 307. 67. Securities Commission Malaysia, Islamic Securities, pp. 7-8. 68. Y. al-Shubaylī, ‘Iṣdār wa Tadāwul’, pp. 10-12. 69. Whilst the majority of Sharīʿah scholars disallow trading debt-based ṣukūk, the Sharīʿah Committees of Bank Negara Malaysia and the Security Commission permit trading debt-based ṣukūk. 70. Accounting and Auditing Organisation for Islamic Financial Institutions, Shariah Standards, p. 311. It is important to note that the ratio of illiquid or tangible assets required for the tradability of ṣukūk differs. Whilst AAOIFI requires 30% of the ṣukūk assets to be tangible, some scholars may require a higher ratio. 71. Y. al-Shubaylī, ‘Iṣdār wa Tadāwul’, p. 11. 72. Majallat al-Buḥūth al-ʿIlmiyyah, Vol. 40, p. 363. 73. W. Zuhaylī, Al-Fiqh, Vol. 4, p. 378. 74. Al-Kāsānī, Badā’iʿ, Vol. 6, p. 562. 75. K.D.M.A.W. al-Siwāsī, Sharḥ, Vol. 6, p. 429. 76. Al-Siwāsī, Sharḥ, Vol. 23, p. 302. 77. S.D.A.B.M.A.B.S. al-Sarkhasī, Al-Mabsūṭ, Vol. 14, p. 246. 78. Ibid. 79. M.A. al-Dasūqī, Hashiyat al-Dasūqī, Vol. 4, p. 22. 80. Saḥnūn and Mālik ibn Anas, al-Mudawwanah, Vol. 3, p. 312. 81. S.D.M. al-Sharbīnī, Mughnī al-Muḥtāj, Vol. 3, p. 323. 82. A. R.M. Ibn Qāsim, Ḥāshiyat al-Rawḍ, Vol. 4, p. 326. 83. M. Y. al-Bahūtī, Kashshāf al-Qināʿ, Vol. 8, Chapter on Reconciliation (Ṣulḥ), p. 300. 84. A.R. Al-Saʿdī, Taysīr, p. 271. 85. I. M. Al-Shāṭibī, Al-Muwāfaqāt, Vol. 1, p. 440. 86. A.H., Al-Naysābūrī, Al-Mustadrak, No. 3419; Al-Ḥākim rated it as a sound ḥadīth. See also al-ʿAsqalānī, Fatḥ al-Bārī, Vol. 13, p. 280. 87. A. Ibn Taymiyyah, Majmūʿ Fatāwā, Vol. 21, p. 538. 88. A.M.M. al-Bābirtī, Al-ʿInāyah, Vol. 3. 89. B.D.I. Al-Maqdisī, Al-ʿUddah, p. 239. 90. N. Ḥammād, Fī Fiqh al-Muʿāmalāt, pp. 201-3. 91. Majallat al-Buḥūth al-ʿIlmiyyah, Vol. 76, p. 316. 92. AAOIFI, Sharīʿah Standards, p. 402. 93. A.S. Abū Ghuddah, ‘The usufruct right in real estate’, p. 148. 94. Ibid., p. 152. 95. N. Ḥammād, ‘Financial engineering’, pp. 8-34. 96. For further information on this ṣukūk and the details of agreements, see Saudi Electricity Company, Sukuk Expiring 2027 Offering Circular. 97. For further information on this ṣukūk and the details of agreements, see Saudi Basic Industries Corporation, Sukuk Expiring 2027 Offering Circular. 143

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7 The Case for Receivables-Based S ụ ku‾k: A Convergence between the Malaysian and Global Sharīʿah Standards on Bayʿ al-Dayn?* Rafe Haneef The global ṣukūk market is undoubtedly the most exciting sector in the Islamic finance industry. Although the growth of the ṣukūk market was dented by the 2008 global financial crisis, it has bounced back relatively well and fast in 2011. The total volume of ṣukūk issued globally in 2011 was around US$27 billion and is expected to increase to US$44 billion in 2012.1 It is noteworthy that around 60% of the total issuance in 2011 was in Malaysian ringgit, which signifies the leadership role of Malaysia in the ṣukūk world. Malaysia pioneered the global ṣukūk market in 2002 by successfully offering its landmark US$600 million global ṣukūk to global investors.2 It is important to note that the Malaysian global ṣukūk became a viable proposition due to the invention of the asset-based structure. The birth of asset-based ṣukūk signifies the first wave of innovation in the global ṣukūk market and much literature is available on this subject.3 The global ṣukūk market subsequently saw the advent of two novel ṣukūk structures, namely, the blended assets ṣukūk and asset-light ṣukūk. These new structures were introduced to solve the main problem faced by the issuers who lack suitable Sharīʿah-compliant physical assets to support their ṣukūk issuance and this development marks the second wave of innovation in the global ṣukūk arena. Whilst the asset-based ṣukūk required 100% physical assets that are Sharīʿah compliant to support the ṣukūk at the time of issuance, the blended-assets structures only required a minimum of 51% physical assets, the remaining 49% comprising Sharīʿah-compliant receivables. For ease of understanding, all Sharīʿah-compliant assets, including intangible assets and rights, which are not cash or receivables, will be referred to in this chapter as ‘physical assets’ or ‘non-ribawī assets’. All cash and/or receivables will be referred to as ‘cash assets’ or ‘ribawī assets’. Subsequently, the 51% minimum threshold was further reduced to 30% physical assets at the time of issuance. To meet the growing demand of * Reprinted by permission of the International Shari'ah Research Academy for Islamic Finance (ISRA).

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issuers who did not even have the minimum 30% physical assets, the asset-light ṣukūk structure was conceived. The asset-light ṣukūk does not require any physical assets at the time of ṣukūk issuance and is based on a muḍārabah arrangement between the issuer and the ṣukūk holders, with the muḍārib effectively ending up guaranteeing or protecting the principal investment and the expected return of the ṣukūk holders. The asset-light ṣukūk faced fierce criticism from many Sharīʿah-fuqahā’, academics and practitioners and this led to an effective ban on asset-light ṣukūk from the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in 2008.4 Again, there is much available literature covering these developments.5 This chapter will focus on the blended-assets ṣukūk, known as wakālah ṣukūk, and in particular the fiqhī analysis behind the requirement to have a minimum threshold (either 51%, 33% or 30%) of physical assets. Whilst the Malaysian fuqahā’ have allowed the sale of ṣukūk having 100% receivables, the fuqahā’ from the rest of the world have only permitted the sale of ṣukūk having substantial physical assets. The advent of wakālah ṣukūk, which blends different types of physical assets and receivables, poses an interesting fiqhī question on the exact extent of physical assets required for trading purposes. Is a ṣukūk with 90% receivables and 10% physical assets permissible for trading under Sharīʿah? What is the fiqhī rationale for requiring a minimum threshold of 33% or 30% physical assets? Can this threshold be lowered to just 10%? These important fiqhī issues will be explored in this chapter.

The Launch of Wakālah S ̣uku‾k by the Government of Malaysia The Malaysian government, having successfully launched two global ṣukūk ijārah issues in 2002 and 2009 – which both received overwhelming response from the global investor community – decided to enter the global ṣukūk market with another innovative structure. The government was mindful of the challenges faced by ṣukūk issuers who were facing constraints in terms of finding 100% physical assets that are Sharīʿah compliant to support the ṣukūk issue. The government decided to test a new version of the blended ṣukūk, which was structured as shown in Chart 1. Under wakālah ṣukūk, a special purpose vehicle is established to act as trustee for ṣukūk holders who provide the trustee the ṣukūk proceeds that will be utilised on behalf of ṣukūk holders as follows: • Twenty-six per cent of the ṣukūk proceeds will be used to buy from the government certain physical assets that are Sharīʿah compliant; • Twenty-six per cent of the ṣukūk proceeds will be used to buy certain 145

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shares that are Sharīʿah compliant to the special purpose vehicle; • The special purpose vehicle will lease the physical assets to the government for five years (and 10 years for the ten-year ṣukūk); • The remaining 48% of the ṣukūk proceeds will be used to buy certain Sharīʿah-compliant commodities, which will then be sold to the government on a murābaḥah basis, payable after five years (and 10 years for the ten-year ṣukūk); and • The government is appointed as agent (wakīl) of the special purpose vehicle to, among other things, manage the assets leased by and the shares owned by the special purpose vehicle. Chart 1 Ṣukūk al-Wakālah: Structure Overview: Government of Malaysia's USD 2 Billion Dual-tranche Ṣukūk al-Wakālah

Source: HSBC Amanah

Salient Features The following five salient features of wakālah ṣukūk need to be highlighted: 1. The sale of physical assets and shares is done by way of valid and enforceable contracts of sale, which, effectively, transfer beneficial ownership from the government to the special purpose vehicle. The sale contracts satisfy all Sharīʿah requirements for a valid sale. However, the government does not register the sale of physical assets or shares at the land office or company share registry to avoid tax 146

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complications. However, this does not affect the validity or legal enforceability of the sale contracts. 6 2. The special purpose vehicle sells the commodity, e.g. the palm oil traded in Bursa Malaysia, to the government on a murābaḥah basis at a price equal to 49% of the ṣukūk proceeds. The 1% increase is the profit margin for the murābaḥah trade. The government will sell the commodity to other commodity suppliers throughout Bursa Malaysia7 on a spot basis on the same day of the murābaḥah trade to receive cash proceeds equal to 48% of the ṣukūk proceeds. The spot sale of the commodities by the government is effectively a form of tawarruq and the government does not take any price risk or market risk in relation to the commodities, so long as the government sells the commodities within the same day. 3. At the maturity of the ṣukūk, the government will undertake8 to purchase the physical assets and shares, worth 52% of the ṣukūk proceeds, at a price equal to 51% of the ṣukūk proceeds. Together with 49% of the commodity murābaḥah price, the total sum payable by the government to the special purpose vehicle at the maturity of the ṣukūk will be equal to 100% of the ṣukūk proceeds. This ensures that the ṣukūk holders have certainty in receiving their full investment at maturity. 4. The special purpose vehicle will lease the physical assets to the government at a rental equal to the expected periodic distribution amounts payable by the special purpose vehicle to the ṣukūk holders. Although the physical assets comprise only 26% of the ṣukūk portfolio value, the rental charged will be equal to the expected yield on the entire ṣukūk portfolio. Hence, the 1% profit from the commodity murābaḥah trade and any dividends received from the shares held by the special purpose vehicle are not relied upon for the purpose of paying the periodic distribution amount to ṣukūk holders. 5. The government is appointed as wakīl to manage the leased assets and shares on behalf of the special purpose vehicle and in return the government receives a nominal fixed fee and an incentive fee equal to all dividends received from the shares held by the special purpose vehicle. The special purpose vehicle also surrenders all other incidental rights like voting to the government pursuant to a deed of surrender. This ensures that all incidental rights are exercised by the government without any need for consent from the special purpose vehicle or ṣukūk holders.9 The above features are presented in the diagram below for ease of understanding: 147

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Chart 2 Ṣukūk al-Wakālah: Structure Overview: Government of Malaysia's USD 2 Billion Dual-tranche Ṣukūk al-Wakālah

Source: HSBC Amanah

Fiqhī Analysis The concept of blended-assets ṣukūk was first discussed in November 2000 at a forum organised by the Islamic Development Bank (IDB). This prototype was introduced as a Sharīʿah-compliant blended-assets ṣukūk (see Chart 3). The concept of blended-assets ṣukūk became a reality with the successful offering of the inaugural ṣukūk by the IDB in 2003. The IDB ṣukūk had an underlying mixed portfolio comprising of 51% physical assets and 49% receivables that are Sharīʿah-compliant. The IDB ṣukūk structure is set out in Chart 4. Sale of Portfolio with Mixed Assets From a fiqhī perspective, a ṣakk that has 100% cash or receivables as underlying asset is only tradable at par. This fiqhī ruling is based on the prohibition of ribā al-faḍl as proscribed in the following ḥadīth: Gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, must be equal on both sides and hand to hand. Whoever pays more or demands more (on either side) indulges in ribā.10 148

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Receivables from Shari’ah compatible financing (including ijarah, istisna’, murabahah and bay’ al-salam financing)

Property

2. SPV1 Leases the Property for 10 Years

1. Corporate transfers the Property and/or Receivables (“Assets”) [Assumption: Assets are valued at more than US$500M]

Corporate

5. At Maturity (Year 10) the SPV2 will put the Property to SPV1 for the Redemption Price

3. SPV1 packages the Assets into a portfolio (“Portfolio”) and sells the Portfolio at a Discount, say US$500M

SPV 1

6. SPV2 collects the lease rentals and the Receivables (through SPV1) and distributes the Annual Returns and the Redemption Amount at maturity to the Investors

SPV 2

4. SPV 2 Creates a Trust in respect of the “Assets” and issues sukuk aIijarah to raise the US$500M

The sukuk will be listed, rated and also approved by an internationally recognised Shari’ah Board Sukuk

The sukuk will be traded in the Secondary Market through appointed Market Makers.

Market

Secondary

Conventional)

(Islamic /

Investors

Table 7.3 Resource Mobilisation through Islamic Financial Instrument by Corporates in IDB Member Countries Chart 3 Resource Mobilisation through Islamic Financial Instrument by Corporates in IDB Member Countries

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Murabaha

ICD

Investors

5. ICD (as 3rd Party Buyer) ‘delegates’ the agency role to IDB

4. SPC appoints ICD (a 3rd Party Buyer) as agent to collect the receivables from the Assets

Sukuk

1. Islamic Development Bank (‘IDB’) ‘bundles’ certain ijarah assets (min 51%), istisna’ assets and murabahah receivables that it owns (‘Assets’) and sells the Assets as a pool for $400 million

IDB

2. Sells the Assets to SPC for $400m

SPC

3. SPC creates a trust in respect of the Assets and issues 5-Year sukuk to raise $400 million

US$400m in Sukuk by the IDB, Minimum 51% Assets

6. IDB provides certain ‘guarantees’ in respect of the Assets

Chart 4

Table 7.4 US$400m in uk k by the IDB, Minimum 51% Assets

Hence, if the ṣukūk represent 100% cash, they can only be traded or negotiated at par. Any trading at par or discount will tantamount to ribā. If, conversely, the ṣukūk represent 100% receivables, say rentals or trade debts due to the obligor, the majority of contemporary fuqahā’ have banned the trading of such ṣukūk, based on the prohibition of bayʿ al-dayn. Sheikh Taqi Usmani, a prominent contemporary faqīh, has extensively discussed the tradability of debt instruments and the prohibition of bayʿ al-dayn and come to the conclusion that a ṣakk representing 100% receivables can only be traded at par.11 Accordingly, a ṣakk that represents 100% cash or 100% receivables or a mixture of cash or receivables, in whatever proportion, cannot be traded or negotiated except at par. This would mean that such ṣukūk become commercially unviable. Investors would rarely agree to buy a ṣakk that can only be traded at par. The contemporary fuqahā’, however, have allowed ṣukūk that represent a mixed portfolio comprising both physical assets and cash assets to be traded at premium or discount. The fiqhī reasoning behind this ruling is essentially based on the basic principle in muʿāmalāt that everything is permissible unless clearly prohibited by any evidence (dalīl) derived from the primary or secondary sources of Sharīʿah.12 A survey of these sources reveals that the following aḥādīth have clear application to the sale of asset that comprises both ribawī and non-ribawī elements. In the context of blended-assets ṣukūk, the cash-asset is the ribawī component, given that the exchange of cash asset for a premium or discount will lead to ribā. The physical asset is the non-ribawī component, where the physical asset can be exchanged with cash at a premium or discount. The aḥādīth reported in Ṣaḥīḥ Muslim are as follows: Faḍālah ibn ʿUbayd al-Anṣārī reported: A necklace having gold and gems in it was brought to Allah’s Messenger (peace be upon him) in Khaybar and it was one of the spoils of war and was put up for sale. Allah’s Messenger (peace be upon him) said, ‘The gold used in it should be separated’, and then Allah’s Messenger (peace be upon him) further said: ‘(Sell) gold for gold with equal weight.’ Faḍālah ibn ʿUbayd reported: I bought on the day (of the victory of Khaybar) a necklace for twelve dinars (gold coins). It was made of gold studded with gems. I separated (gold from gems) in it, and found (gold) of more (worth) than 12 dīnārs. I made a mention of it to Allah’s Apostle (may peace be upon him), whereupon he said: ‘It should not be sold unless it is separated.’ Ḥanash reported: We were along with Faḍālah ibn ʿUbayd (Allah be pleased with him) in an expedition. There fell to my and my friend’s lot a necklace made of gold, silver and jewels. I decided to buy that. 151

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I asked Faḍālah ibn ʿUbayd, whereupon he said: separate its gold and place it in one pan (of the balance) and place your gold in the other pan, and do not receive but equal for equal, for I heard Allah’s Messenger (may peace be upon him) as saying: He who believes in Allah and the Hereafter should not take but equal for equal.13

The above aḥādīth show that the necklace was made of gold and pearl and was bought by Faḍālah for 12 dīnārs. Historically, one dīnār was equal to around 4.4 grams of gold and 12 dīnārs would have represented 52.8 grams of gold.14 When Faḍālah found out that the necklace had contained gold worth more than 52.8 grams, he referred the matter to the Prophet (peace be upon him). Given that gold cannot be exchanged except in equal weight and on a spot basis, the Prophet (peace be upon him) told him that the necklace should not have been sold without first ascertaining its weight of gold. Many classical fuqahā’ from the Mālikī, Shāfiʿī and Ḥanbalī schools, have prohibited the sale of an asset which comprises both ribawī and non-ribawī items based on these aḥādīth.15 It is apparent that these fuqahā’ feared that the ribawī item may be indivisible from the non-ribawī item, thereby making it difficult to ascertain the exact value of the ribawī item. Consequently, the parties may end up exchanging the ribawī item at a discount or a premium, thereby attracting ribā al-faḍl elements into the transaction. Several classical fuqahā’ from the Ḥanafī school, such as, Ḥammād ibn Abū Sulaymān, al-Shaʿbī and al-Nakhaʿī, however, have taken a more progressive approach by allowing a sale of assets with mixed items if the parties can verify the value of the ribawī item and exchange equal value for it.16 They took the view that the Prophet (peace be upon him) did not prohibit the sale of gold necklace with pearls embedded. The above aḥādīth only establish the requirement to ascertain the value of gold prior to the sale and to pay equal amount of gold dīnārs for it. For example, if the weight of gold in the necklace has been ascertained at the time of sale as equal to say 57.2 grams or 13 dīnārs in value, the sale of the necklace is permissible if the purchase price paid by Faḍālah was 13 dīnārs. The aḥādīth also do not prohibit the payment of additional consideration for the pearls. Following from the above example, any amount paid above 13 dīnārs will be treated as consideration for the pearls. However, if the payment is less than 12 dīnārs, when the gold content of the necklace is equal to 13 dīnārs, the sale will be prohibited due to presence of ribā alfaḍl. The consideration for the pearl, however, could be of any value given that pearl is a non-ribawī element. Hence, it would be permissible if the necklace had been bought for, say, 15 dīnārs or even 30 dīnārs. Equally, a sale of price of 13 dīnārs would be also equally permissible, although no consideration has been paid for the pearls. 152

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In relation to wakālah ṣukūk, many contemporary fuqahā’17 have ruled that, when wakālah ṣukūk represent both cash assets and physical assets, the value of the cash assets must be first determined and the purchase price for the wakālah ṣukūk has to be equal or greater than the value of the cash assets (the balance amount being consideration for the physical assets). Accordingly, if a wakālah ṣukūk with a par value of US$100 million represent physical assets worth US$50 million and cash assets worth US$50 million, the wakālah ṣukūk can only be sold at US$50 million or more. In the context of the government of Malaysia’s wakālah ṣukūk issue, the value of cash assets at the time of wakālah ṣukūk issuance was US$576 million and the wakālah ṣukūk was subscribed by investors at a par value of US$1.2 billion. Hence, the offering of wakālah ṣukūk is entirely in line with principles of Sharīʿah. The contemporary fiqhī ruling, however, seems to be silent on the minimum price payable for ṣukūk secondary market trading. For instance, can the original buyer sell the wakālah ṣukūk in the secondary market at a discount of say, 70% when the wakālah ṣukūk represent 49% cash assets? Will such a trade lead to ribā al-faḍl given that cash assets worth 49% are being sold for cash worth 30%? Is there a need for a minimum price requirement? These questions will be tackled in the latter part of this paper. The 51% Physical Assets Threshold Some contemporary fuqahā’ have ruled that, in relation to a mixed portfolio asset, the value of physical assets should be at least 51% of the total value of the mixed portfolio. This ruling seems to have been based on a more conservative fiqhī approach to limit the extent of cash assets in a mixed portfolio. This view is based on the legal maxim, al-ḥukm li al-ghālib (the ruling of majority shall apply), which is adopted by all four schools in their elaboration of certain Sharīʿah issues. The legal maxim is derived indirectly from several Qur’ānic texts. One such verse is: ‘And true will be the weighing on that Day; and those whose weight [of good deeds] is heavy in the balance – it is they who shall attain to a happy state.’18 Another verse relied on is: ‘They will ask thee about intoxicants and games of chance. Say: “In both there is great evil as well as some benefit for man; but the evil which they cause is greater than the benefit which they bring”’ (2:219).19 Ibn al-Jawzī, commenting on the above verse, says that: The phrase ‘in both there is great evil as well as some benefit for man’ implies equality between the evil and benefit. However, the phrase, ‘but the evil which they cause is greater than the benefit which they bring’ renders the evil portion to be in the majority, while the benefit 153

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part is rendered as the minority. Therefore, the ruling of majority shall prevail.20

This analysis shows that the majority portion need not be significant. A simple majority, say 51%, can render the whole thing or matter to be treated the same as that of the majority. Based on this juristic principle, the contemporary fuqahā’ require the physical assets component of the mixed portfolio to be more than the cash assets. The fuqahā’ prescribed a simple majority rule as a minimum threshold for the physical assets component. This ruling was adopted in a number of ṣukūk issues, including the 2011 Malaysian government ṣukūk and the IDB’s 2003 ṣukūk. In the Malaysian ṣukūk, the physical assets and shares component of the mixed portfolio was valued at a minimum of 52% of the total mixed portfolio. Relying on the above juristic principle, the 52% majority physical assets will render the whole mixed portfolio as physical assets and, therefore, permitted to be traded in the secondary market. The 33% Physical Assets Threshold The contemporary fuqahā’ who rely on the 33% physical assets threshold also rely on al-ḥukm li al-ghālib (the ruling of majority shall apply) to support their position. The only point of divergence is that these fuqahā’ give a different meaning to the word ‘majority’. To them, majority means more than one-third of something. To support this interpretation, they rely on the following ḥadīth narrated by Saʿd ibn Abī Waqqāṣ: I said, ‘O Messenger of Allah! I have a lot of money, and no heirs but my daughter. Shall I give (bequeath) two-thirds of my wealth as charity?’ He (peace be upon him) said, ‘No.’ I said, ‘Then half of it?’ He (peace be upon him), ‘No’. I said, ‘then one-third of my wealth?’ He (peace be upon him) replied, ‘Yes, one-third; and even one-third is too much. Indeed, to leave your inheritors rich (after your death) is better than leaving them as a burden begging from people.’

In this ḥadīth, the Prophet (peace be upon him) said: ‘and even one-third is too much’. Applying the fiqhī principle of mafhūm al-mukhālafah (counterimplication) the proponents derive the ruling that since an amount equal to or more than one-third is considered as significant and impermissible, the counter-implication of this ruling is that anything which is less than onethird is regarded as insignificant and therefore permissible.21 Hence, when considering whether blended-assets ṣukūk are tradable, the proponents will rule that, if the physical assets component is equal to or more than onethird, it is regarded as significant and permissible to be traded. The critics 154

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argue that this reasoning is rather convoluted. They contend that, when applying the principle of the above ḥadīth to blended-assets ṣukūk, the proper determination should be whether the cash component is equal to or more than one-third, because ‘even one-third is too much’. If bequeathing more than one-third of one’s property is impermissible because it is too much, then trading a ṣukūk that has a cash component of more than onethird should also be impermissible because it is too much. One should not simply imply through the counter-implication argument that the above ḥadīth lays a general rule that up to a third of something can be a permissible component and the remaining two-thirds can be non-permissible. Whilst the jury is still out as to whether the 33% asset threshold is permissible, the author believes that the physical asset threshold requirement (either 51% or 33%) is not particularly relevant within the context of blended-assets ṣukūk that satisfy the minimum price requirement. The Minimum Price Requirement As discussed within the context of the sale of necklace embedded with pearls, the Sharīʿah requirement is that the minimum price (in gold dīnārs) has to be equal to the weight of gold of the necklace. Is there a minimum price requirement for wakālah ṣukūk representing a mixed portfolio of 51% physical assets and 49% cash assets? Apparently, contemporary fuqahā’ have not prescribed any minimum price requirement for the blended-assets ṣukūk. The issue of minimum price does not really arise at the time of ṣukūk issuance given that the ṣukūk will be subscribed at par, and the price will be greater than the amount of 49% receivables. However, in the secondary market, trading a ṣukūk may end up being exchanged at a discount and sometimes could be at a deep discount. If, for example, a blended-asset ṣukūk with a par value of US$100 is exchanged in the secondary market for US$40, will such exchange be tantamount to ribā al-faḍl? Contemporary fuqahā’ seem to have taken the view that as long as the blended-assets ṣukūk comply with the 51% or 33% assets threshold requirement, the ṣukūk can be exchanged at any value. The author, however, believes that blendedassets ṣukūk cannot be traded below the value of the component-based receivables on the following analysis. The majority of classical fuqahā’ have ruled that, when gold is inextricably mixed with silver, for example a gold ring that has silver content and the seller does not know the exact amount of the gold content, such an item cannot be sold to buyer for gold dīnārs. As mentioned in the aḥādīth narrated by Faḍālah, the gold content must be first separated from the silver and weighed to ascertain the exact measure. Within the context 155

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of the ring above, where it is not viable to separate the gold content, the contracting parties are faced with the following two options: 1. If the ring has considerable gold content, i.e., the majority of the ring is gold, then, although the exact amount of gold is not known, applying the juristic principle of al-ḥukm li al-ghālib (the ruling of majority shall apply) the ring will be considered in its entirety as gold. Consequently, the seller cannot exchange it for gold dīnār because the exact amount of gold is not known but can sell it for, say, silver dirhams. The ḥadīth on ribā al-faḍl clearly allows the exchange of gold for silver in whatever quantity or value, as long as such exchange is done on a spot basis. 2. If, conversely, the majority substance of the ring is silver, although the exact amount of silver is unknown, then the ring will be considered in its entirety as silver. Consequently, the seller cannot exchange it for silver dirhams because the exact amount of silver is unknown but can sell it for, say, gold dinars. Within the context of blended-assets ṣukūk, the parties can identify clearly and ascertain the value of the receivables represented by the ṣukūk. In relation to the Malaysian government’s wakālah ṣukūk, the value of receivables denominated in US dollars will always be equal to 49% of the par value of the ṣukūk, which is also denominated in US dollars. Unlike the ring example above, there is no ambiguity in the exact amount of the receivables represented by the ṣukūk at any point in time during the life of the ṣukūk. Accordingly, it is not permissible for such ṣukūk to be sold or traded in US dollars below the value of the US dollar receivables. For instance, if the par value is US$100 the minimum purchase price at any time cannot be less than US$49 (being equal to 49% of the receivables). Asset Threshold Vs Minimum Price – the Sharīʿah Implications on Ṣukūk Trading When the amount of the ribawī substance is not clearly ascertainable, as in the ring example above, the application of non-ribawī asset threshold becomes critical. Hence applying the asset threshold test, a ring with majority of gold in it will be considered as gold in its entirety and such a ring cannot be sold for gold dīnārs. Without an asset threshold requirement, it will be difficult to derive a fiqhī ruling. The contemporary fuqahā’ have, within the context of Sharīʿahcompliant equities of companies having a mixed portfolio of tangible and intangible assets, cash and receivables, applied an asset threshold 156

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test of cash assets not exceeding 33% of the total assets or the market capitalisation of a company. Hence, if a company has up to 33% cash assets, the company will be deemed to have 67% physical assets (i.e., nonribawī assets) and accordingly the entire assets portfolio of company will be deemed as non-ribawī assets. The equities of such companies can then be traded at any price. The contemporary fuqahā’ have not insisted on any minimum price requirement, for example, not to trade the equity below the value of 33% cash assets. Considering that it is impossible to monitor the exact quantum of cash and receivables of a company that is a going concern, at the time of trading its shares, it is not practical to insist on a minimum price requirement for share trading. Hence, the current fiqhī ruling, which relies only on asset threshold test for equity trading, seems to be entirely in line with the spirit of Sharīʿah. However, in relation to blended-assets ṣukūk, there is no ambiguity in the value of the cash assets at the time of ṣukūk trading. As highlighted above, the amount of cash assets in the Malaysian government’s ṣukūk will remain constant and clearly known to the ṣukūk holder. The author submits respectfully that through applying the principles established in the aḥādīth narrated by Faḍālah, if the blended-assets ṣukūk represents 49% cash assets, then it simply cannot be exchanged below the value of 49% cash assets. If a blended-asset ṣukūk represents 90% cash assets, then, applying the same principles, such ṣukūk cannot be exchanged below 90% cash assets. Based on the above analysis, a blended-assets ṣukūk can be freely traded even if it represents, say, 90% cash assets and 10% physical assets, as long as it is not traded below 90% of the ṣukūk par value. By way of illustration, a 90% cash assets ṣukūk with US$100 face value can be traded at any price above US$90. If it is traded at US$105, for example, US$90 will be deemed as consideration for US$90 worth of cash assets and the remaining US$15 will be treated as consideration for US$10 worth of physical assets. If it is traded at, say, US$95, US$90 will be deemed as consideration for US$90 worth of cash assets and the remaining US$5 will be treated as consideration for US$10 worth of physical assets, given that there is no Sharīʿah restriction in selling physical assets for a discount. If it is traded at, say, US$90, the whole amount will be deemed as consideration for US$90 worth of cash assets and the remaining US$10 worth of physical assets will deemed as a gift, given that there is no Sharīʿah restriction in transferring physical assets, without any consideration, by way of gift. The ṣukūk, however, cannot be traded below US$90, say, US$85, given that US$85 will be deemed as consideration for US$90 worth of cash assets, leading to ribā al-faḍl. 157

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If there is a concern that a gift of physical asset accompanying an exchange of US$90 as consideration for US$90 worth of cash assets may lead to ribā, then the minimum price requirement can be increased to US$91 – in which case, US$90 will be deemed as consideration for US$90 worth of cash assets and the remaining US$1 will be treated as consideration for US$10 worth of physical assets, given that there is no Sharīʿah restriction on the extent of discount given. Any trading of such ṣukūk below US$91 will be prohibited. By having a minimum price requirement for the trading of ṣukūk, there appears to be no real Sharīʿah justification for imposing at least 51% or 33% physical assets in blended assets ṣukūk. The following discussion will further substantiate this Sharīʿah position.

A Maxim Cannot Override a Dalīl from the Primary or Secondary Sources of Sharīʿah Although this maxim has been applied by fuqahā’ many times in different contexts, it remains a maxim of fiqh to be applied when there is no specific evidence from the primary or secondary sources of Sharīʿah. As discussed above, the aḥādīth anarrated by Faḍālah have direct relevance for the context of blended-assets ṣukūk. The principles established by the aḥādīth, being a primary source of Sharīʿah, should prevail over a general fiqhī maxim, such as al-ḥukm li al-ghālib (the ruling of majority shall apply).

The Case of Mudd al-ʿAjwah Has Direct Relevance for the Tradability of Blended Assets S ̣uku‾k The classical Ḥanafī fuqahā’ have discussed in detail the matter of mudd al-ʿajwah22 (the exchange of, say, one mudd, a unit of measurement, of ʿajwah dates with one mudd of ʿajwah mixed with ʿanbarah dates or any other goods). The Sharīʿah requires a spot exchange of same type of dates (e.g., ʿajwah) to be of similar quality (e.g., Grade A) and quantity (e.g., a kilogram) to avoid ribā al-faḍl. However, if a person exchanges one kilogram of Grade A ʿajwah with two kilograms of Grade A ʿajwah mixed with Grade B ʿanbarah dates, then such an exchange is allowed and is discussed as mas’alah mudd al-ʿajwah by the Ḥanafī fuqahā’. The Ḥanafī school allows a ribawī item to be exchanged with another item which consists of both ribawī and non-ribawī items as long as the single ribawī countervalue (one kilogram of Grade A ʿajwah) is greater than the ribawī component of the mixed countervalue (say, the weight of Grade A ʿajwah in the mixed countervalue is approximately 40% or 0.8 kilograms). In essence, this requirement is to ensure that the incremental 158

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ribawī countervalue (i.e., the additional 0.2 kilogram of Grade A ʿajwah in the single countervalue) is exchanged for the non-ribawī component of the mixed countervalue (i.e., 1.2 kilograms of Grade B ʿanbarah). If, conversely, one kilogram of Grade A ʿajwah is being exchanged with two kilograms of Grade A ʿajwah mixed with Grade B ʿanbarah but the weight of Grade A ʿajwah is approximately 60% (or 1.2 kilograms), then this will lead to ribā al-faḍl. The mudd al-ʿajwah examples share many of the characteristics of tradability of ṣukūk representing physical assets and cash assets. Accordingly, the contemporary fuqahā’ should rely on the principles established by mudd al-ʿajwah, as opposed to relying on the ruling of the majority shall apply maxim. Lastly, applying the maxim that the ruling of the majority should apply on blended assets ṣukūk may end up contravening the ruling established in the above-mentioned ḥadīth narrated by Faḍālah, since imposing either the 51% or 33% threshold may lead to an exchange of blended assets for a price that is below 51%. Consequently, this will lead to an explicit breach of all Sharīʿah texts that prohibit exchange of ribawī assets for ribawī assets in unequal amounts.

Conclusion In conclusion, applying the maxim that the ruling of the majority should apply to permit the trading of blended assets ṣukūk, which have clearly identifiable cash assets, at any price lacks adequate Sharīʿah grounds. The fiqhī maxim is a general ruling that cannot prevail over the principle established in mudd al-ʿajwah cases, which is a specific ruling that has direct relevance to blended assets ṣukūk. Ṣukūk that have, for example, 90% cash assets and 10% physical assets, therefore, can be traded validly in the secondary market as long they are not exchanged below the value of the cash assets. If the investors fear that the ṣukūk may end up being traded below the 90% threshold, the issuer can increase the quantum of the physical assets to, say, 20% and reduce the cash assets to 80%. This will allow the ṣukūk holder greater flexibility to trade at a minimum of 80% (or 81%, to avoid any gift of physical assets) to par value. If the ṣukūk price unexpectedly drops to, say, 50%, the ṣukūk holder will not be able to sell it in the secondary market in compliance with the Sharīʿah, given that the buyer will be buying a ṣukūk representing 80% cash assets for only 50% of its value. The ṣukūk holder can either hold to maturity and claim the full redemption price from the ṣukūk issuer or exchange the ṣukūk with a non-ribawī asset (for instance, commodity as countervalue) at whatever 159

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value. The Sharīʿah does not prohibit the exchange of cash assets with commodities and the value of the commodities could be less than the value of cash assets represented by the ṣukūk. Hopefully, this fiqhī position will bring the current divergence between the Malaysian and Middle Eastern fuqahā’ on the issue of bayʿ al-dayn to a point of convergence.

Bibliography Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), ‘Shari’ah Board Ruling of February 2008’, , retrieved 5 March 2013. Al-Hajjaj, A.H.M., Ṣaḥīḥ Muslim, trans. A. H. Siddiqui. , retrieved 4 March 2013. Bloomberg, ‘MENA Capital Markets 2011 League Tables’, , retrieved 1 January 2012. Broome, M., A Handbook of Islamic Coins (London: Spink & Son, 1985). Haneef, R., ‘From “asset-backed” to “asset-light” structures: The intricate history of ṣukūk’, ISRA International Journal of Islamic Finance, 1/1 (2009), pp. 103-126. Haneef, R. ‘Recent trends and innovations on Islamic debt securities: Prospects for Islamic profit-and-loss-sharing securities’, in S. Nazim Ali (ed.), Islamic Finance: Current Legal and Regulatory Issues (Cambridge: Islamic Finance Project, 2005), pp. 29-61. Ibn al-Jawzī, A.F.J.A.M., Zād al-Masīr fī ʿIlm al-Tafsīr (Provisions for the Journey in the Discipline of Qur’an Commentary) (Lebanon: Dār al-Kutub al-ʿIlmiyyah, 2002). Ibn Taymiyah, A.A-H., Al-Fatāwā al-Kubrā (The Great Compilation of Islamic Legal Opinions) (Cairo: Dar Al-Kutub Al-‘Ilmiyyah, 1998). Kamali, H., Islamic Commercial Law: An Analysis of Futures and Options (Cambridge: Islamic Text Society, 2000). Kuwait Finance House Research Ltd., Global Sukuk al-Wakala Report 2012, , retrieved 27 December 2012. Ministry of Endowments and Islamic Affairs of Kuwait, Al-Mawsūʿah alFiqhiyyah (Encyclopaedia of Islamic Jurisprudence) (Kuwait: Tibaʿ Dhāt al-Salāsil, 1986). Qaraḍāghī, M., Athar al-Duyūn wa Nuqūd al-Sharikah aw al-Maḥfaẓah ʿalā Ḥukm Tadāwul al-Ashum al-Ṣukūk wa al-Wiḥdāt al-Istithmāriyyah (Jeddah: Islamic Development Bank Centre for Research and Training, 2003). Usmani, T. An Introduction to Islamic Finance (Karachi: Maktabah Maariful Quran, 2008). Usmani, T. ‘Sukuk and their contemporary applications’, Al-Qalam, 2008, , 4 March 2013. Usmani, T., An Introduction to Islamic Finance (Karachi: Maktaba Maariful Quran, 2008).

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Notes 1. Bloomberg, ‘MENA Capital Markets 2011 League Tables’; for different figures and growth forecasts, see Kuwait Finance House Research Ltd., Global Sukuk al-Wakala Report 2012. 2. For further reading on this subject, see R. Haneef, ‘Recent trends and innovations on Islamic debt securities’. 3. For further reading on this, see R. Haneef, ‘From “asset-backed” to “assetlight” structures’. 4. See Accounting and Auditing Organisation for Islamic Financial Institutions, ‘Shari’ah Board Ruling of February 2008’; for background information on the AAOIFI ruling, see T. Usmani, An Introduction to Islamic Finance. 5. For further reading, see Haneef, ‘From “asset-backed” to “asset-light” structures’. 6. The sale of beneficial ownership has evoked much debate on the validity of ṣukūk from a Sharīʿah perspective and for further discussion on this matter, see Haneef, ‘Recent trends and innovations on Islamic debt securities’, pp. 35-6. 7. The supplier buying the commodities from the government is independent of the supplier selling the commodities to the special purpose vehicle and there is no element of bayʿ al-ʿinah involved. 8. Such undertaking is structured in the form of unilatarel waʿd or promise given by the government in favour of the special purpose vehicle. 9. This arrangement, achieved through the deed of surrender, is in line with nature of wakālah ṣukūk, which is a fixed income instrument and any requirement for consent from a special purpose vehicle or the wakālah ṣukūk holders will make the wakālah ṣukūk issuance overtly complex and operationally cumbersome. 10. Usmani, Introduction to Islamic Finance, pp. 216-18 11. Ibid. 12. H. Kamali, Islamic Commercial Law, pp. 65-70. 13. A.H.M. Al-Ḥajjāj, Ṣaḥīḥ Muslim, Book 10, Ch. 22, nos. 3863-7. 14. See M. Broome, A Handbook of Islamic Coins, p. 137. 15. A.A-H. Ibn Taymiyah, Al-Fatāwā al-Kubrā, vol. 28, p. 29; Ministry of Endowments and Islamic Affairs, Kuwait Al-Mawsu‘at al-Fiqhiyya 22 (Kuwait: Tiba’at dhat al-Salasil, 1986), vol. 22, p. 76. 16. Ministry of Endowments and Islamic Affairs of Kuwait, Al-Mawsūʿah alFiqhiyyah vol. 22, p. 76. 17. Including Sheikh Taqi Usmani (Pakistan), Sheikh Nizam Yaqubi (Bahrain) and Dr. Mohamed Elgari (Saudi Arabia), based on author’s personal discussions with them. 18. Qur’an (7:8), M. Asad translation. 19. M. Asad translation. 20. A.A-F.J.A.M. Al-Jawzī, Zād al-Masīr fī ʿIlm al-Tafsīr, p. 205. 21. M. al-Qaraḍāghī, Athar wa al-Duyūn, p. 54. 22. Ministry of Endowments and Islamic Affairs of Kuwait, Al-Mawsūʿah alFiqhiyyah vol. 22, p. 76.

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Interview with Professor Abbas Mirakhor on ‘S ̣uku‾k: Issues & Reforms’ by Sheila Ainon Yussof The ṣukūk industry as reported in the media in 2009 was plagued with ‘default likelihood’. One recurring issue is the discrepancy between Sharīʿah contracts and the governing law of the ṣukūk in executing and interpreting the transfer of assets to ṣukūk holders. As we know investors under Sharīʿah principles are given full recourse to trust assets with a right to liquidate them to recover investments, whereas under governing law they are treated like subordinated creditors. How can the ṣukūk industry resolve this conflict of laws in an environment where English law governs the majority of ṣukūk? Can harmonisation of laws iron out this discrepancy? The major lesson of the few ṣukūk defaults or near defaults, the most famous being those in the US, UK, and in Dubai, has been the need for ensuring legal strength of true sale in contracts. A number of Muslim scholars had long criticised provisions of ṣukūk contracts that did not envision complete transfer of property rights claims in case of default. This is the requirement of Sharīʿah-based finance. Reference is made to the Qur’an (2: 275), where the basis of transactions contracts is predicated on the foundation of al-bayʿ, defined in the lexicons of the Qur’an as ‘exchange of property for property’. In economic terms this is understood as full transfer of property rights claims resulting from the contract of al-bayʿ. This is rightly understood to be the same concept as the ‘true sale’. There is a great need to research how common law and Sharīʿah requirements can converge. One possible avenue is the way common law approaches contracts, in that any two parties can engage in any contract and it will be considered binding. The broad freedom of contract is recognised by Sharīʿah. As often emphasised by one of the most distinguished Muslim Sharīʿah scholars, Professor Hashim Kamali, the fundamental principle of Islamic contract law is ibāḥah, i.e., the permissibility of contracts so long as the subject of exchange and the procedures of operationalising the contract are not prohibited. It would be a great contribution by legal experts and Sharīʿah scholars to see how a convergence between common law and Islamic law of contracts could be achieved. Currently there is a dichotomy between the Gulf States and the practices of the Malaysian ṣukūk industry. Can AAOIFI [Auditing and Accounting Organisation for Islamic Financial Institutions] rulings and guidelines 162

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help in developing a common best practice in ṣukūk issuance and trading if participating countries are mandatorily made to subscribe to the international standard setter’s parameters? It should be recalled that without the innovative spirit of Malaysian scholars and financial professionals as well as the strong support of the Malaysian government, especially during the late 1980s and 1990s, the Islamic finance industry would have not been able to achieve the remarkable progress noted by all observers. The pace of that innovative spirit slowed somewhat in the early years of the new millennium but has, fortunately, picked up again. The forum provided by the AAOIFI for discussion of issues is a healthy and constructive approach to clarifying various views and reaching decisions. Making the rulings of AAOIFI mandatory is an issue that requires considerable deliberation, lest it chokes off the innovative spirit that a nascent industry needs for making progress. AAOIFI’s ruling/ban on the ‘repurchase undertaking’ feature in ṣukūk structures (equivalent to guaranteeing the return of capital to ṣukūk holders and forbidden in Sharīʿah) has resulted in the decline of issuances of profit sharing based structures such as muḍārabah and mushārakah. Do you think this will hamper the industry’s on-going effort to promote and develop risk-for-return principles and move away from risk transfer principles? It is arguable whether the AAOIFI’s ruling can be held solely responsible for the paucity of risk-sharing contracts and instruments in the industry. Practitioners see risk-sharing contracts as risky and claim that their clients are reluctant to assume high risks. Hence, efforts of the industry have focused on developing low-risk, highly liquid, and short-term instruments. However, there seems to be confusion between the concepts of risk taking and risk sharing. Risk taking is a real sector phenomenon whereas risk sharing is involved in the financing of the project. When an entrepreneur makes a decision to undertake a productive project, the risk is taken. That risk does not increase when it migrates from the real sector to the financial sector in search of financing. A given real sector project can be financed in three ways: through risk transfer, risk shifting or risk sharing. The latter reduces risk for individual investors rather than increases it. Beyond the issue of risk, however, there are other important concerns that need to be addressed. One is the lack of an incentive structure strong enough to elicit positive response from industry players. The most important elements of such an incentive structure are well known. One element is the need to create a level playing field between debt and equity. Bias toward the interest rate mechanism permeates throughout the economy 163

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in macroeconomic policies, commercial laws, administrative procedures, and accounting rules. Another element is the need for strong existence of the rule of law, clear property rights rules, contract enforcement, strong judiciary, protection of freedom of contract, and strong governance rules. Together, these constitute the institutional structure of the economy. These and a number of other rules have been prescribed in the Qur’an and operationalised by the Sunnah of the Beloved Prophet as the temporal head of state in Madīnah. These structures can only be put in place by governments. Another crucially important element is for Muslim governments to find ways and means of non-debt creating flows, domestic and external, to finance their expenditures. This will provide the market with low-risk, high-quality non-interest-based instruments that can serve as the growth engine of the industry. There is an industry need for a transparent and established benchmark for future cash flow valuation of all Islamic finance instruments, which includes ṣukūk in its pricing and profit making. Is it feasible to develop an Islamic pricing benchmark that is not pegged to interest-based benchmarks (KLIBOR, LIBOR) to calculate profits? Do you have an Islamic pricing benchmark model that the industry can adopt? There are various published research papers proposing Sharīʿah-based or Sharīʿah-compliant benchmarks and further research is being carried out to suggest others. There is, however, an issue that should be noted. The industry realises that it has to deal with the big banks in the conventional finance system. Choosing a benchmark with which the players in that system are comfortable, like LIBOR, is a way to ease transactions with these global banks. An acceptable benchmark would have to be credible, consistent and easy to understand. Such a benchmark would be obtained when and if Muslim governments were to issue sovereign risk-sharing instruments. The market-determined rate of payoffs on these instruments could easily serve to benchmark domestic and external financial transactions. Islamic banking requires that gains be based on real economic activity that benefits society rather than profiting select individuals. Do you think that asset-backed Islamic securitisation or ṣukūk are benefiting society in terms of infrastructural developments, or do they constitute merely another avenue to enrich HNWI [high net worth individuals] to the detriment of the larger segment of society? Can micro-financing be developed and expanded by Islamic financial institutions to help in funding the entrepreneurial capabilities of the HNI [have not individuals]? 164

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As was mentioned earlier, the entire industry is a work in progress. Quick and negative judgements such as expressed in a number of quarters are not warranted. Legitimate criticisms are constructive, but totally rejecting Islamic finance is neither correct nor helpful. Similarly, judgements about instruments developed thus far should be tempered with the realisation, alluded to above, that there is a self-correcting mechanism at work that mitigates the risk of entrenched unhelpful procedures and instruments. The use of structured products to finance infrastructure projects on [a] non-ribā basis is a relatively new concept. Clearly, infrastructural projects create employment and income. As such they are beneficial. [The] non-debt based nature of ṣukūk financing provides an added advantage. On microfinance, the Qur’an provides the best instrument for this purpose: al-qarḍ al-ḥasan. However, not much research effort has been expanded in exploring the potential of this powerful instrument. It is mentioned in nine verses of the Qur’an in some of which it is placed on a par with ṣalāh and zakāh. Few Muslims know of the importance of this tool of redistribution. Again, to help eradicate poverty, [a] strong enough incentive structure has to be put in place to enable Muslims to become familiar with this instrument and the associated rewards, as stated in the Qur’an and emphasised in the Traditions of the Beloved Prophet. We need to allow financial institutions to organise ways and means of mobilising al-qarḍ al-ḥasan resources to reduce poverty through employment-creating opportunities. Sharīʿah scholars have come under closer scrutiny today for becoming ‘too permissive in their approvals’ or because the composition of the Sharīʿah committees does not allow for a multidisciplinary assessment on system implications. Do you think that Malaysia can overcome these obstacles through the new Sharīʿah Governance Framework implemented in January 2011 where Islamic financial institutions are required to have on their Sharīʿah Board a cross-section of scholars from various disciplines? It should be kept in mind that Islamic finance, as well as other areas that are of interest in the contemporary renaissance of Islam, is still very much a work in progress. There may be some valid criticism of some actions or decisions but overall Sharīʿah scholarship is constantly evolving. What is admirable is that the profession of Sharīʿah scholarship is subject to vociferous internal, constructive scrutiny. After all, it was the sharp internal criticism by Sharīʿah scholars on issues regarding ṣukūk that has opened the possibility of modification. This is the strength of Sharīʿah relating to finance that is not matched by other systems of thought. That is, there is no self-correcting mechanism relating to social issues and praxis in other 165

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systems of thought. Effective influence of religious scholars that can have such profound impact on the market does not exist elsewhere. The example mentioned in your question about the Sharīʿah governance framework is further evidence of this influence. Compare this with the effectiveness of all the efforts of the late Pope John Paul II in his speeches, admonitions, sermons, encyclicals to steer entrepreneurs, CEOs, corporations, and firms in Christendom to follow the path of justice and fairness. For some his important positions on justice, fairness, human dignity, true purpose of life and economic and financial issues related to it, see the English translations of the writings of His Holiness, such Centesimus Annus, Laborem Exercen, Evangelium Vitae and Sollicititudo Rei Socialis. See also quotations from him in Mirakhor and Hamid [in] Islam and Development. That said, much reform is needed in the way Sharīʿah is applied at the present in the industry. At the same time, though, one should not rule out the chances of success of the efforts of those scholars who pursue changes that would lead to desirable results.

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Interview with Raja Teh Maimunah on ‘Issues in the Prevailing Financial Architecture with Special Reference to S ̣uku‾k’ by Zarina Nalla You have been an investment banker for most part of your career and ‘converted’ to Islamic finance in 2005. What is the differentiating principle of Islamic finance, in your understanding? Equitable financing and funding the real economy underlie Islamic finance, from which conventional banking has moved away. It has instead begun to make money out of trading on nothing, whereas, in Islamic finance, you need to be backed up by a true transaction. Making money from nothing is un-Islamic. The central features of Islamic finance that many are familiar with are the prohibition of usury or ribā, investments in non-permissible activities, and transactions involving maysir (gambling). There is also a prohibition on entering into a transaction that has an element of uncertainty on the subject matter or gharar. For instance, trading in something that one does not own. In contemporary finance, this means that naked trading of derivatives is disallowed (though writing a derivatives contract for hedging purposes may be deemed permissible). This current financial crisis is a credit crisis that could have been averted if the world had adopted the principle that we should be funding the real economy. The massive liquidity shortfall that occurred was the result of excessive leverage and speculative activities including dealings with the sub-prime mortgage papers. What you are buying is something not tangible, you don’t own it; you finance a piece of paper without a derivative product. Derivatives are allowed for the purpose they were meant for, which was to hedge financial transactions, but over time people took a hedging tool and traded on the hedging tool itself, decoupling derivatives from their true purpose. Those activities can hardly lay claim to having funded the real economy. It seemed that conventional financial markets were driven primarily by profit maximisation at all costs. What in your opinion is the current challenge facing the world of Islamic finance? When the world is so entrenched in the conventional system, the key concern is: how do you pitch to the market? The biggest challenge is 167

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pitching to consumers. You will be asked: is this new way cheaper, if not why should we do it, and people think that once it is interest-free then it must be cheaper and no cost is involved. How do you make Islamic finance attractive? You must pitch the philosophy to the buyers and the consumers. Let us take the concept of muḍārabah or mushārakah: you have the expertise but no money or have the money but no expertise, maybe we share 30 and 70; this is the equity structure in Islamic financing. What is the difference between asset-backed vs asset-based ṣukūk in layman’s terms? Asset-backed ṣukūk means that the ownership of the asset would have been transferred to the investor, for instance if you do an ijārah of a ship, the ownership of the ship will be transferred to the investor. So you are an issuer and you want to buy the ship, you are a financing company. You want to buy a ship and you want to raise 300 million dollars to buy it. Based on ijārah, you raise financing by going to the market, I will own the asset and I will lease it to you. In the asset-based system, on the other hand, the ownership may not be transferred to the investor, only the beneficial ownership of the asset will be transferred to the investor. Hence the asset can still be kept by the SPV [special purpose vehicle], somebody else or even the original owner. There is much debate today, especially among scholars, who say that, in the assetbased system, there is no real transfer of the title of assets and so this makes it less compliant. What is your opinion, from a practitioner’s viewpoint, that ṣukūk need to be asset-backed to be compliant and not asset-based? I disagree with this viewpoint. I am not sure where the scholars are coming from and when I ask them to explain clearly how this benefits the industry they are unable to give me a clear answer from a practitioner’s angle. Proponents of this view feel that, because the investor has a right over the asset, this would then protect his rights more. In practical terms there are a few things that must be considered: there are some jurisdictions that have not introduced tax neutrality; therefore, insisting on the transfer of ownership will only attract tax and will make this structure more costly and hence unattractive. For instance, in most cases when one has to sell, lease back, and buy back, he will attract stamp duty. With the exception of 168

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Malaysia and perhaps two other countries, Singapore and the UK, the rest of the world does not provide tax neutrality – not even Indonesia. If the cost becomes more expensive for the issuer, would he then bother to do it as an Islamic structure? No he wouldn’t. Hence, given this situation, insisting on a transfer of ownership acts as a deterrent to the growth of ṣukūk. Secondly, scholars insist that asset-based structures are wrapped and packaged, like conventional bonds, and that the investor’s rights are not being protected. As I said, this boils down to the legal framework; this is where, when I discuss the details with some scholars, they come to realise the difference. Some countries have adopted the common law or English law, where the transfer of beneficial ownership is allowed. These countries recognise the concept of trust law and the concept of trustee: even though I do not transfer the ownership of the asset to your name as long as I transfer the beneficial ownership you have a beneficial right to the asset, although I am the legal registered owner. I have a lesser right to deal in the asset than you, I cannot deal in the asset without your permission, for all intents and purposes I am just the legal owner but you have full rights over the asset, under the concept of common law and beneficial ownership. Under these circumstances the rights of the investor are not diluted at all, so it becomes irrelevant for that person to become a registered owner… and then again… you can say why can’t you make me the registered owner? Say we are in Australia and not in the UK, where there is no tax neutrality. If you insist on pursuing that route of transferring ownership of the underlying assets, you will attract tax. There is a need to ask the fundamental question of what is to be gained or what is the objective of demanding an asset-backed system. The main issue with scholars is that the moment it is asset-based, they see it is wrapped just like a conventional bond and they say that investors’ rights are not protected. In uṣūl al-fiqh it comes down to the underlying objectives and reasons. If you ask scholars why you need ṣukūk to be asset-backed half of them cannot tell you why. If the argument is that the investor’s rights need to be protected, this can be tackled if we have a legal framework that assures you that investors are protected. Our concern is then settled, but what, then, becomes of the difference between asset-backed and asset-based ṣukūk? Even if it is asset-backed … let’s take the Nakheel ṣukūk as an example. The question is what has been transferred to you: a four-billion-dollar pile of sand. The whole issue of ṣukūk blew up because of the Nakheel ṣukūk … people suddenly said that Islamic structures are not safe unless you say it is 100% mushārakah, which is not the case. It is credit; people still look at the cash flow … and what about in places where there are civil law codes, say in France or Germany, where there is no concept of trust law, no concept of 169

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beneficial ownership? Under those circumstances they are forced to make it asset backed. The asset-backed versus asset-based argument is parallel to the equity and debt argument. People say that the equity structure is more equitable than the debt structure … they say ṣukūk are debt-like … the various structures from equity to the cost-plus structures and the murābaḥah structures that we have are very debt-like. I think some of these conclusions are oversimplified; we must have a combination of products, fixed and floating to match consumer appetite and manage liquidity. How did the Nakheel failure take place in your opinion and what are the lessons one can learn from this? Investors and market observers alike were too quick to see the failure of Nakheel to meet its debt repayment as a failure of the instrument – i.e., ṣukūk, whereas the frustration I suspect stems mainly from the fact that they all thought that the Nakheel ṣukūk were guaranteed by the sovereign i.e. failsafe. The lesson learnt here is that a guarantee, if not explicit, cannot be relied upon. There are other lessons to be drawn upon as well. There is a pressing need for the capital market to be more regulated, especially in young markets such as the Gulf Cooperation Council (GCC), where authorities would have to play a more interventionist role to nurture the markets back to health by introducing tighter rules on issuances of ṣukūk – e.g., in Malaysia, ratings are mandatory and only investment-grade papers can be sold. Most markets lack wisdom at one time or another regardless of age and what is hoped is that they will learn from their mistakes and improve on the past. The Asian currency crisis had cut so deep that Asian markets still bear scars from the wounds and whilst the excitement of credit derivatives on sub-prime mortgages engulfed much of the West, Asian financial institutions generally kept at bay. The Malaysian ṣukūk market, whilst experiencing a slowdown due to global economic conditions, had not suffered to the same extent as the GCC. It is imperative to note that the ringgit ṣukūk market still dominates the global ṣukūk market and that the credibility of the instrument itself is not being questioned in Asia, but the credit reasonableness of each issue is always being put to test. It is not good enough to entice Asian investors with high yields if the paper does not make the credit. Investors must also learn to ask questions and not get caught in the frenzy of a bull market and rely on ratings at face value. The recent ṣukūk 170

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defaults should not be regarded as a failure of the instrument in itself, but a myriad of things typical of any credit issue. The hope is that markets become wiser and embrace better credit review practices. When consumers buy, say, Australian government bonds, they are given a capital guarantee and also enjoy fixed returns. Hence issuers have this obligation, which some observers say is unfair, because Islam demands that risks be shared by the lenders. Hence consumers must be made to understand that, if you want profitability, then you must also share the risk. Can you please comment? We may not always be able to guarantee everything but it is possible to give consumers some expectation or indication of a fixed return. For instance, under a leasing arrangement, I get rental of, say, 10% yield of this building, so I can give you 8%. I know what cash flow I will have, sometimes for three years even up to 15 years, in the shipping and aviation industry especially, the lease is up to seven years. We know upfront what kind of returns we will attract. Our borrowing cost is also fixed: when it is, say, inter-bank or when we borrow from customers, like simple deposits. We live in a world where we are trying to win people over from conventional banking. We are being criticised in Malaysia: our conventional banks offer 3% and the murābaḥah deposits also offer 3%, but please imagine if we do not offer our consumers anything or give them any indication … who will put their money with us? We cannot be idealistic. In terms of murābaḥah, we say this is an indication and as Muslims you do not ask for guarantees, as for ṣukūk there is no government guarantee per se, but having said that, there are ways to enhance your credit – even Islam allows third-party support … third-party pledges … not to guarantee the returns but to step in when something happens. I ask you: isn’t there an obligation to protect the economic well-being of the ummah? People cannot be expected to park their life savings with us and risk losing all their money; it is unreasonable. In terms of asset allocation and asset portfolio management there is a wide spectrum from risky to no risk. If we have the mushārakah type totally it will be very risky. Then you have the rental or ijārah type with reduced risk and then you have the no-risk type, which is murābaḥah. One must have a mixture of all three. I know scholars such as Sheikh Taqi Usmani are not happy when we try to mix the Islamic structure with some kind of cushion. For instance, the ijārah and mushārakah structures in Malaysia tend to offer a re-purchase agreement that one can sign upfront, which means the rental ijārah is for 171

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seven years and the original owner of the ship has the right to buy the ship back and you can sign this upfront at a pre-agreed price. The Shāfiʿī scholars say this is acceptable but the Ḥanafīs this is ḥarām. Why is this ḥarām? Like the concept of organised tawarruq, I disagree with the OIC Fiqh Academy, who came up with a ruling, which said that organised tawarruq is ḥarām. We developed a commodity murābaḥah platform when I was at Bursa Malaysia called Bursa Sūq Al-Sila’ to facilitate tawarruq transactions. I asked: where does it say that it is ḥarām? I contend that, if we are worried of rogue practices, then we do something constructive about it, e.g., draw up a clearly defined framework to govern such activities, rather than dismissing them as non-permissible. There are only two dissenting views that I know of … and Sheikh Nizam Yaquoby once remarked ‘where does it say in the Qur’an that the more disorganised you are the more Islamic you become?’ Do you think that agreeing on a price of a purchase that will take place in the future is not the ideal situation? Future prices may change. Coming to your earlier point of total risk sharing, well here it is. The person is taking a risk buying something that maybe cheaper or more expensive tomorrow or even obsolete in seven years’ time. This is the risk that you take. Fiqh al-muʿāmalāt is such an intellectual subject … one sheikh I spoke to said that God left room for interpretation to accommodate the evolving world. For instance, qurbāni: some feel that we need to perform qurbāni exactly the way that the Prophet (peace be upon him) did. We need to shake the man’s hand to do the ʿaqd… so how, then do you do qurbāni in Cambodia, [where] it is not acceptable? If you want to follow literally how the Prophet (peace be upon him) performed businesses and that is through a handshake then I cannot carry out ʿaqd through internet banking. I disagree with some of these classical jurists who take a literal view of matters and they study the practices of the Prophet (peace be upon him) 1400 years ago. Until today, I have seen clients in the GCC requiring palladium to be on the table so that the two parties can shake hands to execute a commodity murābaḥah transaction. We do billion dollars worth of trade, so how are we going to deliver this asset to you only for you to send it back to me? Some of them give this a lot of attention. For instance, in personal financing, you do the commodity murābaḥah, they put US$100,000 worth palladium on the table for the person to see it and take possession and shake hands. I have seen it all and this is because the Sharīʿah committee hangs 172

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on to the classical jurists’ view. So when the contemporary jurists take a more pragmatic view, they unfortunately become labelled as ‘liberal’, which is not a good term in the sector. With this attitude, how do we grow the ṣukūk? The biggest issue I have with ṣukūk is that the market is so small, and this is because it is hard to persuade people to embrace it exactly for these reasons, and also for all other reasons I have mentioned earlier: the assetbacked versus asset-based problem; there are places that do not have the concept of beneficial ownership, like South Korea. Then if you insist on asset-backed ṣukūk you would have to pay high taxes, it becomes expensive and this dissuades people from doing it. Islamic finance practitioners and Muslims generally need to pitch this better to the rest of the world. Many have observed that the Muslim world is not embracing ṣukūk. Can you comment on this? Before we pitch to the rest of the world why are not we ourselves doing it? A year ago the Malaysian government went to the market and raised US$1.2 billion; it did not need the money. It did not need US dollars because ringgit financing is actually cheaper than US dollar financing. In fact the Malaysian ṣukūk market is the cheapest ṣukūk market in the world; the ringgit ṣukūk market is actually cheaper than the ringgit bond market in Malaysia but the government went to the market to facilitate benchmark pricing, purely to facilitate price discovery, to help corporations and other governments around the world to get the feel of what would be the right price if you were to tap into the capital markets. The reason the Malaysian government is going out had very little to do with funding or financing its needs; it was purely to facilitate the development of the global ṣukūk market. In Malaysia the ringgit ṣukūk market is a very developed market at this point in time – it actually represents 83% of the GDP in Malaysia. We now have a full benchmark year curve for ṣukūk ranging from one month to 50 years, so that in itself has actually facilitated the growth of the capital market. One of the challenges that most of the industrial players see is that, on its own, industries and corporations will not be able to tap into the Islamic capital markets without help from the sovereigns around the world, particularly in raising financing in domestic currency. Where the ringgit is concerned, it requires the government to facilitate the government-backed benchmark issues to provide that kind of ringgit benchmark. There is no other jurisdiction or market that has a programme (other than Malaysia and Bahrain) that facilitates its Islamic market, especially its 173

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ṣukūk market. Until there is support from central banks and governments to facilitate the pricing and benchmarking, it will be very difficult to develop the Islamic capital markets, especially the ṣukūk markets of the Organization of the Islamic Conference states. The Islamic finance industry is currently worth US$1.139 trillion. However, 90% of the assets sit in seven countries – Qatar, Bahrain, Malaysia, Iran, Saudi Arabia, UAE and Kuwait – out of the 57 OIC countries. Even our neighbour Indonesia is not doing this, and neither is Pakistan. It is clear that the majority of Islamic nations have generally not embraced Islamic finance with vigour. There are those who contend that it is not yet an established industry – hence they adopt a wait and see approach. This can only delay the growth of this industry to a meaningful size if market participation is low, which in turn inhibits its growth and maturity. Greater participation by Islamic nations will undoubtedly enhance the vibrancy of the industry and consequently deepen the Islamic financial markets. If more nations adopt ṣukūk, say, to fund public infrastructure, there will be more supply of instruments of different maturity profiles in the market to facilitate liquidity management. The size of the ṣukūk market as of 2010 is said to be US$130 billion. The total global bond market as of 2009 is estimated to be about US$83 trillion. Hence the establishment of new Islamic banks will enhance the number of players within the industry, and thus expand the network and global connectivity required to deepen the Islamic money markets. This will in turn facilitate the growth and development of the Islamic economies as Muslims worldwide will have greater access to funding. Another challenge we face today is that many Islamic countries do not have enabling legislation, which would allow our banks to operate – specifically tax laws, which can be a bane to any meaningful progress in this industry. As mentioned, Islamic banking transactions are likely to attract taxes in most jurisdictions – e.g., stamp duty, capital and real property gains tax, namely on sale, and buy-back or lease-back contracts. Consistent throughout many jurisdictions, this has been a challenging hurdle to cross, as many countries fear that amendments to such laws would result in loss of revenue. Paradoxically, a number of non-Islamic nations have recognised the commercial opportunities the industry presents and have initiated the required changes in their laws to enable the offerings of Islamic financial products and enhance their positions as financial centres. Educating lawmakers and regulators in Islamic countries on Islamic finance and its impact on both societies and national revenue is thus paramount to ensure that misconceptions and fears are being addressed at the highest levels. 174

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Another major challenge the industry faces is the lack of tools to manage liquidity effectively. Managing liquidity is arguably the most critical element in the risk management framework of the financial industry. Managing short-term liquidity is especially challenging for Islamic banks due to the absence of an international Islamic money market. These banking products are supposed to be Islamically-inspired products – hence they are labelled with Arabic terms … there is much value in a word for some. Do you have any comments? Malaysia took a different approach. Overnight we had a greater reach. When we pitch to the Europeans, we pitch differently; we must not use religion… we must not use Islamic terms which is off-putting. We can instead call it participation banking like it is called in Turkey. This obsession with terminologies is problematic: why do you have to call it ijārah, or mushārakah… why can’t we call it for what it is? What is mushārakah? It is a partnership, the nature is participatory, if we are in France call it in French. I don’t speak French. What is ijārah? It is a lease. There are Muslims who insist that we should call it ijārah and nothing else … even ‘operating lease’ is unacceptable. I have met Muslims who say that we must use the Arabic terms no matter what. This over-zealousness does not help our cause at all. Is this daʿwah? Let me ask you: when you go and see a non-Muslim, do you say ‘Brother, embrace, from tomorrow onwards you cannot drink nor eat pork; you cannot do this and cannot do that etc…’ is that how we do daʿwah? You need to get him to buy in, ask him to do the dos, do not talk to him about the don’ts yet. In time inshā’ Allāh he will leave the don’ts. So now we need him to buy into the philosophy: why is Islamic finance better than conventional banking? Because it is truly better, because it can actually protect us from the next financial onslaught. I have said this before in an article that, in trying to govern this next banking framework, some principles of Islamic finance should be looked at. For us Muslims we look at our divine source for guidance, for the non-Muslims they will look at the source as just that, a source and take the wisdom from it. I also disagree with calling it ‘ethical banking’, because this implies that the rest of them are unethical. For those who are uncomfortable with the term ‘Islamic finance’, we could perhaps call it for what it is – participation banking – because it is participatory in nature. This is why there are not enough people embracing it. We must learn to be inclusive and learn how to pitch it correctly so that it can be attractive. For a lot of countries this is true: please do your research. 175

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The South Koreans failed twice to pass the ṣukūk law in parliament because the Christian lobby was not happy. The Islamic terms were a big deterrent. They said this will encourage terrorism funding and that they are a secular society. In France, it is the same thing; it has become a religious issue. We should not pitch from an Islamic perspective. Are our regulators doing enough to push for the growth of ṣukūk? Malaysian ṣukūk has grown to unbelievable levels. Over 65% of Malaysia’s bond market is already Islamic. I hope that the more developed Muslim countries will lead the way by doing government benchmark issues, which we only see in Malaysia and Bahrain. When you don‘t have price guidance and people do not understand structures, coupled with problems such as the Nakheel failure, then people tend to take the view that Islamic structures are more risky, and then investors immediately put a premium onto the price. So something that could otherwise have a rating of AA ends up being more expensive if we were to raise it in a Sharīʿah-compliant structure. However, Malaysia has proven that this should not need be the case – a credit is a credit, if a credit agency has given a AA it is a AA, if anything it should be cheaper because, a AA conventional bond does not have any asset behind it. The following is a comment from Mohammad Faiz Azmi, Global Islamic Finance Leader, PricewaterhouseCoopers: Some robust countries (in Africa) that do not need funding are also issuing ṣukūk with the prime objective of familiarising themselves with them. They say ṣukūk are new and unusual and they come up with a small issuance (it was just over US$100 million). The idea is that, when they need ṣukūk, they will already have the infrastructure needed in place. We also tend to forget that every time a bank gets set up, they need to put their money into something; it may be loans or financing or it may be paper. The problem is that there is simply not enough good-quality paper to invest in and that is why one major question in the Islamic financial world is how do you create more ṣukūk or other types of investment-grade paper that Islamic banks may invest in as a temporary measure before they start financing other businesses? That is why currently there is this initiative where 12 governments have combined their efforts to set up the Islamic International Liquidity Corporation. The idea behind this corporation is to issue sovereign ṣukūk papers using the assets of these 12 governments. 176

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Contributors’ Biographies (in order of contribution to this volume) Faizal Ahmad Manjoo was born in Mauritius in 1960. He completed most of his tertiary studies in South Africa at the Rand Afrikaans University and Madrasah Arabia Islamia. He holds qualifications in the fields of law, management, Islamic studies, mediation and arbitration and finance. He is an admitted attorney-at-law at the Pretoria High Court, South Africa and is presently lecturing on Islamic law and Islamic Finance at the Markfield Institute of Higher Education, UK, at post-graduate levels. He has authored many articles on Islamic finance and sits on the Sharīʿah supervisory boards of several Islamic financial institutions. He is also currently studying for his PhD on Islamic pensions. Raja Teh Maimunah Raja Abdul Aziz is the former Global Head of Islamic Markets at Bursa Malaysia. She has over 18 years’ banking experience, focusing on investment banking and Islamic finance. Prior to joining Bursa Malaysia, she was Chief Corporate Officer and Head of International Business of Kuwait Finance House (Malaysia), where she was responsible for the bank’s regional expansion and establishment of its Singapore and Australia offices. She also served at RHB Investment Bank, where she was responsible for the establishment of the investment banking division, and CIMB Investment Bank, covering debt and equity origination and equity sales. She served at Pengurusan Danaharta Berhad (Malaysia’s national asset management agency), tasked with restructuring the banking sector following the Asian financial crisis. She holds an LLB (Hons) degree from the University of East London and acts as an advisor on Islamic finance and banking at the World Islamic Economic Forum (WIEF) Foundation. She is also a member of the Islamic Finance Committee within the Malaysian Institute of Accountants (MIA). Abbas Mirakhor is currently First Holder of the INCEIF Chair of Islamic Finance. Formerly he served as Executive Director of the International Monetary Fund (IMF), representing the Iranian government. He was also Professor of Economics at the Florida Institute of Technology. He received his PhD from Kansas University and was awarded the Islamic Development Bank (IDB)’s 2003 Prize in Islamic Economics, together with Dr Mohsin Khan. He has authored or co-authored a series of books, 177

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including: Globalisation & Islamic Finance: Converge, Prospects & Challenges (2009); New Issues in Islamic Finance and Economics: Progress and Challenges, (2009); An Introduction to Islamic Finance: Theory and Practice (2006); Theoretical Studies in Islamic Banking and Finance (2005); Theoretical Studies in Islamic Banking and Finance (1st edition) (1988), Islamic Banking (1987); Stabilization and Growth in an Open Islamic Economy: An IMF Working Paper (1988); Analysis of ShortTerm Asset Concentration in Islamic Banking (1987); and Optimal ProfitSharing Contracts and Investment in an Interest-Free Islamic Economy, (1986). Dr Mirakhor has also published many articles and scholarly papers. Muhammad al-Bashir Muhammad al-Amine is the Head of Sharīʿah Compliance, Audit and Product Development at Unicorn Investment Bank. He was directly involved in the structuring and development of various products used by the bank, and in organising workshops to educate bank staff on principles and structures of Islamic finance. He joined Unicorn in 2005 and has been actively involved in its transactions in private equity, capital markets, mergers and acquisitions, corporate finance, asset management and treasury. He lectures on a part-time basis at the Faculty of Laws at the International Islamic University Malaysia, Ibn Sina Institute of Technology (Malaysia), the Matriculation Centre International Islamic University Malaysia, the Bahrain Institute of Banking and Finance, the Kingdom University in Bahrain and the Open University of Malaysia in Bahrain. He is the author of Sukuk and Islamic Securitisation Markets: Financial Engineering and Product Development (forthcoming); Risk Management in Islamic Finance: An Islamic Analysis of Derivatives Instruments in Commodity Markets (2008); and Istisna (Manufacturing Contract) in Islamic Banking and Finance Law and Practice (2001 and 2006). He has authored a number of articles that have been published in internationally refereed journals. Dr Muhammad Al-Bashir holds an LLB (Sharīʿah) from the Islamic University – Madīnah, a Master of Comparative Law (MCL) degree from the International Islamic University Malaysia and a PhD in law, also from the International Islamic University Malaysia. Rafe Haneef is currently the CEO of HSBC Amanah Malaysia and responsible for HSBC Amanah Global Markets in Asia Pacific. He has played a leadership role in developing ṣukūk and Islamic structured and project finance since 1999 at HSBC, ABN AMRO and Citigroup. He was previously the Head of Islamic Banking for Citigroup Asia, based in Kuala Lumpur, responsible for developing Malaysia as a regional Islamic finance hub for Citigroup and spreading its Islamic business footprint across 178

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the region. Prior to joining Citigroup, he established the Global Islamic Finance Department at ABN AMRO, based in Dubai, and was in charge of the Islamic wholesale and retail businesses for the group. Prior to that he was with HSBC Amanah in London and Dubai, focusing on Islamicallystructured cross-border transactions and the ṣukūk market. He was also a managing director at Fajr Capital, a Dubai-based Islamic investment company, looking at principal investments in the Islamic financial sector. Haneef read law and Sharīʿah at the International Islamic University in Malaysia. He was admitted to the Malaysian Bar and practised law in Malaysia, specialising in Islamic finance. He then pursued his Master of Laws degree at Harvard Law School before qualifying at the New York Bar. Mohammed Imad Ali is the Islamic Control Officer for Citi, based in Dubai. He works closely with the Islamic finance business team as well as the legal and compliance committees. Imad is the primary contact point for coordination with Citi’s Sharīʿah Advisory Board and advises Citi internally on Sharīʿah-related matters.  Prior to Citi, Imad was with HSBC Amanah in Dubai, where he worked in the Sharīʿah compliance department advising on Sharīʿah matters, monitoring and auditing the global markets, wealth management, private banks, and treasury businesses for Sharīʿah compliance. Prior to HSBC Amanah, he worked as a lawyer within the Islamic finance team at Denton Wilde Sapte. He obtained his Master’s degree in Comparative Laws from the Islamic University Malaysia, specialising in Islamic banking jurisprudence. He is admitted as a lawyer in India.    Sheila Ainon Yussof is a Senior Analyst at the International Institute of Advanced Islamic Studies (IAIS) Malaysia. Before establishing her legal practice as an advocate and solicitor, she accumulated ten years of corporate and consultancy experience as a human resource and communications specialist. After 17 years of legal work in conveyancing, banking and Sharīʿah, she specialised further by acquiring expertise in Islamic banking, takāful and Islamic capital markets, where structuring of Islamic financial instruments (ṣukūk, Islamic structured products) was her specialty. She is a Chartered Islamic Finance Professional (CIFP, Masters degree equivalent), gained from INCEIF, and holds a Master’s in Comparative Laws from the International Islamic University Malaysia. Her current challenge is to complete her PhD in Islamic banking and finance at IIIBF by 2012, where her contribution to the takāful industry will be through the proposed development of a model operational audit framework for family takāful. Abdul Karim Abdullah @ Leslie Terebessy is Research Fellow at IAIS Malaysia, a position he has held since February 2008. He has conducted 179

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research on issues pertaining to Islamic finance. He published ‘The role of adjustable rate subprime mortgages and credit default swaps in the current financial crisis’, in the October 2010 issue of Islam and Civilisational Renewal (ICR), and ‘Overcoming weaknesses in sukuk structures: Towards risk sharing’, in the July 2011 issue of the ICR. He obtained an MA from the University of Toronto, specialising in political science, and an MEd from the Ontario Institute for Studies in Education, University of Toronto, in moral and religious education. Prior to joining IAIS, he lectured in literature in English at the University Sains Islam, Malaysia, with a focus on Shakespeare, creative writing, and English for special academic purposes. While at USIM, he edited Islamic Studies in World Institutions of Higher Learning, the INFAD (World Fatwa Institute) Bulletin (English section), as well as the English section of the USIM website. While at USIM, he delivered a workshop on how to write a research paper. Prior to joining USIM, he was a lecturer in economics in several private institutions of higher learning in Malaysia and Canada. Sirajulhaq Hilal Yasini studied Sharīʿah with traditional Sharīʿah scholars and is a Sharīʿah and law graduate from al-Azhar University in Egypt. He holds a Master’s degree in Banking and Financial Law from the Boston University School of Law and his research area is Islamic transactional law. Sirajulhaq started his career in Islamic finance in HSBC Amanah in 2005. He worked with Citi Islamic from 2007 to 2010 and established its Sharīʿah department. Currently, he is the Global Head of Sharīʿah in HSBC Amanah, responsible for HSBC Amanah’s compliance with Sharīʿah. Sirajulhaq’s expertise includes advising and structuring products and transactions for capital markets, investment banking, treasury, commercial banking, private banking, private equity, asset/wealth management, consumer banking, structured products, and takāful. He speaks English, Arabic, Pashto, Persian, and Urdu. Nermin Klopic is a graduate in Islamic law from the Islamic University of Madīnah. He also holds Postgraduate Diploma in Islamic Judiciary and Politics from the same university and holds a Postgraduate Diploma in Teaching Arabic Language from King Saud University, Riyadh. Klopic also holds a Master’s degree in Islamic Finance from INCEIF, Malaysia, the topic for his Master’s project being: ‘Shariah parameters of maṣlaḥah in financial transactions’. He has worked in the fields of education and research, and has also been attached to ISRA, Malaysia, as assistant researcher. He is currently working in the Sharīʿah department at HSBC Amanah, as Manager, Shariah Advisory and Research. 180

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Transliteration Table Transliteration Table

vi

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Glossary Al-bayʿ

Exchange of property for property. Trading.

Al-bayʿ bithaman ājil

Under this concept, the bank will purchase an asset at cost price and sell the same to the customer at cost plus profit, on deferred payment basis, at the time and price agreed to by both parties, payable by fixed instalments. Deferred payment sales.

Allah

The Name of the Creator of the Universe and all that it contains according to Islam. Derives from the word ilāh which means ʻthe One deserving all worshipʼ, the One to Whom all hearts submit in love, fear, reverence, desire, trust and sincerity, and to Whom all limbs submit in all forms of worship such as prayers, supplications, sacrifices, invocations, etc.

Al-qarḍ al-ḥasan

Good loan; interest-free loan. No-cost loans are designed for poor or needy people. These are mostly backed by collateral securities. Otherwise generally loans provided by banks do not charge any interest but they take service charges to cover up the costs.

Amānah

Lit. reliability, trustworthiness, loyalty, honesty; Technically, an important value of Islamic society in mutual dealings; anything that is in posses­sion of a person who is not the owner of it for safekeeping. In case of unintended loss to the thing, he is not obliged to pay compensation. Trust, trusteeship.

Amīn

Custodian or guardian; trustee.

ʿAqd

Agreement, contract.

Bayʿ al-ʿinah

This is contract for a buyback. Under this contract, a seller buys back the assets he or she sold on a deferred basis but at a higher price.

Bayʿ al-dayn

Sale of debt. This is the Sharīʿah principle that governs the sale and purchase of debt certificates.

Dayn

Loan, due, receivable, debt.

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Fair value

A valuation, in accordance with standard methodology, that is reasonable to all parties involved in a transaction in light of all pre-existing conditions and circumstances.

Faqīh (pl. fuqahā’)

Jurist; an Islamic scholar who can give an authoritative legal opinion or judgement. Jurists who give opinion on various issues in the light of the Qurʼan and the Sunnah and who have thereby led to the development of fiqh.

Fatwā (pl. fatāwā)

A religious decree; a legal verdict given on a religious basis. The sources on which a fatwā is based are the Holy Qurʼan, Ṣaḥīḥ Bukhārī and Muslim, and all other authenticated aḥādīth.

Fiqh

Muslim jurisprudence; it covers all aspects of life, religious, political, social or economic. In addition to religious observances (prayer, fasting, zakāt and pilgrimage) it covers family law, inheritance, social obligations, commerce, criminal law, constitutional law and international relations, including war. The whole corpus of fiqh is based primarily on the Qurʼan and the Sunnah and secondarily on ijmāʿ and ijtihād.

Fuqahā’

See faqīh.

Gharar

Deceptive ambiguity. Uncertainty, hazard, chance or risk, ambiguity and uncertainty in transactions. Technically, the sale of something which is not present at hand; or the sale of something where the consequences or outcomes are not known. It can also be a sale involving risk or hazard in which one does not know whether it will come to be or not, such as fish in water or birds in the air; or an event where assurance or non-assurance is subject to chance and thus not known to parties in a transaction. It also means uncertainty or hazard that is likely to lead to a dispute in a contract. Excessive risk-taking especially in financial contracts and transactions.

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Ḥalāl

Things/acts lawful in Islamic law; permissible. The concept of ḥalāl has spiritual overtones. In Islam there are activities, professions, contracts and transactions which are explicitly prohibited (ḥarām) by the Qur’an or the Sunnah. Barring them, all other activities, professions, contracts, and transactions etc. are ḥalāl. This is one of the distinctive features of Islamic economics vis-à-vis Western economics where no such concept exists. In Western economics, all activities are judged on the touchstone of economic utility. In Islamic economics, other factors, mostly spiritual and moral are also involved. An activity may be economically sound but may not be allowed in the Islamic society if it is not permitted by the Sharīʿah.

Ḥarām

An act or product that is unlawful or prohibited in Islam. Forbidden, illegal. Act or conduct that incurs both blame and punishment.

Hibah

This term means gift. When somebody takes a loan from any Islamic bank, they do not charge any interest on it, but the person who borrows money gives a gift voluntarily, known as hibah. Gift, unconditional transfer of assets to another person or institution.

Ḥukm (pl. aḥkām)

Verdict; rule; command; prescription; the ḥukm of a contract is a term for the legal effects of the contract, as distinguished from its ḥuqūq (rights of performance of the contract). Ruling, judgement, Sharīʿah value.

Ḥuqūq (sing. ḥaqq)

Rights; Lawful claims.

Ibāḥah

Permissibility. The permissibility of contracts so long as the subject of exchange and the procedures of operationalising the contract are not prohibited.

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IjÉrah

A contract between a lessor and a lessee in which the lessor being the owner of the property allows the lessee to enjoy the usufructs of the property at agreed terms on the rental and period of lease. This financial instrument is designed for financing vehicles, machinery and equipment, and airplanes. This is a lease agreement in which one party leases the asset to another at a pre determined condition and rent. Before that, the bank buys the item from market and leases it to the client, than at the maturity of the contract the lessee pays the amount (lump sum or instalment decided at the time of contract) and if he wishes he can become the owner of the item (optional). The ownership risks are borne by the bank as well as the right to sell the asset in the market.

Ijmāʿ

Consensus of opinion of Muslim jurists on a specific matter; consensus of the jurists on any issues of fiqh after the death of the Prophet, peace is on him. See also fiqh. General consensus of the community or scholars. The unanimous agreement of the mujtahidūn (scholars capable of deducing the law from its sources) of the Muslim community of any period following the demise of the Prophet Muhammad on any matter.

Ijtihād

Lit: effort, exertion, industry, and diligence. Technically, endeavour of a jurist to derive or formulate a rule of law on the basis of evidence found in the sources; scholarly effort through which a jurist/scholar derives Islamic law on the basis of the Qurʼan and Sunnah. Independent reasoning or interpretation.

Imām

The head of state. Leader of the congregational prayer; also used for the founders of different schools of Muslim jurisprudence or other eminent jurists and also for the prominent descendants of ʿAlī ibn Abī Ṭālib and distinguished Shia theologians. In aḥādīth it has also been used to refer to the ruler.

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Intangible assets

An identifiable non-monetary asset without physical substance. An asset that can neither be seen nor touched. The most common of these are competencies, i.e.: market power, goodwill, patents, trademarks and copyright.

Isnād

The chain of transmission of a tradition.

Istiḥsān

Juristic preference, also equity. When enforcement of normal rules in a particular case fails to provide a satisfactory solution, the judge or jurist should attempt to provide a preferable or equitable solution. Principle according to which the law is based upon a general legal principle in preference to a strict analogy pertaining to the issue, the principle is used by the Ḥanafīs as well as the Mālikīs.

Istiṣnāʿ

Commissioned production. The literal meaning of the word is ‘asking someone to manufacture’. Such contracts are widely used for construction of buildings and related products, manufacturing of aircrafts, ship, machines, etc. Such contracts also involve a sale contract between a buyer and a seller to sell an asset before it comes into existence. To fulfil the contractual conditions either the seller will manufacture the asset on his own or ask someone else to deliver it to the buyer on a predetermined date. A contract of sale of specified assets to be manufactured or constructed, with an obligation on the part of the manufacturer or builder (contractor) to deliver them to the customer upon completion.

Istisnāʿ asset

Subject matter of the istisnāʿ contract which shall be an asset to be manufactured or constructed and is able to be transformed, processed, converted or changed to meet the purchaser’s specifications.

Jahālah

Lack of knowledge. Uncertainty; uncertainty in a contract that may lead to a later dispute.

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Juʿālah

The undertaking of one party (the jāʿl, bank or employer) to pay a specified amount of money to another party in return for rendering a specified service in accordance with the terms of contract. A contract wherein one party offers a specified compensation to anyone who achieves a determined result, such as returning a fugitive individual or a stray animal or constructing (a structure) or tailoring (clothes), and other types of work and services where leasing is permissible. Offering a reward to an unspecified worker.

Market value

The value of an asset if it were to be sold on the open market at its current market price.

Maysir

Gambling. Literally means getting something too easily.

Muḍārabah

This is a kind of partnership between two parties where one partner promises to provide the capital (rabb al-māl) and the other one promise to be an investment manager. Profit is distributed at a predetermined ratio while entering into the contract, but in case of loss, only the capital investor (rabb al-māl) will bear it. The investment manager does not guarantee to earn profits unless it is a case of violation of contractual terms.

Muʿāmalāt (sing. muʿāmalah)

Civil and commercial transactions.

Murābaḥah

A contract for buying and selling assets whereby the price which includes a profit margin is agreed upon by both parties (the purchaser and seller). These agreements allow Islamic banks to purchase specific commodity on the client’s behalf. In return the client promises the bank to purchase the commodity from bank at a deferred price (which includes the cost plus profit margin). Hence it includes two contracts, one between bank and the seller (generally the bank authorises the ultimate buyer to receive the delivery of goods as its agent) and the other is between the bank and the client. 187

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Mushārakah

Partnership. Mushārakah is quite similar to muḍārabah with a small difference that in case of mushārakah both parties are the capital owners and the manager can participate in management as well as in the profit and loss. Profits can be distributed at a predetermined ratio but the losses have to be borne in the capital investment ratio only.

Operating lease

A lease contract in which the lessee does not have the intention to own the asset.

Pari passu

Ranking equally, e.g. when a new issue of shares is said to rank pari passu with existing shares, the new shares carry the same dividend and winding-up rights as the existing shares. A pari passu bank loan is a new loan that ranks on level par with older loans.

Qarḍ

A loan given for a good cause in the name of Allah, in hopes of repayment or reward in the Hereafter; debt.

Qiyās

The extension of a Sharīʿah value from an original case to a new case because the latter has the same effective cause as the former. Lit. analogy; syllogism. Technically, analogy through which Islamic law is derived from a textual injunction for a given nontextual matter. Analogy, analogical reasoning.

Qurʼan

The Holy Book containing the actual words of Allah revealed to the Prophet Muhammad (peace be upon him). This Holy Book of the Muslims consisting of the revelations made by God to the Prophet Muhammad, peace be on him, during his prophethood of 23 years. The Qurʼan lays down the fundamentals of the Islamic faith, including beliefs and all aspects of the Muslim way of life. These are supplemented or further elaborated by the Sunnah. The Qurʼan consists of 60 parts  (aḥzāb), 114 chapters (sūrahs), and 6,666 verses (ayāt). In all references to the Qurʼan in the text (e.g., 30: 41), the first number refers to the sūrah and the second to the āyah or verse.

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Rabb al-māl

Capital provider, ṣukūk holder, capital owner.

Rahn

Pledge or lien.

Ribā

Interest. Literally means increase, addition, expansion or growth. It is, however, not every increase or growth that has been prohibited by Islam. In the Sharīʿah, ribā technically refers to the premium that must be paid without any consideration. According to the jurists of Islam this definition covers the two types of ribā, namely ribā al-faḍl and ribā al-nasī’ah. Example One of ribā: if A sells $100 to B with $110, the premium of $10 is without any consideration or compensation. Therefore this amount of $10 will be ribā. Example Two of ribā: if A lends $100 to B (a borrower) with a condition that B shall return to him $110 after one month. In this case the premium that must be paid by the borrower to the lender along with the price is ribā because the premium of $10 is without any consideration.

Ṣalāh

Ritual prayer.

Salam

It is a kind of sale where a prepaid item is delivered at a future predetermined time. Here the price is paid on the spot but the delivery is received in the future. This is an exception to Islamic law where the existence of goods is necessary to enter into a contract but in case of salam it is not necessary that the goods sold are in physical existence while entering into a contract. Forward sale.

Sharīʿah

Islamic Jurisprudence. Divine law consisting of Qurʼan and Sunnah and on justification.

Sharīk

Partner. Investment manager.

Shirkah al-ʿaqd

A partnership of contract.

Shirkah al-milk

A partnership of property.

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Ṣukūk

Plural of ṣakk. Check, certificate of debt, certificates of investment. Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct or services, or (in ownership of) the assets of particular projects or specific investment activity; this applies after acquisition of the value of the ṣukūk and the closing of subscription, beginning with the employment of funds received for such purpose for which the ṣukūk were issued. Ṣukūk meeting this definition are known as ‘investment ṣukūk’ (alṣukūk al-istithmāriyyah), in distinction from shares and conventional bonds.

Sunnah

Any saying of Prophet Muhammad (peace be upon him) or his act or any act of his Com­panion endorsed by him. After the Qurʼan, the Sunnah is the most important source of the Islamic faith and refers essentially to the Prophets example as indicated by his practice of the faith. The only way to know the Sunnah is through the collection of aḥādīth.

Taḥjīr

Earmarking a piece of wasteland that has no owner by an individual in order to rehabilitate it. (This establishes the right of ownership on such land.) To put a stone and other things on the boundaries of land, so that other persons may not lay hands on it.

TakÉful

Islamic Insurance. A scheme of mutual support that  provides insurance to individuals against the hazard of falling into unexpected and dire need.

Tangible assets

An asset that has a physical form.

Ujrah

This term broadly refers to as fee or a financial charge for services. The concession for a known amount.

Ummah

Refers to the whole Muslim community, irrespective of colour, race, language or nationality, which carry no weight in Islam.

Usufruct

Benefits of an asset which can be enjoyed by a person without altering the substance of the asset.

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Uṣūl al-fiqh

Principles of Islamic jurisprudence.

Waʿd

Promise or undertaking.

Wakālah

A contract where a party authorises another party to act on behalf of the former as long as he is alive.

Wakīl

Investment agent.

Working capital

The part of the capital of a company that is employed in its trading operations. It consists of current assets less current liabilities.

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INDEX Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) 11-14, 17-19, 21-22, 25, 30-32, 34-35, 41-44, 48, 52, 5456, 62, 64-65, 67, 97-99, 111, 115, 134-135, 141-143, 145, 160-163 Bank Negara Malaysia 32, 143 benchmarking 2, 101, 110, 112, 174 bonds 1-3, 7, 12, 17-19, 25, 28, 31-32, 35, 40-41, 53-54, 57, 60-61, 63, 66-67, 69, 71, 74, 76-79, 86, 89-90, 93-94, 100-101, 103, 124, 169, 171, 190 conventional bonds 1-3, 7, 19, 32, 41, 57, 60, 66-67, 71, 90, 101, 124, 169, 190 Islamic bonds 2, 25, 28, 31, 53-54, 61 common law 4, 7, 9, 23, 36, 162, 169 compliance 2, 7-8, 23-25, 32, 34-37, 39, 41-42, 49-50, 90, 96-99, 102-106, 108-112, 159, 179-180 concession rights 8, 113-115, 126, 133-134, 137 countervalue 16, 81, 158-159 debt instruments 1-3, 36, 63, 106, 151 dīnār 152, 156 English law 15, 17, 20, 35, 51, 162, 169 equity 10, 16, 18, 26, 28, 36, 61-63, 70, 74-77, 79, 84, 94, 96, 99, 157, 163, 168, 170, 177-178, 180 fixed income 18, 32, 100, 112, 161 Gulf Cooperation Council (GCC) 19, 29, 33, 49-50, 170, 172 guarantees 5-6, 10, 20, 62, 82, 171 income and capital guarantees 3, 6, 76, 79, 84-85, 90 Ḥanafīṣ 117, 122, 128-129, 131-134, 152, 158, 192 Ḥanbalīṣ 129-131, 133, 152 ijtihād 24, 29, 49, 98 interest 2-4, 10, 13, 16-20, 22-23, 25, 27, 37-38, 45, 47, 49, 57, 59, 64, 66, 6972, 74, 76-90, 94, 99, 104-105, 124-125, 135-137, 164-165, 168, 182 International Islamic Rating Agency (IIRA) 8, 50, 101-103, 109 investor protection 4, 6, 9 Islamic Debt Securities (IDS) 72 Islamic Finance Information Service (IFIS) 13, 53-54 192

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Islamic Financial Services Board (IFSB) 12, 22, 26, 31-32, 53-54 Islamic Fiqh Academy 26, 30, 54, 120, 134, 140, 142 leasing 14, 21, 91, 95, 99, 116-118, 121, 129-130, 171, 187 London Interbank Offered Rate (LIBOR) 2, 44, 164 Malaysian Rating Corporation (MARC) 101, 103, 106, 108-110, 112 Mālikīs 121, 129-131, 133, 152 marketing rights 61, 114-115, 119-120, 124, 135, 137-138 Middle East and North Africa (MENA) 33, 101, 160-161 Moody's 19-20, 26, 28, 32, 43, 53, 56, 101, 103-104, 108 Muslim World League 120, 134, 140, 142 obligor 4, 19, 36-38, 41, 95, 107, 112, 151 Organisation of Islamic Cooperation (OIC) 11, 23, 123, 172, 174 originator 2, 5-6, 8, 12-13, 15-20, 22-23, 34-37, 40, 43, 46,-48, 58-60, 6267, 88, 99-100, 103, 110 ownership 4-7, 9-10, 12-13, 15-19, 22, 30,-32, 34-36, 38-43, 47-49, 51, 5759, 61-62, 64, 66, 75, 87, 99-100, 106, 111, 117, 119, 124-125, 135, 168-169, 190 beneficial ownership 4, 13, 16-17, 30, 35-36, 39-41, 57, 67, 99, 146, 161, 168-170, 173 legal ownership 6-7, 16, 35, 39 partnership 19, 21, 42, 67, 84-86, 89, 118-119, 125, 133, 175, 189 profit and loss sharing 18, 57, 70, 80, 84, 86-87 purchase undertaking 11-15, 18, 20, 22-23, 30, 37-38, 41-44, 48, 57, 61-62, 64, 137 rating 7-8, 14, 18-19, 32, 35, 39, 41-43, 47, 50, 57, 62-66, 71, 95-112, 176 Rating Agency Malaysia (RAM) 101, 103, 106-108, 110, 112 replication 3 repurchase undertaking 34, 42, 163 risk 2, 6, 12, 15-17, 23, 32, 39, 42-43, 47-48, 51, 57, 65, 67, 71, 75-76, 7879, 81-82, 84, 88-90, 96-97, 100-101, 103, 163, 165, 171-172 asset risk 5, 35, 39, 41 risk of assets 51 risk of the asset 36, 43 business risk 100 collective or systemic risk 70 counterparty risk 112 193

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credit risk 6, 17, 20, 36, 41, 43, 45, 103-104, 107-108 credit risk assessment 103, 106 credit risk assessment rating 103 credit risk bias 103 credit risk perspective 104 credit risk profile 106 currency risk 104 default risks 108 default risks rating 109 legal risk 23 market risk 147 monetary risk 98 originator risk 5 ownership risk 16 price risk 147 risk-and-reward sharing 100 risk appetite 101 risk aspects of the sukuk 96 risk-based pricing 109 risk-for-return principles 163 risk management 175 risk of default 2-3, 79, 94 risk of losses 75 risk of non-repayment 81 risk of Sharīʿah non-compliance 96 risk profile 1, 101-102, 106, 108 risk-reduction 74 risk sharing 1-3, 7, 77, 79, 84, 87, 90, 163-164, 172, 180, 194 benefits of risk sharing 3 principle of risk sharing 90 risk sharing contracts 77, 163 risk sharing instruments 1, 87, 164 risk sharing securities 1, 79 risk shifting 163 risk taking 163 risk transfer 163 194

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risk transfer principles 163 risk-transferring contracts 77 Sharīʿah credibility risk 103 Sharīʿah non-compliance risk 97 Sharīʿah risk 24 ṣukūk risk 47 sale 4-12, 15-20, 22, 27, 29-30, 32, 34-41, 43-45, 47-49, 59-61, 64-66, 80, 87-88, 90, 95, 111, 118, 120, 122-123, 125, 128-133, 135-136, 145147, 151-152, 155, 161-162, 174, 182, 189 sale that falls short of a true sale 4, 7 true sale 4-7, 9-12, 15-16, 18, 20, 30, 34-36, 39, 41, 44-45, 47-49, 64-65, 111, 162 valid sale 7, 30, 146 Securities Commission of Malaysia (SCM) 31-32 securitisation 6-8, 11, 14, 18, 20, 23-27, 31-32, 48-51, 61, 65-68, 91, 96-97, 99, 105-106, 111, 123-124, 126, 133, 164 Shāfiʿīs 115, 121, 129-131, 133, 152, 172 shares 2, 18, 31, 36, 38, 45, 59, 61-62, 69, 72, 74-80, 87, 89, 94, 124, 135, 146-147, 154, 157, 190 Sharīʿah Advisory Council (SAC) 31-32 Sharīʿah Quality Rating (SQR) 102 special purpose vehicle (SPV) 5, 13, 15-18, 20, 25, 27, 36, 43, 47-48, 58, 88, 99-100, 105, 138, 168 Standard & Poor’s (S&P) 101, 103-105 ṣukūk asset-backed ṣukūk 5-7, 9, 11-12, 14, 17-18, 20, 35-36, 40, 45, 48, 65, 100, 103, 107, 111, 164, 168-169, 173 asset-based ṣukūk 4, 7, 11-12, 15, 19-20, 35, 39-40, 64, 100, 103, 109, 111, 135, 168 debt-based ṣukūk 135, 143 muḍārabah ṣukūk 30, 41-42, 44, 60, 62, 89 muḍārabah-based ṣukūk 21 muḍārabah ṣukūk structures 41 ṣukūk al-muḍārabah 125 murābaḥah ṣukūk 34, 60, 72, 87, 91, 93, 99, 124-125, 135, 146-147, 170172, 187 195

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murābaḥah ṣukūk structures 60 murābaḥah-tradable ṣukūk 32 mushārakah ṣukūk 30, 34, 41, 44 mushārakah-based ṣukūk 21 mushārakah-exchangeable ṣukūk 73 ṣukūk al-mushārakah 125 participatory ṣukūk 2, 21, 72, 87-89 ṣukūk defaults 1-2, 4, 9-10, 34, 46, 71, 97, 162, 170 ṣukūk ijārah 34, 62, 72-73, 87, 99-100, 112, 145 ijārah-based ṣukūk 21 ṣukūk mudarabah 13-14, 90 ṣukūk murabahah 87 ṣukūk mushārakah 2, 47, 73, 90 trade-based ṣukūk 87 wakālah ṣukūk 8, 30, 34, 41-42, 44-45, 73, 145-146, 153, 155-156, 161, 196 wakālah-based ṣukūk 21 wakālah ṣukūk assets 39 wakālah ṣukūk holders 161 wakālah ṣukūk issuance 153, 161 wakālah ṣukūk issue 153 wakālah ṣukūk structures 41, 62 usufruct 32, 117-119, 124-125, 129-135, 138, 143, 190

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