Understanding Sukuk | Farmida Bi, Partner, Norton Rose

Let me start by assuming no knowledge and talking about Sukuk. As you know, the short description of a Sukuk is an Islamic bond, but that's not quite right. A bond is normally a piece of paper which is an IOU — it's an obligation where I say I, Farmida, promise to pay you, Jibreel, 100 million pounds on the 20th of November 2014, with interest every six months at a rate that we're going to agree. And so that's a debt obligation.

A Sukuk is different because what it does is represent a share in the actual property that is represented by the Sukuk. So AAOIFI, which is the auditing and accounting organization for Islamic financial institutions, based in Bahrain — it's effectively a voluntary body, it has no external standing, but I think it has become increasingly important. In addition to producing auditing standards, it produces Sharia standards. Their definition of the Sukuk is the one that's now widely used in the market, and it's the one set out on the slide. It is a certificate of equal value which represents undivided shares in the ownership of tangible assets.

And it's this concept of a direct proprietary interest that is causing the French so many problems at the moment. You may have heard that the French government is trying to introduce a Sukuk law which has just been thrown out by a Constitutional Court on the ground that it wasn't introduced properly — it was added on to another piece of legislation. But because France has a civil law system which doesn't recognize, or hasn't traditionally recognized, the concept of trust, trying to create a direct proprietary link between the holder of this Sukuk and the underlying asset in the absence of a trust arrangement has always been extremely difficult for them.

From an English law perspective, it's very easy. I declare a trust, and what I'm saying is I now hold my interest in this Sukuk for you because you've given me the money, and you have a direct interest that's enforceable as a result. So that's the definition — it's not a debt instrument, it's something that gives you a direct proprietary interest in the underlying asset.

The next thing is: is it a debt security or an unregulated collective investment scheme? A collective investment scheme is usually a fund or a pool where each of us contributes some money and that pool itself goes out and invests in a product. And our analysis has always been that a Sukuk is, from an English law perspective, an unregulated collective investment scheme. For a long time the Financial Services Authority refused to engage with that. They have now accepted that Sukuk are unregulated collective investment schemes, that they should not be, and there is some secondary legislation going through at the moment where, as a matter of legislation, Sukuk will be treated like bonds, like debt instruments. But that is effectively changing the law.

And then the issue that's becoming, I think, crucial now is: are Sukuk asset-pass-through or asset-based? If we have time, I'll talk briefly about the Sukuk in the market that have defaulted or that are in trouble. And my view, talking to journalists this morning, is the prospectuses, the documents, are absolutely clear that almost every Sukuk in the market is asset-based. It's not, as it's sometimes described, an asset deal. And by that what I mean is: there is an asset that underlies this Sukuk, but when things go wrong, your right to that asset is transferred by a contractual arrangement in the document — typically a purchase undertaking — and so what you're left with is a contractual right, but to that purchase undertaking. You don't have a right to the asset.

On a well-known transaction that some of you are aware of — the Saudi Al Arkham Sukuk — it is interesting that some of the extremely sophisticated investors who are Sukuk holders in that transaction don't really understand whether they have a right to the underlying asset or not. In most cases, they do not have a direct right to the asset when things go wrong. When things are going right, they do, but contractually they've given it up. So most of the Sukuk in the market are asset-based and not asset-backed.

I think the growth of Sukuk over the last four years, from about 2003–2004 onwards, has been one of the biggest changes in the capital markets. There are about 100 billion of Sukuk outstanding now, and as I've said, most of them are asset-based. They represent ownership of an underlying pool of assets. In an insolvency or a default situation, your recourse is to the purchase undertaking — it's like a guarantee. I'll describe it when we move on to a diagram of a structure. And the fact that your recourse is to the contractual claim contained in the purchase undertaking is reflected not just in the rating that's given to the Sukuk — which is based on the rating of the provider of the purchase undertaking — but that's also how the stock exchanges treat the Sukuk. They're treated like guaranteed notes where the guarantor is the entity that has provided you with a purchase undertaking.

There are many Islamic structures that can underlie a Sukuk, but the three most common are Ijara, Musharaka, and Mudaraba. And since the AAOIFI statement that some of you may be aware of last February about fixed-price purchase undertakings, Ijara now heavily dominate the market, but also traditionally Musharaka and Mudaraba. An Ijara is a lease — I buy a property and then lease it back, and it's the rentals from that lease which generate the returns that are paid to Sukuk holders. A Musharaka is a joint venture where one party contributes physical assets and the other contributes cash, and the physical assets have to be at least a third of the overall pool. With the Mudaraba, there's no physical asset at all. And I will describe three structures where each of those different underlying structures are used.