The market for sukuk, Islamic bonds, experienced phenomenal growth during its first years in existence. At its inception in 2001 the market was worth less than $500 million (Dh1.83 billion) yet by 2007 the value of sukuk issued around the world was greater than $60bn.
Despite this, in 2008, the number of sukuk issued globally declined for the first time. Market commentators attribute this to a number of factors, including the global financial turbulence and resulting market conditions. Additionally, the default by the Kuwaiti firm Investment Dar on a $100m sukuk and the headlines relating to Nakheel has possibly led to investor uncertainty regarding the treatment of sukuk in a default scenario.
In particular, recent events may have left investors nervous as to whether they have a claim over the assets underlying the issuance or not, and whether or not sukuk are more secure than conventional bonds because they are backed by tangible assets. If there is a claim over the assets, investors could expect priority in realising their investment in a default scenario. However, if this is not the case, investors would be unsecured creditors in the bankruptcy of a debtor.
This uncertainty may have arisen because a number of structural features are typically present in sukuk such that they are constructed on the foundations of tangible assets, for example, land, real estate or machinery and equipment. However, have some investors been wrong in their belief that sukuk offer a more secure investment than conventional bonds? To-date, the issuers of sukuk and the financial experts who assist in selling such securities have tried to meet the requirements of Sharia-compliant investors who have sought a similar fixed-income risk profile to a conventional bond. Those are usually based on the financial performance of a corporate entity with which they are familiar and in which they wish to invest.
In the majority of unsecured sukuk transactions the investors ultimately have no direct recourse to the assets themselves. The repayment of their investment is dependent on the exercise of a purchase undertaking by the seller of the assets at maturity or upon default. Thus, as with a conventional bond, the investors take credit risk on the seller who has granted the purchase undertaking. Although typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default.
As a result, offering documents prepared for most sukuk transactions have very little disclosure (if any) in respect of the physical asset; instead, disclosure focuses principally on the balance sheet and business and risks of the seller. While Sharia principles do require a transfer of control and risk (as well as reward) in relation to an asset from the seller to the investors, the actual analysis of 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 a necessary feature of sukuk.
So what alternative Sharia-compliant structures exist for an investor who wishes exposure to asset-risk and to have direct recourse to those assets? One conventional product that has attracted a great deal of attention over the past few years has been asset-backed securitisation. One of the cornerstones of the majority of conventional asset-backed securitisation transactions is a true-sale of assets. In order for the instruments ultimately evidencing an investment in an asset-backed transaction to achieve the appropriate credit rating, the transfer or sale of assets needs to be a sale which would survive the insolvency of the original owner (ie the assets are isolated from the bankrupt estate of the seller).
This is only achievable to the extent that the transfer represents a true transfer of ownership which is legally perfected. While Sharia principles seem harmonious with the nature of asset-backed securitisation, for securitisation to become more mainstream in the GCC, three prerequisites will be required: firstly, investors will need to demonstrate a commercial desire to take the risk (and reward) associated with the true sale of assets in an asset-backed structure, including the management of those assets in a default scenario; secondly, those companies seeking finance will need to demonstrate a desire to sell their assets (which will have accounting and shareholder equity implications); and thirdly, a robust legal framework will need to evolve as bankruptcy and asset-selling laws in many jurisdictions in the GCC remain opaque and militate against securitisation structures.
In conclusion, the outlook for the sukuk market remains positive, with Standard & Poor's indicating that the total amount of sukuk issued or being talked about in the market is estimated to be $50bn. The global financial turbulence has resulted in a number of high-profile defaults, and this has generated a timely debate by market participants as to the nature of investors' recourse to the underlying assets (if any).
In turn, this will inevitably result in a better understanding by investors, bankers, originators and lawyers alike of what the consequences of a default are, leading to further innovation and development of existing sukuk structures and the further evolution of Islamic debt structures. Debashis Dey is the head of capital markets, Middle East and Stuart Ure a senior associate at Clifford Chance