By : Haifa Al Mahmoud, Malak Bakhsh, Sara Aref
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuk as certificates that provide the investor the right to own the underlying revenue-generating assets and rights and/or services, besides of the income stream they might yield. Sukuk are normally ruled by English law in cases of dispute or arbitration, owing to its trustworthy law provisions.
Since mid-2000s, Sukuk emerged with growing popularity as a realistic and practical shariah compliant long-term financing tool. Malaysia is the largest country in the world for sukuk market, and is committed to continuously advance its financial services industry to meet the ever growing needs of its stakeholders who include, businesses, investors, and the government. Additionally to appeal on the regional and global market levels. This has led to the Sukuk markets around the world to grow and raise significant sources of capital despite a series of substantial amount of sukuk defaults in the Gulf Corporation Countries (GCCs) had blemished the market’s confidence on sukuk, as well as some Malaysian cases such as of Johor Corporation, Ingress Sukuk, Tracoma Holdings, and Nam Fatt Corporation.
Implications of sukuk default
Sukuk defaults elevated numerous questions about the underlying structures and capability of the sukuk as an alternative source of funding as this is issue very crucial since it affects the welfare of all the involved stakeholders. This has laid down more emphasis on the need to identify default risk in sukuk in order to better supervise and manage its affiliated risks. High degree of certainty was needed concerning the post-default process in sukuk transactions since the risk for a default is inherent in all sorts of transactions. Now, the utmost carefully structured products could flop due to conditions beyond investors’ control.
Therefore, this paper aims to shed light on the issue of sukuk default and its implication on several cases. Also, it attempts to analyze the implication of sukuk default on a country’s reputation, the legal aspect and on the investor’s protection.
As previously mentioned above, the market for sukuk has developed quickly over the last few years with regards to size, numbers, and complexity. Sukuk is now known as a substitute for conventional bonds and is employed in Islamic financing framework for the last two decades. It provides access to foreign governments and corporations to an enormous and increasing Islamic liquidity pool of funds, other than conventional methods.
While sukuk are supposed to be more secure than the conventional bonds, since they are performed only on asset backed assets, sukuk are now asserted to have lost trustworthiness as a practicable and worthwhile Islamic long-term project financing instrument. Due to the complexity of their structure and several legal issues, it was difficult to apply a reliable rating process for sukuk. However, from a rating view point, evaluating the risk of the issuer’s innate credit strength is central to the final rating result. This was acknowledged when a series of default events took place.
For instance, the period 2003 till 2010 witnessed a series of default in some counties. On top of them is Malaysia with nine big cases, then Pakistan with two and one default event in each of Saudi Arabia. Kuwait, and the USA. Those default cases are: Saad Group’s Golden Belt($650 M), East Cameron Gas ($165.6 M), The Investment Dar Company($100 M), New Allied Electronics Indus-tries ( $ 16.4 M) + Maple Leaf(Rs8 billion), Oxbridge Height ($2.82 M), Hartaplus, Ingress ($ 7.2 M), Oilcorp Bhd ($ 20.6 M), PSSB Ship management (RM40 m), Tracoma Holdings (RM 100 m), M-Trex Corporation (RM 60 m), Englotechs HOLDING (RM 50 M), Straight A’s portfolio (RM 200 M), and Malaysian International TunaPort (RM 240 m ). Based on information from RAM rating agencies, there were 24 recorded default events in Malaysia over the period 2003-2010. Other defaults did follow the ones mentioned earlier. A sample of those defaults will be discussed in the next part in this research along with the reasons that lead to their occurrence.
Court cases relating to defaulted sukuk
The first case of default revolves around East Cameron Partners (ECP). The structure of the sukuk was made in the following sequence. The issuer SPV, East Cameron Gas Company (ECGP), which is incorporated in Cayman Islands issued USD165.7 million worth of sukuk. The proceeds of the sukuk would be employed to buy the ORRI from the Purchaser SPV, just after the Funding Agreement for USD$ 113.8 million would be made. The left over sum was to be used for a development plan, standby account, and to purchase put options for natural gas to hedge against the risk of fall in gas prices. Then, the originator paid his share of the capital in the form of a transmission of ORRI into the buyer SPV. The next step was that the purchaser SPV would be holding ORRI in the properties, would then entitled to around 90 percent of East Cameron Partners’ net revenue generated though gas production. The gas and oil production would be sold to two sources with Merill Lynch acting as a backup. The Proceeds of the oil and gas sale would be channeled into an allocation account. When sukuk reach maturity, the issuer SPV would exchange all the sukuk against the amount left to be transferred to the sukuk holders.
Reason of default was because that the originator attempted to wrap the sukuk assets that was royalty interests on oil and gas revenues kept by an offshore special purpose vehicle (SPV), into its domain, while the sukuk issuer had been publicized as bankruptcy tool. Meanwhile, the assets were moved in a seemingly shariah compliant true sale. The court holding was that the originator had already sold the underlying assets in a true sale deal.
The second case was for a 5-year musharakah sukuk was issued by The Investment Dar (TID) with the association of ABC Islamic Bank (Bahrain) in 2005. The sukuk offered 6-month LIBOR plus 2% annual, while the 2006 sukuk issue guaranteed a LIBOR plus 1.25 percent for the first 3 years and LIBOR plus 1.75 percent for the rest of the remaining period, to be paid every six months. The Sukuk issued in 2005 were registered on the Bahraini Stock Exchange whereas the 2006 sukuk were issued and registered in Dubai International Financial Exchanges. The first issue was limited and was established in the Cayman Islands. Next, sukuk are issued by the SPV to sukuk investors, primarily against the proceeds of the sukuk. The second issuance was a trust agreement with sukuk holders, the SPV entered into a musharakah agreement, in which the SPV capitalized the proceeds of the sukuk to hold 48.78 of musharakah capital. Instantaneously, the originator, TID, paid its share by shifting all rights, benefits, and entitlements to the TID vehicles and property to musharakah, valued at $157.5 million valuation as specified by a third party and arranged by the partners, thus acquiring the outstanding 52.22 percent of capital in musharakah. The total amount was invested in the motor vehicles and in property assets. The musharakah assets were converted into 150 units, in which TID acquired 76.83 units and the issuer held 73.17 units. The agreement was that the returns on the underlying assets were to be split among the SPV and TID. For more security for the investment, the originator offered an undertaking to repurchase the SPV portion in the underlying assets at the end of sukuk period or in case of early insolvency. As agreed upon between the originator and the SPV, management of the musharakah would be carried out by the originator, in exchange for a fee and plus an incentive fee in case the musharakah accounts would provide a net profit during a given time. The structure of the sukuk was approved by the shariah boards on each partner side.
Later when the agreement took place, TID defaulted under a $100m sukuk in January 2009. The sukuk was ruled by English law using an offshore SPV and the underlying assets were located in Kuwait. Since the sukuk were asset-based, investors were at the theoretical positon to sell the assets if TID. Following in March 2010, TID gained court defense under Kuwait’s new financial firmness law that ceased all lawsuits related with insolvency towrds TID. TID subsequently settled with Sukuk holders on a six year period of restructuring.
Reasons for Default
TID was in good financial condition till 2007. But during 2008, TID reported a net loss of KD 80. 3 million, for the first time since its foundation. Two reasons were behind this situation. First, was the unrealized losses of KD 88.14 million relating to an impairment in the value of investments in associates. Second, was the actual realized losses of about KD 9.3 million on investments, which in the eventually led to the downfall of the company. During late 2008, TID defaulted on its debt obligations as to liquidity problems. Early in 2009,TID entered in a debt restructuring plan.
The third sukuk default occurred on mid-2009, where a Saudi business company defaulted on periodic disbursements. Consequently, Moody’s lowered the rating of the company to junk grade. Few banks in the Gulf were affected harshly by the Saad sukuk default for of their exposure to the deeply distressed Saudi conglomerates who are Saad Group and Ahmad Hamad Al Gosaibi and Brothers.
Saad Sukuk Structure was based on lease and sublease contracts. The transaction was structured according to a head lease agreement, Golden Belt 1 Sukuk Company, which is a SPV listed in Bahrain, entered into a long Head Lease Agreement with the chairman of Saad, in which the SPV, as head lessee, obtains some land parcels on lease from the Head Lessor, Mr Al-Sanea, for 25 years maturity. The net takings of the sukuk would be employed to pay the total rental amount due in upfront by the issuer/head lessee to the head lessor. Then, the Golden Belt 1 issues sukuk of $650 million in exchange of the leasehold rights on the land parcels and pays full rental payment upfront to owner of Saad Group. Afterwards, according to a sub-lease agreement, Golden Belt 1 sub-leases the land parcels to Saad for five years in return for half yearly rental payments at LIBOR plus 0.85 percent, which happened to be the same return as paid for the Sukuk that was an Ijara contract. This would lead to Saad transfering the rental amounts to the SPV at the promised rate, which enables the SPV to transfer the rental amount to the sukuk holders accordingly. Once they reach maturity, sukuk are then exchanged by the sukuk holders, Saad transfers the sukuk amount to the SPV. 7. The SPV, subsequently pays out the sukuk amount to the investors.
Reasons for Default
Saad company had a huge default amount that was $15.7 billion, comprising its Islamic bonds. Saad was confronted with huge liquidity crisis during 2008 and was not able to service its debt obligations promptly. The originator company was surprisingly providing improper and misleading information that was not never delivered to the regulators. Consequently, the Saudi Arabian Monetary Authority (SAMA) halted Saad group assets on May 2009. Additionally, was accused of dishonesty and fraud and was charged of USD10 for misappropriation of the funds of Algosaibi Investment Holding company, the formal owner of the SPV. As a result, the accounts of Saad in Cayman Islands, which were valued at around $9.2 billion, were frozen by November 2009.
The fourth and last sukuk case to be discussed in this research will be Nahkeel sukuk, which was Dubai-based. Nahkeel was a high profile and the largest ever sukuk default case to date. It was issued late in 2006, with maturity of 3 years, which raised a total of $3.5 billion. The sukuk were registered on the Dubai International Financial Exchange. The purpose of the sukuk was to finance a property development project for one project in Dubai, which is Nahkeel Co. PJSC. A SPV was established for this purpose under the name of Nahkeel Development Limited. The originator, Nahkeel Holdings 1, was a subsidiary of Nahkeel World, which was itself owned by another public sector company, Dubai World. Nahkeel Holdings 1, Nahkeel Holdings 2 and Nahkeel Holdings 3 held full ownership in Nahkeel Co. PSJS. The sukuk had the status of a sovereign bond by the rating agency as they were issued by public sector. Investors then, expected an implicit government warranty for the sukuk. In addition the sukuk had a Moody’s (A1) and Standard & Poor’s (A+) ratings.
The Nahkeel sukuk had been issued on an Ijarah manfaa basis, which enabled sukuk holders’ to obtain the leasehold interest of the primary assets without transferring the title of the assets to them via SPV. Thus, Sukuk holders had only the right to the stream of income generated by the assets but not on the assets themselves.
The agreement was structured that the SPV, namely Nahkeel Development, would issue Nahkeel sukuk to raise $3.5 billion to purchase the leasehold interest in definite land, building and other property at the Dubai Waterfront, which was valued at that time at AED 15.5 billion in 2006 by Jone Lang Lassalle. The SPV would then transfer the collections of the sukuk to Nahkeel holding 1 and purchases leasehold rights of the underlying properties from Nahkeel Holding 1, for 50 years. Additionally, the SPV, would lease the sukuk assets to Nahkeel Holding 2 for a period of 3 years. The SPV would upon maturing of the lease period at specific price and with payment of the other half of the rental payments.
By November 2009, Dubai World demanded a restructuring of its $26bn debt. Investors feared that its $4bn Nakheel sukuk would also default. The sukuk was governed by English law and structured using English trust law concepts to bestow only beneficial ownership on the investors in the form of leasehold rights. Significantly, leasehold rights are not deliberated real rights under UAE law, where the assets indirectly owned by the government were located. Eventually, the default was prevented by Abu Dhabi bailout of $5 billion.
Reasons for Insolvency/default
On the outbreak of the financial crisis over the period 2007-2009, the macroeconomic condition forced Dubai’s government to seek a standstill for $59 billion debt owed by one of the state-owned companies Dubai World, including Islamic sukuk of 3.5 billion. Several factors interplayed and lead to the factors which caused Dubai World to in effect default, including huge short term borrowings, decrease in oil prices, the explosion of the real estate price bubble because excessive supply of residential and commercial properties. At that time, the value of Nahkeel was not clear. Furthermore, the guarantee of Dubai World became worrying since the holding company itself was additional negatively affected by the financial crisis. Moreover, being a holding company, Dubai World may have superior creditors than sukuk holders. Finally, the sukuk’s default was activated by the exact financial situation of the obligor. It was held that if the majoirty of funds in related parties had been utilized sensibly, the halt demand for at least the Nahkeel sukuk, could have been prevented.
Despite the defaults which faced Islamic sukuk in the past years in several countries especially in the gulf however it seems Islamic sukuk are still in demand and actually growing and becoming very popular, perhaps due to the increased regulation. This demand can be attributed to that Islamic sukuk are founded on Shariah principles and on real assets such as real estates.
The overall market sentiment show that many investors and business yet believe in rightly believe that Islamic sukuk have decent investment forecasts and are safer than other forms of investment investments when compared with other conventional instruments..
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