The issuance of world’s first Green SRI sukuk by Malaysia not only serves as a testament for its leadership in sukuk market but also exemplifies the country’s commitment towards green and sustainable responsible investments. Malaysia’s experience in facilitating the green sukuk issuance by developing the necessary framework and infrastructure for a conducive market of green sukuk is set to become a model in bridging Islamic finance and SRI industry. more
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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Fitch Ratings has assigned Hazine Mustesarligi Varlik Kiralama Anonim Sirketi’s (Hazine) USD1.5bn of global certificates (Sukuk), due 26 March 2018, a ‘BBB-‘ rating. The certificates have a profit rate of 2.803%.
Hazine, an asset leasing company incorporated solely for the purpose of participating in this transaction, is wholly owned by the Republic of Turkey, acting through the Undersecretariat of the Treasury.
The rating reflects Fitch’s judgement that the Sukuk can be considered an unconditional, unsubordinated and general obligation of the Republic of Turkey, ranking equally with Turkey’s other senior unsecured obligations. The rating is therefore in line with Turkey’s Long-term foreign currency Issuer Default Rating (IDR) of ‘BBB-‘ on which the Outlook is Stable.
The Sukuk follows an ijara’ (leasing) structure. The issuer has purchased publicly-owned real estate from the Republic of Turkey using the proceeds from the Sukuk. These assets have been leased back to the Republic for a period equal to the tenor of the Sukuk; in return the Republic makes semi-annual rental payments to the issuer at least equal to periodic distribution amounts made by the issuer to the Sukuk investors.
The transaction documents incorporate a purchase undertaking requiring the Republic to repurchase the assets on maturity (or earlier, in the event of dissolution/default), together with any outstanding distribution. Certificates are unsecured and certificate holders have no direct recourse to the lease assets.
While certain transaction documents relating to this issue, being governed by English law, may not be enforceable under applicable law, including Turkish law, Fitch’s rating for the certificates reflects the agency’s belief that the Republic of Turkey would stand behind its obligations under the transaction documents.
By assigning a rating to the certificates, Fitch does not express an opinion on the Sukuk structure’s compliance with Sharia principles.
The ministry’s director for Shariah financing, Dahlan Siamat, said the government issued its first Islamic bond, known as sukuk, in 2008, and as of Thursday it had issued a total of Rp 120 trillion.
“The achievement has been supported by excessive demand for sukuk in the domestic market,” Dahlan said in Surabaya on Thursday.
“The potential for state sukuk in the country is developing rapidly, given that 80 percent of Indonesians are Muslims and there remains large potential for them to become investors.”
Indonesia has been selling conventional and Islamic bonds during the past year to help plug its growing budget deficit. The country’s budget shortfall is forecast to reach 2.23 percent of the gross domestic product this year, according to a revised 2012 state budget.
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IRELAND plans to become the first European nation to sell sovereign sukuk — Islam-approved financial certificates — as its equal tax treatment for Islamic-finance products attracts investors.
The Government has agreements with more than 60 countries to avoid double taxation on Islamic transactions, Micheál Smith, the south-east Asia director of IDA Ireland, said.
Islamic finance assets around the world may rise about 16% to €1,240 billion this year, Raj Mohamad, managing director at Five Pillars, a consulting firm based in Singapore, told Bloomberg Television yesterday.
While plans to sell sukuk by Britain, France and Luxembourg have stalled, Mr Smith said Ireland will push ahead with a sale.
“Ireland will be going back to the bond market and a sukuk is an option when conditions are right. We also hope to form more working groups with Muslim countries such as Malaysia to build up a critical mass of expertise as the objective is for Dublin to become a centre of excellence for Islamic finance.”
Ireland introduced tax legislation for products that comply with Islam’s ban on interest in 2010, Mr Smith, who is based in Singapore, said.
The Central Bank has a Shariah team overseeing its Islamic funds, which total about €390m under management.
The Irish Stock Exchange listed its first sukuk in 2005 and Ireland is a popular choice for sales because the nation offers a “relatively inexpensive” and timely listing process, he said.
The Government last sold bonds in September 2010, the year it had a deficit that was the highest as a percentage of gross domestic product in the developed world. The Department of Finance estimates the ratio dropped to 10.1% of GDP in 2011 from 31% the previous year.
CIMB Group Holdings, the world’s biggest sukuk arranger, said this week that it got approval to set up the first Shariah-compliant equity funds from Malaysia in Ireland.
Ireland’s bid to become an Islamic finance hub received a boost in October when Goldman Sachs Group got approval from the nation’s central bank to list its $2bn (€1.55bn) sukuk programme. The planned sale has attracted criticism among Islamic scholars, with some saying the proceeds may not be used according to Shariah law.
CIMB-Principal Islamic Asset Management, based in Kuala Lumpur, chose Ireland for its Islamic equity funds because there’s no double taxation and no withholding tax on interest payments, Jim McCaughan, chief executive of US-based venture partner Principal Global Investors, said on Monday.
An initial investment of $20m (€15.5m) will be put into three funds that will open for subscription next month, he said.
“We expect interest from Europe, Malaysia and more importantly the Persian Gulf and other Muslim countries,” Mr McCaughan said. “People are getting wealthier and want to diversify their funds.”
Global sales of sukuk, which pay asset returns instead of interest, total €4.7bn this year, compared with €500m in the same period in 2011, according to data compiled by Bloomberg. Offerings reached a record $36.3bn last year, surpassing the $31bn raised in 2007.
The difference between the average yield for sukuk and the London interbank offered rate, or Libor, narrowed two basis points to 299 basis points yesterday, according to the HSBC/Nasdaq Dubai US Dollar Sukuk Index.
The average yield has climbed nine basis points, or 0.09% point, this year to 4.08%.
Shariah-compliant bonds have dropped 0.1% in 2012, according to the HSBC/Nasdaq index, while debt in developing markets declined 0.2%, JPMorgan Chase & Co’s EMBI Global Composite Index shows.
The Bloomberg Malaysian Sukuk Ex-MYR Index of foreign currency Islamic debt sold by companies in Malaysia rose 0.5% this year to 104.919 yesterday. The gauge increased 5.9% in 2011.
Britain cancelled what would have been the first sukuk sale by a Western government last February, saying the debt didn’t offer value for money. Luxembourg ruled out a plan to sell Islamic bonds in 2011 because the government saw no need to raise additional funding. France has legislation in place to facilitate a sale and has yet to proceed with an issue.
Ireland has a Muslim population of 30,000, according to a Department of Finance document covering the nation’s Islamic industry issued in March 2010. Roman Catholics make up 87% of Ireland’s population.
The Islamic Cultural Centre for Ireland and the Immigrant Council of Ireland have all called for more Shariah-compliant initiatives, the report said.
“There’s been no objection to Islamic products being sold in Ireland,” said Mr Smith, who is also a director in charge of the 10-member Association of Southeast Asian Nations at the IDA.
The European debt crisis provides an opportunity for Islamic finance to grow given it is rooted in ethics and religion, according to Nik Norzrul Thani, the chairman of Malaysian law firm Zaid Ibrahim & Co.
“What Ireland is doing is a step in the right direction,” Nik Norzrul said in an interview in Kuala Lumpur.
“Ireland’s ambition to be a Shariah-compliant hub is a recognition that Islamic finance isn’t only for Muslims.”
source : Irish Examinar
Indonesia may issue Islamic treasury bills and retail sukuk this year to diversify funding sources, develop the Islamic debt market and finance the state budget deficit, finance ministry officials said on Monday.
ISLAMIC financial institutions looking into tawarruq, a controversial Islamic financing structure, should instead consider sukuk ijarah, or Islamic bonds, when looking at options to raise cash, a study said.
In its basic form, tawarruq allows the sale of an asset on a deferred payment basis. The purchaser then sells the asset to a third party to get cash. But so-called organised tawarruq has divided scholars who debate whether allowing such transactions via banks still meet syariah laws.
In a paper, Shochrul Romatul Ajija, an Indonesian student taking her Master of Economics at the International Islamic University Malaysia, said tawarruq is gaining popularity in Malaysia and has been established as syariah-compliant. “It helps people who need cash on short notice … it is not a loan,” she said.
She said should Brunei wish to start providing tawarruq financing, it can be done to help people who are in need of cash in the short term.
But in her paper, Shochrul said that if Islamic financial institutions need an alternate solution to prevailing liquidity management challenges, they can turn to sukuk ijarah, or Islamic bonds.
Sri Anne Masri, a local Islamic business consultant, said, “The Islamic banking industry must seriously differentiate itself from the conventional banks, not just by replicating conventional products.” She added that tawarruq is being used today as either a liquidity facility (inter bank placement) or a credit facility (credit financing) as it is a highly profitable business.
The First Global Investments, an Islamic investments firm, defines tawarruq as, reverse murabahah. “As used in personal financing, a customer with a genuine need buys something on credit from the bank on a deferred payment basis and then immediately resells it for cash to a third party. In this way, the customer can obtain cash without taking an interest-based loan,” it said.
Shochrul said that the use of tawarruq came under scrutiny because people were finding it difficult to find other brokers to sell their tawarruq to, and that was when the banks started to arrange buyers and sellers in order to make the sale, which is prohibited in the syariah context. “This is what is called organised tawarruq and it is not syariah-compliant,” she said.
In her paper, she said that should Islamic financial institutions decide to use tawarruq, they should note that it should “only be used in extreme cases where no option is available, to avoid interest”.
She said that widespread use of tawarruq is harmful to the industry in the long run, stressing syariah boards have to “strictly monitor all tawarruq-based transactions”.
The Organisation of Islamic Conference Fiqh Academy, an Islamic studies academy in Jeddah, Saudi Arabia, in April 2009, ruled that organised tawarruq was “impermissible” due to the arranged nature between the Islamic financial institutions and the people.
source : The Brunei Times