A newly familiar instrument
The word sukuk has become popularised – or at least better known than it was before at the English Bar and in broader legal and financial circles – by the government’s announced intention (in October of last year) to issue a first sovereign sukuk denominated in pounds sterling in an amount of about £200 million this year or next.
Preparations are under way led by HM Treasury. Efforts to this end have been in progress since 2007 with a variety of expert groups, consultations and feasibility studies conducted under the auspices of the government since then. After several years of concluding that such an issuance would not be value for money, the plan is one among several measures designed to promote the UK (and the City of London most especially) as a world centre of Islamic finance.
In addition to the aim of encouraging the inclusion of British Muslims, these measures and the sukuk issue in particular have the potential of attracting inward investment and of inviting further access to liquidity and foreign investment in the foreseeable future by means of corporate issuances of sukuk as well as continued and increased listing of foreign sukuk on the London Stock Exchange.
‘Sukuk’: a genealogy
In Arabic the word ‘sukūk’ is the plural of ‘sakk’ – which means legal instrument, document, deed, or cheque (Hans Wehr Dictionary of Modern Arabic). Some observers consider ‘sakk’ as the etymological origin of the contemporary conventional instrument, the cheque. The Dictionary of Islamic Finance (Aly Khorshid, ed., Euromoney 2011 at 41) traces sukuk to the Umayyad period (661-750 CE) of early Islamic history, when soldiers and civil servants were paid in the form of sukuk redeemable for cash and commodities such as grain.
In their modern instantiation the governments of Bahrain (2000) and Malaysia (2002) each originated pioneering sovereign sukuk. In 2004, the German state of Saxony-Anhalt completed the first sovereign sukuk issuance in Europe. Dubai (United Arab Emirates), Saudi Arabia, Kuwait, Qatar and Pakistan among others have also closed large sovereign or quasi- sovereign sukuk (Ariff, Safari and Mohamed in Ariff, Iqbal, and Mohamad, eds., The Islamic Debt Market for Sukuk Securities, Edward Elgar 2012 at 29-35). Part of the appeal of the UK sovereign sukuk is the possibility of tapping liquidity pools abroad – particularly but not only in the oil and gas wealthy states of the Gulf.
The LSE has listed at least 25 sukuk issuances with the first corporate sukuk listed there in 2006 (Tabreed Finance) and the sovereign sukuk of other countries not long thereafter (Gillian Walmsley in Sohail Jaffer, ed. Islamic Investment Banking, Euromoney 2010 at 47).
Definition of sukuk
An international standards-setting organisation based in Manama, Bahrain – the Accounting and Auditing Organisation of Islamic Financial Institutions (‘AAOIFI’) -- formulated the most widely cited contemporary definition (‘the AAOIFI definition’) of sukuk as
Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services (in the ownership of) the assets of particular projects or special investment activity [Standard 17(2)]
Three principal attributes of sukuk emerge from the AAOIFI definition. First, as a certificate, sukuk are a kind of security -- like a share or a bond. Some types of sukuk can be traded on a secondary market, although others cannot. (Frequently investors buy and hold until the maturity date due to the limited availability of sukuk secondary markets worldwide.)
Second, ownership – as a result of a true sale/purchase. The ownership is fractional and each individual certificate represents an equal part of the whole.
Third, sukuk are asset-based. However there is a broader definition of asset that goes beyond a physical or tangible asset (for example, an airplane), to include rights of use (for example, lease rentals) and services or investment activities. The asset may be a single asset or a pool of assets. Sukuk are intended to be used for particular projects rather than for general operating costs or financial needs; this requirement strengthens the claim to being asset-based.
Assets and ownership
The asset itself must be lawful (halal). Assets that would be unlawful (haram) would be those involving alcohol, pornography, pork or gambling. For this reason some scholars would consider for example a resort or a restaurant or the hospitality industry broadly conceived haram due to the associated sale and consumption of alcoholic beverages. Some scholars would also consider arms and industries associated with military equipment and procurement off-limits. Depending upon the stringency of interpretation a substantial number of assets and associated industries would be excluded as the potential asset base of a sukuk.
Although the evidence is mixed and opinion divided some proponents claim that the emphasis on asset basing (or backing) in Islamic financial transactions reduces the risk that Islamic finance poses – both to the local and to the global financial system. The asset requirement and the emphasis on limiting and sharing risk disallows a high degree of leveraging -- of the sort that contributed to the 2007-2009 global economic crisis. From another perspective the asset requirement also acts as a brake on the Islamic finance and banking industry due to the added difficulty and lead-time required to locate assets (that are also lawful).
A further reason for the insistence on ownership in a sukuk issuance is a result of Islamic law’s preference for commerce and the collective participation in a commercial enterprise. In addition there is a disapproval of the commodification of money (which is instead deemed a medium of exchange only) and a ban on trading in debt. Interest-based debt transactions are unlawful and charging or paying interest is anathema at Islamic law.
In addition to the ban on interest (riba), speculation or excessive uncertainty (gharar) and gambling or games of chance (maysir) are also prohibited. Risk and uncertainty are inevitable in any transaction so gharar is (arguably) best interpreted as a ban on excessive levels of risk and uncertainty.
Sukuk are not infrequently equated with bonds producing the appellation ‘Islamic bonds.’ This is a helpful shorthand for those familiar with conventional finance; furthermore the economic function of sukuk can mirror that of conventional bonds. However scholars of Islamic law would maintain that the equation is not strictly accurate as the requirement of assets and ownership render sukuk equity, not debt, instruments.
Sukuk and all other instruments authorised in Islamic banking and finance claim consistency with the principles of Islamic commercial jurisprudence (fiqh al-mu’āmalāt). This central tenet of the business enterprise is commonly summarised as that of ‘shari’a compliance.’
It should be noted, however that shari’a is not a comprehensive legal code; nor could it be considering its pre-modern origins. In the context of contemporary banking and finance shari’a is better understood as an ensemble of principles and accepted practices the application and enforcement of which requires some flexibility, adaptation, as well as interpretative acumen and jurisprudential skill.
Hence the UK sovereign issue, as with other shari’a-compliant transactions, must be vetted by Islamic legal scholars who apply the existing rules and principles to the particular transactions ex ante, and who monitor compliance ex post. These scholars should also have a role in reviewing and approving the actual transactional documentation. International standards-setting organisations including the AAOIFI and also (in Malaysia) the Islamic Financial Services Board (‘IFSB’) have published guidance on the attributes and the responsibilities of shari’a scholars -- who are typically constellated as a shari’a board, and employed by an Islamic financial institution.
The corporate governance of Islamic financial institutions poses specific challenges, as well as regulatory issues with which the Financial Conduct Authority (‘FCA’) must deal. For example possible divergence between shari’a boards could be exploited in a form of arbitrage, undermining the perceived shari’a compliance of the issue (and of the sector more broadly). Depending upon the incentive structures in which shari’a scholars are embedded, conflicts of interest are also possible. In addition to specialising in Islamic commercial jurisprudence shari’a scholars must possess a sufficient understanding of modern economics, financial law and UK regulations.
Advising HM Treasury on the Sukuk
No public announcements have been made about the composition or personnel who will comprise the shari’a board for the sovereign issue. However the Treasury has selected Linklaters to advise on it, together with HSBC Bank (Natalie Stanton, “Linklaters wins role for Government on UK first-ever Sukuk issue” The Lawyer 31 January 2014). The selection of HSBC is open to some question since HSBC appears to be exiting the Islamic financial sector, having closed its dedicated retail division HSBC Amanah in the UK and several other countries (bank notice at http://www.hsbcamanah.com accessed 17 March 2014) in October 2012 (Patrick Jenkins and Camilla Hall, “HSBC’s Islamic closures highlight dilemma” Financial Times 7 October 2012) although it remains an active participant in the global sukuk market.
Types of nominate contracts underpinning sukuk
As a capital market overlay, sukuk sit atop a contract or a series of nominate contracts. There are fourteen contract types that have received wide recognition both by the AAOIFI and by shari’a scholars internationally. Each contract type may be used singly or combined with the other contract types as the underlying commercial and contractual basis for a sukuk.
The sequence of consultation papers and responses published by HM Treasury (in collaboration with the Debt Management Office and with the Financial Services Authority as it then was) took up for consideration two possible contract types out of the fourteen (“Government sterling sukuk issuance: a consultation” November 2007).
The first of these is a purchase and lease back agreement (sukuk al-ijara). The second is a partnership contract (sukuk al-mudaraba.) In both cases a trust (a Special Purpose Vehicle; hereinafter ‘SPV’) acts as the issuer of the sukuk certificates. The SPV is bankruptcy remote from the originator -- in the case of this sovereign issue, the government.
Lease rentals are the source of returns to investors in this contract. The government identifies an asset or pool of assets to sell to the SPV (‘the asset’). The SPV gives the investors the sukuk certificates in exchange for capital which funds the purchase of the asset from the government. The SPV then leases the asset back to the government on pre-agreed commercial terms.
The government also enters a purchase agreement with the SPV, undertaking to buy back the asset at maturity (‘the promise to purchase’).
The rental payments for the usage (usufruct) of the asset by the Government (with the government being responsible for its maintenance) are transferred by the SPV to the sukuk holders as periodic distributions -- the equivalent of the periodic coupon payments of a conventional bond.
At maturity the promise to purchase operates. The asset is sold back to the government and the SPV transfers the purchase funds to the investors as the redemption payment.
In this contract type investors purchase the sukuk from the SPV. The SPV transfers the proceeds to the government, which acts as the entrepreneur and which invests that capital in a shari’a compliant investment activity (‘the investment asset’) on terms set out in the sukuk issuance prospectus.
In addition to the mudaraba agreement between the government and the SPV, the government also acts as obligor furnishing an undertaking to purchase the investment asset at maturity (‘the purchase promise’).
In a pre-agreed ratio the government transfers the returns from the investment asset to the SPV as periodic profit distributions. The SPV in turn channels the distributions to the investors -- in the equivalent of the periodic coupon payments of a conventional bond.
At maturity the purchase promise operates. The government buys the investment asset and the SPV transfers the proceeds as the redemption payment to the holders of the sukuk.
From a low base Islamic finance has grown rapidly over the last decade or so. Although its products -- including most prominently sukuk -- are still novel, there is a critical mass of practitioners and professionals possessing increasing familiarity and with it the ability to better meet the legal, regulatory, accounting and technical challenges that remain.
Whilst starting small the initial UK sovereign sukuk is a measured and careful first step in increasing and diversifying the scope of financial services in this country. It is a promising if incremental development.
Door Tenant, Temple Court Chambers (London)
Associate Professor, Akita University (Akita, Japan)