Emergence of Sukuk

Ironically, my learning curve on Sukuk coincided with the world coming to know of this fascinating instrument 19 years ago in 2002.

I had recently joined the Islamic bank back then, and was trying to come to terms with the do’s and don’ts of Islamic finance when the first-ever sovereign rated and publicly listed Sukuk facility was thrust upon me by the head of corporate banking to deal with. Perhaps this was due to my conventional banking background on syndication loans and bonds.

This was a US$500 million (currently called ‘benchmark’ size) Sukuk Ijarah transaction launched by Malaysia in 2002 with a five-year term. The Sukuk facility was an asset-based transaction whereby the government hospitals and ministry buildings worth a little over US$600 million were used. These ring-fenced assets were sold to a special-purpose shell company and the government immediately took them on lease from the same company.

The transaction entailed two separate transactions viz. a sale and purchase transaction for the purchase of assets by the company and a lease transaction whereby the assets were taken on lease by the government. The lease rent was based on a certain periodic LIBOR [London Inter-bank Offered Rate] plus a defined margin which was paid regularly during five years. At the maturity of the transaction, the assets were purchased back by the government from the company at the same price it had sold to it, and the transaction was successfully wound up upon redeeming the Sukukholders.

Although the Sukuk facility was originally launched for US$500 million, the subscription had reached over US$1 billion. Normally, when a bond is oversubscribed, the originator attempts to mop up the maximum possible amount by increasing the bond’s size. Such over-allotment is called the ‘greenshoe option’ and the funny term was first derived when the Green Shoe Company based in Boston in the US declared in 1919 that it will be allotting more shares than it had initially sought due to greater public demand resulting in oversubscription.
However, in the case of the Malaysian Sukuk, although the subscription was double the launch amount, it was not possible for the government to absorb the full amount by increasing the size of the Sukuk to US$1 billion. But why?

The reason is simple. The value of the assets ring-fenced for the purpose of issuing the Sukuk was circa US$600 million and the government could not raise the Sukuk amount beyond the value of the assets which were required to be sold to the special-purpose shell company and taken on lease by the government. This was the first time that I learned the term ‘asset-based Sukuk’ and appreciated the concept of ‘safety valve’ in Islamic finance.

The first set of Sukuk documents when printed occupied two normal box files. It will be pointless to name all documents but the main ones focused on by the Shariah board were the sale and purchase agreement, lease agreement, trust deed and the two undertakings (the funding documents). The remaining documents were the usual capital market and listing documents which are common for both bonds and Sukuk.

The line-by-line examination of the funding documents proved a steep learning curve for me. The wholesale changes needed by the scholars had irritated the legal counsel who had prepared them, albeit they showed lots of forbearance.

Being the first Sukuk transaction, the debate between the scholars and lawyers was of high quality and substance. At times, I felt it will be difficult to find common ground among them since certain points had become sticky; however, the scholars accommodated the lawyers in the best interest of this landmark transaction and to promote Sukuk issuance. Looking back, I admire the scholars’ wisdom since this Sukuk transaction became the trailblazer and scores of Sukuk soon followed through in quick succession.

Oops, I did not realize that while describing the emergence of Sukuk, I consumed almost the entire space for this week’s article. Let me now try to provide you with the definition on Sukuk.

The term ‘Sukuk’ is plural for ‘Suk’ which in Arabic means a certificate. So, therefore, Sukuk translates into ‘certificates’ — the same as ‘bond’ being one and ‘bonds’ the plural.

The best technical definition that I have so far come across on Sukuk is from AAOIFI Shariah Standard No 17 Article 2. I append it below:

“Investment Sukuk are certificates of equal value representing undivided share in the ownership of tangible assets, usufruct and services or in the ownership of the assets of particular projects or special investment activity. However, this is true after the receipt of the value of Sukuk, the closing of subscription and the employment of funds received for the purpose of which the Sukuk were issued.”

From the said definition, you will notice that the first difference between the bonds and Sukuk is that the latter hold indivisible ownership of a particular asset. Clarifying it further, the Sukuk amount is divided into a certain defined number of units.

For example, if the Sukuk facility is issued for US$1 million comprising 1,000 units of US$1,000 each, this will mean that each unit or certificate represent the ownership in the Sukuk asset to the extent of the value of the unit, ie US$1,000. If an investor purchases 100 units, he will be acquiring the 10% ownership of the Sukuk asset or up to US$100,000. Nevertheless, such ownership shall be indivisible or in other words, commonly owned with the holders of the remaining Sukuk units or certificates.

The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.

Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected]

Next week: Discussion on Sukuk to continue.