Revisiting the old debate of Sukuk being a DCM or ECM instrument

From the last few articles, I have been explaining the similarity of certain Sukuk processes and procedures with those related to the issuance of conventional bonds. However, please be mindful that I am not trying to prove that bonds and Sukuk are the two sides of the same coin. No, they are not.

The point I am simply trying to bring home is that the world’s capital markets have evolved and have agreed over certain best practices for the issuance of securities, primarily bonds. Where do we look at for such guidelines? The most recognized resource is none other than the International Capital Market Association (ICMA) .

The ICMA was formed in 2005 as a trade association with the mission to promote the international market for debt securities — also known as the debt capital market or DCM — through a set of best practices, guidelines, rules, recommendations and standard documentation. As per its website, the ICMA also disseminates information and encourages dialogue between DCM stakeholders, and provides networking opportunities for market participants through conferences, seminars, roundtables and other channels.

It was but natural that upon emergence, Sukuk shall adopt the same internationally recognized route in order to be acknowledged as the capital market animal, and find the desired investors. But the similarity ends here since the structural differences between bonds and Sukuk are poles apart.

Well, if that is the case, why are Sukuk lumped as a DCM instrument instead of an equity capital market (ECM) tool, particularly when it is as clear as daylight that Shariah does not permit trading in debt? Moreover, no Sukuk can be issued without either an existing asset or the development of a future asset by utilizing the proceeds of the same Sukuk. Debt securities do not have such a prerequisite.

This question has been asked by me several times and answered by the legal fraternity in my circle of acquaintances in an unconvincing manner. They say that 99% (or more) of Sukuk issuances do have two elements which make Sukuk closer to a DCM instrument and away from an ECM instrument. First, the return to Sukuk investors is fixed and the fixed income is the hallmark of DCM instruments. Second, invariably all Sukuk have a guarantee for payment in the shape of a ‘purchase undertaking’ and this characteristic is enough to classify them as debt.

My disagreement to the aforementioned has been on the ground that fixed income is not enough to classify Sukuk as DCM instruments. This is because a Sukuk Ijarah facility where the ownership of the leased asset is with the investors through a special purpose shell company does have the fixed income in the shape of lease rent. It does not mean that the Sukuk amount is a debt on the lessee.

The connected argument is on purchase undertaking which is inappropriately considered as the guarantee for payment of the Sukuk amount plus the return. I would like to advise my industry colleagues to carefully read the contents of a purchase undertaking.

I have myself drafted many and reviewed countless purchase undertaking documents prepared by lawyers and nowhere did I find any unconditional financial guarantee to repay the Sukuk amount. As the name suggests, a purchase undertaking is a mere promise to purchase the Sukuk asset by its executor (ie obligor or the originator of the Sukuk) in the event of default in meeting with its commitment toward the Sukuk investors.

The litmus test whether the purchase undertaking acts as guarantee shall be when the Sukuk asset suffers total loss — for example burnt down, sank (in the case where the Sukuk asset is a marine vessel) or got destroyed in an earthquake or a flood? Will the purchase undertaking still be legally valid when there is nothing remaining to be purchased by the obligor? Of course, the purchase undertaking shall become null and void upon destruction of the Sukuk asset and the Sukuk investors shall be compensated from the insurance proceeds.

Hence, if the purchase undertaking cannot ensure to pay to Sukuk investors in case of a total loss to the Sukuk asset, it must not be considered akin to a financial guarantee and therefore, in my opinion it is incorrect to clasify the Sukuk as DCM instrument instead of ECM where it truly belongs, irrespective of the fixed return and the purchase undertaking.

Moving on, another similarity between bonds and Sukuk is the requirement of issuing the prospectus or the offering circular for the Sukuk. This is a comprehensive document which contains a full set of information an investor may be interested to go over before sparing some cash to buy the Sukuk.

It is an incorrect notion in the market that the offering circular is the offer from the originator to potential investors and if they accept it, the deal is done. From a Shariah angle, an offering circular is actually an invitation to potential investors by the originator to submit the investment offer through the subscription application.

Here, the right to accept the offer rests with the originator and if he does so, the deal is done. In the case where the originator receives several investment offers (subscription), exceeding the Sukuk amount, the originator shall have the right to select which offers he accepts, or alternatively distributes the Sukuk amount among all subscribers pro-rata. So therefore, another myth is busted through this space that the offering circular is an offer. It is simply an invitation to investors.

Furthermore, if we consider the offering circular as an offer, how would the subscription applications be treated since all of them shall be deemed to be the acceptance, irrespective of the Sukuk amount? A penny for your thoughts?

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 the offering circular shall continue.