Understanding Sukuk: Innovations in Islamic Finance

1. Sukuk Innovations by: Wan A Rahim Kamil ICM Consultant, Securities Commission Malaysia

2. Sukuk as a consequent of Islamic securitisation • Also known as Islamic bonds - but better described as “Trust Certificates” or “Participation Securities” • “ Grant investor a share of an asset along with the cashflows and risk commensurate with such ownership” • Prescribed as “securities” under the Islamic Securities Guidelines to give wider definition • Can be consistent with conventional asset-backed securities (ABS) or conventional unsecured lending – depending on the structures CERT 22-23 May 2007

3. Issuance of Sukuk must be supported by an underlying asset • From Shariah perspective, Islamic financing should only be raised for trading in specified and identified Shariah compliant assets • In general, trading of indebtedness is prohibited, unless it is traded at par • Middle East and some other jurisdictions only allow debt trading at par • Malaysia – trading of indebtedness is permissible at any value provided the underlying contract is Shariah e.g. Bai’ Bithaman Ajil / Bai’ Dayn • Return for investment in sukuk in most cases are linked to cash flows and performance of underlying assets CERT 22-23 May 2007

4. Possible Contracts for Project Funding Needs • Consider a rental of the asset instead of a sale: • Project rents it from outsourced party; • Actually investors purchased the asset and rents it to the project, thus: • Objective of use of asset achieved; • Investors subject to similar cash-flow risk if it had gone into a murabahah contract; • At end of period, project company could opt to purchase the asset, considering that it would have already paid in full. CERT 22-23 May 2007

5. Best achieved through an Asset Backed Securitisation (“ABS”) exercise: • What qualifies as assets? • Investment entries through Participatory Contracts; • Need to comply with guidelines or regulations on ABS. CERT 22-23 May 2007

6. Definition of Assets • Under the shari’ah the assets must meet the necessary conditions: • Must exist physically (land, building, machinery) • Must be pure; • Must have use (however restricted to halal use and not for example for operations of casino or alcohol sales outlet); • Must be owned by the seller; • Must be free from encumbrances; • Must be known by specifications, descriptions, location, etc. CERT 22-23 May 2007

7. What are Participatory Contracts? Such as … Participatory Contracts (risk participation) Mudharabahor Trust Loan-Investments: Contract between fund owner and entrepreneur whereby returns are pre-agreed based on profit achievements but losses borne just by capital provider. Entrepreneur only provides management expertise. Musharakahor Joint Participations: Pooling of capital resources among several parties based on pre-agreed proportions of profit distributions and losses borne according to equity contributions. CERT 22-23 May 2007

8. Applications • These are extensions to equity-related instruments. • Musharakah is close to joint participations; • Mudharabah is a semi-equity semi-debt instrument. • Can be applied to needs normally raised under subordinated debt structures. CERT 22-23 May 2007

9. Participatory Contracts • Participatory Contracts of: • Musharakah or general partnership under profit-loss sharing formula. Partners: • Share profits in accordance with pre-agreed proportions and not necessarily based on capital investment; • Bear losses in proportion to capital contribution. • Partners might forgo rights to management to other partners. • Managing partner liable for losses due to mismanagement or wrong business judgments. CERT 22-23 May 2007

10. 2. Mudharabah Trustee investment contract that is semi-equity and semi-debt in nature. • Marriage between capital and entrepreneurship; • Profit sharing contract whereby: • one party, the capital provider or rabb al mal provides the necessary capital for the venture, • The other party, the mudharib, provides the expertise for the venture. • Profit sharing not based on capital but based on pre-agreed proportion of achieved profits. • Genuine business losses borne in entirety by rabb al mal. CERT 22-23 May 2007

11. Asset Backed Securitisations: • Create new opportunities to popularise mudharaba or qirad, and/or musharkah contracts, • Ability to ring-fenced risks with more secured contracts such as ijarah, murabaha, salam or other compounded contracts of exchanges, whereby • Risks mitigated through secured cash-flow streams and with lesser operational and credit risks, • More shari’ah compliant due to Special Purpose Vehicle involved in direct investments or business activities – avoidance of Bai’ al Dayn issues. CERT 22-23 May 2007

12. 3 3 Special Purpose Vehicle (“SPV”) (Mudharib) 7 Subscription for Certificates ($) 1 Expenses for meeting operational requirements 4 Direct Investments through ijarah, murabahah or other real estate businesses or trading activities Mudharaba or Musharakah Certificates 2 5 6 Cash-flow stream ($) Pool of Investors (Rabb al Mal or Musharkah Partners) Profit Distribution CERT 22-23 May 2007

13. Asset Backed Securitisation 3. Originator 3a. SPV Investors 2. 4. 1. • Sale of asset to the SPV – True Sale • SPV issues asset-backed securities to investors • Proceeds from the sale of ABS go to the Originator • (Interest) & principal repayments to Investors CERT 22-23 May 2007

14. Islamic Asset-Backed Sukuk adds a new dimension to ICM products • True sale – legally belong to SPV • Non-recourse sukuk / ABS - credit risk performance is determined solely by underlying asset • SPV – bankruptcy remote (independent) • Correspondence of income streams with actual income and value of the assets • Ratings are primarily dependent on a risk analysis of the assets or performance of assets • Unilateral purchase undertaking (if any) – at market value CERT 22-23 May 2007

15. Ambang Sentosa BBA (ABS) –domestic version of Islamic securitisation Originator Identified Asset: Rights, title and interest over the balance sales proceeds of two development projects Proceeds from BBA transaction used to purchase Identified asset • Hibah (Gift) • Aqad Asset 2.Investor purchase asset (gift) Ambang Sentosa Investor 3. Cash 4. Sale of asset on deferred payment (BBA) 5. ASSB issue BAIDS to investor • Underlying assets to execute BBA are assets awarded by 3rd party – need tangible assets to avoid debt-for-debt transactions which is prohibited both in Msia and international • Cash flow is still based on receivables CERT 22-23 May 2007

16. Cagamas Sukuk Musyarakah (RMBS) - does it comply with international Shariah standards ? Trustee Cagamas (Transaction Administrator & Administrator) Represent Sukukholders Sukuk issued to investors Investors Sale of GSHFs GOM (Originator & Servicer) Cagamas MBS Proceeds from sukuk Purchase consideration • Sale of Islamic house financing receivables • Debt trading – sold at discount not at par • Although investors formed as musyarakah venture CERT 22-23 May 2007

17. Golden Crop Sukuk Ijarah (ABS) – compliance with international Shariah standards Share Trustee Originator sell the plantation asset to the Issuer Boustead Group (Originators) Golden Crop Returns (Issuer) Trustee Issuer leases back the plantation asset to the Originator Subordinated Musyarakah facility with LTAT Sukukholders LTAT Sukuk Ijarah CERT 22-23 May 2007

18. Islamic Asset Backed Securities issued in Malaysia * International Shariah compatible structure CERT 22-23 May 2007

19. Majority of sukuk has been on simple “ijarah” structure – unsecured financing / asset-based • Originator seeking financing “sells” the assets to SPV for a value equal to financing required and lease it back • SPV – subsidiary of originator; • Lease payments provide fixed income stream which may be benchmarked to an index / LIBOR +; • Conducted on non true-sale basis so repayment and risk/performance is not asset backed but originator based; • Purchase undertaking of asset at maturity with pre-determined value; CERT 22-23 May 2007

20. Ratings are primarily dependent on the riskness of the borrower / sponsor / originator / lessee; • Assets only used to facilitate Shari’ah compliance. CERT 22-23 May 2007

21. Sukuk Al-Ijarah - Asset Based Transaction Originator SPV Sukuk Sale of asset Sukuk Sukuk Sukuk proceeds Sukuk Sukuk proceeds Asset repurchase Periodic payments: Lease flows and principal (via amortisation/repurchase) Lease & repurchase payments for assets • Non-true sale – condition to repurchase at maturity • Payment of rental / profit can be derived from ijarah or other sources CERT 22-23 May 2007

22. Sukuk Al Ijarah – Asset Backed • There are also structures of sukuk al ijarah under an Asset Backed Scenario. • True sale, though • The ownership of the SPV is transferred to the originator or the lessor at end of lease. Original underlying sale has been true sale. CERT 22-23 May 2007

23. Asset Provider Investors 2. Certificates of Investments 3. Sale & Purchase of Asset (payment of asset acquisition Cost US$) Asset 1. Offer for Sale of securities SPV 4. Transfer of Ownership of Asset to SPV $ Step 1 1st Transaction: SPV and Asset Provider 1st Relationship: SPV and Investors Creation of Sukuk al Ijarah CERT 22-23 May 2007

24. SPV Project Owner 1. Execution of al ijarah contract ASSET 2. Rental of Asset on fixed term and fixed rental basis Ijarah Rental Obligation Certificates (evidence of obligations) 3. Issuance of ijarah rental Obligations Promissory Notes to SPV implying cash flow stream on asset. Step 2 CERT 22-23 May 2007

25. 1.Regular Ijarah Rental Payments SPV Project Owner 3. Final Repayment Representing Total Settlement equal to Initial Purchase Price Of Asset by SPV Asset 5. Asset transferred to Project Owner Investment Certificates Holders 2. Scheduled Distributions of Coupon Payments to Holders Of Investment Certificates issued by SPV 4. Payment of Final Amount being final settlement of Obligations under Ijarah Contract CERT 22-23 May 2007

26. Assets purchased by the SPV are funded by the issuance of floating rate Trust Certificates, representing beneficial ownership in the assets and having beneficial rights on the lease; • Upon maturity of the lease, SPV sells asset to the Project Owner at the original price. Proceeds from this sale will be utilised to meet the final payment to investors. CERT 22-23 May 2007

27. Sukuk al Ijarah can be: • short term facility instruments i.e. as per structure of sukuks issued by the Bank Negara and/or Government of Malaysia to replace T-Bills; or • Medium to long term facilities but with rental settings made every scheduled periods of say 3 or 6 months each year. CERT 22-23 May 2007

28. 2. Musharakah Investment Agreement Ordinary Equity Musharakah Investors 7. $ Profit Payments & Repurchase or Redemption of MPS MUSHARAKAH PREFERENCE SHARES (‘MPS’) 1. 3. $ for Working Capital Needs 9. $ Dividends $ Income Stream 7. $ Ijarah Rental Payments PROJECT Co. Ijarah SPV 6. Ijarah contract Rental of Equipment 4. 5. $ Participation Into Mudharabah Sukuk Mudharabah 8. $ Mudharabah Profit Payments Project Funding through COMBINATION OF PARTICIPATORY AND IJARAH CONTRACTS Financial Investors CERT 22-23 May 2007

29. Sukuk Khazanah Exchangeable Sukuk(Asset Swap) Khazanah Investors Khazanah & Other Sellers Cash Settlement Purchase Right Deed Sale of Equity Pool Sale Price (Principal) ($) Default / Maturity Purchase Undertaking Deed $ Sale of Equity Pool Issuer Rafflesia SPV II Sale Price (Principal) ($) Sukuk Proceed ($) CERT 22-23 May 2007

30. Some notable Sukuk issued in the global markets CERT 22-23 May 2007

31. CERT 22-23 May 2007

32. Asset-Based Sukuk vs Asset Backed Sukuk CERT 22-23 May 2007

33. CERT 22-23 May 2007

34. END Thank You wark06@gmail.com CERT 22-23 May 2007