Sukuks: the growth of Islamic finance
Over the last few years there has been a dramatic growth in the use of Islamic finance techniques in raising capital that complies with the requirements of Shari'a law. According to recent reports assets invested in an Islamic, Shari'a compliant, manner are now estimated to exceed US$250 billion with the pool of money held by Muslim investors estimated at US$1.5 trillion (and growing rapidly with high oil prices). The growth of the Sukuk market, which only opened in 2002 with the Malaysian government US$600 million Sukuk issue, is a prime indicator of this trend. By 2004, US$6.7 billion of capital was raised through the issue of Sukuks and in the first six months of 2005 the total raised reached US$6.2 billion.
What is a Sukuk?
Under the Koran, interest (riba) earned on money (for example, a loan) is forbidden, but many other types of finance are allowed. The basic principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. The classic Sukuk structure involves an acquisition of a property asset by a special purpose company (SPC) established in a tax neutral jurisdiction. The company funds itself by the issue of Sukuk, declaring a trust in favour of the Sukuk holders. The Sukuk holders receive a return based on the rental income of the asset, taking the credit risk of the underlying lessee (see box "Classic structure").
There are a number of accounting and tax consequences which can arise when a UK property is transferred to a UK based SPC but these are beyond the scope of this article.
The growth in the Sukuk market is due to the confluence of a number of factors ranging from the geopolitical impact of the 9/11 atrocities to a more general interest in developing Shari'a compliant products and structures. The fundamental drivers behind the Sukuk market are the same as those for the conventional securities market as it aims to:
Broaden the pool of investors.
Spread risk away from financial institutions.
Dis-intermediate the link between investors and borrowers.
Although the market is relatively small, the excess liquidity currently being pumped into Gulf economies means that another pool of investment funds is becoming available to corporate treasurers. As the market is developing rapidly and the jurisprudence from the Islamic scholars is becoming more settled, the issue costs for a Sukuk structure continue to fall. The TCIP (Trust Certificate Issuance Programme) established by the Islamic Development Bank (IDB) in May 2005 marks a further step in the development of the Sukuk market with the IDB able to use some of the financial assets on its balance sheet to underpin Sukuk issues under a medium term note (MTN) like programme structure. The TCIP structure is similar to that outlined above with the underlying assets being a mixture of ijara (lease), murabaha (instalment sale) and istisna'a (conditional sale) contracts.
The main stumbling block for accessing the Sukuk market is the availability of underlying assets that generate a Shari'a compliant income stream. An interest-derived income stream will not be eligible for inclusion in a Sukuk, but a rental-based income stream (whether from real estate or movable property) is ideal. The most popular asset class to date is real estate where rental income can be generated to provide cash flow returns to holders and repurchase obligations can be entered into to ensure principal repayments on the scheduled maturity dates. Other eligible assets have included aircraft, car fleets, pipelines and large air conditioning units.
Before being brought to market any Sukuk will need a declaration or opinion from Shari'a scholars that the relevant transaction complies with Shari'a law. There has been a degree of confusion as to the interplay between compliance with Shari'a law and with the enforceability of the relevant contracts. Recently, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd & Ors, the Court of Appeal held that an Islamic financing agreement which was expressed to be governed by both English and Shari'a law was governed by English law (www.practicallaw.com/5-102-6474). The court held that the question of whether or not a contract was Shari'a compliant does not have a bearing on its enforceability. This confusion can of course be minimised by clear drafting.
It is expected that there will be continued strong growth in the Sukuk market. There is increasing standardisation of Sukuk documents in the marketplace which will drive costs down and improve the competitiveness of these instruments.
Andrew Roberts is a partner and Katsumasa Suzuki is an associate at Linklaters.