Introduction to Sukuk 1

Briefing note March 2013

Introduction to Sukuk According to a recent report by Thomson Reuters, the global sukuk market is expected to grow 141% to reach US$292 billion in issuances by 2016, up from US$121 billion in 2012

see our client briefing entitled "Islamic What are Sukuk? Finance" Spring 2012 for further Key issues Sukuk is the Arabic name given to a information). The basic Islamic financial certificate and its origins can principle is that money is not a „ What are Sukuk? be traced back to the Middle Ages commodity and, therefore, it is not „ Sukuk Structures where papers representing financial possible to earn profit from its simple „ General Structural obligations originating from trade and utilisation as it has no intrinsic value Considerations other commercial activities were and is merely a means of exchange. „ Conclusions utilised within Muslim societies. Profit must be earned through trade Although sukuk are sometimes and taking part in the risks of a referred to as Islamic bonds because transaction. „ Free Zone FZE they essentially replicate interest ("JAFZ") Sukuk – advising JAFZ Prior to the development of the sukuk bearing bonds in a Shari'a compliant on refinancing of its liabilities product there was a scarcity of manner, they are better described as through the use of a hybrid Islamic products that could provide a an asset based investment as the structure comprising an Islamic mid to long term investment and investors own an undivided interest in bank loan facility and issue of a which could readily be traded in the an underlying asset in proportion to new sukuk, with both having the secondary market, both from a their investment and as such take the benefit of a wide range of practical perspective and from a risk in, and benefit derived from, the security governed by an Shari'a perspective. The sukuk is underlying asset. This ownership intercreditor agreement. The ideal from the perspective of the interest is evidenced by sukuk consent solicitation was the first Islamic investor and, given that it is certificates held by the investors. time in the region that a call typically an ownership interest in a option had been inserted into a real underlying asset and not just a In simple terms, monies raised by the sukuk. issue of sukuk certificates are used to debt instrument, is a freely tradable „ Qatar Islamic Bank ("QIB") invest in an underlying asset, a trust instrument. Sukuk – advising Deutsche Bank is declared over that asset as a result Some of the most recent, notable AG, London Branch, HSBC Bank of which the certificate holders own a examples of sukuk transactions on plc, QInvest LLC and Standard beneficial interest in that asset in which Clifford Chance has advised on Chartered Bank as arrangers on proportion to their investment and are include: the update by QIB of its US$1.5 entitled to all of the benefits billion Trust Certificate Issuance emanating from the asset including a „ Republic of Turkey Sukuk – Programme. proportion of the economic returns advising HSBC Bank plc, generated by that asset. Citigroup Global Markets Limited „ Islamic Bank PJSC and Liquidity Management House ("DIB") Sukuk – advising As with all Islamic financial for Investment Company K.S.C.C. Deutsche Bank, Dubai Islamic transactions, sukuk are based on as joint lead managers and the Bank, NBD Capital, Islamic principles and jurisprudence dealers on the standalone, debut HSBC and National Bank of Abu (the Shari'a) which are derived from a sukuk issuance by the Republic Dhabi, as arrangers and dealers number of sources, including the of Turkey of US$1.5 billion on the update of DIB's U.S.$2.5 primary source of the Qu'ran (please certificates. billion Trust Certificate Issuance

2 Introduction to Sukuk

Programme and the subsequent Programme listed on the London „ Nakheel Trade Creditor Sukuk issuance of U.S.$500 million trust Stock Exchange, subsequent – advising Nakheel on a AED8.5 certificates thereunder. programme updates and the billion trade creditor sukuk „ Saudi British Bank – advising issuances of US$250 million programme, the first sukuk HSBC as lead manager in (now redeemed) and two programme in the GCC to relation to the issuance by Saudi issuances of US$500 million trust incorporate tap mechanics. British Bank of SAR1.5 billion certificates each thereunder. „ Government of Malaysia Sukuk trust certificates in Saudi Arabia „ DP World Sukuk – advising DP – advising CIMB, Citi, HSBC and by way of private placement. World Limited on the US$1.5 Maybank as Joint Lead The proceeds of the issuance billion sukuk-al-mudaraba, Managers and Joint Bookrunners comprised tier 2 capital for Saudi offered outside the US pursuant on the Government of Malaysia's Arabian regulatory capital to Regulation S and to US US$2 billion dual-tranche purposes and were used by institutional investors pursuant to sukuk-al-wakala issuance, the Saudi British Bank to strengthen Rule 144A, dual listed on the largest dual-tranche global its capital base. London Stock Exchange and sovereign US dollar sukuk ever „ Saudi Arabian General NASDAQ Dubai. issued and the first global Authority of Civil Aviation „ Bank Al Jazira Sukuk – advising, sovereign USD sukuk for 2011. ("GACA") Sukuk – advising together with Al-Jadaan & „ First Gulf Bank ("FGB") Sukuk GACA in relation to the issuance Partners Law Firm, Bank Al – advising Citi, HSBC and in the Kingdom of Saudi Arabia of Jazira on a subordinated sukuk Standard Chartered on the SAR15 billion (approximately due 2021 callable with step-up in establishment of FGB's US$3.5 US$4 billion) trust certificates 2016, comprised of a hybrid billion Trust Certificate Issuance (this was the largest sukuk to mudaraba and murabaha Programme, listed on the London date in the Kingdom of Saudi structure and represents the first Stock Exchange. Arabia and the first sukuk sukuk issuance and the first „ Sharjah Islamic Bank Sukuk – issuance by a Government entity regulatory capital transaction by advising Sharjah Islamic Bank on with the benefit of an express a fully Shari'a compliant bank in its US$400 million trust certificate guarantee from the Saudi Saudi Arabia. issuance which was listed on the Ministry of Finance). „ Majid Al Futtaim Holding LLC London Stock Exchange. „ Commercial Bank ("MAF") – advising the Joint „ The Government of the emirate P.J.S.C. ("ADCB") Sukuk – Lead Managers on MAF's US$ 1 of Ras Al Khaimah ("RAK") – advising ADCB in relation to the billion Reg S sukuk programme advising Citigroup Global issuance of wakala and comprised of a Wakala structure Markets Limited and The Royal mudaraba based US$500 million and issuance of U.S.$400 million Bank of Scotland plc on the trust certificates, listed on the trust certificates due 2017. region's first ever sukuk liability London Stock Exchange. „ Sukuk – advising management exercise for the „ HSBC Bank Middle East Sukuk Citigroup Global Markets Limited, Government of RAK and the – advising HSBC Bank Middle Dubai Islamic Bank P.J.S.C. and sukuk programme update. East in connection with the Standard Chartered Bank as „ sukuk programme – update of its London listed US$5 Joint Lead Managers on the advising Citigroup Global billion sukuk issuance establishment of Tamweel's Markets and The Royal Bank of programme and a US$500 million US$1 billion Trust Certificate Scotland on the establishment of sukuk issuance under the Issuance Programme and a global sukuk programme for programme. issuance of Irish Stock Exchange Emirates Telecommunications „ Emirates Islamic Bank Sukuk listed US$300 million trust Corporation. Programme – advising Emirates certificates due 2017. This „ SBG Sukuk Limited trust Islamic Bank on the programme comprised a hybrid certificate – advising HSBC establishment of its US$1 billion wakala and mudaraba structure. Saudi Arabia Limited on the Trust Certificate Issuance 53782-6-5769-v1.3 ME-8000-BD-PR

Introduction to Sukuk 3

issuance by SBG Sukuk Limited second and third Issuances sukuk is the first ever ijara sukuk of a sukuk-al-murabaha trust under that programme. programme in the UAE and is the certificate to local investors in „ Saudi Bin Ladin Group Sukuk first ever rated sovereign Saudi Arabia. – advising HSBC Saudi Arabia issuance in Dirhams. „ Nomura Holdings Sukuk – Limited as lead manager on the „ Saudi Electricity Company advising Kuwait Finance House issuance of over SAR1 billion Sukuk – advising HSBC Saudi (Malaysia) Berhad as lead sukuk-al-mudaraba maturing Arabia Limited as Lead Arranger arranger in relation to Nomura 2013. on a SAR5 billion sukuk Holdings' US$100 million two „ Dubai Electricity and Water (US$1.33 billion) for Saudi year benchmark sukuk-al-ijara Authority Sukuk – advising Electricity Company, which was certificates. This was the first DEWA in relation to its AED3.2 listed on the Saudi Stock ever US dollar-denominated billion sukuk (sukuk-al-ijara), Exchange. sukuk issuance by a Japanese DEWA's debut sukuk issuance „ Jebel Ali Free Zone Authority corporation. which is listed on NASDAQ (JAFZA) Sukuk – advising the „ Government of Malaysia Sukuk Dubai. Jebel Ali Free Zone Authority and – advising Barclays Capital, „ Aldar Properties PJSC Sukuk – Jebel Ali Free Zone FZE on a CIMB and HSBC as lead advising Abu Dhabi Commercial AED7.5 billion Reg S sukuk for arrangers in relation to the Bank PJSC, Barclays Bank PLC, Jebel Ali Free Zone FZE, the US$1.25 billion global sukuk Credit Suisse Securities (Europe) largest dirham denominated issuance by the Government of Limited, Dubai Islamic Bank sukuk issued in the UAE. Malaysia. PJSC, First Gulf Bank PJSC, „ Aldar Properties PJSC Sukuk – „ General Electric Sukuk – Lehman Brothers International advising Aldar Properties PJSC advising the joint lead managers (Europe), National Bank of Abu on its debut issue of US$2.53 on the US$500 million sukuk Dhabi PJSC and Noor Islamic billion convertible sukuk issued by GE Capital Sukuk Ltd. Bank PJSC as joint lead certificates listed on the London The assets underlying the sukuk managers of the issuance of Stock Exchange. The deal was are interests in a portfolio of AED3.75 billion sukuk notable for being not only the aircraft and rental payments from (sukuk-al-ijara). third largest sukuk issue in the the lease of such aircraft. This „ Issue of 's first Gulf region but also the largest transaction was the first exchangeable Islamic bond – convertible sukuk that can investment grade sukuk for a US advising the investment holding convert into listed shares on an corporate. arm of the Government of UAE exchange. „ Tourism Development and Malaysia on the issue of a „ Saudi Basic Industries Investment Company PJSC US$750 million sukuk, the world's Corporation (SABIC) Sukuk – Sukuk Programme – advising first exchangeable Islamic bond. advising HSBC Saudi Arabia on the establishment of Tourism We have subsequently advised Limited as arranger and lead Development and Investment on two further issues of sukuk, of manager of a SAR3 billion Company P.J.S.C.'s US$850 million and US$350 (US$800 million) sukuk issue by US$1,450,000,000 sukuk Trust million respectively. SABIC. This was the first sukuk Certificate Issuance Programme „ Government of Ras Al to have been publicly offered in and inaugural issuance. Khaimah Sukuk – advising the Saudi Arabian domestic „ Islamic Development Bank Standard Chartered Bank as market and to be admitted to the Sukuk – advising The Islamic arranger on the establishment of Official List maintained by the Development Bank in relation to the RAK Capital US$2 billion Saudi Capital Market Authority. the 2009 update of its US$1.5 sukuk trust certificate issuance „ PCFC Development FZCO billion sukuk trust certificate programme for the Government Sukuk – advising the Dubai issuance programme and the of Ras Al Khaimah and Ports Authority in connection with drawdown thereunder. The its US$3.5 billion

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4 Introduction to Sukuk

sukuk-al-musharaka which was example, the sukuk-al-wakala, also purpose vehicle (SPV). The SPV will listed on the Dubai International being increasingly utilised. finance this acquisition by cash raised Financial Exchange. This was by the issue of sukuk certificates. This article examines these two the first sukuk which is The SPV will then lease the same structures in more detail below. convertible into equity. physical asset to a third party, often Sukuk-al-Ijara the originator itself. The lease rental Sukuk Structures payments will 'mirror' the coupon The ijara is a Shari'a compliant lease. payments due under the sukuk In any sukuk transaction, the It is a hybrid between an operational certificates and the cash flow from the issuance of sukuk certificates will lease and a finance/capital lease with lease rentals will be used to service simply raise a cash amount required certain 'ownership' risks, such as the those coupon payments. by an originator. The issuance itself obligation to undertake capital will not entitle the investors to a return maintenance of the leased asset and An example of a classic sukuk-al-ijara on their investment and, therefore, the obligation to insure the asset, structure would be as follows: must be supplemented with another remaining with the lessor. The lessor

Islamic financing structure. may appoint an agent, usually the Although it is possible to interpose a lessee itself, to carry out these duties Certain issues arise in the context of sukuk issuance onto any Islamic on its behalf under a servicing agency a sukuk-al-ijara which should be financing structure, historically, the agreement. In a simple sukuk-al-ijara considered: the originator, or a third party most prevalent structures used in the „ the sukuk issue requires the connected to the originator, will sell sukuk space were ijara, mudaraba transfer of real assets by the and musharaka structures. certain physical assets to a special However, in 2008, AAOIFI issued a statement criticising the use of fixed price purchase undertakings to guarantee returns in sukuk-al-mudaraba and sukuk-al-musharaka structures. AAOIFI stated that these structures are intended to be similar to equity-based instruments and therefore any returns to the investors cannot be fixed at the outset – the investors must share any losses arising out of the sukuk assets. Subsequently, this led to a significant decline in musharaka and mudaraba based sukuk issuances as investors in the market were not prepared to invest in instruments that exposed them to risks that are not normally associated with debt-based instruments. As a consequence, since 2008, the sukuk-al-ijara structure has become the predominant structure with other structures, for

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Introduction to Sukuk 5

originator to the SPV, however, asset the originator may be able to any shares or sukuk certificates held the transfer is often not a 'true transfer a usufruct which is then by it into a portfolio which is then sold transfer' in that the sale is not leased back to the originator provided to the investors. The income derived perfected. Although the transfer that such a usufruct is recognised by from the portfolio is used to service may not be a 'true' transfer, the the relevant legal and regulatory the coupon payments due under the potential tax implications still regimes. Within the United Arab sukuk certificates. need to be examined on a Emirates the use of a right to develop The trustee will typically appoint the transaction specific basis. land (known as a Musataha) has originator as its agent (wakil) to been used within the framework of a „ the size of the sukuk issue is manage the portfolio. Unlike a sukuk-al-ijara transaction on a restricted to the value of the musharaka or a mudaraba where the number of issuances, for example, assets which are being managing partner or the mudarib has the sukuk programme established by transferred by the originator to some investment discretion, the the Tourist Development and the SPV. Additionally, once the wakil's role in a sukuk-al-wakala is Investment Company PJSC was assets have been used for the generally limited to collecting income based on a Musataha structure. It is purposes of a sukuk issuance generated by the portfolio, also possible to have the originator they cannot be used for any other maintaining the underlying assets grant a head lease instead of selling purpose until the sukuk has comprised in the portfolio and acting an asset. For Shari'a reasons, the matured and redeemed; and on the instructions of the Trustee to head lease would have to enure for a „ in the event that the assets suffer replenish the portfolio with additional sufficiently long period of time such a total loss, for Shari'a reasons underlying assets from time to time. that it is considered to be akin to an the rental payments under the Given the limited nature of the wakil's ownership interest. ijara must cease and the role, the wakil is not held to be a purchase undertaking would Sukuk-al-Wakala partner or a mudarib in the become ineffective. As a arrangement for Shari'a purposes and consequence, the Investors It is not always possible to identify a therefore does not need to share the would have no method of tangible asset of sufficient value that risk of loss in the arrangement. As a generating a return to fund can be used for the purposes of a consequence of this, the originator in coupon payments nor are they sukuk issuance and indeed it is for its corporate capacity is permitted, able to exercise the purchase this reason that sukuk-al-musharaka under Shari'a, to grant a fixed-price undertaking in order to redeem and sukuk-al-mudaraba structures purchase undertaking to purchase the the sukuk certificates. Both of were so prevalent pre-2008. As portfolio on redemption of the sukuk these concerns can be discussed earlier, the use of these certificates. addressed through the service structures has become problematic agency arrangements and in for investors since it is no longer An example of a simple particular the insurance possible to guarantee a return to them sukuk-al-wakala would be as follows: obligations placed on the through a fixed-price purchase originator as service agent. undertaking. An alternative structure Historically, the sukuk-al-ijara that has been used recently, structure was frequently used due to particularly by Islamic financial its relative simplicity. However, since institutions acting as originators, is the the AAOIFI statement of February sukuk-al-wakala structure. 2008, its most attractive feature is In a simple sukuk-al-wakala, it is generally considered to be the permissible for the originator to permissibility of a fixed-price "package" its underlying investments purchase undertaking within the and sell them to the issuer in return structure. Variants of the basic for a purchase price. An Islamic sukuk-al-ijara structure have financial institution is therefore able to developed over the years including, package, for example, its ijara for example, instead of selling an contracts, murabaha receivables and 53782-6-5769-v1.3 ME-8000-BD-PR DM Ref 6 Introduction to Sukuk

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Certain issues arise in the context of a sukuk al-wakala which should be „ number of additional mechanics transactions including most notably considered: can be introduced into the the US$1.5 billion sukuk programme structure, such as the provision „ the underlying investments may update for the Islamic Development of a Shari'a compliant liquidity amortise over the life of the Bank where Clifford Chance acted as facility, in order to mitigate this sukuk and therefore the value of international counsel to the issuer and risk; and the sukuk assets will decline over MAF's US$ 1 billion Reg S sukuk time. In order to maintain the „ the rate of return generated by programme where Clifford Chance value of the sukuk assets the underlying investments may acted as international counsel to the additional assets will need to be not necessarily mirror the rate of Joint Lead Managers. substituted into the portfolio from return under the sukuk time to time; certificates. At times it could be General Structural less than or in excess of the „ the income from the underlying periodic distribution amount. In investments is used to service Considerations order to cater for excess returns the periodic distributions under a reserve account can be the sukuk certificates. There is a Mitigating Asset Recourse introduced into the structure. residual risk that there may be a Risk The reserve account would also customer default under the Given that most originators have no serve as a source of funding in underlying investments which desire to actually lose the physical the event of a shortfall. could lead to a shortfall on any asset in question, that is of course given periodic distribution date. This sukuk-al-wakala structure has assuming that the initial transfer is a A been used on a number of recent perfected sale in the first place, rather than permitting the investors to have 53782-6-5769-v1.3 ME-8000-BD-PR

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recourse to the physical asset upon a Credit Enhancements an underlying asset. So what would default, certain procedural safeguards happen if there was an Issuer default? Although the preferred route for credit are built into the structure so as to In a conventional bond the enhancement is the use of a ensure that the possibility of asset bondholder would simply accelerate fixed-price purchase undertaking, for recourse is mitigated. The preferred the debt so that the full amount would reasons outlined earlier in this briefing, route for doing so is for the originator become immediately due and payable. this is not always possible. As such, to grant a purchase undertaking, or In the context of a sukuk however, a number of structural enhancements put option, in favour of the SPV there is no debt to accelerate. To try have been introduced into many enabling the SPV to put its interest in and replicate the economic equivalent, sukuk structures in recent the sukuk assets back to the upon an Issuer default the Issuer (or transactions including, for example, originator for a pre-determined price delegate which is usually appointed to additional mechanics that provide for upon either an originator default, a safeguard the interests of the note funded and unfunded reserve default by the SPV (with the latter holders) can typically exercise the accounts and the provision of Shari'a being exercised by a delegate purchase undertaking (for all amounts compliant liquidity facilities. appointed to monitor the interests of outstanding) and would then have a the sukuk certificateholders) or the Special Purpose Vehicle debt claim against the originator maturity of the sukuk. The (SPV) which is due and payable. In pre-determined price would be an structures where a fixed price amount equal to the principal amount As most sukuk issues involve the use purchase undertaking is not to be redeemed under the sukuk of an SPV as the issuing entity, acceptable other avenues for certificate plus the coupon amount consideration ought to be given to the crystallising a claim in an amount outstanding at the time the purchase jurisdiction of incorporation of the equal to the debt amount would need undertaking was exercised. SPV. In addition to the usual to be explored, for example, through Interestingly, this changes the risk concerns of creditor protection and the use of insurances or by claiming profile of the transaction from the bankruptcy remoteness, the for breach of contract. asset risk of the underlying asset to jurisdiction of incorporation of the the credit risk of the entity to which SPV may be driven by factors such as Conclusion the assets can be put in a default. the nature of the assets that will form Although the sukuk market did suffer Following rating conventions, a sukuk the sukuk assets. By way of example, as a result of the wider global with a purchase undertaking would in some Gulf States non-nationals economic crisis, in 2011 the total not have a rating higher than the may not own real estate and, sukuk issued reached US$84.4 billion, rating given to the entity to which the therefore, in those instances the up 62% from 2010, with the total sukuk assets can be put as the special purpose issuing vehicle will issue for 2012 exceeding US$100 primary risk to the investor is not the need to be incorporated onshore. billion and the global sukuk market asset risk but the credit risk of the Acceleration expected to see demand reach originator. US$900 billion by 2017, according to As discussed above, a sukuk is not a a recent report by Ernst & Young. debt instrument but is a certificate that represents an ownership interest in

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8 Introduction to Sukuk

Authors

Qudeer Latif Debashis Dey Simon Sinclair Partner Partner Partner T: +971 43620 675 T: +971 43620 624 T: +44 207006 2977 E: qudeer.latif E: debashis.dey E: simon.sinclair @cliffordchance.com @cliffordchance.com @cliffordchance.com

David Dunnigan Stuart Ure Crawford Brickley Partner Partner Partner T: +44 207006 2702 T: +971 43620 659 T: +852 2825 8836 E: david.dunnigan E: stuart.ure E: crawford.brickley @cliffordchance.com @cliffordchance.com @cliffordchance.com

Matt Fairclough Partner T: +852 2825 89 E: matt.fairclough @cliffordchance.com

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