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Islamic Sukuk Concept & Applications
Muhammad Faisal Shaikh
Head,Corporate & Product Development

BankIslami Pakistan Ltd
Ramadan 13, 1428 September 26, 2007

Islamic Sukuk-Introduction
 Bonds are important part of overall financial system.  Well developed bond markets ensures stable financial system as it minimize over-reliance on financing from the banking sector.  The development of the bond market allows for access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows for the diversification of risks by issuers and investors.

Islamic Sukuk-Introduction
 Dealing in Bonds is not permissible according to Shariah because of two aspects.  Firstly, they represent a portion of Debt payable by the issuer. Earning any kind of profit falls under the category of RIBA as defined in the Hadith

“Every loan that draws any premium is Riba”.
Hadith is reported by Hazrat Harith ibn Abi Usamah in his Musnad. (See Supreme Court Judgment December 23, 1999)

Islamic Sukuk-Introduction
 Second aspect pertain to the trading of Bonds.  Shariah prohibits trading of debts (Bai Dayn) as it involves Gharar.

Islamic Sukuk-Introduction
Sukuks( ) are developed as alternative of Bonds. A Sukuk represents proportionate actual or beneficial ownership in an Asset or a Pool of identified assets. For a defined period the Risk and Return associated with such Assets belong to Sukuk holders which makes their return permissible for the holder.

Islamic Sukuk-Introduction
Trade of such Sukuks is permissible, because it will be equivalent to the sale/ purchase of holder’s proportionate share in the assets. However, trading of Murabahah Salam Sukuks is not permissible. and

Islamic Sukuk-Difference with
Bonds
Sukuks

 Represents the direct  The bond stands for a pro rata ownership of loan repayable to the the holder in the holder in any case, assets of the pool. and mostly with interest.  Sukuk holder generally earn return from income generated through the asset

Conventional Bond

Islamic Sukuk-International
Overview

Today, the global Sukuk market, denominated in international currencies, is estimated to be $18 billion. If domestic sukuk issuance is included, it has now exceeded $50 billion. Although the size of the market may seem modest by global standards, the sukuk market has been registering an average growth of 40% per annum.

Source: Dr Zeti Akhtar Aziz, Governor, Bank Negara Malaysia, Sukuk Summit 2007, London Khaleej Times (June 22, 2007)

Islamic Sukuk-International
Overview

High levels of surplus savings and reserves in Asia and Gulf region has further boosted demand for Sukuks. Asia has a savings rate which is higher than any other region in the world and is expected to remain between 30 and 40 per cent of GDP for many years to come. The Middle East and in Asia, two of the fastest growing regions in the global economy are expected to spend $500 billion and $1 trillion respectively on infrastructure over the next five years — Islamic capital market, in particular the sukuk market, will serve as an important

Source: Dr Zeti Akhtar Aziz, Governor, Bank Negara Malaysia, Sukuk Summit 2007, London Khaleej Times (June 22, 2007)

Islamic Sukuk- Local
Overview

In Pakistan, the first Islamic Sukuk was issued in 2002 when Sitara Chemicals Industries issued its MTFC. However, the market really started in FY 2005 and since then Sukuks worth at least Rs. 30 billion has been issued or are in the process of issuance. Market is growing at a very healthy rate as large corporates and conglomerates such as WAPDA, Engro Chemicals, PEL, EDEN Developers, Maple Leaf Cement, etc are using Sukuk to fund their

Islamic Sukuk-Types
The issuance of Sukuk requires an exchange of a Shariah compliant underlying asset for a financial consideration through the application of various Islamic commercial contracts such as the Mudarabah, Musharakah, Ijarah, Istisna, Salam and Murabahah. The equity-based nature of Mudarabah and Musharakah Sukuk exposes investors to the risks connected with the performance of the project for which the financing is raised.

Islamic Sukuk-Types
In contrast, issuance of Sukuk on principles of Ijarah and Murabahah yields deterministic receivable and hence result in predictable and somewhat fixed returns for the prospective investors.

Sukuk Al Ijarah

Islamic Sukuk-Sukuk Al Ijarah 
Ijarah is an Islamic conventional leasing.

alternate

of

Issuing certificates of ownership of assets, leased to a particular customer is known as Sukuk Al Ijarah or simply Ijarah Sukuk. Ijarah Sukuk concept is one of the most popular concepts among issuers of global Islamic Sukuk. A simple process is explained next.

Islamic Sukuk-Sukuk Al Ijarah 

If a Company requires, for example, Rs. 500 million for the purchase of land, real asset, equipment etc it can issue Ijarah sukuk equaling that amount in small denominations, say Rs. 500,000 each.

After collection of funds from the investors the company either purchases the asset on behalf of the Sukuk investors or transfers the ownership of the already acquired asset to sukuk holders usually by establishing a Special Purpose Vehicle (SPV), which owns the underlying assets.

 The investor or sukuk holders owns the asset held by SPV as Trustee in the form of Sukuk. The asset is then leased to the firm and the lease proceeds from the asset is distributed to the sukuk holders as return/dividend. The returns on the sukuk certificates could be either fixed or floating. As the expected returns (pre-determined rental payments) are fixed and can be treated as predictable like the coupon payments of a conventional bond.

Islamic Sukuk-Sukuk Al Ijarah

Ijarah sukuk can be issued through a financial intermediary, a bank or a brokerage house or directly by the users of the lease asset. A third party can also guarantee rental payments.  Since the yield is predetermined and the underlying assets are not liquid but tangible and secured, thus the Ijarah certificate can be freely traded in the secondary markets at par, premium or discount.

Islamic Sukuk-Sukuk Al Ijarah

Sukuk Al Ijarah Structure

ABC Ltd. (Corporate)

ABC Ltd. wishes to purchase a new asset and plan to raise finance through issuance of Islamic Sukuk.

Supplier

ABC Ltd.

Supplier of the Asset is identified and negotiations is finalized by ABC Ltd.

Supplier

ABC Ltd.

Issuer SPV (LLC 100% owned ABC Ltd.)

SPV is created by ABC Ltd. as a limited liability Company.

Supplier

ABC Ltd.

Issuer Payment Suku SPV made to ks Supplier (LLC Title is 100% transferred owned to SPV ABC Ltd.)

Investors

Proceed s

SPV issues certificates and receives proceeds which are used to purchase asset from the supplier

SPV holds Asset as Trustee and leases the plant to ABC Ltd. as per rules of Ijarah
Issuer SPV
ABC Ltd.

SPV holds Plant/ Asset as Trustee Investor

SPV leases Plant to ABC Ltd. on Ijarah

ABC Ltd. (Lessee)

Issuer SPV

Investors

Periodic Lease Rentals Semi-annual coupon distribution amounts

ABC Ltd. (Lessee) pays periodic rentals to SPV for tenors & amounts matching the coupon & tenor of the Sukuks

Exercises the purchase undertaking. Asset transferred to ABC Ltd. ABC Ltd. (Lessee) Issuer SPV Investors

Redeems the Pays the Trust exercise price Certificates at at dissolution dissolution •ABC Ltd (Lessee) give the SPV an irrevocable purchase undertaking to purchase the Asset at maturity. •Exercise Price = Initial Purchase Price of Asset + service costs. •Asset is transferred back on maturity, upon payment of

Islamic Sukuk-Sukuk Al Ijarah Important
Conditions

Ijarah Sukuk represents the holder's proportionate ownership in the leased asset. The holder will assume the rights and obligations of the owner/lessor to the extent of his ownership. As owner the holder will have the right to enjoy a part of the rent according to his proportion of ownership in the asset.

Islamic Sukuk-Sukuk Al Ijarah Important
Conditions

In the case of total destruction of the asset, holder will suffer the loss to the extent of his ownership. SPV rules in Pakistan does not allow SPV to hold actual tangible assets, therefore, the asset is shown on the books of the client itself instead of SPV.

Islamic Sukuk-Sukuk Al Ijarah
Essential Condition “It’s essential that the Ijarah Sukuks are designed to represent real ownership of the leased assets, and not only a right to receive rent.”

Islamic Sukuk-Sukuk Al Ijarah Innovation in
Pakistan

In Pakistan essentialy the same structure has been used to develop Sukuks based on Diminishing Musharakah.

Islamic Sukuk-Sukuk Al Ijarah Innovation in
Pakistan

There are two basic differences Diminishing Musharakah Sukuks: Underlying Assets is jointly owned by investors and issuer according to specified percentage.  Ownership is also transferred periodically to the issuer.

in

 Ijarah is essential part of a Diminshing Musharakah transaction under Shirkatul

Islamic Sukuk-Sukuk Al Ijarah Documentation
Documents executed in a Sukuk Issue based on Diminishing Musharakah (under Shirkat-ul-Milk arrangement) are: 1. Investment Agency Agreement 2. Asset Purchase Agreement 3. Musharakah Agreement 4. Service Agency Agreement 5. Payment Agreement 6. Undertaking to Purchase Sukuk Units 7. Undertaking to Sell Sukuk Units 8. Trust Deed 9. Letter of Hypothecation/Other Security Documents

Islamic Sukuk-Sukuk Al Ijarah 1. Investment Agency
Agreement Through this Agreement, all Participating Islamic Financial Institutions ('Investors') appoint a Bank/FI as 'Investment Agent' to carry out all actions (including entering into all Sukuk related Transaction documents) for and on behalf of all Investors in respect of Sukuk Issue.

Islamic Sukuk-Sukuk Al Ijarah 2. Asset Purchase Agreement
Investment Agent (acting for and on behalf of Investors) buys undivided beneficial ownership in specified fixed assets ('Musharakah Assets') in partnership with Issuer at a preagreed price (equivalent to the Sukuk Issue Amount) via the Asset Purchase Agreement. Legal title of the assets remains with the Issuer and only the beneficial title will remain with the Investors.

Islamic Sukuk-Sukuk Al Ijarah 2. Asset Purchase Agreement
Musharakah Assets can be: (i) Already existing, and owned by the Issuer. This would become a Sale and Lease Back (SLB) case. SLB cases are done only after approval of Shariah Adviser and are undertaken mainly to settle existing conventional banking loans of Issuer. (ii) New, and would be purchased from third party. E.g. fixed assets purchased for expansion projects.

Islamic Sukuk-Sukuk Al Ijarah 3. Musharakah Agreement
Investment Agent (acting for and on behalf of Investors) and Issuer will enter into a Musharakah Agreement to jointly own Musharaka Assets. Each Investor’s entitlement to the Musharakah Assets will be undivided and shall for the purpose of more particular determination constitute of ‘Sukuk Units’. Share of each Co-Owner will be specified in the Musharakah Agreement.

Islamic Sukuk-Sukuk Al Ijarah 4. Service Agency Agreement
Issuer is appointed 'Service Agent' via signing of Service Agency Agreement between Investment Agent (acting for and on behalf of Investors) and Issuer. Service Agent will be responsible for: (i) Ensuring all major maintenance of the Musharakah Assets;

Islamic Sukuk-Sukuk Al Ijarah 4. Service Agency Agreement
(ii) Paying ownership related expenses and taxes; and (iii) Arranging Takaful/Insurance of the Musharakah Assets. Such ownership related expenses/taxes incurred by Service Agent on behalf of Musharakah Co-Owners will be reimbursable from Investment Agent.

Islamic Sukuk-Sukuk Al Ijarah 5. Payment Agreement
Investment Agent (acting for and on behalf of Investors) will allow Issuer to use Investors' share of the Musharakah Assets against periodical KIBORbenchmarked Rental Payments in terms of the Payment Agreement. From Shariah perspective, this is basically an Ijarah Agreement. The tenor of the Payment Agreement will be matched with the Musharakah tenor.

Islamic Sukuk-Sukuk Al Ijarah 6. Undertaking to Purchase
Sukuk Units Undertaking to Purchase Sukuk Units is a promise undertaken by Issuer in favor of the Investment Agent for: (i) the periodical purchase of Sukuk Units (representing Investors' undivided beneficial ownership in the Musharakah Assets); and (ii) the purchase of all outstanding Investors' Sukuk Units in case of an

Islamic Sukuk-Sukuk Al Ijarah

7. Undertaking to Sell Sukuk Units Undertaking to Sell Sukuk Units is a promise undertaken by the Investment Agent in favor of Issuer granting a call option to Issuer to purchase all or part of the Sukuk Units. In SLB cases, purchase/sale of Sukuk Units will only start after at least one year from the Musharakah Commencement Date/Asset Purchase Date.

Islamic Sukuk-Sukuk Al Ijarah 8. Trust Deed
Trust Deed will be executed between Trustee (appointed by Investors for the Sukuk Issue) and Issuer detailing the responsibilities of the Trustee during the tenor of the Sukuk Issue.

Islamic Sukuk-Sukuk Al Ijarah 9. Letter of Hypothecation/Other
Security Documents Letter of Hypothecation and Other related Security Documents will be executed by Issuer in favor of Trustee for security purposes.

Sukuk Al Salam

Salam is an Islamic mode of finance. Under a Salam transaction the seller makes an advance payment for goods which are to be delivered later provided the goods are defined and the date of delivery is fixed Government of Bahrain first issued Salam Sukuks as an alternate to short term government treasury bill.

Islamic Sukuk-Sukuk Al Salam

Islamic Sukuk-Sukuk Al Salam

Under the transaction Government took an advance payment from the investors for a future delivery of Aluminum ingots. A paper was issued as an acknowledgment of receipt which is known as Salam Sukuk. Upon delivery of Aluminum ingots to the investors at the time of completion of Salam contract, Government sold ingots to third parties as agent of the investors. The difference between Sale and Purchase price was the profit of the investors.

Islamic Sukuk-Sukuk Al Salam

On the same lines Government of Pakistan can also issue Salam Sukuks to cater to the short term liquidity management issues of Islamic Banks. A proposed structure is discussed next.

Islamic Sukuk-Sukuk Al Salam

On behalf of Govt. of Pakistan, Zarai Taraqiati Bank Limited (ZTBL) may sell the commodity to the buyers on Salam basis which in this case would be Islamic Banks. In this transaction, various banks may participate in the Sukuk and one Bank would act as trustee nominated to represent other banks wishing to participate in the Al Salam contract.

Islamic Sukuk-Sukuk Al Salam

As consideration for advance payment, ZTBL will undertake to supply a specified amount of a commodity say wheat at a future date. ZTBL would arrange the commodity by providing Shariah compliant funding to farmer e.g. It may purchase wheat on the basis of Salam from the farmers. Simultaneously a third party such as PASSCO may provide an undertaking to the Trustee to purchase wheat at an specified higher price thus ensuring profit of the investor banks.

Islamic Sukuk-Sukuk Al Salam

Upon delivery Trustee would appoint PASSCO its agent to take delivery from ZTBL. After taking delivery its premises PASSCO will inform the Trustee which would sell the wheat to PASSCO. Payment received from PASSCO would be distributed among the investor banks along with the profit. Banks may also provide funding on the basis of Murabahah to PASSCO for the purchase of same wheat.

Islamic Sukuk-Sukuk Al Salam Important
Conditions

Salam Sukuk represent investors shares in the Advance Price paid to the seller. Since its a dayn, it cannot be traded in the secondary market.

Islamic Sukuk-Sukuk Al Murabahah
Sukuks can also be issued against a Murabahah transaction. Under the transaction investors would provide funding to purchase some assets for the issuer. Acknowledgment of their investment would be regarded as Murabahah Sukuk. The asset would be purchased from its supplier and would be immediately sold to the issuer against deferred price. Profit earned from the transaction would be distributed among the investor

Islamic Sukuk-Sukuk Al Murabahah Important
Conditions

Murabahah Sukuk represent investors shares in receivable from the purchaser Since its dayn, it cannot be traded in the secondary market.

Sukuk Al Musharakah

Islamic Sukuk-Sukuk Al Musharakah
 Musharakah is a mode of financing against which Sukuks can be issued.  If a comapany required financing for any of its project through Musharakah it can issue Sukuks against which investors would provide funding as per the rules of Musharakah.

Islamic Sukuk-Sukuk Al Musharakah 

Every Sukuk would represent holder's proportionate ownership in the assets of the Musharakah.

 Once the majority of the cash amount is converted into fixed assets, these Musharakah Sukuk can be treated as negotiable instruments in the secondary market. .

Islamic Sukuk-Sukuk Al Musharakah Important
Conditions 

Profit earned by the Musharakah is shared according to an agreed ratio between the Issuer and Investors at an agreed ratio.

 Loss is shared on pro rata basis.  Profit & Loss is shared between the investors as per investment ratio only.

Islamic Sukuk-Sukuk Al Musharakah Important
Conditions 

To ensure tradability of the Sukuks following condition should be adhered to:

All the assets of the Musharakah should not be in liquid form. At least 20% of the value of Portfolio should be invested in non-liquid assets.

Islamic Sukuk-Sukuk Al Musharakah

 Musharakah Sukuks can be used for number of purposes including: Construction of Projects and factories Expansion Projects Working Capital Finance  Sitara's Musharakah's TFC advised and arranged by Meezan Bank Ltd. is an excellent example of a Musharakah Sukuks.

Musharakah Term Finance Certificates by Sitara Chemicals Industries Ltd

Islamic Sukuk-Sukuk Al Musharakah
Sitara Chemical Industries Limited  Incorporated In Year 1981, Listed on All Stock Exchanges in Pakistan.  Commencement Production in 1984.  The Company’s of Core Business Soda is Of Commercial

Manufacturing Largest Pakistan.

Caustic

Producer Of Caustic Soda In

Islamic Sukuk-Sukuk Al Musharakah
     

Issuer Total Issue Size Public Issue Tenor Profit Payment

Sitara Chemical Ind. Rs. 360 Million Rs. 105 Million 5 years (Aggregate) Six monthly

Private Placement Rs. 255 Million

Based on profit and loss sharing on the Operating profits of the Chemicals Division

Issue Value of Rs 360 Mn   PSR for 1st Rs 100 Mn Operating Profit Level -1 MTFC Holders 43% 28.9% 14.3% Company
For each Subsequent Rs 100 Mn of Operating Profit

MTFC Holders 7.2% 4.8% 2.4%

Company

100% O/S 67% O/S 33% O/S

56.8% 71.1% 85.7%

92.8% 95.2% 97.6%

Islamic Sukuk-Sukuk Al Musharakah Profit & Loss

Sharingwas linked to the Operating Profit of  Profit the Chemical Division.
 Level 1 Profit: On First Rs. 100 Million Operating Profit @ 12% p.a. of the Outstanding Principal.
 If Operating Profit is less than Rs. 100

Million then: Actual profit entitlement rate = (Actual Operating Rs.100 million)* 12% profit/

Islamic Sukuk-Sukuk Al Musharakah Profit & Loss
Sharing Level II Profit:
 2% p.a. of the outstanding principal on

each subsequent Rs. 100 million operating profit(over and above first Rs. 100 Million).
 If operating profit falls between the two

brackets of Rs. 100 million then: Profit entitlement rate=(Actual operating profit/Rs. 100 Million) * 2%

Islamic Sukuk-Sukuk Al Musharakah
Reserves

Profit & Loss Sharing- Takaful
 The Company formed and maintains Takaful Reserve during the tenor of the TFCs to mitigate the risk of loss for the TFC holders.

 TFC holders also contributed 25% (1/4th ) of their level II Profit to Takaful reserve annually during the tenor of

Islamic Sukuk-Sukuk Al Musharakah
Reserves

Profit & Loss Sharing- Takaful
 The Company transfered Rs 50mm in the reserve.

 In case of no losses during TFCs tenor the amount contributed by the company and TFC holders will be paid on final settlement.

Islamic Sukuk-Other types
 Sukuks are also issued under other Islamic mode of finance and currently much focus is given Sukuk Al Intefah which is transfer of usufruct instead of ownership of the asset.  Other types include Sukuk Al Muzar'a (sharecropping), Sukuk Al Musaqa (irrigation), Sukuk Al Mugharasa (agricultural) etc.

Islamic Sukuk-Other types
 Sukuks are also issued under hybird structures where number of Islamic modes of finance are used to issue a single Sukuk.  Under these structures each of Islamic mode is applied at different intervals to cater to different requirements of the issuer. .

Islamic SukukStandardization
 AAOIFI has also issue Shariah standards for Sukuks and its expected that issuance of these standards would help reducing differences in fatwas issued for Sukuks.

Islamic Sukuk-Criticism
 Some Sukuks are criticized for their close resembelence with conventional bonds.  Many times these closeness is created to adhere to the tax and other regulatary laws of the country.  For example, in Pakistan SPVs cannot hold actual assets. For this reason assets cannot be carved out from the balance sheet of the issuer which creates complexities in identification of the assets and only a hypothecation

Islamic Sukuk-Criticism
 Similarly, concept of the Diminishing Musharakah financing is not there in the stamp duty laws of Pakistan, which compels banks to sell share in assets without any legal registration.  It should be noted that concept of Diminishing Musharakah is recognized in British stamp duty laws since April 2003.  Nevertheless, not all of this criticism is incorrect, and therefore it should be ensured that unesseccary usage of

Islamic Sukuk-Criticism
 The problems could be resolved by Shariah rating systems  This will help investors in making informed decisions regarding the authenticity of the Shariah structure of the Sukuk.

Islamic Sukuk-Benefits
 Sukuk can be used very effectively as a halal alternate to conventional bonds for provding funding for matching maturities and without relying too much on commerical banking sector.  Another aspect of Sukuks which make them more effective than bonds is there ability to mobilize and motivate investors to work for the overall benefit of the issuer. .

Islamic Sukuk-Benefits
Sukuks for Government Projects 

Sukuks based on Ijarah can be used very effectively to finance Government projects.

 If general public is involved in the construction of these project through issuance of Sukuks, it can give them sense of ownership.  Effective usage of such Sukus would increase the ratio of success and ratio of sustainbility of the projects by many folds.

Islamic Sukuk-Benefits
Sukuks by Private Sector

 Corporate Sector can also benefit from unique characteristic of Sukuks.  Musharakah Sukuks can be used to associate general customer with the company.  Sense of ownership and share in the profit of the company can be used as a marketing tool for the products of the company especially in FMCG sector.

Islamic Sukuk-Benefits
Sukuks by Private Sector

 “The more company earns the more return investor would get” concept can revolutionalize sales.  Even Sukuks Al Ijarah would help the companies to position themselves as an caring member of the society by involving community in the business of the company.

Islamic Sukuk-Conclusion
 Sukuks can be used very effectively to obtain Shariah Compliant funding which surely bring Allah's blessing and barakah for the business.  Issuers can also benefit from the huge increase in liquidity in the Islamic world, and can tap on these new sources of funds. Raising funding from the Islamic bond market in the current environment has been 10 to 20 basis points lower than mainstream bonds.

Islamic Sukuk-Conclusion

...And whosoever fears Allah and keeps his duty to Him, He will make his matter easy for him... (Surah Al Talaq Ayat 04)

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