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IMPLICATION OF SUKUK STRUCTURING: THE COMPARISON ON THE

STRUCTURE OF ASSET BASED AND ASSET BACKED IJARAH SUKUK

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IMPLICATION OF SUKUK STRUCTURING:

THE COMPARISON ON THE STRUCTURE OF ASSET BASED AND ASSET BACKED
IJARAH SUKUK

Nurul Aini Muhamed*

Rafisah Mat Radzi**

The selection of sukuk structure is very important to the sukuk issuing process
because it has different implications for investors, especially in the event of a
default. Some pointed their fingers at the Islamic structures and have begun
questioning the Shariah compliance of the issuances. Some have blamed
Shariah as the source of real estate manipulation (such as is alleged to have
occurred regarding Dubai’s recent crisis). Investors are currently taking a
meticulous approach in their investment because they fear the risk of default
as has been experienced in the industry. This stance limits the issuance of
sukuk in the future. The decision concerning structuring selection - either
asset-based or asset-backed - must for this reason consider the implications
this has for protecting investors. This paper aims to identify the implications of
sukuk investors choosing an asset-based or asset-backed structure. This will
involve analyzing sukuk ijarah which have been issued based on the two
above-mentioned structures. The results will provide a practical insight into the
implications and will throw further light on the decision-making process that is
involved in sukuk issuance.

Field of Research: Islamic Finance

1. Introduction

Sukuk is as type of financial instrument that is increasingly accepted and widely

issued in the Islamic finance industry. It is perceived to be an acceptable alternative
to conventional bonds which have been extensively used in the debt market. The
issue of default regarding sukuk instruments especially in the Middle East, however,
has changed the picture. Such events have undeniably influenced the volume and
level of capital involved in sukuk issuance. This unexpected issue has led to
questions concerning the basic structure of sukuk itself, which has implications for
economic and political issues in the home country where the sukuk is issued.

* Nurul Aini Muhamed, Faculty of Economics and Muamalat, Universiti Sains Islam Malaysia.
Email:nurulaini@usim.edu.my

** Rafisah Mat Radzi, School of Commerce, University of South Australia

Email:matry014@students.unisa.edu.au

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Taking this issue as the main topic of this paper, the authors aim to examine the
implications of the sukuk structure, by focusing on the sukuk ijarah. The sukuk ijarah
has been chosen based on the fact that this type of sukuk is widely issued in the
global Islamic debt market. To achieve this aim the sukuk ijarah - in the context of
asset-based and asset-backed structures - is discussed and the strengths and
weaknesses of each structure are compared. This will help us to understand the
nature of each structure and to recognize which is the best one that can preserve
investors’ rights in the event of a default, even though there is no way to eliminate
the risk of investment.

This paper is organized as follows: (1) overview of development of the global sukuk
market, (2) Shariah issues and the decline in sukuk issuance, (3) the main principles
of sukuk issuance, (4) implications for sukuk holders in case of sukuk default by
focusing on sukuk ijarah, and (5) conclusion.

2.0 Overview of development global sukuk market

Islamic finance – which means financial institutions and products designed to comply
with the central tenets of Shariah (or Islamic law) - has been a rapidly growing
phenomenon within the global finance industry since the 1970s. Many reputable
Islamic banks came into being during the 1970s, including Nasser Social Bank Cairo
(1972), Islamic Development Bank (IDB) (1975), Dubai Islamic Bank (1975), Kuwait
Finance House (KFH) (1977), Faisal Islamic Bank of Sudan (1977) and Dar Al-Maal
Al-Islami (1980). Continuing demand throughout the 1990s the market for Islamic
financial products had attracted the attention of several Western commercial banks,
which started to offer specialised financial services to high net worth individuals and
later at the retail level through ‘Islamic windows’. Western financial market players
that were attracted included Citibank, ABN AMRO, HSBC and others which
established their own Islamic windows or subsidiaries to attract petrodollar deposits
from the Middle East and Muslim clientele in local markets (Khan & Bhatti 2008,
pp.709-710). Beginning with only as much as US$6 billion in the early 1980s, the
size of Islamic financial and banking activities surpassed US$250 billion in 2006
(Iqbal & Tsubota 2006). Currently, around 300 financial institutions are working
according to the Islamic principles and they operate in over 75 countries (El-Quqa et
al. 2009).

Though initially concentrated in the Middle East (especially Bahrain) and South-East
Asia (particularly Malaysia), Islamic finance principles are now increasingly found
elsewhere. This includes developing economies where the financial sector is almost
entirely Islamic (such as Iran and Sudan) or where Islamic and ‘conventional’
financial systems coexist (including Indonesia, Malaysia, Pakistan and the United
Arab Emirates) (El Qorchi 2005). Currently, Islamic finance is also appearing in the
United States, with significant activity taking place in the United Kingdom and more
recently in Europe, Africa and Indonesia (IFSL 2009). Assets in other Western
countries are currently small but a number of countries, particularly France, are
looking to develop a presence in Islamic finance (IFSL 2010).

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The Islamic finance industry has grown massively in response to a profusion of

investment products, which in turn have been fuelled by an increasing demand for
investments that comply with Islamic law. Of all the rapidly growing Islamic capital
market securities none are gaining in popularity as much as sukuk. Since its debut in
the 1970s, the world has witnessed a strong growth in global sukuk issuance. Since
2000, it had not shown any sign of slowing down until the recent global financial
crisis (Figure 1). The Islamic finance industry and in particular the global sukuk
market experienced a problem in 2008, when global sukuk issuance declined by
more than 50% compared to 2007. This marked an astonishing reversal in the strong
growth trend that had been witnessed in recent years.

Globally, credit market underwent a significance decline in debt issuance, mainly

driven by credit crisis that forces investors to step aside from the money market,
hence exhausting resources for sukuk as well (El-Quqa et al. 2009). Due to this
credit crunch, the Gulf Cooperation Council1 (GCC) and Malaysia have been the
hardest hit, experiencing declines in sukuk issuance of 55% and 59% respectively.
The GCC sukuk market has been largely driven by the booming real estate sector
and a collapse in property prices would naturally prompt negative rating actions
(Hijazi et al. 2009).

1
GCC states include: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates

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Figure 1: Total Global Sukuk Issuance (Domestic and International) Sovereign,

Quasi Sovereign & Corporate issues (All Currencies)

Source: IIFM Sukuk Report, International Islamic Financial Market, (IIFM at

http://www.iifm.net/)

Despite decline in sukuk issuance, the prospects for the sukuk market are positive
because strong demand still exists. In 2009 the sukuk market was on the road to
recovery, in that cumulative sukuk issuance topped the symbolic bar of $100 billion.
Again in 2009 in the major trend in Islamic finance was for Asian countries to cement
their lead in sukuk issuance. Asia ended 2009 as the major regional engine of
growth for the sukuk market, accounting for 63.9% of issuance; Malaysia alone was
the source of 54.1% of issues (Damak, Esters & Maheshwari 2010).

There is strong growth of global sukuk issuance trend witnessed in recent years as it
has been enjoying tremendous growth since its debut in 1970s continuing its
explosive growth in 2007. However, the Sukuk market did not do well after the
unraveling of the subprime crisis. It faced unprecedented challenges; witnessed
global Sukuk issuance had declined by more than 50% by then end of 2008. It
demonstrates that the growth in sukuk had not been insulated from the global
financial crisis, albeit has not been as great as for its conventional counterpart.
Despite having suffered a contraction amid the credit crisis, the sukuk market now
faces a new challenge. There has recently been a series of high profile sukuk
defaults, and these have implications for sukuk holders’ protection.

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3. Shariah issues and decline in sukuk issuance

The year 2008 was a difficult one for the Islamic capital market. Having suffered a
contraction amid the credit crisis, the debates over Shariah compliance with regard
to the sukuk structure did lead to negative repercussions. In addition, a series of high
profile sukuk defaults resulted unprecedented challenges for the sukuk market.

The Sukuk market did not do well the year after the unravelling of the subprime crisis.
Total Sukuk issuance plunged 66% year on year in 2008 (RAM 2009), exhibiting no
immunity from the global counterpart. Sukuk issuance began slowing down in late
2008, partly due to the global economic downturn, the international Sukuk market
faced lower levels of liquidity, resulting from declines in oil prices and reduced
investor confidence (Ilias 2009). Since the sukuk market seemingly flourished to
some extent despite the subprime crisis, many had thought that Islamic finance
would be able to ride out the meltdown due to its particular features. This, however,
was not the case; it had simply led to some unreasonable expectations for the
Islamic financial services industry. Nonetheless, the sukuk market was more or less
insulated because it did get into the synthetic products. It is important for investors
to understand that, like other financial tools, these instruments are also exposed to
hazards such as credit risk.

Indeed, the reasons for the decline in sukuk are many, not least of which were
declining oil prices and depressed economic conditions. At the same time, Shariah
issues concerning sukuk musharakah and sukuk mudharabah after the AAOIFI’s2
statement on the structures’ compliance led to negative repercussions. For example
in 2007, the respected Pakistani scholar Usmani delivered a bombshell, suggesting
that the most popular type of sukuk structures, responsible for up to 85% of issues,
were unlawful according to Shariah (Reuters 2007). The ruling from the AAOIFI that
questioned the issue of Shariah compliance regarding some sukuk structures also
acted as a break on issuance in 2008.

Over the past year, sukuk ijarah has become the dominant sukuk structure in terms
of issuance volume (Figure 2), followed by sukuk musharakah and sukuk
mudharabah; these latter two have become accepted structures. Ijarah forms the
most common and simplest form of Shariah complaint regarding sukuk. The first few
sukuk issued on the international market were all based on this particular structure
because it lends itself easily to Shariah compatibility (Mokhtar & Thomas 2009). The
AAOIFI’s statement that 85% of the sukuk sold in the market might not be Shariah-
compliant created panic and confusion. The statement had been based on its
observation of the excessive use of purchase undertakings in partnership-based
sukuk, such as sukuk mudharabah and sukuk musharakah. A sukuk closely
resembles conventional fixed income securities by promising to repurchase the
underlying assets at the face value of the sukuk, in the event of default or upon
maturity - regardless of the true value of the said assets. In some cases the issuer
will even promise to top up the difference if the profit from the sukuk transaction falls

2
Accounting Auditing Organisation for Islamic Financial Institutions
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short of the expected level. These similarities are too close for comfort to Shariah
scholars (RAM 2010b).

Figure 2: Structural break down of total global sukuk issuance: Jan 2001- 31
December 2009

Murabaha
1% Wakala or
Islamic
Exchangeabl Hybrid Investment
e Bond 1% 1%
18%
Ijarah
44%

Mudharaba
h
13%

Musharakah
22%

Percentage of total value

Murabaha, 2 Wakala or
Investment,
Islamic Hybrid 1
Exchangeabl Sukuk, 3
e Bond, 9 Ijarah, 39

Mudharabah
,6

Musharakah,
18

Number of Issues

Source: IIFM Sukuk Report, International Islamic Financial Market, (IIFM at

http://www.iifm.net/)

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Early in 2008 the AAOIFI made a recommendation to Islamic finance market

participants to refrain from issuing sukuk structures that have a purchase undertaking
or guarantee from the sukuk issuer to repurchase at a future date at a specific price.
In the AAOIFI’s view, this structural mechanism does not comply with a fundamental
principle of Shariah, namely profit and risk sharing. However, although AAOIFI
standards are widely followed (without obligation) across many countries, they are
only implemented by Bahrain, the Dubai International Financial Centre (DIFC) in the
UAE, Jordan, Lebanon, Qatar, Sudan and Syria (Hijazi et al. 2009, p.1). Although
difficult to measure, most probably as a direct consequence of the debate on Shariah
compliance among scholars, this controversy over Shariah compliance has partly
contributed to the decline in sukuk issuance.

3.1 The issues regarding sukuk default

While the Islamic finance industry initially has been less affected by the financial
crisis and global economic downturn compared to conventional counterpart, there
are ongoing challenges, particularly for the sukuk market and for some Islamic
banks. The sukuk market declined in 2008, but despite the recovery in issuance to
$20 billion during 2009 (IFSL 2010), it is being tested by its ability to deal with recent
high profile sukuk defaults.

The East Cameroon sukuk was launched in July 2006 in the US to raise US$167.8
million. It was issued by East Cameroon Partners LP and is considered to be the first
sukuk to run into trouble (Elmalki & Ryan 2010b). Then, Investment Dar, which is a
Kuwaiti investment company that owns a 50% stake in luxury British car maker
Aston Martin Lagonda Ltd, missed a payment on a US$100 million sukuk in May
2009, becoming the first company from the Middle East to default on its Islamic
bonds. This was followed by Golden Belt 1, a special purpose vehicle builder owned
by Maan Al Sanea (Saudi’s Saad Group), defaulting on a US$650 million sukuk in
August 2009 (RAM 2009). Subsequently, the Nakheel’s almost-defaulted US$3.52
billion sukuk ijarah added salt to the wound. Thanks to Abu Dhabi’s last minute
rescue, the looming default had been avoided. Nakheel ultimately repaid its sukuk in
December 2009 after Abu Dhabi, the oil-rich neighbour, stepped in with a US$10
billion bailout which was more than enough to the US$4.1 billion due to the former’s
sukuk holders. The remaining US$5.9 billion of the bailout will help meet the
obligations to trade creditors and contractors of Dubai World (Hasan 2010).

In addition to the wider problems generated by global financial markets as a result of

the credit crisis, the reputation of sukuk as being potentially a safer investment
instrument than vanilla corporate bonds took a battering after investors were left
nursing potentially heavy losses following several high profile sukuk defaults. Some
have questioned Shariah supervision over these defaults. The fact is that sukuk’s
relative security has received increased scholarly attention due to certain core
principles that have contributed to insulating it from global financial disasters (Aziz &
Gintzburger 2009). While some have argued that there is no such thing as a default
in Islamic finance due to profit sharing and the risk avoidance nature of relevant
transactions, others blame Islamic structures and have begun questioning the
Shariah compliance of the issuances (RAM 2010a).
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In the case of East Cameroon’s sukuk, the company filed for bankruptcy protection
after its offshore Louisiana oil and gas wells failed to yield the expected return, partly
due to hurricane damage (Fidler 2009). The Nakheel example suggested that there
was no Shariah compliance, which caused great concern3. In the case of East
Cameroon’s sukuk, the company filed for bankruptcy protection after its offshore
Louisiana oil and gas wells failed to yield the expected return, partly due to hurricane
damage (Fidler 2009). It is a relatively straightforward problem of excessive leverage
and the failure of the underlying assets to generate sufficient cash flow to repay the
debts, but was somewhat complicated by its connection with a sovereign
government. The cause of Dubai World’s crisis was not Islamic finance, but over-
leveraging. The default is more a consequence of the economic difficulties in the
Middle East4, rather than flaws in sukuk and Islamic finance per se. For the most
part, the Nakheel sukuk emerged as a casualty of over-optimism in the Dubai
property market.

Obviously, the occurrence of all the high profile sukuk defaults had nothing to do with
the validity of sukuk methodology. Most, if not all, of the sukuk defaults were the
result of market and credit risks rather than a structural or Shariah-related concern.
In fact, all defaults and potential defaults have been driven by credit market and
credit risks (Remo-Listana 2010). These deals would have gone wrong even if they
were conventionally financed. These reminded all those involved in the market that
defaults can and do happen in Islamic finance. Billed as safer than traditional
financing facilities due to the requirement for physical assets to underpin deals,
sukuk holders now worry that they may not have legal safety nets in cases of default.

In general, the reasons for decline in sukuk are numerous, not least of which were
falling oil prices and depressed economic conditions. At the same time, Shariah
issues concerning sukuk musharakah and sukuk mudharabah following the AAOIFI’s
statement on the structures’ compliance also had negative repercussions. Another
reason for the downturn was defaults in sukuk issues. The market had experienced a
few defaults and this had raised a number of questions relating to the rights of sukuk
holders. Several issuers had been experiencing difficulties and initiated restructuring
strategies. There had also been the subject of the courts’ interpretation of sukuk
holders’ rights. The debate on asset-based versus asset-backed structure had also
surfaced, particularly over the comparative treatment of sukuk holders.

3
There had also been additional protection for the sukuk holders in the form of pledge vis-`a- vis 18.89% of
unlisted Nakheel stock and a mortgage over the underlying assets. From the structure itself, it is clear that the
sukuk complies with shariah requirement to have real underlying assets from which revenue can be generated
and shared with the sukuk holders. All in all, the Nakheel sukuk had been structured in accordance with the
shariah guidelines RAM 2010a, 'The Case of Wrongly Accused', in Sukuk Focus May 2010, RAM Rating Services
Berhad, Kuala Lumpur, pp. 9-10.
4
However, when the global financial crisis hit the Gulf countries, investors started losing confidence in the
market. Private investments in commercial and residential estates dried up, particularly in Dubai - leading to a
sharp plunge in property prices. Dubai property prices reportedly shrank 20% to 30% within 6 months; by the
end of 2009; prices had plummeted almost 60%. Most of the much-hyped developments in Dubai had been
either put on hold or shelved, including the Palm Jebel Ali and Dubai Waterfront developments. Ibid.
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4. The main principles of sukuk

Sukuk (singular of sak) has its origins in the Arabic term and it literally refers to
certificates (Wizarah al-Awqaf wa al-Shu'un al-Islamiyyah 1983). Specifically, sukuk is a
debt instrument that is arranged by the issuer to accumulate wealth from investors or
sukuk holders and supplied it to the deficit unit, which is the business entity. In
general, there are three main parties involved in most sukuk issuances, consisting of
the (i) business entity, (ii) Special Purpose Vehicle (SPV) or issuer, and (iii) the
sukuk holders.

Unlike equity that is based on shirkah al-inan and where sharing ownership of
company’s underlying assets is the goal, sukuk is largely accepted as a debt
instrument even though several sukuk have been structured using partnership-based
contracts, for example sukuk mudharabah and sukuk musharakah contracts. In
practice, the sukuk instruments are designated as Islamic bonds, and accordingly
there are different criteria of sukuk compared to conventional bonds.

Issuing of sukuk instruments must abide by Islamic teachings which emphasize

certain prohibitions (i.e, riba’, maysir, gharar and alcohol- and pork-related activities
investments). Additionally, justice must present in the early process of issuing
sukuk, in the redemption process and when sukuk has matured. From the Islamic
perspective, the tangibility and existence of an asset is very important since it can
principally protect the rights of involved parties in sukuk issuance and later
transactions. In this case, Islam prefers real assets compared to assets in the form of
cash, debt and receivables. As such, many have argued that the type of involved
assets in the sukuk structure and chosen contracts do affect the rights and
obligations of all involved parties, especially in the event of a default.

The establishment and fulfilment of issuers’ obligations to investors are closely linked
to several factors such as: (i) types of contracts used in the sukuk issuance, (ii) the
status of sukuk, either categorized as asset-based or asset-backed, (iii) and the
performance of the business entity receiving the funding from sukuk holders, through
the issuers or SPV. The profitability of sukuk issuance must be aligned with Shariah
compliance. For these reasons, there are principles that must be followed
concerning sukuk issuance, reflecting the abovementioned factors: (i) all rights and
obligations should be clearly defined; (ii) the income from sukuk should be related to
the project, which was financed by this issue; and (iii) sukuk should be backed by
real assets.

5. Implications for sukuk holders in case of default by focusing on sukuk ijarah

Unlike conventional bonds, sukuk issuances cannot be judged by their cover or

“contract” type. For instance, sukuk ijarah may be asset-based or asset-backed,
yielding a wholly different risk profile in the event of default and liquidation. Similarly,
within sukuk musharakah, differences can emerge between asset-based, project-
backed and asset-backed. Therefore, one cannot assess the risks associated with
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each issue by merely understanding the structure such as sukuk mudarabah, sukuk
musharakah or sukuk ijarah, since the legal structure behind the “type of issue” and
the actual risk characteristics of the issue can vary significantly, even within each
structure. Therefore, this study will focus solely on sukuk ijarah since it has become
the dominant form of sukuk structure in terms of issuance volume, pertaining
comparative treatment of sukuk holders in case of default.

5.1 Ijarah as a mode of financing and how it differs with Bai’ (sale)

In any given year, ijarah structures have represented between 25% and 70% of all
sukuk issued (IIFM 2009). The global sukuk market began in Malaysia with sukuk
ijarah, which was issued by Kumpulan Guthrie in 2001 (Jaafar 2007). Subsequently,
a second ijarah transaction in the form of the Malaysia Global Sukuk was launched
in 2002, allowing Malaysia to achieve a further significant milestone when the
government issued the first global sovereign sukuk. This resulted in the raising of
US$600 million. This issuance allowed it to become an international benchmark for
the issuance of global sukuk. The sukuk issue was listed on the Luxembourg Stock
Exchange, Labuan International Financial Stock Exchange and Bahrain Stock
Exchange (Laldin 2008). Over the years, the ijarah or leasing certificate concept has
become internationally accepted. Leasing easily fits into the model of fixed coupon
bonds and floating rates notes, and it has benefitted from a long history of leasing–
based securities going back to the 1800s (Thomas 1995). In fact, during the
collapse of the international credit markets in 2008, ijarah became particularly
important as they provided a blending of undivided ownership of the asset to
investors and made accurate credit analysis possible.

The basic idea of the ijarah contract concerns owner leasing out an asset or
equipment to a client, at an agreed rental fee and pre-determined lease period, as
per the ‘aqd’ (contract). The ownership of the leased equipment remains in hands of
the lessor. As illustrated by Usmani (2002, p.109), in Islamic jurisprudence the term
ijarah can be used in two different situations: (i) the transaction where the equipment
is hired by someone else; or (ii) ‘the usufructs of assets and properties and not to the
services of human beings, by means to transfer the usufruct of a particular property
to another person in exchange for a rent claimed from him’. The second type of
ijarah has gained acceptance as an alternative to the Islamic instrument, particularly
in Middle East countries. The second type of ijarah is also more relevant as it is
generally used as a form of investment as well as mode of financing.

Originally, leasing was not originally a mode of financing, it was simply a transaction
meant to transfer the usufruct of a property from one to another person for an agreed
period of time. Besides the general ijārah contract, Islamic banks have developed
another mode of financing that could be seen as a derivative of the ijārah contract.
This is known as ijārah wa iqtinā or ijārah muntahiya bi al-tamlīk (lease ending in
ownership or hire-purchase). ijārah wa iqtinā is an alternative to conventional lease
purchase contracts developed by Islamic banks. The mechanism of ijārah wa iqtinā
is more or less the same as that of ijārah explained above. The only difference is that
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the former includes the promise by the lessor to transfer ownership of the leased
asset to the lessee after the lease period is over. This promise is only binding on the
lessor, as the lessee has the option to buy the leased asset at the end of the lease
period. The lessee can also return the asset to the lessor. In any case, the promise
must be one-sided as promises from both sides would render this contract invalid
according to the principles of Shari’ah (Smolo 2009). The ijarah concept has been
further expanded in Malaysia using the principle of ijarah thumma albai or leasing,
followed by sale and purchase. Under this concept, upon the expiry of the leasing
period, the lessee enters into a second contract to purchase the goods from the
lessor at an agreed price (Ismail & Ayob 2002).

In general, the rules of ijarah, in the sense of leasing, correspond to the rules of sale
as both mean transferring something to another person for a valuable consideration.
The only difference between ijarah and a sale is that in the latter case the corpus of
the property is transferred to the purchaser, while in the case of ijarah, the corpus of
the property remains in the ownership of the transferor, but only its usufruct, i.e. the
right to use it is transferred to the lessee. Furthermore, the difference between sale
and lease contract is that the latter is always time-bound, meaning that the lease has
to terminate the contract at any point in time, while sale implies a definite transfer of
ownership of the sold asset just after the sale is executed, along with its risk and
reward (Ayub 2007, p.280).

The basic sukuk ijarah is a securities issuance where the underlying transaction
between the issuer and obligor involves a lease of tangible or intangible property.
There are four basic approaches to structuring leases (Mokhtar & Thomas 2009,
pp.145-146):
1. involving three parties with the acquisition of an asset by investors from a
supplier and its onward lease to the obligor
2. involving two parties with a sale leaseback of the underlying asset
3. involving asset securitization in which the originating party sells assets from
its balance sheet into the control of investors who enjoy the risk and reward of
the underliers without recourse to the originator; and
4. involving the lease of an asset to be delivered in the future.

In the securitisation process (Diagram 1), sukuk ijarah refers to an Islamic bond for
the buying and leasing of assets by investors to the issuer. Such sukuk shall
represent the undivided beneficial rights (or ownership or interest) in the asset held
by the trustee on behalf of the investors.

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Diagram 1: Ijarah-Based Securitization

Source: Obaidullah (2005, p. 170)

Nowadays, most recent sukuk structures are sukuk ijara where the originator
seeking financing transfers certain assets to a Special Purpose Vehicle (SPV)
(Elmalki & Ryan 2010a).

5.2 Asset-based and asset-backed sukuk: How do they differ?

Shariah principles must be applied when structuring Shariah-compliant financial

products, including sukuk. Similarly, Shariah principles, must also be applied when
sukuk default and liquidation situations arise. In relation to the risks associated with
each issue, it is important for investors to understand the structure as well as risk
characteristics of the issue as it can vary significantly. For instance, an sukuk ijarah
may be asset-based or asset-backed, yielding a wholly different risk profile to each in
the event of a default and/or liquidation. This is owing to the terms asset-based and
asset-backed themselves. Although they are very similar, they do have significant
differences in terms of ownership, asset recourse to the investor and rating
perspective. These differences are summarized in Table 1 below.

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Table 1: The main differences between asset-based sukuk and asset back sukuk
Asset-based sukuk Asset-backed sukuk
Ownership Only provides artificial An asset-backed sukuk implies
ownership rights to the that ownership rights extend to the
“usufruct” of certain physical actual underlying assets such as
underlying assets, instead of physical real estate or
relying on the obligor’s credit rights/usufruct from particular
quality to ensure that the intangible but valuable assets.
Sukuk performs.
Asset The recourse of the investor Recourse of the investors is to the
recourse to is to the creditworthiness of asset-issuing vehicle and the
the investor the ultimate obligor sukuk investors bear any losses in
case of impairment of the sukuk
Rating Corporate rating methodology Asset-backed rating methodology
is used for asset-based will be used for the asset-backed
transaction of sukuk sukuk transaction, which involves
whenever a corporate obligor securitisation. Here, credit risk is
is the key driver affecting determined solely by the
credit risk of sukuk. performance of underlying assets.
Adapted from : Farook (2010b), and Noor (2009)

In an asset-based sukuk, the originator typically transfers only the beneficial

ownership or equitable interest in the assets to the SPV issuer; therefore it is not a
true sale. It is for this reason that these are merely credit-backed securities with no
real recourse to physical assets. From the Shariah perspective, it is essential that a
sukuk is backed by a specific, tangible asset throughout its entire tenure and sukuk
holders must have a proprietary interest in the assets which are being financed
(Yean 2009). Therefore, to be consistent with Shariah principles there must be a
transfer of assets. However, since investors have no recourse to these assets, the
transaction does not focus on asset risk, but rather on the credit worthiness of the
sponsors of the sukuk. If the originator fails to pay any amount payable pursuant to
the transaction documents, the certificate holders normally have no recourse against
the originator or the issuer/trustee. These types of sukuk do not grant the certificate
holders the right to cause the sale or other disposition of any of the trust assets on
default (Ryan & Elmalki 2010).

From the credit rating agency perspective, the rating of this asset-based sukuk relies
primarily on the quality of the obligor or lessee’s credit risk, irrespective of firstly the
actual or potential usufruct of the leased asset, or secondly the timely payment of
rent to the sukuk investors. As reflected in the coupon payments, this would depend
on the credit standing of the obligor or lessee. One of the rationales behind asset-
backed sukuk is the likelihood of obtaining higher ratings; as such sukuk are linked
to the credit of the originator who raises the funds, not to physical assets (Khnifer,
Mohammed 2010).

In contrast to asset-based sukuk, an asset-backed sukuk implies that the ownership

rights extend to the actual underlying assets such as physical real estate or rights or
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usufruct from particular intangible but valuable assets. Asset-backed securities

represent the real form of securitization as they expose the sukuk investors to real
value and risk of the underlying asset. This is usually evidenced by an independent
legal opinion stating that the rights to the underlying assets have been perfected
through a “true sale” transfer to the issuing SPV and thereafter, the originator has
limited or no access to such assets as part of its assets pool (Farook 2010a). On
default by the borrower, sukuk holders are able to exercise certain rights of
ownership and control over such assets. The elements of true sale, fundamental to a
securitization, must be present in an asset-backed sukuk. An asset-backed Sukuk is
similar to a securitization in that it is a non-recourse obligation; credit risk
performance is determined solely by the underlying asset (Ryan & Elmalki 2010).
From a credit rating agency’s perspective, as the asset-backed sukuk are
characteristically non-recourse sukuk, with the underlying assets forming the lone
source profit and capital payment, the credit risk of this type of sukuk is determined
by the performance and credit quality of the underlying asset. Specifically, this asset
is cash flow and in some situations, has an expected value at maturity given that
various stressful scenarios (Noor 2009).

5.3 A closer look at the reality of sukuk ijarah: The case of Tamweel PJSC
asset-based vs. asset-backed

The terms asset-based and asset-backed are very similar in meaning; however,
sukuk investors in these two sets of sukuk are taking very different risks as be seen
the case concerning Tamweel PJSC, the UAE-based Islamic home finance provider.

In the Tamweel asset-backed sukuk, freehold titles numbering approximately 1,000

properties are transferred to sukuk investors along with associated ijarah cash flows;
these are the sukuk assets. The underlying assets that back this lease-to-buy Ijarah
are single family homes (villas). They constituted Shariah-compliant residential
mortgage-backed securitization (RMBS) transactions worth $210 million and had
four Sukuk Ijarah tranches. The property or land titles are registered in the name of
the investors at the relevant land department. Any losses on those cash flows (that
ultimately arise from the sale of distressed property) are passed on to sukuk holders,
who are exposed to the asset risk. Even upon the insolvency of Tamweel, the assets
will continue to pay the sukuk investors. The Sukuk should survive. The asset-
backed bankruptcy remote nature of this Sukuk means the senior notes obtain an
Aa2 rating – the maximum possible in the UAE (Howladar 2009).

The second issuance of Tamweel is an asset-based one where the investors’ legal
rights for ownership of the underlying assets are limited. Tamweel Sukuk Limited
(“TSL”) is an SPV incorporated in the Cayman Islands and was created for the
purpose of issuing Sukuk Trust Certificates to investors. The proceeds would be
used to acquire a pool of Shariah-compliant assets from the mortgage finance
company Tamweel. TSL, as trustee, will acquire the assets in the trust. After
examining the TSL prospectus, there was no clear indication that the $299.6 million
sukuk issue was an asset-based one. When it came to transferring the portfolio of
assets, the originator provided no assurance that any rights, titles, and interest in
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and to the portfolio assets had been or would be transferred to the trustee (Khnifer
Mohamed 2010). The rating of this sukuk is A3 which is four notches below the
secured one due to its asset-based nature. This sukuk would not survive the
bankruptcy of Tamweel (Howladar 2009). Unlike asset-backed sukuk, these
certificate holders have no recourse against any other assets of the issuer or trustee,
or have any right to cause the sale or other dispersal of any of the trust assets,
except during the initial purchase undertaking (Yean 2009 ). In this regard, the rights
of sukuk holders in the event of default will vary, depending on whether the sukuk
structure is an asset-based or an asset-backed one.

6. Conclusion

The defaults facing various sukuk instruments in the current market are therefore not
entirely disastrous events. Considering the recent financial crisis that has had a
strong impact on the global financial sector including Islamic finance industry, the
sukuk defaults that have occurred have only been a drop in the ocean compared to
their conventional counterparts. In fact, a sukuk default can be regarded as akin to
‘one bad apple will not spoil the entire barrel’. Despite the decline in sukuk issuance,
the prospects for the sukuk market are still positive because the demands for it in
2009 put the sukuk market well on the road to recovery.The most important thing is
that, like other financial tools, these instruments are also exposed to hazards such
as credit risk. Additionally, each default represents another incremental opportunity
to learn more about the relevant sukuk and its underlying structure. One can assess
the risks associated with each issue better by understanding not only sukuk ijarah,
but also other structures such as sukuk mudarabah and sukuk musharakah. The
rights of sukuk holders in the event of a default will vary, depending on whether the
sukuk structure is an asset-based or an asset-backed one.

It should be evident that a default on an asset-based sukuk is the same to investors

as a default on unsecured bonds. No recourse can be expected against any of the
assets used in the sukuk. On the other hand, asset-backed sukuk may become more
widely used as they would have the ability to take possession of the asset(s) backing
the sukuk. However, this argument should not be construed as an attempt to
discredit the use of asset-based sukuk. Similar to conventional unsecured bonds,
they are a useful way for companies to raise finance. Asset-based sukuk may be
more suitable where legal title to assets cannot be transferred to investors. The
asset-based sukuk is more appropriate when there are restrictions on foreign
ownership of certain asset classes such as real property. In addition, asset-backed
sukuk may not be adequate in circumstances where the enforceability of assets may
provide a challenge, such as sovereign–related or sovereign-owned assets.

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