Sukuk.

1. Asset Backed v Asset
Based Sukuk
BY: CAMILLE PALDI
CEO OF FAAIF

2. There are some contentious issues related to the contemporary sukuk from Shari’ah perspective.
One issue relates to the sale of assets and its implications to risks and returns for investors and
issuers of sukuk.

3. An asset-backed sukuk will involve a true sale and transfer the assets from the originator to the
sukuk-holders.
The transfer of ownership in the legal sense will involve effective registration of the property in
the name of new owners and will be binding in any court process.

4. As a result of the sale, the asset would move from the balance-sheet of the obligor to the
investors (through the SPV).
In the case of bankruptcy of the obligor, the investors would have recourse to the asset and will
have priority claims over unsecured creditors.

5. Asset-based sukuk replicates a conventional unsecured bond, but uses an asset in the contract
to fulfill the formal Shari’ah requirements.
The requirement of transfer of ownership in the sale of the asset is allegedly fulfilled in its
beneficial or constructive ownership by the investors.
In reality, the sale of the underlying asset is not true either from accounting or legal
perspectives.

6. A key element in these types of sukuk is the use of a purchase undertaking whereby the
originator promises to purchase the asset back at par value either at maturity or in the case of
early termination (such as bankruptcy of the originator).
Through the sale brought about by the undertaking, the credit exposure of the investors is
transferred to the obligor and the investors will rank pari passu with other unsecured debtors in
terms of their claims.
As ratings are based on the substance, Moody’s considers the asset-based sukuk as a
conventional unsecured bond with no recourse to the asset and rates the instruments according
to the obligor’s credit worthiness.

7. The sukuk market is dominated overwhelmingly by the asset-based sukuk.
Only 11 out of 560 sukuk issues or around 2% qualify to be asset-backed as these fulfill the
Shari’ah requirements on an actual sale of the underlying asset to the investors.
Concerned about the incoherent practice in the market, the Shari’ah Board of AAOIFI issued a
statement in February 2008 to stress that sale of the assets to the sukuk holders must be true
with all associated rights and obligations of ownership and must be reflected in the accounting
books.

8. The dominance of asset-based sukuk is sometimes blamed on the inconsistency of Islamic
contracts with the prevailing non-Islamic legal framework and economic incentives of suppliers
and demanders of sukuk.
The fact that some asset-backed sukuk have been issued in Malaysia and the Gulf Cooperation
Council region and that these resemble the widely prevalent asset-based securities in
conventional markets indicate that the legal obstacles are not constraining factors.

9. Yet, the economic arguments of not using asset-backed sukuk are also weak.
On the supply side, the originators can get relatively higher ratings compared to their asset-
based counterparts, which can substantially reduce the cost of funds.
For instance, Moody’s rated the Tamweel’s asset-backed sukuk the maximum possible in the
UAE of Aa2.

10. An asset-based sukuk by the same company was four notches below A3 during 2009.
On the demand side, the asset-backed sukuk provides a safer bankruptcy remote investment
option to the investors.

11. Simply put, asset-backed sukuk are similar to asset-backed securities with the necessary
securitization element present.
The originator who wants to raise funds sells the income of the generating asset to a special
purpose vehicle (SPV) under a legal true sale.
As a result of the legal true sale, the investors (i.e. sukuk holders) enjoy bankruptcy remoteness
where the creditors of the originator cannot claw back the asset from the sukuk holders if the
originator is facing bankruptcy.

12. Therefore, the underlying assets are the sole recourse to the sukuk holders and the actual
performance of the underlying asset will determine the return to the sukuk holders.
If the underlying asset is performing while the originator is facing bankruptcy, the sukuk holders’
payment will be uninterrupted.

13. If the underlying asset is not performing, the sukuk holders are affected because they have no
recourse to the originator.
In asset-backed sukuk, investors have recourse to the asset and not the originator.

14. In asset-backed sukuk, investors enjoy asset-backing, they benefit over some form of security or
lien over the assets, and are therefore in a preferential position over other, unsecured creditors.
In other words, in the event the issuer were to default or become insolvent, the note holders
would be able to recover their exposure by taking control of and ultimately realizing the value
from the asset(s).
It also requires the element of securitization to be present – true sale, bankruptcy remoteness,
and enforceability of security.

15. In asset-based sukuk, the originator undertakes to repurchase assets from the issuer at maturity
of the sukuk, or upon a pre-defined early termination event, for an amount equal to the
principal repayment.
In such a repurchase undertaking, the true market value of the underlying asset (or asset
portfolio) is irrelevant to the sukuk note holders, as the amount is defined to be equivalent to
the notes.
In this case, note holders have no special rights over the assets and rely wholly on the
originator’s creditworthiness for repayment, either from internal sources or from its ability to
refinance.

16. Thus, if the originator is unable to honor its obligation to repurchase the assets, the note holders
are in no preferential position to any other creditors, or indeed in no weaker position to any
other unsecured creditor stressing the importance that the purchase undertaking ranks pari
passu with any other of the originator’s senior unsecured obligations.

17. In an asset-based sukuk, although an asset may be used in the structure, it does not necessarily
drive the return to the sukuk holders.
Through a number of credit enhancement features (purchase undertaking, liquidity facility, etc.)
the recourse of the sukuk holders is not to the asset but to the issuer.
If the asset is not performing, the issuer may still have to pay the expected return by exercising
the credit enhancements

18. If the issuer defaults, the sukuk holders will only have limited right of disposal because they will
be required to sell the asset (if any) to the issuer.
Asset-based sukuk attempts to emulate the behavior of bond issuance in conventional space.

19. THE END