The issue of shariah compliance and the Nakheel sukuk

Izabella Kaminska

The issue of shariah compliance and the Nakheel sukuk
Posted by Izabella Kaminska on Nov 30 10:33.
When is a sukuk not a sukuk?

When it fails to be shariah compliant, of course.

And the key issues, it seems, that may or may not make a sukuk shariah-compliant relate to principal protection and the bondholder’s unsecured status.

After all, if there’s one tenet that applies to sukuk bonds more than any other it’s the concept of “no risk, no reward”. The idea of principal protection in that case goes completely against the ethos of Islamic finance.

In the years leading up to the financial crisis, however, sukuk structures became increasingly dependent on mirroring traditional structures in a bid to attract western investors. Clauses, trusts and guarantees were all built in to make them more conventional — especially when it came to protecting the par value of bondholders’ investments and making the certificates unsecured in nature.

Fast forward to 2008, and the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) — the body which maintains and promotes shariah standards for Islamic financial institutions — began to take issue with these quasi-Islamic quasi-Western looking structures.

As the Middle East North Africa Financial Network (MENAFN) reported in April 2008:

The global Islamic capital market, of which the Sukuk sector is the most important, is still reverberating from the recommendations of the Shariah Committee of the Bahrain-based Accounting and Auditing Organization for Islamic Institutions (AAOIFI) relating to current Sukuk structures and their issuance. One scholar reportedly said that 80 percent of current Sukuk structures are not Islamic, a statement which has unfortunately made the headlines the world over.

The developments stem from a meeting of the Shariah Committee of AAOIFI held in Bahrain in February 2008 which issued new recommendations regarding Sukuk structures and issuance especially relating to the ownership of underlying assets in a sukuk transaction and the guarantee of the principle investment to Sukuk certificate holders. The immediate reaction of some bankers has been that the recommendations may put a dampener on the issuance of future sukuk because of these extra ‘constraints’ and thus affect their future tradability.

In April 2009, meanwhile, — a global provider of sukuk information – reported:
April 2009 Up to US$15 billion (Dh55.09bn) of sukuk, or Islamic bonds, have been shelved since the onset of the financial crisis because the specialised debt instruments became indistinguishablee from conventional bonds, an Islamic banking expert says. New issuance of sukuk had completely dried up because Islamic banks were structuring them incorrectly from the start, said Sohail Zubairi, the chief executive of the Dubai Islamic Bank  unit Dar al-Sharia, which advises on how to structure Islamic financial products. “We lost at least $10bn to $15bn since the onset of the crisis - I’m talking about the second half of 2008,” Mr Zubairi told Reuters.

Which shows that even a year ago there was already a question mark over the valuation of such pseudo-sukuk products. In fact, Moody’s flagged up the risk in January 2009, attributing the decline in sukuk issuance since the Lehman crisis to this very issue of uncertatinty over compliance. As the ratings agency stated at the time:
“Early in 2008, the Accounting Auditing Organisation for Islamic Financial Institutions (AAOIFI) recommended that Islamic finance market participants should refrain from issuing Sukuk structures that have a purchase undertaking or a guarantee from the Sukuk issuer to repurchase at a specific price at a future date.

This is because AAOIFI believed that this structural mechanism is not compliant with a fundamental principle of Shari’ah, namely profit and risk-sharing,” Mr. Hijazi explains. At the same time, Sukuk issued through securitisation became a mainstream financial vehicle. One of the key fundamental objectives of Shari’ah is asset ownership and the sharing of profit and losses, which are features of many asset-backed Sukuk structures, including Mudarabah, Musharaka and Investment partnership. AAOIFI standards are widely followed (without obligation) across many countries, but are only adopted by Bahrain, Dubai International Financial Centre in the UAE, Jordan, Lebanon, Qatar, Sudan and Syria.

It’s probably worth noting therefore that Dubai World’s Nakheel sukuk — being both unsecured and principal protected — would perhaps in the eyes of the AAOIFI fall under the non-compliant umbrella. (You can read the full terms and conditions underpinning the certificates in the prospectus, which can be found here.)

Indeed, as Maverecon blogger Willem Buiter, an advocate of a ‘true’ Islamic-finance solution to the global crisis, noted back in July:
What we need is the application of Islamic finance principles, in particular a strong preference for profit-, loss- and risk-sharing arrangements and a rejection of ‘riba’ or interest-bearing debt instruments.  I am not talking here about the sham sharia-compliant instruments that  flooded the market in the decade before the crisis; these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts, but met the letter if not the spirit of sharia law, in the view of some tame, pliable and quite possibly corrupt sharia scholar.  I am talking about financial innovations that replace debt-type instruments with true profit-, loss- and risk-sharing arrangements.

Which, of course, echoes the quest we’ve seen from the European Union to impose some burden sharing on bondholders in the crisis too.

In that case, can it be that Dubai — perhaps under pressure from Abu Dhabi — is keen on a little burden-sharing of its own? This is especially so if one assumes legal proceedings held in the UAE would likely side with the views of the AAOIFI, potentially rendering  Nakheel’s certificates unlawful and unenforceable.

What’s more, Nakheel’s own prospectus says that it’s only because the issuer waives his immunity from UAE law that the bond guarantees par value at all.

Yet as the prospectus also warns:
The Declaration of Trust is governed by English law and is subject to the non-exclusive jurisdiction of the English courts. The laws of the Emirate of Dubai and (to the extent applicable in the Emirate of Dubai) the federation of the UAE (UAE law) do not recognise the concept of trust or beneficial interests and, accordingly, there is no certainty that the terms of the Declaration of Trust would be enforced by the courts of Dubai. The concept of agency is, however, recognised under UAE law.

Which leaves us to wonder whether this whole Dubai World standstill is actually the beginning of a much wider pseudo-sukuk related case?

The Nakheel sukuk, after all, is just the the tip of the iceberg when it comes “out of the money” sukuks currently in the market place.