Question # 99: How is sukuk different than bonds? Investing in sukuks of Islamic banks allowed?
bismi-llahi r-raḥmani r-raḥīm,
Assalamu ‘laikum warahmatullahi wabarakatuh,
All praise and thanks are due to Allah (سبحانه و تعالى), and peace and blessings be upon His Messenger (صلى الله عليه و سلم).
Dear questioner,
First of all, we implore Allah (سبحانه و تعالى) to help us serve His cause and render our work for His sake.
Shorter Answer: Sukuks (“Islamic Bonds”) are Shari`ah based substitutes for conventional securities or bonds. They represents either a proportional or an undivided interest in an asset or pool of assets with the right to a proportionate share of cash flow or other benefits (interest-free payments or rentals) and risks of ownership until the maturity date or sale of Sukuks.
AAOIFI Shari`ah Chairman, Sheikh Muhammad Taqi Usmani statement in February 2008 that 85% of Gulf sukuk do not comply with Islamic Law (shari’ah) stormed the market. He stated that issuers of Sukuk have expended a great deal of effort to make them competitive with the conventional bonds prevalent in today’s capital markets and therefore, Sukuk now carries the same characteristics of bonds. His main points of criticism were:
- The assets in many Sukuks are shares of companies that do not confer true ownership (i.e., ownership in real assets) but merely offers Sukuk holders a right to returns;
- Most Sukuk are identical to conventional bonds with regard to the distribution of profits from their enterprises at fixed percentages based on interest rates. The Sukuk clause in the contract states that if the actual profits from the enterprise exceed the percentage based on interest rates, then that amount of excess shall be paid in its entirety to the enterprise manager as an incentive for good management. Hence, if one of the two parties stipulates for itself a specific amount (of profit), the mudarabah is void. Also, incentive, if any should be linked to what exceeds the minimum amount of expected profits from the enterprise (for which the Sukuk were issued) and not to the cost of financing (interest rates). This is no incentive but rather a method for marketing Sukuk on basis of riba.
- The manager’s also commits, that if the actual profits are less than the prescribed percentage based on interest rates, to take upon himself to pay out the difference to Sukuk holders, as an interest free loan to the Sukuk This is recoverable either from the amounts in excess of the interest rate during subsequent periods, or from lowering the cost of repurchasing assets at the time the Sukuk are redeemed. Such transactions come under the heading of a sale with a credit, which was prohibited by Prophet (صلى الله عليه و سلم).
- As reward always follows after risk, the return of investors’ capital cannot be guaranteed in Shari`ah compliant dealings. However, in all of today’s Sukuk, there is a binding promise by the manager that he will purchase the assets represented by the Sukuk at their face value upon maturity, regardless of their true value or market value on that day. Such a commitment is unlawful, irrespective of the manager’s role as an investment manager, mudarib, or as a partner, sharik, or as an investment agent, wakil.
Lastly, he stated that it is now incumbent upon these Islamic banks and financial institutions to work towards the development of authentic products that are free from riba, and that aim to serve the higher purposes of Islamic law. None of this will come about without the guidance and encouragement of Shari`ah supervisory boards, while upholding the Shari`ah Standards issued by the Shari`ah Council.
According to Ghada Essam, post 2008, Sukuk still have had the same violations and the same credit enhancers that AAOIFI and all prominent scholars prohibited, such as having the exercise price at face value, the Sukuk managers making up shortfalls and seizing surplus profits, fixed periodic distributions and associated bilateral binding contracts. Sukuk contracts’ clauses directly violate Shari`ah rules because most scholars review and approve the structure while solicitors are consigned to writing up the contracts. Hence, there is need for scholars to not only approve the structure, but also monitor implementation.
Long Answer:
DEFINITION OF SUKUK
The prohibition of interest in Shari`ah debars the use of pure debt security. Therefore, conventional bonds and other derivative instruments that rely on profiting holders by providing returns based on interest are unavailable to Muslims. However, creation of an obligation linked to the performance of a real asset is acceptable in Shari`ah. Under such circumstances, the creation of Islamic financial securities can be done using the process of asset securitization (taskeek), whereby existing assets of the company are identified, pooled, and then securities are issued against them. (‘Islamic Finance: A Guide for International Business and Investment’ by Habiba Anwar) This is when Sukuk comes into play.
Sukuks (or popularly known as an Islamic or Shari`ah compliant “bond”) are Shari`ah based substitutes for conventional securities or bonds. They are derived from trading in or production of real and tangible assets or their usufruct and services. The buyer or holder of Sukuks acquires exclusive ownership over the underlying assets, and receives interest-free payments or rentals until the maturity date or sale of Sukuks. (‘Developments in Islamic Banking’ by M. Mansoor Khan and M. Ishaq Bhatti)
DIFFERENCE BETWEEN SUKUK AND CONVENTIONAL BONDS
| Point of Distinction | Sukuk | Conventional Bonds |
| Nature | Sukuk represents ownership on the part of the certificate holders in the commercial or industrial enterprises for which they were issued. It represents undivided ownership in specific assets, projects or services.
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The bond holder enters into a debtor-lender relationship with the bond issuer. In its simplest form, a bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bondholders, on certain specified dates, interest and principal. |
| Basis of Return | Sukuk holders have proportionate beneficial ownership for a defined period in the underlying asset. Hence sukuk holders are entitled to share in the revenues generated (or bear losses incurred) by the sukuk assets as well as being entitled to share in the proceeds of the realization of those assets. | Regular interest payments made to the bond holders is determined as a (fixed/ floating) percentage of the capital. Hence, profits earned by the enterprise accrue entirely and exclusively to the issuer. |
| Principal | There is no guarantee by the issuer to the return of principal. | The redemption of principal is guaranteed at the time of maturity irrespective of whether the enterprise was profitable or not. |
| Security | Sukuks are secured by ownership rights in the underlying assets or projects in addition to any collateral security.
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Most bonds have no specific security attached to them and are referred to as “unsecured debentures”. Hence, in a default situation, the bondholders rank equally with the other unsecured creditors of the company. |
| Asset Backing | Securities should be backed by real underlying assets. A minimum of 51% tangible assets is contemplated in most cases. | Generally this is not required is case of bonds. |
| Purpose | Sukuks can be issued only for Shari’ah-compliant transactions/ activities/ projects. | There is no such ethical or religious requirement for issuance of bonds. |
CONSTRUCTIVE CRITICISM
AAOIFI[1] Shari`ah Chairman, Sheikh Muhammad Taqi Usmani in February 2008 stated that 85% of Gulf sukuk do not comply with Islamic Law (shari’ah). His Paper on ‘Sukuk and their Contemporary Applications’ states: “…The basic concept behind issuing Islamic Sukuk… is for the holders of the Sukuk to share in the profits of large enterprises or in their revenues. If Sukuk are issued on this basis they will play a major role in the development of the Islamic banking business and thereby contribute significantly to the achievement of the noble objectives sought by the Shari`ah… [However,] the issuers of …Sukuk have expended a great deal of effort to make them competitive with the conventional bonds prevalent in today’s capital markets. By endowing these Sukuk with the same characteristics of bonds, they have attempted to facilitate their acceptance in both Islamic and conventional markets. [The mechanisms developed by the issuers of Islamic Sukuk of today to distinguish Sukuk from conventional bonds can be studied] …in the light of the following three points:
- Bond Holders’ Ownership of Enterprise Assets
Generally, Sukuk represent ownership shares in assets that bring profits or revenues… – this is the one characteristic that distinguishes Sukuk from conventional bonds. However, quite recently, the market has witnessed a number of Sukuk in which there is doubt regarding their representation of ownership. For example, the assets in the Sukuk may be shares of companies that do not confer true ownership but which merely offer Sukuk holders a right to returns. Such Sukuk are no more than the purchase of returns from shares; and this is not lawful from a Shari`ah perspective…
- Regular Distributions to Sukuk Holders
In reference to the second point, most of the Sukuk that have been issued are identical to conventional bonds with regard to the distribution of profits from their enterprises at fixed percentages based on interest rates (LIBOR). In order to justify this practice, the issuers include a paragraph in the contract which states that if the actual profits from the enterprise exceed the percentage based on interest rates, then that amount of excess shall be paid in its entirety to the enterprise manager (whether a mudarib, or a partner, or an investment agent) as an incentive for the manager to manage effectively. I have even seen in the structure of certain Sukuk that they do not state that such excess will become the right of the manager as an incentive but, instead, they state no more than that the holders of the Sukuk will be entitled to a fixed percentage based upon the rate of interest at the time of regular distributions (as if the excess as an incentive was established by estimation or by exigency). If the actual profits are less than the prescribed percentage based on interest rates, then the manager may take it upon himself to pay out the difference (between the actual profits and the prescribed percentage) to the Sukuk holders, as an interest free loan to the Sukuk holders. Then, that loan will be recovered by the lending manager either from the amounts in excess of the interest rate during subsequent periods, or from lowering the cost of repurchasing assets at the time the Sukuk are redeemed as will be explained in detail in the third point.
- Guaranteeing the Return of Principal
Virtually all of the Sukuk issued today guarantee the return of principal to the Sukuk holders at maturity, in exactly the same way as conventional bonds. This is accomplished by means of a binding promise from either the issuer or the manager to repurchase the assets represented by the Sukuk at the stated price at which these were originally purchased by the Sukuk holders at the beginning of the process, regardless of their true or market value at maturity.
Then, by these complex mechanisms, Sukuk are able to take on the same characteristics as conventional, interest-bearing bonds since they do not return to investors more than a fixed percentage of the principal, based on interest rates, while guaranteeing the return of investors’ principal at maturity.
From the Shari`ah perspective, there are three questions:
One: Stipulating an Incentive for the Manager
With regard to the stipulation of an incentive for the manager of the enterprise, its justification may be found in what certain jurists have mentioned in regard to the lawfulness of offering incentives in contracts of wakalah or in brokerage.
Al-Imam al-Bukhari mentioned the same on the authority of the two companions: Said Ibn `Abbas: “There is no impediment to one’s saying, ‘Sell this cloth and whatever is in excess of this or that will be yours.'” Said Ibn Sirin: “When someone says, ‘Sell it for this much and whatever profits are realized beyond that will be yours, or will be shared between us,’ then there is no problem with that.”
This opinion was adopted by the Hanbali School of jurisprudence. In Al-Kafi by Ibn Qudama it is written: If someone says, “Sell this for ten, and whatever you receive in excess will be yours,” then that excess will be lawful for the seller because Ibn `Abbas did not see any impediment to doing so. (Ibn Qudamah, Al-Kafi, vol. 2, p. 253)
This opinion is recorded by Ibn Abi Shaybah in his Al-Musannaf from Ibn `Abbas, Ibn Sirin, Shurayh, `Amir al-Sha`bi, al-Zuhri, and al-Hakam. `Abd al-Razzaq added Qatada and Ayyub to those who agreed. The arrangement, however, was considered makruh (undesirable) by Ibrahim al-Nakha`i and Hammad, as related by `Abd al-Razzaq, and by al-Hasan al-Basri and Tawus ibn Kaysan as related by Ibn Abi Shaybah. (Ibn Abi Shaybah, Al-Musannaf, vol. 6, pp. 107-108) This is the opinion of the majority, other than the Hanbali scholars.
Al-Hafidh Ibn Hajr commented on the opinion of Ibn `Abbas mentioned by al-Bukhari: This, too, refers to the wages of a broker. But, as these are unknown, the majority of jurists have not allowed the arrangement, saying if the broker sells the item for the owner on this basis, he will be entitled to no more than the fee customarily awarded for similar sales. Some jurists have interpreted the statement by Ibn `Abbas to mean that he saw the situation as analogous to that of a partnership. The same interpretation was given by Ahmad ibn Hanbal and Ishaq. Ibn al-Tin recorded that some jurists stipulated, for its acceptance as lawful, that people at the time understand the price of the goods to equal more than what was stated; but his opinion was challenged on the grounds that ignorance of the actual amount of the fee still remains. (Ibn Hajr, Fath al-Bari, vol. 4, p. 451)
Badr al-Din al-`Ayni wrote: As to the opinion of Ibn `Abbas and Ibn Sirin, well, the majority of scholars do not allow such a sale. Among those who disliked it are Sufyan al-Thawri and the jurists from Kufa. Likewise, al-Shafi`i and Malik did not allow it. If someone sells on this basis he will be entitled to a fee equal to what is customary for such a sale. Ahmad and Ishaq, however, have allowed the sale, saying, “This is actually a partnership, for at times a partner will not profit.” (Badr al-Din al-`Ayni, `Umdah al-Qari, vol. 12, p.133)
Of course, all of this is said in relation to the fees of a broker if other than the excess over the stated original price of the sale is not specified. However, if the broker’s fee is stated as a determined amount, and then the broker is told, ‘If you sell this for more than this, the excess will be yours in addition to your predetermined fee,’ then it should be clear that the majority will not oppose it. This is because the ignorance with regard to the fee is lifted when it is determined in advance. Then, if the broker sells the item for more than a certain amount, the excess will be his as an incentive for better management.
On this basis, the Standard for Mudarabah approved by the Shari`ah Council reads as follows: “If one of the two parties should stipulate for itself a specific amount (of profit), the mudarabah will be void. This prohibition, however, is not inclusive of an agreement by the two parties that if the profits exceed a certain percentage then one of those two parties will receive the excess exclusively such that the distribution will be according to what the two have agreed.” (AAOIFI Standard 13, para 8.5)
The operations manager in a Sukuk will manage on the basis either of its being a wage-earning employee (ajir) or an investment agent (wakil), thus resembling a broker, or on the basis of its being an investment manager (mudarib), or a working partner (sharik `amil). All of these possibilities are covered by the Standard. However, when the jurists gave permission for this arrangement, they did not consider that it would be used to carry out operations on the basis of interest rates or to maintain the status quo of the conventional, riba-based market. The right of the manager to an amount in excess of the prescribed percentage has been called an incentive for better management of the assets. Such an incentive, however, may only be understood as an incentive if it is linked to what exceeds the minimum amount of expected profits from the commercial or industrial enterprise for which the Sukuk were issued. For example: if the minimum amount of expected profits is 15%, then it may be said that the actual profits in excess of that percentage may be paid the manager as an incentive. This is because that excess amount may logically be ascribed to good management. The problem is that the prescribed percentage in these Sukuk is not linked to the expected profits from the enterprise, but to the costs of financing or to the prevalent rates of interest in the market; rates that vary every day, or every hour of the day. Obviously, there is no connection between these and the profitability of the commercial or industrial enterprise. Oftentimes, this rate will be considerably lower than the expected rate of return from the enterprise. Thus, for example, if the expected rate of return from the enterprise is 15%, the interest rate at the same time may be no more than 5%. If, owing to poor management, the actual return from the enterprise falls to 10%, then how may what is in excess of 5% given to the manager as a reward for “good management”? How can this be, even when poor management resulted in profits dipping from [an expected] 15% to only 10%? It should therefore be clear that what is being called an “incentive” in these Sukuk is not truly an incentive but rather a method for marketing these Sukuk on basis of interest rates. It should also be clear that this aspect is not free of legal repugnance (karahah), even if we do not declare it prohibited (haram) outright.
Two: Stipulating Loans when Profits Fall Below Prescribed Percentages
There is absolutely nothing in the Shari`ah to justify a loan when actual profits are less than the prescribed percentages. The one undertaking the loan is the operations manager, and the manager is the one that sells the assets to the Sukuk holders at the beginning of operations. If it is then stipulated that the manager will make loans to the Sukuk holders at times (for distribution) when actual returns fall below the (promised) rate of return, the transaction will come under the heading of a sale with a credit. It is well known that the Prophet (صلى الله عليه و سلم) prohibited sales linked to credits. The same was related by Malik in his al-Muwatta on the authority of trusted narrators (balaghan), and by Abu Dawud and al-Tirmidhi whose version reads, “A sale and a credit are not lawful.” Al-Tirmidhi added, “This is a good and a sound hadith.”…The entire community of scholars is agreed on this (prohibition) and no one is known to have held a dissenting opinion. Ibn Qudamah wrote: If someone sells on condition that the purchaser gives credit (to the seller), or advance him a loan, or if the buyer stipulates the same, that will be unlawful and the sale will be void. This is the opinion of Malik and al-Shafi`i, and I know of no dissenting opinion. (Ibn Qudamah, op. cit., vol. 4, p. 162)
With regard to the mechanism used in the Sukuk, the manager is not willing to offer the loan unless he receives more than his due share of the actual profits by means of the “incentive” which is stipulated for him when the percentage of actual profits exceeds the percentage based on the prevalent interest rate of interest. Therefore, such a loan, in view of the opinion voiced by Ibn Qudamah, is emphatically all the more unlawful.
At times, the manager who undertakes the loan may be a partner in the enterprise, or a mudarib. Such an undertaking [on his part], too, is in opposition to the requirements of the contract and falls under the same prohibition as that against a sale linked to a credit (or a loan) in exactly the same way. Thus, it is not lawful.
Three: The Manager’s Promise to Repurchase Assets at Face Value
The third issue is that in true commercial enterprises, where the Shari`ah is concerned, the return of investors’ capital cannot be guaranteed. In Shari`ah compliant dealings, reward always follows after risk. The legal presumption with regard to Sukuk is that there can be no guarantee that capital will be returned to investors. Instead, they have a right to the true value of the [Sukuk] assets, regardless of whether their value exceeds that of their face value or not. All of today’s Sukuk, however, guarantee by indirect means Sukuk holders’ principal. The manager pledges to the Sukuk holders that he will purchase Sukuk assets at face value upon maturity, regardless of their true value on that day. What this means is that the principal paid originally by the Sukuk holders will be returned to them at maturity. There is no other significance to such a commitment. If the enterprise is not profitable, the losses will be borne by the manager. If it is profitable, however, the profits will accrue to the manager, regardless of how great the amount. The Sukuk holders have no right to other than the return of their principal, as is the case in conventional bonds.
In considering the lawfulness of this commitment, we note that the manager of the Sukuk may act in his capacity as an investment manager, mudarib, for the Sukuk holders, or as a partner, sharik, or as an investment agent, wakil, for them. [However, commitment to investors for guaranteed capital in any of the above mentioned capacity is unlawful. Let analyze the three cases:]
First: Commitment by a Mudarib
The Standard on Mudarabah approved by the Shari`ah Council states: “If the loss at the time of closing operations is greater than the earnings, the losses will be deducted from the capital and the manager, in his capacity as a trust holder, amin, will not bear any of the loss as long as there is no negligence or mala fides on his part. If the costs are equal to the earnings, the investors will receive their capital back, and the mudarib will earn nothing. When profits are earned, these will be distributed among the two parties (investor and manager) in accordance with what the two have decided.” (AAOIFI Standard 13, 7.8)
Second: Commitment by a Sharik
The Standard… states: “It is lawful for one of the parties to the partnership to issue a binding promise to purchase the assets of the partnership during the period of partnership or at the time of dissolution at market value or at an agreed price at the time of purchase. A promise to purchase the assets at face value, however, is unlawful.” (AAOIFI Standard 12, paragraph 3.1.6.2)
In the Basis for Conclusions for the Standard it is stated: “The justification for the ruling of “unlawful” with regard to the binding promise by one of the partners to purchase the assets of the partnership at face value is that this is the same as a capital guarantee, which is unlawful. The justification for a ruling of “lawful” for repurchase at market value comes from the fact that there is nothing in this arrangement that guarantees anything to the partners.” (AAOIFI Standards, p. 230)
Certain contemporary scholars have attempted to justify a commitment that implies a capital guarantee by saying that while it may be prohibited in a partnership of contract, shirkah `aqd, it is not prohibited in a partnership of property, shirkah milk. They then claim that the sort of partnership that occurs in Sukuk (especially Sukuk with leased assets) is a partnership of property and not a partnership of contract. However, when we consider the reality of these two types of partnership, it is clear that the type of partnership that occurs in Sukuk is a partnership of contract and not a partnership of property. This is because the purpose of the partnership [in these Sukuk] is not merely to own physical assets for the purpose of consumption or personal benefit but for the purpose of joint investment. This is the fundamental difference between a partnership of property and a partnership of contract.
If we were to open this door, the managers of Islamic banks would then be able to guarantee the capital of depositors by committing to purchase shares in investment accounts at their face value; thus negating the single difference between conventional deposits and deposits in Islamic banks.
Third: A Commitment by an Investment Agent
Agency, wakalah, is a contract of trust, amanah; and there can be no guarantees except as regards negligence or mala fides. The aforementioned commitment is tantamount to a guarantee and is therefore unlawful. This point is mentioned in para 1/2/2 of the Standard for Guarantees, issued by the Shari`ah Council, as follows: “It is not lawful to stipulate a guarantee from a mudarib, or an investment agent, or a partner among partners, regardless of whether the guarantee is for the principal or for the profits. Likewise, an operation may not be marketed on the basis that investor capital is guaranteed. …It is unlawful to combine agency with a guarantee in a single transaction because to do so is contrary to the requirements of both. This is because to stipulate a guarantee by an investment agent transforms the operation into a loan with ribawi interest, guaranteeing [the return of] principal while offering returns from the investment.”
The Higher Purposes of Islamic Economics
The noble objective for which riba was prohibited is the equitable distribution among partners of revenues from commercial and industrial enterprises. The mechanisms used in Sukuk today, however, strike at the foundations of these objectives and render the Sukuk exactly the same as conventional bonds in terms of their economic results. Islamic banks were not established so that they could offer the same products, and engage in the same operations, as conventional banks in the prevalent interest-based banking system. Instead, the purpose was to gradually open up new horizons for business, commerce, and banking that would be guided by social justice in accordance with the principles established by the Shari`ah of Islam.
Undoubtedly, Shari`ah supervisory boards, academic councils, and legal seminars have given permission to Islamic banks to carry out certain operations that more closely resemble stratagems than actual transactions. Such permission, however, was granted in order to facilitate, under difficult circumstances, the figurative turning of the wheels for those institutions when they were few in number [and short of capital and human resources]. It was expected that Islamic banks would progress in time to genuine operations based on the objectives of an Islamic economic system and that they would distance themselves, even step by step, from what resembled interest-based enterprises. What is happening at the present time, however, is the opposite. Islamic financial institutions have now begun competing to present themselves with all of the same characteristics of the conventional, interest-based marketplace, and to offer new products that march backwards towards interest-based enterprises rather than away from these. Oftentimes these products are rushed to market using ploys that sound minds reject and bring laughter to enemies.
In order to promote Sukuk, the justification given is that international ratings agencies will not grant the desired, investor-grade ratings unless these mechanisms are used to guarantee the return of principal to investors, and to distribute profits from capital at specified rates. Without these mechanisms, so they say, it will not be possible to market Sukuk widely. The answer to this objection is that if we are to continue to run behind the international ratings agencies, agencies that do not distinguish between halal and haram, it will never be possible for us to move forward with authentic Islamic products which actually serve the purposes of Islamic economics. This is because these agencies have matured in an interest-based atmosphere that is unable to acknowledge the quality of an investment unless its capital is guaranteed and its returns are distributed on the basis of interest. At the same time, the quality of a product from a Shari`ah perspective depends upon the sharing of risk and the equitable distribution of profits between investors. Thus, the Islamic mentality is diametrically opposed to the mentality of those institutions.
It is now incumbent upon these Islamic banks and financial institutions to cooperate among themselves for the purpose of developing authentic products that are far removed from empty stratagems, free from all association with riba, and that aim to serve the higher purposes of Islamic law in the spheres of economics, development, and social justice. None of this will come about without the guidance and encouragement of Shari`ah supervisory boards, [while] upholding the Shari`ah Standards issued by the Shari`ah Council, standards which are not insensitive to the real needs of these institutions.
Summary and Recommendations
- Sukuk should be issued for new commercial and industrial ventures. If they are issued for established businesses, then the Sukuk must ensure that Sukuk holders have complete ownership in real assets.
- The returns of enterprises should be returned to Sukuk holders regardless of what amounts they reach after costs, including the manager’s fees, or the share of the mudarib in profits. If there is to be an incentive for a manager, then let it be based on the profits expected from the enterprise and not on the basis of an interest rate.
- It is unlawful for a manager to lend money when actual profits are less than expected.
- It is unlawful for a manager, whether a mudarib or a partner or an agent, to commit to repurchase of assets at face value. Instead, their resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase.
- Shari`ah supervisory boards must abide by the Shari`ah Standards issued by the Shari`ah”
(The above is the concise version of Sheikh Muhammad Taqi Usmani’s Paper on ‘Sukuk and their Contemporary Applications’)
CURRENT STATUS
Ghada Essam[2] discusses in ‘Islamic Finance news’ that “Sukuk essentially were designed to become the Shari`ah compliant alternative to conventional bonds, a funding tool that ideally should represent equity, ownership and profit sharing. Therefore, for those who framed Sukuk as a fixed income product, Sukuk were in no competition with conventional bonds, because of their higher risk and higher costs.
For this reason, market players have tried hard over years to find ways to shift the structure of Sukuk from an equity-based one to a debt-based one. Through different mechanisms, both explicit and implicit, Sukuk structures have been tailored to guarantee capital, to guarantee profit, to restrict ownership and to eliminate rights of disposal. Revenues and profits therefore became independent of the performance of the underlying asset. Through these ‘credit enhancers’ Sukuk have shifted to become a form of interest-paying syndicated lending.
The first alarm bells over these violations came with the famous statement by Sheikh Taqi Usmani in February 2008, when he announced that 85% of GCC Sukuk were not Shari`ah compliant. Indeed the statement, coming from such a prominent scholar, stormed the market and prompted AAOIFI to issue a further six rules to complement the basic Sukuk Shari`ah standards, and address the core common violations that were widespread at that time.
Many scholars and researchers believe that this announcement was influential and corrective enough that post February 2008, Sukuk structures were back on a Shari`ah track. But in fact we find this not true, as Sukuk (particularly equity-based) issued post 2008, still have the same violations, and the same credit enhancers that AAOIFI and all prominent scholars prohibited; such as having the exercise price at face value, the Sukuk managers making up shortfalls and seizing surplus profits, fixed periodic distributions and associated bilateral binding contracts.
The challenge is present because most scholars review and approve the structure while solicitors are consigned to writing up the contracts. This is one of the main reasons we find clauses that directly violate Shari`ah rules or are in contradiction to other clauses in the same contract. This could be, mostly, the reason why we find names of prominent scholars approving the Sukuk, while the structure has some core violations prohibited by the same group of scholars who have approved the Sukuk….
On the Shari`ah front, we need scholars to not only approve the structure, but monitor implementation. In fact this was one of the recommendations by Sheikh Usmani and AAOIFI in 2008, and still to date, no Sukuk has ever given in its periodic reports to either the board that originally approved it nor to Shari`ah auditors. This has to become an obligatory requirement, that all Sukuk should have periodic supervision of adherence to Shari`ah throughout the tenure of the Sukuk. And these governance reports should be, by obligation, publicly available and not restricted, as is the case today…” (‘Shari`ah screening of Sukuk: A challenge’, Features, Volume 10, Issue 11 dated 20 March 2013)
Allahu A’lam (Allah (سبحانه و تعالى) knows best) and all Perfections belong to Allah, and all mistakes belong to me alone. May Allah (سبحانه و تعالى) forgive me, Ameen.
Wassalaam
[1] Accounting and Auditing Organization for Islamic Financial Institutions (Bahrain-based Islamic international standard setting body established in 1991 for Islamic corporations and the industry. Members include central banks, Islamic financial institutions and other industry participants)
[2] Sukuk Product Manager at IdealRatings
