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Overview of Sukuk Puzant Merdinian, SJ Berwin LLP April 2009

1 St East and Central Africa Conference on Islamic Banking. Overview of Sukuk Puzant Merdinian, SJ Berwin LLP April 2009. 1 St East and Central Africa Conference on Islamic Banking. Agenda. Brief history and meaning Modern application Categories of permissible sukuk

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Overview of Sukuk Puzant Merdinian, SJ Berwin LLP April 2009

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  1. 1St East and Central Africa Conference on Islamic Banking Overview of SukukPuzant Merdinian, SJ Berwin LLPApril 2009

  2. 1St East and Central Africa Conference on Islamic Banking Agenda • Brief history and meaning • Modern application • Categories of permissible sukuk • Use of sukuk by sovereign and corporate issuers • Evolution and growth of the sukuk market – selected transactions • Comparing sukuk with bonds • Prevalent Shariah-compliant structures utilised in sukuk • Key structural and legal considerations • Shariah compliance and market conditions • Future of sukuk • Q&A

  3. Brief History and Meaning 1St East and Central Africa Conference on Islamic Banking • Origins of sukuk - the concept of transferring financial obligations dates back to the ancient Middle East • references to sakk (sukuk in plural) in hadith and athar • Lisan Al Arab definition – “to strike” or “to hit” as in “to strike one’s seal on a document” • Medieval Times - the word “cheque” or “check” derived from sakk - the term sukuk extensively used in relation to the transfer of financial obligations - permissible v impermissible sukuk

  4. Modern Application 1St East and Central Africa Conference on Islamic Banking • Sukuk represent an undivided beneficial ownership of, and the return generated from, an underlying asset • The Accounting and Auditing Organisation for Islamic Finance Institutions (“AAOIFI”) Shariah standard 17 (Investment Sukuk) definition: • certificates of equal value put to use as common shares and rights in tangible assets, usufructs and services; or • equity in a project or investment activity • Sukuk must be carefully distinguished from equity notes and bonds

  5. 1St East and Central Africa Conference on Islamic Banking Categories of Permissible Sukuk • AAOIFI has specified 14 categories of permissible sukuk. In broad summary, they are securitisations: • of an existing or to be acquired tangible asset (ijara); • of an existing or to be acquired leasehold estate (ijara); • of presale of services (ijara); • to fund construction (istisna’a – construction contract); • of the presale of the production of goods or commodities at a future date (salam); • to fund the acquisition of goods for future sale (murabaha); • to fund capital participation in a business or investment activity (mudaraba or musharaka); • to fund various asset, goods or services acquisitions which are then entrusted to an agent (wakeel) to manage on behalf of the owners; and • to raise funds for agricultural land cultivation, land management and orchard management activities

  6. Use of Sukuk by Sovereign and Corporate Issuers 1St East and Central Africa Conference on Islamic Banking • Balance sheet management • Provides the ability to monetise a broad universe of existing Islamic financial activities • Attracts global investors – very beneficial for emerging markets • Provides a method to achieve long term financing while allowing for programme formats (EMTNs)

  7. Use of Sukuk by Sovereign and Corporate Issuers – Cont’d 1St East and Central Africa Conference on Islamic Banking • Provides an attractive capital market exit • Secondary market tradability • A tool to manage liquidity in a credit crunch • A method to attract ethical investors who are seeking to: - invest in socially responsible activities; or - make a constructive contribution to an emerging market

  8. Use of Sukuk by Sovereign and Corporate Issuers – Cont’d 1St East and Central Africa Conference on Islamic Banking • Additional considerations for a sovereign issuer are: • unlocking new sovereign markets • an alternative to raising taxes • funding project and infrastructure development • promoting jurisdictions as a regional/global financial centre (e.g. London, Hong Kong, Nairobi) • demonstrating its commitment to Islamic Finance

  9. Evolution and Growth of the Sukuk Market 1St East and Central Africa Conference on Islamic Banking • The market size of sukuk was estimated to be over US$ 110 billion as of January 2009 (International Islamic Financial Market) • There has been significant proliferation of sukuk over the last six years • Governments, quasi-governments and corporates have been active issuers

  10. 1St East and Central Africa Conference on Islamic Banking Selected Sovereign Transactions • Malaysian ijara sukuk, 2002 • Dubai Civic Aviation Authority – Musharaka sukuk, 2004 • German State of Saxony - €100 million ijara sukuk, 2004 • Qatar – US$700 million ijara sukuk, 2005 • Bahrain has executed several sukuk issuances (ijara and salam) since 2003 • Pakistan – US$600 million ijara sukuk to finance the Lahore to Islamabad motorway, 2005 • Dubai Metals and Commodities Centre – quasi government US$200 million musharaka sukuk • Indonesia – IDR 4.7 trillion debut rupee musharaka sukuk, 2008 • Sovereign initiatives are in existence throughout the globe

  11. 1St East and Central Africa Conference on Islamic Banking Selected Corporate Transactions • Bahrain Financial Harbour – US$270 million istisna’a/ijara project finance sukuk, 2005 • Nakheel – US$3.52 billion project finance ijara sukuk in 2006 • DP World – US$1.5 billion musharaka sukuk (convertible into shares) in 2007 • Gulf Finance House – US$1 billion sukuk EMTN in 2007 • Aldar Properties – Equity Linked US$2.53 mudaraba sukuk in 2007 (investment plan) • Tamweel – US$210 million ijara sukuk (one of the first true sale securitisations), testing a new property law in DIFC in July 2007 -

  12. 1St East and Central Africa Conference on Islamic Banking Comparing Sukuk with Bonds • Sukuk do not represent issuer debt, but represent an undivided ownership share in the specific assets/projects/services • Asset backed/Asset based • A minimum of 51% tangible assets • Claims • sukuk holders have ownership claims on the specific underlying assets/projects/services • Security • secured by ownership rights in the underlying assets or projects in addition to any other structured collateral enhancement mechanisms

  13. Comparing Sukuk with Bonds Cont’d 1St East and Central Africa Conference on Islamic Banking • Principal and return • not guaranteed by the issuer • Purpose • must only be issued for purposes permitted by Islam (halal) • Tradability • sale of ownership interest in a specific asset/project/service • Responsibility of holders • sukuk holders have responsibility for defined duties relating to the underlying assets/projects/transactions limited to the extent of participation of the issue • Use of proceeds • sukuk proceeds must be hypothecated and earmarked for a specific use. This is an essential tool to achieve proximity of assets to sukuk holders.

  14. Sale Undertaking Asset Sale Agreement sukuk issuance Transfer of sukuk property SUKUKHOLDERS ISSUER OWNER/ ORIGINATOR Cash sukuk proceeds Ijara Lease Agreement Purchase Undertaking Prevalent Structures utilised in Sukuk 1St East and Central Africa Conference on Islamic Banking Ijara sukuk

  15. SUKUK HOLDERS sukuk issuances sukuk proceeds MUSHARAKAPARTNER Purchase Undertaking ISSUER/TRUSTEE AS MUSHARAKA PARTNER MUSHARAKA Fund contribution Fund contribution Management Agent Profit Distribution Profit Distribution PURPOSE IS TOGENERATE PROFIT 1St East and Central Africa Conference on Islamic Banking Prevalent Structures utilised in Sukuk Cont’d Musharaka Sukuk – Pre AAOIFI Clarification in February 2008

  16. SUKUK HOLDERS sukuk issuances sukukproceeds SECURITYPACKAGE MUSHARAKAPARTNER ISSUER/TRUSTEEAS MUSHARAKA PARTNER MUSHARAKA ProfitAllocation ProfitAllocation CashContribution Fundcontribution (including credit enhancement) ProjectRevenue(Issuer acts as Cash Manager) PURPOSE IS TO GENERATE PROFITS 1St East and Central Africa Conference on Islamic Banking Prevalent Structures utilised in Sukuk Cont’d Musharaka Sukuk – Post AAOIFI Clarification (a possible structure)

  17. SUKUK HOLDERS sukuk issuance sukuk proceeds ISSUER (RABB-AL-MAAL) MUDARIB Capital Services MUDARABA AgencyAgreement Profit Distribution Profit Distribution INVESTMENT PLAN 1St East and Central Africa Conference on Islamic Banking Prevalent Structures utilised in Sukuk Cont’d - There has been limited use of this structure thus far, but it has a good future Mudaraba sukuk - Limited use of purchase undertaking

  18. 1St East and Central Africa Conference on Islamic Banking PrevalentStructures utilised in Sukuk Cont’d Murabahasukuk SUKUK HOLDERS Sukuk issuance Sukuk proceeds Metal Purchase Agreement Spot Market payment METALSELLER ISSUER Title to metal Title to Metal Deferred Payments Spot Market payment METALPURCHASER CUSTOMER Title to metal Metal Sale Agreement - Extensive use in the Far East, there are limitations on tradability elsewhere

  19. 1St East and Central Africa Conference on Islamic Banking Prevalent Structures utilised in Sukuk cont’d Istisna’a/Ijara sukuk - Construction Finance Funding SUKUKHOLDERS Sukuk issuance Sukuk proceeds Sale Undertaking Ijara ISSUER LESSEE RentalPayments Purchase Undertaking Istisna’a CONTRACTOR

  20. 1St East and Central Africa Conference on Islamic Banking Key Structural and Legal Considerations • Taxation • applicable to underlying structures and issuers • direct tax • stamp duty land tax • capital gains tax • withholding tax • value added tax • Regulatory classification of sukuk • impact of stabilisation, tradability and selling restrictions • Availability of identifiable assets to back the sukuk issuance • Local law issues relating to trusts, property laws, etc • SPV issuer/trustee – delegation • Rating criteria • Shariah compliance

  21. 1St East and Central Africa Conference on Islamic Banking Shariah Compliance & Market Conditions • Recent developments • December 2007 - Sheikh Usmani letter • 14 February 2008 – AAOIFI Shariah pronouncement, clarifying that: (i) Sukuk, to be tradable, must be owned by the sukuk holders with all the rights and obligations of ownership of real assets (ii) The Manager of sukuk issuances must certify the real transfer of such assets (iii) It is not permissible to agree to purchase assets from sukuk holders for a nominal value • It is permissible to agree to purchase assets at net value, market value • Shariah-compliant credit support is still permissible • Consequences of the pronouncement

  22. Future of Sukuk 1St East and Central Africa Conference on Islamic Banking • Despite the challenges, the future of sukuk looks bright due to the nature and utility of the instruments • Secondary market tradability is improving • Tax and regulatory conditions are being put in place • There is active development of hedging techniques and other necessary conditions for its proliferation

  23. 1St East and Central Africa Conference on Islamic Banking

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