Saturday October 3, 2009

Sukuk investors’ position amid defaults

By RAM Rating Services

ONE of the more contentious topics in the market today is the rights of sukuk holders in the event of non-payment or default. Do they have a claim on the underlying assets in the sukuk formation?

Where do they stand in the line-up of creditors, given the general belief that sukuk are the more secured investments compared to their conventional counterparts largely because of the asset backing.

Line-up of creditors

Given the Syariah emphasis that financing should be raised with respect to an economic activity, all sukuk share a common feature in that they often take shape with an asset (or assets) at their core.

Still, and as noted in our Malaysian Sukuk Handbook, RAM Ratings has always taken the view that the credit implications of asset-based sukuk do not equate to those of asset-backed securities.

Where there has been a real (true) transfer of asset ownership to a special-purpose vehicle (SPV) that has been formed to issue the sukuk, then the investors would have a legitimate claim on that particular asset that has been sold to them.

Asset ownership, in this instance, would strengthen the investors’ rights on the underlying asset(s) in the event of default or liquidation.

Asset-backed sukuk are characteristically non-recourse sukuk, with the underlying asset(s) forming the lone source of profit and capital payments.

From a rating perspective, the credit risk of this type of sukuk will be solely determined by the performance and credit quality of the underlying asset(s), i.e. their cashflow and, in some situations, expected value at maturity given various stressed scenarios.

On the other hand, without a true sale (i.e. assets have not been transferred to the sukuk holders) and if the asset is present simply for the purpose of Syariah compliance, we believe that the legal recourse and cure for the sukuk holders are likely to be no more than those of unsecured creditors.

In this instance, everyone will be entitled to a share of the asset(s).

From the rating perspective, an analysis of the asset will be inconsequential; instead, we will focus on the creditworthiness of the corporate obligor, with the final assigned rating depending on the ranking of the sukuk vis-a-vis the obligor’s existing senior unsecured obligations.

Usually, the obligor will be the issuer (borrower); in some cases, however, the task may fall on the originator, sponsor or lessee via the existence of a purchase-undertaking agreement.

Most of the sukuk issued in the local market take the form of asset–based sukuk. Only a handful entail true sale of the underlying asset(s) to investors and effectively provide legal ownership rights in the event of default.

Typically, sukuk formation involves investors forming a Musharakah among themselves pursuant to a Musharakah contract, and subscribing to the issued sukuk.

The Musharakah capital received from the investors is subsequently invested by the issuer in a Musharakah venture, e.g. one that involves the purchase and leasing of assets pursuant to an Ijarah contract, or the purchase of receivables pursuant to a Murabahah or Bai Bithaman Ajil contract.

The issuer customarily declares a trust over the assets in favour of the sukuk holders, with the latter having beneficial ownership of the underlying asset(s).

Legal ownership, however, remains with the original asset owner. The intent of the issuer in this instance is to have an unsecured funding source.

Law and order

The legal documentation governing the transaction firmly renders the sukuk a financial obligation, listing the sukuk holders as creditors (as opposed to owners or equity holders) and ranking them pari passu with conventional creditors (within the same class of creditors).

The growth of Malaysia’s sukuk market has been nothing short of remarkable.

Its development has been accompanied by extensive and wide-ranging measures aimed at ensuring the soundness and integrity of the market, and to preserve investors’ confidence in the Shariah-compliant aspect of the products and services.

In Malaysia, sukuk issuance is governed by various legislations as well as rules, guidelines and practice notes issued by the relevant authorities, in particular the Securities Commission for the onshore Islamic capital market (ICM), and the Labuan Offshore Financial Services Authority (or LOFSA) for the offshore ICM.

The existence of a standard documentation framework in a recognisable pattern and format adds comfort to both the financing and investment fraternities.

The documentation for the issuance of sukuk, e.g. the trust deed and trust certificates, are the same as that for conventional bonds, given Syariah neutrality on the many commercial and legally related clauses applicable to both instruments.

The robust supervisory structure, established governance and disclosure standards, and the highly developed legal framework and court system also provide the necessary protection and comfort to investors.

Like its conventional counterpart, Malaysia’s sukuk market has benefited from credit-risk benchmarks provided by compulsory rating requirements, which have been in place since 1992; these aid investors in the areas of transparency and timeliness of information.

The Malaysian sukuk market is also supported by a centralised, national-level syariah advisory council – to facilitate shared understanding and uniformity on Syariah interpretation.

The comprehensive market infrastructure as well as legal and regulatory regimes of the Malaysian sukuk market has not only provided clarity on the rules of the game, but also routinely rises to the occasion and provides ample protection to both sukuk issuers and investors

Over to the GCC market

While the Malaysian market has seen sukuk defaults and restructuring, it seems that the same is a new phenomenon in the GCC market.

The robustness of the legal and regulatory system governing the Islamic finance industry in the Gulf has been tested for the first time.

In May 2009, The Investment Dar Co – a Kuwaiti investment company that owns 50% of luxury-car maker Aston Martin Lagonda Ltd – became the first GCC entity to default on its Islamic bonds, after having missed a payment on a US$100mil sukuk maturing in 2010.

In Saudi Arabia, investors of Saad Group’s US$650mil Golden Belt 1 sukuk have set up a committee to discuss debt restructuring.

The sukuk issuance, scheduled to mature in 2012, is said to be teetering on the brink of default.

While the profit payment for May 2009 has been made, investors are apparently doubtful about the next scheduled payment this coming November.

In July, Dubai-based property developer Nakheel announced a revision in the terms of payments for its US$750mil sukuk due in 2011; however, uncertainty still shrouds its US$3.5bil sukuk obligation that will mature in December this year.

Outside of the Gulf, East Cameron Gas Co – the first American company to issue sukuk (in 2006) – filed for bankruptcy protection in October 2008.

In this case, some US$167.8mil of sukuk had been affected.

Although RAM Ratings does not rate sukuk issues originating from the Gulf market, we understand that most of such sukuk have been issued by offshore special-purpose vehicles governed by English law.

Given that, a ruling may have to be sought in an English court, and this would then need to be enforced in the Middle East, where most of the assets backing the sukuk issues are located.

There are very limited precedents of English judgements being enforced in the Gulf.

It has been estimated that approximately US$10bil of bonds are due to mature this year.

We have also been made to understand that the general inclination is for market players to opt for roundtable discussions and consensus-based restructuring, as opposed to court judgements.

We view this as a positive step that should result in some clarity on the issue of investors’ safety – a critical aspect for sustainable market development.

Even with the probability of an uptick in defaults, and putting aside the pecking order of sukuk holders in the event of default, the credit profiles of most RAM Ratings-rated sukuk are envisaged to remain resilient against the challenging environment, with the median rating remaining within the A1/AA3 rating bands.

This is because the bulk of our sukuk portfolio has been raised against infrastructure assets such as power projects, tolled roads and water operators.

The underlying project economics and revenue-generating aptitude, combined with project or structured-finance covenants, tend to afford such issuances high credit ratings.

Based on our historical insight on the probability of defaults, high-investment-grade issues, such as infrastructure-linked sukuk, should be able to weather the storm quite well.

In contrast to the Malaysian story, however, the GCC sukuk market has been largely driven by the booming real-estate sector. Therefore, a collapse in property prices would naturally prompt negative rating actions.

Despite the glitches, twists and turns experienced by the market, we maintain that the Malaysian sukuk market will remain a “blue ocean” for issuers and investors alike; in short, an attractive asset class for many market participants.

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