Sukuk: Too many moving parts?

Joe Bradford

| 04/15/2010

Having done research on the structuring of Sukuk, I’ve been thinking lately on the ability of a Sukuk market to actually flourish. What incentives does any Sukuk issuer have to assure the success of their Sukuk? With exception of one type of obligation underlying the Sukuk (that being debt from murabaha), there can be no guarantee of coupon payments, no guarantee of principle, and no recourse unless negligence is proven.

In a Murabaha sukuk, unless that murabaha is a one-off purchase and resale of assets, then there is nothing guarantee a future need to create the debt that would become the coupon payment and repayment of the principle?

Even Ijara (lease) sukuk, which purportedly are the easiest of structures to synthesize Sukuk under, are questionable. Are these “true leases” or merely disguised security interests? If I lease you an asset (which was most likely purchased from you in the 1st place) then stipulate that you rent it from me for 10 years, all the while making it virtually impossible for you to break the contract without guaranteeing the profit and principle I was trying to synthesize in the first place, am I really leasing you this asset? Am I really transferring the asset back to you through a “hiba” (gift), nominal payment, or separate “purchase” agreement? Or have I merely securitized my debt along with an implicit guarantee, something that all too much resembles “Bai’ al-wafa” or “Bai’ al-amanah”?

Consider how the difference between a True Lease and a disguised Security interest is differentiated between in the UCC code:

The key element is that the erstwhile lessee has an unavoidable obligation to pay the supposed lessor for the possession and use of the asset, and this duty to pay extends over the life of the arrangement, and cannot be terminated by the lessee.

Interestingly, the UCC sets forth this first vital attribute, and then adds a series of four other characteristics that must also be found if the transaction is to be deemed a security interest and not a lease.

The four items are:

1) the original term of the supposed lease is equal to or greater than the economic life of the asset;

2) the putative lessee must renew the lease for the remaining economic life of the property or is required to take ownership of it;

3) there is an option to renew for the remaining economic life of the asset, but no additional or only nominal consideration need be paid to exercise that option; or

4) the supposed lessee has an option to purchase the property for little or no additional consideration. UCC 1-201 (37)(a).

Plainly, any and all of the above are indicia of true ownership by the lessee. A so-called “lease” whose original or extended term encompasses the entire economic life of an asset indicates ownership, and lacks intent to return the goods to the supposed lessor. The lack of a requirement to pay any additional money or an insignificant amount to extend a lease says much the same as to the true intent as the parties to create a security interest. Finally, compelling the supposed lessee to eventually own the asset is the final straw; without question it demonstrates that the “lessor” has no real intention of retaking the asset.

It would seem that unless a Sukuk is issued by a large Gov’t authority (so well backed that one need not worry about default) or is a legally binding obligation to pay interest on a debt (exactly what Sukuk were created to avoid) accompanied by a robust legal system that will enforce that claim, fears of failure do not easily subside.

Given the nontransparent nature of many of the markets in which Sukuk are issued, the intertwined nature of relationships to meet both financial, shariah, and legal concerns, the inefficiencies create from doing so, and the lack of added value from these structures, are we dealing with simply too many moving parts? Or are we simply insisting on appearances while fooling ourselves of the function?


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