article 11 sukuk guidebook

8/7/2019 Article 11 Sukuk Guidebook

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Dubai International Financial CentreSukuk Guidebook


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Table of Contents


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5

Preamble 7

Chapter 1. Origin and Development o Sukuk in Islamic Finance 8

Chapter 2. Sukuk Structures

Part 1. Sukuk al-Ijara 13

Part 2. Sukuk al-Musharaka 20

Part 3. Sukuk al-Mudaraba 28

Part 4. Sukuk al-Salam 34

Part 5. Sukuk al-Istisnaa 40

Part 6. Sukuk al-Murabaha 46

Part 7. Sukuk al-Istithmar 51

Part 8. Sukuk al-Wakala 57

Part 9. Others 64

Chapter 3. Issuing Sukuk rom the DIFC 66

Chapter 4. Listing Sukuk on NASDAQ Dubai 72

Chapter 5. Sukuk and Regulatory Licensing in the DIFC 82

Chapter 6. Challenges or the Future Development o Sukuk 88


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DIFC Sukuk Guidebook6

Disclaimer

Cli ord Chance LLP has developed this Guide to assist those parties interested in learning about sukuk generallyas well as to gain an understanding o Islamic Capital Markets nancing. This Guide provides a summary o theunderlying concepts in sukuk and examines the issues acing the sukuk industry, both in the DIFC and beyond;now and in the uture.

This Guide also sets out the DSFA regulatory environment or sukuk and the scope or application o suchrequirements.

This Guide provides an introduction to Islamic nance as well as a summary o the regulatory requirements andthe applicable operating environment or the o er o Islamic nance in or rom the DIFC. This Guide is onlyintended to provide guidance on the Islamic aspects o sukuk, irrespective o whether the sukuk is to be used

or Islamic securitisation or Islamic corporate instruments.

This document does not constitute Sharia or nancial advice, nor does it replace the regulatory requirementso the DFSA or DIFC. It should be read in conjunction with the detailed requirements o the DFSA and DIFCto orm a de nitive view in terms o the application o the relevant operating environment in the DIFC to eachindividual set o circumstances.

The contents o the Guide do not necessarily represent the views or opinions o the DIFC.

This Guide was prepared in November 2009 and to the best o the authors knowledge was based on in ormationcurrent and accurate at that time.


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7

Preamble

Cli ord Chance is one o the worlds leading law rms, helping clients achieve their goals by combiningthe highest global standards with local expertise. The rm has unrivalled scale and depth o legalresources across the our key markets o the Americas, Asia, Europe and the Middle East, and ocuseson the core areas o commercial activity: capital markets; corporate and M&A; nance and banking; realestate; tax; pensions and employment; litigation and dispute resolution. Cli ord Chance has 29 o cesin 20 countries and operates a best riends arrangement with AZB & Partners in India and Lakatos,Kves & Partners in Budapest, in addition to a co-operation agreement with Al Jadaan & Partners LawFirm in Saudi Arabia.

Cli ord Chance lawyers advise internationally and domestically; under common law and civil law systems;in local and cross-border transactions; on day-to-day operations and the most challenging deals. Cli ord Chance was ranked tier one in more international tables than any other rm in the ChambersGlobal 2009 Directory. This independent analysis ocuses on the Firms legal ability, pro essional conduct,client service, and commercial awareness, and these rankings provide outstanding recognition or theFirms breadth o expertise and consistency o quality across global markets.Cli ord Chance has or many years been involved in Islamic nancing techniques and Islamic productdevelopment. As the Islamic nancing market has expanded and become more sophisticated, Cli ordChances involvement and expertise in this eld has increased and the Firm can draw on its substantialexperience o Islamic nancing including Islamic tranches o project nancings, Islamic unds (includingin rastructure unds and principal protected unds), Islamic risk management products, acquisition, corporateand real estate nance as well as sukuk (both corporate sukuk and Sharia compliant securitisation).

In the past year Cli ord Chance has closed more than US$42 billion worth o Islamic nance transactions- groundbreaking deals that have provided innovative Sharia compliant structures or clients in marketsacross the world. Cli ord Chance was named as Best Islamic Legal Advisory Firm in the EuromoneyIslamic Finance Awards or 2008 and 2009, and is consistently recognised as a leading Islamic nancepractice by Chambers Global and other Islamic nance directories such as Islamic Finance News.

Members o the Firms Islamic nance team, located in London, Dubai, Abu Dhabi, New York, Singapore,Hong Kong, Paris and elsewhere in our international network o o ces, have extensive expertise andexperience in both Islamic nance and conventional nance and are at the ore ront o innovation as

Islamic nancing techniques and products evolve.

This Guide has been a collaborative e ort between Cli ord Chance, DIFC, DFSA, NASDAQ Dubai andAmanie Islamic Finance Consultancy and Education LLC. The Cli ord Chance authors, led by GlobalHead o Islamic nance, Qudeer Lati , include Andrew Henderson, Paul McViety, Greg Man, FerzanaHaq, Shauaib Mirza and Cheuk Yin Cheung.

For urther in ormation about Cli ord Chance see www.cli ordchance.com


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Chapter 1Origin and Development of Sukukin Islamic Finance


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Chapter 1

Origin and Development o Sukuk in Islamic Finance

The high-pro le growth and prevalence o sukukin the Islamic nance industry in recent years hasmade the term, sukuk, synonymous with theIslamic capital markets. This Sharia compliantalternative to interest-bearing investmentcerti cates or xed income securities has ledto the product being commonly re erred to asIslamic bonds in recognition o its ability too er Islamic investors a means o subscribingto certi cates which represent a right to receive

a share o pro ts generated by an underlyingasset base and that is capable o being tradedon the secondary market.

This has made sukuk an attractive product tosovereign and corporate issuers alike, who haveused sukuk to tap into a wider range o nancingsources or their increasingly sophisticated

nancing and investment purposes.

There is empirical evidence to suggest thatsukuk structures were used within Muslimsocieties as early as the Middle Ages, wherepapers representing nancial obligationsoriginating rom trade and other commercial

activities were issued.

The word, sukuk, can also be traced back toclassical commercial Islamic literature, used inre erence to certi cates or goods or groceries(sakk al-badai) as the method o paying thesalaries o government o cers, who wouldlater redeem such certi cates in line with their

day-to-day consumption o such goods orgroceries. However, the sukuk, as understoodin its contemporary orm, lies in a decision o theIslamic Jurisprudence Council (the IJC) dated6-11 February 1988 which provided that,

any combination o assets (or the usu ruct o such assets) can be represented in the orm o written fnancial instruments which can be sold at a market price provided that the compositiono the group o assets represented by the sukuk consist o a majority o tangible assets.

Although the IJCs decision is not binding onany particular party, the signi cance o theinstitution in the Muslim world saw the tradingo securitised Islamic nancial instrumentswhich were approved as being Shariacompliant in Malaysia rom 1995. Although thesale o debt instruments (bai dayn) is permittedby the Sha jurisprudence prevalent in Malaysia

and Indonesia, the more conservative schoolso thought prevalent in the Gul CooperationCouncil (the GCC) countries saw thesecondary trading o sukuk certi cates as aconceptual hurdle as it could be interpreted asthe trans er o debt at a price other than its ace(or par) value, thus generating non-permittedinterest (riba).

Emergence o sukuk in contemporary Islamic fnance

Introduction

Origins o Sukuk


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1 The Centre or the Study o Global Governance, The Development o Islamic Finance in the GCC, London, May 2009.2 AAOIFI Sharia Standard No.17.

A standard in May 2003 on InvestmentSukuk published by the Accounting andAuditing Organisation or Islamic FinancialInstitutions (AAOIFI)2 led to a paradigm shi tin the development o Islamic nancial products,

which had traditionally been illiquid and hadlacked the qualities o market orientation morecommonly associated with their conventionalcounterparts. The standard was backed by 14prominent Islamic scholars rom the MiddleEast, Malaysia, Indian Sub-continent (especiallyPakistan) and A rica (especially Sudan) andhelped create cross-border convergence onsukuk across the our main schools o Islamic

jurisprudence.

Since then, the sukuk industry has seenunprecedented growth as a viable alternativeto mobilising long term savings and investment

rom Islamic investors as well as providing aliquidity management tool or Islamic nancial

institutions such as pension and zakat undsand insurance (taka ul) institutions, particularlygiven the negotiable nature o the productand its listing on recognised stock exchanges:NASDAQ Dubai being one o the prominentexchanges. For corporates wishing to reducetheir dependence on bank acilities or who wishto seek alternative (and o ten cheaper) sourceso unding, a sukuk issuance is increasinglybecoming a easible option.

However, as trading in real assets is permitted,the Bahrain Monetary Agency (now the CentralBank o Bahrain) issued the rst sovereignsukuk based on the ijara structure amountingto US$100 million in 2001. (Please re er toPart 1 (Sukuk al-Ijara) o Chapter 2 (SukukStructures) or urther details o sukuk al-ijara).Since then, the global Islamic capital market hasseen much larger sovereign and quasi-sovereignsukuk issues such as the US$600 millionissuance by the Malaysian government in 2002and the US$3.5 billion sukuk al-mudaraba by

Ports & Free Zone Corporation in 2006 orthe acquisition o P&O by Dubai World, whichattracted GCC-based investors such as Islamicbanks as well as domestic investors.

As at the time o writing, the United ArabEmirates is the GCC leader in terms o sukukissuance by value, with a total o US$26,823million rom 34 issuances between 2000-2008 compared to US$4,543 million rom 89issuances in Bahrain over the same period 1.

Jurisprudential developments and evolution o sukuk


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In addition, a number o other capital markets-based institutions are likely to play a prominent

role in achieving the required nexus betweensukuk issuers and investors to establish anattractive trading plat orm:

DIFC: already enables the registrationo special purpose companies or sukukissuers wishing to seek a more domesticalternative to incorporation in jurisdictionssuch as the Cayman Islands or othertraditional o -shore jurisdictions;

NASDAQ Dubai: already enables publiclisting o sukuk issuances to help issuers toattract the maximum number o investors;and

Rating Agencies: who can assist withproviding more transparency on the creditrisk o a sukuk product and, comparableto a conventional bond issuance, a

recognised rating o the originator canimprove the marketability o the relevant

sukuk certi cates. Sukuk ratings havealready been provided by the prominentrating agencies and the InternationalIslamic Rating Agency was also establishedwith similar aims.

From its origins as papers representingremittances rom trades in the Middle Agesto the investment and liquidity managementtool it is today, the evolution o sukuk is a

testimony to the ability o Islamic jurisprudenceto move with the times to meet the increasinglysophisticated nancing needs o both Muslimsand non-Muslims seeking to participate in theIslamic nancial markets. The developmento regulatory, legal and capital marketin rastructures will assist in seeing the sukukmarket through sustainable growth into the

uture.

The continued growth and development othe sukuk market also requires support romparallel developments in legal and regulatoryin rastructures, both in domestic marketsand beyond. A number o well-recognisedinstitutions have already played signi cant rolesand are likely to attract increasing ocus romsukuk investors and issuers:

AAOIFI: in addition to its ongoing annual

publication o Sharia and accountingstandards and guidelines on Islamic

nancial products, it has also announced

its intention to screen products or Shariacompliance in the uture;

International Islamic Financial Market(IIFM): based in Bahrain and responsible orthe development o a secondary marketincluding standardisation o documents;and

Islamic Financial Services Board (IFSB):based in Malaysia and responsible or thedevelopment o prudential standards orIslamic nancial institutions.

Facilitation through Capital Market In rastructures

Facilitation Through Legal and Regulatory In rastructures


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Chapter 2Sukuk Structures


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3 Source: Moodys Investors Service Special Report January 2009.

Chapter 2

Part 1: Sukuk al-Ijara

The most commonly used sukuk structure (basedon volume o issuances during 2008) 3 is that osukuk al-ijara. The popularity o this structurecan be attributed to a number o di erent

actors; some commentators have described itas the classical sukuk structure rom which allother sukuk structures have developed, whilstothers highlight its simplicity and its avour withSharia scholars as the key contributing actors.In the Islamic nance industry, the term ijarais broadly understood to mean the trans er othe usu ruct o an asset to another person inexchange or a rent claimed rom him or, moreliterally, a lease.

In order to generate returns or investors,all sukuk structures rely upon either theper ormance o an underlying asset or acontractual arrangement with respect to thatasset. The ijara is particularly use ul in this

respect as it can be used in a manner thatprovides or regular payments throughoutthe li e o a nancing arrangement, togetherwith the fexibility to tailor the payment

pro le - and method o calculation - in orderto generate a pro t. In addition, the use oa purchase undertaking is widely accepted inthe context o sukuk al-ijara without Shariaobjections. These characteristics make ijararelatively straight orward to adapt or use in theunderlying structure or a sukuk issuance.

Examples o recent sukuk al-ijara issuancesadvised upon by Cli ord Chance LLP and listedby originators on NASDAQ Dubai are:

Nakheel, US$3,520 million issued inDecember 2006, ollowed by subsequentissuances o US$750 million in January 2008and AED3,600 million in May 2008; and

Dubai Electricity & Water Authority (DEWA),AED3,200 million issued in June 2008.

Set out below is an example o a sukuk al-ijarastructure, based upon a sale and leasebackapproach.

Introduction


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Figure 1: Structure o Sukuk al-Ijara

ORIGINATORas Seller

ORIGINATORas Lessee

ISSUER SPVas Issuer and as Trustee

INVESTORS

ORIGINATORas Oblogor

under Purchase Undertakingand under Sale Undertaking

ORIGINATORas Servicing Agent

11Appointment asServicing Agent

Reimbursements of Servicing Costs(set-off againstSupplemental Rental)

9 Exercise Price

10 DissolutionAmount

PeriodicDistributionAmounts

8Sale of Assets

5Lease of Assets

4 Sale Price(Considerationfor Sale)

3

Sale of Assets

12

Cash

1Sukuk(Trust Certicates)

6 Rentals

2

7


Overview o Structure(Using the numbering rom Figure 1 above)

Issuer SPV issues sukuk, which represent1.an undivided ownership interest in anunderlying asset or transaction. They

also represent a right against Issuer SPVto payment o the Periodic DistributionAmount and the Dissolution Amount.

The Investors subscribe or sukuk and2.pay the proceeds to Issuer SPV (thePrincipal Amount). Issuer SPV declaresa trust over the proceeds (and any assetsacquired using the proceeds seeparagraph 3 below) and thereby acts asTrustee on behal o the Investors.

Originator enters into a sale and purchase3.arrangement with Trustee, pursuantto which Originator agrees to sell, and

Trustee agrees to purchase, certain assets(the Assets) rom Originator.

Trustee pays the purchase price to4.Originator as consideration or itspurchase o the Assets in an amountequal to the Principal Amount.

Trustee leases the Assets back to Originator5.under a lease arrangement (ijara) or a termthat refects the maturity o the sukuk.


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Originator (as Lessee) makes Rental6.payments at regular intervals to Trustee(as Lessor). The amount o each Rentalis equal to the Periodic DistributionAmount payable under the sukuk at thattime. This amount may be calculatedby re erence to a xed rate or variablerate (e.g. LIBOR or EIBOR) dependingon the denomination o sukuk issuedand subject to mutual agreement o theparties in advance.

Issuer SPV pays each Periodic Distribution7.Amount to the Investors using the Rentalit has received rom Originator.

Upon:8.an event o de ault or at maturity(i).(at the option o Trustee under thePurchase Undertaking); or

the exercise o an optional call (i(ii).

applicable to the sukuk) or theoccurrence o a tax event (both atthe option o Originator under theSale Undertaking),

Trustee will sell, and Originator willbuy-back, the Assets at the applicableExercise Price, which will be equal to thePrincipal Amount plus any accrued but

unpaid Periodic Distribution Amountsowing to the Investors.

Payment o Exercise Price by Originator9.(as Obligor).

Issuer SPV pays the Dissolution Amount10.to the Investors using the Exercise Price ithas received rom Originator.

1112 Trustee and Originator will enter intoa service agency agreement wherebyTrustee will appoint Originator as itsServicing Agent to carry out certaino its obligations under the leasearrangement, namely the obligationto undertake any major maintenance,insurance (or taka ul) and payment otaxes in connection with the Assets. Tothe extent that Originator (as ServicingAgent) claims any costs and expenses

or per orming these obligations (the

Servicing Costs) the Rental or thesubsequent lease period under the leasearrangement will be increased by anequivalent amount (a SupplementalRental). This Supplemental Rental due

rom Originator (as Lessee) will be set oagainst the obligation o Trustee to paythe Servicing Costs.

Set out below is a summary o the basicrequirements that should be considered whenusing ijara as the underlying structure or theissuance o sukuk:

The consideration (Rentals) must be at anagreed rate and or an agreed period;

The subject o the ijara must have avaluable use (i.e. things without a usu ructcannot be leased);

The ownership o the asset(s) mustremain with the Trustee and only theusu ruct right may be trans erred to the

Key Features o the Underlying Structure


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originator (there ore anything which canbe consumed cannot be leased by way oan ijara);

As ownership o the asset(s) must remainwith the Trustee, the liabilities arising romthe ownership must also rest with theTrustee (as owner) - an asset remains therisk o the Trustee throughout the leaseperiod (in the sense that any harm or losscaused by the actors beyond the controlo the Originator is borne by the Trustee);

Any liabilities relating to the use o theasset(s), however, rest with the Originator(as lessee);

The Originator (as lessee) cannot usean asset or any purpose other than thepurpose speci ed in the ijara (or lease)agreement (i no purpose is speci ed,the Originator can use such asset or the

purpose it would be used or in the normalcourse o its business);

The asset(s) must be clearly identi ed inthe ijara (and identi able in practice);

Rental must be determined at the timeo contract or the whole period o theijara. Although it is possible to split theterm o the ijara into smaller rental periods

where di erent amounts o rent may becalculated or each such rental period, theamount o rental must be xed at the starto each such rental period and Sharia willconsider each rental period as a separatelease;

I an asset has totally lost the unctionor which it was leased, and no repair is

possible, the ijara shall terminate on theday on which such loss (a Total Loss)has been caused. I there has been a TotalLoss, the Trustee may have the right/abilityto substitute or replace the a ected asset- although, in reality, it would only look todo so i the Originator (as service agent)is able to use the insurance (or taka ul) orany other total loss proceeds to procuresubstitute or replacement assets;

I a Total Loss is caused by the misuse ornegligence o the Originator, the Originatorwill be liable to compensate the Trustee ordepreciation in the value o the a ectedasset, as it was immediately be ore suchTotal Loss; and

In the event that an asset has only su eredpartial loss or damage, the ijara will

continue to survive with respect to thatasset.

The above requirements are based on theprinciples set out in Accounting and AuditingOrganization or Islamic Financial Institutions(the AAOIFI) Sharia Standard No. 9 (Ijarahand Ijarah Muntahia Bittamleek) and otherestablished principles relating to Ijara.


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Table 1

Document Parties Summary / Purpose

Sale and Purchase

Agreement

Originator (as Seller) and

Trustee (as Purchaser)

From Trustees (and the Investors) perspective, this

is the document that gives ownership o revenue-generating assets (i.e. the Assets).

From Originators perspective, this is the documentunder which it receives unding.

Lease (Ijara) Agreement Trustee (as Lessor) andOriginator (as Lessee)

Trustee leases the Assets back to Originator in amanner that:

gives Originator possession and use o thei.Assets so that its principal business cancontinue without interruption; and

through Rentals it generates a return orii.Trustee (and the Investors).

Service AgencyAgreement

Trustee (as Lessor / Principal)and Originator (as ServicingAgent)

Allows Trustee to pass responsibility or majormaintenance, insurance (or taka ul) and payment otaxes (i.e. an owners obligations) back to Originator.Any reimbursement amounts or service chargespayable to Servicing Agent are set o against (i)a corresponding supplementary rental under theIjara or (ii) an additional amount which is addedto the Exercise Price (payable under the PurchaseUndertaking or the Sale Undertaking, as applicable).

Purchase Undertaking(Wad)

Granted by Originator (asObligor) in avour o Trustee

Allows Trustee to sell the Assets back to Originator ian event o de ault occurs or at maturity, in return orwhich Originator is required to pay all outstandingamounts (through an Exercise Price) so that Trusteecan pay the Investors.

Continued

17

In addition to the o ering, trust and listingdocumentation (the requirements o which arediscussed in more detail in Chapter 3 (IssuingSukuk rom the DIFC) and Chapter 4 (Listing

Sukuk on NASDAQ Dubai)), the ollowingdocumentation is typically required or a sukukal-ijara transaction:

Required Documentation


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Sale Undertaking (Wad) Granted by Trustee in avouro Originator (as Obligor)

Allows Originator to buy the Assets back rom Trusteein limited circumstances (e.g. the occurrence o a taxevent), in return or which Originator is required to payall outstanding amounts (through an Exercise Price) sothat Trustee can pay the Investors.

Substitution Undertaking(Wad) - OPTIONAL

Granted by Trustee in avouro Originator (as Obligor)

Allows Originator to substitute the Assets (which itmay need to sell or otherwise dispose o ) or someother assets having at least the same value andrevenue-generating properties.


The growth o the sukuk market has led to thedevelopment o a number o hybrid structuresaround the sukuk al-ijara model in order toprovide additional fexibility - particularly whenselecting underlying assets. A ew o thesedevelopments are summarised below:

In order to enable investors to receivecompensation where an asset is still underconstruction, certain Sharia scholars havepermitted the use o the orward leasearrangement (known as ijara mawsu ah al-dimmah). This orward lease agreementis normally combined with an istisnacontract (or procurement agreement),under which construction o the asset is

commissioned. This structure is discussedin more detail later in this Chapter 2 (SukukStructures) at Part 5: Sukuk al-Istisna; and

I legal and/or registered title to a particularasset exists and (due to, by way o example,the prohibitive cost implications or taximplications o registering such a trans ero title) it is not possible to trans er thatlegal / registered title, certain structureshave been approved that allow an ijara

to be put in place despite the act thatthe trustee does not have outright legalownership o that asset. For example:

it may be possible, depending on the(i)asset type and the view taken by the

relevant Sharia scholars, to rely uponthe concept o bene cial ownershipin structuring a sukuk al-ijaratransaction. The sale and purchaseagreement (in the sale and leasebackstructure discussed above) woulddocument the sale and trans er to thetrustee o the bene cial ownershipinterest in the underlying asset - andsuch bene cial ownership interest

would be su cient to enable thetrustees entry into the leasebackarrangements contemplated in theexample above;

where the usu ruct o an asset is(ii)recognised by the underlying legaland regulatory regime, it may bepossible to create di erent categorieso usu ruct and or the sale o ausu ruct to be relied upon or the

Related Structures / Structural Developments


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purposes o structuring a sukuk al-ijara transaction. An example o thisis through the grant o a musatahainterest (a right in rem), the holder(or musatahee) is given the rightto use and develop land with suchrights over that land in a manner thatallows the holder to be the outrightowner o the buildings constructedon that land during the period othe musataha. It should howeverbe noted that a musataha providesan interest less than reehold orabsolute ownership. The musataharight, when created, is granted bythe owner o the reehold propertyto the holder. The right, while not aleasehold interest, is quite similar toa leasehold interest. Certain Sharia

scholars consider this su cient toenable the holder (or musatahee),in turn, to lease the land and anybuildings thereon to the originatorunder an ijara arrangement. Basically,a musataha contract replaces the saleand purchase agreement in the saleand leaseback structure discussedabove; and

it is also possible or a head-lease(iii)arrangement to be used instead othe sale and purchase agreement(in the sale and leaseback structurediscussed above), such that thetrustee is granted a long-term rightto use an asset under the head-lease, thus allowing the trustee toenter into a sub-lease (the ijara).


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Chapter 2

Part 2: Sukuk al-Musharaka

Prior to the AAOIFI statement in 2008 (theAAOIFI Statement), one o the morecommonly used sukuk structures was that osukuk al-musharaka. However, ollowing on

rom the AAOIFI Statement criticising the use opurchase undertakings in sukuk al-musharakastructures (as urther discussed below underthe heading AAOIFIs Statement o 2008),the popularity o this structure has declined inrecent times.The term musharaka is derived rom the wordshirkah, which means partnership. In its simplest

orm, a musharaka arrangement is a partnershiparrangement between two (or more) parties,where each partner makes a capital contributionto the partnership (i.e. to the musharaka),in the orm o either cash contributions orcontributions in kind. Essentially, a musharakais akin to an unincorporated joint venture butmay, i required, take the orm o a legal entity.

The musharaka partners share the pro ts o themusharaka in pre-agreed proportions and sharethe losses o the musharaka in proportion totheir initial capital investment.Musharaka arrangements can be structured in anumber o di erent ways; however, in practicethe ollowing two structures are utilised or thepurposes o issuing sukuk. These are:

Shirkat al-Aqd commonly re erreda.

to as the business plan musharaka; itis an arrangement pursuant to whichthe Originator and the Trustee agreeto combine their e orts and resources(typically in the orm o cash and/or otherasset rom the Originator and the Trustee)towards a common objective; and

Shirkat al-Melk commonly re erred tob.as the co-ownership musharaka; it is anarrangement pursuant to which either (i)

the Originator and the Trustee contributecash to the musharaka to purchase anasset together or (ii) the Originator sellsan ownership interest in an asset to theTrustee as a result o which the Originatorand the Trustee become co-owners o thatasset.

When structuring a sukuk issuance pursuantto a shirkat al-melk structure, the rst step iso ten to analyse what exactly the business oan originator entails and what assets (i any)are available to support the issuance o sukuk.At the outset, i it is not possible to identi y atangible asset that is capable, rom a legal andSharia perspective, o being contributed to themusharaka itsel , it will be necessary to considerthe shirkat al-aqd structure (as well as thoseoutlined in the rest o this Chapter 2 (SukukStructures)).

All sukuk structures rely upon the per ormanceo an underlying asset or arrangement inorder to generate returns or investors. Themusharaka is no di erent in this respect andcan be implemented in a manner that provides

or regular payments throughout the li e o thesukuk, together with the fexibility to tailor thepayment pro le - and method o calculation - inorder to generate a pro t. These characteristics

make musharaka relatively straight orward toadapt or use in the underlying structure or asukuk issuance.

One example o a sukuk al-musharaka issuancelisted by an originator on NASDAQ Dubai isthe Jebel Ali Free Zone FZE AED7,500 millionsukuk issued in November 2007, where Cli ordChance LLP acted as legal counsel to theoriginator.

Introduction


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Figure 2: Structure o Sukuk al-Musharaka (based upon a shirkat al-aqd arrangement)

ORIGINATORas Partner MUSHARAKA


INVESTORS

ORIGINATORas Obligor

under Purchase Undertakingand under Sale Undertaking

ORIGINATORas Managing Agent

11Appointment asManaging Agent

Incentive Fees

9 Exercise Price



8Sale of

MusharakaUnits

6

Share of prot andloss

4

Contributionin Cash or in Kind

3Cashcontribution

12

Cash


5 Share of prot and loss

2

7

21

Set out below is an example o a sukuk al-musharaka structure, based upon a shirkat al-aqdarrangement.

Issuer SPV issues sukuk, which represent1.an undivided ownership interest in anunderlying asset, transaction or project.They also represent a right againstIssuer SPV to payment o the PeriodicDistribution Amount and the DissolutionAmount.

The Investors subscribe or sukuk and pay2.

the proceeds to Issuer SPV (the PrincipalAmount). Issuer SPV declares a trustover the proceeds (and any assets o themusharaka see paragraph 4 below)and thereby acts as Trustee on behal othe Investors.

Trustee enters into a musharaka3.arrangement with Originator, pursuant to

Overview o Structure

(Using the numbering rom Figure 2 above)


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which Trustee contributes the proceedsrom the issuance o the sukuk into the

musharaka and is allocated a number ounits in the musharaka in proportion toits capital contribution.

Originator enters into a musharaka4.arrangement with Trustee, pursuant towhich Originator makes a contributionin cash or in kind into the musharakaand is allocated a number o units inthe musharaka in proportion to itscapital contribution to the musharaka.The contributions by the Trustee andthe Originator collectively orm themusharaka assets (the MusharakaAssets).

On each periodic distribution date Trustee5.shall receive a pre-agreed percentageshare o the expected pro ts generatedby the Musharaka Assets and, where

the Musharaka Assets generate a loss,Trustee shall share that loss in proportionwith its capital contribution to themusharaka. Trustees share o pro ts willtypically be a percentage high enough toat least equal the Periodic DistributionAmounts payable under the sukuk.

On each periodic distribution date6.Originator shall receive a pre-agreed

percentage share o pro ts generatedby the Musharaka Assets and, wherethe Musharaka Assets generate aloss, Originator shall share that loss inproportion with its capital contribution.

Issuer SPV pays each Periodic Distribution7.Amount to the Investors using the pro t ithas received rom the Musharaka Assets.

Upon:8.

an event o de ault or at maturity(i).(at the option o Trustee under thePurchase Undertaking); or

the exercise o an optional call (i(ii).applicable to the sukuk) or theoccurrence o a tax event (both atthe option o Originator under theSale Undertaking),

Trustee will sell, and Originator will buy,all o Trustees units in the musharakaat the applicable Exercise Price, whichwill be an amount equal to the Trusteesshare in the air market value o theMusharaka Assets at the time o sale.The Exercise Price will be used to pay thePrincipal Amount plus any accrued butunpaid Periodic Distribution Amountsowing to the Investors.

Pre-AAOIFIs Statement, the Exercise Price

was o ten xed at the outset to be anamount equal to the Principal Amountplus any accrued but unpaid PeriodicDistribution Amounts owing to theInvestors. However, ollowing on romthe AAOIFI Statement the general Shariaposition is that where the Originatorand the purchaser under the PurchaseUndertaking are the same entity, theExercise Price cannot be xed in this

manner and must instead be determinedby re erence to the market value o theMusharaka Assets at the time o sale(please see the section below under theheading AAOIFIs Statement o 2008

or urther in ormation). As a result othis, there is a risk that the Exercise Pricewill be less than the amount requiredto pay the Principal Amount and allaccrued but unpaid Periodic DistributionAmounts owing to the Investors. In


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23

order to mitigate this risk, additionalstructural enhancements can beincorporated into the structure including(i) the maintenance o a reserve accountinto which excess pro ts rom time totime during the li e o the sukuk are heldand used to make up any short alls inany payments due to Certi cateholders;and/or (ii) the option o a third partyproviding Sharia-compliant liquidity

unding to und any short alls in anypayments due to Certi cateholders (seethe section below headed Key eatureso the Underlying Structure or urtherdetail). These mitigants do not howeveraddress all the risks associated with anexercise price linked to market price othe assets.


Issuer SPV pays the Dissolution Amounts10.to the Investors using the Exercise Price ithas received rom Originator.

1112 Trustee and Originator will enter intoa management agreement wherebyTrustee shall appoint Originator as

Managing Agent to manage themusharaka in accordance with an agreedbusiness plan. To the extent that thepro t received by Trustee in any periodis greater than the Periodic DistributionAmounts or that period, the ManagingAgent shall be entitled to such excessas an advance per ormance ee. UnderSharia, all payments made under themusharaka are deemed to be onaccount and will be adjusted on themusharaka end date to refect the actualand nal pro ts / losses o the musharaka.As a result o this, any excess pro t paidto the Managing Agent is consideredto be an advance per ormance eethat is re undable at all times until themusharaka end date. Typically, in theevent that on any periodic distributiondate there is a short all between thepro t received by Trustee and thePeriodic Distribution Amount then due,

Managing Agent will be obliged toreturn such advance per ormance eesto remedy the short all. However, onthe musharaka end date, any advanceper ormance ees not required to bereturned can be conclusively retained bythe Managing Agent.

Set out below is a summary o the basicrequirements based on established principlesand the AAOIFI Sharia Standards No.12 (Sharika(Musharaka) and Modern Corporations), whichshould be considered when using musharakaas the underlying structure or the issuance osukuk:

Managing Agent must operate the

musharaka business and invest theMusharaka Assets in accordance with themusharaka business plan that will havebeen agreed between the partners andwill have been tailored in accordance withthe principles o Sharia;

The ratio o pro t sharing must be agreedat the outset and, unlike losses, does not



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have to be in proportion to each partnerscapital contribution. However, it is notpermissible to agree a xed pro t amount

or either Originator or Trustee;

Losses o the musharaka must be shared bythe partners in proportion to their capitalcontributions to the musharaka;

Any pro t distributed prior to maturity ortermination o the musharaka is deemedto be in advance and is treated as an onaccount payment which shall be adjustedto the actual pro t Originator and Trusteeare entitled to at that time;

The musharaka must have a degree otangibility and this tangibility (or asset-backing ratio) can vary between 33% and50%, depending on the Sharia scholarsinvolved;

There is a possibility that the pro tsreceived by Trustee on or prior to anyperiodic distribution date are less than therelevant Periodic Distribution Amounts.Appropriate mechanical enhancementscan be incorporated into the musharakastructure to mitigate this risk. For example,surplus pro ts on any Periodic Distribution

Dates can be held in a reserve accountand amounts held in such reserve accountcan be drawn to und any short alls in

uture Periodic Distribution Amounts orin the Exercise Price (as discussed above).Secondly, the provision o third-party,Sharia-compliant liquidity unding can beaccommodated into the structure to alsocover any such short alls; although, it isimportant to note that any such third-partyprovider can only have the right, and mustnot be obliged, to provide such Sharia-compliant liquidity unding. The Trusteewill be under an obligation to repay theSharia-compliant liquidity unding romany proceeds remaining a ter the sukukhave been redeemed in ull; and

Both Originator and Trustee can, roma Sharia perspective, terminate themusharaka at any time a ter giving notice.On termination o the musharaka, and

provided that the Purchase Undertakinghas not been exercised by Trustee, thetangible assets comprised in the musharakawill be liquidated and, together with theintangible assets, be distributed betweenOriginator and Trustee in proportion to theunits (or capital contribution) held by eachparty in the musharaka.


Sukuk on NASDAQ Dubai)), the ollowingdocumentation is typically required or a sukukal-musharaka transaction:



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Table 2

Document Parties Summary / PurposeMusharaka Agreement Originator (as Partner) and

Trustee (as Partner)From Trustees (and the Investors) perspective, thisis the document that creates the musharaka, gives itan ownership interest in the Musharaka Assets andentitles it to a share o the profts generated by thoseMusharaka Assets.


Management Agreement Trustee (as Partner) and

Originator (as ManagingAgent)

Allows Trustee to appoint Originator to manage the

Musharaka Assets in accordance with an agreedbusiness plan.

Allows Originator to implement the unding receivedrom Trustee (and the Investors) in accordance with its

business plan.



Allows Trustee to sell all o its units at market valuein the musharaka to Originator i an event o de aultoccurs or at maturity, in return or which Originatoris required to pay the market value o those units(through an Exercise Price - please also see the section

below under the heading AAOIFIs Statement o2008) which is then used to service all outstandingamounts owing to the Investors.

Sale Undertaking (Wad) Granted by Trustee in avouro Originator (as Obligor)

Allows Originator to buy Trustees units in themusharaka rom Trustee in limited circumstances (e.g.,the occurrence o a tax event), in return or whichOriginator is required to pay all outstanding amounts(through an Exercise Price) so that Trustee can pay theInvestors.

25

Shirkat al-MelkAn alternative to the shirkat al-aqd musharakaarrangement described above is the shirkat al-melk arrangement, which broadly operates as

ollows:

Either (i) Originator and Trustee bothcontribute cash to the musharaka or thepurposes o jointly acquiring an asset, or (ii)Originator sells a portion o its ownershipinterest in an asset to Trustee;



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Originator and Trustee become co-owners o the relevant asset, each withan ownership interest in the whole othe asset. As a result o this, shirkat al-melk arrangements cannot be divided orunitised in the manner that shirkat al-aqdarrangements can (as described above);

On maturity or early dissolution due to anevent o de ault, optional call or tax event,Trustee would sell its ownership interestback to Originator or an Exercise Price.Similar to the shirkat al-aqd structure, pre-AAOIFIs Statement, the Exercise Price waso ten xed at the outset to be an amountequal to the Principal Amount plus anyaccrued but unpaid Periodic DistributionAmounts owing to the Investors. However,

ollowing on rom the AAOIFI Statementthe general Sharia position is that wherethe Originator and the purchaser under thePurchase Undertaking are the same entity,

the Exercise Price cannot be xed in thismanner and must instead be determinedby re erence to the market value o theMusharaka Assets at the time o sale(please see the section below under theheading AAOIFIs Statement o 2008 or

urther in ormation). Again, as a result othis, there is a risk that the Exercise Price

will be less than the amount required topay the Principal Amount and all accruedbut unpaid Periodic Distribution Amountsowing to the Investors. This risk canbe mitigated by integrating additionalstructural enhancements into the structureincluding (i) the maintenance o a reserveaccount (as discussed above); and (ii) theoption o a third party providing Shariacompliant liquidity unding to undany short alls in any payments due toCerti cateholders (see the section aboveheaded Key eatures o the UnderlyingStructure or urther detail ); and

For the purposes o such an arrangement,it will also be necessary to consider whatinterest is being sold to Trustee (i.e. legalor bene cial).

As an additional structural enhancement,the Trustee could lease its ownership

interest in the Musharaka Asset(s) to theOriginator in return or periodic rentalpayments. I such an enhancement isimplemented, the points highlighted inPart 1 (Sukuk al-Ijara) o this Chapter 2(Sukuk Structures) will also need to beconsidered.

Where a sukuk is structured to be amortising,a diminishing musharaka arrangement can beimplemented. Pursuant to this arrangement,both the Originator and Trustee must jointlyown the asset and on any date on which theamortisation is to occur, Trustee would sell

some o its units or part o its co-ownershipinterest in the musharaka asset(s) to Originator.As a consequence o such sale, Trustees unitsor ownership interest (as the case may be) inthe Musharaka Asset(s) decreases over the li eo the sukuk.

Diminishing Musharaka


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AAOIFIs Statement o 2008

Be ore the AAOIFI Statement it was possible orthe Originator to grant a purchase undertakingto the Trustee and or the Exercise Price to bea xed amount determined in accordance witha ormula (and not by re erence to the marketvalue o the Musharaka Assets). The ExercisePrice would there ore typically have been, inthe event o a de ault or maturity, equal to the

ace amount o the sukuk plus any accrued butunpaid Periodic Distribution Amounts. TheInvestors were there ore guaranteed to receivetheir principal investment and pro t (subject tothe usual risks, such as insolvency, present inany sukuk or conventional bond structure).However, under the AAOIFI Statement, Shariascholars have taken the view that it is notpermissible or an Originator to grant a purchaseundertaking to the Trustee to purchase the

Musharaka Assets or any amount other thanthe Trustees share o the market value o theMusharaka Assets at the time o sale. Thepremise or this ruling has been that sukukal-musharaka are analogous to equity-basedinstruments and there ore the partners in themusharaka must take the risk o both pro t andloss. Determining the value o the MusharakaAssets by re erence to the ace amount o thesukuk (or by re erence to a short all amount)is akin to a guarantee o pro t and principal,which, unless given by an independent thirdparty (i.e. anyone other than the Originator),is not permitted under Sharia. This ruling hasresulted in a signi cant decline in the numbero sukuk al-musharaka issuances in 2008 and2009.


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Introduction


Chapter 2

Part 3: Sukuk al-Mudaraba

When structuring a sukuk issuance, the rst stepis o ten to analyse what exactly the business oan originator entails and what assets (i any)are available to support the issuance o sukuk.I at the outset, it is not possible to identi y aspeci c tangible asset or investment, the sukukal-mudaraba (or a sukuk al-musharaka, pleasere er to Part 2 o Chapter 2) may be a viablealternative to the sukuk al-ijara structure.

In the Islamic nance industry, the termmudaraba is broadly understood to re er to a

orm o equity-based partnership arrangementwhereby one partner provides capital (the Rabal-Maal) and the other provides managerialskills (the Mudarib).

The same characteristics o the mudarabastructure can also be adapted or use as theunderlying structure in a sukuk issuance as each

Investors purchase o sukuk would representunits o equal value in the mudaraba capital,and are registered in the names o the sukukcerti cateholders on the basis o undividedownership o shares in the mudaraba capital.The returns to the Investors would representaccrued pro t rom the mudaraba capital at

a pre-agreed ratio between the Rab al-Maaland the Mudarib, which would then passto the Investors according to each Investorspercentage o investments in sukuk mudaraba.Examples o recent sukuk al-mudarabaissuances and advised upon by Cli ord ChanceLLP are:

SAR1 billion issuance by Purple Island/BinLaden in November 2008 (no purchaseundertaking)

Abu Dhabi Islamic Banks AED2 billionTier I issuance issued in February 2009 (nopurchase undertaking);

DP World, US$1.5 billion issued in July2007, which was part o a US$5 billionglobal medium term note programme;and

IIG Funding Limited, US$200 millionissued in July 2007 and listed on NASDAQDubai.

Set out on the ollowing page is an example oa typical sukuk al-mudaraba structure.


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Figure 3: Structure o Sukuk al-Mudaraba

MUDARABA ENTERPRISE

MUDARABA AGREEMENT ORIGINATORas Mudarib

ISSUER SPVas Trustee and Rab al Maal

INVESTORS

4

Enterprise and Management

7

Cash2

1Sukuk (TrustCerticates)

3Cash

9 Periodic return fromMudaraba prots

8 Share in Mudaraba prots(if any) according to theMudaraba Agreement

5Cash + Enterpriseand Management

6 Mudaraba prots (if any)

Performance fees (if any)according to the Mudaraba Agreement

29

Issuer SPV issues sukuk, which represent1. an undivided ownership interest in anunderlying asset, transaction or project.They also represent a right against IssuerSPV to payment o expected periodicreturn rom Mudaraba pro ts.

The Investors subscribe or sukuk and2.pay the proceeds to Issuer SPV (thePrincipal Amount). Issuer SPV declaresa trust over the proceeds (and any assets

or Mudaraba interests acquired using theproceeds) and thereby acts as Trustee onbehal o the Investors.

Issuer SPV and Originator enter into a3.Mudaraba Agreement with Originatoras Mudarib and Issuer SPV as Rab al-Maal, under which Issuer SPV agrees tocontribute the Principal Amount or thepurpose o a Sharia compliant Mudarabaenterprise.



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Originator, as Mudarib under the4.Mudaraba Agreement, agrees tocontribute its expertise and managementskills to the Sharia compliant Mudarabaenterprise, with responsibility ormanaging the Rab al-Maals cashcontribution in accordance with speci edinvestment parameters.

Issuer SPV and Originator enter into the5.Mudaraba enterprise with the purposeo generating pro t on the PrincipalAmount.

Pro ts generated by the Mudaraba6.enterprise are divided between IssuerSPV (as Rab al-Maal) and Originator (asMudarib) in accordance with the pro tsharing ratios set out in the MudarabaAgreement but accrued or the durationo the Mudaraba enterprise.

In addition to its pro t share, Originator7.(as Mudarib) may be entitled to aper ormance ee or providing itsexpertise and management skills ithe pro t generated by the Mudarabaenterprise exceeds a benchmarkedreturn. This per ormance ee (i any)would be calculated at the end o theMudaraba term and upon liquidation othe Mudaraba.

Issuer SPV receives the Mudaraba pro ts8.and holds them as Trustee on behal othe Investors.

Issuer SPV (as Trustee) pays each periodic9.return to Investors using the Mudarabapro ts it has received under theMudaraba Agreement.

On maturity o the sukuk al-mudaraba, the

Mudaraba enterprise would be dissolved inaccordance with the terms o the MudarabaAgreement and the Trustee would exercise apurchase undertaking to call on Originator tobuy the Mudaraba interests rom the Trustee atmarket value so that the proceeds can be usedto service the outstanding amounts due to theInvestors. The Investors would be entitled toa return comprising their pro rata share o themarket value o the liquidated Mudaraba capitaland the pro t generated by the Mudarabaenterprise and accrued during the term o thesukuk issuance.

Upon maturity, the assets o the Mudarabaenterprise would be liquidated and the proceedswould be applied: rstly, in the return o thecapital initially contributed by Issuer SPV; andsecondly, in the distribution o any remainingdissolution returns between Issuer SPV andOriginator in accordance with the same pro tsharing ratios. Issuer SPV (as Trustee) then

pays such dissolution returns to the Investorsredeeming the sukuk certi cates.

Although the pro ts generated during the termo the Mudaraba enterprise are accrued ordistribution on dissolution at maturity, periodicaldistributions to Investors may nonetheless beachieved during the term o the sukuk issuancethrough payments o advance pro ts.This would typically be e ected by way o a

constructive liquidation o the Mudaraba assetsat speci ed intervals whereby the amounts oadvance pro t would represent the di erencebetween:

the market value o the Mudaraba(i)assets on the relevant constructiveliquidation date; and

the par value o the Mudaraba(ii)assets.


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Set out below is a summary o the basicrequirements that should be considered whenusing mudaraba as the underlying structure orthe issuance o sukuk:

Originator (as Mudarib) dischargesand per orms its obligations under theMudaraba Agreement with the degreeo skill and care that it would exercise inrespect o its own assets;

An investment plan in respect o theMudaraba enterprise will be tailored withinSharia parameters to meet the nancingobjectives o the sukuk al-mudaraba asset out in the Mudaraba Agreement (theterms o which would also be speci ed inthe sukuk prospectus);

The Mudaraba would be entered into

on a restricted basis (an al-mudaraba al-muqayyadah) in which Originator (asMudarib) must invest the sukuk proceeds inaccordance with the speci ed investmentplan. For Sharia purposes, at least 33%o the capital o the Mudaraba enterpriseshould be invested in tangible assets(also known as the asset-backing ratio ortangibility requirement) at all times;

The pro t sharing ratio between IssuerSPV (as Rab al-Maal) and Originator (asMudarib) must be agreed at the time o theconclusion o the Mudaraba Agreement,but this cannot be expressed as a ratebased on each partys contribution in theMudaraba enterprise nor as a pre-agreedlump sum;

Any losses o the Mudaraba enterprisewould be borne by Issuer SPV (as Rab al-Maal), although its liabilities are limitedto proceeds invested (there ore, Investorswould not be liable or more than theirinvestment into the sukuk al-mudaraba);and

The risk o passing any losses o theMudaraba enterprise to Investors may bemitigated through the use o a purchase

undertaking granted by Originator(as Promissor) in avour o Issuer SPV(as Promisee) so that in the event thatproceeds rom the Mudaraba enterpriseare insu cient in meeting any amountspayable by Issuer SPV to Investors, IssuerSPV may call on Originator to purchaseits Mudaraba interests or a price whichrepresents their market value.



Sukuk on NASDAQ Dubai)), the ollowingdocumentation is typically required or a sukukal-mudaraba transaction:



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Table 3

Document Parties Summary / PurposeMudaraba Agreement Originator (as Mudarib) and

Trustee (as Rab al-Maal)Sets out the terms o the Mudaraba enterprise underwhich the Trustee shall invest the Principal Amountand prescribes the proft sharing ratios between theparties.



Allows Originator to buy the Mudaraba interests romTrustee or an exercise price which is equal to themarket value o such interests on the exercise datei an event o de ault with respect to the Originatoroccurs during the term o the Mudaraba enterpriseor on the date o the dissolution o the Mudarabaenterprise so that Trustee may apply the proceeds topay Investors.


Be ore the AAOIFI Statement it was possible orthe Originator to grant a purchase undertakingin avour o the Trustee whereby the exerciseprice would be a xed amount determined inaccordance with a ormula that would ensurethat the exercise price would:

in the event o a de ault or on maturityo the sukuk, be equal to the par valueo the sukuk plus any accrued but unpaidMudaraba pro ts; or

in the event o a short all between anyamount actually received by the Trustee

rom the Mudaraba enterprise and thepro ts received by the Trustee and thedistribution amount due to the Investors,be equal to the short all,

rather than a ormula would re erence themarket value o the assets o the Mudarabaenterprise. The use o such purchaseundertakings, in e ect, ensured that theInvestors were almost certain to receive theirprincipal sukuk investment and pro t (subjectto the usual risks such as insolvency present inany sukuk or conventional bond structure).

However, under the AAOIFI Statement, Shariascholars have taken the view that it is notpermissible or an Originator to grant a purchase

undertaking to the Trustee to purchase theMudaraba assets or any amount other thanthe Trustees share o the market value o theMudaraba assets at the time o sale. The premise

or this ruling has been that sukuk al-mudarabaare analogous to equity-based instruments and

Structural Developments/AAOIFIs Statement o 2008


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33

there ore the partners in the Mudaraba musttake the risk o both pro t and loss. Determiningthe value o the Mudaraba assets by re erenceto the par value o the sukuk (or by re erenceto a short all amount) is akin to a guarantee opro t and principal which, unless given by an

independent third party (a party other than theOriginator), is not permitted under Sharia. Thisruling is another reason why the sukuk markethas not seen a revival o the sukuk al-mudarabastructure.


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Chapter 2

Part 4: Sukuk al-Salam

Generally, in order or a sale to be valid underSharia the object orming the subject mattero the sale must be in existence and in thephysical or constructive possession o theseller. The exceptions to this general positionare sales e ected pursuant to salam and istisnacontracts.

In its simplest orm, a salam contract involvesthe purchase o assets by one party romanother party on immediate payment andde erred delivery terms. The purchase price othe assets is typically re erred to as the salamcapital and is paid at the time o entering intothe salam contract. The assets sold under thesalam contract are re erred to as al-muslam

hi, delivery o which is de erred until a uturedate.

A salam contract may be construed as being

synonymous with the objective o a orwardsale contract. Forward sale contracts aregenerally orbidden under Sharia unless theelement o uncertainty (gharar) inherent insuch contracts is e ectively eradicated. For thisreason, certain criteria must be met in order

or a salam contract to be Sharia compliant.These requirements are discussed in more detailbelow under the heading Key Features o theUnderlying Structure.

Although the use o salam has been, and is,utilised by some institutions or short-termliquidity purposes, its use as the plat orm orissuing sukuk, as an alternative to conventionalbonds, is rare in comparison to some o themore prevalent structures like sukuk al-ijara. Thelimited use o this structure can be attributed toa number o actors, namely the non-tradabilityo the sukuk and the requirement that theOriginator must be able to deliver certain

standardised assets to the Issuer at certainuture dates which may be di cult where the

Originators business model does not provideor this.

When structuring a sukuk issuance as a sukukal-salam, the rst step will involve analysingwhat exactly the business o the Originatorentails and what standardised assets (i any)the Originator is able to deliver to support theissuance o the sukuk. At the outset, i it is notpossible to identi y any such assets, it will benecessary to consider other possible structures(including those outlined in the other parts othis Chapter 2 (Sukuk Structures)).

As with the other sukuk structures, it is possibleto structure a sukuk al-salam in a manner thatprovides or regular payments throughout theli e o a nancing arrangement, together with

the fexibility to tailor the payment pro le - andmethod o calculation - in order to generate apro t. The AAOIFI Sharia Standards perceivedebt securitisation and tradability as non-Shariacompliant. As such, although the characteristicso salam make it relatively straight orward toadapt or use in the underlying structure or asukuk issuance, its use remains rare in practiceas the salam contract creates indebtedness onthe part o the seller thereby rendering these

sukuk non-tradable in nature.

As at the date o this Guide no sukuk al-salamissuances have been listed by originators onNASDAQ Dubai.

Set out on the ollowing page is an example oa sukuk al-salam structure.

Introduction


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Figure 4: Structure o Sukuk al-Salam

ORIGINATORas Seller

ORIGINATORas Seller


INVESTORS

ORIGINATORas Obligor under Purchase

Undertaking and underSale Undertaking

ORIGINATORPurchase

Undertaking

9Sale-back of Salam Assets

Exercise Price

7 Purchase Price



6Periodic sale-backof Salam Assets

4 Sale Price(Considerationfor Sale)

3

Sale of Salam Assetswith delivery on a

deferred basis

10

Cash


5 Delivery of Salam Assets

2

8

35

Issuer SPV issues sukuk, which represent1.an undivided ownership interest in

certain assets (the Salam Assets) tobe delivered by Originator. They alsorepresent a right against Issuer SPV topayment o the Periodic DistributionAmount and the Dissolution Amount.

The Investors subscribe or sukuk and2.pay the proceeds to Issuer SPV (thePrincipal Amount). Issuer SPV declaresa trust over the proceeds (and any assetsacquired using the proceeds see

paragraph 3 below) and thereby acts asTrustee on behal o the Investors.

Originator enters into a sale and purchase3.arrangement with Trustee, pursuantto which Originator agrees to sell, andTrustee agrees to purchase, the SalamAssets rom Originator on immediatepayment and de erred delivery terms.The quantity o the Salam Assets soldwill typically be engineered at the outsetto be an amount that is su cient tomake periodic deliveries o a proportion



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o the Salam Assets during the li e o thesukuk (in order to allow or paymentso Periodic Distribution Amounts, seebelow or urther in ormation) and tomake a single delivery o the remainingproportion o Salam Assets on maturityor an early redemption o the sukuk(in order to allow or payments o theExercise Price, see below or urtherin ormation).

Trustee pays the sale price to Originator4.as consideration or its purchase o theSalam Assets in an amount equal to thePrincipal Amount.

Prior to each date on which Periodic5.Distribution Amounts are due to theInvestors, Originator delivers a proportiono the Salam Assets to Trustee.

Originator (as Obligor) purchases a6.

proportion o the Salam Assets romTrustee or an agreed Purchase Price.

Originator pays the Purchase Price as7.consideration or purchasing a proportiono the Salam Assets. The amount o eachPurchase Price is equal to the PeriodicDistribution Amount payable under thesukuk at that time. This amount will becalculated by re erence to a xed rate

or variable rate (e.g. LIBOR or EIBOR)depending on the denomination o sukuk

issued and subject to mutual agreemento the parties in advance.

Issuer SPV pays each Periodic Distribution8.Amount to the Investors using the PurchasePrice it has received rom Originator.

Upon:9.An event o de ault or at maturity(i).(at the option o Trustee under thePurchase Undertaking); or

The exercise o an optional call (i(ii).applicable to the sukuk) or theoccurrence o a tax event (both atthe option o Originator under theSale Undertaking),

Originator will be obliged to deliver allo the Salam Assets (which have not yetbeen delivered) to Trustee and Trusteewill sell, and Originator will buy, the

Salam Assets at the applicable ExercisePrice which will be equal to the PrincipalAmount plus any accrued but unpaidPeriodic Distribution Amounts owing tothe Investors.


Issuer SPV pays the Dissolution Amount11.

to the Investors using the Exercise Price ithas received rom Originator.

Set out below is a summary o the basicrequirements based on established principlesand the AAOIFI Sharia Standards No.10 (Salamand Parallel Salam), which should be considered

when using salam as the underlying structureor the issuance o sukuk:

There must be no uncertainty between



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37

the Originator and the Issuer as to thecurrency, amount and manner o paymento the salam capital;

Payment o the salam capital must bemade immediately at the time o entry intothe salam contract;

The Salam Assets can only be (i) ungiblegoods that can be weighed, measured orcounted and the individual articles o whichdo not di er signi cantly, or (ii) assetsmanu actured by companies that can beidenti ed by standardised speci cationsand are regularly and commonly availableat any time;

The Salam Assets cannot be (i) a specifcasset; (ii) gold, silver or any currency i thesalam capital was paid in gold, silver or anycurrency; (iii) any asset or item or which theOriginator may not be held responsible (e.g.

land or trees); and (iv) any asset or item whosevalue can change according to subjectiveassessment (e.g. precious stones);

The Salam Assets must be assets or whicha speci cation can be drawn up at thetime o sale so that the Originator can beheld to that speci cation;

The quality, quantity and time o delivery o

the Salam Assets must be clearly known tothe Originator and the Trustee in a manner

that removes any uncertainty or ambiguitywhich may lead to a dispute;

Provided that the salam capital is paid atthe time the salam contract is entered into,the delivery o the Salam Assets can occurperiodically by way o instalments;

The Trustee cannot sell the Salam Assetsbe ore it has taken delivery o the SalamAssets as this would amount to the sale oa debt, which is orbidden under Sharia.However, delivery o the Salam Assets priorto the agreed delivery date is permissible;

The sukuk certi cates held by the Investorsare generally non-tradable as they representa debt (the debt being the uture deliveryo the Salam Assets). This is, however,the general position. In principle, oncethe Salam Assets (or a proportion thereo )have been delivered and provided that as

a result o such delivery the tangibility othe pool o sukuk assets at that time (i.e.the Salam Assets delivered) is su cient tosatis y Sharia requirements (which canvary between 33% and 50%) the sukukcan be traded at that time; and

The liabilities associated with the SalamAssets remain with the Originator and onlyonce the Salam Assets have been delivered

to the Trustee do the liabilities pass to theTrustee.


Sukuk on NASDAQ Dubai)), the ollowingdocumentation is typically required or a sukukal-salam transaction:



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Table 4

Document Parties Summary / PurposeSalam Agreement Originator (as Seller) and

Trustee (as Purchaser)From the Trustees (and the Investors) perspective,this is the document which gives the right to receivedelivery o the Salam Assets, which once deliveredto the Trustee will be sold by the Trustee in order togenerate revenue to service the sukuk.

From the Originators perspective, this is the documentunder which it receives the unding.

Purchase Undertaking

(Wad)

Granted by Originator (as

Obligor) in avour o Trustee

Allows the Trustee to sell the Salam Assets back to the

Originator*:(i) periodically, prior to the date on which a PeriodicDistribution Amount is due in return or which theOriginator is required to pay an amount equal to thePeriodic Distribution Amount (through the PurchasePrice) so that the Trustee can pay the PeriodicDistribution Amount to the Investors; and

(ii) i an event o de ault occurs or at maturity, inreturn or which the Originator is required to pay alloutstanding amounts (through an Exercise Price) so

that Trustee can pay the Investors.Sale Undertaking (Wad) Granted by Trustee in avour

o Originator (as Obligor)Allows the Originator to buy the Salam Assets back

rom the Trustee* in limited circumstances (e.g., theoccurrence o a tax event), in return or which theOriginator is required to pay all outstanding amounts(through an Exercise Price) so that Trustee can pay theInvestors.

* The sale o the Salam Assets by the Trustee to the Originator can only occur a ter the Originator has delivered(either physically or constructively) the Salam Assets (or, in the case o periodic sales, a proportion thereo ) tothe Trustee.



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39

Although Islamic nancial markets have seenrapid growth in recent times in the size andnumber o sukuk issuances, the use o sukukal-salam by originators and Islamic nancialinstitutions has been very limited. As a directconsequence o this, there has been a signi cantlack o development o the structure outlinedabove.

An alternative to the sukuk al-salamarrangement described above, and onethat has been implemented in practice ( orexample, by the Central Bank o Bahrain) orshort term investment purposes, is where theOriginator does not buy back the Salam Assets

under the Purchase Undertaking but is insteadappointed by the Trustee as its agent to sell theSalam Assets at the time o delivery throughits distribution channels to a third party in theopen market or a price at least equal to theamounts due under the sukuk. This would,however, expose the Investors to risk that theOriginator either: (i) may not be able to sell theSalam Assets to a third party; (ii) may be ableto sell the Salam Assets but at a price lowerthan the amount due under the sukuk; and (iii)where a third party has already undertaken topurchase the Salam Assets, that third party ailsto do so.



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Chapter 2

Part 5: Sukuk al-Istisna

Alternatively re erred to as the Islamic projectbond, the structure o sukuk al-istisna hasnot been that widely used. Although, at rstglance, the structure appears ideal or the

nancing o green eld development, certainstructural drawbacks have proven di cult toovercome and, as a result, sukuk al-istisna hasnot eatured as an alternative source o Islamic

unding on multi-sourced project nancing inthe manner once predicted.

O particular signi cance is the prevailing viewthat sukuk al-istisna are not tradable during theconstruction period. In addition to this, thedi erent approaches taken by Sharia scholarsto advance rentals and istisna terminationpayments have also led structurers to considerother more fexible structures (such as sukukal-musharaka).

Broadly speaking, istisna translates as being toorder a manu acturer to manu acture a speci cgood or the purchaser. Under an istisna, itis important that the price and speci cation othe good to be manu actured are agreed at theoutset.

In the modern day context o Islamic nance, theistisna has developed into a particularly use ultool in the Islamic unding o the construction

phase o a project it is o ten regarded as beingsimilar to a xed-price turnkey contract.In order to enable investors to receive a returnduring the period where assets are beingconstructed under an istisna arrangement,some Sharia scholars have permitted the useo a orward lease arrangement (known as ijaramawsu ah al-dimmah) alongside such istisnaarrangement. Accordingly, sukuk al-istisnao ten combines an istisna arrangement with a

orward lease arrangement whilst the istisna

is the method through which the investorscan advance unds to an originator, the ijaraprovides the most compatible payment methodto those investors.

The use o staged payments (a commoneature in istisna construction arrangements

see urther below) may however result in anunutilised amount o sukuk proceeds beingheld in the structure or a prolonged periodduring construction (pending the achievemento the relevant milestones). Accordingly, itmay be necessary to consider investing theseamounts in Sharia-compliant investments inorder to mitigate negative carry (i.e. periodicdistributions continue to be payable whilstcash remains unutilised a position which islikely to be unacceptable to the originator). Itshould, however, be noted that this approachto investment o the unutilised sukuk proceeds

has received some criticism.

As o the date o publication, there are nosukuk al-istisna issuances listed by originatorson NASDAQ Dubai.

The Qatar Real Estate Investment Company(QREIC) sukuk o ering in 2006, which has anistisna component to its structure, is listed onthe Euro MTF market o the Luxembourg Stock

Exchange. The 2008 issue o a second sukukby National Central Cooling Company (Tabreed)also has an istisna and is listed on the LondonStock Exchange.

Set out in the ollowing page is a basic exampleo a sukuk al-istisna structure.

Introduction


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Figure 5: Structure o Sukuk al-Istisna

ORIGINATORas Contractor

ORIGINATORas Lessee


INVESTORS

ORIGINATORas Service Agent

ORIGINATORas Obligor under Purchase

Undertaking and underSale Undertaking

11Appointment asServicing Agent

5Forward Leaseof Assets

Reimbursements of Servicing Costs(set-off againstSupplemental Rental)

9 Exercise Price*

* See below regarding IstisnaTermination Payment



8Sale of Assets4 Contract Price(by way of Phase Payments)

3

Undertakes to deliverAssets at a Future Date

12

Cash


6 Advance Rentalsand Actual Rentals

2

7

41


Issuer SPV issues sukuk, which represent1.an undivided ownership interest in an

underlying asset or transaction. Theyalso represent a right against Issuer SPVto payment o the Periodic DistributionAmount and the Dissolution Amount.

The Investors subscribe or sukuk and pay2.the proceeds to Issuer SPV (the PrincipalAmount). Issuer SPV declares a trust over theproceeds (and any assets acquired using theproceeds - see paragraph 3 below) and therebyacts as Trustee on behal o the Investors.

Originator enters into an istisna arrangement3.with Trustee, pursuant to which Originator

agrees to manu acture or construct certainassets (the Assets) and undertakes todeliver those Assets at a uture date, andTrustee agrees to commission those Assets

or delivery at such uture date.

Trustee pays a price (typically by way4.o staged payments against certainmilestones) to Originator as consideration

or the Assets in an aggregate amountequal to the Principal Amount.


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Trustee undertakes to lease the Assets5.to Originator under a orward leasearrangement (known as ijara mawsu ah al-dimmah) or an overall term that refectsthe maturity o the sukuk.

Originator (as Lessee) makes payments o :6.Advance Rental prior to the delivery(i).o the Assets; and

Actual Rental ollowing the delivery(ii).o the Assets,

at regular intervals to Trustee (as Lessor) inamounts which are equal to the PeriodicDistribution Amount payable under thesukuk at that time. These amountsmay be calculated by re erence to a

xed rate or variable rate (e.g. LIBOR orEIBOR) depending on the denominationo sukuk issued and subject to mutualagreement o the parties in advance.

Issuer SPV pays each Periodic Distribution7.Amount to the Investors using theAdvance Rental or, as the case may be,the Actual Rental it has received romOriginator.

Provided that delivery o the Assets has8.occurred, upon:

an event o de ault or at maturity(i).

(at the option o Trustee under thePurchase Undertaking); or

the exercise o an optional call (i(ii).applicable to the sukuk) or theoccurrence o a tax event (both atthe option o Originator under theSale Undertaking),

Trustee will sell, and Originator willpurchase, the Assets at the applicable

Exercise Price, which will be equal to thePrincipal Amount plus any accrued butunpaid Periodic Distribution Amountsowing to the Investors. Any terminationoccurring prior to the delivery o theAssets will be dealt with under theistisna arrangement - with a re undand compensation amount (an IstisnaTermination Payment) being requiredin order to leave Issuer SPV with aclaim against Originator or an amountsu cient to cover the Dissolution Amount(taking into account that the Issuer SPVwill also be required to re und AdvanceRentals to the Originator (as Lessee)under the orward lease arrangement see urther below).

Payment o Exercise Price by Originator9.(as Obligor) or, i termination occursprior to delivery o the Assets, paymento the Istisna Termination Payment by

Originator (as Contractor).

Issuer SPV pays the Dissolution Amount10.to the Investors using the ExercisePrice (or, i termination occurs priorto delivery o the Assets, the IstisnaTermination Payment) it has received

rom Originator.

1112. Trustee and Originator will enter into

a service agency agreement wherebyTrustee will appoint Originator as itsServicing Agent, on and rom deliveryo the Assets, to carry out certain oits obligations under the orward leasearrangement, namely the obligationto undertake any major maintenance,insurance (or taka ul) and paymento taxes in connection with theAssets. To the extent that Originator(as Servicing Agent) claims any costs


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43

and expenses or per orming theseobligations (the Servicing Costs)the Actual Rental or the subsequentlease period under the orward leasearrangement will be increased by an

equivalent amount (a SupplementalRental). This Supplemental Rental due

rom Originator (as Lessee) will be seto against the obligation o Trustee topay the Servicing Costs.

Set out below is a summary o the basicrequirements that should be considered whenusing a combination o istisna and orwardleasing as the underlying structure or theissuance o sukuk:

The price and speci cations or the good orasset need to be speci ed at the outset;

It is quite common or the purchaser tosplit the purchase price (paid in advance)into staged payments that correspond to

certain milestones that are agreed up rontwith the contractor;

Although it is not necessary to x thetime o delivery under the istisna, thepurchaser may elect to x a maximum time

or delivery - this essentially means that,i the contractor delays delivery a ter thescheduled completion date, the purchaserwill not be bound to accept the goods and

to pay the price;

Liquidated damages provisions maybe included in order to incentivise thecontractor to deliver on schedule (and tomitigate late delivery risk);

Although not universally accepted, themajority o Sharia scholars consider

orward leasing permissible on theunderstanding that: advance rentals are

taken into account (as rental which hasbeen paid) and have to be re unded in ulli the assets are never actually delivered orleasing. Such matters have to be care ullyaddressed in the documentation in orderto ensure that the commercial deal isnot disturbed: or example, by care ulcalculation o any termination paymentsthat are triggered i a termination occurspre-delivery (i.e. it becomes necessary toensure that the amount payable by thecontractor upon termination o the istisna

arrangement is su cient to cover theDissolution Amount); and

Following delivery o the asset(s), the basicrequirements o an ijara discussed earlierin this Chapter 2 (Sukuk Structures) atPart 1: Sukuk al-Ijara in the section titledKey Features o the Underlying Structurewould otherwise apply.

The above requirements are based onthe principles set out in AAOIFI ShariaStandard No. 11 (Istisna and ParallelIstisna) and other established principlesrelating to istisna.



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Table 5


Istisna Agreement Originator (as Contractor)

and Trustee (as Purchaser)

From Trustees (and the Investors) perspective, this

is the document that gives ownership o revenuegenerating assets (i.e. the Assets) at a uture date.


Certain termination rights are granted to Trustee suchthat, prior to delivery o the Assets, Trustee is able toclaim a re und and compensation amount (by way oan Istisna Termination Payment) su fcient to cover theDissolution Amount.

Forward Lease (IjaraMawsu ah f al-Dimmah)Agreement

Trustee (as Lessor) andOriginator (as Lessee) This contains an undertaking to lease such that,ollowing delivery o the Assets, Trustee leases theAssets to Originator in a manner that:

gives Originator possession and use o thei.Assets so that its principal business cancontinue without interruption; and

through Actual Rentals it generates a debt-ii.based return or Trustee (and the Investors).

Prior to delivery o the Assets, Advance Rentals are

paid by Originator in order to generate a debt-basedreturn or Trustee (and the Investors).

Service AgencyAgreement

Trustee (as Lessor / Principal)and Originator (as ServicingAgent)

On and rom delivery o the Assets, this allows Trusteeto pass responsibility or major maintenance, insurance(or taka ul) and payment o taxes (i.e. an ownersobligations) back to Originator. Any reimbursementamounts or service charges payable to Servicing Agentare set o against (i) a corresponding supplementaryrental under the Forward Lease or (ii) an additionalamount which is added to the Exercise Price



Sukuk on NASDAQ Dubai)), the ollowingdocumentation is typically required or a sukukal-istisna transaction:



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(payable under the Purchase Undertaking or the SaleUndertaking, as applicable).



Allows Trustee to sell the Assets back to Originator ian event o de ault occurs or at maturity, in return orwhich Originator is required to pay all outstandingamounts (through an Exercise Price) so that Trusteecan pay the Investors.

Applies only on and rom delivery o the Assets.

Sale Undertaking (Wad) Granted by Trustee in avour

o Originator (as Obligor)

Allows Originator to buy the Assets back rom Trustee

in limited circumstances (e.g. the occurrence o a taxevent), in return or which Originator is required to payall outstanding amounts (through an Exercise Price) sothat Trustee can pay the Investors.

Applies only on and rom delivery o the Assets.

45

The ollowing structural re nements are possible inrespect o the sukuk al-istisna structure describedabove:

I legal and/or registered title to a particularasset exists and (due to, by way o example, theprohibitive cost implications or tax implicationso registering such a trans er o title) it is notpossible to trans er that legal / registered title,it may be possible, depending on the asset

type and the view taken by the relevant Shariascholars, to rely upon the concept o bene cialownership in structuring a sukuk al-istisnatransaction. The istisna agreement (in thestructure discussed above) would documentthe trans er to the trustee o the bene cialownership interest in the underlying asset - andsuch bene cial ownership interest would besu cient to enable the trustees entry into the

orward leasing arrangements contemplatedin the example above; and

Some Sharia scholars regard the istisnaarrangement as one that has to be enteredinto strictly between the purchaser and thecontractor and that the contractor has tobe the person who will actually constructor manu acture the asset. Adopting thisapproach, the Trustee would be required tohave a relationship directly with the ultimatecontractor / manu acturer and not theOriginator. In order to avoid the di culties

o such an analysis, it is sometimes necessaryto re-characterise the istisna arrangementas a procurement arrangement, wherebythe Originator is obliged to procure theconstruction / manu acture and delivery o theunderlying asset(s). The Originator therebyretains the direct contractual relationship withthe ultimate contractor / manu acturer.

Structural Developments and Observations


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Chapter 2

Part 6: Sukuk al-Murabaha

Although the sukuk al-murabaha structure isless commonly used in comparison to someo the other sukuk structures described inthis Chapter 2 (Sukuk S

article 11 sukuk guidebook

Documents