Shariah Compliant Securitisation Presentation to Derivatives and Structured Products Working Group

Jonathan Lawrence (London) and Remsen Kinne (San Francisco)

Thursday 4 February 2010

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What is Shariah?

“O you who believe! Stand out firmly for Allah, as witness to fair dealing, and let not the hatred of others to you make you swerve towards inequality and depart from justice.”Qur’an 5:8

In the business context, Shariah is a means of conducting business through a distinct set of rules designed to facilitate fairness.

High correlation between Shariah compliant investing and socially responsible investing

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Where are Shariah rules codified?

Interpretations of the Qur’an from various Islamic schools of thought

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

The fact remains: Shariah mandates are not always consistently applied from Scholar to Scholar. Information is asymmetric, and Shariah Advisers and lawyers skilled in the area become useful to work through the counter-intuitive results

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Shariah terms

Halal – that which is permitted or compliant Haram – that which is not permitted Riba – charging of interest or unjustified increase Gharar – the taking of unreasonable risk; preventable

uncertainty Maisir – betting; gambling; reliance on chance or

speculation, rather than effort

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Industry prohibitions

Gambling Pork production or consumption Adult Entertainment Banking and finance Alcohol production or consumption Weapons production Tobacco production or use

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Riba

The charging of sums for borrowed money (i.e. interest) is forbidden

But the pledging of Halal assets, the guarantying of obligations and the leasing of property under what we might consider a finance lease (or ijara) is permissible

Murabaha is the selling of a commodity at an agreed upon mark-up, and is used in Shariah as a fixed income investment substitute.

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Shariah Finance Themes

Connection to underlying assets Commercial risk taking and sharing by all parties

(including financier) Entrepreneurship Returns linked to actual investment outcomes Sharing profit and loss Specific credit particpation in identified business

risks Satisfaction of commercial and Islamic law

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Islamic securitisation

Transforms bilateral risk sharing between borrowers and lenders into market-based refinancing of one or more underlying Islamic finance transactions

Scholar verification process: (i) type of assets; and (ii) transaction structure including credit enhancement and ownership conveyance

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Conditions

Real purpose behind fund raising; type of asset identified and not consumable

Investor pay-off from profitable ventures only Collateral assets must not be debt, cash or haram No interest generation Investors hold unconditional, unsecured payment

obligation (no guaranteed promissory note) Ownership element

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Conditions (continued)

Investor contribution proceeds not invested in short term cash instruments or interest bearing debt

Underlying assets not used for speculative purposes and low turnover

Takaful insurance Credit enhancement and/or liquidity support in

permissible form

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Sukuk

Most popular ABS structure within Islamic finance, legitimised in February 1988

Financial instruments / trust certificates representing undivided ownership share in underlying asset or interest held by issuer

Most sponsored by sovereign and quasi-sovereign issuers in Islamic countries

Right to share in profits and asset realisations Bought and sold in secondary market and used in

conjunction with other structures

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Sukuk al Ijara

CERTIFICATE HOLDERS

SELLER SPV ISSUER LESSEE

Purchase price (issue proceeds)

Issue proceeds

Sells assets

Return Issues Sukuk

Leases assets

Rent

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Sukuk al Musharaka

CERTIFICATE HOLDERS

SPV ISSUER

VENTURE

ORIGINATOR

Return Issues Sukuk

Issue proceeds

Cash contribution

Contribution in kind (at least 30%)

Share in profit and losses

Share in profits and losses

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Credit enhancement

Permitted, providing underlying assets not recharacterised

Types: First-loss accounts Non-interest bearing liquidity facilities Over-collateralisation Tranching

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Rating Criteria and Risk

Same criteria as conventional product Lack of same historical data Concerns over legal regimes / lack of rules in

jurisdictions in which underlying assets located Thinner secondary trading market Regulatory risk on failure of Shariah compliance

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Challenges

Limited enabling legislation Restrictions on foreign ownership of assets and

enterprises Limited enabling infrastructure e.g. SPVs, trusts Reference assets meeting Shariah criteria Historically no strong funding / balance sheet

rationale

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East Cameron Gas Sukuk case

East Cameron Partners (“Originator”) Musharaka sukuk July 2006 Fund Originator’s purchase of lender’s net profits

interest in and further development of Louisiana offshore natural gas properties

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Issuer: East Cameron Gas Co.(Cayman) Amount: $165.67 million Expected return: 11.25% Maturity: 13 years Rating: CCC+ Distribution: Regulation S/Regulation D Listing: N/A Governing law: U.S./Louisiana

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Securitized asset: Right to oil and gas overriding royalty interest (“ORRI”)

Repayment: From proceeds of Originator’s sales to offtakers (quarterly)

Offtake split: ~11% Originator/~90% Purchaser (Issuer’s Louisiana SPV subsidiary)

Closing reserves: ~$53 million aggregate to Issuer and Originator reserve accounts

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True sale of ORRI (RE under Louisiana law) to Purchaser by Originator

Over-collateral/projected pre-maturity full payout from ORRI funding to Purchaser

Gas offtake contract price collar Sukuk secured by assets of Issuer (ORRI and

secured accounts)

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Key Shariah compliance features Lawful underlying asset – oil and gas Acquisition of physical asset by Purchaser -- RE Risk sharing -- through Issuer/Purchaser funding

agreement True commercial value of collar – customary, well-

established pricing mechanisms Fatwa by Shariah advisors

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Reserve shortfall enforcement event (rating downgrade to CC)

Originator filed Chapter 11 October 2008 U.S. Bankruptcy Court W. D. Louisiana True sale ruling DIP financing by Sukuk investors

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GE Capital Sukuk case

Sukuk Aircraft Leasing, Inc. (“Servicing Agent”) Ijara sukuk variation December 2009 Fund purchase price for Issuer’s purchase of

portfolios of aircraft leases and beneficial ownership interests in leased aircraft from LLCs wholly-owned by Servicing Agent (“Originators”)

Servicing Agent is wholly-owned by General Electric Capital Corporation (“GE Capital”)

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Issuer: GE Capital Sukuk Ltd (Bermuda) Amount: $500 million Return: 3.875% Maturity: 5 years Rating: AA- Distribution: Regulation S Listing: LSE, NASDAQ Dubai, Bursa

Malaysia Governing law: England and Wales (except

Guarantee governed by New York law)

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Securitized asset: Aircraft leases and beneficial ownership interests in leased aircraft

Repayment 1: From Sharia compliant lease payments (semi-annually to

maturity) Repayment 2: Proceeds of Originators’

repurchase of aircraft and leases (at maturity) Closing reserves: $50 million to Issuer reserve

account for maturity/early termination

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GE Capital unsecured Guarantee Insurance undertaking (Servicing Agent) Reserve accounts reverse commodity murabaha

transactions (Issuer/Servicing Agent)

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Key Shariah compliance features Strip non-compliant portion of lease payments –

donate to charity No Sukuk holder interest in non-compliant insurance

proceeds – Servicing Agent loss payee Risk sharing – Issuer formed as trust, Sukuk

certificates evidence holders trust interests Risk sharing – unsecured payments to Sukuk holders

and unsecured guarantee No Issuer rights to receive interest – judgment interest

waiver Review by Shariah advisors (Citi Islamic Investment

Bank, Goldman Sachs International)

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“We intend to be regular issuers in the sukuk market and are heartened by the support we have seen in this first transaction.” quote attributed to GE senior vice president and

treasurer

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Shariah finance challenges

Scholars and schools of thought Lack of standardisation / certainty Often unrated, rating agencies require government

guarantees Transaction costs Asset ownership by financier involves potential

liability e.g. environmental, warranty claims Insurance / takaful Tax treatment

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Islamic securitisation

Conclusion Any questions?

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Further resources

www.aaoifi.com Accounting and Auditing Organization for Islamic Financial Institutions

www.islamic-finance.com www.securities.com/ifis Islamic Financial Information

Services (subscription required) www.shariahcap.com Shariah Capital www.sii.org.uk/web5/infopool.nsf/html/qintifq Securities

& Investment Institute: Islamic Finance Qualification

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Disclaimer

This webinar and these slides are for informational purposes only and do not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.