Contractual Enforceability Issues: Sukuk and Capital Markets Development

I. SUKUK (ISLAMIC BONDS AND SECURITIZATIONS): AN INTRODUCTION It is only in the last few years that capital markets access has been successfully achieved through the use of instruments that are compliant with the principles and precepts of Islamic Shari'ah. The Sharf ah-compliant instruments that have been most successfully used for that access are the sukuk. But the degree of access thus far achieved has been limited, and primarily restricted to issuances by sovereign entities. Thus, the development of a viable and robust Islamic capital market remains a vision, but it is beginning to take form. While primary capital markets access is developing, the development of Islamic secondary markets remains essentially nonexistent. The early sukuk issuances have been structured to allow trading of those instruments, but actual trading is minimal. Nonetheless, the potential of the sukuk as a backbone of Islamic capital markets, especially secondary markets, is recognized and acts as a further inducement to the already accelerating trend toward the use of sukuk as a primary financing vehicle for Shari* ah -compliant sovereign, corporate, project, and asset finance. In common parlance, and particularly in light of recent issuances, sukuk are often referred to as "Islamic bonds."1 They are actually more akin to "passthrough certificates,"2 "equipment trust certificates," or "investment certificates"3 due to ownership attributes. Thus, a sakk represents a proportional or fractional undivided ownership interest in an asset or pool of assets. There are two general types of sukuk: Islamic bonds and Islamic asset securitizations. Islamic bonds are based, ultimately, upon the credit of an entity-issuer, guarantor, or other credit support provider-that is participating in the transaction, rather than on specific assets and cash flows derived from those specific assets. securitizations involve asset transfers from an originator into a trust or similar special purpose vehicle ("SPV") with sukuk issuance by that SPV and payments on the sukuk derived from the payments received in respect of those transferred assets. Most sukuk offerings to date have been of the bond type, and the ultimate credit in most of those bond offerings has been a sovereign entity. There have been very few, if any, true asset securitizations, largely because of the inability to obtain ratings from major international rating firms (ratings have been obtained for the sovereign bond issuances based upon the rating of the sovereign credit). The Accounting and Auditing Organization for Islamic Financial Institutions ("AAOIFI") has issued the Standard for Investment Sukuk ("AAOIFI Sukuk Standard").4 Under the AAOIFI Sukuk Standard, sukuk are defined as certificates of equal value put to use as common shares and rights in tangible assets, usufructs, and services or as equity in a project or investment activity.5 The AAOIFI Sukuk Standard carefully distinguishes sukuk from equity, notes, and bonds.6 It emphasizes that sukuk are not debts of the issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects, or investment activities. Sukuk may not be issued on a pool of receivables. Further, the underlying business or activity, and the underlying transactional structures (such as the underlying leases), must be Shari'ahcompliant (for example, the business or activity cannot engage in prohibited business activities). The AAOIFI Sukuk Standard provides for fourteen eligible asset classes. In broad summary, they are securitizations: (a) of an existing or to-be-acquired tangible asset (ijara, or lease); (b) of an existing or to-be-acquired leasehold estate (ijara); (c) of presales of services (ijara); (d) of presales of the production of goods or commodities at a future date (salam, or forward sale); (e) to fund construction (istisna'a, or construction contract); (f) to fund the acquisition of goods for future sale (murabaha, or sale at a markup); (g) to fund capital participation in a business or investment activity (mudaraba or musharaka, or types of joint ventures); and (h) to fund various asset acquisition and agency management (wakala, or agency), agricultural land cultivation, land management, and orchard management activities. …