When Investment Dar, a Kuwaiti investment company, bought a 51 per cent stake in the maker of James Bond’s favourite car – Aston Martin – in 2008, many people commented on the transaction as “James Bond versus Islamic Bond,” because the transaction was partly financed by a sukuk – also known as an Islamic bond. That particular year proved to be the worst in the last five years. However since 2008, the Islamic bond market has bounced back, with Malaysia leading the way.
Bonds are interest-based fixed return securities, issued by governments and corporations to raise capital for business. Bonds are considered not in conformity with Shari’a primarily because they are interest-based (offer a pre-agreed rate of return to the bondholders), which is prohibited in the Shari’a.
Many people think that Islam prohibits interest only in consumption loans and that in business dealings interest is acceptable, as the borrower pays interest from their profit. This is a misconception. Islam prohibits interest in all its forms, whether for consumption or for business purposes, and whether this is small or exorbitant. It must also be clarified that the most appropriate translation of the Quranic word “riba” is “interest” and not “usury,” which is wrongly adopted by most of the English translators of the Holy Quran.
An Islamic alternative to bonds is known as “sukuk” in Islamic banking & finance. Sukuk, which is plural for the Arabic word sakk, is an investment certificate of equal value representing undivided shares in ownership of tangible assets, usufruct and services, assets of particular projects or special investment activity. Sukuk are different from the ordinary shares of companies in that the latter are issued on all the assets of a company while the former may be issued on some selected assets of the company. In practice, ownership of the underlying assets of sukuk gives the sukuk holders preference over shareholders in the event of financial distress or bankruptcy of the company.
In the most commonly used structure of sukuk, a government or a corporation sells an asset to investors for a specific period and then buys it back at the end. Between the sale and buy-back, the government/corporation leases the asset and pays rentals to the investors. An example of such a type of sukuk is the US$600 million sukuk issued by the government of Pakistan in 2005. This is also known as an ijara (leasing) sukuk. In an ijara sukuk, it is important that the underlying asset is sold to the investors and that this sale must be deemed as a true sale from the viewpoint of Shari’a. This is normally achieved by setting up an independent company – also known as a Special Purpose Vehicle (or SPV) – for the benefit of the investors. The asset is sold to this SPV for a cash price.
Shari’a requires that the SPV (if set up as a limited liability company) must be owned by the investors or at least must serve the best interests of the investors (if set up as a trust). It is important that the government or corporation in need of money (also known as obligor) must not own the SPV, even if the obligor attempts to serve in the best interests of the investors. If the SPV is owned by the obligor, then the obligor ends up selling the asset to itself, which does not make any sense (both legally as well as in shari’a).
There are other types of sukuk. If an obligor does not have an asset to sell, then a sukuk based on a partnership contract such as musharaka or mudaraba can be issued to raise capital. Musharaka is a partnership contract between two parties who jointly contribute capital and management to do business together with an agreement to share profit and loss. Mudaraba, on the other hand, is a financing contract whereby the investor finances a business managed by someone, with a view to share the profit with the manager in accordance with a pre-agreed ratio.
Examples of partnership-based sukuk include Rs. 360 million sukuk issued by Sitara Chemicals Industries Limited Pakistan in 2002. In such a case, the obligor invests the money raised through the issuance of sukuk, in a Shari’a compliant project. The obligor’s main objective is to develop the project for itself by using the money raised from the sukuk holders. Shari’a treats such sukuk very similar to shares, with the difference being that the sukuk are issued only on a specific project and not on the whole company.
There are some other structures on which sukuk can be based. In fact, there are about 30 types of sukuk in the market, including hybrid sukuk, convertible sukuk, exchangeable sukuk, and complex sukuk. An important consideration from a Shari’a viewpoint is whether sukuk can be traded in the secondary market or not. As a rule of thumb, sukuk are tradable if they are issued on tangible assets. In some cases, the sukuk are issued on receivables only, in which case the sukuk represent debt. Shari’a does not allow trading in debt and hence any sukuk issued on debt and debt like assets must not be traded in the secondary markets.
At the end, it must be emphasised that while Shari’a allows for issuing fixed income securities such as bonds, one must not forget the real differences in the underlying structures of such Shari’a compliant securities and instruments. This is why many people rightly argue in favour of Islamic nomenclature, even though it proves to be a hindrance to the understanding of Islamic banking & finance in the wider financial markets.
The writer is a Shari’a advisor to a number of banks and financial institutions and can be contacted at humayon@humayondar.com