Modern Sukuk Structure, Capital Markets Compliant?| IRR Part XIV

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

OUTLINE OF A MODERN SUKUK STRUCTURE – IS IT CAPITAL MARKETS COMPLIANT OR NOT?

            Over time, efforts have been made to better adapt the Sha’ariah compliant models noted above to the needs of the capital markets. Thus, in the area of Sukuk[1]financing, a number of innovations have been introduced to make Sukuk appear to perform more like a bond financing. This includes the following:

1. A credit enhancing guarantee, by the sovereign state or other credit- worthy sponsoring party, of the Sukuk offering, which, in effect, transforms the Sukuk into what amounts to sovereign or other credit-worthy corporate debt[2].
2. A separate set of loan-like documents is executed and embedded in the Sukuk structure described below, which attempts to mimic the more traditional note and mortgage used in capital markets transactions.

a. Three special purpose entities (“SPE’s”)  are created.

b. One is owned by the borrower, one is owned by the lender and one is owned by a servicer employed by the lender.

c. The borrower causes the transfer of title to the real estate to the servicer’s SPE.

d. The servicer’s SPE enters into an Ijara type lease transaction with the borrower’s SPE, as more fully discussed below.

e. The servicer’s SPE enters into a note and mortgage with the lender’s SPE,  whereby the real estate is putatively encumbered

A similar structure is used to finance goods except that instead of an Ijara type structure underlying the transaction, a Murabaha (deferred purchase price) arrangement is entered into by the servicer’s SPE, which takes title to the goods and resells them to the borrower’s SPE at an interest-based markup.. However, the lender’s SPE and servicer’s SPE enter into a note and security (pledge) agreement (instead of a mortgage) to encumber the goods. .

The problems associated with these structures are manifold. Indeed, in recent times, as they have been tested in bankruptcy courts or in restructurings, the basic flaws have become manifest, as outlined below.

Summarized below is a compilation of some of the issues presented by the Sukuk structure described above:

1. Whether it is the underlying Ijara or Murabaha structure, as the case may be, the rent or marked-up purchase price, respectively, are interest-based amounts; not the real market rent or purchase price. Thus, the rent or marked-up purchase price, respectively, is computed, like interest, as a function of the principal amount loaned. In substance, this is hardly the kind of arrangement that many Sha’ariah scholars accept as being Sha’ariah compliant.
2. Furthermore, the embedded set of loan documents noted above, that are indeed interest bearing, give lie to the pretentions that the structure is Sha’ariah compliant. Yes, the note is not signed by the borrower, but the transaction is an integrated one. The embedded mortgage securing the note in the underlying Ijara structure does encumber the real estate. Similarly the embedded pledge that encumbers the goods purchased in the underlying Murabaha structure. In addition there is a three-party agreement required that is signed by the borrower’s SPE, the servicer’s SPE and the lender’s SPE. This required document brings the lender and borrower together in manner that validates the interest bearing note and mortgage structure so critical to the capital markets. It also integrates the Sha’ariah compliant structure and the non-Sha’ariah compliant documents embedded therein in a meaningful way, as discussed below.
3. Pre-payment also creates a number of issues. This is because the Sukuk documents (based on a rental structure under the Ijara format or the deferred purchase arrangement under a Murabaha format) don’t permit pre-payment. Nevertheless, the practice is to permit pre-payment with a concomitant reduction in the rent or marked-up purchase price, as the case may be, to account for the shorter duration that the loan is extant and hence the reduced imputed interest accrued thereon. But there is no document executed at the closing that permits the foregoing. This creates a number of legal issues in the case of consumer lending such as home mortgages. This includes the truth in lending requirements as well as local consumer protection laws designed to prohibit this kind of predatory lending. Imagine having to pay what amounts to all the interest for the entire term, even if prepay.
4. The ownership of the real estate by a bank lender or its agent (i.e.: the servicer), on its behalf, creates legal, regulatory and liability concerns. Banks are generally not permitted to own real estate (with limited exceptions as noted herein). The ownership of real estate, even for a moment of time can expose the lender to potential environmental liabilities. This is because if the lender is in the chain of title then it may have cleanup responsibilities. On the other hand as a mere mortgagee, there is an innocent lender exception built into the federal law. As an owner of real estate, there is exposure to other liabilities as well, including slip and fall cases and as the landlord with respect to any tenants.
5. There are income tax concerns arising out of the ownership, directly or indirectly, of real estate while the parties might argue that in substance the transaction is a loan for tax purposes, there is no assurance that this position will be respected. As a matter of form, the lender, through its agent, is the owner of the property.. Often these concerns are addressed in the three-party agreement noted above. However, there is no assurance that federal and local taxing authorities will accept the agreement of the parties as determinative.
6. There are also other local tax concerns. Thus, for example in New York City, there are transfer taxes and mortgage taxes. In the Sukuk structure noted above based on an underlying Ijara, instead of one transfer tax on the transfer from the seller to the buyer in a typical transaction, there would be three transfer taxes due, as follows; a) on the transfer to the servicer SPE, b) another on the Ijara lease (as a lease with option to buy) and then c) yet another on the ultimate transfer to the borrower. These are significant costs, typically equal to upwards of 4% or more of the purchase price (albeit, somewhat less on the rental value the Ijara lease). Imagine having to pay 12% of the price instead of 4%. Although the Ijara structure does not require a mortgage, the more modern Sukuk does and thus, there is mortgage tax due. However, this is typically the case in a traditional home mortgage financing as well.
7. There are bankruptcy remoteness concerns with the various Sha’ariah structures noted above. In the case of Sukuk, the servicer’s SPE is really the agent of the lender. Furthermore, the three-party agreement links all of the parties in what amounts to a re-characterization agreement. Among other things, it provides that while the lender is nominally the owner of the real estate, it is intended that the borrower be the owner. Furthermore, it typically fills in a number of gaps in the documents. Thus, the borrower is permitted to cure a mortgage default. The lender also benefits from a number of indemnities by the borrower, including in the case of fire or other casualty. This is because under the Sha’ariah in order to qualify as a genuine lease, the landlord must retain certain responsibilities, such as with regard to fire and casualty. However, under the usual financed lease arrangement, it is the tenant who is responsible for these risks. Indeed the landlord is supposed to be insulated from most risks associated with ownership of the real estate. This is so as to be able to finance against the net lease arrangement with respect to the real estate. However, if the landlord does not share in at least some of the risks, then the structure is not Sha’ariah compliant. The methodology used to deal with this issue is to set forth an agreement by the tenant to reimburse the landlord in a separate instrument. The landlord ostensibly bears the risk of loss by reason of fire or other casualty under the Ijara lease document. However, that risk is ameliorated by tenant/borrower under the three-party agreement. The fact that the tenant then separately reimburses the landlord for any expenditures incurred for this purpose is ignored from a Sha’ariah point of view.[3]
8. In the case of a Murabaha based transaction covering the purchase of  goods there is a genuine issue as to whether the implied warranties and express warranties flow to the borrower as the ultimate purchaser. This is because the borrower does not buy from the real seller. It buys from the bank intermediary. It can sue the bank but that will not sit well with the typical lender. A 4-party agreement that links the lender, servicer, borrower and seller would work but then this is the kind of linkage that is an anathema under the Sha’ariah. Moreover, not every seller will cooperate with this kind of arrangement. Also the lender is in the middle yet again and can be sued. The 4-party agreement might deal with this concern, but query whether a disclaimer of liability by a bank lender in consumer context will work as intended, as noted below.
9. In the consumer context, the bank is exposed to liability as the seller that would ordinarily not be the case in a traditional bank loan setting. Consider, the bank may not be able effectively to disclaim these liabilities in the consumer context.
10. 10.  The whole issue of priority is at issue in a bankruptcy context, even when there is a separate embedded set of loan documents, as noted above. Even under State law there can be efforts made to seek a re-characterization of the transactional documents that can cause unpredictable results. Consider for example the option to buy reserved to the borrower under the typical Ijara. If the bank goes bankrupt it can just terminate the option as an executory contract. Remember, the bank own the real estate, not the borrower. This has caused all sots of issues in Canada, the US and elsewhere[4].
11. 11.  A Bankruptcy court might re-characterize the structure as the loan and then restructure it as a true interest-bearing loan, instead of the interest based structure that is more costly and unwieldy.

12. In the typical Ijara arrangement, the borrower’s down payment for the real estate is characterized as the initial rent under the Ijara lease. However, in a foreclosure context, the borrower could argue that this is a sham and the structure clogs up the borrower’s equity of redemption. This could prevent a foreclosure. Indeed, litigating just what the substance of the structure is under state law could delay any enforcement for years. The lender might believe it could terminate the Ijara lease for non-payment and just go into landlord and tenant court to obtain possession of the real estate. But there is no certainty this will be the case. Indeed, it is more likely that the borrower would seek and obtain a Yellowstone injunction to prevent termination while seeking declaratory judgment that the lease is nothing more than a financing device. If the borrower is successful then that would require a plenary foreclosure action, instead of a summary landlord and tenant proceedings.. In a bankruptcy context, the court could rightly find that the lease is not an ordinary one. This means that it does not have to be accepted or rejected within a short prescribed period of time. Rather, the debtor could argue because of the equity implicit in the initial rent payment and the option to buy set forth in the lease equal to the principal amount of the loan, that the lease is nothing more than a financing device. Therefore, as long as the borrower has equity in the property, the automatic stay against enforcement might be  continued by the court, while the matter is litigated.

13. The three-party agreement noted above would typically include a subordination by the borrower as tenant under the Ijara lease to the mortgage held by the lender. Furthermore, there would be a cross default between the mortgage and Ijara lease. As noted above, the borrower would typically obtain the right to direct access to cure defaults under the mortgage (and recognition by the lender of these rights) to preserve borrower’s beneficial equity in the real estate. This likely creates issues as to whether the structure is indeed Sha’riah compliant. Consider this cumbersome and more structure, likely does not accomplish the intended purpose of being Sha’ariah complaint. As noted herein, it is likely not capital markets’ compliant either.

1. 14.  Because the borrower does not sign the note, the lender cannot just seek direct recourse against the borrower. It must proceed against the servicer SPE as the obligor under the note and under the mortgage that secures the same. Upon foreclosing under the mortgage it can then seek a writ of assistance to vacate the borrower tenant under the Ijara lease that was cross defaulted with the mortgage. However, as noted above, the tenant/borrower can then seek bankruptcy protection arguing that the lease is not an ordinary one; but, rather a financing device. There would appear to be no personal liability of the borrower for the principal amount of the note plus accrued interest or for the rent post termination and vacateur. Thus, the lender might eventually obtain the collateral but the borrower has no personal liability.

15. The protections a traditional bank lender expects, such as a priority lien on the collateral, may not be present. This includes an embedded set of  mortgage documents under the Sha’ariah compliant structures described above. After all they do not purport to create a genuine interest bearing loan nor do they establish a priority lien securing the repayment of the loan. In form they are an equity devices. Also absent are the typical intercreditor agreements designed to confirm the ordering of priorities among the various classes of lenders and their remedies upon a default. As far as the Sha’ariah formats are concerned, the financing structures are not loans and hence an intercreditor agreement is inappropriate. As noted above, even the three-party agreement in the Sukuk structure is problematical.

1. 16.  The Sha’ariah compliant structures likely do not result in a perfected security interest that will survive challenge in the US courts and especially the bankruptcy courts. Even when an embedded set of conventional loan documents are used, the recourse is against the intermediary servicer’s SPE, not the actual borrower. This creates a genuine issue for revolver type financings against accounts receivable or inventory. This is because it is constantly being repaid and replenished at the borrower operating company level; but, there is no direct access permitted.  Moreover, there is no real recourse against the borrower operating company and its assets. Furthermore, as noted above, in the bankruptcy context, there are likely to be all manner of claims of preference and even equitable subordination that would prejudice the rights of the lender. These kind of issues are at variance with the reasonable expectations of traditional lenders in the capital markets.  This also complicates any restructuring, because instead of simplicity of execution (which is generally a threshold requirement of most restructurings,) the Sha’riah would require implementation of the same cumbersome and unwieldy structures that created these issues in the first place. What a conundrum? Imagine the problem of beginning with a structure and set of documents that cannot be readily enforced in the manner the capital markets expect, for all the reasons noted above and likely others as well. Consider further the problem of having to restructure because of a borrower’s default and bankruptcy and having to embrace the same unwieldy and less than readily enforceable structure again. As noted below, this is not just a theoretical problem. It was the subject of an actual bankruptcy court case summarized below.

17. As noted above, the increased costs associated with Sha’ariah compliant structures are significant. Moreover, because of the additional risks associated with these cumbersome and non-compliant structures from a capital markets point of view, they are priced at a significant premium above the pricing applicable to more traditional capital markets’ products.

1. 18.  The structures don’t anticipate a bankruptcy by the lender. This can undermine the whole Sha’ariah compliant structure that was intended to benefit not harm the borrower. Furthermore the structures don’t contemplate the possibility of a bankruptcy of the intermediary servicer, which could compromise the rights of the lender and the borrower. Imagine if the servicer goes bankrupt. It actually has the title to the homes or other assets. The creditors of the servicer could access the homes or other assets and, in effect, abscond with the equity of the borrowers. It could also seek to restructure the lenders position under certain circumstances[5]

In recent times we are facing the phenomena of banks or other lenders facing bankruptcy[6]. Among other things, genuine concerns were raised that a lender (or its trustee in bankruptcy) could successfully assert that the real estate under an Ijara arrangement was indeed owned by and was a genuine asset of the lender.. Thus, instead of being the typical mortgage holder, which has a loan to be repaid and only a lien on the real estate, the lender could be deemed town the real estate. This would severely prejudice he ordinary borrower. This is because the borrower may have a real equity in the home that should be protected, it appears that a Sha’ariah compliant Ijara structure may permit the lender to abscond with the real estate (including the borrower’s equity) and defeat the rights of the tenant/borrower. As noted above, the tenant/borrower’s option to purchase is an executory contract that can be cancelled in a bankruptcy. As a matter of form under the ijara documents, the equity was an initial payment of rent. The possible increase in value of the real estate since it was purchased (and hence build up in equity) is yet another issue to be considered. Remember, in this case it is the lender that is bankrupt; not the borrower. Thus, the Sha’ariah compliant formats can put innocent borrowers at risk if the lender has financial issues or goes bankrupt.  Unscrambling the egg to make substance triumph over form is not an easy road to travel. It could take years of expensive litigation with no certainty as to the outcome. Other intervening creditors of the lending company (having nothing to do with the homes owned by the lender under the ijara structure or the tenant borrowers with options, could assert rights that are superior to those of the borrowers.

There have been a number of spectacular Sukuk defaults that are the subject of litigation or restructurings that have received press[7]. These provide insights into just how these structures work in practice. It is an understatement to suggest that the issues, like those outlined above, have been uncovered, which challenge the very essence of the concept of Sha’ariah complaint financing. This is true not only in Western courts, but even in the courts of Islamic states, as noted above. Moreover, it appears that in many Islamic jurisdictions bankruptcy laws have not been developed in practice.[8] This creates a real concern about the potential for unpredictable results[9], an anathema to the capital markets. This and the other problems described above arise because of the fundamental incompatibility of the Sha’ariah compliant products outlined above with the actual practices in the capital markets.

In point of fact it is just this simple. If the loans meet the requirements of the capital markets then the reward is the lowest financing cost in history. If not, then go elsewhere, because the capital markets cannot readily handle non-compliant financial products. The Halacha adapted itself to these requirements as noted above. A truly parallel structure is required if ready access is sought to the capital markets. And, why not? The benefits to the borrower are enormous. Why pay more for what is in essence the same thing? After all, in practice, loans on interest, no matter how styled have been an integral aspect of Islamic society from the very beginning and to date. Notwithstanding all the pious pronouncements the fact is a Moslem bank customer, who seeks a so-called Sha’ariah complaint financing, pays more. Who benefits? It’s the lender. The lender is typically another Moslem. This is because the concept of Sha’ariah complaint financing is supply side driven at its very essence. In effect, the rich Moslem is still taking advantage of his poorer compatriot. Non-Moslem banks like HSBC, in the UK, appear to be giving up providing Sha’ariah compliant home financings[10]

Moslems in the US face a clear choice; use the traditional bank next door and pay a significantly lower cost or pay more because there is concern about whether this is prohibited Riba. Consider however, that there is a similar concern about the more costly Sha’ariah compliant products.

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[1] So called Islamic bonds; but this is a misnomer, because even under more modern structures, it can hardly be said that these instruments are bond debt as more fully described below in this article.

[2] See for example the S&P rating reported by Reuters on 9/11/12 of the Axiata Group’s Sukuk trust certificates that were rated BBB-. Among other things, S&P reportedly looked to the Axiata Group’s purchase undertaking and liquidity shortfall coverage, which S&P interpreted to be an obligation of the Axiata Group to make all the payments needed to insure the issuer had sufficient funds to pay the certificate holders on time.

[3] The Halacha does not accept this distinction, as noted above. If the landlord does not bear any risk then the lease is not genuine. It is viewed as nothing more than a financing device. In effect the landlord is lending the real estate to the tenant and the rent is then Ribit

[4] See discussion by Dr. El-Gamal supra at footnote 179, at page 13, where reference is made to cases in Saudi Arabia, and other Islamic jurisdictions which may hold that if not Sha’ariah compliant then no obligation to pay the interest based amount because prohibited Riba

[5] For example if certain of the loans were over-collateralized. See for example the GGP Bankruptcy (Case Number 09-11977 in the US Bankruptcy Court, Southern District of New York).

[6] See UM Financial Inc. that was ordered into receivership in October 2011, as reported in an article in Reuters entitled Canada bankruptcy may hurt Islamic finance in N. America, by Shaheen Pasha and Cameron French, (December 5, 2011).

[7] Ibid. See also the default by The Investment Dar Company of Kuwait as reported in the Inside Edge at the Oxfordbusinessgroup online entitled Rethinking Restructuring: Sharia-Compliant Firms Face Different Criteria for Getting Back on Track. In that matter, the article reports that a London Judge agreed with Dar that an agreement with the Blom Bank of Lebanon was not Sharia compliant. Therefore, repayment would force Dar to ignore its founding principles. What is most problematical is the fact that a British Judge ruled on the basis of Sharia law and not British law. This seems to be an anomalous case. However, as noted in the Section XIV below on Blowback, this is a possibility in the US, as well.

[8] See for example the Arcapita Bank Bankruptcy case pending before Judge Lane in the Southern District of NY, which was filed in 2012. See also Arcapita Still Working to Secure Financing from Silverpoint, published October 19,2012 on Dow Jones Newswires and an Article by Jacqueline Palank in the Wall Street Journal of October 5, 2012, entitled the Bankruptcy Week Ahead, which also discusses the status of the Arcapita bankruptcy and the difficulties it is having obtaining debtor-in-possession financing. This is because of the need to be Sha’ariah complaint. It should also be noted that, among other things, Judge Lane felt that the fees for the Sha’ariah compliant DIP financing at issue were too high.

[9] Imagine if a Islamic court applied Koran Chapter 2, verse 280, which requires the lender afford, the debtor who faces hardship in paying his debts, an extension of time to pay, until the debtors financial condition improves. Furthermore the Koran then suggests that it is better just to waive repayment, as an act of charity. While a most noble view of debtor- creditor relations, it is the kind of unpredictable results that are an anathema to the capital markets. Sha’ariah compliant products do cost more. Indeed as the issues of enforceability are actually tested in practice  it is likely that a re-pricing will occur and/or Sha’ariah compliant products will be panned by the capital markets. As noted above, this is beginning to occur. In the East Cameron Gas Sukuk , which went into default in 2008 and subsequent bankruptcy, the court considered the issue of whether the Sukuk holders actually owned a portion of the company’s oil and gas. The company argued the transaction was merely a disguised loan and that there was no real transfer of the oil and gas royalties. The bankruptcy judge however rejected the company’s position and ruled that the Sukuk holders invested in reliance on the fact that they actually owned the royalty interests. However, the judge’s ruling was not final and he gave the company the right further to argue their position. This and other Sukuk defaults are described in Q Finance: Bankruptcy Resolution and Investor Protection in Sukuk Markets, online.

[10] See a report in Shariah Finance Watch online, entitled, More Evidence of the Failure of Shariah Banking in the UK: HSBC Drops Sha’ariah Mortgages dated October 9, 2012.