Unlike conventional bonds that are debts,
sukuk represents undivided beneficial ownership in the underlying assets and resemble equity instruments in some respects. Islamic financial instruments are said to have performed better than conventional bonds during the 2008 global financial crisis because they were asset based and therefore less exposed to speculation and leveraging. While conventional bonds are debt instruments and founded on interest payments,
sukuk are based on an underlying asset and their returns are based on the performance of the underlying asset. Financing in Islam is invariably based on illiquid assets of invariably real assets and inventories. That asset based municipal
sukuk is linked to real economic activity that helps augment stability and transparency in the financial sector and boost investor confidence and participation. A
sukuk turns out to be more flexible over time because payments are tied to underlying returns where all parties could contribute to success rather than to fixed interest and schedules.
All Islamic finance contracts must be based on underlying real assets as part of the securitization process. The requirement of assets underpinning a
sukuk contract serves as a self-protecting mechanism that limits speculative trading, avoiding risky credit extensions and over-exposure jeopardising the investors. The asset based finance products often provide contractual certainty and transparency through clearer roles and outcomes with the support of dispute resolution mechanisms. The specification of assets potentially creates competitive pricing and greater demand.
All Islamic contracts require a tangible asset but there is innovation and sometimes controversy over choice of assets. The different
sukuk contracts are organised around a range of assets. Obviously, the assets would depend on its availability and investor preference but also its appropriateness to contracts based on sale, lease, agency or partnership. As
sukuk assets cannot be used or reused for another contract, issuers have to be careful with their choice. Rather than specific assets for each project, a large pool of investable funds could cover a number of projects, as has been done in Sudan and Iran. This would be relevant to municipalities who may be carrying out several infrastructure projects simultaneously or need to mobilise funds for several objectives.
Sukuk are broadly characterised as asset-backed or asset-based depending on the nature of the asset and the directness of reliance on the asset for the contract performance. Though asset backed
sukuk are theologically promoted and do exist, they are relatively rare.
Sukuk that transfer full legal owner-ship of the underlying assets to the investors are known as asset backed but
sukuk that merely confer ‘beneficial ownership’ to the investors are known as asset-based. Unlike a true sale, which transfers legal ownership of the asset sold to the investors, an asset based
sukuk merely creates ‘beneficial’ ownership. Under
Sharia principles, each financial transaction must be tied to a “tangible, identifiable underlying asset” or pool of assets. The
sukuk holders have an undivided or collective interest in the same. Asset based
sukuk identifies a tangible asset or a pool of assets but in case of default, the
sukuk holders do not have recourse to the asset, but the issuer.
In the simplest contracts based on lease (
ijara), the underlying asset is land or physical assets. The municipal
sukuk would typically involve the newly created intermediary SPV or issuer and the originator (municipality) entering into a sale and purchase agreement in relation to certain assets that would generate rent or income for investors. Under the
ijara agreement those assets would be returned or leased back to the munic-ipality on completion of the
sukuk period under the
sukuk terms. Thus, municipalities seeking to use high value unused or underutilised assets can deploy this mechanism. When Jordan, Bahrain and Malaysia used
sukuk to raise money for expanding their infrastructure, airports or airlines, all they had to do was identify physical assets such as land, airport buildings or aircrafts; though these became more difficult to find when further money needed to be raised. The 2004 Saxony-Anhalt municipal
sukuk is an example of using specific state-owned real estate assets in an
ijara structure. Another typical example is the
sukuk used by the Government of Dubai in 2014, issuing USD 750 million using real estate located in the UAE as the tangible asset.
Though there might be reluctance to trade in public or government property given the assumed risks, the use of municipality property as assets is less risky than it seems. The municipality transfers the technical title of the property to the SPV but often still retains access to or control of the asset that may be needed by the municipality or PPP initiative for the performance of the contract, for example where a stadium is listed as underlying asset. Thus, the
sukuk assets are technically kept separate from the issuer’s or municipal assets, with the SPV holding the title of the underlying assets and use the funds its generates to pay investors but will return the title to the originator on completion of contract. In practice, though, the municipality continues to use the assets (for instance under a lease in the
ijara), or to manage the assets (for instance under a
mudaraba arrangements on joint venture or profit sharing).
Land based financing (LBF) is a potential source of municipal financing with the local authorities being able to generate revenue from unlocking land values, without having to do much. LBF tools being implemented or developed include taxing of land or building value, lease or sale of public land, land readjustment, betterment levies, special assessments and sale of development rights. These tools are equally promising in Muslim countries where conventional financial instruments are deployed but the Islamic financial and legal implications of LBF have not been documented or discussed. For example, the sale or lease of public land or sale of development rights that alters land use would be impacted by Islamic land tenure to the extent applicable. Where Islamic finance is used in infrastructure projects, the structure of LBF components could vary given the principles discussed earlier. The Islamic finance aspects of LBF are beyond the scope of this chapter but a review of Islamic land tenure would be useful.
Islamic land tenure is highly developed with a web of tenures that incorporates individual private as well as collective customary rights. While it recog-nises private (
milk) and state (
miri) land tenure, there are differences with equivalent Western land doctrines arising out of ethical Islamic legal principles limiting unbridled ownership. There are also distinctive land concepts such as unlocking of land values in endowments (
waqf) to finance urban development and property rights for those who enliven dead or empty land (
mawat). There are also rules relating to pre-emption (
shufa) or preferential rights of neighbours. It outlines extensive rights not only for owners but users, with productive use often overturning absentee ownership. Choudhury writes that in Islamic land financing arrangements non-capital actors are recognised as partners. The ethical and participative ethos in Islamic finance is reinforced by the principles of Islamic land tenure, which still resonate in contemporary land practices in the Muslim world.
Given that physical assets may not be available and the full transfer of tangible assets could be cumbersome,
sukuk have been innovative in expanding the asset classes. Apart from physical assets other types of ‘assets, usufruct or services’ are contemplated under contracts based on agency (
wakala), sales such as costplus (
murabaha), futures contract (
salam or bai
salam), construction financing (
istisna), cultivation agreement (
muzara) among others. Where physical assets are not available, the asset can be usufruct
or services capable of generating periodic returns for the investors. Under
sukuk the underlying asset is not a physical asset but the capacity of, or rights to commercial activities, allowing for the use of intangibles in
sukuk. Such asset classes include airtime vouchers, intellectual property rights, tariffs from on electricity meters and receivables due on petrochemical marketing contracts. For example, the Ooredoo, the Qatari telecommunications company, which had no substantial physical assets used airtime vouchers as the underlying asset in its USD1.25 billion ‘airtime’
sukuk in 2013, an innovation since followed by others.
An example of
waqf (endowments) underpinning
sukuk is USD 390 million
sukuk intifa (time share) in Makkah, Saudi Arabia in 2000 where the contractor, the Binladin Group, received on a BOT (Build- Operate-Transfer) concession contract for 28 years relating to
waqf land and in return built shopping complexes, towers and a hotel for issuer as payment. Another example is the Dubai Municipality and private partners working on establishing an 15-hectare Endowment Park in 2017 using the concept of collective outsourcing with
waqf whereby community members donate palm trees for the park which will also house a charity date-packing factory.
The flexible use of assets improves prospects for expansion of municipal
sukuk. In 2005, the municipality of Pasir Gudang in the State of Johor in Malaysia issued a municipal
sukuk for about USD15 million to beautify the city using, not physical assets but, the tax revenue stream as the underlying asset. This shows, municipal revenue streams are a vital source of creditworthiness. Another innovative example is the Indonesian retail sovereign
sukuk for Hajj services vouchers
that raised USD3.15 billion in 2013 to finance the budget deficit. This
ijara khadamat contract used in the issuance of this
sukuk a mechanism based on future service transaction, along with the pre-sale of the cost of services and their expected benefits.
The use of intangibles as underlying assets in a
sukuk could be controversial. Where a
sukuk certificate is a monetary debt as in
murabaha, it is considered a non-negotiable instrument incapable (owing to
Sharia restrictions) of being traded in the secondary market at a premium.
Sharia prohibits this as amount to trading in debt, as is the prevail-ing view in the GCC and Pakistan. However, Malaysian jurists’ have adopted a more liberal interpretation and allow
murabaha trading. However, the general practice is that
murabaha or intangibles may be tradable, even in the GCC and Pakistan, if they are a small part of a larger portfolio of
sukuk assets including tradable instruments, such as
musharaka (joint venture) or
mudaraba (profit sharing).
The choice of asset for the purposes of the
sukuk, and whether the
sukuk is asset backed or based will have a bearing on what happens in case of default. Where municipal property is the underlying asset in an asset based
sukuk, there is no true sale but only transfer of beneficial ownership and
sukuk holders will likely have to sue the municipality itself. Where there are non-physical assets, or intangibles, the
sukuk holders have to proceed against the municipality as in normal disputes. Thus, rating agencies look at the nature of the
sukuk contract and its underlying asset but also the capacity of the municipality. While
sukuk certificates technically represent an underlying ownership interest in an asset, in practice most issued
sukuk are unsecured and thus operate as conventional bonds in case of default.