Introduction

Islamic banking transactions are based on Islamic principles and jurisprudence (Shari'a) including the primary source of the Qu'ran. The basic Islamic principle is that money is not a commodity and therefore it is not possible to earn profit from its simple utilization as money has no intrinsic value and is merely a means of exchange. Profit must be earned through trade and taking part in the risks of a transaction. Following on from this premise there are a number of other Islamic finance principles that must be borne in mind when structuring Islamic compliant deals:

Key Issues

• Speculation (maisir): Contracts which involve speculation are not permissible (haram) and are considered void. Islamic law does not prohibit general commercial speculation (which is evident in most commercial transactions) but does prohibit speculation which is akin to gambling, more particularly, gaining something by chance rather than by productive effort. However, the distinction between speculation in genuine commercial trading and speculation in gambling arrangements is not very clear and in each individual case the commercial substance of the transaction must be analyzed to evaluate whether or not it is permissible under Islamic law.

• Unjust enrichment/Unfair exploitation: Contracts where one party gains unjustly at the expense of another are considered void. Again it is not clear exactly what would amount to unjust enrichment and in each contract the commercial substance of the transaction must be I analyzed to evaluate whether or not it would amount to unjust enrichment under Islamic law.

• Interest (riba): The payment and receipt of interest (riba) under Islamic law is prohibited and any obligation to pay interest is considered void. Islamic principles require that any return on funds provided by the financier be earned by way of profit derived from a commercial risk taken by the fmancier.

"Any Loan that draws profit is Riba"

• Uncertainty (gharrar): Contracts which contain uncertainty (gharrar), either as to the fundamental terms of the contract, or the actual subject matter is considered void.

Bai-Al-Dain (Sale of Debt)

Dain means 'debt' and Bai means 'sale', therefore Bai-al-Dain connotes the sale of debt. A 'debt' receivable in monetary terms corresponds to money, and every transaction where money is exchanged for the same denomination of money, the price must be at par value. Any increase or decrease from one side is tantamount to 'riba' and can never be allowed in Shari'a. Therefore, trading of any debt based securities and interest paid thereon (as practiced in conventional debt markets) is not allowed in Islamic Shari' a.

Resolution of Islamic Fiqh Academy

The Council of the Islamic Fiqh Academy, in its sixth session held in Jeddah, Kingdom of Saudi Arabia, from 17 to 23 Sha'baan 1410 H (corresponding to 14-20 March 1990), resolved the following concerning `Bonds':

First: The bonds which represent an undertaking to pay its amount along with aninterest related to its face value or to a pre-determined profit are prohibited in Shari'a. Their issuance, their purchase and their negotiation, are all prohibited because they are interest-bearing loans, no matter whether their issuing authority belongs to the private sector or is a public entity related to the State. The change in the nomenclature, such as calling the bonds "certificate" or investment securities" or "saving certificates" or calling the interest "profit" or "income" or "service charge" or "commission" has no effect on the aforesaid ruling.

Second: The "zero coupon bonds" are also prohibited because they are loans sold at a price inferior to their face value, and the owners of such bonds benefit from the difference in their prices which is considered a discount on the bonds.

Third: Similarly, the "prize bonds" are also prohibited because they are loans in which a liability to pay a pre-determined profit or an additional amount is undertaken in favor of their bearers as a whole, or in favor of an undermined number of persons out of them. Moreover, these bonds have a resemblance with gambling ("Qimar").

Resolution of AAOIFI Shari'a Board

The issuance of all kinds of bonds is prohibited when these bonds include stipulations for the return of the amount of loan and excess in any form, whether such excess is paid at the time of the satisfaction of the principal amount of loan, is paid in monthly or yearly installments or in another manner and whether this excess represents a percentage of the value of the bond, as in the case with most types of bonds, or a part of it, as is the case with zero-coupon bonds.

Likewise, prize bonds are also prohibited. This applies irrespective of the bonds being private, public or governmental. Trading in bonds, both sale and purchase, is prohibited and so is their pledging and endorsement and so on. The Shari' a substitute for bonds are investment Sukuk.

Sukuk - Shari'a Compliant Alternative

Sukuk (plural of Sak) is an Arabic word which means `certificates'. Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of the assets of particular projects or special investment activity.

Sukuk are certificates issued in the name of the owner or bearer in order to establish the claim of the certificate owner over the financial rights and obligations represented by the certificate.

Sukuk represent a common share in the ownership of the assets made available for investment whether these are non-monetary assets, usufructs, services or a mixture of these entire plus intangibly rights, debts and monetary assets. These Sukuk do not represent a debt owed to the issuer by the certificate holder. The owners of these certificates share the return as agreed at the time of issuance and bear the losses in proportion to the certificates owned (held) by them.

The distinguishing feature between conventional bonds and Sukuk is that bond is a contractual obligation whereby the issuer is obliged to pay to bond holders, on certain specified dates, interest and principal. In
comparison, under a Sukuk structure the Sukuk holders each hold an undivided beneficial ownership in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets as well as being entitled to share in the proceeds of the realization of the underlying assets.

Sukuk can be issued on a short-term, medium-term or long-term basis in accordance with the principles of the Shari'a. The Sukuk may also be issued without specifying a period depending upon the nature of the contract underlying the Sukuk issue.

BASIC SUKUK STRUCTURE

Generally, Sukuk are a form of commercial paper that provides an investor with ownership in underlying assets. It is an assets-backed security that has a stable income and shariah-compliant trust certificates.

Types of Sukuk

There are different kinds of Sukuk of different maturities that can be issued in a Shari'a complaint manner. Issuance of Sukuk is quite popular these days for raising long term finance and majority of the Sukuk that have been issued to date are based on the concept of Ijarah. However, there is a great potential still untapped in utilizing different Islamic modes for the issuance of Sukuk.

Some of the most commonly used types of Sukuk are discussed below:

1- Sukuk-al-Ijara

The Ijara is a shari'a compliant lease. It is a hybrid between an operational lease and a finance/capital lease with certain’ ownership' risks, such as the obligation to undertake capital maintenance of the leased asset and the obligation to insure the asset, remaining with the lessor. The lessor may appoint an agent, usually the lessee itself, to carry out these duties on its behalf under a servicing agreement. In a simple Sukuk-al-Ijara the originator will sell certain physical assets to a special purpose vehicle (SPV) or appoint a trustee. The SPV will finance this acquisition by cash raised by the issue of sukuk notes. The SPV will then lease the same physical asset to a third party, often the originator itself or a third party connected to the originator. The lease rental payments
Sukuk Holder will 'mirror' the coupon payments under the sukuk and the cash flow from the lease Process Return rentals will be used to service the coupon payments under the sukuk This structure, Issuer given its relative simplicity and ease of understanding, has been used in a number of earlier sovereign sukuk issues. As there may be legal and public policy considerations involved in a sovereign or quasi-sovereign disposing of public assets there has been a preference for sovereigns and quasi-sovereigns to use an underlying head lease -sublease structure rather than a sale lease structure.

The critical issue from a shari'a perspective is that the SPV should have ownership rights
prior to granting the lease (or sub-lease), a sufficiently long headlease will be deemed, from a shari'a perspective, as akin to ownership. Each investor would therefore own a proportionate interest in the underlying asset and any revenue being generated by that asset. An example of a classic:

Given the relative simplicity of the Sukuk-al-Ijara structure this has been used on a number of the earlier sukuk issues including the sovereign sukuk issues by Malaysia and Bahrain in 2002 and Pakistan in early 2005.

a) Sukuk of ownership in leased assets

These are certificates issued either by the owner of a leased asset or a tangible asset to be leased by promise, or they are issued by a financial intermediary acting on behalf of the owner with the aim of selling the asset and recovering its value through subscription so that the holders of the Sukuk become owners of the assets.

The certificate holders jointly own the assets through an undivided ownership sharing the profits and losses on the basis of the partnership that exists between them. Such Sukuk are tradable and redeemable at the market price or at a rate agreed upon between the certificate holder and the issuer.

b) Sukuk of ownership of usufructs of assets

These are Sukuk issued by the owner of an existing asset (or owner of the usufruct of an existing asset (lessee) with the aim of leasing the asset (or subleasing the usufruct) and receiving the rental from the revenue of subscription so that the usufruct of the assets passes into the ownership of the holders of the Sukuk.

The sukuk holders become joint owners of the usufruct sharing its benefits and risks. It is permissible to trade in securities of ownership of usufructs of tangible assets prior to a contract for sub-leasing the assets. When the assets are sub-leased, the Sukuk represents rent receivables, which makes it a debt owed by the second lessor and thus becomes non-tradable.

c) Sukuk of ownership of Services

These are Sukuk issued for the purpose of providing services through a specified provider (such as educational benefits in a nominated university) and obtaining the service charges in the form of subscription income so that the holders of the Sukuk become owners of these services.
It is permissible to trade in securities of ownership of services to be provided by a specified party prior to sub-leasing such services. When the services are sub-leased, the certificate represents rent receivables to be collected from the second lessee. In this case, the certificate represents a debt and is, therefore, subject to the rules and regulations of disposal of debts.

2- Sukuk-al-MusharakalDiminishing Musharka

Given the lack of flexibility inherent in the Sukuk-al-Iajra, another sukuk product known as the Sukuk-al-Musharaka has been developed. This suknk variant permits greater flexibility in the asset transfer to cash to be raised ratio as the amount of cash to be raised does not need to correspond to the value of the assets available for transfer into the musharaka.

A Musharaka constitutes a form of a joint venture and may, depending on its precise terms, also be a partnership.

Although the Shari'a perceives the Musharaka as an independent entity it is not a legal entity in its own right under English law and would simply be construed as an agreement between two parties. In a Musharaka two partners/sponsors will agree to combine their resources for a joint enterprise, often with one party contributing the cash and the other contributing the expertise or some other contribution-in-kind.

In a simple Sukuk-al-Musharaka the two partners would be the originator and a SPV. The originator will contribute assets to the Musharaka and the SPV will contribute cash raised from the issue of Sukuk notes. As the Musharaka is not a legal entity, the partners will appoint a managing agent to act on behalf of the Musharaka and this managing agent will often be the originator itself. The contributed assets, also known as the Musharaka assets, are then employed by the managing agent to generate a cash return to service the coupon payments. The originator upon maturity of the Sukuk may retain any cash generated in excess of the coupon payments.

Classical example of a Sukuk-al-Musharaka would be as follows:

This Sukuk-al-Musharaka structure has been used on a number of recent transactions.

a) Participation certificates

These are certificates representing projects or activities managed on the basis of Musharaka by appointing one of the partners or another person to manage the operation.

b) Investment agency Sukuk

These are certificates that represent projects or activities managed on the basis of an investment agency by appointing an agent to manage the operation on behalf of the Sukuk holders.

The issuer of these certificates is investment agent, the subscribers are the principals and the realized funds are the entrusted capital of the investment. The Sukuk holders own the assets represented by the certificates with its benefits and risks, and they are entitled to the profits, if any. The investment agent is entitled to an agency fee irrespective of the profit or loss of the business.

3- Mudaraba Sukuk

These are certificates that represent projects or activities managed on the basis of Mudaraba by appointing one of the partners or another person as the mudarib for the management of the operation.

The issuer of these certificates is the Mudarib, the subscribers are the owners of capital, and the realized funds are the Mudaraba capital. The certificate holders own the assets of Mudaraba in proportion to the financial value of the certificates they own. The certificate holders and the Mudarib are entitled to an agreed ratio of profit whereas the loss is solely borne by the subscribers of the Sukuk.

4- Salam Sukuk

Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advanced price fully paid at spot. Here the price is cash, but the supply of the purchased goods is deferred. The permissibility of Salam was an exception to the general rule that prohibits the forward sales.

Salam has become a liquidity management tool for Islamic banks by providing short term investment opportunities in Salam Sukuk. It has provided an alternative to the conventional Treasury Bills in few Islamic countries.

The issuer of the Salam Sukuk is a seller of the goods of Salam, the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam Capital) of the goods. The holders of Salam Sukuk are the owners of the Salam goods and are entitled to the sale price of the certificates or the sale price of the Salam goods sold, if any.

It is not permissible to trade in Salam Sukuk during the term of the Sukuk since the underlying asset is a debt created through advance payment of the sale price. Such debt will only be converted into a tangible asset at the end of the maturity when the Salam subject matter is delivered.

5- Murababa Sukuk

`Murabaha' is a specific kind of sale where the commodities are sold on a cost-plus basis.

This kind of sale has been adopted by the contemporary Islamic Financial Institutions as a mode of financing. Murabaha involves purchase of a commodity by a bank on behalf of a client and its resale to the latter arrangement the financier discloses its cost and profit margin to the client.

Murabaha Sukuk is certificates of equal value issued for the purpose of financing the purchase of goods through Murabaha so that the certificate holders become the owners of the Murabaha commodity. The issuer of the certificates is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity and the realized funds are the purchasing cost of the commodity. The Sukuk holders own the Murabaha commodity and are entitled to its sale price.

Murabaha is a transaction, which cannot be securitized for creating a negotiable instrument to be sold and purchased in the secondary market. The reason is that in case of Murabaha, as undertaken by present financial institutions, the commodities are sold to the clients immediately after their purchase from the original supplier, while the price being on deferred payment basis becomes a debt payable by the client. So, Murabaha Sukuk/certificate only represents a monetary debt receivable from the client in the form of Murabaha price which is non-negotiable as per the rules of Shari'a. Because, transfer of the Sukuk to a third party will mean transfer of money and money can only be exchanged against money at par value. This restricts the possibility of creating a secondary market for Murabaha Sukuk. However, trading of Murabaha certificates is permissible after purchasing .the Murabaha commodity and before selling it to the buyer.

6- Istisna' Sukuk

"Istisna" is the second kind of sale where a commodity is transacted before it comes into existence. It means to order a manufacturer to manufacture a specific commodity for the purchaser. The manufacturer uses his own material to manufacture the required goods. It is necessary for the validity of Istisna', that, the price is fixed and that necessary specification of the subject matter is fully settled between the parties. It is not necessary in Istisna' that the price is paid in advance; rather it may be deferred to any time according to the agreement of the parties.

Istisna' Sukuk are issued with the aim of mobilizing funds to be employed for the production of goods so that the goods produced comes to be owned by the certificate holders. The issuer of Istisna' Sukuk is the manufacturer (supplier/seller), the subscribers are the buyers of the intended product, while the funds realized from subscription are the cost of the product. The Sukuk holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on the basis of a parallel Istisna', if any.

It is permissible to trade in or redeem Istisna' certificates if the funds have been converted, into assets owned by certificate holders. If the realised funds are immediately paid as a price in a parallel Istisna'a contract or the manufactured item is submitted to the ultimate purchaser, then trading in Istisna' certificates is subject to rules of disposal of debts.

The instrument of Istisna' may be used for project financing or building a bridge or a highway. The modern BOT (Buy, Operate and Transfer) agreements may also be formalized on the basis of Istisna'. Istisna' Sukuk may be issued to raise finance for the construction of highways, motorways, airports etc.