1st Annual Islamic Finance Conference Sukuk for Infrastructure Financing & Financial Inclusion Strategy

Neil D Miller

Global head of Islamic Finance, Linklaters LLP

May 2016

Panel 3: Sukuk Issuance for Infrastructure Financing

Sukuk for Infrastructure: GCC Experience

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What will be covered?

> Ambition versus reality & the meaning of ‘infrastructure’

> Talking about the GCC

> A word on structuring…

> Specimen GCC Project Sukuk: SATORP & SADARA

> Complex intercreditor issues

> A further word on structuring

> The need for certainty & consistency

> Future prospects and alternative approaches

> Capacity based Sukuk

> ECA supported deals

> Covered Sukuk

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Ambition versus reality

> Let’s get real…

> Much of the chatter in the market suggests that Sukuk are the perfect tools for

financing infrastructure

> The reality is very different - the amount of infrastructure that has been financed by

Sukuk to-date is virtually insignificant…

> …although Shariah-compliant banking & project finance (i.e. non Sukuk) has been

significant and (by comparison) prolific

> What do we mean when we talk about infrastructure financing?

> ‘Infrastructure’ can take a wide variety of forms – the way it is financed can also vary

significantly

> ‘Public’ versus ‘private’ – what qualifies as ‘developmental’ infrastructure?

> ‘Project’ or ‘limited recourse’ finance – these terms invoke a very specific

understanding so far as bankers and financiers are concerned

> And by the way – financing projects/infrastructure using conventional bonds is also a

rarity…

3

Talking about the GCC (1)

> “A cohesive region comprising countries that share common and compatible laws

under similar enabling frameworks…”

> Unfortunately - the previous sentence does not describe the GCC! It is virtually

impossible to talk about the GCC as a whole, especially in the areas of Islamic finance

and infrastructure development

> Enabling framework - the necessary components of the ‘enabling framework’ with

regard to both Islamic finance and infrastructure financing have evolved and continue

to evolve differently in each GCC member state. A few examples:

> Kuwait – recent new laws regarding Sukuk and PPP

> UAE –

> the Ruler of Dubai has exhorted governmental & quasi governmental entities to

favour Islamic methods when raising finance;

> significant use of Sukuk by GRE’s for general corporate purposes (i.e. as

opposed to specific projects)

4

Talking about the GCC (2)

> Qatar – although Qatar has implemented a segregation policy between conventional

and Islamic banks, there is no legal obligation to adopt Islamic finance for infrastructure

> Oman - the last GCC member state to officially recognise Islamic finance; although a

newcomer it is progressing legislation in many areas including most recently the new

Sukuk regulations following the successful first sovereign Sukuk

> KSA –

> the jurisdiction where the first project Sukuk have been deployed (see SATORP &

SADARA comments below). Not surprising as significant project finance had

previously taken place in the Kingdom.

> remains difficult for international investors to get comfortable with treatment under

local law. Bilateral Investment Treaties may enhance investor protections.

> Policy guidance

> Consistent policy guidance on the role and application of Islamic finance or the

approach to procuring and financing different types of infrastructure does not exist

across the GCC (and may even differ within country (such as between Abu Dhabi &

Dubai in the UAE))

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Talking about the GCC (3)

> Falling Sukuk volumes in 2016 -

> “The total value of Sukuk issued during the quarter tumbled to $767 million down from a quarterly average of $2.65 billion in 2015, the Arab Monetary Fund (AMF) said. The market did not see much issuance activity in the first quarter of 2016…

> The article encouraged GCC financial regulators to develop the enabling framework for

Sukuk

> There’s an opportunity in [the GCCs sukuk markets] because of the huge infrastructure financing, but I think they need to develop the infrastructure and to have a proper legal and tax environment

for the structuring of the sukuk and the SPV (Special Purpose Vehicle) laws. Once you have these done, there’s already excess liquidity in the market, and banks, especially after Basel III, are looking

for high-quality, highly-rated sukuk, so I think the opportunities are many, he [Aamir Iqbal] told Gulf News on the sidelines of an industry event.”

[Reported on 11 April 2016 with regard to Sukuk in the GCC, Islamic Finance Monitor Worldwide]

> A different story from 5 months ago –

> “2016 could be a promising year for Sukuk and infrastructure bonds in the GCC, with its less-

developed financial sector and regulations still being built for PPP and Islamic finance.”

> [Reporting comments from Fitch Ratings Co. in December 2015]

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A word on structuring

> Infinite flexibility – friend or foe?

> Some Shariah scholars speak about the infinite flexibility of Islamic financial methods

when compared to the ‘singular’ conventional loan

> In reality, the infinite variability in structural approaches across jurisdictions (even

within the GCC) can be a headache for Islamic financiers

> A few examples:

> Istisna’a & parallel Istisna’a – second Istisna’a makes this fixed price

> Istisna’a & Ijara Mawsufah fi al Dhimma (forward lease)

> Wakala & Ijara / Ijara Mawsufah fi al Dhimma – or ‘procurement’ facilities –

especially in KSA

> Musataha agreements – a legislative basis in the UAE Civil Code

> There are many variations or nuances that can affect the way any of these broadly

defined methods can actually be utilised. Variations may be scholar-driven or

jurisdictionally-driven

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The SATORP Refinery & Petrochemical Project

> One of the largest project financings at the time (2011) involving 19 different financing

facilities to raise over US$8.5 billion of funding:

> Seven Export Credit Agencies

> 24 banks providing US$ and Saudi Riyal commercial debt

> 13 financial institutions providing US$ and Saudi Riyal Islamic Finance facilities*

> Domestic Development Agencies (PIF and SIDF)

> Senior Shareholder Loans (Saudi Aramco and Total)

> Provisions made in finance documentation for Sukuk and IPO

> *IF Tranches – constituted over US$1.4 billion of SATORP financing and utilised a

combination of Islamic techniques in different facilities including Murabaha, Istisna’a,

Wakala, procurement and Ijara

Saudi / Regional Financial Institutions US$1,234,000,000

International Financial Institutions US$195,000,000

Total US$1,429,000,000

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SATORP Sukuk

> SATORP – the Sponsors were keen to maximise funding sources by including Sukuk as part of initial funding plan but it was not ready in time

> A detailed accession mechanism was negotiated and included in the financing documentation to provide for Sukuk when it is ready

> Specialist Linklaters teams advised each of the Sukuk JLMs and the other Finance Parties on key challenges for incorporation of Sukuk, including:

> establishment of accession regime

> approach to the taking of construction risk (including sharing of Sponsor completion support)

> disclosure of information and access to information for Sukuk-holders

> voting and decision-making

> Market first - When introduced (to replace Senior Shareholder Loans) the SATORP Sukuk became the first debt capital markets instrument to support a greenfield project in the Middle East but likely to set precedent for future issues

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SADARA Sukuk

> SADARA – this Sukuk transaction followed a year after (December 2012) the SATORP deal

> Another immensely complex project financing involving numerous modes of Islamic finance wrapped into a Sukuk architecture including the following:

> Musharaka-based structure

> Procurement Agreement

> Forward lease

> Even the ‘simplified’ diagram in the Prospectus (available on the SAMA website) is complex

> The parties list illustrates the number of advisors and consultants required if this type of Sukuk is to happen

> A deal driven also by the credit of the shareholders that founded Sadara Chemical Company, namely: Saudi Aramco, DOW and its wholly owned indirect subsidiary DEH

> Although illustrative, transactions like SATORP and SADARA may not necessarily reflect future infrastructure requirements across the GCC which will often be less complex and smaller in scale

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Complex intercreditor issues include…

> Pari Passu and Pro Rata

– Coordination of Islamic and other tranches

– Ranking of payment obligations on pari passu

basis

– Prepayments on pro rata basis

> Use of special purpose vehicle

– Perceived benefits for IF Banks

– Increased structural complexity can give rise to

increased regulatory/legal risks for other lenders

– Saudi specific issues (Article 180 of Companies

Law)

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> Dealings with assets

– IF structures involve transfers of assets between

borrower and IF Banks/IF structures

– Restrictions placed on IF Banks to ensure they do

not deal inappropriately with leased assets

> Acceleration

– Event of default can lead to demand that borrower

immediately acquires leased assets by paying IF

Banks all outstanding amounts (equivalent of

acceleration under conventional loans)

– Problems arising pre-construction of the assets

Fundamental differences – keep in mind the following – as currently practiced

> Sukuk – the vast majority of Sukuk are asset-based (i.e. unsecured) transactions

> Project finance – most infrastructure financing involves limited recourse security

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Complex intercreditor issues continued…

> Islamic Pledge Agreements

– Development of innovative security structures to ensure leased assets are subject to overall intercreditor security ‘pool’

– IF Banks provide security interest in leased assets direct to Onshore Security Agent

> Additional Credit Facilities

– Sponsors requirement for flexibility to bring in future debt by way of additional IF financing involving existing project assets

– Need to ensure that future IF structures do not interfere with existing IF structures (including project assets already subject to IF lease arrangements)

> Total loss

– What happens if leased assets are destroyed?

– Termination of lease arrangements with immediate effect and mandatory prepayment across other facilities

– Approaches used to minimise risk of “Total Loss Event” occurring

> Third party environmental liabilities

– Perceived increase in risk of third party claims to IF Banks

– Additional protections for IF Banks (additional borrower indemnities, insurance)

– But balance against IF Banks ‘over-reaching’

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A further word on structuring

> The problems of complexity

> Project financing is complex, often expensive and always time-consuming

> Sukuk are one of the most complex Shariah-compliant instruments

> Experience suggests the difficulties involved in seeking to use an already complex capital market instrument to achieve infrastructure financing objectives tends to be under-estimated

> Sukuk tend to favour refinancing once project completed and operational

> Designing new and innovative approaches

> Alternative methods - different ways of financing infrastructure can be found (see below also) but more

work needed to achieve suitability for Shariah purposes

> Caution - some other conventional methods of financing infrastructure have proven overly complex and

more expensive than the methods they replaced (e.g. the UK PFI experience) so caution needed when adopting them in other jurisdictions

> Courage - the Islamic finance industry needs to have the courage to create its own modus operandi which may include designing new legal architectures that work ‘in country’

> But investor demands and expectations also have to be kept in mind – this will only achieved if the enabling framework (a) exists and (b) ensures certainty & consistency

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The need for certainty & consistency

> Macro level – the policy point again

> There is a need to develop a common policy approach across IDB Member States if

Sukuk-based infrastructure financing is to develop in any meaningful way

> Micro level - within most GCC countries significant further work still needed on the enabling

framework in areas such as:

> Tax treatment - Islamic products need supportive frameworks

> Legal issues – amongst many that need attention some of the more important include:

> securities laws & regulations

> robust legal frameworks for transfer and custody of assets

> bankruptcy and insolvency

> SPV regimes

> trust laws (or substantively equivalent mechanisms)

> Shariah scholars - need to develop consistent positions – ideally across jurisdictions – on

structures and key intercreditor issues

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Future prospects & alternative approaches

> Future demand - every forecast we read at the moment describes massive

infrastructure needs across many IDB Member countries in the Middle East, Asia and

North Africa

> The current global economic position – especially the reduced oil price – indicates that

governments will need to find new ways to fund major projects

> Track record – the past 10 years have witnessed an upward trend in the size and

frequency of IF tranches on major projects; IF only project finance deals have emerged;

predominantly bank financed

> Role of capital markets – investors in the capital markets (generally) do not get involved

in deals; they want a rating and a clean promise to pay

> Alternative approaches - possibilities include the following:

> Capacity based Sukuk – extending the range of applications (see below)

> Covered Sukuk – creating secured Sukuk but not full securitisations (see below)

The capacity-based Emirates Sukuk issues in 2013

> Why choose this transaction? Not a classic infrastructure Sukuk but an example of innovation. Similar methods have been used in the telecoms sector with Airtime.

> Analogous situations - it should be possible to extend this approach to a wide variety of infrastructure & developmental assets…

Key features of the Emirates Sukuk

> Previous Sukuk – The Sukuk issued by Emirates Airlines in 2005 Sukuk was a ‘traditional’ Sukuk al-Ijara that utilised aircraft as the underlying asset.

> Response to customer needs - Emirates required a scalable Sukuk structure which did not intrude on its business model. It also required an instrument that was capable of being amortised. Amortisation is not typically a feature of capital market financings but demonstrates the flexibility of the instrument and may be helpful in infrastructure transactions. Flydubai has since issued a non-amortising version of this type of Sukuk.

> Intangible asset – The underlying intangible asset used in the Sukuk represented a progression from the ‘airtime’ financing technique first developed for the telecoms industry. A capacity-based solution was devised using an aviation industry metric of overall capacity known as the ATKM (and defined for the purposes of the Sukuk as ‘Allotted Rights to Travel’). As used by Emirates, the metric combines passenger capacity (‘RPKM’) and freight transport capacity (‘FTKM’). This metric is reported in the Annual Report and Accounts of the airline so has not been ‘manufactured’ solely for use in the Sukuk.

> Shariah structure – The Shariah techniques used in the structure are a forward sale (based on the principles of Salam) and the appointment of a sales agent (pursuant to a Wakala arrangement), and they were combined as follows:

> Forward sale – a quantum of future ATKMs were sold by Emirates to the SPV for immediate payment and future delivery (the principles of a salam sale) under a “Purchase of Services Agreement” (the nomenclature was important for the Shariah scholars).

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Key features of the Emirates Sukuk continued…

> Agency arrangement – the SPV appointed Emirates to act as its agent (‘Wakeel’) under a ‘Service Agency Agreement’ to sell the ATKMs on its behalf in accordance with an agreed sales schedule

designed to generate sufficient revenue to pay sums due under the Sukuk.

> Amortisation & Partial Dissolution – As mentioned earlier, unusually for a Sukuk transaction, this structure provided for amortisation by requiring ATKMs to be sold for not less than the Minimum Price

set for each Distribution Period (in accordance with a table in the Terms & Conditions); in this manner each certificate was ‘partially redeemed’ on each Partial Dissolution Date – which dates correlated with

the Periodic Distribution Dates.

> Sales Shortfall – the Service Agency Agreement contains an obligation on Emirates (as service agent) to make up the difference if actual sales of ATKM’s were less than the minimum required in any

Distribution Period by payments out of the Reserve Account.

> Purchase undertaking – The instrument typically used to trigger redemption at maturity of many Sukuk

is the Purchase Undertaking. In the Emirates’ Sukuk, this was not needed at redemption by which time the Certificates should be fully redeemed. If there is a Dissolution Event however, then the Purchase Undertaking can be exercised to oblige Emirates to buy back any unsold ATKMs.

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Further developments at Emirates

> ECA supported Sukuk - building on the success of its earlier Sukuk al Ijara (2005) and the ATKM capacity-based

Sukuk (2013) in 2015 Emirates raised further Sukuk funding using an innovative structure that combined both the ATKM element and the more traditional Ijara approach. The most novel aspect of the transaction was the fact that a European export credit agency (ECGD of the United Kingdom) was willing to support the transaction with a guarantee of the United Kingdom government. The interesting features of the transaction, so far as this paper is concerned, are as follows:

> Shariah structure – the transaction demonstrated that with the right structure and credit, it is possible to use Sukuk for financing the manufacture and purchase of major industrial assets (the transaction financed the manufacture and delivery of 4 A380 aircraft with a transaction value just below $1 billion). Although there is much discussion about the suitability of Islamic finance for infrastructure and so-called ‘project Sukuk’, the reality is very different. Ignoring the Malaysian market, which has its own idiosyncrasies, there have been very few true project Sukuk and most that have been issued in such a way that the Sukuk portion of the overall project is introduced to refinance the project upon completion.

> Pre-completion period – in the 2015 Emirates deal the ATKM portion of the Sukuk was used to finance the pre-delivery period.

> Post-delivery - upon the delivery of each aircraft, the Ijara portion of the Sukuk provides the mechanism whereby the Sukuk holders recover their investment over the tenor of the Sukuk.

> Takeaways – the Emirates deal provides a basis for thinking about how to structure future Sukuk which have to manage completion period risks. Of course, from an investor perspective, the availability of support from ECGD will have helped to mitigate any perceived risk in the transaction. In case it is relevant, if projects in the GCC have any UK sourced inputs (such as design, procurement or project management services or any materials and equipment, the United Kingdom Government is willing to provide ECGD support and that could help make a secured Sukuk more attractive to investors). The author of this paper was in conversations with UK government officials on 12 January 2016 where the desire of UK Export Finance (i.e. ECGD as branded for business) to support overseas Shariah-compliant transactions where British products and services were involved was reconfirmed.

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Innovative thinking leads to further applications

> Extending the permissible asset class - The challenge for the Islamic finance industry will be to explore the extent to

which output or capacity-based products and services can be used to underpin Islamic transactions (whether Sukuk

or otherwise) in the future.

> Highways as an example - The Dubai RTA financing in the UAE several years ago was based on receivables

generated by traffic passing along the tolled motorways of Dubai. Motorways have been financing by Islamic banks

using various methods in the past, principally based on Istisna’a arrangements. A capacity based approach to the

financing of roads is feasible but there is a distinction between tolled roads and non tolled roads. It is not yet clear if

the practice of ‘shadow tolling’ would be approved by Shariah scholars as proving a sufficiently robust measurement

of value in the real economy. If this were approved, then a new method may become viable.

> Educational facilities as an example - The techniques of PPP arrangements often require certain performance and

availability characteristics to be met before the project company becomes entitled to receive payments. By way of

example: how might such an arrangement work in the context of financing the construction and operation of schools?

In this context, it is not yet known if Shariah scholars would be willing to accept as a permissible asset something that

might be described as follows: “X number of school desks available for Y number of students for Z number of days in

any specified period”. If the Shariah scholars were able to accept such a formulation, then it may be possible to

establish a genus of such assets that could be (a) sold to Sukukholders for immediate payment and future delivery

(i.e. under a Salam arrangement) whereupon (b) the project company or operator would enter into a Wakala

arrangement to organise the future sale of such assets. Clearly, it would be important to know what the “offtake”

arrangements were going to be, so as to ensure that the available school places would be paid for in order to

generate the necessary returns to investors.

> Further applications of the principle - There is no reason in principle why these techniques could not be expanded to

various types of products and services provided they can be shown to be Shariah permissible activities that deliver

necessary products and services to the real economy.

Covered Sukuk

> Introduction to covered Sukuk - Covered Sukuk have not to-date been issued in any meaningful quantity so it is difficult to comment

upon them as a generic instrument within the Islamic capital markets. Theoretically, a covered Sukuk would be designed to provide similar credit and security characteristics to those of a covered bond.

> Malaysian example - so far as we are aware (based on recent research we have undertaken) the only publicly issued covered Sukuk that we have found information about took place in Malaysia in November 2013. This was arranged by one of the leading

Malaysian banks for Malaysian Building Society Berhad. Unfortunately, the main Islamic financing technique adopted was commodity Murabaha which we do no believe would be marketable in the GCC. There were however some interesting aspects of

the structure that may be helpful if Sukuk were to be used for financing infrastructure in the GCC.

> The cover pool assets - To create a viable covered Sukuk it would be necessary to establish a pool of collateral (the ‘cover pool

assets’) that will be available as security for the obligations of the obligor under the issuance and to which investors could have recourse. The precise way to achieve may vary depending upon the nature of the issuer/obligor and the assets involved.

> Conventional covered bond market – the conventional market, as developed in the United Kingdom, provides guidance on the structures used for covered bonds and adopts two main forms: contractual and statutory. For our purposes, the differences

between the two models are not relevant. In the United Kingdom, the majority of covered bonds have utilised residential mortgages as cover pool assets and the security effect is achieved through over-collateralisation.

> The cover pool guarantor - under a conventional covered bond the issuer usually establishes a limited liability partnership (‘LLP’) to act as owner of the cover pool assets. The LLP acquires the cover pool assets from the issuer (or another seller) and the cover

pool assets are secured in favour of the bondholders. Covered bonds in the UK are direct, unsecured and unconditional obligations of the issuer (usually a bank) and the issuer’s payment obligations are guaranteed by the LLP. The cover pool assets are held as

security for the guarantee.

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Final remarks

> Reinventing the wheel - there are no “new” products

> Adaptation - but existing methods can and should be adapted for

Shariah purposes

> Industry stakeholders – the industry’s stakeholders must create

policy frameworks that offer a cohesive and consistent approach

> Regulators and legislators – must do the hard work of creating the

legal, regulatory and fiscal frameworks that are ‘fit for purpose’

designing new laws if required

> Shariah – Scholars need to standardise Shariah positions on key

structures & intercreditor issues

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Questions?