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Ṣukūk Default and Issues in Their Resolution: The Case of Villamar Ṣukūk

Salman Syed Ali

IIFM Session at WIBC 2016, Bahrain: Islamic Finance Seminar

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◊ Islam’s prohibition of interest

◊ Emphasis on transparency

◊ Truthfulness and

◊ Fairness in dealings

=> Resolution of a default or bankruptcy quick and smooth

However, the reality in the ṣukūk market is that it takes a very long time and complex negotiations to settle a default or a bankruptcy.

Resolution of Sukuk: Possible Ideal … , but the Reality!

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The purpose of this study is to understand the nature and causes of the difficulties encountered in quick settlement of defaulted ṣukūk.

It also aims to identify the Sharīʿah issues faced in the resolution and settlement process.

The Purpose

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Analyze this ṣukūk and its default with a view to find:

How a mushārakah ṣukūk can ever default?

What operational and structuring factors cause delay in default resolution of mushārakah ṣukūk?

What lessons can be learned from this episode?

Key Questions

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◊ Background

◊ Structure of Villamar Ṣukūk

◊ Analysis of Delayed Resolution by Asking Four Questions

◊ Lessons Learned for Mushārakah Ṣukūk

Outline of Presentation

Background

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The nature of the problems encountered in the default resolution will greatly depend on the type of ṣukūk under consideration, therefore, to keep this case study within practicable boundaries, we focus attention on mushārakah ṣukūk only.

Specifically, we focus on Villamar Ṣukūk. It was a mushārakah ṣukūk launched in 2008, after the issuance of the 2007 AAOIFI revised Sharīʿah standard for ṣukūk. The revised standard was issued in response to the controversy over the legitimacy of many ṣukūk products, particularly the mushārakah ṣukūk in which the capital of a partner is guaranteed by a buy-back promise by the other partner.

The Villamar Ṣukūk was unique in that it was a mushārakah ṣukūk without the buy-back promise, thus complying with this aspect of the AAOIFI’s revised ṣukūk standard.

Background

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The Ten Ṣukūk in Default after the Global Financial Crisis

1 The Nakheel Group – UAE

6 International Investment Corporation – Kuwait

2 Gulf Holding Company (Villamar Ṣukūk) – Bahrain

7 Saad Group (Golden Belt) – Saudi Arabia

3 Dana Gas – UAE

8 Arcapita Bank – Bahrain

4 Gulf Finance House – Bahrain

9 The Investment Dar – Kuwait

5 Tabreed Ṣukūk – UAE

10 East Cameron Partners – USA

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Setting aside Nakheel Group Ṣukūk, the nine ṣukūk in default amounted to US$3.166 billion and accounted for about 7 percent of the total ṣukūk issuance by 2008.

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Structure of Villamar Ṣukūk

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Villamar Sukuk Structure [Issued in 2008, US$190 million, to mature in 2013]

Pledge of Shares in RSRED

Profit Allocation Contribution “in kind” by way of a license (granting a license to develop and certain other rights to the Land.

Standby Letter of Credit (USD 35 m)

Project Sponsor Returns Proceeds

CERTIFICATE HOLDERS

MUSHARAKA WITH BUSINESS PLAN

ISSUER TRUSTEE AS A MUSHARAKA PARTNER

SECURITY AGENT

RSRED AS A MUSHARAKA PARTNER

GULF HOLDING COMPANY

RSRED AS MANAGER

Management Agreement (signed on the behalf of the Musharaka by the Issuer)

Cash Contribution

Profit Allocation

Project Revenue (Issuer acts as Cash Manager)

Analysis by Four Questions

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oQ1. Can a Mushārakah Default?

oQ.2 What are the key feature of a mushārakah and test of its validity?

oQ.3 Can Trust Structure be misused?

oQ.4 Can Trust and its Governance Issues be Ignored?

◊ The scenario that a mushārakah ṣukūk has defaulted is itself surprising. Default can occur in debt or debt type contract.

◊ In a mushārakah, the partners share in profits and losses, so there is no contractually defined fixed payment. Hence, there can never be default in mushārakah but a bankruptcy or insolvency is possible.

Q1. Can a Mushārakah Default?

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◊ In mushārakah ṣukūk the word default does not fit.

Conclusion to Q.1

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◊ The difference between an interest-based debt contract and a partnership contract lies in the conflict of interests and alignment of interests of the two parties. In interest-bearing debt, if a default occurs then the interests of the lender

diverge greatly from that of the borrower. The lender would like to get the interest payment as well as whatever amount of the principal is recoverable, even if this move leaves nothing for the borrower.

In a partnership contract, the interests of the two parties move in harmony both during the upside as well as during the downside of the business. The partners share in profit according to pre-agreed ratio. If a loss occurs it will be shared pro-rata in proportion of the capital share of the partners.

Q.2 What are the key feature of a mushārakah and test of its validity?

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◊ These ṣukūk are not really partnerships. The term mushārakah ṣukūk is misnomer.

Conclusion of Q.2

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45˚ line ◊ Interest-based debt return

profile ( )

◊ Traditional musharakah return

profile ( )

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Project’s Profit

Investor-1’s Portion of Profit

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◊ An important feature of the Villamar Ṣukūk structure was creation of a Trust to hold assets on behalf of the ṣukūk holders.

◊ It also served to keep an impenetrable separation between the ṣukūk holders and the project assets.

◊ Creation of a Trust or an SPV in Ijarah ṣukūk is understandable to create a bankruptcy remoteness between the obligor and the assets which are sold and leased, the subject matter of ijara ṣukūk. Should there be remoteness between the partners and the assets of the partnership even in case of bankruptcy? That is, should partners not have a recourse to the partnership assets in case of winding up of the partnership? What are the consequences of such non-recourse? These important questions have not received adequate attention in the literature on mushārakah ṣukūk.

Q.3 Use and Misuse of Trust Structure

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◊ The offering circular states that: Each Ṣukūk Certificate evidences an undivided beneficial ownership in the Trust Assets calculated pro rata based on the face value of the Ṣukūk Certificates (as defined in Condition 4.1, Summary of the Trust) and will rank pari passu, without any preference, with the other Ṣukūk Certificates.

◊ “Once the Declaration of Trust has been declared, the Ṣukūk Certificates will represent a beneficial right to the Trust Assets held by the Trustee on trust for the benefit of the Certificate holders. The recourse of the Certificate holders against the Issuer or Trustee is limited to the proceeds from the Trust Assets and once the Trust Assets have been realized and applied, the Certificate holders shall have no further rights against the Issuer or Trustee.” (Preliminary Offering Circular, page 25).

◊ The ‘Trust’ comprised of specific assets: Issuer’s shares in the Mushārakah, income receivable from the Mushārakah, and a security (mortgage) package contributed by the RSRED. The ṣukūk holders’ recourse to the assets, in the event of loss or discontinuity of Mushārakah business, if incurred without any fault or negligence of the Mushārakah Manager, was made limited to the assets of this Trust only. Not to the Mushārakah or its project or its partners.

Some Trust Clauses

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When money collected but not yet invested

Trust Ṣukūk holders

1 Assets Liabilities Assets Liabilities

+ Ṣukūk Proceeds Debt to Ṣukūk holders

+ Credit to Issuer (-) Price Paid for Ṣukūk

0

When investment in Mushārakah takes place

Trust Ṣukūk holders

2 Assets Liabilities Assets Liabilities

+ Mushārakah Shares + Mushārakah Shares

+ Ṣukūk 0

(-) Ṣukūk Sale Proceeds

(-) Debt to Ṣukūk holders

(-) Credit to Issuer

After the bankruptcy of underlying project

Trust Ṣukūk holders

3 Assets Liabilities Assets Liabilities

Residual net Assets of the underlying project

Mushārakah Shares + Mushārakah Shares 0

(-) Ṣukūk

Balance Sheets of the Trust and the Ṣukūk holders at Different Stages

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◊ These mushārakah ṣukūk are analogous to the restricted certificates over mushārakah shares in which the holder of the derivative financial product never has recourse to the underlying real asset.

◊ Thus, in essence mushārakah ṣukūk would be financial derivatives only and therefore subject to very different rules, not same as ṣukūk.

Conclusion to Q.3

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Pool of Shares in a Business

Sukuk Investors

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◊ There were several governance and operations issues in the Trust created by the Issuer in the Villamar Ṣukūk.

◊ Weaknesses of legal standing, incentives and powers rendered the Trust incapable of safeguarding the interests of the ṣukūk holders.

◊ What is the Declaration of Trust and what are its terms and conditions? What does it say about the rights and responsibilities of the Trustees? Who will pay for the work of the Trust? What legal protections does the Trust have under the trust laws of the issuer entity country and the trust laws of the country where the ṣukūk assets are located?

Q.4 Can Trust and its Governance Issues be Ignored?

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◊ Without a proper balanced & independent Trust and without the requisite powers with the trustees, a Trust cannot achieve the desired goal of fairness and efficiency.

Conclusion to Q.4

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Key Lessons

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1. This ṣukūk had many desirable properties and conditions built into its structure, however it failed to be a mushārakah on a number of key requirements and conditions.

2. The successful subscription of the Villamar Ṣukūk shows that the lending investors desired a lending instrument (competitive returns and principal secured) and the borrowing debtors desired a debt instrument. However, at the same time both the lenders and borrower also wanted to ‘feel’ that they are abiding by Sharīʿah. This contradictory behavior (pursuit of worldly desires and lip service to religion) cannot bring the fruits of Islamic finance to the society. It shows a weakness in society that has to be addressed by all stakeholders at their respective level of work.

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3. Interest-bearing debt has inherent conflict of interest between the lender and the borrower, which gives rise to stark differences in the behaviors of the two parties in the event of default or bankruptcy. The profit sharing (mushārakah) does not give rise to the same type of conflict of interest between the two partners. If same conflicts arise in mushārakah, then this is an indication of some flaw in the product structuring or its implementation despite its formulation as partnership.

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4. Creating a Trust and appointing the Trustees without endowing them with necessary independence and powers to protect the interests of the beneficiaries will not be helpful. Rather such Trust itself becomes a source of delays in resolution of bankruptcy.

5. There is a need to provide collective bargaining power to the ṣukūk holders.

6. A Trust, which is proactive, independent, and endowed with appropriate powers to protect the interest of ṣukūk holders will be more beneficial than a Trust only to create a separation of assets.

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7. In a partnership ṣukūk (mushārakah ṣukūk ) the remoteness between the partners and the assets of the project can be made for the normal course of business. However, this remoteness has to vanish in case of bankruptcy or early winding up of the partnership.

8. There are social, economic and religious consequences of the kind of non-recourse tolerated in Villamar Ṣukūk. First, it contributed to delay in resolution and hence the economic losses in terms of potential other uses of the assets and property. It also kept the assets concentrated and frozen with one partner (RSRED) to the exclusion of a large number of ṣukūk holders who could not utilize it.

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9. By not launching a true Mushārakah Ṣukūk but structuring it as de facto debt certificate through roundabout methods, an important opportunity of attracting a different type of investors was lost. The opportunity to make market correction in the pricing of real estate was also lost.

10. Advantages of Islamic finance are lost when Sharīʿah-compliant finance is rendered ambiguous to the finance community and the public at large.

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THANK YOU

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ssyedali@isdb.org

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