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Opalesque Islamic Finance Intelligence

Lex Islamicus: When Sukuk Default - Asset Priority of Certificate-holders vis a vis Creditors Mohammed Khnifer

Thursday, September 02, 2010

Mohammed Khnifer is regarded as part of a 'second generation' of Islamic banking practitioners who have a solid academic background in Islamic finance. He is a holder of an MSc in Investment Banking & Islamic Finance from Reading University and is a Chartered Islamic Finance Professional (CIFP) from INCEIF. He is one of the most prolific and well-known journalist specializing in Islamic Finance today. For the past six years he has been in charge of the editorial content for the Islamic Banking section of Al Eqtisadiah (Kingdom of Saudi Arabia).

Asset-backed or Asset-based Issuance?

Sukuk is considered the most sought after financial instruments in the Islamic Finance industry. Western investors view them as debt-like fixed-income instruments, whereas Muslim investors purchase them as it complies with their religious beliefs, but at the same time serve their needs for relatively less-risk investments than equities or real estate.

Sukuk were in the spotlight lately with a high profile defaults that helped to create new perspective on the way these instruments should be legally structured. In this research, three sukuk issuances will be examined: 1) the asset-backed Tamweel RMBS, 2) the asset-based Tamweel Sukuk Limited ("TSL"), 3) the asset-backed issuance of East Cameron Gas (ECG), which has defaulted.

Before we examine the underlying assets of these issuances we need to shed light on a highly controversial subject, i.e., the ownership of the assets underlying sukuk. Just like most bonds, most sukuk issued today are asset-based, which grants the certificate holder rights on a portion of the cash flows. There are often no direct links to actual assets, which is a condition of Shariah. One of the rationale behind asset-based sukuk is the likelihood of obtaining higher ratings, as such sukuk are linked to the credit of the originator that raises the funds, not to physical assets.

From the Shariah perspective it is essential that sukuk are backed by a specific, tangible asset throughout its entire tenure and sukuk holders must have a proprietary interest in the assets which are being financed (Yean, 2008). Indeed, in its recent pronoucement the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) advised originating companies to sell and "legally" transfer ownership of the underlying assets to investors. Michael McMillen (2008) defines asset-backed sukuk as asset securitizations involve asset transfers from an originator into a trust or similar SPV, with sukuk issuance by that trust or SPV and payments on the sukuk derived from the payments received in respect of those transferred assets.

In the past years, Tamweel PJSC ("Tamweel") has issued three types of sukuk, one of which was hailed as the first true sale by the industry. The Shariah-compliant residential mortgage backed securitization (RMBS) transaction was worth US$210 million and had four ijarah sukuk tranches. The underlying assets that back this lease-to-buy ijāra are single family homes (villas). Moreover, villas are in short supply in a rapidly growing real estate market with limited available expansion space and infrastructure. These types of properties are thought to be more resistant to price volatility and depreciation (as compared with apartments, of which there are many more). Further, villa purchasers tend to be families, rather than more transient, single residents (McMillen, 2008).
In the case of these first Tamweel sukuk freehold titles to the underlying properties were transferred to the sukuk holders along with the associated ijarah cash flows (Yean, 2008). Further, and importantly, property titles are registered in the name of the SPV that issued sukuk and sold them to sukuk holders. Any losses on those cash flows (that arise from the sale of distressed property) are passed on to the SPV and subsequently the sukuk holders, who are then directly exposed to asset price risk and as a result its liabilities.
There has been a healthy debate between scholars and lawyers over "legally" registering ownership of assets to sukuk holders as the fees of such registration are costly for the issuer. But, legal ownership acts also as a protective legal buffer if Tamweel, for example, went into insolvency. Unlike asset-based sukuk, this type of securitization should continue to perform regardless of the financial distress of the originator and certainly the process of liquidating the assets will be much easier for the sukuk holders.


The second issuance of Tamweel is an asset-based one where the investor's legal rights for the ownership of the underlying assets is limited. Tamweel Sukuk Limited ("TSL") is a special-purpose vehicle incorporated in the Cayman Islands and created to issue Sukuk Trust Certificates to investors and use the proceeds to acquire a pool of Shari'ah-compliant assets from the mortgage finance company Tamweel. TSL, as Trustee, will acquire the assets in the Trust. This special issuance contains two types of sukuk, which merges it into one asset. It has a portfolio of leased assets (i.e. residential ijarah lease-to-own assets) as well as portfolio of Istisna'a property assets that are under construction.

After examining the TSL prospectus, there was no clear mentioning that the $299.6 million sukuk issue is an asset-based one. Nonetheless, there were some signs that this is the case. When it comes to transferring the portfolio of assets, the originator gave no assurance that any rights, title and interest in and to the portfolio assets has been or will be transferred to the trustee (TSL Prospectus, 2008). Unlike asset-backed sukuk, these certificate holders have no recourse against any other assets of the issuer or the trustee or any right to cause the sale or other dispersion of any of the trust assets, except during the initial purchase undertaking.

On the other hand, East Cameron Gas Co.'s $165.67 million investment trust certificates are an asset-backed sukuk that were secured by an interest in the oil and gas royalty rights on two gas fields in the Gulf of Mexico. It was structured as a Musharaka (an onshore SPV) between an offshore SPV domiciled in the Cayman Islands and the originator, East Cameron Partners. The offshore SPV issued sukuk and contributed the proceeds to the onshore SPV, while the company made an in-kind contribution of the overriding royalty interest (ORRI) in the lease properties (Goud, 2009).

The unique part of this Musharaka sukuk is the ORRI, which is recognised legally in Louisiana as real property. The ORRI gives the onshore SPV the right to receive a certain volume of production-oil and gas-over the term of the sukuk (Goud, 2009). The oil and gas is then sold and the proceeds are split between the issuer and the offshore SPV, which uses the funds to pay the periodic payments and repayment of principal to sukuk investors. According to Blake Goud, an Islamic finance researcher, the ORRI provides the investors with protection greater than many other debtors in bankruptcy proceedings. This protection is created with a "true sale" of the ORRI to an SPV to ensure it is bankruptcy-remote; that is, through a structure to minimise the chance that the ORRI can be included in the issuer's bankruptcy estate, which would subject it to claims by other creditors.

Bankruptcy Remoteness and Why it is Crucial

SPVs are often described as "bankruptcy remote." Moreover, it is used in the context of a transaction where underlying assets are being isolated for the benefit of the sukuk holders (for example, assets are being "sold" to a bankruptcy remote SPV). Hence, the newly created SPV has no exposure to the liabilities of the originator, other than the liabilities of the underlying assets. There are some countries where bankruptcy remoteness is assisted by legislation. For instance, in the Cayman Islands it is possible to receive a certificate from the Government confirming that the newly formed SPV does not ever need to pay tax for 20 years, thus eliminating a potential liability.

In the light of the above instance, the asset-backed sukuk holders can reap the full benefit of bankruptcy remoteness. After identifying which assets are to be securitized, the originator of the securitized assets transfers those assets to the SPV. The SPV will then hold the assets for the benefit of the sukuk holders and issue the sukuk to them. The purpose of this asset transfer is to separate the assets from the risks associated with the originator. This is done especially to reduce the risks associated with a potential bankruptcy or insolvency of the originator, and place them in a vehicle (i.e., an SPV) that has a low likelihood of bankruptcy or insolvency (McMillen, 2008).

To apply the above in our case study, Tamweel PJSC (the originator and one of the two servicers) is under severe liquidity pressure. As Tamweel RMBS constitutes a true sale, the sukuk holders are assured that their underlying assets had been removed from the estate of the originator. Because of this bankruptcy remoteness, the assets will continue to produce rental payments even if the originator files for bankruptcy. This makes the certificate holder only exposed to the originator as a servicer and not the source of cash flows.

Nevertheless, the bankruptcy remoteness function cannot work properly with the asset-based issuance where the beneficial right of the assets is usually sold to the SPV. From a legal perspective, the originator owns the underlying assets and not the certificate holders who have a weaker stake to the underlying assets. This means if the originator files for Chapter 7, the sukuk structure can collapse as it will be wrapped up in a bankruptcy of the originating company. Thus, the sukuk holders will join other creditors to make claims on the assets, which might have a beneficial ownership or fully owned by the SPV.

Contrasting Fixed and Variable Income Streams

The income streams for Tamweel RMBS are both fixed and floating rate. The total instalment due is derived from three components of rent to be paid: (i) fixed rental amount for the recovery of the principle (Hoelter, 2007); (ii) variable rental, which is the profit calculated on the reducing balance of the fixed rentals at a fixed rate, in the case of fixed ijarah, or, in the case of flexible ijarah or hybrid Ijarah, at a rate (linked to the Emirates Interbank Offered Rate, EIBOR) which may be reset on a regular basis by the originator (Tamweel RMBS Prospectus, 2007); a supplementary rental calculated by reference to the obligations, expenses and fees the lessor incurs in maintaining and repairing the properties (Hoelter, 2007).

For the periodic distribution of Tamweel Sukuk Limited, the certificate holders are entitled for a floating rate at EIBOR (UAE Interbank offered rate) 3 months plus 2.25% (TSL Prospectus, 2008). On the other hand, the East Cameron sukuk had a fixed payment (11.25% annually). However, there was also a variable component because the sukuk returns depended upon the production quantities (the overriding royalty interest specified a fixed quantity of natural gas be delivered to SPV). It also contained a redemption feature by where a percentage of the sukuk would be redeemed if production exceeded a certain level.

Risk Exposures for Sukuk-holders

The certificate holders of Tamweel RMBS are clearly exposed to the assets that backed such issuance. The credit risk of this true, asset-backed sukuk is driven primarily by the credit risk of the underlying assets, including its liabilities, which have been "sold" to investors, and not the credit risk of Tamweel itself. Despite the stressed economic environment in the UAE this well seasoned ijarah portfolio is performing well with 0.00% defaults since issuance and 0.25% of 60+ day delinquencies as of August 2009 (Howladar, 2009). Nevertheless, there are risks of losses associated with declining property values, lack of liquidity in the property market-which would make it more difficult to sell properties-and the high exposure to expatriates who may leave Dubai with short notice if economic conditions deteriorate further.

The asset-backed sukuk has multiple classes (A, B, C and D) of investors, with each class having a more senior legal claim to the secured assets (which are very similar in nature to securitized mortgages elsewhere). Thus, there is a risk relating to the level of the sukuk class one purchases due to what they call the "waterfall" effect if payments slow, delinquencies rise, and defaults increase.

For example, in the waterfall structure, no amounts will be paid to the holders of a class of notes until all amounts owing to the holders of every class of notes having a higher payment priority have been paid in full (Tamweel RMBS Prospectus, 2007).

The complex engineered structure of Tamweel RMBS also makes it exposed to exchange rate movements which may adversely affect the issuer's ability to meet its obligations under the notes (Tamweel RMBS Prospectus, 2007). Issues may arise due to the fact that the ijara rental payments are designated in Emirati Dirhams ("AED") and the sukuk payments are in U.S. dollars. While the dirham is currently pegged to the U.S. dollar, there is a possibility, although considered remote, that the fixed rate may be removed in the future. Currency hedges with through banks and exchanges could be effective to address various currency and exchange rate issues of this type (McMillen, 2008).

On the other hand, the asset-based TSL is not legally "backed" by an asset. Hence, its rating is driven directly by the strength or weakness of Tamweel, not the assets. This sukuk was downgraded August 2009 in line with deterioration of the originator and its market. In light of their exposure to the originator, sukuk holders are exposed to Tamweel's customer credit risk as well as its operational risk (TSL Prospectus, 2008). In addition to the risk of over-concentration, i.e. Tamweel's business is regionally concentrated in the UAE. It is noteworthy that upon the insolvency of an asset-based sukuk originator, the assets involved would be taken back by the bankruptcy estate. Sukuk holders have no right to cause any sale or disposition of the trust's assets (TSL Prospectus, 2008). Sukuk investors would have no first-lien or prior ranking or security above any other unsecured creditor (Howladar, 2009).

Further to the above, there is a Shariah risk embedded within the sukuk certificate. There is no assurance that the certificates will be Shariah compliant as differences in opinion among scholars are possible (TSL Prospectus, 2008). In the prospectus, TSL advised investors to obtain their own independent Shariah advice as to the permissibility of the structure, the issuance, and the trading of the certificates. On the other hand, the lack of a liquid sukuk secondary market could adversely affect the liquidity and value of the certificate holders' investments.

As the East Cameron Gas issuance involves in the energy sector, sukuk holders were exposed to certain risks. For example, the volatility of natural gas and condensate prices may adversely affect payments on the sukuk. In order to hedge against severe price fluctuations in oil and gas markets, there was a Shariah -compliant hedge that established a price collar between $7 and $8 per million BTU (MMBtu) on half the expected products gas production, and a put option at $6 per MMBtu for an additional quarter of anticipated production (Goud, 2009).

One should mention the risk of natural catastrophe. The originator's business is located in the Gulf of Mexico and this concentration of activity makes its business vulnerable to the risks associated with that region, including the effects of severe weather. Shortly after the September 2008, hurricane Katrina damaged the underlying assets of the sukuk, S&P downgraded the issuance as a result of the negative impact from the hydrocarbon mix shortfall enforcement event on the overriding royalty interest in oil and gas reserves (ORRI), which is the primary collateral for the sukuk. This enforcement event was triggered by the breach of the 90% minimum stressed reserve level of the hydrocarbon mix threshold stipulated in the transaction documents (Lampasona, 2009).

There are also different types of risks that the issuer may incur. The prospectus has placed great emphasis on the originator's possible failure to successfully develop exploitable reserves or improve production capabilities. This may adversely affect the viability of its operational structure. Moreover, unless the originator replaces its oil and natural gas reserves, its reserves and production will decline, which would adversely affect the payments on the sukuk. There is also uncertainty with respect to U.S. tax treatment of the sukuk, and alternative tax characterizations by the U.S. regulatory authorities may materially affect investments in the product (ECG Prospectus, 2006).

The Role of Rating Agencies

Before we tackle the role of rating agencies in regard to the above issuances, we should first shed light on their methodology for rating such complex instruments. All the rating agencies concur that their ratings are an opinion about the ability and willingness of the originator to meet financial obligations in a timely manner, without commenting on Shariah compliance. Investors rely on such ratings in order to evaluate the risk aspects of the sukuk. From the originator's perspective, a good rating will allow for a well-priced and viable sukuk for the capital markets.

Standard & Poor's details its approach by dividing the sukuk into two categories: 1) Sukuk with full credit-enhancement mechanisms. Under this structure, the sukuk receive an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral (Hassoune, 2007). The guarantor provides Shariah-compliant shortfall amounts in case the SPV cannot make payment. The ratings on this type of sukuk are largely dependent on the creditworthiness of the guarantor; 2) Sukuk with no credit-enhancement mechanisms , i.e., the pure asset-backed sukuk. The ratings on these sukuk are largely based on the ability of the underlying assets to generate sufficient cash to meet, in a timely manner, the SPV's obligations. Standard & Poor's ratings, in this particular case, are based on the performance of the underlying assets under different stress scenarios along with the expected value of these assets at maturity.

All rating agencies exercise due diligence before the rating is given. Moody's ratings address the expected loss on an investment relative to the promise as well as the risk of default. Khalid Howladar (2009) reveals the key substance of a sukuk is the return/profits, payment/cash flows of the instrument as well as risk of loss, or how much income/profit can the investor expect to receive when comparing it to how much was due/expected.

Moody's also relies heavily on legal opinions from law firms expert in local and international law as to how the law would be expected to operate in such circumstances. If Moody's believes that such contracts are not binding or that they are voided in a bankruptcy court situation, then it gives limited value to the assets in the structure. This is why the risk and rating analysis is usually focussed on the issuing corporate or bank.

Now that we know the background, we should now examine how the two Tamweel sukuk issuances were rated. In August 2009, Moody's lowered Tamweel's long-term issuer rating to Baa1 from A3. The ratings remain on review with direction uncertain. Given the direct link for an asset-based sukuk, the rating on Tamweel's $299.6 million asset-based Sukuk was also lowered to Baa1 from A3, and also remains on review with direction uncertain. The same issuance was downgraded by Fitch to BBB+ from A. Meanwhile, the asset-backed sukuk (Tamweel RMBS) continues to do well. Hence, no rating downgrade from Aa2, Baa1 and Ba1 for the Class A, B and C notes. For Fitch, there was no downgrading from AA, BBB+ and BB- for the Class A, B and C notes. The D tranche was unrated by both agencies.

On the other hand, the asset-based TSL was engineered to trigger a redemption event, once the obligor is downgraded by at least two notches at any one time between the closing date and the maturity date. Following the occurrence of a rating downgrade event, the certificates may be redeemed in full on the rating downgrade redemption date at the redemption amount, and the trust shall be dissolved following such payment in full (TSL Prospectus, 2008). Indeed this explains the risk associated to asset-based issuance and why this structure was engineered to mitigate such risk for the sukuk holders.

In the case of East Cameron Gas Co.'s $165.67 million investment trust certificates (sukuk), surveying the securitization was vital for the sukuk holders. S&P downgraded the transaction to 'CC' from 'CCC+ when the structure hit a trigger, breaching a 90% minimum stressed reserve level of the hydrocarbon mix threshold. In March 2009, the agency cut the deal to 'D' on skipped payments and withdrew the rating; the latter event was in response to a failure to receive servicer reports (Lampasona, 2009). The deal initially stood at CCC+ largely because significant amounts of the energy deposits that collateralize the deal were proven undeveloped at that time.

Legal Risk and the Role of the Legal Adviser

After examining the prospectus of Tamweel RMBS and Tamweel Sukuk Limited, it is fair to say that the certificate holders share the risk of not enforcing a foreign judgment in Dubai. Under current law, the courts of Dubai are unlikely to enforce a foreign judgment without re-examining the merits of the claim and may not observe a choice by the parties of foreign law (such as English law, Cayman Islands law or Jersey law) as the governing law for a transaction. This could have an adverse effect on the amounts available to be paid to the certificate holders (Tamweel RMBS Prospectus, 2007). Judicial precedents in Dubai generally have no binding effect on subsequent decisions. These factors create greater judicial uncertainty.

For Tamweel RMBS, the asset composition elements and the legal structure of the sukuk were designed to minimize significant uncertainties. Those uncertainties include: (a) uncertainties as to the interpretation, application and enforcement of relevant laws (most notably, recently-issued bankruptcy and collateral security laws that have not been the subject of judicial proceedings); (b) bankruptcy exposures of the title holders to the properties (McMillen, 2008); (c) incomplete title registrations in respect of the properties as a result of the implementation of a new title registration process at the newly-established registration authority (Dubai Land Development).

On the other hand, Tamweel Sukuk Limited has a different type of legal risk as it is exposed to the originator and not the underlying assets. In the event of Tamweel's insolvency, UAE bankruptcy law may adversely affect Tamweel's ability to perform under the purchase undertaking and the service agency agreement and therefore the trustee's ability to make payments to certificate holders (TSL Prospectus, 2008). Ultimately the payments distributions linked the certificates are dependent upon Tamweel making payments to the trustee. If Tamweel fails to do so, it may be necessary to bring an action against Tamweel to enforce its obligations before the UAE courts which may be costly and time consuming.

As for East Cameron Gas (ECG), it was unique from the start. Apart from the legal complexity of the sukuk structure, there was a lack of information on how the articles of the investment offering prospectus stood in the face of bankruptcy court. In October 2008, East Cameron Partners (the originator) filed for Chapter 11 and created uncertainty about how the sukuk holders would be treated under U.S. bankruptcy law, which was as-yet untested using this kind of Shariah-compliant structure. The Islamic finance industry had to wait a year and a half to hear the bankruptcy judge issuing a court order accepting the transfer of East Cameron's assets to the sukuk holders. Finally the Islamic industry could rest, knowing precedent was established in this critical area of creditor rights with Islamic structures.

In this section, I will attempt to highlight the sequence of events for this case, a case which tested the viability of the sukuk structure within the U.S. legal system. Most importantly, we will come to realize whether the advantages of an asset-based sukuk and a bankruptcy-remote SPV can indeed trigger protection of sukuk holder rights on claims to underlying assets.

As is commonly known a company is in a situation of severe financial distress, it will often do whatever it can to back away from legal obligations to the creditors who once funded its investment activities. Sukuk holders were not an exception. The originator tried to wrap up the sukuk holders' assets and claimed that the transaction was not a "true sale" but a secured loan disguised as a true sale. Under conditions of a true sale the sukuk investors should logically have sole rights to the underlying assets. Under such conditions the originator, behind the sukuk holders in claims to assets, would lose its rights and would have rights to the assets only after resolving creditor claims in Chapter 7 (liquidation).

Indeed the legal risk was real and a worst case scenario was possible, especially for a secular legal system that does not recognize Shariah structured instruments. In July 2009, Aleqtisadiah newspaper quoted a source close to the case admitting that there is a need to "establish the sukuk holders ownership of the assets in such a way that courts around the world recognize their ownership rights and rule accordingly" (khnifer, 2009). He continued, "At present, the matter is unclear as to whether sukuk holders enjoy contractual rights to the assets like bondholders, or creditors, so that judges will therefore not rule in favour of their ownership, or whether they enjoy proprietary rights and are therefore considered by the courts to be equity holders," (khnifer, 2009).

The anonymous source then admitted how the originator, investment banks and law firms spent little time discussing how to protect sukuk holders' rights in case a default event took place. "In their desire to deliver products (sukuk) that resemble credit instruments (like bonds), originators have sometimes blurred the distinction between credit and equity; and this has led to difficulties for sukuk holders" (khnifer, 2009). "the originator spent a lot of time on the matter of credit enhancements (protecting banks) and very little time on protecting investors' rights," the source added (khnifer, 2009).

In an order dated 31 March 2010, the judge issued a decision which, surprisingly, vindicated the East Cameron Sukuk structure as there was mounting criticism over the legal firm who structured them. It was a victory for the structure in that the Sukuk certificate holders were able to get full ownership and possession of the assets without sharing it with the other creditors. As a matter of U.S. law, the result is the treatment of the SPV assets as being the product of a true sale. According to Robert E. Michael, bankruptcy lawyer at Robert E. Michael & Associates PLLC, (personal communication, 24 April 2010), the true sale element was upheld by allowing the debtor SPV to be the Seller. This essentially meant that the SPV did in fact own the assets, and was not merely a collateral holder for secured loans.

A court document points out that the judge approved the Asset Purchase & Sale Agreement between East Cameron Partners and EC Offshore Properties, Inc., which is owned by the certificate holders. According to Blake Goud, (personal communication, 25 April 2010), the Asset Purchase Agreement transferred the title over both leases (East Cameron block 71/72) to the sukuk certificate holders. "The purchase price, which will not be paid in cash, includes the liabilities assumed by the buyers, as well as the $4.865 million extended as Debtor In Possession financing (DIP)," he said after examining the court order. The total DIP financing includes all principal, interest, fees, expenses and other charges (Goud, 2010).

To put it bluntly, it appears the sukuk legal structure was in fact imperfect to some extent. For example and without going into details, there were two SPVs, one on- and the other offshore. As the transaction is asset-backed it should have made it easier for the sukuk holders to trigger the bankruptcy and take control of the assets. However, due to legal flaws in the structure they had to wait a year and a half for resolution. In light of recent developments, it becomes clear a third SPV independent of the others needed to be formed under a Musharaka, which would have made the separation of the assets from the bankruptcy estate much easier.

While the event proved successful for sukuk investors, it was nonetheless a setback for the Islamic finance industry in that the deal was structured as a purchase, not a distribution to owners. According to Mr. Michael, the result was a decision that accomplished everything the Islamic finance wanted on a practical level. The assets of the sukuk will go to the certificate holders free and clear of claims of creditors of others; but doing so created a precedent where they did not own undivided interests in the assets. Thus, there is legal precedent here, which should concern lawyers, that the sukuk certificate holders were treated as if they were third party buyers, not owners or even secured lenders.

All in all, we are certain from the ECG sukuk that it was the first legal case in Islamic finance history that proved the asset-backed structure (as opposed to the asset-based structure) can indeed protect investors once a default event is triggered. We can as well say in confidence that if these securities were asset-based, then the sukuk holders would have joined the queue with the other creditors. Hopefully lessons learned will contribute to a new generation of sukuk with more thorough due diligence and greater legal protection for investors.



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