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While S&P has a generally positive view of the new requirements for Shari’ah governance and disclosures, it is likely that three areas might present risks.
Tuesday 22, January 2019
S&P Global Ratings believes the proposal by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) for Sukuk governance, if implemented, can help boost the credibility of Sukuk and minimize some of the risks, particularly those related to noncompliance with Shari’ah.
On the other hand, some of the proposals could open the door to unforeseen risks. While S&P has a generally positive view of the new requirements for Shari’ah governance and disclosures, it is likely that three areas might present risks: the proposal to keep the special-purpose vehicle (SPV) issuing the Sukuk totally independent from the sponsor; the requirement for the effective transfer of the underlying assets; and the requirements for the valuation of the underlying assets.
Most Sukuk issued to date are based on contractual obligations of their sponsors. But if AAOIFI's proposal is implemented, the market might depart from this common practice and shift toward Sukuk where repayment is based largely on the underlying assets themselves, including recourse to them under scenarios of default. However, the market appetite for such instruments is yet to be demonstrated. Therefore, two points that require clarification are the mechanisms of recourse of investors in case of Sukuk resolution and whether it would still be acceptable to issue Sukuk where repayment relies solely on the contractual obligations of sponsors.
The Positives S&P believes that AAOIFI's proposals could help boost the credibility of Sukuk and minimise the risks related to non-Shari’ah compliance. Among other requirements, the proposed standard specifies that: the Sukuk's sponsors must ensure the assets are managed in line with their contractual obligations and no breach occurs; Sukuk are subject to an internal audit of its compliance with contractual terms, AAOIFI standards, regulatory requirements, and Shari’ah rules; Sukuk are subject to periodic oversight by the Shari’ah board with a process to escalate any risks related to noncompliance with Shari’ah to regulators and Sukuk holders.
The proposal also recognises that the possibility of change in a Shari’ah ruling (fatwa) for specific reasons, such as significant changes in the business or operations or the originator or the Sukuk assets, or a change in the relevance of the earlier Shari’ah standard that was applied, or any possible error in the original ruling.
However, the standard requires that under such a scenario, any change in the legal documentation of the Sukuk shall be based on the principle of justice and equity and ensure that any revision in the Shari’ah standard causes minimum harm to Sukuk holders. Moreover, the standard requires that any termination of the Sukuk shall not result in an unjustifiable material loss to the Sukuk holders.
The proposal requires an external Shari’ah audit of the Sukuk at least once a year with reporting to the various stakeholders. Such provisions might help the Sukuk market by reducing the risks of the instrument being seen as non-Shari’ah compliant. They can also minimise the risk of using Shari’ah compliance as a reason to avoid delivering on contractual obligations.
In 2017 for example, Dana Gas reportedly defaulted on its Sukuk, alleging a lack of Shari’ah compliance, which triggered lawsuits in the UK (the court rulings were in favor of Sukuk holders) and in Sharjah. In the end, Sukuk holders decided to settle with Dana Gas rather than try to enforce the UK judgment in Sharjah. Among other things, the Dana Gas case illustrates the potential additional risks to which Sukuk holders might be exposed when dealing with Shari’ah-compliant products. It highlights the potential issues that arise when trying to enforce foreign judgments in local jurisdictions, especially when Shari’ah is the ultimate source of the law. Finally, Dana Gas also again moved the debate about standardisation of legal documents and Shari’ah interpretation to the top of the agenda for policymakers.
S&P summarised the proposals made by AAOIFI that could trigger unforeseen risks as follows:
Appointment of an independent trustee AAOIFI requires the appointment of an eligible and reliable trustee that: understands and demonstrates compliance with Shari’ah; is independent and objective; demonstrates creditworthiness and financial stability; and complies with best practices of relevant responsibilities.
S&P considers these requirements as a potentially disruptive change because currently the SPV issuing the Sukuk generally acts as the trustee of the transaction. The SPV generally has no history of operations and is incorporated solely for the purpose of participation in the transaction. To ensure the protection of investors, usually the trustee unconditionally delegates its authority to a delegate, which is typically an independent party. It is therefore necessary that the standard clarify whether this is an acceptable solution.
In its proposal, the AAOIFI would require the sponsor neither have effective control nor management of the SPV nor direct or indirect equity stake in the SPV. Moreover, AAOIFI requires the absolute transfer of the assets to the SPV in a manner that creates a legal impediment for the sponsor or its creditors to have any legal rights over the assets in the event of bankruptcy of the sponsor.
S&P is of the view that this requirement is contrary to market practices where the sponsor of the Sukuk itself usually owns the SPV. The risks related to conflicts of interest are usually dealt with through the delegation of authority to an independent party. It is possible that if the AAOIFI proposal is implemented as proposed, it could raise roadblocks for sovereign Sukuk issuance as it might appear to be a disguised privatisation, for example. The absolute transfer of the underlying assets is also contrary to market practices.
While Sukuk terms and conditions usually include provisions for transferring the underlying assets, it is understood that issuers and investors don't want to make such a transfer and keep recourse only to the sponsor (and in no case to the underlying assets). The effective transfer of the underlying assets could provide some form of credit enhancement, whose benefits depend on many other factors, but might also weaken the credit quality of the sponsor (as it will be deprived of these assets).
The standard requires that assets be transferred to the SPV at their fair market value or a value that is reasonably close to it. It also clarifies that in no case should Sukuk assets be transferred between parties at a value considered inappropriate or exploitative for either party.
This requirement is contrary to the market practice where the value and transfer of the asset is set at the onset of the transaction for its whole duration. Under the purchase undertaking, for example, the sponsor of the Sukuk generally undertakes to buy back the underlying assets at a predetermined price equal to the principal of the transaction.
While the legal language of the purchase undertaking is designed to protect investors against the risks that the sponsor might question this price, AAOIFI's proposal could open the door to such a scenario. It could also result in a loss for Sukuk holders in jurisdictions where Shari’ah is the ultimate source of the law. The typical example would be a real estate company using some of its real estate assets as underlying assets for a Sukuk issuance, refusing to execute a purchase undertaking on the ground that real estate assets have dropped in value and the exercise price of the purchase undertaking is no longer a reflection of the fair value of the assets. S&P is therefore of the view that AAOIFI needs to clarify whether current market practices will still be acceptable when the standard is implemented. If the standard is implemented as proposed, the interest of issuers and investors in Sukuk might decrease. Some of these requirements might also increase the complexity of Sukuk and the costs related to issuance compared with conventional bonds, thereby reducing their attractiveness to issuers and investors.
S&P Global Ratings published its methodology for rating Sukuk in January 2015, outlining the five conditions that a Sukuk has to fulfill to achieve the same rating as on the sponsor. One of these conditions is the sufficiency of contractual obligations of the sponsor for the repayment of Sukuk holders (principal plus all or the last periodic distribution amount in a scenario of early dissolution). However, AAOIFI's proposal to transfer the underlying assets from the sponsor to Sukuk holders could change the way the ratings agency looks at these transactions. S&P could instead use either its structured finance methodology or our corporate methodology to rate the Sukuk.
If the corporate methodology applies, for the rating of an instrument to benefit from collateralization, the underlying asset has to be sufficiently liquid and of a good quality. The legal environment needs also to fulfill certain requirements. Furthermore, if several of the sponsor's assets are tied to its Sukuk issuance, it could have negative consequences for the ratings. Finally, if sponsors can challenge their contractual obligations based on the change in the value of the underlying assets, the transaction might not be ratable due to lack of sufficiency of contractual obligations.
Similarly, if the Shari’ah compliance of a transaction is questioned after the closing of the transaction and results in a significant change in the legal obligations of the sponsor, the rating might be revised—and even lowered to a very low rating category if S&P were to consider the changes akin to a distressed exchange.