1. 2008 Sukuk and Structured Products Wan Abdul Rahim Kamil ICM Consultant Securities Commission Malaysia INCEIF 14 November 2009 2009 1

2. Content What is Sukuk Contracts underlying issuances Payment structures Distinctions between sukuk Modes of issuing sukuk - Asset based: debt securitisation - Asset based: sukuk al ijarah - Asset backed - Investment Sukuk Musharakah between investors: sukuk istithmar Musharakah between investors and issuer Enhancements 2009 2

3. What is Sukuk?  Securitisation:  financial engineering process of the creation and issuance of fixed or floating income securities,  payments of principal and profits are derived from cash flows generated by the indebtedness that it represents or from the receivables or revenue derived from the pool of assets that underline the transaction in the issuance of the aforementioned securities.  Sukuk represents certificates of equal value that represents:  an undivided interest (proportional to the investor’s participation) in the ownership of an underlying asset (both tangibles and intangibles),  usufruct,  services or  investments of particular projects or special investment activity.  The Sukuk thus forms the financial claim that is manifested in the form of securities whose essential feature is marketability.  Unlike a bond that are confined to the old structure of loan upon which interest are imposed; sukuk are structured out of innovative applications of Islamic financial contracts.  Sukuk however, has certain similarities to revenue bonds because they are structured in tandem with physical assets that have revenue streams.  The underlying revenue streams from these assets are the source of income for investment-capital recovery and for paying the profits on the Sukuk. 2009 3

4. Contracts Underlying Sukuk Structures  A sukuk can be structured based on  any or a combination of two or more, of the Islamic contracts of transactions such as the contracts of participations (‘uqud ishtirak) of Mudharabah and Musharakah, and contracts of exchanges (‘uqud mu’awadhat) of Shariah compliant assets, of Bai’ bithaman ajil, Murabahah, Salam, Istisna’, and Ijarah.  The application of these contracts of transaction results in  the sukuk backed or secured by such assets, thus having an in- built security to the investments.  Under events of default or more appropriately termed, occurrence of termination events by the sukuk issuer, the sukuk generally reasonably assures sukuk holders i.e. the investors, by virtue of them having an undivided interest in the ownership of the sukuk assets, of the ability to recover their investments whether in full or in part, from the liquidation of the assets. 2009 4

5. Sukuk Payment Structures Generally the payments on the sukuk are structured in two forms:  Representing the amortising of the invested capital together with the profits (fixed or floating) derived from the investments  This is normally known as Amortising Securities or Amortising Sukuk;  Where payments of the derived profits (fixed or floating) are made periodically during the tenure of the sukuk, while the payment that represents the invested sum is scheduled at the end of period i.e. at the final maturity date of the sukuk.  This is normally known as Non-Amortizing Securities or Non- amortising Sukuk.  Lately there have been innovations whereby the redemptions to the sukuk are in the form of exchangeables such as equities or commodities.  In the case of exchangeable with equity, the periodic payments to the sukuk could be from the dividend income stream paid on the equity. 2009 5

6. Distinctions between the Sukuk  As sukuk are issued based on various contracts of transaction, there are differences in what they legally represent.  Sukuk that represents ownership of asset, its usufruct or services (the “Underlying Asset”)  the claim embodied in the sukuk is not just a claim to the underlying asset, but also the rights to the cash flow and proceeds from sale of the assets.  This is pertinent to sukuk ijarah, where the sukuk are akin to trust certificates bearing undivided ownership in the leased asset and the rights to the cash flow stream arising from it. 2009 6

7. Cont’d..  For sukuk issued as evidences of indebtedness arising from sale of asset, based on contracts of exchange other than ijarah, such as those arising from bai’ bithaman ajil, murabahah and istisna’  the claim is on the obligations arising from the applied contract of exchange  In this case the sukuk does not represent ownership on the physical asset as the ownership of the asset has been transferred to the obligor, though in certain cases, depending on the credit strength of the obligor, assets are provided as collateral or security to the indebtedness. 2009 7

8. Cont’d..  For special investment activities funded through musharakah or mudharabah the sukuk musharakah or sukuk mudharabah represents  the undivided interest of the holders in the equity of the specific investments.  Sukuk musharakah are used for mobilizing funds for establishing new projects or developing an existing one or financing a business activity on the basis of partnership contracts.  The certificate holders become the owners of the project or the assets of the activity, in proportion to their respective shares.  Profits from the investments are distributed in accordance to pre-agreed proportions among the holders but losses are pro-rated in accordance to proportions of equity held. 2009 8

9. Cont’d..  Sukuk mudharabah represents ownership of units of equal value in the mudharabah equity and are registered in the names of holders on the basis of undivided ownership of shares in the mudharabah scheme  Returns due to the holders as owners of capital, normally are distributed according to the percentage of ownership of the shares.  Losses under mudharabah are borne in totality by the sukuk holders and they are apportioned among them in accordance to percentages of the shares owned  unless the said losses are attributed to the negligence and/or wilful misconduct of the mudharib, who will be responsible for the same. 2009 9

10. □ Sukuk thus is different from conventional bonds as : the latter are interest-bearing securities arising out of the securitisation of loan contracts, whereas □ Sukuk are representations of ownership claims in  a pool of assets or  rights to receivables or  participations. Cont’d.. 2009 10

11. Procedures for Issuing Sukuk □ In Malaysia, the issuance of sukuk would require □the approval of the Securities Commission Malaysia (SC) under section 212 of the Capital Markets and Services Act 2008 and in this regard,  such issuance must comply with the Guidelines on the Offering of Islamic Securities (Guidelines).  In addition, the structure of Sukuk must be confirmed and approved by a Shariah adviser approved by the SC. ―A Shariah adviser can be an independent Shariah adviser approved by the SC or a Shariah committee attached to a financial institution that operates Islamic banking activities approved by Bank Negara Malaysia (BNM) or the Central Bank. □As a guide, the SC Shariah Advisory Council, which is responsible for advising the SC on all matters, related to the comprehensive development of the Islamic capital market in Malaysia, and functions as a reference centre for all Islamic capital market issues, has outlined several Shariah principles that could be adopted in the structuring and issuance of sukuk. 2009 11

12. Modes of Issuing Sukuk □ Sukuk are issued are under several forms such as:  Asset-based Sukuk:  That evidences indebtedness that originates from contract of exchanges of murabahah, bai’ bithaman ajil or istisna’, arising from back to back sale of the issuer’s assets. ―Such Sukuk gives the holders the rights to the obligations attached to the indebtedness;  Arising from Ijarah contracts through sale and leaseback or lease of third-party held acquired assets with purchase option obligations (financial lease); □ Asset-backed Sukuk, and □ Investment Sukuk 2009 12

13. 1(a). Asset-based Sukuk: Debt Securitisation □ The feature of such Sukuk is  the issuance of securities to evidence the indebtedness and  the right to the obligations attached to it, arising from Shariah compliant contracts such as those arising from contracts of exchange transaction of murabahah, bai’ bithaman ajil or istisna’. Under the Malaysian rulings, an intangible asset in the form of such financial obligation is acceptable for use as the underlying asset for Sukuk issuances provided  they are transacted on cash basis (on spot). □The structuring of such financial obligations into capital market securities adds value in terms of credibility and liquidity to the indebtedness. □Traditionally securitisation has been used as a mode of financing by converting the illiquid pool of asset into more liquid marketable securities, but □contemporary structuring is also motivated by higher returns, diversification, hedging objectives apart from plain vanilla funding. □Asset-based sukuk under this structure represents cash flows that include profits on the basis of either being fixed or variable for maturities that can be fixed, revolving, either long term or short term. As a credit enhancer, the underlying asset in the initial contract of exchange transaction is taken as collateral for the securities. □An example of such asset-based securitisation is the bai’ bithaman ajil Islamic debt securities or BaIDS. Normally, the creation of the debt is facilitated by a bai’ inah structure, if the client owns the asset. 2009 13

14. DIAGRAM 1: Securitisation of Debt Financier 2) Cash payment of proceeds (equivalent to purchase price) 4) Client issues sukuk to evidence their indebtedness arising from Step 3 above BaIDS 1) Sells assets to financier at purchase price on cash basis 3) Financier resells asset to client at a selling price equivalent to the purchase price plus profit (on deferred basis) Client Fund flows at future dates Note: The bai’ bithaman ajil transaction is a component of the entire bai’ inah structure. 2009 14

15. 1 (b). Asset-based Sukuk: Financial Ijarah □Another instance of asset-based Sukuk is under the sale and leaseback or lease of third party asset, with a purchase option obligation given to the lessee. □The underlying asset in this transaction is the leased asset and in view of the structure being a finance lease, □the ultimate ownership of the asset will be passed to the lessee through pre-agreed settlement consideration, upon the maturity of the lease. 2009 15

16. DIAGRAM 2: Sale and Leaseback Financier 2) Cash payment of proceeds (equivalent to purchase price) Sukuk al Ijarah 5) Client given the option to purchase the leased asset at end of lease period Client 3) Financier leases the asset back to client 4) Client issues sukuk to evidence the rental obligations under the ijarah contract arising from Step 3 above 1) Sells assets to financier at purchase price on cash basis Fund flows at future dates 2009 16

17. Malaysian Global Sukuk □ Under this transaction, the investors pool their capital by way of subscribing to the sukuk issued by the SPV. □The proceeds will be utilised to purchase the land parcels, under a true-sale transaction, from the Federal Land Commissioner. □The relationship between investors will be under a collective investment arrangement. 2009 17

18. DIAGRAM 3: STEP 1 - Pooling of investments 4) Payment for purchase price of land parcels (USD) 3) Subscriptions (USD) 2) Offer of Sukuk Sukuk / Investment Certificates 1) Sale and purchase of land parcels SPECIAL PURPOSE VEHICLE (Malaysian Global Sukuk) SPECIAL PURPOSE VEHICLE (Malaysian Global Sukuk) Federal Land Commissioner Investors Land Parcels (LP) 5) Beneficial title to LP transferred to SPV 1)The SPV, upon having the beneficial title to the land parcels transferred to it, then enters into an ijarah contract with the Government of Malaysia. The SPV is the lessor and the Government is the lessee. 2009 18

19. DIAGRAM 4: STEP 2 - Ijarah of land parcels and sale upon dissolution 5) Dissolution Amount 1) Leases LP Government of Malaysia SPECIAL-PURPOSE VEHICLE (Malaysian Global Sukuk) SPECIAL-PURPOSE VEHICLE (Malaysian Global Sukuk) 2) Ijarah rentals (periodic obligations) Sukuk Ijarah Ownership Trust 3) Periodic payments 6) Sale proceeds upon dissolution Sukuk Investors Fund flows in future 1)Upon expiry of the ijarah contract, the SPV - as the lessor - will transfer ownership of the SPV and beneficial title to the land parcels to the Lessee (Diagram 4). The pre- agreed Dissolution Amount will be equivalent to the face value of the sukuk. 4) Sale upon Dissolution 2009 19

20. 2. Asset-backed Sukuk □Asset-backed Sukuk is a securities formation process, in the form of capital market instruments i.e.  Sukuk, of equal value that represents an undivided interest in the ownership of an underlying Shariah compliant cashflow generating asset.  A Special Purpose Vehicle (SPV) held and managed by trustees, legally will be under the control of the holders of the securities or sukuk will acquire the asset under a true-sale arrangement.  The function of the SPV thus is to hold the assets on behalf of the investors or Sukuk- holders, by way of a trust deed created over the assets.  The relationship between the sukuk investors is in the form of a collective investment contract of musharakah or mudharabah.  The originator i.e. the entity seeking to transfer or dispose of its asset to the SPV must not hold any equity stake directly or indirectly in the SPV, i.e. bankruptcy- remote. This structure differentiates the concept from asset-based securitisation due to the true-sale of the asset by the originator to the SPV and the insulation of the investors from insolvency risks arising from the originator.  The true sale and the restriction of the originator from being an owner or shareholder of the SPV results in the asset transfer being a bankruptcy remote transfer.  What it means is that the transfer of the assets by the originator to the SPV is such that even if the originator were to go bankrupt, or get into other financial difficulties, the rights of the investors on the assets held by the SPV is not affected. In other words, the investors would continue to have a paramount interest in the assets irrespective of the difficulties, distress or bankruptcy of the originator. 2009 20

21. DIAGRAM 5: Asset-backed Securitisation - creation of Sukuk 4) Asset Purchas e Price (RM) 3) Subscriptions (RM) 2) Sukuk offer 1) Asset SPA SUKUK TRUSTEES Represent Sukukholders XYZ Bhd. (Originator) XYZ Bhd. (Originator) Investors Special Purpose Vehicle 4 4 1. Sales and Purchase Agreement for asset (true sale) executed between Originator and SPV 2. SPV is owned by trustees and the Originator is not a shareholder to it 3. SPV issues sukuk to investors 4. Investors subscribe for sukuk 5. SPV uses subscription proceeds to pay asset’s purchase price to Originator, and simultaneously issues sukuk to investors 2009 21

22. □ This concept of securitisation may be applied to □ any asset that has a reasonably ascertainable value, or that generates a reasonably predictable future stream of revenue. □It can therefore be applicable as well to receivables or debt for as long as the transfer is a genuine transfer, and not as a mere paper transaction. □In other words, the transfer of receivables has to be a true sale of the receivables, and not merely a financing against the security of the receivables. □Such an example is the Cagamas RMBS involving the sale of the Government Servants House Financing (GSHF) Receivables Cont’d… 2009 22

23. DIAGRAM 6: Asset-backed securitisation – Cagamas Mortgage Backed Sukuk Cagamas (Transaction Administrator & Administrator) Cagamas MBS (SPV) Purchase consideration Investors Proceeds from sukuk Trustee Government of Malaysia (Originator & Servicer) Sale of GSHFs DIAGRAM 6: Asset-backed securitisation – Cagamas Mortgage Backed Sukuk Represent Sukukholders 2009 23

24. □ Asset-backed securitisation thus is □an asset-based transaction in which the funding for the acquisition of the asset is derived from investments evidenced by the sukuk issued by the SPV. □The asset is purchased from the originator under a true sale arrangement □The true sale isolates the asset completely from the originator and at the same time all rights and obligations in the said asset are thus transferred to the SPV □However, all obligations on the sukuk i.e. the income stream attached to it shall rest upon the originator who now plays the role as servicer i.e. the entity that is undertaking to administer the assets or perform such other services on behalf of the SPV as may be required in the said securitisation transaction. Cont’d… 2009 24

25. DIAGRAM 7: Asset-backed Securitisation - role of servicer 1. 3) Distribution of income to sukuk holders 2) Income to SPV 4 XYZ Bhd (Servicer) XYZ Bhd (Servicer) Special Purpose Vehicle Investors ABS Sukuk ASSET Income stream Fund flows in future 1.The asset will be administered or managed by the Originator, which is now the Servicer 2. Income from the asset is paid to SPV 3. SPV distributes income to Investors, as per agreed schedule of payments, and simultaneously issues sukuk to investors 2009 25

26. SC’s Definition of ABS □ The SC defines Asset-backed Securities as □private debt securities or Islamic securities that are issued pursuant to a securitisation transaction. □Such securities shall exclude all debt securities or Islamic securities that are capable of being converted into equity howsoever and whether redeemable or otherwise.  Examples of such excluded securities include exchangeable bonds and private debt securities or Islamic securities with attached warrants[1].[1] [1] Securities Commission: Guidelines on the Issuance of Asset-Backed Securities, 26 July 2004. Pg 1 2009 26

27. 3. Investment Sukuk □Unlike an asset-backed securitisation where the sukuk is issued by the SPV, Investment Sukuk is : issued directly the originator of the venture to the investors.  In the case of Mudharabah, the originator will be the managing partner of the venture without contributing any capital, but only his skills and expertise.  In the case of Musharakah, the originator can be an equity partner to the venture that will be formed by contributing capital in the form of cash or kind, to it. Investment sukuk thus are securities issued as evidence of the relationship between the investors and the originator. In Malaysia, issuance of Investment Sukuk is guided by the Guidelines on the Offering of Islamic Securities. 2009 27

28. Forms of Investment Sukuk □The sukuk issued by the originator, to the investors - normally in the form of Sukuk Musharakah[1] or Sukuk Mudharabah[2][1][2]  represents evidence of their capital contributions to the investment activity, and  their rights to the cashflow from this activity. □The sukuk structure normally involves the provision of additional protection to investors against late payment of obligations, potential risks on loss under events of default or occurrence of termination events by the sukuk issuer, in the form of credit- and/or liquidity-enhancement schemes, such as stand-by liquidity facilities or purchase undertakings under the principle of wa’d[3].[3] □ The 3 structures currently adopted for special investment activities are:  Musharakah or Mudharabah between investors. Musharakah between investors and the originator or issuer for undertaking special projects. Musharakah between investors and the issuer for participation in the issuer’s business operations. [1][1] Sukuk musharakah is a certificate that evidences undivided pro-rated ownership of the investors vis-à-vis the projects or activities under the musharakah venture. One of the partners or a third party may be appointed as a representative to manage the projects or activities. In the primary market, a minimum of 2 partners is required for the issuance of sukuk musharakah. [2][2] Sukuk mudharabah is a certificate that proves the investor’s ownership of the projects or activities under the mudharabah venture. The project is managed by the mudharib or an appointed third party. [3][3] A unilateral promise by the issuer or partner, which is not stipulated as part of the transaction agreement. 2009 28

29. 1) Musharakah or Mudharabah between Investors □Under this concept, the financiers form a collective investment agreement among themselves for purposes of investing in a venture. This is normally termed as Istithmar bil wakalah or Investment through Agent under the AAOIFI standard.  An example of such a case is Nucleus Avenue (M) Berhad’s (“Nucleus”) Sukuk Musharakah (refer to Diagram 8).  The investors in this case formed a musharakah among themselves, to invest in the sukuk issued by Nucleus, a Musharakah venture company, i.e. a vehicle created to own certain income-generating trust assets. 2009 29

30. 1.Nucleus’ issuance of the Sukuk Musharakah and investments by the investors were simultaneously conducted. The latter are classified as Senior and Junior investors, and are entitled to Senior Sukuk and Junior Sukuk, respectively. The sukuk in this case are trust certificates that represent the sukuk holders’ proportionate undivided ownership in the trust assets 2.Nucleus will issue unilateral wa’d as purchase undertaking for relevant portions of the trust assets, upon maturity of the sukuk or upon occurrence of dissolution events, at pre-agreed redemption amounts. 3.Under the terns of the investments, the income generated by the trust assets must be distributed to the sukuk holders, based on pre-agreed ratios. Cont’d… 2009 30

31. DIAGRAM 8: Musharakah among investors 2) Purchase Undertaking to purchase relevant portions of the Trust Assets upon maturity of the Sukuk at the Exercise Price, or upon dissolution events at the pre-agreed Redemption Amount 2) Purchase Undertaking to purchase relevant portions of the Trust Assets upon maturity of the Sukuk Exercise Price, or upon dissolution events at the pre-agreed Redemption Amount 1 1 1. Musharakah 1 SENIOR INVESTORS Musharakah 1 SENIOR INVESTORS Musharakah 2 JUNIOR INVESTORS Musharakah 2 JUNIOR INVESTORS Nucleus Avenue (M) Berhad (Issuer) Nucleus Avenue (M) Berhad (Issuer) Senior Sukuk Junior Sukuk 1. Investment in NAB Trust Assets Trust Assets 2009 31

32. 2) Musharakah between investors and originator or issuer to undertake special project □An example of such an investment between investors and originator to undertake a special project is Assar Chemicals Sdn Bhd’s (“Assar”) RM150 million Serial Sukuk Musharakah (“Assar Sukuk”), issued in 2005. □Under the Assar Sukuk transaction, the investors and the originator established a musharakah venture under the style of Assar Senari Sdn Bhd (“ASSB”), with respective equity contributions of 87% and 13%. The business objective of ASSB is to develop an independent oil terminal (“IOT”) for the storage and delivery of petroleum products within the Kuching area in Sarawak, Malaysia. □ Upon completion of said terminal, the musharakah  will lease the facility to Assar for a period of up to 9 years. The terminal will then be used to cater to the storage and delivery requirements of 2 major petroleum companies operating out of Kuching. □The transaction structure for the Assar Sukuk is illustrated in Diagram 9 below:  Assar issues sukuk musharakah, capital injections into ASSB.  Trustee appointed to manage the IOT project. Ijarah agreement executed between Assar and the Trustee, acting on behalf of ASSB; to commence upon commissioning of the IOT.  Completed IOT handed over to ASSB, as the owner. 2009 32

33. DIAGRAM 9: Musharakah between investors and issuer to undertake special project 4 2 1) Issuance of Sukuk Musharakah Assar Chemicals Sdn Bhd (Issuer) Assar Chemicals Sdn Bhd (Issuer) Sukuk Investors Sukuk Musharakah Musharakah Venture (ASSB) Invest Capital (87%) Invest Capital (13%) 11 TRUSTEE Construct IOTCompleted IOT Owned by Assar Chemicals Sdn Bhd (Servicer) Assar Chemicals Sdn Bhd (Servicer) Lease (ijarah) of completed IOT 3 2009 33

34. Musharakah between investors and issuer to participate in the issuer’s business □This enables investors to participate in the business of the issuer, by way of a preferential participation process. □A close comparison to such musharakah is the issuance of preference shares by companies.  An example of musharakah between investors and issuer for participation in the issuer’s business is AmIslamic Bank Berhad’s (“AmIslamic”) Subordinated Sukuk Musharakah 2009 34

35. DIAGRAM 10: Musharakah between investors and issuer for participation in issuer’s business Income Distribution Sukuk Proceeds MUSHARAKAH VENTURE Declaration of Trust Issuer’s account in BNM AmIslamic Bank’s Islamic financial activities Sukuk Account AmIslamic Bank Berhad (Issuer) AmIslamic Bank Berhad (Issuer) Investors (Sukuk holders ) Issues Sukuk Musharkah Sukuk Proceeds 2009 35

36. □The issuer issues subordinated sukuk musharakah to investors in consideration of their capital contributions to the Musharakah venture. □The musharakah venture involves the participation of investors or sukuk holders in the general Shariah-compliant financial- services business of the issuer. AmIslamic, the issuer, is the musharakah manager for this musharakah venture. □The creation of the trust in favour of the sukuk holders will, inter alia, evidence the following:  Creation of the trust relationship between the issuer and the sukuk holders, under which the trust will hold the trust asset (i.e. the sukuk account and permitted investments from funds in the said account) for the benefit of the Sukuk holders.  The issuer’s obligations under the musharakah venture.  Sukuk holders share the income from the musharakah venture, based on their respective proportions of the face amount of the sukuk; losses will be based on and limited to each musharakah partner’s respective capital contribution to the musharakah capital (equivalent to the amount of issued sukuk). Cont’d… 2009 36

37. Other Issues □ Credit Enhancements:  Purchase Undertakings  Fixed Income enabling mechanisms □However late last year, AAOFI in Bahrain has raised concerns that the implanting of these two mechanisms have breached the rulings of Shariah. Purchase undertakings for example are allowed by AAOIFI only for Ijarah and not for other contracts unless the asset is transacted at the exercise date at market values and not at pre-agreed prices. Liquidity facilities by way of loans from the client or originator is disallowed unless the profit top-ups are from profit equalisation reserves created from the excess profits achieved by the mudharib or managing musharik. 2009 37

38. 2008 THANK YOU rahim@seccom.com.my 2009 38