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KLIFF 2022 PROGRAMME BOOK

Complexity is still an issue.

– Issuers are increasingly realizing that sukuk are more complex and time-consuming than conventional bonds, although
some players are taking the sukuk route because they expect to diversify their investor base. The good news is that the
market seems to have overcome difficulties related to AAOIFI Standard 59 implementation. However, if Sharia scholars
push to further weaken legal documentation, and sukuk instruments lose their fixed-income characteristics while adding
significant risks compared with bonds, sukuk’s attractiveness and market prospects will likely reduce.

Resolving Risks Related To AAOIFI Standard 59 Helped

Many hybrid sukuk are structured around a combination of tangible assets and commodities. Standard 59 altered the
requirements for a transaction feature that is necessary for Sharia compliance: the tangibility ratio. Before the adoption of the
standard, issuers were required to have at least 51% tangible assets and a maximum of 49% commodities at the transaction’s
inception. The maintenance of this ratio through the lifetime of the transaction was on a best-effort basis, and remedial actions
in the event of a breach were unclear. With the adoption of Sharia Standard 59, the maintenance of a 51% tangibility ratio
became a legal requirement throughout the transaction’s lifetime and the remedies for a breach were clarified.

From a creditworthiness perspective, Standard 59 created three main risks: exposure to residual asset risks, a potential change
to investors’ ranking in a liquidation scenario, and higher liquidity risk for issuers and investors.
To resolve the issues created by this standard, lawyers introduced the following changes:

A conservative definition of a partial-loss event that makes this unlikely to occur (even if one of the assets is
subject to some form of impairment), which addresses exposure to residual asset risk. For some structures, residual
asset risk increases as a partial loss event (in addition to total loss event) becomes relevant. Indeed, in a transaction with several
assets, if one or more are destroyed, the tangibility ratio could be breached, and investors may not be fully reimbursed without
recourse to the sponsor. Liquidity-strapped issuers could use some of the language in the new definition of a partial-loss event
to manage their payment obligations if needed.

The sponsor is obliged to remain in control of the assets, thereby minimizing the risk of investors’ rank changing
in a liquidation scenario. Standard 59 affects the language related to the indemnity typically offered by the sukuk sponsor
as an independent entity in case it fails any of its contractual obligations. This could make sukuk creditors akin to subordinated
creditors because contractual obligations might not be perceived as having the same ranking as financial obligations. To resolve
this issue, lawyers introduced an obligation for the sponsor to remain in constructive or actual holding/control of the assets.
With this, the sponsor can indemnify investors since the sukuk obligation is no longer seen as a debt because tangible assets
are involved. However, this obligation could be seen as somewhat contradicting the sale of the assets to the special purpose
entity issuing the sukuk at inception.

Increasing liquidity risk for issuers and investors is still unresolved but instances of dissolution are rare. Standard
59 creates new potential scenarios for early sukuk dissolution. If the issuer has insufficient unencumbered assets on its balance
sheet, there is prepayment risk for the underlying assets or, in a partial loss event, the sukuk could need to be repaid before
maturity. For some issuers, this could be problematic since it requires liquidity planning. This risk is unresolved, but early
dissolution is expected to occur in rare cases. Issuers or sponsors have an incentive to keep transactions rolling to avoid the
crystallization of this risk.

At some stage, the opposing forces of Sharia scholars advocating more equity-like characteristics and investors preferring
more debt-like characteristics could disrupt the market. This may materialize if scholars question the valuation mechanisms for
underlying assets, the setting of a purchase price at the time of issuance, or the payment of rent that is uncorrelated with the
value of the underlying assets. In our view, if sukuk become an equity-like instrument, investors and issuers might lose interest
in the market. Therefore, standardizing and satisfying the requirements of all stakeholders could help the industry remain
attractive. We note that there are sukuk structures similar to the full spectrum of instruments, from fixed income to equity.

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