A securitisation is a structured finance transaction whereby an asset (including payment streams from assets) is separated from the owner or originator of such asset and independently financed based upon the characteristics of such asset. To accomplish this, typically a single purpose entity (an “SPE”) is created that purchases the asset from the owner/originator.
The SPE obtains the funds for the purchase by issuing securities – typically sukuk, which are financial certificates backed by tangible assets, frequently real estate, where the purchaser has a proportional ownership interest in the underlying assets. Sukuk are very similar to conventional bonds: purchasers seek to generate a profit, the sukuk mature at a set date and they are backed by one or more classes of assets. Sukuk differ in that investors are not guaranteed to make a profit as with interest, but rather share profit and loss by reason of the ownership and operation of the underlying asset.
The most common form of securitised Islamic transactions are sukuk ijara transactions. Similar to conventional securitisations, sponsors may purchase groups of loans from loan originators, pool these loans, divide them into tranches and sell them to different types of investors. While sukuk ijara structures may mitigate risk for the loan originator, they may increase investor risks, particularly in a volatile economy, including non-liquidity of the sukuk ijara, as well as tax risks, political, economic and social considerations, currency conversion risks and uncertainty in enforcement in light of current law in many Middle Eastern jurisdictions. Credit risk may also be significant: a borrower may default and there is the risk that the underlying asset legally may not be foreclosed upon, or, if it is foreclosed upon, an asset repossessed after a lessee default may be sold or re-leased at a price lower than the original contract price.
In structuring a sukuk ijara, it may be preferable to establish the SPE in a common law jurisdiction, such as the Cayman Islands, where law and practice are well-established and precedence has real judicial value. If a default should occur and problems of enforceability arise, the holder of the sukuk may be more comfortable conducting an action where law and precedents are established and are more likely to bring predictability to a legal or equitable enforcement action – although a separate action may still be necessary to be brought pursuant to local law in order to foreclose on a particular asset or realise a judgment (particularly if it involves real property).
A key difference between a conventional finance lease and a sukuk ijara is in the identity of the risk-taker. While, in a conventional finance lease, the lessee assumes the risks and benefits of ownership, in an ijara arrangement the lessor bears the risk of property damage, although that risk is often contractually transferred to the lessee (or when the ijara is sold as a sukuk ijara, the sukukholders bear the risk). In the basic sukuk ijara transaction, originators sell existing or future revenues from lease receivables from one or more Islamically-acceptable assets to an SPE, which then issues unsecured sukuk securities to market investors whose investment does not involve guaranteed, interest-based earnings. Depending upon the asset type utilised, the SPE acquires ownership rights in either (i) existing assets within a lease-purchase or sale-repurchase agreement or (ii) future assets as an equity investor and then structures anticipated cash flows from these assets into sukuk payment obligations of one or more risk levels and maturities.
The implementation of Islamic securitisation requires assessment and verification under Shariah principles of (i) the type of assets in the underlying portfolio and (ii) the transaction structure, including the configuration of any permitted credit enhancement and the form of ownership conveyance. Investors must have a meaningful participation in profit or loss resulting from a real economic activity within an interest-free structural arrangement.
Islamic securitisation must confer upon investors clearly identifiable rights and obligations in religiously acceptable tangible assets, and ensure direct participation in any distribution of risk or reward between lenders and borrowers with limited mitigation and/or indemnification through credit enhancement. Underlying assets must not be debt, cash or a prohibited activity and must not be associated with excessive speculation or uncertainty. Investors must hold an unconditional and unsecured payment obligation and not a guaranteed promissory note. Any form of credit enhancement and/or liquidity support and any limitations of prepayment risk must be in a permissible form and in accordance with the pronouncements of the Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI).
Islamic law does not proscribe the use of credit enhancement, so long as it is optional for investors and does not change the overall character of the transaction: for example, tranche subordination in a conventional securitisation can be replicated by a lease-buyback (ijara) transaction under Shariah law. Sukuk certificates also convey an equity interest to investors in the form of a call and/or put option on partial or complete ownership of the underlying assets, including the right to a calculable rate of return as a share of profit and the repayment of principal. It should be noted that Shariah compliance of sukuk securitised transactions is often criticised by Islamic scholars on the grounds that (i) the discount on the issued sukuk may be considered the functional equivalent to interest, and (ii) the guaranteed profit from a discounted offer to purchase or sell the assets does not expose investors to meaningful investment risk.
Securitisation helps financial institutions to meet their own credit demands by creating new financial products which disaggregate, repackage and distribute asset risk (both inherent and extrinsic in nature) in markets where suitable hedging instruments may not be available or permissible. Securitisation can also facilitate the market entry of new finance companies into traditional markets dominated by a few large players exerting control and limiting the availability of risk-seeking capital. Amid regulatory, tax and legal reforms ongoing today in Islamic countries, securitisation helps accommodate a growing investor base, particularly pension and fund investors with a need for long-term, highly-rated local currency investments. Thus, it improves risk diversification within the financial sector, increases overall financial sector sophistication and contributes to the development of a more liquid yield curve in poorly-developed financial and legal systems.
For a securitisation market to develop, a comprehensive and modern securitisation framework satisfactorily addressing the legal, regulatory, accounting and tax issues must be implemented.
On the legal side, a modern insolvency and bankruptcy law must be implemented in order to assure that the assets being securitised are the subject of a “true sale” and are available to the originator’s creditors, since one of the primary objectives of securitisation transactions is to separate the underlying collateral from the credit risk of the originator and vest it in the SPE. Shariah law does not recognise the separation of legal and equitable title, and, therefore, “true sales” in Shariah jurisdictions must be structured as a sale of the legal interest in the collateral to the SPE in a way that satisfies all applicable Shariah requirements (such as notification of the transfer to all debtors and receipt of their confirmation, if applicable).
A modern insolvency law would also permit legal counsel to confirm in its non-consolidation opinion that creditors of the parent company will not be able to force the parent company and the SPE to be deemed one economic unit thereby permitting those creditors to reach the assets of the SPE through a consolidated bankruptcy or insolvency process. Similarly, a modern insolvency and bankruptcy law would confirm the bankruptcy-remoteness of the issuing SPE, whose purpose must be limited to the securitisation transactions and certain logically-related activities, and which must be restricted as to its ability to incur debt and initiate bankruptcy or insolvency proceedings.
A modern securitisation law must also to clarify investors’ first priority security interest in the collateral, subject only to creditors who are mandatorily preferred by law, which security interest must be perfected in accordance with applicable law. Without such a law, Shariah does not recognise the concept of a security interest in a manner consistent with the understanding in Western jurisdictions, and it is therefore difficult to obtain clear legal opinions confirming the nature of the security interest created under the transaction documents and any perfection requirements, such as registration or other recordation. Similarly, a modern securitisation law would permit confirmation in legal opinions that remedies are exercisable under transaction documents upon the occurrence of default in compliance with Shariah precepts.
All of the foregoing changes in law are required in order that transactions may obtain a credit rating, which is an essential ingredient in any successful securitised transaction.