Proposed New Sukuk Guidelines to Boost Standardization of Rules

Dubai: New proposals by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) for accounting and classification guidelines for sukuk issued by Islamic financial institutions are expected to boost the much needed standardisation of rules, according to credit rating agency Standard & Poor’s.

The AAOIFI’s latest proposal on sukuk accounting states that Islamic financial institutions can report sukuk as on- or off-balance-sheet instruments; the main determinant of the classification would be the effective control of the underlying assets.

“In our view, this coupled with AAOIFI’s recent proposal on centralised Sharia boards — could help the market move forward with standardising the legal structure of sukuk and Sharia interpretation,” said S&P Global Ratings’ Global Head of Islamic Finance, Dr. Mohamed Damak.

In the recent past, there have been some ambiguities in how legal obligations of sukuk sponsors are worded. However, if the AAOIFI’s proposal is adopted, lawyers and sukuk structures could have a basis for strengthening legal protection for sukuk holders.

The new proposal recognises that issuers can report on-balance-sheet sukuk as a liability, quasi equity, or equity. “We believe that, if implemented, the proposal could lead to tighter legal documentation regarding the obligations of sponsors of sukuk instruments categorised as a liability,” said Dr Damak.

More clarity

S&P expects the AAOIFI’s proposed financial accounting standard No. 29 will help achieve greater clarity on the different types of sukuk in the market. The proposal distinguishes between two broad types of sukuk — on balance sheet and off balance sheet — based on the effective control of the underlying assets. Moreover, it proposes to classify on-balance-sheet sukuk either as a liability, quasi equity, or equity.

“We are of the view that the proposal not only recognises that sukuk can be issued in the form of a liability of its sponsor, but also paves the way for strengthening the legal documentation for this type of sukuk,” said Damak.

The rating agency had recently noted that the documentation for sukuk that would be classified as a liability sukuk appears somewhat vague with regard to the legal obligations of the sponsor. Language that is subject to legal interpretation, and does not create firm obligations, was introduced by certain lawyers in response to some Sharia scholars’ concerns that sukuk might create a liability between the sponsor and the investors, which in their view goes against the principles of Sharia.

To restore the fixed-income characteristics of this type of sukuk, some lawyers subsequently made the creation of contractual obligations between the sponsor and the special purpose vehicle issuing the sukuk a prerequisite to closing a sukuk transaction.

“We believe the AAOIFI’s proposal, if adopted, could bring much needed clarity on whether sukuk can be structured and issued as liability instruments. Coupled with the AAOIFI’s previous proposal on centralised Sharia boards, we think this could strengthen the case for standardising the legal and Sharia aspects of sukuk,” said Dr Damak.

Risks

Analysts say the proposed changes could benefit from recognising any independent contractual or promissory arrangements associated with sukuk issuance as part of a sukuk’s core contracts. In most cases, these contracts create a financial liability for the sponsor to pay back investors, thereby exposing sukuk holders to risks related to the sponsor’s incapacity to honour its obligations.

The presence of such contracts is an important factor for holders of liability-type sukuk, especially those investors whose interest is not primarily motivated by the Sharia-compliant nature of the transaction.

The proposal also talks about the possibility of classifying sukuk as equity or quasi equity. Another aspect requiring further clarification pertains to the rules for the tradability of liability-type sukuk. For a long time, sukuk were considered a buy-and-hold investment. However, as the market matured and attracted more issuers and investors beyond those seeking Sharia compliance, tradability became an important factor and a way to enhance the liquidity of sukuk instruments in the secondary market.

Greater standardisation is expected to make the industry more attractive to issuers.

Lack of standardisation of legal documentation and Sharia interpretation is often cited as one of the main reasons behind muted activity on the sukuk market over the past few years. In recent years several issuers in core Islamic finance countries have tapped the conventional markets because of the relative ease of that process

Important in ratings

The AAOIFI’s proposal, by enabling the classification of a sukuk as a liability, will help strengthen the legal documentation of sukuk, assuming the AAOIFI also recognises the additional independent contractual arrangements associated with sukuk issuance as part of a sukuk’s core contracts.

“Equity-like features do not imply that we would not rate a sukuk; rather, we would not assign a rating if there is a lack of sufficient contractual obligations, or if the sponsor’s legal obligations are revocable. Under our methodology, our ratings on equity-type sukuk would likely be lower than on liability-type sukuk,” added Dr Damak.

Originally published on www.gulfnews.com