A second installment in my series on Islamic Financing and Restructuring.
But first just a note that I am not a lawyer and the following is not legal advice.
Tonight I want to look at The Investment Dar's "TID Global Sukuk 1" issued in September 2006.
Before we set off, let's make sure we have the right gear in our "kit":
- AAOIFI February 2008 Sukuk Principles - You'll recall the issuance of this document was credited with causing turmoil in the market. Here's Norton Rose's take.
- TID Global Sukuk 1 Offering Memorandum ("OM")
- TID Global Sukuk 1 Musharaka Agreement ("MA")
Some short details on the transaction:
- US$150 million issue
- Five-year final maturity with Periodic Distribution Profit computed at Libor plus 1.25% for the first three years and then Libor +1.75% for the last two with payments each 20 March and September.
- Principal repayment at the final maturity date (Musharaka End Date). A "bullet" structure.
- Islamic structure - Musharaka (Profit Sharing Agreement). TID to contribute value in kind in form of Trust Assets 8,532 cars (as per the MA) plus property in Kuwait. As a result, TID will hold 51.22% of the Musharaka.
- Legal structure - limited recourse certificates - recourse is to the Trust Assets. Additional protection is given by a Purchase Undertaking by TID. Re the Purchase Undertaking OM Section 8 (Pages 66-67) set forth an Early Redemption Date (voluntary redemption). OM Section 9 (Pages 67-68) set forth redemption under a Dissolution of the Trust. You might consider this a guarantee but don't let AAOIFI hear you say that.
Let's turn to the detail.
(1) The Trust Assets
As per the OM page 7 "Proceeds of the Trust Assets are the sole source of payments on the Certificates".
Let's take a close look at them given their importance.
As per the MA Section 2.5 (d) "It
[TID] shall hold and maintain such registered title as agent for the Musharaka and shall not do or omit to be done any act, matter or thing which will, or might reasonably be expected to, result in either of the Partners [TID and the Sukuk holders] breaching any of its obligations under any Transaction Document."
AA: In other words, the Trust Assets remain legally registered in the name of TID. The issue here is similar to that discussed in my earlier post about The International Banking Corporation and its trust arrangements with its parent, Ahmad Hamad AlGosaibi and Brothers. One needs to be sure that such arrangements are "bullet proof" so that one's trust assets don't wind up in the legal estate of the agent.
The critical issue for investors then is the strength of the trust agreement and its enforceability under Kuwait law. Why Kuwait? Because that's where these assets are located. The trust indenture itself is drawn under English law as are the other Transaction Documents. Since the Sukuk certificates are subject to English law, there is some logic in having a key document like the Trust Agreement also subject to English law. However, marching into a Kuwaiti court with an English law agreement does pose some problems. Kuwait does not have reciprocal agreements with England to honor each other's court judgements. And any local judge - not just a Kuwaiti - may wish to review the case.
(2) The Purchase Obligation
As per the OM Sections 8.1 and 8.2 (Page 66), investors have a "put option". Nor more than 180 days and no less than 120 days prior to the Early Redemption Date (the sixth Periodic Distribution Date, i.e. 20 September 2009), the investors can require the Trustee (TID) to buy all or a portion of their certificates. and the Trustee is legally obliged to buy them.
The Purchase Obligation is also triggered by a Dissolution Event (an "event of default" in typical non-Shari'ah finance speak).
The Purchase Undertaking is included to give investors recourse to TID so that they have a claim on its creditworthiness. Clearly, the benefit of this arrangement depends on the ability and willingness of the Trustee to make such a purchase. Assuming it works, TID is in effect an obligor on the certificates.
And note, if TID is an obligor (as in a guarantee) but does not pay, that guarantee obligation should be pari passu (equal in status) to funded debt - at least in most jurisdictions.
The critical issue then is how a court treats the Purchase Undertaking. Is it the equivalent of a guarantee? If so, it then becomes an obligation equivalent to a loan made to the Trustee. TID gives a representation to this effect in the OM on Page 4. If the Purchase Undertaking is merely a commercial contract, could a court void it? I don't know enough about Kuwaiti law to provide a definitive answer. Would a Kuwait court take an English law determination?
(3) Periodic Distribution Amounts
Under a Musharaka, the partners participate pro-rata in profits and losses. Since this is really a borrowing, the transaction has to be structured so that the Sukuk investors get their interest payment only.
Let's step through the document.
First, there is the obligatory comment in the OM (Page 3): "Each Musharaka Partner, pursuant to the Musharaka Agreement, shall be entitled to share in the profits of the Muskahara and bear losses of the Musharaka ratably in accordance with the proportion that such Musharaka Partners' Units in the Musharaka bear to the aggregate of the Units then held by both Musharaka Partners". AA: The Shari'ah principle is upheld.
Second, on the same page: "The Management Agent [TID] shall be entitled to a management incentive fee computed as provided below. AA: Nothing obnoxious to the Shari'ah in compensating the Managment Agent for doing a good job.
Third, on the same page: "The Management Agent is entitled to certain fee ("Incentive Fee") when, in respect of any Accounting Period (as defined herein), the Musharaka Accounts (as defined herein) show a Net Cash Profit payable to the Issuer greater than the Periodic Distribution Profit Amount [Libor plus the margin]". AA: In other words, any profit over the Periodic Distribution Profit Amount (let's call that interest for the moment) is the Incentive Fee to the Management Agent. That's some incentive. But it achieves the goal. This is a borrowing and the lender is entitled to his interest. Exercise left for the student: Are Shari'ah principles pristine at this juncture?
(4) Accounting Treatment
TID's last annual audited statement was issued for Fiscal 2007. This Sukuk and one issued previously are shown as liabilities in the balance sheet, equivalent to borrowings. Note 18 describes the Sukuk transactions in more detail.
Section 18.2 of that Note states: "Islamic Sukuk are secured by assignment of finance receivables amounting to KD 18,251,420 as of 31.December 2007 (KD 30,495,918 as of 31 December 2006)." AA: This structure was approved prior to the AAOIFI February 2008 statement of principles. While the balance sheet treatment looks uncomfortably close to a loan, one could argue that since TID is the majority owner of the Musharaka, under accounting principles it must consolidate the entire entity.
(5) Restructuring Issues
(a) Strength of the Trust Arrangement
The Sukuk and non Sukuk holder are going to be motivated by their assessment of the value of the assets in the Trust. If there is real value there, the non Sukuk holder will attack and the Sukuk holder will uphold the Trust Agreement. If not, the Sukuk holder might try to argue that there was no Trust so that he can access more assets as a general creditor. In such a case the non Sukuk holder would argue for the Trust.
Another issue has to do with Sukuk holders changing the Trustee. If the Trustee is in difficulty, getting the Trust Assets registered in another Kuwaiti entity's name - one not in a debt restructuring - would be ideal. Without the text of the Declaration of Trust, it's not possible to determine what can be done. It would be a matter of law as one would expect the English law firms involved in drafting the Transaction Documents would try to incorporate this principle. The potential "rub" would be Kuwaiti law and practice.
What's also important here is the precise claim the investors have over the Trust Assets. Is it merely the proceeds they generate? Or do the investors have the right to the assets themselves?
(b) Management Agreement
What are the circumstances under which the Sukuk investors can replace the Managment Agent? If the Agent is unable to fulfill his duties, the underlying property might suffer dimunition in value. Those obligated under the car or property receivables might have a legal right to hold payment. Or might choose to take advantage of diminished oversight to try to avoid their own obligations. Again one would expect this to be addressed in the Management Agreement And like the Trustee issue above, Kuwaiti law and practice would be the practical issues. There is a disconcerting statement on Page 3 in the OM in the Management Agreement section "... the Management Agent shall be irrevocably appointed as manager of the Musharaka."
(c) Purchase Undertaking
Is this the equivalent of a guarantee? Or a voidable contract? Again a logical target for a non Sukuk holder creditor to attack. This would be similar to the attempt made by the non Shari'ah BIB creditors described in my first post on this topic.
(d) Public Policy
As a final word, it's important to recognize that public policy is highly likely to influence decisions - not merely the letter of the law. Countries in the area are unlikely to set precedents which undermine "Islamic banking".
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