Sukuk on Trial

A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debt holders, or creditors, of the issuer.

A debt that requires the borrower to return more than what was lent to them is forbidden in Islam.

In the prophet Muhammad’s farewell sermon he is reported to have said:

“God has forbidden you to charge interest, therefore all interest obligations shall henceforth be waived. Your principal, however, is yours to keep. You will neither inflict nor suffer inequity.” [1]

Since a bond is an interest-bearing loan given by the holder to the issuer, they are prohibited in Islam.

Sukuk [plural of Sak] are widely regarded as the Islamic equivalent of bonds. Theoretically, in contrast to conventional bonds, which merely confer ownership of a debt, sukuk grants the investor a share of an asset along with the commensurate cash flows and risk. [2]

Even before investigation, you should be skeptical about sukuk. This is because the description of Sukuk matches that of dividend yielding equity. Therefore, if sukuk actually hold true to their description they are an entirely redundant product. So why were Sukuk invented if identical products already exist?

Our investigation into whether sukuk charge interest will consist of answering two main questions:

1- Is financing being provided? If yes, then:

2- Is the financier contractually guaranteed to benefit in return for providing financing?

You may be asking: well don’t you want to know how sukuk work? No. I don’t feel like playing that game. Interest is defined as a contractually guaranteed benefit for the financier in return for the use of their money. When it comes to classifying something as interest-bearing debt:

  • Whether or not there is an asset involved makes no difference.
  • Whether or not the interest payments are made from the rent that is collected on a property makes no difference.
  • Whether or not the financed party is using the money they are financed with in Shari’a compliant activities makes no difference.

So, question 1: Is financing being provided?

One party in the sukuk contract is receiving funds (the issuer) while another party (the holder) is providing the funds.

According to Sukuk.info:

“Sukuk can provide a tool for corporates who are in need of cash for specific objectives to raise the necessary funds.”

In 2010, Malaysia’s strategic investment fund issued Sukuk worth 1.5bn Singapore dollars to finance Singapore City Development Limited’s acquisition of parkway holdings.[3]

Sukuk were issued in the Iranian Capital Market in January 2011 to finance Mahan Airline Company.[4]

From the definition of Sukuk and examples of it in use, we can comfortably answer our first question with: Yes, sukuk are definitely used by their issuers to receive financing.

Which brings us to question 2 in our investigation: Is the financier contractually guaranteed to benefit in return for providing financing?

Simply put, If sukuk holders (financiers) are contractually guaranteed a fixed-income stream which totals to more than what they invested, then there is a guaranteed benefit that is being promised to them. This guaranteed benefit is a form of prohibited interest in Islam which would make sukuk not compliant with Shari’a.

Don’t get the involvement of a tangible asset confused with the actuality of profit-and-loss sharing. Remember, home mortgages involve a tangible asset and yet are just as guilty of charging interest as if they hadn’t. No definition of interest-bearing debt mentions the absence of a tangible asset as a requirement for classifying something as interest. I’ll repeat: Is the capital provider in sukuk contractually guaranteed to benefit in return for providing financing? If they are, then they are guilty of charging interest on debt.

Now that we know what we are looking for, let’s look at the evidence…

Exhibit A: Defaults

On October 16th 2008 East Cameron Partners (ECP), a US oil and gas company, filed for bankruptcy protection under chapter 11 of the US Bankruptcy code, claiming its inability to pay the periodic returns on its USD 166 million sukuk issued in June 2006.

Subsequently, the first sukuk default in the Gulf region occurred on 12 May 2009 when Investment Dar, a Kuwaiti Islamic investment company, declared its failure to pay biannual return on its USD 100 million sukuk.

Just a few weeks later, Saad Group, a Saudi conglomerate, failed to pay periodic rental payments on its USD 650 million sukuk, issued in 2007.[5]

These three incidents of default (and many like them) suggest that there are obligations which the sukuk issuers were unable to meet. If sukuk were truly a profit-and-loss sharing product, why are some issuers defaulting? Logically, profit-and-loss sharing implies that when an investment doesn’t pay off as expected, no default happens, the investors simply receive a lower return than they initially expected.

The defaults suggest contractual guarantees of benefit that the sukuk issuers made to their financiers and were unable to honor.

Exhibit B: Testimony of the defendant.

Specifically, I’m talking about how sukuk issuers describe their product to investors.

Take for instance Ijara Sukuk Issued by the Pakistani government. In their “Investor Guide” it is mentioned that:

“The profit on the sukuk is paid semi-annually on the basis of rental rate announced by the State Bank of Pakistan prior to the start of each half year”.[6]

Emphasis here on the word prior. How are profits announced before they are actually realized? What other profit-sharing financial instrument announces their profits, let alone commits to paying investors a share of those quantified profits, before those profits are actually realized?

Further, if you google the “rental rates” announced by the “State Bank of Pakistan” you’ll find things like: “rental coupon rate at 9.9791 per cent per annum for the Government of Pakistan Ijara Sukuk 3-year…The coupon rate amount will be paid on April 23, 2015”.[7]

Basically this says that investors in 3 year sukuk will be paid a 9.9791% annual return. In other words, the 9.9791 coupon rate is applied to how much money the investor invested not how much profit the particular investment actually earns. No reference to realized profit is made, and I’m inclined to believe this is for good reason, which is that the investors’ returns don’t actually depend on profits. If these sukuk were truly issued on a profit-loss sharing basis then one would expect them to be quoted as offering a % of profit rather than a % of principal invested.

Examples of other sukuk issuances show the same pattern: profits being quantified before realization and commitments being made based on the principle the investor invests rather than the profits that are actually realized. These practices suggest violations of true profit-and-loss sharing and therefore run afoul of Islam’s prohibition of interest-bearing debt [known as “riba” in Islamic jurisprudence].

Some have suggested that because bonds and sukuk offer different yields to maturity when issued by the same corporation under identical conditions, that this is proof that bonds and sukuk are different products.[8] I contend that it is possible for the same exact product to be valued differently by consumers when presented in different packages. In fact, this is precisely why so much effort is put into packaging and marketing products. Go to your local supermarket and walk through any aisle, you’ll immediately become aware of how much effort has gone into designing the packaging for the goods on the shelves. This effort is only spent because it is very fruitful for the bottom line companies. Similarly, the packaging of sukuk is a sharia-compliant investment, the packaging of bonds is interest-bearing debt, this has a direct effect on what consumers are willing to pay.

I also contend that it is possible for the same exact product to be valued differently when presented to different markets of consumers. In fact the very definition of price is where supply and demand meet. Different markets have different values for supply and demand at any given time. The market for bonds is not the same market for sukuk and therefore differ in their supply and demand quantities. This too has a direct effect on the pricing of sukuk and bonds.

Accordingly, it is absolutely false to suggest that because bonds and sukuk have different yields to maturity when offered under identical conditions they are, in substance, different products.

In summary, promising a predetermined fixed income for investors while at the same time claiming to be a product that is based on profit-and-loss sharing is a contradiction. It’s one or the other but can’t be both.

Profit-and-loss sharing is 100% compliant with Shari’a principles. The existence of a tangible asset doesn’t really matter as long as there is an equitable split of risk between the financier and the financed. However, once there are guarantees of benefit to one party, we are no longer dealing with equitable risk distribution. Instead, we are dealing with the precise type of inequity which the prophet Muhammad reminded us to stay clear of in his farewell sermon.

I claim that there are no “Islamic” fixed-income investments. If you want to invest your money in a way that complies with Islamic teachings, you have to be willing to engage in real business activity which means you have to be willing to assume your fair share of risk.

References:

  1. Sahih Bukhari. “Volume 3, Book 034 “Sales and Trade””. Usc.edu. Retrieved 2012-11-19.
  2. http://thatswhy.isdb.org/irj/go/km/docs/documents/IDBDevelopments/Internet/thatswhy/en/sukuk/what-is-sukuk.html
  3. http://en.wikipedia.org/wiki/Sukuk
  4. http://en.wikipedia.org/wiki/Sukuk
  5. http://www.researchgate.net, Sukuk Defaults On Distress Resolution in Islamic Finance, Pages 12-13
  6. http://www.sbp.org.pk/dmmd/Guidelines/Sukuk.pdf, Page 3
  7. http://www.brecorder.com/pakistan/banking-a-finance/202293-sbp-declares-rental-coupon-rate-of-gop-ijara-sukuk.html
  8. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1783551

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