SHARIAH ANALYSIS OF SALE/DEBT BASED SUKUK: THE MALAYSIAN SAGA

By: Mughees Shaukat1

Abstract
A phenomenon that has generated considerable interest in the Islamic finance industry in recent years is the emergence of Islamic securitization (sukuk) which has considerable abilities to offer innovative financial solutions. Not only is the product a genuine contribution to product innovation endeavors but also resonates well with other conventional capital market parallels. Malaysia, backed by its aim to become the hub of Islamic banking and finance has gained some unprecedented ground; more so when it comes to SUKUK. The Malaysian sukuk market dominated by Sale/Debt Based sukuk has experienced phenomenal growth ever since its inception, However it has also raised many controversial issues (as is clear from this research). A financial products claim of being Shariah compliant cannot be accepted unless it is shown to be in consonance with the objectives of Shariah. The mechanisms used in such Sukuk today however, strike at the foundations of these objectives and rendering Sukuk exactly the same as conventional bonds in terms of their economic results. This study has tried to prove this point by going few steps further and used different Methods determining the legality of Shariah compliant instruments by going the beyond traditional contractual approach parameter. New parameters include financial reporting, legal documentation of contract and intent of the Shariah in terms of fulfilling Maqasid Al-shariah. This study while highlighting a number of controversies and issues pertaining to the much criticized contemporary Malaysian practices of sukuk, has also raised a lot of question marks on the future of sukuk and the whole industry. After all the Islamic in Islamic economics and finance should relate to the social and economic ends of financial transactions, rather than the contract mechanics through which financial ends are achieved.

Mughees Shaukat is currently a PhD Researcher & Assistant Researcher in Islamic banking and finance and is working alongside Distinguished Scholars and IDB Award winners, Prof. Dr. Abbas Mirakhor (The First Holder of INCEIFs Chair in Islamic Finance) and Prof. Dr. Zubair Hasan (Professor of Islamic Economics- Dept of Economics and Governance-INCEIF) in his various research works in INCEIF & ISRA Kuala Lumpur, Malaysia. He is also the Honorary Lecturer in the London School of Islamic Banking & Finance. London, U.K. He holds a Masters in Islamic finance from INCEIF and has published a number of articles in the field of Islamic finance. He sits on the Editorial Board of The GLOBAL ISLAMIC FINANCE MAGAZINE. U.K. Previously he has been mentoring and teaching management accounting based on his chartered management accounting and business administration background. He is also frequent Columnist at the Global Islamic Finance Magazine and on various other platforms. He can be contacted via: email: mughees_cima@yahoo.com; Phone:+60178726766

1. Introduction.
As a relatively young asset class in the global capital market, the sukuk market However alongside this entire boom has had its fair share of controversies and it seems that the gloom has taken precedence over Galore, casting some serious shadows on its acceptability as a shariah complaint product. So much so that it has raised voices even to the extent of it being rather a replication than an innovation in the breed of Islamic financial products. The recent chain of defaults in sukuk has further rubbed salt to the wounds and has thus provided even more impetus on this constant but fair bashing of sukuk. All forms of sukuk have been over the Bunsen burner particularly ever since the pronouncement by a renowned shariah scholar and the chairman of AAOIFI who considered 85% of sukuk specifically those pertaining to the Equity based Family of sukuk. The criticism has no borders; it seems never ending and has taken all kinds and forms of sukuk to the cleaners, be it the musharakas and the mudarabas from the equity based structures, to the ijarahs from the lease based categories and all the debt/sale based sukuk structures based on murabaha, salam, istisna and the ever controversial BBA (Al Bai Bithaman Ajil) faces problems typical of its early stage of development. In this relation, some Muslim scholars have questioned its level of compliance with the Shariah law, particularly on how they are structured. This paper will dwell on it from here and as is in compliance to the essence of this whole writeup, will only focus on the censorious debate regarding the debt/sale based category of sukuk, and hence subsequently attempts to explore the controversies or issues surrounding these sukuk, particularly in the light of observations and resolutions issued by the Shariah Board of AAOIFI, the OIC Fiqh Academy and the juristic point of views, based on the relevant data eyed of about more than 200 sukuk that had been issued based on sale contracts till 2008-2009. The term sheets of these sukuk and their contractual structures had been analyzed to identify Shariah issues. Our discussion will be further substantiated with a couple of relevant case studies based on the Malaysian issuances to facilitate our findings. The approach involves no rocket science. We will get the ball rolling by delineating the ever foundational understanding of the very underlying Islamic contracts that from the basis of these sukuk in section 2. Section 3 will be homing in on the product i.e. Sale/Debt Sukuk itself in a thorough methodological fashion by going through the steps/process involved in such issuances. Since such sukuk are overwhelming darlings to the Malaysian Islamic financial sector, our scrutiny will solely revolve around issuances from this region. Section 4 will lay the foundational explanation of the Shariah parameters methodology which we will be using as a acid test approach to test the Islamicity or Shariah compatibility of this product(s). With some substantial support from our case studies and based on our Four Shariah parameters approaches, section 5 will venture in to performing this test of Shariah compatibility and will indulge into some detailed analysis pertaining to these sukuk, thereby forming the basis of our Shariah analysis as per our methodology. Lastly our discussion will then glide into section 6, where we go on to make some concluding remarks and put forward some suggestions.

2.0 Definition of Sale Contract.

In the classical Arabic language, the word for sale is Bay which literally means arm, which has been elaborated as indicating that one extend his arm to exchange commodities in a sale. If we refer to the Majallah Ahkam Adliyyah sale is defined as means to exchange property for property. This definition includes the exchange of a commodity for another commodity or of commodity for money or money for money. It is only through a unanimous judgment of the jurists through ijma, that the legality of contract of sale as mode of transfer of property to fulfill needs was established. Referring to the Quranic viewpoint Sale has been prescribed as an important trade tool with the requirement of mutual consent in trade and transactions. Surah al-Nisa:29 reads: O you who believe do not take the properties among you by illegal means unless by way of trade and mutual consent. Again in contrast to the prohibition of riba, Allah had permitted sales as general alternative Surah Al-Baqarah : 275 : And Allah has permitted trading and prohibited riba. This Quranic verse clearly and explicitly made sale permissible in contrast to the prohibition of riba. The prophet himself and many of his companions were traders who involved in selling and buying directly. The prophet when asked by one of the companion: What are the best forms of income generation? replied: A mans labour and every legitimate sale.

2.1 Basic Requirements of Sale Contracts.

In the classical books on fiqh and issues of trade, the jurists have identified various types of sales and their related rulings and requirements, basing their decisions on the general provisions of the Quran and traditions of the prophet. Generally, all types of sale contract are constructed upon some common pillars and basic requirements. For instance the Hanafis hold that the only pillar of a sale is the offer and acceptance and other aspects of the sale automatically follow. While on the other hand, the majority opined that there are 3 essential elements of sale: 1) Parties to the contract of sale (seller and buyer) 2) Subject matter of the sale (price and what is priced) 3) Offer and acceptance or sighah In accordance with the very basic principle in the Islamic law of contract the consent of both parties is essential. Beside verbal expression, writing and sign can also be a form of offer and
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acceptance. Majority of jurists accept silent consent by actual exchange of goods (taati) due to common practices. As for the contracting parties, the seller and the buyer, a few requirements must be fulfilled to form a valid sale from them. The parties must possess contractual capacity (Al Ahliyyah) or the right given to a person to involve in a contract and bear all its consequences like they must attain the age of puberty (baligh), and the person should be of sound mind (sanity) and the ability to manage wealth wisely (rushd). Only the person who has these criteria will have the capacity to give his consent validly. With reference to the subject matter of the sale, a few requirements are needed for a valid sale: 1) Suitability of a subject matter for a contract. In other words, it must have property value. Thus, non valuable property in the eyes of the Shariah like wine or dead animal cannot be the subject matter of a sale. Properties must also be legally owned by the parties or authorized as an agent to the owner.2 2) Known to both parties. This can either be ascertained by physical viewing or by description. The parties must know exactly what he is selling or buying to avoid dispute in the future. Thus, selling of something which is not known constitute gharar and therefore is not valid. 3 3) Capability to be handed over or delivered. Thus it is not valid to sell something where the seller is not in a position to deliver the subject matter like to sell a stray animal because the seller cannot deliver it to the buyer. 4) Presence of the subject matter at the time of the contract. This is required because the prophet forbade selling of a good which does not exist, for example to sell embryo which still in the womb of its mother or selling of fruits before its perfect appearance. The exception from this condition is permitted in the case of salam and istisna contracts. Thus, there are three types of sale by reference to the time of delivery of the subject matter and manner of payment: a) Both the price and the goods are present at the time of contract and exchanged simultaneously, this is the common type of sale. b) The subject matter is present but the price will be delivered at a later agreed period of time or known as deferred payment sale. c) The price is present but the goods will be delivered at a later agreed period, known as contract of Salam. The offer and acceptance which indicates the mutual consent of the parties must fulfill the following requirements:
2

Ibnu Hajar al-Asqalani, Fath al-Bari, Beirut, Dar al-Fikr, 1993, vol. 5, p. 323. Muhammad Rawwas Qalahji, Mausu`ah Fiqh Umar bin al-Khattab, Beirut, Dar al-Nafais, 1986, pp. 3435.

1) Clear and understandable wording, conforms to the words and terms normally used in the custom of the parties to indicate a particular type of contract. 2) Conformation of ijab to qabul. The terms must be completely in agreement to each other. Meeting of the minds of contracting parties is essential. 3) Connection of Qabul/acceptance to Ijab/offer, the offer not withdrawn before acceptance.

2.2 Classification of Sale Contracts.

By standard classification criteria, contract of sale is generally divided into two: valid sale and invalid sale. A valid sale is the one that satisfies all the conditions of a sale. On the other hand, invalid sales are those whereby one or more of its conditions is not fulfilled. For example, the sale is not valid if the contracting parties or one of them does not possess legal capacity or when the subject matter does not exist at the time of the contract. Further contracts of sale can be also divided into a few types according to distinctive nature and characteristics. Some basic types of sale contracts which had been used for the issuance of sukuk will be discussed below to explain their nature and basic requirements. Bai al-murabaha.

Literally the word murabaha comes from the root word ribh means profit or gain. Technically, it is a sale of a commodity at the price the seller had purchased it with the addition of a stated profit known by both seller and buyer. It is a cost plus profit sale in which the seller is required to expressly disclose his cost price as well as the profit he is charging. What differentiate murabaha from other types of sales is the element of disclosure on the part of the seller the actual cost he has incurred in acquiring the commodity, and the amount of profit he is charging. It is due to disclosure requirement which is essential in murabaha, it had been classified within the category of trust sale whereby the seller has the duty to disclose the cost and the profit to the purchaser. As to other requirements, all conditions and rulings of sale contract applicable to murabaha sales. Bai Bithaman Ajil (BBA).

Bai Bithaman Ajil or bai muajjal means simply a sale in which the parties agreed that the payment of price shall be deferred as agreed in clear terms. The essential requirement here is that the due date of payment as well as manner of payment is fixed in an unambiguous manner. The jurists are unanimous in approving deferred payment sales. In the longest Quranic verse, Allah had described the procedure including proper documentation for the debt transaction: Surah Al-Baqarah 2:282 : O you, who believe, when you deal with each other in transactions involving future obligations in a fixed period of time, reduce them into writing.. This Quranic verse provides a premise for BBA and its deferred payment feature. The word tadayantum in this verse means entering into a debt contract involving future obligation which
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is obviously one of the considerations of the contract brought forward to a definite future. The legitimacy of deferment of price payment in a sale was further supported by a hadith quoted by Aishah that the Prophet (p.b.u.h.) bought foodstuff on credit from a Jew and gave him his shield as collateral. Bai al-Salam.

Salam is a future delivery sale contract where the price is paid in advance and the subject matter of the sale is deferred to a specified future. It is a sale with an advance payment for future delivery. The legality of Salam has been approved explicitly by the Prophet (p.b.u.h.): Whoever enters into a forward contract let him specify a known volume or weight and a known term of deferment. In this hadith the prophet had explicitly approved the practice of Salam by the people of Madinah adding the condition that all material information regarding the subject matter and time of delivery must be clear to the parties as to avoid the element of uncertainty (gharar).

Bay al-Istisna.

Literally the word istisna is a derivative from the root word sana or to manufacture or to construct something. Istisna is an order or request to manufacture something, whereby the requestor invited, induced or caused another to make or manufacture some goods for him. Technically, it is a contract to purchase for a definite price something that may be manufactured later on according to agreed specifications between the parties. In other words, it is a contract of sale of specified items to be manufactured or constructed with an obligation on the part of the manufacturer or contractor to deliver them to the customer upon completion.

2.3. Statistics of Islamic debt based Sukuk:

Chart 1: Sale Based Sukuk based on contract used Source: Mughees Shaukat 2010

Chart 2: Sale Based Sukuk by years of issuance. Source: Mughees Shaukat 2010

Chart 3: Breakdown of the Sale Based Sukuk by years. Source: Mughees Shaukat 2010

The representative numbers project a very convincing picture of the growth in sale based sukuk starting from 2000 with a surge in 2005 which shows some drastic issuance of these sukuk making up 25.11% of the total issuance in all these years

Chart 4: Sale based sukuk by countries of origin and years of issuance. Source: Mughees Shaukat 2010

In term of the countries of origin in which the sukuk were issued, it has been observed that only 4 countries had issued sale based sukuk i.e. Malaysia, Bahrain, Pakistan and Indonesia. However, Malaysia has dominated the scene in such issuance followed by Bahrain.

3.0. Malaysian Sale Based Sukuk

The Malaysian Sale Based Sukuk are more dominantly based on three forms of the sales contract, The Murabaha, BBA and Istisna. One of the most popular modes is the Murabaha debt papers. The Murabaha facility involves the purchase of assets by the financiers and the immediate sale of those assets back to the issuer with a mark-up agreed upon by both parties. The issuers obligation to settle the purchase price is securitized via the issuance of Murabaha notes. In the BBA facility, the issuer sells the assets to the financiers who immediately sell it back to the issuer with a higher price. Payment of the debt is usually on an installment basis with a longer period compared to the Murabaha facility. In substance, it works exactly like the longterm Murabaha, except that payment can be in deferred terms. BBA bonds can be structured to simulate fixed rate bonds. In Istisna principle, the issuer and contractor will enter into a contract. This construction contract is in fact an Istisna order made by the issuer to the contractor. Even though the identified assets projects are uncompleted, ownership already lies with the issuer. Therefore, the issuer can sell the uncompleted asset to the financiers. The financiers will then resell the identified assets to the issuers, based on deferred payment terms. The issuers obligation to settle the purchase price is securitized via the issuance of Istisna notes or bonds.

3.1. Stages of Sukuk Development.

Malaysia with its booming Islamic finance has been in the forefront of the Sukuk issuance. Most of the domestic issuance has been dominated by debt based nature involving the Murabaha, BBAs and Istisna. These Islamic bonds have been heavily structured using bai al-inah and bai al
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dayn contracts,which has attracted heaps of criticism from all-over, challenging their compliance with Shariah. To start the discussion it is worthy to look at the three main steps involved in the bond issues as has been delineated by Rosly and Sanusi.4 Step 1: Securitization The creation of the bay al-inah assets Step 2: Islamic Bond/Sukuk issues Issuance of debt certificate Shahdah al-dayn Step 3: Trading of debt certificates buying and selling of debt certificate in the secondary market using the contract of bay al dayn. STEP I: The Creation of a Bai al- Inah Underlying Asset. Asset securitization is the essence of Islamic bond issues as a bond must assume the role of almal or property to qualify as an object of sale. An object of sale in the Islamic law of contract must be a property of value. When a bond certificate is supported by an asset as evidenced via the securitization process, it is transformed into an object of value and therefore qualifies to become an object of trade whereby it can be purchased and sold in both the primary and secondary market. Investors then will have the right to sell (haqq mali) these bonds. In the bay al- inah asset securitization, the financier purchases an asset from the issuer and sells it back to the same party at a credit price. This buy-back agreement will ensure that the issuer will receive the money in cash while financier will be paid a prefixed or contracted amount in a future date. Debt payments will be made by installment through bond issues. The difference between cash and mark-up price will represent the profit due to the financier.The underlying asset is therefore crucial in determining the Islamicity of these bonds.5 STEP II: Issuance of Islamic Debt Certificate (Shahdah al-Dayn). As mentioned above, debt certificates issues is valid only when it is supported by an asset. The underlying security here normally is the BBA or Al-MURABAHA asset. If an Istisna contract is used, we can call it Sukuk al-istisna. Islamic bonds new issues can be categorized into two, namely bonds issues with coupons and those without. The former is known as the Islamic coupon bond while the latter Islamic zero coupon bond. Islamic Coupon Bond. The term coupon here denotes the profit portion of the Islamic bond issues in both almurabaha notes issuance facility (MuNif) and al-bai-bithaman ajil Islamic debt securities
4

The excerpts above involving the three steps are based and extracted from Rosly, Saiful and Sanusi Mahmood . The Application of Bay Al-inah and Bay Al-Dayn in Malaysian Islamic Bonds: An Islamic Analysis. International journal of Islamic financial services Vo1 No2.
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In the Malaysian experience these assets include factories, equipment, stock and inventory and even intangible asset such as a list including building and properties, an example of which is a Sukuk Murabaha issued by Amanah International Sdn bhd with a list including building and properties as an underlying asset. More over shares of companies and even a pool of assets which at times involved receivables have also been categorized among underlying assets. See Rosly, Saiful and Sanusi Mahmood (1999).

(BaIDS). The difference between MuNif and BaIDS is mainly on their respective maturities. Long-term (round 10years or so) issues normally apply the al-bai-bithaman ajil buy-back contract, while short-term and medium term (between 5 to 10years) issues will use al murabaha. MuNif and BaIDS, originate two types of debt certificate. Certificates that represent the capital component are called primary notes while the profit portion is known as secondary notes or coupon notes. In the sale/debt based sukuk, coupon refers to the profit or mark-up portion of the deferred sale and not interest. So, one can easily say that the Islamic version of the conventional coupon bonds is MuNif and BaIDS. Islamic Zero Coupon Bonds. These are bonds sold at a discount. Although no coupon or interest payments are made, the implicit interest is the difference between par value and discount value. The operating principle is based on sale contract (al-bai) which makes it a valid transaction in Islamic law. Step III Trading of Debt Certificate Discounted Bai al-Dayn. When a debt certificate is securitized, it now becomes property (al-mal) which is also an article of trade. The trading i.e. sale and purchase of the debt certificates is called bai al-dayn. In Malaysia, the contract is bai al dayn at a discount is acceptable while Middle-east Ulama considered it invalid even though the debt is supported by underlying assets. Any profit created from the sale and purchase of a debt is riba. As an example Hashim holds a bond worth RM1000. His urgent need for cash makes him sell the bond to Haroon for RM900. For whatever reasons, Haroon purchases the RM900 bond because he felt the price of bonds may go up. He will dispose the bond when price exceeds to RM950 to make a RM50 which according to Islamic law is riba. In the case of a zero coupon Islamic bond, the company issues the bond to say, Ibrahim at a discount, say RM900. The bond is redeemable at par value of RM1000 upon maturity. In other words, when the bond matures, Mr. Ibrahim sells the bond to the issuer or another dealer for RM1000. Here trading of debt took place where Mr. Ibrahim receive RM100 as profit over a period of 1 year. In the Malaysian Islamic capital market, the $100 profit is considered permissible (halal) while it is not permissible (halal) in the Middle-East countries although the bond is asset backed, it is therefore not surprising to observe that none of the deals made in the Arab countries so far has embraced bai al dayn bonds.

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4. The four critical Litmus test approaches.

With the discussion on the historical evolution and different types of sukuk in place along with the three stage development model of Sukuk now clearly laid out, the story of the Sukuk doesnt end here. The element of the word Islamic along with any instrument or any activity in this world immediately propels the activity into a very highly sensitive area which is associated with over a billion Muslims. When you relate anything to the religious worldview of any group of people the activity becomes sacred and a means of worship and religious adherence for the practitioners. Keeping in mind that the Sukuks need to be critically examined and need to go through strict compliance with the principles of Shraiah not only at superficial level and in the theoretical framework but in the actual operational reality. Rosly (2010) while giving a fractioned point of view critique of the Sukuk acid test form mentions four critical stages: Aqad approach Legal Documentation Financial Reporting Maqasid al Shariah Approach

4.1. Aqad approach.

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In Arabic, al-aqd literally means an obligation or a tie6. It is an act of putting a tie to a bargain. The Aqad approach is directly linked to the implication of Halal and Haram in Islamic transactions. As expected from Muslim believers, Halal should be observed, and Haram should be avoided. As the first step of an Islamic transaction, the Aqad should as a consequence fully comply with Shariah. To avoid dispute and gharar, Islamic contracts should disclose the following: 1) Buyer and seller 2) Price 3) Subject matter 4) Offer and acceptance. Each of the previous steps carries enough details to avoid as much as possible disputes. Since, the buyer and the seller are named and recognised as legitimate, responsible and individuals. Moreover, several references to the obligation for Muslims to fulfil their engagements are stipulated in the Quran, like in the verse 1 of Surah 5, and verse 34 of Surah 17. As an irrevocable source of reference for Islamic transactions, Quran enhances the importance of Aqad for Muslims and as a consequence, enhances the importance of contracts in general. Furthermore, the seller must own what he sells, and the subject matter should be pure, recognised as tradable in Islam. Indeed, forbidden goods or services to be used by Muslims are also forbidden to be traded by Muslims. In that perspective, the subject matter should be precisely detail. The buyer should be aware of the price, and as responsible individuals, through this contract, each counterpart validates the offer by the acceptance of the contract. Any sort of gharar found in the contract will immediately invalidate it. Thus, the structure of the Aqad enables to evaluate if the contract is: Shariah based, and Shariah compliant

The first point being enhanced by the definition of the subject matter, while the second part is covered through the 4 points stipulated earlier. Nevertheless, we will see how the legal documentation can create a conflict in the contract in the issuance of Sukuk, or in more basic Islamic financial instruments such as Murabaha. Thus, legal

For more details on aqd, see Mahmod Sanusi and Saiful Azhar Rosly Fiqh muamalat for Islamic Financial Practitioners (unpublished), 2008.

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documentation should be considered as complementary to the Aqad, and developed in the same way.

4.2. Legal Documentation Approach.

We can consider Aqad as the foundation of Islamic contracts. Legal documentation is a detailed report presenting the rights and obligations of each counterpart. This document has several objectives. In case the outcome of the contract is not fulfilled, the blameable party can be sewed or forced to comply with its contractual obligations; those ones being stipulated in the legal documentation. Not only legal documentation is to be provided in case of business to business transactions, or between professionals, but even when a business is concluding a contract with individuals. Though, consumer protection is to be considered when realizing the legal documentation. Malaysia has several laws related to consumer protection, but contract in Islam are by nature protecting and enforcing fairness in transaction; meaning that no Shariah compliant contract can by its nature bring more benefit to one part compared to the other. As a consequence, sellers are bound by their contract to provide the right weight and measures, to stipulate in case of default or damage in the subject matter of the contract, and to be held responsible for any hidden defect. Such responsibility is the risk and reward of the seller, and the justification of his profit in the sale. Islamic financial product should as such carry legal documentation in line with the Aqad. Unfortunately, in the case study developed later, we will see that conflict arise between Aqad and legal documentation in the issuance of Sukuk, which lead to a non Shariah compliance of the product, even though, its Aqad are perfectly in line with the expectation of Shariah in Islamic transactions.

4.3. Financial Reporting Approach.7

Accounting can be defined as the process of identifying, measuring and communicating economic information to permit informed judgment and decisions by users of the information. In Islam accounting fall under the purview of hisb and part and parcel of the al-hisbah system. The purpose of financial statements or financial reporting is to provide information about the financial strength, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions. It serves to eliminate ambiguities (gharar) in financial contract through factual reporting of the said transaction. More importantly, financial reporting explains what exactly was transacted in the business dealings such that one is able to know whether, say, a transaction is a loan or a sale,
7

The philosophy of the topic and the basic understanding has been taken from Shariah Compliant Parameters Reconsidered Saiful (2010)

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whether a sale is a true one or not. This is important because accounting information is used by investors who make economic decisions by making predictions of future cash flows of company they invested in. For this very reason, financial reporting should be understandable, relevant, reliable and comparable as laid by the International Financial Reporting Standard (IFRS). This is an Islamic imperative that all IFIs must subscribe to such that stakeholders can gauge its real value to society. Under the ambit of Islamic Finance, transactions and contract can be structured and legal implications of the contractual clauses may not be in contradiction with any of the principles of Islam when analyzed on standalone basis. The story of that transaction or instrument being halal does not end here; the accounting and the financial reporting of the particular transaction should also project and be in compliance with the rules of Shariah. What the accounting reports is the actual cash flow in a financial transaction. If we call any transaction Halal and permissible for Muslim Investors, it is not purely the legal and Aqad framework that we need to analyze, the accounting treatment should be in a line with Shariah, and represent the true nature of contracts used. The intent and the purpose of the very nature of Islamic finance is lost and my stand remains continuing to develop solutions that mimic the conventional system will not develop Shariah based finance.

4.4. Maqasid al Shariah Approach.

Under the debate on the Maqasid al Shariah, we first need to consider what the Maqasid al Shariah, represents. The purpose of the Shariah is the preservation and protection of the basic necessities (daruriyat) of man without which life would probably be filled with anarchy and chaos and thus become meaningless. Basic necessities in Islamic law are religion (Din), Life (Nafs), Family (Nasl), Intellect ('Aql) and Property (Mal). As Saiful (2010) highlights Shariah principles can best be understood from an angle it is destined for, namely the purposes and objectives of Islamic law (Maqasid al-Shariah). This will prove more effective since it allows Islamic financial institutions to match their products and commercial viability more accurately to the demands of Islamic ethics and morality and hence justice (adl). This is because the Maqasid of Shariah serves to do two essential things, namely tahsil, i.e. the securing of benefit (manfaah) and ibqa, i.e. the repelling of harm or injury (madarrah) as directed by the Lawgiver. With this thought in mind we further on to analyze and critically test the viability of any instrument and transaction in Islamic Finance under this criterion. A product or a transaction as earlier mentioned may be legally structured but the critical aspect that needs to be taken in consideration is the manfaat and the mudaraat. The modern day Sukuk or Islamic Bonds need to pass through this Shariah Compliance parameter to be reckoned as Halal. One of the critical elements that need to be considered is the niyat or the purpose and intention of the Sukuk. If the purpose of the Sukuk is for something which does not fall under the purview of halal activities, then the very first maqsad of Shariah protection of din is lost, as then the Sukuk investors are contributing to an activity which Shariah doesnt allow.

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One of the premises of the prohibition of riba is the property rights in Islam, as riba is taking of another persons property unjustly. Under the Maqasid al Shariah, it violates the aspect of the protection of mal. A Sukuk which contradicts this principle or renames the riba with Arabic terminologies or the proceeds of the Sukuk issuance which may be used partially or fully in any riba based activity, becomes in violation of the Shariah Compliance Parameters. The debate on the four approaches is mainly to build a case of a more in-depth analysis of two case studies in the following section to highlight some of the fallacies that we are being sold under the guise of Islamic Finance. The critical aspects of the filter for Total Shariah Compliance are lost and forgotten as would be evident in the following sections.

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CASE STUDY 1:
TESCO MALAYSIA MURABAHA NOTES Issuer: Tesco stores (Malaysia) Sdn Bhd Lead Arrangers: CIMB Investment and Standtard Chartered Malaysia Trustee: CIMB Trustee Berhad
UK-Based food retailer Tescos Malaysia affiliate, Tesco Stores (Malaysia) Sdn Bhd obtained approval from the SC to raise fund of to RM 750million and it issued securities in form of ICP and IMTNs on November 13, 2007. The Islamic commercial papers (ICPs) and the Islamic medium term notes (IMTNs) were based on murabaha and hence securities under this principal are known as Murabaha Notes. Part of the proceeds rose from this issuance (7-15 years maturity) refinanced Tesco Malaysias then existing external debt (up to RM228 million), and the remainder was used for its Shariah-complaint general corporate purposes. Tesco Malaysias murabaha notes applied the Bai al-inah concept in which Tesco Malaysia first sold a pool of its Shariah-complaint assets to the trustee, holding on trust for the investors, for cash. This was documented at the asset purchase agreement (APA). Immediately afterwards, the trustee sold the assets back to Tesco Malaysia on a deferred basis at a higher price. This was documented in the asset sale agreements (ASAs). The trustees purchase price (first leg of the transaction) represents the cost price to the investors and the amount of funds that Tesco Malaysia required to retire its debt and support its operations. The sale price (in the second leg) represents the nominal value of the notes which includes the profit margin to investors. Since this was a commercial paper/medium-term note programme, the total issuance involved a series of bai al inah transactions. Figure 1.1 below depicts the structure of the murabaha notes. 1. The issuer (Tesco Malaysia) from time to time sells the relevant Shariah-compliant assets to the trustee (APAs). 2. Trustee pays the purchase price. 3. The trustee immediately sells assets back to Tesco Malaysia via asset sale agreement (ASA). 4. Tesco Malaysia issues sukuk to evidence its obligations to pay the sale price to the trustee.

Figure 1.1: Tesco Malaysia Murabaha Notes Source: Mughees Shaukat (2010) 16

CASE STUDY 2:
SWEETWATER SPV SDN BHD (BBA SUKUK ISSUANCE) Issuer: Sweetwater Sdn Bhd [SPV] Lead Arranger: Avenue Securities Sdn Bhd (ASSB) Trustee: May Bank Trustees Berhad.
SSPV used here as an SPV (Special Purpose Vehicle) is a wholly owned subsidiary of TSWA-The Sweet Water Alliance. The SPV shall only carry out activities which are specifically tailored as if it is a bankruptcy remote SPV8. Incorporated in 0805 with the sole purpose of issuing purposed BaIDs. It also obtained approval from SC the security commission of Malaysia to raise funds of as much as RM195, 000,000 through issuing BaIDS in October 2005 based on Bai Bithaman Ajil-BBA. This Sukuk deal is interesting because it contains not only all the common practices of other such issuances like the application of Bai al-Inah and Bai al-Dayn, it has gone few steps further by applying Hibah and re-Hibah and violating the basic requirement of an SPV that it should be a completely INDEPENDENT entity. In this case the SPV in from of SSPV in fact a wholly owned subsidiary of TSWA i.e. the holding company. Prior to the issuance date the asset owner (TSWA) who is the holding company of SSPV which is also the SPV, will Hibah the underlying assets to the issuer SSPV. For this purpose TSWA and the issuer will enter into a deed of Hibah (deed of gift) whereby TSWA will give and convey to the issuer the BENEFICIAL INTEREST in the identified assets thus entitling the issuer to deal with the beneficial interest in the identified assets (see articlet) (The Underlying assets in this deal are the ordinary shares of the issuer in SPLASH Holding9. Is it Shariah complaint to use the shares as the underlying assets?). Once this process is over, the issuer (SSPV) will then sell these hibah assets to the primary subscribers through asset purchase agreements (APAs). Then Primary Subscribers will straight away then sell these assets back to the issuer through asset sale agreements at a price higher than what they were purchased the first time. This unconditional obligation of the issuer to pay the selling price will be evidenced by the issuance of BaIDs. These BaIDS as normal with such other Malaysian deals is also tradable in the secondary market on the basis of Bai al-dayn. Figure 1.2 depicts the structure of the deal. 1. 3rd party (TSWA) will first hibah the underlying assets to be used for this deal to SSPV. 2. The Issuer (SSPV) will sell these assets to the investors at a purchase price through Asset Purchase Agreements (APAs). The payment will be made to the issuer on spot. 3. The Investors will then sell back the same assets straight away to the issuer but at a higher price including a profit margin through asset sale agreements based on Bai al-Inah. 4. The issuer (SSPV) will issue sukuk (BaIDS) to evidence his obligation to pay the sale price. 5. Once the Sukuk has grown to Maturity The Very underlying assets will then be given back to the 3rd party (which by the way is not the real owner but the beneficial owner of the assets) through the process of re-hibah.

8 9

See the term sheet of SSPV sukuk article (vii) on Principal activities. See article 18ort of the term sheet of SSPV sukuk deal.

17

Figure.1.2: Sweetwater Spv Sdn Bhd (BBA Sukuk Issuance) Source: Mughees Shaukat (2010)

5. Critical analysis of the Cases in view With the FOUR Approaches.

Based on the scrutiny of the cases above, we further progress by testing the cases as for the 4 shariah parameters approaches we previously laid. To test the islamicity and shariah compliance of this sukuk. From our study a number of issues that has been raised that disdains this four dimensional test and hence are proven abrogative to shariah and the compliance to shariah. the issues pointed out are as follows: FIRST: AQAD FAILURE. BAY AL-INAH Under bay al-inah asset securitization, investors purchase assets from a company and then sell the asset back to the same company at a mark-up price; the payment to the investors will be made at a future date. For instance, a company has assets worth RM 2 million, which are then securitized in order to obtain financing. The assets will be sold to investors at the price of RM 2 million. Then, the investors will resell the assets back to the company at RM 2.5 million (price higher than RM 2 million). The bay al-inah concept is used when assets are securitized using murabahah and Al-Bai-Bithaman-Ajil contracts. The issues of Bai al-inah in the above class of sukuk relates directly to the failure in the Aqd parameter test approach. Although the rest of the basic elements that satisfies the Aqd approach are present e.g. the two parties are there, the subject matter is there (though in many deals the subject matter used raises questions on the acceptability of it to be ised as an underlying asset), the price is also known and offer and acceptance is also there. Even though all the basic necessities of the contarct are seeminghly being fulfilled here but since the contract is applied and based on the ever controversial Bai alinah There are scholars who claim that bay al-inah contract is impermissible under Islamic principles because the difference between the original price that a company sells to the investors, and the price that investors resell to the company conveys the existence of riba (usury), and the motive behind the contract is to legalize something which is illegal. However, according to Shafii School, such a transaction is valid by the external evidence that they were properly concluded; the unlawful intention is immaterial, unless it is explicitly mentioned in the contract.
18

Contradictory to the Maliki and Hanbali jurists, the contract of bay al-inah is not valid because it constitutes a legal device to get a loan with interest (motive of bay al-inah); these jurists also highlights the importance of motives in determining the legality or illegality of contracts. The prohibition of such a contract is also based on the consensus of Islamic jurists (Ijma Ulama) and the Hadith narrated by Ibn Qayyim: A time is certainty coming to mankind when they legalize (Yastahillun) the Riba under the name of Bay. The use of Bai al-inah and the way its done makes the whole Islamic deal similar to loan deal as in conventional practice thus hence in the far reach spreading a credit culture akin to conventional finance since hardly any difference is seeable. And since there has been a few cases of sukuk that have defaulted and needed restructuring, the restructuring of the Kesturi 2004 istisna sukuk 10which was maturing in 2011 is just one latest evidence of the Hiyal in form of Bai al-inah that may lead to fatal consequences and eventually credit crisis or perhaps Bai alInah subprime crisis next to which is financial instability and a massive reputational risk for Islamic finance which potentially is supposed to be the cure.

SECOND: MAQASID FAILURE. BAY AL-DAYN When companies issue securities or certificates to investor, as an evidence of indebtedness, sometimes these securities are traded in the secondary market, that is, the investors sell the

10

"There is a need for a new sukuk issuance as there's a mismatch between the asset and the company's financing requirements," said a source familiar with the latest proposed issuance.Konsortium Lebuhraya Utara-Timur (KL) Sdn Bhd (Kesturi) was given a 34-year concession to design, construct, operate and manage DUKE in August 2004. The company is wholly owned by Nuzen Corp Sdn Bhd, which in turn is 70 per cent held by Wira Kristal Sdn Bhd and 30 per cent by Malaysian Resources Corp Bhd. Under a debt restructuring exercise, Kesturi will issue a senior sukuk of up to RM780 million and a junior sukuk of up to RM50 million for a 17-year tenure. Proceeds will be used to redeem an earlier sukuk issued in October 2005. Kesturi will also seek a Danajamin guarantee for the senior sukuk issuance, based on an Ekovest Bhd announcement to Bursa Malaysia two weeks ago. However, Business Times has learnt that the guarantee is likely to come with conditions, including a top-up of funds by shareholders of the company. When contacted by Business Times, Kesturi declined to comment on its proposed sukuk issuance or its debt restructuring exercise. After consulting with its lead arranger CIMB Investment Bank Bhd, a Kesturi spokesperson said it was unable to provide information as the restructuring was in the final stages and would be firmed up within a month or so. Kesturi's sukuk issuance five years ago was also RM780 million, for a 13-year tenure to finance the construction of DUKE. The amortisation of this sukuk is spread over nine years, with the first sukuk redemption of RM50 million due this October. Although a proposed issuance date for the new sukuk is still being firmed up, the company is likely to raise funds soon. A Malaysian Rating Corp Bhd (MARC) report issued in January said the company's management had admitted that slower traffic would mean a greater risk of not meeting debt conditions and repayments. The report also said that toll revenues were expected to be insufficient to cover Kesturi's April 2010 profit payment although a shortfall was likely to be funded using its finance service reserve account maintained under the sukuk. DUKE, which saw its first phase completed in December 2008, opened fully last May, slightly behind its original schedule. (Business Times)

19

certificates to a third party. Since the certificates represent debt of the companies to investors, trading of these certificates is called bay al-dayn. In Malaysia, Shariah scholars said that trading of debt at market prices is allowed because debt, which are created according to Islamic principles are considered as assets. This is so because debt (bonds) represents financial rights to the holder and financial obligation to the borrower (company issuing the certificates). However, most Hanafis, Hanbalis and Shafiis jurists agreed that debts are not allowed to be sold to non-debtor or a third party at all because the selling of debt involves the element of gharar and selling of something, which the seller does not possess. Nevertheless, there are Malikis and some Hanbalis and Shafiis jurists who allow selling of al-dayn to a third party; their argument was that since the creditors (investors) has the right to sell the debt to the debtor or companies (when bonds are redeemed), thus the creditor has the right to sell it to a third party provided that the following rules are adhered to: i) The dayn must be a conformed debt and the contract must be performed on the spot, not deferred in order to avoid selling of debt for debt, which is prohibited in Islam. ii) The debtor or company issuing the debt certificates must be financially capable of fulfilling the debt, and must accept and recognize the sale made by investors to third parties so that the debtor will not deny the sale. The purpose of this condition is to avoid any dispute between the parties. iii) If debt is money, its price in another debt must be equal in terms of amount or quantity; thus, if the value of the debt certificate is RM1000, then its selling price (to third party) must equal to RM1000 too. The scholarly and practitioner opinion on these two matters ranges wide and has opened a major debate on this matter. The issue directly going against the Maqasid Approach. If Islamic financial products are found to pull people to fall into debts and bankruptcy, how can we explain it has a worthy alternative to conventional financing? It shall then remain prohibited since it has failed to repel the harm, thus defeating the very purpose of the Shariah. Such practice fosters debt trading, and the culture of debt in Islamic societies. THIRD: LEGAL DOCUMENTATION FAILURE: The issues of SPV which directly links to the general and legal status of it i.e. on its degree of independence from the sukuk issuing company and on its basic requirement of being bankruptcy remote e.g. in SSPV sukuk article (vii). Both of these basic requirements has been frivolously violated, where the SPV is in many issuance have actually been a subsidiary of the issuer which has been given a status of SPV only meant for the purpose of the sukuk issuance eventually making it non-bankruptcy remote. LEGAL DOCUMENTATION FAILURE: The FOURTH issue on our list is the issue of pricing such a deal(s) is another important issues that we have pointed from our analysis which again does not come good when tested with a legal documentation as the issues relates directly to this category. In TESCO case, the PTC shows how the price has been determined:
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This calculation method is to be analyzed critically. Indeed, the pricing method is based on a benchmark referring to LIBOR and KLIBOR as the conventional benchmarking is done. As such, it doesnt fit for sukuk as Islamic financial product. FIFTH: FINANCIAL REPORTING & LEGAL DOCUMENTATION FAILURE: the frequent use of Hibah and re-Hibah in these forms of sukuk where a third party some way or the other agrees to hibah the relevant assets, which are to be used as underlying for the issuance of the required sukuk, in order to make the issuer who has no ownership of the asset the beneficial owner so that he can use the assets just for the purpose of the issuance to raise funds [SSPV Sukuk deal article(t) and in Oxbridge Murabaha issue-04/05]. Eventually at the end of all when the sukuk is matured, those very assets after fulfilling the required purposes are then Hibah back to the real owner. This whole process raises some serious issues which directly link to the concept of ownership of the relevant assets for the purpose of sale in the view of Shariah. Shariah requires the seller to own the assets before he can sell them to the other party. This is the basic requirement before entering into any sale contract. The asset should be owned in such a way that the owner should have a full and real procession of them. In other words he should be the real owner and not a beneficial one meaning he should have full control over it so that he can run the risk of any loss or gain or even damage to it. The owner should be able to practice his/her free will over the assets meaning he can do whatever he wants and use it the way he likes but within the ambit of Shariah. Beneficial ownership as is the case in a number of these sukuk contradicts all of these basic Shariah requirements and hence it violates and invalidates the whole Islamic concept of Sale, thus making the whole transaction invalid and hence contradictory to Shariah which is the most severe consequence to a so called Islamic transaction. It means in such transaction the real ownership of the assets has never been transferred at any point be it to the issuer from the real owner or to the investors when it is further sold to the investors in an extensive approach and then re-sold back to the issuer using Al-Inah as mentioned previously. Thus it is very clear that although it is a sale transaction and the assets are sold, they are just used rather fictitiously to raise fund under the Islamic banner but in an un-Islamic way through financial artifice or Hilah
21

(legal stratagem). Even the financial reporting parameter approach test appreciates our finding. In asset-financing such as murabaha or BBA contract, the bank/issuer is expected to own the asset before making the sale. The principle that one must not sell what one does not own confirms that the bank/issuer must hold ownership of asset prior to sale and thus record it in the balance sheet. Such accounting treatment is an inevitable fact and any Islamic bank that failed this test is guilty of riba since it indicates that no true sale exists. Although bank may hold the asset for a few days or even hours, proper accounting must be uphold. Financial reporting can prove that a bay al-enah sale is not a true sale but only a fictitious one. Although the aqad approach says bay al-enah is valid (sahih), but not actual sale ever took place since no recording of purchase is evident in the balance sheet. How about when the khiyar al-ayb or the option of defect comes into play which is a legal right. This means the customer who is now the issuer here does not need to stipulate a special clause or provision of the option at the time of contracting. It comes automatically with the BBA sale, but which party is responsible to cater for such an option is it the issuer who was the seller in the first step or the sukuk holders when they sold the asset back to the issuer. Nothingn is mentioned about such an event(s) in the contract or the proper legal documentation is lacking as the whole deal is structured as a carbon copy of a conventional bond deal hence the very methods even to come up with the contarct and the legal documentation is no different from a conventional bond deal rather Bai-inah and hence the Islamic label is used to convert a conventional deal in an Islamic deal. The question is that how can you call this practice Islamic, how can one term it an Islamic Sukuk or even Islamic finance for that matter? The list does not end here in fact it has a lot more to it and as we indulge more, we move on to the LEGAL DOCUMENTATION & AQAD FAILURE: The SIXTH issue that we raise. The issue here relates to the presence of collateral and often guarantee ( SSPV, J(iv) and TESCO 24(a)),by a third party which has not even been found independent of the sukuk issuing party particularly when the issuance is not a sovereign one as has been the case in most of the sale based sukuk issuance in Malaysia. This issue can be seen in all the credit enhancement clauses given in the term sheets of majority of these sukuk. Before we explore any further, very briefly we understand what credit enhancement is in sukuk? This sort of Sukuk receives an irrevocable third-party guarantee, usually by a parent or original owner of the underlying collateral. The guarantor provides Shariah compliant shortfall amounts in case the issuing vehicle (usually a special purpose vehicle or SPV) cannot make payment. The ratings on this type of Sukuk largely depend on the creditworthiness of the guarantor or entity providing the credit enhancement mechanisms and other financial obligations of the guarantor. When it comes to the act of Guarantee, Shariah has some basic rulings. It says very clearly that guaranteeing is a voluntary act and should not be a conditional one; it can be performed in form of a gift or donation, hence the guarantor should not ask for any fee or compensation in any way for such guarantee as it will violate the very concept of a voluntary act. Therefore it must and cannot be stated in contract either implicitly or explicitly as a pre-condition or even after the contract has been concluded.11 In other words the conclusion of a sale contract as in here should
11

The OIC Fiqh Academy summarized its decision on guarantee by third party that it may be issued by a third party who has no connection whatsoever with the mudharib if it is done by way of tabarru` and is not included as a

22

not be based or concluded on a decision of offering such a guarantee. The contract should be abrogated as a result of the absence of such voluntary offer of guarantee has been made conditional of the contract. The practitioners as is the case in these sukuk should abstain from making such conditional guaranteeing recur, for its recurrence would mean that it has become an established custom, which would have the force of a condition according to the general Shariah rule. Nevertheless there is no harm in such guarantees being offered as a pure gift or donation meaning that they are voluntarily done. Shariah also further ordains that such guarantees alongside being done voluntarily should be done by third party, a party who is completely independent to the other concerned parties, meaning this third party should not be a party having an interest or stake in the deal in anyway. However in the sukuk that we have studied the third party i.e. the guaranteeing party envisaged have most likely been an interested party somehow or the other. Such party is no longer considered a third party and thus would not serve as a legally acceptable donor of the guarantee in the eyes of Shariah. Not only this, they also seek certain amount of fee (Ujrah) for their guarantee. Ujrah refers to rental or fees for usage of labour and benefits. In the current economic context, it may be applied to salaries, wages, fees, commission and the like.12 The majority of past Islamic jurists were of the view that the charging of fees on kafalah is not permissible. This view is based on the argument that a kafalah contract falls under `uqud tabarru`at which is voluntary and benevolent in nature. Hence, no fee is to be charged.13 Wahbah Al-Zuhaili was of the view that to charge ujrah on kafalah is permissible based on maslahah and societys needs14. Syeikh Ahmad Ali Abdullah was of the view that when there is a condition that the kafalah bears a fee, the said condition is considered valid. He also emphasized that kafalah contract is not qardh15. He supported his views with qiyas, referring to
condition in the actual mudharaba contract sealed and signed by both parties. The Shariah Council for Accounting and Auditing Organization for Islamic Institutions (AAOIFI) in its 6 th meeting on 19-23 May 2001, allowed for third-party guarantees other than investment agents or business partner towards the liability of investment losses. However, this is on the provision that the guarantee given is not tied to the original (for example) mudharaba contract.The basis of their decision is tabarru` which is allowed by Shariah. Husain Hamid Hassan (OIC, Majallah Majma` al-Fiqh al-Islami, Jeddah, 1988, no. 4, vol. 3, p. 1875.) summarized the basis of the permissibility of third party guarantees based on the views of the Maliki Mazhab which allow wa`d mulzim (promises that must be kept). It is further strengthened by maqasid Shariah (Shariahs objective) which allows for such action. Moreover The Fatwa Council of Jordan legitimized third-party guarantees based on debts. This resolution was made as the basis in drafting section 12 of the Muqaradhah Act which pertains to the guarantee concerned (This section states that The government guarantees the payment of sanadat muqaradhah upon maturity. This payment guarantee is in the form of interest-free qardh bestowed by the government for implemented projects. Please refer to OIC, Majallah Majma` al-Fiqh al-Islami, no. 4, vol. 3, p. 1980). However, the OIC Fiqh Academy, disagrees with the basis of third-party guarantees that are based on debt and resolved that third-party guarantees have to be in the form of tabarru`. Otherwise, the contract is deemed to be an interest-bearing debt which is not permissible. 12 Securities Commission, Guidelines on the Offering of Islamic Securities. 13 Al-Hattab, Mawahib al-Jalil, Beirut, Dar al-Fikr, 1992, vol. 5, pp. 111, 113.
14

Al-Zuhaili, Al-Fiqh al-Islami, vol. 5, p. 161. OIC, Majallah Majma` al-Fiqh al-Islami, Jeddah, 1986, no. 2, vol. 2, pp. 11461147.

15

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fees that are permissible to be collected on utilizing someones reputation and also on performing incantation using Quranic verses. Some of the past Islamic jurists allowed both situations and can be used as fees on the guarantee since it is similar from the aspect of work done 16. The OIC Fiqh Academy and the Shariah Council AAOIFI resolved that ujrah on kafalah/dhaman is not permissible. However, the guarantor may claim for actual expenses incurred on the guarantee17. MAQASID FAILURE: The SEVENTH issue that has been raised from our research study is the issue dealing with how the proceeds that has been raised from the sukuk issuance have been used. In other words have they been used in a Shariah complaint or a Shariah contradictory way. In the case of Tesco Malaysia given above it is evident from its term sheets that a significant portion of the proceeds raised form the issuance has been used to refinance existing external debt (up to RM228 million; article 13). In case of SSPV sukuk (article K), where RM115million has been used to refinance TWSAs borrowings. Another example of such a case is in the murabaha sukuk deal of BCHB- Bumiputra-Commerce Holdings Berhad where again a part of the proceeds raised were used to settle the already existing borrowings of the issuer. The question is that how valid it is to raise another debt to settle the previously existing one? Were the investors aware of such usage of proceeds beforehand? Is not it a financial artifice to raise fund to settle pervious debt by not letting the investors know? It seems a clear case of legal stratagem to raise money in a so called Shariah complaint manner which it seems not to be. The sukuk issued by the International Finance Center and the World Bank based on BBA deal also rings the bell with such issue, where the proceeds raised from BaIDS were just used for general operations of IFC- International finance corporation. The challenge to Shariah is that IFC and neither the World Bank has an Islamic portfolio, so for which general operations were the proceeds applied? The point to stress here is that not only raising the proceeds should be Shariah compliant but also the end use of them in the same manner is what completes the circle for a true Shariah complaint product. The above examples miss not one but both the points substantiating a clear effort of Them molding Shariah accordingly rather than the other way round. MAQASID & LEGAL DOCUMENTATION FAILURE: The EIGHTH issue that our study has pointed out concerns the Event of Default clauses even the cross default clauses in nearly all the sukuk deals (e.g. in X, (vi) of SSPV sukuk, Oxbridge sukuk issue in 04/05 and article 25(f) in TESCO deal). One of the more contentious topics in the market today is the rights of

16

OIC, Majallah Majma` al-Fiqh al-Islami, no. 2, vol. 2, pp. 11341135. OIC, Majallah Majma` al-Fiqh al-Islami, no. 2, vol. 2, pp. 12091210. AAOIFI, Al-Maayir al-Syariyyah,

17

Bahrain, 2002, pp. 75, 88.On the other hand some other contemporary jurist allowed the charge in the guarantee based on the ground that there is no specific injunction from the text but it has been deduced from the prohibition of riba as one of its ancillary consequences. They view the existing guarantee differently base on the current business scenario and wider scope of the international trade which required many tools and instruments to facilitate the various transactions. Therefore the guarantee becomes very necessary due to the difficulty to find guarantors who can provide this type of service free of charge. This type of guarantee is not a simple procedure but it is complex and complicated; transaction with risk involve in the operation which require market study and business commercial activities.

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sukuk holders in the event of non-payment or default. Do they have a claim on the underlying assets in the sukuk formation? Where do they stand in the line-up of creditors, given the general belief that sukuk are the more secured investments compared to their conventional counterparts. Given the Shariah emphasis that financing should be raised with respect to an economic activity, all sukuk shares a common feature in that they often take shape with an asset (or assets) at their core. Where there has been a real (true) transfer of asset ownership to a special-purpose vehicle (SPV) that has been formed to issue the sukuk, then the investors would have a legitimate claim on that particular asset that has been sold to them, but not so without a true sale (i.e. assets have not been transferred to the sukuk holders), and if the asset is present simply for the purpose of Shariah compliance, we believe that the legal recourse and cure for the sukuk holders are likely to be no more than those of unsecured creditors. Even from the rating perspective, an analysis of the asset will be inconsequential; instead, we will focus on the creditworthiness of the corporate obligor. Asset ownership, in this instance, would strengthen the investors rights on the underlying asset(s) in the event of default or liquidation. However, in the Malaysian Sale/Debt based sukuk the issuer customarily declares a trust over the assets in favor of the sukuk holders, with the latter having beneficial ownership of the underlying asset(s). Legal ownership, however, remains with the original asset owner as has been made clear earlier. The intent of the issuer in this instance is to have an unsecured funding source. However, the event of default clauses studied add further to the gravity of the controversy when/where it clearly also states that if the issuer even defaults on any other of his obligation which may have no direct or indirect link to the concerned deal will also render the issuer as similar to defaulting in the sukuk deal. The exact wordings of the clauses in a condensed form are as follows: (i) Any indebtedness of the Issuer becomes (after the expiration of any applicable grace period) due or is declared due before its stated maturity as a result of default or is not paid on its due date; (ii) Any guarantee or similar obligation of the Issuer is not discharged at maturity or when called; (iii)Any security for such indebtedness becomes enforceable. The legal documentation governing the transaction firmly renders the sukuk a financial obligation, listing the sukuk holders as creditors (as opposed to owners or equity holders) and ranking them pari passu with conventional creditors (within the same class of creditors).
TABLE 1: Shariah Issues in Sale/Debt Based Sukuk.
Shariah Issues Issues Description Issues Shariah Issues Description

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Bai al-Dayn (Maqasid issue)

This issue arises from trading of the sukuk at discount. Secondly, This may also include the issue of type of asset used for securitization whereby the assets securitized are financial receivables (debt).

SPV (legal documentation issue)

Analysis on the legal position of the SPV from Shariah perspective, independence of SPV from the originator. The calculation method is to be analyzed critically. Indeed, the pricing method is based on a benchmark referring to LIBOR and KLIBOR as the conventional benchmarking is done. As such, does it fit for sukuk as Islamic financial product? Hibah clause from a third party as a legal device to enable the sale and subsequently re-hibah to return to the original position. The ownership is in question as no evidence of ownership even from financial reporting aspect. Flow of the fund and the stages of the Shariah contracts. The issue of which contract performed first. The APAs or ASAs the whole transaction is simultaneous. Credit enhancement for the sukuk whether in Shariah compliant manner, guarantee of third party with fees. Usage of the proceed whether for Shariah compliant purposes?

Pricing of Sukuk Legal Documentation Issue)

Hibah and re-hibah clauses (Financial reporting & Legal documentation issue)

Contractual (Aqad issue)

flow

Bai al-Inah Issue)

(Aqd

Sale and buy back arrangement between the same parties on the same asset, one with cash price which is lower and another with deferred higher price. Investors made profit on the difference between the two prices

Collateral and guarantee (legal documentation issue) Usage of the proceed (Maqasid issue) Event of Default Clauses (Maqasid and legal documentation issue)

What constitute the event of default clause, whether the conditions imposed contrary to the sale contract and compliant with the Shariah requirement, effect of the event of default on the sale contract.

6. Conclusion and Suggestions.

The market for sukuk experienced phenomenal growth ever since its inception, with ever encouraging growth and development of the sukuk market, has raised many controversial issues as is clear from this research. For reasons more to do with form than substance, Sukuk became the attractive and talked-about face of the Islamic finance industry in the mid-2000s, for good or for bad. The upside of this was that we could all revel in the newest, biggest, fastest, most complicated structures used in Sukuk as they hit the headlines of the media in the Gulf and parts of Asia. However, if we consider the matter from the perspective of the higher purposes of Islamic law or the objectives of Islamic economics, then Sukuk are inimical in every way to these higher purposes and objectives. The noble objective for which riba was prohibited is the equitable distribution among partners of revenues from commercial and industrial enterprises18. The mechanisms used in Sukuk today as has been up-rooted from this research, however, strike at the foundations of these objectives and render the Sukuk exactly the same as conventional bonds in terms of their economic results.
18

Usmani, M.T (2002). An Introduction to Islamic Finance. The Hague: Kluwer Law International.

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Undoubtedly, Shariah supervisory boards, academic councils, and legal seminars have given permission to Islamic banks to carry out certain operations that more closely resemble stratagems than actual transactions. Such permission, however, was granted in order to facilitate, under difficult circumstances, the figurative turning of the wheels for those institutions when they were few in number (and short of capital and human resources). It was expected that Islamic banks would progress in time to genuine operations based on the objectives of an Islamic economic system and that they would distance themselves, even step by step, from what resembled interest-based enterprises. What is happening at the present time, however, is the opposite. Islamic financial institutions have now begun competing to present themselves with all of the same characteristics of the conventional, interest-based marketplace, and to offer new products that march backwards towards interest-based enterprises rather than away from these. In order to promote Sukuk, the justification given is that international ratings agencies will not grant the desired, investor-grade ratings unless these mechanisms are used to guarantee the return of principal to investors, and to distribute profits from capital at specified rates. Without these mechanisms,it will not be possible to market Sukuk widely as could be learned from the recently concluded 4th Islamic Capital Market Forum held in the Security Commission of Malaysia on July 1st 2010. The answer to this objection is that if we are to continue to run behind the international ratings agencies, agencies that do not distinguish between halal and haram, it will never be possible for us to move forward with authentic Islamic products which actually serve the purposes of Islamic economics. This is because these agencies have matured in an interest-based atmosphere that is unable to acknowledge the quality of an investment unless its capital is guaranteed and its returns are distributed on the basis of interest. There are increasing murmurs in financial circles as to why these agencies are allowed to continue rating debt issues? As the bond issuers themselves have to pay for the evaluation exercise, there candidly is scope for the ratings moving in tandem with the payments19 (Hasan 2010) -The more you can pay, the better they rate is the mantra for these agencies.

6.2. Back to basics.

Sukuk has lost a lot of credibility of late. Is this justified? Yes, it is entirely justified. The industry made some big mistakes as has discussed in our study and it is now paying the price. But there is a sense of inevitability about these mistakes. Without making them, we would not be in the position that we are today, armed with a welter of information about how we go about undoing the mistakes of the past. Did we get it wrong? Yes, we got it wrong. We grew everything too fast and with this fast growth of Islamic finance, there has also been an increase in the expectations gap between Islamic finance practitioners and civil society members about the role that Islamic financial institutions (IFIs) should play in society. There is a growing feeling that speed is no advantage if
19

Hasan Zubair: (2009), Dubai turmoil before and after the bailout online at http://mpra.ub.uni-muenchen.de/19484/ MPRA Paper No. 19484, posted 21. December 2009.

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things tend to move off the course20 (Hasan 2010): after all the primary objective of all activity financed Islamically is the realization of benefit to people and fulfilling Maqasid Al-shariah. In other words, it is not just about money.

6.3. Identifying the problem.

Based on our FOUR dimensional shariah parameters approach, we run into the Shariah issues which has been discussed in some detail earlier creating a dichotomy whether these structures are actually Shariah compliant or not. Perhaps the issue touched upon here is more dangerous than imagined as it concerns itself more with Islamic finance structures in general, the foundational Shariah ordainments and the fatwas that are attached to them. Then there is the issue of whether or not they are asset backed or asset based. These are the kinds of questions that become very important in the event of a default. The typical investor wants to know what recourse they would have in the event of a default. The real dilemma here is whether ownership of the asset in all structure when it is transferred to an SPV is a real transfer or not. If it is real enough to satisfy the Shariah scholars then presumably it must be real enough to satisfy the courts in the event of default. This is one of the core questions that should be answered after the current spate of defaults on Sukuk have washed their way through the courts. These recent events may have left investors nervous as to whether they have a claim over the assets underlying the issuance or not, and whether or not sukuk are more secure than conventional bonds because they are backed by tangible assets. If there is a claim over the assets, investors could expect priority in realizing their investment in a default scenario. However, if this is not the case, investors would be unsecured creditors in the bankruptcy of a debtor. This uncertainty may have arisen because a number of structural features are typically present in sukuk such that they are constructed on the foundations of tangible assets, for example, land, real estate or machinery and equipment. However, have some investors been wrong in their belief that sukuk offer a more secure investment than conventional bonds? To-date, the issuers of sukuk and the financial experts who assist in selling such securities have tried to meet the requirements of Shariah-compliant investors who have sought a similar fixed-income risk profile to a conventional bond21. Those are usually based on the financial performance of a corporate entity with which they are familiar and in which they wish to invest. In the majority of unsecured sukuk transactions the investors ultimately have no direct recourse to the assets themselves. The repayment of their investment is dependent on the exercise of a
20

Hasan Zubair: (2010), Islamic Finance: Structure-objective mismatch and its consequences. Published in ISRA

international journal of Islamic finance vol 2 Issue 1, June 2010 and also available Online at http://mpra.ub.unimuenchen.de/21536/ MPRA Paper No. 21536, posted 22. March 2010.
21

Sol, J. (2008). Prospects and challenges for developing corporate sukuk and bond markets. International Journal of Middle Eastern Finance and Management, 1(1), 20-30.

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purchase undertaking in some sukuk or by the credibility of the seller of the assets at maturity or upon default22. Thus, as with a conventional bond, the investors take credit risk on the seller who has granted the purchase undertaking. Although typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default. As a result, offering documents prepared for most sukuk transactions have very little disclosure (if any) in respect of the physical asset; instead, disclosure focuses principally on the balance sheet and business and risks of the seller. While Shariah principles do require a transfer of control and risk (as well as reward) in relation to an asset from the seller to the investors, the actual analysis of whether a transfer of the asset is perfected and immune from the bankruptcy of the seller (a typical feature of conventional, asset-backed securitization) has not been a necessary feature of sukuk as has been pointed out in our study.

6.4. How do we fix it?

We fix it by building a robust, comprehensive and dynamic regulatory-prudential-supervisory framework to accommodate Sukuk. No-one can do this alone. It has to be a collaborative effort and we should all feel obligated to play our part. By all standards sukuk is one of the most significant financial innovations and additions to the Islamic Finance industry product range in the recent past. It has confirmed its viability as an alternative means to mobilize long-term savings and investment from a huge investor base which is keen to invest in formats compliant with the Islamic Shariah. This development has been fuelled not only by the desire to raise funds in a Shariah-compliant methods but also by the other excellent attributes of the product as already discussed. A permanent solution to these problems would be a long process. It resides in the systematic harmonization of documentation of Islamic financial contracts, the minimization of the differences between Shariah boards and the codification of fundamental principles of Islamic commercial law into clear set of legislation based on core Shariah principles and international best legal practices. Such a process will not be effective unless some countries adopt these principles as basis for national legislation. A transitional solution would be a process of standardization of Islamic financial contracts by identifying the fundamental Shariah principles which must be incorporated into a particular contract23. The standardized contracts need to be endorsed by the Shariah Board of Islamic infrastructure institutions such as AAOIFI, IIFM, IIRA and IFSB in order to give it an international dimension and acceptability in court litigation. It is also quite encouraging that a number of industry building institutions have been created over the past few years to offer certain services needed for the success of the product and, thereby, contribute to the creation of the much needed Islamic Capital Market. Notable among such institutions are the following: Liquidity Management Centre (LMC) International Islamic Financial Market (IIFM)
22

Wilson, R. (2004). Overview of the Sukuk Market, in Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk, Euromoney Books. 23 Islamic Financial Services Board. (2007). Islamic Financial Services Industry Development (Ten-Year Framework and Strategies). Policy Dialogue Paper No. 1 (May).

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 International Islamic Rating Agency (IIRA) Admittedly, however, with all the progress made, the sukuk market is far from realizing its full potential and the idea of a fully Islamic secondary market remains a distant away. The cumulative value of sukuk issues outstanding is only a fraction of the market demand. For instance, sukuk Al ijarah which has been the dominant type of sukuk so far is only one of the 14 asset classes that have been approved by the AAOIFI standard. In fact sukuk Al ijarah has its own shortcomings including the fact that it may not always be easy pooling sufficient quality unencumbered assets to support a good issue in the market. Nevertheless, unless good domestic capital markets offering long-term investment opportunities are developed by the OIC countries, then the behavior of Islamic investors may not change substantially from previous prototypes. Another matter that is hanging fire in Islamic finance is of regulatory rules, procedures and authority allocation. Much laudable work has been done in this area but regulation will always remain an issue in finance for both economic and ideological reasons. However In Islamic finance the regulators have got the opportunity to streamline inter alia the legal advisement system24. The task may, for example, be centralized as in Malaysia. Finance is not without economics. For keeping the bigger picture in view to make implications of proposed regulations clearer, well qualified economists must be associated with advisement as full members at all levels25 (Hasan 2010). The world has more wealth today than any time before. Much of this wealth is in the hands of people who have lots to spare. Add to this the financial institutions entrusted with money by the rich, the not so rich and even by the masses, in order to earn more money for them. Much of the prosperity the world enjoys today depends on the productive employment of this liquidity. Sukuk are very convenient vehicles of transferring some of this liquidity to people capable of employing it into productive projects. A diverse spectrum of investment vehicles serves persons with different perceptions of risks and returns. Debt-based financing that some of the sukuk include i.e. those which we have discussed in our study, shifts the risks involved in wealth creation on to the user of funds. Inside the same country this method of financing tends to make the rich richer and the poor poorer, relatively speaking. At the international level, debt financing has been ruinous for many developing countries in Asia and Africa26. The Islamic way of risk sharing, on which genuinely Islamic sukuk should be based, would make the additional wealth created with the use of the existing wealth to be shared between fund users and fund owners while both bear the risks involved and the resulting loss27. As a necessary step towards a just and equitable society, bai al-dayn or selling of debt should also be disallowed (that too on discount). To prevent a thriving market for debt it is necessary to prohibit exchange of debt with cash at a discount in line with the well known Shariah prohibition
24

Sidiqqi, M.N. (2006). Islamic Banking and Finance Theory and Practice: Survey of State of Art in Islamic Banking & Finance. Islamic Economics Studies, Vol. 13, No. 2. 25 Hasan Zubair: (2010), Islamic Finance: Structure-objective mismatch and its consequences. Published in ISRA International journal of Islamic finance vol 2 Issue1, June 2010 and also available Online at http://mpra.ub.unimuenchen.de/21536/ MPRA Paper No. 21536, posted 22. March 2010. 26 Al-Suwailem, S. (2006). Hedging in Islamic Finance. Jeddah: IRTI
27

Norman, T. (2009). Sukuk, where next? Global Arab Network, July 6, 2009.

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of exchanging unequal quantities of the same money or unequal quantities of debts. Shifting the risk of default is a transaction accompanied by excessive uncertainty (gharar). Transactions focused on risk shifting imply gambling like speculation as they rely on difference in tastes for risk and nothing more28. On the other hand risk sharing arrangements are essentially cooperative ways to meet lifes contingencies. Risk sharing is a way of facing risk. I do not dispute the empirical fact that sale and purchase of debts at discount (sometimes very big discounts) has greatly contributed to the expansion of the debt market. Also true is the claim that an expansion of the debt market enables more developmental projects to be undertaken. But has it contributed to welfare? It has certainly not contributed to equity. Furthermore, the phenomenon of junk bonds has increased the vulnerability of the financial markets to speculation and further weakened the nexus between the real and financial markets. The lender has a right to write off whole or part of the debt. He can accept a less than full payment from the debtor. In other words a debt instrument can be exchanged for less than equal amount in cash from the debtor. To argue from this in favor of allowing discounting of debts is not correct as discounting in the debt market does not alter the debtors obligation to pay the full amount when the time comes. As a matter of fact those who buy debts at a discount do so in order to make a profit by getting par value when the debt matures. Focus on Ethics, social responsibility and transparency is the need of the hour. Policy makers meeting at the World Islamic Economic Forum in Kuala Lumpur this week plan to spur growth in an Islamic financial-service industry, whose assets totaled $1 trillion last year, WIEF Chairman Musa Hitam said in a May 14, 2010 interview said that The global debt crisis has increased international demand for standardized alternative investments that practice ethics. It is the moral high ground where Islamic finance can lead the conventional system (but) by example; The virtues of being virtuous (Hasan 2010). The recently released AAOIFI standards cover 13 aspects of social responsibility such as client engagement, employee welfare, charity, environment, investment quotas and others. On these criteria, the overall response of the IFIs on social responsibility is found quite encouraging even as the performance varies widely between institutions. More has to be done until the man in the street feels that something for him is being done (Hasan 2010). Our analysis has fittingly proved that these sukuk have failed on all four grounds of Aqd, Legal Documentation, Financial reporting and on the fulfillment of Maqasid alShariah. Not a single approach when tested came out clean and issue free and rings alarm bells to the viability of the industry which carrying a religious tag with it making it all the more sensitive. However we must not lose sight that Islamic finance is no more than a highway under construction in a vast road map of economies intended to develop with Islamic orientation. Related issues have to be attended simultaneously if Islamic finance is to deliver. Political will alone is the key that can unlock the doors to prosperity along the right path. And remember, no public policy, however well designed, is worth more than what it is in practice. Governments in

28

Iqbal, Z., Mirakhor, A. (2007). An Introduction to Islamic Finance- Theory and Practice. Wiley Finance Editions,

John Wiley and Sons, Inc., Hoboken, New Jersey.

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various countries -irrespective of their shades - have to demonstrate that Islamic norms can well be converted into ground realities to become a way of life.29

29

Mughees Shaukat: (2010) A Model Gauging The Performance Of Islamic Banks In Compliance To Maqasid AlShariah. Published in Global Islamic finance magazine U.K. January issue.

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