Call for sukuk investors' protection

Following Islamic bond defaults, new rules are needed

LONDON // Dubai and other regional financial centres need legal systems that protect Islamic bond investors in the event of a default, a top Islamic scholar says. "What good is it in the event of a default if you can't have access to the underlying assets?" said Rifaat Abdel Karim, the secretary general of the Islamic Financial Services Board, a body based in Kuala Lumpur that sets standards for Sharia compliance. "As an investor you need to know what you get."

Several defaults on Sharia-compliant bonds, or sukuk, during the global financial crisis have tested their young legal structures for the first time. The Investment Dar, a Kuwaiti company that owns half of the British luxury car maker Aston Martin, was first in the Gulf to default after it missed a regular payment on a US$100 million (Dh367.3m) sukuk last May. Saad Trading, Contracting and Financial Services, part of Saudi Arabia's Saad Group, defaulted on a $650m sukuk last November.

The defaults have led to uncertainty about legal protections for investors. In some cases, the concern has been that investors may not have the right to own property assets posted as collateral for sukuk: most Gulf countries restrict foreign ownership of property. In other cases, confusion has arisen over whether investors have recourse to the assets that back them. "Many sukuk are based on or are backed by assets that may be located in different jurisdictions," Mr Rifaat said at a conference in London. "Complications exist in many jurisdictions today, especially in relation to property law and transferable interests."

Sukuk behave like conventional bonds but avoid Islam's prohibition on charging or receiving interest through a variety of complex lease agreements. The presence of land and other assets that allow sukuk to avoid interest have sometimes led investors to believe they can take ownership of those assets in the event of default. That, however, simply is not the case for the vast majority of sukuk, according to Khalid Howladar, a vice president at Moody's Investors Service who specialises in Islamic finance.

When Gulf companies started issuing sukuk about five years ago, Mr Howladar said, "you had a demand for debt from investors and a demand for debt from borrowers. The compromise is to have something that looks like an Islamic risk-sharing asset-backed instrument and present it as such but ultimately, when you look at the 200 pages of documents, which most investors don't do, you just have a bond. That's not a problem in a boom but then when you have economic distress people are focused on what happens in a default."

Since the financial crisis and Dubai World's debt troubles, which involved sukuk issued by Nakheel, a property subsidiary, few companies in the Gulf have dared to test investor appetite for Islamic debt. A handful of sukuk have since been issued by governments in the Gulf and South East Asia along with a few from corporations in Saudi Arabia and elsewhere but far less than before the global crisis.

Any change in legal structures arising from recent sukuk defaults will probably be visible only when markets recover and companies again consider raising money with sukuk explicitly backed by assets, Mr Howladar said. Observers are also hoping for more harmonisation of sukuk structures, which vary considerably between jurisdictions.