Licenses have now been issued by the Central Bank of Oman (the “CBO”) for some Islamic banks and windows in the Sultanate of Oman. Islamic banking, finance and investment activities have commenced. Banks, each to their shared and separate visions, are avidly pursuing realization of market opportunities and provision of Islamic financing services. There is considerable discussion, in the private sector and among regulators, regarding investing in and issuing sukuk and developing the “finance side” of the Islamic capital markets. The early focus on the sukuk markets is to be expected, given that the sukuk markets are the largest and most rapidly growing area of Islamic finance.
This post provides an introduction to the sukuk discussion in Oman as that discussion is framed by the Draft Sukuk Regulations (the “Regulations”) that have been circulated by the Capital Markets Authority (the “CMA”) and, to a lesser extent, by the Islamic Banking Regulatory Framework (as discussed in our most recent Client Alert). There is on-going discussion of changes to the Omani tax regime to address taxation (or exemption from taxation) for sukuk issuances in Oman. When those changes are proposed, a future post will be devoted to those changes and their implications.
Capital Adequacy Considerations And The Islamic Banking Framework
The Framework provides a standard definition of sukuk as certificates representing a proportional undivided ownership right in tangible assets, a pool of tangible assets or a business venture, in each case in accordance with the Shari’a. It notes characteristics of asset-based and equity-based sukuk. With restrictions, it permits banks to act as an asset originator with respect to its own assets, a sponsor of a sukuk issuance involving customer assets, and a servicer of sukuk payments and/or assets.
The Framework’s focus is primarily capital adequacy determinations and requirements. As such, it distinguishes situations in which the licensed bank assumes all rights and obligations in respect of an asset or pool of assets (i.e., ownership is transferred) and situations involving securitization exposures (i.e., the bank is, or acts in a capacity where it is considered to be, the originator of a sukuk issuance or an issuer or servicer). In the former (banking book) situation, the analytical focus is on the nominate contract structure underlying the sukuk; i.e., a salam, istisna’a, ijara, musharaka, mudaraba or other contract. In the latter (securitization issuance) situation, the focus is on the structure that applies as among the asset originator, the sukuk issuer and the sukukholder. The primary structures are asset-based sukuk that pass ownership risks to the sukukholder, such that the risks are those of the underlying assets. Asset-based sukuk may include originator repurchase obligations, such that applicable credit risks are those of the originator, as supplemented by any credit enhancements provided by the issuer. In a pass-through asset-backed structure, the asset originator provides recourse to the sukukholder but the issuer provides Shari’a-compliant credit enhancement by guaranteeing repayment in the event of originator default.
Sukuk Issuances And The Capital Markets Sukuk Regulations
The sukuk definition in the Regulations is similar, but not identical, to that of the Framework. Sukuk are defined in the Regulations as “negotiable capital market instruments (such as notes or certificates) that represent or evidence a proportionate interest in underlying assets or revenues and have been structured according to Shari’a precepts”. The obvious differences pertain to negotiability and interests in revenue streams.
Some of the more notable aspects of the Regulations are (a) the structure of and constraints on sukuk issuance, (b) the introduction of financial trust concepts into Omani law, (c) provision for a general assembly of sukukholders and a sukuk agent to monitor on behalf of the sukukholders, and (d) the requirement for a defined “Disputes Settlement Committee” (usually the Appeals Committee under the Capital Market Law) as the exclusive dispute resolution forum. Each of these aspects is introduced below.
As one might expect, every instrument that is issued or marketed as a sukuk must be reviewed by a Shariah Supervisory Board (an “SSB”) comprised of at least three competent scholars, with competency being established and demonstrated in writing. The Regulations provide considerable flexibility as to which SSBs are permissible: (i) that of the obligor (the entity directly or indirectly responsible for the repayment of the sukuk or the entity benefiting from the issuance proceeds); (ii) a sukuk-specific SSB; (iii) the sponsor’s SSB; and (iv) an independent Shari’a consultancy firm in Oman or elsewhere.
Issuers and Obligors
Sukuk may be issued only by an Omani joint stock company or a defined “SPV”, in each case approved by the CMA, and pursuant to the CMA-mandated template sukuk prospectus (no draft is yet available). Only an Omani joint stock company may act as an obligor (if CMA-approved and so long as the sum of its obligations under its bonds and its sukuk does not exceed its net equity value).
An “SPV” is defined as an Omani limited liability company that is subject to specific stated requirements, is established specifically for a “Transaction”, and is subject to CMA approval. A “Transaction” is a Shari’a-compliant structured finance transaction for the benefit of an obligor, including an issuance listed on the Muscat Securities Market or another exchange acceptable to the CMA and “any other type of capital market transaction approved by the CMA”.
The initial capital and any capital contributions must be in cash, not in kind (except, presumably, the sukuk assets). The shareholder of an SPV must be either (x) a Corporate Services Provider that is holding the shares in trust for charitable purposes in accordance with certain stated requirements, or (y) an Omani subsidiary or affiliate of the Corporate Services Provider established solely as a nominee company and holding the shares in the SPV in trust for those charitable purposes, or (z) another SPV. Any attempted transfer of shares to any other entity is void. A “Corporate Services Provider” is a CMA-accredited accounting firm, a licensed Omani law firm, a CMA-licensed securities company, or another CMA-approved commercial company.
Permissible activities of an SPV are limited to:
- (a) acquisition (via lease, title transfer, risk transfer or otherwise) or disposal of any asset (tangible or intangible, and not limited to receivables and shares) in connection with or for the purpose of a Transaction; (b) obtaining any type of financing (bank or capital markets), granting any security interest over its assets, providing any indemnity or similar support for its shareholders or agents, and entering into any type of hedging arrangements or other legal documents, in each case in connection with or for the purpose of a Transaction;
- (c) financing of the obligor or another SPV;
- (d) acting as a trustee or agent for any Transaction participant;
- (e) entering into a partnership or other Shari’a-compliant structure in connection with a Transaction;
- (f) any other activity approved by the CMA; or
- (g) any ancillary activities related or incidental to the foregoing.
If an SPV engages in any other activity, the CMA may, after a reasonable cure period, apply to the courts of competent jurisdiction to forcibly liquidate and dissolve the SPV.
Numerous provisions of the Regulations pertaining to SPVs remain bracketed and will evolve as comments are provided. These include requirements, or exclusions, pertaining to annual financial statements and the auditing of accounts.
Structural Elements: Mandatory and Permissible
The Regulations specify both mandatory and permissible structural features. As a mandatory matter, the sukuk must be structured such that:
- (a) the arrangements provide for a sukukholder to pay a sum of money (capital) to the sukuk issuer;
- (b) the arrangements identify assets or a class of assets which the issuer holds for the purpose of generating income or gains, directly or indirectly;
- (c) the arrangements specify a term after which the sukuk ceases to have effect;
- (d) the issuer undertakes to make, to the sukukholder, (i) capital repayment (the “redemption payment”) at the end of the term, as a lump sum payment or in installments, and (ii) other “additional payments” during or at the end of the sukuk term;
- (e) redemption of the sukuk issue by the sukukholders (through their general assembly) is permitted if the issuer does not adhere to issue conditions; and
- (f) the notes or certificates issued as part of the arrangements are admitted to trading on the Muscat Securities Market or another exchange approved by the CMA.
The listing requirement is puzzling given that many other provisions of the Regulations acknowledge and permit private placements of sukuk. Private placements must be approved by CMA. There are particularized requirements for disclosure to the CMA prior to any approval of a private placement. Many disclosure provisions remain bracketed, such as those pertaining to the names and nationalities of all offerees and their experience and qualifications as experienced investors and those pertaining to whether offerees are related to one another, and a requirement that the issuer’s legal counsel certify compliance with all legal requirements relating to private placements.
Sukuk assets may be “property of any kind, including rights in relation to property owned by someone other than the sukuk issuer” and may be acquired before or after the arrangements go into effect. This is commendably broad and flexible. As noted above, both tangible or intangible assets are permitted (thereby allowing for transactions involving patent rights, copyrights and similar intangible property, if Shari’a-compliant). Flexibility regarding the timing of asset acquisitions allows sukuk issuances to fund asset acquisitions and is consistent with the Accounting and Auditing Organisation for Islamic Finance Institutions’ (AAOIFI) sukuk standard.
Other permissible structural elements include:
- (1) sukukholder ability to terminate the arrangements prior to expiration of the sukuk term in certain circumstances (see the general assembly discussion below);
- (2) the ability to reduce the redemption price with decreases in the value of the sukuk assets or diminution of the income stream generated by those assets;
- (3) options for payment of the redemption price, in whole or in part, through the issuance of shares or other securities, and for other events allowing conversion of sukuk into shares during the term (i.e., convertibility options);
- (4) broad discretion to structure the additional payments “wholly or partially by reference to the value of or income generated by the sukuk assets” or “in some other way”;
- (5) allowance of compulsorily transfer of sukuk assets by the issuer to the obligor (if clearly disclosed to sukukholders); and
- (6) the ability to constitute the arrangement as a “declaration of trust”.
Commendably, the “declaration of trust” element infuses an entirely new concept – the financial trust – into Omani law. The financial trust seems akin to a common law trust, although, where comprised for charitable purposes (e.g., the benefit of education, religion, art, health or environmental protection or other public benefit), it seems akin to a waqf.
A financial trust is created by either:
- (a) the execution of a written instrument creating a trust (a “Trust Instrument”) and transferring legal ownership of the trust property from the settlor (the creator of the trust) to the trustee; or
- (b) a written declaration of trust pursuant to which the settlor undertakes to hold the trust property as the trustee;
in each case for the benefit of the beneficiaries or a charitable purpose, and, in each case, in accordance with the trust instrument. A financial trust must be recorded in the CMA’s Register of Financial Trusts.
A financial trust may only be created by:
- (1) an SPV, in which case the beneficiaries are limited to sukukholders of the issuance by that SPV and the agents, custodians and nominees of those sukukholders;
- (2) a shareholder in an SPV, in which case the trust property is limited to that shareholder’s shares in the SPV and property resulting from holding or disposing of such shares, and the trust property must be held for charitable purposes or for such beneficiaries as the CMA approves; or
- (3) by such other person or entity and/or in such other circumstances as the CMA may approve.
The settlor is given broad discretion to constitute the terms of the trust in the trust instrument and the Regulations provide for both mandatory and permissive provisions in the trust instrument. The trust instrument must contain provisions:
- (a) identifying the settlor and the trustee;
- (b) identifying the beneficiaries or the class of beneficiaries, or providing information allowing identification of that class, or stating that the trust property is held for a charitable purpose (as described above);
- (c) describing the trust property or its characteristics so as to allow its identification;
- (d) specifying the term of the trust and early termination events and conditions (trust property reverts to the settlor unless otherwise provided in the trust documentation);
- (e) specifying the duties and obligations of the trustee; and
- (f) addressing such other matters as the CMA shall determine.
The trust instrument may contain provisions providing for:
- (1) the rules governing dealings in trust property;
- (2) the duties and powers of the trustee;
- (3) the rights of beneficiaries and their respective shares in the trust;
- (4) the name by which the trust shall be known;
- (5) the consequences of termination of the trust;
- (6) the execution of the duties of the trustee and the relationship between the trustee and each of the settlor and the beneficiaries;
- (7) the powers reserved by the settlor in respect of the trust property (these reservations may not prejudice the purposes of the trust or the independence of the trustee);
- (8) the manner and extent to which products, revenues and growth generated by the trust property are added to the trust property and the rights of the settlor to add to the trust property;
- (9) circumstances in which the trustee may disclose accounts, data and information involving the financial trust;
- (10) circumstances in which the trustee may delegate its duties and responsibilities; and
- (11) the remuneration of the trustee, if any (which may be out of trust property if that is the original arrangement, although increases may not be taken from trust property unless all beneficiaries agree).
The trustee must be independent of, and must act without interference or guidance from, the settlor (unless the trustee is the settlor, and (presumably) subject to settlor reservations of powers as set forth in the trust instrument).
The trustee must act in good faith, with honesty and due care, in the best interests of the beneficiaries (including where this is to the detriment of the settlor, in cases where the trustee is the settlor), in accordance with best practices, and in accordance with the Trust Instrument.
The trustee must keep the trust property segregated from the properties of other financial trusts and from the trustee’s own properties. The trustee must notify the settlor and the beneficiaries “of any matter that may have an important effect on the value of the Trust Property” from time to time. It must keep accounts of the trust property and is prohibited from disclosing accounts, data and information pertaining to the trust except as permitted in the trust instrument and in certain other limited circumstances. The trustee is prohibited from using trust property for personal benefit or allowing anyone to benefit from such property contrary to the terms of the trust instrument.
The provisions of the Regulations pertaining to trustee liability seem inconsistent and confusing. The trustee has personal liability, from its own funds, for losses and damage resulting from its breaches of the trust instrument or the Regulations and for its intentional error and recklessness. Any agreement exempting a trustee from personal liability, in whole or in part, for its intentional error or recklessness is void. No such consequences are stated in the Regulations for attempts to exempt the trustee from personal liability resulting from breach of the trust instrument or the Regulations.
The trustee is jointly liable with its delegate for actions (and omissions?) of that delegate resulting in loss or damage to the trust property or the beneficiaries. This provision does not reference personal liability and is not limited to circumstances involving breaches of the trust instrument or the Regulations, intentional error and recklessness.
The trustee is not personally liable for acts (or omissions?) of its delegates where the delegation does not specify the person to whom delegation is made or for acts (or omissions?) of experts or professionals retained by the trustee, although the trustee will be personally liable where it fails to exercise appropriate due diligence in selecting such delegate, expert or professional and where the trustee issued erroneous instructions to the delegate, expert or professional. Special rules apply where there are multiple trustees (e.g., trustees that recorded their dissent to an act or omission giving rise to compensable loss or damage will not be jointly liable for such loss or damage).
Finally, it should be noted that the Disputes Settlement Committee (the “Committee”) has been designated to address a range of matters involving charitable trusts, situations that are not resolved by the trust documents, transactions involving trustee conflicts of interest, disclosure of accounts, data and information pertaining to trusts, and various failures to comply with the Regulations.
The Committee has “exclusive jurisdiction” in the foregoing matters and “in settling all disputes that relate to a financial trust and arise between any of the Trustee, the Settlor and Beneficiaries”. Opinions of the Committee are binding upon the parties to the dispute. The Committee does not seem to have jurisdiction over matters involving third parties.
The settlor and the beneficiary may request a decision of the Committee regarding (w) termination or expiry of the trust and transfer of trust property, (x) removal of the trustee for “serious breach” of the trust instrument or the Regulations, inability to perform its obligations, or failure to meet a qualifying condition under the Regulations, (y) appointment of a successor trustee, and (z) “any other appropriate decision or guidance directly related to [the] Regulations or the Trust Instrument”. Obviously, interpretive issues will arise under these provisions.
While the trustee is not empowered to seek guidance regarding the foregoing matters, it may seek Committee approval of “a proposed action that is of benefit to the Financial Trust where such action is not expressly permitted under a Trust Instrument”. The Committee’s powers seem to be expansive, at least in this context: the Committee “will not usually approve an action that is expressly prohibited under the Trust Instrument……”
A final provision of the Regulations pertaining to the Committee remains bracketed, and is worthy of careful consideration. It proposes the adoption of a “purposive approach in interpreting any Trust Instrument and any provision of [the] Regulation” and permits consideration of “the laws and jurisprudence of any other appropriate jurisdiction that recognizes trust arrangements”. This seems a salutary approach to introducing trust concepts into a legal system that does not recognize trusts: an approach that may avoid the contortions experienced in civil law systems (such as France) as they have sought to obtain the benefits of the common law trust (and waqf).
The General Assembly, the Sukuk Agent and Corporate Governance
All sukukholders are afforded a range of corporate governance protections, including a sukukholder’s general assembly and a sukukholder’s agent. A general assembly must be formed for each sukuk issuance at the issuer’s expense, and all sukukholders may attend the meetings. Sukukholders holding at least 10% of any issue may convene general assembly meetings to examine financial statements and financial information. No change may be made to the issue conditions without the consent of two-thirds of the sukukholders present at a meeting. The sukukholders (by two-thirds majority) may redeem the issue if the issuer fails to comply with the issue conditions.
The quorum for a general assembly meeting is two-thirds of the issue, in person or by proxy. If a quorum is not so achieved, a second meeting may be scheduled and is valid if attended by one-third of the issuance. Passage of resolutions requires two-thirds of those present at a valid meeting. Extension of an issue’s payment period and early redemption require a meeting attended by two-thirds of the issuance.
The issuer’s board of directors must appoint an agent meeting certain qualifications and having at least the minimum responsibilities described in the Regulations. Those responsibilities, generally described, are to monitor the performance by the obligor and the issuer of obligations set forth in the prospectus and to protect the interests of the sukukholders. The agent may seek the assistance of professionals and experts. There is no specification of who will bear the costs of or incurred by the agent but, given the allocation of general assembly costs to the issuer, it seems likely they will be for the issuer’s account.
The agent is required to:
- (a) call for periodic reports from the issuer and, where there are credit risk exposures, the obligor, and inspect the books, records, assets, and any documents pertaining to the sukuk’s credit rating;
- (b) ensure payment of any profit to sukukholders;
- (c) monitor issuer and obligor compliance with issue conditions;
- (d) verify redemptions and conversions in accordance with the prospectus;
- (e) call general assembly meetings “on any event which may materially affect the interests of the Sukukholders” or on request of 10% or more of sukukholders;
- (f) ensure utilization of sukuk proceeds in accordance with the prospectus;
- (g) verify the absence of material changes to the issue structure without the requisite sukukholder consent at a general assembly meeting; and
- (h) carry out other acts necessary for the protection of the sukukholder interests.
The current draft of the Regulations, while incomplete, provides an outline of how the Omani sukuk markets will be structured. Market participants are urged to become involved in the discussion, to provide comments to the CMA, and to assist in shaping this important capital market.