Islamic Project Finance - Part 2

This is the second part of a series of articles discussing Shari’ah-compliant structures used in project financing transactions. This article discusses the Sukuk (i.e., Shari’ah-compliant capital markets instruments) structure, which is now becoming a popular option for financing infrastructure projects in the Middle East.

Sukuk
Sukuk (plural of Sak) is the Arabic term for financial certificates.  The Accounting and Auditing Organisation for Islamic Financial Institutions (“AAOIFI”) defines Sukuk as “certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity.”  

Sukuk Structures
From a structural perspective, Sukuk can be divided into two types of transactions, namely, asset-based or asset-backed.  Asset-based Sukuk issuances are usually referred to as Islamic bonds whereas asset-backed Sukuk issuances are normally referred to as securitisations.

The Sukuk issuer (normally a special purpose vehicle (“SPV”) issues certificates into the capital markets in both kinds of Sukuk issuances (mentioned above).  In both the structures, the Sukuk issued represents undivided beneficial ownership interests of the Sukuk investors in the assets of the Sukuk issuer.

Of the two structures mentioned above, the asset-based structure is utilised in project financing transactions.  We discuss below the most commonly used asset-based Sukuk structures that are used for project financing, namely, the Sukuk al-Ijarah structure and the Sukuk al-Istisna’a structure.

A.  Sukuk al-Ijarah
An Ijarah is a lease contract for the transfer of the usufruct of an asset to another person in exchange for a rent claimed from that person.

The Sukuk al-Ijarah structure employs the principles of Ijarah, whereby the ownership or benefit/usufruct of corporeal assets are transferred from an originator  to an SPV, which then leases back the said assets to the originator* for a specific duration.

As a first step, an SPV is incorporated/established, which then issues Sukuk into the capital markets. Each Sukuk holder subscribes to the Sukuk issue of the SPV by contributing cash to the SPV in return for its Sak.

The SPV declares a trust over the Sukuk issuance proceeds in favour of the Sukuk holders.  The SPV then applies the Sukuk issuance proceeds to purchase the assets from the originator and pays cash to the originator as consideration for the said purchase.  The cash is utilised by the originator for the purposes for which the Sukuk were issued.

Thereafter, the SPV leases the assets back to the originator under an Ijarah contract, whereby the originator (in the capacity of a lessee) makes periodic rental payments to the SPV (in the capacity of a lessor).  The periodic rental payments are then passed on to the Sukuk holders as periodic distribution amounts.

The rental payments under the Ijarah contract can be structured in a manner so as to provide the desired return on the Sukuk. The rate of return can therefore be set as a fixed rate or a floating rate.
Under a purchase undertaking, the originator repurchases the assets upon maturity of the Sukuk.  The purchase price, being an amount equal to the aggregate face value of all the Sukuk plus any accrued but unpaid periodic distribution amounts, is passed on to the Sukuk holders for repaying their principal.  The said purchase undertaking also grants an option to the SPV (acting as the trustee for the Sukuk holders) to require the originator to purchase the assets upon the occurrence of an event of default.

Under a sale undertaking, the originator is granted an option to purchase the assets for a price equal to the aggregate amount of the Sukuk issuance proceeds plus any accrued but unpaid periodic distribution amounts upon the occurrence of specific events.

The SPV (as owner of the Sukuk assets) and the originator (as service agent) also enter into a service agency agreement where the SPV appoints the originator as its agent to manage the assets comprising the Sukuk and carry out the services with respect to the major maintenance, insurance and payment of ownership-related taxes pertaining to the Sukuk assets.

B.  Sukuk al-Istisna’a
An Istisna’a is a contract of sale where a commodity is transacted before it comes into existence.  It is an order to a manufacturer to manufacture/construct a specific asset for the purchaser in return for a fixed price to be paid up front.

The principles of Istisna’a are used in structuring Sukuk for project financing where an SPV issues Sukuk into the capital markets and uses the proceeds from the Sukuk issuance to pay the originator (in the capacity of a contractor) in exchange for the construction and delivery of the project (i.e., Istisna’a assets) in the future.  This structure has therefore become particularly useful in financing the construction phase of a project.

Under a Sukuk al-Istisna’a, upon issuance of the Sukuk into the capital markets and their subscription by the Sukuk holders, the SPV declares a trust over the proceeds of the Sukuk issuance in favour of the Sukuk holders.  The SPV (in the capacity of a purchaser) then enters into an Istisna’a contract with the originator (in the capacity of a contractor) where the originator agrees to construct specific assets and undertakes to deliver the said assets to the SPV at a future date.  In return, the SPV pays the Sukuk issuance proceeds to the originator as consideration for the construction and delivery of the assets.

Simultaneously with the execution of the Istisna’a contract, the SPV and the originator enter into a forward Ijarah contract pursuant to which the SPV (in the capacity of a lessor) agrees to lease the assets back to the originator (in the capacity of a lessee) under a forward Ijarah (known as al-Ijarah al-Mawsufah fi al-Dhimmah) during the construction period of the project and under a normal Ijarah following the delivery of the assets so that the SPV receives periodic rental payments during the entire tenor of the Sukuk which payments are then passed on to the Sukuk holders as periodic distribution amounts.

The SPV and the originator also enter into a service agency agreement, a purchase undertaking and a sale undertaking for the same purposes mentioned in Section A (Sukuk al-Ijarah) above.

*The term “originator” wherever used in this article means the party initiating the process of obtaining project finance. Usually, the originator is the sponsor of a particular project who is responsible for the incorporation/establishment of an SPV as a medium to raise funds for the project.