Islamic Finance - Part 3

This is the third part of a series of articles discussing Shari’ah compliant structures used in project financing  transactions.  In  the  second  part  of  this  series,  we  discussed  two  Sukuk  (i.e.,  Shari’ah compliant capital markets instruments) structures used to finance particular projects. In this article, we will discuss the third structure, namely, the Sukuk al-Musharakah structure and the different ways in which it can be used in project financing transactions.

Sukuk al-Musharakah

The term Musharakah literally means sharing. This term is derived from the Arabic word Shirkah, which means partnership. In Shari’ah, Musharakah means a partnership arrangement formed between two or more partners for some business purpose where each partner makes a contribution (in cash or in kind) to the Musharakah (i.e., the partnership). The profits of the Musharakah are shared amongst the partners according to an agreed ratio whereas the losses are shared according to the ratio of their respective contributions.

Musharakah can be divided into two structures, namely, the Shirkat-ul-Aqd structure and the Shirkat- ul-Milk  structure  for  the  purposes  of  Sukuk  issuance  for  financing  a  particular  project.  We  are discussing below the salient features of the said structures and the key principles involved in their utilization in project financing transactions.

A. Shirkat-ul-Aqd (Partnership by contract)

In this type of Shirkah, Musharakah is created by a mutual contract between the originator and the trustee where the originator and the trustee agree to contribute their efforts and resources towards achieving a common business purpose.

For the purposes of structuring a Sukuk issuance based on the Shirkat-ul-Aqd structure, a special purpose vehicle (“SPV”) is established to hold the Sukuk holders’ interest in the Musharakah. The SPV issues Sukuk certificates representing an undivided ownership interest in the underlying Musharakah and the Sukuk holders contribute towards the capital of the Musharakah by contributing cash to the SPV in exchange for Sukuk certificates.

A trust is declared by the SPV over the proceeds and any asset(s) acquired therefrom.  The SPV acts as a trustee for and on behalf of the Sukuk holders. Subsequently, the trustee enters into a Musharakah agreement with the originator where both the trustee and the originator contribute towards the capital of the Musharakah. In return, both the trustee and the originator receive a proportionate number of units in the Musharakah. Contribution from the trustee comes in the form of proceeds from the Sukuk issuance. The respective contributions of the trustee and the originator are used for the purposes of the Musharakah.

The profits generated from the Musharakah are shared between the originator and the trustee in an agreed proportion. The said proportion may not necessarily be the same as the proportion of their respective contributions to the Musharakah. The trustee’s share of the profits is calculated in such a manner so as to be enough to pay the periodic distribution amounts to the Sukuk holders.

The losses, on the other hand, are shared strictly in proportion to the respective contributions of the trustee and the originator to the Musharakah.

The trustee and the originator also enter into a purchase undertaking pursuant to which the trustee is granted the right to require the originator to purchase the Musharakah asset at an agreed exercise price on the maturity of the Sukuk or upon the occurrence of an event of default; thereby dissolving the Musharakah. The exercise price is equal to the Sukuk holders’ subscription amount plus any accrued but unpaid periodic distribution amounts.

In some cases, the originator is granted a call option by the trustee under a sale undertaking pursuant to which the originator can require the trustee to sell the Musharakah asset to the originator prior to the maturity  of  the  Sukuk.  The  sale  price  in  such  cases  is  equal  to  the  Sukuk  holders’  amount  of contribution to the Musharakah plus any accrued but unpaid periodic distribution amounts.

Under a management agreement, the trustee appoints the originator as the managing agent to manage the joint venture according to an agreed business plan. In consideration for its services, the originator is paid a nominal management fee.

B. Shirkat-ul-Milk (Partnership by joint ownership)

Under this structure, Musharakah is created by the joint ownership of the originator and the trustee in a particular asset. This joint ownership can be created in two ways, either by both the originator and the trustee making cash contributions to the Musharakah for jointly acquiring an asset, or by the originator selling its ownership interest in an asset to the trustee.

There are three essential ingredients of this structure. The first is that both the originator and the trustee are the joint owners of the relevant Musharakah asset. Secondly, the originator (in the capacity of a lessee) utilizes the share of the trustee (in the capacity of a lessor) in the Musharakah asset. Lastly, the originator buys back the share of the trustee in the Musharakah asset.

To begin with, the SPV issues Sukuk into the capital markets. The Sukuk holders subscribe to the Sukuk by contributing cash to the SPV in return for Sukuk certificates. The Sukuk certificates represent the proportionate ownership of the Sukuk holders in the underlying Musharakah asset.

The SPV declares trust over the Sukuk issuance proceeds and acts as a trustee for and on behalf of the
Sukuk holders.

The trustee and the originator then enter into a Musharakah agreement pursuant to which they jointly acquire the Musharakah asset or the trustee acquires the ownership interest of the originator in the Musharakah asset (as the case may be). Following such acquisition, the originator and the trustee become co-owners of the Musharakah asset.

Under a rental agreement, the originator (in the capacity of a lessee) uses the trustee’s share in the Musharakah asset against periodic rental payments. Such rental payments are then passed on by the trustee to the Sukuk holders as periodic distribution amounts.

The originator, pursuant to a purchase undertaking, purchases the units or the ownership interest of the trustee in the Musharakah asset on specified dates. Such purchase can be either during the tenor of the Sukuk or at maturity.

Where the Sukuk is structured on a diminishing Musharakah basis, the units are purchased during the term of the Sukuk. With each such purchase, the ownership interest of the trustee in the Musharakah asset decreases with corresponding increase in the originator’s ownership interest.

The originator and the trustee also enter into a management agreement under which the trustee appoints the originator as its agent to manage the Musharakah asset and to carry out the services pertaining to the major maintenance, takaful and payment of ownership-related taxes and expenses in
respect of the Musharakah asset.