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Sukuk in Malaysia

Universiti Kebangsaan MalaysiaFakulti Undang-undangSarjana Undang-undang Perniagaan

Musbri MohamedDIL; ADIL ( ITM )MBL ( UKM )

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Islamic finance involves structuring investments and transactions in a way that complies with the strictures of Islamic law, or shariah, which is intended to govern all aspects of Muslim life, including business affairs.

Over the past decade or so Islamic financial sector has grown and gained strength by the creation of various support and infrastructure institutions, and expanded from being a banking-based industry to more wider areas incorporating capital market-based products and services. Indeed Islamic capital market like conventional counterpart is an important component of the overall Islamic financial system. It facilitates the transfer of investible funds from economic agents in financial surplus to those requiring funds

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One of the most fundamental prohibitions is the charging of interest i.e riba . The key idea is that investors should not make money off simply lending money. This puts shariah at odds with most conventional financing techniques, such as loans and bonds. So deals have to be structured in other ways, often as leases, profit-sharing, or trading. Shariah also bans investing in a number of activities that are considered sinful, such as gambling, pornography, the manufacture or distribution of alcohol or tobacco, and the consumption of pork. It additionally prohibits highly speculative investments and investing in companies that are highly leveraged (that have excessive amounts of debt).

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In classical period Islam Sakk (sukuk) – which is cognate with the European root “ cheque" (which itself derives from Persian)- meant any document representing a contract or conveyance of rights, obligations or monies done in conformity with the Shariah .

Empirical evidence shows that sukuk were a product extensively used during medieval Islam for the transferring of financial obligations originating from trade and other commercial activities.

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Bankers, lawyers and shariah scholars have come together to develop a number of different investment vehicles that comply with these prohibitions. One of the most recent innovations is the sukuk, which has been dubbed an Islamic bond and is similar to an asset-backed security. A sukuk can be structured to offer a fixed return similar to the interest on a conventional bond. But unlike a bond holder, a sukuk holder is granted an ownership interest in the assets or business being financed, and the return is tied to the performance of the underlying assets.

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One of the real trailblazers in the industry is Malaysia, which pioneered the use of the sukuk and still accounts for a majority of the Muslim world's sukuk offerings.

"Malaysia's efforts in positioning itself as an Islamic banking hub are paying off. Despite similar ambitions from neighbouring Brunei and Singapore, the country is the undeniable centre of Islamic banking activity in the region," said Zhang Wei, a research analyst at The Asian Banker, a Singapore-based leading provider of strategic business intelligence for the financial services community.

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The creation of Islamic money market and capital market is another landmark development in the area of Islamic finance in Malaysia. A wide range of instruments has been developed to facilitate the effective management of liquidity and funding by the Islamic financial institutions.

The Government of Malaysia has been very supportive in the development of Islamic Capital Market (ICM ) . In 2001, the Minister of Finance launched the Capital Market Master plan and one of the six strategic initiatives in the plan was to establish Malaysia as an international centre for Islamic capital market activities. The rapid development of Islamic Capital Market (ICM) started in 1990 when Shell MDS Sdn Bhd issued the country's first Islamic bond.

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The encouraging development in the ICM has encouraged major market players to issue sukuk (Islamic bonds) and some of the major sukuk issued since 1997 to 2010 are listed below :

1. In 1997, Khazanah Nasional Berhad launched the Khazanah Murabahah Bond, which is a zero coupon bond based on murabahah and bay’ al-dayn concept.

2. In 2002, Kumpulan Guthrie Bhd issued a US$150 million sukuk ijarah: the first global corporate Islamic bond issue ever recorded. The issue was listed on the Labuan International Financial Exchange (LFX) and constituted the first tranche of a US$395 million sukuk ijarah programme.

3. The Malaysian government launched a landmark sukuk ijarah bond issue (Malaysian Global Sukuk) worth US$600 million, becoming the first country in the world to issue a global sovereign Islamic bond in 2002.

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4. In 2004, Sarawak Corporate Sukuk Inc a special purpose vehicle established by the Sarawak Economic Development Corporation (SEDC) launched a maiden five -year US$350 million global sukuk ijarah.

5. International Finance Corporation (IFC), the private arm of the World Bank issued RM500 million Islamic bonds, which was the first issuance of ringgit-denominated Islamic bonds by a supranational body in 2004.

6. In 2005, The World Bank issued RM760 million Islamic bonds that will mature in 2010. This ringgit-denominated issue is the largest supranational deal in the ringgit bond market.

7. In 2009 the Malaysian Government issued RM5bil worth of Sukuk Simpanan Rakyat.

8. The latest development is that Bank Negara Malaysia (5) on 10 of May, 2010 release a press statement that Malaysian Government will issue RM3bil worth of Sukuk 1Malaysia 2010 on June 21, 2010.

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Sukuk are among the best ways of financing large enterprises that are beyond the ability of a single party to finance. Sukuk can be structured alongside different techniques.

While a conventional bond is a promise to repay a loan, Sukuk constitutes partial ownership in a debt (Sukuk Murabaha), asset (Sukuk Al Ijara), project (Sukuk Al Istisna), business (Sukuk Al Musharaka), or investment (Sukuk Al Istithmar).

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The sukuk are structured based on the specific contract of exchange of Shariah-compliant assets. Such contracts can be made through the sale and purchase of an asset based on deferred payment, leasing of specific assets or participation in joint-venture businesses. Hence, the issuance of sukuk is not an exchange of paper for money with the imposition of an interest but rather an exchange of Shariah-compliant asset for some financial consideration applying various Shariah principles, such as bai' bithaman ajil (BBA), murabahah, ijarah, mudharabah and musyarakah that allow the investors to earn profits from the transactions.

The essence of sukuk, in the modern Islamic perspective, lies in the concept of asset monetization - the so called securitisation - that is achieved through the process of issuance of sukuk (taskeek). Its great potential is in transforming an asset’s future cash flow into present cash flow. Sukuk may be issued on existing as well as specific assets that may become available at a future date.

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Despite progress in the improvements and introduction of an enabling Islamic capital market environment through various Shariah-compliant product innovations like sukuk, some structures which attempt to achieve the same economic outcome like conventional bond distort the Maqasid al-Shariah. This distortion stems from the restricted view of understanding Shariah, by only focusing on the legal forms of a contract rather than the substance especially when structuring a financial product. The overemphasis on form over substance lead to potential abuse of Shariah principles in justifying certain contracts which in fact contradictory to the Shariah text and ultimately undermining the higher objectives of Shariah.

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Maqasid al-Shariah is the objectives and the rationale of the Shariah. A comprehensive and careful examination of the Shariah rulings entails an understanding that Shariah aims at protecting and preserving public interests (maslahah) in all aspects and segments of life. Many Shariah texts state clearly the reasoning behind certain Shariah rulings, suggesting that every ruling in Shariah comes with a purpose, which is to benefit the mukallaf (accountable person). For example, when Quran prescribes Qisas (retaliation), it speaks of the rationale of it, that applying retaliation prevents further killing “There is life for you in Qisas”. Similarly, when Quran prohibits wine it says that wine is the works of devil as it causes quarrel and instills hatred and enmity among Muslims “The devil only wants to excite enmity and hatred between you in intoxicants and gambling and hinder you from remembrance of Allah and from prayer”.

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In Malaysia , the operation of sukuk is under Securities Commission Act 1993 (SCA) . The Shariah Advisory Council (SAC) of the Securities Commission (SC) is a committee established by the SC in 1996 under section 18 of the Securities Commission Act 1993 (SCA). The SAC was given the mandate to ensure that the running of the Islamic capital market (ICM) complies with Shariah principles. Its scope of jurisdiction is to advise the SC on all matters related to the comprehensive development of the ICM, and functions as a reference centre for ICM-related issues. The members of the SAC consist of Islamic scholars, jurists and Islamic finance experts. The Shariah committee and Shariah adviser for Islamic unit trust schemes must be approved by the SC, satisfying the criteria stipulated in paragraph 6.05 of the Guidelines on Unit Trust Funds.

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Where a Shariah committee is appointed, the committee must consist of at least three members who are individuals, be independent of the management company and be registered with the SC.

In the case of a Shariah adviser (company), the company must have in its employment, a minimum of one full-time officer designated to be responsible for Shariah matters relating to the funds.

Approval by the SC for an independent Shariah adviser for sukuk is based on satisfying the criteria stipulated in paragraph 6.01 of the Guidelines. For companies, the criteria stipulated in paragraph 6.02 must also be satisfied.

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The Kuala Lumpur Shariah Index (KLSI) was launched on 17 April 1999 to meet the demands from local and foreign investors who seek to invest in securities which are consistent with Shariah principles. It acts as a benchmark for tracking the performance of Shariah-compliant securities and making better informed decisions. The Islamic unit trust schemes are collective investment funds which offer investors the opportunity to invest in a diversified portfolio of Shariah-compliant securities which are managed by professional managers in accordance with the Shariah. The Islamic unit trust schemes are required to appoint a Shariah committee or Shariah adviser as stipulated in paragraph 6.04 of Guidelines on Unit Trust Funds to ensure that their operations are in accordance with Shariah principles. The schemes are available in many forms such as Islamic equity funds, Islamic bond funds, Islamic index funds and others.

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The issuance of sukuk is regulated by the SC through the framework provided under the Guidelines on the Offering of Islamic Securities (Guidelines). The structure of sukuk must be confirmed and approved by a Shariah adviser who is appointed by the issuer. A Shariah adviser can be an independent Shariah adviser approved by the SC or a Shariah committee attached to a financial institution that operates Islamic banking activities approved by the Central Bank.

Sukuk can be structured by applying various Shariah principles and concepts that are listed in Appendix 1 of the Guidelines. They have been endorsed by the SAC as appropriate for structuring sukuk. Prior consultation with the SAC is needed if the Shariah principle or concept applied by the issuer is not among those stated in Appendix 1 of the Guidelines. Prior consultation is also encouraged for any principle or concept stated in Appendix 1 which has no market precedence.

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Some of Dubai's most high-profile Islamic finance deals, including advising the underwriters, Dubai Islamic Bank and Barclays, on a $1 billion sukuk offering for the expansion of the Dubai airport and a $3.5 billion sukuk issued in connection with Dubai Ports World's $6.8 billion acquisition of P&O, the largest sukuk offering to date. Total Sukuk issued as at 5th August 2009 amounted to US$133 billion .

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Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sakk (Islamic bond) effectively requires payment for the time-value of money . This can be regarded as the fundamental test of interest . Sukuk offer investors fixed return on their investments which is also similar in appearance to interest in that the investor's return is not necessarily dependent on the risks of that particular venture.

However, banks that issue Sukuk are investing in assets and not in currency. The return on such assets takes the form of rent, and is evenly spread over the rental period. The productivity of the asset forms the basis of the fixed income stream and the return on investment. Given that there is an asset underlying the value of the certificate, there is more security for the investors involved, accounting for the additional appeal of Sukuk as a method of financing for investors.

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As the industry continues to mature, it faces other challenges, as well. The deals are often segmented among regional markets, and although a few countries have defined parameters for what counts as Islamic finance, most financial institutions continue to rely on their boards of shariah scholars to determine whether individual transactions comply with Islamic law.

Shariah scholars review transactions to determine whether they comply with Islamic law before issuing a pronouncement, or fatwa, that is akin to a legal opinion, approving the deal and assuring investors that it is acceptable from a religious perspective.

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Islamic Capital Market is an important component of the overall Islamic Financial System especially in providing an element of liquidity to the otherwise illiquid assets. Like its conventional counterpart, Islamic capital markets complement the investment role of the Islamic banking sector in raising funds for long-term investment. These long-term investments are facilitated through various Shariah contracts and instruments ensuring efficient mobilization of resources and their optimal allocation.

One of the most popular instruments used today in Islamic Capital Market is Sukuk. Various structures of Sukuk based on Ijarah, Musharakah, Mudharabah and hybrid forms have evolved. However these innovations have invoked many Shariah issues and controversies .

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Islamic banks should do away all the controversial contracts that may impede the growth and progress of Islamic banking and finance industry. This controversies can make it difficult to structure cross-border deals or develop financial products that can sell across the Muslim world. For example, Saudi Arabia-based scholars often judge Malaysian deals to be too "flexible."

As Shari’ah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money (or anything that has the genus of money) alone. This generation of money from money (simplistically, interest ) is "Riba", and is forbidden. The implication for Islamic financial institutions is that the trading and selling of debts, receivables (for anything other than par), conventional loan lending and credit cards are not permissible.

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This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract, which causes issues for Islamic scholars when considering the application of derivatives . Sharia also incorporates the concept of maslahah or "public benefit", denoting that if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks, may fall into this category, but there is still much discussion yet to come on this issue.

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If sukuk goes for litigation under the present situation in Malaysia , where Islamic banking litigation is tried under civil law, this clearly goes against the grain of Syariah. In the case of Bank Kerjasama Rakyat Malaysia Bhd. v. Emcee Corp Sdn Bhd held that although the said facility was granted under Islamic principles, the laws applicable were the National Land Cade and the Rules of the High Court 1980.

It is therefore necessary that Islamic banking litigation be tried by a Muslim judge in the interim until such time that it can be brought under the ambit of the Syariah court system. It is suggested that a panel comprising of muslim civil court judges and Syariah court judges should hear matters concerning Islamic banking. Besides, fundamental changes have to be instituted to the Federal Constitution.

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It is interesting to note the attitude of the English Court of Appeal in the recent case of Shamil Bank of Bahrain v Beximco Pharmaceuticals Ltd & Ors where the English court showed openness to consider the Shariah principles and called evidence from the Shariah experts before making its decision.

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The various credit enhancements embedded in sukuk structures resemble the conventional bond features. These innovations inevitably aim at achieving the same economic outcome like conventional bonds. Consequently these fixed-income enabling mechanisms embedded into equity based sukuk had been the subject of strong criticisms by various parties in terms of their compliance with the Shariah requirements of mudharabah and musharakah contracts. In particular, Shariah Board of Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) published a statement in February 2008 suggesting that Musharakah and Mudharabah sukuk with the credit enhancement mechanisms as practiced by the market was not in congruent with the Shariah principles .

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The fundamental characteristics of equity-based sukuk are based on two basic features; firstly, the capital cannot be guaranteed; and secondly, the periodic returns are also dependent on actual profits made and can be variable. However, these Shariah strict prescriptions of equity-based sukuk structure may not be an attractive to conventional mind-set risk-averse investors. In particular, the characteristics of mudharabah and musharakah do not meet the risk appetite of investors who mainly expect capital preservation and fixed income instruments as commonly featured in conventional bond instruments .

It is not permissible to guarantee the capital or profit in an equity-based sukuk transaction. In mudharabah sukuk for instance, the mudharib is considered as the manager and trustee (amin) of the mudharabah fund and its project .

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There is a tendency in many Islamic financial institutions today to conveniently use dharurah as an excuse to legalise certain transactions such as the issue of profit-and principal-guaranteed in equity-based sukuk structure although all jurists agree on its impermissibility. Oftentimes the so-called Islamic products are rushed to market using ploys that sound minds reject and bring laughter to enemies . Legalizing a forbidden thing on the grounds of dharurah is supposed to solve a problem not to create a bigger one. Islamic banks have been in the business for more than three decades, and so far they still offer the same excuses of dharurah and the impracticality or impossibility of adopting lawful business contracts, due to the existence of certain obstacles and deterrents. The questions are: do these obstacles and hindrances still exist after more than four decades of Islamic banking development? Are there any indications to suggest a possible change? How has this excuse of dharurah affected the behavior of Islamic banks in product innovation?

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Islamic banking in Malaysia , like any other banking system, must be viewed as an evolving system. No one disputes that there is a definite desire amongst Muslim savers to invest their savings in ways that are permitted by the Islamic shari'ah. Nevertheless, they must be provided with halal returns on their investments. It is now incumbent upon these Islamic banks and financial institutions to cooperate among themselves for the purpose of developing authentic products that are far removed from empty stratagems, free from all association with riba, and that aim to serve the higher purposes of Islamic law in the spheres of economics, development, and social justice.However, the concepts of Islamic banking and finance are still in their early stages of development and Islamic banking is an evolving reality for continuously testing and refining those concepts including the sukuk.

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Malaysia as one of the trailblazers in the industry which pioneered the use of the sukuk and still accounts for a majority of the Muslim world's sukuk offerings. The issuance of Sukuk on the basis of the rules of the shining Shariah of Islam is among the objectives of Malaysian Islamic banking, and is also one of the greatest means of establishing Islamic economies in local and global society. This, however, is on condition that the tools used to develop and structure Sukuk are in consonance with the fundamental principles of Islamic shariah which distinguish Islamic economic systems from others.

Sukuk are a means for the equitable distribution of wealth as they allow all investors to benefit from the true profits resulting from the enterprise in equal shares. In this way, wealth may circulate on a broad scale without remaining the exclusive domain of a handful of wealthy persons.

Thank You.