In conventional finance, those who default on their payments or that consistently pay late are usually penalized by altering their interest rates, usually connected to their credit rating. This is problematic when it comes to sukuk because, unlike conventional banking, Islamic banking operates under Shariah compliant principles, which prohibit interest. Issues of defaults on loans, late payments, and how to deal with them are problematic for both conventional and Islamic banking. To ensure that the system works, affected parties need to be compensated somehow, and those that default should be penalized. Otherwise, the potential for abuse is too great. In this article we’ll take a look at cases in the last few years where these situations occurred and how they were handled.

In 2009, the entire Islamic debt market froze. This was due to a near default on a sukuk by Nakheel, a government owned property developer in Dubai. This sukuk was worth $3.5 billion USD. The main reason for the market freeze was the uncertainty about how the default would be handled if it happened. This is due to the fact that the Islamic financial market is still quite young, and many of these cases had no precedent. In the end, the sukuk was repaid thanks to intervention at the last minute by the government of Abu Dhabi.

Two important cases of sukuk default occurred in Kuwait in 2009. Investment Dar and International Investment Group (IIG), both based in Kuwait, had to default on sukuk worth $100 million USD and $200 million USD respectively. Investment Dar restructured the sukuk in 2011, converting the debt into equity in the company’s assets. IIG restructured its sukuk in order to alter its payments to a more manageable format. Dana Gas, in the United Arab Emirates, missed a payment on a $920 million USD sukuk. This case is being followed closely due to the way in which the restructuring of the sukuk is being handled consensually among the parties involved. This case could provide a model for futures defaulters in the area.

In general, Malaysian sukuk defaults have had better luck dealing with defaults. Several have defaulted since early 2009 without causing too many problems to the market. Fortunately, Malaysia has a developed legal framework in regard to Islamic finance that lets banks handle defaults in a manner similar to conventional bonds.

Sukuk adhere to an Islamic view of finance, avoiding Riba (generating money from money, i.e. interest or usury), bonds are securities that are very Riba due to the fact that they have a fixed interest.

There are five important differences between sukuk and traditional bonds:

1. Sukuk indicate ownership of an asset. Bonds indicate a debt obligation.

2. The assets that back sukuk are compliant with Shariah. Assets backing bonds may include products or services that are against Islam.

3. Sukuk are priced according to the value of the assets backing them. Bond pricing is based on credit rating.

4. Sukuk can increase in value when the assets increase in value. Profits from bonds correspond to fixed interest, making them Riba.

5. When you sell sukuk, you are selling ownership in the assets backing them. The sale of bonds is the sale of debt.

Sukuk are backed by tangible assets, rather than by debt. Sukuk ownership indicates ownership of an asset that has value. Although, a bond may also indicate this, the real definition of a bond simply indicates a debt obligation. At its root, the relationship between the issuer of a bond and the consumer is very different from the relationship between the issuer of sukuk and the purchaser of sukuk. In the case of a bond, the consumer is acting as the loaner and the bond issuer as a loan recipient. In this case, the loan has a fixed interest, therefore being Riba. In sukuk, the purchaser is purchasing an asset that has value rather than participating in an implicit loan agreement.

Another important difference between bonds and sukuk is that the assets involved in sukuk certificates comply with all laws of Islam. In the case of bonds, the bond certificate may be backed by assets that are not compliant with Shariah, which may be bundled together with other types of assets without the consumer’s knowledge. The consumer of sukuk is assured that the value of the certificate corresponds to assets that are in the public good and not related to activities or products that are against Islam.

Although some may argue that the differences between sukuk and bonds are merely technicalities, these differences matter to Muslims. In fact, the practice of profiting from money alone, at the expense of productivity and real people has been one of the drivers for many of the economic problems that have plagued the world in the last decade. Interest and artificial inflation of prices based on debt rather than on real value is the main reason why bubbles form, burst, and then lead to recessions and depressions. Sukuk, unlike bonds, are priced according to the real market value of the assets that are backing the sukuk certificate. Bond pricing is based on the credit rating of the issuer. This is necessary in the case of bonds because when you sell a bond on the secondary market, you are actually selling the debt in the underlying loan relationship. The sale of a sukuk on the secondary market is simply the sale of ownership in the asset.

The main advantage of sukuk over traditional bonds is that their value increases in relationship to the assets backing the sukuk certificate. If the asset raises in value, then the value of the ownership of that asset, backed by the sukuk, increases. Bonds do not have this characteristic. It is not possible to raise the main debt in a bond and increase in revenue from a bond is the direct result of the fixed interest rather than in any kind of tangible increase in value or productivity.

This is not to say that bonds and sukuk are not similar in certain ways. Both can be turned into cash by selling them on the secondary market. Based on the strength of their backing, both bonds and sukuk can be ranked by ranking institutions. There is also similar variance in bond and sukuk designs and issuers, allowing consumers to have a variety of options when looking into these financial instruments.

Bank Negara Malaysia’s Shariah Resolutions in Islamic Finance documents Shariah rulings made by Bank Negara Malaysia’s Shariah Advisory Council (SAC).

Sukuk Education – Shariah-Resolutions-2nd-Edition-En

The structure of a Sukuk makes enforcing investor rights in the event of a default different from a conventional Bond.

The modified role of the Trustee

Whilst similarities between Sukuk and Bonds are numerous, in the case of a missed payment or default, the role and power of a Trustee are considerably different in a Sukuk structure from that in a bond.

In the event of a conventional bond default, the Trustee of the bond acting on behalf of bondholders can sue the issuer for the missing interest.

In the case of a Sukuk default, the challenges the Sukuk certificate holders face are that in a Sukuk structure, the Trustee is the issuer and a special purpose vehicle (SPV). Hence, it is pointless suing the Issuer, as it would be no more than a shell company in an offshore jurisdiction such as Cayman Islands setup for the sole purpose of declaring a trust and holding the assets of a Sukuk issuance. Its directors would be nominal (typically from a local law firm) and in the event of a default, this SPV would have no interest in enforcing against the underlying issuer to pay the missed rental payment.

To address this problem, in a Sukuk structure the SPV delegates all of its trustee functions, except the core holding of the asset to a professional Trustee, so we end up with the same type of Trustee as used in conventional bonds who then polices the issuance to maturity.

Collapsing a Bond vs. the Purchase Undertaking Agreement

In the case of a serious event resulting in the underlying issuer missing (or likely to miss) a number of payments, the treatment of bond and Sukuk holder varies.

In a bond rather than sue for each missed interest payment, the bondholders have a contractual right to be put out of their misery and collapse the entire bond with the intention of getting missing interest payments and their capital back.

In a Sukuk, certificate holders have no such right, as they cannot sue the Obligor (underlying issuer) because there is no contractual agreement in place between Obligor and certificate holders. The certificate holders can sue the SPV, but the SPV as part of its set-up would be structured so that it is bankruptcy remote in that its only obligation would be to pay to holders what it has received, so if the Obligor does not pay the rent to the SPV, the SPV has no obligation to pay the holders.

In order to provide equality in comparison to bondholders, Sukuk holders whilst not having the right to collapse the Sukuk as per conventional bonds, do have a contractual right to force the Obligor to buy back the assets in the event of the Obligor failing to meet any of its obligations. This right is written into the Purchase undertaking agreement, which is one of the contractual documents forming the Sukuk.

Paper by Jolyn Ang Yi Qin, discusses Sukuk in context of Shari’a Compliance, and in doing so provides a primer of Sharia prohibitions and some of the structural elements of Sukuk.

Are Sukuk Truly Islamic?

Muslims consider interest as a modern equivalent to Riba; that is an income that is not earned or is unfair. The main problem with Riba is that from the very start it represents an unfair situation for one of the two parties in a business transaction or loss. Regardless of the circumstances, Muslims consider that the very concept of an interest rate is inherently unjust either to the lender or the receiver. Usury, the common translation for Riba, is simply an excessively high interest rate.

Since an excessively low interest rate would also expose the lender to a loss, Muslims consider that interest is not congruent with an equal distribution of income. Any transaction that involves interest will necessarily hurt one of the two sides; it is essentially a gamble, which is also prohibited by Islam.

Another problem with the concept of interest is that it is an earning that is not based on whether the capital was used or not. It is not earned nor deserved, and comes from an imaginary source. Muslims reject earnings that have absolutely no real value to the community or to the real world. Riba forces the debtor and, indirectly, the community, to take a financial risk. Interest inherently results in unfair income distribution and guarantees that the people that already have capital will earn money regardless of their investment or business. An example of the hurtful effects of interest rate manipulations can be clearly seen in the global financial crashes of 2008 and 2009.

Muslims consider that Riba is not only an oppressive practice, it also involves exploiting those in need. A fundamental part of being a Muslim involves that those who have wealth need to assist those that do not. Involving a guaranteed income from the loans, regardless of the result of the business venture or investment, is an unfair practice. Muslims would consider it fair if both parties earned an income based on the profit of the investment, rather than from an imaginary, unearned source. A society in which the wealth is accumulated only among those that are already wealthy increases the difference between classes. It also restricts wealth circulation, since lenders would only lend money to those that can pay the interest rates. Islamic economics considers that a healthy economic system exists in a state of balance between those that consume and those that produce. In an Islamic economic system, practices such as interest-free lending, charity, profit sharing, and restrictions on legitimate ways to gain returns on capital help fix this imbalance that has become such a severe problem in traditional capitalism. Interest allows a certain social class to gain income from their capital without contributing to society at all. A society in this state ultimately stagnates and starves from their lack of contribution.

An old (but gold) presentation by now defunct Dar Al Istithmar, some still relevant today. Download below.

Sukuk Structures

The December 2002 fatwa issued by al-Azhar’s Institute of Islamic Jurisprudence is viewed as legitimizing the collection of interest in the context of bank deposits.

This fatwa follows the Azhar view that interest is simply a form of profit on a mudarba and characterises the depositor-bank relationship as that of an investor and his investment agent and legitimized collection of a fixed profit percentage (interest).

Text of the query and fatwa

Re: Investing Funds in Banks that pre-specify profits

Prof. Dr Hassan Abbas Zaki, Chairman of the Board of Directors of the International Arab Banking Corporation sent a letter dated 22/10/2002 to the Honorable Great Imam Dr Muhammad Sayyid Tantawi, Shaykh-ul-Azhar stating the following:

Honorable Dr. Muhammad Sayyid Tantawi—As-Salamu alaykum wa raHmatu Allahi wa Barakatuh:

The customers of the International Arab Banking Corporation forward their funds and savings to the bank, which uses said funds and invests them in permissible dealings, earning a profit which is distributed to the customers at prespecified amounts and agreed-upon time periods. We request that you kindly inform us of the Legal status of this transaction,

Chairman of the Board of Directors,
Dr. Hassan Abbas Zaki.

Attached to this letter was a sample document for the dealings between an investor and the bank. (The second page has a small sample document informing a customer that his account of LE 100,000 is renewed for the calendar year 2002, with added “return rate of 10%” in the amount of LE 10,000, thus bringing the account balance to LE 110,000.)

The Honorable Great Imam forwarded the letter and its attachment to the Islamic Research Institute for consideration during its first following meeting. The Institute convened its meeting on Thursday 25 Shaban 1423 (October 31, 2002) during which time the issue was presented. Following the deliberations and studies of the members, the Institute decided: Approval of the ruling that investing funds with banks that predetermine profits (tuhaddid al-ribh muqaddaman) is Islamic-Legally permissible, and there is no harm therein.

Since this topic is of particular importance for citizens who wish to know the Islamic-Legal status of their investments with banks that pre-specify profits, and since there havebeen numerous questions about this issue, the General Council of the Islamic Research Institute has decided to prepare an Official fatwa backed by the Legal Proofs, as well as a summary of the Institute Members’ reasoning, to give citizens a full picture of the issue and instill confidence [in the decision].

The general council presented the full text of the fatwa to the Islamic Research Institute meeting on Thursday 23 Ramadan 1423, equivalent to November 28, 2002.

After reading the fatwa and taking account of the members’ comments on its language, they approved the fatwa.

This is the text of the fatwa:

Those who deal with the International Arab Banking Corporation, or other banks, thus giving their funds and savings to the bank as an agent (wakil) in Legally permissible investments in exchange for a pre-specified profit that is given to them at agreed-upon periods.

This dealing, in this form (Surah) is Legally permissible, and there is no Legal suspicion (shubha) associated with it. This follows from the fact that there is no Canonical Text (naSS) in the Book of Allah or the Prophetic Sunnah that forbids this type of transaction, wherein the profit or return is pre-specified, as long as both sides mutually consent to this type of transaction.

Allah (Most High) said: “O people of faith, do not devour each other’s property unjustly, but let there be among you trade by mutual consent”
(Al-Nisaa 4:29).

In other words, O you who have the proper faith in Allah, it is not permissible for you, and not proper for any of you, to devour the property of another in invalid and forbidden ways that Allah (Most High) has forbidden—such as theft, usurpation, riba, and other acts that Allah (Most High) has forbidden. However, it is permissible for you to exchange
benefits among yourselves through transactions initiated by mutual consent in a manner that does not make permissible what has been forbidden, or make forbidden what has been permitted.

This applies whether the mutual consent is established verbally, in writing, by physical signaling, or in any other way that implies mutual acceptance and agreement of the two parts.

In this regard, there is no doubt that mutual agreement over prespecification
of the profit is acceptable legally and logically, so that each party may know his rights.

It is well known that when banks pre-specify for their customers their profits and returns, those profits/returns are fixed after a detailed study of the international and domestic market conditions, and the economic circumstances in society, in addition to the special conditions and nature of each transaction, and the average profitability of each such transaction.

Furthermore, it is well known that those fixed rates of return may be adjusted upward or downward. For instance, Investment Certificates at their inception paid 4 percent returns, whose rate of return later increased to over 15 percent, and then more recently declined to approximately 10 percent.

The party that specifies this rate of return that is subject to upward and downward revision has the responsibility of determining that rate, according to the instructions of the specific authorizing national agency.

Advantages of this pre-specification of the rate of return—especially during this time in which deviation from Truth and truthfulness is rampant—accrue to the funds-owner, as well as the managers of banks that invest those funds:

• The funds-owner benefits by knowing his rights without any degree of ignorance or uncertainty (jahala), and thus can plan his life accordingly.
• The managers of banks also benefit from this specification [of rates of return] since it gives them the incentive to maximize their profits to exceed the amount they guaranteed for the funds-owner. Thus, the excess profits after paying the funds-owners their rights accrue to the bank managers as compensation for their effort and diligence.

It may be said in this regard: But banks may lose, so how can banks pre-specify profits to those who invest with them?

In answer [we say]: If a bank loses on any one transaction, it makes a profit on many others, and thus covers its losses with its profits. This fact notwithstanding, in case of an overall loss, the matter can be referred to the legal system.

In summary, pre-specification of profits for those who invest their funds through an investment agency with banks or other institutions is Legally permissible, and above Legal suspicion (la shubhat fiha). This transaction belongs to the domain of benefits that were neither explicitly permitted nor explicitly forbidden (min qabil al-masalih al-mursalah), and does not belong to the domains of creeds or formal acts of worship, wherein change and alteration is not allowed.

Based on what has been stated [we rule that] investing funds with banks that prespecify profits or returns is Legally permissible and there is no harm therein, and Allah [only] knows best.

(Shaykh-ul-Azhar Dr Muhammad Sayyid Tantawi,
27 Ramadan 1423 AH, 2 December 2002 AD)

The economic law of Islam has been revealed by the Almighty through His last Prophet (sws) for the purification of the economy. It is based on the Qur’ānic philosophy of creation. According to this philosophy, the Almighty has created this world as a trial and test for man; every person has therefore been made to depend on others for his living.

No one in this world can live independently as regards his needs and requirements. A person of the highest rank must turn to the most ordinary to fulfill them. In other words, every single person has an important role to play, without which this world cannot continue. This role depends upon his abilities, intelligence and inclinations as well as upon his means and resources, which vary from person to person. In fact, it is because of this variation that a society comes into being. Consequently, laborers and workers, artisans and craftsmen, tillers and peasants are as indispensable as scholars and thinkers, savants and sages, leaders and rulers. Every individual is an integral component of society and contributes to its formation according to his abilities. The Qur’ān says:

نَحْنُ قَسَمْنَا بَيْنَهُمْ مَعِيشَتَهُمْ فِي الْحَيَاةِ الدُّنْيَا وَرَفَعْنَا بَعْضَهُمْ فَوْقَ بَعْضٍ دَرَجَاتٍ لِيَتَّخِذَ بَعْضُهُمْ بَعْضًا سُخْرِيًّا وَرَحْمَةُ رَبِّكَ خَيْرٌ مِمَّا يَجْمَعُونَ (٣٢:٤٣)

We have apportioned among them their livelihood in this world [in such a manner that] We have exalted some in status above others so that they can mutually serve each other. And better is your Lord’s mercy than what they are amassing. (43:32)

By creating various classes of people, the Almighty is testing whether the big and the small, the high and the low create a society based on co-operation and respect or create disorder in the world by disregarding the role each person has been ordained to play. The latter attitude would, of course, lead them to humiliation in this world and to a grievous doom in the Hereafter. The Qur’ān says:

وَنَبْلُوكُمْ بِالشَّرِّ وَالْخَيْرِ فِتْنَةً وَإِلَيْنَا تُرْجَعُونَ (٣٥:٢١)

We are trying you by giving you happiness and sorrow to test you, and to Us you will be returned. (21:35)

It is to salvage man in this trial that the Almighty has guided him through His Prophets and revealed this economic law to cleanse and purify him.

Following is a summary of this law:

1. The Obligation of Zakāh: It is obligatory upon a Muslim to pay Zakāh according to the way prescribed by the Sharī‘ah from his wealth, produce and livestock if he is liable to it.

2. Sanctity of Ownership: If a Muslim has paid his Zakāh dues, then his rightfully owned wealth cannot be usurped or tampered with in any way, except if on account of some violation by him. So much so that an Islamic State has no authority to impose any tax other than Zakāh on its Muslim citizens.

3. Formation of a Public Sector: For the just distribution of wealth, the establishment of a public sector is essential. Consequently, everything which is not, or cannot be owned by an individual should in all cases remain in the ownership of the state.

4. Incompetence: Since a person’s way of using his wealth and property also influences the development and welfare of a society, the state, while acknowledging him to be the owner, has the right to deprive him from using them if he is proved to be incompetent.

5. Usurpation of Wealth: It is prohibited to devour other people’s wealth and property by unjust means. Gambling and interest are some horrendous forms of usurpation. Other economic activities should also stand permissible or prohibited in the light of this principle.

6. Documentation and Evidence: In affairs such as various financial transactions, making a will and acquiring a loan, the parties involved should write down a document and call in witnesses to safeguard against any moral misconduct by either of the parties.

7. Distribution of Inheritance: The wealth of every Muslim must necessarily be distributed after his death among his heirs in the following manner:

If the deceased has outstanding debts to his name, then first of all they should be paid off. After this, any legacies he may have bequeathed should be paid. The distribution of his inheritance should then follow.

No will can be made in favour of the heirs ordained by the Almighty. Similarly, no one can be an heir to a deceased who has severed his kinship with him because of some inappropriate deed or conduct.

After giving the parents and the spouses their shares, the children are the heirs of the remaining inheritance. If the deceased does not have any male offspring and there are only two or more girls among the children, then they shall receive two-thirds of the inheritance left over, and if there is only one girl, then her share is one-half. If the deceased has only male children, then all his wealth shall be distributed among them. If he leaves behind both boys and girls, then the share of each boy shall be equal to the share of two girls and, in this case also, all his wealth shall be distributed among them.

In the absence of children, the deceased’s brothers and sisters shall take their place. After giving the parents and spouses their shares, the brothers and sisters shall be his heirs. The proportion of their shares and the mode of distribution shall be the same as that of the children stated above.

If the deceased has children or if he does not have children and has brothers and sisters, then the parents shall receive a sixth each. If he does not even have brothers and sisters, then after giving the husband or wife his (or her) share, one-third of what remains shall be given to the mother and two-thirds to the father. If there is no one among the spouses, then all of the inheritance shall be distributed among the parents in this same proportion.

If the deceased is a man and he has children, then his wife shall receive one-eighth of what he leaves, and if he does not have any children, then his wife’s share shall be one-fourth. If the deceased is a woman and does not have any children, then her husband shall receive one-half of what she leaves and if she has children, then the husband’s share is one-fourth.

Together with these rightful heirs or in their absence or, as in some cases, from the left over inheritance, the deceased can make a near or a distant relative, aside from his parents and children, an heir. If the relative who is made an heir has one brother or one sister, then they shall be given a sixth of his share and he himself shall receive the remaining five-sixth. However, if he has more than one brother or sister, then they shall be given a third of his share and he himself shall receive the remaining two-thirds.

If a person dies without making anyone his heir, then his remaining legacy shall be distributed among his male relatives according to the principle ‘اَلْاَقْرَبْ فَالْاَقْرَبْ’ (nearest to the next nearest).

The Islamic economic system places restriction on the means by which any individual may obtain wealth. While many of the same principles of supply and demand as in traditional Western economics apply in Islamic finance, everything is tempered by a strict adherence to the laws of the Qur’an. As such, Muslims are encouraged to enjoy everything that was put on Earth by God, but not everything is meant for consumption and there are some practices and goods that are considered unlawful or Haram.

To acquire properties and to own goods, Islam places certain restrictions. The first of these being that it is Haram to win money or goods through games of chance or gambling. This is because the process of gambling involves taking another person’s money without work involved, something that is quite contrary to a well functioning society. Gambling implies the possibility of easy money, money without work, and Islamic society necessarily requires every member of the community to be productive. The Qur’an is quite clear about the prohibition of gambling and all Muslims are urged to stand against games of chance.

Another restriction on the way one earns money is that no person is allowed to acquire goods or money through usury. Usury is considered unhealthy for the community since it, again, rewards individuals without the need for work. It encourages people to sit on their money and to collect rewards without actual labor, preying on those that are most needy in the community. Usury is destabilizing in that it creates social warfare and a hatred of the rich by the poor, an ill will that is in part justified because the rich get richer with no work on their part. God permits trading and business but forbids usury in all its forms in the Qur’an. In fact, God goes farther to say that the increase of wealth through usury is directly related to God’s displeasure while money that is given instead in charity will attract the pleasure of God with the giver.

Islam is also quite clear about not allowing people to become rich by exploiting the weak. It goes on to say that taking advantage of the weaknesses of other human beings for one’s own gain is an unacceptable way of gaining wealth, and completely against God’s will. The Qur’an also goes farther and states that using the law to one’s advantage in a fraudulent or devious way so that one may acquire another person’s property is not lawful. Only trading and mutual consent between two parties is accepted under the rules of Islamic law. Something that is also considered a mortal sin is taking the property of orphans or of people at a disadvantage through fraudulent or exploitative means. The concept of justice in Islam recognizes an important property, that of Ihsan. Ihsan refers to giving more to those that are at a disadvantage so that they can stand at the same level as the rest of the community in all matters of life. Exploiting those that are at a disadvantage (the orphans, widows, people that are crippled or sick, those living in poverty, the elderly, etc.) is unlawful and goes quite clearly against the principles of Islam.