ANALYSIS - Sukuk: safe Islamic investments or risky business?

For years, sukuk have been structured and sold as Islamic bonds, but a high-profile default is renewing debate about whether they are in fact equity-like instruments that expose investors to greater risk.

As the sukuk market emerges from the shadow of the global credit slump, the $1 trillion industry is grappling with the extent to which sukuk should mirror conventional bonds, an issue which will determine holders' returns and whether they will be first to be repaid if the investments sour.

How investors view sukuk could influence demand for the best-known sharia financing tool and the pace at which Islamic finance and $107 billion sukuk market will grow.

Sukuk are strictly ownership certificates, but in practice they have become known as Islamic bonds with their investors holding debt.

The question of a sukuk holders' rights has come under scrutiny after an issuer, U.S. energy firm East Cameron, filed for bankruptcy in October 2008.

The case, which is still proceeding in a U.S. bankruptcy court, could shed light on the extent to which East Cameron's sukuk holders own the oil revenues that underpinned the sukuk issue and indicate how sukuk should be structured so that holders get paid in the event of bankruptcy.

The East Cameron sukuk holders are considering a plan of reorganisation which has yet to be filed with the bankruptcy court, said Michael McMillen, a partner with the East Cameron sukuk holders' lawyers Fulbright & Jaworski.

"Alternatives being considered for the reorganisation plan include collapsing the current structure in such a manner that the sukuk holders will become equity holders in the debtor entity," McMillen said.

"It is hoped that East Cameron Partners will emerge from bankruptcy protection some time in early 2010."

The legal debate over protection for sukuk investors is largely unchartered territory, as Islamic finance has only gained prominence in recent years.

The East Cameron case, and recent defaults, such as by Kuwait Investment Dar this year, are expected to provide guidelines for a market that is already subject to varying regulatory and sharia standards worldwide.

Lawyers expect more sukuk defaults to emerge as traditional Islamic banking centres struggle to recover from recession and a real estate slump. Dubai, one of the hardest hit hubs, is working to repay and restructure some of its $80 billion debt.

"A U.S. investor would want to have the sukuk classified by the court as debt, not as equity," said influential U.S.-based sharia scholar Sheikh Yusuf Talal DeLorenzo, referring to sukuk in general.

"Even though that goes against the sharia characterisation, in court if it's classified as debt then the debtors stand in line before equity holders and they're more likely to get paid."

As sukuk transactions go through the entire process from documentation to dispute resolution, sharia advisers, lawyers and judges will have a hand in deciding if the instruments are debt, equity or an asset class of their own.

"To say sukuk are bonds is like trying to fit a square peg into a round hole," said Megat Hizaini Hassan, who heads the sharia banking practice of Malaysian law firm Zaid Ibrahim & Co.

"There has been considerable work to ensure it does function as such ... for commercial reasons. But that's not something that should be continued forever because one is trying to contort the features to ensure that it does function like a debt instrument."

AAOIFI, an influential Bahrain-based industry body, defines sukuk as certificates of equal value representing undivided shares in ownership of tangible assets and services, suggesting investors are more owners than debt holders.

PURIST OR PROFITABLE?

Earlier debate about where sukuk really fit in among the asset classes was ignited by a 2008 AAOIFI ruling questioning the use of repurchase undertakings -- pledges found in many sukuk that the borrower will pay back their face value at maturity -- in sukuk using the mudaraba and musharaka structures.

AAOIFI said such pledges violate the duty to share risk in mudaraba and musharaka, a ruling which some lawyers said drew a distinction between sukuk and conventional bonds.

The ruling, coupled with the onset of the global credit crisis, caused sukuk issuance to tumble over 50 percent to $14.9 billion in 2008, some bankers have said.

Muddassir Siddiqui, a Dubai-based lawyer, said the effect of the ruling is to forbid a purchase undertaking at the nominal price in these structures. These pledges had effectively guaranteed investors' capital, which together with a return would amount to interest-based lending.

"A purchase undertaking which is based on the agreement of the parties at the time of the purchase for the market value or any other formula is accepted," said Siddiqui, who heads Denton Wilde Sapte's Middle East Islamic finance practice.

Applying a strict or 'purist' definition of sukuk could also affect investors' returns.

Sukuk now offer returns that are benchmarked against conventional interest rates. But some religious scholars object to this, saying returns should instead be pegged on expected revenues from the underlying asset.

Some lawyers also think such a format would alienate bond investors who want fixed returns.

"For the moment, it is going to be regarded as a debt instrument because you are looking at the type of investor," said Mohamad Illiayas, an Islamic banking lawyer in Kuala Lumpur.

"Are you looking at someone who is going to go in for the long haul or someone who's looking for annualised return, preferably a fixed return? The crowd you will get will be the latter."

(Editing by Kim Coghill)

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