A COMPARATIVE STUDY OF ASSET BASED AND

ASSET BACKED SUKUK FROM THE SHARIAH

COMPLIANCE PERSPECTIVE
AHMED ABDIRAHMAN HERZI
Universiti Sains Islam Malaysia

ABSTRACT asset backed, shariah, regulatory frame-

work sukuk
The aim of this article is to compare
between asset based and asset backed INTRODUCTION
sukuk structures and their compliance to
the shariah. The article has been intended Sukuk is plural of Sakk, legal instrument,
to figure out the motives that asset based is the Arabic name for financial certificates,
sukuk structure is the most dominant in the but commonly referred to as "sharia com-
sukuk market in the face of the critics that pliant bonds, are one of the important
have been elevated by many scholars since instruments in Islamic capital and money
2007. The two structures of Asset backed markets. The Accounting and Audit Organi-
and Asset based Sukuk are compared in zation for Islamic Financial Institutions
their technical and commercial features (AAOIFI) defines sukuk as certificates of
using literature-based methodology, which equal value representing undivided shares
is a qualitative approach. It is highlighted in ownership of tangible assets, usufruct
that asset backed sukuk structure is more and services or (in the ownership of) the
compliant to the Shariah compare to Asset assets of particular projects. On the other
based Sukuk in a form and substance. This hand, bond is defined as a pure debt
article found that there are three reasons security issued to finance any activities
that could be explained why asset based and whose price solely depends on the
sukuk structure is the most dominant in creditworthiness of its issuer (Godlewski et
the market up to 2014, namely shariah, al., 2011). These definitions clearly differen-
legal framework and market demand. The tiate sukuk from bond both in concept
research is intended to figure out why and structure. As a consequence, some
these two structures are not in the same scholars are in the opinion that it is rather
level of demand in market and to create inappropriate to call sukuk as an "Islamic
civic awareness in the importance of bond". Although the sukuk term has been
compliancy to shariah in the form of used since the classical period of Islam, the
JMFIR Vol. 13/No.1 JUNE 2016

substance. This research is expected to current form of sukuk has only taken the
contribute to regulators such that they attention of the world since 2002. A report
can amend some of their governing and by Bloomberg mentions that during 2002-
regulatory frameworks and create a condu- 2007, the volume of global sukuk issuance
cive environment for the sukuk market increased from below USD5billion in 2002
players to enhance asset backed Sukuk. to USD30.8 billion in 2007 (Sarea, 2012).
This data clearly shows us that sukuk has
Keywords: Market demand, asset based, become one of the areas in Islamic finance
25
 with spectacular growth for the last decade. based" and "equity or participation based".
However, the tremendous growth in the For example, Islamic financial services board
industry as it has been mentioned earlier (IFSB) guideline No 2 released in 2005
had been disrupted in 2008 due to a state- defines the former as a sukuk where the
ment released in November 2007 by Shaikh underlying assets offer fairly predictable
Muhammad Taqi Usmani, Chaiman of the returns to the sukūk holders, such as in the
AAOIFI shariah board, declaring that up to case of Salam, Istisna and Ijārah”. The latter
85% of the sukuk issued up to then may category is defined as sukuk where the
not have been fully shariah compliant. As a returns are determined based on a profit and
result, the volume of business for sukuk fell loss sharing in the underlying investment,
from USD 30.8 billion in 2007 to USD 1.4 which does not offer fairly predictable
billion in 2008 (Sreih, 2011). The statement returns” (IFSB, 2005). Eventually, after some
also prohibits the usage of some credit default cases in sukuk market in 2008 due
enhancements mechanisms in equity based to the global financial crisis, the issue of the
sukuk due to their non-compliancy with ownership in the sukuk asset appeared,
Shariah. The above mentioned announce- resulting in the popularity of categorizing
ment has also generated a shariah compli- the sukuk into asset based and asset backed
ance risk as one of the risks faced by sukuk structures (Abdullah, 2012). According to
holders (Hidayat & Abu Bakar, 2011). This Securities Commission Malaysia (SCM), the
type of risk is not clearly noted in the sukuk classification of sukuk into asset based and
market within 2002-2007 periods. But, the asset backed is made based on the sukuk's
following years (2008-2011) have witnessed technical and commercial features. In the
the appearance of this risk in the market first category, the underlying asset used
leaving us with some important notes to be to structure the issuance remains on the
understood. One of the notes is the issue of balance sheet of the originator after the
asset based and asset backed sukuk. There- issuance of the sukuk. In this category, the
fore, this study attempts to explore this issue originator only passes beneficial ownership
in order to explain why the issue still remains of the asset to sukuk holders, while still
hot in the market despite it has been raised keeping its legal ownership. In other words,
since the early 2008. In other words, the from the legal perspective there is no true
objectives of this study include ,figuring out sale in asset based structure since sukuk
and analyzing the Shariah Compliance holders do not have any concern in the
of asset based and asset backed sukuk underlying asset. As a consequence, the
structures from shariah perspective, sukuk holders cannot sell the asset to a third
exploring the reasons why asset based party. It also means the sukuk holders only
Sukuk structure became dominant in the have the recourse to the originator/obligor.
market and to identify the relevancy of On the other hand, asset backed sukuk can
Asset backed Sukuk structures investment be defined as an Islamic security issued
in the developing countries. pursuant to a securitization transaction
(SCM, 2009). Based on the above definition,
LITERATURE REVIEW it is clear that the securitization transaction
is the most important feature of asset
In the beginning of its appearance, sukuk backed sukuk (Dusuki & Mokhtar, 2010).
was only categorized as "trade or asset This transaction involves true sale and
26
Table 1:
Differences Between Asset Based and Asset Backed Sukuk

A COMPARATIVE STUDY OF ASSET BASED AND ASSET BACKED

SUKUK FROM THE SHARIAH COMPLIANCE PERSPECTIVE
S/N Categories Asset Based Asset Backed

1 Source of payment The source of payment comes The source of payment comes
from originator/obligor's from the revenue generated
cash flows. by underlying asset.
2 Presentation/disclosure The asset stays on the balance The asset is separated from
of the asset sheet of originator/obligor. the originator's book.
3 Type of Sukuk holders' Beneficial ownership with no Legal ownership with right to
ownership right to dispose the asset. dispose asset.
4 Recourse Purchase undertaking at par Sukuk holders only have
from obligor is the ultimate recourse to asset thus asset
recourse. The recourse is only plays genuine role in
to obligor and not the asset. defaults.

the transfer of legal ownership of the asset commercial features between asset based
from the originator to a third party, which and asset backed sukuk structures. The
is normally a Special Purpose Vehicle (SPV). methodology reveals a range of experts'
The SPV is in turn an explicit trustee of the opinions in the field regarding the issue
sukuk holders that receives fees as the issuer which is used to fulfill the objectives of
of the sukuk, while the sukuk holders are the study.
the legal part-owners of the underlying
asset that receive a return on investment DISCUSSION
based on the performance of the under-
lying asset (Sreih, 2011). In other words, for Sukuk are Islamic certificates of investment.
the payment, the sukuk holders rely solely They signify co-ownership of productive
on the underlying asset since the asset is resources, known as the “underlying assets.”
already separated from the originator's Because income to sukuk holders is gene-
book and there will be no recourse to the rated by trading or real investment rather
originator. Some important notes for the than mere lending, sukuk holders earn
underlying asset are that the asset must be profit rather than interest. As co-owners
acceptable according to shariah principles, of productive assets, sukuk holders face
able to generate cash flows and there must the risks of ownership. In particular, they
be no barrier that prevents the transfer of face the risk that their assets may not gene-
legal ownership of the asset from the rate profits or that may even incur losses.
originator to SPV (SCM, 2009). Table 1 They also face the risk that the assets may
below summarizes the differences between be damaged or destroyed completely.
asset based and asset backed sukuk.
Risk taking is one of the requirements of
METHODOLOGY earning lawful profits in Islam. Another
requirement is to share profits and losses.
This article uses qualitative method research For a person to claim a share of income
in order to compare the technical and generated by an investment he/she helps
27
 to finance, without taking responsibility and the underlying asset is just used to
for its outcome, is inconsistent with the facilitate the shariah requirement. In other
ethos of Islam. Income needs to be earned, words, there is no true sale transaction in
if not by effort, then at the very least by asset based sukuk. The sale transaction in
taking risk. this structure is made just to comply with
shariah in form but not in substance. While
Typically, sukuk are categorized into “trade- in fact, all financial instruments must fulfill
based” and “participatory,” depending on formal and substantial compliance in order
whether they are issued to finance trade to be labeled as shariah compliant securities
or investment. As a result of some recent (Dusuki, 2010). In addition, the return that
defaults of a number of sukuk and the near the sukuk holders obtain is also not linked
defaults of others, a new classification with the asset used in the deal.
entered the sukuk discourse, that between
“asset-backed” and “asset-based” sukuk. Sukuk holders do not have the rights
to sell the underlying asset
Therefore comparing the structures and As it has been discussed earlier that sukuk
features of the asset based and asset holders do not have interest in the under-
backed sukuk Based on our analysis, we lying asset, thus they cannot sell the asset
found that asset backed structure is more to third parties. The restriction has not only
compliant to Shariah principles than asset raised a question whether asset based sukuk
based sukuk. The reason is that asset structure truly comply with shariah principles
backed nature of Islamic financing and but also somewhat against the fairness
some shariah issues in the asset based principle (A'dalah) especially in the case
structure (Abdullah, 2012). Dusuki (2009) of default. Are sukuk holders' interests
highlights some of the shariah issues of adequately taken care of given the fact
asset based sukuk: that they don't have any legal ownership
1. The contradiction between legal of the underlying assets?
documentation and shariah requirement.
2. Sukuk holders do not have the rights to The usage of wa'ad (purchase under-
sell the underlying asset. taking) in equity based sukuk has made
3. The usage of wa'ad (purchase under- the sukuk in substance debt based
taking) in equity based sukuk has made instrument
the sukuk in substance debt based Unconditional purchase undertaking (wa'ad)
instrument. at par acts as a guarantee of principal and
4. SPV's independency. return regardless of the performance of
the venture. The purchase undertaking
The contradiction between legal docu- (waa'd) is an acceptable instrument when
mentation and shariah requirement it is used on its own. But, when the wa'ad is
From shariah perspective, the underlying combined with other credit enhancements,
asset belongs to the sukuk holders. How- it changes a participatory contract in
ever, there is no indication in the legal shariah (Musharakah and Mudarabah) into
documents of asset based sukuk that the a resembled debt security. In other words,
sukuk holders own the underlying asset. it creates indebtedness in trust contracts
Thus, only beneficial ownership is transferred similar to conventional bond contract.
28
 It also means that asset based sukuk in asset into third party since the asset
substance is the same as conventional is separated from the book of the
bond. According to AAOIFI standard on originator.
sukuk, a prospectus to issue any certificates B) For sukuk holders: Asset backed
(not only those which are equity based) structure can be used by sukuk holders
must not contain any clause that the issuer to diversify their investments, thus
is obliged to compensate certificate holders minimizing their investment risks.
up to the nominal value in situations Sukuk holders are also free from the
other than torts and negligence, or that he bankruptcy risk of the originator since
guarantees a fixed percentage of profit they have a recourse only to the
(Ayub, 2007). Referring to the standard, underlying asset not to the originator.
it is clear that asset based sukuk structure Surprisingly, despite the shariah issues
has shariah issues. in asset based sukuk and the additional
advantages offered by asset backed
SPV's independency sukuk, up to 2012, the asset based
In asset based structure, sukuk holders structure, is still the most common
through SPV have the recourse to originator/ form of sukuk issued in the market. It
obligor in case the underlying asset does is reported that currently around 90
not provide enough cash flows. Thus, the percent of sukuk issuances are asset
SPV is credit-linked to the obligor. In this based (Pasha, 2012). Therefore, this
case, the rating bodies will not consider the study also attempts to find out some
SPV as an independent entity. According possible reasons that might explain
to many guidelines, a true sale requires why asset based is still preferable than
the SPV to be an independent entity from asset backed sukuk based on literatures
originator. It again indicates that asset and industry experts' opinions. In
based structure does not fulfill the criteria general, the reasons can be classified
of a true sale. into shariah, legal framework and
market demand (SCM, 2009; Dusuki
The above highlights also indicate that & Mokhtar, 2010; Abdullah, 2012;
moving towards asset backed structure Pasha, 2012).
is highly recommended. In addition to Shariah reasons: (a) Limited numbers
better compliancy to shariah principles, of suitable asset classes. One of the
asset backed sukuk structure also has requirements of asset backed sukuk is
many advantages to both originator and the availability of underlying assets for
sukuk holders. Among them are (Khan, a true sale. As it has been mentioned
2007; SCM, 2009) who highlighted the earlier, the underlying assets must
JMFIR Vol. 13/No.1 JUNE 2016

following: comply with shariah and some

A) For an originator: asset backed structure additional criteria in order to be
has created a new source of funding qualified for a securitization transaction.
for a financial institution and other For example, loans and receivables are
companies. Asset backed structure also obviously not the options since they
reduces asset and liability mismatch must be traded at par. With lack of
since it monetizes previously illiquid suitable asset classes that fulfill the
assets. It also transfers the risks of the criteria, obviously asset backed structure
29
 is not preferable. (b) Another shariah asset portfolios and structure of asset
reason is the argument raised by some backed sukuk. Sukuk have made
shariah scholars about the permissibility investors in the market looking for the
of beneficial ownership in Islam. This sukuk that are structured as debt
argument has been used by shariah instruments. (c) Another argument is
scholars as the basis for asset based since many sukuk holders and potential
sukuk approval. In other words, shariah sukuk investors are not shariah
wise, there are still many proponents conscious, some of them are even
to asset based sukuk despite the critics non-Muslims, they are not concerned
and issues raised by the opponents. with the issue of shariah compliancy
thus preferring asset based sukuk
Legal framework: Despite sukuk being structure that guarantees their capital
viewed as shariah compliant instrument, and income. (d) In addition, most
in practice, the sukuk issuances are still sukuk issuers want to raise capital
governed mostly by common law without having to legally sell their
(English law). As a consequence, sukuk assets. In other words, the market
issuance has to comply with accounting, prefers Islamic securities that fit the
tax and legal standards for a conven- credit environment.
tional bond (the closest conventional
finance instrument to sukuk recognized Based on the above explanations, it is clear
by common law). Comparing the two that there is a dilemma between shariah
sukuk structures, asset based sukuk is concerns, legal framework and market
the most suitable structure for the demand surrounding the issue of asset
issuance since it resembles the features based and asset backed sukuk. In one side,
of conventional bond. In addition, there are shariah issues in asset based sukuk
common law recognizes sales that fall as they have been raised by many scholars.
short of true sales as valid sales However, the legal framework of the sukuk
(Abdullah, 2012). With asset based which is based on common law still suits
sukuk dominating the market no asset based structure than asset backed
wonder that sukuk is also called "Islamic structure. In addition, the market seems to
bond". In addition, it is also reported prefer the asset based structure than asset
that in some jurisdictions, structuring backed structure. This dilemma also poses a
asset backed sukuk is costly and time question to all Islamic finance stakeholders:
consuming (Pasha, 2012). "should shariah always be accommodative
to all these issues in favor of legal frame-
Market demand: (a) Asset backed work and market demand?” Since shariah
sukuk structure is more complex as gives rooms for different interpretations
compared to asset based, thus potential of its principles especially in the cases of
investors seem to be unfamiliar with transactions (muammalah), there are always
the structure. As a result, asset backed ways to find legitimacy in form for some-
sukuk may be priced more expensive thing that seems wrong in substance.
than asset based. (b) In addition, lack
of trained and skilled personnel where Therefore, in order to solve this issue, it is
not many can manage and analyze important to refer it to one of the primary
30
sources of knowledge in Islam which is the shifted to the Special Purpose Vehicle (SPV)
sayings (hadith) of the Prophet (p.b.u.h). with elements of a true sale. The asset

A COMPARATIVE STUDY OF ASSET BASED AND ASSET BACKED

SUKUK FROM THE SHARIAH COMPLIANCE PERSPECTIVE
In one of his sayings, the Prophet said: is the only object of recourse for the sukuk-
"All deeds depend on intention". Since the holders. Thus, the impairment of the asset
wisdom behind the establishment of Islamic or non-performance thereof reflects directly
finance is to dedicate all aspects of our lives in the value of the sukuk that the investors
to the teachings of Islam, all acts should be hold. According to the Islamic Financial
based on sincere intention (Hidayat, 2010). Services Board (IFSB), in an asset-backed
Therefore, it is very important for all Islamic sukuk, the investors will bear any losses
finance stakeholders to purify their inten- due to the impairment of the asset(s);
tions thus any decisions made will reflect likewise the sukuk investors have recourse
shariah principles both in form and subs- to the asset(s) and not to the originator.
tance. As a result, the welfare of the society Thus, in time of default, investors will not
(maslahatul ammah), other objectives be able to recourse to the originator, but
of shariah (maqasid al-shariah) and most instead, they have to recourse directly to
importantly the blessing of Allah will the asset; exposing them to losses if there is
be achieved. any impairment to the asset. In addition,
asset-backed sukuk lead to full-transfer
According to the Fatwa from (ISRA) The of the legal ownership of the underlying
International Sariah Research Academy for asset(s). To further comprehend on the
Islamic Finance, dated on October, 2013 issuance of asset-backed sukuk, the
Edition stated that asset-backed sukuk are transaction steps are as delineated in the
a type of asset/business venture that is fully table below.

Table 2:
Descriptions of Asset Backed Sukuk

Steps Description

1 The originator will sell the Sariah compliant assets to an SPV. In the ABS Guidelines
2004, it clearly states that any transfer of assets to an SPV in a securitization
transaction (this includes Islamic financing receivables) must comply with the
criteria of a true-sale.

2 The SPV then issues the asset-backed Sukuk to the investors. The money paid
by the investors in subscribing to the asset-backed sukuk includes the
proceeds of the issuance that will be used to pay the originator in return for
the sale of the assets.

3 An asset-backed sukuk provides sukuk-holders with an undivided proportionate

beneficial interest in the assets, thus permitting them to receive the streams of
cash flow attached to the assets.

Source: Securities Commission

31
 Compared to the Asset based Sukuk, also as a percentage of the total amount of a
has been released fatwa by (ISRA) The given loan). Asset-based sukuk are also
International Sariah Research Academy for commonly referred to as “Islamic bonds”
Islamic Finance, dated on October, 2013 and from a legal perspective in term of
Edition, the details of this fatwa focused taxation, asset-based sukuk are treated as
on the Asset-based sukuk are a type of bonds. According to IFSB, in an asset-based
asset/business venture that involve full sukuk, the investors have to recourse either
recourse to the originator or issuer, but not to the originator (via purchase undertaking)
to the asset. There occurs no true sale of or the issuer (via guarantee). To further
the underlying asset by the originator to comprehend the method of issuing asset-
the sukuk investor. Instead of the sukuk based sukuk, the table below delineates
investor attaining real ownership of the the transaction steps for ijarah sukuk as
asset, the sukuk investor will only attain an example.
beneficial ownership. The asset-based
sukuk are structured mainly to replicate CONCLUSION
the conventional bonds. In addition, the
dividends are calculated as a percentage The issue of asset based and asset backed
of the total amount “invested” rather than sukuk has been one of the heated and
as a percentage of total profits (similar to debatable topics in Islamic finance industry
the way interest payments are determined since 2008. Since the issue has not been

Table 3:
Ijarah Asset-Based Sukuk Structure Transaction Steps

Steps Transaction

1 The sukuk investors will pay sukuk proceeds to the Special Purpose Vehicle (SPV).

2 Upon receiving the proceeds, the SPV then issue the sukuk certificates to the
sukuk Investors.

3 The SPV will then purchase an asset from the obligor/originator and obtains the
ownership of the asset.

4 The SPV in its capacity as a lessor (act on behalf of investors) will lease through an
ijarah agreement the same asset back to the obligor.

5 The obligor in its capacity as a lessee will pay rentals to the SPV of the asset.

6 The rentals will be distributed back to the sukuk holders.

Source: Al Maghlouth (2009)

32
resolved, this study attempts to compara- asset-backed sukuk in their jurisdictions
tively analyze the two structures from (Pasha, 2012). The template comes with
shariah perspective based on available a master agreement aimed to provide a
literatures. It is found that asset backed standardized platform from which issuers
sukuk structure is more compliant to could structure asset backed sukuk in line
shariah both in form and substance than with their own jurisdictions and increase
asset based structure. This study also awareness about the product.
identifies a dilemma between shariah
concern, legal framework and market In addition to the above practical solution,
demand as a factor that leads to minimum it is also the time for all Islamic finance
application of asset backed sukuk structure stakeholders to create more awareness to
in practice. Therefore, it is important to the market players that Islamic finance is not
urge the legislators in countries where just about complying with shariah in form
Islamic finance is operating to come out but also in substance. Only when compliancy
with legal framework that is suitable and with both is fulfilled, a financial instrument
preferable to issue asset backed sukuk. can be labeled as shariah compliant (Dusuki,
A practical solution is currently being 2010). Finally, it is only through compliancy
developed by the Bahrain-based Inter- with shariah both in form and substance, the
national Islamic Financial Market (IIFM). welfare of the society (maslahatul ammah),
The institution is developing a template other objectives of shariah (maqasid al-
aimed to help sukuk issuers to overcome shariah) and most importantly the blessing
legal and operational difficulties in issuing of Allah will be achieved.

JMFIR Vol. 13/No.1 JUNE 2016

33
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Received Date: 29 th September 2015

Acceptance Date: 4 th May 2016
34