Fitch - Criteria Report_Fitch's Approach to Rating Sukuk (2007).pdf

Corporate FinanceCriteria ReportAnalystsFinancial InstitutionsPhilip Smith, London+44 20 7417 4340philip.smith@fitchratings.comCorporatesRaymond Hill, London+44 20 7417 4314raymond.hill@fitchratings.comPublic FinanceRichard Fox, London+44 20 7417 4357richard.fox@fitchratings.comStructured FinanceNick Eisinger, London+44 20 7417 4341nick.eisinger@fitchratings.comGlobal Infrastructure GroupLaurence Monnier, London+44 20 7417 3546laurence.monnier@fitchratings.comRelated Research• “Securitisation and Shari’ah Law”, 24March 2005• “Recovery Ratings: Developing anEffective Methodology for Banks”, 27September 2005• “Islamic Banking – Factors in RiskAssessment”, 5 March 2007Fitch’s Approach to RatingSukuk• IntroductionThis report outlines Fitch Ratings’ approach to rating Sukuk.These are bonds structured in accordance with Islamic Shari’ahprinciples and are typically in the form of trust certificates orparticipation securities. Instead of interest, which is unacceptableunder Shari’ah law, the bond investor receives a share of theprofits generated by the underlying assets being financed. Fitchbelieves that these instruments can be rated and, although thestructure adds to the apparent complexity, Fitch’s current ratingmethodologies and rating scales can accommodate Islamic debtinstruments. Depending on the precise structure of the bond, therating may be linked to the rating of the originator of thetransaction or to the underlying assets if the bond satisfies theagency’s requirements for a true securitisation. While this reportfocuses on recent experience, Islamic finance is in continuousevolution. Fitch will continue to monitor developments and willreview its criteria to reflect any future changes.While the issuance of Sukuk is still small compared withconventional bonds, these instruments are experiencing rapidgrowth (see “Appendix 2”). Issuance to date has been mainly bysovereigns (notably Bahrain, Malaysia, Qatar and Pakistan),corporates, supranational organisations and, to a lesser extent,Islamic banks.Islamic FinanceIslamic finance is subject to Shari’ah law, which is a system ofbeliefs revealed in the Qur’an and the Sunnah. Shari’ah is ageneric term. While scholars agree on the main principles, thereare differences in interpretation between the various schools ofIslamic religious scholarship and different jurisdictions. In manycountries, Islamic and conventional institutions operate side byside.Fundamentally, Islamic finance must avoid the receipt/payment ofinterest (“riba”). Instead, the parties must share the risks andrewards of a business transaction. The transaction should have areal economic purpose without undue speculation and not involveany exploitation of either party or any activities considered sinful.Pure financial transactions are generally not acceptable underShari’ah law. In practice, Islamic transactions tend to be assetbased,although the underlying assets do not necessarily constitutecollateral and the transactions may, therefore, be effectivelyunsecured. Even where the assets constitute collateral, the legalenvironment may well prevent significant and timely recoveries.Originator-backed SukukSukuk are structured such that investors have a beneficial interestin the cash flows generated by the underlying assets. Assets areusually sold by the originator to an SPV in the form of a trust. Thetrustee issues certificates representing the investors’ ownershipinterest, while the proceeds are used to purchase the assets. The5 March 2007www.fitchratings.com

Corporate Financeinvestors receive a distribution representing aproportion of the returns generated by the assets,which continue to be managed by the originator. Theassets are typically “ijara” contracts (leasing) butmay include other forms of Islamic financing, eg“murabaha” (sale of goods at a higher predeterminedprice payable usually in instalments), “istisna’a”(sale of assets to be constructed/manufactured,payable in instalments) or “musharaka” (partnership).While the distribution may appear variable, it isusually possible to determine a fairly preciseexpected rate of return based on the underlyingcontracts, and the transaction documents mayindicate a benchmark rate of return.However, while the investor shares in the returnsgenerated by the underlying assets, his risk relatingto the underlying assets has, to date, beencontractually limited. The originator may provide aliquidity facility to match receipts to the contractualperiodic distributions and eliminate any volatility inthe cash flows deriving from the assets. In addition,the documentation may incorporate a purchaseundertaking, whereby the originator is committed torepurchase the assets at a predetermined price onmaturity (or earlier, in the event of default by eitherthe issuer or the originator), together with anyoutstanding distribution. The investor is, therefore,protected against any valuation risk relating to theunderlying assets. The purchase undertaking may befurther reinforced by an explicit guarantee from theoriginator.Events of default and recoveries: Documentationviewed to date incorporates events of default similarto those seen in conventional prospectuses. Theseinclude failure to perform any obligations laid downin the agreements, failure to pay any amounts due(both periodic distributions and repayment onmaturity), failure to comply with any notices,unlawful actions, cessation of operations, insolvency,or any arrangements/deferment in relation to anyindebtedness. These events of default may bereinforced by a negative pledge and cross-defaultclauses, which further link the performance of theoriginator and the Sukuk.Unlike a true securitisation, the investors do not haveany recourse to the underlying assets in the event ofdefault. Default accelerates the purchase undertaking,which, if not fulfilled, would trigger a claim by theinvestors against the originator. This would beimmediately due and payable, and would be pursuedthrough the commercial courts. The assets within theSukuk would be available for all senior unsecuredcreditors of the originator, and the investors wouldordinarily rank as senior unsecured creditors of theoriginator. They would rank pari passu with othersenior unsecured creditors, except for anypreferential creditors as determined by localcommercial law.Although Sukuk are asset-based, the originator’scontractual obligations – whether represented by aguarantee or not – clearly determine that the creditrisk of the Sukuk reflects that of the originator ratherthan the underlying assets. The Sukuk’s Long-TermRating cannot therefore exceed the Issuer DefaultRating (IDR) of the originator, and would ordinarilybe in line with the originator’s IDR. This assumesthere are no substantial preferential creditors rankingahead of the certificate-holders and no constraints onthe originator’s obligations or additional risk factorsrelating to the Sukuk, which would lead the agencyto notch down from the IDR. Fitch would make useof its current rating methodology appropriate foreach originator to establish the IDR.In other words, in normal circumstances, suchoriginator-backed Sukuk would be considered tohave average recovery prospects, with an impliedRecovery Rating of RR4 and a Long-Term Rating inline with the originator’s IDR. Additional notchingwould only be possible if there were tangible assetswhich could increase the recovery prospects to RR3or above – and where Fitch could be satisfied thatthe transaction was genuinely secured.Legal status: Sukuk issued in the internationalcapital markets are typically governed by Englishlaw and subject to the jurisdiction of the courts ofEngland (or other recognised international law andjurisdiction), but any judgement would probably bereviewed by the courts where the originator isdomiciled – and may not be enforced. While thesecourts would ordinarily act in accordance with localcommercial law, they may be influenced by Shari’ahlaw, which adds further uncertainty to anyjudgement, for example due to potential differencesin the interpretation of default. (In the event thattransactions were governed solely by localcommercial and/or Shari’ah law, such transactionsmight prove difficult to rate, considering theunpredictability of any judgement.) Recoveries, evenunder commercial law, may also be subject to delaysdepending on the efficiency of the local legal system.However, this also applies to conventional bondsissued in the same country, and this risk is alreadyreflected in the IDR of the originator.While Fitch reviews the prospectus and supportingdocumentation and will seek a legal opinion whereconsidered necessary, ratings assigned to Sukuk donot imply any confirmation that the Sukuk areShari’ah-compliant. This responsibility lies with theoriginator’s Shari’ah board, which will have issued aFitch’s Approach to Rating Sukuk: March 20072

Corporate Financelegal opinion (“fatwa”) prior to the launch of theSukuk. There is, however, the risk that otherShari’ah scholars could take a different view fromthe originator’s Shari’ah board. While there is broadagreement on Shari’ah principles, there aredifferences of interpretation which the agency wouldnot be in a position to anticipate or assess.Asset-backed Sukuk (Securitisations)Ratings for Sukuk in the form of securitisations, iewhere the rating has been linked to the underlyingassets, have been prevented to date by a number offactors. These have essentially related to legaluncertainty, as certificate-holders must have anundoubted first-priority claim over the underlyingassets in the event of default. Although cross-bordertransactions are typically subject to English law andthe jurisdiction of the English courts, any judgementwould probably require ratification by the courtswhere the originator and/or issuer are domiciled andwhere the underlying assets are located. Apart fromthe fact that Shari’ah law is open to interpretation,the legal systems in most Islamic countries allow thecourts more discretion and do not take into accountlegal precedent, assuming that any prior judgementshave even been recorded or where there have beenany similar transactions to test local judgements.This lack of certainty is clearly reflected in the legalopinions received to date by Fitch.In order to achieve a real securitisation, thetransaction should, among other factors, represent atrue sale, ie the underlying collateral has been validlytransferred to the SPV (or, at least, ring-fencedsimilar to the collateral pools of covered bonds). Inthe event of the insolvency of the originator or theSPV’s parent company, the underlying collateralmust remain completely separate from the assets ofthe originator/parent company. In addition, the riskof any insolvency proceedings being brought againstthe SPV should be remote, while the investorsshould have first priority over the underlyingcollateral, without any risk of the sale subsequentlybeing overturned by the local and/or Shari’ah courts.Fitch has not reviewed any transaction to date whichwould satisfy these requirements and allow theagency to assign an enhanced rating to thetransaction. However, this is a rapidly evolvingmarket, and structured Sukuk, which satisfy theserequirements, may appear in the future.• Appendix 1Ratings of Originator-backed SukukExamples of Sukuk where ratings have beenassigned in line with the IDR of the originatorinclude:Islamic Development Bank (IDB):Issue of USD400m in trust certificates in August2003.Assets representing financing extended togovernments and public sector institutions in theform of ijara, murabaha and istisna’a contracts weretransferred by the originator, IDB, to theissuer/trustee, Solidarity Trust Services Limited,Jersey. The trust certificates are guaranteed by IDB,which will repurchase the Sukuk assets in full onmaturity in August 2008, or earlier if a dissolutionevent occurs. Distributions are serviced out of theprofits generated by the assets, but IDB is alsoproviding a liquidity facility to cover any timingdifferences. As the trust certificates rank at least paripassu with all other senior unsecured obligations ofIDB, Fitch assigned a rating in line with IDB’s IDR,currently ‘AA+’.Abu Dhabi Islamic Bank (ADIB):Issue of USD800m in trust certificates inDecember 2006 under the bank’s USD5bn TrustCertificate Issuance Programme.Assets (entirely ijara contracts) were transferred bythe originator ADIB to the issuer/trustee, ADIBSukuk Company Limited, Cayman Islands. Inaccordance with the programme documentation,ADIB will repurchase the Sukuk assets (consideredto be held in co-ownership) in full on the maturity ofeach issue, or earlier if a dissolution event occurs.ADIB will also pay any outstanding distributions onmaturity and is providing liquidity to cover anytiming differences in receipt of profits generated bythe assets. However, investors have no rights torealise the assets in the event that ADIB does notmeet its obligations. ADIB’s senior obligationsunder the programme rank at least pari passu with itsother senior unsecured obligations, includingcustomer deposits. As a result, Fitch assigned arating in line with ADIB’s IDR, currently ‘A’. Anysubordinated issues under the programme would beassigned expected ratings of ‘A-’.Fitch’s Approach to Rating Sukuk: March 20073

Corporate Finance• Appendix 2Market BackgroundThe size of the Sukuk market, encompassing bothdomestic and international issues, is estimated ataround USD60bn. Total Sukuk issuance in 2006 wasof the order of USD20bn – a rise of almost 50%. 1International Sukuk issues(No per annum)25201510502002 2003 2004 2005 2006Source: BloombergRinggit issues out of Malaysia, where the marketbegan in the early 1990s, continue to dominate interms of the number of issues – over 95% of the totalin 2006 – but, with growing issuance out of the Gulf,Malaysia’s share in terms of the value of issuancefell to just over 60% in 2006. 2Sukuk Issues(USDbn per annum)1210Dollar issuesNon dollar issuesGulf currencies are linked to the US dollar and mostof their Sukuk are US dollar-denominated.International Sukuk outstanding (more than 50 issuessince 2002) are now approaching USD20bn – overhalf of them issued in 2006 when internationalissuance reached USD10.8bn. Gulf issuers accountfor 85% of this outstanding stock and virtually all of2006’s issuance.Issuance by Country(USDbn per annum)1210864202002 2003 2004 2005 2006*Includes Pakistan, QatarSource: BloombergUAE Saudi Arabia KuwaitBahrain Malaysia Others*With high oil prices swelling regional liquidity andspawning huge infrastructure spending, Gulfissuance has grown rapidly and is expected tocontinue growing. Issuance in 2006 was four timesgreater than in 2005, with two mega issues, each ofUSD3.5bn, from borrowers located in Dubai: DubaiPorts and Nakheel Development. Total issuance outof the UAE amounted to USD8.75bn, while SaudiArabia was a distant second with issuance ofSAR3bn (USD0.8bn). However, the Saudi issue,from Saudi Basic Industries (SABIC), wasnoteworthy as the first such issue from Saudi Arabia.8642Issuer Type, by ValueFinancialInstitutions11%02002 2003 2004 2005 2006Source: BloombergMalaysia’s Sukuk are targeted at the domesticmarket. International issuance, by contrast, is largelya Gulf phenomenon, helped by the fact that all theCorporate48%Sov/QuasiSovereign41%1 Euromoney, January 2007 and Bloomberg. There are alternativesources of issuance data, with estimates of market size thereforevarying2 DealogicSource: BloombergFitch’s Approach to Rating Sukuk: March 20074

Corporate FinanceSukuk issuance from the Gulf now rivalsconventional bond issuance out of the region, withshares of 44% and 56%, respectively.Corporates and sovereign/quasi-sovereigns havedominated issuance so far. Corporates accounted foralmost half of 2006’s issuance, dominated byNakheel. Quasi-sovereign issuance was confined toDubai, with Dubai Ports and Dubai Dept. of CivilAviation. Sovereigns that have issued in the past areMalaysia (2002), Bahrain (2002), Qatar (2003) andPakistan (2004). A German Land, Sachsen-Anhalt,also issued in 2004.Copyright © 2007 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. All of theinformation contained herein is based on information obtained from issuers, other obligors, underwriters, and other sources which Fitch believes to be reliable. Fitch does not audit orverify the truth or accuracy of any such information. As a result, the information in this report is provided “as is” without any representation or warranty of any kind. A Fitch rating is anopinion as to the creditworthiness of a security. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is notengaged in the offer or sale of any security. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors bythe issuer and its agents in connection with the sale of the securities. Ratings may be changed, suspended, or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch doesnot provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability ofany security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, otherobligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rateall or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as anexpert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of Great Britain, or the securities laws ofany particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than toprint subscribers.Fitch’s Approach to Rating Sukuk: March 20075