Sukuk accounting takes standardization debate to new level

AAOIFI’s proposal could increase industry attractiveness

S&P Global Ratings believes the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)’s proposal for accounting and classification guidelines for sukuk issued by Islamic financial institutions, if implemented, represents a boost for proponents of standardization. In our view, this--coupled with AAOIFI’s recent proposal on centralized Sharia boards--could help the market move forward with standardizing the legal structure of sukuk and Sharia interpretation.

In the recent past, we’ve observed some ambiguity in how legal obligations of sukuk sponsors are worded, which according to our understanding was primarily in response to some Sharia scholars’ requests. However, if the AAOIFI’s proposal is adopted, lawyers and sukuk structurers could have a basis for strengthening legal protection for sukuk holders. Overview

The AAOIFI’s latest proposal on sukuk accounting states that Islamic financial institutions can report sukuk as on- or off-balance-sheet instruments; the main determinant of the classification would be the effective control of the underlying assets.

n The proposal also recognizes that issuers can report on-balance-sheet sukuk as a liability, quasi equity, or equity.

We believe that, if implemented, the proposal could lead to tighter legal documentation regarding the obligations of sponsors of sukuk instruments categorized as a liability.

We may refrain from rating a sukuk transaction if the documentation doesn’t include sufficient contractual obligations for full repayment. Under our methodology, our ratings on equity-type sukuk would likely be lower than on liability-type sukuk.

In our view, the AAOIFI’s exposure draft of its proposed financial accounting standard No. 29 will help achieve greater clarity on the different types of sukuk in the market. The proposal distinguishes between two broad types of sukuk--on balance sheet and off balance sheet--based on the effective control of the underlying assets. Moreover, it proposes to classify on-balance-sheet sukuk either as a liability, quasi equity, or equity. We are of the view that the proposal not only recognizes that sukuk can be issued in the form of a liability of its sponsor, but also paves the way for strengthening the legal documentation for this type of sukuk.

Recently, we’ve noted that the documentation for sukuk that would be classified as a liability appears somewhat vague with regard to the legal obligations of the sponsor. Language that is subject to legal interpretation, and does not create firm obligations, was introduced by certain lawyers in response to some Sharia scholars’ concerns that sukuk might create a liability between the sponsor and the investors, which in their view goes against the principles of Sharia. To restore the fixed-income characteristics of this type of sukuk, some lawyers subsequently made the creation of contractual obligations between the sponsor and the special purpose vehicle issuing the sukuk a prerequisite to closing a sukuk transaction.

We believe the AAOIFI’s proposal, if adopted, could bring much needed clarity on whether sukuk can be structured and issued as liability instruments. Coupled with the AAOIFI’s previous proposal on centralized Sharia boards, we think this could strengthen the case for standardizing the legal and Sharia aspects of sukuk. We also think the proposal could benefit from recognizing any independent contractual or promissory arrangements associated with sukuk issuance as part of a sukuk’s core contracts. In most cases, these contracts create a financial liability for the sponsor to pay back investors, thereby exposing sukuk holders to risks related to the sponsor’s incapacity to honor its obligations. We consider the presence of such contracts to be an important factor for holders of liability-type sukuk, especially those investors whose interest is not primarily motivated by the Sharia-compliant nature of the transaction.

The proposal also mentions the possibility of classifying sukuk as equity or quasi equity. While we have observed issuance of such instruments over the past few years, in the Gulf Cooperation Council (GCC) and elsewhere, they remain the exception rather than the norm. The cost of issuing these types of instruments is usually higher than for the liability type, since the risks are higher. We therefore think liabilitytype sukuk will continue to dominate the sukuk market.

Another aspect requiring further clarification pertains to the rules for the tradability of liability-type sukuk. For a long time, sukuk were considered a buy-and-hold investment. However, as the market matured and attracted more issuers and investors beyond those seeking Sharia compliance, tradability became an important factor and a way to enhance the liquidity of sukuk instruments in the secondary market. In our view, the Basel III liquidity coverage ratio (LCR) requirement will increase the demand for high-quality liquid assets in the Islamic finance industry. Sukuk issued by governments, highly rated corporate entities, and multilaterals can play a role in helping the industry comply with that requirement. Yet achieving LCR compliance would necessitate not only unified rules for sukuk tradability but also the listing of sukuk on established markets.

For issuers, greater standardization of legal documentation and Sharia interpretation could also help facilitate sukuk issuance and increase its attractiveness. We see the lack of standardization of legal documentation and Sharia interpretation as one of the main reasons behind muted activity on the sukuk market over the past few years, although we have seen some signs of revival in the first quarter of 2017. Several issuers in core Islamic finance countries have tapped the conventional markets because of the relative ease of that process.

We therefore think the AAOIFI’s proposals will further fuel the debate regarding the infrastructure to address shortcomings of the sukuk issuance process.

In our methodology for rating sukuk, published in 2015, we outlined five conditions that a sukuk has to fulfil in order to be rated at the same level as its sponsor.