I had planned on writing an update on the Arcapita bankruptcy case this weekend for the newsletter, given that the deadline for Arcapita to submit its reorganization plan was January 5th. However, during the week, Arcapita requested another extension for its exclusive period to submit a bankruptcy plan, which would not be particularly notable had there not already been several other extensions in the past month.
In the bankruptcy process, the debtor is allowed an initial 90-day period where the debtor has an exclusive right to file a reorganization plan. In Arcapita’s case this was extended another 180 days to October 15th, and then extended again until December 15th. However, when the extension was requested through December 15, Arcapita said (PDF) they “shall not request a further extension of the Exclusive Filing Period beyond the extension to December 15, 2012”.
When they requested the further extension past December 15, Arcapita said they were ready to submit the plan and attributed the delay to: “the continuation of further discussions among the Debtors, the [Creditor’s] Committee, and various other constituencies regarding a proposed settlement of intercreditor issues”. The court approved a one-week extension to December 22, but Arcapita requested another short extension to January 5, which was also approved (PDF).
Two days before the deadline, Arcapita requested another short extension (PDF) until January 14th, which it again attributes to delays in resolving intercreditor issues (essentially how to allocate losses to creditors of Arcapita Bank and the holding company for the company’s investments, Arcapita Investments Holding Limited). In the filing, Arcapita notes that “In this instance, it is also clear that the Debtors are not seeking to use exclusivity as a method of pressuring creditors into accepting their demands”.
While that may be true, it is nonetheless concerning that Arcapita’s creditors are deadlocked at the moment about who should take losses in the various entities, particularly since Arcapita also filed this week a motion to set the procedure to streamline Arcapita filing objections to creditor claims (i.e. Arcapita requesting that the court reject certain claims filed by creditors) (PDF).
Now, however, let’s back up a bit for some perspective on the case overall. Arcapita is an Islamic private equity company that made many investments before the crisis, and just one since, buying the women’s apparel retailer J. Jill. The way it made its investments was to acquire the assets in leveraged buy outs (LBOs) using debt at the deal level, and then selling on a part of their equity investments to investors, who also were able to invest alongside Arcapita in murabaha working capital loans to the portfolio companies through unrestricted investment accounts.
On the bank level, Arcapita also had a $1.1 billion murabaha financing, a syndicated financing that it used to leverage its own balance sheet. The murabaha matured in March 2012 and during 2011, Arcapita tried to refinance the murabaha, but was unsuccessful, a failure that Arcapita’s management attributed to the flare-up in the European debt crisis in August 2011. To keep things moving along, Arcapita took two additional murabaha financings from Standard Chartered Bank, which received a secured interest in Arcapita’s investments (the equity that they retained on their balance sheet).
By March, Arcapita was still unsuccessful at rolling over the maturing syndicated murabaha, a portion of which was acquired in secondary markets by hedge funds who used their holdings to press for full repayment upon maturity, forcing Arcapita to file for Chapter 11 bankruptcy. During the bankruptcy process, Arcapita has continued to use its cash to support its portfolio companies, to keep them within the parameters of the debt covenants with the portfolio-company-level debtholders (which is separate from the syndicated murabaha and SCB’s secured murabaha financing).
In the meanwhile, Arcapita was also negotiating $150 million in Shari’ah-compliant debtor-in-possession (DIP) financing, which was granted in mid-Dececmber (PDF). That financing was provided through a commodity murabaha (the full agreement is available in this PDF from the court). This financing is designed to provide Arcapita with the liquidity it needs until it can submit a plan, have it approved and exit bankruptcy.
What remains as yet undetermined is the reorganization plan, and specifically it will contain a plan for Arcapita to exit bankruptcy as a functioning entity, or as one focused on winding down its operations and selling over time its investments. For now, we must wait until January 14th to see what Arcapita hopes to do, unless there is a further extension.
One of the areas where Islamic finance has not found a good solution for financing is in education. There are few options for Shari’ah-compliant financing of education. This is surprising and disappointing because education is one area where promoting increasing access can have broad benefits for both the student and the rest of the economy. There is, however, an option that I think should be developed, but will require significant work, primarily in developing the ‘supply’ of financing.
In the US, for example, there are no options available for education financing, which has led many students to either pass up on education (or delay it while they study to be able to save enough to pay in cash), or to use interest-based financing on the grounds of it being a necessity. A middle ground strategy is for students to take federally subsidized student loans, where the US government subsidizes the students by paying the interest on the loans while the student is in school. To avoid paying interest, students will save up (from working during school) to be able to pay off the loan before the subsidy disappears 6 months after graduation.
This is not a solution to the lack of availability of education financing, and there are few others elsewhere in the world. For example, the UK government is considering developing a commodity murabaha-based financing option. According to an article from 2008, the Islamic Bank of Britain offered a commodity murabaha based student loan product, but I could not find it on their website, so it may have been discontinued. The benefits of this approach is that making something available is better than nothing, although using commodity murabaha should be seen as a stop-gap option.
What about elsewhere in the world? Malaysian Islamic banks offer a bay’ al-inah product for education financing, but given the lack of acceptance of bay’ al-inah outside of Malaysia, this is unlikely to be adopted by Islamic banks in the rest of the world. In Egypt, National Bank for Development, working with Abu Dhabi Islamic Bank (which itself offers the same product) provides financing using an ijara for services structure.
In an asset-based ijara, a bank will buy an asset and lease it to the customer with the bank profiting from the rent paid for the use of the asset during the term of the financing, with the lease ending with the customer taking ownership of the asset (ijara muntahia bittamleek). In education financing there is no tangible asset that can be bought and leased, but the ijara contract can still be used but with an intangible asset (an education).
In the ijara services structure, the bank pays the educational expenses (i.e. tuition) up front and enters into an ijara services contract for a longer term (in the case of the NBD ijara services product, it can be for as long as 60 months). It is unclear why the ijara services product is not used by more Islamic banks, but it may present more of a risk since it is an unsecured financing product (after an education is bought by the bank, if the customer defaults, the bank cannot take possession of the underlying asset because it is an intangible asset).
The risk of lending to an individual student may be the reason the product is not widely available from Islamic banks, but is there a way to make a more diversified portfolio through a sukuk that can be sold to investors? The new draft Sukuk Standards from the Dubai Financial Market describe:
“These Sukuk represent for their holders a common share in the ownership of services that could be either ascertained or established as a liability by description (from a specific or nonspecific service provider). The provider of these services commits himself to provide them to others against a determined fee, whether in person or through what he undertakes to provide of facilities, means, equipment, devices or other things. […] These Sukuk grant their holders the right of subleasing the service against a determined fee, which constitutes the return of these Sukuk.”
Securitizing student loans would provide greater diversification, which would be important for unsecured creditors. The conventional analogue to an ijara services sukuk are student loan securitizations, where student loans are bought and combined into a single financial product. When I was speaking to people who study sukuk, the main questions for an ijara services sukuk for education financing were around getting the sukuk rated and generating demand for the sukuk.
It is never going to be enough to develop a sukuk structure that accomplishes a useful social purpose for it to succeed. It will always have to demonstrate financial sense to attract the demand by investors to make for a successful sukuk issuance. And with education financing making up such a small part of the Islamic banking industry, it will unfortunately not be forthcoming in the near-term, and that is unfortunate.
Sukuk have been the hot item in Islamic finance for many years, and with the record year for new issuance just ending—2012 saw $140 billion in new issuance—and there is more likely than not a new record coming from 2013. And the issuance has come with limited new Shari’ah objections to the structuring of sukuk, unlike the previous high in 2007 when Sheikh Taqi Usmani declared that 85% of sukuk were not Shari’ah-compliant. The collapse in new issuance was affected, but only in a minor way, by that declaration (the financial crisis had a much more significant impact).
However, there are unsettled issues I believe in sukuk that may be the subject of the debate in the coming year. The obvious first look would be at the use of repurchase agreements in ijara sukuk, which were specifically exempted from the blanket prohibition included in the AAOIFI 2008 sukuk resolution. There are points to argue in that debate, for sure, and it may come up, but I think 2013 could be the year of the “Use of Proceeds”.
In so many areas, contracts are structured to provide definitive certainty to how transactions work in order to avoid the problems associated with gharar. There probably isn’t a problem with leaving a lot of uncertainty in the use of proceeds section because, after all, running any business involves a lot of uncertainty that has nothing to do with gharar. These finer points of contractual specification are probably best left to the scholars who have many years of experience in deciding what is ok and what is not from a Shari’ah perspective.
However, there is almost a degree of willful ignorance in the design of some sukuk to conceal the end use of proceeds in many sukuk. I am not suggesting there is anything nefarious in the sukuk structures, just that they include frequent use of a set of blinders to contain the vision into the entire transaction based on a very legalistic view of the world.
The sukuk offering transaction is one between the issuing SPV and the subscribers and the “Use of Proceeds” description in offering documents is incredibly vague. “The net proceeds of the issue of the Certificates will be paid by the Issuer on the Closing Date to the Seller as the purchase price for the Assets Portfolio” reads one use of proceeds section (in its entirety).
The quote used above from an Islamic bank’s sukuk, so the proceeds are being raised through a Shari’ah-compliant sukuk structure to support a Shari’ah-compliant institution. But the same legal maneuver was used to structure the Goldman Sachs sukuk, which received significance criticism on the grounds that the use of proceeds was not Shari’ah-compliant.
From the way I understand the justification of the GS sukuk was that it was Shari’ah-compliant because under the murabaha structure, the commodities were bought using the proceeds of the sukuk and then sold to GS with deferred repayment with the one condition that they could not be re-sold to the commodity supplier from which they were purchased (although they can be re-sold to other commodity market participants). This defense was used by Asim Khan, an MD at Dar Al-Istithmar in response to the criticism. Other than that, the guidelines were: “The net proceeds of each Series issued under the Programme will be applied by the Trustee and GSI […] for its general corporate purposes and to meet its financing needs.”
A question arises with these types of structures where Shari’ah-compliance is judged with respect to the transactions between the SPV and the sukuk investors, and not the ultimate use of the funds. Are the SPVs inserted between the source of funds and the ultimate use to conceal the eventual use of the funds? Is there enough disclosure to investors (who are responsible themselves for determining whether the sukuk is Shari’ah-compliant) when the “Use of Proceeds” section of the prospectus can be as little as two lines long?
Even Oman, the last country in the GCC to allow Islamic finance which has been praised for its conservative approach to the industry, notes in its Islamic Banking Regulatory Framework: “The funds raise through the issuance of Sukuk should be applied to investment in specified assets rather than for general unspecified purposes. This implies that identifiable assets should provide the basis for sukuk”. Yet, from my reading of the draft sukuk law there is no restriction (beyond what a Shari’ah board would allow) on the ultimate use of the proceeds by the company (as the originator of the sukuk). All the focus remains on the SPV in its role as issuer of the sukuk and acquirer of an asset used for the transaction.
I’ll start my conclusion with re-emphasizing that there is not really an issue with the vast majority of sukuk issuers. Most use the proceeds, sourced through SPVs for legal reasons, for halal business purposes. However, it is very easy, as the Goldman Sachs sukuk demonstrated, to create a sukuk structure which could both maintain compliance with the “Use of Proceeds” section of its offering documents (and the Shari’ah review thereof) while potentially funding non-Shari’ah-compliant activities.
So far there is a significant separation between the oversight of the use of proceeds by the SPV and by the originator due to the current form-based focus in Islamic finance. That will only lead to trouble, as the pushback against the Goldman Sachs sukuk suggested. However, as I mentioned, a more thorough review and disclosure of the Use of Proceeds will only adversely affect a small minority of new sukuk and the affected sukuk are more likely than not to be ones that attract criticism in the market.
There is a lot of criticism of the use of derivatives in Islamic finance because they are viewed as being speculative and the worst form of innovation by Islamic financial institutions. Some of the criticism is warranted, where derivatives are used for speculative purposes unrelated to some other economic activity. There is a legitimate concern that it is difficult in most cases to determine the underlying intent behind a derivatives transaction, which has made it hard to justify the use of derivatives at all.
On his blog, Humayon Dar describes a hypothetical wa’d based structure for a foreign currency swap used by a company importing soya beans from the U.S. The result of the transaction is that the importer is hedged within a small band (Rs. 99 and Rs. 100 per US#) against fluctuations in the PKR/USD exchange rate. The mechanics of the transaction involve two promises, one from the bank to exchange rupees at $0.01 per rupee and a promise by the importer to exchange rupees at Rs. 99 per $1. In terms of options, the transaction would be a collar (holding rupees equal to the purchase price payable in 30 days and being short a call option and long a put option). In the transaction, the exercise price of the wa’ds are different to fulfill the condition that “only unilateral promises (or two or more unequal and non-diagonal promises) are binding”.
The mechanics of the transaction are not unique to the example given of an importer wanting to hedge the price of a commodity being imported, which makes it potentially used for speculation on the movements in the PKR/USD exchange rate. So what conditions could make this applicable as a hedge and not able to be used to speculate on the currency fluctuations?
One potential is to make the currency hedging contract available only to companies that are receiving trade financing from the International Islamic Trade Finance Corporation. That body, a part of the Islamic Development Bank group, provides trade finance to companies in the IDB member countries using murabaha, but only offers financing in US Dollars, Euro, British Pounds and Japanese Yen.
The International Islamic Trade Finance Corporation (ITFC) buys the asset that the company needs and, subject to some conditions (either a parent company guarantee, export credit insurance, or government guarantee) will sell it to the company with deferred payment. The asset is then shipped directly from the supplier to the company and the company pays the ITFC.
This type of trade finance is provided to larger companies directly and is of less applicability to small and medium sized businesses who are still in need of financing. The ITFC has a financing program tailored to SMEs where a domestic bank is placed in the middle of the transaction so that the financing is provided by the ITFC and the credit risk for the company remains with the domestic bank. However, from the ITFC brochure (PDF) it is not clear whether the currency terms are the same as the direct murabaha trade financing provided to larger companies, but it is likely to be restricted to those four currencies).
This is where the wa’d based currency hedge could be used to make the ITFC financing through domestic banks more useful for SMEs who are not likely to absorb currency risks themselves. The structure of the transaction is a two-tiered murabaha financing where the ITFC and the domestic bank enter into a murabaha transaction, as do the domestic bank and company. Both of these murabaha agreements would be in one of the four currencies the ITFC uses. The ITFC buys (and sends payment to the supplier) and resells the asset to the domestic bank deferred repayment, which then turns around and sells the asset on the company (to whom the asset is shipped). Then the domestic bank enters into a wa’d currency swap with the company to provide hedging against currency fluctuations.
This type of transaction could be criticized still for the use of two wa’d with only slightly different exchange rates which circumvents the idea that “two equal and diagonal promises are considered as a contract, and […] gives rise to a binding forward sale contract [which] is not in compliance with Shariah.” However, it does limit the risk that the intent of the transaction was speculation on the exchange rate since it is offered to facilitate international trade in an asset the company needs. This is further supported since, in Malaysia for example, it is not permissible to charge a fee for the wa’d for currency hedging. The bank instead makes a spread between the cost charged by the ITFC and the cost paid by the company for the underlying asset.