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Wednesday, 28 May 2008

A Look at Musharakah Bonds



Riyadh, Asharq al-Awsat- Musharakah Mutanaqisah bonds rank second in volume within the sukuk [Islamic bonds] market. What is meant by Musharakah Mutanaqisah bonds is that the financier (the issuer) regularly purchases his partners’ (sukuk holders) shares in the project until their full shares are purchased, which is called Idfa al Sukuk [full acquisition of bonds].

Such bonds are used to finance real estate and infrastructure projects, which are characterized by flexibility in issuance conditions. This means that the financing project need not already exist and the bonds may be issued to finance its construction or develop an existing project. Moreover, the issuing company is capable of using its assets as a share in these bonds, and the bonds are characterized by flexibility in the distribution of profits between the issuer and the sukuk investors.

Musharakah bonds represent part-ownership of a particular project. Although they are similar to shares, they are subjected to a limited duration of time and can also be adjusted to have a higher ceiling of profit for sukuk holders.

But Musharakah Mutanaqisah bonds have recently come under fire in jurist circles due to the presence of a commitment made by the issuers of some of these bonds to repurchase the bonds from holders using historical cost or predetermined values. The origin of this controversy lies in the fact that this commitment guarantees a given partner’s capital, which is prohibited by Islamic Shariah since Shariah provisions stipulate that there are “no rewards without risks” and that “profits must be accompanied with liability” in accordance with the Islamic Hadith. Furthermore, under this commitment, the partner’s capital is transformed into a loan and therefore, any increase in the loan value falls under the type of interest that is prohibited by Shariah.

However, the presence of such non-compliant Shariah elements does not invalidate these bonds and nullify them from the structure of Islamic bonds; rather the error must be rectified and Shariah-compliant alternatives must be sought to cover the risks that arise in the absence of such commitment.

One of the alternatives is to raise the return on these sukuk so that there can be an even proportion between risks and returns.

It is unreasonable that the return on these sukuk is calculated according to SIBOR (Singapore Interbank Offered Rate) and LIBOR (London Interbank Offered Rate), where the risks are almost absent with the exception of the usual credit risks entailed in this kind of finance.

This explanation of Musharakah Mutanaqisah bonds could be considered a preface to the subject matter, namely, the use of Musharakah bonds in financing the establishment of the King Abdullah Financial District (KAFD) which is a project owned by the Public Pensions Agency and is expected to cost 30 billion Saudi Riyals (US $8 billion).

The Agency issues Musharakah Mutanaqisah bonds at each stage of the project so that the assets at each point can be transferred to the company that has been established for specific purposes. At a later stage, the Agency acquires all these bonds by repurchasing them at a price that is specified in the issuer’s prospectus. In the prospectus, the issuer (the Agency) is not obliged to purchase [the bonds]. However, sukuk holders will be obligated to sell to the issuer at the price stated in the prospectus whenever the issuer wants; in this way, the Agency guarantees that sukuk holders will not be able to dispose of the assets, and the profits will be calculated according to the potential risks.

It is permissible to stipulate that the profits gained from sukuk holders should not exceed a certain rate that will be determined in the prospectus. The Agency appoints a bond assets director who will be given the profit surplus of sukuk as an incentive for efficient management.

Following this method to finance the KAFD will accomplish the following interests:

1 – It will provide the project with the necessary finance far from the complications and conditions of bank finance.

2 – It will contribute to absorbing part of the liquidity that exists in the market as a result of the reduction in interest.

3 – This kind of finance, and the financial and administrative requirements and procedures such as disclosure, transparency and administrative governance that it entails, will remain limited within the scope of this project and will not be used as part of the Agency’s other activities contrary to offering the Agency’s real estate branch as a public company.

4 – The bond holders’ ownership of the project is temporary, which will expire when the issuer acquires the sukuk in contrast to finance as it is presented as a public company.

5 – It will allow both institutions and individuals of the private sector to benefit from these massive projects.

6 – It will contribute to the development of the Shariah-compliant capital market in Saudi Arabia.

MUSHARAKAH: the bank provides funding to entrepreneurs, who also contribute capital. Profits from the venture are shared.

* Lahem al Nasser is an Islamic banking adviser.

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