The UK Consultation on Islamic Bonds
By Puzant Merdinian, SJ Berwin – Available at: http://www.gtnews.com/article/7556.cfm
This article will briefly analyse the joint consultation paper published by the Financial Services Authority (FSA) and HM Treasury on 10 December 2008 on the regulatory treatment of alternative finance investment bonds (AFIBs). The AFIB concept has been chiefly identified with sukuk (Islamic bonds), but can also refer to any financial instrument with similar characteristics.
The overarching aim of the consultation is to ensure that AFIBs are treated in a consistent manner with other financial instruments exhibiting similar economic characteristics, so as to achieve legal and regulatory certainty in classification of sukuk given their growing importance to the London capital markets. This initiative, in turn, falls within a broader UK government objective as explained in the consultation paper, consisting of:
1. Enhancing the UK’s competitiveness in financial services by establishing the UK as a gateway for international Islamic finance.
2. Ensuring that everybody, irrespective of their religious beliefs, has access to competitively priced financial products.
The consultation paper is open to responses from the public for 12 weeks from the date of its publication.
Sukuk and Current UK Legislation. According to the leading Islamic standard-setting Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) sukuk standard, sukuk (sakk in the singular) are defined as “certificates of equal value put to use as common shares and rights in tangible assets, usufructs and services or as equity in a project or investment activity.” Sukuk usually take the form of trust certificates typically issued by a special purpose vehicle (SPV) situated in a jurisdiction with a low or nil tax regime. The SPV issuer purchases Shariah-compliant assets backing the sukuk from the sukuk originator, who is also the ultimate borrower in the structure. In addition, the SPV issuer is a trustee holding the sukuk asset property on trust for the sukuk holders, who in effect end up owning undivided beneficial ownership interests in the sukuk property. Since one of the principal tenets of Islamic finance is that debts can not be traded below or above their par value, this structure makes it possible for the sukuk to be tradable (as it represents interests in assets rather than debts), which is essential for fixed income capital market instruments.
Sukuk are one of the most prominent Islamic financial instruments. The consultation paper says “according to a recent industry survey, the UK has over £18bn worth of Shariah-compliant assets, the eighth largest amount in the world”, and adds that since July 2008 “there have been 18 AFIB issuances listed in London, valued at more £6.5bn.” Classifying Islamic financial instruments, such as sukuk, under the existing regulatory regime in the UK has posed challenges, as it is difficult to map these products completely in the various and moving parts of the existing legislation. Although AFIBs are designed to replicate the economic characteristics of conventional fixed income securities, the variety of underlying Shariah-compliant structures utilised in sukuk issuances makes it difficult, under the existing legislation, for all such instruments to be consistently classified as bonds. Therefore, a determination is made by the regulators on a case-by-case basis, with some sukuk ending up being classified as guaranteed bonds (when the sukuk is of the so-called ‘asset-based’ type) and others falling within the definition of a Collective Investment Scheme (CIS) as set out in the Financial Services and Markets Act (FSMA 2000) (when the sukuk tends to be of the so-called ‘asset-backed’ type).
A detailed discussion as to the structural differences between ‘asset-based’ and ‘asset-backed’ types of sukuk is beyond the scope of this article. In brief, although asset-based sukuk may have underlying assets in the structure, they essentially require some form of Shariah-compliant guarantee or a purchase undertaking from the borrower to the SPV issuer. Therefore, although in theory all sukuk are documented as limited recourse obligations of the SPV issuer, in reality the investment decisions of the sukuk holders are based on the credit strength of the borrower. By contrast, in asset-backed sukuk, the risk is truly related to the performance of the underlying assets and these securities are akin to conventional asset-backed securities. As a consequence, the credit rating agencies may assess the two different types of sukuk differently, choosing, in the case of the asset-based sukuk type, to evaluate the credit strength of the ultimate obligor, rather than probability of default (as in the asset-backed sukuk), which creates additional divergence in the analysis of various sukuk structures.
New FSA and HM Treasury Proposals
The varying classifications of sukuk create legal uncertainty. For example, if classified as a CIS, sukuk are subject to increased regulation both at the SPV issuer level (including authorisation costs and periodic fees) and at the distribution level, since the regulatory regime for distribution of CIS is more complex than that for the distribution of bonds.
In order to align the regulatory treatment of AFIBs with conventional fixed income securities, the FSA and HM Treasury are seeking to introduce legislative changes. The consultation paper sets out four policy options. The FSA and HM Treasury’s preferred option does not distinguish between private and public issuance of AFIBs. Under this policy option
* The FSMA 2000 (Regulated Activities) Order 2001 (RAO) would be amended to include AFIBs as a specified investment on the same basis as instruments creating or acknowledging indebtedness.
* AFIBs would be explicitly excluded from the CIS definition by amending the Schedule to the FSMA 2000 (Collective Investment Schemes) Order 2001 (CIS Order).
* A unique definition of AFIBs would be created, consistent with relevant tax legislation (that is, Section 48A of the Finance Act 2005).
In addition, the consultation paper proposes that all AFIBs should be subject to mandatory listing requirements on a recognised stock exchange, in order to avoid the arbitrage risk resulting from the proposed legislative changes (i.e. the risk that the exclusion of sukuk issuances from being classified as a CIS is exploited by instruments not intended to be so excluded). A draft statutory instrument making these amendments to the RAO and the CIS Order is included as Annex B to the consultation paper. The remaining three options outlined in the consultation paper, all of which are considered inferior by the FSA and HM Treasury, are as follows:
This option is substantially the same as Option 1. However, it proposes that AFIBs are defined in the existing tax legislation contained in Section 48A of the Finance Act 2005. Option 2 would be inferior to Option 1 since:
* Changes to the definition for tax purposes may have unintended consequences for the regulatory regime.
* Some of the existing tax provisions are not relevant for regulatory purposes.
* There may be differences in interpretation by tax and regulatory authorities leading to uncertainty for market participants.
This option is also substantially the same as Option 1, except that instead of creating a new category of specified investment, AFIBs will be included in the list of instruments in an existing specified investment under Article 77 (instruments creating or acknowledging indebtedness) and Article 78 (government and public securities) of the RAO. Option 3 would also be inferior to Option 1 since it would distinguish between AFIBs issued by the private and public sector, which is not believed to be the government’s intention. The implementation of Option 3 would also result in the creation of a lengthy article covering a number of different instruments or in the need to define AFIBs in a separate section of the RAO as a result of the fact that Article 77 of the RAO only defines some instruments creating or acknowledging indebtedness.
Do nothing. As already discussed, this would mean that the regulatory treatment of sukuk would be based on the interpretation of existing regulations, which market participants are concerned leads to regulatory and legal uncertainty.
Cost Benefit Analysis of New Proposals
The consultation paper explains that it would be necessary for it to perform a cost benefit analysis when implementing its preferred legislation contained in Option 1, in light of: the increased costs associated with upgrading the FSA technology platforms to accommodate AFIBs; and costs associated with the proposed mandatory listing of AFIBs. By way of example, the consultation paper says the cost of implementing the Markets in Financial Instruments Directive (MiFID), which according to the government was a much larger exercise, was £1m. Therefore, although it is possible that the above described additional costs of implementing Option 1 may be material, the benefit from increased sukuk issuance and tradability is likely to outweigh any such cost increases.
If Option 1 is implemented, the consultation paper states that AFIB issues will be subject to marginally higher one-off costs resulting from them being listed as debt securities (approximately £10,000 per issuance, according to the consultation paper), but marginally lower on-going costs (approximately £5,000 per issuance per year). Further, the consultation paper provides an estimate, by way of example only, according to which, in present value terms, for an AFIB of duration of five years or less total cost savings for an issuance are estimated to be around £35,000 per annum (as set out in the FSA’s Collective Investment Schemes Handbook). The consultation concludes that implementing Option 1 would lead to cost savings in the long run.
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