Religious scholars are imposing tougher rules on the sale of Islamic bonds to investors after stating that most of the securities may not fully conform to the teachings of the Muslim faith.
Investors bought $30 billion of so-called sukuk in the past year that avoid breaching Shariah law prohibitions on the payment or receipt of interest by using property or other assets to provide an income, according to data compiled by Bloomberg. New guidelines demand that investors become the legal owners of those assets rather than nominal holders, the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions said on its Web site.
The rules from AAOIFI's board of 18 religious advisers led by Chairman Sheikh Muhammad Taqi Usmani will make it harder for companies to issue Islamic debt at a time when borrowing is already shrinking because of the global credit crisis. Sales of sukuk dropped to $856 million so far this year from $4.7 billion in the first quarter of 2007, Bloomberg data show.
''This is a paradigm shift and will make life difficult for chief financial officers used to the existing structures,'' Moody's Investors Service analyst Khalid Howladar said in a phone interview from Dubai today.
Shariah restricts investors to transactions based on the exchange of assets rather than money alone, so interest payments are banned. Working with Islamic advisers, banks including Citigroup Inc. and HSBC Holdings Plc have built the market for sukuk to $60 billion from almost nothing in a decade, based on Bloomberg and Standard & Poor's data.
Borrowers and their bankers until now created a fixed income for investors by promising to buy back the assets underlying sukuk at their face value on maturity, irrespective of whether the assets made or lost money, Moody's Howladar said. These types of agreements are banned under the tougher rules because Shariah demands buyers and sellers share profits or losses from their transactions.
''Blemishes'' have crept in that the industry must now ''rid'' itself of, AAOIFI's board of scholars said last month. As much as 85 percent of sukuk sold to date may not comply with all the precepts of Shariah, the board said.
The new rules force issuers of sukuk to legally transfer the ownership of assets to bondholders. The assets must be tangible rather than a cash flow.
''What the scholars are trying to do is make sukuk asset- backed rather than just asset-based,'' said Arul Kandasamy, the Dubai-based head of Islamic finance for Barclays Capital.
Borrowers won't have to restructure bonds already sold to comply with the new guidelines, AAOIFI financial consultant Majd Bakir said in a phone interview from Bahrain.
Jebel Ali Free Zone FZE, Dubai's state-run operator of a business park adjoining the Jebel Ali port, raised $2 billion in the biggest sale of sukuk from the Gulf in the past six months. Buyers of the bonds have no legal claim on the underlying assets and have an ''implicit guarantee'' the issuer would cover any payment shortfalls, S&P said in a report in January.
Banks and borrowers rely on approval from recognized Shariah scholars to be able to sell their sukuk to devout Muslims. Sheikh Usmani advises the Islamic finance unit of HSBC, the No. 2 underwriter of sukuk last year, according to Bloomberg data. Usmani didn't respond to two e-mails seeking comment on the rules.
Fellow AAOIFI board member Sheikh Mohammed Elgari advises Citigroup and Merrill Lynch & Co., and Sheikh Nizam Yaquby advises banks including BNP Paribas SA, Lloyds TSB Group Plc and Standard Chartered Plc, according to HSBC.
AAOIFI accounting standards are binding in six Arab countries and the Dubai International Financial Centre, a base for banks including Goldman Sachs Group Inc. and UBS AG. Regulators in countries including Malaysia, Saudi Arabia, Australia and South Africa base their rules for sukuk on AAOIFI's guidelines.
While the rules will mean ''slightly'' higher costs on sukuk until the new structures become commonplace in about a year, clarity on the guidelines is positive for the market, said Haris Irfan, a Deutsche Bank AG director responsible for Islamic finance in Dubai.
It will ''give comfort to some investors who had shown concern'' about the scholars' comments on Shariah compliance, said Irfan. ''We're already moving away from guaranteed returns to more risk-sharing structures'' for planned sales, he said.
Companies planning sukuk sales include Bahrain Islamic Bank, which on March 11 said it plans to raise as much as $664 million from the securities to finance expansion. The U.K., Japan and Thailand are among governments that may sell sukuk, helping the market grow to $200 billion by 2010, Moody's said in a report last month.
''The likely impact of this is that either the sukuk market becomes more based on Islamic securitizations or it bifurcates, with some sales becoming truly asset-backed and other issuers choosing to continue with existing structures,'' Moody's Howladar said.
