Boarding Complete: An Islamic Rendering
Part II of II
In our previous issue, we discussed the Shariah principles of ijara, simple ijara, ijara wa iqtina, ijara mawsufa fi al dimmah, istisna’a, and how ijara and mawsufa fi al dimmah work. Our attorney’s had detailed the different types of leasing provided by Shariah law. But there is more yet to come. This Part II of the article gives a detailed description of sukuk, murabaha, mudarabah, and how financial leasing applies to the leasing of aircrafts.
What may be surprising from a Western perspective is the ingenuity and reliance on Islamic principles such as those detailed previously and below regarding financial leasing. The ban of levying interest is an intricate art of financing which questions the very business nature of forward-thinking financial institutes and other entities dealing with financial matters. So, continue reading to understand further the principles ascribed by Shariah law and their implementation.
Sukuk is a form of an asset-backed trust certificate (bond) which is issued to the investor as evidence of ownership of an asset or part ownership or its usufruct (earnings) based on the principles of Shariah. Sukuk differs from conventional bonds regarding asset ownership, investment criteria, issue price and unit, investment rewards and risks, and effects and cost. Unlike conventional bonds which can be issued without underlying assets, Sukuk is always issued upon underlying tangible asset either in ownership or an underlying master lease agreement, Sukuk Al-ijara. Accordingly, the Sukuk represents a share in an underlying asset whereas an ordinary bond accounts for a share of the debt. The conventional bondholder may get a principal amount upon bond maturity or coupon payment while Sukuk investors acquire shares of profits from an underlying asset. The Sukuk can be tradable or nontradable. The types of Sukuk certificates are based on al salam, murabaha, muskarakah, mudarabah, and ijarah.
Typically Sukuk Al-ijara is commonly used for aircraft financing. In this type of transaction, a special purpose vehicle (SPV) will purchase the asset and lease it ultimately to end-user who wanted to use the asset under structured arrangements. An SPV will issue Sukuk certificate under note issuance facility to entitle the holder of Sukuk an ownership and right to receive a proportion of rental payment. The particular transaction is provided below under the heading ‘how does Islamic financial leasing work for aircraft leasing.
The Murabaha is simple but extensively used as a buy and sell technique also known as cost-plus financing. In a Murabaha transaction, the client seeks to finance from a financial institution. The seller in this transaction is obligated to disclose to the buyer or the client the cost price of the asset. Typically, the client approaches the financier for funding the purchase of the asset; the financier will purchase the asset and take the necessary title either directly or through an agent and may use it's own fund or fund invested by investors. The financier discloses cost as well as the profit margin for financing to its client. The financier then sells such asset to a client with a cost and a profit margin disclosed. The client can make deferred payment terms. Some schools questions this type of transaction, but it remains acceptable by most schools because by purchasing the asset the financier assumes the risk attached to the asset and therefore such a risk entitles the financier to profit while selling. As a fixed price is typically set at the start of the transaction the client has no influences as to variations in the base lending rate and the transaction is not affected by gharar.
The following example will make clear the process of such a transaction. The financier and bank enter into a Murabaha agreement with the client, later the client is appointed as an agent to purchase goods on the financier's behalf, and the financier will disburse such money to the client for the purchase of goods. The client takes possession in the name of the financier. Therefore, transfer of the risk to the financier as an owner takes place. Upon purchase, the client will offer to purchase and upon acceptance of such offer the sale concludes with a transfer of title.
It is a profit sharing and trust financing technique wherein many investors pool their funds together and become shareholders in major financial projects. This transaction is a form of partnership by an equity type investment wherein one partner provides capital (rabb ul amal), one that is commonly the beneficial owner, the other party manages the investment and is responsible for operations and the management of the business (Mudarib). The financier acts as Mudarib and finances large projects on behalf of investors. The financier may put its funds or act on behalf of depositors with the financier serving as a trustee for the investors and thereby assumes fiduciary responsibilities. Alternatively, the financier can provide funds to the client who acts as Mudarib. The partners acting as investors and the one managing the business must distribute the profits by a fixed and pre-determined ratio. In case a financier acts on behalf of depositor-investors, the fixed financier's share is from the revenue generated who in turn pays its depositors all the profits received after deducting its fees.
The losses and profits under Mudarabah are born due to an investor (rabb ul-amal). Accordingly, the loss is carried by investor unless negligence, misconduct can be attributed to, or any terms of the contract that are breached by, the Mudarib. Any assets acquired by Mudarib are in possession of investor and managed by Mudarib on behalf of investor's. Financiers utilize the Mudarabah funds for further Islamic transactions such as Murabaha, ijara’a, or Istisna’a, etc.
How does Islamic financial leasing work for aircraft finance?
After the global financial crisis in 2007 – 08 the use of Sukuk as alternate funding source was used by aviation sector. UAE was the largest Sukuk market in the middle east in 2011 with 69% of Sukuk issuance in logistics and real estate market which was overtaken by Kingdom of Saudi Arabia (KSA) in 2012 according to Zawya reports. However, the International AirFinance Corp’s launch of a US Dollars 5 billion Shariah-compliant aircraft leasing fund represented the first time exclusive utilization of an Islamic finance structure for their aircraft financial leasing operations. Further, Dubai Islamic Bank (DIB) and Air Arabia announced the signing of an aircraft financing deal in November 2014 to facilitate the delivery of six new Airbus A320 aircraft's in 2015. Increasingly, the Islamic aircraft lease financing is in use by international airlines including, Etihad Airlines, Saudi Arabian Airlines, Air Arabia, Emirates, Malaysian Airlines, Turkish Airlines and by some of the world's largest aircraft leasing companies. Air Arabia has received a total of 29 of the 44 A320 aircraft's it ordered from Airbus in 2007 though the use of Islamic financing arrangement with DIB.
We will now consider the Islamic structure of ijara being used in practice. The Sukuk al-ijara is most commonly used technique for aircraft leasing. In this transaction, the owner (lessor) assigns the right to use aircraft to an airline company (lessee) for a pre-determined monthly rental payment. The operation is not simple as it seems by the statement above hence it will be explained with the examples as employed below:
I. The airline company wishes to purchase an aircraft and plans to raise finance through the issuance of Sukuk. Identification of the seller or supplier of the aircraft occurs, and negotiations are entered into and finalized between the seller and airline company. Next, an SPV is created by the airline company as a separate company or such structure as deemed fit, which is 100 %, i.e., entirely owned by the airline company. (The rationale behind creating an SPV to purchase the asset is that airline companies often prefer to keep their fleet new and cannot afford to continue the purchase of new aircraft as per the changes in new technologies that are entering the market due to innovations of leading aircraft manufacturers.) The SPV will then issue Sukuk certificates and receive the proceeds which are used to purchase new aircraft from the manufacturer or seller. Now the SPV will hold the aircraft as a trustee for the investors and will lease the aircraft to the airline company under the ijara arrangement. Later as per the ijara arrangement between the airline's company and SPV, the airline's company will pay rentals to SPV for tenure and amount matching the Sukuk coupon's amount and tenure. The SPV will then pay investors through a semi-annual coupon distribution of value. Airline companies may grant irrevocable purchase undertakings to buy the aircraft on the maturity of Sukuk. Upon maturity, the SPV redeems the trust certificate for investors at the dissolution of the SPV. The SPV will receive the purchase price from the airline company at dissolution. The purchase price given by the airline company will be the initial purchase price of aircraft plus service or managing fees. The aircraft is transferred to the airline company upon payment to SPV/Sukuk holder.
II. The other option that can be used by airline companies is that they may purchase the aircraft and sell it to SPV which will lease it back to the airline company. This transaction is called sale and leaseback. In any of the above scenarios, the SPV will act as a trustee for Sukuk holder after issuing Sukuk certificates. SPV will hold the aircraft as an asset in its balance sheet or place the asset in trust. Again the same process of receiving proceeds from investors and paying investors proceeds from lease amount proportional to their share and ownership in the asset will follow.
III. Usually, in the above scenarios, the lessor, i.e., SPV under such Islamic transaction being the owner of the aircraft remains liable for ownership taxes, if any, major maintenance and hull and equipment insurance. However, in practice should neither the lessor nor airline company wish such responsibilities to be taken upon by the lessor. Therefore, the lessor will appoint the airline company as service agent and thereby repay the service agent (airline company) these costs. Ordinarily, these repayment obligations endured by the lessor will be paid pack to the lessor by the airline company in the form of extra rent to set off. Therefore, the liability passes to the lessee but in Shariah compliant ways.
IV. In case, the financier such as a bank or financial institute is financing the aircraft they would prefer acting as an investor (rabb ul amal) and enter into mudarabah with the SPV (mudarib) who will be an investment manager. Under this mudarabah, the financier will pass their funds to mudarib for its use in agreement with the investment strategy. The mudarib (SPV in this case) will hold a small proportional interest in profits and will not be responsible for any losses except such losses which are caused by its negligence, misconduct or fault.
The Airfinance Journal examines the financial structures of global airlines and rewards the best financing structures in different categories. The case study of some award winning deals will make clear to the readers the practical implementation of Islamic financial leasing transactions.
In 2008, the transaction between Etihad and Al Hilal Bank, Abu Dhabi (the Bank) won Airfinance's Award for Journal Middle East Deal of the Year in 2008 for financing structure of an Airbus A340-600 for Etihad. The transaction documents involved were ijara and mudarabah. The Islamic financier appointed a Bank as an investment agent by entering into Investment Agency Agreement. The Bank as an investment agent entered into a mudarabah agreement with the SPV. This SPV was a Cayman Islands company. The Bank was acting as an investor (on behalf of Islamic financier as investment agent) hence it was rabb ul-amal, and SPV was mudarib. Under this investment strategy, the SPV acquired the Airbus and then leased it to Etihad by use of the funds given by the Bank as an investor. The Bank as an investment agent entered into an administrative agency agreement with the SPV and SPV appointed the Bank as an agent of mudarib for performing certain actions. The proceeds received by SPV, as the mudarib, with a small deduction in a percentage of profits were payable to the Investment Agent i.e. the Bank under the mudaraba agreement. Distribution of the profits received by the Bank to the Islamic financiers will take place under the Investment Agency Agreement.
The SPV also entered into ijara with Etihad and appointed Etihad as its service agent. The lease payable by Etihad included fixed rents, variable rent and an extra sum to set off the reimbursements obligations owned by SPV as lessor, to Etihad as the service agent.
Another recent example of exceptionally innovative financing structure was carried out by Emirates known as Emirates ECA Sukuk. This is first ever Export Credit Agency (ECA) backed Sukuk transaction. In this deal, the Khadrawy Limited (Cayman Islands) incorporated SPV issued certificates, which comprised US Dollars 913 million Sukuk due in 2025. The Sukuk has ten-year tenor and were listed on London Stock Exchange and NASDAQ Dubai. The proceeds of this Sukuk have used for pre-funding the aircraft financing of four Airbus A380-800 aircraft. The pre-funding issues were managed by an innovative combination of ijara and manfa’a (sale of the right to use the asset for a pre-determined period) wherein the tangibility of aircraft during the pre-funding period was overcome by usufruct represented by tone kilometers.
The deals in Islamic financial structures have not only garnered the attention of Muslim states but have also earned appreciation from Western countries, countries in Europe, Asia and other parts of the world, who are actively exploring the Shariah ways of investments and financing. The appreciation of Shariah principles has explored further ways of addressing the concerns of the conventional financing industry and sponsors. Our GCC based firms will be happy to structure and assist you with your ventures for explorations into Islamic financing transactions.