Sukuk: An Overview

INTRODUCTION

Over the years, the international and domestic capital markets, in exploring various
forms of funding options, have facilitated the prominence of ethical-based debt
financing. In recent times, the government and corporate entities in Nigeria have
increasingly been accessing the capital markets to attract funding from investors
inclined to a peculiar form of ethical-based debt instruments known as "Sukuk".

Sukuk refers to sharia-compliant financial instruments representing undivided

interests in the ownership of defined assets. Sukuk are based on prescribed
principles of Islamic law, and "Sukuk" as an Arabic term relates to investment
certificates or notes that indicate: Proportionate interest of the holders in the
ownership of tangible assets, usufructs, and services; or investment in the assets of
particular projects and activities that adhere to the principles of sharia.

A typical Sukuk transaction is similar to a conventional bond issuance, wherein the

investor (in this case the Sukukholder) is entitled to receive income from the assets
or projects that the invested funds were used to finance. In a Sukuk, the issuer of
the Sukuk (e.g, the government or a sponsored special purpose vehicle) sells an
investment certificate to Sukukholders at a pre-determined price. The issuer, or
where applicable, the government, then uses the proceeds from the sale of the
investment certificate or note to finance an asset or a project, such as a road
construction. In return, each Sukukholder holds partial ownership of this asset and
is paid an income according to the terms of the parties' agreement. However, unlike
conventional bonds, the structuring of Sukuk requires sharia-compliant underlying
asset and adherence of the structure to Islamic law.

Islamic law principle prohibits the lending of money with interest payments,
thereby forbidding the use of conventional bonds for financial transactions. Sukuk
is therefore used as an alternative to conventional bonds, and it does not indicate
the existence of any debt obligation as the issuer uses the proceeds from the
certificate to purchase an asset, of which the investor also receives partial
ownership.

As a financing mechanism, the aim of a Sukuk is to connect liquid entities with

persons who require capital to finance the purchase of an asset or the execution of
a project. This ensures that persons who have capital are provided with an avenue
to invest in certificates or notes, subject to an agreement to receive returns over a
period.

Sukuk definition:
Sukuk, often referred to as "Islamic bonds," are financial instruments used in
Islamic finance that comply with sharia principles. Unlike conventional bonds that
generate interest, Sukuk represent ownership in an underlying asset or project,
allowing investors to earn a share of profits rather than interest.

Regulation of Sukuk in Nigeria

The concept of Sukuk is as old as Islam. Islamic communities had used Sukuk as
"papers" to represent financial commitments that originate from trade and other
economic transactions. Historically, the first Sukuk transaction is stated to have
taken place in Damascus, Syria, in the 7th century.

The modern resurgence of Sukuk has been propelled by the renewed recognition of
the concept by the Islamic fiqh academy of the organization of Islamic countries,
and the Accounting and Auditing Organization of Islamic Financial Institutions
(AAOIFI). These institutions are standard-establishing organizations in the Islamic
finance industry and have enabled Sukuk structures to be developed leading to the
first successful modern issuance of Sukuk by the Malaysian government in 1983.

Under Nigerian law, Sukuk is regulated by the provisions of the Securities and
Exchange Commission rules 2013 (as amended) (the SEC rules) and the
investments and Securities act, while the primary regulator is the Securities and
Exchange Commission (the SEC). In addition, the Nigerian exchange limited,
FMDQ exchange limited and FMDQ private markets limited have also prescribed
rules and regulations governing the listing of Sukuk on their respective platforms.
Pursuant to the SEC rules, public companies, special purpose vehicles, the
government, state governments, local governments, and government agencies, as
well as multilateral agencies, are eligible to issue, offer or make an invitation of
Sukuk upon seeking the SEC's approval.

Specifically, the SEC rules provide that the issuer of a Sukuk shall appoint a SEC
registered Sharia adviser of good repute and character, adjudged to be sound and
with necessary qualification in Islamic fiqh or Islamic jurisprudence, Islamic
finance and capital market. The Sharia adviser shall deliver to the SEC a
documentary pronouncement on the Sukuk's compliance with Sharia law. Further,
the SEC rules prescribe that an underlying asset, whether tangible or intangible,
shall be made available by the issuers as a condition precedent to the issuance of
the Sukuk. It is important to note that the purchase price of the underlying asset
must not be more than 1.5 times its market value. In the same vein, the issuer is to
ensure that the certificate or notes in connection with a Sukuk issuance is rated,
and the rating must be made available throughout the tenure of the Sukuk issue.

Structuring Sukuk transactions in Nigeria

In structuring Sukuk transactions, the factors to consider include:
 Whether or not there will be a transfer of title.
 The nature of assets;
 applicable tax and zakat.
 Tradability of the Sukuk; and
 The applicable laws.

Forms/ types of Sukuk

There are forms which Sukuk transactions may be structured in, as approved by the
AAOIFI. However, only four Sukuk structures are recognized by the SEC which
may be adopted individually or combined based on the issuer's need.

1. Sukuk al-ijarah (lease contract)

Some schools of thoughts consider the ijarah Sukuk as the classical Sukuk
structure and some analysts consider that it is the most used structure. These
are based on the principle of "ijarah," which is like a lease contract.
 Investors buy Sukuk that represent ownership in a tangible asset, and they
receive periodic rental payments from the issuer. This structure involves the
sale and lease-back of assets in existence (eg, real estate, plant and
machinery, aircraft, and ships, as well as other tangible assets), which can
also be structured as a master lease or sublease arrangement. The rental rates
of return on Sukuk ijarah can be fixed or floating. The cash flows from the
lease which comprise of rental and principal repayments are passed through
to Sukukholders in the form of coupon and principal payments. This
structure was adopted for Nigeria's novel Sukuk issuance by the Osun state
government.

2. Sukuk mudarabah Sukuk:

These are based on the concept of "mudarabah," which is a partnership
where one party provides the capital (investors) and the other provides the
expertise (issuer). Profits are shared according to a pre-agreed ratio, while
losses are borne by the investors.

3. Sukuk al-istisnah (exchange contract):

Sukuk al-istisnah is also referred to as an exchange contract. This structure
involves the sale of an identified asset, with an obligation on the part of the
seller to manufacture or construct, using his own materials and to deliver the
constructed goods or project on a pre-determined date in return for an agreed
price to be paid as a lump sum or in instalments. It is typically curated for the
sale of goods or commodities to be produced in the future. The structure is
especially suitable for financing large infrastructure projects.

4. Sukuk al-musharakah (sharing contract)

The musharakah Sukuk structure involves a sharing contract. It is a
partnership between an entity, usually a special purpose vehicle and an
obligor, wherein they contribute funds and jointly own the assets purchased
with proceeds of the issuance. The musharakah structure is the most suitable
structure if the originator does not own an actual tangible asset or does not
have sufficient funds to purchase such an asset to permit an ijarah structured
on a sale and leaseback arrangement.
5. Sukuk al-murabaha (financing contract)
This Sukuk structure essentially involves a financing contract, and it is
typically used where no tangible underlying assets can be identified in the
issuer or originator's business or operation. Sukuk murabaha takes the form
of a sales contract whereby commodities are sold at a price which includes
the purchase price, plus a margin of profit agreed upon by both parties
concerned. Typically, proceeds from the issuance of Sukuk are used to
purchase and take title of the commodities from a supplier or vendor and sell
to the Sukuk originating entity at a cost, plus a reasonable profit payable in
the future. This structure entails the seller disclosing in advance to the buyer
the profit to be made in the transaction.

6. Wakalah Sukuk:
These are structured based on a "wakalah" contract, where investors provide
funds to the issuer, who acts as an agent (wakil) to manage the funds and
invest them in sharia-compliant activities. Profits are shared between the
issuer and investors.

7. Salam Sukuk:
These Sukuk are connected to the "Salam" contract, which involves the sale
of goods in advance with deferred delivery and payment terms. The issuer
raises funds by selling Sukuk and uses the funds to purchase goods. Profits
are generated when the goods are sold.

8. Convertible Sukuk (Sukuk al-iltizam):

These Sukuk allow investors to convert their Sukuk into shares of the
issuing company's stock under certain conditions that is they combine
features of both Sukuk and convertible Securities this provides an added
layer of flexibility to the investment.
 Apart from the structures stated above, the SEC may also approve innovative
Sukuk structures from time to time. Since Nigeria's first Sukuk issuance in 2013
by the osun state government, which was utilized for the construction of 26
schools by the state government using ijarah Sukuk of 11.4 billion naira
(approximately $27.5 million), Sukuk issuances in the Nigerian financial markets
have been infrequent. Some of the major issuances are:

 Construction of luxurious apartments in ikoyi – lagos by lotus capital

limited, using 1 billion ($27.4 million) of private Sukuk of al-istisna; and
 Construction of roads by the federal government, using ijarah Sukuk of 100
billion ($241 million).

Parties to a Sukuk
The professional parties and transaction documents required in a Sukuk largely
depend on the structure adopted by the parties. In practice, the parties to a Sukuk
issuance include:
a) The issuer (this is usually the government, corporation)
b) Investors (individuals, institution, etc)
c) Financial advisor or issuing house.
d) Trustees (a neutral third party that represents the interest of the investors)
e) Solicitors; and
f) The receiving bank and Sharia adviser ( Islamic scholar or board of scholars
who ensure that the Sukuk structure and the underlying assets comply with
Islamic principles)

Key features of Sukuk

The key features of Sukuk are the following:

a) Sukuk represent the proportionate ownership of the underlying assets

b) The Sukuk proceeds must be used only on Sharia-compliant activities.
c) The trading of Sukuk in the Secondary market, allowing investors to buy or
sell them before maturity needs to comply with Sharia requirements.
 d) Sukuk holders do not earn interest; instead, they receive a share of the
profits generated by the underlying asset or project.
e) Sukuk need to adhere to sharia principles, including the prohibition of
interest (usury) and the avoidance of investments in industries like alcohol,
gambling, and pork.
f) Sukuk are often issued by governments, corporations, and other entities to
raise funds for various projects, including infrastructure development and
business expansion.

Benefits of Sukuk
Sukuk complies with sharia principles while boosting the standard of living in
society and assisting the economy. However, Sukuk also brings several other
important benefits. Sukuk:

Future of Sukuk in Nigeria

The Sukuk market is currently attracting attention globally. It is expected that it
will continue to attract more attention, especially from some of the world's largest
institutional investors who may consider Sukuk as the most effective way of
investing in emerging markets and diversifying their investment portfolios in
Nigeria.

In the coming years, more Sukuk issuances from multi-national corporations will
likely surface, especially those with significant operations in the muslim societies.
In november 2009, in an attempt to diversify its source of financing, general
electric, a company ranked in fortune 500, became the first global multinational
corporation entrant into the Sukuk market, with a $500 million issuance to
investors in the middle east, asia and europe. Since then, more multi-national have
followed suit.

According to the global Sukuk market dashboard issued by fitch ratings, the global
outstanding Sukuk as of the third quarter of 2021 is approximately $775.4 billion.
Sukuk supply is expected to rise in the first quarter of 2022 after it showed strong
growth during 2021, supported by strong investor appetite and issuers' refinancing
and funding diversification needs.

In Nigeria, Sukuk bonds are a viable investment option and are beginning to gain
more investors' attention and confidence. The debt management office recently
listed the 162.557 billion naira ($292 million), seven-year, government ijarah
Sukuk with a rental rate of 11.20% on the floor of the Nigerian exchange limited
and FMDQ Securities exchange limited, which further confirms the viability of
Sukuk as a financing option. There are approximately 90 million muslims residing
in Nigeria and this population creates a reasonable mass for Islamic finance in the
retail, corporate and sme landscape, all of which could help grow both corporate
and sovereign Sukuk issues in Nigeria.

Also, on 28 october 2021, the national pension commission (the commission)

announced the introduction of the non-interest fund and issuance of its operational
framework for the non-interest fund. The introduction of the non-interest fund is in
furtherance of the commission's objective to provide diverse investment portfolio
options, and to meet the increasing demand by pension contributors and retirees to
invest in non-interest ethical instruments. Based on the regulation on investment of
pension fund assets issued by the commission in 2019, pension fund administrators
are permitted to invest pension fund assets under their management in Sukuk and
other Sharia non-interest compliant instruments registered with the SEC.

Challenges and considerations:

a) Standardization: lack of standardization across Sukuk structures and
contracts can make it challenging for investors to compare and assess
different Sukuk offerings.
b) Liquidity: SECondary market liquidity for Sukuk can vary, impacting the
ease of buying and selling.
c) Regulatory environment: regulatory frameworks for Sukuk issuance and
trading can differ between countries, affecting cross-border investments.
d) Risks: as with any investment, Sukuk carry risks, including project-related
risks and market fluctuations.

Sukuk market and growth:

The Sukuk market has witnessed significant growth since its inception, with
increasing participation from governments, corporations, and financial institutions.
It has become a vital component of Islamic finance and has attracted interest from
both Islamic and non-Islamic investors seeking sharia-compliant investment
options.

Conclusion:
Sukuk, as sharia-compliant financial instruments, offer investors an alternative to
conventional bonds by focusing on ownership and profit-sharing rather than
interest. With various types of Sukuk available and an evolving market, they
provide a unique investment opportunity for those looking to align their
investments with Islamic principles while participating in diverse SECtors of the
economy.