Sukuk market: 4 years after Islamic banking was introduced, there are still glaring Legal gaps in Islamic finance in Uganda

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Last updated on July 14th, 2021 at 12:22 pm

Four years after the Financial Institutions Act, 2004 was amended to provide for Islamic banking, interestingly, there hasn’t been a discussion surrounding how these Islamic banking financial institutions, companies or the sovereign (government) intend to issue Sukuk, an Islamic version of the bonds and bills. Regulators – Bank of Uganda and Capital Markets Authority have been largely mute on this issue.

In its strict sense, a sukuk is an Islamic financial certificate, similar to a bond in western finance, that complies with Islamic religious law commonly known as Sharia. Since the traditional western interest- paying bond structure is not permissible, the issuer of a sukuk sells an investor group a certificate, and then uses the proceeds to purchase an asset, of which the investor group has partial ownership. The issuer must also make a contractual promise to buy back the bond at a future date at par value.

Since Islamic banking was introduced in 2016, I expected Capital Markets authority to align certain regulations of the authority to make the issuing of Islamic corporate sukuk possible. But they are largely asleep, as usual.

The U.K in 2014, became the first sovereign out of the Islamic world to issue sukuk, 200 million pounds worth of sukuk, were issued by the government. The idea was to stimulate Islamic investment in Britain. The £200 million of Sukuk, which matured on 22 July 2019, were sold to investors based in the UK and in the major hubs for Islamic finance around the world. The profit rate on the Sukuk has been set at 2.036% in line with the yield on gilts of similar maturity.


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Britain’s sovereign Sukuk used the Al-Ijara structure, the most common structure for sovereign Sukuk, with rental payments on property providing the income for investors. The Sukuk is underpinned by three central government properties. The issue settled on 2 July 2014, and was to be listed on the London Stock Exchange.

An example of sukuk

The most common form of a sukuk is a trust certificate. Surprisingly, these certificates are governed by western law. However, the structure of this type of sukuk is fairly complicated. The organization raising funds first creates an offshore special purpose vehicle (SPV). The SPV issues trust certificates to qualified investors and puts the proceeds of the investments toward a funding agreement with the issuing organization. In return, the investors earn a portion of the profits linked to the asset.

Sukuk structured as trust certificates are only applicable if the SPV can be created in an offshore jurisdiction that allows trusts. This is sometimes not possible. If an SPV and trust certificates can’t be created, a sukuk can be structured as an alternative civil-law structure. In this scenario, an asset-leasing company is created in the country of origin, effectively purchasing the asset and leasing it back to the organization in need of financing.

Sukuk have become extremely popular since 2000, when the first sukuk was issued by Malaysia. Bahrain followed suit in 2001. Fast forward to current times, and sukuk are used by Islamic corporations and state-run organizations alike, taking up a large share of the global bond market. As of now, in our bond markets, regulators aren’t thinking about this yet, creating legal gaps in our Islamic finance.

Islamic law prohibits what’s known as “riba,” or interest. Therefore, traditional, western debt instruments cannot be used as investment vehicles. To circumvent this, sukuk were created in order to link the returns and cash flows of debt financing to a specific asset being purchased, effectively distributing the benefits of that asset.

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Before issuing, the issuer must ask what the asset is. All sukuk have some kind of asset. The asset should have the following qualities;

  • It should be qualified (it should be easy to describe what the asset is)
  • It should be quantified (size)
  • It should have value, and
  • should be revenue generating.

On the aspect of revenue generating, the asset could for example be leased back to the obligor so that this asset generates certain income, which income should be shared with the investors. This asset can be either tangible or intangible. Intangible assets can be marketing rights, concession agreements or intellectual property generally.

Therefore, if an asset meets those qualities, it can be used as an underlying asset in a sukuk transaction. For instance a barren piece of land, for the purposes of agriculture can’t be used as an underlying asset in a sukuk.

Special purpose vehicle (SPV) for a sukuk

Unlike our conventional bond markets, if you are to issue a sukuk, you need to create an SPV. And Capital Markets Authority and Bank of Uganda should look into this. In sukuk issuing, the entity seeking financing creates something akin to a shell company for the purpose of the financing. For example, if a company wants to issue a sukuk, then this company can’t just directly raise funds. This company has to raise funds through a structure in form of a company, which will be an SPV. The main advantages of forming a special purpose vehicle is that there are no taxation issues, because generally, these SPVs are set up in tax free zones. However, in Uganda a lot remains to be seen if the taxation regime could favour this.

The other main advantage of a SPV is that in the event the company seeking financing through a sukuk goes insolvent, then that insolvency shouldn’t interfere with the transaction because the financing has been raised through an SPV.  However, in common law jurisdictions without protections for SPV financing for Islamic finance, a conflict could arise in regard to common law anti-deprivation principles of insolvency.

It could be viewed as taking out assets from a company to deprive company creditors of proceeds in the event of an insolvency. Therefore, Capital Markets Authority and Parliament should study this carefully.

The 2011 case of Belmont Park Investments PTY Ltd v BNY Corporate Trustee Services Ltd a UK insolvency law case, which is a persuasive case in our jurisdiction, concerns the general principle that parties cannot contract out of the insolvency legislation. The principle has two key aspects, of which the Supreme Court of the United Kingdom ruled that only the first was relevant on the facts of the case:

⦁ The anti-deprivation rule, which is aimed at attempts to withdraw an asset on bankruptcy or liquidation or administration, thereby reducing the value of the insolvent estate to the detriment of creditors.
⦁ The pari passu rule, which reflects the principle that statutory provisions for pro rata distribution may not be excluded by a contract which gives one creditor more than its proper share.

The facts of this case are: Lehman Brothers, prior to its 2008 filing for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code, created a package of 19 special purpose vehicles (including Lehman Brothers Special Financing Inc) known as the “Dante Programme.” They issued 180 series of notes with an aggregate principal amount of $12.5 billion. A group of 29 Australian investors, headed by Belmont, instructed BNY Corporate Trustee Services Ltd, the trustee for several of the notes in question, to have the issuer of the notes cancel the swap agreement.

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The Belmont group, together with Perpetual Trustee Co Ltd (another note holder) launched claims against BNY to realize upon the collateral over any priority held by LBSF under the agreement. LBSF was joined as a party to the action. This was seen as trying to contract out of insolvency. Therefore, necessary legal protections for SPV Islamic sukuk should be put in place.

Sukuk – Ijara type

Sukuk – ijara means a lease sukuk.  An example of a lease sukuk: There is company X, which has certain real estate assets that desires to issue a sukuk. Like I had discussed earlier, to issue a sukuk, generally, an SPV needs to be created. This SPV will then issue a sukuk to the investors, to get some kind of liquidity from the investors. Instead of the investors giving their liquidity to the Company, they give that liquidity to the SPV. In return for that liquidity given, the SPV issues sukuk to the investors. The SPV from the collected proceeds then enters into a sell and purchase agreement with the company that created this SPV.

The SPV then purchases these real estate assets from the company. These assets like discussed earlier must have these qualities; they should be qualified, quantified (size), have value, and should be revenue generating. The SPV will then declare a trust over the sukuk assets leased to it. The SPV would then act as a trustee for the investors. After purchasing the assets from the company, the assets must then generate revenue. How do the assets generate revenue? The SPV leases the assets back to the company. Therefore, a lease agreement is entered between the SPV and the company.

Sukuk – al mudaraba type

In the Islamic finance industry, the term mudaraba is broadly understood to refer to a form of equity-based partnership arrangement whereby one partner provides capital (the Rab al-Maal) and the other provides managerial skills (the Mudarib). Sukuk al mudaraba is rarely used but the recent examples of recent sukuk al-mudaraba issuances and advised upon by Clifford Chance LLP are:

⦁ SAR1 billion issuance by Purple Island/Bin Laden in November 2008 (no purchase undertaking)
⦁ Abu Dhabi Islamic Bank’s AED2 billion Tier I issuance issued in February 2009 (no purchase undertaking);
⦁ DP World, US$1.5 billion issued in July 2007, which was part of a US$5 billion global medium term note programme and
⦁ IIG Funding Limited, US$200 million issued in July 2007 and listed on NASDAQ Dubai.

What is the structure of sukuk Al mudarabah?

The same players are involved. There is a company seeking to raise funds, investors, an SPV, the project and the capital. The process flows like this: The investors subscribe to the sukuk and advance the capital to the SPV. The SPV then enters into a mudaraba agreement with the company.

In the Mudaraba agreement, the SPV is the investor. The company is appointed as the manager to invest the capital of the investors in a project, in a form a restricted project, meaning its agreed in the mudarabah agreement what the investment plan would be, which area of business the company would invest, and what the expected profit from the project which the company or sovereign would be undertaking by using the proceeds of the investors.

Therefore, a detailed plan is agreed in the mudarabah agreement between the SPV and the company on how the liquidity or funds would be invested for a return. There is no contribution from the company or sovereign. The only contribution is effort and skill. The capital contribution is from the investor/ SPV.

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In a mudaraba sukuk, the principles of the mudarabah are strictly followed, that is, in case of a loss, the loss is born by the SPV/Investor, provided of course, there is no negligence on the part of the company or sovereign in terms of managing the project. The profit between the company and SPV could be agreed in the mudaraba agreement. For example, the profit ratio could be agreed as 70:30, meaning 70 goes to investors and 30 to the company.

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The main issue in the mudaraba agreement is that at the maturity of sukuk, the company or sovereign, is not legally mandated to provide undertaking which it agrees on purchasing of the underlying sukuk assets at a pre-agreed value. This is the main problem why mudaraba is not generally being used, because it’s difficult from a sharia perspective for the company or sovereign to give such an undertaking, saying for example, that after 5 years it would purchase the underlying assets of the mudaraba sukuk at a certain value, which is the face value of the sukuk.

What our regulators, Bank of Uganda and Capital Markets Authority should carefully study is the feasibility of the requirement that in order for a sukuk to be tradable, there should be 1/3 of the value of the asset in tangible form. For example, if they are investing in a business and they are holding 90% of the proceeds as cash and only 10% of the proceeds are invested in a certain business, then in such a case the tradability of the sukuk will be affected. The sukuk should have tangible assets behind it. It can’t have just cash. Why? because when a sukuk has just cash, and it is being traded, then there is a premium or discount, that will be considered as interest or riba. It is imporatant to know that in a sukuk mudaraba, there should be 1/3 of assets in tangible form in the sukuk structructure.

Most importantly, in the sukuk al mudaraba, the company or sovereign won’t be help liable for losses of the project, provided there is no negligence on the part of the sovereign or company. In a mudaraba sukuk, there is a sale undertaking by the SPV and a purchase undertaking by the company. The purchase undertaking could be triggered in the event of maturity or default and the sale undertaking is triggered by a tax event and a pre-payment event. Therefore, when URA is proposing taxation in Islamic finance, they could be careful not to propose taxation that will kill the sukuk market.

I have also noticed recently that in mudaraba structures, on a periodic basis when the profit is given to the sukuk holders, there has to be a constructive liquidation of the mudaraba. A constructive liquidation means that after every periodic payment, for instance 6 months, there is a calculation of how much profit has been generated through the mudaraba. That profit is being distributed through the SPV to the investors.

At maturity or in case of default, there is actual liquidation of the assets, meaning the sukuk assets are purchased back out of the sukuk structure and the proceeds are passed back to the sukuk holders.

In a mudaraba sukuk, the sovereign or company can give a liquidity facility but it cannot be legally binding on the company or sovereign. This is done in case the expected returns are not generated from the project.

As the Ugandan government comes up with taxation of Islamic banking, they should be careful not to put in place a regime that will kill the sukuk market, which could help raise the much needed finance.


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