Sukuk Group Report

Tamweel RMBS, Tamweel Trust Certificates and East Cameron Gas

TUTOR NAME: SIMON ARCHER Maryam Ghuloom Hasan 20024178 Adji Hafiz Sjadzali Housam Jouni 20029200 20023518

1. Asset-backed versus Asset-based Sukuks

According to MIFC (2012), asset-backed sukuk entitles sukuk holders to the ownership of the asset, which is legally recognized. The holders receive the return and principal from the backed asset, which means in the case of the originators bankruptcy, the return on the asset is not going to be affected. On the contrary, asset-based sukuk is based on an underlying asset, which is not legally owned by the sukuk holders. Tmaweel RMBS Tamweel Residential ABS Ltd transaction of Residential Mortgage Backed Securitization (RMBS), worth USD210m was based on an asset-backed Sukuk. This transaction had four Ijarah Sukuk tranches, where family houses (property) in Dubai backed them. The evidence for this sukuk issuance being an assetbacked, is due to the true sale and transfer of ownership and title of the asset (property), in addition to the ijarah cash flows, from the Tamweel PJSC (originator) to Tamweel Properties Limited (Special Purpose Vehicle) and finally to the sukuk holders (Yean, 2010). The true sale was confirmed by legal opinions and Fitch ratings, in which UAE law governed this transaction (Fitch Ratings, 2007). Tamweel Trust Certificate In the prospectus for the certificate there is no explicit mention of true sale of the underlying, whereby legal ownership of the physical underlying asset is transferred from originator to SPV. Certificate holders are entitled to Tamweels rights, title and interest, but this is taken to mean that they are limited to the benefit and usufruct of the asset. Therefore, they are asset-based sukuk. Furthermore, the contract stipulates that certificate holders are not entitled to call for the liquidation of the Trust Asset (TSL, 2008). In effect, the underlying asset is not legally under the ownership of the certificate holders. Certificate holders are only entitled for recourse to Tamweel but as represented by the Trustee or the delegate in the event of failure by originator in meeting any scheduled periodic payment and/or principal.

 East Cameron Gas The case of East Cameron Gas Sukuk would be one with an asset-backed issuance. A Musharaka contract was structured between an offshore SPV in the Cayman Islands created by ECG and East Cameron Partners. In this case, the asset that was sold and acted as collateral, which was an interest in the gas and oil rights on two fields in the Gulf of Mexico. The royalty interest and lease properties were recognized as real assets since they give the offshore SPV the right to receive a portion of oil and gas. This oil and gas is later sold, and the profit is shared between the offshore SPV and the issuer (Islamic Finance News, 2006).

2. Bankruptcy Remoteness

Bankruptcy Remoteness can be best described as the situation where an entity creates a subsidiary or a Special Purpose Vehicle (SPV) that is insulated and protected from any financial or credit risk from the remaining parts of the entity. The bankruptcy remote entity is usually structured in such a manner that even if the main entity goes bankrupt, the former would not. It is prohibited for the bankruptcy remote entity to take on any debt; instead, its sole purpose is to own an asset that acts as collateral for debt that the main entity has undertaken. Hence investors in bankruptcy remote entities or Special Purpose Vehicles are protected from any financial risks undertaken by management of the main entity (Gaon, 2010). This type of entity is especially crucial in the energy industry. That is because it allows the main entity to use a SPV to finance large projects without exposing the entire company to risk. Because of the volatile nature of the energy prices, energy industry cash flows can be quite volatile as well; therefore with an SPV, that price & cash flow risk is greatly mitigated. That way, the SPV is not exposed to the liabilities of the main entity and vice versa. A company can undertake an expensive project in the form of that SPV, so that if the project fails or is not as expected; it would have negligible or no negative effects on the main entity. Not only that, but in the case of bankruptcy remoteness, the assets of the SPV will continue to provide and generate cash flows even if the main

entity files for bankruptcy. Also, in the case of ECG where the SPV was based in the Cayman Islands, it is possible not to pay income tax by the SPV for the first 20 years of its creation; which eliminates another significant liability. However, it is important to note that when creating an SPV, the bankruptcy remoteness concept does not apply to asset based issuances where only the beneficial right of the asset is sold to the SPV; instead, the whole asset must be owned and managed by the SPV.

3. Sukuk Income Streams

Tmaweel RMBS Tamweel RMBS income stream consist of three components. First, fixed rental payment, which is based on, the recovery of the principal of the property. Second, a variable rental based on the Emirates Interbank Offered Rate (Eibor). Third, an additional rental in relation to the fees related to the repairing and maintaining the properties by the originator (Fitch Ratings, 2007). Therefore, this could conclude that Tamweel RMBS is based on both fixed and variable return. Tamweel Trust Certificate In the case of Tamweel trust certificate, the receivable periodic payment comprises of a fixed component of 2.25% plus the EIBOR applicable in the time of payment of the face value of the certificate (TSL, 2008). Thus, the income stream for the shareholder is not fixed, as there is a variable component of the EIBOR. East Cameron Gas East Cameron sukuk is based on both fixed and variable income streams. The fixed payment was about 11.25% per annum and the quarterly variable payment, which is dependant on the sukuk returns on the quantity produced. However, the fixed payment was more dominant than the variable one CPI Financial (2006). Moreover, these sukuk had a unique feature of being redeemed if the production goes beyond a specific level.

4. Risk Exposures of the Holders of the Sukuk

Tmaweel RMBS While asset-backed sukuk in the case of Tamweel RMBS has its advantages of not being affected in the case of the insolvency of the originator or issuer, it had its disadvantages of exposing the holders to credit risk in the case if the asset is undervalued in the market (Fitch Ratings, 2007). This credit risk is exposed to property (the backed asset) in Dubai, which arises from different factors such as the declining housing values and illiquid market, non-resident lessee who would leave Dubai if economic conditions worsen. In relation to the four ijarah tranches (A, B, C and D), these are treated as a waterfall effect, where in terms of default, priority of payment would go first for A then B then C, and finally D. In addition, Tamweel RMBS sukuk structure exposes its sukuk holders to foreign exchange risk, because of payments in different currencies. More specifically, Ijarah rental payments are due in Emirati Dirhams (AED), whereas US dollars are used in terms of sukuk payments. This risk is nowadays stable due to the AED being pegged to the US and thus the main problem would arise in the future if these currencies were not pegged anymore. Tamweel Trust Certificate For holders of Tamweel trust certificate, several risks are taken on. Under credit risk, the holders are exposed to the risk that the issuer SPV has in meeting its obligation to meet payments of periodic and principal nature. As the certificate is not backed by assets, holders are exposed to Tamweels risks in meeting their general obligations as a business (CPI Financial, 2009). Another risk involved is liquidity risk, whereby no party bound by the contract is under any obligation to insure or guarantee that a secondary market will develop significantly to support the trading of the certificate. Subsequently, in the case of a secondary market developing, there is market risk involved in the changing prices of the market. Significantly, the certificate holders are holding legal risk in particular with respect to limited recourses. Under the contract, holders can exercise their rights

to demand the purchase of their certificates by Tamweel in the event of dissolution. However, this is the extent of the legal course of action recognized by the contract. Under these conditions certificate holders are not given certainty as to how the event will be settled to compensate for the breach of contract on the part of Tamweel. East Cameron Gas As East Cameron Gass sukuk is asset-backed, the implication to the certificate holders with regards to risk lies in the nature of the asset itself. In this case, where the asset is the overriding royalty interest (ORRI) produced from the rig, certificate holders are exposed to the volatility of oil and gas prices. Credit risk is also a considerable risk as there are possibilities that the asset fail to generate the promised return due to several causes. Related to this, the issuer also noted the possibility of the well failing and does not make any guarantee to better production capabilities. The implication on the legal risk for certificate holders then is that, if the royalty fails to generate sufficient funds, they are not entitled to recourse to East Cameron Gas to meet the deficit (Faboozi, 2008). East Cameron Gass sukuk issuance was also a very new scheme that did not have precedent with regards to its legal treatment. In this sense, although in theory certificate holders are entitled to the asset, the lack of previous experience in legal treatment still posed an air of uncertainty. More legal aspects of risks will be discussed in section 6.

5. The Role of the Rating Agencies

Tmaweel RMBS In the case of Tamweel RMBS, Gekht & Heemskerk (2007) illustrated that Moodys uses the individual analysis model and a cash flow model. It looks at the asset backed by the sukuk and assesses the volatility of its prices, in addition to looking at its quality and predicts the probability of default. For the four ijarah sukuk tranches, it has not changed its ratings as the quality of the assets (properties in Dubai) are stable and thus the ratings were Aa2, Baa1, Ba3 for

classes A, B and C respectively. Fitch also did not downgrade the ratings for these classes and they are at AA, BBB+ and BB- for A, B and C respectively. Both agencies, left class D unrated. Tamweel Trust Certificate For the trust certificate, the agencies involved in rating Tamweel were directly assessing the credit worthiness of Tamweel and not the asset, as the issuance is asset-based. Considering this, the role of the agencies were then to provide investors with the rating of Tamweel as they are obligors to the payments for periodic payments, principal and any other event requiring payment from them. In addition to this, both rating agencies involved here, Moodys and Fitch plays a role that could trigger a clause in the contract. The contract stipulates that should a Rating Downgrade Event occurs, redemption is to be paid in full, subsequently dissolving the trust in the process. The exact condition under which this course of action will take place is in the event that either or both of the agencies downgrade the rating of Tamweel as obligor by at least two notches. This downgrade, however, could only be made significant under this contract when it happens due to the reduction of ownership, direct or otherwise, of the Government of Dubai in the obligor (TSL, 2008). Hence, the rating agencies take into account several entities when considering the rating of the certificate. As it is an unsecured instrument, Tamweel itself as obligor are the subject of the rating. As a natural extension, then, the Government of Dubai, as main owner of Tamweel through direct and indirect holding of share capital, is also considered by the agencies to play a significant part in Tamweels rating. Hence, their credibility and participation are also considered in the rating. Ultimately, these rating agencies, through making public their opinion to the market, help the pricing for the certificates. East Cameron Gas The deal of $165.77 million investment trust certificates issued by East Cameron Gas (ECG) was rated as CCC+, due to the large amount of undeveloped energy deposits, which backed, by this deal at that time. ECG case

was one the most innovative, interesting and first USA based entity, which was also the first sukuk rated by Standard & Poors (CPI Financial, 2006). Following the underperformance in hydrocarbon mix (September 2008), in relation to the royalty interest in oil and gas reserves, which breached the 90% minimum requirement of the reserve level for the hydrocarbon mix threshold, Standard & Poors downgraded the rate for this issuance to CC and proved that ECG is in a negative credit worth status (Reuters, 2009). This downgrade was also due to the change in quarterly repayment to monthly repayment. Moreover, ECG was then downgraded in March 2009 to D as a result of not receiving servicer reports.

6. Legal Risk in Sukuk Issuance

Legal risks in Sukuk issuance mainly consist of the inability of the issuing countrys law to enforce investors interests and right while complying with Shariah law, as the latter would remain the sole governing law over the Sukuk. Since the structure of the Sukuk issued in the case of East Cameron Gas is quite complex, it comes as no surprise that several legal risks stemmed from the Sukuks issuance (Faboozi, 2008). For example, the information relating to the guidelines in case of bankruptcy was not clear; hence when East Cameron Gas filed for bankruptcy in October 2008, there was confusion to how Sukuk holders should be treated, especially since this was the first Shariah compliant structure of its kind to be tested. Because of that, the originator attempted to explain the sukuk holders assets as collaterised loans as opposed to true sales. However, since the US legal system does not recognize the Shariah compliant financial structures, the ownership rights of the sukuk holders cannot be rightly represented. To peoples great surprise however, in March 2010, East Cameron Gass sukuk structure was cleared of any suspicion, the decision still remains a controversial subject since the court recognized that there was a sale of assets and not just a secured loan. It is suggested that the legal structure of the sukuk here is the culprit as 3 SPVs would have been a better option to make a clear cut separation between the bankruptcy estate on one hand, and the remaining assets on the other. Therefore the US law firm that advised on the ECG Sukuk issuance should take

part of the blame. However, one must not be too harsh since the Sukuk holders did win the assets and since this was a case where an asset backed transaction proved to be safer than an asset based transaction for certificate holders.

References

CPI Financial (2006) East Cameron Gas Sukuk. Available at: www.cpifinancial.net (Accessed on 2nd March 2012). CPI Financial (2009) Moodys reviews ratings on Tamweel Residential ABS CI (1) Sukuk transaction. Available at: www.cpifinancial.net (Accessed on 2nd March 2012). Faboozi, F., J. (2008) Handbook of Finance: Financial Markets and Instruments. Johm Wiley & Sons: New Jersey

Fitch Ratings (2007) Tamweel Residential ABS CI (1) Ltd. Available at: www.fitchratings.com (Accessed on 13th March 2012). Gaon, S. (2010) Asset-Backed Securities: Costs and Benefits of Bankruptcy Remoteness. Oxford Journals, (10). Gekht & Heemskerk (2007) Moodys Approach to Rating RMBS in Emerging Securitisation Markets EMEA. Available at: Islamic Finance News (2006) Deal of the Year 2006. Islamic Finance News, pp.32-34. MIFC (2012) Definition of Sukuk. Available at: http://www.mifc.com/index.php? ch=footer_faq&pg=footer_faq_suk&ac=51 (Accessed on 11th March 2012). Reuters (2009) S&P on East Cameron Gas Co (Sukuk) 2006. Available at: http://uk.reuters.com/article/2009/01/14/idUKN1447583720090114 (Accessed on 11th March 2012). TSL (2008) Tamweel Sukuk Limited Prospectus. Available at: http://www.google.co.uk/url? sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCgQFjAA&url=http%3A%2F %2Fwww.tamweel.ae%2FDocuments%2520Files%2FDownloads%2FTamweel %2520Sukuk%2520Prospectus.pdf&ei=pzpqT6gHeKx0QXp4eCBBw&usg=AFQjCNGvoKDGu21Zi4fL7NVDL3LWSNERvQ&sig2= vwaGQo3DLZ5UpPvmbBBuEQ (Accessed on 10th March 2012) Yean, T.,W. (2010) Sukuk: Issuances and the way forward. Available at: https://www.google.co.uk/search?q=Sukuk%3A+Issuances+and+the+way+forward. +&ie=utf-8&oe=utf-8&aq=t&rls=org.mozilla:en-US:official&client=firefox-a (Accessed on 5th March 2012).