By Rizwan H Kanji and Tom O’Neill, partners at King & Spalding
When the first sukuk in Turkey was issued by KuveytTürkKatilimBankasi A.Ş. in 2010 through a Cayman Islands special purpose vehicle, the legal and tax infrastructure in Turkey was almost non-existent. Over the last four years, laws and regulations pre-approving certain Islamic structures and providing for the incorporation of asset leasing companies (Turkish special purpose vehicles) (ALC) have come into force and the tax treatment of certain Islamic structures has been addressed favourably.
These changes have facilitated frequent sukuk issuances by the Turkish participation banks as well as by the Republic of Turkey. It is not surprising that sukuk issuance is increasingly becoming an attractive alternative source of funding in Turkey, particularly when potential pricing and funding diversification benefits are considered together with these market developments. In 2015, we expect many Turkish corporates will consider issuing sukuk as an alternative or supplement to conventional bonds and loans. We set out below some of the key points for Turkish corporates to take into consideration with regard to structuring and issuing sukuk.
In all Islamic finance structures (including sukuk), returns to sukuk holders must originate from or in relation to underlying assets or ventures. The returns must also be Shari’ah compliant and accordingly, cash flows must flow from Shari’ah compliant assets and/or ventures. Turkish corporates will therefore need to ensure the availability of eligible assets from a Shari’ah compliant perspective for sukuk issuance.
In addition, at least 51 per cent of the issue amount of the sukuk will need to be supported by tangible assets (which should form part of the Shari’ah compliant underlying assets) to permit the sukuk to be available for trading in the secondary market at a premium or discount. The 51 per cent.requirement may be particularly helpful to Turkish corporates that may not have available unencumbered tangible assets equivalent to 100 per cent. of the issue amount of the sukuk.
Moreover, there is no clear definition of tangible assets in Islamic finance jurisprudence. Case by case analysis together with international counsel experienced in Islamic finance across different jurisdictions as well as eventual interaction with leading Islamic scholars will be required on this threshold topic. Turkish corporates involved in diverse businesses will have a wide range of asset classes on their balance sheets that will not have been considered for asset eligibility in the context of sukuk issuances by the Turkish participation banks. In our experience, telephonic airtime and intellectual property in relation to software licences are examples of corporate assets previously deemed to be tangible assets from a Shari’ah perspective for sukuk issuance outside of Turkey. We have also been involved in numerous structuring discussions and asset eligibility determinations with corporates in many jurisdictions and have frequently engaged in discussions of this issue with leading Islamic scholars, with whom we have excellent relations.
Use of Proceeds
The proceeds from the issuance of sukuk will need to be used in accordance with the principles of Shari’ah. Simply put, the proceeds should not be used towards anything which may be deemed to breach principles of Shari’ah, such as but not limited to, interest bearing return investments, alcohol, gambling and related ventures. While this requirement is unlikely to be difficult to comply with for Turkish corporates, how Shari’ah compliance is achieved will be a function of the issuer’s business and industry.
Existing Negative Pledge Clauses
Based on our experience on Turkish transactions and on the advice provided by Turkish legal counsel, the Lease Certificates Communiqué (Serial No. III/61.1) (the Lease Communiqué) Article 5 (2) contains an inadvertent potential constraint on the issuance of sukuk by Turkish corporates. It states that if the underlying assets are capable of registration of transfer, the transfer should be registered. Moreover, Article 61(4) of the Capital Market Law No. 6362 (the Capital Markets Law) provides that “In case: (i) the issuer cannot fulfil its undertakings arising from the lease certificates [i.e. sukuk] when they fall due; (ii) the management or the audit of the issuer is transferred to a public institution; (iii) the operation permit of the issuer is revoked; or (iv) the issuer is bankrupt, the proceeds gained through the assets under the portfolio of the issuer are to be primarily used for the payments to lease certificate holders. In such a case, the Capital Markets Board is entitled to take any kind of precautions in order to ensure the protection of rights of the lease certificate holders.”
The inadvertent result of these laws is that, with respect to assets whose transfers may be registered, such as real estate and shares, sukuk holders, in an event of default, would by operation of law have recourse to the assets of the ALC issuer. This effectively may turn some Turkish sukuk into asset backed rather than an asset based sukuk. This result is particularly anomalous when one considers that 98% of the sukuk issued globally are asset based rather than asset backed. This in turn may breach standard negative pledge covenants contained, for example, in the terms and conditions of Eurobonds that have been issued by various Turkish corporates or Loan Market Association standard form negative pledge clauses. The Lease Communiqué approves alternative structures which do not trigger the requirement for the registration of transfers. These alternatives will also need to be discussed with experienced international counsel and may require discussion with the Capital Markets Board (CMB).
Recent transactions in diverse markets have demonstrated increased investor appetite for longer term Shari’ah compliant paper. This trend has included sukuk issuances outside of Turkey by corporate issuers as well as sovereign and quasi sovereign issuers such as in Dubai, Saudi Arabia and Malaysia. In Turkey, the Republic issued a 10 year sukuk in 2014 after having earlier issued sukuk with shorter tenors and Bank Asya and Albaraka issued a 10 year tier II subordinated sukuk in 2013 (whose maximum 10 year tenor was, however, dictated by regulatory requirements). Other sukuk issued by the Turkish participation banks, however, have had shorter tenors ranging within more customary periods of five to seven years. Turkish corporates should seek advice from their investment banks regarding optimal tenors and their pricing implications. In the event a Turkish corporate does consider issuing sukuk with a longer maturity, the offering structure is may be more likely to include an offering into the United States in compliance with Rule 144A under the Securities Act in view of the importance of U.S. market demand for paper with longer maturity.
While sukuk in Turkey and elsewhere have been listed in different venues in Europe, the Irish Stock Exchange has more recently emerged as a frequent listing venue due to a variety of factors, including some flexibility around eligibility and financial statement criteria as well as response time for prospectus review, which includes, in practice two-three days for initial review of the prospectus. For example each of the issuances by Turkish participation banks in 2014 and 2013 were listed on the Irish Stock Exchange, as have been all of the Republic of Turkey’s sovereign sukuk issuances.
The amount of time required to draft the prospectus, together with time required to prepare the originator’s consolidated financial statements to be included in the prospectus, will often drive the transaction timetable for a sukuk issuance. Initially, Turkish corporates should consider, together with their investment banking advisors and their counsel, whether to access the U.S. market under Rule 144A under the Securities Act. To date, all sukuk issued out of Turkey to the international markets have been offered outside the United States only, although there are many examples of sukuk offered into the United States under Rule 144A from other jurisdictions. The preparation of a prospectus for a non U.S. offering may (but will not always) involve less disclosure and accompanying due diligence in important areas, such as the scope of the operating and financial review (or its equivalent section) in the prospectus, which sets out the originator’s analysis of its consolidated results of operations and financial condition, as well as the scope of the documentary due diligence investigation (data room).
However, Turkish corporates have a long history of accessing the international equity markets, and more recently the international Eurobond markets, under Rule 144A. Indeed, Turkish corporates considering issuing sukuk that have already offered Eurobonds are likely to be able to use, or readily adapt and update, large portions of their existing Eurobond prospectuses for their sukuk offerings. Moreover, in our experience and relative to other jurisdictions, many Turkish companies produce their annual and interim consolidated financial statements relatively quickly, which should facilitate market access as has been the case for other types of securities offerings. Finally, based on corresponding practice in the Eurobond markets and subject to discussion with investment banking advisors, Turkish corporates should be able to include in their sukuk prospectuses financial statements that are prepared in accordance with CMB Principles rather than International Financial Reporting Standards (IFRS). This should be helpful in particular for Turkish corporates whose shares are listed on the Istanbul Stock Exchange, who will already have an obligation to produce accounts prepared in accordance with CMB Principles but not IFRS (although for many companies the differences between the two will not be material).
Currency of Issuance
Turkish counsel will advise that Turkish law does not limit the currency in which a sukuk may be issued; any currency is possible provided there is investor appetite. The U.S. dollar remains preferred for Middle Eastern investors—an important part of the investor base for any sukuk issuance–as this minimizes exchange rate risk in jurisdictions where the local currency of the investor is pegged to the U.S. dollar. U.S. dollar denominated issuances are more likely to be offered into the United States under Rule 144A.
If the offering of a sukuk by a Turkish corporate be extended into the United States under Rule 144A, it will likely be necessary, because of the issuance structure through an ALC, for the issuer to be exempt from registration under the U.S. Investment Company Act of 1940. This is likely to mean (and has meant for Rule 144A issuances outside of Turkey) that in addition to restricting sales to qualified institutional buyers (QIBs) in the United States under Rule 144A, sales will need to restricted to QIBs that are also qualified purchasers (QPs) under the Investment Company Act. However, both of these categories of investors are large institutions whose definitions overlap to a significant extent. In our experience most investment banks will advise their issuer clients that this additional restriction is unlikely to present significant marketing concerns. Special considerations will need to be taken into account for an issuer that would consider issuing to QPs/QIBs under Rule 144A after having conducted an offering or offerings of sukuk outside the United States only in accordance with Regulation S under the U.S. Securities Act.
Various Turkish Approvals
Turkish counsel will advise that there are a number of approvals required from the CMB in order to issue sukuk. The first key approval relates to incorporation of the ALC, whose criteria are set out in the Lease Communique. The second key approval is the registration approval which includes the approval of the sukuk structure and documentation. On application to the CMB for either approval, the CMB will announce the application publicly on its website. This publication requirement should be taken into account when considering transaction timetables and the point at which the Turkish corporate would want, and its investment banking advisors would recommend, that the transaction become visible to the market.
As in a conventional Eurobond, an investment grade rating provides commercial benefits ranging from pricing to attracting different types of investors such as sovereign pension funds. In an asset based sukuk, the approach is predominantly to structure the sukuk to reflect the corporate risk of the originator. Accordingly, in our experience rating agencies have in most instances assigned to the sukuk the rating assigned to the Turkish corporate. Turkish corporates should discuss all ratings considerations with their investment banking advisors. * * * The application of these considerations to a particular issuer will require further discussion that is specific to a Turkish corporate and its objectives in issuing sukuk. We would be delighted to discuss potential issuances with Turkish corporates and bring our considerable experience to bear.