Restructuring of Sukuk could be more challenging amid COVID-19

Fitch Ratings-Dubai/London- The economic volatility caused by COVID-19 highlights the need for an effective bankruptcy resolution system in most Islamic finance markets, Fitch Ratings says.

This includes the need for better protection for sukuk and bond holders’ rights. Providing remedies, and making recovery prospects more predictable is also needed.

However, the restructuring of sukuk could be more challenging due to structural complexity and sharia requirements.

“We might see the bankruptcy systems tested once the regulatory flexibility and financing deferral programmes are withdrawn. Also if sukuk and bonds face default or are in distress, and go through resolution processes.”

Bankruptcy regimes in key sukuk-issuing jurisdictions are at various stages of development. They also remain largely untested and under-developed.

Many of these jurisdictions have updated their bankruptcy laws in recent years.

It remains to be seen how bankruptcy courts treat sukuk defaults compared to bond defaults in such events. Whether investors will have full recourse to the issuers, and if sukuk certificate holders will be able to enforce their contractual rights in local courts.

COMPLICATIONS

Most sukuk issued so far create an economic effect similar to conventional bonds.

However, whereas most sukuk instruments resemble debt obligations (eg ijara or murabaha sukuk), they can also resemble equity-like investments (eg mudarabah or musharakah sukuk).

Hybrid sukuk, which could have both equity- and debt-like components (eg mudaraba-murabaha sukuk), are also on the rise.

These distinctions could complicate creditor/sukuk-holder treatment and affect their recourse, debt ranking and recoveries upon issuer default. At end-3Q20, 81% of Fitch-rated sukuk were investment-grade.

Fitch classifies 80% of key sukuk-issuing jurisdictions in Group D under its “Country-Specific Treatment of Recovery Ratings Criteria”.

Group D jurisdictions are those where the law is not supportive of creditor rights, and/or where significant volatility in the application of law and legal enforceability of any claim materially limits the practical chances of recovery or greatly increases the volatility of recovery prospects.

Malaysia and UAE are the only countries among Islamic finance’s core markets that are classified in the higher category of Group C countries.

These are jurisdictions where the combination of the rule of law and the structural features of the insolvency framework are moderately above average.

In Malaysia, which has the largest market share of sukuk issuance globally, it takes about one year to resolve insolvency with a recovery rate of 81 cents on the dollar, according to the latest World Bank report.

The GCC is one of the most active regions for sukuk issuance, but bankruptcy resolution regimes are in the early stages of development and remain largely untested.

However, in recent years Saudi Arabia, UAE, Kuwait, Bahrain and Oman have begun modernizing their regimes, adopting many features of modern, Western-style insolvency regimes.