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Sukuk Al Mudaraba: Issues Relating To Distribution Of Losses Between The Issuer And Investors

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Companies have increasingly looked to Sukuk issuances as a
Shari’a compliant method to raise finance for their growing
financial needs. Sukuk attracts investors in the region and
internationally who are keen to invest in Shari’a compliant
instruments. Unlike bonds, Sukuk are structured as asset based
certificates which represent an interest (typically ownership or
usufruct rights) in the underlying assets. The most popular Sukuk
structures include the Sukuk Al Ijara, based on a lease finance
structure, Sukuk Al Mudaraba based on a joint investment structure
and Sukuk Al Musharaka based on a partnership structure.

One of the key debates centres around the issue of sharing of
losses between the investors and the issuers. In a conventional
bond issuance, the issuer is responsible for the payment of
interest and principal to the bondholders without any correlation
to the performance of the issuer’s underlying business.
However, in equity linked Sukuk structures such as the Sukuk Al
Mudaraba and Sukuk Al Musharaka, there are restrictions both from a
legal perspective as well as from a Shari’a perspective on
guaranteeing the principal and profit elements.

Who Bears the Losses?

According to the definition provided by the Accounting and
Auditing Organiszation for Islamic Financial Institutions
(‘AAOIF’) of Mudarabah certificates (Mudarabah Sukuk), the
issuer of the certificates is the Mudarib or manager of the
capital, the subscribers are the Rab Al Maal or the owners of the
capital, and the proceeds of the issuance form the Mudaraba
capital. The Mudaraba capital is then used for investing in the
issuer’s business which forms the Mudaraba. The Sukuk
certificate holders who proportionately own the assets of the
Mudaraba, are entitled to a preagreed share of the profits and bear
the losses in proportion to their respective share in the Mudaraba
capital, if any, unless such loss is a result of the negligence of
the Mudarib (Issuer). The distribution of profit between Rab Al Mal
and the Mudarib should be clearly defined in the Mudaraba agreement
between the parties. If the parties to a Mudaraba agree to a fixed
return on investment or a guarantee of capital, such agreement will
be inconsistent with Shari’a principles as agreed by
Shari’a scholars. The applicable AAOIFI guidance provides:
‘The Sukuk manager can only guarantee to repay the capital to
Sukukholders at face value in cases of negligence or violation.
Sukukholders in a mudaraba or musharaka based structure need to
understand that the Sukukholder must have some risk in these
structures. Shariah principles encourage the sharing of risk and

Profit distribution in Mudaraba can only be made after the
capital of Rab Al Mal has been restored. The additional profit over
and above the capital is distributed as profit at a preagreed ratio
between the Mudarib and Rab Al Mal. If there are losses, such
losses are offset by any profit made and then from the Mudaraba
capital if necessary. This concept of profit distribution is
contrary to the conventional notion of bonds being ‘fixed
income’ instruments and many attempts have been made to develop
instruments such as the ‘purchase undertaking’ to safeguard
and lock-in the principal and profit element or coupon payments
under the Sukuk certificates.

Position under Civil Code: Losses and guarantee of capital

The UAE Civil Code also governs Mudarabah arrangements. The UAE
Civil Code confirms the position of Shari’a scholars regarding
who bears the losses. Article 704 of the UAE Civil Code addresses
the issue of bearing losses in Mudarabah agreements. The Article
states that:

  1. Rab Al Mal shall bear, alone, the loss, and any condition to
    the contrary shall be void.

  2. If any part of the Mudarabah capital deteriorates, it shall be
    deducted from the profit and, if it exceeds it, the remainder shall
    be charged to the capital. The Mudarib shall not guarantee the

Mitigation through Purchase Undertaking

The purchase undertaking has been used as a mechanism to
mitigate losses arising from the Mudarabah in order to protect the
investment of the investors. Under the purchase undertaking, the
Mudarib undertakes to purchase the Mudarabah assets from the
subscribers at the aggregate of the face value of the certificates
and the accrued profit. The purchase undertaking is triggered on
each periodic payment date or upon the occurrence of an event of
default. The purchase undertaking serves as a call option granted
by the issuer to the certificate holder under which the investment
(principal amount) and the coupon payment is guaranteed.

Enforceability of Purchase Undertaking

As noted above, Article 704 of the UAE Civil Code requires the
investor to bear its proportionate share of the losses in a
Mudaraba. From a Shari’a point of view (as noted by AAOFI), it
is permissible for an issuer of the Sukuk to undertake to purchase
the Mudaraba assets at market value and not at a predetermined
fixed price. These factors do put in doubt the viability of the
purchase undertaking in the context of the Mudaraba structure under
UAE law.

To mitigate against this risk, the transaction documents
relating to a Sukuk Al Mudaraba are often made subject to English
law. In a recent decision of the English court in Dana Gas PJSC v
Dana Gas Sukuk Ltd & Ors [2017] EWHC 2928, involving a Sukuk
that was structured as a Mudaraba, the judge stated that the
purchase undertaking in that instance was enforceable and
disregarded both UAE law and Sharia principles. Mr. Justice Leggatt

‘As mentioned earlier, the Purchase Undertaking is governed
by English law and so (as Dana Gas is constrained to accept) it is
English law which determines whether the Purchase Undertaking is a
valid and enforceable contract. It is perfectly lawful in English
law to guarantee the return from an investment and to pay and
receive compensation for the use of money. Prima facie, therefore,
the Purchase Undertaking is a valid and enforceable contract
whatever view would be taken of its validity and enforceability if
UAE law were applicable.’


In light of the provisions of Article 704 of the UAE Civil Code
and AAOIFI’s interpretation of the usage of purchase
undertakings, there are concerns relating to the usage of purchase
undertakings where a Mudaraba is used to structure the Sukuk. The
Mudaraba continues to be an attractive structure for equity linked
Sukuk and we expect that it will continue to be used with the
appropriate mitigants.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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