Sukuk is the plural form of the Arabic word 'sakk' and refers to an investment certificate. In the Middle Ages, Sukuk were extensively used by Muslims and represented papers denoting financial obligations from commercial activities. Additionally, they were used by the government as a form of partial payment for government servants and soldiers, entitling holders of sakk, known as grain permits, to receive a predetermined amount of commodities from the state treasury on the maturity date. 

Nowadays, Sukuk is a well-known and successful product in Islamic finance. Like other Islamic financial products, Sukuk transactions must comply with Sharia norms, rules, and principles. One key principle is the requirement for a tangible underlying asset. Unlike bonds, the funds raised through Sukuk cannot be used for the issuer's general financing needs. This makes Sukuk a hybrid security with features of both bonds and stocks. Similar to a bond, Sukuk is a fundraising tool for the originator. However, unlike bonds that offer a fixed return, Sukuk holders have a financial claim to share in the profits of a partnership, project, or service. This profit-sharing aspect makes them similar to stocks. Additionally, Sukuk holders, like stockholders, have ownership rights in the underlying asset but don't have voting rights or control over it. Investors contribute to Sukuk by purchasing a share, raising funds for the orinator (government or company). Sukuk entitle holders to periodic payments throughout the investment period and a final payment at maturity depending on the contractual arrangement of Sukuk. The returns on Sukuk are influenced by interest rates and the supply and demand of capital in the bond market.

Sukuk structure. Sukuk is always based on an underlying asset. Issuing Sukuk involves creating a Special purpose vehicle (SPV, or in some jurisdiction referred to as a special purpose entity). This is a separate legal entity, typically a limited company, set up for a specific purpose. A company (Sukuk originator) transfers assets to the SPV for the SPV to manage or use to finance projects. Sukuk as an investment vehicle allows the company:

• to raise funds for large projects
• offset risks to its entire business if the project fails, and 
• secure the interests of Sukuk holders by separating the underlying asset from the company's balance sheet in case of bankruptcy of the Sukuk originator. 

Sukuk structures are built on Islamic business contracts and can be flexible in design. Several factors influence the design, including:

• Compliance with Sharia principles
• Desired risk profile for both originator and investor
• Preferred cash flow patterns for both parties
• Market acceptance

Based on the underlying contract, Sukuk can be structured as:

• Equity-based model: Sukuk holders partner with the originator in a new or existing venture, sharing profits.
• Debt-based model: This is similar to a conventional bond. The most common example is Ijara Sukuk, which functions like a bond by providing periodic lease payments similar to a bond's coupon.

A key difference from conventional bonds: Sukuk holders are always considered equity holders, not debtors. This is because they hold ownership rights in the underlying asset, regardless of the model (equity-based or debt-based).

Asset-backed and asset-based Sukuk. There are two main categories of Sukuk based on the underlying asset: asset-backed and asset-based. This distinction can also influence potential market acceptance.

Structure

• Asset backed-Sukuk: A true sale transaction occurs, where the originator sells the asset to a special purpose vehicle (SPV) that issues the Sukuk. The principal amount is secured by the underlying asset's value. Returns and repayments are directly financed by the asset's cash flow. As a result, it involves granting the investor (Sukuk holder) a share of a tangible asset or business venture along with a corresponding share of the total risk that is a share commensurate with this ownership.  
• Asset-based Sukuk: It involves a sale-leaseback agreement with the originator, who retains a binding promise to repurchase the underlying assets at maturity. The issuer (SPV) purchases underlying assets using the funds raised from Sukuk issuance. The issuer then invests, trades, or leases these assets on behalf of Sukuk holders.

Ownership and Risk Sharing 

Asset-backed Sukuk: Investors (Sukuk holders) in asset-backed Sukuk own a share of the underlying asset or business venture, along with a proportionate share of the risks involved.

Asset-based Sukuk: It grants only beneficial ownership to the Sukuk holders. They are entitled to the cash flow revenues of the asset but don't have recourse to the underlying assets themselves. These assets are not used as collateral in case of default. As a result, investors have no claim on the assets if the originator defaults.

Returns

• Asset-backed Sukuk: Returns of asset-backed Sukuk depend on performance of the underlying asset.
• Asset-based Sukuk: It offers a potential for steady cash flow payments.

Investor Protection

• Asset-backed Sukuk: Sukuk holders have no recourse to the originator if payments are lower than expected. At the same time the issuer's assets are not liable in case of default of the originator.
• Asset-based Sukuk: Sukuk holders have an unsecured debt claim on the originator, meaning they cannot directly claim the underlying assets if the originator defaults. They rely on the originator's promise to repurchase the assets. In some cases, asset-based Sukuk may include a third-party guarantee of cash flow payments to Sukuk holders, regardless of the Sukuk's performance.

Loss Sharing 

• Asset-backed Sukuk: Sukuk holders bear any losses if the underlying asset's value declines. 
• Asset-based Sukuk: There is no loss sharing in asset-based Sukuk. 

Pricing 

• Asset-backed Sukuk: Sukuk price is determined by the asset's value.
• Asset-based Sukuk: It focuses on the originator's creditworthiness, similar to a conventional bond, not the asset value as in asset-backed Sukuk. The issuer's creditworthiness determines the Sukuk price. Investors receive cash flow from the assets (or potentially from other sources), but they don't have full ownership of the assets.

Benefits

• Asset-backed Sukuk: It offers true ownership of the asset to Sukuk holders, facilitating risk sharing between them and the originator. The originator is not obligated to repurchase the assets or take full responsibility in case of default. However, returns of investors are determined by performance of the underlying asset. 
• Asset-based Sukuk: Asset-based Sukuk offer a potential for steady cash flow payments. However, investors do not have recourse to the underlying asset in case of default of the originator. 

Sharia-compliance concerns

• Asset-backed Sukuk: These instruments are generally considered Sharia-compliant due to the true sale of the underlying asset to the Sukuk holders. This directly transfers ownership, fulfilling the Islamic principle of ownership in transactions.
• Asset-based Sukuk: Sharia scholars raise some concerns regarding asset-based Sukuk:  
• Ownership vs. Recourse: While Sukuk holders have beneficial ownership, they cannot directly sell the asset to recover capital in case of default. They rely on the originator's promise to repurchase the asset. This structure raises questions about true ownership transfer. 
• Pricing Focus: Unlike asset-backed Sukuk where pricing is tied to the asset's value, asset-based Sukuk pricing focuses solely on the originator's creditworthiness, similar to a conventional bond. This can deviate from the Sharia emphasis on underlying asset value.

Trading Sukuk. It's important to carefully review the Sukuk's terms and conditions to understand any restrictions on trading. Here's what to consider for Sukuk tradability:

• Sukuk structure and jurisdiction: The tradability of Sukuk depends on its structure and the jurisdiction in which it is issued, as it is subject to considerations regarding the issue of selling debt (bay al-dayn). There are differences in interpretation by Islamic jurists on this matter. It is permitted to sell equity-based Sukuk, such as Mudarabah, without considering the provisions of the sale of debt or the portion of debts within its assets, regardless of the debt ratio, as long as such debts are generated from business turnover and are ancillary to the entity's activity. As for tradability of Hybrid Sukuk or mixed asset Sukuk which may consists of Sukuk using debts (like Murabaha, pre-delivery Forward Ijarah or Istisna facilities) as well as tangible assets (like Mudaraba, post-delivery Ijarah, or Wakala facilities), it should be ensured that the ratio of tangible assets are at least 51% of the total assets. It is because of the issue concerning ceiling debt. 
• ‘Bay al-dayn’ refers to the transaction of debt obligations.The Hanafi and the Hanbali madhhabs do not allow trading ‘bay al-dayn’. The Maliki madhhab allows trading ‘bay al-dayn’ under strict conditions. The Shafi’i madhhab allows ‘bay al-dayn’ provided the debt is "guaranteed” and represents debt arising from transaction in goods that must be delivered immediately. Given the differences, in jurisdiction as Malaysia its Securities Commision allow trading Sharia-compliant debt products which forms the basis of Sharia-compliant money market instruments in the country, while in jurisdictions of other major Islamic markets as Middle East and GCC, trading Sharia-compliant debt products disallowed.
• Contractual restrictions: Some tradable Sukuk structures might include restrictions on trading. These restrictions could be:
• Holding period: Sukuk holders might be required to hold the Sukuk for a certain period before they can sell them.
• Pre-emption rights: The originator or other Sukuk holders might have an option of the right to buy back the Sukuk before it's offered to the broader market.

AAOIFI ruling on trading Sukuk.

As to what follows: The Shari'ah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), in view of the increased use of Sukuk worldwide, the public interest in them, and the observations and questions raised about them, studied the subject of the issuance of Sukuk in three sessions; first, in al-Madinah al-Munawwarah, on 12 Jumada al-Akhirah 1428 AH (27 June, 2007), second, in Makkah alMukarramah, on 26 Sh'aban 1428 AH (8 September, 2007), and third in the Kingdom of Bahrain on 7 and 8 Safar 1429AH (13 and 14 February, 2008).  

Following the meeting of the working group, appointed by the Board, which met in Bahrain, on 6 Muharram 1429AH (15 January, 2007), which was also attended by a significant number of representatives from various Islamic banks and financial institutions, the working group presented its report to the Shari'ah Board. 

After taking into consideration the deliberations in these meetings and reviewing the papers and studies presented therein, the Shari'ah Board - while re-affirming the rules provided in the AAOIFI Shari'ah Standards concerning Sukuk - advises Islamic financial institutions and Shari'ah Supervisory Boards to adhere to the following matters when issuing Sukuk: 

First: Sukuk, to be tradable, must be owned by Sukuk holders, with all rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally as well as in accordance with the rules of Shari'ah, in accordance with Articles (2)1 and (5/1/2)2 of the AAOIFI Shari'ah Standard (17) on Investment Sukuk. The Manager issuing Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets. 

Second: Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally, in accordance with the guidelines mentioned in AAOIFI Shari'ah Standard (21) on Financial Papers.  

Third: It is not permissible for the Manager of Sukuk, whether the manager acts as Mudarib (investment manager), or Sharik (partner), or Wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus. It is not objectionable to distribute expected earnings, on account, in accordance with Article (8/8)3 of the AAOIFI Shari'ah Standard (13) on Mudaraba, or to obtaining project financing on account of the Sukuk holders. 

Fourth: It is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase, in accordance with Article (3/1/6/2)4of AAOIFI Shari'ah Standard (12) on Sharikah (Musharaka) and Modern Corporations, and Articles (2/2/1)5 and (2/2/2)6 of the AAOIFI Shari'ah Standard (5) on Guarantees. It is known that a Sukuk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or his non-compliance with the investor's conditions, whether the manager is a Mudarib (investment manager), Sharik (partner) or Wakil (agent) for investments. 

In case the assets of Sukuk of al-Musharaka, Mudarabah, or Wakalah for investment are of lesser value than the leased assets of "Lease to Own" contracts (Ijarah Muntahia Bittamleek), then it is permissible for the Sukuk manager to undertake to purchase those assets - at the time the Sukuk are extinguished - for the remaining rental value of the remaining assets; since it actually represents its net value. 

Fifth: It is permissible for a lessee in a Sukuk al-Ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he {lessee} is not also a partner, Mudarib, or investment agent. 

Sixth: Shari'ah Supervisory Boards should not limit their role to the issuance of fatwa on the permissibility of the structure of Sukuk. All relevant contracts and documents related to the actual transaction must be carefully reviewed {by them}, and then they should oversee the actual means of implementation, and then make sure that the operation complies, at every stage, with Shari'ah guidelines and requirements as specified in the Shari'ah Standards. The investment of Sukuk proceeds and the conversion of the proceeds into assets, using one of the Shari'ah compliant methods of investments, must conform to Article (5/1/8/5)7 of the AAOIFI Shari'ah Standard (17). 

Furthermore, the Shari'ah Board advises Islamic Financial Institutions to decrease their involvements in debt-related operations and to increase true partnerships based on profit and loss sharing in order to achieve the objectives of the Shari'ah.  

_______

2. Definition of Sukuk: Investment Sukuk are certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity, however, this is true after the receipt of the value of the Sukuk, the closing of the subscription and employment of funds received for the purpose for which the Sukuk were issued. 

2 5/1/2 It is permissible to issue certificates for (to securitize) assets that are tangible assets, usufruct and services by dividing them into equal shares and issuing certificates for their value. As for debts owed as a liability, it is nor permissible to securitize them for the purpose of trading. 

3 8/8 The Mudarib is entitled to a share of profit as soon as it is clear that the operations of the Mudaraba have led to the realization of a profit. However, this entitlement is not absolute, as it is subject to the retention of interim profits for the protection of the capital. It will be an absolute right only after distribution, i.e. when actual or constructive valuations take place. It is permissible to distribute the realized profit among the parties on account, in which case the distribution will be revised when actual or constructive valuation takes place. The final distribution of profit should be made based on the selling price of the Mudaraba assets, which is known as actual valuation. It is also permissible that the profit be distributed on the basis of constructive valuation, which is valuation of the assets on the basis of fair value. Receivables shall be measured at the cash equivalent, or net realizable, value, i.e. after the deduction of a provision for doubtful debts. In measuring receivables, neither time value (interest rate) nor discount on current value for extension of period of payment shall be taken into consideration. 

4 3/1/6/2 It is permissible for a partner to issue a binding promise to buy, either within the period of operation or at the time of liquidation, all the assets of the Sharika as per their market value or as per agreement at the date of buying. It is not permissible, however, to promise to buy the assets of the Sharika on the basis of face value. 

5 2/2 Guarantees in trust (fiduciary) contracts 

2/2/1 It is not permissible to stipulate in trust (fiduciary) contracts, e.g. agency contracts or contracts of deposits, that a personal guarantee or pledge of security be produced, because such a stipulation is against the nature of trust (fiduciary) contracts, unless such a stipulation is intended to cover cases of misconduct, negligence or breach of contract. The prohibition against seeking a guarantee in trust contracts is more stringent in Musharaka and Mudaraba contracts, since it is not permitted to require from a manager in the Mudaraba or the Musharaka contract or an investment agent or one of the partners in these contracts to guarantee the capital, or to promise a guaranteed profit. Moreover, it is not permissible for these contracts to be marketed or operated as a guaranteed investment. 

6 2/2/2 It is not permissible to combine agency and personal guarantees in one contract at the same time (i.e. the same party acting in the capacity of an agent on one hand and acting as a guarantor on the other), because such a combination conflicts with the nature of these contracts. In addition, a guarantee given by a party acting a an agent in respect of an investment turns the transaction into an interest-based loan, since the capital of the investment is guaranteed in addition to the proceeds of the investment, (i.e. as though the investment agent had taken a loan and repaid it with an additional sum which is tantamount to riba). But if a guarantee is not stipulated in the agency contract and the agent voluntarily provides a guarantee to his clients independently of the agency contract, the agent becomes a guarantor in a different capacity from that of agent. In this case, such an agent will remain liable as guarantor even if he is discharged from acting as agent. 

7 5/1/8/5 The prospectus must state that the investment of the realized funds and the assets into which the funds are converted will be undertaken through Shari’ah-compliant modes of investment.