On 26 January, the world’s largest Sukuk listed on the Dubai International Financial Exchange (see box “Sukuk al-Musharaka”).
The issue by PCFC Development FZCO (a special purpose vehicle (SPV) formed by Ports, Customs & Free Zone Corporation (PCFC)) (the issuer) is of interest to practitioners in the UK not just because of its size and its connection with the £3.9 billion recommended takeover offer for P&O by PCFC’s subsidiary, DP World, due to complete on 2 March, but also because of certain innovative features, in particular, convertible trust certificates.
“What is also interesting is that we are seeing conventional transactions with a large funding need now turning to the Islamic markets to meet some or all of that need,” says Farmida Bi, one of the partners at Denton Wilde Sapte in London who advised the joint lead managers and bookrunners, Barclays Capital and Dubai Islamic Bank PJSC, on the issue.
Moreover, the size and level of innovation involved in these deals makes it critical that the documents are in a form that is easily recognisable to participants in the international financial markets.
The Islamic finance market continues to grow apace. Dubai Islamic Bank told Reuters that the Sukuk was significantly oversubscribed. The company ended up raising 25% more capital than originally planned and, according to Barclays Capital (Reuters, 12 January), the Sukuk priced at a significantly lower cost than was anticipated.
Interest in Sukuks is not limited to the Middle East. A growing number are listed in Luxembourg and, although there are no Sukuks listed in London to date, the trend may spread.
“What we have is Middle Eastern issuers that are keen to tap the European markets,” says Bi, “coupled with a strong appetite for Shari’a compliant finance from Muslim and non-Muslim investors keen to invest in the booming Middle East market.”
Simon Sinclair, the partner at Clifford Chance in London who advised PCFC, agrees: “We’re at a very interesting stage in the Islamic financing market and this landmark deal shows the sophistication of the market and depth of appetite for this kind of investment.”
The issuer entered into a joint venture (Musharaka) with PCFC to earn profit from the application of the Musharaka’s capital in accordance with an agreed business plan (see boxes “Deal structure” and “Sukuk al-Musharaka”).
PCFC made a contribution in kind valued at US$1.5 billion; the issuer contributed the proceeds of the issue in cash (US$3.5 billion).
The issuer declared a trust under English law over certain of its assets (primarily its rights to share in the profits of the Musharaka) in favour of holders of trust certificates issued by it, thereby giving investors a pro rata share in the underlying trust assets (see box “Trust structure”). The trust certificates carry the right to participate in a possible future public offer of shares by PCFC or its subsidiaries.
Holders of the trust certificates, which mature in 2008, receive a return based on a fixed return of 7.125% per annum if a qualifying public offer takes place and 10.125% if it does not.
PCFC was appointed managing agent of the Musharaka and retains, as management incentive fees, any excess profit of the Musharaka over the return paid on the trust certificates.
As managing agent, PCFC is to use its expertise in the port and maritime business to pursue the Musharaka’s business plan. This includes investing in the Shari’a compliant activities of any member of the PCFC group (including DP World).
These were:
Convertibility. Under the terms of the certificates, the issuer is required to give notice of any qualifying public offering to the certificate holders. The holders then have the option to redeem up to 30% of their certificates in return for shares in the relevant offeror. If no qualifying public offer takes place within two years, holders are compensated by a higher return.
Convertible bonds are fairly common but this is the first convertible Sukuk. Even in the convertible bond market, bonds that convert only on the happening of a possible future IPO of an unspecified company are very rare. According to Sinclair, this gave rise to considerable complexity in structuring the transaction.
Under Shari’a, contracts which contain uncertainty (gharrar) are considered void. However, the fact that conversion of the trust certificates is contingent and the identity of the company into whose shares the certificates convert is unknown did not give rise to a concern regarding uncertainty. This is because the identity of the company would be known before the option was exercised.
“IPOs are very rare and very popular in the Middle East,” says Bi, “so we may see more convertible notes like this. And if we do, they are likely to be very successful.”
Look-back option. If there is no qualifying public offer in the two years, the look-back option gives holders the opportunity to participate in a qualifying public offering up to 12 months after the certificates have been redeemed.
The option added a further level of complexity to the issue because it had to last beyond maturity of the bonds. Therefore, it was necessary to address practical issues such as how to identify bondholders and how to enshrine the right in contract. It was also necessary to enable certificate holders to pay back the higher return they had received.
These included the following:
Parallel agency. As UAE law does not recognise trusts, the PCFC issue had to provide (as other similar issues invariably do) for a parallel agency structure so that the issuer was constituted as agent for the certificate holders for the purposes of UAE law in addition to being an English law trustee (see box “Trust structure”).
Transaction administrator. As is commonly the case in capital markets issues, the actual issuer in the PCFC issue was an SPV. An SPV typically has no employees, so a transaction administrator is usually appointed to act as agent for the certificate holders and make any relevant decisions.
In the PCFC issue, the transaction administrator (Deutsche Bank AG) had to play a considerably greater and more complex role than usual.
Collective investment scheme. According to the offering circular, the PCFC issue, like other Sukuks, constituted a collective investment scheme not authorised, recognised or otherwise approved by the UK Financial Services Authority.
Price stabilisation. Shari’a forbids short sales (that is, selling something the seller does not yet own). This means that the lead manager in a Sukuk issue cannot sell certificates in the market before the issue for the purpose of supporting the market price of the certificates (that is, pre-issue price stabilisation). Post-issue price stabilisation is not prohibited.
Therefore, the stabilisation statement in the PCFC offering circular provided that stabilisation would not begin until on or after the date on which the final terms of the offer were disclosed.
Sara Catley, PLC.
The PCFC issue was structured as a Sukuk al-Musharaka. A Sukuk is a financial instrument (such as a certificate or note) that has economic similarities to a bond but is structured so as to comply with Shari’a (see also News brief “Sukuks: the growth of Islamic finance”, www.practicallaw.com/5-201-1985).
Shari’a comprises Islamic principles and jurisprudence derived from a number of sources, including the Koran. Principles relevant to the financial markets include overlapping prohibitions on riba (interest), maisir (speculation akin to gambling), gharrar (uncertainty) and unjust enrichment.
There are numerous kinds of Sukuk, of which the Sukuk al-Musharaka is one. Under a Sukuk al-Musharaka, investors participate directly in a joint venture, taking some of the risks of participation in the commercial venture and an agreed return. Any kind of profit sharing ratio can be set but losses must be shared in a way that is proportionate to the amount invested.
By declaring an English law trust over its assets, the issuer is able to give holders of trust certificates a direct interest in the undivided assets of the Musharaka (see box “Sukuk al-Musharaka”). This is necessary because, in order to comply with Shari’a, the return the certificate holders receive has to come from the use of the underlying assets of the Musharaka. The trustee arrangement is recognised under Shari’a because the concept of a trustee is similar to that of a Mudarib under Shari’a: a person who holds an asset or acts on behalf of another.