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Additional Provisions for Sukuk Corporate and Sukuk Sovereign Transaction Types

 

16 February 2011

On 2 November 2010, the International Swaps and Derivatives Association, Inc. (ISDA) published the Additional Provisions for Sukuk Corporate and Sukuk Sovereign Transaction Types (the Additional Provisions).  

Allen & Overy acted as counsel for this project. The Additional Provisions are designed for use with the ISDA Credit Derivatives Physical Settlement Matrix to document CDS transactions on Reference Entities that are ultimate obligors under sukuk so that sukuk can constitute either Obligations or Deliverable Obligations for purposes of those CDS transactions. The Additional Provisions are essential because a sukuk obligation would not normally be deliverable under a vanilla CDS contract. Market Participants can incorporate the Additional Provisions automatically by specifying one of the following Transaction Types in the confirmation for the CDS transaction: Sukuk Corporate, Sukuk Sovereign, Standard Sukuk Corporate or Standard Sukuk Sovereign.

The Additional Provisions make certain amendments to the 2003 ISDA Credit Derivatives Definitions, as supplemented by the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions (published on July 14, 2009) (together, the Credit Derivatives Definitions). The main thrust of these amendments is to provide for sukuk (referred to in the Additional Provisions as Sukuk Obligations) to qualify as Obligations and/or Deliverable Obligations notwithstanding the fact that they are not directly obligations of the Reference Entity: the sukuk certificate itself will usually be issued by an SPV, with the Reference Entity being the ultimate credit funding the SPV in order for the SPV to make payments to certificateholders. Certain Credit Events as well as Obligation Characteristics/Deliverable Obligation Characteristics are applied at both the Sukuk Obligation level as well as at the level of the obligation pursuant to which the Reference Entity funds the SPV (the Recourse Obligation), given that the Recourse Obligation is the real source of funding for the sukuk certificate.

Terms used but not defined in this Alert shall have the meanings given to them in the Additional Provisions or the Credit Derivatives Definitions, as applicable.

Key Features

The Additional Provisions make a number of technical amendments to the Credit Derivatives Definitions. We highlight some of the key features and amendments made below.
 
Qualifying Sukuk Obligation
 
The definition of Sukuk Obligation has been drafted relatively widely to capture different types of sukuk structures. Where the Reference Entity is not the issuer of the sukuk (the Sukuk Issuer) the requirement is that the Sukuk Issuer has recourse to the Reference Entity in order to fund its payment obligations under the Sukuk Obligation. There is no reference to Shari'a-compliance in the definition. This leaves open the possiblity that obligations which would not generally be understood to be sukuk could nonetheless fall within the definition. The decision not to require Shari'a-compliance to be a requirement for an obligation to qualify as a Sukuk Obligation was based on the differences of opinion as to what constitutes Shari'a-compliance and the fact that a fatwa (a pronouncement from a Shari'a scholar that something is Shari'a-compliant) might not always be obtained for obligations which are otherwise recognised as sukuk.
 
The Recourse Obligation has to then satisfy certain Obligation Characteristics (as set out in the Additional Provisions) in order for the Sukuk Obligation to constitute a Qualifying Sukuk Obligation (so at this stage, the Obligation Characteristics are applied at the Recourse Obligation level only).
 
Obligation/Deliverable Obligation Characteristics
A Qualifying Sukuk Obligation that satisfies certain Obligation Characteristics or Deliverable Obligation Characteristics (as set out in the Additional Provisions) will constitute an Obligation and/or Deliverable Obligation respectively. At this stage therefore, the test is applied at the Sukuk Obligation level. As a result, certain events (such as Credit Events) will apply to such Sukuk Obligation and such Sukuk Obligation will be deliverable under a CDS contract which would not normally be the case had the Additional Provisions not been incorporated. The Credit Derivatives Definitions would continue to apply in their normal fashion for any conventional obligation of the Reference Entity such that both Sukuk Obligations and conventional obligations could be deliverable under the same CDS contract.
 
Markit Published Sukuk Obligation
In addition to Qualifying Sukuk Obligations that satisfy the relevant Obligation/Deliverable Obligation Characteristics, any Obligation set forth, as of the Event Determination Date (or if later, the date of the DC Credit Event Announcement) on the relevant sukuk obligations list published by Markit Group Limited (Markit) (referred to in the Additional Provisions as a Markit Published Sukuk Obligation) will constitute a Reference Obligation, unless the Confirmation for the CDS transaction specifies one or more Reference Obligations, in which case, only those Reference Obligations specified in the Confirmation will constitute Reference Obligations (therefore overriding anything on the Markit list).
 
As with the process for LPN Reference Entities, Markit conducts a dealer poll to determine whether an obligation should go on the list (once a dealer has requested for such obligation to go on the list). A legal test is not applied to the obligation (as it would in order to determine whether a Qualifying Sukuk Obligation constitutes an Obligation or Deliverable Obligation) but dealers can vote as to whether such obligation should go on the Markit list.
 
The consequence of having, for any particular CDS transaction, Reference Obligations determined by what obligations are on the Markit list as of the Event Determination Date, rather than the Trade Date, allows for greater fungiblity of the CDS transaction.
 
Other amendments
There are a number of other amendments that have been made to the Credit Derivatives Definitions to cater for the nature of a sukuk such that the Credit Derivatives Definitions can work for both Sukuk Obligations as well as conventional debt obligations side by side. The Credit Events that apply can now be triggered in respect of either the Reference Entity or the Sukuk Issuer and at both the Recourse Obligation level and the Sukuk Obligation level. This is important because the Recourse Obligation is the real source of funding for the Sukuk Obligation. There are also amendments made to cater for the fact that although Sukuk Obligations are limited recourse obligations, certain provisions apply disregarding such limited recourse nature – for example, the Failure to Pay Credit Event keys off Expected Payments rather than actual payments otherwise a Failure to Pay might not occur in the event of a shortfall in payment given the limited recourse nature of a sukuk.

 

 

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