Sukuk Defaults and Its Implication: A Case Study of Malaysian Capital Market

Transcription

1. 8th International Conference on Islamic Economics and Finance Sukuk Defaults and Its Implication : A Case Study of Malaysian Capital Market Hafizi Ab Majid1 Shahida Shahimi2 Mohd Hafizuddin Syah Bangaan Abdullah3 Sukuk have become increasingly popular as a feasible and viable shariahcompliant long-term financing instrument. Being the leader in sukuk market, Malaysia is committed to evolve its financial services sector to serve the needs of businesses and consumers, as well as to increase its appeal in the regional and global market shares of selected niches, in particular, the sukuk market. Sukuk markets around the world are growing to becoming significant sources of capital even though a series of high profile sukuk defaults in the Gulf Corporation Countries (GCCs) had tarnished the market's confidence on sukuk. Malaysia had also recorded several cases of sukuk defaults such as of Johor Corporation, Ingress Sukuk Berhad, Tracoma Holdings Berhad and Nam Fatt Corporation Berhad. The issue of sukuk default is very crucial since it affects the welfare of its stakeholders. Identification of default risk in sukuk is important for supervision and risk management purposes. Certainty with regard to the post-default process in sukuk transactions is necessary because the risk for a default exists in all types of transactions. Even the most prudently structured products can fail due to circumstances outside investors‟ control. Therefore, this paper aims to discuss the issue of sukuk default and its implication on Malaysian capital market. At the same time, it also intends to investigate the implication of sukuk default on a country‟s reputation, the legal aspect and on the investor‟s protection. The impact of sukuk default on Malaysian capital market as a hub for global Islamic finance industry is also discussed comprehensively in this study. It is hoped that this study will help sukuk issuers and rating agencies for estimation of credit risk and setting corporate pricing on a risk adjusted return basis, as well as the regulators in ensuring market stability and efficiency towards sustainable economic growth. Keyword: capital market; default; Islamic finance; Malaysia; sukuk rating. 1. Introduction The sukuk market has grown rapidly over the last few years in terms of size, numbers and sophistication. Sukuk has become an alternative for conventional bonds and being used in financing for the last twenty years. It provides sovereign governments and corporations with 1 Lecturer of Finance, School of Management, Faculty of Economics & Management, Universiti Kebangsaan Malaysia (Corresponding author). Email: hafizi_m@ukm.my 2 Senior Lecturer of Islamic Economics, Banking and Finance, School of Economics, Faculty of Economics and Management, Universiti Kebangsaan Malaysia. Email: shahida@ukm.my 3 Lecturer of Finance and Risk Management, School of Management, Faculty of Economics and Management, Universiti Kebangsaan Malaysia. Email: m_hafiz@ukm.my 1
2. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation access to the huge and growing Islamic liquidity pool, in addition to the conventional investor base. However, the series of high profile sukuk defaults in the Gulf Corporation Countries (GCCs) such as Investment Dar, Saad Group and Dubai World’s Nakheel Sukuk in 2009, as well as the East Cameron Sukuk (US) have astounded the market’s confidence in the global Islamic finance industry, provoking a debate on investors’ protection and rights. Although sukuk is claimed to be more secured than the conventional bonds due to the requirement of physical assets to underpin deals, sukuk is now asserted to have lost credibility as a feasible and viable Islamic long-term project financing instrument. In the Malaysian context, despite being a leader in sukuk market, Malaysia has also recorded cases of sukuk defaults such as of Johor Corporation, Ingress Sukuk Berhad, Tracoma Holdings Berhad and Nam Fatt Corporation Berhad. Although sukuk defaults in Malaysia are not widely discussed, the issue raises concern on the investors’ protection and the survival of Malaysian capital market in the future. A default occurs due to the breach of any binding obligations under the original terms of the agreement between the issuer and the sukukholders. Apparently, both contractual parties must fulfill their obligations under the contract or agreement. The complexity of structure and several legal issues may be significant on rating process, but from a rating perspective, assessing the risk of the issuer's inherent credit strength is fundamental to the final rating outcome. In other words, performance of the sukuk issuer highly affects the final rating on the sukuk itself. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) guidelines emphasize the difference between sukuk and conventional bonds. These guidelines indicate that sukuk does not represent a debt owed to the certificate holder by the issuer, sothat the owners share in the returns and bear the losses. Furthermore, the standards state that the documentation must explicitly abide shariah (Islamic law) and that a shariah board of the capital market regulatory body must monitor its implementation.1 Conventional bond default provisions that are frequently incorporated into sukuk documentation appear to provide investors with an Islamic instrument that is similar to the conventional bonds. While fatwas2 are procured to provide comfort that instruments are shariah-compliant, such endorsements are subject to different interpretations. When fatwas contravene AAOIFI standards, their reliability becomes tenuous. Even when they may be compliant with a standard, which has been passed with a narrow majority, a structure may be called into question by the individual judge, who may subscribe to the strong minority view. Rating on sukuk reflects the (credit) worthiness and stability of sukuk. By having the annual rating reviews conducted by the respective rating agencies, sukuk investors are adequately informed of the issuer’s status and progress. In addition, the rating changes on sukuk may be significant to the possibility of sukuk default to a certain extent. Generally, sukuk with higher rating is unlikely to default and vice versa. This study will discuss on the sukuk defaults in Malaysia and its implication on the Malaysian capital market with a special reference to the selected cases of Malaysian defaulted sukuk. This paper will follow qualitative or descriptive research method, related to the issues of sukuk defaults by selecting a few cases of defaulted sukuk that may affect the Malaysian capital market. So far, studies on sukuk defaults are very limited as compared to conventional bond defaults. Hence, this study contributes to the literature by providing constructive discussion on sukuk defaults and their implication on Malaysian capital market. This study will benefit the regulators, investors, industry players and also researchers in this area. 2
3. 8th International Conference on Islamic Economics and Finance The remainder of this paper is organized as follows ; Section 2 deliberates on the sukuk insights. Section 3 outlines the research design. Section 4 discusses the sukuk development in Malaysia and provides an evidence of sukuk defaults. Section 5 presents the analysis and discussion of sukuk defaults and its implication on Malaysian capital market and finally section 6 concludes. 2. Sukuk Insights 2.1 Sukuk concept Sukuk are among the financial instruments for raising funds and are vital vehicles for resource mobilization, whether in the public or private sector (Mohd Hafizuddin et al., 2010). According to AAOIFI (2002), sukuk refer to investment products and can be defined as “certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”. As a certificate, sukuk is documented the undivided pro-rated ownership of underlying assets and the sak (singular of sukuk) is freely traded at par, premium or discount (Securities Commission of Malaysia (SC), 2010). Based on both definitions, sukuk can be further defined as commercial papers that provide an investor with ownership in an underlying asset. It is an asset-backed trust certificate evidencing ownership of an asset or its usufruct. It has a stable income and complies with the principle of shariah. Unlike conventional bonds, sukuk need to have an underlying tangible asset transaction, either in ownership or master lease agreement. In economic terms, there are three common types of sukuk; namely fixed-income sukuk; asset-backed sukuk (ABS); and hybrid sukuk (Zawya, 2009). Sukuk can be of many types depending on Islamic contracts or principles of financing and trades used in the structuring process. AAOIFI has issued standards as guidelines for 14 different types of sukuk, which can be classified as tradable and non-tradable, development and industrial project financing. However, the most common principles used in sukuk structuring are mudharabah,3 musharakah,4 murabahah,5 ijarah,6 BBA,7 salam8 and istisna‟.9 So far, among all the available structures, sukuk BBA and sukuk murabahah are the two sukuk with the highest default cases in Malaysia. In fact, sukuk BBA was the sukuk with the most issuance in Malaysia in 2004, before the Malaysian sukuk market got dominated by musyarakah sukuk beginning 2006. Sukuk BBA is a financial certificate based on BBA contract as evidence of ownership right of the investors on the underlying assets (Ab Ghani, 2006). This sukuk is not similar to bond because the latter represents debt obligation of the issuer. It is created to service the need for working capital or to re-finance existing debt, normally to be used in the transportation sector, especially in the shipping and aircraft sectors, real estate, construction, and also in the petrochemical projects. In BBA structure, payment is deferred and final price should be contractually agreed and known to both parties, the time and mode of payment should be ascertained and there is no requirement to state the cost price and amount of mark-up. The issuer of this sukuk has the right to get fund from the investors, meanwhile the investors have right to resale the sukuk to another party to gain additional profit. If the real value of sukuk BBA is not suitable with the previous contract, the investors have the right to object and return it to the initial issuer. 3
4. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation 2.2 Selected sukuk structures in Malaysian capital market The Malaysian sukuk market took off in 1990 with the world’s first sukuk issuance by Shell MDS. Since 2006, global demand for Malaysian sukuk has been increasing and the issuances are based on the globally accepted contracts of mudharabah, ijarah and musharakah. Since then, the market has expanded, not only in term of size but also sophistication that shows structures based on ijarah, musharakah and murabahah are now common in practice. Ijarah is a manfa‟ah (usufruct) type of contract, where the owner leases out an asset to a client, at an agreed rental fee and pre-determined lease period, as per the aqd (contract). Normally, the ownership of the leased asset remains in the hands of the lessor. Based on this structure, the sukuk holders own equal shares on the underlying asset (or its usufruct). Basically, the sukuk holders hold the right to own the asset and collect the rental payment or dispose the sukuk at any time (Noor Inayah et al, 2011). Again, these rights depend on the structure of ijarah whether asset-backed sukuk ijarah or asset-based sukuk ijarah. Asset-backed sukuk allows the holders to liquidate the underlying asset in the event of default to recover most of their investments (Noor Inayah et al, 2011). On the other hand, asset-based sukuk only represent beneficial ownership on the underlying asset and it restricted the holders’ right in the event of default. Figure 1 shows the common structure of sukuk ijarah, which involves three parties i.e. originator, special purpose vehicle and the sukuk investors. Source: Abstracted from Wilson (2008). Figure 1: Basic Structure of Sukuk Ijarah 4
5. 8th International Conference on Islamic Economics and Finance Steps in Sukuk Ijarah transaction (1) (2) – (3) (4) (5) – (6) (7) – (8) The originator sells certain assets to special purpose vehicle (SPV) at an agreed pre-determined purchase price. SPV will raise funds to finance the purchase of the assets through the issuance of sukuk and sell to investors. A lease agreement is signed between SPV and the originator for a fixed period of time, where the obligator leases back the assets to lessee. SPV receives periodic rentals from the originator. These are distributed among the investors i.e. the sukuk holders. At maturity, the SPV sells the assets back to the seller at a predetermined value. This proceed will be used to reimburse the certificate holder at issue price. Meanwhile, the concept of murabahah has been used to develop an innovative Islamic finance contract, including sukuk. Murabahah refers to the sale of goods at certain price that comprised the purchase price and profit margin agreed by contractual parties. Thus, sukuk murabahah refers to the certificates of equal value issued for the purpose of financing the purchase of goods through murabahah. By doing so, the investors of the sukuk holders are the legal owner of the murabahah commodity. The issuer of the certificate is the seller of the murabahah commodity, the subscribers are the buyers of that commodity, and the realised funds are the purchasing cost of the commodity. The certificate holders own the murabahah commodity and are entitled to its final sale price upon the re-sale of the commodity. Murabahah sukuk have, however, become popular in Malaysian capital market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price. Common structure of sukuk murabahah is shown in Figure 2. Figure 2: Sukuk Murabahah Structure 5
6. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Steps in Sukuk Murabahah transaction 1 2 3a & 3b 4a & 4b 5a & 5b 6 A master agreement is signed between the SPV and the borrower SPV issues sukuk to the investor and received sukuk proceed SPV buys commodity on spot basis from commodity supplier SPV sells the commodity to the borrower at the spot price plus profit margin, payable on instalments over an agreed period of time. The borrower sells the commodity to the commodity buyer on the spot basis. The investors receive the final sale and profits. 2.3 Credit risk and rating In the case of credit (default) risk, there is always a probability that a corporate borrower will not be able to meet its contractual obligations and may renege from paying the principal and the profit due. Even for the typical high-grade borrower, this risk still exists even though it may be very small, perhaps 1/10 of 1 percent per year. Although this type of risk does not seem large, it is in fact highly significant, and can increase quickly with little warning. Furthermore, margins in corporate lending are very tight, and even small miscalculations of credit risk can undermine the profitability of lending. Unexpected realizations of the risk have destabilized, de-capitalized, and destroyed many international corporate institutions. In Malaysia, all debt securities including sukuk issues are required to be accompanied by a credit rating at all times. A credit rating is a mechanism through which an independent third party, i.e. the credit rating agency (CRA),10 makes an assessment on the likelihood of a corporate issuer’s default on its debt repayments. It focuses on a specific debt instrument and not the overall creditworthiness or financial standing of the corporate issuer. A rating will take into consideration various enhancement tools like guarantees, sinking funds, letters of credit or any other mechanism devised to reduce the default risk of specific issues. Thus, a corporate may be assigned different rating categories for different debt issues across time (RAM Ratings, 2010). However, rating is not a recommendation to purchase, sell or hold a security’s market price or its suitability for a particular investment, nor does it involve any audit by the rating agency (RAM Ratings, 2010). Malaysia is one of the first few countries in the world to require the recognition of CRAs for the purpose of rating a bond or sukuk issue. This is in recognition of their vital role in evaluating the probability of default of sukuk issue, and the importance investors place on ratings for their investment decisions. CRAs are required to be recognized by the SC for the purpose of rating debt or sukuk issues in Malaysia, pursuant to the Guidelines on Recognition of Credit Rating Agencies by the Securities Commission for the Purpose of Rating Bond Issues. 2.4 Rating performance and sukuk defaults Bandyopadhyay (2006) reports that as the credit quality worsens i.e. decline in the rating grades, the probability of default (PD) increases. Furthermore, the PD jumps sharply as soon as the rating move from investment to non-investment grades (i.e., from BBB rating to BB) and that justifies the reason for a study on the rating performance and sukuk defaults. He also observes that rating stability declines as the credit quality worsens. The higher risk in the bottom grades 6
7. 8th International Conference on Islamic Economics and Finance (mainly non-investment grades) calls for developing a corporate default predictor model that would better capture the firm’s characteristics and could give an early warning signal of corporate distress. This issue is very relevant and significant not only for conventional corporate bond, but also for sukuk. Furthermore, in the wake of a series of high profile sukuk defaults in the GCCs, such as Investment Dar, Saad Group and Dubai World’s Nakheel Sukuk in 2009, sukuk are alleged to have lost credibility as feasible and viable Islamic long-term project financing instrument (Raja Teh Maimunah, 2010). 3. Research Design This paper will follow qualitative or descriptive research method, related to the growing issues of sukuk defaults by focusing on the development of theory through a case study approach (Eisenhardt, 1989; Yin, 1994). The ultimate objective of the study is to provide an understanding on the default cases and its implication on capital market. The general discussion on Malaysian defaulted sukuk will cover the period of 1997 to 2010 (14 years). This paper will discuss on the selected defaulted sukuk cases. For this purpose, a Murabahah Islamic Debt Securities issued by Johor Corporation, Sukuk Ijarah issued by Ingress Sukuk Berhad and Murabahah ICP/IMTN issued by Nam Fatt Corporation Berhad will be discussed in the context of Malaysian capital market. Sources of data include observation, documents and texts (i.e. archival research), specifically from the SC, RAM Ratings and MARC, and authors’ analysis on the subject matter. Written data sources include published and unpublished documents, company reports, reports, newspaper articles and others. The information on defaulted and solvent firms is collected from Malaysia Rating Corporation Berhad’s (MARC) annual or monthly ratings of middle to short-term corporate sukuk issued by companies from 2000 until 2010, which later turn out to be defaulted. The financial information of these companies over the period is obtained from the MARC and Rating Agency Malaysia (RAM) databases, as well as Securities Commission’s website. 4. Overview of Sukuk in Malaysia 4.1 Sukuk development Malaysia has emerged as leader in sukuk market since the first corporate sukuk issuance in 1990 by Shell MDS Sdn. Bhd. This is due to the consistent growth in the issuance of sukuk, increase in the level of knowledge and numbers of expertise amongst market players and progressive development of the Malaysian legal framework. This situation makes Malaysia the world’s largest sukuk issuer with more than 60% of outstanding global sukuk (as at end of 2009). From total sukuk issued globally, 66.8% with a value of USD 67,872 million were issued in Malaysian market, as illustrated in Table 1. As at end June 2010, local currency sukuk market stood at a whopping USD76.4 billion or 35.5% of total bond market outstanding. This is attributable to various factors including well-executed policies, facilitative regulatory environment, increasing numbers and sophistication of intermediaries that continue to push the frontiers in terms of product innovation as well as the existence of a complete, matured and well established Islamic financial system. 7
8. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Table 1: Regional Break-up of the Domestic Sukuk Market Country Volume (US$ millions) Asia Malaysia Indonesia Pakistan Brunei Singapore GCC Saudi Arabia UAE Bahrain Qatar US, Europe and Africa US Germany Gambia Sudan Total No. of Issues % of Total Value 67,872 1,923 1,657 740 99 792 48 31 13 2 66.8 1.9 1.6 0.7 0.1 7,665 7,151 1,508 137 10 10 77 1 7.5 7.0 1.5 0.1 1 1 1 20 1,007 0.2 0.1 0.0 12.4 100.0 167 123 0.388 12,614 101,656 Source: International Islamic Financial Market-IIFM (2009) Malaysia’s Islamic capital market continues to show vibrant growth as can be seen from the ever-increasing size and diversity of sukuk offered. This is attributable to various factors including well-executed policies, facilitative regulatory environment, increasing numbers and sophistication of intermediaries that continue to push the frontiers in terms of product innovation as well as the existence of a complete, matured and well-established Islamic financial system. Figure 3 depicts total outstanding sukuk issued by public and private sectors from 1990 to 2010, dominated by corporate issuers for the period of 1997-2008, government related entities in 2009, and sovereign in 2010. 8
9. 8th International Conference on Islamic Economics and Finance Source : IFIS & RAM Ratings (2010). Figure 3: Sukuk Issuance by Type of Issuer in Malaysia (USD mil.) The corporate debt securities and sukuk market had withstood severe stress during the 1997/1998 Asian financial crisis, and again during the economic slowdown in 2001 following the collapse of the information technology (IT) bubble in the advanced economies. Notably, corporations that have funded their long-term capital investments or business expansion projects with long-term debt securities and sukuk had escaped the negative effects of credit crunches, interest rate spikes and exchange rate depreciation. This had contributed to the stable performance of the debt securities and sukuk. Besides avoiding the risks of currency, maturity and asset-liability mismatches, only debt securities and sukuk that carry investment-grade ratings from the domestic rating agencies had been allowed to be issued in the Malaysian market during the early years. Mandatory rating, together with the requirement for investment-grade ratings (removed as the market matured), had helped boost investor confidence during the domestic debt securities and sukuk market’s nascent phase. The market integrity and confidence established during the formative years, which had led to successful redemptions of debt securities and sukuk upon maturity, had in turn stimulated confidence in and acceptance of long-tenured corporate debt securities and sukuk, some of which stretch for over 30 years. 4.2 Evidence of default in capital market The debt securities and sukuk issued in the Malaysian market are mostly rated from AAA to BBB, although most issues tend to cluster around the AA category. Table 2 explains total corporate bond (inclusive of sukuk) defaults in Malaysia, from 1997 to 2009. Note that there had been no default prior to 1997. By referring to the default rate by no. of issuers (column 5), there is a significant correlation between no. of issuers and issues (positive value of %). The overall defaults involve quite a huge amount of money (RM12.9 billion). 9
10. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Table 2: Total defaults (1997 – 2009) Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Total Total defaulted No. of issuers No. of issues 1 16 4 6 4 3 2 6 2 2 3 49 1 20 5 12 12 3 2 6 2 4 5 70 Default rate (by no. of issuers) Amount of rated debt (RM million) 30 3,820 1,850 1,875 2,757 225 98 1,182 366 300 394 12,896 Defaults with bank guarantees (%) No. of issuers No. of issues 0.6 8.8 2.5 3.6 2.3 1.9 1.1 3.3 1.0 1.1 1.6 1.9 1 11 3 4 1 1 1 21 1 12 3 9 1 1 1 27 No. of issuer defaults ex-bank guarantee Adjusted default rate (by no. of issuers) (%) 5 1 2 4 3 1 5 2 2 2 25 2.8 0.6 1.2 2.3 1.9 0.6 2.8 1.0 1.1 1.1 1.1 Note: No default prior to 1997. Source: RAM Ratings (2010) Thus, it is interesting and important to investigate the issue of defaults, so that the implication of sukuk defaults on the Malaysian capital market could be minimized in future. 5. Analysis of Sukuk defaults in Malaysia Standing true to Islamic principles, sukuk are perceived to be ethically protected from turning bad. However, when sukuk defaults had been scrutinised by the practitioners and academicians, concerns had been raised on the reliability of their structures and Shariah supervision. This has created the perception that sukuk may not be any safer than conventional bonds in terms of investor protection and the treatment of defaults. This situation will also tarnish the reputation of Malaysian capital market since Malaysia has been recognized as the hub for Islamic capital market in the world. Unlike the high-profile default cases in the Middle East, Malaysia’s sukuk defaults have received less criticism and scrutiny from global industry players. The reasons are due to our robust supervisory structure, established governance and disclosure standards, and the highly developed legal framework and court system which provide the necessary protection and comfort to investors. It is very interesting and vital to investigate the defaults issue and its implication, especially for the sukuk since there are a lot of issues and debates in terms of their structure and concept, particularly from the shariah perspectives (Rosly & Sanusi, 1999; AlAmine, 2001 & RAM Ratings, 2010). Despite the wide variance in ratings, the default rate for Malaysian sukuk in 2009 was relatively low at 0.46 per cent (SC, 2010). For the period of 1997 – 2010, there are altogether 24 cases of sukuk default, as illustrated in Table 3. Of all cases, they were mainly structured based on murabahah and BBA contracts – 12 on murabahah, 11 BBA, and only one on ijarah. BBA had been a popular shariah contract for sukuk when the Islamic capital market was first developed in Malaysia. Due to some of the controversial elements embedded in the structure, however, it is 10
11. 8th International Conference on Islamic Economics and Finance only accepted in the Malaysian market . Under the BBA structure, eligible sukuk investors will first purchase (from the issuer) the underlying assets at an agreed purchase price. The assets must be certified as Shariah-compliant and of sufficient value, as per the pricing guidelines of the SC’s Shariah Advisory Council. The assets will subsequently be sold back to the issuer at cost plus a profit on deferred payment. Therefore, BBA sukuk contract will be used to securitize shariah-compliant assets and it adds value to the debt facility, in terms of credibility and liquidity. Table 3: Total Defaulted Sukuk (1997 – 2010) Issuance Date 17 Apr 1997 Rating Agency RAM Ratings Initial Rating# A2 25 Jan 1999 RAM Ratings BBB3 21 Sept 2000* MARC 11 Dec 2000 Issuer Type of Sukuk Amount (RM mil) 150 Date of Default 21 Nov 2003 Final Rating D Hualon Corporation (M) Sdn Bhd Bai‟ Bithaman Ajil Islamic Debt Securities (BaIDS) Johor Corporation Murabahah Islamic Debt Securities 500 27 June 2002 D AID/ MARC2ID Europlus Corporation Sdn Bhd BaIDS 250 10 Mar 2006 DID RAM Ratings BBB3 Moccis Trading Sdn Bhd BaIDS 50 3 June 2003 D 22 Feb 2001* MARC AID Maxisegar Sdn Bhd BaIDS 300 10 Mar 2006 DID 24 July 2003 MARC MARC3ID Perspektif Perkasa Sdn Bhd Murabahah Underwritten Notes Issuance Facility (MUNIF) 188 10 Mar 2006 DID 19 Sept 2003 MARC MARC3ID Stenta Films (M) Sdn Bhd MUNIF 90 20 Sept 2007 DID 28 Nov 2003 MARC AAID Malaysian Merchant Marine Berhad BaIDS 120 2 Apr 2010 DID 30 Dec 2003 MARC AID/ MARC2ID Evermaster Berhad BaIDS & Murabahah Multi-Option Notes Issuance Facility 50 & 40 31 Dec 2008 DID 1 Apr 2004 MARC A+ID/ MARC1ID Pesaka Astana (M) Sdn Bhd BaIDS 200 30 Sept 2005 DID 9 July 2004 MARC A+ID Ingress Sukuk Berhad Sukuk Ijarah 160 13 July 2009 DIS 7 Oct 2004 MARC AID/ MARC2ID Oilcorp Berhad Murabahah IMTN/ MUNIF 70 7 Oct 2009 DID 19 Oct 2004 RAM Ratings A3/P2 BSA International Berhad Murabahah CP/ MTN 150 28 May 2008 D 11
12. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation 4 Nov 2004* MARC Jana Niaga Sdn Bhd MUNIF 100 15 Nov 2007 DID 12 Nov 2004 RAM Ratings The Royal Mint of Malaysia Sdn Bhd Murabahah MultiOption Notes Issuance Facility 55 8 June 2007 D 15 Dec 2004 MARC AAID PSSB Ship Management Sdn Bhd BaIDS 40 15 Dec 2009 DID 28 Jan 2005 MARC AID Tracoma Holdings Berhad BaIDS 100 29 Jan 2009 DID 8 Mar 2005 MARC MARC2ID M-Trex Corporation Sdn Bhd Murabahah ICP 60 21 May 2009 DID 29 Apr 2005 RAM Ratings A1(s)/ P1(s) Oxbridge Height Sdn Bhd Murabahah IMTN/ MUNIF 104/ 50 6 Apr 2009 D 26 Sept 2005 MARC AID Englotechs Holding Bhd Murabahah MTN 50 27 Mar 2009 DID 28 Oct 2005 RAM Ratings A2 Memory Tech Sdn Bhd BaIDS 320 7 June 2007 D 31 Jan 2006 MARC A+ID/ MARC1ID Nam Fatt Corporation Berhad Murabahah ICP/ IMTN 250 6 Apr 2010 DID 13 Apr 2007 MARC MARC1ID Straight A's Portfolio Sdn Bhd MUNIF 200 11 Dec 2009 DID 17 May 2007 MARC A+ID Malaysian International Tuna Port Sdn Bhd BaIDS 240 18 Nov 2009 DID Note: AID/ MARC2ID A2/ P2 # For details of rating definition used by MARC & RAM Ratings, refer to Appendix 1 & 2. * Date of issuance is based from press releases on rating agencies’ website/internal database. Sources: RAM Ratings (2010) Based on the RAM Rating’s data and the statistics provided by SC, the first defaulted sukuk in Malaysian capital market is Murabahah Islamic Debt Securities issued by Johor Corporation (JCorp), a market-driven Johor State Government-linked Corporation. The corporation is one of Malaysia’s leading business conglomerates, comprising more than 280 member companies. As a public enterprise entity, JCorp plays a major role to foster economic growth in the state particularly in several high potential economic sectors including agrobusiness, industrial development, property and others. This sukuk was issued in January 1999 and defaulted after three years in June 2002. This is the first case of defaulted sukuk in Malaysia and the largest amount of defaulted sukuk in the history of Malaysian capital market so far. There is limited studies and discussion on this defaulted sukuk due to the status of this corporation as the state government-linked corporation. As per today, JCorp continue to dedicate itself in 12
13. 8th International Conference on Islamic Economics and Finance creating new opportunities not only for its own corporate growth and expansion but also towards contributing country ’s economic enhancement. On the other hand, the latest Malaysian defaulted sukuk is a Murabahah ICP/IMTN that was issued by Nam Fatt Corporation Berhad. Nam Fatt is a multinational group with over 1,000 personnel employed in thirty-one subsidiaries and four associated companies. This company has international presence in six countries through their worldwide offices and have gone beyond Malaysian shores, to Singapore, Brunei, Indonesia, Thailand, Vietnam, China, Japan, Turkmenistan, Sudan and the Middle East This 250 million Malaysian Ringgit sukuk used the Islamic financing principle of Murabahah, a secured financing of an asset on a deferred payment basis with a pre-agreed payment period. Figure 4 shows the timeline of Nam Fatt sukuk since it was issued until defaulted on April 2010. Full information on the rating trend starting from initial rating to the final rating in the event of default could be found in Appendix 3. Figure 4: Nam Fatt Corporation Rating Timeline Besides Nam Fatt, Tracoma is another case of sukuk defaults in the Malaysian capital market. Tracoma’s vast experience and good track record as one of the leading local manufacturers of automotive components, and its commendable financials was reflected in November 2004, when MARC assigned an initial rating of AID to the issue. In October 2006, premised on Tracoma’s delay in depositing the monthly amount in the PSA required for the upcoming profit payments due in January 2007, MARC placed Tracoma’s RM100 million BaIDS on a negative outlook. Due to Tracoma’s tight liquidity position and limited financial flexibility, exacerbated by it’s weaker than expected cash flow, a couple of downgrades had been instituted during the annual rating reviews on the BaIDS. In late January 2009, due to Tracoma’s 13
14. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation failure to redeem its first RM50 million series based on the original scheduled maturity date of 28 January 2009, as confirmed by the trustee, MARC downgraded the rating of the BaIDS to DID. The missed payment had been treated as an indication that the company was facing financial distress. On 2nd November 2009, Tracoma’s proposed RM100 million restructured Bai‟ Bithaman Ajil Debt Securities was issued in response to Tracoma’s debt restructuring plan. Based on this latest development, MARC has withdrawn its D rating and assigned CID rating on the BaIDS. Since the restructuring plan, Tracoma has proposed further changes to the structure of BaIDS, which have yet to be finalised. Finally, in July 2010, MARC has withdrawn its C ID rating on Tracoma proposed BaIDS and reinstated it’s DID rating on the Tracoma’s defaulted BaIDs. Figure 5 shows the timeline of Tracoma sukuk since it was issued until defaulted on July 2010. Figure 5: Tracoma Holding Berhad Rating Timeline MARC has taken the decision to discontinue analytical coverage on the BaIDS until the conclusion of Tracoma’s debt restructuring. The rating agency will not be performing ongoing surveillance on the BaIDS with immediate effect. By this time, there is no news on the restructuring plan and MARC is still waiting for any restructuring progress confirmation by the company. Besides JCorp, Nam Fatt and Tracoma, Ingress sukuk is another case of sukuk defaults in Malaysia. Since this sukuk was the only defaulted sukuk that structured based on ijarah contract, it was a hot topic for the discussion among the market players and academia. As per the structure in Figure 6, the sukuk holders possess undivided proportionate beneficial ownership of the assets and the rights, titles, interests and benefits under all the transaction documents. In addition, a 14
15. 8th International Conference on Islamic Economics and Finance purchase and sale undertaking is exercisable by both Ingress and ISB for the redemption of the sukuk upon the maturity of the issuance , or upon the occurrence of a dissolution event or an event of default vis-à-vis repaying any outstanding balance. Figure 6: Sukuk Ijarah Transaction Structure Referring to Figure 7, it shows that on 8th June 2004, the rating of A+ID has been assigned by MARC that reflects Ingress’ track record as one of the leading local automotive component manufacturers with a diversified customer and geographical distribution. The rating has been reaffirmed for a few times before being downgraded to A IS on 28th December 2007. The downgraded rating reflects Ingress deteriorating profitability and the breach of its debt-to-equity covenant, resulting from additional debt assumed to fund its substantial capital expenditure in respect of its Thailand operations. On 25th February 2009, MARC has downgraded its rating to A-IS from AIS due to the deteriorating liquidity position and declining profitability of Ingress and followed by a few downgrades until MARC has downgraded its rating to C IS from BB-IS on 6th July 2009 due to ISB’s decision to postpone RM45.0 million of the RM50.0 million upcoming first tranche sukuk payment due on July 9, 2009 for six months. Finally, the sukuk has been downgraded to DIS on 13th July 2009 reflects to ISB’s failure to meet its first tranche sukuk payment of RM50 million in full, based on the original scheduled maturity on July 9, 2009. 15
16. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Figure 7: Ingress Sukuk Berhad Rating Timeline Finally, MARC has withdrawn its DIS ratings on Ingress Sukuk Berhad’s (ISB) RM160 million Sukuk Al Ijarah Programme with immediate effect following the full redemption of the sukuk and cancellation of the programme on July 2, 2010. Based on the defaulted sukuk cases discussed, even though sukuk default may not pose significant threat to the capital market, however, it does have an impact on the overall reputation of Malaysia as the international hub for Islamic finance, where investors and other countries worldwide monitor the development of this particular capital market, the sukuk issuance. For a corporation that issues the sukuk in order to raise capital, the failure to make a timely payment as agreed in the contract raises the probability of default on that particular sukuk. If it fails to pay on time and finally declares a default, the rights of the firm's shareholder are affected as well. Therefore, it is crucial that the sukuk issuer takes immediate action if it foresees a possibility of defaulting. In this case, the issuer could opt for a refinancing or a restructuring. There are cases where defaults on sukuk had almost been declared, but the issuers took actions before the defaults were declared, and the sukuk was either restructured or refinanced. As evidence, Talam Corporation had already restructured its sukuk before declaring a default, whilst in the case of Ingress; the firm restructured its sukuk only after having declared a default. Another major issue in sukuk default is the investors' right and protection. Since many perceive that sukuk should be more secured rather than the conventional bonds, the default should be seen as something to be avoided from the perspective of investment attraction. In this 16
17. 8th International Conference on Islamic Economics and Finance case , since sukuk has a different structure compared to conventional bond, the protection actually depends on the structure of the contract; i.e investors' protection in ijarah sukuk structure might be different, as compared to musharakah sukuk structure. That is why it is very interesting to investigate and explore defaulted sukuk contracts in Malaysia since their structures are totally attractive from the financial and investment perspectives. This may be due to the different school of thought in Malaysia, opposed to the Middle-East countries. From the legal point of view, the discussions and debates in the Islamic finance world show that any disputes in the contract may lead to shariah non-compliance risk. Like the Middle East countries, Malaysia has also had its fair share of sukuk defaults, albeit a lower issuance value. Nonetheless, what protected Malaysia from the negative impact are the tight regulations and laws that bind the sukuk market. Both sukuk and conventional bonds are governed by similar standards, guidelines and laws that issuers have to abide by. Sukuk are therefore considered as a financial obligation, whereby the investors are recognised as creditors and rank equally with other conventional creditors. This provides some level of comfort to the investors, knowing that they are adequately protected in any unfavourable event. 6. Conclusion In the current environment, the demand for sukuk is significantly exceeds the supply. The phenomenal demand has been spurred by the high levels of surplus savings and reserves in Asia and Gulf regions. The sukuk market brings with it many benefits to both issuers and investors. Issuers can benefit from the huge increase in liquidity in the Islamic world, and can tap on these new sources of funds. An increased number of multilateral agencies are issuing sukuk to finance development projects. In addition, both government agencies and the corporate sector have considered the sukuk market as an attractive source of financing. What are the wider impacts for the sukuk defaults in the Malaysian capital market? Sukuk default in Malaysia may not pose significant threat to the local capital market; however it does have an impact on the overall reputation of Malaysia as the hub for global Islamic finance. In the Middle East, investor sentiment for sukuk issuances has been severely damaged when the Nakheel initial debt standstill and this might have halted strong rebound of the sukuk market in the wake of continued uncertainty about investor protection. Generally, there is a concern about whether shariah compliance might hamper an orderly dispute resolution under conventional law and about the legal enforceability of asset claims under the AAOIFI recommendations on sukuk structures. Considerable heterogeneity of scholastic opinion continues to hamper the creation of a consistent regulatory framework and corporate governance principles. Islamic jurisprudence is neither definite nor bound by precedent in absence of unified principles on which shariah scholars decide on compliance of new products. Fragmented opinions of shariah boards have inhibited universal recognition and enforceability of rulings, which has raised the issue of “non-shariah compliance risk”. Malaysia conforms to consistent and clear investors' protection whereby the investors are well aware of their position and options. Whilst the investors' protection is very much intact and market-tested, the legal and recovery process is also in order. Apart from being well-regulated by various standards and guidelines, Malaysia is also the only country that makes it compulsory for all tradable corporate debt securities to be rated - to enhance investors' confidence and to assist in the investment decision-making process. Another distinguishing factor for the Malaysian sukuk market is the establishment of a centralised, national level Shariah supervisory board, which 17
18. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation ensures that every sukuk issued in Malaysia, is in full compliance with the Shariah. All these factors provide sufficient protection to investors in the sukuk and conventional bond markets. The tight rules and regulations that bind the sukuk market have protected Malaysian capital market from the negative perception. Issuers have to abide by similar standards, guidelines and laws that govern both sukuk and conventional bonds. Sukuk are also considered as financial obligations since the sukuk investors are recognized as creditors and rank equally with other conventional creditors. Knowing that they are adequately protected in any unfavourable event, this provides some level of comfort to investors. Besides, the 10th Malaysia Plan which spurs numerous proposals for the construction, facilities and utilities projects, makes sukuk as one of the alternatives for the project financing. End Notes: 1 AAOIFI Shari’ah Standard No. 17 (Investment Sukuk) as adopted on May 8, 2003. An Islamic religious ruling, a scholarly opinion on a matter of Islamic law. 3 A contract made between two parties to finance a business venture. The parties are a rabb al-mal or an investor who solely provides the capital and a mudarib or an entrepreneur who solely manages the project. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. If the business is a loss, it will be borne solely by the provider of the capital. 4 A partnership arrangement between two parties or more to finance a business venture whereby all parties contribute capital either in the form of cash or in kind. Any profit derived from the venture is distributed based on a pre-agreed profit sharing ratio and a loss is shared on the basis of capital contribution. 5 A contract made between two parties to finance a business venture. The parties are rabb al-mal or an investor who solely provides the capital and mudarib or an entrepreneur who solely manages the project. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. If the business is a loss, it will be borne solely by the provider of the capital. 6 A manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to a client at an agreed rental fee and pre-determined lease period upon the `aqd (contract). The ownership of the leased equipment remains in the hands of a lessor. 7 A contract referring to the sale and purchase transaction for the financing of an asset on a deferred and installment basis with a pre-agreed payment period. The sale price includes a profit margin. 8 A contract whereby payment is made in cash at point of contract but delivery of asset purchased is deferred to a pre-determined date. 9 A purchase order contract of assets whereby a buyer places an order to purchase an asset to be delivered in the future. The buyer requires the seller or a contractor to construct the asset and deliver in the future according to the specifications given in the sale and purchase contract. Both parties decide on the sale and purchase prices and the settlement can be delayed or arranged based on a schedule of work completed. 10 There are two licensed CRAs in Malaysia which provide independent opinions on the credit risks and potential default risks of specific issuers. The first rating agency, RAM Rating Services Berhad (then, Rating Agency Malaysia Berhad (RAM), was established in November 1990; and the second is Malaysian Rating Corporation Berhad (MARC) was incorporated in October 1995. 2 18
19. 8th International Conference on Islamic Economics and Finance References Ab Ghani , A. M. 2006, Islamic Financial System: Theory and Application in Malaysia, Percetakan Nasional Malaysia Berhad, Kuala Lumpur, Malaysia. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). 2002, Investment Sukuk (Shar‟iah Standard No. 18), Accounting and Auditing Organization for Islamic Financial Institutions, Manama. al-Amine, M.B.M. 2001. The Islamic Bonds Market: Possibilities and Challenges International Journal of Islamic Financial Services, Vol. 3/ No.1. Asquith, P., Gertner, R. & Scharfstein, D. 1994. Anatomy of financial distress: an examination of junk bond issuers, Quarterly Journal of Economics, pp. 625-58. Aziz, A., Emanuel, D. & Lawson, G. 1988. Bankruptcy prediction: an investigation of cash flow based models, Journal of Management Studies, Vol. 25, pp. 35-51. Bandyopadhyay, A. 2006. “Predicting probability of default of Indian corporate bonds: logistic and Z-score model approaches”, The Journal of Risk Finance, vol. 7, no. 3, pp. 255-272. Casey, C. & Bartczak, N. 1985. Using operating cash flow to predict financial distress: some extensions, Journal of Accounting Research, Vol. 23 No. 1, pp. 384-401. Denis, D.J. & Denis, D.K. 1994. Causes of financial distress following leveraged recapitalizations, Journal of Financial Economics, Vol. 37 No. 2, pp. 129-57. Eisenhardt, K. M. 1989. “ Building Theories from Case Study Research”, Academy of Management Review, vol. 14, no.4, pp 532 – 550. Gentry, J.A., Newbold, P. & Whitford, D.T. 1985. Classifying bankrupt firms with funds flow components, Journal of Accounting Research, Vol. 23 No. 1, pp. 146-59. Grunert, J., Norden, L. & Weber, M. 2005. The role of non-financial factors in internal credit ratings, Journal of Banking and Finance, Vol. 29, pp. 509-31. International Islamic Financial Market (IIFM). 2009. Sukuk report: a comprehensive study of the International sukuk market. 1st Eds. Retrieved: 5 September 2010 Available at http://www.iifm.net/default.asp?action=category&id=66 International Islamic Financial Market (IIFM). 2010. Sukuk Report: A Comprehensive Study of the International Sukuk Market. 1st Eds. Retrieved: 5 September 2010. Available at http://www.iifm.net/default.asp?action=category&id=66 Kranhnen, J.P. & Weber, M. 2001. Generally accepted rating principles: a primer, Journal of Banking and Finance, Vol. 25, pp. 3-23. Lang, L.H.P. & Stulz, R.M. 1992. Contagion and competitive intra-industry effects of bankruptcy announcements, Journal of Financial Economics, Vol. 32 No. 1, pp. 45-60. Mohd Hafizuddin Syah Bangaan Abdullah, Hafizi Ab Majid & Shahida Shahimi. 2010. “Sukuk Structure and Underlying Risks: Lesson from Malaysia”. Paper presented at the 4th Islamic Banking, Accounting and Finance 2010, Negeri Sembilan, Malaysia, 13-14 October 2010. Noor Inayah Yaakub, Hafizuddin Syah, Wan Kama Mujani, Kamaruzaman Jussof and Mohamad Abdul Hamid, 2011, Middle-East Journal of Scientific Research 7 (Special Issue of Diversity of Knowledge on Middle East), 7(7); 22-30 Opler, T.C. & Titman, S. 1994. Financial distress and corporate performance, Journal of Finance, Vol. 49, pp. 1015-40. 19
20. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Raja Teh Maimunah Raja Abd Aziz, 2010. “Sukuk Have Lost A Lot of Credibility of Late. Is This Justified? Did We Get It Wrong? How Do We Fix It? What Are The Alternatives to Sukuk?”, So Far Journal, vol. 1, no. 1, pp. 7-9. RAM Ratings. April 2010, 2009 Corporate-Default & Ratings-Performance Study (1992–2009), RAM Rating Services Berhad, Kuala Lumpur. RAM Ratings. May 2010, Sukuk Focus, RAM Rating Services Berhad, Kuala Lumpur. RAM Ratings. August 2010, Sukuk Focus, RAM Rating Services Berhad, Kuala Lumpur. Securities Commission of Malaysia (SC). 2010. List of sukuk approved by Securities Commissions. Retrieved 3 July 2010. Available http://www.sc.com.my/paper.asp ?pageid=603&menuid=&newsid=&year=2009 Saiful Azhar Rosly & Sanusi, M., 1999. The Application of bay al-inah and bay al-dayn in Malaysian Islamic Bonds, Journal of International Islamic Financial Services. Scott, J. 1981. The probability of bankruptcy: a comparison of empirical predictions and theoretical models, Journal of Banking and Finance, Vol. 5, pp. 317-44. Wilcox, J.W. 1971. A simple theory of financial ratios as predictors of failure, Journal of Accounting Research, Vol. 9 No. 2, pp. 389-95. Zawya, 2009. Collaborative Sukuk Report: An Agenda Setting Study for the Growth and Development of the Global Sukuk Industry. Retrieved 5 July 2010. Available at www.zawya.com/sukuk/report 20
21. 8th International Conference on Islamic Economics and Finance Appendix 1 MARC ’s Rating Symbols and Definitions Islamic Capital Market Instrument Ratings Long Term Ratings MARC’s Long-Term Ratings are assigned to Islamic capital market instruments with maturities of more than one year. These ratings specifically assess the likelihood of timely payment of the instrument issued under the various Islamic financing contract(s). Investment Grade AAAID AAID AID BBBID Non-investment Grade BBID BID CID DID Description Extremely strong ability to make payment on the instrument issued under the Islamic financing contract(s). Very strong ability to make payment on the instrument issued under the Islamic financing contract(s). Risk is slight with degree of certainty for timely payment marginally lower than for instruments accorded the highest rating. Strong ability to make payment on the instrument issued under the Islamic financing contract(s). However, risks are greater in periods of business and economic stress than for instruments with higher ratings. Adequate ability to make payment on the instrument issued under the Islamic financing contract(s). Vulnerable to moderately adverse developments, both internal and external. Description Uncertainties exist that could affect the ability of the issuer to make payment on the instrument issued under the Islamic financing contract(s). Significant uncertainty exists as to timely payment on the instrument issued under the Islamic financing contract(s). Slight adverse developments could impair issuer’s ability to fulfill such obligation. Possesses a substantial risk of default, with little capacity to address further negative changes in financial circumstances. Failed to make scheduled payment on the instrument issued under the Islamic financing contract(s). Notes : Long-Term Ratings from AA to B may be modified by the addition of a plus (+) or minus (-) suffix to show relative standing within the major rating categories. Bank-guaranteed issues will carry a suffix (bg), corporateguaranteed issues, a (cg), issues guaranteed by a financial guarantee insurer (FGI), an (fg), and all other supports, an (s) when such guarantees or supports give favourable effect to the assigned rating. 21
22. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Short-Term Ratings MARC’s Short-Term Ratings are assigned to Islamic capital market instruments with original maturities of one year or less, and are intended to assess the likelihood of timely payment of the instrument issued under the various Islamic financing contract(s). Investment Grade MARC-1ID MARC-2ID MARC-3ID Non-investment Grade MARC-4ID DID Description Extremely strong capacity to make timely payment on the instrument issued under the Islamic financing contract(s). Strong capacity to make timely payment on the instrument issued under the Islamic financing contract(s). Timeliness of payment is slightly susceptible to adverse changes in operating circumstances and economic conditions. Adequate capacity to make timely payment on the instrument issued under the Islamic financing contract(s). Moderately adverse changes in operating environment and economic conditions may weaken financial capacity to fulfill such obligation. Description Vulnerable to non-payment of instrument issued under the Islamic financing contract(s). Capacity to make payment on the instrument is dependent upon favorable business, financial and economic conditions. Failed to make scheduled payment on the instrument issued under the Islamic financing contract(s). Notes: Short-Term Ratings will also carry a suffix (bg) for bank-guaranteed issues, (cg) for corporate-guaranteed issues, (fg) for FGI-guaranteed issues, and (s) for all other supports when such guarantees or supports give favorable effect to the assigned rating. Subscript „ID‟ for Long-Term and Short-Term Ratings denotes Islamic Private Debt Security. Rating Outlook MARC’s Rating Outlook assesses the potential direction of the Islamic Capital Market Instrument Rating over the intermediate term (typically over a one to two-year period). The Rating Outlook may either be: Outlook POSITIVE NEGATIVE STABLE DEVELOPING Description indicates that a rating may be raised; indicates that a rating may be lowered; indicates that a rating is likely to remain unchanged; or indicates that a rating may be raised, lowered or remain unchanged. 22
23. 8th International Conference on Islamic Economics and Finance Appendix 2 RAM ’s Rating Symbols and Definitions Debt-Based Sukuk An Issue Rating for a debt-based sukuk is RAM Ratings' current opinion on the creditworthiness of a particular debt-based sukuk. It reflects the overall capacity and willingness of an issuer to meet the financial obligations on a particular debt-based sukuk on a full and timely basis, taking into account its expressed terms and conditions. RAM Ratings’ sukuk ratings are, however, not a measure of compliance with Shariah principles or the role, formation, practices, legitimacy and soundness of the Shariah advisors’ recommendations and decisions. Long-Term Ratings Grade AAA AA A BBB BB B C D Description A sukuk rated AAA has superior safety for payment of financial obligations. This is the highest long-term Issue Rating assigned by RAM Ratings to a debt-based sukuk. A sukuk rated AA has high safety for payment of financial obligations. The issuer is resilient against adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated A has adequate safety for payment of financial obligations. The issuer is more susceptible to adverse changes in circumstances, economic conditions and/or operating environments than those in higher-rated categories. A sukuk rated BBB has moderate safety for payment of financial obligations. The issuer is more likely to be weakened by adverse changes in circumstances, economic conditions and/or operating environments than those in higher-rated categories. This is the lowest investment-grade category. A sukuk rated BB has low safety for payment of financial obligations. The issuer is highly vulnerable to adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated B has very low safety for payment of financial obligations. The issuer has a limited ability to withstand adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated C has a high likelihood of default. The issuer is highly dependent on favourable changes in circumstances, economic conditions and/or operating environments, the lack of which would likely result in it defaulting on a particular sukuk. A sukuk rated D is either currently in default or faces imminent default on its financial obligations, whether or not formally declared. The D rating may also reflect a distressed exchange, the filing of bankruptcy and/or other actions pertaining to the issuer that could jeopardize the payment of a particular sukuk. 23
24. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Short-Term Ratings Grade P1 P2 P3 NP D Description A sukuk rated P1 has high safety for payment of financial obligations in the short term. This is the highest short-term Issue Rating assigned by RAM Ratings to a debt-based sukuk. A sukuk rated P2 has adequate safety for payment of financial obligations in the short term. The issuer is more susceptible to the effects of deteriorating circumstances than those in the highest-rated category. A sukuk rated P3 has moderate safety for payment of financial obligations in the short term. The issuer is more likely to be weakened by the effects of deteriorating circumstances than those in higher-rated categories. This is the lowest investmentgrade category. A sukuk rated NP has doubtful safety for payment of financial obligations in the short term. The issuer faces major uncertainties that could compromise its capacity for payment of a particular sukuk. A sukuk rated D is either currently in default or faces imminent default on its financial obligations, whether or not formally declared. The D rating may also reflect a distressed exchange, the filing of bankruptcy and/or other actions pertaining to the issuer that could jeopardise the payment of a particular sukuk. For long-term ratings, RAM Ratings applies subscripts 1, 2 or 3 in each rating category from AA to C. The subscript 1 indicates that the issue ranks at the higher end of its generic rating category; the subscript 2 indicates a mid-ranking; and the subscript 3 indicates that the issue ranks at the lower end of its generic rating category. In addition, RAM Ratings applies the suffixes (bg) or (s) to ratings which have been enhanced by a bank guarantee or other supports, respectively. Partnership-Based Sukuk An Issue Rating for a partnership-based sukuk is RAM Ratings' current opinion on the creditworthiness of a particular partnership-based sukuk. It reflects the overall capacity and willingness of an issuer to meet the payment of capital and expected returns on a full and timely basis, taking into account the expressed terms and conditions of the investment contract. RAM Ratings’ sukuk ratings are, however, not a measure of compliance with shariah principles or the role, formation, practices, legitimacy and soundness of the shariah advisors’ recommendations and decisions. 24
25. 8th International Conference on Islamic Economics and Finance Long-Term Ratings Grade AAA AA A BBB BB B C D Description A sukuk rated AAA has superior safety for payment of capital and expected returns . This is the highest long-term Issue Rating assigned by RAM Ratings to a partnership-based sukuk. A sukuk rated AA has high safety for payment of capital and expected returns. The issuer is resilient against adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated A has adequate safety for payment of capital and expected returns. The issuer is more susceptible to adverse changes in circumstances, economic conditions and/or operating environments than those in higher-rated categories. A sukuk rated BBB has moderate safety for payment of capital and expected returns. The issuer is more likely to be weakened by adverse changes in circumstances, economic conditions and/or operating environments than those in higher-rated categories. This is the lowest investment-grade category. A sukuk rated BB has low safety for payment of capital and expected returns. The issuer is highly vulnerable to adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated B has very low safety for payment of capital and expected returns. The issuer has a limited ability to withstand adverse changes in circumstances, economic conditions and/or operating environments. A sukuk rated C has a high likelihood of not meeting the payment of capital and expected returns. The issuer is highly dependent on favourable changes in circumstances, economic conditions and/or operating environments, the lack of which would likely result in it not fulfilling the terms of the investment contract. A sukuk rated D is either currently not meeting or will not meet the payment of capital and expected returns. The D rating may also reflect a distressed exchange, the filing of bankruptcy and/or other actions pertaining to the issuer that could jeopardize the fulfillment of the investment contract's terms. 25
26. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Short-Term Ratings Grade P1 P2 P3 NP D Description A sukuk rated P1 has high safety for payment of capital and expected returns in the short term. This is the highest short-term Issue Rating assigned by RAM Ratings a partnership-based sukuk. A sukuk rated P2 has adequate safety for payment of capital and expected returns in the short term. The issuer is more susceptible to the effects of deteriorating circumstances than those in the highest-rated category. A sukuk rated P3 has moderate safety for payment of capital and expected returns in the short term. The issuer is more likely to be weakened by the effects of deteriorating circumstances than those in higher-rated categories. This is the lowest investment-grade category. A sukuk rated NP has doubtful safety for payment of capital and expected returns in the short term. The issuer faces major uncertainties that could compromise its capacity for fulfilling the terms of the investment contract. A sukuk rated D is either currently not meeting or will not meet the payment of capital and expected returns. The D rating may also reflect a distressed exchange, the filing of bankruptcy and/or other actions pertaining to the issuer that could jeopardize the fulfillment of the investment contract's terms. For long-term ratings, RAM Ratings applies subscripts 1, 2 or 3 in each rating category from AA to C. The subscript 1 indicates that the issue ranks at the higher end of its generic rating category; the subscript 2 indicates a mid-ranking; and the subscript 3 indicates that the issue ranks at the lower end of its generic rating category. In addition, RAM Ratings applies the suffixes (bg) or (s) to ratings which have been enhanced by a bank guarantee or other supports, respectively. 26
27. 8th International Conference on Islamic Economics and Finance Appendix 3 Rating Trend for Defaulted Sukuk a ) Ingress Sukuk Berhad Rating History Date Rating Status Event Rating Jun 8, 2004 A+IS INITIAL Rating Dec 8, 2005 A+IS AFFIRMED Rating Oct 12, 2006 A+IS REAFFIRMEDSTA  MARC has assigned a rating of A+IS that reflects Ingress’ track record as one of the leading local automotive component manufacturers with a diversified customer and geographical distribution; and above average financial results characterized by its favourable operating profit margin.  The rating affirmation of A+IS on ISB Sukuk Al Ijarah Issuance is underpinned by Ingress track record as one of the leading local automotive component manufacturers with a diversified customer and geographical distribution; and its fairly strong financial profile.  MARC has affirmed Ingress Sukuk Berhad’s (ISB) RM160 million Sukuk Al Ijara Issuance at A+IS with stable outlook; reflecting Ingress track record as one of the leading local automotive component manufacturers with a relatively diversified customer base and geographical distribution, and it’s fairly strong financial profile. 27
28. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation MARCWATCH Jul 31, 2007 A+IS MARCWATCHDEV MARCWATCH Oct 30, 2007 A+IS MARCWATCHDEV Rating Dec 28, 2007 AIS DOWNGRADED (MARCWATCHUPL) MARCWATCH Apr 11, 2008 AIS MARCWATCHDEV 28  The MARCWatch placement follows a recent confirmation from CIMB Trustee Berhad that a breach in the Debt to Equity Ratio had occurred based on Ingress’ audited accounts for the financial year ended 31 January 2007.  Ingress Sukuk Berhad’s (Ingress) A+IS rating on its RM160.0 million Sukuk Al Ijara Issuance Programme remains on MARCWatch Developing pending the completion of MARC’s annual rating review.  The rating has been placed on MARCWatch Developing since July 30, 2007 as a result of a breach in the Debt to Equity Ratio according to the Ijarah Agreement dated 1 July 2004.  MARC has lowered its rating from A+IS, and removed it from MARCWatch Developing.  The downgraded rating reflects Ingress deteriorating profitability and the breach of its debt-to-equity covenant, resulting from additional debt assumed to fund its substantial capital expenditure in respect of its Thailand operations.  MARC has placed rating of AIS on MARCWatch Developing following Ingress’ announcement dated April 10, 2008 to Bursa Malaysia in response to a notice by CIMB Trustee Berhad for noncompliance of financial covenants under the Sukuk issuance.
29. 8th International Conference on Islamic Economics and Finance MARCWATCH Jul 11 , 2008 AIS MARCWATCHDEV MARCWATCH Jul 28, 2008 AIS MARCWATCHNEG MARCWATCH Oct 30, 2008 AIS MARCWATCHNEG 29  MARC’s AIS rating on Ingress Sukuk remains on MARCWatch Developing following an extension of the remedy period given to Ingress until July 26, 2008, to resolve a breach in certain financial covenants under the Ijarah Agreement.  MARC has revised its MARCWatch placement from Developing following Ingress’ failure to rectify the breach in certain financial covenants under the Ijarah Agreement.  MARC has been informed by Ingress that the remedy period granted by the Sukukholders up to July 26, 2008 has not been further extended and the company has yet to conclude a refinancing scheme in relation to the Sukuk.  MARC’s long-term rating of AIS remains on MARCWatch Negative, where it had been placed on July 28, 2008 following the company’s failure to remedy the noncompliance with certain financial covenants of the Sukuk.
30. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Rating Feb 25, 2009 A-IS Rating Mar 31, 2009 BBB-IS DOWNGRADED-  MARC has downgraded its NEG rating to A-IS from AIS.  The rating remains on MARCWatch Negative where it had first been placed on July 28, 2008.  The downgrade incorporates the deteriorating liquidity position and declining profitability of Ingress and continuing existing noncompliance with certain financial covenants under the Sukuk. MARCWATCH-  MARC has lowered its rating NEG to BBB-IS from A-IS and maintains the lowered rating on MARCWatch Negative where it had been first placed on July 28, 2008.  The downgrade considers Ingress’ insufficient liquidity resources as well as the lack of positive developments with regard to its refinancing initiatives and asset disposals vis-à-vis its upcoming scheduled RM50 million Sukuk redemption in July 9, 2009. 30
31. 8th International Conference on Islamic Economics and Finance Rating Apr 10 , 2009 BB-IS Rating Jul 6, 2009 CIS Rating Jul 13, 2009 DIS DOWNGRADED-  MARC has lowered its rating NEG to BB-IS from BBB-IS.  The lowered rating remains on MARCWatch Negative.  Since MARC’s downgrade of ISB’s sukuk rating on March 31, 2009, ISB has failed to make a RM25 million payment into the Ijarah Service Rental Account (ISRA) within the required deadline of April 9, 2009.  Therefore, the MARCWatch Negative incorporates the possibility of the rating being further lowered if ISB fails to meet its sinking fund build-up requirement within the 30-day remedy period. DOWNGRADED  MARC has downgraded its rating to CIS from BB-IS.  The rating remains on MARCWatch Negative.  The rating action is based on ISB’s decision to postpone RM45.0 million of the RM50.0 million upcoming first tranche sukuk payment due on July 9, 2009 for six months. DOWNGRADED  MARC has downgraded its rating to DIS from CIS.  The rating of DIS reflects ISB’s failure to meet its first tranche sukuk payment of RM50 million in full based on the original scheduled maturity on July 9, 2009. 31
32. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Rating Feb 2, 2010 DIS UPDATE Current Rating Aug 13, 2010 DIS WITHDRAWNREDEEMED 32  MARC has issued this rating update in connection with Ingress pursuant to a confirmation received from its facility agent that approval has been obtained from the sukukholders for a further sixmonth extension of the redemption date of the first tranche of the sukuk programme to July 9, 2010 from January 9, 2010.  The redemption dates for the second and final tranches of the sukuk remain unchanged at July 9, 2010 and July 8, 2011, respectively.  MARC’s rating of DIS on the sukuk remains unchanged and continues to reflect an uncured payment default on its first tranche of the sukuk programme based on its July 9, 2009 original scheduled maturity.  The rating will remain at DIS until the default is cured or the rating is withdrawn upon the completion of parent, Ingress Corporation Berhad’s (Ingress), restructuring process.  MARC has withdrawn its DIS ratings following the full redemption of the sukuk and cancellation of the programme on July 2, 2010.
33. 8th International Conference on Islamic Economics and Finance b ) Nam Fatt Corporation ICP/IMTN Rating History Rating Date Dec 21 2005 Rating MARC-1ID /A+ID Status INITIAL Rating Dec 21, 2006 MARC-1ID /A+ID AFFIRMED Rating Aug 1, 2007 MARC-1ID /A+ID REAFFIRMED 33 Event  MARC has assigned a rating of MARC-1ID /A+ID. The rating reflect a tight issue structure with pre-determined criteria of contracts.  The structural element of this contract enhances the credit strength of Nam Fatt with good operating track record and improving financial profile.  The rating affirmation of MARC-1ID /A+ID with stable outlook premised on the tight issue structure governing the facility.  With strict drawdown and restriction type of contract which includes other clearance from MARC the contract will not have negative impact.  MARC has affirmed Nam Fatt Corporation Berhad’s (Nam Fatt) ratings for its RM250 million Islamic Commercial Paper/Islamic Medium Term Notes Programme (ICP /IMTN) at MARC-1ID /A+ID.  The rating predicted on the facility’s tight issue structure confines the utilization of drawdown for specific contracts or projects ensure them with creditworthy counterparties can be financed.
34. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation Rating Nov 24, 2008 MARC-1ID /A+ID MARCWATCH & Rating Dec 30, 2009 MARC-3ID /BBB+ID AFFIRMED-DEV  MARC has affirmed its rating of MARC-1ID / A+ID on Nam Fatt Corporation Berhad’s (Nam Fatt) RM250 million Islamic Commercial Paper/ Islamic Medium Term Notes Programme (ICP/ IMTN).  The affirmed ratings reflect the structural protections afforded to noteholders under the rated facility. MARCWATCH-  MARC has downgraded its NEG & ratings on Nam Fatt DOWNGRADE Corporation Berhad’s (Nam Fatt) RM250 million Islamic Commercial Paper/Islamic Medium Term Notes Programme (ICP/ IMTN) to MARC-3ID/ BBB+ID from MARC-1ID/ A+ID, and concurrently placed the ratings on MARCWATCH Negative.  The downgrade reflects significant and severe deterioration in the credit profile of Nam Fatt due to material delays in the progress of certain existing projects and unresolved claims in respect of its Sudan-based Melut Basin contract. 34
35. 8th International Conference on Islamic Economics and Finance MARCWATCH & Rating Mar 16, 2010 MARC-4ID /CID DOWNGRADED (MARCWATCHUPL) MARCWATCH & Rating Apr 6, 2008 DID MARCWATCHDEV  MARC has downgraded its ratings on Nam Fatt Corporation Berhad’s (Nam Fatt) RM250 million Islamic Commercial Paper/Islamic Medium Term Notes Programme (ICP/IMTN) to MARC-4ID/CID.  The rating downgraded reflecting from Nam Fatt’s failure to meet its principal and interest payment of about RM13.2 million to Bank Kerjasama Rakyat Malaysia Berhad on March 15, 2010  MARC has downgraded its long- and short-term ratings on Nam Fatt Corporation Berhad’s (Nam Fatt) RM250 million Islamic Commercial Papers/Islamic Medium Term Notes Programme (ICP/IMTN) as follows:   35 Long-term debt rating to DID from CID Short-term debt rating to DID from MARC-4ID
36. Center for Islamic Economics and Finance , Qatar Faculty of Islamic Studies, Qatar Foundation c) Tracoma Holding Berhad Rating History Rating Date Rating AID Nov 29, 2004 Rating INITIAL AID Apr 7, 2006 MARCWATCH MARCWATCH & Rating MARCWATCH Oct 3, 2006 AFFIRMED AID MARCWATCHNEG BBB+ID Feb 26, 2007 Jul 25, 2008 MARCWATCH & Rating MARCWATCH & Rating Jul 31, 2008 Rating Jan 23, 2009 Rating Status Oct 30, 2008 Jan 29, 2009 DOWNGRADED (MARCWATCHUPL) BBB+ID MARCWATCHNEG BB+ID BID CID DID DOWNGRADED (MARCWATCHNEG) DOWNGRADEDNEG (MARCWATCHUPL) DOWNGRADEDNEG DOWNGRADED (WITHDRAWNDEFAULT) 36 Event  Tracoma’s vast experience and good track record as one of the leading local manufacturers of automotive components, and its commendable financials  Tracoma Group’s proven track record as a Tier-1 local automotive component manufacturer coupled with its on-going expansion plans.  Tracoma’s delay to deposit the monthly built up in the PSA  Current negative domestic automotive industry outlook reflecting weak industry fundamentals , have an adverse impact on Tracoma’s future operating & financial performance.  Reflects heightened concerns about Tracoma’s ability to make a RM 25 million scheduled payment  Company’s tight liquidity position and limited financial flexibility  Heightened concerns over Tracoma’s ability to redeem its first BaIDS series  No payment made on its first BaIDS series of RM 50 million  Tracoma’s failure to redeem its first BaIDS series of RM 50 million, company is facing financial distress.
37. 8th International Conference on Islamic Economics and Finance Rating Rating Rating Nov 2 , 2009 Mar 5, 2010 July 15, 2010 CID RESTRUCTURED  Proposed structured, reflects CID DID DOWNGRADED 37  The rating agency notes that since the assignment of the preliminary rating to the restructured debt instrument in November 2009, Tracoma has proposed further changes to the structure of the BaIDS, which have yet to be finalised