Implications of the evolution of sukuk from asset-backed to asset-based structures

Summary

People use terms such as "asset backed" and "asset based" with sukuk without being clear what they mean.
After defining the terms, I point out that investors in asset based sukuk have much less protection in the event of default by the sponsor.
The credit ratings agencies have been saying the same thing for many years, but few people paid attention until the financial crisis hit some of the Gulf states.

The magazine Islamic Finance News in its edition of 7 November 2012 posed the following question to its forum of experts:

The full responses are only available to readers of the magazine. However I have reproduced my own response below.

I understand “Asset backed” to mean that the underlying asset has fully transferred to the ownership of the sukuk structure. Consequently insolvency of the original owner which has sponsored the sukuk’s creation does not imperil the asset. Furthermore failure by the sponsor to perform its contractual obligations will mean that the special purpose vehicle (SPV) used to issue the sukuk can sell the asset and distribute the funds to the sukuk investors.

I understand “Asset based” to mean that the underlying asset is not fully transferred to the sukuk issuing SPV. Instead the SPV merely has some legal rights sufficient to enable the Shariah Supervisory Board to sign off the sukuk as Shariah compliant. If the original owner becomes insolvent, its creditors can seize the asset. Conversely the SPV does not have sufficient ownership of the asset to sell it in the case of failure by the original owner to honour its contractual commitments under the sukuk arrangements, such as paying rent for use of the asset.

For many years the ratings agencies warned that most sukuk being issued by GCC [Gulf Cooperation Council] companies should be regarded as only being asset based (using the above definitions) for several reasons, including insufficiently developed insolvency laws and local restrictions on ownership of land by foreign persons. Investors largely ignored these warnings until the recent Gulf financial crisis.

Investors in asset based sukuk (using the above definitions) have much less security than investors in asset backed sukuk. They need to satisfy themselves that they are being paid a return commensurate with the additional risks that they are taking on.