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First published in the 1LoD Global Benchmarking Survey & Annual Report 2019
Islamic finance remains one of the fastest growing sectors in the international finance industry. Estimates of the current size of the Islamic Finance market range from US$1.66 trillion to US$2.1 trillion, with an expectation that the market will expand to reach US$3.4 trillion by the end of 2018.
Islamic finance is well suited to asset finance and has adapted to provide an alternative to conventional financing structures, building upon the religious and legal principles which are at its foundations.
Islam is not just concerned with the relationship between God and man but is a system of beliefs governing all aspects of life including trade and commerce. At its core, Islamic finance is not just concerned with a prohibition on interest but aims to promote transparency, morality and fair dealing in business. The principles on which Sharia compliant financing is based include:
An Islamic financial institution will usually employ a Sharia scholar or Sharia board of scholars to advise on the development of transaction structures and to rule on the compliance of transactions with Sharia principles.
Most Sharia compliant aircraft finance transactions are structured using an Ijara. This is a form of lease pursuant to which the owner of the aircraft transfers the legal right to use and derive profit from the aircraft to another person for an agreed period and agreed rent. An Ijara can be combined with sale and purchase undertakings between lessor to lessee to create a product akin to a finance lease (an Ijara wa iqtina).
Nonetheless an Ijara is different from a conventional lease. The requirements of Sharia challenge the traditional allocation of risk and responsibility between lessor and lessee in an aircraft lease transaction. For example, in an Ijara as the ownership of the aircraft is not transferred, the liabilities of the ownership of the aircraft remain with the lessor. As a consequence, in an aircraft Ijara it is usually the lessor rather than the lessee who is expressed to remain responsible for the performance of major maintenance and structural repair and for obtaining hull insurance. Similarly if the aircraft suffers a total loss then no further rent is due from the lessee. Certain scholars take the view that rent should also cease where an aircraft suffers damage not amounting to a total loss if the aircraft is taken out of service as a result.
An Ijara needs to abide by the principles of certainty. It is sometimes argued by scholars that the Ijara contract should be entered into on the actual delivery date of the aircraft and can not be signed in advance with delivery subject to the fulfilment of conditions precedent. The term of the Ijara needs to be certain. Whilst rent can be determined by a formula, the basis of the calculation should be clearly established. Confirmation of the amount of rent due is sometimes required in a notice from the lessor to the lessee which the lessee is then entitled to accept or reject.
An Ijara also needs to abide by the principle of fairness. For example, events of default are often limited to circumstances within the direct control of the airline (such as non payment). Other circumstances such as illegality events or material adverse changes in market conditions may give a right for the lessor to require the lessee to purchase the aircraft but are not of themselves events of default. Some scholars also take the view that indemnities should reflect an allocation of fault rather than an allocation of risk.
Although in some circumstances Sharia principles may appear to conflict with conventional notions of risk allocation between a financier or lessor and a lessee, it is important that Sharia compliant transaction documentation does reflect commercial reality. For example, it would be rare that a lessor had sufficient maintenance and insurance capability to support the commercial operation of an aircraft. Techniques have therefore developed to ensure that, whilst the documentation conforms to the principles of Sharia, it recognises that the airline will maintain and insure the aircraft in practice.
Over the last few years we have seen a number of aviation entities make a foray into the Islamic finance market. Examples of this include the launch of a US$5 billion Shariah-compliant aircraft leasing fund by International AirFinance Corp, representing the first time that an aircraft financing company has exclusively utilised an Islamic finance structure for their leasing operations. In addition, many of the world’s leading airlines have issued Islamic bonds (or “sukuk”) to raise funds via the debt capital markets, generally for the purpose of funding the acquisition or leasing of new aircraft. These airlines include amongst others Emirates, Etihad Airlines, Saudi Arabian Airlines, Air Arabia, Royal Jordanian, Pakistan International Airlines, SriLankan Airlines, Garuda Indonesia, Malaysian Airlines, Turkish Airlines, Ethiopian Airlines and AirAsia. As well as the more vanilla sukuk issuances by airline companies, there is also a growing appetite to explore more innovative Islamic products.
An example of innovation in Islamic airline financing is the Emirates ECA sukuk, the first ever Export Credit Agency (ECA) backed sukuk transaction;the proceeds of which were used for the pre-funded aircraft financing of four Airbus A380-800 aircraft, subsequently leased to and operated by Emirates. The transaction was the largest ever capital markets offering in the aviation sector to have the benefit of an ECA guarantee and was the first time this alternative source of funding had been successfully used to pre-fund the acquisition of aircraft.
The certificates, which comprised US$913 million sukuk due 2025, were issued by a Cayman Islands incorporated special purpose vehicle, have a tenor of ten years and were listed on both the regulated market of the London Stock Exchange and NASDAQ Dubai and were issued in line with Regulation S and Rule 144A of the United States Securities Act of 1933. The transaction used an innovative Islamic finance structure which was based on a combination of ijara (leases) and manfa’a (usufruct represented by available tonne kilometres, an airline industry measure of total capacity) to overcome challenging Islamic structuring issues on ‘tangibility’ during the pre-funding period. This innovative structuring allowed a sukuk financing to be combined with pre-funded aircraft financing, which then also benefited from an ECA, UK Export Finance guarantee.
The current availability of Islamic finance as a source of financing for aircraft should not be over stated. Market activity in the aviation sector remains concentrated in the traditional centres of Islamic finance such as the Middle East and Malaysia. Islamic debt finance generally remains a more expensive source of funds than conventional debt finance and the term of the financing typically falls short of the 10 to 12 year loan terms available from conventional lenders.
However there is potential for broader market participation. We are already seeing Islamic finance being considered as the basis of a number of new products, including enhanced equipment trust certificates (EETCs), tax leasing structures and Islamic securitisation as the aviation and Islamic finance industries continue to collaborate. It is hoped that such innovation will further increase the significance of Islamic finance as a source of finance for the aviation industry.
First published in the 1LoD Global Benchmarking Survey & Annual Report 2019
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