Purchase Undertaking

A purchase undertaking is a unilateral, binding promise in which one party, usually the originator or obligor of a sukuk, undertakes to buy the underlying assets from the sukuk issuer at a specified time or on specified events. In most sukuk those events are the scheduled maturity date and any dissolution event, such as a payment default. The exercise price is normally set so that it equals the face amount of the certificates plus any accrued but unpaid periodic distribution, which is how sukuk investors get their principal back.

The purchase undertaking is one of the most important documents in a sukuk transaction, because it converts an investment in assets into an exposure that behaves much like a senior unsecured bond. It is also one of the most debated, since its pricing determines whether investors genuinely share in asset risk.

In a typical structure, the originator sells or leases assets to a special purpose vehicle, which issues sukuk certificates to investors and holds the assets on trust for them. During the life of the sukuk, the investors receive periodic distributions from rent, profit or other income. At the end, the issuer needs a way to turn the assets back into cash. The purchase undertaking provides it: the issuer, or the trustee on the investors' behalf, can require the originator to purchase the assets at the exercise price.

The undertaking is usually expressed as a wa'd, a unilateral promise that Islamic jurisprudence treats as binding in commercial settings, rather than as a bilateral sale agreed in advance. A bilateral forward sale of the assets at a fixed future date would raise objections in fiqh al-mu'amalat, while a promise from one side does not create a sale until it is exercised. A matching sale undertaking is often given by the issuer to the originator, letting the originator call the assets back, for example on an early redemption for tax reasons.

The central issue is the price. If the originator must repurchase at face value regardless of what the assets are worth, investors are protected from any fall in asset value, and the sukuk looks economically like a loan with a guaranteed return of capital.

In 2007 Sheikh Muhammad Taqi Usmani, then chairman of the Shari'ah Board of AAOIFI, criticized the market practice of fixed-price purchase undertakings in partnership-based sukuk. AAOIFI's 2008 resolution on sukuk followed: in mudarabah, musharakah and wakalah sukuk, the manager or partner may not promise to buy the assets at their nominal value, and a repurchase should be at market value or a price agreed at the time of sale. The resolution allowed a lessee in an ijarah sukuk to undertake to buy the leased asset at its nominal value, because the lessee is not a partner or manager of the investors' capital.

Market practice adapted. Many issuers moved toward ijarah, hybrid and murabaha-based structures in which a face-value purchase undertaking remained acceptable, while partnership sukuk used other mechanisms.

The purchase undertaking is a large part of why most sukuk are described as asset-based rather than asset-backed. In an asset-based sukuk, investors have a right to the assets in Sharia terms, but their real recourse on default is a claim against the originator under the purchase undertaking, ranking alongside the originator's unsecured creditors. In an asset-backed sukuk, the assets are transferred in a true sale and investors rely on the assets themselves. Rating agencies typically rate asset-based sukuk on the credit of the obligor for this reason.

Because the undertaking is the main repayment source, its enforceability matters. Sukuk documents are often governed by English law while the assets and the originator sit in another jurisdiction, so investors may need a local court to enforce an English judgment. The Dana Gas dispute of 2017, in which the issuer argued that its mudarabah sukuk had become non-compliant with Sharia and therefore unenforceable in the UAE, showed that the structure could be challenged and highlighted Sharia non-compliance risk for investors. The Sharia supervisory board fatwa issued at launch is meant to reduce that risk but cannot remove it.

A company raises USD 500 million through a five-year ijarah sukuk. It sells a portfolio of buildings to the issuer and leases them back, paying rent that funds the periodic distributions. It also gives a purchase undertaking. At maturity, the trustee exercises the undertaking and the company pays USD 500 million plus any unpaid rent to buy the buildings back. That payment is passed to investors and the sukuk are redeemed.

• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)