Sukuk Recovery Is Still Untested in Most Islamic Finance Markets

The majority of the Organization of Islamic Cooperation (OIC) countries covered by Fitch Ratings’ updated Country-Specific Treatment of Recovery Ratings Criteria fall into the lowest level of recovery, says Fitch. However, sukuk recoveries given default vary between key issuing jurisdictions and remains largely untested and under-developed. There are also very few legal precedents in terms of effective enforcement in many of the jurisdictions where sukuk issuance is prevalent.

Fourteen of the 57 OIC countries are covered by the updated criteria. Countries are split into four groups (A to D), with differing caps on instrument ratings and recovery ratings (RRs) based on country-specific factors. Whilst none of the OIC countries is in Group A, over half are in Group D – the group with the lowest level of recovery.

The UAE and Qatar are the only countries among the core Islamic finance markets that are classified in the second-highest category, Group B, defined as jurisdictions where the recoveries range from superior to poor. Saudi Arabia, Bahrain, Oman and Malaysia are Group C, with recoveries ranging from good to poor. Fitch classifies the remaining eight OIC countries – Azerbaijan, Indonesia, Jordan, Kazakhstan, Morocco, Nigeria, Turkiye and Uzbekistan – in Group D, where the recoveries range from average to poor.

Bankruptcy laws have been updated over recent years in many of the countries in which Islamic finance is prevalent. However, there is little precedent as to how bankruptcy courts might treat sukuk defaults, and whether this might be different to bond defaults in such events, and if sukuk certificate holders will be able to enforce their contractual rights in local courts. English law often governs sukuk issued on the international capital markets, but some of the documents would be governed by local law from where the originator is domiciled – local courts would review the documentation as well as any judgement, which could be subject to local restrictions on enforceability.

As sukuk default resolution and recovery has few legal precedents in most key markets, the level and scope of investors’ ability to exercise their contractual rights is uncertain. As of end-1Q23, only 0.24% of all issued sukuk had defaulted, with the first Fitch-rated sukuk defaulting in 2021. Additionally, in 1Q23, 78.5% of Fitch-rated outstanding sukuk were investment-grade. Sharia (Islamic rulings) has an influence on the sukuk rating process, but being rated does not necessarily imply that the sukuk are sharia-compliant.

The classification of countries is based on the assessment of each country’s governance environment, leveraging three indicators reported by the Worldwide Governance Indicators project of the World Bank. Qatar and the UAE, both Group B countries under Fitch’s assessment, had some of the highest rankings of the 55 covered OIC countries. The UAE recorded the highest rank (82.2) for Regulatory Quality, followed by Brunei and Qatar. Qatar scored 81.3 under the indicator Rule of Law, followed by Brunei and UAE, and Brunei ranked highest under the Control of Corruption indicator, at 86.1, followed by the UAE and Qatar.