23 September 2010

By: Fawaz Elmalki and Edward Stone, Conyers Dill & Pearman

Bermuda continues to be a popular choice of domicile for businesses in the Middle East and Asia. The success of Bermuda companies has long been reflected by their prevalence in investment fund formations in the region and their use in a myriad of other transactions including joint ventures, corporate restructurings, private equity and real estate acquisitions and personal holding companies. Offshore trusts have long been used in the Middle East and Asia for estate planning purposes but with the growth in the availability and use of non-charitable purpose trusts, offshore company and trust structures are now regularly used by financiers in the region for a variety of finance and structured finance transactions, including Islamic finance transactions.

Islamic Finance and Bermuda

Islamic financing institutions have developed a wide range of techniques using offshore vehicles which allow them to uphold religious and legal principles whilst enabling them to offer viable financial products. Bermuda companies and trusts are commonly used in a number of Islamic finance structures as highlighted below.

Sukuk

Perhaps the most commonly known Islamic financing instrument, the sukuk is still popular with Middle Eastern and international investors despite the global economic downturn.  Global sukuk issuance surged by more than 40 per cent in the first 10 months of 2009 compared to the same period in 2008 according to a recent Moody’s Investors Service report. Bermuda’s popularity as a jurisdiction for the domicile of the issuer of a sukuk is increasing and Bermuda is becoming the jurisdiction of choice for sukuk issuances backed by aircraft. Under the popular sukuk al ijara, the originator (or borrower) seeking financing “sells” the assets (such as aircraft) to a special purpose vehicle (the “SPV”) which is frequently incorporated in an offshore jurisdiction such as Bermuda.  The SPV is typically owned by a purpose or charitable trust which is also frequently established in one of the foregoing jurisdictions.  The SPV will issue sukuk, or trust certificates, and invest the proceeds in assets.  Sukuk are typically structured as trust instruments governed by English law.  The issuer of the sukuk will then hold the assets on trust for the benefit of the holders of the sukuk, using the income from the assets to make periodic payments to the sukuk holders.  Bermuda companies and trusts will also have a meaningful role to play in istisna'a sukuk, musharaka and mudaraba sukuk which normally involve the use of an SPV as the issuing entity.

In common with securitisation and other structured finance transactions, rating agencies apply selected criteria to assign credit ratings to SPVs issuing sukuk.   Experience drawn from securitisation transactions and recent sukuk indicates that rating agencies are satisfied with the corporate laws of Bermuda when assigning ratings to their transactions involving issuers in this jurisdiction.

Ijara

In a simple ijara financing, the financier buys the asset from the supplier and will normally take an increased and ongoing risk while holding such asset.   For example, the financier will often take responsibility for the insurance and major maintenance of the asset throughout the life of the ijara.   In order to mitigate any additional risks inherent to such an ijara structure, financiers often establish an offshore limited liability company to act as the lessor.

In addition, offshore companies and trusts are often used in ijara sale and leaseback structures where the lessor is incorporated in Bermuda and owned by a charitable or purpose trust established in these jurisdictions. The ijara sale and leaseback structure is especially popular in asset financing structures.  In a typical aircraft financing structure, an SPV is incorporated to act as owner and lessor or as lessee and sub-lessor of the aircraft.  It is often not possible or desirable for any of the parties to the transaction to own the SPV directly or to include the SPV as a balance sheet asset.  A solution, as discussed further below, is to establish an offshore trust pursuant to which a trustee holds the shares of the SPV.

Musharaka

Bermuda companies owe their growing popularity in musharaka structures to their well established use in conventional joint-ventures.     Bermuda offers modern common law based corporate statutes which offer the parties a stable legal framework within which to reach arrangements regarding the management of the musharaka. Bermuda companies are often used in plain vanilla structures where the parties are each issued shares in the musharaka.   In addition, a variety of more complex musharaka structures may be envisaged including one where a Bermuda company declares a trust over the musharaka assets and issues musharaka units to the musharaka partners.  

Wakala

Bermuda entities are increasingly used in sophisticated wakala structures in which the wakeel, incorporated offshore, will purchase assets and hold legal ownership of such assets on behalf of a syndicate of investors including banks.  For example, a Bermuda company will act as investment agent on behalf of a syndicate of investors in relation to asset financing structures which may be in the form of a musharaka or ijara.   The syndicate of investors will often require that such  a Bermuda company be excluded from their balance sheet in which case a Bermuda trust will be formed pursuant to which the trustee will own the company’s shares.    In addition, to give additional comfort to the investors but subject to the company holding legal title to the assets, the Bermuda company may also declare a trust over the assets it owns in favour of such syndicate of investors.

Trusts - Innovative yet established

Trusts as shareholder of the SPV

Where an SPV is used, as in an ijara sukuk, an ijara sale and leaseback or a musharaka structure, it is often the case that, as noted above, none of the parties to the transaction will wish to own the SPV directly or to include the SPV as an asset on their balance sheet.   In such cases, and also for those parties who are looking for a neutral party in a network of commercial transactions, the solution is typically to establish an offshore trust in the same jurisdiction as the SPV to hold the shares of the SPV.   The combination of a company wholly-owned by a trust provides the means by which bankruptcy remoteness can be achieved, while enabling the transaction to be effected “off balance sheet” or as an “orphan” structure in relation to its originator.  Neutrality is achieved by appointing an independent locally licensed trust company as trustee of the offshore trust.

In Bermuda a variety of trusts can be established, including discretionary trusts, charitable trusts (“charitable trusts”) and non-charitable purpose trusts (“purpose trusts”).  Historically charitable trusts, the beneficiaries of which are solely charities, were used in financing structures because trusts for non-charitable purposes were not until relatively recently recognised by the courts.  Bermuda was the first jurisdiction, in 1989, to introduce legislation expressly permitting the creation of purpose trusts.  The other jurisdictions have since followed suit and introduced legislation in broadly similar terms so that purpose trusts can now be created provided generally that their particular purposes are sufficiently certain, capable of fulfillment, lawful and not immoral or contrary to public policy.  Purpose trusts, because there is no beneficial owner of the trust assets, are particularly attractive for effecting off-balance-sheet transactions and financing commercial transactions, both conventional and shariah compliant.  In a typical ijara financing transaction, the purposes are normally to (a) subscribe for the shares of the SPV, (b) hold those shares, (c) support the SPV in pursuing the particular transaction in question, (d) enter into the relevant transaction agreements and (e) unwind the structure at the completion of the transaction.

In Bermuda, purpose trusts are created under the Trusts (Special Provisions) Act 1989.  This statute was amended by the Trust (Special Provisions) Amendment Act 1998 which has led to expanded opportunities for the use of purpose trusts.  Under the amended legislation there is no requirement for a Bermuda purpose trust to have an enforcer (although one is usually appointed) nor to have a local or licensed trustee. 

The main advantages of purpose trusts established in Bermuda are threefold:

1. The purposes of the trust and therefore the duties of the trustees can be linked and specifically tailored to the particular contemplated transactions, so that in addition to subscribing for shares of the SPV, retaining those shares and supporting the activities of the SPV in the transactions, the trust can be authorised to or restricted from carrying out certain activities in connection with the contemplated transaction.  In contrast, the duties of the trustees of a charitable trust are to maximise the benefits for the charity or charitable purposes and, depending on circumstances, a conflict of interest may arise.
2. A charitable trust that is created primarily to facilitate a particular structure or transaction and where the benefits to the charity are not maximised may be exposed to a “substance over form” argument that the trustees are really acting in the interests and for the benefit of those who benefit from the structure.
3. Most offshore centres that follow English common law principles, grant jurisdiction to the Attorney General (or some similar public official) to enforce charitable trusts that are not being properly administered for the benefit of the charity.  Whilst it is not known of any instance where the Attorney General has sought to enforce a charitable trust that is being used in a commercial structure, the risk cannot be entirely discounted in any jurisdiction where such enforcement powers exist.  Purpose trusts are enforced by the persons chosen by the parties and appointed in the trust instrument to enforce them.

The advantage of the charitable trust over the purpose trust is mainly one of nexus.  It could be argued in some circumstances that a trust appearing to be for a certain purpose or purposes is in fact a trust for the benefit of an ascertainable person.  This might give rise to a tax liability in the home jurisdiction of such a person. Although there is English case law authority that, where the benefit to a person is so indirect or intangible or is otherwise so framed so as not to give such person any locus standi to apply to the Court to enforce the trust, the trust would be considered as a purpose trust.  If the benefit is not so indirect, the trust may conversely not be considered a purpose trust.  Of course, the taxation rules in the home jurisdiction may apply different tests to determine whether a taxable benefit arises and those rules would need to be considered appropriately.  A properly structured charitable trust from which distributions are made from a realistically set level of dividend paid by the SPV may therefore be preferable as the charities would be the person deriving a benefit.  If taxation is not an issue, as is often the case in many Middle Eastern based transactions, a purpose trust may be preferable.

The SPV as trustee

In many typical sukuk, musharaka and wakala structures, the SPV will, as described above, declare itself as trustee of the assets it owns in favour of the investors.  When this happens care must be taken to ensure that the SPV does not require licensing for carrying on trust business as this will inevitably lead to increased regulation, administration and costs. 

One way to avoid any licensing requirements is to ensure that the SPV can benefit from an exemption from the trustee licensing rules, usually by qualifying as a private trust company on the basis that it acts as trustee of a limited number of connected trusts or some other specific exemption.

Bermuda private trust company legislation is particularly attractive to Islamic finance practitioners because of the simplicity of its provisions with regards to the trustee licensing exemption.  Provided that the SPV’s capacity as trustee is limited to the trusteeship of a trust or group of trusts specified in its memorandum of association, it will be exempt from licensing. There is no requirement to demonstrate that the SPV is issuing any type of financial instrument.

Meeting Market Challenges

Bermuda has been, and continues to be, a leader among offshore financial centers, with modern corporate law statutes making it a jurisdiction of choice for international businesses and their advisors. The consultation by the Bermuda government and regulatory authorities with market participants and representative organizations is a central aspect in allowing this jurisdiction to maintain its vibrant and relevant approach to the provision of investment vehicles for use in conventional and Islamic finance transactions. More recently, it is noteworthy that Bermuda’s commitment to international tax transparency standards has been recognised by the Organisation for Economic Co-Operation and Development (“OECD”) which has moved the jurisdiction onto the OECD’s “White List” of jurisdictions that are compliant with international tax transparency standards.

As demonstrated above, Bermuda companies and trusts play key roles in Islamic finance transactions and offer flexible solutions to this nascent industry. Already widely recognized for its contribution to conventional finance, Bermuda has shown its determination to maintain its leading role in the growth of the Islamic finance industry.