Islamic AircraftFinance

October 2008

Strictly private and confidential

Contents

Islamic Aircraft Finance 1

1. Some fundamentals 2

2. Typical structures for acquiring aircraft 3

3. Taking an Islamic equity interest in aircraftleased conventionally 4

4. Islamic aircraft Funds 5

5. Sukuk for aircraft portfolios 8

6. Principal Shariah issues relating to Ijara contracts 10

7. Simmons & Simmons 12

For more information 13

Offices 16

Islamic Aircraft Finance

Islamic finance – financings structured in ways to comply with the parameters ofIslamic law (Shariah) – has grown largely as a result of its application in assetfinance. Assets ranging from real estate and ships to aircraft and commoditieshave been financed in a Shariah-compliant manner by both conventional andIslamic financial institutions.

The aircraft sector in particular is one that is receiving increased attention fromMiddle Eastern airlines, asset managers and Islamic financial institutions. Aircraftare de facto permissible assets under Shariah. Despite rising oil prices and ageneral downturn in Western economies, the Middle Eastern travel industrycontinues to grow with the emergence of new airlines and orders for new aircraft.Several airlines have stated their intention to purchase their aircraft in a Shariah-compliant manner. Islamic asset managers and Islamic financial institutions arealso looking to diversify their investments – already heavily exposed to real estate– to other asset classes including aircraft.

This briefing examines in some detail the various structures that have been used inIslamic aircraft finance and illustrates some of the issues to look out for. Forairlines who have no spiritual necessity to obtain Shariah-compliant finance butwish to diversify their sources of finance, Simmons & Simmons also publish abriefing entitled “Islamic finance for conventional corporations” that may be ofinterest.

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1. Some fundamentals

Islamic finance differs from conventional finance in one crucial way: Shariahforbids the payment and receipt of interest. Since Shariah pursues the objective ofjustice for mankind, practices that are believed to be contrary to justice aredisallowed under Shariah. Some commentators mistakenly refer to Islamic financestructures as synthetic arrangements to circumvent these rules. As will be seen inthe remainder of this briefing, although there may be economic similaritiesbetween an Islamic finance structure and a conventional financing, there willnecessarily be differences – particularly from a risk perspective – between the twoproducts.

Recognising (and, where possible, mitigating) such risks is therefore essential toany Islamic financing, particularly with aircraft finance.

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2. Typical structures for acquiring aircraft

2.1 Trade at a mark-up (Murabaha)

In this structure, the financier acquires the aircraft from the vendor at cost andon-sells the aircraft to the airline at a mark-up and on deferred payment terms.The economics of this structure are similar to a fixed term loan and the mark-up isinevitably benchmarked against a conventional index such as LIBOR. Because of itsfixed-price nature, it is suitable for short tenors. The aircraft itself is mortgaged assecurity for the airline’s payment obligations under the Murabaha contract.

2.2 Leasing (Ijara)

Because of the similarities with a conventional finance lease, the Islamic lease(Ijara) is the most popular structure in Islamic aircraft finance. In this structure, thefinancier acquires the aircraft from the vendor at cost and leases the aircraft tothe airline for the duration of the financing. Shariah permits sale-and-lease backand on many occasions the vendor of the aircraft in these structures is in fact theairline itself. The aircraft is typically mortgaged as security for the airline’s paymentobligations under the Ijara contract.

The rent payable by the airline is benchmarked as per the Murabaha contract andthe rental amount may incorporate partial-payments of the principal (an Ijara waIqtina – effectively a hire-purchase). The airline undertakes to purchase the aircraftback from the financier at maturity or on default and the value to be paid for theaircraft is equal to the outstanding amount of the financing at the date of suchpurchase. The product is suitable for longer tenors and may be offered withfloating rates of rent.

2.3 Diminishing Partnership (Musharakah Muntanakisa)

The Diminishing Partnership structure is growing in popularity in real estate financeand may become more dominant for aircraft finance. In this structure, thefinancier acquires the aircraft jointly with the airline from the vendor. Their sharesin the aircraft are proportionate to their capital contributions. The financier leasesits share in the aircraft to the airline pursuant to an Ijara contract and the rentpayable is benchmarked as per the Murabaha contract. The airline undertakes topurchase the financier’s share in the aircraft over time or as a bullet at maturity.

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3. Taking an Islamic equity interest in aircraftleased conventionally

In addition to financing the acquisition of new aircraft, Islamic financialinstitutions and asset managers also actively acquire interests in aircraft that arealready the subject of a finance lease.

However, conventional finance leases are not always Shariah-compliant. Many ofthe provisions of such leases mirror the conventional loan that finances thecompany that owns the relevant aircraft (in particular, the rent calculations).Furthermore, the allocation of risks and default provisions in the lease itself will notbe Shariah-compliant (see section 6).

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4. Islamic aircraft Funds

4.1 Fund establishment

As noted earlier, Islamic financial institutions and Islamic asset managers are keento diversify their portfolio of investments, which includes the acquisition ofaircraft. It is possible to structure a Shariah-compliant aircraft fund using the sameunderlying structures as a conventional fund with a corporate or limitedpartnership structure at the fund level. Shariah issues do arise below the fund level,such as the whether streams of income are Shariah compliant (see section 6.5).Most importantly for a Shariah-compliant aircraft fund, the acquisition of therelevant aircraft must be undertaken in ways that are Shariah-compliant.

4.2 A typical aircraft acquisition for a fund

Inevitably, investors will look to leverage their investments to enhance theirinternal rate of return. This is normally achieved using the Ijara structure identifiedabove. In the context of a fund, the principal steps involved in a Shariah-compliantleveraged acquisition of an aircraft are as follows:

(a) The Islamic Investors incorporate and capitalise a special purpose vehicle(ProjectCo) for the purpose of the relevant acquisition.

(b) An orphan special purpose vehicle (FinCo) is incorporated for the purposes ofacquiring title to the aircraft. FinCo is financed by the financiers (the Finance).If the Finance is conventional, it will take the form of a loan. If the Finance isIslamic, FinCo is normally appointed as an Investment Agent to invest thefinance monies on behalf of the financiars.

(c) The purchase contract with the Vendor of the aircraft is usually negotiated bythe Airline, who nominates FinCo as the recipient of legal title to the aircraft.

(d) FinCo pays the Vendor for the aircraft using the Finance and the equity ofProjectCo (see section 6.1).

(e) FinCo grants an Ijara (lease) to ProjectCo. Since the financial obligations ofProjectCo are derived from a Shariah-compliant lease (the Ijara), the IslamicInvestors are not concerned if the Finance is conventional. The rent payable byProjectCo to FinCo under the Ijara mirror the repayment terms of the Finance(if conventional) or are stand-alone provisions in the Ijara (if Islamic).

(f) ProjectCo grants an operating lease to the Airline (the Operating Lease).

(g) The rental proceeds under the Operating Lease are first used to repay therental obligations under the Ijara. Any surplus is distributed to the IslamicInvestors.

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(h) The rental proceeds under the Ijara itself are used to repay the Finance.

(i) ProjectCo grants a unilateral undertaking in favour FinCo, promising topurchase the aircraft at maturity or on default (the Purchase Undertaking). Theprice payable under the Purchase Undertaking by ProjectCo is equal to theoutstanding Finance at the date of exercise.

(j) FinCo grants a unilateral undertaking in favour of ProjectCo, promising to sellthe aircraft to ProjectCo on demand (e.g. if there is a third party sale) (the SaleUndertaking). Similarly, the price payable under the Sale Undertaking byProjecCo is equal to the outstanding Finance at the date of exercise.

(k) FinCo appoints ProjectCo as its service agent to undertake major maintenanceand repair and procure insurance in respect of the aircraft on behalf of FinCo(see section 6.2)

(l) A comprehensive security package is provided by ProjectCo in favour of FinCo(Security Package 1). FinCo too provides a security package to the financiersincluding an assignment of its rights under Security Package 1. Sometimesfinanciers require the Airline to guarantee the obligations of FinCo.

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The above steps can be illustrated diagrammatically as follows

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FinCo

Financier(s)

Finance

title to the aircraft

Repaymentof finance

Securitypackage 2

Finance & Equity

Sale of aircraft

Islamicinvestors

Vendor ProjectCo

Aeroplane Airline

Equity Returns

OperatingLease

Rent

Rent

Purchase Undertaking;Security Package 1

ljara; Sale Undertaking;Service Agency Agreement

5. Sukuk for aircraft portfolios

Islamic aircraft portfolios yield themselves very easily to securitisation, which canbe done by way of a Sukuk. Sukuk are Shariah-compliant certificates that provideinvestors with an income profile that has the economic characteristics of a bond.Sukuk are in fact wrappers that sit on top of an underlying Shariah-compliantstructure. Where the structure underlying the Sukuk consists of aircraft leases, thestructure can in economic terms become an asset-backed securitisation. Airlinesmay consider using the Sukuk al Ijara structure to securitize their fleet.

A Sukuk al Ijara may be created from an aircraft portfolio as follows:

(a) The airline would sell specific aircraft to a special purpose vehicle (the Issuer).The Issuer issues Sukuk certificates to the market and uses the proceeds ofsuch issuance to pay for the purchase of the aircraft.

(b) The aircraft are held by the Issuer on trust for the holders of Sukuk.

(c) The Issuer leases the assets back to the airline for a fixed period of time andfor a rent pursuant to an Ijara contract (see section 2.2). The rental incomewould be shared between the Sukuk-holders pro rata to their respectiveinvestments.

(d) At maturity, the airline has the right to purchase the aircraft back from theIssuer. The price payable by the airline for the aircraft represents theredemption value for the holders of Sukuk.

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The above steps can be illustrated diagrammatically as follows:

Sukuk are attractive in the current market, particularly if they are structured asSukuk al Ijara, as they are tradable and, when rated, make attractive liquiditymanagement instruments for Islamic financial institutions. A Sukuk issuance insuch a way may also benefit from a credit enhancement by introducing finance inthe manner set out in section 4.2.

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Sukuk proceeds

Sale of aircraft

Sukuk-holders

Airline(as seller)

Issuer

Airline

Sukukproceeds

Rent income andredemption proceeds

Lease Rent

6. Principal Shariah issues relating to Ijaracontracts

6.1 Equity injection

There are various mechanisms available for the Islamic investors to provide part-payment for an aircraft. The appropriate mechanism will depend on the specifictransaction. However, this is generally done by way of a lump sum payment by thelessee pursuant to the Ijara that is expressed as the first rent instalment or anadvance payment of rent representing rent that is payable in subsequent rentperiods.

6.2 Major maintenance and repair

Under Shariah, a lessor is responsible for major maintenance and repair andinsurance in respect of its property. The lessee is responsible for ordinarymaintenance and repair only. Invariably, banks who are, or establish, a lessor arenot willing to take on such responsibilities. The lessor will therefore appoint thelessee as its service agent to undertake major maintenance and repair and procureinsurance on behalf of the lessor in return for a service agent fee. The amount ofthe service agent fee is usually added to the rent payable by the lessee under theIjara and the two payments are set-off.

6.3 Destruction of aircraft

Lessees under Shariah pay their lessor a rent for the right to occupy a property. If alessee’s use of the property is impaired (for example, if the property is destroyed),the lessee cannot be compelled to continue paying rent. This is in contrast with aconventional loan where the borrower continues to service the loan if theproperty is destroyed until the insurance proceeds are received.

6.4 Floating rates of rent

Shariah requires that payments under debt contracts are specified, otherwise thecontract would be void for uncertainty. To avoid floating rates of rent becomingvoid for uncertainty, Ijara contracts define ‘rent periods’ during which the rate ofrent payable by the lessee is fixed. The rent payable in a subsequent rent periodwould be determined prior to the commencement of that rent period and thus afloating rate of rent is achieved over the term of the lease. To remain compliantwith Shariah, the lessee would be granted an option to settle their outstandingobligations early if they are unhappy with the revised rate of rent.

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6.5 Permissible activity

Although the aircraft is under Shariah a de facto permissible asset, Shariah is alsoconcerned with the activities that are conducted on the aircraft or the usetowards which the aircraft is applied. Some investors therefore consider theincome from alcohol sales on the aircraft to be impure under Shariah. To theextent that they are able to identify the appropriate quantum of such sales, theamount is deducted from the rent payable by the airline under the operating leaseand distributed to charity.

6.6 Break costs

The recovery of breakage costs by banks upon an early settlement in Ijaracontracts can be a tricky issue. Since the payment obligations in such contracts arefixed to avoid becoming void for uncertainty, the levy of non-liquidated costs onthe lessee are generally not permissible. As a consequence, some banks limit thelessee’s rights to an early settlement to the start and end of rent periods so as toavoid incurring a break cost. However, these limitations are not alwayscommercially acceptable as it would affect the resale or refinancing of an aircraft.

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7. Simmons & Simmons

Simmons & Simmons is a world-class law firm, providing clients with quality legaladvice, whenever and wherever they need it. We have over 2,000 people in 20offices situated in key business and financial centres across Europe, the MiddleEast and Asia.

Our Islamic finance practice has extensive experience in developing Islamicfinance products and providing our clients with an end-to-end solution – fromconception to implementation. Our clients include Islamic financial institutions,conventional financial institutions and corporations. Moreover, the practice has adeep understanding of both market-practice and best-practice in Islamic finance.

We are able to prepare a comprehensive risk assessment for all of thetechnologies outlined in this briefing (from a conventional legal as well as aShariah perspective) and offer risk-mitigation strategies tailored to the needs of aclient. We also have unique expertise of discussing the mechanics of thesetechnologies with regulatory authorities and addressing any issues of regulatoryconflict directly with Shariah scholars.

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For more information

Muneer KhanT +971 (0)4 709 6699E muneer.khan@simmons-simmons.com

Muneer heads the international Islamic Finance Practice at Simmons & Simmons.He has seven years of experience in advising the World’s leading institutions andadvisors in the area of Islamic finance and has developed a close relationship withmany of the major Shariah scholars. Muneer is a member of the HM Treasury’sIslamic Finance Technical Group and the Working Group in Standardisation.Muneer is particularly well regarded for his expertise in Islamic financingstructures, with a specific focus on Shariah compliant investment funds.(Recommended in Banking: lenders and borrowers, PLC Which Lawyer? 2008).

He has also been named as an expert on Shariah-compliant investment funds inWho’s Who Legal, United Arab Emirates (2008). Muneer has appeared onnumerous television and radio interviews including CNBC Arabia and ArabianRadio Network.

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Tariq Hameed, AssociateT +971 (0)4 709 6667E tariq.hameed@simmons.simmons.com

Tariq is an award-winning English solicitor who joined Simmons & Simmons in2008. He was awarded the Professional Excellence Award at the inaugural MuslimPower 100 Awards in 2007 in recognition of his achievements in Islamic financeand promoting the industry. He was a member of the Islamic Finance ExpertsGroup that advises HM Treasury on Islamic finance strategy and is a member ofthe UK Trade & Investment Islamic Finance sub-committee where he chairs thelegal work group.

Tariq was one of the co-organisers of the seminal Islamic Finance & TradeConference 2006 where the current Prime Minister, the Rt. Hon. Gordon BrownMP, famously announced his intention to make the UK “the gateway for Islamicfinance and trade.” Tariq recently devised and launched a consultation for thestandardisation of transparency in Islamic finance for the protection of Muslimconsumers in the UK. He has appeared on numerous television and radiointerviews including BBC radio, the Islam Channel and Kuwait Television.

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