Islamic Aircraft

Finance

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 aircraft

leased 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 of
Islamic law (Shariah) – has grown largely as a result of its application in asset
finance. Assets ranging from real estate and ships to aircraft and commodities
have been financed in a Shariah-compliant manner by both conventional and
Islamic financial institutions.

The aircraft sector in particular is one that is receiving increased attention from
Middle Eastern airlines, asset managers and Islamic financial institutions. Aircraft
are de facto permissible assets under Shariah. Despite rising oil prices and a
general downturn in Western economies, the Middle Eastern travel industry
continues 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 are
also 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 in
Islamic aircraft finance and illustrates some of the issues to look out for. For
airlines who have no spiritual necessity to obtain Shariah-compliant finance but
wish to diversify their sources of finance, Simmons & Simmons also publish a
briefing entitled “Islamic finance for conventional corporations” that may be of
interest.

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 1. Some fundamentals
Islamic finance differs from conventional finance in one crucial way: Shariah
forbids the payment and receipt of interest. Since Shariah pursues the objective of
justice for mankind, practices that are believed to be contrary to justice are
disallowed under Shariah. Some commentators mistakenly refer to Islamic finance
structures as synthetic arrangements to circumvent these rules. As will be seen in
the remainder of this briefing, although there may be economic similarities
between an Islamic finance structure and a conventional financing, there will
necessarily be differences – particularly from a risk perspective – between the two
products.

Recognising (and, where possible, mitigating) such risks is therefore essential to

any 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 and
on-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 is
inevitably benchmarked against a conventional index such as LIBOR. Because of its
fixed-price nature, it is suitable for short tenors. The aircraft itself is mortgaged as
security 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, the
financier acquires the aircraft from the vendor at cost and leases the aircraft to
the airline for the duration of the financing. Shariah permits sale-and-lease back
and on many occasions the vendor of the aircraft in these structures is in fact the
airline itself. The aircraft is typically mortgaged as security for the airline’s payment
obligations under the Ijara contract.

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

2.3 Diminishing Partnership (Musharakah Muntanakisa)

The Diminishing Partnership structure is growing in popularity in real estate finance

and may become more dominant for aircraft finance. In this structure, the
financier acquires the aircraft jointly with the airline from the vendor. Their shares
in the aircraft are proportionate to their capital contributions. The financier leases
its share in the aircraft to the airline pursuant to an Ijara contract and the rent
payable is benchmarked as per the Murabaha contract. The airline undertakes to
purchase the financier’s share in the aircraft over time or as a bullet at maturity.

3
 3. Taking an Islamic equity interest in aircraft
leased conventionally
In addition to financing the acquisition of new aircraft, Islamic financial
institutions and asset managers also actively acquire interests in aircraft that are
already the subject of a finance lease.

However, conventional finance leases are not always Shariah-compliant. Many of

the provisions of such leases mirror the conventional loan that finances the
company that owns the relevant aircraft (in particular, the rent calculations).
Furthermore, the allocation of risks and default provisions in the lease itself will not
be 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 keen
to diversify their portfolio of investments, which includes the acquisition of
aircraft. It is possible to structure a Shariah-compliant aircraft fund using the same
underlying structures as a conventional fund with a corporate or limited
partnership 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 the
relevant 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 their

internal rate of return. This is normally achieved using the Ijara structure identified
above. In the context of a fund, the principal steps involved in a Shariah-compliant
leveraged 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 of
acquiring 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 is
Islamic, FinCo is normally appointed as an Investment Agent to invest the
finance monies on behalf of the financiars.

(c) The purchase contract with the Vendor of the aircraft is usually negotiated by
the 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 of
ProjectCo (see section 6.1).

(e) FinCo grants an Ijara (lease) to ProjectCo. Since the financial obligations of
ProjectCo are derived from a Shariah-compliant lease (the Ijara), the Islamic
Investors are not concerned if the Finance is conventional. The rent payable by
ProjectCo 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 the
rental obligations under the Ijara. Any surplus is distributed to the Islamic
Investors.

5
 (h) The rental proceeds under the Ijara itself are used to repay the Finance.

(i) ProjectCo grants a unilateral undertaking in favour FinCo, promising to

purchase the aircraft at maturity or on default (the Purchase Undertaking). The
price payable under the Purchase Undertaking by ProjectCo is equal to the
outstanding Finance at the date of exercise.

(j) FinCo grants a unilateral undertaking in favour of ProjectCo, promising to sell

the aircraft to ProjectCo on demand (e.g. if there is a third party sale) (the Sale
Undertaking). Similarly, the price payable under the Sale Undertaking by
ProjecCo is equal to the outstanding Finance at the date of exercise.

(k) FinCo appoints ProjectCo as its service agent to undertake major maintenance
and 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 financiers
including an assignment of its rights under Security Package 1. Sometimes
financiers require the Airline to guarantee the obligations of FinCo.

6
The above steps can be illustrated diagrammatically as follows

Islamic
Financier(s)
investors

Security Finance Repayment Equity Returns

package 2 of finance

Rent

ProjectCo
Finance & Equity

Vendor FinCo Purchase Undertaking;

Sale of aircraft Security Package 1

ljara; Sale Undertaking;

Service Agency Agreement

title to the aircraft Operating Rent

Lease

Aeroplane Airline

7
 5. Sukuk for aircraft portfolios
Islamic aircraft portfolios yield themselves very easily to securitisation, which can
be done by way of a Sukuk. Sukuk are Shariah-compliant certificates that provide
investors 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-compliant
structure. Where the structure underlying the Sukuk consists of aircraft leases, the
structure can in economic terms become an asset-backed securitisation. Airlines
may 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 of
such 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 and
for a rent pursuant to an Ijara contract (see section 2.2). The rental income
would be shared between the Sukuk-holders pro rata to their respective
investments.

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

8
The above steps can be illustrated diagrammatically as follows:

Sukuk-holders

Sukuk Rent income and

proceeds redemption proceeds

Sukuk proceeds
Airline
Issuer
(as seller)
Sale of aircraft

Lease Rent

Airline

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

9
 6. Principal Shariah issues relating to Ijara
contracts
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 specific
transaction. However, this is generally done by way of a lump sum payment by the
lessee pursuant to the Ijara that is expressed as the first rent instalment or an
advance payment of rent representing rent that is payable in subsequent rent
periods.

6.2 Major maintenance and repair

Under Shariah, a lessor is responsible for major maintenance and repair and
insurance in respect of its property. The lessee is responsible for ordinary
maintenance and repair only. Invariably, banks who are, or establish, a lessor are
not willing to take on such responsibilities. The lessor will therefore appoint the
lessee as its service agent to undertake major maintenance and repair and procure
insurance on behalf of the lessor in return for a service agent fee. The amount of
the service agent fee is usually added to the rent payable by the lessee under the
Ijara 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 a
lessee’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 a
conventional loan where the borrower continues to service the loan if the
property is destroyed until the insurance proceeds are received.

6.4 Floating rates of rent

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

10
6.5 Permissible activity

Although the aircraft is under Shariah a de facto permissible asset, Shariah is also
concerned with the activities that are conducted on the aircraft or the use
towards which the aircraft is applied. Some investors therefore consider the
income from alcohol sales on the aircraft to be impure under Shariah. To the
extent that they are able to identify the appropriate quantum of such sales, the
amount is deducted from the rent payable by the airline under the operating lease
and distributed to charity.

6.6 Break costs

The recovery of breakage costs by banks upon an early settlement in Ijara

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

11
 7. Simmons & Simmons
Simmons & Simmons is a world-class law firm, providing clients with quality legal
advice, whenever and wherever they need it. We have over 2,000 people in 20
offices situated in key business and financial centres across Europe, the Middle
East and Asia.

Our Islamic finance practice has extensive experience in developing Islamic

finance products and providing our clients with an end-to-end solution – from
conception to implementation. Our clients include Islamic financial institutions,
conventional financial institutions and corporations. Moreover, the practice has a
deep understanding of both market-practice and best-practice in Islamic finance.

We are able to prepare a comprehensive risk assessment for all of the

technologies outlined in this briefing (from a conventional legal as well as a
Shariah perspective) and offer risk-mitigation strategies tailored to the needs of a
client. We also have unique expertise of discussing the mechanics of these
technologies with regulatory authorities and addressing any issues of regulatory
conflict directly with Shariah scholars.

12
For more information
Muneer Khan
T +971 (0)4 709 6699
E 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 and
advisors in the area of Islamic finance and has developed a close relationship with
many of the major Shariah scholars. Muneer is a member of the HM Treasury’s
Islamic Finance Technical Group and the Working Group in Standardisation.
Muneer is particularly well regarded for his expertise in Islamic financing
structures, 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 in

Who’s Who Legal, United Arab Emirates (2008). Muneer has appeared on
numerous television and radio interviews including CNBC Arabia and Arabian
Radio Network.

13
 Tariq Hameed, Associate
T +971 (0)4 709 6667
E tariq.hameed@simmons.simmons.com

Tariq is an award-winning English solicitor who joined Simmons & Simmons in

2008. He was awarded the Professional Excellence Award at the inaugural Muslim
Power 100 Awards in 2007 in recognition of his achievements in Islamic finance
and promoting the industry. He was a member of the Islamic Finance Experts
Group that advises HM Treasury on Islamic finance strategy and is a member of
the UK Trade & Investment Islamic Finance sub-committee where he chairs the
legal work group.

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

14
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