Dar Al-Arkan Real Estate Development Company’s (Dar Al-Arkan) US$450 million hybrid Sukuk issuance of 2010 marks the first issuance of a high-yield Sukuk ever, and the first Rule 144A Sukuk issuance in the Kingdom of Saudi Arabia.

The Sukuk which is due in 2015 will yield 10.75% and allow US investors to participate for the first time in a Saudi Sukuk issue. The transaction represents a unique pairing of Islamic finance in the Kingdom of Saudi Arabia with one of the world’s most liquid investment structures.
Dar Al-Arkan is a leading real estate developer in the Kingdom of Saudi Arabia. It is involved in all major aspects of real estate development, including sourcing and purchasing land, overseeing design and construction and marketing and sales. Its business is focused on planning and developing basic infrastructure for undeveloped lands for residential and commercial use in addition to the development and sale of residential units.

Sukuk Structure
Dar Al-Arkan’s Sukuk was issued to finance its projects, which are usually carried out by its subsidiaries. The issuer of the Sukuk is Dar Al-Arkan International Sukuk Company II, a wholly owned Cayman Islands SPV of Dar Al-Arkan. The Issuer, pursuant to a declaration of trust, undertakes to hold its interests under the Sukuk terms in trust for the benefit of the Sukukholders.

Pursuant to an investment management agreement between the issuer and Al-Arkan Sukuk Company acting as an investment manager, the investment manager is required to invest the proceeds of the sale of the Sukuk in a portfolio of Murabahah and Ijarah investments, which is expected to generate periodic returns equal to the periodic profits that the Sukukholders are entitled to under the Sukuk certificates. The return on the Sukuk will be paid on a semi-annual basis.
The Murabahah and Ijarah investments to be made by the investment manager will be undertaken with subsidiaries of Dar Al-Arkan, to finance their projects.
Under the Ijarah investments, a subsidiary of Dar Al-Arkan will enter into a sale and lease-back arrangement with the Investment Manager whereby that subsidiary will sell part, or all of its assets to the Investment Manager, which will then use the Sukuk proceeds to pay for those assets. Subsequently, the subsidiary will enter into an Ijarah agreement with the investment manager to lease back those assets.

The Dar Al-Arkan subsidiary will then use proceeds from the sale to finance its projects and the investment manager will use the rent payable by the subsidiary to pay a portion of the periodic return due to the Sukukholders.

Under the Murabahah investments, a subsidiary of Dar Al-Arkan in need of materials for its projects will request the Investment Manager to purchase those materials using the Sukuk proceeds and sell the materials to it on a cost-plus basis via installments. The mark-up at which the materials are sold to the subsidiary will constitute the return on the Murabahah investments; from which the return on the Sukuk will be paid to the Sukukholders.

According to Shariah principles, liquid assets can only be traded at par value, without any profit. In order to allow the Sukuk to be tradable at a fluctuating price and pay a profit, the underlying asset must therefore be an illiquid asset. In the case of Dar Al-Arkan, the illiquid nature of the Sukuk Portfolio is ensured by requiring that Ijarah investments shall constitute at least 51% of the Sukuk Portfolio.

Guarantee
The Sukuk is guaranteed by Dar Al-Arkan by way of a guarantee issued in favor of the issuer, whereby Dar Al-Arkan undertakes to pay the issuer for payment to the Sukukholders any shortfall in the profits due to the Sukukholders at any given time in certain limited circumstances.
On the maturity date, if there is any shortfall between the amount realized from liquidating the Sukuk Portfolio and the par value of the Sukuk, Dar Al-Arkan undertakes to make up the shortfall.

However, given that the Shariah prohibits guaranteeing capital in any investment or any profits received thereon, the guarantee is only triggered when the abovementioned shortfalls result from the negligence or the failure of the investment manager to comply with its obligations under the terms of the Sukuk and the various transaction documents. The guarantee specifically excludes the fluctuation in value of the underlying real estate or commodities to which the Ijarah and the Murabahah investments relate to as an event that would trigger the terms of the guarantee.

“High-Yield” Covenants
Dar Al-Arkan’s Sukuk issuance represents the first Sukuk issuance in the GCC region with a proper covenant package. The offering circular sets out in full detail the covenants to which the guarantor is subject to in addition to any qualifications or exceptions.

Pursuant to the guarantee issued by Dar Al-Arkan, these covenants include— among others— incurrence of additional indebtedness, paying of dividends to shareholders, selling of assets, entering into transactions with affiliates, engaging in different business activities, creation of liens on assets to secure debt, entering into sale and leaseback transactions and merging or consolidating with another company. However, some of these covenants cease to apply once the Sukuk receives an investment grade rating (one of the four highest rating categories) from Moody’s and Standard & Poor’s and for the duration that the rating is maintained. In line with the high-yield deals in the US and Europe, these covenants are dubbed “incurrence” and not “maintenance” covenants.
Sukuk Dissolution
Two days prior to the maturity date in 2015, the investment manager shall liquidate the Sukuk Portfolio and pay the proceeds of such liquidation to the Sukukholders. Upon the occurrence of an event of default under the Sukuk terms, the issuer shall exercise it rights under the Investment Management Agreement and direct the investment manager to liquidate the Sukuk Portfolio and pay the liquidation proceeds to the Issuer for payment to the Sukukholders.

If additional amounts with respect to the Sukuk or the Sukuk Portfolio become payable as a result of a change or an amendment to any applicable law, the issuer, by giving a
notice to the Sukukholders, has the right to redeem the Sukuk in whole, and not in part.

Conclusion
The success of the Dar Al-Arkan Sukuk represents another significant milestone in the development of Islamic finance in the Kingdom of Saudi Arabia. The success of the issuance was all the more remarkable in view of the downcast mood surrounding regional Sukuk issuances.

The Dar Al-Arkan issuance has provided a foundation for future similar transactions and establishes another funding source beyond the traditional sources of capital in the Kingdom of Saudi Arabia.