Islamic Finance. An introduction. Contents. September Introduction Shari ah law Products Banking Services Practical points

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1 Islamic Finance An introduction September 2007 Contents Introduction Shari ah law Products Banking Services Practical points

2 Introduction The continuing development and growth in wealth throughout many Muslim states has led to a growing pool of money looking for a home in investments which are consistent with the values of the Islamic faith. These instruments have been made on the basis of traditional structures and techniques which have evolved and been refined, within the parameters of Islamic jurisprudence, to accommodate modern financial institutions and financing requirements. This market sector is currently worth approximately US$400 billion and continues to grow at a rate of 15% each year. Shari ah law Sources Islamic finance is finance which is compliant with Islamic (or Shari ah) law. Shari ah law is not a codified system of law and any transaction will still need to be governed by the laws of a suitable jurisdiction. Shari ah law is derived from the following sources: Qur an - this contains the rules explicitly established by God as set down by the Prophet Mohammed; Hadith these are the sayings and reported actions of the Prophet Mohammed and are collectively known as the Sunnah; Fiqh - this is a body of Islamic jurisprudence which has been built up over the last 500 years and includes detailed coverage of commerce, finance and taxation issues. Main Principles Interpretations of the key principles can vary. However, the main principles of Shari ah law relevant to Islamic finance are: Interest (Riba) The payment and receipt of interest are prohibited. Money is regarded as merely a means of exchange, with no intrinsic value, and any obligation to pay interest is considered void. Strictly speaking, the concept of riba extends beyond interest and usury and can best be described in terms of the prohibition of unfair exploitation by one party who owns a product (which would include money or capital) which another party wishes to acquire. Given that interest-earning investments are prohibited, banks using Islamic finance products must obtain their earnings by or through profit-sharing investments or fee-based returns. In addition, in order to have a legitimate business loan under Shari ah law, it is essential that the financier should take part of the risk in the project being financed. Otherwise any gain over the amount owned will be classified as interest. Although the taking or receiving of interest is prohibited, this will generally not prohibit the use of an interest rate as a means of calculating a profit entitlement or level of rent. Speculation (Maisir) Shari ah law does not permit gambling or forms of speculation akin to gambling. As a result, many Islamic financial institutions feel unable to enter into derivative transactions such as swaps, futures, options or contracts that insure for a profit. These products are often not permissible (haram) and have been declared void. Prohibited investments Investments involving certain products, such as pork, alcohol or armaments, and activities such as gambling, are prohibited. Accordingly, Islamic institutions may encounter difficulties with investments in businesses such as hotels and the entertainment industry. However, recently there has been a relaxation in certain areas. Examples include the financing of shopping centres, which may be deemed to be Shari ah compliant even though they contain an off licence or a bookmaker, or investments in an asset such as a hotel which derive a small proportion of its revenue from the sale of alcohol.

3 Uncertainty (Gharar) The existence of uncertainty in a contract is also prohibited, particularly uncertainty as to one of the fundamental terms (such as subject matter, price or time of delivery). Accordingly, when entering into a contractual relationship, there must be a full disclosure by both parties. Any type of transaction where the subject matter, the price or both are not determined and fixed in advance will be viewed with suspicion under Shari ah law. This includes a prohibition on selling something that one does not already own. This is relevant, for example, in relation to the financing of construction projects. Uncertainty is also one of the reasons why a conventional insurance arrangement is not permissible under Shari ah law. Public Interest (Maslahah) Any product should be in the public interest. Trade and enterprise, which can generate real wealth for the benefit of the community as a whole, are encouraged between partners sharing profits and losses. On occasions, maslahah can be useful in overriding other Shari ah rules. For example, maslahah is often used to overrule gharar (uncertainty) when financing construction projects. Unjust enrichment Contracts where one party is regarding as having unjustly gained at the expense of another are considered void. This principle is wide. For example, it is not possible for a financier to benefit financially by imposing and retaining a default fee on debt which is unpaid. However, there are solutions to this (see Practical points Default below). Procedure An institution providing Islamic products will refer any new product to its Shari ah board. The Shari ah board consists of a number of learned scholars (muftis). They monitor the workings of the bank, approve all new products and review any products which they consider may be doubtful under Shari ah law. In reaching their decisions the Shari ah board consider the Qur an, the Sunnah and the Fiqh. After concluding their deliberations they will issue a judgement (fatwah), determining whether or not the product conforms with Shari ah law (halal). In addition, the International Association of Islamic Bankers, an independent body, supervises the workings of individual Shari ah boards while its Supreme Religious Board studies the fatwahs of the various Shari ah boards of the member banks to determine whether they conform with Shari ah law. Products There are many variations of products in the Islamic finance market, but they generally are based around the following structures: Murabaha (cost-plus financing) This is a method of asset acquisition finance. The financier and its customer enter into a contract for the sale of assets or goods at a price that includes an agreed mark up. The financier then purchases the assets required by the customer and sells them to the customer at a mark-up. It is essential that the profit mark-up is fixed before the deal closes and that it cannot be increased, even if the customer does not take the item within the time stipulated in the contract. Typically the mark-up will be fixed to a benchmark, such as LIBOR, so the economic effect is similar to an interest calculation under a conventional facility. It is also common for the lender to adopt an agency arrangement under which the customer takes delivery of the item from the seller as agent of the lender. Lenders may also act on behalf of a syndicate of other financiers pursuant to a funding arrangement (see Mudarabas/Investment Agency Agreements below). Payment will normally be made over time by instalments and the arrangement may be secured. These products are Shari ah compliant as by taking title to the asset (albeit for a brief period of time, perhaps just a few seconds) before selling it on, the lender is assuming an element of risk. This creates a

4 number of additional considerations for the lender (see Practical points Ownership below). The murabaha is used frequently in trade financing arrangements, and has also been used for the acquisition of shares. Murabahas make up approximately 75% of the total number of transactions on the Islamic transactional market. Tawarruq/Reverse Murabaha A relatively new variation on a murabaha is a tawarruq or reverse murabaha. The financier (or its agent) purchases an asset at market value and then immediately sells the asset at an agreed mark-up price to the customer on a deferred payment basis. The customer then immediately sells the asset at market value to a third party and receives immediate payment for the asset. The result is that the customer receives a cash amount and has a deferred payment obligation for the marked-up price to the financier. As with a murabaha financing, the financier that is a party to the tawarruq could be acting on behalf of other financiers pursuant to a funding agreement. The concept of a revolving tawarruq has also been developed in recent years. Whilst this is akin to a conventional revolving facility in certain respects, the rollover mechanics are dealt with differently. The most common approach to dealing with this, albeit not universally accepted, is to net-off the cashflows from each of the maturing and new murabaha contracts on the equivalent of a rollover date. A tawarruq facility enables Shari ah compliant funding for customers who require a cash advance. Mudaraba/Investment Agency Agreement (profit sharing) This is a profit sharing contract with one party, the investor (rab ul maal) providing the capital and the other party (mudarib) providing its expertise in investing the capital and managing the investment. The mudarib takes a management fee which is usually limited to a share of the profits of the fund and certain expenses. The financier (mudareb) holds the funds on trust for the investor. There are two forms of mudaraba. The first is a mudaraba al muqayyada (restricted mudaraba). A restricted mudaraba is contractually limited by time and place and to one kind of investment and investor. The second form is a mudaraba al mutlaqa (unrestricted mudaraba), which is for general purposes investment and is unrestricted by time, place, kind of investment or investor. Almost all modern mudarabas are structured with limited liability. A similar product is an Investment Agency Agreement. This operates in a similar way to a mudaraba, however, the investment agent has far less autonomy than a mudareb and the investors exercise a far greater degree of control. This is often used in situations similar to the facility agent/participating bank role in a conventional syndicated facility. Investment funds and savings accounts operated by Islamic financiers often operate on this basis. Musharaka (partnership financing) The term Musharaka literally means sharing and involves a partnership between two parties who both provide capital towards the financing of new or established projects. The financier and the customer finance a project in agreed proportions in the form of either cash contributions or contributions in kind. The musharaka partners share the profit in whatever proportions they may agree but losses must be shared in proportion to their initial investment. A variation of this is the diminishing musharaka where the customer makes a series of payments to the financier over time. As the investment participation of the financier decreases the financier gradually transfers its ownership interest to the customer.

5 Ijara (operating leasing) and Ijara Wa Iqtina (finance leasing) The financier buys the asset required by the customer and leases it to the customer for a rental fee. The term of the lease and rental fees are agreed in advance. However, the rental fees may be set using a benchmark, for example LIBOR. The asset remains owned by the financier which will endeavour to recover the capital cost of the asset plus a profit margin out of the rentals payable. As the financier is providing the asset rather than funds the return is in the form of rent, rather than principal and interest. The financier will often appoint a special purpose company to hold the asset to deal with issues such as owner liability, regulatory and tax issues. Financiers may also act on behalf of a syndicate of other financiers pursuant to a funding arrangement (see Mudarabas/Investment Agency Agreements above). If the lessee is to have a right to purchase the asset at the end of the leasing period this is known as an ijara wa iqtina (finance lease). However, unlike a typical finance lease, the obligation to insure and undertake any maintenance remains with the financier although the financier will usually appoint the customer as its agent to carry out these duties. This product is most often used to lease machinery, equipment, buildings or other capital assets. Istisna a (construction financing) This is a method of providing finance for the construction phase of a project and involves a parallel contract structure being put in place. In a parallel contract structure, the customer commissions the construction of the asset from the financier who enters into a parallel contract with the manufacturer under which the financier commissions the construction of the asset. The financier then funds the manufacturer during the construction of the asset, acquires title to the asset on completion and either sells it to the customer on agreed deferred payment terms (murabaha) or alternatively leases the asset to the customer (ijara). The financier charges the customer the price it has paid to the manufacturer plus profit. The financier therefore takes the risk involved in the manufacture of the asset. This product is often used to fund the construction of major industrial projects and large items of equipment such as turbines for power plants, ships and aircraft. Bai Salam (forward financing) In a bai salam, the financier acquires assets from the customer by payment of a discounted price in advance and then sells the assets on delivery, either back to the customer or to a third party for a profit. There are similarities between a bai salam and an istisna a. However, an istisna a is more limited in that it must always be utilised for assets which are to be manufactured. In addition, under a bai salam, the purchase price for the asset must be paid in full at the outset and the date for delivery must also be fixed. This is not required under a istisna a. This product is most often used to provide working capital. Sukuk (bond issue) A sukuk is effectively a type of Islamic bond, which represents a proportionate interest in an underlying tangible asset and revenue. Where, for example, the underlying asset is an ijara, a special purpose company will typically purchase an asset and lease it to the ultimate purchaser under back to back arrangements. The special purpose company will then issue sukuk certificates under a note issuance facility which entitles the holders of the sukuk certificates to a pro rata ownership of the asset and a right to receive a proportion of the rental payments. It is a negotiable instrument, which depending on the underlying asset, can be sold and purchased in the secondary market. Although a sukuk certificate may be considered the Islamic equivalent of a bond or capital market debt instrument, it is important to distinguish between a sukuk certificate, a conventional unsecured bond and a bond issued under a securitisation. The sukuk certificate is an asset based security where the

6 primary credit risk is that of the issuer, which is obliged to pay the sukuk holder irrespective of the performance of the underlying asset. However, a conventional unsecured bond does not give any ownership rights in an underlying asset but rather just a contractual claim against the issuer. In a securitisation, the bondholder, takes credit risk on the cash-flow being securitised, with the issuer simply being used to pass through the underlying debtor credit risk. Derivative Products There is a lack of standardisation of both the products themselves and the documentation in respect of Shari ah compliant derivative products. In addition, the use of structures to replicate conventional derivative products has met with varying levels of approval amongst the schools of Islamic jurisprudence, as some consider them to be speculative or uncertain. However, the market has developed the following products: Foreign Exchange Swaps Whilst conventional foreign exchange contracts are not permissible, certain scholars have permitted alternative solutions including for example, back-toback interest free loans of different currencies. These loans do not carry any interest or other benefit and are considered to be entirely separate from one another. A further alternative is a promise based contract (waad) where the party that is looking to hedge will undertake to buy a currency from a third party at some point in the future. The essential elements of the waad include the purchase price of the currency, the delivery date and the fact that it cannot be conditional on any event. Profit-rate Swaps These are used by financiers and their customers in substitution for conventional interest rate swaps are commonly based on Murabaha based commodity contracts. Arbun (pre-purchase of right to acquire asset) An arbun contract provides for the purchaser to make a deposit (which forms part of the purchase price) for the purchase of an asset at a later date on the understanding that, should the sale of the asset not proceed (for instance if the purchaser elects not to proceed), the seller will be permitted to retain the deposit. The arbun contract has been likened to an option. Banking Services Islamic financial institutions (or the Islamic finance arms of conventional lenders) can also raise funds through providing general banking services. Current accounts These do not earn the depositor any income, whether directly or indirectly. If the funds are used by the bank to produce income, this is at the bank s risk and the bank will retain any profits. Fees may be charged by the bank for the management of such accounts. Funds can be withdrawn on demand. Investment accounts The management of these funds will normally be for a specified period and in investments selected at the discretion of the bank acting as trustee for the depositors. Profits and losses are shared between the investors who also bear the risk of loss. The bank will receive a management fee from any profits generated. Withdrawal of funds is subject to a notice period and preset restrictions. Savings accounts These do not enjoy a predetermined rate of interest, but do entitle the depositor to a profit share at the end of the financial year. This figure will be derived from

7 the profits that the bank has earned from the funds on deposit throughout the year. A management fee is payable and the risk of loss is borne by the depositor. In addition, there may be restrictions placed on the frequency with which a depositor may make withdrawals or at least a requirement to give notice of such a withdrawal. Overdrafts These are only provided in cases of genuine need, emergency or where a customer has sufficient funds but is temporarily unable to gain access to them. In such circumstances, the bank may decide to grant an interest-free loan, or Qard Hassan, which could be converted into an equity stake in the customer s company, subject to any restrictions in that company s constitutional documents, any shareholder s agreement or applicable law. Credit cards These are a relatively new development. The customer pays the bank a fixed amount for credit. The amount paid is linked to the bank s evaluation of the customer s credit worthiness. The customer receives a credit ceiling which is fixed regardless of how much the customer intends to use. Accordingly the customer is effectively paying for the credit limit rather than for interest on the account. This is more expensive than a traditional credit card as the customer may often be paying for a credit limit which may not be completely utilised. Mortgages Islamic mortgages are usually structured as either a murabaha, an ijara wa iqtina or a diminishing musharaka, and require the financier to take legal title to the property before title is transferred to the customer. Stamp duty was payable on both the transfer to the financier and the subsequent transfer to the customer, until the double charge was removed pursuant to the Finance Act 2003, putting traditional and Islamic mortgages on an equal tax footing. Under the Finance Act 2005 murabaha and mudaraba arrangements are considered to be an Alternative Finance Return and a Profit Share Return respectively. Accordingly on certain conditions, payments under such arrangements can be treated as if they were payments of interest for tax purposes. Practical points Ownership risks In nearly every method of Islamic financing, it is necessary that the financier is at some stage the owner of the financed asset. It can be the case that the asset will be retained by the financier for a considerable period and this brings with it legal issues concerning ownership such as insurance, third party liability and maintenance risks. It is also necessary to consider whether the proposed structure is treated for tax purposes in a manner which is disadvantageous when compared to a conventional loan. The use of vehicles in tax neutral jurisdictions or double taxation treaties may be required to alleviate such tax issues. Finally, if the financier is to sit between the supplier and the customer, the customer must be sure that he can rely on any warranties in the initial purchase agreement between the supplier and the financier. Security A financier will normally expect to receive a mortgage over the asset being financed as security and it is necessary to consider the law of the jurisdictions involved as to whether it is possible to take security. For example, in certain Middle Eastern countries mortgages over moveable assets are forbidden and a financier can only take a security if it takes a pledge of the asset. Since a pledge requires the financier to take actual possession of the asset this technique can be of limited use. It is worth noting that so long as a transaction can be declared Shari ah-compliant by a Shari ah board, it is possible to choose a governing law that enables the

8 security objectives of the financier to be achieved, e.g. English law see below. Default In normal financing transactions, there is usually a provision for default interest to be paid on late payment on the amounts due. This is not possible in Islamic financing. It is, however, possible to achieve a similar effect but in a different way. The financier applies a formula to a daily rate for the period of late payment. The financier then deducts from this amount any administrative and professional costs they incur in recovering the debt. Any balance that is left over is paid to a charity. Importantly, the costs that the financier can recover do not include the cost of alternative funding as is often the cash with conventional facilities. Integration Provided that the Shari ah compliant facility is kept separate from the other conventional facilities, it is increasingly possible to have both types of products financing the same project. An example where this has occurred is in large infrastructure projects, particularly those in the Islamic world. Indeed, in the vast majority of Muslim countries, a conventional banking system is specifically legislated for and exists in parallel with the Shari ah, so that a person seeking finance is permitted to obtain capital from both conventional and Islamic sources. Governing law The governing law and jurisdiction provisions of an Islamic facility are generally the same as those for a conventional facility. Where the agreements are governed by English law the English courts will apply English concepts of contractual construction to Islamic finance disputes before them (Beximco Pharmaceuticals Ltd v Shamil Bank of Bahrain (EC [2004] EWCA Civ 19). Importantly, the substance of the agreements must be Shari ah compliant a mere statement to the effect that they are subject to Sharia ah principles will not suffice. Other Documentation Issues Adherence to Islamic principles raises a number of other documentation issues, in particular in relation to the treatment of profit margins on a prepayment, margin protection provisions, the transferability of debt (which can generally only be traded at par) and the commitment fee (which cannot be included).

9 Contacts Jon Fife, Senior Partner Banking/Property and Asset Finance t: +44 (0) e. Andrew Evans, Partner Asset Finance t: +44 (0) Guy Usher, Partner Structured Finance/ Derivatives t: +44 (0) e. Steven Cole, Solicitor Banking/Asset Finance t: +44 (0) e.

10 Field Fisher Waterhouse LLP 35 Vine Street London EC3N 2AA t. +44 (0) f. +44 (0) This publication is not a substitute for detailed advice on specific transactions and should not be taken as providing legal advice on any of the topics discussed. Copyright Field Fisher Waterhouse LLP All rights reserved. Field Fisher Waterhouse LLP is a limited liability partnership registered in England and Wales with registered number OC318472, which is regulated by the Law Society. A list of members and their professional qualifications is available for inspection at its registered office, 35 Vine Street London EC3N 2AA. We use the word partner to refer to a member of Field Fisher Waterhouse LLP, or an employee or consultant with equivalent standing and qualifications.