MICHELE O. PENZER, MELISSA S. ALWANG, AND SALMAN AL-SUDAIRI

Transcription

1 SHARI AH-COMPLIANT FINANCINGS: NEW OPPORTUNITIES FOR THE U.S. MARKET MICHELE O. PENZER, MELISSA S. ALWANG, AND SALMAN AL-SUDAIRI This article provides a brief introduction to the principles that govern Shari ahcompliant investments and explains the financing structures that have been previously used by Shari ah-compliant equity investors to access the traditional United States capital and loan markets. It also briefly discusses the issues surrounding structuring a compliant obligation to be purchased by Islamic investors. Although still relatively uncommon in the United States, the worldwide Shari ah-compliant financing market has recently shown significant growth and maturity in Europe, Asia and the Middle East. It is estimated that global assets managed according to Shari ah principles may exceed US $1 trillion within a few years, 1 which has fueled the demand for Shari ah-compliant investment opportunities. As more investors based in Muslim countries such as sovereign wealth funds, state-owned companies and high net-worth individuals look to make acquisitions in the United States, the demand for Shari ah-compliant acquisition financing is expected to grow. In addition, Shari ah-compliant financing may interest Islamic buyside investors who have traditionally avoided accessing the United States financial markets for lack of products that meet their Shari ah requirements. Michele O. Penzer and Melissa S. Alwang are finance partners with Latham & Watkins LLP and Salman Al-Sudairi is an associate with the firm. The authors can be reached at michele.penzer@lw.com, melissa.alwang@lw.com, and salman.alsudairi@lw.com, respectively. 59

2 BANKING LAW JOURNAL THE SHARI AH RULES WHAT MAKES A STRUCTURE COMPLIANT From the perspective of the traditional American debt investor, the first key rule to understand is that Shari ah prohibits riba, which is generally defined as interest. This effectively means that a compliant investment cannot be structured as traditional debt for borrowed money. As a result of this restriction, Islamic financing institutions have developed sophisticated interest-free banking transactions that are principally based on concepts of partnership and profit-loss sharing. Additionally, Shari ah prohibits gharar an unacceptable level of risk or uncertainty. Therefore, any Shari ah financing transaction must not be deemed speculative or otherwise uncertain. 2 Furthermore, a Shari ah-compliant transaction must not involve investments that are otherwise prohibited in Islam, such as investments in gambling operations, alcohol or pork products. 3 These Shari ah rules arise from a religious-based legal system derived from three sources: the Quran (the main religious text in Islam), hadith (the sayings of the prophet) and ijma (the consensus of Shari ah scholars). What any individual investor or equity sponsor is willing to deem as Shari ahcompliant is most often dependent upon the Shari ah committee or advisor that is reviewing the particular product or structure. Islamic financial institutions typically have a Shari ah committee or board of advisors that reviews financing structures and issues opinions as to their compliance with Shari ah principles. Some investors may themselves also employ the services of Shari ah scholars to review and evaluate the compliance of such structures. The three Islamic structures that are most often discussed in the United States are the ijara (lease financing), the murabaha (cost-plus financing) and the sukuk (Islamic bonds). THE IJARA-MURABAHA ACQUISITION FINANCING STRUCTURE The most common Shari ah-compliant financing structure that has been used in the United States as a means for Islamic equity sponsors to access the United States financial markets is the ijara-murabaha acquisition financing 60

3 SHARI AH-COMPLIANT FINANCINGS structure. This structure requires two simultaneous financing arrangements, the first comprising a conventional term loan and revolver which is made available to a newly formed, single-purpose vehicle (the SPV) owned by a corporate service company, 4 and the second comprising the Shari ah-compliant financing provided by the SPV to the operating company (the Opco) owned by the Islamic equity sponsor, consisting of an ijara financing (to mimic the term loan) and a murabaha financing (to mimic the revolving facility). 5 Although the lenders to the SPV are not party to the ijara or murabaha, they will have the opportunity to set the affirmative and negative covenants, representations and warranties, and events of default that will be included in such documents, which provisions will govern the operation of the Opco. Lease (Ijara) Murabaha Acquisition Financing Transaction Structure Corporate Services Company Islamic Investors Loan Facilities Shari ah Compliant Financing Lenders SPW Borrower Opco Term Loan Facility Revolver Facility Ijara (saleleaseback) Murabaha (working capital) Guarantor Subsidies 61

4 BANKING LAW JOURNAL HOW THE IJARA (LEASE) WORKS The ijara is a lease that has elements of an operating lease and a financing lease. Typically, the SPV purchases certain assets from the Opco. 6 The SPV then enters into the ijara and leases those same assets back to the Opco for a series of specified rent payments. The duration of the lease and the amount and timing of the rent payment obligations are fixed at the signing of the agreement and mirror the obligations of the SPV to the Lenders holding the term loan. The rent payable to the SPV under the ijara is the sum of (i) a base amount, which is a portion of the acquisition cost for the leased assets equal to the SPV s amortization obligations on the term loan and (ii) a rental rate, which is an amount calculated at a spread over the London Interbank Offered Rate (LIBOR) on the remaining unpaid acquisition cost. Additionally, the Opco is granted a call option to purchase all or part of the leased assets prior to the maturity date from the SPV for a designated purchase price (which may include a premium and which will reduce the remaining unpaid acquisition costs). This call option is meant to mimic the voluntary prepayment mechanics of the term loan and provides for a reduction in the amounts otherwise owed to the SPV (and the premium for an early repurchase tracks the prepayment fee for early repayment of the term loan). The SPV is granted a put option to obligate the Opco to purchase all or part of the leased assets prior to the maturity date upon the occurrence of certain events (including the typical mandatory prepayment events). This put option is meant to mimic the mandatory prepayment mechanic of the term loan by ensuring that the SPV has a right to cash at the corresponding time that the SPV is required to make a prepayment of its term loan. The put option also obligates the Opco to purchase the leased assets for the remaining unpaid acquisition cost upon an event of default which, in turn, provides the SPV with a source of funds in the event that its term loan is accelerated. HOW THE MURABAHA WORKS The murabaha is a cost-plus financing which involves the purchase of a commodity (often a metal such as tin) by the SPV and the immediate resale of the commodity to the Opco on deferred payment terms at cost, plus some 62

5 SHARI AH-COMPLIANT FINANCINGS agreed amount of profit. Any time that the Opco decides to utilize the murabaha, it makes a request to the SPV to purchase the commodity, and the SPV, in turn, makes a matching drawdown under its revolving credit facility and uses those funds to purchase the commodity through an agent. Once the SPV completes its purchase of the commodity, it issues a notice to the Opco accepting the Opco s offer to purchase the commodity. The commodity is sold to the Opco at an agreed deferred payment price that factors in a profit that matches the interest payment for the revolving loan under the SPV s conventional facility. The Opco takes title to the commodity, but not delivery. It then enters into a concurrent arrangement with its agent to sell the commodity for cash. The agents that purchase the commodity for the SPV and sell the commodity for the Opco are appointed under the murabaha documentation and are Islamic commodities specialty traders. The purchase and sale are consummated simultaneously and for equivalent prices. In this manner, cash is obtained by the Opco, with a deferred payment obligation to reimburse the SPV at a purchase price equivalent to the principal amount of the revolving loans borrowed plus a profit set at a spread to LIBOR that matches the interest payable by the SPV under the credit agreement for revolving loans. At the time of the deferred purchase price payment (which will be no later than three months from the initial purchase of the commodity to synchronize with the interest payments due on the revolving loans), the cash payment for the profit and the deferred purchase price for the commodity itself will be paid to the SPV. If the Opco continues to need liquidity, it will roll over into a new commodities purchase contract and the SPV will establish a new LIBOR period under the credit agreement with the lenders which matches the term of the new commodities purchase contract. 7 THE COVENANT STRUCTURE In order to ensure that the Opco is subject to the affirmative and negative covenants and representations and warranties that it would otherwise have been subject to had it entered into a traditional credit agreement directly, the financial institution providing the conventional loan will require that the SPV s agreements with the Opco contain representations and covenants 63

6 BANKING LAW JOURNAL that would mirror those found in a conventional financing. The administrative agent and collateral agent under the credit agreement will also act as administrative agent and collateral agent under the SPV s Shari ah-compliant financing documents. In order to maintain the integrity of the Shari ah-compliant financing, its documents (those between the SPV and the Opco) cannot refer to the conventional financing, nor can the financial institution providing the conventional loan have direct recourse against the Opco or any of its subsidiaries. Amendments, consents and waivers with respect to the Shari ah documents generally will require the vote of the requisite lenders under the credit agreement, and will require 100 percent lender consent where such amendments would affect any provisions that mirror those whose amendment would require 100 percent lender consent under the credit agreement, such as decreases in profit or rent. In working with this back-to-back documentation structure, there are a few issues to note: While the financing markets have been comfortable with the risks associated with the back-to-back nature of the financing and security arrangements, there is no body of bankruptcy law specific to Shari ahcompliant financing. However, in a situation where both the SPV and the Opco are debtors in bankruptcy, bankruptcy specialists would generally expect the creditors to make a motion to collapse the structure, which should be granted. If the SPV is not in bankruptcy but the Opco is, then there would likely be a two-step process, first foreclosing on the SPV or its assets and then asserting the SPV s claims directly against the Opco in its bankruptcy. It is certainly possible that both could be in bankruptcy yet the court refuses to collapse the structure (leaving the lenders to assert their claims solely against the SPV, while the SPV can resolve its claims against the Opco separately), but most insolvency experts believe such a result to be highly unlikely. In order to comply with Shari ah principles for an ijara, the lease of the assets by the Opco from the SPV must provide that the assets will be owned and maintained by the SPV. However, the parties typically enter into a supplemental agreement whereby the Opco covenants to assume 64

7 SHARI AH-COMPLIANT FINANCINGS all owner responsibilities with respect to the assets, including responsibilities to maintain, repair and insure the assets. In addition, the sale of the assets by the Opco to the SPV and the lease of those assets back to the Opco by the SPV are typically structured to be treated, for United States federal income tax purposes, as a secured financing. This enables the Opco to remain as the owner of the leased assets for US federal income tax purposes and therefore avoid any taxable disposition of the leased assets while remaining eligible for any depreciation associated with such assets. 8 In addition, because the borrower is an SPV, the Lenders must also review the structure for other tax concerns, such as thin capitalization issues, which might arise. Most conventional loans usually require the borrower to enter into interest rate hedges or currency swaps. However, certain conventional hedging products provided in most Western jurisdictions may contravene Shari ah principles, and thus may not be permitted under Shari ahcompliant structures. By contrast, some derivative instruments, such as caps or floors, may be used to limit exposure to interest rate and currency fluctuation. Furthermore, Islamic financial institutions may offer alternative hedging products that are Shari ah-compliant. Most conventional loans usually require the borrower to maintain some level of insurance. However, customary insurance provided in most Western jurisdictions may contravene Shari ah principles, and thus may not be permitted under a Shari ah-compliant structure. The principle behind the prohibition of insurance by some Shari ah scholars is based on the fact that an insured pays a sum certain to guard against something that may or may not happen, which constitutes an unacceptable level of risk, i.e. gharar. As a result, a market for a new type of Shari ahcompliant insurance has emerged, known as takaful (cooperative insurance). The principal behind takaful is that policyholders cooperate with one another by pooling their subscription payments, such that any losses or liabilities are spread among all cooperating policyholders and no one party derives an unfair gain at the expense of any other party. Therefore, some Sharia ah scholars may argue that in order for the acquisition financing structure to be compliant, the Opco and the SPV 65

8 BANKING LAW JOURNAL may not be permitted to insure their assets under any form of insurance other than takaful. Because the SPV has no source of income other than those payment obligations created under the Shari ah documentation, the arranger, agents and lenders (collectively, the Secured Parties) must ensure that there is a payment obligation from the Opco to the SPV to match each payment obligation of the SPV to the Secured Parties. This presents a challenge with some obligations, such as indemnities, expenses and other ancillary obligations under the credit documents, because the Shari ah documentation may not reference the traditional financing. In the case of indemnities, expenses and other similar ancillary expenses, the Shari ah documentation will provide for broad language to compensate the SPV for any cost or diminution with respect to expected profit. The Secured Parties must be comfortable that the Opco will not later dispute that such broad language was intended to cover all such expenses at the SPV level. Some Shari ah scholars may object to the structure outlined above because the SPV s source of capital is not Shari ah-compliant, deeming it to be an artificial product created to mimic a conventional product that is based on interest. Although many Shari ah committees and advisors have approved this back-to-back structure, scholars from more conservative jurisdictions may have a different opinion. SUKUK STRUCTURES One of the most common financing obligations purchased by Islamic investors seeking a syndicated type of product is the sukuk (Islamic bond). According to Dealogic, by the end of 2007 there had been more than 1,100 worldwide sukuk offerings, with an estimated deal value exceeding US $64 billion, and Ernst & Young estimates that the sukuk market is likely to reach US $100 billion in The biggest market for such offerings has traditionally been Malaysia, with Indonesia, Pakistan, the United Arab Emirates and Saudi Arabia having active markets as well. 10 The main underwriters of sukuk offerings worldwide have been regional and local Islamic financing 66

9 SHARI AH-COMPLIANT FINANCINGS institutions. However, the LPC Goldsheets published Mandated Arranger and Arranger league tables for 2007 that indicated that traditional Western banks such as Citibank, Royal Bank of Scotland, Deutsche Bank, Credit Suisse, Barclays, JPMorgan and Lehman Brothers have also actively participated in sukuk issuances. 11 A sukuk is essentially an asset-backed security structured in a Shari ahcompliant manner, and is somewhat similar to a trust certificate. The basic framework is that a special purpose vehicle issues sukuk (or certificates) to Islamic investors and uses the proceeds of the issuance to purchase a pool of assets (typically one or more Shari ah-compliant contracts, such as ijara or murabaha contracts similar to the ones discussed previously). The stream of income generated from the Shari ah-compliant contracts is used to fund the payments to the holders of the sukuk. Most Shari ah scholars agree that the pool of assets should not only be comprised of instruments, such as murabaha contracts, which are viewed as representing an interest in a stream of payments, as opposed to an ijara, which is viewed as representing an interest in the underlying assets themselves. Typically sukuk are either (1) ijara sukuk, which are certificates issued off of stand-alone assets such as land or equipment, providing regular payments that are often benchmarked to LIBOR, or (2) hybrid sukuk, such as a portfolio of ijara contracts and murabaha contracts (however, at least 51 percent of the portfolio must typically consist of ijara contracts). Additionally, traditional financing ratings companies such as Moody s, Standard and Poors, and Fitch, as well as specialized Islamic finance rating companies, offer ratings services for Islamic finance products, including sukuk. In working with sukuk structures, there are a few particular issues to note, including the fact that tax or other concerns may limit the practicality or availability of certain assets for such structures and that some institutional investors may be restricted (by the terms of their own funding vehicles or governing documents) from purchasing assets other than debt securities or loans. In addition to the above structures, there are a number of other Shari ahcompliant financing structures used around the world. Such structures include musharaka (partnerships), mudaraba (venture capital financings), istisna a (manufacturing contracts), salam (forward-sales) and hybrid struc- 67

10 BANKING LAW JOURNAL tures combining one or more of the other generally accepted Shari ah-compliant structures. CONCLUSION The growth of assets held by investors interested in complying with Shari ah principles presents opportunities for institutions looking to access this significant source of capital. With careful structuring, products for these investors may be crafted that both address the needs of these investors (whether on the sponsor side or the syndicate side) and the traditional concerns of syndicated lenders. NOTES 1 Islamic Banking: Can You Afford to Ignore It?, The Boston Consulting Group, April 2008, available at Islamic_Banking_Apr_2008.pdf. 2 A determination of what constitutes an unacceptable level of risk is very factspecific. Generally, a Shari ah committee or advisor reviews and approves each financing transaction before it is deemed to be Shari ah compliant. This committee, based on its review of the entire transaction, assesses whether or not the level of risk breaches the unacceptable threshold. 3 For example, some Shari ah scholars would argue that an investment in a restaurant that serves alcohol would be prohibited. However, other Shari ah scholars take a more moderate view and would argue that if alcohol sales at such restaurant are less than some small percentage of the revenue of the restaurant, the investment may still be compliant. Additionally, in some circumstances, an investment may be viewed as being compliant if the portion of profit generated from prohibited activities is donated to charity. 4 This corporate services company is paid a fee by the equity sponsor to provide this service, but the corporate services company is not affiliated with and is not controlled by the equity sponsor. 5 While this Client Alert generally refers to this acquisition financing structure as ijara-murabaha, there are some variations. For example, a second murabaha may be substituted to mimic the term loan if the Opco assets are not of the type that can be readily sold and leased back. Murabaha structures may also be used to mimic a 68

11 SHARI AH-COMPLIANT FINANCINGS second lien term loan, a bond or a PIK instrument. 6 Note that these assets are generally of the type that can be transferred without requiring third-party consents or recordation. 7 Note that depending on the particular transaction, some Islamic banks may deem murabaha structures to be non-compliant. 8 Some ijara-murabaha structures also utilize side letters to confirm the US tax law treatment of the transaction and indemnify the SPV for any tax expenses incurred in connection with the overall transaction. 9 Sukuk Market to Hit $100 Bln in 2008: E&Y, Reuters, February 5, 2008, available at idusl According to Dealogic there has only been one sukuk offering in the United States in the last two years, the East Cameron Gas Co., which was recognized as the first ever Shari ah-compliant securitization originated out of the US. 11 LPC Goldsheets, January 7,