CELESQ Webinar Fundamentals of Shariah Finance Law

Steven J. Adelkoff, Jonathan Lawrence, Remsen M. Kinne IV Wednesday November 4 2009

Fundamentals of Shariah Finance Law

Introduction International perspective Basic Shariah rules

What is Shariah?
O you who believe! Stand out firmly for Allah, as witness to fair dealing, and let not the hatred of others to you make you swerve towards inequality and depart from justice. Quran 5:8 In the business context, Shariah is a means of conducting business through a distinct set of rules designed to facilitate fairness. High correlation between Shariah compliant investing and socially responsible investing
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Where are Shariah rules codified?

Interpretations of the Quran from various Islamic schools of thought Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) The fact remains: Shariah mandates are not always consistently applied from Scholar to Scholar. Information is asymmetric, and Shariah Advisers and lawyers skilled in the area become useful to work through the counter-intuitive results

Shariah terms
Halal that which is permitted or compliant Haram that which is not permitted Riba charging of interest or unjustified increase Gharar the taking of unreasonable risk; uncertainty Maisir reliance on chance or speculation, rather than effort

Industry prohibitions
Gambling Pork production or consumption Adult Entertainment Banking and finance Alcohol production or consumption Weapons production Tobacco production or use

Riba
The charging of sums for borrowed money (i.e. interest) is forbidden But the pledging of Halal assets, the guarantying of obligations and the leasing of property under what we might consider a finance lease (or ijara) is permissible Murabaha is the selling of a commodity at an agreed upon mark-up, and is used in Shariah as a fixed income investment substitute.

Riba
Things to Watch Out For: Default Interest Administrative fees for late payments Consideration in respect of third party guaranties (see AAOIFI Shariah Standard No. 5) Preferred Shares are generally not permitted (AAOIFI Shariah Standard No. 21); but dividends distributed from profits are permitted.

Gharar
The act of taking on unreasonable uncertainty Examples of Gharar:
Gambling Insurance FX Trading Options on stock (AAOIFI Shariah Standard No. 21, paragraph 16 of Appendix B)

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Shariah Finance Themes

Connection to underlying assets Commercial risk taking by all parties (including financier) Entrepreneurship Returns linked to actual investment outcomes Sharing profit and loss

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Shariah Finance Structures

Mudaraba Musharaka Murabaha Tawarruq (Reverse Murabaha) Ijara Ijara wa-iktina Bai salam Bai al inah Istisnaa Sukuk

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Mudaraba
Risk sharing; profit and loss sharing Limited partnership: one partner provides capital; other partner provides expertise/effort and makes business decisions Restricted or unrestricted Examples:
funded participation arrangement establishment of investment fund

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Mudaraba

INVESTOR(S) (Rab al Maal)

Share in profits and losses
Fee (based on share of profits)

MANAGER (Mudarib)
Provides expertise and manages funds

Invests funds

FUND

PROJECT/ENTERPRISE

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Musharaka
Risk sharing; profit and loss sharing in same proportions General partnership / joint venture arrangement between financier and investor Provides equity funding to a venture; greater riskreward factors and greater investor say in project management

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Musharaka

FINANCIER

CUSTOMER

Cash contribution

Share in profits and losses

Share in profits and losses

Contribution in kind (at least 30%)

VENTURE

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Murabaha
Asset based Trade finance / Acquisition finance Unconditional contract of sale; goods, cost price, mark-up and payment date = defined and agreed Profit from marked-up sale price (not interest) paid in instalments Examples:
import-export finance infrastructure project financing leveraged acquisition

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Murabaha
Payment of Purchase price Payment of purchase price plus premium (deferred)

SUPPLIER

FINANCIER

CUSTOMER

Sale of asset

Sale of asset

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Tawarruq (Reverse Murabaha)

Asset based Freely tradable commodities e.g. platinum, copper (silver and gold are considered currency and cannot be used) Provides customer with a cash sum Customer then has deferred payment obligation to financier

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Tawarruq (Reverse Murabaha)

Payment of purchase price plus premium (deferred) Payment of purchase price

SUPPLIER

FINANCIER

CUSTOMER

THIRD PARTY

Sale of asset

Sale of asset

Sale of asset

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Ijara
Asset based Hybrid between conventional operational and finance leases; a business process Analogous to secured loan Examples:
aircraft finance ship finance project finance

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Ijara
Payment of purchase price Rent (= purchase price plus premium)

SUPPLIER / MANUFACTURER

FINANCIER

CUSTOMER

Sale of asset

Lease of asset

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Ijara wa-iktina
Asset based Lease with option for lessee to purchase leased asset Analogous to finance lease / hire purchase contract Examples:
medium term trade finance of equipment refinancing under sale and leaseback

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Bai salam
Asset based Forward purchase of specified asset paid in full for supply on pre-agreed fixed future date Working capital facility, especially for pre-export facilities

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Bai salam
Purchase price (discounted) Purchase price (plus premium)

SUPPLIER

FINANCIER

CUSTOMER

Sale of asset (delivery deferred)

Sale of asset (delivery deferred)

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Bai al inah
Asset based Sale and buy-back transaction Customer sells asset to financier and then buy it back at higher price Provides customer with cash sum Not approved by majority of Shariah scholars: profit differential constitutes riba Permissible practice in Malaysia

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Istisnaa
Asset based Funding agreement for production, manufacture or construction of asset to agreed specification: all specifications, delivery options, payment conditions and pricing must be agreed in contract No fixed delivery date and no payment in full at outset required Advance funding of:
major industrial, construction and real estate development project finance large equipment e.g. ships, aircraft

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Istisnaa
Purchase price Purchase price plus premium (deferred)

DEVELOPER/CONTRACTOR/ MANUFACTURER

FINANCIER

CUSTOMER

Sale of developed equipment/construction

Sale of developed equipment/construction

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Sukuk
Financial instruments / trust certificates representing undivided ownership share in underlying asset or interest held by issuer Right to share in profits and asset realisations Debt capital markets fundraising Bought and sold in secondary market Used in conjunction with other structures

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Sukuk al Ijara

CERTIFICATE HOLDERS

Issue proceeds

Return

Issues Sukuk

Sells assets

Leases assets

SELLER
Purchase price (issue proceeds)

SPV ISSUER
Rent

LESSEE

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Sukuk al Musharaka
CERTIFICATE HOLDERS

Issue proceeds

Return

Issues Sukuk

SPV ISSUER
Cash contribution Share in profits and losses Share in profit and losses

ORIGINATOR
Contribution in kind (at least 30%)

VENTURE

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Shariah finance challenges

Scholars and schools of thought Lack of standardisation Transaction costs Asset ownership by financier involves potential liability e.g. environmental, warranty claims Insurance / takaful Tax treatment

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Fundamentals of Shariah Finance Law

Conclusion Any questions?

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Further resources
www.aaoifi.com Accounting and Auditing Organization for Islamic Financial Institutions www.islamic-finance.com www.securities.com/ifis Islamic Financial Information Services (subscription required) www.shariahcap.com Shariah Capital www.sii.org.uk/web5/infopool.nsf/html/qintifq Securities & Investment Institute: Islamic Finance Qualification

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Disclaimer
This webinar and these slides are for informational purposes only and do not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with a lawyer.

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