Did She Say That?

http://www.financeasia.com/article.aspx?CIaNID=118130
Dubai World creditors await court definition of Sukuk
At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

The quandary faced by the holders of Nakheel’s Sukuk has been well documented and discussed in recent weeks. At this juncture, how they will move forward with the restructuring depends on how the courts define this instrument called Sukuk.

In the above article, the global head of Islamic markets at Bursa Malaysia claims that a Sukuk is a bond. I find it appalling that a person of such stature as Raja Teh with all her experience can come up with such a statement which IMHO seriously undermines the principles of Islamic finance.

In case she forgot, a Sukuk is defined as follows:

“Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity” by Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI, Standard 17).

“A document or certificate that represents the value of an asset” by The Securities Commission (SC).

A bond is defined as a fixed interest financial asset. Bonds pay the bearer a fixed amount a specified end date. A discount bond pays the bearer only at the ending date, while a coupon bond pays the bearer a fixed amount over a specified interval (month, year, etc.) as well as paying a fixed amount at the end date.

Click here for a comparison between Sukuks and Bonds.

If Sukuk is a bond, why bother with the Shariah structures & approvals, legal documentations etc.? Why bother calling it a Sukuk?

Let’s put it this way, Sukuks and bonds are like fish and chicken, they are both sources of food and can be cooked the same way but they will NEVER look the same, taste the same, they will never be the same.

It is a credit issue, so going forward, let’s use Nakheel/Dubai World as an example and learn from it. The first and most important lesson to remember is to structure a Sukuk as a Sukuk and not as a bond. And that includes evaluating the credit from the Sukuk perspective and not the bond perspective.

For as long as the Islamic finance industry is lead by people with a conventional worldview on Islamic finance, it will never break away from being a conventional product with an Arabic name.

Saxony-Anhalt Sukuk Ijarah

In 2004, a €100 million Sukuk, structured as a Sukuk Ijarah, was issued in the federal state of Saxony-Anhalt in Germany with The Federal Republic of Germany guaranteeing the debts of Saxony-Anhalt. The underlying transactions are a number of buildings owned by the Ministry of Finance. The master lease was sold for 100 years to a special purpose vehicle, incorporated in the Netherlands for tax reasons. The SPV in turn rented the properties back to the Ministry of Finance for five years. The certificate holders receive a variable rent benchmarked to the EURIBOR over the leased period and the Sukuk is listed on the Luxembourg Stock Exchange. Incidentally, as of July 2007, the Saxony-Anhalt Sukuk remains the only sovereign Sukuk from a non-Islamic country to have tapped the market.

I am of the opinion that the Saxony-Anhalt is one of the best examples of how a Sukuk Ijarah should be structured, apart from one element – determination of the rental rates. Why can’t the issuer set the returns based on the actual, prevailing, market determined rental rates? Wouldn’t that have made it more authentic?

Wa'd

Wa’d is a unilateral promise and is considered as a voluntary contract. Al-Zarqa’ opines that it does not convey any binding effect on the promisor hence they are not obliged to fulfil the promise and will not be liable in a case where they fail to fulfil the promise made to the promisee.

The BNM Shariah Council in its 49th meeting held on 28th April 2005 / 19th Rabiul Awal 1426 resolved that an Islamic banking institution is allowed to enter into forward foreign currency transaction based on unileteral binding promise (binding only on the promisor) and the compensation for breaching of promise could be implemented. This permissibility is only applicable for currency hedging purposes. Such a transaction may be arranged between the Islamic banking institution and its customers, or between the Islamic banking institutions, or between the Islamic banking institutions and conventional banking institutions.

The fatwa of Islamic Bank of Jordan (Jordan Islamic Bank, al-Fatawa al-Syar’iyyah, 2001, v2, p.29) states that the bilateral promise made in currency exchange where it bonds both parties to the contract, is generally prohibited (umum al-nahyi) as it amounts to bai` al-kali’ bi al-kali’ (sale of debt with debt). However, if the promise is made unilaterally i.e. binding only on one party who made the promise, then the transaction is allowed.

Ibn Hazm (Ibn Hazm, al-Muhalla, Dar al-Turath, Cairo, V.9, p.583) has also allowed the promise made to sell and purchase of currency with an agreed price on the same day followed by actual conclusion of the contract afterward. The parties is also given the choice to proceed or not to proceed with the agreement made and thus do not conclude the actual contract. This is permissible according to Ibn Hazm as the promise is not binding on the parties.

Having said all that, it is clear that Wa'd is a non-binding unilateral promise meaning that in the event the promisor decides to rescind the promise, the promisee is in no position to demand compensation. In reality however, most banks demand compensation for breach of promise. How is it non-binding then?

Moving Away from Tawarruq?

Twenty-six Islamic banks signed off on a standardised Wakalah deposit agreement, which some bankers said could help the industry reduce its reliance on the controversial Commodity Murabahah structure, Reuters reports. “Besides cost and resource savings, the adoption of the standardised Wakalah placement agreement would promote transparency, consistency, operational efficiencies and robustness in Islamic deposit placement transactions,” said the Association of Islamic Banking Institutions Malaysia, which launched the template agreement. “In six months’ time, all the banks will be using the Wakalah,” said one Malaysian Islamic banker. “It has fewer issues than the Commodity Murabahah.”

Wakalah is an agency structure where a depositor or investor authorises an agent (the bank) to invest his funds in Shariah compliant assets or businesses.

Finding alternatives to replace controversial instruments is a step in the right direction and it augurs well for the industry.

Organised Tawarruq not a perfect structure

In its basic form, Tawarruq is an asset sale to a purchaser with deferred payment terms. The purchaser then sells the asset to a third party to get funds. Organised Tawarruq is similar although the transactions are executed through banks.

Reuters reports Shariah adviser Rusni Hassan saying that Organised Tawarruq as it is currently practised is not ideal from the Shariah's viewpoint.

According to the report (Nov 4, 2009), Rusni opines that organised Tawarruq should avoid specifying beforehand the parties' obligations under the contract although this protects their legal rights, backing a divisive Fiqh Academy ruling that had thrown the industry into turmoil. She objects to organised Tawarruq because the two contracts are in one when they should be independent of each other.

I agree with her views but I foresee it will further divide the industry especially when respected scholars like Nizam Yaqubi and Akram Laldin see no harm in organised Tawarruq.

Other scholars who disapprove of Tawarruq include Muhammad Nejatullah Siddiqi and Monzer Kahf.

Siddiqi views Tawarruq to be identical to interest based loans both from the functional and macroeconomic perspective. His justification for categorising Tawarruq as non-compliant is due to its harms (mafasid) being greater that its benefits (masalih). He lists;
1) creation of excessive debt;
2) exchange of money with more money in future, which is unfair in view of the risk and uncertainty involved;
3) debt proliferation, which is liken to gambling and speculation;
4) inflationary expansion;
5) inequity in the distribution of income and wealth;
6) greater instability in the economy; and
7) inefficient allocation of resources.
as the many harms of Tawarruq.

Kahf opines that Tawarruq is worse than the practice of interest-based loan legally and economically.

I have to disagree (with apologies) with Sheikhs Yaqubi and Akram on the permissibility of Tawarruq. Being of limited knowledge, I depend on the views and opinions of the scholars and in this case the arguments presented by Siddiqi make more sense to me.

Cost of Funds

When determining the interest rate to charge borrowers, one of the factors to consider is the cost of funds, i.e. the price the bank has to pay to the owners of the funds, who are either depositors or lenders for using the funds.

On the other hand, a partnership or trade based (Islamic) financial transaction should not have a cost of funds simply because the owners of the funds are not lending or selling the funds and therefore should not expect any consideration for the transaction. Funds are monetary capital and Shariah stipulates that money cannot be traded because it is not a commodity, it is merely a medium of exchange.

So, technically, under Shariah terms, capital has no cost. Surely this is a concept which traditional conventional bankers may find difficult to grasp.

Why is money devoid of any cost?
This is because the owners of money cannot expect to earn more money without undertaking some form of economic activity. Shariah stioulates that owners of money cannot trade the money for profit. Any exchange of money which is not equal in amount constitutes riba.

When determining the profits to be charged to customers (‘profits charged’, oxymoron?) for a Murabahah or Istisna transaction, banks cannot base it on the cost of funds simply because there is no cost to start of with. The cost of funds arises when Shariah based banks operate in an identical manner to a conventional banks, i.e. as an intermediary between lenders and borrowers.

Mudharabah and Musharakah are NOT Debt Contracts. Get it?

A Shariah expert claims that Asset-based Sukuk Mudarabah and Musharakah will fall out of favour as it is hard to accommodate a ruling on repurchase pledges, indicating the market would be permanently affected by the decree.

According to Moody’s, the issuance of Musharakah and Mudarabah based Sukuk fell 83 percent and 68 percent respectively last year.

Bankers and lawyers have been seeking ways to structure Sukuks that comply with a 2008 ruling by AAOIFI which forbids “borrowers” in Sukuk Mudarabah and Musharakah from promising upfront to pay back their face value at maturity. This follows a rule that parties must share risks under these structures but the industry had been concerned it would make Islamic bonds less palatable to investors. But the market is trying to find ways to accommodate the prohibition. However, Shariah adviser Dr Mohd Daud Bakar said it would be tough to do so, "It's very difficult because it goes against the very essence of Mudarabah and Musharakah because you cannot guarantee the capital (or profits) in equity-based contracts." (Reuters)

Which is exactly my point. Mudarabah and Musharakah are equity-based contracts and therefore should not be treated as debt-based contracts. Why the industry continues to structure debt papers based on an equity structure baffles me.

A Sukuk is not a bond and a Sukuk is defined by the underlying contract that governs it.

After so many years of being exposed to Shariah based finance, I’m stumped that the so called Islamic bond fund managers (and the rest of the market really) still view Mudarabah and Musharakah Sukuks as debt instruments. Well, I’m telling them again – it’s NOT. Sukuk Mudarabah and Musharakah investors are not borrowers, they are partners who are supposed to understand and willing to assume risks associated with such investments.

The market should take the lead by re-identifying their investment needs and demand the appropriate structure. If they want to invest in fixed income instruments, look for Ijarah, Murabahah or Istisna based structures.

If they want to invest in Mudarabah and Musharakah Sukuks, they better make sure they are looking at them from the equity perspective.

The reason why we are facing this problem is because we (the market/industry) continue to apply Shariah based finance on the conventional platform. If a Mudarabah and/or Musharakah based Sukuk has identical features with a conventional bond, why bother having an Islamic finance industry? Since the underlying structure is identical, we might as well merge the two since there is no difference apart from the name and legal documentation.

The growth of the Sukuk market can only be achieved if the industry accepts Sukuk as a unique instrument instead of equating it to and treating it like a conventional bond.

Islamic Derivative Contracts Soon?

Reuters reports that the first template for over-the-counter Islamic derivative contract will be launched this year or by early 2010. The contract is expected to pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions.

According to Ijlal Ahmed Alvi, chief executive officer of the International Islamic Financial Market (IIFM), "It's a completely new instrument. We have done the consultative work. Now what we are waiting for is the Sharia meeting... some time in December". The IIFM, an industry body backed by the central banks of several Muslim countries, has been working with the International Swaps and Derivatives Association (ISDA) on the contract. Once in place, the new Islamic derivatives contract is expected to initially attract at least 150 players.

Scholars are however split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others dismiss them as speculative transactions, which Islam forbids.

My contention is that derivative instruments is not the only solution to hedge of risks. There is no need for Shariah based finance to mimic each and every conventional instrument. Isn’t there any indigenous Shariah based risk management tool?

3Ps – Products, Placement, Promotion

Experts (in Islamic banking & finance) are saying that in order to effectively challenge and compete with conventional finance, Islamic finance needs more products and a wider distribution channel. It would be difficult to attract liquidity into the industry without adequate products and distribution network. This growing industry also needs to develop more unique financial solutions and not resort to merely replicating conventional finance’s product line.

The wealthy GCC sovereign funds are believed to resort to investing in conventional products due to the lack of Shariah approved investment options.

Shariah based finance and investment is mainly based on partnerships and joint-ventures making it suitable for private equity ventures, venture capital as well as asset management. These sectors will allow the Islamic finance industry to create products according to Shariah values, especially on the prohibition of riba via pre-determined return rates.

According to a report published by Ernst & Young this year, as of 1Q 2009, there are only 14 Shariah compliant funds larger than USD500 million out of the 750 Islamic mutual funds under management. Total assets under management is less than USD50 million.

John Sandwick, an Islamic asset management consultant claims that the supply of Islamic funds is not enough to satisfy the demand. The market needs more products. The advent of the pension fund in the Middle East as well as the growing takaful industry will definitely increase the need for more products.

Experts also pointed out most Islamic funds tend to focus on equities and real estate and not much asset diversification especially into fixed income investments.

Sukuk is a ready made instrument to facilitate the Islamic asset management industry. Ijarah, Murabahah and Istisna based Sukuk will provide asset managers with more fixed income investment options.

Silke Bernard, a lawyer specialising in funds said, Islamic funds lacked access to the large distribution platforms used by asset managers and that Islamic funds often lacked the required minimum size of typically USD100 million and a track record of several years required by large asset managers.

It is often pointed out that there is a sizeable amount of Islamic (GCC) wealth looking for Shariah compliant investments. There have also been claims that Shariah compliant investment is already attracting a global fan base from Europe to Australia and Japan and this augurs well for the industry’s long term growth.

Controversies / Issues in IBF

Bay Inah / Tawaruq
Is viewed by some observers and practitioners as a hilah (legal trick), as the objective of the transaction is to exchange of money in different quantities at different times.
The argument for legalising or forbidding Inah and Tawarruq is based on the intention (niyyah) of the parties, i.e. real vs. declared intention.

Bay Inah is a legal sale in the Shafie School, where the intention is not a significant element in determining the validity of the contract. This is the basis for the endorsement of Bay Inah by BNM’s and SC’s SAC.
Rayner (The Theory of Contract in Islamic Law, 1991) concludes that the Malikis and Hanafis give due effect to the real intention or niyyah of the parties, but that as regards illicit motives both schools are reluctant to make such an uncertain element as motive a dependent factor of a legal act. The Hanbali School however, always gives precedence to real intention over declared intention. According to him, the general tendency of Islamic law seems to be to give priority to the declared intention. However, in the Shafie School, this is not just a tendency but a doctrinal stance.

Debt - property or money?
The Malaysian (presumably based on the Shafie’s opinions) view is that debt is a property and hence can be traded freely. For example, a RM100 million debt can be exchanged for RM90 million in cash without any implications.

The middle eastern views debt as money and therefore can only be changed with money of equivalent value. The RM10 million difference in the above example is therefore riba.

Purchase undertaking in an Ijarah transaction - valuation issues?
A purchase undertaking is part of an Ijarah transaction for the sole purpose of returning the leased asset(s) back to the originator. The Purchase undertaking (PU) is present because it was never the intention of the originator to sell the assets in the first place. Another reason is to facilitate the redemption of the principal, similar to the mechanics of a conventional bond/loan which explains why the PU is undertaken at nominal value and not marked to the prevailing market values.

The issue with PU is not whether it is allowed by Shariah or not but it has more to do with the price transacted under the undertaking. If the price is based on the prevailing price at the time of executing the undertaking, I see no issues. It is about justice and fairness to the contracting parties. If the market price is below the PU exercise price, it would mean injustice to the purchaser and conversely, it would be unfair to the seller if the market price is more than the price transacted under the PU.

Purchase undertaking in a Musharakah/Mudharabah transaction – capital protection?
Like the PU in an Ijarah transaction, its presence in a Mudharabah/Musharakah transaction is to facilitate the principal redemption to mirror the mechanics of a conventional bond. A PU under this circumstance tantamount to guaranteeing capital. It is permissible for a third party to guarantee capital but it should be done on the basis of hibah (gift).

BBA, Justice Abdul Wahab and the Court of Appeal

In July 2008, High Court judge Datuk Abdul Wahab Patail had ruled that the application of the BBA contracts in Arab Malaysian Finance Berhad v Taman Ihsan Jaya & Others (2008) was contrary to the Islamic Banking Act 1983 (IBA).

On March 31, the Court of Appeal unanimously overturned Abdul Wahab's much-debated judgment in the Bank Islam Malaysia Bhd v Ghazali Shamsuddin & Two Others, and nine other cases.

Abdul Wahab Patail ruled that BBA is a loan transaction and not a trade based financing. This is because there is no transfer of title from the customer to the bank during the PPA and hence the bank has no legal or beneficial capacity/right to make a valid sale under the subsequent PSA. This was why there was a fear of default under BBA contracts because the contract itself is deemed not enforceable.

Therefore, the BBA is deemed a conventional loan with an Arabic name, the form changes but in substance it is still a plain conventional loan and the profits charged under a BBA transaction are therefore deemed to be interest.

On 31st March (the report in the Malaysian Reserve is 6 months late), the 3 member CoA ruled that Abdul Wahab had erred in making his judgement and reversed the ruling, re-establishing BBA as a bona fide sale transaction and upholding to sanctity of the BBA contracts. The 3 member bench rules that “civil courts should not decide whether a matter is in accordance with the religion of Islam”. Such issues need to be solved in consultation with Islamic scholars. And since BNM’s SAC has endorsed BBA as an approved product, civil court judges should not dispute it.

My opinion – the BBA was created in 1983 based on the conventional loan platform to enable Islamic finance to break into the market while operating on the existing platforms. It was true 26 years ago when awareness on Islamic finance was low and such products were necessary to avoid “cultural shocks”. But as knowledge on Islamic finance grew, such Inah based products are not necessary anymore; the market has more understanding of the Islamic financial system and is ready to accept the structural differences.

Abdul Wahab was arguing on valid grounds, he is merely exposing the “loan behind the façade of a trade” element of the BBA.

It is about time the market, the regulators and the judiciary accept the fact that BBA is a product designed to ease the entry of Islamic finance into the market. It has outlived its purpose and should be phased out completely.

Tendering for Short Term Papers

In the Malaysian debt market, a short term bond is called a Commercial Paper (CP). A CP is either issued via a tender or private placement. In a tender, the CPs will be issued to the highest bidder(s) making the tender process a platform for investors to demand a rate of return that matches their risk appetite and/or investment objective. The basis for the bids is on the credit worthiness of the issuer. Once the CPs is issued to the winning bidders, the issuer is compelled to pay the promised returns to the investors.

Surprisingly, the same tender process applies to the Islamic CPs (ICP). I can understand if the ICPs are issued based on the Ijarah or Murabahah contract, there should not any problem with individually setting the rental or mark-up. The problem is when Musharakah and Mudharabah based CPs are subjected to the same procedure. I just cannot comprehend how an investor can demand, upfront, a fixed profit from a Musharakah/Mudharabah venture. It is totally against Shariah principles and contravenes the “profit and loss sharing” (PLS) model. Although the transaction documents clearly states that the returns are merely “expected” profits but in all likelihood, the projection will be met, 100% of the time.

What’s worse, the ICP is (usually) issued at a discount to nominal value and the issue price is calculated in accordance with the formula specified in Part III, Section 5 of the FAST Rules, the same formula used to calculate the discount for the conventional CPs.

Shariah based instruments and transactions may not be compatible with conventional platform all the time, it must un on its own unique platform.

So much for being in the forefront of Islamic finance.

Liquidity Management

Conventional wisdom states that money must generate returns all the time, even when it is idle. Hence the creation of the money market, a place for trading idle money. When there is a trade, there will be a price; and the price of money is the interest rate. What determines the interest rate? Other than the forces of demand and supply; monetary policy, expectation of changes in the base rate, inflation also influences the price of money.

The money market is also a place where mismatches in assets and liabilities are rectified. Banks with excess funds (liabilities > assets) will sell (lend) the idle cash in the money market and banks facing a shortage of funds (assets > liability) will buy (borrow) money from the market.

The money market is therefore crucial to ensure the banking system and the economy works smoothly.

Why then do I say that the money market is an anomaly in Shariah based finance?

Firstly (I’m already sounding like a broken record), my understanding is, Shariah prohibits the trading of money because money is not a commodity; it is merely a tool to facilitate trade. Money is potential capital, useful only when put into productive economic use.

Secondly, money is a ribawi item, one which cannot be exchanged unless it is equal in value and transacted spot. The following hadith is the basis of this ruling.

The Prophet s.a.w. said “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt should be exchanged like for like, equal for equal and hand to hand [on the spot]. If the types of the exchanged commodities are different, then sell them as you wish, if they are exchanged on the basis of a hand-to-hand transaction. (Sahih Muslim)

Therefore, the act of lending overnight money at 3.2%, contravenes the above hadith because (1) the exchanged value differs and (2) it is not exchanged on spot basis.

Then Tawarruq came along. Liquidity management in a Shariah compliant manner is now possible via the buying and selling of commodities (which does not leave the warehouse and is reused again and again for subsequent transactions). The route is longer but the objective is met nonetheless, money is exchanged in different amounts at different times, made “permissible” due to the presence of the trade. It sounds like a hilah to me because the whole transaction is undertaken merely to circumvent Shariah ruling on riba. It also does not entail any direct economic activity. The biggest beneficiary is the commodity brokers, getting paid for facilitating a seemingly pointless transaction.

No doubt, there will be times of excess liquidity and it does not make economic sense to keep the potential capital idle without generating any income.

This excess liquidity can be channelled towards financing short term projects or providing short term funding. Trade financing would be a good place to start. Retailers/traders usually buy from suppliers or wholesalers or manufacturers on credit terms. Banks could offer a short term murabahah facility to finance this type of transactions in the form of a 3 day, 1 week, 2 week or 30 day murabahah financing. This would channel the excess liquidity towards funding real economic activity.

Another way to absorb the excess liquidity is by way of a short term lease. A clearing house needs to be set up. The clearing house shall own a pool of tenanted properties. When a bank (or anyone for that matter) has excess liquidity, they will purchase property from the clearing house and the rental will be paid to them. When they need the cash, the property will be sold back to the clearing house at market value. In most cases, the purchase and sale price would be the same as it is quite unlikely for real estate values to fluctuate very much in the span of a few weeks.

Both methods entails actual economic activity and the returns from the investment are generated from actual economic activity.

There is always a Shariah based solution to every financial need. If there isn’t, the financial transaction is probably not in tandem with Shariah in the first place.

Islamic Structured Investment

An Islamic Structured Investment (or deposit) is an investment product which is linked to or benchmarked against a Shariah compliant underlying range of performance indicators such as equities, real estate or commodities. There are some Shariah compliant structured products in the market which is benchmarked against (Shariah compliant) indices, foreign exchange and even inter-bank offered rates. The returns from the structured investment are therefore dependant upon the performance of the underlying range of performance indicators.

A structured investment can either be principal protected or non-principal protected.

A Shariah compliant structured investment works the same way as their conventional counterpart, the only difference is in the nature of the underlying asset, it must not contravene Shariah principles.

The mechanics are as follows:
The promoter pool funds via the sales of the structured investment. The contract between the promoter and investor is usually that of a wakalah fi istithmar (investment agent).

For a principal protected structured investment, the promoter will split the funds into two, one portion will be invested in the Islamic money market or a fixed income instrument (zero coupon / discounted Sukuk) and a smaller portion will be utilised to purchase an option, applying the Urbun contract and referenced against the underlying.

The investment in the (Shariah compliant) fixed income instrument is for the purpose of reserving the principal investment and the option will provide the upside, if any.

The capital protection will only be enjoyed if the investment is held to maturity. Any premature withdrawal will result in the investment being valued at market and the investor will incur mark-to-market losses.

The maths is basically, allocate a portion based on the prevailing (profit?) rates that will ensure the capital is 100% preserved at the end of the investment tenure. The balance will be used to purchase an option. The participation rate (in the upside) of the option may not be 100% as it will depend on whether the balance after setting aside for the money market/fixed income Sukuk is sufficient. In some cases, the participation rate is less than 100% meaning the option holder is not entitled to all of the gains made from exercising the option.

Let’s dissect the structure.
Pooling of funds for investment purposes are perfectly fine and Shariah compliant.
Investing a portion to preserve capital – this would be done via the money market using Tawarruq. My stand on Tawarruq can be found here

Capital preservation is often a sticky issue with Shariah, if economic conditions go against the investment, what right does the investors have to demand full capital preservation? It becomes a zero sum game and there will be one party in the transaction who will lose out at the expense of the other. Shariah based finance is about justice and equity, sharing of profits and losses.

Buying an option using Urbun*, putting a deposit/downpayment to earn rights to purchase an asset – sounds compliant but are indices, foreign exchange and even inter-bank offered rates Shariah compliant assets? Does buying an intangible asset serve any economic purpose? I have no issues on Urbun for tangible assets like property or commodities.

My take on structured investment is it sort of looks and sounds like a mutual fund with a derivative (the option) and capital preservation elements. My views on derivatives can be found here and I’m of the opinion that capital should be positively correlated to the economy, preserving it would entail going against economic trends and causing some party somewhere to suffer more losses than necessary.


*Urbun is sometimes spelled Arboon

Islamic Profit Rate Swap (IPRS)

IPRS is the Shariah compliant version of the conventional Interest Rate Swap (IRS). The IPRS/IRS is a risk management tool whereby an institution which is contracted to pay fixed profit rates may hedge its risks by swapping the fixed rate payment obligation for another party’s floating rate obligations. IRS refers to a generic rate swap in which one party pays a fixed rate while receiving a floating rate. As in the IRS, the notional principal in an IPRS transaction is never exchanged, only the difference is settled.

The IRS is a derivative product and the widely accepted market standard is the International Swap & Derivatives Association, (ISDA).

As usual, I want to be the party pooper. My question is; is IPRS a Shariah based solution or a conventional product made Shariah compliant?

Azrulnizam Abdul Aziz of Standard Chartered Bank Malaysia (now Saadiq) describes the Islamic Profit Rate Swap as follows (Islamic Finance news (IFN) Guide 2007):
The Islamic Profit Rate Swap (IPRS) was introduced to assist in the management of profit rate risks, thus enhancing cash flows. Profit rate swap is a mechanism structured to allow bilateral exchange of profit streams using two parallel and back-to-back Islamic marked-up sale transactions (Murabahah).
It comprises of three possible structures, namely the IPRS, Islamic Cross-Currency Swap (ICCS) and Islamic Forward Rate Agreement (IFRA). In IPRS, a series of Murabahah sale and purchases are conducted, allowing parties to swap or exchange profit rates from fixed to floating rate or vice versa.

Therefore, in theory, an Islamic Profit Rate Swap would operate in the following manner:

Party A purchases assets on Murabahah (fixed mark-up/profit) terms. They know the exact amount of profit due throughout the repayment tenure.
Party B enters into a Musharakah venture. They can estimate the returns but would not know exactly how much profit is made until the accounts are finalised.
An IPRS would entail Party A paying Party B a fixed, known amount of profit while Party B pays A an amount which is only known at the end of the financial year. The two profit amounts will not be identical; being identical defeats the whole purpose of the transaction!

A Murabahah or Istisna transaction has a fixed profit rate. Ijarah transaction can have a fixed lease rate while Musharakah and Mudharabah have variable profit rates, even loss rate!

If profits are made by the Musharakah (or Mudharabah) venture, the swap works fine(-ish). What if the venture suffers a loss? What is swapped?

An IPRS utilises the controversial Tawarruq structure. If the two parties are merely paying each other the (cash) amount of profits, utilising Tawarruq clearly shows an attempt to circumvent Shariah prohibition of exchanging unequal amount of money (which results in riba).

I would conclude that the IPRS is not a solution based on Shariah principles. An IRS is created with the primary objective of capitalising on the movements of interest rates. It is a tool to make (or save) money from the movements in the price of money (interest). It does not entail any productive economic activity. It is merely a transfer of money from one party to another.

How then does an Islamic financier hedge against movements in profit rates? Profit rates, unlike conventional interest rates are dependent on the underlying transaction. There is no one universal profit rate across the board. A Murabahah profit rate for a risky aerospace venture for example, would not be equal to the profit rate of an identical Murabahah transaction involving the government’s (less risky) purchase of educational equipment. Similarly, the Ijarah rate for a residential property is not the same as that of a CBD commercial property. For equity based contract like Mudharabah and Musharakah, profits cannot be guaranteed; returns depend on actual performance of the venture.

My stand remains – continuing to develop solutions that mimic the conventional system will not develop Shariah based finance.

The “will” to regulate

Islamic finance could also face a systemic failure and reputation risk unless there is a unified and dynamic regulatory framework applied not only domestically but also globally, warned an economist and former International Monetary Fund (IMF) executive director Dr Abbas Mirakhor.
He added that the industry may have more regulatory standards but there is no implementation of the standards in a unified manner and there is no organisation that supervises the instruments. Therefore, Mirakhor said that to ensure a decent chance of growth and development, one has to make sure the regulations are unified and accepted by all jurisdictions.
“We need to create a uniformed standardisation for Shariah products and at the same time you need a uniformed, comprehensive and universal regulatory system in place, which can have the authority of early warning when it comes to weak instruments," he said.
However, the question is whether it should be done via an association of Islamic banks or central banks that have Islamic Finance operating in its jurisdiction. Such arrangements are not difficult but it depends very much on the "will" of the participants, said Mirakhor. (Bernama)

In my previous posting, I made a feeble attempt at article review in which one of the points raised was the difficulty in finding a unified opinion due to the differing mazhabs followed by the different scholars. It was also raised that perhaps a product should be approved with a “warning” label as to which mazhab the approval was arrived at.

Speaking about “will”, a lot of jurisdictions leave the Shariah compliance and monitoring role to the individual banks, the question is, are the banks willing to let go of this “power” to approve products?

Given this major obstacle in reaching a unified stand, how then do we proceed with a global, central authority to supervise and regulate the industry? I feel the IFSB, AAOIFI, Fiqh Academy are global institutions which can (and should) play the regulators role, if allowed.

I agree with Mirakhor when he said a regulatory authority “needs to have enough mandate to supervise/regulate the policy”. Getting the mandate however, might not be so easy.

Article review – “Is AAOIFI Ban on Musharaka Sukuk Justified?”

A not so comprehensive review on the above article which appeared in the May/June issue of the Islamic Banker.

The title itself is misleading – AAOIFI did not ban Sukuk Musharakah, it is banning the current model of Sukuk Musharakah which has the elements of purchase undertaking (PU) and guarantees.

The gist of this article is based on the views of one mazhab overriding the views of the other mazhabs.

Badlisyah (BAG) – arguments for the Malaysian market player from the Malaysian (Shafie) perspective.

P.10, Col 1, para 3, line 4 – contradiction, Musharakah is NOT a debt instrument. It should not be treated as such as it defeats the purpose of structuring a Sukuk based on the principles of Musharakah.

P.10, Col 1, para 3, lines 6 to 10 – the Malaysian investors, market, legal and regulatory framework unfortunately does not support the Musharakah model. It is still a debt based market with debt based regulatory framework.

My opinion on the PU – giving debt characteristics to an equity based instrument. This is to satisfy the demands of the investing public who wants an “Islamic” structure but also wants the features of a debt.

My opinion on AAOIFI’s announcement - it should not create a panic, there should be a consensus on the “effective” date as in anything issued prior to the announcement should be given an exemption from the ruling.

Permissibility of debt trading – it is true that differing mazhabs have differing views, this is where the industry needs a respected global body to lay down the law as to which mazhab prevails. Alternatively, allow the practices of all mazhabs and leave it to the market to decide whether they want to subscribe to a certain issuance or not. In this case, each Sukuk issuance has to come with an additional label – that of the approving mazhab.

True sale versus Beneficial sale – BAG argues that it is merely an accounting issue. He contends that a beneficial sale is as good as a true sale (despite the asset still remaining in the balance sheet of the seller). The purpose of a sale in an Islamic transaction is to give absolute rights of the asset to the buyer (i.e. Sukuk investors). My question is; does beneficial sale accord absolute rights to the buyer when challenged in court, given that the name on the title remains under that of the seller?

My opinion on the trading of banking stocks on the GCC stock markets - the reason why they are traded at a discount is due to the fact that stock valuation is done based on conventional norms. If stock valuation is done with Shariah considerations, it may yield different prices.

BAG uses the argument that the PU is merely a Wa’d (promise) which is not legally binding. If the PU is put to test and challenged in court, would the holder of the undertaking be compelled, by law, to honour the undertaking? If they are, then it is no longer a Wa’d but a legally binding contract instead.

Loan/top-up/liquidity arrangement in case of shortfall in profits – in equity based structures, are the managers allowed to do the same? BAG again argues that this arrangement is merely a Wa’d and therefore not legally binding. Again, will it stand if challenged in court?

A guarantee by a third (non-related) party is seen as an act of benevolence, it should not have any strings attached or payments charged.

The recurring argument of substance over form – different mazhabs have different opinions on the subject and all their opinions are valid from the Shariah perspective. Again, to overcome this obstacle, label a product based on the approving mazhab and let the market decide.

P.14, Col 1, para 6, last 2 lines – oxymoron, Musharakah is not a fixed income instrument.


My conclusions –

Musharakah = equity. Therefore, if we choose to structure a Sukuk based on the principles of Musharakah, we should also adhere to the principles that govern equity structures.

Shariah parameters are split between the 4 main mazhabs. Any stand or ruling must be accompanied by the basis, i.e. which mazhab it was based on. At the end of the day, it is for the market to decide which is best suited for their needs.

The Derivatives Debate

Derivatives are contracts which derive (hence the name derivative) its value from an underlying asset. Derivative contracts are used to manage risk, manage uncertainty, which is Shariah complaint. If this is so, why is there continuous debate and dispute on the status of derivatives from the Shariah perspective?

Agil Natt, chief executive of INCEIF points out that Islam encourages managing risk but he also asks how do you draw the line between risk management and gambling/speculating?

His comments are valid in the sense that the two reasons investors use derivatives are for risk management/hedging and speculation. The irony is that these two types of investors often work against each other; hedging aims to protect an investor from a volatile market (by taking an offsetting position to the investor's current position) while the speculator loves volatility, his objective is to profit from a rise or a fall in the price of a security.

Over time, simple derivative contracts like forwards have evolved into futures, options and the more complex credit default swaps and even OTC bets on bond defaults.

If the objective is to manage risk, financial instruments should focus on that – risk management. Regulators and product developers must not allow any speculative elements and/or opportunities to exist in the risk management process.

Mufti Taqi Usmani of the Fiqh Academy of Jeddah in an article answering a set of posed questions on the topic (New Horison, June 1996, pp 10-11), argues that futures contracts are invalid because:

"Firstly, it is a well recognized principle of the Shariah that purchase or sale cannot be affected for a future date. Therefore, all forward and futures contracts are invalid in Shariah; secondly, because in most futures transactions delivery of the commodities or their possession is not intended. In most cases the transactions end up with the settlement of the difference in price only, which is not allowed in the Shariah."

The Editorial of islamic-finance.com has this to say about derivatives:
"We can protect you against market volatility" the investment bankers tell their clients. But the market volatility is caused by the activities of those very same investment bankers, and so the clients are sold nothing for something. Protection against a danger that never needed to exist in the first place. Sadly, the world learned little from the derivatives explosion. By the time the internet boom collapsed, a new generation of clients was learning about the motivations that really drive bankers and advisors. The clients tend to be offered the products that provide financial institutions with the highest profit margin.

Shariah has no objections to hedging one’s risk but the industry participants must ensure that the risk management tools are Shariah based and not used for speculative purposes.

Bay al-Dayn

Mohd Johan Lee is an Islamic finance lawyer and managing partner of law firm J.Lee & Associates. In an article published by Reuters News on 24 June 2009 titled “No debt sales, no progress for Islamic finance?” he concluded the following;

It is indeed for the development of Islamic banking and monetary market that the sale of debt on spot be allowed. Without such practice, the creditors and bankers in an Islamic banking system cannot securitise their debts as practiced by the conventional system.

Thus, the permissibility of such debt sales is crucial to ensure the liquidity of the Islamic money market and Islamic banking system.

Without such debt sales, the Islamic finance industry can not be developed forward. This is because, without such debt trading, Islamic bankers will be stuck with their debt. As in typical banking practice, a low liquidity ratio would incapacitate the investment (and depository) business.

I’m not a lawyer or a Shariah scholar but one thing I stand by is practising Islamic banking the Islamic way, therefore I tend to not agree with his stand that “creditors and bankers in an Islamic banking system cannot securitise their debts as practiced by the conventional system, and therefore will at the losing end". My question is do we need to securitise like the conventional system? Do we need to securitise at all?

A securitisation usually involves the setting up of a Special Purpose Vehicle (SPV) to purchase debt obligations (Receivables) from a corporate or financial institution (the Originator) and issuing bonds secured over this pool of Receivables. Most conventional securitisations have some form of credit enhancements and the most popular is selling the Receivable at a discount. Receivable is a debt and Shariah doesn’t allow selling debt above or below par.

Saying “without such debt sales, the Islamic finance industry can not be developed forward” shows that he doesn’t understand that the Islamic finance industry is partnership, trade and justice driven and not debt driven like the conventional economic system. The conventional fractional reserve banking system is a system based on debt and artificial money creation but the Islamic financial system is built on real, productive economic activities.

On the same note, I find the Islamic money market a bit of an anomaly; if Shariah prohibits the trading of money, what then is traded at the Islamic money market?

AAOIFI Shari’ah Resolutions: Issues on Sukuk

Issuer: Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

The Shari'ah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), in view of the increased use of Sukuk worldwide, the public interest in them, and the observations and questions raised about them, studied the subject of the issuance of Sukuk in three sessions; first, in al-Madinah al-Munawwarah, on 12 Jumada al-Akhirah 1428 AH (27 June 2007), second, in Makkah al-Mukarramah, on 26 Sh'aban 1428 AH (8 September 2007), and third, in the Kingdom of Bahrain on 7 and 8 Safar 1429AH (13 and 14 February 2008).

Following the meeting of the working group, appointed by the Board, which met in Bahrain, on 6 Muharram 1429AH (15 January 2007), which was also attended by a significant number of representatives from various Islamic banks and financial institutions, the working group presented its report to the Shari'ah Board.

After taking into consideration the deliberations in these meetings and reviewing the papers and studies presented therein, the Shari'ah Board - while re-affirming the rules provided in the AAOIFI Shari'ah Standards concerning Sukuk - advises Islamic financial institutions and Shari'ah Supervisory Boards to adhere to the following matters when issuing Sukuk:

1. Sukuk, to be tradable, must be owned by the Sukuk holders, with all the rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally, as well as in accordance with the rules of the Shari'ah, in accordance with Articles (2) and (5/1/2) of the AAOIFI Shari'ah Standard (17) on Investment Sukuk. The Manager issuing the Sukuk must certify the transfer of ownership of such assets in its (Sukuk) books, and must not keep them as his own assets.

2. Sukuk, to be tradable, must not represent receivables or debts, except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation, in which some debts, incidental to physical assets or usufruct, were included unintentionally, in accordance with the guidelines mentioned in AAOIFI Shari'ah Standard (21) on Financial Papers.

3. It is not permissible for the Manager of Sukuk, whether the manager acts as the mudharib (investment manager), or sharik (partner), or wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus. It is not objectionable to distribute expected earnings, on account, in accordance with Article (8/8)3 of the AAOIFI Shari'ah Standard (13) on Mudaraba, or to obtain project financing on account of the Sukuk holders.

4. It is not permissible for the mudharib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase, in accordance with Article (3/1/6/2) of AAOIFI Shari'ah Standard (12) on Sharikah (Musharaka) and Modern Corporations, and Articles (2/2/1) and (2/2/2) of the AAOIFI Shari'ah Standard (5) on Guarantees. It is known that a Sukuk manager is a guarantor of the capital, at its nominal value, in case of his negligent acts or omissions or his non-compliance with the investor's conditions, whether the manager is a mudharib (investment manager), sharik (partner) or wakil (agent) for investments.

In case the assets of Sukuk of al-musharaka, mudharabah, or wakalah for investment are of lesser value than the leased assets of ‘Lease to Own’ contracts (Ijarah Muntahia Bittamleek), then it is permissible for the Sukuk manager to undertake to purchase those assets - at the time the Sukuk are extinguished - for the remaining rental value of the remaining assets; since it actually represents its net value.

5. It is permissible for a lessee in a Sukuk al-ijarah to undertake to purchase the leased assets when the Sukuk are extinguished for its nominal value, provided he {lessee} is not also a partner, mudharib or investment agent.

6. Shari'ah Supervisory Boards should not limit their role to the issuance of fatwa on the permissibility of the structure of Sukuk. All relevant contracts and documents related to the actual transaction must be carefully reviewed {by them}, and then they should oversee the actual means of implementation, and then make sure that the operation complies, at every stage, with Shari'ah guidelines and requirements, as specified in the Shari'ah Standards. The investment of Sukuk proceeds and the conversion of the proceeds into assets, using one of the Shari'ah-compliant methods of investments, must conform to Article (5/1/8/5) of the AAOIFI Shari'ah Standard (17).

Furthermore, the Shari'ah Board advises Islamic financial institutions to decrease their involvements in debt-related operations and to increase true partnerships based on profit and loss sharing, in order to achieve the objectives of the Shari'ah.

In the end, all praise is due to Allah, Lord of all the Worlds!

Universities Joining the Islamic Finance Bandwagon

Apparently, the Islamic finance industry was not badly affected by the global financial turmoil. One of the main reasons for this is because they are not exposed to the toxic assets that brought down most of the other banks. The resilience of the Islamic banking industry may not be fully attributed to prudent credit management or exceptional management skills; they were saved by Shariah’s prohibition of speculation, gambling (maisir) and uncertainty (gharar).

This September will see new courses and postgraduate qualifications in Islamic finance springing up throughout the UK and elsewhere in Europe. This development is sort of unusual because a few years ago, Islamic finance was viewed with extreme skepticism, often associated with terrorism and human rights abuses.

In the UK, interest in the sector reflects the government's intention to promote Britain as an Islamic finance centre. The UK already leads Europe not only in the number of locally established Islamic financial institutions but also in the number of Islamic finance training courses it offers, from entry to postgraduate level. Last December, the Treasury published a paper setting out the government's aim for London to be "Europe's gateway to international Islamic finance". This acknowledged that the industry was still young and therefore not yet experiencing skills shortages, but predicted that it soon would be.

The Guardian, (Tuesday 28 July 2009) reports that a few UK Universities have responded positively to this new opportunity. Newcastle University is offering an MSc. in finance and law with Islamic finance from next academic year. Henley Business School at the University of Reading has been offering an MSc in investment banking and Islamic finance since last year, with students spending the second part of the year in Kuala Lumpur. The University of Bangor in Wales has also been running its Islamic finance MA and MSc for a year and is considering introducing a new MBA in the subject, while the first students to take an Islamic finance option as part of an executive MBA offered in Dubai by Cass Business School will graduate this summer. Durham, which has been offering postgraduate research degrees in Islamic finance for some time, is now introducing a taught MA and MSc (the MSc is more quantitative), to respond to demand. Elsewhere in Europe, Reims Management School is offering a new specialist course in Islamic banking and finance for students on its masters in management programme, taught in English.

Strangely, two specialist Islamic Masters programmes running in the UK a few years ago, at the University of Durham and Loughborough University, were cancelled. Durham still offers a summer school and is the world's largest research hub for Islamic finance, with 25 PhDs at work at the university, but Rodney Wilson, professor of economics at Durham, says there was simply not enough demand from the right students.

Stefan Szymanski, professor of economics at Cass says "You just have to measure how many billions of dollars Islamic finance already handles in a year, if that grows over the years; it (Islamic finance) will become a universal part of every business school."

This is a good development, it bodes well for the industry, let’s hope that the universities teaching Islamic finance courses possess the qualified teaching expertise and are not in it just to capitalise on the wave of interest in the subject.

Sukuk Ijarah, Part II – Transaction Flow

This structure applies the Ijarah Muntahiah Bittamlik contact.

Ijarah is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the aqad (contract). The ownership of the leased asset remains in the hands of the lessor for the duration of the lease.
Muntahiah Bittamlik describes the transfer of the title of the leased asset to the lessee at the end of the lease tenure.

The transaction flow for my version (as opposed to the version practised in the Malaysian market) of the Sukuk Ijarah is as follows:

1. The purpose of this transaction is to raise funds, therefore; the Issuer shall identify an (a pool of) asset(s) to be sold to the Investors. The Issuer enters into a Sale and Purchase Agreement with the Investors whereby the Legal ownership of the asset(s) is transferred to the Investors at the prevailing market price and on a willing buyer willing seller basis. The cash proceeds from the sale is utilised by the Issuer as they wish.

2. Trustees shall be appointed to hold the Assets in trust on behalf of the Investors. The Investors will have a pro-rata undivided beneficial interest in the Assets.

3. In the same session, after executing the Sale and Purchase Agreement, the Issuer will execute the Ijarah Agreement with the Investors. Under the terms of the Ijarah Agreement, the Issuer leases the Assets from the Investors for a predetermined period at a predetermined Ijarah rate. The Ijarah rate shall include two elements, the rental element and the asset price element.

4. The Issuer issues Sukuk Ijarah to the Investors as evidence of their lease and its obligations. The Investors are now known as the Sukukholders

5. Under the terms of Ijarah Muntahiah Bittamlik, the beneficial ownership of the Asset is transferred to Issuer at maturity of the Sukuk Ijarah provided the Issuer meets in full the obligations stipulated under the Ijrah Agreement.

6. In an event where the Issuer fails to honour its lease obligations, the Sukukholders (Asset owners) shall repossess the Assets and dispose them to the market to recover their investment.

Note: Steps 1, 2, 3 and 4 occurs consecutively in the same session.

Sukuk Ijarah, Part I

Ijarah - is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period upon the aqad (contract). The ownership, rights and obligations as the owner of the leased asset remains in the hands of the lessor for the duration of the lease. Any costs incidental to the usage are the responsibility of the lessee.

A Fixed Asset based Sukuk Ijarah should have the characteristics of a Real Estate Investment Trust (REIT). If I was to structure a Fixed Asset Sukuk based on the Ijarah contract, it would probably have the following characteristics:

Issuer:
An SPV owned by the Trustees on behalf of the Sukukholders

Principal Activities of the Issuer/SPV:
Owner, manager and Lessor of [warehouses/hypermarket/office, commercial, industrial, educational, residential buildings/ships/aeroplanes – thereafter referred to as ASSETS].

Tenure of Investment:
5 years (for example)

Structure Description:
Investors will receive Sukuk Ijarah issued by the SPV as evidence of their investment in the SPV. SPV shall utilise the investment proceeds to acquire ASSETS (as described in [the hypothetical] Appendix A). The legal title of the ASSETS shall be transferred to the SPV and held in trust for the Investors.

The ASSETS shall not engage or be a party to any activities contrary to or forbidden by Shariah.

The ASSETS shall be leased to the market at the appropriate lease rental rates (as verified by the appointed valuer or industry expert) and for a lease period not exceeding 5 years (or any number of years as agreed by the investors).

Any costs incidental to ownership such as taxes and insurance shall be borne by the Lessor.

Any costs incidental to usage, such as utilities expenses, repairs due to wear and tear and content insurance shall be borne by the Lessee.

Lease rental net of (minimal) SPV cost shall be remitted to Sukukholders half yearly (or annually, quarterly, monthly)

SPV shall instigate legal action against lessees who deliberately and fraudulently dishonour the lease agreements. Failure of the lessees to pay rental due to economic reasons does not require immediate legal action. Instead, a solution has to be found to ensure the lessees are able to resume payment of the rental soonest possible.

Investors wishing to exit the investment, at any time, may sell their share of ownership to anyone, at the prevailing market price of the asset. The prevailing market price shall be based solely on the market value of the asset or NAV.

At the end of 5 years, the ASSETS shall be sold to the market at current prices and Investors will receive their share of the sales proceeds according to their share of investment.
The investors may decide to continue with the investment if the so wish and investors wishing to exit the investment may dispose their shares in the manner described above.


Difference from some of the Malaysian Sukuk Ijarah in the market:

• Under this structure, the SPV assumes full legal ownership of the assets, not just the beneficial ownership.
• This structure does not have a purchase undertaking with a predetermined price, the properties are disposed to the market, at market prices.
• Rental is priced at the real market rental rate and not benchmarked against any interbank rate (LIBOR etc) or interest rates.
  

This structure is basically a REIT. It is not a mind-boggling alien structure that should be scorned upon so correct me if I’m wrong, why isn’t there any such Sukuk structure out the in the market?

Shariah Compliant vs. Shariah Based

The difference is quite obvious; a Shariah compliant product is one that meets all compliance criteria, it may not necessarily be Shariah based (like “Shariah compliant derivatives” for example) but it is sufficient that it does not contravene any Shariah ruling. A Shariah based product on the other hand is already compliant; it is after all based on Shariah perimeters which makes compliance automatic.

Shariah compliant products may have its origins in conventional banking. To make a financial instrument Shariah compliant, all that needs to be done is to remove those elements or components which contradict with Shariah and replace them with a Shariah acceptable concept. Multiple contracts may be used to facilitate and complete the transaction and inevitably some form of legal trickery could be involved. I would agree with the definition of a Shariah compliant product being a conventional product which has been “Islamised”. An example of a Shariah compliant product is an Ijarah transaction where only the beneficial ownership is transferred and not the legal ownership.

A Shariah based product is a financial instrument which is derived from the laws of Shariah. It may share some similarities with existing conventional products but it did not originate form any conventional products. Structuring Shariah based financial solutions is easier because there is no need to find ways to circumvent Shariah prohibitions in order to achieve Shariah compliance. A Mudharabah venture capital model is an example of a Shariah based product.

Making existing financial products Shariah complaint is an easy, short term approach. It will satisfy the market’s need for Shariah compliant products but it will not distinguish Islamic finance as an alternative model to conventional banking. Merely Islamising and making existing conventional products Shariah compliant will cause the Islamic finance sector to converge with the conventional sector. Convergence means being one and the same and since Islamic finance is not the same as conventional finance; convergence should not be allowed to happen.

BBA is an example of a Shariah compliant financial product whose roots can be traced to conventional debt based lending. As a consequence, the mechanics and pricing of a Bai Bithaman Ajil financing is identical to that of a conventional loan.

Being different products running on different concepts and platforms, convergence cannot happen even on pricing. An Ijarah based mortgage carries different risks compared to a collateralised debt based mortgage. Therefore, given the different risk elements of the two similar products, the pricing cannot be identical; it should reflect the underlying risks involved.

Islamic finance is an alternative to conventional finance and hence convergence should not happen.

Bursa Suq Al Sila

I have always thought that Shariah based finance is always trade based as decreed in the Quran, 2:275 “… Allah hath permitted trade and forbidden usury …“

Based on my limited knowledge, a trade is a transaction where money and physical goods or services are exchanged. Therefore, is it a bona fide trade when the intention to take physical possession in absent?

Inah is a contract involving the movement of money form one party to another using “trade” to facilitate the transfer. The trade in Inah is (IMHO) a smokescreen, a legal trick to “legalise” the transfer of money including the additional (profit) amount. The Malaysian market has finally accepted this fact and phased out the use of Inah when conducting Shariah based financial transactions. The argument is however based on the number of contracting parties and NOT the absence of intention to take physical delivery of the traded goods. Based on the “number of contracting parties” view, the Tawarruq is formulated and deemed compliant despite the intention of taking physical delivery is still absent (OIC’s Fiqh Academy decided that Tawarruq may not be compliant after all but some scholars argue that “organised Tawarruq” should be allowed – I have no idea what organised Tawarruq is).

So, how do we move money from one party to another the Shariah compliant way? Where and how do we place idle funds?

I propose a property clearing house be set up, containing a pool of real estate assets, each individual property with their own legal title. The properties must be generating economic activity/value such as a warehouse, shophouse or residential properties, or even industrial properties/factories. The clearing house will own all the property and sell the property to those wanting to place idle funds for short periods. The properties will then be leased back to the clearing house and at the end of the agreed lease period be sold back to the clearing house at current market value. Given that the lease/investment period is short, between 1 week and 6 months, fluctuation in values should not be too drastic.

The proposed structure will at least eliminate the element of buying and selling assets purely for the purpose of transferring money and getting a little bit more back. The lease and sell back will be determined based on the prevailing market prices thus eliminating concerns concerning riba and gharar.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any enonomic activity but instead it creates debts.

What is Tawarruq? To me, it is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another. I commented on the issue previously (http://shariah-finance.blogspot.com/2009/05/commodity-trading.html) and I sort of feel vindicated by OIC’s declaration.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. My guess is Commodity Murabahah will be next.

Defaulting Sukuks

Reuters reported that industry experts are warning more Sukuk defaults are coming after Kuwaiti firm Investment Dar defaulted on their USD100 million Sukuk. At the same time, Saudi conglomerates Saad Group and Ahmad Hamad Algosaibi & Bros are restructuring their debt, triggering concerns of a spill over effect on the Islamic finance industry. Neale Downes, a Bahrain-based lawyer at Trowers & Hamlins, estimated that 5-8 percent of Islamic bonds, or sukuk, in the market are susceptible to default as many were raised for real estate projects which have been hurt by the slowdown. "The longer the global recession goes, the higher the likelihood of default," said Mohammad Faiz Azmi, global Islamic finance leader at PricewaterhouseCoopers. "People are now using reserves or savings to try to keep themselves going. How long can that last? So far what we've seen is the tip of the iceberg."

My question is; if the Sukuk is structured on a pure profit and loss sharing (PLS) concept, can it default? In my opinion, PLS structures do not recognise defaults. This is because by definition, PLS means sharing profits when they are made (according to predetermined ratios) and absorbing losses when they arise. PLS is not a contract where returns (coupons/profits/dividends) are guaranteed regardless of actual performance. Defaults are caused by the guarantee d returns element in the structure – just like in the conventional bond arrangements.

However, Sukuks structured on an Ijarah or Murabahah contracts may default if the contracted payments are not made. This is because such contracts are not contracts of partnership but instead lease contract (Ijarah) and debt contract (deferred payment Murabahah). In this case, payment of coupon/profit/lease is contracted and obligatory, non-payment will result in a default.

When reporting on Sukuk defaults, it must be made known what is the underlying contract it was based on. I am still of the opinion that partnership based Sukuks have no risk of default apart from in cases of negligence or fraud.

Controller of Compliance

Dr Mohamad Nedal Alchaar, secretary-general of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) declared at the IFN 2009 Issuers & Investors Asia Forum that his organization will determine the Shariah compliance of a product, and that this could be done from the latter half of next year.

This model of a central body deciding/monitoring/controlling Shariah compliance of financial products is not new; Bank Negara Malaysia and the Securities Commission is already playing that role (for the Malaysian market) as no product is allowed to be sold without their seal of Shariah compliance.

With a central compliance regulator, what will happen to the individual FI’s Shariah Advisory Committee (SAC)? What is their role? Are their decisions/recommendations binding? A central Shariah compliance authority could relegate their role to a mere secretariat, vetting Shariah issues before being approved (or rejected) by the central body.

A central, globally accepted Shariah controller of compliance being the standard setter and standard bearer could help in solving the standardisation issue. But, isn’t the OIC Fiqh Academy already doing that?

Any central body wishing to determine the Shariah compliance of a product would not be successful if standardisation of the Shariah interpretation is not in place. We should work towards that first.

Project Finance

There are many definitions for project finance.

Finnerty (1996, p. 2) defines project finance as:
. . . the raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.

Nevitt and Fabozzi (2000, p. 1) define it as:
A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

The International Project Finance Association (IPFA) defines project finance as:
...the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.

The above definitions mainly describe project finance from the debt perspective i.e. as a loan transaction.

Mechanics of a Shariah based project finance:

If a project is financed under the contract of Istisna, the project sponsor or initiator shall award the construction job to a contractor and the contractor will be paid according to the agreed terms, be it progressively, periodically or bullet payment at satisfactory completion etc. The price paid will include the contractor’s profit margin.

The project sponsor/initiator may raise the funding for the project via a Mudharabah or Musharakah arrangement whereby investors are invited to participate in the project. The returns from the Mudharabah or Musharakah venture cannot be predetermined and it shall be sourced from the cash flow or revenue of the project. It is therefore acceptable that no returns will be earned during the construction and pre-operating period. The project is owned by the Mudharabah or Musharakah investors/venture and upon completion; they may lease the asset for rental income or sell the asset for profit.

Ijarah Mausufah Fi Dhimmah is an arrangement whereby the financiers of a project are able to earn the lease rental during the construction period in the form of advanced lease. The setback of this arrangement is that should the project stall or fail, the owners will have to repay the Lessee(s) the advance lease paid.

There is always a completion risk in project financing. Should the project fail to be completed, the contractors should be paid what is due to them based on the work done. The Mudharabah or Musharakah investors will then share, according to their respective rights; the proceeds form the disposal of the project. The investors have no recourse to claim the full amount of their investment unless fraud or negligence on the part of the contractor or project manager is proven.

The main difference between Shariah based PF and conventional PF are;

(1) Ownership of assets (project)
Under conventional financing the project is held as collateral and the financers can claim from project sponsors for any shortfall in repayment.
Under Shariah financing, the asset/project is owned by the financiers and therefore they can only claim up to the value of the asset/project or the outstanding lease rental and nothing more.

(2) Returns from financing
Conventional financiers are repaid a fixed, predetermined payment over a specified period regardless of the profitability of the project. Any overdue payment will be charged a penalty and a default will force the asset to be forced-sold to recover the debt. Any shortfall will be met by the project sponsor.
Under Shariah financing, the investors are paid returns only when the project has positive cashflow. They can only claim for payment if fraud or negligence on the part of the contractor/project manager is proven.

(3) Risk
Conventional project financing places the construction, completion, market risks on the borrower and the bank (financier) only assumes the credit risk of the borrower.
Shariah financing distributes the risks amongst all the parties involved in the project. No one party can be insulated from the risk, unless fraud and negligence is proven.


Having being so used to earning predetermined returns with some recourse, banks would naturally be hesitant to finance projects the Shariah way. To overcome this, Shariah based project financing has to be marketed differently, highlighting the merits of risk-reward sharing and equitable distribution of income.

Vulnerability of Islamic finance exposed?

Sukuk defaults expose vulnerability of Islamic finance

MANAMA/KUALA LUMPUR: First defaults of Sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the $1 trillion Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in Sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or Sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait’s Investment Dar said in May it had defaulted on a $100 million Sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, Sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

“Secular, non-Shariah courts upholding those structures are more likely to consider Sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders,” said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

A $650 million Sukuk issued by troubled Saudi group Saad, which is undergoing debt restructuring, for example is seen as an asset-based, rather than an asset-backed, Sukuk. Yields of the Sukuk jumped to above 70 percent in mid-June, as investors feared a default of the issue.

Most Sukuk are structured as asset-based instruments, rather than asset-backed securitization where “you always have a claim for that particular asset that has been sold to you as the investor”, said Megat Hizaini Hassan, an Islamic banking lawyer in Kuala Lumpur.

“Everybody is chasing the same assets if they have not been transferred to the name of the Sukuk holders,” said Samer Amro, senior associate at law firm Dewey LeBoef. Other uncertainties are likely to arise from Sukuk defaults, including a debate about how courts will interpret repurchase clauses which are structured to follow a controversial ruling by prominent jurist Sheikh Muhammad Taqi Usmani in late 2007. Taqi had ruled that repurchase guarantees found in most Sukuk contradict Islamic laws, as they violate the principle of sharing risks and returns.

“If you’re looking at the newer structures where the repurchase obligations are left to be determined at the time of repurchase, there may be some issues there,” said Megat Hizaini. “You don’t really know how the courts will treat it in the situation,” he said.

Islamic finance is governed by scholars’ rulings, national regulators and its own standard-settings bodies such as Bahrain-based AAOIFI, the Accounting and Auditing Organization for Islamic Financial Institutions.

“In the Middle East, it’s going to put to the test many of the legal protections that were originally built into the Sukuk,” said Mohammad Faiz Azmi, global Islamic finance leader at PriceWaterhouseCoopers, adding that countries in the region typically do not have bankruptcy laws as sophisticated as in Europe.

“When these Sukuk start to default, it would be very apparent which jurisdiction has a more robust system than others,” he said.

Corporates with perceived higher risks that are facing high borrowing costs and a sluggish regional IPO (initial public offering) market could use true Sukuk sales with full ownership transfers as an avenue to the capital markets.

“It adds some credit-enhancement, it adds credit-worthiness,” said Rizwan Khan, a senior associate at law firm Norton Rose.

But the paperwork involved in registering ownership transfers in the Gulf Arab region and restrictions on foreign ownership of land make true Sukuk sales difficult.

Issuers have to register the SPVs, to which asset ownership would have to be transferred, in Bahrain or the Cayman Islands, as regulatory frameworks in other Gulf countries like Saudi Arabia and Kuwait do not fully cover Sukuk structures. This turns the SPV into a foreign buyer, limiting the pool of assets.

“This is not going to change unless laws are enacted, in particular on the ownership issues,” Khan said.

Source: Reuters, Monday 20 July 2009 (27 Rajab 1430)


The article above highlights and proves how identical the Sukuk is with conventional bonds as most investors are not expected to have better legal redress than conventional bondholders as underlying assets have not been truly transferred to them. This will lead to Islamic bondholders not having any more legal safeguards than conventional counterparts in case of default because their structure is merely asset-based and not asset-backed where they have a claim for that particular asset that has been “sold” to them. To make it worse, the courts may regard the Sukukholders as mere creditors instead of equity holders.

A good way to address this issue is to ensure that future Sukuk issuances be done in the true Shariah spirit, especially when it comes to asset ownership. The transfer of assets in such transaction must not be done just for the purpose of making it “Shariah compliant”. In a Shariah based structure, the equity element is always present, the debt element comes later. It is not possible to structure a debt based Sukuk without having equity ownership first.

Standardisation of Shariah Rulings

Bank Negara Malaysia introduced the “Shariah Parameters” with the objective of providing a comprehensive understanding of the principles and basis of adopting Shariah contracts for Islamic finance products in order to standardise the Islamic finance practices. The parameters are designed to clarify concepts, principles and conditions of Shariah contracts and provide the basis for decisions on matters relating to conditions, mechanisms and implementation of Shariah contracts.

Standardisation does not mean restrictions. It simply means things are done in a more consistent manner, avoiding confusion and disputes. I would think reaching a consensus on Shariah rulings would not be such a big problem as many scholars are already sitting on committees in different “Shariah jurisdictions”,* which often come up with different fatwas/rulings.

Standardisation will also enable a better understanding of Shariah based finance among the newcomers to the industry. It will eliminate confusion and make it easier to grasp the principles that govern the industry. Documentation and structures will be more comprehendible and legal disputes can be settled in a more orderly and consistent manner.

Will standardisation create a straightjacket and stifle creativity? I doubt so. In fact it will enable creativity to be undertaken more systematically in the presence of consistent guidelines and parameters.

With this standardisation, a Shariah decision made in Bahrain, Abu Dhabi, Kuala Lumpur or even London will be understood, accepted and applicable globally. This will enhance the efficiency and effectiveness of the industry and hopefully will open up more avenues for innovation and growth.

Standardisation will eliminate the Malaysian standard, GCC standard etc. It will create just one global standard and that bodes well for the industry.

*By Shariah jurisdictions I mean Malaysia, GCC and Europe/North America where the fatwas tend to be different depending on the Mazhab and the scholars’ individual interpretation.

Asset Based vs. Asset Backed

A brief definition of the two forms of financing:

Asset Based:
Methods of financing in which investors look to the cash flow from an asset or a pool of assets for a return on, and the return of their investment.

Asset Backed:
A term used to describe a security which is backed or secured by a pool of assets such as leases or receivables, but not real estate. The security shall be serviced by the cash flow derived from the pool of assets.


Given the definitions, which would be the preferred structure for Shariah based financing?

The important thing to consider is the ownership of the (real) asset and not just the rights to the earnings or cash flow. For example, an Ijarah structure requires full ownership before one can lease out and earn lease rental from an asset. Therefore, in order to make it comply with Shariah, the structure must define the ownership of the asset as well as the rights and responsibilities of the owners and the counterparties.

There is nothing wrong with a security that derives its cashflow or income from a pool of assets. But in a partnership based structure, the rights to income from an asset is derived from the ownership of the asset and full ownership means legal ownership and not merely beneficial ownership. There must be a true sale of the assets and not merely an artificial beneficial sale.

Whether we call it asset based or asset backed, we must ensure that the assets and the rights associated with ownership belong to the rightful parties.

Training Islamic Banking and Finance Professionals

Any discussion on Islamic banking and finance is never complete without lamenting on the shortage of skilled IBF professionals. This lack of expert human resources is due to so much demand chasing so few talents. But before we dwell further on the matter, we should first define what an IBF professional is.

To be an IBF professional as a person must first;

• Appreciate the values promoted by Islam;
• Understands why Islam forbids certain things and/or activities; and
• Must never think/behave/act like a conventional banker.

How do we achieve this? How do we mould such a banker?

We should start form the very basics. These professionals must be told and reminded from the very beginning that Islamic and conventional banking are two distinctly different financial models. They should not in any circumstances apply conventional banking practices into Islamic banking. These professionals must be trained to look at Islamic banking from the Islamic banking angle and not from the perspective of conventional banking.

The Shariah based financial model, as the name suggests, is guided by the rules of Shariah and what can or cannot be done is determined by Islamic law. Therefore, in order to effectively promote Islamic banking and finance, the promoter must understand and acknowledge the governing rules. One need not be a Muslim to understand and appreciate Islamic law; the only thing needed is an open mind.

Understanding Islamic law would also mean understanding the mechanics of Islamic financial transactions, why certain activities are prohibited and why certain things need to be done in a certain way.

For the industry to prosper, all its components must be equipped with the necessary expertise. Therefore, when talking about IBF professionals, we should not be just looking at the bankers. The scope must be expanded to include the solicitors, accountants, rating agencies, trustees, media, investors and the regulators.

Shariah based finance is actually very simple and straight forward. We will complicate things every time we practice Islamic banking the conventional way.