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.