Islamic Financing Products and Concepts, Current Market Trends and Opportunities. Nadim Khan, Partner, Herbert Smith LLP July 2010

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1 Islamic Financing Products and Concepts, Current Market Trends and Opportunities Nadim Khan, Partner, Herbert Smith LLP July

2 Overview Introduction to Islamic Finance The Key Products The Compliance Issues Trends and Future Opportunities 2

3 Introduction to Islamic finance What is Islamic Finance? No single definition though widely understood to mean commercial financial activity that complies with principles of Islamic jurisprudence i.e. Shari ah Modern Islamic Finance products aim to achieve similar business goals offered by conventional products e.g. banking, investing, funding Shari ah has guidance on what is acceptable/not acceptable behaviour in Muslim life This includes economic and commercial activity 3

4 Main Shari'ah prohibitions Riba the prohibition against the charging of interest but it is wider than this usury or unjust enrichment (e.g. extortionate credit bargains) Gharar uncertainty there must be full disclosure (e.g. certainty as to the subject matter or price of a contract) Maisir speculation or gambling "obtaining something easily or becoming rich without hard effort" Assured Profit the Islamic financier should only generate benefit from the project in which he invests and must assume some risk Unethical Investment Islam is intolerant of certain products (e.g. alcohol, armaments and pork) and activities (e.g. gambling, entertainment, hotels) 4

5 Islamic finance the principal techniques Contract based the Shari'ah has an established framework of commercial contracts and legal relationships The principal Islamic contracts Murabaha cost plus financing Istisna'a a variation of Murabaha that permits goods to be financed whilst under construction or manufacture Ijara/Ijara-wa Iqtina leasing and leasing with a purchase option Mudaraba trust financing (used to enable syndication) Musharaka joint venture Sukuuk Islamic bonds 5

6 Products: The Murabaha

7 What is murabaha financing? Basics of cost plus financing the sale of an asset on deferred payment terms deferred sale price comprises of cost price plus a profit title to the asset transfers to the customer at time of trade deferred sale price payable by the customer at a later date (perhaps through instalments) Other key features fixed rate product asset must be Islamically acceptable adherence to other Shari ah principles typically requires exchange of notices and confirmations 7

8 Mechanics of a pure murabaha trade ISLAMIC BANK 1. Bank appoints Customer as Agent (either disclosed or undisclosed) CUSTOMER (as Agent) 3. Delivery of Assets SUPPLIER 5. Title to Assets Deferred Sale Price e.g. 90 days later Title to Assets vests with the Bank but not possession, which remains with Customer 2. Purchase of Assets - immediate cash settlement with monies from Bank paid to the Supplier (either directly by the Bank or through the Agent) CUSTOMER (as Purchaser) 8

9 Commodity-based murabaha (tawarruq) 4 Islamic Bank 5 3 Customer 1 Commodity Brokers e.g. London Metal Exchange 2 1. Bank sources and pays for commodities (i.e. spot [x]) 2. Commodities are notionally transferred to Bank (book entries) 3. Murabaha transaction occurs i.e. sale on deferred payments terms (cost price [x] + LIBOR + margin) 4. Customer appoints Bank as agent to sell commodities back to market at spot 5. Cash 9

10 Revolving trades under a commodity-based murabaha Settlement Date 1 Settlement Date 2 Settlement Date 3 Settlement Date 4 No Set -Off 90 Days 90 Days 90 Days 90 Days DAY 1 EXPIRY DATE Maturity Date 1 Maturity Date 2 Maturity Date 3 Settlement Date = trade takes place Maturity Date = trade matures 10

11 Syndicated murabaha facilities Investment agency (wakala) or special (restricted) mudaraba Bank Syndicate $ Return Investment Agency or Mudaraba Agreement $ Participations Investment Agent or Mudarib $ Cost Price Title Vendor $ Deferred Sale Price Title Customer 11

12 Case study: telecoms financing Sub- Participant Bank Participation Sub-Participation Agreement Lending Bank Insurance cover for liability in respect of political and commercial risks Repayment + Interest (mirror profit) Loan Assignment of rights under the Murabaha Agreement Islamic Financier (IF) SPV (as Seller) Murabaha Facility Equipment sale $ Payment + Profit Appointment $ Payment Customer (as Agent for IF) Equipment Supply Contract ECA Support Customer (as Purchaser) Equipment delivery Equipment Supplier 12

13 P r i n c i p a l A g e n t Case study: acquisition financing Guarantees Security Appoint Security Agent (Bank) Agency Participant Banks Investment Agent SPV Cost Price Murabaha Deferred Sale Price (Cost Price + Profit) Purchaser Co Cost Price SPA (including wording contemplating agency) Vendor Co Appoint Nominated Delegate (Bank) Sells shares in Target Co Acquires shares in Target Co as agent of Investment Agency SPV Target Co 13

14 Products: The Musharaka 14

15 What is Musharaka financing? Basics Co-operation between two (or more) parties Contribution in cash and/or kind Utilisation of contributions and skills to create a profitable venture and generate returns Other Key features Classic characteristics of an equity product Parties must be treated on a pari passu basis Can be structured as a corporate or contractual joint venture arrangement N.B. The views of AAOIFI 15

16 Musharaka (joint venture) ISLAMIC FINANCIERS INVESTMENT AGENT as Investor Partner PROFIT PROFIT CUSTOMER as Commercial Partner MUSHARAKA UNITS MUSHARAKA UNITS CASH CONTRIBUTION Musharaka SPV CONTRIBUTION IN KIND PURCHASE UNDERTAKING RE UNITS SALE UNDERTAKING RE UNITS MASTER LEASE AGREEMENT MANAGEMENT AGREEMENT CUSTOMER as Obligor CUSTOMER as Lessee CUSTOMER as Manager 16

17 Products: The Ijara

18 What is Ijara financing? Ijara Leasing The legal background Shari ah recognises the principle of usufruct that the owner of an asset may part with possession of that asset and charge a third party for use of that asset Leasing techniques have developed steadily since 2000 The modern imperatives there are two reasons why leasing is critical to the future development of Islamic finance: floating rate offers the ability to compete with conventional products on pricing and tenor asset based retaining a ownership interest" in the asset allows the Islamic financier to participate in many deals that would not otherwise be capable of being financed 18

19 Ijara (operating lease) Lessor/Financier "Owner" Purchase price Title Vendor Rental Payments Lessee Grant of Lease Notes 1. Parting with possession and charging for use (usufruct) 2. Enables a floating rate 3. Rental values may vary 4. No strict equivalence to western operating and finance leases 5. Insurance & maintenance 19

20 Products: The Sukuk

21 Sukuk Characteristics Slow and gradual development of Islamic Capital market Instruments. Starting to gather pace. Economic qualities of traditional Bonds without breaching fundamental Shari ah principles. Islamic equivalent to conventional debt capital markets Characteristics Minimum tangible asset backing thresholds Sukuk proceeds invested into Islamic contractual structures evidenced by Islamic contract(s) such as leases The participant s interest represents an undivided proportionate interest in the underlying assets Notes are freely tradable pricing determined by the market (N.B. Sukuk Al Murabaha) 21

22 Global Sukuk Issuance Source: Zawya 22

23 Sukuk Issuance by Region 2009 Source: Zawya 23

24 Sukuk Structures Multiple Sukuk products are now available in the market Format of Sukuk and nature of assets to be brought into structure determined by: Asset availability Legal constraints Distribution requirements Focus on Sukuk Al-Ijara Sukuk Al-Intefah Sukuk Al-Musharaka Islamic Project Bond 24

25 The Ijara Sukuk Investors Sukuk $$ Tenant and Ultimate Purchaser Lease Issuer SPV $$ $ Land Land Land Owner Purchase undertaking 25

26 Ijara Sukuk: drawbacks Asset required Due diligence Potential breach of covenants Asset locked up Tax treatment (e.g. Stamp Duty, Sales Tax) Do you have a Spare airport? 26

27 The Sukuk Al Intefah Structure 3) Sukuuk Proceeds Payment of Advance Rental under Head Lease 6) "Coupons" 1) Head Lease agreement Customer 4) Sub-Lease Agreement Issuer SPV 2) Cash 2) Certificates of Participation (Sukuk al Intifah) Sukuk Participants 5) Rental Payment under Sublease 7) Termination Payment at maturity 8) Principal Payment at Matunity 27

28 Sukuk al Intefah Comparable to Sukuk al ljara, regarding: documentation tradeability of the instrument Different in that: no legal transfer of tangible assets Sukuk proceeds applied as advance rental payment under a long leasehold interest assets are sub-leased back to the legal owner 28

29 The Sukuk al Musharaka SUKUK HOLDERS ISSUER SPV as Investor Partner PROFIT PROFIT CUSTOMER as Commercial Partner MUSHARAKA UNITS MUSHARAKA UNITS CASH CONTRIBUTION Musharaka SPV CONTRIBUTION IN KIND PURCHASE UNDERTAKING RE UNITS SALE UNDERTAKING RE UNITS MASTER LEASE AGREEMENT MANAGEMENT AGREEMENT CUSTOMER as Obligor CUSTOMER as Lessee CUSTOMER as Manager 29

30 Service Agency Purchase Undertaking Sale Undertaking Advance Rentals For Uncompleted Project Segments Master Forward Lease Islamic Project Bond SUKUK HOLDERS Stage Payments Licence and all requisite Authorisations ISSUER SPV (as Employer and Lessor) Master Istisna'a Approved Sub-Contracts Sub-contractors Delivery Project Manager PROJECT COMPANY (as Lessee) SUB-LEASES WITH ULTIMATE TENANTS 30

31 Key Issues and Opportunities Broad scholar acceptance of structures (N. B. AAOIFI pronouncements on Sukuk Al-Musharaka) Asset Selection and a lock up Economic life Depreciation Local legal concerns: Foreign ownership Financial Services / Securities Regulations Tradeability 31

32 Trends in the Sukuk Market Number of Issuances set to increase late 2010 early 2011 Two major trends: - Adoption of Tax Neutrality Increase in other enabling laws to facilitate issuance of sukuk in UK, Luxembourg, France and Ireland World s first Euro sukuk likely to be issued by UK or Luxembourg New potential sovereign issuances: Turkey, South Korea, Thailand, Hong Kong, U.K., France, Germany, Holland 32

33 The Compliance Issue Shari ah risk Shari ah rules are open to interpretation (as are the rules of any legal system) no consensus of scholars on many issues different schools of law; geographical spread (Gulf vs. South East Asia) applying faith based rules and principles to financial innovations 33

34 The compliance issue gaining Shari ah approval English qualified lawyers do not opine on Shari ah compliance Some general background: Every Muslim is his own scholar Scholars and jurists are those individuals who have made the study of the Quran their life s work; previously not commercial men 34

35 The compliance issue gaining Shari ah approval (2) The role of the modern Shari ah adviser: Tend to be full time scholars or jurists, and have greater commercial awareness Seek to be appointed by an institution to provide a holistic service looking at entire product range with annual Shari ah audits Shari ah panels and limited numbers of scholars help to improve consistency There is now a shortage of experienced scholars. Several commercial Shari ah advisory services established 35

36 The compliance issue governing law Many Muslim countries have parallel legal systems the Shari ah applies to private life commercial codes (in the Middle East these are very often based on the Napoleonic code) govern commercial activity Some regional institutions and some Shari ah scholars insist Shari ah should prevail as the chosen law of the contract The international approach English law the preferred choice Several recent English cases include Shamil Bank v Beximco High Court : Religious Supervisory Board court will not look behind RSB certification Court of Appeal reaffirmed the High Court 36

37 Islamic finance: future opportunities Islamic Project Finance Structural innovation Increasing popularity in historically difficult markets Award-winning deals Capital Markets Convertible Sukuk Multiple Sukuk options: Murabaha Istisna a Musharaka Ijara and Ijara mawsufah fi al dhimmah Tradeable Sukuk and development of secondary market: global listings Islamic securitisation Shari ah compliant asset portfolios Not just an Islamic concern 37

38 Islamic finance future opportunities (2) Structured Finance Hedging and derivative-type products (profit rate swaps and forex products) Treasury products Takaful and re-takaful Islamic Corporate Finance Private equity Islamic investment funds 38

39 Islamic finance future opportunities (3) Growth Global listings of Islamic capital markets products which jurisdictions will be the European and Far East centres of Islamic finance Islamic retail banking Non Islamic parties to Shari ah compliant transactions / ethical financing Standardisation and centralisation 39

40 Contact information Nadim Khan, Partner Head of Global Islamic Finance Group Tel: Mobile:

41 Alliance offices 41

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