CELESQ Webinar Fundamentals of Shariah Finance Law

1. CELESQ Webinar Fundamentals of Shariah Finance Law Steven J. Adelkoff, Jonathan Lawrence, Remsen M. Kinne IV Wednesday November 4 2009

2. Fundamentals of Shariah Finance Law • Introduction • International perspective • Basic Shariah rules

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

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

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

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

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

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

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

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

12. Shariah Finance Structures • Mudaraba • Musharaka • Murabaha • Tawarruq (Reverse Murabaha) • Ijara • Ijara wa-iktina • Bai salam • Bai al inah • Istisna’a • Sukuk

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

14. Mudaraba MANAGER (Mudarib) INVESTOR(S) (Rab al Maal) Fee (based on share of profits) Share in profits and losses Provides expertise and manages funds Invests funds FUND PROJECT/ENTERPRISE

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

16. Musharaka FINANCIER CUSTOMER Share in profits and losses Share in profits and losses Cash contribution Contribution in kind (at least 30%) VENTURE

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

18. Murabaha Payment of Purchase price Payment of purchase price plus premium (deferred) SUPPLIER FINANCIER CUSTOMER Sale of asset Sale of asset

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

20. Tawarruq (Reverse Murabaha) Payment of purchase price Payment of purchase price plus premium (deferred) Payment of purchase price SUPPLIER FINANCIER CUSTOMER THIRD PARTY Sale of asset Sale of asset Sale of asset

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

22. Ijara Rent (= purchase price plus premium) Payment of purchase price SUPPLIER / MANUFACTURER FINANCIER CUSTOMER Sale of asset Lease of asset

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

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

25. Bai salam Purchase price (discounted) Purchase price (plus premium) SUPPLIER FINANCIER CUSTOMER Sale of asset (delivery deferred) Sale of asset (delivery deferred)

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

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

28. Istisna’a Purchase price plus premium (deferred) Purchase price DEVELOPER/CONTRACTOR/ MANUFACTURER FINANCIER CUSTOMER Sale of developed equipment/construction Sale of developed equipment/construction

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

30. Sukuk al Ijara CERTIFICATE HOLDERS Issue proceeds Return Issues Sukuk Sells assets Leases assets SELLER SPV ISSUER LESSEE Purchase price (issue proceeds) Rent

31. Sukuk al Musharaka CERTIFICATE HOLDERS Issue proceeds Return Issues Sukuk ORIGINATOR SPV ISSUER Share in profits and losses Share in profit and losses Contribution in kind (at least 30%) Cash contribution VENTURE

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

33. Fundamentals of Shariah Finance Law • Conclusion • Any questions?

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

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