Critical Factors For The Development and Growth of Islamic Finance in the West

1. Critical Factors For The Development and Growth of Islamic Finance in the West Michael J.T. McMillen Berkeley Law Islamic Finance Symposium April 9, 2011

2. Contact Information Michael J.T. McMillen River Stone Capital, LLC (law firm soon to be announced) E-mail: mjtmcmillen@gmail.com U.S. Mobile: +1-646-337-3113

3. Topics for Today

4. Topical Overview • Objectives • Five Critical Factors • Some History • The Dow Jones Fatwā • Bifurcated Structures – the ʾIjāra (Lease) • Myth: Complexity • Sukūk • Musings

5. Objectives

6. Objectives for Today • Objectives for Today • Consider the critical factors that enabled the development and influence the form of Islamic finance and investment in the West • Which entails a bit of history and a dip into a structure • Identify a select group of dynamic tensions that exist in the Islamic finance (and investment) industry, particularly with respect to Sharīʿah compliance

7. Five Critical Factors

8. Five Critical Developments • ʾIjmāʿ (consensus) sought by small group of scholars - mid-1990s • Nominate Contracts as building blocks – mid-1990s • Dow Jones Fatwā – equity side of capital markets – 1998 • Sharīʿah-compliant structures for Western transactions – “bifurcated structures” – 1997-2000 • Sukūk – finance or “debt” side of capital markets - especially after 2002 • The red stars in the history section

9. Some History

10. Timeline: Modern Islamic Finance Adapted from: Yusuf Talal DeLorenzo and Michael J.T. McMillen, Law and Islamic Finance: An Interactive Analysis (2007), and Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. Dates are approximate. Inception of thinking; Development of the Sharīʿah: Nominate Contracts 633 800 1000 1300 1500 1700 1900 1996 2011

11. Timeline: Modern Islamic Finance Adapted from: Yusuf Talal DeLorenzo and Michael J.T. McMillen, Law and Islamic Finance: An Interactive Analysis (2007), and Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. Dates within any given period are approximate Modern Islamic “finance” begins: focus on “investment” side; move to ʾjmāʿ; nominate contracts as building blocks Gulf Investment House Bifurcated US residential real estate ʾistisna ʿ– ʾijāra structures (Maconda Park – Truman Park) Post WWII independence leads to new nationalisms and the popular revival of indigenous institutions Islamic banks open in Asia and Europe. Real Estate, leasing and commodities Saudi Chevron bifurcated rahn-ʿadl structure Arcapita Watermark Paddlesports: private equity 1970’s 1980’s 1990’s 1996 1998 1999 2000 2001 Islamic banks and finance houses open in Middle East Dow Jones Islamic Market Index Fatwā Conventional banks open “Islamic windows”: deposit side focus United Bank of Kuwait IIBU equipment leasing funds – operating leases in the US KFH Lease Fund and Wafra lease funds – US equipment operating leases; Investcorp conventional and Islamic residential fund

12. Timeline: Modern Islamic Finance Adapted from: Yusuf Talal DeLorenzo and Michael J.T. McMillen, Law and Islamic Finance: An Interactive Analysis (2007), And Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. dates within any given period are approximate First Compliant ETFs and REITs Sharīʿah-compliant private equity: Aston Martin Islamic Indexes delist Enron, Worldcom, Tyco - months before their falls East Cameron bankruptcy filing Sukūk, Islamic asset and whole-business securitizations: AAOIFI Standard AAOIFI Sukūk Clarification HSBC Amanah Global Properties Income Fund: real estate 2001 2002 2003 2004 2005 2006 2007 2008 Rated sukūk based on US assets: East Cameron Oil & Gas First sukūk - value of issues doubles each succeeding year until 2008 Fatwā for Sharīʿah-compliant short sales and options Compliant assets on the LME total US$100 Billion

13. Development of the Sharī`ah as Law of Commerce • Sharīʿah principles (re commerce and finance) grew out of trade - in the Arabian peninsula 1,400 years ago. • The paradigm structures are: • sales • partnerships

14. Revival and Recovery • ʾIjmā: Consensus necessary across four primary Sunnī madhāhib (schools of Islamic jurisprudence): think of product development and sales difficulties in the period prior to consensus (transaction costs)

15. Revival and Recovery • Historically, under the Sharīʿah, there were a limited number of contractual transactional forms for the conduct of business – the “nominate contracts” • Trade-based – quite rigid – ‘silo’ approach still predominant up to 1998 • They included: • Loans (qarḍ hassan) • Gifts • Sales (bay), such as murābaha (sale at a mark-up) • Leases – a type of sale of the usufruct (ʾijāra) • Joint ventures and partnerships (sharikāt, muḍāraba) • Manufacture or construction contracts (istisnaʿ) • Agency (wakāla) • Others

16. Transition Factors • Scholars and practitioners began moving away from a conception of the nominate contracts as being immutable and rigid • Toward a more flexible conception of these structures as ‘building blocks’ • Structures are developed to allow conventional interest-based financing to participate in the transaction (examples later) – bifurcated structures

17. The Dow Jones Fatwā

18. Permissible Impurity and Purification: the Dow Jones Fatwā • Prior to 1998, any violation of Sharīʿah, however slight, rendered the transaction impermissible • Prior to 1998, a totally observant Muslim could not purchase a share of stock – ribā being a major constraint • Dow Jones Islamic Indexes fatwā of 1998 (amended 2003) • The tests: permissible business (“core” business), permissible instruments, and permissible impurity and financial tests • Institutionalization of a degree of “permissible impurity” • Institutionalization of cleansing or purification • Cleansing and purification – small amounts of impermissible interest income could be cleansed or purified by donation to charity

19. Bifurcated Structures: Generic ʾIjāra

20. First Sharīʿah-Compliant Structures • Assumption: US and European banks needed to finance real estate transactions in, first, the US and, later, Europe • These banks would only make conventional interest-based loans • Familiarity • Credit and underwriting • Regulatory and tax • Other reasons • Bifurcated structures making use of both Sharīʿahstructures and conventional structures in an overall transaction that is determined to be Sharīʿah-compliant by the Sharīʿah scholars • The first structures made use of the ʾijāra (lease) – basically a leveraged lease format – familiar to bankers and lawyers • Those structures remain predominant throughout the world – adjusted for each jurisdiction

21. Synchronicity and Comfort • History of Documents – Lender Bias • Initial Bank Representation • No Bank – No Deal • Modifications With Market Acceptance • Modules: • Backbone • Covenants • Representations and Warranties • Events of Default • Insurance • Rental Factors (lease rates) • Land and Property Description • Risk Grid

22. LOAN AGREEMENT • Commitment to Lend • Rate Calculations • Disbursement Mechanics • Amortization • Mandatory Prepayment • Conditions Precedent • Representations and Warranties • Voluntary Prepayment • Covenants • Events of Default • Remedies • Indemnities Standard Loan Agreement

23. LOAN AG • Commitment to Lend REEMENT • Disbursement Mechanics • Rate Calculations • Conditions Precedent • Amortization • Representations and Warranties • Mandatory Prepayment • Voluntary Prepayment • Covenants • Events of Default • Remedies • Indemnities Disbursement – Repayment Mechanism

24. LEASE (IJĀRA) [CONSTRUCTION(ISTISNA’A)] LEASE(IJĀRA) • Commitment for Construction • Rent Rate Calculations • DisbursementMechanisms • Periodic Rent • Conditions Precedent • Covenants • Representations and Warranties • Representations and Warranties • Covenants • Events of Default • Remedies • Indemnities PUT and CALL OPTIONS • Mandatory Prepayments • Voluntary Prepayments Reallocation of Provisions Acquisition transactions have no istisnaʿ – that is for construction and development financings with multiple draws 24

25. Bifurcated Structure - ʾIjāra Compliant Non-Compliant Bank Fund Conventional Loan Agreement Other Loan Documents Lease (ʾIjāra) Understanding to Purchase Project Company Funding Company Understanding to Sell Managing Contractor Agreement Tax Matters Agreement Occupational Tenant Leases Occupational Tenants 25

26. Tenant Compliance Issues • Tenants may not engage in prohibited businesses (alcohol, pork, interest-based financing, non-mutual insurance, gambling, pornography, prostitution) • The Fund Manager, on behalf of the Fund and the Project Company, will investigate the business of every occupational tenant • Each occupational tenant lease must be Sharīʿah compliant

27. Tenant Compliance Issues • Permissible impurity and cleansing doctrines come into play • Recall that the test pertains to the “core business activities” of the relevant entity – from the Dow Jones fatwā • Available alternatives issues (an ATM, a restaurant with a bar, back office operations of an insurance company, and other examples) • Cleansing by donation of a portion of the proceeds • Request to make lease compliant at inception; obligation to make it compliant upon releasing or renewal of lease – accommodation to market realities • These tests have the effect of limiting the pool of properties available for investments by a Sharīʿah-compliant fund • Investors and lenders must consider whether the property will draw sufficient tenant interest based upon property type (office, industrial, mixed use, etc) and locations • Not an issue for residential properties

28. Lease (ʾIjāra) Bank Loan Payments Dividends Conventional Loan Agreement Other Loan Documents Debt Service Lease (ʾIjāra) Funding Company Rent Project Company Occupational Tenant Leases Rent The Funding Company, as the lessor, will lease the Project to the Project Company, as the lessee, pursuant to the Lease (ʾIjāra). This is a Sharīʿah-compliantlease. In the US, Rent equals periodic debt service, precisely. Occupational Tenants

29. Understanding to Purchase and Understanding to Sell Understanding to Sell is a “call option” for the project, in whole or in part. The strike price equals all amounts due on the conventional loan. All voluntary prepayments. Bank Conventional Loan Agreement Other Loan Documents Debt Service Lease (ʾIjāra) Understanding to Purchase/Sell Funding Company Project Company Strike Price Title Occupational Tenant Leases Understanding to Purchase is a “put option” for the project, in whole or in part. The strike price equals all amounts due on the conventional loan. Sharīʿah rule on inability to collect future rents. Need mechanism to accelerate. All mandatory prepayments. Occupational Tenants

30. Tax Matters Agreement The Tax Matters Agreement indicates that the structure is a loan for US federal tax and provides a transactional roadmap for the IRS, designating the allocations of portions of Basic Rent and the purchase prices under the Understandings that are interest, principal, etc. Bank Loan Project Company Funding Company Tax Matters Agreement Interest and Principal via Basic Rent Payments Purchase Price Payments Occupational Tenant Leases Occupational Tenants

31. Myth: Complexity

32. Myth: Complexity • A frequent comment about Islamic finance is that it is too complex for widespread use, especially in the West • Look at the leasing context, and compare the ʾijāra with the leveraged lease • This is the most widely used structure for real estate investments, private equity investments and a wide range of other transactions • It is one of two structures used for Sharīʿah-compliant home financings (the other is the diminishing mushāraka)

33. ʾIjāra Structure Bank Fund Conventional Loan Agreement Other Loan Documents Debt Service Lease (ʾIjāra) Project Company Funding Company Rent/Purchase Price Understanding to Purchase Understanding to Sell Managing Contractor Agreement Occupational Tenant Leases Occupational Tenants

34. Rents: Basic, Supplemental EquityFunds DebtFunds 18 IndentureTrustee 12 13 Progress Payments, Purchase Price 14 Debt Service 20 Lenders Indenture/Mortgage, Assignments of Lease and Rents, Assignment of Lessee Security Agreement and Construction/Purchase Agreement Reserve Fund ContractorManufacturer 21 Notes, Bonds 16 10 ParticipationAgreement Owner Trustee Lessor Title 22 15 Lessee SecurityAgreementLessee Mortgage Owner TrustAgreement 8 11 TrustCertificate Revenue not needed for Debt Service 1 9 Equity Participant 23 Assignment ofConstruction/Purchase Agreement InternalRevenueService 7 Tax Benefits 17 Site Lease 2 Construction/Purchase Agreement Offtake Agreements Supply Agreements Tax Indemnity Agreement OperatingAgreements 3 5 4 6 17 Site Lessor Contractor/Manufacturer Offtakers Suppliers Operator Complexity – The Leveraged Lease Revenue not needed for Debt Service 23 OperatingExpenses 19 Lease Lessee

35. Rents: Basic, Supplemental EquityFunds EquityFunds DebtFunds 18 12 12 13 Lender Progress Payments, Purchase Price 14 Debt Service 20 Indenture/Mortgage, Assignments of Lease and Rents, Assignment of Lessee Security Agreement and Construction/Purchase Agreement Reserve Fund ContractorManufacturer 21 16 Funding Company Lessor Title 15 Lessee SecurityAgreement 11 Revenue not needed for Debt Service 1 Equity Participant 23 Assignment ofConstruction/Purchase Agreement InternalRevenueService 7 Tax Benefits 17 Construction/Purchase Agreement Offtake Agreements Supply Agreements OperatingAgreements 3 5 4 6 Contractor/Manufacturer Offtakers Suppliers Operator Complexity - ʾIjāra OperatingExpenses 19 Lease, Put, Call, Managing Contractor Lessee

36. The Complexity Myth and Misconception • At present, most Islamic finance transactions are less complex than their conventional equivalents • It is anticipated that the level of complexity of Islamic and conventional finance transactions will be essentially the same as more “compound” transactions (involving both Islamic and conventional participants) are effected and as Islamic finance becomes more sophisticated

37. Sukūk

38. Definition and Overview • Growth since 2003 – one of the fastest growing areas • One of the first instruments to access the debt side of the capital markets • Sukūk are of two types: • “Bond” structures – herein lies the problem – consider “whole business securitizations” • Asset securitization structures • Most transactions to date are bond structures that involve, ultimately, a sovereign credit • Only a few (one?) asset securitization sukūk

39. Definition and Overview • AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) sukūk standard • Definition: • certificates of equal value put to use as common shares and rights in tangible assets, usufructs and services or as equity of a project or investment activity • distinguished from equity, notes and bonds • they are not debts of the issuer • may not be issued on a pool of (impermissible) receivables • underlying business contract or undertaking must be Sharīʿah-compliant

40. Fundamental Definitional Queries • By definition, a sakk represents a fractional undivided interest in the underlying asset • It is quite similar to a “pass through certificate”, circa 1983, in US mortgage-backed securities practice • What is “fractional undivided ownership”? • Tax benefits and burdens to certificate holder? Consider, e.g., depreciation, investment tax credits, phantom income, etc. • Environmental liability to certificate holder? • , • Sukūk are owned, overwhelmingly, by banks, insurance companies, institutional investors and governments (consider Malaysia) • What of ownership of the usufruct rather than the underlying asset itself? • Consider these issues as we work through the discussion of sukūk

41. Categories • 14 acceptable categories • Securitization of: • an existing or to be acquired tangible asset (ʾijāra) • an existing or to be acquired leasehold estate (ʾijāra) • presale of services (ʾijāra) • pre-sale of the production or provisions of goods or commodities at a future date (salam) • funding cost of construction (istisnaʿ) • funding acquisition of goods for future sale (murābaha) • capital participation in a project or business (muḍāraba or mushārakah) • various asset acquisition and agency management (wakāla), agricultural land cultivation (musra’a), land management (muqārasa) or orchard management (musāqā) activities

42. Issuances Generally: to September 2008 Total Issuances: US$ 87,955.22 million Total Offerings: 596 Sovereign Issuances: 35% Corporate Issuances: 65% Malaysia Issuances: 267 (44.80%) Total Volume: US$ 37,696.72 million (42.86%) Bahrain Issuances: 150 (25.17%) Total Volume: US$ 6,149.78 million (7.00%) UAE Issuances: 34 (5.70%) Total Volume: US$ 26,977.48 million (30.67%) Total Number: Malaysia + Bahrain: 69.97% Total Volume: Malaysia + UAE: 73.53% Compare: Gambia: 36 (6.04%) and US$ 11.49 million (0.0%) Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

43. Issuances by Industry Sector Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

44. Issuances by Sharī`ah Structure Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

45. Issuances by Sharī`ah Structure and Year Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

46. Issuances by Tenor and Dollar Volume Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

47. Annual Issuances by Tenor and Number Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.

48. Generic Sukūk al-ʾIjāra Structure Prior to the global financial crisis, banks expressed a willingness to purchase the sukūk. None done in US as yet. Most transactions involve sales of sukūk in the markets. What markets? Local banks and and Western banks and insurance companies have been major purchasers. Thus far, however, these have involved sovereign credits on the obligations. Holders Proceeds Sukūk Lease (ʾIjāra) Understanding to Purchase Funding Company Understanding to Sell Managing Contractor Agreement Occupational Tenant Leases Off-takers / Tenants Project Company

49. Musings

50. Conclusions - Musings • Islamic finance is all around you, and it will continue to expand • United States (in particular ) and the West: • one of the largest Islamic finance markets • an unheralded leader in the development of sophisticated structures for Islamic finance • Islamic finance is structured finance that is already familiar to many; it is not mystical • There have been various instances of doctrinal compromise that have facilitated the growth of the Islamic finance industry, and many of those compromises acknowledge Western financial market practices • These compromises are areas of dynamic tension, and the doctrinal disparity decreases with time • At the regulatory level, the global reevaluation presents an opportunity to consider and integrate Islamic financing principles; and that is occurring • The greatest opportunity is enhanced cultural understanding and appreciation