ISLAMIC FINANCE

In 2006 Dubai Ports World made global headlines with its takeover of the UK’s international ports operator P&O. One of the reasons it attracted so much attention was the method chosen to finance the acquisition – the sukuk, a bond-like product generally adjudged to be compliant with the principles of Shari’ah or Islamic law. Demand was so strong that the initial $2.8bn issue was raised to $3.5bn, and ultimately drew $11.4bn in subscriptions, about half of them from overseas investors.

The P&O takeover was not an isolated incident and sukuks have been used to raise funds on a comparable scale several times since. But the growing popularity of this and other Islamic financial products in M&A, project and consumer finance has sparked a heated debate that centers around one pivotal question: do some of the new financial instruments currently being packaged under the Islamic finance banner actually comply with Shari’ah law?

Shari’ah Law
Islamic finance is finance under Shari’ah law as set out in the Qur’an and the Sunna. Shari’ah law is a body of religious principles open to subtle nuances of interpretation and applied to law and “life and behavior” in various ways. Partly because of this and partly because much of the classical interpretation of the law developed at a time when many of today’s financial concepts simply did not exist, there is no single, absolute set of rules that constitute a universally applicable point of reference for either the financial or business communities.

Crucially, however, Shari’ah law prohibits the taking or receiving of interest (riba); any transaction involving masir (speculation or gambling); and gharat, or uncertainty about the subject matter and terms of contracts, which includes a prohibition on selling something that one does not own.

In order to ensure that they comply with these and other principles, all Islamic banks have a Shari’ah board that monitors its workings and scrutinizes any new transaction that might be deemed doubtful from a Shari’ah standpoint – and has the power to sanction or dismiss as they see fit. What may be deemed acceptable by one Shari’ah board may not pass muster with another. These boards are in turn supervised by the independent International Association of Islamic Bankers and their rulings by the Supreme Religious Board.

Core Products
The restriction on interest-earning investments is nevertheless at the heart of Islamic financial principles and means that Islamic banks must make money through either fee-based returns or profit-sharing investments. Since the 1960s when the first “modern” Islamic bank was set up in Egypt, several basic project financing methods have been developed that are commonly deemed to conform to these strictures.

• Murabaha, or cost-plus financing
  This is a method of asset acquisition finance. It involves a contract between a bank and client for the sale of goods or property at a pre-agreed profit margin, either a percentage of the purchase price or a lump sum. The bank then proceeds to buy the goods or property and sells it to the customer. The profit mark-up is generally benchmarked against conventional interest rates, but is fixed before the deal closes and cannot be increased. Payment is usually made in installments.
• Mudaraba, or profit-sharing
  In this instance, one party provides 100% of the capital and the other party (the mudarib) provides the investment expertise, the project management and, where appropriate, the lab our. Any profits are distributed according to a predetermined ratio – as are the losses. This arrangement is commonly used in investment funds with investors providing money to the bank which invests it and takes a management fee.
• Musharaka, or partnership financing
  This involves two parties entering into a partnership and putting capital towards project financing (either new or established). Profits are shared on a pre-agreed ratio so that managerial and other non-financial inputs can be recognized and remunerated as well as the proportion of equity.
• Ijara, or leasing
  Here, the bank and client enter into a contract whereby the bank buys and leases out equipment to the client for a rental fee. The bank retains ownership of the equipment and seeks to recover its capital cost and to make a profit from the rental fees which are agreed in advance. Ijara can be applied to both operating lease and lease purchase agreements.
• Istisna’a, or commissioned manufacture
  One of the biggest obstacles for clients looking to use the Islamic banking system is the restriction embedded in the concept of gharar against selling something that one does not own. This can cause problems in the property and construction industries particularly as it effectively means that a building cannot be sold to a client before completion. An Istisna’a contract offers a route round this. In such an agreement, one of the parties is contracted to manufacture, construct or produce something according to certain pre-determined specifications and to deliver it over an agreed period.
• Sukuk, or leased-back government and corporate bonds
  While interest is at the heart of most conventional transactions involving bond issues and trading, sukuks have instead been designed as long-term securities. Critically, however, they require the borrower to guarantee repayments of the securities at face value on maturity or in the event of a default. Many distinguished scholars argue that this violates the risk- and profit-sharing requirement of Shari’ah law.

The role of ICA

Our philosophy
There has always been a degree of debate around Islamic financial products and by their very nature the Shari’ah boards that supervise the growing number of Islamic banks now operating in the Middle East will continue to offer subtly differing interpretations of their compliance with Shari’ah law. Raising finance successfully through the Islamic banking system has therefore always called for a high level of local and cultural affinity and a thorough knowledge of the financial system and banking sector.

In ICA’s view, the current debate around sukuks and other financial products that some scholars claim merely imitate Western-style interest-based products only accentuates the need for this affinity and knowledge. We believe that many of the new products on offer are incompatible with a truly Islamic economic system.

Because we are an ethically and socially responsible company committed to exerting a positive influence on the communities of the Middle East, our business philosophy is instead based on a traditional understanding of Islam as it pertains to finance. Although not controversial, our approach is nevertheless innovative. In cases where it is not possible to implement the ideal Islamic financial solution, we will provide clients with guidance to the next best alternatives.

Our services
At ICA we offer

• Advice on Shari’ah compliance
• Islamic financial product design
• Advice on Islamic corporate finance
• Islamic investment research
• Training

In each case we work closely with our clients to identify their requirements, providing written reports, financial analysis and Shari’ah legal opinions as required. We try to ensure that our clients are aware of the key Shari’ah and commercial issues that we have considered when providing our recommendation, enabling them to make informed decisions of their own in the chosen fields of endeavor.

We work in association with a variety of international firms known for their expertise and long-standing experience of the sector. Our main international associate is Zest Advisory LLP in London.