CELESQ Webinar Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way

Steven J. Adelkoff, Jonathan Lawrence, Remsen M. Kinne IVJune 23 2009

2

Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way Introduction Basic Shariah Rules

3

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

4

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

5

Shariah terms

Halal – that which is permitted or compliant Haram – that which is not permitted Riba – charging of interest Gharar – the taking of unreasonable risk; gambling

Sukuk – Shariah compliant debt Ijara – Shariah compliant lease Takaful – Shariah compliant form of insurance Maduraba/Musharaka – forms of partnership Murabaha – a form of Shariah compliant forward sale for commodities that is used as a fixed income substitute

6

Industry prohibitions

Gambling Pork production or consumption Adult Entertainment Banking and finance Alcohol production or consumption Weapons production Tobacco production or use

7

Shariah-compliant investment screens

Screens haram industries Screens use various ratios to determine if a company is too leveraged

AAOIFI Shariah Standard No. 21 forms the basis of the theoretical underpinnings for screens and ratios.

Debt to assets of 30% or less (3/4/2 of Standard 21)

Impermissible income of 5% or less (3/4/3 of Standard 21)

Many companies are now failing the total debt to market capitalization ratio test

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

Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way Conventional Leasing v Shariah Compliant Leasing (Ijara)

12

Ijara

Literal translation: providing goods or services for temporary use against a wage

Qur’an legitimacy: “said one of them, ‘O my father engage him on wages’” (Qur’an Surah al-Qasas verse 26) and “if you had wished, surely you could have exacted some recompense for it” (Qur’an Surah al-Kahf verse 77)

13

Ijara (cont’d.)

Sunnah legitimacy: “whoever hired a worker must inform him of his wages” and “ give a worker his wages before his sweat is dried”

Scholar reasoning: Ijara is a convenient means for people to acquire the right to use assets that they do not own since not all people may be able to own tangible assets

AAOIFI Standard No. 9

14

Lease terms

Amendments to terms Duration Commencement date Deposit monies to secure the lease Two contracts for same asset for same period

Sub-leases Sale and leaseback

15

Use of the real estate

Prohibitions: Gambling Alcohol Pork Western style insurance and banking Defence industry Adult entertainment

Controlling sub-leases and assignments

16

Treatment of rent

Fixed for life of lease or adjusted periodically

Rent variation via reference to benchmark based on clear formula

Payment by lump sum or instalments Late payment Lease repricing Rent acceleration

17

Obligations of lessors and lessees

Maintenance Major repairs Insurance cost Property defects Lessee misconduct Insurance

18

Guarantees and rental income

Security to secure rental payments and against misuse of the property

Instalments may be accelerated on failure to pay one instalment

No increase in rental due to delay Charitable donation in lieu of penalty payment

Future rental payments may not deducted from security enforcement

19

Selling of or damage to the leased asset Termination of Ijara lease on sale of property to lessee

Lessee’s consent not necessary for sale to third party

Total destruction: Ijara lease terminates

Partial destruction: Lessor liable for damage or destruction of leased asset unless result of lessee’ misconduct or negligence

20

Termination, expiry and renewal

Termination by mutual consent Unilateral termination Breach of lease terms Death of a party Total destruction of real estate Expiry at term Continuation for good cause Renewal by agreement or automatically

21

Leases that end in lessee ownership

Ijara Wa Iqtina Resolution of the International Islamic Fiqh Academy No. 110 (4/12)

Finance lease Unilateral promise of ownership transfer by lessor at end of lease term

Unilateral promise with purchase schedule Purchase at end of lease term or in stages Lessor may not force lessee to buy

22

Leases that end in lessee ownership (cont’d) Ijara Mawsoofa Bil Thimma

Often used in project finance Redeemable lease which buys out completed project

Agreed in advance with initial construction deal

23

Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way Sukuk - Shariah Compliant Leverage

24

Underlying principles

Asset backing Entrepreneurial investment Defined credit participation Specific real business risk (vs. guaranteed interest-based return)

25

Definition of Sukuk

Sukuk terminology Shariah-compliant securitized credit financial instruments

26

Definition of Sukuk (cont’d)

Participation certificates Evidence investors’ right to return based on profitable investment

Return results from actual asset ownership

27

Structure

Shariah-compliant underlying asset Originator/sponsor sells asset to special

purpose vehicle Asset sale transaction may be, for example, a

lease back or a sale-repurchase Concurrent transaction by SPV with asset

user, for example lease and purchase SPV issues securities to investors Investors hold direct ownership interest in

underlying asset through SPV Pass-through payments

28

Sukuk documentation

Documentation issues

29

Other key issues

Bona fide purpose Return from profitable activity only Return not from debt, cash or other prohibited assets

Insurance Credit enhancement, liquidity support, limitations of prepayment risks, guarantees

30

Governance and Regulatory Considerations Shariah rulings Commercial securities, taxation laws Regulatory organizations

31

Recent Developments

Principal guarantees/repurchase agreements

Accounting standards

32

Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way Shariah Scholars and Advisers Anti-Money Laundering

33

Shariah scholars

Part Judge, Part Jurist Usually operates in Shariah Boards of three or more

Issues a Fatwa (Fatawa in the plural) No particular governing body or rules, just schools of thought and AAOIFI

High demand and short supply Certain Scholars are exceedingly influential in certain countries

There are no standard setting bodies, and Scholars have latitude. Information is asymmetrical. But sometimes Scholars disagree.

34

Shariah advisers

Has relationships with various Scholars Has structuring expertise and knows what the Scholars will accept

Is the bridge builder between conventional structuring of equity, debt or investment partnerships and Shariah

35

Purification

The act of purging oneself of impure profit, by contributing the profit to charity

A function of the Shariah Board is to tell investors what percentage of their profit is subject to purification

Shariah Boards use to recommend the charities to contribute Haram profits; modern practice is simply to allow investors to contribute impure profits to the charity of their choosing

36

Tales of anti-money laundering Compliance in Shariah

The Challenges of AML-KYC in Shariah Investing

Who mandates which charities may receive purification dollars?

The home address of “Two Oak Trees down the long road, and take a left at the Big Stone”

When utility bills are in Arabic

37

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

38

Attracting and Using Middle Eastern Money - Investing in Real Estate in a Shariah Compliant Way Conclusion Any questions?