copyright © 2008-2011 michael j.t. mcmillen; all rights reserved 1 critical factors for the...

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved1

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


Michael J.T. McMillen

River Stone Capital, LLC

(law firm soon to be announced)

E-mail:[email protected]

U.S. Mobile:+1-646-337-3113

Contact Information


Topics for Today


Topical Overview

Objectives

Five Critical Factors

Some History

The Dow Jones Fatwā

Bifurcated Structures – the ʾIjāra (Lease)

Myth: Complexity

Sukūk

Musings


Objectives


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


Five Critical Factors


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


Some History


Timeline: Modern Islamic Finance

633 800 1000 1300 1500 1700 1900 1996 2011633 800 1000 1300 1500 1700 1900 1996 2011

Inception of thinking; Development of the Sharīʿah:

Nominate Contracts

Inception of thinking; Development of the Sharīʿah:

Nominate Contracts

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.

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved

Islamic banks open in Asia and Europe. Real Estate, leasing and commodities

Islamic banks open in Asia and Europe. Real Estate, leasing and commodities

Dow Jones Islamic Market Index FatwāDow Jones Islamic

Market Index Fatwā

Modern Islamic “finance” begins: focus on “investment” side; move to ʾjmāʿ; nominate contracts as building blocks

Modern Islamic “finance” begins: focus on “investment” side; move to ʾjmāʿ; nominate contracts as building blocks

11


1970’s 1980’s 1990’s 1996 1998 1999 2000 20011970’s 1980’s 1990’s 1996 1998 1999 2000 2001

Post WWII independence leads to new nationalisms and the popular revival of indigenous institutions

Post WWII independence leads to new nationalisms and the popular revival of indigenous institutions

Islamic banks and finance houses open in Middle EastIslamic banks and finance houses open in Middle East

Conventional banks open “Islamic windows”: deposit side focusConventional banks open “Islamic windows”: deposit side focus

Gulf Investment HouseBifurcated US residential real

estate ʾistisna ʿ– ʾijāra structures

(Maconda Park – Truman Park)

Gulf Investment HouseBifurcated US residential real

estate ʾistisna ʿ– ʾijāra structures

(Maconda Park – Truman Park)

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

United Bank of Kuwait IIBU equipment leasing

funds – operating leases in the US

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

KFH Lease Fund and Wafra lease funds – US equipment operating leases;

Investcorp conventional and Islamic residential fund

Arcapita Watermark

Paddlesports:private equity

Arcapita Watermark

Paddlesports:private equity

Saudi Chevron bifurcated rahn-ʿadl structure

Saudi Chevron bifurcated rahn-ʿadl structure

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved

Compliant assets on the LME total US$100 Billion

Compliant assets on the LME total US$100 Billion

12


2001 2002 2003 2004 2005 2006 2007 20082001 2002 2003 2004 2005 2006 2007 2008

Islamic Indexes delist Enron, Worldcom, Tyco - months before their falls

Islamic Indexes delist Enron, Worldcom, Tyco - months before their falls

First sukūk - value of issues doubles each succeeding

year until 2008

First sukūk - value of issues doubles each succeeding

year until 2008

Sukūk, Islamic asset and whole-business

securitizations: AAOIFI Standard

Sukūk, Islamic asset and whole-business

securitizations: AAOIFI Standard

Rated sukūk based on US assets: East Cameron Oil & Gas

Rated sukūk based on US assets: East Cameron Oil & Gas

First Compliant ETFs and REITsSharīʿah-compliant private

equity: Aston Martin

First Compliant ETFs and REITsSharīʿah-compliant private

equity: Aston Martin

AAOIFI Sukūk Clarification

AAOIFI Sukūk Clarification

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

HSBC Amanah Global Properties

Income Fund: real estate

HSBC Amanah Global Properties

Income Fund: real estate

Fatwā for Sharīʿah-compliant short sales

and options

Fatwā for Sharīʿah-compliant short sales

and options

East Cameron bankruptcy filing

East Cameron bankruptcy filing


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


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)


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


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


The Dow Jones Fatwā


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


Bifurcated Structures:Generic ʾIjāra


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 Sharīʿah structures 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


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


Standard Loan Agreement

• Rate Calculations

• Amortization

• Mandatory Prepayment

• Commitment to Lend

• Disbursement Mechanics

• Conditions Precedent

• Representations and Warranties • Voluntary Prepayment

• Covenants

• Events of Default

• Remedies

• Indemnities

LOAN AGREEMENT


Disbursement – Repayment Mechanism

• Rate Calculations

• Amortization

• Mandatory Prepayment

• Voluntary Prepayment

• Covenants

• Events of Default

• Remedies

• Indemnities

REEMENT

• Commitment to Lend

• Disbursement Mechanics

• Conditions Precedent

• Representations and Warranties

LOAN AG


Reallocation of Provisions

24

• Commitment for Construction

• Disbursement Mechanisms• Conditions Precedent• Representations and Warranties

• Covenants

LEASE (IJĀRA)[CONSTRUCTION

(ISTISNA’A)]

PUT and CALL OPTIONS

• Mandatory Prepayments

• Voluntary Prepayments

• Rent Rate Calculations• Periodic Rent• Covenants• Representations and

Warranties• Events of Default• Remedies• Indemnities

LEASE(IJĀRA)

Acquisition transactions have no istisnaʿ – that is for construction and development financings with multiple draws


Bifurcated Structure - ʾIjāra

25

Understanding to Purchase

Lease (ʾIjāra)

Understanding to Sell

Managing Contractor Agreement

Conventional Loan AgreementOther Loan Documents

Bank

Project Company

Funding Company

Occupational Tenants

Occupational Tenant Leases

Fund

Non-Compliant Compliant

Tax Matters Agreement


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


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


Lease (ʾIjāra)


Lease (ʾIjāra)


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-compliant lease. In the US, Rent equals periodic debt service, precisely.

Rent

Rent

Loan PaymentsDividends

Project Company

Funding Company

Debt Service


Understanding to Purchase and Understanding to Sell

Understanding to Purchase/Sell

Lease (ʾIjāra)


Occupational Tenant LeasesUnderstanding 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.

Strike Price

Debt Service

Title

Project Company

Funding Company

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.





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.

Project Company

Funding Company

Bank

Loan

Interest and Principalvia

Basic Rent PaymentsPurchase Price Payments


Myth: Complexity


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)


ʾIjāra Structure


Lease (ʾIjāra)




Bank

Project Company

Funding Company

Occupational Tenants


Fund

Debt Service

Rent/Purchase Price


Complexity – The Leveraged Lease

Revenue not needed for Debt Service

1Lease

ContractorManufacturer

IndentureTrustee

Equity Participant

Lenders

Lessee

Site Lessor

Operator

Owner Trustee

Lessor

InternalRevenueService

Contractor/Manufacturer

SuppliersOfftakers

Site Lease2

Construction/Purchase Agreement

3Supply Agreements

4Offtake Agreements

5Operating

Agreements 6

Assignment ofConstruction/Purchase

Agreement 7

Owner TrustAgreement 8

Notes, Bonds10

Lessee SecurityAgreement

Lessee Mortgage 11

EquityFunds 12

DebtFunds 13

Progress Payments,

Purchase Price14

Title 15

Indenture/Mortgage, Assignments of Lease and

Rents, Assignment of Lessee Security Agreement and Construction/

Purchase Agreement16

TrustCertificate 9

Tax Benefits17

Rents: Basic, Supplemental 18

OperatingExpenses 19

Reserve Fund21

Debt Service20

ParticipationAgreement 22

Revenue not needed for Debt Service 23

23

Tax Indemnity Agreement

17


Complexity - ʾIjāra

1Lease, Put, Call,

Managing Contractor

ContractorManufacturer

Lender

Equity Participant

Lessee

Funding Company

Lessor

InternalRevenueService

Construction/Purchase Agreement

3Supply Agreements

4Offtake Agreements

5Operating

Agreements 6

Assignment ofConstruction/Purchase

Agreement 7

Lessee SecurityAgreement

11

EquityFunds 12

DebtFunds 13

Progress Payments,

Purchase Price14

Title 15

Indenture/Mortgage, Assignments of Lease and

Rents, Assignment of Lessee Security Agreement and Construction/

Purchase Agreement16

Tax Benefits17

Rents: Basic, Supplemental 18

OperatingExpenses 19

Reserve Fund21

Debt Service20

Revenue not needed for Debt Service 23

EquityFunds 12

Operator Contractor/Manufacturer

SuppliersOfftakers


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


Sukūk


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


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


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


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


Issuances Generally: to September 2008

Total Issuances: US$ 87,955.22 millionTotal Offerings: 596

Sovereign Issuances: 35%Corporate Issuances: 65%

MalaysiaIssuances: 267 (44.80%)Total Volume: US$ 37,696.72 million (42.86%)

BahrainIssuances: 150 (25.17%)Total Volume: US$ 6,149.78 million (7.00%)

UAEIssuances: 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.


Issuances by Industry Sector



Issuances by Sharī`ah Structure



Issuances by Sharī`ah Structure and Year



Issuances by Tenor and Dollar Volume

0

20

40

60

80

100

120

140

160

180

3 Months 6 Months 1-4 Years 5 Years 6-9 Years 10-19 Years 20 Years

Al Sa laam Al -Istithmar I jarah Istisnaa Modarabah Murabaha Musharaka



Annual Issuances by Tenor and Number



Generic Sukūk al-ʾIjāra Structure


Lease (ʾIjāra)

Sukūk




Proceeds

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.


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


Attributions

Alhambra, Moorish architectural detail

Sarouk Fereghan Carpet, detail, North Persia, circa 1910, signed TaushandjianSotheby’s


Attributions

Samarkand Carpet, Eastern Turkestan, circa 1900Sotheby’s

Mosque ,Cathedral de Qous, ornamentation, G. Weber, lithographer New York Public Library


Attributions

Faiences Murales - du Tekyeh des Derwiches (SVIIe.siecle),New York Public Library

Timurid blue and white lotus bowl., Persia, 15th century,Sotheby's. L10223-206-lr-1


Attributions

Abbasid lustre pottery bowl, Iraq or Tunisia, 2nd half of 9th century,Sotheby’s L10225-60-lr-1

Kahsan pierced white ware pottery bowls, Persia. circa 1200,Sotheby's. L10225-79-lr-1


Attributions

Late Ayyubid - Early Mamluk, deep bowl, Raqqa or Damascus. mid-13th centurySotheby's, L10223-171-lr-1

Safavid Bombroon Pottery Bowl, Persia, 17th centurySotheby's, L10223-210-lr-1