There has been a dramatic surge in demand for Shari’ah compliant investment products which offer a broad appeal beyond its traditional Muslim base. Recent reports indicate a 15 – 20 per cent per annum growth in Shari’ah based investment products, with the total market in Shari’ah financial products now reported to exceed $800 billion (and estimated to grow to around $1.6 trillion by 2012).
Keen to cultivate the Irish legal and regulatory environment for establishing Shari’ah compliant funds, the Irish Financial Services Regulatory Authority (the “Financial Regulator”), recently confirmed the establishment of a dedicated regulatory unit for the authorisation of Shari’ah funds in Ireland.
The purpose of this briefing note is to explore the main Shari’ah principles in terms of Islamic finance together with an analysis of the key features and categories of Shari’ah compliant investment funds. The legal and regulatory environment in Ireland is also discussed.
- THE MAIN PRINCIPLES OF SHARI’AH RELEVANT TO ISLAMIC FINANCE
The basis for all Islamic finance lies in the principles of the Shari’ah. The main precept established by those principles essentially emphasises the importance of social justice and equality.
A fundamental aspect of Shari’ah investments is the prohibition of any form of interest (riba). Shari’ah regards money as simply a means of exchange, without intrinsic value and holds that money cannot be used to make money. Compliance with Shari’ah also bars financial speculation, the selling of property that the vendor does not legally own, requires that financial returns are derived from physical assets and ostensibly bars the use of leverage, short-selling and derivatives. Other key principles include the emphasis on equitable contracts and a prohibition on investing in certain industries, details of which are elaborated on below.
- STRUCTURE OF A SHARI’AH COMPLIANT INVESTMENT FUNDS
Shari’ah fund structures are typically similar to conventional structures, however the fund and its individual investments must remain compliant with Shari’ah. A fund can be created using any of the legal structures available for the establishment of investment funds in Ireland, such as, an investment company, unit trust, common contractual fund or investment limited partnership and will appoint service providers and a board of directors or trustee to take overall responsibility for the fund in the same way as a conventional fund does.
A Shari’ah fund can be structured based on the Mudaraba contract under which investors (Rab al- Maal) contribute funds to a fund manager (mudarib), which provides investment management services through investment in Shariah compliant assets in return for remuneration generally including a share of the profits.
2.1 Shari’ah Board
In order to monitor Shari’ah compliance, the fund may appoint a Shari’ah advisory board which is typically made up of renowned Islamic scholars who are experts in Shari’ah law. The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), the industry level body for Shari’ah funds, has stated that a Shari’ah board must consist of at least three Shari’ah scholars. The board performs a variety of functions and is typically involved in the process of structuring the fund and reviewing its constitutive documents and material contracts to ensure their compliance with Shari’ah law.
Once the Shari’ah board satisfies itself that the fund’s rules are in compliance with Shari’ah principles, it issues a Fatwa (legal pronouncement) in verification of this. The fund will generally only be marketed when the Fatwa has issued. Upon the launch of the fund, the Shari’ah board provides ongoing guidance to the directors of the fund and to the investment manager on matters of Shari’ah law and in particular whether the proposed investments of the fund are Shari’ah compliant. Further, as it is inevitable that some of the income generated by the fund will be tainted by interest based income, the Shari’ah board will also guide the fund’s management as to how this income should be purified. As recommended by the AAOIFI, the rulings of the Shari’ah board may be binding on the management of the fund.
It is essential that the fund’s prospectus clearly outlines the details of how the fund will ensure Shari’ah compliance. It is critical that the prospectus indicates whether the Shari’ah board’s role will be on an executive or an advisory basis. The Financial Regulator will not seek to regulate or approve the Shari’ah board if it is acting in an advisory capacity only.
- SHARI’AH SCREENING METHODOLOGY
When determining whether a particular fund is Shari'ah compliant, there are two basic screening processes based on business activities and financial ratios that are generally applied prior to deciding whether or not a stock should form part of the eligible investment universe. The first of these screens often referred to as the “industry screen” functions in eliminating any haram (in which one should not invest) business from the universe. Initially, companies involved in any of the following activities will be filtered out as non Shari’ah compliant:
- Pork related products
- Entertainment (Casinos, Gambling, Cinema, Music, Pornography and Hotels)
- Weapons, arms and defence manufacturing
- Conventional Finance (non-Islamic Banking, Finance and Insurance, etc.)
The test which a company must typically satisfy is generally that at least 95 per cent of its gross revenues are generated by activities other than those mentioned above. In addition to avoiding these impermissible activities, a manager must take precaution to ensure that a target company abides by certain “financial screens” and does not engage in, or rely upon, financing that would otherwise eliminate investment eligibility. The following financial ratios must generally be met for companies to be considered as Shari’ah compliant:
- Debt is less than 33 per cent of total assets
- Cash and Interest bearing items are less than 33 per cent of total assets
- Accounts receivable and cash are less than 50 per cent of total assets; and
- Total interest income is less than 5 per cent of total revenue
Shari’ah funds may track an Islamic index as their investment policy, and one such index of Shari’ah compliant equities is the Dow Jones Islamic Market World Index (the “Down Jones Index”). The Dow Jones Index screens the business activities and the financial ratios of the companies within the index, and removes stocks which are not suitable for Islamic investment purposes. The Shari’ah Board will still be required to monitor the portfolio of the fund to ensure that its investment portfolio is halal (Shari’ah compliant), as even Shari’ah compliant equities will yield small percentages of income considered to be “impure” by Shari’ah standards and must undergo a purification process, details of which are set out below.
- TYPES OF SHARI'AH FUNDS
There are many forms of Shari'ah compliant fund which manage to operate within the confines of Shari'ah law. The following is a brief description of the main categories of Shari'ah compliant funds:
4.1 Equity Funds
Equity funds are the most common type of Shari’ah fund. In an equity fund, the profits are mainly achieved through capital gains made by purchasing shares and also by the dividends distributed by the relevant companies.
There are currently divergent views regarding investments made in companies, which although predominantly Shari’ah compliant, may from time to time inadvertently breach Shari’ah principles. The more traditional school of thought is that every share-holder of a company is a partner (sharik) of the company and thus is responsible for any non-Shari’ah compliant transaction in which the company is involved. However, a large number of contemporary scholars do not share this view and believe that investors are not partners in the company but are merely investors. Therefore, if a company is engaged in a halal business and keeps its surplus money in an interest-bearing account, wherefrom a small incidental income of interest is received, it does not render all the business of the company unlawful.
4.2 Ijara Funds
Another type of Islamic fund is an ijara fund, which will usually be established for the purpose of purchasing assets and then leasing those assets to third parties in turn for income. The assets that are leased out must be used in a halal manner and the leasing arrangement must conform to the principles of Shari’ah law. The ownership of the assets remains with the fund and the rentals are charged from the users.
4.3 Commodity Funds
Another possible type of Shari’ah fund is a commodity fund which derives income from the purchase and resale of commodities. In order for the fund to be Shari’ah compliant, the following conditions most be fulfilled:
- The commodity must be owned by the seller at the time of sale, therefore, short sales are prohibited
- Forward sales are not allowed except if the Islamic contracts Istisna'a and Bay al-salam are used
- The commodities must be halal; and
- The price of the commodity must be fixed and known to the parties
4.4 Murabaha Funds
A murabaha is a type of commodity fund in which the fund purchases a commodity and then sells it immediately on a "cost-plus" basis. Consequently, the fund will not own tangible assets but will instead consist of obligations owed to it by third parties. The costs and profit margin must be agreed in advance. If a fund is created to undertake this kind of sale, it should be a closed-end fund and its units can not be negotiable in a secondary market.
4.5 Mixed Funds
A mixed fund is one where the subscription amounts are employed in different types of investments, such as leases, commodities and/or various other equities. Such a fund must follow the roles prescribed for each type of investment, whether it is investing in leases or commodities.
4.6 Hedge Funds
At first glance, the concept of a Shari’ah compliant hedge fund appears unattainable. The majority of hedge funds pursue long/short strategies and/or employ derivatives such as futures, swaps and options. In order for a fund to be Shari’ah compliant, the fund manager must shun activities that could be deemed speculative, involves uncertainty or entails the payment of interest. What’s more, Shari’ah law requires the seller to have possession of the underlying asset that is the subject of the transaction and so this constrains the hedge fund manager’s ability to enter into conventional futures, derivatives contracts and short sales.
While traditional short sales are impermissible, several Shari’ah compliant alternatives have been created to replicate their economics as closely as possible. Demand for Shari’ah compliant hedge funds is set to continue as investors in Islamic countries increasingly recognise the benefits of noncorrelation, risk reduction and diversification that they can bring to an investment portfolio. This growth in demand is likely to bring greater consensus among Islamic scholars on techniques that are acceptable under Shari’ah principles which will create greater certainty for fund promoters and investors alike.
- SHARI’AH PURIFICATION PROCESS
Another distinguishing feature of Shari’ah funds is “income purification”. Despite applying rigorous screening criteria, it is often inevitable that a fund will receive income that has been tainted by impermissible activities or ambiguous (shub’hah) sources.
The Shari’ah board will usually provide a purification ratio to ensure that impure income is calculated by the fund, and that a corresponding percentage is deducted from the earnings passed on to investors through the dividends, thereby ensuring that these are free of impurities and completely halal. The methodologies for calculation may differ from one Shari’ah board to another and in some cases the fund may simply publish its own purification ratio thereby allowing investors to make the appropriate donations to charity. What is essential is that the fund is actually committed to, and regularly engaged in, such purification in a manner that accords with Islamic law. All impure income is generally separated at the earliest possible opportunity and donated to an eligible charity. The remaining halal segment is then considered to have been purified.
- SHARI’AH ONGOING MONITORING
Ongoing monitoring of the Shari’ah fund’s investments is essential to ensure strict adherence to the screening criteria. This is achieved by reviewing a fund’s business and financial activities which usually occurs on a quarterly basis. An annual review of the investment portfolio by the Shari’ah board has become standard. The board then issues a compliance report after their review.
Arrangements should be in place to track any public announcement by a company pertaining to a major change in its business activity or any action that would negatively affect its financial ratios for screening purposes.
The various service providers to the Shari’ah fund also play an important role in ensuring full Shari’ah compliance. In the case of the administrator it is essential that Shari’ah guidelines are implemented on cash management, subscriptions and redemptions and that all fund monies are kept separate from other monies, in non-interest bearing accounts.
6.1 Consequences of non-compliance
The Shari’ah board and the investment manager must adopt a framework to deal with any violations of Shari’ah screening process. The investment manager is usually responsible for capital losses if it has advertently invested in a company that did not meet the Shari’ah screening test. If a situation occurs where a company inadvertently invests in a company that did not meet the Shari’ah screening criteria, the investment manager should dispose of the shares of the non-compliant company immediately upon becoming aware of the error, and should report any such incident to the Shari’ah board. All income from the stock in that period will need to be purified for the period that the non-compliance occurred.
- REGULATION OF SHARI’AH FUNDS IN IRELAND
As well as the recently established dedicated regulatory unit for the authorisation of Shari’ah funds in Ireland mentioned at the outset of this briefing, the Financial Regulator has also confirmed that it will proactively engage with its regulatory counterparts in the Middle East and North Africa (MENA countries) and other jurisdictions in order to share an understanding of the respective regulatory systems. This is intended to facilitate the timely approval of investment managers and promoters from these jurisdictions choosing Ireland as a domicile for their international investment funds.
The Financial Regulator does not impose an additional regulatory framework for Shari’ah funds over and above what is warranted of other investment funds. In terms of the Shari’ah board the Financial Regulator does not deem it appropriate to judge between the different interpretations of Shari’ah made by the board and does not seek to regulate the substance of the board’s activities. However it would expect to know, from an operational and financial perspective, exactly what role the Shari’ah board will play in running of the fund.
The Financial Regulator will not seek to regulate the Shari’ah board if it is acting in an advisory capacity only. However, if the board members are intended to play an executive role they would need to satisfy the Financial Regulator as to their competence, capability and experience.
Also, the Financial Regulator, will not be concerned with the Shari’ah compliance of the fund’s investment portfolio. It will however look at whether the prospectus is drafted in a clear and transparent manner so that investors are clearly able to understand the basis on which the fund will operate.