Syndicated finance involves a group of investors or financial institutions pooling their resources to provide finance to the customer. This principle applies equally to both conventional and Islamic finance. The Islamic financiers will act through one Islamic financier and will cooperate through an agreement, which will describe their respective rights and obligations. It is often called a participation agreement or an investment agency agreement.
Under this arrangement, there would be just one Islamic financier that interfaces with the customer and the parties’ respective rights and obligations will depend on the role of the Islamic financier that interfaces with the customer. Generally there are two possibilities, namely:
- Wakala (agency); or
It is always possible that legal issues unrelated to the Shari’ah may impact the role being played by the representative Islamic financier or the ability to extend certain types of finance. For example, if the finance involved real estate, local laws might require the person holding title be a national of the country or licensed to do business in the country where the real estate is located or might prohibit real estate being held by one person on behalf of others who were not nationals or residents of that country. The syndicate members and their representative in a conventional financing, however, would also likely face similar issues.
A wakala is an agency arrangement. The Islamic financiers will appoint one of them or a third party to be their agent (called a wakil). With a conventional facility there will be a facility agent and, to the extent that security is provided, there would be a security trustee or a security agent (and sometimes both). In terms of security, the decision as to whether to use a security trustee or a security agent will depend on the applicable governing law where the security is located. If the jurisdiction follows an English common law system which recognizes trusts (or if it is a civil code jurisdiction but which has passed specific laws recognizing trusts) the representative of the syndicate will be termed a security trustee. If the applicable jurisdiction does not recognize trusts, then the role will be that of a security agent. In some financings (for example with sukuk), one sometimes sees both roles being used (one being documented under English law and one under the local law); often this is done out of abundance of caution although, as security would normally be enforced in the jurisdiction where the security is located, if that jurisdiction does not recognize trusts, the local courts will probably either not enforce the trust arrangements or would interpret them as being agency arrangements.
The same sort of issues will arise with a wakala arrangement. The wakil is an agent and therefore would, on the face of it, act as the agent of the participating Islamic financiers and hold the security as agent. Nonetheless, there may be reasons why the Islamic financiers would want the wakil to hold security as a trustee, if this was recognized under applicable law. The reason for this centres on what would happen if the wakil became insolvent. Here the security might, as a matter of local law, fall into the general asset pool of the wakil such that the participating Islamic financiers would only have an unsecured claim against the wakil. If a trustee is recognized under applicable local law then, if the trustee became insolvent, the usual outcome will be that the security will remain the property of the beneficiaries, being the participating Islamic financiers.
A wakil, while an agent, does have various “trust” obligations towards its principals under Shari’ah principles, and as such there would not appear to be any restriction on a wakil taking on trustee obligations as these do not cut across the broad concept that the wakil is supposed to be acting and holding property on behalf of and in the interests of, its principal.
In practice, the participation agreement between the syndicate members and the wakil contains provisions that are very similar to those found in a conventional loan agreement. For example, one will normally find the following provisions:
- Appointment of the agent;
- Participation of the participating financiers;
- Prepayment (where applicable) and increased costs (although there are certain Shari’ah issues relating to increased costs);
- Payments by the participants and by the agent;
- Refund, sharing and further payments;
- The role and duties of the agent;
- Costs and expenses; and
- Assignment procedures.
There can sometimes be problems about including exculpatory provisions that favour the facility agent/ security trustee which are routinely found in a conventional facility agreement. Statements that a facility agent has no trustee or fiduciary obligations are sometimes questioned by Shari’ah advisers on the grounds that a wakil does have certain “trust” obligations as an amin – these broadly can be considered to be acting in good faith and for the best interests of the principal, which can get quite close to fiduciary responsibilities.
It is a requirement that the wakil is paid a fixed fee (although additional fees, such as incentive fees, can be paid; however, with this type of finance, incentive fees would not be likely) and that the wakil is reimbursed any expenses that it makes on behalf of its principals. These Shari’ah requirements will not normally be an issue and are also found in conventional financings.
Sometimes when parties are structuring a transaction, they will talk about the representative of the participants being a mudarib. This means that the arrangements contemplate using a mudaraba structure. This involves investors (called rabb al-maal) providing funds to a mudarib (an investment manager) to invest on their behalf pursuant to a business plan and feasibility study. It is critical for Shari’ah compliance that the mudarib is entitled to a share in the profits rather than a flat fee. A mudarib can also be paid an incentive fee but, as stated above in relation to a wakala arrangement, this would not normally be found with a syndicated financing.
Any losses would be borne by the rabb al-maal unless the losses were caused by the negligence or default of the mudarib. If a loss is shown then, under Shari’ah principles, the burden of proof shifts to the mudarib to prove that the loss was not caused by its negligence or default. It may be, however, that the law of evidence followed by a secular court before which any dispute came, would still place the burden of proof on the Islamic financiers.
It would be incumbent on the mudarib to produce a business plan and a feasibility study and these are likely to be important if any losses were suffered because, while the mudarib cannot be required to guarantee profits or a return, if the business plan and/or the feasibility study were negligently prepared and losses subsequently suffered, they could be used in evidence against the mudarib.
Due to the additional obligations imposed on a mudarib, usually the financier that is to act as the “facility agent” will not want to take on this role. To the extent that the representative of the syndicate members wants to take on a role that is similar to that under a conventional facility, it will usually elect to be a wakil.
Structured Islamic finance
Structured finance has no particular definition. Generally, it will involve the packaging together of various legal structures to produce a financial product or solution. The starting point will be to analyse the commercial objectives of the customer. Once those are known then it is a question of looking at the possible Shari’ah-compliant financing techniques and undertaking any necessary due diligence, which can extend to matters such as legal research, tax analysis and a review of any underlying assets that are to be employed in the Islamic financing.
With complicated transactions (which is often the case with certain structured Islamic finance products) the challenge is to find a structure that will simultaneously line up the Shari’ah requirements, the secular legal parameters and the commercial objectives of the customer. Especially with capital market structured products, there will usually be many documents and the structure will often involve a large number of transactional sequences, all of which will require to be vetted and approved by the Shari’ah Supervisory Board that must issue its fatwa. From a transactional perspective, therefore, it is important to obtain initial approval from the Shari’ah Supervisory Board as soon as possible in relation to the structure. Once this has been approved, then it is usually prudent to have the Shari’ah Supervisory Board vet the initial drafts of the documents to ensure that there are no fundamental errors from a Shari’ah perspective; it is not advisable to only ask the Shari’ah Supervisory Board to approve the documentation once they have been fully negotiated. By that time closing dates would have been pencilled in but, if the Shari’ah Supervisory Board at that stage reverts with material objections, the documents may have to be significantly amended and this is likely to have a knock-on impact on the projected closing date1.
Two examples of Islamic structured products are considered to show some of the issues that will be faced from a practical perspective. Clearly, however, these two examples are not all encompassing, as the scope of Islamic structured products is unlimited.
Derivative style products
Derivative style financial products raise particular difficulties under the Shari’ah. When viewed in a Shari’ah context, conventional derivative products often involve speculation and uncertainty and these two principles are Shari’ah repugnant. Structuring techniques have been used recently to create financial products that increase their projected returns by reference to indices that are not based on Shari’ah products. These have employed salam or murabaha investments (often backed up with capital guarantee mecha¬nisms) coupled with wa’ad (undertakings or promises) from a financial institution to pay the investors additional amounts over and above the returns on their investments if an index (which may be based on non-Shari’ah compliant products) produces a higher rate of return. This is an example of a structured Islamic finance product that uses various interlocking agree¬ments, investments and indices to create a level of return which the customer wishes to achieve. It is fair to say, however, that this particular type of product has not been accepted as being in compliance with the Shari’ah by all Shari’ah scholars.
An example of a suk2 as a structured product was the $210 million secured floated rate notes issued by Tamweel Residential ABS CI (1) Ltd in July 2007.3 A diagram of this highly structured product is attached as an exhibit to this chapter.
The customer, Tamweel PJSC (based in Dubai, United Arab Emirates [UAE]) wanted to free up its balance sheet by selling part of its residential financing portfolio (which, as an Islamic financial institution, had been structured to be Islamically compliant through the use of an ijara structure). Under the ijaras, its customers would lease a villa or apartment from Tamweel and pay rent. At the end of the lease term, if all of the rental payments had been made, the customer lessee would obtain title to the property. From a Shari’ah-compliant perspective, some of the main structuring issues were as follows:
- The investors should only have recourse to the assets;
- The issue had to have multi-tranches;
- There had to be a liquidity facility; and
- As the revenue stream from the ijaras was in UAE dirhams and the issue was to be in US dollars, there had to be a currency exchange mechanism.
Recourse to assets
The issue was structured along the lines of a securitization. Sukuk should involve the investors being the owners of the pool of assets that they acquire and with the investors looking to the revenues and returns generated by the assets as being their sole payment source. This is the classic conventional securitization model. Most sukuk have involved investors acquiring assets but, in reality, the main focus of the investors has been on the credit worthiness of the party that issued an undertaking to purchase the assets from the investors if, for example, there was an event of default. This meant that often sukuk have been asset backed, rather than asset based. The recent statement issued by AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) has, however, raised concerns about the use of such undertakings in certain circumstances.4
The Tamweel issue did not have this type of purchase undertaking. The commercial objective of the originator was to ensure that the pool of assets that it was disposing of would become off balance sheet; having any form of contingent liability through a purchase undertaking issued by the originator would, therefore, not be acceptable. It should also be noted that when one is structuring sukuk on a securitization basis and in particular where sukuk are to be rated, the rating agencies will also want to see a true sale legal opinion that will clearly establish that title to the assets has passed to the investors with no recourse back to the originator (other than in limited circumstances, such as misrepresentation). Accordingly, structuring the issue to be non-recourse to the originator (other than in very limited circumstances) met the requirements not only of the customer but also the rating agencies and also fell within Shari’ah parameters.
It is customary with a conventional securitization for there to be different classes which will be paid differing returns and which have different priorities. The challenge in structuring the transaction was that this seemed to be against Shari’ah principles, which require that all investors should be equal. The Shari’ah advisers undertook a significant amount of research and concluded that the issue could be structured in such a manner because it was possible for the investors to agree to subordinate their interests so that different classes of investors obtained differing returns and at different times. The analysis was based on the premise that all investors have equal co-ownership interests and, furthermore, that each investor is entitled to do whatever they wish with their interests. On this basis they were entitled to give instructions (through agreeing to the terms and conditions of the issue) that amounts due to be paid to them arising from their co-ownership interest could be paid to other investors in priority to them and/or that all or part of any amounts due to them could be paid to other investors.
Based on this Shari’ah analysis and advice, it was then possible to structure the issue and the documentation such that there were different classes, which had different payment priority rights and different payment returns. The result of this structuring was that the requirements of the customer and the investors were met in a manner that was held to be Shari’ah compliant.
While there are certain differences in opinion as to whether a liquidity facility can be provided in a Shari’ah-compliant manner, the structuring of the issue required that if there was, for example, an administrative delay in the collection of rentals under the ijaras which constituted the pool of assets, such that on a payment date, there were insufficient funds available to pay the investors, the shortfall would be paid under a liquidity facility. Amounts drawn under the liquidity facility would be repaid from subsequent ijara proceeds.
In structuring this part of the offering, it was not possible for any loan facility to be conventional as the entire structure had to be Shari’ah-compliant. Accordingly the facility was structured as being a qard al-hassan. This is a loan that is acceptable under the Shari’ah but one where there is no interest or other return based on the mere provision of the funds (as this would amount to riba which is prohibited). To deal with the requirement of the lender that it needed some recompense, the Shari’ah advisers agreed that certain payments could be made for administrative services that were being performed in making available and monitoring the provision of the qard al-¬hassan financing. Based on this conclusion, therefore, it was possible to structure such a facility that met the requirements of the various parties.5
Currency exchange mechanism
The investors purchased assets that constituted real estate interests which were subject to ijara (leasing) contracts for residential buildings. The rental payments were in UAE dirhams. However, the investors wished to be paid in US dollars. While the UAE dirham is pegged to the US dollar, there was a concern about what would happen if the peg were broken. Therefore, there had to be arrangements whereby, if the exchange peg was broken, a financial institution would agree to exchange UAE dirhams in the future for US dollars at the pegged rate.
In order to structure and draft the documentation, it was first necessary to obtain guidance from the Shari’ah advisers. The exchange of money does cause some Shari’ah-related issues. However, the principle of there being an undertaking from a bank to purchase UAE dirhams in return for US dollars was found to be acceptable provided that:
- There was merely an undertaking from the exchange bank to exchange if called upon by the issuer (rather than a binding two party agreement);
- If the issuer wished to exchange it would need to send a notice to the exchange bank providing full details as to the amount and the date of the exchange;
- There would then be an agreement entered into by both parties to reflect that particular sale; and
- The sale/exchange should take place on the same day as the agreement to sell/purchase.
However, there were some practical concerns that had to be addressed. Having a separate sale and purchase agreement signed by both parties each time that there was an exchange was going to cause operational difficulties. After discussions with the Shari’ah advisers, it was accepted that when the notice of exercise was sent by the issuer, the exchange bank would only have to sign and return the notice, which would contain language that, as a matter of English law, would constitute a concluded sale and purchase agreement.
The other commercial issue was that it would not always be possible to exchange the currencies on the same day as the signed and returned notice but, in this instance, the Shari’ah advisers were willing to approve the exchange if it occurred no later than two business days from the date of the notice. This approval was given on the Shari’ah ground of necessity because, within the international banking system, the movement of funds might require two business days for the exchange to be completed. In this way, through an exchange of views between the financial institutions and the Shari’ah advisers, it was possible to structure an exchange mechanism that met all parties’ concerns.
As can be seen from the issues that have been highlighted, in structuring Islamically compliant products it is necessary to ascertain early on what are the commercial aims of the parties and then tailor those aims to reflect the requirements of the Shari’ah as well as applicable secular law but in a manner that still means that the commercial aims are being met. While this process can take time, there are usually solutions that can be found.
Please see original document to view flowchart.