A new trend in project financing
A large number of project financings in the Middle East have an Islamic finance tranche. Despite the current economic climate, the GCC states are continuing to develop their infrastructure (power, water, roads and other utilities). Traditionally, large multi-billion dollar petrochemical and infrastructure projects were financed by conventional lenders (Conventional Lenders). Islamic finance structures are now featuring alongside conventional financing in the same project. The variety of Islamic financial instruments developed by the Shari’ah scholars and the Islamic finance industry has supported this growth.
Let’s consider a project funded by one or more syndicated loans provided by Conventional Lenders. The Islamic financiers (Islamic Financiers) are only a party to the Islamic tranche. However, it is also possible for a Conventional Lender to be a party to the Islamic tranche (in addition to, or as well as, the Conventional tranche). The relationship between the Conventional Lenders and the Islamic Financiers is regulated through an intercreditor or common terms agreement. As the name suggests, the common terms agreement contains the terms that apply to both the Conventional Lenders and Islamic Financiers, such as events of default, representations and warranties and undertakings.
Key Islamic finance structures
The key Islamic finance structures used for project financing include the ijara mawsufah fi al dimmah and the istisna’.
Forward lease (ijara mawsufah fi al dimmah)
A forward lease is structured so that the leasing arrangements commence when the asset has been constructed or manufactured. While the asset is being constructed or manufactured, the Islamic Financier can charge advance rent. However, if the asset is not ready for leasing by the leasing commencement date, the lessee can walk away from the arrangement and demand back the advance rent.
An istisna’ is a form of sale and purchase agreement. It is one of the exceptions to the general rule that the asset that is the subject matter of the contract should exist when the contract is entered into. The seller agrees to manufacture or construct an asset to be delivered in the future. Payment can be made either at the end of the period or, more usually, by instalments. One drawback with an istisna’ is that, because it is a sale and purchase agreement, the purchase price must be fixed at the outset. It has been adapted for use with Islamic financing and works, on its own, as a form of fixed rate financing. However, if the tenor of the istisna’ is long (which would normally be the case for a project) then it is not an attractive proposition for an Islamic Financier. Therefore, an istisna’ is usually coupled with a forward lease. During the construction phase, the Islamic Financier’s return comes, not from the istisna’, but from the forward lease.
Other structures, such as musharaka (joint venture), have also been used, but not as widely. It is beyond the scope of this article to discuss these in detail. See our Islamic finance Glossary of Terms for definitions.
Mixed conventional and Islamic financing
What issues arise when a project financing contains both conventional and Islamic tranches?
In a conventional financing Conventional Lenders will assess the commercial viability of the project based on (i) the engineering, procurement and construction contract, (ii) any applicable operation and maintenance agreement, (iii) any off-take agreements and (iv) related project documentation. However, Islamic Financiers need to have a contract with the participants and the project entity so there are a number of issues that need to be considered if there is a joint financing of a project with Conventional Lenders.
In a conventional loan, the principal amount may be drawn down in stages during the availability period. This is not always necessarily the case with an Islamic tranche, for example an ijara lease facility. Where the asset exists when the facility is entered into, the supplier or manufacturer must be paid the full purchase price. However, if a forward lease is used in conjunction with an istisna’, the payments could be made by instalments or at the end of the istisna’. It is important to ensure that the istisna’ stage payments match the drawdown profile of the Conventional Lenders.
Co-ordinating payments to financiers
Interest periods under a syndicated loan should correspond to the relevant periods under the Islamic financing (i.e., lease periods, deferred payment periods, periodic distribution dates etc.) so that payments are made to the Islamic Financiers and the Conventional Lenders at the same time. This ensures parity between the Conventional Lenders and the Islamic Financiers, which is usually the commercial understanding between the parties.
If the convention and Islamic trances contain different drawdown profiles, this could affect the strength of the voting rights of the Conventional Lenders and the Islamic Financiers. If the voting rights are based on amounts outstanding, this could favour the Islamic Financiers. For example, a murabaha financing, where the deferred payment price includes the profit for the entire financing period would result in the Islamic Financiers having greater voting rights. In some cases, therefore, the Conventional Lenders may negotiate fixed voting rights by reference to financial Commitments of the Conventional Lenders and the Islamic Financiers instead of the amounts outstanding.
Interest of Islamic Financiers
Proprietary or contractual interests of the Islamic Financiers
Some documents, such as purchase undertakings in Islamic finance structures, create proprietary or contractual interests in favour of the Islamic Financiers. Often these cannot be mortgaged. The ability of the Islamic Financiers to exercise their rights under a purchase undertaking will usually be triggered by an event of default. However, how and when those rights are exercised will need to be co-ordinated with the exercise of the rights of the Conventional Lenders.
Title to “security assets” in the name of Islamic Financiers
A security trustee or security agent will hold the security interests under the intercreditor arrangements for the benefit of both the Conventional Lenders and the Islamic Financiers. Whether a trustee or agency structure is used will depend on whether the applicable jurisdiction recognises the concept of a trust. A Conventional Lender will not own assets, but will have security interests granted in its favour. However, depending on the Islamic facility (such as an ijara or musharaka), an Islamic Financier may have title to certain assets. In an ijara financing it will own the leased asset and in a musharaka financing it will own an equity interest in the partnership or joint venture.
Where assets are in the name of the Islamic Financier there are various points to consider:
- Will the Conventional Lenders be content to rely merely on the Islamic Financiers contractually agreeing to share any proceeds on disposal of the project or any assets on an event of default? An intercreditor arrangement setting out the agreement could be more appropriate.
- Depending on the applicable law, it may be possible for the Islamic Financier to grant a security interest in favour of the security trustee or agent as long as the monetary obligation being secured can be determined.
- If a special purpose company (SPC) is used, the SPC could grant the security interest to the security trustee or agent so that any title transfer to the Islamic Financier would be subject to that security interest.
- If the asset that the Islamic Financier owns is merely a contractual interest (which may be done so that registration fees are not incurred on the transfer), the customer (in whose name the legal title remains) could grant the security interest to the security trustee or agent.
Insurance and total loss (ijara)
The Islamic Financier, as the lessor, cannot charge rent after a total loss occurs. This means that the ability of the Islamic Financiers to access the insurance proceeds becomes critical in order to recover the amounts they have financed. Parties need to consider these issues:
- If the insurance proceeds are not sufficient, would the Islamic Financiers have a claim against the lessee (acting as the service agent) if it failed to fulfil its insurance obligations? If so, should this claim be subject to the pari passu requirements?
- Many insurance policies give the insurer the option to pay out against a rebuild. Will this mean that the Islamic financing must continue, but based on the rebuilt assets?
- Would a total loss trigger an event of default under the conventional syndicated loan? If so, how would this leave the Islamic Financiers when a total loss could not be an event of default and when many Shari’ah scholars do not permit a total loss to trigger the rights under a purchase undertaking?
All of these will be points for negotiation, however the Islamic Financiers will still be required to have the transaction approved by their Shari’ah scholars.
Payments on enforcement
In a murabaha or an istisna’ financing, on a default, the amount claimed will include a profit element that is calculated over the full murabaha or istisna’ period. In contrast, with a conventional financing, the amount of interest is that which has accrued up to the occurrence of an event of default.
The Conventional Lenders may, therefore, feel that the Islamic Financiers’ pro rata entitlement to a share in any enforcement proceeds (based on amounts outstanding) means that they benefit more than the Conventional Lenders.
Interest on enforcement
On an enforcement, a court judgment may award interest on amounts due under the conventional financing tranche and in relation to the Islamic financing tranche. The Islamic Financiers cannot share in these amounts as this is contrary to the principles of Shari’ah. The Conventional Lenders will need to consider if the Islamic Financiers should be paid additional amounts from other payments (that would normally be shared pro rata) in order to equalise the position.
A good understanding of Islamic financing structures and the relevant payment profiles is essential when considering whether to add an appropriate structure to a conventional syndicated loan for a project financing. Identifying the key issues in a mixed financing early should help eliminate misunderstanding and ease negotiations, which, in turn, will assist the growth of Islamic project financing.
Originally published in Islamic Finance News’ Guide to Leading Lawyers 2010