Legal and Practical Aspects of Islamic Securitisation - Essay Example

Legal and Practical Aspects of Islamic Securitisation The Shariah governs all aspects of Islamic finance to the extent that interest and speculation are both banned. Islamic finance under the auspices of the Shariah also mandates that interest is required to come from profits that have mutual commercial risks as opposed to a guarantees on returns. Despite these Shariah driven restraints, Islamic finance is capable of structuring substitutes that are synthesized with equities, derivatives and mortgages that are associated with traditional financial tools. In this regard, Islamic finance depends in large part on structured schemes for the transfer of assets between creditors and debtors so as to closely resemble interest generating financial instruments known to traditional finance. Since loans under Islamic finance laws are founded on the idea of asset-backed and ascertained credit activities with specified commercial risks, asset-backed securitization that can provide risk-return constructs that parallel traditional securitisations, can be consistent with the Shariah. The numerous securitization tools have not been adopted by Islamic finance as a result of Shariah constraints relative to the trade in interest yielding debt and the uncertainties relative to enforcing the interest of the investor under Islamic laws. Since 2002, however, there have been a number of promising developments in Islamic securitization. This research study provides a critical analysis of Islamic securitization with a view to identifying what is permitted in terms of Shariah compliant securitization and why. Ultimately Shariah compliant securitization are non-financial assets. This paper will therefore describe and analyze non-financial assets permitted under Islamic finance such as ijara assets, bai’salam assets, sukuk assets and assets pools under a mudaraba or a musharaka system. The goal of this research study is to provide a clearer insight into and understanding of Islamic financing and how securitized products are justified and structured under Islamic finance. Table of Contents Abstract……………………………………………………………………………………1 I. Introduction………………………………………………………………………..3 II. Legal Aspects of Islamic Financing/Securitization……………………………….5 III. Different Islamic Securitised Products……………………………………………9 a. Ijara……………………………………………………………………….9 b. Mudaraba…………………………………………………………………11 c. Musharaka………………………………………………………………..12 d. Sukuk…………………………………………………………………….13 IV. Critical Aspects of Islamic Securitisation………………………………………15 V. Conclusion………………………………………………………………………19 Bibliography……………………………………………………………………………. I. Introduction The term “Islamic finance” is a recent invention having only appeared in the middle of the 1980s. Previously, any commercial activities that complied with Islam was referred to as “interest free” or “Islamic banking”.1 The impetus for establishing Islamic financial systems grew out of perceptions on the part of many Muslims that they existed in an essentially hostile “non-Muslim environment.”2 Spurred by the increase in rich oil resources during the 1973 – 1974 after a global oil crisis, oil producing Muslim countries were encouraged to implement innovative financial tools that closely resembled those used by Western businesses.3 In more recent times, Islamic Banking and Finance initiatives have expanded at a rapid rate throughout Muslim countries and in non-Muslim countries with large Muslim populations. As a result, Islamic Banking and Finance is gaining currency in significant Western businesses.4 This is an interesting and unique development given that Islamic finance is governed by the Shariah and as such is not a universal concept. The fact is the Shariah or Islamic law governs all daily activities of Muslims. From a financial perspective, the Shariah governs not only how capital can be acquired but also how it can be discharged. While wealth may be acquired, it may only be acquired by methods that are fair to all participants. Therefore underhanded taxation, exploitive conduct and profits that cause social ills are not permitted under Shariah principles. Inevitably, these principles place a number of constraints on how firms conduct business for the purpose of realizing a profit.5 At the heart of Islamic finance is prohibitions against riba which is frequently characterized as interest.6 In traditional finance, there are distinctions between interest that is usury and interest that is acceptable. In Islamic finance, any interest is deemed to be usury in nature is therefore unacceptable. Other Shariah prohibitions include a prohibition against uncertainty. In this regard, any terms and conditions in a contract will only be permitted if the risks involved are unambiguously understood by all involved in the financial activity.7 Under the Shariah, risks and profits must be shared by the parties involved in the financial transactions. Moreover, investments in sectors that are deemed to be injurious to society such as alcohol, pornography, pork products and gambling are not encouraged. Finally, Financial transactions are required to be connected to what is characterized as a “tangible identifiable underlying asset”.8 In this regard, the Shariah does not regard money as an asset because it is intangible and therefore not permitted to earn returns.9 It follows from these Shariah principles that a majority of Islamic financial undertakings are founded on asset backing. As such, asset securitization is entirely consistent with the Shariah compliant finance. In this regard, asset securitization: …describes the process and the result of issuing certificates of ownership as pledge against existing or future cash flows from a diversified pool of assets (“reference portfolio”) to investors.10 In order to be Shariah compliant, the diversified asset pools may not be interest bearing.11 However, there are ways to resolve this restraint so the securitization can be brought into compliance with Shariah principles. How securitization are conducted under the Shariah in Islamic finance is at the heart of this study. It is therefore important to first examine the legal and practical aspects of securitization under Islamic finance. Once the legal aspects are identified and evaluated, the non-financial assets in practice will be identified. The critical aspects of Islamic securitization will then be analyzed. II. Legal Aspects of Islamic Financing/Securitisation Islamic securitization is described as a “legal structure which satisfies” Islamic finance requirement and “replicates the economic purpose of” conventional “asset-backed securitization” constructs in which a receivables’ rights are moved from the originating source to a “special purpose vehicle (SPV/Issuer)” and from there notes are issued and sold.12 Essentially, the legal aspects of Islamic securitization are complicated because they bring together two very different legal systems. One is the Sharia law and the other is the universally developed standards referred to as the “new lex Mercatoria”. Essentially, the new lex Mercatoria is the arm of private international law which constructs the major securitizations’ market.13 Lahlou and Tanego explain that: In Islamic securitization, any project or tangible physical assets that are capable of generating a legitimate income stream from a Sharia perspective can be securitized and thus, this financing technique marks an opportunity for Islamic institutions to demonstrate their competitiveness and to broaden and deepen their markets.14 In any event, the major concern for Islamic securitization is the requirement that they are Sharia compliant. This engages some inquiry into what it means to be Sharia compliant. To start with, Sharia finance insists that all finance are based on contract criteria and its corresponding prohibitions. In this regard, all Islamic economic transactions are founded on principles of contracts and other tools. The four main criterion for Islamic contracts are: 1. The agreed price must be arrived at mutually and there must not be any duress. 2. Parties must be competent and able to appreciate the consequences of their conduct. 3. When the parties are negotiating the terms of the contract, the subject matter must exist and must be capable of delivery with certainty and honesty. 4. The contract cannot be founded on anything that is prohibited by the Sharia.15 The first three requirements are not unknown to either common law of civil law systems. However, the fourth requirement introduces a presumption that Sharia law has to be known so that the prohibitions under Sharia law are met with respect to contractual terms under a Islamic financial instrument or transaction. In this regard there are basically 7 Sharia prohibitions. They are: 1. Acquiring returns on loans such as riba. 2. Undue uncertainty relative to a financial contract. 3. Gambling generally as it is based on chance and therefore risk. 4. Restructuring debts for the purpose of compensation. 5. Trading debts at a discounted rate. 6. “Forward foreign exchange transactions.”16 Among the seven prohibitions the prohibition against riba and gharar (uncertainty) are the most problematic for the conventional asset-backed securitization transactions. Riba is problematic because under conventional securitization all notes calculated to have economic value are attached to some form of interest rating. With respect to gharar, conventional securitization are characterized by “tranching and waterfall payout” which will be regarded as intolerable uncertainties under Islamic principles.17 The Sharia’s prohibition against riba and gharar can be justified on a number of grounds. Firstly, money is not deemed to have substantive value. Secondly, commodities have the potential to have diverse qualitative value as opposed to money. Thirdly, money consisting of the same currency cannot have distinguishing features in a particular transaction. According to Norman: Sharia law distinguishes between money and commodities because the intended use of money is to act as a measure of value rather than to be the subject matter of a trade.18 It therefore follows that a majority of traditional securitization products such as mortgage-backed assets are inconsistent with the Sharia because its income, not necessarily the principal, in terms of cash capital is tantamount to riba. Likewise other securitization assets such as the collateralized debt obligation (CDO) and like instruments are generally prohibited under the Sharia because there are debts as opposed to “an allowable commodity or activity”.19 Despite these prohibitions, Islamic securitization is possible and has been constructed around allowable assets. There are a number of securitization assets that are allowable under the Sharia. Specifically, assets that are physical in nature such as machines and plants as well as traditional securitization transaction techniques are compatible with the Sharia.20 Islamic financial markets provide a number of legal methods by which to accommodate securitization. These methods attempt to accommodate those who provide securitization and those who use funds inclusive of sales, financial trade and investments. From a legal perspective these methods are referred to as “nominate” contracts because they delineate the specific legal relations.21 From the perspective of financial institutions, these relations are referred to as “transactional contracts” and/or “intermediation contracts”.22 Transactional contracts are characterized by asset-backed securitization; equity operative and other activities that are connected to social interest. Most of the transactional contracts are contracts for the trade in commodities.23 Essentially, Ijara, Mudaraba, Musharaka and Sukuk are Islamic techniques for forming transactional contracts that form a “risk continuum” which “at one extreme offers asset-backed securities” as well as the other extreme of “equity participation.”24 Each of these techniques are examined below. III. Different Islamic Securitised Products A. Ijara The ijara also known as the al-ijarah is a leasing note which is asset backed. Essentially the ijara provides credit in exchange for rent “over the term of the temporary use of an asset” that is in existence.25 It is “conditional on the future (re-) purchase of the assets by the borrower”.26 The cash returns on the lease provides the principal characteristic of the debt. The lessor who is ultimately the financier, acquisitions this asset from the borrower or from a third party upon the borrower’s request and subsequently lets it to the borrower or a third party where relevant for an agreed rent that is paid in agreed upon installments.27 The financier retains the legal title during the length of the transaction and assumes all costs in connection with the title to the asset. However, any cost associated with the asset’s use will be assumed by the lessee. In the event the ijara is a financed lease and therefore an ijarah wa iqitina similar to an Islamic mortgage: The repayment through lease payments might also include a portion of the agreed resale price (in the form of a call option premium), which allows borrowers to gradually acquire total equity ownership for a predetermined sales price.28 If upon maturity, the lessee fails to take advantage of the call option, the lender discharges it for the purpose of realizing the “put option” or “salvage value”.29 When there is a functioning lease with a commitment to repurchase, the asset is repatriated to the borrower for the initial price or on an agreement upon market value or any other previously agreed terms. In such an eventuality, the put option on the part of the lender is reflective of a repurchase commitment on the part of the borrower at the existing outstanding balance value. This can automatically arise in specific circumstances like the accumulation of arrears or simple default.30 Essentially, ijara-based securitization represents securitization in physical assets rather than financial assets. In encapsulates the transfer of a physical asset and as a result the risks and payoffs surrounding ownership to investors. In this regard, ownership is actually the equivalent of title to a physical asset that arises upon the issuance of a lease held against the income from rent.31 The fact is, debt under the Sharia can only be transferred at par value while physical assets can always be transferred at an agreed upon price. Moreover, risk is shared by all investors as they all become part owners of the assets which are held against future rent installments.32 B. Mudaraba The mudaraba asset is a pool that either holds funds that are not yet distributed or acquired assets. The party issuing the mudaraba is referred to as the fund manager or the mudarib. The mudaraba asset is highly controversial as a Sharia compliant securitization as it has been characterized as this distribution of a “downstream sukuk” that is essentially the trading in cash or receivables.33 Similarly, the mudaraba is criticized for its trade in units or the issuance of sukuk before funds are distributed for the acquisition of assets. The argument in both scenarios is that mudaraba permits trade in terms of “money for money at differential prices” and the corresponding profit is prohibited riba.34 Despite these misgivings about the mudaraba, numerous Islamic banks use funds under the mudaraba rules for the purpose of purchasing assets in realty. This is primarily accomplished by virtue of leveraged and unleveraged cash capital in which the leverage is positioned as assets. Unleveraged assets ought to be acceptable because sukuk is issued in terms of part ownership of assets and this in turn is accompanied by a corresponding income or risk share. As for leverage assets, a number of Islamic banks the asset is a SPV. However, as Watson and Carter explain this should be settled by the financier who is a third party and then issue the sukuk out of the SPV to the financier so as to make it more Sharia compliant and less controversial.35 C. Musharaka The musharaka is essentially a partnership where the parties are partners in a transaction although the underlying SPV, which is held on behalf of those in possession of the sukuk are usually sleeping partners and are not participating in the transaction in meaningful ways. Each of the partners will invest in a business or a project that is regulated by the musharaka contract. The partners’ SPV share is equally divided and sold to those holding the sukuk. At maturity, those holding the sukuk sell off the units to the partners forming the partnership.36 Essentially, the Musharaka securitization involves partners contributing to a specific project and sharing both its benefits and risks. The profits to be shared are typically agreed to on a ratio beforehand. However, losses are distributed in a manner that is proportionate to each partner’s own investment in the project. Therefore a financial institution will furnish some of the required funding necessary with the institution sharing in both the gains and losses which are all agreed upon in advance of the transaction.37 Where there is a musharaka securitization arrangement, each of the participants can be provided with a certificate of participation which reflects his/her share of the title to the assets involved in the enterprise or the project that is being financed. After non-liquid assets are acquired, the musharaka certificates can be used as negotiable instrument and can therefore be traded.38 D. Sukuk Sukuk is an investment instrument that was first introduced in 2002 by Malaysia when it issued a sukuk backed by the government.39 The sukuk is defined as: Asset-backed instruments representing a beneficial ownership interest in the underlying asset. Sukuk is a certificate that resembles in many respects a traditional bond or asset-backed security, but is technically neither debt nor equity.40 Sukuk is plural for the work Sak or Sanadat which literally means certificate. The certificates reflect the owner’s portion of holdings of a single part of a whole underlying asset in which the certificate holder is responsible for all rights and liabilities attached to the asset.41 Standards for investing in sukuk are regulated by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). According to the AAOIFI a sukuk is a certificate: equal value put to use as common shares and rights in tangible assets, usufructs, and services or as equity in a project or investment activity.42 The AAOIFI takes pains to ensure that the sukuk is distinguished from bonds, equity and notes. According to the AAOIF the sukuk is not a debt accrued to the party issuing it. In fact the sukuk is an interest that is proportionate and attached to underlying assets, services, projects, usufructs or investment transactions. The sukuk cannot be a part of a receivables’ pool. Moreover, the business or activity to which it is attached as well as the transaction constructs are required to be Sharia compliant.43 Essentially, by virtue of the AAOIFI standards, the sukuk is required to be set up so that: All income must originate out of the underlying transactions the funds were used for and not merely to produce interest; The sukuk is required to be backed by genuine underlying assets which must be permitted by the Sharia; and All duties and rights must be unambiguously ascertained.44 According to Gurulkan, the Sukuk is without question “the most successful innovation” in Islamic financial history.45 Worldwide, the sukuk has been distributed at a rate that demonstrates an increase from US$7.5 billion since its introduction to more than US$118 billion by 2008. This represents a Compound Annual Growth Rate of more than 32 percent for that period.46 All indications are therefore that, the sukuk is well regulated to ensure that it is Sharia compliant and this explains it huge success. The presumption is that Muslims are comfortable with the sukuk as an Islamic securitization tool that adheres to the standards and principles under the Sharia. IV. Critical Aspects of Islamic Securitisation The major challenge for Islamic securitization is the expansion into secular markets. The question is whether or not Islamic finance in general can enjoy a peaceful co-existence in a secular market where Islamic securities are required to regulated pursuant to Sharia principles and standards. Moreover, there is the question of whether or not Islamic financial institutions are required to be subject to the same prudential regulation and governance as traditional financial institutions.47 Although non-Islamic jurisdictions do not incorporate Sharia principles and standards into the regulatory regime, the concept of party autonomy will function to permit accommodating Sharia principles. The fact is, parties to a contract that includes arrangements for Islamic securitization can ensure that their contract incorporate or is set up so as to safeguard against activities that are prohibited by the Sharia.48 A more profound problem arises out of the degree to which Islamic securitization should be subjected to prudential controls. It might be argued that since Islamic securitization is virtually risk free in that it is based on sharing profits and losses, minimal prudential oversight is all that is needed. According to Hesse, Jobst and Sole this is “a common misunderstanding”.49 However, there are a number of justifications for subjecting Islamic financial institutions to the same degree of scrutiny as traditional financial institutions. There are essentially “moral hazard considerations”, protection for the depositors’ interest and system functioning.50 The two most significant problems associated with Islamic securitization in terms of integration is the laws the regulate asset ownership and the degree of uncertainty relative to interpreting both contracts and the law. There are many different jurisdictions in the GCC and Middle East and North African states that it is impossible to deduce a common denominator that could produce a single Shari compliant asset-back securitization instrument. 51 A security transaction instrument produced in one Islamic country is likely to be incompatible with the Sharia principles and concepts in another. In this regard, those non-Islamic providers attempting to produce a Sharia compliant instrument will likely have to have many other documents as one instrument will not be readily accepted in all Islamic countries. This means hiring experts on the Sharia standards for virtually each of the Islamic countries targeted by the non-Islamic service provider. The underlying problem overall is the complexity of the Islamic securitization constructs. The fact that it does not permit riba and the resulting project and its assets must be physical in nature and acceptable, invariably means that structuring a Sharia-friendly securitization transaction is complicated exercise. As Norman explains: There is more to structuring a Shari’a compliant securitization transaction that a simple rewriting of conventional transaction documentation.52 In this regard it would perhaps be best if experts from each of the Islamic schools convened and attempted to draw out a list of physical assets and acceptable assets and investment tools. This list should be circulated among all financial institutions and as such would recognize a common standard and would therefore harmonize Sharia principles. This would ensure the prohibitions under the Sharia are the same among all Islamic countries. This would certainly be helpful to non-Islamic countries that provide Islamic finance and securitization. It would save these institutions the burden of having to ensure that each transaction is Sharia compliant for a specific set of customers from various Islamic countries. Ownership of assets is particularly problematic as well. In order for a securitization transaction to be structured in an efficient and effective way, there must be good title attached to the assets on the part of the issuer. If funding is by virtue of sukuk, the AAOIFI requires that the holder of the sukuk has “effective title over the assets.”53 Be that as it may, in a number of Middle East and North African countries as well as GCC countries, the laws differ considerably as to the ownership of assets by foreigners. As a result: It may not be possible for a foreign incorporated issuance vehicle to own underlying assets.54 In addition, some Islamic jurisdiction forbid foreigners owning sukuk. This has serious consequences for the expansion of the sukuk as a securitization instrument. Essentially, it limits the extent to which sukuk issuers can target specific markets. In other words, foreign sukuk holders may be hesitant to secure the sukuk if they are unable to trade it in some countries. Norman also notes that: One of the largest potential opportunities for securitization structures within the GCC region is in real estate. 55 The fact is, a number of GCC nationals have placed significant investment in realty in both the US and Europe over the years. As Norman explains: With the high demand for housing and numerous commercial real estate developments within the GCC, particularly in Saudi Arabia and Dubai, would suggest that this would be the ideal asset to structure for a sukuk based securitization programme.56 However, there is a serious difficulty with respect to the constraints among the laws in a number of GCC countries relative to foreign title to assets. In Dubai for example, foreign ownership is frowned upon. While the law does not specifically explicitly forbid ownership, it does not permit it either. Therefore there is a lot of uncertainty associated with foreign title to such an extent that it functions as a serious obstacle to the expansion of the realty as a viable asset in securitization transactions.57 Saudi Arabia’s Foreign Investment Law 2000 appears on its surface to welcome foreign ownership and investment in realty. However, Article 8 reads as follows: The foreign facility licensed under this Act shall be entitled to possess the required real estates as might be reasonable for practicing the licensed activity or for the housing of all or some of the staff…58 All indications are therefore that the foreign investor is restricted in how he can own real estate in Saudi Arabia and how he can use that real estate. First the foreign investor must be a licensed investor. Secondly he/she may only own realty for the purpose of conducting his/her licensed activity or for housing staff. In other words, the foreigner will not be able to invest in any of the securitization transactions offered under Islamic finance. More particularly the foreign investor will not be able to use the ijara leasing system with respect to his real estate. Ultimately, there can be no leasing of the property nor may he/she conduct a resale and neither may he/she engage in development activities. V. Conclusion In the final analysis, Sharia constraints on riba and gharar means that Sharia compliant securitization transactions have an uneasy co-existence with traditional interest yielding debt securitization transactions. With these prohibitions on debt trading and the problems attending the valuation of funding contracts, Islamic securitization are complicated and present themselves with concepts and money management that are difficult to process. Even so, both conventional and Islamic banks have been able to replicate traditional securitization transactions that for the most part satisfy Sharia standards.59 Even so, there are concerns that Islamic securitization is difficult to process and conceptualize. It is particularly difficult for market expansion although Islamic securitization has gained currency and wealth over the relatively short history of Islamic finance. However, the problems associated with Islamic securitization implies that should these problems be eradicated, Islamic securitization could be even more successful. As it is, despite its success, Islamic securitization is not reaching its full potential. One of the most immediate problems is connected to ascertaining what amounts to Sharia compliant transactions and involves a great deal of uncertainty. There are divergent laws and policies among Islamic states so that it is virtually impossible for a foreign investor to predict how and if his/her securitization transaction will be restricted or banned in Islamic countries. Essentially, while the securitization transaction may satisfy the Sharia standards in one Islamic country it may not do so in another Islamic country. The second most immediate problem for the foreigner wishing to participate in Islamic securitization is foreign ownership. Again there is a lot of uncertainty involved in whether or not a foreigner can own sukuk and where he/she can own sukuk. As a result, in the face of such uncertainty there a lot of non-Muslims that would hesitate about owning sukuk or engaging in an Islamic securitization transaction. Moreover, since foreigners are not permitted to own realty in some Islamic countries and in others they are restrained in how they can use that property, there are major barriers to foreign entrants to any asset-backed securitization offered in Islamic countries. Once these barriers are reduced, if not eliminated it would be interesting to see just how much Islamic securitization will grow. The fact is, despite these barriers and the difficulties with conceptualizing and processing Islamic securitization, it has been relatively successful as a global incentive. No doubt, if Islamic countries come together to agree on a uniform code of standards for Islamic securitization and remove some of the barriers preventing greater non-Islamic participation, Islamic securitization is expected to reach its full potential and to expand even farther. Bibliography Textbooks Ilias, S. Islamic Finance: Overview and Policy Concerns. (DIANE Publishing 2009). Hassan, K. and Lewis, M. 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Norman, T. ‘Securitisation Structures With an Islamic Framework.’ (July 2005) ISR 2-5. Richardson, C. ‘Islamic Finance Opportunities in the Oil and Gas Sector: An Introduction to an Emerging Field.’ (2006) 42 Texas International Law Journal, 119-152. Zaman, A. ‘Islamic Economics: A Survey of the Literature’. (2002) Religions and Development Research Programme Working Paper No. 22. Table of Statutes Foreign Investment Law 2000. Read More