SHARI’AH-COMPLIANT FINANCINGS: NEW
OPPORTUNITIES FOR THE U.S. MARKET
MICHELE O. PENZER, MELISSA S. ALWANG, AND SALMAN AL-SUDAIRI
This article provides a brief introduction to the principles that govern Shari’ahcompliant investments and explains the financing structures that have been
previously used by Shari’ah-compliant equity investors to access the traditional
United States capital and loan markets. It also briefly discusses the issues surrounding structuring a compliant obligation to be purchased by Islamic
investors.
A
lthough still relatively uncommon in the United States, the worldwide Shari’ah-compliant financing market has recently shown significant growth and maturity in Europe, Asia and the Middle East. It
is estimated that global assets managed according to Shari’ah principles may
exceed US $1 trillion within a few years,1 which has fueled the demand for
Shari’ah-compliant investment opportunities. As more investors based in
Muslim countries — such as sovereign wealth funds, state-owned companies
and high net-worth individuals — look to make acquisitions in the United
States, the demand for Shari’ah-compliant acquisition financing is expected
to grow. In addition, Shari’ah-compliant financing may interest Islamic buyside investors who have traditionally avoided accessing the United States
financial markets for lack of products that meet their Shari’ah requirements.
Michele O. Penzer and Melissa S. Alwang are finance partners with Latham &
Watkins LLP and Salman Al-Sudairi is an associate with the firm. The authors can
be reached at michele.penzer@lw.com, melissa.alwang@lw.com, and salman.alsudairi@lw.com, respectively.
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THE SHARI’AH RULES — WHAT MAKES A STRUCTURE
“COMPLIANT”
From the perspective of the traditional American debt investor, the first
key rule to understand is that Shari’ah prohibits “riba,” which is generally
defined as interest. This effectively means that a compliant investment cannot be structured as traditional debt for borrowed money. As a result of this
restriction, Islamic financing institutions have developed sophisticated interest-free banking transactions that are principally based on concepts of partnership and profit-loss sharing. Additionally, Shari’ah prohibits “gharar”—
an “unacceptable” level of risk or uncertainty. Therefore, any Shari’ah
financing transaction must not be deemed speculative or otherwise uncertain.2 Furthermore, a Shari’ah-compliant transaction must not involve
investments that are otherwise prohibited in Islam, such as investments in
gambling operations, alcohol or pork products.3
These “Shari’ah” rules arise from a religious-based legal system derived
from three sources: the Quran (the main religious text in Islam), hadith (the
sayings of the prophet) and ijma’ (the consensus of Shari’ah scholars). What
any individual investor or equity sponsor is willing to deem as “Shari’ahcompliant” is most often dependent upon the Shari’ah committee or advisor
that is reviewing the particular product or structure. Islamic financial institutions typically have a Shari’ah committee or board of advisors that reviews
financing structures and issues opinions as to their compliance with Shari’ah
principles. Some investors may themselves also employ the services of
Shari’ah scholars to review and evaluate the compliance of such structures.
The three Islamic structures that are most often discussed in the United
States are the ijara (lease financing), the murabaha (cost-plus financing) and
the sukuk (Islamic bonds).
THE IJARA-MURABAHA ACQUISITION FINANCING
STRUCTURE
The most common Shari’ah-compliant financing structure that has been
used in the United States as a means for Islamic equity sponsors to access the
United States financial markets is the ijara-murabaha acquisition financing
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structure. This structure requires two simultaneous financing arrangements,
the first comprising a conventional term loan and revolver which is made
available to a newly formed, single-purpose vehicle (the SPV) owned by a
corporate service company,4 and the second comprising the Shari’ah-compliant financing provided by the SPV to the operating company (the Opco)
owned by the Islamic equity sponsor, consisting of an ijara financing (to
mimic the term loan) and a murabaha financing (to mimic the revolving
facility).5 Although the lenders to the SPV are not party to the ijara or
murabaha, they will have the opportunity to set the affirmative and negative
covenants, representations and warranties, and events of default that will be
included in such documents, which provisions will govern the operation of
the Opco.
Lease (Ijara) – Murabaha Acquisition Financing
Transaction Structure
Corporate
Services
Company
Islamic
Investors
Shari’ah
Compliant
Financing
Loan
Facilities
SPW
Borrower
Lenders
Term Loan
Facility
Revolver
Facility
Opco
Ijara (saleleaseback)
Murabaha
(working
capital)
Guarantor
Subsidies
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HOW THE IJARA (LEASE) WORKS
The ijara is a lease that has elements of an operating lease and a financing
lease. Typically, the SPV purchases certain assets from the Opco.6 The SPV
then enters into the ijara and leases those same assets back to the Opco for a
series of specified rent payments. The duration of the lease and the amount
and timing of the rent payment obligations are fixed at the signing of the
agreement and mirror the obligations of the SPV to the Lenders holding the
term loan. The “rent” payable to the SPV under the ijara is the sum of (i) a
“base amount,” which is a portion of the acquisition cost for the leased assets
equal to the SPV’s amortization obligations on the term loan and (ii) a “rental
rate,” which is an amount calculated at a spread over the London Interbank
Offered Rate (LIBOR) on the remaining unpaid acquisition cost.
Additionally, the Opco is granted a call option to purchase all or part of
the leased assets prior to the maturity date from the SPV for a designated purchase price (which may include a premium and which will reduce the remaining unpaid acquisition costs). This call option is meant to mimic the voluntary prepayment mechanics of the term loan and provides for a reduction in
the amounts otherwise owed to the SPV (and the “premium” for an early
repurchase tracks the prepayment fee for early repayment of the term loan).
The SPV is granted a put option to obligate the Opco to purchase all or
part of the leased assets prior to the maturity date upon the occurrence of certain events (including the typical mandatory prepayment events). This put
option is meant to mimic the mandatory prepayment mechanic of the term
loan by ensuring that the SPV has a right to cash at the corresponding time
that the SPV is required to make a prepayment of its term loan. The put
option also obligates the Opco to purchase the leased assets for the remaining
unpaid acquisition cost upon an event of default which, in turn, provides the
SPV with a source of funds in the event that its term loan is accelerated.
HOW THE MURABAHA WORKS
The murabaha is a cost-plus financing which involves the purchase of a
commodity (often a metal such as tin) by the SPV and the immediate resale
of the commodity to the Opco on deferred payment terms at cost, plus some
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agreed amount of profit. Any time that the Opco decides to utilize the
murabaha, it makes a request to the SPV to purchase the commodity, and
the SPV, in turn, makes a matching drawdown under its revolving credit
facility and uses those funds to purchase the commodity through an agent.
Once the SPV completes its purchase of the commodity, it issues a notice to
the Opco accepting the Opco’s offer to purchase the commodity. The commodity is sold to the Opco at an agreed deferred payment price that factors
in a “profit” that matches the interest payment for the revolving loan under
the SPV’s conventional facility. The Opco takes title to the commodity, but
not delivery. It then enters into a concurrent arrangement with its agent to
sell the commodity for cash. The agents that purchase the commodity for
the SPV and sell the commodity for the Opco are appointed under the
murabaha documentation and are Islamic commodities specialty traders.
The purchase and sale are consummated simultaneously and for equivalent prices. In this manner, cash is obtained by the Opco, with a deferred
payment obligation to reimburse the SPV at a purchase price equivalent to
the principal amount of the revolving loans borrowed plus a profit set at a
spread to LIBOR that matches the interest payable by the SPV under the
credit agreement for revolving loans. At the time of the deferred purchase
price payment (which will be no later than three months from the initial
purchase of the commodity to synchronize with the interest payments due
on the revolving loans), the cash payment for the profit and the deferred
purchase price for the commodity itself will be paid to the SPV. If the Opco
continues to need liquidity, it will roll over into a new commodities purchase
contract and the SPV will establish a new LIBOR period under the credit
agreement with the lenders which matches the term of the new commodities purchase contract.7
THE COVENANT STRUCTURE
In order to ensure that the Opco is subject to the affirmative and negative covenants and representations and warranties that it would otherwise
have been subject to had it entered into a traditional credit agreement directly, the financial institution providing the conventional loan will require that
the SPV’s agreements with the Opco contain representations and covenants
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that would mirror those found in a conventional financing. The administrative agent and collateral agent under the credit agreement will also act as
administrative agent and collateral agent under the SPV’s Shari’ah-compliant financing documents.
In order to maintain the integrity of the Shari’ah-compliant financing,
its documents (those between the SPV and the Opco) cannot refer to the
conventional financing, nor can the financial institution providing the conventional loan have direct recourse against the Opco or any of its subsidiaries. Amendments, consents and waivers with respect to the Shari’ah
documents generally will require the vote of the requisite lenders under the
credit agreement, and will require 100 percent lender consent where such
amendments would affect any provisions that mirror those whose amendment would require 100 percent lender consent under the credit agreement,
such as decreases in profit or rent.
In working with this back-to-back documentation structure, there are a
few issues to note:
•
While the financing markets have been comfortable with the risks associated with the back-to-back nature of the financing and security
arrangements, there is no body of bankruptcy law specific to Shari’ahcompliant financing. However, in a situation where both the SPV and
the Opco are debtors in bankruptcy, bankruptcy specialists would generally expect the creditors to make a motion to collapse the structure,
which should be granted. If the SPV is not in bankruptcy but the Opco
is, then there would likely be a two-step process, first foreclosing on the
SPV or its assets and then asserting the SPV’s claims directly against the
Opco in its bankruptcy. It is certainly possible that both could be in
bankruptcy yet the court refuses to collapse the structure (leaving the
lenders to assert their claims solely against the SPV, while the SPV can
resolve its claims against the Opco separately), but most insolvency
experts believe such a result to be highly unlikely.
•
In order to comply with Shari’ah principles for an ijara, the lease of the
assets by the Opco from the SPV must provide that the assets will be
owned and maintained by the SPV. However, the parties typically enter
into a supplemental agreement whereby the Opco covenants to assume
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all “owner” responsibilities with respect to the assets, including responsibilities to maintain, repair and insure the assets. In addition, the sale
of the assets by the Opco to the SPV and the lease of those assets back
to the Opco by the SPV are typically structured to be treated, for United
States federal income tax purposes, as a secured financing. This enables
the Opco to remain as the owner of the leased assets for US federal
income tax purposes and therefore avoid any taxable disposition of the
leased assets while remaining eligible for any depreciation associated
with such assets.8 In addition, because the borrower is an SPV, the
Lenders must also review the structure for other tax concerns, such as
thin capitalization issues, which might arise.
•
Most conventional loans usually require the borrower to enter into
interest rate hedges or currency swaps. However, certain conventional
hedging products provided in most Western jurisdictions may contravene Shari’ah principles, and thus may not be permitted under Shari’ahcompliant structures. By contrast, some derivative instruments, such as
caps or floors, may be used to limit exposure to interest rate and currency fluctuation. Furthermore, Islamic financial institutions may offer
alternative hedging products that are Shari’ah-compliant.
•
Most conventional loans usually require the borrower to maintain some
level of insurance. However, customary insurance provided in most
Western jurisdictions may contravene Shari’ah principles, and thus may
not be permitted under a Shari’ah-compliant structure. The principle
behind the prohibition of insurance by some Shari’ah scholars is based
on the fact that an insured pays a sum certain to guard against something that may or may not happen, which constitutes an unacceptable
level of risk, i.e. gharar. As a result, a market for a new type of Shari’ahcompliant insurance has emerged, known as takaful (cooperative insurance). The principal behind takaful is that policyholders cooperate with
one another by pooling their subscription payments, such that any losses or liabilities are spread among all cooperating policyholders and no
one party derives an unfair gain at the expense of any other party.
Therefore, some Sharia’ah scholars may argue that in order for the
acquisition financing structure to be compliant, the Opco and the SPV
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may not be permitted to insure their assets under any form of insurance
other than takaful.
•
Because the SPV has no source of income other than those payment
obligations created under the Shari’ah documentation, the arranger,
agents and lenders (collectively, the Secured Parties) must ensure that
there is a payment obligation from the Opco to the SPV to match each
payment obligation of the SPV to the Secured Parties. This presents a
challenge with some obligations, such as indemnities, expenses and
other ancillary obligations under the credit documents, because the
Shari’ah documentation may not reference the traditional financing. In
the case of indemnities, expenses and other similar ancillary expenses,
the Shari’ah documentation will provide for broad language to compensate the SPV for any cost or diminution with respect to expected profit.
The Secured Parties must be comfortable that the Opco will not later
dispute that such broad language was intended to cover all such expenses at the SPV level.
•
Some Shari’ah scholars may object to the structure outlined above
because the SPV’s source of capital is not Shari’ah-compliant, deeming
it to be an artificial product created to mimic a conventional product
that is based on interest. Although many Shari’ah committees and advisors have approved this back-to-back structure, scholars from more conservative jurisdictions may have a different opinion.
SUKUK STRUCTURES
One of the most common financing obligations purchased by Islamic
investors seeking a syndicated type of product is the sukuk (Islamic bond).
According to Dealogic, by the end of 2007 there had been more than 1,100
worldwide sukuk offerings, with an estimated deal value exceeding US $64
billion, and Ernst & Young estimates that the sukuk market is likely to reach
US $100 billion in 2008.9 The biggest market for such offerings has traditionally been Malaysia, with Indonesia, Pakistan, the United Arab Emirates
and Saudi Arabia having active markets as well.10 The main underwriters of
sukuk offerings worldwide have been regional and local Islamic financing
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institutions. However, the LPC Goldsheets published Mandated Arranger
and Arranger league tables for 2007 that indicated that traditional Western
banks such as Citibank, Royal Bank of Scotland, Deutsche Bank, Credit
Suisse, Barclays, JPMorgan and Lehman Brothers have also actively participated in sukuk issuances.11
A sukuk is essentially an asset-backed security structured in a Shari’ahcompliant manner, and is somewhat similar to a trust certificate. The basic
framework is that a special purpose vehicle issues sukuk (or certificates) to
Islamic investors and uses the proceeds of the issuance to purchase a pool of
“assets” (typically one or more Shari’ah-compliant contracts, such as ijara or
murabaha contracts similar to the ones discussed previously). The stream of
income generated from the Shari’ah-compliant contracts is used to fund the
payments to the holders of the sukuk. Most Shari’ah scholars agree that the
pool of assets should not only be comprised of instruments, such as murabaha contracts, which are viewed as representing an interest in a stream of payments, as opposed to an ijara, which is viewed as representing an interest in
the underlying assets themselves.
Typically sukuk are either (1) ijara sukuk, which are certificates issued off
of stand-alone assets such as land or equipment, providing regular payments
that are often benchmarked to LIBOR, or (2) hybrid sukuk, such as a portfolio of ijara contracts and murabaha contracts (however, at least 51 percent
of the portfolio must typically consist of ijara contracts). Additionally, traditional financing ratings companies such as Moody’s, Standard and Poors,
and Fitch, as well as specialized Islamic finance rating companies, offer ratings services for Islamic finance products, including sukuk.
In working with sukuk structures, there are a few particular issues to
note, including the fact that tax or other concerns may limit the practicality
or availability of certain assets for such structures and that some institutional investors may be restricted (by the terms of their own funding vehicles or
governing documents) from purchasing assets other than debt securities or
loans.
In addition to the above structures, there are a number of other Shari’ahcompliant financing structures used around the world. Such structures
include musharaka (partnerships), mudaraba (venture capital financings),
istisna’a (manufacturing contracts), salam (forward-sales) and hybrid struc-
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tures combining one or more of the other generally accepted Shari’ah-compliant structures.
CONCLUSION
The growth of assets held by investors interested in complying with
Shari’ah principles presents opportunities for institutions looking to access
this significant source of capital. With careful structuring, products for these
investors may be crafted that both address the needs of these investors
(whether on the sponsor side or the “syndicate” side) and the traditional concerns of syndicated lenders.
NOTES
Islamic Banking: Can You Afford to Ignore It?, The Boston Consulting Group,
April 2008, available at http://www.bcg.com/impact_expertise/publications/files/
Islamic_Banking_Apr_2008.pdf.
2
A determination of what constitutes an “unacceptable” level of risk is very factspecific. Generally, a Shari’ah committee or advisor reviews and approves each
financing transaction before it is deemed to be Shari’ah compliant. This committee,
based on its review of the entire transaction, assesses whether or not the level of risk
breaches the “unacceptable” threshold.
3
For example, some Shari’ah scholars would argue that an investment in a restaurant that serves alcohol would be prohibited. However, other Shari’ah scholars take
a more moderate view and would argue that if alcohol sales at such restaurant are
less than some small percentage of the revenue of the restaurant, the investment may
still be compliant. Additionally, in some circumstances, an investment may be
viewed as being compliant if the portion of profit generated from prohibited activities is donated to charity.
4
This corporate services company is paid a fee by the equity sponsor to provide
this service, but the corporate services company is not affiliated with and is not controlled by the equity sponsor.
5
While this Client Alert generally refers to this acquisition financing structure as
“ijara-murabaha,” there are some variations. For example, a second murabaha may
be substituted to mimic the term loan if the Opco assets are not of the type that can
be readily sold and leased back. Murabaha structures may also be used to mimic a
1
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second lien term loan, a bond or a PIK instrument.
6
Note that these assets are generally of the type that can be transferred without
requiring third-party consents or recordation.
7
Note that depending on the particular transaction, some Islamic banks may deem
murabaha structures to be non-compliant.
8
Some ijara-murabaha structures also utilize side letters to confirm the US tax law
treatment of the transaction and indemnify the SPV for any tax expenses incurred
in connection with the overall transaction.
9
Sukuk Market to Hit $100 Bln in 2008: E&Y, Reuters, February 5, 2008, available
at
http://www.reuters.com/article/IslamicBankingandFinance08/
idUSL0535173820080205.
10
According to Dealogic there has only been one sukuk offering in the United States
in the last two years, the East Cameron Gas Co., which was recognized as the first
ever Shari’ah-compliant securitization originated out of the US.
11
LPC Goldsheets, January 7, 2008.
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