Dubai, United Arab Emirates Photo by Nicholas Pitt / Getty Images RF / Newscom
In the financial world, the dos and don'ts of Shari'a (Islamic law) can be complicated. But with the right legal advisers, most conventional financial products can be made Shari'a-compliant.
The growth of the Islamic banking and finance industry has encouraged international bankers and investors to seek to demystify the mechanics and components of Islamic banking products. While significant progress has been made in recent years in structuring and marketing Shari'a-compliant investment products within the frameworks of various legal systems, there remains a need for greater integration between Islamic financial institutions and the international banking community. The accreditation of Shari'a-compliant investment products and Islamic financial institutions constitutes a major challenge in many jurisdictions, particularly in the United States and the European Union.
The analysis of the legal implications of Shari'a-compliant investment products should start with the identification of financial institutions that are permitted to offer the products. From a Shari'a point of view, almost any financial institution is permitted to offer Islamic investment products (unless that financial institution is prohibited for regulatory reasons from doing so). A non-Islamic bank or a non-Muslim can engage in trading or investing in a Shari'a-compliant manner. A conventional financial institution in London or New York can, therefore, develop financial products that cater to the needs of its Muslim customers. In many instances, this does not require the formation of an independent subsidiary. Typically, a separate department or “window” within an institution can develop and offer Shari'a-compliant products. Some jurisdictions, however, may require that Islamic banking licenses be independent from conventional licenses, with the result that the banking industry in such a jurisdiction provides for two parallel systems, namely Islamic and conventional.
In structuring Islamic investment products, promoters and issuers must satisfy the demands of individual and institutional investors in the jurisdiction where they intend to offer these products. It follows that promoters of Islamic funds and issuers of Islamic instruments, including conventional banking institutions, should develop both a generalized understanding of Islamic law and a working knowledge of the regulatory system in the jurisdiction where the investment vehicle will be structured. In addition, knowledge of the regulatory system of the jurisdiction in which the product is to be offered, if different, is also required. The financial advisers should work with the legal and Shari'a advisers to fine-tune their product ideas and vehicle structures to ensure full legal and Shari'a compliance.
The decision by a financial institution to structure an Islamic product requires the early engagement of legal counsel and Shari'a advisers. Despite the recent growth in Islamic banking, there are few legal advisers in major financial centers who have developed the know-how and experience that would permit them to actively participate in the process of structuring and documenting “quality” cross-border Islamic financial products. To be effective, such legal advisers require both a thorough understanding of Shari'a and familiarity with Western financial market practices. In particular, legal advisers must possess a good understanding of Islamic law so that legal issues can be addressed in compliance with the requirements of Shari'a, and in doing so must be able to communicate in a positive and constructive manner with Shari'a advisers.
The decision to domicile an investment vehicle in a particular jurisdiction will necessarily require legal advice about the regulatory and tax regimes in such jurisdiction, based on the proposed Islamic structure. For example, an Islamic structure that involves multiple asset transfers is likely to prove to be expensive in a jurisdiction that imposes taxation on each asset transfer.
Non-Islamic financial institutions often rely on recommendations made by their legal counsel or experienced counterparties in selecting Shari'a advisers on a product-by-product basis. Islamic financial institutions, however, have their own Shari'a supervisory boards that provide advice and Shari'a auditing with respect to all investment products offered by the institutions. Most jurisdictions require that financial institutions licensed to provide Islamic banking have their own Shari'a supervisory boards.
Shari'a advisers represent differing schools of Islamic jurisprudence, although many of them are knowledgeable in the teachings of the key schools. The market’s leading Shari’a advisers combine an in-depth knowledge of Islamic law with a good understanding of conventional financial and economic concepts, and have the ability to communicate in English. The mandate given by promoters of Islamic investment instruments to Shari’a advisers typically includes assisting in the development of a suitable structure for the proposed investment product, reviewing documentation, issuing a Shari’a compliance certificate and providing ongoing supervision – the Shari’a audit – to ensure that the implementation of such structure is Shari’a-compliant.
Whether a financial institution is structuring a conventional or Islamic investment vehicle, the local legal environment must be capable of accommodating the proposed structure as well as offering a favorable tax treatment. Some jurisdictions are extremely flexible in adapting to both conventional and Islamic structures, particularly Bahrain and Malaysia. In addition, the Cayman Islands and the British Channel continue to attract a growing number of Islamic funds and instruments. A primary reason for the trend towards setting up Islamic investment vehicles in tax-friendly common law jurisdictions stems from their advanced trust systems, which offer protection for the investors’ beneficiary ownership over the relevant assets.
Notably, investing in compliance with Shari’a requires adherence to certain investment guidelines, including sector and financial screens. Sector screens overlap to a great extent with the investment guidelines of ethical or “green” funds. For example, an Islamic investor or fund manager is not permitted to invest in gambling and entertainment facilities, alcohol production and distribution or arms. Financial screens, which are highly quantitative, seek to enhance the financial soundness of the investment and reduce the element of uncertainty and speculation. The investment manager of an Islamic fund, being one in which investors pool money to be invested in Shari’a-compliant investments to earn legitimate profit, will need to comply with the sector and financial screens.
In addition, Shari’a prohibits speculative investments and the generation of income by way of interest. This is primarily due to the fact that Shari’a requires that any return on funds invested by an investor, or lent by a lender, be the outcome of a commercial transaction in which the investor or the lender risks its capital. As a result, capital-guaranteed funds and investments are not Shari’a-compliant. The alternative is a fund or an instrument that offers capital protection without guaranteeing the capital.
Many financial industry professionals today are involved in the development of Shari’a compliant alternatives to most of the conventional investment vehicles and products available in Western markets. Working together with experienced legal counsel and established Shari’a advisers, they have created Shari’a equivalents to a number of investment vehicles. For example, in Islamic long-only equity funds (which do not take “short” positions on stocks), amounts raised from investors are invested in shares of listed companies – provided that such companies have been declared to be Shari’a-compliant. The companies in whose shares investment is permitted may be identified as Shari’a compliant by reference to their inclusion in “Islamic” indices such as the Dow Jones Islamic Market Index or the TII-FTSE Islamic Index. The companies included in these indices will have been declared Shari’a-compliant by the indices’ respective Shari’a advisers.
Otherwise, the compliance of a company with Shari’a, and thus the permissibility of its shares as an investment for Shari’a purposes, will be verified by the respective fund’s Shari’a supervisory board. In either case, regular Shari’a auditing is usually conducted by the Shari’a advisers to ensure the Islamic investment vehicle’s continued compliance with the requirements of Shari’a. The ongoing Shari’a compliance of the investment should be subject to a regular (annual or semi-annual) audit by the Shari’a supervisory board, although external accounting firms also can be appointed to audit an Islamic investment vehicle’s compliance with its investment guidelines.
Rather significantly, the list of Shari’a-compliant investment instruments is not exhaustive, as Shari’a advisors focus their audit on the structure of the investment itself. This means that certain well-established non-Islamic or conventional investment mechanics also prove to be compliant with Shari’a. Shari’a finance and investment precepts are likely to prove compatible with some of the established legal principles in force in Western jurisdictions. In fact, one can argue that U.S. oil and gas law, under which oil and gas rights are characterized as severable and alienable real property with well-recognized legal attributes, satisfies a number of Shari’a requirements. Such characterization, with its well-defined scope and its ability for ring-fencing, would facilitate to a great extent the structuring of sukuk (Islamic bonds) instruments that are linked to U.S. oil and gas rights.
With Shari’a encouraging risk taking and prohibiting interest, unleveraged venture capital funds provide yet another ideal tool for making investments in an Islamically compliant manner. A number of conventional venture capital funds have passed Shari’a compliance tests with only minor adjustments being made to the offering document and ancillary agreements. In each case, a Shari’a supervisory board was appointed and detailed Shari’a compliance criteria were introduced and implemented.
The discussion becomes more complex in the context of private equity funds, particularly those that utilize leverage to purchase a controlling stake in a target company or that invest in leveraged target companies. An Islamic private equity fund must finance the acquisition of a target company by using Shari’a-approved mechanisms. In addition, the leverage of the target itself is often relevant. Different schools of Islamic jurisprudence have different views on the subject. Some Shari’a advisers believe that if an Islamic private equity fund were to purchase a controlling stake in a leveraged company, then such a fund would be given a fixed period of time (perhaps three years) to pay off the target company’s debt or convert it into Islamically acceptable debt. Another view prohibits the acquisition of target companies if their debt exceeds one-third of the total capital of the target company.
In such cases, debt should be reduced to one-third of the total capital of the target company prior to the acquisition being approved. In all situations, the activities of the target company should be Shari’a approved. Therefore, investing in companies that are involved in industries such as gambling, conventional banking and insurance, arms manufacturing and alcohol is strictly prohibited. In addition, issues such as the nature of the debt (Islamic or non-Islamic) and the manner in which the total capital of the target company is calculated can be troublesome. Again, however, many of these complications can be resolved with early assistance from the right legal and Shari’a advisers.
Ayman H. Abdel-Khaleq is a partner with the Dubai, United Arab Emirates, office of Vinson & Elkins. He has a broad corporate practice that includes the structuring of Shari’a compliant structures, including asset-backed financing, private equity and investment funds.
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