McMillen Critical Factors in Development of Islamic ... · Cartoon copyright The New Yorker (appeared in May 30, 2011 issue) ... AAOIFI Standard Rated µ l » l based on US assets:

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved 1

Critical Factors in the Development of Modern Islamic Finance:

The as a Transnational Rule of Law Framework

and the Classical Role of Scholars

Michael J.T. McMillen

Financial Regulation in a Global Market:

Moving Beyond the State

June 10, 2011

Goodenough College, London


Michael J.T. McMillen

River Stone Capital, LLC

(law firm to be announced)

E-mail:

[email protected]

Mobile:

+1-646-337-3113

Contact Information


Topics for Today


Topical Overview

Objectives, Vehicle, Context

Five Critical Factors

Some History

The Dow Jones

Bifurcated Structures the (Lease)

Musings

Appendix A:


[particularly] investment

often conventional interest-

(a) a conventional interest-based financing and

(b) a -compliant structure


PerspectiveCartoon copyright The New Yorker (appeared in May 30, 2011 issue)


Objectives, Vehicle, Context


Objectives and Vehicle

Objective:

Explore Islamic finance and investment as a movement to:

Reestablish and reassert the as a rule of law framework

Reestablish and reassert the role of the scholars as it existed

prior to the Tanzimat (1839-1876 in the Ottoman Empire)

necessary for effective functioning of the as the rule of law

Vehicle:

Summarizing five critical factors in the development and growth of

modern Islamic finance and investment


Context: Noah Feldman

Consider the thesis presented by Noah Feldman in THE FALL AND RISE OF THE

ISLAMIC STATES

Feldman is not the only Islamic scholar that has advanced this thesis

However, his presentation of the thesis in this book is particularly

accessible and is one of the few presentations that has accessed a

broader public audience


as a Rule of Law Framework

invoked and invokes:

a core idea of law, a commitment to a legal order;

the conception of a system justified by law, a system that

administered and administers basic government through law;

the conception that the was the rule of law, and the Islamic

state governed by the was an Islamic state that was subject

to the rule of law.

Law alone is not enough need societal, governmental, economic and

the vehicles for coordinated group action.

them law is homeless and thus is not really law at all

Islamic finance industry as an institution


Focus: Islamic constitution and its balance of powers the Islamic state

with the as the governing law

scholars were critical they were the counterbalance to the

executive (caliph, ruler) the balance between the ruler and the law

itself

Role of scholars: to interpret the , to determine the substance of

The effectiveness of the scholars came through their ability to confer

legitimacy on the ruler

Ottomans, during the Tanzimat, removed the lawmaking authority of the

scholars and thereby their status as the legitimating

constitutional authority


Feldman argues that the return to the is, in some regards, a

return to the rule of law framework

He focuses exclusively on political elements (using the Muslim

Brotherhood platform as his primary example)

And makes no mention whatsoever of financial factors or Islamic finance

My conclusion: Islamic finance provides far greater support for his

argument as to the trend and the basic principles

It is return to the as a rule of law framework

The role of scholars in Islamic finance is more akin to the

role of the scholars prior to the Tanzimat


Five Critical Factors


Five Critical Developments

(consensus) sought by small group of scholars - mid-1990s

Nominate Contracts as building blocks mid-1990s

Dow Jones equity side of capital markets 1998

-compliant structures for Western transactions

1997-2000

- especially after 2002

The red stars in the history section


Some History


Timeline: Modern Islamic Finance

633 800 1000 1300 1500 1700 1900 1996 2011

Inception of thinking;

Development of the :

Nominate Contracts

Adapted from: Yusuf Talal DeLorenzo and Michael J.T. McMillen, Law and Islamic Finance: An Interactive Analysis (2007),

and Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. Dates are approximate.

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved

Islamic banks open in Asia

and Europe. Real Estate,

leasing and commodities

Dow Jones Islamic

Market Index

;

nominate contracts as building blocks

17


2000 2001

Post WWII

independence

leads to new

nationalisms

and the popular

revival of

indigenous

institutions

Islamic banks and finance

houses open in Middle East

Gulf Investment House

Bifurcated US residential real

estate

structures

(Maconda Park Truman Park)


and Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. Dates within any given period are approximate

United Bank of Kuwait

IIBU equipment leasing

funds operating

leases in the US

KFH Lease Fund and Wafra lease funds

US equipment operating leases;

Investcorp conventional and Islamic

residential fund

Arcapita

Watermark

Paddlesports:

private equity

Saudi Chevron

bifurcated

rahn-

structure

Copyright © 2008-2011 Michael J.T. McMillen; all rights reserved

Compliant assets on the LME

total US$100 Billion

18


2001 2002 2003 2004 2005 2006 2007 2008

Islamic Indexes delist

Enron, Worldcom, Tyco -

months before their falls

First -

value of issues

doubles each

succeeding

year until 2008

, Islamic asset

and whole-business

securitizations:

AAOIFI Standard

Rated based on US assets:

East Cameron Oil & Gas

First Compliant ETFs and REITs

-compliant private

equity: Aston Martin

AAOIFI

Clarification


And Yusuf Talal DeLorenzo presentation of February 17, 2009, US Treasury. dates within any given period are approximate

HSBC Amanah

Global Properties

Income Fund:

real estate

for -

compliant short sales

and options

East Cameron

bankruptcy filing


Revival and Recovery

: Consensus necessary across four primary (schools

of Islamic jurisprudence)

Think of product development and sales difficulties in the period prior to

consensus (transaction costs)


Revival and Recovery

Historically, under the , there were a limited number of contractual

transactional forms for the conduct of business

Trade-based quite rigid

They included:

Loans ( hassan)

Gifts

Sales (bay), such as (sale at a mark-up)

Leases a type of sale of the usufruct ( )

Joint ventures and partnerships ( , )

Manufacture or construction contracts ( )

Agency ( )

Others


Transition Factors

Scholars and practitioners began moving away from a conception of

the nominate contracts as being immutable and rigid with only one

such structure used per transaction

Structures are developed to allow conventional interest-based financing

to participate in the transaction (examples later) bifurcated structures

- which also involve more than one nominate contract


The Dow Jones


Permissible Impurity and Purification: the Dow Jones

Prior to 1998, any violation of , however slight, rendered the

transaction impermissible

Prior to 1998, a totally observant Muslim could not purchase a share of

stock being a major constraint

Dow Jones Islamic Indexes of 1998 (amended 2003)

instruments, and permissible impurity and financial tests

Institutionalization of cleansing or purification

Cleansing and purification small amounts of impermissible interest

income could be cleansed or purified by donation to charity


Bifurcated Structures:

Generic ra


First -Compliant Structures

Assumption: US and European banks needed to finance real estate transactions in,

first, the US and, later, Europe

These banks would only make conventional interest-based loans

Familiarity

Credit and underwriting

Regulatory and tax

Other reasons

Bifurcated structures making use of both structures and conventional

structures in an overall transaction that is determined to be -compliant by

the scholars

The first structures made use of the (lease) basically a leveraged lease

format familiar to bankers and lawyers

Those structures remain predominant throughout the world adjusted for each

jurisdiction


Synchronicity and Comfort

History of Documents Lender Bias

Initial Bank Representation

No Bank No Deal

Modifications With Market Acceptance

Modules:

Backbone

Covenants

Representations and Warranties

Events of Default

Insurance

Rental Factors (lease rates)

Land and Property Description

Risk Grid


Standard Loan Agreement

Rate Calculations

Amortization

Mandatory Prepayment

Commitment to Lend

Disbursement Mechanics

Conditions Precedent

Representations and Warranties Voluntary Prepayment

Covenants

Events of Default

Remedies

Indemnities

LOAN AGREEMENT


Disbursement Repayment Mechanism

Rate Calculations

Amortization

Mandatory Prepayment

Voluntary Prepayment

Covenants

Events of Default

Remedies

Indemnities

REEMENT

Commitment to Lend

Disbursement Mechanics



LOAN AG


Reallocation of Provisions

29

Commitment for

Construction

Disbursement Mechanisms



Covenants

LEASE ( )

[CONSTRUCTION

( )]

PUT and CALL OPTIONS

Mandatory Prepayments

Voluntary Prepayments

Rent Rate Calculations

Periodic Rent

Covenants

Representations and

Warranties

Events of Default

Remedies

Indemnities

LEASE

( )

Acquisition transactions have no that is

for construction and development financings with

multiple draws


Bifurcated Structure -

30

Understanding to Purchase

Lease ( )

Understanding to Sell

Managing Contractor Agreement

Conventional Loan Agreement

Other Loan Documents

Bank

Project

Company Funding

Company

Occupational

Tenants

Occupational Tenant

Leases

Fund

Non-Compliant Compliant

Tax Matters Agreement


Tenant Compliance Issues

Tenants may not engage in prohibited businesses (alcohol, pork, interest-

based financing, non-mutual insurance, gambling, pornography,

prostitution)

The Fund Manager, on behalf of the Fund and the Project Company, will

investigate the business of every occupational tenant

Each occupational tenant lease must be compliant


Tenant Compliance Issues

Permissible impurity and cleansing doctrines come into play

entity from the Dow Jones fatw

Available alternatives issues (an ATM, a restaurant with a bar, back office

operations of an insurance company, and other examples)

Cleansing by donation of a portion of the proceeds

Request to make lease compliant at inception; obligation to make it compliant

upon releasing or renewal of lease accommodation to market realities

These tests have the effect of limiting the pool of properties available for

investments by a -compliant fund

Investors and lenders must consider whether the property will draw sufficient

tenant interest based upon property type (office, industrial, mixed use, etc) and

locations

Not an issue for residential properties


Lease ( )

Occupational Tenant

Leases

Lease ( )



Bank

Occupational

Tenants

The Funding Company, as the lessor, will lease the Project

to the Project Company, as the lessee, pursuant to the

Lease ( ). This is a -compliant lease. In the

US, Rent equals periodic debt service, precisely.

Rent

Rent

Loan Payments

Dividends

Project

Company

Funding

Company

Debt Service


Understanding to Purchase and Understanding to Sell

Understanding to Purchase/Sell

Lease ( )



Bank

Occupational

Tenants

Occupational Tenant

Leases

whole or in part. The strike price equals all amounts due on the

conventional loan. rule on inability to collect future

rents. Need mechanism to accelerate. All mandatory

prepayments.

Strike Price

Debt Service

Title

Project

Company

Funding

Company

whole or in part. The strike price equals all amounts due

on the conventional loan. All voluntary prepayments.



Definition and Overview

Growth since 2003 one of the fastest growing areas

One of the first instruments to access the debt side of the capital

markets

are of two types:

herein lies the problem

Asset securitization structures



Mostly lease-based structures (38% by issuance and 34% by dollar

volume)

Most issuances are sovereign credits, ultimately

Only a couple asset securitization issuances

Financial services and real estate dominated until financial crisis of 2007

Short-term and long-term are relatively infrequent (Bahrain short-

term exception)

See Appendix A


Issuances Generally: to September 2008

Total Issuances: US$ 87,955.22 million

Total Offerings: 596

Sovereign Issuances: 35%

Corporate Issuances: 65%

Malaysia

Issuances: 267 (44.80%)

Total Volume: US$ 37,696.72 million (42.86%)

Bahrain

Issuances: 150 (25.17%)


UAE

Issuances: 34 (5.70%)


Total Number: Malaysia + Bahrain: 69.97%

Total Volume: Malaysia + UAE: 73.53%

Compare: Gambia: 36 (6.04%) and US$ 11.49 million (0.0%)

Source: Michael J.T. McMillen

and John A. Crawford, Sukuk in

the First Decade: By The

Numbers, Dow Jones Islamic

Indexes Newsletter, Issue 3,

2008.



Conclusions - Musings

Islamic finance is all around you, and it will continue to expand

Western jurisdictions:

among the largest Islamic finance markets

unheralded leaders in the development of sophisticated structures for Islamic

finance

Islamic finance is structured finance that is already familiar to many; it is not

mystical

There have been various instances of doctrinal compromise that have facilitated

the growth of the Islamic finance industry, and many of those compromises

acknowledge Western financial market practices

These compromises are areas of dynamic tension, and the doctrinal disparity

decreases with time

The greatest opportunity is enhanced cultural understanding and appreciation


Conclusions - Musings

Application of the does work as a rule of law framework in the

Islamic finance and investment context

The role of the scholars in the Islamic finance and investment

context is very much the same role as existed prior to the Tanzimat (1839-

1876 in the Ottoman Empire)

The Islamic finance and investment industry is one of the fundamental

as

the rule of law and is thriving (although the 2007 and continuing financial

crisis has had a profound effect)





AAOIFI (Accounting and Auditing Organization for Islamic Financial

Institutions) standard

Definition:

certificates of equal value put to use as common shares and rights in

tangible assets, usufructs and services or as equity of a project or

investment activity

distinguished from equity, notes and bonds

they are not debts of the issuer

may not be issued on a pool of (impermissible) receivables

underlying business contract or undertaking must be -

compliant


Fundamental Definitional Queries

By definition, a sakk represents a fractional undivided interest in the

underlying asset

mortgage-backed securities practice

Tax benefits and burdens to certificate holder? Consider, e.g.,

depreciation, investment tax credits, phantom income, etc.

Environmental liability to certificate holder? ,

are owned, overwhelmingly, by banks, insurance companies,

institutional investors and governments (consider Malaysia)

What of ownership of the usufruct rather than the underlying asset itself?

Consider these issues as we work through the discussion of


Categories

14 acceptable categories

Securitization of:

an existing or to be acquired tangible asset ( )

an existing or to be acquired leasehold estate ( )

presale of services ( )

pre-sale of the production or provisions of goods or commodities at a

future date (salam)

funding cost of construction ( )

funding acquisition of goods for future sale ( )

capital participation in a project or business ( or

)

various asset acquisition and agency management ( ),

agricultural land cultivation ( ), land management ( )

or orchard management ( ) activities


Issuances Generally: to September 2008

Total Issuances: US$ 87,955.22 million

Total Offerings: 596

Sovereign Issuances: 35%

Corporate Issuances: 65%

Malaysia

Issuances: 267 (44.80%)


Bahrain

Issuances: 150 (25.17%)


UAE

Issuances: 34 (5.70%)


Total Number: Malaysia + Bahrain: 69.97%

Total Volume: Malaysia + UAE: 73.53%

Compare: Gambia: 36 (6.04%) and US$ 11.49 million (0.0%)






2008.


Issuances by Industry Sector

Source: Michael J.T. McMillen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008.


Issuances by Structure



Issuances by Structure and Year

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2000 & before 2001 2002 2003 2004 2005 2006 2007 2008

Million (US$)

Musharaka Murabaha Modarabah Istisnaa Ijarah Al Salaam Al-Istithmar






2008.


Issuances by Tenor and Dollar Volume

0

20

40

60

80

100

120

140

160

180

3 Months 6 Months 1-4 Years 5 Years 6-9 Years 10-19 Years 20 Years

Al Sa laam Al -Is ti thmar I jarah Is tisnaa Modarabah Murabaha Musharaka






2008.


Annual Issuances by Tenor and Number



Generic al- Structure

Understanding to Purchase

Lease ( )

Understanding to Sell

Managing Contractor Agreement

Holders

Project Company Funding Company

Off-takers /

Tenants

Occupational Tenant

Leases

Proceeds

Prior to the global financial crisis, banks expressed a

willingness to purchase the . None done in US as yet.

Most transactions involve sales of in the markets.

What markets? Local banks and and Western banks and

insurance companies have been major purchasers. Thus

far, however, these have involved sovereign credits on the

obligations.



Attributions

Alhambra, Moorish architectural detail

Sarouk Fereghan Carpet, detail, North Persia,

circa 1910, signed Taushandjian


Attributions

Samarkand Carpet, Eastern Turkestan, circa 1900

Mosque ,Cathedral de Qous, ornamentation,

G. Weber, lithographer

New York Public Library


Attributions

Faiences Murales - du Tekyeh des Derwiches

(SVIIe.siecle),

New York Public Library

Timurid blue and white lotus bowl., Persia, 15th

century,

Sotheby's. L10223-206-lr-1


Attributions

Abbasid lustre pottery bowl, Iraq or Tunisia, 2nd

half of 9th century,

-60-lr-1

Kahsan pierced white ware pottery bowls, Persia.

circa 1200,

Sotheby's. L10225-79-lr-1


Attributions

Late Ayyubid - Early Mamluk, deep bowl, Raqqa

or Damascus. mid-13th century

Sotheby's, L10223-171-lr-1

Safavid Bombroon Pottery Bowl, Persia, 17th

century

Sotheby's, L10223-210-lr-1