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Sunday, 17 April 2011

Islamic Funds – Sharia Law and Investment Structures

Modern Islamic banking is just 35 years old, increasing from US$10 million in 1975 to now over US$250 billion under management with dedicated Islamic banks, together with another US$200 billion with units of conventional financial institutions. This rapid expansion in just three decades has not only attracted the interest of conventional bankers and borrowers, but also increasingly of investment fund structurers and promoters. Western financial institutions are working closely with their Islamic counterparts to develop this sector and meet the needs of a huge customer base worldwide.
It is worthwhile noting that Islamic finance is not confined to Muslim countries but is spread over Europe, the United States and the Far East; nor is it limited to Islamic borrowers, but is also used by many companies as an alternative source of funds. The principles of Islamic banking are similar in many respects to conventional banking, asset financing and project financing principles commonly used and applied under English law worldwide.
Islamic Finance
Islamic finance is the application of the Sharia to the finance sector. Although it is most well known for its prohibition of interest, Sharia is, in fact, a wholly different “philosophy” from the conventional western outlook of finance. The Sharia explains in detail the Islamic concepts of money and capital, the relationship between risk and profit, and the social responsibilities of financial institutions and individuals. Based on this philosophy, Sharia-compliant instruments and techniques have been developed and successfully used by Islamic finance units and customers worldwide in the funding of items such as property, ships, hotels and power plants.
The payment or receipt of all forms of usury (Riba) is strictly forbidden by the Quran, as well as gambling and uncertainty. Therefore, all sorts of interest payments common in conventional banking fall under the category of Riba, whether disguised as “commission,” a fixed or variable add-on or a discount.
The purpose of this prohibition is to prevent exploitation from the use of money and to share profit and loss. Money should be used for a proper economic purpose and not treated as a commodity on which a return can be made by reference to time. Islamic scholars agree money is simply a means of exchange and not an asset, and should therefore not grow over time. However, capital can earn the returns derived from the productive use of capital.
It is also forbidden for any Islamic institution or investment fund to deal in the following goods:
(a) alcoholic drinks;

(b) pork, ham, bacon and related by-products;
(c) dead animals (i.e., those not slaughtered according to the rules of the Sharia);
(d) gambling machines;
(e) anti-social and immoral goods such as tobacco, pornography, drugs, etc.;
(f) gold and silver, except for spotcash; and
(g) armaments and destructive weapons.

Since almost all of today’s companies deal with some form of interest or otherwise prohibited activity, some Sharia advisory boards have determined an upper limit to what percentage of a company’s income can be earned through interest and/or such activities. It would be unacceptable to invest in a firm that exceeds this limit.
Islamic Investment Funds Structures
As shown above, Islamic instruments can be used in many types of fund structures. Sharia-compliant property funds, in particular, are increasingly being used in the U.K. and are promoted by many institutions. Investors from the Middle East have long regarded commercial real estate as a favorite form of investment, with an emphasis on certain commercial property sectors and geographic regions.
Islamic investment funds operate by investors contributing money that is then invested so that profit can be earned in a manner compliant with Sharia. The validity of the units, shares or certificates issued in the fund is subject to two conditions.
First, they must carry a pro rata profit actually earned by the fund, instead of a fixed return being tied up with their face value. As stated earlier, neither principal nor profit can be guaranteed and profit/loss must be in proportion to how successful the fund is. If the fund earns large profits, the return on the investor’s subscription will increase to that proportion. However, if the fund suffers a loss, the investor will also have to share in the loss.
Second, the amounts pooled must be invested in Sharia-compliant trading activity companies. If, for example, the fund invests in the hotel or leisure sector, the Sharia board must be satisfied that the income that will be used to repay the investors, in the form of rental or return on investment, is not made up of income from the sale of prohibited items such as alcohol. If it is, then such income must be below certain thresholds (as agreed by the Sharia board); otherwise, the proportion of income derived from interest or alcohol that exceeds such thresholds must be given to charity.
In Ijara funds, the amount subscribed is used to purchase real estate (via a special purpose vehicle) for the purpose of leasing out the real estate and charging rental, which then forms the income of the fund that is distributed pro rata to subscribers, who hold certificates of proportional entitlement that represent pro rata ownership of their holdings in the tangible assets of the funds (also known as sukuk). These funds are normally marketed to high-net-worth individuals or banks. The life of the fund is usually fixed.
A sukuk is fully negotiable and can be bought and sold on the secondary market. New purchasers of sukuk “step into the shoes” of the original holder, taking the certificate (ownership) and hence, all the profit, but also the rights, obligations and liabilities that accompany it. Requirements for validity include that leased assets must have some usufruct, assets must be Sharia compliant in their nature and the lessor must abide by any ownership responsibilities imposed by Sharia. In addition, rental must be fixed and known by the parties (or ascertainable by means of a formula) at the beginning of a contract.
Sharia Advisory Boards
All financial institutions that offer Sharia-based services or products (such as investment funds) will have a Sharia committee or board. These boards are comprised of Islamic scholars and practitioners who provide the Islamic financial institutions with guidance and supervision. The Sharia board members are independent of the Islamic finance institution and are not employees. Like an audit by an accounting firm, these boards often submit a Sharia audit for the annual report of the Islamic institution they represent and issue Sharia compliance certificates.
The Sharia advisory board works closely with the bankers and lawyers to structure instruments so that they meet Sharia and commercial requirements. Standard documentation has been developed by the financial institutions covering their main areas of activities. However, they will need to refer back to the board whenever there is a deviation to ensure that no inadvertent breach of Sharia or the compliance certificate has occurred.


(Forbes/5 April 2011)

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