01 Jan 2008 Shariah Compliance & Investment Funds
Due to the large amount of middle-eastern assets deposited with Geneva-based banks, there has been a recent surge in demand for Shariah compliant investment schemes by Swiss portfolio managers. There are constant requests for an increased amount of legal information in the Shariah compliance field. As such, this article sets forth the principles for structuring a Shariah compliant fund.
What size is the Islamic finance industry and how does it evolve? Estimates varied considerably in the past and until recently there was no reliable benchmark available to investors. Arguably the biggest boost came when Dow Jones and Lipper launched their set of indices covering Islamic funds. On its end, Failaka Advisors, a leader in the field of Islamic funds, also started issuing a quarterly Islamic Funds Report compiling information, performances and underlying investments of more than 100 Shariah compliant funds. The latest effort to benchmark the market took place recently in November 2007 when the finance magazine “The Banker” published the first comprehensive “Top 500 Islamic Financial Institutions” analysis of the Islamic financial industry. The analysis shows that Shariah compliant assets reached USD 500 billion in 2007. These initiatives are welcome, but the Islamic finance industry will only develop in the long term if western jurisdictions provide a reasonable regulatory framework for Islamic financial transactions. Some European countries are acting pro-actively in this respect. In November 2007, the UK Financial Services Authority (“FSA”) issued a report on Islamic Finance and Regulatory Challenges. The FSA waived many obstacles for Shariah compliant transactions. At the same time, the French government announced that it is contemplating to promote Paris as a hub for Islamic Finance. Several Swiss banks including UBS AG and Credit Suisse have branches in the Middle East offering services compatible with Islamic banking practices. Faisal Private Bank was the first bank which started operating according to Shariah principles on Swiss soil. The bank was awarded a full banking license in 2006. Other financial institutions follow the trend. Hopefully, the practice of the Swiss Federal Banking Commission (“SFBC”) and of the Tax Authorities will evolve quickly to be more Islamic banking friendly.
Islamic Funds are in most cases based on a mudarabah contract (profit sharing partnership) and have similar structures as ordinary mutual funds. A mudarabah agreement is a contract under which investors entrust money to an agent (similar to a fund manager – “mudarib”), who is to perform Shariah compliant investments and then return the principal and a pre-agreed share of the profits.
The investors receive a document certifying their subscription and entitling them to the pro- rata profits actually earned by the Fund.
The documentation of the fund mainly consists of the mudarabah contract (collective investment contract), the offering memorandum and, if necessary, an investment regulation.
The mudarabah contract provides sufficient flexibility to structure a fund with broad investment criteria. However, there are certain overreaching principles of Shariah which need to be factored into a fund’s investment strategy and restrictions.
Profit & Loss
The profits generated by the fund are divided between the mudarib and the Investors in accordance with a predetermined formula. The rate of return of the investors is tied up to the actual profit earned or loss suffered by the fund. If the Fund earns profits, the return of the investors will increase in that proportion. However, losses are also borne by the investors to a maximum of their investment.
No fixed rate of return can be guaranteed.
The mudaribs charge a specific rate for their time and effort in managing the assets (while management and performance fees are permitted under the mudarabah contract, the fee schedule must be carefully reviewed). Where losses occur, the mudaribs’ losses are limited to that of their time and efforts.
Hidden fees/disguised interest charges, provisions which allow one party to charge a fee not agreed in advance and contracts which are biased in favor of one party are prohibited.
Developing an Islamic fund poses many challenges particular to Islamic investing. While elimination of Riba (interests) is an important feature of the Islamic financial system, Islamic finance involves much more. To be Shariah compliant, an underlying investment must also not involve: (i) maysir (prohibition of gambling and speculating); (ii) gharar (prohibition of uncertainty. The prohibition on gharar is often used as the grounds for criticism of conventional financial practices such as short selling, speculation and derivatives), (iii) rishwah (corruption), (iv) and jahl (ignorance).
All underlying assets must be halal. Investments in liquor, pork, night clubs, weapons or pornography fall outside permissible domains. Funds typically may not deal in equities issued by companies which engage in non-compliant enterprises including conventional banking and insurance (except for Islamic banks or takaful insurance), gambling, sales of alcohol or pork bellies, or companies earning profits based on interest bearing investments.
Shariah also has a number of fundamental requirements governing the sale of assets which typically apply to commodity funds. A sale is only valid and binding if the asset is in direct or indirect possession of the seller at the time of the contract and if the seller has good title. This principle was a hurdle during many decades for short selling. However, alternatives have been developed by contemporary scholars to enable forwards and futures transactions (see below).
Liquid assets are not negotiable under Shariah precepts. Liquid assets, cash or cash equivalent (such as T-Bills) must be purchased or sold at par value.
Non-Shariah compliant assets and activities are referred to as “haram”.
Based on the composition of the underlying investments, Shariah compliant funds may be classified into the following types:
There are a limited number of companies in which a Shariah compliant fund may legitimately invest; most companies invest in interest-based debt finance and their surplus cash in interest bearing bank accounts or other non-Shariah compliant investments. Hence, more flexible criteria have been developed to permit investment in entities which have merely incidental non-halal features.
The following conditions should be satisfied:
- The main line of business of the company is halal and excludes interest-based activities (Ribah). Shares of companies providing conventional banking, insurance or other haram services fall outside the permissible
- If a company’s main activity is permissible but it invests, lends or otherwise deposits its surplus funds in interest-bearing accounts or borrows money on interest, the mudarib and investors must express their disapproval at the annual general meeting of the If the company continues with this prohibited activity, purification will be required (see below).
- The company must own at least some illiquid assets otherwise its shares will be classified as non-negotiable by If all the assets of a company are in liquid form, (i.e. cash), its stock must be purchased or sold at par value. The required percentage ratio of illiquid assets ranges from 33% to 51%, but there are many different schools of thought on this issue.
In practice it is difficult to ensure that a company operates at all times with no leverage or zero interest. Therefore, the majority of scholars accept that investment funds invest in companies with less than one-third leverage and interests related ratios to the extent that the fund purifies the haram profits. Profits can accrue either through dividends distributed by the company or through the appreciation of its shares. In the first case where the profits are earned through dividends, if a company earns interest on account, an equivalent proportion of any dividend paid to the fund must be given to charity (purification), be it at the fund or the investor level. If 7% of the income of the company arises from interest-bearing deposits, 7% of the dividends must be given to charity. Some scholars believe the same concept of purification should also apply to capital gains, to the extent that the market price of the stock incorporates any discernible element of interest.
Murabaha is similar to cost-plus financing. It is a sale contract whereby the fund purchases specified commodities at the request of a third- party and resells them to the third party on a cost- plus basis. The third party purchases the commodities on the basis of deferred payment. The cost and profit margin must be agreed in advance. Murabaha arrangements only apply to commodities trade transactions. A murabaha fund should always be close-ended and its units cannot be negotiated on a secondary market. Since the commodities are re-sold to the clients immediately after their purchase by the fund from the original supplier and since the resale price is paid on a deferred basis, the fund’s balance sheet mainly consists of account receivables and cash. Therefore, the units of the murabaha funds are considered a liquid asset. Liquid assets can only be traded at par value by Shariah which excludes negotiations on a secondary market.
The Swiss Federal Law on Collective Investment Schemes provides that a contractual mutual fund must be open-ended. Since murabaha funds are close-ended by Shariah, it doubtful whether a murabaha fund can be structured under Swiss law. The SFBC will have to issue some guidance when the first cases will be submitted for their review.
An Ijara fund is a purchase and lease-back vehicle. The capital of the fund is used to purchase tangible assets or real properties which are leased to third parties. The ownership of these assets remains with the Fund. Rentals are the only source of income for the fund. The management fee may be a fixed amount or a proportion of the rental income. Assets leased by the fund must be used in a halal manner. The contract between lessor and lessee must be Shariah compliant. A majority of Shariah compliant real estate funds use ijara arrangements.
Hedge Funds and Short Sale Solutions
As it is strictly prohibited by Shariah to sell an asset before it is actually owned, traditional short contracts have historically been banned by Shariah. Accordingly, Islamic investors were prevented from investing in traditional hedge funds and commodity funds with a short and forward sales strategy. In most cases, Islamic investors are prohibited from short selling equities which they do not own.
Fortunately, alternatives to these general prohibitions have been developed in order to facilitate deferred sale such as:
Bai Salam (deferred delivery) contracts have been developed to synthesize futures and forwards. The buyer pays the seller the full price for a specific good up-front against deferred delivery. The Bai Salam contract is subject to several conditions including: (i) Full payment by buyer at the time of the sale; (ii) The underlying asset must be fungible and the quantity, quality, maturity date and place of delivery must be clearly pre-agreed by the parties; (iii) The underlying goods or commodity must exist and be in physical or constructive possession of the seller at the time of the contract.
The contract differs in two respects from a forward contract: (i) the full price is paid at the time of the contract as opposed to a forward contract where payment occurs at delivery; (ii) the pricing is also different. The price in a Bai Salam contract is the spot price minus a discount while there is usually no discount in a forward contract. The rationale being that the buyer must be compensated for credit and delivery risk exposure.
Bai Salam is one way to avoid the principles of maysir and gharar. The uncertainty about the market price trends is waived. In addition, the seller has already direct or indirect ownership over the goods at the time of the contract.
Istisna (progressive financing) is a work in progress contract used for trade finance such as pre-shipment export finance. It is primarily a deferred delivery sales contract similar to Bai Salam and to conventional work in progress financing. The fund makes progress payment of the purchase price of the commodities, gets the commodities and delivers them at a future date to a new purchaser. The feature of Istisna is that nothing is exchanged at spot or at the time of contract. Istisna contracts open the way to a number of new possibilities of business contracts including some forms of futures contract trading of processed commodities, as it allows for the deferral of both ends of the contract: delivery as well as partial payment. The difference between the price received from the purchaser and the price paid to the supplier constitutes profit for the fund.
Bai Al-Arbun (non refundable deposit) is a sales agreement in which a security deposit is given in advance as a partial payment towards the price of the commodity purchased. The deposit is nonrefundable and is due to seller to if the buyer fails to comply with the contract. Bai Al-Arbun are viewed by some scholars as a Shariah compliant type of option (put) through which one party buys the right to purchase from the other party specified goods for a specified price at a certain date against the payment of a premium.
Risk Factors specific to Shariah compliant investment strategies must be included in the prospectus including the liquidation process. Assets which were Shariah compliant at the time of the investment, but subsequently became non- compliant must be liquidated. If an equity fund purchases stocks in a company which decides to invest in a casino, the investment manager and/or prime broker will have to liquidate the shares as soon as practicable even if the market price of the stock has fallen.
The Shariah board appointed by the investment manager and its Shariah advisers will examine the structure of the fund, its trading objectives, the legal documentation, the execution flow, the purification process and determines on an on- going basis whether the activity is and remains Shariah compliant. Provided that the scholars are satisfied that the activities of the fund will adhere to Shariah rules, they will issue a religious ruling (fatwa) which in turn will give prospective investors the necessary confidence to invest.
License and Surveillance
A Shariah compliant fund incorporated in Switzerland is subject to surveillance by the SFBC irrelevant as to whether it is distributed to retail or accredited investors. A foreign fund distributed in or from Switzerland must also seek a license by the SFBC if public offering is made in Switzerland (for details see our Newsletter of October 2007 “Public Offering – Revised Circular 03/1”). The license is only granted if the fund is registered in a jurisdiction having equivalent prudential standards as Switzerland. However, if the foreign fund is only designed for accredited investors, no license is required in Switzerland.
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This newsletter is for information purposes only. It does not constitute professional advice or an opinion. Please contact Mr. Dominique Lecocq on firstname.lastname@example.org for any questions.