‘Knowledge has no borders, wisdom has no race or nationality. To block out ideas is to block out the kingdom of God.’
Aristotle appearing to Caliph Al-Mamun in a dream
Deutsche Bank was ablaze with excitement. Safa Tower had cemented the bank’s name in the Middle East, but PCFC had put Deutsche’s Islamic team on the world map. The Financial Times featured Bossuyt’s bald-headed and beaming face on the front cover of its Islamic finance supplement in June 2006,1 and the team expanded to accommodate its burgeoning pipeline of deals.
Bossuyt and two Oxford-educated bankers were joined by a team of younger structurers: a British-born Pakistani with a physics degree from University College London, the team’s only woman, immaculately presented in business suit and hijab (the Muslim headscarf); a British Nigerian, an industrial chemist from Imperial College London, towering over his colleagues at six foot something and an expert in derivatives; a senior Malaysian structurer who provided reach into the world’s largest Islamic finance market; and a fast-talking Jordanian youngster. Two aggressive senior sales staff completed the recruitment process.
They wouldn’t let deals like PCFC slip through their conventional colleagues’ butter-fingers into the hands of competitors. They were young, dynamic and edgy in stark contrast to their socially awkward Indo-Pakistani brethren at competitor banks. Their suits were tailored, not off the peg, and they rumbled into DIFC’s underground car park every morning in Italian supercars. Junior team members were encouraged to challenge their seniors and robustly defend their ideas. Morning meetings were informal and non-hierarchical, ranged around a flip chart with scattered diagrams and equations. Bossuyt eschewed his prerogative to luxuriate in a glass-enclosed corner office, choosing instead to be a man of the people and seat himself at the end of a row of desks. He even declined the seat closest to the giant window overlooking Dubai’s incredible panorama, and passed it on to me instead. I wasn’t about to complain.
The Belgian boss of Deutsche’s Islamic finance team was socially egalitarian but intellectually elitist. Our office environment at the Dubai International Financial Centre was non-sacrosanct, verging on a social club for well-dressed geeks, on one occasion transforming into an impromptu venue for an arm-wrestling tournament. The enormous Nigerian took on his diminutive Pakistani senior across a filing cabinet, locked grimly together for what seemed like an age as the office egged them on loudly. The kerfuffle prompted Deutsche’s country head to poke his head out of the glass door of his office. At first the throng swarming around the two combatants quietened and nervously parted to allow the big boss through. But he giggled at the sight and the throng resumed raucously. This is what he wanted. A team that didn’t live by the dry conventions of title and conformity. It had to have an intense and sharp quality, to do things the others didn’t. As if to confirm the team’s unpredictability, the smaller man won, hijabi match referee declaring the Nigerian’s loss by technical default by bending his wrists to avoid touching down. An unsuccessful attempt to exploit a legal loophole on this occasion, remarked one office comedian.
Islamic finance was hot and suddenly everyone wanted a piece of the action. But the complexity of Sharia-compliant products was ratcheting up and few had a grip on the structural and legal nuances.
Arif Naqvi wanted to be in on it badly. A well-known deal maker based in Dubai, Naqvi was the suave chief executive of an upstart regional private equity house, a financial institution that buys and sells privately held companies with their clients’ money. Naqvi had an eye for a cheap company with potential for growth. He bought it, re-engineered its balance sheet, installed new management, and sold on the enterprise for a tidy profit. The Middle East had rarely before seen an operator of his type. He dared to have the same global ambitions as the big bad American ‘buy-out’ houses, and modelled his firm on his brash American cousins.
Nowhere were those ambitions more apparent than in Naqvi’s bold courting of Deutsche Bank as a partner in the regional buy-out market. With Deutsche’s help, Abraaj Capital raised US$2 billion internationally to invest in infrastructure in the region. Islamically.
The Infrastructure and Growth Capital Fund would be Abraaj’s flagship fund and the relationship with Deutsche would grant the private equity firm access to an Islamic structuring capability that Naqvi’s own otherwise impressively capable investment executives lacked. The $2 billion that Abraaj and Deutsche had raised was eye-catching enough, but Naqvi set his sights higher. If his team could pull off just one massive leveraged buy out, the type of heavily debt-financed acquisition of a rich trophy asset that would make headlines in the Financial Times or Wall Street Journal, then he would cement his local reputation on an international scale. And Sharia compliance would be his unique selling point.
On 30 May 2007, together with some co-investors, Abraaj Capital’s Sharia-compliant fund purchased all the shares in a company called Egyptian Fertilizers Company – or EFC – Egypt’s largest private-sector producer of integrated nitrogen fertilizer (known by its chemical name, urea). It cost the fund $1.4 billion plus the $465 million already owed by the company’s balance sheet in existing (conventional) debt. Including transaction fees, the total purchase price was a whopping $1.9 billion and the fund would need to raise debt financing from a syndicate of banks to make it happen.
At first, the deal team at Abraaj worried that the short bid timetable for the acquisition would not enable them to structure Sharia-compliant financing in time. This is Egypt, they said. The legislative framework is hard enough for a conventional financing, let alone Islamic. The deal requires a ‘multi-tranche’ structure – that is, one that requires the debt to be cut up into a number of discrete packages owing to the huge size of the acquisition. It requires a refinancing of existing conventional debt in the company. It’s a structural nightmare, they protested.
Over at Deutsche Bank, the bankers on the emerging markets financing desk were similarly pessimistic. Schooled in conventional acquisition finance, Islamic finance was too exotic, too unknown, to be trusted. But their colleagues on the Islamic desk begged to differ and asked Sheikh Hussain to solve the impasse.
We met the scholar in his office in downtown Dubai. ‘Bring your client and the bankers to me’, he said, then reiterated a now familiar mantra in his rich Egyptian accent: ‘If you go to the doctor but you do not tell him all your symptoms, your background, your lifestyle, then he cannot give you the best advice. They must give me all the information – balance sheet and cash flow, which party earns what, who takes what risk, and all of the requirements of the different parties to the transaction.’ He meant not only the principals in the transaction, but also the government, the regulators and tax authorities. ‘If they provide me with all the symptoms, I will find a comprehensive cure.’
So convinced was he that a commercially viable solution was possible that he offered to complete the structuring and documentation in conjunction with the legal teams within three months of the official tender offer. Three months for an unprecedented deal in a nascent industry, where the pessimistic emerging markets bankers at Deutsche might have baulked at the thought of two years, just like the Safa Tower deal before.
The conventional bankers at Deutsche and their client at Abraaj didn’t believe him. The pugnacious scholar was either crazy or a genius. They understood the concept of a sale and leaseback – a real economy transaction that relies on a real underlying asset – but couldn’t find a way for the underlying assets of the target company to be bought and leased back to the company by a foreign financial institution in Egypt without a tortuous licensing process, certainly one that would take longer than the mandatory offer period. Nor were they at ease with security and enforcement issues related to such a structure in the Egyptian legislative environment – the only way to enforce their security rights over ‘their’ assets would be via a local agent bank. This wasn’t the comfortable and familiar jurisdiction that Western bankers were used to. It was a volatile emerging market. International banks don’t like locals having control over their assets when the deal goes pear-shaped. What other solution could there be?
The default option of the ubiquitous commodity murabaha structure had been vetoed by the conservative Sheikh Hussain for looking too much like a conventional loan. If it looks like a loan, smells like a loan and acts like a loan, it is a loan, he reasoned – it doesn’t matter what fancy Arabic words you attach to the finance documents. So the bankers in Deutsche’s offices on London Wall did what all bankers do when chasing their year-end bonus: choose the path of least resistance. They would pursue a conventional interest-bearing loan to finance the deal and worry about Sharia later.
Undeterred, the Dubai-based Islamic specialists approached the scholar with an idea. In a meeting room we huddled round a white board covered in the scrawl of contractual structure diagrams and wondered out loud: what if the banks bought the finished product from the company for future delivery? What if the ‘senior’ tranche of the financing – the piece that is lowest risk for lenders as it gets paid back to them before anyone else gets their money – was in fact not a loan, but a contract of exchange, a sale and purchase agreement between the banks and EFC?
The idea had precedent, except that such a precedent was from 1,400 years ago – from seventh-century Arabia, in fact. At that time, a farmer lived a tough life, his fortunes subject to the vagaries of a harsh desert climate. If he couldn’t lock in a price for his produce before the harvest, he risked not feeding his family for eleven months of the year. So he sold his crop in advance to different buyers, spreading out his income over the year. This forward sale of a commodity became known as the salam contract, allowing the farmer to ensure his family’s financial security by receiving money today for delivery of a specified quality and quantity of produce at a specified point in the future. We wanted to transform a classical concept into its modern-day equivalent.
‘As the bank, we buy the urea from EFC for $850 million on day one’, we suggested to Sheikh Hussain, ‘and they deliver the product to us for selling on into the market over a period of eight years, the term of the equivalent debt financing.’ This would be a real economy transaction, one where the bank acts as a merchant, buying and selling on a product – an Islamic transaction.
Sheikh Hussain paused, smiled and slowly nodded his head. ‘Praise be to Allah’, he affirmed in Arabic in a low voice, as if speaking to himself. ‘You have learnt well.’
The bankers in London were furious. ‘Insanity!’ screeched Deutsche’s senior director on the emerging markets structuring desk during a conference call with her colleagues in Dubai. ‘That is a ridiculous idea, and will never work. Let’s move on and look for something else.’ But the Dubai team wouldn’t let it drop and continued to explore the idea with the sheikh and the bank’s legal counsel at the elite English law firm Clifford Chance.
In the automotive and high-technology industries, this kind of behind-the-scenes unsanctioned project, typically undertaken in secret by a small group of technical experts, bypassing the normal bureaucracy of an organization, would be termed ‘skunk works’. Skunk works can often result in a radically new product that may later gain official sanction. With a Samadiite sitting in each of the three firms – Deutsche, Abraaj and Clifford Chance – somehow a critical mass of ideas could be crystallized into an executable plan, building on the personal relationships between these skunk works specialists. It would be an opportunity for us to roll out a six-hundred horsepower fire-breathing monster from the secret shed to show off to our colleagues, who in contrast might perhaps spend their days building humble family sedans on the factory floor.
Would the idea work? And would such a radical financing be possible without this proximity of lifestyle and community that the Samadiites were blessed with? This would become the largest ever buy out in the Middle East, and indeed the largest Sharia-compliant buy out the world had ever seen. Failure would be highly visible and Naqvi’s bold ambitions would not tolerate it, nor indeed, in turn, the careers of those involved.
The skunk works specialists needed to do more than just theorize. They had to convince their colleagues that the concepts of a millennium-old legal system could be applied to a modern cross-border acquisition financing in an emerging market. This was the type of transaction that would normally require an investment bank to simultaneously juggle jurisdictional, regulatory and tax challenges, challenges that are typically more nebulous in emerging markets than in developed markets. By adding Sharia into the mix, acquiring high-value companies through a multi-tranche financing might ordinarily lead a deal team to believe that the financing was impossible, and perhaps even abandon the cause.
To appease the conventional bankers, the initial injection of debt funding was arranged on a conventional basis in order to meet the acquisition timetable, albeit with a clear expectation of refinancing via a Sharia-compliant take-out within a pre-agreed time frame. This time frame was set at six months, but subject to a number of transaction-specific provisos.
At first, the suggestion circulated among the London bankers that their colleagues in Dubai simply didn’t understand the commercial and risk parameters that a global investment bank operated under, and that perhaps the Dubai bankers simply weren’t up to the task. To the sophisticated London bankers, their Dubai colleagues were the underachieving cousins sent off to far lands to tend to peripheral matters in the family business. A seventh-century contract to sell farm produce in an ultra-sophisticated twenty-first-century multi-tranche cross-border acquisition financing? These guys were nuts. But as the Samadiites put together the legal terms for their proposed forward purchase of the underlying manufactured product – fertilizer – the credit traders at Deutsche Bank began to give serious consideration to this fantastical trade. Banks, after all, are in the business of making money. If they see an opportunity for profit, then providing their risk management committees are satisfied with various levels of security and collateral in a deal, then why not? An istisna contract – that is, the forward purchase of a manufactured commodity over time – may have had its origins in the salam contract of seventh-century Arabia, but it was just a contractual tool. And contracts, after all, are what modern banks are geared to analyse and quantify.
Despite the internal conflicts, the istisna structure started to come together. Deutsche Bank entered into an agreement to purchase the urea on day one for $850 million, the amount of ‘senior’ debt required – that is, the piece that gets paid back to lenders before anyone else gets their investment back. The urea would be manufactured and delivered in pre-agreed quantities and quality, and to a pre-agreed delivery schedule. Thus, Deutsche Bank became a buyer of urea via a forward sale agreement according to a delivery schedule that gave it the same economics as a conventional loan. The forward sale agreement provided the standard protections found in a conventional senior debt financing, including various financial covenants, standard representations and warranties, events of default; all the features that one might find in any large-scale complex conventional financing – so the screechy conventional bankers back in London need not worry that an apparently archaic system of contract law might disadvantage them in some way.
Naturally, investment banks are not in the business of warehousing vast quantities of stock unrelated to their core business. In order not to inundate a bemused mail room on London Wall with millions of sacks of fertilizer over eight years (the term of the ‘loan’), and to minimize the commodity risk and maximize the credit quality of the transaction, the bankers arranged a long-term buyer – an ‘offtaker’ – for the urea. This assurance of ‘offtake performance’ – in other words an assurance the goods would find buyers – was provided by a performance guarantee from the company itself, and from the company’s owners.
This was a little awkward from a Sharia perspective: after all, an Islamic financing was not supposed to guarantee its repayment, otherwise it would be a conventional debt. But Sheikh Hussain deemed there to be sufficient risk in the transaction to allow the company to provide an obligation of performance. Instead of an outright guarantee of repayment, the company would be required to replace the offtaker within a specified time frame in the event of an inability to offtake.
Despite the rigour of the structure from a Sharia perspective, some compromises had to be reached. Ownership of the underlying assets of a company is not always commercially palatable to international banks. They deal in debt and cash, not bags of fertilizer. Local ownership laws in many emerging markets, especially in Egypt, may be incompatible with the transfer of title to foreign entities. Tax regulations might also have made this transaction legally and economically prohibitive. However, in such extenuating cases, scholars may be comfortable with ‘constructive’ ownership and possession of an asset by passing beneficial interest in an asset to the bank or its SPV without changing legal title.
In addition, the choice of jurisdiction of the various legal entities incorporated for the purposes of executing the different legs of such a transaction may require specific tax considerations in respect of dividends or profit rates, and the treatment of withholding taxes. How such payments were construed by the Egyptian tax authority was of paramount importance in determining such details, and a significant due diligence exercise was undertaken in this regard. Additionally, the purchase and resale of an asset (in this case due to the banks’ requirement for an offtaker) may incur multiple stamp duties, and once again the final structure and choice of jurisdiction go hand in hand with such considerations. Ironically, sophisticated non-Islamic jurisdictions like the United Kingdom dealt with the subject of punitive taxes for Islamic transactions better than majority-Muslim nations in the emerging markets.
So it wasn’t a perfect structure from a Sharia perspective. Full legal ownership and physical possession had to concede to beneficial interest and constructive possession. But without the appropriate tax and ownership concessions from the relevant authorities, this mild fudging of the Sharia issues was deemed by Sheikh Hussain to be an acceptable compromise.
Finally, the transaction would not have been complete without refinancing the piece of debt that sat in between the senior debt tranche and shareholders’ equity in priority of repayment, the so-called ‘mezzanine’ tranche since it is repaid before the shareholders who take on the most risk (in the form of shares) and get paid in dividends from the bottom line profits, but after senior debt providers who take on the least risk and get paid out first from the business expenses. The mezzanine financing proved to be a much more straightforward structure, since its very nature was ideally suited to a refinancing via a type of investment partnership contract known as a musharaka – the same type of contract used in the PCFC sukuk. Thus, the two partners of this musharaka were the issuer (in other words the note holders or investors) who contributed cash of $400 million, and the company itself, which contributed capital worth $675 million in the form of equity. Job done.
As is typical in such investment partnership transactions, the company, EFC, acted as the managing partner entrusted to manage the joint venture capital in order to generate a profit according to an agreed business plan. Just like the PCFC sukuk, under the terms of a purchase undertaking, the assets in the partnership would be repurchased on maturity of the financing by the obligor – the company itself. Thus, just like the PCFC sukuk, investors in this tranche of financing were promising to buy back their investment at a pre-determined price. In time, Mufti Taqi Usmani would have something to say about this apparent breach of Sharia guidelines on true risk sharing, but for now it seemed to work, and Sheikh Hussain had no objections.
Given the enormous size of this acquisition, and the consequential need for multi-tranche financing, it was clear that conventional banks in the syndicate – particularly those participating only in the least risky senior tranche – would require the same protection of their position that they typically enjoyed in conventional transactions. They wouldn’t want to have the same loose protections as the more risky mezzanine financiers. In a conventional transaction, this would be solved relatively simply by the addition of an ‘intercreditor agreement’, that is, an agreement between financiers to give preference to those institutions who have invested in the senior tranche. Thus, in the event of a default by the company in repaying its obligations, all the various banks involved in the transaction would look to the intercreditor agreement and be repaid in order of their risk preference: senior creditors first, mezzanine next, and equity shareholders last.
Unfortunately this was not so straightforward. In Sharia, capital providers in a venture may not enjoy economically preferential terms over any other investor, since to do so might encourage the rich and powerful to exploit the poor and weak. In this case, the need to balance the requirements of conventional banks with the Sharia was overcome by the use of a Sharia-compliant intercreditor agreement, the first of its kind in acquisition financing.
The solution was mutuality. Mutual insurance companies have operated in the West for over 300 years, though their ancient ancestors may have been the public institutions established by men like Umar ibn al-Khattab, the second caliph after the Prophet’s death. Today, takaful insurance companies – the Sharia-compliant equivalent of conventional insurance companies – may operate by pooling the funds of policyholders on a mutual basis, with each policyholder ‘guaranteeing’ the financial wellbeing of fellow policyholders in the event of a calamity.
The intercreditor agreement in this case worked on a similar premise, the resulting document balancing the needs of senior versus mezzanine finance providers, and conventional bridge finance providers versus refinanced Islamic tranches. Junior capital providers mutually guaranteed the payment of senior providers in certain circumstances by promising to give up payment in those circumstances, a radically new and proprietary technique for an Islamic financing.
The EFC deal had been an immense effort, and a vindication of the Samadiites’ skunk works approach. It remains the largest Islamic buy out ever conducted, and bigger even than the biggest conventional buy out in the Middle East. And yet, despite the success of the transaction, as the deal approached its closing stages, a deal-weary senior executive at Abraaj Capital called me to express his concern over the Sharia requirements of the fund that he had set up alongside the bankers from Deutsche.
‘We’ve been having a think internally’, he told me. ‘We’re wondering if we can make this a “best efforts” Sharia fund. It’s just unnecessarily complex to do these acquisitions under the fund, and we don’t think the additional Islamic liquidity justifies the effort.’
It seems he was telling me he wanted to be half pregnant. Either he was or he wasn’t, I advised. The investors in the fund have already put their money in. If he returned to them now and said we tried to do deals on a Sharia-compliant basis but it was just too hard and we had gone conventional instead, how would they respond? Quite apart from the reputational impact of a ‘best efforts’ fund, there might have been the very real possibility of legal action by investors who thought they were buying a permissible (halal) product.
Islamic finance had proven more alien than he and his colleagues had at first imagined. This need to find a real asset and share in its risk was not an easy way to make money. Trading of debt, of cash flows, was so much easier: lend a buck, make a few cents – a paper trade. A financial transaction, not a real economy one. It doesn’t matter what comes in between.
In the end, Abraaj relented and realized that as such financings would become commonplace as the region’s economy continued to grow, understanding of Sharia structures and processes would become an essential ingredient to success. After the pain of this transaction they would be well on their way to that understanding and would find each successive deal easier to close. Without the will to overcome the constraints set by law, by regulators and by tax authorities within a Sharia framework, and without the technical skill set to execute, such deals will falter.
Investors were becoming increasingly aware that they could now invest in all sorts of assets on a Sharia-compliant basis, and many would no longer be willing to accept excuses that a deal could not be closed because of Sharia constraints. As Sheikh Hussain often said, ‘For every one door in Sharia that closes, a hundred others will open.’ Financing an asset conventionally now meant that issuers and borrowers could potentially close the door on a massive demographic constituency, and thus possibly deny themselves the opportunity to realize the maximum value of their assets. No deal was now too sophisticated for Islamic finance. You just needed to work a little harder at it.
* * *
Commercial tensions surface regularly in the Islamic finance industry, more so than in conventional transactions. After all, participants are consciously attempting to balance commercial needs with an ethical outlook. And since the ethical basis of Islamic finance does not exist in a readily codified form, it can be frustrating for those unused to this new form of financing. Often conventional bankers perceive Islamic finance as nebulous and shape shifting, impossible to tie down to a simple set of rules, as well as likely to result in diminished returns.
The issue of balancing ethics with the pursuit of profit is not confined to Islamic finance alone. In December 2013, an investigative journalist from the BBC uncovered an unpleasant consequence of giving to charity in the UK: some of the country’s leading charitable organizations, including Comic Relief and Save the Children, invest their surplus funds in companies whose activities might not accord with the sentiments of donors.2 Comic Relief, for example, holds tens of millions of pounds at any one time, and invests those funds in companies across the asset spectrum including arms manufacturers, tobacco and alcohol companies. The charity claims that those funds ‘deliver the greatest benefits to the most vulnerable people’ – including those fighting tuberculosis caused by tobacco – and has a mission statement to ‘[work] to reduce alcohol misuse and minimise alcohol related harm’.3 Is that what donors would want, the pursuit of profit at all costs?
And was it right that at a time when the public is especially mindful of the impact of high energy prices on the weak and vulnerable, that such a prominent charity as Save the Children had censored criticism of energy firms who acted as corporate partners to the charity? Save the Children’s fuel poverty campaign had run for only one winter, one former senior executive claiming that his efforts to highlight the issue of rising energy prices having been quashed internally. One multinational energy firm had been singled out for praise in that campaign – on account of its corporate relationship with Save the Children – and subsequent internal emails revealed that the charity was pitching to become a charity partner to yet another multinational energy supplier.4 Not only would impoverished families be denied a champion for their cause, but justice and ethics had also become victims.
In much the same way, the Church of England had come in for recent criticism following the Archbishop of Canterbury’s public condemnation of high street ‘payday’ lenders – charging vulnerable borrowers usurious rates – only to discover that his own Church endowment funds were an investor in the controversial UK payday lender, Wonga.5 There was a delicious irony in the thought that if the Church had appointed a Sharia-compliant asset manager, it might not have been so embarrassingly exposed. That’s not to say the Islamic community is immune from such a faux pas: my local mosque’s endowment fund has unwittingly become the landlord to a convenience store selling liquor. It’s not easy to keep such a dirty little secret for long, and clamours by the local Muslim community to divest may eventually force the mosque to offload the property in a depressed real estate market.
The argument put forward by proponents of such investment policies is that an organization acting in the interests of others – whether they are shareholders or charity recipients – must invest with a view to generating the highest possible returns. In many cases, there is an unquestioned assumption that introducing ethical parameters will automatically diminish those returns. However, events of the last several years have revealed that ethical funds – including Islamic ones – have tended to avoid those types of investment that were excessively risky, highly indebted, or participated in activities whose ethics were dubious. The financial services sector is an excellent example: the sector’s exposure to intangible and exotic derivative instruments that brought down the world’s economy has meant that conventional funds severely underperformed ethical funds that avoided financial stocks or companies with large debt burdens or heavy exposures to derivative contracts. Islamic funds have therefore done remarkably well by comparison to their conventional peers in recent years.
The bare facts themselves may not be enough to convince the decision makers. It took a confluence of factors – not least of which was the geographic proximity and close friendships of the Samadiites – to ensure a successful acquisition of Egyptian Fertilizers Company. As the largest and most complex Islamic financing of its time, it may not have happened had the Islamic skunk works specialists at Deutsche not carved their own path. The financing of the Dubai government’s purchase of P&O had been a similar trial in many ways. But now, slowly, the conventional banking industry was becoming familiar with the role that Islamic finance could play in executing the biggest and most complex deals, adding extra liquidity to the market, bringing a new breed of investor to the table. And as more deals would come to market, the standards applied to those deals would tighten, and conventional bankers and clients would grow even more frustrated that the framework of Islamic finance wouldn’t stand still long enough for them to understand it fully.
This was particularly apparent in the raising of a sukuk by the Malaysian government in 2010. The sukuk industry had been left reeling after Mufti Taqi Usmani’s now infamous comments to the Reuters reporter in 2008 that most sukuk at the time were not compliant with Sharia. Since those comments, sukuk issuances had been sporadic and cautious, a slowdown further exacerbated by the downturn in the global economy.
But in 2010 the Malaysian government invited banks to raise US$1 billion of financing on its behalf in the Islamic capital markets, the kind of deal size that warrants the description of ‘benchmark’. In the post-2008 era of increased scrutiny from Sharia scholars, the lucky banks and law firms selected to raise funding for the state were acutely aware of the need to set a higher standard for this transaction than had been observed in earlier sukuk transactions. Whereas treasury officials insisted on replicating contractual documentation from previous Malaysian sovereign sukuk and the more recent Republic of Indonesia sukuk, the assembled bankers and lawyers – many of them Samadiites – suggested that in such a case their scholars would struggle to sign off on the deal.
The asset structure had already been decided – that is, the underlying real economy transaction that would underpin the financial one. Government officials and their bankers selected a portfolio of twelve government-owned hospitals as the assets that would form the basis of the sale and leaseback. The assets were, of course, engaged in a Sharia-compliant activity and had no conventional debt or other encumbrances associated with them. They would be placed in trust on behalf of sukuk holders and leased back to the government for the duration of the sukuk, following which ownership would revert to the government.
The big-picture structure had been approved, relevant governmental approvals granted to transfer the assets and issue the bond, contracts were drawn up, and the banks’ syndicate desks, manned by armies of salesmen and -women champing at the bit, waited on standby to sell the securities to investors. So far, so good.
As the deal approached its closing stages, the bankers from HSBC, Barclays and CIMB arrived in the tropically leafy town of Putrajaya at the government offices just south of Kuala Lumpur. They were here to deliver bad news to their counterparts across the table from the Malaysian Ministry of Finance. The scholars were not willing to provide their fatwa, or legal certification, on this transaction: the adherence of this deal to Sharia was not of a sufficiently high standard.
In transactions of earlier years, scholars had tended to look at the overall structure of a deal, checking off the big-picture Sharia requirements rather than wading through 1,000 pages of dense contractual language and commenting on each and every applicable clause. But times were changing. Mufti Taqi Usmani had inspired a new approach. A worldwide insistence from both investors and scholars on increased Sharia scrutiny meant that no scholar could afford to be seen to be the one who let riba, gharar and other prohibitions slip through his net, no matter how tiny the infringement. In previous sukuk transactions, the scholars, lawyers and bankers had simply not devoted as much attention to ensuring that the tiniest of details in the contractual documentation had been thought through.
Seated at the boardroom table in the Ministry of Finance, the government treasury solicitor and her team of finance and legal specialists blinked disbelievingly and looked at each other. They didn’t quite understand what they were hearing from the gentlemen from HSBC and Barclays. The weekend was approaching and volatility of debt capital markets meant the client was in no mood to delay this any further. This deal had to be launched to investors right now, before market conditions turned against them.
Then the tone of the meeting turned nasty. To the head of the treasury team, it sounded like the banks were saying ‘thanks for playing, game over’. Any reticence of the banks to go through with this would probably irreparably damage their chances of being offered a government mandate again. Any delay would seriously hamper their chances of winning any mandates in the near future. It was a sobering thought: HSBC, the pioneer of global Islamic banking for the masses, denied entry to one of Islamic banking’s biggest markets. Not for the first time, ever-tightening standards of Sharia were causing some to question whether raising Islamic capital was really worth the effort.
To make matters worse, the government’s own legal and Sharia advisors were not themselves seasoned Islamic capital markets veterans, and could not advise their client on the reasonableness of the banks’ request to rewrite the deal docs. To the civil servants seated on one side of the table, this seemed like an attempt to delay the transaction for reasons that weren’t clear. They turned to their advisors, a partner from the English law firm Allen and Overy, and their in-house Sharia advisors, who merely shrugged their shoulders pathetically: the law partner was not familiar with matters of Sharia, and the Sharia advisors knew little of international capital markets nor – evidently – current Sharia standards.
‘What are the scholars objecting to?’ asked the head of the treasury team, bristling at the suggestion that a Malaysian sukuk could not be Sharia compliant. They were, after all, a predominantly Muslim country, their government a pioneer of the industry. How dare these peddlers of usury tell them they weren’t Islamic enough.
‘Are you telling us the last sukuk we did was not Sharia compliant?’ She turned her head towards her own Sharia advisors who stared vacantly across the table, desperately trying to avoid eye contact with the bankers who seemed to know more about their subject than they did.
For perhaps the first time on a South-East Asian sukuk, the banks and the scholars were taking a belts-and-braces approach to certifying the transaction. They would leave no stone unturned and no clause in the documentation unexplored. Their objections were to individual clauses, the impact of which would only be felt in exceptional circumstances, and therefore had tended to be glossed over in past deals.
What happens, for example, if for whatever reason it became illegal for a non-governmental entity (like the sukuk investors’ special purpose vehicle) to own government-run hospitals? Let’s imagine the government were to pass legislation independently of this transaction that public sector assets, or assets of a specific nature that included hospitals, could not be owned or leased by a private sector entity. The solution in previous sukuk contracts – enshrined in the so-called ‘illegality clause’ – was for the government to continue to pay the rental amount to sukuk holders. Surely investors would not have a problem with this? After all, they would be paid even though they no longer own the asset.
At that point, the whole deal becomes null and void, argued the bankers on advice from their scholars. Even if the government is prepared to continue to pay the bond coupons, this would be classified in Sharia as an ‘unjust enrichment’: the trading of cash flow, not a real asset. Money for nothing, in other words. The Sharia insisted that there had to be an underlying reason for the payment – an asset legally owned by the lessor with true usufruct for the lessee (from the Latin usus et fructus – usage and enjoyment). If the assets are no longer owned and used by the SPV, then the SPV has no basis to charge a rent against them, and the transaction must be wound up instead.
‘But why should we not pay rent if we agree to pay and investors agree to receive payment?’ argued the exasperated treasury officials.
‘This goes to the heart of Islamic finance’, answered the Samadi banker from HSBC. ‘Without an underlying asset, there is no sukuk al-ijara [rental-based sukuk]. If we agree to the language which has been in place on countless previous transactions, our scholars will not sign off, and you will not have the Islamic distribution you were looking for.’
The banker from Barclays, also a Samadiite, concurred. ‘Sure, we can sell this to our conventional investor base, but without the changes requested, we don’t get the fatwa and we don’t have a sukuk. We have a bond. And the investors will not be the people you are looking to attract.’
The Malaysian treasury team refused to back down and the bankers furiously texted and emailed their scholars – amongst them Sheikh Nizam Yaquby – thousands of miles away in the Gulf to seek a compromise. The scholars would not budge. This is a new era, they said firmly. If companies and governments do not want to conform to the rules of Sharia, they are free to issue conventional bonds. Our job is not to acquiesce to commercial pressures. Our job is to see that Sharia is upheld.
And though the industry had been criticized for the acquiescence of scholars in the past, and the inherent conflict generated when scholars are paid by the institutions who seek their approval, finally Taqi Usmani’s message was getting through. Maybe his services might also have benefited the rating agencies, the organizations paid by banks to approve nonsense ratings on the banks’ complex investment products, which ultimately precipitated the global financial crisis.
With no choice left and the weekend almost upon them, the unhappy treasury boss shook her head and approved the changes. Perhaps inwardly she felt that her own advisors had not fought her corner hard enough, though perhaps she also felt that they just weren’t in the game. The all important fatwa was issued, and banks’ syndicate teams sprang into action, placing the sukuk with investors across the world.
So strong was the oversubscription that the Ministry of Finance opted to increase the original size of the placement to $1.25 billion, the biggest ever dollar-denominated sovereign sukuk, and so strong was it a template for future deals that the sukuk was named deal of the year by two industry journals.6 Perhaps, just perhaps, investors really did care about the standards of Sharia applied to Islamic finance.
* * *
The murky world of ‘alternative investments’ and hedge funds seems apparently far removed from Islamic notions of transparency and fair profit. Notorious for their aggressive trading strategies, and perhaps unkindly maligned by those who believe them to profit out of volatility and others’ misery, hedge funds have been described by one prominent German politician as ‘swarms of locusts’,7 voraciously devouring all in their path in the quest to make profit for their elite investors. If greed is good, then hedge funds are presumably the best.
Their purpose is a simple one: to make returns that are hedged against market volatility. In other words, to give investors a stable return, or an ‘absolute return’ – one that remains relatively constant (and positive) even in turbulent times. But over the years, hedge fund managers have discovered increasingly exotic ways to invest, employing complex and arcane methods to boost their investors’ returns. Not content with merely going long (buying shares) and shorting (selling shares they borrow but do not own) to balance their portfolios, they now engage in the trading of convertible bonds, derivatives and other exotic instruments. Some hedge funds specialize in so-called ‘event driven’ opportunities, effectively taking a punt on a certain event occuring, such as a merger of two companies or the default of a nation’s debt obligations.
As rich investors with the means to invest in their funds have gravitated away from the traditional asset manager – the ‘long only’ manager whose job is typically to manage a portfolio of shares over decades of steady growth – the size of hedge funds has grown and so has their influence. Now, the stock price of large corporations can be heavily influenced by one trade by a large hedge fund, leading many to question whether more should be done to rein in their power.
Trading of such an aggressive nature – profit being apparently the sole motivator – would seem incongruous in the context of Islamic finance. Do Islamic investors want absolute returns generated by this kind of fund manager? According to one hedge fund advisor, the answer was yes.
In 2007, just before that previously staid British investment bank Barclays Capital was starting to make waves in international waters by closing the net on failed US bulge bracket firm Lehman Brothers, Barclays was approached by a little known US hedge fund advisory firm based in Connecticut to provide a brokerage service – known in the hedge fund industry as prime brokerage – on a Sharia-compliant basis.
‘What would we need to do that for?’ asked the prime brokers. ‘What’s the value add for our business?’ The answer from the hedge fund advisor Shariah Capital was a brand new customer, one who had previously had zero access to absolute return strategies through ‘long/short’ hedge funds – funds that simultaneously buy some equities in the form of publicly traded shares and hedge their position by selling others that they borrow from the market. A new product, a new class of investor, never previously accessed in this manner: 100 per cent market share of the Islamic hedge fund market.
Shariah Capital had gigantic ambitions: to become the first universally accepted Sharia-compliant hedge fund manager; to raise US$1.5 billion from Barclays’ investor base in the Middle East and elsewhere; and to source the very best hedge fund managers through Barclays’ prime brokerage relationships in order to make use of the proprietary methods they had pioneered.
Although Shariah Capital’s ambitious plans were driven by a brash US management keen to bring their uniquely American style to the Islamic finance industry, the intellectual driving force behind this proprietary Sharia-compliant shorting method – selling stock that one does not own – was Shariah Capital’s rather more phlegmatic chief Sharia officer, Sheikh Yusuf Talal DeLorenzo.
Though conservative and unassuming by nature, Sheikh Yusuf had nevertheless previously been unreservedly vociferous in his condemnation of the conventional banking industry’s cynical manipulation of Islamic finance. His greatest ire was reserved for recent techniques adopted by bulge bracket firms to replicate conventional derivatives under the wrapper of Sharia compliance. It would be ironic that the product he would bring to the market a couple of years later was itself the subject of criticism from some quarters: the thought of maverick ‘hedgies’ punting their unique brand of aggressive trading strategies was anathema to many conservative Islamic banking specialists.
But that tired stereotypical description would not have been fair to Sheikh Yusuf, not by a long stretch of the imagination. A softly spoken and thoughtful man with a trim white beard, his gentle personality brought a much-needed balance to the fast-talking hedgie culture of Shariah Capital. A specialist in the jurisprudence of Islamic transactions, he had previously served as a Sharia advisor to dozens of firms before he came to the attention of Shariah Capital.
Unusually, they asked him to join their management team, a departure from the usual role that scholars fulfil within financial institutions. Typically scholars tend to sit on a number of independent Sharia boards, and act in concert with other scholars to vet and approve products for compliance with Sharia. But perhaps in this case, Shariah Capital had felt it necessary to capture the services of one of the US’s only internationally recognized advisors in the field, rather than fight other firms for a chunk of his time.
Born Anthony DeLorenzo, he was the grandson of half-Catholic, half-Methodist Sicilian immigrants to the US, but was raised in neither religion. Whilst a student at Cornell he elected to spend some time studying abroad and found himself in Casablanca reading the Quran, before moving on to Cairo and Karachi. His conversion to Islam was cemented by a change of name and marriage to a Pakistani.
During his thirty-year career, Sheikh Yusuf served as an advisor on Islamic education to the Pakistani president in the early 1980s, working at the time with the eminent scholar Sheikh Hussain Hamed Hassan, and later published A Compendium of Legal Opinions on the Operations of Islamic Banks,8 the first English/Arabic reference work on the fatwas issued by Sharia boards. As the number of advisory roles with financial institutions grew, a hedge fund manager in Greenwich, Connecticut, came knocking on his door, looking to create a Sharia-compliant hedge fund.
Despite an underlying unease in the Islamic finance industry at the thought of Islamicizing an ‘advanced form of speculation’,9 Sheikh Yusuf kept an open mind. If Islamic finance was predicated on the prohibition of interest and uncertainty, and abhorred the creation of wealth through idleness or gambling, then was there an intrinsic harm in creating a financial instrument that generated absolute returns by hedging itself in a Sharia-compliant manner?
It took years of running back and forth between London and New York for Sheikh Yusuf to crack the code with fellow scholars, and draw up a set of workable prime brokerage documents with Barclays Capital. In what would become a radical breakthrough for the industry, he settled on a type of contract in Sharia known as the arbun as a viable basis for replicating the economics of a short sale, the fundamental trading strategy necessary to balance a stock portfolio in the simpler hedge funds.
In 2008, Sheikh Yusuf published his white paper ‘The Arboon Sale: A Shariah Compliant Alternative to Selling Short with Borrowed Securities’. In it, he reasoned that there was unanimity of agreement amongst scholars on the impermissibility of the sale of borrowed shares and, as a result, in Sharia the seller must first establish ownership of the subject of the sale. One cannot sell what one does not own.
He suggested that it was a mistake to assume that hedge funds could never become Sharia compliant, but criticized the use of ‘artificial solutions’ aimed at circumventing Sharia by ‘swapping’ returns from hedge funds, a clear dig at a recent technique developed by Deutsche Bank to replicate synthetically any economic effect, no matter how impermissible the underlying asset. The architect of Deutsche Bank’s derivative products was none other than Sheikh Hussain Hamed Hassan, a one-time colleague of Sheikh Yusuf, and so the seeds of a scholarly spat were sown: my method is more Sharia compliant than yours.
Sheikh Yusuf was not alone in this opinion. A long-time critic of what he called ‘Sharia arbitrage’ techniques – that is, the provision of products whose exorbitant cost is justified by an apparent adherence to religious guidelines – fellow US scholar Mahmoud El-Gamal had previously likened Islamic finance to an elaborate con, preying on people’s religious insecurities. ‘Don’t take my duck, sprinkle holy water on it, and say it’s a chicken’, he told The Wall Street Journal.10 Perhaps Professor El-Gamal would have been equally critical of Shariah Capital’s efforts in the field, in spite of Sheikh Yusuf’s involvement.
So what is an arbun? In a conventional sense, it’s like an ‘option’, a type of financial instrument that gives the buyer the right – but not the obligation – to buy an asset. So a share option is the right to buy a share for a particular value in the future. An investor might buy an option for shares in Microsoft instead of the shares themselves (called the ‘underlying’). The price of the option would be much less than the price of the share itself. This price is called the premium, and its value is dependent on the likelihood of the underlying asset – in this case Microsoft shares – passing a predetermined ‘strike price’. If the share price of Microsoft fails to pass the strike price, the option is worthless and the investor has wasted his premium, a bit like losing his deposit on goods he has decided not to purchase outright. If Microsoft rises in value, the investor cashes in his option and reaps the difference between the actual market price of the shares and the strike price (minus, of course, the premium he has already paid). So it is a way for investors to ‘gear up’ their returns for a small outlay.
In classical Islamic jurisprudence, the arbun contract was a downpayment by a buyer towards the purchase of an item from a seller. So, a bit like a modern financial option: if the buyer opted to complete the sale, the arbun would count towards the total purchase price; if the buyer didn’t complete, he would forfeit his deposit.
Sheikh Yusuf’s white paper went on to refer to the 1993 ruling by the Fiqh Academy on the arbun contract, as well as classical narrations, as evidence of the arbun’s suitability for the purchase of shares.11 Shariah Capital, like Deutsche Bank before them, opted to reveal its proprietary methodology to the market, though of course for any competitor to implement a similar Sharia-compliant prime brokerage platform would not be trivial, requiring a significant allocation of time and resources. Let’s use Sheikh Yusuf’s own worked example to understand how the arbun is used to enable a prime broker to short sell a stock.12 It’s a little involved but it’s also an insight into how Sharia scholars and structurers find ingenious solutions to conventional problems.
Imagine a long/short hedge fund analyses the performance of a company, ABC, and concludes that its stock price is likely to fall within the next sixty days. The parties to this trade are the hedge fund trader and his prime broker; a first seller looking to divest its shares in ABC; a buyer or investor willing to buy shares of ABC at the market price; and a second seller willing to sell shares of ABC at market price in sixty days. Now imagine the share price of ABC on day one is $10. Let’s assume the hedge fund trader decides to buy ten shares of ABC under certain conditions of sale: he makes a downpayment to the first seller of $10 through the prime broker and the first seller delivers all ten shares. If the hedge fund trader happens to sell the stock within sixty days, the first seller gets to keep the original $10 downpayment and the hedge fund will pay him in kind for the remaining nine shares that are owed to him. If the hedge fund trader does not sell the stock in sixty days, then the first seller will keep the downpayment and the hedge fund will return all ten shares. This sale can be documented as an arbun.
Immediately after the purchase by the hedge fund, the hedge fund trader negotiates a sale with a buyer through the prime broker. The conditions of the sale are cash for immediate delivery of ten shares at $10 per share. The trader receives $100 and delivers ten shares to the buyer. The trader’s current position shows he has $90 in cash ($100 from the sale minus $10 in downpayment to the first seller), and owes the first seller nine replacement shares.
Now let’s go to day sixty. The hedge fund trader buys nine replacement shares from a second seller in the market (via the prime broker). The stock price has fallen to $9 per share as the trader had predicted, and he pays $81 to the second seller. He delivers nine shares of ABC to the first seller as per the terms of the original sale agreement. The first seller has now received the original $10 downpayment and has nine shares of ABC. The hedge fund trader now has $9 net in cash (the previous balance of $90 minus the $81 he just paid for replacement shares to the first seller) and no shares. Thus, as a result of the fall in share price, he made a small profit without selling stock that he did not himself own. Conversely, if the share price had risen against his original prediction, he would be out of pocket by a similar magnitude.
We have just replicated a short trade but we didn’t sell something we didn’t own. Is it unethical, or contrary to the spirit of the Sharia, to employ Sharia-compliant contracts to replicate the effect of shorting? Are critics of Islamic finance right in thinking there can be no such thing as an Islamic hedge fund? Even in developed Western markets, in recent years there has been a clamour from politicians to outlaw so-called ‘naked shorting’ of the market – that is selling a security one does not own, without first borrowing the security or ensuring that it can be borrowed before it is due to be delivered to the buyer. Indeed, the Securities and Exchange Commission (SEC), the federal agency responsible for regulating the US securities industry and US exchanges, enacted a new ruling in September 2008 immediately after the collapse of Lehman Brothers and Bear Stearns, as well as the government bailout of insurance company AIG. The ruling banned the practice of naked short selling, thus mitigating the possibility of market participants driving down the price of a company’s stock. The US was not alone in this action.
Free market advocates contend that short selling brings much needed liquidity to the securities markets. Just as liquidity is important when share prices are rising so that a true and fair share price is reached as quickly as possible in the market, there is a powerful argument that share prices should also reach equilibrium as quickly as possible on the way down, and short selling is the oil that lubricates those downward price movements – an aid to price discovery and a natural brake on overvaluation of share prices. Even the more extreme practice of naked short selling – short selling without borrowing the security – has its advocates (though few) since the practice can be beneficial in enhancing liquidity in shares that are difficult to borrow. However, critics often point to the usage of naked shorting in market manipulation, damaging companies and threatening markets that are broader than merely the company whose stock is being manipulated. After all, one can sell an unlimited amount of shares if one doesn’t need to borrow them.
I don’t know about you, but I’m starting to feel a little uneasy. Hedge funds that short stock are notorious for driving down the price of those securities until companies are bled to death. As much as free market advocates may defend the practice of shorting as contributing to efficient markets, there must have been an underlying moral principle against Islam’s ban on selling something that one doesn’t own.
Sheikh Yusuf recognized these concerns in his white paper and addressed them. ‘In a garden’, he wrote, ‘a hedge is used to protect flowers from the feet of people walking by.’ Hedge funds are designed to protect investors’ capital against volatility, not to make wild speculative gambles, he suggested. The funds that his colleagues would be sourcing for this Sharia-compliant platform would be ‘risk averse and profitable’,13 and indeed some of the most respected hedge fund managers had opted to join the platform. He went on to refute the suggestion that hedge funds intrinsically engage in speculative behaviour. ‘All business is based on a degree of speculation because no one, other than the Almighty, knows the future.’ Risk and reward are linked and need balance, and the prohibition against uncertainty is not intended to dissuade the merchant from seeking reward. The scholar differentiated between ‘undisciplined and uncontrolled speculation’ and the kind of detailed analysis employing sophisticated tools that hedge funds engaged in to balance risk and reward.
And what of short selling? Given that Muslims believe there to be an inherent wisdom in the prohibition against selling that which one does not own, how can one justify a technique that mirrors the same effect? Sheikh Yusuf argued that selling a stock in the expectation that its price will fall was morally little different to buying it in the expectation its price will rise, providing one does not breach the Sharia requirement on ownership. Indeed, he suggested, short selling has, historically, often been a trading strategy employed on heavily overvalued securities, thus providing a much needed balance and integrity to markets.
Shariah Capital was now in business.
But the timing was horrendous. It took a year of complex structuring and negotiation between the Sharia advisors and the prime brokers to establish the platform. Shortly after the green light had been given to raise funds for the platform, Wall Street stalwart Bear Stearns collapsed under the weight of its exposure to mortgage-backed securities, and vultures circled Lehman Brothers, the US’s fourth largest investment bank, as it desperately negotiated a rescue deal. A few months later, a wealth manager named Bernard Madoff was arrested on charges of defrauding investors of $65 billion in the largest fraudulent pyramid scheme ever uncovered. The Wall Street Journal described his Ponzi scheme as contributing to ‘a national crisis of confidence and distrust of the financial system’.14 In the melee of meltdowns across asset classes, hedge funds around the world made enormous losses and hedge fund investors gripped their wallets tightly. Shariah Capital was able to raise only $200 million from the Dubai government instead of the $1.5 billion it had hoped for, and the Islamic finance industry was forced to admit that the time to introduce such an ultra-sophisticated investment product had long since faded.