Chapter 15
Sharia-Compliant Project Financing
Muslims, or followers of Islam, comprise more than one quarter of the world's population, and Muslim countries produce more than 10 percent of the world's gross domestic product. Because Muslims represent a very important and growing segment of the world economy, Islamic finance represents an increasingly important segment of the world financial landscape. Islamic finance differs from Western finance in several fundamental ways. In particular, Islamic finance transactions and financial instruments must be structured so as to comply with the religious principles of Sharia. Sharia refers to the body of religious laws and principles that guide every aspect of a Muslim's life, including participation in financial transactions.1 This chapter describes how Sharia shapes Islamic financial products and transactions.
Islamic finance seems to have grown significantly within the past decade. It has become a major component of the global financial system. The Islamic finance market, based on assets considered Sharia-compliant, is in excess of $1 trillion as of 2011. Figure 15.1 provides a breakdown of these assets. The market has been growing at an average annual rate of about 20 percent per year since 2006.2 Islamic banks, which conduct billions of dollars of transactions each day, were affected by the recent financial crisis but weathered it better than many Western financial institutions because Sharia prohibits speculative investments, and Islamic financial institutions generally tightly limit their exposure to derivatives.3 They were not as exposed as many of the conventional banks to the toxic derivatives that caused large losses. However, they have a preference for transactions backed by physical assets, such as real estate, and consequently suffered losses along with other real estate investors when real estate assets fell in value during the recent crisis.
Figure 15.1 Breakdown of $1 Trillion of Sharia-Compliant Assets Worldwide, 2010
Source: April 11, 2011 Presentation by Emad Y. Almonayea, Vice Chairman, Managing Director, and Chief Executive Officer of the Liquidity Management House for Investment, Kuwait Finance House Group. Information obtained from central banks, Islamic Financial Services Board, Zawya, and KFHR.
Islamic finance is well suited to project financing because it is structured around physical assets. There are challenges in designing the financing structure both to comply with Sharia principles and to fit the risk-return characteristics of the project, which require creative legal and financial engineering. Islamic countries have a very substantial need for infrastructure investment to support their rapid economic growth. These countries also have large pools of wealth that are seeking profitable investment opportunities. Project financing opportunities abound, and I expect that Islamic project finance will play an increasingly important role in furthering the economic development of these countries.
Islamic finance is likely to keep growing as the Muslim population expands and its wealth grows. The basic techniques of Islamic finance will become more standardized as the industry develops, which will enhance its development. As the Islamic finance market grows, Western financial institutions will increasingly open “Islamic finance windows” to participate in the market's growth. Their participation will bring additional capital and stimulate financial innovation. In addition, various organizations, such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), are working to promote the growth of the industry by trying to achieve agreement on transaction structuring criteria and product standards.
This chapter explains how the basic Sharia principles affect Islamic financing transactions and financial instruments, describes the main Sharia-compliant debt and equity transaction structures, and discusses the application of Sharia-compliant Islamic financing to finance large capital investment projects, including project finance. It also explains how Sharia-compliant financing differs from traditional Western financing techniques and product structures and illustrates how it can be tailored to finance large projects in Islamic regions of the world where this form of financing must conform to strict religious principles. Project finance engineers need to be aware of the special conventions and restrictions that apply in Islamic finance in order to be in a position to tap this source of funding for their projects.
What Is Islamic Finance?
Islamic finance refers to all financial activity in which Muslims engage. Islamic finance involves using traditional financial and investment techniques and structures that have been tailored to comply with Sharia principles. Sharia refers to the entire body of rules that govern the life of a Muslim.4 It is a body of religious law, which is based primarily on the deeds and writings of the prophet Mohammed and which secondarily can also be interpreted by skilled Sharia religious scholars. Their interpretations of Sharia are crucial in determining which structures and techniques comply with Sharia and are therefore permitted in the Muslim world (and which are not permitted).
Religious and Legal Basis for Islamic Finance
Islam has no central governing authority. Likewise, Sharia is not based on the law of any particular political jurisdiction. Instead, it is universal law, which is then applied to national law. There is consensus on many rules of Sharia law, which are recognized the world over. But interpretations of Sharia can differ along philosophical lines. For example, there are more liberal interpretations (and also more conservative interpretations) of what transaction structures will comply with Sharia. The resulting lack of international consensus presents an important challenge to the developers of Islamic financing strategies and instruments. However, it is important to note that there is a desire to harmonize the interpretations of Sharia to achieve consistency.
Sharia has four basic sources, which form the foundation for Islamic finance. The two primary sources are the Quran, which Muslims believe is the word of God as transmitted to the prophet Mohammed, and the Sunna, which are the recorded sayings and deeds of the prophet Mohammed. These primary sources of Sharia provide the basic framework for the life of a Muslim. There are also two derived sources of Sharia, Ijma (consensus) and Qiyas (analogy), through which Muslim scholars derive Sharia principles based on the Quran and the Sunna. Ijma, or scholarly consensus, requires the agreement of Muslim religious scholars as the basis for legal decisions that can be derived from the two primary sources. Second, Muslim religious scholars use Qiyas, or legal analogy, to derive rulings, again based on the two primary sources, on new matters that fall outside the scope of Ijma. For example, the Quran prohibits alcohol because it causes intoxication; by analogy, recreational drugs have also been deemed impermissible for the same reason.
Financial institutions that have an Islamic finance practice retain a religious board composed of Islamic scholars, which are commonly referred to as a Sharia committee. This committee guides the financial institution in structuring Sharia-compliant transactions and designing Sharia-compliant securities. For example, the committee will examine a proposed transaction for compliance with Sharia. If it approves the transaction, the Sharia committee will issue its opinion, which is really a religious legal ruling called a fatwa, approving the transaction. The committee also typically reviews the financial institution's overall activities and furnishes guidance concerning how it should conduct its operations so as to remain Sharia-compliant.
Key Principles of Sharia
Islamic finance is guided by the five fundamental principles of Sharia. These fundamental principles are typically characterized with respect to the basic financial structures, financial instruments, and financial practices they prohibit and those they do allow. This characterization is probably the result of the emergence of Islamic finance in a world financial system that already has myriad financial structures already in place and well developed markets and financial practices that are in use every day. In such a world, two questions naturally arise: Which of the existing structures and techniques are permissible under Sharia, and of those that are not permissible, how, if at all, can any of them be reengineered to become Sharia-compliant? Put simply, financial market participants will ask Sharia scholars what they can and cannot do within the existing system so as not to run afoul of Islamic law.
If there is a unifying theme in Islamic law as it applies to financial transactions, it is that Islamic finance should emphasize real productive transactions and eschew purely monetary or speculative activities. This theme underlies the five fundamental principles that prohibit:
Riba (unjust enrichment). This is arguably the best-known prohibition and is popularly known as the prohibition against the payment of interest. Sharia regards money as simply a medium of exchange and a unit of measurement and not as a store of value. It views interest as an improper payment for the use of money. In contrast, profit is the reward for someone who takes on the risks of ownership of a productive asset. Money cannot be made the centerpiece of a transaction. Accordingly, a loan is not permitted because it is viewed as a lease of money in exchange for interest. Masir (gambling or speculation). Islamic law prohibits transactions based on pure chance or excessive speculation, rather than on productive activity. It declares gambling unacceptable because it can lead to an immoral compulsion to gamble or to a social evil like poverty. Masir does not prevent normal commercial risk-taking. In fact, commercial risk-taking is a key aspect of almost every Islamic financial transaction. Gharar (unnecessary risk). Sharia prohibits uncertainty in contracts; all the basic terms of the contract must be absolutely certain when the contract is signed to avoid unnecessary risk. For example, Sharia forbids the sale of a building prior to its construction because of the uncertainty as to its existence at the time the contract is signed. The sale would be legal once ground has been broken because the uncertainty regarding the commencement of construction has been resolved. Jahl (unfair advantage). Islamic law forbids one party to a transaction from exploiting, or taking unfair advantage of, the other party to the transaction. For example, one party should not exploit the other party's lack of knowledge about critical factors associated with a proposed transaction. As a second example, if one party is experiencing financial distress, then the other party should not exploit that situation to the counterparty's detriment. Instead, the two parties should seek a resolution that is equitable to both parties. Rishwah (corruption). The purpose as well as the structure of a transaction must comport with Sharia. In particular, the transaction must not have an unethical or corrupt purpose. For example, Sharia-compliant investors may not invest in companies that operate casinos (since masir is forbidden) or conventional banks (since riba is forbidden) or distribute products such as alcohol, tobacco, or pork products that are prohibited according to Islamic religious practice.Islamic Financial Instruments
Islamic financial instruments can be issued to raise funds for a project, such as an infrastructure project in a Muslim country where the financing must be Sharia-compliant. To date, the development of Islamic financial instruments has focused on designing structures that are similar to conventional Western financial instruments but with the Sharia-forbidden features replaced. Table 15.1 indicates that $43.8 billion equivalent of Islamic financing took place in the global capital market in 2011 and identifies the financial firms that were the lead managing underwriters. These firms, which include large Western financial institutions as well as Islamic financial institutions, played a leading role in designing the financing structures.
Table 15.1 Total Islamic Financing Lead Managing Underwriters, 2011 (Dollar Amounts in Millions)a.
a Includes both eligible Islamic bonds and Islamic loans.
b Based on equivalent dollar amount.
Source: Bloomberg, L.P.
Islamic financial instruments must be designed to comply with Sharia and approved by a Sharia committee. In most cases, the underlying financial technique relies on either an asset-based structure or a risk-sharing structure. Asset-based structures are similar to debt instruments and, most notably, leases because there is usually a transfer of an underlying physical asset involved. Risk-sharing structures are similar to equity instruments and, most notably, joint ventures or limited partnerships because there is a sharing of profits, losses, and risks involved. This section describes the typical debt-like and equity-like Islamic financial instruments and explains how they can be used as part of the project financing mix.
Debt-Like Instruments
The market for Islamic bonds is large and growing. Table 15.2 indicates that $36.7 billion equivalent of Islamic bonds were issued in the global capital market in 2011. Islamic financial institutions are the leading financing agents but Western financial institutions are trying to play a more active role.
Table 15.2 Islamic Bond Issue Lead Managing Underwriters, 2011 (Dollar Amounts in Millions).
a Based on equivalent dollar amount.
Source: Bloomberg, L.P.
Debt-like Islamic financial instruments are structured as fixed claims. They are designed around an asset-based structure. These structures include a transfer of one or more physical assets. The finance provider develops or acquires the asset(s) and then sells or leases the asset(s) to the customer (the party for whom the financing is arranged). Examples of such structures include morabaha, ijara, salam, istisna, and sukuk. These examples are described next.
Morabaha (purchase and sale). Morabaha transactions are structured as purchase-and-sale transactions. They are often used to provide short-term working capital financing, trade credit, or sometimes acquisition financing. An Islamic financial institution or another finance provider buys an asset, which a customer has previously selected. It then sells that asset to the customer for delivery at a later date at a higher price. The resale price equals the original purchase price plus a profit markup. The customer is often permitted to make installment payments. The profit markup is usually based on a market benchmark rate, such as one of the London interbank offer rates (LIBOR).5 Ijara (lease). An ijara contract is a lease. Ijara transactions are used to finance the purchase of a specific asset or pool of assets, often real estate. It can also be used to finance corporate acquisitions. An Islamic financial institution buys an asset and leases it to the customer in return for a regular series of lease payments. The lease rate, which is based on a market benchmark rate such as one of the LIBOR rates, is usually reviewed periodically during the lease term and adjusted, if appropriate. The lease rate incorporates the finance provider's profit. This profit is permitted because the financial institution owns the asset and therefore bears the risks of ownership. Salam (forward purchase). A salam contract is a forward purchase agreement. The financial institution pays its customer at the time it signs the contract for an asset that will be delivered on a specified future date. The purchase price is discounted typically based on a market benchmark rate, such as one of the LIBOR rates, because of the difference between the payment and delivery dates. Istisna (commissioned manufacture). Istisna contracts are similar to salam contracts except that the asset is custom manufactured, rather than available in the market. Istisna contracts are used to provide advance funding for construction or development projects. The finance provider agrees to buy an asset made by another party and commits to make a series of payments. These payments are often geared to specified milestones, such as project completion. Sukuk (undivided ownership share). Sukuk (singular sakk) represent an undivided ownership interest in an underlying asset or pool of assets that are owned by the sukuk issuer. They are loosely referred to as “sukuk bonds.” Indeed, they are often structured so that the economics of sukuk ownership are very similar to the economics of bond ownership. However, strictly speaking, sukuk are different from conventional bonds, which are contractual obligations to repay borrowed money with interest. They also differ from conventional equities, which are ownership interests in the securities issuer. Sukuk holders are entitled to receive a proportionate share of the returns generated by the underlying assets.Table 15.3 International Sukuk Lead Managing Underwriters, 2011 (Dollar Amounts in Millions).
Source: Bloomberg, L.P.
Figure 15.2 Geographical Breakdown of Global Sukuk Issues in 2011
Source: Zawya Sukuk Quarterly Bulletins 1Q2011–4Q2011.
Equity-Like Instruments
Equity-like Islamic financial instruments are structured as residual claims. They are based on a risk-sharing concept. These structures involve the assumption of commercial risk. The finance provider enters into a venture with the customer (the party for whom the financing is arranged), and they share in the profits and losses of the venture. Examples of such structures include modaraba and mosharaka. These examples are described next.
Modaraba (limited partnership). The modaraba structure is very similar to a Western limited partnership. An Islamic financial institution raises funds from investors, which it invests in a project. An entrepreneur provides the management skills to operate the project. The financial institution compensates the entrepreneur for managing the project, deducts its fee for managing the investors' funds, and distributes the remaining profits to its investors. Mosharaka (general partnership or joint venture). The mosharaka structure is very similar to a Western general partnership or a joint venture. The structure is often used to provide long-term financing for a project. A mosharaka contract is similar to a modaraba contract except that the managers and financiers are partners; the furnishing of capital and management of the project entity are shared. A finance provider and its customers both contribute cash and other assets to a project entity and then share in the risks and rewards of the project in agreed percentages. The customer is usually the managing partner with responsibility for investing the venture's assets and managing it.Structuring Sharia-Compliant Financial Transactions
As with conventional financing, Islamic financing structures often combine more than one of the foregoing techniques to obtain the desired financing package. In addition, large-scale infrastructure projects may include both Sharia-compliant tranches of financing and conventional tranches of financing. The example described later in the chapter concerns a project that used both Sharia-compliant and conventional financing structures.
Regulatory considerations can affect the structural design. In many jurisdictions, like the U.S., banks and other financial institutions face regulatory constraints on their ability to participate directly in Islamic finance transactions. In all of the transactions described earlier in this section, the finance provider may participate as a partner of or a direct counterparty to the finance user. Direct participation in such structures may be problematic for banks and other financial institutions. For example, U.S. banks are generally not permitted to own real estate unless they are using it in their own business or are holding it after enforcing on collateral for a loan that defaulted. This restriction would preclude a bank from participating directly in a Sharia-compliant structure that uses real estate as the physical asset.
Where regulatory restrictions preclude direct participation, an indirect transaction structure may be used. For example, the financial institution can form an SPE. It can lend funds to the SPE using its conventional loan documentation. This feature is important because financial institutions generally prefer to use their own conventional loan documentation to reduce transaction costs and reduce document risk. The SPE, which is owned by a third party that is not affiliated with the financial institution, uses the funds it borrowed from the financial institution to fund its participation in the Sharia-compliant facility. The two transactions must be structured so as to enable the SPE to meet all its obligations under the conventional loan because the Sharia-compliant facility is the only source of income available to the SPE.
The payment provisions, covenants, and other terms of the loan and the Sharia-compliant financing structure are crafted so that the two sets of documents are fully coordinated to blend the two financing structures effectively into one. This process often requires some creative legal engineering, which the example presented later in the chapter illustrates.
Example of an Islamic Financial Instrument Issued to Fund a Project
The East Cameron Gas Project company issued sukuk to raise funds to finance oil and gas drilling off the Louisiana coast in the Gulf of Mexico.10 The $165.67 million of East Cameron Gas 11.25 percent sukuk due 2019 were issued in July 2006. The issue utilized the sukuk al-mosharaka (general partnership) structure described earlier in the chapter. The issue illustrates the applicability of sukuk financing to large projects, particularly in the oil and gas industry. It was the first sukuk issue backed by U.S. oil and gas assets. Purchasers included both Islamic investors and traditional Western asset-backed bond investors. Figure 15.3 provides a summary of terms. The sukuk issue illustrates how Islamic finance structures are compatible with some of the well-established Western financial structures for asset-based financing.
Figure 15.3 Summary of Terms for East Cameron Gas Sukuk Project Bonds
Source: “Islamic Finance News Awards: Deals of the Year 2006 Handbook,” www.islamicfinancenews.com, pp. 32–34.
| Issuer: East Cameron Partners. |
| Type of Instrument: Sukuk al-Mosharaka. |
| Amount: US$165.67 million aggregate principal amount of the sukuk. |
| Credit Agency Rating: CCC+ by Standard & Poor's. |
| Coupon and Repayment of Principal: The sukuk will bear a rate of return of 11.25 percent per annum (the “Coupon”). The Coupon is paid quarterly and is accompanied by equally periodic installments of principal redemption. Unlike a traditional bond, the issuer does not redeem the entirety of the principal on the maturity date. The royalty on the oil and gas rights is the only collateral in the structure, so adequate revenues are required for reliable returns. |
| Scheduled Maturity Date: Payment, along with the investors' interest in the royalty, is expected to cease in July of 2019, 13 years from the date the deal was closed. |
| Principal Company Description: East Cameron Partners (“ECP”) is a small, privately owned explorer and producer of oil and gas headquartered in Houston, TX. Two underwater gas claims off the coast of Louisiana are the company's primary assets, on which Macquarie Bank holds a lien. Although ECP is also considered guarantor of the sukuk, the company is not subject to third-party recourse in the event of default because the royalty is the only collateral. |
| Purpose of Instrument: The funding provided by the sukuk was used to cover the operating costs and capital requirements of offshore well drilling in the Gulf of Mexico. |
| Mandated Lead Financing Arrangers: Merrill Lynch and BSEC. |
The proceeds from issuing the East Cameron Gas sukuk were used by East Cameron Partners, L.P. (ECP), a Texas-based oil and gas company, to fund capital and operating costs of drilling for oil and gas in the Gulf of Mexico. ECP set up a bankruptcy-remote special purpose vehicle (SPV) in the Cayman Islands to issue the sukuk certificates.11 This SPV then entered into a funding arrangement with a U.S. SPV, which in turn purchased an overriding royalty interest from East Cameron Partners tied to specific federal leases in the Gulf of Mexico. It was structured to qualify as a true sale of an undivided beneficial ownership interest in real property for both U.S. bankruptcy law and Sharia purposes. Structuring these arrangements required creative legal and financial engineering to satisfy Sharia constraints as well as the corporate, securities, and bankruptcy laws and regulatory restrictions in multiple non-Islamic jurisdictions.
The East Cameron Gas sukuk structure took advantage of the complementary relationship between the precepts of Islamic finance and the precepts of U.S. oil and gas law.12 In general, oil and gas assets are Sharia-compliant. Oil and gas rights are characterized as real property with well-established legal attributes, which satisfy several Sharia requirements. Under Louisiana law, oil and gas assets in the ground and certain rights granted in such assets, including royalty interests, are treated as real estate. Moreover, the owner of an oil and gas property can transfer a nonoperating economic interest, such as an overriding royalty interest, to a third party who can hold it as real property. The ability to transfer a Sharia-compliant asset to a third party who would then hold it as real property makes the royalty interest suitable as the basis for asset-based Islamic finance. The East Cameron Gas sukuk financing securitized the royalty interest.
The East Cameron Gas sukuk investors could expect to receive a fixed 11.25 percent rate of return consisting of periodic profit-sharing payments from the income generated by the royalty and, in addition, payments designed to return the investors' principal. However, the financing was nonrecourse to ECP. The investors' returns depended on the investment performance of the underlying oil and gas assets in conformity with Sharia principles. In particular, ECP did not guarantee the return of investors' principal, and Standard & Poor's rated the sukuk CCC+.
The East Cameron Gas Project sukuk are noteworthy because they illustrate how Western energy firms can tap into the growing Islamic capital markets for financing projects even when the assets are located outside Islamic jurisdictions.13 For example, renewable energy assets would seem to be an ideal candidate for Islamic financing in view of Sharia's emphasis on ethical behavior and socially responsible (e.g., green) investments.
Islamic Derivatives
It was noted earlier in this chapter that Sharia forbids masir (gambling or speculation) and thus transactions based on pure chance or excessive speculation. Sharia distinguishes between these activities and productive endeavors. Masir does not prevent normal commercial risk-taking. On the contrary, as explained in a preceding section, commercial risk-taking is a key aspect of all Islamic financing structures.
The Islamic prohibition against masir disqualifies conventional futures, forwards, options, and many types of conventional swap contracts because Sharia scholars view them as essentially speculative instruments. Nevertheless, Islamic financial engineers have developed Islamic derivative products, which serve the same purposes as conventional derivative instruments but are Sharia-compliant. Their use is still controversial because of the difficulty in simultaneously achieving derivative risk management functionality and Sharia compliance.
What Are Islamic Derivatives?
Islamic derivatives are Sharia-compliant contracts that seek to replicate as closely as possible the financial performance of conventional derivative instruments without coming into conflict with Islamic law. In particular, the prohibitions on paying interest and on taking unnecessary risk must be overcome to achieve Sharia compliance. To address the first concern, derivative products must be structured around underlying transactions in tangible assets, as opposed to just cash flows. One of Sharia's basic tenets is that risk should be shared among the participants to a transaction and that the sharing of returns, or profit, must be tied directly to the sharing of risks. To address the second concern, derivative products need to be structured to provide a fundamental risk-sharing mechanism.
Derivative instruments, or at least the functions they perform, are potentially just as important in Islamic finance as they are in conventional finance. Derivatives are useful in managing interest rate, currency, and other risks; they facilitate price discovery; they can reduce transaction costs; they can increase liquidity; and they can improve tax efficiency.
The rest of this section briefly describes four of the more widely used Islamic derivative products.
Currency Swap
The Islamic currency swap is similar to a conventional currency swap. A conventional cross-currency swap has three basic components: (1) initial exchange of the two currencies at the prevailing spot rate; (2) exchange of interest payments, which are netted, at regular intervals during the term of the swap; and (3) final exchange of the same two currencies, usually in the same amounts as in the initial exchange. A conventional currency swap runs afoul of the restrictions on riba (interest), masir (gambling), and gharar (unnecessary risk).
The Islamic currency swap structure, which achieves Sharia compliance, uses reciprocal morabaha (purchase and sale) transactions. These are debt-like instruments, which were described in the preceding section. Using a pair of debt-like instruments reflects the fact that the back-to-back loans of the 1970s were the precursor of the modern currency swap. The two parties to the currency swap enter into a morabaha contract and a reverse morabaha contract to sell Sharia-compliant market-traded commodities, such as aluminum and copper, to each other for immediate delivery but with deferred payments.14
Profit Rate Swap
The Islamic profit rate swap is similar to a conventional interest-rate swap. However, in view of the Islamic prohibition on interest, any reference to interest would be problematical, hence, the need for a new descriptor. A conventional interest-rate swap involves the exchange of interest rate payment obligations without any exchange of principal. Interest payments are based on a notional amount and are netted at regular intervals during the term of the swap. The prototypical interest-rate swap exchanges fixed-rate payments for floating-rate payments. This transaction runs afoul of the restrictions on riba (interest), masir (gambling), and gharar (unnecessary risk).
Similar to the Islamic currency swap, the Islamic profit rate swap structure uses reciprocal morabaha (purchase and sale) transactions. A term morabaha contract generates a stream of fixed payments, which have a fixed cost element and a fixed profit element. Second, a series of reverse morabaha contracts generate the floating-rate leg of the profit rate swap, in which the cost element is fixed but the profit element is floating. As with the Islamic currency swap, the morabaha transactions are structured around the purchase and sale of market-traded commodities.15
Foreign Exchange Option
Islamic foreign exchange options are structured to perform like a conventional foreign currency option. They utilize a wa'ad, which is a traditional Islamic product that when applied to a commercial transaction embodies a unilateral promise. This product fits nicely into an option structure. While a traditional option contract gives the contract holder the right without an obligation, such as the right to purchase foreign currency at a stated exchange rate, the second party is obligated to perform if the option is exercised, in this case, to deliver the stated amount of foreign currency at the stated exchange rate.
The typical Islamic option structure relies on the distinction under Sharia between creating an option and trading it.16 Creating an option for a bona fide hedging purpose is permissible because it reduces gharar (unnecessary risk). However, trading an option for speculative gain is forbidden by Sharia in the eyes of many Sharia scholars because it involves masir (gambling). There is an obvious tension between these two activities, which generally correspond to the two sides of the option transaction. The tension is potentially resolved through the use of the wa'ad.
For example, suppose an Islamic project entity wishes to purchase a foreign exchange call option to hedge some of its foreign currency risk exposure. The option writer promises the hedger to sell a stated amount of a specified currency in return for another currency at an agreed exchange rate on an agreed date. The hedger acknowledges the option writer's promise. It does not issue a promise of its own but delivers a fee (the option premium) to the option writer. The fee is nonrefundable regardless of whether the hedger exercises the call option by enforcing the wa'ad. The hedger will decide whether to enforce the wa'ad (i.e., exercise the option), depending on whether the call option is in-the-money on the exercise date. The uniquely Islamic feature of this option is that if the hedger decides not to exercise the call option, it does not simply let it expire as with a Western option, but instead, it sends a cancellation notice to cancel the wa'ad.
Total Return Swap
A conventional total return swap gives an investor economic exposure to an asset without requiring the investor to hold it. The returns on the desired asset can be exchanged for a stream of returns based on LIBOR (or another asset, index, or security). A similar payment profile can be obtained by employing a reciprocal wa'ad structure.17
An SPV issues certificates to investors for cash. The SPV uses the cash to purchase a pool of Sharia-compliant assets. The investors get exposure to these assets through two mutually exclusive wa'ads. The SPV promises to sell the Sharia-compliant assets to a financial institution on a specified determination date under one wa'ad whose wa'ad sale price depends on the performance of the assets, and the financial institution promises to buy the Sharia-compliant assets from the SPV at the same wa'ad sale price on the same determination date. Only one wa'ad, the one that corresponds to the promise that is in-the-money, will be exercised.18 The SPV winds up with the market value of the assets, which it uses to redeem the investors' certificates.
This structure takes advantage of the equivalence among (a) a long forward contract, (b) a swap with a single exchange of payments, and (c) a European long call option–short put option pair having the same exercise price and expiration date. A sequence of reciprocal wa'ads can be designed to provide the payment structure of a conventional total return swap, which typically has a series of payments.
ISDA/IIFM Tahawwut Master Agreement
The ISDA/IIFM Tahawwut Master Agreement can be used to document the four Islamic derivative products described in this section, which are based on the morabaha and wa'ad Islamic products.19 It is patterned after the ISDA Master Agreement for conventional derivatives transactions. As with conventional derivatives products, the ISDA documents can be used to document the more frequently used products but may not be able to handle more recently developed and more exotic products until the legal documentation has caught up with the financial innovation.
Example: The Saudi Chevron Petrochemical Project
A project located in an Islamic country has to employ a financing structure that complies with Sharia. When capital is sourced from Western financial institutions, and especially when it is combined with capital from Islamic lenders or investors, meeting the traditional requirements of Western financings while satisfying the strictures of Sharia may require creative legal and financial engineering. The international bank financing structure designed for the Saudi Chevron Petrochemical Project illustrates how collateral security structures can be designed for a project financing to meet Western banks' collateral requirements while complying with the precepts of Islamic law. This project financing represented one of the first attempts to execute such a complicated structure, and its success set an important precedent for subsequent large project financings as well as other forms of securitization.
The Saudi Chevron Petrochemical Project was the first limited-recourse project financing in the Kingdom of Saudi Arabia. It employed a hybrid financing structure based on a Sharia-compliant collateral security mechanism, known as rahn-adl (rahn means “mortgage/pledge” and adl means “trustee/arbitrator”).20 This structure, which has been widely used in Middle Eastern project financings, is noteworthy because it bridges Western and Islamic financial systems with their divergent credit, economic, and legal standards. It is also noteworthy because of the unusual initial design process, which was the opposite of the methodology for structuring project financings in other jurisdictions. Usually, the design process begins with the Western model as the base structure. This framework is then fine-tuned for the host country's laws by adding appropriate host country elements to the structure. The design of the Saudi Chevron Petrochemical Project's financial structure proceeded in the opposite direction.21 The first principles of Sharia served as the starting point for the design work, and additional structural elements were then added to satisfy the collateral security requirements of the Western bank lenders.
The Saudi Chevron Petrochemical Project is a benzene and cyclohexane feedstock production facility owned and operated by the Saudi Chevron Petrochemical Company, a 50/50 joint venture between the U.S.-headquartered Chevron Corporation and the Saudi Industrial Venture Capital Group (SIVCG), an alliance of 78 prominent Saudi businessmen and seven Saudi-based joint stock companies interested in domestic industrial development.22 In contrast to the East Cameron Gas Project discussed earlier in the chapter, which relied upon a public sukuk bond issue, loans to the Saudi Chevron Petrochemical project were provided by syndicated groups of Western and local commercial banks with additional loans from the Saudi Industrial Development Fund (SIDF).23 The bank lenders had precise credit policies to which the loans had to conform, and they were accountable to their respective jurisdictional lending laws and requirements as well as to those of Saudi Arabia where the project is located. Banks usually require a first priority security interest, and their security requirements are generally more stringent in a project financing because they have at most limited recourse to the credit of the project sponsors.
The inter-creditor arrangements between the Western banks and the local banks raised some challenging issues, which had to be resolved in structuring the financing. For example, the Western bank loans were conventional interest-bearing loans, rather than an Islamic financing structure. The main issue between the two groups of lenders involved the differing requirements for perfection of their security interest in the project's assets, i.e., the assurance of adequate collateral and the final declaration that no competing liens or third-party claims could subordinate the banks' claim on the collateral. Whereas Western banks perfect their security interest in the loan collateral by placing a lien on the collateral and recording the lien with the relevant regulatory authority, Sharia generally requires actual possession of the collateral by the lender. This was a difficult condition for many Western banks because ownership of a mortgagor's assets, in any true sense, is generally not permissible under U.S. or any other common law systems absent the occurrence of an event of default (as defined by the loan agreement).24 Since actual possession is difficult to achieve for certain types of assets, such as intellectual property rights or an operating plant, local Saudi Arabian banks often prefer lending based on parent company or third-party guarantees. However, providing parent company guarantees conflicts with the limited-recourse nature of project financing, and it would have eliminated one of the main benefits the sponsors hoped to achieve by financing the Saudi Chevron Petrochemical Project on a project basis.
The location of the Saudi Chevron Petrochemical Project on Saudi soil made the project company's adherence to Saudi laws and compliance with Sharia the overriding financial structuring issue. The banks and equity sponsors were therefore required to center both the capital structure and the legal documentation for the project loans on Islamic principles and practices. Centering the financing details first around Sharia and then using the flexibility of Western common law to tailor the financing structure to the requirements of the Western banks would ultimately prove to be the most practical way to proceed.25
The bank financing employed a rahn-adl structure, which was able to resolve the conflicting interests of the Western commercial banks, the Islamic financial institutions, and the equity sponsors (Chevron and SIVCG) regarding the security interest in the collateral for the bank loans:
Islamic law's requirement of “possession” for perfection of a security interest poses a challenge when dealing with the intangible assets characteristic of large industrial projects, such as intellectual property rights, goodwill, and cash from nonoperating activities. When such assets are not accepted as physical property by Sharia scholars or when an inconclusive verdict is reached, recourse to a third party's assets may be required to secure the loan. If the Western banks had acted in tandem with the Islamic banks on this issue, the financing structure would have precluded a limited-recourse structure. Also, the Western banks would not allow outside parties to have first liens on those assets they would normally consider to be appropriate collateral for their loans. Moreover, any request for sponsor or third-party recourse would also be a main point of contention with the equity sponsors, especially Chevron, because that is exactly what large American corporations would like to avoid by entering into a project financing. Besides agreeing on the acceptable loan collateral, the Western banks had to agree on which legal jurisdiction would govern the lending relationship and the legal interpretation of the loan documents. It would have to be one with well-established banking and securities laws to minimize the lenders' legal risk exposure. The Western banks viewed structuring the bank financing primarily around Sharia fundamentals as an adaptable approach, but they were advised by counsel that it would be risky to record a security interest and conduct business in a jurisdiction without independent common law or extensive financial precedent.26 The collateral status of many types of assets under Sharia was still poorly defined when these discussions were taking place, and future Saudi court decisions concerning the legal treatment of different asset types were seen at the time as unpredictable. It was thus in the interest of all the banks to agree on an acceptable legal jurisdiction. Although the Saudi banks involved were interested in developing the domestic bank loan market and were opposed to what some of them viewed as the speculative practices of the Western banks, they recognized that cooperating with the Western banks was necessary to achieve adequate funding for the project as well as to be able to draw on the financial expertise of the Western banks. The equity sponsors would benefit from having the banks agree on an established banking jurisdiction because the resulting lower risk of unpredictable legal or regulatory problems would mean greater liquidity and less restrictive loan terms from the banks.Since there were several types of project assets with unprecedented status under Islamic law, each was analyzed and appropriate legal measures were ruled on separately. The rahn-adl structure that emerged used this case-by-case analysis to determine the collateral status of each asset, including intellectual property and technology licenses. The tangible assets like equipment and property qualified as property recoverable for a debt, known under Islamic law as marhoun. A rahn, or mortgage, was granted on each marhoun to two adlan. An adl is a type of trustee-arbitrator whose special status under Sharia will be explained later. The two adlan, an Onshore Security Agent and an Offshore Security Agent, were given the responsibility of holding the loan collateral as well as administering the overarching legal documentation for the project. All of the assets deemed as marhoun were deposited with the Onshore Security Agent, and their security structure was therefore governed by Saudi law. The Offshore Security Agent was established in England and held mainly those assets that were not considered tangible collateral under Sharia, such as executed original contracts and financial instruments with negotiable values.
All of the security interests held by the Offshore Security Agent were subject to English law. The Facilities Agreement and the Financing Agreement, two documents that detailed lending terms from the bank consortium, were also governed by English law and were thus more familiar to the Western financial institutions. The local bank loans, on the other hand, were subject to nonconflicting onshore security agreements and remained Sharia-compliant. A harmonious balance was struck between the onshore and offshore security arrangements through the use of creative liquidity management.
Revenue from overseas sales of the project's benzene and cyclohexane feedstock was held as security for the loans by the Offshore Security Agent, and the Western banks considered it the first-line collateral for their loans. Free cash could be transferred to the Onshore Security Agent to pay for plant operations, but only when necessary so as always to maintain an adequate offshore liquidity cushion. The Offshore Security Agent relied on having adequate liquidity reserves to cover any unexpected fall in revenue while the Onshore Security Agent had to ensure that the project company maintained profitable plant operation and effective risk management to be able to meet its financial obligations. Despite this dual collateral and security interest structure, the project still complied with Sharia. The Master Security Agreement and the rahn for all the tangible property and immovables were held by the Onshore Security Agent.
Even with the status of the collateral settled, there remained the issue of how the bank consortium's security interests in the marhoun collateral would be treated under Saudi Arabian law. The security interests could be characterized as “powers of attorney,” but they did not confer actual ownership by the mortgagee. Each adl is a trustee-arbitrator, a form of agent. A bank serving as agent for a project loan gains power of attorney by perfecting a security interest in the loan collateral through standard recordation and documentation. This gives the agent the right to act as the trustee if a predefined “credit event” occurs and seize the collateral securing the loan for the purpose of repaying the loan. Sharia regulations in Saudi Arabia do not recognize this right as conferring an actual ownership interest in the project company, nor do they necessarily nullify such a prearranged structure on domestic soil. However, since banks cannot own stakes in projects directly and still be considered lenders, Western bank lenders were concerned at the time that the project company might be allowed to revoke the banks' power of attorney and the agency arrangement, and freeze access to the loan collateral in time of financial distress, simply by claiming the banks' lack of a legally documented ownership interest. However, this situation would undermine the project financing by potentially depriving the bank lenders of access to their collateral.
This lack of legal recognition for the interest of third-party lenders is not absolute in the Islamic world. Even in Saudi Arabia, where judicial rulings in financial matters tend to be relatively conservative, certain authorities may still recognize the security interest as perfected and irrevocable by third-party lenders as long as their interest in the project can be explicitly proven and as long as the power of attorney carries a limited, pre-determined duration.27 The rahn-adl structure is well suited to this situation and can achieve both limited liability for the equity sponsors and what can essentially be considered a perfected security interest for lenders. Saudi Arabian law recognizes a type of mortgage/pledge arrangement, al-rahn, which makes a designated property into security for a debt that is to be repaid from such property. In a rahn the designated marhoun is deposited with a special trustee-arbitrator, the adl, mutually agreed by the parties. Their special status gives adlans more extensive privileges than a Western agent bank would customarily have.28
This structure played a critical role in underpinning the debt financing for the Saudi Chevron Petrochemical Project. The project company irrevocably granted security interests in the project's marhoun to the Onshore and Offshore Security Agents, who were made “parties” to the key project documents and explicitly granted the ability to sell the collateral directly and exercise other remedies in the wake of a credit event.29 Neither the equity sponsors nor the bank consortium exerted control over the adlan. The marhoun, or collateral assets, could not be forced from the adlan into the hands of the equity sponsors nor could they be repossessed and liquidated by the bank lenders except under the terms of the rahn. After all the substantive issues had been addressed satisfactorily, the project's rahn-adl structure was deemed Sharia-compliant and accepted by the parties to the project.
After the plant went online in mid-1999 and operated successfully, Saudi Chevron Phillips Company30 announced a second phase in 2002, which would involve a second petrochemical plant specializing in styrene, propylene, and motor gasoline production with annual capacities of 715,000, 250,000, and 405,000 tons, respectively. The debt capital was provided primarily by Saudi banks. A third phase costing $5.2 billion was announced in 2006 for the production of ethane, propane, and their derivatives.
The Saudi Chevron Petrochemical Project's rahn-adl structure set an important precedent for Islamic project financing. It has since been implemented in numerous other projects. The flexibility to secure a larger amount of capital from two different lending sources once thought to be mutually exclusive has been a boon to project finance in Islamic jurisdictions. Future possibilities seem very promising.
The Future of Islamic Project Finance
As the Islamic finance industry expands, one of its most significant challenges will be finding enough appropriately qualified Sharia scholars. There is currently a shortage of such scholars for financial transactions, which hampers financial innovation. Sharia scholars are typically heavily involved at the planning stage of a financial transaction because their advice is often crucial to how a transaction is structured. The shortage of scholars is particularly important in the area of project finance because these financings are complex, as the preceding example illustrates, and thus require adequate financial knowledge as well as the requisite religious scholarship.
Philosophical Differences
There are some fundamental philosophical differences within the Islamic finance industry that must be addressed as the industry grows. There are two competing schools of thought concerning how Islamic finance should evolve. On the one hand, some believe that Islamic financiers should implement financial structures and employ financing techniques that essentially replicate conventional Western financial structures and techniques but in a Sharia-compliant manner. Innovation in that case involves engineering the structures and techniques to purge them of the objectionable features.
A more fundamentalist school of thought holds that Islamic financiers should reengineer how the financial markets are structured and reorganize the way they operate to reflect better Sharia's humanitarian and equitable principles and goals. Innovation in that case entails remaking the financial world in a Sharia-compliant manner.
Islamic industry participants disagree about whether the industry should focus on standardizing current structures to reduce transaction costs or instead on developing new structures more in keeping with Sharia principles. Those that argue for standardization maintain that the currently used Islamic finance transaction structures, which have passed muster with Islamic scholars, need to be standardized to encourage the development of secondary markets, which would facilitate greater pricing transparency and improved liquidity and attract new sources of capital. Those who hold to more fundamentalist beliefs argue that the currently employed financial structures are flawed and should not become the market standard.
There are significant differences in the practice of Islamic finance in the two large market centers that currently dominate the industry. The Gulf Cooperation Council countries (Saudi Arabia, the United Arab Emirates, Kuwait, Qatar, and Bahrain) are generally more conservative in their interpretations of what Sharia permits whereas the Muslim countries in Southeast Asia (namely, Malaysia and Indonesia) have been somewhat more flexible in their interpretations of Sharia's restrictions on financial transactions. This difference in approach makes for a more diverse industry but one that is evolving along two different fronts.
This situation appears to be restraining the growth of Islamic finance. There is a lack of product standardization and a lack of harmonization in the standards that are applied in different jurisdictions to assess Sharia compliance. This lack of harmonization is especially important in the case of more complex products, such as Islamic derivatives.
Perhaps more concerning, there is no codified body of law that applies to Sharia-compliant products and transactions. There are no central or regional regulatory bodies to provide market oversight; regulation takes place at the micro level with each Islamic bank appointing its own Sharia committees to opine on transactions and products. Different Sharia committees may have divergent views concerning what is permitted under Sharia. This divergence of opinion is more problematical for newer, more exotic structures, which tends to restrain product innovation. A centralized regulatory authority that could produce a set of industry guidelines and resolve disagreements over Sharia compliance would speed market acceptance of new products and stimulate the growth of the Islamic finance industry.
Conclusion
Islamic finance is developing rapidly as financial engineers work with Sharia scholars to craft new financial instruments and transaction structures that comply with Sharia. With Muslim populations and economies growing rapidly, Sharia-compliant project financing will play an increasingly important role in global infrastructure development. The large pools of wealth in these countries will also be available to finance projects in Western countries. But this will happen only if financing structures can be developed that satisfy both conventional Western lending standards and the strictures of Islamic law. The structures discussed in this chapter are but a starting point. I expect that Islamic financial instruments will continue to evolve and that the markets for them will continue to expand to meet the demand for Sharia-compliant project financing.
The Saudi Chevron Petrochemical Project illustrates the feasibility of combining Western and Islamic funding sources to finance a single project. Western and Islamic funding structures were once thought to be incompatible. They are not. Blending funding from multiple sources is often crucial for a large project. For projects in Islamic countries, the blend must include financing that complies with Sharia. The Saudi Chevron Petrochemical Project evidences that with some creative legal and financial engineering, the two funding sources can be combined without either source having to compromise its basic principles.