Introduction

In part one of this article, we looked at some of the general issues that arise when doing business with Muslim communities.  Part two looks at some of the structures used for Islamic financial products and delves into some of the specific issues that arise in practice.  Before looking at the above mentioned structures in any detail, it would be useful to identify some of the more pertinent concerns that Muslim scholars have raised in connection with conventional financial products.

Conventional commercial arrangements usually provide for interest to be paid, whether as an integral part of the transaction (such as in financing arrangements) or as a charge that is levied on default.  Muslim scholars regard interest as being repugnant to Islamic law and this gives rise to the challenge of structuring funding products so that they do not involve interest.

Contrary to a view that is sometimes encountered, Islamic law does not prohibit earning a return on money.  What is prohibited is structuring that return as a fixed return determined on the basis of the capital advanced.  Islamic law compliant funding structures are designed to provide a return determined not with reference to the capital advanced, but with reference to resale margins (murabahah structure), usufruct values (ijarah or lease structure) or profit participation arrangements (mudarabah and musharakah structures), amongst others.  These structures are described below.

Islamic law prohibits a range of activities (such as gambling and conventional banking and insurance).  Islamic law compliant structures are designed so as to avoid these activities.  Investment products must therefore be structured so that investments in companies that engage in prohibited activities are excluded.

Islamic law also prohibits contracts with excessive uncertainty and transactions where the performance of one of the parties is contingent on an uncertain future event.

The Murabahah Structure

The murabahah structure is based on the principle of resale at a profit. 

This principle can be used for asset finance.  The funder purchases the asset and pays cash for the asset, after which the funder sells the asset to its client for a deferred price, which includes a mark up determined with reference to market considerations and the time over which the deferred price is to be paid.

This structure differs from conventional loans in that the mark up is fixed at the time of contract.  Unlike interest, the funder’s return does not increase if the client defaults on an installment, and similarly, it does not decrease if the client is able to accelerate payment.  This creates certain concerns, which can be addressed by careful structuring and prudent management of the murabahah book.

Additional difficulties arise in the case of assets that attract a levy on transfer of ownership.  This is dealt with later in the article.

The Ijarah Structure   

In terms of the ijarah structure, the funder purchases the asset in question and leases the asset to its client.  The rental is market related, but usually includes an additional component representing payment of the purchase price of the asset.  At the end of the lease period, the client would have paid the purchase price, in addition to rentals representing the return of the funder.

Various legal mechanisms can be used to give effect to the transfer of ownership in ijarah structures.

Sophisticated ijarah structures allow for co-ownership of the asset in question with adjustment of the co-ownership interest of the funder corresponding to payments of capital and further advances.

The Mudarabah Structure

The mudarabah structure is suited for trade finance, where the murabahah structure is not appropriate or the funder requires exposure to the upside of the trading operations.  In simple terms, the murabahah structure involves two parties, one of whom provides capital only, whilst the other provides entrepreneurship (and possibly capital, as well).  The funder provides capital to its client and is entitled to return of the capital, to the extent not lost in trading operations, in addition to an agreed percentage of profits.

Although the mudarabah structure allows the funder to participate in the upside of trading operations, the funder is also exposed to losses and importantly, may suffer loss of capital without any right of recourse against the client.

Musharakah structures are similar to mudarabah structures, the main difference being that both parties provide capital and participate in management.

Investment Products

Islamic law compliant investment products must be structured in a manner that complies with Islamic law and must furthermore only invest in underlying investments permitted by Islamic law.  Three structures are commonly used: mudarabah, musharakah and wakalah structures.

In terms of the mudarabah structure, the investor provides capital to a fund manager.  The investor and the fund manager are each entitled to a percentage of the profits, after return of capital to the investor.  Mudarabah structures are suitable for private equity funds and certain collective investment scheme structures.

In the musharakah structure, several investors provide capital and participate jointly in managing the fund.  After capital is returned, they share in the profits in the proportions agreed by them at the time of investment.  Musharakah structures are suited for investments by well capitalised entities with the resources and appetite necessary for active participation in the management of their investments.

Wakalah structures are simple agency arrangements in terms of which investors provide capital to a fund manager, who manages the fund in exchange for an agreed fee.  Collective investment scheme structures and segregated portfolios are often structured on a wakalah basis.

Practical Issues

The murabahah structure creates the prospect of double transfer duty on fixed property transactions as murabahah involves two transfers of ownership.  This risk potentially arises with regard to securities and securities tax, as well.  Various mechanisms have been utilised to address this concern, but it is questionable whether any of these mechanisms is legally sound.  Certain jurisdictions, such as the United Kingdom, have introduced legislation to ensure that transfer duty is paid only once in these transactions.

The two transfers of ownership in murabahah structures also create the risk that value added tax (“VAT”) would be levied twice, thus potentially increasing the cost of Islamic law compliant funding structures based on murabahah, particularly where the client is not a VAT vendor.

In practice, it is not always possible for investment structures to avoid interest income, or other non-permitted income, from accruing.  Islamic law compliant funds usually establish processes to identify non-permitted income and exclude this income from the fund.

Islamic law compliant structures are generally supervised and monitored by a supervisory committee of Islamic law and other experts.  Their role is to certify that the structure and its ongoing operations comply with Islamic law.  Difficulties can arise due to differences of opinion amongst specialists in Islamic law and care must be taken when appointing committee members to ensure that they enjoy credibility in the relevant target market.

Documenting Islamic law compliant structures in a manner that satisfies prudent drafting and other legal requirements presents an immense challenge.  It is important to ensure that the contractual arrangements required by Islamic law are actually put in place in a manner that is legally enforceable.  We have seen structures where compliance with Islamic law is reflected in marketing material, but the legal mechanisms referred to in the marketing material have not actually been established.  The role of lawyers would be to ensure that the requirements of the Islamic law experts are appropriately recorded in legally binding documents.  Another defect often encountered in legal documents for Islamic law compliant structures is that the workings of the structure are inadequately set out.  This creates the risk of contracts being void for vagueness or being otherwise incapable of implementation due to critical issues not having been properly dealt with.

Conclusion

Islamic finance represents a growing market in the contemporary economy.  Given the expansion of South African financial and investment institutions into Africa and the rest of the world, companies that are able to address the needs of the Muslim communities they encounter will gain a competitive advantage over their less prepared counterparts.

by Shahid Sulaiman
B ED (King Saud University) (first class honours)
MA (University of Jordan)
LLB (cum laude)
LLM (UNISA)
Certificate in Securitisation (UCT)