Re-framing a Loan as an Islamic Finance Structure

A successful
“Islamic finance”-road show
- re-frame a conventional loan scheme to
an Islamic finance structure - have the cutting edge -

Paul Wouters - Lawyer
Counsel Bener Law Office – Istanbul Turkey
pwouters.law@gmail.com
Singapore Dec 2009

A successful "Islamic finance"-road show

Who should have a look at this presentation

At present you have a concrete project that needs financing and you
were planning to attract financiers / investors to support you with
conventional, interest based finance.

Together with your accountant or auditor, you probably drafted an
executive summary (1) with the financial data / collateral .. that your
prospected financier / investor expects to see, (2) with the projected
IRR and (3) with any further merits of the deal.

You probably are ready to start your road show or maybe even
conducting it as we speak.

Paul Wouters - Bener Law Office

A successful “Islamic finance”-road show

Who should have a look at this presentation (ctd)

And then someone did mention the possibility of “Islamic finance” to
you. It is a buzzword, but you have no experience yet.

You wonder : is Islamic finance something for me ?

Maybe you even plan to present your existing financial exec-sum to
some Middle East or Southeast Asia based Islamic bankers in order to
obtain “Islamic finance”.

Then this small presentation is meant for YOU.



First orientation :

I am not a Muslim – “Islamic finance” therefore is nothing for me ?

WRONG : Islamic finance is accessible to everyone.

I am a Muslim – when I lend money from another Muslim, we are
making “Islamic finance” ?

WRONG : when a Muslim lends money from another Muslim, that
is not necessarily “Islamic finance”. In fact, any loan of money
could involve Riba. It is not the religion of the people involved
that decides if something is Islamic finance, it is the way that
money is put to work that makes finance Islamic compliant or
not.



First orientation (ctd) :

You did hear that Islamic finance actually is the same as conventional
finance ? Islamic finance is “only hiding the interests” ?
WRONG :
YES: it is finance consisting out of a business transaction
for a profit;
BUT NO: Islamic finance is about the way money “is put to work”.
That is in business situations that create permissible profit and
NOT by a mere loan of cash that generates impermissible profits
(interests) or RIBA.
The Islamic finance project and its' documentation and structuring
will therefore not be centered around a loan agreement, but around a
business agreement. We will touch this aspect briefly later in the slide
show.



Option 1 – the object is to finance 1 single project only

In a conventional environment one prepares the financial data and
looks for the necessary collateral. Then a bank or financier is visited
negotiate a loan and the terms and conditions thereof.

Depending on the creditworthiness of the debtor, the value of the
collateral and the solidity of the project one will get more / less money
in the form of a cheaper / more expensive interest-based loan .



Lesson 1 – the Islamic Bank / Investor does not extend
pure financial loans

Basically, in Islam a financial loan is extended for charitable reasons
only (Qard Hasan) .

This does not mean however that Islamic finance is “for free”. The
same as in conventional finance, one will enter into a business
transaction that will cost money. Only this time it will be structured
in a “real economy”-deal with a more transparent and just profit
margin.



Solution – package the finance needs in a partnership or a
business deal

If the finance needs can be translated to the acquisition or production
of assets, there could be several ways to solve your problem :

1. isolate the assets or activity into a partnership that meets Islamic
standards (Mudarabah or Musharakah are widely used) OR maybe –
if accepted - even use a Special Purpose Vehicle SPV-structure. One
puts labor (and maybe some investment) into the partnership and the
financier helps out with the rest of the needed financial means.

The way of profit sharing is agreed upon with the financier and - if so
desired - the conditions of his exit out of the project.



Case 1– “diminishing musharakah” house financing

2
1
20 / 100
Client
House 3
Finance 1
Financier
1
80 / 100

1. Agreed upon part in capital gives pro rata in property units
2. Client pays periodic rent to occupy the units that are property
of the financier
3. Client pays periodicy a part of capital and acquires steadily all
the property of all units until full exit financier
(simplified model)


Solution – package the finance needs in a business deal or
partnership (ctd) :
2. look for an Islamic based or at least Islamic compliant business
contract with potential finance features.
Islamic law recognizes different types of nominate contracts
(Murabahah, Ijarah, Istisna, Salam etc) that may allow the
construction or acquisition of assets or services against deferred
payment and such with various delivery conditions. This will be
subject however to specific rules and regulations that might differ
from the conventional framework that you are familiar with.
Example: your financier buys the asset cash from a producer. He
then sells it down to you with deferred payments against an agreed
upon mark up (using a Murabahah contract).
Other structures that resemble conventional construction contracts,
leasing etc are also available.



Case 2 – “ijarah muntahia bi tamleek” or financial
leasing-type contract
2b
Financier Client
2a

1b 1a
Manufacturer

1a.Financier buys goods cash for 1000 with promise to lease from
client (client may act as agent bank to assure conformity goods)
1b.Delivery goods to financier (client may act as agent bank to assure
conformity goods)
2a.Client leases goods from financier at 1000+
2b.At lease end delivery property of the goods to the client as gift
or for consideration
(simplified model)


It is important to know that the Islamic financier will exclude some
industries (gambling …). Or that IF he might be able to allow certain
“haram” activities (sale of alcohol …) and some exposure to
conventional interest based products, such will be in minor
proportion only and probably with time bars combined with the
“cleansing” of any non-permissible profits. Such cleansing will result
in less residual profit and will therefore diminish the appetite of your
potential Islamic financier to go ahead.

Other financial ratios and business reasons also might prevent the
financier from easy dealing with structures that are for example too
cash-liquid.

The use of conventional trust.. structures mostly is allowed, but whilst
the Islamic partnerships and nominate contracts resemble sometimes
closely the conventional ones, small differences can have big
consequences that may decide on the viability of the project.



Option 2 – looking for stable business partner

In a conventional environment one prepares the financial data, looks
for a partner and convince him of the viability and profitability of the
enterprise.

The partner will analyze the projected return on investment, market
evolutions etc. Subsequently he will negotiate the conditions of his
entry. Conventional legal structuring is very flexible and inventive in
terms and conditions. We assume that you are familiar with those
aspects (waterfalls, convertible bonds etc).



Lesson 2 – observe Islamic limitations

As stated above, the use of conventional trust and company structures
mostly is allowed. But even when the traditional Islamic partnerships
are set aside in favor of those, certain of their ground rules will have
to be respected. It is important that you are aware of the basic
understandings.

Some activities or industries are not suitable for Islamic investments
and residual presence of conventional interest based financing can
cause problems. Also liquidity management of the venture has to be
looked at.

As stated above, there also will be some financial ratios to be taken
into consideration, next to industry screening.



Case 3 – “mudarabah” partnership for point-of-sales

4
2 Client /
POS- mudarib
venture 3 1
Financier
1
4
1. Financier invests capital
2. Client invests labor only and manages the venture
3. Client may receive monthly advance on profits for his labor
(refundable if no profits show at the end)
4. Profit share according to agreement – loss only for capital
financier except by serious breach management client/mudarib
(simplified model)


Option 3 – what about the so-called SUKUK ?
The Islamic Fiqh Academy decided already more then 30 years ago
that the issuance of and trading in shares (on the stock exchange) is
permissible.
Conventional bonds however represent a pure debt obligation (IOU
from loan debt) and moreover contain the impermissible “riba”
(usually translated to “usury” or “interest”). They cannot be used in
Islamic finance.

However, debt arising from (deferred) payment liabilities stemming
from an Islamic contract can be securitized into Islamic bonds. Since
such is also a pure financial obligation (IOU from contract debt),
trading should be cash and at par value.



Option 3 – what about so-called SUKUK ? (ctd)
Islamic finance developed another financial instrument : Sukuk.
Very summarized, Sukuk give title to a part of an underlying asset
and the income thereof: it is not a pure financial debt instrument, but
an equity-title.
That underlying asset preferably generates more or less fixed income
streams (for instance: rental income), that on their turn result in
regular pay outs to the Sukuk holders. Another similarity with
conventional bonds is that Sukuk usually have a 3 up to 10 year
maturity. These are aspects that the market of the conventional bond
holders specifically is looking for.
One could say that Sukuk represents equity that however usually
behaves like a conventional bond (medium term maturity and fixed
income streams).



Option 3 – what about the so-called SUKUK ? (ctd)
Some jurisdictions already have specific Sukuk-regulations in place
and others – mostly global financial centers - are planning them.

Most types of Sukuk structures are acknowledged by the different
Islamic jurisdictions. But not ALL structures will be allowed
everywhere, nor be freely tradable everywhere.

Not all Sukuk are aimed to the global market and/or are not expected
to be tradable then at face value. But for others certain structuring
might prevent international Islamic investors to participate in the
issuance or on the contrary specifically interest them.

The same would apply to conventional products that are tailored too
much towards a specific market or jurisdiction.



Option 3 – what about the so-called SUKUK ? (ctd)

Approaching Islamic financiers to place Islamic Sukuk therefore
needs sufficient consideration.
One should comply with the local standards of the place of issuance,
but if one also want to target an international investor audience, one
might need some more consideration and eventually use different
structures or even different jurisdictions.
This entails that whilst most projects can be the subject of Sukuk
issuance, not all those Sukuk might attract investors from all over the
world. A project or the way it is structured may be suitable for
Islamic financing, but might or might not fill the (tradable) Sukuk-bill
of your targeted partners.
It is worthwhile to stress that large scale project finance, turnkey and
infrastructure projects are daily routine for regular Islamic (non-
Sukuk) finance.


Case 4 – “mudarabah” partnership Sukuk financing
2
4
Manager /
Mudarib 5 Mudarabah 3 Compliant
Venture
Project
SPV 5
2
5 1 1
Investors
1. Investment 100 by investors in
SPV in return for Sukuk
2. Mudarabah: Cash contribution
SPV/ labor contribution manager
3. Investment 100 in project
4. Advance mudarib remuneration (refundable if ultimate loss)
5. Profit / loss (loss absorbed by SPV only up to 100)
(simplified model)


Case 5 – “ijarah” Sukuk financing
2
6
SPV Investors

1 3 4 5 1. Originator sells asset for 100 to SPV
Originator 2. SPV issues Sukuk and receives 100

asset
from investors
3. Originator leases asset back at 100 +
4. Originator pays rent that is paid down
to investors (income stream)
5. At end of lease the asset is bought back by the originator at 100
6. Proceeds are distributed to investors
(simplified model)



Option 4 – Investment funds

The Islamic finance universe knows Reit, Private Equity Funds, Unit
Trusts, Funds of Funds etc.
Often conventional trusts, companies … can be used, subject to not
violating the basic features of the Islamic partnerships. The financial
instruments representing parts in the funds might possibly be floated
on the stock exchange and/or might be freely tradable.
Islamic investment strategies are however imposed. Those investment
targets that violate industry screenings (haram-halal) or financial
screenings (targets that are too cash liquid or too loaded with
conventional interest debt / income) are excluded or only allowed
within certain conditions (cleansing interests or haram income or
sale). Conventional debt “leverage” is problematic.
Mostly Shari’ah Boards are appointed that will set those investment
criteria and certify ongoing compliance therewith.



Unit holders Investments
Case 6 – Islamic REIT

Trustee 3 2

Manager
I-REIT 1

4
Shari’ah
5 Board

1. I-Reit makes investments and distributes returns to unit holders
2. Unit holders hold I-Reit units in return for capital input and receive returns
3. Manager gives management services in return for management fees
4. Trustee represents unit holders in return for trustee fees
5. Shariah Board advices Manager and I-Reit on Shariah issues
(simplified model)



Shari'ah differences and perceived Shari'ah risk
Because of different cultural and jurisprudential interpretations. the
same “Code Napoleon”-based civil law might allow 'blue' in Spain but
prescribe 'yellow' in the Netherlands.
Such issues also exist between the various Islamic jurisdictions and
interpretations. The Shari'ah indeed knows several mazhab (schools
of thought) that geographically can be located on the global map.
Just be aware of this and relax. Do not get influenced by a
spectacular fatwa of a Shari'ah scholar representing a minority
position from a school different from the one that dominates the
jurisdiction where your deal will be executed or eventually tried in
court or later on enforced.
The basic wisdom is always the same: Respect the ground rules. Do
what you are allowed to do. Stay away from what you are not allowed to
do. And be careful and slightly conservative when you enter a gray
zone.


Conclusion

Conventional loan documentation cannot simply the “translated” to
an Islamic finance-environment by changing dots and commas.

A first analysis will help to understand the available ways of Islamic
finance that might suit the specific finance needs.

It will give insight into the mechanisms of the specific deal and make
one understand if they are what one is looking for and whether or not
one stands a chance in obtaining a positive result.

These are the vital questions : Is the underlying project suitable for
Islamic finance ? What structure might be advisable ? And if needed:
can tradable Sukuk be issued ?



Know that your competitors are asking the Islamic bank / investor for
“a loan” and be aware of the fact that such is exactly what he does not
want to hear.

You may talk “loans and interests” with your conventional
banker. But also your prospective Islamic partner deserves to
hear the arguments and handed the tools that he is used to
work with.

His interest or disinterest in a project depends on the way
it is presented. A good or bad first impression often
decides on success or failure.



Do not blindly assume that a conventional executive summary
and road show will convince (or even interest) the potential
“Islamic finance” partner.

First understand the own needs within the framework of Islamic
finance. Then translate them to the language of the prospected
financier/ investor. Have the cutting edge.

From project analysis to deal closing.

Paul WOUTERS
Lawyer



For more information:

Paul Wouters
Lawyer Antwerp (Belgium) Bar Association
Counsel Bener Law Office – Istanbul Turkey
pwouters.law@gmail.com

Bener Law Office
Yapi Kredi Plaza C Blok Kat 4
34330 Istanbul - Turkey
www.bener.av.tr
info@bener.av.tr

This document is provided for information
purposes only and contains generalizations
and simplifications for the needs of the
presentation. It is intended to highlight issues
only and no to be comprehensive.
Professional legal advice or relevant Shari’ah
opinion should be obtained before taking or
refraining from any action as a result of the
contents of this document.

.

Re-framing a Loan as an Islamic Finance Structure

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