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Fundamentals of Shariah Finance Law
IntroductionInternational perspective
Basic Shariah rules
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What is Shariah?O you who believe! Stand out firmly for Allah, aswitness to fair dealing, and let not the hatred ofothers to you make you swerve towards inequalityand depart from justice. Quran 5:8 In the business context, Shariah is a means ofconducting business through a distinct set of rulesdesigned to facilitate fairness.High correlation between Shariah compliantinvesting and socially responsible investing
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Where are Shariah rules codified?Interpretations of the Quran from various Islamicschools of thought
Accounting and Auditing Organization for IslamicFinancial Institutions (AAOIFI)The fact remains: Shariah mandates are not alwaysconsistently applied from Scholar to Scholar.Information is asymmetric, and Shariah Advisersand lawyers skilled in the area become useful towork through the counter-intuitive results
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Shariah termsHalal that which is permitted or compliantHaram that which is not permitted
Riba charging of interest or unjustified increaseGharar the taking of unreasonable risk; uncertaintyMaisir reliance on chance or speculation, ratherthan effort
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Industry prohibitionsGamblingPork production or consumption
Adult EntertainmentBanking and financeAlcohol production or consumptionWeapons productionTobacco production or use
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RibaThe charging of sums for borrowed money ( i.e.interest ) is forbidden
But the pledging of Halal assets, the guarantying ofobligations and the leasing of property under whatwe might consider a finance lease (or ijara ) ispermissible
Murabaha is the selling of a commodity at anagreed upon mark-up, and is used in Shariah as afixed income investment substitute.
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RibaThings to Watch Out For:
Default Interest
Administrative fees for late paymentsConsideration in respect of third party guaranties(see AAOIFI Shariah Standard No. 5)Preferred Shares are generally not permitted
(AAOIFI Shariah Standard No. 21); but dividendsdistributed from profits are permitted.
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GhararThe act of taking on unreasonable uncertaintyExamples of Gharar:
GamblingInsuranceFX TradingOptions on stock (AAOIFI Shariah Standard No. 21,paragraph 16 of Appendix B)
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Shariah Finance ThemesConnection to underlying assetsCommercial risk taking by all parties (including
financier)EntrepreneurshipReturns linked to actual investment outcomesSharing profit and loss
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Shariah Finance StructuresMudarabaMusharakaMurabahaTawarruq (Reverse Murabaha)IjaraIjara wa-iktinaBai salam
Bai al inahIstisnaa Sukuk
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MudarabaRisk sharing; profit and loss sharingLimited partnership: one partner provides capital;
other partner provides expertise/effort and makesbusiness decisionsRestricted or unrestrictedExamples:
funded participation arrangementestablishment of investment fund
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Mudaraba
INVESTOR(S)(Rab al Maal )
MANAGER(Mudarib )
FUND
PROJECT/ENTERPRISE
Fee(basedonshare ofprofits)
Providesexpertiseandmanagesfunds
Investsfunds
Share inprofitsandlosses
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MusharakaRisk sharing; profit and loss sharing in sameproportions
General partnership / joint venture arrangementbetween financier and investorProvides equity funding to a venture; greater risk-reward factors and greater investor say in project
management
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Musharaka
FINANCIER CUSTOMER
VENTURE
Share inprofits andlosses
Contribution inkind (at least30%)
Cashcontribution
Share inprofitsandlosses
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MurabahaAsset basedTrade finance / Acquisition finance
Unconditional contract of sale; goods, cost price, mark-upand payment date = defined and agreedProfit from marked-up sale price (not interest) paid ininstalmentsExamples:
import-export financeinfrastructure project financingleveraged acquisition
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Murabaha
CUSTOMERFINANCIERSUPPLIER
Payment ofPurchase price
Payment of purchaseprice plus premium
(deferred)
Sale of assetSale of asset
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Tawarruq (Reverse Murabaha)Asset basedFreely tradable commodities e.g. platinum, copper
(silver and gold are considered currency and cannotbe used)Provides customer with a cash sumCustomer then has deferred payment obligation tofinancier
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Tawarruq (Reverse Murabaha)
CUSTOMERFINANCIERSUPPLIER
Payment of purchase priceplus premium (deferred)
Sale of assetSale of asset
THIRD PARTY
Payment ofpurchase price
Sale of asset
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IjaraAsset basedHybrid between conventional operational and
finance leases; a business processAnalogous to secured loanExamples:
aircraft financeship financeproject finance
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Ijara
CUSTOMERFINANCIERSUPPLIER / MANUFACTURER
Rent (= purchase priceplus premium)
Lease of assetSale of asset
Payment ofpurchase price
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Ijara wa-iktinaAsset basedLease with option for lessee to purchase leased
assetAnalogous to finance lease / hire purchase contractExamples:
medium term trade finance of equipmentrefinancing under sale and leaseback
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Bai salamAsset basedForward purchase of specified asset paid in full for
supply on pre-agreed fixed future dateWorking capital facility, especially for pre-exportfacilities
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Purchase price(discounted)
Bai salam
CUSTOMERFINANCIERSUPPLIER
Purchase price(plus premium)
Sale of asset (deliverydeferred)
Sale of asset(delivery deferred)
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Istisnaa Asset basedFunding agreement for production, manufacture orconstruction of asset to agreed specification: all
specifications, delivery options, payment conditions andpricing must be agreed in contractNo fixed delivery date and no payment in full at outsetrequired Advance funding of:
major industrial, construction and real estate developmentproject financelarge equipment e.g. ships, aircraft
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SukukFinancial instruments / trust certificates representingundivided ownership share in underlying asset or
interest held by issuerRight to share in profits and asset realisationsDebt capital markets fundraisingBought and sold in secondary marketUsed in conjunction with other structures
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Sukuk al Ijara
CERTIFICATE HOLDERS
SELLER SPV ISSUER LESSEE
Purchase price(issueproceeds)
Issueproceeds
Sells assets
Return IssuesSukuk
Leases assets
Rent
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Sukuk al Musharaka
CERTIFICATE HOLDERS
SPV ISSUER
VENTURE
ORIGINATOR
Return IssuesSukuk
Issueproceeds
Cashcontribution Contribution in kind (atleast 30%)
Share inprofitandlosses
Share inprofitsandlosses
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Shariah finance challengesScholars and schools of thoughtLack of standardisation
Transaction costsAsset ownership by financier involves potentialliability e.g. environmental, warranty claimsInsurance / takaful Tax treatment
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Fundamentals of Shariah Finance Law
ConclusionAny questions?
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DisclaimerThis webinar and these slides are for informationalpurposes only and do not contain or convey legal
advice. The information herein should not be usedor relied upon in regard to any particular facts orcircumstances without first consulting with a lawyer.