Tarini Barat (LPC 2012/3) reviews the 25/04/2013 visit of John Dewar, partner at Milbank, Tweed, Hadley & McCloy LLP:
On 25th April, the Commercium Colloquium hosted John Dewar, partner at Milbank, Tweed, Hadley & McCloy and head of the firm’s Islamic finance practice. Mr. Dewar, having just returned to London from Saudi Arabia, gave a presentation introducing the basic principles of Islamic finance techniques.
Context
Islamic Finance has been spreading widely, especially after the credit crunch in 2008. Mr. Dewar explained, that with the downfall of western banks, it was Islamic finance, and in particular Islamic banks that were willing and able to invest money and provide financing for infrastructure, petro-chemical and project finance deals, not just in the Middle East but also Pakistan, India, Malaysia and beyond.
The increasing profile of Islamic finance has meant that Islamic financing techniques now often sit side by side with conventional financing on large global projects and Mr. Dewar shared stories of deals in Texas and Vietnam which involved elements of Islamic finance.
What is Islamic finance?
Islamic finance is the conduct of commercial and financial activities in accordance with Islamic law, i.e. Sharia’a.
There are five key principles in Sharia’a that underpin Islamic finance: -
• Riba: any profit or benefit must be linked to performance of a real asset and its risk. One cannot use money to make more money such as in the case of interest on a loan.
• Gharar: there must be a certainty of contractual terms such as subject matter, price and time of delivery.
• Maisir: commercial risk taking is encouraged but contracts tantamount to gambling are prohibited such as hedging.
• Unjust enrichment
• Unethical purpose or trading in forbidden goods or assets are not allowed.
How are these principles applied?
The banks that invest through Islamic finance techniques have a Sharia’a board. As most Islamic finance deals are bespoke transactions, during the development and structuring process for these transactions they share the term sheet (providing all the details of the transaction) with Islamic scholars, who conduct research to see if the transaction is compliant with Islamic law principles. The scholars will issue fatawa (legal opinions) as to whether the transaction is compliant with Sharia’a. Mr. Dewar emphasised how essential the fatwa [this being singular of sukuk] is to the transaction and in attracting investors; however, he did mention that fatawa issued by the banks made clear that they provided one such legal opinion and that investors might sometimes also undertake their own research as to the compliance of the transaction with Sharia’a and may challenge a fatwa issued by a bank’s Sharia'a board.
Key aspects of Islamic finance structures
Mr. Dewar outlined in his presentation that Islamic finance techniques are asset backed and involve the transfer of risk and ownership from the customer to the banks. It is this Sharia’a-compliant transfer of risk or asset that allows the bank to earn money on its financing deals.
There were three main categories of Islamic finance structures that Mr. Dewar went through: -
• Asset-backed
• Risk-sharing
• Sukuk, aka "Islamic bonds"
ASSET-BACKED
Murabaha (Cost Plus Financing)
A murabaha transaction involves the purchase of an asset by the financier (on behalf of the client) who then sells the asset to the client for the cost of the asset plus a pre-stated margin on a deferred payment basis, which may be pegged to a benchmark such as LIBOR.
[This and all images were kindly provided to guests by John Dewar.]
Ijara (lease purchase finance)
The ijara is a form of lease financing where the lessor/financier purchases the asset from the supplier and then transfers possession to the lessee/client with a profit margin built into each lease payment over the term of the lease.
Istisna’a (commissioned manufacture of specified asset)
The istisna’a is a construction and procurement contract for commissioned manufacture of a specified asset. Following a request from the client, the financier procures contractor to manufacture the specified asset. Client contracts to act as wakil (agent) of financier. Upon construction, the contractor transfers the title to the asset to the financier, who will then either sell the asset to the client outright or lease the asset to the client under an ijarah.
RISK-SHARING STRUCTURES
Mudaraba (investment fund arrangement)
A mudaraba is an investment fund arrangement under which the financier acts as capital provider (rab al-mal) and the client acts as mudareb (akin to an investment agent) to invest the capital provided by the rab al-mal and manage the partnership. Profit of the venture can be distributed between the parties at a predetermined ratio but with any loss (subject to whether the loss is caused by the mudareb’s negligence) being borne by the rab al-mal.
Musharaka (joint venture arrangement)
The financing arrangement for a musharaka is similar to that for a mudarabah, except that any losses are borne in proportion to the capital invested by both the client and the financier.
SUKUK
Often referred to as an Islamic bond, a sakk [sakk being singular of sukuk] represents an undivided beneficial ownership interest in an underlying asset. Unlike conventional bonds where the holder is paid a fixed or floating interest, the returns on a sakk are linked to the performance of a real asset and are also exposed to the risks associated with ownership of the asset. The sakk is linked to the asset through either an ijarah or musharaka arrangement to generate revenues. Below are two respective figures: -
Mr. Dewar also went through a sukuk structure that combined both musharaka and ijarah structures, which was similar to the structure of a deal that Milbank had been acting on.
Q&A following presentation
After the presentation, the floor was thrown open for questions and there was keen interest shown by the audience. Students asked a wide range of questions touching on the Sharia'a board process and methods of gaining expertise in this field.
Mr. Dewar recommended students who were interested in gaining a better understanding of this field to read Islamic Finance: Law and Practice published in 2012 by Oxford University Press. He also shared with us a book he has edited, International Project Finance: Law in Practice published in 2011 by Oxford University Press.
The presentation on Islamic finance provided students with a broad primer. Mr. Dewar was able to outline and bring to life the intricacies of Islamic financing techniques and principles by providing first hand experiences and anecdotes. His presentation not only helped to demystify complex transaction structures but also helped us to appreciate the growing role of Islamic finance in the global market.
On 25th April, the Commercium Colloquium hosted John Dewar, partner at Milbank, Tweed, Hadley & McCloy and head of the firm’s Islamic finance practice. Mr. Dewar, having just returned to London from Saudi Arabia, gave a presentation introducing the basic principles of Islamic finance techniques.
Context
Islamic Finance has been spreading widely, especially after the credit crunch in 2008. Mr. Dewar explained, that with the downfall of western banks, it was Islamic finance, and in particular Islamic banks that were willing and able to invest money and provide financing for infrastructure, petro-chemical and project finance deals, not just in the Middle East but also Pakistan, India, Malaysia and beyond.
The increasing profile of Islamic finance has meant that Islamic financing techniques now often sit side by side with conventional financing on large global projects and Mr. Dewar shared stories of deals in Texas and Vietnam which involved elements of Islamic finance.
What is Islamic finance?
Islamic finance is the conduct of commercial and financial activities in accordance with Islamic law, i.e. Sharia’a.
There are five key principles in Sharia’a that underpin Islamic finance: -
• Riba: any profit or benefit must be linked to performance of a real asset and its risk. One cannot use money to make more money such as in the case of interest on a loan.
• Gharar: there must be a certainty of contractual terms such as subject matter, price and time of delivery.
• Maisir: commercial risk taking is encouraged but contracts tantamount to gambling are prohibited such as hedging.
• Unjust enrichment
• Unethical purpose or trading in forbidden goods or assets are not allowed.
How are these principles applied?
The banks that invest through Islamic finance techniques have a Sharia’a board. As most Islamic finance deals are bespoke transactions, during the development and structuring process for these transactions they share the term sheet (providing all the details of the transaction) with Islamic scholars, who conduct research to see if the transaction is compliant with Islamic law principles. The scholars will issue fatawa (legal opinions) as to whether the transaction is compliant with Sharia’a. Mr. Dewar emphasised how essential the fatwa [this being singular of sukuk] is to the transaction and in attracting investors; however, he did mention that fatawa issued by the banks made clear that they provided one such legal opinion and that investors might sometimes also undertake their own research as to the compliance of the transaction with Sharia’a and may challenge a fatwa issued by a bank’s Sharia'a board.
Key aspects of Islamic finance structures
Mr. Dewar outlined in his presentation that Islamic finance techniques are asset backed and involve the transfer of risk and ownership from the customer to the banks. It is this Sharia’a-compliant transfer of risk or asset that allows the bank to earn money on its financing deals.
There were three main categories of Islamic finance structures that Mr. Dewar went through: -
• Asset-backed
• Risk-sharing
• Sukuk, aka "Islamic bonds"
ASSET-BACKED
Murabaha (Cost Plus Financing)
A murabaha transaction involves the purchase of an asset by the financier (on behalf of the client) who then sells the asset to the client for the cost of the asset plus a pre-stated margin on a deferred payment basis, which may be pegged to a benchmark such as LIBOR.
[This and all images were kindly provided to guests by John Dewar.]
Ijara (lease purchase finance)
The ijara is a form of lease financing where the lessor/financier purchases the asset from the supplier and then transfers possession to the lessee/client with a profit margin built into each lease payment over the term of the lease.
Istisna’a (commissioned manufacture of specified asset)
The istisna’a is a construction and procurement contract for commissioned manufacture of a specified asset. Following a request from the client, the financier procures contractor to manufacture the specified asset. Client contracts to act as wakil (agent) of financier. Upon construction, the contractor transfers the title to the asset to the financier, who will then either sell the asset to the client outright or lease the asset to the client under an ijarah.
RISK-SHARING STRUCTURES
Mudaraba (investment fund arrangement)
A mudaraba is an investment fund arrangement under which the financier acts as capital provider (rab al-mal) and the client acts as mudareb (akin to an investment agent) to invest the capital provided by the rab al-mal and manage the partnership. Profit of the venture can be distributed between the parties at a predetermined ratio but with any loss (subject to whether the loss is caused by the mudareb’s negligence) being borne by the rab al-mal.
Musharaka (joint venture arrangement)
The financing arrangement for a musharaka is similar to that for a mudarabah, except that any losses are borne in proportion to the capital invested by both the client and the financier.
SUKUK
Often referred to as an Islamic bond, a sakk [sakk being singular of sukuk] represents an undivided beneficial ownership interest in an underlying asset. Unlike conventional bonds where the holder is paid a fixed or floating interest, the returns on a sakk are linked to the performance of a real asset and are also exposed to the risks associated with ownership of the asset. The sakk is linked to the asset through either an ijarah or musharaka arrangement to generate revenues. Below are two respective figures: -
Mr. Dewar also went through a sukuk structure that combined both musharaka and ijarah structures, which was similar to the structure of a deal that Milbank had been acting on.
Q&A following presentation
After the presentation, the floor was thrown open for questions and there was keen interest shown by the audience. Students asked a wide range of questions touching on the Sharia'a board process and methods of gaining expertise in this field.
Mr. Dewar recommended students who were interested in gaining a better understanding of this field to read Islamic Finance: Law and Practice published in 2012 by Oxford University Press. He also shared with us a book he has edited, International Project Finance: Law in Practice published in 2011 by Oxford University Press.
The presentation on Islamic finance provided students with a broad primer. Mr. Dewar was able to outline and bring to life the intricacies of Islamic financing techniques and principles by providing first hand experiences and anecdotes. His presentation not only helped to demystify complex transaction structures but also helped us to appreciate the growing role of Islamic finance in the global market.
