Tamara Lucas (LPC 2012/3) reviews the 25/04/2013 visit of John Dewar, partner at Milbank, Tweed, Hadley & McCloy LLP:
John Dewar, a partner in the London office of of Milbank, Tweed, Hadley & McCloy, has a wealth of experience across the Middle East, Africa and India in Sharia’a-compliant financing. Following a fascinating talk, he was particularly generous with his time, answering all the questions sparked by many issues raised — all the more impressive given that he had stepped off a plane that morning from Saudi Arabia.
Rather than reiterate all the specifics of Islamic deal structures given in the talk, I recommend the PLC UK law overview of Islamic finance.
Background
Milbank specialises in corporate finance; i.e. banking capital markets and project finance, mergers and acquisitions, often cross-border. The main jurisdictions which Milbank deals with are New York, England and Germany. English law is often used in financing projects because the investment community is familiar with it and the courts in England are trusted to come to the right judgment, if proceedings are issued. Fortunately the default rates in project finance are very low and litigation is rare.
John Dewar began his career in project finance, especially energy projects. His first project involving Islamic finance was 20 years ago in Karachi, but it was another 10 years before his next Sharia’a-financed project. Over the years the sector continued to grow, experiencing rapid development after the banking crisis. Previous inhibitors to growth had included the relative expense of Sharia’a-compliant financing, regulatory and tax issues, and ethical considerations. There was some debate, for instance, as to whether Islamic banks could accept deposits. Post banking crisis, the margins worldwide had tripled, narrowing the disparity between Sharia’a and other financing structures. Some jurisdictions, and in particular the UK, addressed regulatory and tax disadvantages to encourage the UK to be in the forefront of this developing financing structures. Methods of structuring deals to comply with Sharia’a law developed. The problems in other structures, exemplified by the banking crisis made people and companies more receptive to the principles of Sharia’a financing.
What is Sharia’a financing?
Sharia’a financing is a type of deal structure which has been certified by a committee of Sharia’a law scholars. There are several schools of thought in Sharia’a law. Different schools predominate in different areas: for example, Hanbali is dominant in Saudi Arabia. Different banks have their own Sharia’a committees and different practices. The most conservative compliance is in Saudi Arabia. Malaysia, for instance, has more liberal interpretations of Sharia’a-compliant financing. There are no set forms for a deal (which would be comparable to those recommended by the the Loan Market Association for instance) nor is there consensus as to precisely how deals should be structured to be compliant.
Sharia’a financing is usually in conjunction with conventional banking arrangements. If the deal is certified as Sharia’a-compliant this is merely an opinion of the Sharia’a board which has been appointed by the bank or project. Investors are supposed to do their own assessment as to whether they consider that the product or deal meets the requirements of Sharia’a law.
Sharia’a-compliant financing is now potentially available worldwide. John Dewar has seen Islamic financing used in deals in Texas and has recently been consulted on its possible use for a project in Vietnam. The lack of liquidity in the banking sector, tripling of margins, normalising of deal structures, improved regulatory adjustments and distrust of the conventional banking sector have fuelled growth in the Islamic finance sector. Population growth and growing GDP also helps – money is being deposited and is available for investment. The heartland is in big project finance and asset based deals. The Middle East has always favoured investment in infrastructure but Islamic banks are growing further afield. Conventional banks such as HSBC have now established Islamic finance divisions and John Dewar believes that these giants of conventional financing they will become the major players in Sharia’a financing in the next 10-15 years.
Principles
Sharia’a-compliant deal structures are based on principles of trading used in the Islamic world for centuries. This means that there is a basis of consensus to work from. There are two main types of deal: asset-backed deals and risk-sharing deals. All deal structures are used to adapting to commercial realities, whilst adhering to strict principles: -
• Riba: any profit must be linked to performance of a real asset and a share of the risk. (As a shorthand riba is often referred to as the no-interest principle.) In practice it means that the lender must own the asset before advancing money.
• Gharar: there must be no uncertainty in the deal. This is much stricter than the certainty required in English law contracts.
• Maisir: there must be no speculation, such as gambling. This makes contracts which work on principles similar to derivatives controversial. The Swaps and Derivative Association (ISDA) has devised a Sharia’a-compliant document but this is not universally accepted.
• Unjust enrichment of the lender is forbidden.
• Unethical purpose or trading is prohibited (so a project cannot be connected to alcohol or gambling, for example).
Within these principles John Dewar felt there was considerable flexibility within financing arrangements. There was a sense of collaboration to find an appropriate commercial and ethical solution. "Everything is permitted unless it’s prohibited."
The process
Every Islamic company has a committee of Sharia’a scholars who scrutinise day-to-day activity of the company; new transactions (non-repeated) must be checked and amended if required. At the end of the year the scholars issue a letter stating that the business has been run according to principles of Sharia’a law, which will be included in the company’s annual report.
When working on a deal the contract must be submitted to the Sharia’a board for scrutiny. The contract may have to be translated as well. Aside from any delays in translation, the board may take 2-3 weeks to comment on the contract. The comments must then be addressed by the lawyers, who return the document to the Sharia’a board. When they are happy, the main board can assess the contract from a commercial perspective.
Large transactions will be reviewed by the committee, and if approved a legal opinion (fatwa) will be issued stating that the deal is Sharia’a compliant.
Drafting the contract
When drafting the contract, which is usually based on English law, you must consider Sharia’a principles and the local framework as well. Some national laws are mandatory and cannot be derogated from. Also, if a court in the Middle East, for instance, is asked to apply English law, they may not want to disregard the legal practices of that country. There are many considerations in drafting. The client must be advised of potential problems and when considering so many legal practices it is not always possible to ‘draft your way out of it’.
Following the Shamil Bank judgment (Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain EC [2004] EWCA Civ 19) which stated that Sharia’a law was not a temporal law and could not be applied to a contract, there was much consternation in the Middle East as to the effect on Sharia’a compliant contracts. Consequently, in Saudi Arabia, there is a preference for using Saudi law and not English law. This affects inter-creditor relationships. The complex deal structure usually has an international element. To make the deal acceptable to the other creditors there is usually a provision that those creditors can have disputes heard in English courts under English law.
Deal structures
Deal structures in Islamic finance broadly fall into the following categories: -
• Asset-backed: -
o Murabaha: cost plus financing
o Ijarah: lease purchase financing
o Istisna’a: commissioned manufacture of specified assets
• Risk-sharing: -
o Mudaraba: investment fund arrangement or financed by way of trust
o Musharaka: joint venture or financed through partnership
• Sukuk: Sharia’a-compliant financial instruments including bonds
• Sharia’a-compliant derivatives
The above structures can be used individually or in combination. Flexibility and adaptability appear to be hallmarks of Sharia’a financing.
John Dewar foresees rapid growth in the next 10-20 years.
If you’d like to find out more, John Dewar has edited the book International Project Finance published in 2011 by Oxford University Press which has a chapter on Islamic Finance. A new edition will be published in 2014.
John Dewar, a partner in the London office of of Milbank, Tweed, Hadley & McCloy, has a wealth of experience across the Middle East, Africa and India in Sharia’a-compliant financing. Following a fascinating talk, he was particularly generous with his time, answering all the questions sparked by many issues raised — all the more impressive given that he had stepped off a plane that morning from Saudi Arabia.
Rather than reiterate all the specifics of Islamic deal structures given in the talk, I recommend the PLC UK law overview of Islamic finance.
Background
Milbank specialises in corporate finance; i.e. banking capital markets and project finance, mergers and acquisitions, often cross-border. The main jurisdictions which Milbank deals with are New York, England and Germany. English law is often used in financing projects because the investment community is familiar with it and the courts in England are trusted to come to the right judgment, if proceedings are issued. Fortunately the default rates in project finance are very low and litigation is rare.
John Dewar began his career in project finance, especially energy projects. His first project involving Islamic finance was 20 years ago in Karachi, but it was another 10 years before his next Sharia’a-financed project. Over the years the sector continued to grow, experiencing rapid development after the banking crisis. Previous inhibitors to growth had included the relative expense of Sharia’a-compliant financing, regulatory and tax issues, and ethical considerations. There was some debate, for instance, as to whether Islamic banks could accept deposits. Post banking crisis, the margins worldwide had tripled, narrowing the disparity between Sharia’a and other financing structures. Some jurisdictions, and in particular the UK, addressed regulatory and tax disadvantages to encourage the UK to be in the forefront of this developing financing structures. Methods of structuring deals to comply with Sharia’a law developed. The problems in other structures, exemplified by the banking crisis made people and companies more receptive to the principles of Sharia’a financing.
What is Sharia’a financing?
Sharia’a financing is a type of deal structure which has been certified by a committee of Sharia’a law scholars. There are several schools of thought in Sharia’a law. Different schools predominate in different areas: for example, Hanbali is dominant in Saudi Arabia. Different banks have their own Sharia’a committees and different practices. The most conservative compliance is in Saudi Arabia. Malaysia, for instance, has more liberal interpretations of Sharia’a-compliant financing. There are no set forms for a deal (which would be comparable to those recommended by the the Loan Market Association for instance) nor is there consensus as to precisely how deals should be structured to be compliant.
Sharia’a financing is usually in conjunction with conventional banking arrangements. If the deal is certified as Sharia’a-compliant this is merely an opinion of the Sharia’a board which has been appointed by the bank or project. Investors are supposed to do their own assessment as to whether they consider that the product or deal meets the requirements of Sharia’a law.
Sharia’a-compliant financing is now potentially available worldwide. John Dewar has seen Islamic financing used in deals in Texas and has recently been consulted on its possible use for a project in Vietnam. The lack of liquidity in the banking sector, tripling of margins, normalising of deal structures, improved regulatory adjustments and distrust of the conventional banking sector have fuelled growth in the Islamic finance sector. Population growth and growing GDP also helps – money is being deposited and is available for investment. The heartland is in big project finance and asset based deals. The Middle East has always favoured investment in infrastructure but Islamic banks are growing further afield. Conventional banks such as HSBC have now established Islamic finance divisions and John Dewar believes that these giants of conventional financing they will become the major players in Sharia’a financing in the next 10-15 years.
Principles
Sharia’a-compliant deal structures are based on principles of trading used in the Islamic world for centuries. This means that there is a basis of consensus to work from. There are two main types of deal: asset-backed deals and risk-sharing deals. All deal structures are used to adapting to commercial realities, whilst adhering to strict principles: -
• Riba: any profit must be linked to performance of a real asset and a share of the risk. (As a shorthand riba is often referred to as the no-interest principle.) In practice it means that the lender must own the asset before advancing money.
• Gharar: there must be no uncertainty in the deal. This is much stricter than the certainty required in English law contracts.
• Maisir: there must be no speculation, such as gambling. This makes contracts which work on principles similar to derivatives controversial. The Swaps and Derivative Association (ISDA) has devised a Sharia’a-compliant document but this is not universally accepted.
• Unjust enrichment of the lender is forbidden.
• Unethical purpose or trading is prohibited (so a project cannot be connected to alcohol or gambling, for example).
Within these principles John Dewar felt there was considerable flexibility within financing arrangements. There was a sense of collaboration to find an appropriate commercial and ethical solution. "Everything is permitted unless it’s prohibited."
The process
Every Islamic company has a committee of Sharia’a scholars who scrutinise day-to-day activity of the company; new transactions (non-repeated) must be checked and amended if required. At the end of the year the scholars issue a letter stating that the business has been run according to principles of Sharia’a law, which will be included in the company’s annual report.
When working on a deal the contract must be submitted to the Sharia’a board for scrutiny. The contract may have to be translated as well. Aside from any delays in translation, the board may take 2-3 weeks to comment on the contract. The comments must then be addressed by the lawyers, who return the document to the Sharia’a board. When they are happy, the main board can assess the contract from a commercial perspective.
Large transactions will be reviewed by the committee, and if approved a legal opinion (fatwa) will be issued stating that the deal is Sharia’a compliant.
Drafting the contract
When drafting the contract, which is usually based on English law, you must consider Sharia’a principles and the local framework as well. Some national laws are mandatory and cannot be derogated from. Also, if a court in the Middle East, for instance, is asked to apply English law, they may not want to disregard the legal practices of that country. There are many considerations in drafting. The client must be advised of potential problems and when considering so many legal practices it is not always possible to ‘draft your way out of it’.
Following the Shamil Bank judgment (Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain EC [2004] EWCA Civ 19) which stated that Sharia’a law was not a temporal law and could not be applied to a contract, there was much consternation in the Middle East as to the effect on Sharia’a compliant contracts. Consequently, in Saudi Arabia, there is a preference for using Saudi law and not English law. This affects inter-creditor relationships. The complex deal structure usually has an international element. To make the deal acceptable to the other creditors there is usually a provision that those creditors can have disputes heard in English courts under English law.
Deal structures
Deal structures in Islamic finance broadly fall into the following categories: -
• Asset-backed: -
o Murabaha: cost plus financing
o Ijarah: lease purchase financing
o Istisna’a: commissioned manufacture of specified assets
• Risk-sharing: -
o Mudaraba: investment fund arrangement or financed by way of trust
o Musharaka: joint venture or financed through partnership
• Sukuk: Sharia’a-compliant financial instruments including bonds
• Sharia’a-compliant derivatives
The above structures can be used individually or in combination. Flexibility and adaptability appear to be hallmarks of Sharia’a financing.
John Dewar foresees rapid growth in the next 10-20 years.
If you’d like to find out more, John Dewar has edited the book International Project Finance published in 2011 by Oxford University Press which has a chapter on Islamic Finance. A new edition will be published in 2014.
