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FEATURE: A Guide to the Principles of Islamic Finance

|Oct 9|magazine12 min read

Shari'a is derived from Islamic sources including the holy Quran (the primary source), the sayings (Hadith) and the teachings (Sunnah).

Whilst not a codified body of law, certain principles must be complied with to ensure that any contract is Shari’a-compliant, or, in other words is compatible with the rules, principles and parameters of Islamic law. Fundamental principles include:

  1. the charging of Riba (interest) is prohibited;
  2. profit, loss and an element of risk must be prevalent in the transaction;
  3. the subject matter of the transaction must be Halal (permissible) e.g. must not be related to alcohol, pork or gambling;
  4. the prohibition of Maysir (speculation or gambling); and
  5. there must be contractual certainty in the transaction i.e. no Gharar (uncertainty).

Non-adherence to any one of the above will be considered by Shari’a scholars and supervisory boards as rendering the whole transaction as null and void from a Shari’a perspective.

Governance issues: role of Shari’a supervisory boards

Shari’a supervisory boards are constituted of Islamic scholars with expertise in finance and Islamic commercial jurisprudence. They play a pivotal role in any transaction with an Islamic facet; providing sign off by way of a Fatwa (or opinion) that the transaction in question is Shari’a-compliant.

It is crucial that the Shari’a supervisory board (whether an in-house team or a third party institution specialising in such matters) is engaged early in any Islamic transaction giving investors reassurance and avoiding closing delays.

Differing views are held by many Shari’a supervisory board members when interpreting Shari’a principles, often resulting in discrepancies, or an inconsistency in the application of such principles in legal documentation within Islamic finance transactions.

Whilst there is a push for standardisation, many believe attaining the standardisation achieved in the conventional market (through the Loan Market Association standards) is a distant reality.

Fatwas are typically issued on the closing of a transaction and reassure investors that the transaction is in line with the principles of Shari’a. Fatwas are also becoming increasingly detailed, often reiterating the mechanics of a transaction in the body of the Fatwa itself.

Whilst it may have once been perceived that the role of the Shari’a supervisory boards ended upon the issuance of a fatwa, it is now common for Shari’a supervisory boards to delve into the mechanisms with which a transaction is implemented post-close; most commonly by way of annual audits.

Thus, it is very important for ‘borrowing’ vehicles to ensure their internal governance is well maintained otherwise a transaction which had been signed off as Shari’a- compliant pre-closing could thereafter be regarded as non-Shari’a-compliant.

Islamic finance and investment instruments

The final choice of Shari’a-compliant finance structure will depend upon, amongst others, the nature of the underlying assets and the business and the industry of the corporate or target, in addition to local law, regulatory and tax considerations. The main Islamic finance and investment instruments are:

  1. Wakala – an agency arrangement whereby the client appoints the financial institution (“FI”) to invest on its behalf monies in a certain venture and the pre-agreed profit will be on-paid to the client.
  2. Murabaha – cost plus financing, typically a sale and purchase structure whereby a FI purchases commodities/goods upon a client’s request. The client makes deferred payments covering costs and an agreed profit margin in favour of the FI.
  3. Ijara – a sale and leaseback structure under which a FI purchases capital in the form of equipment or property and then leases it back to the customer. The FI retains ownership of the asset.
  4. Musharaka – this can take several forms but essentially is a partnership structure whereby all partners participate and share in the ownership of a property or asset. This venture results in profit and loss sharing between the partners.
  5. Mudaraba – a contract entered into between an entrepreneur who contributes his/her expertise (and may also contribute capital) and an investor who contributes only capital. Each partner earns a pre-agreed ratio of profit realised by the venture. 
  6. Sukuk – whilst not an investment instrument in itself, it is akin to a bond structure in conventional financings whereby a finance structure (as described above in (a) through (e) above) is utilised to back and create a beneficial ownership interest in the Shari’a-compliant assets that are the subject matter of the transaction. In a Sukuk transaction, the revenues generated from the assets are used to pay investors which include a pre-agreed profit amount or rate.

Article written by Ayman A. Khaleq, Managing Partner of the Dubai office and Amanjit K. Fagura, Associate in the Dubai office of global law firm, Morgan Lewis