Posted May 6, 2015
Islam Meets Wall Street
By CAREN CHESLER
Saqib Awan was working as an attorney at the global law firm DLA Piper when his firm was asked to advise a Saudi Arabian company as it structured a bond deal that would comply with Islamic law, also known as Sharia law. The type of bonds, called sukuk, usually involve placing assets into a special purpose vehicle (SPV) and then issuing certificates that give investors an ownership stake in the asset pool. Since Islamic law prohibits the charging or paying of interest, sukuk transactions often look more like equity than debt.
The problem was, Awan’s client didn’t want to move the underlying assets into an SPV. He didn’t want to pay the costs associated with moving the assets off of its balance sheet or suffer the risk that the assets might be lost. Awan’s firm told the client the assets had to be transferred on to the books of the SPV in order for the deal to be Sharia compliant. However, the company hired an Islamic scholar, who said such a move was not necessary. The company opted to keep the assets on its own books.
“If you asked 20 Sharia scholars, they would say this was not the way it’s supposed to be done. It was a bit odd,” says Awan, now a senior consultant to a sovereign wealth fund in the United Arab Emirates.
The deal highlights one of the main questions in Islamic finance today: What is compliant under Islamic law, and who gets to make that determination? These questions are becoming increasingly important as the Islamic finance sector flourishes.
Islamic financial institutions worldwide hold about $1.8 trillion in assets—and are likely to sustain double-digit growth over the coming few years to reach about $3 trillion, according to a report this year by Standard & Poor’s.
The sukuk market alone has doubled in the last three years, with annual issuance rising sharply from less than $32 billion in 2010 to a record $118 billion at year-end 2014, according to Moody’s.
The deal involving Awan’s client underscores the dilemmas faced by advisors and other professionals in this sector.
A fundamental concept in sukuk is that the holder can redeem his shares at any time and get his money back or get possession of the underlying assets on a pro rata basis. But in the case of Awan’s client, the assets weren’t even owned by the entity issuing the sukuk. They were still owned by the parent company. Not only was this a legal issue, but it was a breach of Sharia law, where it is prohibited to sell something you do not own.
“Either the issuer managed to convince the scholar that he could do this or … there was limited information presented to the scholar,” Awan says.
Ideally, the scholar should be involved in the process throughout and sign off on all of the documents, Awan says, but in reality some Islamic scholars serve on dozens of Sharia boards.
“I highly doubt they can go through all of the documents on each deal and consider its individual merits,” Awan says.
Growth in the Islamic finance sector is expected to continue this year, as oil-exporting countries in the Middle East and Southeast Asia tap the sukuk market to finance infrastructure projects, Moody’s says. Malaysia accounts for two-thirds of all global sukuk issuance, but in 2014, countries such as the Maldives, Senegal, South Africa and the U.K. also turned to this market to borrow funds. It costs a bit more to issue sukuk than conventional bonds, but experts say that could change as the market becomes more standardized and liquidity grows. A few corporations in the Middle East have issued sukuk for less than they would have paid to issue conventional bonds, according to S&P.
“We anticipate that the premium for sukuk issuance over conventional bonds rates would decline if sukuk documentation were more highly standardized and default resolution mechanisms clearer,” S&P analysts wrote in the report.
Demand for Islamic financial products has increased over the last decade—not just in the Gulf and Southeast Asia, but also in America. There are 5.7 million Muslims in the U.S. with $98 billion in disposable income, according to a report by DinarStandard, and many are looking for Sharia-compliant investments. The American Muslim population is younger than the national average and the education and income levels are on par with the average American household’s, says the study. And wealthy Muslims are looking for some of the same things rich American investors seek: capital preservation, education savings and retirement planning.
“Some are now software engineers and doctors, and they’re finding financial success and want to do something about their financing goals,” says Naushad Virji, CEO of ShariaPortfolio in Lake Mary, Fla. “Many of them are people whose parents and grandparents never had 401(k)s or worried about education savings.”
Virji says he receives inquiries from new Muslim investors daily, and his assets under management are growing at a rate of about $5 million a month.
“We have a team of 12 people and we’re still hiring to keep up with demand,” Virji says.
Ernst & Young estimates global Islamic banking assets will exceed $3.4 trillion by 2018. Even if Muslims represent just 10% of world GDP, their high saving rates means that wealth is being generated in the hundreds of billions of dollars each year, making the Muslim population worth noting for wealth managers, experts say. In Asia alone, more than 2.6 million high-net-worth individuals control an estimated $8.4 trillion in assets, according to the International Centre for Education in Islamic Finance.
Wealthy Muslims, like everyone else with that kind of money, need private bankers and wealth managers to help them with educating their children, preparing for retirement, funding their chosen lifestyle and ensuring a smooth transition of assets upon their deaths.
But for many advisors in the U.S., it’s a peculiar market—many Muslims require Sharia-compliant investments, but not a lot of financial experts have expertise in Sharia law.
Serving this population as a financial advisor is a tall order, as devout Muslims are prohibited from investing in instruments that generate interest and taking on trading risk without having a real asset underlying the deal. There are also prohibitions on investing in activities prohibited in Islam, such as the consumption of alcohol, tobacco and pork; gambling; pornography; and weapons manufacturing. Hotels, cinemas and music companies are also prohibited, as are conventional insurance and financial services firms.
Moreover, there are also stipulations for a company’s capital structure. For example, accounts receivable must be less than 30% of assets—to ensure the company does not engage in too much lending—and the total debt must be less than 30% of its market capitalization to make sure the firm is not overleveraged.
Satisfying these prohibitions is difficult, as many modern finance instruments, from treasury bills to currency futures, involve lending money on interest, the sale of risk or both. Even real estate investment trusts have become problematic, because if a REIT buys a shopping mall that includes a liquor store or smoke shop, some scholars would say the REIT is no longer Sharia-compliant.
“There’s demand for innovation, but it’s not just creating Sharia-compliant debt. It’s about creating instruments that truly reflect the principles of Islamic finance, which are about profit sharing and risk sharing,” says Shakeeb Saqlain, founder of Islamicbanker.com. He notes that venture capital is a good fit. “The demand is there, but the industry needs something more than just Sharia-compliant loan deals that are simply conventional products re-engineered.”
Saqlain expects innovation in the Islamic finance sector to come as the demand increases.
It won’t be easy, though, says Meagan Froemming, a visiting fellow at Harvard University’s Islamic Legal Studies program. Deals often involve multiple layers to enable them to be Sharia-compliant, and that can lead to added costs, such as double taxation. Getting around the mortgage prohibition might involve a bank buying a house and then selling it back to the owner, but every time the house changes hands, the transaction is taxed, she notes.
“You do multiple transactions and restructure the way returns are granted in order to avoid interest or avoid making money on money, but it becomes a complicated process that may have higher transaction costs,” she says.
Another problem: When the contracts comply with Sharia law, what happens if something goes wrong and they have to be adjudicated? There have been a couple of cases in New Jersey, for instance, where the parties chose to have their case tried under Sharia law and the court agreed to do it.
“American law enables parties to choose which laws they want to apply, but it’s been an issue when people choose Sharia law. What does that mean? And will American courts or U.K. courts see that as a legitimate choice? There’s been no clarity on this issue,” Froemming says.
But one of the biggest issues is the diverging opinions about what makes investments Sharia compliant. While equity-related instruments and businesses that are ethically and socially responsible are generally considered universally acceptable, views on other instruments can differ by scholar, region and sect of Islam.
“The lack of standardization in the industry is a problem,” Froemming says. “There are serious differences of opinion as to what determines what is Sharia compliant in the industry.”
There’s also been skepticism about the endorsement process.
“They have these quote-unquote Sharia boards, but they can be similar to the rating agencies during the financial crisis, where all these terrible derivatives were rated triple-A, but by whom? By the people who paid the check to the rating agencies. It’s the same problem here,” says Matthew Martin, founder of Blossom, a microfinance network based in Jakarta, Indonesia.
He cites the sale/leaseback structure many Muslim borrowers use to get around the ban on paying interest. In one of these deals, a bank might sell the borrower a commodity, like wheat or barley, for, say, $200,000, and then buy it back for $100,000. Theoretically, the borrower will then owe the bank $100,000, which he will repay in installments, creating the mathematical equivalent of making principal and interest payments.
“Many [Islamic] scholars have ruled this type of financial arrangement is valid, with certain conditions,” Martin says.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Saudi Arabia, is part rating agency and part regulatory board, not unlike the old Financial Accounting Standards Board (FASB). They have about 20 Islamic scholars from around the world, including the U.S., who discuss issues of Sharia compliance and render opinions about particular deals.
“If you want to launch a sukuk, you need to present it to them and get their stamp of approval,” Virji says. “If you come to some mutual fund companies, and you’ve got a project, whether it’s a REIT or sukuk, one of the things we want to know is who endorsed this in terms of Sharia compliance. Is it backed by AAOIFI or not?”
The lack of standardization can limit the type of investments available because, faced with diverging scholarly opinions, some managers opt out of an asset class altogether. When it comes to REITs, for instance, some scholars say they should be avoided because it’s impossible to determine what percentage of tenants in, say, an underlying mall will be selling items that are prohibited under Sharia law.
“It’s so murky, some managers just avoid REITs altogether,” says Imraan Jakoet, portfolio manager at Sanlam Investments in Bellville, South Africa.
The lack of standardization in what makes an instrument Sharia compliant can be seen in a $2 billion sukuk issue Goldman Sachs tried to sell back in 2011. While the deal was blessed by eight of the world’s top Islamic scholars, it became entangled in a debate over whether the bonds would continue to trade at par after they were sold. A properly constructed sukuk limits the debt to the value of the underlying assets. There were also questions about how Goldman planned to use the proceeds and whether those uses would comply with Islamic law.
“Goldman’s controversial sukuk in 2011 did not establish a clear link to the assets backing the sukuk, undermining some of the principles behind Islamic finance,” says Saqlain of Islamicbanker.com.
Goldman refrained from offering the bonds, restructured the deal and last October brought it to market with five other lenders. It sold well, as did a sukuk deal last year by the U.K., which lured bids for more than 10 times the amount offered.
Of course, not all Muslims are as strict as others. One attorney, who structures Sharia-compliant trusts for Muslim clients and requested anonymity, says some clients want language in their trusts to ensure no money is invested in the typical Sharia prohibitions, but they wouldn’t really mind if they owned a hotel that sold alcohol, for instance. He’d define those investors as “morally compliant”: They’re doing the right thing, but their trust structure wouldn’t likely be approved by an Islamic scholar. And then there are the strict Muslims who want everything done by the book and want their trust signed off by a scholar. Those scholars can be expensive, the attorney says. He likened them to lawyers, where the most well known can charge in the tens of thousands of pounds to render an opinion.
“Some people want their trust documents to say, ‘I don’t want pork or gambling or alcohol,’ but they’re very happy for the trustees to buy a hotel that makes lots of money,” the attorney says.
Most of his Muslim clients have fallen into the former category, he says. He estimates that less than a quarter take the more conservative approach.
But while not all need a scholar to sign off on every investment, many generally want their portfolios to be largely limited to Sharia-compliant listed equities and mutual funds, such as the Amana Income and the Amana Growth funds, as well as sukuk and real estate.
“There’s a lot of depth in listed equities. When you move into fixed income, that’s where we don’t have as much offerings as some institutional investors might want. One of the challenges of the industry is developing enough fixed-income product to meet the needs of sophisticated investors,” says Aamir Rehman, managing director at Fajr Capital Advisors, a Dubai-based Islamic finance advisory firm.
The first Sharia-compliant ETF was launched in August in the U.S.; several companies are working on Sharia-compliant REITs. There’s also a compliant fixed-income mutual fund in the U.S., run by Azzad Asset Management, that invests in sukuk and Islamic bank deposits. Financial experts say the crowdfunding concept may also be a good fit for Islamic investors, since it’s a reward-based equity structure rather than debt.
Martin, of Blossom, actually started his microfinancing network last October after realizing there weren’t a lot of Sharia-compliant financing options for entrepreneurs. He couldn’t go to a bank for a loan because Muslims are prohibited from paying interest. Blossom is a microfinancing network that provides capital in amounts of $10,000 to $200,000 to Muslims who can’t borrow money from a bank, though those providing the financing are not making loans. Rather, they’re getting an equity interest in the business they’re capitalizing.
Martin says his model is different than a bank making a conventional loan, where the borrower must repay a fixed amount regardless of whether the business prevails. His company offers profit-sharing instruments.
“It doesn’t matter whether there’s a typhoon or your business goes to zero. The bank will hound you until you send the monthly check,” Martin says. “With the profit-sharing model, it’s completely based on the performance of the business. If the business does well, the investor does well. If they’re not profitable, the lender does not profit. It treats the borrower as a partner.”
The Sharia screens are similar to those used in socially responsible investments (SRI)—with some exceptions. For example, Muslims have a prohibition on investments related to pork.
“There are a substantial number of faith-based institutions that invest in Islamic funds precisely because of those ethical screens, like tobacco, alcohol, gambling and firearms. Those screens are very common across almost every faith,” Rehman says.
And like with SRI investments, some might question whether investors are getting the best returns, given that their investment decisions are ultimately based not on finance but on religion. Experts, however, say many Muslim investors don’t necessarily care about achieving the best possible returns. They value spirituality as highly as they value returns, and if their non-financial values cut into returns, so be it.
“People want to see that their investments are consistent with their values, irrespective of what religious background they come from,” Rehman says.