Norton Rose LLP has advised clients in leading the way in the development of structured Shariah compliant products. In particular, we advised on the launch recently of the Al-Safi trust, a fund intended to comply with the principles of Shariah. Together with other fund structures under development and being discussed in the industry, are we witnessing the rise of the Shariah compliant ‘hedge’ fund?
There are nearly 500 Islamic equity funds worldwide, with total assets under active management of between US$50 billion and US$70 billion1. The size of the Islamic equity fund industry has tripled over the past five years2. This growth is expected to continue, with the prediction that Islamic assets under management are growing at an annual rate of around 20%3. The demand for ethical-based financing has seen a global rise, most notably in the sphere of Islamic finance. Islamic finance seeks to comply with the rules, principles and parameters of Islamic commercial jurisprudence (Shariah) whilst combining the promotion of ethical and socially responsible investment. Islamic finance has developed by providing a permissible (or halal) alternative to the payment of interest under conventional debt financing instruments. However, recently we have witnessed a demand for a wider range of financing structures to be applied to new products, including equity-linked products.
The spirit of Islamic finance is more akin to equity-based financing as opposed to debt-based, as it relies on a concept of profit and loss sharing between the counterparties. Hence, the traditional Islamic fund is based on a partnership-based model eg. the Musharakah. The Musharakah involves sharing any loss between the investors in proportion to the capital invested, whilst any profit is shared between the parties at pre-agreed levels. This model has been favoured by Shariah scholars as it incorporates the cornerstone of Islamic finance – risk sharing. As such financing techniques evolve in order to meet investor demand and fulfil changing investment criteria, the more traditional boundaries of Islamic finance are consequently expanding into new areas of structured finance. Practioners in the industry have been working closely with Shariah scholars in order to develop Shariah compliant products within such a framework.
Funds whose returns are linked to equity exposures often utilise techniques involving a long or short sale of such equities. Recently, both the SEC and the FSA (as well as regulators in other jurisdictions) have announced significant restrictions on the ability to short sell many types of shares. Prior to such restrictions, however, short selling was often used by conventional funds to create a required exposure by borrowing an equity and selling this in the market with the intention of purchasing the equity later at a lower price in order to repay the loan.
An arrangement comprising a sale of an equity which the seller does not own, however, would not be Shariah compliant. However, we have witnessed recent developments involving a traditional Shariah contract, called an Arbun, which has been used to provide Islamic investors with exposure to Shariah compliant equities that creates similar exposures. This structure functions by replicating (to an extent) the economic effect of short selling, however due to the underlying structure it has received approval from Shariah scholars. The Arbun is a sale contract based on a deposit in respect of the purchase price of an equity with complete performance of the contract due at a future date. Ownership of the equity under the Arbun structure is, therefore, established before the subsequent sale and hence this method has been deemed Shariah compliant.
The Al-Safi trust, which utilises the Arbun contract, is a multi-class, Cayman-based trust which seeks to provide a Shariah compliant solution to investors seeking to broaden their exposures in return for potentially higher returns.
A distinctive feature of a Shariah compliant fund is the requirement for a Shariah board (usually comprising at least three scholars) with expertise in finance and Shariah matters to undertake a detailed examination of the structure and documentation of a proposed transaction or product to ensure it complies with Shariah and will often issue a Fatwa (an Islamic juristic opinion) in order to approve such documentation or structure. The Shariah board will approve a set of Shariah compliant investment guidelines to be used by an investment manager to govern the investments made by the fund. Investments in certain products (such as alcohol and pork), certain industries (such as gambling and the manufacturing of armaments) and certain investment strategies (such as speculative or interest-related strategies) will be prohibited.
For corporate governance reasons, the Shariah monitoring function is often split between a Shariah advisor (conducting internal day-to-day monitoring to ensure the fund’s compliance with Shariah investment guidelines) and an external Shariah board (providing guidance on investment guidelines, purification and undertaking an independent audit on a periodic basis). The Al-Safi trust has adopted this two-tier structure and four leading international scholars have been appointed to the Al-Safi Shariah board to provide a Shariah oversight function, together with an expert Shariah advisor to provide day to day monitoring of the investments of the trust.
Another function of a Shariah board is to provide guidance on purification. Any income generated by an Islamic fund must be ‘purified’ as it is likely some income may have been derived from interest-based transactions orfrom other non-halal sources. The tainted income may either be deducted prior to distribution of dividends or the investors may be informed of the amount that should be deducted to achieve a Shariah compliant return and it is left to the investor to purify the income by, for example, donating a portion to charity. The Al-Safi model (like other structures we have advised on) adopts the latter approach. The Al-Safi trust has been structured as an ‘umbrella’ trust with multiple sub-trusts. This structure minimises cross liabilities between different sub-trusts as any liabilities or expenses incurred with respect to a particular sub-trust are ring-fenced within that sub trust (ie. are enforceable against the assets of such sub-trust only). This assists in mitigating the investor’s risk and prevents cross-contamination between different sub trusts.
Other than the exposures being created and the Shariah compliance elements discussed above, the underlying structure of the Al-Safi trust is no different to a conventional fund structure. This should provide comfort to investors as such structures have been widely used in the market previously.As we have discussed above, market forces have led to the creation of funds which seek to comply with Shariah to provide investors with alternative Shariah compliant investment models. From an industry which developed to provide an alternative to debt financing based on interest, there is now an increasing demand for Shariah compliant equity financing.
The structures discussed in this article seek to widen the range of financing techniques and asset classes available to Islamic and non-Islamic investors who wish to broaden their range of exposure to Shariah compliant equity returns. With the current market conditions also aiding in the development of alternative and innovative financial products, we are clearly witnessing further development and expansion of the industry into new areas. THFJ
Dean Naumowicz is a partner in the International Securities Group. Uzma Khan is an associate in the Corporate Finance Department at Norton Rose LLP