Critical Factors For The Development and Growth of

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Critical Factors For The Development and Growth of Islamic Finance in the West Michael J. T. Mc. Millen Berkeley Law Islamic Finance Symposium April 9, 2011 1 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Contact Information Michael J. T. Mc. Millen River Stone Capital, LLC (law firm soon to be announced) E-mail: mjtmcmillen@gmail. com U. S. Mobile: +1 -646 -337 -3113 2 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Topical Overview § § Five Critical Factors § Some History § The Dow Jones Fatwā § Bifurcated Structures – the ʾIjāra (Lease) § Myth: Complexity § Sukūk § 4 Objectives Musings Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Objectives for Today § Consider the critical factors that enabled the development and influence the form of Islamic finance and investment in the West § Which entails a bit of history and a dip into a structure § Identify a select group of dynamic tensions that exist in the Islamic finance (and investment) industry, particularly with respect to Sharīʿah compliance 6 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Five Critical Developments § § Nominate Contracts as building blocks – mid-1990 s § Dow Jones Fatwā – equity side of capital markets – 1998 § Sharīʿah-compliant structures for Western transactions – “bifurcated structures” – 1997 -2000 § Sukūk – finance or “debt” side of capital markets - especially after 2002 § 8 ʾIjmāʿ (consensus) sought by small group of scholars - mid-1990 s The red stars in the history section Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Timeline: Modern Islamic Finance Adapted from: Yusuf Talal De. Lorenzo and Michael J. T. Mc. Millen, Law and Islamic Finance: An Interactive Analysis (2007), and Yusuf Talal De. Lorenzo presentation of February 17, 2009, US Treasury. Dates are approximate. Inception of thinking; Development of the Sharīʿah: Nominate Contracts 633 10 800 1000 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved 1300 1500 1700 1996 2011

Timeline: Modern Islamic Finance Adapted from: Yusuf Talal De. Lorenzo and Michael J. T. Mc. Millen, Law and Islamic Finance: An Interactive Analysis (2007), and Yusuf Talal De. Lorenzo presentation of February 17, 2009, US Treasury. Dates within any given period are approximate Post WWII independence leads to new nationalisms and the popular revival of indigenous institutions 1970’s Islamic banks open in Asia and Europe. Real Estate, leasing and commodities 1980’s Islamic banks and finance houses open in Middle East Conventional banks open “Islamic windows”: deposit side focus 11 Gulf Investment House Bifurcated US residential real estate ʾistisna ʿ– ʾijāra structures (Maconda Park – Truman Park) Modern Islamic “finance” begins: focus on “investment” side; move to ʾjmāʿ; nominate contracts as building blocks Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved 1990’s Saudi Chevron bifurcated rahn-ʿadl structure 1996 1998 Arcapita Watermark Paddlesports: private equity 1999 2000 2001 Dow Jones Islamic Market Index Fatwā United Bank of Kuwait IIBU equipment leasing funds – operating leases in the US KFH Lease Fund and Wafra lease funds – US equipment operating leases; Investcorp conventional and Islamic residential fund

Timeline: Modern Islamic Finance Adapted from: Yusuf Talal De. Lorenzo and Michael J. T. Mc. Millen, Law and Islamic Finance: An Interactive Analysis (2007), And Yusuf Talal De. Lorenzo presentation of February 17, 2009, US Treasury. dates within any given period are approximate First Compliant ETFs and REITs Sharīʿah-compliant private equity: Aston Martin Islamic Indexes delist Enron, Worldcom, Tyco months before their falls Sukūk, Islamic asset and whole-business securitizations: AAOIFI Standard HSBC Amanah Global Properties Income Fund: real estate 2001 2002 2003 First sukūk value of issues doubles each succeeding year until 2008 12 East Cameron bankruptcy filing Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved 2004 Fatwā for Sharīʿahcompliant short sales and options AAOIFI Sukūk Clarification 2005 2006 2007 2008 Rated sukūk based on US assets: East Cameron Oil & Gas Compliant assets on the LME total US$100 Billion

Development of the Sharī`ah as Law of Commerce Sharīʿah principles (re commerce and finance) grew out of trade - in the Arabian peninsula 1, 400 years ago. The paradigm structures are: • sales • partnerships 13 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Revival and Recovery § ʾIjmā: Consensus necessary across four primary Sunnī madhāhib (schools of Islamic jurisprudence): think of product development and sales difficulties in the period prior to consensus (transaction costs) 14 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Revival and Recovery § Historically, under the Sharīʿah, there were a limited number of contractual transactional forms for the conduct of business – the “nominate contracts” § Trade-based – quite rigid – ‘silo’ approach still predominant up to 1998 § They included: § § § § 15 Loans (qarḍ hassan) Gifts Sales (bay), such as murābaha (sale at a mark-up) Leases – a type of sale of the usufruct (ʾijāra) Joint ventures and partnerships (sharikāt, muḍāraba) Manufacture or construction contracts (istisnaʿ) Agency (wakāla) Others Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Transition Factors § Scholars and practitioners began moving away from a conception of the nominate contracts as being immutable and rigid § Toward a more flexible conception of these structures as ‘building blocks’ § 16 Structures are developed to allow conventional interest-based financing to participate in the transaction (examples later) – bifurcated structures Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Permissible Impurity and Purification: the Dow Jones Fatwā § Prior to 1998, any violation of Sharīʿah, however slight, rendered the transaction impermissible § Prior to 1998, a totally observant Muslim could not purchase a share of stock – ribā being a major constraint § Dow Jones Islamic Indexes fatwā of 1998 (amended 2003) § The tests: permissible business (“core” business), permissible instruments, and permissible impurity and financial tests § Institutionalization of a degree of “permissible impurity” § Institutionalization of cleansing or purification § Cleansing and purification – small amounts of impermissible interest income could be cleansed or purified by donation to charity 18 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

First Sharīʿah-Compliant Structures § Assumption: US and European banks needed to finance real estate transactions in, first, the US and, later, Europe § These banks would only make conventional interest-based loans § § Familiarity Credit and underwriting Regulatory and tax Other reasons § § The first structures made use of the ʾijāra (lease) – basically a leveraged lease format – familiar to bankers and lawyers § 20 Bifurcated structures making use of both Sharīʿah structures and conventional structures in an overall transaction that is determined to be Sharīʿah-compliant by the Sharīʿah scholars Those structures remain predominant throughout the world – adjusted for each jurisdiction Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Synchronicity and Comfort § History of Documents – Lender Bias § Initial Bank Representation § No Bank – No Deal § Modifications With Market Acceptance § Modules: § § § § 21 Backbone Covenants Representations and Warranties Events of Default Insurance Rental Factors (lease rates) Land Property Description Risk Grid Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Standard Loan Agreement LOAN AGREEMENT • Commitment to Lend • Rate Calculations • Disbursement Mechanics • Amortization • Conditions Precedent • Mandatory Prepayment • Representations and Warranties • Voluntary Prepayment • Covenants • Events of Default • Remedies • Indemnities 22 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Disbursement – Repayment Mechanism LOAN AG REEMENT • Commitment to Lend • Rate Calculations • Disbursement Mechanics • Amortization • Conditions Precedent • Mandatory Prepayment • Representations and Warranties • Voluntary Prepayment • Covenants • Events of Default • Remedies • Indemnities 23 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Reallocation of Provisions LEASE (IJĀRA) [CONSTRUCTION (ISTISNA’A)] LEASE (IJĀRA) • Rent Rate Calculations • Commitment for Construction • Periodic Rent • Disbursement Mechanisms • Representations and Warranties • Conditions Precedent • Covenants • Representations and Warranties • Events of Default • Covenants • Indemnities Acquisition transactions have no istisnaʿ – that is for construction and development financings with multiple draws • Remedies PUT and CALL OPTIONS • Mandatory Prepayments • Voluntary Prepayments 24 24 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Bifurcated Structure - ʾIjāra Compliant Non-Compliant Bank Fund Conventional Loan Agreement Other Loan Documents Lease (ʾIjāra) Understanding to Purchase Funding Company Understanding to Sell Managing Contractor Agreement Project Company Tax Matters Agreement Occupational Tenant Leases Occupational 25 Tenants 25 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Tenant Compliance Issues § Tenants may not engage in prohibited businesses (alcohol, pork, interestbased financing, non-mutual insurance, gambling, pornography, prostitution) § The Fund Manager, on behalf of the Fund and the Project Company, will investigate the business of every occupational tenant § Each occupational tenant lease must be Sharīʿah compliant 26 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Tenant Compliance Issues § Permissible impurity and cleansing doctrines come into play § Recall that the test pertains to the “core business activities” of the relevant entity – from the Dow Jones fatwā § Available alternatives issues (an ATM, a restaurant with a bar, back office operations of an insurance company, and other examples) § Cleansing by donation of a portion of the proceeds § Request to make lease compliant at inception; obligation to make it compliant upon releasing or renewal of lease – accommodation to market realities § § Investors and lenders must consider whether the property will draw sufficient tenant interest based upon property type (office, industrial, mixed use, etc) and locations § 27 These tests have the effect of limiting the pool of properties available for investments by a Sharīʿah-compliant fund Not an issue for residential properties Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Lease (ʾIjāra) Loan Payments Dividends Debt Service Conventional Loan Agreement Other Loan Documents Lease (ʾIjāra) Funding Company Rent The Funding Company, as the lessor, will lease the Project to the Project Company, as the lessee, pursuant to the Lease (ʾIjāra). This is a Sharīʿah-compliant lease. In the US, Rent equals periodic debt service, precisely. 28 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved Project Company Rent Occupational Tenant Leases

Understanding to Purchase and Understanding to Sell is a “call option” for the project, in whole or in part. The strike price equals all amounts due on the conventional loan. All voluntary prepayments. Debt Service Conventional Loan Agreement Other Loan Documents Lease (ʾIjāra) Funding Company Understanding to Purchase/Sell Strike Price Project Company Title Understanding to Purchase is a “put option” for the project, in whole or in part. The strike price equals all amounts due on the conventional loan. Sharīʿah rule on inability to collect future rents. Need mechanism to accelerate. All mandatory prepayments. 29 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved Occupational Tenant Leases

Tax Matters Agreement The Tax Matters Agreement indicates that the structure is a loan for US federal tax and provides a transactional roadmap for the IRS, designating the allocations of portions of Basic Rent and the purchase prices under the Understandings that are interest, principal, etc. Bank Loan Funding Company Interest and Principal via Basic Rent Payments Purchase Price Payments 30 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved Tax Matters Agreement Project Company Occupational Tenant Leases

Myth: Complexity § A frequent comment about Islamic finance is that it is too complex for widespread use, especially in the West § Look at the leasing context, and compare the ʾijāra with the leveraged lease § This is the most widely used structure for real estate investments, private equity investments and a wide range of other transactions § It is one of two structures used for Sharīʿah-compliant home financings (the other is the diminishing mushāraka) 32 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

ʾIjāra Structure Bank Fund Conventional Loan Agreement Other Loan Documents Debt Service Lease (ʾIjāra) Funding Company Understanding to Purchase Understanding to Sell Project Company Managing Contractor Agreement Rent/Purchase Price Occupational Tenant Leases Occupational Tenants 33 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Complexity – The Leveraged Lease Equity Funds 12 Progress Payments, 14 Purchase Price Debt Service Revenue not needed for Debt Service Reserve Fund 21 9 Lessee Security Agreement Lessee Mortgage 8 Trust Certificate Tax Benefits 10 Operating Expenses Revenue not needed for Debt Service Lease 23 11 1 Lessee Assignment of Construction/Purchase 7 Agreement Internal Revenue Service 17 19 Participation Agreement 22 Lessor Equity Participant 23 Owner Trustee 15 Owner Trust Agreement 20 Notes, Bonds 16 Title Rents: Basic, Supplemental 18 13 Lenders Indenture/Mortgage, Assignments of Lease and Rents, Assignment of Lessee Security Agreement and Construction/ Purchase Agreement Contractor Manufacturer Debt Funds Indenture Trustee Site Lease Tax Indemnity Agreement 17 Operating Agreements Offtake Agreements Construction/ Purchase Agreement Supply Agreements 5 6 2 3 4 Site Lessor Operator 34 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved Offtakers Suppliers Contractor/ Manufacturer

Complexity - ʾIjāra Equity Funds Lender Indenture/Mortgage, Assignments of Lease and Rents, Assignment of Lessee Security Agreement and Construction/ Purchase Agreement Debt Service Operating Expenses Debt Funds 20 12 19 13 16 Title Contractor Manufacturer Rents: Basic, Supplemental 18 Funding Company 15 21 Lessor Progress Payments, 14 Purchase Price Equity Participant Revenue not needed for Debt Service Tax Benefits Equity Funds Lessee Security Agreement 11 Lease, Put, Call, Managing Contractor 1 Assignment of Construction/Purchase 7 Agreement 23 Internal Revenue Service 17 Lessee 12 Operating Agreements Operator 35 Reserve Fund Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved Offtake Agreements 5 6 Offtakers Construction/ Purchase Agreement Supply Agreements 3 4 Suppliers Contractor/ Manufacturer

The Complexity Myth and Misconception § § 36 At present, most Islamic finance transactions are less complex than their conventional equivalents It is anticipated that the level of complexity of Islamic and conventional finance transactions will be essentially the same as more “compound” transactions (involving both Islamic and conventional participants) are effected and as Islamic finance becomes more sophisticated Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Definition and Overview § Growth since 2003 – one of the fastest growing areas § One of the first instruments to access the debt side of the capital markets § Sukūk are of two types: § § “Bond” structures – herein lies the problem – consider “whole business securitizations” Asset securitization structures § § 38 Most transactions to date are bond structures that involve, ultimately, a sovereign credit Only a few (one? ) asset securitization sukūk Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Definition and Overview § AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) sukūk standard § Definition: § certificates of equal value put to use as common shares and rights in tangible assets, usufructs and services or as equity of a project or investment activity § distinguished from equity, notes and bonds § they are not debts of the issuer § may not be issued on a pool of (impermissible) receivables § underlying business contract or undertaking must be Sharīʿahcompliant 39 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

$Fundamental Definitional Queries § By definition, a sakk represents a fractional undivided interest in$ Fundamental Definitional Queries § By definition, a sakk represents a fractional undivided interest in the underlying asset § It is quite similar to a “pass through certificate”, circa 1983, in US mortgage-backed securities practice § What is “fractional undivided ownership”? § Tax benefits and burdens to certificate holder? Consider, e. g. , depreciation, investment tax credits, phantom income, etc. § Environmental liability to certificate holder? § , § Sukūk are owned, overwhelmingly, by banks, insurance companies, institutional investors and governments (consider Malaysia) § What of ownership of the usufruct rather than the underlying asset itself? § Consider these issues as we work through the discussion of sukūk 40 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Categories § 14 acceptable categories § Securitization of: § § § § 41 an existing or to be acquired tangible asset (ʾijāra) an existing or to be acquired leasehold estate (ʾijāra) presale of services (ʾijāra) pre-sale of the production or provisions of goods or commodities at a future date (salam) funding cost of construction (istisnaʿ) funding acquisition of goods for future sale (murābaha) capital participation in a project or business (muḍāraba or mushārakah) various asset acquisition and agency management (wakāla), agricultural land cultivation (musra’a), land management (muqārasa) or orchard management (musāqā) activities Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Issuances Generally: to September 2008 Total Issuances: Total Offerings: US$ 87, 955. 22 million 596 Sovereign Issuances: Corporate Issuances: Malaysia Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. Bahrain UAE 35% 65% Issuances: Total Volume: 267 (44. 80%) US$ 37, 696. 72 million (42. 86%) Issuances: Total Volume: 150 (25. 17%) US$ 6, 149. 78 million (7. 00%) Issuances: Total Volume: 34 (5. 70%) US$ 26, 977. 48 million (30. 67%) Total Number: Malaysia + Bahrain: 69. 97% Total Volume: Malaysia + UAE: 73. 53% Compare: Gambia: 36 (6. 04%) and US$ 11. 49 million (0. 0%) 42 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Issuances by Industry Sector Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. 43 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Issuances by Sharī`ah Structure Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. 44 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Issuances by Sharī`ah Structure and Year Million (US$) 35, 000 Musharaka Murabaha Modarabah Istisnaa Ijarah Al Salaam 2004 2005 2006 Al-Istithmar 30, 000 25, 000 Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. 20, 000 15, 000 10, 000 5, 000 0 2000 & before 45 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved 2001 2002 2003 2007 2008

Issuances by Tenor and Dollar Volume Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. 46 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Annual Issuances by Tenor and Number Source: Michael J. T. Mc. Millen and John A. Crawford, Sukuk in the First Decade: By The Numbers, Dow Jones Islamic Indexes Newsletter, Issue 3, 2008. 47 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Generic Sukūk al-ʾIjāra Structure Sukūk Proceeds Prior to the global financial crisis, banks expressed a willingness to purchase the sukūk. None done in US as yet. Most transactions involve sales of sukūk in the markets. What markets? Local banks and Western banks and insurance companies have been major purchasers. Thus far, however, these have involved sovereign credits on the obligations. Lease (ʾIjāra) Understanding to Purchase Understanding to Sell Managing Contractor Agreement Occupational Tenant Leases 48 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Conclusions - Musings § Islamic finance is all around you, and it will continue to expand § United States (in particular ) and the West: § § one of the largest Islamic finance markets an unheralded leader in the development of sophisticated structures for Islamic finance § § There have been various instances of doctrinal compromise that have facilitated the growth of the Islamic finance industry, and many of those compromises acknowledge Western financial market practices § These compromises areas of dynamic tension, and the doctrinal disparity decreases with time § At the regulatory level, the global reevaluation presents an opportunity to consider and integrate Islamic financing principles; and that is occurring § 50 Islamic finance is structured finance that is already familiar to many; it is not mystical The greatest opportunity is enhanced cultural understanding and appreciation Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Attributions Alhambra, Moorish architectural detail Sarouk Fereghan Carpet, detail, North Persia, circa 1910, signed Taushandjian Sotheby’s 53 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Attributions Samarkand Carpet, Eastern Turkestan, circa 1900 Sotheby’s Mosque , Cathedral de Qous, ornamentation, G. Weber, lithographer New York Public Library 54 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Attributions Faiences Murales - du Tekyeh des Derwiches (SVIIe. siecle), New York Public Library Timurid blue and white lotus bowl. , Persia, 15 th century, Sotheby's. L 10223 -206 -lr-1 55 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Attributions Abbasid lustre pottery bowl, Iraq or Tunisia, 2 nd half of 9 th century, Sotheby’s L 10225 -60 -lr-1 Kahsan pierced white ware pottery bowls, Persia. circa 1200, Sotheby's. L 10225 -79 -lr-1 56 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved

Attributions Late Ayyubid - Early Mamluk, deep bowl, Raqqa or Damascus. mid-13 th century Sotheby's, L 10223 -171 -lr-1 Safavid Bombroon Pottery Bowl, Persia, 17 th century Sotheby's, L 10223 -210 -lr-1 57 Copyright © 2008 -2011 Michael J. T. Mc. Millen; all rights reserved