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Legal Risks and Good Governance for the Growing Islamic Finance Industry Hamid Yunis Partner Legal Risks and Good Governance for the Growing Islamic Finance Industry Hamid Yunis Partner Karachi December 2006

Contents 1. Fundamentals of Islamic (Shariah Compliant) Finance n 2. Overview of Islamic Finance Contents 1. Fundamentals of Islamic (Shariah Compliant) Finance n 2. Overview of Islamic Finance Market n n n 3. 4. n n n Background Products and processes Regulator/operator issues Specific issues International Guidance Basel IFSB Standards General Principles n 6. Types of Islamic Finance Products Basic Assumptions Additional Matters Use of Islamic Finance in Different Market Sectors Governance n 5. Basic requirements and philosophy Non executive functions Conclusion 1

n Fundamentals Islamic (Shariah) Finance: n n n n Quranic (Shariah Law) principles; Riba n Fundamentals Islamic (Shariah) Finance: n n n n Quranic (Shariah Law) principles; Riba (“interest/unjustified rewards/unlawful gain”); Gharrar (“uncertainty, risk, speculation”); Halal (“religiously permissible”); Haram (“not religiously permissible”); Qard Hasan – (“good loan”); Al-Wadia – (“safekeeping”). 2

n Basic Requirements and Philosophy n n n true risk sharing; no exploitation of n Basic Requirements and Philosophy n n n true risk sharing; no exploitation of a weaker position; not socially unproductive; not economically wasteful; promotes economic and social development; and charitable (“zakat”). 3

Overview of Islamic Finance Market n n n Islamic and Dual Banking Systems Retail Overview of Islamic Finance Market n n n Islamic and Dual Banking Systems Retail Islamic finance products offered for a number of years, some low key e. g. Middle Eastern banks, others high profile e. g. HSBC Islamic Windows in major Global Banks Islamic Bank of Britain Primary Market: initially basic finance products Compatibility with conventional products 4

n Types of Islamic Finance Products: n n n Equity; Trade Financing; Asset Financing n Types of Islamic Finance Products: n n n Equity; Trade Financing; Asset Financing Lending; Wholesale & Retail Products: • • loans; partnership investments; forex; fund transfers; letters of credit; securities safe keeping; investment management and device; 5

n Islamic Finance (Cont’d): n n n Al-Wadia (safekeeping): usually not remunerated; Takaful (Insurance); n Islamic Finance (Cont’d): n n n Al-Wadia (safekeeping): usually not remunerated; Takaful (Insurance); Funds Work; SUKUK/Securitisation (Capital & Secondary Markets); and Derivatives/Funds Management. 6

n Basic Assumptions Underlying asset must be acceptable n Different interpretations on what proportion n Basic Assumptions Underlying asset must be acceptable n Different interpretations on what proportion of asset must not be “haraam” n Proposed structure of transaction has to be acceptable n No prohibited activities (proportionate approach) n Need to account for regulatory requirements and comply with two sets of law (Shariah and law of country) n 7

n Additional Matters n Zakat (specified amounts to be allocated from disposable income); n n Additional Matters n Zakat (specified amounts to be allocated from disposable income); n Shariah Boards – competition, pragmatic approaches; n Urf (custom); n Darura (overriding necessity); n Maslaha (general interest to justify); n Hiyal (ruse) 8

Use of Islamic Finance in Different Market Sectors Real Estate n Project Financing n Use of Islamic Finance in Different Market Sectors Real Estate n Project Financing n n n Co-financings (Power, LNG, Oil & Gas) Retail Banking Depositors n Investment Account Holders n n General Leasing n n n Ijara Asset Finance Bond (SUKUK) Issuance Private Equity Funds Insurance (Takaful) Capital Markets (Sukuk/Arboun/Salaam) 9

Governance Background Developing, structuring and marketing Shariah compliant financial products can be cumbersome and Governance Background Developing, structuring and marketing Shariah compliant financial products can be cumbersome and complex n IIFS needs to account for regulatory requirements and comply with two sets of jurisprudence/law (Shariah and the law and regulations of relevant jurisdiction) n 10

Products and Processes need to be effective from the following viewpoints: n n n Products and Processes need to be effective from the following viewpoints: n n n n Understandable Competitively priced Tax effective Available and transparent Not administratively burdensome Not “alien” to regulatory requirements Governance of institution offering Islamic financial services needs to be the same 11

Regulator/Operator Issues Scope for the continuing development of good corporate governance in the field Regulator/Operator Issues Scope for the continuing development of good corporate governance in the field of Islamic finance n No inconsistency with Shariah n 12

Specific Issues Islamic finance industry needs to, in particular, focus on issues regulators will Specific Issues Islamic finance industry needs to, in particular, focus on issues regulators will be concerned with n Remember that Shariah-compliance will not normally be an issue for non-Islamic countries or where Shariah is not part of a general legal framework n Shariah Supervisory Board presence and scrutiny therefore essential n 13

Specific Issues (cont…) n n n Islamic finance industry regulators need to consider regulation Specific Issues (cont…) n n n Islamic finance industry regulators need to consider regulation of Shariah Supervisory Board Islamic financing industry need for a unified front to regulators Standardisation of models used, terminology and treatment Dissemination of codes of best practice Practical Adaptability 14

Guidance Many forms of International and National Guidance available n OECD principles n UK Guidance Many forms of International and National Guidance available n OECD principles n UK Stock Exchange Combined Code n Cadbury Report n Hempel Report n Higgs Report n 15

Guidance (cont…) France/Germany: different forms of governance models n US: Sarbannes-Oxley n Other/Corporate Governance Guidance (cont…) France/Germany: different forms of governance models n US: Sarbannes-Oxley n Other/Corporate Governance Standards n Country Specific n Accounting and Industry Specific n IFSB guidance n Principles outlined n “Comply or Explain” n 16

Basel n Basel Committee on Banking Supervision 1999 paper n 2006 paper n 17 Basel n Basel Committee on Banking Supervision 1999 paper n 2006 paper n 17

General Principles Establish Good Governance Policy as a principle of Shariah n Monitoring and General Principles Establish Good Governance Policy as a principle of Shariah n Monitoring and work of n n n n Board Committees Executive Management Shariah Supervisory Board Internal and external auditors Different Stakeholders Mechanisms of balancing the roles of different stakeholders i. e. ) shareholders, management, IAHs 18

Non Executive Functions n Role of non-executive directors/managers Guidance n Oversight n Compliance issues Non Executive Functions n Role of non-executive directors/managers Guidance n Oversight n Compliance issues n Future compliance policy n 19

Contact: HAMID YUNIS Taylor Wessing Carmelite 50 Victoria Embankment Blackfriars London EC 4 Y Contact: HAMID YUNIS Taylor Wessing Carmelite 50 Victoria Embankment Blackfriars London EC 4 Y 0 DX Tel: 0207 300 7000 Fax: 0207 300 7100 Direct: 0207 300 4088 E-mail: h. [email protected] com Web: www. taylorwessing. com 20

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