The twentieth century witnessed the revival of Isla= mic finance in various parts of the Muslim world as an alternative mode of financing that is in compliance with shari‘a. From its mundane beginnings, when Islamic financiers were mainly providing Islamic trade financing solutions, the Islamic finance industry today offers a wide range= of products and services including personal finance, corporate finance, project finance, equity funds, property funds, and private equity. All these produc= ts and services are structured in accordance with shari‘a principles as interpreted in their respective jurisdictions. The existing product range, which is often priced competitiv= ely, provides Muslims with a viable option to manage their financial matters Islamically.

With the dawn of the twenty-first century, w= e are witnessing the Islamic finance industry constantly venturing into new and exciting areas of finance. One of the important recent endeavors is the development of Islamic debt securities commonly known as sukuk. Most Islamic financiers often end up with high levels of liquidity due to various reasons. The Islamic finance industry also lacks shari&#= 8216;a-compatible derivative products that could mitigate any asset-liability mismatch risks.= The high levels of liquidity often led to inefficiency in the Islamic finance market and the industry leaders actively sought solutions. The sukuk, which is a tradable and potentially liquid investment, was seen as a possible avenue for the Islamic financiers to invest their surplus liquidity.

HISTORY OF ISLAMIC DEBT SECURITIES

Interestingly, sukuk or sakk is not a new invention of the Islamic finance industry. The concept of sukuk has been with the Islamic wo= rld since the early days of Islamic civilization. Malik has recorded the first historical account of sukuk in = his famous treatise al-Muwatta. It = is stated that in the first century Hijri (corresponding to the seventh century AD) the Umayyad government would pay soldiers and public servants both in c= ash and in kind. The payment in kind was in the form of sukuk al-badai, which has been translated as “commodity coupons”[48] or “grain permits.”[49] The holders of the sukuk were entitled to present the sukuk on its maturity date at the treasury and receive a fixed amount of commodity, usually grains. Some of the holders used to sell their= sukuk to others for cash before the maturity date. Although the validity of such trade was been questioned by scholars of that period, it shows that the concept of sukuk al-badai as a tradable instrument has been known to the Islamic world for a very long tim= e.

The word sakk, though it may sound unfamiliar, is astonishingly well known to all of us. The origin of the wor= d check, ubiquitous in the modern financial world, is from the Arabic word sakk. It is well known that many of the commercial practices and customs of the Muslim world were transmitted to medieval Europe through Islamic Spain, and= sakk is one of them.= [50] However, like many other invention= s of Islamic civilization, the concept of sukuk was not exploited to its full potential by the Muslims. The financial commu= nity in the West adopted and refined the concept of sukuk and expanded its scope of use to a wide range of commerci= al and financial activities. Today, we see the Islamic financial world adopting the practices of Western finance and adjusting them to meet the requirement= of shari‘a.

In 2001, almost fourteen centuries later, th= e sukuk re-emerged in Bahrain as an Islamic alternative to conven= tional debt securities.[51] The State of Bahrain= [52] offered its inaugural sukuk al-ijara issue in the domestic market. The i= ssue amount was USD250 million and had a tenor of five years. The sukuk al-ijara= concept was derived from the prevai= ling practices of “lease ending with purchase” (ijara muntahia bi-tamlik) which is commonly known in conventional finance as “finance lease.”= [53] The sukuk carried six-monthly lease rentals that were fixed at the lease inception and paid in arrears during the lease term. The sukuk offering was highly successful. The Bahrain sukuk issue was a major milestone in Islamic finance as it marked the birth of an Islamic capital market where Islamic equity and debt-based instruments are issued and traded.

In 2002, the Federation of Malaysia created another landmark by issuing the first Islamic securities that complied with= the U.S. Regulation S and Rule 144A formats that are used for conventional glob= al bonds.[54] The Malaysian sukuk al-ijara was the first sukuk to be listed in the Luxembourg Stock Exchange and rated by Standard & Poor’s and Moody’s. The USD600 million sukuk was offered globally to Isla= mic and conventional investors including “Qualified Institutional Buyers” in the United States. The issue was hugely successful and was twice oversubscribed. The Malaysian sukuk was a significant development because it was able to successfully fuse the concept of sukuk al-ijara= with conventional bond practices su= ch as listing, ratings, dematerialized scripts, and centralized clearance.

Subsequently, there have been a number of successful sukuk issues in Regulation S format, incl= uding the Islamic Development Bank’s offering of USD= 400 million sukuk in 2003, the Stat= e of Qatar’s debut USD700 million sukuk al-ijara issue in 2003, and the Kingdom of B= ahrain’s USD250 million = sukuk al-ijara= issue in 2004. These successful iss= ues have created a lot of excitement in the Islamic finance markets and more issuers are looking at the sukuk option as a viable and attractive alternative source of funds. This paper w= ill examine some of the key sukuk products currently available in the Islamic finance markets and analyze the structure of each product. It will highlight the salient features of each product and examine the various sha= ri‘a innovations and the legal aspects of the structures. The paper will also lo= ok at the prospects for Islamic profit sharing products[55] and the current impediments to the growth of such products.

SUKUK AL-IJARA

A sukuk al-= ijara issue is typically structured as fo= llows:

Figure 1. A Typical Suk= uk al-Ijara= Structure

The above structure was used, with minor modificati= ons, in the USD250 million Kingdom of Bahrain sukuk al-ijara issue, the USD600 million Federatio= n of Malaysia sukuk al-ijara issue, = and the USD700 million State of Qatar sukuk al-ijara issue. The underlying assets were bought from the seller and immediately leased to the lessee based on the principle of ijara muntahia bi-tamlik (lease ending with purchase). The S= PC will act as the trustee for the sukuk holders and will distribute = to the sukuk holders the rental procee= ds of the leased assets in accordance with the terms of the trust. At the end of = the lease period the SPC will sell the assets to the original seller for a sum equal to the original sale price, which the SPC will distribute to the sukuk holders to redeem the sukuk. Some of the salient feature= s of the sukuk al-ijara are discussed be= low.

Sukuk Characteristics

One of the fundamental requirements of shari‘a for a security to be tradable is that the security must reflect or evidence the security holder’s share in an underlying asset or enterprise.= [56] For example, contemporary shariR= 16;a scholars have allowed investment in equity or share in a company on the bas= is that the security reflects the holder’s ownership of the underlying assets of the company. Through the ownership of the company the shareholders are deemed to indirectly own the assets held by the company.[57] By making a link between the ownership of the company with the ownership in= the company’s assets, the shari&#= 8216;a scholars have been able to allow “the buying and selling of these securities on the model not of partnership in the enterprise,[58] but of undivided co-ownership of the company’s assets.”[59] If the company as a going concern makes a profit by trading in goods, asset= s, or services the shareholders are entitled to receive from the company a sha= re in the profit through dividends.

A conventional bond, on the other hand, typi= cally confers on the bondholder a contractual right to receive from the issuer of= the bond certain interest payments during the life of the bond and the principal amount at the maturity of the bond. The bondholders themselves are deemed as creditors to the issuer of the bond and are ranked as senior unsecured and unsubordinated creditors of the issuer in priority to the shareholders.[60] The juridical nature of a conventional bond is clearly contrary to shari‘a.

The major challenge was to structure a shari‘a-compatible instrumen= t that embodies the ownership characteristic of an equity instrument as well as the priority status and the fixed income characteristics of a bond instrument. = In addition to those, the shari‘= a-compatible instrument also has to be transferable, rated by recognized rating agencies, listed on major securities exchanges, cleared through major clearinghouses,= and documented, in terms of legal documents and disclosures, on par with the prevailing standards in the conventional bond market.

After much concentrated effort, a shari‘a-compatible solution = was finally found, interestingly, with the aid of the common law of trust. At common law, when a = person holds an asset on trust for another, the latter can be construed as the beneficial owner of the asset held by the former. The relationship between = the trustee and the beneficiary is evidenced by a trust deed executed (often unilaterally) by the settlor. The trust deed can also be documented to allow the relationship between the trustee and the beneficiaries to be created through the issuance of a trust instrument by the trustee to the beneficiary or class of beneficiaries. For instance, a settlor can create a trust over, sa= y, a house pursuant to a trust deed and appoint a trustee to issue trust instrum= ents to a class of beneficiaries. The class of beneficiaries will be limited to = the investors who purchase the trust instruments offered by the trustee for a certain consideration. The investors who purchase the trust instruments will automatically become the beneficiary of the trust and be construed as pro-r= ata owners of the house held on trust by the trustee. The trust deed can also be structured to allow the holders of the trust instrument to transfer the tru= st instruments to others on a willing-buyer and willing-seller basis. If the trustee leases the house to a tenant for a fixed or variable rental term, t= he holders of the trust instrument will be entitled to a pro-rata share of the rental income derived from the house held on trust.= [61]

These characteristics of the trust instrumen= t squarely meet the requirements of shari‘a. The trust instrumen= ts were aptly named in Arabic as sukuk= or sukuk al-ijara because the trust assets were lease= d out to produce a lease income. The holders of the sukuk will be construed under shari‘a as co-owners of an asset, although held on trust, similar to a shirkat al-milk. As a co-owner of an asset, each co-owner is entitled to sell his share in t= he asset without the consent of the other co-owners at whatever price he can command in the market. When the trustee receives the variable rentals from = the lessee, the sukuk holders will receive a proportionate share in the rental proceeds. At the maturity of the lease, which corresponds to the redemption date of the sukuk, the trustee will sell the trust asset to the lessee for a price equal to the original acquisition cost of the trust asset.[62] With the proceeds of the sale, the trustee will redeem the sukuk and the sukuk holders will receive their principal investment. The payment profile of the sukuk is thus comparable to a conventional bond or a floating rate note.

The lessee’s obligation to pay the lea= se rentals and the purchase price will be ranked as a senior unsubordinated de= bt obligation of the lessee toward the trustee, as lessor. This ranking in priority is also comparable to the ranking of a conventional bond instrumen= t.

The concept of trust instrument is also familiar to the conventional investors. In the United States, for example, Equipment Trust Certificates<= !--[if supportFields]> XE "Certificates, Equipment Trust" or ETCs have been widely used since= the time of the railway boom. A railway company will order the rolling stock fr= om the manufacturer and request the manufacturer to sell the rolling stock to a trustee company set up by the railway company.= [63] The railway company will then agree to lease the rolling stock from the tru= stee for an agreed period. The trustee will then issue trust certificates to the investors to raise the funds required to pay the manufacturer. From the proceeds of the lease collected from the railway company, the trustee will = pay the periodic interest and the principal amount to the trust certificate holders. Since the trustee will own the rolling stock, it will be able to repossess the rolling stock if the railway company defaults on the lease and re-lease it to other railway companies. Because the rolling stock was quite standardized and there was a deep secondary market for it, the trustee was = able to obtain the lowest rates in the bond market.= [64]

The commonality between the sukuk and the trust instrument, such as the ETC, is a key factor because it made the sukuk familiar and easily acceptable to the conventional investors, the leading rating agencies, the major securities exchanges, and the leading clearinghouses. The sukuk issue= s by the Federation of Malaysia, the Islamic Development Bank, and the State of Qatar were all rated by international rating agencies like Moody’s, Standard &am= p; Poors, or Fitch. The sukuk issu= es were also successfully listed on leading exchanges such as the Luxembourg S= tock Exchange, the Labuan International Financial Exchange, and the Bahrain Stock Exchange. The sukuk were also c= leared through Euroclear and Clearstream. These features made the sukuk a truly tradable security that met the requirements of shari‘a as well as the expectations of the conventional bond investors in line with the bond market norms.

Legal and Beneficial Ownership

In the Malaysian sukuk issue, one of the shari‘a concerns was that the trustee was only acquiring the beneficial ownership of the assets held on trust. Usually, when a seller sells a landed property to= the buyer, the buyer will acquire the legal ownership of the property when the seller transfers the title to the property to the buyer after receiving full payment from the buyer. In the Malaysian sukuk issue, the seller[65] sold the landed assets to the trustee but did not transfer the title to the landed assets to the trustee in order to avoid payment of certain charges a= nd taxes. Instead, the seller declared that it was holding the landed assets on trust for the buyer. The concern from a shari‘a perspective was whether such a transfer is valid under shari‘a.

The position under Malaysian law, which is q= uite similar to the position at common law, is that when the buyer pays the full consideration for a landed asset, the seller becomes a bare trustee and the buyer[66] becomes the beneficial owner of the landed assets.= [67] As a bare trustee the seller cannot dispose the land to another without the consent of the beneficial owner. From a legal perspective, the law considers the beneficial owner as the true owner with the power to possess and dispose the landed assets.[68] To protect the rights of the beneficial owner against any third party who m= ay claim any interest on the landed assets held on trust, the bare trustee was required to procure a trust endorsement on the land title held at the land registry.[69] The trust endorsement will give a clear notice to third parties of the beneficial owner’s right in the landed assets and will avoid the bare trustee from inadvertently transferring the landed assets to any third part= y.

The distinction between legal and beneficial ownership was initially not familiar to most = shari‘a scholars particularly those who come from civil law jurisdictions.= [70] There is no concept of beneficial ownership in civil law. Through fresh interpretations, the contemporary s= hari‘a scholars were able to extend the scope of ownership in shari‘a to include the concept of beneficial ownership wh= en, as illustrated in Malaysia, the true owner in the = eyes of law is the beneficial owner and the seller remains only as a bare truste= e.

Unilater= al Undertaking to Buy the Assets

The issue of whether a unilateral purchase undertaking given by the lessee to the trustee = is a binding promise has been debated among the contemporary shari‘a scholars. Some scholars are of the view that a unilateral purchase undertaking or promise does not create a legal obligation at all but only a moral obligation on the part of the promisor. = The proponents of this view rely on the opinions of Abu Hanifa, Shafi‘i, Ahmad, and some Maliki jurists. The opponents of this view, however, argue that unlike a bilateral contract of deferred sale,= [71] all unilateral undertakings or promises to do something in the future are v= alid arrangements that are binding on the promisors. The opponents rely on the authority of a prominent companion of the Prophet and the opinions of other renowned scholars including al-Bukhari. Some other scholars, particularly f= rom the Maliki school, have taken the middle view that a unilateral undertaking= is only binding on the promisor if “the promisor has caused the promisee= to incur some expenses or undertake some labor or liability on the basis of [t= he] promise.”[72] It has been argued elsewhere[73] that the proponents of the view that a unilateral undertaking is not bindin= g at all have not been able to successfully attribute their views to Abu Hanifa = and Malik. As mentioned below, both the Hanafi and Maliki jurists have recogniz= ed the validity of the promise to effect a sale in future made by the buyer in= a bay‘al-wafa’ contract<= !--[if supportFields]> XE "bay‘ al-wafa’" . Furthermore, there is = also evidence in the primary sources of = shari‘a, the Qur’an and the Sunna<= !--[if supportFields]> XE "Sunna" , to imply that a promise is binding on the promisor. It is mentioned in the Qur’an: “O ye who believe! Why say ye that which ye do not? Grievously odious is it in the sight of God that ye say that which ye do not.”[74]

There are also compelling social and economic arguments to support the view that a unilateral purchase undertaking or promise should be binding. Imagine someone promising to another that if the latter goes and buys certain goods from the market, the promisor will buy t= he goods from him at a specific price. If the promisor is allowed to repudiate= his promise and decline the goods, the promisee will be left exposed to the ris= k of liquidating the goods without any remedy against the promisor. The promisee= may suffer economic losses due to the breach of promise. For example, the promi= see may end up selling the goods to another at a discounted price. This will seriously hinder the development of various economic activities such as the= murabaha contracts where the financier will = be relying on the promise of the client when it purchases the goods ordered by= the client.

Based on these grounds and the views taken b= y many prominent scholars, the Islamic Fiq= h Academy resolved= [75] that a promise made in a commercial transaction, like a murabaha contract, is binding on the promisor subject to the following conditions:

the promise must have induced the promisee to inc= ur some liability;

if the promise is to purchase something in the future, the parties must enter into the actual sale contract at the appointed time; and

if the promisor breaches his promise, the promisee can seek legal remedy in a court of law for specific performance or damages.[76]

Contemporary scholars have extended the above ruling to the sukuk al-ijara issue and ruled as valid the unilat= eral purchase undertaking given by the lessee to buy the asse= ts at the maturity of the lease.[77] This was a significant development that made the sukuk issue economically feasible. Otherwise, it would lead to = an inequitable result where the lessor would be exposed to the economic losses that may result from the breach of promise while the promisor would be abso= lved of any liability.[78]

Sale of = Assets to the Original Seller

Another concern among some shari‘a scholars was the issue of the trustee selling the assets back to the lessee (being the original seller) at the original cost. Their view was that this arrangement resembles the contract of bay‘al-wafa’ which has= been prohibited on the basis of riba= by the Maliki and Hanbali schools as well as the earlier gene= ration of scholars from the Hanafi and Shafi‘i schools. Bay‘al-wafa’ is a contract usually involving a land= ed asset where the seller will sell the landed asset to the buyer for an agreed price and subsequent to the sale the buyer will promise to sell the landed asset back to the seller whenever the seller pays an amount equal to the original purchase price paid by the buyer. The later generation of scholars from the Hanafi and Shafi‘i schools, including the prominent Hanafi scholar Ibn Abidin, however, have allowed this type of contract provided th= at the promise is made after the sale has been concluded and the promise itsel= f is not made a condition of the sale contract.= [79] They took the opposite view that such a transaction actually prevents one f= rom getting involved in riba and therefore should be allowed.[80] Some Hanafi scholars have even all= owed a bay‘ al-wafa’ trans= action where the promise has been given prior to the sale itself.= [81]

Historically, bay‘al-wafa’ arrangements have been widely practiced in Central Asia and South East Asia= for a very long time and they have been recognized as valid by many Islamic scholars.[82] In a sukuk issue the sale of the assets to the trustee is made independent of the purc= hase undertaking given by the lessee to the trustee = and the undertaking itself is not made a condition to the sale contract. Based = on this arrangement contemporary scholars have allowed the sale of the assets = back to the original seller.

Sale of = Assets at Market Value

Some scholars took the view that the sale of= the assets to the lessee should be at market value determined at the time of ac= tual sale.[83] From a classical fiqh perspective, the predominant view i= s that the sale price has to be known to both the seller and the buyer in advance = in order to make the contract valid. The Shafi‘i and Maliki schools have both maintained that a= ny ambiguity and ignorance of the price will vitiate the contract and that uncertainty or gharar is removed only by determining a sp= ecific price.[84] The Hanbali scholars Ibn Taymiyya and Ibn Qayyi= m, however, have taken a = more liberal view by stating that the price can be determined by assigning a fix= ed amount or by reference to a certain convention, for example, “the pri= ce which other people pay; or the market price, provided that the parties find [that] agreeable and is clear enough to avoid disputes.”[85] These opinions, when extended to the unilateral purchase undertaking given by the lessee, mean that the price of the asset can either be determined as= a fixed sum at the inception or at the time of actual sale based on the market practice. Since both these options were validly recognized under shari‘a, the unilateral purc= hase undertaking given by the lessee in the Malaysia= n sukuk issue to buy the assets at a specified amount based on the original purchase price paid by the trustee i= s a valid arrangement under shari‘= ;a. This was in fact in line with the majority view that required a fixed sum t= o be determined by the parties at the inception of a bilateral or unilateral arrangement in order to avoid any g= harar.

Late Pay= ment Treatment

Another contentious issue in contemporary fiqh is whether a creditor is entitled u= nder shari‘a to charge a late pay= ment to a debtor who has either delayed = or defaulted on a payment obligation. The general principle of shari‘a is that any addition= al amount charged to a debtor for any late payment is riba and is clearly prohibited. This for= m of riba is commonly known as riba al-jahiliyya.= [86] Accordingly, in the early days of Islamic finance, the murabaha and ijara contracts did not contain any provi= sion allowing the Islamic financiers to charge any late payment amount f= rom the purchasers or the lessees. This practice naturally resulted in some deb= tors abusing the system by delaying, often willfully, the payments due to the Islamic financiers while making every effort to make their payments on time= to their conventional lenders. The conventional lenders will invariably impose= on the debtors late-payment charges, which are sometimes compounded on a daily basis. The strong moral basis behind the prohibition of riba al-jahiliyya is that a debtor in difficulty should be give= n a respite until he can improve his financial conditions instead of imposing on him further hardship in the form of late payment charges. The prevailing practices, however, led to a moral hazard whereby the Islamic financiers, a= nd their depositors, were exposed to hardship caused by the willful delays of = the debtors.

A fresh shari‘a interpretation was required to address the contemporary problem faced by the Islamic industry. The scholars who favored the late payment compensation to be charged to the d= ebtor relied on the well-known hadith= that “a wealthy person who de= lays the payment of his debts, subjects himself to punishment and disgrace.̶= 1;[87] It is not uncommon for a wealthy p= erson to be short of liquidity due to excessive leverage or a lavi= sh lifestyle and based on the above ha= dith he should not be excused for delaying a payment obligation to another. He should be penalized for the delay and for causing the hardship to the credi= tor. The form of punishment includes payment of monetary compensation to the creditor. Therefore, late payment charges can be validly imposed on a willf= ul defaulter.

The opponents of the above view, however, co= ntend that any penalty on the defaulter can only be imposed by a competent judici= al authority or by arbitration. Shari&= #8216;a does not allow a creditor to decide unilaterally that the debtor has willfu= lly defaulted and also impose the quantum of compensation payable by the debtor. Unless a creditor brings a legal action against the debtor to prove the wil= lful default, the creditor cannot claim compensation from the debtor.

The middle view is that a creditor can valid= ly procure the debtor to irrevocably undertake that if he delays any payment d= ue to the creditor, he will donate to a charity nominated by the creditor a specific amount of money. Since the creditor does not receive the late paym= ent amount or benefit from it, the scho= lars have allowed such an undertaking without any need for the creditor to bring= a legal action. If the debtor fails to honor his undertaking, the creditor can enforce the undertaking in a court of law.= [88] The scholars hope that this mechan= ism will eliminate or reduce the moral hazard faced by the creditor. This method was accordingly adopted in the Qatar sukuk issue.

For practical purposes, the scholars have al= so allowed a debtor who delays any payment to pay the late payment amount directly to the creditor who= will then donate the late payment amount to charity after deducting any administrative expenses that the creditor has incurred in monitoring and recovering the delayed payment. This method for recovering a late payment amount was adopted in the Malaysian sukuk issue.

SUKUK AL-ISTITHMAR

The USD400 million sukuk issue by the Islamic Development Bank (IDB) was based on the following structure:

Figure 2. Structure of the USD400 Million Sukuk Issue by the Islamic Development Bank

The IDB suk= uk issue was highly structured and a detailed elucidation of the structure is beyond the scope of this paper. Some of the key characteristics are discuss= ed below.

Mixed Portfolio of Assets

One of the most innovative shari‘a features in the IDB sukuk is the extension of the khulta principle to the field of commercial transactions like the sale of a mixed portfolio of assets consisting of tangible as= sets and receivables. The validity of sale of receivables or debt, known in fiqh as bay‘al-dayn or bay‘ al-kali’ bi-al-kali’, has been a contentious subject among contemporary scholars. The majority of= scholars in the Middle East have taken the view that the sale of debt or receivables is not allowed under= shari‘a because it is tainte= d by riba. This ruling severely constrains the Islamic financial institutions from securitizing the receivables due from their murabaha facilities, which form the bulk of = their assets. However, utilizing the principle of khulta, the Islamic financiers can now create a mixed portfolio or a mixed fund= [89] by pooling together the receivables (dayn) with tangible or physical assets= (‘ayn) and then sell the mix= ed portfolio. The important criterion from a shari‘a perspective is that the percentage of tangible assets in the mixed portfolio has to be at least 51 percent.

When an object consists of two substances an= d one of those is prohibited under shari&= #8216;a, the object can still be construed as shari‘a-compatible if the quantity of the non-compatible substance is insubstantial. For examp= le, if a ring is made of gold and silver, it is permissible for a Muslim male to wear it if the quantity of the gold substance is insubstantial. Opinions di= ffer among scholars as to what amounts to an “insubstantial” quantit= y. Most scholars have taken the view that the non-compatible substance will be regarded as insubstantial if the quantity of the shari‘a-compatible substance is at least 51 percent.[90] Some Hanafi scholars have taken a = more liberal view of the khulta principle. They have not allocated = any fixed percentage or quantity but have left the matter to be decided on a case-by-case basis. Hence, there may be circumstances where even if the non-compatible component is more than 50 percent, the object can still be considered to be shari‘a-= compatible as a whole.

In the IDB sukuk, the mixed portfoli= o consisted of ijara assets comprising 65.8 percent of the portfolio and murabaha and istisna‘ receivables comprising 34.2 percent. The 65.8 percent of ijara assets is comprised of certa= in physical assets owned by the IDB and which have been leased out to various counter parties. Since the ijara assets can be freely transferred at any price by the IDB, by mixing the murabaha receivables (dayn) with ijara assets (‘ay= n) the IDB was able to transfer the mu= rabaha receivables as well.

<= /p>
<= /p>
Replacem= ent of Maturing Assets

Since the receivables in the mixed portfolio= will mature during the life of the = sukuk, the sukuk structure has to accommodate two changes in circumstances. First, the composition of the portfolio will evolve into a mixed portfolio = of ijara assets, murabaha and istisna‘ receivables, and cash from the matured receivables. In this scenario, t= he cash will be re-invested in new ija= ra assets or new murabaha trades t= o be sourced by the IDB. The key aim is to ensu= re that the cash is not held idle and is promptly invested in shari‘a-compatible assets.

Secondly, some of the ijara assets in the portfolio may be redeemed from the portfolio prior to the sukuk maturity. In= the event, the composition of the mixed portfolio will change and the percentage of ijara assets may fall below the 51 percent requirement and may taint the shari‘a-compatibility of the whole portfolio. The shari&#= 8216;a scholars have tackled this matter quite ingeniously. They have allowed the percentage of the ijara assets = in the mixed portfolio to temporarily drop to the level of 25 percent of the total portfolio during the interim period when the cash is being re-invested into= new ijara assets. The key objective= is to give sufficient time for the cash to be re-invested in ijara assets so that the makeup of ijara assets can be increased back to the level of at least 51 percent. However, if the level of i= jara assets falls at any time below the threshold of 25 percent, the level of shari‘a tolerance comes to a= n end and the portfolio has to be promptly unwound. The IDB will then be bound to buy the mixed portfolio of assets at a price equal to the original price paid by the sukuk holders.

Net Asset Value Computation

Another important principle laid down by the contemporary scholars in the IDB sukuk is that the value of the murabaha and istisna‘ receivables to be included in the mixed portfolio can be based on their net asset val= ue (NAV). The pricing model for= both the murabaha and istisna‘ financing consists of two components: the cost a= nd the agreed profit margin. The shari= ‘a scholars have allowed the NAV for the murabaha and the istisna‘ receivab= les to be calculated net of all agreed profit margin. In the past, it was unclear whether the value of the murabaha and istisna‘ receivables can = be computed based on an NAV basis. The NAV computation method as adopted in the IDB created a strong precedent and is more pragmatic and in line with the n= eeds of the industry.

The same computation method has been adopted= for the NAV of the ijara assets that were computed on the basis of the net lease rentals after deducting the profit margin component. It is a well-entrenched principle that an ijara asset, = being a tangible (‘ayn) asset, = can be sold at whatever price that the parties may mutually agree including on an = NAV basis. The NAV computation method for ijara assets in the IDB sukuk was therefore in line with the prevailing practice.

Seller&#= 8217;s Guarantee

Another significant principle applied in the= IDB sukuk issue is that the seller of an asse= t can independently guarantee the performance of the end-user of the asset or the payment obligations of a third party emanating from the asset. For instance, the seller of a house subject to a lease can guarantee to the buyer that if= the lessee defaults on the lease payment obligations, the seller will indemnify= the buyer. The key conditions for the validity of the guarantee are: (1) that t= he guarantee should be independent of the sale of the house and should not be = made a condition to the sale contract; (2) the guarantor should not charge any consideration for the guarantee; and (3) the guarantor should not act as ag= ent or mudarib= of the person whose liability is be= ing guaranteed.[91]

To meet all the three conditions above, the = mixed portfolio was sold by the IDB to a third party= [92] and the third party then sold the mixed portfolio to the issuer. The IDB th= en provided the guarantee directly to the issuer covering the payment obligati= ons of all the lessees and the murabaha= and the istisna‘ counter parties. There was no consideration paid by the issuer to the IDB. The issuer then appointed the third party as its agent to administer and service the mixed portfolio.[93] Without the third party’s involvement, the issuer would have to directly appoint the IDB as its administrative and servicing agent. This would then mean that the IDB would= not be able to provide the guarantee to the issuer because it also has to act as the agent of the issuer.

Liquidit= y. This will mean that the periodic payment dates cannot be set in advance, which will in turn lead to other logistical problems for the issuer and the investors. To mitigate the timing mismatch difficulties, the s= hari‘a scholars have allowed the IDB to provide an interest-free liquidity facility to the issuer whereby if t= here is a shortfall in the proceeds on the prescribed distribution date, the iss= uer can draw an amount equal to the shortfall from the liquidity facility. The issuer will then be able to make the full distribution payment on the prescribed distribution date. When the issuer finally receives the proceeds, the advance made by the IDB through the liquidity facility will be repaid in full.[94] This unique shari‘a innovation was able to resolve the issues raised = by the potential timing mismatch and facilitate the successful issuance of the= IDB sukuk.

BAY‘ BI-THAMAN ‘AJIL= BONDS

Bay‘ bi-thaman ‘ajil (BBA) bonds are the most popular form of Islamic debt securities in the Malaysian domestic debt capi= tal market and in recent years have accounted for almost half of the total new = debt securities issued in the domestic market. The structure of the BBA bonds, w= hich is fairly simple, is set out below:

Figure 3. Bay‘ bi-Thaman ‘Ajil Bond Structure

The BBA bond structure is built upon the principles of bay‘al-‘i= na and bay‘ al-dayn, which a= re briefly discussed below.

Bay‘ al-‘Ina

A transaction involving two sales where the = seller sells an asset to the buyer on a spot payment basis and the buyer then immediately sells it back to the seller at a higher price on a deferred pay= ment basis is known in fiqh as bay‘bi-thaman ‘ajil[95] or bay‘ al-‘ina. The term bay‘ al-‘ina also includes a transaction where the seller sells an asset to the buyer on= a deferred payment basis and the buyer then immediately sells it back to the seller at a lower price on a spot payment basis. Both parties end up execut= ing two contemporaneous contracts, one for spot payment and another for deferred payment, without taking any delivery or possession of the underlying asset.=

The contemporary scholars who support the va= lidity of bay‘al-‘ina rely on the views of Shafi‘i<= !--[if supportFields]> XE "Shafi’i school&quo= t; and Zahiri schools.= [96] They maintain that the validity of contracts is to be examined only through their external manifestation. The motive of the parties to the contract is immaterial and it does not invalid= ate the contract. Hence, the motive of the parties in entering into the two sal= es in a bay‘ al-‘ina arrangement is irrelevant. The argument goes that only God knows the motive= of man and man judges only the external deeds. The motive is left to God. These scholars rely on a hadith that states that in certain areas of human affairs, such as marriage, divorce, and manumission, motive or intent= ion of the parties is irrelevant.[97]

The opponents of bay‘ al-‘ina strongly contend that the hadith relied on by the proponents do not establish a general rule that in matters of personal affairs such as marria= ge, divorce, and commercial transactions one should not look at the intention of the parties. The well-established rule in Islam, they contend, is that all actions are judged by the intention of the parties. The hadith cited by the proponents merely lay down an exception to = the general rule in certain limited circumstances. The reason for the exception= , as pointed out by Ibn Qayyim, is that the acts of marriage, divorce, and manumission involve the right of God (haqq Allah) and it is not desirable for huma= ns to act in jest with God. The Prophet, due to the magnitude o= f the acts involved, had imposed the strict obligation on those who make statemen= ts in jest. This exception is only confined to marriage, divorce, and manumiss= ion and accordingly the hadith clea= rly mentions only these three circumstances. If it had been meant to include all types of commercial contracts the Prophet would have expressly mentioned it. Since no such express statement was made, the hadith should only be confined to areas of marriage, divorce, a= nd manumission and there is no justification to extend it to commercial transactions.

The proponents also rely on another hadith regarding a case of adultery and the issue of li‘an.[98] In this case, there was a strong possibility that the accused was taking a false oath, but despite that the Prophet decided that she was not guilty bas= ed on her oral statement and her external conduct. This hadith was relied upon to prove that motive or intention is not relevant in personal matters that include commercial transactions. The opponents strongly deny this by submitting that the Prophet in hearing the dispute was weighing between two probabilities: the probability that the ch= arge against the accused was true and the probability that her oath denying adul= tery was truthful. The Prophet acting as a judge had to weigh both probabilities= and deliver a just ruling. Based on the peculiar facts of that case, the Prophet decided that the probability of the truth of an oath was stronger. The hadith, therefore, does not suppor= t the proposition that one is always judged by one’s external deeds rather = than one’s intention or motive.

The majority of the scholars have therefore decided that bay‘al-‘in= a is not a valid contract under shari‘a and regard it as a hila or hiyal (legal fiction) to practice riba.[99] The Malaysian scholars, however, h= ave adopted the minority opinion and allowed it as a valid shari‘a transaction.

Bay‘ al-Dayn

The debt arising out of the two contracts of= sale or exchanges (awad al-muawadhat= ) as described above are securitiz= ed using the concept of bay‘al-d= ayn. Pursuing the above example, the corporation will evidence its debt (i.e., t= he sale price payable on deferred terms) to the underwriters by issuing debt securities known as shahadat al-day= n and these are comparable to zero coupon securities. The debt securities or BBA<= !--[if supportFields]> XE "Bay‘ bi-thaman a‘jil bonds" bonds are issued to the underwriter= s at par. The underwriters will then offer the securities in the primary market = at a discount similar to a primary offering of zero coupon bonds.

The subject of bay‘ al-dayn is still being debated by contempor= ary shari‘a scholars. The majori= ty of the scholars in the Middle East have prohibited bay‘ al-dayn on the basis of an ijma‘ (consensus of opinion) among the scholars. Ahmad has recorded that such an ijma‘ has taken place. These scholars also rely on a hadith<= !--[if supportFields]> XE "hadith" = ;where it is reported that the Prophet has expressly prohibited bay‘ al-kali’ bi-al-kali&#= 8217;.= [100]<= /span> Others argue that if the exchange of $100 toda= y for $110 payable in cash one month later is considered as riba, it is inconceivable that shari̵= 6;a would allow an exchange of $100 today for $110 worth of receivables that wi= ll accrue one month later. The “prohibition of bay‘ al-dayn is a logical consequence of the prohibition = of riba<= !--[if supportFields]>= or interest. A ‘debt’ receivable in monetary terms corresponds to money, and [in] every transacti= on where money is exchanged for the same denomination of money, the price must= be at par value. Any increase or decrease from one side is tantamount to riba and can never be allowed in shari‘a.”[101]<= /span>

The proponents of bay‘ al-dayn, however, contend that there is no evidence to support the existence of an ijma‘ on the issue of bay‘ al-dayn. They also maintain that the various schools have different views on what constitutes bay‘ al-dayn or bay‘ al-kali&#= 8217; bi-al-kali’ = ;and it is impossible for an ijma‘= to materialize with such a divergence in views. They also rely on prominent scholars like Ahmad, Ibn Qudama, and Ibn Taymiyya who h= ave refuted the validity of the hadith<= /i> prohibiting bay‘ al-kali’ bi-al-kali’. They conclude that since there is no clear evidence in the shari‘a that prohibits bay‘ al-dayn,<= /i> the guiding principle should be that it is a permissible transaction.[102]<= /span> However, they have not been able to respond to the argument of the opponents that the debt, being traded for mo= ney, should also be treated as money and consequently money traded at a discount= is tainted with riba.

The scholars in Malaysia have adopted the minority view and = using the concept of bay‘al-‘= ina and bay‘ al-dayn were able to permit the issuance of= bay‘ bi-thaman ‘ajil b= onds.[103]<= /span> Both these contracts have been prohibited by scholars in the Middle East.

PROSPECTS FOR ISLAMIC PROFIT SHARING PRODUCTS

The common thread permeating all the three sukuk structures discussed above is that = all these structures share a close resemblance to conventional debt securities.= In particular, their economic profile is often identical to that of a conventi= onal bond. All of them have a fixed income component, either in the form of a fi= xed profit margin or variable lease rental. Like conventional debt securities, = all of them have a redemption feature where the principal investment is returne= d at the maturity date of the sukuk.= These features have inevitably led to the criticism that the Islamic alternatives= are merely alternatives in form and not in substance. They argue that if in substance the Islamic alternatives are not dissimilar to their conventional counterparts then the Islamic products are merely another type of product = within the broad range of conventional products. The argument does hold certain we= ight when one looks at it from purely an economic perspective. For customers who seek Islamic alternatives, often the paramount consideration is whether the Islamic products offered are competitively priced. The yardstick used for measuring the competitive pricing for Islamic products is unfortunately the pricing prevailing in conventional finance. For example, when a customer wa= lks into an Islamic bank seeking Islamic home finance, one of the key considerations for the customer is whether the pricing of the Islamic produ= ct is on par with the conventional mortgage products available in the market. Hence, if the pricing for a fixed rate 20-year mortgage is 10 percent par, = the customer will invariably demand the same pricing for the Islamic product. W= hile the majority of the customers seek Islamic finance solutions to satisfy the= ir religious convictions, the economic reality is that the pricing considerati= on often prevails over their religious convictions. If the pricing of the Isla= mic product is more expensive, then there will be less demand for the Islamic alternative. It appears that only a handful of customers will be prepared to pay a premium for an Islamic solution.

Pricing = an Islamic Debt-Based Product

Faced with this reality, the Islamic finance providers are compelled to structure the Islamic products in a manner so that the risk profil= e of the Islamic alternatives is as close as possible to their conventional prod= ucts. For instance, if we look at the mur= abaha home financing solutions available = in the market it will be evident that the risk profile of the murabaha is not dissimilar to the risk profile of a conventional mortgage. The Islamic financier will buy the property chosen by the customer and immediately sell the property to the customer for a fixed price payable over a period of, say, ten years pursuant to a murabaha arrangement. To secure the deferred payment obligation= s of the customer the Islamic financier will take a mortgage over the property. = What is the risk profile of this transaction?&n= bsp; The Islamic financier is exposed to the credit risk of the customer = and this risk is secured by the value of the property held on mortgage. IsnR= 17;t this risk profile identical to the risk profile of a conventional mortgage? The law of one pric= e[104]<= /span> would dictate that in an efficient market similar products must be priced alike; otherwise it would create riskless arbitrage opportunities. It follo= ws from this principle that an Islamic home finance product, which shares a similar risk profile to a conventional mortgage, must share the same pricin= g as the conventional mortgage product. The stark reality is that Islamic finance providers, being driven by the customers to price their products competitiv= ely with the conventional products in the marketplace, are compelled to structu= re the Islamic alternatives with a comparative risk profile. If a 20-year fixed rate conventional mortgage is priced in the market at 10 percent pa, a 20-y= ear murabaha financing will inescapabl= y also be priced at 10 percent pa. This then raises the question of whether the similarity in risk and pricing profile makes the products like murabaha or ijara doubtful in the eyes of shari‘a.

Fortunately, the Qur’an has addressed = this very question where the text states: “they (non-believers) say: ‘Trade is like usury, but God hath permitted trade and forbidden usury.’”[105] According to the renowned commenta= ries of the Qur’an,[106] this verse was revealed to address the confusion among the non-believers regarding a particular type of transaction prevailing at the time of the Prophet. It was common at that = time for people to buy goods and commodities on credit or deferred payment terms= and the sellers would charge a higher price for the credit sale. For instance, = if the cash sale price is $10, the price for a deferred sale payable in one month might be $12. = If at the time of payment, the buyer requests an extension of one month, the sell= er would increase the price to $14 and then grant the extension. The Prophet h= as prohibited any increase in the debt in return for an extension of time and = such increase is known in fiqh as riba al-jahiliyya. The non-believers “used to say that it is all equal whether we increase the price in the beginning of the sale, or we increase it at the time of maturity. Both are equal.”[107]<= /span> To them the $2 increase at the tim= e of sale is the same in substance as the $2 increase at the time of extension. = Why should the first $2 be allowed as sale and the second $2 prohibited as riba? This complex issue was resolved by= the Qur’an in very simple terms: “God hath permitted trade and forbidden usury.” According to a prominent jurist:

The Holy Quran could have mentioned the difference between interest and profit in pure logical manner, and could have explained how the profit in a sale is justified while the interest is not. The Holy Quran cou= ld have also spelled out the evil consequences of riba on the economy. But this line of argument was intentionally avoided. . . . The hint given is that the question whether these transactio= ns have an element of injustice is not left to be decided by human reason alon= e, because the reason of different individuals may come up with different answ= ers and no absolute conclusion of universal application may be arrived at on the basis of pure rational arguments. . . . [O]nce a particular transaction is = held by Allah to be haraam, there is no room for disputing it on the basis of pu= re rational argumentation because Allah’s knowledge and wisdom encompass= es all those points which are not accessible to ordinary reason.[108]<= /span>

The above verse and commentary clearly lend support= to the view that the similarity from a risk and return profile between a murabaha sale and a conventional loan financ= ing does not necessarily mean that the = murabaha sale is tainted with riba. From a shari‘a viewpoint,= the similarity in risk and pricing profile does not affect the shari‘a authenticity of these products.

The Role= of Debt in Islam

One could then argue that the above conclusi= on would mean that the Islamic finance industry could be built on the basis of= murabaha, istisna‘, ijara and other similar debt-oriented products, all of which would have risk and retu= rn profiles comparable to conventional financial products. We have already seen the economic resemblan= ce between a murabaha and a loan transaction. An ijara muntahia bi-t= amlik transaction, where the lessor lease= s an asset with an option to sell to the lessee, also has some resemblance to a conventional finance lease. An isti= sna‘ arrangement, where the Islamic financiers will finance the construction of an= asset and then sell the completed asset to the customer, also shares common featu= res with a conventional construction loan facility. In all these Islamic transactions the customers incur debt obligations, either in the form of installment payments or lease rentals or purchase consideration payable und= er a purchase undertaking.= [109]<= /span> This then attracts the criticism that Islamic finance, as currently practic= ed, is actively promoting debt transactions in the society instead of promoting= the Islamic profit sharing products. If, for the sake of argument, a financial system moves from a conventional debt-based financing model to an Islamic debt-based financing model, will the ills of a debt-driv= en financial system be removed from the Islamic model? According to a prominent jurist, w= hen “the whole economy turns into a debt-oriented economy. . . . [It] not only dominates over the real economic activities and disturbs its natural functions by creating frequent shocks, but also puts the whole mankind under the slavery of debt.”[110] One then wonders whether the Islam= ic finance model based on predominantly debt-based solutions will end up experiencing the same problems encountered in the conventional finance mode= l.

The above criticism does have some merit whe= n one looks deep into the wisdom or hikma= behind the prohibition of riba<= !--[if supportFields]>= . One of the values behind the prohibition is to discourage Muslims from incurring debt without a reasonable need. For example Muslims are discourag= ed from incurring debt for “living beyond one’s means or to grow one’s wealth.” It has been said elsewhere that “[t]he well known event that the Holy Prophet (pbuh) refused to offer the funeral prayer (salat al-janaza) of a p= erson who died indebted was, in fact, to establish the principle that incurring d= ebt should not be taken as a natural or ordinary phenomenon of life. It should = be the last thing to be resorted to in the course of economic activities.̶= 1;[111]<= /span> If one wants to grow one’s w= ealth through commercial and other revenue-generating activities, Islam actively promotes financing through equity participation and profit and loss sharing= mechanisms such as mudaraba or musharaka. It follows from this analysis that a debt incurred through murabaha, ijara, or other comparable products wil= l be discouraged under shari‘a= if the debt has been incurred without a reasonable need. The key issue for consideration, then, is what is a “reasonable need”?

When analyzing a reasonable need, the schola= rs usually look at various factors including, among others, the nature of the need, the economic conditions of the debtor, and the prevailing conditions = in the country of the debtor. The scholars are not oblivious to the reality of= the prevailing economic conditions in the world today. For instance, they clear= ly understand that under the current economic conditions it is extremely diffi= cult for many individuals to acquire a house without incurring a debt. For many individuals, even a lifetime of savings may not be sufficient to achieve th= eir aspiration of owning a home. In many markets house prices keep increasing a= t an alarming pace and one may not be able to rely on savings alone to purchase a house. And no one will deny the fact that owning a house for self-occupation has become an indispensable requirement. It can therefore be strongly argued that if one can only acquire a house through incurring a debt, then such a = debt is a just and reasonable need. The = shari‘a should therefore allow the individual to incur a debt provided there is no element of riba involved. The homebuyer can seek Islamically structured home financing based on, say, murabaha, ijara, or musharaka mutanaqisa. Conversely, if someone wants to incur a debt to acquire a h= ouse in the south of France for his family to use during the summer break, most scholars may conclude that such a debt is for an unreasonable or excessive = need and should be discouraged.[112]

The = shari‘a scholars believe that, by screening the use of Islamic debt-oriented produc= ts through the filter of reasonable need, the Islamic products will not be used to proliferate the spread of debt in the society. Such a safeguard will hopefully prevent the Islamic finance model from inheriting the kind of problems encountered in t= he conventional finance world. Like many other predicaments faced by the contemporary Muslim world, the hurdle lies in the implementation. Islamic finance is currently being used to finance almost all the needs of the soci= ety, from financing a home to financing a holiday. In its zeal to compete with t= he conventional finance world, the Islamic finance industry is constantly innovating to produce various Islamic alternatives to match the conventional product range. While innovations are certainly healthy and always welcomed,= the Islamic finance industry should be careful to avoid being used as a medium = to proliferate debt in society. Various safeguards should be built in to screen the type of debt that can be incurred Islamically. Indiscriminate extension= of credit without the safeguards provided by shari‘a will eventually lead to the Islamic finance industry facing the same proble= ms that are faced by the conventional finance industry.

Impediments to the Growth of Islamic Profit Sh= aring Products

If the Islamic finance industry is aware of = the potential hazards linked to debt-based products, why is the industry not actively promoting or offering more Islamic profit sharing products? The Islamic finance industry is co= nstrained by several factors in seeking to do this and some of them are highlighted below.

1. Mindset in the indu= stry

In any given industry the most important fac= tor for its success is its human resources. The Islamic finance industry is no exception. Since the Islamic finance industry is relatively new, most of the Islamic finance practitioners have been appointed from the conventional fin= ance market. It is inevitable that most of the practitioners, having been brough= t up in the conventional banking environment, will find it difficult to shift fr= om the conventional finance mindset to an Islamic finance mindset. Due to the familiarity with conventional debt products, the practitioners often tend to perceive Islamic products purely from a debt perspective. Oft= en the key focus and energy is concentrated on finding Islamic substitutes to the conventional products that the practitioners are familiar with. For example= , a practitioner with a corporate loan origination background may, consciously = or subconsciously, end up designing an Islamic product comparable to the conventional counterpart. Often an Islamic product is offered to the custom= er in the same way as a conventional product, without taking the extra effort = to explain the rationale behind the Islamic structure or to explain the pricing justification. Many a time we hear the simplistic response: “The Isla= mic product is the same as the conventional product. Instead of paying interest= you pay a profit or rental.” This type of approach and mindset is injurio= us to the industry and a paradigm shift is urgently required. The industry lea= ders should promptly look into this issue and develop training programs and workshops to inspire an indigenous culture and frame of mind in the Islamic finance industry. In particular, the programs should focus on the developme= nt of real alternatives, based on profit and loss sharing mechanisms, for suitable commercial= or productive activities.[113]

2. Customers’ reluctance to share the economic upside

The customers who seek Islamic finance solut= ions also view Islamic products through the spectacles of conventio= nal finance. Most of the customers, being familiar with conventional finance products, expect to see in the Islamic structure some resemblance to the conventional counterpart particularly in terms of pricing and security. If = the customer can get a clean corporate loan at say 5 percent p.a., it expects t= he same terms for the Islamic facility. If the corporation is offered an alternative Islamic financing structure based on a profit and loss sharing<= !--[if supportFields]> XE "profit and loss sharing&= quot; mechanism, most often the offer is declined. From a conventional finance perspective, the corporation’s = key aim is to maximize profits for its shareholders.= [114]<= /span>

If, say, a corporation obtains a loan of $10= 0 at 5 percent p.a. and is thereby able to generate a profit of $10, the corporati= on has maximized its profit by $5 after paying the $5 interest. And if the pro= fit generated is $15, the corporation has maximized its profit by $10. If the s= ame corporation were to take an Islamic profit and loss sharing facility with a profit ratio of, sa= y, 50:50, in the first scenario where the profit generated is $10, the company will increase its own profit by $5. The remaining $5 will be distributed as profit to the Islamic investors. In the second scenario, however, the corporation only gets $7.50 because it has to share the profit of $15 with = the investors in the ratio of 50:50. This scenario makes the profit and loss structure less appealing to most of the customers. The following third scen= ario, however, is beneficial to the customers if they were to take the Islamic alternative. Assuming the profit generated is only $3, the corporation will still make a profit of $1.50 because it only has to distribute $1.50 to the Islamic investors as their share of the profit. Under the conventional loan, the corporation would have suffered a $2 loss since it has to pay a fixed interest amount of $5. But in reality, the well-established corporations are not prepared to share the economic upside. Often they are tempted by the best-case scenarios where they can maximize their profits manifold and the worst-case scenarios are disregarded as remote.

The above example, although rather simplisti= c, shows that profit and loss sharing solutions do not generate much appe= al, particularly among the well-established corporations. Newly established companies, who often find debt financing too costly or limited, however, ma= y be attracted by the profit and loss sharing solutions, but, unfortunately, very few investors will have an appetite for such type of credit risks. This ano= maly is likely to remain so long as the corporations have access to conventional debt solutions at competitive rates. We hope, however, that one day a parad= igm shift will occur among the Muslim corporations and they realize that Islam provides only a limited role for leverage and they reorganize their financi= ng requirements through profit and loss sharing means. Contemporary scholars, realizing the problems faced, have even allowed the financiers to agree on “capping” their potential returns on their investment with the corporation. If the investment generates profit beyond the agreed cap, the financiers will distribute the upside to the corporation as an “incen= tive fee.” It is hoped that this mechanism will persuade the well-established corporations to accept Islamic profit sharing products.

3. Investors’ av= ersion to sharing the economic downside

On the other side of the coin, some Islamic investors are risk-averse and reluctant to share the economic downside of t= he Islamic profit and loss sharing mechanisms. These investors are use= d to investing in Islamic investments with a fixed income profile like murabaha, ijara, and istisna‘. Their investment strategy is often conservative and has little room for tak= ing equity-type risks where the investors are also exposed to the economic down= side of the investment. This mindset again inhibits the development of Islamic profit sharing products. Frequently, the investment strategy is designed by practitioners who come f= rom conventional commercial banking backgrounds. Most of these practitioners ha= ve little exposure to profit and loss participation investments and lack the necessary skill sets. Investing in profit and loss sharing ventures require= s a different type of (and more onerous) due diligence exercise and investment analysis compared to debt-based investments. These investments also require= the investors to regularly monitor the performance of the business. Occasionall= y it may require the investors to take over the conduct of the business and appo= int their own management to replace the defaulting entrepreneur. These tasks require resources with a wide range of skills including corporate finance a= nd private equity expertise. The Islamic investors must therefore employ more people with such backgrounds to enable the shift from debt-based products to the Islamic profit sharing products.

The industry is not expecting all the invest= ors to convert overnight their investment strategy to one entirely based on profit= and loss sharing investments. The Islamic investors = must gradually revise their investment strategy in line with the ideals of Islam= ic finance and give priority to Islamic profit sharing products. This will certainly take time and needs the critical support of all the corporations and entrepreneurs who seek Islamic financing. If the entrepren= eurs are hesitant to take Islamic profit sharing products, then there will be le= ss interest among the Islamic investors. Conversely, if the Islamic investors = are reluctant to invest, there will certainly be less interest among the entrepreneurs. It is encouraging to note that some Islamic banks have been strongly advised by their= shari‘a committees to develo= p and invest more in Islamic profit sharing products.= [115]<= /span>

4. Moral hazard

Another reason for the slow development of I= slamic profit sharing products is the minimal level of corporate transparency and corporate governance prevailing in most Muslim countries= . Some Muslim countries also lack a well-defined property rights law, which is critical for profit and loss sharing mechanisms to work.= [116]<= /span> The investors also fear the lack of transparency and good corporate governa= nce among the entrepreneurs (mudarib= ). There is always the concern tha= t the entrepreneurs may conduct the business dishonestly and may disclose a lower profit. All these concerns, added to the lack of accountability on the part= of the entrepreneurs who violate these obligations, result in the Islamic investors shying away from Islamic profit sharing products. To alleviate th= ese moral hazards, Islam advocates the importance of good corporate governance = and transparency in all dealings including commercial transactions. The Qur’an unequivocally states:

O ye who believe! When ye deal with each other, in transa= ctions involving future obligations in a fixed period of time, reduce them to writ= ing. . . . Let him who incurs the liability dictate, but let him fear his Lord Allah, and not diminish aught of what he owes. . . . And if one of you depo= sits a thing on trust with another, let the trustee (faithfully) discharge his trust, and let him fear his Lord. Conceal not evidence; for whoever conceals it—his heart is tainted with sin. And Allah knoweth all that ye do.[117]<= /span>

These Qur’anic injunctions highlight t= he duty of the entrepreneur who is entrusted with the trust obligations to exercise proper care and due diligence and conduct the business (for exampl= e, a mudaraba= = ;business) in a transparent manner. The mudari= b= is obligated to conduct the business profitably within the boundaries of shari‘a and to truthfully make a fu= ll disclosure of the business profits and distribute the due share of profits = to the rabb al-mal (investors). The mudarib is also fully accountable for any breach of trust inclu= ding any negligence in carrying out the terms of the investments or willfully defaulting in his duties. Since Islam firmly advocates the importance of go= od corporate governance and transparency, it is obligatory = upon all Muslims to implement them in their daily activities.

The industry leaders, realizing the importan= ce of implementing these safeguards, have established the Islamic Financial Stand= ards Board (IFSB) that will, among other things, promulgate standards for corporate governance and transparency for the Islamic fi= nance industry. The IFSB, based in Malaysia, is expected to issue standards that = meet the international prudential standards and comply with the principles of shari‘a. The Muslim countrie= s will then adopt these standards and proper sanctions will hopefully be put in pl= ace by the respective countries for any breach or violation of these standards. These standards and sanctions, once in place, will create a conducive platf= orm for Islamic profit sharing products to flourish and reform the current landscape of the Islamic finance industry.

5. No level playing fi= eld

Another barrier to the entry of Islamic prof= it sharing products is the uneven tax treatment current= ly in place for equity-based products. Interest payment, and correspondingly prof= it payment in murabaha and rental payment in ijara, are = all tax deductible on the ground that they constitute cost items. A profit distribution under a mudaraba XE "mudaraba (si= lent partnership)" = or musharaka is, on the other hand, not tax-deductible. The distribution is made net of tax. This unfair tax treatm= ent frequently makes the Islamic profit sharing products more expensive for the corporations. The existing tax environment inevitably makes leverage and gearing more attractive to the corporations.= [118]<= /span> Assuming the corporate profit tax = rate is 30 percent and a corporation, with say $100 equity, borrows $900 at 10 percent p.a. and makes a profit of 20 percent, then the leverage will produ= ce a return on equity of 77 percent for the corporation.= [119]<= /span> Conversely, if the corporation rai= ses the $900 in equity instead of debt and still makes a profit of 20 percent, = the return on equity is merely 14 percent.= [120]<= /span> The existing environment creates an uneven playing field for the Islamic investors who are keen to offer Islamic profit sharing products. The econom= ics of the profit and loss sharing mechanism simply makes it less appe= aling for the corporations. The industry regulators must take urgent steps to ref= orm the tax system in their respective countries and to create a level playing field for the Islamic profit sharing products. Perhaps, with equal tax treatment, the interest among corporations to seek profit and loss sharing solutions may increase and promote less reliance on the Islamic debt-based products. Obviously, more research has to be done in this area before it ca= n be successfully implemented.

CONCLUSION

The various sukuk products discussed above have opene= d up to the Islamic finance market a new and attractive asset class with a fixed income profile and tradability feature. This asset class will hopefully be = able to consume the huge surplus liquidity existing in the Islamic finance mar= ket. The credit goes to contemporary sha= ri‘a scholars who were able to inspire and guide the industry in producing the various shari‘a innovatio= ns that made the sukuk a reality t= oday. The sukuk product, however, sho= uld be employed judiciously to ensure that it is not used as an avenue to prolifer= ate debt in society. The Islamic finance practitioners should channel their foc= us and energy in spreading the growth of Islamic profit sharing products. There are various hurdles but these are not insurmountable. History speaks = for itself. Three decades ago, very few would have believed that the sukuk would be a reality. Perhaps,= three decades from now, the Islamic profit sharing products will be the mainstream products in the Islamic finance market.

[1] Professor of Government and Middle Eastern Studies, Department of Governmen= t, University of Texas (Austin).

[2] Union of Arab Banks 2004. An announcement for the Fourth Annual Islamic Fin= ance Summit sponsored in London by Euromoney claims that Islamic finance is grow= ing 15 percent per year. See http://www.euromoneyseminars.com/pdfs/ ELE667.pdf (last visited December 6, 2004).

[3] In its 2003 Annual Report, the Nat= ional Commerce Bank explains that its retail banking “provides banking services, including consumer lending, current accounts and investment management services to individuals and small sized businesses in addition to Islamic products in compliance with Shariah rules and supervised by the independent Shariah Board.” See http://www.ncb.com.sa/fin/03/notes2.pdf (last visited December 6, 2004).

[4] Al Rajhi Banking and Investment Co= rporation alone had 14 percent of the kingdom’s commercial banking deposits in 2000, and some 30 percent of all commercial banking deposits were non-interest-bearing in 2001. See Henry and Wilson 2004: 7, 109-114.

[5] Ahmad Najjar founded the first rural cooperatives in Egypt in 1963, modeled on German Sparkassen = employing profit sharing techniques for financing small enterprises. To stay out of political trouble with Nasser, who had repressed the Muslim Brotherhood, he= did not make any references to Islam. But he subsequently played an active role= as an adviser to the transnational group of banks established by Prince Mohamm= ed Al Faisal until the mid-1980s, when they split over ideological and business differences. See Clement M. Henry, = The Mediterranean Debt Crescent (University Press of Florida, 1996), 269-27= 5.

[6] See infra, pp. 19-21 for definitions of these terms.

[7] Warde 2000: 5.

[8] Vogel and Hayes 1998: 1-2, 19, 23.=

[9] The current members are listed on the IFSB website at www.ifsb.org/index.php?ch=3D3&pg=3D7&ac=3D10 (last visited December= 6, 2004).

= [10]<= /a> See the AAOIFI website at http://www.aaoifi.com/ (= last visited December 6, 2004).

= [11]<= /a> McMillen notes, “It is assumed for purposes of this essay that the Shari‘a= -Compliant Investor desires to achieve a specific inter= nal rate of return (the ‘Target IRR’) on its investment and is willing to participate at a level = of risk that is generally associated with equity capital investments. It is further assumed that the Shari̵= 6;a-Compliant Investor is willing to forgo returns in excess of the Target IRR.” Th= ose returns could be viewed as an option. Note Mahmoud Al-Gamal’s observation: “Protected capital mutual funds marketed in Saudi Arabia= tend to rely on non-Islamic partner= s or advisers to receive an option-like payment as management or advisory fees (= e.g. by capping investor returns at some percentage, and giving the partner/advi= ser all excess returns above that level as fees, i.e. paying with a call option).”

= [12]<= /a> In The Muqaddimah (Bollingen ed= ition, Princeton University Press, 1967), p. 300, Ibn Khaldoun observes that “Commerce is a natural way of making a living. However, most of its practices and methods are tricky and designed to obtain the (profit) margin between purchase prices and sale prices. This surplus makes it possible to = earn a profit. Therefore the law permits cunning [hiyal] in commerce … [a= s long as it does not] mean taking away the property of others without giving anyt= hing in return.”

= [13]<= /a> See her chapter on Kuwait in Henry and Wilson 2004: 168-190.<= /p>

= [14]<= /a> The “must-read” analysis of the phenomenon is Anonymous (Michael Scheuer), Imperial Hubris: Why the West is Losing the War on Terr= or (Washington, D.C.: Brassey’s, Inc. 2004).

= [15]<= /a> Reseach Affiliate, Center for International Studies, Massachusetts Institut= e of Technology (Cambridge, Massachusetts).

= [16]<= /a> Lannoo 1995: 5.

= [17]<= /a> See Warde 1998 and 2002.

= [18]<= /a> The “Greater Middle East” initiative was, for example, at the center of the June 2004 meting of the G8 meeting in Sea Island, Georgia.

= [19]<= /a> See the issues raised in Taylor 2004.

= [20]<= /a> Janahi 1995: 28.

= [21]<= /a> Janahi 1995: 42.

= [22]<= /a> See Allen 2001: 13, and Temple 2001: 73.

= [23]<= /a> Another thing made possible by deregulation was that investment bankers cou= ld group deposits into insurable $100,000 bundles and place them in savings and loans offering high returns.

= [24]<= /a> Vickers 1997: 98.

= [25]<= /a> Algabid 1990: 182.

= [26]<= /a> Vogel and Hayes 1998: 139.

= [27]<= /a> al-Harran 1995: xi and 135.

= [28]<= /a> Vogel and Hayes 1998: 125-128.

= [29]<= /a> Vogel and Hayes 1998: 9.

= [30]<= /a> Vogel and Hayes 1998: 143.

= [31]<= /a> Udovitch 1970: 170-248.

= [32]<= /a> See for example Ziaul Haque, Riba: The moral economy of usury, interest= , and profit (Lahore: Vanguard 1985), 190-214.

= [33]<= /a> al-Omar and Abdel-Haq 1996: 43.

= [34]<= /a> Parigi 1989: 137.

= [35]<= /a> Kazarian 1993: 179.

= [36]<= /a> Potts et al. 1992: 77-78.

= [37]<= /a> Warde 2000: 84.

= [38]<= /a> Algabid 1990: 182.

= [39]<= /a> DiFonzo 1983.

= [40]<= /a> Saleh 1986: preface.

= [41]<= /a> Zubeida 1997: 113.

= [42]<= /a> “If the debtor is in difficulty, grant him time till it is easy for h= im to repay. But if you remit it by way of charity, that is best for you if you only knew.” (Qur’an: 2:280.)

= [43]<= /a> Warde 2000: 112-117.

= [44]<= /a> al-Omar and Abdel-Haq 1996: 101.

= [45]<= /a> Wilson 1991: 109.

= [46]<= /a> Wilson 1991: 8.

= [47]<= /a> Head of Islamic Finance, ABN AMRO (Dubai, UAE).

= [48]<= /a> See Kamali= 2000 for more details.

= [49]<= /a> See Ibn An= as 2000: 296.

= [50]<= /a> Schact 1982.

= [51]<= /a> In 2000, the State of Bahrain led the way by issuing the innovati= ve sukuk al-salam but these securities were non-trada= ble.

= [52]<= /a> As it was then known; now the Kingdom of Bahrain.

= [53]<= /a> For a detailed exposition of ijara<= /i> muntahia bi-tamlik, see Standard no. 9, Shari‘a= Standards of the Accounting and Aud= iting Organization for Islamic Financial Institutions= (1424-5 Hijri / 2003-4 AD).

= [54]<= /a> Prior to that, in December 2001, Kumpulan Guthrie Berhad, a Malaysian public listed company involved in the plantation and construction sectors, has off= ered a sukuk al-ijara issue in the U.S. Regulation S form= at. The company offered a USD150 million sukuk issue with a floating rate return and the tenor was divided into three years (USD50m) and five years (USD100m). The sukuk was listed on the Labuan International Financial Exchange.

= [55]<= /a> The term “Islamic profit sharing product” refers to a product or security that is structured on the principle of profit and loss sharing based on mudaraba, musharaka, or similar concepts.

= [56]<= /a> The asset or enterprise itself has to be shari‘a-compatible. Hence, an enterprise involved in alcohol or gambling is not compatible with= shari‘a.

= [57]<= /a> At one time the common law also used to treat the shareholders as having so= me sort of equitable interest in the assets of a company. The company itself w= as deemed as holding the assets as trustee for the shareholders. However, the prevailing common law position is that a share is a chose in action which confers on the shareholders the contractual right to vote, to receive dividends, return of capital upon winding up, and other rights exce= pt that it does not confer a right to possess any physical assets. Gower’s Principles of Modern Com= pany Law (Paul L. Davies ed.= , 6th ed. 1997), 299-302.

= [58]<= /a> It is important to note that, from a shari‘a perspective, if the shares in a company are construed as co-ownership in an enterprise only, the shareholders will then be construed as partners in an enterprise like mudaraba= and the strict rules of mudaraba will come into play. But = when the link is made with the ownership in the assets owned by the company, the shareholders will be treated as co-owners of an asset or shirkat al-milk = ;and this will allow a co-owner to freely sell his share without the consent of = the other co-owners. See Vogel and = Hayes 1998: 175-176.

= [59]<= /a> See ibid.,= 175.

= [60]<= /a> See genera= lly, Ravi C. Tennekoon, The Law & Regulation of International Fin= ance (1991), 161-176.

= [61]<= /a> See Pettit 1997: 14-17.

= [62]<= /a> This aspect of the transaction is structured as an ijara= muntahia bi-tamlik in line with the Standard no. 9, Shari‘a Standards of the Accounting and Aud= iting Organization for Islamic Financial Institutions= (1424-5 Hijri / 2003-4 AD).

= [63]<= /a> The trustee company will be an or= phan entity with no corporate relationship with the railway company.

= [64]<= /a> Fabozzi and Modigliani 2002: 515-516.

= [65]<= /a> The Federal Land Commission, a statutory body that holds all federal lands = in Malaysia.

= [66]<= /a> The buyer, however, has to be a bona fide purchaser for value without notic= e of any prior third party rights attached to the landed asset.

= [67]<= /a> This principle was firmly laid down in the Malaysian case of Borneo Housing Mortgage Finance Bhd v.= Bank Bumiputra Malaysia Bhd, [1991] 2 MLJ 261.

= [68]<= /a> Such a disposal, however, has to be made through the bare trustee who will have to comp= ly with the instructions of the beneficial owner.

= [69]<= /a> This endorsement is done under section 344 of the Malaysian National Land C= ode, 1965. For more details see Mary George, Malaysian Trust Law (1999), 11.

= [70]<= /a> Most of the countries in the Gulf Cooperation Council are civil law jurisdictions.

= [71]<= /a> The concept of unilateral undertaking or promise has a unique existence in Islamic law because Islamic law prohibits= an agreement to sell in future (i.e. a deferred sale) and only allows a sale contract where the property in the goods is transferred to the buyer at the time of contract. Most Muslim jurists argue that for a valid sale under shari‘a, at least one of the counter values, either the purchase price or the goods, has to be delivered= at the time of contract. Deferring both counter values at the time of contract vitiates the contract. Murabaha= contracts, for instance, have been allowed because only one of the counter values, i.e. the purchase price, is= deferred. Another example is the salam XE "bonds, salam" contract, where only the commoditie= s are deferred while the purchase price is paid at the time of contract. The only exception seems to be the istisna&#= 8216; contract, where both counter values= are allowed to be deferred based on the prevailing custom (urf). For a detailed discussion on the shari‘a treatment of deferred sale, see Kamali 2000: 131. = For a comparative analysis of the common law position, where both a deferred sa= le and a sale contract are allowed, se= e Goode 1995.

= [72]<= /a> Usmani 2002: 122.

= [73]<= /a> Ibid., 123.

= [74]<= /a> Qur’an: 61:2-3 (Abdullah Yusuf Ali translation).

= [75]<= /a> Islamic Fiqh Academy 1988.

= [76]<= /a> Actual damages are confined to “actual monetary loss suffered by [the promisee], but will not include the opportunity cost.” Usmani 2002: 1= 26.

= [77]<= /a> It has been argued elsewhere that the scope of the Islamic Fiqh Academy resolution should not be extended b= eyond the ambit of murabaha transactions and an example was giv= en of a salam transaction involving unilateral pr= omise that could lead to “anomalous and radical” results from a shari‘a perspective. Vogel a= nd Hayes 1998: 126-128. While there is some merit in limiting the scope of the resolution in cases where it may lead to inconsistent results, this should = not in itself be taken as a ground to bar the extension of the resolution to ca= ses where if the promisor is allowed to repudiate his promise it would lead to = an inequitable situation.

= [78]<= /a> It is interesting to note that this development in the contemporary fiqh has some resemblance to the develop= ment of the principle of promissory estoppel at common law. The common law had f= or a long time taken the stand that a promise made in a commercial transaction is only binding if there was consideration for it. In the celebrated English c= ase of High Trees, [1947] 1 KB 130, Denning J., changed the course of common law by ruling that when a person m= akes a promise and knows or reasonably should know that the promisee will rely on his promise, the promisor will be bound by his promise if the promisee has actually relied on that promise and acted upon it. The court ruled that it would otherwise be inequitable to the promisee if the promisor is allowed to dishonor his promise in such circumstances. This is a classic instance where equity has come to remove the rigors of common law, which would have allowe= d to the promisor his strict right to retract his promise. Since High Trees, there has been a pleth= ora of cases reaffirming the principle of promissory estoppel.

= [79]<= /a> Nyazee 1995: 74.

= [80]<= /a> See Malays= ian Securities Commission 2002: 26-28.

= [81]<= /a> Usmani 2002: 87-89 and 123.

= [82]<= /a> In Malaysia, there is ample evidenc= e that such arrangements have been in practice for decades and they have been recognized as valid contracts under shari‘a.

= [83]<= /a> It is important to observe that, like the issue revolving unilateral undertakings, the issue of selling = back the asset to the original seller at the original price goes to the root of = ijara muntahia bi-tamlik where the lessee will invariably undertake to buy the assets from the lessor at the original cost. Such prac= tice has been in vogue for a long time and has been endorsed by Standard no. 9, = Shari‘a= Standards of the Accounting and Aud= iting Organization for Islamic Financial Institutions= (1424-5 Hijri / 2003-4 AD). This ma= tter therefore should not be confined to sukuk issues alone. If the practice is acceptable in ijara muntahia bi-tam= lik transactions, it should be automatically applicable to sukuk al-ijara since the underlying transaction evidenced by the sukuk is ijara muntahia bi-tamlik.

= [84]<= /a> Kamali 2000: 95.

= [85]<= /a> Ibid., = 95.

= [86]<= /a> To connote a type of riba widely practiced during the pre-Isl= amic days in Arabia.

= [87]<= /a> See Usmani 2002: 134.

= [88]<= /a> Whether such an action will be enforceable in a court of law will depend on= the respective legal jurisdiction. Under English law, the current view is that = such an undertaking will be enforceable by the creditor although the creditor is= not the recipient of the payment.

= [89]<= /a> The concept of a mixed fund has been espoused for some time by prominent scholars like Sheikh Taqi Usmani and the IDB sukuk has caused the concept to gather wi= der acceptance. See Usmani 2002: 21= 8.

= [90]<= /a> Based on the bare or simple majority rule. A similar rule was used in scree= ning shari‘a-compatible equiti= es: only equities of companies having not more than 45 percent account receivab= les were accepted as shari‘a-= compatible. See the Methodology Overview of= Dow Jones Islamic Market Indexes (visited April 10, 2004) at www.djindexes.com/= jsp/imiMethod.jsp.

= [91]<= /a> It is important to note that the above principle does not extend to the sel= ler guaranteeing the performance of the asset itself. For example, the seller o= f an equity or share in a company cannot validly guarantee that the equity will yield a certain amount of dividends (e.g., if the share does not yield the dividends as guaranteed, the seller will then indemnify the buyer to the ex= tent of the deficit). The ambit of the guarantee as used in the IDB sukuk is only confined to the obligations= of an end-user of the assets.

= [92]<= /a> Islamic Corporation for the Development of the Private Sector (“ICD”) was involved as the third party in the IDB sukuk issue.

= [93]<= /a> The third party then delegates the administration and servicing obligation = to the IDB. From a shari‘a perspective, this arrangement does not create a l= ink between the issuer and the IDB. There is no contractual nexus between the issuer and the IDB and thus the IDB is not treated as the agent of the issu= er.

= [94]<= /a> Alternatively, the advance received by the issuer can be repaid when the portfolio is sold back to the IDB under the purchase undertaking. The exercise price for= the portfolio will include an amount equal to the outstanding advances.

= [95]<= /a> The term bay` bi-thaman ‘ajil (similar to bay‘ al-mu’ajjal) is used main= ly in Malaysia.

= [96]<= /a> Malaysian Securities Commission 2002: 21.

= [97]<= /a> The hadith relates to the pronouncement of nikah or talaq in jest. It has been recorded that the Prophet said: “He who jests with the = words that will make a binding contract of marriage, or with the words that prono= unce a divorce or declare a slave free, shall be taken to have meant the words seriously.” See Malik Ibn= Anas, al-Muwatta, Book 28 (Aisha Abda= rahman at-Tarjumana & Yaqub Johnson translation).

= [98]<= /a> The hadith relates to li‘an and the wife of Hilal bin Umaiyyah. The wife of Hil= al was charged with adultery and she denied the charge by taking the oath. Bef= ore taking the fifth oath, she faltered. It seemed for a moment that she might admit adultery but then she said that she was not going to dishonor her tri= be by admitting adultery and took the fifth oath denying adultery. Here, there= was a strong possibility that she was taking a false oath, but despite that the Prophet decided that she was not guilty bas= ed on her external deed (oral statement); see Muhammad Al-Bukhari, Sahih al-Bukhari, Volu= me 6, Book 60 (M. Muhsin Khan translation).

= [99]<= /a> Malaysian Securities Commission 2002: 21.

[100]= Kamali 2000: 128 (citing the hadith reported by Musa ibn Ubayday on the narration of Abd Allah ibn Umar).

[101]= Usmani 2002: 217.

[102]= Kamali 2000: 125-130.

[103]= Malaysian Securities Commission 2002: 16-19.

[104]= A well-entrenched principle of economics which states that the same item or closely equivalent item must sell for the same price or related prices in an efficient marketplace. The principle also shows that financial products with similar cash flows or payoffs should command the same price thereby denying= the arbitrageurs the opportunity to profit from riskless arbitrage opportunitie= s.

[105]= Qur’an: 2:275 (Abdullah Yusuf Ali translation).

[106]= Usmani 2000b: 36-37.

[107]= Ibid., 37.

[108]= Ibid., 87.

[109]= Particularly in an ijara muntahia bi-tamlik transaction.

[110]= Usmani 2000b: 101 (citing the existing state of economic affairs in the wor= ld where many countries, including those in the developed world, are over-burd= ened by excessive domestic and foreign debts, which in some cases even exceed the country’s total GDP). See= also Tarek El Diwany, The Problem with Interest (1997), 61-74, 115-122.

[111]= Usmani 2000b: 100.

[112]= Some contemporary scholars argue that the issue of reasonable need is very subjective and should be left to the individual incurring the debt. If the debtor decides that it is a reasonable need for him, he can incur the debt through Islamically structured financing.

[113]= Not all financing needs are suitable for profit-sharing mechanisms. For instance, consumption-related transactions like home and car financing are = not suitable for profit-sharing modes of financing. Although home financing products have been structured through musharaka mutanaqisa, the underlying transaction is still based on ijara= .

[114]= Islam also encourages the maximization of profit but within the framework o= f shari‘a that, among other th= ings, discourages leverage and encourages growth through profit and loss sharing<= !--[if supportFields]> XE "profit and loss sharing&= quot; mechanisms.

[115]= All Islamic banks offer profit and loss sharing investment accounts where the depositors share the prof= its and the losses with the Islamic banks. But these funds are invested in main= ly murabaha, ijara, and istisna‘ products.

[116]= In some countries ownership in a company and landed property has to be effe= cted through a local sponsor and the enforceability of the contractual arrangeme= nt between the investors and the local sponsor is often hazy.

[117]= Qur’an: 2:282-283 (Abdullah Yusuf Ali translation).

[118]= For an interesting discussion on the negative impact of leverage to the eco= nomy and the limited role of leverage in an Islamic economy, see Tarek El Diwany, The Problem with Interest (1997), 167-172.

[119]= ($200 profit minus $90 interest minus $33 tax) / $100 (equity) =3D $77.

[120]= ($200 profit minus $60 tax) / $1,000 (equity) =3D $140.

[121]= Partner, GLEISS LUTZ (Frankfurt, Germany). The author specializes in international corporate and M&A work with a particular focus on the MENA region.

[122]= G= oode 1995: 162.

[123]= Market Intelligence, cf. for example, www.islamic-banking.com/conference/conf-documentation-report.php. For a mor= e comprehensive analysis of the case, see Uma= r F. Moghul and Arshad A. Ahmed, “Contractual Forms in Islamic Finance Law= and Islamic Investment Co. of the Gulf (Bahamas) Ltd. v. Symphony Gems & Ors.,” Fordham International Law Journal = 25 (2003): 150, and Bälz 2004b: 117-134.

[124]= February 13, 2002. To my knowledge, the case has not been published. The following quotations are taken from the transcript provided by Beverly F. Nunnery & Co.

[125]= Vogel and Hayes 1998: = 141.

[126]= Islamic Invest= ment Company of the Gulf v. Symphony Gems, 4-5.

[127]= Ibid., 5-6.

[128]= Ibid., 12.

[129]= Ibid., 22-23.

[130]= Ibid., 23.

[131]= January 28, 2004, [2004] EWCA Civ 99. The following quotations are taken fr= om the transcript by Smith Bernal Wordwave Ltd.

[132]= Ibid., no. 1

[133]= For a more comprehensive discussion, see Bälz 2004a. Among these quest= ions are whether the parties indeed intended to subject the agreement simultaneo= usly to two legal orders (Islamic and English Law) or at least, in effect, subje= ct the exercise of rights granted under the agreement to the mandatory princip= les of Islamic law. Further, one may raise the question of whether the parties = did intend to determine a proper law of the contract pursuant to which the transaction contemplated in the agreement may be deemed void.

[134]= For a more detailed discussion see Bälz 2001: 73-85.

[135]= Collins 2000: 1223.

[136]= Shamil Bank v.= Beximco, no. 51.

[137]= Ibid., no. 52.

[138]= Ibid., no. 55.<= /p>

[139]= For a more detailed di= scussion of this type of transaction, see Vogel and Hayes 1998: 142-143.

[140]= English translation by the author.

[141]= This opinion is forcefully put forth, e.g., by Von Bar and Mankowski 2003: 87-88. It conf= orms to the predominant, albeit not entirely uncontested opinion in German legal literature (see the references ibid.).

[142]= Wichard 1996: 262-302; Berg= er et al. 2002: 12-37. Both authors emphasize the importance of non-governmental rule-making from an empirical/sociological perspective.

[143]= English translation by the author.

[144]= W= agner 2002: 791 with further references.

[145]= W= hich is, practically speaking, the case if the venue or place of arbitration, as the case may be, is located in Germany.

[146]= V= on Bar and Mankowski 2003: 87-88.

[147]= For a critical discussion from a comparative perspective, see Zweigert and Kötz 1987: 433-434.

[148]= O= ne can only speculate about the outcome. The agreement at hand, which resembled a synthetic murabaha= , may well be contrary to a = more orthodox interpretation of shari= 216;a principles. The possible consequences, however, are not very clear. One approach would be to hold that the agreement is void only as far as the pay= ment of “interest” is concerned. Based on such an understanding the = bank would be able to collect the principal without, however, being entitled to = the mark-up. If and to the extent one holds that the agreement is void altogeth= er, the question arises whether the bank may nevertheless collect the principal pursuant to the rules of unjustified enrichment (which would be the position under German law; see Bundesgerichtshof, judgments of July 29, 1989, Wertpapiermitteilungen 1083 and Ju= ne 15, Neue Juristische Wochenschrift = 1993, 2108).

[149]= B= undesgerichtshof, judgment of October 14, 1998, Neue Juristische Wochenschrift 1999, 574 f.

[150]= Saeed 1999: 108-118.=

[151]= For details see www.aaoifi.com.

[152]= Accounting and Auditing Organization for Islamic Financial Institutions= 2003.

[153]= For a more comprehensive discussion, see Bälz 2004a.

[154]= Partner, King & Spalding LLP. The author is resident in the firm’s New York and London offices. All intellectual property rights, including copyright, are retained by Michael J. T. McMillen. The author expresses his gratitude to the shari‘a = scholars who considered the many complicated aspects of the South Korean transaction that forms= the basis of this case study and to the entities involved in that transaction. Confidentiality considerations prevent the identification of those scholars= and entities, but do not diminish the author’s gratitude. The author also= expresses his gratitude to other shari‘= a scholars who consulted on many of the complicated shari‘a questions and issues raised by the structuring of this transaction, most notably Mohammed Ali Elgari, Sheikh Nizam Yaquby, and Sheikh Yusuf Talal DeLorenzo. For the same confidentiality reasons, the author could not descr= ibe to these scholars all aspects of the South Korean transaction, nor could he identify the transaction or the participants in the transaction to these scholars, when discussing aspects of the transaction with them. Nevertheles= s, as always, these gentlemen were generous with their thoughts, their wisdom, their criticism, their humor, their time, and their creative suggestions.

[155]= This essay will not focus directly on asset-based securitizations of the ty= pe evidenced by the recent sukuk XE "sakk (pl. sukuk)"<= /span> issuances. Nor wi= ll this essay focus on the pooling and related statistical concepts that under= pin the predictability concepts that are essential to securitization.

[156]= The description of the transactional case study set forth in this essay dep= arts from the actual facts of the South Korean transaction in various particulars. Those departures are intended to highlight certain issues pertaining to shari‘a com= pliance as well as to protect client confidences.

[157]= Any departures from compliance with the shari‘a that may be perceived, asserted, or identified by any reader are the so= le responsibility of the author, whether resulting from the author’s understanding (or lack thereof), characterization, or interpretation of the relevant shari‘a principl= e or precept, and are in no way attributable to any of the shari‘a scholars mentioned in footnote 1 of this essay.

[158]= Bank for International Settlements 2003: sections 502 and 503. Securitizati= on is to be distinguished from factori= ng (although the differences may be slight in sophisticated securitization transactions). In a factoring transaction, the factor purchases receivables from the originator at a disc= ount and the factor thereafter collects on the receivable. In a securitization transaction, a “Special Purpose Vehicle” is established and that Special Purpose Vehicle purchases the receivables and issues asset-backed securities based upon the receivables. The Special Purpose Vehicle relies u= pon the quality of the receivables (and the statistical construction of the poo= l of receivables, among other factors) to reduce risk, rather than on its abilit= y to collect on those receivables.

[159]= This essay provides only a general description of some of the more important and generic aspects of securitization. The securitization markets are now highly developed and sophisticated marke= ts and there are a myriad of structures used for different types of securitizations. None of those more sophisticated structures is discussed in this essay. Similarly, this essay does not consider many of the essential features and considerations relating to even a relatively simple securitization, such as overcapitalization of the conduit special purpose entities, credit and liquidity enhancements, capitalization, or ta= x and accounting rules applicable to different types of single-seller conduit and multiple seller conduit securitizations. For an interesting comparison of t= he earliest securitizations with more recent securitization trends, compare The Handbook of Mortgage-Backed Securi= ties, Frank J. Fabozzi, ed. (1985) (hereafter “Fabozzi 1985”), with the rev= ised version of The Handbook of Mortgage-Backed Securities, Frank = J. Fabozzi, ed. (2001).

[160]= See, e.g.,= 11 U.S.C. § 541 with respect to the bankruptcy laws of the United States = of America.

[161]= In contemporary sophisticated securitization transactions, the range of the diff= erent types of SPV Securities is broad and covers short-term, medium-term, and long-term instruments, including commercial pa= per and a broad range of different types of notes, as well as equity instrument= s.

[162]= A sukuk has many similari= ties to a “pass through certificate” in the non-Islamic capital mark= ets, although most pass through certificates do not represent interests in shari‘a-compliant assets or receivables pertaining to shariR= 16;a-compliant assets. See, e.g., Fabozzi 1985, pages 101-147 discussing mortgage pass thr= ough certificates in the early years of securitizations.

[163]= Unless otherwise noted, this essay assumes (a) that the SPV Securities will not be “pass through certificates” or similar securities that are structured so th= at the holder of the SPV Securities owns a fractional undivided interest in the individual or pooled receivables and all of the payments in respect of the receivables are passed through to the holder of the SPV Securities, and (b) that the yield on the SPV Securities is established as a designated rate of interest or profit. The pass through structure, and variations on that structure, are akin to sukuk XE "sakk (pl. sukuk)"<= /span> structures in whi= ch the holder of the sukuk owns a frac= tional undivided interest in the assets which have been leased to end users pursua= nt to different ijara = ;arrangements that provide the receivable for payment of the sukuk.

[164]= Note, however, that SPV Securities may bear credit enhancem= ents, such as guarantees and insurance, and payments might then be made from the proceeds of the credit enhancement device.

[165]= The most well-known “rating agencies” are Standard & Poor’s Ratings Group, Moody’s Investors Services, Inc., Duff and Phelps, and Fitch Investors Service, Inc.

[166]= These assumptions regarding the Target IRR and returns in excess of the Tar= get IRR are consistent with the position of the actual Shari‘a-Compliant Investor in the transaction that forms the b= asis for the case study discussed in this essay. However, that actual Shari‘a-Compliant Investor w= as also willing to invest on a “pure equity” basis, with all atten= dant equity risks and rewards, including entitlement to returns in excess of the Target IRR. The structure that was developed for the transaction and that is discussed in this essay allowed for either type of participation by the Shari‘a-Compliant Investor.<= /p>

[167]= The special purpose entity will have no assets other than the Project.

[168]= The mortgage and other security documents securing the Senior Bonds are not discussed in this essay and are not shown on the accompanying slides.

[169]= The Junior Bond Amount will usually be greater than the amount of the exces= s of the Acquisition Price over the Senior Bond Amount so as to provide for other deposits, payments, and reserves. Such other deposits, payments, and reserv= es may include (a) payment of transaction costs, (b) provision of working capi= tal, (c) initial funding of reserves (such as maintenance reserves, capital improvement reserves, tax reserves, insurance reserves, and debt service reserves), and (d) provision for certain other identifiable future payments. These deposits, payments, and reserves will be determined and negotiated on= a case-by-case, transaction-by-transaction basis. In addition, the structurin= g of the transaction in accordance with applicable laws, particularly applicable= tax laws in a number of different jurisdictions, may have the effect of reducing the Junior Bond Amount. See the section of this essay entitled “Economics and Pricing.”

[170]= As an example of a structural variation, there may be an equity entity, in addition to the Senior Bond Holder and the Residual Interest Purchaser, that receives pure equity payments after the making of all payments in respect of the Senior Bonds and the Junior Bonds. That variation is not presented in t= his essay. This essay assumes that the Residual Interest Purchaser, as the hold= er of the Junior Bonds, will receive all amounts remaining in the Project Owner a= fter payment of the Senior Bonds (and after payment of operating costs and fundi= ng of reserves). Thus, the Junior Bonds effectively constitute pure equity for purposes of this transaction. These assumptions are in accordance with the structure of the actual transaction that forms the basis of this case study= .

[171]= The mortgage and other security documents securing the Junior Bonds are not discussed in this essay.

[172]= Less the amounts referred to in footnotes 15 and 21.

[173]= But see the section of this essay entitled “Economics and Pricing.”

[174]= The nature of the operating payments, deposits, and reserves, and the order= in which each is made or funded, varies from transaction to transaction and is heavily negotiated in every transaction. For example, there may be maintena= nce reserves, capital improvement reserves, working capital reserves, tax reser= ves, insurance reserves, debt service reserves in respect of the Senior Bonds, a= nd a wide range of other reserve accounts and categories. The parties will negot= iate the amount and timing of deposits to each of the reserve accounts. Similarl= y, the parties will negotiate the order in which operating expense payments are made and the order, relative to all other deposits and payments, in which payments are made in respect of the Senior Bonds. These parameters, includi= ng the amounts and order of deposit and payment, will be set forth in the documents in a series of provisions (collectively often referred to as the “cashcade” or “waterfall”) that may vary depending = upon the financial strength of the Project and the absence or existence of an ev= ent of default (as well as other factors).

[175]= The Ultimate Tax Owner is not shown on the diagrams included in this essay. Although not discussed in this essay, the structure that was developed for = the Securitized Acquisition Financing Transaction can also be used where this ownership assumption is not true and there is either joint ownership of the Project Company by another third party entity as well as the Residual Inter= est Purchaser or exclusive ownership by such a third party; in each such case t= here will be modifications to the economics and pricing of the Junior Bonds, the purchase of the residual interest, and the sale of the sh= ares in the Investor Entity.

[176]= Revenue Procedure 75-21 (1975), Internal Revenue Service of= the United States of America Department of the Treasury (“Rev. Proc. 75-21”). See also Revenue Procedure 75-28, which elaborated on the guidelines set forth in Rev. Proc. 75-21 and certain fili= ng information requirements, Revenue Procedure 76-30 (1976), which addressed t= he definition of “limited use property,” and Revenue Procedure 79-= 48, which addresses certain lessee-funded improvements to leased property. Reve= nue Ruling 55-540 (1955-2 Cumulative Bulletin 39), although superseded in substantial part by Rev. Proc. 75-21, is useful for an historical understan= ding of factors that may indicate that a transaction is a conditional sale rather than a true lease.

[177]= For example, the essay assumes that, for depreciation purposes, the buildin= gs constituting real property will be depreciable over 30 years on a straight-= line basis and that certain other property constituting portions of the Project = will be depreciable over other, sometimes much shorter, periods on different accelerated depreciation formulas. This essay assumes that a qualified consultant will determine the applicable depreciation class and methodology= for each asset constituting a part of the Project, as is customarily done in transactions of this type.

[178]= Rev. Proc. 75-21 and related Revenue Procedures address a number of other factors, of less importance to this essay, that relate to true lease characterization, including: (1) the definition of the term of the lease (h= ere, the End User Lease) for purposes of determinations of true lease status; (2) fair market value lease renewal terms; (3) provision of the cost of the pro= perty by the lessee (the End User Tenant) and related parties; (4) prohibitions on the provision of debt financing by the lessee (the End User Tenant) and rel= ated parties to the lessor (the Project Company); (5) demonstrations of the likelihood of profit on the leasing transaction apart from tax benefits, including profits in respect of the residual interest or residual value of the property; (6) uneven rent considerations; (7) prohibitions on the inclusion of “limited use property” in true leases; (8) lessee financing of improvements; (9) residual interest or resi= dual value sharing arrangements; and (9) the payment of transaction costs for tr= ue lease transactions.

[179]= Any such sale, transfer, and conveyance must meet applicable legal requirem= ents pertaining to the validity of the transaction and the applicable contract. Thus, for example, the transaction and related contract cannot be in violat= ion of public policy and must comply with requisite formalities. It is assumed = for purposes of this essay that all such requirements are met and that the transaction is legally permissible. A discussion of those requirements and formalities is beyond the scope of this essay.

[180]= While it does not constitute definitive substantive law and does not take i= nto account variations among the different schools of Islamic jurisprudence with respect to any specific principle or precept, for convenience this essay ma= kes reference to the English language translation of the Majallat Al-Akham Al-`Adliyya made by Judge C. A. Hooper, The Civil Law of Palestine and Trans-J= ordan, Volumes I & II (1933), reprinted in 4 Arab Law Quarterly (August 1986= ) (the “Majelle”), as illustrative of applicable shari= 216;a principles and precepts. Reference is also made to Financial Transactions in Islamic Jurisprudence, Wahban Al-Zuhayli’s Al-Fiqh Al-Islami wa ‘Adillatuh (Isla= mic Jurisprudence and its Proofs), translated by Mahmoud A. El-Gammal (2003) (“Al-Zuhayli –El-Gamal”), which is a translation of Volume 5 of Al-Fiqh Al-‘Islami wa ‘Adillatuh, fourth edition (Damascus 1997) and appears in two volumes= .

[181]= Mejelle, A= rticles 197 – 200, 205, 209, 221 and 363; Al-Zuhayli – El-Gamal, Volume= I, Chapters 1 – 4, pages 5–163. See, also, Majelle, Articles 230 – 236 in respect of appurtenances, fixtures, and items of property, including fruits of, or increases in, the property prior to delivery of the property.

[182]= Mejelle, A= rticles 186 – 189.

[183]= Majelle, A= rticles 214 and 215. Article 214 indicates that the “sale of an ascertained, jointly owned undivided share in a piece of real property owned in absolute ownership prior to division, … is valid.” Article 215 provides that a person “may sell his undivided jointly owned share to some other person without obtaining the permission of his partner,” although various shari‘a scholars, in discussions with the author, have indicated that contractual provisions may be used to introduce the concept = of partner consent to this type of arrangement.

[184]= Majelle, A= rticle 216, which states: “The sale of a right of way, and the right of taki= ng water and of a right of flow attached to land and of water attached to canals[,] is valid.”

[185]= Majelle, A= rticle 253; Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at pages 56 and 6= 0-61 (noting also that not all shariR= 16;a scholars are in agreement that the real property may be sold by the purchaser before receipt).

[186]= Majelle, A= rticles 237 and 238.

[187]= Majelle, A= rticles 245 – 250; Al-Zuhayli – El-Gamal, Volume 1, § 3.2.1, at pa= ge 53, § 3.2.2, at page 63 (citing Al-Sarakhsi (1st edition) ((Hanafi), v= ol. 13, p. 192), Al-Kasani (Hanafi), vol. 5, p. 244, ‘Ibn Al-Humam ((Hana= fi), vol. 5, p. 109), and ‘Ibn ‘Abidin ((Hanafi), vol. 4, p. 43 onwa= rds, and noting that the seller has voluntarily forfeited its right to withhold = in an agreed installment sale transaction), and § 4.3.9, at pages 119-120 (noting that all four major schools of Islamic jurisprudence consider the installment sale a valid sale arrangement).

[188]= Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at page 57.

[189]= Majelle, A= rticle 252; Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at pages 56 and 61-62.

[190]= Majelle, A= rticle 262.

[191]= Majelle, A= rticle 278, which states the rule for transactions of sale for immediate payment. = The right of retention may be lost in various circumstances, including where the seller gives delivery without having received the purchase price or where t= he seller postpones payment of the price after having sold for immediate payme= nt. See, e.g., Majelle, Articles 281= and 284, respectively. See, also, Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at pages 64-66.

[192]= Majelle, A= rticle 284; Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2.

[193]= Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at page 64, noting that the Hanbali school is of the position that the = seller must deliver the property prior to receipt of the purchase price in all cas= es, including installment sale transactions.

[194]= Majelle, A= rticle 300; Al-Zuhayli – El-Gamal, Volume 1, chapter 5, at pages 165-231, which discusses the vario= us types of options recognized by each of the four major schools of Islamic jurisprudence (seventeen by the Hanafis, two by the Malikis, sixteen by the Shafi‘is, and eight by the Hanb= alis). The options must be exercised within a defined time period. See, Majelle, Articles 301 – 309.

[195]= Majelle, A= rticles 310 – 312. See, also, Majelle, Articles 356 – 360 in respect of misrepresentati= on and deceit.

[196]= Majelle, A= rticles 316 – 317.

[197]= Majelle, A= rticles 320 – 335.

[198]= Majelle, A= rticles 336 – 355.

[199]= Majelle, A= rticles 313 – 315.

[200]= Majelle, A= rticles 380 – 387.

[201]= Majelle, A= rticle 387.

[202]= Al-Zuhayli – El-Gamal, Volume 1, § 3.2.2, at pages 66-70. This discussion notes that “if a person purchases wheat in a house, and the seller gives him the key to the house saying: ‘I have given you full access and permission to take the object of sale’, then the buyer wou= ld have received the object of sale” (pages 66-67), and, in footnote 44, noting that giving full access and permission to the buyer is receipt by the buyer even if the buyer did not literally receive the property. This discus= sion notes a similar position by the Malikis and the Shafi‘is with respect to access= and permission, stating that delivery of the keys would constitute access and p= ermission. The Hanbali position, as summarized in that same work, is that possession is determined by the nature of the property. With respect to the Hanbali position in the Kingdom of Saudi Arabia, see McMillen 2001.

[203]= The residual interest itself exists at the time the contr= act of purchase and sale is made and at the time of the transfer of the ownership = of the residual interest; it has value at the time of the making of such contr= act and thereafter. Thus, at the time of “delivery” (see the further discussion in this section) of the residual interest to the purchaser (whic= h is in the present, at the time of the making of the contract and the execution= of the related deed) and thereafter, all benefits appertaining to the residual interest will be for the account of the purchaser.

[204]= Absent a total condemnation and taking, which is addressed in the relevant contracts, the land will be in existence at the Commencement of Residual Us= e. The building may not be in existence, or may be in existence in modified fo= rm at the Commencement of Residual Use. If the relevant contract of sale and purchase is otherwise drafted in accordance with the shari‘a (for example, with respect to maintenance requirements, delineation of property elements constituting the Project and allocation of price to each of such elements, and adjustments to be made to= the purchase price in respect of loss, damage, and destruction depending upon causation, compensation, and other relevant factors), the purchase price in= an installment sale would be appropriately adjusted in accordance with the ass= ets in existence, and the condition of such assets, at the time of Commencement= of Residual Use. The parties would agree on the relevant risk allocation provisions, consistent with the sha= ri‘a, in the contract of sale and purchase.

[205]= The use of both the Intermediate Investor Entity and the Investor Entity is frequently necessitated by applicable real estate laws (including laws pert= aining to foreign ownership of real property in a given country), tax laws (includ= ing those pertaining to taxation of interests in real property, those pertainin= g to taxation of sales of stock, and those pertaining to the ability to make payments to offshore entities with the minimum amount of taxation), and oth= er applicable laws.

[206]= See the section of this essay entitled “Economics and Pricing.”=

[207]= Ibid.

[208]= There are other similar matters in respect of the component transactions th= at relate to “closing out” the overall transaction (e.g., the sale of the residual int= erest, the shares in the Investor Entity, or the shares of the Project Company after the Commencement of Residual Use). See “Closing Out the Transaction.” However, the structure was designed to ensure flexibili= ty at the time of Commencement of Residual Use so that determinations and allocations made at the commencement of the financing transaction would not unduly restrict available alternatives at the time of Commencement of Resid= ual Use. Thus, this essay does not focus on the economics and pricing of these “closing out” transactions.

[209]= The Shari‘a= -Compliant Investor will have to fund the Junior Amount= by getting money, directly or indirectly, into the Residual Interest Purchaser. The Shari‘a-Compliant Inv= estor may not hold an equity interest in the Residual Interest Purchaser because = the Junior Bonds will bear a rate of interest and because the Residual Interest Purchaser will hold an actual or constructive equity interest in the Project Owner (the Project Owner will have non-conforming obligations on the Senior Bonds as well as the Junior Bonds and the Project Owner will be a party to a non-compliant End User Lease with an End User Tenant in a non-conforming business). A qard hassan, non-interest-bearing loan, from the Shari‘a-Compliant Investor or the Intermediate Investor Entity is one alternative solution to this issue.

[210]= See, for example, the discussions of c= urrent transactions at Michael J. T. McMillen, “Shari‘a-Compliant Finance Structures and the Development of an Islamic Economy,” The Proceedings of the Fifth Harvard U= niversity Forum on Islamic Finance: Islam= ic Finance: Dynamics and Development (2003), 89–102; McMillen 2001; and Michael J. T. McMillen, “Islamic Shari‘a-Compliant Project Finance: Collateral Security and Financing Structure Case Studies,” The Proceedings of the Third Harvard Unive= rsity Forum on Islamic Finance: Local Challenges, Global Opportunities (2000), 111-131.

[211]= Basel II Accord, section 502.

[212]= Independent researcher. The author is thankful to M. Anas Zarqa and M. Umer Chapra for their comments on an earlier dr= aft of this paper.

[213]= Saleh 2002: 92-93.

[214]= Because the same scholars have been involved in all these forums, hopefully= no substantial issues will be overlooked.

[215]= Zarqa and Elgari 1991: 25-57.

[216]= Hammad 1985: 104, 106.

[217]= Zarqa 1985: 96.

[218]= Zarqa and Elgari 1991: 37-38.

[219]= al-Dareer 1985: 112, and Abdu= l Barr 1991: 61.

[220]= al-Dareer 1985: 112.

[221]= Abdul Barr 1991: 62.

[222]= Zarqa and Elgari 1991: 37. Also in Elgari et al. 1993: 93 (Arabic section), clauses 4 and 5 of Appendix 9.

[223]= al-Roobi 1992.

[224]= Elgari et al. 1993.

[225]= Islamic Fiqh Academy 2000: 104.

[226]= Ibid., 252.

[227]= Chapra and Khan 2000: 72.

[228]= Ibid., 73.

[229]= Ibid., 73.

[230]= Ibid., 72.

[231]= State Bank of Pakistan 2004: 3.

[232]= Islamic Fiqh Academy 2000: 234.

[233]= Chapra and Khan 2000: 78.

[234]= Ibid., 79

[235]= Ibid.

[236]= Ibid., 80.

[237]= Securities Commission 2002.

[238]= Usmani 2000a.

[239]= Archer and Karim 2002: 132.

[240]= al-Amine 2001: 3.

[241]= Ibid., 4.

[242]= Rosley and Sanusi 1999.

[243]= Ishak 1997: 6.

[244]= Ibid., 7

[245]= Ibid.

[246]= Ibid., 8.

[247]= Professor of Economics and Statistics at Rice University, where the author holds the endowed Chair in Islamic Economics, Finance and Management. Addre= ss: Dept. of Economics – MS 22, Rice University, Houston, TX 77005, elgamal@rice.edu.

[248]= Opening speech by the governor of the Bahrain Monetary Agency, as reported in Monday Morning, February 25, 2004,= cf. www.zawya.com/story.cfm? id=3DZAWYA20040225134523. The issue of strict adhe= rence to Islamic principles is normally reduced to approval by shari‘a boards. Indeed, recent Islamic banking laws in a number of countries and jurisdictions explicitly list the need for appointm= ent of a three-member shari‘a= board that is required to write periodic reports on adherence to the shari‘a, which reports must = be included in Islamic financial institutions’ annual reports. See, for instance, the Islamic banking Law no. 30 of 2003, published (with correctio= ns) by the official Kuwaiti government newspaper Al-Kuwait Al-Yawm (Kuwait Today) on June 8, 2003 (issue 619, 49th year), Article 9= 3.

[249]= Al-Sadr 1969.

[250]= Humud 1976.

[251]= For instance, M. Uzair, An Outline = of Interestless Banking (Karachi: Idaratul Ma`arif, 1955), and M. N. Siddi= qi, Banking without Interest (Leiceste= r, UK: The Islamic Foundation, 1983).

[252]= For a discussion of a recent heated debate, see M. El-Gamal, “Interest and the Paradox of Contemporary Islamic Law and Finance,” Fordham International Law Review (December 2003), 108-149.

[253]= For instance, see M. S. Khan and A. Mirakhor (eds.), Theoretical Studies in Islamic Banking= and Finance (Houston: The Institute for Research and Islamic Studies, 1988)= .

[254]= Initially, the focus was on the prohibition of riba. More recently, avoiding forbidden gharar= has also been important to the development of takaful as an alternative to conventional insurance, as well as the ongoing attempts to synthesize Islamic derivative securities to replace conventional options. F= or an economic explanation of the roots of this “closest permissible alternative” approach, see M. El-Gamal, “The Economics of 21st Century Islamic Financial Jurisprudence,” Proceedings of the Fourth Harvard University Forum on Islamic Finan= ce (Cambridge: Center for Middle Eastern Studies, Harvard University, 2002), 7= -12.

[255]= Al-Najjar 1993. See also, Sheikh Saleh Kamel’s acceptance speech for = the Islamic Development Bank’s prize in Islamic finance in 1996 (quoted in El-Gamal, “Interest and the Paradox”= ).

[256]= This focus on form rather than substance defies a famous Islamic juristic dictum: “What matters in contracts is substance (lit. meaning), and n= ot wording and form” c.f. ibn Qayyim al-Jawziyyah, I`lam al-Muwaqqi`in `an Rabb al-`Alamin (Bayrut, Dar al-Kutub al-`Ilmiyyah, 1996), vol.3, pp.78-80. However, as distasteful as it may sou= nd, surprisingly many Islamic finance practitioners defend legalistic formalism with the example of marriage contracts, wherein the contract form can distinguish between one of the best permissible practices (valid marriage),= and one of the worst sins (adultery). Since this example has been repeated frequently, it is worthwhile to note that its tastelessness is surpassed on= ly by its jurisprudential incoherence. A fundamental difference between this exam= ple and the case of financial transactions (which renders the analogy flagrantly invalid) is the default ruling of prohibition of sexual relations unless legalized through a marriage contract, as opposed to the default ruling of permissibility of all financial transactions, except for those including a prohibiting factor (e.g., riba<= !--[if supportFields]> XE "riba" <= ![endif]--> or gharar).

[257]= See al-Qar= adawi 1987. The binding promise fatwa= was based on the opinion of the Mal= iki jurist ibn Shubruma, and adopted in= the first international conference of Islamic banks in Dubai, 1978.

[258]= Usmani 2002: 67.

[259]= Available on the OCC website at www.occ.treas.gov/interp/nov99/int867.pdf. Similar language was used earlier for lease financing (under the Arabic ter= m ijara), essentially accepting UBK’s argument that “the economic substance” of ijara finan= cing makes the transaction equivalent to secured lending, which is part of conventional banking practice; see www.occ.treas.gov/interp/dec97/int806.pd= f.

[260]= For a comprehensive list of opinions and texts upon which they were based, = see W. al-Zuhayli, Financial Transactio= ns in Islamic Jurisprudence (trans. M. El-Gamal), (Damascus: Dar al-Fikr, 200= 3), 1:214-216.

[261]= Ibid., 217.

[262]= See Bahrain Times, July 13, 2004: “Ba= hrain: $250 million BMA Sukuk listed on BSE.”

[263]= At least one banker operating in the United States indicated to me that he would prefer financing auto purchases through tawarruq, since the transactions costs associated with murabaha (which requires two sales of the ca= r) and ijara (which requires additional costs for title, insurance, etc.) are simply too high. In his view, tawarruq gives him a tool to offer auto loans at more competiti= ve rates, using a method that is approved by the relevant jurists.

[264]= Please see M. N. Siddiqi’s paper in this book, which discusses the is= sues of legal objectives (maqasid al-shari‘a) much more extensively, and eloqu= ently, than I do.

[265]= Abdel-Fadil 1989.

[266]= Monday Morning= , February 25, 2004.

[267]= This popular saying (cited by everyone from evangelical preachers, to music bands, see, respectively, www.covchurch.org/cov/news/item3369.html and www.ocweekly.com/ink/02/47/music-kane.php) is likely an elaboration (possib= ly apocryphal, but illustrative nonetheless) on a passage in Luther’s “Address to the Nobility of the German Nation” in 1520, wherein= he said: “A cobbler, a smith, a peasant, every man, has the office and function of his calling, and yet all alike are consecrated priests and bish= ops, and every man should by his office or function be useful and beneficial to = the rest, so that various kinds of work may all be united for the furtherance of body and soul, just as the members of the body all serve one another,” c.f. Fordham University’s Modern History Sourcebook at www.fordham.edu/halsall/mod/luther-nobility.html. Banking, like all other professions, can be beneficial to society when practiced in an ethical and professional manner. In that regard, an Islamic banker does not need to mar= ket his craft as “Islamic banking,” just as religious practitioners= of other trades do not need to use religious brand-names.

[268]= International Consultant, Fulbright & Jaworski (Houston, Texas).

[269]= A relatively small percentage of contemporary Islamic finance fatwas= are issued by scholars who do not hold any employment or advisory positions= at IFIs, such as the fatwas issued by the Grand Sheikh of al-Azhar University in Cairo, government-appointed muftis, and members of other fiqh research institutions or committees= .

[270]= Riyaa 1996: 325-329.

[271]= al-Ba’li 1991: 247, 248.

[272]= Simmons 1997.

[273]= al-Ba’li 1991: = 247.

[274]= Ibid., 252-253.

[275]= Fox 2000: 1103.

[276]= This is based on a classical disti= nction in usul al-fiqh (principles of legal reasoning) literature between azima (the hukm under normal circumstance) an= d rukhsa (hukm under exceptional circumstances or case of necessity). Usuli scholars divide r= ukhas into three different levels: = (1) rukhas wajiba (mandatory exceptional dispensations), which must be followed upon the occurrence of its specified circumstance or conditions, e= .g., the rukhsa given to a starving = person with no access to food to eat mayta= (meat of non-ritually slaughtered animals), otherwise prohibited under shari‘a; (2) rukhas manduba (recommended exceptional dispensations), e.g., the permission to shorten the daily prayers during travel time; and (3) rukhas mubaha (dispensations that are neither recommended nor reprehensible), e.g., salam (forward sale contract). See Qasim 1988: 235.

[277]= al-Shanibi 2000, 1: 213.

[278]= AAOIFI 2004.

[279]= Ibn Qayyim 1998: 4:229.

[280]= There are five possible qualifications to any act under shari‘a: wajib (obligatory), mandub (recommend= ed), mubah (indifferent), makruh (reprehensible), and haram (forbidden).

[281]= Buhayri 1974: 24-27.

[282]= Ibn Qayyim 1998: 3:163-164.

[283]= Qur’an 20:7.

[284]= al-Shaybani 1997: 159.

[285]= There is a distinction between stratagems that are used to turn a prohibite= d act into a permissible one (prohibited stratagems) and stratagems that are used= to turn a reprehensible act into a permissible one (reprehensible stratagems). Allowable stratagems (makharij shar’iyya) are legal techniques that ease the legal requirements = in a given case without turning a prohibited or a reprehensible act into an allowable one.

[286]= This story is known in both Bukhari and Muslim’s collections of Proph= etic reports and establishes the prohibition of the exchange of good dates for b= ad dates without the mediation of currency (here dirham). This report, coupled with others that extend the prohibition to other goods (often six, despite the difference in determining them), is the main source of prohibiting what is known as riba al-faal (riba of excess; an excess in the exchange of certain goods that= are considered ribawi items, susceptible to riba) under shari‘a. Discussions among H= anafi and Shafi‘i jurists about the rationale behind = this prohibition are particularly heated. See al-Zanjani and Ialih 1987.

[287]= Ibn Qayyim 1998: 4:222.

[288]= Vogel and Hayes 1998: 40.

[289]= Ibid., 40.

[290]= Ibn Taymiyya 1987: 3:363.

[291]= Decision issued by the Council’s fifteenth session held in Mecca on October 31, 1998.

[292]= Decision issued by the Council’s seventeenth session held in Mecca on December 13-17, 2003; cited in “al-Tawarruq ka-ma Tujrih ba’d al-Masarif fí al-Waqt al-Hadir” by ‘Abdul Allah ibn Muhammad Zuqayl, available at http://= saaid.net/Doat/ Zugail/298.htm (visited November 6, 2004).

[293]= Hummud 1976: 497.

[294]= Ibid., 476-481.

[295]= Ibid., 306, 307.

[296]= For more detail on this contract, see al-Ashqar 1995: 13-48, and ’Ani= yyah 1986: 114.

[297]= See the opinion of Sheikh ‘Abdul ‘Aziz Bin Baz, the late grand mufti and head of the Council of Senior Religious Scholars in Saudi Arabia, cited in al-Ashqar 199= 5: 54-55; Misri 2001: 250-253; Ashqar 1995: 12-48.

[298]= Islamic Fiqh Academy 2000: 86.

[299]= Ibid.

[300]= Ashqar 1995: 30-31.

[301]= See Misri 2001: 50.

[302]= Fayyaa = 1999: 27; Ashqar 1995: 87.

[303]= Manager, Shari‘a= Compliance, HSBC<= !--[if supportFields]> Financial Services (Middle East) Li= mited (Dubai, UAE).

[304]= The Basel Committee= comprises the G-10 countries plus Luxembourg and Switzerland.

[305]= For an official summary of the New Basel Accord, see Basel Committee on Banking Supervision (BCBS) 2004.

[306]= Saidenberg and Schuermann 2003.

[307]= Hayes et al. 2002.

[308]= See Saiden= berg and Schuermann 2003: 8.

[309]= See BCBS XE "Basel Committee on Banki= ng Supervision (BCBS)" 2004.

[310]= See Khan XE "Khan, Tariqullah" <= ![endif]--> and Ahmad 2001.

[311]= Ibid.

[312]= See Saiden= berg and Schuermann 2003: 1.

[313]= Ibid.

[314]= I= n case of a run on the bank it is highly unlikely that the Islamic banks would be in a position to repay dem= and deposits. This effectively transfers the business risk from the investment deposits to demand deposits. Conversely the demand deposits increase the leverage of Islamic banks and as a result their financial risk and overall stability.

[315]= See Saiden= berg and Schuermann 2003: 1.

[316]= Griffith-Jones et al. 2002.

[317]= Ibid.

[318]= Ibid.

[319]= The statistics are old but it is difficult to get hold of the most current statistics. Euromoney is working on a project to develop a detailed databan= k, but its project is still in the making.

[320]= Zions Bancorporation 2003.

[321]= Ibid.

[322]= For a detailed discussion on the issue see Basel Committee= 2003.

[323]= Ibid.

[324]= See Sundararajan and Errico 2002: 4-5.

[325]= Ibid.

[326]= Comment by America’s Community Bankers, November 3, 2003, to FDIC on = the New Basel Accord.

[327]= BCBS 2004.

[328]= The Basel II Capital Accord: Where Do Arab Banks= Stand? (The Report of the Union of Arab Banks, September 2003). On file with the author.

[329]= See Khan XE "Khan, Tariqullah" <= ![endif]--> and Ahmad 2001.

[330]= Ibid.

[331]= This alternative, an offspring of Narrow Banking, is being argued by Mr. Iq= bal Khan, CEO of HSBC<= !--[if supportFields]> Amana, as the future course for Islamic banks.

[332]= Presentation made at the Annual General Assembly Meeting of IFSB held at Nusua Dua, Indonesia, on March 31, 2004.

[333]= This paper is based on field research made possible by the Fulbright Commission and the Social Science Research Council.

[334] Qatar Postdoctoral Fellow, Center for Contemporary Arab Studies, Georgetown University, Washington, D.C.

[335]= See Smith 2004: 168-190.

[336]= The original transnational Islamic banks were the Saudi-owned Al-Baraka and = Faisal Islamic Bank, but other domestically-oriented banks are now expanding. For example, Kuwait Finance House is now established in Turkey and Ba= hrain, has been granted a lic= ense to establish a bank in Malaysia, and has applied for on= e in Lebanon.

[337]= For a discussion of the potential costs of implementing international standards, especially by small firms in the developing world, see the 2001-2 World Development Report (WDR), “Institutions for Markets,” the World Bank, section 1.71-1.75.

[338]= Interview with Paul Kennedy, author of Doing Business with Kuwait = ;(London: Kogan Page Ltd, 1997), December 19= 99. An example of a traditional Islamic transaction used in informal trade in Saudi Arabia is the “10-14,” where a= suq merchant could get an Islamically acceptable loan by paying 14 riyals on a = old bag of rice worth only 10 riyals.

[339]= Wilson 2002. In December 2001 there existed 105 Islamic mutual funds, and o= nly twelve of them were directed at emerging markets.

[340]= The unusual nature of the enterprise is noted by Abdel Karim 1995b.

[341]= Interviews with Farooq A. Ashraf, Banking Supervision and Examination Department, UAE Central Bank, January 2001; Salah K= ohli, assistant manager, Supervision Department, Kuwait Central Bank, November 1999; discus= sion with Abdel Razaq Abdul Khalik Abdulla, internal audit manager, Bahrain Islamic Bank, January 2001, on its = early dealings with the Bahrain Monetary Authority.

[342]= Abdel Karim 1990: 302.

[343]= Ibid., 303.

[344]= This outcome is consistent with collective action theory, which suggests th= at market makers are willing to take on the added costs of organizing. See Ols= en 1965: 29-31.

[345]= Abdel Karim 1995a: 121.

[346]= Related in an interview with Rifaat Ahmed Abdel Karim, secretary general of AAOIFI, Bahrain, December 11, 2000.

[347]= AAOIFI 2004.

[348]= Malaysia’s current debate over accounting stand= ards for Islamic banks was recently discussed on an Islamic investors’ website. See H= afizah 2001.

[349]= The need for the central bank support is duly noted by Abdel Karim 1990: 304-305.

[350]= Khan and Mirakhor 1991; Ul Haque and Mir= akhor 1998.

[351]= Errico and Farahbaksh 1998.

[352]= Quoted in Abdel Karim 1996: 32.

[353]= Ibid., 33.

[354]= The IMF report studying the application of prudential regulations to Islamic banks even suggests increasing the recommended Basel CAR to above 8 percent.

[355]= KFH Annual Report 2001; or see graph in Abdel Karim 1996: 39.

[356]= This argument is laid out in Abdel Karim 1996: 32-44.

[357]= Ibid., 39.

[358]= In some sense Islamic banks are less vulnerable to ratings agen= cies because they are not on the bond market (ratings affect the bond prices for= a bank). Still, the ratings affect their business in letters of credit and tr= ade facilities, and there are general reputational costs as some banks are unwilling to accept dealings with lower rated banks.

[359]= Capital Intelligence rating of Faisal Islamic Bank-Egypt, 1998.

[360]= Interview with David Marston, IMF Division Chief of Banking Supervision and Regulation, May 2002.

[361]= Interview with Andrew Cunningham, Moody’s Ratings Agency, London, September 14, 2002.

[362]= Interview with Andrew Cunningham, September 14, 2002.

[363]= Interview with David Marston, May 2002.

[364]= Interview with Andrew Cunningham, September 14, 2002.

[365]= Interview with Taha Al-Tayeb, director of the Islamic Banking Program, Bahr= ain Institute of Banking and Finance (B= IBF), June 23, 2002.

[366]= Interview with Abdel Rais Abdul Majid, chief executive officer of the International Islamic Financial Market, Manama, Bahrain, June 23, 2002.

[367]= The exception to this has been Malaysia, which issues Islamic government bonds, but the legal basis for this is contested in the more conservative Gulf.

[368]= Interview with Abdel Rais Abdel Majid, June 23, 2002.

[369]= Mentioned in a talk by Pervez Said, director of the Islamic Banking Departm= ent, State Bank of Pakistan, before the Sixth Harva= rd University Forum on Islamic Finance, May 8-9, 2004.

Credit Risk	Operational Risk
1.	Standardized Approach	1.	Basic Indicator Approac= h
2.	Foundation IRB Approach	2.	Standardized Approach
3.	Advanced IRB Approach	3.	Advanced Measurement Ap= proach

Islamic Financial Insti= tutions by Region (% Numbers)	Funds Managed by Islamic Financial Institutions by Regions (%)
Europe & America	9.4%	Europe & America	8.2%
Africa	10.6%	Africa	1.2%
Other M.E.	15.3%	Other M.E.	19.7%
G.C.C	22.4%	G.C.C	64.7%
Asia	42.2%	Asia	8.2%

Islamic Banks and Finan= cial Institutions by Size of Assets	Islamic Banks and Finan= cial Institutions by Size of Capital
Assets (US$ Millions)	Frequency Distribution	Size of Capital (US$ Millions)	Frequency Distribution
0-50	39	0-25	55
51-100	13	26-50	10
101-200	4	51-75	6
201-300	3	76-100	2
301-400	8	101-150	2
401-500	1	151-200	2
501-1000	3	201-300	2
> 1000	7	Total	79
Total	78

Corporate Loans	26% Reduction
Small to Medium-sized Enterprise Loans	39% Reduction
Residential Mortgages	56% Reduction
Credit Card Receivables=	16% Reduction
Other Customer Loans	25% Reduction

	Central Govt	Public Sector	Bank	Non-Bank
OECD	0%	20%	50%	100%
Non-OECD	20%	40%	70%	120%

Director

INTRODUCTION

HISTORY OF ISLAMIC DEBT SECURITIES

SUKUK AL-IJARA

SUKUK AL-ISTITHMAR

PROSPECTS FOR ISLAMIC PROFIT SHARING PRODUCTS

CONCLUSION

Part III

SALE AND SECURITIZATION OF DEBT

INTRODUCTI= ON

THE INFLUENTIAL ROLE OF ISLAMIC FINANCE FATWAS

INDEPENDENCE OF ISLAMIC FINANCE MUFTIS

Islamic Position on Muftis’ Compensation

The Independence of IFI Muftis under Conventional Professional Standards

PROBLEMS ASSOCIATED WITH FATWAS’ FOCUS

ON PERMISSIBILITY

POTENTIAL FATWA ABUSES IN THE PRACTICE OF ISLAMIC FINANCE

CONCLUSION

Part IV

INTRODUCTION=

THE NATURE OF INTERNATI= ONAL INTEGRATION

ISLAMIC INTEGRATION: THE CREATION OF AAOIFI

THE POLITICS OF STANDARD SETTING: THE CASE OF

CAPITAL ADEQUACY REGULATIONS

Ta= ble 5. Basel Capital Adequacy Ratio and Risk Grid

THE PROBLEM OF RATINGS AGENCIES AND<= /span>

THE CREATION OF THE IIRA

MAKING A MARKET: THE INTERNATIONAL ISLAMIC

FINANCIAL MARKET (IIFM<= /span>) AND LIQUIDITY

MANAGEMENT CENTER (LMC<= /span>)

<= /o:p>

Glossary

Research Affiliate= , Center for International Studies, Massachusetts Institute of Technology; Cambridge, Massachusetts