Shifting from Murabaha to Mudarabah Based Finance

NEWHORIZON July-December 2014 IIBI LECTURES

Introduction

Mr Raza, Managing Director of IFAAS, said that the challenge Islamic finance is facing is its significant growth, but, at the same time, Islamic banks are relying on murabaha/commodity murabaha/tawaruq solutions to avoid risks associated with mudarabah, musharakah and to some extent wakala. Murabaha is a very straightforward, Shari’ah-compliant sales contract, however, when it is used in a certain way, in tawaruq, reverse murabaha or commodity murabaha, its compliance with the spirit of Shari’ah becomes rather controversial and questionable. Due, however, to certain limitations the industry has faced over the last 20-30 years, banks have favoured murabaha, which is quite close to conventional banking products offering fixed rate returns.

Islamic finance products need to fulfil the spirit of Shari’ah, as well as meeting client needs, being competitive in the market and profitable. The industry, however, has to move on and so there is a move to develop products based on mudarabah, musharakah and wakala.


The Problems with Traditional Mudarabah

Mudarabah is a partnership agreement, where one party provides the capital (rab ul-Mal) and the other party provides the labour, work or expertise (mudarib). This type of contract is very much preferred from the Shari’ah point of view, because the majority of scholars believe this represents the true spirit of Islamic Shari’ah, however there are issues that make the banks reluctant to use it for three main reasons.

Moral Hazard

There is a high probability of fraud or falsified financial disclosures, because the financial institution is only providing the capital and the client is deploying the funds and has no financial input into the structure. The possibility of the client committing fraud by, for example, having one set of books for the tax authorities, one for the bank and one for themselves, is high. Mr Raza said that such practices have been seen in the Islamic finance industry. He cited an example from his own experience, where a London-based Islamic lender had been persuaded to try out mudarabah. The client, a high-street retailer, presented a balance sheet showing the costs of running the business going up and income falling resulting in a loss, which the bank as rab ul-mal has no choice but to accept.

Agency Problems

When the money is coming from a third party and the client has no financial stake, the client tends to become more aggressive in their risk taking; they do things they would not do if their own money was at stake. They also start to make uninformed decisions.

Adverse Selection

Mudarabah is a profit-sharing instrument, but clients sometimes see it as a loss-sharing instrument. When an organisation is anticipating a profit, they will go to a conventional financial institution and take out a fixed rate loan. When, however, they are anticipating a loss they may go an Islamic lender and try to get a mudarabah agreement, because they know they will then be able to share the losses with the lender. Islamic lenders need, therefore, to be very careful and vigilant about how they select their clients.

A New Mudarabah Solution

In response to these problems IFAAS has developed a new solution. IFAAS has looked critically at the three problems outlined above and ways to control them, while keeping strictly to the requirements of mudarabah.

The solution allows the client to use any amount of funds up to an agreed limit as either working capital or as an overdraft facility; risks are reduced by control functions that have been embedded in this solution and it is efficient reducing transactional costs inherent in certain instruments.

There are, of course, some limitations. The solution is targeted mainly at well-established, medium and large-sized businesses with a proven track record and a good accounting structure in place. This solution is not for individuals raising a personal loan, nor for start-up businesses or small businesses that lack a robust accounting structure.

How the Process Works

The client will approach the bank and following due diligence an agreement will be reached on the borrowing limit and the profit-sharing arrangements. They will also reach agreement on the expected profit rate, because mudarabah by its very nature cannot guarantee a specific return.

The facility is made available to the client and can use the bank’s funds up to the agreed limit, as and when required. The bank will send a monthly statement to the client showing the amount of the facility used during the month and the advance profit. Under the IFAAS solution the client will be asked to pay the agreed expected profit rate for that month in advance of the mudarbaha’s maturity, when the final calculation will be made. If at that time the profit does not reach the expected rate, the bank will have to return any over payments to the client.

The client will also be required to send the headline figures from the quarterly management accounts to the bank and a statement about the achievability of the expected profit based on current business performance. The IFAAS solution contractually obliges the client to send these documents to the bank, which is why it is important for the client to have a robust accounting structure, because without it they will not be able to fulfil this requirement. This proactive approach is designed to ensure that they can be stopped before they go into a loss-making situation.

The Profit Calculation

Profit will be calculated in three stages. In the first instance, say the facility limit granted was £40,000 and the mudarabah profit-sharing ratio is 99% for the bank and 1% for the client, if there is a profit. The bank, however, is expecting a profit rate of 5%. The client’s existing business already has assets deployed in the business and they are generating profits and this capital consisting of the current assets – cash and inventory, not the fixed assets will be taken into account.

What will happen then is, say the client has drawn down £30,000 out of the possible £40,000 and their own capital is £70,000, the total capital of the mudarabah becomes £100,000. Say the gross profit for the period is £10,000, the gross profit will be split according to the capital ratio, so the client will get a £7,000 share of the profit and the mudarabah profit will be £3,000. The mudarabah profit will be shared according to the capital ratio, so £30 for the client and £2,970 for the bank, which is way above the 5% expected profit rate.

If the bank takes that £2,970 from the client, the product is simply not viable. IFAAS have, therefore, created a profit stabilisation reserve. At a profit rate of 5% for a £30,000 loan, the profit going to the bank should be £1,500, so the client pays £1,500 to the bank and the balance of £1,470 will be put into a profit reserve, which is retained by the client to use or not as they see fit, but if the profit rate falls below the expected rate of 5% later during the period of the mudarabah the bank can call on that reserve in its entirety or in part. The client will have the obligation of paying the reserve to the bank if there are any losses and this debt will take priority over any other debts the client may have.

Controls

There are controls around this structure. Firstly, the client’s business must be an established business with a good track record and a robust accounting system including projected accounts. Second, there will be ongoing monitoring through quarterly accounts, which will have to be presented to the bank. Third, there will be a stream of monthly income to the bank. This is unlike most other mudarabah agreements, where a lump sum is payable at the end of the term.

There is also a control designed to reduce any potential loss. Under the contract the client will be unable to sell their goods or services below cost. This is critical, because that is where the majority of the fraud and moral hazard lies. We understand that in some businesses, such as those dealing in perishable goods, there is a need to sell products before they go off. In this case the client, under the contract, must inform the bank that they are going to sell at below cost. The profit calculation is strictly based on gross profit, so that the client cannot manipulate the accounts by artificially inflating expenses. This again is aimed at reducing moral hazard.

In Conclusion

We believe this a Shari’ah-compliant, commercially-viable and practical solution. From a risk management point of view we have made it a contractual obligation not to sell the goods or services below cost price thus minimising fraud and moral issues; the use of gross profit rather than net profit also minimises fraud and the creation of a profit reserve to offset losses or lower than expected profits is a further protection for the lender. These controls can be used not only in mudarabah, but in any sort of transaction, for example musharakah or wakala.

The benefits for the customer are that it is very convenient to have an agreed facility that can be used as and when required. It is very flexible in that it is not tied to financing, say a certain item of equipment; it can be used for anything in the customer’s business. It is very easy; there are no complex procedures to follow. The customer is simply required to submit four or five headline figures from their monthly or quarterly accounts.

The benefits for the bank are that it requires minimal management – perhaps 15 minutes a month to review the accounts submitted by the customer. It also allows Islamic banks to be very competitive with the conventional market, by getting rid of all the onerous transactional costs of murabahah. The risk profile is also much more moderate, because of the profit reserve and also a regular income.

This product has already been implemented in a number of banks. It has received Shari’ah approval from banks in the UAE, Sudan and Oman. It has been implemented not only for large and medium-sized corporate but also for micro finance projects in Palestine on a pilot basis.


finance sector, the IFP DataBank http://www.ifpprogram.com/

The Shari’ah Compliance Audit in Islamic Banking

NEWHORIZON, IIBI LECTURES

Defining Shari’ah

Mr Alamad opened this lecture by defining Shari’ah compliance. Shari’ah is the divine law as revealed in the Qu’ran and Sunnah, the prophetic traditions of Muhammad (pbuh) consisting of his sayings, practices and tacit approvals and disapprovals of the actions of his companions at that time. That leads us to the sources of Shari’ah, which are important, because they are used by Shari’ah scholars and Islamic jurists to extract Shari’ah rulings or address issues in relation to Islamic finance. They will refer, first and foremost to the primary sources, the Qu’ran and the Sunnah and also to secondary sources.


The Qu’ran and Sunnah contain the constant rules that do not change and are unaffected by time or place. For example, the Qu’ran states clearly that usury is prohibited. There are also some flexible Shari’ah rulings that Islamic scholars can use to address new issues. Sunnah as a primary source of Shari’ah addresses some of the issues raised in the Qu’ran and expands on them to some extent. It provides the tools to address new issues raised by Islamic finance.

The secondary sources of Shari’ah are contained in Ijma, which is the consensus of qualified scholars. There are some Islamic bodies, which to some extent represent the concept of Ijma such as AAOIFI and the Islamic Fiqh Academy. Both of these bodies comprise Islamic scholars representing the Muslim world. They meet on a regular basis to discuss new issues that they need to research and make Shari’ah rulings about them. As a result of their activities around 50 standards have been issued by AAOIFI regarding Islamic financial institutions. Those standards, however, do not address every issue that Islamic banks may face. For example, Islamic banks operating in the UK may face issues different from those faced by their counterparts in the GCC or Malaysia. It is then the role of the bank’s Shari’ah supervisory committee to address those issues based on the constant Shari’ah rules set out in the Qu’ran and Sunnah.

Another instrument is analogical reasoning or qiyas. It is based on taking an existing issue in the Qu’ran and Sunnah, analysing the rationale of this issue and comparing it to the new issue. If the new issue has the same rationale as the existing issue, it will have the same ruling. Take for example the drinking of alcohol. It is clearly forbidden in the Qu’ran. Scholars at the time explored the rationale for forbidding alcohol and concluded that intoxication led to people being unaware of their surroundings, becoming aggressive, etc; drinking alcohol has negative consequences. The Qu’ran, however, recognised that there are some benefits. People trade in it and make profits, but the harm coming from drinking outweigh these benefits and that is why Muslims were forbidden to drink alcohol.

Today there are different kinds of drugs such as heroin and cocaine, but there is no specific ruling in the Qu’ran or Sunnah regarding these drugs. When the rationale was examined, however, it was very similar to alcohol, so scholars applied the ruling relating to alcohol to drugs.

Qiyas could be used in Islamic finance to deduce a Shari’ah ruling say for new products. Islamic banks, for example, have to manage risks. Conventional banks use interest rate swap agreements to manage risk, but on the basis of qiyas Islamic banks cannot use these because of the ban on riba.

There is also ijtihad or personal interpretation. That is basically the ijtihad of a bank’s Shari’ah supervisory committee relating to a particular issue. The committee will issue a fatwa for the bank to follow.

There are some other secondary sources which say that if there are benefits to be derived from a products or service, a social good and there is nothing in Shari’ah specifically forbidding it, then that will be permitted.

Two Types of Shari’ah

Islamic jurists define Shari’ah into two types. The first is called fiqh or jurisprudence and defines the relationship between man and God. The other type relates to transactions, buying and selling and that is the one that relates to Islamic finance.

The difference between the two is that Shari’ah is the law and jurisprudence or fiqh is the understanding of this law. To take a simple example, the NHS bill currently negotiating its way through the UK Parliament will eventually become a law, but that law will not address every single detail of the day-to-day operation of the NHS. When it passes into the hands of NHS Trusts for implementation, they will interpret how this law will affect each Trust and its practices. Shari’ah operates in a very similar way.

Shari’ah Governance in Islamic Banks


The Shari’ah supervisory committee will usually consist of at least three scholars, who are experienced in the field of Islamic financial transactions and in Shari’ah. This is an independent committee; it does not report to the board, the management committee, the executive or anyone else in the business.

There is also a Shari’ah compliance department and that too does not report to anybody in the business. Their direct report is to the Shari’ah supervisory committee. The Shari’ah compliance department monitors the day-to-day operations of the Islamic bank, advising senior management and the different operational departments on Shari’ah and any issues. Part of their role is to conduct a Shari’ah compliance audit. Effectively this means that Islamic banks have an extra layer of compliance compared to conventional banks.

The Concept of Shari’ah Compliance

The concept of Shari’ah compliance is nothing new in Islam; it dates back to the time of the Prophet (pbuh) more than 1,4000 years ago. It is known as al-hisbah and it is in the Qu’ran in Surah al Nisa, verse 82. At the time of the Prophet Muhammad (pbuh), he was the point of reference and he conducted the supervision of markets himself. For example, he was once in a market and saw a man selling wheat. He put his hand in the sack of wheat and found that it was wet. He asked the seller what was wrong with his wheat. The man said it was wet because of the rain. Obviously wet wheat weighs heavier then dry wheat, so it was a way of cheating. The Prophet (pbuh) said, ‘Whoever cheats is not of us’. This is one of the constant rules of Shari’ah and it is very important in Islamic finance, because, if Islamic banks try to mislead their customers or give them a product that is not suitable for them, it is a form of cheating. Auditors need to be aware of such things in any product offered by Islamic banks.

The task of market supervision continued after the time of the Prophet (pbuh). In the first instance it was his companions, the caliphs, who used the same methods to supervise markets. There is one famous story about a mother and daughter who used to sell milk. One of the caliphs, Umar overheard the mother telling the daughter to add water to the milk. The daughter replied that they should not do that. The mother responded that Caliph Umar was not there, but the daughter said, ‘but God is seeing us’.

It is not just about supervision; it is the conscience of people working within the Islamic finance industry that is important. Supervision can achieve the objective to a certain extent, but if people in Islamic finance are not trained to the right level and made aware of the extent of compliance with Shari’ah and ethical values, they will not have a conscience. This is the problem with the banking system. If we have a banking system with the right ethical values, we would not be where we are now with all the banking scandals and crises.

Part of the Shari’ah-compliance framework is that people joining an Islamic bank must have Shari’ah-compliance training, so that they are aware of the values and ethics to be observed. It is a bank’s duty to train them, because you cannot hold them responsible if you do not train them. After that time the concept of hisbah or market supervision started to be more constitutionalised. The state became responsible for supervision. The supervisor would be chosen by the state on the basis of certain qualifications, which were similar to the qualifications of Shari’ah scholars or jurists, who need to understand Shari’ah and assess what is right or wrong in the market.

When Islamic banks began to emerge 40 years ago, there were no established rules about how Islamic finance should operate and so they needed supervision in the form of a Shari’ah supervisory committee and an internal Shari’ah compliance department to work with the bank’s management and staff on a daily basis, guiding them and ensuring there is a Shari’ah risk framework in place. The biggest risk for Islamic banks is Shari’ah non-compliance.

The concept of Shari’ah supervision is based on the Shari’ah ruling of commanding the good and forbidding the bad, but that can only be done by qualified people. That is why Islamic banks have to have this sort of governance framework.

Shari’ah Compliance Audits

The term Shari’ah compliance audit is a new term and it is derived from the concept of hisbah. The Shari’ah audit process is similar to the normal internal audit process, although they are two different functions with the Shari’ah audit covering issues not covered by the normal audit.

The Shari’ah audit process starts with a plan. The audit is then carried out and the findings and recommendations are discussed with a view to strengthening Shari’ah compliance. The findings are then discussed with the Shari’ah supervisory committee and finally there are follow-up discussions with management and the different departments in the bank. This is a continuous cycle.

The findings will be classified as good, satisfactory, room for improvement or unsatisfactory. To be classified as good the bank needs to demonstrate a proactive approach that identifies issues before they become problems.

Shari’ah Compliance Audit Methods

The first method is financial concentration of undertaken financial transactions. Let us say the bank concentrate on commercial property finance, particularly big deals. This is an area where there might be short cuts or errors on which the auditor can focus. The second method is typical and untypical transactions. A current account is fairly automated and so manual involvement is minimal. This process would be initially signed off and approved for Shari’ah compliance. It will be audited, but the auditor will focus on untypical transactions, e.g. products that are tailored for particular customers, because they are more prone to breaches and errors.

The third method is core and outsource business methods. If a bank, as many financial institutions do, outsource to a third party, the likelihood of breaches is greater than in internal processes, so there is a good reason to focus on this type of transaction.

The Scope of the Shari’ah Compliance Audit

The main scope of the Shari’ah audit is to review all contracts and agreements within the scope of the Shari’ah compliance audit, all regular reporting, internal communication between the department being audited and other business areas, investments and the associated documentation being managed by the department being audited, reports from internal and external auditors, invoices and purchase orders, foreign exchange transactions, investment certificate transactions, review of all shares being purchased, profit calculation and distributions for investment clients and shareholders (this is a particular issue as core banking systems work around the concept of interest payments and the basis of calculation in Islamic banks is obviously very different), disposal of non-Shari’ah-compliant income, review of expenses and fees charged, ensuring new and amended products are signed off and a review of all procedures and policies.

Main Challenges

Regulations in the UK are issued for banks in general. It may, however, be difficult for Islamic banks to comply with some of those regulations. Mr Alamad said that banks had been able to raise some of these issues with the regulator and develop a solution that has then been incorporated into the regulations. There are also legal challenges.

Market constraints are another factor that affects Islamic banks. For example, conventional banks can charge redemption fees of 2-3% on a mortgage; Islamic banks cannot do this, because the structure that they use for home finance is different. At many conferences attendees will hear speakers say that Islamic banks should incorporate Shari’ah objectives, Maqasid, in their products, but they do not tell you how to do this. For example, one Shari’ah objective is protecting the religion of Islam. By offering Shari’ah-compliant alternatives to conventional banking products, Islamic banks are effectively meeting this objective.

Another key challenge is developing the next generation of experts. If we do not have the right experts, Islamic banking will not grow in the right way or at the right pace.

Liquidity is also a big issue for Islamic banks. This is one that is being addressed with the regulator.

Finally, Shari’ah-compliance needs to find a middle way between being too lax and overly inflexible. Scholars and other experts need to understand both Shari’ah and the way the financial system works to understand how best to implement Shari’ah in the world of finance.

Takaful Investment Portfolios: A Study of the Composition of Takaful Funds in the GCC and Malaysia (A Book Review )

Abdulrahman Khalil Tolefat and Mehmet Asutay. Publisher: John Wiley & Sons (2013)
ISBN-10: 1118385470 ISBN-13: 978-1118385470
Reviewed by: Camille Paldi, CEO, FAAIF Limited and Events DMCC
Managing Director, ilovetheuae.com

By: Camille Paldi.

Takaful Investment Portfolios: A Study of the Composition of Takaful Funds in the GCC and Malaysia provides an explanation and analysis of the investment of takaful funds in the GCC and Malaysia between 2002 and 2005 and explores the rationale behind such decisions. In addition, the authors discuss and analyse takaful investment trends and developments.

This book contains some useful information and statistics regarding three classes of takaful fund investments in the GCC and Malaysia including equities, sukuk and real estate over a period of several years in the early twenty first century. I had to sift through a thick maze of academic prose and pages of jargon, however, in order to get to the useful information contained in the book. Although this information is slightly outdated for industry use, it provides an insight into past trends.


The study may also reveal gaps in the asset classes for the takaful industry. After conducting a thorough analysis of the investments of takaful funds of the GCC and Malaysia from 2002-2005, the author concludes that convergence is likely in the investment behaviours of takaful companies in the GCC and Malaysia once the primary and secondary markets for sukuk develop in the GCC and an international regulatory framework is practiced. This book may be highly useful and relevant for students and academics and those practitioners wishing to get a glimpse of past industry trends.

Chapter 1: Introduction provides an overview explaining the rationale for the research aims and objectives, scope and delimitation and research methodology.

I enjoyed the academic and scholarly discussion of the takaful concept in Chapter Two: Insurance and Islamic Law: An Introduction to Takaful. There are some interesting references to the Qu’ran and Sunnah as well as to scholars of the past. I prefer, however, to see more of the author’s original opinions rather than heavy reliance on other authors. Furthermore, I want to see an explanation of the cited statement as the author is relying on another author to relay his point. For example, in Chapter Two, the author writes: ‘Moreover, it is also claimed that commercial insurance leads to negligence (Moghaizel, 1991), murder (Al-Sayed, 1986; Hassan, 1979) and is exploitative of people’s needs (Mawlawi, 1996) and that the control of government may fall to powerful insurance companies (Abdu, 1987).’ I would like to see some kind of original and authentic explanation of this statement from the viewpoint of the author. For instance, how does commercial insurance lead to negligence, murder and exploitation? Furthermore, why and how would control of government fall into the hands of powerful insurance companies and what then would these insurance companies do with the government under their control? In addition, it is always an interesting scenario to witness secular-trained academics incorporating religion into their work. The religious references are presented in quite a secular and neutral manner, which makes the book quite easy to understand and digest by anyone whether they are religious or not.

Chapter Three contains a comprehensive academic explanation of the various takaful models. In addition the author explains the differences between takaful, commercial and mutual insurance and trends and developments in the takaful industry. The entirety of Chapter Four discusses research methodology, which is geared for academics rather than industry practitioners.

Chapter Five on Exploring Investment Behaviours and Investment Portfolios of Takaful Operating Companies in the GCC and Malaysia is where I finally found the hidden treasure. The chapter is full of interesting facts and figures, analysis and comparisons regarding the investment of takaful funds in equities, sukuk, and real estate in the years 2002 – 2005. This information, however, may or may not be indicative of present and/or future trends as we are now in 2015, ten years past the period of this study. It is, however, interesting information and may be useful to academics. This book may also provide a rough idea on how to perform a feasibility study at the inception of a takaful company in a particular jurisdiction or geography or serve as a guide in conducting another similar academic study.

Although Chapter Six: Locating the Differences Between Actual and Desired Investment Portfolios contains some interesting discussion about the actual and desired investment portfolios of the GCC and Malaysia, I found that much of this chapter could be skim read and probably should have been deleted from the book.

In Chapter Seven: Contextualising the Findings, the only pertinent information includes the discussion on how takaful funds manage their liquidity and the figures for return on investment for the GCC and Malaysian Takaful Funds for the period 2002-2005.

Chapter Eight: Conclusions and Recommendations provides recommendations for regulatory authorities, takaful operating companies and Islamic banks/windows. I found these quite interesting and highly useful especially in regard to who should be making the investment decisions and the need for more legislation and regulation of the takaful industry in the UAE and globally. The author also explains the research limitations in this study. The author states that focusing the research only on the initial period of the takaful industry during the years 2002-2005 could perhaps be considered a shortcoming. Furthermore, the author explains that another limitation may lie in the sample size that was chosen. The author says that the sample is so small – less than 30 companies – that parametric statistical tests could not be used in this study. Second, even using nonparametric statistical tests, the small number of takaful companies operating in Malaysia limited the author to performing a comparison between the GCC and Malaysia. This can be seen where the author tried to study the differences between levels of actual and desired investment portfolios between the GCC and Malaysia. The author was not able to adopt the Wilcoxon Signed-Rank Test for Malaysian companies.

GUIDELINES FOR INVESTMENT MANAGEMENT FOR TAKAFUL OPERATORS

(The following is based on a paper produced by the Islamic Banking and Takaful Department at Bank Negara Malaysia)

The approach for investment management adopted by each takaful operator may vary depending on a wide range of factors, including the size, level of sophistication and complexity of the takaful operator’s investment activities. Basic principles such as accountability and responsibility of the board of directors and senior management are needed for robust risk management policy and adequate monitoring and controls by all takaful operators.

• Takaful operators should ensure that the objectives, management and activities of investments comply with Shari’ah principles at all times.
• Takaful operators should have in place investment and risk management policies describing the overall investment framework. The overall investment policies and strategies should be communicated to all staff involved in investment activities.
• In developing the investment strategy of the takaful fund, takaful operators should take into account the reasonable expectations of participants and that the investment strategy is consistent with the disclosure made under the respective products.
• Due to the different nature of the liabilities, takaful operators should have separate investment strategies for family and general takaful business in situations where both businesses are undertaken by the same entity. For family takaful business, takaful operators will also need to consider separate investment strategies for participants’ investment funds and participants’ risk funds due to potential differences in objectives of both funds. The investment strategy for participants’ risk funds would need to take into account the ability of the fund to meet takaful liabilities. The investment strategy for the participants’ investment fund would need to take into account the ability of the fund to meet future tabarru’ deductions and reasonable expectations of an investment return as well as consider whether certain products need to have a specific investment strategy which is commensurate with the risk and liability profile of such products.
• Takaful operators should have a comprehensive risk management framework that include, amongst others, the setting of investment strategies and policies, developing an oversight mechanism with appropriate review and monitoring and control procedures. The risk management framework must also cover the risks associated with investment activities that may affect the coverage of takaful liabilities and capital positions. The main risks include market, credit and liquidity risks.
• Takaful operators should have in place clear governance procedures over investment decision-making processes and ensure a proper segregation of duties to ensure sufficient checks and balances are in place within the organisation.
• As a part of good risk management and for proper monitoring and control of the investments, takaful operators should establish adequate internal controls to ensure that assets are managed in accordance with the takaful operator’s approved investment policies and in compliance with legal, accounting and relevant risk management requirements. These controls should ensure that investment procedures are subject to effective oversight – a function that is responsible for ensuring the effectiveness of the investment policies and procedures of the takaful operator as well as ensuring the implementation of investment policies is in line with approval from the board of directors. Takaful operators would need to ensure that the personnel in this oversight function are suitably qualified to perform such responsibilities.
• Takaful operators must establish contingency plans to mitigate the effects arising from deteriorating market conditions and procedures to monitor and control a takaful fund’s exposure to fluctuations in profit rates, foreign exchange rates and market prices. • The roles of the Shari’ah Committee of takaful operators should be clearly set out to ensure the effectiveness of the Shari’ah governance framework including appropriate procedures to ensure that investment portfolios are Shari’ah-compliant and screening processes to identify returns from tainted/non-halal income and the disposal of such income.
• The board of directors of the takaful operator has the ultimate accountability for the investment of takaful funds.

The Use and Abuse of Limited Liabilities (Summary of Workshop).

NEWHORIZON

By: S Nazim Ali, Professor and Director, Centre for Islamic Economics and Finance, Qatar Faculty of Islamic Studies, Hamad Bin Khalifa University, Qatar Foundation, Doha, Qatar.


The 7th London School of Economics (LSE) Islamic Finance workshop was organised (2013) against the backdrop of the global financial crisis that had impacted all and sundry. The workshop had focussed on ‘Insolvency and Debt Restructuring in Islamic Finance’. At the conclusion of the workshop many of the participants shared their feeling that the issue of debt and restructuring is closely linked to the concept of limited liability for corporate, hence the majority of the participants decided to vote in favour of ‘Use and Abuse of Limited Liability’ for the 8th LSE Workshop.

The topic of the workshop, ‘Use and Abuse of Limited Liability’ was examined from the following angles:

• Juridical person and limited liability: separate concepts or interdependent. What is the extent of justification for them under Islamic law?
• Similarities, differences and implications of a ‘juridical person’ in Shari’ah. Does the concept violate Islamic principle of al-kharaj bi al-daman?
• Can examples of ‘juridical person’ be emulated in and extended to other areas?
• Islamic view on one juridical person creating another juridical person.
• Benefits and costs of a Limited Liability Company to investors, shareholders, managers and the society at large.
• Various possible models under Islamic Laws.

Objectives

The main purpose of the workshop was to envisage various models or structures of organising business that retain the beneficial aspects of limited liability while avoiding the misuse of the concept. Accordingly the objectives set for the workshop were as follows:

1. Revisiting the debate on the Shari’ah viewpoint of juridical person and limited liability;
2. Understanding advantages and benefits of limited liability to economy and business (public) in general and to promoters, shareholders, and employees in particular;
3. Discussing disadvantages and misuses: causes and extent;
4. Exploring remedies and options.

Professor Frank Vogel, the moderator of the workshop, re-emphasised the importance of gathering five key stakeholder groups at the workshop, namely: Shari’ah scholars, economists, practitioners, lawyers and industry organisations. He said that every time we pick a worthwhile and substantive issue the real purpose is to use the issue to debate how the industry itself makes decisions – how it weighs considerations that are ethical, religious, legal, economic, financial, professional, political, reputational, and purely pragmatic to come to a conclusion on a specific issue.

Professor Vogel divided the agenda of the day-long workshop into three parts.

1. The Shari’ah issues and positions on juridical person and limited liability;
2. The economic issues and consequences of the use (maslaha) and abuse (mafsada) of the limited liability concept and how to manage the costs and benefits;
3. Shari’ah compliant optimal organisational forms in the context of the benefits and misuses of limited liability.

Limited Liability and Legal Personality: Benefits, Costs and Concerns

The workshop began by listing several benefits of limited liability such as ability to bring together large groups of investors as one body, providing continuity for the enterprise regardless of the changing circumstances of shareholders and shielding the shareholders from unanticipated liabilities arising from the running of the business. It also provides investors an opportunity to diversify their investments across various projects rather than just in projects that they can manage themselves. Limited liability also enables small savers to invest in businesses that otherwise may be confined to wealthier investors.

These benefits, however, come with certain disadvantages. For example; it allows business managers to sometimes indulge in excessive risk taking by borrowing huge amounts of money to increase profits and hide behind the corporate veil if the venture fails, which results in the privatisation of gains and socialisation of losses. Many of the ills in today’s financial system, such as short-termism in the financial markets, excessive indebtedness and speculative risk-taking can be attributed to the concept of limited liability as those responsible are able to protect their personal wealth regardless of what happens to the venture for which they are responsible.

The presenter also posed certain questions to the participants. For example:

• When can the corporate veil be pierced? And should it be automatic or should it be looked at on a case-by-case basis?
• What are the implications for bankruptcy and defaults within limited liability? Should we go for a regulated limited liability regime or should it be limited liability as a rule?
• Whether limited liability and legal person can be separated in Shari’ah or it has to be combined for a Shari’ah ruling.
• How to deal with different shades of limited liability company (LLC)? In different countries and at different times the limited liability concept can be applied differently.
• Can an LLC by itself create other LLCs and what are the parameters for it? Where to put a stop to this process and on what basis?
• What are the different shades of legal personality?

Scope of Limited Liability and Legal Personality in Shari’ah

The participants agreed that interpretations of Shari’ah have allowed the concept of juridical person and limited liability and their use is widespread in Islamic finance and in Muslim countries in general. More importantly the concept has been accepted across the world including by the Islamic standards setting bodies such as AAOIFI and Majma Fiqh al-Islami, etc.

One participant highlighted the concept of separation between ownership and management. Referring to the mudaraba contract it was pointed out that any liability incurred by the mudarib without the express permission of the rabbal maal is the responsibility of the mudarib. Therefore, to shift the responsibility onto the rabbal maal (beyond his capital), it has to be proved that all the actions of the mudarib were conducted keeping the maslahah of the rabbal maal. For example, if an Islamic bank fails, its creditors cannot have any recourse to the mudaraba fund (or investments accounts) managed by the Islamic bank as the fund does not belong to the bank. The debate on this issue concluded that overall there are many more benefits in limited liability that serve maqasid al Shari’ah than causes for disquiet. A hadith related to Saeed ibn Mohal was also quoted in this context where the Prophet Muhammad allowed his creditors to take recourse to the garden that he had and beyond which they had no claim. Taking a cue from this ruling it was argued that creditors have no claim over the future earnings of the bankrupt, let alone having any claim in the Hereafter.

A participant then questioned what stopped classical fuqaha from not starting a joint partnership with limited liability? This was clarified: since the concept of juridical personality was not established at that time, any business was actually a personal company owned by its partners, who were liable for the responsibilities through their personal wealth. After the concept of juridical personality was introduced and developed, however, it was adopted under Shari’ah.

A participant noted that taking a historical perspective, the idea of a limited liability corporate as a separate legal entity was developed in the time of European expansion to fund the exploration and exploitation of global resources. It provided a successful corporate structure for that purpose and has since been adapted to suit contemporary commerce. The emergence and development of the limited liability corporate structure proceeded without any serious engagement by Muslim jurists and scholars. The association of the limited liability corporate with colonial forerunners such as the East India Company led to the development of many negative connotations about this emerging structure to facilitate commerce. This is very similar to negative sentiments about capitalism due to its close association in Muslim minds with colonialism. There is, therefore, a need to separate these negative sentiments from the arguments based on the usefulness or otherwise of the underlying substance of the limited liability corporate.

It was also suggested that profit sharing is the opposite of lending money at interest or the prohibited riba. Profit sharing requires business partnerships and it is these business partnerships, which early on did not have limited liability, that have evolved into limited liability companies.

Managing Abuses in Limited Liability

The discussion then veered toward managing abuses. The moderator posed the question: what is required from an Islamic point of view to rectify abuses and whether it is sufficient to just rely on western legal systems, which focus more on managers and majority shareholders when it comes to managing abuses?

A participant pointed out that the real question in this regard is who controls decisions and who is responsible for abuses. In a small private company shareholders make decisions and should be liable. In a large company, however, it is managers and not shareholders who run the business. The moderator then asked, if you are in a position to control the actions of your company, does Shari’ah say you should also face the consequences even beyond limited liability? Two of the Shari’ah scholars answered that if the shareholders are represented by a board of directors then the directors shall be responsible for any act of omission or commission as per the corporate governance code, which covers potential misuse of limited liability. If, however, the board of directors has been acting according to the articles of association and terms and conditions of their appointment then the responsibility for their actions will fall on the shareholders.

It was also highlighted that economic development requires risk-taking. If there is too onerous a burden imposed on those running limited liability corporations, putting their personal wealth and by implication the well-being of their families at risk, it may dissuade risk-taking to the detriment of economic development.


Piercing the Corporate Veil: When and How

This session began with issues related to piercing the corporate veil and under what conditions it may be pierced in the United Kingdom. It was suggested that the only possibility of piercing the veil is in a situation where the corporate form is used to avoid an existing liability. As far as future obligations are concerned it is acceptable to use the form to limit your liability, even in cases which appear unacceptable. For example, a pharmaceutical company that has a product that they think will hurt people, yet they develop it in a subsidiary, the corporate veil will not be pierced. When asked about the possibility of managers/directors being held responsible for their actions, it was clarified that, save in the situation where the company is already in insolvency, the directors have an obligation to use the powers they have to promote shareholder value. As long as the company is a going concern, those directors are not burdened with the interests of creditors. The moderator then asked the scholars if they would be satisfied with the corporate governance rules as practiced in the United Kingdom. One Shari’ah scholar suggested that rules for piercing the veil should be made clear and objective rather than left to the sole interpretation of judges. Another participant noted that limited liability companies did not grow organically in Islamic culture. The SPV (special purpose vehicle) model is also imported from the West. Instead of trying to find Islamically unique solutions to those problems, therefore, we should accept the solutions that are applicable in those countries. Another participant refuted this assertion on the ground that Shari’ah allows borrowing outside the realm of rituals. He argued, ‘You can use a tool you have not developed, but it must conform to the rules of Shari’ah. It is important to develop necessary sensors to detect specific pitfalls and dangers to be able to protect yourself”.

The Role of SPV’s and Limited Liability in Sukuk

Many participants raised the question of the growing use of SPVs in issuing sukuk (Islamic debt securities). Some of them were very critical of the miniscule capital base of these SPVs and called for restrictive use of these structures. One participant suggested AAOIFI should come up with a Shari’ah standard on SPVs. Another participant noted that the demand for restrictive use of SPVs is not because of its limited liability feature nor are SPVs invented on the advice of Shari’ah scholars, but lawyers need them for various reasons including tax benefits and bankruptcy remoteness. He cautioned that the concern should actually be how these SPVs are used as a tool and whether they are used for private gains or for the benefit of society at large. If these vehicles are used to defraud people then they should be dealt with accordingly.

Another participant pointed out that the issue of transfer of ownership of assets into SPVs is not clear and therefore the ultimate responsibility still lies with the corporate (originator). It was also noted that many sukuk holders instead of claiming assets go for recourse to the originator.

A practitioner who has been part of many landmark sukuk stressed that the SPVs are created for nothing but logistic purposes. Since there are thousands of sukuk holders, a vehicle is needed to represent them. Since at the time of issuance the investors are not there, the documents are signed saying it is on behalf of beneficiaries who will come later. The SPV is needed to buy the assets on behalf of future investors and then to lease the same on behalf of the sukuk. The trust structure facilitates the transferability and allows the documents to be signed in advance of issuance itself. SPVs own the assets on behalf of the investors. From an accounting perspective also legal ownership rests with the lessee.

The SPV structure also plays an important role in acquiring high-risk assets, where the financiers want to ring fence the liability by creating an orphan SPV, where the shares are held in trust for some charity. A charity is brought into the picture because it cannot be sued. In case of something going wrong the banks have a first priority charge over the asset and if a third party claim is enforced, you say the ultimate owner is a charity which cannot be sued. It was argued that in the absence of limited liability, nobody would finance aircraft. The SPV, therefore, is a standalone entity without any ulterior motive or purpose.

Summary and Conclusion

The last session of the workshop was devoted to summarising the day-long discussions and drawing some conclusions from it.

The moderator invited responses to the idea of imposing liability on the shareholders and managers for the misuse of limited liability. He also suggested the institution of non-legally-binding but ethical standards or industry standards under the corporate governance rules. He wanted to know if the discussion could be enlarged to include trusts and mutuals as they too are reported to have been used inappropriately. He asked participants to highlight whether there is any Shari’ah-specific suggestion and criteria or it is acceptable to work with the existing system. He further asked participants their views on whether transparency in disclosure is a sufficient requirement to justify limited liability or whether the existence of a separate legal person underlying the concept of dhimmah is also required as a basis and what is the logic behind the Shari’ah acceptance of these notions. What is the possibility under Islamic law of imposing additional obligations of disclosure? Who will enforce them and in what context will they be enforceable?

Participants reacted to these queries in different manners. One noted that any new structure that is developed is for a purpose, but over a period it starts getting misused. The message is to remain vigilant, therefore, as the issue is more of a regulatory than statutory nature. Some others tried to cite real life examples. For instance, Malaysians have a statutory provision for piercing the veil in case of tax evasion. One participant highlighted the role of credit bureaus in providing disclosures and making available the necessary information about the creditworthiness of the borrower. On the other hand some contended that a credit history is not available for all transactions and more importantly it is not accessible to all. One participant highlighting the Shari’ah aspect referred to a hadith describing delayed payment as an injustice punishable by exposing the delinquent.

A suggestion was made to put some sort of restrictions on limited liability. One participant tried to highlight the difference between natural factors leading to failure and fraudulent behavior. Another suggested providing incentives to those who are cautious in incurring obligations or taking too much risk. To control the misdemeanor, especially in the context of overleveraged banks it was suggested that a look should be taken at the German mutual and cooperative bank model, where shareholders could be made liable beyond their share capital. The moderator highlighted Saudi corporate practices where shareholders are required to provide guarantees if their company’s capital drops to one quarter of its total obligation. One participant drew attention to the new Malaysian Companies Act imposing higher duties on managers and increasing shareholders’ responsibility.

One participant argued that the business known as the John Lewis Partnership in the United Kingdom could be a model for Islamic enterprises. John Lewis is owned on trust for the benefit of its members. Every employee of John Lewis becomes a member on the day they join. The trustee of the settlements is the John Lewis Partnership Trust Limited. Its chairman is the partnership chairman and its other directors are the deputy chairmen. The Partnership is governed according to a written constitution, which is subordinate to and must not conflict with the settlements. Power in the partnership is shared between three governing authorities: the Partnership Council, the Partnership Board and the Chairman. Profits are used to sustain commercial vitality and distribute to the members. Each year every employee receives a percentage of their salary as a bonus. The company also provides benefits such as holiday houses that the partnership maintains. Employees who have worked at the company for 10 years or more also continue to receive benefits after they retire such as 20% off John Lewis products. The John Lewis partnership with its happy customers, employees and management may be what we would want Shari’ah businesses to consider as a model.

Looking from another perspective it was observed by participants that the current financial system has a deep influence on the capital structure used by companies. Since debt is made cheaper than equity, it is unlikely that reliance on debt will change unless equity and debt are brought to a level playing field. The systematic preference of debt over equity runs like an underlying theme behind abuse of limited liability.