Shariah Compliant Funds Rising and Shariah Compliant Securitization April 24, 2012 Alhuda-CIBE Trainings Avari Towers, Karachi Shariah Compliant Funds Rising and Shariah Compliant Securitization April 24, 2012 Alhuda-CIBE Trainings Avari Towers, Karachi Abdul Samad Shariah Advisor The Bank of Khyber

Rulings In Islam These 5 primary objectives follow by Shariah can be observed though the Al Ahkam (rulings) upon which Fiqh (Islamic Jurisprudence) rotate around. The rulings are categorized as follows: These 5 primary objectives follow by Shariah can be observed though the Al Ahkam (rulings) upon which Fiqh (Islamic Jurisprudence) rotate around. The rulings are categorized as follows: a. Wajib (obligatory) a. Wajib (obligatory) e. Haram (unlawful) e. Haram (unlawful) b. Mustahab (recommended) (Sunnat) b. Mustahab (recommended) (Sunnat) c. Mubah (permissible) c. Mubah (permissible) d. Makruh (disliked) d. Makruh (disliked)

Islam and Shariah Islam Aqidah (Faith & Belief) Shariah (Practices & Activities) IBADAT (Man to God Worship) Muamalat (Man to Man Activities) Political Activities Economic Activities Banking & Financial Activities Social Activities Akhlaq (Morality & Ethics)

Most Important Islamic Teaching Related To Business 1. Elimination of Interest (Raba) 2. The prohibition of uncertainty (Gharar) 3. The prohibition of Gambling (Qimar) 4. The precipitation of games of chance (Maser) 5. Honesty and Fair Trade (Ghishsh and Khilabah) 6. Spending in the Good Cause 7. Buy Back 8. Two Mutually Conditional Contract 9. Entitlement to profit depends on liability for risk

Human Financial Needs Fulfillment of Financial Needs Own CapitalOthers’ Capital Equity Financing Debt Financing

Shirkah

Scope of the Presentation Terminology of Musharaka Terminology of Musharaka Types of Musharaka Types of Musharaka Structure of Musharaka Structure of Musharaka Rules of Musharaka Rules of Musharaka Capital; Capital; Profit and loss; Profit and loss; Termination Termination Security / Collateral in Musharaka Security / Collateral in Musharaka Concept of limited liability Concept of limited liability Modern partnerships Modern partnerships Banking application Banking application Case in point Case in point

MEANING OF SHAIRKAT The literal meaning of Musharakah is sharing. The root of the word "Musharakah" in Arabic is Shirkah, which means being a partner. The literal meaning of Musharakah is sharing. The root of the word "Musharakah" in Arabic is Shirkah, which means being a partner. Under Islamic jurisprudence, Musharakah means a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution. Under Islamic jurisprudence, Musharakah means a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution.

LEGITIMACY OF SHIRKAT Allah- Subhana- o-Ta’ala has declared that He becomes a party in a business between two Musharakain until one indulges in cheating or breach of trust (Khayanah) with other in Musharakah.” (Sunan-i-Abi Daud, Kitabul Buyuo) Allah- Subhana- o-Ta’ala has declared that He becomes a party in a business between two Musharakain until one indulges in cheating or breach of trust (Khayanah) with other in Musharakah.” (Sunan-i-Abi Daud, Kitabul Buyuo)

Types of Shirkah Shirkah Shirkat-ul-Milk (Co- ownership) Shirkat-ul-Aaqd (Contractual Partnership)

Shirkat-ul-Milk (Joint ownership) Joint ownership of two or more persons in a particular property/ asset with out any business intention. This comes into being as a result of joint purchase, joint acceptance of gift or a bequest and inheritance of joint property etc.

Types of Shirkat-ul-Milk Shirkat-ul-Milk Optional (Ikhtiari) Shirkat-ul-Milk Optional (Ikhtiari) This comes into operation through the act of parties e.g., purchase of asset with mutual consent. Shirkat-ul-Milk Compulsory (Ghair Ikhtiari) Shirkat-ul-Milk Compulsory (Ghair Ikhtiari) This comes into operation without any action on the part of parties e.g., ownership of heirs on the inherited property.

Shirkat-ul-Aqd Shirkat-ul-Aqd (Joint venture/partnership). Shirkat-ul-Aqd or Contract Partnership is an Agreement between two or more parties to combine their assets or to merge their services or obligations and liabilities with the aim of making profit. Shirkat-ul-Aqd or Contract Partnership is an Agreement between two or more parties to combine their assets or to merge their services or obligations and liabilities with the aim of making profit. It can also be referred to as a joint commercial enterprise or activity It can also be referred to as a joint commercial enterprise or activity

Difference between Shirkat-ul-Aqd and Shirkat-ul-Milk In Shirkat ul Aqd both parties create partnership for sharing profit earned by Shirkah asset, while in Shirkat ul milk both partners do not intend to earn profit from Shirkah asset. In Shirkat ul Aqd, each partner is an agent of others while in Shirkat ul Milk each partner is stranger with respect to other’s share.

Shirkat-ul-Wojooh (Credit Partnership) Shirkat-ul-Aamal (Work Partnership) Shirkat-ul-Amwal (Investment /Capital Partnership) Kinds of Shirkat-ul-Aqd Kinds of Shirkat-ul-Aqd

Shirkat-ul-Amwal Where all the partners invest some capital into a commercial enterprise and share its profits according to agreement.

Shirkat-ul-Aamal Where all the partners jointly undertake to render some services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. Where all the partners jointly undertake to render some services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. For example, if two persons agree to undertake tailoring services for their customers on the condition that the wages so earned will go to a joint pool which shall be distributed between them For example, if two persons agree to undertake tailoring services for their customers on the condition that the wages so earned will go to a joint pool which shall be distributed between them

Shirkat-ul-Wujooh Where the partners have no investment at all, they purchase commodities on deferred price by their goodwill and sell them on spot. Their capital is their credit worthiness and reputation.

Shirkat-ul-AmwalShirkat-ul-WojoohShirkat-ul-Aamal Shirkat-ul- Mufawadah Shirkat-ul-I nan All the three are further divided in to two types: Types of Shirkat-ul-Aqd

Subdivision of Shirkat-ul-Aqd 1-Shirkat-ul-Mufawadah: 1-Shirkat-ul-Mufawadah: Where capital, profit, loss and management are equal among the partners. 2-Shirkat-ul-Inan: 2-Shirkat-ul-Inan: Partners’ share capital, management, profit and risk are not equal and may differ for each partner. This is common type of partnership.

SHIRKAH Shirkat-ul-Aqd Shirkat-ul- Amwal Shirkat-ul- Mufawadah Shirkat-ul-Inan Shirkat-ul-A’mal (Shirkat-ul- Abdan) Shirkat-ul- MufawadahShirkat-ul-Inan Shirkat-ul- Wajooh Shirkat-ul- Mufawadah Shirkat-ul-Inan Shirkat-ul-Milk OptionalCompulsory

Rules of Shirkat-ul-Milk Each partner is a stranger with respect to the share of the others. The partners are not allowed to undertake any act of disposal with respect to the other’s share except with the latter’s permission. Each partner can sell his own share without the other partners’ consent, except in cases where share of one partner can not be distinguished from the other.

Rules of Shirkat-ul-Milk Profit & loss will be according the ratio of ownership. Expenses related to ownership will be borne by all partners according to the ratio of ownership. Every partner has the right to sale/gift/lease to the extent of his share. One partner can promise to purchase the share of other partner at any price, may be at face value, market value or pre-agreed price.

Shirkat-ul-Ammwal Definition: It is an agreement between two or more persons to invest a sum of money in a business and share its profits according to agreement. The investment of this partnership consists of capital contributed by the partners.

SHIRKAT-UL- AMWAL: Capital of Musharakah It should be known, ascertained and available at the time of contract. The value should be agreed upon in case of kinds; The value should be agreed upon in case of kinds; Capital paid in different currencies should be valued into the currency of Shirkah; Capital paid in different currencies should be valued into the currency of Shirkah; Capital advanced by the parties. Should be uniform (currency of partnership). Share capital in a Musharakah can be contributed either in cash or in the form of commodities In the letter case the market value of the commodities shall determine the share of the partner in the capital.

Capital of Musharakah Capital of partnership is Amanat in the hands of partners. If loss occurred due to negligence, the partner responsible for loss, will compensate the loss.

Management of Musharakah Each partner has right to take part in Musharakah management. Each partner has right to take part in Musharakah management. The partner may appoint a managing partner by mutual consent. The partner may appoint a managing partner by mutual consent. One are more of the partners may decide not to work for the Musharakah and work as a sleeping partner. One are more of the partners may decide not to work for the Musharakah and work as a sleeping partner. It is not allowed to specify a fixed remuneration to a partner Musharaka who manages funds or provides some form of other services, such as accounting; It is not allowed to specify a fixed remuneration to a partner Musharaka who manages funds or provides some form of other services, such as accounting; However, it is permissible to give him a greater share of profit than he would receive solely on the basis of his share in the partnership capital; However, it is permissible to give him a greater share of profit than he would receive solely on the basis of his share in the partnership capital;

Distribution of Profit The ratio of profit distribution must be agreed at the time of execution of the contract. The ratio of profit distribution must be agreed at the time of execution of the contract. It is not necessary for sharing profit according to proportionate capital contribution; It is not necessary for sharing profit according to proportionate capital contribution; It is not allowed to defer the determination of profit until realization of profit. The ratio must be determined as a proportion on the actual profit earned by the enterprise. The ratio must be determined as a proportion on the actual profit earned by the enterprise. Not as percentage of partner’s investment. Not as percentage of partner’s investment. Not in lump sum amount. Not in lump sum amount It is not allowed to defer the determination of profit until realization of profit. 2. A sleeping partner cannot share in the profit more than the percentage of his capital.

Rules of Profit Determination/Distribution No guarantee can be given by the partners for the payment of profit or capital. Different partners may be given different weightings according to amount and period of their investment. Tiered profit sharing ratios can also be agreed. Tiered profit sharing ratios can also be agreed. Profit ratio can either be fixed or variable according to the tiers; Profit ratio can either be fixed or variable according to the tiers; Both partners can agree that first 6-month profit e.g. will be distributed at ratio of 50% : 50% and next 6- month profit will be distributed at ratio of 30% : 70%.

Rules of Loss Determination/Distribution Sharing of Loss: Sharing of Loss: As a matter of principle the loss has to be shared according to the ratio of capital contribution; As a matter of principle the loss has to be shared according to the ratio of capital contribution; Partners are not allowed to adopt any other mechanism except the mechanism that ensure distribution of loss among partners on pro rata basis; Partners are not allowed to adopt any other mechanism except the mechanism that ensure distribution of loss among partners on pro rata basis; Any other arrangement, even agreed upon by partners, will be invalid and void. Any other arrangement, even agreed upon by partners, will be invalid and void. It is not allowed to hold one partner or group of partners liable for entire loss.

-All partners in Shirkah maintain the assets of the partnership as a trust. -No one is liable except in cases of breach of the contract, misconduct or proven negligence. -Negligence will be considered to have occurred in any of the following three cases: (i) A partner does not abide by the terms and conditions of the contract; (ii) A partner works against the norms of the concerned business; and (iii) The established ill-intention of a partner. -The profit or even capital of any partners cannot be guaranteed by the co-partners. -One partner can demand from another partner to provide any surety, security or pledge to cover the case of misconduct and negligence. Guarantees in Shirkah Contracts

Rules of Musharakah – termination Musharakah terminates in any of the following event: Musharakah terminates in any of the following event: Death of a partner during the Musharakah; Death of a partner during the Musharakah; Heirs of the deceased partner have option either to draw the share of the deceased from the business, or to continue with the contract of Musharakah; Heirs of the deceased partner have option either to draw the share of the deceased from the business, or to continue with the contract of Musharakah; If any one of the partners becomes insane or otherwise becomes incapable of effecting commercial transactions, the Musharaka stands terminated. If any one of the partners becomes insane or otherwise becomes incapable of effecting commercial transactions, the Musharaka stands terminated. In normal course of business, every partner has a right to terminate the Musharakah at any time after giving notice to other partner; In normal course of business, every partner has a right to terminate the Musharakah at any time after giving notice to other partner; In this case, if all the assets of the Musharakah are in cash form then they will be distributed pro rata between the partners; In this case, if all the assets of the Musharakah are in cash form then they will be distributed pro rata between the partners; In case they are mixed assets the partners may agree either on: In case they are mixed assets the partners may agree either on: Physical distribution of the assets among partners; or Physical distribution of the assets among partners; or Liquidation of the assets in open market (market price); or Liquidation of the assets in open market (market price); or Internal liquidation i.e. purchasing from one partner share of other at any agreed price between them; Internal liquidation i.e. purchasing from one partner share of other at any agreed price between them;

Rules of Musharakah – termination with one partner In case a partner wishes termination of the Musharakah, while others do not, this can be achieved by mutual consent; In case a partner wishes termination of the Musharakah, while others do not, this can be achieved by mutual consent; The partners who wish to run the business may purchase the share of the other partner who wants termination; The partners who wish to run the business may purchase the share of the other partner who wants termination; The reason is that the termination of Musharakah with one partner does not imply its termination between other partners; The reason is that the termination of Musharakah with one partner does not imply its termination between other partners; However, in this case, the price of the share of the leaving partner has to be determined by mutual consent; However, in this case, the price of the share of the leaving partner has to be determined by mutual consent; In case of dispute on the valuation of the share the leaving partner may compel other partners on the distribution of the assets; In case of dispute on the valuation of the share the leaving partner may compel other partners on the distribution of the assets; However, if they are not divisible then the partner may an arbitrator to solve the dispute; However, if they are not divisible then the partner may an arbitrator to solve the dispute;

Musharakah – banking application Musharakah is top preferable mode of financing recommended by Islam; Musharakah is top preferable mode of financing recommended by Islam; It one of the important factors that help in achieving ‘distribution of wealth’ which is a key feature of Islamic financial and economic system; It one of the important factors that help in achieving ‘distribution of wealth’ which is a key feature of Islamic financial and economic system; As Mudarabah, Musharakah is also not a vastly practiced Islamic mode of financing by Islamic banks due to certain reasons; As Mudarabah, Musharakah is also not a vastly practiced Islamic mode of financing by Islamic banks due to certain reasons; However, Musharakah could easily be used as a vast mode of financing for almost every financial need; However, Musharakah could easily be used as a vast mode of financing for almost every financial need; Below are some fields where this mode can easily be applied: Below are some fields where this mode can easily be applied: Long-term Finance; Long-term Finance; Running Finance (limited scope); Running Finance (limited scope); Investment Banking; Investment Banking; Project Financing; Project Financing; Private Equity Investment; Private Equity Investment; Redeemable capital investment. Redeemable capital investment.

Islamic securitisation Transforms bilateral risk sharing between borrowers and lenders into market-based refinancing of one or more underlying Islamic finance transactions Scholar verification process: (i) type of assets; and (ii) transaction structure including credit enhancement and ownership conveyance

Conditions Real purpose behind fund raising; type of asset identified and not consumable Investor pay-off from profitable ventures only Collateral assets must not be debt, cash or haram No interest generation Investors hold unconditional, unsecured payment obligation (no guaranteed promissory note) Ownership element

Sukuk Most popular ABS structure within Islamic finance, legitimised in February 1988 Most popular ABS structure within Islamic finance, legitimised in February 1988 Financial instruments / trust certificates representing undivided ownership share in underlying asset or interest held by issuer Financial instruments / trust certificates representing undivided ownership share in underlying asset or interest held by issuer Most sponsored by sovereign and quasi- sovereign issuers in Islamic countries Most sponsored by sovereign and quasi- sovereign issuers in Islamic countries Right to share in profits and asset realisations Right to share in profits and asset realisations Bought and sold in secondary market and used in conjunction with other structures Bought and sold in secondary market and used in conjunction with other structures

Sukuk al Ijara CERTIFICATE HOLDERS SELLERSPV ISSUERLESSEE Purchase price (issue proceeds) Issue proceeds Sells assets Return Issues Sukuk Leases assets Rent

Sukuk al Musharaka CERTIFICATE HOLDERS SPV ISSUER VENTURE ORIGINATOR ReturnIssues Sukuk Issue proceeds Cash contribution Contribution in kind (at least 30%) Share in profit and losses Share in profits and losses

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