Sukuk: Too many moving parts?

Having done research on the structuring of Sukuk, I’ve been thinking lately on the ability of a Sukuk market to actually flourish. What incentives does any Sukuk issuer have to assure the success of their Sukuk? With exception of one type of obligation underlying the Sukuk (that being debt from murabaha), there can be no guarantee of coupon payments, no guarantee of principle, and no recourse unless negligence is proven.

In a Murabaha sukuk, unless that murabaha is a one-off purchase and resale of assets, then there is nothing guarantee a future need to create the debt that would become the coupon payment and repayment of the principle?

Even Ijara (lease) sukuk, which purportedly are the easiest of structures to synthesize Sukuk under, are questionable. Are these “true leases” or merely disguised security interests? If I lease you an asset (which was most likely purchased from you in the 1st place) then stipulate that you rent it from me for 10 years, all the while making it virtually impossible for you to break the contract without guaranteeing the profit and principle I was trying to synthesize in the first place, am I really leasing you this asset? Am I really transferring the asset back to you through a “hiba” (gift), nominal payment, or separate “purchase” agreement? Or have I merely securitized my debt along with an implicit guarantee, something that all too much resembles “Bai’ al-wafa” or “Bai’ al-amanah”?

Consider how the difference between a True Lease and a disguised Security interest is differentiated between in the UCC code:

The key element is that the erstwhile lessee has an unavoidable obligation to pay the supposed lessor for the possession and use of the asset, and this duty to pay extends over the life of the arrangement, and cannot be terminated by the lessee.

Interestingly, the UCC sets forth this first vital attribute, and then adds a series of four other characteristics that must also be found if the transaction is to be deemed a security interest and not a lease.

The four items are:

1) the original term of the supposed lease is equal to or greater than the economic life of the asset;

2) the putative lessee must renew the lease for the remaining economic life of the property or is required to take ownership of it;

3) there is an option to renew for the remaining economic life of the asset, but no additional or only nominal consideration need be paid to exercise that option; or

4) the supposed lessee has an option to purchase the property for little or no additional consideration. UCC 1-201 (37)(a).

Plainly, any and all of the above are indicia of true ownership by the lessee. A so-called “lease” whose original or extended term encompasses the entire economic life of an asset indicates ownership, and lacks intent to return the goods to the supposed lessor. The lack of a requirement to pay any additional money or an insignificant amount to extend a lease says much the same as to the true intent as the parties to create a security interest. Finally, compelling the supposed lessee to eventually own the asset is the final straw; without question it demonstrates that the “lessor” has no real intention of retaking the asset.

It would seem that unless a Sukuk is issued by a large Gov’t authority (so well backed that one need not worry about default) or is a legally binding obligation to pay interest on a debt (exactly what Sukuk were created to avoid) accompanied by a robust legal system that will enforce that claim, fears of failure do not easily subside.

Given the nontransparent nature of many of the markets in which Sukuk are issued, the intertwined nature of relationships to meet both financial, shariah, and legal concerns, the inefficiencies create from doing so, and the lack of added value from these structures, are we dealing with simply too many moving parts? Or are we simply insisting on appearances while fooling ourselves of the function?

Mustafa Zarka – A list of his works:

Mustafa Zarka, one of the most prolific scholars of the last century, was a rarity amongst intellectuals. Not only had he mastered the Hanafi school of jurisprudence, reached the level of tackling higher legal debate outside of his specific school, but had also studied western law to the extent that he could see the need for synergy between the two, instead of viewing them as absolute opposites.

I thought I would put together a list of his works for future reference, and perhaps find others interested in his writtings that may put me on to some that I’ve missed in this list.

1-      al-Madkhal al-Fiqhi al-‘Aam (المدخل الفقهي العام): A General Introduction to Islamic Law; an introductory work written focusing on more general precepts and theories in Islamic law, written with a style that can be easily understood by both students of fiqh and students of law.

2-      Nazariyyat al-Iltizaam al-‘Aamah (نظرية الالتزام العامة): The General Theory of Obligation; a seminal work on how Islamic law handles rights and obligations.

3-      ‘Aqd al-Bai’ (عقد البيع): The Sales Contract; this book was to be the first in a re-assessment of Fiqh works, progressing from the General to the specific. I was told the Shaikh passed away shortly after this work and thus the series was never finished.

4-      Al-Fatawa (الفتاوى): A collection of his various fatawa. It is important to note that this does not contain the countless fatawa that the Shaykh gave as a founding member of AlRajhi Bank’s Shariah Board.

5-      Al-Fi’l al-Daar wa ‘l-Daman fihi (الفعل الضار والضمان فيه): A study of Torts and compensation; this work was based on Jordanian law, prefixed with relevant material from Islamic law, the law on which it was based was then amended. This was one of a series of books for creating a civil law based on Islamic texts to be used in the United Arab Republic.

6-      ‘Aqd al-Istisnaa’ (عقد الاستصناع): Procurement contracts. I have yet to see this book in print, even though a friend says he has a copy.

7-      Al-Istihsan wa al-Masalih al-Mursala fi al-shari`a al-islamiyya wa usul fiqhiha
(
الاستحسان والمصالح المرسلة في الشرعية الإسلامية وأصول فقهها): A book dealing with public welfare and legislative license in Islamic law.

If anyone else knows of others not listed, please mention them in the comments.

The cross jurisdictional challenges of standardizing Shariah compliant documents

Many hurdles are faced if Shariah compliant documentation is to be standardized. Of these are the jurisdictional challenges of drafting legal documentation to comply to basic shariah principles, comply to local and national laws, and still remain commercially viable. One major consideration for those that work on the drafting is the ability to craft into the documentation the remedies that are natural to an independent and functioning Islamic legal system, things such as misconduct, negligence, damages etc.

For example, some forms of compensatory damages, while applicable under the common law, may not be acceptable under Islamic law. Awards for liquidated damages are similar, especially in wakala agreements where an agent (wakeel) can not be held liable for losses except in the case of wilful misconduct and negligence. Another point of contention comes up with lost opportunity costs, something that has not been hashed out yet by tradtionalist Islamic scholars giving fatwa in Islamic finance.

To be able to incorporate all principles inherent to Islamic law, along with (and most importantly) being enforceable in the jurisdiction in which the contract is governed, is a challenge that unless faced, will continue to plague Islamic Finance deals for some time.

World of WealthCraft: Using a virtual hand to nurture Islamic finance growth

The Big Money suggests using  “massive, multiplayer, online role-playing games like World of Warcraft and Second Life….for studying economic behavior and testing economic-policy theories”.

This would be interesting to see in Islamic finance. I don’t know of anyone that has attempted similar except for Dr. Sami al-Suwailem in his paper “Islamic Economics in a Chaotic World” where he compares Chaos theory, Neoclassical economic theory, and Islamic economic theory.

I wonder how hard it would be to expand this type of thing; Different states could be set up: Dual conventional-Islamic states (like Malaysia), Islamic states (like Sudan), & Hybrid states (like the KSA), and conventional states. Interactions would be regulated by an IMF or IDB type entity, or both.

Iit would be interesting to see what results we could get.

Governing Jurisdiction – The litmus test of “real” Islamic Finance

While reviewing several cases of defaults, disputes, and disruptions in Islamic Finance deals that have made the press, I noticed that almost every case that has been litigated on has been in a western common law court (UK-USA).

Thinking out loud, I wonder if this is the litmus test for “real” Islamic Finance? Not that bringing the case to court is the litmus test, nor that the ruling issued is either. My point here is that designating the governing jurisdiction as a common law court gives away something somewhat subtle, however inferred, concerning the intentions, and more importantly, the expectations of the contracting parties.

Presuming here that that external factors such as a judge’s ability to determine a contract to be Islamically acceptable is not a factor due to proficient negotiation and contract formation by the parties, let’s ask the question:

How many cases have been approved as “Shariah Compliant” yet when taken to court have been ruled to be not-so-Islamic?

Rent to Own Leases (Ijara wa iqtina’): Fringe Banking & Financial Distress

Legal Theory Blog posts about Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress (Indiana Law Journal, Forthcoming) on SSRN.

I’m interested in the guarantee mentioned below. Does Islamic Finance allow for a guaranteed return, even if done through Lease (Ijara)? Because Islamic Finance is not contained by one single regulatory system, some of the arguments made will be difficult to apply. However, given that Islamic Finance makes a claim of ethical perdominance, can we say that this sort of guarantee goes against the ethical framework Islamic finance is to promote?

Highlights from the abstract:

  • Critics of fringe banking – products like payday loans, pawn loans, and rent-to-own leases – frequently argue that using these products causes borrowers to experience financial distress. This argument has enormous intuitive appeal: Fringe credit is very costly, and usually the borrowers who are forced to use it are already in a serious financial bind. Taking on additional debt and paying high costs for it, the reasoning goes, drives them over the brink.
  • This Article represents the first attempt to uncover the relationship between fringe banking and financial distress by systematically analyzing the structure of fringe credit markets and characteristics of specific fringe credit transactions.
  • I argue that the link between fringe banking and financial distress is dubious. Because fringe creditors cannot rely on borrowers’ credit scores to predict whether they will be repaid, creditors structure fringe credit products to virtually guarantee repayment.
  • Because repayment is guaranteed by the structure of the transaction, it is nearly impossible for borrowers to take on unmanageable debt loads.
  • Policymakers lump fringe credit together with other forms of credit that do cause financial distress, resulting in misguided and overly broad policies.

Consultation, Moral Hazard, & Shariah Boards

While preparing my Masters thesis, I came a across an interesting quote from Muhammad b. Idris al-Shafi’i, the famous jurist and author of the first work of Islamic legal theory, al-Risalah. After explaining the need to consult others before issuing juristic opinion:

[Consultation should be sought] regardless of whether those consulted agree or disagree; in fact those that disagree [with you] should be given priority, so as to help resolve what juristic opinion is applicable. One should ponder over their evidences, then decide. [al-Bahr al-Mudhhab of al-Ruyani 11/170]

Shariah Boards tend to lean towards one legal methodology; that is expected in any decision making group. There has been a trend though to filter opinions until the only thing you are left with are those that you agree with (or should I say, agree with you).

This seems similar to a moral hazard, when a party insulated from risk may behave differently than it would behave if it were fully exposed to the risk. Excluding dissenting opinions would protect any group from the risk of re-evalution, analysis, and reputation risks. If we consider Shariah Boards to be representative of general shareholder assembly, any Shariah Board which is asymmetric in its makeup would seem to be susceptible to a double-sided principal–agent problem.

A possible “Islamic” alternative to Microlending

Muhammad Yunus having won the Nobel prize for economics, Microfinance has become a hot item for many seeking to make money and “lend” a helping hand. Much criticism has surrounded Microfinance, from Muslims and Non-Muslims alike, questioning the ethics and viability of the practice.

Objections generally center on the fact that it is an interest (Riba) based system, loaning out small amounts of money at a very high rate. Exploitation of women is another big concern. The majority of Microfinance and Micro-credit agencies cater solely to women, even though this apparently is a good thing, many of those women act merely as collection agents for the male members of their families who spend the money while the women bear the credit risk. Additionally, dependence on loans leads to circular borrowing and may constitute a minor form of debt slavery, forcing people out of waged work and into the informal economy.

These points aside, the objective here is not to dwell on the objections to or attempt to dismantle this system, but instead to promote a more ethical and credit-safe alternative to such practices.

Many proponents of “Islamic Finance” promote profit-sharing schemes that reduce credit risk and ensure profit-loss equity among the involved parties. One such method that may provide an alternative is called “Credit-Based Mudarabah”.

Mudarabah is an Arabic word for silent partnership,

Sharikat alMuDarabah: a partnership of two parties in which one provides capital and the other provides labor. (For more on partnerships look here)

One method that the researcher mentioned was “credit-based Mudarabah” i.e. a credit-based silent partnership.

Credit-based Silent Partnership

Parties involved:

There will be one party that will provide the labor, known here as the “Agent”. The other party will provide capital, known here as the “Financier”.

How it works:

  1. The agent and the financier enter into a partnership agreement
  2. The two parties agree that the financing will not be provided until
    the business deal is arraigned with the various other parties involved.
  3. Once proof of the deal is presented to the financier, payment is made
    to the third party selling the goods, and profits are shared between the
    financier and the agent.

An example:

  1. Take into consideration this scenario:
  2. An agent purchases concrete for re-sale with the option to
    return or cancel within 48 hours.
  3. He then signs agreements with the purchasers of the concrete for delivery at the specified date.
  4. Upon closure of the deal, he presents proof of purchase for re-sale and
    closure of re-sale to the financier, who then would issue payment to the
    concrete salesman.
  5. Profits from the re-sale would be divided up between
    the agent and the financier.

Benefits of this method:

  1. Cancellation of the last deal would cancel the first, and sales risk
    is minimized.
  2. Credit-risk and risk of failure are brought to a minimum, as are the
    problems of misreporting

Additional considerations:

  1. The method is applicable for both wholesale and retail
  2. If the trade between the suppliers, the agent, and the retailers is constant, then there would only have to be an agreement to supply, with order amounts on a case by case agreement, an OCO (one cancels the other) agreement can be done in case the retailers or the financier defaults, so safety guards are in place.

Islamic Economics vs. Global Capitalism

Islamic Economics is a topic of great interest nowadays. Sometime ago an article appeared in the LA times, asking the question “Will capitalism fall victim to its own success?

From the article:

Karl Marx is turning in his grave. Or perhaps not, because some of his writings eerily foreshadowed our era of globalized capitalism. His prescription failed, but his description was prescient.

I assume that he is pointing to this quote from the Communist Manifesto:

The development of Modern Industry, therefore, cuts from under its feet the very foundation on which the bourgeoisie produces and appropriates products. What the bourgeoisie therefore produces, above all, are its own grave-diggers. Its fall and the victory of the proletariat are equally inevitable

But with all the criticism that can be heaped on capitalism, what are the alternatives? Social Democracy is named, as is Chavez and his “21st Century Socialism”.

Then there is “Islamic Economics”…

From the article:

What, after all, are the big ideological alternatives? …
Islamism — billed as democratic capitalism’s great competitor in a new ideological struggle — offers no alternative economic system (aside from the peculiarities of Islamic finance) and does not appeal beyond the Muslim umma. Most anti-globalists are better at pointing out the failings of global capitalism than they are at suggesting systemic alternatives. “Capitalism should be replaced by something nicer,” read a placard at a May Day demonstration…

Islamism, according to the author ( and I assume meaning the practice of Islam on more than a personal level) is insufficient in developing an alternative economic system. There are more than enough writings on “Islamic Economics” but with economics largely an empirical science, can the ideology of Islam to develop an “Islamic theory of economics” i.e. one that guides the normative values of economics in a manner conducive to Islamic belief and practice?

Much of what has been written in this field is extremely vague. Concepts of “Justice” and “equality” abound, re-iterated with the same examples of prohibiting “Riba” and usurpation of property. In fact, there seems to be a trend in many of these writings. When socialism was big in the Muslim world, many such writings reflect that influence, stressing wealth distribution and state regulation. Nowadays, with the socialist influence waning, more capitalist leaning thought has entered the fray. All in all, there is still alot of research that needs to be done. Economists such as Timur Kuran present the same picture of “Islamic Economics” that the author of the above quoted article does. Others have been equally critical, yet without avail. There seems to be a stagnancy in admitting the need for progression in the area of economics, Islamic economics that is. So while many Muslims believe that they are simply being sticklers for orthodoxy, in fact they may be merely following trends, something alluded to in several hadeeth.

This method of innovation-trailing in areas of economics and finance has lead to no substantial alternative to be developed for the benefit of mankind, much less the benefit of Muslims. While some characterize critique of Islamic Economics as a form of self-hate, hypocrisy, or support for non-Islamic systems, they should recall the statement of Umar ibn AbdulAziz “May God bless the person who presents to me my faults.”

Also from the article:

Does the lack of any clear ideological alternative mean that capitalism’s triumph is secure? Far from it. For a start, the history of capitalism hardly supports the view that it is an automatically self-correcting system. As George Soros (who should know) points out, global markets are now more than ever constantly out of equilibrium — and teetering on the edge of a larger disequilibrium. Again and again, capitalism has needed the visible hands of political, fiscal and legal correction to complement the invisible hand of the market.

So if Islamic Economics is an alternative system, what sort of corrective mechanisms are sanctioned to offset disequilibrium? Most research, as alluded to in the article, has centered on issues of Islamic finance. Issues that for the most part are micro-economic in nature, and do not present an “Islamic” concept of a general regulatory framework or a theory of political economy.

In “The Worldly Philosophers” Robert L. Heilbroner lists three ways in which societies have dealt with such precariousness of human nature: tradition, authoritarianism, and market systems. In the past, it seems that much of the research and application of Islamic law as applies to economics, business and finance seemed to concentrate of the tradition of the Madhahib (juristic schools) and their analysis of the “permissibility of contracts“. As alluded previously, authoritarian attitudes to these subjects took hold in the attempt to develop a viable Islamic counter-culture to what was thought to be the invasion of the “Un-Islamic” ideas of Capitalism and Democracy. Now the only thing left is the development of market system reflecting the objectives of Islamic Law.

What sort of political correctionary methods are sanctioned by Islamic Law? If the Islamic economy is not authoritarian, then is it laissez-faire? What sort of fiscal policy does Islamic economics advocate? Classically this was spoken of in the books of politic or “al-Siyasah al-Shar’iyyah”. However, there is great emphasis in those works on revenue from natural resources and appropriation of war-spoils, with  Zakat and land taxation another large part of that discourse. With modern market economies and the spread of fiat currency, what is the Islamic view of Seignorage? What of taxation? (the latter being a particularly touchy topic in some medieval legal discourse). Many more modern topics would not even be mentioned.

As for legal corrections, this area has been particularly problematic for me. We find that one of the staunchest prohibitions in the Quran to be that of the prohibition of “Riba”. However, all of the punishments and admonishments attached to this form of transaction are of a moral type attached to other-worldly punishment. The question then remains: How can something that is viewed as so severe in its practice, be allotted a punishment that does not even equal that of the least of punishments for misappropriation of personal property (theft, etc.)

Admittedly, I am not an economist, I am a student of Law. If the assertions or assumptions that I have made here are wrong, please let me know. I would love to learn from you.

In closing, the article mentions:

Marx thought capitalism would have a problem finding consumers for the goods that improving techniques of production enabled it to churn out. Instead, it has become expert in a new branch of manufacturing: the manufacture of desires. It’s that core logic of ever-expanding desires that is unsustainable on a global scale. But are we prepared to abandon it?

A good question as many Muslim countries head down the path of Prophecy, importing some of the most detrimental aspects of capitalism without a 1/2 of the social and economic regulations needed to allow for longevity.

Islamic legal development: In spite of vs. in light of

On issues of Islamic legal development theory, one point popped in my mind today when thinking about Ahkam al-Sharikat that is the Law of business partnerships. This point is, and hence the title, is “In spite of vs. in light of”.

What I mean by this is that in the development of Islamic Law, certain aspects of that legal system developed “in light of” the texts. Many if not most of these are things which are explicit in nature, and are related in numbered explicit texts or innumerable implicit ones.

Take for instance the law of Business partnerships. There is a whole array of laws in all of the various books of classical Islamic law regulating this sector of the law. However, upon closer analysis, we find that there are only about 3-4 verses of the Quran if not less, and 10-15 hadith at most that speak on this topic specifically. When they do, it is usually after the fact, i.e. a transaction or partnership was created, a problem was presented, and then the prophetic guidance was given for that problem. That would then necessitate that the law as presented in the sacred texts developed in a reactionary manner to the prominent social convention of the time, and in general presents a broad regulatory framework for the issue at hand.

When we look at the books of Islamic law however, we see that they spell out for us only five types of partnerships (barring the agriculture based ones of Musaqah, etc.). Those five types are:

1- Sharikat al-‘Inan: a partnership of two parties both providing capital and sharing equally in labor.

2- Sharikat al-Abdan: a partnership of two parties sharing equally in labor with no capital investment from either of them.

3- Sharikat al-Wujuh: a partnership between 2 or more people whom enter a mutual liability based on their collective influence to enter a deal.

4- Sharikat alMuDarabah: a partnership of two parties in which one provides capital and the other provides labor.

5- Sharikat al-MufawaDah: Being a partnership that includes all of the previous

Now the presence of these in classical works of fiqh is all fine and dandy. However the problem comes when we wish to apply them to modern forms of partnership such as corporations, LLC’s, etc.

And this is where the differentiation comes in, and draws us to ask some questions:

– Were these forms of partnership decreed by sacred text?

– Or were they conventions that were prevalent at the time?

– If new contracts arise, are we obligated to refer them back to the codified from of these medieval partnerships?

– Or do we look to the texts for broad regulatory guidelines and accept that the base ruling of all contracts and conditions is that they are permissible?

I’ll only take one type of partnership contract here, that being Sharikat al-Abdan.

Sharikat al-Abdan is usually substantiated by the statement of Abdullah ibn Mas’ud who said “Myself, Ammar, and Sa’d were were partners in anything that we gathered on the day of Badr; Sa’d returned with two captives, and Ammar and I returned with nothing.” This was narrated by al-Nisa’i, and is a weak hadith.

The scholars of the Shafi School rejected this form of partnership, while the majority accepted it. Now despite this hadith being weak, lets just say that it was authentic for arguments sake. In fact there may be supporting evidence for it, although I haven’t gone back to look. The scholars of the Shafi School may have rejected it based on the principle that the statements of the Sahabah are not admissible as evidence. They may have considered weak.

Regardless, let’s look at the context of the hadith. It is hardly a prophetically ordained mode of partnership. It is also not conclusive that there was any prophetic approval of the contract.

Even though the majority of scholars may have allowed it based on this statement, it doesn’t follow that we are in need of this statement of that companion to say that this is allowed. Additionally, to designate a distinct type of partnership based on this would also not follow. Leaving the very open ended agreement that “partnerships are permissible as long as there is no harm” would have seemed more conducive to growth of the Muslim economy and in line with the flexibility of Islam.

Those that admitted this statement as evidence for the permissibility of this type of partnership then formulated all types of rulings for default, harm, and profit distribution, etc. and designated various sub-categories of this partnership agreement, all based not on text, but on the convention that was agreed upon in that time and place. Even though this fit the constraints of the era they lived in, it was detremental in that later generations took these rulings to embody Islamic legal canon, and as such everything after that was illegitimate. In essence the Majority of Scholars went the way of the Zahiri school as per contracts and their creation, contradicting themselves in principle.

Shihab al-Din al-Qarafi says:

Holding to rulings that have been deduced on the basis of custom, even after this custom has changed, is a violation of Unanimous Consensus (‘Ijma) and an open display of ignorance of the religion

Here we then see that with the development of this section of law that it developed very much in spite of specific textual guidance in contrast to developing in light of that guidance. Not that that is a bad thing per se, however when convention and custom then changes, it is important to relegate differences and rulings on the permissibility of a said action back to the broad regulatory framework as found in the sacred texts, instead of judging a later period convention according to that of an earlier one.

Anyone seeking to study Islamic Law as relates to Business and finance should then analyze the issues at hand, it being preferable for those capable of doing so to infer directly from the texts their broad maxims that regulate the sector in question, rather than appealing to the authority of the past or invoking the sacrosanctity of discontinued convention.