HOW UKK COMPLY WITH THE LAWS OF THE SHARAH

A Paper Presented at the 7th Sharah Conference for Islamic Financial Institutions

Organized by

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Bahrain

Written by

Dr. Mu ammad Al Elgari King Abdul Aziz University - Jeddah

In the Name of Allah, the Most Compassionate, the Most Merciful

All Praise is due to Allah alone. May His peace and blessings be upon our leader, Muhammad, his household and his Companions.

1. The Meaning of akk

uk k have assumed great importance at this stage in the development of Islamic banking. This is because of the unique financial and investment features they provide. They partially fulfil the need for a comprehensive range of Islamic financial instruments of diversified risk. uk k provide an alternative to traditional tradeable fixed-return securities, which are considered an important element in the array of instruments in financial markets. akk is an Arabized Persian word that refers to a document in which transactions, acknowledgments and assurances are recorded. The plural of akk is uk k, just as the plural of fals (a base-metal coin) is ful s. It can also take the plural of ik k, similar to the pattern of sahm (share) and sih m (shares); it can also take another plural form: aukk. akk was also used to refer to a document recording a debt. In the medieval period, Muslims were familiar with akk as the name for a document issued by the ruler entitling the recipient to provision; e.g., it would state, Soand-so is entitled to such-and-such amount of grain, or the like.

2. Conventional Bonds

Bonds are tradeable securities that document a loan and the interest on it. The bondholder is the lender, and its issuer is the borrower. They are issued by corporations, governments and banks. The capital (face value) and interest (whether fixed or linked to an index) is guaranteed by the issuer. Therefore, the relationship between the bondholder and the bond issuer is a debtor-creditor relationship. 2

3. The Definition of ukk

ukk are tradeable investment certificates that establish the holders ownership of an asset that produces regular, recurring income. They are characterized as low-risk investments with predictable yields. The issuer of the instrument does not guarantee the capital (nominal value) or the yield except in case of transgression or negligence.

A akk is similar to a stock in that it represents ownership of income-generating assets, but it differs from it in that its risk is low and the return is predictable, similar to the yield of a long-term lease contract and the like.

4. Correcting a Common Mistake uk k are frequently called Islamic bonds. This is wrong. There are similarities between uk k and bonds, but the differences are so much greater that it is not correct to use the term bonds (as the word is used in the financial industry) for Islamic uk k. The most important difference between the two terms is that the akk does not represent a debt obligation upon the issuer, and it is incorrect to characterise it as fixed income, a term used with bonds; the yield of uk k is only predictable or expected.

5. Credit Ratings for ukk

Conventional debt securities comprise a single risk, which is the credit risk, i.e. the ability of the borrower (issuer) to pay the interest and principal of the loan on the date or dates specified for that purpose. A bonds rating is primarily based on the rating of its issuer. If the issuers credit status is excellent, the bond will (in most cases) be rated to reflect that credit status, and vice versa. The rating is very important for investors, as they cannot verify the credit status of the issuer by themselves and depend almost entirely on the ratings issued by rating agencies. 3

The rating of uk k is not so simple because their rating is based on a number of factors; the most important of them is the contractual formula existing between the issuer of uk k and the holders of those uk k. That is what determines the type of risk the uk k-holders face.

In the case of uk k ij rah, the uk k rating is influenced by the credit status of the issuer, as it owes the uk k-holders the rental, which represents the periodic return. (This is based on the view that it is the lease contract itself that creates entitlement to the rental income.) It is also relevant to the issuers commitment to buy the underlying asset at the end of the contract, for the fulfilment of this commitment is also linked to the credit status of the lessor (issuer). This is the way in which uk k ij rah resemble bonds in terms of credit rating. However, another factor remains outside the scope of credit rating. It is the market risk, in that the uk k-holders are the owners of the source of the return (real estate and the like), and this is subject to price fluctuations. This opens up the possibility of loss due to price volatility, i.e., market risks. This element differentiates uk k ij rah from bonds. As for the ratings of uk k murabah and uk k mush rakah, the matter is even more complicated. As a result, they are virtually unrated at the present time.

6. ukk are not Debts

It is known that conventional bonds are debt securities and that the subject of the contract is a liability and not an existing commodity. As for the subject of the uk k contract, it is an existing revenue-generating asset that the uk k-holders own. Financial designers have sought to make the structure of uk k as close as possible to the structure of conventional debt securities in their desire to make

uk k full substitutes for such debt securities. In doing so, they have modelled them on bonds secured by mortgages of physical assets. It is well known that a bond secured by mortgage of a physical asset is a loan instrument that establishes a liability upon its issuer for the amount of the loan plus the interest on it. However, the loan is secured by the mortgage of a physical asset, so that, if the debtor is unable to pay, the bondholders can foreclose on the mortgage, and the issuer cannot prevent them from doing so. That is so even though they do not own the mortgaged asset; they only take it over to attain their right. This is the content of conventional securities.

To achieve formal compliance with the requirements of the Shar ah while maintaining the actual content of conventional securities, they structured the uk k to give the uk k-holders limited ownership of the asset that would have been mortgaged in a conventional security, and they introduced a purchase undertaking by the issuer to buy the asset at the uk ks face value. The return from conventional securities is not linked to the mortgaged asset; rather, it is an obligation owed by the issuer; while the source of the return on Islamic uk k is the asset owned by the ukk- holders ; it is not a liability of the issuer. That is why they structured the ownership in the manner described above; however, they added to it what are called liquidity facilities. This is an undertaking by the issuer, in the event of [the assets] inability to generate the promised return, to pay the uk k-holders the full dividend from its own money on each payment date, with the understanding that that amount will recovered at a later time. There is no problem with that; but the problem is in an additional stipulation that, in case the income generated in the following periods is not sufficient to repay the loan, the issuer cannot claim the amount from the uk kholders. This delinks the dividends from the economic activities of the asset owned by the uk k-holders; instead, they become a liability upon the issuer. ukk have become a form without substance.

7. Determining the Legality of ukk

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in Bahrain issued a report regarding uk k. It confirmed in the report what it had previously issued on the Shar ah standards for uk k. The report detailed the important elements that constitute the basic requirement for Shar ah compliance when issuing uk k. The report contained answers to a number of questions that have arisen recently regarding uk k. It can be said, based on AAOIFIs report, as well as the view adopted by Shar ah Advisory Boards on uk k offerings, that the following elements are critical to achieving the Islamic legality of uk k:

First Element: The uk k-holders ownership of the income-generating asset must be established by the recognized means, procedures and documentation required by law. It is known that the laws, regulations and procedures vary from one country to another, but what is important is the ability of uk k-holders to prove their ownership of the securitized asset, in case of adjudication before the concerned bodies. Whatever is required by law to establish that must be included in the uk k structure, so that there can be no dispute between the uk k-holders and any other owner of a given asset. There is no single universal format for establishing ownership of property that does not differ from one country to another, but the common denominator is the ability, in the event of adjudication, to prove ownership so as to preclude dispute [of that issue] by the uk k issuer.

Second Element It is not permissible for a partner or murib or agent to make a binding promise to buy [the asset] at face value. It is permissible for him to promise to buy it at the market value or at a purchase price determined by experts at the time of sale, or at a mutually agreed price at the time of sale. 6

Third Element There is no objection to liquidity facilities, provided that the issuer recovers what it provided as liquidity facilities from the entitlements of the uk k-holders, whether from the income generated by the owned asset or from their capital when the asset is sold at the end of the [contract] period.

8. There can be no ukk without a promise to sell at face value.

This slogan is frequently repeated by a number of specialists who believe that, if uk k are to have any economic benefit, they must fundamentally differ from stocks in terms of limiting risk to credit risk. This is achieved by the issuer issuing a promise to buy [the asset] at the same nominal value at which it issued the bond. It becomes an obligation on the issuer to return the capital as a quid pro quo for the credit rating (because it is a debt or resembles a debt) in a manner not very different from conventional bonds. When the relationship between the issuer and the uk k-holder is that of partnership in the capital or profit (i.e., mush rakah or murabah), the promise to buy in the manner described above leads to one partner guaranteeing the other partner's share of the partnership or a muribs guarantee of the capital or profit. This is contrary to the consensus of the Muslims of the past and the present, and it is not acceptable. In case the relationship between the issuer and uk k-holder is that of lessor (uk k-holder) and lessee (issuer), the issue is easy. Shar ah Advisory Boards have endorsed the permissibility of the promise of purchase; i.e., the lessee promises to purchase the leased asset. It cannot be said that the uk k has by that become like a conventional bond because that is debt certificate; as for this bond, it is the ownership of a leased asset.

9. The Root of the Problem is Insistence on Emulating Conventional Products

Islamic banking has been accused of having an orientation that is conventional banking with an Islamic face, meaning that whatever products it offers resemble conventional products; they have merely restructured the contractual relationships between the parties so that they comply with Shar ah requirements on a purely formal level. It is a stinging and painful accusation, but the description is, to a certain extent, not too far from the truth. There is no problem with emulating conventional products, provided that it doesnt become a trap that we cannot get out of, which is more or less what the pessimists are constantly warning of. Worse than that is making emulation of conventional products a criterion for acceptance or rejection of any new idea or suggestion. The time has come to try to derive solutions from our Shar ah instead of adopting the solutions of others and adapting them to meet the minimum requirement of the law in terms of legitimacy. There should be financial products that fulfil the legitimate needs of the people; people need financial instruments with low risk and predictable profit. [This need] on the part of both issuers and investors is a legitimate need. There are some types of economic activities that cannot afford high-risk investments due to the nature of the activity, such as tak ful companies. If there are no such instruments in the market, the alternative will be an interest-bearing debt certificate.

The right way for the development of uk k is to create financial instruments based on partnership such as uk k mush rakah and uk k murabah but not limited to the "form" of a murabah contract (or a mush rakah contract), but rather, embody their content and meaning. There is nothing wrong with seeking to reduce risks to a minimum, as long as none of the limits set by the Shar ah are breached. A muribs guarantee of [the capital providers] capital or profit invalidates the murabah contract, except in case of transgression or negligence. Transgression and negligence are the major 8

bases for liability in trust contracts ( uq d al-am nah). There is a need for further consideration, reflection and thought, particularly regarding custom, which has a major role to play in specifying the limits of liability. This has not yet been given the study it deserves. We do not want a guarantee that will change the relationship between the parties to that of creditor and debtor, but at the same time we want to build a productive relationship based on honesty, sincerity and efficiency in work, and to achieve justice between the parties without prejudice or injustice against each other. The Shar ah has not blocked any door to the arm without opening doors to what is allowed and l. Therefore, the correct way al forward is to develop uk k mush rakah and uk k murabah.