Sharia is here to stay:
Islamic finance moves into the mainstream*

Sharia compliant finance products are here to stay, argues ALEX INNES, as a growing component of both domestic and offshore transactions.

The use of specialist Islamic finance products within the wider investment market (both on- and offshore) has increased, partly due to the recent expansion of Sharia compliant mortgage options, but also because of the slowdown in more conventional lending.

Although Islamic finance is only a relatively small part of the global industry, it has grown by around 15% in each of the last three years and has continued to grow in the face of challenging economic conditions. The more recent impetus has been provided by non-Muslim investors, attracted by the fact that funding is more readily available than conventional debt, as well as the opportunity to invest  in the still relatively buoyant Middle East.

Islamic finance covers all financial activity that enables investments to be made in conformity with Sharia (Islamic principles and jurisprudence) and involves investment techniques and structures to create arrangements that are, broadly, analogous to conventional finance, but which are Sharia-compliant. Islamic finance techniques differ, but most are either asset or risk based so that a structure might rely on a transfer of underlying physical assets in which the funder will at some point acquire the assets and assume commercial risk (similar to a sale and leaseback structure).

Alternatively, the funder and customer might enter into some form of joint enterprise and share in the profits and losses (the model suggested for Scottish mortgages). In practice, transactions will often combine a number of these techniques to produce the desired economic result and it is common for larger deals (such as significant infrastructure projects) to incorporate both Sharia-compliant and conventional aspects.

An area of growth relates to financial instruments known as Sukuk and usually in the form of certificates, which represent an undivided ownership share in an underlying asset or interest held by the issuer. This distinguishes them from both conventional bonds (which represent debt obligations of the issuer) and conventional equities (which represent ownership interests in the issuer itself).

The basic principle is that an ownership share in the underlying asset entitles the holder to a proportionate share of the returns generated by the asset and so the overall economic effect is similar to a conventional bond. Sukuk are used in combination with other techniques to allow a Sharia-compliant return on the underlying asset (such as rent, for example).

Yet the Islamic finance industry faces a number of challenges, including the fact that there are very few qualified Sharia scholars and there is no global consensus or regulation. This, combined with a high level of innovation and low transaction volumes, means that documents for the market (and the Sukuk market, in particular) tend to be tailor-made for individual transactions, leading to higher transaction costs.

The Government has indicated that it will monitor developments and act as necessary. For example, consideration is being given to SDLT, stamp duty and capital gains tax issues relating to Sukuk and further measures are likely to be announced this year, while the FSA and Treasury are also consulting on regulatory treatment.

However, it has also made it clear that it does not intend to adopt a state-led approach to the standardisation of products and documentation. Some progress has been achieved already by the adoption of standards created by international Islamic finance bodies, and adapting conventional practices (including guidelines issued by the Loan Market Association). So it is believed that the industry should continue to lead improvements in this area.

Similarly, the view is that industry should lead initiatives to raise awareness of Islamic finance, with Government support where appropriate, and should take the lead in addressing any skills issues faced by the sector.

Islamic finance is here to stay and will continue to move into the wider market, both on- and offshore. As such, it is important to be aware of it and, with experience of Sharia-compliant structures allied to offshore expertise, Semple Fraser can advise on all aspects of structuring and financing Islamic deals. 

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Semple Fraser LLP is a leading commercial law specialist, offering advice of the highest quality across a range of areas. With lawyers qualified in both Scots and English law, we have advised on numerous property finance transactions throughout the UK. The Banking & Finance Group of Semple Fraser LLP has expertise in all areas of banking and property finance, and works closely with the other specialist areas of the firm to provide the complete service to clients.

For more information on these topics, please go to www.semplefraser.co.uk, or contact Alex Innes on 0131 273 3771 or alex.innes@semplefraser.co.uk

Alex Innes is Head of the Banking & Finance Group of Semple Fraser LLP

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