The potential of Shariah-based syndication finance

Syndicated Islamic Finance is growing at unprecedented levels. Syndication means joint financing by more than one bank/FI to the same borrower against common terms and conditions governed by a common document (or set of documents). It is a good avenue through which large amounts of finance can be raised, while at the same time reducing the risks of each of the syndicated co- lenders. In syndication loan process, one bank or financial institution acts as the lead bank or lead arranger or mandated lead arranger (MLA). In larger syndication loan, there is more than one MLA who is responsible to arrange the required fund for the borrower. A syndication loan process may allow participating syndicated lenders to reduce their individual exposure and therefore, lower the risks associated with the loans/investments.
Syndicated Islamic Finance functions are a similar way to its conventional method. However, as with the most of Islamic finance, there are some differences. The majority of Islamic Finance scholars are of the opinion that when the lead bank looks to syndicate the loan or investment, it must sell it down at par. Therefore it cannot sell the debt at a discount or a premium. The lead bank is, however, allowed to charge an administration fee for managing the syndication process.
In Islamic syndication financing process, banks typically enter into an Investment Agency Agreement (IAA), which relies on the principle of agency. The lead bank will enter into an IAA with the participating investors in the syndicate, where the lead bank will also be a part of the syndication. In conventional method of syndication process, it is called facility agreement (FA).
Generally, the lead bank acts as the wakeel (the agent) and the banks participating in the syndication act as muwakkils (the principal) in the contract. The wakeel is the managing agent of the funds and the muwakkils are the providers of the fund. The IAA stipulates the conditions of participation and describes the underlying contract documents to be entered into the wakeel, the purpose for which the funds should be employed and the obligations of the parties involved.
While there are a few differences between Islamic syndicated loans and conventional syndicated loans, the principal difference is the philosophical underpinning of these transactions. In conventional loan syndications, commercial and legal considerations are generally the only issues that determine the terms and forms of these transactions and the rights of the parties. By contrast, in case of Islamic loan syndications, the conditions will be complied with like, a) Shariah principles including the prohibitions against riba, gharar and maysir, b) restrictions to invest in products and services that are haram. For example, the borrower cannot be involved in the manufacture, production or sale of tobacco products, pork or alcohol or involved in providing gambling or pornographic activities or services, c) necessary approval of Shariah scholars or the Shariah committees of the lenders.
There are some challenges of shariah-based syndication. While Islamic syndicated financing is derived from the same fundamental notions and shares some of the same commercial considerations as a conventional syndicated financing, it presents some unique issues. These issues include: the absence of standard documentation, the Shariah approval process, the methods of syndication and same legal platform globally.
The Islamic finance industry does not have a universally agreed form of documentation to match its conventional counterparts (which tend to use the documents prescribed by a loan market body, such as the Loan Market Association (LMA) in the UK and the Loan Syndication Transactions Association (LSTA) in the US. As a result, the documents used in a Shariah-compliant structure must be vetted by the lenders (with the assistance of their in-house legal team or external legal advisors) to ensure that they understand their rights and obligations under the documents. This may be a cumbersome and time-consuming process. However, these documents are typically based on LSTA and LMA forms, which enable conventional lenders to participate in an Islamic syndication by giving them an established frame of reference for understanding their rights. The investment agent or lead arranger can take responsibility to nominate a common legal counsel to vet the syndicated documents under Shariah.
The loan and syndication documents must also be approved by the Shariah scholars or boards of the lenders. This may restrain the syndication process because the arranger may not be able to sell down its underwriting commitment to a new bank or financial institution unless the financing or the structure is deemed compatible with Shariah, as interpreted by the Shariah scholars or boards of that new bank or financial institution. As noted above, certain transaction structures have been criticized as disguised loan transactions and some Islamic financial institutions will not participate in them. These syndication-specific issues are in addition to the other issues that the Shariah approval process may present such as: the insufficient number of Islamic scholars who are available to assess the Shariah-compliance of Islamic finance transactions and the over-representation of certain scholars on the boards of certain companies.
The arranger, the lenders and their respective counsel must also consider when and how the loan should be syndicated. Assignment or Novation of the loans depending on the structure of the transaction, Shariah scholars or the Shariah committees of the investment agent may not permit it to novate or assign its financing commitment. Shariah prohibits trading in debt. The sale by the arranger of an interest in the loan, which is the essence of the syndication process, is not permissible. As a result, any novation or assignment must be of an asset. This is not an issue for asset-backed structures such as ijara or istisna'a. In these structures, the investment agent is selling its interest in the underlying asset (the asset under lease in the case of an ijara transaction or the asset being manufactured in the case of an istisna'a). However, this is an issue in structures that rely on a payment stream, such as the Murabahahor, the Tawarruq. In these structures, once the investment agent has sold the asset to the borrower, its only interest is to receive the purchase value of that asset.
Many conventional syndications have flex language that allows the arranger to change the terms of the loan to give it the flexibility it may need to attract investors. Some of these transactions also include reverse flex language that gives the investment agent the right to modify the terms and conditions of the financing to make it more favourable to the borrower if the loan is oversubscribed and give the borrower the benefit of an attractive deal. Flex language can also be incorporated in Islamic syndicated financing. Depending on the change the agent wants to make, the investment agent may need to obtain the approval of its Shariah committee. In addition, the agent must consider whether it can sell down the loan at a premium or discount. Generally, Shariah scholars and boards only permit a sell down if it is done at par or if there is a tangible asset that backs the commitment being syndicated. This is intended to mitigate the argument that the lead bank is trading in debt, which is generally not permissible under Shariah principles. This, however, may cause a problem for the investment agent if the transaction is fully underwritten, because it would be forced to fund the entire commitment if it cannot sell the loans at a discount to attract investors.
Many conventional loan syndications give the lenders the right to participate the loans. Although superficially an Islamic syndication has components that are similar to participation, it is a very different structure. If the lenders are considering participation, they must consider the following issues also:
n Will it be permitted by their Shariah committees? Because of the prohibition against trading in debt, a lender who wishes to participate a portion of its loan must do so at par unless the transaction is using an asset-backed structure. If an asset-backed structure is being used, the lender can sell any portion of its interest in the underlying asset at any price it chooses.
n If permitted, can it be affected through a funded or unfunded arrangement? In a funded arrangement, the participant gives the existing lender a deposit up front (which is a portion of the principal amount of the loan), to be repaid from the proceeds of the loan. By contrast, in an unfunded participation, the participant agrees to give the existing lender a portion of the loan under certain circumstances (for example, if the borrower defaults).
There is so much potential for Islamic syndicated finance to grow and expand, being a useful and important financing tool particularly at times of financial crisis, due to escalation of risks and pooling of resources. Despite controversies surrounding certain Islamic financing structures, the flexibilities accorded by Islamic principles present the market participants with opportunities to push for more innovative and attractive Islamic syndicated finance products.
The writer is Deputy Managing Director & Chief Business Officer
of Prime Bank Limited.
[email protected]