Shereen Okkeh considers the practical application of the proposed new Islamic finance Shari’a standards which have been announced by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) as it prepares to launch a sweeping review of the industry.
- AAOIFI recently announced that there will be a major review of how the Islamic finance industry operates through the introduction of seven new standards.
- The seven new standards are designed to assist scholars decide whether financial activities and products conform with Shari'a principles and address issues including: financial rights, bankruptcy, capital protection, entrusting money to an agent for investment, contract termination, liquidity management (including sources and uses of funds and offering rules for calculating and distributing profits from investment instruments) and types of trust.
- The standards seek to strengthen the certification process for scholars and provide new guidance on the relationship between Islamic financial firms and their Shari’a boards similar to international best practices on terms of reference for financial institutions’ board of directors.
- AAOIFI standards are currently not compulsory and are not backed by any legal sanctions for failure to apply such standards, and as such it is totally discretionary for banks and financial institutions whether to apply them or not.
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) was established in 1990 and is based in Bahrain. AAOIFI is an Islamic international independent non-for-profit corporate body that develops accounting, auditing, governance, ethics and Shari’a standards for Islamic financial institutions and the Islamic finance industry globally.
AAOIFI recently announced in its annual meeting in Bahrain on the 8-9th of May 2012, that there will be a major review of how the Islamic finance industry operates by introducing seven new standards which aim to improve the operations of Shari’a boards, as well as strengthening the certification process for scholars and fostering the rise of a new, younger generation of Islamic scholars through new and improved training courses.
The Seven Standards
It has been reported that the seven new standards address issues including (i) financial rights and their management (ii) bankruptcy (iii) capital protection (iv) entrusting money to an agent for investment (v) contract termination (vi) liquidity management and profit calculation and (vii) types of trust.
Capital protection has been widely discussed in the industry over recent months. Some investment firms are keen to offer capital protection in their products, however Islamic principles do not allow companies to promise guaranteed returns.
We have witnessed in recent years many instances where an Islamic bank would enter into a wakala (agency) agreement with another Islamic financial institution to invest in certain Shari’a compliant products and the bank, acting as muwakkil or principal, would argue that the wakala was in fact a finance arrangement and that the returns on the investments must be guaranteed by the wakil or agent.
Under a wakala agreement the muwakkil and the wakeel both share in the profit and the risk of loss. The expected profits specified in a wakala agreement are indicative only and do not constitute a guarantee of the return. If the Wakeel makes a profit by the maturity date, the profits are shared with the muwakkil. Conversely, if a loss is made this loss is borne by the muwakkil in the absence of negligence, fraud or wilful default by the wakeel.
Having references to EIBOR or LIBOR as a threshold for calculating the expected profits which the Wakeel is to generate or the late payment amount, has been argued to be haram because the calculation of the threshold is based on a conventional bank's calculation of the cost of its money either to borrow or to lend and therefore may be deemed riba (usury or interest) as it is based on the cost of money which is technically not allowed under Shari'a Principles.
Therefore, it will be interesting to see how AAOIFI standards will address such issues in relation to capital protection.
AAOIFI's new standards are also expected cover the ways in which financial institutions manage their liquidity, including the sources and uses of funds and offering rules for calculating and distributing profits from investment instruments.
How to increase liquidity has been a key concern for Islamic banks. It has been reported that in April 2012, two global bodies namely Bahrain-based International Islamic Financial Market (IIFM) and the International Swaps and Derivatives Association (ISDA) launched a standard contract for Islamic profit rate swaps, which banks can use to manage their exposures over varying time periods. It yet remains to see how the AAOIFI standards will address this issue.
However, the extent to which, if any, issues concerning contract termination, bankruptcy and types of trust will be addressed remains to be clarified. It will be interesting to see how the new AAOIFI bankruptcy standards will work in light of the new proposed federal bankruptcy law for the UAE.
Islamic finance has witnessed a tremendous growth both within the Middle East region and outside it in the last few years. This is due to several factors including the strong support of large pools of Shari’a compliant funds in the Gulf and southeast Asia, which have not pulled back during the global financial crisis as Western funds did, as well as the Arab Spring uprisings that brought along with them a wave of new ideologies which, in some cases, are more prone towards Islamic principles.
However, such growth has also exposed certain weaknesses in Islamic finance. One such weakness is the lack of a clear consensus on what products and procedures are or are not permissible, with the Shari’a boards of individual banks and investment firms issuing conflicting rulings as well as often having one Shari’a board advising two different banks or investment firms on the same transaction.
This has led to some ambiguity in the way standards are being applied by the different Shari’a boards and a lack of transparency in the regulation of Islamic finance deals.
Lack of consensus amongst Shari’a boards has been evident in many of the deals we have advised on in the past, where the Shari’a board of one party to a transaction would give a certain interpretation on a provision of the agreement and the Shari’a board of the counterpart would give a different interpretation. This is compounded with the fact that sometimes the same Shari’a board represents both parties to a transaction. In such case there is a clear conflict of interest in acting for both parties to an agreement, and in the case of a wakala agreement having the best interest of the principal and the agent at the same time may prove almost impossible. If there is a dispute the Shari’a board will be acting for both the plaintiff and defendant. We do not think that such a position is tenable.
The ambiguity in the regulations have also led some financial institutions, such as Kuwait’s Investment Dar, to argue in court that contracts into which they had entered were not valid because they were not Shari’a compliant in the first place. Although Investment Dar’s argument was eventually rejected by the courts, it shed light on the lack of harmonious application of Shari’a standards and the ambiguity often involved.
In October 2011, Goldman Sachs had announced that it plans on a US$2 billion sukuk issue which would make it one of the first top Western banks to raise money in this way, its own Shari’a advisers approved the plan whereas some other scholars criticised it for not being Shari’a compliant. Seven months later, the sukuk has not been issued and it is not clear when it might be. Therefore, for many in the industry, AAOIFI’s planned reforms were received with great enthusiasm.
2. Shari’a Boards
AAOIFI currently offers two professional credentials which have been criticised as not being sufficiently rigorous and easy to obtain. There are now plans to improve the operations of Shari’a boards by strengthening the certification process for scholars and developing new guidance on the relationship between Islamic financial firms and their Shari’a boards “similar to international best practices on terms of reference for financial institutions’ board of directors” (AAOIFI’s Secretary General).
AAOIFI is also said to be looking at ways of fostering the rise of a new, younger generation of Islamic scholars, through steps such as training courses and as moving away from the handful of Shari’a scholars who have been on Shari’a boards for years and hold multiple board positions.
In our opinion, having Shari’a Scholars who are well trained and experienced in applying Shari’a principles in case of dispute between parties should be at the forefront of AAOIFI’s reform plans given the growth of Islamic finance deals and the increase in the number of agreements entered into between parties that opt to have Shari’a principles as the governing set of principles in case of dispute.
There is much debate on the Governing Law and Jurisdiction wording that is often included in Islamic finance documentation which states that any dispute “shall be governed by the laws of the UAE to the extent that such laws do not contradict Shari’a principles, in which case the Shari’a principles will prevail”. Under the UAE Civil Code priority is given to the UAE laws where it is clear on a particular point. Where there are no specific provisions in the federal laws that address such a point, a judge may revert to the Islamic Shari’a principles. Sharia scholars’ evidence ought to assist the court in determining if a deal was compliant or not but ultimately the court will decide the matter.
Therefore, having a clear understanding by the Shari’a boards of how Shari’a principles apply is of utmost importance in the case of a dispute where a judge may seek the Shari’a scholars’ advice.
AAOIFI standards are currently not compulsory and are not backed by any legal sanctions for failure to apply such standards, and as such it is totally discretionary for banks and financial institutions whether to apply them or not. Most countries, except for Bahrain and Qatar, use AAOIFI as references only without making them compulsory. Qatar has also issued a ban on conventional banks from offering any Shari’a compliant products or services in an attempt to streamline the Islamic windows.
Creating a compulsory code of conduct and strengthening enforcement of AAOIFI’s standards across the globe is likely to result in a more transparent and rigorous system of operation in the world of Islamic finance. It is understood AAOIFI expects to release a final draft of the reforms towards the end of 2013 at the earliest.