The Idea of Islamic Finance by Michael J.t. Mcmillen

Introduction

Michael J.T. McMillen is a lawyer by profession. He currently serves Curtis, a law firm, in the capacity of a Partner. His legal career is focused on project financing. He is also the Managing Director at a law firm called River Stone Capital. In addition to this, he has been teaching Islamic Finance to the law and business majors at University of Pennsylvania.He is the first one to introduce the idea of Islamic Finance to the American Bar Association and this earned him the title of being it’s Founding Chairperson. He was further nominated as the Chair of the Board twice. Euromoney has awarded him the distinction of being the Top 19 Pioneers of Modern Islamic Finance. He was also awarded the Best Legal Advisor, in the field of Islamic Finance, by the Euromoney, twice.

Since his work was primarily focused in the Middle East, and particularly in Saudi Arabia, he was given Sheikh Mohammad bin Rashid al Makhtoum award. This was to commemorate his efforts in introducing the first diminishing Musharaka and the first limited recourse project financing in Saudi Arabia.As far as McMillen’s academic background is concerned, he studied business administration at the University of Wisconsin. He then went on to pursue a degree in law from the same university and graduated in 1976. He augmented his studies further by studying medicine at the Albert Einstein College. Throughout his academic career, he was awarded distinctions for outstanding performance. In spite of studying medicine, he limited his professional experience to the realms of law. He has been practicing law since 1976. He is primarily known for his work in the field of Islamic Finance with an emphasis on project financing, sharia compliance and structuring sharia compliant financial products.

Over the course of forty years, McMillen’s law practice has been concentrated in project financing for manufacturing concerns, particularly in the energy, oil and gas sector. He is credited for leading the first limited recourse financing project in the history if Saudi Arabia and this has earned his numerous awards and titles such as the “Deal of the Year Award”. While working for an electric utility based company in the Kingdom of Saudi Arabian, he designed the first diminishing musharaka agreement.

McMillen made a note of the excess liquidity in the Middle East and realized that financial institutions that lend a hand to Middle East will not only be able to diversify in terms of identifying a new market but also establish long term relationship earn goodwill. Michael’s primary approach, as a lawyer, to drafting security documents involves starting with Shariah complaint terms first and then making adjustments to English law. This approach ensures that the credit guarantees do not lose their effectiveness and yields financing at lower rates.

Saudi Arabia always had trouble obtaining funds for large scale projects because the most commonly used financial products weren’t Shariah compliant. This was hindering their economic growth. The issue with mortgages and pledges was that they were not recorded, that is, it wasn’t know which lender has the right to asset. The right, in case of default, will be determined by the court through litigation. Therefore, financing was mostly done through local banks and this did not provide the ideal asset allocation from a diversification perspective. This also meant limited options for home financing.

The Mortgage Law are inconsistent with Saudi Arabia’s Shariah laws. Therefore, a need arose to create Rahn outside the Mortgage Law. Rahn states that when a charge is created, it can be either a pari passu, where everyone has an equal right to the asset. or it can have levels, where the first charge has a first right or priority over the asset.McMillen was on the legal counsel of Saudi Chevron petrochemical financing project. This was an opportunity for Michael to make the first limited recourse financing project in the history of Saudi Arabia and very quickly was adopted by the entire Kingdom of Saudi Arabia and the greater part of Middle East.

The main participants were the Project company, Saudi Chevron Petrochemical Company and the lenders. The major lenders included Chase Investment Bank Limited as the lead banker along with Gulf International Bank and Industrial Bank of Japan. The financing structure comprised of multi tranche loans which were secured against the future cash flows from the project and creating a charge over all present and future assets of the project and the Project Company. The agents were also appointed, one looking after the assets located outside of the country and the other looking after assets within the country. Inorder to make the financing product shariah compliant, it is necessary to for the investors to have some form of possession over the physical asset. However, giving actual possession of assets poses a great deal of risk therefore attempts at recording the assets in the past have been unsuccessful.

The Saudi government, therefore, thinks recourse through third party is the most effective option available. In case of the plant at Chevron, a limited recourse option was included, that gives investors right to some assets but not all assets. Due to the decrease in credit default risk, the cost of financing went down and meant the profitability would be higher. The Arab economy was in a growth phase and therefore, local and international banks took it as an opportunity to diversify their portfolios and increase their profitability. The bankers and legal counsel had to construe a security document that was shariah compliant, as Shariah is the governing law in the Kingdom of Saudi Arabia, in addition to the terms satisfying the lenders and raising the required amount of funds. The general approach taken my banks in the past was they would start with the American or British law and start making adjustments to it to make it shariah compliant. However, the final document by this time had lost it’s effectiveness to raise funds.

Therefore, Michael and his team reverse engineered the deed. They started the deed with the Shariah and made adjustments to it to satisfy the American and British laws. This proved to be more effective as British law offers greater flexibility.To prepare a line of defence and to protect the immovable assets, In cases of insolvency, cash was set as the first line collateral. The cash and other liquid/current assets arose from operations and sale of goods. The non current assets were identified as the ultimate collateral. The cash was placed at a bank in a third party offshore country, in case of Chevron, it was in England to assure the creditors.In order to understand the different claims on an asset (marhun), Michael’s team started their research with the very basic asset, used in the jurisdiction of Saudi Arabia, a camel. They then extended their search to other assets such as intellectual property, current and non-current assets. The concept of adl (trustee) is known to both Western law and Shariah. The person is mutually decided by the parties involved.

Since Chevron had both on shore and off shore assets, two ahls / trustees were appointed each looking after assets in their respective jurisdiction. An issue arose over the the governing law that would be used to monitor and enforce the security agreements. It was concurred that the English law will be used for the off shore assets and Arab law would be used for the on shore assets. As a result, two security documents came into being. The second issue arose over the appointment of adl / agent and the power of attorney. While the Arab law are revocable at the wish of either of the parties to the contract but the Principal’s powers supercede that of the rest. This puts the bank at risk and therefore it was decided that both the marhun documents and the assets will be placed with the adl but the adl could not sell it without the Principal’s permission.

The Saudi Arabian government was not in favour of recording the mortgage in the name of the banks as it assumes the payments in this regard are interest based. The idea was possession is central to a shariah compliant mortgage based transaction. Therefore a pari passu charge was created. A Bill of Possession was created for each Adl and then a Common agreement was drafted by bringing together the two individual Bills of possession.The Chevron case and the Rhan Adl structure is now used as a standard agreement and has opened new avenues for Arab based companies to exhaust for loans. In the past, companies used to heavily rely on personal and corporate guarantees. The use of Rahn Adl is now being extended to home financing and it is encouraging banks to commit to loans for longer durations.

Sharikat Mahassa Murabaha Financing

Through this project Michael used his legal experience to find a shariah acceptable way for debt financing an electric utility project in Saudi Arabia. The project was essentially for expanding the current power generation capacity of the power plant and to set up a transmission system. The legal counsel made use of sharikat mahassa, which is essentially an Islamic mode of joint venture financing. In order to make sure the third party has no or limited recourse to the assets, it is imperative that the third party remains unaware of the identities of the contracting parties. There were essentially five parties - the utility company, three banks and the engineering, procurement and construction (EPC) company.

Under a murabaha agreement, the bank purchases the asset, for it’s client, from a third party and resells it at a profit. The profit is declared at the start of the agreement. For the murabaha to work the bank could not resell the asset to the utility company until the bank had obtained ownership of the asset and made the payment to the EPC. The EPC was to remain unaware of the parties in the joint venture, that is, the banks. In sharikat, the banks or the investors hold a portion or a hissa (share) in the joint venture. They identify certain milestones during the construction of the project and purchase shares, in accordance with their share of the loan, from the EPC.By not disclosing their identity to the EPC, the banks were able to limit their losses. The major issue that arose from this was Shariah centred. Certain interpretations of the shariah said limiting the liability of the banks by not disclosing their identity will render the murabaha void. However, the arab interpretation of the Shariah allowed it. Had it not been permissible, the stage where the bank holds ownership of the asset, the bank is exposed to a great deal of price fluctuation risk and murabaha does not allow bank to change the price or their profit once the agreement has been signed.

The other possible disagreement with the Shariah Board was over the identification of milestones and selling the assets in parts. While some boards concurred with this practice other said it was advisable to sell the asset once it was completed in full. However, this exposed the banks to immeasurable risks. The repayment scheme was designed in such a manner that during the first two years, the part corresponding to the construction of the plant, no repayments will be made. By the end of the second year, the plant was expected to be commercially operational and capable of repaying it’s loan. During these five years, sixty consecutive payments were to be made.

Middle East’s First Diminishing Musharaka

Michael McMillen, while working in Saudi Arabia, introduced diminishing Musharaka financings for the first time in Saudi Arabia. The project was centered in the Saudi Arabian electric sector, and was later modified and extended for application in other sectors. His views were appreciated in the Islamic countries and became popular among many Islamic economies. His further work and research on house building finances set the founding pillars of modern day Islamic financing contracts. All of Oman adopted Michael’s designed structure of diminishing musharaka for home financing.

The key features that set apart a diminishing Musharaka contract are as follows:

• The bank and client jointly own the property
• The bank gives it’s share to the client and the bank gets rental payments in return
• The client has an obligation to repurchase these shares form the bank with the passage of time
• The rate at which units are repurchased varies from contract to contract
• As more units are purchased, the risk is transferred from the bank to the client.

Therefore, the rent is adjusted.Under such an agreement, the first step involves the purchase of the asset by the Bank’s Client. The property is jointly owned (Shirkat ul Mulk) by the customer and the bank. The bank meets the financing part of the agreement. More than one bank may be involved in the financing. Such type of a transaction is necessary for a diminishing Musharaka to take place and permitted as per Islamic Shariah.Once the property has been jointly acquired in the name of the customer and the bank, the bank will then proceed to lease the entire property to the customer and charge rent on the entire property. Certain scholars have raised concerns about selling the property to a third party. However, jurists have concurred that as long as the undivided property has been sold, it is acceptable. This is to ensure that the possession of asset aspect is satisfied.On the third stage, the Client starts purchasing the undivided units of the property from the Bank on a timely basis and hence the overall share of the Client in the ownership of the property increases as time passes.

Typically, the prices of the undivided units is decided with a mutual consent and the purchases payments are made according to an amortization schedule (used by the financier i.e. Bank). Every month, a payment is made to the Bank by the Client that includes a portion of principal amount as well as the rent of the property as the Client resides in it during the term of the agreement. The amortization schedule is almost identical to a typical loan schedule of a conventional 10 or 15-year mortgage financing. However, the terms are decided in the supervision of renowned Muslim Jurists and the Fatwas of Jurists belonging to different sects are considered and kept in mind.

The main problems that arose in such transactions included the conditions that were put in these agreements which is not allowed in Shariah. Therefore, the promise made to buy the house by the Client in several undivided units is made. The promise made is enforceable according to the majority Muslim Jurists as per the Shariah Law and such type of contract is known as “Bai-Bilwafa”.Therefore, it can be safely said that Michael J. T’s endless efforts and hard work has brought results for numerous matters that were previously unresolved. He has given the Muslim Ummah safe alternatives of the already existing types of transactions and without the elements of anything which can be considered as forbidden according to Sharia.

It is deduced from Michael’s work that after Saudi Arabia, Oman is also likely to offer house building loans to its people and is interested in the benefits that diminishing Musharaka has to offer. It is only a matter of time before other Muslim nations join and decide for themselves as well. According to Michael, he believes that as the Sultanate of Oman brings up the latest regulatory framework applicable to Islamic Banking, the latest trends of the industry will be gaining popularity in the country and the Islamic Finance will become a growing field. The diminishing Musharaka agreement can be terminated with mutual consent of the Bank and the Client if any or both parties’ interests start to differ after some time into the transaction. There can be two ways through which a diminishing Musharaka is dissolved.

In one way, the diminishing Musharaka is dissolved through the selling of the underlying property to a third party and the Bank and the Client both keep the profits in the ratio of the undivided units in their ownership at the time of the dissolution of partnership. In another way, the diminishing Musharaka is dissolved after the Client decides to purchase all the remaining units of the house by paying the total price up-front to the bank. Under this, new prices are decided (equal to the outstanding principal plus accrued profit plus fees, costs and expenses). If the Client fails to make all of the remaining payments for the units, the property is sold at an auction and the amount received Is used to make payments to the Bank and any remaining amount is given to the Client if the total value generated is greater than what was decided in the agreement.

In McMillen’s opinion the one thing that discourages the growth of Islamic products is the credit rating system. Since sukuks are often presumed as the shariah complaint version of bonds, the same credit rating system is used for both products. Since the present day credit rating system is built on the fundamentals of interest based financing, sukuks often end up getting a lower rating than a comparable bond. He therefore suggests targeting jurisdictions that have an understanding of shariah based financing and securitization. From a long term perspective, McMillen suggests working in collaboration with the major financing bodies, such as the World Bank, European Bank and the International Finance Corporation, to bring about reforms.