Once a niche for specialised institutions, Islamic finance has moved into the mainstream. Specialised regional Islamic institutions are experiencing significant growth; a swathe of international banks including HSBC, Citigroup, BNP Paribas and UBS have entered the market, and most recently the first standalone Islamic project financing – the Al Waha polypropylene and propane dehydrogenation project in Saudi sponsored by Sahara and Basell – reached financial close.

The UK is even looking at changing its tax treatment of Islamic product to give UK borrowers easy access to shari'ah compliant debt.

With growth has come product diversification and increasingly innovative financial structures. Islamic finance has become a significant and growing component of project finance, particularly for infrastructure projects in the Middle East.

In most Islamic financings incorporated within a multi-sourced project financing, the Islamic element of the project debt is provided pari passu with the other senior debt. Istisna'a and Ijara elements are frequently used: For example, Dolphin Energy signed a $1 billion four-year Istisna'a in September 2005, at the time the largest Shari'ah-compliant funding to be completed in the oil and gas sector (for more details search 'Dolphin' on www.projectfinancemagazine.com).

In March 2006, the $9.9 billion PetroRabigh petrochemical project also reached financial close. The deal incorporated a $600 million Islamic tranche provided by leading Saudi, regional and international banks – the largest long-term Islamic project financing in the Middle East and the first multi-sourced project financing in Saudi Arabia.

Islamic project documentation

Although becoming mainstream, the incorporation of Islamic debt into commercial project financings makes for more complicated documentation. Below is an example of a transaction that Freshfields advised on, summarising the structure and the documentation used: This transaction is for illustration purposes only and should not be considered as representative of all other Islamic project financings or as a model for other transactions.

Summary of key documents

The Islamic finance providers established an Islamic SPV to operate as their financing vehicle to own certain project assets and lease those assets to the borrower. The Islamic finance providers and the Islamic SPV appointed an Islamic bank as facility agent to perform each of their respective obligations under the Islamic financing documents, which included the following:

1. Islamic facility agreement

This credit agreement set out the terms regarding conditions precedent, representations and warranties, covenants, events of defaults and payment provisions on broadly identical terms to the obligations in the non-Islamic-compliant documents, (bar the payment of interest and procurement of insurance).

Istisna'a

This operated during the construction phase. Istisna'a is a type of sale contract under which one party agrees to produce a commodity which currently does not exist and sell it to the other party at the agreed price. Here, the borrower agreed to develop, construct and deliver the project assets according to certain specifications and sell the project assets to the Islamic SPV. The Islamic SPV agreed to pay for the project assets by phased payments (equivalent to advances of finance) to the borrower. If the borrower failed to deliver the project assets by the due date, it was liable to pay liquidated damages.

Subject to the intercreditor agreement, acceleration of the Islamic facility agreement would lead to termination of the Istisna'a. Upon termination, the borrower was to reimburse to the Islamic SPV all payments received less the amount of any liquidated damages paid, and the Islamic SPV was to waive all its rights and claims to ownership and title to the assets. The Ijara would also not come into effect.

Ijara

This operated after completion of construction. Ijara is a form of lease that provides for the financing of assets by the bank at the client's request and is based on an agreed rental. Following delivery of the project assets under the terms of the Istisna'a, the Islamic SPV agreed to lease the project assets to the borrower for the period of the lease and the borrower agreed to pay lease payments (equivalent to debt service) to the Islamic SPV. As owner of the assets, the Islamic SPV had de facto security over them.

Akin to the restrictions and covenants placed upon the borrower according to conventional debt facilities, the borrower undertook to use the leased project assets solely for the purposes contemplated in the Islamic facility agreement. Furthermore, the Islamic SPV and the Islamic facility agent made no representation or warranty as to the project assets so that risk of title, defects etc lay with the borrower who waived any claim caused by the project assets. The Islamic SPV's right to take any enforcement action (ie remedies following events of default) were governed by the terms of the intercreditor agreement.

The borrower was entitled to terminate the Ijara voluntarily by giving notice. Upon termination (including payment of the final lease payment (i.e. maturity), the Islamic SPV was to sell the project assets to the borrower according to the sale undertaking (see below) and the Islamic facility agreement. Subject to the terms of the intercreditor agreement and the other non-Islamic finance documents, the Ijara could be terminated following certain events of default.

During the term of this Ijara, the ownership of the project assets remained with the Islamic SPV. The borrower could require the Islamic SPV to repair, reinstate or replace project assets that were damaged or destroyed, save to the extent that such damage or destruction was caused by the borrower's wilful misconduct or gross negligence.

The Islamic SPV remained responsible for the major maintenance (maintenance of a capital nature) of the project assets so that they continue to provide the service for which the borrower leased them, although it was acknowledged that these maintenance obligations (and the procurement of insurance) would be sub-contracted to the borrower under the service agency agreement (see below). As with the 'operational covenants' contained in conventional financing of this nature, the borrower was responsible for 'ordinary maintenance' (eg inspections of the project assets, maintaining such assets in good and serviceable repair and maintenance of records).

2. Investment agency agreement

The Islamic finance providers and the Islamic SPV authorised the Islamic facility agent to act on their behalf to exercise their respective rights and perform their respective obligations under the Islamic finance documents. The Islamic finance providers, the Islamic SPV and the borrower acknowledged that the payments made by the Islamic facility agent directly to the borrower (sourced from the Islamic finance providers under the Islamic facility agreement) were payments satisfying the Islamic SPV's obligation to pay consideration for the project assets under the Istisna'a agreement.

3. Service agency agreement

The Islamic SPV owned the assets and appointed the borrower as its service agent to operate and maintain the leased project assets, keep such assets fully insured and pay any applicable ownership taxes, thereby restoring certain of the risks of asset ownership to the borrower.

4. Sales undertaking

The Islamic SPV undertook to sell the leased assets to the borrower upon payment of a lease termination payment (ie discharge of all outstanding amounts owed, effectively allowing prepayment of the Islamic facility and release of the rights of the Islamic finance providers upon discharge of the Islamic financing).

5. Purchase undertaking

The borrower undertook to purchase the leased project assets from the Islamic SPV upon payment of a lease termination payment (ie an acceleration of the Islamic facility).

1. Construction phase – borrower develops, constructs and sells project assets to Islamic SPV.
  As consideration, Islamic SPV makes phased payments to borrower (equivalent to loan advances).
2. Post-construction phase – Islamic SPV leases projects assets to borrower. Borrower makes lease payments (equivalent to debt service).

Other key features

Intercreditor arrangements

Given the principles behind Islamic financing outlined above, the Islamic finance providers were not party to the other finance documents. However, each of the Islamic finance providers were, through the Islamic facility agent, bound by the intercreditor agreement with the non-Islamic lenders and, therefore, subject to the intercreditor provisions governing the relationship between the lenders. These provisions included the method of voting and decision-making; arrangements for joint consultation and actions regarding approval rights and waivers; limitation of the parties' rights of enforcement upon default; and the application of proceeds upon enforcement.

Conditions precedent, warranties, covenants, events of default etc

This Islamic facility agreement contained various representations and warranties, covenants and events of default by the borrower.

Guaranteed returns

Unlike conventional financing, the Islamic facility agreement did not provide a guaranteed interest rate of return, as the prohibition of interest is a significant principle of Islamic financing. As an alternative, the Islamic finance documents provided for advance amount payments (providing an effect similar to interest calculated on the outstanding principal on or before the lease began) and a lease variable element (providing an effect similar to interest calculated at any time after the lease began).

While the Islamic finance documents did not contain any express provision for the payment of default interest, failure by the relevant party to pay any amount owing under the applicable Islamic finance document resulted in an obligation to make a payment connected to the delay. If an Islamic finance provider received a payment that was solely attributable to the borrower's delay in payment, that participant was required to hand over the net amount (after deducting the actual costs and expenses suffered or incurred by it as a consequence of the borrower's failure to comply with the applicable Islamic finance document) to such charitable foundation or scientific or medical institution as it selected.

Future prospects

The number and range of Islamic structured products is likely to continue to expand, as the finance community seeks to tap into the significant funds of Islamic investors seeking Shari'ah-compliant investments.

The increased participation in recent years of Islamic banks in financing infrastructure projects particularly in the Middle East, is very encouraging and will certainly lead to innovation in structuring and sourcing finance for projects.
Involvement of Islamic tranches in large infrastructure projects such as Qatargas II, PetroRabigh, and Oman Sohar Smelter clearly reflects the growing use of Islamic debt in the Middle East's project finance activity. These projects demonstrate the conventional banks' keenness to get involved in this field and that through careful structuring international banks and Islamic banks can successfully co-finance large-scale projects. The size of Islamic finance tranches in multi-sourced financings will increase and wholly Islamic financings of infrastructure projects will inevitably develop further.

Retaining conventional style documentation and a bankable governing law together with a greater consistency in approach among the Shari'ah boards seem to be key aspects in the growth of Islamic finance. Also crucial will be the ways lenders can innovate to meet the needs of the significant Islamic investor base.

The author:

Harnek Shoker is of counsel in the Dubai office of Freshfields Bruckhaus Deringer. He has worked on a variety of project finance transactions throughout Europe, the Middle East, and Asia.
The information and opinions contained in this document are not intended to be a comprehensive study, nor to provide legal advice, and should not be relied on or treated as a substitute for specific advice concerning individual situations.
This document does not reflect any changes in law or practice after 10 November 2006.