An Islamic product range has been developed for project finance, and has been deployed on several occasions. But issues surrounding advance payments, prepayment and total loss recur. These issues continue to dissuade the majority of sponsors from relying upon an Islamic tranche to fund or partially fund their Middle East projects. However, Shari'ah scholars and other key players are addressing these issues and pragmatism has become more common. However, Islamic project finance products are still far from commoditised.

Islamic finance has been a source of funds for many years, but it is only in the last few years that a product range has been developed that allows it to be applied in the Middle Eastern project finance market. The product range was developed for a number of reasons. One of those reasons was a desire by some sponsors to diversify their funding sources, due to the perceived or real liquidity shortfalls in the conventional bank debt market in the Middle East.

Since the beginning of 2000 at least 12 project financings that include an Islamic tranche component have been, or are in the process of being, arranged in the Middle East. Scarcely a large number when measured against the numerous project financings in the region since the start of 2000.

Sponsors (and their financial advisers) prefer to satisfy their financing requirements for a project through the conventional debt market, rather than through a mix of conventional debt and a Shari'ah compliant financing tranche. And for good reason. There are significant issues that exist in relation to the treatment of factors relevant purely to an Islamic tranche. Overcoming those issues is sometimes complex and can certainly be time-consuming - the latter being anathema to a sponsor wanting to raise finance.

The basic Islamic product for project financing is a lease (or the Ijara). The lease is extended from the Islamic financiers to the project company for an asset or assets over a given period with an option available to the project company to acquire the asset at the end of the lease. The lease can have a long term, often capable of matching the tenor of conventional debt.

It is the treatment of the asset that is the subject of the lease from a Shari'ah perspective that gives rise to the three issues that will be discussed. The first issue arises in the context of greenfield projects where the asset needs to be built, or at least delivered, before it can be leased to the project company. The second arises from any pro rata prepayment requirements across facilities, and the third relates to total loss of the asset.

Advance Rentals

In the context of a traditional forward lease structure (Ijara Mawsufah fi al Dhimmah), Islamic financiers can encounter considerable difficulty in being able to accept a return on their financing contributions prior to the commencement of the lease period of the assets that they are financing.

In a project finance scenario it is not uncommon for assets to be delivered and deemed capable of generating a return only at commercial operation of a project. This would only be likely to occur, depending upon the size and nature of the development, after construction, often long after the Islamic financiers would have closed with the project. So whereas their conventional counterparts would be receiving returns on their loans under the conventional facilities, the Islamic financiers would face a negative cash carry, having disbursed funds for the development and/or procurement of the assets the subject of the forward lease, but facing no prospect of a return on such disbursements for, potentially, an extended period.

The issue arises because, from a Shari'ah perspective, it is difficult to see how any return on the Islamic financiers' contributions in the period up to the delivery of the Islamic assets can be characterized as being a return generated from the assets themselves. These assets would not in this interim phase be delivered and capable of being leased, and therefore generating a return.

Some of the more progressive Shari'ah scholars have, however, considered it acceptable to provide for the payment of advance rentals during the development and/or procurement period until such time as the Islamically financed assets are actually delivered. This approach acknowledges the investment made by the Islamic financiers and recognizes that Islamic financiers need to see a return on such investment during a potentially protracted development period if the appetite for longer-tenor investment in this sector is to be sustained.

There are two main conditions that most of the Shari'ah scholars are agreed upon with regards to the payment of advance rentals, and how these ought to be characterised. The first is that, as such payments are rental amounts paid in advance, these should be deducted from rentals that fall due once the assets are delivered and the lease period begins. This is dealt with by providing for advance rental payments to be an additional component of the aggregate rental calculation after the lease has commenced, such that amounts paid as advance rentals are added to the first rental payment payable post-delivery or, alternatively are apportioned pro rata across all rental payments post-delivery, and set off against payments actually received as advance rental.

The second is that if the Islamic assets are not delivered and the lease period in respect of these does not commence, any advance rental payments made should be immediately returned for the obvious reason that the proposed Islamic assets are not capable of generating a lease return. In such circumstances the Islamic financiers would seek to rely on their termination rights under the Istisna'a, or works contract for the development and/or procurement of the assets in order to ensure that any obligation to repay advance rental amounts was adequately covered.

Prepayment

The ability to prepay is well established in conventional debt facilities. The project company simply prepays part of a debt obligation. But this is not so simple where a Shari'ah compliant lease structure is being used. The prepayment under the Islamic lease facility is typically structured through a call option mechanism. Under this, the project company is granted a call option by the Islamic financiers enabling it to purchase all or some of the Islamic assets at their outstanding base value on notice during the course of the lease period.

One of the constraints on the utilization of a conventional call option structure is that some Islamic financiers are of the view that Shari'ah does not permit an agreement for the sale of assets in the future under most Islamic (including Ijara (leasing)) products. The two most common exceptions to this (the Istisna'a and the Bei al Salaam) are not by themselves suited to long-term financing.

The position commonly accepted as being Shari'ah compliant is having a unilateral promise to sell granted by the Islamic financiers in favour of the project company. The enforceability of such a promise is not altogether clear. There is currently some debate as to whether the scope of the call option could be extended to offer a greater degree of flexibility in its use. As previously mentioned, the common position is that where a number of assets are subject to a lease, a call should only be exercisable against a specific asset or assets and in respect of the total outstanding base amount value of such asset(s) such that any prepayment is tied to the outstanding base amount value of such asset(s).

It may be possible to exercise a call against all Islamic assets such that the project company purchases an interest in all of the Islamic assets in proportion to their outstanding base amount values by the call price (prepayment amount) being applied pro rata against the outstanding base amount values of all existing assets. Under this structure the project company is provided with a proportionate beneficial interest in each asset similar to the interest held by each of the Islamic financiers. In such circumstances, the project company is required to forego any right it has to receive rentals or any other rights in the Islamic assets.

Total loss

Total loss provisions in Islamic financings continue to be grey areas in Shari'ah compliant leasing. There are a number of divergent views on the total loss scenario in the leasing context. The generally accepted principle is that if an asset suffers a total loss, it is no longer capable of generating a return and so the obligation to pay rentals in respect of such asset immediately ceases upon it having suffered such a loss.

It is also generally accepted that in such circumstances the Islamic financiers should, as owners, have primary recourse to the insurances in place for such asset (and indeed most Islamic financiers will insist on being named as beneficiaries under all policies procured for such assets). For some institutions, the extent of their recourse will be limited to the policies; the project company cannot be obliged to make the institutions whole, due to the Shari'ah principle that since the assets are owned by the Islamic financier it should assume the risk of total loss. In such circumstances therefore, the Islamic financiers are required to assume insurance risk including any delay in the processing and/or payment of a claim or non/inadequate payment under the policies.

Some Shari'ah Supervisory Boards, however, have accepted the position that the Islamic financiers may assign their rights to the insurance proceeds in favour of their appointed maintenance and insurance agent (which will typically be the project company) in exchange for the agent agreeing to make the Islamic financiers whole by payment upfront of a termination payment calculated to cover outstandings under the lease. While this approach is not universally accepted, it again demonstrates willingness on the part of the scholars to try and develop solutions to the constraints presented by the Shari'ah.

This naturally gives rise to intercreditor issues. To mitigate those issues, the project company (or the maintenance and insurance agent) can be required to replace an Islamic asset that has suffered a total loss with an appropriate asset that can become an Islamic asset for the purposes of the Islamic tranche. This can be structured so that there is no interruption to the Islamic tranche or the financing package taken as a whole.

Conclusions

A conventional debt facility does not have an identical risk profile to that of a Shari'ah compliant facility, although terms have become more convergent. Most of the key players have been extremely helpful in that process and have come to the table recognising that there are some greater gains to be had in the long term.

However, we are some way off from having a standard and agreed approach to the issues that arise and it is this that is limiting the attractiveness of Islamic financing products to sponsors wishing to raise capital in the Middle East. With the massive financing requirement in the Middle East over the next few years, there is little doubt that Islamic finance can and will take an increasing role in contributing to that requirement. But the degree of that contribution will be determined largely by the ability of the applicable Shari'ah scholars and key Islamic institutions to create a convergence in their respective views, so that Islamic products will ultimately be commoditised and not suffer from structural uncertainty.

John Inglis and Nadim Khan:

John is a partner in Norton Rose's Energy Projects Group in London. Nadim is a senior associate in the firm's Banking Department based in Dubai. Both John and Nadim have worked on numerous multi-sourced financings in the Middle East involving an Islamic tranche.