The Project Finance Law Review: Islamic Finance
Islamic finance is concerned with the conduct of commercial and financial activities in accordance with Islamic law, or shariah (derived primarily from the Quran, the holy book of Islam, and the Sunnah, words or practices instituted or approved by the Prophet Muhammad (PBUH)). Islamic finance emphasises productive economic activity over pure speculation, and encourages transaction counterparties to share profits and losses to promote collaborative efforts.
For project financings to be shariah-compliant, structures and techniques have been developed to accommodate the priorities of such Islamic-compliant participants. This chapter will:
- outline the key principles relevant to Islamic finance transactions (Section II);
- examine the typical funding structures deriving from those principles (Section III);
- discuss the application of Islamic finance principles and structures in a project finance context (Section IV); and
- address the particular challenges of combining Islamic finance with conventional project financing techniques (Section V).
II Principles of Islamic Finance
Shariah is a body of law applicable to Muslims governing conduct within Islam, and is derived from two main sources; the Quran and the Sunnah (the words and deeds of the Prophet Muhammad (PBUH)).
There are a number of prohibitions under shariah that are relevant to commercial activities. Generally, if something is not prohibited (haram), it is allowed under shariah (halal). Therefore, to ensure compliance with Islamic law, individuals and companies must seek ways to arrange their affairs in accordance with a set of key principles that underpin the relevant prohibitions.
The shariah principles that are relevant to project finance are as follows:
i Riba (excess)
Riba means making unjust or excessive gains from commercial arrangements while assuming little or no risk, and is strictly prohibited under shariah. The prime example of riba is the charging of interest on a loan – mere exposure to the creditworthiness of the borrower over time is seen as insufficient risk for the reward received. The effect of this principle is that any provision involving payments that could be deemed interest would be void. Instead, the lender must participate in some way in the potential profits and losses of the enterprise being financed.
ii Gharar (uncertainty)
The prohibition on gharar means that any agreement whose fundamental terms are deemed too uncertain is invalid under shariah. For example, some insurance contracts where there is uncertainty around the occurrence of an event could be void under this principle. This is to encourage disclosure of details as between the parties and limit the impact of chance.
iii Maysir (speculation)
While the ordinary commercial risk of carrying on a business is permissible, shariah prohibits transactions that rely predominantly on speculation. On the basis of this principle, together with gharar above, many conventional derivatives contracts are problematic from an Islamic finance perspective.
iv Qimar (gambling)
In a similar vein to some of the above principles, any transactions that are tantamount to gambling are prohibited under shariah.
In addition to complying with the above principles, lenders wishing to be shariah-compliant must take care not to invest in certain prohibited (haram) products or businesses, such as casinos or drinking establishments.
III Islamic finance structures
The primary structures used in Islamic finance transactions represent a way to meet the priorities of investors and entrepreneurs in various circumstances while adhering to Islamic finance principles. These structures are in widespread use among industry participants seeking to be shariah-compliant, though there may be nuances according to the jurisdiction and other local considerations.
All of the main Islamic finance structures share common features. These include the sharing of profit and loss among transaction parties (and consequently a preference for equity over debt), and the involvement of real and tangible assets. Because of these features, Islamic finance is used as a form of both asset-backed and asset-based financing.
i Ijarah (lease)
The ijarah is typically used in project financings where the asset already exists in some form. It is a type of lease arrangement whereby the lender takes ownership of an asset and leases certain usage rights over it (known as usufruct) to the project company in return for rental payments.
The two types of ijarah are the ijarah wa iqtina, in which the asset is sold back to the project company either at the end of the term or over the course of the lease period (akin to a finance lease), and an arrangement more akin to an operating lease whereby the lender retains the asset after the lease has ended.
Forward sales are generally prohibited under shariah for reasons of uncertainty (gharar). However, shariah does permit a form of forward lease common in project financings known as ijarah mawsufa fi al-dhimma. Under this arrangement, rental payments only become due once the project company takes delivery of the asset, which ensures sufficient certainty.
The istisnah is also commonly found in project financings as well as other contexts. Unlike the ijarah, it is more suited to financing an asset that is yet to be built or developed. Under this structure, a contractor undertakes to construct or develop an asset, and in return receives payment from the financier, either in the form of an upfront advance or phased payments over the course of the construction period. On completion, and provided certain specifications are met, the contractor delivers the asset to the financier who sells (or leases) it immediately on to the project company. In practice, this company is often the same entity as or affiliated with the contractor.
The murabahah is well suited to trade finance scenarios and can be adapted to form a structure that mirrors the effect of a conventional loan without riba (the commodity murabahah). Under the traditional murabahah structure, the financier purchases the asset from a supplier then sells it on immediately to the customer in return for a deferred payment. This deferred payment includes a mark-up reflecting the amount that would be paid as interest under a conventional facility agreement.
The mudarabah is suitable for investment ventures in which the financier agrees to have a closer involvement in the project, and is used for shariah-compliant investments. It is a joint arrangement in which the financier (known as the rab-al-mal) contributes capital and the other party (the mudarib) is responsible for carrying out the work, usually for a fee. The parties agree in advance the proportions in which to share any profits between them.
The rab-al-mal is the only party that assumes the risk of losses resulting from the venture, and any attempts to transfer this risk to the mudarib are likely to be prohibited under shariah principles. An example of this is UAE-based issuer Dana Gas, who was arguing that its mudarabah should be unenforceable as the risk of losses was improperly mitigated by a guarantee provided to the rab-al-mal by the mudarib.
The musharakah is seen as the most suitable vehicle for sharing profits and losses in accordance with shariah principles. This is because it involves agreeing the proportions in which profits are shared but agreeing that losses are to be distributed to the parties according to the amount of capital each has invested. Control in this arrangement is usually exercised by one of the parties as agreed, though both are entitled do so under the musharakah structure.
In a variation of this structure, one party can buy out the interests of the others (for a negotiated fee) over the term of the musharakah. This is known as musharaka muntahiya bittamleek, or a diminishing musharakah.
Sukuk are bond-like instruments and are often referred to as such. However, although they mirror the effects of conventional debt securities, they are trust certificates. Under a sukuk instrument, one party holds an asset on trust for the sukuk holders, and the issuer of the instrument makes predetermined payments to those investors based on the income from the underlying assets. Those payments ensure a regular return and the certificates can be redeemed once they mature. In addition, sukuk are in certificated form and can be traded on securities exchanges if listed. Such features mean sukuk act in analogous ways to conventional debt-based bonds, while complying with shariah principles.
The two main types of sukuk structures are asset-backed sukuk (where certificate holders hold direct (beneficial) rights in the underlying assets), and asset-based sukuk (where investors are only entitled to the cash generated by those assets).
Each of the structures referred to above can also be combined effectively in a project financing context. A common example of this would be using a mudarabah or musharakah as an investment vehicle to provide capital for the construction of an asset by means of an istisnah. An ijarah structure could then be used for the leasing of the completed asset to the project company.
IV Islamic Project Finance techniques
Typically, a large project will require multiple funding sources for both the construction and post-completion phases (a multi-source project), enabling project risk to be spread among a greater number of investors. The need to obtain funding from certain countries may also be driven by geopolitical considerations.
In a shariah-compliant financing, such sources might include financial institutions providing facilities analogous to loans, Islamic financial institutions (IFIs) or investors in sukuk (transferable financial instruments analogous to bonds), alongside conventional lenders, Export Credit Agencies (ECAs) and bondholders.
Each of these participants has different objectives and requirements. IFIs must ensure a high level of adherence to shariah principles, both in how finance is provided and the purpose or purposes for which the funds are used. ECAs, on the other hand, are concerned with the extent to which funds are used to promote exports for the country of origin.
The way in which the financing is arranged must therefore accommodate the needs of each of these funding sources. For example, a separate Islamic facility with separate documentation will cater for the IFI that is prohibited from lending directly to the project company lest any return be considered riba. Meanwhile, project sukuk might also be used to gain access to a larger pool of investors.
The remainder of this section will examine the Islamic facilities and project sukuk financing methods in more detail within the context of a multi-sourced project financing.
i Islamic facilities
The two main types of Islamic facility are wakala-ijarah and istisna'a-ijarah.2 These both enjoy widespread commercial acceptance and tend to be used in combination. Project sukuk have also been used in multi-source project financings in the Middle East.3
Wakala-ijarah and istisna'a-ijarah facilities
First, the assets to be financed using Islamic bank facilities are identified, known as the Islamic assets. The construction financing for these Islamic assets only is provided by the wakala agreement under the wakala-ijarah facility, and the istisna'a agreement under the istisna'a-ijarah facility. Meanwhile, conventional facilities provide the financing for the rest of the assets in the project.
In a conventional project financing arrangement, the project company will make phased payments upon request to an engineering, procurement and construction (EPC) contractor, known as EPC milestone payments, out of funds received under a bank facility. In an Islamic facility, amounts equivalent to EPC milestone payments are instead provided by the IFI to an Islamic facility agent, which then pays these amounts to the project company. In return, the project company makes rental payments (mirroring the interest under a conventional facility) to the IFI's agent. These will be paid in advance while the Islamic assets are being constructed.
Once the Islamic assets are complete and operational, the IFI (either directly or through a special purpose vehicle) leases the right to use the assets to the project company in return for lease payments, under an agreement known as the ijarah mawsufa fi al dhimma. Generally, once the lease period expires, the project company takes ownership of the Islamic assets. However, in certain cases, ownership might be transferred gradually to the project company over the course of the lease, for example, in an istisna'a-ijarah arrangement.
Governing law and dispute resolution
Islamic facility agreements give rise to particular challenges when it comes to both the governing law to be used and the appropriate jurisdiction for the resolution of disputes. One common preference is for English law to be the governing law in respect of Islamic bank facilities in project financings and for the English courts to resolve disputes arising under them. This is because the English courts have long been prepared to hear disputes arising in other countries provided that the agreements are governed by English law. It also means the parties can rely on an established and consistent case law that does not have multiple interpretations (or madhabs) and is used to dealing with issues arising in complex, cross-border financings. The English courts are also seen as generally more favourable to creditors than forums in other jurisdictions.4
However, this approach gives rise to the risk of conflict of laws issues. This is firstly because of the doctrine of lex situs, which states that it is the law of the jurisdiction in which an asset is located that should govern the proprietary aspects of that asset. This means that if the project is to finance an asset in one country, then the law of that country may have automatic jurisdiction over the agreements underpinning the project. Moreover, a given agreement may be unenforceable if it is inconsistent with the local country's laws.
A second concern in respect of shariah-based provisions is that it may be unclear whether English law or shariah principles should prevail in case of a conflict. In approaching this question, it is worth asking whether English judges possess the necessary expertise to decide cases involving Islamic principles, and if they were to do so, which interpretation (or madhab) they would apply.
The English courts have customarily approached these issues by ruling that any shariah-based elements are part of the commercial content of an agreement, not its legal and justiciable provisions. Therefore, only English law principles will be applied and the parties must satisfy themselves that the document is shariah-compliant using other channels.5
In practice, this is done by an agreed expert on shariah giving a fatwa (or ruling) to the above effect, before the parties enter into the agreement. The parties will typically include provisions within the facility agreement acknowledging that each is satisfied that the document in question is fully compliant with shariah and that the fatwa stating this is legitimate.6
Participants in project financings are increasingly opting for Islamic facility documents to be governed by local laws, particular for Middle Eastern projects. This may be owing to the requirements of the local country, the doctrine of lex situs as outlined above or the influence of domestic lenders.
Events of default
With multiple financing instruments using a variety of structures and having a variety of objectives, it is important for the project company in multi-source project financings to agree a common terms agreement (CTA) with the financing parties, which sets out the terms that are common to all the instruments in the project. It will then need to be an event of default under the CTA if an event of default occurs under one of the Islamic facility documents. This guarantees that the various facility documents are linked for the purposes of events of default, remedies, revenue and enforcement cash waterfalls, and that the conventional facilities are ranked pari passu with the IFIs where this reflects the intention of the parties.
Termination and mandatory prepayment
In a conventional loan facility, the lender accelerates the amounts lent on the occurrence of an event of default, by issuing an enforcement notice and calling in the loan pursuant to the relevant provisions in facility documents. In a shariah-compliant arrangement, acceleration occurs by the providers of the Islamic financing requiring a 'termination sum' from the project company. In an istisna'a–ijarah facility, this is done by the IFIs exercising a kind of put option known as a purchase undertaking, while in a wakala–ijarah facility, they would require the lessee to make a termination sum payment in accordance with the lease agreement.
ii Project sukuk
Under a sukuk, the returns payable to the certificate holders are based on the performance of a real asset, which makes it an ideal structure for use in project financings.
One type of structure that is frequently used is the sukuk al–ijarah, which is employed in asset-backed and asset-based financings. Under this arrangement, the trust certificates are issued by a special purpose vehicle (SPV), which uses the proceeds to acquire certain assets from the seller (the Islamic assets). The SPV acts as agent and trustee for the sukuk holders, who each have a joint and undivided proprietary interest in the Islamic assets (along with the other holders). The Islamic assets are then leased to the project company, which makes rental payments to the SPV in exchange. The amounts paid as rent will include both the price of the assets and a margin as markup, which may be fixed or floating (based on LIBOR). The issuer uses the rental proceeds to make periodic payments to the certificate holders such that each investor obtains a return on their investment on a pro rata basis. At maturity, the project company is required to purchase the Islamic assets from the issuer for an amount equal to the outstanding rental payments. The issuer uses these funds to make a final distribution in redemption of the certificates from the investors.
In a multi-sourced project financing, project sukuk are typically asset-based, meaning that the issuer is a senior creditor and is entitled to the monies received from disposal of the assets should investors vote to accelerate upon an event of default, among other sources of funds. Thus, the certificate holders are only entitled to the cash amounts due and payable to the issuer – they do not have a right to take ownership of the underlying assets or sell them to repay debts owing to them under the certificates. It is only when all the finance parties vote for a general acceleration pursuant to an inter-creditor agreement that the issuer, acting on behalf of the certificate holders, has right as a senior creditor to take possession over the secured assets of the project.
Status of the project sukuk
The parties must decide, prior to entering into a project sukuk, how the instrument should rank in relation to the other senior facilities. If a pari passu arrangement is chosen, there are several issues to consider: whether the periodic distribution amounts should be paid at the same level in the cash flow waterfall; whether the security given by the project company should be shared among different creditors; and what arrangements should be put in place in respect of inter-creditor voting rights.
Holders of sukuk certificates may enjoy rights akin to those granted to investors in conventional bonds issued under Regulation S or Rule 144A of the US Securities Act 1933. This is the case in respect of certain voting rights such as on specified waivers or the right on an event of default to trigger and vote on enforcement action. Investors in both types of instrument also receive the benefit of incurrence covenants only.7
Other matters to consider when structuring and issuing a project sukuk
The following key considerations apply when structuring and issuing a project sukuk (most are also relevant to conventional bond issuance).
Given that the distributions made to certificate holders by the issuer may be treated differently for tax purposes depending on the jurisdiction, it is important to choose the place of incorporation for the SPV issuer with this consideration in mind.
If the project sukuk are denominated in a different currency to that in which the revenues of the project are generated, this will expose investors to exchange rate fluctuations. The currency of the sukuk certificates may therefore need to be the same as the project currency. There may also be local regulations that restrict the currencies that can be used for the project sukuk.
The SPV issuer, together with the project company, will need to publish a prospectus and comply with any other applicable capital markets regulations. While this document will in most respects be the same in form and content as prospectuses for conventional listed securities, a project sukuk prospectus will also include the fatwa attesting to the instrument's compliance with shariah. This is typically prepared by the shariah supervisory board of the SPV issuer, the project company, or the joint lead managers of the sukuk.
More generally, the risk of non-compliance with shariah principles should be mitigated to the extent possible, both when it comes to the project sukuk and any other Islamic finance arrangements. The importance of this was seen in the case of Dana Gas PJSC v Dana Gas Sukuk Ltd and others.8 In that case, one party argued that a mudarabah agreement governed by UAE law did not comply with key shariah principles (following a development in jurisprudence), and that as a result the purchase undertaking agreement based on it (which was governed by English law) should be found to be void on the grounds of mistake. This argument was rejected by the English High Court because there were contractual safeguards that addressed any risk of non-compliance with shariah that had been agreed between the parties. In addition, there was a dispute over the location in which the obligations of the contract should be considered to have been performed. The court found that as payments under the purchase undertaking agreement had been made to a London bank, the correct location was not the UAE but England. Neither shariah nor UAE law were therefore relevant to whether the agreement was enforceable. The case demonstrates the essential nature of provisions within contracts that deal with non-compliance with shariah (for example, warranties and representations). The outcome also has a significant bearing on the performance of payment obligations in jurisdictions that are not governed by shariah.
V Integrating the Conventional and Islamic Facilities
Any issues that might appear when combining the Islamic structures discussed above with conventional elements of the financing must be addressed and solved as early as possible in the structuring process. Many of those issues and their solutions have been mentioned already in other sections of this chapter. The most important among them are those relating to the relationships between the different finance parties, and in particular the inter-creditor arrangements between IFIs and conventional lenders.
For example, it is essential as an inter-creditor matter to harmonise provisions dealing with events of default and the exercise of remedies between the conventional facilities and the Islamic facilities. No creditor would be willing to accept another being able to accelerate its loan following an event of default under that facility, but not be able to accelerate itself upon occurrence of the same event. After all, though the asset or assets in question may have several very different sets of funding arrangements, it is one project being funded and must be treated as such.
Care must also be taken over the coordination of payments from the project company from its cash waterfall to the creditors, both when it comes to scheduled payments and prepayments (mandatory or voluntary). This depends on the commercial terms that have been agreed, but will be especially important if the IFIs rank pari passu with the conventional lenders. In a typical pre-enforcement waterfall under an inter-creditor deed, the IFIs and the senior conventional lenders are entitled to returns in proportion to the level of their investments.
However, some scholars ruling on shariah compliance may not allow certain funds to be distributed to conventional lenders, such as sale proceeds from the Islamic assets or rental payments under a lease made prior to the transfer of the asset to the project company.
The Islamic and conventional financing parties must therefore agree the following:
- the circumstances under which decisions under the inter-creditor agreement and the CTA are to be made jointly between the conventional lenders and the IFIs;
- whether an IFI can unilaterally take a decision to accelerate its own facility, with the effect that acceleration is not required to occur under the conventional facilities; and
- if the conventional lenders need to be consulted on an acceleration decision, what the voting threshold should be – a lower threshold is advisable because there are usually many more conventional lenders than IFIs, so it may be difficult to obtain sufficient consent.
The extent of the security given by the project company is also a significant consideration when incorporating Islamic finance into a project financing. A key question is whether the scope of the security should be limited to the project company's obligations to the conventional lenders, or whether it should also cover obligations to the IFIs. Finally, because security is usually given over the whole project, it is important to take into account the effect of this on the Islamic assets and any sharing of security among the various creditors, including with the conventional banks.
1 Munib Hussain is a senior associate at Milbank LLP.
2 The Shuaibah IWPP project in Saudi Arabia was the first to use the wakala–ijarah facility structure in December 2005. It was later used in the Marafiq IWPP located in Jubail, Saudi Arabia (May 2007), the Al Dur IWPP located in Bahrain (June 2009) and the PP11 IPP (June 2010). Examples of the application of istisna'a–ijarah structures include the Qatargas 2 LNG project located in Qatar (December 2004), the Rabigh refinery located in Saudi Arabia (March 2006), and the PP11 IPP.
3 The Sadara Integrated Chemical Project located in Saudi Arabia (June 2013) and the SATORP Jubail Export Refinery Project located in Saudi Arabia (June 2010) were both examples of this.
4 Though it has been implemented in various countries such as Saudi Arabia, shariah cannot be said to pertain to any particular country. This connection is a requirement of an agreement's governing law under the Convention on the Law Applicable to Contractual Obligations 1980 (the Rome Convention).
5 See Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd  2 All ER (Comm) 849. A recent judgment in the English High Court (Dana Gas PJSC v Dana Gas Sukuk Ltd and others  EWHC 2928) also confirmed that this was the correct approach. The latter case involved a UAE-based issuer called Dana Gas (DG), which argued that its mudarabah sukuk should not be enforced on several grounds, including non-compliance of the sukuk with shariah. DG initially attempted to obtain a judgment in the Sharjah Federal Court of First Instance. However, because it was English law that governed several of the sukuk documents, it also successfully applied to the English High Courts for an interim injunction preventing any declaration of event of default or dissolution event from the certificate holders under the sukuk. DG partially based its argument for this on the Ralli Bros principle, which renders unenforceable any contract governed by English law containing an obligation to take an action in a certain location where doing so in that location would be unlawful. A judgment handed down on 17 November 2017 found DG to be unsuccessful on all grounds.
6 Any sukuk prospectus will also include a similar disclaimer from the issuer.
7 In a possible exception to this, however, the project sukuk in two Saudi Arabian projects (the Sadara Integrated Chemicals Project and the SATORP Jubail Export Refinery Project) ranked predominantly pari passu in relation to the conventional senior debt. This was done so that the certificates would appeal to Saudi Arabian investors who buy these kinds of securities with a view to holding them for a long period of time. This is for several reasons: firstly, conventional debt securities issued under Rule 144A or Regulation S would not normally have the level of protection afforded by both maintenance and incurrence covenants; secondly, certificate holders would be able to redeem them early whenever any of the senior facilities were subject to a mandatory redemption; and finally, investors would also benefit from the security given in the project financing on a pari passu basis with the other senior creditors.
8  EWHC 2928 (Comm).