During recessionary times, one might ask a question: Is it possible to combine profit with business ethics and still earn money? When even those too big to fail can feel threatened and weakened by the contemporary state of the global economy, one should direct him or herself towards a way of doing business that respects higher moral values. Halal project finance can be seen as such an example.
Halal project finance is a project finance that is compliant with Shari’ah principles. In terms of project finance in general, one can say that it is one of the most popular modes of financing/investment. For example, Public Private Partnership (PPP) financing is where a state is involved and where the purpose of such financing comes down to providing the society with a public infrastructure facility like a bridge or a hospital. In conventional project finance (that is not the halal one), the main part of business is profiting from the investment itself and transferring risk. It means that the project itself should possess the ability to repay itself and also to divide the risk among the parties involved.
The parties to a standard project finance transaction include: sponsors, lenders and Special Purpose Vehicles (SPVs). While the lenders (usually the banks) provide the basic capital for financing (loan facility) the project (for instance, building a national road) and the role of the sponsors can vary. The public sponsors (representing the state) wish to reach a certain social goal (building a hospital) and can provide other parties involved in the project with the plot and building permissions. There are also private sponsors who can take part in the project for a variety of reasons such as private investors that participate in the structure for purely financial purposes. They allocate some part of their capital and they treat the project as an investment with a partially guaranteed return. On the other hand, the so called industrial sponsor can use the project as a way to facilitate or to improve the effectiveness of their existing business activity.
For project finance, there is always a special entity created called special purpose vehicle (SPV). The SPV is usually an entity that is legally and financially independent from the other parties. However, the independence of the SPV can be treated as superficial as the sponsors can act as its shareholders and in such way influence the activity of the company. The role of the SPV is to execute the project, manage it and to perform the main tasks (like choosing and employing the contractors, for instance).
In terms of risk transfer, as mentioned previously, all parties share the risk; nevertheless, the main burden of risk lies with the SPV. The question of the right risk management is especially crucial in project finance schemes that intend to comply with Shari’ah. If parties wish to perform in accordance with the Holy Qur’an they have to be aware of both compliance and legal risk that ought to be thoroughly analyzed prior to commencement of the project.
The first thing in halal project finance to be taken into account is the very purpose of the project. It has to be compliant to Shari’ah in its nature and has to agree with Maslaha (that is to serve the needs of the Muslim community and mankind). The aim of the project cannot at any stage contravene the principles of Shari’ah. For instance, the aim should not be limited to only making profit and should not involve accruing of interest. Moreover, if the whole project (or its authors, to be precise) intends to comply fully with Shari’ah, a due diligence should be conducted before project start.
Such due diligence should be conducted in terms of the project’s compliance with Shari’ah, where all parties involved should be scrutinized to eliminate the risk of mixing halal capital with non-halal one. Also, the parties involved cannot have any business experience contradictory to Shari’ah.
Analysis of the aforementioned factors can be seen as weighing of regulatory or compliance risk. Within this type of risk, one can also see the reputation risk which is very important for halal institutions. Their position on the market as halal firms depends on the compliance of their activities with Shari’ah. If even one of the issues (from the Shari’ah point of view) is not observed it could tarnish their reputation. I would even suggest that in case of halal investment the reputational and compliance risks are the most crucial and should be thoroughly examined prior to the investment. In order to mitigate the risk, one can address an Islamic finance rating company. Such firms offer an analysis of an investment or of a transaction in terms of its Shari’ah’s observance. A certificate issued by such a company can be treated as a guarantee that an examined business is compliant with Shari’ah.
The other question worth mentioning in respect to halal project finance, is the application of Islamic finance vehicles in such projects. The said SPV can function on the grounds of both musharakah and mudarabah. Musharakah is generally regarded as a perfect vehicle for joint venture investments. In case of PPP, where the state is involved, musharakah mutanaqishah seems to be a good solution. In musharakah mutanaqishah the shares of one shareholders are gradually taken over (purchased) by the other shareholder. In terms of PPP, such vehicle allows the state to actively participate in the project and also secure the full ownership by the state of a final product of the project.
If a mudarabah model is chosen as a SPV in project finance, then the contractor (or a party executing the contract – e.g. sponsor) will act as a mudarib and the state (or financial investor) as rabbul mal. The role of mudarib in such project is to provide know-how for the project, project management , and the role of rabbul mal is to provide the capital and equity (shares, land etc.). Mudarabah is a comfortable solution for these project that involve division of know-how and financing. Islamic banks as lenders can act as rabbul mal and contractors as mudarib. An SPV can also issue sukuk as a partial return for the lenders and sponsors involved in the project. That way, the SPV would combine two roles – an executive manager of the project and the issuer of the stocks (sukuk).
Also, to transfer the risk from the project finance, one can apply the solutions used in securitization and transfer the claims to another SPV (created for this very purpose) to issue some claim- backed shares (sukuk). Therefore, one can use two SPVs, and each one of them will play a different role in a project, also bearing in mind that in such way the risk will be additionally divided and hence lower for the sponsors and lenders. It is of great importance for the lenders as they invest their capital in the project and they expect the project to provide profit for them. If the project does not bring the expected return, the further division of risk could help. Also, if the parties decide to look for additional return for themselves or for the third parties, the SPV issuing sukuk can be regarded as an additional source of capital and risk transfer.
When incorporating a SPV, the parties have to verify if the laws of a country where the project is to be conducted do not contravene the basic principles of Shari’ah. If not, the parties should find the best legal model of a company that would be most suitable for the project and in particular, from a tax perspective. In many countries, an Islamic finance transaction can result in double taxation. The articles of association of the SPV should contain provisions that stipulate the aim for which the vehicle was created as well as the provisions stipulating that the SPV acts in compliance with the respective laws and principles of Shari’ah. The company can also employ a compliance officer for the project that will monitor the activity of the SPV and all stages of the project in terms of their compliance with Shari’ah. The existence of a compliance officer is also among other factors mitigating compliance and hence reputational risk.
The companies that wish to take part in halal project finance are the companies that want to act for the sake of barakah. And that is why such projects should be encouraged and popularized. However, one must not forget the risks present in such transactions. Tarnishing the reputation of such companies not only is detrimental to the project itself but also the reputation of Islamic finance institutions in general. And the participants in the halal projects have to be aware of these issues.
Beata Paxford, PhD, is an attorney at law and an assistant professor at the Chair of commercial law at Kozminski University in Warsaw, Poland.