Issue Twelve

Boom time for lawyers in Gulf

The expansion of law firms into the Gulf states mirrors the increase of work in conventional and Islamic finance. Evelyn Fernandez reports on the underlying causes and prospects for legal services The pace of economic development in the Gulf Cooperation Council (GCC) countries may not be Formula One, but it certainly is fast-moving. Dubai's crane-spotted skyline is evidence of the rapid growth, and a presence in the region has become strategically important. Among the services setting up shop are international law firms hoping to compete with established names such as Norton Rose, Clifford Chance and White & Case, all with long histories in the Middle East. The new contingent includes Herbert Smith, Vince & Elkins, DLA Piper and Linklaters, each looking to carve a big slice of the regionís burgeoning economy. Craig Nethercott, co-head of the Islamic finance practice at White & Case in London, says the infux of law firms in the GCC is a second wave. The firmís regional office in Riyadh was established in 1991. High oil prices, capital repatriation, increased liquidity as well as the growth of international and indigenous banks in the region were key drivers for the first wave of law firms. Norton Rose, which began operations in Bahrain back in 1979, set up an office in Dubai four years ago. It is now considering a third regional office. Dominic Harvey, managing partner of the firmís Bahrain office, contends: It is only in the last five years, as the economic growth curve rose sharply, along with the bull market in the GCC, that firms moved to add the Middle East into their expansion strategies. Vince & Elkins is one example. V&E, headquartered in Houston, opened its Dubai office four years ago and has 10 lawyers servicing its clients with plans to grow the office "significantly" this year. Additional regional offices are under consideration. V&E's work in the Gulf comprises representation in leading regional and international energy projects, private equity, capital markets and real estate. It is also witnessing increasing demand for legal services in litigation and intellectual property.

Protect your assets

All banking transactions carry a certain level of risk. But in Islamic banking, the more conventional risk management strategies might not be enough to assess transactions, writes Nadeem Syed. The standard risks associated with all financial products such as credit risks and market risks are also related to the conventional product risk profiles and are not a distinct topic of discussion from a strictly Islamic banking perspective. Islamic financial products relate largely to trade-based or asset-based financial instruments. Hence, risks associated with these businesses tend to be reflected in these financial instruments as well. In most methods of Islamic finance, the financial institution is at some stage the owner of the financed goods. In a few cases, particularly asset financing, certain risks may be attributable to legal ownership. There may also be obligations associated with the asset/transaction that must be assessed at the structuring stage to avoid surprises. Here are some common risks and issues. If the asset is destroyed or becomes unfit for use while the financier owns it, responsibility falls on the financier, so long as the customer did not cause the damage willfully or negligently. Potential liabilities, for example, environmental, incurred due to owning or supplying the asset, must be considered. The responsibilities of insurance and maintenance of the asset should be carefully allocated between the obligor and the bank typically according to each specific transaction. Risks relating to product liabilities/warranties need to be assessed. These can be minimised through proper legal documentation and permissible assignments. It is important to analyse how the proposed Islamic facility structure is treated for tax purposes. It's possible that this financing may be disadvantageous relative to a conventional loan—for example, tax exposures connected with the physical location or operation, or the particular characteristics of the asset. It may be possible at times to manage such issues through the use of financing vehicles in tax neutral jurisdictions or countries having taxation treaties.

Adapting to emerging trends

The Islamic economic system could provide a useful means for helping Muslims reduce dependency on non-Muslims, increasing investment and sustaining growth, writes Professor Amer Al-Roubai. In the past several decades, Muslim countries haven't been successful in achieving a satisfactory level of economic development. As a result, there has been a call for an alternative economic approach, so that Muslim economies can free themselves from the public_html of Western theoretical paradigms. Since independence, following the Second World War, Muslim countries have employed a wide range of capitalistic and socialistic economic ideologies, but have failed to gain adequate socio-economic progress. In most Muslim countries, economic policies remain incapable of combating poverty, creating employment opportunities, increasing productivity, enhancing competitiveness and improving human development. Not only are income inequalities between and among Muslims large, but also the knowledge gap between Muslims and non-Muslims is widening. Although they represent approximately one-quarter of the world's population, Muslim countries in aggregate account for less than five per cent of global income. With the exception of a few oil-rich states, human development in Muslim countries ranks among the lowest of all nations. The call for economic restructuring and accelerating socio-economic development has brought the subject of Islamic economics to the centre of the debate. Islamic economics and Islamic finance have been introduced as an alternative for Western economic ideologies and financial services, which are incompatible with the existing cultural, ethical, social and environmental realities of local development.

Salam provides the solution

Traditional hedge funds use non-Shariah compliant transactions such as derivatives, which have led to a distrust of the instrument. The salam method may provide the answer, writes Dr Muhammad Qattan Since the first hedge fund was set up in 1949 by Alfred Jones, "the father of the hedge fund", and Fortune reported in 1966 that his strategy outperformed conventional funds by 87 per cent over the previous 10 years, the hedge fund industry has gone from strength to strength. There are now 8,000-10,000 hedge funds available from nearly 3,000 managers worldwide, with at least US$1.16 trillion under management. More than 56 per cent of all hedge fund managers are in the US, 38 per cent are in Europe and three per cent are in Asia. It is estimated that 67 per cent of Asia-Pacific hedge fund managers pursue the long/short equities strategy. Of all hedge fund assets, 46 per cent are invested in the US, 40 per cent in Europe and 9 per cent in Asia. In the Middle East, there were more than US$28.8 billion investments in hedge funds in 2005. According to the the Bank of New York, Middle East investment companies will pump no less than US$71 billion into hedge funds until 2010, which will form 14 per cent of the total investments in hedge funds. A fund of funds is very much related to hedge funds. It forms 17 per cent of all hedge fund strategies and, according to industry sources, 20-25 per cent of all hedge fund assets. At the time of writing in March, there were 1,134 funds of funds. Of these, 114 are specifically global long/short equity funds of funds, which are expected to maintain a 14 per cent compound annual growth rate. It is the general consensus that hedge funds cannot be considered as a homogeneous asset class, because hedge fund appellation follows all kinds of strategies and structures. Generally, hedge funds offer the chance to play against the markets, using short-selling, futures and other derivative products. They are also a way of offsetting investment risk. In theory, "perfect hedging" is a strategy to offset gains and reduce losses.

Addressing Basel II compliance

Compliance with Basel II is a way of forcing major changes within banks by local regulators. There must be consultation to address issues that may be disadvantageous to Islamic banks, says Asad Jafree. The Islamic Financial Services Board (IFSB) finalised its guidelines for Basel II in December 2005 with the objective of addressing the specific structure and contents of the Shariah-compliant products not specifically addressed by the Basel II guidelines to standardise the approach in identifying and measuring risks in Shariah-compliant products and services and in assigning risk weights that meet internationally acceptable prudential standards. The IFSB guidelines have been based on those of the Basel committee, with modifications and adaptations to cater for the characteristics of Shariah-compliant products and services. Islamic banks differ from conventional banks due to the exposure of market risk (in addition to credit risk) in their banking book products, depending on the nature of the Islamic product and the stage of the contract. The guidelines cover asset-based Islamic financial instruments—murabaha, salam, istisna, and ijara—profit-sharing Islamic financial instruments—musharaka and mudaraba—sukuk (securities) and investment portfolios and funds. There are several differences between the guidelines issued by the Basel committee and IFSB, far too many to detail elaborately in this article; however, I have summarised some of the key differences that could affect the capital intensiveness or lead to potential competitive disadvantages for Islamic banks. Namely, I will cover the following issues:  Constituents of regulatory capital and consolidation and deduction framework.  Advanced approaches for the calculation of risk-weighted assets. π Treatment of equity exposures in the banking book. The IFSB guidelines do not clearly detail the constituents of tier one and tier two capital. Conventional banks are permitted to include subordinated debt in their tier two capital.

Follow the yellow BRIC road

Emerging markets such as Brazil, Russia, India and China (BRIC) are providing fertile ground for lucrative returns and a way to diversify Shariah-compliant portfolios, writes Andrew Broadley Investment markets thrive on uncertainty. What makes one person believe that he should sell certain shares at the current price and another person decide that he should buy those shares at the very same price? The seller is happy to sell because he thinks that his share is now at fair value and worth disposing of; the buyer is happy to buy because he believes that the share price is undervalued and is on the way up. Who will be right? If there were certainty in future share price performance, it is unlikely that the seller and buyer would conclude the transaction. The uncertainty allows both to make judgments about the future and reach different conclusions on the best path to follow. It would have been rewarding to know whether to buy shares at the start of and throughout the really big economic boom periods—the Industrial Revolution; the growth of the US economy; the spectacular rise of the Japanese economy; the emergence of the Asian tigers; the information technology and communications boom. The investment returns would have been handsome, but only if one had known when enough was enough and it was time to be a seller. There are many persuasive factors to indicate that the next big investment theme will include one or all of the emerging markets of China, India, Brazil and Russia. The current argument goes that China and India have large and growing populations, which are moving to the cities, acquiring jobs, earning money and becoming middle-class consumers. Their abundant supply of labour provides a global competitive advantage to manufacturing companies and outsource-service businesses. There is an inflow of capital into the region fuelling growth. It follows there will be many companies that can successfully and profitably provide the goods and services these large populations will demand. The argument extends to identify that Brazil and Russia are abundantly blessed with natural resources and that there will be many companies that can harvest them and make significant profits given the undoubted demand from the never-satisfied world.