Order of Seminar

1. Allen & Overy Islamic Derivatives SeminarRichard Tredgett, Andrew Sulston & Nick Williams, Partners Priya Uberoi & Ian Carnochan, Senior Associates 28 November 2008

2. Order of Seminar • Islamic Finance – An Introduction • Islamic Hedging and Risk Management (Ta’hawut) • Sharia-compliant Funds and Hedge Funds • ISDA / IIFM Ta’hawut Master Agreement • Conclusion

3. Islamic Finance – An Introduction Priya Uberoi, Senior Associate

4. So what is Islamic Finance? Isn’t it just a lot of funny sounding words and over-complicated structures?

5. Background • Body of institutions and commercial and financial arrangements which adhere to the core tenets of Islamic law (Sharia) • The idea of Sharia-compliant financing has been prevalent for over 1,400 years (at the advent of Islam), slowly evolving over the centuries • Phase of more dramatic growth can be traced back to the founding of the Islamic Development Bank (some 30 years ago) and more recently the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the International Islamic Financial Market (IIFM)

6. Growth so far………. • The industry has been growing at around 10% per annum (FSA) for the last decade with Allen & Overy helping to lead the way • Over the last five years, Islamic banking assets have been growing at a rate of just under 20% p.a. (Financial Times) • Steady rise in Sukuk issuance from $500mln in 2002 to $60bln in 2007 (Standard & Poor’s) • Balance sheets of Islamic banks grew by 40% in 2007 (Euromoney) • Estimated 300 Islamic Financial Institutions holding $700bln of assets under management and the industry could control $4trln of assets by 2010 (The Economist)

7. A Global Rapidly Expanding Industry • Many banks are establishing Islamic banking operations, joint ventures and subsidiaries in the Middle East (e.g. Deutsche Bank) • Ever increasing range of Sharia-compliant indices produced by Dow Jones, FTSE, Standard & Poor’s and MSCI • The industry has increasingly international appeal (significant recent developments in traditionally non-core markets including the UK, Turkey, Egypt, Pakistan, Morocco and Tunisia) • Estimated 1.2 – 1.5bln muslims globally, 20% of world’s population • UK government support - HM Treasury's Islamic Finance Experts Group was established in April 2007 to advise the government on supporting the development of Islamic finance in the UK, and cementing London as a global Islamic finance industry hub.

8. The Vital Statistics • The Islamic finance industry is already a $1trln industry (Global Investment House) • Industry growth estimates predict 15-25% annual growth over the next five years (Risk Magazine and The Economist) • The global Sukuk market is valued at $70bln and is expected to top the $160bln mark by the end of the decade (Standard & Poor's) • Over $1trln in projects in the Middle East already in the pipeline • Middle Eastern investors estimated $1,200bln of investment in international assets in recent years (HSBC) • Despite oil prices tumbling 56% from a record $147.27 on July 11 (Bloomberg), oil at $50 is enough to sustain growth (Saudi Arabian Monetary Agency) and the Middle East region is expected to earn $20trln of oil revenue in coming years and as much as a third of this may be invested in the Islamic finance sphere (Financial Times / KPMG)

9. The Sovereign Wealth Funds • The Sovereign Wealth Funds (SWFs) in GCC at present collectively manage $1.5trln assets • SWFs of the GCC states hold assets estimated at (IMF, 2008): • UAE – $875bln • Saudi – $289bln • Kuwait – $213bln • Qatar – $50bln • Oman – $2bln • Bahrain – $10bln (Sovereign Wealth Fund Institute) • Projections suggest that foreign assets under management of SWFs could reach $6-10trln by 2013 (IMF, 2008)

10. Sovereign Wealth Funds and recent market turmoils • While SWFs do not want to be seen as white knights, they are not sitting on the sidelines (Financial Times) • The Qatar Investment Authority and Abu Dhabi’s ruling family have together recently invested £5.8bln in Barclays Plc, representing a stake of over 30% (Financial Times, Reuters) • The Abu Dhabi Investment Authority, which in November 2007 bought a $7.5bln stake in Citigroup, is already eyeing attractive US assets (Reuters), KKR has appointed Lehman’s ex head of sovereign wealth to push into the Middle East (Financial Times), Prudential is in talks with two SWFs over the sale of a 20% stake in the insurer (The Independent) • “The Gulf states will have a vital role to play in agreeing the plans to get the world economy moving again…. they are increasingly important source of inward investment in the UK” (Gordon Brown) • The US would welcome investment from SWFs (Deputy US Treasury Secretary – Robert Kimmitt), France’s state-owned finance house wants SWFs to become co-investors in a new investment fund used to fend off foreign predators (Reuters) • Although SWFs are expected to become more cautious and conservative about their investments, and more likely to shop around and hold out for bargains, they will be looking for opportunities (Financial Times)

11. Sharia Fundamentals • Sharia carries ethical, social, political and religious dimensions that informs its structure • It is derived from a number of primary (Quran, Sunnah and Hadith) and secondary sources (Ijtihad, Ijma and Qiyas) • Not a codified body of law • There are a number of schools of jurisprudence (Madhabs) • There are a number of core tenets of Sharia which must be considered in the context of financial transactions

12. Tenets of Islamic Economic Thought • Riba - Prohibiting the receipt and payment of interest - the return of an investment should be linked to profits actually generated • Gharar - Avoiding uncertainty - e.g., traditional insurance, indemnities, options, need to be adapted • Maisir - Discouraging speculative behavior - e.g., speculation, gambling, games of chance • Sharik - Advocating risk sharing – investors should earn returns by sharing profits and assuming the risk of any loss • Haraam/Halal - Prohibiting haraam activities - e.g., activities that are strictly forbidden under Sharia, such as financial investments in alcohol, pork related activities, tobacco, gambling and pornography • ‘Aqd - Maintaining the sanctity of contracts

13. In the Context of Derivative Transaction • For example, a conventional cross-currency swap would infringe the tenets of: • Riba • Gharar • Maisir

14. So how do we approach this as lawyers? • It is all about innovation • Using knowledge of both: • classical Islamic financial and commercial arrangements; and • conventional products, to create new structures that replicate the returns of conventional products but in a way that does not offend the tenets of Sharia.

15. Sharia Scholars & Boards • The Scholars • Small number of scholars specialising in the application of Sharia who have played a significant role on the offshore structures to date • There is a wide range of views and scope for uncertainty • Notable scholars include: • Sheikh Taqi Usmani (Pakistan) • Sheikh Nizam Yaquby (Bahrain) • Sheikh Hussain Hassan (Dubai) • Dr. Mohammed Ali Elgari (Saudi Arabia) • Dr. Abus Sattar Abu Ghuddah (Syrian based in Saudi Arabia) • Dr. Muhammad Imran Ashraf Usmani (Pakistan) • Dr. Mohd Daud Bakar (Malaysia) • Sheikh Yusuf Talal De Lorenzo (USA)

16. Sharia Scholars & Boards • Role of Scholars • Islamic institutions place reliance on their opinions (fatwas) in determining whether transactions are in compliance with Sharia • Weight is given to the identity of the scholars • Prior to launching a transaction, the scholar/board will issue a fatwa confirming that the transaction adheres to the tenets of Sharia (this fatwa may be disclosed) • Appointing and Dealing with Scholars and Sharia Boards • Scholars may be employed on a transaction by transaction basis or through the establishment of a Sharia board • Establishment of a Sharia board can provide greater comfort to Islamic investors or counterparties • Based predominantly in the Middle East and Pakistan • Typically three scholars on retainer • Typically commercially astute and have exposure to issues through acting on several Sharia boards for various banks (often with educational background in Western economics or finance) • Involved whilst settling the term sheet and in reviewing the penultimate draft of documents • Typically contact is through telephone, fax and email but meetings also usually required • Typically a renowned scholar can earn up to $250,000 on a capital markets deal • Fatwa • One, some or all parties to a transaction may or may not be bound by the fatwa • Not all aspects of the transaction necessarily have to be covered by the fatwa • No precedent system for fatwas (save for public deals)

17. Documentation and Enforceability • Legal documents are usually drafted to be governed by either English or New York law • Questions of enforceability of obligations are dealt with according to the applicable national law • With exceptions (Sudan, Iran and Saudi Arabia), Sharia is not the national law • As Sharia is not the governing law of the documentation, being bound by Sharia is essentially elective and seen as an extra layer of compliance • The Shamil case affirms that English courts will only ever seek to interpret English law and will not interpret Sharia • It is for each party to satisfy itself that a transaction is compliant with Sharia • Subsequent ruling by scholars that a transaction does not comply with Sharia will not affect its enforceability under the applicable national law

18. Islamic Hedging and Risk Management (Ta’hawut)Andrew Sulston, Partner Priya Uberoi, Senior Associate Ian Carnochan, Senior Associate

19. Islamic Hedging and Risk Management Given the core Sharia tenets one might conclude that derivative transactions may contravene the prohibitions of gharar (uncertainty), maisir (speculation) and riba (interest)

20. Islamic Hedging and Risk Management • However, market witnessing embryonic stage of an OTC Islamic derivatives market • In November 2006 Bank Islam Berhad and Bank Mumalat Malaysia Berhad agreed to execute a pro-forma derivative Master Agreement for documentation of Islamic derivative transactions • ISDA/IIFM joint initiative to develop a Sharia-compliant Master Agreement. ISDA (International Swaps and Derivatives Association) IIFM (International Islamic Financial Market) • Most common forms of derivative transactions used by Islamic banks and corporations are cross-currency swaps, profit rate swaps, total return swaps and fund index-linked derivatives • In recent years, some Sharia scholars have gradually accepted the use of hedging as a tool of prudence and risk management • “There are a few instruments which have been ‘tamed’ and designed to be alternatives (to) conventional derivatives. These are relatively new and we have to look into them” (Sheikh Nizam Yaquby) • Given current market volatility, producers, consumers, counterparties and scholars are more aware of the need of hedging market risk and demand for such products is growing accordingly

21. Islamic Hedging and Risk Management Through innovative structuring of traditional Islamic products (e.g. Murabaha, Wa’ad, Arbun and Salam) we can replicate conventional derivative cash flows in order to generate a similar economic profile in a Sharia-compliant manner and actually increase the range of asset classes traditionally not available to the Islamic investor

22. STEP 2 Financier sells Assets to Buyer for $(x + y) (where y is the pre-agreed profit element) Assets Price $(x+y) STEP 1 Financier buys Assets from Seller for $x STEP 3 Buyer settles price at end of an agreed period in one lump-sum or in instalments Assets Price $x Murabaha – cost-plus financing FINANCIER (BANK) BUYER (COUNTERPARTY) SELLER *Islamic finance is based on real assets

23. IDR interest quarterly (Interim Amount) IDR 350 at maturity (Final Amount) 1 Initial ExchangeIDR 350 at inception BANK ISLAMIC COUNTERPARTY USD 100 at inceptionInitial Exchange 2 USD interest quarterly (Interim Amount) USD 100 at maturity(Final Amount) Conventional Cross-Currency Swap (IDR / USD) • Islamic Counterparty = Paying IDR and Receiving USD • Bank = Paying USD and Receiving IDR

24. An amount from the Islamic Counterparty’s own funds in USD/IDR to be used to fund Reverse Murabaha + an amount in IDR as collateral 5 9 1 Deferred Payment at IDR 665 in 40 instalments Immediately following Re-sells Metals at IDR 350 Sells Metals at cost price (IDR 350) After instructions to Bank to act as Collateral Manager for the Islamic Counterparty under the Reverse Murabaha Term Murabaha Buys Metalsat Cost Price from own funds 2 Seller On-Sells Metals at IDR 350 ISLAMIC COUNTERPARTY BANK On-Sells Metals at USD 100 Proceeds in USD for Islamic Counterparty’s own use 3 7 4 6 Reverse Murabaha 8 Sells Metals at IDR 350 Deferred Payment at USD 190 in 40 instalments Sells Metals at Relevant Amount Islamic Cross-Currency Swap (IDR / USD) CASH ACCOUNT COMMODITY BROKER Buyer Seller Buyer immediately To cash account of the Islamic Counterparty with Bank SUPPLIER Sharia-compliant Separation between Murabahas • Islamic Counterparty = Paying IDR and Receiving USD • Bank = Paying USD and Receiving IDR

25. FIXED RATE PAYER FLOATING RATE PAYER Conventional Interest Rate Swap Series of fixed rate payments Series of corresponding floating rate payments • Each of the fixed and floating rate payments is made by reference to a preagreed notional amount

26. COLLATERAL ACCOUNT FLOATING RATE PAYER Sells Commodities FIXED RATE PAYER Sells Commodities SUPPLIER SUPPLIER Islamic Profit Rate Swap Cashflow = Aggregate Deferred Sale Price = Cost price + Fixed Profit portion Term Murabaha Security for taking credit risk on the Counterparty BANK Delivers Commodities Sells Commodities $ Cost Price Revolving Murabahas to match the periodic payment dates under the Term Murabaha Cashflow = Full commodity value + floating rate profit portion (linked to LIBOR) payable at the end of each revolving Murabaha (NB. The full commodity value payable should mirror the corresponding Cost Price payment under the Primary Murabaha)

27. UK Tax - Introduction • UK government’s aim for Sharia-compliant products to be taxed in the same way as equivalent financial products • UK tax legislation • "Alternative Finance Arrangements" • Description of certain types of structures (Murabaha, DiminishingMusharaka, Sukuk, Mudaraba, Wakala) • Other requirements • UK tax consequences • Loan • Interest

28. UK Tax – Profit Rate Swap • Purchase and Resale (Murabaha) • One of parties has to be a financial institution • Difference between sale price and purchase price = return on an investment of money at interest • UK tax consequences if an alternative finance arrangement within the UK tax rules? • Taxed as loan relationship • Interest - withholding tax • If not treated as an alternative finance arrangement? • General UK tax principles • Non-UK parties with UK agent?

29. Conventional Credit Default Swaps • Recent excitement in market to produce a Sharia-compliant credit default swap (CDS) • Attempts have been made to create this product • What is a conventional CDS? • CDS is contract whereby a Credit Protection Buyer purchases credit protection from a Credit Protection Seller on a third party Reference Entity / Reference Obligation • CDS can be either cash / physically settled • The Credit Protection Buyer pays a premium to the Credit Protection Seller in return for a payment that is triggered on the occurrence of a set of pre-defined Credit Events

30. Islamic Credit Default Swaps • First Method • Capped indemnity structure • Whereby an Islamic institution sold credit protection to a bank on Reference Obligations under a capped indemnity Problems • Credit Protection Buyer has to suffer an actual loss, whereas in a conventional CDS no loss is necessary to trigger a payment • The amount of the credit protection has to be “capped” to ensure compliance with Sharia, as cannot have an unlimited Indemnity, principal of gharar – avoiding uncertainty • Insurance re-characterisation concerns • Second Method • Cash settled CDS based on a bespoke A&O Sharia-compliant Master Agreement • Working with clients to come up with alternatives as to how to produce an Islamic CDS

31. SPV uses £ to purchase Shares in e.g. BA 7 2 1 5 3 4 9 6 8 Shares Coupon payments (converting conventional cash flows into Sharia-compliant cash flows - matches deferred basis income stream from the Reverse Murabaha) Reverse Murabaha £ Sells Commodities SPV SPV receives dividends on shares Investors/CertificateHolders Bank Trust Certificates Receive £ for Commodities on a deferred basis Murabaha SPV uses £ from dividends to purchase Commodities at spot market rate Commodities Reverse Convertible Structure Markets Sells into the market SUPPLIER

32. What are Sharia-compliant (Halal) Shares? • Easy answer - Shares listed on the DJIMI (Dow Jones Islamic Markets Index) • One example of how the DJIMI categorises a share as being “non haraam” employs specific screens • Industry Screen (Sin Screen) - excludes shares in companies that deal in haraam activities e.g. gambling, insurance, casinos and pornography • Debt Equity Screen - excludes shares in companies whose total debt comprises 33% or more of its balance sheet • Many other types of screens that organisations use to categorise whether shares are haraam or halal

33. Wa’ad Structure • Literally means “promise” • Can be regarded as a unilateral undertaking by one party to do or not to do certain actions in the future • Does not bind anyone but the promisor (i.e. the party giving the undertaking) • Contrast this with a bilateral contract (aqd’) which binds both parties to the contract • English law, draft under deed poll: lack of consideration

34. Wa’ad Structure • Binding nature and enforceability is a subject of debate amongst scholars • Sample of views: Group A Imam Abu Hanifah, Imam Al-Shafai’, Imam Ahmad and some of the Maliki Jurists • Fulfilling a promise is noble but it is neither mandatory nor enforceable through a court of law Group B Samurah b. Jundub, Umar b. Abdul Aziz, Hasan Al-Basri, Said b. al-Ashwa’, Ishaq b. Rahwaih, Imam Al-Bukhari and some Maliki Jurists • Fulfilling a promise is mandatory and the promisor is under a moral as well as a legal obligation to honour his promise Group C Some Maliki Jurists, Islamic Fiqh Academy (IFA) • A promise is not binding under normal circumstances but becomes binding where the promisor has caused the promisee (i.e. the party having the benefit of the undertaking) to incur certain expenses or undertake work or any form of liability

35. Single Wa’ad (FX Put Option) • In the event the customer does not deliver a cancellation notice in respect of a Wa'ad, the cashflows will be as follows: Purchase price in currency 2(Payable on Settlement Date) Bank(Seller) Customer(Buyer) Specified amount of currency 1(Payable on Settlement Date) Non-refundable fee (Payable on Trade Date) • In the event the customer delivers a cancellation notice to the bank in respect of a Wa'ad, the cashflows will be as follows: Bank(Seller) Customer(Buyer) Non-refundable fee (Payable on Trade Date)

36. 3 4 £ to purchase the Assets(Purchase Price) Sharia-compliant Assets Wa’ad (1) – Issuer promises to sell the Assets at Wa’ad Sale Price Issue Price Certificate Holder Bank Issuer 1 6 Wa’ad (2) – Bank promises to buy the Assets at Wa’ad Sale Price Certificates 5 7 2 Wa’ad Sale Price Sharia-compliant Assets Double Wa’ad Structure (Total Return Swap) Markets

37. Sharia-compliant Funds and Hedge Funds Nick Williams, PartnerPriya Uberoi, Senior Associate 28 November 2008

38. Current State of the Sharia Funds Market • Despite the latest market turmoils, financial institutions are still pressing ahead with Sharia-compliant funds: • BNP Paribas has just launched its first Sharia-compliant fund, the Global Equity Optimizer (The National, UAE Newspaper); • Currently $21bln invested in Sharia equity funds (Faliaka Advisors)

39. Funds - What’s happening in the Sharia funds market? Strategies – participating in and sharing the risks of a joint venture • About two thirds: • Index tracker funds – Sharia indices e.g. Dow Jones/FTSE • Long equity funds • Sukuk/income funds • Balanced managed funds • Real estate/private equity/infrastructure • Hedge funds • Fund of funds Structures: • Retail or institutional investors/HNWI • Regulated Funds • Alternative investments: • Closed ended structures: • Private Equity/Infrastructure/Opportunistic Real Estate Funds • Open ended structures: • Listed equity • Core Real Estate Funds • Hedge Funds • Umbrella structures

40. Types of Funds – varying with liquidity of assets Private Equity Funds Infrastructure Funds Opportunistic RE Funds Hedge Funds Core RE Funds UCITS/ Regulated Funds Fixed Income Funds High MispricingRisk Low Low High Liquidity of Underlying Investment

41. Executives/Sponsor [Carry structure] Manager -usually regulated Advisory Agreement Management Agreement 100% Carried Interest Partner GP -usually SPV Possibly sub-advisor LP GP Investors Fund LP (limited partnership) LP Feeder LPs [Investments, usually through holding structure] Structure diagram - closed ended Limited Partnerships

42. US Tax-Payer Investors Non-US and US Tax-Exempt Investors Fees Fees On-Shore Feeder Fund (Partnership) Off-Shore Feeder Fund (Cayman OEIC) Master Fund (Cayman OEIC) Investments Structure diagram - Hedge Funds

43. Structure diagram – “Umbrella” fund Investors Investors Investors Investors Service providers Protected/Incorp. Cell Company/Segregated Portfolio Luxembourg / Cayman / Guernsey / Jersey Sub-fund 1 Sub-fund 2 Sub-fund 3 Sub-fund 4 Investment Manager Investment Manager Investment Manager Investment Manager Holdcos / Investments Holdcos / Investments Holdcos / Investments Holdcos / Investments BK:10165333

44. Funds - What do I have to do to make my fund Sharia-compliant? • Strategy: • Investment criteria and structuring • Sharia board • On establishment • Ongoing role – depends on the strategy • Annual review • Specific investments • Fund of funds • Structure • Usual drivers – liquidity of investments; location of investments and investors; tax and regulatory issues • Meeting the requirements of Sharia in arrangements between investors, managers and service providers • Relationship between manager and investors – agent/steward – duties of trust and confidence • Information disclosure – investment risk/fee arrangements • Fund mechanics – Riba – equalisation mechanics; defaulting investors

45. Hedge funds and Sharia concerns What is a hedge fund? • A hedge fund is a private investment fund open to a limited range of investors which undertakes a wider range of activities in liquid investments • There are a very wide range of different strategies followed by hedge funds – it is hard to generalise • This talk is focusing on those that pursue absolute return strategies of a certain basis points above a chosen benchmark

46. Hedge funds and Sharia concerns • Hedge funds often seek to use the following three techniques: • Leverage - to amplify profits and investments; • Short selling - selling borrowed securities which are expected to decrease in value; and • Derivatives - to hedge their exposure to various underlying assets and instruments. • The concept of hedging and a hedge fund was initially misconstrued by many Sharia scholars as relating to a "complete elimination of risk" and it was seen to go against the principle of returns being proportionate to risk • Richard Phillipson, a principal at London-based consultants Investit was quoted in the Financial News: “If you can make a Sharia hedge fund then anything is possible”

47. Conventional Short Selling • Short selling is the practice of selling borrowed securities in the hope that the price of such securities subsequently falls so that they can then be bought back at a lower price • On 19 September 2008, the UK Financial Services Authority (the FSA) introduced temporary measures prohibiting the creation or increase of net short position in UK financial sector companies and requiring disclosure of all net short positions in excess of 0.25% or more of the share capital of those companies • Only market makers (entities dealing as principal in equities, options or derivatives as part of their business of receiving orders from clients) are exempt from the prohibition and requirement of disclosure • The equivalent of the FSA in various EU jurisdictions, Australia, the US and Russia have implemented similar bans aimed at curbing the short selling of financial stocks

48. Short Selling under Sharia • The Hadith prohibits one from selling something one does not own: This would prohibit the borrowing of shares for sale at a gain (i.e. short selling) • However Islamic hedge funds are being set up and running successfully • Barclays Capital (in conjunction with Shariah Capital) launched a prime brokerage platform (Al Safi Trust) in June 2008, based its short selling mechanism on Arbun structure • Newedge Group (a brokerage jointly owned by Calyon and Société Générale) launched its Sharia-compliant offering in October 2005, based its short selling mechanism on Salam structure • Sharia-compliant hedge funds are estimated to be worth $5bln (Oracle Investment Management)

49. Short selling using Salam $98 ($100 less $2 Spread) on Day 1 (4) Buys ‘S’ from the market on Day 10 (5) Buyer Seller Price: $100 on Day 1 (3) Advises to sell (overvalued) ‘S’ to Buyer (1) Prime Broker (PB) Hedge Fund (HF) Sells ‘S’ in the market on Day 1 (2) Price: $80 on Day 10 (6) Delivers ‘S’ on Day 10 (7) ‘S’ = Sharia-compliant share

50. Short selling using Arbun $68 ($70 less $2 Spread) on Day 1 (4) Price: $70 on Day 1 (3) Buys ‘S’ from the market on Day 10 (6) Advises to sell to Buyer an option to purchase ‘S’ (1) Hedge Fund (HF) Prime Broker (PB) Buyer Seller Price: $80 on Day 10 (7) Sells option to Buyer to purchase ‘S’ (2) Delivers ‘S’ on Day 10 if option is exercised (8) Pays the remaining price of $30 on Day 10 (if option is exercised) (5) ‘S’ = Sharia-compliant share