Shariah-compliant investment funds are a special class of investment vehicles that operate according to the principles of Islam. They are prohibited from investing in any undertakings whose underlying activities are involved in any non-halal items such as tobacco, gambling, weapons and alcohol. Furthermore, a Shariah fund may not invest in interest bearing instruments and cannot engage in short-selling.
The Malta Financial Services Authority (the “MFSA”) has recently published a Guidance Note on the structuring of Shariah-compliant investment funds in Malta within the current regulatory framework applicable to investment funds, thereby paving the way for establishing Malta as a gateway to Islamic finance. The Guidance Note also identifies a number of structural issues which fund managers (mudarib) will have to consider before they can designate their fund as being Shariah-compliant.
All investment funds require a constitutive document to regulate the internal functioning and ongoing operation of the fund. While non-Shariah funds have a memorandum and articles of association, partnership deed, contract or other organisational arrangement; Shariah funds are typically based on the Mudaraba contract Under the Mudaraba contract, an investor (rabb al-mal) provides capital to another person or body (taking the role of the fund manager – mudarib), who then uses his / its investment knowledge and expertise to invest the capital raised according to the principles of Shariah law in accordance with the guidance of the Shariah Scholars making up the Shariah Advisory Board. Any profits generated by this contractual arrangement are divided between the mudarib and the rabb al-mal in accordance with a predetermined formula. Management and performance fees are also permitted under the Mudaraba contract.
Structuring of Shariah-Compliant Funds in Malta
Shariah-compliant funds may be set up as either Retail Funds, which can be structured as UCITS or non-UCITS schemes, or otherwise set up as Professional Investor Funds (“PIFs”) targeting either experienced investors (EUR 10,000 minimum initial investment requirement), qualified investors (EUR 75,000 minimum initial investment requirement) or extraordinary investors (EUR 750,000 minimum initial investment requirement). The choice of structure depends, however, on the nature of the fund’s underlying investments as well as the investment techniques and processes to be adopted by the fund manager.
While Shariah-compliant equity funds can be set up as UCITS, non-UCITS or PIFs; Ijarah funds (a type of leasing fund), commodity funds and Murabaha funds (also known as “cost-plus funds”) can only be licensed in Malta as a PIF.
The Shariah Advisory Board
The fund manager must appoint a Shariah Advisory Board composed of at least two internationally recognised Islamic Shariah Scholars, who must be independent from the fund manager. Alternatively, the fund manager may opt to appoint a corporate Shariah Advisor, which would in turn appoint its own Shariah Advisory Board. The role of the Shariah Advisory Board is to provide the fund manager and board of directors with ongoing guidance on Sharia law and ensure that all existing and proposed investments are and remain Shariah-compliant. The MFSA Guidance Note also requires that the Shariah Advisory Board carry out, prior to the submission of any application documents to the MFSA, a Shariah compliance review of the fund structure and the investment methodology of the fund manager, including the Shariah Guidelines as set out in the Prospectus and in accordance with which the fund manager shall operate. Following this review, the Shariah Advisory Board must set out its opinion on the proposed structure, investment methodology and applicable Shariah Guidelines and issue its approval.
The prospectus of a Shariah fund must disclose certain information, in addition to that information having to be disclosed by non-Shariah funds. The MFSA Guidance Note requires the prospectus of a Shariah fund to contain the following:
- Information regarding the members of Shariah Advisory Board or the corporate Shariah Advisor, as the case may be;
- Reference to the fact that the fund or the Shariah Advisor may replace any members of the Shariah Advisory Board with individuals whom it considers to be of equal standing and reputation;
- The terms of appointment of the Shariah Advisory Board;
- Reference to the Shariah compliance review carried out by the Shariah Advisory Board prior to the launch of the fund and to the final opinion given by the said Board;
- The main features of the Shariah Guidelines to be followed by the fund, setting out:
- the nature of assets which the fund will not be permitted to invest in;
- the investment strategy / stock selection technique to be adopted by the fund manager;
- permitted asset classes and screening processes to be adopted and applied;
- any applicable leverage restrictions;
- where applicable, the possible distribution of income to third parties who are not investors in the fund (such as charities) and the nature of such income and the criteria for determining when this can be done, to whom and the maximum permitted limit on such distributions, together with information on any potential tax implications for investors;
- full disclosure on all Shariah related processes and potential outcomes (e.g. purification or cleansing of dividends received, etc);
- the requirements related to Shariah compliance, vetting and certification by the Shariah Advisory Board both before and after the launch of the fund;
- A disclaimer stating that: (i) the directors and fund manager are responsible for ensuring that the fund satisfies the relevant Shariah principles and requirements as disclosed in the prospectus; and (ii) that the MFSA has not assessed the competence or otherwise of the members of the Shariah Advisory Board and has made no assessment of the accuracy or completeness of statements made or opinions expressed with regard to the compliance of the fund with Shariah principles, and will not be monitoring the extent of compliance of the fund with such principles on an on-going basis;
- the risks related to the limitation of the investment universe in order to comply with principles of Shariah law (e.g. increased costs and taxes owing Shariah requirements, lower returns and higher volatility than non-Shariah funds, etc);
- a warning that prospective investors should not rely solely on the pronouncement of the Shariah Advisory Board as to the compliance of the fund and its investments with Shariah principles, in deciding whether to invest, and that they should consult their own Shariah advisor as necessary;
- disclosure of the increased susceptibility of a Shariah fund to fluctuations in the value of its underlying investments resulting from adverse economic or business conditions owing to the concentration of the fund’s portfolio to Shariah-compliant investments;
- risks related to changes in Shariah-compliant investments and strategies, which may result in a reduced opportunity to sell and higher costs of trading;
- increased counterparty risk due to a limited number of prime brokers and administrators in the market place offering the required level of Shariah compliance as well as the risk of increased costs owing to the lack of a competitive marketplace;
- risk warning on the possible increased costs to be incurred by a Shariah-compliant fund compared to a non compliant one;A description of the risks associated with investing in a Shariah-compliant fund, particularly:
- risks associated with the limited number of Shariah-compliant cash management
- tools and techniques and the consequential risk of lower returns compared to those generated by conventional cash management methods;
- risks associated with decreased financing opportunities and increased financing costs owing to Shariah requirements, as well as the increased liquidity risk due to borrowing restrictions and illiquid investments and potential foreign exchange risk in view of hedging restrictions;
- risk of liquidating non-Shariah compliant investments at times which may be unfavorable resulting in losses.
- Information regarding the treatment of the fund’s investments which in the opinion of the Shariah Advisory Board are no longer Shariah-compliant and the time within which the fund is permitted to liquidate such positions.
Audited Financial Statements
Every year, all Maltese-domiciled investment funds must draw up and submit audited financial statements for the previous accounting period accompanied by a director’s report and an auditor’s report. Together with these, a Shariah-compliant fund must also draw up and submit with its audited financial statements a Shariah Advisory Board report, containing:
- a) the opinion of the Shariah Advisory Board on whether the fund has complied with the principles of Shariah law and the Shariah Guidelines during the period concerned; and
- b) information on:
(i) any distributions of income to entities other than investors in the fund,
(ii) the circumstances which led to such distributions (e.g. “purification” in the case of non-halal income) and
(iii) the recipients of such funds.
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