A Shariah Compliant Alternative to Selling Short with Borrowed Securities by Shaiykh Yusuf Talal De Lorenzozulkiflihasan
Available at: http://www.shariahcap.com/the_arboon_sale_english.pdf
Until the present stage of its development, modern Islamic Finance has been without the ability to profit rom falling markets or even to protect stock market investments from downward trends. It is widely acknowledged in Shariah finance circles that the conventional methods for hedging, and the short sale in particular, are simply unacceptable owing to their use of elements that are contrary to Shariah principles and precepts. However, for the past several years scholars and experts have indicated a growing consensus that it may be possible, at least in theory, to use classical transactional models like salam and arboon to provide investment managers with effective tools for hedging and managing risk, including the ability to profit when the price of shares declines. This White Paper outlines the development of the Arboon Sale by Shariah Capital as a practical solution for the Al Safi Trust, providing investment managers with an effective way to benefit from stock market investments regardless of market trends. Most importantly, the Arboon Sale solution is completely Shariah compliant and has been certified as such by means of a fatwa signed by senior and experienced Shariah scholars, each of whom is a member of the Shariah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the standard setting board for the modern Islamic financial industry.
Difficulties with Conventional Short Sales
Since conventional short sales require the sale of borrowed shares, such sales are clearly contrary to Shariah rules. There is complete unanimity of agreement among Shariah scholars on this point. In order to sell something, according to the Shariah, one must first have ownership of what is to be sold, or the subject of the sale. Under Shariah rules, then, if securities are to be sold into the market, the seller must first establish ownership of those securities. It is not possible, using conventional prime brokerage documentation, for a hedge fund manager to be Shariah compliant and to borrow shares of stock from a prime broker and then sell those shares into the market. It is for this reason that hedge funds are widely understood to be non-compliant with Shariah norms. It is for this reason too that it is widely believed that hedge funds will never become Shariah compliant.
It is perhaps this mistaken belief that has led some product providers to have recourse to artificial solutions which attempt to circumvent Shariah strictures by swapping returns from hedge funds, even though the hedge funds themselves are without Shariah supervision and may invest in anything from currency futures to interest-bearing instruments like T-bills and bonds; and may even include shares of companies in the business of gambling or alcohol. Such defeatist stratagems, however cleverly engineered or labeled (one such calls itself “Shariah Conversion Technology”), have been rejected by the market. Other difficulties associated with short sales as practiced by prime brokers using the conventional borrow and sell methodology include a series of interest-based charges for services and, remarkably, interest payments on borrowed securities; any and all of which render the transaction unacceptable from a Shariah perspective. None of this, however, need concern the Muslim investor any longer. The Arboon Sale is the ideal solution to all of these problems.
Shariah-based Strategies for Shorting
The conventional short sale is a forward-looking transaction that involves different times for initiation and completion. In this respect, it is immediately suggestive of two types of sales sanctioned by classical Islamic law. These are the salam and the arboon sales. The salam sale, used historically in an agricultural context, was designed to provide farmers with seeds and, at the same time, to offer merchant/financiers protection from price fluctuations on the crops which they effectively financed by providing the farmers with seeds. The arboon sale also has its roots in classical Islamic law. In an arboon, the seller takes an earnest money deposit from the buyer with the understanding that the deposit will be credited toward the price if the sale is concluded, and forfeited if it is not. From a theoretical perspective, both of these sales would appear to be suitable for replicating the conventional short sale in a manner that complies with Shariah.
Approval for the Arboon Sale
While both of these transactional models have been approved by Shariah supervisory boards around the world and are routinely used by Islamic banks and multinational banks with Islamic windows as base solutions for financing, only the arboon model has been found suitable for use in compliance with both AAOIFI and SEC (Securities and Exchange Commission, the US regulator of stock markets) standards and regulations.
Original approval for the arboon sale came from the Jeddah-based OIC Fiqh Academy which reviewed the arboon transaction and found it acceptable for use by modern Islamic banks and investment houses. This decision is documented in the Journal of the Islamic Fiqh Academy, 1993, vol. 1, number 8, p. 641. The use of the salam model in the sale of securities, however, is prohibited by AAOIFI Shariah Standards, as below: The basis for the impermissibility of salam in shares is that the subject matter of salam is a debt and not an ascertained thing, while in shares of corporations nothing works except ascertainment. This is done by mentioning the name of the corporation whose shares are desired through salam thereby rendering the shares an ascertained thing and not a liability for a debt. Shares cannot, therefore, essentially be the subject matter of the contract of salam. Further, salam in shares implies the sale of ascertained things that are not owned and this is not permitted. AAOIFI Standard 21 – Financial Paper (Shares and Bonds), at Appendix B: Basis of the Sharia Rulings, Art. 14, page 377 of the 2004-2005. Thus, even though in theory both models may be adapted for use by a prime broker as short sale alternatives, in practice only the Arboon Sale is acceptable under present Shariah standards.
The Arboon Sale in Classical Islamic Jurisprudence
The Arboon sale, also known as `urboon, arbaan and urbaan, is known to have been practiced in the time of the second Caliph, Umar ibn al Khattab which indicates that its origins were earlier and, most importantly, that it was considered a lawful transaction in the earliest days of Islam. A reliable report was related on the authority of trusted narrators that Nafi’ ibn `Abd al Harith purchased a house to be used as a prison from Safwan ibn Umayyah on the condition that if Umar approved the purchase the down payment would become a part of the purchase price, and if Umar did not approve then the down payment would be kept by the seller, Safwan. As explained in the preceding section, “Approval for the Arboon Sale”, modern scholars are agreed on the acceptability of the Arboon sale in general. In addition to support for Arboon in the writings and research of individual scholars and Shariah boards all over the globe, the decision of the OIC Fiqh Academy on the matter has never been disputed. As a result, the arboon sale is regularly used in a variety of financings offered by Islamic banks and finance houses all over the world today.
The Workings of the Arboon Short Sale
The Arboon Sale is an alternative transaction which replicates the economic results of a conventional short sale without using the “borrow and sell” method of shorting employed by conventional prime brokerages for their hedge fund clients. In essence, the Arboon Sale is a sale transaction which has the effect of generating a net economic benefit arising from a fall in the price of the shares. A complex transactional process is required to achieve the same economic benefit as a conventional short sale by means of the Arboon Sale. Several different Shariah, regulatory, legal and commercial elements are involved; and the legal documentation for the same is extensive. For example, it is not enough to work with a hedge fund manager, however willing the manager may be to comply with the investment guidelines specified by a Shariah Supervisory Board. This is because the hedge fund manager does not control the short sale process but depends instead on the services of a prime broker. Only a prime broker is in a position to provide the complicated series of services required for short sale transactions.
More importantly, only a prime broker has the contracts that satisfy the various legal, regulatory, exchange and prime broker credit and balance sheet requirements and parameters, such that all such transactions may take place in accordance with stock exchange house rules and regulatory requirements (such as the US Securities and Exchange Commission’s regulations). Then, while the creation and certification, by means of a fatwa, of Shariah-compliant short sale methodology is key to the Shariah compliant short sale alternative, there are many other factors that comprise the process. Perhaps among the most influential of these scholars are Dr. Yusuf al-Qaradawi and Shaykh Mustafa al-Zarqa, both of whom have pointed in their writings to the utility of Arboon and its harmony with the spirit of Shariah law which seeks to remove hardship and bring ease. In order to understand the workings of the Arboon Sale alternative it may be helpful to compare the Arboon Sale to the classical arboon sale model and also to a conventional, “borrow and sell” short sale.
Comparing Features of the Short and Arboon Sales
1. In a Shariah-compliant Arboon Sale, stocks are purchased using an arboon contract so that the investor actually takes ownership of the stocks. By means of the arboon contract, no stocks are borrowed. In a conventional short sale, shares are borrowed under a “Master Securities Lending Agreement” and then sold into the market. The Arboon Sale employs a “Master Securities Arboon Sale Agreement” instead to ensure the investor’s ownership of whatever stocks are later sold into the market.
2. In a classical arboon sale, the buyer agrees to purchase goods by paying earnest money against an agreed sale price. In the Arboon Sale, the prime broker agrees to sell stock to the investment manager at the quoted (and therefore agreed) market price. The investment manager makes an arboon down payment and assumes ownership of the stocks.
3. The Arboon Sale equivalent is structured with a specified “date of ultimate settlement of the purchase and sale” at which time the unpaid portion of the purchase price has to be paid (the “Closing Date”). This complies with the condition stipulated by the OIC Fiqh Academy that a time period for payment of the remaining purchase price must be specified.
4. In the classical arboon sale, if the buyer does not complete the purchase within the time period specified, he must return the goods and forfeit the down payment of earnest money. In the Arboon Sale, if the investment manager decides not to complete the sale, he returns the shares and forfeits the arboon earnest money.
5. In a classical arboon sale, once the purchaser has paid the arboon earnest money to the seller, he is free to dispose of whatever he purchased. In an Arboon Sale, once the investment manager has made a down payment equal to a margin account deposit, he may arrange through the prime broker to sell the stocks purchased by means of the Arboon Sale to a third party at the market price when the sale is concluded.
6. In order to close out the transaction in the Arboon Sale, the investment manager instructs the prime broker to purchase the required number of stocks from the market at the market price. Using these securities, the investment manager terminates the Arboon and the Prime Broker retains the earnest money. The same process is used in a conventional short sale.
No transaction can be certified Shariah compliant by a Shariah Supervisory Board unless the underlying contracts conform to the principles and precepts of the Shariah. As the prime broker transacts on behalf of the investment manager, it is essential that all prime broker contracts and related documentation for conventional short sales be replaced by contracts and documentation for the Arboon Sale. Unless this is done, none of the transactions described above may be considered Shariah-compliant. The Al Safi Trust platform utilizes an alternative set of prime brokerage documentation by means of which all trades, whether long or short, may be conducted in accordance with Shariah rules, with no interest, no prohibited terms and conditions, and no prohibited sales (like the sale of what one does not rightly own, or like the purchase or sale of prohibited businesses like pork or alcohol production, banks and insurance companies, and so on). In order to ensure Shariah compliance, all managers on the Al Safi Trust platform are contractually obligated to settle short sales through one prime broker. Shariah compliant contracts allow the prime broker to process trades initiated by the platform’s hedge fund managers, while avoiding all the prohibited elements (interest, prohibited terms, prohibited businesses) that are present in prime brokerage contracts commonly used by hedge funds for conventional short sales.
The Arboon Sale solution for hedge funds goes beyond the usual development of a financial product because Shariah compliance requires more than structuring and monitoring a fund to ensure compliance of the hedging strategy and the securities held in the investment portfolio by means of screening, investment guidelines, and oversight by a qualified Shariah supervisory board. Most importantly, the Arboon Sale for hedge funds requires fundamental changes to the way that trades are processed. In particular, the contracts that underlie the exchange of securities must be made to comply with Shariah rules. Without these modified legal documents, no short sale solution, however sound its Shariah methodology may be, can be considered Shariah compliant.
SHAYKH YUSUF TALAL DELORENZO is a Chief Shariah Officer at Shariah Capital, a scholar of Islamic Transactional Law. Based in the Washington, DC area, he has served as a Shari’ah advisor to dozens of international financial entities, including index providers, institutional investors, home finance providers, international investment banks and a variety of asset managers. Shaykh Yusuf is the author of the three volume Compendium of Legal Opinions on the Operations of Islamic Banks, the first English/Arabic reference on the fatwas issued by Shari’ah boards, and has published several papers and chapters in books on the subject of modern Islamic Finance. He also serves as a member of the Shariah board of AAOIFI, and is a member of the ISRA Council of Scholars attached to the Central Bank of Malaysia
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