Part IV: Agency (wakala)
In this part of our Islamic finance series, we discuss the mechanics of a Shari’ah agency arrangement (wakala) and some key legal considerations that parties must consider when engaging in such a transaction.
A more recent innovation to Islamic finance and bond structures, a wakala is an arrangement whereby the principal appoints an agent (wakeel) to carry out a specific task on its behalf.
The principal (the investor) typically appoints the agent to invest funds provided by the principal into investments or assets and the agent lends it expertise and manages those investments on behalf of the principal for a particular duration, in order to generate an agreed profit return.
The wakala concept is also used frequently in sale and purchase transactions (where the agent can buy or sell assets on behalf of the principal) and assignment of debt, guarantees and pledges. The principal and agent enter into a wakala agreement, which governs the appointment, scope of services and fees payable to the agent, if any.
While the wakala (agency) structure has some similarities with the mudaraba structure, the main difference is that unlike a mudaraba, in which profit is divided between the parties according to certain ratios, an investor via a wakala structure will only receive the profit return agreed between the parties at the outset. Any profit in excess of the agreed upon profit return will be kept by the agent as a performance or an incentive fee.
Some of the advantages of adopting the wakala structure are as follows:
• The portfolio of assets may comprise of a broad range of Shari’ah compliant assets that are selected by the agent for a period of time corresponding to the duration of the agreement or bond. The criteria for the assets included in the portfolio must be set or approved by the relevant Shari’ah board. However, the range of assets may be fairly broad and could include equities, other Shari’ah compliant assets (such as a Shari’ah loan or other Islamic bonds) and even other types of derivative products, provided they meet Shari’ah guidelines.
• It allows the agent to build its balance sheet by acquiring the investments comprised in the portfolio and to utilise those investments as underlying assets for an Islamic bond issuance.
• It enables the agent to utilise certain assets that cannot be traded on the secondary market such as Shari’ah loan (murabaha) contracts. These products are debt arrangements and are financial assets and, as such, they are unsuitable as underlying assets for bond issuance for trading purposes. However, they could form part of a portfolio of assets, provided that at least 30% of the portfolio comprises tangible assets (such as ijara (lease buy-back) or equities or other asset-based sukuk). This enables the wakeel to mix and match different types of assets and effectively utilise those assets, which, by themselves, may not comply with the tangibility criteria. Therefore, the wakala structure may be particularly useful for Islamic banks and financial institutions, which tend to have a large number of commodity murabaha contracts on their balance sheets.
The flow chart below is an example of a typical wakala structure.
Overview of structure
(1) The wakeel seeking the investment opportunity establishes a special purpose vehicle (SPV). The investors subscribe for the bond (which represent an undivided ownership interest in the wakala assets);
(2) The SPV, in its capacity as the principal, enters into a wakala (agency) agreement with the agent to invest the bond proceeds in Shari’ah compliant assets, selected by the agent, on behalf of the SPV;
(3) The proceeds generated from a bond is used by the agent to purchase the selected wakala assets from one or more sellers;
(4) The wakala assets will be held and managed by the agent, on behalf of the SPV, for the duration of the bond in order to generate an expected profit to be agreed upon by the principal. The wakala assets will generate a profit return, which will be held by the agent on behalf of the SPV.
(5) The SPV receives a specified amount from the profits earned from investing into the wakala assets. Any profits generated in excess of the agreed amount are paid to the agent as an incentive fee
(6) The SPV uses its share of the profits to pay periodic distribution amounts to the bond holders (investors).
Set out below are some basic requirements and issues to be considered when entering into a wakala agreement:
• The scope of the wakala arrangement must be within the boundaries of Shari’ah i.e. the principal (SPV) cannot require the agent to perform tasks that would not otherwise be Shari’ah compliant;
• The subject matter of the wakala arrangement must be clear and unambiguous and must be set out in the wakala agreement i.e. the duration of the agency, the type or criteria of assets the agent can select, the fees payable to the agent for its services and the conditions for termination of the wakala agreement. Note that the agent must be paid a fee, even if nominal, in order for the wakala to be valid.
• The principal, in whichever form, can only receive the expected profit, as agreed, i.e. the amount used to fund the periodic distribution amounts. Any excess will be held by the agent for its benefit.
• The wakala assets must comply with the eligibility criteria. The agent must ensure that at least 30% of the portfolio of wakala assets are comprised of tangible assets, such as murabaha or equities or other asset-based bonds. This is the minimum percentage as prescribed by the Accounting and Auditing Organisation for Islamic Financial Institutions.
• The general consensus of most Shari’ah boards also impose further criteria which includes (but is not limited to) the following:
– If the pool of assets comprises of equities (company shares), the agent may only purchase shares of companies where the primary business activity is compliant with Shari’ah – for example, companies whose primary business activity is connected with alcohol, pork – related products, or gambling would be prohibited.
– The agent may only be permitted to purchase equities listed on an index that has been approved as Shari’ah compliant.
– If the pool comprises of other bonds, the bonds must have been approved by the relevant Shari’ah board and must be backed by tangible assets.
To develop a working understanding of other Shari’ah compliant finance facilities such as profit-sharing arrangements, partnerships and joint ventures and Shari’ah loans, please click on the relevant links below:-
Part I: Profit-sharing (mudarabah)
Part II: Partnership and joint venture (musharaka)
Part III: Shari’ah loans (murabaha)
Alternatively, you may click on this link to see further information on our main site.
Feel free to telephone our London office on +44 (0) 20 3588 3500 to speak directly to one of our lawyers on your investment needs.
Have you ever used an agency arrangement? We would love to hear about your experience. Please leave a comment or any questions in the section below.