ASAR Al-Ruwayeh & Partners (ASAR) recently acted as counsel to Ahli United Bank B.S.C. (AUB) in relation to the successful takeover by Kuwait Finance House K.S.C.P. (KFH) through a listed share swap transaction. The deal, valued at USD11.6 billion, resulted in KFH’s expansion to become one of the largest banks in the MENA region with over $118 billion in assets, an increased presence in 12 countries, and a team of over 17,000 experienced professionals. Most notable in this acquisition is that AUB holds a Central Bank of Bahrain (CBB) license as a conventional retail bank, whereas KFH operates strictly as an Islamic financial institution, following Shari’ah principles.
While the transaction presented a number of unique challenges including the swap of shares by issuers in two different jurisdictions (Bahrain and Kuwait), newly revised statutory squeeze-out provisions and a cross-border listing, this article focuses on the unique consequences to a conventional bank when being taken over by a Shari’ah compliant institution.
Under CBB regulations, conventional bank licensees are permitted to undertake Islamic transactions subject to maintaining appropriate Shari’ah advisory resources; however, an Islamic bank is precluded from conventional financing. Shari’ah compliance prohibits interest bearing loans, other complex conventional instruments (e.g. derivatives contracts) are likewise contrary to Shari’ah due to aspects of uncertainty (gharar) and speculation (maysir) associated with such transactions. Moreover, Islamic institutions are precluded from most investments that do not comply with Shari’ah laws, and certainly controlling interests in non-Shari’ah compliant assets and businesses. In light of the overarching restrictions, a core consideration for our client, AUB, in responding to the takeover bid related to its (eventual) conversion into an Islamic financial institution.
It would seem that an Islamic bank would be unable to acquire or merge with a conventional bank while maintaining its Shari’ah compliant nature. Such a move would naturally involve active participation in riba, among other non-Shari’ah compliance practices. Several helpful fatawa have been issued which allow for the acquisition of non-Shari’ah businesses on the condition that a roadmap to render those businesses Shari’ah compliant is contemplated. Such acquisitions are generally subject to a limited time period to restructure/re-finance conventional instruments or dispose of same to not force a “fire sale” or impede the commercial viability of an acquisition. Of course, the acquirer must remain focused on that designated timeline in formulating its path to full conversion.
The next consideration relates to the target’s regulatory license. In Bahrain, conventional banks are permitted to engage in Shari’ah compliant transactions—a crucial feature to an effectively timed conversion. In the AUB case, its formal conversion to an Islamic retail bank is eligible to be delayed while, simultaneously, AUB is positioned to ensure that all of its new products are Shari’ah compliant. In other cases, conversion would be required to occur immediately with the residual conventional products being run-off or restructured.
The restructuring of conventional products represents another roadblock in the conversion process required by the acquisition. A nominal amendment to a conventional product without altering its underlying structure is not sufficient to achieve absolute Shari’ah compliance. By way of example, changing the term “interest” to “profit” in references to financing on the bank’s documents and agreements without changing the contractual structure on which the profit is being charged (e.g. Murabaha) is typically not sufficient as charging money on money is prohibited under Shari’ah; wealth can only be generated through legitimate trade and investment in assets. All Shari’ah compliance financing structures are developed on the notion of providing a real object (i.e. a commodity or a service) to the debtor in return for interim or final payments in the future, or sharing the risks and profits with the debtor in relation to an investment project. Similar analyses would apply to conventional derivatives, bonds and deposit instruments.
In developing a system for converting conventional banking products, various options have emerged, including for example: run-off (usually applied for loans expected to fully mature and reach repayment within the designated period to continue holding conventional products); re-financing (usually applied to bilateral loans); re-designation (for current and savings accounts); and Shari’ah wrapping (for derivatives and other complex instruments). The benefits and complications of these conversion structures vary. Re-financing would represent the most commonly required conversion approach, but this would require the consent of the borrower. How to communicate with borrowers and achieve a solution can be difficult and, particularly with recent inflation, a borrower would not desire for any borrowing rate to be reset to current market rates (albeit under a Shari’ah product). A bank must balance commercial considerations and the timeline requirements to solve the complex puzzle of conversion.
Consideration of the products, for all its complexity, pales in comparison to the minefield of ensuring that security interests continue in relation to the underlying payment obligations. Achieving re-financing or Shari’ah wrapping often requires novation, which under Bahrain law includes the replacement of one obligation with another. While not entirely settled, the concept of novation for creating a new debt is expressly outlined under Bahrain’s Civil Code. Since the initial consideration underlying the first debt has been created and is not replaced, the concerns over a non-Shari’ah initial lending are not necessarily defeated. Conversely, the Civil Code expressly describes novation as having the effect of extinguishing the original obligation and its accessories with replacement by new obligations.
Security interests are permitted, under the Civil Code, to be transferred to the new obligations; however, same requires that the transfer of security be apparent from the novation agreement or the circumstances of the case that such forms the intention of the parties. In case Shari’ah conversion through novation would be rejected by a Shari’ah board (or the court upon further dispute), the persistence of security under the novation provisions of the Civil Code would be likewise undermined: under Bahrain law, a security cannot be separated from the debt it secures as regards its validity and extinction. So, a pure re-financing, whereby newly provided financing is utilized to repay outstanding conventional loans, would necessitate new security.
A few nuanced features of Bahrain law may afford a stronger position to creditors than other countries. For example, Bahrain has no security hardening period and security granted in connection with financing is excluded from invalidation for preference (absent fraud or similar improprieties). Also, Bahrain law clearly allows for the assignment by a secured creditor of their priority, the process and mechanics of such a unique form of assignment are not well established by court precedent, albeit creditors may find comfort in relation to assignment relating to registered encumbrances. When the acquisition (including by merger) of a conventional bank occurs in jurisdictions without such enhanced protections and rights for secured creditors, the risks of losing security interests (and the associated impact on Capex) may reach a level to influence the deal pricing and even completion. A due diligence of the security interests and considerations of the legal regime will be key factors in the deal negotiation.
Lastly, a brief note on Shari’ah wrapping. Conversion of a conventional bank also requires a review of interbank dealings, which in many instances involves foreign counterparties. In this context, it is common to adopt a “wrapper” structure with approval by the purchaser’s Shari’ah board, so that the instruments held by the target are facially Shari’ah compliant. Often a wrapper would involve a third party issuing Shari’ah instruments marked to the underlying conventional instrument, but without a direct ownership or control element. The increased availability of Islamic derivatives has been instrumental in facilitating Shari’ah wrapping of most types of instruments; the primary exception being interest rate swaps.
In the modern, highly complex banking environment, a major takeaway from acquisitions like the takeover of AUB is that the Shari’ah conversion process of conventional banks is a necessary but volatile aspect of any acquisition by an Islamic bank. A pre-determined action plan, based upon effective due diligence, early liaison with Shari’ah boards and effective legal advice allows the parties to successfully navigate this process and benefit from the plethora of synergies in the growing Islamic finance market.