- Historical BackgroundMan invented money as the first measure of value and store of wealth; hence money contributed in facilitating trading operations and expanding the volume of trade between dealers both within the same country and among different countries. Money continued to perform as a barter tool till the time it became solely unable to do the same full role, particularly when commercial transactions have a fixed term. Where every trader has kept his/ her money in the vaults till the time to discharge debts when falling due, could hinder the money from investment. In addition to that, the booming trade and expansion have resulted in the traders’ increased feeling of the need to secure the route for their trade from acts of piracy and banditry.Consequently traders felt the necessity to search for a way to achieve their safety in the face of dangers of theft and loss and to unseal tangles in relations between creditors and debtors especially if they are traders. Also to enable them fulfill their obligations without hindering money from investment in addition to executing the forward exchange process between without any concerns.Thus business environment has resulted in the invention of both the securities and commercial paper. Displayed below are the types and uses of both and the difference between them:
- SecuritiesIt is any instrument – of any legal form – which establishes a share in a marketable finance transaction.
Securities are classified as per issuance criteria as follows:
- Conventional securities
- Islamic Sharia consistent securities
- Islamic Sharia compliant securities
Securities are divided into four types as follows:
- Bonds/ Sukuk and other instrument convertible into shares in the company’s capital
- Units of funds
- Financial derivatives
- All marketable public debt instruments that are issued by government and public entities and bodies.
We set out below each type:
The share is a shareholder’s equity in the company’s capital which gives the right to participate in the General Assembly meetings and in the management of the company through membership on the board. It also gives the right to gain a percentage of the company’s profits and participate in the distribution of assets upon liquidation.
Shares are defined as marketable indivisible Sukuk of equal value and represent the right of the shareholder’s equity as a partner in the issuer company.
Types of shares
- Ordinary shares
These are shares that give equal rights to their owners. As long as the shares are of same class; the rights conferred by these shares are equal. These rights include the right to get an equal proportion of the profits, the right to attend and vote in the company’s general assembly meetings and the right to get an equal proportion of the company’s assets upon liquidation.
- Preference shares
These are shares that give more rights than the rights granted by the ordinary shares.Such shares enjoy certain privileges in vote rights, profits, realization value or any other rights provided that the shares are of the same nature of equal rights and privileges.The preferred shares are divided into the following types:
- Redeemable preferred shares: it is the type of preferred shares that can be redeemed either on a specific date or after a specific period of time during the issuer duration.
- Irredeemable preferred shares: it is the type of preferred shares that can not be redeemed by the issuer within the period specified in the company’s contract and the value of these shares shall be settled upon issuer liquidation.
- Convertible preferred shares: it is the type of preferred shares that gives its holders the right to convert such shares into ordinary shares in the issuer share capital at a subsequent date.
- Non-convertible preferred shares: it is the type of preferred shares that does not give its holders the right to convert such shares into ordinary shares in the issuer share capital at a subsequent date.
- Participating preferred shares: it is the type of preferred shares that gives its holders the right to participate in earnings surplus along with ordinary shareholders after the distribution of dividends at a specified rate to these shareholders.
2-2 Bonds/ Sukuok
Bonds is a borrowing process undertaken by shareholding companies through issuing bonds at fixed interest rate and for a defined period of time at the end of which the bonds value shall be paid back.
A bond is a financial instrument entails indebtedness of issuer for the favor of bond holder who will hereby gain periodic distributions during the bond’s period or a payment or more of depreciation settlement or gain both payments which leads upon maturity to discharge of such bond.
Types of bonds:
- Government bonds: these are bonds issued by the government, ministries or public authorities and institutions, either through direct or indirect issuance or fully secured from the mentioned entities.
- Convertible bonds: these are bonds that entitle their holders the right to convert into shares at a subsequent date.
- Asset-backed securities: these are bonds have its structure based on key elements, including:
- The right of bond holders to recourse (directly or indirectly) against bond assets.
- Isolate bond assets and securitize them in a way to protect them from other creditors’ claims.
- Bondholders reliance on the assets of those bonds as a major source of periodic distributions and repayment of depreciation.
- Bondholders bear the risk of any loss in the value of bond assets.
Sukuk are considered the Sharia-compliant type of bonds. Sukuk or the so-called “Islamic securities” are the process of issuing official documents and financial certificates equal to the value of common share in an ownership, whether it is the benefit, right, a combination of both, a sum of money, or debt, where this ownership is already existed or under establishment, and is issued by virtue of a binding legitimate contract.
Sukuok are documents of equal value which represent common shares in the ownership of properties, benefits, services or assets in a particular project or investment activity.
The types of Sukuk:
- Governmental Sukuoks: these are Sukuk issued by the government, ministries or public authorities and institutions, whether through direct or indirect issue or fully secured by the mentioned entities.
- Convertible Sukuk: the type of Sukuk that give holders the right to convert into shares at a subsequent date.
- Sukuk based on assets: Sukuk do not entitle their holder to recourse (directly or indirectly) against the assets of those Sukuk. Holders of asset based Sukuk may recourse against outstanding liability of obligor mainly based on the creditworthiness of the obligor and their ability to repay.
- Asset-backed Sukuk: Sukuk have its structure based on key elements, including:
- The right of Sukuk holders to recourse (directly or indirectly) against Sukuk assets.
- Isolate Sukuk assets and securitize them in a way to protect them from other creditors’ claims.
- Sukuk holders reliance on the assets of those Sukuk as a major source of periodic distributions and repayment of depreciation.
- Sukuk holders bear the risk of any loss in the value of Sukuk assets.
Sukuk principle is based on participation in “finance” of a project or long or short-term investment, as per sharia rule stating that (Al Ghunm Bil Ghurm) “Risk to Win basis” i.e. participating in the profit and loss, which is equivalent to what is globally known in the trade, finance and corporate filed as stock system. Sukuk itself can be regarded as shares or stocks in an Islamic system, where a corporate is established, the partners are participating in the establishment of this company by offering certain shares to be subscribed by each individual at his/ her desire, then these sukuk are to be offered for public offering to individuals to be bought at their price. The sukuk holder has the right to participate in management, in the capital and in trading and has the right to grant gift and inheritance and all terms related to financial transactions.
There are many various types of sukuk, which vary depending on its objective, and these types include:
- Investment sukuk is securities indicates the right to own the project, which is financed from the funds of these sukuk, and sukuk holder is entitled to an agreed proportion of the project’s profits, according to the profit and loss achieved.
- Mudharaba Sukuk which are used by the Mudhareb to use funds of these sukuk in financing a project. Mudhareb is the manager and in charge of such project in his capacity as – speculator – in return for getting certain share of the project’s profits. That is to say the Mudhareb gets a value and proportion greater than the other sukuk holders because the Mudhareb works as the project manager in addition to funding the project, and no loss charged.
- Istisna’a sukuk are instruments issued by the government or some companies that wishes to finance large projects in the country, as infrastructure projects.
- Murabaha instrument bears the same value of the purpose for which it was purchased in a project and profit is entitled to sukuk holder to buy and sell equipment at Murabaha transaction.
- Musharaka instrument which is closest type to the principle of stocks, and is issued by the project sponsors and agents.
- Ijara instrument which relates to leased properties where the profit is from renting properties related to these instruments.
- Trade instrument, the same so-called “financial sukuk (instruments)” which are requested by the government from financial institutions such as banks to issue these sukuk (instruments) to be used in the purchase of materials at a determined Murabaha rate.
- There are several other types of sukuk (instruments) that we do not have room to explain, including salam instrument, benefits instrument, Muzara’a (farming) instrument, Mugharasa instrument, Musaqat (irrigation) instrument, services instrument and many other types of instruments.
2-3 Units of investment funds
Investment funds are considered investment instruments that grant individuals – who do not have the ability to directly manage their investments – the opportunity to participate in the financial global or local markets. The concept of investment funds represents simply a large number of investors are combining their resources and managing it by specialized financial institutions to achieve the benefits that cannot be achieved individually. Investment managers have the experience which ensures the achievement of higher returns compared to returns that could be achieved if the investor solely has run their own funds especially in markets they little information about. In addition, consolidating the funds in one investment fund will lead to reducing the investors’ administrative burden, as well as reducing the risks to which the individual investor may be exposed in the financial markets.
Investment Fund is an independent commercial entity managed by the fund manager and is divided into units. Each unit holder is treated as a shareholder stock in companies within permitted by the articles of association of the Fund.
Investment funds are diversified into several types as per marketability of units issued by such funds. This type is also divided into two types. There are a closed investment funds, which indicates that a limited number of individuals have established these funds and it belongs to a certain category of investors. In addition we have open-ended investment funds where it can accept any individual wishes to invest with entry and exit at any time. Also there is another type of investment funds which are formed on an ad hoc basis which consist of money market funds in addition to ordinary equity funds and bond funds, balanced funds, which are also known as diversified funds. Further specialized investment funds, which includes certain industries of the banks sector or chemical industries etc. There is another type of investment funds, which are defined by objective and the last type is Islamic investment funds.
The following is a review of classification of investment funds:
Investment funds by marketability of units
Investment funds by marketability of units issued are included into two forms:
- Closed-ended investment funds:
It is a fund with a defined capital and its units may not be redeemed until the end of Fund duration. The fund’s capital may increased or reduced as determined by its articles of association.
- Open-ended investment funds
It is a fund with a variable capital that may be increased by issuing new investment units or may be reduced by redeeming some of its units during the period specified within its articles of association.
Investment funds by offering
Investment funds by offering are classified into two categories:
- Public offering funds
- Private placement funds
Investment funds by nature of its activity
Investment funds by its nature of activity
Following types of funds are classifies in this category:
- Monetary instruments funds
- Equity Funds
- Debt instruments funds
- Private equity funds
- Real estate funds
- Holding fund
Investment funds by their objectives
Following funds are classifies in this category:
- Aggressive Growth Funds
- Growth Funds
- Growth and Income Funds
- Income Funds
- Global Funds
- Tax – Managed Funds
- Dual Objective Funds
Islamic investment funds
The most important merit that distinguishes Islamic investment funds from other investment funds is directing its resources towards investments that are in line with the idea of Islamic investment. Furthermore, Islamic investment funds is not just a financial intermediary as is the case in investment funds established by the conventional banks, investment companies and insurance companies, but these funds, in addition, are adopting Islamic investment approach that blends between capital and work. Islamic investment funds represent a speculative venture (Mudharabah company contract) between the Fund’s management that will perform works only and the Fund’s subscribers who represent employers gaining (investment units) which represent a common share in the Fund’s capital. The management shall invest in a variety of different and diversified projects as well as investment in securities of firms that are in compliance with idea of Islamic investment.
2-4 Financial Derivatives
Financial derivatives are financial instruments that derive their value from the performance of a real asset or financial asset or the performance of a market index. Real assets include: international commodity (such as gold, oil, metals, wheat, rice, etc.. While financial assets include securities such as shares and bonds. Financial derivatives help transfer the financial risks among the contracting parties across regulated or parallel financial markets. The value of derivative instrument depends on the asset price or indicators subject of the contract. Unlike debt instruments, there is nothing to be paid in advance to be recovered and there is no accrued return on investment. Financial derivatives are used for a number of purposes, including risk management, hedging against risks, arbitrage between markets and also for the purposes of pure speculation.
The most common forms of derivatives are:
- Commercial PapersCommercial papers are used for commercial transactions as a substitute for money to facilitate transactions between traders. Commercial papers are easily created and transferred. They are unconditional instruments including specific data prescribed under law. Through commercial papers, a person called the “debtor” undertakes to pay a certain amount of money to a person called “the creditor” or to another person called the “beneficiary”.Financial papers includes four types, namely: check, bill, trust receipt, promissory note and debt declaration; all of which are commercial papers and are considered methods for guaranteeing and protecting the rights. These are most common in people’s daily transactions. In practice, it has been established to accept these papers as tools to settle debt, like money. Through these papers, the creditor can secure his rights and money with others.
Commercial papers include five main types as follows:
- Bank check
- Promissory note / bond to the order of
- Trust receipt
- Debt declaration
- Documentary credits
- Tools handled among banks exclusively
- Insurance policies
- Rights from pension funds to beneficiaries
3-1 Bank Check
Check is a commercial paper written as per the data stipulated under. The check is an unconditional order from the “drawer” to the drawee” or to bearer. The check is payable on sight.
Kuwaiti Commercial Companies Law allows the release of check amount on sight even if the date written on the check has not come yet. A check must be withdrawn to a bank and the amount must be available on the account in bank at the time of issuing the check otherwise it is considered a crime of issuing a check against no balance.
The penalty of check against no balance has become a misdemeanor under law No. 84 issued in 2003. However, the legislators give the check a legal protection. Legislators consider that just signature on the check even without balance available at the drawee’s bank shall deem it as legal check regardless of the drawer’s intention. Thus the check was and is still a tool of payment like cash in commercial transactions
The bill is the oldest types of financial securities. It is a commercial paper that include a written unconditional order with specific date issued by the drawer (the bill issuer) by which another party (drawee) undertakes to pay a certain amount of money to a third party (beneficiary) on sight. The transaction parties of a bill may be two or three parties.
3-3 Promissory Note
The promissory note is a type of financial papers. It is an unconditional instrument issued as per the information stipulated under law by the drawer (the issuer) to pay to another party (drawee) a certain amount of money. The transaction parties of promissory note are two only.
3-4 Trust Receipt
Trust Receipt is a commercial paper in transactions. Law considers trust receipt as a deposit contract where the amount mentioned in the receipt is handed over to the debtor by way of deposit or trust. The debtor shall pay the amount to its owner on demand or at the date specified in the receipt.
Trust receipt is also subject to Kuwaiti Penal Law like checks. Accordingly, in case of default of the trust receipt value, the perpetrator is considered to have committed a dishonesty crime like the crime of issuing a check against no balance. Article 240 of the Penal Law stipulates that:
« A punishment of imprisonment for a term not exceeding three years and a fine not exceeding three thousand rupees, or both shall be imposed on anyone who acquires money owned by others, based on deposit, rent, mortgage, agency or anyone else providing account for this use, or based on a legal provision or a court order, that takes over that money for himself or disposes it off for his own interest or intentionally spoils that money»
At maturity date, if the debtor or the nominee has not paid back the amount, he shall be considered dishonest and shall be punished as honesty violator.
3-5 Debt Declaration
Debt declaration is a commercial paper for commercial transactions. Debt declaration is a formal undertaking of payment issued by a competent employee at the Ministry of Justice at the request of the debtor and his acceptance of the debt. All necessary information shall be included such as the name of creditor, the amount and date of payment. In most cases, all debt declarations are concluded with a writ of execution. As such, if the debtor does not repay at maturity, the creditor does not needs to have a judgment from the court, but can get all executive actions against the debtor such as travel ban and seizure on bank accounts, cars and movables. However, no arrest and imprisonment of the debtor can be executed as such actions are only taken after issuing a legal judgment.
Legal proceedings to be taken by the creditor for judicial collection of commercial papers
In case of debtor’s default to repay the aforesaid commercial papers, the beneficiary shall have the right to resort to court to get its rights established by check, bill of exchange, promissory note or the trust receipt by issuing payment order by the court against the debtor in accordance with Article 166 of the Procedure Law which has taken into account simplifying the procedures and quick decision on payment order to protect the rights. It stipulated:
«The debt shall be an amount of money such as a loan or a check or a bill of exchange, and to be of certain amount, matured and established by an official or customary paper signed by the debtor».
In case of meeting all the above conditions, a payment order is issued against the debtor.
Debtor grievance against the payment order
Law has given the debtor, against whom a payment order has been issued, the right to challenge the order through the grievance or appeal if grievance timings overdue. The debtor’s submits its grievance within ten days from the date of notifying the debtor with the issue of the payment order. The appeal shall be submitted within 40 days of notifying of the payment order because grievance period is ten days plus thirty more days for appeal. During that period, the debtor may file a grievance against the payment order.
- The difference between the financial securities and commercial papersThe differences between financial securities and commercial paper are as follows:
S. Description Financial securities Commercial papers 1. Issuer Financial securities are issued in bulks by government bodies, institutions and are traded by organizations and people. Commercial papers are issued when necessary by institutions / persons for the benefit of institutions / persons 2. Conditional or not Financial securities may be conditional Commercial papers are unconditional otherwise, they loses their characteristics as commercial papers 3. Issue objectives They are either to invest in the company’s capital or its financing, in the form of a loan, to meet the company’s financing needs These are instruments issued for settlement of a specific commitment as a result of commercial trading; such as payment of the price of goods or services 4. Issue value Equal in value at each issue The value varies at each issue 5. Trading markets Negotiable and traded in markets Non-negotiable, with no markets to be traded in. 6. Term These represent a short, medium and long term investment tools. Short-term (from one day to 270 days) 7. Interest bearing Financial securities do not bear interest but are subject to the performance of the securities and the terms of the maturity. The debtor and creditor may agree for charging interest for the term on the commercial paper 8. Discount at banks Non-discountable at banks Discountable at banks 9. Use for debt settlement Financial securities are not acceptable as a method for debt settlement because they are vulnerable to price fluctuations. Acceptable as a method for debt settlement because of their value stability. 10. Recoverability The buyer of a financial security does not guarantee the financial solvency of the issuer for recovery of the same value. The issuer of a commercial paper guarantees settlement of the amount at maturity otherwise prevented by the issuer bankruptcy. 11. Validity Financial securities are valid unless invalidated by law. The rights under commercial paper are subject to prescription after a relatively long period, (for example five years) determined by the legislative system in each country.