Saudi Arabia comprises more than half of the GCC Islamic finance market in terms of Islamic assets and represents a far greater percentage of the sharia-compliant syndicated and project financing market. With Islamic syndicated loans in the first five months of 2012 surpassing the full 2011 figures largely on the back of Saudi mega-deals, this is showing no signs of slowing. However, Saudi Arabia has not always been a powerhouse of Islamic finance and is a relative newcomer to the market. While Islamic project and syndicated financing dates back to the early 1990s, the take-off point for its rapid expansion in Saudi Arabia was the mid-2000s.

The catalysts for the explosion of Islamic finance in Saudi Arabia included:

• The fatwa issued in 2005 in Saudi Arabia directing that a halal investment in the Saudi equities market required that not only were the activities of the company halal but it must also be financed in a predominantly sharia-compliant manner;

• A requirement that entities taking feedstock allocations in Saudi Arabia must offer shares to the public; and

• The rapid gain in retail market share by the fully sharia-compliant Al Rajhi Bank. As a result, Saudi banks became more focused on sharia-compliant financing, as were sponsors and borrowers. Between 2005 and 2008 there was a seismic shift in the Saudi finance market towards Islamic-compliant structures.

Fuelled by steeply rising oil prices, the Saudi project finance market experienced an unrivalled period of growth during this time. The Islamic project financing market grew with it; since the fully sharia-compliant Al Waha Petrochemicals project in 2006, all significant Saudi project financings have included an Islamic tranche.

Financing Structures

While there are variations in the structures used in Islamic project financings in Saudi Arabia, the most common approach which has developed is a combination of istisna (or procurement) and ijara arrangements.

The traditional istisna approach requires the financiers to enter into a direct contractual relationship with the contractor which would usually be backed by the contractual arrangements between the financiers and the project company.

This approach exposes the financiers to a greater degree of risk and also creates additional complexities in transactions which combine conventional and Islamic financing.

A variation of this approach is where the istisna is entered into between the financiers and the project company, specifically allowing the project firm to subcontract to the contractor its obligation to construct and deliver the project assets.

A more recent and more broadly used arrangement is the procurement approach. Under a procurement agreement, the project company undertakes to procure the construction and delivery of the project assets from the relevant contractor. The terms of the engineering, procurement and construction (EPC) contract are usually referenced in the agreement, thus avoiding the need for detailed specifications as are found in the istisna approaches.

The financiers and the project company will typically enter into a forward lease agreement, which provides for advance rentals to be paid by the project company to financiers prior to the completion of the leased asset and then lease payments following delivery.

Following the delivery of the project assets to the financiers, the financiers appoint the project company as service agent in order to manage various ownership-related responsibilities such as insurance and major maintenance. Purchase and sale undertakings are also in place to provide mechanisms for dealing with termination and pre-payment.

Future Demand

The demand for project financing in the Middle East in general and Saudi Arabia in particular remains high due to the further development of the oil and gas markets, infrastructure requirements and the responses of various regional governments to the events of the Arab Spring. Estimates are in the region of $150bn-250bn over the next 10 years.

Post global financial crisis, the development of project finance in the Middle East has been impacted by myriad influences including the retreat of the European banks, the rise of the export credit agencies, the shift east towards Japanese, Korean and Chinese banks and export credit agencies (ECAs) and the impact of Basel III on long tenor appetite. Perhaps the most significant result of these market shifts is the need for sponsors to tap alternative sources of liquidity. Indeed, the ECAs have made a substantial contribution towards the successful closing of a number of regional transactions. It is typical for either direct or covered funding from ECAs to account for up to 25% of project finance packages. It is also the case that the entrance of Asian ECAs reflects a similar shift towards Asian EPC contractors and suppliers, with a move away from traditional US and European participants.

An interesting recent innovation in the area of Islamic project finance was the Saudi Aramco Total Refining and Petrochemicals Company (SATORP) project sukuk (Islamic debt instrument). The SR3.75bn ($1bn) musharaka sukuk formed part of the $8.5bn financing of a refinery project in Jubail, a joint venture between Saudi Aramco and Total. The sukuk comprises an istisna for the construction phase and a forward lease. With a 14-year tenor, it is a novelty in the Saudi sukuk market, where five-year tenors are the norm, yet was over-subscribed 3.5 times.

The SATORP sukuk is clearly a step forward in the diversification of the sources project financing in Saudi Arabia. Undoubtedly investors took great confidence in the guarantee from Saudi Aramco which underpins the sukuk and this feature may limit the precedent value of this form of financing to credits of the likes of Saudi Aramco, or to refinancing existing project assets.

The Islamic project financing market has matured significantly since the mid-2000s and financing costs and transactional costs are converging with its conventional equivalent. With the demand for project financing increasing across in Saudi Arabia, and the supply of participants diminishing, Islamic project financing will comprise an increasingly significant part of the project financing market.

The Mortgage Law

The much anticipated Mortgage Law for Saudi Arabia was enacted by Royal Decree No. M/49 on 13 Shaban 1433 H (July 3, 2012). The Mortgage Law is part of a collection of five laws, all enacted together on the same day, but under different royal decrees. The four other laws are the Enforcement Law, the Real Estate Financing Regulations, the Finance Licensing Regulations and the Finance Companies Control Regulations.

The five laws between them set out regulations governing the registration and enforcement of mortgages and also the establishment of finance companies in Saudi Arabia.

The laws were published in the Official Gazette in August 2012 and are now in force. The Saudi Arabian Monetary Agency (Central Bank) circulated drafts of the proposed implementing regulations to banks and other concerned market participants in November 2012.

Registration Of Mortgages

Under the Mortgage Law, in order to be both effective against third parties and enforceable, a mortgage must be registered with the relevant Real Estate Registry in accordance with the Real Estate Registration Regulations enacted by Royal Decree No. M/6 dated 11 Safar 1423 H (April 24, 2002).

The Real Estate Registry has not so far been widely implemented throughout the Kingdom of Saudi Arabia; in fact the only register in place is in Huraymila Governorate, which lies about 80 km to the northwest of Riyadh. Until registers are in place, the Mortgage Law provides that mortgages over real estate shall be recorded by the local notary public on the relevant land title deed. The time of registration of the mortgage will determine priority among mortgagees over the same real estate.

Significantly, the Mortgage Law does not preclude the registration of mortgages in favour of commercial banks. Saudi Arabian notaries public have previously declined to record mortgages over real property in the name of a commercial bank as mortgagee, on the grounds that such mortgages secure an indebtedness which has been tainted by interest contrary to the sharia, and therefore that the religious beliefs of the notaries public would be compromised if they recorded such mortgages.

The introduction of a law for the registration of mortgages generally, and which does not preclude the registration of mortgages in favour of commercial banks, thus constitutes a landmark development in the evolution of the Kingdom’s legal framework.

Requirements For A Valid Mortgage

In setting out the requirements for a valid mortgage, the Mortgage Law reflects underlying principles of sharia. At the time the mortgage is granted the real estate must be in existence, owned by the mortgagor and capable of being disposed by the mortgagor. It should also be readily identifiable. Buildings and improvements fixed to the real estate will be covered by the mortgage unless otherwise agreed upon.

The mortgage over the real estate will not secure income generated by the real estate unless agreed by the mortgagor and the mortgagee. The mortgage must state the specific or maximum anticipated amount of the secured debt. This is necessary to satisfy the sharia principle that the mortgage must specify the amount equal to all obligations secured by the mortgage.

Enforcement Of Mortgages

The Enforcement Law provides for the creation of Execution Departments at courts in the provinces and main cities of the Kingdom of Saudi Arabia, which shall be responsible, together with other relevant authorities, for the enforcement of judicial orders in respect of mortgages. If a mortgagor is in default of repayments, the Enforcement Law provides that the mortgaged real estate can be sold through auction in accordance with the procedures set out in the Enforcement Law.

Real Estate Financing Regulations

The real estate financing regulations set out a number of important provisions governing the Kingdom’s new mortgage regime. These regulations set out new rules for the establishment, licensing and operation of finance companies, which will be able to carry out real estate financing, as well as other activities, such as finance leasing.

The regulations also contemplate the creation of a market for mortgages and provide for lenders to sell mortgages to companies who can securitise them for onward sale to investors. In addition to enabling banks to take mortgage loans off their balance sheets, it is possible a market for mortgages will assist in the further development of the sukuk market in Saudi Arabia.

Further, under the regulations, a bank will be able to register title to residential premises in its own name in connection with the provision of financing for home loans. This means a bank is able to secure its interest by taking actual title to the real estate, effectively as an alternative to taking a mortgage over the real estate.

This new rule is an exemption to the restrictions under Article 10 of the Banking Control Law of 1966 which states that banks cannot hold title to land except for use as office premises, as accommodation for employees or as part of the process of enforcing a mortgage over real estate.