Participation Term Certificate

Since June 1980, the issue of fresh debentures has generally been discouraged and instead, the Controller of Capital Issues has permitted the issuance of PTCs. This instrument of financing has been in operation since then in substitution to debenture financing and it is, therefore, often heard that perhaps it is a debenture called by a different name. Conceptually, if not practically, the difference between the two lies in the fact that unlike debentures, PTCs should not carry a fixed rate of return and, therefore, should have participated in losses as well. However, they are similar, considering the fact that they do not comprise part of pennanent capital of an enterprise but are for a stipulated term. In fact, PTC is one of the forms of redeemable capital as defined by the Companies Ordinance, 1984.

The mode was originally intended for medium- and longterm fixed capital needs of business entities until these have been largely replaced by term finance certificates (TFCs) which are fundamentally based on mark-up. TFCs, therefore, do not and have not participated in losses of the investee companies. It should, however, be appropriate to emphasise that since the financial and economic relationship envisaged under PTCs is not that of a debtor and a creditor but as partners in business venture providing capital resources which are usually scarce, a great deal of business judgement on the part of the financier is imperative in the matter of portfolio selection. I would view this aspect of interest-free financing not as its weakness but as the fundamental premises on which the hope of the very success of interest-free participatory financing shall be dependent. The inclination of the financiers to divert the scarce capital resources only to such projects and entities where these can be used profitably and efficiently should have served as a built-in guarantee or at least a safeguard against financial catastrophes but in practice, we observed otherwise. This factor should have assumed greater significance in the context of public-sector undertakings as well, some of which are now being privatised, who according to the then policy of financial reorientation, should have been denied budgetary support for their balancing and modernisation or for new investment. This aspect of economic policy, if practised objectively both in public and private sectors, shall augur well in promoting competition for the scarce capital finances and resources available on the market. This by itself should infuse competition between the nationalised public sector and a healthy private sector purely on considerations of commercial profits. 1 mention this because it is not uncommon to hear from public-sector undertakings which are in red that profit is not their business or consideration and that they are involved in the high-sounding game of achieving social objectives. While there is no denying the fact that the attainment of social objectives by any enterprise, let alone a public-sector enterprise, is a commendable pursuit but that should not be a garb to camouflage their inefficiencies and losses. Another inherent advantage in a profit-sharing arrangement is that it would provide the much-needed incentive for the mobilisation of savings which would be made possible through efficient use of capital.

Before undertaking discussion on those aspects of PTC arrangements which are questionable, 1 would like to present principal elements of a typical PTC arrangement.

1. PTC financing was fundamentally intended for medium- and long-term financial needs of business entities.
2. Funds under the PTC arrangements were obtained either from a single financial institution or from a financing consortia or syndicate.
3. Investment under PTC is evidenced by PTC certificates issued by the fund-using entities and included in the definition of “securities” under the Capital Issues Act, 1947 and “redeemable capital” under the Companies Ordinance, 1984.
4. Project financing and underwriting of public floatation of shares were also financed through PTC.
5. Business entity is expected to pay to the financial in situation or bank provisionally on half-yearly basis ar agreed percentage of anticipated profits with a provision for final adjustment at the end of the financial year against profits ultimately accruing to the PTC holders.
6. In the event of loss, the financier, i.c. the financial institution, is legally expected to refund the share o profit received by it half-yearly on a provisional basis. It is, however, generally provided that loss sustained by an entity in any accounting year will firs be adjusted against the reserves of the company an( the balance, if any, in the subsequent year shall bi available for appropriation between the parties ii agreed proportion.
7. The share of profit accruing to the PTC holder shall be deemed to be an expense not only in determining the distributable profits between the parties to the arrangement but also for the purposes of taxation.
8. If the fund-using entity distributes profit to the PTC holders within 30 days of the close of annual ac counts, a rebate of 2 percent shall be allowed where by PTC holders shall be entitled to a maximum prof it of 15 percent per annum on the face value of PTC
9. The financial institution shall have a right to cove 20 percent of the principal amount of the PTC intc ordinary shares at par value so long funds against PTCs are outstanding. This right of option shall hi exercised in the event the average rate of profit, u which the PTC holders are entitled, falls below the agreed minimum.

One of the most conspicuous features of PTC- arrangement is that pending commercial production and generation of op creational profits, financial institutions desire to be compensate cd and the compensation takes the form of a discount, usually 12 percent per annum, computed from the date of release of fund by the financial institution or the syndicate until the entity goes into commercial operation. The agreements further provide that the borrowing entity will issue further PTCs to the extent of the amount of discount and such PTCs are to rank pari passu with original PTCs in terms of future entitlement to profits and losses. Agreements have also come to notice where the entity is obliged to pay in cash the amount of discount stated above. This aspect is very close to an interest- bearing arrangement which thus mars the very objective for which the new scheme was conceived. I have no doubt that having initiated the new arrangement with an integrity of purpose, the fund-providing agencies would deal with this aspect with sagacity and due regard to the fundamental tenets on which the whole system of interest-free economy is based. During the preproduction stage, there should be no question of any compensation to the financier in any form and there should be no entitlement to any profits as none accrues until commercial operation starts. Also, the provision to claim commitment charge on undisbursed funds, just as in a loan agreement, seems out of place under an interest-free arrangement.

Another aspect of PTC arrangement is the provision to entitle PTC holders to an amount of profit as would yield a certain minimum return, say, 17 percent of the PTC investment whereby the purported objective would be to provide incentive to the fund-using entity to maximise its profits and retain the same, by enabling PrC holders to be entitled only to a maximum agreed proportion of profit. Although, in practice, a minimum return commensurate with the erstwhile interest seems to be the more pronounced objective. While the apparent spirit of motivation inherent in the contemplated arrangement which it sought to provide to finance may apparently not be suspect, our banks and financial institutions could not divorce themselves from the thinking which is germane to and associated with an interest-bearing arrangement. It would thus be seen that the provisions of the agreement such as above tend to indicate that our financial institutions do not find themselves satisfied unless they are entitled to and ensure firmly a rate of return which they were getting hitherto in the form of interest on their lending’s. Undoubtedly, the injunctions of Shari‘ah do permit sharing of profits in any agreed ratio but in the present phase of transformation, every effort needs to be made to ensure that investors and investees are able to free themselves from the mental subjugation. This could be achieved by discreetly eliminating provisions in the financial arrangements which may be akin to or even lend to seem like one based on interest.

Of all the provisions in the PTC agreement, the one relating to treatment of losses or profit falling below the norms is most debatable. It is being argued that such measures serve not only to act as deterrent against malpractices but are also in the nature of a compromise formula in substitution of an intensive monitoring or interference which would otherwise be inevitable in the day-to-day affairs and management of the investee company.

There appears to be reluctance on the part of banks and financial institutions to share losses of the business venture in which they pretend to be partners, but in real sense they are not. Agreements provide that:

Any shortfall in share of profit in any year against the agreed norm shall be compensated for out of the profits of the subsequent years until fully rewarded, meaning that in no ease should the bank or financial institution receive an amount less than the agreed minimum. This feature of guarantee in a perverted form, though not so termed, is in utter disregard of the Shari*ah injunctions for distribution of profit.

In the event of loss, it would first be adjusted against the existing reserves. Since reserves belong exclusively to owners or shareholders as part of equity, under all concepts of corporate jurisprudence, why should the entire loss in any year be absorbed by the reserves? In fact, the losses should be pro rata between the “partners” in business and be charged off accordingly.

In the event of loss, the total amount of PTCs outstanding shall be transformed to the extent of share of PTC holders in the loss in convertible shares which, for all practical purposes, be deemed similar to preference shares in terms of rights and privileges. In the year following loss, should there be profit, such convertible shares shall be reconverted back to PTCs and entitled to its shares of profit. In no event, the investor, i.c. bank or financial institution, is willing to be exposed to share loss which runs contrary to the spirit and objectives of an interest-free arrangement.

Ebrahim Sidat

Source: Elimination of Riba, Khurshid Ahmad, Khalid Rahman and Zahed A. Valie. Repulished with permission.