ISLAMIC BANKING: A WESTERN LAWYER’S PERSPECTIVE
MICHAEL CLODE
The aim of the discussion on general legal issues is to describe the aspects of Islamic transaction documents which, from the English perspective, we often have difficulty with. The transaction review will demonstrate how these difficulties arise in practice and illustrate how these transactions are actually structured. Many people find discussion on the issues of Islamic banking helpful, but what they really need to understand is how those issues arise in practice.
The relevance of English law to Islamic transactions derives from the choice of governing law for the financing documents and other agreements relating to those transactions. As for many international financial transactions, the banking community requires the certainties which interpretation of documents in accordance with English law is considered to provide.
In the context of a large number of Islamic countries, because of historical relationships with the English law system, the similarities between local and English law mean that the choice of English law is often not particularly controversial. There is certainly nothing to indicate that the practice of choosing English law will change.
Liability
In nearly all of the traditional forms of Islamic finance the lender is at some stage the owner of the goods which are the subject of the financing involved, and, clearly, the longer the financier retains the asset, the greater the exposure to ownership-derived liability. In Ijara this will be as the owner of the goods being leased and in a Murabaha as the seller of the goods concerned. In contrast, such an element of risk does not exist in a conventional transaction, where a financier merely lends money to a borrower for the acquisition of an asset.
To date, there has been little concern expressed as to the risks to which these roles expose the lender However, legislation, either new legislation in the traditional areas of operation or existing laws in new areas of operation, imposes liabilities on owners or vendors. Even where the lender’s liability may seem remote, the lender’s “deep pocket” will inevitably result in it being considered as a potential target for litigation.
A financier’s ownership of goods gives rise to a range of potential liabilities in English-law-governed transactions and it is true to say that similar problems arise in other jurisdictions. Under English law, a lender cannot normally be held liable for damages or losses caused by an asset merely because the lender owns the asset; the lender must be at fault in some way, except where the lender assumes liabilities pursuant to a contract, although in a few cases strict liability applies.
Nevertheless, lenders must be aware that third parties harmed by an asset owned by a lender may well seek compensation from them. In a leasing transaction, lessors will seek to avoid fault-based liabilities and potential contractual liability by ensuring that the following are covered by the lease:
a) lessor only gives such title as it receives;
b) only warrants quiet enjoyment as against itself;
c) reasonably excludes warranties on quality; and
d) lessee obligation to inspect the asset before delivery and to maintain the asset.
A lessor may also have liabilities imposed on it under the Occupier’s Liability Act 1957. This may be the case if the lessor decides to impose restrictive maintenance conditions on the operator. The Act focuses upon the degree of control exercised over the asset in question. If a lessor is considered to be an occupier by the Act, it owes a duty of care to persons, for example, passengers who are legitimately on the premises. For the purposes of the Act, assets such as aircraft are deemed to fall within the definition of “premises”.
Under the Unfair Contract Terms Act 1977, an owner would be prevented from excluding liability for death or personal injury caused by its negligence in such circumstances. Attempts to exclude other liability must accord with the terms of the Unfair Contract Terms Act.
Lenders owning or leasing land face civil and criminal sanctions under the wave of new legislation designed to protect the environment. The penalties are not restricted to those who cause pollution; land-owners may have to meet the cost of cleaning up polluted land, irrespective of whether they were responsible for the damage. Environmental surveys should therefore be considered wherever there is the potential for environmental liability.
European legislation is having profound impact in this area, extending its influence to air and water pollution. Proposals have also been made to make fault irrelevant in allocating liability for environmental damage.
Product liability arises wherever sub-standard goods cause damage or injury to a user. The statutory basis for this liability is the Consumer Protection Act 1987. Overseas lenders can still be affected by the Consumer Protection Act: defective goods “provided” from outside England to customers in England are a potential source of liability.
With the increasing complexity of the transactions involving Islamic finance, with the world becoming increasingly litigious and with the ability of a party to protect himself by contractual terms increasingly restricted, I believe that this is an area which will need considered attention in the next few years. These problems are manageable, but at present they are not being addressed, or at least not in an adequate manner.
Warranties
As more and more sophisticated goods become the subject of Islamic finance, the need to ensure that the eventual user has the benefit of warranty claims against the manufacturer becomes increasingly important. At the same time, the lender or owner will wish to avoid potential liability.
Islamic lenders, as vendors or lessors, are, under English law, subject to several statutes, most notably the Sale of Goods Act 1979 and the Sale and Supply of Goods Act 1994, which imply certain conditions into contracts involving their assets. These implied conditions cover, for example, the quality of, and the lender’s right to sell or lease, the goods. Contrast this to the position in a traditional Western financing transaction, where a lender of money does not assume such responsibilities.
Since Islamic lenders deal primarily with commercial customers, the implied term as to quality can be excluded, but only where an exclusion is reasonable in the context of all relevant circumstances. On a practical note, the lender should aim to exclude as far as possible any implied conditions as to quality.
It is not possible to exclude the implied conditions as to title. A lender should therefore ensure that it has good title to an asset before selling it on to a customer in a Murabaha transaction.
Again, these matters can successfully be addressed, but at present they are largely ignored. I also believe that, particularly given that many of the countries in which Islamic finance is operated have legal systems based on the English common law tradition with its emphasis on the importance of privity of contract, insufficient attention has been given to maintaining the responsibility of the original producer of goods for damages suffered by the eventual user.
Interposing the ownership of the financier breaks the privity of contract, which would apply if there were a direct sale contract between the manufacturer and eventual user.
Conflicts of Laws
The particular relevance of English law for Islamic transactions derives from its choice as the governing law of many transactions. Although the principal agreements, for example, in an Islamic transaction may be English-law governed, it is likely that some of the documents will be under local law e.g., in a Murabaha financing, the purchase agreement and the agreement which governs the relationship between the local agent and the purchaser.
Such agreements are not expressed to be governed by English law because they involve only local parties and will therefore be most effectively enforced in the local courts. Indeed, if appropriate recognition of judgement treaties does not exist between the relevant countries, an English court judgement may have no value at all in enforcing against the local counterparty in its home country.
Two particular considerations need to be borne in mind in relation to the conflict of law position.
1. On the basis that some transaction documents are subject to different interpretations from others, are there any inconsistencies in the transaction structure as a whole?
2. Are there any concepts which do not properly “fit” the governing law system to which they are subject? Problems often occur where concepts have been incorporated into local law documents from the English law financing agreements. Local lawyers obviously need to confirm that the relevant provisions are effective.
For example, Murabaha transactions typically rely on a “chain of agencies” with the agency agreements governed by a different legal system. Agency is always an uncertain area of law and there are real risks of disparities between the agency arrangements, resulting in an exposure for one or more of the parties.
Regulation
A further development which we see as becoming increasingly relevant from the English lawyer’s perspective is an increase in the regulation of Islamic banks. Although it is not appropriate, within the confines of this article, to speak in any detail about the regulatory regime currently applying to Islamic banks in this country this is likely to be an area to which increasing time and attention will be paid in Islamic ttransactions.
The increase in regulation is in part due to the world-wide trend towards greater regulation triggered, at least in Europe, by some spectacular failures of regulation. The most high profile was, of course, BCCI. There, the fact that there was no one country with overall regulatory responsibility appears to have been a major factor in delaying the discovery of the massive frauds and losses involved.
A shortfall of $7 to $8 billion is a staggering amount – equivalent to over 10% of all Islamic deposits. It is fortunate that the Islamic banking arm of BCCI was relatively small.
There have, of course, been other failures. Barings springs to mind, as does Johnson Matthey. That case was interesting in that there was no real fraud involved only massive incompetence. The only minor fraud concerned a small bribe to a junior official, who was so naive that he allowed the briber to draw the money from his Johnson Matthey account, hand it over at Johnson Matthey to the miscreant, who promptly paid it back into his own account at the Bank. Not, in the same league as the BCCI fraudsters.
However, strengthening of regulation arises also because the regulators themselves have until now been somewhat frightened of Islamic banking because they have not altogether understood it.
This is no longer the case in many jurisdictions and as the regulators become more confident and more experienced, the regulatory regime will tighten. For instance, Pakistan has recently introduced new prudential regulations.
Of course, hand-in-hand with regulation must go the question of accounts and auditing. Some progress has been made towards agreeing common bases for assessing risk in Islamic financings. For the majority of banks increased supervision will not be a problem and indeed many banks may welcome a tighter watch being kept on other less scrupulous banks, whose default might damage the reputation of the industry generally.
Murabaha
There are a number of key features that we have seen in nearly all the Murabaha transactions we have dealt with. Before identifying these features, it is probably worth reviewing the typical structure of a Murabaha financing, including the parties involved and the stages in the transaction.
The parties involved include, of course, the banks who want to lend into the structure and their agent, the Mudarib, appointed under a Mudaraba Agreement. At the other end of the structure there will be the purchaser who is seeking the benefit of the facility in order to purchase goods and the supplier or manufacturer of those goods. The local agent who acts as an intermediary and agent to the banks is a frequent feature of these transactions.
The stages of a typical Murabaha transaction are therefore as follows:
(i) purchaser submits order to local agent for goods it requires;
(ii) Local agent informs Mudarib, its principal, of the proposal;
(iii) Mudarib agrees to finance the purchase of the proposed goods;
(iv) Local agent passes this information to Purchaser through an “Offer”;
(v) Purchaser accepts the Offer which binds it contractually to purchase the goods;
(vi) Local agent, acting through purchaser, enters into a contract to buy goods from Supplier;
(vii) Purchaser, acting for itself, enters into a contract to buy goods from local agent;
(viii) Banks make their “contributions” to the Mudarib.
(ix) Agent passes the fund to its agent, the local agent;
(x) Local agent pays the supplier. The transaction is then completed until the Purchaser’s repayment obligation arises after a period normally between 6 and 12 months. Then…
(xi) The purchaser pays the deferred sale price, that being the purchase price plus costs, to the local agent as agent for the Mudarib;
(xii) The local agent pays this amount, less its fees, on to the Mudarib;
(xiii) The Mudarib distributes it to the banks pursuant to the terms of the Mudaraba Agreement.
(a) Advances
The Murabaha financing documents usually envisage a series of “drawdowns” (stages viii and ix). The availability will be limited to a specified period after signing and a provision is usually included providing for a minimum amount to be drawn-down per month. The multiple draw-down mechanism is included because some Purchasers have on-going rather than day-one requirements. However, it is equally possible to provide for the full facility to be drawn down on day one.
(b) Deferred Payment Term
The purchase price will be paid by the banks to the supplier on day one (stages viii, ix and x). The purchase price to be paid by the purchaser to the banks will be paid on a deferred date after receipt of the goods (stages xi, xii and xiii). This is often twelve months after receipt of goods although the price may be payable in instalments e.g., six, nine and twelve months after delivery.
A “renewal” mechanism can also be incorporated into the Murabaha documents. This will allow the bank, through its agent, to “renew” the Murabaha financing at the end of the initial deferred payment period. The outstanding deferred payment is therefore made but immediately followed by a new financing on exactly the same terms as the previous financing.
This technique may give the purchaser the comfort of some assurance as to the continuing availability of funds in a market where development is impeded by the deficiency of long-term funding. However, it should be noted that the banks are obliged to renew the arrangement, although they have a number of “material adverse change-type” let-outs if they do not wish to proceed. These let-outs will cover circumstances in which the banks are experiencing funding difficulties.
(c) Purchase Price
The basis for determination of the banks’ fees is a matter for agreement with the purchaser, who will find these costs included in the purchase price. The fees charged by lenders in the interest-based banking community may be an influence. The risk borne by the Mudarib which, applying Islamic principles, justifies its fee, is the banks’ ownership risk in the asset being transferred to the purchaser.
(d) Local Agent
The Mudarib may appoint a local agent to purchase the commodities on its behalf and to act as its agent in the relationship with the purchaser. The reasons for this appointment may be two-fold:
1. The local agent’s experience in setting up commodity purchases of the type envisaged by the transaction. It may in fact be a form of state-owned financial institution conducting such agency activity for the purpose of attracting foreign investment; and
2. the residence of the local agent in the locality of the purchaser and the supplier.
The local agent can also have a currency exchange function, converting the foreign currency to local currency before paying the supplier (stages ix and x) and vice versa (stages xi and xii) when passing funds up to the Mudarib. The local agent may also have responsibility for making any necessary arrangements with the central bank to ensure sufficient foreign currency is available.
The local agent will often be required to guarantee that a specific percentage of the purchase price will be paid by the purchaser The local agent’s liability for the purchase price collected from the purchaser (stage xi) is limited to this percentage amount. The risk justifies the local agent’s fee and also gives the Mudarib the additional comfort of a local agent having conducted some due diligence on the purchaser The local agent’s fees are deducted from the sale price (between stages xi and xii).
(e) Purchaser as Agent
To simplify the relationship with the Supplier, the purchaser will usually act as the local agent’s agent for the purchase of the goods (stage vi). This means that the supplier need only deal with purchaser It also gives the purchaser a direct role (albeit as agent) in the relationship with the supplier.
This is sensible in a situation where the banks and the local agent are not giving the purchaser any warranties in relation to the commodities and therefore will expect the purchaser to rely on its relationship with the supplier.
The purchaser will need to notify the supplier that he is the agent of the local agent (and in turn the Mudarib) in respect of the purchase. This is usually a benefit, as the supplier knows that he is being paid by a bank and sometimes discounts can often be negotiated in exchange for the relative certainty of payment.
(i) Syndication
The Mudarib will syndicate the loan to a series of banks. The syndication document will be a form of a Mudaraba Agreement. It deals with, inter alia, the manner in which the participating banks fund their contributions and the allocation of the fees earned by the agent (or principal Mudarib) on the transaction.
Ijara
Ijara contracts tend to be very similar to a non-Islamic lease. At a more general level it is worth noting that in non-Islamic leasing transactions the banks’ return is based on the cost of assets leased. This would be unacceptable under Islamic laws and therefore the return to the bank under Ijara is related to the profitability of the asset used by the lessee.
Ijara contracts may be entered into for long-, medium-or short-term and may be adapted to fulfil the functions of either conventional finance or operating leases.
The following points distinguish Ijara from conventional non-Islamic lease:
(a) Rental Payments Based on Cost of Funds
Difficulties arise where a lessor has financed the acquisition of an asset with floating-rate funds and this asset is to be leased to an Islamic lessee. In these circumstances, in non-Islamic transactions the owner will usually, through a finance lease, pass the fluctuating rate down to the lessee through the rentals payable by the lessee under the lease. Obviously, this poses difficulties in the Islamic context where lease rentals cannot be expressed by reference to interest rates.
A possible approach is for lessor and lessee to enter into successive leases with rental amounts to be decided later in all but the first. For example, if a three-year lease could be entered into, the first one-year lease would have the rent included but the second two leave the rent to be completed later. The rent would be agreed between the parties in years two and three.
However, there is the obvious danger that agreement in later years is not reached and therefore the leasing arrangements collapse. Alternatively, some form of agreement could be entered into describing the basis for agreeing the rental figures in years two and three.
Generally, arrangements for agreeing lease rentals outside the terms of the lease need to be considered carefully and any appropriate Sharia approvals obtained.
(b) Default Interest
Non-Islamic leases provide for default interest on late payment of amounts due under the lease. In an Islamic lease, a different approach must be adopted: this can be achieved by providing for some form of discounting formula. This could be by way of an agreed rate of discount for each day that payment is made prior to a backstop date.
If payment is made on the due date no extra charge is payable. If payment is made after the due date but before the backstop date, an agreed amount of discount is deducted from the rental payments. However, if payment is made after the backstop date, the lessor cannot recover compensation for the delayed payment.
The backstop date is chosen to reflect a commercial period in which funds might be expected at the latest to be paid, perhaps 30 days. Alternatively, the “payment-on-time” discount can be applied to reduce the amount payable to exercise an option over the asset.
(c) Insurance
In Islamic transactions, the owner or lessor of an asset should assume, or be responsible for, the management risk in respect of the asset. The owner/lessor thus agrees to pay for insuring the asset for certain risks.
In an aircraft lease, these would usually be all hull risks, war risks and spares. Liability insurance can be left with the operator. The lessee contracts for the insurance and the owner/lessor pays the lessee.
A conventional operating lease will provide for the obligation to arrange and pay for insurance to be the responsibility of the lessee. The increased responsibilities of the owner/lessor will be reflected in the amount of the lease rentals payable.
(d) Maintenance
Islamic law, in contrast to the approach taken in a conventional Western lease, envisages that the lessor would be responsible for maintaining the asset. The lessor may however appoint the lessee to carry out the maintenance on its behalf. In a similar way to insurance costs, allocation of maintenance responsibilities is likely to be reflected in the amount of the lease payments due from the lessee.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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