ISSUES IN ISLAMIC LEASING
DEREK WEIST
Basic lease contracts originated centuries ago from Muslim trading, when usury was as unacceptable to Christians as it was to Muslims. It is therefore not surprising that ‘modern’ conventional lease agreements, which have developed from these basic contracts, are essentially acceptable to Islamic investors today.
Ijara, (operating leases or rental agreements) and Ijara Wa-Iqtina (lease purchase or finance leases) are both based on the principle of a working partnership between the owner of the asset – a lessor, and the user of the asset – a lessee, with tangible assets being financed, frequently for production purposes.
Clearly, there are some clauses that have crept into the typical conventional lease agreements (notably to do with penalties for late payment, and clauses that load the agreement too much in favour of the lessor) which need revision in order to comply with the Sharia. However, these revisions tend to be at the margin and do not normally require a wholesale re-write.
My own experience of Islamic leasing primarily arises from helping to develop and advise on IIBU’s Ijara Leasing Fund, which has now been running for two years, leasing assets valued at around $ 100 million to prime corporates in the United States.
The main issues arising from Islamic leasing can be divided into “Islamic” and “General” issues. Islamic investors have concerns relating to risk and return that are similar to those raised by non-Islamic investors. For example, all investors, whether Islamic or non-Islamic (and non-Islamic investors make up around 40 per cent of the total invested in the IIBU Leasing Fund), ask similar questions about how credit risk and residual value risk is mitigated.
In addition to the general questions raised on the Fund, Islamic investors need to be satisfied that the whole structure is demonstrably in accordance with the Sharia.
It is essential that any lease arrangement can be shown to demonstrate justice for all parties and that there is a genuine partnership between lessor and lessee. If the leases are to be put in a Fund, it is also important that there is complete disclosure, to investors in the Fund, of the duties and responsibilities of each party and the remuneration received for these duties.
These concepts of equity and transparency are not dissimilar to those required by the current investment regulations that we have had to comply with in setting up the IIBU Fund, which is regulated by the Central Bank of Ireland.
Our experience has indicated that Sharia scholars have subtly different views on the acceptability of the wording of leasing arrangements. We had to make a number of changes to the agreements in the early days of the Fund, both before and after the initial Dealing Day in April 1994.
We have benefited from valuable input from a number of different investors’ Sharia advisers, enabling us to be relatively confident that future Islamic investors will have no material objection to either the existing Fund structure or the individual agreements.
Prospective Islamic bank investors in the IIBU Fund are therefore able to review, in addition to the prospectus (which, for example, prohibits both gearing and the earning of interest), all the agreements between the different parties to the Fund. There is also full disclosure of all lessees, equipment types, lease terms and Fund valuations. The United Bank of Kuwait provides investors with audited financial accounts of the Fund each year and interim accounts at each half year. As shareholders, investors are also entitled to attend the Fund’s AGM each year.
In our role of investment advisers, we regularly visit the Fund’s Lease Managers in the US, and some investors have joined us on these visits. We have even been aware of certain Islamic institutions taking it upon themselves to arrange their own visits, although they have not necessarily been investors (or even prospective investors) in the IIBU Fund!
Investors typically spend a lot of time discussing the Fund’s investment criteria with UBK, focusing on what is actually happening in the Fund, irrespective of the documentation. For example, we run through the existing lessees and asset types and provide credit assessments of lessees and leases on request. Investors can therefore be satisfied that the Fund does not lease equipment to companies to be used in the production or sale of alcohol, gambling, pork, firearms or any other prohibited activity.
Issues relating to tax efficiency
Clearly, a tax efficient structure is of appeal to any investor in a tax neutral jurisdiction. The launch of IIBU’s Fund was put back by almost six months when we found out that the initial proposed structure, although probably tax efficient regarding US withholding tax, was dependent on arrangements which could not be guaranteed to continue indefinitely.
The structure of the Fund now comprises a Master Lease/Sub-lease arrangement, with the Fund entering into a Master Lease Agreement with a US Special Purpose Company (SPC). The SPC’s Sub-leases are with prime US corporates. The asset is sold to the Fund and the Sub-lease is assigned to the Fund.
The wording of the Master Lease and Purchase Agreements was critical, both to ensure that the Fund, for US tax purposes, could not be deemed to be conducting business in the US, and to ensure that the wording did not conflict with Islamic principles.
Achieving a tax efficient and Sharia acceptable structure has been expensive and time-consuming. However, it is better to be sure that the Fund is tax efficient than to bring investors into a tax net which is not normal for them.
The Fund itself is established as a variable capital company registered in the Dublin tax-free zone. Non-Irish investors, therefore, have no liability to pay tax in Ireland.
Issues relating to liquidity
Typical Ijara operating leases of general equipment in the US normally run for between three and five years, whereas many investors are not interested in committing their funds for this period. However, liquidity can be significantly enhanced by investors putting their money into a fund with leases of different maturity dates.
A diversified leasing fund is actually more liquid than many would expect. A study showed that a $100 million fund generates between $30 million and $35 million in cash pe r annum, which is available for reinvestment, distribution or share redemption.
(This has also helped convince some of the Fund’s non-Islamic investors that the risk associated with rising interest rates is mitigated to some extent by reinvestment of regular cash surpluses in leases with higher yields).
Another factor that provides liquidity is the depth of the secondary market for general equipment in the US for assets still on lease. Approximately $130 billion of assets are currently on lease in the US. There are a number of brokers and dealers who are prepared to make a price for many different types of assets on lease, which can potentially provide more liquidity for a fund and, in certain circumstances, provide the fund with additional capital gains.
As we felt that this was not enough for some investors, (particularly Islamic banks with high liquidity requirements) the Fund entered into an agreement with UBK whereby UBK will underwrite the liquidity of the Fund every six months so that investors can be guaranteed a purchaser for their shares at least twice each year This is, in a sense, what made this Fund unique.
Liquidity has been a major talking point with many of our investors. Most now agree that, in the case of a fund with more than 300 leases of varying maturity dates, this is more of an issue in theory than in practice, particularly as the Fund now has more than 50 investors.
Issues Relating to Risk and Reward
It is obvious that all investors wish to see maximum returns for minimal risk.
UBK has a strong credit culture and a significant number of its staff have been formally trained in credit analysis. It has considerable expertise in US corporate credit analysis, and its US Corporate High Yield Funds continually outperform most other funds in the market and regularly appear in the Wall Street Journal’s top five performers in their sector.
The lessees in the IIBU Fund are, however, predominantly investment grade and the weighted average lessee rating (by value) would equate approximately to a single “A”. The Fund, as such, is designed for investors uninterested in taking material credit risk.
All leases have to pass a four-tier credit approval process, i.e., from the Lease Originator, IIBU’s own analysts, UBK’s independent Credit Department and, finally, the Board of Directors of the Fund. The Board has two external directors, including the CEO of the largest independent stockbroking firm in Ireland. UBK actually invests directly in the Fund; our investors like to see that we have something to lose if things go wrong.
There is possibly scope for (and Islamic investor interest in) a fund that takes more credit risk in its lessee choice, particularly as there is always an asset that can be retrieved from a lessee who defaults. In addition, it is quite normal in the USA for many lessees who have filed for Chapter 11 bankruptcy protection to continue to pay the lease rentals, rather than see an asset (which could be the key to their continuing operations) being reclaimed by the lessor. However, we remain to be convinced that the lessor is properly compensated by the returns achievable for taking this sort of additional credit risk.
Residual Value Risk
At the end of the Ijara contract, the asset remains the property of the lessor. There are not normally any purchase or renewal options exercisable by the lessor against the lessee at the end of the term.
The statistics that we have analysed from a number of different sources show that actual achieved residual values, for the same type of asset, vary from lease to lease. This can be because one lessee may renew the lease for a long period, thereby generating superior returns, or it may be just because the prices fluctuate on the second-hand market owing to changes in supply and demand.
Diversification is therefore just as important as a prudent initial estimate of residual values, so that minor under-performances on some leases will be offset by over-performances on others.
There is a strong market for buying and selling second-hand, previously leased assets in the US. There are a number of publications, guides and auction handbooks, as well as brokers, manufacturers and valuers, that provide a guide as to the likely residual value of the asset at the end of the lease term, bearing in mind the likely variations in achievable results.
In order to mitigate the residual value risk taken on leasing general equipment, it is best to do the following:
a). Only lease assets that are bought and sold regularly on the secondary market,
b). Be prudent with the estimate of the residual value when pricing your bid for the lease, so that you do not price the lease at an uneconomically low level,
c). Diversify your portfolio of asset types being leased to reduce dependence on the second-hand values of specific asset types. For example, a fund that leases equipment in a single sector (medical, high-tech or whatever) is taking a substantial risk on that sector’s performance.
Ownership
There have been well-publicised examples of equipment lessors in the US suffering from fraud, gross negligence or just sheer carelessness, and losing considerable sums as a result of not ensuring that they receive good title to the equipment.
Therefore, as well as ensuring that we only deal with the most reputable lease originators in the US and top-quality lessees, the Fund employs a top firm of lawyers to oversee the sale and assignment of the assets and leases to the Fund every time that the Fund purchases assets. They ensure that the necessary sub-lessee consents are received, that the UCC filings are properly made and that all title documents are properly drafted.
We made a conscious decision at the outset that we should not cut corners in making certain that the Fund has good title to the equipment and this gives considerable comfort to IIBU Leasing Fund investors.
Fund Valuation
The estimation of residual values on our Fund is of crucial importance because it is an open-ended Fund which is valued every three months by independent valuers in Ireland. A major factor in the valuation (and a major area of subjectivity) is the estimated residual value of each asset in the Fund.
Our valuers therefore ensure that the estimate is sufficiently prudent that the residual value stands a very good chance of being achieved, yet should not be so prudent as to prejudice the returns achievable by existing investors compared with those achievable by future investors. Again, this is part of the practice by which all investors should be treated fairly and equally.
In conclusion, it should be said that there are a number of issues that need to be considered carefully in order to structure leases and leasing funds in accordance with the Islamic Sharia, particularly if they are also to be tax efficient and give an acceptable return without taking too much risk.
Islamic investors want good investments structured in accordance with the Sharia. We believe that the IIBU Fund is a good example of this. To those considering entering this market, we believe that there are a number of key issues to be addressed which may be satisfactorily dealt with by:
a). taking Sharia advice from a number of scholars,
b). taking a prudent approach to tax planning,
c). ensuring that all lessees are of an appropriate quality,
d). ensuring that the residual value estimates on each lease are sufficiently prudent,
e). ensuring that the Fund receives good tide to the equipment,
f). obtaining regular independent valuations of the Fund to show that the capital value of the Fund is not eroded.
Clearly, there are many different sectors and countries in which to engage in leasing and in the future one would hope that these will be opened up to provide good investment opportunities for Islamic investors around the world.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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