LEGAL ISSUES IN ISLAMIC FINANCE
ROBERT FUGARD
Islamic finance is not just a way of conducting banking business without interest.
This is a misconception frequently entertained by secular financiers and stems from a misunderstanding of the ethical rationale for Islamic finance and makes it easy to overlook legal differences from conventional financing methods in the way in which Islamic finance is provided.
A failure to appreciate these differences could lead to parties encountering difficulties which could be avoided or minimised if dealt with at the structuring stage in a transaction.
The Islamic principle which has arguably the greatest impact on the way in which Islamic finance is conducted is the Islamic prohibition of Riba, which is generally understood to mean the charging of interest.
The prohibition of Riba is, however, more complex than simply a ban on the charging of interest and may be understood as an objection to charging for the mere use of money.
A person may earn a return on his money if he invests it in a productive enterprise and assumes the risk of losses as well as sharing in the profits of that enterprise. So, whereas the loan on interest is the principal secular way of funding the acquisition of assets, the principal Islamic asset-financing techniques involve the financier assuming many of the incidentals of ownership of the asset being financed.
Bearing this in mind, this paper will discuss certain key legal and contractual issues concerning the Islamic financing of assets. It will not discuss individual financing techniques in detail, but will refer by way of illustration to Murabaha (or cost-plus financing) and Ijara (or leasing) contracts, on the grounds that these constitute perhaps the most easily recognisable Islamic asset-financing techniques which are commonly used both in their own right and, increasingly, as building blocks in larger and more complex transactions with an Islamic finance element.
The perspective adopted in this paper is that of an institution wishing to structure a financing transaction conforming to Islamic principles, but governed by English law. Many of the points discussed would, however, also be relevant under many of the other principal secular systems of law.
Structure
The way in which the asset is to be financed will depend on a range of commercial factors, such as the nature of the asset, the length of the financing required, whether the manufacture of the asset must be financed in addition to its acquisition and, critically, the extent to which the financier wishes to take the credit risk of the customer.
For example, the financing of an asset by means of Ijara will require the financier to take and retain title to the asset for the duration of the financing; the financier will have the security of the asset in the event of payment default by the customer, together with the ability to adjust rentals periodically to reflect its funding costs or to match the customer’s ability to make payments to the customer’s cash flows. The financier under Ijara, however, has to assume the risks accompanying ownership of the asset for the duration of the financing, including the risk of loss of the asset and the risk of claims by the customer and by third parties.
By contrast, under a Murabaha, the period of ownership of the asset by the financier is typically relatively short (or even nominal) and the ownership risks to which it is exposed are correspondingly more limited. If, however, the customer is to pay for the asset on a deferred basis, the financier will be unable to rely on its ownership of the asset as a means of protecting its investment, although it may take a security interest in the asset, such as a mortgage (to the extent that local law permits), or a guarantee to secure the payment of the purchase price by the customer.
Legal Factors
The principal legal factors affecting the way in which the asset will be financed will relate to taxation and the approach of applicable laws to ownership and the availability of security interests.
a) Taxation
A conventional debt financing of the acquisition of an asset will raise taxation questions which, while potentially complex, will be relatively familiar to financiers. Where the same aim is achieved using Islamic techniques, the financier will be earning its profit by assuming, even if only temporarily, an ownership interest in the asset. The financier will therefore have to consider carefully whether the proposed structure would render it subject to tax in its own jurisdiction as well as in any of the other jurisdictions connected with the financing.
Taxes may arise as a result of the capital gain made by the financier on selling the asset, the liability of the financier or its customer to pay value added tax upon its acquisition of the asset, or on the payment of rentals and the incidence of documentary taxes such as stamp duty upon the transfer of title to the asset or the assignment of warranties. Use is made by financiers both of affiliated companies incorporated in tax-neutral jurisdictions and of applicable double taxation treaties to manage the tax efficiency of the transaction.
b) Acquisition and Loss of Title
The law of the jurisdiction in which the asset is located will have to be examined carefully to ensure that the financier will be capable of taking and passing title in the asset to the customer and, where the financier’s retention of title is the key to the financing (such as under an Ijara), retaining title for the duration of the financing.
It will be necessary to consider the formalities required for perfecting the transfer of title – ownership of certain assets such as aircraft or ships may require registration, and registration may be subject to restrictions (for example, on the grounds of nationality).
Consideration must also be given to the circumstances in which title to the asset may be lost; for example, in many jurisdictions an asset which is fixed to a building or to land will be deemed to form part of the building or land, and ownership of the asset will pass to the owner of the building or land.
Similar provisions also exist in some jurisdictions where certain types of movable asset are fixed to other movable assets so that, for example, title to an aircraft engine may be deemed to pass to the owner of the aircraft to which it is attached at the time.
Whereas it is relatively common for secular leasing transactions to be structured on the basis that the lessor will never in fact own the leased asset (multi-tiered aircraft-financing transactions are an example of this), or on the basis that legal title to the leased asset has in fact already passed to the lessee (for example, United Kingdom tax leases of fixtures), the inability of a financier to obtain and retain title to an asset throughout the financing term under an Ijara is likely to prevent the Ijara from taking place or to cause it to terminate prematurely.
c) Security
The financier may expect to receive a mortgage over an asset to secure, for example, the obligation of a customer to pay it the deferred purchase price of an asset under a Murabaha. Again, the approach of jurisdictions to the availability of mortgages (particularly over movable assets) varies considerably. In the United Kingdom, for example, mortgages of movable assets are possible. By contrast, in certain Middle Eastern countries, mortgages of movable assets are not generally possible and security can only be taken by a financier if it takes a pledge (usually involving it taking physical possession) of the asset, which is likely to defeat the point of the financing.
Even where a non-possessory security interest is possible, factors such as the requirements for registration, notarisation, consularisation, translation and the payment of fees and documentary taxes (often at a relatively high percentage rate of the sum secured) may themselves have an impact on the attractiveness of security as a part of the transaction structure.
Consequences of Ownership
Where a financier acquires ownership of an asset as the means of financing, it will inevitably expose itself to an element of risk which would not be present had it merely lent money for the acquisition of the asset. These risks will be present whether the financier’s ownership is prolonged (as under an Ijara) or for a relatively short time (as under a Murabaha).
(a) Delivery Risk
A basic structural risk arises from the Islamic requirement that the financier may not contract to sell or lease an asset prior to acquiring it, with the result that the customer may, in principle, refuse to take the asset on lease or to purchase it once the financier has acquired it for that purpose. This risk is often mitigated in practice by the customer acquiring the asset as agent for the financier and promising to take it on lease or to acquire it thereafter under an agreement entered into in a form agreed at the time the agency is concluded.
As the financier’s agent, the customer should not agree to take delivery of the asset if it is not satisfied that the asset complies with the specification that it has agreed in relation to its own purchase or lease of the asset; if, however, the customer simply changes its mind after acquiring the asset on behalf of the financier, the financier may, to the extent that it has suffered loss as a result of the customer’s breach of promise, seek damages from the customer.
To guard further against this risk, the terms of the agency may require the customer to use its own funds to acquire the asset and provide for the financier to reimburse it for the purchase price. Here the financier would seek to set off any losses incurred by it as a result of the customer’s non-completion against its obligation to reimburse the customer.
(b) Asset Risk
If the asset is destroyed or rendered unfit for sale or lease while owned by the financier, for reasons not attributable to the customer, this will be a risk borne by the financier. Under an Ijara, where the financier will be at risk for the duration of the financing, the financier will typically seek to protect the value of its asset by obtaining the customer’s agreement to maintain and operate the asset within certain agreed parameters and will retain the right to inspect its asset periodically to check compliance with this.
If the asset is rendered unsuitable for the purpose for which it is leased, then it is generally thought that the customer must be released from its obligation to pay rentals; in this respect an Ijara differs considerably from standard practice under a secular lease where a customer is generally required to continue to pay rentals irrespective of any inability to use the leased asset (the so-called “hell or high-water clause”).
As with a secular lease, the financier will normally seek to manage the risk of loss or damage to its asset by means of insurance; this raises further issues which will be touched upon briefly later.
(c) Implied Terms
As the supplier of the asset to its customer (whether by sale under a Murabaha or by lease under an Ijara), the financier will assume responsibilities with respect to the asset which it would not have if it merely lent money to its customer to acquire the goods. Jurisdictions will frequently imply terms into a contract to supply assets (such as implied warranties of title, quality or fitness for purpose) which would in principle make the financier responsible to the customer for shortcomings in the asset, and may legislate to restrict the extent to which a supplier can contract out of those responsibilities.
The financier’s starting position will always be to try to obtain its customer’s agreement that the asset supplied is in all respects satisfactory to it and to forego any right it may have to claim against the financier for the asset’s shortcomings. The financier’s ability to restrict its warranty of title in a Murabaha is likely to be extremely limited, while, as mentioned above, the customer will not generally be obliged to pay rentals under an Ijara if the financier’s lack of right to lease the asset prevents the customer from using it. The extent to which the financier may limit its other responsibilities as supplier of the asset will be governed by the laws applicable to the contract.
Liability
The financier must also consider carefully the risk of its incurring liability arising through its owning or supplying the asset.
(a) Fault-based Liability
If the asset causes harm to third parties while owned by the financier, third parties may look to the financier to make good their losses, particularly if the entity having operational control of the asset has insufficient funds to compensate their losses. A financier would in most circumstances be able to avoid liability if it could show that it was not at fault, since ownership alone will not normally give rise to liability. Where the financier leases the asset, it will probably stipulate that the asset should be maintained in a particular manner and it may, especially in relation to substantial assets such as aircraft, retain rights to inspect and, if necessary, correct shortcomings in the asset’s maintenance. The greater the financier’s involvement in the asset, however, the greater the scope for it to be found at fault.
(b) Occupiers’ Liability
In some instances, a financier may be held liable to third parties simply by owning or supplying an asset and careful consideration must be given to its ability contractually to limit this liability or to pass the risk to the customer. For example, under English law, a financier could in principle incur liability as an “occupier of premises” under the Occupiers Liability Act 1957 if, as a lessor, it retains a high degree of control over the leased asset (for the purposes of the Act, premises would include vehicles such as aircraft or ships). Liability under this Act may only be excluded to the extent compatible with the Unfair Contract Terms Act 1977 and in any event, it is not possible to exclude by contract liability to third parties.
(c) Environmental Liability
Perhaps a more topical example of a financier’s potential liability to third parties is liability for environmental damage. Many jurisdictions now impose liability on the owner of property from which pollution emanates, with sanctions ranging from the obligation to pay clean-up costs to criminal sanctions in certain extreme circumstances. Legislative protection for the environment is clearly approached differently by differing jurisdictions, with the European Community, for example, legislating on water, hazardous substances, air pollution and environmental management with proposals suggested to make environmental liability strict or no-fault-based.
(d) Product Liability
A final example of potential financier liability is that of product liability. Many countries have enacted legislation which imposes liability wherever a person suffers death, personal injury or damage to property as a result of a defective product. While liability will principally attach to manufacturers of defective goods, it may (as under the United Kingdom’s Consumer Protection Act 1987) attach to a person importing goods into the European Community from outside the Community, in order to supply them to a customer.
Risk Management
If the risks faced by Islamic financiers of assets are not altogether different from those faced by secular financiers, there are differences in the way in which the financier may allocate risks between itself and its customer, or hedge its risks by sharing them with third party risk-takers, such as insurers.
The most obvious risk management strategy is the financier’s knowledge of its customer and, where the financing entails an enhanced exposure to the asset, the financier must also understand clearly the nature of the asset it proposes to finance.
The structure chosen for the financing will reflect the financier’s assessment of its customer’s creditworthiness as against its willingness to assume prolonged asset risk. Whichever structure is chosen, however, the first step for the financier should be the identification of all relevant legal risks. This may entail a thorough investigation of the laws relating to ownership, security, taxation and contractual warranties in a number of jurisdictions, but an early investigation of the legal environment of a transaction is the best way of avoiding costly and frustrating delays when the transaction is under way.
Financiers generally seek to place as many risks as possible with their customers. This will involve a financier not only limiting a customer’s recourse to the financier by the exclusion of warranties by the financier (in its capacity as seller or lessor), but also shifting the responsibility for third party liability and for loss or damage to the asset to the customer, by means of wide-ranging indemnity provisions and by obliging the customer to pay the financier “come what may”.
Given that the financier is generally expected to bear asset risk itself in Islamic finance, the extent to which the financier will be able to achieve this shift of risk will depend, among other things, on what its Sharia committee will permit.
A financier’s liability to third parties is clearly not purely a concern in Islamic financing and in secular financings the financier will routinely seek wide-ranging indemnity protection from its customer. This approach will not always be acceptable in Islamic financing, where the lessor is likely to have to retain responsibility for claims which have not actually arisen through the fault of the customer.
Whatever the balance of risk achieved between financier and customer, the financier will wish the risk of damage or loss to the asset and liability to third parties to be covered by insurance. Under secular financing, insurance is generally the responsibility and the expense of the customer Under an Islamic financing, consistent with the principle that risk (other than in relation to the actual liability of the customer) should remain with the financier, insurance of the asset is generally the responsibility and the expense of the financier.
The extent to which insurance may be used to hedge risk and the type of insurance that may be used is itself the subject of debate; different views exist as to whether secular insurance is acceptable or whether Islamic insurance (or Takaful) should instead be used. In each instance a decision will have to be taken by the financier’s Sharia committee.
Remedies
One of the considerations to be taken into account when structuring the financing will be the ease with which the financier can recover sums due to it. This will depend on a number of factors, including the legal characterisation of the sums due, the location and means by which disputes are to be resolved, and the location of the customer’s assets. The subject of dispute resolution is rather too large a subject to cover here, but a few points of particular importance should be mentioned.
(a) The Nature of the Claim
Under English law, the legal character of an amount due will have a considerable impact on the case with which it may be recovered. For example, the sale price due from a customer under a Murabaha would be characterised as a debt, and being of a fixed amount, proceedings to recover it ought not to be unduly complicated.
On the other hand, a claim arising from a failure by a customer to pay amounts due under an Ijara may be characterised as a claim for damages; to be claimable, damages must first be quantified and may be reduced by the financier’s duty to try to reduce its losses.
While attempts may be made by parties to simplify the process of determining losses by agreeing in advance the amount to be paid by the customer upon a breach (i.e., “liquidated damages”), courts will not always give effect to such an agreement, particularly if the amount agreed to be payable appears to be penal in nature.
(b) Dispute Resolution
Parties to an international financing may find it hard to agree upon the appropriate jurisdiction for the resolution of disputes, with either party resisting the resolution of disputes by the domestic courts of the other party. Whatever the merits of the parties’ feelings on the matter, the issue is often resolved by an agreement to submit disputes to a forum which is independent of either party, such as the domestic courts of a third-party jurisdiction or to arbitration.
From the financier’s point of view, any forum chosen must be acceptable under the domestic law applicable to its customer (or, at least, to the place in which its customer’s assets are located), since there is little point in obtaining a judgement against a customer in one forum if, in order to execute the judgement against the assets of the customer, the matter must be re-heard in the jurisdiction where the assets are located.
This issue will be of particular concern if the domestic law of the jurisdiction where the assets are located has as its base the Sharia, if the courts of that jurisdiction take a different view of the conformity of the transaction to the Sharia from, for example, the Sharia committee of the financier.
A related, if hopefully theoretical, concern involves the possibility of a customer incorporated in a jurisdiction whose domestic law is based on the Sharia seeking to avoid its obligations under a financing contract by arguing in the courts of the chosen forum that it did not have the power to enter into the transaction on the basis that it was contrary to the Sharia as interpreted by the courts of its place of incorporation – even if the financing contract was enforceable under the governing law of the contract.
There appears to be no instance in which an Islamic institution has sought to avoid its obligations by raising this argument before an English Court. The prudent way of trying to prevent such a surprise is, of course, for the financier to require a legal opinion in the jurisdiction of incorporation of its customer to the effect that the customer has, among other things, the capacity to enter into the transaction and that a judgement given by the courts of the chosen forum would be enforceable in the jurisdiction in which the customer is incorporated.
Conclusion
In its greater reliance on passage of title and on ownership as a means of financing assets. Islamic finance raises a series of issues with which secular asset financiers will be broadly familiar When structuring an Islamic asset- financing transaction, the mechanical differences from secular financing that should be considered stem predominantly from the different balance of risk allocation between financier and customer that is required by Islamic financing contracts and from the greater restrictions placed upon the way in which a financier may manage its risk.
To conclude then with a statement of the obvious, perhaps the best advice to parties proposing to structure the financing of assets conforming with Islamic principles is for them to consider the legal environment in the relevant jurisdictions in detail at the outset and, where necessary, to take local legal advice at the earliest possible opportunity.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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