Oliver Agha is a Partner in the Abu Dhabi office

Islamic finance is growing by leaps and bounds. However, while growth appears unabated is all truly well? Oliver Agha of Holland & Knight shares his expertise through an article on the challenges the industry faces and suggests imperative measures to fill in the legal gaps.

Islamic finance has, to date, sailed past the debt crises that affected the conventional industry largely unscathed. This is because (i) Islamic banks are precluded by mandate from investing in interest-bearing debt instruments and bifurcating assets from receivables (and unbundling and selling risk) and (ii) the industry was nascent and not fully vested in the global economy and so avoided the general conflagration.

However, Islamic finance faces challenges. A core concern relates to the legally deficient structures that have been used to construct many Islamic finance products and resulting documentation. If remedial action is not taken to address the legal gaps in documentation and legal lacunae in the structures, the industry risks declining morale among stakeholders who suffer adverse legal judgments and consumers. This article addresses some core issues and suggests remedial measures going forward.

LOSING SIGHT OF THE FOREST FOR THE TREES

Concepts that are permissible by themselves are applied broadly resulting in illogical and undesirable effects.

TABURRU/DONATION

Islamic insurance (takaful) is being built on structures that suffer from egregious enforceability issues. 'Uncertainty' and 'speculation' are said to exist in insurance. To avoid these twin perils, the customer 'gifts' the premium and the insurer gifts back the 'insurance proceeds' upon the occurrence of an insurance event. However, it is doubtful if the 'uncertainty' and 'speculation' are correctly attributed to an Islamic insurance contract in the first place. Furthermore, to effect the contract through an alternate structure does not (i) solve the identified issues (assuming they were problems in the first place) (ii) help in the proper development of the industry.

Uncertainty confusedly attributed to Islamic Insurance

Some suggest that Islamic insurance suffers from 'uncertainty' (gharar) because of not knowing when or whether an insurable event shall. They point, analogously, to a contract for the delivery of an unborn calf and attribute the same 'uncertainty' in an insurance contract. However, this analogy fails under critical analysis. The prohibition of gharar in its classic sense prevents transactions for which the subject matter does not exist (e.g., sale of an unborn calf) – as the calf may never be conceived, it is unfair on the prospective buyer to be a counterparty to a future sale. Insurance on the other hand has a defined subject matter that is very much in existence. The subject matter is property/life that may be damaged and the peace of mind the insured has knowing that his/her family shall be protected if the insured event occurs; if the event does not occur then there will be no issue for the insured as he/she can continue earning/functioning. While the occurrence of damage is of course uncertain, the insurer only makes payment once the damage is certain and after proper claim verification. Thus, either the insured event occurs and payment is made or it does not and therefore there is no need for payment to be made (both scenarios of which are absolute and only contingent). In contrast, in the unborn-calf scenario the buyer is relying on the sale of the unborn calf and has not agreed any contingency for the contract not being fulfilled. Therefore, the kind of gharar that is attributed by some to takaful simply does not apply – as explained – and therefore the application to taburru is awkward at best and legally flawed at worst. It is also suggested by some that there is a gaming element in insurance (maysir – gambling) and this too is removed by the donation fix. In conventional insurance, this element was extracted out of such contracts by the requirement of 'insurable interest.' This meant that only those that had a potential loss to insure may obtain insurance – the exact same methodology exists for takaful contracts and thus, this argument is also misapplied.

As relevantly, the stated reason for the taburru construct (to remove the gharar (uncertainty) or the maysir (gambling) from the takaful transaction is equally problematic because it does not prevent the supposedly 'uncertain' transaction but facilitates it through a (misapplied) legal stratagem (hiyal) – that is explained in the next paragraph.

Once an insured event occurs, the takaful company, without any legal obligation, donates the insurance amounts to the insured (participant). Naturally, these donations are being made without any legal obligation – as under law on donations, once something is given as a gift nothing can be expected in return. So, through the unilateral donations, effect is given to precisely the uncertain contract that was identified.

In sum, the transaction is not being prevented but facilitated by this hila (hiyal) or legal fiction. Two, the kind of 'uncertainty' to be prohibited is not true gharar. Lastly, even if uncertainty is deemed to exist, taburru does not solve it – it just creates a legally unenforceable way to attempt to put the contract together.

Islamic standards, unfortunately, reflect this confusion with some references to premium payments being 'donations' and others being 'contributions.' When read in the aggregate, the standards can only be sensibly read to suggest 'obligatory contributions' as a building block in an enforceable contract rather than 'discretionary donations.' Naturally, greater clarity needs to be reflected in the standards to settle the confusion and help the considered development of the nascent takaful industry.

ENFORCEABILITY OF A PURCHASE UNDERTAKING AT FAIR MARKET VALUE

In some Islamic financing structures, the documents give the Islamic financier a purchase undertaking obligating the Islamic 'borrower' to buy out the Islamic financier at a stated or at a fair market value as a reliable 'exit.'

Is this necessarily correct?

Does a purchase undertaking at a stated value not contravene the fundamental premise of risk sharing? Clearly, there are serious enforceability issues for purchase undertakings at stated/fixed values in most circumstances.

What about purchase undertakings at fair market value? Is the exercise of such always necessarily legally enforceable? What happens if an Islamic financier invests in a line of business of a client (e.g., inventory) and then close to or at liquidation of customer decides to sell the goods (at fair market value)? While the goods may well fetch their value – is that a fair arrangement as no debts/credits are being considered against such sale. In other words, such an arrangement may well result in preferential payments to the financier and therefore contravene both the letter and the spirit of the financing partnership (musharaka or a variant thereof). In fact, notwithstanding the nature of the documentation, the law would likely result in a set-aside of such a purchase undertaking if the underlying construct is in fact a partnership variant. The reason for such is that a promise by one partner to purchase another's portion of inventory/assets at FMV at a future date without regard to losses associated with such a line of business is of questionable enforceability because the law of jurisdictions (e.g., including the UAE). On point, UAE law, e.g., prohibits redistribution of partnership losses. Therefore, such an undertaking would be deemed a redistribution of partnership losses because it contravenes the core principle of loss sharing in a partnership. There are other Shari'ah permissible means to achieve the same ends and provide legally enforceable contracts (but broad application of a principle without a due examination of the transactional particulars is perilous.

CHOICE OF LAW

Many contracts today subject Islamic transactions to English Law provided that in a conflict, Shari'ah prevails. The impact of this (and application of English Law) would result presumably as English Law governing the contract. While English Law has deep commercial depth and predictability, it nevertheless could be applied to uphold constructs (permissible under English Law) but inimical to Islamic precepts.

ADVANCE RENTALS IN FORWARD IJARA FINANCINGS

In many forward ijara property financings (whether individual home or project financings), financiers take advance rentals (or are owed the same) during construction as a credit toward rent payable once the property is delivered. The problem occurs when there is a delay or lack of delivery of the property/project – in that case the financier is left with little or no recourse to hold on to such funds or collect them as the case may be. However, the property is not in existence so any 'forward lease' of such asset is questionable in the first place (the uncertainty mistakenly attributed to insurance is more apt here). It is more appropriate to document this period with alternate Islamic constructs that are far better suited to delineate the rights and obligations and protect the parties.

Furthermore, the 'under construction period' is in any case inadequately documented and therefore confusion reigns as to the rights and obligations of the respective parties (including the customer (party requesting the financing), Islamic financier and the property developer). What is needed, of course, is a sound structure documented clearly setting forth the parties' rights (and providing for alternate means for Islamic financiers to have recourse to customer for payments advanced during this period that are actually permissible under Shari'ah). The issues with the deficient documentation are compounded by the lack of regulation that can assist judges, largely untrained in the discipline of Islamic finance, in adjudicating complex cross-border asset disputes triggering conflict of laws.

WHAT SHOULD BE DONE?

  • Develop and Enact Comprehensive Regulations: Jurisdictions must develop comprehensive regulations that delineate the stakeholders rights and obligations; considered growth can only occur when there is a clear legal and regulatory framework and consistency in the application of a reliable rule of law; sadly, the Islamic finance world is a very far from this goal except for a few notable exceptions (e.g., Malaysia)
  • Amend Constitution of Shari'ah Boards: Shari'ah Supervisory Boards should include Shari'ah Lawyer and a Financial Advisor (as is recommended by AAOIFI, a supra-national Islamic Standard Setter) to inform the scholars of the often hidden legal/financial issues that are implicated in the envisaged structures
  • Establish a Central Shari'ah Board: Countries need Supervisory Shari'ah Boards as adjunct to the Central Banks that regulate disparate Shari'ah Boards and pronouncements
  • Establish a World Class Islamic Dispute Resolution Centre: An Islamic DR Centre that renders reliable Islamic law judgments in accordance with a published framework of core Islamic principles/ guidelines (courts generally struggle to address the complex arrangements between stakeholders and in most jurisdictions there is no legal or regulatory framework that judges can rely on in such determinations) is the need of the hour
  • Training: It is imperative for bankers, lawyers and stakeholders to have training the Islamic law and jurisprudence; unless such legal training/knowledge is acquired, the documentation may continue to suffer from serious legal issues attendant in complex transactions

CONCLUSION

As the Islamic finance industry develops, it is becoming imperative, inter alia, to develop a broader Shari'ah Supervisory Board that includes lawyers/advisors, as recommended by AAOIFI. In most jurisdictions there is no governing Central Shari'ah Board linked to the Central Bank; therefore, the Shari'ah Supervisory Boards for the institutions assume a defacto quasi-regulator role for the institution and by default for the Islamic finance industry. Strengthening such rulings with legal and commercial inputs will better enable the industry to sail past, and not into, dangerous waters that face the Islamic finance ship on its journey. Courts today struggle to address the complex arrangements between stakeholders and in most jurisdictions there is no legal or regulatory framework that judges can rely on in such determinations. For Islamic finance to develop properly – reasoned judgments, published opinions and impeccable analysis must support judgments. Reasoning must transcend obfuscation – or we risk both public and spiritual opprobrium.

The Quran repeatedly calls its adherents to reason – noting that the worst in God's eyes are those who are 'deaf' and 'dumb' who do not apply reason and such are subject to being debased in life. "Indeed the worst of beasts in Allah's sight are the deaf and the dumb who do not apply reason." 8:22 " " . . . [God] lays defilement on those who do not apply reason." 10:100.

Originally published in The Oath.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.