1 1 february 2011 dealing with defaults and restructuring issues in islamic finance april 9, 2011 -...
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1February 2011
Dealing with Defaults and Restructuring Issues in Islamic Finance
April 9, 2011 - Berkeley Law School
9016025
Muddassir Siddiqui
Partner, Head of Islamic Finance Middle East
T +971 4 405 4323
snrdenton.com
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Pre-Islamic Financing
Partnerships of various kinds– Mudarabah (profit & loss sharing basis)– Musharakah (profit & loss sharing basis)
Riba– Riba al-Nasiah – Riba al Fadl
Maisir – Gambling, Gharar, Ansab – Azlam
Deferred payment sale with mark-up (debt based financing) Salam – Forward Sale (debt based financing) Islam accepted some and prohibited and reformed other practices God has permitted trade and forbidden Riba الربا حرم و البيع الله أحل Time Value of Money (( الثمن من قسط allowed if part of a trade للزمن
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Mudarabah (Commenda – Limited Partnership)
Financier(s) (Rabbul Maal) provide the capital
Entrepreneur(s) (Mudarib) work the capital
Both share in actual profits on the basis of an agreed %
Mudarib is not permitted to guarantee a fixed profit to the financier
Return on the basis of how much capital financier provided for how long (interest) is prohibited
Both share in the risk of loss
Financier risks loss of capital
Financier's loss is limited to his capital contribution (limited liability)
Mudarib risks loss of labor
Mudarib is not permitted to guarantee the return of capital, unless negligent or acting beyond his mandate
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Musharakah (Partnership)
Partners provide capital and work Partners share in actual profits on the basis of an agreed % No partner is permitted to guarantee a fixed profit to the other
partner on the basis of how much capital he provided for how long (interest)
No partner is permitted to guarantee the other partner the return of his capital
Each partner must share in the risk of loss in proportion to his share in the capital
Sharing in the risk of loss at a lower % than his contribution in the capital would mean partial capital guarantee by other partners – this is not allowed
All partners risk the loss of their capital and labor, unless one of them is found negligent or acting beyond his mandate
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Al-Qard al-Hasan (Charitable Loan)
Loan amount can be guaranteed by the borrower
Lender may require collateral or third party guarantee
Lender is not allowed to take more than the amount lent (interest)
If the debtor cannot pay, give him time
No increase in the amount of debt is allowed in lieu of extension
If the debtor is in distress forgive (wholly or partially) your debt
Forgiving and giving the debtor time is better in the eyes of God
However, if there is an asset, you may recover your debt by selling the asset
Debt must be paid. Delay in the repayment of debt, with ability to pay, is a grave sin
Debt may be paid by a relative to relieve a deceased from his burden
February 2011
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Main Characteristics of Traditional Islamic Financing
Involves actual traders– earned two profits; one from sale the other from
financing. Full sharing in the risk of loss and profits No capital guarantee if the financier also desired a profit No fixed profit
In the ’70s, Islamic financial institutions tried ” يضارب back to back Mudarabah “المضارب IF as Mudarib received deposits and then as Rabb ul-Maal
invested the funds
February 2011
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�ٍSearch for Products Suitable for Islamic Banking
Islamic Banks are part of the world legal system Effected by existing laws and market conditions Bankers are not merchants - financial intermediary role Banking laws Banking activities restrictions Tax laws Sales tax (double taxation); interest (paid or received) receive
favourable treatment (tax deductions, lower tax rates) Consumer protection laws Sale warrantees; risks associated with ownership of assets Competition with conventional financing - need for a level
playing field
February 2011
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From PLS to Debt Based Instruments
February 2011
80’ shift towards debt instruments Time Value of Money is acceptable if it is an integral part
of trade but not if it is cash now for more cash later Murabaha (Mark-up Sale) help the buyer Salam (forward sale) help the seller Ijarah (Leasing, Lease to own, forward lease) Istisna’a with parallel Istisna’a Salam with parallel Salam Sukuk (Islamic Bonds) Tawarruq (Monetization)
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Form Over Substance
February 2011
Banks are in the business of financing
In order to make financing an integral part of trade, the scholars required that they became Sellers or buyers in Murabaha and reverse Murabaha
Lessor in Ijarah
Builders in Istisna’a
Buyers or sellers in Salam and parallel Salam
Owners in Sukuk (Islamic Bonds)
Buyers and sellers in Tawarruq (Monetization)
This dual role created conflict between commercial reality and contract form. Source of synthetic contracts
The margin earned from financing not enough to cover the cost and risk of seller. Use of disclaimers
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When a Default Occurs
Legal steps:– Co-operative or hostile parties– Restructuring v. Litigation– Syndicated financing – Islamic + conventional– Understand underlying agreement – both substance
and form– Dealing with multiple Shari’ah Boards – differences of
opinion
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Challenges Under Distress or Default
Most distressed deals have been voluntarily restructured to date
Some have gone to litigation The outcome of the litigation will primarily depend on the
site of the court and law
February 2011
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Restructuring a Syndicated Financing
Syndicated financing with conventional participants? IF receive return via ownership, conventional via debt Pari Passu expectation - Inter-creditors agreements Multiple Shari’ah Committee approvals? Default interest not permissible Delay the payment date of the debt in lieu of
additional payment (interest) - No Sell the debt at a discount to a third party – No Islamic restructuring - Nature of the contract.
Complex, with exposure to additional taxes and liabilities. Example buy and lease back
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Voluntary Restructuring (I)
Issues relating to specific transactions: Commodity Murabaha – refinancing through a replacement
Murabaha – what if the customer is technically insolvent? Can the new purchase and sale of commodity arrangements be attacked under bankruptcy legislation?
Trade Murabaha – asset sold back to the IFI (for an amount to clear the deferred sale price obligation under the trade Murabaha) and then leased back to the customer (i.e., a new Ijarah financing).
Possible insolvency law issues Some Shari’ah scholars would not allow it
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Voluntary Restructuring (II)
Ijarah – if the lessee defaults and reneges on its purchase undertaking obligations can the lessor (the IFI) sell the asset and keep all of the proceeds if they exceed the balance of unpaid fixed rent?
Mudarabah - extend the life of the Mudarabah Mudarabah - sell the units to the Mudarib at a mark-up with
delayed payment with proper guarantees
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Jurisdiction Issues
In deciding a dispute a court may:
Look at the commercial reality and intentions of the parties and rule accordingly
Read the terms of the contract and apply it literally Based on the totality of its terms, restructure the contract and
apply the law to restructured contract Remove the Shari'ah repugnant terms and rules on the basis of
corrected contract Invalidate the whole contract for Shari'ah violations
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Case Study - Who has the Jurisdiction
Saudi Board of Grievances
Khalid Bin Abdulaziz Alanzan v. Saudi American Bank (Samba Financial Group), dated
17/1/1429, (26/1/2008)
The plaintiff opened an account with the bank for trading in precious metals on margin
The [plaintiff] asserted that the Commercial Circuit of the Board of Grievances had
jurisdiction over this case .... The Defendant countered ... Jurisdiction belongs solely to the
Committee for the Settlement of Banking Disputes
In considering the nature of the relation between the Plaintiff and the Defendant, the Second
Circuit found that the Plaintiff considers the agreement with the Defendant to be a
"Commercial Agency for Trading," while the Defendant considers it a "Loan and Credit
Facilities" type of relation. However, the Circuit is concerned about the substance, not the
title ...
The Board of Grievances characterised the contract as an agency contract and found that
the terms of the contract violated Shari'ah rules and invalidated the contract
February 2011
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Risk of a Shari’ah Repugnancy
Beximco Pharmaceutical V. Shamil Bank – English Court of Appeal
Murabaha Contract
– "When the parties entered into the Murabaha Agreements ...neither side was under any illusion as to the commercial realities of the transactions, namely the provision by the Bank of working capital on terms providing for long term repayment, and both were content "to dress the loan transactions up as Murabaha sales (or Ijarah leases)"
TID v. Blom – English High Court – Investment Wakalah contract
After looking at the terms of the investment wakalah contracts, the English High Court stated that it was "a device to enable what would at least to some eyes appear to be the payment of interest under another guise, that is at least an indirect practice of a non-Shari'ah compliant activity."
February 2011
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Case Study – Malaysia BBA cases
Bank Islam Malaysia v. Azhar Osman, Malaysia High Court Murabaha (BBA) contract - early payment discount Bank refused to give a discount for the early payment and
argued the “BBA contract in a way differed from conventional banking because it was a sale transaction”
Held … “it could not be regarded as a sale transaction … The bank should not be allowed to enrich itself with an amount which was not due”
The court looked at the commercial reality as opposed to the form
February 2011
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Case Study: Re-characterization of the Contract
The Ijarah contract in reality is a deferred payment sale contract (Dubai court, 24/3/2010)
"The criteria of characterisation of contract is based on the true reality and the joint intention aimed by the will of both contracting parties…. from that the proper characterisation of the contractual relation between them, it is a sale contract. The court does not recognize the characterization of the contract by the contracting parties as a lease contract associated with a promise of sale and purchase merely because their intention at the time of contracting was to make a complete sale"
Re-characterisation often changes of applicable rules, rights and obligation of the parties
February 2011
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Case Study: Fix the Contract
Arbitrators found the following terms of a Mudarabah agreement repugnant to the Shari'ah:
– interim distribution of "on account" profits;
– obligation of the Mudarib to provide collateral and - in case the collateral value declines - provide additional collateral;
– in case of loss, the Mudarabah would convert to a loan contract; and
– the Mudarib seeking the permission of the financier before concluding a transaction.
Arbitrator found these terms Shari'ah repugnant and ruled that the dispute must be judged on the basis of remaining valid terms on the Mudarabah contract
February 2011
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Asset Based or Asset Backed
Nature of Sukuk assets – True sale?– Perfection of transfer of title– Existence of purchase undertaking
Have the Sukuk-holders agreed to restrict rights to enforce?
…Under no circumstances shall the Trustee/Transaction Administrator have any right to cause the sale or other disposition of the sukuk assets except through Purchase Undertaking…
ISRA 98% asset base limited recourse
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22February 2011
Dealing with Defaults and Restructuring Issues in Islamic Finance
April 9, 2011 - Berkeley Law School
9016025
Muddassir Siddiqui
Partner, Head of Islamic Finance Middle East
T +971 4 405 4323
snrdenton.com