Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?
REQUIREMENTS OF THE CAPITAL MARKETS
A fundamental requirement of the capital markets is the need for predictability. This is an essential and overriding concern. It helps explain why there has been resistance to embracing Sha’ariah compliant products that vary from the basic format of a secured first mortgage loan repayable with interest. In commercial real estate finance, the basic financing documents are a note (evidencing the loan) that is secured by a first mortgage against income producing real estate and a collateral assignment of the rents.
In this kind of a finance product, the legal structure is intended to isolate the real estate and income derived from the real estate (in the form of rent) from the claims of others. The documentary and structural means for accomplishing the foregoing has been validated by an applicable body of law that governs how these devices act and will be enforced in practice.
The process of isolating the real estate and derivative income begins with the law that permits a loan to be secured by a first lien on the real estate and the income derived there from. The principal and interest is secured by the income producing property and is protected, as a matter of law, from the borrower, any creditors of the borrower and others who might claim precedence over the rights of the lender holding the first mortgage. This includes other lenders to the borrower who are not similarly secured by a first mortgage on the real estate . It also includes someone who might assert a right to purchase the real estate or other rights that accrue after the date of the lien under the mortgage.
The capital markets have demanded an even further refinement of the security mechanism of the first mortgage loan. This includes applying principles of so called “bankruptcy remoteness”. The near perfect device of the first mortgage is not wholly sacrosanct. There can be disruption by other creditors even if they are not priority ones. This could result in a bankruptcy where they could be unpredictable results. Since the basic requirement for the success of the capital markets (and hence the very beneficial borrowing rates and terms) is the need for predictability, every legal means possible must be employed to avoid a bankruptcy by the borrower and the unpredictability associated with bankruptcy. Among the tools used is the “Special Purpose Entity”[1] that further enhances the isolation of the real estate and the rental stream derived there from, so as to be available to repay the principal amount of the loan plus interest.
The use of non-loan structures that do not necessarily achieve the same results is problematical from a capital markets’ prospective. Indeed, the variation of the basic underlying structure (from a loan to something else) is enough to spook the existing capital markets (that are essentially based on this most useful loan structure as noted above). The Heter Iska, Murabaha, Musharaka and Ijara documents and legal structures are, therefore, not particularly useful in this context. They detract from the simplicity and legal elegance of a note, secured by a first mortgage lien on an income producing property. They can and do produce anomalous results that are unpredictable because facially they undermine the fundamental principle that the borrower be, unqualifiedly, liable for the repayment of the loan with interest. The only relevant questions should be whether it was funded and paid.
Lending is a world where summary judgment must be the rule. The existence of a triable issue is an anathema. It not only delays the collection process (possibly for years), it might even yield a genuine defense to payment. In this regard, it is important to recognize that the money was borrowed and the capital markets count on the borrower having the legal obligation to repay the principal amount together with interest in a manner that can be enforced in summary fashion.
Interestingly, as noted above, a religious court would heartily agree. Avoiding the obligation to repay is not the kind of relief that any religious court would likely grant a borrower. It is an abuse for a borrower to seek to re-characterize the documents as anything other than an absolute payment obligation. The religious authorities know better than to do anything of the sort. This is because they recognize that the object of the mechanisms that were created was to facilitate the free flow of capital from lender to borrower; not to frustrate it.[2] The documents should not be abused so as to defeat the rights of the lender to repayment.
Yet, this is not always the way a US court would interpret the very same documents. Indeed, as noted above, the manner in which a US court might interpret a Heter Iska or Sha’ariah compliant legal structure and document can be at variance with the intent of the religious authorities that created the religious oriented structures and documents in the first place. After all, the goal is to achieve the same result as a loan with interest. However, as noted above, that may not be what always happens in a US (or Bankruptcy) court interpreting these very same documents. Moreover, even if the borrower does not raise issues as to the meaning and enforceability of the religious sourced documents, other creditors might, and they likely would be successful. This is because all of the religious oriented structures noted above are designed, technically, to shift to the lender some risk of loss structurally. This is precisely the kind of other risks that the capital markets are dedicated to avoiding, as a threshold condition to accessing the markets. Indeed, whether it is a financeable lease structure, deferred purchase arrangement, Heter Iska or partnership like structure, the restructuring of a loan to conform to religious requirements means that it is no longer just an ordinary loan. Those alternative structures are subject to all the infirmities that the capital markets products have been wonderfully designed to avoid. If truly interpreted as they appear to demand, the religious oriented financial products just don’t meet the capital markets tests for a useful financial product. They do not appear to be genuine loans on their face. Yet, no religious court would, in effect, agree with this view. This is because in practice, they would interpret the legal structure and documents to be a binding and enforceable obligation of the debtor intended to reach the same result as a loan. But, alas, that is not what the documents appear to say or do. No US Court can or should be bound to hold only in accordance with what a religious court would find under similar circumstances. The laws in the US just don’t work that way. Indeed, as noted below, they may be prohibited constitutionally,[3] from acting that way.
This is also why the capital markets demand uniformity of documents and structure. The results are very beneficial. On the one hand, the borrower benefits from lower cost of funds. On the other hand, the lender benefits from greater certainty and hence the more favorable pricing.
The beauty of this capital markets product is how well they function in serving the needs of lenders, as well as borrowers who meet the standards for accessing the markets. The use of the terms “loan”, “principal” and “interest” are very important. This is because under applicable law, the principal together with interest thereon is able to be secured by a first lien on the real estate (and by extension the income derived from the real estate in the form of rent). Other obligations cannot be so secured. This includes a purchase and sale obligation. Monies invested as equity, as opposed to the principal amount outstanding under a loan, cannot be similarly secured and isolated from priority claims by others. This is also the case when interest on a loan is compared to dividends, deferred purchase price, rent, distributions or other analogous structures under the Sha’ariah. Thus, for example, the rent charged under an “Ijara” arrangement (instead of interest) or the premium purchase price paid, under a “Murabaha” arrangement, to yield the equivalent of interest, cannot be so secured. But that in fact is the nub of it; because neither the Heter Iska under the Halacha, nor the Sha’ariah compliant forms were intended to be enforced in this manner. The Sha’ariah and Halacha have legal limitations that are inconsistent with those that animate the capital markets. Thus, instead of permitting a secure payment obligation, they appear to frustrate this very goal. In effect, by crafting financial products that are inconsistent with the requirements of the capital markets, cannot be similarly enforced under applicable US law and may have unpredictable results, issues are created; not useful solutions.
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[1] A stand-alone entity (typically an LLC, in the real estate context so as to be a tax pass-through vehicle with limited liability). Its only purpose is to be the mortgagee. It is usually prohibited from doing any other business or activity. The term “SPE” is an acronym that stands for the term, Special Purpose Entity.
[2] Some even suggest that the object is to achieve the lowest possible rate of interest. Hence, a structure that would result in a higher interest being charged is to be avoided.
[3] Under the Establishment clause of the First Amendment to the Constitution
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Tagged: Capital Markets, Requirements
Leonard Grunstein 
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