Constitutional Considerations Under Establishment Clause | IRR Part XV

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

US CONSTITUTIONAL CONSIDERATIONS UNDER THE ESTABLISHMENT CLAUSE

Legal efforts to accommodate religious practices may sometimes violate the US Constitution by unlawfully fostering a particular religion or favoring one religious view over another within a particular religion or creed.

The First Amendment to the US Constitution contains the so-called “Establishment Clause” which prohibits the establishment of any particular religion and provides for a separation between church and state.  The First Amendment also provides for freedom of exercise of religion.  The line between permitting the free exercise of religion and the prohibition against establishing religion can sometimes be blurred.  After all, the free exercise of religion in its many various forms can sometimes lead to civil disputes among adherents to a particular religion.  Does that mean that the courts are off-limits to disputes that may involve religious as well as monetary disputes.  Where to draw the line is also a fair question.  The US Supreme Court, in dealing with these kinds of issues, has developed a body of case law that can help analyze the questions posed in this article.

The test for determining whether the enforcement of a particular principle of religious origin is constitutionally prohibited is commonly referred to as the “Lemon Test”.  It is named after the Supreme Court decision in Lemon v. Kurzman.[1]

In the Lemon case, the Supreme Court outlined its analysis of whether the government was acting impermissibly to support the enforcement of a particular religious practice or principle.  It sets out a three-pronged test.  Thus, a law or governmental activity, dealing with a religious practice or principle, is unconstitutional, unless it satisfies all three prongs of the Lemon Test summarized below:

(i)  it has a secular purpose;

(ii) its principal or primary effect neither advances nor prohibits religion; and

(iii)            it does not foster excessive entanglement with religion.

If a law or governmental activity fails to meet any of the three prongs of the Lemon test then the law or activity violates the Establishment Clause.

To violate the secular purpose test, the law or governmental activity must be motivated wholly by religious considerations as the Supreme Court found in Lynch v. Donnelly.[2]  If there is also a secular purpose articulated then this first prong of the Lemon test is deemed satisfied.

In the case of Riba and Ribit, it is hard to justify that there is any secular purpose.  It is wholly a matter of religious law and practice.  It does not have a comparable purpose under US law, where the matter of charging interest on a loan is not wrong.  Indeed, it has become the basis of one of the most successful economic systems in history.  The only concern under US law is usury (i.e., the charging of excessive interest).  The prohibition in principle against charging any interest just does not resonate under US law and practice.  Given the lower rates of interest prevailing in our economy (especially when compared to the alternative of a wholly equity based transaction), it is fair to say that it is often the debtor who desires (or even insists) on paying interest instead of a share of the profits.  A loan is typically less expensive than the equity equivalent.  The risk and credit profile is exceedingly different for a loan (and especially a first mortgage loan against income producing property) as compared to the alternative of a partnership or other equity like investment.  There is no genuine reason for anyone to use the Heter Iska or the Sha’ariah compliant vehicles, noted above, other than to fulfill a religious obligation.

There is also no plausible secular purpose for codifying under US law these religious oriented financial structures.  The only reason to deal with them at all is to respect religious sensibilities.  While that is admirable, the Establishment Clause was designed to curtail that impulse.  This is especially so where there are differing views and practices within the religion or as to the particular religious principle at issue.  In effect, the US courts would be forced to enforce one particular view within the religion over another.  However, as noted herein, the Courts are prohibited constitutionally from choosing one religious view within a particular religion over another.  This is a critical impediment to US court involvement in what is after all a religious question, as more fully discussed below.

It is also important to note that the governmental activity may still be unconstitutional if the valid secular objectives can be readily accomplished by other means (see Larkin v. Grendel’s Den, Inc.[3]).  The secular purpose cannot be a sham or secondary to a religious objective.  While opening up additional sources of capital may be an admirable objective, it is secondary to enforcing a religious requirement.

The second prong of the Lemon Test deals with whether the law or activity has the primary or principal effect of either advancing or inhibiting the religion.  In recent decisions, the Supreme Court has further analyzed this element of the Lemon Test as precluding the endorsement or disapproval of religion.  It cannot, in effect, make Islam or Judaism the law of the land.  It is one thing to harmonize with religious canons; it is another to foster religion by endorsing an Islamic or Jewish law or practice.  Accommodation of religion is different from fostering religion.  It is a continuum and at some point it may devolve into an unlawful fostering of religion (see Corporation of the Presiding Bishopric of the Church v. Amos[4]).

The second prong of the Lemon Test is violated where the government itself has advanced religion through its own activities and influence.[5]  Thus, cases involving Ribit and Riba and defining and enforcing a Heter Iska or a Sha’ariah compliant structure to mimic a loan plus interest are in effect endorsing and incorporating Halacha or the Sha’ariah into US law.  This alone may be sufficient to invalidate any court action under the Lemon Test.

The third and final prong of the Lemon Test analyzes whether there is “excessive entanglement” between government and religion.  The third prong of the Lemon Test originated in an earlier decision of the Supreme Court in the United States v. Ballard.[6]  In the Ballard case, the Supreme Court held that secular courts are incompetent to determine the truth or falsity of religious beliefs.

In the Presbyterian Church v. Mary Blur Hull Memorial Presbyterian Church[7] case, the Supreme Court ruled that the First Amendment Establishment Clause prohibits government from resolving underlying controversies over religious doctrine or from employing organs of government for essentially religious purposes.  The government may not determine issues of religious doctrine.  Moreover, the job of making these determinations cannot be delegated by the government to religious authorities and then enforced by the government.  In essence, under those circumstances, the government would be enforcing the decisions of a religious body over members of its religion.  This is especially so where there were disputes within the religion as to the appropriateness of a particular doctrine espoused by some, but not all, of the members of that religion.  This kind of court intervention would constitute excessive entanglement.

The very terms “Ribit” and “Riba” are inherently religious in meaning.  They do not have a corresponding term under US law.  As noted above, while loosely defined to mean interest, the actual meaning of the terms encompasses all manner of transactions that would not be defined as interest under US law.  Moreover, within the applicable religious laws, there are serious disagreements as to what constitutes a prohibited  transaction and what is permitted.

Thus, there are eminent Islamic scholars and authorities that assert that Riba means the equivalent of compound interest (i.e., interest on interest[8]) and not ordinary interest.  Furthermore, the original Biblical proscription has greatly expanded over time been by Rabbinic or other enactment under the Halacha.  This has similarly  been the case under the Sha’ariah.  Thus, what is or is not Ribit or Riba has changed over time and is not universally accepted by all members or authorities within the applicable religion.

The purpose and intent of the Heter Iska under the Halacha is religious in nature.  Similarly, the Ijara, Murabaha and Musharaka are also religious in purpose and intent.  Expert religious authorities are required to interpret these religious oriented structures and documents properly, as intended.  Indeed, even with the help of religious experts they are still subject to misinterpretation.  The results that might be obtained in a wholly religious context can and do differ from what a US court might find.  Indeed, as shown above, a US court might render a wholly unintended (and even wrongful) result from a religious prospective.  Moreover, religious exerts can and do disagree.  As shown above, there are legitimate differences among religious authorities.

Consider another example of this Constitutional issue in practice.  The government has attempted to deal with matters of Kashrus and Halal.  It has created organs of government that were designed to enforce standards of what is Kosher and what is Halal.  However, there is no universally accepted standard of just what is Kosher and what is Halal within the respective religions.  The Government’s attempts to legislate a definition in accordance with a particular standard have been rejected by a number of courts as unconstitutional under the Establishment Clause.  For example the NJ Supreme Court[9] recently threw out the New Jersey Kashrus Law because of the Constitutional principle of separation of Church and State.  This is because the definition of the term “Kosher”[10] can only be decided under religious law.  There are divergent views as to the meaning of the term.  If the US courts require religious scholars to testify as to the meaning of the term religiously, then it violates the Establishment Clause of the Constitution.  Moreover, not everyone within the religion agrees as to the meaning of the term Kosher.  There are different standards enunciated by various authorities within the religion.  Defining kosher as in accordance with a particular standard was held to be excessive entanglement of the sort prohibited by the Constitution.[11]

The term Halal[12] is similarly the subject of divergent views.  Thus, for example, whether a particular prayer is recited at the moment of slaughtering or not can make something that is Halal according to many, Haram[13] according to some.

Championing one view over another within a particular religion is just the sort of excessive entanglement the Establishment Clause (and the case law thereunder) was intended to curtail.

Consider too that both the terms Kosher and Halal, on the one hand, and Ribit and Riba, on the other hand, are defined and encompassed within the body of law within their respective religions dealing with sins.[14]  This as opposed to matters of commerce between parties.  In Halacha, the body of law encompassing the laws of what is and isn’t Kosher are known as Yoreh Deah.[15]  The laws of business and other interactions between one individual and another are known as Choshen Mishpat.[16]  Interestingly, the law of Ribit is not a part of the section known as Chosen Mishpat.  Rather, it is a part of the body of law known as Yoreh Deah (just like the laws of what is and is not Kosher).  Similarly, the term Halal and the fact that if something is not Halal it is Haram (i.e., it is a sin to violate this requirement).

Violating these religious laws is not a matter of civil liability.  Instead, it is a matter of sin.  How more religious can the terms be? Indeed, but for the Biblical prohibition (that is the religious source of these rules), they would not have been prohibited in the natural order of things.

Consider how Western civilization developed the concepts of trade and commerce and how vital the banking/lender function is to the proper functioning of the economy and society.  Thus as a matter of rational development of laws, there is no intuitive bar to charging interest.  Indeed, the contrary is likely true.  Hence the US laws that permit and, indeed, encourage the loan/interest structure, as a foundational element in our economy.  The first mortgage loan financing structure (and the capital markets that encompass this financing product) developed naturally over time.  As it turns out, it yielded an enormous benefit to society, in the form of substantially lower cost of funds than was prevalent at the time when the religious rules against charging interest were first promulgated.[17] As many Halachic and Sha’ariah religious scholars agree,[18] the capital markets have benefitted and not burdened our society.  In line with the foregoing, usury (excessive interest) is prohibited under US law.  Ordinary and reasonable rates of interest are encouraged.  These substantive issues are at the heart of the problem, since choosing one view over another within the religion constitutes excessive entanglement.  In this regard, I can’t help but note the trend in Sha’ariah compliant banks to have a religious board that supervises various aspects of lending.  This goes beyond just dealing with the permissible versus impermissible loan structures (that would constitute prohibited Riba); it goes to whether the intended purpose of the loan is Haram.  Thus, a loan to a developer for the purpose of creating a drinking establishment (or other such prohibited uses under the Sha’ariah) might be rejected because it is Haram.  The government, in enabling this kind of banking establishment and insuring bank accounts, as well as, creating a secondary market (Freddie Mac or Fannie Mae) to purchase Sha’ariah compliant (wholly religiously motivated financing) products, may be violating the third prong of the Lemon Test.

The kind of governmental actions noted above may even violate the second and even the first prong of the Lemon Test.  In essence, the Government is enabling a religious view and delegating to a religious board its role as an organ of government.  It is empowering the religiously oriented bank to act for purely religious purposes.  In doing so it is also endorsing it.  This goes well beyond excessive entanglement.

Beyond the Lemon Test, there is also the test enunciated in Larson v. Valente.[19]  In the Larson case, the Supreme Court held that, even where the Lemon Test is not violated per se, there can still be an issue of choosing one religious denomination over another.  One religious denomination cannot be officially preferred over another.  Taking sides in a religious matter, effectively discriminating in favor of one sect requires the state to take an official position on religious doctrine and creates an impermissible fusion of governmental and religious functions by delegating civic authority to individuals or bodies chosen according to religious criteria (see Commack Self-service Kosher Meats, Inc. v. Weiss).[20] Deferring to the interpretation of religious authorities in reaching an official position constitutes excessive entanglement under these circumstances.  It is impermissible for the state including a court to weigh the significance and the meaning of disputed religious doctrine (see Presbyterian Church in the US v. Mary Blue Hull[21]).   Similarly, can’t employ a religious organization as an arm of the civil [government] to perform the function of interpreting and applying state standards.[22]

We are a land of toleration and of diversity of views.  Our country has thrived on the principles enunciated in the First Amendment Establishment Clause that prohibits just this kind of governmental activity.  People should not be required to accept religious practices contrary to their own religious beliefs.  Efforts by the courts or government to interfere with the religious beliefs and the free exercise of religion by individuals are just wrong.

Rather than seeking protection by the government of a particular religious view or practice, recourse should be had to religious authorities as to religious matters.  The Establishment Clause was enacted for this very purpose.  As the Supreme Court stated in McCollum v. Board of Education,[23] by allowing government to interpret a inherently religious term and impose its interpretation on members of that religion is constitutionally defective.  The government, including the courts, should not be interpreting religious doctrine and its proper application.  A US court should not be deciding who is a good Christian, Jew or Muslim and whether their actions are right or wrong from a religious point of view.  This not only violates the Establishment Clause it could possibly lead to interference with free exercise as well.  As noted below, the better view constitutionally is to allow each to function within their own sphere and not mix religious practices with financing structures, but more on this below.  Both religion and government can best work to achieve their lofty aims if each is left free from the other within their respective sphere.”

Denominational preference violates the Establishment Cause (see Barghout v. Bureau of Kosher Meats and Food Control,[24] a 4^th Circuit Court of Appeals opinion, citing Larson v. Valente, Hernandez v. Commissioner[25] and of course the Lemon case.  It is impermissible for the court to sponsor one view and create a symbolic union between church and state (see Larkin v. Grendel’s Den, Inc.,[26] and see also Ran-Dav’s County Kosher, Inc v. New Jersey.[27] The Larson[28] denominational preference test takes precedence over Lemon.  The concept predates Lemon (see Hernandez, see also the Estate of Thorton, et al v. Caldor.[29])  In the Thorton case, the court struck down a Connecticut blue law.  The court held that government can’t impose an absolute duty on businesses to conform their business practices to the particular religious practices of the employee.  An individual in pursuit of his own religious views can’t use the courts to impose those views on others and force them to conform their conduct to his own religious beliefs.[30]  Government action that has the primary, not incidental or remote, effect of impermissibly advancing a particular religious practice, is constitutionally prohibited.  It conveys a message of endorsement of a particular religious belief to the detriment of those who don’t share that belief, a’la Lynch.[31]

The English courts have taken a similar position.  Thus in Islamic Investment Company of the Gulf v. Symphony Gems NV[32] and in Beximco Pharmaceutical v. Shamil Bank of Bahrain,[33] there were assertions made that the markup charged was prohibited Riba and that Islamic Sha’ariah Law governed.  In both cases, the English Courts reasoned that the Sha’ariah was not the recognized law of the State.  Moreover, different Islamic legal scholars might differ in practice as to whether a particular structure was or was not prohibited Riba.  The English Courts determined that they could apply English law only.

---

[1] 403 U.S. 602 (1971)

[2] 465 U.S. 668, 680 (1984)

[3] 459 U.S. 116, 123-124 (1982)

[4] 483 U.S. 327, 334 (1987)

[5] Id. at 337

[6] 322 U.S. 78 (1944)

[7] 393 U.S. 440 (1969)

[8] Infra footnote 86

[9] See discussion below

[10]A term that denotes the fact that only certain types of meat, fish and fowl may be eaten and then only after satisfying the requirements for ritual slaughtering, salting and watering, as applicable, as well as other detailed rules and regulations (including no mixing of meat and milk products), collectively referred to as the Laws of Kashrut.

[11] I.e., under the Establishment Clause of the First Amendment.

[12] An equivalent concept to Kosher; but under the Sha’ariah, with its own detailed rules and regulations.

[13] Forbidden under the Sha’ariah (the equivalent of a sin).

[14] Yoreh Deah vs. Choshen Mishpat

[15] A codification of the Halacha (set out topically) by Rav Yosef Karo. It is viewed as one of the most definitive works of the Halacha.

[16] The Volume dealing with commercial law by Rav Yosef Karo.

[17] See Section 88 of the Code of Hammurabi and the 20% interest rate noted therein. In the Middle Ages, rates even higher rates were prevalent.

[18] See the discussion relating to the Sha’ariah below.

[19] 456 U.S. 228 (1982)

[20] 204 F3rd 415 (2001)

[21] Supra footnote 158

[22] Id. at 451. Furthermore, in the case of the religious advisory board for a Sha’ariah compliant bank, there is in effect state reliance or sponsorship of a religious authority on matters of religious doctrine. It provides a symbolic, and more so an actual benefit, in sponsoring the activities of one view and in effect disparaging other views within the same religion.

[23] 33 U.S. 203, 212 (1948)

[24] 66 F3rd 1337 (4^th Cir.-1995).

[25] 490 U.S. 680, 695 (1989)

[26] 459 U.S. 116, 125-126 (1982)

[27] 608 A.2^nd 1365 (NJ-1992); cert. denied 113 S.Ct. 1366  (1993)

[28] 608 A2nd 1353 (NJ-1992).

[29] 472 U.S. 703 (1985)

[30] Justice Learned Hand cited in the Burger[30] decision at page 709

[31] See discussion of Lynch above.

[32] 2002 WL 346969  (QBD–Comm Ct-2002)

[33] 1 W.L.R. 1784 (Court of Appeals England and Wales-2004)

Modern Sukuk Structure, Capital Markets Compliant?| IRR Part XIV

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

OUTLINE OF A MODERN SUKUK STRUCTURE – IS IT CAPITAL MARKETS COMPLIANT OR NOT?

            Over time, efforts have been made to better adapt the Sha’ariah compliant models noted above to the needs of the capital markets. Thus, in the area of Sukuk[1]financing, a number of innovations have been introduced to make Sukuk appear to perform more like a bond financing. This includes the following:

1. A credit enhancing guarantee, by the sovereign state or other credit- worthy sponsoring party, of the Sukuk offering, which, in effect, transforms the Sukuk into what amounts to sovereign or other credit-worthy corporate debt[2].
2. A separate set of loan-like documents is executed and embedded in the Sukuk structure described below, which attempts to mimic the more traditional note and mortgage used in capital markets transactions.

a. Three special purpose entities (“SPE’s”)  are created.

b. One is owned by the borrower, one is owned by the lender and one is owned by a servicer employed by the lender.

c. The borrower causes the transfer of title to the real estate to the servicer’s SPE.

d. The servicer’s SPE enters into an Ijara type lease transaction with the borrower’s SPE, as more fully discussed below.

e. The servicer’s SPE enters into a note and mortgage with the lender’s SPE,  whereby the real estate is putatively encumbered

A similar structure is used to finance goods except that instead of an Ijara type structure underlying the transaction, a Murabaha (deferred purchase price) arrangement is entered into by the servicer’s SPE, which takes title to the goods and resells them to the borrower’s SPE at an interest-based markup.. However, the lender’s SPE and servicer’s SPE enter into a note and security (pledge) agreement (instead of a mortgage) to encumber the goods. .

The problems associated with these structures are manifold. Indeed, in recent times, as they have been tested in bankruptcy courts or in restructurings, the basic flaws have become manifest, as outlined below.

Summarized below is a compilation of some of the issues presented by the Sukuk structure described above:

1. Whether it is the underlying Ijara or Murabaha structure, as the case may be, the rent or marked-up purchase price, respectively, are interest-based amounts; not the real market rent or purchase price. Thus, the rent or marked-up purchase price, respectively, is computed, like interest, as a function of the principal amount loaned. In substance, this is hardly the kind of arrangement that many Sha’ariah scholars accept as being Sha’ariah compliant.
2. Furthermore, the embedded set of loan documents noted above, that are indeed interest bearing, give lie to the pretentions that the structure is Sha’ariah compliant. Yes, the note is not signed by the borrower, but the transaction is an integrated one. The embedded mortgage securing the note in the underlying Ijara structure does encumber the real estate. Similarly the embedded pledge that encumbers the goods purchased in the underlying Murabaha structure. In addition there is a three-party agreement required that is signed by the borrower’s SPE, the servicer’s SPE and the lender’s SPE. This required document brings the lender and borrower together in manner that validates the interest bearing note and mortgage structure so critical to the capital markets. It also integrates the Sha’ariah compliant structure and the non-Sha’ariah compliant documents embedded therein in a meaningful way, as discussed below.
3. Pre-payment also creates a number of issues. This is because the Sukuk documents (based on a rental structure under the Ijara format or the deferred purchase arrangement under a Murabaha format) don’t permit pre-payment. Nevertheless, the practice is to permit pre-payment with a concomitant reduction in the rent or marked-up purchase price, as the case may be, to account for the shorter duration that the loan is extant and hence the reduced imputed interest accrued thereon. But there is no document executed at the closing that permits the foregoing. This creates a number of legal issues in the case of consumer lending such as home mortgages. This includes the truth in lending requirements as well as local consumer protection laws designed to prohibit this kind of predatory lending. Imagine having to pay what amounts to all the interest for the entire term, even if prepay.
4. The ownership of the real estate by a bank lender or its agent (i.e.: the servicer), on its behalf, creates legal, regulatory and liability concerns. Banks are generally not permitted to own real estate (with limited exceptions as noted herein). The ownership of real estate, even for a moment of time can expose the lender to potential environmental liabilities. This is because if the lender is in the chain of title then it may have cleanup responsibilities. On the other hand as a mere mortgagee, there is an innocent lender exception built into the federal law. As an owner of real estate, there is exposure to other liabilities as well, including slip and fall cases and as the landlord with respect to any tenants.
5. There are income tax concerns arising out of the ownership, directly or indirectly, of real estate while the parties might argue that in substance the transaction is a loan for tax purposes, there is no assurance that this position will be respected. As a matter of form, the lender, through its agent, is the owner of the property.. Often these concerns are addressed in the three-party agreement noted above. However, there is no assurance that federal and local taxing authorities will accept the agreement of the parties as determinative.
6. There are also other local tax concerns. Thus, for example in New York City, there are transfer taxes and mortgage taxes. In the Sukuk structure noted above based on an underlying Ijara, instead of one transfer tax on the transfer from the seller to the buyer in a typical transaction, there would be three transfer taxes due, as follows; a) on the transfer to the servicer SPE, b) another on the Ijara lease (as a lease with option to buy) and then c) yet another on the ultimate transfer to the borrower. These are significant costs, typically equal to upwards of 4% or more of the purchase price (albeit, somewhat less on the rental value the Ijara lease). Imagine having to pay 12% of the price instead of 4%. Although the Ijara structure does not require a mortgage, the more modern Sukuk does and thus, there is mortgage tax due. However, this is typically the case in a traditional home mortgage financing as well.
7. There are bankruptcy remoteness concerns with the various Sha’ariah structures noted above. In the case of Sukuk, the servicer’s SPE is really the agent of the lender. Furthermore, the three-party agreement links all of the parties in what amounts to a re-characterization agreement. Among other things, it provides that while the lender is nominally the owner of the real estate, it is intended that the borrower be the owner. Furthermore, it typically fills in a number of gaps in the documents. Thus, the borrower is permitted to cure a mortgage default. The lender also benefits from a number of indemnities by the borrower, including in the case of fire or other casualty. This is because under the Sha’ariah in order to qualify as a genuine lease, the landlord must retain certain responsibilities, such as with regard to fire and casualty. However, under the usual financed lease arrangement, it is the tenant who is responsible for these risks. Indeed the landlord is supposed to be insulated from most risks associated with ownership of the real estate. This is so as to be able to finance against the net lease arrangement with respect to the real estate. However, if the landlord does not share in at least some of the risks, then the structure is not Sha’ariah compliant. The methodology used to deal with this issue is to set forth an agreement by the tenant to reimburse the landlord in a separate instrument. The landlord ostensibly bears the risk of loss by reason of fire or other casualty under the Ijara lease document. However, that risk is ameliorated by tenant/borrower under the three-party agreement. The fact that the tenant then separately reimburses the landlord for any expenditures incurred for this purpose is ignored from a Sha’ariah point of view.[3]
8. In the case of a Murabaha based transaction covering the purchase of  goods there is a genuine issue as to whether the implied warranties and express warranties flow to the borrower as the ultimate purchaser. This is because the borrower does not buy from the real seller. It buys from the bank intermediary. It can sue the bank but that will not sit well with the typical lender. A 4-party agreement that links the lender, servicer, borrower and seller would work but then this is the kind of linkage that is an anathema under the Sha’ariah. Moreover, not every seller will cooperate with this kind of arrangement. Also the lender is in the middle yet again and can be sued. The 4-party agreement might deal with this concern, but query whether a disclaimer of liability by a bank lender in consumer context will work as intended, as noted below.
9. In the consumer context, the bank is exposed to liability as the seller that would ordinarily not be the case in a traditional bank loan setting. Consider, the bank may not be able effectively to disclaim these liabilities in the consumer context.
10. 10.  The whole issue of priority is at issue in a bankruptcy context, even when there is a separate embedded set of loan documents, as noted above. Even under State law there can be efforts made to seek a re-characterization of the transactional documents that can cause unpredictable results. Consider for example the option to buy reserved to the borrower under the typical Ijara. If the bank goes bankrupt it can just terminate the option as an executory contract. Remember, the bank own the real estate, not the borrower. This has caused all sots of issues in Canada, the US and elsewhere[4].
11. 11.  A Bankruptcy court might re-characterize the structure as the loan and then restructure it as a true interest-bearing loan, instead of the interest based structure that is more costly and unwieldy.

12. In the typical Ijara arrangement, the borrower’s down payment for the real estate is characterized as the initial rent under the Ijara lease. However, in a foreclosure context, the borrower could argue that this is a sham and the structure clogs up the borrower’s equity of redemption. This could prevent a foreclosure. Indeed, litigating just what the substance of the structure is under state law could delay any enforcement for years. The lender might believe it could terminate the Ijara lease for non-payment and just go into landlord and tenant court to obtain possession of the real estate. But there is no certainty this will be the case. Indeed, it is more likely that the borrower would seek and obtain a Yellowstone injunction to prevent termination while seeking declaratory judgment that the lease is nothing more than a financing device. If the borrower is successful then that would require a plenary foreclosure action, instead of a summary landlord and tenant proceedings.. In a bankruptcy context, the court could rightly find that the lease is not an ordinary one. This means that it does not have to be accepted or rejected within a short prescribed period of time. Rather, the debtor could argue because of the equity implicit in the initial rent payment and the option to buy set forth in the lease equal to the principal amount of the loan, that the lease is nothing more than a financing device. Therefore, as long as the borrower has equity in the property, the automatic stay against enforcement might be  continued by the court, while the matter is litigated.

13. The three-party agreement noted above would typically include a subordination by the borrower as tenant under the Ijara lease to the mortgage held by the lender. Furthermore, there would be a cross default between the mortgage and Ijara lease. As noted above, the borrower would typically obtain the right to direct access to cure defaults under the mortgage (and recognition by the lender of these rights) to preserve borrower’s beneficial equity in the real estate. This likely creates issues as to whether the structure is indeed Sha’riah compliant. Consider this cumbersome and more structure, likely does not accomplish the intended purpose of being Sha’ariah complaint. As noted herein, it is likely not capital markets’ compliant either.

1. 14.  Because the borrower does not sign the note, the lender cannot just seek direct recourse against the borrower. It must proceed against the servicer SPE as the obligor under the note and under the mortgage that secures the same. Upon foreclosing under the mortgage it can then seek a writ of assistance to vacate the borrower tenant under the Ijara lease that was cross defaulted with the mortgage. However, as noted above, the tenant/borrower can then seek bankruptcy protection arguing that the lease is not an ordinary one; but, rather a financing device. There would appear to be no personal liability of the borrower for the principal amount of the note plus accrued interest or for the rent post termination and vacateur. Thus, the lender might eventually obtain the collateral but the borrower has no personal liability.

15. The protections a traditional bank lender expects, such as a priority lien on the collateral, may not be present. This includes an embedded set of  mortgage documents under the Sha’ariah compliant structures described above. After all they do not purport to create a genuine interest bearing loan nor do they establish a priority lien securing the repayment of the loan. In form they are an equity devices. Also absent are the typical intercreditor agreements designed to confirm the ordering of priorities among the various classes of lenders and their remedies upon a default. As far as the Sha’ariah formats are concerned, the financing structures are not loans and hence an intercreditor agreement is inappropriate. As noted above, even the three-party agreement in the Sukuk structure is problematical.

1. 16.  The Sha’ariah compliant structures likely do not result in a perfected security interest that will survive challenge in the US courts and especially the bankruptcy courts. Even when an embedded set of conventional loan documents are used, the recourse is against the intermediary servicer’s SPE, not the actual borrower. This creates a genuine issue for revolver type financings against accounts receivable or inventory. This is because it is constantly being repaid and replenished at the borrower operating company level; but, there is no direct access permitted.  Moreover, there is no real recourse against the borrower operating company and its assets. Furthermore, as noted above, in the bankruptcy context, there are likely to be all manner of claims of preference and even equitable subordination that would prejudice the rights of the lender. These kind of issues are at variance with the reasonable expectations of traditional lenders in the capital markets.  This also complicates any restructuring, because instead of simplicity of execution (which is generally a threshold requirement of most restructurings,) the Sha’riah would require implementation of the same cumbersome and unwieldy structures that created these issues in the first place. What a conundrum? Imagine the problem of beginning with a structure and set of documents that cannot be readily enforced in the manner the capital markets expect, for all the reasons noted above and likely others as well. Consider further the problem of having to restructure because of a borrower’s default and bankruptcy and having to embrace the same unwieldy and less than readily enforceable structure again. As noted below, this is not just a theoretical problem. It was the subject of an actual bankruptcy court case summarized below.

17. As noted above, the increased costs associated with Sha’ariah compliant structures are significant. Moreover, because of the additional risks associated with these cumbersome and non-compliant structures from a capital markets point of view, they are priced at a significant premium above the pricing applicable to more traditional capital markets’ products.

1. 18.  The structures don’t anticipate a bankruptcy by the lender. This can undermine the whole Sha’ariah compliant structure that was intended to benefit not harm the borrower. Furthermore the structures don’t contemplate the possibility of a bankruptcy of the intermediary servicer, which could compromise the rights of the lender and the borrower. Imagine if the servicer goes bankrupt. It actually has the title to the homes or other assets. The creditors of the servicer could access the homes or other assets and, in effect, abscond with the equity of the borrowers. It could also seek to restructure the lenders position under certain circumstances[5]

In recent times we are facing the phenomena of banks or other lenders facing bankruptcy[6]. Among other things, genuine concerns were raised that a lender (or its trustee in bankruptcy) could successfully assert that the real estate under an Ijara arrangement was indeed owned by and was a genuine asset of the lender.. Thus, instead of being the typical mortgage holder, which has a loan to be repaid and only a lien on the real estate, the lender could be deemed town the real estate. This would severely prejudice he ordinary borrower. This is because the borrower may have a real equity in the home that should be protected, it appears that a Sha’ariah compliant Ijara structure may permit the lender to abscond with the real estate (including the borrower’s equity) and defeat the rights of the tenant/borrower. As noted above, the tenant/borrower’s option to purchase is an executory contract that can be cancelled in a bankruptcy. As a matter of form under the ijara documents, the equity was an initial payment of rent. The possible increase in value of the real estate since it was purchased (and hence build up in equity) is yet another issue to be considered. Remember, in this case it is the lender that is bankrupt; not the borrower. Thus, the Sha’ariah compliant formats can put innocent borrowers at risk if the lender has financial issues or goes bankrupt.  Unscrambling the egg to make substance triumph over form is not an easy road to travel. It could take years of expensive litigation with no certainty as to the outcome. Other intervening creditors of the lending company (having nothing to do with the homes owned by the lender under the ijara structure or the tenant borrowers with options, could assert rights that are superior to those of the borrowers.

There have been a number of spectacular Sukuk defaults that are the subject of litigation or restructurings that have received press[7]. These provide insights into just how these structures work in practice. It is an understatement to suggest that the issues, like those outlined above, have been uncovered, which challenge the very essence of the concept of Sha’ariah complaint financing. This is true not only in Western courts, but even in the courts of Islamic states, as noted above. Moreover, it appears that in many Islamic jurisdictions bankruptcy laws have not been developed in practice.[8] This creates a real concern about the potential for unpredictable results[9], an anathema to the capital markets. This and the other problems described above arise because of the fundamental incompatibility of the Sha’ariah compliant products outlined above with the actual practices in the capital markets.

In point of fact it is just this simple. If the loans meet the requirements of the capital markets then the reward is the lowest financing cost in history. If not, then go elsewhere, because the capital markets cannot readily handle non-compliant financial products. The Halacha adapted itself to these requirements as noted above. A truly parallel structure is required if ready access is sought to the capital markets. And, why not? The benefits to the borrower are enormous. Why pay more for what is in essence the same thing? After all, in practice, loans on interest, no matter how styled have been an integral aspect of Islamic society from the very beginning and to date. Notwithstanding all the pious pronouncements the fact is a Moslem bank customer, who seeks a so-called Sha’ariah complaint financing, pays more. Who benefits? It’s the lender. The lender is typically another Moslem. This is because the concept of Sha’ariah complaint financing is supply side driven at its very essence. In effect, the rich Moslem is still taking advantage of his poorer compatriot. Non-Moslem banks like HSBC, in the UK, appear to be giving up providing Sha’ariah compliant home financings[10]

Moslems in the US face a clear choice; use the traditional bank next door and pay a significantly lower cost or pay more because there is concern about whether this is prohibited Riba. Consider however, that there is a similar concern about the more costly Sha’ariah compliant products.

---

[1] So called Islamic bonds; but this is a misnomer, because even under more modern structures, it can hardly be said that these instruments are bond debt as more fully described below in this article.

[2] See for example the S&P rating reported by Reuters on 9/11/12 of the Axiata Group’s Sukuk trust certificates that were rated BBB-. Among other things, S&P reportedly looked to the Axiata Group’s purchase undertaking and liquidity shortfall coverage, which S&P interpreted to be an obligation of the Axiata Group to make all the payments needed to insure the issuer had sufficient funds to pay the certificate holders on time.

[3] The Halacha does not accept this distinction, as noted above. If the landlord does not bear any risk then the lease is not genuine. It is viewed as nothing more than a financing device. In effect the landlord is lending the real estate to the tenant and the rent is then Ribit

[4] See discussion by Dr. El-Gamal supra at footnote 179, at page 13, where reference is made to cases in Saudi Arabia, and other Islamic jurisdictions which may hold that if not Sha’ariah compliant then no obligation to pay the interest based amount because prohibited Riba

[5] For example if certain of the loans were over-collateralized. See for example the GGP Bankruptcy (Case Number 09-11977 in the US Bankruptcy Court, Southern District of New York).

[6] See UM Financial Inc. that was ordered into receivership in October 2011, as reported in an article in Reuters entitled Canada bankruptcy may hurt Islamic finance in N. America, by Shaheen Pasha and Cameron French, (December 5, 2011).

[7] Ibid. See also the default by The Investment Dar Company of Kuwait as reported in the Inside Edge at the Oxfordbusinessgroup online entitled Rethinking Restructuring: Sharia-Compliant Firms Face Different Criteria for Getting Back on Track. In that matter, the article reports that a London Judge agreed with Dar that an agreement with the Blom Bank of Lebanon was not Sharia compliant. Therefore, repayment would force Dar to ignore its founding principles. What is most problematical is the fact that a British Judge ruled on the basis of Sharia law and not British law. This seems to be an anomalous case. However, as noted in the Section XIV below on Blowback, this is a possibility in the US, as well.

[8] See for example the Arcapita Bank Bankruptcy case pending before Judge Lane in the Southern District of NY, which was filed in 2012. See also Arcapita Still Working to Secure Financing from Silverpoint, published October 19,2012 on Dow Jones Newswires and an Article by Jacqueline Palank in the Wall Street Journal of October 5, 2012, entitled the Bankruptcy Week Ahead, which also discusses the status of the Arcapita bankruptcy and the difficulties it is having obtaining debtor-in-possession financing. This is because of the need to be Sha’ariah complaint. It should also be noted that, among other things, Judge Lane felt that the fees for the Sha’ariah compliant DIP financing at issue were too high.

[9] Imagine if a Islamic court applied Koran Chapter 2, verse 280, which requires the lender afford, the debtor who faces hardship in paying his debts, an extension of time to pay, until the debtors financial condition improves. Furthermore the Koran then suggests that it is better just to waive repayment, as an act of charity. While a most noble view of debtor- creditor relations, it is the kind of unpredictable results that are an anathema to the capital markets. Sha’ariah compliant products do cost more. Indeed as the issues of enforceability are actually tested in practice  it is likely that a re-pricing will occur and/or Sha’ariah compliant products will be panned by the capital markets. As noted above, this is beginning to occur. In the East Cameron Gas Sukuk , which went into default in 2008 and subsequent bankruptcy, the court considered the issue of whether the Sukuk holders actually owned a portion of the company’s oil and gas. The company argued the transaction was merely a disguised loan and that there was no real transfer of the oil and gas royalties. The bankruptcy judge however rejected the company’s position and ruled that the Sukuk holders invested in reliance on the fact that they actually owned the royalty interests. However, the judge’s ruling was not final and he gave the company the right further to argue their position. This and other Sukuk defaults are described in Q Finance: Bankruptcy Resolution and Investor Protection in Sukuk Markets, online.

[10] See a report in Shariah Finance Watch online, entitled, More Evidence of the Failure of Shariah Banking in the UK: HSBC Drops Sha’ariah Mortgages dated October 9, 2012.

Requirements of the Capital Markets | IRR Part XIII

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

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.

Circle up with Leonard Grunstein on Google+

---

[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

Sha’ariah Compliant Structures | IRR Part XII

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

SHA’ARIAH COMPLIANT STRUCTURES

Under the Sha’ariah, various transactional structures have been developed that mimic a loan structure, with an interest-like payment, but, which are intended not to fall astray of the prohibitions against Riba.[1]  The term “Sha’ariah compliant” has been used to describe these various formats. In essence, like Rav Chama’s dictum in the Talmud,[2] a derivative-like structure may be formulated that creates a stream of interest-like income, but does not fall astray of the prohibition against Riba.

It would appear that words do matter. In essence, calling interest rent or a deferred purchase premium price is deemed to be Sha’ariah compliant, as noted below. As more fully discussed below, the Sha’ariah compliant formats outlined below can be said to be a loan analogue, which at its very essence is a loan repayable with interest. However, the form of the transaction is something else, it would appear that in this context, form does govern over the substance.

All this is fine and good when tested wholly within the religious jurisprudential system that gave birth to the concepts.  However, when the particular mechanisms are analyzed and tested under another system of law, then unpredictable and unexpected results can occur.  To better understand the issues, set forth below is a description of some of the more prevalent Sha’ariah compliant structures.

When dealing with real estate financings, one of the following Sha’ariah compliant  structures is generally employed:

1.         Murabaha;

2.         Musharaka; or

3.         Ijara.

The “Murabaha” financing structure is based on a credit price that has a premium built in to account for the time value of money.  Thus, the credit price is higher than the all-cash price that would otherwise pertain.  It generally takes the form of an installment sales agreement.  When real estate is being financed, it conforms to a deed of trust like legal structure, as more fully described below.

In the Murabaha structure:

1. The borrower agrees to pay for the property over a period of time in agreed upon installments.  These obligations are set forth in a deed of trust like document that secures the payment obligations.
2. In the event of a default, the borrower is liable for the full contract price.[3]  The contract price is equal to the full amount of the principal amount advanced by the lender  plus interest, costs and other fees.  These are all rolled up into the deferred purchase price.  These amounts can’t be charged separately.
3. The conveyance of actual title to the property from the middleman (i.e., the lender’s designee as the holder of the deed of trust) generally awaits the time when payment in full is made.  This is the recommended procedure.  Some do make the conveyance immediately after the documentary closing.  This would tend to make the transaction appear more like a conventional mortgage financing structure.

The need for the lender or its nominee to hold title to the real estate during the term of the financing until payment in full is made is a serious structural problem for the typical bank lender in the US.  The ownership of real estate brings with it all of the burdens of real estate with none of the benefits (which remain with the borrower).  Thus, unlike the typical mortgage where the lender has no real responsibility for operating or other liabilities of the real estate, in the Murabaha structure, technically, the lender bears these responsibilities.  Indeed, a clever Plaintiff’s attorney might successfully argue that this is in fact the case.  Once the jump is made from religious documents enforceable only under religious law to actual US legally enforceable documents, there are a number of unexpected consequences that may ensue.  This goes beyond just issues of priority in a legal and/or bankruptcy context.  It also includes such matters as environmental issues, slip and fall cases or landlord and tenant claims.  Indeed, it is possible in a bankruptcy scenario that the lender’s claims may be equitably subordinated to other creditors claims because the lender is, in effect, the owner of the real estate.

The “Musharaka” financing structure is similar to a Heter Iska format.  The term “Musharaka” literally means partnership.  It combines a partnership-like relationship with a put/call as to the lender’s ownership interest in the investment vehicle.  The put price is unrelated to the value of the property.  It is based on a deferred purchase price arrangement,[4] as more fully described below.

In the Musharaka structure used by some banks:

1. The lender contributes (loans) the funds needed by the borrower to acquire the property.  The lender does so under an agreement whereby it ostensibly will participate in the profits generated in accordance with a pre-agreed formula.
2. The borrower participates by managing the joint venture and putting in so-called sweat equity.[5]
3. The borrower buys out the lender over time by making periodic payments (of what amounts to principal plus interest) until full ownership of the property is acquired at the end of the term.

The Musharaka structure compounds the issues noted above relating to the Murabaha.  This is because in the Musharaka, the lender and borrower are actually described as partners.  The fact that it may be a disguised loan under US law might enable the borrower to thwart the lender if there is any equity value over and above the loan amount.  On the other hand, in a loss situation, the buy out concept actually subordinates the lender’s right to payment to the creditors of the joint venture, which would likely take precedence under US (and especially bankruptcy) law.

The “Ijara” financing structure is based on a lease to own structure, as more fully described below.

In the Ijara structure, the lender buys the real estate and leases it to the borrower.  At the end of the lease, the lender sells the property to the borrower for the original acquisition price.  The rent is equal to the interest that would otherwise be charged for the loan.

The lease payments are said to be for the use of the real estate.  However, the rent is not a market rent.  Instead the amount fixed is nothing more than interest on the principal amount advanced by the lender.  It bears no relationship to the fair market rental value of the property.  Indeed, if the lease were tested in a US court, it might be viewed as a sham.  In reality it is a nothing more than a disguised loan (or, in the context of real estate, sometimes referred to as an equitable mortgage[6]).

The loan documents for the Ijara are based on a lease structure, as follows:

1. The term of the lease begins on the date that the asset (i.e., real estate) is delivered by the borrower/tenant  to the lender/landlord.
2. The tenant cannot be forced to buy the real estate at the end of the term of the lease.  The tenant however, has the option to purchase the property on or before the expiration of the term of the lease.
3. To be Sha’ariah compliant, the lease should not be the kind of triple net financing lease, noted above, where the tenant assumes all of the obligations as to the property leased and the lender bears no risk of loss.  The lender, as the landlord, must retain some risk of ownership.  This might include paying the real estate taxes, bearing the risk of loss on a fire or other casualty and paying for property insurance and/or structural repairs.  However, under the Sha’ariah (as opposed to the Halacha) the tenant may agree to reimburse the landlord for these expenditures, which would be rolled up into the lease payments.  Under the Halacha, this risk of loss must be borne by the landlord and can’t be reimbursed by the tenant, or it’s not a genuine lease.

There has been some effort made to adapt this kind of Ijara structure to the capital markets.  Thus, Fannie Mae reportedly committed to invest $10 million in home financings originated by the American Finance House Lariba Bank.  Using this kind of structure.  However, it is of limited applicability because it varies so much from the typical capital markets financial products that are based on a loan payable with interest.  It also fails because of all of the other concerns noted above.

Other lenders like the Bank of Kuwait (through the Al-Manzil Islamic Financial Services in New York), reportedly use the Murabaha structure noted above for home mortgages in New York, Connecticut and California.  Guidance Financial Group, in Washington DC, reportedly uses the Musharaka based structure for its real estate loans.

Besides the capital markets concerns noted above, there are also other concerns; they range from regulatory and accounting concerns (i.e., having real estate instead of loans on the books and because a bank lender cannot generally be in the real estate business[7]) to tax issues (like who is the real owner for depreciation and other purposes or is the transaction treated as nothing more than a disguised loan).  There are also significant title concerns (i.e., who is the real owner), as outlined below.

The matter of title insurance can be very challenging.[8] This is because the typical mortgage lender requires a lenders policy be issued as a condition to closing.  Under the typical lender’s title policy, the lender is ensured that:

(i)             it has a priority first mortgage lien on real estate;

(ii)           it is also ensured that its borrower is the sole owner of  the real estate; and

(iii)          that title to the real estate is not otherwise encumbered, except in a manner expressly agreed to by the lender.

This is antithetical to this Sha’ariah compliant structure.  While attempts have been made to create a lenders policy based on the Murabaha, as the equivalent of a deed of trust (in lieu of a mortgage), as noted above, this may not  necessarily be the functional equivalent.  This is because, there is a difference between insuring a first mortgage lien securing a loan and insuring the payment obligations under an installment purchase agreement (which may not be insurable at all).  The Murabaha is even more complicated because it’s a partnership and a buyout of a joint venture interest in the entity that owns the property.  In the case of the classic Ijara, there is no lender’s policy.  It is submitted that a leasehold title insurance policy is possible.  However, in the classic Ijara, it’s not a mortgage or loan at all; or is it?

Interestingly, the conceptual arrangements embodied in the three Sha’ariah compliant structures, outlined above, were not followed in practice by the Talmud, for a variety of reasons.[9]  Nevertheless, the Sha’ariah embraced them and hence the differences between these bodies of law that derive from the same Biblical sources of prohibition.  They however evolved in their own unique fashion over time.

Thus, for example, the Talmud prohibits a credit price that is higher than the all-cash price.  The Sha’ariah, on the other hand, does not accept this Talmudic prohibition.  It is not Biblically proscribed[10] and like the lease of real estate structure noted above, the Sha’ariah developed in a different direction from that of the Halacha.

The Talmud also did not accept the concept of a lease being exempt from Ribit, where, as a practical matter, the landlord bears no actual risk of loss, as noted above.  A true lease requires the landlord to bear the risk of loss for fire or other casualty.  Thus, in the case of a fire, the tenant is not liable to replace the property.  The Sha’ariah overcomes this issue by asserting (although technically speaking, the landlord must bear some risk of loss), that doesn’t mean, contractually, the borrower can’t agree to reimburse the landlord for the loss.  The Halacha doesn’t make this fine distinction and views this as a disguised loan arrangement and not as a true lease.

Connect with Leonard Grunstein on Facebook

---

[1] As discussed above, the definition of Riba is in dispute. Some Sha’ariah authorities maintain that it is only interest on interest (i.e., compound interest) or a usurious rate of interest that is Riba and Haram (prohibited as a sin). Ordinary interest would not therefore be Riba according to these authorities. This seems to mirror Western traditions that prohibit excessive interest (i.e., usury) but not ordinary interest.

[2] Supra footnote 118

[3] The contract price has no relationship to the actual value of the property. It is as noted above just a loan with interest by another name.

[4] i.e. just like the contract price, the put price is the principal amount of the loan plus interest and other costs, all rolled up into one fixed amount.

[5] I note in passing, that under the Heter Iska arrangement, the recipient manager must be paid separately for this work. It can be a somewhat higher percentage of profits to recognize this contribution or even a nominal sum paid for the services.

[6] Consider the analogous concept of a car lease. It is just financing paper if the monthly rent is not a market one. An artificial rent amount that is nothing more than a monthly installment of principal and interest is likely a financing device; not a genuine lease. Similarly the purchase option; a fair market value option price is indicative of a real lease. On the other hand, a fixed purchase option price that is the equivalent of what the principal outstanding balance would be for a loan product with the same payment terms is likely a financing device and not a real lease. There are differences in the tax treatment of a real lease and a financing device. A business may deduct rent under a genuine lease of property used in the business. However, only interest is deductible in a loan not the payments of principal. Furthermore, if really a financing device and the true beneficial owner is the borrower (with all of the benefits and burdens of ownership and otherwise satisfying the applicable requirements of the IRS), and then the borrower may be entitled to a depreciation deduction.

[7] There are limited exceptions upon a foreclosure or deed in lieu and then only for a limited period of time.

[8]  See Insuring Title and Islamic Restricted Financing by Junie E. Caspi (2004).

[9] There is a third line of reasoning reported in the Talmud (Talmud Tractate Bava Metzia page 69b) which differs from the Iska structures noted above and which has not been followed in practice.  In Tractate Bava Mezia (Talmud Tractate Bava Metzia page 69b), Rav Chama (an Amora in the Talmud) considers the concept of one individual renting money to another.  It would appear that this might be a possible construct whereby the individual providing the money could charge a rent for the money.  The Rivash (Rav Isaac ben Sheshet, a 14^th century Halachic authority) explains that the basis for Rav Chama’s view is that in fact words (i.e., form) do matter (over substance). Thus, by referring to the transaction as a rental and providing for the payment of an annual rent and not interest, the proscription against Ribit might be avoided, according to Rav Chama.  Tosafot (supra footnote 118, alongside the text cited above) in commenting on this text notes that there is a difference between a lease of an article of personal property and a lease of money.  In the case of personal property, the article is returned intact at the conclusion of the lease.  Moreover, as a matter of law, it is the lesser who bears the risk of loss on a casualty (as opposed to the lessee).  Thus, a lease of property is not really comparable to a lease of money.  Money, after all, is fungible.  Thus, once the money is used by the lessee it is unlikely that the same money would be returned. Also, if the money is stolen, what then?  Does the lessor/lender bear the risk of loss or does the lessee/borrower? Although Rav Chama’s concept was not followed in Halachic practice, interestingly, though, this approach found greater acceptance under the Sha’ariah, as more fully described below.

[10] See the Mishna on page 60b of Talmud tractate Bava Metzia. See also the Tosafot (as well as the Ritva) on the text describing how this is a Rabbinical enactment and not Biblically proscribed,

Analysis of Prohibition Against Riba in Practice & Rules | IRR Part XI

Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?

By: Leonard Grunstein

 

AN ANALYSIS OF THE NATURE OF THE PROHIBITION AGAINST RIBA AND ITS APPLICATION IN PRACTICE, INCLUDING WHETHER ENTITIES ARE SUBJECT TO THE SAME RULES AS INDIVIDUALS

It is respectfully suggested that not all interest is prohibited Riba and not all Riba is interest[1].

Consider for example the 16^th century Ottoman Cash Waqfs[2]. They were permitted to charge interest. A Waqf[3] was viewed as a separate legal entity (as distinguished from the individuals who invested or operated the same). There is also a Fatwa[4] issued by Ebusud Effendi, the 16^th century Mufti of Istambul that expressly determined that a Waqf and Charitable Trust could charge borrowers interest and pay interest to the providers of capital to the entities. Many a 16^th century effendi made profit this way. The use of an entity as an intermediary shielded both the debtor paying interest to the entity and those providing capital to the entity and thereby earning interest from the prohibition against Riba. The interest had to be fair in theory. Indeed Cash Waqfs were said to be formed to help borrowers, who were otherwise paying excessive rates of interest.

Yahia Abdul-Raman[5], relying on the Fatwa of Baraka[6]reports that the term interest can be used in documents to satisfy local legal requirements, so long as Riba was not practiced in the transaction. The Fatwa itself states that there is no objection to using the term interest as an alternative to profit or rate of return. Hence it is possible to have a parallel set of documents with the term interest being used as appropriate to satisfy capital markets requirements, so long as Riba is not practiced. However, just what is or is not Riba was not defined.

Al Baraka Bank in London devised a structure for interest bearing loan documents to be imbedded in the transactional documents that are otherwise Sha’ariah compliant. This was done in an attempt to thereby achieve satisfaction of the requirements of the capital markets, without falling astray of the Sha’ariah. Thus, it employs a Mushraka[7] framework, where under the Bank and borrower initially buy the home to be financed as a joint venture; but the Bank retains title to the property, as described below. The Bank then sells its interest to the borrower at a mark up that reflects the interest factor it charges. Ownership of the property however remains with the Bank until the purchase price is paid in full (i.e.: the principal and interest factor that comprises the mark up). However, consistent with UK law, the Bank also takes a mortgage lien against the property. The borrower enters into a lease with the Bank of the property, where under the borrower rents the property from the Bank at a rental rate equivalent to the monthly interest and amortization payments that would ordinarily be charged (albeit at a higher rate of interest that the prevailing rates for a traditional mortgage loan). In essence it is viewed as an installment sales contract under the Sha’ariah and a mortgage loan that is interest bearing under UK law.

The concept of having a separate set of traditional interest bearing loan documents could be very useful, if properly structured. A good example of how this can be successfully accomplished is noted above in the discussion of the use of a Heter Iska. Just embedding a set of traditional loan documents in a Shariah complaint structure may not be the appropriate solution. On the other hand, if properly structured, then conceptually it can be adapted to meet the requirements of the capital markets, as well as, US legal requirements. Indeed, courts in the UK dealing with a Murabaha[8] structured product with parallel interest bearing note and mortgage held that under English law the interest earning note prevailed[9].

However, as more fully discussed below, just embedding a set of more traditional loan documents in a structure that is inconsistent with capital markets and likely Sha’ariah requirements may not be advisable, for the reasons set forth below. Consider the inconsistent expectations. The bank hopes the documents will be interpreted in favor of the traditional loan documents embedded in the structure so as to have an ordinary interest bearing loan obligation that is secured by a priority first mortgage on the property. On the other hand, the borrower desires that the transaction be Sha’ariah compliant and not be viewed as an interest bearing obligation that is likely prohibited Riba according to many Sha’ariah scholars and others. The courts or other juridical authorities in the US and in the Islamic world may have conflicting views as to how to interpret and enforce the various documents encompassing the transaction between the bank and borrower. There is a need for clarity and predictability and yet it is conspicuously absent, as described in this article. As noted below in the discussion of modern Sukuk structures, these issues have been put into focus with unintended and less than desirable results.

Sukuk bond structures are very interesting. Instead of being asset based (i.e.: with a security interest in the assets or mortgage on real estate) they are said to be asset backed (i.e.: the lender actually owns the assets). However, as discussed below this is not always so clear. Typically, an Ijara[10] rental structure is then employed, if the underlying collateral is real estate. It provides for a rental arrangement with the borrower under a lease of the property, with the rental being tied to the yield agreed to with the lender. As noted below there is no thought given to providing for a genuine market rent, it is just a derivative interest based financial arrangement.

However, as more fully discussed below, many such Sukuk structures also provide for a set of loan documents to be embedded in the transactional structure. These are not exactly typical mortgage loan documents that are compliant with capital markets requirements. They may in fact be a vain effort to mimic those kind of loan documents; but, as noted below, the path taken is anything but traditional from a capital markets’ prospective. For example, instead of providing for a first priority mortgage securing an interest bearing note, it provides for a putative mortgage lien securing a buy-sell arrangement between the borrower and lender. This is more like a preferred equity structures that mimics equity. Indeed, depending on the vagaries of the forum dealing with the matter, it might be interpreted as an equitable loan between the lender and borrower or it might be viewed as just plain equity. The buy-sell arrangement is another way of saying the preferred equity must be repaid. It purports to convert what looks like equity into a loan. However, even if that is the case, it is on a subordinated basis; rather than on a priority basis of the sort represented by a first mortgage against the property. There are real risks associated with this kind of arrangement, both structural and from a bankruptcy point of view, as discussed below[11].

Abu Hanifa[12] was one of the greatest known Imams in history.  He issued a Fatwa[13] (commonly known as the Hanifa Fatwa) ruling that there was no prohibition against charging Riba in a foreign land (i.e.: a country not under Islamic sovereignty and control and where Islamic law is not the law of the land). The Fatwa of Sha Abdul Aziz of India goes even further and just flat out permits Muslims to lend non-Muslims on interest[14].

It would appear that some Sha’ariah scholars have adopted the position that whether a Waqf, government treasury or bank, a legal person (i.e.: entity, as opposed to an individual) is not subject to the prohibition against Riba (when it pays or charges interest). This includes the scholarly work done by the Mufti of and various Sha’ariah legal authorities at the Al-Azhar University in Egypt. For example, Dr. Muhammad Shanqri al-Fanjar of Al-Azhar asserts that bank interest is not Riba. He views the blanket equation of Riba and interest as something to be avoided.[15]

Similarly, as noted above, Sheikh Dr. Muhammad Sayyid Tantawi, the Grand Mufti of Egypt and a leader of Al-Azhar, held that government bond interest is not Riba[16]. Dr. Tantawi viewed government bond interest as, in essence, a sharing arrangement in the government’s profits.

Dr. Tantawi also issued a Fatwa on December 2, 2002, in which he held, in effect, that bank interest is permitted, as more fully discussed below. In his Fatwa, Dr. Tantawi noted that it is well known banks fix the pre-specified return to depositors (i.e.: interest rate on deposits) after a detailed study of the international and domestic market conditions and the economic circumstances in society. This, as well as, the special conditions and nature of each transaction and the average profitability thereof are also considered by the bank in setting the pre-specified return (i.e.: interest rates) payable to depositors. He summarizes his position in the Fatwa as follows:

“In summary, pre-specification of profits for those who invest their funds through an investment agency with banks or other institutions is legally permissible, and above legal suspicion (la shubhat fiha). This transaction belongs to the domain of benefits that were neither explicitly permitted nor explicitly forbidden (min qabil al-masalih al-mursalah), and does not belong to the domain of creeds or formal acts of worship, wherein change and alteration is not allowed.

Based on what has been stated [we rule that] investing funds with banks that pre-specify profits or returns is legally permissible and there is no harm therein, and Allah [only] knows best.”

Shaykh Mahmud Shaltut Grand Imam of Al-Azhar ruled that post office savings interest and state bond interest was not prohibited Riba[17]. He reasoned that a pre-fixed share of the profits (which is equivalent to an interest rate) is not prohibited Riba, if offered by the State or an affiliate thereof. He goes on to say that there is no exploitation of either party in this kind of arrangement[18]. This concept is a dramatic breakthrough in thinking by Sha’ariah scholars. It laid the groundwork for the  even more dramatic Fatwa by Dr. Tantawi[19] noted above.

These eminent Sha’ariah authorities ruled that banks can, in effect, pay interest to depositors, in the form of pre-specifying the profits or return as a percentage of the amount deposited by the customer (i.e. interest in common parlance). It is not a percentage of the actual profits of the bank, In essence, just don’t use the term interest expressly and it’s permitted. Whether it’s a prefixed share of profits as a percentage of the principal amount invested or some other analogous formulation for interest, form appears to govern over substance.  Thus, the concept of “interest based” products being permitted as opposed to “interest bearing” products. Dr. Tantawi goes on to explain that the pre-fixing of profits benefits the depositor in this age of corruption, dishonesty and greed. He goes on to say that just as profits may be shared by two parties, so too can the parties agree that one would receive a pre-specified share of profits.[20] Tantawi rules that this concept does not contradict the Koran or the Sunnah. It benefits both parties and forbidding it would result in harm[21].

Others have found that the use of the term interest does not in and of itself violate the prohibition against Riba. Thus, Sheikh Dr. Yusuf Al-Quaradawi and others issued a Fatwa in October 1990, ruling that it is possible to use the term interest, instead of the term profit or rate of return, in order to benefit from the financial advantages granted by the relevant authorities in the West with regard to deposits and financings. This would include using the term interest in tax declarations or the documents used by the bank in various financings. It is respectfully suggested that this Fatwa recognizes the need for a parallel set of loan documents so as to better access the capital markets. At the same time, there would also be a Sha’ariah compliant structure and set of documents, so as not to fall astray of the requirements of the Sha’ariah. This concept is more fully discussed below. It is also helps support the proposed solution set forth in Section XVIII below.

Notwithstanding these well reasoned, expedient and useful Fatwas and scholarly approaches described above, that are sensitive to the realities of the marketplace and the human condition and provide a nuanced and practical approach to dealing with the issues, there are conflicting views. Some have scholarly pretensions but many are pronouncements made by the more nationalistic side of Islam. They do not seek to live side by side with non-Moslems or integrate. Rather, it would appear they want to conquer and impose their own brand of Islam on others. One such harsh critic of Islamic banking (including the Sha’ariah compliant forms they have adopted) was Osama Bin Laden. He was the notorious head of the terrorist organization Al-Qaeda until his demise. Among other dastardly acts, he was responsible for the 9/11 bombing of the World Trade Center and the thousands of deaths of innocent souls in New York City. In a rambling so called Fatwa he published[22], declaring war against the US, he included a statement to the effect that the banks in Saudi Arabia violated the prohibition against Riba. There was no discussion of the Sha’ariah or analysis of just how this was so, in theory or in practice.  It was just one of many baseless pronouncements he made in his so called Fatwa. Interestingly, notwithstanding his pronouncements, even Osama bin Laden reportedly had a bank account.

However, even as these extremist views are being forcefully expressed, interest or its equivalent is being charged and paid by Moslems in Islamic and non-Islamic jurisdictions. Described below are some of the so-called Sha’ariah compliant structures.

---

[1] See An Economic Explication of the Prohibition of Riba in Classical Islamic Jurisprudence by Dr. Mahmoud A. El-Gamal (2001) in the Proceedings of the Third Harvard University Forum of Islamic Finance.

[2] Supra footnote 183 at page 6. Of Article by Dr. Farooq, noted therein. See also An Analytical Review of Different Concepts of Riba (Interest) in the Sub-Continent by Farooz Azizi, Muhammed Mahmud and Emad u Karin in Kasbit Business Journal 1 (1): 36-43  (Fall 2008)., that asserts that Riba is compound interest (i.e.: usury) and that it is extreme exploitation that is restricted by the Koran. It goes on to state that borrowing for trading purposes on interest and Bank interest is not prohibited Riba.

[3] a religious or other foundation.

[4] Supra Footnote 183, at page 10 of Article by Dr. Farooq, which cites the Fatwa of Ebusud Efendi, a 16^th century Mufti of Istambul, permitting a Waqf to charge interest. See also discussion by Timur Kuran,  supra footnote 162, at pages 7-8. See further discussion by Dr. El-Gamal,, supra footnote 176, at page 109. Finally, see The Concept of Artificial Legal Entity and Limited Liability Company by Mahmoud M. Sanusi in Critical Issues on Islamic Banking and Finance and Takaaful, beginning at page 192, et seq.

[5] A founder of the American Finance House-LARIBA.  Parenthetically, the term LARIBA can be loosely defined as no Riba.

[6] Reported in The Art of Islamic Banking and Finance at Page 213.

[7] See discussion below regarding this type of Sha’ariah compliant financing structure.

[8] As defined below.

[9] See, for example, the Beximco  UK case described in Section XII below.

[10] As defined below.

[11] See The Logic of Financial Westernization in the Middle East by Timur Kuran in the Journal of Economic Behavior and Organization, Vol, 56 (2005) beginning at page 553.

[12] A 7^th century Islamic religious legal authority and Imam.

[13] See Masri and Keller (1997)- Reliance of the Traveler: The Classic Manual of Islamic Sacred Law Umdat Al- Salik at page 944. See also Dr. Salah al Sawi, A Polite Reconsideration of the Fatwa Permitting Interest-Based Mortgages for Buying Homes in Western Society-2001 (www. Islamic-Finance.com), which argues that the Hanafi Fatwa should be limited to circumstances of necessity, only, where there is no other possible alternative.

[14] Supra Footnote 187, at page 38.

[15]Supra footnote 183, at page 25 of Dr. Farooq’s article.

[16] Ibid at page 17 of Dr. Farooq’s article.

[17] Ibid at page 16 of Dr, Farooq’s article.

[18] Ibid

[19] Chibli Mallat, Tantawi on Banking Operations in Egypt in Islamic Legal Interpretation: Mufti and their Fatwas at page 286 (1996). See also Fatwa of Ibn Baz ( Abdul Aziz ibn Abdullah ibn Baz),Grand Mufti of Saudi Arabia,  Ruling 137 in Volume 19 beginning at page 240, in opposition to Tantawi’s  view.

[20] Ibid at page 118.

[21] Ibid at page 119.

[22]  Dated August 23, 1996 and reproduced by PBS Newshour Online (at www.pbs.org/newshour terrorism/bin laden fatwa 1996…html).