Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?
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:
- 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.
- 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.
- 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:
- 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.
- The borrower participates by managing the joint venture and putting in so-called sweat equity.[5]
- 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:
- 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.
- 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.
- 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.
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[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 14th 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,
Leonard Grunstein 