Interest, Ribit and Riba: Must These Disparate Legal Concepts Be Integrated or Is a More Nuanced Approach Appropriate for the Global Financial Community?
The Article provides a timely analysis of the recent defaults, bankruptcies and attempts at restructuring of Sha’ariah compliant financial products, including. the spectacular bankruptcy by a Sha’ariah compliant institutional lender, which threatens to undermine the very basis for these products. It discusses the structural issues exposed by these events as well as the inherent incompatibility between existing Sha’ariah products and the requirements of the capital markets.
The success of the capital markets in the US in delivering low cost financing of homes and income producing properties is incomparable. Among the requirements for accessing the capital markets is the need for a pristine interest payment stream that is fully secured, with a priority lien on the collateral, and which is readily enforceable. Predictability is the key. Financial products, developed under other systems of law and practice that don’t yield the expected results achievable using the model satisfying the requirements of the capital markets are problematical. They may be denied ready access to the capital markets or be priced at a premium to traditional financial products satisfying the requirements of the capital markets.
The Article traces the origin and development of the Sha’ariah prohibition against Riba, and explores relevant sources, including a number of Fatwas. It also discusses the earlier and parallel development of the Halacha prohibiting Ribit . This includes its successful adaptation over time to deal with changing economic conditions, such as permitting borrowers a means of ready access to the capital markets and the benefits of lower cost financing. There is also a discussion of the unique role banks or other entities play under the Halacha and the Sha’ariah when compared to an individual. It would appear that banks are not necessarily subject to the prohibition against Ribit or Riba, respectively.
A survey of relevant cases under NY law (as well as certain cases in the UK and elsewhere) is also presented. Certain constitutional aspects of applying religious oriented laws are also explored.
The Article suggests that a more nuanced approach is required that both recognizes and respects the traditions of each system of law and practice and yet permits ready access to the US capital markets. The article concludes with a proposed solution that is based on precedent within the Sha’ariah and Halacha. The solution is consistent with the author’s own experience in practice, in structuring such financial products, in a manner that is capital markets’ compliant.
KEY WORDS: Interest, Riba, Ribit, Sha’ariah Compliant, Capital Markets, Heter Iska, Sukuk, Ijara, Murabaha, Fatwa.
INTRODUCTION
In a global economy, with lenders and borrowers[1] from different cultures and disparate systems of law and ethics, conflicts can arise.
This article deals with the apparent conflict of laws and ethical traditions between US law,[2] on the one hand and the Halacha[3] and Sha’ariah,[4] on the other hand, as it pertains to loans and the charging of interest.
There are already a number of cases in the US[5] that have dealt with the nature and enforceability of a Heter Iska.[6] This body of common law has developed over the years and provides us with guidance as to how a US court might view religiously oriented documents and structures under the Sha’ariah. As noted below, the results are not always predictable and unexpected consequences may occur. Indeed, it appears the existing religious oriented formats and structures currently used in practice may not always work as intended, as more fully discussed below. This raises a number of issues, including legally and philosophically.
Furthermore, as a practical matter, it would appear that the capital markets cannot readily accommodate these Sha’ariah and Halachic compliant formats (designed to deal with the apparent prohibition against charging interest[7] in the form of Ribit[8] and Riba,[9] respectively). This is because they fall astray of the existing legal and other requirements for accessing the capital markets.
Among other things, the following issues are presented:
1. Do the existing Halachic and Sha’ariah compliant legal structures and documents work as intended under US law? This includes both the concepts of a parallel set of religious oriented documents and the more integrated versions in uses in Sha’ariah compliant banks, as summarized below. Implicit in this analysis is the question of what documents govern (when dealing with a parallel set of religiously oriented documents) and how to interpret the religiously oriented provisions in the documents.
2. Are the US courts best suited to decide matters of interpretation of religiously orientated documents? After all, as noted below, the courts, perforce, must rely on religious experts. Moreover, as noted below, these religious experts may themselves be in conflict because of disputes as to the meaning or applicability of the religious doctrine at issue before the particular court. Furthermore, as discussed below, a US court[10] might decide an issue differently than a religious court would,[11] yielding a contrary result to what was actually intended by the parties.
3. Can a US court even decide these kinds of issues under the Establishment Clause?[12]
4. Beyond the legal issues noted above, do the existing religious oriented financial mechanisms work, in terms of enabling access to the capital markets or is there a problem? Moreover, if the current religious oriented structures and documents in use don’t permit a favorable execution within the existing capital markets, and then is there another possible solution?
5. Is there really a conflict in principle or in practice? Stated another way, is this more a matter of form over substance or are the Western laws and traditions in fatal and irreconcilable conflict with the near Eastern traditions of the Halacha and Sha’ariah. Furthermore, is there more philosophical coherence conceptually than might superficially appear to be the case? Moreover, is a more nuanced approach in practice a possible solution to the problem?
It is suggested that a resolution of these issues would be helpful in order to permit the free flow of capital through the capital markets, from sources of capital that adhere to the Halacha or Sha’ariah, to those in need, on the favorable terms and conditions that are the hallmark of the capital markets.
To better understand the problem; consider the basic real estate financing structure so prevalent in the US, Europe and throughout Western culture. It is based on a loan, evidenced by a note and secured by a mortgage that is repayable with interest. This is a recognized and accepted financing format under the law and traditions of the West. It has enabled individuals to buy a home with the help of a local bank or other source of funding within the capital markets on very favorable terms and conditions. It also underlies the financing of office, industrial, multi-family, hospitals and other types of real estate, whether existing or in development. Indeed, it is one of the essential structural components of the capital markets and the sine quo none of CMBS.[13] It has been tested in the US courts (including Bankruptcy courts) and through numerous economic cycles of downturn and growth. It has been refined over time so as to yield consistent and predictable results. In short, it is a battle-tested format that accounts in no small measure for the success of the capital markets.
As noted above, the essence of the capital markets’ compliant loan structure is predictability. After all, the lender loaned the money to the borrower and is entitled to receive it back with interest as agreed to by the parties. There can be no ambiguity when it comes to this basic and essential agreement between the parties.
The underlying problem is that this simple, elegant, efficient and successful financing structure appears to be expressly prohibited under the Halacha and Sha’ariah. Indeed, the concept of repaying a loan with interest would appear to be an anathema under the Halacha and Sha’ariah. This is not a matter of style or perception. It appears to be a genuine conflict between Western culture and law and public expressions of the near Eastern traditions and legal codes of the Halacha and Sha’ariah. Western legal systems[14] permit the payment and receipt of interest. The Halacha and Sha’ariah prohibit Ribit and Riba, respectively and thus, would appear to prohibit the payment or receipt of interest.[15] Any such prohibited acts are deemed sins[16] under the Halacha and Haram[17] under the Sha’ariah.
Nevertheless, for thousands of years under the Halacha and for well over a thousand years under the Sha’ariah, there have been various practices permitted that, at the very least, mimic interest, but are not considered “Ribit”[18] or “Riba”.[19] What these structures are and how they originated, both conceptually and in practice and developed over time, are subjects of this article.
The broader question though is, in light of the legal and ethical traditions embodied in the Halacha and Sha’ariah, on the one hand and Western law and practices, on the other hand, can East meet West; do these religiously oriented structures and documents work in practice or do they cause unintended consequences? Is there a gulf so wide that it can’t be bridged or otherwise resolved?
At first blush, it appears well neigh impossible to meld these opposing systems of law and tradition, because of fundamental and irreconcilable theoretical conflicts. Indeed, as more fully discussed below, a New York court[20] in considering the effect of a Heter Iska found that there was a triable issue as to what the parties intended. The court was concerned that the transaction at issue might not be an ordinary, simple loan; but rather some kind of an equity or partnership arrangement. The difference between the two is striking, as more fully discussed below. Moreover, as shown below, a Bet Din[21] applying the Halacha would likely have determined that the transaction should be enforced as a loan repayable with interest. This kind of improbable result points to the need to better understand the various religiously oriented formats summarized below. This so as to avoid these kinds of results that are contrary to the intent of the parties and the very systems of law that created them in the first place.
It is suggested that a nuanced approach, which permits the systems to exist side by side at some level, might be possible. Developing an approach to enable the free flow of capital worldwide is certainly a worthy object. Indeed, the Talmud recognizes this as a most worthy goal, citing the legal maxim of “don’t shut the door on borrowers”.[22] Nevertheless, accomplishing this in practice is no mean achievement.
Over the years, I have worked on developing solutions reconciling religious sensibilities with US lending practices, acceptable to a variety of banks, institutional and other lenders, borrowers, religious authorities and governmental regulators. One example comes to mind because of the diverse composition of the parties involved. An Egyptian banker acting on behalf of a Saudi-managed fund introduced the matter to me. They were interested in providing financing to a Pakistani real estate developer. The security was a development parcel in New Jersey. It was encumbered by a building loan mortgage provided by a major bank from China, with a branch office in New York City. I was approached because of my reputation as a real estate finance expert, who also had experience in crafting financing structures that did not violate the law against Ribit under the Halacha. They hoped I could also craft a financing structure that provided for a secure rate of return that was not prohibited Riba and, hence, was Sha’ariah compliant. At the same time, the financing structure had to conform to the requirements of the Chinese Bank (and by extension, the capital markets). This is because the real estate (including the buildings and other improvements to be constructed thereon) was encumbered by the Bank’s Building Loan Agreement and Mortgage. This very same real estate was also intended to secure the new Sha’ariah compliant financing structure I was charged with creating.
How therefore to craft a Sha’ariah compliant financing vehicle that could be rationalized with the typical US loan structure. To succeed, it had to be satisfactory to the new financing source (requiring compliance with the Sha’ariah and their financial, legal and religious advisors), as well as, the US bankers (including underwriting, credit, legal and compliance), regulators, rating agencies, traders and investors, who are an integral part of the capital markets.
To better appreciate the relevant issues requires some background. Therefore, set forth below is a discussion of the meaning of terms such as “Ribit” and “Riba”. Although the words are loosely translated to mean interest, this would appear to be a misnomer. The terms Ribit and Riba might be better translated as meaning any addition or increase[23] not strictly speaking just interest. But a true definition of the terms can only be derived from a rigorous legal analysis of the applicable religious principles that coined the terms in the first place. Indeed, as shown below, these terms embody all sorts of things that would not ordinarily be defined as interest. Moreover, there are times when what is commonly understood to be interest is religiously defined not to be Ribit or Riba. This is particularly relevant when viewed in the context of an analysis of the evolution of the Halacha and Sha’ariah in response to the needs of lenders and borrowers and changing conditions over the years. A matrix of guiding principles is also outlined below and is used as a tool to show the interplay of these systems of law and practice with the requirements of the capital markets and US law.
I begin with a discussion of Ribit because, among other things, it is first in time historically. It is also because there is already a well-developed body of case law and business practice dealing with the Halachic prohibition against Ribit and the Heter Iska solution. As such, we are provided with a source of guidance as to how religious oriented forms and structures have been developed and treated legally by the US courts and in practice by the capital markets. Having participated personally in developing some of the solutions under the Halacha and in respect of US law and the capital markets, I was privy to discussions about various approaches and considerations that resulted in establishing viable solutions that proved to be acceptable to the capital markets.
Section I of this Article contains a discussion of the definition of the term “Ribit” and the origin and nature of the prohibition.
The article then goes on to deal with a number of Halachic solutions to the problem, beginning in Section II with the original Talmudic Iska format. Theory versus practice is then analyzed in Section III. The article then discusses the later development of the Heter Iska structure in Section IV and its evolution over time in Section V. Section VI continues with a discussion of whether a bank is treated differently from an individual lender under the Halacha.
Section VII deals with the response of the US courts to the Heter Iska.
Section VIII discusses why, in light of applicable US case law, the Heter Iska should not be signed by the parties.
Section! IX discusses the sources of the prohibition against Riba.
Section X analyzes the definition of the term Riba.
Section XI discusses the nature of the prohibition and the rules that developed over time dealing with the practical application of the prohibition. This includes an analysis of whether entities are subject to the same rules as individuals when it comes to the prohibition against Riba. A number of Fatwa and other scholarly positions are discussed dealing with when and under what circumstances the prohibition against Riba does or does not apply.
Section XII outlines a number of Sha’ariah compliant structures in current use.
Section XIII discusses the requirements of the capital markets and analyzes how the existing religious oriented documents and structures outlined in this article are inconsistent with those requirements. In this regard, it should be noted that the Heter Iska format has been adjusted to conform to the needs of
of the capital markets, as described in this article. However, the Sha’ariah compliant formats have not made such an accommodation; and, hence, the emergence of some of the problems described in this article.
Section XIV outlines a modern Sukuk structure and analyzes whether it successfully achieves the goal or remaining Sha’ariah compliant while, at the same time, satisfying the requirements of the capital markets.
The integration of religious oriented structures and forms in our society in the US also has a constitutional dimension. This is discussed in Section XV.
Section XVI discusses the disconnect between the concept of Riba in theory and in practice.
It would appear that efforts being made by proponents of the use of Sha’ariah in the US have encountered a negative reaction. This blowback is discussed in Section XVII.
A proposed solution is outlined in Section XVIII. The solution offered is then critically analyzed against the criteria outlined in this article. The conclusions reached are not just theoretical. They are often based on insights derived from my own real life experiences in the field.
It is important to recognize that the development of a useful proposal must, first and foremost, be based on a genuine respect for each of the legal systems. Value judgments about which system may or may not be more appropriate or ethical are exceedingly contra-productive. Indeed, such pronouncements are often the product of ignorance, not just about one of the systems of law being discussed; but, often all of them. Each of the systems has withstood the test of time and reflects the majesty of their traditions. They deserve our respect.
[1] The terms lender and capital provider, landlord, vendor or investor are used interchangeably. The terms borrower and capital recipient, tenant, vendee, operating member or manager are also used interchangeably. Religiously oriented documents or structure sometimes employ one of these other terms in order to distinguish the transaction in form from a loan; similarly the use of the term borrower. Interestingly, the Talmud, in Tractate Bava Batra, uses the term “Malveh” (literally, lender) to mean obligee and “Loveh” (literally, borrower) to mean obligor (see Elon: Ha-Mishpat Ha-Ivri – 1:483).
[2] The term US law is used generically to distinguish between Western legal traditions, on the one hand and the Halacha and Sha’ariah, on the other hand. This article is based primarily on New York law (unless otherwise specified) and Federal law where applicable. These are used as representative examples of US law and Western legal and ethical traditions.
[3] The body of Jewish law derived from the Bible as elucidated in the Talmud and by early codifiers and commentators and later religious authorities, as more fully outlined below.
[4] The body of Islamic law derived from the Koran and as elucidated by later religious authorities and scholars.
[5] See the discussion of Heter Iska cases below and in particular the IDB case.
[6] A document and structure in use under the Halacha that is designed to avoid the prohibition against Ribit, as more fully discussed below.
[7] Plato in the Republic prohibited lending on interest. Aristotle in his Politics (at page 1258) thought it an unnatural mode of producing income (i.e., selling money instead of goods). According to Aristotle, it was the most hated sort of wealth which makes gain out of money itself. Money according to Aristotle was intended just to be a medium of exchange. Thomas Aquinas in his Summa Theological II (at page 78) thought “it is by very nature unlawful to take payment for the use of money but, which payment is known as interest.” However, this all changed with the advent of a mercantile instead of an agrarian economy. Thus Calvin beginning in 1547 spoke of reasonable interest charges for money being acceptable. Only excessive interest was wrong. After Henry the VIII broke with Rome, England in 1545 passed a law permitting interest to be charged up to a maximum of 10% per annum. In the 19th Century, the Roman Catholic Church acknowledged that moderate rates of interest were not to be disturbed.
[8] The terms Ribit and Riba, literally, mean increase. As more fully discussed below, this is a wholly religious based formulation. It has no counterpart under US law.
[9] Ibid.
[10] See the discussion of the IDB case below.
[11] See the discussion of Heter Iska below and how the pre-conditions to bringing a claim thereunder are virtually impossible to satisfy.
[12]See the discussion of cases under the Establishment Clause of the First Amendment to the US Constitution below.
[13] An acronym, meaning Commercial Mortgage Backed Securities. In a typical CMBS offering, an investment bank pools a portfolio of individual loans secured by first mortgages against real estate (usually rental properties and hence the term “commercial”) and sells certificated interests in the pool to institutional investors, like banks, insurance companies or funds. Often the interests are tranched so that the portion of the aggregate loan amount that represents a lower loan to value ratio (i.e. the most senior interests) are sold to investors for a correspondingly lower yield and the portions that are at the higher end of loan to value within the offering are sold for a higher yield. Often the investment bank making a CMBS offering earns not only fees for the underwriting, banking and placing the CMBS; but, also premiums, if the actual yield at which it is sold is less than the underlying stated contract interest rate of the loans in the pool of mortgages that are being securitized.
[14] New York or Federal law is the primary source of law under discussion in this article, unless otherwise stated.
[15] The Halacha even goes so far as to prohibit scribes from drafting the offensive loan documents and witnesses from affixing their signatures. Under the Halacha, an offending lender or borrower is disqualified as a witness generally because of the odiousness of the sinful practice of paying or receiving prohibited interest. (See Talmud Tractate Bava Metzia Chapter 5, at page 11.) There is also a discussion in Talmud Tractate Sanhedrin (at page 25) concerning how those who collect Ribit are not qualified to be a witness. See also Rambam-Mishna Torah: Hilchot Edut 9:1.
[16]See discussion below as to the fact that viewed as sinful conduct but not necessarily civilly actionable.
[17] Literally, forbidden (i.e. sinful).
[18] Exodus 22:24; Leviticus 25:36-37; Deuteronomy 23:20; Ezekiel 18:13: Psalms 15,5 ; Nehemiah 5:1-13; and Proverbs 25:8.
[19] Koran 3:130; and 2:275-6
[20] See the discussion of the IDB case and other cases dealing with Heter Iska below.
[21] See the discussion below of how a Bet Din (or Religious Tribunal) would typically, as a threshold matter, reject a borrower’s claim of defense to payment under a Heter Iska.
[22] Talmud Tractate Bava Metzia at page 68a.
[23] or in the case of Riba, an excess, as more fully discussed below.
Leonard Grunstein 