A fundamental difference between conventional and Islamic finance is that, as the Islamic system does not permit risk-free capital, those operating under the Shariah framework cannot profit from the lending of money. Accordingly, the charging of interest known as riba is prohibited by the Shariah and instead, a system of risk sharing is promoted.
"It is important that commitment fees are agreed upfront so that they are not construed as riba"
Riba can be defined as any increase over and above the principal amount payable under a contract, which is not covered by a corresponding increase in labour, commodity, risk or expertise. The rationale behind the prohibition is to promote an economic system where all forms of exploitation are eliminated based on justice between the financier and entrepreneur. Under the Shariah, money is not regarded as an asset and, accordingly, it is not permissible to earn a direct return from it. Instead, Islamic finance has developed certain structures that allow companies ready access to financing in a way that does not conflict with the principles of the Shariah.
A transaction employing an Islamic-compliant structure must adhere to the principles and objectives of the Shariah. This means that riba must not arise and that the other Islamic prohibitions including those on gharar (uncertainty), maysir (gambling), fraud, coercion and exploitation of needs are complied with. In addition, it is important that the transaction does not relate to any haram (forbidden) object; for example alcohol, pork or impermissible financial instruments.
Many large project financings in the Middle East and north Africa in recent years have included an Islamic tranche. Where financings incorporate both Islamic and conventional tranches, care must be taken to ensure that the Islamic portion does not give rise to riba. In light of this, it is important to consider the areas of a transaction that could give rise to riba and the ways in which Islamic structures overcome this hurdle.
Mark-up and purchase price
The Shariah stipulates that payments under a contract have to be agreed at the time of signing the relevant documentation. They cannot be changed afterwards as any increased payment could be construed as riba.
"Banks are not permitted to charge any additional amounts over and above what is agreed at the time of signing
By way of example, murabaha is a Shariah-compliant financial instrument that avoids riba. A murabaha is a contract for the sale of goods under which a bank or financial institution agrees to purchase in its own name goods identified by the buyer, and sell those goods to the buyer on a deferred payment basis. The instalments that the buyer pays to the bank over time will cover the amount spent by the bank in purchasing the goods for the seller, plus a pre-agreed mark-up, which is the profit element for the bank. This structure is often referred to as cost-plus financing and permits borrowers to purchase assets on a deferred payment basis, which is Shariah-compliant. Importantly, the agreed mark-up compensates the bank for its role in the transaction and must be agreed at signing. Any increase in this sum after the buyer has assumed liability for paying this amount could be construed as riba and/or gharar, and would therefore be impermissible. In the conventional framework, this type of transaction would be structured as an interest-bearing loan, which a borrower would use for the purposes of purchasing certain defined assets.
Another type of Islamic finance structure is ijarah. Ijarah is a Shariah-compliant lease contract that, in its most basic form, consists of a bank or financial institution purchasing an asset and making it available to a customer for an agreed period of time at an agreed rental. This transaction involves the lessor, typically a bank, purchasing an asset from the seller at an agreed price. Next, the lessor leases the asset to the lessee in exchange for rental payments. The rental value is typically based on the aggregate of the cost incurred by the lessor for the purchase of the asset, plus a reasonable rate of return to recompense the lessor for its role in the transaction. At the end of the lease term, the lessee may be given the option to purchase the asset from the lessor. As with the purchase price of an asset under a murabaha, the rental payments under an ijarah must be fixed at the point of signing and cannot be increased from that point in time, otherwise they could be construed as riba.
In Islamic finance transactions, it is important that commitment fees are agreed upfront so that they are not construed as riba. This is in contrast to the approach adopted under conventional financings, where the commitment fees regarding a particular payment period are determined and paid in arrears at the end of that period when the amounts drawn under the facility are known.
"The fact that the penalty will be paid to charity is typically stipulated in the underlying documentation"
Our firm recently advised a lender on a Shariah-compliant reserve based lending facility to an independent oil and gas exploration and production company. That transaction was structured as a murabaha. Pursuant to that structure, the purchase price under the commodity sale transaction had to be fixed upfront, and so the price assumed the maximum commitment fee was payable. At the end of the relevant payment period, a calculation was made of the actual amount of commitment fees due. The borrower was held to be in default only if an amount equal to the actual commitment fees was not paid, and the excess was carried forward to the next payment period.
Administrative fees for late payments and default interest
In conventional loan agreements, it is common for lenders to charge borrowers default interest or administrative fees for late payment. Conversely, in Islamic finance transactions, banks are not permitted to charge any additional amounts over and above what is agreed at the time of signing the relevant agreements. This would include, for example, the charging by the lessor of an additional sum upon non-payment by the lessee of rental income under an ijarah. If any such payments form part of the bank's income, they could be considered riba. Accordingly, Islamic scholars, the vast majority of Shariah Boards and the Islamic Fiqh Academy of the Organisation of the Islamic Conference generally accept that, in such circumstances, any penalty or other increased amount imposed for delayed payment must be paid to charity, unless it can be demonstrated that such amounts cover actual additional costs incurred by the bank. The amount donated may vary according to the period of default, and may be calculated on a percentage per annum basis. The fact that the penalty will be paid to charity is typically stipulated in the underlying documentation, together with the basis for calculating this amount. The charity is invariably a charitable fund maintained by the bank, but it could also be maintained by the state, in which case any amounts received are donated to projects that involve some element of public interest. This interest can also be specified in the underlying documentation.
Consideration for third party guarantees
Under Shariah law, a contract whereby one person undertakes to assume the payment obligations of another is known as kafalah (guarantee). The Shariah stipulates that guarantees are gratuitous contracts and, on that basis, banks may not charge for providing them. The reason for this prohibition is that the guarantor who, for example, is assuming the payment obligations of a company under a financing with a different bank, cannot charge a fee for advancing any amount as this would fall under the definition of riba. However, it is generally accepted that a bank is permitted to charge a fee representing actual administrative expenses it incurs for the services it renders. Some banks acting as a third party guarantors claim the right to seek fees commensurate with those charged by conventional banks. Importantly, these fees will exclude the interest that a conventional bank would accrue from the date of demand (if this occurs) and the date of actual settlement by the client.
Conventional insurance typically cannot be used in Islamic finance transactions because it involves riba. Riba arises both directly (due to the premiums outweighing the amounts insured) and indirectly (by insurers investing the funds they receive for undertaking their insurance obligations in interest-based businesses). In addition, conventional insurance companies may invest in sectors or industries that are forbidden. To overcome these obstacles, takaful is commonly used, if available. Takaful is a form of Shariah-compliant insurance based on the principle of mutual assistance. It involves members contributing money into a pooling system to guarantee each other against any loss or damage, which may be suffered by one of the members. The policyholders are considered joint investors, with the insurer acting as a manager on behalf of the policyholders. The manager will invest the fund in Shariahcompliant assets that do not breach any of the Shariah prohibitions. The policyholders share in the profits and losses of the fund, although a positive return on policies is not legally guaranteed (as a fixed profit guarantee would be construed as riba). While takaful goes a long way in protecting the interests of those who use it, a number of issues need to be addressed, including adequate capitalisation to enable takaful operators to effectively compete with their conventional counterparts.
By Fulbright & Jaworski partner Andrew Hart, and associates Alex Childs and Conor Boyle, in London