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Legal aspects of islamic finance
The Islamic Bank of Translavia (IBT), while making the transaction under the Ijarah Islamic financing technique, needs to consider different laws and risks that can be brought in by this transaction. There are various issues that should be arranged by IBT so that they can make the correct decision that will not hamper their status. The financing under Ijarah to East Airlines (EA) will bring favorable results but should be handled along the lines of law in which they are going to make the transaction. The issues that might bring in risk when bank will follow Ijarah terms under the UK law must be noticed and handled so that they can mitigate the risks that they might face in this transaction.
The focus of this paper will be on exposing and discussing the risks that might arise in case of financing aircraft purchase. The paper will focus on the risks that IBT will be exposed to through following Ijarah as compared to other conventional form of financing. The paper will highlight the measures that will help in mitigating the underlying risks. Finally, a law clause will be provided with regard to this transaction of financing four aircrafts under Ijarah.
What is "Ijarah?"
Ijarah is an Islamic financing technique used in Islamic banking as a mode of financing assets to the customers. In Islamic banking Ijarah is used in the form of leasing . Due to its varied advantages Islamic banks, use Ijarah so that they can better use their resources and funds such as reserves available with the bank. The asset is purchased by the bank from the seller and thus, bank holds the ownership of the asset. In this form of Ijarah, the asset is leased out to the customer by the bank. The holder of the asset has to pay a specified amount of lease or rent to the bank for using the asset. London Interbank Offered Rate (LIBOR) can be used as a leasing rate under this Ijarah transaction. Both the parties with their mutual agreement fix the rent for the asset but it can be changed by the concern of both the parties during the period of contract. Even the rent rate can be increased after a pre-determined period say one year. The contract can also bind both the parties that in case of increase in inflation rate the rent will also increase by same rate. As if the inflation increases by 2% the rate will also increase by 2%. Even the contract can include provision in case the government increases the tax or tax on property increases that the increase in tax will be accommodated with increase in rent by the same amount. The payment of the lease can be made in installments. The end-user of the asset does not hold the right of ownership, although the asset is in its possession. Since the possession holder does not have the right of ownership, he has no right to transfer or sell the underlining asset.
Background to the transaction with certain aspects of Ijarah
IBT will purchase four aircraft for US $50 million from Universal airways as per the selection of the East Airlines. Since contract will be made under Ijarah, it can be presumed that the aircraft will be leased out to East Airlines for which it will pay rent to the bank. Thus, the real ownership of the aircraft will remain in the hands of the bank, although the possession of aircraft will be transferred to East Airlines under the Islamic financing technique. But IBT should also make the contract in such a way that it includes an obligation on the part of EA to accept the aircrafts on lease. As in case of no promise it can also reject the possession of aircrafts on rent. As the bank is the owner of the aircrafts it can sell the aircrafts in the market to recover its investment. Even a different promise can be made to sell the asset at an agreed price at the end of the contract.
IBT should clearly understand the aspects of Ijarah in order to ensure that liability of the heavy investment in the four aircraft of about US $50 million does not go wrong . Ijarah has certain specific aspects such as it works like an operating lease where the bank will purchase the underlining asset that in this case is aircraft and then will hand over the possession of the aircrafts to EA for a specific period. The period of contract in such a mortgage is short. The EA in response has to pay bank lease for the period of financing and even return the possession of the aircrafts at the end of the contract period. Thus, the ownership will remain in the hands of the bank and EA will pay rent against the use of the asset. The rent will be fixed after considering the depreciation amount of the asset .
Key Issues and advice for IBT for the transaction under Ijarah terms
There are various issues and risks involved in dealing in terms of Ijarah for the Islamic bank. IBT follows all rules and regulations of Islamic banking finance to govern terms of contract but as there are differences between this system and English law. Under the English law, if a lessee does not pay the lease amount, the banks can impose any monetary penalty on the lessee and uses it as operating income but under the Ijarah contracts, banks are stopped to use monetary penalty as its income. The monetary penalty amount is donated to society under the Islamic banking. Even the terms of Ijarah leasing is provided by the Islamic banks under the principles of Shari'a advisory board creates risks that are not found in the conventional lending made by the other conventional banks . On the other hand, lease holders reap many benefits of Ijarah. The terms and condition are considerably more limited in Ijarah contracts than in traditional leases contracts. All expenses of Ijarah contract are treated as operating expense, so the lease holder and lease-lend can get tax benefits.
If IBT holds the ownership with itself and the contract is terminated at an early stage or even at the end of the contract, it could face risks in case value of the aircraft got reduced dramatically at the end of the contract. The profits of the bank could hamper as it will not receive enough by selling the aircrafts even in the market, thus creating losses . The risk may also become higher if the customer refuses to purchase the asset. Another risk is that if the EA defaults on their contract, the Bank will experience heavy losses. The burden of credit and default risk might arise in this case and IBT has to feel the tough time due to big losses. Under Ijarah terms, IBT has to see the maintenance of the aircraft over the life of the contract which seems likely to incur significant maintenance costs as the aircraft demand maintenance of high level . Even the negligence on the part of EA can destroy the assets and bank may have to bear high maintenance cost.
Another issue that might arise is that aircrafts are purchased by the bank but the EA refuses to take the possession of the aircrafts on rent . The issue under the law will generate as in relation with the asset. The relation between the buyer and the seller should be cordial and there should be a clear discussion on the terms of the contract between the buyer and the seller .
Outflow of the funds for aircraft purchasing can create an issue. Since this will make less liquidity and reserves in the hands of the bank. This can bring in issues between the bank and its customers as the liquidity risk spreads. This liquidity risk can create an operational risk as banks feel the pressure of liquidity crunch. This pressure can destabilize the financial stability of the bank and even hinder its business and funds. Rise in inflation over the period of contract may also cause risk as the returns of the bank may get reduced due to inflation risk.
The Ijarah leasing tax also applies on the same basis as on the conventional lease but the difference is that as Ijarah both include purchasing an asset for the customer and leasing the asset the tax applies twice on the Ijarah terms as it is not in accordance with the English law to make such an arrangement. The tax might be an issue in this condition for the IBT. Thus, the Ijarah contracts should be clear that can explain, that the contract is purchasing of an assets or leasing contract.
Even the ownership risk taken by the Islamic bank under Ijarah terms are not taken by the conventional banks in their conventional lending. Islamic banks offer financing with an ownership stake with them contrary to conventional banks that provide transfer of ownership through financing even in case of part payment and mostly in case of full payment. One of the issues that are clearly different from conventional lending are related to the penalty clause in case of default or late payment of installment.
Unlike conventional lending under Ijarah terms, one of the issues is that IBT will not lay out a penalty to EA in case of late payment or in case of default of the payment as taking extra money is not regarded fine under the Islamic financing technique . IBT has to understand that this might create heavy losses to the bank. Therefore, in order to make the terms of the Ijarah contract better and to make such that it can be approved by the IBT's Shari'a Supervisory Board it can lay a penalty in case of default or late payment. It can be considered under a charity clause where the penalty received will be transferred to a charity.
In order to obtain the approval of the Shari'a board, IBT should disclose all the terms of the Ijarah contract clearly with the leasing terms of payment. The customer is liable to make free his obligations timely but still some real hindrances arises there are exemptions to that by the virtue of Islamic holy faith. Thus, in case of genuine financing difficulty, the customer should be given relief and payment can be taken when it becomes capable of paying such an amount. These are different from conventional lending as there is hardly any relief given and even the high penalties are laid on the person in case of default.
The Shari'a board will not give the permission of keeping any financial security such as stocks or bonds as collateral as they are subject to interest payments . The terms of the contract under Ijarah should highlight that payment be made directly into the bank account. These matters and with the content of the Shari'a board the approval can be received on the transaction. A Shari'a board typically approves that instead of laying down interest that is a financial penalty in case of non- payment the bank can lay down other non-monetary penalties on the customer. Apart from taking the possession of the aircraft, they can also mark the customer as bad so that it cannot take any loan in the future also from any other bank.
There are certain risks and issues that are similar in Ijarah leasing and conventional lending but still among various differences on the issues one of the issues is that as in case of Ijarah leasing contract the owner is the bank for the asset the insurance cover is also provided by the bank in contrast to conventional lending the same has to be cover by the customer.
Mitigation of the risks in the transaction
IBT can use a variety of ways to mitigate the risks that will arise from the Ijarah leasing. IBT has to make its focus on the Shari'a advisory board approval and also abide and make changes as per the English law in order to mitigate issues that will be there in case of Ijarah.
In order to mitigate the risks of maintenance and selling the aircraft to another party at the end of the contract, IBT can use ‘Ijarah Muntahia Bittamleek' . Ijarah Muntahia refers to a lease contract which ends with transfer of ownership of lease property. This addition in the terms of Ijarah safeguards the interest of IBT. Under this IBT will not be liable for the maintenance of aircraft and even selling them at the end of the contract. This will shift this responsibility to EA. As the possession is with the EA, the maintenance cost and the burden of selling or acquiring the ownership at the end of the contract becomes the liability of the East Airlines. Another thing IBT can do is that EA can be made trustee of the asset by a trust receipt and thus, can be made responsible to use the asset and the care the asset as a trustee. This will reduce maintenance of aircrafts. To avoid the risk of major destruction in the asset, IBT can use the ‘Takaful'. As it will make EA liable for any expenses that will occur due to any unspecified repairs or occurs due to any contingency.
The bank and the customer can also go in for Ijara wal- Iqtina in Ijarah contract. In the Ijara-wal-Iqtina, the property and equipment are provided on the basis of pre-decided rent and unilateral undertaking of bank or client that after lease payment, the transfer of ownership of property will be transferred to lessee. This will avoid the risk as under this bank can make a contract where the ownership will get transferred to the customer at the end of the contract. The bank is also based in London thus; it is perfect to make a transaction taking LIBOR as a standard rate. EA should be asked to make ‘Hamish Jiddiyah'. As in this case any real loss occurred by the bank in case of late payment of rent is paid by the EA. The over and above payment will be transferred to a Charity account.
In order to mitigate the loss that might occur if EA rejects the purchase of aircrafts on rent and does not enter into contract, bank can bind EA under an obligation at the time of purchasing aircrafts. In this obligation ‘Hamish Jiddiyah' can be taken from EA. Bank thus, will have to sell the aircrafts in the market but any losses from this sale will be borne by EA.
The doctrine of privity is also an important matter that the bank should consider while making the contract. This doctrine reveals that other than the parties of contract third party can also make its interference, if required. Thus, the valuation and rights of the contract should be fair and as per the standards since government and legal bodies can create an issue in case of non-compliance of the rules of the commercial law. The law by its virtue can create hinders if it feels any other rules are inadequately followed by the parties to the contract. Thus, if a bank needs to make sure that they monitor and control their activities and make a transaction that could be free from such an issue .A bank has to consider the various rules and regulations of the commercial law so that it can satisfy the provisions, which will help to mitigate risk.
Another risk of increase in inflation can be offset by including a floating rate with the approval of Shari'a advisory board. This floating rate can either be adjoined with the inflation and can be increase as per the increase in inflation or a set benchmark, such as discussed earlier , can be taken with a pre-defined range.
All the risks such as of default or loss of the capital can be safeguarded by using a better credit rating system and deeply analyzing the credit worthiness of the customer before offering him the required asset as in this case the financing of the aircraft for EA. Under Islamic and English law as discussed earlier, IBT can include such non-financial penalties in the terms of the Ijarah contract that are obligatory for both the laws as to the English law and the Shari'a board. The benefits in the general course should be shared between the bank and the EA as a partnership.
Choice of law clause for this transaction
In the case of Shamil Bank v Beximco the English court also revealed that the bank had met its contractual obligations as per the English law whereas it is not contractual with the Islamic religious law. Bank stated that there are no set rules that form the principles of Shari'a. It revealed that its principles are followed by the Islamic banks worldwide so that they can act as per their religious supervisory board. The court decided that the contract can not be governed by the principles of Shari'a and the English law. The reasons behind that there must not be two different sets law as the shari'a and the English law governing one contract. The other reason that the sharai'a law cannot be the covering law since the Rome Convention (1980) states that the governing law should be national law . As a result, the shari'a law is not a national law. Therefore, the transaction of IBT with East Airlines can also be made compatible with the principles of Shari'a board by drafting the contract in such way that the most important terms which might conflict with English law in clear way the would prevent any dispute not just at the time of signing but for the life of the transaction. In this way IBT can manage this transaction of financing aircraft without any hindrances in the future.
The transaction between IBT and the EA can be made compatible with the English law and Ijarah terms of Islamic banking. Islamic law, which is governed by the Shari'a board, has religious concerns and is quite a unique form of law under Ijarah leasing arrangement in contrast to other conventional laws for lending on the lease. It is hard to find legal support for its principles in modern commercial dealings. A Shari'a board and the terms of the Islamic banking and Ijarah are governed by the holy faith. Thus, principles of Shari'a can be accepted and governed in a systematic way by taking into consideration the aspects of Shari'a board so that any disagreement between Shari'a principles can be reduced and can be made acceptable as per the English law.
Exchange in Satisfaction and User Agreement (ESUA) and Murabahah agreements also support the compatibility that is between the principles of Shari'a and English law. They stated that English law is one such law that can support the principles accepted by the glorious Shari'a board for Islamic banking . Thus, the governing law clause for this transaction of financing four aircraft for EA will be drafted in an appropriate manner so that no further issues and risks arise. The law clause as per the best arrangement, and if considering the wording given by the ESUAs and Murabahah agreement for this transaction, can governed by the clauses of English law. This should be done after giving due respect to the principles of Shari'a board and acting in accordance with its religious principles.
Both parties included in the transaction, the IBT and EA should understand that the basic principles of Shari'a boards will be applicable on the Ijarah contract and issues like gaining the approval of Religious Supervisory Board (RSB) on the matters of the contract shall be included in the contract while making English law as an enforceable law in case of any disagreements. Thus, when the parties as per specific principles of Shari'a approve English law up to the limit that will be best suited to them, to the extent that they can make a best fit contract. Thus, the bank shall be able to follow the Islamic religious principles even by operating in the international context and under the English law.
It is advised that the transaction between the IBT and EA can be best formed under the governing law of England and Wales, as they are compatible with the principles of Shari'a advisory and religious boards. The different issues and risks that might arise due to Ijarah terms to the bank can be mitigated and reduced, if they are analyzed and monitored in advance. The bank can make certain terms and engage itself in making the transaction in good faith by analyzing the credit rating of EA.
The transaction of financing four aircraft is a significant investment that can hinder the financial stability of the bank, if any disarrangement occurs in between the duration of the contract. The Ijarah terms of leasing are different from conventional lending and thus, utmost care is required that the transaction should be conducted after understanding both the Islamic law and English law as to avoid the extra risks and issues that are related to the Ijarah leasing arrangement. The law clause should be formed specifically after analyzing the risks associated with the Ijarah so as legal support of the English law can be availed in case of default.
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