1. 1 1 February 2011 Dealing with Defaults and Restructuring Issues in Islamic Finance April 9, 2011 - Berkeley Law School 9016025 Muddassir Siddiqui Partner, Head of Islamic Finance Middle East T +971 4 405 4323 muddassir.siddiqui@snrdenton.com snrdenton.com

2. 2 Pre-Islamic Financing  Partnerships of various kinds –Mudarabah (profit & loss sharing basis) –Musharakah (profit & loss sharing basis)  Riba –Riba al-Nasiah – Riba al Fadl  Maisir –Gambling, Gharar, Ansab – Azlam  Deferred payment sale with mark-up (debt based financing)  Salam – Forward Sale (debt based financing)  Islam accepted some and prohibited and reformed other practices  God has permitted trade and forbidden Riba أحل الله البيع و حرم الربا  Time Value of Money (( للزمن قسط من الثمن allowed if part of a trade

3. 3 Mudarabah (Commenda – Limited Partnership)  Financier(s) (Rabbul Maal) provide the capital  Entrepreneur(s) (Mudarib) work the capital  Both share in actual profits on the basis of an agreed %  Mudarib is not permitted to guarantee a fixed profit to the financier  Return on the basis of how much capital financier provided for how long (interest) is prohibited  Both share in the risk of loss  Financier risks loss of capital  Financier's loss is limited to his capital contribution (limited liability)  Mudarib risks loss of labor  Mudarib is not permitted to guarantee the return of capital, unless negligent or acting beyond his mandate

4. 4 Musharakah (Partnership)  Partners provide capital and work  Partners share in actual profits on the basis of an agreed %  No partner is permitted to guarantee a fixed profit to the other partner on the basis of how much capital he provided for how long (interest)  No partner is permitted to guarantee the other partner the return of his capital  Each partner must share in the risk of loss in proportion to his share in the capital  Sharing in the risk of loss at a lower % than his contribution in the capital would mean partial capital guarantee by other partners – this is not allowed  All partners risk the loss of their capital and labor, unless one of them is found negligent or acting beyond his mandate

5. 5 Al-Qard al-Hasan (Charitable Loan)  Loan amount can be guaranteed by the borrower  Lender may require collateral or third party guarantee  Lender is not allowed to take more than the amount lent (interest)  If the debtor cannot pay, give him time  No increase in the amount of debt is allowed in lieu of extension  If the debtor is in distress forgive (wholly or partially) your debt  Forgiving and giving the debtor time is better in the eyes of God  However, if there is an asset, you may recover your debt by selling the asset  Debt must be paid. Delay in the repayment of debt, with ability to pay, is a grave sin  Debt may be paid by a relative to relieve a deceased from his burden February 2011

6. 6 Main Characteristics of Traditional Islamic Financing  Involves actual traders –earned two profits; one from sale the other from financing.  Full sharing in the risk of loss and profits  No capital guarantee if the financier also desired a profit  No fixed profit  In the ’70s, Islamic financial institutions tried  ”المضارب يضارب“ back to back Mudarabah  IF as Mudarib received deposits and then as Rabb ul-Maal invested the funds February 2011

7. 7 ٍSearch for Products Suitable for Islamic Banking  Islamic Banks are part of the world legal system  Effected by existing laws and market conditions  Bankers are not merchants - financial intermediary role  Banking laws  Banking activities restrictions  Tax laws  Sales tax (double taxation); interest (paid or received) receive favourable treatment (tax deductions, lower tax rates)  Consumer protection laws  Sale warrantees; risks associated with ownership of assets  Competition with conventional financing - need for a level playing field February 2011

8. 8 From PLS to Debt Based Instruments February 2011  80’ shift towards debt instruments  Time Value of Money is acceptable if it is an integral part of trade but not if it is cash now for more cash later  Murabaha (Mark-up Sale) help the buyer  Salam (forward sale) help the seller  Ijarah (Leasing, Lease to own, forward lease)  Istisna’a with parallel Istisna’a  Salam with parallel Salam  Sukuk (Islamic Bonds)  Tawarruq (Monetization)

9. 9 Form Over Substance February 2011  Banks are in the business of financing  In order to make financing an integral part of trade, the scholars required that they became Sellers or buyers in Murabaha and reverse Murabaha  Lessor in Ijarah  Builders in Istisna’a  Buyers or sellers in Salam and parallel Salam  Owners in Sukuk (Islamic Bonds)  Buyers and sellers in Tawarruq (Monetization)  This dual role created conflict between commercial reality and contract form. Source of synthetic contracts  The margin earned from financing not enough to cover the cost and risk of seller. Use of disclaimers

10. 10 When a Default Occurs  Legal steps: –Co-operative or hostile parties –Restructuring v. Litigation –Syndicated financing – Islamic + conventional –Understand underlying agreement – both substance and form –Dealing with multiple Shari’ah Boards – differences of opinion

11. 11 Challenges Under Distress or Default  Most distressed deals have been voluntarily restructured to date  Some have gone to litigation  The outcome of the litigation will primarily depend on the site of the court and law February 2011

12. 12 Restructuring a Syndicated Financing  Syndicated financing with conventional participants?  IF receive return via ownership, conventional via debt  Pari Passu expectation - Inter-creditors agreements  Multiple Shari’ah Committee approvals?  Default interest not permissible  Delay the payment date of the debt in lieu of additional payment (interest) - No  Sell the debt at a discount to a third party – No  Islamic restructuring - Nature of the contract. Complex, with exposure to additional taxes and liabilities. Example buy and lease back

13. 13 Voluntary Restructuring (I) Issues relating to specific transactions:  Commodity Murabaha – refinancing through a replacement Murabaha – what if the customer is technically insolvent? Can the new purchase and sale of commodity arrangements be attacked under bankruptcy legislation?  Trade Murabaha – asset sold back to the IFI (for an amount to clear the deferred sale price obligation under the trade Murabaha) and then leased back to the customer (i.e., a new Ijarah financing).  Possible insolvency law issues  Some Shari’ah scholars would not allow it

14. 14 Voluntary Restructuring (II)  Ijarah – if the lessee defaults and reneges on its purchase undertaking obligations can the lessor (the IFI) sell the asset and keep all of the proceeds if they exceed the balance of unpaid fixed rent?  Mudarabah - extend the life of the Mudarabah  Mudarabah - sell the units to the Mudarib at a mark-up with delayed payment with proper guarantees

15. 15 Jurisdiction Issues In deciding a dispute a court may:  Look at the commercial reality and intentions of the parties and rule accordingly  Read the terms of the contract and apply it literally  Based on the totality of its terms, restructure the contract and apply the law to restructured contract  Remove the Shari'ah repugnant terms and rules on the basis of corrected contract  Invalidate the whole contract for Shari'ah violations

16. 16 Case Study - Who has the Jurisdiction  Saudi Board of Grievances  Khalid Bin Abdulaziz Alanzan v. Saudi American Bank (Samba Financial Group), dated 17/1/1429, (26/1/2008)  The plaintiff opened an account with the bank for trading in precious metals on margin  The [plaintiff] asserted that the Commercial Circuit of the Board of Grievances had jurisdiction over this case.... The Defendant countered... Jurisdiction belongs solely to the Committee for the Settlement of Banking Disputes  In considering the nature of the relation between the Plaintiff and the Defendant, the Second Circuit found that the Plaintiff considers the agreement with the Defendant to be a "Commercial Agency for Trading," while the Defendant considers it a "Loan and Credit Facilities" type of relation. However, the Circuit is concerned about the substance, not the title...  The Board of Grievances characterised the contract as an agency contract and found that the terms of the contract violated Shari'ah rules and invalidated the contract February 2011

17. 17 Risk of a Shari’ah Repugnancy  Beximco Pharmaceutical V. Shamil Bank – English Court of Appeal  Murabaha Contract –"When the parties entered into the Murabaha Agreements...neither side was under any illusion as to the commercial realities of the transactions, namely the provision by the Bank of working capital on terms providing for long term repayment, and both were content "to dress the loan transactions up as Murabaha sales (or Ijarah leases)"  TID v. Blom – English High Court – Investment Wakalah contract  After looking at the terms of the investment wakalah contracts, the English High Court stated that it was "a device to enable what would at least to some eyes appear to be the payment of interest under another guise, that is at least an indirect practice of a non-Shari'ah compliant activity." February 2011

18. 18 Case Study – Malaysia BBA cases  Bank Islam Malaysia v. Azhar Osman, Malaysia High Court  Murabaha (BBA) contract - early payment discount  Bank refused to give a discount for the early payment and argued the “BBA contract in a way differed from conventional banking because it was a sale transaction”  Held … “it could not be regarded as a sale transaction … The bank should not be allowed to enrich itself with an amount which was not due”  The court looked at the commercial reality as opposed to the form February 2011

19. 19 Case Study: Re-characterization of the Contract  The Ijarah contract in reality is a deferred payment sale contract (Dubai court, 24/3/2010)  "The criteria of characterisation of contract is based on the true reality and the joint intention aimed by the will of both contracting parties…. from that the proper characterisation of the contractual relation between them, it is a sale contract. The court does not recognize the characterization of the contract by the contracting parties as a lease contract associated with a promise of sale and purchase merely because their intention at the time of contracting was to make a complete sale"  Re-characterisation often changes of applicable rules, rights and obligation of the parties February 2011

20. 20 Case Study: Fix the Contract  Arbitrators found the following terms of a Mudarabah agreement repugnant to the Shari'ah: –interim distribution of "on account" profits; –obligation of the Mudarib to provide collateral and - in case the collateral value declines - provide additional collateral; –in case of loss, the Mudarabah would convert to a loan contract; and –the Mudarib seeking the permission of the financier before concluding a transaction.  Arbitrator found these terms Shari'ah repugnant and ruled that the dispute must be judged on the basis of remaining valid terms on the Mudarabah contract February 2011

21. 21 Asset Based or Asset Backed  Nature of Sukuk assets –True sale? –Perfection of transfer of title –Existence of purchase undertaking  Have the Sukuk-holders agreed to restrict rights to enforce?  …Under no circumstances shall the Trustee/Transaction Administrator have any right to cause the sale or other disposition of the sukuk assets except through Purchase Undertaking…  ISRA 98% asset base  limited recourse

22. 22 February 2011 Dealing with Defaults and Restructuring Issues in Islamic Finance April 9, 2011 - Berkeley Law School 9016025 Muddassir Siddiqui Partner, Head of Islamic Finance Middle East T +971 4 405 4323 muddassir.siddiqui@snrdenton.com snrdenton.com