Issues in Islamic Finance What Insolvency Practitioners Need to Know

A fundamental tenet of the practice of law has always been that lawyers must understand the business of their clients. For insolvency lawyers, this typically has required the development of an in-depth understanding of how banks operate.
As banks increasingly give way to asset-based lenders, hedge funds, and private-equity firms as the core providers of commercial capital, insolvency lawyers have had to keep pace with the development of complex lending and recovery businesses. This trend has been spurred in part by the excess liquidity in the global marketplace over the last few years, which has allowed borrowers to become more demanding about what types of lending vehicles and products they wish to avail themselves of. Islamic finance is poised to achieve—or arguably already has achieved—this status in the Western World. This article provides insolvency practitioners with a primer on Islamic finance and the potential issues it may raise in an insolvency context.
While the practice of Islamic finance in the Muslim world dates to the Middle Ages, the first modern Islamic bank was established in Egypt in 1963. [1] Following this initial experiment, the Organization of Islamic Countries (OIC) created the Islamic Development Bank (IDB) in 1974, giving momentum to the interest-free banking system based upon Shariah (Islamic law) principles. [2] This revitalization was prompted by the increased liquidity from the first oil price shock of 1973 to 1974, in addition to increased demand by Muslim populations seeking financial services compatible with their religious beliefs. [3]
The past two decades have seen record high growth rates for Islamic banks around the world in both number and size. The entire banking systems of Iran, Pakistan, and Sudan have converted to Islamic banking, while other countries frequently have Islamic financial institutions alongside conventional banks.
Market share of these banks in Muslim countries is estimated to have risen from 2 percent in the late 1970s to 15 percent in the mid 1990s. [4] Consequently, global financial institutions, such as HSBC, Deutche Bank, and Citigroup, are capitalizing on this niche market by establishing Islamic banking subsidiaries or having extensive involvements in this field. [5] Today, 284 institutions operating in 38 Muslim and non-Muslim countries worldwide offer Islamic financial services. In addition to banks, Islamic capital markets, mutual funds, and insurance services also are developing. [6]

Modes & Methods

Islamic finance is based upon Shariah principles derived from the Holy Quran and the Sunna, and its central feature is the prohibition of payment and receipt of interest (riba). [7] Explanations proposed by Muslim scholars for this ban are that interest serves as unearned income, prevents full employment, and can lead to monetary crises. [8] Other Shariah restrictions that affect Islamic finance include those against speculation and gambling (maser), uncertainty of subject matter and contractual terms (gharar), and capital that has no social purpose beyond unfettered return. [9]
Although Shariah imposes a ban on interest, it recognizes capital as a factor of production and allows owners of capital to share in a surplus that is uncertain, as long as there is no prior claim on interest. Thus, a viable alternative to charging interest has been profit sharing with a predetermined ratio. [10]
The Western system of equity financing is probably most comparable to Islamic finance. Depositors in Islamic banks are like shareholders who earn dividends when the bank makes a profit and lose a portion of their savings if the bank suffers a loss. [11] The main restriction is that depositors are not entitled to any addition to the principal sum unless they partake in some risk. [12]
There are five basic Islamic financing methods, each of which can be understood under the framework of existing Western financial instruments. [13] They are:
  • Murabaha, or cost-plus financing, is a method of asset acquisition finance. The transaction occurs when the bank purchases an asset at the request of its client and then sells it back to the client on a deferred sale basis with a markup. The markup is determined before the purchase takes place and cannot be modified during the life of the contract. Murabaha is primarily applied to trade finance but can also be used for real estate and project financing. [14]
  • Ijara and Ijara wa-Iqtina are Islamic leasing arrangements that are comparable to Western operating and finance leases, respectively. Ijara is like an operating lease in that a bank rents an asset to its client for agreed payments throughout a specific period of time, but the client does not have the option of owning the asset. Similar to a finance or capital lease, Ijara wa-Iqtina allows a client to own the asset at the termination of the lease. In both cases, the leased assets must have a secure productive life and the lease payments cannot be based upon speculation. [15]
  • Istinsa operates like a commissioned manufacture and often is used to finance long-term, large-scale facilities. The Islamic bank will manufacture assets, usually through a parallel contract with another institution. It then sells them to a client at a reasonable profit in exchange for taking on the risk of manufacturing the assets. [16]
  • Mudaraba is similar to a Western limited partnership, whereby one party contributes capital to a business and the other party provides expertise. A profit-sharing ratio is arranged and agreed upon prior to undertaking the project. [17]
  • Musharaka can be compared to a joint venture in that two parties provide capital toward the financing of a project that both may manage. Profits are shared based on a prearranged ratio, but losses are distributed in proportion to equity participation. [18]
One of the major reasons financial institutions are trying to integrate and implement Shariah-compliant systems is that it opens the opportunity to tap into the funds of Islamic investors. [19] While many Muslim countries have established Western-style stock markets, some are now attempting to apply Shariah principles to trading. Tough challenges will arise in this process, especially given the Islamic restriction against gambling (qimar). Nonetheless, Malaysia already has made great progress in this field with the establishment of Islamic brokerage houses and an Islamic stock index with 170 listings. [20]
The Islamic bond market, which was not even in existence in 2000, also has made an impressive debut, reaching $6.7 billion in 2004. The income streams from these bonds are based upon Musharaka, Murabaha, and Ijara structures, rather than an interest system. [21] As new Islamic financial products are introduced, these markets undoubtedly will become more prevalent and sophisticated in the future.

Insolvency Concerns

In theory Islamic or Shariah-based legal systems, such as those found in Pakistan, Saudi Arabia, or Sudan, can adequately address insolvency issues arising out of Shariah banking arrangements. How these legal systems attempt to do this is a complex and interesting subject that is beyond the scope of this article. Of more immediate concern to most insolvency professionals is the confluence of Shariah banking transactions with Western, particularly common-law, legal systems. The United Kingdom, for example, already has a number of high street banks offering Shariah-based financing products sanctified by local religious boards.
The introduction of these products raises a number of general policy issues for Western banks. In murabaha real estate transactions, for example, the bank effectively becomes a landlord. For most large commercial banks, this business will be relatively new to them and is fraught with risk. Moreover, a bank that chose to offer Islamic finance products to depositors (as opposed to just borrowers) would need to retain a clearly differentiated status between shareholders’ capital and clients’ deposits to ensure that profit sharing was administered in accordance with Islamic Law. This may be a difficult undertaking for a publicly traded bank that has many shareholders.
Apart from these concerns, however, is the issue of how Islamic finance transactions will be treated in cases of insolvency. Given the relative novelty of these transactions in Western countries, there is little jurisprudence on the topic. But it is not difficult to envision the types of issues that may arise in the coming years:

  1. The Bank as Landlord. As described earlier, murabaha transactions can be crafted to allow for the purchase of real estate by the bank, rather than the borrower, and the creation of what is, in effect, a traditional mortgage, by way of a long-term lease with an automatic transfer of title at the end of the lease term. Upon default of a traditional mortgage, particularly in industrial situations, a bank may take steps to avoid becoming a “mortgagee in possession,” at least until it is satisfied that there are no serious environmental concerns with the property. Where a murabaha real estate transaction interacts with a typical restructuring law, however, an insolvent debtor may have the ability to disclaim the unexpired portion of the murabaha lease, thereby causing possession and control of the property to revert automatically to the de facto control of the bank/landlord. Undoubtedly, banks will erect the necessary corporate firewalls to address such risks. But at a minimum, reputational risk should be a large concern.
  2. Substance Over Form. At a basic level, there is a concern as to whether the bank’s retention of title in both Ijara and Ijara wa-Iqtina transactions will be definitive in insolvency situations. Many modern personal property security laws apply to any transaction that, in substance, creates a security interest. In the past, courts therefore have disregarded retention of title clauses in leases and have determined that the transaction was in fact a financing one—requiring the interest to be perfected under the relevant personal property security regime. Absent specific carveouts for Islamic transactions in such regimes, this issue is likely to be a significant one.
  3. The Bank as Controlling Mind of the Company. In typical lender-borrower relationships, banks often take scrupulous care to avoid taking steps that could result in them being deemed to be in control of their borrower. In mudaraba—and in particular, in musharaka—transactions, this may be impossible. If a court could find that a bank, particularly on the eve of a company’s insolvency, was a controlling mind of the company, there are a number of implications to consider:
Corporate Governance. The biggest area of concern is the broad playing field on which issues involving corporate governance and insolvency collide. This is especially true in jurisdictions in which modern insolvency laws impose liability on officers and directors for actions taken on the eve of insolvency. In many civil law systems, these can include business judgments made in good faith that nonetheless contribute heavily to the insolvency of a company. In many jurisdictions, regardless of the cause of the insolvency, officers and directors bear personal responsibility for particular statutory liabilities, such as employee withholdings and sales tax. Banks in musharaka transactions will have to ensure that these liabilities are met on an ongoing basis or risk exposing the bank to liability for them. Some jurisdictions impose fiduciary responsibilities on controlling minds of a corporation to ensure that lenders are not misled or wrongly induced into advancing further funds to a company. Finally, virtually every modern insolvency law imposes some level of liability on officers and directors for carrying on business (and accruing debt a company is unlikely to be able to repay) during the pre-insolvency period. Banks will have to ensure that they take adequate steps to stop such trading from taking place.
Equitable Subordination. In recent years, courts have employed the doctrine of equitable subordination (which can result in secured debt being subordinated to unsecured debt) to correct what they have seen as various forms of malfeasance by banks. It is difficult to anticipate precisely when this doctrine will be employed, but it is not difficult to see how the heavy involvement of a bank in the effective management of a business venture that becomes insolvent could result in the bank’s interest being equitably subordinated.
Undoubtedly, Western banks will attempt to mitigate these risks through the use of corporate structures, carefully crafted contracts (drawing on existing precedents within the world of Islamic finance), and even various forms of indemnities or insurance. If insolvency jurisprudence has taught anything over the last 10 years, however, it is that corporate veils can be pierced and contracts set aside when the larger interests of stakeholders demand it. Put another way, no “ring-fence” is entirely secure.
This is not to suggest that Shariah financing transactions are to be avoided or feared. In fact, there are compelling arguments that Shariah- based financing results in more efficient allocations of capital, greater stability, and larger growth. [22] Moreover, as noted earlier in this article, the depth of financial markets in many Western countries will ensure that the market responds to borrowers’ increasing demands for a diversity of lending products. Instead, lenders—and perhaps more importantly, their professional advisors—will have to be sure to understand the complexities and risks associated with these transactions and ensure that appropriate measures are in place to reduce exposure.
This article has been prepared by the authors in their respective personal capacities and not in their capacities as World Bank staff. The authors wish to gratefully acknowledge the assistance of Robert Liu, Glenn Martin, Thierno Balde, and Vijay S. Tata in the development of this article.
The findings, interpretations, and conclusions expressed in this article do not necessarily represent the views of thexecutive directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data contained in this article.