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The Nakheel Sukuk and the Special Tribunal Related to Dubai World

The Nakheel Sukuk and the Special Tribunal Related to Dubai World

 

Nakheel is a member of Dubai world and one of the UAE’s largest property developers.  Dubai World is one of the largest global holding companies and was established to hold the interests of the government of Dubai in companies under common management control.  In December 2006, Dubai Islamic Bank arranged the Pre-Qualified Public offer Equity Linked Sukuk issue for Nakheel.  The sukuk was approved by the Shari’ah Board of Dubai Islamic Bank.  It was documented according to the Eurobond Standard (Reg S) and was listed on the Dubai International Financial Exchange.  It was the largest sukuk offering executed in the world at US$3.52 billion at that time.  The issue was oversubscribed by 2.5 times and the total order book was US$6 Billion.  As the sukuk were given the status of sovereign bond, investors assumed this was a government guaranteed sukuk, which gave them a false sense of security.  Moody’s and Standard and Poor’s gave the sukuk an A+ rating.  The governing law of the sukuk was English and UAE law. (Islamic Finance News Deals of the Year: 2006)

 

The underlying sukuk structure was the sukuk manfaa-ijarah.  Salah says that this structure resembles a conventional lease-and-lease back transaction between the party who is in need of financing or the originator and a Special Purpose Vehicle (SPV).  The transaction starts with the originator, who sets up an SPV and selects certain tangible assets for the transaction.  The originator leases the tangible assets pursuant to a Head Ijarah Lease Agreement to the SPV, usually for a long period of time (i.e. 50 years).   The entire lease sum is paid up front.  This amount is financed by the SPV through the issuance of sukuk.  The SPV holds the assets in trust for the sukuk holders.  For the sukuk to be tradable in the secondary markets, the sukuk holders must gain some form of ownership in these underlying tangible assets.  This is structured by giving the sukuk holders the beneficial ownership of these assets.  As the beneficial owners, the sukuk holders are entitled to the profit that is generated over these underlying assets.  Next, the SPV leases the tangible assets back to the originator in accordance with the sub-ijarah lease agreement for a short period i.e. three years.  During the lease period, the SPV holds the assets in trusts as a trustee for the sukuk holders.  The originator makes periodic lease payments to the SPV.  The sukuk holders are entitled to these lease payments, since they are the beneficiaries of the underlying tangible assets.  The SPV in turn pays these lease payments as periodic payments on the sukuk to the sukuk holders.  At maturity date (I.e. after three years), the Sub Ijarah Lease Agreement ends and the Head Ijarah Lease Agreement is terminated.  The originator pays an amount of money equal to the principal amount of the sukuk holders.  The SPV will use this sum to repay the principal amount to the sukuk holders.  (Salah: 2010)

 

Specifically, the sukuk proceeds were used to fund the development of several projects including Jebel Ali Village, Jumeirah Islands, Dubai Promenade, the Lost City, Jumeirah Park, Jumeirah Village, Dubai Waterfront, and International City.  The developer wanted to build a city twice the size of Hong Kong Island, with skyscrapers for 1.5 million residents ringed by a 75 Km canal at Dubai Waterfront. (Salah: 2010). The return on the certificates were calculated on the basis of a fixed return of 6.345% per annum (the QPO yield).  On the 14th June and 14th December in each year (Each periodic distribution date) commencing on 14th June 2007, the issuer will pay periodic distribution amounts to each certificate holder calculated as the product of 50% of the QPO yield and the principal amount of the certificate on a 30/360 basis. In addition, on the redemption date the issuer will pay to each certificate holder (i) the final distribution amount calculated as the product of 50% of the QPO Yield and the principal amount of the certificates on a 30/360 basis.  (Islamic finance News Deals of the Year: 2006)

 

The originator was Nakheel Holdings – 1 LLC.  Nakheel Holdings 1, 2, and 3 were subsidiaries of Nakheel World LLC, which held 100% of the shares in all three Nakheel Holdings.  All three Nakheel Holdings had a subsidiary, Nakheel PJSC, which was operating in the real estate sector in Dubai.  The parent company and 100% shareholder of Nakheel World was Dubai World, a 100% state-owned company.

 

The Nakheel Sukuk was structured as a 3 year Pre-QPO Equity Linked Ijarah Sukuk wherein funds were raised at the Nakheel Holdings 1 (obligor) level.  Under a purchase agreement, certain pre-identified assets were sold to Nakheel Development Limited, an offshore special purpose vehicle (Issuer SPV) that was formulated as a free zone company in the Jebel Ali Free Zone. (Islamic finance News Deals of the Year: 2006)  The SPV issued trust certificates (sukuk) for US$3.52 billion in order to purchase assets from Nakheel Holdings 1 for 50 years including land, building, and property at the Dubai Waterfront valued at AED 15.5 billion dated October 31, 2006 by Jone Lang Lasalle. (Zaheer: 2013 )  The purchased assets were subsequently leased by the SPV, as trustee to the sukuk holders, to Nakheel Holdings 2 for a period of 3 years. Half of the lease amount was paid to sukuk holders via the SPV and the other half is deferred until the maturity of the sukuk.  (Zaheer: 2013)

 

The lease comprised six consecutive periods of six months each. (Salah: 2010) The rental payments of the lease periods matched the periodic distribution payments on the sukuk so Nakheel SPV would pay the lease payments to the sukuk holders.  At the redemption date of the sukuk, the lessee had to purchase the sukuk assets from the lessor in accordance with a purchase undertaking at a certain exercise price.  This exercise price was equal to the redemption amount of the sukuk and would be used to pay back the principal amount to the sukuk holders.  In this way, the sukuk were redeemed (Salah: 2010).

 

A co-obligor guarantee was executed by Nakheel Holdings 1, Nakheel Holdings 2, and Nakheel Holdings 3 (together the co-obligors) in favor of the issuer SPV under which the co-obligors jointly and severally, irrevocably, and unconditionally guarantee the payment, delivery, and other obligations of each other under the transaction documents.  (Islamic finance News Deals of the Year: 2006)

 

As a form of credit enhancement, Dubai World (Guarantor) also granted a guarantee in favor of the issuer under which the guarantor has irrevocably and unconditionally guaranteed the payment obligations of the guarantor under the Dubai World guarantee constitute unsecured, direct, unconditional, and insubordinate obligations of the guarantor, which will at all times rank pari passu with all other unsecured and insubordinate obligations of the guarantor. Further, in order to secure the payment obligations of the co-obligors, Nakheel Holdings 1 has granted a mortgage over property and a share pledge of Nakheel PJSC shares in favor of the security trustee.  (Islamic finance News Deals of the Year: 2006)

 

There is a guaranteed allocation in the sukuk structure.  Under the subscription rights sale undertaking, the sukuk structure incorporated a guaranteed allocation of 25% of the sukuk amount to investors in any qualifying public offering (QPO) undertaken by the Nakheel group during the tenor of the sukuk.  A QPO means any primary or secondary equity offering of the authorized or issued share capital by any member of the Nakheel Group including in the form of global depository receipts, American depositary receipts, any offering of mandatory exchangeable or convertible bonds, warrants and rights issues, in each case listed on any international stock exchange. Each certificate provides the holder the right to subscribe for QPO shares at the discount of 5% on the indicative share price on each QPO that is launched prior to redemption of the certificates.  A QPO shall be deemed to be launched when the initial, preliminary, pathfinder or other equivalent offering document is published and/or made available to potential investors in connection with that QPO.  The rights of certificate holders in aggregate is limited to an aggregate number of QPO shares equal to 30% of the aggregate number of QPO shares to be issued.  As such, the aggregate value of the subscription rights in all QPO launched after the closing date and prior to the redemption date including the value of the subscription rights in that QPO does not exceed in aggregate US$880 million, being 25% of the sukuk issuance amount.  However, in the event that the Nakheel Group does not float shares, then investors will receive a higher yield of up to 200 bps depending on the value of the subscription rights allocated to the sukuk holders.  (Islamic finance News Deals of the Year: 2006)

 

The sukuk had a three year tenor, but investors will also receive look back rights for allocation of Nakheel Group QPO shares that extend into a fourth year.  If a QPO takes place between years 3 and 4, investors can participate as though the QPO had taken place at the end of three years.  On December 14, 2009, the lessee had to purchase the sukuk assets from the lessor in accordance with a purchase undertaking at a certain exercise price.  However, the Nakheel sukuk was now nearing default as the Nakheel Holding was highly leveraged and it cash flow dried up when Dubai’s property sector experienced a slow-down after the global financial crisis.  (Islamic finance News Deals of the Year: 2006)  In November 2009, Dubai World requested a restructuring of its $26 billion debt.  Investors feared that its $4 Billion Nakheel sukuk would also default.

 

The question arises as to how a default or disputes involving Nakheel or Dubai World would be settled under English and UAE laws?  According to Friel and Kumpf, the sukuk was governed by English law and structured using English trust law concepts to bestow only beneficial ownership on the investors in the form of leasehold rights. (Friel and Kumf: 2015)  This means that there was no proprietary transfer of ownership rights in these underlying tangible assets from Nakheel Holdings 1 to Nakheel SPV – there was merely a transfer of leasehold rights. (Salah: 2010)  Leasehold rights are not considered real rights under UAE law, where the assets indirectly owned by the government were located.  Government assets may not be attached under UAE law. (Friel and Kumf: 2015)  Because  the contractual agreements (i.e. purchase undertakings, guarantees, etc.) are not sufficient to give protection to creditors in an insolvency scenario involving all parties (including the guarantors), proprietary rights are especially important.  (Salah: 2010)  In Dubai, they are viewed as unregistered personal contractual rights binding the parties as opposed to rights attached to the land in question.  (Salah: 2010)  In the case of insolvency, proprietary protection is more important than a contractual agreement.  (Salah: 2010)

 

In order to secure the position of the sukuk holders as secured creditors through Nakheel SPV, security rights were granted.  In addition, there were also rights of mortgages granted by Nakheel Holdings 1 to the underlying tangible assets.  (Salah: 2010) However, neither security rights or rights or mortgages offered the protection required by sukuk holders to safeguard their investments.

 

Although the default was prevented by an Abu Dhabi bail out, a Special Tribunal Related to Dubai World was created to adjudicate disputes involving Nakheel, Dubai World, and its’ subsidiaries using amended DIFC law, commercial custom, principles of justice, Dubai legislation, and various Regulations at the DIFC Courts.  The Ruler of Dubai, His Highness Sheikh Mohammed Bin Rashed Al Makhtoum, issued (Dubai) Decree 57 of 2009 to establish the Dubai World Tribunal related to the settlement of the financial position of Dubai World and its subsidiaries.  This stipulated that any claims by or against Dubai World and its subsidiaries were to be decided by a three to five man tribunal.  (Holman Fenwick Willan)

 

The Tribunal is entitled to hear and decide, inter alia, any demand to dissolve or liquidate the state-owned corporation, which is Dubai World and/or its subsidiaries.  The Tribunal has jurisdiction to hear and decide any demand or claim submitted against the Dubai World Group including hearing and deciding any demand to dissolve or liquidate the Dubai World Group; and any person related to the settlement of the financial obligations of the Dubai World Group, including the Chairman and members of the Board of Directors, as well as all the employees and workers of the Dubai World Group.  That jurisdiction was extended to include disputes brought by Dubai World and its subsidiaries by Decree No. 11 of 2010 – Amending Decree No. 57 of 2009.  The Tribunal has power to issue any interim and interlocutory orders and decisions, including injunctions preventing any person from undertaking an act or requiring a person to perform an act, or other order as the Tribunal considers appropriate.  Decisions and orders of the Tribunal are to be issued by the unanimous or majority votes of its members and in the name of the HH The Ruler of Dubai.  The decisions and orders of the Tribunal are final, irrevocable and not subject to any appeal or review. The decisions and orders issued in the Emirate by the Tribunal are to be executed by a competent execution judge.  The execution judge is not to take any action that may hinder the execution of the decision or order issued by the Tribunal.  The Tribunal is to have its seat and hold hearings in the DIFC.  All proceedings are to be open to the public unless the Tribunal decides otherwise for considerations relating to the conduct of justice or to protect confidentiality of information.

 

Rather than create a tribunal for each individual sukuk default with its own laws, rules, and seat, it makes more sense and would streamline sukuk dispute and default adjudication if there existed one global entity such as the Sukuk Bankruptcy Tribunal (SBT) where all sukuk disputes and defaults were settled according to a standardized dispute resolution contract with a built in dispute resolution mechanism, arbitration centre, SBT law, arbitration rules, and  the procedural laws of the Seat, which would be Dubai.

 

In fact, Dubai World is an interesting case because as the laws of England and the UAE were designated in the prospectus, both English law and UAE law have bankruptcy laws and procedures.  However, the Ruler of Dubai, Mohammed Bin Rashid Al Maktoum, authorized the formation of an independent ad hoc tribunal based on the laws of the DIFC with amendments to settle any claims arising from the Dubai World and Nakheel bankruptcies.  It would certainly be erratic and harmful to the Islamic finance industry if every time we have a sukuk default, an ad hoc and independent tribunal formulated on its own laws, rules, and procedures was established to adjudicate the sukuk default, dispute, or bankruptcy.

 

Decree No. 57 for 2009 set up a three to five man tribunal (Article 2) to hear and decide any demand or claim against (a) Dubai World and/or its Subsidiaries, including hearing and deciding any demand to dissolve or liquidate Dubai World and/or its Subsidiaries; and (b) Any person related to the settlement of the financial obligations of Dubai World and/or its Subsidiaries, including the Chairman and members of the Board of Directors, as well as all the employees and workers of Dubai World and/or its Subsidiaries.  The Tribunal can also issue the interim and interlocutory orders and decisions, including injunctions to any person to act or not to act, or other order as the Tribunal considers appropriate.  The Tribunal, may as it considers appropriate, assign or appoint as experts persons having expertise and competence in the matters submitted to it.  (Article 3)

 

As its governing law, the Tribunal chose (Article 4) (1) DIFC Law No (3) of 2009 Concerning the law of insolvency, according to the amendments in the Schedule hereto; (2) The Regulations issued by the Board of Directors of the DIFCA Concerning DIFC Insolvency Regulation, according to the amendments stated in the Schedule hereto; (3) DIFC Law No (10) of 2004 Concerning the Court of DIFC, according to the amendments stated in the Schedule hereto; (4) Legislation in force in the Emirate; (5) Commercial Custom; and (6) Principles of Justice, and rules of righteousness and equity.

 

Article 5 states that the Tribunal shall have its seat and hold its hearings in the DIFC and that all decisions are final, irrevocable, and not subject to any appeal or review.  According to Article 8, the Government and the DIFC shall provide the necessary administrative and financial support to the Tribunal for it to discharge its duties under this Decree.  The Chairman of the Tribunal or the Tribunal member, to who he delegates such responsibility, shall undertake the task of supervising all the administrative and financial affairs relating to the work of the Tribunal.

 

The Tribunal issued its first Practice Direction on 30 March 2010 clarifying that it will respect and enforce arbitration agreements.  Counterparties who agreed to arbitration clauses in their contracts with Nakheel (and related Dubai World entities) are not entitled to commence their proceedings before the Tribunal.  In this case, the parties to the dispute would have to initiate arbitration and then apply to the Tribunal for the enforcement of the arbitration award. (Holman Fenwick Willan)

 

On 22 September 2011, the Tribunal issued Practice Direction 3 of 2011, which mentions that Nakheel PJSC and certain of its subsidiaries and affiliates ceased to be subsidiaries of Dubai World with effect from 23 August 2011.  The Tribunal continues to exercise jurisdiction over proceedings commenced before 23 August 2011, but it is unclear how things will proceed for disputes arising after this date.  (Holman Fenwick Willan)

 

Potential claimants may now have to apply to the Director General of the Department of Legal Affairs for the Government of Dubai pursuant to Government Claim Law No. 3 of 1996 (as amended) and the law establishing the Department of Legal Affairs for the Government of Dubai Law No. 32 of 2008.  This would add a further layer to the dispute resolution process.  In addition, one must have the approval of the Government of Dubai to enforce an award against the Government of Dubai. (Holman Fenwick Willan) Hence, with the split of Nakheel to the government, even with this Special Tribunal Related to Dubai World, it is difficult to enforce judgments against the Government of Dubai as their approval is required for such enforcement.  Once a judgment is enforced at the Special Tribunal Related to Dubai World, it is final, irrevocable, and not subject to review and/or appeal as per Article 5 of Decree No. 57 of 2009.

 

I think it is clearly evident the advantages of creating the Sukuk Bankruptcy Tribunal (SBT) as part of the Dubai World Islamic Finance Arbitration Centre (DWIFAC) and Jurisprudence Office (DWIFACJO) in settling the world’s sukuk disputes.  A standardized dispute resolution contract with a built in dispute resolution mechanism would be attached to all sukuk transactions around the world designating the SBT as the dispute resolution mechanism.  Any dispute in a sukuk would be dealt with first by the built in contractual dispute resolution mechanism in the SBT sukuk contract as described herein in the DWIFAC procedure and only if the ruling of the Dispute Adjudication Board (DAB) was not followed or a Notice of Dissatisfaction was filed can the dispute then be directed to the SBT for arbitration.

East Cameron Gas Sukuk Bankruptcy

East Cameron Gas Sukuk Bankruptcy

East Cameron Partners (ECP) issued sukuk of USD165.67 million in June 2006 with a maturity period of 13 years as a private placement under Regulation D and an international offering under Regulation S, which means that the sukuk certificates represented an ownership stake in ECG. (Colon: 2019)  East Cameron Partners (ECP) was an independent oil and gas exploration company that owned leasehold interests in a producing natural gas and condensate field in federal waters adjacent to Cameron Parish, Louisiana.  East Cameron’s leasehold interests consisted of a 100% undivided record title interest with a 79.87% net revenue interest subject to certain Overriding Royalty Interests in East Cameron Block 71/72.  These lease interests arose from federal oil and gas leases governed by the Outer Continental Shelf Lands Act and administered by the Minerals Management Service of the United States Department of the Interior. (East Cameron Partners L.P. v. Louisiana Offshore Holding LLC & Ors [2009]..)

ECP saw the sukuk issuance as an affordable and flexible finance opportunity through which it could raise the funds needed to purchase other shares from the non-operating partner, Macquarie Bank, whom wished to sell its share in the business.  The underlying contract was musharakah in which sukuk investors owned so called Overriding Royalty Interest (ORRI) in two gas properties located in the shallow waters offshore the state of Louisiana, USA through an SPV.  Specifically, the structure of the transaction involved the purchase of an ORRI carved out of US federal offshore leases as mentioned herein.  Under local (Louisiana) law, ORRI are considered real property.  Because the transaction involved real property, the Shari’ah Scholars approved this as an asset-backed securitization in the form of a sukuk al-Musharakah.  The sukuk investors share the profits and losses in the production of the originators in a pre-determined ratio determined by their relative capital shares fixed in the sukuk documents.  The SPV was called East Cameron Gas Company (ECGP) and incorporated in the Cayman Islands.  (Goud: 2010)

The Issuer entered into a funding arrangement with Louisiana Offshore Holdings (LOH) with the proceeds of the issue flowing back to the oil and gas operating company, ECP.  Proceeds from the gas production flowed to LOH (Owner of the ORRI) and were shared between the Issuer and ECP.  The Issuer passed along its share of the proceeds to the ECP sukuk investors to repay the 11.25% expected return and part of the principal. (Hawkamah Institute of Corporate Governance: 2011)  Although the investors would share in the profits or losses derived from the success or failure of the underlying assets, the investors bore the risk of the oil and gas reserves being insufficient to fully support the issuance of the sukuk, natural disaster risk, and price fluctuation risk.  (Hawkamah Institute of Corporate Governance: 2011)

 

This was the first sukuk issued by a company based in the United States and rated by Standard and Poor’s.  The sukuk were initially rated CCC+ by Standard and Poor’s and then downgraded to CC and finally D. Although the East Cameron Gas sukuk had a fixed payment of 11.25% annually, there was also a variable component because the sukuk returns depended upon the production quantities  (the ORRI specified a fixed quantity of natural gas be delivered to the SPV).  It also contained a redemption feature by where a percentage of the sukuk would be redeemed if production exceeded a certain level.

Sukuk holders were also exposed to risks found in the energy sector i.e. the volatility of natural gas and condensate prices, which may adversely affect payments on the sukuk.  In order to hedge against severe price fluctuations in oil and gas markets, there was a Shari’ah compliant hedge that established a price collar between $7 and $8 per million BTU (MMbtu) on half the expected products gas production and a put option at $6 per MMbtu for an additional quarter of anticipated production (Goud: 2010).

Further described in the offering document was that closing transactions would occur including “purchase of natural gas put options for US$4.05 million pursuant to a Hedge Agreement (the “Hedge” Agreement) with Merrill Lynch Commodities, Inc. (the “Hedge Counterparty”) that, in combination with other hedges provided under the Hedge Agreement, are intended to mitigate the Purchaser SPV’s exposure to change in natural gas prices.  In addition, Merrill Lynch Credit Products LLC would provide a letter of credit on behalf of the Purchaser SPV to secure the Purchaser SPV’s obligations under the Hedge Agreement.  The Shari’ah compliant hedges limited the impact of rising and falling prices on the ability of the production to be sufficient to generate returns for investors.  (Goud: 2010)

 

In sum, the issuer SPV, East Cameron Gas Company (ECGP), incorporated in the Cayman Islands issued USD165.7 million of sukuk whose proceeds would be used to buy the ORRI from the Purchaser SPV following a Funding Agreement for USD$113.8 million.  The remaining amount was appropriated for a development plan, a reserve account, and the purchase of put options for natural gas to hedge against the risk of fall in gas prices.  The originator contributed his share of the capital in the form of transfer of ORRI into the purchaser SPV.  Next, the purchaser SPV, holding ORRI in the properties, would be entitled to around 90 percent of ECP’s net revenue generated through gas production.  (Zaheer: 2013)

The production would be sold to two off-takers with Merrill Lynch as a backup off-taker.  Proceedings of the oil and gas sale would be transferred to an allocation account.  After paying around 20 percent to government and private ORRI, the remaining amount would be transferred to the Purchaser SPV.  Next, the purchaser SPV would allocate 10 percent for the originator and the remainder for the payment of expenses, periodic sukuk returns, and redemption amount.  Any excess amount would go to originator and early redemption of the sukuk equally.  Upon maturity of sukuk, the issuer SPV would redeem all the sukuk against the amount left to be transferred to the sukuk holders (Zaheer: 2013).

Instead of being solely used to support the capital and operating costs of drilling and operating wells in the Gulf of Mexico for East Cameron Partners, the proceeds were also used to pay most of the conventional debt of the company.   This brought the debt-to-equity ratio of the company to a Shari’ah compliant level, however, also bankrupted the sukuk.

Furthermore, the originator’s business was located in the Gulf Of Mexico making it vulnerable to severe weather and other effects.  Shortly after the September 2008 Hurricane Katrina damaged the underlying assets of the sukuk, S & P downgraded the issuance as a result of the negative impact from the hydrocarbon mix shortfall enforcement event on the overriding royalty interest in oil and gas reserves (ORRI), which was the primary collateral for the sukuk.  This enforcement event was triggered by the breach of the 90% minimum stressed reserve level of the hydrocarbon mix threshold stipulated in the transaction documents (Lampasona, 2009).  Thus, in 2008 ECP experienced a shortfall on the ORRI in oil and gas, which is the primary collateral used as the underlying asset to the sukuk contract.  Consequently, the shortfall event triggered breach of approximately 90% of the reserve level of the threshold contained in the contractual agreement. (Busari: 2019)

On September 17, 2008, a Notice that an Exogenous Enforcement Event, namely a Hydrocarbon Mix Shortfall Exogenous Enforcement Event, was served on the Purchaser SPV (LOH) and East Cameron Partners LP (the “Originator” and, subsequently, the “Debtor”)(McMillen: 2011)  S& P downgraded the transaction to CC from CCC+ when the structure hit the aforementioned trigger, breaching 90% minimum stressed reserve level of the hydrocarbon mix threshold.

On October 16, 2008 East Cameron Partners filed for bankruptcy protection under chapter 11 in the United States Bankruptcy Court for the Western District of Louisiana “Bankruptcy Court”, claiming its inability to pay the periodic returns on the East Cameron Gas sukuk to sukuk certificate holders.

In March 2009, the agency cut the deal to D on skipped payments and withdrew the rating; the latter event was in response to a failure to receive service reports (Lampasona: 2009).

 

The issue at hand for the Bankruptcy Court was whether or not the transaction  was a secured loan or a true sale.  True sale is a situation whereby contractual parties agree to transfer a financial asset for fair value with the intent of a sale (Busari: 2019)  The originator claimed that the transaction was not a true sale, but a secured loan.  ECP argued that the ownership of ORRI was not transferred from ECP to Louisiana Offshore Holdings or “LOH” as the transaction was not a true-sale agreement.  ECP further claimed that the underlying asset is merely a pledge as security for a loan in favour of LOH.  (Busari: 2019)

 

Specifically, according to Colon, ECP requested that the bankruptcy court declare (1) the sukuk transaction was a loan; (2) that the conveyance of the ORRI (i.e.) the underlying asst securitizing the sukuk and making the private/international offering of ECG a worthwhile investment, did not transfer ownership of the ORRI to ECG; and (3) the ORRI, was merely security for ECG’s loan to ECP.  (Colon: 2019).  Colon points out that ECP requested the court to interpret the distinctions of the sukuk transaction that made in Shari’ah compliant as ineffective, as nothing more than a conventional secured loan. (Colon: 2019)

 

Under conditions of a true sale, the sukuk investors would have the sole rights to the underlying assets and would not have to stand in line behind any other creditors.  The contractual agreement of the true sale would ensure the bankruptcy remoteness of the SPV whereby in the event of a default, the sukuk holders could have recourse to the underlying asset that has been established through a true sale agreement. (Busari: 2019)  Under the secured loan, the originator would have rights to the assets only after resolving creditor claims in Chapter 7 liquidation.

 

In a motion to dismiss ECP’s complaint and accompanying memorandum of law, the Sukuk Certificate Holders responded to the request for declaratory judgment by arguing: (1) that the ORRI conveyance was indeed a true sale under controlling Louisiana law; (2) that ECP’s statements of law should be disregarded in favour of Louisiana’s version of the Uniform Commercial Code; (3) that the complaint should be dismissed because it asked the court to rewrite the contract; and (4) the complaint should be dismissed because though asking the court to recharacterize the sukuk as a loan, it left out every major detail of what the loan should be. (Colon: 2019).  The Court granted the sukuk certificate holders motion to dismiss and the court did not deviate from the objective terms of the sukuk agreement. (Colon: 2019)

 

The court found that it was a true sale and that the sukuk investors had the sole rights to the underlying assets. Hence, it was decided that the sukuk holders are the owners of the ORRI from the oil and gas reserves as the ORRI is considered real property in the jurisdiction of the state of Louisiana. However, the matter was unclear as to whether sukuk holders enjoyed contractual rights to the assets like bondholders or creditors or whether they enjoyed proprietary rights and were, therefore, considered by the courts to be equity holders (Khnifer, 2010).

 

The court ruled that the SPV assets would be treated as the product of a true sale.  The sukuk certificate holders were able to get full ownership and possession of the assets without sharing it with the other creditors.  This essentially meant that the SPV did in fact own the assets and was not merely a collateral holder for secured loans.  While the event proved successful for sukuk investors, it was a setback for the Islamic finance industry in that the deal was structured as a purchase rather than a distribution to owners.  The assets of the sukuk went to the certificate holders free and clear of claims of creditors, however, a precedent was set that the sukuk certificate holders did not own undivided interest in the assets.  The sukuk certificate holders were treated as if they were third party buyers rather than the asset owners or even secured lenders (Khnifer: 2010).  The Bankruptcy Court did not apply Shari’ah law to the transaction and settled the sukuk bankruptcy as a conventional and common law transaction thereby turning it into a conventional transaction by default. However, the court did uphold the sukuk agreement.  It would be ideal if there was one Sukuk Bankruptcy Tribunal (SBT) attached to the Dubai World Islamic Finance Arbitration Centre (DWIFAC) to settle all of the world’s sukuk disputes and bankruptcies located in Dubai, UAE rather than common law jurisdictions scattered around the world.

How Does Islamic Home Financing Work?

Diminishing musharakah is a financing program based on declining partnership used for the purchase of homes, assets, or businesses. In diminishing musharakah home finance, the customer makes a down-payment and the bank finances the remaining amount through the sale of equity units to the customer. The customer purchases each equity unit over a scheduled period of payments and becomes the owner of the equity unit. The customer purchases each equity unit until all equity units have been purchased and the customer becomes the owner of the house in full and title is transferred from the bank to the customer. In this manner, the bank and customer are co-owners until the customer becomes the full owner of the property. At the same time, the customer moves into the house and in addition to purchasing equity units on an instalment basis, the customer also pays rent. The rental payments, however, decline according to the purchase of units in the equity unit purchase plan by the customer and the bank’s declining share of ownership in the house. As the customer purchases more equity units from the bank and becomes a larger owner in the house while the bank’s share in the house decreases, the customer subsequently pays a decreasing rental payment.

 

I illustrate this concept in a chart produced below based on a chart by Dr. Muhammad Hanif. Dr. Muhammad Hanif gives the example that a house valued at 1 Million USD Dollars is the subject-matter of a diminishing musharakah contract. Dr. Hanif explains that if the customer makes a down-payment of 20% or USD$200,000 dollars, the bank finances the remainder of the house at USD$800,000 dollars. The bank’s share in the house is divided into eight equity units to be sold over eight years at USD$100,000 each to the customer. The customer purchases each equity unit on an annual basis for eight years increasing his/her ownership of the house by a further 10% each year. Therefore, the customer pays USD$800,000 dollars to the bank in equity units for the eight equity units over eight years. In addition, as the customer has moved into the house upon joint-purchase, the customer pays rent to the bank for renting the bank’s share in the house. In year one, the customer pays 80,000 USD in rent or 10% of USD$800,000. In year two, the customer pays the bank $70,000 USD in rent according to the same formula, In year three, the customer pays the bank $60,000 USD in rent according to the same, In year four, the customer pays the bank $50,000 USD in rent according to the same formula, In year five, the customer pays the bank $40,000 USD in rent according to the same formula, In year six, the customer pays the bank $30,000 USD in rent according to the same formula, In year seven, the customer pays the bank $20,000 USD in rent according to the same formula, and in year eight, the customer pays the bank $10,000 USD in rent according to the same formula. The total that the customer pays to the bank in rent is $360,000 USD over eight years. In addition to paying the bank $800,000 USD for the eight equity units over eight years, the customer pays the bank $360,000 USD in rent over eight years. The rental payments decrease on an annual basis as the share of ownership in the house increases for the customer and decreases for the bank.

 

 

 

According to Meezan Bank, this arrangement allows the bank to claim rent from the customer according to the bank’s proportionate share of ownership in the property and at the same time allows the bank periodical return of a part of the bank’s principal through purchase of the units of the bank’s share by the customer.

 An illustration of the main difference between diminishing musharakah in home finance and conventional mortgages is that if for some reason there is a default in Year 4 of the diminishing musharakah program, the bank will sell the house as co-owner with the customer, and if the house sells at the original estimated value, the customer shall get back $500,000 USD or the amount he/she paid in equity units and the bank shall take 500,000 USD or the value of the bank’s equity units in the house or in the same proportion. In a conventional mortgage, the bank would keep the entire sale price.

 

Steps in Detail (Meezan Bank) 

1.  Create a joint-ownership in the property (shirkat ul milk) between bank and customer;

2.  Bank leases bank’s share in the house to the customer and charges the customer rent.

3.  The client purchases units of the bank’s share in the house through an equity unit instalment purchase plan.

4.  There should be a one-sided promise from the client, firstly, to pay to the bank the agreed rent for the bank’s leased share in the house and secondly, to purchase the equity units of the bank according to the equity unit instalment purchase plan.

5.  The joint-purchase (sale and purchase) contract and the contract of lease may be joined in one document whereby the bank agrees to lease the bank’s share to the client after joint-purchase of the house. This is allowed because Ijarah can be affected for a future date. At the same time, the client may sign a one-sided promise to purchase the units of the share of the bank periodically and the bank may undertake that when the client purchases a unit of the bank’s share, the rent of the remaining units will be reduced accordingly.

6.  At the time of the purchase of each unit, sale must be affected by the exchange of offer and acceptance at that particular date.

7.  It will be preferable that the purchase of different units by the client is affected on the basis of the market value of the house as prevalent on the date of purchase of that unit, but it is also permissible that a particular price is agreed in the promise of purchase signed by the client. (In reality, the bank may have to book the purchase price at the outset of the contract)

 

 

Regulatory Landscape of Islamic Finance in the US

Regulatory landscape of Islamic finance in the US 

By Camille Paldi

There are currently 25 Islamic financial institutions (IFIs) operating in the US.  These institutions are state-chartered entities subject to the same state and federal regulatory guidelines, corporate governance, banking and insurance operations, and tax treatment as conventional financial institutions in the US.  The US has not adopted any federal legislation specifically addressing Islamic financing as of yet (Vogel: 2016).  Although IFIs may be qualified to do business in different states, the majority of an IFI’s assets are located in the institution’s home state and licensing and other conditions must be satisfied with respect to any state where the IFI seeks to be qualified as a bank or mortgage or loan finance provider (Vogel: 2016).  CAMILLE PALDI examines the US regulatory landscape and the possibilities for Islamic finance business in the US in the future. 

Illinois and other states have enacted a ‘wild card statute’, which allows IFIs chartered in these states to do anything that is permitted by the Office of the Comptroller of the Currency (OCC) to be done by national banks (Vogel 2016). The existing US Islamic banks, such as Devon Bank and University Bank, are state-chartered, state-licensed banks, which have FDIC insurance for depositors (Vogel 2016). Three main regulatory issues for Islamic finance include bank ownership of real estate; good programs for anti-money laundering (AML) and Bank Secrecy Act (BSA) compliance; and whether deposits can be approved and insured (Lynn: 2009).

 

US bank offerings abroad

The Board of Governors of the Federal Reserve of the United States allows US financial institutions to offer Shari’ah compliant products in foreign countries where they are mandatory or where they are necessary for the financial institution to be competitive (Vogel:2016).

 

Foreign IFI offerings in the US

Foreign financial institutions may offer in the US Islamic banking structures approved by the OCC or the Office of the Comptroller of the currency, which includes the Ijarah and Murabahah structures for home mortgages and retail financing such as the United Bank of Kuwait (UBK).  Foreign institutions are required to comply with all applicable federal and state law, including obtaining all requisite state banking and retail lending licenses for the offering of approved products in those states where they operate (Vogel: 2016).  As a recent trend, Muslim investors from the GCC countries have sought to diversify their financial portfolios and to invest their wealth into US assets.  For example, Arcapita Bank and UBK have structured Shariah compliant transactions in private equity and real estate in the US to meet client demands (Ilias: 2010).

 

Two OCC rulings in favor of Islamic banking in the US

Only two rulings have been issued by the OCC in 1997, approving an Ijarah and Murabahah structure for home financing and other retail financial products. (Vogel 2016) In 1997, the United Bank of Kuwait (UBK) requested interpretive letters from its regulator, the Office of the Comptroller of the Currency (OCC) on Ijarah and Murabahah mortgage products.  The OCC approved both on the grounds that they were economically equivalent to traditional conventional products (Ilias 2010). In terms of Ijarah, the OCC determined that Ijarah is the functional equivalent of secured lending.  In 1999, the NYSBD or New York State Banking Department also approved the Ijarah and agreed with the OCC that the product was functionally equivalent to secured real estate lending.  In terms of Murabahah, the OCC determined that the bank would be functioning as a riskless principal (Cavanaugh: 2011).

 

According to John Vogel, these structures have now been approved by the Federal government, the New York State Banking Department, and the banking authorities of several other states.  Furthermore, the relevant authorities have removed the double tax jeopardy of these products where tax was incurred by initial purchase and at transfer of final payment.  The tax authorities in New York and other states have handled this issue by eliminating double tax burdens on a case-by-case basis where the Shariah compliant structure was equivalent to a conventional financing transaction.  In 2008, the NYS tax department determined that no real estate transfer tax is due when the deed is transferred by a bank to its customer at the end of the lease term in accordance with the terms of the Ijarah arrangement (Vogel 2012).

In terms of Musharakah (and diminishing Musharakah), this type of joint-ownership is not approved for use by banks in the US and is used only by nonbank mortgage lenders in the US.  The Musharakah transaction must be structured to be the functional equivalent of a debt transaction. (Hartom: 2014)

In the US, housing agencies Freddie Mac and Fannie Mae started buying Islamic mortgages in 2001 and 2003 to provide liquidity and they are now the primary investors in Islamic mortgages (Rutledge: 2005). Companies such as LARIBA, Bank of Whittier, and Guidance Residential are offering home financing through the Ijarah and Murabahah models.

 

Islamic deposit products

In terms of Islamic deposit products in the US, deposit products must be guaranteed by FDIC or the Federal Deposit Insurance Corporation (Vogel: 2016).  A Shari’ah compliant profit and loss deposit product is difficult where the deposit must be insured by FDIC as losses cannot be shared by the bank and customer in the US.  In 2001, SHAPE Financial Corporation sought FDIC Deposit insurance for an Islamic deposit-like product based on profit and loss sharing.  The FDIC refused because the bank would be sharing loss with the customer (Haltom: 2014).  SHAPE was forced to change the product structure to be based solely on profit and not loss sharing.  The SHAPE profit sharing deposit pays a yield upon the gross operating profit of University Islamic Financial Corporation’s Shari’ah compliant portfolio of assets, including mortgage-alternative assets.  The yield may drop to zero, but there is no possibility of loss of principal because the account is FDIC insured (Cavanaugh: 2011).

 

 

 

Central Shariah authority in the US

The US does not have a Shari’ah central authority like many Islamic countries, which is responsible for insuring that transactions or products are Shari’ah compliant or for regulating how Shari’ah professionals are appointed to and composition of Shari’ah boards.  IFIs in the US are not required to maintain their own Shari’ah supervisory boards, but may work with the Shari’ah board of another IFI, the Shari’ah Board of America, or other scholars such as AMJA or the American Muslim Jurists Association. (Vogel: 2016).

 

Takaful  

The ‘establishment clause’ of the First Amendment to the US Constitution presents an obstacle to the successful introduction of Takaful and re-Takaful to the US as this mandates separation of church and state and prohibits the favoring of one religion over another.  In addition, each state determines its own licensing requirements for insurance companies.  In order to obtain a license, an insurance company must demonstrate that it has the experience and management capability to run the company and that it is financially sound.  Insurance companies are also required to justify their premium rates.  In addition, insurance companies must meet or exceed the solvency requirements set by the state.

 

Furthermore, there may be limits on the types and concentration of investments made with collected premiums via each state’s insurance laws. For example, investment in non-Shari’ah compliant investment grade rated bonds may be the only option.  Therefore, it may not be possible to have 100% Shari’ah compliant Takaful in the US, however, if written into the contract, Takaful is still possible.

 

Since the members in a Takaful arrangement agree to insure one another and share in risks and profits, there may be some obstacles in establishing the company as a financially sound insurance provider and in justifying Tabarru or donation amounts. In case of potential insolvency, the shareholders’ fund must provide an emergency loan to the takaful company to meet existing claim obligations.  Capital requirements imposed on US insurance companies may not take into account the separation between policy holder and stakeholder funds in Takaful insurance.

 

Another obstacle includes the fact that setting up a state or federal Shariah Board for the Takaful fund may contravene the separation of church and state. However, it may be possible to outsource this function to foreign countries, other IFIs, or organizations such as AMJA.

 

Sukuk

The US has seen two major Sukuk issuances — the US$165.67 million East Cameron Gas Sukuk, which was the first Sukuk al Musharakah in America backed by oil and gas assets and the US$500 million General Electric Sukuk (Sukuk al Ijarah backed by aircraft leases).  Both New York and Illinois have enacted legislation enabling Sukuk transactions and Islamic finance.  Goldman Sachs issued a US$2 billion Sukuk in 2012.  There are currently no listings of Sukuk on the US security exchanges.

 

Dispute resolution

The US has no special courts, tribunals, arbitral or other bodies, which have jurisdiction to hear Islamic finance disputes in the US.  Islamic finance disputes are subject to US federal and state courts and depending on the contract, may be subject to arbitration.  (Vogel: 2016)  I recommend forming one global, centralized Islamic finance arbitral tribunal with a standardized dispute resolution contract for Islamic finance, Sukuk, Sukuk bankruptcy, and Takaful.

 

Conclusion

There are currently no applications for a fully fledged Islamic Bank in the United States.  Islamic banking in the US remains largely confined to home finance and further to the two approved models of Ijarah and Murabahah home financing. However, there also exists banking, asset management, sukuk, takaful, and funds.  There has been no new regulatory developments affecting the retail market since the late 1990’s. Institutions wishing to engage in Islamic finance will have to address various challenges, many of which are briefly stated in this article.

 

Camille Paldi, graduated from the Durham University Islamic Finance Program in the UK, an International Bar Association Scholar 2009/2010 and a qualified lawyer in the UK through the UK QLTT in 2013. Paldi is the founder of Ethical Finance Forum based in Palo Alto, CA, USA.  She can be contacted at paldi16@gmail.com or camille@ethicalfinanceforum.org.

 

 

Book Review for The Art of Riba-Free Islamic Banking and Finance (2014) by Dr. Yahia Abdul-Rahman

Book Review for The Art of Riba-Free Islamic Banking and Finance (2014) by Dr. Yahia Abdul-Rahman

 

By: *Camille Paldi

Founder of the Ethical Finance Forum

 

This book is a fascinating account of the journey of Dr. Yahia Abdul-Rahman and his family in their journey to America from Egypt in 1968 in his pursuit of several MA degrees and a PHD and a glimpse into his rich professional life, which includes the pioneering of no interest banking in the United States through his highly successful venture LARIBA and Whittier Bank in Southern California, USA. The LARIBA system and Bank of Whittier serves all 50 states in America and services a portfolio of no-interest financing that is worth approximately USD $400 million. In 2001 and 2002, Fannie Mae and Fannie Mac approved the LARIBA financing system.

 

Dr. Rahman asks the reader, ‘What is the first thing when one thinks of when one hears the term Islamic Banking?’ The most common answer was ‘vast amounts of oil money from the Gulf countries, which are waiting to find investment opportunities.’ However, Dr. Rahman goes on to explain the rich philosophical roots embedded in Christianity, Judaism, and Islam behind the no interest finance principle and shows with real-life examples how the majority of people and the economy become more financially sound and stable under a system where money is not rented, but where the bank acts as a finance house that invests in people, productive trade, and promotes economic growth and expansion. Americans are definitely curious about this new brand of banking as the author reveals that between 2000 and 2009, the LARIBA site attracted more than 1 million unique visitors whom were exploring the topic of interest-free banking. In fact, LARIBA has been showcased on ABC Nightly News, The Los Angeles Times, USA Today, the Dallas Morning News, the Wall Street Journal, the Washington Post, the Houston Chronicle, the Chicago Tribune, and the Detroit Free Press to name a few. When concerns about anything ‘Islamic’ arose in society after September 11, 2001, Dr. Rahman became involved in inter-faith activism and obtained a historic announcement from the Fuller Theological Seminary in Pasadena, CA that the Christian God and the Muslim God was in fact the same God and this pronouncement was published in the Los Angeles Times on December 3, 2006. In fact, the Bible is rich in language which condemns excessive interest and usury as this creates hardship for the normal person and turns people into slaves of the money-lenders. In fact, one can recall that in the Bible, Jesus went to the marketplace to crush the money-lenders stalls. Jesus Christ stated that one of his goals is to drive the money changers out of the Temple (John 2:15-15; Matthew 21:12-13; M ark 11:15-18). A story about community controversy in Nehemiah 5 concerns oppressive lending: It may refer to charging interest or to other tough actions, such as foreclosing on personal properties. It alludes to two reasons for debt: crop failure and imperial taxation. The story makes clear the results of default. One may forfeit fields, orchards, and houses, and/or one may end up in slavery. Rahman says that his brand of no-interest banking is in fact a manifestation of Christian, Jewish, and Islamic values particularly in concern to usury or renting money for profit, which is prohibited in all of the Holy Books. Basically, no interest finance helps one to live within one’s means, avoid exorbitant debt, enables one to have more cash to invest in his/her business, children, homes, cars, and education, promotes cash flow throughout the economy, promoting economic stimulation and growth as well as induces the optimal health of the individual, family, society, and world at large . S.C. Mooney, an author and Protestant opponent to interest finance states, “What is being argued here is not a new idea or a new interpretation of Scripture. It is the historic position. This is not a call to strike out in a new direction; it is a call to return to faithfulness to God.”

 

Throughout the book, the author explains the modes of no-interest finance compared to interest finance and the two foundations of the no-interest banking system, (1) Commodity Indexation and (2) Marking to Market. The no-interest discipline clearly states that fiat (paper) money can be used, and the U.S. dollar may continue to be the reserve currency of the world along with maybe the euro, but gold or a basket of commodities may be used to calibrate the real value of the currency. President John F. Kennedy and James Baker III (1987) have both approved and proposed these concepts previously in US history and monetary policy. John F. Kennedy attempted to introduce silver certificates with Executive Order 11110. In fact, at one time in history, the US dollar was backed by gold. Under the rule of the British Empire, the British pound sterling and the gold standard were adopted around the world. In 1913, the gold cover for Federal Reserve notes was set by 1913 law to be 40%. In 1945, the gold reserves against Federal Reserve notes were reduced to 25%, and to continue the inflation spiral, this figure (25%) had to be reduced to zero. Toward the end of WWII, the US dollar and gold became the principal international reserve assets under the Bretton Woods Agreement. The US dollar became the world reserve currency, and it was treated as if it were gold because the agreement defined its value to be $35 per ounce of gold. On August 15, 1971, President Richard Nixon ordered the gold window closed, ending the international currency’s link to gold. In fact, the US Constitution says that each state shall issue currency in gold and silver. Some speculate that the authors of the US Constitution may have extracted this principle from the Qu’ran. Thomas Jefferson indeed did have his own Qu’ran collection and often studied these books for various principles of social justice, commercial dealings, fiscal and monetary policy, and treatise’s on government.

 

This no-interest discipline is implemented in order to price things fairly in the market while detecting any overpricing ‘bubble.’ In fact, it is interesting to note that Dr. Rahman through his LARIBA system detected the 2008 bubble as early as 2005 using this Commodity Indexation Discipline. In fact, this system helps to fairly define prices and to standardize and stabilize markets, allowing the efficient working of the market forces of supply and demand. It lays the foundation of fair pricing for products and services, based on real market values within an open and free market operation. Thus, we can see that the no-interest banking brand is not based on renting money at a rental price (interest), but on the actual measured fair market rent of properties, businesses, and services. This system is also the main reason for the superior portfolio performance of LARIBA since 1988.

 

Dr. Rahman gives the following example of how the no-interest discipline may be used to buy a house. The buyer who wants to obtain no-interest finance and the no-interest bank should mark the house to market. The best way of doing this is to find out how much a similar house in the same neighborhood and with similar specifications would rent/lease for in terms of U.S. dollars per square foot (or euros/square meter). This mutually agreed-upon live market lease rate is used to calculate the rate of return on investment of the proposed purchase and no interest transaction, looking at it as a no-interest investment. If the rate of return on investment makes economic sense, the no interest bank proceeds to finance (invest in) the property. In addition, the no-interest bank does its best to make the monthly payments in the no-interest mode of finance competitive with those offered by conventional banks. Basically, the author summarizes that the no-interest banking and finance discipline , in an effort to neutralize the effects of the prevailing fiat currency in the local markets, requires that the financier first apply the Commodity Indexation Discipline to check, in a macroeconomic way, on the existence of a bubble in the business/asset that is being considered for finance. This process is followed by the Mark-to-Market Discipline and approach, evaluating the economic prudence by calculating the real return on investing in this item, using its actual real market rental value. In this way, it is affirmed that money is not rented with interest and that the rent is that of the market rent of the facility in the marketplace.

 

Through using the no-interest discipline, Dr. Rahman states that we may enter into a new era where:

  1. We normalize prices expressed in fiat money in order to be expressed in the real no-interest value of that currency in terms of staple food and other commodities that are in the economy. (2) Apply the Commodity Indexation Discipline for the early detection of local or international economic bubbles by using the no-interest currency to measure prices and disengage price fluctuations due to normal supply-and-demand factors from major change due to speculation using regular banknote fiat paper currencies. (3) and Devise a fair and intelligent tax policy that will enhance the vibrancy of the economy and create new job opportunities and prosperity leading to peace, happiness, and more production, leading to world peace among all nations.

 

In addition, in the subsequent chapters of the book, the author explains the concept of money, the money creation process, the fractional reserve banking system, the financial crisis, spells out US banking regulations and the supervision process, details the US banking system (state, national, federal reserve), discusses conventional and no-interest banking products, and shows how the no-interest model fits into the US banking and legal system without having to change the laws of the USA. Dr. Rahman consistently backs up theory with real-life examples and case-studies, giving a firm impression and understanding of how the no-interest finance models work in the real banking world and the real results. In addition, Dr. Rahman has placed a series of review questions at the end of each chapter to solidify the reader’s understanding of the core banking concepts, which he presents to the reader in a clear, logical, and efficient fashion.

 

Dr. Rahman articulates how the most historic moment for the LARIBA no-interest finance model came in 2001, when Freddie Mae approved LARIBA. In, 2002, Fannie Mae followed suit. The support of Freddie and Fannie helped the growth of no-interest home mortgage financing in America. With the support of Freddie and Fannie, LARIBA went from financing 2-3 to 50 homes per month for US citizens. Dr. Rahman describes another first in the history of the United States financial event when LARIBA and FANNIE MAE joined forces to issue no-interest mortgage backed securities. This book is definitely worth reading for anyone curious about no-interest finance and its benefits and success rates as compared to the conventional banking system.

 

Camille Paldi, graduated from the Durham University Islamic Finance Program in the UK, an International Bar Association Scholar 2009/2010 and a qualified lawyer in the UK through the UK QLTT in 2013. Paldi is the founder of Ethical Finance Forum based in Palo Alto, CA, USA.  She can be contacted at paldi16@gmail.com or camille@ethicalfinanceforum.org.

The Regulatory Landscape of Islamic Finance in the USA

The Regulatory Landscape of Islamic Finance in the USA

By: Camille Paldi

 

 

Introduction

There are currently 25 Islamic financial institutions operating in the United States.  These institutions are state-chartered entities subject to the same state and federal regulatory guidelines, corporate governance, banking and insurance operations, and tax treatment as conventional financial institutions in the US.  The US has not adopted any federal legislation specifically addressing Islamic financing. (Vogel:2016)  Although IFI’s may be qualified to do business in different states, the majority of an IFI’s assets are located in the institution’s home state and licensing and other conditions must be satisfied with respect to any state where the IFI seeks to be qualified as a bank or mortgage or loan finance provider. (Vogel: 2016)  Illinois and a number of other states have enacted a ‘wild card statute’, which allows IFIs chartered in these states to do anything that is permitted by the OCC to be done by national banks. (Vogel: 2016) The existing US Islamic banks, i.e. Devon Bank and University Bank, are state-chartered, state-licensed banks, which have FDIC insurance for depositors. (Vogel:2016)   Three main regulatory issues for Islamic finance include bank ownership of real estate; good programs for anti-money laundering (AML) and Bank Secrecy Act (BSA) compliance; and whether deposits can be approved and insured. (Lynn: 2009) This short article aims to examine the US Regulatory Landscape and the possibilities for Islamic finance business in the USA in the future.

 

US Bank Offerings Abroad

The Board of Governors of the Federal Reserve allows US financial institutions to offer Shari’ah compliant products in foreign countries where they are mandatory or where they are necessary for the financial institution to be competitive.  (Vogel:2016)

 

Foreign IFI offerings in the United States

Foreign financial institutions may offer in the US Islamic banking structures approved by the OCC or the Office of the Comptroller of the Currency , which includes the ijarah and murabahah structures for home mortgages and retail financing i.e. United Bank of Kuwait (UBK).  Foreign institutions are required to comply with all applicable federal and state law, including obtaining all requisite state banking and retail lending licenses for the offering of approved products in those states where they operate. (Vogel: 2016) Muslim investors from the GCC countries have sought to diversify their financial portfolios and to invest their wealth into US assets.  I.E. Arcapita Bank and United Bank of Kuwait have structured Shari’ah-compliant transactions in private equity and real estate in the United States to meet client demands. (Ilias: 2010)

 

Two Office of the Comptroller of the Currency “OCC” Rulings in favor of Islamic Banking in the USA

Only two rulings have been issued by the OCC in 1997, approving an ijarah and murabahah structure for home financing and other retail financial products. (Vogel: 2016) In 1997, the United Bank of Kuwait (UBK) requested interpretive letters from its regulator, the Office of the Comptroller of the Currency (OCC) on ijarah, a financial structure in which the financial intermediary purchases and then leases an asset to a consumer for a fee, and murabahah, where the financial intermediary buys an asset for a customer with the understanding that the customer will buy the asset back for a higher fee, mortgage products.  The OCC approved both on the grounds that they were economically equivalent to traditional conventional products. (Ilias: 2010) In terms of ijarah, the OCC determined that ijarah is the functional equivalent of secured lending.  In 1999, the NYSBD or New York State Banking Department also approved the ijarah and agreed with the OCC that the product was functionally equivalent to or a logical outgrowth of secured real estate lending.  In terms of murabahah, the OCC determined that the bank would be functioning as a riskless principal.  (Cavanaugh: 2011)

 

The OCC was able to look beyond the restrictions on bank ownership of real estate to conclude that the risks that drove the general restrictions were not present because the transactions were equivalent to secured loans or riskless principal transactions. (Rutledge: 2005) These structures have now been approved by the Federal government, the New York State Banking Department, and the banking authorities of several other states.  Furthermore, the relevant authorities have removed the double tax jeopardy of these products where tax was incurred by initial purchase and transfer of final payment.  The tax authorities in NY and a few other states have dealt with this issue by eliminating double tax burdens on a case-by-case basis where the Shari’ah compliant structure was in substance equivalent to a conventional financing transaction.  In 2008, the NYS tax department determined that no real estate transfer tax is due when the deed is transferred by a bank to its customer at the end of the lease term in accordance with the terms of the ijarah arrangement.  (Vogel: 2012)

 

In terms of musharakah (and diminishing musharakah), this type of joint-ownership is not approved for use by banks in the United States and is used only by nonbank mortgage lenders in the United States.  The musharakah transaction must be structured to be the functional equivalent of a debt transaction.

 

In addition, the states of New York and Illinois have enacted legislation intended to encourage Islamic finance transactions, such as the elimination of a double real-estate transfer tax in an ijarah sale-leaseback transaction.  In the United States, housing agencies Freddie Mac and Fannie Mae started buying Islamic mortgages in 2001 and 2003 to provide liquidity and they are now the primary investors in Islamic mortgages. (Rutledge: 2005) Companies such as LARIBA, Bank of Whittier, and Guidance Residential are offering home financing through the ijarah and murabahah models.

 

Islamic Deposit Products

In terms of Islamic deposit products in the US, deposit products must be guaranteed by FDIC or the Federal Deposit Insurance Corporation. (Vogel:2016)  A Shari’ah compliant profit and loss deposit product is difficult where the deposit must be insured by FDIC as losses cannot be shared by the bank and customer in the US.  In 2001, SHAPE Financial Corporation sought FDIC Deposit insurance for an Islamic deposit-like product for which returns would fluctuate with the bank’s profits and losses.  The FDIC refused because the deposit could decline in value and the bank would be sharing loss with the customer. (Haltom: 2014)  SHAPE was forced to alter the product to be based solely on profit and not loss sharing.  The SHAPE profit sharing deposit pays a yield upon the gross operating profit of University Islamic Financial Corporation’s Shari’ah compliant portfolio of assets, including mortgage-alternative assets.  The yield may drop to zero, but there is no possibility of loss of principal because the account is FDIC insured.  (Cavanaugh, 2011) Therefore, it is hence a profit-sharing instrument, which is allowed in the US.  One suggestion has been made to treat this deposit product as an investment security regulated by the SEC rather than a banking product regulated by state and federal banking regulators.  (Vogel: 2016)

 

Restriction on Investments

The range of permissible investments that commercial banks may hold is restricted in the US.  In addition, commercial banks must meet numerous disclosure requirements in order to comply with regulatory policy such as the Truth in Lending Act.  These requirements typically mandate advance disclosure of APR or Annual Percentage Rate and other terms that do not fit the principles on which Islamic finance is structured.  (Rutledge: 2005)

 

Central Shari’ah Authority in the USA

The US has no central authority responsible for insuring that transactions or products are Shari’ah compliant.  IFIs in the US are not required to maintain their own Shari’ah supervisory boards, but may work with the Shari’ah board of another IFI, the Shari’ah Board of America, or other scholars such as AMJA or the American Muslim Jurists Association.  There is no regulatory approval required for the appointment by an IFI of Shari’ah Supervisory Board members in the USA.  (Vogel:2016)

 

Takaful  

The ‘establishment clause’ of the First Amendment to the US Constitution presents a serious obstacle to the successful introduction of takaful and retakaful to the US, as this mandates separation of church and state and prohibits the favoring of one religion over another.  In addition, the insurance regulatory regime in the US poses a problem for the introduction of takaful, as each state determines its own licensing requirements for insurance companies.  In order to obtain a license, an insurance company must demonstrate that it has the experience and management capability to run the company and that it is financially sound.  Insurance companies are also required to justify their premium rates.  In addition, insurance companies must meet or exceed the solvency requirements set by the state.  Furthermore, there may be limits on the types and concentration of investments made with collected premiums via each state’s insurance laws. For example, investment in non-Shariáh compliant investment grade rated bonds may be the only option.  Therefore, it may not be possible to have 100% Shariáh compliant takaful in the USA, however, if written into the contract, takaful is still possible. Since the members in a takaful arrangement agree to insure one another and share in risks and profits, there may be some obstacles in establishing the company as a financially sound insurance provider and in justifying tabarru or donation amounts. In case of potential insolvency, the shareholders’ fund must provide an emergency loan to the takaful company to meet existing claim obligations.  Capital requirements imposed on US insurance companies may not take into account the separation between policy holder and stakeholder funds in takaful insurance. Another obstacle includes the fact that setting up a state or federal Shariáh Board for the takaful fund may contravene the separation of church and state. However, it may be possible to outsource this function to foreign countries.  One option is to draft neutral legislation that would redefine solvency requirements, taking into account that certain insurers may choose to structure the division between shareholder and policyholder funds differently.  Another option includes to offer takaful explaining in the contract that non-Shariáh compliant investment grade rated bonds are being used.

 

Sukuk

The US has seen two major sukuk issuances – the USD165.67 million East Cameron Gas Sukuk, which was the first sukuk al musharakah in America backed by oil and gas assets and the USD 500 million General Electric Sukuk (sukuk al ijarah backed by aircraft leases).  Both New York and Illinois have enacted legislation enabling sukuk transactions.  Goldman Sachs issued a $2billion sukuk in 2012.  There are currently no listings of sukuk on US security exchanges.

 

Dispute Resolution

There are no special courts, tribunals, arbitral or other bodies, which have jurisdiction to hear Islamic finance disputes.  Rather, such disputes are subject to resolution before the applicable US federal and state courts in accordance with applicable rules of jurisdiction and venue and may be subject to arbitral action if required by the terms of a contract between the parties to the dispute. (Vogel:2016)  I recommend forming one centralized Islamic finance arbitral tribunal with a standardized dispute resolution contract for Islamic finance, sukuk, sukuk bankruptcy, and takaful.

 

Conclusion

There are currently no applications for a fully fledged Islamic Bank in the United States.  Islamic banking in the US remains largely confined to home finance and further to the two approved models of ijarah and murabahah home financing. There has been no new regulatory developments affecting the retail market since the late 1990’s. Institutions wishing to expand product lines will have to address various challenges, many of which are briefly stated in this article.

 

 

 

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UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance