Re Bank of Credit and Commerce International SA
Re Bank of Credit and Commerce International SA
Re Bank of Credit and Commerce International SA
____________
Re Bank of Credit and Commerce International SA
• Debtors: Rayners and others borrowed $ 3.5 m to invest into certain property
• Creditors: BCCI- the Bank
• Security: Rayner’s property as well as Jessa’s letter to create charge over his deposits
with the Bank i.e. $ 1.5m
• BCCI is in liquidation and the bank
• Claims against Rayners for $ 3.5m
• Claim against Jessa’s deposit $ 1.5m
• Owes Jessa $ 1.5m as their depositor subject to pari pasu
• BCCI’s liquidator: Rayners pay full amount of $ 3.5m
• Rayners: Set off against Jessa’s deposit
• Court held: Rayners owed to repay the full amount and no set off is possible
• Reasons:
Charge was to trigger the set-off- it actually did
Letter created a security-charge
Letter created flawed security as it did not create personal/contractual liability on the part of
Jessa
Set off required ‘mutuality’-
Jessa being third party did not create the mutuality
Mutuality existed between Rayners and the BCCI
Effects of the security-letter
• The first B paragraph purports to grant the bank a proprietary interest, in the form of a
lien or charge, over Mr. Jessa's deposit.
• The second paragraph is a warranty that he has not previously encumbered his interest in
the deposit and a covenant that he will not do so in the future. And
• The third paragraph is a contractual agreement that the deposit will be repayable only if
all the liabilities of Rayners have been repaid.
• The document does not contain any promise by Mr. Jessa to pay what may be due from
Rayners to the bank.
Hire/purchase or secured transaction?
• Hire-purchase/ credit Sale
• Customer: Makes installments Rs 100 for 10 months
• Retailer: Transfers computers worth Rs 1000
• No recourse to the asset/computers
• Secured loan
• Customer: Makes installments Rs 100 for 10 months
• Retailer: Transfers computers worth Rs 1000
• In case of failure to pay all the installments, the retailer will have recourse to the
computers- equity of redemption
What is a Charge?
• Sec 859A provides for registration of charge.
• ‘Charge’ has not been defined in the Companies Act 2006
• Swiss Bank Corp v Lloyds Bank Ltd [1982] AC 584 (CA)
• '… a security whereby real or personal property is appropriated for the
discharge of a debt or other obligation, but which
• does not pass either an absolute or a special property in the subject matter of the
security to the creditor,
• nor any right to possession
• In the event of non-payment of the debt, the creditor's right of realization is by
judicial process '
Problem with this definition
1- It covers equitable charges and
2- Requires judicial process for enforcement
According to Charles Proctor,
• '[S]ection 859A is apt to refer to any voluntary arrangement designed to provide to the
lender priority over particular assets of the charger in the event of its insolvency and
which includes powers of realization, appropriation or sale whether by virtue of the terms
of the arrangement or by law.’
• Bank having a contractual right of set-off over deposits will amount to charge
• Customer with the contractual obligation that certain deposits will not be repayable until
a particular facility has been discharged will not create a charge but a mere right of
retention
Need for security?
• The effect of a security is to establish rights of a 'proprietary nature'
• This right has an impact on the rights of other creditors
• Difference between secured and unsecured creditor lies in the creation of security
Recharacterization
• Recharacterization creates uncertainty I.e.
• Sale/purchase or sale/lease back agreements recharacterized as a security arrangement.
Scope and Extent of security
• The extent and scope of the security document are set through provisions such as
• 'as from time to time varied, extended, amended or replaced'
• Thus, the original security remains effective if
• the maturity date of the underlying facility is extended, or
• if the interest rate is increased by an amount appropriate to reflect the borrowers'
deteriorating credit quality.
• For example:
Payments now will be made within 15 months. The amount to be paid is Rs 2,000
Public Trustee of Queensland v Octaviar Ltd
• Octaviar: Gave a security/created charge 'Security A'
• '[A]ll monies, obligations and liabilities of any kind that are or may in the future
become due, owing or payable, whether actually, contingently or prospectively by
[Octaviar] in relation to any Transaction Document ...'
• 'Transaction Document'
• A $250 million facility agreement between the lender and Octaviar Castle Pty
Ltd- a subsidiary of Octaviar
• Any document designated by as a 'Transaction Document'
• Young Village Estates (YVE Guarantee): Octaviar had previously provided a guarantee
(YVE guarantee) to the same lender in respect of a facility granted to another of its
subsidiaries YVE.
• YVE Guarantee was not backed by any security.
• As a result of deteriorating financial situation Octaviar executed an agreement whereby
YVE Guarantee was regarded as 'Transaction Document’ to back it by ‘Security A’
• The issue in the court was whether the 'Security A' covered the YVE guarantee?
• The Queensland Supreme Court held that
• Execution of the agreement to include 'YVE Guarantee' as Transaction Document
was valid.
• However, 'Security A' did not cover the YVE Guarantee as the YVE guarantee as
a Transactional Document had the effect of increasing the amount secured or
creating a new security interest over the assets concerned
• The agreement was not filed (registration), the attempt to extend the charge to
cover the YVE Guarantee was ineffective as against a liquidator or administrator
of Octaviar
• Queensland court of appeal overturned the decision and rendered the extension of
‘Security A’ to cover YVE Guarantee to be a valid extension of charge not requiring
registration.
• The court of appeal held that variation in the charge requires registration. Registration is
not required for the extension in coverage.
The Companies Act 2006
• Sec 859A(2) provides that,
• 'The Registrar [of companies] must register the charge if, before the end of the period
allowed for delivery, the company or any other person interested in the charge delivers to
the registrar for registration a section 859D statement of particulars'
• Every charge created by a UK registered company is subject to the requirement of
registration of charge.
• In case of the charge created by a written document, a certified copy of the document is
required along with 'the statement of particulars' to register the charge
Statement of particulars
• 1- Details of charger company
• 2- Nature and extent of the security
• 3- Identity of the charge
• 4- Description of 'negative pledge' I.e. subsequent charge
Registration of charge?
• Registration protects the other creditors of the charger
• A void security will not result in vitiating the contractual obligation to repay money
which was intended to be secured by the charge.
Registration requirement
• The 21 day period for registration of the charge runs from the date after the date on which
the charge was created.
• The court has discretion to extend the 21-day period if
• Non-registration was due to inadvertence and does not prejudice creditors or
• It is otherwise just and equitable to do so
• Validity of the security agreement will affect the registration
• Registration requirement applies to assets outside UK held by UK registered Company
• In case of acquisition of property with pre-existing charge- registration is required
• 'Certificate of registration' will be conclusive evidence that the requisite documents have
been delivered to him within the required period for delivery.
• Any extension in the nature and scope of charge needs to be registered as well
Exception from registration requirements
• A charge over a cash deposit in favour of a landlord- tenancy agreement
• Charge created by a member of Lloyds in respect of underwriting business and
• Charge excluded from the registration requirement under any other Act- financial
collateral arrangement
Foreign Assets
• A UK registered company is required to register charge regardless of the geographical
location of the asset. This is logical because searching the charges register of a UK
company would be concerned about the security subsisting over assets anywhere in the
world.
• Whether a security created over foreign asset will be a question of English law. The court
will assess the need for requirement of registration based on the examination of the
security creating document. If the security creating document meet the definition of
charge under English law, registration will be required.
• An English court will enforce an English Law charge over a foreign asset even though the
security may be unrecognized or invalid in the country in which the asset is situate. In
British South Africa Co v De Beers Consolidated Mines Ltd, the English court enforced a
floating charge situate in Scotland.
• However, in order to ensure enforcement of charge in a foreign country, a charge should
be registered locally too.
• A foreign company is required to register charge in England, if the company’s charged
assets are located in England
• There are two formalities in law
• A- Writing- sec 1 (3), the Law of Property Act 1989 requires a deed to be executed in its
full text, and that the mortgagor cannot simply leave executed, blank pages in the
possession of his advisors for use at the completion
• B- Registration is required for the validity of security against third parties- So that third
party dealing with the charger should discover the existence of the security.
Session 17
Negotiable instruments
According to DV Cowen and L Gering in Cowen on the law of negotiable instruments in south
Africa (5th edn, 1985) Negotiable instrument is a document of title embodying rights to the
payment of money or a security for money, which by custom or legislation
1- Transferable by delivery (or by endorsement and delivery) with holder acquiring the right to
sue on it in his own name and in his own right
2- A bona fide transferee acquires good title to the document and rights in it even though his
predecessor had a defective or no title
• This protection to bona fide purchaser is an exception to the nemo dat rule
Examples of negotiable instruments:
Not negotiable instrument
• Bills of lading
• Dock warrants
• Delivery orders
• Postal or money orders
• Registered share certificates
• Registered debentures
• Insurance policies
• IOUs
What is an instrument?
• An instrument has been described as ‘ a document of title to money’
• A document of title to money contains an undertaking to pay a sum of money such as a
promissory note or
• An order to another to pay a sum of money to the person giving the order or a third
person such as in a bill of exchange.
• An instrument is ‘deliverable’ when it is made payable to bearer or specific person
through endorsement on the back
• As a chattel
• Rights on and to the negotiable instrument
• Proprietary nature of the negotiable instrument
• Special kind of chattel
• As an obligation
• As a new and independent obligation
• As a contract
• Application of the doctrine of consideration and
• As a special kind of contract
• Right on and to it:
• The negotiable instrument is a physically tangible thing, and just as one speaks of
ownership of or title to, a chair or a car, so one can speak of ownership of a negotiable
instrument.
• Right on it: right to demand the sum payable on it
• Right to it: right to hold the instrument
Proprietary nature of the negotiable instrument
• Owner of a negotiable instrument can retain possession of it, sell it, transfer it, give it as a
gift, destroy it or alter it
• Possession and ownership can be retained separately- how?
• Unlawful possession triggers the law of conversion i.e. owner gets the right to demand
restitution of the instrument or is value.
Negotiability:
‘Its capacity to be acquired free from defects in the title of prior parties which characterizes an
instrument as ‘negotiable’ in the strict sense of the word.
According to Blackburn J, negotiable instrument has two characteristics
1- Transferable like cash; by delivery
2- protection to bona fide purchaser
Crouch v credit foncier of England:
• Plaintiff claims
• The property in debenture was transferred to him by delivery- deliverable state
and
• The right to sue was also transferred to him- no transfer of right to sue if
purchaser is aware of defect in title- bona fide purchaser acquiring better title
• In Dixon v Bovill, Lord Cranworth said,
• ‘[T]he law does not … enable any man by a written engagement to give a floating
right of action at the suit of any one into whose hands the writing may come, and
who may thus acquire a right of action better than the right of him under whom he
derives title’
Difference between contractual and negotiable instrument:
• Simmons v London Joint Stock Bank [1891], Bowen LJ distinguished between contractual
and negotiable instrument
• A contractual document in other words may be such that, by virtue of its delivery, all the
rights of the transferor are transferred to and can be enforced by the transferee against the
original contracting party, but it may yet fall short of being a completely negotiable
instrument, because the transferee acquires by mere delivery no better title than his
transferor’
Advantages of negotiable instruments
• Overcome the common law restriction on transfer of debt
• Easy transferability with no requirement of
• Writing or
• Notice to obligor
• Bona fide purchaser’s right
• Readily sold to raise cash
Cebora SNC V SIP LTD [1976]
• Plaintiff: Sells the right to exclusively supply its product in the UK
• Defendant: draws five bills of exchange
• Dispute: non delivery of goods and bills dishonored
• Registrar refused the defence of non-delivery to dishonor the bills and said
• ‘the bona fide holder for value of a bill of exchange is entitled … on its maturity to have
it treated as cash … the court will refuse to regard either as a defence or as grounds for a
stay of execution, any set off … or any counterclaim …’
Nova (Jersey) Knit ltd v Kammgarn Spinnerei GmbH
English co: Sold machines
German co: Drew bills of exchange
Bills got dishonored and German co raised the defence and counter claim of mismanagement of
partnership and defects in machinery
House of Lords held German co liable for full payment of bills of exchange without set off or
counter claim
Defenses available against the NEGOTIABLE INSTRUMENTS
• Failure of consideration- goods supplied did not meet the contractual requirement
• Partial failure of consideration- part of the supplies did not meet the contractual
requirements
• Validity of the instrument is called in question on misrepresentation or conspiracy
Not the legal tender
• Although negotiable instruments are treated as cash but they are not legal tender. In Re
Cahrge Card Services Ltd [1989], Browne-Wilkinson V-C said
• ‘It is common ground that where a debt is ‘paid’ by cheque or bill of exchange, there is
presumption that such payment is conditional on the cheque or bill being honored.’
Mercantile usage and negotiable instruments
• In Goodwin v Robarts [1875], Cockburn CJ recognize mercantile usage whereas in
Clerke v Martin [1702], Lord Holt declared the Promissory Notes was not negotiable and
denied to sanction the mercantile usage.
• Even if the usage is of recent origin the courts will still recognize it.
• Mercantile usage must be
• Reasonable, certain and notorious
• Generally in use and not ‘a custom or habit which prevails only in a particular
market or particular section of the commercial world’ Easton v London Joint
Stock Bank [1886]
• Must not be non-negotiable or transferable by some other method
Goodwin v Robarts [1875]
• Goodwin purchased Russian and Hungarian scrip through his stockbroker
• The stockbroker retained the possession of the scrip
• The stockbroker fraudulently pledged it with a bank as a security for loan
• The stockbroker went bankrupt and the bank sold the scrip
• Goodwin sued the bank for the realization of sale proceed
• Bank argued the scrip was negotiable by delivery, Goodwin lost the title
Session 18
International bond market
• Pre-history
• Share capital
• Loan capital
• Eurodollar market
• Negotiable instruments
• Bond documentation
• Temporary Global Notes Permanent Global Notes
• Modern Era
• Emergence of ICSDs
• New Global Note Structure
• Legal analysis of bonds market
Development of international bond market:
• Until 1945, currencies used to remain within the boundaries of their states. To make
payments for international trade in dollars, the borrower used to approach US based
banks or investors for instance.
• After World War II, the US financed rebuilding of Europe through the Master Plan. As
the result, the European companies received large amount of payments in US dollars
• During the Cold war in 1950s and 1960s, international trade was conducted in the US
dollars. Soviet bloc preferred to keep the US dollar in European Banks instead of US
based banks
• This gave birth to Eurodollar market-the large pool of US Dollars held outside the US
was available as an alternative source of funding for companies and governments.
Eurodollar market in Europe
• In 1963, Kennedy Administration introduced Interest Equalization Tax- 15% surcharge
on interest received by US lenders and investors from non-US borrowers
• In 1965, Foreign Credit Restraint Program- limited the amount of credit the US banks
could make to non-residents.
• In 1966, the Regulation Q lowered the rate of interest payable by the US banks on
deposit.
• Financing of trade and infrastructure led to the growth of Eurodollar market.
• New emerging middle class in Europe was not interested in investing into dollar but they
preferred to invest into debt securities which could be held for the long term or sold for
cash. This was particularly the case to avoid taxes.
What is bond?
• ‘Bond is used as a generic term to include all obligations and instruments which
constitutes or evidence long-term indebtedness, and which are traded between investors
during the period between their issue and the date of redemption’
How do companies raise capital?
• Bank loans
• Share capital- equity investors
• Loan capital-
Bank loans
• Most commercial banks raise funds by taking deposits from retail customers or from
other banks by way of deposits which are payable on demand or within a short period.
• On the other hand lending for long term will expose the bank to potential liquidity
squeeze.
• Long term credit needs of large companies are met by Borrowing from the
• Investors willing to lend for long term or
• Offer share capital to the investors
Share Capital-Equity investors
• Growth of the Joint stock company marked the beginning of international trading
• Why do companies issue share?
• What is legal definition of share?
• ‘[A] share appears to me to be closely akin to a debt…’ Fry LJ in Colonial Bank v
Whinney [1885] 30Ch D 261
• Shares are not held in trust- Borland’s Trustee v Steel Brothers & Co [1901] 1 Ch
279
• Shares include rights and obligations
• Shares are choses in actions and transferable and transfer of share requires
registration
Scenario A
• Depository in France goes bankrupt
• ICSDs can claim the bond’s delivery or
• Liquidator Depository will retain the bond inviting all potential claimholders to
ascertain priority
• Who owns the property- which country’s private international law is applicable?
Scenario B
• Depository bank in Paris is incorporated in Netherlands
• Insolvency proceedings in Dutch court will determine the ownership right to the bond
according to Dutch law
• If the Dutch private international law are similar to the English private international law-
French law will be applicable as the since the note was physically in France
Session 19
Historical development of EC Securities Law
• Absence of single market was an obstacle to economic development of European
Economic Community (EEC)
• Harmonization of separate securities codes was a way to break down barriers and move
towards single markets
• The Investment Services Directives (ISD) 1993
• Market in Financial Instruments Directives (MiFID) 2007
• The Lamfalussy Report
The Lamfalussy process
• The Lamfalussy process comprised four level of legislation
• Framework principles
• Implementing measures
• Cooperation and
• Enforcement
• A single rulebook across the entire EU- the Larosiere Report
EC Directive relating to securities
• The Consolidated Admissions and Reporting Directive- CARD
• The Prospectus Directive
• The Transparency Obligations Directive
• The MiFID
Market Abuse
• Criminal offences of inside dealings
• The FCA imposes penalties for inside information
• The Listing Rules contains code for market conduct to prevent inside dealings
Power of Punishment by the FCA
• Under FSMA 2000, the FCA has four separate powers to prohibit, suspend or control
securities transactions
• Power to suspend listing- sec 77
• Suspend or prohibit an offer of transferable securities to public- sec 87K
• Suspend or prohibit admission to trading on a regulated market- sec 87L
• Suspension on the ground of breach of the disclosure rules- sec 96C
Session 21
Purpose of forum selection
• Forum selection cannot be universal for instance a judgement obtained in the UK to
freeze assets in China can only be enforced if English court has jurisdiction in China to
enforce its judgment.
• Jurisdiction to hear the dispute and
• Jurisdiction to enforce the dispute
• To ensure additional forum
• Insulate against the adverse legislation introduced by the borrower’s country
• Standards of the courts in terms of expertise, impartiality and accommodating procedures
No express forum selection
• Long arm rule is applicable in the absence of an expres selection of forum i.e.
• ‘A court having some connection with one of the parties or transaction has jurisdiction’
Universal jurisdiction
• Agreement by defendants to submit to a jurisdiction of a court
• In common law countries place of incorporation confers the jurisdiction
• In Roman Germanic (civil law) the ‘seat’ is decisive of
• Principal place of business or
• Central control of the company is exercised
Article 1
• 1. This Regulation shall apply in civil and commercial matters whatever the nature of the
court or tribunal. It shall not extend, in particular, to revenue, customs or administrative
matters.
Session 24
LEHMAN BROTHERS- What went wrong?
• Exposed to risk in
• Real estate
• Collateralized Default Obligations (CDOs)
• Credit Default Swaps (CDS)
• Through Repo 105, Lehman concealed $ 50b in bad assets off the balance sheet.
• Repo transaction- finding a counterparty which was willing,
• for a fee, to take those $ 50b off Lehman’s balance sheet and
• Put it into its own balance sheet for a few days
• subject to an obligation that Lehman would repurchase those assets at an
identified time in future
• When faced with huge losses, Lehman brothers could not acquire capital to cover the
losses on account of liquidity issues existed in the market at that time
Credit Rating Agencies
• Conflict of interest- being paid by the issuer of securities
• A large number of ratings turned out to be wrong
Camerata Property Inc v Credit Suisse Securities (Europe) Limited-2011
• The Claimant - Camerata Property Inc, an investment vehicle owned by a trust.
• The Defendant -Credit Suisse Securities (Europe) Ltd, financial advisor
• In July the Claimant purchased $12million worth of notes issued by Lehman Brothers
through the Defendant.
• When Lehman Brothers went bankrupt in September 2008, the Claimants lost their
investment.
• It was contended that the Defendant gave
• negligent advise and/or
• advice in breach of contract
• The Claimant asserts that had the advice not been negligent it would have sold the
Lehman notes before Lehman collapsed.
• The court held that
• An exclusion clause in the terms and conditions for acts other than gross
negligence would stand.
• In any event, there would be no negligence where the proper standard of
reasonable care and skill was exercised.
• The court found that the Defendant had not been negligent in failing to give
warnings given that Lehman Brothers’ collapse was not foreseeable.
Credit Default Swaps-CDO
• Before the financial crisis of 2008, there was more money invested in credit default
swaps than in other pools.
• The value of credit default swaps stood at $45 trillion compared to
• $22 trillion invested in the stock market,
• $7.1 trillion in mortgages and
• $4.4 trillion in U.S. Treasury.
• In mid-2010, the value of outstanding CDS was $26.3 trillion.
• A credit default swap (CDS) is a type of credit derivative that provides the buyer with
protection against default and other risks.
• The buyer of a CDS makes periodic payments to the seller until the credit maturity date.
In the agreement,
• The seller commits that, if the debt issuer defaults, the seller will pay the buyer all
premiums and interests that would’ve been paid up to the date of maturity.
• Speculation
• Historically, bond issuers almost never go bankrupt. So, many banks and hedge
funds figured they could make a fortune by selling CDSs, keeping the premium,
and almost never having to pay out anything.
Collateralized Debt Obligation – CDO
• A collateralized debt obligation is named for the pooled assets — such as mortgages,
bonds and loans — that are essentially debt obligations that serve as collateral for the
CDO.
• Securities firms, who approve the selection of collateral, structure the notes into tranches
and sell them to investors;
• CDO managers, who select the collateral and often manage the CDO portfolios;
• Rating agencies, who assess the CDOs and assign them credit ratings;
• Financial guarantors, who promise to reimburse investors for any losses on the CDO
tranches in exchange for premium payments; and
• Investors such as pension funds and hedge funds.
• Lehman Brothers investment bank owed $600 billion in debt, out of which $400 billion
was covered by CDS. The bank’s insurer, American Insurance Group, lacked sufficient
funds to clear the debt, and the Federal Reserve of the United States needed to intervene
to bail it out.
PANIC
• Regulators tried to sell Lehman to private sector- no buyer emerged
• Chancellor of the Exchequer Alastair Darling refused to sanction Barclays acquiring
Lehman Brothers
• Moral Hazard argument prevailed- Lehman was allowed to file for liquidation
Immediate aftermath of Lehman’s bankruptcy
• Crisis management was not governed by the law instead the law was used as a tool to
overcome the crisis.
• Moral hazard argument therefore did not stand on the cost and benefit analysis.
• Panic ensued in the Stock Markets and inter-bank markets with the news of liquidation of
Lehman Brothers.
• Lack of confidence resulted in lack of trust among banks
TARP- US
• Consequent bail outs
• Freddie Mae
• Fannie Mae
• AIG
• TARP was a $ 750b worth bail out program
• TARP has been enormously criticized for absence of checks and balance and
accountability against the Wall Street financial institutions
• The bail out funds were used to pay bonuses to failing institutions’ staff such as $7,700 as
bonus for a kitchen assistant at AIG
• While Wall Street financiers were bailed out, ordinary Americans went insolvent and
their homes being repossessed
• President Bush stood up with the financial institutions which caused the crisis 2008
Bail out in the UK
• The Banking (Special Provisions) Act 2008 and the Banking Act 2009 granted the state
the power to bail out and nationalize troubled institutions
• Deposit guarantee scheme and then nationalization of Northern Rock by Bank of England
Beginning of the crisis
• ‘Credit crunch’ or liquidity drying up began in 2007
• BNP showed sign of troubles and Northern Rock had a bank run in 2007
• Norther Rock’s new CEO Mr. Applegarth was funding long term commitments through
short term funds- a poor strategy
• Unlike Lehman, Citigroup was nationalized
Citigroup
• Citigroup constantly bypassed regulations
• Citigroup hid huge losses in the department created to deal in CDOs
• CEO, Citigroup said,
• ‘When the music stops, in terms of liquidity, things will be complicated. But as
long as the music is playing, you’ve got to get up and dance. We are still dancing’
• The US government injected $ 25b through TARP and $ 20b through other sources.
Session 22
Islamic Finance as a part of International Finance
• Islamic finance comprises 3-4% of the entire International finance in the globe.
• 80% of Islamic finance comprises of Islamic Banking industry
• 80% of Islamic banking relies on Murabaha structure
Sources of Islamic law
• Quran
• Sunnah
• Ijma’a- consensus
• Qiyas- analogy
• Ijtehad- Opinion of jurists
The fundamental principles of Islamic Finance
• Riba
• Gharar
• Maisir
• Unjust enrichment
• Islamic principles of finance do not have binding obligations in courts of law. In other
words unlike Hudd offences, non-Shariah complaint financing is not subject to Islamic
penal code.
• However, in finance, the validity and enforceability of obligation is crucial to both
parties. Therefore, Islamic finance market is called ‘customer driven market’ which relies
on demand from customers.
Riba
• Riba is an Arabic term which means ‘to increase’. Any increase which results in an unjust
increase is prohibited.
• Money does not have an intrinsic value therefore earning money over money is
prohibited. Money is just a medium of exchange
• Initially, exploitation resulting from the use of loan to earn profit was identified i.e.
‘[T]hat which you lend to increase in the property of others will not increase with God,
but that which you give out in charity, seeking God’s pleasure, it will surely multiply’.
Surah 30:39
• Later increased interest on overdue debts and subsequent compound interest were
prohibited i.e.
‘O Ye who believe, devour not interest, for it goes on multiplying itself; and be mindful
of your obligation to Allah that you may prosper’ Surah 3:130
• The Shariah Appellate Bench, Supreme Court of Pakistan defined riba as
• ‘A transaction of money for money of the same denomination where the quantity
on both sides is not equal, either in a spot transaction or in a transaction based on
deferred payment … Such a transaction would be riba… whether the additional
amount stipulated over the principal amount of the loan or debt is large or
small…’
• The judgment questions the entire conventional banking industry in Pakistan.
• Commitment commission and fee for provision of services i.e. Debit card service charge
do not amount to interest
• However, penalties or late payment charges are riba
Gharar
• Gharar refers to transaction based on incomplete information which leads to uncertainty
i.e. insurance contracts. Insurance contract is based on uncertain future events.
• Similarly, derivatives are based on promise to buy/sell in future date at certain price
generates uncertainty about the trading actually happening.
• Investment in spot and forward foreign exchange contracts was held to be invalid. The
Court of Cassation in Abu Dhabi reasoned that
‘the intention of both parties was to generate profit from the fluctuation of the various
currencies’
• Nonetheless, every contract inherently has some degree of uncertainty i.e. parties going
default, death, storms, strikes etc
• Therefore, gharar invalidates a contract if two conditions are met
• The risk of uncertainty is significant and
• The risk affects the price or subject matter of a contract
• In order to help Islamic financial institutions, manage the risk through derivative trading,
International Swaps and Derivatives Association (ISDA) and International Islamic
Financial Market (IIFM) have designed Shariah complaint Derivatives Document
Maisir
• Maisir refers to speculative contracts where the outcome depends on luck or chance i.e.
gambling or lottery etc
Unjust enrichment
• ‘Deal not unjustly and you shall not be dealt with unjustly’ Surah 279
• Any contract resulting in one of the parties getting unjust benefits at the cost of the other
party. For example, late payment fee/penalty for delay in the payment of installments is
unjust if the fee/penalty exceeds the actual loss.
• However, this practice questions the constant delays in payment- moral hazards
Rules Governing Islamic finance Transactions
• Islamic finance operates on Islamic principles. These principles are not codified or
enacted into laws.
• These principles are subject to differences of opinion among four schools of thoughts.
• These principles are also subject to local customs, interest of community/ maslahah and
the compulsion of necessity/darura-Malaysian practices
• A distinct feature of Islamic financial institutions (IFIs) is Shariah Supervisory Board
(SSBs). SSBs advise and supervise the IFIs’ compliance with the Shariah or Islamic
principles of finance.
• SSBs’ statement becomes part of the financial statement of the IFIs.
• In Malaysia, the Shariah Advisory Council of the Central Bank of Malaysia regulates the
SSBs in the country according to the Central Bank of Malaysia Act 2009, ss 51-58.
• Shariah Board, SBP issues standards for the guidance of Islamic banks in the Pakistan.
• Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) and
Islamic Financial Services Board (IFSB) are standard setting bodies for global Islamic
finance industry.
• In the absence of interest, IFIs generate profit through
• Provision of assets- sale
• Provision of services- rent and
• Taking risk- on occupation of property or other assets
Islamic Finance in Court of Law
• Riba Judgement declared the entire conventional finance industry to be un-Islamic and
therefore unconstitutional- Pakistan
• Islamic finance principles do not form part of a country's legal system. Additionally, the
IF principles have conflicting interpretations- the UK
• The US- Islamic financing techniques are highly suspicious I.e.
• Violate the Establishment clause of the First Amendment- no religion should be
promoted
• Promotes terrorist financing- complicated structure
• Malaysia
Features of Islamic Finance Product
• “And Allah has permitted trading and prohibited riba. (Al-Baqra)”. ‘Interest’ is prohibited
but ‘profit’ is permitted.
• Shariah complaint-financing is not available for
• Manufacturing or sale of alcohol
• Pork products
• The provision of conventional banking activities
• Gambling and
• Pornography/ adult entertainment
• Islamic finance product structure comprises of following fundamental structure
• The sale of an asset on deferred terms, with a pre-agreed profit mark-up
• The provision of assets for use by the customer at a rental charge and
• The sharing of profits from a joint venture or similar arrangement.
• The above structure is also known as “simple istisna'”, where it is assumed that the buyer
has the required financing to directly coordinate with the manufacturer on the project. If
the buyer does not have the financing, then the below parallel istisna' structure can be
used.
Istisna' Documentation
• There are three sets of documentation involved in istisna':
• 1. Master Istisna' Agreement
• The agreement is signed between the Bank and the Customer, outlining the terms
and conditions of the production of goods, including: cost price, delivery location,
quantity and quality.
• 2. Agency Agreement
• In the case of Agency Agreement, the Bank will appoint the producer of goods its
Agent to sell the goods. Generally, this documents also sets out the agency fees
schedule (Notice of Appointment).
• 3. Corporate Guarantee
• This agreement is between the Bank and the Customer, guaranteeing the payment
obligation in the case of default. This can include a mortgage or pledges on
receivables.
Bai ina
• Assets are wide ranging under the books of the Banks; table, chairs, pieces of land, ATM
machines, computers, company shares, subdivided properties, and many others.
• The main argument was that the intention of the contract is not to trade (buy & sell) an
asset, but to create a debt to which a margin is built in. This margin is seen as too close
for comfort to the concept of interest on top of a loan.
lease agreement
• Leasing is well known in the west as a mode of finance. There are many reasons why an
agent will opt for leasing rather than borrowing from the bank to purchase the needed
asset. For example:
• (a) It is easier to lease then borrow for short term needs since it mostly do not
require credit evaluation.
• b) Gives more freedom of changing equipment as technology advances.
• (c) Easier to get finance through leasing for companies with lower credit standing.
These kinds of companies may not be able to borrow from banks or the public and
if they do, have to pay high of interest.
• (d) In many cases leasing can be advantageous from taxing point of view. These
advantages may accrue to lessee and sometimes to the lessor since equipment
leased remains the ownership of the lessor and hence can be counted, from tax
point of view, an investment
Ijara/Islamic lease
• Bank/Financial institution- Lessor- owns and transfers a car to lease for Rs 60,000
• Customer/company- Lessee- takes the possession of the car to pay monthly rent of Rs
1,000 for 5 years
• On completion of 5 years’ payments. The bank will resell the car to customer for Rs 1 or
gift it to the customer for free through Waa’d.
Ijara and Conventional Lease
• Difference between Ijarah and Conventional Lease
• Ijara asset is insured through Takaful
• In case of loss not covered by insurance, lessor/bank under Ijara will bear the
loss- lessee incurs the loss in lease
• In ijara, lessee is responsible for the wear and tears resulting from his use of the
asset
Musharaka- profit loss sharing
• A joint partnership agreement between bank and customer
• To carry out business activities
• Every partner has the right to manage the venture
• Every partner shares in the profit and loss of the venture according to agreed upon ratio
Diminishing musharaka- Islamic Home financing
• The LaRiba bank in the U.S. follows:
• Let us assume that a potential buyer is interested in purchasing a home worth
$150,000. The buyer approaches an Islamic financial institution for the purchase
of the property and puts 20 per cent of the price ($30,000) as down payment (the
down payment required differs between financial institutions. In some cases it is
as low as 5 percent ).
• The financial institution pays for the other 80 per cent of the price ($120,000).
This agreement results in 20 per cent of the home ownership belonging to the
client and the remaining 80 percent to the financial institution.
Example of payment schedule for a home-loan under Musharaka
Sukuk
• Sukuk represent certificates of equal value that evidence undivided ownership or
investment in the assets using Shariah principles and concepts endorsed by the Shariah
Advisory Council.
• Essentially, when you invest in Sukuk, your money is put into the assets of a project or
investment in order to generate profit. The investor receives a margin of that profit based
on a pre-agreed ratio.
• Mudaraba sukuk-manager/sukuk holders/other partners
• Musharakah sukuk- bank/sukuk holders/other partners
• Ijara sukuk
• Wakala sukuk
• East Cameron Sukuk
Wakala/Agency
• Islamic agency agreement
• Under the general principles of Islamic Shari'a, a wakala agreement is an agency
agreement whereby the wakil acts as an agent for the muwakkil in accordance with the
provisions of the wakala. An action performed by the wakil as an agent on behalf of the
muwakkil/principal is deemed an action by the muwakkil/principal himself. However, the
wakil is under a duty of care and skill to act diligently when performing his obligations.
• Use of wakala for the purposes of Murbaha is very common
Al-Waad
• Al-Waad is unilateral in nature i.e. a gift, and binds the maker only. Islamic scholars have
different views with regard to the liability imposed upon the parties of the promise.
• Some schools of thought opine that a promise made by a person to another is religiously
binding (Mulzim diyanatan) but not a legal duty (Mulzim qadha’an). This is because Al-
Waad is part of a voluntarily contract (aqd tabarruat). Therefore, the judge has no way of
enforcing this, because the second party has nothing more than a moral right.
• Commonly used with murabaha sale and ijara when the asset is gifted
Attitude towards conventional structures
• Derivatives
• Bank Guarantee
• Documentary Credits
• Customer Guarantee
• Security
• Currency trading
• Set off
• Default
• Debt financing- bonds is prohibited whereas equity financing- stocks/funds is permissible
• Debit cards permissible but credit cards are not permissible
Derivatives trading
What are financial derivatives?
• A derivative product is a financial product that is derived from another financial product
i.e. underlying asset.
• Types
• Forwards
• Futures and
• Options
• Purpose
• Hedging to manage risk
• Speculation to generate income
Hedging and speculation
• Shortages are dangerous because they lead to price spikes or rationing of resources.
That's why commodities speculators help to keep an eye on overall production,
recognizing shortages and moving product to places of need (and consequently higher
profit) through intermediaries—the middlemen who use futures contracts to control their
costs.
• Speculators can make a lot of money when they are right, and that can anger producers
and consumers alike. But these outsized profits are balanced against the risks they protect
those same consumers and producers from.
• With all the negativity aimed toward short-sellers and speculators, it's easy for us to
forget that their activities maintain prices, prevent shortages and increase the amount of
risk they undertake
Derivatives under Islamic finance principles
• ISDA and IIFM have jointly designed the ISDA/IIFM Tahawwut (Hedging) Master
Agreement. Under this agreement, derivative trading will be made permissible for
hedging purposes.
Bank Guarantee Documentary Credits
Customer Guarantee
• Bank Guarantees are permitted subject to following conditions i.e.
• Shariah complaint venture- subject matter
• No fee charged for the provision of the guarantee
• Fee for administration and other service can be charged
• Letter of Credit (LC)-guarantee to cover an export/import transaction is also permissible
subject to the conditions mentioned above
• IFIs accept guarantees from customers. IFIs are not obliged to inquire Shariah complaint
arrangements between the customer and the guarantor
Security
• It is permissible for IFIs to require security to cover a financing facility.
• A single asset can be made the subject of a series of successive security interests,
provided that the situation is disclosed to each party.
• The charge (financier/IFI) has the usual rights of enforcements and is not liable for lose
or damaged to the charged property unless it results from its own negligence or
misconduct.
Currency Trading
• Transaction in spot market are allowed provided that cross-payments are actually made
• If a transaction is to be settled on a future date, it must be settled at the spot rate on that
day and not by reference to pre-agreed rate.
Set off
• Set off in terms of currency exchange is permissible
• Also set off on the event of insolvency is permissible
Default
• Restructuring through increasing interest rate in the event of default is not permissible.
• In the event of default, it is permissible
• To accelerate all remaining payments
• Impose legal cost associated with the default on the debtor and
• Impose charity to penalize for the default
Session 23
• Murabaha- financing arrangement
• Tawarruq- reverse murabaha
• Bai’ Salam- Sale
• Bai’ al’ina- Sale
• Ijara- lease
• Istisna
• Musharaka- partnership
• Mudaraba- partnership
• Sukuk- bonds certificates
Pakistan
• Riba Judgement
• Charity clause
The UK
• Islamic Investment Company of the Gulf v Symphony Gems
• Beximco Pharmaceuticals Ltd v Shamil Bank of Bahrain
• The Investment Dar Company v Blom Development Bank
• Dubai Islamic Bank v PSI
The US
• Kevin Murray v Fed
• East Cameron Sukuk