Shari'ah Finance and the Equipment Leasing Industry

Shari'ah financing, at its most basic, means transactions that are compliant with the principles as set out in the Qur'an. The principles are derived from five basic sources: 1) the Qur'an (the Holy Book revered by Muslims); 2) the Sunna (the practice and traditions of the prophet Mohammed); 3) the Qiyas (a comparison, used to resolve issues that have no clear-cut ruling in the Qur'an or the Sunna, by considering similar issues in those texts having no clear rulings); 4) Ijtehad (the diligent judgment of the scholars through reasoning and logic); and 5) the Ijmaa (a consensus or agreement used for issues which require Ijtehad). In essence, Shari'ah principles require Muslims to act in a morally and socially aware manner, being conscious of the effects of their actions. See J. Michael Taylor, 'Islamic Commercial Banking ' Moving into the Mainstream?' (2005) 18 Transnat'l Law 417 at 418.

Two essential or overriding principles of Shari'ah-compliant transactions are:

1) Transactions involving interest, known as riba, are prohibited; and

2) Risk/uncertainty, known as gharar, must also be avoided.

The prohibition of gharar prohibits undertaking an unreasonable level of risk or uncertainty. Gharar does not prohibit a Muslim financier from entering into a lease with a less creditworthy obligor, but prohibits the financing of a to-be-determined object.

Another overriding concept is the financing itself, which must be Halal, or not for a prohibited purpose. For instance, if the financing were in support of the pornography or liquor industry (two areas strictly prohibited under the Qur'an), then the transaction would be prohibited as well. For most of the equipment finance industry, this will not be too great an impact.

Shari'ah Scholar: Supervisory Boards

While these principles have clear boundaries, they are very broad. Accordingly, there is a significant amount of varied interpretation as to the meaning and application to finance structures. Any Jewish or Christian religious scholar or, for that matter, practicing Jew or Christian, knows that different rabbis or clergy may interpret the Bible in different ways. The same is true under Islam. A Shari'ah-compliant investor needs to know however, that its transaction does indeed comply. In this regard, there are a number of Shari'ah schools of thought and boards that review transactions to provide the required assurances. This, of course, adds an extra layer of bureaucracy that would not otherwise exist in conventional financing.

While there is a general consensus amongst Muslim scholars as to what is required in order for a transaction to be Shari'ah-compliant, there is broad disagreement as to what structure and which provisions are acceptable. Based on completed transactions, it appears that transactions under a Malaysian supervisory board have different compliance requirements than those as set out by a Saudi Arabian board. It is not that one board is correct and another not, but that investors favor following the precepts of one group over another. See Babback Sabahi, 'Islamic Financial Structures as Alternatives to International Loan Agreements: Challenges for U.S. Financial Institutions' (2005) 24 Ann. Rev. Banking & Fin. L. 487.

In all cases, however, there must be a recognized board approving the transaction as Shari'ah-compliant in order for investors and/or lessees to feel comfortable that a transaction is acceptable. This is not to say that each lease needs to be approved, but that the general form of the lease and the method by which the Shari'ah financier obtained the investment would need to be approved. For instance, all securitizations with Shari'ah-compliant investors need some form of board approval; a Shari'ah scholar would need to be retained to develop the structure. It is beyond the scope of this article to discuss the securitization structures that are utilized for Shari'ah-compliant transactions, but it may be said that this is both a growing market in London and New York, and is obtaining enhanced recognition worldwide.

The inclusion of these religious supervisory boards tends to increase the cost of a transaction and, as such, before entering into a sophisticated structure, this needs to be priced into the transaction. Typically, if the transaction is small or is a one-off, the costs of obtaining the supervisory-board-approval may make the transaction prohibitively expensive. If, on the other hand, the transaction is relatively large and/or will generate significant funding, then it may be worthwhile.

This problem of uncertainty and lack of consistency is being addressed in the Islamic world by Islamic governments establishing standard guidelines to be followed. This includes looking to organizations such as the Islamic Financial Services Board ('IFSB') and the Accounting and Auditing Organization for Islamic Financial Institutions ('AAOIFI') and consulting fiqh (Islamic jurisprudence). It is anticipated that as standardization improves, uncertainty and costs will decrease. The equipment finance professional must be mindful, however, of the type of board approval it obtains since it will dictate the size of the potential market. For example, if the transaction is approved by the Malasim board but not the Saudi board, then he will attract only that corresponding portion of the market.

Equity Financing

Due to these basic principles, Islamic finance or Shari'ah-compliant finance has (at least prima facie) a different appearance than that which is conventional in the Western world. Shari'ah finance structures are more equity-based since the finance company will own shares and/or a joint venture interest in a particular project, giving rise to certainty of repayment over time. That being said, these structures are not within the scope of this article.

Ijara/Lease

One of the classic structures which is Shari'ah-compliant is the lease or ijara. The actual lease document does not set out the payment of interest (other than perhaps in the case of a late payment) but merely sets out that the lessee pays for the use of equipment over time, and that the lessor continues to own the goods or equipment during the lease's term. There is no riba (or interest), and avoidance of gharar (or risk) can be accomplished if the equipment is known at the time of entering into the lease (which is the typical situation). The lease structure, with a few modifications, complies with Shari'ah principles and provides for particular opportunities.

An ijara's essential differences from a conventional lease are listed below. It should be noted, however, that within this list, there is uncertainty as to the level of strict adherence that is required: Different boards disagree on some of these areas. A good discussion of ijaras can be found in an article titled 'Ijarah' by Maulana Taqi Usmani, but, notwithstanding the authoritative tenor of the article, other commentators have dissimilar views.

Basic elements of an ijara:

1) The rent must be fixed during the entire lease term; any change in the rent would require entering into a new lease. Stated otherwise, there is no prohibition against raising or lowering the rent, but any such increase or decrease must be specifically set out under the terms of a new lease.

2) The actual term of the lease must be set out in the agreement.

3) The lessor is permitted to claim compensation from the lessee for the misuse of the leased assets, including ordinary wear and tear. This is a subject on which boards may disagree.

4) The lessor is responsible for structural maintenance of the assets, and this obligation may not be passed on to the lessee; however, an agency relationship could be utilized. Again, there is some divergence of opinion on this issue.

5) The lessor is entitled to rent as long as the lessee has the enjoyment of the leased assets as specified in the ijara. If the lessee does not have enjoyment of the item leased, as upon destruction or condemnation of the equipment, the lessee may rescind the ijara, and the lease will be terminated.

6) The lessor (as opposed to the lessee) is responsible for insuring the equipment, but the cost can be passed on to the lessee in the form of rent. Nothing prohibits the lessor from obtaining payment from the insurance company upon destruction of the equipment, but the lessor may not directly require the lessee to pay upon destruction of the equipment.

7) The object, or manfa'a, must have sufficient economic value in substance at the time of entering into the equipment lease. If the object does not have economic value, then the rent can only be required once the object has economic value. In other words, the progress payment structure may not be available. Further, rent cannot be collected until the equipment is in the lessee's possession.

8) Care must be taken in how the lessor obtains rights in the property. The lessor can engage the lessee as his agent to purchase the assets, but this must be set out in a separate contract.

9) If there is an end-of-term purchase option for the goods, this must be documented separately and may only be binding on the lessor ' not the lessee. There seems to be some difference in opinion about how to document/structure such an arrangement, but there is little debate that a purchase structure may be developed.

10) Opinion is mixed as to the rights of the lessor upon the lessee's default. There is one school of thought that states that the only rights are to past-due rent and to repossession of the equipment, not to a right to sue for the net present value of the future rent. Another school of thought appears to provide for the same remedies as are common in traditional financing; that is, except for penalties.

11) A penalty for late payment is generally prohibited, but some structures utilize a charity-based method of requiring the lessee to make a charitable donation if he is late in making a payment. Some schools accept that a late charge, as opposed to interest, is acceptable.

12) Subleasing is permitted, but care must be taken, especially in how a sublease is structured.

In classic equipment leasing terms, the conservative interpretation of an ijara works well for collateral that retains its value and where maintenance can be provided by third parties. This would be an 'operating lease.' A more liberal view of an ijara has more flexibility and is a classic 'net lease.' The hell-or-high-water provisions that are the cornerstone of a conventional lease continue to be a part of an ijara subject to the covenant of quiet enjoyment. It is clear that an ijara would not be an appropriate structure for financing strictly soft costs or where progress payments are required (it should be noted that there are other structures that could be utilized under Shari'ah to finance these types of transactions). In addition, the requirement that the lessor be obligated to take out insurance should not be problematic as this is a structure that is not uncommon in the equipment leasing industry.

Given some of the requirements of the lease, and depending on the interpretation that is used, aircraft financing may turn out to be one of the most likely markets. The aircraft maintains its value; the maintenance can be undertaken by third parties; insurance can be made readily available; and the transaction can be large enough to justify the added costs. Another promising area is the sub-prime market: Its increased access to capital means that it may be able to absorb the higher costs of funds needed to absorb the regulatory boards' costs.

Market Opportunity

There are potentially two specific market opportunities. For one, there is a growing interest among investors in the Western world, especially those who follow Islamic precepts to enter only into Shari'ah-compliant transactions. If an equipment financier were able to provide individuals and/or companies with the option of Shari'ah-compliant transactions mirroring the noncompliant transaction in cost, it may open up a market that would otherwise have been unavailable. While this is particularly true for finance companies that have significant operations in the Muslim world, it should not be overlooked by Western-based finance companies for growth within their home market.

The second opportunity ' and perhaps the more interesting one, particularly given the current credit crunch that is affecting North American markets ' is the opportunity to tap into additional sources of capital that may not otherwise be available. If finance companies were able to structure their transactions such that investing in their company and/or purchasing their transactions were Shari'ah-compliant, these leasing companies may find enhanced liquidity for their transactions.

As noted above, it appears that the Shari'ah-compliant ijara is the ideal vehicle for the equipment lease to expand into new markets. With only slight modifications to its current practices, an equipment financier would be able to make a product available to a wider range of clients than it currently does without increasing its risk. While there would be some upfront costs in developing these structures, the ability to enhance market reach should prove worthwhile to financiers who are increasingly being requested to provide this product to its market. Further, and perhaps more importantly, it would allow certain equipment financiers to achieve enhanced liquidity for their portfolio with only minor changes to their general operating structure. As a result, it is likely that we will see an increasing number of ijara-structure transactions over time.

Jonathan Fleisher is a partner in the Financial Services and Business Law Groups of the Toronto-based firm of Cassels Brock & Blackwell LLP. He has particular expertise assisting U.S. commercial finance companies, both public and private, with establishing operations in Canada, providing both legal and practical business advice. He is the only Canadian lawyer to sit on a sub-committee of the Equipment Leasing Association. His expertise also extends to all forms of debt finance including sub-debt, venture financings, convertible debt, tranche b debt, and asset based lending. He may be reached at [email protected] or 416-860-6596.

Shari'ah or Islamic-compliant financing is gaining a foothold in international finance transactions. As the investment community becomes more global in nature, there is an increased demand for Shari'ah compliant transactions. The equipment finance industry is one of the few sectors in the finance world that could enter this market without having to significantly modify the way it does business or its documentation. The opportunities are twofold: First, they involve providing a financial product to a growing market segment; and, secondly, they involve providing access to capital to fund transactions.

This article provides an overview to equipment finance professionals as to certain opportunities that may exist within this market for both increasing customer base and obtaining sources of capital. This is by no means a definitive or exhaustive work but, at best, an introduction to certain of the basic concepts underlying Shari'ah finance. It will become apparent that while there are some concepts that are clear, there is much debate as to what is and is not allowed. It should also be noted that the author, while being knowledgeable about equipment finance law in North America, is not a Shari'ah scholar but merely has a broad understanding of certain of the basic ideas. As such, nothing in this article should be relied upon without an in-depth review by a Shari'ah scholar.

Basic Shari'ah Principles

Shari'ah financing, at its most basic, means transactions that are compliant with the principles as set out in the Qur'an. The principles are derived from five basic sources: 1) the Qur'an (the Holy Book revered by Muslims); 2) the Sunna (the practice and traditions of the prophet Mohammed); 3) the Qiyas (a comparison, used to resolve issues that have no clear-cut ruling in the Qur'an or the Sunna, by considering similar issues in those texts having no clear rulings); 4) Ijtehad (the diligent judgment of the scholars through reasoning and logic); and 5) the Ijmaa (a consensus or agreement used for issues which require Ijtehad). In essence, Shari'ah principles require Muslims to act in a morally and socially aware manner, being conscious of the effects of their actions. See J. Michael Taylor, 'Islamic Commercial Banking ' Moving into the Mainstream?' (2005) 18 Transnat'l Law 417 at 418.

Two essential or overriding principles of Shari'ah-compliant transactions are:

1) Transactions involving interest, known as riba, are prohibited; and

2) Risk/uncertainty, known as gharar, must also be avoided.

The prohibition of gharar prohibits undertaking an unreasonable level of risk or uncertainty. Gharar does not prohibit a Muslim financier from entering into a lease with a less creditworthy obligor, but prohibits the financing of a to-be-determined object.

Another overriding concept is the financing itself, which must be Halal, or not for a prohibited purpose. For instance, if the financing were in support of the pornography or liquor industry (two areas strictly prohibited under the Qur'an), then the transaction would be prohibited as well. For most of the equipment finance industry, this will not be too great an impact.

Shari'ah Scholar: Supervisory Boards

While these principles have clear boundaries, they are very broad. Accordingly, there is a significant amount of varied interpretation as to the meaning and application to finance structures. Any Jewish or Christian religious scholar or, for that matter, practicing Jew or Christian, knows that different rabbis or clergy may interpret the Bible in different ways. The same is true under Islam. A Shari'ah-compliant investor needs to know however, that its transaction does indeed comply. In this regard, there are a number of Shari'ah schools of thought and boards that review transactions to provide the required assurances. This, of course, adds an extra layer of bureaucracy that would not otherwise exist in conventional financing.

While there is a general consensus amongst Muslim scholars as to what is required in order for a transaction to be Shari'ah-compliant, there is broad disagreement as to what structure and which provisions are acceptable. Based on completed transactions, it appears that transactions under a Malaysian supervisory board have different compliance requirements than those as set out by a Saudi Arabian board. It is not that one board is correct and another not, but that investors favor following the precepts of one group over another. See Babback Sabahi, 'Islamic Financial Structures as Alternatives to International Loan Agreements: Challenges for U.S. Financial Institutions' (2005) 24 Ann. Rev. Banking & Fin. L. 487.

In all cases, however, there must be a recognized board approving the transaction as Shari'ah-compliant in order for investors and/or lessees to feel comfortable that a transaction is acceptable. This is not to say that each lease needs to be approved, but that the general form of the lease and the method by which the Shari'ah financier obtained the investment would need to be approved. For instance, all securitizations with Shari'ah-compliant investors need some form of board approval; a Shari'ah scholar would need to be retained to develop the structure. It is beyond the scope of this article to discuss the securitization structures that are utilized for Shari'ah-compliant transactions, but it may be said that this is both a growing market in London and New York, and is obtaining enhanced recognition worldwide.

The inclusion of these religious supervisory boards tends to increase the cost of a transaction and, as such, before entering into a sophisticated structure, this needs to be priced into the transaction. Typically, if the transaction is small or is a one-off, the costs of obtaining the supervisory-board-approval may make the transaction prohibitively expensive. If, on the other hand, the transaction is relatively large and/or will generate significant funding, then it may be worthwhile.

This problem of uncertainty and lack of consistency is being addressed in the Islamic world by Islamic governments establishing standard guidelines to be followed. This includes looking to organizations such as the Islamic Financial Services Board ('IFSB') and the Accounting and Auditing Organization for Islamic Financial Institutions ('AAOIFI') and consulting fiqh (Islamic jurisprudence). It is anticipated that as standardization improves, uncertainty and costs will decrease. The equipment finance professional must be mindful, however, of the type of board approval it obtains since it will dictate the size of the potential market. For example, if the transaction is approved by the Malasim board but not the Saudi board, then he will attract only that corresponding portion of the market.

Equity Financing

Due to these basic principles, Islamic finance or Shari'ah-compliant finance has (at least prima facie) a different appearance than that which is conventional in the Western world. Shari'ah finance structures are more equity-based since the finance company will own shares and/or a joint venture interest in a particular project, giving rise to certainty of repayment over time. That being said, these structures are not within the scope of this article.

Ijara/Lease

One of the classic structures which is Shari'ah-compliant is the lease or ijara. The actual lease document does not set out the payment of interest (other than perhaps in the case of a late payment) but merely sets out that the lessee pays for the use of equipment over time, and that the lessor continues to own the goods or equipment during the lease's term. There is no riba (or interest), and avoidance of gharar (or risk) can be accomplished if the equipment is known at the time of entering into the lease (which is the typical situation). The lease structure, with a few modifications, complies with Shari'ah principles and provides for particular opportunities.

An ijara's essential differences from a conventional lease are listed below. It should be noted, however, that within this list, there is uncertainty as to the level of strict adherence that is required: Different boards disagree on some of these areas. A good discussion of ijaras can be found in an article titled 'Ijarah' by Maulana Taqi Usmani, but, notwithstanding the authoritative tenor of the article, other commentators have dissimilar views.

Basic elements of an ijara:

1) The rent must be fixed during the entire lease term; any change in the rent would require entering into a new lease. Stated otherwise, there is no prohibition against raising or lowering the rent, but any such increase or decrease must be specifically set out under the terms of a new lease.

2) The actual term of the lease must be set out in the agreement.

3) The lessor is permitted to claim compensation from the lessee for the misuse of the leased assets, including ordinary wear and tear. This is a subject on which boards may disagree.

4) The lessor is responsible for structural maintenance of the assets, and this obligation may not be passed on to the lessee; however, an agency relationship could be utilized. Again, there is some divergence of opinion on this issue.

5) The lessor is entitled to rent as long as the lessee has the enjoyment of the leased assets as specified in the ijara. If the lessee does not have enjoyment of the item leased, as upon destruction or condemnation of the equipment, the lessee may rescind the ijara, and the lease will be terminated.

6) The lessor (as opposed to the lessee) is responsible for insuring the equipment, but the cost can be passed on to the lessee in the form of rent. Nothing prohibits the lessor from obtaining payment from the insurance company upon destruction of the equipment, but the lessor may not directly require the lessee to pay upon destruction of the equipment.

7) The object, or manfa'a, must have sufficient economic value in substance at the time of entering into the equipment lease. If the object does not have economic value, then the rent can only be required once the object has economic value. In other words, the progress payment structure may not be available. Further, rent cannot be collected until the equipment is in the lessee's possession.

8) Care must be taken in how the lessor obtains rights in the property. The lessor can engage the lessee as his agent to purchase the assets, but this must be set out in a separate contract.

9) If there is an end-of-term purchase option for the goods, this must be documented separately and may only be binding on the lessor ' not the lessee. There seems to be some difference in opinion about how to document/structure such an arrangement, but there is little debate that a purchase structure may be developed.

10) Opinion is mixed as to the rights of the lessor upon the lessee's default. There is one school of thought that states that the only rights are to past-due rent and to repossession of the equipment, not to a right to sue for the net present value of the future rent. Another school of thought appears to provide for the same remedies as are common in traditional financing; that is, except for penalties.

11) A penalty for late payment is generally prohibited, but some structures utilize a charity-based method of requiring the lessee to make a charitable donation if he is late in making a payment. Some schools accept that a late charge, as opposed to interest, is acceptable.

12) Subleasing is permitted, but care must be taken, especially in how a sublease is structured.

In classic equipment leasing terms, the conservative interpretation of an ijara works well for collateral that retains its value and where maintenance can be provided by third parties. This would be an 'operating lease.' A more liberal view of an ijara has more flexibility and is a classic 'net lease.' The hell-or-high-water provisions that are the cornerstone of a conventional lease continue to be a part of an ijara subject to the covenant of quiet enjoyment. It is clear that an ijara would not be an appropriate structure for financing strictly soft costs or where progress payments are required (it should be noted that there are other structures that could be utilized under Shari'ah to finance these types of transactions). In addition, the requirement that the lessor be obligated to take out insurance should not be problematic as this is a structure that is not uncommon in the equipment leasing industry.

Given some of the requirements of the lease, and depending on the interpretation that is used, aircraft financing may turn out to be one of the most likely markets. The aircraft maintains its value; the maintenance can be undertaken by third parties; insurance can be made readily available; and the transaction can be large enough to justify the added costs. Another promising area is the sub-prime market: Its increased access to capital means that it may be able to absorb the higher costs of funds needed to absorb the regulatory boards' costs.

Market Opportunity

There are potentially two specific market opportunities. For one, there is a growing interest among investors in the Western world, especially those who follow Islamic precepts to enter only into Shari'ah-compliant transactions. If an equipment financier were able to provide individuals and/or companies with the option of Shari'ah-compliant transactions mirroring the noncompliant transaction in cost, it may open up a market that would otherwise have been unavailable. While this is particularly true for finance companies that have significant operations in the Muslim world, it should not be overlooked by Western-based finance companies for growth within their home market.

The second opportunity ' and perhaps the more interesting one, particularly given the current credit crunch that is affecting North American markets ' is the opportunity to tap into additional sources of capital that may not otherwise be available. If finance companies were able to structure their transactions such that investing in their company and/or purchasing their transactions were Shari'ah-compliant, these leasing companies may find enhanced liquidity for their transactions.

As noted above, it appears that the Shari'ah-compliant ijara is the ideal vehicle for the equipment lease to expand into new markets. With only slight modifications to its current practices, an equipment financier would be able to make a product available to a wider range of clients than it currently does without increasing its risk. While there would be some upfront costs in developing these structures, the ability to enhance market reach should prove worthwhile to financiers who are increasingly being requested to provide this product to its market. Further, and perhaps more importantly, it would allow certain equipment financiers to achieve enhanced liquidity for their portfolio with only minor changes to their general operating structure. As a result, it is likely that we will see an increasing number of ijara-structure transactions over time.

Jonathan Fleisher is a partner in the Financial Services and Business Law Groups of the Toronto-based firm of Cassels Brock & Blackwell LLP. He has particular expertise assisting U.S. commercial finance companies, both public and private, with establishing operations in Canada, providing both legal and practical business advice. He is the only Canadian lawyer to sit on a sub-committee of the Equipment Leasing Association. His expertise also extends to all forms of debt finance including sub-debt, venture financings, convertible debt, tranche b debt, and asset based lending. He may be reached at [email protected] or 416-860-6596.