UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Archive for December 28, 2010

Unsettling Islamic Finance Disputes

 

 

Currently, the practice for Islamic Finance Dispute Resolution is to have disputes settled by the Laws of England and Wales or the State of New York, often times subject to Sharia’h law.  I recognize that these jurisdictions are well-established and well-recognized for handling business transactional disputes, however, inserting these two jurisdictions in the governing law clauses of Islamic Finance contracts is a grave mistake.  First of all, these two jurisdictions generally do not recognize Sharia’h law is a system of law capable of governing a financial transaction.  However, the Islamic Financial transaction itself is rooted in Sharia’h law and principles as well as the Qu’ran.  Therefore, some aspect of Sharia’h must be applied in settling an Islamic Finance dispute to preserve the Islamic Finance transaction.  Furthermore, a judge in England and New York may have had no exposure to Islam, Islamic Finance, or Islamic culture except in a negative light.  However, a judge in the UK is more likely to have heard of Islamic Finance concepts, but most likely has no grasp on Islamic Finance, its’ structures, principles, implementation, or how to resolve disputes in such situations.  Therefore, when an Islamic Finance dispute goes before a judge in England or New York, the transaction by default turns into a conventional transaction as the judge declares Sharia’h law to be invalid and applies the laws and principles of conventional finance only to the Islamic Finance transaction.

Blom Bank Judgment and Implications for the Islamic Finance Industry

 

 

Blom Bank Judgment

In the case of Investment Dar Co KSCC v Blom Developments Bank Sal [2009] EWHC 3545 (Ch) High Court of Justice Chancery Division, TID successfully claimed that to uphold the Wakalah that it had entered into with Blom Bank would be un-Islamic and a breach of its statutes.  TID won the appeal case largely because the dispute was administered by an English Court where the judge had absolutely no understanding of Islamic finance and applied conventional finance and common law to the dispute which by default turned the transaction into a conventional transaction.

The Two Claims

“The two claims were advanced in the Particulars of Claim, one on the contract itself, where it was alleged that default had been made in making payments due pursuant to the master wakalah contract and secondly a claim expressed to be based in trust founding itself also on the terms of the master wakalah contract. The master found that there was an arguable defence to the contractual claim but not to the trust claim.  TID appealed and Blom sought to uphold the decision of the master on the alternative basis that he should have got judgment on the contract claim.  The judgment that the master granted was for repayment of all the principal sums advanced or deposited and not for any profit element or as TID would have it, interest.”

Judge Perle QC in his judgment stated that the Wakalah Agreement  ‘For all intents and purposes the commercial result is equivalent to that of a deposit at interest.’  Judge Perle QC applied conventional western finance concepts to the Islamic finance transaction and came to this conclusion thereby turning the transaction by default into a conventional western finance transaction.

Judge Perle QC stated that ‘A further recital was that the contract had been entered into and signed by both the parties to regulate the mechanism and procedures for accepting the muwakkil/depositor’s funds by the wakeel and their investment in the treasury pool in the agreed manner and the payment of profit to the muwakkil/depositor upon completion of each Wakalah period.’  The judge then goes on to say that ‘Thus the form was that of an investment by TID as agent’ and further applies western concepts to the Islamic finance transaction and further turns the deal into a western finance transaction.

A Wakalah is not a deposit at interest.

According to HM Revenue and Customs, (A UK entity), a Wakalah Investment is the following:

“This is an investment product, which functions in the same way as Mudarabah, which is discussed at VATFIN8600. The difference between the two is that with a Mudarabah all the profit is divided between the parties, whilst with a Wakalah the investor receives only the agreed ratio against investment. Anything made above that ratio is kept by the financial institution and not given to the investor.

Example: An investor agrees to invest a sum with the bank for an agreed return (e.g. 5%). The bank pools the investor’s funds with the funds of other investors and its own capital and invests in Sharia’h compliant assets. At the end of a given period (e.g. a month) the bank returns the invested sum to the investor along with the agreed 5%. Any additional revenue that the bank makes on the customer’s money is kept by the bank (e.g. if the bank makes 6% then 5% is given to the customer and the additional 1% is kept by the bank). If the bank does not make the agreed percentage return then the investor gets what has been made whilst the bank gets nothing (e.g. if only 4% is achieved then the investor gets the full 4%).”

Judge Perle QC states that “That example seems to presuppose that any shortfall is at the risk of the depositor or investor so that it can fairly be seen as a true investment agency, the bank in that example keeping any surplus over the agreed return, whilst the shortfall is borne by the depositor/investor.”  However the Judge has got it wrong here again.  If TID as the agent does not reach the agreed target, than the investor or Blom retains the entire return.  However, if TID exceeds the target, TID gives Blom the funds plus the agreed 5% return and anything over that TID keeps.  Any shortfall is not at the risk of the depositor or Blom.  Either way Blom gets funds.  The risk lies with the agent TID.  IF TID does not meet the target, the investor keeps all of the return.

In this matter the Judge re-states clauses 5.4 and 5.5 of the Wakalah Agreement in question and states that ‘We appear in those circumstances to be moving away from the concept of pure agency or trust.’  However, a Wakalah is not a common law agency or trust.  The judge goes onto nullify the agreement based on the fact that the Wakalah Agreement does not meet the criteria of a common law trust.

In the judgment, Judge Perle QC repeatedly states, ‘Thus there was an unconditional obligation to pay the on account profit in the amount of the anticipated profit whether or not it had in fact been earned by the investment (so called) in the treasury pool.’  The judge goes on to say, “ That is to say, although the on account payment of the anticipated profit was expressed as an on account payment, any surplus in fact went to the wakeel, TID, as an incentive so that the anticipated profit was in fact the only profit that could be made by Blom.”  But this is how the Wakalah works. However, the judge uses this argument to discredit the validity of the Wakalah and consider it null and void.

The Judge goes on to state: “There was no provision anywhere down to that point (or later) for the muwakkil/depositor, Blom, to bear any losses should losses be made or to receive less than the anticipated profit should the actual profit be less than that.   (But this is how Wakalah works)  “On the contrary, the unconditional obligation to make an on account payment of profit in the amount of the anticipated profit was in the other direction.” (But this is how Wakalah works)

The Judge states, “Furthermore, under clause 9.11, the wakeel, TID, undertook to indemnify the muwakkil/depositor, Blom, against amongst other things, any loss it might suffer or incur as a result of any wakalah transaction or the wakeel acting as its agent.” (But this is how Wakalah works).  The Judge than states, “Thus Blom was in a position where the only risk it took was of the insolvency of TID.”  However, this is again incorrect because Blom would lose the excess profit in the event that the investment resulted in excess of a 5% return, the amount of which TID would be entitled to keep under the Wakalah Agreement.

The Judge goes on to say that ‘The Wakeel, TID, was bound to pay that sum unconditionally and the depositor, Blom, under no circumstances had the right to anymore than that sum.’

True but that is the way Wakalah Investment works.  The Judge elaborates this argument to deny the existence of a trust.  The Judge says, ‘ That was objected to before me by TID on the basis that, if one looks at the contract as a whole, and in particular the provisions for pooling of funds and the actual obligations of TID, which were essentially obligations to pay sums irrespective of whether they had been earned, the label of trust used in the contract is something which I should ignore.’

The judge says, “I do not think it is established that the contract gives rise to a trust.”  The Judge goes on to state that the contract is null and void incapable of being saved by severance.

The Judge then goes on to say that, ‘It is said on behalf of TID that that contract amounted to a non-compliant Sharia’h transaction because in reality and substance what TID was doing was taking deposits at interest.’  The Judge goes on to agree with TID and refers to the Wakalah Agreement as simply an agreement to take deposits at interest, turning the transaction into a de facto western finance transaction.  The Judge says, “I agree that the court should approach the matter with some circumspection, but that does not take anything away from what is essentially a simple point, albeit difficult to apply, namely, that where one finds, as one does in this master wakalah contract, a device to enable what would at least to some eyes appear to be the payment of interest under another guise, that is at least an indirect practice of a non-Sharia’h compliant activity.’  Thus, here we have a UK Judge with absolutely no Sharia’h law training ruling on whether a transaction is Sharia’h compliant!

Based on the Judge’s opinion that the transaction was not Sharia’h compliant and that the Wakalah did not form a trust,  the Judge then goes on to suggest common law remedies, further turning the transaction into a conventional western finance transaction.  The Judge says, “On the footing that the transactions were ultra vires and void, that would give rise to a restitutionary claim in principle either based upon a failure of consideration or payment under a mistake but it would not in the absence of knowledge of the invalidity or mistake on the part of TID necessarily give rise to a trust claim.  Moreover, if there were a trust claim the appropriate remedy would be for an account and possibly an interim payment, not for the whole judgment sum.’ That would be good if this were a conventional western finance transaction, but in Wakalah, the money was being held on trust according to the terms of the Wakalah Investment Agreement (contractual) and the dispute should not be settled according to English trust law.  Contrary to English Trust Law but according to the Wakalah Agreement, if TID did not reach a certain target, Blom was entitled to whatever return TID had made using Blom’s deposits as breach of contract and trust.   However, the Judge allowed the appeal by TID of the judgment for $10,733,292.55 USD in favor of Blom and instead ordered an interim payment to Blom Bank as the Judge stated that TID was liable for at least the whole of the amounts deposited.  But under the Wakalah, Blom Bank was entitled the rate of return which TID had made if the target wasn’t met.

The Judge ordered an interim payment to be paid to Blom based on the fact that the contract was null and void (no trust) and that the transaction was ultra vires (not Sharia’h compliant), however, in reality the amount paid to Blom should have been the rate of return and should have been paid to Blom based on the fact that TID defaulted on the contractual obligation of gaining a return on investment according to the Wakalah Agreement, which was also a breach of trust.  By applying Western Trust Concepts to an Islamic finance transaction, the judge defacto turned the transaction into a western finance transaction (in both the first instance and appeal).  The UK appeal judge was also in no position to make rulings on Sharia’h law and compliance.

UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance