Critical elements in the process of institutional change, even profound change, frequently occur without warning or preparatory fanfare. That has been true with regard to the implementation of Islamic banking in the Sultanate of Oman, as illustrated by the issuance by His Majesty Sultan Qaboos bin Said, on 22nd Muharram 1434 A.H. (6 December 2012 A.D.), of Royal Decree 69/2012, Amending Some Provisions of the Banking Law promulgated by Royal Decree 114/2000 (the “Islamic Banking Decree”). In addition, the Central Bank of Oman (the “CBO”) issued Circular IB 1 on 18 December 2012, which adopted the relevant Islamic banking regulations (the “Islamic Banking Framework”) with only minor amendments to the previously circulated draft. The long-anticipated Royal Decree consists of only three sentences. The amendments to the Banking Law (the “Islamic Banking Law”) are comprised of only 12 sentences set forth in six Articles in one new chapter of the Banking Law (Chapter Six, entitled, quite simply, “Islamic Banking”). The Islamic Banking Framework runs to 589 pages, plus some amendments in Circular IB 1. It is anticipated, however, that the changes effected by the Royal Decree will be significant as the Sultanate embarks upon the age of Islamic banking, finance and investment.
The Islamic Banking Law leaves much to the Islamic Banking Framework and future regulations, circulars and guidelines. But, laying the foundation for the development of the Islamic banking industry in Oman, the Islamic Banking Law does specifically address four critical substantive structural elements, as well as a few procedural elements of the transactional structure of Islamic banking in Oman. This article focuses on those four areas, leaving discussion of the Islamic Banking Framework to future articles.
The four substantive structural elements are: (i) the transactional base of Islamic banking in the Sultanate, and some fundamental requirements pertaining to that transactional base; (ii) the status of Islamic banking and Islamic banking transactions in terms of taxation, land law constraints and the provisions of other areas of substantive law; and (iii) two matters pertaining to Shari’ah supervisory boards, one at the level of the individual banks and one at some higher level.
The procedural matters pertain to: (a) the obligation of the Board of Governors of the CBO (the “Board of Governors”) to issue the Islamic Banking Framework; (b) the obligation of the CBO to license Islamic banks and Islamic windows at conventional banks; and (c) interpretation of the Islamic Banking Law, particularly as its provisions may conflict with other laws, rules, regulations and Royal Decrees. As is so often the case, a great deal of substantive law impact is embedded within the procedural provisions.
Transactional base of Islamic banking
The Islamic Banking Law (specifically Article (124)) is expansive in authorizing Islamic banks to make use of essentially all Shari’ah-complaint contracts and structures in Islamic banking transactions. It mandates that Islamic banks perform those transactions in a manner that does not contradict the Shari’ah (leaving aside for the moment the critical analysis of how the substantive principles of Shari’ah are to be determined and interpreted). By way of example, and not by way of exclusive itemization, Article (124) affords special attention to four types of Shari’a-compliant transactions. Each authorization is gratifyingly broad, and it is likely, in each case, that applicable restrictions will be set forth in the Islamic Banking Framework and future circulars and guidelines. And it is apparent, in each case, that further clarification of the scope of each authorization is necessary. First, Islamic banks are authorized to accept deposits and manage restricted and unrestricted investment accounts, whether those accounts are operating on the basis of charges or profits or otherwise.
Second, Islamic banks are authorized to finance and invest through mudaraba, musharaka, murabaha, ijara, salam, istisna, qard hasan and other Shari’ah-compliant contracts and structures.
Third, Islamic banks are authorized to issue asset-supported or project-supported sukuk and invest in asset-supported and project-supported sukuk. There is no indication of how an Islamic bank might go about issuing an asset-based or project-based sukuk. Presumably, issuance by the bank for its own account and based upon its own assets is permitted.
It would seem that this provision also allows for a broader sukuk issuance authority in order to allow Islamic banks to fulfill the functions of building capital markets and facilitating financing of bank clients. That would likely entail issuances by bank subsidiaries where the subsidiaries are capitalized by assets provided by third-party entities (i.e., customers of the Islamic bank). The use of bank subsidiaries is prudent as a matter of bank regulatory policy and practice; among other reasons: it is undesirable to allow an Islamic bank (or any other bank) to have liability on sukuk structured on the assets or projects of third parties – those liabilities should be isolated into subsidiaries holding those assets or projects. If this bank-subsidiary issuance structure is permissible, the sukuk markets in Oman have been given a major structural boost. And, depending upon the interpretation of the Article (125) tax exemption (discussed in the next section of this article), it seems likely that tax impediments to the use of such structures also have been removed. Thus, for example, it is arguable that the 12% tax that would be levied on a special purpose vehicle (“spv”) established as a sukuk issuer is not applicable if that issuer spv is a subsidiary of an Islamic bank effecting a Shari’ah-compliant banking transaction. Obviously, clarification is needed on these matters, and some clarification may be forthcoming as the Capital Markets Authority considers sukuk regulations for Oman.
Fourth, Islamic banks are authorized to deal in real estate and movables, including by way of selling, purchasing, investing in, renting and leasing real estate and movables, and this authorization is expressly stated to be an exception to and from restrictions in the laws referenced in the Islamic Banking Decree (presumably the Land Law) and related laws and Royal Decrees. This is a monumental modification of the laws that goes to the heart of Islamic banking and the use of Shari’ah-compliant structures because essentially all Shari’ah-compliant structures make use of land and movables: the essence of Islamic banking and Islamic finance is the involvement of tangible assets. This provision is discussed in the next section of this article.
Status of Islamic banking transactions: Tax, Land Law, and others
The Islamic Banking Law seems to override a number of Oman’s existing laws, rules and regulations, including, in particular, the Land Law promulgated by Royal Decree 5/80 and tax laws pertaining to land transactions. Clause (D) of Article (124) of the Islamic Banking Law provides that Islamic banks are entitled to deal in real estate and movables, including (without limitation) by way of selling, purchasing, investing in, renting and leasing real estate and movables and that this authorization is an exception to and from restrictions in the laws referenced in the Islamic Banking Decree (presumably the Land Law) and related laws and Royal Decrees. The Article (124) authorization is supplemented by Article (125), which provides that licensed Islamic banks are exempted from charges imposed by transactions related to the ownership, leasing and renting of real estate and movables where the transactions are performed for the purpose of providing Islamic banking services.
The lists of illustrative activities in Articles (124) and (125) do not match. Article (125) does not include references to ‘selling, investing and other dealings’, while Article (124) does refer to those activities. It is unknown whether this mismatch is intentional. Logic would dictate that ‘selling, investing and other dealings’ in real estate and movables in the course of practicing Islamic banking also should be exempted from charges, particularly in light of the nature of Islamic banking transactions, including with regard to the matters discussed in the next paragraph.
The scope of the exemption from land-related charges is undefined. Certainly it must encompass transfer taxes applicable to interests in land. Hopefully, the provision will be applied in such a manner that Islamic banks will not suffer charges or impositions that would not be incurred by a conventional bank on a similar banking transaction. Some of the more problematic areas of application of the exemption provision will arise in Islamic banking transactions that give rise to accretions or profits that are not incurred in conventional banking transactions. Consider, for example, mudaraba and musharaka arrangements involving interests in land where the transaction results in capital gain on the land interest. It will be necessary to consider, on a charge-by-charge basis, every charge of every type to determine whether it is appropriate to exempt Islamic banking transactions from each of those charges.
The second clause of Article (126) of the Islamic Banking Law provides the customary, but quite important, catch-all statement to the effect that ‘all that contradicts or contravenes the amendments set forth in the Islamic Banking Decree shall be revoked’. This provides comfort that other laws, rules and regulations that interfere with the implementation of Islamic banking in Oman will be removed. Resolution of these conflicts is left to the future. Potential conflicts are many and varied. This article mentions a few, such as taxation on land-related capital gains incurred because of the use of a Shari’ah-compliant structure and, as discussed in the next section, enforcement of determinations of the supreme authority for Shari’ah oversight. But many more can be easily imagined. These include not only charges in the nature of taxes, but also liabilities and impositions that arise because of the use by an Islamic bank of Shari’ah-compliant contracts or structures. Consider, for example, environmental liability or third-party liability arising as a result of the ownership or control of a land interest by a mudaraba or musharaka used by an Islamic bank to provide transactional financing. Will the Islamic bank be exempted from liabilities such as these? Will these types of liabilities be assessed only against the assets involved in the transaction? Or will the Islamic bank itself have liability? Much remains to be determined in the future.
Shari’ah supervisory matters
The Islamic Banking Law requires each institution doing Islamic banking to establish a Shari’ah supervisory board. The form, prerogatives and functioning of these Shari’ah supervisory boards are to be governed by the Islamic Banking Framework, as are the qualifications and conditions applicable to members of the Shari’ah supervisory boards. One of the more interesting features of the Islamic Banking Law as it pertains to Shari’ah supervisory boards is the requirement that the appointment of the board members and the determination of the compensation of board members are to be established by the general meeting of the Islamic bank. No separate provision is made in respect of these matters in the case of Islamic windows of conventional banks, but, presumably, the same concept would apply. Some of these matters were addressed, in part, in one of our previous articles on Islamic finance, which is available on our blog at http://omanlawblog.curtis.com/2012/12/one-of-first-matters-to-be-addressed-as.html.
Article (126) B of the Islamic Banking Law sets forth a requirement that has been described by various market participants as “unexpected”. It requires the Board of Governors to establish a supreme authority for Shari’ah oversight (the “Oman SOA”) and to specify the form, prerogatives and functioning of the Oman SOA as well as the qualifications and conditions applicable to members of the Oman SOA. The Oman SOA has not yet been established, and no guidance has been provided as to the nature of its role, function, power, authority or institutional status. Will the Oman SOA set standards for different contracts and structures (such as mudaraba, musharaka, ijara, murabaha, wakala, and the like) and require that the Shari’ah supervisory boards of the Islamic banks implement transactions in accordance with those standards? Will courts and arbitrators be required to submit Shari’ah matters to the Oman SOA? If any such submission is required, will the determinations of the Oman SOA be advisory in nature or will they constitute binding determinations? No indication has been provided with respect to any of the foregoing questions, or any other similar matter. One may surmise that the pronouncement establishing the Oman SOA will specify its role, function and power and authority, although that pronouncement will likely leave much to future determinations.
The Islamic Banking Law does not make reference to any paradigm or source that might provide guidance in respect of the role, function, power, authority, and institutional status of the Oman SOA. However, one might consider, as a possible paradigm, the central Shari’ah Advisory Council (the “Malaysia SAC”) of Bank Negara Malaysia, the Central Bank of Malaysia (“Bank Negara”). Bank Negara comprised the Malaysia SAC, under the auspices of Bank Negara, in 1997 as the highest Shari’ah authority for Islamic finance in Malaysia. The Malaysia SAC’s authority in its ‘regulatory’ function allows it to ascertain Islamic law for the purposes of Islamic banking, takaful, Islamic finance, Islamic development finance, and other business which is based on Shari’ah principles. The Malaysia SAC also has an advisory function, pursuant to which it is responsible for validating all Islamic banking and takaful products to ensure their compatibility with Shari’ah principles.
The Malaysia SAC was further institutionalized, defined and empowered pursuant to the Central Bank of Malaysia Act 2009, Act 701, Laws of Malaysia (the “CBMA”; available at http://www.bnm.gov.my/documents/act/en_cba.pdf), particularly in respect of its ‘regulatory’ function. Pursuant to the CBMA, Bank Negara is required to consult the Malaysia SAC on any matter relating to Islamic financial business and any matter pertaining to the performance by Bank Negara of its business or affairs or under any law in accordance with the Shari’ah (CBMA, Article 55(1)). Any financial institution may seek a ruling or the advice of the Malaysia SAC in respect of the operations of its business; no provision mandates that the SAC take such a request and render a ruling or advice (CBMA, Article 55(2)). Further, a court or arbitrator in any proceeding in any court or before any arbitrator is required to consider the published rulings of the Malaysia SAC and is required to refer any question concerning a Shari’ah matter to the Malaysia SAC for a ruling or advice (CBMA, Article 56). Articles 57 and 58 of the CBMA provide that the Malaysia SAC determinations in respect of each of the foregoing matters prevails, including over determinations of courts and arbitrators and contrary rulings of other financial institutions and in respect of rulings provided in response to requests made by financial institutions.
The definition of the nature, role, functions, power, authority, and institutional status, among other elements, of the Oman SOA is likely to be one of the most difficult challenges facing the Board of Governors in connection with the design of the Islamic banking model and practical implementation of Islamic banking in Oman. It entails delicate balancing among the CBO, the Oman SOA, the Islamic banks, and the Shari’ah supervisory boards of those Islamic banks. It further entails a careful reconsideration of the relative power, authority and institutional status, with respect to dispute resolution, among the courts and arbitrators, on the one hand, and the Oman SOA, on the other hand. The policy issues are many, and the effect on the existing legal and regulatory system is likely to be profound.
Regulations and licensing
Two Articles of the Islamic Banking Law, constituting a total of two sentences, address obligations in respect of issuance of Islamic banking regulations and the licensing of Islamic banks and Islamic windows of conventional banks. Each of these matters will be discussed in greater detail in future Client Alert articles, particularly those dealing with the Islamic Banking Framework.
Very simply, the Board of Governors is obligated to issue the Islamic banking regulations, as well as circulars and guidelines, in respect of certain enumerated matters and, in open-end format, other non-enumerated matters. As noted above, the CBO issued the Islamic Banking Framework on 18 December 2012 pursuant to Circular IB 1. The enumerated matters are licensing, governance, Shari’ah control, capital, credit, limits of investment and exposure, accountability, reports, disclosure and risk management. This sentence lays the foundation for the Islamic Banking Framework and for a dynamic, ongoing regulatory process that includes regulations, circulars and guidelines in a system that will be familiar to all parties that have banking experience.
With respect to licensing, the CBO is mandated to issue licenses to Islamic banks and Islamic windows of conventional banks. Those matters are addressed in the Islamic Banking Framework with respect to both banking and investment banking activities.
Interpretations of Islamic banking
As noted in other sections of this article, there are significant unresolved questions regarding the interpretation of different provisions of the Islamic Banking Law. These include the scope of taxation exemptions, the scope the revocation of laws, rules and regulations that contradict or contravene the Islamic Banking Law, and the status of the determinations of the Oman SOA vis-à-vis court and arbitrator determinations.
Two provisions of the Islamic Banking Law (Articles (121) and (124)) seem to indicate that whoever interprets the Islamic Banking Law must do so in a manner that does not contradict the essential substantive principles and nature of Islamic banking. A likely interpretation of that mandate is that application and interpretation of the Islamic Banking Law must be in accordance with the substance of the applicable Shari’ah principles. This interpretation gives rise to some delicate policy issues relating to the relative powers, authorities, institutional status, rights, and responsibilities of different branches and organs of government. One will have to consider the Oman SOA as an organ of government for purposes of these policy determinations. For example, the Board of Governors, in the exercise of its Article (126)(B) establishment obligation, may vest the Oman SOA with the ultimate authority to determine the substance of those Shari’ah principles, at least as a primary matter. That would seem to vest exceptional ‘judicial’ or ‘quasi-judicial’ authority in the Oman SOA, and will certainly raise the issue of the balance of power and authority as between the courts and arbitrators and the Oman SOA. In considering the policy arguments, and the inter-branch balancing, it is worth noting that Article (124) seems to indicate that Islamic banks must practice Islamic banking in accordance with the restrictions set by the Board of Governors, even where those restrictions might conflict with interpretations of the regular nature of the applicable Shari’ah principles.
The long-awaited Islamic Banking Decree giving effect to the Islamic Banking Law is now effective. It will result in profound changes in the law of Oman. Over time, it will result in profound changes in the financial markets in Oman. And, over time, it will influence the essence of the Omani culture. The Islamic Banking Law sets forth some elemental principles and the outline of the basic structure of Islamic banking. Much remains to be clarified as the Islamic Banking Law is implemented in the coming months and years. The Islamic Banking Framework, and related circulars and guidelines, will be a first step in resolving some of the many issues. But numerous other matters, some being of a fundamental policy nature, will remain and be resolved incrementally as the Islamic banking system evolves and becomes a part of the fabric of Omani existence. It is our hope that transparent and comprehensive discussions of these issues and these policy matters will accelerate and that the public will be better informed and served as a result.
Monday, January 14, 2013