Wednesday, August 1, 2012

Islamic Banking: Home Purchase Financings I - The Lease

This is the second in our continuing series of articles on basic Islamic banking, finance and investment concepts. This article, and subsequent articles, begin to explore the palette of products that are available to customers of Shari`ah-compliant banks. It seems appropriate to begin with hearth and home, which is a fundamental focus of individuals, banks and other finance providers, the business community and governments. It is a topic of acute interest in the Middle East at the moment as a result of the recent adoption of a mortgage law in Saudi Arabia. As a result of that law, housing finance in Saudi Arabia is anticipated to grow, and constitute an entirely new industry. 1 That development is expected to enfranchise a significant portion of the Saudi population as home financing becomes available and the Saudi population moves to home ownership and enhanced participation in the Saudi economic system. The mortgage law implements Shari`ah-compliant rahn- concepts and will stimulate the growth of Shari`ah-compliant home financing, and thus the growth of Islamic banking. Spill-over stimuli in surrounding countries is inevitable. And, as one of their first products, Islamic banks in the Sultanate of Oman will likely offer home purchase financing.

We will summarize five of the most frequently used home purchase financing structures provided by Islamic banks. They are: (a) the lease (ijara); (b) the diminishing partnership or diminishing musharaka (musharaka mutanaqisa); (c) the cost-plus sale (murabaha); (d) the deferred payment sale (bay bithaman ajil), which is used in Malaysia and Indonesia but only infrequently elsewhere; and (e) the two-tier construction contract financing (istisna – parallel istisna), which is a construction financing structure rather than a purchase structure.

Some of these structures are used in Islamic banking, finance and investment transactions other than home purchase financing. Accordingly, this and subsequent articles discuss each of these structures in some detail before moving on to other structures.

Lease Financing: In Principle

The lease (ijara) financing structure is the most widely used Shari`ah-compliant structure in the world for sophisticated financings. It is simple in concept. An Islamic Bank (usually through a surrogate) purchases a house using the Bank’s funds (in the leverage amount, say, 75% of the house purchase price) and funds from the Home Buyer (in the down payment amount of, say, 25% of the purchase price).

The acquisition of the house is illustrated in FIGURE 1: PURCHASE OF HOUSE (a surrogate purchase, through a “Funding Company” is illustrated).

In the Figure 1 example, the house is owned by the Bank surrogate, the Funding Company. The house is then leased to the prospective Home Buyer for a period of time (say, 15 or 30 years). The Bank’s return is the profit on the lease. The lease rent schedule will be quite similar to a conventional home purchase financing amortization schedule. If the Home Buyer makes all its rental payments over the term, the Home Buyer may purchase and take title to the home for a further final payment, which is usually nominal.

The making of multiple rent payments, the use of those rent payments to make payments on the bank financing, the making of the final purchase payment, and the transfer of title to the Home Buyer are illustrated in FIGURE 2: RENT, FINANCING AND PURCHASE PAYMENTS. 2

This article assumes that the Funding Company is a disregarded entity for income tax purposes. That is not the case in many jurisdictions, and in those jurisdictions additional expense items are structured at the Funding Company level to offset the “rental income” of the Funding Company.

An ijara is a lease of an object or services involving the transfer of the usufruct or manfa’a (the use of an object or the services of a person) for a rent consideration. The nature of the usufruct must be precisely defined, the rental consideration must be for a fixed value, 3 whether payable in a lump sum or installments, and the term of the lease must be precisely determined. Both the rent and the term must be clearly ascertained and designated in the lease. The rent may escalate or diminish during the term so long as the amounts of such escalation and/or decrease are specified and known to both parties. 4 The lessor is responsible for structural maintenance of the assets and correlative obligations (e.g., casualty insurance) and these obligations may not be passed to the lessee pursuant to the lease. The lessor is entitled to receive its rent as long as the lessee has the enjoyment of the leased assets as specified in the lease, but not after termination of the lease.

Lease Documentation

FIGURE 3: GENERIC IJARA (LEASE) FINANCING: DOCUMENTATION summarizes the documentary structure for a lease structure (without security documentation).

The structure depicted in Figure 3 is of a generic home financing transaction. However, this structure (in various iterations) is used in a wide range of transactions, including financings of real estate, petrochemical, electricity, mining and infrastructure projects, among others. It is also the base structure for private equity transactions. It is used in Middle Eastern, North American, European and Asian jurisdictions.

The lease structure may be a “bifurcated structure” involving a conventional loan arrangement for leverage (or gearing), or purely Shari`ah-compliant. Referring to Figure 3, a bifurcated structure will entail a conventional interest-bearing loan from the Bank to the Funding Company pursuant to the Financing Documents (to the left of the dotted red line). All documents and transactions to the right of the dotted red line will then be compliant with the Shari`ah. Bifurcated structures are quite common as they allow conventional banks to participate in Shari`ah-compliant transactions. 5 The reasons for the widespread acceptance of this structure by interest-based financiers are apparent: those financiers make conventional loans, as they would in any financing; the relevant credit, underwriting and risk criteria are essentially the same as in any conventional financing, as is the analyses of those elements; there are no changes to financial reporting conventions; and there are no changes to the financier’s back office operations. The entirely compliant version is more frequently encountered in jurisdictions within the Organisation for Islamic Cooperation.

In most jurisdictions, banks are not permitted to own real property. 6 In order to take control of a house (and related land) for the purpose of leasing it to a home purchaser, the bank will arrange to have the property owned in a special purpose entity (each, a “Funding Company”) by a third party. 7 While title to the house (and possibly the land) will be in the Funding Company, that entity will usually have no ability to make any decisions or determinations with respect to the property; all such decisions and determinations will be made by the Bank, a process that is established and controlled pursuant to the Financing Documents.

As noted above, and in Figure 1, the Home Buyer will inject a down payment and the Bank will provide the leverage financing. In a bifurcated structure, the leverage will be in the form of a conventional interest-bearing loan. If an Islamic Bank is providing the leverage financing, the structure for the contribution of funds by the Bank will vary from one jurisdiction to another. For example, the Bank may inject equity funds into the Funding Company. Or the Bank may purchase a sukuk issued by a Funding Company or another vehicle that effectively securitizes the rent flows from one or more Funding Companies. Alternatively, the Bank may take a participation interest in a Funding Company, with the profit being all of the rent flow on the Lease (Ijara) between that Funding Company and its related Home Buyer(s). Or the Bank may structure a musharaka or mudaraba arrangement that controls the Funding Company, with essentially all of the profits (derived from rental income) of the musharaka or mudaraba going to the Bank.

The Funding Company will lease the project assets to the Home Buyer pursuant to the Lease (Ijara). The basic rent payable by the Home Buyer to the Funding Company under the Lease (Ijara) will be structured to be exactly equivalent to the debt service payable by the Funding Company to the Bank under the Financing Documents (and related documents).

The transaction will be structured such that any default on the Lease (Ijara) (and related documents) will constitute an event of default under the Financing Documents. That is relatively easy to achieve by inserting a cross-default to the Lease (Ijara) as an event of default in the Financing Documents. The obverse is more difficult to achieve because applicable Shari`ah precepts preclude having one of the Lease events of default being a Financing Document event of default. The earliest structures achieved the desired result by mirroring, with precision, the representations, warranties, covenants and other provisions of the Financing Documents in the Lease (Ijara) and related documents. This was a tedious and costly process and more expeditious methods of achieving this result have since been developed.

The Understanding to Purchase is a Shari`ah-compliant sale and purchase agreement that allows the Funding Company, at the direction of the Bank, to cause the Home Buyer to purchase the house upon a Lease event of default (and upon the occurrence of any other mandatory prepayment provision). This is necessary because the Shari`ah prohibits acceleration of future rents, and future rents will include all the outstanding principal of the financing at any given time. The purchase price will be equal to the outstanding principal under the Financing Documents from time to time. The Home Buyer may also desire to prepay the financing, in whole or in part. The Understanding to Sell is a purchase and sale agreement that allows this result. The purchase price will be equal to the amount of the financing prepayment at any given point in time. In the case of each Understanding, the purchase price will be initially paid by the Home Buyer to the Funding Company; the Funding Company will then use those funds to make payment under the Financing Documents.

Shari`ah principles and precepts applicable to leasing preclude the lessor from passing structural maintenance obligations (and correlative obligations) to the lessee pursuant to the Lease (Ijara), thereby precluding “triple-net” leasing that is so common in Western financial arrangements. To bring the Shari`ah-compliant financing transaction into harmony with existing Western markets, a mechanism is invoked to shift the structural maintenance obligations (and correlative obligations) to the Home Buyer (lessee). This occurs in the Managing Contractor Agreement where the Funding Company (lessor) hires the Home Buyer to perform structural maintenance and to undertake defined correlative obligations.

The Managing Contractor Agreement contains a second set of provisions that address the making of decisions and determinations and the direction of actions by the Funding Company. Basically, these provisions provide that any decision or determination to be made by the Funding Company (a) with respect to the Lease (Ijara) and the Understanding to Purchase will be made by the Bank, 8 and (b) with respect to the Financing Documents will be made by the Home Buyer. The result is the removal of the Funding Company from decision-making. Of course, nothing is quite so simple as one would like. Frequently, the Bank is not willing to make these decisions and determinations on behalf of, or to direct actions by, the Funding Company. This reluctance may relate to liability concerns or internal institutional practices. Similarly, for Shari`ah reasons, the Home Buyer is unable to make decisions and determinations and have responsibilities in respect of the Financing Documents and related conventional interest-bearing arrangements. Harmonization of these positions with the principle stated in the first two sentences of this paragraph entails some careful structuring and drafting, but is achieved in the Managing Contractor Agreement.

Collateral Security

Collateral security structures for the lease transaction are quite similar to those in a conventional interest-based home financing, although the exact structures will vary from jurisdiction to jurisdiction.

FIGURE 4: COLLATERAL SECURITY graphically depicts a generic collateral security structure for a lease-based financing.

There is a mortgage from the Funding Company to the Bank with respect to all right, title, interest and estate of the Funding Company in and to the house and the land. In addition, the Funding Company will collaterally assign to the Bank whatever collateral security the Funding Company received from the Home Buyer. This security package will secure the obligations of Funding Company to the Bank under the Financing Documents, i.e., the repayment of the financing. It is exercisable by the Bank upon an event of default under the Financing Documents.

The Home Buyer will provide to the Funding Company a security interest in and to all of the Home Buyer’s right, title, interest and estate in and to the house and the land. That security interest may also include other assets of the Home Buyer, possibly including monies in the Home Buyer’s bank accounts. It also may include a personal guarantee of the Home Buyer in respect of the rent and purchase payments. These security interests are exercisable by the Funding Company (at the direction of the Bank) upon a Lease event of default, but not a Financing Document event of default that is not a Lease event of default. This collateral may not secure the Financing Document obligations, only certain Lease and related obligations.

Future articles

Our next Client Alert article will continue the discussion of Shari`ah-compliant home purchasing financing products. We will take up diminishing musharaka structures and murabaha structures and then move to istisna` – parallel istisna` structures.

As the Sultanate of Oman prepares to roll out its new legal and regulatory framework for Islamic banking in the coming months, we will be covering Islamic banking in the Client Alert as it is an important and growing field. This article is the second in a series by Curtis partner Michael J.T. McMillen, an Islamic finance specialist based in our New York office who provides support to our Islamic banking practice in Oman and throughout the Middle East region.

1. The long-awaited Saudi mortgage law was approved by the Council of Ministers of the Kingdom of Saudi Arabia on July 2, 2012. The draft of that law that was approved by the Shura Council is analyzed in Michael J.T. McMillen, Rahn Concepts in Saudi Arabia, Formalization and a Registration and Prioritization System, available at It is currently unknown if the final version varies from that draft. A structure used to obtain and enforce rahn (mortgage and pledge under the Shari`ah) in Saudi Arabia, without regard to the new law, is discussed in Michael J.T. McMillen, Islamic Shari’ah-Compliant Project Finance: Collateral Security and Financing Structure Case Studies, 24 FORDHAM INT’L L.J. 1184 (2001).
2. This article assumes that the Funding Company is a disregarded entity for income tax purposes. That is not the case in many jurisdictions, and in those jurisdictions additional expense items are structured at the Funding Company level to offset the “rental income” of the Funding Company
3. Variable rate leasing arrangements are widely used, and are expressly authorized in Ijāra Standard, § 5/2/3, of the Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”)
4. The rent may not increase as a result of delays in payment of the rent (see, e.g., AAOIFI Ijāra Standard, at § 6/3) although an “interest” or “late payment” charge may be imposed if it is donated to charity (see, e.g., AAOIFI Ijāra Standard, at § 6/4).
5. Consider, for example, Western jurisdictions that have no Islamic banks
6. Other than certain specific and limited categories of properties: for example, those necessary for the bank’s operations (e.g., offices) and, on a temporary basis, those that have been foreclosed upon .
7. Often the Funding Company is owned by a corporate service company. Ideally, there will be one Funding Company for each property, which isolates liability, bankruptcy, tax and other exposures on a per-property basis. In many jurisdictions, it is difficult to establish corporate (or limited liability company) vehicles and one Funding Company may hold multiple properties, each leased to a different Home Buyer. Other important concerns relate to tax treatment in each specific jurisdiction. For example, will a Funding Company be a taxable entity or an entity that is disregarded for tax purposes? Will the Funding Company or the Home Buyer be the tax owner for local law purposes? The reasons for the widespread acceptance of this structure by Western financiers is apparent: those financiers make conventional loans, as they would in any construction (or acquisition or other equivalent) financing; the relevant credit, underwriting and risk criteria are essentially the same as in any conventional financing, as is the analyses of those elements; there are no changes to financial reporting conventions; and there are no changes to the financier’s back-office operations. Considerations of the types mentioned in this note, while critical, are not discussed in this introductory article.
8. The Bank should not and will not make decisions or determinations with respect to (a) the Understanding to Sell or (b) the Managing Contractor Agreement itself. The former allows the Home Buyer to prepay the financing by way of voluntary prepayment. These rights are unrestricted in conventional financings and the Shari`ah-compliant should be in no more of a disadvantageous situation. The decision-making provisions of the Managing Contractor Agreement are self-effecting in all situations, including non-default and default scenarios, and those arrangements should not be modified by security documents that shift decision-making to the Bank in all default circumstances.