In this article, Ms Ungureanu discusses how the shipping industry is an essential pillar of international trade and global economics. As the shipping industry has not been immune to the 2009 banking crisis, Ms. Ungureanu discusses how applying Sharia law compliant financing could pose as a solution to those players in the industry looking to find alternative channels of finance.
Diana Ungureanu, ‘West meets East: An Overview of Sharia-Compliant Ship Financing (Online Law Journal, 22 November 2018).
1. Contextual Introduction
The shipping industry is an essential pillar of international trade and global economics. Additionally, it is also a capital-intensive industry which is sensitive to the ups and downs of the shipping cycle. As states across the globe are establishing their manufacturing expertise and production efficiency, global trade has developed at an ever increasing rate.1 Bankers, insurers and investors have found great opportunity to accrue capital resulting in the building of highly performing and technologically advanced ships, as well as the expansion and development of port infrastructure and communication links. As a result of this, between the years 2000 and 2009 the cash capital available had more than tripled in value and the shipping industry had experienced a boom.2
However, the shipping industry has not been immune to the international banking crisis which culminated in 2009 leaving long-lasting recessive effects.3 This led to a depreciation of ship values and a decrease in freight rates.4 Sequentially, businesses engaged in commercial shipping activities suffered as a result of banks limiting new lending ventures and restructuring their debt in an attempt to keep their doors open. Nowadays, by comparison to the austerity measures employed during the crisis, conventional banks are making available new loan facilities, yet remain cautious as to who they lend their capital to. Stephen Marais, INCE&CO London partner, stated that ‘the liquidity crisis is far from over’.5
Stakeholders with a vested interest in any shipping activity are looking to tap into alternative channels of finance. One such alternative is known as Sharia-compliant finance. In the crisis period, Sharia-compliant financial institutions were affected but were far more resilient than conventional financial institutions. In a 2010 survey carried out by the IMF it was established that their asset growth during the crisis was twice as high as that experienced by conventional financial institutions.6 Nowadays, there are an estimated 600 Sharia-compliant financial institutions worldwide in 76 jurisdictions.7 Furthermore, a 2013 study concluded that there was a total of $1.8 trillion worth of Islamic finance assets divided between Sharia-compliant banking and the Sukuk market (the Islamic equivalent of the bond market). It is predicted that by the year 2020 this will reach a total of $6.5 trillion.8
Doubt as to the relevance of this type of finance in a European context is eliminated when considering the UK and Luxembourg as examples of a growing European interest, the UK has expressed interest in the Sukuk market by attracting ‘new money’ through a £200 million Islamic bond which was issued in 2014 (although it wasn’t the first).9 Luxembourg also issued its own €200 million Islamic bond. Both were heavily oversubscribed and in 2017 Luxembourg was named by Deloitte ‘the gateway for Islamic finance and the Middle East’.10 Furthermore, during an IE Business School seminar in 2016, Mr Luis M. Linde, Bank of Spain Governor, stressed Spain’s interest in exploring this alternative form of finance despite it not yet being materialised in a fund or a financial product.11 As a result, the IMF is urging states and international financial organizations to implement a regulatory framework for Sharia-compliant financial instruments in order to ensure stable growth of the economy.
For these reasons this paper examines the different types of Sharia-compliant financial structures available to the shipping industry and the legal aspects pertaining to them in order to achieve two ends. Firstly, that of increasing the awareness of legal, business, and shipping professionals to an ever-growing and alternative financing opportunity. Secondly, to critically analyse the legal readiness of the EU and its respective national jurisdictions to regulate Sharia-compliant financial institutions in domestic and European economies.
2. Sharia finance
Sharia-compliant finance represents a class of financial services which adhere to strict Islamic economic principles. The model of finance is structured in such a way as to comply not just with the law of contract between the parties but also with the canon law of Islam. It emerges from a number of sources such as the holy book of Islam (Quran), the authenticated sayings and actions of Prophet Muhammad (Sunnah) and rulings or interpretations by Islamic scholars (Fiqh). This is defined by the IMF as being a financial structure which ‘does not permit receipt or payment of interest (riba), excessive uncertainty (gharar), gambling (maysir), short sales or financing activities that it considers harmful to society.’12 By many it is deemed to be an ethical means of finance which is founded on a fair division of risk, avoiding economically wasteful activities and not exploiting the weaker party. Indeed, the transaction must be proven to have a genuine economic purpose, otherwise be prohibited.
The standpoint of these prohibitions is the ideological principle that financial gain ought to be the result of a proportional supply of work effort or some other factor of production. Furthermore, it seeks to encourage business partnerships where the risk is equitably and proportionally divided. Journalist Timothy Spangler claims that despite its inevitable shortcomings and pitfalls, it has the potential to feed in to a sustainable economic system.13
3. Islamic Financial Instruments of Ship Finance
The Sharia compliant products mostly resorted to by players in the shipping industry are: Murabaha (cost plus finance), Istisna (procurement), Musharaka (profit and loss sharing), Ijara (lease finance) and the Sukuk (Islamic bonds). These are asset-based instruments founded on the principle of diminishing and dividing risk.
3.1 Murabaha finance (Cost plus finance)
This type of finance takes place when a client (borrower) interested in acquiring an asset, such as a ship, requests the bank (lender) to purchase it in its own name, possibly through an agent. The client and the bank enter into a Murabaha agreement which specifies the conditions of the relationship between the two parties. Namely that the bank shall purchase the asset immediately and the client shall buy the asset from the bank at a specified price. This price is the sale value of the ship plus a profit margin as established by the bank. The profit margin is determined in accordance with the level of risk the bank is incurring and it is typically adherent to international reputable indices such as the London Interbank Offered Rate (Libor) or Euro Interbank Offered Rate (Euribor).14 Once the asset is purchased by the bank, it is sold to the client according to the conditions of the agreement. The client may pay either in instalments by a specified date, or in one lump sum on an agreed future date. Whilst similar to conventional banking, Islamic scholars disagree it is one and the same since there is no interest charged for the use of money. It is a profit charge as result of rendering a service which is that of risk assumption by the bank.
There are three main risks associated with this type of finance. Firstly, the risk that the client refuses to purchase the asset from the bank. This is dealt with through a promise of purchase agreement and the payment of a security (an earnest deposit). Secondly, if the client is late on payments, the bank cannot charge them any ‘late fees’ since this is prohibited under Sharia law. However, it may compel the client to carry out a set of payments to charity which has the same deterrent effect as a ‘late fee’ despite neither party benefiting from it. Lastly, in cases of default of the client, the bank is allowed to take possession of securities in order to make good for the expenses. It is also possible to make use of an Islamic insurance policy known as Takaful to balance out the risks associated with potential default.
3.2 Istisna finance (Procurement)
In many respects, it is similar to Murabaha finance but it is typically preferred in relation to shipbuilding projects. The Istisna agreement is essentially a cash sales contract based on the promise of future delivery of an asset which is in building phase at the time the contract is drawn up.15 In this particular structure, the ship-owner (the borrower) independently negotiates the building of a vessel with a shipyard (the manufacturer) and subsequently requests that a bank (the lender) enters into an Istisna agreement with the shipyard. This agreement reflects the pre-negotiated conditions whilst recognizing the bank as the one financing the project instead of the borrower. Having said that, the Istisna agreement also outlines the relationship between the borrower and the bank. The bank pays the instalments required for the building of the ship under the conditions of the agreement. However, once the ship is completed, it is sold to the borrower at a pre-agreed price, or in some cases, it is leased out to the borrower under another Sharia compliant contract which is Ijara.
Due to its similarity to the Murabaha finance, the same risk management solutions apply.
3.3 Ijara finance (Lease)
Under this structure, the usufruct of an asset (e.g. a vessel) is passed to another party (the lessee) against a periodic rent payment, with an option to buy the asset at the end of the lease period.16 This does not apply to financing shipbuilding since the asset in question must already be in existence at the time the Ijara contract is entered into. As with typical lease agreements, the ownership rights and all related responsibilities remain vested with the lender (the person leasing out the ship).
This structure of finance starts with the lender establishing a special purpose company (SPC). The bank (lender), through the SPC, enters into an agreement with the client (borrower) to purchase an asset such as a ship. Subsequently, once the ship is in the ownership of the SPC, an Ijara agreement is entered into between the borrower and SPC establishing the borrower as the agent responsible for the management, maintenance and insurance of the ship. Furthermore, the borrower also enters into an agreement of purchase with the SPC for the purchase of the ship at the end of the lease period or at another future date. In the meantime, the borrower pays the lender a lease fee adhering to international indices such as Libor or Euribor. In the end stage, the ship is meant to be transferred from the ownership of the SPC to that of the borrower.
There are many risks associated with this kind of finance. For instance, the borrower’s refusal to lease the ship after the lender has purchased it can be circumvented by entering into a promise of lease agreement by binding the borrower to the action of leasing the ship from the lender. In the event the borrower defaults on payment during the period of the lease, the lender may use any securities or collaterals to make good for the default. Furthermore, a matter of interest for both parties is the risk of major structural damage that a ship is exposed to throughout its life. This is typically mitigated by ensuring that the borrower takes out Takaful insurance on the ship. In the event that there is an early termination of the lease, the ship may be sold on the open market. Furthermore, there is the risk that the borrower misuses or damages the ship. One of the ways that the lender can ensure that borrower is making good use of the asset is by compelling the borrower to issue a trust receipt in favour of the lender. This document binds the borrower to make use of the ship as a trust. Subsequently, the lender may ensure that the borrower purchases the vessel at the maturity of the agreement by entering into a separate promise of purchase agreement to this effect.
3.4 Musharaka finance (Profit and loss sharing)
This structure is not as perfect of a fit for the financing of vessels as the previous structures. Regardless, it still has a level of flexibility that may be applied to the financing of marine assets. It is mainly applied to finance the purchase of second-hand ships. Under this structure, all the parties who have a share in the transactions are liable to share the risks associated with the transaction and to divide the profits in accordance with their share of capital initially contributed; their equity interest.
A Musharaka agreement is entered into between the lender and the borrower. It states both parties’ intent and the amount of their respective contributions for the purchasing of a ship. This agreement also states that once the ship is bought and delivered it falls under the ownership of the borrower. The losses each party is liable for are also specified in the agreement which are typically, established according to their equity interest in the transaction. The borrower’s role in the Musharaka partnership is that of an appointed trustee of the partners as well as the technical partner. Both the lender and the borrower pay their afore-mentioned shares to the seller of the ship. The Musharaka agreement also stipulates a bareboat charter agreement between the borrower and a third party. Once the ship is delivered and chartered out, the payments received by the borrower from the chartering agreement are used to purchase a greater share of equity under the Musharaka agreement until the lender is bought out.
This structure is subject to two main risks. Firstly, the partners to the Musharaka agreement may be negligent in taking care of the assets, or they might be guilty of a breach of contract. Typically, the lender may request that the borrowing partners of the agreement dedicate a number of securities to the benefit of the lender in cases of misconduct of breach of contract. Subsequently, it may also impose on the borrowing partners the duty to make certain charitable payments as a means of deterrence. Secondly, there is the risk that the assets of the agreement are lost. The Takaful insurance is a solution to this end.
3.5 Sukuk finance (Islamic bond market)
This type of finance is the one that had the biggest success on the European market.17 It is also employed when significantly larger funds are required. The Accounting and Auditing Organization for Islamic Financial Institutions’ (AAOFI’s) defines the Sukuk market as “certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”.18 The subject matter of this type of finance is the buying and selling of ownership in an asset rather than it being a capital loan. Whilst the structure of the Sukuk finance is typically based on that of Ijara (lease) as a result of the assets being immovable in nature, it has been increasingly employed in situations where the subject matter is a financial contract. There are two types of Sukuk structures which may be used for financing of the ship industry. One is called Sukuk Al Ijara and the other is Sukuk Al Istisna.
Under the Sukuk Al Ijara structure, a special purpose vehicle (SPV) is created by the lending institution. The lender, through this SPV may declare a trust in favour of the investors who contribute capital in exchange of Sukuk certificates at pre-agreed price. The borrower then transfers the title of the asset to the SPV which, in turn, leases it back to the borrower who must pay rent on the asset. This leads to the borrower entering into a contractual agreement to purchase the asset back at a future maturity date. The rent paid by the borrower to the SPV is used to provide the investors with a return on their initial contributions. Upon maturity of the agreement, the borrower must buy the asset at the purchase price and the Sukuk certificates are redeemed.
The second structure of the Sukuk, is ideally used for financing the building of marine assets. Sukuk Al Istisna essentially starts off the same way as Sukuk Al Ijara. It is based on the existence of an SPV set up specifically for this end. The lender issues certificates at an agreed price which investors buy. The funds at the disposal of the SPV are then used to fund the building of the marine asset. Once the asset is completed, the SPV becomes its owner and the borrower may purchase the vessel or lease it. The respective payment owed may either be carried out in instalments or in one lump sum. The proceeds of the sale transferred to the SPV in exchange of the ownership title over the asset are then distributed to the investors of the Sukuk agreement.
4. Legal and practical considerations of Sharia compliant finance
Despite many European countries successfully engaging in Sharia compliant financial products, there are various practical and legal considerations which must be given importance. These often act as deterrents to classic lending institutions even though they are proven to be cost efficient.
For instance, it is evident that one way that conventional finance is rendered Sharia-compliant is by having the lender take up full or partial ownership of an asset before selling it or leasing it to the borrower. The question of ownership and the legal obligations attached to it is a matter of concern mainly to the lender. For instance, responsibilities of repair and maintenance temporarily fall on the lender. This results in the lending institution having to assume the risks of ownership between the time of delivery of the asset and the time when the borrower buys it from the lender. Expenses which fall on the lender typically reflect back onto the borrower and is detrimental to the overall competitiveness of the lender. Whilst Takaful insurance policies may be taken out to circumvent this19, an a priori solution would be forum shopping. In practice lenders are aware of this risk, therefore they set up their special purpose vehicles (SPV) in favourable jurisdictions. This is why there is a significant amount of SPV companies pertaining to Sharia-compliant funds in jurisdictions such as the British Virgin Islands and the Cayman. The process of offshoring is in accordance with Sharia principles of fairness and equity since it significantly decreases the likelihood of conflicts and puts both lending and borrowing parties on equal footing. However, on a more concrete basis, offshoring is advantageous to Sharia-compliant finance because of the strong business-friendly political foundation of offshore centres, favourable regulatory frameworks and legal systems based on English law. Supporters of offshoring argue that these jurisdictions are also advantageous because they adhere to international standards of investor protection and anti-money laundering (AML) frameworks. However this point is largely debated.20
Taxation is a matter of great concern to both lending and borrowing parties. Therefore, setting up the structures in financial offshore centres that are tax-neutral or tax-free is an added push for institutions to engage in forum shopping. Whether it be a matter of taxing incoming profits or charging VAT, the additional charges are passed on to the borrowing party which act as a deterrent. Any opportunity which allows for decreasing or eliminating tax is helpful to establish a strong financial product.21
As mentioned, English law is preferred when specifying the governing laws of a Sharia-compliant finance document. The governing law of any contract should provide a level of certainty and clarity of rights and obligations. According to the Rome Convention22, parties are allowed to specify the governing law of a contract provided that it is codified law of a country. Hence, Sharia law cannot be specified as governing law since it is not codified. This brings about a conflict of laws in terms of applicability and compliance, especially in instances where Sharia-compliant finance prohibits something which is allowed in the governing jurisdiction. The issue was dealt with in the landmark case Shamil Bank of Bahrain EC v. Beximco Pharmaceuticals Ltd.23 This case dealt with a conflict of governing law in a Murabaha agreement. The agreement stated that it is “subject to the principles of the glorious Sharia, [and that] the agreement would be governed by and construed in accordance with the laws of England”. Beximco Pharmaceuticals Ltd. claimed that the agreement consisted of a hidden interest (usury) which would be in violation of Sharia law. In the first instance, the courts had to analyse whether Sharia law had to be considered instead of UK law, or whether both could apply in conjunction. The court decided that, besides the conditions found in the Rome Conventions requiring that the governing law be the codified law of a country, there could only be one governing law to an agreement. This eliminated the possibility of both laws applying and creating a conflict. Subsequently, the English court affirmed that the introduction of two governing laws meant that the parties did not explicitly agree on the contract being governed by Sharia law. This reluctance and near impossibility of English courts to apply principles of Sharia-law has pushed parties to contracts to solely specify the law of the UK as governing law. This, however, is taken from a European perspective. It is worth noting that other jurisdictions such as that of New York are also sought after.24
Another conflict of laws occurs in relation to the Murabaha agreement and the English Sales of Goods Act 1979 and the Unfair Contract Terms Act 1977. The Murabaha agreement consists of the very thing which both Acts look upon unfavourably. Namely, in so far as indemnities are involved.25 This is to show that the structuring of Sharia-compliant finance in foreign jurisdictions is not an easy task. One way to reconcile Sharia law with a foreign jurisdiction is to renounce the right to any Sharia based defences within the contractual agreement. Having said that, this must go through a Sharia Board which is appointed to oversee that financial products and bank policies adhere to Sharia principles.
A Sharia board (consisting mainly of Sharia scholars) is engaged in order to study and scrutinise both the overall bank policy and specific products or transactions. This is a requirement in order to achieve the status of ‘Sharia-compliant’ financial product. Due to the fact that this status is awarded based on scholarly interpretation, it may not be in line with the needs and expectations of the parties seeking funding. In these cases the board must be sufficiently competent to provide sound arguments and solve any disputes at the outset. These boards are overseen by international organizations such as the “Accounting and Auditing Organization of Islamic Financial Institutions” (AAOIFI) and the Malaysia International Islamic Finance Centre in Kuala Lumpur.26
5. Concluding remarks and areas of further research
There is a clear and increasing demand for Sharia-compliant financing structures. Europe is notoriously open and opportunistic. Its history in shipping and strong legislative framework makes the collective of its jurisdictions attractive to the setting up of funds. Muslim investors are reaching out, as are stakeholders in the shipping industry. Europe is simply acting as the meeting ground between the two. The concerns of the IMF for jurisdictions to create a regulatory framework for Sharia-compliant funds is dealt with by states on a domestic level. Leading European jurisdictions are altering and broadening the clauses regulating their conventional markets rather than introducing new and complex rules for the Sharia-compliant funds. The biggest issue in relation to Sharia-compliant ship finance is the setting up of the financing structures and dispute settlement. Keeping the Sharia-compliant fund agreement within one jurisdiction makes matters much simpler and drastically decreases the possibility of legal conflict. However, by nature, shipping and the contracts which come with it, are anything but limited to one jurisdiction.
This paper brings to light two additional areas of research. Namely the study of forum shopping in relation to the setting up of SPVs and its impacts on the shipping industry, as well as a critical analysis of the Sukuk bond being introduced in the monetary policy of the EU. Both are a worthwhile scholarly pursuit and would contribute to furthering our understanding of Sharia-compliant funds and its future as a stable source of maritime finance.
References: 1 World Trade Organization, World Trade Statistical Review, 2016. 2 Kalgora, B. and Christian, T. (2016) The Financial and Economic Crisis, Its Impacts on the Shipping Industry, Lessons to Learn: The Container-Ships Market Analysis. Open Journal of Social Sciences, 4, 38-44. 3 Meenaksi, Bhirugnath, “The impacts of the global crisis 2008-2009 on shipping markets: a review of key factors guiding investment decisions in ships” (2009). World Maritime University Dissertations. 212. 4 INCE&CO International Law Firm, business & finance SHARI’A COMPLIANT METHODS FOR THE FINANCING OF SHIPS, <http://www.incelaw.com/cn/documents/imported-documents/pdf_library/strands/business/shariaship-finance.pdf> (accessed on 1 December 2017). 5 Ibid. 6 IMF Survey 2010: Islamic Banks: More Resilient to Crisis?, <https://www.imf.org/en/News/Articles/2015/09/28/04/53/sores100410a> (accessed on 5 January 2018). 7 Joseph N. (2015) Islamic Finance in Shipping: Dawn of a New Reality. In: Schinas O., Grau C., Johns M. (eds) HSBA Handbook on Ship Finance. Springer, Berlin, Heidelberg. 8 RFiGRB Global Retail Banker, <https://www.rfigroup.com/global-retail-banker/news/uae-global-islamicfinance-reach-us65-trillion-2020> (accessed on 23 December 2017). 9 Financial Times, UK Sukuk bond sale attracts £2billion in orders (2014), <https://www.ft.com/content/7c89467e-fc4e-11e3-98b8-00144feab7de > (accessed on 5 January 2018). 10 Deloitte, Luxembourg: the gateway for Islamic finance and the Middle East, May 2017. 11 Gulf Business, Why Islamic Finance is picking up in Europe, July 2016 <http://gulfbusiness.com/islamicfinance-in-europe/> (accessed on 1 December 2017). 12 International Monetary Fund, Islamic finance and the role of the IMF, February 2017, <http://www.imf.org/external/themes/islamicfinance/ > (accessed on 5 January 2018). 13 The Guardian, Could principles of Islamic finance feed into a sustainable economic system?, October 2013, <https://www.theguardian.com/sustainable-business/islamic-finance-sustainable-economic-system > (accessed on 1 December 2017). 14 Ibid. 15 Ibid. 16 Ibid, pg 332. 17 Ibid. 18 Ibid. 19 Ibid. 20 Joanna Hosack, Why Islamic finance and offshore financial centres go hand in hand, March 2016 <http://www.harneys.com/publications/articles/why-islamic-finance-and-offshore-financial-centres-go-handin- hand >(accessed on 5 January 2018) 21 Ibid. 22 Convention on the Law Applicable to Contractual Obligations 1980, art. 3.1. 23 Kaul&Narciso,2016, Clash of Jurisdictions: Applicability of Islamic financial principles under UK law, Lexology <https://www.lexology.com/library/detail.aspx?g=ceb68949-cc02-4176-ae65-e5296286a24c>. 24 Ibid. 25 Ibid. 26 Ibid.
