The last paragraph of my article 119 needs further explanation. To save you from going back to the article, I append below the paragraph:
‘With reference to my statement that the risk mitigation in Islamic financing contracts is embedded within the contract, and that it does not require any external support, this is to be noted that while Khalid was paying the cost of the property to the Islamic bank in periodical installments, the registered title to the part ownership gradually acquired by Khalid from the bank through such rent payments continued to remain with the Islamic bank till the end of the Ijarah tenure when at that time the bank transferred the title to Khalid through a sale or gift agreement’.
It is a long sentence but let me break it down for the sake of clarity. The first part says that you do not need any external guarantee or security for the Ijarah arrangement entered into between the partners of a jointly owned asset if one partner leases the undivided share of its ownership in the asset to another.
It means that the Islamic bank having leased its part of the Musharakah asset to Khalid shall not need to seek any mortgage or collateral from him in order to secure the bank’s Ijarah exposure. This is because the bank shall continue to hold the same prorated ownership in the jointly registered title from the beginning to the end of the Ijarah term, which was originally acquired by it at the time of entering in to the Musharakah agreement with Khalid.
Further defining this point, as and when Khalid pays the rent installment, a part of it shall be appropriated by the Islamic bank toward the recovery of its investment in the property in a manner so that over a period, the bank is able to redeem the original investment in the property in full. However, it is important to note that while the bank is recovering its equity in the property during the Ijarah tenure, technically its ownership in the property continues to decline. Nonetheless, the registered title representing the pro rata undivided ownership of the bank shall continue to remain stationary at the original level until the successful completion of the Ijarah term. At that time, the bank shall transfer full registered ownership of the property to Khalid.
Assume due to any reason Khalid defaults during the lease term: what shall be the implication on the bank’s funding for the property? Firstly, being an Islamic bank, it should allow reasonable time to Khalid to remedy the situation. If that requires the bank to reschedule the Ijarah term by reducing the amount of monthly payment through the increased number of installments, reducing the variable element of the rent (bank’s profit) or providing a grace period, the bank shall have the Shariah and ethical onus to do so.
Nevertheless, if it turns out that Khalid will not be in a position to meet the revised softer terms too, the Islamic bank shall have the right to dispose of the property in the market at the best available price. In such situation, the bank shall have the first right to recover the balance of its investment in the property including any unpaid variable element of the rent or any major maintenance cost it may have incurred on the upkeep of the property. The residual amount shall be paid to Khalid, which may or may not be equal to his contribution in purchasing the property jointly with the bank.
I purposely did not mention the promise to lease document (see articles 62 and 64) which the Islamic bank may have obtained prior to commencing the lease for the Musharakah property. My reason is that in such a situation where Khalid shall not be in a position to continue paying the rent, how will he be able to fulfil his promise to buy the Islamic bank’s share in the jointly owned property in case of default?
A question, which should come to the readers’ minds, is why the Islamic bank has the priority in appropriating the sale proceeds to redeem not only its remaining original investment but also any unpaid profit amount besides any other eligible cost? Why the sale proceed of the property is not distributed between the Islamic bank and Khalid pro-rata i.e. in the ownership ratio after taking in to consideration the amount of fixed element paid by Khalid till he defaulted, or at least as per the original Musharakah contributory ratio?
The response to all of the above questions is that the Islamic bank entered into the Musharakah transaction at the request of Khalid. Moreover, the bank leased its part of the property ownership to Khalid at the clear terms and condition that in case of default by him, the bank shall exercise the put option provided by Khalid through the ‘promise to lease’ document, unilaterally signed by him. As per the promise to lease document, Khalid granted the first right of redemption of the equity investment in the property to the bank.
Moreover, since the bank’s ownership in the registered title continued to remain at the original level despite Khalid making payment on this count through rent, the bank’s legal position remained over-securitized at all times. Thus, the Islamic bank does not need any outside collateral or guarantee to mitigate the risk of entering in to the diminishing partnership transaction with the client since such risk-mitigation is achieved in Islamic finance from within the structure.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next Week: Explanation on the remaining aspects of diminishing Musharakah shall continue.