As discussed last week, by entering into a management agreement, the appointing partners continue to remain fully responsible for the acts of the partners appointed by them as their agents to manage the Musharakah affairs on their behalf. This is true to the extent that the appointed partners adhere to the management agreement terms.
The Shariah principles on a Musharakah contract stipulate that by default, all partners are agents of one another, even in the normal situation where all are jointly contributing to the efforts of running the Musharakah affairs. Therefore, the management agreement shall entail the situation of double agency for the appointed partners. Nevertheless, it is important to note that nothing changes from a Shariah perspective, except that the appointing partners are not opting to get fully involved in the day-to-day Musharakah operations and have assigned this responsibility to the appointed partners, which is perfectly alright.
What if the appointed partners breach any of the management agreement terms? The appointing partners may allow them to remedy the situation within a specified period of time and upon redressing the abnormality, the management agreement shall continue unabated. Nonetheless, if the remedial period expired without repairing the irregularity, the management agreement shall stand terminated.
Fine. Then what? Any thoughts? Have you heard of a term called ‘cross default’? It is profusely found in the conventional bond, syndication, club deal or even bilateral loan documentation signed by the borrower with the lender institution. The cross default clause in a loan agreement triggers a situation where the borrower is assumed to have defaulted in a particular loan transaction which is running normally, if he has defaulted on any other obligation with the same lender or another lender.
An example of a cross default is that a business entity shall automatically be considered as a defaulter on a recently obtained import loan from Bank A if it could not pay the installment of a term loan with Bank B due to any genuine reason, such as a delay in realizing the trade receivables, which is beyond its control.
So what is the treatment of a cross default situation in Islamic finance? Let us return to the default in the management agreement described previously. If we apply the classic Fiqh approach, the cross default does not apply here since the termination of the management agreement shall result in the appointing partners returning to their original position of playing an active role in the running of the Musharakah affairs whereas the appointed partners shall no more be fulfilling the additional responsibility of working for the appointing partners. In other words, if there is a default in one agreement, as per the traditional Shariah position, it will not unnecessarily reflect on the other transactions the obligor may have entered into — and performing normally.
Then why do we find the cross default provision in the documentation for almost all Sukuk and syndication and the other Islamic financing transactions? This is mainly due to the fact that the documentation for such transactions are prepared by the same law firms which are overwhelmingly occupied in preparing the conventional loan documentation where the odds are routinely staked against the borrower.
In my previous role in Islamic financing advisory, I had submitted the matter to the learned Shariah scholars for an Islamic consortium finance transaction documentation I was advising. The guidance was plain and simple which is that the Shariah requires each contract to be independent of the others and no interdependence (which is the norm in conventional finance) of different contracts is permitted in the same way as the Shariah principles do not allow combining two or more contracts into one.
I remember the Shariah position had become a point of contention since some of the conventional banks which were eager to participate in the high profile Islamic transaction had insisted on the inclusion of the cross default provision on the grounds that they would not get clearance from the internal legal team if the clause is not added to the documentation.
The members of the bank’s Shariah board internally debated the matter and agreed with a majority vote to allow the insertion of the cross default clause in the Islamic consortium transaction documentation as a special case so as to break the stalemate and complete the transaction in the interest of time but only after getting the written confirmation from the obligor that it has no objection to it, and that it is willing to be exposed to the risk of settling the finance prematurely should it happen that it defaults in any of its other financial commitments elsewhere, be they Islamic or conventional.
Since then, the cross default provision has started to appear in Islamic finance documentation although, in my personal opinion, it is akin to accommodating an alien in your household.
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].