Islamic Finance Focus Group


Comments upon MFSA Consultation Document

“Islamic Finance in Malta – Application to Banking and Securities”

Legal aspects – Dr. James Muscat Azzopardi B.A., M.A., LL.D
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Introduction


Dr. James Muscat Azzopardi has been commissioned by the MIM and the MUBE to draft a legal reaction to the MFSA’s Consultation Document on Islamic Finance in Malta.

. The comments are numbered according to the relative Chapters within the Consultation Document for ease of reference.


1. Chapter 3 - Sharia Principles and the Islamic Economic Model


The Consultation Document includes a brief summary of the basic principles that form the basis of Sharia law regarding commercial transactions. We would like to point out some other points to be taken into consideration in this regard – our comments will highlight both positive as well as negative issues.


1.1 Positive Aspects


First of all, the Focus Group points out that Malta’s decision to embrace Islamic finance will be perceived as a political issue as well as a financial and legal decision. This decision is seen as a positive step in terms of inclusion - the setting up of a regulatory system that includes the possibility of Islamic finance will allow Muslims to access markets that have until today been solely based upon Western principles. This approach has been followed both by the FSA in the UK as well as by the Federal Reserve in the US, in accordance with the principle that all citizens should be allowed to fully observe their religious convictions (unless contrary to public policy).

We are aware that the decision to promote Malta as a centre for Islamic finance will also lead to a concerns regarding terrorist finance. However, we see this as a positive rather than a negative issue – Malta is today known to be a reputable jurisdiction and the MFSA has an excellent reputation in addressing concerns regarding the source of funds. It is naturally far easier to control funds that are domiciled in reputable jurisdictions, as has been the case with London.

Islamic finance is also attractive to non-Islamic investors who are seeking ethical investment, also referred to as Socially Responsible Investment (SRI). Such investors are attracted by the prohibition of investment in morally questionable activities such as the gambing and betting industry or the pornography industry.

1.2 Concerns

The decision to allow Islamic finance also leads to other concerns, principally about the lack of certainty surrounding the principles of Sharia law and in relation to issues of corporate governance, especially in relation to the role of the boards of scholars that decide upon the interpretation of Sharia law.

i. Legal Uncertainty

Unlike the Western systems of civil and common law, Sharia law remains largely subject to varying interpretations, and this leads to legal uncertainty. A particular transaction may be deemed to be Sharia-compliant by one Board but rejected by a different Board.

This uncertainty is outside the scope of the MFSA and of Maltese legislation, but the Focus Group is concerned about the possibility that any disputes about structures that are set up in Malta may have a negative effect on Malta’s reputation as a financial services centre, especially if the structure is internationally well known.

A lack of certainty may also lead to loss of consumer confidence in products offered by credit institutions. In extreme cases, a lack of defined rules regarding Sharia compliance or otherwise may lead to a sudden and general lack of confidence in a credit institution should the institution enter into a transaction/s that may be viewed by certain scholars as being contrary to Sharia principles.

One possibility is that of introducing legislation whereby all contracts are regulated by a recognised and approved law, such as the law of an EU member state. Indeed, several Islamic transactions are today regulated by UK law. It would then be up to the parties to ensure that their relationship is compliant with Sharia law, however Maltese Courts will be able to decide on the transaction by applying Maltese law.

ii. Role of Sharia Supervisory Boards.

It is clear that the MFSA is not in a position to decide upon whether a proposed structure is compliant with Sharia law – this would be up to the Board of Islamic scholars, usually known as the Sharia Supervisory Board (SSB).

In brief, the Focus Group is concerned at the corporate governance issues that arise as a result of the influence on a credit institution that is exercised by a Board, which Board is itself unregulated, unsupervised and unaccountable.

The Focus Group is also closely following developments in London, and shares the FSA’s concern about the precise role of these Boards. The FSA currently examines whether the role of the SSB is executive or advisory – the FSA’s concern being that an executive role may lead to issues relating to the fitness or otherwise of the advisors and possible conflicts of interest if the same SSB is advising several different structures.

The SSB is responsible for verifying that all banking operations are practised in accordance with Islamic law. Thus it has the authority to reject any application or project that is believed to be in contradiction with Islamic law. The Focus Group is concerned that this may lead to a situation where the SSB exercised an unhealthy measure of discretion over a credit institution’s commercial decisions, which may ultimately be prejudicial to shareholders. The integrity of a credit institution is therefore directly dependent on the integrity of the SSB, but the SSB will not be regulated by the MFSA.

Another concern is the possible issue of conflict of interest - in a relatively small jurisdiction such as Malta, credit institutions will be depending on the same SSB, who will therefore be provided with detailed information about transactions carried out by different institutions.

The Focus Group is also concerned about the increased risk of insider trading associated with these Boards, especially in view of the fact that the SSB are not regulated per se.

The Focus Group recommends that as far as possible, the MFSA attempts to ensure that the role of the SSB is clearly defined and is well-known to customers, in light with the Basel II requirements regarding transparency, as discussed below.



iii. Transparency and Corporate Governance

Another of the Focus Group’s concerns relating to the role of the SSB is that of transparency. Article 809 of Basel II states that market discipline requires measures that “allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.” The MFSA is to ensure that Islamic Banking institutions that are licensed in Malta keep customers fully informed about the principles that govern the Bank’s governance. Any uncertainty regarding the interpretation of Sharia law will inevitably lead to uncertainty about the corporate governance of Islamic Banks. We will address this concern in further detail in due course.










2. Chapter 4 – Islamic Banks and Financial Institutions


2.1 Musharaka: Joint Ventures/Equity Participation

The Focus Group has several concerns regarding musharaka transactions, especially in regard to corporate governance and project risk. One concern is the potential liability of the financial institution in the eventuality of insolvency of the joint venture. Will banks be required to ensure that all liabilities are immediately accounted for?

One must also consider the possibility of Maltese Courts piercing the corporate veil (vide recent judgements in Price Club cases), which would lead to the Bank being held to be liable for any debts incurred by the joint venture. We recommend that the MFSA ensures that these concerns are adequately addressed while enabling musharaka transactions, and we also recommend that the MFSA retains the current limitations on credit institutions’ funds being invested in other companies as arising from the Banking Act.

We note that the MFSA intends to “review these requirements in order to determine whether they should be retained/revised in view of the above operational structure of a Sharia Institution”. The Focus Group recommends that the requirements are not changed specifically for Islamic banks – there cannot be any discrimination between Islamic or other credit institutions, as this would naturally be unfair on non-Islamic institutions.





2.2 Mudaraba: Profit Sharing

These types of transactions lead to the credit institution’s association in the risk factors inherent in the borrowers’ business, and as regulator the MFSA is to ensure that this risk is adequately catered for.

It is very important to point out that under the traditional view of mudaraba, customers who “deposit” assets in an Islamic credit institutions are not depositories but are effectively holders of profit-sharing and loss bearing investment accounts. Indeed, in a typical Islamic bank structure, these accounts make up the majority of the assets that are available to the Bank for investment.

However, holders of these accounts do not enjoy any governance rights, although they are effectively shareholders in the credit institution. In fact, there is a considerable difference between the rights enjoyed by actual shareholders in the credit institutions and those enjoyed by customers, who as we have seen are effectively shareholders since they participate in any profit or loss by the institution.

The Focus Group has also considered the difficulty that arose in the UK regarding the definition of a deposit. Under our Banking Act, a deposit is defined as “a sum of money paid-in on terms under which it will be repaid, with or without interest or a premium and either on demand or at a time or in circumstances agreed by or on behalf of the person making the payment and the person receiving it”. However, under a typical mudaraba contract the customer is required to accept the loss of the capital.

The FSA’s solution was to require the credit institution in question to state that all its depositors were entitled to full repayment of all deposits. The customer would then enter into a voluntary agreement whereby he/she would accept to relinquish to the right to full repayment.

Finally, the Focus Group highlights the concern regarding the compatibility of mudaraba transactions with Basel II requirements regarding the necessary mechanisms for effective discipline over the governance of the credit institution.



2.3 Murabaha: Cost Plus Contracts

The Consultation Document has already mentioned the risk factors associated with the ownership of the assets by the credit institution.

However, it is our view that murabaha contracts will be facilitated in Malta by our system of hypothecs as security over assets, as opposed to jurisdictions where the only security allowed in the actual pledging of the assets in question.

In fact, the Focus Group is of the opinion that from the legal point of view a murabaha transaction is not that different from a traditional loan secured by a hypothec over property, apart from the question of transfer of ownership – until a loan that is secured by a hypothec is paid, a credit institution in Malta is effectively the owner of the property in question, and may exercise the right to such ownership in the case of default on loan repayments.

The similarities and differences between murabaha transactions and Maltese Civil Law provisions relating security for loans deserves more detailed study.

2.4 Bai’ muajjal: Deferred Payment Contracts

We note that the Consultation Document has already addressed the two principal legal concerns associated with this type of transaction – the operational restrictions imposed by the Banking Act and the necessity of drafting legislation that will avoid the imposition of additional stamp duty on the extra transaction.







2.5 Ijara: Leasing

In the view of the Focus Group, as long as a transaction is treated by an Islamic credit institution as a finance lease, then this type of transaction should not create any significant legal obstacles in light of current Maltese legislation. However, this will depend on the particular interpretation of Sharia law that is applied - according to certain interpretations, the bank as lessor in an ijara transaction is to be exposed to a significantly higher level of operational risk than a lessor under a conventional finance lease.

The Focus Group recommends that the MFSA ensures that contracts relating to ijara transactions are based on standard deeds that are compliant with Maltese law relating to finance leases.

One must keep in mind that the concept of an Islamic contract is fundamentally different from the common law/civil law notions regarding contracts. This is a general observation, and does not only apply to ijara leasing. Islamic contracts are to be based on equality, and it is fundamental that the different options available to each party are included in the contract. This implies that a party may avoid the transaction that is the object of the contract even after the contract has been signed – this is a notion that does not fit in with the Maltese legal system and this is why we are recommending the use of Maltese law in regard to products to be licensed by the MFSA. An Islamic contract may also be null if it is found to result in riba or gharar – generally translated as interest and inequality or uncertainty.

The Focus Group also points out that Ijara leasing (including an ijara with diminishing musharaka) may lead to civil law issues relating to creditors’ rights in the case of insolvency of the purchaser/lessee – there appear to have been no reported cases in the UK until now, but we look forward to this issue being clarified by UK courts in due course.


2.6 Bai’Salam: Pre-Paid Purchases of Goods

The Focus Group is concerned about the level of risk that is associated with this type of transaction – as we are dealing with commodities, the principal risk is the price risk in case of default. Again, this risk is to be assessed in the light of the requirements of Basel II.

2.7 Bank Accounts

We have already addressed our concern in this regard in Section 2.2 above.


3. Chapter 5 – Sharia Funds


The Focus Group agrees with the position taken by the Consultation Paper – as long
as Sharia-compliant funds confirm to the requirements set up by Maltese law, such funds are to be allowed to set up as PIFs. The question of whether the funds are Sharia compliant or otherwise is strictly outside the remit of the MFSA, for obvious reasons.

However, this is another area where the role of the SSB (as well as the extent of influence) is to be clearly defined when structuring and licensing the fund in Malta.










4. Chapter 6 – MFSA’s approach to authorisation


The Focus Group strongly recommends following the approach taken by the FSA in this regard. This recommendation is based on the fact that Malta is in a similar position to the UK – a non-Muslim country attempting to accommodate Sharia compliance within a common law jurisdiction. We are following developments in other centres of Islamic finance such as Dubai and Bahrain, however these developments are of limited relevance within the local scenario. Notwithstanding the above, one cannot ignore developments in Malaysia, since Malaysia has proven to be remarkably innovative in the field of Islamic finance - in 2005 Malaysia issued the world's first rated Islamic residential mortgage backed securities, and in 2006, the world's first listed Islamic Real Estate Investment Trusts (REITs).

The recent paper on Islamic Finance in the UK, published by the FSA in November 2007, describes the FSA’s approach as “non-discriminatory” and correctly points out that it would not be fair for the FSA to vary its standards for any one type of operation. We recommend that the MFSA adopts a similar attitude, summed up by the abovementioned paper as “no obstacles, but no special favours”.

In fact, as long as properly regulated, Sharia compliant structures may prove to be ultimately even safer that conventional financial products. Apart from the normal KYC and anti-money laundering provisions, professionals working on Sharia compliant products are also required to carry out a thorough examination of all sources of funds in order to ensure Sharia compliance, and this may be considered to be an extra level of filtering. The prohibition of any funds coming from the gaming and alcohol industries is also an advantage, as the gaming industry is well-known for its high prevalence of money laundering opportunities such as online poker rooms.

The Focus Group feels that it is in the interest of the MFSA to issue clear guidelines about the possibilities of structuring Sharia compliant products in Malta. This will allow the promotion of Malta as a possible jurisdiction for Sharia compliant products.




Dr. James Muscat Azzopardi
Muscat Azzopardi & Associates