As the Shariah addresses human activity generally, so does Islamic finance – in principle particularly – go beyond mere technicalities and legalities, urging a concern for all of creation as service to the divine Islamic tenets, for example, promote honesty, transparency and fairness, express concern for the well-being of employees, partners and counterparties, and place certain limits on monopoly and wealth concentration. These more general principles, along with the detailed legalities, fit together within the purpose of Islamic law: securing benefit and preventing harm.
The US is not normally considered among the most significant markets for Islamic finance. And to date, governmental and regulatory efforts to welcome and integrate Islamic finance into the prevailing system have not been as conspicuous as those made by certain other western nations such as the UK.
But there are, in fact, important regulatory efforts and successes that continue to allow Islamic finance to innovate and succeed in the US. Many of these achievements have had an impact on Islamic finance globally.
This article explores the compatibility and challenges of implementing Islamic financial – legal principles within the US regulatory framework as well as the innovation that has taken place in overcoming some of these challenges.
Compatibilities and Tensions
As an industry in the US, Islamic finance has a straightforward, practical objective – to conduct business transactions profitably and responsibly. Those concepts are defined by Islamic norms; the concern does not affect policy shifts. In transacting, Islamic parties do, of course, carefully and diligently seek to comply with applicable US laws. Such an objective renders compatibility with US laws, at the outset, an achievable task.
The US Islamic finance market may be subdivided into two segments: One segment we might term the wholesale or foreign institutional market. Here, we mostly see foreign Islamic institutions and investors targeting the US with real estate acquisition and construction as well as corporate acquisition in the form of leveraged buyouts. Less frequently, we see growth equity type investments and through private investment funds and similar structures. This segment also consists of domestic institutions offering Islamic products.
The second market segment consists of a retail market where American needs are identified and addressed (often self-addressed) to enable the acquisition of homes, retirement savings and general consumer banking in accordance with the tenets of Islam. Overlap between these two segments is rare and has taken place, for example, in the form of multinational financial institutions offering Islamic products to US persons, as in the recent sukuk issuance by General Electric, and various US asset managers providing products and opportunities to Islamic investors.
Two Legal Systems
It may surprise some to learn that Islamic financial laws and US regulations are not (in our experience and knowledge) wholly inconsistent. In fact, in the financial realm, we find a number of similarities and parallels between the two. There is even research evidencing the origin of many aspects of Anglo-American contract law and trust law in Islamic law.
The introduction of this article spoke of broad purposes of Islamic law and the various subjects upon which it advises. When viewed in this light, we further find a number of parallels between Islamic law and US law, at a theoretical or 'policy' level.
Both legal systems, for instance, share concerns against exploitation and unjust enrichment, seek to preserve and protect property rights, and enact laws to fulfil such purposes.
At a more particular level, we find the detailed requirements of each legal system having parallels in the higher purposes of the other. The importance of honesty, transparency and fair dealing within Islamic law, for example, may be analogised to the rationale and purposes of US securities laws and consumer protection regulations.
Much of the challenge in the US vis-à-vis Islamic finance does not come from conflicts of law but from varying business practices and expectations, as shown below.
The Shariah has a broad freedom to contract, and some interpretations have it broader than others. Consent and the rights of the parties are critically important, and the subject of the transaction must not be prohibited by Islamic law.
Similarly, US contract law affords a broad freedom to contract so long as the subject matter is not prohibited by US laws. While one can certainly argue that what are prohibited under US laws are fewer than that under Islamic law and these differences represent a significant 'philosophical' difference, practically speaking, there is generally little difference when transacting.
Moreover, what is prohibited under Islamic law is not generally, if ever, required by US contract law. Consequently, we find this breadth and close agreement between the two legal systems allowing parties to engage in Islamic transactions and to come to such terms as the parties may agree.
As many Islamic transactions contractually stipulate US laws (such as Delaware of New York) as governing, it is hoped that parties may take comfort that the US courts have generally been enforcing the agreements and documents as written.
The most conspicuous features of Islamic finance are its prohibitions of gharar and, more so, riba. It is usually because of these two prohibitions that many view Islamic financial laws and US financial laws as incompatible and diametrically opposed.
But as has been shown by various others, these prohibitions are indeed not unique to Islam and, at the very least, many of the purposes for which such prohibitions are believed to have been legislated are important to the US legal system albeit in differing forms.
Very often, gharar can be alleviated by proper specification of material terms and conditions (such as subject matter, price and time of delivery) at the time of contracting. Such specificity is a common best practice in the US. But the prohibition of gharar has other, sometimes unexpected, implications, resulting, for example, in some derivatives and certain contract provisions such as post-closing purchase price adjustments, being deemed impermissible. The Islamic investor understands that such limits are, per the Shariah, ultimately beneficial and represent potential opportunities for substantive innovation.
Certainly, Islam's prohibition of riba creates some interesting tensions and challenges in the US (and elsewhere). It would be rather difficult to assert that any Islamic party was obligated by US law to engage in a ribawi transaction (except in very limited, narrow instances).
But one could assert that certain laws, namely tax laws and those regulations governing banks as well as prevalent business practice or custom, have created challenges if not outright contradictions at times.
US tax laws give preferential treatment to debt-based instruments and to interest earned on debt which treatment is not afforded to equity. Islam's preference, particularly in the consumption context, to not incur debt and to take on a market or asset risk instead seems to stand in tension with these tax laws.
As such, Islamic parties must decide whether to utilise debt instruments, which might be interpreted and recharacterised by US tax authorities as interest-bearing, to utilise equity structures, or when possible (and agreeable to a conventional counterparty), to not seek the recharacterisation as interest-bearing loans (and thus forego the aforementioned preferential treatment).
Perhaps more significantly, US laws governing banks and banking stand in direct conflict with the notion under Islamic law that to legitimately profit, a financier must bear a market or asset risk and not merely a credit risk. For example, US banks are not permitted to own real estate unless held for their own use or as collateral in connection with an enforcement action. Moreover, as a matter of custom, banks strongly prefer to utilise (their own) standard (and conventional) loan documentation. This customary preference, coupled with the aforementioned regulations, prohibits banks from directly participating in an Islamic financing, and some might argue from bearing the risks required of Islamic law.
This challenge was addressed by the Office of the Comptroller of the Currency (OCC) several years ago in the form of two letters of guidance enabling US banks to participate in Islamic transactions on certain specified terms. These letters stand among some of the most important regulatory successes of Islamic finance, assisting and enabling Islamic finance and creating some of the first Islamic leveraged acquisitions.
Other successes include the New York State Banking Department approving Islamic home financing structures, the board of governors of the Federal Reserve allowing US financial institutions to engage in Islamic transactions in countries where required to do so or where it may be a competitive necessity, and New York tax authorities issuing rulings eliminating the additional taxes which might otherwise result from a Murabahah-based home financing structure. Some of these regulatory approvals might be said to utilise a substance over form approach – which is the subject of an important ongoing debate as the Islamic finance industry matures – and thus setting the stage for the next challenge to be overcome.
A number of other important innovations with global implications have been achieved within the US, often as a result of, or enabled by, the abovementioned regulatory milestones. These include some of the first leveraged private equity buyouts, residential and commercial mortgage financing structures, sukuk issuances using Rule 144A of US securities laws, and the recent Islamic derivatives contract launched by the International Swaps and Derivatives Association (ISDA) with Bahrain-based International Islamic Financial Market (focusing on profit ratio and currency swaps). Certain Islamic transactions have also come before various US courts, including home financings in the recent credit crisis and the East Cameron Gas Sukuk project which is in bankruptcy. It is hoped that these proceedings will provide further information with which Islamic finance in the US can continue to flourish.
Umar F Moghul specialises in banking and finance, private equity and real estate. He has represented many clients in Islamic financing and investment transactions, and is a lecturer in Islamic law at the University of Connecticut School of Law.
This article first appeared in Islamic Finance News (20 October 2010, Volume 7, Issue 42, Pages 14-15). For more information, please visit www.islamicfinancenews.com