Legal and Shariah issues and challenges in cross-border Financing

Issues and challenges

1.  Choice of law

As with their conventional counterparts, Islamic fi nancial institutions shall carefully consider which law is to govern the contracts and the relationship between the parties if, for example, the Islamic fi nancial institution, the client and the asset(s) are located in three diff erent jurisdictions. That’s paramount so as to ensure the contracts are legally binding and the parties can have the
contracts legally and eff ectively enforced. While the issues revolve mostly within these parameters in conventional transactions, Islamic fi nancial institutions will face additional risk due to contractual provisions that would require the contract and the parties to abide by certain Shariah standards in addition to the applicable legal requirements.

Having such a clause in the agreement is necessary and yet it may be challenged. In fact, there are precedents where such a provision was held to be unenforceable by arbitrators (see among others: In re Arbitration Between Petroleum Dev. (Trucial Coast) v. Sheikh of Abu Dhabi, 1 Int’l & Comp. L. Q. 247, 250–51 (Sept. 1951) and Ruler of Qatar v. International Marine Oil Co., 20 I.L.R. 534 (1953)). This risk was tested in an English court in the celebrated Beximco case (Shamil Bank of Bahrain EC v. Beximco Pharm., [2004] WCA (Civ) 19, [1], [2004] 1 W.L.R. 1784, 1787) and the Court of Appeal held the statement to be invalid. Although it is arguable that the decision will diff er today following the introduction of new wordings in the Rome I Regulation, the risk of non-recognition of Shariah or non-enforceability of Shariah principles due to non-compatibility with the lex lociremains

2. Proper forum

Determining the proper forum for dispute resolution is very important in the event the parties cannot have an amicable sett lement. This is due to several factors including to ensure the chosen forum will recognize that the contract is lawful and binding on the parties. Furthermore, the forum should have the authority and mechanism to ensure enforcement. Usually, the rule of thumb is to follow where the asset is. In the case of Shariah compliant fi nancing, however, that may not be the best option in cases where assets are merely used as underlying assets for the transaction and/or where the assets are located in a jurisdiction where Shariah principles are considered foreign. Additionally, Islamic financial institutions should take the additional precaution to ensure that it will not choose a forum where the prevailing view in that jurisdiction is in conflict with Shariah principles and/or the structure applied in the contracts.

3. Taxation

The risk of double taxation is another aspect that the parties have to carefully consider before entering into crossborder fi nancing. In fact, the risk increases when the fi nancing is based on Ijarah (or its variation) or Murabahah where the local law requires the legal transfer of the title to signify ownership and the Shariah board of the entity requires the title to be obtained prior to the subsequent Murabahah sale. The complication that may arise here is that not only taxes may be charged for the act of providing a fi nancing facility, the parties may also be subjected to multiple taxes for each transaction they need to undertake as part of the Shariah compliant fi nancing structure. Unless the parties carefully examine the implication that each part of the transaction structure may pose, it is plausible that the parties may be subjected to taxes from all angles.

4. Other issues

The absence of appropriate Islamic finance law or regulations regulating Mudarabah, Musharakah or Wakalah as a form of fi nancing would make these options less appealing to the industry. Such an absence creates the risk that each arrangement will be subjected to the lex loci parameters which are not necessarily Shariah compliant let alone be intended to support Shariah compliant financing arrangements. Recommendation There are ways to mitigate the risks and to try to overcome the challenges. Among the factors to consider are: Firstly, when the risk of non-acceptance or application is high, consider a fi nancing-based structure such as Murabahah, Musawwamah or Tawarruq. This is because such an arrangement creates a fi nancing and thus, from the point the fi nancing is created, the parties may ride on the traditional law applicable in the relevant jurisdiction to enforce each other’s obligations. Secondly, when the use of the asset is made mandatory but the country has yet to have suitable regulations to place the Shariah compliant structure on par with its conventional counterpart, choose an asset-backed structure as opposed to the asset- ased one. That’s especially when the lex loci requires legal registration and/or the tax law’s position is unclear. Thirdly, when there are assets available, consider securitization or Sukuk. Many countries have adapted their position to facilitate Sukuk and when properly structured, the certifi cates will be marketable globally to both Muslim and non-Muslim investors alike. Lastly but most importantly, having a framework on Islamic fi nance that includes the harmonization of local rules and regulations will facilitate cross-border financing and mitigate risks associated with it.