Islamic financing and foreclosure.(FEATURE)

IN THE PAST SEVERAL YEARS, THE UNITED STATES HAS SEEN substantial growth in a subsection of international finance sometimes called "Islamic Finance." Although conclusive data is not yet available, Forbes magazine recently estimated that at least $500 billion in assets around the world are managed in accordance with Islamic principles--known in Arabic as Shari'ah--and the sector is growing at more than 10 percent per year. Management consultants McKinsey & Company predicted that the value of assets managed by Islamic banks will grow to $1 trillion by 2010 as more Muslims seek financial services that comply with their beliefs.

Islamic finance is, in many ways, similar to socially conscious investing and is based on the principles of Shari'ah, which typically prohibit investment into industries such as gambling, pornography, alcohol, tobacco, defense, banking and insurance. The most well-known aspects of Islamic finance are the prohibitions of: 1) interest (riba); 2) speculation, betting and gambling (maisir), including the trade or exchange of money for debt in the absence of an underlying asset transfer; and 3) preventable uncertainty (gharar) occurring, for instance, in certain financial derivative instruments and forward contracts.

As opposed to conventional finance, where interest represents the agreed-upon cost for funds, the central concept of Islamic financing is the prohibition of riba. Most Islamic scholars agree that riba covers not only usury but also the charging of interest and any predetermined rate of return that is guaranteed regardless of how an investment performs. Since Islamic finance permits only those forms of finance that are interest-free, financial relationships between banks and borrowers are governed by shared business risk (and returns) from investment in lawful activities. Profits must not be guaranteed in absolute terms but in specified ratios, and can only accrue if the investment itself yields income.

Shari'ah -compliant mortgage financing emulates key economic features of secured lending through (more) complex financial structures. We first discuss the common forms of Islamic financings and how they each compare to traditional mortgage financings to understand the foreclosure issues facing courts. There are three main types of Islamic financing structures available when purchasing and refinancing real estate to replace the traditional mortgage structure: 1) Ijarah is the rental of a property by the bank to the customer, combining aspects of a finance with an operating lease; 2) Murabaha is the acquiring of property first by the bank, as identified by the customer, then the selling of it to the customer at an agreed-upon markup; and 3) Musharaka is used now as a primary means of a diminishing partnership between a bank and the customer. For a longer list of terms commonly used in Islamic financing and their respective definitions, please see the Islamic Financial Services Board's Web site at www.ifsb.org.

IJARAH

Ijarah, or lease-based transactions, are becoming increasingly popular and are a significant portion of the current Islamic banking and finance market, particularly in the U.S. Ijarah is a form of leasing in which the bank acquires the asset, whether real estate or otherwise, and then immediately leases that asset to its customer for a determined period of time at the end of which the customer will own the asset, either by the terms of the lease or by purchasing it at an agreed-upon nominal sales price. Both the acquisition by the bank and the lease to the customer are intended to occur at a single closing. This form of financing is used for both acquisitions and refinancings.

Regulatory agencies have examined the question of whether U.S. banks may enter into Ijarah transactions. The Office of the Comptroller of the Currency, for instance, has issued a detailed advisory letter guiding U.S. banks so as to lawfully enter into Ijarah transactions.

In purchase financings, the customer identifies the real estate for which it seeks financing from the bank. As with traditional real estate purchases, the customer will have entered into a sale contract for the real estate with a seller prior to obtaining financing. Either prior to or at the closing of the purchase, the customer obtains the seller's written consent to designate the bank to purchase the real estate. Under this designation, the bank does not typically assume any other obligations or liabilities under the sale contract. Moreover, the seller is instructed to look only to the customer for any claims it may have under the sale contract.

In refinancing transactions, the customer will sell to the bank assets already owned by the customer. The bank will then lease those assets back to the customer. The transaction is in effect substantially similar to a sale-leaseback.

At the closing of either a purchase or refinancing transaction, the bank will purchase the assets for their specified purchase price less any advances already paid by the customer and any customary adjustments that may be appropriate. It should be noted that banks many times choose to take title to the real estate in each transaction through a special purpose company created specifically for that transaction. At this closing, the bank will lease the assets to the customer.

The price paid periodically by the customer under the lease includes a rental (or, for tax and the bank's bookkeeping purposes, an interest) component. It also includes an amount that goes toward the acquisition of the asset (or, for tax and the bank's bookkeeping purposes, a principal component). The bank may determine these periodic payments in the manner it deems appropriate (subject to applicable law). Shari'ah scholars reluctantly permit this calculation to be linked to interest rates such as LIBOR, although in residential mortgages they may seek to impose a floor and ceiling as a means of consumer protection. It is not uncommon in these types of transactions for the resale price determination to assume that a conventional loan was in fact being made by the bank to the customer and to incorporate the bank's usual credit evaluation processes. In fact, the customer typically signs an agreement stating that it not only agrees with tax treatment of the price but will similarly present it as such for its own tax reporting purposes.

As it would in a conventional loan financing, the customer grants the bank a security interest, whether in the form of a leasehold mortgage, security agreement, assignment of rents or otherwise, to secure its obligations to the bank.

As with conventional financings, a customer may be afforded a right to prepay, in whole or in part. However, because of certain Islamic principles, these concepts are set forth in a separate written instrument often labeled a call option. Furthermore, those instances in which the bank may seek to accelerate payment, such as situations of default or condemnation, are addressed in a written instrument often labeled a put option, where the bank has the right to put the assets to its customer for its purchase.

Banks are usually concerned with the nature and extent of their liability because of their ownership of the assets in Ijarah transactions. Ijarah transactions traditionally provide that the bank is making no representations and warranties regarding the assets, and places the burden of inspection and all maintenance, charges, taxes and other impositions and liabilities relating to the assets solely upon the customer. In addition, the customer indemnifies the bank for any claims made relating to the property, as well as any breaches by the customer of the Ijarah transaction.

MURABAHA

Murabaha is commonly translated as a "cost plus markup" sale and is the most popular and most common form of Islamic financing, and has been in use in New York State by HSBC to provide home financing. A Murabaha transaction is initiated by a customer applying to the bank through its normal credit application process, subject to the bank's usual criteria, but also to any further considerations the bank may deem appropriate. The bank may issue a pre-approval letter or commitment letter, as it deems appropriate.

Like the Ijarah transactions discussed above, regulatory agencies have examined the question of whether U.S. banks may enter into Murabaha transactions. For example, the Office of the Comptroller of the Currency similarly issued a detailed advisory letter for how U.S. banks may lawfully proceed in Murabaha transactions.

In a Murabaha, the customer identifies real estate for which it seeks financing from the bank and enters into a sale contract for the purchase of that property from the seller. Either prior to or at closing, the customer obtains the seller's written consent to designate the bank as purchaser of the real estate. Under this designation, the bank typically does not assume any other obligations or liabilities under the sale contract. Moreover, the customer agrees in writing not only to purchase from the bank the assets in question but also to indemnify the bank should it fail to do so.

At closing, the bank purchases the assets for the prespecified purchase price pursuant to the sale contract, less any advances already paid by the customer, and any customary adjustments that may be appropriate. It should be noted that banks often choose to take title to the real estate in each transaction through a special purpose company created solely for that specific transaction. At this same closing, the bank then immediately resells the assets to the customer at a price marked up from that which the bank paid. As it would in a conventional loan financing, the customer grants a security interest to the bank, whether in the form of a mortgage, security agreement, assignment of rents or otherwise, in order to secure its obligations to the bank.

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