Part III: Shari’ah loans (murabaha)
In Part III: Shari’ah loans (murabaha), we explain the sometimes complex mechanics of a murabaha loan as well as key legal considerations to take into account when entering into this type of transaction, either as a borrower or lender.
Murabaha agreements are an example of debt financing in the Islamic finance industry, hence a Shari’ah loan.
The term is understood to refer to a contractual agreement between the seller (the Lender) and a buyer (the Borrower) where the seller buys and sells a specific asset on behalf of the buyer and transfers the proceeds of sale to the buyer. The proceeds thereafter is considered the loan amount. The buyer in return repays the seller for the proceeds (i.e. the loan amount) with deferred payments.
The deferred payment is composed of the price the asset was purchased by the seller and a pre-agreed mark – up that represents the profit generated from the seller’s involvement in the transaction. The buyer pays the deferred price periodically.
The flow chart below is an example of a typical murabaha structure.
Overview of structure
(1) The Lender will purchase commodities from a commodity supplier at the price the Borrower wishes to borrow;
(2) The Borrower then purchases the same commodities from the Lender at the deferred sale price, which is usually the cost price of the commodities plus the pre-agreed profit, to represent the Lender’s involvement. That sum represents the loan and profit the Lender wishes to receive back and is usually repaid in instalments;
(3) With regards the physical commodities, the Lender on-sell these commodities to a third party commodities broker (effectively momentarily changing its hat – so to speak – acting momentarily as the borrower’s agent) for the cost price;
(4) To bring the arrangement full circle, as explained, the Lender transfers the proceeds from the sale of the commodities to the Borrower, i.e. the revenue received from the third party buyer, and through careful drafting (amongst other things) includes provision for (i) its profit and (ii) instalment repayment deadlines; thereby creating the loan.
Set out below are some basic requirements and issues to be considered when entering into a murabaha agreement:
• Ensure that the deferred sale price is at an agreed rate and for an agreed period;
• To ensure that a Lender obtains marketable title to facilitate the on-sale to the Borrower or third party commodities broker, the Lender should require certain representations and warranties from the original commodity supplier that the commodities are free from encumbrances or liens;
• There is a risk of price fluctuation in commodity market value during the period of ownership of the commodity by the lender. This can be mitigated by minimising the duration of the Lender’s ownership and specifying the Deferred Sale Price payable by the Borrower;
• If the Borrower requests physical delivery (as opposed to constructive delivery), there is a risk that the commodities might be damaged in transit. The Lender can mitigate this by undertakings from the Borrower in the murabaha agreement to accept the commodities on an ‘as is’ basis;
• The administrative process can be streamlined by the Borrower appointing the Lender as its selling agent under a selling agency agreement to sell the commodities to a third party commodity broker in its capacity as an agent. This is illustrated by step 3 in the flow chart above.
• Tax liabilities in respect of the acquisition and sale of the commodities should be considered in order to maximise the preservation of the cost price. This will depend on the type of commodity involved and the jurisdiction of the parties.
In the next part of the Islamic Finance series, the Saracens commercial team discuss the Shari’ah agency facility (wakala).
To find out more on the typical Shari’ah financing products, you may click on this link to see further information on our main site.
Feel free to telephone our London office on +44 (0) 20 3588 3500 to speak directly to one of our lawyers on your investment needs.
Have you ever used a Shari’ah loan? We would love to hear about your experience. Please leave a comment or any questions in the section below.
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