The impact of AAOIFI Standard 59 on Murabaha financings
Bahrain / Banking and Finance
Law Update: Issue 361 - Education
Natalia KumarSenior Counsel,Banking and Finance
Muhammad Ammad YasinSenior Associate,Banking and Finance
The Accounting and Auditing Organisation for Islamic Financial Institutions (“AAOIFI”) adopted Shari’a standard 59 (“Standard 59”). As a result, the traditional murabaha structure under which rollover of a Murabaha contract was a central feature, is no longer held to be Shari’a compliant by AAOIFI. The basic premise for this is that a traditional murabaha structure looks and feels too much like a conventional loan. In light of this, there are two (2) possible alternative Murabaha structures which may be adopted. This article will provide an overview of these two (2) alternative Murabaha structures.
This structure is gaining traction with some market participants and involves entering into a "long Murabaha" contract and a series of separate "periodic Murabaha" contracts. This structure avoids the potential double exposure risk and extra day's profit under the one-day gap structure discussed below.
A long Murabaha contract is entered into for the entire tenor of the financing (for each disbursement) with a deferred sale price equal to the cost price (i.e. the principal amount of the financing) and profit (calculated at the agreed margin rate). The deferred payment price is then paid in instalments on the deferred payment dates under that long Murabaha contract reflecting the agreed amortisation payment profile and margin component of the profit for the financing through to the final maturity date.
The long Murabaha contract is supplemented by a series of periodic Murabaha contracts, with profit at the agreed benchmark rate being covered under the periodic Murabaha contracts. A point to note is that under the periodic Murabaha contract, the cost price component of the deferred payment price is set off against the proceeds of the commodities when on sold by the financier on behalf of the customer (as a messenger/facilitator of the customer).
In respect of the profit payable under the long Murabaha contract (i.e., at the margin rate) and the profit payable under a periodic Murabaha contract (i.e. at the benchmark rate), the payment dates are usually aligned.
This structure utilises a purchase undertaking whereby the customer undertakes to enter into a periodic Murabaha contract on the first day of each profit payment period (if profit is calculated using a forward-looking benchmark rate) or the last day of each profit payment period (if profit is calculated using a backward looking benchmark rate). To cover the risk of a customer refusing or failing to enter in to a periodic Murabaha on the relevant date, the purchase undertaking would typically include provisions in relation to “deemed acceptance” by the customer of periodic Murabaha contracts and indemnities in favour of the financier.
Under the long-short structure, utilisation of a Murabaha facility usually is as follows:
the customer delivers to the investment agent/financier a duly completed request to purchase;
based on the request to purchase, the investment agent/financier purchases commodities and on purchase thereof, the investment agent/financier issues an offer to the customer;
the customer then accepts the offer by issuing an acceptance notice or countersigning the offer to signify its acceptance of the terms thereof;
a long form Murabaha contract is concluded, based on the terms of the offer and acceptance, on issuance of the acceptance by the customer.
A periodic Murabaha contract is entered into as follows:
the investment agent/financier issues an exercise notice under the purchase undertaking either, as noted above, on the first day of each profit payment period or the last day of each profit payment. Along with the exercise notice, a completed form of the periodic Murabaha contact (which is typically annexed to the purchase undertaking) is issued to the customer for countersignature; and
the customer signs the periodic Murabaha contract and returns it to the investment agent/financier within a specified deadline, failing which the customer is deemed to have accepted the periodic Murabaha contract (unless the customer has raised any objections before the expiry of the deadline for execution of the periodic Murabaha contract).
The second alternative Murabaha structure involves a day one Murabaha contract being entered into as would have been the case under a traditional Murabaha structure but then, in contrast to a traditional Murabaha structure where a subsequent Murabaha contract is entered into on the maturity date of that Murabaha contract, a new Murabaha contract (“One Day Gap Murabaha Contract”) is entered into one business day before the maturity date of the maturing Murabaha contract. The commitment reduction schedule (which, in practice, is akin to an amortisation schedule in a conventional context) is aligned accordingly, with payments on that earlier business day too instead of the final business day of the calculation period.
This structure involves a double exposure for the financier during the one business day period between the date on which new funds are advanced under the One Day Gap Murabaha Contract and the date on which those funds are deployed by the customer to partly settle the maturing Murabaha contract (“Risk Period”). However, this would require a promise/commitment by the customer that the customer will use the funds under the One Day Gap Murabaha Contract to only partly settle the maturing Murabaha. There is a potential risk that such a promise/commitment by the customer may raise Sharia issues. Another potential risk of this structure is that in the event the customer becomes insolvent during the Risk Period, then technically, the financier would be required to disburse the funds if required by the liquidator of the customer (as these funds technically belong to the customer).
In practice, however, the investment agent/financier could mitigate this risk by disbursing the funds under Murabaha contract to an account of the customer held with the financier that has a debit block to mitigate the double exposure risk. Secondly, as a result of this structure, an extra day's profit would accrue, but there are ways to address this.
Over the last one year, we have seen market participants in Bahrain adopting the long-short structure as opposed to the one-day gap structure. However, there are early days and it is yet to be seen if one or both structures are adopted by the market participants in Bahrain.
For further information,please contact Natalia Kumar and Muhammad Ammad Yasin.
Published in September 2023
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