Replacement of a leased asset

My last article dealt with the partial and total loss of an asset under the normal lease and forward lease.

Normal lease is where the leased asset is identified and existing, whereas the forward lease is where the asset is simply described and is delivered by the lessor to the lessee on a future date.

We learned that whilst the lease terminates upon the asset under a normal lease suffering total damage, it continues under a forward lease arrangement. Why is that?

The reason why the lease of an identified asset under normal lease comes to an abrupt end upon losing the asset is that the identified asset was "one and the only" which were lost and as such the lease of that particular asset must come to an end.

To the contrary, the asset under forward lease was simply a "described one" and hence can be replaced with another one having similar description, usefulness or capacity.

Under a forward lease arrangement, it is the right of the lessor to seek from the lessee to continue with the lease term by providing it with another asset similar to the one lost. At the same time, the lessee is liable to accept the alternate asset if it serves the same purpose as was achieved by the lessee from the originally provided asset. However, the lease rent will pause for the period that the lessor arranges the alternate asset.

If the alternate asset provided by the lessor proves to be inferior or not at par with the one which got damaged, the lessee will have the right not to accept the new asset and instead seek termination of the lease.

Alternatively, the lessee may seek reduction in the lease rent commensurate with the decline in the quality of the leased asset compared to the original one. If the lessor finds it difficult to locate the replacement of the lost asset, it may propose the lessee to terminate the forward lease agreement, in which case the lessee may agree to do so with or without compensation for the actual loss suffered by the lessee as a result of the loss of asset.

All of this must be part of the forward lease agreement at the time of entering into it or achieved through an amendment to the agreement prior to the occurrence of total damage.

In a total loss situation under a forward lease arrangement, the lessor may or may not wait for the insurance proceeds for purchasing the new asset. If it does wait for the insurance proceeds, it is likely to result in the delay in resumption of the lease rent.

The lessee may have the right to terminate the lease if providing the replacement asset is delayed by the lessor beyond a reasonable timeframe. The scholars have no issue if the lessor arranges to acquire the new asset by assigning the insurance proceeds to the supplier of the new asset or obtains it on credit which does not include the element of interest. This will hasten the entire process of providing an alternate asset to the lessee and hence will facilitate continuation of the lease term.

In order to avoid such tricky situation under a forward lease arrangement, an Islamic financial institution (IFI) entrusts the entire responsibility of purchasing the replacement asset on to the shoulders of the lessee by making it lessor's service agent.

By virtue of this arrangement, which does not violate any Sharia principles and has been approved by the Sharia scholars, the lessor IFI not only is able to mitigate the risk of ending up buying an inappropriate replacement asset but also makes sure that it does not loose out much on the lease rent by fixing a reasonable time limit for completion of the replacement of the lost asset.

On the other hand, the service agency agreement provides adequate flexibility to the customer (lessee) to receive the full insurance proceeds and to utilise the same in sourcing the appropriate asset in replacement of the lost-one since it will be fully aware of the technical specifications of the asset required by it.

The writer is the vice-president, Sharia structuring, documentation and product development, Dubai Islamic Bank.