Examining how IFI carries risks in leasing transactions

Our current subject covers the risks an Islamic Financial Institution (IFI) carries in the financial leasing transactions.

We know that an IFI, being the lessor to the asset, has the responsibility of an owner and while fulfilling the same, is exposed to certain high value and at times unknown costs. How this risk is mitigated by the IFI in a leasing transaction?

If an IFI is expected to cover these big ticket expenses, will it be in a position to remain profitable from a leasing transaction?

Let us examine as to how an IFI conducts itself in such thorny situation and what solution is offered by Sharia to maintain the leasing transactions profitable from an IFI's perspective and at the same time to keep the transaction Sharia-compliant.

To summarise, our last article on the subject dealt with the mechanism for IFIs to successfully manage the risky part of a leasing transaction whereby, being the owners, they must fulfill their primary obligation of maintaining the leased asset. The task gets challenging if the asset is of technical and complex nature such as aircraft, marine vessel, industrial plant etc.

We also briefly touched upon the conditions precedent which have no room in Sharia documentation since Sharia requires completion of all such conditions prior to attending the signing of transaction documents.

Reverting to our subject, in order to meet with its ownership obligations, an IFI enters into a service agency agreement with the client, appointing it as the IFI's agent to carry out major maintenance and take care of insurance and taxation matters on behalf of the IFI.

The service agency agreement stipulates that the customer, in the capacity of agent, would carry out all required major maintenance to the leased asset in order to keep the asset in good working condition.

Since the customer would do it in the capacity of IFI's agent, all costs incurred by it are payable by the IFI (Principal). Some scholars take the position that in fact costs of such routine major maintenance should be ascertained and paid out by the principal to the agent from time to time in advance as the agent is not supposed to spend any amount from its own pocket.

If the agent spends any money on carrying out the agency tasks, it will tantamount that the agent has given a loan to the principal and as you are aware, any loan in Sharia must be free of any costs/interest. These scholars argue that it is unfair to put the agent into such a position that it is forced to incur certain costs on behalf of the principal in order to fulfill its obligations under the service agency agreement.

Notwithstanding the above position taken by some scholars, the majority of them have approved a position whereby if the agent has incurred certain costs in carrying out major maintenance to the leased asset or in keeping the asset fully insured, it will be entitled to deduct such costs from the rent it pays to the IFI in the capacity of lessee.

Here the question arises that how two different aspects i.e. the lease and service agency can be amalgamated. The reply to that point is that Sharia is fair when it comes to protecting the interests of all concerned parties in a transaction and as such, the lessee automatically acquires the right of set off if it has not been paid by the lessor for certain jobs which it carried out as the lessor's agent.

This mechanism allows the agent, who is also the lessee, to deduct the costs of major maintenance, insurance, taxation, etc (all termed as the service amount) from the periodical rent it pays to the IFI. On the other hand, if the IFI has paid or reimbursed the service amount to the agent, it is permitted to increase the lease rent for the next rental period by the same amount.

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