Islamic financing of business jets is becoming more common and the transaction structure is not completely different to conventional leases. However, there are key differences and issues that will arise with Ijaara aircraft leases, writes Charles Viggers of Watson, Farley & Williams LLP.
The Sharia-compliant, Islamic financing of aircraft is no longer new but the adaptation of the typical financing structure and the interaction between the conventional “Western” and Islamic players active in such financings make transactions of this type particularly interesting for those involved.
The transaction structure of a typical Islamic financing of aircraft is not totally dissimilar to that of a conventional structure. However, as might be expected, many of the conventional provisions are replaced by markedly different provisions so that the documentation respects the principles of Sharia.
Whilst many much more complex Sharia-compliant structures have been brought to the market, we introduce here some of the issues that may arise on even a relatively simple Ijaara lease financing.
We have been pleased to advise a leading French bank on its Islamic financing of business jets for a Middle Eastern operator (the “Operator“). The Operator had agreed to purchase the aircraft new from the manufacturer and was seeking Islamic financing for them. Whilst many Sharia experts might frown upon the financing of ‘private’ jets and the lavish lifestyle that they may seem to encapsulate, these aircraft were specifically business jets and the financing was for an established Sharia-compliant business operator and therefore considered acceptable.
To finance the Operator’s purchase of the aircraft, our client formed a syndicate of investors with a group of leading Middle Eastern banks (together the “Investors“).
They together agreed to invest in the purchase of the aircraft under an investment management agreement (rather than a conventional loan agreement) under which they appointed one of their number as investment manager (the “Investment Manager“).
The Investors included at least one Islamic bank that was (as an institution) required to comply with the principles of Sharia and at least one conventional bank. This mix gave the syndicate of Investors a certain dynamic as the understandings and expectations of each Investor were not always immediately aligned, be it on some of the Sharia aspects of the transaction or on the aircraft specific nature of the transaction.
For each aircraft, the Investment Manager arranged for a special purpose company to be incorporated to act as owner of the aircraft (the “Owner“), through which the Investors channelled their investment in the aircraft.
The Operator, who had shortly beforehand purchased the aircraft from the manufacturer, agreed to sell the aircraft to the Owner for the agreed purchase price.
The Owner funded its payment of the purchase price with, in part, the Investors’ investment and, as to the balance, by a significant up-front payment of rent under the Sharia-compliant lease agreement(Ijaara) into which the Owner agreed to enter with the Operator (the “Ijaara“) and under which the Operator agreed, amongst other things, to pay rent (including a profit element (or return) on the Investors’ investment) over the term of the Ijaara.
Rather than complicate the structure with the legal issues that would arise if the Investment Manager and the Owner had entered into a wakala agency agreement (pursuant to which the Owner would agree to hold title to the aircraft as agent of the Investment Manager), the transaction was structured and the Investors’ investment in the aircraft was protected by, in the first instance, the Owner declaring a trust over all of its rights in the aircraft, the Ijaara and the other transaction documents to which the Owner was party, pursuant to an English law declaration of trust (the “Declaration of Trust“).
In addition to the Declaration of Trust, the Investors sought to protect their investment by taking, amongst other security, a conventional aircraft mortgage over the aircraft as security for the performance of the Owner’s (re)payment and other obligations to the Investors, under the transaction documents, in respect of their investment in the aircraft.
Special Sharia features
The documentation of the transaction described above contained a wealth of features specific to the Sharia-compliant financing of aircraft, common to many such financings.
Floating rate rent and other obligations: Perhaps somewhat surprisingly for the uninitiated, it seems acceptable in Islamic financings that rent (including a profit element (or return) on the investors’ investment) and other amounts due
under the transaction documents can be calculated and payable by reference to a conventional floating “interest” rate (LIBOR, for example). However, the documents should include a mechanism whereby the amount calculated to be payable is notified to the operator, by a rent renewal notice, for acceptance or rejection before the amount actually becomes due. The consequences of rejection of a rent renewal notice would include termination of the Ijaara and acceleration of the obligation to repay the investors’ investment and it might be expected that the operator would accept rent renewal notices (rather than reject them) to avoid such consequences.
Security Deposit: In the transaction described above, supplementing the conventional aircraft mortgage and other security that the Owner granted in favour of the Investors, the Operator was also required to pay a cash security deposit to the Owner as security for the Operator’s performance of its obligations under the Ijaara (including the obligation to pay rent).
Of course, “interest” may not accrue on a cash security deposit in a Sharia financing. However, the bank with whom the security deposit is placed may agree, depending on various factors including the amount of the security deposit, to invest the security deposit in suitable Sharia-compliant products (such as short term, relatively liquid wakala arrangements) to generate a profit element for the depositor (i.e. the Operator). If the transaction then runs smoothly, the depositor may legitimately expect that the initial amount of the security deposit and the profit element earned by the investment of the security deposit in suitable Sharia-compliant products would be repaid to the depositor in due course.
Liquidated Damages / Late Payment Charges: The operator would be expected to pay liquidated damages or late payment charges if it defaults or is late in performing its obligations under the Ijaara.
Perhaps somewhat surprisingly, it seems acceptable that such damages or charges may be calculated by reference to a conventional floating “interest” rate (LIBOR, for example).
However, it also seems well established that to the extent that the amount of the damages or charges so calculated exceeds the costs actually incurred by the non-defaulting party in respect of the operator’s default, the principles of Sharia would require that such excess be paid to charity.
The specific charity to whom this excess would be paid would typically be selected by each nondefaulting party’s Sharia committee(s) or, alternatively, by a single Sharia committee that the nondefaulting parties would together designate to take decisions of this nature during the term of the Ijaara financing.
Insurance: In marked contrast to a conventional financing, in an Islamic financing the owner is prima facie required to assume responsibility for certain risks that can be insured.
However, in the field of aircraft finance, it is the operator that typically contracts insurance to cover all risks linked to its operation of the aircraft.
The typical Sharia financing would therefore include a service agency arrangement under which the owner appoints the operator to contract insurances on its behalf.
The operator therefore contracts insurances covering risks relating both to the ‘hull’ (the aircraft itself) and to liabilities that the parties involved in the operation and financing of the (including the investors) might incur to third parties as a result of the operator’s operation of the aircraft.
The “agreed value” that the insurers would agree to pay in respect of the ‘hull’ (the aircraft itself) should the aircraft suffer a devastating accident (or ‘total’ loss) would typically cover just the outstanding amount of the investors’ investment in the aircraft rather than also the portion of the value of the aircraft that the operator may by then have paid under the Ijaara (as up-front rent and as rent over the term of the Ijaara).
Of course, the conventional “Western” insurance product is generally not considered Sharia-compliant. However, whilst Sharia-compliant Takaful insurance is becoming increasingly available, it seems that Sharia scholars recognise that it is not yet sufficiently widely available in the international insurance market and, accordingly, they do not seem to object to the parties (i.e. the operator) contracting conventional “Western” insurance and reinsurance products.
Maintenance: In, again, marked contrast to a conventional financing, in an Islamic financing the owner is prima facie required to perform or contract ‘heavy’ maintenance in respect of the aircraft (the major checks that an aircraft has to pass every 5 or 10 years or so) whilst the operator will prima facie be required to perform or contract ‘light’ maintenance.
As with the insurances (referred to above), in a typical Sharia financing the
owner would therefore appoint the operator under a service agency arrangement
to perform or contract ‘heavy’ maintenance in respect of the aircraft.
Voluntary prepayment: Some Sharia institutions consider that prepayment cannot be totally voluntary but that any offer voluntarily to prepay must be put to the owner of the aircraft for acceptance or rejection.
Sale Undertaking and Purchase Undertaking: Should the financing unwind for any reason, the owner would want to have some comfort that the operator would purchase the aircraft.
A typical Sharia financing transaction would therefore include an independent, stand-alone sale undertaking by the owner (a “Sale Undertaking“) and an independent, stand-alone purchase undertaking by the operator (a “Purchase Undertaking“) under which the owner would agree to sell and the operator would separately agree to purchase the aircraft should the financing unwind for any reason.
If the operator terminates the Ijaara prior to the end of the term of the Ijaara, it might be expected that it will also exercise its option under the Sale Undertaking to have the owner transfer title to the aircraft to the operator. The operator would presumably by then have paid a significant portion of the total cost of the aircraft (whether as up-front rent or as rent over the term of the Ijaara) and may be incentivised to exercise its option under the Sale Undertaking.
In the perhaps unlikely event that the operator does not exercise its option under the Sale Undertaking, the owner would have the option under the Purchase Undertaking to require the operator to purchase the aircraft.
If the owner fails to exercise its option to require the operator to purchase the aircraft within a short period of the operator serving notice of early termination of the Ijaara, the Ijaara would in due course terminate and the owner would retain title to the aircraft on the expiry of the Ijaara. Logically, the owner would then look to remarket the aircraft to a third party and to use the sale proceeds to repay the investors’ investment in the aircraft. In these circumstances, the owner would also be required specifically to indemnify the investors in respect of any loss that they might suffer as a result of the owner’s failure to exercise its rights under the Purchase Undertaking (i.e. any loss that the investors suffer as a result of the delay caused by the owner needing to remarket and later sell the aircraft to a third party rather than simply exercising its rights under the Purchase Undertaking and selling the aircraft to the operator on the expiry of the term of the Ijaara).
Non-Islamic banks and Sharia committees: We have mentioned the dynamic that there may be within a syndicate composed of Islamic investors and non-Islamic investors.
As the negotiations of any transaction’s documents proceed, the investors may need to seek the advice of their respective Sharia committees (assuming each has one) as to how or whether particular conditions will be acceptable for that investor.
By way of example, we have needed to seek the input of the investors’ Sharia scholars in the context of the question whether rent should continue to be payable if the aircraft suffers a ‘partial’ loss that would not constitute a ‘total’ loss but would prevent the operator from using the aircraft (if, for example, a truck were to run into the parked aircraft and damage part of the fuselage, the aircraft being immobilised whilst repairs are made). Whilst it seems to be accepted that rent should cease to be payable as such by the operator if the aircraft has suffered a ‘total’ loss, the position is less clear if the aircraft has only suffered a ‘partial’ loss. Some investors may feel that rent should cease to be payable while the aircraft is repaired whilst others may consider that rent should continue to be payable.
Similarly, during the life of the transaction, some provisions of Islamic transactions may require that the relevant parties (including non-Islamic banks) seek the advice of their respective Sharia committees (assuming, as before, that each has one) as to what to do in any particular circumstance.
By way of example, as above, if liquidated damages are payable in respect of the operator’s default, the documentation may require that the excess (referred to above) (i.e. the amount of liquidated damages paid to each investor to the extent they exceed the actual losses suffered by such investor as a result of the default) be paid to such charity as each investor’s Sharia committee may select.
However, if an investor is not itself an Islamic bank and is therefore not itself (as an institution) required to comply with the principles of Sharia, that investor may not have its own Sharia committee and may not feel obliged to pay such excess to charity at all.
To avoid any misunderstanding, the investors may together agree to appoint a single Sharia committee to decide such matters on behalf of all of the investors.
Addressing the same point, some Islamic banks may require that every document in a transaction includes an express waiver of interest expressly waiving the receipt of any amount in the nature of interest, whether derived directly from the transaction documents or indirectly pursuant to the judgment of any court (or arbitrators), noting that if a transaction dispute comes to be settled in court (or by arbitration), that court (or the arbitrators) may award interest on amounts that are determined to have been payable.
Funding Indemnity: It seems that a funding indemnity is considered to be too closely linked to the value of money over time to be permitted in a Sharia financing. Such an indemnity in respect of the investors’ lost opportunity, should the investors fund their investment in the interbank market but should the deal not proceed, finally, seems to be considered not to be permitted.
Signing: It is particularly important that all documents be signed and become ‘live’ in the correct order clearly to distinguish the investors’ investment in the aircraft and the owner’s purchase of the aircraft from the operator’s taking the aircraft on lease pursuant to the Ijaara. To achieve this, it may be necessary to introduce a short time lag between the signature of documentation relating to the sale of the aircraft and the investors’ investment in it and the signature of documentation relating to the Ijaara and the delivery of the aircraft under the Ijaara.
Disclaimers as to the aircraft’s condition on delivery: A typical conventional sale and leaseback transaction would include an obligation on the part of the seller / lessee to accept the aircraft under the lease agreement immediately following the sale of the aircraft pursuant to the sale agreement. However, as above, in Islamic financings, to make clear that the investment and the Ijaara are distinct transactions, some Islamic banks may not agree that the operator should be obliged to accept the aircraft under the Ijaara. In these circumstances it may be necessary for the owner to accept an element of risk as to whether or not the operator will indeed take the aircraft on lease under the Ijaara although in practice it may be hoped that this risk is theoretical.
Legal opinions: Whilst a law firm can of course give legal opinions as to, for example, the English law or French law aspects of Sharia financings, a law firm would not typically be qualified to give legal opinions as to Sharia law. A law firm advising on a Sharia financing would typically make this clear by including clarificatory limitation language as to the scope of the opinion.
As Middle Eastern aircraft buyers continue to seek new finance opportunities, so we expect Islamic banks and conventional “Western” banks more frequently to seek to combine their strengths and expertise to offer Sharia-compliant aircraft finance products. Key to the negotiation and success of any Islamic financing of aircraft is a shared understanding of the principles of Sharia as they may be applied to the very specific domain of aircraft finance.
A version of this article was first published with Mustapha Mourahib of Clifford Chance in the French language Journal des Sociétés (no. 77, June 2010, p. 26).