The Islamic Finance Development Indicator Report, published jointly in December 2015 by Thomson Reuters and the Islamic Corporation for the Development of the Private Sector (the development arm of the Islamic Development Bank) lists Bahrain, for the third year running, as the leading Islamic Finance market in the GCC, and the second globally.
With the influx of western business in Bahrain, and the growth of Islamic Finance in the English-speaking West, many Islamic Finance agreements are governed by English law. As such any dispute arising from these agreements would usually be dealt with by the English Courts.
The English Supreme Court’s recent judgment in Cavendish Square v El Makdessi; Parking Eye v Beavis  UKSC 67 (the “Judgment”) suggests that the use of penalty clauses in Islamic Finance contracts under English law may be treated differently by the courts and that parties to current contracts (especially those suffering delays or non-performance) might have to reassess their own potential liability.
The Judgment confirms and strengthens the availability of liquidated damages where a contract is governed by English law. In essence the Judgment states that, as long as the sum specified in the contract as liquidated damages is not “out of all proportion” to the breach, the specified sum will be recoverable.
The first step, therefore, is to consider whether a legitimate interest is served by the penalty or liquidated damages clause, and, if so, then to determine whether the provision made for that interest is “extravagant, exorbitant or unconscionable”.
The use of penalty clauses in Islamic Finance contracts is in itself not an uncontroversial topic and there is a lack of uniformity on the application of such clauses among Fiqh scholars. The general prohibition of Riba means that collection of late payment interest is not permitted under Islamic Finance agreements. This, of itself, does not, necessarily, amount to a total prohibition on penalty clauses.
Certain Islamic jurisdictions allow for penalties to be applied in certain circumstances. Whilst a conservative interpretation of Riba might look askance at such developments, the widely accepted position in these jurisdictions appears to be that creditors may impose penalty clauses for late payment, but that any excess beyond the actual damage suffered by the creditor should be donated to charity.
Therefore the first consideration is whether a legitimate interest is served by such a clause (which seems likely, as it prevents a financial loss) and secondly to determine whether the provision is “extravagant, exorbitant or unconscionable”, which seems unlikely given that the amounts collected over and above the actual loss suffered, will go to charity.
Whilst this reasoning has yet to be tested, and it seems likely that lenders under conventional structures will have a more straightforward argument should such a clause be challenged, it does suggest that the English Courts will be more minded in future to allow these clauses to be upheld, if correctly drafted.