In a first, the Bankruptcy Court for the Southern District of New York in the Arcapita Bank case had to decide whether Shari’a compliant investment agreements, providing for Murabaha and Wakala transactions, qualify for the safe harbor protections provided in the bankruptcy code for securities contracts, forwards and swaps. The court held that they do not. Since the opinion runs about 100 pages long, we attempt to distill some very basic facts concerning Shari’a compliant transactions and point to important holdings made by the court.

Shari’a Compliant Transactions

Shari’a law prohibits interest. As a result, financial firms developed various structures to mimic interest without running afoul of the prohibition. Two such structures were involved in the Arcapita Bank case.

One was Murahaba transactions. In these transactions, the investor transfers funds to the bank which uses the funds to purchase a commodity as an agent for the investor. In turn the bank agrees to purchase the commodity in the future on an agreed upon repurchase price which effectively provides the investor with an agreed return.

The other was Wakala transactions. In Wakala transactions, the bank offers to invest the client’s funds in assets that have certain expected returns. Although the bank has no repurchase obligation the evidence convinced the court that expected return is, in fact, paid 99% of the time.

The crux of the case was post-petition setoff exercised by the two defendants. The unsecured creditors committee argued that the setoff was done in violation of the automatic stay since it was prohibited by section 553 of the bankruptcy code for two reasons: (i) the claims and debts were not mutual since Arcapita’s debts were post-petition, while the investors’ debts were pre-petition and (ii) the transactions that gave rise to Arcapita’s debts were entered for the purpose of obtaining setoff, and thus ineligible for setoff under section 553 (a)(3)(C).

The defendants argued that setoff was permissible since the transactions qualified as safe harbored securities contracts, forwards or swaps.

Setoff issues

First, the defendants argued that the safe harbor provisions override the principle that setoff of post and pre-petition debts is not permissible since these debts lack mutuality. Acknowledging that the exercise of setoff in the context of a safe harbored contract is not limited by the stay, the court held that nothing in the safe harbor provisions, or their legislative history, overrides the mutuality requirement that is a threshold requirement for the setoff right to even exist.

Second, there must be a right under applicable law to exercise setoff. The defendants argued that such right exists under Bahraini law, the applicable non-bankruptcy law. Yet, the evidence established that the Central Bank of Bahrain, as the defendants’ regulator, issued to them a direction to either return the funds to Arcapita, or seek permission from the bankruptcy court to withhold the funds. The defendants never complied with these directions. The court found that these directions overrode any setoff right that the defendants may have had under Bahraini law and therefore concluded that the defendants had no setoff rights under the applicable law.

Finally, the court found that Arcapita’s debts were incurred to obtain setoff. Looking at the pattern of the business activities among Arcapita and the defendants, the court concluded that the transactions that gave rise to Arcapita’s debts were entered into on the eve of bankruptcy, never before did Arcapita place investments with one of the defendants and rarely with the other, and the amounts of the transactions were unusual among the parties.

Securities Contract Safe Harbor

The defendants argued that the transactions were contracts for the purchase and sale of security, or other agreements that are similar to the list of transactions provided for in the securities contract definition.

Focusing on the economic substance of the transactions, the court concluded that they were essentially similar to loan agreements-the party investing the funds was entitled to repayment of the principal investment plus an agreed upon return. The court recognized that the transactions could have been structured in a format similar to bonds, but they were not. And the court emphasized that the agreements lacked the hallmark of securities like bonds, debentures or notes since they were not publicly traded nor listed, were not fungible and were illiquid.

The defendants argued that the agreements were considered securities in Bahraini and Islamic funding markets and thus, qualified as any other interest commonly known as a security. The court rejected this argument finding no support for the proposition that the definition of security under the bankruptcy code is controlled by views held in a foreign country and was concerned with the resulting inconsistency that such an approach will bring as something might be considered as a security in some countries, but not others.

Forward Contracts and Swaps Safe Harbor

To qualify as a forward contract under the bankruptcy safe harbor, the contract must meet four elements: (i) substantially all expected costs of performance are attributable to a related commodity, (ii) the contract has a maturity date of more than two days after the contract was entered into, (iii) the price, quantity and time of performance is fixed at the time of contracting and (iv) the contract has a relationship to financial markets.

The court found that the transactions at hand failed at least the second and fourth factors. The relationship to financial markets element requires that the primary purpose of the transaction be financial and risk-shifting in nature, i.e., hedging. But the transactions here had no risk shifting faculties since the prices were fixed. They also failed the two days requirement since the contracts required immediate delivery of the underlying commodity.

Swaps Safe Harbor

The court found that the parties did not swap financial instruments and therefore the agreements were not similar to any other listed example of swap agreement.

Looking Forward

In light of the novelty of the transactions and the issues involved, we expect the decision to be appealed. One should reserve judgement on its implications until the appellate process is concluded. In the meantime, however, parties should take stock of its important implications:

(i) Shari’a compliant transactions that are structured to imitate loans are at risk of not qualifying for safe harbor protections even where structured to involve a commodity,

(ii) A regulator’s order to seek an order authorizing the exercise of setoff, if not followed, may be viewed as eliminating a party’s setoff right,

(iii) In analyzing what constitutes a security, the court focused on the attributes of equity securities and as to notes, appears to have imposed a requirement that they be publicly traded, listed on an exchange and be liquid,

(iv) An instrument that may be viewed as a security under foreign law, may not qualify as a security under the bankruptcy code, and

(v) A swap essentially requires the exchange of financial instruments although many qualified swaps lack this characteristic, i.e., total return swap.

These are weighty and important issues that could create uncertainties in the operation of the safe harbor provisions far beyond Shari’s compliant transactions.