In November 2015 the publication of “City UK’s” annual review of the Islamic Finance industry, entitled “Leading Western Centre for Islamic Finance’ (the “Report”), was preceded by only a matter of weeks by the publication of the UK Supreme Court’s judgment in Cavendish Square v El Makdessi; Parking Eye v Beavis [2015] UKSC 67 (theJudgment).

On the face of it these two publications would seem wholly unrelated, however given the reconsideration of the UK law on liquidated damages set out in the Judgment, and the role of penalty clauses in Islamic Finance agreements governed by UK law, both of these matters may be more connected than one might at first think.   

The Report:

The Report highlighted a number of prescient and interesting facts, including the following:

  1. There are 20 banks offering Islamic financial services in the UK and 5 fully compliant Shari’ah banks;
  2. UK Islamic Banks’ assets totalled USD$ 4.5b (as at end of 2014); and
  3. The majority of Islamic contracts are governed by English law

The Report also highlighted several key real estate developments in London financed partly or wholly by Islamic financial products including the Shard, the Olympic Village and the redevelopment of Chelsea Barracks. 

It is clear therefore that there exists a prevalence of Islamic Finance agreements currently governed by UK law and that any dispute arising from these would in the usual manner be dealt with by the UK Courts. The issuance of the Judgment however seems to suggest that going forward the use of penalty clauses in Islamic contracts under UK law may be treated differently by the courts and that parties to current contracts (especially those suffering delays of non-performance) might have to reassess their own potential liability.

The Judgment and liquidated damages:

The Judgment both confirms and strengthens the availability of liquidated damages where a contract is governed by the laws of England and Wales. 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 recoverablei.

In particular, the Judgment rejected the previous “dichotomy” between liquidated damages and penalties, under which a sum would only be correctly considered to be recoverable if it represented a “genuine pre-estimate” of the loss that would be suffered following a breach.  A sum that did not meet that test was liable to be wholly struck down as a penalty. Given that legitimate interest in performance, it is reasonable for a sum to be pitched at a level intended to deter a breach (however, that sum must not be pitched at a level that is designed only to punish).

As such the Judgment ruled that the true test to be applied is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation.

The first step, therefore, is to consider whether a legitimate interest is served by the clause, and, if so, then, secondly, to determine whether the provision made for that interest is “extravagant, exorbitant or unconscionable”.  

The treatment of penalty clauses under Islamic Contracts:

The use of penalty clauses in Islamic 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 (of course) not permitted under Islamic finance agreements, but this does not, necessarily, amount to a total prohibition on penalty clauses per se.

Certain jurisdictions (Pakistan and Bangladesh for example) allow for penalties to be applied in negotiated contracts in certain circumstances and the Central Bank of Malaysia issued guidelines in 2012 to its licensees which sets out how late payment charges could be applied. Whilst a conservative interpretation of riba might look askance at such developments, the widely accepted position in these jurisdictions appears to be that under Islamic agreements creditors may impose penalty clauses for late payment but that any excess in the penalty imposed beyond the actual damage suffered by the creditor should be donated to charity (as the Malaysian Central Bank guidelines suggested).

This interpretation has been applied by HSBC Amanah which had a policy whereby they applied a charge (presented as an administration fee) for late payments but if the fee payable exceeded the actual expense incurred, the surplus is donated to charity.

A (New) interpretation?

Previously the UK court’s interpretation of such a clause would have been to strike it down as a penalty, as a clause that allowed for excess sums that would not benefit the creditor could not have been a “genuine pre-estimate of the loss suffered”. The Judgment however has introduced an element of doubt as to this interpretation.  

As previously stated the first consideration under the Judgment’s rationale was whether a legitimate interest is served by such a clause (which seems likely, as it prevents a financial loss to the lender) and secondly to determine whether the provision by the clause is “extravagant, exorbitant or unconscionable”, which again seems unlikely given that the amounts collected will go to a charitable organisation (the key may well be the “exorbitance” or otherwise of that contribution).

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 suggested that the UK courts will be more minded in future to allow such clauses to be upheld, if correctly drafted.    

The Judgment has suggested that clauses widely used under Islamic contracts are now more likely to be recognised under UK law. Given the multitude of Islamic contracts currently governed by English law, as well as those financial transactions set out in the Report, this profound shift in the position of the UK courts to such clauses may require that all parties review their own obligations and potential financial position in the event of debtor default.