This recent decision in the English courts concerning a Wakala transaction has caused some disquiet among participants in the Islamic finance market. Our view is that, while the case raises several interesting issues, it does not fundamentally undermine Wakala transactions or the Islamic finance market generally. In short:
- The case is only procedural and makes no final determination of the issues.
- At the heart of the case was an argument concerning whether the Wakeel lacked capacity to enter into the transaction on the basis that its objects clause prohibited non-Shariah activities and that the Wakala transaction was in truth a disguised interest bearing deposit. Lack of capacity is not a new legal risk and can arise on any transaction, Islamic or conventional, where the counterparty is incorporated in a jurisdiction where companies have limited capacity and contracts outside that capacity are treated as void.
- Pending trial, the court has ordered that the Wakeel must repay the full amount of the original investment (but not the profit element) as an interim payment.
Blom Developments Bank Sal (Blom) (incorporated in Lebanon) placed two sums (US$10 million and US$1.5 million) (the Capital Sum) with The Investment Dar Company (TID) (incorporated in Kuwait) in two transactions performed under a master wakala agreement (the Master Wakala Agreement). A Wakala is a type of agency agreement commonly used in Islamic Finance transactions.
Article (5) of TID’s memorandum of association stated:
“The objectives for which the company is established shall be Sharia compliant. None of the objectives shall be construed and interpreted as permitting the company to practice directly or indirectly any usury or non-Sharia compliant activities.”
The Master Wakala Agreement was expressed to be governed by English law and provided that TID would invest the Capital Sum in a Shariah compliant manner. At the end of the agreed investment period for each transaction TID had an obligation to pay to Blom the Capital Sum plus a return which was fixed at the time of deposit (the Anticipated Profit). A Wakala is a type of agency agreement commonly used in Islamic Finance transactions.
Having fixed the Anticipated Profit on both transactions, the main risk that Blom took on was TID’s ability to pay out both Capital Sum and their respective Anticipated Profit at the end of the investment period. Towards the end of 2008 it became apparent to Blom that TID had cash flow difficulties and, having agreed to renew the Wakala transactions several times, Blom eventually issued proceedings in the English High Court at the end of January 2009 for payment of the Capital Sum together with the Anticipated Profit, and applied for the claim to be dealt with by way of summary judgment. In opposing this application TID argued that the Master Wakala Agreement did not comply with Shariah principles and, as TID was prohibited by its constitutional documents from entering into non-Shariah compliant activities, the Master Wakala Agreement was beyond the corporate powers of TID and therefore void. It is this argument that will cause concern in the Islamic finance market.
Summary of the decision
For a Claimant’s summary judgment application to be successful, the Claimant must show that the Defendant has no real prospect of successfully defending the claim that has been brought and there is no other compelling reason for a trial. In such a summary judgment application the court is not required to consider the full facts of the matter and only considers whether the Defendant has at least an arguable defence to the claim based on the limited information available to the court at what will be an early stage of the claim. If the court believes that there is at least an arguable defence it must order a full trial of the claim.
At first instance, the Master found that the ultra vires argument put forward by TID was arguable and provided TID with a potential defence to the claim. However, Blom had also advanced a claim based on trust concepts and the Master considered that TID had no arguable defence to this claim and so awarded summary judgment to Blom for the “trust asset” element of the claim, being the Capital Sum but not the Anticipated Profit. TID appealed this decision.
On appeal the court came to the same substantive conclusion, but for different reasons - namely that even if TID was correct and the Master Wakala Agreement was void, Blom would be entitled to the return of the Capital Sum by way of restitution (rather than by way of return of trust property).
The court was required to consider the following issues in the appeal:
Was the Master Wakala Agreement ultra vires TID? TID alleged that the Master Wakala Agreement amounted to a non-Shariah compliant transaction because in reality what TID was doing was taking deposits with an interest based return (contrary to the Shariah compliant object in its memorandum of association). The court held that questions of capacity of a corporate entity are governed by the law of the place of incorporation (in this case Kuwait) and the fact that the Master Wakala Agreement was governed by English law was irrelevant. The court agreed with the Master’s decision that this defence was at least arguable and therefore a triable issue did exist. The court did not consider the expert evidence on Shariah law that was presented, holding that this would need to be considered at a full trial. The finding that the argument presented by TID was an arguable defence should not be seen as an indication that the Court believed the defence would be successful at trial. In fact the Court expressed the view that this defence was essentially a “lawyer’s construct” and should be approached with some circumspection especially since the Sharia committee of TID had expressly approved the transaction and TID had confirmed this in the Master Wakala Agreement.
If the Master Wakala Contract was found to be void at trial could the Claimant nevertheless recover the Capital Sum? The court found that even if the transactions were ultra vires and void (as TID claimed) that would nonetheless give rise to a claim in restitution by Blom for the full amount of the Capital Sum (but not the Anticipated Profit) subject to any available defences.
If Blom did have a restitutionary claim for the Capital Sum, could TID raise the defence of innocent change of position? TID argued that it could be said that it had innocently changed its position by investing the funds in good faith upon the assumption that it was free to do so. The court commented that TID had done so on the assumption that it would have to pay the funds back and it did not seem in those circumstances that the defence of change of position would have any likelihood of success. The court commented that ultimately, if the Master Wakala Agreement is intra vires, the contract claim would succeed and if not, the restitutionary claim would succeed. In either event, TID would be liable at least for the full amount of the Capital Sum, if not the Anticipated Profit.
Should the court grant an interim payment? The English court has the power to grant an interim payment, i.e. to order the payment of an amount before a full trial representing the amount the court believes that the claimant may recover at a full trial of the claim. Considering the circumstances and the finding that TID would be liable at least for the whole of the Capital Sum, the Court found it was appropriate to make an order for an interim payment for the full amount of the Capital Sum. Although TID was given leave to defend the claim, this has been made conditional upon TID paying the full amount of the Capital Sum to Blom.
To whom should the interim payment be made? An interim payment order can be set aside if the trial court comes to a different decision at trial. TID therefore expressed concern that as Blom was a Lebanese company owing no allegiance to the English Court, if TID was ultimately successful at trial, TID would have no means of recovery from Blom. TID therefore asked for the interim payment to be paid into court pending final resolution of the claim. The Court was not persuaded by this concern and held that as far it could see, one way or another Blom would be bound to succeed and therefore the payment was to be made to Blom unconditionally.
Does this case undermine the integrity of Wakala products or the wider Islamic Finance market?
This is not a decision that should be seen as undermining the integrity of Wakala products or the wider Islamic Finance market more generally. It is also reassuring that the English Court used its power to order an interim payment to achieve the practical result that Blom recovered its initial investment, represented by the Capital Sum, without delay while the claim proceeded to trial.
What will happen next?
It remains to be seen whether this case proceeds to a full trial and, if it does, what the outcome will be once proper consideration has been given to evidence going to the merits of the defence, rather than simply its potential existence. On the basis of facts that are publicly available it seems unlikely that TID’s defence will succeed but, even if it does, on any view TID is liable to repay the Capital Sum and so the only live issue at trial will be whether TID can recover the Anticipated Profit.
How do I deal with the ultra vires risk?
The defence raised by TID that the Master Wakala Agreement was not compliant with Shariah and therefore was outside the corporate powers of TID has understandably caused concern. It is however important to note that the Court in this case did not make any decision on the merits of this defence and in fact expressed the view that this defence should be treated with scepticism. All that was decided on this point was that such a defence could in theory be arguable and hence leave to defend was granted provided Blom is paid the full amount of the Capital Sum first. Lack of capacity is not a new legal risk and can arise on any transaction, Islamic or conventional, where the counterparty is incorporated in a jurisdiction where companies have limited capacity and contracts outside that capacity are void. In practice the constitutional documents of many Islamic financial institutions are not always as clear as they could be on questions of capacity and is not necessarily commercially practicable to change them. The ultra vires risk should therefore be seen as part of the legal and emerging market risk matrix that has to be examined when dealing with such entities. A legal opinion from suitably qualified local lawyers will of course opine on the question of corporate capacity but in giving a clean opinion on capacity, inevitably the law firm in question will assume that the transaction documents are Shariah compliant in line with the decision of the relevant Shariah scholars. This is understandable as the law firm will not be qualified to opine on Shariah compliance but it does emphasise the need for proper due diligence on the capacity of the contracting entity, the need to understand the consequences of a contract entered into without capacity under the law of the place of its incorporation and the need to price any risks identified into the transaction.
Does this case undermine the decision in the Shamil Bank of Bahrain EC v Beximco Pharmaceuticals case?
Some participants in the market have questioned whether this case undermines the decision of the English court of appeal in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd and others. However the Shamil Bank case raised an entirely different legal question. By way of reminder, that case concerned a Murabaha agreement. The agreements each contained a governing law clause which stated that “Subject to the principles of the Glorious Shariah, this agreement shall be governed by and construed in accordance with the laws of England”. The defendants defaulted on their payments and the claimant applied for summary judgment against them for amounts due under the Murabaha agreement. The principal defence advanced by the defendants was that, on the true construction of the governing law clauses, the agreements were only enforceable in so far as they were valid both in accordance with the principles of the Shariah and in accordance with English law, and that the agreements did not in fact comply with Shariah law in that they were in truth disguised interest bearing loans. The English court read the governing law clause as a reference to English law only and so the defence based upon the contracts being disguised loans which were contrary to principles of Shariah failed. However, the point is that a choice of English law is only generally a choice of English contract law (including questions such as requirements of form, construction, breach and damages) and not every concept of English law. English law treats the question of the legal capacity of a foreign company as governed by the law of the place of incorporation and so a choice of English law to govern the contract is not a way of avoiding the risk that the law of the place of incorporation may state that a contract entered into by a company which exceeds its powers is ultra vires and void.
Accordingly, the best practice regarding ensuring the choice of law clause in Shariah transactions is unchanged, namely that the agreements should contain:
- recitals and representations and warranties that the parties are satisfied that the agreement does comply with Shariah;
- a provision whereby each party agrees that it will not seek to challenge the enforceability of the agreement in the future for reasons of non-compliance with Shariah principles - this is intended to create an “estoppel” as a matter of English law; and
- a governing law clause that provides for the contract to be governed only by the laws of England (without reference to Shariah).
However, it is important to appreciate that none of this will necessarily help if the transaction is outside one of the counterparty’s capacity. This is because the contract (and with it any recitals, contractual representations and promises not to challenge Shariah compliance) will be of no affect if the contract is ultra vires and void under the law of the place of its incorporation.