Public – Item 6
RULES & ETHICS COMMITTEE
26 March 2007
CLASSIFICATION – PUBLIC
Islamic mortgage finance
EXECUTIVE SUMMARY
Summary
1.
The purpose of this paper is to provide new members of the Rules and Ethics
Committee with some background information on Islamic mortgage finance. The
opportunity has also been taken to update the Committee on developments since
the issues were last considered in September 2006.
Recommendation
2.
That the Committee notes this paper.
Annex
Extracts from practice rule 6
Author
Date
Angela Doran
12 March 2007
This paper is for noting
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Islamic mortgage finance
Summary
1.
The purpose of this paper (which is for noting) is to provide new members of the
Rules and Ethics Committee with some background information on Islamic
mortgage finance. The opportunity has also been taken to update the Committee
on developments since the issues were last considered in September 2006.
The Islamic Mortgages Working Party
2.
The Islamic Mortgages Working Party (the Working Party) was established to
consider the nature of Islamic mortgages, to identify legal issues arising from the
operation of Islamic mortgages, and to consider the inter-relationship between
Islamic mortgage structures and practice rule 6.
3.
The Working Party reports to the Rules and Ethics Committee, and includes
representatives from this Committee, the Conveyancing and Land Law Committee
of the Law Society, and a City firm with practical experience of Islamic law.
Types of Islamic mortgage
4.
Conventional interest-based mortgage products available in England and Wales
are unsuitable for Muslims, as Islamic law forbids the receipt and payment of
interest. Various methods of financing a purchase to comply with Islamic law have
been developed:
Murabaha finance
5.
The Murabaha method of Islamic finance involves the lender buying the
property and immediately selling it on to the buyer/borrower at an enhanced
price, determined by the number of years the purchase price is to be paid
over. Once the intermediate purchase and sale by the lender has taken
place, the buyer/borrower becomes the registered proprietor. The lender
takes a first charge over the property as security for payment of the purchase
price instalments due over the agreed term.
6.
The outcome is that a situation akin to a conventional mortgage comes into
existence. There is a legal charge in favour of the lender and the borrower
occupies the property as the owner.
7.
This method is inflexible as the amount payable over the agreed term cannot
be varied. It tends to be used for commercial and commodities transactions
with limited terms of five to 15 years.
Ijara finance
8.
The Ijara method of Islamic finance involves the lender buying the property
and entering into a deferred contract for sale to the buyer/borrower at the
same price. The buyer/borrower then occupies the property under a lease
from the lender, and pays both rent and instalments of the purchase price to
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the lender over the agreed term of years in order to acquire ownership at the
end of that term.
9.
There is no mortgage of land as the lender owns the property until the end of
the term. The borrower does not become the registered proprietor until the
deferred contract for sale is completed.
10.
This method is flexible as the rent payable can be varied throughout the term
in line with agreed indicators. It tends to be used for residential transactions.
Diminishing Musharaka finance
11.
A modified form of Ijara contract is now becoming popular. Under a
diminishing Musharaka contract, the lender still buys the property and
becomes the legal owner, but the beneficial ownership is shared. The
borrower gradually acquires an increasing beneficial interest in the property
by virtue of the initial deposit and the payments made over the agreed term.
12.
The borrower occupies the property under a lease from the lender and pays
rent to the lender in respect of the lender’s beneficial interest in the property,
in addition to paying instalments of the purchase price. The lender remains
the legal owner of the property until the borrower has a 100% beneficial
interest in the property, at which point the lender transfers the legal estate in
the property to the borrower in accordance with the deferred contract for sale.
Barriers to Islamic finance
13.
A Bank of England Working Group was set up in 2002 to look at the barriers
preventing Islamic mortgage products from being developed in the UK. The
aim was to enable lenders to offer competitive products compliant with Shari’a
law but comparable in cost and operation to conventional mortgages. For
example, the double stamp duty land tax burden has largely been removed.
14.
Another barrier identified by the Bank of England Working Group (now
disbanded) relates to rule 6 of the Solicitors’ Practice Rules 1990 (avoiding
conflicts of interest in conveyancing). (Rule 3 of the Law Society’s Code of
Conduct will eventually supersede practice rule 6 but is not yet in force. It
makes no material changes to practice rule 6 in the context of the issues
under consideration.)
15.
A non-Muslim buying residential property with the aid of a conventional
mortgage will almost invariably have a solicitor who acts also for the lender,
and thus pays only one set of legal fees. In the case of an Islamicallycompliant mortgage, there is an apparent requirement for separate
representation which means that Muslim buyers/borrowers pay two sets of
legal fees. (The complexity of the transaction and number of documents
involved also means that legal fees are higher than usual.)
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Conflict of interests
Practice rule 6
16.
Practice rule 6 applies to both residential and commercial conveyancing
transactions and is based on the fundamental duty at common law that a
solicitor must not act for two or more clients where there is a conflict, or a
significant risk of conflict, between the interests of those clients. It is a
requirement both at law and in conduct that a solicitor must not act for more
than one client if there is a conflict of interests between them. Extracts from
rule 6 are annexed.
17.
There are very few circumstances under rule 6(2) where a solicitor may act
for both seller and buyer because of the inherent risk of a conflict of interests
arising.
18.
By contrast, rule 6(3) permits solicitors to act for both lender and borrower in
a “standard mortgage” (basically where a main-stream lender offers a
mortgage on its standard terms). Separate representation has always been
required in an “individual mortgage” (basically where there is an element of
negotiation of the terms).
19.
Representing both the lender and the borrower in a standard mortgage is
permitted on the basis of a limited retainer with the lender confined to work
falling within the normal role of a conveyancing solicitor. A solicitor cannot
accept instructions to act for the lender, as well as the borrower, if the
lender’s instructions extend beyond the parameters set out in paragraph (c) of
rule 6(3). In addition, separate representation is always required if a conflict
of interests exists or arises in the circumstances of a particular transaction.
20.
In the case of an Islamically-compliant mortgage, the question arises whether
there is an inherent risk of a conflict of interests by virtue of the lender
becoming the intermediate seller (Murabaha transaction), or the intermediate
lessor and seller (Ijara/diminishing Musharaka transaction).
21.
It also needs to be borne in mind that lenders, as well as borrowers, need
independent advice and solicitors who act in their best interests. The law and
conduct provisions relating to conflict exist to protect lenders as well as
borrowers.
Legal advice
22.
The Law Society sought the advice of Counsel on the nature and validity at
law of Islamic mortgages and the legal issues which arise from their
operation. A copy of the opinion, dated June 2005, is available from the
author on request.
Murabaha finance
23.
Counsel concluded that the Murabaha type scheme is in substance very
close to a mortgage transaction, and does not appear to give rise to any
greater risk of a conflict of interests than in a conventional Western mortgage.
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He advised that the Law Society could amend practice rule 6 to enable a
solicitor to act for both parties to a Murabaha type transaction.
24.
In the first stage of a transaction, there is a genuine sale by the original seller
to the lender, which puts the lender in the position of a seller and not merely a
mortgagee. There is, therefore, a need to amend rule 6(2) to allow the
buyer/borrower’s solicitor to act for the seller/lender and buyer/borrower
where the sale is a component part of a Murabaha transaction.
25.
Such a rule change may be of limited value in practice if Murabaha
mortgages are used in commercial and commodities transactions, where
terms tend to be negotiated between the parties’ solicitors and separate
representation is necessary.
26.
In addition, Counsel was concerned at the apparent lack of any provision in
the Murabaha documentation to allow for an equitable recalculation of the
enhanced element of the purchase price on an early redemption, following the
sale of the property by the borrower (or by the lender in a repossession).
Professional Ethics understands that the fixed price is an essential
component of a Murabaha mortgage, with any discount on early repayment
being at the lender’s discretion. This gives rise to a conflict of interests
between the parties and the need for separate representation.
Ijara finance
27.
Counsel concluded that the Ijara scheme is not in substance a mortgage
transaction, and gives rise to the clearest of conflicts of interest between the
borrower and the lender, making separate legal advice for each party a
necessity.
28.
The main problems with the Ijara “mortgage” arise from the fact that the
borrower is an assured tenant, not the legal owner of the property. The
borrower is vulnerable to termination of the tenancy (on mandatory grounds in
the case of rent arrears) and loss of the right to possession.
29.
The lender is also entitled to rescind the deferred sale agreement in the case
of rent arrears, so there is no equitable right to possession, or to repay the
loan and recover the property.
Joint statement of the Working Party and Committee
30.
The Working Party and Committee considered that in view of Counsel’s
advice, the complexity of the legal position, and uncertainty as to how Islamic
mortgage products will be dealt with by the courts, rule 6 should not be
amended at present. The following statement was agreed on 25 September
2006:
“It is a fundamental principle of common law, which practice rule 6 reflects,
that a solicitor cannot act for both parties where there is a conflict of interests.
For so long as, and to the extent that, any property finance product (including
Shari’a compliant products) gives rise to a conflict of interests, practice rule 6
will apply to prevent a solicitor from acting for both parties.”
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31.
This statement allows for the possibility of a change to rule 6 in circumstances
other than a change in law; for example, if the nature of Islamic products
develop in such a way as to remove the conflicts of interest inherent in the
present products.
32.
It is hoped that the statement can be incorporated in the next edition of the
Conveyancing Handbook due to be published later this year or, failing that, in
the following edition. Although the Handbook refers to key regulatory
provisions relevant to conveyancers, it is essentially a practical guide for
conveyancers produced by the Law Society.
FSA regulation
33.
Since 31 October 2004, mortgage activities have been regulated by the
Financial Services Authority (FSA). Murabaha contracts have been regulated
by the FSA since 31 October 2004, as they are very close in structure to
conventional mortgages and are regarded as meeting the requirements of a
regulated mortgage contract.
34.
An Ijara contract does not meet the requirements of a regulated mortgage
contract but will, under recent legislation, become a regulated activity and fall
within FSA regulation (as a “home purchase plan”) from 6 April 2007.
35.
FSA rules will require providers (lenders) of Ijara contracts to point out the
legal risks, arising from the structure of home purchase plans, that consumers
(borrowers) may not readily appreciate. Matters identified by the FSA
include:

as the provider owns the property and the consumer is a tenant, the
consumer may lose the right to stay in the property if he or she
breaches any of the terms of the agreement with the provider;

if a provider becomes insolvent, ceases trading or sells to a third
party, the consumer may lose the right to stay in the property unless
the lease is properly registered;

if a provider ceases trading, the consumer may lose the right to buy
the property at the end of the agreement, unless the contractual terms
between the consumer and the provider are specifically enforceable;

if a provider ceases trading, the consumer may lose the right to his or
her beneficial share in the property, unless the arrangement under a
diminishing Musharaka arrangement has been recorded;

under an Ijara arrangement, the consumer does not have a recordable
increasing share in the property but simply makes pre-payments on
account. In the event that a provider ceases trading, the consumer
may lose all those pre-payments, unless the right to purchase the
property is specifically enforceable.
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36.
The FSA will also require providers of home purchase plans to draw the
consumer’s attention to the importance of obtaining independent legal advice
and the need to budget for two sets of solicitors’ fees. A particular concern of
the FSA is that some borrowers under Ijara contracts may choose to
represent themselves in order to reduce the cost of the transaction (paying
the legal costs of the lender’s solicitor only).
37.
Although FSA regulation will ensure that the potential risks to consumers and
the need for independent legal advice are highlighted, it cannot solve the
legal disadvantages and risks associated with these products.
Financial Markets Law Committee
38.
The Financial Markets Law Committee (FMLC) has links to, but is
independent of, the Bank of England. An FMLC working group has been
established, comprising members of the FMLC and Law Society, to look at
the issues surrounding Islamic mortgage finance.
39.
The FMLC has been involved in extensive correspondence with the Treasury,
including the preparation of a briefing paper, in an attempt to persuade the
Treasury to refer Islamic mortgages to the Law Commission for a
consideration of mortgage law and consumer protection in relation to these
products. The Treasury has declined to refer the subject to the Law
Commission, possibly because it prefers to see what effect FSA regulation
will have.
The Law Commission
40.
The Law Commission is in the process of establishing its 10th work
programme. The FMLC (with the support of the Law Society) will be making
a direct approach to the Law Commission to look at the legal issues
surrounding Islamic mortgage finance.
41.
In addition, the Law Society will be making its own submission direct to the
Law Commission to demonstrate the importance of the issues raised by
Islamic mortgage finance to both consumers and solicitors. The Law Society
has met the Commission and is to write a paper setting out the issues.
(Professional Ethics has suggested that this paper might mention the support
of the SRA for a Law Commission project.)
42.
As well as supporting a Law Commission project, the role of the SRA will be
to continue to monitor developments and keep under review the need for
guidance.
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Recommendation
That the Committee notes this paper.
Annex
Extracts from practice rule 6
Author
Date
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Angela Doran
12 March 2007
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ANNEX
RULES & ETHICS COMMITTEE
26 March 2007
Extracts from practice rule 6
Rule 6 (Avoiding conflicts of interest in conveyancing, property selling and
mortgage related services)
(1) (General)
This rule sets out circumstances in which a solicitor may act for more than one party
in conveyancing, property selling or mortgage related services, in connection with:
(i)
the transfer of land for value at arm's length;
(ii)
the grant or assignment of a lease, or some other interest in land, for
value at arm's length; or
(iii)
the grant of a mortgage of land.
The rule must be read in the light of the notes.
Notes
*****
(iv)
Whether a transaction is "at arm's length" will depend on the relationship
between the parties and the context of the transaction, and will not necessarily
follow from the fact that a transaction is at market value, or is stated to be on
arm's length terms.
A transaction would not usually be at arm's length, for example, if the parties are:

related by blood, adoption or marriage;

the settlor of a trust and the trustees;

the trustees of a trust and its beneficiary or the beneficiary's relative;

personal representatives and a beneficiary;

the trustees of separate trusts for the same family;

a sole trader or partners and a limited company set up to enable the
business to be incorporated;

associated companies (i.e. where one is a holding company and the other
is its subsidiary within the meaning of the Companies Act 1985, or both
are subsidiaries of the same holding company); or

a local authority and a related body within the meaning of paragraph 6(b)
of the Employed Solicitors' Code 1990.
*****
(2) (Solicitor acting for seller and buyer)
(a)
A solicitor must not act for seller and buyer:
(i)
without the written consent of both parties;
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(b)
(ii)
if a conflict of interest exists or arises; or
(iii)
if the seller is selling or leasing as a builder or developer.
Otherwise, a solicitor may act for seller and buyer, but only if:
(i)
both parties are established clients; or
(ii)
the consideration is £10,000 or less and the transaction is not the
grant of a lease; or
(iii)
there is no other qualified conveyancer in the area whom either the
seller or the buyer could reasonably be expected to consult; or
(iv)
seller and buyer are represented by two separate offices in different
localities, and:
(A)
different solicitors, who normally work at each office, conduct
or supervise the transaction for seller and buyer; and
(B)
no office of the practice (or an associated practice) referred
either client to the office conducting his or her transaction; or
(v)
the only way in which the solicitor is acting for the buyer is in
providing mortgage related services; or
(vi)
the only way in which the solicitor is acting for the seller is in
providing property selling services through a SEAL.
*****
Notes
(i)
If a builder or developer acquires a property in part exchange, and sells it on
without development, he or she is not, for the purpose of this rule, selling "as a
builder or developer".
(ii)
The test of whether a person is an "established client" is an objective one; that is,
whether a reasonable solicitor would regard the person as an established client.
(iii)

A seller or buyer who is instructing the solicitor for the first time is not an
established client.

An individual related by blood, adoption or marriage to an established
client counts as an established client.

A person counts as an established client if selling or buying jointly with an
established client.
The consideration will only count as £10,000 or less if the value of any property
given in exchange or part exchange is taken into account.
*****
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(3) (Solicitor acting for lender and borrower)
(a)
A solicitor must not act for both lender and borrower on the grant of a
mortgage of land:
(i)
if a conflict of interest exists or arises;
(ii)
on the grant of an individual mortgage of land at arm's length;
(iii)
if, in the case of a standard mortgage of property to be used as the
borrower’s private residence only, the lender’s mortgage
instructions extend beyond the limitations contained in
paragraphs (3)(c) and (3)(e), or do not permit the use of the
certificate of title required by paragraph (3)(d); or
(iv)
if, in the case of any other standard mortgage, the lender’s
mortgage instructions extend beyond the limitations contained in
paragraphs (3)(c) and (3)(e).
*****
(c)
A solicitor acting for both lender and borrower in a standard mortgage
may only accept or act upon instructions from the lender which are limited
to the following matters:
(i)
taking reasonable steps to check the identity of the borrower (and
anyone else required to sign the mortgage deed or other document
connected with the mortgage) by reference to a document or
documents, such as a passport, precisely specified in writing by the
lender;
*****
(ii)
making appropriate searches relating to the property in public
registers (for example, local searches, commons registration
searches, mining searches), and reporting any results specified by
the lender or which the solicitor considers may adversely affect the
lender; or effecting search insurance;
(iii)
making enquiries on legal matters relating to the property
reasonably specified by the lender, and reporting the replies;
*****
Notes
(i)
A mortgage is a “standard mortgage” where (1) it is provided in the normal
course of the lender’s activities; (2) a significant part of the lender’s activities
consists of lending; and (3) the mortgage is on standard terms. An “individual
mortgage” is any other mortgage.
*****
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