Dominant shari’a opinion prohibits selling debt for a price other than its face value. This prohibition covers both discounts and premiums in the sale/purchase of debt. Thus an individual, corporate or any other institution (eg, government) is not allowed to sell to a third party the debt a debtor owes to it, for a price other than the face value of the debt. Furthermore, there is a clear prohibition of selling debt for debt even if the two (deferred counter-values) are equal.
There is a simple rationale behind it. Islam does not allow re-pricing of debt even if it is between the initial creditor and debtor. This is so because pre-agreed (contractual) re-pricing of debt is likely to give rise to the pre-Islamic practice of interest, known as riba al-jahiliyya, which Islam prohibited. Thus, if party A owes $100 to party B, it is not permitted for the two parties to agree a priori to renegotiate the debt during the term of the debt agreement.
Although a creditor enjoys discretion to offer an early payment rebate to the debtor, shari’a does not allow formalising this discretion in the original debt agreement between the two parties. In the case of a late payment by the debtor, classical shari’a opinion disallows a penalty, although the contemporary shari’a view is flexible. In the modern day practice of Islamic banking, default penalty is allowed, as long as it is used only as a deterrent to wilful non-payment or delay on part of the creditor. In practice, this means that the creditor should not benefit, directly or indirectly, from the amount of the penalty; rather it should be given away as charity.
Discretionary rebate is normally applied on early payment but may also be exercised if payments remain in accordance with the contractual schedule. It is equally permissible (rather preferred) for the debtor to pay more than he borrowed, as long as it remains discretionary on the part of the debtor and there is no contractual agreement on it between the two parties.
In both the rebate and penalty cases, effectively the debt agreement is re-negotiated — potentially shortening the contract in the case of rebate (certainly in the case of early payment) and prolonging in the case of late payment or default. An important point to consider here is that the issue of rebate must remain non-contractual (and hence non-binding in nature).
Although re-pricing and limited re-negotiation of debt contracts is possible between a creditor and debtor even in Islamic finance, the mechanisms of doing so do not allow creditors to sell their debt in a meaningful way to a third party for a discounted price. For example, consider bank A that owns a murabaha asset with a face value of $100, which was created by selling a shari’a compliant asset to a client C on a deferred payment basis. Applying the prohibition of discounted trading in debt, Bank A can sell the murabaha asset (debt in the form of receivable) to a third party B for a price no other than $100, which must be paid on spot (by B). If A wants to sell this debt to B for a lower price, say $90, it could do so only after unilaterally forgiving (or writing off) $10 from the debt owed by C, and then selling the remaining debt for its face value of $90. Of course, this makes little sense for B who would otherwise wish to benefit from the discount. Having said that, there might be some cases wherein Parties A and B still wish to proceed with the transaction, which would be in compliance with Shari’a.
While discounted sale of debt is prohibited, shari’a allows partial transfer of debt through agency-based debt collection. Thus, it is permissible for a creditor A to appoint a third party B as its agent to collect its debt receivable against a fixed fee and/or variable rate determined by B’s performance.
In practice, a combination of undiscounted trading in debt and the agency-based debt collection contracts can affect the economic effects of discounted trading in debt. For example, a corporate owning a debt-based portfolio worth $100 may wish to “sell” it off by selling 50 per cent of it rto a third party for its face value, that is, $50. In addition, it appoints the same third party as its agent to collect the remaining 50 per cent of the debt from its debtors against an agency fee of 50 per cent of the amount collected. This combination of debt sale and debt collection gives rise to a Shari’a compliant way of achieving the economic effect of selling $100 worth of debt, with a 25 per cent discount.
There are two major differences between this shari’a compliant solution and the conventional discounted trading in debt. First, during the term of the contract between the creditor and its agent, the debt (50 per cent of the total in this example) remains on the creditor’s balance sheet until it is paid off (that is, it is collected by the agent). Second, the combination of (undiscounted) sale of debt and agency for debt collection is a performance-based arrangement, as the amount of “discount” very much depends on the recovery/collection of debt. If the agency fee was a fixed percentage of the amount recovered/collected, the combination model would offer a variable “discount” depending on the performance of the agent. If, for example, the agent recovers only $5 out of the total $50 to be collected then based on the agency fee of 50 per cent of the amount collected, total “discount” received by the party B will be 4.5 per cent. The discount increases to 8.3 per cent, if B collects $10 instead, reaching to 25 per cent when all the $50 debt is collected.
This combination-based debt trading has a built-in regulatory mechanism, as it allows a party to “sell” only part of its debt. An implication of this is that only a fraction of the total debt owned by a business can be offloaded from its balance sheet. It should remain the prerogative of the industry regulator to determine what proportion of debt a business can offload from its balance sheet by determining a threshold for the sale of debt and debt collection in combination-based debt trading models.
The writer is a shari’a advisor to a number of banks and financial institutions and can be contacted at [email protected]