In a recent opinion arising from the Chapter 11 proceedings of Arcapita Bank, Judge Alvin Hellerstein of the US District Court for the Southern District of New York affirmed a bankruptcy court decision denying safe-harbor protection to Shari'a-compliant Murabaha investment agreements.1 Specifically, the district court held that the Murabaha agreements at issue did not qualify as securities contracts, forward contracts, or swap agreements under the safe harbor provisions of the US Bankruptcy Code. The district court's decision in Arcapita is among the few decisions specifically addressing treatment of Islamic finance transactions in a US bankruptcy proceeding. The Arcapita decision also is among the first times that any court in the US or England has addressed in depth the treatment of a Shari'a-compliant product and how it should be classified according to relevant laws.
Murabaha Transactions Generally
Murabaha agreements comply with Shari'a law's restriction against traditional lending for interest. As explained by Judge Hellerstein, in a Murabaha transaction, "[a] placing party transfers funds to a receiving party (a party in need of funds)" and "[t]he receiving party, acting as an agent for the placing party, purchases specified commodities on the placing party's behalf."2 "The receiving party immediately agrees to repurchase those commodities from the placing party on a cost-plus basis to be paid on an agreed future date" and, thus, "creates an obligation to repurchase by the receiving party, and the placing party expects to receive the agreed-upon repurchase price."3
Murabaha agreements form the basis of a substantial majority of Shari'a-compliant transactions in the market, so the examination of their nature, and how that dovetails with US bankruptcy laws, is a welcome development in the small but growing body of case law that deals with Islamic finance instruments.
Arcapita Bank's Murabaha Transactions
In 2012, Arcapita Bank B.S.C.(C) ("Arcapita Bank")—an investment bank and global manager of Shari'a-compliant alternative investments headquartered in Bahrain—entered into two commodity investment agreements with Bahrain Islamic Bank ("BisB")—a commercial bank also headquartered in Bahrain.4 In accordance with Shari'a law and customary Islamic banking and finance practice, the transactions were structured as Murabaha investments rather than traditional lending transactions so as not to run afoul of the prohibition against interest under Shari'a law.5 Under those two Murabaha investments, BisB invested $9.8 million with Arcapita Bank. Separately, Arcapita Bank made $30 million of its own Murabaha investments with BisB.6
Arcapita Bank's Chapter 11 Cases and Subsequent Litigation
Arcapita Bank filed for Chapter 11 protection in the US Bankruptcy Court for the Southern District of New York on March 19, 2012.7 Approximately one week later, BisB repaid $20 million of Arcapita Bank's matured Murabahainvestments but withheld $10 million in additional matured Murabaha investment proceeds.8 Arcapita Bank demanded that BisB turn over the remaining $10 million in proceeds, but BisB refused.9 Instead, BisB communicated with Arcapita Bank that it had exercised a right of setoff under Bahraini law of the debts owing between itself and Arcapita Bank.10
On August 26, 2013, Arcapita Bank's official committee of unsecured creditors (the "Committee") commenced adversary proceedings against BisB in the bankruptcy court, asserting claims for, among other things, violation of the automatic stay under section 362(a) of the US Bankruptcy Code and seeking turnover of the $10 million in proceeds under section 542(b) of the US Bankruptcy Code.11 BisB argued in a cross-motion for summary judgment that, among other things, the Murabaha transactions were protected under the safe harbor provisions of the US Bankruptcy Code either as securities contracts, forward contracts, or swap agreements.12The safe harbor provisions of the US Bankruptcy Code provide, among other things, that specified non-debtor counterparties to a securities contract, forward contract, or swap agreement may exercise a contractual right to liquidate, terminate, or accelerate the contract by virtue of the bankruptcy or insolvency (or similar status) of the debtor.13 The non-debtor counterparty's exercise of such contractual rights are not stayed by the automatic stay.14
As explained below, the bankruptcy court denied BisB's cross-motion and granted the Committee's cross-motion for summary judgment as to its claims for turnover under section 542(b) of the US Bankruptcy Code and violation of the automatic stay under section 362(a) of the US Bankruptcy Code (but denied damages as to the stay violation).15 In particular, the bankruptcy court held that the Murabaha agreements did not qualify as securities contracts, forward contracts, or swap agreements and thus were not covered by the US Bankruptcy Code's safe harbor provisions applicable to these agreements.16
SDNY Affirms Bankruptcy Court Ruling
On appeal, the district court affirmed the bankruptcy court's findings and judgment that the Murabaha agreements were not protected by the safe harbor provisions.17
The district court held that the Murabaha agreements were not securities contracts.18 In doing so, the court noted that BisB itself characterized the Murabahas as "liquidity management tools, designed to allow the equivalent of interest to be paid on loans, rather than investments."19 The district court also concluded that the bankruptcy court correctly interpreted the Murabaha agreements as "loan-like" rather than as securities contracts.20
In addition, the district court held that the Murabaha agreements, on their face, did not qualify as securities because the definition of "securities contract" in section 101(49)(B)(vii) of the US Bankruptcy Code specifically excludes a "debt or evidence of indebtedness for goods sold and delivered or services rendered."21 The Murabaha transactions fell within this exclusion because, among other things, the transactions provided for the "purchase, and repurchase, of the same commodities, plus an increase."22
The district court also held that the Murabaha agreements did not qualify as forward contracts23 for two primary reasons.24 First, the contracts did not have a "relationship to the financial markets" as their primary purpose was not risk-shifting in nature because they provided for immediate delivery of the underlying commodity and did not expose either party to the risk of price fluctuations.25 The district court further explained that "[n]othing in the record indicates that the [M]urabahas involved speculation on the price of the underlying commodities, which might have brought the transactions within the safe harbor provisions."26 Indeed, from an Islamic finance practitioner's perspective, it is a central pillar of Islamic finance that speculation is specifically prohibited, and it would be at odds with prevailing scholarly interpretation to suggest that a Murabaha agreement was being used to speculate on commodity price movements.
Second, the contracts did not have a required maturity date of more than two days after the agreement was entered.27 Rather, the agreements provided for immediate delivery of commodities in exchange for deferred payments, and because courts have regarded the delivery date as the maturity date for safe harbor purposes, the Murabaha agreements were not forward contracts under the US Bankruptcy Code.28
Finally, the district found that the Murabaha agreements were not "swap agreements,"29 which under the US Bankruptcy Code are defined to include "commodity forward agreements."30 The court's reasoning on this issue paralleled its reasoning for holding that the Murabaha agreements were not forward contracts.31
Not Consistent with Safe Harbor Statutory Purpose
As an additional matter, the court found that, even assuming the Murabaha agreements were swap agreements, BisB could not claim protection under the swap agreement safe harbor provision in section 560 of the US Bankruptcy Code because BisB was not claiming or seeking to exercise a right to liquidate, terminate, or accelerate the agreement.32 Similarly, the court held that BisB was not entitled to forward contract safe harbor protection under section 556 of the US Bankruptcy Code because BisB was not seeking to liquidate, terminate, or accelerate any contract. Rather, the district court held that BisB merely sought to "enforce pre-petition transactions and retain the proceeds."33
This case represents one of the first times that a US or English court has conducted a comprehensive legal analysis of the nature of a Murabaha agreement. To date, case law on Islamic finance transactions has been limited and mostly comes from English courts. These cases have tended to involve an ultra vires claim by one of the parties that: (i) it is a Shari'a-compliant institution that is only permitted to enter into Shari'a-compliant contracts; (ii) the contract at issue was not, in fact, Shari'a-compliant; and, therefore, (iii) the party is not required to perform as the performance would be ultra vires, i.e., beyond its corporate powers. The ultra vires arguments in such cases have generally failed, with courts generally declining to apply Shari'a principles but instead interpreting matters using English contractual principles as the governing law of the contract.
The matters at issue in this case were more complex and nuanced. However, practitioners should take comfort that the market-accepted interpretation of a Murabaha agreement has been supported by a US bankruptcy court and on appeal to a US district court. In particular, it is typically understood that the trading of commodities in Murabaha transactions is not intended to provide any form of speculation or market-related risk as it relates to such commodities. Rather the commodities are assets that can be sold by one party to the other for spot delivery and deferred payment terms. It is those deferred payment terms that allow a profit to be charged on the cost price of the commodities, thus mimicking the returns that would be paid on a conventional finance agreement. The judgment handed down in Arcapita supports this interpretation, which provides comfort to market participants. It remains to be seen, however, whether the market will respond to the decision in Arcapita by requiring the parties to Murabaha agreements to specifically acknowledge that the Murabaha agreement is not a securities contract, forward contract, or swap agreement, whether for purposes of the US bankruptcy laws or other applicable law.
Another point of note is that Murabaha agreements generally contain a waiver of the right to receive interest, including interest awarded by a competent court. However, in Arcapita, there was no contractual interest-waiver clause at issue. As a result, the bankruptcy court awarded prejudgment interest at 9 percent (the New York statutory rate), finding that doing so was consistent with Bahraini Civil Code provisions regarding remedies for breach of contract.34 The district court affirmed the bankruptcy court's judgment on this issue. In future cases where a contractual waiver of interest is at issue, a court's decision may turn on the specific wording of any interest-waiver clauses included in the relevant Murabaha agreements.
The decision in Arcapita is noteworthy for practitioners in Islamic banking and finance and illustrates that courts will closely scrutinize whether a party is entitled to the protections of the US Bankruptcy Code's safe harbor provisions applicable to securities contracts, forward contracts, and swap agreements. The case bears continued watching, as BisB has appealed the district court's decision to the US Court of Appeals for the Second Circuit.
1. The opinion is available at In re Arcapita Bank B.S.C.(C), No. 21 CIV. 8296 (AKH), 2022 WL 1620307 (S.D.N.Y. May 23, 2022).
2. In re Arcapita Bank B.S.C.(C), No. 21 CIV. 8296 (AKH), 2022 WL 1620307, at *2 (S.D.N.Y. May 23, 2022).
4. See id. at *2-3.
5. See id.
6. See id. at *3-4.
7. See id.
8. See id.
9. See id. at *4.
10. See id.
11. See id.
12. See id.
13. See 11 U.S.C. §§ 555, 556, 560. Such a contractual termination clause is commonly referred to as an "ipso facto" clause. The US Bankruptcy Code provides parallel safe harbors applicable to repurchase agreements and master netting agreements. See 11 U.S.C. §§ 559, 561. However, those safe harbors were not at issue in Arcapita.
14. See 11 U.S.C. §§ 362(b)(6), (17).
15. See id.
16. See id.
17. See id. at *18.
18. See id. at *11-12.
19. Id. at *12.
23. Under section 101(25)(A) of the US Bankruptcy Code, a "forward contract" is defined in relevant part as "a contract . . . for the purchase, sale, or transfer of a commodity . . . with a maturity date more than two days after the date the contract is entered into . . . ." 11 U.S.C. § 101(25)(A).
24. Arcapita Bank, 2022 WL 1620307, at *12-14.
26. Id. at *13.
27. See id. at *12.
28. See id. at *12-14.
29. See 11 U.S.C. § 101(53B)(A)(i)(VII).
30. Arcapita Bank, 2022 WL 1620307, at *12-14.
31. See id.
32. See id. at *14.
33. See id.
34. The Murabaha agreements were governed by Bahraini law.
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