Losing Interest: Financial Alchemy in Islamic, Talmudic, & Western Law

• Author: Michael H. Lubetsky
• Pages: 06

2009 Trandafir International Business Writing Competition winner. The author would like to thank Mohammad Nsour, whose Islamic Law course at McGill University originally inspired this Article, as well as Joshua A. Krane and Lucan Gregory for their insightful comments. Special thanks are also due to Note Editor Umair Kazi and the rest of the editorial staff at Transnational Law and Contemporary Problems. The author is currently an associate at Davies Ward Phillips & Vineberg LLP. The views expressed in this Article are those of the author alone.

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I Introduction

That they took usury, though they were forbidden; and that they devoured men's substance wrongfully; we have prepared for those among them who reject faith a grievous punishment.¹

Compare the cases of Alex and Ahmed, both of whom want to buy a house worth $100,000. Alex goes to a bank, takes out a one-year loan of $100,000 at 5 percent interest, and uses the money to buy the house. Ahmed goes to an Islamic bank and arranges for the bank to purchase the house for $100,000 and to immediately resell it to him at a 5 percent mark-up, payable next year. The cash flows are identical, ² yet to a Muslim, the two transactions have very different legal and spiritual consequences. In Alex's case, the 5 percent premium constitutes interest, which renders the contract void under Islamic law ('sharia") and potentially earns Alex and his banker a reservation in Hell. In Ahmed's case, however, the 5 percent premium constitutes a legitimate trading profit of a bai' bithaman ajil financing contract. How can these two essentially identical transactions have such different consequences?

The debate over what constitutes interest extends far beyond the Muslim world. Talmudic and canon law include bans on interest, which Jewish and christian lenders alike have long sought to circumvent. Modern financiers continue to use a variety of stratagems to exact interest in excess of that allowed by criminal and civil usury statutes. corporate accountants have numerous incentives to classify financing costs as something other than interest to improve financial ratios. Whether a certain cash flow constitutes Page 233 interest also has enormous consequences, either positive or negative, in tax planning.

A review of these disparate situations, however, reveals that different legal traditions have tended to adopt different approaches to interest-avoiding transactions, with sharia law, in particular, taking a conspicuously permissive approach compared to others. Some or all of the mark-up in Ahmed’s bai’ bithaman ajil contract, for example, would almost certainly be deemed interest by an accountant, a Western jurist, or a rabbi. A closer look at some of the underlying principles of Islamic legal doctrine and a comparison with other modes of legal thinking can help explain why sharia has developed such a permissive attitude.

To facilitate this analysis, Part I of this Article provides a brief overview of the bans or restrictions on interest in various legal traditions. Part II proposes a two-dimensional typology of normative orders, uses it to classify sharia, Talmudic law (“halakha”), Western law, and Generally Accepted Accounting Principles (“GAAP”), and formulates hypotheses on how the typology can predict attitudes towards interest-avoiding fictions. Part III tests the hypotheses using the doctrine and jurisprudence of the four identified legal traditions. The analysis ultimately shows that Islam’s ready acceptance of interest-avoiding transactions results from its formalist attitude towards legal interpretation and its ordering vocation-a combination of qualities that distinguish sharia from other major legal traditions.

II Restrictions On Interest In Different Legal Traditions

A Sharia

Islam’s ban on interest stems from three passages in the Quran that forbid riba ( , literally “increase” or “growth”), ³ which subsequent Islamic scholarship divided into riba al-nasi’a (interest on loans) and riba al-fadl (unequal exchange of commodities). ⁴ The exact definition and scope of both forms of riba have generated centuries of animated debate. ⁵ In modern times, however, leading sharia jurisprudence from Egypt ⁶ and Pakistan ⁷ concur Page 234 that riba includes all forms of interest on a debt, including "any amount, however little, stipulated in addition to the principal in a transaction of loan."⁸ Notwithstanding dissenting opinions,⁹ including a decision from the Dubai Court of Cassation,¹⁰ this definition represents the dominant view among Muslim jurists today, particularly in countries that aspire or purport to implement sharia law.¹¹

Because of the ban on riba, borrowers and lenders alike in the Muslim world have sought to structure their financing transactions so as to repackage the interest as trading profit.¹² The most common structures include the mudaraba (similar to a preferred shareholding), murabaha (commissioned purchase and resale), ijara (sale-and-leaseback), tawarruq (commodity-intermediated loan), istisna (contract for manufacture), and salaam (forward purchase).¹³ Through careful structuring of these transactions, Islamic financiers can also create various forms of sukuk, which is securitized debt, that is virtually indistinguishable from simple debentures.¹⁴

B Western Law

Western law, in both its common and civil law manifestations, has long featured interest regulation.. In the civil law tradition, polemics against usury date back to Roman times. Roman law banned interest altogether in the Lex Genucia of 340 B.C.E., but eventually established a legal rate of 1 percent per month.¹⁵ Lending, even at the legal rate, came under attack with the advent of Christianity, as the Catholic Church strongly condemned usury Page 235 and campaigned against it with ever-increasing vigor throughout the Middle Ages.¹⁶ The 1311 Church Council of Vienna declared usury a violation of both divine and human law and ordered the excommunication of all public officials who allowed lending on interest in their jurisdictions.¹⁷ However, reformation and industrialization ultimately motivated the legalization of interest-based lending, beginning in Austria in 1787 and continuing in France during the Revolution.¹⁸ By the late 19th Century, most of Europe and Latin America had no maximum interest rate and very little interest regulation in general. ¹⁹However, this state of affairs proved relatively short-lived, and state after state-led, again, by France in 1807-reintroduced criminal and civil regulations capping interest rates or otherwise subjecting loan contracts to judicial scrutiny. ²⁰

In England, actions for usury originally fell under the primary jurisdiction of the ecclesiastical courts.²¹ By the 15th Century, the growth of the commercial class and the resulting demand for credit converted usury into a temporal issue, and Parliament enacted a statutory ban on interest-lending in 1487.²² Enforcement proved sporadic, however, and the ban gave way to interest regulation with the 1545 Act Against Usury,²³ which allowed loans to bear interest up to 10 percent per annum.

Today, throughout common law jurisdictions, charging interest above a prescribed statutory rate elicits both criminal and civil sanctions. ²⁴ Contracts that exact criminal levels of interest have routinely been found void for reasons of public policy²⁵ and have exposed lenders to liability for unjust Page 236 enrichment and violations of consumer protection statutes.²⁶ Even without prescribing particular limits on interest rates, a variety of statutory provisions allow courts to review and revise loan or credit contracts judged "extortionate and grossly extravagant" or "unconscionable."²⁷

In Western law, the characterization of a particular cash flow or accrual as "interest" can also have enormous tax implications. Investors may prefer to have interest revenues repackaged as capital gains²⁸ or business profits,²⁹which generally qualify for lower tax rates than interest income. Borrowers can often also benefit from repackaging interest as capital expenditures, since it may allow for increased accelerated depreciation. ³⁰ A firm with large accumulated losses may prefer to subsume its debt expenses in its capital losses that can be carried forward indefinitely, rather than in its operating losses that can only be carried forward twenty years. ³¹ On the other hand, since interest is tax deductible and dividends are not, a profitable business can benefit from repackaging its equity financing costs as interest, a form of financial alchemy that can directly increase the firm's value.³²

To get around interest regulation and for tax planning purposes, Western lenders and borrowers have developed techniques to reconstitute interest as trading expenses or the like. Credit sales were recognized as a form of interest as early as the 13th Century, when Milo of Evesham was charged with usury for selling "his grain more dearly than it was worth on the day when it was sold."³³ Medieval Europe saw inter alia the commercialization of Page 237 the mortgage (revocable sale),³⁴ the double stoccado (contracting the loan through a series of artificial sales of a basic good),³⁵ and forward currency transactions (interest included in the exchange rates).³⁶ In modern times, financiers have sought to avoid usury and disclosure regulations through ancillary fees, bundling lending with other...