The increasing importance of Middle East-based Sovereign Wealth Funds has highlighted the need for an understanding of the potential similarities and differences between Islamic and Spanish finance principles, says Eduardo Sebastián de Erice of Allen & Overy in Madrid.

"Spanish law offers a stable legal framework and wide variety of established financial products that, to a greater or lesser extent, should be capable of being adapted to reflect Islamic financial principles. Nonetheless such contracts would need to be carefully structured and drafted both to fully absorb these principles and to avoid breaching Spanish mandatory rules (for example, usury rules).

It is not the intention of this note to explain Islamic finance but to highlight the rationale behind Islamic compliant banking products. Islam establishes a number of do's and dont's in connection with the operation of banks and of financial products, which may or may not conflict with Spanish (and more generally international) banking and trade principles. Most notable in this respect is the prohibition by Islam of the receipt of interest (riba).

There is however another big difference, in the commercial emphasis of western and Islamic banks. Whilst the primary focus of a western bank is profitability, an Islamic bank must focus the use of its resources towards social assistance. Deposits in Islamic banks are used towards the development of social projects and social needs (a concept similar to Spanish savings banks' obra social). They must do this however without any speculation – due to the prohibition of riba – and on the contrary will look to share the risk or reward of a project.

Losses and profit sharing products

Islam recognises two broad types of financial products: those in which an Islamic bank will share losses and profits, and those that do not breach the prohibition on charging interest.

Almudarabah

In substance, this is an association between two parties, for a limited period of time, to develop an otherwise legal activity but which is prohibited by Islam (for example, gambling or alcohol-related activities).

A bank may participate as a partner investing in the project against a specified share in the profits of the venture. If the project makes a loss the bank's exposure is unlimited in amount, but vis-à-vis its partners it will share the loss proportionately to its investment.

It is important to note that the share in the gains cannot be a fixed amount, rather it can be a fixed share of the profits, and must be preestablished in the agreement. In this type of product, the bank may participate in the management of the project. The ownership of the asset or the project is shared by the partners so that in the event of a liquidation the bank would be able to make a claim proportional to its investment.

Almusharakah

This is similar to the almudarabah except that the bank's losses will be limited to its investment, and that the bank shall not participate in the management of the project. In this type of product, the financial needs of the project will be mainly (if not solely) covered by the bank whilst the partner will contribute its labours (eg management of the project). The bank will however have no claims over any of the assets.

Islamic finance admits a combination of almusharakah and almudarabah products, so that a bank may invest part of its funds under one or the other structure.

In Spanish law it is possible to establish partnership agreements similar to both of these structures under a venture participation agreement (contrato de cuentas en participación). This type of contract is not regularly used in Spain, as investments in projects are usually effected through shareholdings in mercantile companies, or other financial instruments – such as profit sharing loans or preferred shares (in the case of credit entities and listed companies) – that enable a wider mix of financial exposures and returns for financial investors.

In addition, a Spanish bank will not usually invest directly in a project but instead through specific investment funds (eg infrastructure funds) and usually through limited liability companies to restrict their exposure.

The prohibition on charging interest

Almurabaha

This is an intermediate sale and purchase transaction, whereby a bank will purchase an asset – following a client instruction – and re-sell it to the client for a higher price.

It is necessary that the transfer of property to the bank is fully completed and so is the subsequent transfer of the property to the client. It is usual that the re-sale price is deferred in time and paid by instalments (this is termed bai muaáyal) but it is possible also to retain title to the asset until the price for the asset has been fully paid. The gain will not be treated as interest but as a capital gain.

Spanish practice accepts the possibility of selling goods by instalments (venta a plazos) but in this type of agreement the seller may or may not withhold title to the asset until the price is fully paid.

The almurabaha could fit into this contractual category, however under the contractual structure of the almurabaha there could be a re-characterisation risk – as the bank financing the acquisition of the asset is acting on the client´s instruction. The gain may be characterised as interest, while the issue as to whether or not usury laws would apply may also need to be examined.

This risk could be mitigated substantially if the bank was to purchase assets to re-sell at its own risk, but this is not the practice generally in Spanish banking practice. It is not however entirely unknown as such risk and venture business is undertaken, for example, in the commercial financial leasing of vehicles.

Alsalam

This equates to a futures contract, under which a bank will sell an asset or commodity that is deliverable in the future, but is only acceptable for such assets whose quality and quantity can be pre-determined (as the price is payable before the asset is delivered).

This type of contract is not dissimilar to commodities or securities future contracts that are habitual in Spanish financial and commodity markets in relation to exchangeable assets. It is less common to find futures agreements for nonexchangeable assets (such as real estate) but these would however be lawful under Spanish law.

Alistiznae

This is a contract for sale in which the purchaser contracts the construction of an asset (this includes real estate assets) for a fixed price and subject to specified quality and quantity terms, to be delivered at a specific date. The intention is to determine a fixed price for the finished product.

When applied, for example to real estate, the bank will purchase the property and finance its construction and then sell it to the client for a fixed price. The consideration can be paid upon the sale of the property, or it can be deferred. This is not dissimilar to turn-key construction contracts, admitted under Spanish law, except that a Spanish bank will not assume any property or ownership related risks, only financial risks.

Qard hasan

This is a loan without interest, in which the borrower only has to repay the principal.

Spanish law admits the possibility to make loans with or without interest, although usury laws will void a contract whereby the borrower would admit to having received a loan in excess of the amount it has really received.

Ijara

This is a contract used to finance fixed assets under which a bank buys an asset and leases it to a client over a fixed period of time, with or without a purchase option at the term of the lease.

Financial leases and operating leases acknowledged in Spanish banking practice share common elements with the ijara structure. The major difference is that they usually include an element of interest repayment however, under the Spanish civil code (coupled with freedom of contract principles) it should be possible to structure an ijara lease that complies with Spanish law.

Islamic bank accounts

Islamic banks, like any Western bank, can offer current accounts, savings accounts and deposit accounts to their clients.

In the case of a current account, the client may deposit and withdraw money freely, transfer and receive funds from third parties, purchase foreign currencies against the funds in the bank account, and draw cheques against the account. The bank may charge a fee for this service – as with Spanish bank accounts.

Islamic banks offer two broad types of deposit options:

(i) Non-remunerated deposits, in which case the client may withdraw funds at any time; and

(ii)Investment deposits (effectively an almusharakah) in which the client will share the profit or loss of the investments managed by the bank, but at the same time is able to recover amounts deposited. These types of deposits may also be agreed for a minimum or a fixed term.

This is a concept similar to a collective investment scheme (or private equity fund) although these are regulated investment services for which a licence would be required – so this type of product could not be offered in Spain without complying with the relevant investment services regulations.

Eduardo Sebastián de Erice is a partner in the Finance and Capital Markets Department at Allen & Overy in Madrid. He has an emphasis on regulatory and structured and asset finance issues and can be reached at This email address is being protected from spam bots, you need Javascript enabled to view it