A staple in any business plan is an exit strategy. Some businesses have the foresight and operate in a manner which allows them to exit the market before bankruptcy; for others, exit is prompted by insolvency, personal bankruptcy among the largest shareholders and a general inability to continue operations financially.
In primarily Muslim nations, Shari'ah compliance makes lending and borrowing guidelines, bankruptcy and insolvency systems different from those in non-Muslim nations. Islamic finance is a trillion dollar industry forecasted to grow more than 15% annually over the next few years.
1.5 billion Muslims worldwide are the target market of institutions offering Islamic financial products, but in some cases non-Muslims make up as much as half of Islamic bank customers.
Islamic finance is more conservative than OECD-based banks. Risks are managed differently and are more avoidable under the Islamic system to protect against crises like those which recently affected global financial markets. In the Islamic system, financial products are priced and valued based on existing assets rather than other financial products. In the financial crisis, the leverage ratio of assets to capital in the MENA region was below 10:1, while in Europe it was over 30:1, and over 20:1 in the US, which helped make the Islamic banks more able to recapitalize their operations than EU and US banks. Just as with "Riba", or usury, short selling is also banned.
Companies are required to list all assets and liabilities on balance sheets, and off-balance sheet derivative structures are not allowed.
Currency hedging is prohibited because physical assets do not back the transaction, and commodity futures are prohibited because one is not allowed to profit from assets that do not yet exist.
Honesty and fairness in accordance with the Holy Qur'an have been considered the principles of Islamic finance. Verses such as Qur'an 4:29, 23:8, 83:1-6, and al-Bukhari 1934 relate to the conduct of business and help establish a business code or management fatwa. Among other passages, Qur'an 2:188, 2:280 establishes a basic rule on the handling of debts by creditors, and helps define the concept of financial justice.
Increased business activity, increased lending and borrowing, and thus defaults, failures to repay on debt, foreclosures, bankruptcy and insolvency have created demand for more Islam-centric processes through which debtors and creditors can resolve their issues. A 2008 Journal of Political Economy study by two World Bank and two Harvard researchers stated that there are four main insolvency legal origins: English, French, German, and Nordic. The Saudi Arabian and United Arab Emirates (UAE) commercial and company laws were found to be of English origin, and their bankruptcy laws of French tradition , though neither England nor France is primarily Islamic nor a member nation of the Organization of The Islamic Conference, which all four nations under review in the present report are.
This report offers a review of insolvency laws in Saudi Arabia, the UAE including the Dubai International Financial Centre (DIFC), Indonesia, and Malaysia. Islamic finance is positioned as a safe and effective model which can be an alternative to or competitor of the OECD-based banking systems.
Saudi Arabia
The "Doing Business 2009" World Bank-IFC report on "Closing a Business" found that the Saudi insolvency process took an average of 1.5 years for businesses to go through, compared to an average 3.5 years in the MENA region, and 1.7 years in OECD. The Saudi system was found to be expensive, with the cost of the insolvency process being 22% of the estate (avg. 14.1% in MENA, 8.4% in OECD), and inefficient, with the recovery rate of 37.5 cents on the dollar (29.9¢ in MENA, 68.6¢ in OECD).
The Saudi Arabian Monetary Authority regulates the credit system. The Ministry of Commerce and Industry's Regulations for Companies and other orders provide rules for insolvency. Insolvency, bankruptcy, and creditors' rights are also governed by the Commercial Court Law (CCL) and Bankruptcy Avoidance Regulations (BAR).
Creditors may apply freely to the Ministry of Commerce or Board of Grievances to initiate proceedings; debtors' applications may only be submitted with the consent of shareholders who must apply to the court (Article 108 of the CC L, 10 and 109 of the CC System). The Grievances Board does not have specialist chambers or members, and judges are not tenured or required to have specialized insolvency training. Insolvency practitioners are not regulated.
Due to inefficiencies and high costs, the bankruptcy system is essentially unused by debtors and creditors. Payments are prioritized including costs and expenses from liquidation in the first spot, followed by one month's wages to employees, housing and business rentals, servants and clerk's wages and wife's dowry in the second spot, and lastly other creditors. Upon commencement of proceedings, unauthorized disposition of the debtor's estate is prohibited; a stay of all creditor action is imposed, with limited exceptions for secured creditors.
Reorganization is not provided for by law, though in practice informal restructuring and rescheduling is common via bilateral agreements.
Debt for equity swaps are permitted.
There is no formal test of insolvency determined by law. Debtors must provide financial records including all assets and liabilities to the investigatory body. A trustee is mandatory and assigned by the court. There are no formal provisions for recognition of foreign insolvency proceedings or for cooperation with extra-jurisdictional courts, though foreign representatives have access to Saudi courts which may facilitate recognition of foreign proceedings through the Grievances Board. Uncooperative debtors may face court trials, arrest by the Trade Council, or be put under police surveillance.
UAE
The UAE is famous for its laws that make bounced checks a criminal offense, something senior government officials have said need to be changed, along with bankruptcy laws. Chapter 11 style provisions for reorganization have been desirable for businesses and to public officials like the director of the Dubai Chamber of Commerce and Industry. Calls for reform have been consistent through the financial crisis, during which the UAE financial and business professionals found they needed new and further protections under the law.
The Commercial Transactions Law No. 18 of 1993 governs insolvency.
Security enforcement, which is handled through the courts, can be expensive, require large amounts of time and results are unpredictable.
Culture prohibits enforcement of security on the debtor's home, and debtors often stall the security enforcement process. On average, insolvency proceedings take 5.1 years, cost 30% of the estate, and recover only 10.2¢ on the dollar.
Shari'ah and culture may influence out-of-court settlements, though it is uncommon. Debt for equity swaps are permitted but not common, and there is no debt trading.
Neither debtors nor creditors use the insolvency laws frequently. After commencement of the proceedings, which creditors or debtors may initiate, unauthorized transfers of the debtors' property are prohibited, with limited exceptions for secured creditors. A judge, inspector, and trustee are appointed upon declaration. The trustee continues to operate the debtor's business and may complete or terminate contracts.
Creditors must lodge claims within 10 days of the commencement of proceedings, within 30 days for foreign creditors. The law does not contain provisions for recognition of proceedings commenced in other jurisdictions or for cooperation with courts in other jurisdictions. Reorganization is not provided for under the law. Insolvency practitioners are not regulated.
DIFC
This financial free zone has the power to create its own legal and regulatory framework for civil and commercial matters. The DIFC has its own court system which operates within its jurisdiction. Debt collection, registration of security interests, and searching the register are regarded as reliable, transparent, but expensive and cost inefficient. Enforcement of security rights is by judicial means only. There are no reliable credit information systems available to the business community.
Consensual arrangements to resolve liquidity problems are encouraged. Debt for equity swaps are allowed, but subject to oversight, and debt trading is common. The Companies Law can hold directors liable for trading while insolvent.
The insolvency laws are relatively developed for the region, and the system balances interests of debtors and creditors. Both liquidation and reorganization are provided for under the law, but reorganization is not common.
Under the Insolvency Law No. 7 of 2004, either creditor or debtor may apply to commence proceedings. Companies are considered unable to pay debts when a debt of more than $2,000 is unpaid for 3 weeks (Art. 51 of 2009 Law N. 3) if a creditor proves a company is unable to pay its debts on due dates. If the court finds the company's current assets less than current liabilities, including account contingent and prospective liabilities, a debtor may be deemed insolvent.
Upon
commencement, unauthorized disposition of the debtor's estate is prohibited, with exceptions for secured creditors. The court may appoint an administrator who will assume responsibility for the estate, and the liquidator may complete or terminate contracts.
For Chapter 2 cases of "voluntary winding up", Article 36 of DIFC Insolvency Law No. 3 of 2009 requires the liquidator to summon a meeting of creditors within 28 days of deciding the company is unable to pay debts; creditors must be notified by post within 7 days of the meeting. The liquidator is obligated to provide creditors with the company's information. Chapter 3 cases of "creditors' voluntary winding up", under Article 39 of the 2009 Law No. 3 require a meeting of creditors to be summoned within 14 days after a company meeting is held wherein voluntary winding up is proposed, and creditors are to be notified within 7 days of the meeting. Liquidation expenses are prioritized before all other claims.
Recognition of foreign proceedings is provided for in the case of foreign companies under Article 82 of the 2009 Law.
A recognized company may end up in court if unable to pay debts, or dissolved and deregistered in its place of origin, or if it has ceased to operate in the DIFC.
The Registrar may cancel or suspend the registration of, or impose conditions or restrictions on, or require changes from a practitioner or official liquidator in cases involving improper practices or contraventions of rules.
Indonesia
Bankruptcy is defined as the inability to pay off expired debts. Priority is given to employees in the event of bankruptcy; Act No. 13 of 2003, Article 165, grants workers rights to standard severance, compensation, and reward pay if the business goes bankrupt. Employment may be terminated by the debtor or receiver with 45 days notice.
Law Number 37 of 2004 on Bankruptcy Suspension and Payment replaced the 1905 Law on Bankruptcy and its 1998 amendment. Debtors, creditors, and public prosecutors may apply.
Independent receivers will handle up to three bankruptcy and suspension of payment cases simultaneously.
Although debtors lose rights to control and manage assets while in bankruptcy, the boards at the company remain responsible for operations. Once a bankruptcy decision is declared, debtors are to be released from police detention.
Suspensions of payment may be applied for by creditor or debtor.
A judge and administrator will manage the debtor's asset with the debtor upon registration. Temporary suspensions are mandatorily granted within 3 days when debtors apply, and within 20 days when creditors apply. The court will hold a hearing within 45 days from the date of temporary suspension. If the debtor is not present at the hearing, the suspension will automatically terminate and the court must declare the debtor bankrupt. For the purposes of the law, bankruptcy and insolvency are different issues. Insolvency occurs when a plan is not present or is rejected.
Upon insolvency, the magistrate may hold a meeting with creditors to discuss settlement of the estate and to verify claims. The process is considered slow in Indonesia. Upon a declaration of bankruptcy, execution rights of creditors are deferred for up to 90 days; secured creditors must exercise rights within 2 months of insolvency. Out-of-court procedures are available and restructuring or reorganization are common outcomes of informal methods. Long and medium term debt trading is not common, though short term debt in the form of commercial paper and promissory notes is commonly traded, but not among debtors in corporate insolvency. Practitioners may be unqualified and/or corrupt.
Malaysia
The former British colony takes its bankruptcy law from the English origin. Bankruptcy is defined as the inability to pay off expired debts, exceeding RM30,000. Secured creditors' rights and clearing charges are prioritized above employee creditors' rights, which are above federal taxes and common creditors' rights. The 1965 Companies Act, 1966 Companies Regulations, and 1972 Companies (Winding up) Rules regulate insolvency practitioners.
Section 176 of the Companies Act relates to reorganization. The Malaysian Department of Insolvency offers information, aid, and access to forms online or in person, with the website receiving over ten thousand visitors per month.
There is no discrimination as to recognition of claims of foreign and local creditors. Part IV of the Bankruptcy Act stipulates that the receiver of insolvent estates is acting manager and may raise money or authorize a special manager to conduct business in the interest of creditors, or summon a meeting of creditors. Upon recognition of insolvency by the Director General, no creditor may commence any legal proceeding for retrieval of the debt or exercise rights over property, with limited exceptions for secured creditors. The court may detain or arrest the debtor if he is a flight risk. No specific amount of time is provided within which a meeting of creditors must be made after receipt of the order. In essence, the bankrupt may be treated as a criminal. Judges and practitioners may not be technically experienced or qualified.
Discussion
A more organized, collaborative effort among primarily Islamic nations would likely benefit the financial sector. Among nations under study, the DIFC and UAE provided the best information for research purposes, which was the easiest to locate and access in the English language. Malaysia was second best. Indonesian laws were reviewed by the Asian Development Bank in English, which made analysis of their structure easier, though reports and releases from the government itself were not easy to locate and access online in English; Saudi Arabia provided the least official information.
The United Nations Commission on International Trade Law (UNC ITRAL) and the World Bank make recommendations for insolvency systems and push for international standards. The DIFC has a system which is recognized as an international standards-based model, though the domination of international groups like the UN and specialized agencies like the World Bank by OECD nations may cause in part the standards to be unappealing for the primarily Muslim world. OECD standards are influenced by systems inclusive of techniques, products, services, and structures which are not Shari'ah-compliant, and thus even the best of those systems may be inadequate for full application within an Islamic system.
Debt enforcement is crucial to economies just as debt is a key component of a strong system. According to Djankov et al, "Insolvency institutions are generally perceived to perform poorly."
Outside of courts, debt enforcement is limited to remedies like foreclosure and some informal workouts; aside from that, creditors are left with reorganization and liquidation, both of which are court supervised.
Reorganization is the only procedure which is aimed at rehabilitating the company, but this is not available in many countries. Of course some businesses are incapable of recovering, and in those cases creditors may prefer to recover any interest they can, including those cents on the dollars.
The absence of reorganizational options in bankruptcy and insolvency systems leaves a crucial flaw which costs creditors financially and economically. Judges, administrators, trustees, liquidators, and other insolvency practitioners should be trained in some business administration discipline and have adequate knowledge of the law.
There should be a scheduled timeseries process for all bankruptcy and insolvency filings. Some businesses should have access to credit information systems. Bankruptcy and insolvency should lose their stigma and criminal laws should not be applied where fraud, deceptive practices, malfeasance, and other crimes aside from the mere act of becoming bankrupt or insolvent are not present. Generally honest debtors should not be considered as deviants, and this "hitherto" system under Islam, which the OECD Observer compared to the "cutthroat" westernized systems, should apply the greater, gentler side of Shari'ah and Allah's rule.
The use of assets to back all financial products obviously poses unique risks, and limits the potential profit that can be made offering credit, especially in "musharaka" and "mudaraba" arrangements. Intellectual property should then be considered as real assets, which can be used to value and price financial products; the value of people should be incorporated.
Conclusions
The Holy Qur'an says, "If the debtor is in a difficulty, grant him time till it is easy for him to repay; but if you waive the sum by way of charity, it will be better for you, if you understand it." (Qur'an 2:280). So the Muslims should work harder at understanding it, and also learn that we no longer operate on the gold standard, but have a much more forgiving system, even in hard times. About the author
Adam Tanielian is 33 years old and works as a secondary school mathematics teacher near Bangkok, Thailand. He was born in Michigan, USA. Adam earned his bachelor's degree from Michigan Technological University, where he studied electrical engineering, business, psychology, and Japanese while also playing varsity football as a scholarship athlete. Since 2005, Adam has worked as an English math and science teacher for 6 years in Thailand, including 10 months of volunteer teaching, and 1 year in China. He was awarded a Master's Degree in Business Administration from the Institute of International Studies at Ramkhamhaeng University in 2010 and expects to complete his Doctorate in Law in 2012. adam.tanielian@iis.ru.ac.th
© Business Islamica 2012
