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DR HISHAM DAFTERDAR
In the first part of this series, we looked at the first stage of the diminishing musharakah contract signed between an awqaf foundation based in the Emirate of Ajman, UAE and a private developer.
After completion of the project, the relationship between the partners began to change from being collaborative and conciliatory during the construction phase to adversarial and conflicting during the operational phase.
Leasing issues
The first problem was about the tenancy mix. The new suburb was thinly populated and the demand for retail space was very weak. The developer could not lock in an anchor tenant like a supermarket or a department store or international tenants, who are key to attracting other businesses.
The second problem was that Awqaf had vetoed applications from some businesses that were considered to be repugnant to shariah such as amusement and leisure businesses, cinemas, arcade games, pawnshops and conventional banks.
The third problem was the lease terms which included high rental rates, common area charges, and share of the municipal and real estate taxes and insurance.
Partners in conflict
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For approximately two years, less than ten tenants negotiated rental agreements, and the mall was operating at a loss. This situation caused a conflict and soured the relationship between the awqaf foundation and the private developer. The developer, as the majority partner, had to bear the bigger share of the loss and blamed the awqaf foundation for its restrictive rental covenants. The foundation on its part felt that it had entered into a dark tunnel and that the project, instead of being a source of revenue, became a financial burden.
Going to arbitration
The dispute escalated to the point that both parties had to invoke the arbitration clause in the contract. The arbitrators advised the partners to engage a specialised commercial property management firm to lease and manage the mall. The consultant advised the partners to consider offering lease incentives such as rent-free periods, reduced rentals and fit-outs. This strategy succeeded in attracting a few more tenants, but the rental revenue did not cover all the expenses. The developer, in order to stem the loss, sought to exit from this partnership by offering to sell his share in the partnership. The awqaf foundation was given the right of first refusal and refused.
However, the foundation agreed that the developer may sell his share to a third party subject to their approval. The terms of the offer were too vague to be considered by any serious buyer.
Gradually, with the ongoing development and population growth in the area, more businesses were attracted to the mall. About 90 percent of the shop units were leased, and the project started to net positive results after three years from opening. All prior years losses were recouped, and the net profit was divided between the two partners proportionate to their original ratios.
A change in positions
The lure of profits, and the capital appreciation of the project, led to a change in the positions of the two partners and sparked new disagreements and arguments. This time it was the awqaf foundation who wanted to end the partnership and offered to buy out the developer’s share in the project. Awqaf took the position that the partnership is a diminishing musharakah and therefore has the right to accelerate the exit of the diminishing partner. The developer on his part rejected the offer and argued that the promise to sell his share (the building) is not binding according to Shariah and is legally non-enforceable. The developer’s argument was based on the premise that a forward or future sale is not permitted from a Shariah perspective, especially that no consideration (i.e. sale price) was stated in the contract and the construction cost does not reflect current market value.
Back to arbitration
The arbitrators considered the case and ruled as follows:
- Since the buy/sell condition in the contract is not made in absolute terms and since there is no defined consideration, the buy/sell condition can only be construed as a promise to buy/sell.
- A promise creates a moral obligation but cannot be enforced legally or under Shariah.
- Under the prevailing property law in the country, the building is an immovable property and therefore is considered as land improvement. This means that the building becomes part of the land, and together they form a homogenous capital.
- In conclusion, the arbitrators opined that notwithstanding the terms of the diminishing musharakah, the partnership should continue and neither partner can force the dissolution of the partnership.
Based on the arbitrators’ decision, the diminishing partnership was transformed into a permanent partnership. This made the developer effectively a majority owner of the waqf (land and building) with a controlling interest of 66.6 percent.
Issues and constraints
No mode of financing comes without a dose of pain. In a diminishing musharakah contract, the problem revolves mainly around the sale provision. The ownership of the building by the developer will be liquidated progressively in favour of the awqaf foundation until awqaf eventually owns the entire project. From a Shariah and legal perspective, the sale provision does not constitute a sale contract. A sale contract should stipulate the price and the time period for settlement. In a diminishing musharakah neither of these two elements can be stated in definite terms. It is unjust to fix the future price of the building before it is constructed. The sale or part sale can only be effected at the prices prevailing at the time of the actual sale. This would entail market valuation on each settlement date. Therefore, the sale provision in diminishing musharakah can be nothing but a non-binding, non-enforceable promise.
Other issues of concern include the following:
- The profit to be realized from the project cannot be accurately estimated. Therefore, awqaf’s share may differ from what was expected, and this could affect its revenues.
- The developer/financier cannot ascertain the period until full recovery of principal and profit.
- Any financing mode for which a repayment period is not known, is considered flawed from a commercial standpoint.
- There is no justification under Shariah for imposing penalty fees for early (or late) settlement.
- Most scholars consider that the sale provision in a diminishing musharakah agreement a promise to sell that creates a moral obligation but is not binding. The developer (building owner) may not want to fulfil the promise to sell if the value of his share in the project is appreciating and the profit potential is higher than expected. In this case the diminishing partnership becomes a de facto permanent partnership.
- One of the unique risks of this mode is that if the project location has to be acquired or removed by government for a public purpose, awqaf as the landowner may receive compensation or a substitute location, while disputes are likely to arise regarding adequate compensation to the building owner.
- Most real estate laws consider any building or structure with embedded foundation in the land as land improvements, and hence become part of the land. Therefore, in this case the foundation and the developer become partners in both the land and the building. This is tantamount to the developer becoming the part owner of the waqf property. Some scholars consider this situation to be an infringement of Shariah, while others allow it under the rules of istibdal where awqaf substitutes an undefined part of the land for an undefined part of the building.
Lessons learned
The development of awqaf assets offer an opportunity to advance awqaf missions and enhance operational capabilities, but the risk elements increase uncertainty of success. Diminishing musharakah is a mode of financing based on profit and loss sharing. Therefore, the tenor, i.e. the duration of the agreement, cannot be reliably determined. The ambiguity of the buy/sell provision in the contract is a cause of conflict between the partners and has the potential to change the nature of the relationship between them.
This case raises ethical questions. A contract is in essence an exchange of promises which the parties commit to. The diminishing musharakah agreement was signed with the reciprocal understanding and commitment of the two parties to all its clauses.
However, while the parties agreed to the same terms on paper, they had different expectations about how the agreement would benefit them in practice. The attitudes and behaviours of the partners had changed as the conditions on the ground changed.
Awqaf and the private sector have different goals and metrics that drive them. Awqaf’s commercial strategies are more about development and social impact. The private developer, on the other hand, is focused on maximizing profits and does not want to be distracted with a social mission. Awqaf properties cannot be used as collateral. The security taken by the financiers is largely confined to the assets they finance and not to the inalienable waqf assets. This security becomes difficult to call upon when a tangible asset becomes an inseparable part of another tangible asset. It’s like trying to unscramble scrambled eggs.
On structuring a diminishing musharakah agreement, questions arise about a number of factors. The cost of contracting with the wrong private developer is high especially when there are risks awqaf weren’t aware of, or when there is a serious lack of understanding of the other partner’s motives and concerns, and when the agreement is poorly worded.
