Managing compensation and risk mitigation issues in forward lease contracts

In-Depth Analysis

The last article dealt with the situation of the total destruction of the leased asset under a forward lease contract. Pursuant to the explanation, readers will now appreciate that, unlike the termination of an ordinary lease contract upon the occurrence of total loss of the leased asset, the destruction of the leased asset under a forward lease contract does not warrant the termination of the forward lease contract. To refresh, the leased asset under a forward lease contract is not readily available but rather it is known through the description it would hold once it comes into being. As such, in case of the total annihilation of such an asset, the lease contract shall remain intact but the rent shall be paused until such time that the lessor arranges an alternate asset of a similar description. In fact, it is the right of the lessee to demand from the lessor to provide a new asset with the same description as entered into in the forward lease contract. A question was left in article 77 that now needs to be addressed. It was with regards to the nature of a forward lease contract being a financial lease whereby the lessee shall acquire the title to the leased asset upon the successful culmination of the contract — what shall be the lessee's situation if the asset gets totally destroyed in the middle of the lease term and the lessor is unable to provide a replacement asset with similar specifications in order to resume the lease and the lessor requests the lessee to agree to terminate the forward lease contract? Well, in the case of destruction of the leased asset due to the lessee's negligence, Shariah principles stipulate that the lessee shall be responsible to procure the alternate asset with similar specifications, request the lessor to inspect the asset and acquire the title so as to resume the lease. It will be at the discretion of the lessor if it would like to seek compensation for the lost profit (variable element of the lease rentals) from the lessee for the period of the interruption of the lease rent. If the lessee is unable to provide the alternate asset, it will be responsible to compensate the lessor for the outstanding fixed element amount related to the lost asset in the lessor's books. It is therefore emphasized by the Shariah supervisory board of Islamic financial institutions to invariably obtain Takaful cover for any asset financed by it. As such, if the leased asset gets partially destroyed due to no fault of the lessee, the Islamic financial institution will rely on claiming the amount spent on restoration from the Takaful cover provider. This will protect the Islamic depositors from getting hit for the cost of repairs. From a risk perspective, the Ijarah product is a fairly robust product for an Islamic financial institution. If an Islamic financial institution grants the financial lease facility to a customer over a movable or immovable asset at a 20% or 30% margin, from day one, the Islamic financial institution shall hold the 100% title to the leased asset whereas its financing shall be restricted to 70% or 80%. As the lease gradually progresses toward the completion date, the lessor's title over the leased asset shall remain fixed at 100% whereas the finance it has provided shall continue to get reduced with every lease rent payment, thereby strengthening the Islamic financial institution's security position over the leased asset.