Third-party funding and Shariah (Islamic) compliance

Third-party funding (TPF) of disputes is now an established financial product in many jurisdictions around the world, including in Europe and the US. The use of TPF has also been growing in the Middle East, especially since the start of the Covid-19 pandemic, with interest coming both from funders entering the market, as well as from claimants wishing to use external finance for their disputes. This rapid growth is not surprising as the region is made up of civil and Shariah (Islamic law) jurisdictions. As a result, they do not have the ancient common law doctrines of champerty and maintenance which prohibited TPF in common law jurisdictions for many years.

Put simply, TPF involves a commercial funder providing financial support to a claimant to cover the costs of litigation or arbitration in exchange for a share of the proceeds if the claim is successful. The concept of transferring this legal risk from one party to another in a manner that is Shariah compliant, will be of relevance for both claimants and also institutions that operate in an Islamic environment.  In addition to assisting claimants with finance for their claims, TPF may be of interest to Islamic investors who wish to diversify their investment portfolio by investing with fund managers that specialize in dispute financing investments.

Principles of Islamic Business Transactions

Islamic banking, Islamic finance or sharia-compliant finance is banking or financing activity that complies with Shariah. Before considering how it applies to TPF, the following is a brief summary of the principles behind Islamic Business Transactions (IBT).

IBT must have the following attributes to be Shariah compliant:

1. Lawful – The subject matter must be lawful. In the eyes of Shariah, lawfulness is interpreted to mean ‘permissibility’ of the subject matter under Islamic law.
2. Certainty – IBT should not involve transactions characterized as ‘uncertain’. Uncertainty in IBT refers to transactions which contain elements of fraud or speculation.
3. Transactions to satisfy four conditions – For a valid contract, there must be (i) an offer, (ii) acceptance, (iii) involvement of parties and (iv) purpose of the contract.
4. No interest – The transaction must not involve interest or ‘riba’.

Islamic structures

Although there are a number of structures used for IBT, from a TPF perspective the most relevant is the ‘partnership’ based on a Mudarabah and Musharaka, which are transactions in which one party invests capital to become partners with the other. The return of the investing party depends on the actual performance of the performing party.

• Mudarabah – In a TPF arrangement, a Mudarabah structure is where the funder provides capital for financing the claim (‘Rab-ul-Amal’) and the client, together with the expert assistance of a law firm (the ‘Mudarib’), implement the strategy for recovery. Although similar to a partnership, a funding arrangement does not require a separate company to be created as recoveries are typically paid to a designated account. In a Mudarabah structure, profits are distributed in a pre-determined fixed ratio, similar to how the economic rights of a TPF arrangement is structured.
• Musharakah – This is similar to a Mudarabah contract. However, the main difference is that both parties provide capital towards the investment. This is an arrangement that also exists in TPF agreements where the claimant is willing to commit to finance a portion of the expenses alongside the funder. Profits are determined on a pre-determined ratio and losses would be in line with the amounts invested by the funder and claimant.

Shariah investing

TPF is an attractive asset class for investors as it is unrelated to market fluctuations. For example, in the current pandemic there has been a significant increase in demand for TPF. For the Shariah compliant investor, the availability of tools to hedge risk are limited and often come at a premium. Although Shariah compliant products continue to innovate, TPF is an ideal alternative asset class for Islamic investors looking to diversify their investment portfolio.

In a TPF arrangement, the investor providing the funds becomes a ‘’shareek” partner entitled to a share of the proceeds of a judgment or arbitral award if the claim is successful. Equally important, the financing provides the claimant with access to justice which may not have been otherwise possible. In doing so, the external funder is acting on the Islamic principle of “mutual co-operation in the doing of good and being heedful”.

The Shariah perspective on the arrangement between funder and claimant is that of a partnership. In the same way that the funder is entitled to share the money awarded to the claimant in a successful case, the funder shares the risk of losing the claim, and therefore the investment as well. As both partners share the risk in an agreed proportion, the arrangement complies with the Shariah norms of Mudarabah and Musharakah.

Shariah compliant features

It is often said that TPF is in the public interest as it provides increased access to justice, particularly in countries where a state sponsored system of legal aid is not available. Therefore, from a public policy perspective, TPF may be seen in a positive light on the basis that it corresponds with the concept in Shariah law known as “Maslahah”. This allows prohibition or permission of a thing according to whether it serves the public interest of the Islamic community. All legal systems regard access to justice as being in the public interest. Therefore, it is unlikely Islamic countries would take a different approach.

The Shariah prohibition of gambling is well known. Its defining characteristic is the prohibition of ‘easy acquisition of wealth by chance’ or ‘effortless gain at the cost of others’. It is important to consider that funders carry out extensive due diligence and research into the merits of a case before agreeing to fund it. Funders also assume the significant risk of the case failing and losing all the money they have invested in the case. Experienced funders will provide monitoring services and case relevant intelligence and/or settlement assistance, working together with the legal team. The transaction is therefore a long way from being an ‘easy acquisition of wealth by chance’.

Any uncertainty about the terms of the funding arrangement are avoided by the negotiation and execution of a detailed Litigation Funding Agreement (LFA) between the funder and claimant. The LFA, which is at the heart of all funding arrangements, sets out the precise relationship between the funder and claimant and the duties and obligations on all parties.

Conclusion

From a Shariah financing perspective, if an LFA is drafted in accordance with a partnership structure of a Mudarabah or Musharakah between funder and claimant, and does not contravene the basic doctrines of Islamic law (for example, gambling, speculation and interest), then there is no reason that the arrangement would not be approved by a recognized Islamic scholar as Shariah compliant financing. TPF provides opportunities for Islamic investors who are looking to diversify their investment portfolio in an alternative asset class that is also Shariah compliant. It also provides access to justice for claimants who require finance to bring their claims.

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