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Conventional Bank's Dilemma: Restructuring Finance Facilities

by Khozem Haidermota

Senior Partner, Haidermota & Co.


Risk of bank failure and economic stagnation from increasing non-performing loans ("NPLs") within Pakistan’s commercial banking sector is no mystery.  While conventional banks1 have a wide range of measures available to deal with NPLs, the merits of resolving NPLs of circumstantial defaulters vide restructuring cannot be overstated.

Restructuring involves an arrangement whereby a viable credit is recovered through modification of the terms and conditions of the finance agreement for the benefit of the debtor. With the dual objective of securing recovery of the debt and revival of the debtor’s business, restructuring is a reconciliatory and rehabilitative arrangement between the bank and its customers to break past non-performing relationships.

Introduction of the mark-up system of financing vide State Bank of Pakistan’s (“SBP”) BCD Circulars 13 and 32 of 1984 (“Mark-up Circulars”) has had widespread implications for restructuring of loans. The courts have, in several cases, hampered recovery by conventional banks of restructured liabilities on grounds of direct and/or indirect violation of the basic tenets of the mark-up system. A perusal of the relevant judicial pronouncements reveals that judicial interpretation, application and enforcement of the Mark-up Circulars is inconsistent and confusing. The objective of this article is to highlight, from a legal perspective, some of the complexities involved in restructuring under the mark-up system.

Part I of this article, by way of background, discusses restructuring under the mark-up system. Part II illustrates the legal uncertainty created by conflicting and diverse judicial pronouncements on two significant aspects, i.e “disbursement” and “mark-up on mark-up” involved in restructuring of loans. Part III briefly examines the adverse impact of legal uncertainty on recovery and resolution of NPLs and provides recommendations to address the same.

Part I – Mark-up System & Restructuring

Conventional financing in the present day is based on “mark-up” or “buy back” system of lending as introduced by the Mark-up Circulars2 with the intention to shift over to an Islamic and non-interest based system of banking. Under the mark-up system, conventional financing is structured by way of a mark-up agreement under which the bank advances a sum of money to the borrower as the sale price of certain goods sold by the borrower to the bank. There is a simultaneous buy-back of the goods by the borrower from the lender at a marked up price which is payable on deferred basis. Finance agreements are structured in this manner merely to address the restriction under the Mark-up Circulars prohibiting local banks to extend any interest based financing. However, unlike Islamic murabaha financing documents, where the assets are (or ought to be) identifiable and specifically stated, the assets in case of conventional financing are invariably fictional in nature and there is no physical sale or purchase of assets.

Under the interest based system, restructuring can be carried out vide a simple amendment to the original finance agreement to modify interest payments and tenor. In contrast, restructuring under the mark-up system according to various judicial pronouncements, cannot be executed by amending the original mark-up agreement so as to alter or enhance the purchase price (marked up price) under the original mark-up agreement by charging additional mark-up or “mark-up on mark-up” upon default by the borrower. The same is not permitted in so far as the original mark-up agreement represents a past and closed sale/purchase transaction, repayment terms of which cannot be modified. In order to overcome this hurdle, conventional banks under the mark-up system commonly restructure loans by way of a fresh finance facility vide a fresh mark-up agreement with a fresh repayment schedule, thereby indirectly extending the maturity of the loan. Under the fresh mark-up agreement, the conventional bank and the borrower execute a further fictional sale and purchase of assets on deferred payment basis, wherein the outstanding amount under the original mark-up agreement is carried forward as the principal amount or sale price under the fresh mark-up agreement. 

Part II- Restructuring & Legal Uncertainty

Judicial pronouncements testing the validity of a restructuring arrangement by way of a fresh finance facility (described above) vis-à-vis the mark-up system, focus on two major aspects of the fresh mark-up agreement, namely: (a) actual disbursement or lack thereof under the fresh mark-up agreement; and (b) charging of additional mark-up on the principal amount or sale price under the fresh mark-up agreement. Such pronouncements are contradictory and confusing as is evident from the discussion hereunder.

(a) Disbursement
Judicial pronouncements on disbursement are at variance. On one hand the Lahore High Court in Habib Bank Ltd vs. Taj Textile Mills Ltd3acknowledged that “obviously in restructuring of loans, no amount is disbursed, rather it is brought forward envisaging as liability of the customer. Therefore, to argue that as no physical disbursement of the amount was made and hence the claim of the bank is false, is a statement which is misconceived and without merit.”4 Similarly in another case, the Banking Court held in Muhammad Arshad and another vs. Citibank N.A.5 (“Citibank Case”), that an “… agreement for the repayment or extension of time in repayment of a finance or for its restructuring or renewal…comes within the ambit of an obligation as is defined in Section 2(e) (1) of [Financial Institutions (Recovery of Finances)] Ordinance No. XLVI of 2001 therefore, the contention of the counsel for the applicants/defendants that no amount was disbursed is devoid of any force.”6 In the latter case, the Honourable Supreme Court on appeal did not give an express ruling that disbursement under the fresh mark-up agreement is not required, but did affirm the Banking Court’s judgment.7 Effectively, such judgments respect the sanctity of the commercial bargain entered into between the borrower and the conventional bank under the restructuring arrangement.

On the other hand there is case-law8 pursuant to which conventional banks will be denied recovery for lack of actual disbursement of funds under the fresh mark-up agreement. Without actual disbursement, the fresh mark-up agreement has been held “to be without consideration and void.”9 According to the courts, since the original sale and purchase has already been consummated on the date of execution of the original mark-up agreement, the practice of subsequently entering into a fresh mark-up agreement with a view to restructure the outstanding original facility without actual disbursement amounts to a continuation of the earlier loan facility and is interpreted by the courts as an attempt by conventional banks to illegally charge mark-up on mark-up.

Even where conventional banks make actual disbursements under the fresh mark-up agreement subsequently used to settle earlier loans, recovery under the fresh mark-up agreement may not be permitted according to a body of judicial opinion.10 The courts have once again interpreted such an arrangement as being, in substance, a continuation of the original finance facility and hence, an attempt by conventional banks to charge mark-up on mark-up. In stipulating conditions that frustrate the very objective of restructuring, the courts have held that “…if the bank is able to establish the fact that the amount has been actually disbursed under the subsequent agreement and it is not for the purpose of adjustment of the previous debts and that there has been a de facto sale and purchase in commodity, in that situation all agreements that may have been entered into for such purposes and independent of the previous agreements can be looked into and money shall be recoverable there against.”11

(b) Mark- up on Mark-up
Mark-up on mark-up was first made unlawful vide Mark-up Circulars and reaffirmed by subsequent notifications and circulars12 issued by SBP from time to time. Majority of the judgments including Habib Bank vs. M/s. Qayyum Spinning Ltd13 and United Bank Limited vs. M/s. Gravure Packaging (Pvt.) Limited,14 place reliance on the Mark-up Circulars and the Federal Shariat Court (FSC) and Shariat Appellate Bench of Supreme Court judgments15 (“Riba Judgments”) to establish that charging additional mark-up is illegal and un-Islamic. According to the courts, “any indirect method employed by the Banks to recover such interest via fresh agreements where there is no transaction of sale or purchase of goods but a fictitious act is done, whereby notional goods are transacted and not detailed in the agreement and a sale and purchase price is agreed upon, ‘is nothing but a fraud on the Constitution, the law and the people of this Country.’”16 Following these judgments conventional banks can only restructure loans if they do not charge additional mark-up under the fresh mark-up agreement.

Having said so, the courts have in several instances adopted a lenient and flexible approach in enforcing the principle prohibiting mark-up on mark-up. There have been cases where: (a) mark-up on mark-up was literally interpreted to allow additional mark-up as long as it was charged only on the outstanding principal amount of the original finance facility and not on the mark-up element;17 and (b) additional mark-up was allowed on the sale price or principal amount (principal plus mark-up under the original loan) under the fresh mark-up agreement.18 It is emphasized that in the Citibank Case, the Supreme Court did not directly discuss the issue of mark-up on mark-up; however, it did permit recovery of additional mark-up under the fresh mark-up agreement.19

Part III – Impact & Proposed Reform

Whilst the State Bank has devised a comprehensive strategy to deal with NPLs by implementing a wide range of regulatory measures, more needs to be done. In particular, SBP needs to appreciate the impact of legal uncertainty on the utility of restructuring as a valuable tool for dealing with NPLs. Lack of guidance and contradictory judicial opinion act as stumbling blocks for conventional banks to effectively restructure NPLs by way of fresh mark-up agreements. Furthermore, inconsistent application and interpretation of the mark-up system creates an unsupportive legal environment that hampers the speedy disposal of recovery cases and resolution of NPLs.

In light of the above, it is recommended that SBP issue an appropriate Circular that would make it clear that Mark-up Circulars are no longer applicable to conventional banks (“Proposed Circular”) in view of the following reasons.  Firstly, it must be appreciated that Mark-up Circulars were introduced as part of the Government’s strategy for a nationwide transformation of the entire financial system of Pakistan to an interest free system. However, the Government and SBP have, in what appears to be a policy change, opted for a gradual shift towards an interest free economy ‘without causing any disruption.’20 As a result, Islamic Banking, which requires all Islamic Banking Institutions 21 to follow Shariah Compliant modes of banking and finance, was introduced as a parallel system to conventional banking. This parallel approach was intended to “eliminate the risk of any major cost/damage to the economy, give a fair change to Islamic banks to develop alongside the conventional banks, and…provide a choice to the people of Pakistan,…to use either of the two systems.”22 Therefore, in light of the present dual system of banking, it can no longer be contended that the Mark-up Circulars ought to be retained for conventional banks for the purpose of bringing financing within the injunctions of Islam.23

Secondly, as discussed, Mark-up Circulars introducing the mark-up system of financing and their inconsistent interpretation and application by the courts has caused serious disruption to the restructuring of loans. The courts have struck down fresh mark-up agreements as an indirect means of charging mark-up on mark-up by effecting a fictional sale and purchase of goods, when the mark-up system itself involves a fictional sale and purchase of goods. While the fictional sale/purchase under the original mark-up agreement has gone unchallenged, various judicial pronouncements nevertheless appear to overlook this fiction at the time of restructuring. Since Mark-up Circulars are the root cause for legal uncertainty in this area, the proposed Circular will not only substantially alleviate the problem of inconsistent judicial opinion but also get rid of the fictional sale/purchase element from finance agreements used by conventional banks.

Finally, even the Riba Judgments corroborating that mark- up on mark- up is illegal and un-Islamic have been set aside and remitted to the FSC under Civil Shariat Review Petition No.1 of 2000.24 Whilst the discussion on “Riba” is complicated and outside the scope of this article, it is nevertheless respectfully stated that from a strict legal angle, the interest based system of banking does not amount to an unlawful or un-Islamic system in so far as the issue of “Riba” remains unsettled as a result of the abeyance of the Riba Judgments.25

Whilst there may be good reasons to issue the Proposed Circular, it may nevertheless raise various issues that may need to be considered. In particular, in the province of Sindh reduced stamp duty on ‘financing documents’ is applicable on mark-up based transactions as provided in Schedule I to the Stamp Act, 1899. Thus, stamp laws on mark-up based financing may be necessary to be appropriately amended26 before issuing the proposed Circular. 27 Another aspect to be considered is the impact of the Proposed Circular on section 26-A28 of the Banking Companies Ordinance, 1962. In other words, once conventional banks are permitted to engage in interest-based lending as a result of the Proposed Circular, will they continue to be restricted, from a narrow legal angle, to accept deposits of money on an interest free basis and on participation in profit and loss of the banking company. It may be noted that even from a practical angle, dismantling the mark-up system for conventional banks may disrupt functioning of banks which are used to the mark-up system.29

Be that as it may, significance of the above Proposed Circular must be understood in the context of the recent statistics provided by SBP on the swelling of NPLs to a record level of about Rs. 474 billion at the end of June 2010.30 Furthermore, NPLs are likely to substantially increase (especially in the agricultural and SME sector) in the wake of the recent flood disaster in Pakistan. Since restructuring is “an important post-disaster tool, to be implemented quickly and strategically, based on a desire to avoid disaster-induced defaults while maintaining a flow of repayments,”31 it is imperative that SBP take the requisite measures to address the problems faced by conventional banks when restructuring loans.


Restructuring is a valuable tool for dealing with NPLs. However, the mark-up system, as introduced by the Mark-up Circulars and interpreted and enforced by the Honourable Courts, is resulting in practical and legal difficulties for conventional banks when restructuring loans by way of fresh finance facilities with fresh documentation. In particular, conflicting judicial opinion on significant issues involved in restructuring, i.e disbursement and mark-up on mark-up has created an uncertain legal setting, adversely affecting recovery and resolution of NPLs. As the root cause of the legal uncertainty emanates from Mark-up Circulars, it is urged that SBP act in redressing the same by issuing an appropriate Circular stipulating that Mark-up Circulars are no longer applicable to conventional banks, after having considered certain ancillary issues identified above. It is emphasised that the proposed reform is by no means an attempt to dismantle the Islamic system of banking in Pakistan in so far as the Mark-up Circulars will continue to be applicable to Islamic Banking Institutions.’32 

The author is a Senior Partner at Haidermota & Co. and his was assisted by Zahra Abid, Associate at Haidermota & Co in preparing this article. Comments may be directed to


‘Ballooning NPLs,’ Business Recorder, August 23, 2010, Editorial section ‘Developments of Islamic Banking in Pakistan & Malaysia: An Analytical Review,’ pgs 1-15. (accessed on September 1, 2010)

Ishrat Husain, ‘Dealing with non-performing loans of banks,’ Home-Page (accessed on August 27, 2010)

Lampros Vassiliou, ‘The restructuring revolution in the Asia-Pacific region,’ in The Asia-Pacific Restructuring and Insolvency Guide 2006, pgs 18-28. (accessed on August 28, 2010)

The Global Development Research Centre, ‘Loan Rescheduling after a Natural Disaster,’ in MBP Rapid-Onset Natural Disaster Brief No. 1, pgs 1-5. (accessed August 28, 2010)

Muhammad Anwar, ‘Islamic Banking in Iran and Pakistan: A Comparative Study,’ in The Pakistan Development Review, 31:4 Part II, (Winter 1992), pp 1089-1097. (accessed August 28, 2010)

State Bank of Pakistan, ‘Islamization of Financial System in Pakistan,’ in Annual Report (2001-2002), Chapter 10, pgs 189-198. (accessed on August 27, 2010)

Vasile Dedu, Sorin Adrian Lazarescu and Dan Costin Nitescu (2009), ‘Banking Restructuring Techniques in the Economical Crisis Context,’ in Journal of Theoretical and Applied Economics, 11(540) (2009), pgs 27-32. (accessed on August 28, 2010)

1 Conventional banks do not include subsidiaries and/or branches of conventional banks providing Islamic Banking services for the purpose of this article.

2 Material parts of BCD Circulars are reproduced herein:

Annexure I of BCD Circular 13 provides “Permissible Modes of Financing”.
                “(B) Trade-related modes of financing including the following:
                  (i) Purchase of goods by banks and their sale to clients at appropriate mark-up in price on deferred payment basis. In case of default, there should be no mark-up on mark-up.
BCD Circular 32 reads, “In exercise of the powers vested in it under the Banking Companies Ordinance, 1962, the State Bank of Pakistan is pleased to direct that as from the 1st January 1985, interest, wherever charged by a banking company/development finance institution in any of the items of bank charges, shall be replaced by a non-interest mode considered appropriate by it. Moreover, overdue/penal interest or mark-up on mark-up shall not be charged by a banking company/DFI as from that date. Instead, it may take legal steps for recovery of the overdue finance.”

3 2009 CLD 1143 [Lahore]

4 Paragraph 7

5 2006 CLD 1011 [Supreme Court]

6 Briefly stated, facts of the case were as follows. The appellants obtained a finance facility of Rs.13, 12,000 from the Bank under a finance agreement dated 21-06-1995 and upon executing all the relevant documents and mortgaging their property. The facility was converted into an installment facility by way of restructuring/renewing the original finance facility, which was acknowledged by the appellants by way of an agreement dated 26-06-1999. Under the restructured/renewed agreement the outstanding liability was reduced from Rs.21, 05,280 to Rs.17, 95,176 by way of repayments. The appellants committed default and their failure to liquidate the outstanding liabilities, necessitated the filing of the suit. The appellants’ application for leave to defend was dismissed by the Banking Court followed by a decree in favour of the Bank for the recovery of Rs.17, 95,176 together with costs and mark-up. The Lahore Appellate Bench of High Court followed by the Supreme Court upheld the Banking Court’s decision.

7 In so far as the Banking Court’s ruling on disbursement went unchallenged by the Supreme Court, it can be argued with force that the Supreme Court, by necessary implication, affirmed the Banking Courts dicta on disbursement. However, the discussion on the soundness of this argument is beyond the scope of this article.

8 See Mushtaq Ahmed Vohra vs. Crescent Investment Bank Limited, 2005 CLD 444 [Karachi]; UBL vs. Ch. Ghulam Hussain 1998 CLC 816 [Lahore]; Habib Bank vs. M/s. Qayyum Spinning Ltd., 2001 MLD 1351 [Karachi]; United Bank Limited vs. M/s. Gravure Packaging (Pvt.) Limited, 2001 YLR 1549

9 Mushtaq Ahmed Vohra vs. Crescent Investment Bank Limited, 2005 CLD 444 [Karachi] decided on 15th June, 2004at page 451

10 Qamaruzaaman Khan vs. Industrial Development Bank of Pakistan and others, 2009 CLD 460 [Karachi]; Habib Bank vs. Qayyum Spinning Ltd. MLD 2001 Kar. 1351

11 Habib Bank vs. Qayyum Spinning Ltd. MLD 2001 Kar. 1351 at paragraph 69

12 Circulars subsequent to Circular 13 and 32, namely BCD Circular No. 27 dated 12.11.1984, BCD Circular No. 37 dated 10.12.1984, BCD Circular No. 23 dated 25.5.1985 and BCD Circular No.4 dated 30.6.1988 further provide that mark- up cannot be charged on ‘marked-up price’ and that Banks/DFIs should ensure ‘that instructions governing elimination of “Riba” from banking are strictly observed both in letter and spirit’. Additionally, SBP by way of BPD Circular No. 24 and BPD Circular No. 37 also set up a committee for resolution of disputes between borrowers and the banks where  mark-up on mark-up was allegedly charged by the banks ‘in violation of guidelines issued by SBP for elimination of “riba” from banking system’.

13 See footnote 9.

14 2001 YLR 1549

15 Dr. Mehmoodur Rehman Faisal and others v. The Secretary Ministry of Law, Justice & Parliamentary Affairs, Government of Pakistan PLD 1992 FSC 1 and Dr. M. Aslam Khaki v Syed Muhammad HashimPLD 2000 SC 225.

16Habib Bank vs. M/s. Qayyum Spinning Ltdat  paragraph 41

17 Habib Bank Ltd. vs. Taj Textile Mills Ltd 2009 CLD 1143 [Lahore]: It is doubtful whether the approach adopted by the Court in Habib Bank Ltd (2009) is consistent with SBP Circulars. SBP Circulars issued subsequent to Circulars 13 and 32 prohibited charging mark –up on “marked-up price”, which suggests that a literal interpretation of charging mark-up on mark-up, as adopted by the Court in Habib Bank case is contrary to law.  Mark-up, as per SBP Circulars, cannot be charged on marked up price, i.e. total outstanding balance (principal plus mark-up) under the original finance facility. 

18 Saudi Pak Commercial Bank Ltd. vs. Qazi Ehtishamul Haq and another, 2008 CLD 566 [Karachi]; Investment Corporation of Pakistan vs. Sheikhupura Textile Mills Ltd. 2004 CLD 1396 [Karachi]; and Yousuf Hardware Industries and others vs. UBL, Spl. HCAs No. 186 & 187 of 1998 [Karachi] (Unreported Judgment).

19 Observations of the Banking Court, Lahore Appellate Bench of the High Court and the Supreme Court read together suggest that the outstanding liability (principal plus mark-up) under the original finance agreement, amounting to Rs, 1,297,000/-, formed the principal amount under the restructuring/renewal agreement dated 26-06-1999. Additional mark-up was then charged under the restructuring/renewal agreement resulting in the marked up price of Rs. 2,105,280/- as mentioned therein. It is therefore, arguable that the Supreme Court by allowing recovery by the Bank of Rs. 1,795,176/-, by necessary implication, allowed charging mark-up on marked- up price. Having said so, the discussion on the merits of this argument is beyond the scope of this article.

20 This decision was made in a meeting held on September 4, 2001 under the Chairmanship of the President of Pakistan, attended by officials of the Ministries of Finance and Law, Governor State Bank of Pakistan, Chairman and some members of the Council of Islamic Ideology and the Chairman of the CTFS and the two Task Forces: (Reference, State Bank of Pakistan, “Islamization of Financial System in Pakistan”, in Annual Report (2001-2002),Chapter 10, pg 194, (accessed on August 27, 2010).

21 Islamic Banking Institutions includes full fledged Islamic banks in the private sector, Islamic banking subsidiaries of commercial banks and stand-alone branches for Islamic banking of conventional banks licensed by SBP in terms of IBD Circular No. 2 of 2004 as amended from time to time.

22 Extracts from the ‘Affidavit’ filed by Deputy Governor of the State Bank in the Supreme Court of Pakistan during a recent hearing of the Riba case. (Reference, State Bank of Pakistan, Annual Report, pg 194)

23 It is not the object of this article to question the validity and/or merits of an Islamic banking system for Pakistan. The argument is merely based on the distinction created by the authorities between Islamic Banking Institutions (see footnote 19) duly licensed by SBP as Islamic Banks on one hand, and conventional banks on the other. In so far as Islamic Banking Institutions are concerned, the same ought to follow Islamic injunctions in letter and spirit.

24 Reported in PLD 2002 Supreme Court 800.

25 It needs to be noted that the Shariah Court alone has the jurisdiction to declare any law as against the injunctions of Islam and invalid and as of today there is no operative judgment which declares any of the laws providing for interest/mark-up as against the injunctions of Islam. It is interesting to note Salman Akram Raja’s comments in his article, “Constitutional Conundrum” featured in the Editorial section of Dawn on May 25, 2010. Mr. Salman raises questions on the viability of “recourse to an open-ended body of Islamic injunctions, and the subjectivity that inevitably accompanies such recourse, as a basis for attacking legislation”. He further states that even though the courts have earlier identified Islam as the “basic structure of the Pakistani constitution and, hence, a ground for the judicial review of not only constitutional amendments but also ordinary legislation”, judgments by the Supreme Court such as Hakim Khan (1992) and the more recent NRO judgment have  declared that “no part of the constitution or other statute could be struck down by the High Courts or the Supreme Court on basis of inconsonance with the injunctions of Islam”.

26 Various provisions of Schedule I of the Stamp Act, 1899 are routinely amended annually as part of the Provincial Finance Acts. Alternatively an appropriate notification may be issued to make the necessary changes.

27 It also needs to be considered whether recoveries under the Financial Institutions (Recovery of Finances) Ordinance, 2001 will be affected in relation to financing that is not mark-up based. Any such contention, however, stands no ground in light of the Lahore High Court judgment of International Finance Corporation v. Sarah Textiles Ltd., 2009 CLD 761 (Lahore) wherein the suit was for the recovery of an interest based facility provided by International Finance Corporation and no defence was raised on the basis that loan was interest based. In fact, the application for leave to defend the suit was denied, while acknowledging that such facility falls within the definition of ‘finance’, that the recipient of such facility is the ‘customer’, and that the same is an ‘obligation’.

28 Section 26A provides as under:
“26A.      Deposits.-(1) Deposits of money may be accepted by a banking company on the following basis:-

1. On participation in profit and loss of the banking company;
2. Free of interest or return in any form, and
3. Until such time as the Federal Government determines and notifies by publication in the official Gazette, that the domestic operations of the banking companies have become free of interest, effective on and from the first of July, 1985.


29 It may be noted that in clarifying that the mark-up system is no longer applicable to conventional banks as a matter of law, the Proposed Circular will not take away the option for conventional banks to continue mark-up based financing, if they so desire.

30 “Ballooning NPLs”, Business Recorder, August 23, 2010, Editorial section.

31 The Global Development Research Centre, “Loan Rescheduling after a Natural Disaster”, in MBP Rapid-Onset Natural Disaster Brief No. 1, pg 5, (accessed August 28, 2010).

32 Whilst Annexure I of BCD Circular No. 13 stands replaced by section ‘E’ of IBD Circular No. 02 dated March 25, 2008 insofar as it relates to Islamic Banking Institutions, the remaining BCD Circular No. 13 continues to be applicable to Islamic Banking Institutions.

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