Whosoever has funds and lends them without interest, of him Scripture says, "He who lends not his money at interest… whoever does these shall forever not falter" (Psalms 15:5).
BABA MEZI'A 71a
Promissory Loans
Biblical law forbids both exaction of interest by a creditor and payment of interest by a debtor. The underlying considerations are two-fold in nature: 1) the obligation to perform charitable deeds includes a responsibility to help the indigent by means of non-interest bearing provident loans. 2) Interest accepted in return for extending a loan involving neither risk of capital nor personal service is perceived as a form of unjust enrichment.
Although in biblical days the economic structure of society was predominantly agrarian and loans were sought primarily for personal purposes, the strictures against usury apply with equal force to loans extended for commercial purposes. During the Middle Ages, Jews, particularly when they were forbidden to own land, turned to commercial pursuits. Frequently, they became merchants engaged in the buying and selling of goods and produce. Such pursuits required capital investment of sums which few individual Jews possessed. In a contribution to the 5737 issue of Torah she-be-'al Peh, Rabbi Shiloh Raphael examines the devices which arose as a means of facilitating commercial endeavors without violation of either the letter or the spirit of Jewish law and explores their applicability to contemporary commercial transactions.
The earliest attempt to overcome these difficulties was that of the 16th-century Polish scholar known as R. Mendel Avigdors of Cracow, who composed the earliest version of the hetter iska. The hetter iska is a document which specifies the terms and conditions under which money is advanced by one individual to another. Its legal purpose is to create a partnership arrangement as distinct from a debtor-creditor relationship.
The formula of the original hetter iska was based upon a ruling recorded in Shulḥan Arukh, Yoreh De'ah 167:1 which provides that funds may be advanced on the condition that the recipient use the funds to buy and sell merchandise on behalf of the person advancing the funds until such time as a stipulated profit has been earned; profit over and above that amount then accrues without limit to the recipient. The sum advanced in this manner is termed "half loan, half deposit" in rabbinic literature. During the initial period the recipient acts solely as a commercial agent on behalf of the principal who advances the funds; only after the originally stipulated profit has been earned does the deposit revert to the status of a loan and the recipient, who was heretofore considered a bailee, becomes a debtor. Subsequently, no profit whatsoever accrues to the lender and hence there is no question of forbidden payment of interest. The text incorporating this formula, which was drawn up by R. Mendel Avigdors for use in lieu of a promissory note, appears in Naḥalat Shiv'ah, no. 40, and is known as the "Hetter Iska of Maharam."
The Ga'on of Vilna, Bi'ur haGra, Yoreh De'ah 167:1, expresses amazement at Shulḥan Arukh's ruling that money may be lent in this manner.In the situation which is outlined, the "agent" undertakes to engage in the purchase and sale of merchandise on behalf of the "principal." However, his sole motivation for doing so is the stipulated agreement between the parties to the effect that the sum advanced will subsequently be available for his own personal use as a loan. Labor or personal services performed on behalf of a creditor as an inducement to extend a loan is a form of interest forbidden by Jewish law. Performance of such services without compensation is, in fact, a disguised interest premium as a precondition for receiving the loan. It is for this reason that Shulḥan Arukh stipulates that the "agent" must be paid for his services, although the payment may be nominal in nature.
In terms of making capital available for commercial purposes, an obvious deficiency with regard to this arrangement is that the "interest" received by the lender is not tied to the period of time his capital is used by the borrower and does not provide for accrual of additional interest in the event that repayment is delayed. Subsequently, a modified form of the hetter iska was developed which had the effect of eliminating this difficulty.1See Ginat Veradim, Yoreh De‘ah, klal 7, no. 4. Under the terms of this modified hetter iska the recipient accepts fifty percent of the funds as a deposit and fifty percent as a loan. Any expenditure of a commercial or investment nature is deemed to be a joint return in which both parties share equally. Thus, technically, half the profits accrue to the "principal" and half to the borrower. The principal may, of course, agree to accept no more than a certain stipulated amount of the profits and the agent may demand that the agreement specify that profits exceeding that amount accrue to the agent as compensation for his services.
In neither of these formulations is the hetter iska a subterfuge or legal fiction. The determining characteristic which distinguishes a loan from a deposit is that a debtor must always repay the full amount borrowed, regardless of any losses he may suffer, while the laws of bailment provide that the bailee need not indemnify the bailor in the event of certain types of losses. Since the hetter iska generates a principal-agent relationship, no payment need be made if bona fide losses occur while the borrower functions as a bailee. Under the terms of Maharam's formula there is no obligation whatsoever on the part of the recipient if the loss is sustained during the initial period; according to the modified version such losses are borne equally by the "principal" and the "borrower." The "principal" may, however, set forth certain stipulations to protect himself against loss. He may, for example, stipulate that the agent must bear all losses unless the merchandise purchased is under the latter's personal supervision at all times or unless the agent can produce two trustworthy witnesses who testify that he has indeed properly discharged all aspects of his trust. R. Israel Isserlin, Terumat ha-Deshen, no. 302, states that the creditor may even stipulate that only the testimony of the rabbi and the cantor of the community will be acceptable, despite the fact that such a condition is, in practice, almost impossible to fulfill.
Conditions such as these serve to protect the capital of the creditor, but do not at all guarantee the payment of "interest" in the event that the debtor denies that he has earned a profit. This drawback was overcome by means of a further stipulation providing that the "principal" may assume that a profit has been earned and that this presumption may be nullified only upon the solemn oath of the "agent" to the contrary. Since, in general, pious Jews abjure oaths, even when called upon to swear to matters which are entirely true, the net effect of a stipulation of this nature is to assure that the creditor will receive "interest" in the form of a guaranteed "profit" even if, in fact, no profit has been earned in any commercial endeavor. Whether or not such an oath may be demanded when the "principal" has personal knowledge of the truth of the "agent's" claim that no profit has been earned is a matter of some dispute. Some authorities assert that an oath attesting to facts already known by the party demanding the oath is forbidden as an oath taken "in vain," i.e., to no purpose. Of course, if an oath cannot be exacted, payment in lieu of the oath cannot be demanded.2Teshuvot Shai, I, no. 3; Panim Me’irot, II, no. 3; Divrei Ḥayyim, II, hashmat-tot, no. 16; and Iggerot Mosheh, Yoreh De‘ah, II, nos. 62 and 63, maintain that such an oath cannot be demanded. However, Teshuvot Maharshag, Yoreh De‘ah, no. 4, disagrees.
The hetter iska was originally designed to facilitate the lending of capital for commercial purposes. Since the capital was, in fact, invested in mercantile enterprises, and since the creditor assumed a measure of risk, the relationship which was formed was—factually as well as technically—that of partners in a business venture. However, with the passage of time, use of the hetter iska became more and more widespread. Greater and greater numbers of Jews earned their livelihood as craftsmen or as hired laborers. The use of a hetter iska by a person who is not in any way engaged in a business enterprise appears to be nothing more than a subterfuge. Rabbi Raphael fails to note that Rabbi Moshe Feinstein, Iggerot Mosheh, Yoreh De'ah, II, no. 62, totally ignoring earlier responsa dealing with this problem, does indeed state that the hetter iska may be employed only when the borrower is engaged in business ventures. Moreover, declares Rabbi Feinstein, both parties must know the nature of the commercial venture for which the money is advanced for "it [the hetter iska] is not an incantation or charm." In Iggerot Mosheh, Yoreh De'ah, II, no. 63, Rabbi Feinstein adds that the written agreement should state that the money advanced must be used for ventures in which it may reasonably be anticipated that the profit will be at least twice the amount of the stipulated "interest." Thus, according to Iggerot Mosheh, the hetter iska is reserved for use in situations in which the interest paid is, in reality, no more than the actual anticipated profit realized on the portion of the merchandise acquired on behalf of the creditor.
The question of the efficacy of the hetter iska in conjunction with non-commercial loans was raised earlier, at approximately the turn of the century, and discussed in detail by Rabbi Shalom Mordecai Schwadron, Teshuvot Maharsham, II, no. 216. Advancing a view contrary to that of Iggerot Mosheh, Rabbi Schwadron justifies the use of a hetter iska in conjunction with loans which are entirely of a personal nature. He concedes that when the funds have not been used for commercial purposes, and no profits have been earned, no interest need be paid. The borrower, however, certainly has the option of using the money advanced for such purposes; indeed, that is the prima facie purpose of the loan as stated in the written agreement. Under the terms of the agreement the lender may demand a solemn oath that the money has not been used to generate profit and that, in fact, no profit has been earned. The amount stipulated as "interest" is then paid by the debtor solely as a means of avoiding the oath which he is otherwise bound to swear.
R. Joseph Saul Nathanson, Teshuvot Sho'el u-Meshiv, Mahadurah Kamma, III, no. 160, justifies an iska arrangement in conjunction with personal loans, for at least some purposes, on entirely different grounds. According to this authority, a loan which makes it possible for an individual to continue practising his profession or to retain his income-generating employment is to be deemed a commercial enterprise. Therefore, according to Sho'el u-Meshiv, a teacher who is burdened by debt or by personal expenses may borrow funds under an iska arrangement if failure to receive the loan would force him to abandon his profession and to seek a livelihood in some potentially more lucrative endeavor. Since the loan enables him to continue in his occupation, the loan constitutes a form of iska in which the financier becomes a partner. The application of this line of reasoning to student loans designed to enable the student to pursue studies which will qualify him to enter a profession or to make him eligible for higher salaried employment is obvious.
In another responsum, Sho'el u-Meshiv, Mahadurah Telita'ah, I, no. 133, Rabbi Nathanson sanctions an iska arrangement in order to enable the recipient to repay a debt and thereby to avert the forced sale of his home. This is categorized as an iska by Sho'el u-Meshiv by virtue of prevention of loss of capital in the sale of the house and avoidance of financial expenditure in the form of rental expenses.
The permissive views of Sho'el u-Meshiv are sharply disputed by R. Meir Arak, Teshuvot Imrei Yosher, I, no. 108. Imrei Yosher maintains that the concept of iska is limited to profits realized from the investment of capital advanced or from sale of merchandise or goods acquired with such capital. Profits realized from avoidance of loss or from income derived from personal employment do not constitute a joint venture and, hence, according to Imrei Yosher, do not justify use of a hetter iska. This latter view is consistent with the position of most authorities including Ginat Veradim, Yoreh De'ah, klal 6, no. 4; Shulḥan Arukh ha-Rav, Hilkhot Ribbit, sec. 42; Kizur Shulḥan Arukh 66:10; and Erekh Shai 177:7.
Rabbi Moshe Sternbuch, Mo'adim u-Zemanim, VI, no. 41, points out that with widespread investment in the stock market on the part of small investors there can be no question with regard to the creditor's lack of personal knowledge that no profit has been earned. Indeed, it is not uncommon for individuals who borrow money for personal purposes to use such funds in an attempt to reap short term profits in the securities market. Since the creditor cannot know that this has not, in fact, occurred, he may, according to all authorities, stipulate that an oath be sworn to that effect.
Rabbi Raphael notes that, in our day, an aversion to oath-taking is no longer to be taken for granted. Understandably, there may, therefore, be a reluctance on the part of some persons to utilize the customary hetter iska. The lender may well anticipate a contingency in which the borrower will indeed swear quite truthfully that he has earned no profit. Rabbi Raphael suggests that the requirement for an oath on the part of the debtor be replaced with a stipulation giving the creditor the right to examine the financial records of the debtor and the right to participate in all decisions with regard to expenditure of the sum advanced. The agreement between the parties would provide that this right be abrogated upon payment of a specified sum or percentage of the capital at the discretion of the debtor.
As has been explained earlier, the hetter iska constitutes a device which is in full conformity with Jewish law. The hetter iska has also been recognized by the civil courts as an instrument creating a bona fide partnership interest providing for a limited return upon an investment rather than as a loan instrument requiring payment of interest on borrowed funds. In Leibovici v. Rawicki, 57 Misc.2d 141, 290 N.Y.S.2d 997 (Civ. Ct., 1968), the court upheld the legality of a hetter iska which provided a return greater than was permitted by usury laws in effect at that time. In this decision, the court specifically denied the plea that the agreement was merely a disguised loan and constituted a subterfuge to avoid the taint of usury. In a number of cases, the courts have ruled explicitly that payment of a portion of profits in lieu of interest with no guarantee of profit is not usury.3See Clift v. Barrow, 108 N.Y. 187, 192-194, 15 N.E. 327, 328-330 (1888); and Mueller v. Brennan, 68 N.Y.S. 2d 517 (Sup. Ct., 1947). In Leibovici v. Rawicki the court recognized that a hetter iska constitutes an agreement of precisely this nature.
A sample draft of a hetter iska agreement in English is appended to this chapter.
Mortgage Loans
A mortgage loan in which the seller accepts a purchase mortgage representing all or part of the purchase price does not lend itself to use of a usual hetter iska. Since no cash is actually advanced by the seller to the purchaser, the purchaser has no opportunity to realize a profit from the investment of such funds. Accordingly, the seller has no reason to demand an oath to that effect and no right to accept a stipulated sum in lieu of an oath. Of course, if it may reasonably be anticipated that the market value of the real estate will rise, a partnership agreement might be drafted which would provide for a specified rate of return in lieu of payment of a partnership share of the actual increment in value. However, in the event that the value of the real estate does not rise and no "profit" is realized, acceptance of "interest" in lieu of profits poses a halakhic problem. It may be argued that if real estate values are a matter of common knowledge, there is really no basis to demand an oath to that effect and hence no right to accept monetary payment in lieu of an oath.
There does, however, exist an entirely different and relatively simple expedient which serves to obviate the prohibition against the taking of interest in conjunction with mortgage loans. This procedure is as follows: Title to a portion of the property directly commensurate in value with the principal of the mortgage is vested in the lender. It is then stipulated that the sum required as interest be paid to the "lender" as rent for use of the portion of the property which belongs to him. Payments which serve to reduce the principal are deemed to represent payment for acquisition of title to a share in the property in direct proportion to the amount paid. Subsequent "interest" payments are reduced because "rent" is paid only on the diminished portion vested in the lender.
There is, however, one serious drawback with regard to an arrangement of this nature. Under the terms of a conventional mortgage loan, should the mortgagor default in payment of monthly installments the property may be foreclosed and seized by the mortgagee. However, the agreement here described creates a situation in which the purchaser and seller share a partnership interest in the property. Hence, if the purchaser should default in his payment of a monthly installment and the property be foreclosed the proceeds of the foreclosure would perforce be divided in accordance with the respective partnership interests of the purchaser and the seller. This result would presumably be unacceptable to most persons contemplating the sale of real estate on terms involving deferred payment.
This problem may, however, be remedied by modifying the agreement to provide solely for regular payments of rent for a set period of time. These rental payments would be set at a sum equal to the amount which would represent the periodic payment of both interest and principal in a conventional mortgage loan. The agreement would further provide that, upon expiration of a stipulated time-period, title pass to the leaseholder without further payment, or upon payment of a nominal sum, provided that all financial obligations have been satisfied.
In the event of default in payment of the "rent" the mortgagee-lessor would be entitled to terminate the lease as is the case in any landlord-tenant relationship. In this way the mortgagee-lessor would regain title and possession of the entire property.
It is readily perceived that, for a variety of legal considerations pertaining to real estate taxes, insurance coverage, etc., it is desirable that title be vested in the lessee-purchaser, just as under a standard mortgage agreement title is vested in the mortgagor. This may be accomplished under the terms of a leasehold agreement as well. It should be emphasized that such a procedure is entirely legal. The lessee-purchaser may be designated as the owner of record even though, in fact, the agreement provides that title is retained by the lessor-seller. The lessee-purchaser is, in effect, the nominee of the lessor-seller and the agreement between the parties to this effect is entirely valid even though it is not reflected in ownership of record.
A further problem which must be addressed is the question of interest deduction for purposes of income tax liability. Ordinarily, interest payments on leases and mortgages are deductible from income, while rental payments are not. It might seem that under the provisions of an agreement of this nature the purchaser forfeits the income tax deduction which he would enjoy under the provisions of a mortgage loan. However, on the basis of a number of court decisions as well as Internal Revenue Service regulations which are presently in effect, it would appear that the purchaser-lessee is fully entitled to deduct any "rental" payment made in lieu of interest which would have been paid under the terms of a conventional mortgage loan.
In an early case, Dorzbach v. Collison, 195 F.2d 69 (3rd Cir. 1952), bearing directly upon this question, a federal court ruled that a deduction must be allowed for payment of a percentage of net profits in lieu of interest. The proprietor of a clothing store had borrowed money from a bank but, when pressed for payment, was unable to satisfy the debt. The proprietor's wife was substituted as creditor under an agreement which provided that the proprietor would pay his wife 25% of the net profits of his clothing store business "in lieu of interest" on monies loaned to him. The court ruled that such payments are deductible as interest.
In another case, Arthur R. Jones Syndicate v. Commissioner of Internal Revenue, 23 F.2d 833 (7th Cir. 1927), the Circuit Court of Appeals ruled that "interest, regardless of the name by which it is called, may be deducted by the taxpayer from its income." This case involved an arrangement designed to circumvent an Illinois usury statute. Instead of entering into a loan agreement providing for payment of 14% interest, the parties agreed that preferred stock be issued which was to be redeemable at par and which would bear a dividend of 14% per annum regardless of earnings. The court held that such "dividends" are deductible as interest.
Reference should also be made to a more recent case, Oesterreich v. Commissioner of Internal Revenue, 226 F.2d 798 (9th Cir. 1955), which deals with a different but related matter. In Oesterreich the court held that an agreement providing for payment of "rent" for a stipulated number of years and conveyance of real estate thereafter for a nominal sum was in reality a contract for sale of land even though it was entitled a "lease" and, for tax purposes, should be treated as a sale rather than as a lease. This ruling was later reaffirmed in Estate of Hedrick v. Commissioner of Internal Revenue, 406 F.2d 587 (9th Cir. 1969), in subsequent litigation growing out of the same transaction.
These determinations are reflected in I.R.S. Tax Regulations 26 CFR §1.163-1 and §1.483-1 which provide that payments readily construed as interest are to be considered as such even though they are not formally designated as interest.
In order to eliminate any doubt it is advisable to include a section in the preamble to the leasehold agreement stating that the transaction is executed in this manner rather than in the form of a mortgage loan because of a desire to avoid the usury strictures of Jewish law. This should serve to demonstrate beyond cavil that the "rental" payments are indeed "in lieu of interest."