Mr. Cohen’s textile business is in dire need of $100,000 working capital. So Cohen approaches Mr. Mamon, a wealthy Jewish businessman. Mamon is prepared to lend Cohen the money but would like to earn 10 percent interest on the loan and receive back $110,000. But this is not possible because Cohen and Mamon would be in violation of the prohibition against paying and receiving interest.
Does this mean Cohen’s business must fail? Certainly not. The rabbis, sensitive to the important role of credit in an economy, permit one to structure the transaction as a partnership agreement rather than a loan agreement and to view the 10 percent as a return on investment rather than interest on a loan. This restructuring of the loan into a partnership agreement is known as heter iska. And this is how it works.
Mamon tells Cohen they are setting up a partnership in which Mamon is investing $100,000 in the business venture as a sleeping partner and Cohen is investing capital as the managing partner. The partnership agreement, the heter iska, between Cohen and Mamon further provides that a portion of the money, say $50,000 (it could be a lower or a higher proportion depending on the terms of the deal) is to be considered an equity investment in the business venture. The other $50,000 is to be considered a loan. The equity portion of the capital is at risk and if it is lost in the business venture, Mamon will not get it back. The loan portion of the capital is not at risk because, under the terms of the heter iska, Mamon will get it back whether the business prospers or fails.
Profits and losses in this partnership arrangement will be shared equally between Cohen and Mamon. If the business fails and all of the capital is lost, Mamon will be entitled to receive the repayment of the $50,000 loan portion but will lose the $50,000 equity portion. If the business venture turns a profit of, say, $20,000, it is shared equally between the partners. Mamon will receive $110,000 – the return of the $50,000 loan, the return of the $50,000 equity investment, and the payment of $10,000 profit from the investment. Cohen will keep $10,000 as his cut of the profit on the $50,000 loaned to Cohen by Mamon and invested by Cohen in the business venture.
As a result of restructuring the loan into a partnership agreement and the profit derived from the business venture, Mamon will come out in the same place as if he had loaned $100,000 and taken 10 percent interest.
But Mamon is still scratching his head. “What if there are no profits from the investment? Worse still, what if all or part of the capital is lost? In a loan, I am entitled to the return of my money irrespective of the success or failure of the business venture and I want that degree of certainty here too.”
The rabbis have a solution for this as well. The heter iska contains a provision that requires any loss of the principal to be verified by two witnesses. From a practical point of view, it will be extremely difficult for Cohen to produce two eligible witnesses to testify to the exact circumstances of the loss of principal. The heter iska provides that in the absence of such witnesses, Mamon is entitled to the return of the entire $100,000.
The heter iska protects the return on the investment as well. It provides that Cohen must affirm under oath, in the presence of a bet din, that he is giving Mamon half of the profits earned. Alternatively, the parties may agree up front at the time the heter iska is entered into, that Mamon will accept a specified pre-agreed amount in lieu of his share of the profits and waive his right to future actual profits in excess of this pre-agreed amount. Such an up front pre-agreed profit is known as sechum hahitpashrut, the settlement amount. Since observant Jews will refrain from taking an oath under most circumstances, Mamon can be quite confident that Cohen would elect to pay the settlement amount out of his own pocket rather that take the oath.
The heter iska will also provide that Cohen is to receive compensation in exchange for his trouble in managing the partnership’s investment. Cohen’s management services cannot be provided free of charge to Mamon because this benefit would be deemed interest to Mamon on the $50,000 loan. The management fee can be a nominal fee of $1 or it can be in the form of a larger cut, a “carry,” of the partnership profits.
The person drafting the heter iska document must take care not to use the words “loan,” “interest,” “lender,” “borrower,” and other such language usually found in loan transactions.
Both parties to the heter iska should understand its terms and conditions. Although binding if consummated orally, the heter iska should preferably be in writing and consummated with a kinyan sudar, an act of closing in which Mamon passes a handkerchief or other article to Cohen, who raises it in a symbolic act of agreement to the consummation of the terms of the transaction.
Would-be critics of the heter iska will be reminded of the advice they may have received from their accountants or lawyers who structure deals in arcane ways to avoid taxation where the law permits it. The wrong word may cost money. As long as the transaction is conducted in accordance with the law it is legal. As long as the heter iska is written in accordance with the halacha, it is legal too.