Islamic Finance: Contract - A look at the definition and the important ingredients

[abdulhakeem]

|By Sohail Zubairi, Special to Gulf News | 16-10-2003

Our last three articles adequately covered the situations where conventional banks usually have concerns over facility contracts while participating in an Islamically structured transaction.

What is the legal definition of a contract under Islamic law? This discussion will deal with important ingredients that make up a contract in the eyes of Sharia.

Meaning of contract

Contract in Arabic is called Aqd. Literal meaning of Aqd is to bind or to strengthen. The word Aqd is also used in Arabic in the sense of confirming an oath. As such, any covenant, pact, agreement and treaty will also be referred to as Aqd since all of them demonstrate firm resolve for execution. Plural of Aqd is Uqood.

Prerequisites

According to Sharia, a contract cannot be defined as such unless it has the following four pre-requisites:
1) Existence of minimum two parties: A contract cannot be formed with the presence of a single party. Although a single intention may lead to various obligations, such as remission of a debt or declaration of donation, etc, these cannot be called contract in Sharia.

2) Offer and acceptance: It is necessary for a contract to have consent by both parties over the purpose and content of the contract. In Arabic it is called Ijab wa Qabool, meaning 'Offer' (Ijab) and 'Acceptance' (Qabool).

An offer can be made by either party in a contract – seller or buyer. Similarly, the acceptance also could come from any of them. As such, if the seller offers to sell his car for Dh25,000 and the buyer accepts it, this will form a valid contract. Likewise, if the buyer states that he is ready to buy the car at the above price and the seller expresses his agreement, this will constitute a contract.

Offer and acceptance could be written or verbal since Islam gives high priority to the fulfillment of one's obligation under a contract, irrespective of whether it is written or verbal.

3) Sharia compliant: The offer and acceptance between the parties should be for a purpose not repugnant to Sharia.

We have earlier learned in detail what activities do not conform to Sharia and therefore, if the parties agree over an act which is out of line with Sharia, the contract will be void under Islamic law.

In order to understand it clearly, if Ahmed signs a contract to borrow money from Badar at a specified interest rate, it will not be considered a valid contract under Sharia since Islam forbids the practice of lending the money on interest.

4) Contract's object: The subject of the contract must change hand upon completion of the contract.

For example, if the contract is for sale of the house by Ahmed to Badar, the ownership of the house must be transferred to Badar upon culmination of contract.

Similarly, if Ahmed agrees to lease the house to Badar, the possession of the house must be transferred to Badar in order to achieve the purpose of the lease contract.

Nature of contracts

Although the above major ingredients may be found in all types of contracts, Islamic jurists have taken great pains in examining various types of contracts one by one and defining their respective nature, parties, roles, conditions, rights and responsibilities.

For instance, a sale contract is different in nature than a hire agreement despite presence of some common elements such as the presence of two parties, offer and acceptance, Sharia compliance and the subject etc.

Will the end result of both contracts be the same? Off-course not, since the subject of the lease contract being a house will continue to be the property of the lessor as against the sale contract where the ownership would be changed to buyer.

The writer is head of risk management at Dubai Islamic Bank.

http://www.gulf-news.com/Articles/news.asp?ArticleID=100371

[abdulhakeem]

Islamic Finance: Differences with conventional banks in joint-financed deals

|By Sohail Zubairi, Special to Gulf News | 02-10-2003

Major differences exist between a conventional bank and an Islamic bank in a jointly financed transaction.

In a conventional leasing agreement of large value, it is common to find a clause relating to the potential of increase in the cost of the asset being leased.

The clause stipulates that if later-on the lessor (lead bank) determines that any of the banks forming part of the lessor group has incurred any increased cost as a result of the introduction of any new tax in its area of operation making the financing expensive, or any new tax on the asset with retrospective effect or enhanced capital adequacy ratio leading to making the lending less attractive or for any other reason, then the lessor bank(s) will have the right to add such increased amount to the lease rent.

Moreover, the lessor bank(s) shall not be obliged to disclose any calculation to the lessee while claiming the increased costs.

Conventional bank would like to see this point in the lease agreement while participating in an Islamic financing transaction. However, from a Sharia scholar's perspective, the point falls under the category of Gharar or element of uncertainty which makes an agreement null and void.

It may not be correct to assume that Sharia is rigid to accommodate subsequent increase in the cost of financing an asset. Following are the Sharia parameters to address such a situation:

The lessee must undertake in the lease agreement that it will be willing to pay higher lease rent to allow the lessor to be able to bear the increased cost related to the financed asset in future, if any.

The undertaking should include, inter-alia, the foreseeable elements of increased cost such as insurance expense, major repair and maintenance, ownership and income taxes, etc. All this may have been paid by the lessor or the lessee in the capacity of lessor's service agent.

Lessee will not be obliged to pay for the increased costs to lessor if it is uncertain and cannot be arrived at with the help of a formulae or if the lessor declines to provide the details of such increased costs, claiming it to be confidential. In short, any element of uncertainty is knocked down by the Sharia Supervision Board of an Islamic bank and which act is not looked with favour by a conventional bank.

It is a practice unanimously adopted by the conventional banks to charge penalty on the amounts delayed for payment by the client. They insist to include this clause in an Islamic facility agreement since they always have it in their own documentation and hence find it difficult to live without it.

Whilst Islamic banks are not allowed by Sharia to charge any such penalty since it will tantamount to Riba (interest), they usually accommodate this demand from conventional banks but add the phrase that such penalty amount will not be taken by them to their profit and will be donated to charity organisations of non-religious nature.

Penalty amount

Why emphasis on non-religious charity? Because penalty amount being usurious in nature cannot be compared to Zakat money which is spent on supporting widows, orphans, religious students, Islamic schools, marriages and the likes. This less contentious issue works in favour of Islamic banks as it discourages the customer from intentionally delaying the payment.

In a conventional financing scenario, a long list of the events of default is provided which includes several events outside the borrower's control, such as, force majeure, nationalisation, requisition, etc.

To the contrary, in an Islamic financing transaction, imposing something on the customer over which he has little or no control is disallowed by Sharia.

Sharia accepts those events as default which are caused by the customer's own fault or negligence or which could have been prevented by him. In a co-financing situation, events of default outside the control of the customer are redefined as 'events of mandatory prepayment' and are covered under a separate document, rather than in the main facility agreements.

The author is head of risk management at Dubai Islamic Bank.

http://www.gulf-news.com/Articles/news.asp?ArticleID=99171

[abdulhakeem]

Islamic Finance: Necessary parameters for an object in a valid contract

|By Sohail Zubairi, Special to Gulf News | 23-10-2003
Dubai:Thursday, October 23, 2003

Last week we examined the definition and pre-requisites of a contract under Sharia law. Continuing with this topic, we will now examine the importance of an object (or consideration) under such a contract.

Following are the eligibility parameters for an object of a contract, as defined by Sharia scholars:

Eligibility for transaction

The object of a contract should be fit or suitable for carrying out a transaction i.e. it should be executable or do-able within the normal business environment. Sharia renders any such contract invalid in situations in which it will be impossible to achieve the consideration for which the contract was agreed.

Let us try to understand this by way of an example. If 'A' offers 'B' a certain amount of money to bring him the moon and 'B' accepts the offer, Sharia rules it out as a valid contract since it will be impossible to carry it out.

Allowable under Sharia

The Islamic jurists have a unanimous opinion that anything which is forbidden by Sharia is not tradable and hence cannot become the consideration or object of a contract. As such, the contract will be void if A and B agree on a liquor deal.

In the same manner, there can be no valid contract for the sale and purchase of stolen goods or delivery of inferior goods now at the promise of returning superior merchandise later as it will constitute one kind of Riba or interest.

Betting, considered a forbidden activity, cannot be the subject of a valid contract under Islamic law. Hence, anything connected with immorality is invalid to be considered an object of a contract under Islamic law.

Own-able by an individual

According to Sharia, no public property or the property for common use such as public hospitals, government offices, roads, springs, canals, rivers, etc. can be made the subject of a contract. This is to prevent an individual from denying their usufruct to the general public.

Religious properties

Any property which is developed in God's name, such as mosques, religious schools, orphanage, graveyards, etc. also cannot be eligible for a contract as it will be tantamount to violating God's right.

Pledged properties

When it comes to the rights of a man, Sharia law protects them fairly by prohibiting to enter into a contract for a property or object which is already mortgaged or pledged to another man. However, it is allowable to trade in such property once the attachment is removed.

Other conditions

In addition to the above, Muslim jurists have attached certain additional conditions to make the object valid for a contract.

These are listed below:

The object of the contract must be existing at the time of making a contract. However, a Salam or an Istisna contract will be valid despite non-availability of the goods or asset at the time of making the contract since there is certainty of the object of the contract being delivered to the buyer in view of the seller's promise and the ability to do so.

The object must exist in reality rather than in the opinion of contracting parties. For example, if the contract was made for the sale of barley but the bags purported to contain barley turn out to congtain rice instead. In this case, the object for which the contract was made (barley) remained non-existent and no contract was made for the object which existed (rice).

The contracting parties must be aware of the exact quality, quantity and specifications of the object of the contract. This is to eliminate uncertainty which may lead to a dispute.

This could be achieved by the inspection of goods conducted by the buyer prior to entering into the contract or through detailed description, if the inspection is not possible due to the object being away from the contracting place.

There is no doubt that the contracting parameters described last week and today, if adopted in their true spirit, can rid the world of a large number of disputes we regularly witness on the commercial scene.

The writer is Head of Risk Management - Corporate Banking, Dubai Islamic Bank

http://www.gulf-news.com/Articles/news.asp?ArticleID=101049

[abdulhakeem]

Islamic Finance: Sharia requires parties entering a contract to have 'perfect capacity'

|By Sohail Zubairi, Special to Gulf News | 11-12-2003

We will take our discussion on contract under Islamic law further by discussing the capacity of the contracting parties.

In Sharia, the word capacity or 'Ahliyyah' represents a person's competence to enter into obligations as well as carry out their execution under a contract. This includes financial contracts.

In other words, capacity can also be defined as the competence of contracting parties to acquire respective rights and liabilities.

Sharia accords rights to a party appropriate to his capacity to exercise them and at the same time imposes liabilities on a person commensurate with his ability to fulfil them. This is because Sharia wants the aim of any valid contract to be the achievement of performance by way of its satisfactory execution.

On the other hand, it is realised in Sharia that all people cannot be equal in acquiring rights and incurring liabilities, such as minors, insane persons, the terminally ill, among others.

For a contract between two persons to be regarded as valid under Sharia, it is necessary that they hold 'perfect capacity'. By perfect capacity, Sharia means that they should be above 15 years of age and possess a sound mind.

How would you judge the above criterion in a person? The Quran defines this in a clear manner through the following verse: "And put the orphans to trial (of their intelligence) until they reach the age of marriage (adulthood); then if you find in them sound judgment, deliver to them their property."

Although the verse is addressed to the guardian of an orphan, it also gives us a guideline to ascertain 'perfect capacity' in a person, which is essential for entering a contract. There are circumstances when this 'perfect capacity' can be temporarily lost. Such circumstances and their interpretation are listed below:

State of intoxication

Islamic jurists accept that a person may not be held responsible for his obligations under a contract if he can prove that he was placed under the influence for the purpose of entering the contract, which he would not have entered had he not been intoxicated.

However, they view that in case of voluntary intoxication, he will be held responsible since it is considered an offence under Sharia to consume such beverages. As such, he cannot be excused from punishment in case of non-fulfilment of his obligation in terms of a contract entered into by him while he was drunk. This is aimed to work as a deterrent.

State of coercion

In Sharia, coercion or duress means to force a person to perform an act which he dislikes and which he would not want to perform under normal circumstances. Coercion could be in the shape of bodily harm, threat to life, confinement, blackmail, or other such unethical steps.

As coercion eliminates genuine intention and the free will from a person of 'perfect capacity', jurists believe that such a person should not be held legally responsible for his obligations under a 'coerced' contract. If such a contract is executed, the coercer will be held responsible for the damages towards the coerced party.

Jurists have made it clear that a court verdict against a defaulter forcing him to sell his assets to pay the debt will not be considered coercion. This is because the verdict is for a just cause and is binding on him since he had signed a contract with his creditor of his own free will.
Furthermore, the court verdict is to protect the interests of the creditor who is a victim.

The writer is a senior manager with Dubai Islamic Bank

http://www.gulf-news.com/Articles/news.asp?ArticleID=105210

[AbuZayd Al-Britaani]

If you are interested, see the book by Mufti Taqi Uthmani : "Islamic Finance"

www.darululoomkhi.edu.pk/fiqh/islamicfinance/islamicfinance.html

[abdulhakeem]

Islamic Finance: Learning rules of wakala and its termination

|By Sohail Zubairi, Special to Gulf News | 01-01-2004

Last week we learned about wakala or agency, including its definition and essential elements. Today's article will deal with the rules of wakala, its termination and related matters.

An agent can be appointed for any act allowed under Sharia. However, we will confine our discussion to the commercial implications of an agency arrangement.

The principal and the agent or wakil have equal rights to withdraw from a wakala agreement by giving agreed upon notice. If there is no notice clause in the agreement, wakala can be terminated at any time.

However, the sudden or notified withdrawal is prohibited by Sharia if it jeopardises the interests of a third party who may have got engaged due to the very wakala agreement.

For example, if the principal has authorised the agent to dispose of certain property owned by the principal for a certain amount and the agent is at an advanced stage of completing the transaction with an interested buyer (e.g. signing an MoU or receiving a down payment, among others), the principal will not be in a position to terminate the wakala agreement whether or not the agreement has a provision for notified or sudden termination.

This is to protect the interests of the third party buying the property as well as to provide cover to the agent who will not be able to retract at that stage from the transaction, entered into by him on behalf of the principal.

Subhead

Some jurists have provided a way out for dismissal of wakala in such a situation. They lay down the necessary condition of consent from the third party to withdraw from the transaction. Moreover, any advance money paid by the third party must be returned to him.

They further elaborate there should be no repercussion or damage of any kind whatsoever to the agent if he has acted in good faith and diligently in discharging the agency's responsibilities.

However, if the agent is found to have transgressed any of the wakala agreement terms, the principal will have the right to dismiss the wakala agreement irrespective of the stage of transaction initiated by the agent on behalf of the principal. This is because the agent overstepped his authority.

An example is where an agent is found selling the principal's property at an amount lower than that specified by the principal or if the disposal was at the instructed price but on a deferred payment basis rather than cash as sought by the principal.

Such disposition will render the agent an unauthorised agent and he will be liable for compensation of the principal as well as the third party for any genuine damages.

A section of Islamic jurists believe that in such a situation, the disposal will remain valid provided the agent does this at his own risk and responsibility.

As such, if an agent disposes of the principal's property at an amount lower than the price sought by the principal but accepts the responsibility of making good the shortfall, it will be considered an authorised agency action.

Similarly, if the agent has been able to sell the property at a price higher than what has been sought by the principal, he will be entitled to retain the surplus. In order to eliminate any ambiguity leading to dispute, jurists do emphasise the need to be clear on the issues of shortfall and surplus within the text of the agency agreement.

In a situation where the agent is not bound by the sale price of a property and neither has he been given clear instructions as to the payment terms, he will be fully empowered to conclude the transaction at any amount or terms irrespective of the expectation of the principal.

Please note that an agent authorised to conclude a sale or purchase transaction on his principal's behalf cannot do so for himself or for his minor child or for a relative not having 'perfect capacity'. However, he can do so for his adult son or wife having 'perfect capacity'.

The writer is a senior manager with Dubai Islamic Bank

http://www.gulf-news.com/Articles/news.asp?ArticleID=106879

[abdulhakeem]

Islamic Banking - some definitions and terms

Published: 11th June 2004
Author: Bob McDowall
Channel: Business and Finance

At the heart of Islamic Banking are questions of morality. Islamic Banking seeks to address the issue by eliminating the concept of interest from banking. This is effected through a number of financing structures, which overcome the interest problem and are discussed briefly below. The critical question is: do they provide a form of finance which not only eliminates the concept of interest but is in full conformity with the spirit of Shari'ah? In other words, these modes of finance should not merely be a change of name to disguise the concept of interest.

Lending Overdrafts: these are provided subject to certain maximum amounts free of charge but, of course, must be viewed from a risk and cost perspective in the context of the overall banking relationship.
No cost loans: these occur where each bank sets aside apart of their funds to grant no-cost loans to "small and needy businesses."
Loans with a service charge: these are loans upon which no interest is charged but where the cost and expense are covered by the levy of a service charge.
Investment Mudarabha: under this scheme banks contribute the finance. The customer provides the resources, skills and management. Profits are shared in a predetermined form but any losses which occur are shouldered by the bank.
Musharaka: under this scheme a bank joins a commercial enterprise in establishing a joint venture, where they participate in predetermined proportions. Profits and losses are shared in a predetermined manner.
Estimated rate of return financing: banks estimate the rate of return on projects and undertakings they are asked to fund. Banks provide funds on the agreement that the negotiated rate of return is agreed.
Trade financing Mark-up: the bank buys the goods for the customer and the customer agrees to repay the bank the price of the goods or services and the predetermined profit at a later stage.
Leasing: the bank purchases goods for the customer. The bank then leases it to the customer for an agreed term. At the end of the term the lessee pays the balance on the price agreed at the beginning of the term and acquires ownership.
Hire purchase: the bank buys goods for the customer. It hires the goods to the customer for an agreed fee and period. At the end of the period the customer automatically acquires ownership of the goods.
Sell-and-buy-back: the customer sells properties to the bank for an agreed and immediately payable price. This is done on condition that the customer buys back the property after a predetermined time and at an agreed price.
Letters of credit: the bank guarantees the import of goods financing the transaction itself for a customer on the basis of sharing the profit from sale or on the basis of a mark-up.
To what extent are these modes of financing genuine and transparent alternatives to interest based form of financing and to what extent are they simply fictions or devices to circumvent the so-called interest problem?

While each transaction differs and each case depends on its own facts, some general observations would appear to be that:

If the bank does not go through the actual visible and demonstrable steps of a transaction but merely confines these to a recitation of these steps in the transaction agreement, there is clearly a failure of agreement with the spirit of Shari'ah. So, for example, in the instance of a hire purchase agreement, where the bank does not actually go out and buy the goods but already possesses the requisite goods, this is a failure of compliance with the spirit of the Shari'ah.
Where banks merely re-compute the notional interest in terms of a mark-up or fee to arrive at an equivalent, there is clearly a failure of compliance with the spirit of the Shari'ah.
Where the spirit behind the transaction is to ensure that the returns are the same as they would be in an interest based environment or avoid losses on profit and loss sharing transactions, where they would in normal events occur, these do not comply with Shari'ah.
Where the returns on Islamic Banking are, in essence, set and determined in the same way as conventional banking, albeit using different language and terminology, banks have not in effect buried the concept of interest based banking. Does this mean that any large international bank providing Islamic Banking products as part of its overall product or service portfolio cannot in the final analysis provide products which comply with the spirit of Shari'ah?

http://www.it-director.com/article.php?articleid=11975

[abdulhakeem]

Q&A: Islamic finance

Susan Smillie and Hilary Osborne
Tuesday February 15, 2005

The decision by Lloyds TSB to offer an Islamic current account highlights the clash between the Muslim faith and the way western banks operate. Traditional UK bank accounts and mortgages do not comply with Islam's sharia law, so in the past people faced a big decision - compromise their beliefs or look for alternative ways to manage their finances.

There are almost two million Muslims in the UK, so it's surprising that it has taken financial services companies so long to wake up to this group of potential consumers by launching products which comply with Islamic law.

What are the main rules for Islamic finance?

The rules lie in the principles of Islam's shariah law, taken from the Qur'an and the Sunnah, (the way) referring to the way in which the prophet Muhammad lived his life.

Central to Islamic finance is the fact that money itself has no intrinsic value, it is simply a medium of exchange. Each unit is 100% equal in value to another unit of the same denomination and you are not allowed to make a profit by exchanging cash with another person. A Muslim is not allowed to benefit from lending money or receiving money from someone.

This means that earning interest (riba) is not allowed. To comply with these rules, interest is not paid on Islamic savings or current accounts or applied to Islamic mortgages.

How do the banking arrangements work for customers?

There are several Islamic financial instruments:

· Ijara works as a leasing arrangement: the bank buys something for a customer and then leases it back to them. Different forms of leasing are permissible, including those where a portion of the instalment payment goes toward the final purchase.

· Murabaha works by the bank supplying specific goods for resale to the customer. This method incorporates a mutually agreed contract and a mutually negotiated margin.

· Musharaka is a joint venture in which the customer and bank contribute to the capital of the operation and agree to share the returns (as well as the risks) in proportions agreed to in advance.

How do the banks make money?
Banks can profit from the buying and selling of approved goods and services. The principal means of Islamic finance are based on trading, and it is essential that risk be involved in any trading activity, so banks and financial institutions will trade in sharia-compliant investments with the money deposited by customers, sharing the risks, and the profits between them.

Islamic banks are structured so that they retain a clearly differentiated status between shareholders' capital and clients' deposits in order to make sure profits are shared correctly.

Although they cannot charge interest, the banks can profit from helping customers to purchase a property using a ijara or murabaha scheme. With an ijara scheme the bank makes money by charging the customer rent; with a murabaha scheme, a price is agreed at the outset which is more than the market value. This profit is deemed to be a reward for the risk that is assumed by the bank.

There are firm laws governing the types of business the banks can trade with. There should be absolutely no investment in unsuitable businesses, including those involved with armaments, pork, tobacco, drugs, alcohol or pornography.

Similar to ethical banking, then?
There is some common ground. Some of the tenets of Islamic banking will appeal to anyone, Muslim or otherwise, who agrees with the underlying principles of equitable distribution for everyone, the ideals of fair trading, spending of wealth judiciously, and well-being of the community as a whole. These principles result in an exacting ethical stance relating to investment.

What choices do people have?
The 1.8 million plus Muslims living in the UK can now manage their money on a day-to-day basis without compromising their deeply held convictions. Alongside Lloyds TSB, HSBC offers a bank account through its Amanah Finance division together with a home-financing scheme. However, although money is held separately to that managed by the rest of the organisation, these are large institutions that are not wholly compliant with sharia principles.

The Islamic Bank of Britain which opened last year operates entirely in accordance with sharia law. It has branches in London and the Midlands and offers a range of savings accounts, a current account and financing deals.

Home buying products, credit or charge cards and other services will be available later this year. The managing director, Michael Hanlon, says its products are competitively priced and "equivalent to those available in a conventional bank".

The Ahli United Bank specialises in home-financing schemes. As well as helping Muslims buy a property to live in, it now offers sharia-compliant funding for buy-to-let property investments.

Useful contacts

· The Institute of Islamic Banking and Insurance (http://www.islamic-banking.com/)
· Islamic Bank of Britain (http://www.islamic-bank.com/)
· HSBC Amanah Finance (http://money.guardian.co.uk/saving/banks/story/www.amanahfinance.hsbc.com)
· Ahli United Bank (http://www.iibu.com/)

http://money.guardian.co.uk/saving/banks/story/0,12410,1415117,00.html (http://money.guardian.co.uk/saving/banks/story/0,12410,1415117,00.html)