ISLAMIC Contract, Commercial, and Financial Law

   

1. Islamic Contract Law

  Frank E. Vogel

Harvard Law School

 

  I.  Some Basic Characteristics of Islamic Contract Law

 

A.  While much of its substance derived from pre-existing laws, this matter was reconceptualized along lines of Qur'anic and prophetic precepts.  These precepts give it its systematic unity and most of its distinct traits

 

B.  Law of discrete contracts, not a law of contract; but it is unified by above-mentioned overarching principles derived from religious revelation

 

C.  Law of sale the basic or default model, drawn upon whenever analogy ..................... permits

 

D.  Generally pragmatic and sophisticated, certainly for its time; unique chiefly due to a few pervasive stringencies owed to religion

 

II.  Glimpse of a Few Formative Revealed Texts

 

A.  Sanctity of property

 

B.  Sanctity of contract

 

C.  Approval of trade and of the market

 

D.  Riba, or usury

 

E.  Maysir, or gambling

 

F.  Gharar, or risk and uncertainty

 

III.  Some Characteristic Resultant Rules

 

A.  Consequences specifically of prohibition on riba or usury

 

1.  Categorical prohibition on default penalties

2.  Loan is charitable.  Cannot require any benefit in return for a loan 

3.  Credit sales are generally permissible, even with mark up for credit term, unless both counter-values are gold, silver, government-issued currencies, or certain staple commodities

4.  Cash sales are categorically permissible at contractual price so long as counter-values constitute different genera, e.g., gold for silver, dollars for riyals, even at a market premium

   

B.  Consequences specifically of prohibition of gharar or uncertainty or risk

 

1.  Valid contract requires that consideration be definite at time of contract, e.g., insurance prohibited

2.  Cannot sell property prior to its “existence”, e.g., unripe fruit

3.  Generally cannot sell property not in possession of seller

4.  Conditional or option contracts generally prohibited; e.g., derivative contracts

 

C.  Sale generally understood as exchange of property, not of promises or obligations; has consequences for remedies

 

1.  Usual remedies are specific performance or rescission

2.  Ordinarily no damages for breach per se, excluding expectation and reliance damages; no lost profits

3.  However, damages if breach assimilated to a tort causing actual, out-of-pocket losses

 

D.  Transactions in obligations or “debt” (dayn), as opposed to concrete specific property (‘ayn), pose special problems

 

1.  As general rule, cannot exchange debt for debt, except at par

2.  A binding transaction usually requires immediate actual or obligatory performance on one side; bilateral executory contracts not binding

3.  Cannot discount debts, at least to third parties

 

E.  Many contracts (termed ja`iz) intrinsically cannot be made prospectively binding

 

1.  This because countervalues in these contracts are not susceptible to being known and defined ab initio

2. Examples are partnership, agency

 

F.  Partnership is affected by certain basic requirements                        

 

1.  Profits must be shared according to pre-agreed percentage shares, not in fixed  or guaranteed amounts

2.  Cannot guarantee, or take collateral for, profits

3.  Losses are borne solely by capital; those providing services lose only their labor       

 

  Glossary

 

‘ariya               gratuitous loan of nonconsumable property; the gift of usufruct

‘ayn                 an existent, tangible thing considered as unique and individual; a thing (Lat. res) as opposed to its usufruct

bay‘                 sale

daman             (1) contract of guarantee (also called kafala); (2) one of two basic relationships toward property, entailing bearing the risk of its loss

dayn                generic property; property defined or contracted for only by its genus, species and other characteristics (usually fungibles); any property, not an ‘ayn, that a debtor owes, either now or in the future; such property when due in the future

gharar             risk, uncertainty

ijara                contract of lease and hire; sale of usufruct

ja'iz                 (1) permissable, lawful, licit, valid; (2) term designating contracts as to which one party or both has the right to terminate the contract at any time with prospective effect

lazim                (1) binding; (2) term applied to contracts insofar as they bind a party, or impose legal obligations on that party

maysir             games of chance (Q 5:90)

qard                 loan of fungible, to be repaid in kind

riba                  usury as forbidden in the Qur'an; interpreted by classical jurists as including interest and various other forms of gain in contract

sharika            partnership; modern company or corporation; applied also to ownership in common

2. Islamic Finance

  Mohammed H. Fadel

Sullivan & Cromwell, LLP, New York, New York

 

I.          Why Islamic Finance?

            A.  Supply of capital

1.  Islamic banks have greater than $100 billion in assets to invest

2. 10% annual projected growth rate of deposits

 

II.        Permissible Credit Transactions in Islamic Law

A.  Cost plus markup sale (murabaha): generally used for short-term trade finance

1.  Merchant wishes to purchase a commodity.  Offers financial intermediary a fixed profit over its costs if it will purchase commodity and re-sell to merchant.  Financial intermediary must bear risk of loss, even if only momentarily, to satisfy requirement that it owns property that it is selling to merchant.

 2.  Substantial amounts of Islamic banks deposits currently used to finance murabaha transactions

 

B.  Credit sale (bay‘ mu'ajjal or bay‘ bi-thaman ajil): credit sale

1.  Seller sells to buyer commodity; buyer agrees to pay sometime in the future

2.  Title transfers upon conclusion of contract, not buyer s payment of price

3.  Seller must deliver immediately

4.  Seller entitled to charge mark-up for deferral based on time-value of money

 

C.  Forward sale (bay‘ salam): purchase price is advanced by buyer against obligation of seller to deliver a generic good in the future.

1.  Used generally to finance production of fungible commodities, e.g., wheat, and hedge commodity price risk

2.  Object of sale must be generally available in market at time and place of delivery

3.  Buyer must may price roughly at time of contract, or else contract is void as bilateral executory contract

4.  Buyer, according to majority rule, cannot resell until she takes delivery; minority rule allows resale so long as commodity is other than food

                        5.  Cannot be used for trade of gold and silver or governmental currencies

 

D.  Contract of Manufacture (istisna‘): distinguished from forward sale in that latter involves fungible goods, while contract of manufacture involves custom designed goods.  It is also more flexible than forward sale:

1.  Immediate payment by purchaser not required

2.  Obligation considered tangible property (‘ayn), not a generic debt (dayn) and therefore, saleable property

3.  Subcontracting permitted, allowing for straightforward financial intermediation:

 

(a)  Host contracts with FI for construction of project; FI subcontracts with sponsor for performance of its obligation.

(b)  Because obligation is deemed to be tangible property (‘ayn), payment terms can be flexible, and possibility for re-sale in secondary market.

 

E.  Lease (ijara/iktira')

1.  A lease is defined as the sale of a usufruct

2.  Both rent and usufruct must be determined with sufficient specificity at time of lease to survive scrutiny for prohibition against speculative contracts

(a)  Floating rate leases, often indexed to LIBOR, however, routinely used

3.  Lessor as matter of law cannot shift risk of loss to lessee, except for losses caused by lessee

(a)  Financial practice of Islamic banks has either been to ignore this requirement or require lessee to purchase casualty insurance naming lessor as beneficiary

4.  Lessee has right of rescission in certain circumstances when future events lessen value of leased property

                        5.  Often combined with option to purchase at end of lease (ijara wa iqtina )

(a)  although such option is of doubtful Islamic validity, lessor routinely performs for reputational or other non-Islamic law reasons

6.  Functionally used as equivalent of secured loan

 

F.  Guaranty Contracts (daman):

1.  valid so long as guarantor does not profit from guaranty

2.  viewed as type of gratuitous contract for which no profit can be earned

 

G.  Permissible Option Contracts in Islamic Law

1.  Down Payment Option (bay al-‘urbun):

(a)  Majority rule rejects this transaction, but permissible according to minority of jurists; use limited to non-fungible goods

                                    (b)  Minority rule upheld in KSA

(c)  Features not well-developed, but similar to concept of earnest money or liquidated damages:

(i)  Buyer under obligation to buy, but if she fails to pay balance, down payment is forfeited to compensate Seller for failed transaction

(ii)  Buyer might bear risk of loss until exercises implied option to rescind contract of sale

2.  Reward Contract (ji‘ala/ju‘l):

(a)  Payment earned only upon completion of specified task

(b)  Optionee s performance is at will;

(c)  Difference of opinion as to whether offer can be withdrawn prior to optionee s completion of performance or whether initiation of performance renders offer binding

 

HI.       Equity Structures

1.  Joint Venture (musharaka):

 

(a)  Comparable to common law partnership

(b)  Partnership return fixed by capital contribution

(i)  Cash

(ii)  Property, real or personalty

(iii)  Labor

(c)  Partners control rights proportional to capital contribution

(d)  Partnership interest in principle cannot be sold; partner must seek dissolution and accounting

2.  Limited Partnership (mudaraba/qirad):

(a)  Investors (rabb al-mal) contribute capital

(b)  Entrepreneur (al-mudarib/al-‘amil) provides management

(c)  Entrepreneur and investors split profit according to contractual formula

(d)  Entrepreneur cannot guarantee return of investors capital, but investors capital must be returned before entrepreneur is entitled to share in investment s revenue and therefore shares features of preferred stock

(e)  Interests of investors saleable property at market value if assets of venture are substantially real assets, e.g., plant, realty and tangible personalty

(f)  If assets substantially cash or debt, then sale of investor interests governed by rules regarding sales of currency and debts

3.  The entrepreneur is permitted to enter another limited partnership with the investors funds (al-mudarib yudarib) and/or enter into joint ventures as a full partner

 

IV.       Islamic Law and the Islamic Financial Industry

A. Shari‘a committees

1.  Islamic banks/investment funds generally include committee of Islamic law experts who pass on Islamic validity of contracts

2.  Will often opine only on Islamic portion of deal, and ignore other pieces of deal.

(a)  If limited partnership prospectus includes guaranty of limited partners capital, it will be held invalid, but if subsequent to creation of limited partnership, the entrepreneur enters into a guarantee, that will not vitiate limited partnership agreement.

3.  Islamic investors rely on reputation of Shari‘a committee in determining whether deal is Islamic

4.  Because of the room for interpretive difference of opinion among jurists, different Shari‘a committees may and do react differently to similar contractual provisions

5.  Some rules seem to be ignored in practice, e.g., requirement that lessor bear risk of casualty loss throughout lease, and prohibition of commercial insurance

B.  Dispute resolution mechanisms

1.  often include mandatory arbitration provisions with choice of British law (and maybe New York in recent deals?) to extent consistent with Islamic law

2.  KSA probably different because Hanbali school of Islamic law applied by government s courts

 3.  KSA acceded to New York Convention on the Recognition and Enforcement of Arbitral Awards of 1958 in 1994

(a)  Foreign judgments and arbitration awards enforced upon showing that foreign jurisdiction would enforce judgments of KSA courts and that award not inconsistent with Islamic law

C.  Remedies for violating strictures of Islamic contract law

1.  Reformation, if practicable, not rescission, preferred remedy

(a)  If contract found to include interest bearing loan, debtor still required to return principle

2.  No criminal penalties for including unenforceable contractual terms

(a)  Parties oftentimes rely on reputation to insure performance in contexts where law does not require it

(i)  Islamic banks will make voluntary capital calls to provide depositors a return equal to passbook rate offered at conventional banks

D.  Islamic law in area of banking and finance is in flux

1.  Convergence: market pressure to offer products whose risk/return profile is similar to those offered by conventional financial industry

(a)  Many proposals to create new Islamic law compliant financial products that mimic conventional financial products by extending features of classical contracts, e.g., transforming a forward sale into a futures contract, or allowing sale of debts in limited circumstances to create secondary markets, thereby increasing liquidity of Islamic investments

2.  Divergence: market pressure to be sufficiently distinctive from conventional banking and finance to justify label Islamic

 

Bibliography for Islamic Contract Law and Finance

 

Ahmad, Khurshid. “Elimination of Riba; Concept and Problems”. In Institute of Policy Studies (ed.)  Elimination of Riba from the Economy. Islamabad: Institute of Policy Studies. 1994

Asad, Muhammad, The Message of the Qur'an, Gibraltar: Dar al-Andalus, 1984

Chapra, M. Umer, Towards a Just Monetary System, Leicester: Islamic Foundation, 1985

Coulson, Noel J., Commercial Law in the Gulf States, London: Graham and Trotman, 1984

Council of Islamic Ideology, Consolidated Recommendations on the Islamic Economic System, Islamabad: Council of Islamic Ideology, 1983

Iqbal, Zamir, “Islamic Financial Systems,” June 1997, http://www.worldbank.org/fandd/English/0697/articles/0140697.htm

Jordan Islamic Bank (JIB), JIB, al-Fatawa al-Shar`iyyah, Amman: JIB, 1984

Khan, Mansoor H., “Designing an Islamic model for project finance,” International Financial Law Review, June 1997, 13

Mallat, Chibli. “The Debate on Riba and Interest in Twentieth Century Jurisprudence” in Chibli Mallat (ed.) Islamic Law and Finance.  London: Graham & Trotman. 1988

Mawdudi, Abu al-A`la, Towards Understanding the Qur'an, trans. Zafar Ishaq Ansari, Leicester: Islamic Foundation, 1988

McMillen, Michael J.T., “Essay: Islamic Shari‘ah Compliant Project Finance: Collateral Security and Financing Structure Case Studies,” 24 Fordham Int'l L.J. 1184 (2001) (describing structure of Islamic financings completed both in the U.S. and Saudi Arabia)

Rahail Ali, “Banking on Islamic finance for projects,” 195 Project Finance International 52 (2000)

Rahman, Fazlur,  “Riba and Interest”, Islamic Studies, March 1964

-------------------, “Islam: Challenges and Opportunities”, in Islam: Past Influence and Present Challenge, Welch and Cachia (ed.), Edinburgh University Press, 1979

Rayner, S.E., The Theory of Contracts in Islamic Law, London: Graham and Trotman, 1991

Saeed, Abdullah, Islamic Banking and Interest, Leiden: E J Brill, 1996

Saleh, Nabil, Unlawful Gain and Legitimate Profit in Islamic Law, 2nd ed., Boston: Graham and Trotman, 1992; 1st ed., Cambridge: Cambridge University Press, 1986

Sanhuri, `Abd al-Razzaq, Masadir al-Haqq fi al-Fiqh al-Islami. Beirut: al-Majma` al-Arabi al-Islami. 1967

Siddiqi, Muhammad Nejatullah, Banking without Interest, Islamic Foundation, Leicester, 1983

-------------------------------------, Issues in Islamic Banking: Selected Papers, The Islamic Foundation, 1983

Uzair, Mohammad, “Impact of Interest Free Banking”, Journal of Islamic Banking and Finance, Autumn 1984

-----------------------, Interest-Free Banking, Royal Book Company, Karachi, 1978

Vogel, Frank E. and Samuel L Hayes, III, Islamic Law and Finance, The Hague: Kluwer Law International, 1998

Warde, Ibrahim, Islamic Finance in the Global Economy, Edinburgh: Edinburgh University Press, 2000

 

 

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