Chapter 8

Legal Documentations in Islamic Finance

8.0. INTRODUCTION

Legal documentation is an important aspect of Islamic finance industry. Islamic financial institutions use the legal documentation on a daily basis, each product is attached to legal documents, either in the stage of design and approval or in the stage of implementation and execution. Lawyers and legal firms are engaged in legal work that is needed to determine the rights, liabilities, and obligation of the contracting parties. By ensuring a sound legal documentation, a Sharī`ah non-compliance risk will be mitigated and managed. Conversely, weak legal documentations that have gaps and loop holes will have a potential Sharī`ah non-compliance risk.

8.1. INTRODUCTION TO LEGAL DOCUMENTATION

The first step in legal documentation is to understand Sharī`ah requirements in contractual agreements, which are understood within the theory of contracts in Islamic commercial law. The Sharī`ah requirements are presented in the form of legal documentation clauses in order to determine the rights and obligation of the contracting parties based on mutual consent. Sharī`ah requirements will be incorporated in the agreement and presented to the contracting parties as legal documentation. After being documented, they will be implemented and enforced, and then they represent the point of reference in case of dispute.

8.2. LAW RELATED TO ISLAMIC BANKING

Islamic banking in Malaysia is operating under a dual banking system in which the Islamic finance and conventional finance coexist together and operate in the same market place. In addition, both systems are governed by the same authority, common guidelines, and common standards, under the supervision of the central bank (Bank Negara Malaysia) and the Securities Commission of Malaysia. Hence, there are some similarities in laws that are applicable for both Islamic finance and conventional finance.

In general, Islamic banking in Malaysia falls under the federal jurisdiction under the federal Constitution, unlike other Islamic matters, such as Muslim family laws and religious offences, which falls under the State jurisdiction. In short, any dispute in Islamic banking shall be referred to the civil courts instead of the state Sharī`ah courts. It’s important to note that, currently, Islamic banks are governed under the Islamic Banking Act of 1983, which has now been replaced by the Islamic Financial Services Act in May 2013.

Under the Central Bank of Malaysia Act 2009, any Sharī`ah issues in relation to financial transactions fall within the purview of Sharī`ah advisory council of Bank Negara Malaysia whose rulings and resolutions will be binding upon the civil courts.

In order for the Islamic legal documentation to be effective, it should comply with the law of the land. On the other hand, whenever any application in banking or finance has civil law requirements and Sharī`ah requirements, the civil law requirements should comply with the Sharī`ah requirements. In case of conflict, the Sharī`ah requirements prevail, and regulations and law requirements should be adjusted to suite Sharī`ah rules and principles.

The case of Bank Islam Malaysia Berhad v Lim Kok Hoe & Anor and other appeals [2009] 6 CLJ 22 stipulates that, notwithstanding that Islamic financing is designed to comply with Sharī`ah requirements, it is still subject to the same set of laws applicable to conventional banking.

The list that follows shows most of the important and relevant laws that are related to Islamic finance.

8.3. GENERAL PRINCIPLES IN LEGAL DOCUMENTATION

Generally speaking, there are some important principles in legal documentation that should be observed to monitor the Sharī`ah non-compliance risk as follows:

• Legal documentation should comply with Sharī`ah law to ensure Sharī`ah compliance.
• Legal documentation should comply with civil law (federal or state law) to ensure consistency and matching between positive law and Sharī`ah.
• Legal documentation should be enforceable by the court to protect the terms and conditions agreed upon.

These principles play a significant role to ensure Sharī`ah compliance, legal and Sharī`ah consistency, preservation of the rights and liabilities of the parties involved in the banking facility.

8.4. LEGAL DOCUMENTATION: DEFINITION AND SHARĪ`AH CONCERN

Legal documentation is a document based on a specific contract/agreement or set of contracts/agreements that reflect the rights and liabilities of the contracting parties as the result of entering into a particular contractual agreement. The rights and liabilities are consequences of terms and conditions stipulated and agreed upon in the contract. There are two requirements in legal documentation. From a Sharī`ah perspective, legal documentation for an Islamic financial product must not contain any element or principle that is not in line with Sharī`ah principles. From a legal perspective, the legal documentation must be valid and enforceable because this is the ultimate aim of this document.

8.5. INCORPORATION OF SHARĪ`AH REQUIREMENTS INTO LEGAL DOCUMENTATION

Legal documentation is the most important and effective method to describe the legal relationship between the parties involved in the contract, the agreed terms and conditions subject to full agreement and consent of the parties. Normally when there is a dispute as a result of a conflict of interest, the legal documentation will be the key evidence for the court to refer to.

Legal documentation should reflect Sharī`ah rules in the relevant contract subject to that particular agreement. Sharī`ah rules should be accommodated and harmonised with the applicable civil law, market practice, and custom. Legal documentation should always demonstrate Sharī`ah rules and regulations; therefore, the clauses and provisions of the contact should not violate any Sharī`ah requirement. Conversely, legal documentation must incorporate all the rules governing the contract depending on the type of the financial transaction such as mudarabah, musharakah, murabah, or others.

The people behind the task of drafting the legal documentation should be equipped with the necessary knowledge and understanding of Sharī`ah requirements to ensure that justice and fairness is reflected. In addition to that, ensuring Sharī`ah compliance throughout the process is designed by the legal documentation that represents the main reference for any particular transaction in Islamic finance.

There are some important aspects that must be taken into consideration when drafting the legal documentation:

• Avoid having any term, clause, or provision in legal documentation that is not consistent with Sharī`ah principles.
• Avoid using conventional terms such as: interest, penalty payment, repayment, loan, penalization of early payment clause, and penalization for late payment, and so on. These terms should not be incorporated in the legal documentation, simply because they don’t belong to the Islamic finance terminology. Furthermore, these terms either confuse the contracting parties, the judge, the lawyer, or they are open to interpretation, which opens a terminology dispute.
• Implement Sharī`ah terminology and terms in order to express the true meaning of the contract as described in Islamic law while avoiding all types of ambiguities that might arise.
• Streamline the terms and conditions by using the popular words/terms implemented in the Islamic market.
• Refer to Sharī`ah standards and resolutions as the main reference for legal documentations.
• Establishing the rights and obligations of the contracting parties clearly.
• Ensure equity and justice in the clauses and provisions of the contract.
• Incorporate Sharī`ah requirements in relevant legal documentation according to the contract subject of the agreement.
• Clearly describe the main Sharī`ah principles in the relevant contract and make provision to refer to other supporting principles when applicable.
• The legal documentations should stipulate the general terms and conditions of the financing facility.
• There’s no necessity to use Arabic terms if the parties and the courts are not conversant with the language; accurate translation in the language of choice will suffice.

The challenges of the legal documentations is the responsibilities of the Sharī`ah board and qualified lawyers whose thorough effectiveness and knowledge render the legal documentation sound, accurate, comprehensive, and Sharī`ah compliant. The meaning of knowledge here is the understanding of Sharī`ah rules and principles and also understanding the legal aspects and principles of Islamic finance practices.

8.6. THE MAIN FUNCTIONS OF THE LEGAL DOCUMENTATION

Legal documentation is designed to describe the contractual agreement between the different parties involved in the financial transaction. It contains T&C agreed upon that must be honored, respected, and executed. The terms and conditions stipulated can be changed and adjusted if both parties agree on that.

The function of the legal documentation can be described as follows:

• Determine the legal relationship between parties involved in the financial transaction.
• Determine the rights and obligations of each party on the contract.
• Express the mutual consent on the T&C agreed upon between the two contracting parties.
• Create a legal document that can be a reference in case of dispute, whereby the T&C stipulated in the contract and agreed upon in the contract will be the final reference to resolve the conflict.

8.7. AREAS IN LEGAL DOCUMENTATION UNDER CONSIDERATION AND REVIEW

Islamic legal documentation covers areas as follows:

• T&C or clauses in legal documentation that are clearly prohibited by Sharī`ah principles (riba).
• The combination of the contracts in the legal documentation (in case the facility requires combining a few contracts).
• The execution of the legal documentation (the sequence).
• The form and the structure of the legal rights and liabilities of the two contracting parties in the legal documentation.
• The T&C or clauses in legal documentation that have ambiguity and may create confusion.

These aspects represent the main areas in legal documentations and are discussed briefly next:

8.7.1. Terms or Conditions (T&C) or Clauses in Legal Documentation That Are Clearly Not Approved by Sharī`ah (Riba)

The T&C are the main contents of any legal documentation. They reflect the parameters to which all parties in a contract have agreed to subscribe. These T&C speak of respective rights, obligations and liabilities that all parties have agreed to adhere to. In the case of a dispute, default, or breach, these T&C will be the point of reference. Some of these T&C are quite standard in the financial market even before the introduction of Islamic finance.

Some may hold that these T&C are plain and neutral and, therefore, can be retained even in the case of Islamic financial legal documentations. Is that true statement? Why?

In answering this argument, we should bear in mind that the legal documentations in conventional finance have been drafted based on two major underlying principles, namely loan and permissibility of interest. Hence, the T&C in banking or PTC (principles, terms, and conditions) in capital market documents reflect the two underlying principles: loan and interest.

T&C such as repayment, penalty interest, and right to recall the facility upon demand, and so forth, are terms designed to suit the principles of the conventional finance. Therefore, if they are used in Islamic legal documentation, very careful attention should be given to them. There is a risk of Sharī`ah non-compliance if there is blind use and implementation of the conventional legal documentation in the Islamic banking and finance without prior careful review, examination, and assessment of the conventional legal documentation in form and substance.

A legal maxim says that everything is permissible unless it is proven otherwise by Sharī`ah. Therefore, from Sharī`ah perspective there is freedom in stipulating the T&C of a contractual agreement, provided they are in line with Sharī`ah rules and principles. Any term or condition contradicting Sharī`ah rules or principles will render the terms or conditions agreed upon null and void. The objectives of the terms and conditions should be heading to the same objectives of Sharī`ah (Maqasid al Sharī`ah).

In legal documentation, the T&C of contracts are determined to establish the firmness or legitimacy of the contract, and address specific needs or requirements of the counterparties.

It is very important to emphasize that legal documentation must not behave like a conventional loan, because the financier is neither a lender nor a borrower. Therefore, generally, terms such as loan, interest payment, and repayment are not relevant to Islamic finance, simply because the terms reflect the act of giving the money to someone after which there will be an interest payment in the form of the repayment of principal plus the payment of a premium on loan is not suitable for a transaction based on sale, equity, or services.

The most challenging part in Islamic finance is that the legal documentations are drafted from a perspective that the Islamic banking facilities are behaving exactly like a loan transaction in conventional finance. This is a serious issue that must be resolved and overcome gradually. Legal documentation should reflect the true meaning of the Islamic principles in financial transaction such as ijarah, murabahah, and so forth. These financial transactions are not loans.

Terms that have no relevancy to the spirit of Sharī`ah must be avoided and replaced with relevant terms. Their presence in legal documentation could dilute the very meaning of an Islamic finance perspective.

It should be noted that there are some terms that are clearly prohibited by Sharī`ah; therefore, they cannot be used in the legal documentation such as riba and others.

8.7.1.1. Riba (Usury)

The term riba cannot be used in Islamic legal documentations because riba is not allowed; therefore, it should be removed from the legal documentation. Riba is equivalent to interest, and usury; therefore, both cannot be used in legal documentation as well.

One may say that every mention of interest should be removed from the legal documentation. Is this a true statement? Why?

To answer this question, we should know that in some jurisdictions, the term interest has taxation implications. Although interest payments are not taxable, the profits and dividends of Islamic products may be taxable as in sukuk ijarah or sukuk musharakah, thereby rendering them not competitive to the conventional products. Many jurisdictions have deemed profit or dividend paid under Islamic financing schemes as interest on the treatment of tax. This is to make Islamic products compatible to conventional products in terms of tax treatment. In some jurisdictions, there is no special treatment given to profit or dividends with regards to tax arising from Islamic financial products like sukuk ijarah when it refers to coupons paid to investors or dividends paid under a mudarabah investment account. The issue arises whether the term interest can be used in these jurisdictions in all relevant legal documentation for a specific purpose, such as avoiding tax implications.

The only outstanding issue is whether it is possible to use the word interest (in the place of profit and dividend, as the case may be) for the specific purpose that it is simply to relieve investors/customers from paying a tax that is not paid under conventional products. Scholars have different views on this issue. Although some might approve the incorporation of the term interest in Islamic-approved products for tax purposes, others might find this objectionable. This incorporation could be deemed permissible provided sufficient illustration or explanation is given to explain the position of this term and why such a term has been incorporated into an Islamic legal document. The term interest is not a feature in contract but incorporated to relieve involved parties from paying some taxes.

8.7.1.2. Loan

The term loan is the second controversial term that cannot be used in Islamic legal documentation unless the loan refers to qard hasan. However, it should be understood that the concept of qard hasan is usually used in Islamic finance and incorporated in legal documentation accordingly. Knowing that will ensure that the term is used accurately in legal documentation.

Qard hasan can be used in Islamic finance area as follows:

• Qard hasan is not used in commercial banking in financing, but in a deposit account.
• In financing, qard hasan is used under micro financing. However, the commercial banks don’t provide this kind of financing normally; it is provided by the non-banking financial institutions that are supported by the government.
• Qard hasan is used as an instrument between the parent bank and its subsidiary when cash or liquidity is needed.
• Qard hasan is used as an instrument between the central bank and the Islamic bank in case the central bank grants a loan to an Islamic financial institution.
• Qard hasan is used in the Takaful when there is a deficit in the risk fund.
• Qard hasan is used in the investment account when the reserve is in deficit.
• Qard hasan is used in profit distribution in sukuk, in case there is no reserve.
• Qard hasan is used in credit card transactions by some Islamic financial institutions.

The concept of loan in legal documentation can be used accordingly, but it is recommended that the word qard hasan be used instead of loan to avoid ambiguity and misunderstanding. In financing, loan cannot be used because the facility in Islamic finance is not regarded as credit extended to the client; rather, it is a facility governed by a particular contract such as ijarah, mudarabah, or others.

As conclusion: Loan is not a financing facility in Islamic finance and legal documentation. Riba is not a profit in Islamic financing facility. Both cannot be used to describe the Islamic financing facility and both terms cannot be incorporated in the legal documentation.

It should be understood that the bank is not a lender but either:

• Seller (such as murabahah/parallel salam)
• Buyer (such as BBA/murabahah/parallel istisna`)
• Partner (such as musharakah)
• Investor (such as mudarabah)
• Capital provider (such as mudarabah)
• Mudarib (such as mudabahah)
• Intermediary (such as wakalah)
• Broker (such as jualah)
• Owner (such as ijarah)
• Lessor (such as ijaraah)
• Lessee (such as ijarah)
• Custodian (such as wadiah)

Legal documentations should reflect the position of the bank and the client according to the nature of their relationship based on the underlying contract used in the banking facility; otherwise, a Sharī`ah non-compliant risk in the legal documentation will be triggered.

Other terms to be avoided in legal documentation are as follows:

• Late payment interest
• Default interest
• Borrower
• Lender
• Borrowed money
• Base lending rate
• Compounding
• Others

8.7.2. The Combination of the Contracts in the Legal Documentation

Combination of contract is an important area in legal documentation; product should be structured in such a way that does not result in Sharī`ah non-compliance risk.

8.7.2.1. The Concept of Combination of Contracts

Combination of contracts is a process that takes place between two parties or more, and entails the simultaneous conclusion of more than one contract. Hence, combination of contracts may take any of the following forms:

• Combining more than one contract without imposing any of them as a condition for the other, and without prior agreement (muata`ah) to do so.
• Combining more than one contract while imposing some of them as conditions in the others, without prior agreement to do so.
• Combining more than one contract subject to prior agreement (muata`ah), but without imposing any of them as a condition in the others.
• Agreement to conclude the deal through any of different contractual forms as will be finally decided in the future.1

8.7.2.2. Forms of Combined Contracts

There are different forms of combination of contract as follows:

• Combined contracts may have a single lump-sum countervalue. For instance, a party may sell his piece of land to another party and simultaneously rent his car to the same party for one month, both against one thousand ringgit.
• Combined contracts may be concluded for separate values. For instance, one party may sell his house to another for one thousand ringgit, and rent his car to the same party for one hundred ringgit per month.
• Some of the combined contracts may be stipulated as conditions in the other contracts. For instance, one party may say to the other party that I will sell you my house for 10,000 ringgit on condition that you undertake to rent the house to me for two years for 1,000 ringgit per year. The sale of the house in this manner could also be concluded on condition that the buyer of the house undertakes in return to sell his car to the seller for 2,000 ringgit.
• Combined contracts may take the form of an exhaustive contractual statement comprising a number of successive parts and stages, which finally lead to realization of the desire of the two parties to conclude the deal in question. For example, the transactions of ijarah ending with ownership, murabahah to the purchase order, and diminishing musharaka.2

8.7.2.3. Sharī`ah Status of Combining Contracts

It is permissible in Sharī`ah to combine more than one contract in one set, without imposing one contract as a condition in the other, and provided that each contract is permissible on its own. Combining contracts in this manner is acceptable unless it encounters a Sharī`ah restriction that entails its prohibition on exceptional basis.

8.7.2.4. Sharī`ah Parameters on Combining Contracts

Sharī`ah parameters in combination of contract are as follows:

• Contracts’ combination should not include the cases that are explicitly banned by Sharī`ah like combining sale and lending in one contract.
• It should not be used as a trick for committing riba such as agreement between two parties to practice riba al fadhl.
• It should not be used as an excuse for practicing riba. The two parties could misuse, for instance, combining contracts when they conclude a lending contract that, at the same time, facilitates some other compensatory gains to them.

• Combined contracts should not reveal disparity or contradiction with regard to their underlying rulings and ultimate goals.

8.7.2.5. Sharī`ah Concessions for Contracts’ Combining

In principle, the Sharī`ah concessions that can be granted to implicit and subsidiary contracts at the time of combining contracts cannot be granted to the same contracts when concluded independently. Here, implicit and subsidiary contracts refer to contractual commitments that are not explicitly embodied in the deal agreement or those that succeed the original commitments of the transaction.

The concessions to be granted in this case should be judged in the light of traditions, practice, and professional experience, and they are subject to clearance by the Sharī`ah supervisory board of the institution.

• Concessions granted to implicit and subsidiary contracts comprise relief from the following Sharī`ah-banned acts:
  • Gharar, which affects financial contracts, may be overlooked in implicit and subsidiary contracts.
  • Jahala, which also affects financial contracts, may be ignored with regard to the object of a subsidiary contract.
  • Sale-based riba and violation of currency exchange rules (as when spot delivery is ignored in a contract that combines currency exchange with money transfer) are also forgivable in subsidiary and implicit contracts.
  • Selling of a debt for another debt may be ignored when it comes in the context of a subsidiary contract. A fitting example here is purchasing (on debt) the shares of an indebted company.
  • Subsidiary and implicit contracts may also be relieved from some prerequisites that underline the validity of contracts (such as offer and acceptance) when such relief is dictated by need or desire to achieve a Sharī`ah-permitted interest.4

8.7.2.6. Pre-Arrangement (Muwathoah) for Combining Contracts

Muwathoah or Tawatu` in fiqh terminology has several meanings, most important among are stated in the following list:

• Explicit or implicit intention of the parties to the contract to use a certain trick for practicing riba through a Sharī`ah-accepted contractual form.
• An unrevealed prior agreement between the two parties to perform a Sharī`ah-permissible act or deal for the sake of finding a Sharī`ah-accepted exit (acceptable trick).
• Coincidence of the intentions of parties to the contract at the stage of preparatory negotiations that precede the signing of the contract.

From fiqh perception, Muwathoah for combining contracts has three distinct characteristics:

Muwata`ah to combine contracts takes several forms, which may be grouped into the following four types:

8.7.2.7. Contemporary Applications and General Rules for Combination of Contracts

According to AAOIFI Sharī`ah standards one of the most distinguishable forms of contemporary financial transactions is the contractual arrangements that comprise a number of contracts and pledges that the parties agree beforehand to execute in a specific manner and according to agreed number of successive stages. Such arrangements aim to achieve a given purpose or interest of the parties to the contract such as performing murabaha on Order of Purchase, ijarah Ending with Ownership, or Declining musharakah.

• Muwathoah, when provided for in the contract and used for combination of contracts, should be observed by, and remain binding to the parties to the contract, subject to Sharī`ah-accepted commercial and banking conventions.
• The pledges contained in such combined contract sets are binding to their respective parties.
• These newly devised sets of combined contracts should observe the general rules of Sharī`ah with regard to structure, rulings, requirements, and conditions in order to be Sharī`ah compliant.
• These contract sets should also observe the Sharī`ah rulings pertaining to combining contracts and may make use of the Sharī`ah concessions in this respect.
• Failure of any of the parties to combined contracts to honor its contractual commitments gives the other party the right of claiming indemnity for the actual injury encountered.6

8.7.3. The Execution of the Legal Documentation

The execution of the contract looks at the sequences of the contracts execution.

8.7.3.1. The Importance of Sequencing

Islamic financial products and services are based on certain contracts. These contracts, unlike a normal loan contract, are essentially based on some logical processes and procedures.

8.7.4. The Form and the Structure of the Legal Rights and Liabilities of the Two Contracting Parties in the Legal Documentation

It should be noted that in some cases, the combination of a few T&C may impair the main objectives of the contract or lead to contradict the very nature of the contract, as a result of which the transaction will be regarded as non-Sharī`ah compliant. The legal documentation along with the terms and condition should be consistent with the underlying contract used in the facility. If the T&C contain any clause that goes against the nature of the contract, the said contract will be defected.

Examples

• A contract of mudarabah or musharakah (equity-based contract) cannot stipulate a condition that the partner shall guarantee the profit, the capital, or both.
• Contract of mudarabah cannot be concluded when there is a condition that the capital will not be provided at the outset of the contract, or by assuming that the capital is in form of debt not due for collection.
• Contract of murabahah cannot be concluded without disclosing the original cost and profit.
• Contract of istisna` cannot be concluded on the conditions that the raw material will be supplied by the buyer, because it will be regarded as ijarah contract and not istisna`.
• Contract of salam cannot be concluded on the condition that the price will not be advanced in the contract and it will be provided through trench or installment.
• Contract of wadhiah cannot be concluded when there is a profit generated, because there is an assumption that there is a discount provided.
• Contract of tawliyah cannot be concluded when there is a profit generated because the contract supposes generating zero profit, because it is a transaction with non-profit.
• Contract of mudarabah cannot be concluded when there is a condition that the profit is fixed and predetermined upfront.

The preceding are some example of T&C that might be incorporated in the legal documentation that trigger Sharī`ah non-compliance risk. These examples can be seen as clauses in the legal documentation that go against the very nature of the contract. Each contract in Sharī`ah has basic rules and principles that should be complied with in order to ensure Sharī`ah compliance status in the structure of the product and its legal documentation.

8.7.5. Terms or Clauses in Legal Documentation That Have Ambiguity and May Create Confusion

There are some T&C that may affect the rights and liabilities of the parties in a concluded contract. The following aspects are clauses that may appear in the legal documentation that need clarification to ensure consistency between Sharī`ah and legal documents.

8.7.5.1. Right to Recall the Facility

Conventionally, this clause is incorporated into any loan contract documentation to enable the lender/financier to recall the facility by terminating the facility and requiring that the customer/borrower settle any outstanding payment on the spot. The clause is triggered when the customer/borrower defaults or breaches any of conditions imposed on him. The same clause is maintained in the Islamic legal documents. The clause is drafted as:

The facility granted herein shall be subject to the bank’s right to recall on demand and to be reviewed from time to time by the bank and nothing in these presents contained shall be deemed to render it obligatory upon the bank either at law or in equity to make any advances or to afford any other accommodation or facility whatsoever to the customer and the bank shall have the right to withdraw the facility at any time it deems fit to do so.

Sometimes, the clause is drafted under recall and acceleration of payment. The clause is drafted in a personal financing offer letter is as follows:

Notwithstanding any other provisions relating to the availability of the facility(s) or any part thereof, the Bank reserves the right to review periodically and accordingly to terminate the facilities or any part thereof, at any time it deems fit by giving written notice of the same, whereupon the facilities or such part thereof shall be terminated and the whole indebtedness or such part thereof shall be payable upon demand. Without prejudice to the generality of the foregoing, the Bank reserves the right to review periodically and accordingly to terminate the facility(s) or any part thereof if the facility(s) is utilised for any purpose which is in contravention of the Sharī`ah.

From one perspective, this clause is acceptable to Sharī`ah principles if the meaning of this clause is deemed to accelerate the outstanding payment upon delay or default in payment. The basis for the condition is that all installments will become due if there is delay as in the hadith of the Prophet (pbuh), that is “Muslims are bound by the conditions they made.” Therefore, if the buyer under murabahah has agreed to this condition, he will be bound by this condition to make the entire payment once he has defaulted on the payment for even one installment.

However, from another perspective, the “right to recall” clause cannot be understood as the right to terminate a contract. This is because according to Sharī`ah principles, a non-payment will not render the contract terminated. A delay in payment will not revoke the contract. Hence, this clause must only be understood as giving the right to the financier to request that the customer has to pay all outstanding payments once he has defaulted. It cannot be construed as a termination of contract.8

8.7.5.2. Repossession of the Asset

The procedure of repossession of the asset, which is very close to the clause of right to recall, has a different procedure depending on the type of the facility offered by the Islamic bank. If it is a sale-base facility, the right of the bank to recall the facility as mentioned earlier will be applicable within the context explained. However, in the case that the facility offered is based on operating leasing or financial leasing, the physical repossession of the asset with its real meaning may take place, because the asset is owned by the IFI.

The clause is drafted also in banking documents of murabahah vehicle term financing facility agreement under the clause of Procedures for Taking Possession as follows:

8.7.5.3. The Limit of the Right of the Bank

There is limit of right for the bank toward the contract agreement such as bai` bithaman ajil (BBA) or other facilities offered, as long as the client honors the agreement and pays the outstanding amount due to him regularly. In this case, the bank has no right to foreclose the property and recall the BBA financing facility. Therefore, the documentation of the debt financing facilities such as BBA should not include any clause mentioning the right to the bank to recall back the facility because the bank cannot repossess the property back. However, the bank will be entitled to this right and be in a position to terminate the scheme of the installment facility. In case the client is unable to pay the bank and settle the outstanding amount, the bank can claim the unpaid amount by using the collateral of the client, by selling it to settle the unpaid amount only, and release the balance to the client. Hence, the action of the bank is against the charged asset and not recourse on the contract itself.

8.7.5.4. Cross Default

This clause in legal documentation is a term that gives the right to a financier to deem a particular financing facility in default because the customer has actually defaulted in another facility, even though this particular customer has not defaulted in that first facility. However, since both are related to each other under a cross-default term, any default in one of the facilities, the other facility, although still good, must be deemed to be equally in default.

An illustration of this case is as follows. A customer has already secured a house financing facility. He is later offered another facility by the same bank, for example, an ijarah car financing. A cross default clause may be incorporated into both financing facilities’ documents. Should this customer default on his house financing obligation by not paying a few installments, his car ijarah financing will be automatically deemed in default.

The clause is drafted in master facility agreement for murabahah overdraft as follows:

The customer herby expressly agrees that if any sums shall be due from the customer to the bank from time to time or at any time or if the customer maybe or become liable to the bank anywhere on banking account or any other account current or otherwise in any manner whatsoever or if default is made in any provisions of such account on any other banking facilities granted by the bank to the customer or in any provisions herein, then in any such event, the monies hereby secured together with all monies payable under such account or other banking facilities aforesaid shall immediately become due and payable and the security herein shall become immediately enforceable.

It is drafted in other legal documentation such as murabahah vehicle term financing facility agreement as follows:

Notwithstanding the provisions relating to the payment of Bank’s Selling Price hereinbefore provided, the Customer hereby expressly agrees that if any sums shall become due and payable from the Customer to the Bank or with any of the institutions within the bank Group of companies from time to time or at any time or if the Customer become liable to the Bank or with any of the institutions within the bank Group of companies anywhere on banking account or any other account current or otherwise in any manner whatsoever or if default is made in any provisions of such accounts or in any other banking facilities granted by the Bank or with any of the institutions within the bank Group of companies to the Customer or in any of the provisions herein, then and in such event, the Facility together with all monies payable under such accounts or other banking facilities aforesaid shall immediately become due and payable and the security herein shall become immediately enforceable.

Based on the preceding clause, all legal consequences will follow such as a notice requiring an entire payment. Although some scholars may approve of this term on the basis of maslahah (public interest), other scholars may object to it because they view it as unfair to the customer.

The incorporation of this term must be subject to the approval of the financier’s Sharī`ah board because there could be more than one opinion on this issue from a Sharī`ah perspective. One of the opinions is that cross-default does not reflect the principle of Sharī`ah in justice and equity, each financial facility should stand for its own, and they must be treated separately. The other opinion is based on cross-default as a mitigation tool to protect the interest of the bank from being financially harmed because of the financial distress of the customer and his potential bankruptcy where he will not be able to fulfill his future financial obligations.9

8.7.5.5. Consolidation and Set-Off

This clause is common and standard in legal document and it means that the financier has the right to consolidate all the accounts that a customer has with the bank/financier such as savings and current and/or investment accounts, for the purpose of using these monies deposited with the bank to settle any payment outstanding to the bank under the principle of set-off or muqasah. A customer may have a few accounts with his bank and at the same time, he may have been granted a few financing facilities such as murabahah house financing. By virtue of this term, if the customer defaults in making the regular installments under murabahah, the bank/financier is entitled to consolidate all the accounts of the customer to set-off the amount payable or owing to the bank/financier. Sometimes the clause is presented under (right of bank to consolidation). The clause is drafted in a master facility agreement for murabahah overdraft as follows:

The bank shall have the right to consolidate any or all accounts of the customer with the bank, such right to be exercised at the bank’s absolute discretion and it is hereby expressly agreed and declared that this agreement shall not be satisfied except on payment by the customer of not only all the MOD (murabahah overdraft) indebtedness but also all monies secured by any other agreement or security created by the customer in favour of or vested in the bank to secure the facility.

The clause is drafted also in other banking documents such as murabahah vehicle term financing facility agreement under the clause of Consolidation and Combination of Accounts as follows:

It is hereby expressly agreed and declared that unless the Bank otherwise agrees, the Customer shall not be entitled to redeem or require the release or discharge of any security given by the Customer to the Bank and whether given now or hereafter except on payment by the Customer of all moneys referred to herein. It is hereby expressly agreed and declared that unless the Bank otherwise agrees in writing the Assignment created herein shall not be terminated except on payment:

i. of all the Indebtedness; and

ii. of all moneys secured by any other security created by the Customer or by any person through whom the Customer claims in favour of or vested in the Bank.

The objective of this clause is to protect the interest of the bank/financier. It is valid practice to set off mutual rights and obligations between two parties, as long as there is an agreement between them.10 According to Bank Negara guidelines, the bank should give notification of 21 days before the preceding takes effect.

8.7.5.6. Right to Debit Account

Sometimes, there is a clause drafted after the clause that gives the bank the right of consolidation. The clause focuses on the right to debit from the account of the customer. This clause is presented under the clause (of right to debit account) and is drafted as follows:

The customer agrees that without prejudice to any other rights and remedies of the bank, the bank shall have the right (without being obliged to) at any time without prior notice to debit the customer’s current or other account or accounts with the bank with the MOD (murabahah over draft) indebtedness provided that no such debiting shall be deemed to be a payment of any of the amount of the MOD indebtedness due (except to the extent of any amount in credit in the customer’s current account or other accounts or accounts with the bank) or waiver of an event of default under the security documents.

The preceding clause sometimes is drafted in different context in the letter offer of the facility as follows:

Any monies due and payable to the bank or advances by the bank on your behalf with regards to the facility(s) may be debited to such accounts as the bank deems fit.

8.7.5.6. Service Charge Relating to Employees Provident Fund Withdrawals

The client should be aware that his consent gives the financial institution the right to debit from his account the service charge relating to employees provident fund (EPF) withdrawals. The clause is drafted as follows:

You shall be liable to pay the sum of RM10 as service charge for provision of information pertaining to you and/or your account by the bank to the Employees Provident Funds (EPF) in the event that any application for housing withdrawal is submitted by you to EPF and such information and/or verification of such information is sought by EPF. It is hereby agreed the bank shall be entitled to debit your account for the said sum without notice.

8.7.5.7. Penalty/Compensation/Late-Payment-Charges Clause

Financial obligations arising from Islamic debt financing modes such as murabahah, ijarah, istisna`, and tawarruq, may not be fulfilled by the customer on time. Conventionally, the financier will impose a penalty on late payments based on a certain agreed formula. Also, this penalty may be compounding in nature. Obviously, this clause is not acceptable from the Sharī`ah perspective. According to respective AAOIFI Sharī`ah standards, the financier is only entitled to charge the defaulting customer an amount of money that is commensurate with the actual cost incurred by the bank/financier. The bank/financier under Sharī`ah principles may, however, request that when the customer delays a payment, he give his word, documented in relevant legal documents, that he will pay an amount of money to be donated to charitable causes.

This penalty clause is merely to deter the customer from defaulting and any money paid by the defaulting customers, other than a portion to compensate actual expenses, must not be regarded as an income to the bank, but must be disposed to charitable organisations.

In Malaysia the bank/financier is allowed to charge the defaulting customer a certain percentage of his outstanding payments or installments to compensate the loss incurred by the bank/financier. There is a guideline by Bank Negara on this issue known as the late-payment charges, where the bank charges compensation (tawidh) of 1 percent from the amount in arrears and upon recall on the total outstanding amount and thereafter at Interbank Money Market Rate after maturity of the financing period, or the actual loss as compensation for default of payment on top of that banks are also allowed to charge penalty (gharamah) over and above the compensation. However, the penalty proceeds must be channeled to a charitable organization.

The clause is drafted in some banking legal documents as a murabahah vehicle term financing facility agreement under the clause of late-payment charges as follows:

This issue can be solved within the Islamic financial institution where the regulator, through a policy, puts pressure on the defaulters by depriving them of obtaining any facility from any Islamic financial institution in the market. Furthermore, the penalty can be imposed only on the dishonest clients who defaults in payment without any reason or reasonable excuse, so they will be liable to pay compensation to the Islamic bank for the loss and damage created by them.

8.7.5.8. Pre-Payment/Early Settlement Clause

A pre-payment clause is related to the right of the customer to pre-pay or to settle outstanding payments early. Without this clause, the customer may not be able to settle early as the decision to allow prepayment will be ultimately vested with the financier. However, if the financier and the customer have agreed on this pre-payment practice according to some procedures, such as an up-front notice, the financier is bound to allow pre-payment by the customer. The clause is drafted in the letter offer as follows:

you may at any time by giving the bank one (1) month notice in writing to pay the indebtedness due under the facility(s) or part thereof then due and payable to the bank

Some legal pre-payments are under the clause of Early Settlement. The clause is drafted in banking documents of murabahah vehicle term financing facility agreement under the clause of early settlement as follows:

Conventionally, the clause will provide a formula of how the full payment will be calculated, which is normally based on deducting the outstanding interest portion from that total amount outstanding prior to a pre-payment date, that is, discounting. The Sharī`ah issue does not relate to the provision of pre-payment but relates to provision of rebate in this pre-payment clause.

8.7.5.9. Rebate on Early Payment

This issue is related to the possibility of having discount in indebtedness in case the client wants to make an early settlement for his outstanding payment. The issue here is whether it is permissible by Sharī`ah to give rebate/ibra for the early payment.

According to the majority of jurists, the concept of rebate/ibra is based on the concept of da` wataajjal (give discount and receive soon),11 as it is known in Islamic legal literature. The majority of the jurists do not allow the discount to be stipulated as a condition in the contract for earlier payment settlement. According to AAOIFI Sharī`ah standards, the practice of rebate or ibra` is permissible provided this is not contractually agreed upon in the contract, that is, this form of pre-payment and rebate is not essentially valid to be incorporated. This term is incorporated by stating that, in the case of a pre-payment, the bank may give a rebate based on the bank’s sole discretion, and this is done without providing any formula of rebate.

On the other hand, it is permissible if the creditor gives a rebate or discount voluntarily without prior condition in the contract. Accordingly, the Islamic banks cannot stipulate in the document agreement clause of the rebate on early payment, nor can the client officially claim his right to receive discount upon early settlement.12

The practice in Malaysia is based on the guidelines of Bank Negara, which allows this clause to be incorporated in the legal documentation because of the uncertainty and ambiguity that should be removed in the legal agreement. The clause is drafted as follows:

The Bank shall grant rebate (Ibra`) to the Customer if, but not limited to the following events:

a. The Customer makes early settlement or early redemption, including those arising from prepayments;

b. In the event of early commencement of Monthly Installment prior to the expiry of grace profit period (for properties under construction);

c. In the event the Effective Profit Rate is lower than the Ceiling Profit Rate; and

d. In the event the actual disbursed amount is less than the Bank’s Purchase Price.

For avoidance of doubt, it is hereby acknowledged and agreed that the rebates referred to herein shall not be construed in any manner whatsoever as cash rebate payable to the Customer, but shall be reflected as a reduction in the profit element of the installments of the Facility. The rebate shall only be deemed granted upon receipt of the settlement/redemption sum as determined by the Bank based on the following formula:

Outstanding Bank’s Selling Price (LESS) Outstanding Financing Amount (LESS) Other Amount Due to the Bank

The Sharī`ah Advisory Council of Bank Negara Malaysia has issued a resolution on ibra` in 2000, where IFIs may incorporate a clause on the undertaking to provide ibra` to customers who make early settlement in the financing agreement on the basis of public interest (maslahah). With the inclusion of ibra` clause in the financing agreement an IFI is required to honour the undertaking or promise to grant ibra` to its customers. In line with the need to safeguard the maslahah (public interest) and to ensure that customer protection is carried out consistently, the SAC in its 101st meeting on May 20, 2010, further resolved the following:

• The bank may obligate IFIs to grant ibra` to customers of sale-based financing.
• In order to eliminate uncertainties pertaining to customers’ rights in receiving ibra` from IFIs, the granting of ibra` must be included as a clause in the legal documentation of the financing.
• To enhance the transparency between contracting parties, IFIs shall provide a payment schedule that discloses the amount owed by the customer and the estimated ibra` that might be received at a certain date to its customers.13

8.8. POTENTIAL AREA OF SHARĪ`AH NON-COMPLIANCE RISK

8.8.1. Fixed Rate and Floating Rate in the Debt Financing Facilities

The nature of fixed-rate financing would enable the clients to plan their cash flow since monthly payment is fixed throughout the financing period. Some customers might prefer to have this kind of facility, instead of having equivalent conventional products, which are floating rate in nature, because the payment of the selling price will be fixed and settled by installment over a long-term period. The worker with fix income can plan his payment properly without affecting his other monthly budgets. It is argued by some that the fixed-rate method of financing might affect the competitiveness as well as the viability of Islamic banks, and sometimes it is not a preferred mode of financing to some clients.

The fluctuation of interest rate sometimes will affect the preference of the client if the interest rates are climbing. These clients would choose fixed rate financing facility, in which BBA is prominent to lock the payment price to protect themselves against the increasing trend of interest rates. But when the interest rates are in a decreasing mode, they will convert their financing to interest-based financing facilities for a relatively lower payment. So, the fluctuation of interest rates in the market will definitely affect the demand for BBA and other Islamic fixed-rate modes of financing. Besides, the fixed-rate modes of financing have also resulted in a funding mismatch to the Islamic financial institutions because their long-term financing was funded by short-term bank deposits, which can give variable returns. It is a disadvantage to Islamic banks as they have locked in their financing profit rates over a long period, while they have to give a competitive rate of return to their depositors; otherwise these depositors will shift their deposits to the conventional banks, which can offer a better rate of return. So, Islamic banks are placed in a very difficult situation. They have to maintain a competitive rate of return and, at the same time, they cannot change the profit rate of the concluded fixed-rate contracts. It is argued that this fixed-rate and price-rigidity factors have rendered Islamic banks to be very vulnerable to economic and interest-rate volatility.

Bank Negara Malaysia had come out with the first variable-rate financing product based on the concept of BBA. Under this BBA financing with ibra` features, the selling price of the asset sold to the customer on deferred terms would be fixed at a profit rate known as the ceiling profit rate. Contrary to the BBA fixed rate, the periodical installments of this financing will fluctuate and vary depending on certain benchmarks and the spread on the customer for a particular period.14

8.8.1.1. Example

To illustrate the aforementioned ibra` concept, consider the following example: If the original monthly installment was RM 1,000.00, but the financing payment plus profit rate of that month (calculated based on certain benchmarks such as BFR plus margin) is lower, certain ibra` will be given to the client, in order to reduce the monthly installments to match those of the current market level. If the interest rate increases beyond the monthly installment payment (BFR plus margin), the effective profit rate will remain at the ceiling rate. This means that the client will only have to pay the installment at not more than the ceiling price that has been agreed upon upfront. It means that the ibra` will be calculated on a monthly basis and will differ from one month to another. On the maturity of the financing, the total installments will be calculated and they should not exceed the original selling price. Any shortfall will be treated as an ibra` (rebate) given to the client. Such variable rate financing products will be able to reduce the vulnerabilities of Islamic banks, especially in a dual banking environment where the Islamic banking system operates in parallel with a conventional financial system. The flexibility of this financial instrument has also manifested the compatibility of the Sharī`ah in providing a necessary mechanism to manage and mitigate risk in the modern financial setting.15 (See Figure 8.1.)

FIGURE 8.1 BBA Variable Rate Financing: Home Financing Is Fixed at 12 Percent, Variable between 4 and 12 Percent

As result of the structure of the floating rate just described, the payment in legal documentation is drafted as follows:

Since effective rate will change based on movement of BFR, the number of installments to fully settle the financing may as such be lesser or more than the prescribed number of installments. In circumstances where BFR continues to increase, the number of installments and/or installment amount may increase but the total installments to be collected shall not exceed the bank’s sale price.

The clause is drafted also in other banking documents such as murabahah vehicle term financing facility agreement under the clause variable-rate financing as follows:

8.8.2. Variation of Installment or Tenure

Variation of installment or tenure is a result of the floating rate. There is a clause in the legal documentation that governs the variation of installment payment or tenure as a result of that. The clause is drafted in banking documents such as murabahah vehicle term financing facility agreement under the clause of variation of installment or tenure as follows:

8.8.3. Risk Taking in the Financial Transaction

The risk taking in the business transaction is one of the requirements for entitlement of the reward and profit. From Sharī`ah perspective, the profit is always associated with the risk, based on the legal maxim al kharaj bi dhaman, the profit should be accompanied by risk and responsibility. Hence, the reward is associated with risk taking. This concept is supported as well by the legal maxim al ghorm bi ghonm. Besides the risk, there are other important components for reward entitlement such as work and responsibility. In conventional banking, the issue is not addressed; risk taking is not considered as one of pre-requirement for the bank’s reward. In conventional banking, the return and profit is based on interest rate that is fixed, predetermined, and guaranteed, regardless of the type of risk element undertaken. The risk in the conventional system is transferred, whereas in Islamic banking it is often shared, whereby the Islamic bank and the client will share different types of risk in different capacity depending on the on-going process and progress of the contract agreed upon. Normally, each one is entitled for reward based on the type risk of taken.

8.8.4. Third-Party Collateral

In some banking facility, the bank requests the applicant to provide collateral in order to grant the facility financing if the client has extra properties to be charged to the bank. However, if the client has no property to be charged to the bank, a third party may get involved to pledge his property in favour of the bank to facilitate the grant of the facility to the client.

From Sharī`ah point of view, it is permissible to create a legal charge over a property that belongs to a third party at his own responsibility and risk. If the collateral is charged through a letter of gift in favour of the applicant, where the hibah facilitates the charge process, the ownership is transferred to the applicant, to be then charged in favour of the bank. The third party must be aware of the consequences of his action in charging his property to the bank and the legal effect of the letter of gift issued to the applicant. The transaction of the letter of gift should be secured to protect the rights of both parties. Alternatively, a third party is given charge, with consent, whereby the owner of the asset will declare consent over his asset in favour to the bank. The hibah contract will be kept by the bank as security documents until the maturity of the financing tenor.

8.8.5. BBA Financing: Selling of the Nonexistent

BBA is one of the facilities in Islamic banking related in Malaysia to different applications. One of them is property business that includes the properties under construction as well. The banks offered BBA home financing as part of the facilities. The issue here arises from the nature of the subject matter of the contract, which is not in existence. This situation may trigger the Sharī`ah non-compliant risk from the perspective of the majority of the scholars. Even though there is an agreement to deliver the property with full specification at a due date but still ambiguity and conflict may arise. Dispute is expected, especially when there is a delay in delivery. The convenient financing mode for property financing under construction is an istisna` contract, which is suitable for projects under construction and housing under development. The financing banking mode of the IFI will be based on the parallel istisna based on future delivery of the asset.

The BBA home financing under construction is a form of bay madu’m. However, it should be noted that in a typical sale contract, one of the conditions is that the mahal al-`aqd or ma`qudalaih (objects of trade) to be traded must exist when the contract is being made. Purchase of an object that does not exist when the contract is being made is considered bai` ma`dum.

The issue was discussed by Islamic jurists when they were debating the condition of an object in a contract of sale. The Hanafi and Syafi`I Mazhab pronounced that the object of sale must be in existence at the time the contract is made. Otherwise, the contract will be deemed invalid because anything that is ma`dum cannot be owned. However, exemption was made to the salam, ijarah, and istisna`contracts, based on the istihsan principle. The Maliki echoed the opinion of the Hanaf I and Syafi`I regarding mu`awadhat maliyah (exchange contract), whereas for the tabarru`at (ownership contract on voluntary basis) such as hibah, they did not impose any condition for an existing object. What was important was that it was expected to exist in the future. The Hanbali Mazhab, on the other hand, did not stipulate this condition. What was important was that a contract should not contain elements of gharar, which is forbidden by Sharī`ah.

Ibnu Taimiyah and Ibnu al-Qayyim analysed the question of bai` ma`dum and concluded a sale was forbidden not because of ma`dum during the contract making, but rather because of the existence of gharar, which is a forbidden element.

This was based on the following arguments: Neither the Quran, the Sunnah nor the Prophet’s companions stated that bai` ma`dum was not permissible. However, a hadith prohibiting the sale of certain goods with features that did not exist. The prohibition was also for goods that are available but simply did not exist at the point of trade. This showed that the prohibition was due to the existence of the gharar element in the trade. There are specific situations where bai` ma`dum is permissible by Sharī`ah and considered valid. An example is the sale of fruits and grains that are about to mature. This is considered bai` ma`dum because the buyer cannot take delivery of the goods and has to wait until the fruits or grains mature. The salam, istisna`, and ijarah contracts are other examples of bai` ma`dum that are permissible based on the principle of istihsan.

All of these examples show that selling something that has not yet existed or is not yet in the seller’s possession at the point of the sale is not forbidden merely because of its ma`dum nature.17 Hence drafting the legal documentation in BBA home financing is based on the views of Ibn Taymiyyah if the Sharī`ah board of the bank subscribe to that view to mitigate the Sharī`ah non-compliance risk. However, istisna remain the best contract that suits the portfolio of selling assets to be manufactured or constructed in the future.

In fact, if we look at the housing development (control and licensing) ACT 1966. Schedule G, the third schedule clause 4 (1), the schedule of payment of purchase price, can easily be adjusted to an istisna contract. See Table 8.1. We can see the payment progress moving passively along with the progress of the construction [Housing Development (control and licensing) ACT 1966, schedule G, the third schedule clause 4 (1)].

TABLE 8.1 Payment Installments for Home Financing

8.8.6. Bai` `inah Transaction in BBA Home-Financing Legal Documentation

The transaction of inaah appears after acquiring beneficial ownership over the property. By concluding the S&P contract agreement, the client will sell the property to the bank, which will subsequently resell the property back to the client based on bay al Innah transaction. Innah concept in the transaction is part of the procedure in BBA facility home financing in Malaysia and the documentations clearly reflect this transaction. BBA is based on combinations of few agreements; one of them is inna contract. Hence, the structure does not demonstrate BBA contract only; rather, it is a combination of more than one contract.

It should be noted that the SAC of BNM, at its fifth meeting on January 29, 1997, passed a resolution that Bai` `inah is a principle that is permissible in the Islamic capital market in Malaysia. Bai` `inah refers to trading whereby the seller sells his assets to the buyer at an agreed selling price to be paid by the buyer at a later date. After that, the buyer immediately sells back the assets to the seller at a cash price, lower than the agreed selling price.

The majority of Islamic jurists state that there are three forms of trading categorised as Bai` `inah, whereby it can be concluded that all the assets sold come from the financier. The financier will sell a product to the buyer at an agreed price to be paid later. The financier then immediately buys back the asset at a cash price lower than the deferred selling price.

Past Islamic jurists had differing views on determining the hukm on Bai` `inah. The following were their views: The majority of scholars were of the opinion that Bai` `inah was not permissible because it was the zari’ah (way) or hilah (legal excuse) to legitimise riba (usury). The Hanafi was of the opinion that Bai` `inah was permissible only if it involved a third party, which would act as an intermediary between the seller (creditor) and buyer (debtor). The Maliki and Hanbali on the other hand, rejected Bai` `inah and considered it invalid. Their opinion was based on the principle of sadd zari`ah, which aims to prevent practices that can lead to forbidden acts such as, in this case, riba.

The basis for the opinion of the majority of the Islamic jurists was the hadith dialogue between Aishah and Zaid bin al-Arqam, which showed the prohibition of Bai` `inah. They also held to the hadith of the Prophet (s.a.w) in which he warned that those who practised Bai` `inah would suffer scorn. The Syafi`i and Zahiri Mazhab viewed Bai` `inah as permissible. A contract was valued by what is disclosed and one’s niyyah (intention) was up to Allah s.w.t. to judge.

They criticised the hadith used by the majority of the Islamic jurists as the basis for their argument, saying that it (the hadith) was weak and, therefore, could not be used as the basis for the hukm. The SAC decided to accept the opinions of the Syafi`i and Zahiri Mazhab in permitting Bai` `inah. Therefore, it can be developed into a product for the Islamic capital market in Malaysia. When institutions or individuals are in need of capital for a specific purpose they can utilise this method of payment, using their assets as mortgage. Because they still need the assets, this method allows them to liquidate without losing the asset.

Revisiting the Rulings on Bai` `inah

The regional Sharī`ah dialogue that was held on June 28–29, 2006, aims at harmonising and promoting understanding amongst the Sharī`ah scholars who are involved in Islamic finance. The dialogue had specifically focused on finding the best solution to resolve the issue of the use of Bai` `inah and tawarruq in Islamic financial system. The council and the participating Sharī`ah scholars had taken a comprehensive approach with regard to Bai` `inah and tawarruq transactions.

Resolution The council in the regional Sharī`ah scholars dialogue on June 29, 2006, or JamadilAkhir3, 1427 resolved that:

The SAC, in its 16th meeting dated November 11, 2000, and 82nd meeting on February 17, 2009, has resolved that a valid Bai` `inah contract shall fulfill the following conditions:

The SAC, in its 8th meeting on December 12, 1998, has resolved that the transaction based on Bai` `inah in the Islamic Interbank Money Market is permissible, subject to the following conditions:

The SAC, in its 82nd meeting on February 17, 2009, has resolved that the stipulation to repurchase the asset in a Bai` `inah contract will render the contract as void.

With regard to the issue of intercondionality of the `inah contract, it is known in the resolution of the SAC as the Stipulation to Repurchase an Asset in a Bai` `inah Contract. The SAC was referred to on the issue of whether the stipulation to repurchase the asset (interconditionality) may be incorporated into both agreements of bay bithamanajil (BBA) based on Bai` `inah, namely, the property purchase agreement and the property sale agreement for home financing concluded between the Islamic financial institution and the customer. This stipulation to repurchase is normally included in the document that indicates the seller’s undertaking to repurchase the asset from the buyer, especially in the recital of the agreement, marketing brochures, supplementary documents, appendixes, and others.

8.8.7. Transfer of Ownership

The BBA along with the other debt financing facilities is a contract of sale that requires the transfer of the ownership as a result of the financial transaction. It should be noted that BBA financing mode is a sale contract where the possession (al-qabd) of the subject matter should truly happen, because the BBA is not loan for financing but real financial transaction based on the exchange of the subject matter of the contract. This Sharī`ah requirement was imposed in order to ensure that the seller is selling what he possesses. The possession can be proven according to the custom, whether it is a physical possession or constructive possession. The issue is how to prove ownership in an exchange contract. Is it through legal title as required by the law or through fulfillment of the pillars of the contract along with their conditions such as offer and acceptance as required by Sharī`ah?

The issue is subject to different views and interpretations, which result in different practices. From a Sharī`ah perspective, the transfer of the ownership of an asset is effected through offer and acceptance, which is expressed verbally or through others means that convey the consent of the contracting parties. The legal documentation is a process to document and record the transaction concluded through offer and acceptance in order to protect the rights and obligation of the contracting parties. This means that if the asset is sold through offer and acceptance, the buyer assumes the ownership of the asset even though the legal title belongs to someone else. In fact we should distinguish between two cases: The first case is trading with the objective of claiming permanent ownership over the asset. In this case, the offer and acceptance should be followed by the transfer of the legal title to secure the interest of the buyer. The second case is trading with the objective to resell the object of the trade or to recycle it in the market from hand to hand. In this case, the offer and acceptance will be sufficient to claim the ownership of the asset without a need to transfer the legal title as long as there is evidence that shows that the contract has been concluded and the asset belongs to the buyer (such deed of assignment in the property business). Hence, the transfer of the legal title, which is a legal requirement, is an option to the buyer from a Sharī`ah perspective. Hence, the ownership is not necessary to be evidenced by the legal title but also through documented offer and acceptance.

8.8.8. Using LIBOR in Profit as Benchmark

There is no doubt that LIBOR (London Interbank Offered Rate) is interest-based, implemented by the conventional financial institutions; it is used widely and accepted internationally. The practice shows that murabahah profit is determined based on the current interest rate, and mark-up is determined by murabahah whether equal to LIBOR or above it. This implementation of LIBOR as benchmark in Islamic financial transaction has been debated among contemporary scholars.

The argument here is that using the conventional benchmark makes the Islamic financial transaction similar to conventional transaction and the financing mode based on an interest-based financing shows some apparent resemblance, which is not preferable. We have to take note that using LIBOR as benchmark and tying up the murabah transaction accordingly is not acceptable. However, using LIBOR as indication for profit rate is accepted and it does not make the transaction invalid. The important Sharī`ah requirement here is that murabahah should fulfill all the terms and conditions imposed by the Sharī`ah.

Example: A and B are two brothers. A trades in liquor, which is totally prohibited in Sharī`ah. B starts a business of soft drinks, but he wants his business to earn as much profit as A earns through trading in liquor. Therefore, he resolves that he will charge the same rate of profit from his customers as A charges over the sale of liquor. Thus, he has tied up his rate of profit with the rate used by A in his prohibited business. One may question the propriety of his approach in determining the rate of his profit, but, obviously, no one can say that the profit charged by him in his halal business is haram, because he has used the rate of profit of the business of liquor as a benchmark.

However, using LIBOR as a benchmark is still a challenge for the Islamic banking industries in order to achieve a full Islamic process flow for any financial banking transaction, because the interest rate will be taken as an ideal for Islamic business transaction and flag for halal product. Furthermore, the non-halal product cannot survive and grow in the Islamic system and Islamic environment, due to the implication of the issue in the financial system. Usmani says:

The Islamic banks and the financial institutions should strive for developing their own benchmark. This can be done by creating their own inter-bank market base on Islamic principles. The purpose can be achieved by creating a common pool which invests in asset-backed instruments like musharakah, Ijarah etc. If majority of the assets of the pool is in tangible form, like leased property or equipment and shares in business concerns etc. its units can be sold and purchased on the basis of their net asset value determined on periodical basis. These units may be negotiable and may be used for overnight financing as well. The banks having surplus liquidity, they can purchase these units and when they need liquidity can sell them. This arrangement may create interbank market and the value of the units may serve as indicator for determining the profit in murabahah and leasing also.20

It is recommended that the Islamic banks should move away from LIBOR and have belief in the global Islamic banking industries so that they are able to create an Islamic system to replace LIBOR with the will and support of the political decision of OIC countries, which represent the key of success for this shift.

Since the establishment of the first Islamic commercial bank in 1975, the Islamic finance industry has been searching for an indigenous benchmark that can be applicable to transactions compliant with Islamic law (Sharī`ah compliant).21 As an ethical financial system, Islamic finance prohibits interest and shuns all interest-related transactions and instruments as these are contradictory to the core principles of Islam. Despite this prohibition, in the absence of a reliable Islamic interbank benchmark, Islamic banks and financial institutions have continued to utilise conventional interest-based benchmarks to calculate their cost of funding with no reference to either their assets’ risk profile or the regional particularities of Islamic banks. The Islamic Interbank Benchmark Rate (IIBR) serves to address some of these concerns by developing a rate that is contributed by and is indigenous to a global panel of Islamic banks and Islamic Banking windows with fully segregated funds. (See Figure 8.2.)

FIGURE 8.2 Methodology of the IIBR

Source: Thomson Reuters (http://thomsonreuters.com/site/islamic-interbank-benchmark-rate/definition-methodology-criteria/).

Uses of the Benchmark

• Pricing of common overnight to short-term treasury investment and financing instruments such as murabaha, wakala, and mudaraba.
• Pricing of retail financing instruments such as property finance, car finance, and other asset financing.
• Pricing/benchmarking of corporate finance and investment assets.
• Pricing of sukuk and other Sharī`ah-compliant fixed income instruments.
• Official incorporation possible for pricing onto confirmations/annexes related to the Sharī`ah-Compliant Hedging Master Agreements.

Methodology

• Rates for Sharī`ah-compliant U.S. dollar (USD) funding in reasonable market size are contributed via Thomson Reuters systems each business day between 9:00 A.M. and 10:44 A.M. (Makkah time–GMT+3) by a panel of 16 Islamic banks or fully segregated Islamic banking windows.
• The panel banks contribute their rate based on a pre-defined question specified by the Islamic benchmark committee and approved by the Sharī`ah committee.
• The rates are snapped by Thomson Reuters at 10:45 A.M. Thomson Reuters undertakes both automated and manual audit and review procedures at this stage to ensure that the rates contributed are genuine.
• The rates are ranked from highest to lowest and the top and bottom quartiles (25 percent) of the rates are excluded to ensure that outliers do not influence the distribution (from 16 contributed rates, 8 rates are excluded—4 each of the highest and lowest rates).
• The arithmetic mean (average) of the remaining mid quartiles’ values is then calculated to produce the IIBR, rounded to 5 decimal places.

The calculation methodology is very similar to the calculation methodology of interest-based benchmarks such as the LIBOR. If that is the case, then what’s the difference?

The fundamental difference is that benchmarks such as LIBOR measure interest, whereas IIBR measures profit. Thomson Reuters calculates hundreds of fixings in various markets globally. The methodology utilised represents a time-tested mechanism to calculate the average cost of funding for any market. A key maxim of Islamic jurisprudence suggests that, in the matter of commercial transactions, everything is deemed permissible unless explicitly stated otherwise. As long as the transacting parties adhere to the principles of Islamic jurisprudence while applying the benchmark to their transaction, it is acceptable to utilise a consensus methodology for the rate fixing.

The banks in conventional fixes are principally involved in interest-based borrowing and lending and are contributing quotes for how much interest they must pay were they to raise funding. The IIBR contributor banks are all either Islamic banks or banks with fully segregated Islamic banking windows and hence limited to only investing in Sharī`ah-compliant assets.

Further, a critical difference between the IIBR and interest-based benchmarks is what exactly they are contributing when they are quoting their rates. The Islamic banks are contributing the rate they would have to distribute to an investor, if they were to raise Sharī`ah-compliant funds, considering the risk profile of the Islamic banks’ underlying assets. The specific question asked to each contributing bank is: “What is the expected profit rate that you would distribute for an interbank Sharī`ah-compliant funding transaction, were you to do so by asking for and then accepting interbank offers for a market amount of U.S. dollars for the tenors specified below?”

Finally, the IIBR is guided by a panel of major Islamic banks and approved by a Sharī`ah committee of internationally renowned scholars.

In treasury or money-market operations, banks expect to earn a return on their money or “interest” not necessarily linked to utilizing the funds for any productive activity. What’s the difference here?

Unlike conventional treasury operations, Islamic treasury transactions are always related to real Sharī`ah-compliant trade (bay`) and investment (istithmar) transactions such as murabahah (cost plus) or wakala (investment agency) or mudarabah (investment management) that the bank undertakes either as a seller, an agent (wakil), or investment manager (mudarib), respectively. Hence, it is necessarily invested in assets that generate return either through sale or yields produced from the underlying investable assets.

Why not build a benchmark based on real economic indicators, for instance CPI, GDP growth, and the performance of the financial or other sectors of the economy?

The ultimate criterion for the industry-wide adoption of any benchmark, particularly one that is published every business day, is the simplicity, reliability, and robustness of its methodology. Additionally, to engender the confidence of financial markets participants, an interbank benchmark must be calculated on every business day with a transparent and simple methodology open to public scrutiny. Benchmarks such as CPI, GDP, growth, and performance are subject to much more volatility, less frequency, and are less opaque in the process by which the underlying metric is calculated. Further, these measures tend to lag far behind market conditions to the extent that they are rendered irrelevant by market participants by the time they are published. Instead, the IIBR will be a lead-indicator able to react to prevailing market conditions on a day-to-day basis.

If the IIBR is meant to be a global benchmark for the Islamic markets, then why are most of the contributor banks in the Gulf Cooperation Council (GCC) countries?

To publish a reliable and realistic benchmark for any interbank transaction, the currency for the benchmark must be uniform across all contributors, as rate differentials are present and sometimes accentuated across currencies. The unique benefit of including GCC banks is that most, if not all, of these banks have substantial reserves/exposure in U.S. dollars, in addition to the fact that five out of the six countries peg their currencies to the U.S. dollar. This effectively allows for a broader representation of banks from various Islamic markets while still remaining within the risk parameters of one currency. In addition, the U.S. dollar still represents the most liquid currency, and most international sukuk continue to be issued in U.S. dollars. It is intended that going forward, other contributor banks in non-GCC countries will apply to participate in the U.S. dollar benchmark to make the benchmark more inclusive and global. On a more strategic level, the GCC-based benchmark can be considered one of the precursors of a truly global and economically integrated Islamic financial market.

8.8.9. Securities or Collateral in BBA and Debt Financing Facilities

The nature of murabahah financing is that the payment is settled later on installment bases, but the commodity is handed over to the client and the amount is practically paid. Due to this deferred payment arrangement, the bank may request a security for the payment of the transaction to mitigate the risk of the financing. In this regard, the bank will ask for some mortgage to be charged to satisfy the bank financing. At this stage, the relationship between the client and bank is creditor and debtor. It is allowed that the client provides a mortgage to the financial institution. According to the Islamic rules pertaining to mortgage, the rahn will remain at the bank risk if the charge is under bank custody. If the security remains with the customer for usage, the risk remains with the customer. The party that handles the asset physically will be responsible for any damage that may occur, until the full settlement of the debt, when the mortgage will be released accordingly. The practice shows that the sold property is given to the financier seller as a mortgage. Under BBA, the property is sold to the customer and no longer belongs to the bank; what remains is the debt that is secured by the said property.

However, there are some rules pertaining to security that must be observed as follows:

• The security can be claimed rightfully where the transaction has created a liability or debt, and no security can be asked from a person who has not incurred a liability or debt. In case of third-party security and guarantee, the security arrangement is between the client and the third party, not between the bank and third party.
• It is permissible that the sold commodity itself is given to the seller as security. Some scholars are of the opinion that this can be done only after the purchaser has taken its delivery and not before. It means that the purchaser shall take its delivery, either physical or constructive from the seller than give it back to him as mortgage in order to distinguish the transaction of sale from transaction of mortgage. According to Taqi Usmani, this condition is required in a cash sale transaction only and not in credit sales. Therefore, it is not necessary that the purchaser take the delivery of the sold property before he surrenders it as mortgage to the seller. The only requirement would be that the point of time when the property is held to be mortgaged should necessarily be specified because, from that point of time, the property will be held by the seller in a different capacity, which should be clearly earmarked.22

8.8.10. Rescheduling of Payments in BBA and Debt Financing Facilities

Obviously, rescheduling of payment arises when the purchaser is not able to pay the debt of the financing according to the agreement with the bank or the financial institutions. However, the issue of rescheduling BBA financing has the same Sharī`ah implication as rollover. Basically, BBA is a banking facility based on sale related to commodity with fixed price agreed upon upfront. The request of the client to reschedule the installment of BBA should not be treated as a loan. The practice of conventional bank in rescheduling the facility is based on the nature of treatment of the bank to the transaction, which is based on loan, and allows the bank to be entitled to additional interest accordingly. This financing treatment and banking approach trigger a Sharī`ah non-compliance risk. If the bank wants to engage in rescheduling BBA, it should be without any additional charges to the original amount (selling price) agreed upon. The original selling price remains as it is by having the same amount in the same currency.23 However, the amount can be revised and the tenor can be extended within the amount predetermined in the contract agreement that represents the selling price.

8.8.11. Securitization of BBA Debt

This issue is related to the possibility of pulling BBA to the capital market as a major segment in Islamic finance by securitizing BBA and issuing sukuk, which is a negotiable instrument to be traded in the secondary market. According to the Sharī`ah requirement in securitization, BBA cannot be securitized, because it represents monetary debt receivable; therefore, the monetary obligation arising out from BBA cannot be used to issue sukuk. The monetary debt of BBA should be treated and transferred at par value. The only possibility that BBA can be securitized is in the case of a mixed portfolio consisting of a number of transactions, such as BBA leasing. This mixed portfolio can be used to issue a negotiable instrument subject to some conditions.24

According to AAOIFI pronouncement, sukuk must not represent debt or receivables. Sukuk representing receivables or debt are not tradable; therefore, securitization must be purely based on assets, usufruct, or services, except in the case in which the financial institution is selling all its assets including the receivables as part of it. A mixed portfolio that consists of physical assets and debt or some receivable, whereby the debt and receivables are included incidental is in accordance with the AAOIFI standard 21 regarding the financial papers in which it allows the trading of sukuk backed by a portfolio consisting of a hybrid asset made up of debts, receivables, and physical assets, where the later constitutes at least 30 percent of the portfolio.25

NOTES

1. AAOIFI, Sharī`ah standards, English ed. (Bahrain: Accounting and Auditing Organization for Islamic Financial Institutions, 2004), 451.

2. Ibid., 452.

3. Ibid.

4. Ibid., 453.

5. Ibid., 454.

6. Ibid., 455.

7. International Centre for Education in Islamic Finance, Applied Sharī`ah Rules in Financial Transactions, CIFP Module (Kuala Lumpur, Malaysia, 2006), 147.

8. Ibid., 142.

9. Ibid., 143.

10. Ibid., 144.

11. “Da` wataajjal” (give discount and receive soon)—this Prophetic statement is based on a hadith in which Abdullah ibnMasud was reported to have said that when the Jews belonging to the tribe of Banu Nadir were banished from Madinah (because of their conspiracies) some people came to the Prophet (pbuh) and said; “You have ordered them to be expelled, but some people owe them some debts which have not yet matured.” Thereupon the Prophet (pbuh) said to them (that is, the Jews who were the creditors), “Give discount and receive (your debts) soon.” The majority of the Muslim jurists, however, do not accept this Hadith as authentic. Even if the Hadith is held to be authentic, the exile of Banu Nadir was in the second year after hijrah, when riba was not prohibited yet.

12. See: Muhammad Taqi Usmani, An Introduction to Islamic Finance (Karachi: Maktaba Ma’ariful Quran, 2005), 141–143.

13. Guidelines of Bank Negara Malaysia on Ibra.

14. International Centre for Education in Islamic Finance, Applied Sharī`ah in Financial Transaction, CIFP Module (Kuala Lumpur, Malaysia, 2006), 176.

15. Ibid.

16. BFR: Refer to the base financing rate published by the Central Bank (Bank Negara Malaysia).

17. Resolution of the Securities Commission Sharī`ah Advisory Council, 2nd ed. (Kuala Lumpur, Malaysia: Sharī`ah Advisory Council of the Securities Commission, 2009), 24.

18. Sharī`ah Advisory Council of Bank Negara, Sharī`ah Resolutions in Islamic Finance, 1st ed. (Kuala Lumpur, Malaysia: Bank Negara Malaysia, 2010), 17.

19. Sharī`ah Advisory Council of Bank Negara, Sharī`ah Resolutions in Islamic Finance, 2nd ed. (Kuala Lumpur, Malaysia: Bank Negara Malaysia, 2010), 113.

20. Usmani, An Introduction to Islamic Finance, 120.

21. http://thomsonreuters.com/products_services/financial/islamic_interbank_benchmark_rate/definition_methodology_criteria, retrieved February 27, 2013.

22. Usmani, An Introduction to Islamic Finance, 126–128.

23. Ibid., 146.

24. Usmani, An Introduction to Islamic Finance, 147.

25. Ahcene Lahsasna and Umar Idris, “Examination of the AAOIFI Pronouncement on Sukuk Issuance and Its Implication on the Future Sukuk Structure in the Islamic Capital Market.” Research paper presented at the 6th International Islamic Finance Conference, 2008, Innovation in Islamic Finance: A Fast Track to Global Acceptance, Monash University, October 13–14, 2008.