Controversies / Issues in IBF

Bay Inah / Tawaruq
Is viewed by some observers and practitioners as a hilah (legal trick), as the objective of the transaction is to exchange of money in different quantities at different times.
The argument for legalising or forbidding Inah and Tawarruq is based on the intention (niyyah) of the parties, i.e. real vs. declared intention.

Bay Inah is a legal sale in the Shafie School, where the intention is not a significant element in determining the validity of the contract. This is the basis for the endorsement of Bay Inah by BNM’s and SC’s SAC.
Rayner (The Theory of Contract in Islamic Law, 1991) concludes that the Malikis and Hanafis give due effect to the real intention or niyyah of the parties, but that as regards illicit motives both schools are reluctant to make such an uncertain element as motive a dependent factor of a legal act. The Hanbali School however, always gives precedence to real intention over declared intention. According to him, the general tendency of Islamic law seems to be to give priority to the declared intention. However, in the Shafie School, this is not just a tendency but a doctrinal stance.

Debt - property or money?
The Malaysian (presumably based on the Shafie’s opinions) view is that debt is a property and hence can be traded freely. For example, a RM100 million debt can be exchanged for RM90 million in cash without any implications.

The middle eastern views debt as money and therefore can only be changed with money of equivalent value. The RM10 million difference in the above example is therefore riba.

Purchase undertaking in an Ijarah transaction - valuation issues?
A purchase undertaking is part of an Ijarah transaction for the sole purpose of returning the leased asset(s) back to the originator. The Purchase undertaking (PU) is present because it was never the intention of the originator to sell the assets in the first place. Another reason is to facilitate the redemption of the principal, similar to the mechanics of a conventional bond/loan which explains why the PU is undertaken at nominal value and not marked to the prevailing market values.

The issue with PU is not whether it is allowed by Shariah or not but it has more to do with the price transacted under the undertaking. If the price is based on the prevailing price at the time of executing the undertaking, I see no issues. It is about justice and fairness to the contracting parties. If the market price is below the PU exercise price, it would mean injustice to the purchaser and conversely, it would be unfair to the seller if the market price is more than the price transacted under the PU.

Purchase undertaking in a Musharakah/Mudharabah transaction – capital protection?
Like the PU in an Ijarah transaction, its presence in a Mudharabah/Musharakah transaction is to facilitate the principal redemption to mirror the mechanics of a conventional bond. A PU under this circumstance tantamount to guaranteeing capital. It is permissible for a third party to guarantee capital but it should be done on the basis of hibah (gift).

BBA, Justice Abdul Wahab and the Court of Appeal

In July 2008, High Court judge Datuk Abdul Wahab Patail had ruled that the application of the BBA contracts in Arab Malaysian Finance Berhad v Taman Ihsan Jaya & Others (2008) was contrary to the Islamic Banking Act 1983 (IBA).

On March 31, the Court of Appeal unanimously overturned Abdul Wahab's much-debated judgment in the Bank Islam Malaysia Bhd v Ghazali Shamsuddin & Two Others, and nine other cases.

Abdul Wahab Patail ruled that BBA is a loan transaction and not a trade based financing. This is because there is no transfer of title from the customer to the bank during the PPA and hence the bank has no legal or beneficial capacity/right to make a valid sale under the subsequent PSA. This was why there was a fear of default under BBA contracts because the contract itself is deemed not enforceable.

Therefore, the BBA is deemed a conventional loan with an Arabic name, the form changes but in substance it is still a plain conventional loan and the profits charged under a BBA transaction are therefore deemed to be interest.

On 31st March (the report in the Malaysian Reserve is 6 months late), the 3 member CoA ruled that Abdul Wahab had erred in making his judgement and reversed the ruling, re-establishing BBA as a bona fide sale transaction and upholding to sanctity of the BBA contracts. The 3 member bench rules that “civil courts should not decide whether a matter is in accordance with the religion of Islam”. Such issues need to be solved in consultation with Islamic scholars. And since BNM’s SAC has endorsed BBA as an approved product, civil court judges should not dispute it.

My opinion – the BBA was created in 1983 based on the conventional loan platform to enable Islamic finance to break into the market while operating on the existing platforms. It was true 26 years ago when awareness on Islamic finance was low and such products were necessary to avoid “cultural shocks”. But as knowledge on Islamic finance grew, such Inah based products are not necessary anymore; the market has more understanding of the Islamic financial system and is ready to accept the structural differences.

Abdul Wahab was arguing on valid grounds, he is merely exposing the “loan behind the façade of a trade” element of the BBA.

It is about time the market, the regulators and the judiciary accept the fact that BBA is a product designed to ease the entry of Islamic finance into the market. It has outlived its purpose and should be phased out completely.

Bursa Suq Al Sila

I have always thought that Shariah based finance is always trade based as decreed in the Quran, 2:275 “… Allah hath permitted trade and forbidden usury …“

Based on my limited knowledge, a trade is a transaction where money and physical goods or services are exchanged. Therefore, is it a bona fide trade when the intention to take physical possession in absent?

Inah is a contract involving the movement of money form one party to another using “trade” to facilitate the transfer. The trade in Inah is (IMHO) a smokescreen, a legal trick to “legalise” the transfer of money including the additional (profit) amount. The Malaysian market has finally accepted this fact and phased out the use of Inah when conducting Shariah based financial transactions. The argument is however based on the number of contracting parties and NOT the absence of intention to take physical delivery of the traded goods. Based on the “number of contracting parties” view, the Tawarruq is formulated and deemed compliant despite the intention of taking physical delivery is still absent (OIC’s Fiqh Academy decided that Tawarruq may not be compliant after all but some scholars argue that “organised Tawarruq” should be allowed – I have no idea what organised Tawarruq is).

So, how do we move money from one party to another the Shariah compliant way? Where and how do we place idle funds?

I propose a property clearing house be set up, containing a pool of real estate assets, each individual property with their own legal title. The properties must be generating economic activity/value such as a warehouse, shophouse or residential properties, or even industrial properties/factories. The clearing house will own all the property and sell the property to those wanting to place idle funds for short periods. The properties will then be leased back to the clearing house and at the end of the agreed lease period be sold back to the clearing house at current market value. Given that the lease/investment period is short, between 1 week and 6 months, fluctuation in values should not be too drastic.

The proposed structure will at least eliminate the element of buying and selling assets purely for the purpose of transferring money and getting a little bit more back. The lease and sell back will be determined based on the prevailing market prices thus eliminating concerns concerning riba and gharar.

Tawarruq – a Tripartite Inah?

The OIC Fiqh Academy rules that organised Tawarruq is unacceptable (Resolution 179 (19/5) 26 – 30 April 2009). In particular they ruled that it came into conflict with Maqasid Shariah (the basic principles underlying Shariah).

Tawarruq is widely used as a liquidity management tool and most scholars sanction the structure. However, some scholars argue it involves legal trickery and contains elements of interest based lending. Tawarruq does not create any enonomic activity but instead it creates debts.

What is Tawarruq? To me, it is basically an Inah with an additional contracting party. The whole process of buying and selling metals/commodities is merely a charade, a legal trick as the main purpose is to transfer cash from one party to another. I commented on the issue previously (http://shariah-finance.blogspot.com/2009/05/commodity-trading.html) and I sort of feel vindicated by OIC’s declaration.

It has always been argued by some that niyah (intention) is secondary when undertaking such contracts. I do not agree. If we exclude niyah, everything will be permissible. A lot of observers have urged Islamic finance practitioners to look at the substance behind the form when structuring Shariah based solutions, the on going debate on substance over form of Islamic banking products and services.

Dr Nikan Firoozye (http://islamic-finance-resources.blogspot.com/) opines that we should categorize products by their Shariah-risk, with hiyal (legal trick) the most risky. I wish to add that if such measure is used, the higher the Shariah-risk is, the less compliant the product is.

Dr Mohammad Akram Laldin, a respected Malaysian religious scholar, disagreed with OIC's ruling, saying organised tawarruq does not violate Islamic law principles. “From the point of view of Islamic law, there is nothing wrong with the transaction itself.” (http://islamicfinanceupdates.wordpress.com/2009/06/04/islam-allows-organised-tawarruq-asset-sales-scholar/)

I do not see this declaration as a hindrance to the growth or development of Shariah based finance. I see it as moving out and away from the conventional norms and in the long run will bode well for Islamic banking and finance. BBA and Inah based products are being gradually phased out in Malaysia and with the latest declaration, expect to see more products being out of favour. My guess is Commodity Murabahah will be next.

Commodity Trading?

I’m not a Shariah scholar but I think I know a “hilah” or legal trick when I see one.

Selling and buying back a commodity (Bai Inah) between two parties is obviously a legal trick undertaken to circumvent the laws of Shariah. But what about artificially trading and exchanging commodities between 3-4 parties? By artificially I mean the trading of the commodities does not bring any economic benefit apart from facilitating the movements of cash and enabling a sum of money today to be returned at a later date inclusive of the “profit”. Hey, I just described Commodity Murabahah.

I have been made to understand and have always believed that Shariah based trade and finance must involve productive economic activity. Transferring commodities within seconds does not create any productive economic activity. Transferring commodities for this purpose tantamount to a legal trick, hilah. Correct me if I’m wrong.

Commodity Murabahah exist for liquidity purposes. Without it, how will Shariah based financial institutions manage their liquidity? Maybe the answer lies in how Shariah based financial institutions look at liquidity management. Do they need it in the first place? Deposits undertaken under the contract of Mudharabah are not demand deposits, they are investments, and liquidating investments has its steps and conditions. Savings deposit under the contract of Wadi’ah is for safekeeping and is not supposed to be utilised. If they are, then the onus is on the FI to meet the withdrawal demands of the customers.

Conventional banks use customer deposits to fund loans. They face the problem of matching short term liabilities with long term assets. Shariah based FI do not face the same dilemma because they are NOT supposed to fund financing with customer’s (Wadi’ah) deposits. Financing are done on a profit sharing basis, it is done in a partnership. Therefore, any financing arrangement is between the customers, and the FI merely acts a facilitator, arranger, manager or if they commit their own capital, as a partner and hence liquidity issues might not occur.

What I’m trying to say is, if Shariah based financial institutions undertake Shariah based financing exactly how it is supposed to be done, they won’t need legal tricks. There is no need to complicate things just to conform to the conventional norms.

Anyone Got Guts?

What does it take to succeed? What does it take to make a breakthrough? Guts, perseverance and belief. IMHO, none of that is presently present in the Islamic banking and finance industry. No, I’m not putting those hardworking Islamic finance professionals down. All I’m saying is the guts to develop a product which is not based on the conventional platform is absent. All the products from the BBA mortgages to the Inah based personal financing and even the Sukuk Musharakah is tailored to run on the conventional platform especially from the pricing aspect. Granted that different prices for identical products cannot happen in efficient markets but one must remember that a Shariah based mortgage and a conventional based one albeit having the same objective (i.e. home ownership) is drawn upon different principles and hence cannot be priced identically.

What we need is the courage to come up with a product or solution that is not only Shariah compliant in form but also in substance. Can we have an Ijarah based mortgage whose pricing is directly tied to the prevailing rental rates regardless of the base financing (lending) rates? It is after all a lease based mortgage. A Sukuk Musharakah in my opinion should not be priced and traded like a debt based bond; it should be priced and traded like an equity based instrument.Shariah based financial solutions are tied to real assets and actual economic activity and hence should be priced and traded accordingly. We have to breakaway from doing things based on the conventional norms and platforms if we are serious about promoting Islamic banking and finance.

Concepts Used in Islamic Trade (and Banking)

Some of the common contracts and concepts used to facilitate trade the Islamic way. These contracts are also used in Islamic banking and finance to facilitate financing transactions.

• "Bai-al-Dayn" - Debt-trading.
• "Bai-Bithaman Ajil (BBA)" - Deferred payment sales. Where goods are sold on a deferred payment basis at a price which includes a profit agreed by both the buyer and seller.
• "Bai Inah" - A buy and sell contract between two parties where one party sells his asset to the other (price is marked up, payment is deferred) and subsequently buys it back at the cost price paid on the spot. This is often considered a hilah to facilitate the transfer of money under the pretext of trading.
• "Bai Salam" - A contract where payment is made spot while the goods are delivered at an agreed later date. A form of advance payment trade but the goods may not necessarily be in existence.
• "Hibah"Voluntary, unilateral gift.
• "Hiwalah" - Transfer of debt.
• "Ijarah" - Lease contract. A lessor (owner) leases out an asset or equipment to its client at an agreed rental fee and pre-determined lease period. The ownership of the leased asset remains in the hands of the lessor for the duration of the lease.
• "Ijarah Muntahiah Bittamlik" - Lease and subsequent purchase. Muntahiah Bittamlik describes the transfer of the title of the leased asset to the lessee at the end of the lease tenure.
• "Istisna" - A contract to manufacture according to given specifications. The payment terms can either be spot, deferred or in instalments.
• "Kafalah" - Guarantee or surety given by one party who agrees to discharge the liability of another party, as stipulated in the terms of the guarantee.
• "Mudharabah" - Profit sharing and loss absorbing agreement between two parties, one the capital provider (Rab-al-mal) and the other, the entrepreneur (mudahrib). The profit-sharing ratio is agreed upon upfront while losses are borne solely by the financier.
• "Murabahah" - Cost plus sale where goods are sold at a profit and the profit margin is known to the buyer.
• "Musawamah" - Bargaining sale where the seller need not disclose the cost"Musyarakah"Limited liability partnership. All partners share profits on a pre-agreed ratio but losses are shared on the basis of equity participation.
• "Qardhul Hassan" - Interest-free loan or benevolent loan without a specified repayment terms or tenure.
• "Rahn" - Collateral. Where a valuable asset is placed as collateral for a debt, he collateral may be disposed in the event of default.
• "Sarf" - Currency exchange, i.e. buying and selling of foreign currencies.
• “Tawarruq” - Used in “Commodity Murabahah” transactions where an agent is appointed by the bank to purchase certain goods (usually metals other than gold and silver) which are sold to the customer at cost price with payment made spot. The customer then appoints the bank to sell the goods to another agent at a marked up price but payment is deferred.
• "Ujr" - Commission or fee charged for services rendered.
• "Urbun" (Arboon) - Earnest money which forms part payment of the price of goods or services paid in advance.
• "Wadiah Yad Dhamanah" - Savings with guarantee. It refers to a contract between the owner of the funds (depositor) and the Bank for safe-keeping purposes and the bank, as trustee, guarantees the repayment of the whole amount of deposits, or any part thereof, upon request.
• "Wakalah" - Agency contract. It refers to the appointment of an agent who is authorised to act according to the term of the agency.

Islamic Finance - a Primer

Islamic finance, as the name implies, is finance based on Islamic laws and norms and is a subset of Islamic economics. The principles of Islamic economics are sourced from the two main sources of Shariah, the Quran and Hadith (sayings of the Prophet pbuh). Contrary to Adam Smith’s theory of self interest, Islamic economics subscribes to the policy of ‘prosper thy neighbour’.

The Western model of finance is based solely on monetary transaction where the bank acts as the middleman between those with excess funds (depositors) and those in need of funds (borrowers). The structure of Western banking is that of a lender-borrower, exchanging money for money. The price of money is interest rates and the determinant of the price is the risk associated with ability of the borrower to repay. The utilisation of the proceeds is of no concern of the bank, only the timely repayments of the loan. Hence, the success of the business does not matter to the bank for as long as loan repayments are met by the borrower. The bank does not assume any risks associated with the utilisation of the funds, even if the economy turns into a recession, the borrowers are still contracted to repay the principal and interest back to the bank within the stipulated period. Failing this will result in further monetary penalty, compounded over time.

Islamic and Western (conventional) finance is akin to Petrol and Diesel engines; they run on totally different platforms. Using the wrong fuel would be very detrimental to the engines. Therefore, how it is conducted; the mechanics and modus operandi, pricing, risk management, repayment, recourse, transaction documentation and marketing and sales must conform to the basic Islamic principle of just and equity.

The most significant difference is the basic concept of Islamic finance – risk sharing partnership instead of a borrower-lender relationship. What this means is that all transacting parties must enjoy equal benefits from the transaction and in a case of a loss, all must share the loss equally. The transactions must be conducted in such a way that none of the parties have an unfair advantage over the others.

Being just and equitable does not mean at the expense of profits. Islamic law requires debts to be paid, contracts to be honoured and promises to be kept. However, there is also a need to be compassionate, when the debtor is facing financial distress, it would be the duty of the creditor to understand and not make matters worse. An alternative arrangement must be made to ensure the debt is repaid. Loans per se are not an Islamic financial instrument. Borrowing and lending money is not encouraged unless in times of distress. Debts or obligations to pay only arise in trade transactions where the payment terms are deferred. The only type of loan recognised under Islamic law is the “benevolent loan” or qardhul hasan. This loan does not carry any interest rate nor does it carry a fixed repayment period. The debtor is expected to repay as soon as he is able and the creditor is not encouraged to demand repayment. The elements of trust and responsibility play a fundamental role in this transaction.

Money according to Islamic law is not a commodity. They are merely the intermediary to facilitate a transaction and therefore on its own cannot be traded.

The main characteristics of Islamic finance include;

• Prohibition of interest (riba / usury).
• Prohibition of elements of gambling and uncertainty.
• Partnership instead of lender-borrower relationship.
• Full transparency and disclosure
• Transaction must not involve prohibited goods and services such as pork, alcohol, gaming, armaments.
• Profit and loss sharing instead of fixed returns on the part of financiers.
• Shariah compliant asset backed financing.
• No short selling, i.e. full ownership must be obtained prior to selling.

Islamic finance can be used to facilitate any kind of financial transactions such as;

• Project financing
• Working capital financing
• Leasing
• Trade financing
• Liquidity management
• Sukuk (investment certificates)
• Takaful (insurance)
• Mortgages
• Asset management
• Hire purchase
  

Common contracts / concepts used in Islamic finance include:

• Murabahah (cost plus sales)
• Ijarah (leasing)
• Musharakah (joint venture)
• Mudharabah (trustee profit sharing)
• Istisna (project financing)
• Salam (forward sales)
• Wadiah (trustee safekeeping)
• Wakalah (agency)
• Kafalah (guarantee)
• Hibah (gift)
• Ibra (rebate)
• Qardul Hassan (benevolent loan)
• Tawidh (penalty)
• Ujr (fee)
• Wad (promise)
• Rahnu (collateral)