CLASSIFICATION OF ISLAMIC FINANACIAL CONTARACTS

INCEIF The Global University in Islamic finance

Kuala Lumpur, Malaysia MIFP Shari’ah Aspects of Business and Finance

Classification of Islamic Financial contracts

Semester Jan 2015

Name: Osman Abdulkadir Said Matric No: 1500131 1

Abstract Islamic financial contracts are classified into different ways. They are classified according to the principles used. Contracts or Islamic financial contract to be legal and enforceable they must conform to the shari’ah rules and principles. There certain conditions that make the contract valid and these valid contracts are enforced at the courts in case any breach of contract terms and conditions. The Islamic financial contracts are classified into sales- based principles, fees-based principles, lease-based principles, profit sharing principles and supporting principles.

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Objectives of the research 1. To identify the Islamic financial contracts 2. To understand the types of Islamic financial contracts 3. To illustrate the elements invalidate the Islamic financial contracts

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Table of contents No.

Topic

Page No

1.0

Introduction……………………………………………………………………………… 5

2.0

Islamic Financial contracts………………………………………… …………………...

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2.1

Elements of Financial contract…………………………………………………………..

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3.0

Types of Islamic financial contracts…………………………………………………….

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3.1

Sale-based Contracts…………………………………………………………………….. 7

3.2

Lease-based contracts …………………………………………………………………

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3.3

Fee-based contracts ……………………………………………………………………

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3.4

Profit-sharing based contracts…………………………………………………………… 9

4.0

Elements invalidate the Islamic financial contracts……………………………………

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5.0

Conclusions ……………………………………………………………………………

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Reference ……………………………………………………………………………….

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1.0 introduction Islamic financial institutions or banks are not institutions that produce a financial contracts or instruments on their own free will rather they are governed by Shari’ah law and shari’ah approved contracts. All the institutions that accept to operate in Islamic business environment either financial institutions or non-financial institutions must comply with the Shari’ah principles and rules. Islamic banks accept deposit, make financing and give investment on projects that improve the economic at large and the society well-being. All the functions of the Islamic financial institution must be in compliance with the Islamic commercial law of Mu’amalat. Producing the Islamic financial product needs to undergo diverse processes and procedures of structuring. The most important is the conformity with the Shari’ah principles otherwise the product wouldn’t be accepted as Islamic product; and the contract would be invalid in the Islamic eyes based on both primary and secondary sources of Shari’ah. Islamic financial contracts are contracts conform to the shari’ah principles. These contracts are to be free from any invalid act that invalidates the financial contract. The principles that govern the Islamic financial contracts are sourced from the Islamic financial sources both primary and secondary. The Quran and the Sunnah are primary sources while the ijma and qiyas and some other sources are secondary sources. While some of the Islamic scholars add the last two ijma and qiyas to the primary sources. In the Islamic financial contracts must be interest-free or riba which is the main income source for the conventional financial and nonfinancial contracts. In Islamic financial dealings it’s intolerable to accept riba and all other element that nullify the contract. Riba is a concept in Islamic financial institutions that refers to charged interest. It is forbidden under Sharia, Islamic religious law, because it is thought to be exploitive. Depending on the interpretation, riba may only refer to excessive interest; however to others, the whole concept of interest is riba, and thus is unlawful. Despite riba there other elements that can invalidate the Islamic financial contracts among these elements is gharar which means uncertain in a contract. Gharar is an Islamic finance term describing a risky or hazardous sale or service, where details concerning the sale or service performance item are unidentified or uncertain. Gharar is generally prohibited under Islam, which unambiguously prohibits trades that are considered to have disproportionate risk due to uncertainty. In the Islamic financial contract like other non-financial contracts it must be in the border of the shari’ah. To be the contact in compliance the Islam shari’ah principles means the contract is halal. In Islam, Halal is an Arabic term meaning “lawful or permissible” and not only encompasses food and drink, but all matters of daily life. On the other; hand non-halah or haram is an Arabic term meaning 5

“Unlawful or impermissible”. The Islamic financial contract must adhere to Islamic contract principles and governance. 2.0 Islamic Financial contracts an agreement with specific terms between two or more persons or entities in which there is a promise to do something in return for avaluable benefit known as consideration.The existence of a contract requires finding the following factual elements: a) an offer; b) an acceptance of that offer which results in a meeti ng of the minds; c) a promise toperform; d) a valuable consideration (which can be a promise or paymen t in some form); e) a time or event when performance must be made(meet commitments); f) terms and c onditions for performance, including fulfilling promises; g) performance. 2.1 Elements of Financial contract In any financial contract must conform to or have the following elements in order the contract to be valid and permissible: a. Offer There must be a definite, clearly stated to do or perform something. The offer is made by one of the contracting parties. The individual that starts is called the offeror and the other party is called the offree. Sometimes the offer can be implied. b. Acceptance The offer can be accepted or rejected. Only what is offered can be accepted exactly as offered without condition. If any new terms are suggested this regarded as a counter offer that can be accepted or rejected.

Acceptance can be given verbally, in writing, or referred by action which clearly indicates

acceptance. c. Intention of legal consequences A contract requires that the parties intend to enter into a legally binding agreement. That is, the parties entering into the contract must intend to create legal relations and must understand that the agreement can be legally.

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d. Consideration In order for a contract to be binding it must be supported by valuable consideration. That is to say, one party promises to do something in return for a promise from the other party to provide a benefit of value (the consideration). For example one part gives the subject matter (the thing to be sold) and the other part gives the money. 3.0 Types of Islamic financial contracts There are different types of Islamic financial contracts, in the following sections. It is being illustrated the various types of Islamic financial contracts. 3.1 Sale-based Contracts A contract of sale can be divided into several divisions based on the perspective from which the division is made. It is important to really understand some of these classifications as some modern Islamic financial instruments are actually extensions of these classifications. a. Musawamah contract Musawamah is one of the sales-based contracts that the financial contracts of Islamic financial institutions. Musawamah contract, the seller and the buyer each one exercises his power. The most common type of Islamic trade where the selling price of a commodity is negotiated between the seller and the buyer, with the cost price being unknown to the latter. Bai al salam is one of sales-based contracts, it is a Musawamah contract. Bai al salam is is a contract in which advance payment is made for goods to be delivered at a future date, following Islam and Islamic shari’ah. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute. This contract has a Musawamah characteristics, the buyer and the seller of the subject matter negotiates the price of the product and the buyer has no the right to enforce the seller to reveal the cost of the product. Revealing the cost of the product is not a condition in this contract and all other Musawamah contracts.

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b.

Amanah contract

Amanah contact or trust sale is a sale that the seller must disclose the cost of the product produced or the cost the product purchased. There are many types of such contract since this piece of writing is limited; murbahah which is one of the Amanah contracts is exemplified. Murbahah is a particular kind of sale, compliant with shari’ah, where the seller expressly mentions the cost he has incurred on the commodities for sale and sells it to another person by adding some profit or mark-up thereon which is known to the buyer. As the requirement includes an "honest declaration of cost", Murbahah is one of three types of bia-al-Amanah (fiduciary sale). The other two types of bia-alAmanah are tawliyah (sale at cost) and wadiah (sale at specified loss). 3.2 lease-based contracts Another way of classification of Islamic finance is lease-based contracts. Lease based contracts is one of the contracts that prevail in the Islamic financial institutions. In this contract, the financial institution lease its own asset to a leasee, the lessor, the Islamic banks earns a lease periodically mostly based on monthly. Though there are various definitions of Al-Ijarah given by the scholars of jurisprudence, they all agree that this contract is a contract on using the benefits or services in return for compensation. In our context, Al-Ijarah refers to a contract to hire, rent or lease. We see the evidence of hire in the story of Musa (Al-Qasas: 26-27) where Musa was hired by his father-in-law to provide a service. There are two main types of subjects in an Ijarah contract: 1. Tasks, where the compensation is for effort expended of skill used (by an employee or a contractor), and 2. Property, where the compensation is for the use of a property (such as a car or a house). The following features of Ijarah differentiate it from a conventional lease: 3. The lessor must own the assets for the full lease period. 4. If the lessee defaults on payments or delays payments, the lessor can’t charge compound interest. 5. The leased asset’s use is specified in the contract.

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3.3 Fee-based contracts There are contracts that contribute to Islamic financial institutions to make profits through charging of fees. These contacts are usually ancillary to the main transaction suchas BBA and mudharabah. The following two types are fee-based contracts: a. Wakalah in essence means agency. A contract of agency can be free-of-charge or with compensation. Islamic banks usually adopt the second option. For instance in a Letter of Credit granted to customer, Islamic banks generate income by imposing certain fees over the granted facility. This fee is taken as the bank acts as the agent of the customer in the trade transaction. b. Kafalah in Islamic finance is a contract of financial guarantee whereby a pledge is given to a creditor by the guarantor that the debtor will pay his debt, fine or any other personal liability. Kafalah is widely used in modern Islamic finance to secure payment from the borrower that has been

granted

financing

under

the Murabahah, Ijara, Salam, Istisna, Musyarakah or Mudharabah principles or letters of credit and documentary credits. 3.4 Profit sharing contracts There are two types of contracts based on the profit-sharing principle. They are musharakah and mudharabah. a.

Musharakah is a contract between partners on both capital and profit. The proportion of profit must be agreed upon at the time of effecting the contract. Otherwise the Musharakah is not valid. Losses in Musyarakah are shared according to contribution of capital by the partners. It is perceived that the sharing of losses does not appeal to the financial intermediaries to offer this product to the market. However

b.

Mudharabah is a partnership in which one party provides the capital and the other provides the labour or skill. The capital provider is known as Rab Al-Mal while the partner who provides skill is known as the mudarib.

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4.0 Elements invalidate the Islamic financial contracts Islamic financial contract are contract that can validate or invalidate. The contract can be valid if the contract is compliance with shari’ah rules and principles. Bearing in mind, before contracting, the contractors must be aware that the underlying subject matter is legitimate or halal, otherwise a contract is not possible. On the other hand; the contract is to be valid and enforceable there are certain conditions and principle to be fulfilled. Some of these conditions are general and some others are specific for certain Islamic contracts. 1. Riba The literal meaning of interest or Al-RIBA as it is used in the Arabic language means to excess or increase. In the Islamic terminology interest means effortless profit or that profit which comes free from compensation or that extra earning obtained that is free of exchange. Hazrat Shah Waliullah Dehlvi a great scholar and leader has given a very concise and precise definition of interest. He says, "Riba` is a loan with the condition that the borrower will return to the lender more than and better than the quantity borrowed." In Islam all types of riba in a contract is not permissible, the contract would be invalid because the one who is accepting the riba or interest is not giving any effort to earn a profit or not taking any responsibility (risk) that would be a cause of the profit. On the other side of the coin; the party that is giving out of the interest feels unfairness and dishonest. And Islam does not approve any unfair and dishonest acts. 2. Gharar Ibn Taimiyah, a leading Muslim scholar, further reasoned "Gharar found in the contract exists because one party acquired profit while the other party did not". The prohibition on gharar would require all investment gains and losses to eventually be apportioned in order to avoid excessive uncertainty with respect to a return on the policyholder's investment. Gharar is variously defined in English as „uncertainty‟ or „deceptive uncertainty‟. The Qur‟an uses the word “al-gharūr” to mean “deceptive”. Ibn Taimiyah writes that gharar exists in a contract when risktaking is combined with the devouring of the property of one party by the other (see Kamali, M. H., Islamic Commercial Law, 2000, p. 151 for a more detailed discussion of these opinions.) 10

3. Maysir Gambling is a game of chance. Formerly a game of chance played by the Arabs before Islam, Maysir came to refer to any game of chance One of three fundamental prohibitions in Islamic finance (the other two being riba and gharar). The prohibition on Maysir is often used as the grounds for criticism of conventional financial practices such as speculation, conventional insurance and derivatives. In the Islamic financial contract is not allowed to practice Maysir and other elements that invalidate the contract such as riba and uncertainty. 4. A condition in a contract Recurrent are the conditions set by a seller or a buyer when concluding a trade transaction. Accordingly, it has become a necessity to study and tackle the different kinds of such conditions, pointing out the legal and the illegal ones among them. The scholars of Islamic Jurisprudence defined a condition (of a trade transaction) as follows: "It is obligating one of the two parties (of the sale) by the other for the benefit of the latter." According to them, a transactional condition is invalid unless it is made at the time of the transaction and embedded in the transactional contract. In other words, a condition is invalid if made before or after concluding the contract.

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There are two kinds of invalid conditions:

1. The first kind is the invalid illegal condition that basically nullifies the selling contract, such as when one of the two parties stipulates another contract within the main one. For example, it is an illegal condition when a seller of a commodity makes a condition that the buyer must make him his partner in business, lend him a sum of money, or permit him to share his house, etc., or that he says, "I sell you this commodity on the condition that you rent me your home." Such a condition is legally invalid so it nullifies the original contract. 2. The second type of invalid transactional conditions is the one which itself is null and void, yet it does not nullify the contract. For example, a buyer of a commodity may make a condition that he will give it back if he undergoes loss, or a seller of a commodity may make a condition that the buyer must not resell it. Such a type of conditions is legally invalid as it violates the principle of a business contract that absolutely allows the buyer to use the (purchased) commodity in whatever manner he likes. 5.0 conclusion Islamic financial contracts have their own principles that are compliant with shari’ah rules and principles. There are conditions that validate these contracts if these pillars and conditions must not be breached. If these pillars are not followed the contract would be invalid and not proper to practice in the Islamic eyes. Islamic financial contracts are contracts conform to the shari’ah principles. These contracts are to be free from any invalid act that invalidates the financial contract. The principles that govern the Islamic financial contracts are sourced from the Islamic financial sources both primary and secondary.

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References

1. http://www.investorwords.com/15589/musawamah.html#ixzz3UpsTR2SX 2. http://en.wikipedia.org/wiki/Murabaha 3. http://www.skrine.com/islamic-finance-contracts-and-products 4. http://www.inter-islam.org/Prohibitions/intrst.htm 5. http://www.islamic-finance.com/item160_f.htm 6. http://www.islamweb.net/emainpage/articles/174331/conditions-of-trade-transactions

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