NEW HORIZON July-December 2014 issue.
Islamic Law in General
In understanding Islamic finance, it is important to start with a brief overview of Islamic law, because Islamic finance is the application of Islamic law to financial and commercial transactions.
1. Islamic law (Shari’ah) is derived from the Qur’an (Islam’s holy book) and the Sunnah (actions and sayings of Prophet Muhammad).
2. The interpretation and application of Islamic law is known as fiqh.
3. There are four mainstream schools of Islamic jurisprudence within the Sunni tradition: Hanafi, Maliki, Hanbali and Sha‘afi.
4. Each of these schools has certain nuanced differences in their respective approaches to interpreting Islamic law. Since Islamic law has developed over 1,400 years, there is not always uniformity in application or interpretation of the governing principles.
5. A third element in Islamic law is ijmaa, or scholarly consensus, in interpreting the Quran and Sunnah. The lack of uniform consensus among scholars voids ijmaa in a particular area of law, thereby allowing for the existence of diverse but equally valid legal holdings. As is the case with many areas of Islamic law, Islamic financial transactions can take many forms depending on the school of thought employed.
This paper will not delve into the different applications of Islamic law to financial transactions under each school of thought. Instead, it will focus on the most common financial structures currently in use. Islamic finance, as a viable alternative to traditional finance, grows out of two major shifts.
• First, Islamic finance has developed in response to the globalisation of financial markets and the adoption of Western financial institutions throughout the world‘s economies. Institutional and contractual practices originating in the Western world have embedded themselves in the economies of the Muslim world.
• Second, Islamic finance is part of a larger trend that began in the 1970s. That trend is the shift towards reintroducing Islamic law in many parts of the Muslim world. Despite this trend, laws and legal institutions derived from Western legal systems remain the dominant modal system.
One of the challenges in developing and applying Islamic law in a wholly Western financial system is that many of the common financial instruments have no counterpart in Islamic law. So, while classical Islamic law may offer a complete body of commercial and contract law, it is important to note that the current Western system of commercial and contract law does not neatly fit into the pre-existing scheme. Thus, Islamic scholars are required to evaluate and determine which Western modes of financial transactions are acceptable and how Islamic law can be interpreted and applied to modern financial instruments to bring them within the purview of Islamic law. As the demand for certain types of financial products grows, Muslim scholars will be pressed to develop Islamically acceptable alternatives. Islamic finance has become the most innovative element of contemporary Islamic law.
According to Frank Vogel, a former Professor at Harvard Law School and a leading expert on Islamic Law generally, Islamic financial analysis can be broken down into two approaches. First is the Islamic law aspect, which aims to characterise modern financial behaviour in terms of Islamic legal rules. This approach accounts for Islamic law‘s concern with individual action and the welfare of the individual as a task delegated to the state.
The second approach is steeped in Islamic economics. Here, the aim is to develop Islamic economies as a viable alternative to the Western economies that predominate. In order to be viable, the Islamic economies must produce more beneficial outcomes than do their Western counterparts. In shaping this new economic theory, economists would, for example, look to Islamic moral principles and legal institutions (e.g., requirements on giving charity). However, since this approach is still in developmental form, Islamic rules ground Islamic finance without much regard for economics. Furthermore, many Muslims are willing to pay a premium to ensure that their business transactions are in line with Islamic principles without having as much concern for profit-maximising outcomes.
Islamic Contract Law
In order to understand modern Islamic law, a brief primer on Islamic contract law is necessary. Islamic contract law centres around rigid nominate contracts that do not have counterparts in conventional finance. Unlike the ideal of freedom of contract, a basic underpinning of the objective theory of contracts adhered to in common law jurisdictions such as the United States, there is no generalised theory of contracts in Islamic law. In particular, the freedom to contract will always be limited by Islamic legal rules that prohibit all transactions involving interest, or riba. Thus, even when the Ottomans introduced a civil code in the 17th century, a general theory of contract was not developed. Instead, jurists developed a number of nominate agreements with their own sets of rules. This structure of nominate contracts grew out of pre-Islamic contracts that were common in the time prior to the 6th century. These nominate contracts were studied and amended to comply with Islamic principles. A number of mechanisms to validate contracts falling outside the nominate scheme were also developed by jurists. An absolute right to contract, however, still remains undeveloped since contracts that violate prohibitions on riba or gharar (uncertainty) cannot be valid.
Contracts under Islamic law were necessary for a limited type of contractual transactional forms under which business was conducted. These contracts led to the development of a set of rigid, trade-based contracts that lay the foundations for contemporary Islamic contracts to be used and developed in the Islamic finance industry.
The prototypical contract was the contract of sale, or bay’. The basic form of the sale contract transferred ownership of some lawful, fixed property immediately deliverable for a determined price. All other contracts derived their form by analogy to the sale contract because Islamic jurisprudence dealt with that method in great detail.
Some typical contracts in Islamic finance included those for loans, gifts, sales, sales at a mark-up (murabaha), leases (ijara), joint ventures and partnerships (musharaka, mudharabah), manufacture and construction contracts (istisna) and agency contracts (wakalah). These contracts are instruments currently in use by Islamic banks and conventional banks offering Islamic products.
The primary focus in this paper will be on mudharabah and wakalah contractual forms. Islamic insurance companies typically use wakalah (agency) and mudharabah (joint-venture partnerships) contracts or a mixed model of a wakalah and mudharabah scheme.
A wakalah contract allows for full representation in most contractual arrangements. The contract can be gratuitous, where the agent provides management without compensation or fee-based. The contract, however, is revocable at will by either party. There are certain rules that militate against the possibility of revocation, but the authority of the agent depends on continued consent from the principal. In the insurance context, this allows an agent to act as manager under a fee-based arrangement.
Another commonly used contract is a murabaha contract. A murabaha contract is essentially the sale of a good with a certain mark-up built into the price. This mark-up can reflect any cost the seller may encounter in the deal. An istisna contract is very
similar to a construction loan. It is a payment arrangement between a buyer and seller for a particular good spread out over a period of time, such as the payment for the manufacturing of a house over the period it is being built. Ijara contracts parallel traditional leases. This kind of contract can either be a lease with a purchase option or a lease of an item that will revert back to the owner upon termination. One key difference between a traditional and Islamic lease is who has responsibility over upkeep of the item. In a traditional lease, the responsibility lies with the lessee; however, in an Islamic lease the responsibility falls to the lessor.
A second key contract form in Islamic insurance is a mudharabah arrangement. A mudharabah contract is an equity investment that is a profit-sharing agreement between two parties. In this type of arrangement, one party supplies the capital, while the other supplies management oversight and entrepreneurial skills. Profit is shared amongst the parties according to an agreed-upon, predetermined formula and risk is carried by each party. The risk carried is in line with the type of investment, money or time each party provides.
Finally, an equity arrangement between two or more parties is known as a musharakah contract. Here, each party contributes both managerial expertise and money according to an agreed-upon formula.
While there is no general theory of contract law, there are certain conditions that agreements must fulfil. In general, there is the requirement of good faith that is derived from the Qur’an: [Fulfil the covenant of God when you have entered into it, and break not your oaths after you have confirmed them ....] Islamic finance scholars have interpreted this verse and many others to read an element of good faith into contractual relationships. Good faith, honesty, disclosure, truthfulness and sincerity make up the moral attributes of a contract. Beyond these requirements, there are three key prohibitions that should not be part of any contract.
The first is a prohibition on interest. While some scholars debate the permissibility of interest in financial transactions, the vast majority of traditional scholars agree on its total prohibition. The prohibition against interest can be found in both the Qur’an and Sunnah. A Qur’anic verse on this point states, ― Allah has permitted trade and has forbidden [interest]. This prohibition‘s importance is evinced by the verses directly addressing the impermissibility of interest. This concept sets Islamic financial transactions apart from conventional business practices. In conventional finance, interest is part and parcel of the structure of most transactions.
The second obligatory prohibition is that against uncertainty or gharar. A well-known saying of the Prophet elucidates this point, stating: ― whoever buys food, let him not sell them until he has possession of them. This rule of fiqh voids the sale of nonexistent or uncertain objects, even if the relative risk is very low. This relates in a sense to the final prohibition that forbids gambling or maysir in Islamically compliant contracts. The Qur’an states, ― intoxicants and gambling ... are an abomination ... eschew these such that ye may prosper. The reasoning for this prohibition stems in part from the idea that gambling may create enmity amongst people.
These prohibitions have broad implications and are equally applicable to insurance contracts. Insurance typically involves risk, uncertainty and interest and therefore it poses a unique challenge to Islamic law. Under traditional Islamic law, the game-oriented risk profiles of insurance would not meet the requirements of a legally-valid contract between parties. In order to work around this inherent obstacle, Islamic scholars have taken a somewhat unique and innovative approach to insurance, which will be explored in the next section.
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