2010 September Singapore Law Gazette Use of Contracts of Sale_docx

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The Use of the Contract of Sale in Islamic

Finance General ConceptsPaul WOUTERS


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The Use of the Contract of Sale in Islamic

Finance General ConceptsPaul WOUTERS

Bener Law Office Istanbul Turkey

(excerpt from Law Gazette An official publication of the Law Society ofSingapore September 2010 full copy available at

http://www.lawgazette.com.sg/2010-09/Default.htm )

Instead of extending loans of money against interest, Islamic financecommonly uses partnerships and commercial contracts to supplyfinance. Permissible profits and social justice are the cornerstones ofan Islamic-style modern economy.

Introduction

The Shariah is not a codified book of law. Its main sources are al-Quran,1 the Sunnah,2 consensus of legal opinion ofIjma3 andanalogy or Qiyas.4 At present, there are four major schools ofinterpretation for the Sunni Muslim community, and one school for the

Shia.5

Islamic banks cannot extend financial loans with interest, since thatwould amount to forbidden Riba. Instead, they will use partnershipcontracts (mostly silent partnerships or Mudaraba and limitedpartnerships orMusharaka).

They will also use sales agreements (see hereunder),6 next to the Ijara

(similar to the conventional leasing contract)7 and Jualah (unilateralcontract promising a reward for the accomplishment of a specifiedtask) that also contain features allowing under certain conditions, pre-

The Author

From origin a Belgian lawyer

specialized in international financial

regulations and corporate consulting,

Paul WOUTERS has been resident inIstanbul-Turkey for years, where he is

counsel to Bener Law Office.

Focusing on Islamic finance and

contract law, he has introductions

from the GCC over Turkey to South

East Asia. Paul is amongst others

Member of the Advisory Board of

Islamic Finance News and consults,lectures and writes on ethical and

legal aspects with respect to the

Islamic finance sector.

He can be reached at

[email protected]

excerpt from Law Gazette An official publication of the

Law Society of Singapore September 2010

Full copy available http://www.lawgazette.com.sg


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Example 1:

Imagine a situation where the buyer asks a professional businessmanto acquire a certain asset (using his specific negotiating skills) andwhere it is agreed before the acquisition that that person will sell the

asset down to the buyer at a fixed mark up.

It is also possible that a deferred payment is negotiated in combinationwith the Murabaha. This is the situation in which contemporaryIslamic finance steps in.

Example 2:

The client informs the financier (can be an Islamic bank or otherwise)of his wish to buy an asset and his need for finance. The financieragrees to the transaction. The client promises to buy the said assetfrom the financier at a certain mark up if the latter buys (or promises tobuy) the goods. Sometimes, this is combined with a promise to sell bythe financier.

To ascertain the conformity of the asset with the wishes of the client at

the time of the acquisition, the financier will usually nominate theclient as his agent (agency agreement). The client will then also

ascertain the conformity of the asset at the time of delivery, againacting as an agent for the financier.

The client will notify the financier of the acquisition. The financier,subsequent to the transaction becomes the initial owner of the asset by

paying the supplier in cash (initial acquisition agreement). Then, hewill sell the asset down to the client, majored by the agreed upon markup (Murabaha agreement). The client will fulfill his financial dues byrespecting the installment period.

The application of the Murabaha and the combination with deferredpayment are regular practices dating back to ancient times. The usethereof on an industrial scale by contemporary banks only cameabout approximately 30 years ago with the introduction of modernIslamic banking.

The financier and the client can agree to a one-off transaction, ortransactions up to a specified limit (facility agreement). For largerbusiness transactions, a syndicated revolvingMurabahaagreement is

usually entered into. The client can buy

goods worth up to a certain amount providedhe keeps meeting the deadlines and maxima.The facility is extended by a lead manager(Islamic bank) acting on behalf of theunderlying syndicate. The duration is usuallyone to three years. Depending on theeconomical situation and the reputation ofthe client, this is sometimes fixed at five to

seven years. Longer terms are rather unusual,unless they are for real estate acquisitions.


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for a certain period. The financier owns that asset through the Sukukand earns revenue (rent or profit) during the lifetime of the Sukuk. Atmaturity, the asset is usually transferred back to the client, who will re-purchase at the agreed upon price, if not, the market price (dependingon the jurisdiction). The basics ofSukuk-issuance will be discussed in

a later article.

Cash procurement or Tawarruq

We will describe the most commonly used version of the Tawarruq asused in contemporary Islamic finance. The same frame used for theBay al-Inah may be employed here using a 4-party structure.

Example:

A good businessman could ask his financier to buy some commoditiesfrom a supplier and sell them down to him with a Murabaha, at anagreed upon profit. The businessman could then sell that commodity to

a third party for cash. He again makes a nice profit and holds cash withonly the deferred payment obligation brought about by the Murabahawith the financier. This would be a legitimate business transaction.

Shariah-compliance has been questioned in somejurisdictions when all is part of a pre-arranged 4-party setup. Here, the client approaches hisfinancier who pre-arranged the following scenariowithout any real intervention of the client.

Example:

The goods that are withheld for the intendedtransactions are commodities that have a smallspread between buy and sell prices eg, buy at

$100 and sell at $99.9, (mostly copper and thelike). The subsequent buy and sell transactions as aconsequence thereof, will only result in a smalltrading loss (of costs and profits to thecommodities traders).

The financier first buys the commodity from thecommodity seller for cash. He then sells the

commodity immediately down to the client usingthe Murabaha with a deferred payment, and withthe agreed upon mark up. The client thenimmediately sells the commodity further down to

the commodity buyer in a cash transaction. In a simple meet, sign andexchange of contracts (maybe even over coffee), the parties initiatereal cash flows and a real flow of goods from the inventory of thecommodity seller to the inventory of the commodity buyer.

The commodity traders generate a profit and fees. The financiergenerates a profit on theMurabaha and the client walks out with cash


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repayment of the sales price. In the mean time, full ownership is

transferred to the buyer, who bears the risk but cannot sell it further

on. The use of the Wafa remains contested in some circles. There also

is the Bay al-Dayn or sale / transfer of debt. If this would be to

another party then the debtor himself, it should be on the spot andwithout discount in order to avoid Riba. There also is the Bay al-

Muzayadah or sale by auction, just to name the most obvious.

7 Traditionally used formats are the Ijara Tasqhilliyah (similar to

operational leasing contract), the Ijara Wa Iqtina or Ijara Muntahia bi

Tamleek (similar to financial leasing) and the Ijara Mausufa fi al-

Dhimmah (forward lease).

8 Originally means the clasping of hands on concluding anagreement The Encyclopedia of Islam, o.c., Vol V KHE-MAHI,

Bay, p 1111.

9 The Majallah al-Ahkam-I-Adliya art 105 (Civil Code of the

Ottoman Caliphate 1877-1926).

10 The Encyclopedia of Islam, o.c., Vol V KHE-MAHI, Bay, p

1111.

11 The Encyclopedia of Islam, o.c., Vol VIII NED-SAM, Riba, p 238

for a general introduction, Abdulkader Thomas (Ed.), Interest in

Islamic economics understanding Riba, Routledge Islamic Studies,

London-UK, 2006 (146).

12 The exact interpretation of minors and the result of inability

remains debated between the different schools or mazhab.

13 A forward sale or salam is only possible under restrictive

conditions.

14 Meaning under his control and all the rights and liabilities have

been transferred to him, including the risk of destruction.

15 Bank Negara Malaysia, June 29th, 2010.

16 Do note that an Islamic guarantee is an act of goodwill. The

guarantor cannot ask for a remuneration, but only for a nominal fee

based upon secretarial costs .17 Consult for instance: Muslim: Book 10: Hadith 3854 Abu Said al-

Khudri (Allah be pleased with him) reported Allahs Messenger (may

peace be upon him) as saying: Gold is to be paid for by gold, silver

by silver, wheat by wheat, barley by barley, dates by dates, salt by salt,

like by like, payment being made hand to hand. He who made an

addition to it, or asked for an addition, in fact dealt in usury. The

receiver and the giver are equally guilty.18 Regular exploitation costs such as salaries and rent cannot be

charged.

Documents

2010 September Singapore Law Gazette Use of Contracts of Sale_docx