Introduction

Key conditions for validity of contracts

Integrity of contractual arrangements

Status and use of promises

Conclusion

INTRODUCTION

As with conventional trade and finance, Islamic finance recognises trade between two parties by virtue of binding agreements or contracts. The reasons for devoting a chapter to the topic of sharia-compliant commercial contracts are as follows:

1. Such contracts will be a feature of all transactions pertaining to sharia-compliant trade. It is therefore essential to understand the principles underpinning Islamic contract law.
2. While there are many similarities between modern-day English commercial law and sharia principles, there are some differences or areas where the sharia has additional requirements.
3. The sharia places great emphasis on clear and unambiguous agreement between two contracting parties and encourages evidence of this agreement in writing, as demonstrated by the following extract from the Qur’an:

O you who believe! When you deal with each other in transactions involving future obligations in a fixed period of time, reduce them into writing ... but for a transaction which you carry out on the spot among yourselves, there is no blame on you if you reduce it not to writing. But take witnesses whenever you make a commercial contract.

(Chapter 2, verse 282)

This chapter will complete the section of the book aimed at equipping the reader with the key concepts and principles required to understand the practice of Islamic finance.

KEY CONDITIONS FOR VALIDITY OF CONTRACTS

The Arabic word for contract is aqd (plural: uqud) and it literally means ‘to bind’. Islamic commercial law classifies contracts into two broad categories: bilateral contracts and unilateral contracts.

Bilateral contracts refer to the usual situation found in commerce and trade – there are two contracting parties agreeing commercial terms pertaining to the subject matter being transacted. Unilateral contracts refer to a situation where one party has decided to confer some benefit, unilaterally, on another party. Usually it is a gratuitous gesture – for example, inheritance given through a will or a donation, e.g. office space free of charge by a building owner. Due to the gratuitous nature of such contracts, the conditions required for bilateral contracts (discussed below) do not apply; indeed, there can even be gharar, the principle of uncertainty set out in Chapter 3.

To recap, a sharia-compliant trade or transaction must be free from contractual uncertainty and ambiguity in the key terms and subject matter of the underlying deal. This is because bilateral contracts require that both parties are protected by clarity in contract terms and by clear principles that need to be adhered to, while with unilateral contracts, one party is conferring benefit to another of their free will and hence there is no need to protect the parties involved.

We will be focusing on bilateral contracts. For such contracts to be valid, they need to meet some basic criteria.

Contracting parties

The respective parties to a contract must be:

• sane: both parties must be mentally sound at the time of contracting with each other;
• mature: the parties must be old enough to understand the implications of their actions. In Islam this is usually taken to be when a person reaches the age of puberty. As we know, English law will usually define a particular age to enter into certain transactions, e.g. a person cannot own a property in the UK until the age of 18. This is the approach adopted in most Muslim countries, i.e. defining a particular age, usually 18, to provide certainty in law.

Subject matter

We discussed the need, in the last chapter, for the subject matter to be free from gharar or uncertainty. The conditions in Islamic law with respect to the subject matter of a contract are required to broadly protect the buyer and to mitigate the risks of the seller not being able to complete his side of the bargain. The following are the general conditions attached to the subject matter of a contract.

Valuable/permissible

The sharia must recognise the item or service being transacted as having value/being permissible. Anything that Islam prohibits, such as alcohol and pork, would not be considered to have value and therefore any contract based on such subject matter would be invalid.

Existence

The subject matter must be in existence at the time of entering the contract. There are a couple of exceptions to this condition, which will be discussed fully in Chapter 5. In brief, they are istisn’a (this refers to the sale of an item that still needs to be manufactured or constructed) and salam (this refers to the sale of fungible items and allows payment by the buyer prior to delivery of the goods; this was permitted originally for farm produce whereby farmers could get paid in advance of producing their crops), both of which allow for flexible payment terms before the item being purchased has been manufactured or delivered.

Ownership

The Prophetic saying ‘do not sell what is not with you’ is often cited as evidence of the principle that a seller must own what they are seeking to sell. Therefore the practice of ‘short selling’, whereby shares, for example, are sold before being legally acquired, is not allowed. The conventional method of short selling is borrowing a stock and selling it on the market (clearly the borrower does not own what they are selling). The short sale is made with the expectation of the price going down, which would allow the investor to buy the shares at a lower price in order to return the shares borrowed earlier and make a profit. This has been expressly forbidden by AAOIFI’s sharia standard 21. Some of the flexibility afforded by conventional short selling has been achieved in a sharia-compliant way by using a non-refundable deposit by the buyer (called arbun) without them having to pay fully for the shares. However, this only enables the buyer to benefit from any upside in the shares by the time the full amount is due – as the buyer cannot sell on the shares until they have fully gained ownership of them.

Deliverability

The seller must have the ability to deliver the subject matter to the buyer, allowing the buyer to take possession at the time of sale. Again this is to protect the buyer from acquiring something they cannot take possession of. There is scope for possession to take place constructively as opposed to physically, for example a car is sold today whereby the buyer can pick it up from a specific location any time in the next week. The car, from today, is in the ownership and constructive possession of the buyer. Accordingly, the risks associated with owning the car pass to the buyer from today and they can even sell the car onwards from today. The parties to a sale can even mutually agree to delay the delivery of the subject matter to a later date.

Offer and acceptance

There has to be an unambiguous acceptance by the buyer of the terms offered by the seller or vice versa (either way both parties have to agree terms unequivocally without doubt). This requires agreement at a particular point in time during a session when the parties are together (physically or remotely) negotiating terms. If one party made an offer and the other party left the room, no agreement could be assumed and subsequent sessions would commence by assuming that no offer was made or agreement reached.

Offer and acceptance can be evidenced verbally, in writing, by a handshake or any other way the relevant parties agree as long as it is clear and understood.

If the above three components of a contract, namely:

1. contracting parties;
2. subject matter;
3. offer and acceptance

comply with the principles stipulated, a valid bilateral contract results between the parties. Any conditions attached to a contract, e.g. the requirement of collateral, are generally permissible as long as:

• they are mutually agreed by the contracting parties;
• they are reasonable, e.g. a car buyer stipulates that he/she wants the car to be serviced prior to executing the purchase. However, a condition such as ‘I will buy your car for £x if you buy my house for £y’ is an unreasonable condition and would not be valid;
• the conditions are in line with generally accepted market practice, e.g. there is a one-year manufacturer’s warranty on electrical goods purchased.

It is worth noting that there is a general principle in sharia to abide by the laws and customs of the country one lives in, as long as there is nothing in those laws and customs that is expressly in contradiction to sharia principles.

In the next chapter we will start looking at the practice of Islamic finance by discussing the various types of bilateral contract used in the industry. Broadly, these bilateral contracts fall into the following categories:

• sale of goods or services;
• leasing of assets;
• partnership agreements between two or more parties;
• security contracts such as providing collateral;
• agency contracts, i.e. becoming the agent of a principal in return for remuneration;
• providing services of safe custody, e.g. a bank charging a fee for the safe custody of the monies held in a current account.

Options with contracts

The sharia seeks to protect consumers/buyers with certain options that they can exercise, which include the:

• option of inspecting the goods/quality – if the goods on inspection do not measure up to what was sold by description and/or quality, then the buyer has the right to return or not go ahead with the transaction;
• option of defect – in a similar way the buyer has the right to return the goods and claim a refund if they prove to be defective;
• option to change mind – buyer and seller have the right to change their mind before the execution of the contract – similar to a ‘cooling-off’ period;
• option of price – the buyer has the right to a fair price within the market range.

INTEGRITY OF CONTRACTUAL ARRANGEMENTS

In general, contractual arrangements that seek to subvert the sharia prohibitions and principles would be invalid. Indeed, the sharia has specifically banned certain contractual arrangements which could be used to overcome sharia prohibitions, as outlined below.

‘Back-to-back’ sales between the same parties

The sharia prohibits back-to-back sales of the same object between the same contracting parties, the second sale being contingent upon the first. This is referred to as ‘bai al-inah’ in Arabic.

For example, I sell my bike to Adam for £500 cash now and simultaneously Adam agrees that once he owns the bike, he will sell it back to me for £600, giving me three months to pay. This has the same effect of giving me a cash loan of £500 on interest, whereby I have to pay £600 in total in three months’ time. Hence, although the two individual sales are halal (permissible) in their own right, as a combined set of arrangements it is open to abuse to mimic the effect of an interest-bearing loan and therefore prohibited.

Prohibition of contingent contracts

The Prophet Muhammad forbade combining two contracts into one where one of the contracts is conditional upon the other. The AAOIFI standard on contract combination states the following:

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

Again the overriding reason for this prohibition is that by combining contracts such that one is contingent on another, the arrangement can be manipulated to subvert sharia principles. A good example of this is an extension of the back-to-back sales example between the same two parties – if one sale is contingent on the other, the effect is to combine the two contracts to subvert the prohibition of interest.

STATUS AND USE OF PROMISES

A promise in Arabic is called a ‘wa’d’. A unilateral promise is where one party promises to do something in the future, e.g. I promise to sell my car to Fred for £1,000 in one month’s time. From an Islamic viewpoint, keeping one’s promise is regarded as very important and not to do so is regarded as immoral and a sign of hypocrisy. The question then arises, are promises enforceable? The OIC’s Islamic Fiqh Academy has ruled that a promise in commercial dealings is enforceable subject to the following conditions:

• The promise is one-sided.
• The promise must have caused the person to whom the promise was made to incur some actual liabilities or losses.
• If the promise is to purchase something, then the actual sale must take place at the appointed time with the exchange of offer and acceptance. The mere promise itself should not be taken as a sale.
• If the person making the promise backs out of the promise, the court may force them to either fulfil it or pay the actual damages to the person to whom the promise was made. Damages will include actual liabilities and not opportunity costs.

The use of promises is very important and widespread in the practice of Islamic banking and finance. Without them many transactions we see today may run into problems from a sharia point of view.

An important example is in the area of home finance. The prevalent form of sharia-compliant home finance involves the consumer renting the house from the financier, and then as a second step buying the house from the financier. If this arrangement was structured as two contracts whereby one was contingent on the other, then as we have seen, this would be prohibited. However, if the purchase of the house was a promise made by the consumer in addition to the rental agreement, then this would not fall foul of the contingent contract prohibition.

As long as these promises are enforceable, it allows banks and other product providers to reduce the level of risk and uncertainty with transactions. Concerns have been expressed about the fact that legally binding promises in substance are very similar to contracts and hence the danger is that the prohibition of contingent contracts can be subverted through the guise of using promises. Proponents of these structures would point out that in substance both parties to the transaction are fully aware of their respective commitments and that there is no intention to manipulate or circumvent sharia principles but a desire to have a structure that allows the bank to play its role as a financier while having some comfort that its customer will honour the original intention and commitment to acquire the property fully.

It is worth noting that two unilateral promises made by two parties regarding the same item would effectively amount to a forward contract, i.e. a contract concluded at a future date. From a sharia perspective, such an arrangement is regarded as neither a valid contract nor binding/enforceable promises.

CONCLUSION

This chapter presents the basic framework and principles of Islamic contract law. The purpose behind the sharia rulings is to protect the buyer and minimise the chances of contractual disputes.

The approach adopted in this book is to present the mainstream and most accepted viewpoints. A key point of reference has been the position adopted by AAOIFI on the topics covered in the book. AAOIFI is a leading self-regulatory body for the Islamic finance industry – it comprises reputed sharia scholars and professionals from around the world and issues sharia and accounting standards (to complement conventional accounting standards) for the Islamic finance industry.

However, it is important to appreciate that underlying many of the topics in Islamic finance is a healthy debate and discourse among scholars and practitioners about the application of traditionally understood sharia principles to modern-day financial practice. An example is the traditional and mainstream view that futures contracts are not allowed as both countervalues – the price and the commodity/subject matter – are exchanged in the future. However, Dr Mohammad Hashim Kamali, Professor of Law at the International Islamic University Malaysia, argues in his book Islamic Commercial Law: An Analysis of Futures and Options (2001) that prohibiting futures on this basis is not necessarily the right conclusion. He argues that:

1. There is a principle in sharia that all commercial activity is permissible unless there is a clear prohibition; in the case of futures it is a relatively new phenomenon and has no clear parallel in traditional Islamic law.
2. Furthermore, futures trading is economically beneficial because it facilitates better production planning in the agriculture and agro-based industries. In these sectors it is also utilised as a hedging device against violent movement in the price of commodities over a period of time which, in the case of agricultural produce, stretches over crop seasons, often from sowing to harvesting time. Futures trading is also used by food processors, merchants and manufacturers as a means of ensuring sales and purchases in advance, without them having to face the uncertainties of marketing at a later occasion: that is, after harvesting or production, as the case may be.

Professor Kamali makes the specific point that futures trading can be allowed if it is used for the beneficial purposes of better planning, etc. – this meets the overall objective of the sharia to enhance the welfare of society (as mentioned in Chapter 1 – the maqasid of the sharia as defined by Imam Ghazali). He makes the general point that it is imperative for scholars and those charged with defining what is permissible and what is not (such as sharia standard-setting bodies like AAOIFI) to not dogmatically apply sharia rules, but to think about the objectives of sharia in their deliberations.

It is beyond the scope of this book to look at all the areas where there are such debates; the idea of this chapter is to give the reader the mainstream, widely accepted fundamentals underpinning Islamic contract law. However, it is important to be aware of the bigger picture and indeed, a recurring theme in this book is the growing view that the Islamic finance industry needs to do more than merely produce products which prima facie meet the sharia rulings but to be a more substantive value proposition by defining itself more in line with the objectives of the sharia – namely, to protect and enhance the interests of society at large.

This brings us to the end of this chapter and the first section of the book aimed at establishing the principles and foundation underpinning the practice of Islamic finance. In essence, all commercial trade is allowed as long as it does not violate the key prohibitions of interest, contractual uncertainty and impermissible activity; the trade must be underpinned by real assets or services and the conditions required for valid contracts must be met. We now have the basic framework and understanding to look at the industry in practice – the key transaction types, specific instruments such as sukuk and particular components of the industry such as Islamic investments/asset management and Islamic insurance (takaful).