Introduction

Equity-type: transactions

Mudarabah (Partnership – one party contributes capital)

Musharakah (Partnership – all parties contribute capital)

Asset finance:
Murabaha (Sale of an asset at a known profit mark-up)
Ijarah (Leasing of an asset)
Istisn’a (Sale of an item to be constructed or manufactured)
Salam (Sale of fungible item yet to be produced)

Other key transaction types:
Wakala (Agent providing services to a Principal)
Hawalah (Transferring a debt)
Rahn (Providing security)
Kafalah (Providing a guarantee)

Conclusion

INTRODUCTION

Part 1 of the book aimed to set the foundation in terms of the principles, beliefs and conceptual framework underpinning the practice of Islamic finance.

We now turn to the actual practice of Islamic finance. Before we launch into the different types of products and transactions, it is instructive to ask the question: in the absence of interest, how could financiers interact with those seeking finance on a commercial basis? The answer to this question will reveal what lies at the heart of Islamic finance.

Broadly, in the absence of interest, financiers can seek to make a return as follows:

1. They can invest their money in partnership with others in some kind of business venture. In essence, this is equity-based finance and the financier’s return will depend on the success or otherwise of the business venture.
2. They can buy assets or goods required by those seeking finance and sell them or lease them to such people, thereby making a profit/return on their investment.

We now start looking at the key transaction types found in the practice of Islamic finance. The key categories are as follows:

1. Equity-type transactions.
2. Asset finance.
3. Others – this covers other key areas including the provision of services such as money transfer, providing collateral and guarantees.

The following transaction types serve to give practitioners in Islamic finance the practical tool kit required to understand and apply the structures underpinning sharia-compliant products.

EQUITY-TYPE TRANSACTIONS

Islam looks favourably upon partnership/equity type arrangements, as evidenced by the following Prophetic statement, attributed to God, i.e. the Prophet Muhammad reported that God says:

I will become a partner in a business between two partners until they indulge in cheating or breach of trust.

The Islamic perspective is that in essence God blesses partnerships that are run with integrity and honesty.

At the heart of equity-based investment is to take commercial risk associated with owning a business. In turn this means sharing the profits or bearing the losses emanating from that business with the other owners. Equity-based transactions are not foreign to modern-day finance; indeed, the modern-day stock markets are testimony to widespread equity investment. Partnerships, private equity and venture capital finance are all built around equity finance. Islamic finance, in placing equity-based finance as a core and central feature of its offering, is not so much bringing something new to the table but rather propagating its wider use, as a profit and loss and risk-sharing model of finance, instead of interest-based finance.

There are two main models or structures used in the practice of Islamic finance in terms of equity-based transactions:

1. Where the financier puts all the capital into the partnership business venture and the other party brings the effort, know-how and skill in undertaking and running the business. In Arabic such an arrangement is called mudarabah.
2. Where all parties put capital into the partnership business venture. In Arabic such an arrangement is called musharakah.

We will now consider each of these in turn, first describing the key features of each transaction type and then looking at the application of these concepts in practice.

MUDARABAH

The key features of this transaction type are as follows:

• The capital is provided by one of the parties to the partnership. In Arabic this party is called the rabb-ul-maal, which literally translates into the ‘owner of wealth’. This party may be considered similar to a passive investor.
• The other party provides the expertise, effort and management in undertaking the business venture/project. In Arabic this party is called the mudarib – in essence, the project manager.
• The two parties, the rabb-ul-maal and the mudarib, agree a profit-sharing ratio upfront.
• Any losses will be borne by the rabb-ul-maal in terms of capital contributed. The mudarib will obviously have lost the time he put into the project. The exception to this rule is if the mudarib is proven to have been negligent in carrying out his duties, in which case he is required to compensate the rabb-ul-maal to the extent of losses incurred due to his negligence.
• The mudarib must not receive a salary from his work, as the essence of mudarabah is a sharing of profits, not a hiring of the mudarib’s labour. Most scholars agree that a mudarib can take out monies to cover his expenses such as travel and subsistence.
• The mudarabah can be arranged as ‘restricted’ or ‘unrestricted’. A restricted mudarabah refers to an arrangement in which the activities of the mudarib in terms of what he can do with the monies put in by the rabb-ul-maal are defined and restricted to certain activities. An unrestricted mudarabah does not establish any restrictions on what business activities the mudarib can undertake.

Application of mudarabah

Business or project finance

Clearly, financiers such as banks can provide business finance to entrepreneurs through this technique. It is well suited to financing start-ups as the entrepreneur has little or no initial capital but has the business idea, skill, time and desire to undertake the business venture. In modern-day banking providing business finance in this way would be seen generally as high risk, but obviously would depend on the business idea and credentials. For example, financing the expansion of a well-established business with a good track record will usually be less risky than financing a start-up bringing a completely new and untried product to the market.

MUSHARAKAH

Essentially there are two types of musharakah:

1. A business partnership/joint venture – referred to in Arabic as sharikah al-’aqd.
2. A partnership of ownership, for example co-owning a property with other parties – referred to in Arabic as sharikah al-mulk.

Business partnership into a joint venture (sharikah al-’aqd)

Within this type of musharakah, three different types of partnership can exist:

1. Partnership by capital (shirkah al-amwal).
2. Partnership by work (shirkah al-amal).
3. Partnership by face (shirkah al-wujooh).

The key features of each of these are as follows.

Partnership by capital (shirkah al-amwal)

• All partners must contribute capital to the project or business.
• The management of the joint venture can be undertaken by either or both parties, or it can be outsourced to a third party. The element of work and management is not integral to musharakah based on partnership by capital.
• The capital contributed by each party must be valued with certainty at the time of forming the partnership, so as to define the relative capital contribution by each party. Any losses will be borne pro rata to capital contributed.
• Profits will be shared according to the split agreed by the parties. For those partners who do not contribute to the management of the business/project, i.e. sleeping partners, their share of profits cannot exceed their stake in the business – for example, if a sleeping partner contributed 20 per cent of the capital, his profit share cannot exceed 20 per cent.
• The capital contributed by the respective parties can be in the form of cash or other assets such as property or land. The important thing is that an accurate valuation of the value contributed by each party is made at the time of forming the partnership.
• All assets of the musharakah are owned by the partners in line with the proportion of capital contributed by each partner.

Partnership by work (shirkah al-amal)

• Partners come together to provide services to their customers. For example, two partners provide accountancy or consulting services such that revenues generated go into one pool, from which profits are distributed according to an agreed profit-sharing ratio.

Partnership by face (shirkah al-wujooh)

• Here the partners have no initial upfront investment. The usual scenario is of the partners seeking to procure merchandise on credit which they can then sell for immediate payment. From the proceeds, they will pay the supplier(s) and share the profits in line with the pre-agreed profit-sharing ratio.

There are key features applicable to all three types of sharikah al-’aqd:

• Profit distribution must reflect the actual profits earned and not be based on a fixed sum of money or a percentage of the capital contributed.
• Profit-share ratios can be amended at a future date by mutual consent of the partners.
• Each partner is entitled to terminate the partnership with prior notice or when set conditions have been met, such as the partnership being set up for only a limited time period, the purpose for which the partnership was set up has been achieved, the partnership becoming insolvent, etc.
• If one partner wants to leave, the other partners can mutually agree to continue the partnership, buying out the leaving partner’s share.

Partnership of co-ownership (sharikah al-mulk)

This kind of partnership comes into existence either by two or more parties mutually agreeing to buy an asset together or through one or more parties gaining an interest in an asset without positively buying a share in it, e.g. inheriting property.

Diminishing musharakah

Before looking at the application and uses of musharakah, it is worthwhile discussing a related concept called ‘diminishing musharakah’. Diminishing musharakah applies to a scenario in which one party reduces their stake in a business/asset/project gradually over time, while the stake of the other party in the partnership grows in an equal and opposite way, such that by the end of a known period one party fully owns the business/asset/project.

In the next section we will see the use of diminishing musharakah in the market.

Application of musharakah

The most common application of the musharakah concept in the Islamic finance industry is that of a business partnership based on capital contribution (shirkah al-amwal):

• Business/project finance – here the financier, e.g. the bank, puts capital into projects/business in partnership with other parties, each party’s respective returns being dependent on the success or otherwise of the project/business. This can be applied to a number of scenarios: finance for a particular project, seed capital for a business, working capital finance, import finance, export finance, etc.
• Asset finance – there are a number of practical examples of financiers such as banks using the technique of diminishing musharakah to finance the purchase of assets such as property. Indeed, sharia-compliant home-purchase plans in the UK tend to be based on the diminishing musharakah concept. This is best illustrated by looking at a scenario.

Let us say a couple wants to buy a house worth £300,000. They can put in £100,000 but need £200,000 finance to buy the house. They apply to an Islamic bank that provides home finance based on diminishing musharakah. On the assumption that the bank agrees to provide the finance, the bank and the couple will buy the property together such that the bank puts in £200,000 and owns 2/3 of the property on day 1, and the couple will put in £100,000 and owns 1/3 of the property on day 1. The bank then provides the facility for the couple to buy the bank’s share over time through periodic payments. Hence the term ‘diminishing musharakah’ as the bank’s share diminishes over time.

Differences between musharakah and mudarabah

At this juncture, it is worthwhile summarising the differences between these two equity-based sharia-compliant modes of finance – see Table 5.1.

Table 5.1 The differences between mudarabah and musharakah

	Mudarabah	Musharakah
Investment	From rabb-ul-maal (‘owner of wealth’ or passive investor)	All parties contribute
Management	Rabb-ul-maal has no right to contribute to management	All partners can participate in the management
Capital appreciation	While profits are shared, all capital appreciation of the investment goes to the rabb-ul-maal	All partners benefit from the capital appreciation of the investment
Liability	Rabb-ul-maal is liable to the extent of his investment and bears financial loss, mudarib loses his efforts	All partners bear losses proportionate to their respective capital contributions

Mudarabah may most closely be compared to a passive equity investor (whether that is on a private equity basis or via public equity markets), while musharakah may be most closely compared to a partnership model.

ASSET FINANCE

As we mentioned, in a world without interest, financiers can make a return on their capital by buying goods or assets and then selling them for a profit or leasing them. We will now look at the transaction types that facilitate this.

Murabaha

Key features of murabaha transactions are as follows.

1. Murabaha refers to a sale transaction in which the seller discloses the cost price of the items they are selling and the profit mark-up they are applying to get to the sale price. However, disclosing the cost price and profit mark-up is not a general requirement of the sharia, i.e. it is perfectly legitimate for a seller to sell something without revealing the cost price and his profit margin; this is something that applies to murabaha only. If the cost price and profit mark-up are not disclosed, this type of sale transaction is called musawamah in Arabic.
2. Murabaha lends itself well to asset financing as the financier can buy assets required by the seeker of finance and then sell them on for a profit. This works because the financier can give deferred payment terms to the recipient of the finance.
3. Deferred payment terms are a common feature of murabaha-based deals for the obvious reason of facilitating finance for those seeking it; however, it is not something required for a murabaha to be valid. It is worth noting that it is permissible to sell items outside of a murabaha, i.e. where the profit mark-up is not disclosed, on a deferred payment basis whereby the goods are supplied now for payment later. In Arabic this is referred to as a bay al mu’ajjal sale (in essence a musawamah transaction with deferred payment).
4. Many assets can be the subject of a murabaha-based transaction, including property, machinery, equipment and commodities. Murabaha is not permitted in a transaction where both countervalues are items that can be subject to riba. In Chapter 3, under the ‘Prohibition of interest (riba)’ section, we discussed that in addition to paper money, six commodities (gold, silver, dates, barley, wheat and salt), and any commodity by extrapolation that could be sold by weight and had the natural ability to be used as a medium of exchange, needed to be exchanged at spot, like for like, otherwise the exchange would be construed as including riba. Hence such items cannot be used in a murabaha.

Islamic banks will typically use a technique called ‘murabaha to the purchase orderer’ when financing assets. This is a simple technique, whereby the party requiring the financing identifies the asset it wants to purchase. The bank then buys the asset and sells it on to this party at a profit mark-up known to both parties on a deferred payment basis, i.e. on a murabaha basis. This is best illustrated by an example:

Due to the fact that the financier invariably ends up with a debt owed to it, i.e. a credit risk, it is common for the financier to seek collateral/security in the form of recourse to the asset itself and/or another asset or to a guarantee.

What happens if the client of the bank wants to pay the amount owed earlier? Do they have the right to any discounts? While payment is usually deferred, the price has been fixed and the seller is not obliged to give any discounts for early settlement of any debt owed to it. The seller, at their discretion, can give a discount in respect of early payment, but it should not be a contractual obligation. This is the official ruling given by the Islamic Fiqh Academy.

What happens if the client defaults on payment? Can the bank charge more than the sale price agreed as a penalty? If the bank were to benefit by charging more than what was agreed, this excess would be regarded as riba. The mainstream practice is to charge a penalty for default that goes towards covering extra costs incurred by the bank in recovering the debt owed to it and/or the remainder/all of it to a charity.

At this point, it is worth comparing a murabaha transaction with a conventional loan on interest, as both transactions end up with a debt owed by one party to another, but one is based on a trade of real assets and the other is a money-for-money exchange – see Table 5.2.

While ‘murabaha to the purchase orderer’ is a technique widely accepted and practised in the Islamic finance industry, there have been some concerns regarding the degree to which the transaction is controlled so as to almost fully eradicate any risk to the financier, and therefore it very much mimics the economic reality of a loan, namely:

Table 5.2 Comparison of a murabaha transaction with a conventional loan

	Murabaha	Conventional loan
Underlying transaction	Sale of real asset, where seller (e.g. bank) must have actual ownership	Money for money transaction, bank does not need to take ownership of any asset
Late payment	Financier cannot benefit from any late payment penalty	Usual feature – lender stands to benefit from any late penalty charges
Early repayment	Seller not obliged to give any discounts and should not be in sales contract – can give early payment discounts out of discretion	Usual feature of loan contracts – early payment terms are stipulated

• The bank gets in place a legally binding promise from the recipient of the finance to purchase the asset.
• In reality, the bank will own the asset for only seconds/minutes, as it almost instantaneously sells on to the purchaser.
• The bank also protects its position by taking collateral/security as with a conventional loan.

I mention these points because it is important to appreciate the sensitivities around different types of Islamic finance instruments. Islamic finance is ultimately a faith-based system of finance and its long-term future as an industry is partly predicated on remaining true to the principles and values taught by the faith. In this case, murabaha is built on the principle of having an underlying trade of assets, whereby a seller has taken some risk in procuring an asset and selling it on at known profit. If the substance of that is undermined in any particular transaction, then it calls into account the credibility of that transaction.

Commodity murabaha

The point being made in the previous paragraph is relevant to a particular application of the murabaha concept, namely commodity murabaha (sometimes referred to as tawarruq). Commodity murabaha has been widely practised in the short history of the modern Islamic finance industry but has provoked widespread criticism for its artificial nature; indeed, while the transaction may technically represent a trade, the substance of the transaction has little or no regard for the asset being transacted.

Commodity murabaha has been widely used to facilitate inter-bank liquidity as well as providing personal and corporate finance. It works as follows:

• Party A has excess liquidity of, say, £1 million and would like to earn a return on it. Party B requires finance of £1 million.
• In a commodity murabaha, Party A and Party B strike a deal whereby Party A will provide finance of £1 million to Party B, based on a commodity trade as follows:
  • Party A would typically buy metals – the London Metals Exchange is used extensively for this – for £1 million. It would attain legal title to these metals.
  • It would then almost instantaneously sell these metals to Party B on a murabaha basis, i.e. in this case for £1 million plus a mutually agreed profit mark-up, let’s say £1.1 million, payable in one year’s time.
  • Party B, at this point of acquisition of the metals from Party A, becomes the legal owner of the metals and has a debt to Party A of £1.1 million payable in one year’s time.
  • Party B, requiring the £1 million, sells the metals, again almost instantaneously after acquisition, back into the market to realise the £1 million in cash.

It can be seen that in reality the underlying metal in the trade has no real commercial value to the parties but rather is used to legitimise the transaction from a sharia perspective. For many, this transaction is therefore artificial and is not in line with the underlying spirit and substance of the sharia.

Many sharia scholars have sanctioned the use of commodity murabaha on the basis that the Islamic finance industry is young and needs mechanisms to operate within the global banking and financial system – for example, inter-bank liquidity needs to be facilitated. However, they have encouraged practitioners and the industry to find other solutions so that its use can be minimised.

In April 2009 the Jeddah-based Islamic Fiqh Academy, an international body of scholars, issued a resolution criticising commodity murabaha/tawarruq as described above as a ‘deception’, damaging its acceptability in the industry.

In recent times Oman has launched its Islamic finance sector and a policy document released by the Omani Central Bank pertaining to the Islamic finance industry states: ‘Commodity murabaha or tawarruq, by whatever name called, is not allowed for the licensees in the Sultanate as a general rule.’ Instead inter-bank liquidity is facilitated through mudarabah, musharakah and wakala structures (we will discuss wakala shortly).

However, AAOIFI has approved commodity murabaha and has issued a sharia standard in relation to it (Sharia standard number 30). The sharia standard contains certain conditions for the transaction to be valid, such as an auditable ownership of the commodity by each party and separation of the purchase and sale arrangements. These conditions seek to promote as much as possible a legitimate trade between two parties. However, the issue of commodity murabaha being a ‘synthetic’ trade in which neither party is interested in deriving any utility from the underlying commodity remains.

Ijarah

The translation of ijarah is ‘to give something on rent’ and refers to two main scenarios:

1. Employment of a person whose services are purchased in exchange for wages – known in Arabic as ijarah ’ala al-ashkash (hire of persons).
2. Transfer of the right to use an asset (referred to as usufruct) in exchange for rent. This is synonymous with leasing an asset and in Arabic is called ijarah al-a’yan.

The second scenario is more relevant when it comes to the Islamic finance industry and the ijarah contract is used extensively in the market.

The key features of an ijarah contract are as follows.

1. The lessor must be the owner of the leased asset and must bear the risks and costs associated with ownership, unless damage/costs occur as a result of misuse or negligence on the part of the lessee. Hence the major maintenance and insurance of the asset is the responsibility of the lessor, while the minor maintenance and cost arising from the use of the leased asset must be borne by the lessee. For example, the landlord/lessor of a property would be responsible for ensuring the structure of the property is sound and maintained – for instance, the roof, the electricity and utilities are working – while the tenant/lessee would be responsible for paying the utility bills and ensuring the property is kept in good order in terms of hygiene and cleanliness.
2. The leased asset must be used for activities that are permitted by the sharia. Either the lease agreement will stipulate what activities can be undertaken by the lessee or the lessee needs to seek permission from the lessor for a new activity not previously agreed.
3. The rental must be fixed and known to both parties. It is permissible to have different rental levels for different periods of the ijarah at the outset of the contract. For example, the rental of a cottage by the coast may be set higher for the summer months. It is also permissible to have a variable rental linked to a particular benchmark or other method, if it is clear and agreed by both parties upfront. Where the rental is variable, then from a sharia perspective it is desirable if the lessee has the option to terminate the contract when the rent is revised, as the rental may increase significantly and/or there is a cap to any potential increase. Both of these things help to mitigate the gharar (contractual uncertainty) that can come in when the future rentals are not known.
4. It is also permissible to express the rental as a percentage of the costs incurred by the lessor in purchasing the asset.
5. Rentals are payable whether or not the lessee uses the asset, e.g. if an office is taken on rent by a lessee, the rental will be payable whether or not they use the office.
6. The ijarah must be for a specified period.
7. Total damage, destruction or significant defect of the leased asset (for example, due to fire) will give the lessee the option to void the ijarah contract. To avoid this, the lessor could try to substitute the damaged asset with another asset that gives the lessee the same benefits. Partial damage to the asset will give an option to the lessee to continue with the contract with or without a proportionate reduction of the rental payments.
8. Apart from the ijarah contract becoming void due to asset damage or destruction, the ijarah can be terminated by mutual consent of the parties. If the lessee contravenes any of the lease agreement terms, the lessor has the right to terminate the lease contract unilaterally.
9. It is not permissible for a lessor to charge the lessee a penalty on late payment with a view to profiting from that penalty. Any such penalty may be used to cover the costs of chasing/recovering the rentals from the lessee and/or donated to charity.
10. The lessee, with the consent of the lessor, can sub-lease the leased asset to a third party.

Ijarah wa iqtina (lease with acquisition)

This refers to an ijarah in which the lessee undertakes to purchase and therefore take ownership of the leased asset at the end of the lease. Another name for this type of lease is ijarah muntahia bitamleek (lease ending in ownership).

These types of ijarah contracts are often compared to conventional financial leases because financial leases will usually also involve ownership passing to the lessee at the end of the lease period.

It is worth noting that the classification of conventional leases into operating and finance leases does not exactly match the classification of ijarah contracts into ‘plain’ ijarah contracts and ijarah wa iqtina contracts. Finance leases are defined to be leases in which the risks and rewards of ownership are substantially transferred to the lessee. Hence a lease can be classified as a finance lease even if ultimately the lessee does not take ownership of the asset. For instance, if a piece of equipment has a useful economic life of five years and it is leased to a lessee for five years, this would be categorised as a finance lease because the lessee will essentially use the asset for its total economic life. From an ijarah perspective, this would be classified as a ‘plain’ ijarah.

In an ijarah wa iqtina, there is usually a unilateral purchase undertaking by the lessee to buy the asset or a unilateral undertaking by the lessor to sell the asset to the lessee at the end of the lease term. The transaction is structured in this way because the sharia prohibits one contract being contingent on another – hence it would not be permissible to agree a sale contract at the same time as the ijarah contract. The use of a unilateral promise overcomes this prohibition. The other way of overcoming this issue is by the lessor gifting the asset to the lessee once all required payments have been made.

Ijarah mawsoofa bil thimma (forward lease)

In a normal sales contract such as murabaha, it is not a valid sale to agree something today for execution in the future. Linked to this is the requirement of the seller to own what they are selling.

In an ijarah, where the lessor already owns the asset, it is permissible to conclude an ijarah contract to provide the asset on a future date. For example, a property owner can execute an ijarah contract today to rent his property to someone in one month’s time.

Rental payments may relate only to the period in which the lessee uses the asset, but it is permissible for the lessee to pay in advance, on the basis that these advance payments are set off against the rentals due for the actual use. So the property owner (the lessor) may request some of the rent due in advance today (i.e. at the completion of the contract), which can then be offset against the rent due for the actual use of the property in the first month. (For instance, if the rent agreed in one month’s time was £1,000, the property owner could request £500 to be paid now.) If, for whatever reason, the lessor fails to provide the asset for use by the agreed date, then the pre-paid rentals will be repayable by the lessor.

From the discussion of ijarah above, it can be seen that it is very similar to the widespread practice of leasing we see in the world today. However, in many modern-day leasing contracts, there will be terms of the leasing contract that conflict with the principles of ijarah. For example, leasing a car is a common scenario. Most car-leasing contracts will require the lessee to procure and bear the cost of insurance for the car. Under ijarah, the lessor as owner of the vehicle should bear this burden.

It is worth summarising the key potential differences between ijarah contracts and conventional leasing contracts – see Table 5.3.

Table 5.3 Potential differences between ijarah contracts and conventional leasing contracts

	Conventional	Ijarah
Rental payments	Contract can stipulate rental payments for periods even when asset is not useable	Can only relate to period of use by lessee No payment due if asset is not useable
Risk of destruction/loss	Often transferred to lessee	Remains with lessor, except in the case of negligence or misuse by the lessee
Insurance and major maintenance	Often on the lessee	Has to be on the lessor
Pricing	Variable or fixed	Variable or fixed (first rental has to be fixed)
Penalty for late payment	Yes	If enforced, has to be paid out in charity less directly related debt-recovery costs

Comparing murabaha to ijarah

We have now looked at murabaha and ijarah – both can be used by financiers to make a return by financing assets. Both techniques are used extensively in the Islamic finance industry. It is worth comparing the two techniques to highlight the differences and relative features of each contract type. Table 5.4 summarises this comparison.

A central point at the outset is that in terms of pricing, ijarah is more flexible. In a murabaha, once the price has been set, it cannot be changed and the financier has to work with a fixed profit mark-up, often over a lengthy deferred payment term. In an ijarah, the rental can be changed periodically and hence offers more flexibility.

Table 5.4 A comparison between murabaha and ijarah

Murabaha	Ijarah
Financier will usually require client to make a prior promise to purchase	Lessee often not required to make promise to purchase asset
Sale of asset	Sale of usufruct
Mark-up on the cost	Profit realised from rent
Fixed profit rate and price	Rent can be variable in each term
Often a short-term financing mechanism	Often a long-term financing mechanism
Cost of asset must be disclosed	Cost of asset does not need to be disclosed
Need to disclose full profit mark-up	Necessary to disclose rental
Ownership is transferred upon signing the contract	Ownership may be transferred later if ijarah wa iqtina

Application of ijarah

Asset finance

Ijarah has been used extensively to provide asset finance to individuals for such things as cars and houses and to businesses for such things as machinery, equipment and property finance.

Ijarah-based investments

Providing investors with the opportunity to invest in assets that are leased out on an ijarah basis is an attractive option. It gives investors the prospect of receiving a predictable income stream and, depending on the quality of the assets and lessee, it can be seen as a relatively low-risk investment.

Risk level

Ijarah is often used in conjunction with other sharia-compliant transaction types. For example, we saw earlier Al Rayan Bank’s home finance advert (an extract of which can be found under the ‘Musharakah’ section). It mentions the following:

Al Rayan Bank’s sharia compliant Islamic mortgage alternatives (Home Purchase Plans or HPP) are based upon the Islamic finance principles of a Co-Ownership Agreement (Diminishing musharakah) with leasing (ijarah).

Here, following the acquisition of the property by Al Rayan and the client jointly, Al Rayan will lease the asset to the client on an ijarah basis.

Capital markets

In Chapter 6 we will be discussing an investment instrument called sukuk, often referred to as an Islamic bond. These instruments facilitate raising large amounts of capital for governments and companies. Many of these sukuk will either be based on ijarah or will involve an ijarah contract. Key reasons for this include the following:

• Ijarah usually corresponds to a predictable income stream, which investors like.
• The issuer of the sukuk can legitimately commit to buying the asset back from the sukuk investors at a future date at a predetermined price. Again investors like this because it gives them greater certainty.

We will discuss this particular application of ijarah when we discuss sukuk in the next chapter.

ISTISN’A AND SALAM – EXCEPTIONS TO THE NORM

In Chapter 4 we discussed the general conditions required for valid commercial contracts as per the sharia. There were several conditions pertaining to the ability of the seller to supply the purchaser with the object of sale: namely that the object of sale must exist, the seller must own the object that they are selling, and they must have the ability to deliver the object to the purchaser upon executing the sale. All these conditions seek to ensure that the sale can be completed as agreed and mitigate the risk of the seller not being able to supply the items of sale.

While this represents the general situation, there are a couple of exceptions that apply in some specific circumstances – transactions that come under the headings of istisn’a and salam. In sharia, there are the following general principles/maxims:

• Hardship calls for simplification of the rules.
• Needs are to be treated as necessities.

The exceptions of istisn’a and salam are based on these principles in relieving potential cash flow pressure for sellers. As we will see below, in both istisn’a and salam, the sellers need time and resources to produce what they sell, and so to make it easier for them they have been allowed to receive payment in advance of supplying the items for sale.

Istisn’a

Istisn’a means ‘to request a manufactured item’.

Istisn’a is a sale contract that applies to manufactured goods or constructed items such as property. In such cases the purchaser is buying something that does not currently exist. An istisn’a contract is executed with the seller contracting to manufacture or construct a non-fungible item over a period of time in return for a price agreed now, payable as agreed by the two parties.

One of the features of istisn’a contracts is that payment terms can be very flexible – payment can be all upfront, in stages, all at the end or even after the end of the manufacture/construction phase – it comes down to what is mutually agreed by the two parties. Most istisn’a contracts in practice are based on staged payments over the period of manufacture/construction.

It is not necessary to appoint a time for delivery. However, the purchaser may appoint a maximum time for delivery beyond which it is not acceptable for the manufacturer to delay.

AAOIFI has allowed the seller to request the purchaser, subject to agreement from the purchaser, to pay a non-refundable deposit (called arbun in Arabic). This would be forfeited by the purchaser if they cancelled the contract after the manufacture process had begun.

Application of istisn’a

Finance for property developers and manufacturers

Financiers can purchase items that qualify for istisn’a such as property prior to manufacture/construction, thereby providing finance for the constructers. The financier will usually make a commercial return on this financing through the onward sale of the manufactured item at a higher price than what it paid. It usually will not wait until the asset is manufactured but will enter into a ‘parallel istisn’a’ contract while the item is being manufactured. In this ‘parallel istisn’a’ contract the financier switches role and becomes the supplier of the asset. Often the financier will pay in advance or upon delivery for the manufactured item in the first istisn’a and the customer of the financier pays in instalments after receiving delivery in the second/parallel istisn’a.

This is best illustrated by an example:

Project financing – istisn’a used in conjunction with ijarah

So far we have described a situation in which the financier enters into an istisn’a contract and then enters into a parallel istisn’a to sell on the manufactured items at a mark-up. Another possibility is for the financier to enter into an istisn’a with the manufacturer to procure and finance the asset and then enter into an ijarah with the party that wants to use the asset. In this way the financier earns its return through the rentals. These transactions are usually structured with the following two additional features:

1. The ijarah is usually an ijarah wa iqtina – that is, the lease usually ends in the ownership of asset transferring from the financier to the lessee.
2. To give the financier some return during the construction phase (which can be several years in very big projects), the ultimate lessee often pre-pays rentals during this phase. Rentals under an ijarah can only correspond to the period of use of the asset – hence any rentals pre-paid are effectively offset against the rentals due once the lessee starts to officially have access to and uses the asset. This type of ijarah (i.e. where there are pre-paid rentals) is called an ijarah mawsoofa bil thimma (forward lease).

During the construction phase, there is often this ijarah mawsoofa bil thimma and once the construction phase is over, there is an ijarah wa iqtina.

A good example of such a transaction was in 2008 when Qatar Islamic Bank (QIB) financed three desalination units in the Ras Abu Fontas A1 (RAF A1) water desalination plant for Qatar Electricity & Water Company (QEWC) for $150 million. The financing was structured as an istisn’a-ijarah scheme spanning 20 years. QIB entered into an istisn’a with an Italian manufacturer to build the plant over a 1.5-year period. During this construction period there was a forward lease rental payable by QEWC to QIB. Once the construction period was over, an ijarah wa iqtina was in place for an 18.5-year period during which QEWC would use and pay rental to QIB for the plant and become ultimate owner of the plant at the end of the lease term.

Salam

Salam is the other exception to the general rule that an item being sold has to be in existence at the time of sale. Istisn’a applies to non-fungible items that need to be manufactured or constructed. Salam applies to fungible items that also require time for production, such as agricultural produce; indeed, the Prophet Muhammad sanctioned payment in advance to farmers before their crops matured, so as to make it easier for them in the period in which their crops were growing.

Salam can be defined as the sale of a defined amount of a fungible object for full payment now for delivery in the future at an agreed time and place.

Key features of a sale based on salam are as follows:

• The object of sale must be specified in quality and amount.
• The object of sale must be fungible – that is, it must be substitutable and therefore freely available in the market place from day one of the contract to the date of delivery, or at least freely available at the time of delivery. Hence salam cannot apply to a non-homogeneous item such as a precious stone or rare painting. This condition is required to protect the buyer who has paid upfront. In the scenario in which the seller fails to produce the items or falls short of the required amount, they are required to procure the items from the market and make good his commitment to deliver the sale items at the specified time and place.
• The buyer can be further protected by requiring the seller to give some form of security or guarantee that can be invoked if the seller fails to supply the goods at the required time.
• In essence, by requiring the item to be fungible, it allows the obligation of the seller to deliver the goods at a specified time in the future to be treated like a debt. Whether the seller succeeds in producing the required goods or not, they will have the ability to repay this ‘debt’ by procuring the goods from the market.
• To trade debt at anything but par is tantamount to riba (interest) and therefore disallowed. Hence a buyer of a commodity in a salam contract cannot sell their right to receive the goods from the supplier they have contracted with for anything but what they paid. Thus salam-based investments are not very popular because of this restriction on their tradability.
• It does not matter where the commodity is produced as long as the requirement to supply the contracted quantity by a specific date is met. Therefore a salam contract should not, for example, refer to the produce of a particular farm or the fruit of a particular tree in case that farm or tree fails to produce the required goods.
• The quality of the goods must be clearly stipulated to ensure there is no ambiguity over what the buyer expects when the goods are delivered in the future.
• Salam can be applied to the sale of fungible commodities that can be measured by weight, volume, length or number – for example, metals such as copper and zinc, grains, oil, sugar, etc.
• In a salam contract, delivery is deferred. Most scholars require the minimum deferment period to be one month. However, the AAOIFI standard on salam (Sharia Standard number 10) does not specify a minimum.
• Payment is required in full upfront from the buyer. Some scholars have allowed a maximum delay of three days. Delaying payment would mean that both delivery of the commodity and the payment are delayed. This would be tantamount to sale of a debt (the commodity) for a debt (payment), which has been forbidden in the sharia. Moreover, the key reason for allowing salam is to alleviate the cash needs of the seller, hence delaying payment would be against this.

Salam cannot be applied to justify the short selling of shares because:

• the shares of a particular company are not necessarily fungible;
• salam is an exception to the normal rules of sale. In sharia, it is impermissible to apply analogy based on an exception to the normal rules.

Application of the salam contract

Finance for producers of fungible items

Financiers such as banks can provide finance to farmers, miners, etc. by paying them now for delivery in the future. They can make a return on this purchase by selling the commodities procured for a higher price. To minimise the risk of the commodities falling in price between paying for them and delivery, the financier will usually seek to lock in a profit by entering into a parallel salam contract, in which the financier enters into a second salam contract, this time as the seller. It will seek to agree a higher price than it paid in the first salam contract. This is best illustrated by an example.

A similar type of arrangement can be used to provide working capital finance for businesses.

It is worth comparing and contrasting the contracts of salam and istisn’a. Both can be viewed as exceptions to the norm in sale contracts for the reasons we have discussed, but apply and work in different ways – see Table 5.5.

Table 5.5 A comparison between istisn’a and salam

Istisn’a	Salam
Applies to assets that are to be either constructed or manufactured	Applies to fungible items such as base metals, agricultural produce and commodities such as sugar and oil
The contract is very flexible in terms of payment timing – can be upfront, phased, at the time of delivery or post-delivery	Payment must be made in full at the beginning of the contract
A maximum time frame can be set for the asset construction/manufacture and delivery	The delivery time is fixed
The contract can be cancelled only before the work starts	The contract cannot be cancelled

We have now discussed six very important transaction types:

Equity-type transactions:

1.	Musharakah.
2.	Mudarabah.
Asset finance:
3.	Murabaha.
4.	Ijarah.
5.	Istisn’a.
6.	Salam.

These represent key structures that are used extensively in the Islamic finance industry and a good grasp of these will enable you to comprehend many of the transactions in the industry. We will now look at some other important transaction types. These, together with the six structures we have already looked at, will be an important part of your tool kit in analysing and understanding sharia-compliant products and transactions.

OTHER KEY TRANSACTION TYPES

Wakala

Wakala means ‘agency’ and refers to a situation in which one party appoints someone as their agent or representative to act on their behalf. It is a simple concept and, as we will see, has gained widespread application in the Islamic finance industry. Some of the key features of wakala are as follows:

• The agent is acting on behalf of the principal and therefore in terms of work carried out by the agent, the agent is not the contractual counterparty in matters pertaining to the object of the agency. Therefore the agent cannot be held liable for any loss, damage or liability arising from the performance of the agency contract.
• The agent is required to carry out his duties in good faith, with due care, attention and skill, and holds any property of the principal on trust. If the agent is guilty of negligence, misconduct or breaching the terms of the agency agreement, then the principal has recourse to the agent to recover the losses they have suffered as a result.
• The remuneration to an agent can be structured in a flexible way. It can be in the form of a wage (in which case the agency becomes a contract of hire) and/or it can have a performance element to it.
• The scope of the activities delegated by the principal to an agent can be restricted or unrestricted. If the activities are restricted and the agent acts beyond the authority given to them, such transactions concluded by the agent are not valid unless permission is given by the principal.
• Agency contracts can also be on the basis of a ‘disclosed agency’ and an ‘undisclosed agency’:
  • Disclosed agency: this is the usual type of agency, where all parties to a contract know that the agent is acting on behalf of the principal.
  • Undisclosed agency: in this situation, the agent does not disclose that they are acting on behalf of a principal. Consequently, the other party to the contract has recourse to the agent only and not to the principal.
• The principal is responsible for all costs and expenses incurred by the agent in performing the work agreed under the contract and must therefore reimburse the agent accordingly.

Wakala contracts can be terminated through the mutual agreement of the agent and principal, death of the principal or agent, completion of the task, destruction of the object of the agency or loss of eligibility (e.g. a person who undertakes the role of agent in managing a principal’s money in terms of investment loses his regulatory licence to undertake such duties).

Application of wakala

There are a number of applications of Wakala.

Savings accounts

When we discussed mudarabah, we saw an example of how Sharjah Islamic Bank had used the mudarabah contract to provide a savings account in which the bank invested the monies of the depositors and shared the resultant profit with the depositors in a pre-agreed profit ratio.

Other banks have instead used the wakala contract for savings accounts. Here the bank acts as a wakil (agent) of the depositors in terms of investing their monies on a sharia-compliant basis. In return the bank receives a fee which can be a fixed amount, linked to the investment amount, and/or have a performance element to it. The following is an extract from the website of Al Rayan Bank (formerly known as Islamic Bank of Britain, IBB) explaining how the bank uses the wakala contract for its savings products. It has a useful FAQ section with it.

Wakala as a tool for facilitating inter-bank liquidity

When we discussed commodity murabaha, we noted the synthetic nature of this transaction and the fact that it has been heavily criticised for this. We also noted that Oman in recent times, for this reason, has prohibited the use of commodity murabaha for inter-bank liquidity purposes. In recent years, wakala has emerged as a widely used alternative – it has greater authenticity from a sharia perspective. Banks with surplus liquidity contract with other banks on wakala basis; that is, they engage the other bank(s) as an agent to invest their monies on a sharia-compliant basis for a fee in return for an expected profit return. The bank acting as the agent (wakil) could be doing this role just to earn fees from it or also to facilitate monies it requires for investment activities in which it wants to participate.

In June 2013, a standard wakala contract template was launched by the Bahrain-based International Islamic Financial Market (IIFM), a non-profit industry body which develops specifications for Islamic finance contracts. The concept of wakala can be applied in:

• Fund management: this is a common application of wakala – the fund manager acts as the agent of the investors in managing the fund and charges a fee for his services.
• Brokering services: this is very common too, for example employing an agent to sell an asset such as a property.
• Islamic insurance (takaful): the contract of wakala is often used within the context of Islamic insurance businesses. The insurance business tends to have two sides – the underwriting of risks and the investment of monies. Both these functions can be delegated to agents by the policy holders. This will become clearer when we discuss Islamic insurance in Chapter 8.

Security contracts

The following transaction types fall under the category of ‘contracts of security’. These contracts are designed to protect creditors from debtors defaulting on the payment terms agreed. These contracts are not primary contracts with original rights and liabilities. Security contracts seek to secure the rights and liabilities that originate from primary contracts such as murabaha, salam, ijarah, etc. Hence security contracts must necessarily relate to a primary contract and will seek to protect the interests of the principal creditor in those primary contracts.

Hawalah

This refers to the transfer of a debt from the person who currently owes the debt (the transferor) to the person named in the hawalah contract (the transferee). A key reason the sharia has sanctioned hawalah is so that debts can be paid more easily, as evidenced by the following Prophetic teaching:

Procrastination in the payment of debts by a wealthy man is an injustice. So, if your debt is transferred from your debtor to a rich debtor, you should agree.

‘Collection of Prophetic sayings’ by Imam Bukhari

It is best to look at a couple of scenarios of how hawalah could work:

• Party A in the UK buys goods on credit from Party B in Malaysia and now has a debt to Party B of £1,000.
• Party A could employ the services of a hawalah operator – Party C (many Islamic banks offer this service) – and transfer the debt it owes to Party B from itself to Party C. This is stipulated in the hawalah contract and now repayment of the debt (£1,000) to Party B must be sought from Party C and not Party A.
• Party C can charge Party A an administrative fee for this service, but this fee cannot be proportionate to the debt transferred – otherwise it could be construed as interest.

Hawalah can also be applied in a situation as follows:

• Party A buys goods on credit from Party B for £5,000. Party A has also lent £5,000 to Party C. Hence you have the following position:
  • Party A has a debt to Party B of £5,000.
  • Party C has a debt to Party A of £5,000.
• A hawalah contract can be constructed so that Party C pays Party B directly, without Party A having to collect monies from Party C and then paying Party B. This serves to simplify matters and can be worthwhile when creditors and debtors are separated geographically.

So far we have discussed hawalah in terms of debt transfer expressed in monetary amounts. It can be applied to debt expressed in terms of fungible assets such as metals (e.g. copper, aluminium, etc.) but not non-fungibles (e.g. buildings). Hence you can transfer a debt expressed in terms of 100kg of sugar, in which 1 kg of sugar is identical to another, while this is not possible with buildings as one building is different from another.

A number of products/services provided by the banking industry today are forms of hawalah, such as cheques, drafts, pay orders, bills of exchange, overdrafts, etc.

Rahn

Rahn in Arabic means to hold. In the context of providing security, it refers to a contract in which the seller/creditor mitigates the risk of payment default by the buyer/debtor by holding as security a physical asset, which can be sold in the event that the buyer does not fulfil his commitment to pay.

The security can be offered in the form of a mortgage or pledge against an asset belonging to the debtor or the creditor can take physical possession of the pledged asset itself. Any surplus proceeds in excess of the outstanding debt realised from the sale of the pledged asset must be returned to the debtor.

Taking security in this fashion is common in transactions such as murabaha and salam, where essentially the outcome of the transaction is a debt that is owed.

A key advantage of a rahn contract is that the pledged asset can continue to be used by the debtor. Therefore, in practical terms it changes very little – the debtor continues using the pledged asset, while the arrangement enhances his creditworthiness and mitigates the risk of non-payment from the perspective of the creditor. The pledge makes a creditor a secured creditor who is normally ranked higher than other creditors who have no pledge or security.

If the creditor holds the pledge asset in physical possession, they have to exercise due care in looking after the asset as they are holding it on trust. If the asset is damaged or destroyed while in their possession without any negligence or fault on their part, the creditor does not suffer the consequent loss on the asset.

Kafalah

Kafalah in Arabic means guarantee and is a contract between the guarantor and the person they are guaranteeing. This can be in the form of a financial guarantee (as most commonly found in the Islamic finance industry), whereby if a creditor defaults on paying a debt, the guarantor will fulfil the obligation on the part of the creditor. A guarantee can also be given in respect of the actions of a person/organisation, e.g. I guarantee that a tutor will be with you every Monday.

• A guarantee may be restricted, e.g. I guarantee £500 of a person’s debt, or, unrestricted, e.g. I guarantee whatever is owed.
• The guarantee can be limited in terms of duration, e.g. I guarantee payment of whatever is the outstanding balance at the end of the month.
• The guarantee can be based on specific conditions, e.g. I guarantee paying the debt of a person if they are made bankrupt.
• A guarantee may be deferred to a specified date in the future, e.g. a guarantor provides a guarantee that they will pay whatever debt is incurred over the next financial year if the creditor fails to do so.

Traditionally, it has not been allowed to charge for guarantees from a sharia perspective. This is because the one paying for the guarantee is uncertain about what they will get in return, i.e. there is contractual uncertainty (gharar) involved. Also they may get more than what they paid for as a fee, hence this could be construed as riba/interest. However, scholars have recognised that guarantees are necessary to give distant, unacquainted traders the confidence to transact with each other. In this context, if the guarantors cannot at least recover their costs of due diligence and processing these guarantees, then they will not provide these guarantees.

Hence AAOIFI standards allow a charge to be made by the guarantor when issuing a guarantee, so long as the amount of the charge is no greater than the administration costs incurred. The guaranteed party is not excused from his obligation because of the guarantee and is therefore still liable for settlement either to the guarantor or to the original creditor.

What, if any, security contract is used to protect the interests of the creditor in a transaction will depend on the suitability of these techniques in a particular set of circumstances and what the parties are willing to agree. It is possible for one obligation to be secured by more than one contract. For example, to secure the debt owed by the buyer in a murabaha transaction it is possible for the buyer to pledge an asset against the debt (rahn) as well as putting a guarantor in place (kafalah).

CONCLUSION

In this chapter we have discussed the features of the key transaction types found in the practice of Islamic finance and given examples of how these are applied in the market. The first step is to understand these as standalone concepts; the second step is to start understanding how these concepts differ and compare, so you can appreciate what transaction type best meets the objective of a particular transaction.

We have seen that a financier could finance the acquisition of an asset such as a building or a machine using the techniques of murabaha, ijarah wa iqtina and diminishing musharakah. What contract type is actually used will depend on what is best suited. For example, if the duration of the finance is a relatively long period, then ijarah may be preferred because of the fact that the rentals can be revised periodically and hence it gives the financier more flexibility, as opposed to fixing a particular price at the outset which cannot be changed, as in a murabaha.

In the real world, financial products and transactions need to be structured to meet the demands and needs of customers. It is no use bringing products to the market based on these contracts if there is no real demand for such products. The contracts and transaction types we have discussed represent key ‘tools’ which can be used to produce sharia-compliant financial products that consumers want. Since the modern Islamic finance industry is relatively new, the challenge is to innovate to bring products to market that meet the needs of consumers and are sincere to the letter and spirit of the Islamic teachings. The role of sharia scholars is very important here, in that they not only understand the sharia rulings but they apply these in the context of modern-day commercial, financial and regulatory realities, so they enable products to be structured that have features that appeal to and meet the needs of consumers and at the same time are commercially viable from a risk, return and regulatory perspective.

An example of where a classical sharia concept has been augmented to make it more commercially viable is that of murabaha to the purchase orderer. In classical murabaha, it is assumed that the seller already owns the assets they are selling on at a known profit mark-up. Scholars have sanctioned the use of this concept with the additional requirement that the seller (i.e. the financier) acquires the asset only once they have received a promise from the ultimate purchaser that the purchaser undertakes to buy the asset from the seller. This is to protect the financier from the negative consequences of the purchaser not going ahead with the transaction and hence makes the transaction more commercially viable.

In summary, this chapter gives you a large part of the tool kit you need to navigate and understand sharia-compliant financial products and transactions. The transaction types enumerated and discussed are by no means exhaustive but will give you a substantial foundation for comprehending Islamic finance market practice.