Chapter 6

Focusing on Contracts

In This Chapter

Understanding how sharia influences Islamic contract law

Noting the sources of Islamic commercial law

Distinguishing promises and contracts

Considering how Islamic contracts are categorized

You may not realize it, but commercial contracts are a big part of your daily life. Think about buying a meal at a fast food restaurant: You hand your money to the cashier and, in return, receive the salty, greasy, delicious burger and fries you’ve been craving all day. Maybe you take public transportation, such as a metro bus: You supply the right number of coins for your destination, and the driver gives you a ticket (or just lets you on board). The same goes for buying groceries or gas, ordering a pizza, and paying for Internet access.

Any time you pay for something — whether it’s a pack of gum, a new car, shares of stocks, or a utility bill — you’re participating in a legally binding contract. If the convenience store clerk takes your money but refuses to give you the pack of gum you paid for, you have the right to challenge his behavior because he didn’t hold up his end of the commercial contract. (I doubt that you’d take that particular case to court, but the law would be behind you if you did.)

In this chapter, I focus on contract law. I use that term to refer to a specific — and important — part of a nation’s commercial law that deals with the legally binding agreement between two or more parties. Different systems of contract law exist across the globe; you find English, Indian, and Australian contract law, for example.

The specific contract law I discuss here is (no surprise!) Islamic contract law. Islamic contract law is a subset of Islamic commercial law, which is a subset of general Islamic law (called sharia). As the Islamic finance industry becomes more popular (see Chapter 4 for information on the industry’s current size and growth projections), the importance of its foundation, Islamic contract law, becomes more prominent. In this chapter, I help clarify what Islamic contracts are and how they relate to Islamic finance.

In this chapter, I discuss contract law from a broad perspective so you can see why contract-based financial products exist. When I describe specific Islamic financial products later in the book, such as banking products (in Chapter 10), investment funds (in Chapter 12), sukuk (the Islamic alternative to bonds, in Chapter 13), and takaful (Islamic insurance, in Chapter 19), I explain the Islamic contract(s) on which they’re based.

Starting with Sharia Compliance

The religion of Islam has three basic components: beliefs, laws, and ethics. I introduce Islamic beliefs and laws in Chapter 2 and devote Chapter 5 to a summary of Islamic ethics as they apply to commercial endeavors.

Islamic law — sharia — governs all the affairs of a Muslim, ranging from consuming food to governing a nation. Muslims believe that Islamic law is divine guidance from Allah (God). Islamic jurisprudence is further divided into these parts:

Laws governing the relationship of man with God (Allah): These laws talk about how an individual should worship his creator. A Muslim can’t worship Allah any way he wants; divine guidelines establish the ways in which a Muslim should worship Allah.

Laws governing the relationship of man with other human beings: These laws cover interactions among people and govern social, economic, and political activities.

Islamic commercial law derives from the Islamic laws that apply to economic activities. According to Islam, Allah has guided humans regarding how they should organize their economic affairs. Islam has set out laws that prohibit certain activities while encouraging other activities. For example, Islam prohibits transactions based on interest, gambling, and speculation (see Chapter 1) while encouraging charity, moderation, and the wise use of the earth’s resources.

As I note throughout this book, Islamic financial institutions must operate according to sharia to achieve what’s called sharia compliance. I explain in Chapter 16 that Islamic financial institutions are governed by sharia boards (groups of Islamic scholars), which make sure that the firms’ contracts, policies, products, and activities are sharia-compliant.

Citing the Sources of Sharia and Islamic Commercial Contracts

Secular law has two broad categories of sources (or origins):

Formal sources of law: These include legislation passed by Congress, a parliament, or another legislative body; rulings made by courts of law (otherwise known as precedents); and treaties signed by legal parties such as two countries.

Informal sources of law: These include customs, standards of justice (which may be a judge’s common sense that’s applied when no applicable law is available), and equity (the search for justice in a particular case in the absence of — or perhaps even in spite of — applicable laws).

If this subject interests you, you may want to check out Contract Law For Dummies by Scott J Burnham (Wiley) or the article “Sources of Law” at http://jurisonline.in/2010/03/sources-of-law/.

Islamic law is based on two primary sources, which are the Quran and sunnah; two secondary sources, which are ijma (consensus) and qiyas (analogy); and some minor sources. I discuss the Quran and sunnah in Chapter 2. In this section, I introduce the secondary and minor sources of Islamic law.

Consensus among Islamic scholars: Ijma

When Islamic scholars can’t find solutions for some of the issues they examine — such as issues that are new to society and not addressed by the Quran or sunnah — they use scientific methods to arrive at answers based on those primary sources of sharia. Islamic law sets out specific principles and rules that apply when scholars use these methods to derive solutions.

What types of issues am I talking about here? Examples include the medical transplant of organs, in vitro fertilization, and surrogacy. Scholars are compelled to offer guidance to Muslims regarding how to act, but they can’t find direct guidance in the Quran or sunnah on whether certain modern practices are acceptable or prohibited by sharia law.

One scientific approach that Islamic scholars take is called ijma. It means “consensus” and refers to studying the collective rulings made by qualified Islamic scholars on new legal issues over a certain period of time. As new issues arise, Islamic scholars make the best decisions they can without compromising the laws set forth in the Quran and sunnah. A majority consensus on a given issue constitutes ijma.

In an Islamic financial institution, for example, the firm’s sharia board may need to make a decision based on ijma if a new product or issue arises that isn’t addressed in the primary sources of sharia. The permissibility of a product called tawarruq is a specific example. As I explain in Chapter 10, tawarruq is a fairly new (and somewhat controversial) financial instrument in which the buyer purchases a commodity from the seller on a deferred payment basis, and the buyer sells the same commodity to a third party on a spot payment basis. The buyer is basically borrowing the cash needed to make the purchase, and after he secures the cash from the second transaction, he pays off the original seller.

Is tawarruq permissible? That depends on where you live. In some countries and regions, the ijma among prominent scholars is that tawarruq is not sharia-compliant. In other areas, scholarly consensus veers the other way. (Clearly, ijma is not always a global consensus.)

Analogy: Qiyas

Qiyas is an analogical approach used by Islamic scholars to resolve questions of sharia compliance on emerging issues. Like ijma, qiyas is applied when the Quran and sunnah make no provision for an issue that must be addressed. An Islamic scholar comes to a conclusion about the new issue by studying solutions to similar issues that are presented in the Quran and sunnah and by making an analogy to the contemporary issue.

Islamic scholars have prohibited the use and sale of marijuana based on the analogical reasoning that it has features of intoxication. The Quran and sunnah explicitly declare that wine and other forms of alcohol are prohibited because they create intoxication. Scholars look at the common feature of intoxication and create an analogy with the use of marijuana.

Minor sources

Other sources of Islamic law include ijthihad (interpretation), istihsan (juristic preference), istisab (presumption of continuity), and urf (common practice). Here’s a brief description of these additional sources. Arguments exist regarding their acceptability as sources of Islamic law, but scholars still use them to derive conclusions regarding legal matters, including those that relate to interpretation of contracts:

Ijtihad (interpretation): An Islamic scholar may independently struggle with an issue and, based on his understanding of the Quran and sunnah, arrive at a conclusion. In this case, the scholar is not following in anyone’s footsteps but is personally struggling to arrive at an answer. (The word jihad, which is the root of ijtihad, means “struggle” or “strive.”) Some scholars don’t agree that ijtihad is a source of Islamic law.

Istihsan (juristic preference): A scholar may consider a variety of judgments arrived at by various means (including ijma, qiyas, and ijtihad) and choose a judgment that best resembles his own preference.

Istisab (presumption of continuity): Scholars debating a legal issue may consider past rulings (precedents) and principles and choose to assume that those rulings and principles continue to apply in the present and the future. Many scholars consider istisab to be weaker than other sources of Islamic law, which means that conclusions based on this method may be overruled if someone uses another, stronger means of deduction.

Urf (common practice): This Arabic word means “to know” and refers to making decisions based on a society’s customs and practices (as long as those customs and practices don’t go against anything explicit in the Quran and sunnah). A key feature of urf is that it can change over time as societies alter their customs and practices based on what they now know.

Introducing Islamic Contract Law

Islamic contract law governs three general types of undertakings: the unilateral promise (wa’d), the bilateral promise (muwaada), and the contract (’aqd). In this section, I describe each of these agreements and then explain the elements that define an Islamic contract and how those contracts may be classified.

What I offer here is a very brief introduction to Islamic contract law; in the space available, I can do no more than offer a broad sweep of the subject matter to give you some context for understanding the Islamic financial contracts I talk about in later chapters. If you’re truly interested in Islamic contract or commercial law, I encourage you to seek out a textbook or other reference that offers much greater detail.

Understanding the unilateral promise (wa’d)

The phrase unilateral promise means that one party binds itself to perform a function (or not to perform a function) in the future. Consider two examples:

Islamic banks commonly offer products based on an ijara contract. As I explain in Chapter 10, the ijara contract involves providing products or services on a lease or rental basis; the bank purchases an asset and gives an individual or entity the right to use the asset for a period of time in exchange for rental payments. In this situation, the bank customer promises the bank that he’ll purchase the asset at the end of the ijara contract period. The customer is thereby making a unilateral promise.

One individual (Mr. X) promises to sell a car to another individual (Mrs. Z) for $10,000. Just because Mr. X makes this promise doesn’t mean that Mrs. Z must accept the offer; Mr. X is simply making a unilateral promise.

As I note later in the chapter, a contract differs from a unilateral promise because a contract is binding on both parties, whereas a unilateral promise is binding only on one party. A unilateral promise may need to be followed by a contract. (For example, for Mr. X to actually sell his car and transfer ownership of it to Mrs. Z, the parties need to execute a contract of sale after the unilateral promise is made.) However, Islamic contract law still applies to a unilateral promise; the person or business making the promise is expected to abide by certain principles and regulations.

Different Islamic scholars hold different opinions about whether unilateral promises are binding and are enforceable. Here are two divergent scholarly opinions:

Fulfilling the wa’d is noble but not mandatory or enforceable through a court of law.

Fulfilling the wa’d is enforceable through a court of law because the promisor has a legal and moral obligation to honor the promise.

Recognizing a bilateral promise (muwaada)

A bilateral promise occurs when two parties perform two separate unilateral promises on the same subject or service. You may assume that this situation describes a contract, but it doesn’t — yet. (As I explain in the next section, a contract requires the existence of six separate elements that may or may not all be present in a bilateral promise situation.)

Here’s an example of a bilateral promise: Mrs. B makes a unilateral promise to Mr. C that she’ll buy Mr. C’s car for $5,000 within the next three months. Mr. C makes a unilateral promise to Mrs. B to sell her the car for $5,000 anytime in the next three months.

Most scholars agree that two unilateral promises aren’t enforceable as a forward contract. (A forward contract is based on the execution of a sale on a future date at the current market price.)

Entering a contract (’aqd)

A contract differs from a unilateral or bilateral promise fundamentally because a valid contract is always legally binding and enforceable. Islamic commercial law states that a valid contract requires six specific elements: an offerer, an offeree, an offer, an acceptance, subject matter, and consideration.

Offerer and offeree: These two are the contracting parties; both must be involved for a contract to exist. (Otherwise, you’re looking at a unilateral promise.) Both parties need to be mentally sound when the contract is signed, and both should be adults (although minors may be able to participate in a contract in some situations).

Offer (ijab) and acceptance (qabul): A valid contract requires both an offer and an acceptance. One party must make a proposal (which creates an obligation), and the other party must consent to it — and communicate that consent to the offerer — in order for a contract to exist.

An offer can be made in various ways:

• Verbally: A verbal offer is usually accepted for an immediate or on-the-spot sale. (For a future sale, scholars recommend that an offer be written.)

• By conduct (without any words, gestures, expressions): For example, a buyer goes to a shop and sees that the price for a chocolate bar is $1. The buyer pays the seller $6 for six bars of chocolate. Here, both the offer and acceptance are implied.

• In writing: An offer can be made in writing for a potential customer. For example, you get a quote for how much it’ll cost to have your air conditioner fixed, and that quote is handed to you in writing.

Subject matter: The subject matter of a contract explains the transaction taking place, such as what services will be performed or what assets will be sold. In Islamic contract law, several key considerations exist regarding the subject matter:

• The subject matter must be lawful and have value for a Muslim. The underlying asset or transaction can’t violate Islamic law. For example, a valid Islamic contract can’t involve interest payments or an asset related to a prohibited industry.

• The subject matter must be specific. No uncertainties should exist. A sales contract must spell out exactly which items are being sold, for example: If an auto salesman and a buyer enter a contract for the sale of a car, the contract must indicate exactly which car is being sold so neither party is confused about what is changing hands.

• The service or asset described in the subject matter must actually exist when the contract is being created. As I explain in Chapter 10, certain exemptions to this rule exist; a bank may offer an istisna contract to support a construction project, for example, or a salam contract may allow for deferred delivery of an asset.

• The seller must actually own the subject matter. This restriction prohibits the short selling of shares because the seller doesn’t own the shares at the time of the sale. However, exceptions related to salam and istisna contracts exist because the asset in question is being constructed or delivered at a future date.

• The seller must be able deliver the subject matter. Islamic scholars have prohibited selling the fish in the water or birds in the air, for example, because the seller can’t promise delivery of these items to a buyer even though they’re real assets that exist in the world.

Consideration: The price consideration is an important element of any contract. Under Islamic law, goods and services may be exchanged for money only, or they may be exchanged for other commodities. A valid contract must spell out what the buyer is giving the seller in exchange for the subject matter.

Classifying Contracts

Like their conventional relatives, Islamic contracts are often categorized in one of two ways: based on the effect of the contract or based on how the contract is used. In this section, I cover the major classifications of contracts in Islamic contract law.

Effect of the contract

Categories of contracts based on the contracts’ effect (their legality) include the following:

Valid contract (a sahih): When a contract contains the necessary elements and meets the conditions I outline in the preceding section, it’s a valid contract. When a contract is valid, it can be executed. Valid contracts can be either enforceable or suspended:

• Enforceable (nafiz): A contract becomes enforceable when both parties involved are competent and authorized to enter into the contract.

• Suspended (mawqoof): A contract can be suspended if the substance and the description are lawful but the contract is concluded without the consent of the party who doesn’t own the subject matter. This situation would apply, for example, if an agent were acting on behalf of a contract principal (either the offerer or offeree) and that agent lacked authorization to complete the contract.

Voidable contract (fasid): A voidable contract may have most of the elements of a lawful contract in place but features some kind of unlawful condition that prevents its complete validity. A contract is voidable, for example, if its subject matter is a transaction that involves interest, gambling, or speculation (which are prohibited by sharia). A contract is also voidable if it involves the sale of an asset that the seller doesn’t yet own. (Note that salam and istisna contracts, which I introduce later in this chapter, are exceptions.) A voidable contract can be transformed into a valid contract by correcting its unlawful feature(s).

Invalid or void contract (batil): Simply put, an invalid or void contract doesn’t meet the conditions I outline earlier in the chapter for a valid contract, and it isn’t close enough to a valid contract to be corrected. (It’s missing too many elements or has too many unlawful features.)

Use of the contract

Contracts may also be classified based on how they’re used in the Islamic finance industry. To start, here are two classifications of this category:

Unilateral contract: A unilateral contract isn’t the same thing as a unilateral promise, but it also doesn’t feature the traditional elements of a valid contract. In this type of contract, the ownership of an asset is transferred from one party to another without any price consideration. A unilateral contract doesn’t require the prior acceptance of the recipient.

These contracts are usually used for gratuitous situations, such as gifts (hiba), interest-free loans (qard hasan), and endowments (waqf). Islamic contract law grants some leniency in the definition of a valid contract here because the intention of such an agreement is charitable; something is being given without expecting any returns. (Only a real sourpuss would argue against the validity of a gift or an interest-free loan to someone in need!)

Bilateral contract: Unlike unilateral contracts, bilateral contracts must meet the guidelines I set forth in the section “Entering a contract.” Most of the contracts that exist in Islamic commercial law can be categorized as bilateral contracts. In other words, bilateral contracts are the default for most contracting situations, including those related to business partnerships, banking, real estate, and trade. In the sections that follow, I offer examples of common types of bilateral contracts.

Contracts of partnership

The development of the Islamic finance industry began with partnership contracts. This type of bilateral contract allows two or more parties to develop wealth by sharing both risk and return.

The two most commonly used partnership contracts are mudaraba and musharaka contracts:

Mudaraba: In a mudaraba partnership contract, one party gives money to another party, which invests it in a business or economic activity. Both parties share any profit made from the investment (based on a pre-agreed ratio), but only the investor (the first party) can lose money if the investment goes wrong.

As I explain in Chapter 10, Islamic banks often use the mudaraba contract with their customers. In the case of an investment account, the customer makes deposits and is, therefore, the investor (rab al mal). The bank is the working partner (mudarib) here, providing expertise in making sound investments.

Musharaka: In a musharaka partnership contract, two or more parties provide investment capital, entrepreneurial skills, and labor. All parties share the profit and/or loss. This type of contract is referred to as a joint venture contract because all participants bring similar resources to the table. Again, I offer much more detail on this type of contract in Chapter 10.

Contracts of safety and security

The contracts I describe here establish some agreement related to safety and security. Several varieties of this contract type are currently available in the Islamic finance industry:

Wadia (safeguarding contract): In this contract, a property owner gives his property to another party for the purpose of safeguarding. In Islamic banks, for example, current (checking) accounts and savings accounts are based on the wadia contract; the bank safeguards the depositors’ funds (flip to Chapter 10).

Hiwala (transfer contract or remittance): In a hiwala contract, debt is transferred from one debtor to another. After the debt is transferred to the second debtor, the first debtor is free from her obligation. Islamic financial institutions use this contract to remit money between people.

Kafala (guaranteed contract): This option is a contract in which a third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability. In conventional finance, this situation is called surety or guaranty. The third party may charge an administrative fee in exchange for assuming the obligation.

Islamic banks use kafala contracts to issue guarantees for their business customers. For example, a bank may guarantee a business customer’s standing in order to facilitate a certain project (so the other party is assured that the business customer will meet its obligation). Or the bank may give a surety to the owner of a ship or to a shipping agent so that a business customer can take delivery of imported goods while original shipping documents are pending.

Rahn (collateral or pledge contract): With this type of contract, a property is pledged against an obligation. In the Islamic finance industry, a customer can offer collateral or a pledge through a rahn contract in order to secure a financial liability. This contract is used by Islamic financial institutions to mitigate credit risk; the institution uses the collateral in case of credit default (see Chapter 17).

Contracts pertaining to the utilization of usufruct

The word usufruct refers to the legal right to use or to earn profits from property that someone else owns or that is owned communally (such as tribal land). These contracts transfer the usufruct (the rights to profit from the property) either for consideration (with an ijara contract) or not for consideration (with an ariyah contract, which allows for an object to be loaned to someone free of charge).

Contracts of exchange

The primary types of contracts used in Islamic commercial law are sales contracts, which involve the transfer of ownership of a lawful commodity (or money). Contracts of exchange facilitate the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money. Many types of sales contracts are available in the Islamic finance industry, including the following, which I detail in Chapter 10:

Murabaha (cost plus) contract: A commodity is sold to the buyer by the Islamic financial institution for its cost plus the profit margin, and both parties know the cost and the profit. The buyer makes deferred payment — either a one-time payment or installments.

Salam (forward) contract: A buyer pays for goods (or the Islamic financial institution does so on the buyer’s behalf), and the goods are delivered in the future. Islamic commercial law generally doesn’t allow forward contracts, but salam is an exception.

Istisna contract: This contract is also a type of forward sale agreement; the Islamic financial institution agrees to buy a project (on behalf of a buyer) that is under construction and will be completed and delivered on a future date.