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Middle East Legal Services
Worldwide: Interest And Islamic Banking
01 November 2007
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Article by Mr Saleh Majid (Advocate (Iraq), Rechtsbeistand (Germany) for business laws of Arab countries, B.A.Law (Baghdad), Dip.Air Law, Postgrad Dip.Law (London), M.C.I. Arb.and
Mr Faris Lenzen, LLM(London), Attorney at Law.
In this article we shall attempt to outline the definition of interest, so called (Riba) under the Sharia or Islamic law, followed by a short survey of the laws of some Arab countries which have prohibited or permitted charging interest. This article is supplementary to a previous article by the authors, entitled: Application of Islamic Law in the Middle East, and would be better understood if read together.
Regulation and prohibition of charging interests are as old as making laws in the human history. Babylon Code of law in 1750 B.C. laid down a number of restrictions and ceilings on the amount of interests.1
Christianity and Judaism have also restricted or prohibited charging interest. That the practice has been different is another question.
Under Islamic Law, charging interest or Riba is forbidden by verses of the holy Koran, and the "Hadith". But the uncertainty and the difficulty lie in the lack of a precise definition of Riba and the types of Riba. This difficulty is further deepened because of the many different opinions between the various schools of Islam.
Sources of Prohibition of Interest
The prohibition of Riba or interest in the Koran came gradual and in stages, starting with discouragement and condemnation of Riba by the Koran to the final prohibition as laid down in the following verse of the Quran:
"Allah permitted the sale and forbade Riba" (Verse 275, Surah Al Baqarah)
The Hadith of the Prophet went further that: "Every loan which attracts benefit is Riba".
The benefit which renders the transaction prohibited may be a sum of money, or any goods of a value.2
Thus, the prohibition has a far wider meaning and application than prohibition of charging interest on loans. It is a prohibition of usury and any unearned accretion on the capital or the principal, whether it is in the form of interest or any benefit.
Definition of Interest
Riba may be defined as: "monetary advantage without counter value, an advantage which is stipulated in favour of one of the parties in exchange of two monetary values".3 It may also be defined as: "any unjustified increase of capital for which no compensation is given".
The Economic Foundation
The basic concept of Islam is that wealth should not be hoarded or wasted, it should be put to productive use so that the owner, the society and the less privileged may share the benefits. It follows that it is not permissible to leave money idle and charge interest or profit from the mere use of the money by another party without regard to risks, or profits, that may generate. Usurers only seek profit, or interest without risks. This is contrary to the foundation of Islamic economy which is based on equity and equilibrium.
From the aforesaid concept stems the principle of profit and risk sharing between the owner of the capital and the other party, i.e. the borrower. Thus, in contrast to the conventional banking, the capital owner cannot claim both a fixed interest as well as the guarantee of the return of his capital.4
Also, Sharia does not consider money as such a commodity, but as a means of payment and as a neutral measure of valuation rather than a commodity by itself
Nevertheless, the owner of the capital may receive compensation on the basis of sharing profits and risks. The prohibition of trading with money plus interest aims at ensuring that money remains a stable value. 5
The aforementioned concepts also signify the basis of economic philosophy and Islamic banking. This underlines the difference between Western and Islamic Banking Systems, as we shall see later. In Islamic economy and banking, both profit taking and risks sharing goes together.
Based on the above, Sharia prohibited usury, as well as transactions having unusual uncertainty and unknown perils called "Gharar", such as gambling, because such transactions run contrary to the principle of balanced relationship or equivalence.
Though, Sharia recognises the sanctity of the contract, the prohibition of usury and contracts of "Gharar" together with some other principles of Sharia (such as unjustified enrichment) have created restrictions on the freedom of contracting, which Islamic banking must observe in any banking transaction.
Usury in Debts
There are several types of usury, some of which are no longer in use.6
Usury in debts or in loans, also called "Riba al-nasia", is the most relevant type of usury practised today. It is a loan or exchange of goods with a condition that the borrower repays the goods or the loan later in addition to an increase in value. Thus, there are two main elements at least:
* Repayment at a future date
* And an increase on the principal given by the creditor.
Repayment of the principal may be:
* Of the same kind whether they are measured or weighed or not, such as selling one ton of wheat for two tons of wheat delivered later, or such as lending £ 100 for £ 120 to be paid later, or
* of a different kind if measured or weighed, such as selling one ton of wheat for 2 tons of rice later, or selling one ton of wheat of a value of £ 10 for £ 20 paid later.
Prior to Islam, usury in debt was a common practice whereby the creditor provided the borrower money or goods and received from the debtor interest or increase periodically, and the principal or the loan was to be returned in full at a future date, a practice called "Ribal al Jahiliya."7
In short, usury in debt, i.e. an exchange of goods whether of the same kinds or not for a delayed repayment with an increase, is prohibited by Sharia according to the verses of Quran and the Hadith. This includes interest charging on loans in today banking transactions. Every loan containing a provision for an increase above the capital is forbidden under Sharia.
It is worthwhile to note that though it is forbidden to agree on an increase in price or value because of delay in repayment, Sharia allows an agreement to sell goods on deferred payment for a price which is higher than the price of the same sale in cash. In this case, and contrary to the ordinary loan agreement, both parties are exposed to certain risks: the seller agrees on a fixed price to be received at a future date, thus accepting the risk if the market price increases at the date of payment. At thesame time, the buyer accepts the immediate transfer of the property of the goods sold, thus assuming all the risks attached to such a transfer of property.
Also, in a contract of sale, deferred delivery of goods or forward purchase, the so called "Sale of Salam", is permitted for a lower price if the goods are specified, as an exception to the prohibition of the rules of Gharar. 8
As to the effect of interest provision on the contract, there exist different views. For instance, Hanafi School considers the provision concerning interest null and void, but the remaining contract as valid. Hanbali School considers a loan agreement with interest ipso facto as null and void.
Below is a short survey of the provisions of some of the civil and commercial Arab Codes dealing with interest followed by certain court decisions.
Interest under Arab Civil and Commercial Codes
The question as to whether charging interest is permissible or illegal has been dealt with by the Arab Civil Codes and Commercial Codes in different manners. It has also been subject to many court decisions in most of the Arab countries. But the outcome has been nearly always in favour of allowing the Western system of interest taking to continue. This is in spite of the constitutional provisions in many Arab countries which declare Islamic law or Sharia as the main source (as in Egyptian constitution) or a source of legislation (as in Kuwaiti and UAE Constitutions), which we have dealt with in a previous article on the Application of Islamic Law in Middle East.
In general the Civil and Commercial Codes of the Arab countries may be divided in two categories as to the manner of dealing with the question of interest:
Firstly: Egyptian Civil Code and those Arab Codes which followed closely the Egyptian Civil Code, whereby charging interest is declared as legal by the relevant Civil Code whether in civil or in commercial matters.
Article 226 of the Egyptian Civil Code provides that:
* If the object of an obligation is payment of a sum of money, the amount of which is known at the date of filing a claim, and the debtor delayed the payment, then the debtor shall pay the creditor as compensation for delay 4 % interest in civil matters and 5 % in commercial matters. Such interest shall be calculated as from the date of filing the case.
As we shall see later, this article 226 was subject of the decision of the constitutional Court of Egypt issued in May 1985.
* Article 171 of the Iraqi Civil Code is identical to the Article 226 of the Egyptian Civil Code, except that the Iraqi Civil Code stipulates that the object of the obligation must be known at the date the obligation arose instead of the time of filing the claim as the Egyptian Civil Code requires.
* Article 227 of the Egyptian Civil Code as well as Article 172 of the Iraqi Civil Code lay down the maximum limits for the interest charged, and provide that the parties in a loan agreement or contract may agree on a rate of interest if it is below the maximum rate.
* Also, Article 231 of the Egyptian Civil Code, as well as Article 173 of the Iraqi Civil Code have entitled the creditor to claim supplementary indemnity in addition to the interest if the creditor suffered loss or damages as a result of gross fault or cheating by the debtor. Similar provisions may be found in other Arab Civil or Commercial Codes, as in article 114 of the Kuwaiti Commercial Code and article 91 of the UAE Commercial Code.
* Article 228 of the Egyptian Civil Code, as well as paragraph 2 of Article 173 of the Iraqi Civil Code provide that in order for the interest to fall due, the creditor shall not be required to prove loss or damage.
* The Syrian Civil Code, Articles 227-229, and the Libyan Civil Code, Articles 229-231, have laid down similar provisions as the Egyptian Civil Code, except that each Civil Code adopted a different maximum rate of interest, which the parties to an agreement must not exceed.
* Egyptian Civil Code, Article 232 and other Arab Civil and/or Commercial Codes have prohibited charging compound interests.
The authors of the Arab Civil Codes, which provided for interest appear to justify that on the ground that: in cases of delay of payment, interest amounts to compensation, because the creditor suffers loss due to lending his capital or as a result of the delay of payment by the debtor, especially when the debtor fails intentionally to pay in time. Some writers have argued that interest in certain cases amount to indemnification or compensation for losses suffered by the creditor. To reach to such conclusion, they have relied on the Islamic principle of "There shall be no unfair loss nor the causing of such loss", among other arguments.9
Secondly: Kuwaiti and UAE Civil and Commercial Codes distinguishes between civil matters, whereby charging interest is not allowed in the Civil Codes, and commercial matters, whereby interest is permitted under the Commercial Codes.
Kuwait
* Article 547 of the Kuwaiti Civil Code states: "1. Loans shall be without interest. Any condition to the contrary shall be void without prejudice to the loan agreement. 2. Any benefit which the lender stipulates shall be deemed as interest".
* Article 550 of the Kuwaiti Civil Code (similar to article 719 of the UAE Civil Code) goes further and states that no account shall be taken of any change in the value of money, i.e. fluctuation, decrease of increase of money.
Notwithstanding the said provisions, Article 102 of the Commercial Code stipulates that "1. The creditor shall be entitled to an interest in a commercial loan unless otherwise is agreed upon. If the rate of interest is not stipulated in the contract, the rate due shall be the 7 % legal rate. 2. If a rate agreed upon is stipulated in the contract, and the debtor delays settlement, the interest for the delay shall be calculated on the basis of the agreed rate". Here, it is noted that Article 102 provides an assumption in favour of the creditor to receive interest, even when the agreement is silent.
* Article 110 of the Kuwaiti Commercial Code lays down provisions similar to Article 171 of the Iraqi Civil Code, and Article 226 of the Egyptian Civil Code by imposing 7 % legal interest on the debtor who fails to pay in time.
* Article 111 of the Kuwaiti Commercial Code lays down a maximum rate of interest similar to Article 227 of the Egyptian Civil Code and Article 172 of the Iraqi Civil Code.
According to Article 3 of the Kuwaiti Commercial Code, the Code applies to all commercial matters, including loan agreement, and prevails over the provisions of the Civil Code.
Thus, we see here a straight forward prohibition of interest under the Civil Code in compliance with the Sharia, while the Commercial Code – as a special law – allows interest charging contrary to the principles of Sharia.
It is worthwhile to recall that Article 1 of the Kuwaiti Civil Code provides that Sharia applies as a source of law in case of the absence of an express legislative provision, but only in the absence of a rule of custom. Also Article 2 of the Kuwaiti Constitution declares that Sharia is a principal source of legislation, among other sources.
U A E
UAE Civil and Commercial Codes have adopted a similar approach as the Kuwaiti Code in prohibiting interest under the Civil Code and allowing it under the provisions of the Commercial Code.
* Article 714 of the UAE Civil Code of 1985 provides that:
"If the contract of loan provides for a benefit in excess of the essence of the contract, otherwise than a guarantee of the rights of the lender, such provision shall be void but the contract shall be valid."
Contrary to the above mentioned provisions, Article 76 of the UAE Commercial Code of 1993 states that a creditor may stipulate interest in a commercial loan agreement. If he fails to stipulate the rate of the interest, the current market interest rate shall apply not exceeding 12 %. Here again, there is a presumption in favour of the creditor to claim interest, even if he fails to stipulate that in the agreement.
* Article 88 of the Commercial Code has laid down provisions (similar to Article 171 of the Iraqi Civil Code, and Article 226 of the Egyptian Civil Code, imposing legal interest for delay in payment.
In Jordan the Civil Code did not deal with interest, but interest is charged in accordance with the provisions of an old Ottoman law as well as the 1988 Code of Civil Procedures.
Decisions of the Courts
Having reviewed briefly the provisions of the laws in some Arab countries dealing with interest, it is worthwhile to see how the court in some Arab countries have dealt with the matter.
Constitutional Court of Egypt
Decision of 4th May 1985
During 1980 Article 2 of the Egyptian Constitution was amended to read that:
"Islam is the religion of the State…. And the principles of the Sharia are THE main sources of legislation".
The Rector of the Al Azhar University filed a case against the President and others claiming that the provisions of Article 226 of the Egyptian Civil Code which allow interest for delay in payment is unconstitutional and contrary to the Article 2 of the Constitution referred to before.
The Court held that: Charging interest is prohibited by Sharia, but Article 2 of the Constitution has no retrospective effect, and therefore Article 226 remained in force and was not effected by the amendment. Article 2 of the Constitution has not made Sharia directly the common law of the land and that it does not directly apply. But, it has imposed an obligation on the legislator to observe and apply Sharia principle in any future legislation. 10
Thus, Article 2 of the Constitution is a limitation on the legislator to apply Sharia in respect of any future enactment, and the laws enacted prior to the date of the amended Article 2 of the Constitution, such as the Civil Code, are not effected. Therefore, Article 226 of the Civil Code remains enforceable, though contrary to Sharia.
This decision of the Constitutional Court is widely criticized as poor and not convincing. It is argued that the provisions of Article 2 of the Constitution and the prohibition of interest have become part of the public order and morals and should be applied at least from the date of the enactment in 1980. And the Constitutional Court has the duty and function to control and ensure that the application of the laws are not in contradiction with the Constitution. It has further been argued that the court might have done better if it had based its decision on the principles of necessities and common interest of the society to justify charging interest under the present economic regime.11
It has also been submitted that imposition of interest under Article 226 of the Egyptian Civil Code and similar provisions is a compensation for loss suffered by the creditor due to the failure of the debtor to pay. The creditor does not stipulate interest under Article 226, but the obligation to pay interest arises after the failure of the debtor to pay. This is in conformity with the Sharia principles of "Theman" that a person causing damage must compensate. In support of this opinion it is also said that: Islam encourages giving loan without interest, but the debtor must act in good faith. The failure to repay the loan in time is intentional fault and amounts to bad faith." Therefore, the reasons "illah" behind the prohibition of interest is not present in such cases. Consequently, it is argued, imposing interest for delayed payment falls outside the prohibition of Riba.12
Kuwait Constitutional Court, Decision of 28.11.1992
An appeal was submitted to the Constitutional Court on the basis that Article 2 of the Constitution provided that Sharia is a main source of legislation and Article 110 and 113 of the Commercial Code permit charging interest for delay in violation of the Constitution. Therefore, the Appellant claimed the court must declare Articles 110 and 113 unconstitutional.
The Court held that:
Article 2 of the Constitution is a directive to the legislator to resort to Sharia as a source among other sources for legislation, but it does not prevent it from applying other sources of law when necessities arise. It imposes on the legislator only a trust to adopt the Sharia principles to the extent possible, it is a political directive to the legislator to adopt Sharia, but the legislator remains free to withdraw principles of law from other sources which the legislator finds suitable. The judge may not ignore an express provision of law such those of Article 110 and 113 and apply Sharia, but he may resort to the application of Sharia only when there is no express provision in the law.13
Sharia is not THE source and not the only source of law. Based on that the court held that Articles 110 and 113 of the Kuwaiti Commercial Code permitting interest are constitutional.
It is noted that the reasoning of the Kuwaiti court runs parallel to the reasoning of the Egyptian Al Azhar case, in certain aspects, except that the Kuwaiti court did not contend that Article 2 of the Constitution has no retrospective effect. But, in both cases the court appeared to aim at one thing, i.e. legitimising interest by all means.
UAE Supreme Federal Court, Decision dated. 06.09.1983
The Defendant, a company, which borrowed a sum of money from a bank, claimed that Sharia has prohibited interest and specially compound interest. Therefore, the Defendant had no obligation to pay the sums claimed by the bank. The appellant, a bank, appealed to the Federal Court in Abu Dhabi against the decision of the lower court for the remaining sum of a loan and interest allegedly due from a company. The appellant contended that the court may apply the Sharia only in cases of absence of an express provision in the law as stated in Article 5 of the Code of the UAE Civil Procedures no. 3 of 1970. Articles 61 and 62 of the said law permit charging interest expressly, therefore the court can not set aside the express provisions of the law and apply the principles of Sharia prohibiting interest.
The Federal Supreme Court held that Sharia has prohibited interest, but has at the same time made exception to the prohibition by the application of the Sharia principle of: "Necessity permits what would be otherwise forbidden". Also, the court further argued that Islamic jurisprudence allows exceptions to a rule when there is overwhelming interest of the society. Based on the foregoing principles, Sharia has recognised sale of "Salam" and contract of "Istisnah" as exceptions to rules, which render the sale of non-existing object invalid.
Based upon the aforesaid principles, charging simple interest should be considered as exception to the rule of prohibition due to the necessities, requirements, and interest of the people. Consequently, the provisions of Articles 61 and 62 of the Code of the Civil Procedures of 1970 are constitutional, the court held.
The court added to the above mentioned reasoning that the judge must respect the will of the parties, and may not ignore the agreement of the parties except in exceptional circumstances. Thus, the court can not set aside the agreement of the parties to pay interest unless the rate is in excess of the maximum legal rate or in cases of compound interests which the law expressly forbade.14
Furthermore, the court held that the interest in the case subject of the appeal amounts to compensation. Accordingly, the court rejected the contention of the defendant.
In another case, the UAE Supreme Court held that though article 714 of the Civil Code prohibits interest, but the Civil Code as such does not apply to commercial transactions, and that charging interest by banks is permitted under the Commercial Code.15
The Civil Procedural Law of 1970 has now been replaced by the new Civil Procedural Law no. 11 of 1992 and Articles 76, 77, 88 and 409 of the UAE Commercial Code of 1993 leave no doubt that charging simple interest in commercial and banking transactions is permitted.
In conclusion, it appears from the foregoing review, that courts and the legislators in the Arab countries have succeeded up to now in paying a lip service to the rules of the Sharia and have survived the conflict created by the application of the Sharia vis a vis the requirements of the modern secular legal and commercial systems.
Islamic Banking
The Islamic financing and banking institutions have grown successfully within the last 20 years in response to popular need in Islamic countries for free interest financing as well as the need of Western and American markets for new capitals. OPEC surplus made it possible for both sides to use the huge surplus money. However, the size of the Islamic Banking transactions remains small as compared to the traditional banking, but it is steadily growing.
It is estimated that there are about US $ 100 billion investment worldwide according to Sharia principles; relatively a small sum but significant considering the short period during which Islamic financial institutions and Islamic funds have existed. The use of Islamic investment funds and banking is not confined to the Middle East but has been adopted by a number of conventional banks in USA and Europe.
We shall attempt here-below to outline the main features of Islamic banking and the differences with conventional banking as well as some of tools used by such institutions as financing instruments.
General Features
Islamic banking refers to a banking and financing system which ensures that the financial transactions conform to Islamic law principles.
The management of such financial institutions includes a board of Islamic scholars and advisors who examine each financial transaction to ensure compliance with Sharia.
In Islamic banking, both risk and profit go together, and depositor is deemed as a shareholder, taking profits or sharing loss. The bank often act as trustee acting on behalf of their clients whether depositors or borrowers in accordance with the principles of Sharia.
The concept of Islamic financing aims not only at making profit, but also at achieving economic development and social justice in comparison with conventional banking system which is based on debts and interests.
The main differences between the conventional and Islamic banking stem from the prohibition of Riba, and "Gharar" or gambling transactions by Sharia, as stated before.16 Also, the prohibition of "Gharar", gambling and aleatory transactions under Sharia lead to restrictions on the activities of the Islamic banks. These are transactions which are too speculative or based on unknown and uncertain events, with significant high risks. These and other rules of the Sharia have shaped the types of financial transactions adopted by Islamic banks. Accordingly, the Islamic financial institutions have developed certain contracting models based on no-interest concept to satisfy the needs of the market.
The following are the most popular banking instruments or model contracts commonly known by their Arabic names:
Murabaha (Trade Financing)
A customer with traditional banking relationships wishes to purchase raw materials or goods for which it does not have the funds to pay the purchase price. It borrows the amount of the purchase price from the bank, which may take a charge or lien against the goods purchased and require the customer to repay the amount of interest. An Islamic institution cannot extend such a loan but it can help the customer to make the purchase by buying the goods from the supplier and then selling the same to the customer at a profit.17
The bulk of Islamic bank funds are operated through murabaha contracts (a sale at percentage mark up). In this type of contract the customer orders the bank to buy goods according to his specifications from a supplier. The customer further promises to purchase these goods from the bank for costs plus a mark up. In practice, the bank purchases the goods only when it is satisfied that the customer will purchase them. This second sale between the bank and its customer is usually on credit. By involving the bank as a seller, the customer can purchase the goods on credit and the bank can claim compensation for their services by demanding a higher sales price. Legally the customer is not just borrowing money for interest but buying goods on credit, permissible under Islamic law. In other words the transaction between the bank and its customer is a sale on credit and not a loan.
The critical difference between a Murabaha financing and traditional purchase financing is that the bank in a Murabaha must actually take title to the goods in question and transfer that title to the ultimate purchaser later. This passage of title raises questions of defects in title, claims, risk of loss, and insurance that must be carefully considered in negotiating and drafting any Murabaha contract. It is also important to determine where and under the law of which nation the title passes, for this will affect whether the title passes at all and whether the purchase and subsequent sale by the Islamic institution or the bank are events subject to transfer, ad valorem, or income taxes of any kind.
To reduce the risks of the bank, in practice, the first and the second sale takes place simultaneously when the title of the goods is transferred to the bank.
Also, an important limitation of the Murabaha arrangement is that it requires three unrelated parties – the supplier, the Islamic institution or the bank and the ultimate purchaser or customer. In such transactions all parties carry certain risks and benefits.
Mudaraba (Profit Sharing Finance)
If a company requires financing a project, but not management or administrative assistance for a project or business opportunity, Islamic institutions or banks may use the Mudaraba contract, in which the Islamic institution or the bank provides the necessary financing and the company provides the work, executes and manages a project. Here there are two phases of transactions. In the first phase, the capital owner deposits his capital in the bank and the bank acts as the party investing the capital, i.e. as "mudarib".
In the second phase, the bank acts as provider of the capital, and the company as a second "mudarib" equivalent to a conventional borrower, which requires and uses the money for a project. The profit (if any) made by the company out of the project is divided according to an agreed proportion between the bank and the company.
The Islamic bank later divides again the profit between the bank and the first capital owner. The bank may also charge fees for its normal services, but not interest.
Such transactions are governed by two basic principals, both derived from Islamic law. Instead of taking interest for lending money, capital providers are involved in a profit and risk sharing arrangement.
The first principle is that the return on capital cannot be fixed in advance but is described by a proportion of profits. The capital provider and the mudarib who makes use of the capital, both share the profit according to agreed proportions.18
The second principle is that the capital owner shares the risks out of the project. Thus, in case of the project looses, the capital owner is liable up to the capital he invested, but not beyond that amount, and the bank does not guarantee the return of the initial capital to the capital owner, and the company or the "mudarib" may lose his labour. Thus, in contrast to conventional banking, the capital provider cannot claim both a fixed interest and the assured return of his capital.
Musharaka, Joint Ventures
A company has a project or business opportunity that requires both financing and management assistance. It may find an Islamic institution willing to enter into a partnership or Musharaka arrangement whereby the company and the Islamic bank are partners in the true sense, sharing equity, management, profit, and losses, according to an agreement made between them. This is Islamic finance in a pure sense, in that it carries out the fundamentals of sharing and putting wealth to productive use.
In entering into a Musharaka arrangement, the considerations are the same as the considerations in any joint venture or partnership. The parties must address the general questions of what the partnership is intended to do, how it will be managed, how the profits and losses will be shared, and how the arrangement can be terminated. Here, the bank may take a lower ratio of profits, but in cases of losses it becomes liable up to its full equity ratio.
A Musharaka arrangement may be related to financing a particular project, whereby the agreement is terminated after completion of the project, or may be linked to a continuing project, in which case the bank receives back its investment progressively according to the project’s ability to repay the initial investment and the agreed profit. The return is based on the revenue out of the project instead of charging interest.
The aforementioned transactions ensure the observance of the riba prohibition and satisfy the rule that when money is lent to another party for a period of time, compensation for the financing may not be a predetermined amount guaranteed by the other party to the contract. Furthermore, such transactions are based on the notion of sharing profit and risks, and on avoiding riskless gains.
There are other instruments and model contracts developed by the Islamic institutions to conform with Islamic principles such as leasing contract (Ijara), whereby a company requests the bank to purchase certain machinery and to lease the machinery to the company for an agreed regular fee.
These and other instruments used by the Islamic banks have proved to be workable, for most of modern transactions are capable to be broken down into sale, purchase, lease and joint venture agreements.19
Also, it is noted that there are continuous efforts to develop new Islamic banking instruments which are in conformity with Islamic principles, and at the same time realistic and profitable.
Islam prohibits interests, but at the same time commands legitimate and fair commerce and legitimate wealth creation. It does not restrict the freedom of contracting and trading as long as they conform to the general principles of Sharia. Islamic banking is still in making and its future depends on its ability to find new ways of trading and investing.20
Footnotes
1. See Mekki I. Lufty, Legal Interests, A Comparative Study p. 161-164 (in Arabic)
2. See Dr. Ahmed .M. Saad,,Delay Interests,Comparative Study,Cairo,1986,(Arabic) pages 90-91
3. Prof. W.M. Ballantyne, Commercial Laws in the Arab Middle East, 1987, p. 122-124
4. Vogel and Hayes, Islamic Law and Finance, 1998, p. 130
5. Ibid Vogel, page 83
6. Supra, Dr. A.M. Saad p. 94-97
7. Supra, Vogel, p. 72
8. Ibid, Vogel, p. 76-77
9. Supra, Dr. A.M. Saad, p. 253-275
10. Ibid, Dr. A.M. Saad, p. 15-43
11. Ibid, p. 36-37
12. Ibid, p. 202-218
13. Prof. Ballantyne, Wither Arab Commercial Laws: Law of God or Mammon?, MEER, Jan. 2000, p. 16-17
14. Supra, Dr. A.M. Saad, p. 18-28; see also Hind Tamimi, Interest Under the UAE Law As Applied by the Courts in Abu Dhabi, Arab Law Quarterly, Part 1, 2002, page 50-3
15. Reported in MEER, March 1999, p. 5
16. Supra, Vogel, p. 110 and 84-88. See alsoF. Al-Omar and M. Abdel Hag , Islamic Banking, 1996, p. 104-108
17. Ibid, Vogel, p. 140-143
18. Ibid, Vogel, p. 130-131
19. See M.J.T. McMillen, „Collateral Security and Financing Structures for Sharia – Compliant Project Finance…”, MEER, August 2001, pages 7, 11-18
20. Supra, F. Al -Omar and M. Abdel Hag, pages 124-126
Worldwide: Interest And Islamic Banking
01 November 2007
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Article by Mr Saleh Majid (Advocate (Iraq), Rechtsbeistand (Germany) for business laws of Arab countries, B.A.Law (Baghdad), Dip.Air Law, Postgrad Dip.Law (London), M.C.I. Arb.and
Mr Faris Lenzen, LLM(London), Attorney at Law.
In this article we shall attempt to outline the definition of interest, so called (Riba) under the Sharia or Islamic law, followed by a short survey of the laws of some Arab countries which have prohibited or permitted charging interest. This article is supplementary to a previous article by the authors, entitled: Application of Islamic Law in the Middle East, and would be better understood if read together.
Regulation and prohibition of charging interests are as old as making laws in the human history. Babylon Code of law in 1750 B.C. laid down a number of restrictions and ceilings on the amount of interests.1
Christianity and Judaism have also restricted or prohibited charging interest. That the practice has been different is another question.
Under Islamic Law, charging interest or Riba is forbidden by verses of the holy Koran, and the "Hadith". But the uncertainty and the difficulty lie in the lack of a precise definition of Riba and the types of Riba. This difficulty is further deepened because of the many different opinions between the various schools of Islam.
Sources of Prohibition of Interest
The prohibition of Riba or interest in the Koran came gradual and in stages, starting with discouragement and condemnation of Riba by the Koran to the final prohibition as laid down in the following verse of the Quran:
"Allah permitted the sale and forbade Riba" (Verse 275, Surah Al Baqarah)
The Hadith of the Prophet went further that: "Every loan which attracts benefit is Riba".
The benefit which renders the transaction prohibited may be a sum of money, or any goods of a value.2
Thus, the prohibition has a far wider meaning and application than prohibition of charging interest on loans. It is a prohibition of usury and any unearned accretion on the capital or the principal, whether it is in the form of interest or any benefit.
Definition of Interest
Riba may be defined as: "monetary advantage without counter value, an advantage which is stipulated in favour of one of the parties in exchange of two monetary values".3 It may also be defined as: "any unjustified increase of capital for which no compensation is given".
The Economic Foundation
The basic concept of Islam is that wealth should not be hoarded or wasted, it should be put to productive use so that the owner, the society and the less privileged may share the benefits. It follows that it is not permissible to leave money idle and charge interest or profit from the mere use of the money by another party without regard to risks, or profits, that may generate. Usurers only seek profit, or interest without risks. This is contrary to the foundation of Islamic economy which is based on equity and equilibrium.
From the aforesaid concept stems the principle of profit and risk sharing between the owner of the capital and the other party, i.e. the borrower. Thus, in contrast to the conventional banking, the capital owner cannot claim both a fixed interest as well as the guarantee of the return of his capital.4
Also, Sharia does not consider money as such a commodity, but as a means of payment and as a neutral measure of valuation rather than a commodity by itself
Nevertheless, the owner of the capital may receive compensation on the basis of sharing profits and risks. The prohibition of trading with money plus interest aims at ensuring that money remains a stable value. 5
The aforementioned concepts also signify the basis of economic philosophy and Islamic banking. This underlines the difference between Western and Islamic Banking Systems, as we shall see later. In Islamic economy and banking, both profit taking and risks sharing goes together.
Based on the above, Sharia prohibited usury, as well as transactions having unusual uncertainty and unknown perils called "Gharar", such as gambling, because such transactions run contrary to the principle of balanced relationship or equivalence.
Though, Sharia recognises the sanctity of the contract, the prohibition of usury and contracts of "Gharar" together with some other principles of Sharia (such as unjustified enrichment) have created restrictions on the freedom of contracting, which Islamic banking must observe in any banking transaction.
Usury in Debts
There are several types of usury, some of which are no longer in use.6
Usury in debts or in loans, also called "Riba al-nasia", is the most relevant type of usury practised today. It is a loan or exchange of goods with a condition that the borrower repays the goods or the loan later in addition to an increase in value. Thus, there are two main elements at least:
* Repayment at a future date
* And an increase on the principal given by the creditor.
Repayment of the principal may be:
* Of the same kind whether they are measured or weighed or not, such as selling one ton of wheat for two tons of wheat delivered later, or such as lending £ 100 for £ 120 to be paid later, or
* of a different kind if measured or weighed, such as selling one ton of wheat for 2 tons of rice later, or selling one ton of wheat of a value of £ 10 for £ 20 paid later.
Prior to Islam, usury in debt was a common practice whereby the creditor provided the borrower money or goods and received from the debtor interest or increase periodically, and the principal or the loan was to be returned in full at a future date, a practice called "Ribal al Jahiliya."7
In short, usury in debt, i.e. an exchange of goods whether of the same kinds or not for a delayed repayment with an increase, is prohibited by Sharia according to the verses of Quran and the Hadith. This includes interest charging on loans in today banking transactions. Every loan containing a provision for an increase above the capital is forbidden under Sharia.
It is worthwhile to note that though it is forbidden to agree on an increase in price or value because of delay in repayment, Sharia allows an agreement to sell goods on deferred payment for a price which is higher than the price of the same sale in cash. In this case, and contrary to the ordinary loan agreement, both parties are exposed to certain risks: the seller agrees on a fixed price to be received at a future date, thus accepting the risk if the market price increases at the date of payment. At thesame time, the buyer accepts the immediate transfer of the property of the goods sold, thus assuming all the risks attached to such a transfer of property.
Also, in a contract of sale, deferred delivery of goods or forward purchase, the so called "Sale of Salam", is permitted for a lower price if the goods are specified, as an exception to the prohibition of the rules of Gharar. 8
As to the effect of interest provision on the contract, there exist different views. For instance, Hanafi School considers the provision concerning interest null and void, but the remaining contract as valid. Hanbali School considers a loan agreement with interest ipso facto as null and void.
Below is a short survey of the provisions of some of the civil and commercial Arab Codes dealing with interest followed by certain court decisions.
Interest under Arab Civil and Commercial Codes
The question as to whether charging interest is permissible or illegal has been dealt with by the Arab Civil Codes and Commercial Codes in different manners. It has also been subject to many court decisions in most of the Arab countries. But the outcome has been nearly always in favour of allowing the Western system of interest taking to continue. This is in spite of the constitutional provisions in many Arab countries which declare Islamic law or Sharia as the main source (as in Egyptian constitution) or a source of legislation (as in Kuwaiti and UAE Constitutions), which we have dealt with in a previous article on the Application of Islamic Law in Middle East.
In general the Civil and Commercial Codes of the Arab countries may be divided in two categories as to the manner of dealing with the question of interest:
Firstly: Egyptian Civil Code and those Arab Codes which followed closely the Egyptian Civil Code, whereby charging interest is declared as legal by the relevant Civil Code whether in civil or in commercial matters.
Article 226 of the Egyptian Civil Code provides that:
* If the object of an obligation is payment of a sum of money, the amount of which is known at the date of filing a claim, and the debtor delayed the payment, then the debtor shall pay the creditor as compensation for delay 4 % interest in civil matters and 5 % in commercial matters. Such interest shall be calculated as from the date of filing the case.
As we shall see later, this article 226 was subject of the decision of the constitutional Court of Egypt issued in May 1985.
* Article 171 of the Iraqi Civil Code is identical to the Article 226 of the Egyptian Civil Code, except that the Iraqi Civil Code stipulates that the object of the obligation must be known at the date the obligation arose instead of the time of filing the claim as the Egyptian Civil Code requires.
* Article 227 of the Egyptian Civil Code as well as Article 172 of the Iraqi Civil Code lay down the maximum limits for the interest charged, and provide that the parties in a loan agreement or contract may agree on a rate of interest if it is below the maximum rate.
* Also, Article 231 of the Egyptian Civil Code, as well as Article 173 of the Iraqi Civil Code have entitled the creditor to claim supplementary indemnity in addition to the interest if the creditor suffered loss or damages as a result of gross fault or cheating by the debtor. Similar provisions may be found in other Arab Civil or Commercial Codes, as in article 114 of the Kuwaiti Commercial Code and article 91 of the UAE Commercial Code.
* Article 228 of the Egyptian Civil Code, as well as paragraph 2 of Article 173 of the Iraqi Civil Code provide that in order for the interest to fall due, the creditor shall not be required to prove loss or damage.
* The Syrian Civil Code, Articles 227-229, and the Libyan Civil Code, Articles 229-231, have laid down similar provisions as the Egyptian Civil Code, except that each Civil Code adopted a different maximum rate of interest, which the parties to an agreement must not exceed.
* Egyptian Civil Code, Article 232 and other Arab Civil and/or Commercial Codes have prohibited charging compound interests.
The authors of the Arab Civil Codes, which provided for interest appear to justify that on the ground that: in cases of delay of payment, interest amounts to compensation, because the creditor suffers loss due to lending his capital or as a result of the delay of payment by the debtor, especially when the debtor fails intentionally to pay in time. Some writers have argued that interest in certain cases amount to indemnification or compensation for losses suffered by the creditor. To reach to such conclusion, they have relied on the Islamic principle of "There shall be no unfair loss nor the causing of such loss", among other arguments.9
Secondly: Kuwaiti and UAE Civil and Commercial Codes distinguishes between civil matters, whereby charging interest is not allowed in the Civil Codes, and commercial matters, whereby interest is permitted under the Commercial Codes.
Kuwait
* Article 547 of the Kuwaiti Civil Code states: "1. Loans shall be without interest. Any condition to the contrary shall be void without prejudice to the loan agreement. 2. Any benefit which the lender stipulates shall be deemed as interest".
* Article 550 of the Kuwaiti Civil Code (similar to article 719 of the UAE Civil Code) goes further and states that no account shall be taken of any change in the value of money, i.e. fluctuation, decrease of increase of money.
Notwithstanding the said provisions, Article 102 of the Commercial Code stipulates that "1. The creditor shall be entitled to an interest in a commercial loan unless otherwise is agreed upon. If the rate of interest is not stipulated in the contract, the rate due shall be the 7 % legal rate. 2. If a rate agreed upon is stipulated in the contract, and the debtor delays settlement, the interest for the delay shall be calculated on the basis of the agreed rate". Here, it is noted that Article 102 provides an assumption in favour of the creditor to receive interest, even when the agreement is silent.
* Article 110 of the Kuwaiti Commercial Code lays down provisions similar to Article 171 of the Iraqi Civil Code, and Article 226 of the Egyptian Civil Code by imposing 7 % legal interest on the debtor who fails to pay in time.
* Article 111 of the Kuwaiti Commercial Code lays down a maximum rate of interest similar to Article 227 of the Egyptian Civil Code and Article 172 of the Iraqi Civil Code.
According to Article 3 of the Kuwaiti Commercial Code, the Code applies to all commercial matters, including loan agreement, and prevails over the provisions of the Civil Code.
Thus, we see here a straight forward prohibition of interest under the Civil Code in compliance with the Sharia, while the Commercial Code – as a special law – allows interest charging contrary to the principles of Sharia.
It is worthwhile to recall that Article 1 of the Kuwaiti Civil Code provides that Sharia applies as a source of law in case of the absence of an express legislative provision, but only in the absence of a rule of custom. Also Article 2 of the Kuwaiti Constitution declares that Sharia is a principal source of legislation, among other sources.
U A E
UAE Civil and Commercial Codes have adopted a similar approach as the Kuwaiti Code in prohibiting interest under the Civil Code and allowing it under the provisions of the Commercial Code.
* Article 714 of the UAE Civil Code of 1985 provides that:
"If the contract of loan provides for a benefit in excess of the essence of the contract, otherwise than a guarantee of the rights of the lender, such provision shall be void but the contract shall be valid."
Contrary to the above mentioned provisions, Article 76 of the UAE Commercial Code of 1993 states that a creditor may stipulate interest in a commercial loan agreement. If he fails to stipulate the rate of the interest, the current market interest rate shall apply not exceeding 12 %. Here again, there is a presumption in favour of the creditor to claim interest, even if he fails to stipulate that in the agreement.
* Article 88 of the Commercial Code has laid down provisions (similar to Article 171 of the Iraqi Civil Code, and Article 226 of the Egyptian Civil Code, imposing legal interest for delay in payment.
In Jordan the Civil Code did not deal with interest, but interest is charged in accordance with the provisions of an old Ottoman law as well as the 1988 Code of Civil Procedures.
Decisions of the Courts
Having reviewed briefly the provisions of the laws in some Arab countries dealing with interest, it is worthwhile to see how the court in some Arab countries have dealt with the matter.
Constitutional Court of Egypt
Decision of 4th May 1985
During 1980 Article 2 of the Egyptian Constitution was amended to read that:
"Islam is the religion of the State…. And the principles of the Sharia are THE main sources of legislation".
The Rector of the Al Azhar University filed a case against the President and others claiming that the provisions of Article 226 of the Egyptian Civil Code which allow interest for delay in payment is unconstitutional and contrary to the Article 2 of the Constitution referred to before.
The Court held that: Charging interest is prohibited by Sharia, but Article 2 of the Constitution has no retrospective effect, and therefore Article 226 remained in force and was not effected by the amendment. Article 2 of the Constitution has not made Sharia directly the common law of the land and that it does not directly apply. But, it has imposed an obligation on the legislator to observe and apply Sharia principle in any future legislation. 10
Thus, Article 2 of the Constitution is a limitation on the legislator to apply Sharia in respect of any future enactment, and the laws enacted prior to the date of the amended Article 2 of the Constitution, such as the Civil Code, are not effected. Therefore, Article 226 of the Civil Code remains enforceable, though contrary to Sharia.
This decision of the Constitutional Court is widely criticized as poor and not convincing. It is argued that the provisions of Article 2 of the Constitution and the prohibition of interest have become part of the public order and morals and should be applied at least from the date of the enactment in 1980. And the Constitutional Court has the duty and function to control and ensure that the application of the laws are not in contradiction with the Constitution. It has further been argued that the court might have done better if it had based its decision on the principles of necessities and common interest of the society to justify charging interest under the present economic regime.11
It has also been submitted that imposition of interest under Article 226 of the Egyptian Civil Code and similar provisions is a compensation for loss suffered by the creditor due to the failure of the debtor to pay. The creditor does not stipulate interest under Article 226, but the obligation to pay interest arises after the failure of the debtor to pay. This is in conformity with the Sharia principles of "Theman" that a person causing damage must compensate. In support of this opinion it is also said that: Islam encourages giving loan without interest, but the debtor must act in good faith. The failure to repay the loan in time is intentional fault and amounts to bad faith." Therefore, the reasons "illah" behind the prohibition of interest is not present in such cases. Consequently, it is argued, imposing interest for delayed payment falls outside the prohibition of Riba.12
Kuwait Constitutional Court, Decision of 28.11.1992
An appeal was submitted to the Constitutional Court on the basis that Article 2 of the Constitution provided that Sharia is a main source of legislation and Article 110 and 113 of the Commercial Code permit charging interest for delay in violation of the Constitution. Therefore, the Appellant claimed the court must declare Articles 110 and 113 unconstitutional.
The Court held that:
Article 2 of the Constitution is a directive to the legislator to resort to Sharia as a source among other sources for legislation, but it does not prevent it from applying other sources of law when necessities arise. It imposes on the legislator only a trust to adopt the Sharia principles to the extent possible, it is a political directive to the legislator to adopt Sharia, but the legislator remains free to withdraw principles of law from other sources which the legislator finds suitable. The judge may not ignore an express provision of law such those of Article 110 and 113 and apply Sharia, but he may resort to the application of Sharia only when there is no express provision in the law.13
Sharia is not THE source and not the only source of law. Based on that the court held that Articles 110 and 113 of the Kuwaiti Commercial Code permitting interest are constitutional.
It is noted that the reasoning of the Kuwaiti court runs parallel to the reasoning of the Egyptian Al Azhar case, in certain aspects, except that the Kuwaiti court did not contend that Article 2 of the Constitution has no retrospective effect. But, in both cases the court appeared to aim at one thing, i.e. legitimising interest by all means.
UAE Supreme Federal Court, Decision dated. 06.09.1983
The Defendant, a company, which borrowed a sum of money from a bank, claimed that Sharia has prohibited interest and specially compound interest. Therefore, the Defendant had no obligation to pay the sums claimed by the bank. The appellant, a bank, appealed to the Federal Court in Abu Dhabi against the decision of the lower court for the remaining sum of a loan and interest allegedly due from a company. The appellant contended that the court may apply the Sharia only in cases of absence of an express provision in the law as stated in Article 5 of the Code of the UAE Civil Procedures no. 3 of 1970. Articles 61 and 62 of the said law permit charging interest expressly, therefore the court can not set aside the express provisions of the law and apply the principles of Sharia prohibiting interest.
The Federal Supreme Court held that Sharia has prohibited interest, but has at the same time made exception to the prohibition by the application of the Sharia principle of: "Necessity permits what would be otherwise forbidden". Also, the court further argued that Islamic jurisprudence allows exceptions to a rule when there is overwhelming interest of the society. Based on the foregoing principles, Sharia has recognised sale of "Salam" and contract of "Istisnah" as exceptions to rules, which render the sale of non-existing object invalid.
Based upon the aforesaid principles, charging simple interest should be considered as exception to the rule of prohibition due to the necessities, requirements, and interest of the people. Consequently, the provisions of Articles 61 and 62 of the Code of the Civil Procedures of 1970 are constitutional, the court held.
The court added to the above mentioned reasoning that the judge must respect the will of the parties, and may not ignore the agreement of the parties except in exceptional circumstances. Thus, the court can not set aside the agreement of the parties to pay interest unless the rate is in excess of the maximum legal rate or in cases of compound interests which the law expressly forbade.14
Furthermore, the court held that the interest in the case subject of the appeal amounts to compensation. Accordingly, the court rejected the contention of the defendant.
In another case, the UAE Supreme Court held that though article 714 of the Civil Code prohibits interest, but the Civil Code as such does not apply to commercial transactions, and that charging interest by banks is permitted under the Commercial Code.15
The Civil Procedural Law of 1970 has now been replaced by the new Civil Procedural Law no. 11 of 1992 and Articles 76, 77, 88 and 409 of the UAE Commercial Code of 1993 leave no doubt that charging simple interest in commercial and banking transactions is permitted.
In conclusion, it appears from the foregoing review, that courts and the legislators in the Arab countries have succeeded up to now in paying a lip service to the rules of the Sharia and have survived the conflict created by the application of the Sharia vis a vis the requirements of the modern secular legal and commercial systems.
Islamic Banking
The Islamic financing and banking institutions have grown successfully within the last 20 years in response to popular need in Islamic countries for free interest financing as well as the need of Western and American markets for new capitals. OPEC surplus made it possible for both sides to use the huge surplus money. However, the size of the Islamic Banking transactions remains small as compared to the traditional banking, but it is steadily growing.
It is estimated that there are about US $ 100 billion investment worldwide according to Sharia principles; relatively a small sum but significant considering the short period during which Islamic financial institutions and Islamic funds have existed. The use of Islamic investment funds and banking is not confined to the Middle East but has been adopted by a number of conventional banks in USA and Europe.
We shall attempt here-below to outline the main features of Islamic banking and the differences with conventional banking as well as some of tools used by such institutions as financing instruments.
General Features
Islamic banking refers to a banking and financing system which ensures that the financial transactions conform to Islamic law principles.
The management of such financial institutions includes a board of Islamic scholars and advisors who examine each financial transaction to ensure compliance with Sharia.
In Islamic banking, both risk and profit go together, and depositor is deemed as a shareholder, taking profits or sharing loss. The bank often act as trustee acting on behalf of their clients whether depositors or borrowers in accordance with the principles of Sharia.
The concept of Islamic financing aims not only at making profit, but also at achieving economic development and social justice in comparison with conventional banking system which is based on debts and interests.
The main differences between the conventional and Islamic banking stem from the prohibition of Riba, and "Gharar" or gambling transactions by Sharia, as stated before.16 Also, the prohibition of "Gharar", gambling and aleatory transactions under Sharia lead to restrictions on the activities of the Islamic banks. These are transactions which are too speculative or based on unknown and uncertain events, with significant high risks. These and other rules of the Sharia have shaped the types of financial transactions adopted by Islamic banks. Accordingly, the Islamic financial institutions have developed certain contracting models based on no-interest concept to satisfy the needs of the market.
The following are the most popular banking instruments or model contracts commonly known by their Arabic names:
Murabaha (Trade Financing)
A customer with traditional banking relationships wishes to purchase raw materials or goods for which it does not have the funds to pay the purchase price. It borrows the amount of the purchase price from the bank, which may take a charge or lien against the goods purchased and require the customer to repay the amount of interest. An Islamic institution cannot extend such a loan but it can help the customer to make the purchase by buying the goods from the supplier and then selling the same to the customer at a profit.17
The bulk of Islamic bank funds are operated through murabaha contracts (a sale at percentage mark up). In this type of contract the customer orders the bank to buy goods according to his specifications from a supplier. The customer further promises to purchase these goods from the bank for costs plus a mark up. In practice, the bank purchases the goods only when it is satisfied that the customer will purchase them. This second sale between the bank and its customer is usually on credit. By involving the bank as a seller, the customer can purchase the goods on credit and the bank can claim compensation for their services by demanding a higher sales price. Legally the customer is not just borrowing money for interest but buying goods on credit, permissible under Islamic law. In other words the transaction between the bank and its customer is a sale on credit and not a loan.
The critical difference between a Murabaha financing and traditional purchase financing is that the bank in a Murabaha must actually take title to the goods in question and transfer that title to the ultimate purchaser later. This passage of title raises questions of defects in title, claims, risk of loss, and insurance that must be carefully considered in negotiating and drafting any Murabaha contract. It is also important to determine where and under the law of which nation the title passes, for this will affect whether the title passes at all and whether the purchase and subsequent sale by the Islamic institution or the bank are events subject to transfer, ad valorem, or income taxes of any kind.
To reduce the risks of the bank, in practice, the first and the second sale takes place simultaneously when the title of the goods is transferred to the bank.
Also, an important limitation of the Murabaha arrangement is that it requires three unrelated parties – the supplier, the Islamic institution or the bank and the ultimate purchaser or customer. In such transactions all parties carry certain risks and benefits.
Mudaraba (Profit Sharing Finance)
If a company requires financing a project, but not management or administrative assistance for a project or business opportunity, Islamic institutions or banks may use the Mudaraba contract, in which the Islamic institution or the bank provides the necessary financing and the company provides the work, executes and manages a project. Here there are two phases of transactions. In the first phase, the capital owner deposits his capital in the bank and the bank acts as the party investing the capital, i.e. as "mudarib".
In the second phase, the bank acts as provider of the capital, and the company as a second "mudarib" equivalent to a conventional borrower, which requires and uses the money for a project. The profit (if any) made by the company out of the project is divided according to an agreed proportion between the bank and the company.
The Islamic bank later divides again the profit between the bank and the first capital owner. The bank may also charge fees for its normal services, but not interest.
Such transactions are governed by two basic principals, both derived from Islamic law. Instead of taking interest for lending money, capital providers are involved in a profit and risk sharing arrangement.
The first principle is that the return on capital cannot be fixed in advance but is described by a proportion of profits. The capital provider and the mudarib who makes use of the capital, both share the profit according to agreed proportions.18
The second principle is that the capital owner shares the risks out of the project. Thus, in case of the project looses, the capital owner is liable up to the capital he invested, but not beyond that amount, and the bank does not guarantee the return of the initial capital to the capital owner, and the company or the "mudarib" may lose his labour. Thus, in contrast to conventional banking, the capital provider cannot claim both a fixed interest and the assured return of his capital.
Musharaka, Joint Ventures
A company has a project or business opportunity that requires both financing and management assistance. It may find an Islamic institution willing to enter into a partnership or Musharaka arrangement whereby the company and the Islamic bank are partners in the true sense, sharing equity, management, profit, and losses, according to an agreement made between them. This is Islamic finance in a pure sense, in that it carries out the fundamentals of sharing and putting wealth to productive use.
In entering into a Musharaka arrangement, the considerations are the same as the considerations in any joint venture or partnership. The parties must address the general questions of what the partnership is intended to do, how it will be managed, how the profits and losses will be shared, and how the arrangement can be terminated. Here, the bank may take a lower ratio of profits, but in cases of losses it becomes liable up to its full equity ratio.
A Musharaka arrangement may be related to financing a particular project, whereby the agreement is terminated after completion of the project, or may be linked to a continuing project, in which case the bank receives back its investment progressively according to the project’s ability to repay the initial investment and the agreed profit. The return is based on the revenue out of the project instead of charging interest.
The aforementioned transactions ensure the observance of the riba prohibition and satisfy the rule that when money is lent to another party for a period of time, compensation for the financing may not be a predetermined amount guaranteed by the other party to the contract. Furthermore, such transactions are based on the notion of sharing profit and risks, and on avoiding riskless gains.
There are other instruments and model contracts developed by the Islamic institutions to conform with Islamic principles such as leasing contract (Ijara), whereby a company requests the bank to purchase certain machinery and to lease the machinery to the company for an agreed regular fee.
These and other instruments used by the Islamic banks have proved to be workable, for most of modern transactions are capable to be broken down into sale, purchase, lease and joint venture agreements.19
Also, it is noted that there are continuous efforts to develop new Islamic banking instruments which are in conformity with Islamic principles, and at the same time realistic and profitable.
Islam prohibits interests, but at the same time commands legitimate and fair commerce and legitimate wealth creation. It does not restrict the freedom of contracting and trading as long as they conform to the general principles of Sharia. Islamic banking is still in making and its future depends on its ability to find new ways of trading and investing.20
Footnotes
1. See Mekki I. Lufty, Legal Interests, A Comparative Study p. 161-164 (in Arabic)
2. See Dr. Ahmed .M. Saad,,Delay Interests,Comparative Study,Cairo,1986,(Arabic) pages 90-91
3. Prof. W.M. Ballantyne, Commercial Laws in the Arab Middle East, 1987, p. 122-124
4. Vogel and Hayes, Islamic Law and Finance, 1998, p. 130
5. Ibid Vogel, page 83
6. Supra, Dr. A.M. Saad p. 94-97
7. Supra, Vogel, p. 72
8. Ibid, Vogel, p. 76-77
9. Supra, Dr. A.M. Saad, p. 253-275
10. Ibid, Dr. A.M. Saad, p. 15-43
11. Ibid, p. 36-37
12. Ibid, p. 202-218
13. Prof. Ballantyne, Wither Arab Commercial Laws: Law of God or Mammon?, MEER, Jan. 2000, p. 16-17
14. Supra, Dr. A.M. Saad, p. 18-28; see also Hind Tamimi, Interest Under the UAE Law As Applied by the Courts in Abu Dhabi, Arab Law Quarterly, Part 1, 2002, page 50-3
15. Reported in MEER, March 1999, p. 5
16. Supra, Vogel, p. 110 and 84-88. See alsoF. Al-Omar and M. Abdel Hag , Islamic Banking, 1996, p. 104-108
17. Ibid, Vogel, p. 140-143
18. Ibid, Vogel, p. 130-131
19. See M.J.T. McMillen, „Collateral Security and Financing Structures for Sharia – Compliant Project Finance…”, MEER, August 2001, pages 7, 11-18
20. Supra, F. Al -Omar and M. Abdel Hag, pages 124-126