Islamic Law of Contracts and
Business Transactions
by
Dr. Syed Zulfiqar Ali Shah
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Summary of last lecture
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Introduction
Mal (WEALTH), USUFRUCT & Ownership
Defining Various Related Terms
Mith¯aq, ‘Ahd or W‘adah, ‘Aqd (Contract)
General Framework of Contracts
Elements of a Contract
Offer and Acceptance: Form of the Contract
Elements of the Subject Matter
Precise Determination of Subject Matter
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Plan of todays lecture
• Possession and Certainty of Delivery of the
Subject Matter
• Broad rules for the validity of MU‘A¯MALAT
• Free Mutual Consent, Prohibition of Gharar,
Avoiding Riba, Avoiding Qim¯ar and Maisir
(Games of Chance), Prohibition of Two Mutually
Contingent Contracts, Conformity of Contracts
with the Maqasid of Shar¯ı´ah, Profits with
Liability, Permissibility as a General Rule
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Possession and Certainty of Delivery of
the Subject Matter
The capacity to deliver the subject matter of the contract at the time of the
conclusion of the contract is an essential condition of a valid contract. If such
a capacity is lacking, the contract is void. The holy Prophet (pbuh) is reported
to have said: “He who buys foodstuff should not sell it until he has taken
possession of it”. It is reported that the Companion Hakim ibn Hizam had
bought some commodities in the times of Umar ibn al-Khattab (Gbpwth), and
intended to sell them to others. Umar ordered him not to sell the
commodities before taking their possession. Zayd ibn Thabit, Abdullah ibn
Umar and Abdullah ibn ’Abbas (Gbpwth) held the same view as that of ’Umar.
Their interpretation implies that the vendor must be the real owner of the
goods and, as such, the owner of their risk and reward. As regards the liability
in case of damage, successors like Ta’aus and Qatadadh opined that if the
goods were damaged before being paid for (in a cash sale), they belonged to
the vendor. But if they were damaged after the purchaser had promised to
take them, they belonged to the latter and the former had to replace them.
Further, according to Muhammad ibn Sirin, if any party in the contract makes
a precondition for the replacement of damaged goods, the liability for such
replacement is on the one who made it.
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Possession and Certainty of Delivery of
the Subject Matter
Therefore, the subject matter of the sale must be in the possession (Qabza) of the
seller at the time the sale is executed. In the case of Salam, certain conditions
have been put in place to rule out the possibility of nondelivery of the goods in a
normal business scenario. For example, only those commodities that are normally
available in the market at the time when delivery has to be made can become the
subject of Salam, so that the Salam seller can get them from the market for
delivery to the Salam buyer if he himself is unable to produce them as per the
agreed specifications. In Istisna‘a, it becomes the responsibility of the
manufacturer/seller to supply the specified asset at the agreed time.
Possession of the subject matter by the seller means that it must be in the
physical or constructive possession of the seller when he sells it to another
person. Constructive (Hukmi) possession means a situation where the possessor
has not taken the physical delivery of the commodity, yet the commodity has
come into his risk and control and all the rights and liabilities of the commodity
are passed on to him, including the risk of its destruction. In the case of
immovable assets, any legal notice of transfer or mutation is sufficient.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
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Free Mutual Consent
All transactions, in order to be valid and enforceable, must be based on free
mutual consent of the parties. The consent that is required for the formation
of a valid contract is free consent. Consent obtained through oppression,
fraud and misperception renders a contract invalid as per Islamic law. It also
requires that consenting parties have certain and definite knowledge of the
subject matter of the contract and the rights and the obligations arising from
it. Accordingly, inspection of the subject matter and proper documentation of
the transaction, particularly if it involves credit, have been encouraged and
emphasized.
Practices like Najash (false bidding to prices), Ghaban-e-Fahish (charging
exorbitant prices while giving the impression that the normal market price
has been charged), Talaqqi-al-Rukban (a city dweller taking advantage of the
ignorance of a Bedouin by purchasing his goods at a far lower price before the
latter comes to the market) and concealing any material defect in the goods
or any value-related information in trust sales like Murabaha have been
strictly prohibited so that the parties can decide with free will and
confidence.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Prohibition of Gharar
All valid contracts must be free from excessive uncertainty
(Gharar) about the subject matter or the consideration (price)
given in exchange. This is particularly a requirement of all
compensatory or commutative contracts. In noncompensatory
contracts, like gifts, some
uncertainty is affordable. Gharar conveys the meaning of
uncertainty about the ultimate outcome of the contract, which
may lead to dispute and litigation. Examples of transactions
based on Gharar are the sale of fish in water, fruits of trees at
the beginning of the season
when their quality cannot be established or the future sale of
not fully defined or specified products of a factory which is still
under construction.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯
T
In order to avoid uncertainty, valid sales require that the commodity being
traded must exist at the time of sale; the seller should have acquired the
ownership of that commodity and it must be in the physical or constructive
possession of the seller. Salam or Salaf and Istisna‘a are the only two
exceptions to this principle in Shar¯ı´ah and exemption has been granted by
creating such conditions for their validity that Gharar is removed and there is
little chance of dispute or exploitation of any of the parties. These conditions
relate to the precise determination of quality, quantity, price and the time
and place of delivery of the Salam goods.
Another relevant example of avoiding uncertainty is that of the sale of debt,
which, per se, is not allowed even at the face value, because the subject
matter or the amount of debt is not there and if the debtor defaults in
payment, the debt purchaser will lose. Therefore, discounting of bills is not
allowed as per Shar¯ı´ah rules. However, subjecting it to the rules of Hawalah
(assignment of debt) will validate the transaction, because under the rules of
Hawalah, the purchaser of debt (if it is on the face value) will have recourse to
the original debtor and Gharar is removed.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Other examples of Gharar-based invalid transactions are
short-selling of shares, the sale of conventional derivatives
and the insurance business. Futures sales of shares, in which
delivery of the shares is not given and taken and only a
difference in price is adjusted, trading in shares of
provisionally listed companies or speculation in shares and
Forex business, in which only the difference is netted and
delivery does not take place, are other examples of Ghararbased transactions.
However, speculation per se, which means sale/purchase
keeping in mind possible change in prices in the future, is not
prohibited. It is only such sales that may involve the sale of
nonexistent and not owned goods/shares and Maisir/Qim¯ar
that are prohibited.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Avoiding Riba
As discussed in detail in previous chapters, Riba is an increase that
has no corresponding consideration in an exchange of an asset for
another asset. The increase without corresponding consideration
could be either in exchange or loan transactions. As Islamic banks
and financial
institutions are involved in real sector trading activities as well as
the creation of debt as a result of credit transactions, they must
give special consideration to avoiding Riba lest their income might
go to the Charity Account due to non-Shar¯ı´ah compliance. In the
conventional
sense, the cost of funds amounts to Riba and they have to make
profit by way of pricing the goods or usufruct of assets and not by
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lending.
BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Avoiding Qim¯ar and Maisir (Games of Chance)
Qim¯ar includes every form of gain or money, the
cquisition of which depends purely on luck and chance.
Maisir means getting something too easily or getting a
profit without working for it. All contracts involving
Qim¯ar and Maisir are prohibited. Present-day lotteries
and prize schemes based purely on luck come under this
prohibition. Dicing and wagering are rightly held to be
within the definition of gambling and Maisir. Therefore,
Islamic banks cannot launch any such schemes or
products
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Prohibition of Two Mutually Contingent Contracts
Two mutually contingent and inconsistent contracts have been prohibited by the holy Prophet
(pbuh). This refers to
1. The sale of two articles in such a way that one who intends to purchase an article is obliged to
purchase the other also at any given price.
2. The sale of a single article for two prices when one of the prices is not finally stipulated
at the time of the execution of the sale.
3. Contingent sale.
4. Combining sale and lending in one contract.
In order to avoid this prohibition, jurists consider it preferable that a contract of sale must relate
to only one transaction, and different contracts should not be mixed in such a way that the
reward and liability of contracting parties involved in a transaction are not fully defined.
Therefore, rather than signing a single contract to cover more than one transaction, parties
should enter into separate transactions under separate contracts. Islamic banks may come across
a number of transactions in which there could be interdependent agreements or stipulations that
have to be avoided. The combination of some contracts is permissible subject to certain
conditions:
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Bai‘ (sale) and Ijarah (leasing) are two contracts of totally different impacts; while
ownership and risk are transferred to the buyer in Bai‘, neither ownership nor risk
transfer from the lessor to the lessee. It is necessary, therefore, that lease and sale are
kept as separate agreements. In Islamic banks’ Ijarah Muntahia-bi-Tamleek (lease
culminating in transfer of ownership to the lessee), the relationship between the
parties throughout the lease period remains that of the lessor and lessee and the bank
remains liable for the risks and expenses relating to ownership. Transferring ownership
risk to the lessee during the lease period would render the transaction void. However,
one of the parties can undertake a unilateral promise to sell, buy or gift the asset at
the termination of the lease period. This will not be binding on the other party.
• Shirkah and Ijarah can be combined, meaning that a partner can give his part of
ownership in an asset on lease to any co-partners. Jurists are unanimous about the
permissibility of leasing one’s undivided share in a property to any other partner.
However, sale of ownership units to the client in Diminishing Musharakah will have to
be kept totally separate, requiring “offer and acceptance” for each unit.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Musharakah and Mudarabah can also be combined. For example, banks
manage depositors’ funds on the basis of Mudarabah; they can also deploy
their funds in the business with the condition that the ratio of profit for a
sleeping partner cannot be more than the ratio that their capital has in the
total capital.
• Contracts of agency (Wakalah) and suretyship (Kafalah) can also be
combined with sale or lease contracts, with the condition that the rights and
liabilities arising from various contracts are taken as per their respective rules.
As per present practice of Islamic banks, Wakalah is an important component
of Murabaha, Salam and Istisna‘a agreements.
• Islamic banks can structure products by combining different modes subject
to the fulfilment of their respective conditions. For example, they can
combine Salam or Istisna‘a with Murabaha for preshipment export financing.
Diminishing Musharakah is also a combination of Shirkah and Ijarah, added by
an undertaking by one party to periodically sell/purchase the ownership
to/from another partner.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Similarly, the exchange of two liabilities is prohibited.
Transactions between two parties involve an exchange of any
of the following types: corporeal property for corporeal
property, corporeal property for a corresponding liability or a
liability for another liability. Each one of these can be
immediate for both parties or delayed for both or immediate
for one party and delayed for the other. In this way, Ibn Rushd
has identified nine kinds of sales. Out of the above categories
of exchange, an exchange involving delay from both sides is
not permitted as it amounts to the exchange of a debt for a
debt, which is prohibited. That is
why full prepayment is necessary for valid contracts of Salam.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Conformity of Contracts with the Maqasid of Shar¯ı´ah
The injunctions of the Shar¯ı´ah are directed towards the
realization of various objectives for the welfare of mankind.
The objectives of the Shar¯ı´ah have been emphasized in a
large number of the texts of the Qur’¯an and Sunnah. Any
contract or transaction that militates against any of these
objectives is invalid in Shar¯ı´ah. It is quite obvious that the
rights of fellow beings have to be honoured in respect of all
transactions. The rights of Allah (SWT) in Shar¯ı´ah also refer
to everything that involves the benefit of the community at
large. In this sense, they correspond with public rights in
modern law. Therefore, any contract should not be against the
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benefits of the public at large.
BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Profits with Liability
This principle states that a person is entitled to
profit only when he bears the risk of loss in
business. It operates in a number of contracts such
as the contract of sale, hire or partnership. Any
excess over and above the principal sum paid to the
creditor by the debtor is prohibited because the
creditor does not bear any business risk with regard
to the amount lent. In sale and lease agreements,
parties have to bear risk as per the requirements of
the respective contracts.
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BROAD RULES FOR THE VALIDITY OF
MU‘A¯MALA¯ T
Permissibility as a General Rule
Everything that is not prohibited is permissible. The
principle of permissibility establishes the fact that all
agreements and conditions contained in them are
permissible as long as they do not contradict any explicit
text of the Qur’¯an or Sunnah. Individuals are not always
in a position to conduct exchange transactions on a spot
payment basis. Many times, one of the two counter
values to an exchange transaction is not exchanged
simultaneously, as happens in credit (Mu’ajjal) or forward
(Salam) transactions.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
In W‘adah or ‘Ahd, one party binds itself to do some action for the other. ’Ahd
generally does not create legal obligation but in certain cases it becomes legally
binding and enforceable. This is where the promisee has incurred some expenses
or taken some liability as a result of the promise. Contingent promises are also
considered binding. Keeping in mind the intricacies of present-day business,
particularly when conducted by Islamic banks, contemporary scholars have
reached the consensus that W‘adah is enforceable by law until and unless the
promisor is not in a position to fulfil it on account of any force majeure. If
nonfulfilment is due to any wilful act of the promisor, he has to make good the loss
to the promisee.24 For example, A promises to sell next month a house to B (a
bank) for $100 000, but subsequently he sells the house to C before the month
elapses. A would be liable to make up any actual loss incurred by the bank, since it
might have made arrangements to lease the house or to sell it or to use it for
accommodation for its staff and thus incurred costs.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
Let’s say A asks bank B to purchase for him a motor car and promises to buy it
from B at $20 000. After B purchases it for the total cost of $18 000, A backs out; B
sells it in the market for $17 000. Now the net loss of $1000 will have to be borne
by A, which the bank can recover from his security or token money (Hamish
Jiddiyah).
The rationale behind this consensus decision is that, in many cases, binding
promises become a genuine requirement, the fulfilment of which does not
amount to violation of any basic Shar¯ı´ah tenet. For example, importers need to
hedge their foreign exchange needs, but since forward contracts of gold, silver or
any monetary units are not allowed as per Islamic principles relating to Bai‘ al Sarf,
they can do this through unilateral promise by any of the parties. Thus, they can
take foreign currency forward cover for genuine business activities allowed by the
Shar¯ı´ah scholars on the basis of promise and simultaneous exchange of the
currencies at the agreed time.
Some scholars have criticized Islamic banks for treating the “promise to purchase”
by the client as binding. But as it does not involve violation of any major Shar¯ı´ah
principle, many edicts have declared it binding, keeping in mind the practical
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problems in finalization of contracts.
W‘ADAH (PROMISE) AND RELATED
MATTERS
The Islamic Fiqh Academy of the OIC has made the promise in
commercial dealings
binding with the following conditions:
1. The promise should be unilateral or one-sided.
2. The promisor must have caused the promisee to incur some
liabilities or expenses.
3. If the promise is to purchase something, the actual sale must take
place at the appointed time by the exchange of offer and acceptance.
Mere promise itself should not be taken as the actual sale.
4. If the promisor backs out of his promise, the court may force him
either to purchase the commodity or pay actual damages to the seller.
The actual damages will include the actual monetary loss suffered by
him, but will not include the opportunity cost.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
According to the majority of scholars, Muwa‘adah or Mu‘ahidah
(bilateral promise) is not allowed in situations where ‘Aqd is not
allowed (e.g. forward currency contracts), and thus not enforceable by
law. However, some scholars of the subcontinent consider bilateral
promise as enforceable by law except for the bilateral promises in
transactions like shortselling of currencies or shares of joint stock
companies. Notwithstanding the binding nature of promise, the
difference between a contract (‘Aqd) and a bilateral promise is that the
ownership in bilateral promise is not transferred at the time of signing
the promise, while in ‘Aqd, not only the ownership transfers but also
the rules of inheritance apply as soon as it is executed.
The binding nature of promise has important implications for Islamic
banks’ operations in respect of Murabaha to Purchase Orderer, Ijarahwal-Iqtina‘, Diminishing Musharakah, which is used by many Islamic
banks in the world for housing finance, and for the disposal
of goods purchased by banks under Salam/Istisna‘a.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
Token Money (Hamish Jiddiyah) and ‘Arb¯un
In the case of binding promises, Islamic banks take token money from the
promisee clients, which is the amount taken from them to convey seriousness
in purchasing the relevant commodity/asset. In Arabic, this is called Hamish
Jiddiyah – the margin reflecting the firm intention of the promisee. Banks
hold token money as a trust and adjust it in price at the time of the execution
of the sale. This means that Hamish Jiddiyah is taken before the execution of
an agreement, as against ‘Arb¯un, which is taken from the buyer as part of the
price after execution of the sale agreement. In cases where the bank
undertakes some activities and incurs expenses in purchasing the asset for
onward sale to the promisee, and the latter fails to honour the “promise to
purchase”, the bank can recover the actual loss from the promisee; the
excess/remaining amount of Hamish Jiddiyah will have to be given back to the
client. The actual loss does not cover the loss in respect of “cost of funds”.
‘Arb¯un is the earnest money given at the time of execution of the sale as part
of the price.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
Such amounts are also taken in tenders, in which the bidders show their
intention to purchase an asset at a certain price and instantly give a part of it
to the seller who has called the bid. If the bid is accepted, the amount
becomes part of the price. So the amount is treated as a trust until the time
of bidding and the nonsuccessful bidders have the right to get it back. Bidders
can cover actual damage sustained in the bidding process. The seller, after
execution of the sale against a part payment, has the right to retain the whole
amount of ‘Arb¯un if the other party has failed to perform within the period
stipulated in the agreement. The AAOIFI, however, considers it preferable to
refund the amount over and above the loss actually sustained by the seller. In
recent years, ‘Arb¯un has become a subject of intensive research in respect of
finding any alternative to the conventional options. It therefore warrants
some detail. Imam Malik has defined ‘Arb¯un in the following words: “It is
when a person buys a slave or rents an animal and says to the seller or the
owner of the animal, ‘I will give you one dinar or one dirham or more or less
and if I ratify the sale or the rent contract, the amount I gave will be part of
the total price. And if I cancel the deal, then what I gave will be for you
without any exchange’.” He considers this deal invalid.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
Two traditions are reported with regard to ‘Arb¯un in
various books of Hadith, one prohibiting and the other
allowing ‘Arb¯un sale. But both of these are considered
weak and unauthenticated. Among the main schools of
Islamic Fiqh, only the Hanbali school considers Bai‘ al
‘Arb¯un a legal contract. They rely mainly on the report
from Naf‘i Ibnal Harith, an officer at Makkah deputed by
Caliph Umar (Gbpwh), which states that he bought from
Safwan Ibn Umayyah a prison house for Caliph Umar
(Gbpwh) for four thousand dirhams on condition that if
the Caliph approved of it, the deal would be final,
otherwise Safwan would be given four hundred dirhams.
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W‘ADAH (PROMISE) AND RELATED
MATTERS
The majority of contemporary jurists are of the view that if a buyer in
actual sale transactions stipulates by his free will and without any
duress that he will either finalize the deal within so many days or the
sale will be considered cancelled and the seller will get the amount
given in advance, it could be considered legal. But open options, even
in valid sales, wherein the parties have no intention to buy and want
profit simply by transferring risk to the other party, are against the
basic philosophy of Islamic finance. That is why conventional options
have not been accepted as genuine instruments in Islamic finance. We
shall discuss this in detail later. Here, we can briefly say that the
concept of ‘Arb¯un is acceptable to the extent of part payment after
finalization of the deal. Its legality as a separate sale, i.e. Bai‘ al
‘Arb¯un, and its implications for the legality of conventional options
are not acceptable, in general, to scholars.
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Summary of Today’s Lecture
• Possession and Certainty of Delivery of the
Subject Matter
• Broad rules for the validity of MU‘A¯MALAT
• Free Mutual Consent, Prohibition of Gharar,
Avoiding Riba, Avoiding Qim¯ar and Maisir
(Games of Chance), Prohibition of Two Mutually
Contingent Contracts, Conformity of Contracts
with the Maqasid of Shar¯ı´ah, Profits with
Liability, Permissibility as a General Rule
• W‘adah (Promise) and Related Matters
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THANK YOU
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