CONTRACTS IN ISLAMIC COMMERCIAL AND THEIR APPLICATION IN MODERN ISLAMIC FINANCIAL SYSTEM

7.0  Contracts of Utilization of Usufruct ('Uqud al-Manfa'at)

The above type contract is divided into two categories which are the transfer of the usufruct for a consideration and the transfer of the usufruct without a consideration. The former is a bilateral contract while the latter is not. The former is known as contract ijarah while the latter is known as 'ariyah contract. The details of these two contracts are as follows:

7.1  Contract of Ijarah (transfer of usufruct for a consideration)

Ijarah is a word that conveys the sense of both hire and lease. Ijarah is of two kinds, namely use of corporeal property which may take one of three forms:

1. Immovable property, such as land or premises


2. Merchandise, such as furniture, machinery, etc.


3. Animals.

The second type of ijarah is personal service. The salient features of ijarah contract are as follows:

1. The lessor must be the absolute owner of the thing or the agent of the owner of his natural or legal guardian.


2. The thing given for rent and the amount of rent should be fully and precisely known to both parties.


3. In a contract of hire, it is necessary to make known the use to which the thing hired is to be put, so as to avoid later dispute.


4. When land is taken for rent, the period must be fixed and the purpose for which it is rented specified.


5. In hiring an artisan, the benefit should be made known by a statement of the nature and method of workmanship.


6. It is the responsibility of the lessor to maintain the property leased in such a way as to retain the benefit of the property.


7. If the lessee damages the property hired, the lessor can annul the lease on application to the court.


8. The lessee can sub-let immovable property but not movable property.


9. The thing hired should be treated as a trust in the hands of the user.

7.2  'Ariyah (Lending for Gratuitous Use)

In addition to the above general rules, the contract of 'ariyah requires the following rules;

1. The lender may withdraw the loan whenever he wishes.


2. The thing lent must be capable of giving a benefit.


3. The thing lent for use must be defined.


4. The borrower becomes the owner of the benefit without giving any payment to the owner.


5. The maintenance of the thing borrowed for use is the responsibility of the borrower.


6. When lending for use is restricted as to time, place and nature of use, the restriction are to be observed.


7. The borrower cannot let or pledge the thing lent for use, the borrower must immediately return it.


8. When the lender demands the thing lent for use, the borrower must immediately return it.


9. The expense and care of returning a thing lent for use fall on the borrower.

8.0  Contracts of Security

Thus type of contract consists of three contracts which are hiwalah, kafalah and rahn explanation of each of the contracts is as follows:

8.1  Hiwalah (Transfer of Debt)

Hiwalah means transferring a debt from one debtor (transferor) to another (transferee). Once the transferee has accepted the transfer of debt, the transferor would be released from any obligation. Therefore, as a consequence of the transfer of debt (hiwalah), unlike suretyship, the debtor who transfer his debt and his surety, if ally, are freed from their respective obligations. The creditor can now claim his debt only from the transferee. The transferee, after payment, has aright to claim the amount so paid from the transferor. In such a case, the transferor's claim from the transferee, of any, will be adjusted towards the claim. However, the transferee would be released from his liability in any of the following four situations:

1. By payment of the debt.


2. By further transferring the debt to another person if the creditor accepts.


3. By cantonments by the creditor.


4. If the creditor dies and person who accepts the transfer is his heirs.

8.2  Rahn (Pledges)

A creditor, whether an individual or a financial institution, prefers to secure a loan either through personal surety or a pledge. Pledge or rahn is to make a property a security in respect of a right of claim, the payment for which may be taken from the value of the property. The main laws relating to pledge, inter alia, are as follows:

1. The contract becomes irrevocable after the pledge is received by the pledgee.

2. One pledge may be exchanged for another.

3. The pledge may, on his own accord, all the contract.

4. Two different creditors may take a common pledge from a single debtor. This pledge will secure the whole of the two debts.

5. When a debt is partly paid off, it does not become necessary to return the part of the pledge equivalent to it in full. The pledge has a right to hold the whole until the debt is paid.

6. If the pledgor has destroyed or damaged the thing pledged, he must pay compensation. If the pledge has destroyed or damaged it, the amount of its value is struck off the debt.

7. If the time for paying the debt has arrived, and the pledgor refuses to make payment, the pledge may approach the court to compel the pledgor to sell the thing pledged in order to pay the debt. On his refusal, the court may sell the pledge to pay the debt.

8.3  Kalafah (Suretyship)

Kalafah means to add an obligation to an existing obligation in respect of a demand for something. This may relate to a person, finance or act (performance). Kafalah relating to a person involves the production of the person for whom the kafalah (bail) has been given. Kafalah relating to finance implies an obligation. Kafalah relating to an act or performance as to ensure the performance of a certain act, the failure of which may render th surety liable and responsible. One important point to be stressed is that kafalah, unlike hiwalah, would not release the principal debtor in whose favour the contract is concluded because kafalah is only an obligation in addition to the existing obligation. Among other rules governing kafalah are as follows:

1. It is lawful to become surety for surety.

2. There may be more than one surety for a single obligation.

3. If persons who are jointly indebted become surety for each other, each of them is liable for the whole debt.

4. The discharge of the surety does not necessarily discharge the liability of the principal debtor concerned. The opposite scenario will be acceptable as far as the discharge is.

5. If a delay is granted to the principal debtor for the payment of his debts, a delay is also granted to the surety principal debtor. But a delay given to the surety is not a delay given to the debtor.

9.0  Introduction to Conventional and Islamic Banking

Conventional banking in the Western world has been evolved about two and a quarter centuries ago, having contemporary with the emergence of industrial civilization. The industrial revolution saw a tremendous expansion in the number of traders, manufactures, industrialists and other entrepreneurs but whose own financial resources were not enough for them to embark on their respective industrial activities. Hence a method had to be found. Thus, the need of financial intermediates gave rise to the conventional banking which later became the backbone of the modern industrial and financial system. This is simply because the rate of economic development is always constrained by the availability of financial resources Economic development needs mobilization of financial resources and channelisation of these sources to appropriate interested sectors.

The banks in the conventional system, acting as intermediaries, accept deposits from the public and lend them to the borrowers, regardless of whether these borrowers are individuals or corporate entities. The bank's profits are mainly attributed to the difference between interest expended (paid) to depositors, and interest earned (received) from borrowers.

Banking and financial houses in Islamic civilization are normally called masarif. Literally, sari means turning, sending and employing. In the technical usage, musarafah signifies the act of dealing, buying and selling and sometimes it has been attributed to change of money. The sarraf or the money changer became an essential feature of every Muslim market. A bank with headquarters in Baghdad and branches in other cities was mentioned in Arabic sources. They carried on business through an elaborate system of cheques and letters of credit which was so developed that is was possible to draw a cheque in Baghdad and cash in Morocco. Indeed, it was reported that in Basrah, the center of trade in the East where each merchant had his own bank account, payment were effected in cheques and never in cash.

The idea of establishing an interest free bank goes back to as early as 1940s. However, the conditions then were not ready for actual establishment of an Islamic bank as not much thought had been given to technical details and actual operation of an Islamic bank. A pioneering experiment of putting the principles of Islamic banking into practice was conducted in Mit-Ghamr in Egypt from 1963-1967 with special emphasis in educating the rural Muslims on the operation of the banking system. In Mit-Ghamr project, a number of accounts were accepted, namely saving accounts, investment accounts and zakat accounts. In the saving accounts, no interest is payable to depositors but they were allowed to the withdrawals. Also, they were eligible for a small short term were allowed to the withdrawals. Also, they were eligible for a small short term free loan for productive purposes. The funds deposited in the investment account were subject to restricted withdrawals and were invested on the basis of profit and loss sharing. On the other hand, the zakat account attracted the payment of zakat to be distributed among the poor and needy. Mit-Ghamr experiment was short lived up to the year 1967 due to political reason.

In short, the establishment of an Islamic bank at Mit-Ghamr in Egypt (1963), brought a remarkable impact on the real implementation of banking practices according to the Shari'ah principles. Twelve years later, through the Organization of Islamic Conference (OIC) an inter-governmental Islamic bank was established, known as the Islamic development bank. Later, many private Islamic banks were established by Muslim entrepreneurs including Dubai Islamic Bank (1975). Dar al-Mal al-Islami (1981), Bank Islam Malaysia Berhad (1983) and a few other Islamic banking institutions operating on an international mandate in non-Muslim soil and environment such as the Dar al-Mal al-Islami (Geneva), Islamic Investment Company (Bahamas) and other places.

Having said this, the philosophy and principles of Islamic banking date back to more than 1,400 years ago, to the Qur'an and the Sunnah of the Prophet (s.a.w). At present, more than 150 Islamic financial institutions operating worldwide. Interestingly enough, Islamic banking is being discovered by western banks as a mechanism to gain access to the large pool of Muslim funds. It is not suprising, therefore, that there is an ever-increasing number of conventional banks providing Islamic investment services to their international clients.

The development of Islamic banking in the twentieth century witnesses the emergence of such institutions in certain countries where such was possible. This development marked the widening of the practice of the Shari'ah principles beyond the boundary of the realm of devotional matters (ibadat) and family and matrimonial matters (al-ahwal al-shaksiyah). The raison d'etre of Islamic banks, generally speaking, is the followings:

1. the absence of interest-nased transactions


2. the avoidance of commercial transactions involving gharar (uncertainty)


3. discouragement of the production of goods and services which contradict the value pattern of Islam; and


4. the payment of an Islamic tax, the zakat.

10.0  Islamic Financial System in Malaysia: An Overview

The introduction of the Interest-Free Banking Scheme (known in its Bahasa Melayu acronym as SPTF, namely Skim Perbankan Tanpa Faedah) in Malaysia in 1993 was premised on a dual banking system; a full-fledged Islamic banking system operating on a parallel basis with a sophisticated conventional banking system. So far, Malaysia is the only do the two systems work on a parallel basis they also utilize essentially the same set of banking infrastructure. This has significant implications in terms of the cost and speed of implementing the Islamic banking system.

The Malaysian model has a number of advantages when compared to the other models of implementing Islamic banking Muslims in countries which have only a conventional system do not have the opportunity to benefit from the facilities of a modern systems without being involved in riba. The same is true in the case of the conventional plus system, where the Islamic banking institutions operate on the fringe of the domestic banking system and the services they offer are neither as comprehensive nor as sophisticated as the conventional system. Among Muslim countries which fall under this 'model' are Saudi Arabia, Bahrain, Bangladesh, Brunei, Egypt, Guines, Indonesia, Jordan, Kuwait, Niger, Qatar, Senegal, Tunisia, Turkey and United Arab Emirates.

The Islamic banking products offered in Malaysia's dual system are therefore much more sophisticated and covering a wider range of services compared to the products offered in the conventional plus system as is the case in the countries listed above. More surprisingly, the Malaysian model of a dual system has proved to overwhelm the model of Islamic banking in some countries such as Iran, Pakistan and Sudan which have an entirely Islamic banking system leaving no room and avenue for conventional banking system. The advantages of the Malaysian model are as follows:

First, the range of Islamic banking products in a dual system tends to be wider when compared to the products in a single Islamic system, since in a dual system Islamic banks have to provide all the services provided by conventional banks.

Second, the Islamic banking products in the dual system, can also be expected to have a higher level of sophistication compared to the Islamic banking products in the single Islamic system in other words, Islamic banks operating in the dual system would have no choice but to create similar sophisticated products on an Islamic basis as did the conventional banks.

11.0  Sources of Fund in Islamic Financial System

As far as sources of fund are concerned, the bank can raise its initial equity (or paid-up capital) in straight forward way through the Islamic equity-financing contract of al-musharakah among its initial shareholders. In the case of SP TF banks, the contributors would be the main banks which shall provide the paid-up capital either on the basis of mudarabah, musharakah or qard hasan respectively. The public could also be the contributors through saving accounts, current accounts and investment accounts respectively. While the first two accounts are basically based on the Islamic contract of wadi'ah yad dhamanah (safe custody based on suretyship), the third account is originated from al-mudarabah contract. In short, the sources of fund for interest-free banks may come from these means which are as follows; shareholders equity, customers' deposit in current account, customers' deposit in savings account, customers' deposit in general investment accounts and customers' deposit in special investment accounts.

As mentioned elsewhere, it is not the institution which distinguishes Islamic financial system from the conventional one it is rather the functions and way they are performed that make the Islamic financial system distinct. Interestingly, deposit taking is one of the sources of fund in the Islamic financial system but the institutions do not pay any interest on the money deposited at the bank. Under the conventional system, the nature of the contractual legal relationship in the sense that the bank is the debtor and the customer is the creditor. However, under Islamic financial system, particularly in Malaysia, the Islamic banks/counters accept deposit for both saving and current accounts under the contract of wadi'ah (safe-custody) coined together with another contract, namely dhaman (surety ship) contract. Ultimately, the accounts are opened under the purview of the contract of Wadi'ah Yad Dhamanah (safekeeping with guarantee).

The very essence of Wadi'ah Yad Dhamanah is that the custodian (the bank) would be able to utilize the money deposited since the custodian would be solely held liable for any damage inflicts on the deposited item. On the other hand, the depositors are given the assurance that they may withdraw their money at any time and above all, their money will be guaranteed from any damage and the like. Also, adopting this approach would entitle the banks to reward their depositors a discretionary reward i.e. hibah. The practice of awarding a hibah to depositors is deemed necessary as interest-free-banking system is operating in a dual banking system and therefore, it needs to be competitive with the conventional banking environment. However, interest-free banks are not allowed to declare nor to promise any amount or rate of hibah up-front as this would be tantamount to riba.

Also, Islamic financial system accepts deposit from the public and private sectors under the contract of mudarabah (profit and loss sharing). This contract is the basis of both General Investment Account and Specific Investment Account. While in the former type of account, the investment project is not defined; the investment project is defined in the latter. Also, the ratio of profit distribution is normally fixed in the former whereas in the latter, this may be usually individually negotiated. The contract of mudarabah is a kind of partnership where one party provides the capital and the other provides the work and management. As in the case of Islamic financial system, the customers or depositors are the investors who provide the capital while the bank act as the manager to convert the capital to profit. The profit, if any will be shared between the two parties based on certain ratio or percentage agreed upon in advance. However, in the event of a loss in the investment, the customers/investors bear all the loss as the manager will lose his time, effort and expected profit.

12.0  Application of Fund in Islamic Financial System

In the area of application of fund, interest-free banking system has relied heavily on two instruments of financing which are murabahah and bay' bithaman ajil. As far as murabahah (cost-plus-sale) is concerned, interest-free banking system has considered it as a short term financing mainly used for working capital financing and Letter of Credit for trade financing. Under this facility, the customer may approach the bank to provide financing for his working capital requirements to purchase stock and inventories, spares and replacements, or semi-finished goods and raw materials. The bank will subsequently sell the goods to the customer at all agreed price comprising its purchase price and a profit margin, and allow the customer to settle this sale price on a deferred term of 30 days, 60 days, 90 days or any other period as the case may be. Murabahah as applied under interest-free banking is not only a financing facility granted for a short period of time but also a deferred payment sale which must be settled in lump sum because it is stated that on due date, the customer pays the bank the agreed sale price.

As far as bay' bi thaman ajil (BBA) is concerned, this facility is used particularly in Malaysia for financing the acquisition of assets and the payment usually is based on instalment basis payable in longer period compared to murabahah facility repayment. The contract of BBA has been utilized by the bank to provide the customers medium and long term financing to acquire items which may include landed property, houses, motor vehicles, furnitures, stock and shares, etc. However, comparatively speaking, house financing is the most popular facility granted under BBA either to purchase a new house; or to purchase existing completed houses; or to build a house on customer's land; or as a refinancing facility. In addition to murabahah and BBA, the Islamic bank also offers ijarah or lease financing. It generally involves the purchase by the bank of a specific asset and its lease to the customer for a long or intermediate plan whereby the bank charges an agreed charge or rent.

One may question how Islamic financial system could be able to offer alternatives to the conventional interest-based loans such as housing loan, bridging loan, project financing, revolving credit/overdraft, share financing, infrastructure financing, discounting of commercial papers, etc. The following is a brief but comprehensive illustration of various products which are able to meet the modern needs of finance but at the same time are compatible with the Shari'ah. We have already dealt with both bay' bi thaman ajil and murabahah which are useful in terms of financing a customer to purchase a commodity be it houses, shop houses, land, motor vehicles, consumer goods, shares, education package and other suitable goods. They are also equally useful for refinancing purposes. In the area of revolving credit or overdraft, some banks have started introducing Islamic revolving credit and Islamic overdraft on the basis of hiwalah with the combination of ju'alah (contract of commission) or wakalah bi al-ajr (agency with fees) which seems to be a good alternative to revolving credit facility or overdraft offered under conventional banking to finance the working capital requirement of the company including overhead expenses. Overhead or utility expenses may include vis a vis water bill, electric bill, rental bill, phone bill, custom duties, consultancy fees and the like.

In fact, interest-free revolving credit may be made available to a customer provided the facility is supported by one of the following trade transactions namely, imports documents, local purchase documents and overhead bill vis a vis utility bills and the like. This facility, in other words, can only be allowed for purchase of goods like raw materials, semi-finished or finished goods including goods like machinery, parts and utility bill. Interest-free revolving credit can only be given to an amount equal but not exceeding the financial value of the trade transaction as indicated in the supporting documents. However, it is to be noted that the proceeds of these expenses must be paid to the vendor or supplier either through the remitting bank or directly, depending on how the documents was received. Proceeds of this facility should under no circumstances be credited to the customer's account because otherwise it will be against the principle of hiwalah. Utilizing hiwalah for a service charge would, it is respectfully submitted, efficiently replace the conventional overdraft and purchase of Bill of Exchange issued under Documentary Credit or Discounting.

Modern Islamic financial system also witnesses the application of Islamic syndication particularly in major project and infrastructure financings. Syndication in financing takes place when a group of financial institutions agree to advance a portion of the fulfilling for a particular project. This kind of financing becomes more and more popular as the Ministry of Finance has issued a directive that all major Malaysian infrastructure projects have to have an Islamic financing component as in the case of Kuala Lumpur International Airport (KLIA) project at Sepang which has secured a portion of Islamic financing in all its stages of construction. As the project are normally large and require large financing, one bank may not be able to provide sufficient financing. Above all, the Central Bank of Malaysia has prescribed that banks may not provide financing to any single customer in excess of the Single Customer Limit which is defined as 30% of the Bank's capital fund. In cases where the financing required is ill excess of the Single Customer Limit, the bank shall arrange for the balance of the provided by other banks. The arranger, also known as manager, lead manager and co-manager respectively, would be entitled for certain amount of fees on the basis of wakalah (agency ship) for his effort and expenses.

Also relevant is the introduction of Murabahah Notes Issuance Facility (MuNIFs) MuNIFs is the interest-free alternative to the conventional revolving underwriting facility. Under MuNIFs, the components of revolving and underwriting are also present. Being structured under the concept of murabahah or cost-plus, the tenderers bid for the purchase price of the underlying assets. Having purchased the assets they are then sold to the issuers at a mark-up price and on deferred periods ranging from one month to one year. This selling price, which the debt created under these contracts of sale, is evidenced by murabahah notes. The debts created out of the murabahah contracts are then securitized through the issuance of Murabahah Notes. The notes will be traded on the secondary market among designated institutions under the concept of bay' al-dayn (sale of debt). Obviously, the notes issuance could be used, inter alia, for working capital requirements and capital expenditures which are useful for any project financing. In addition to what has been said, the idea of Islamic Private Debt Securities (IPDS) would also be significant in promoting the project financing under interest-free banking operations. A good example of IPDS is the one issued under the contract of al-musharakah which was undetaen for Sarawak Shell Berhad in 1991. This musharakah, which falls under the category of musharakah mutanaqisah (decreasing partnership) is a limited contract of participation in terms of duration. The holders of the securities are paid periodically a certain amount of profits from the production turnover of the oil wells based on an agreed proportion, with added bonuses should the turnover exceeds certain levels. In that scheme, the total amount of the facilities was RM 560 Million (US $ 225 Million).

The issuance of Islamic private debt securities is basically based on the concept of securitization. Securitization refers to the creation of tradable certificates evidencing a debt arising out of financing facilities. In brief, securitization is a process that makes debt tradable on the secondary market. The act of securitization is meant for having liquidity which is known in Islamic law as suyulah. The process of securitization is a form of financing by converting the assets, tangible or otherwise, into cash without increasing the leverage on the balance sheet by selling those assets to a special purpose vehicle (SPV) which in turn issues debt securities to finance the purchase. By so doing, the company would be able to get cash which is needed for its projects. As for the SPV, it needs to securitize the debts purchased to be sold to the investors either on the basis of mark-up sale (murabahah) or profit sharing (mudarabah) by issuing murabahah and mudarabah securities respectively.

In Malaysia, the Islamic view point which is now prevalent is that the company may sell the debts to the spy under the purview of bay' al-dayn (sale of debt). Also, in respect to securitization, the financial guarantee is needed to ensure the commitment of the SPV to pay agreed profit and redemption amount of securities to the investors. Perhaps, the role of the Rating Agency Malaysia Berhad (RAM) would be very much relevant to measure the safety of the Islamic securities. Thereof, it has been suggested that the minimum rating to qualify as an investment grade instrument is triple 'B' ('BBB') whereby anything below triple 'B' will be considered as a speculation grade investment.