STANDARD LEGAL DOCUMENTATION FOR ISLAMIC BANKS
OSAMA MOHAMED ALI
The emergence of Islamic banks in the early 70s, as well as their development ever since, as an innovative system offering to clients a number of profit-and-loss-sharing products, such as Mudaraba, Murabaha, Musharaka, etc., has increasingly led many bankers and financial observers to consider Islamic banking as a serious and viable option.
In effect, those who wish to base their banking relations on profitable partnership, rather than on passive financing or mere lending, and, at the same time, wish to give predominance to ethical values, often resort to it as a logical alternative to conventional banking. Nevertheless, the progress and flourishing nature of Islamic banking remains dependent on a number of factors. This article does not pretend to cover all the prerequisites for successful Islamic banking, but only endeavours to look into the specific issue of standardisation of legal documentation for Islamic banks and to analyse its various aspects in the light of future prospects.
Standardisation of legal documentation is generally desirable for practical, operational and jurisprudential reasons. This does not mean, however, that all legal documentation can, or indeed, should, be standardised. For the purpose of this article, it will be useful to divide standardisation into two main categories: internal standardisation, i.e., standardisation within a particular Islamic bank or group, and global standardisation, i.e., standardisation between the Islamic banks or Islamic groups.
While internal standardisation is necessary and relevant for almost all sorts of legal documentation, global standardisation is particularly needed and feasible in the area of Islamic rulings (fatwas), by virtue of which Islamic banks set the ambit and parameters regulating their respective operational activities.
At present, global standardisation appears as an urgent requirement for Islamic banks, as the divergencies with respect to certain definitions and the acceptability parameters of certain financial products are likely to impair the progress of Islamic banking by creating confusion and weakening inter-Islamic bank co-operation, as well as co-operation with other institutions or individuals.
In effect, while Islamic banks agree more or less on the philosophic foundation of Islamic banking, the lack of agreement on certain basic definitions, on the ambit of operational activity and on the structure of certain financial products may, in the medium and long terms, produce a negative impact.
For example, some Islamic banks recognise investment in stocks, financial futures (albeit with certain reservations and conditions) and/or Murabaha, whereas others reject the same as un-Islamic.
Consequently, we believe that global standardisation and uniformity needs to be considered as a priority by Islamic banks in order to enhance their respective credibility and lay solid grounds for effective co-operation, not only between themselves, but also with other institutions and partners. It is believed that the Islamic banks (they still do not have a central regulatory body) will gain tremendously by agreeing on, and abiding by, the basic jurisprudential and legal requirements, including, but not limited to, the following:
1. The definition of the philosophy and basic elements of Islamic banking
a) The central theme: mobilisation of resources with a view to directing them towards income-generating investments, commercial and development activities.
b) The ethical parameters: equality of opportunity between clients, respect for contractual covenants, and equitable determination of profit margins and profit-sharing formulae.
c) Acceptability of compensation in case of default by one of the parties.
d) The type of security Islamic banks can obtain for their financings and under what conditions.
2. Riba and its implications for financial and banking products and institutions
a) Definition of Riba. Is Riba equivalent to interest or usury?
b) Can Islamic banks determine profit margins by referring to LIBOR, LIBID etc?
c) Are all interest-bearing instruments un-Islamic and what is the position vis-a-vis zero coupons?
d) What is the definition of Gharar (uncertainty in contracts) and what are its implications for financial products?
3. The definition of traditional Islamic financial products such as Mudaraba, Murabaha, Musharaka, Ijara, Istisna, Bai al-Salam, etc.
4. Acceptability parameters applicable to investments in stocks, commodities and financial futures markets, as well as acceptability of investment in shares and under what conditions.
5. The mechanism for internal and global Sharia controls through a Sharia council or through individual Sharia advisers, or otherwise.
6. The extent of permission of tax avoidance mechanisms. This is particularly relevant in the case of real estate and leasing transactions in the US, where resorting to interest-bearing loans between two sister companies can greatly reduce the amount of taxes, and where lease payments, i.e., rentals, are considered by the internal revenue to be interest payments, reducing thereby the applicable taxes.
Co-ordinated and concerted action on the above and the adoption of standard criteria will provide a common jurisprudential framework or “grundnorm” on the basis of which banks may pursue their respective product research activities in an efficient, harmonious and coherent manner.
Furthermore, uniformity will probably encourage some still reluctant or hesitant governments and institutions to recognise Islamic banking as a fully-fledged system and deal with it accordingly.
Also, agreement on the basics is likely to be a first step towards the creation of an Islamic capital market, considered by many Islamic and international banks (such as City Bank and Kleinwort Benson) as a potential profit centre and a possible instrument for international financial co-operation.
Standardisation of legal documentation within individual Islamic banks is essential because it tends to streamline and simplify the day-to-day, operational activities of a bank in a cost-effective manner, while providing clarity and predictability in bank/client relationships.
Standardisation also favours smooth interbank co-operation, particularly in the area of co-financings and syndications. Again, the introduction of standard legal documentation has the benefit of facilitating control and audit functions and rendering them more effective.
Finally, in view of the prevailing globalisation of financial markets, standardisation of legal documentation could play a positive role ensuring transparency in the introduction of Islamic banking to the major financial markets, presenting it thereby as a consistent and useful banking option rather than as the “danger of manifestation of conflict between civilisations”, as portrayed by Jonathan E Lewis in an article.
What legal documentation should be standardised?
Standardisation can neither be absolute nor can it, as mentioned earlier, cover all categories of legal documentation. Nevertheless, we submit that the following legal documentation should, as much as possible, be structured in a standard form.
All contracts pertaining to financing may be drafted in a standard form and subsequently cleared by the internal Sharia Supervisory Body, it being understood, however, that whenever such contracts are used, the lawyer will need to amend them, or fill the gaps therein, in accordance with the specific requirements and merits of the transactions concerned, but without modifying the fundamental structure of the document.
A similar procedure may be adopted vis-a-vis Takaful (Islamic insurance), as well as investment contracts relative to foreign exchange commodities and other transactions. The DMI Group has spent considerable time and effort in drafting and clearing such financing and investment contracts, and this exercise has proved to be beneficial and rewarding, both from the operational and cost-effective points of view.
These standard contracts cover, interalia, the following transactions:
• Mudaraba (participation or trust financing),
• Musharaka (mutual participation financing),
• Murabaha (financing resale of goods or mark-up financing),
• Ijara (leasing),
• Ijara wa Iqtina (lease purchase) and
• Qard-AI-Hasana (interest-free loans).
For the DMI definitions of these transactions, please refer to the end of this article. The standard contracts, which were drafted by lawyers and cleared by the Religious Supervisory Board, contain, generally, the following elements:
• A preamble
• Definitions
• Central obligations
• Mode of payment
• Representation and covenants of the parties
• Warranties
• Securities
• Takaful or insurance coverage
• Damages structure
• Arbitration
• General provisions
It is to be noted, however, that standard contracts, though effective, require periodic review, as experience sometimes reveals certain lacunae or weaknesses that need to be remedied. Finally, it is worth mentioning that standardisation of employment and procurement contracts is a far simpler process, as such contracts are generally standard by nature and often highly regulated by law.
The salient features of the main Islamic financing contracts are summarised below.
Musharaka
1. Both the client and the institution participate in the financing of the project, and distribution of profit or participation in losses is calculated on a pro-rata basis.
2. Most of the time, the client, being the expert in the project activity, also manages the project against an agreed-upon management fee. Also, in most cases, the client continues to be the owner of the project and thereof remains responsible vis-a-vis third parties, as the Musharaka contract does not, per se, constitute a partnership or a corporate entity.
3. As in all standard contracts, each party is separately responsible for Zakat in connection with their capital in the project and the revenue thereof. Taxes relating to the project itself are borne by the project, while income tax is borne separately by each of the parties.
4. Securities may take the form of: (a) a security deposit to be held in an investment account with the institutions; (b) other securities, such as mortgage of real estate assets or project equipment.
5. There is no liquidated damages clause, but there is a clause basing the assessment of damages on the return generated by the institution during the period of default.
6. There are cases where a Musharaka takes the form of a ‘diminishing Musharaka’, by virtue of which the share of the institution is gradually bought out by the client.
Mudaraba
1. The financing is provided exclusively by the institution, while the project management and expertise are extended due diligence and care, and utilise the assets of the project exclusively for the purpose of the project, without intermingling them with the client’s own assets. The standard clause stipulates:
“The client shall maintain all project assets in the name of the client, but physically segregated from other assets of the client and free and clear of all liens and encumbrances, except where such liens and encumbrances are in favour of the institution.”
2. The contract specifies the ratio to be applied for the distribution of revenue.
On the other hand, all losses are borne by the institution, except where it is proved that the client committed a breach of the Mudaraba conditions or acted negligently. In such a case, he is responsible for the loss and it is possible for the institution to require a performance bond in this particular context.
Murabaha
1. The purchase price paid by the client includes the actual price paid by the institution under the supply contract, plus actual expenses, including the taxes or customs duties borne by the institution, in addition to the profit margin of the institution, as agreed upon between the parties.
2. The client undertakes to purchase the goods on notice of arrival at the point of destination specified in the supply contract (which is an integral part of the Murabaha contract), and the institution undertakes to deliver the goods or documents of title representing the same to the client.
3. Payment of the price may be immediate or deferred.
4. The institution pays the supplier against the presentation of the shipping documents of the goods, in accordance with the required specifications and free from any defect, according to a certificate issued by an international superintendent company.
5. When the client has approved all terms and conditions of the supply contracts, the institution assigns to the client all its rights relating to warranties against the supplier. On the other hand, disbursement of Murabaha funds is affected only after the furnishing by the client of satisfactory guarantees or collateral in accordance with the Murabaha contract.
6. Risk of loss with respect to the goods passed to the client upon notification of arrival of the goods at the destination named in the supply contract. It is to be noted that in this particular context, as indeed in many other aspects, the general principles of the Islamic Law of Contract are very similar to those of English law.
The property in the goods passes to the buyer at the time when the parties intend it to pass. In most Murabaha cases, there is a sale of specific goods not in a deliverable state, i.e., the seller has to do something to the goods to put them into a deliverable state. Consequently, the property does not pass until that thing is done and the buyer has notice of it.
This is deemed to have been done when the goods arrive at their destination. The goods are then presumed to have been put into a deliverable state; hence the formulation of the clause.
On the other hand, the client must obtain, and demonstrate to the satisfaction of the institution that he has obtained, coverage against any risk of loss of, destruction of, or damage to, the goods. This coverage is by way of a Takaful policy, or a conventional insurance policy if a Takaful policy is not available. Such a Takaful or insurance policy is in favour of the institution.
Ijara and Ijara wa Iqtina
The client undertakes to accept the goods under lease and the institution undertakes to deliver the same under lease to the client at the point of destination specified in the supply contract on notice of arrival given to the client, together with the documents entitling him to take delivery of the goods.
In the case of lease purchase, the client further obligates himself to purchase the goods on the day determined in the annex containing the rentals and purchase price payment dates. Similarly, the institution is obligated to sell the goods on the same date.
It should be noted that even in the case of lease, the client may elect (this is an option and not an obligation) to purchase the goods on any due date at the optional purchase price attributable to that due date by giving notice to the institution at least three days prior to such date. In this event, the client naturally pays all taxes or similar government charges incident to the transfer of the title to him.
The provisions relative to assignment of warranties, risk of loss, insurance coverage and securities are very similar to those applicable to the other transactions, except that, in the case of lease, the ownership title remains with the institution until such time as the client exercises his option or obligation to purchase.
Most Islamic banks did prepare standard account-opening forms, but still more is required with respect to the definitions of Islamic financing and investment instruments. Although this latter aspect, as mentioned earlier, is closely linked to the research and innovation capabilities of each Islamic bank, a general agreement on the definition of parameters governing the introduction of new products could be an effective basis and motivation for research and individual initiative.
It goes without saying that an Islamic bank or group will see to it that Sharia rulings are produced and circulated to the operational staff concerned in a simplified standard form, in order to ensure their systematic application in the main office and throughout the branches and subsidiaries.
While standard financial and financing procedures can easily be applied throughout branches and subsidiaries of Islamic banks, liquidity requirements may vary from one jurisdiction to another and therefore standardisation at subsidiary and affiliate level has to be less stringent.
From this analysis of the relevance and importance of standardisation of legal documentation and brief enumeration of the areas in which standard guide-lines and contracts or other legal documents are required, it can be concluded that Islamic banks need to pursue and intensify their own individual internal standardisation efforts.
More importantly, however, it is recommended that parallel collective effort be exerted, on a priority basis, in order to ensure, as soon as possible, convergence between Islamic banks on the major jurisprudence and operational guidelines referred to above.
The Institute of Islamic Banking and Insurance (IIBI), as well as the International Association of Islamic Banks (lAIB), may promote and organise the convening of an inter-Islamic bank meeting for this purpose, in consultation with the major Islamic institutions.
When such a forum is convened and when formal agreement on standard jurisprudence and operational guide-lines is attained, Islamic banking will have at its disposal a solid common basis on which operational activities can be pursued and developed in a more rational and effective manner, ensuring thereby further progress, recognition and expansion.
The following Islamic financial instruments and modes of financing are utilised by the DMI Group to offer a wide range of Riba-free financial services and facilities. They are used to mobilise and channel funds efficiently and effectively into viable and profitable investments and business operations along Islamic lines.
1. The Mudaraba (participation financing) is an Islamic financial instrument in which there are two parties: the beneficial owner(s) (Rab al-Maal) and the managing trustee (Mudarib). By virtue of the Mudaraba contract, the financial institution may act as Mudarib and therefore has the responsibility for investing funds provided by the client for the purpose.
Alternatively, it may act as Rab al-Maal, supplying funds to the client, who then acts as Mudarib. The parties to the Mudaraba must agree, before any business is undertaken, on the ratio of distribution of the profit.
2. The Musharaka (mutual participation financing) is a joint venture agreement according to which the financial institution advances funds, which are added to the client’s funds, in order to participate in the equity. The parties bear any losses incurred in direct proportion to their contributions. Likewise, profits are shared in direct proportion to the contribution after payment of any agreed management fee.
3. Murabaha (financing resale goods) is a contract in which a client wishing to purchase equipment or goods requests the financial institution to purchase them on his behalf and then sell them to him at cost plus a reasonable profit. Capital and profit due are payable on terms agreed between the parties.
4. Ijara (leasing) permits the financing of equipment, buildings and other facilities by the financial institution, as requested by a client, on the basis of an agreed rental.
5. Under Ijara wa Iqtina (lease purchase), the financial institution finances (purchases) equipment, buildings or an entire project for the purpose of renting the same to the client against an agreed rental, together with the client’s agreement to make payments into an Islamic investment account which will eventually lead, as promised in the agreement, to the client’s purchase of the equipment or project from the institution. Profits accumulating in the investment account accrue to the client.
6. Funds advanced under Qard-Al-Hasana (Interest-free Loan) are for humanitarian and welfare purposes. Repayments are made over a period agreed by both parties, with no profit accruing to the financial institution.
7.Under Composite Financing, a client may be provided with financing in more than one form simultaneously, depending upon the nature of the business involved.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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