University Of East Anglia Norwich Law School

LAW- M605

LEGAL ASPECT OF ISLAMIC FINANCING

PG COURSEWORK 2009-2010

STUDENT REGISTRATION NUMBER [4230531]

Word count 3996

Table Of Contents

1. Introduction 2. Nature of Islamic Financing. 2.1. Definition of Islamic Financing. 2.2. Features of Islamic Financing. 2.3. Major prohibitions of Islamic Financing System. 2.3.1. First, Prohibition of RIBA 2.3.2. Second, Prohibition of Gharar (extreme uncertainty) 2.3.3. Third, Prohibition of Maysir (Gambling) 3. The General Conditions of The Sale Contract in Islamic Financing System 4. Ijarah (leasing) as Islamic Financing Technique (method). 4.1. Introduction. 4.2. Ijarah as a financing technique. 4.3. Ijarah wa iqtina (lease ending with ownership). 4.4. The General Islamic rules of Leasing . 4.5. The Approaches of The Entailed Risks in Ijarah Transactions . 5. The Structure of Ijarah Wa-Iqtina in the Islamic Financing System. 6. The Impact of the Choice of Law on Ijarah Transaction 7. Conclusion 8. Bibliography 9. Appendix A 6

3 4 4 4 5 5 6 7 8 8 8 8 9 9 10 11 12 13 14

1. Introduction It has to be conceded that Islamic financing is one of the most accelerated growing industries in the field of global banking and financial systems during the last three decades. 1 Beginning with Dubai Islamic Bank which was founded in 1975, nowadays there are more than 300 global institutions specializing in Islamic financing across the world. The assets of these institutions are approximately $250 billion with estimated growth at 10-15 percent per annum. 2 This unparalleled growth was no coincidence. There are many factors contributing to this soaring growth, such as the continued prosperity in the middle east states in respect of oil wealth, an increased desire among Muslims to elicit financial services that meet the Sharia (Islamic law) requirements, and the attractiveness of the Islamic financing products which are appealing to both Muslim and non-Muslim investors. 3 It is worth mentioning that Islamic financing is not merely confined to the Middle East or to Islamic countries only, but also, it is sought after, wherever there is a reasonable Muslim community worldwide. 4
The aim of this essay is to advise The Islamic Bank of Transylvania (IBT), which has recently founded

an Islamic bank in the UK, regarding its intent to take a part in Ijarah (one of the Islamic financing techniques) transaction with East Airlines (EA) for the purpose of purchasing four aircrafts which currently are owned by Universal Airways (UA). This advice will draw attention to the pertaining issues of Ijarah transaction including the intrinsic elements which Ijarah contract contain for the sake of eliciting the approval of Sharia (Islamic law) Supervisory Board. Also, it will shed light on the number of legal risks that IBT may encounter during the Ijarah transaction, and to what extent such risks could be diluted.

Faisal Attia,'Do the distinctive features of contemporary Islamic finance lie in its form or substance' (2008) Butterworths Journal of International Banking and Finance Law 599 2 Juan Sol,' Islamic Banking Makes Headway' (2008) IMF Survey Magazine 3 M El-Qorchi, Islamic finance gears up (2005) 42 finance and development 46 4 Alsadek H. Gait and Andrew C. Worthington, 'primer on Islamic finance: Definitions, sources, principles and methods'(2009) Islamic Finance < http://www.business.uq.edu.au/download/attachments/31293547/150_Gait_paper.pdf> accessed 4 January 2010 3

2. Nature of the Islamic financing For the sake of providing a comprehensive advise for IBT, it would be recommended to present at the beginning a brief overview of the nature of Islamic financing.

2.1. Definition The term 'Islamic Financial system' could be defined as 'a financial service principally implemented to comply with the main tenets of Sharia'. 5 Sharia in turn is derived primarily from four sources. First, Quran (the sacred book of Islam) which is consisted of God revelations to Prophet Muhammad. The bulk of Quran legal verses are none detailed. Second, Sunna which is comprised of the sayings, practices and approvals of Prophet Muhammad (May peace be upon him) during his lifetime. The third source is Ijma (consensus) which refers to the consensus of the whole religion scholars on a particular subject in the era of the ages. The last main source of sharia is Qiyas (analogical reasoning). Qiyas is the process of analogical reasoning that aim to provide a legal opinion upon a new case, which is not referred to in previous sources, by comparing it to other refereed cases which have the same effective reason. 6 These authentic sources draw the big picture of the Islamic law. 2.2. The Features of Islamic Financing The Islamic financing framework, at present, has several numbers of characteristics which may be unique in its field. These qualities could be summed up in three prime attributes. First, Money is exclusively a medium of exchange. The concept of money, within Islamic financing system is merely a mean of exchange. Therefore, it is forbidden, in general, under Islamic law to use money as a subject matter of trade. In other words, making profit through trading in money is not allowed in sharia, because money in essence is lacking of genuine value. 7 Second, asset-backed financing. One of the intrinsic qualities which characterizes the Islamic financing system is that, it is an asset backed financing. On the contrary of the conventional system which is dealing merely in money and monetary papers, Islamic financing framework is often grounded on non-liquid assets. The core of any Islamic financing transactions must be something that has a genuine utility. 8 Third, Islamic financing is concerned with ethical investment. The Islamic financing lays a particular stress on the fairness of
5

Alsadek H. Gait and Andrew C. Worthington, 'primer on Islamic finance: Definitions, sources, principles and methods'(2009) Islamic Finance http://www.business.uq.edu.au/download/attachments/31293547/150_Gait_paper.pdf> accessed 4 January 2010 6 Faisal Attia, Introduction to Islamic Finance (University of East Anglia, Norwich 2009) also, Alsadek H. Gait and Andrew C. Worthington, 'primer on Islamic finance: Definitions, sources, principles and methods'(2009) Islamic Finance 7 Faisal Attia,'Do the distinctive features of contemporary Islamic finance lie in its form or substance' (2008) Butterworths Journal of International Banking and Finance Law 599 8 M Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) p xiv. 4

trade. Thus, any transactions containing unethical criteria such as deception, circumventing and monopoly are invalid and not compliant with Islamic law because of the contradiction of such criteria with the overall tendency of Islamic law to achieve social justice and fair economic prosperity. In addition, in spite of the inducement of Islam to achieve the economic wellbeing, sharia differentiates clearly between the acceptable commercial activities and those that are, unacceptable from the Islamic point of view. For example, commercial activities involving alcohol, pork and its products, armaments, gambling...etc are certain to be void within Islamic financing system because it is basically forbidden under sharia. 9

2.3. The Major prohibitions of Islamic financial system It is advisable for international companies that are looking forward to take a part in transactions under Islamic financing system, as is the case with the Islamic Bank of Transylvania, to be keenly aware of the major financial prohibitions lying within the Islamic law. Fundamentally, there are three overarching prohibitions in Islamic law which directly affect Islamic financing industry. 2.3.1. First, Prohibition of Riba (an excess) The term 'Riba', in the strict sense of the word, is ''an excess'' which could be construed in the context of Islamic financing system as ' any unjustifiable increase of capital whether in the form of loans or sales'. The prohibition of Riba, which is derived mainly from Quran, Sunna and Ijma, constitutes a milestone in Islamic financing system. In fact, Sharia has incontrovertibly forbidden the charging of interest on moral grounds. From the Islamic point of view the loan contract is a charitable contract (good deed). The shortfall that would arise on the value of money lent, during the period of the loan is considered Islamically as a charity or a gift from the debtor. Therefore, any loan contracts that would bring any form of benefits for the interest of the lender are unacceptable under sharia. 10 Yet, it is certainly incorrect that Islamic law is ignoring the time value of money. In an interesting manner, this value could be observed in many Islamic financing techniques such as BayMuajjal (sale with deferred payment) technique. 2.3.2. Second, Prohibition of Gharar (extreme uncertainty)

Michael Ainley and others,' Islamic Finance in the UK: Regulation and Challenges' [2007] The Financial Services Authority. 10 Hussam Musa, Saleh M. and Obadi, 'Islamic financial systems'(1997)34 Finance and Development 42,45 also, Faisal Attia, 'Do the distinctive features of contemprary islamic finance lie in its form or substance' (2008) Butterworths Journal of International Banking and Finance Law 599 5

The prohibition of Gharar (extreme uncertainty) sales could be seen clearly through considerable number of Sunna. The concept of Gharar refers to the sale of probable items whose existence or characteristics are not certain, due to their risky nature, which makes the trade similar to gambling.11 This uncertainty could be arisen as a result of lacking of vital information in a contract12 for example, it was mentioned in the following Sunna by Ahmad and Ibn Maajah narrated on the authority of Abo Saeed Alkudry mAbpwh : The Prophet Pbuh has forbidden the purchase of the unborn animal in its mother's womb, the sale of the milk in the udder without measurement, the purchase of spoils of war prior to their distribution, the purchase of charities prior to their receipt, and the purchase of the catch of a diver. 13 The main reason for prohibiting these sales, mentioned above, is the high level of ambiguity or uncertainty which is inherent in such sales. Furthermore, in some of these sales the purchaser does not have the slightest idea what he would obtain. However, in contrast to Riba, a considerable number of Islamic scholars have permitted some of the contracts which include Gharar, provided that this Gharar is minor.14They maintain that there is no contract that is totally detached of any level of Gharar. Thus, they have differentiated between major Gharar and minor Gharar in the validity of the contract or not. Based on this distinction, the Fatwa (a legal opinion by an Islamic scholar) in this field may vary from one scholar to another, in a certain issue15. 2.3.3. Third, Prohibition of Maysir (Gambling) "Maysir" has been explicitly forbidden in the Holy Quran and the Sunna. Given the risky nature of gambling which may result adverse consequences for one of the parties at the expense of the other, Islamic law perceives Maysir as an unacceptable vanity attitude and way to make money. Hence, Islamic financing system considers any contemporary transactions that highly depending on chance, not effort or crafts as unequivocally contrary to Sharia16. But, likewise Gharar, the fatwa about a specific transaction is likely to be different from one scholar to another.

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M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (2000) Rice University, Houston. Faisal Attia, 'Do the distinctive features of contemprary islamic finance lie in its form or substance' (2008) Butterworths Journal of International Banking and Finance Law 599 13 M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (2000) Rice University, Houston. 14 A Al-Saati, The Permissible Gharar (Risk) in Classical Islamic Jurisprudence (2003) 16 Islamic Economics 3. 15 Faisal Attia, Sharia Financial Prohibitions,(University of East Anglia, Norwich 2009) 16 M Iqbal and P Molyneux, Thirty Years of Islamic Banking: History, Performance, and Prospects (New York, Palgrave Macmillan, 2005) also, Faisal Attia, Sharia Financial Prohibitions,(University of East Anglia, Norwich 2009) 6

3. The General Conditions of The Sale Contract in the Islamic Financing System. It is a matter of importance to the Islamic Bank of Transylvania to be familiar with the principles of the Islamic sale contract as it will take a part in sale agreement with UA. Unlike conventional sale contract, Islamic law lays great emphasis on several numbers of conditions which must be fulfilled in any sale contract to comply with sharia. These conditions could be summarised in six prime conditions. First, the merchandise must be owned by the seller at the time of the contract (with some exceptions). Second, the contract of sale must be immediate and final. Third, the merchandises must be precisely identified. Otherwise, the contract will be considered as major Gharar, which is forbidden under Islamic law. Fourth, the sale price must be certain. Furthermore, the price of the sale become immutable once it is fixed. Fifth, the commodity of sale must have a value from an Islamic perspective. Merchandises such as alcohol, pork related products...etc are Haram (forbidden by Islamic law) and have no value under sharia. The sixth condition, the commodity should not be used for forbidden purposes such as armaments. 17

If any contract of sale fails to meet one of these conditions, it is then almost certain to be void under Islamic law. It is, therefore, should be recommended that IBT should make sure, in advance, that its contract with UA has abided the conditions of the sale contract according to Islamic financing system.

4. Ijarah (leasing) as an Islamic Financing Technique. 4.1. Introduction. Ijarah occupies a prominent place in Islamic financing industry. Interestingly, it would serves as a technique of financing as well as a form of investment in Islamic financing system. In essence, the
17

M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (2000) Rice University, Houston. Also, Faisal Attia, 'Do the distinctive features of contemprary islamic finance lie in its form or substance' (2008) Butterworths Journal of International Banking and Finance Law 599

Ijarah, which lexically means 'give something on rent', is a normal commercial activity equivalent to sale. But, in the contract of Ijarah what is in sale is not the asset; it is the usufruct (the temporary right to use and profit from the object) of the asset for a definite period. 18 Islamic law has approved the sale of usufruct as evidenced in a number of the verses of the holy Quran and Sunna. 4.2. Ijarah as a financing technique. The contemporary evolution of the concept of the Ijarah contract as a means of investment, into a means of financing occurred due to certain reasons. In fact, this evolution has emerged discernibly in the western countries through the tendency of some financial institutions to devise an Islamic alternative of giving an interest-bearing loan. They leased some types of object to their customer for a fixed amount, payable monthly, for a definite period. This amount, in effect, encompasses the actual cost of this object plus the stipulated interest. At the end of the leasing period, the ownership of the object transferred directly to the lessee (the customer).19 This innovative technique so-called ' ijarah wa iqtina ' (lease ending with ownership) in Islamic financing industry.

4.3. Ijarah wa iqtina (lease ending with ownership). Ijarah wa iqtina is a normal lease contract with an additional Wa'd (one-sided promise) made by the owner of the leased object that he will gift the object to the lessee at the end of the lease contract, provided that the lessee has paid the full rent to the owner. This one-sided promise is legally binding the owner, whereas the lessee has the option of accepting the object or not. Significantly, Wa'd must be detached from Ijarah contract.20However, using the Ijarah wa iqtina in the context of Islamic financing, as is the case with the Islamic Bank of Transylvania, is subject to several numbers of Islamic rules.

18

M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (2000) Rice University, Houston. also, M Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) 19 M Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) 20 Faisal Attia, Ijarah(lease),(University of East Anglia, Norwich 2009) 8

4.4. The General Islamic rules of Leasing . As IBT is considering entering into an "Ijarah" transaction with EA, firstly IBT must be assured that its Ijarah transaction has satisfied all Islamic rules of leasing. These rules could be summed up in eight basic rules. First, the subject matter of Ijarah must be used in ways permitted under Islamic law. Otherwise, it could not be leased under sharia. Second, likewise sale conditions, the subject matter of lease must be specified, as well as the amount of the rent in order to avoid the major Gharar. Third, the period of the lease must be definite. Fourth, the usufruct of the leased object must be agreed upon in the Ijarah contract. Fifth, the subject matter of lease must be non-consumable. Therefore, matters like fuel, money, eatables .. etc is certain to be unrentable under Islamic law. Sixth, the lessor, in this case is IBT, must own the asset during the period of the lease. Seventh, under Islamic law the leaser bears the risk of any harm or loss arising from factors out of the control of the lessee. The eighth general rule of leasing is that the liabilities related to the ownership of the asset are born by lessor (such as taxes) , whereas the liabilities related to usage, is the responsibility of the lessee. 21

4.5. The Approaches of The Entailed Risks in Ijarah Transactions . According to these rules, there are several issues that should be taken into account by IBT during its Ijarah transaction with EA. First, under Islamic law, the IBT must be owned the four aircrafts before they are leased to East Airlines. This means that after IBT has purchased the aircrafts, it will bear the risk of any possible withdrawal of the EA from the Ijarah transaction for any reason. This high level of risk is not acceptable in the traditions of banking systems. In order to avoid such risk, it could be advisable if IBT requests, in advance, Wa'd (one-sided binding promise) from EA through which the EA promises to lease the aircrafts from IBT once it is owned by them. Given the binding nature of Wa'd in Islamic law, the EA would not be legally able to withdraw from this transaction in the future. Importantly, this Wa'd must be unilateral and detached from the lease contract in order to elicit the support of Sharia Supervisory Board. 22

21

M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (2000) Rice University, Houston. , M Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) and Faisal Attia, Ijarah(lease),(University of East Anglia, Norwich 2009) 22 Faisal Attia, Ijarah(lease),(University of East Anglia, Norwich 2009) 9

Second, unlike conventional financial leasing, under Islamic law, IBT would endure the risks and consequences of any loss or damage that might occur for the aircrafts during the period of Ijarah. This risk could be mitigated and contained comprehensively by arranging Takaful (Islamic insurance) protection for the aircrafts. The cost of this insurance could be added to the monthly rent. Third, according to Islamic rules of Leasing, any liabilities related to the ownership of the aircrafts are born by IBT (as it is the lessor). Thus, IBT will be incurred to pay for the liabilities of the aircrafts, such as the aircrafts taxes, during the leasing period. Once again the cost of these liabilities could be calculated and added to the monthly rent. Forth, in order to avoid any inadvertent default in characterisation by which IBT may fail in purchasing the exact aircrafts which have been specified by EA, IBT should purchase the aircrafts through EA. In other word, EA will buy the aircrafts on behalf of IBT who pays its price (50 million US$) to Universal Airways (the supplier). This approach could be compliant with sharia provided that, the period of the lease starts after the EA has taken delivery of the aircrafts, and not from the day of purchase of aircrafts by the IBT. 23 However, to elicit the support of Sharia Supervisory Board, it is of the utmost importance that IBT follows precisely the Ijarah wa-iqtina structure as set out below. 5. The Structure of Ijarah Wa-Iqtina in Islamic Financing System. The Structure of Ijarah Wa-Iqtina in Islamic Financing System could be divided into three basic stages.24 First stage, The EA will offer Wa'd (one-sided binding promise) through which the EA promises to lease the aircrafts from IBT for a definite period and a specific rent, once the aircrafts are owned by IBT. Second stage, In the light of the EA Wa'd, The Islamic bank (the branch of IBT in London) will arrange for an agency agreement by which the EA will draft a normal sale agreement with universal Airways (the supplier) on behalf of IBT who will pay its price (50 million US$). Notably, this sale agreement must satisfy the general conditions of the sale contract in Islamic financing system. Third stage, after the IBT have completely owned the four aircrafts, it can draft an Ijarah Wa-Iqtina agreement with EA. 25 Significantly, this lease agreement must abide with the rules of Islamic leasing.

23

M Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) also, Faisal Attia, Ijarah(lease),(University of East Anglia, Norwich 2009) 24 Please see Figure 1 in Appendix A. 25 Taqi Usmani, An Introduction to Islamic Finance (The Netherlands, Kluwer Law International, 2002) and Faisal Attia, Ijarah(lease),(University of East Anglia, Norwich 2009) 10

6. The Impact of the Choice of Law on Ijarah Transaction. In spite of this Ijarah transaction has been agreed upon to be governed and construed in accordance with English law provided that, it is not in conflict with the Islamic law, this agreement is high likely to be unlawful under English law. According to article number one of the Rome Convention26 which provides that 'The rules of this Convention shall apply to contractual obligations in any situation involving a choice between the laws of different countries'. Since the Sharia, in effect, is non-national system of law. 27 Thus, IBT must be realised that the words 'subject to glorious Sharia' will constitute no intrinsic value in Its Ijarah agreement with EA at least in the member states of this Convention. Yet, two possible approaches to this issue can be concluded. The first approach is by adding choice of a foreign tribunal in the Ijarah contract. However, this approach may have a weakness due to article number three of the same Convention which has provided that : The fact that the parties have chosen a foreign law, whether or not accompanied by the choice of a foreign tribunal, shall not, where all the other elements relevant to the situation at the time of the choice are connected with one country only, prejudice the application of rules of the law of that country which cannot be derogated from by contract, hereinafter called mandatory rules. In the light of this article the choice of a foreign tribunal will have no value when all the factors of the contract are related merely to one country. The second approach is to satisfy article number one of the Rome Convention, by adding: the Saudi law instead of Sharia law. It is generally recognised that the basic law of Saudi Arabia is based on Sharia and does not override Islamic laws.28 So by changing the wording of agreement from 'subject to the principles of the Glorious Sharia' to 'subject to the principles of the Saudi law' we are, in effect, changing the names and terminology without changing the substance.

26

The Rome Convention is the Convention on the Law Applicable to Contractual Obligations and it opened for signature in Rome on 19th June 1980. 27 Please see Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd and others [2004] 4 All ER 1072 28 Vogel F., Islamic law and legal system: studies of Saudi Arabia (Brill Academic Pub,2000) p xi

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7. Conclusion. This assay has briefly explored the nature of the Islamic financing system in order to provide a comprehensive advice to The Islamic Bank of Translavia on its intention to engage in Ijarah transaction with East Airlines. Also, it has knocked on all relevant issues of the concept of Ijarah as an Islamic financing technique, including its definitions, conditions, Structures and risks which are inherent in Ijarah transaction. Furthermore, It has shed some light on the appropriate wording of the choice of law on Ijarah Transaction, which is corresponding with English law.

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BIBLIOGRAPHY :

Faisal Attia,'Do the distinctive features of contemprary islamic financing lie in its form or substance' (2008) Butterworths Journal of International Banking and Financing Law

M El-Qorchi, Islamic financing gears up (2005) 42 financing and development Alsadek H. Gait and Andrew C. Worthington, 'primer on Islamic financing: Definitions, sources, principles and methods'(2009) Islamic Financing <http://www.business.uq.edu.au/download/attachments/31293547/150_Gait_paper.pdf> accessed 4 January 2010

Taqi Usmani, An Introduction to Islamic Financing (The Netherlands, Kluwer Law International, 2002)

Michael Ainley and others,' Islamic Financing in the UK: Regulations and Challenges' [2007] The Financial Services Authority .

Hussam Musa, Saleh M. and Obadi, 'Islamic financial systems'(1997)34 Financing and Development

M El-Gamal, A Basic Guide to Contemporary Islamic Banking and Financing (2000) Rice University, Houston.

M Iqbal and P Molyneux, Thirty Years of Islamic Banking: History, Performance, and Prospects (New York, Palgrave Macmillan, 2005) also, Faisal Attia, Sharia Financial Prohibitions,(University of East Anglia, Norwich 2009)

Juan Sol,' Islamic Banking Makes Headway' (2008) IMF Survey Magazine A Al-Saati, The Permissible Gharar (Risk) in Classical Islamic Jurisprudence (2003) 16 Islamic Economics

Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd and others [2004] 4 All ER 1072

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Appendix A

- Figure 1

The BANK
1. Wa'd to Lease

The Customer (IBT) East Airlines Company

IBT's branch in London

Ijarah Wa-Iqtina contract. 4

2. Agency Agreement

3. Sale Agreement

The Supplier (IBT) Universal Airways Company

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