ZION Corporate Management & Consultancy - Islamic Finance Institute of Southern Africa

Fundamentals of Interest

Free Banking & Finance

Masterclass

ZCMC

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Manual IFL/DL0209

ISBN No : 978-0-9802689-0-x

Published by the Islamic Finance Institute of Southern Africa

Prepared by Ziyaad Mahomed

29 July 2009
All rights reserved

© Copyright 2009
2009

Islamic Finance Institute of Southern Africa

P O Box 22339, Zakariyya Park, 1828

Tel : +962 79 753 4580 (Amman, Jordan)
Sms : +27 82 55 111 84
[email protected]
[email protected]
www.ifisa.co.za

This Publication is copyright under the Berne Convention. In terms of the Copyright Act of 98 of 1978, no part
of this book may be reproduced or transmitted in any form by any means electronic or mechanical, including
photocopying, recording, or by any information storage and retrieval system, without permission in writing
from the institution.

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BRIEF BIO : ZIYAAD MAHOMED

HIGHLIGHTS

Ziyaad has been involved in the Financial Services industry for the last 13 years.
He began his career as an accountant for a South African publically-listed,
financial information company, Moneyweb, and moved on to become Head of
Accounting, IT and Marketing for a privately-owned retail chain in South Africa.
Ziyaad then co-founded the first Islamic satellite broadcaster in South Africa, Cii,
and was appointed Director and CEO of the media house for 2 years. He also co-
founded Cii Finance, offering Shariah compliance and marketing for the second
Shariah acceptable unit trust in the country.

He is presently a trainer and advisor to Islamic Financial Institutions in Mauritius,

Nigeria, Tanzania, Kenya, Malawi and South Africa. He has consulted and/or
trained more than 3,000 Finance Professionals and Islamic Scholars in most
disciplines within the Islamic Finance sector in Africa, Europe and the Middle East
since 2007.

He is widely regarded as a subject matter expert in Islamic Finance, having

appeared on television in various parts of Africa, frequently interviewed on radio
and newsprint and has been published in seminars, conferences and universities.

He was ranked as the highest rated presenter and trainer for the 2007 and 2009
International Islamic Finance Forums in South Africa, from 36 of some of the best
practitioners in the world.

EDUCATION

He has studied towards a BCom (Accounting) at the University of Johannesburg,

a Postgraduate Diploma in Management (DMS), an MBA through the
Management College of South Africa and a Certificate in Islamic Law from the
University of KZN. He also received certification and training in Banking Disaster
Recovery and Business Continuity Planning, Intensive Money Laundering,
Negotiable Instruments, Financial Advisory & Intermediary Services. He is
trained in Basel II implementation and interpretation. He is certified and trained
in Islamic Jurisprudence, Quranic Science, Arabic and Islamic Traditions from
Scholars in South Africa, Syria, Egypt and Jordan.

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CONTENTS :

MODULE 1 : INTRODUCTION TO ISLAMIC ECONOMIC & ISLAMIC BANKING

PRINCIPLES ______________________________________________________________5

MODULE 2 : RIBA IN ISLAM ________________________________________________20

MODULE 3 : ISLAMIC LAW OF CONTRACTS ___________________________________27

MODULE 4 : ISLAMIC BANKING TECHNIQUES : MUDARABA _____________________41

MODULE 5 : ISLAMIC BANKING TECHNIQUES : MUSHARAKA ____________________51

MODULE 6 : MURABAHA COST-PLUS FINANCING ______________________________58

MODULE 7 : IJARA, IJARA-WA IKTINA, IJARA MUNTAHIA BITTAMLEEK ____________69

MODULE 8 : SALAM & PARALLEL SALAM _____________________________________78

MODULE 9 : ISTISNA & PARALLEL ISTISNA ___________________________________83

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Module 1 : Introduction to Islamic

Islamic Economic & Islamic
Banking Principles

Learning Objectives :

• Identify the factors of production in Islam

• Identify the differences between the Capitalist, Socialist and Islamic Economies
• Sources of law relating to Islamic Economics
• Fundamental principles of Islamic financing
• Distribution of wealth in Islam
• Business transactions in the Islamic Law
• AAOIFI & standards in Islamic Banking

The detailed material for this module can be found in :

1. Recommended Text : “An Introduction to Islamic Finance” by Mufti Taqi

Usmani, under the chapter called : “Some Preliminary Points” – Page 15 to 23

Key Points of the Module

1. Introduction to Islamic Economics

Islamic economics should be seen as part of a dynamic, universal way of life that
promotes social interaction at the highest possible level. Islam is a submission to the
Will of God (Allah), obeying His laws. The Qur’an, considered the word of Allah by
Muslims, lays forth the injunctions that govern the life of a Muslim. This includes acts
of worship, laws on marriage, inheritance and the basis of Islamic economics and
finance.

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Islam has clearly defined the area of economics and has demarcated parameters in
methods of earning, paying , utilising and donating wealth. Accumulation or the
hoarding of wealth has no place in Islam. Islamic economics promotes socio-economic
upliftment and development through the permissible use of funds that have been
provided by the creator of those funds, Allah Himself. While ownership is recognised in
Islam, the essence of ownership is a responsibility provided by Almighty God. Wealth
must be distributed in ways that earn the pleasure of the One who provides it. This
means that prohibited earnings like the return of interest or the sale of immoral products
and services are devoid of all blessing and in fact invoke the anger of Almighty God.

Permissible earnings on the other hand, through legitimate trade and the offering of
beneficial products and services are full of the blessing of Allah.

Allah’s Prophet (PBUH)said :

“May Allah bless a man who is gracious when buying or selling or requiring debt” (Bukhari)

We begin with some key points on the factors of production in Islam as compared to
those in other
popular economic theories. Whilst Islamic economic principles are more than 1,400
years old, they can and have been applied in modern-day economics successfully.

2. Factors of Production in Islam

2.1. Socialist Economy has one :

o Labour only

2.2. Capitalist economy has four :

o Capital
o Labour
o Land
o Entrepreneur or Organisation

2.3. Islamic economy has three :

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o Capital – Means of production which cannot be used in the

process of production, eg liquid cash

o Labour – Any type of human exertion (planning and organising

is also human exertion)

o Land – Means of production used in the process of production

wherein the external form does not change, eg land, houses, motor vehicles,
etc.

3. Islam, Capitalism & Socialism

3.1. Socialism

o Does not accept the concept of private property

o Distribution of wealth is made via a wage
o All capital and all land is surrendered to the State

3.2. Capitalism

o Interest is the reward for capital

o Capital includes machinery (Islamic system includes machinery
under land)
o Only the entrepreneur suffers the risk of loss, i.e. land, capital
and labour still receive their dues
o The benefit and reward of the individual

3.3. Islamic Economy

o Socio-economic justice and equitable distribution of wealth

o Development of the entire community & the eradication of a
concentration of wealth

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o Partners share the risk of reward & loss

o Money is not considered as a commodity
o Financing must be asset-backed

Capitalism Islam Socialism

Generic Concepts Primary Concepts Primary Concepts Primary Concepts

Bounties of God and no

Wealth/Resources Scarcity of resources Scarcity of resources
scarcity

Private Ownership is
The source of exploitation
Ownership Individual freedom accepted but regulated
of labour
by divine law

Personal Satisfaction Equal welfare among the

Lifestyle goals Falaah (Prosperity)
(needs and wants) proletariat

Primary Concepts of Conventional and Islamic Financial Planning

4. Sources of Islamic Law (Shariah)

4.1. There are four sources of Shariah :

4.1.1. Qur’an al Kareem

The Qur’an is the primary source of Islamic Law. Islamic Scholars

are bound by the injunctions of the Qur’an as the primary source of
law.

4.1.2. Sunnah : Hadeeth (Traditions)/ Words or Acts or Tacit

Approval

The Sunnah refers to the words, acts or tacit approval of Noble

Messenger of Allah, Prophet Muhammad (Peace Be Upon Him).
Prophet Muhammad (PBUH) is the guide and teacher of the Muslim
Ummah (nation). He has taught the laws of Islam through his

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Prophetic example, either by his direct commands or sayings, his

noble character or his tacit approval of acts and customs that were
already prevalent during his time.

4.1.3. Ijma’ (Consensus)

Ijma is the consenus amongst the ably-recognised scholars that

provide guidance to the Muslim Ummah (Nation) on various issues.

4.1.4. Qiyas (Analogy)

Qiyas refers to analogy that is extrapolated from a juristic rule

derived from the Qur’an, Sunnah or through Ijma on the basis of an
underlying principle or
‘illah’(underlying rationale for a legal rule)

5. Schools of Thought

It must be noted at this juncture that there are four prominent schools of
thought in Islamic jurisprudence that have provided opinion on juristic
injunctions.

These schools of thought are as follows :

Hanafi - Formed in Kufa by Imam Abu Hanifa. It has based its

rules largely on the results of logical deduction of its scholars on
the basis of Qur’an and hadith.

Shafi’ - Imam Shafi’ was the first to develop a system for

Islamic Law. He establishes the principles of Islamic
jurisprudence (Usul ul Fiqh) in order of priority :

Ijma

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Ra’y (Reasoning primarily through analogy

(qiyas))

Juristic approbation (Istihsan)

Maliki - Imam Malik was the founder of the school that ruled
from the practice of the local community of Madinah, the city of
the Prophet (PBUH).

Hanbali - Imam Ahmad bin Hanbal was the founder of this

school established initially in Damascus, Syria. The Hanbali
school of thought is widely practised throughout the Middle
Eastern region.

6. Fundamental Principles of Islamic/Interest Free Financing – See

summary below :

6.1. Any predetermined, conditional payment over and above the actual
principal amount is prohibited

Islam allows only one kind of loan and that is qard-un-hasan (goodly loan)
whereby the lender does not charge any interest or additional amount over the
money lent. Muslim jurists have construed this principle so strictly that,
according to one commentator "this prohibition applies to any advantage or
benefits that the lender might secure out of the qard (loan) such as riding the
borrower's mule, eating at his table, or even taking advantage of the shade of
his wall."
The principle derived from the quotation emphasises that associated or
indirect benefits are prohibited.

6.2. Profit and loss principle is proportional to the risk

Islam encourages Muslims to invest their money and to become partners in

order to share profits and risks in the business instead of becoming creditors.

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As defined in the Shariah, or Islamic law, Islamic finance is based on the

belief that the provider of capital and the user of capital should equally share
the risk of business ventures, whether those are industries, farms, service
companies or simple trade deals. Translated into banking terms, the
depositor, the bank and the one requiring finance should all share the risks
and the rewards of financing business ventures. This is unlike the interest-
based commercial banking system, where all the pressure is on the
borrower: he must pay back his loan, with the agreed interest, regardless of
the success or failure of his venture.
The principle which thereby emerges is that Islam encourages investments
in order that the community may benefit. However, it is not willing to allow
a loophole to exist for those who do not wish to invest and take risks but
rather content with hoarding money or depositing money in a bank in return
for receiving an increase on these funds for no risk (other than the bank
becoming insolvent). Accordingly, under Islam, either people invest with
risk or suffer loss through devaluation by inflation by keeping their money
idle. Islam encourages the notion of higher risks and higher returns. The
objective is that high risk investments provide a stimulus to the economy
and encourage entrepreneurs to maximise their efforts.

6.3. Making money from money is not Islamically acceptable

Money is only a medium of exchange, a way of defining the value of a thing;

it has no value in itself, and therefore should not be allowed to give rise to
more money via interest payments, simply by being placed at a bank or lent to
someone else. The human effort, initiative, and risk involved in a productive
venture are more important than the money used to finance it. Muslim jurists
consider money as potential capital rather than capital, meaning that money
becomes capital only when it is invested in business. Accordingly, money
advanced to a business as a loan is regarded as a debt of the business and not
capital and, as such, it is not entitled to any return (i.e. interest). Muslims are
encouraged to trade or invest and are discouraged from keeping money idle as
hoarding money is regarded as being unacceptable. In Islam, money represents

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purchasing power and a means of assisting others via means of charity and
empowerment. Money and wealth in general is entrusted to mankind by its
owner - Almighty Allah - to be used in a manner that will gain His pleasure.

6.4. Gharar (Uncertainty, Risk or Speculation) is also prohibited

The prohibition of a Gharar transaction is due to deception. This can arise

either through ignorance of the goods, the price, or through an inaccurate
description of the goods. Bay' al-Gharar is an exchange in which one or both
parties stand to be deceived through ignorance of an essential element of
exchange. It could involve the sale of an item that is not available or wherein
there is significant uncertainty and no entitled ownership, eg. the sale of a fish
in the water or a bird in the air.

There are several types of gharar, all of which are haram. The following are
some examples:

• Selling goods that the seller is unable to deliver

• Selling known or unknown goods against an unknown price, such as
selling the contents of a sealed box
• Selling goods without proper description, such as shop owner selling
clothes with unspecified sizes
• Selling goods without specifying the price, such as selling at the 'going
price'
• Making a contract conditional on an unknown event, wherein the time is
not specified
• Selling goods on the basis of false description
• Selling goods without allowing the buyer the properly examine the goods

6.5. Maysir (Gambling)

Gambling is a form of Gharar because the gambler is ignorant of the result of

his gamble.
It can also be regarded as a transaction in which there is a possibility that one
party can suffer a total loss. It must be noted that while gambling has an

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element of uncertainty, not every type of uncertainty is gambling. The

purchase and sale of derivative products for speculative purposes is a modern
example of gambling.
It should be noted that maysir is one of the key elements in the prohibition of
conventional insurance.

6.6. Products & Services invested in, must be permissible

Trade in alcohol, for example would not be financed by an Islamic bank;

property financing could not be made for the construction of a casino; and
an Islamic bank could not lend money to other banks at interest.

Is Capital Costless in Islam ?

No, Islam recognises capital as a factor of production. However, money is
not seen to have any intrinsic value. Islam therefore distinguishes between
the time value of money and the profit that can be earned through productive
investment. While the time value of money is deemed impermissible by the
majority of the scholars, investment of the capital based on a risk/reward or
profit/loss arrangement is permissible.

7. Distribution of Wealth in Islam

• Overall economic well-being with full employment and optimum rate

of economic growth;
• Socio-economic justice and equitable distribution of income and
wealth;
• Stability in the value of money to enable the medium of exchange to be
a reliable unit of account, a just standard of deferred payments and a
stable store of value.

8. Mobilisation and investment of savings for economic development in an

equitable manner such that all parties concerned receive a just return.

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9. Business transactions, banking & finance in Islamic Law

ISLAM

Aqidah Ibadah Social Activities

(Faith & Belief) Mu’amalat Akhlaq

Dealings with fellow man

Worshipping our Creator

(Morals, Character &

Ethics)

Economic
Activities

Other
Economic Banking &
Activities Finance
Figure 1 : Position of Banking & Finance in Shariah.

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10. Accounting & Auditing Organisation for Islamic Financial

Institutions (AAOIFI)

10.1. The organisation is an International autonomous non-profit making

corporate body established in 1991 in the Kingdom of Bahrain, that
prepares accounting, auditing, governance, ethical and Shariah standards :

o Standard-setting organisation for the Islamic banking and finance

industry that is recognised globally
o Issued 56 standards, and membership consists of over 110
institutions spanning over 28 countries
o Standards are implemented in the leading Islamic banking and
finance centres globally, such as Bahrain, Sudan, Jordan, Malaysia,
Qatar, Saudi Arabia
o Standards are mandatory in certain member countries (eg Bahrain
& Jordan)
o Actively involved in developing the soundness and stability of the
Islamic financial system
o Consists of a 20 member Shariah Advisory Board (Increased from
15 to 20 members in 2007)

10.2. Objectives of AAOIFI :

o Develop accounting and auditing standards relevant to IFI’s

(Islamic Financial Institutions)
o Dissemination of this information through training, seminars and
workshops
o Prepare, promulgate and interpret accounting standards for IFI’s
o Review and amend accounting standards for IFI’s

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10.3. The Standards

10.3.1. Accounting & Auditing Standards

The accounting and auditing standards include the following :

• Objectives and concepts of financial accounting of Islamic
Banks
• General presentation & disclosure of financial statements of
Islamic Banks
• Disclosure & presentation of Islamic Banking instruments
• Disclosure & presentation of zakah
• Auditing responsibilities & compliance with Shariah
• Governance via the Shariah Supervisory Board :
o Appointing members, providing reports
o Conducting Internal Shariah reviews
o Role of the Auditing & Governance Committee for
Islamic Financial Institutions (IFI’s)
• Code of Ethics for Accountants & Auditors of IFI’s
• Code of Ethics for the Employees of IFI’s
• AAOIFI Standards can be applied in line with the requirements of
the IFRS(International Financial Reporting Standards) issued by
the International Accounting Standards Board

10.3.2. Shariah Standards

This is an annual publication that contains the Shariah standards for
the instruments used at the IFI. These standards cover most products
currently used including those discussed in this course.

10. The Islamic Financial Services Board (IFSB)

The Islamic Financial Services Board(IFSB) based in Kuala Lumpur,

Malaysia is also a standard-setting body for the industry. Read more about this

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organisation : www.ifsb.org. The IFSB has 110 members including 27

regulatory and supervisory authorities as well as the International Monetary
Fund, World Bank and the Islamic Development Bank. By December 2005,
the IFSB adopted 2 standards : Principles of Risk Management & Capital
Adequacy Standard for Non-Insurance Institutions offering only Islamic
Financial Services. Other publications include ‘Issues in Regulation &
Supervision of Takaful (Islamic Insurance)’ in August 2006.
11. Other Regulators that support the Islamic Finance Industry

11.1 The International Islamic Rating Agency (IIRA) – Rating of Islamic

Finance Institutions
11.2 The General Council for Islamic Banks & Financial Institutions
(GCIBFI) – Promotion of IFI’s and the concepts relating to Islamic
Banking & Finance
11.3 The International Islamic Financial Markets (IIFM) – Development and
promotion of Islamic Financial Markets
11.4 The Islamic Research and Training Insititute (IRTI) – Promotion of
Islamic research and training

12. The Components of the Islamic Banking & Finance Industry

12.1 Banks

Islamic banking takes different forms within banks. The following structures
are practised internationally :

12.1.1 Fully fledged Islamic Bank

These banks are solely founded on the tenets of the Shariah. They have
independent operating structures that are not part of conventional riba-
based institutions. Only shariah-compliant forms of investment and

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financing is offered. An example in South Africa and the world is

Albaraka Bank Limited.

12.1.2 Window Model

Islamic banking windows operate as the shariah-compliant division of a

conventional bank. This structure usually has a separate unit responsible
for shariah compliant banking products. There is usually an assurance that
there is no contamination of client’s funds with any interest-based funds.
Within a single branch, clients have the option to select Islamic banking
products or the conventional banking option.
An example in South Africa is the ABSA Islamic Banking and Wesbank
Islamic Finance divisions. Internationally, most of the large banking
houses have followed the same route, eg Citibank, HSBC and even Lloyds
of London.

12.1.3 Branches

This model is similar to the windows model. However, in this case,

dedicated branches are established for the delivery of shariah compliant
products.

12.1.4 Subsidiaries

In this scenario, a conventional bank develops a subsidiary under its entity

to deliver shariah compliant products. The advantage of this type of model
is that the subsidiary can establish its own processes and an independent
operating structure. It can also formulate it own policies that are in line
with sharia but still manage to fall within the parent company’s strategies.

12.2 Asset Management

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Investment companies that employ specialist financial analysts allow

individuals the opportunity to invest in shares and equity that would otherwise
be difficult to accurately select. The asset manager ensures that company
shares are purchased according to a strong investment philosophy. The added
advantage for Muslim investors is that asset management companies now
offer shariah compliant unit trusts or mutual funds as they known
internationally.

These unit trusts consist of a portfolio of shares that have been selected by the
asset management team as companies with good value. The companies would
also have to pass the shariah screening process as laid down by AAOIFI, in
order to qualify as permissible shares for the Muslim investor. Very briefly,
some of the parameters include :

No investments into companies that are inherently haraam, eg.
Casino’s, Liquor Groups, Finance houses, Insurance companies,
etc.

The gearing ratio must be be less that 30%

The total income derived from interest-bearing instruments must
be less that 5%

12.3 Takafol

Takafol can be viewed as the Islamic alternative to insurance. Conventional

insurance was ruled impermissible by the Fiqh Council Session in Jeddah in
1985 due to :

Elements of uncertainty

Elements of gambling

Interest-bearing investment

Islamic Scholars have approved a method of mutual assistance that was used
in the Islamic empire also referred to as a joint brotherhood initiative or

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‘Takafol’. In Takafol, a number of participants pool their contributions with

the intention of assisting each other in the event of any participant
experiencing a disaster. A few models exist in the modern application
including the waqf and tabarru models. There is no purchase of an insurance
policy but rather a contribution to a fund for mutual assistance.

Module 2 : Riba in Islam

Learning Objectives :

• Explain the meaning of riba

• Understand what the Qur’anic injunctions are on the prohibition of riba
• Identify the various forms of riba
• Understand the dangers of riba
• Know what other religions say about riba
• Understand the concept of commercial interest and its relevance to riba

The detailed material for this module can be found in :

1. Recommended Text : “Meezanbank’s : Guide to Islamic Banking”

by Dr Muhammad Imran Usmani, Chapters 5 to 8.

2. Recommended Reading : Article on “Interest, Usury, Riba and

the Operational Costs of Banks” by A L M Abdul Gafoor.
(Available on the IFISA website under Resources :
http://www.ifisa.co.za/Resources/Resource_Riba.htm in pdf
format for easy downloading)

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Key Points of the Module

 Literal Definition:

The lexical meaning of Riba is increase; addition; expansion; growth and

excess. The legal sense of the term riba, according the Hanafi jurists, is “An
increase in one commodity for another in an exchange, without compensation
for the increase.”1

 Shariah Definition:

Technically it denotes in a loan transaction any increase or advantage obtained

by the lender as a condition of the loan. In a commodity exchange it denotes
any disparity in the quantity or time of delivery.

Any risk-free or "guaranteed" rate of return on a loan or investment is riba.

Riba, in all forms, is prohibited in Islam. In conventional terms, riba and
"interest" are used interchangeably.

Prophet Muhammad has included the devouring of riba in the seven major
sins.2

 Jahiliyyah (Pre Islamic ) Definition:

It is an excess charged over the principal to grant extensions for the payment
of debt.
If A lends R100 to B (a borrower) with a condition that B shall return R110 to
A after a month, the R10 premium is without any consideration.

1
Kanz Al Daqaiq, Definition expounded also in Ibn Abidin ((Hanafi), Vol 4, pp 184)
2
Narrated by Muslim on the authority of Abu Hurayra (RA).

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Types of Riba

1. The Riba that was understood by the people prior to the advent of Islam,
as explained above.
(Riba for the extension of time or Riba on deferment ) – Riba al
Qur’an :

"0h believers, fear Allah, and give up what is still due to you from the interest
(usury), if you are true believers." [Surah 2 Verse 278]

"If you do not do so, then take notice of war from Allah and His Messenger.
But, if you repent, you can have your principal. Neither should you commit
injustice nor should you be subjected to it." [Surah 2 Verse 279]

2. Sales Riba - Riba al Hadith

When specified items are exchanged for the same kind at unequal
measures or on deferred basis,
this is riba.
Eg One Kg of salt is exchanged for two kg. One kg of dates is exchanged
for two kg of dates,
irrespective of quality.

Prophet Muhammad (PBUH) said:

“Exchange of gold with gold, silver with silver, wheat with wheat, barley with barley,
dates with dates and salt with salt should be of equal quantities and spot. Anyone who
varies the quantities or allows one side of the exchange to be different, indulges in riba for
which buyer and seller are both equally responsible.” 3

From the above explanation it is understood that the term Riba has a wider
connotation than the terms “Interest” and “Usury”

3
Muslim & Musnad Ahmad

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 Riba –al Nasiyah is also known as Riba-al-Quran and Riba-al Fadhl is known
as Riba-al Hadith, because Riba-al Nasiyah was declared prohibited in the
Quran while Riba-al Fadhl was declared prohibited in the Hadith.

 The Riba that is practiced commonly today is Riba-al Nasiyah (excess charged
for the extension of time). The wisdom behind prohibiting this type of Riba is
because there is unequal distribution of wealth as the wealthy capitalists
benefit from interest on money they loan, thereby making the poor poorer.

 Many scriptures teach against the practice of usury.

 The Bible :

Exodus 22:25;

Leviticus 25:36,37;

Deuteronomy. 23:19,20;

Psalms 15:5;

Proverbs. 28:8;

Ezekiel 18:8,13,17;

Ezekiel 22:12.

• Hinduism :

o A brahmana should avoid service of the king, wealth obtained by

agriculture, sustenance derived from trade, all kinds of crooked behaviour,
companionship with any but his wedded wives, and usury.4

o In the 17th century, two new technical terms of interest emerged after the
establishment of the banking system, namely:

• Tijarati Sood (Commercial Interest): Interest paid on loan

taken for productive & profitable purposes.

4
The Mahabharata Santi Parva, Section LXIII, in the Hindu Vedas

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• Sarfi Sood (Usury): Interest paid on loan taken for personal

need and expenses.

 Reason for the prohibition of Riba

o Riba al Fadl was prohibited to avoid injustice and financial losses. The
foundation for the prohibition of Riba al Fadl is to prevent the means
of circumventing the prohibition of the second type of riba : Riba an
Nasiah.5

(This is clearly explained in the verdict of the Supreme Court of Pakistan.

This can be found on the IFISA website under “Riba” in the “Resources”
section as well.)

o Riba an Nasiah was prohibited to prevent major injustice between the

two side of an economic transaction. This injustice could occur due to
significant price fluctuations or other aspects.

 Riba an Nasiah can be classified into two types:

• Simple Interest : Interest calculated only on the initial

investment only.
• Compound Interest : Interest that is added month by month
and calculated on the accumulated amount in order to earn
interest on interest.

5
Al Fiqh Al Islami wa Adillatuh, Vol 5, Chapter 10/3/1 (1997)

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Think Point !

President Obasanjo of Nigeria speaking in the year 2000, commented on his

country’s debt to international creditors, saying :

“All that we had borrowed up to 1985 or 1986 was around $5 billion and we
have paid about $16 billion yet we are still being told that we owe about $28
billion. That $28 billion came about because of the injustice in the foreign
creditors' interest rates. If you ask me what is the worst thing in the world, I
will say it is compound interest.” So $5 billion was borrowed and, fifteen
years later, $44 billion was due (either paid or due to be paid) ! !

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Module Questions :

1. Why is riba forbidden in Islam ?

2. Distinguish between the two types of riba.
3. Is Islam the only religion that forbids interest ?
4. What is the warning that is given to Muslims involved in riba ?
5. Is the receiver of interest the only party that is cursed ? Who else is cursed in
an interest
transaction ?
6. What are some of the sins that riba is compared to in the hadith ?
7. Is money-lending permissible is Islam ?
8. What is the consensus (ijma) amongst the scholars with regards to Riba al
Fadl ?

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Module 3 : Islamic Law of Contracts

Learning Objectives :

• Understand the basic Islamic business principles

• Demonstrate knowledge on the concept of contracts in Islam
• Explain the concepts of unilateral and bilateral promises
• Identify the elements of a valid contract
• Understand the concept of exchange contracts
• Understand the nature of the agency contract
• Be familiar with the basic security contracts

The detailed material for this module can be found in :

1. Recommended Reading : “Islamic Law of Contracts” by Dr M Tahir

Mansuri.

Key Points of the Module

1. Islamic Business Principles

The principles of commerce in Islam are based on the Shariah. Islamic commercial
ethics is based upon divine law as taught by the Messenger Muhammad (PBUH).
Honesty, fair dealing, integrity and piety are all integral to rewarding business
relationships in any way of life. These moralities form the basis of Islamic Commercial
Ethics. If theses universal moralities have been compromised, Islamic contracts cannot
necessarily be valid.

1.1.Honesty & Truthfulness

Anyone involved in business should imbibe the quality of truth in the business practice.
The Messenger (PBUH) of Allah has said,
"Truthfulness leads to righteousness, and righteousness leads to Paradise. A man

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continues to tell the truth until he becomes a truthful person. Falsehood leads to al fujur
(i.e. wickedness, evil-doing), and al fujur (wickedness) leads to the (Hell) Fire, and a
man may continue to tell lies till he is written before Allah as a liar."6

It is also reported that the Prophet (peace be upon him) said regarding traders :

“The merchants will be raised on the Day of Resurrection as evil-doers, except those
who fear Allah, are honest and speak the truth.”7

The manipulation of markets, artificially increasing bids at auctions, short

measurements/weights, concealing faults or defects, hoarding and driving up demand,
cheating and profiteering are all impermissible acts that are void of all blessing and
render transactions invalid.

Allah Most High has commanded the Muslim :

”And, Oh my people, give full measure and weight justly; and defraud not men of
their goods; and do not spread corruption in the land.”8 [Surah 11 Verse 85]

1.2. Disclose Faults, Avoid Deception & Misrepresentation

The Noble Messenger (PBUH) of Allah has stated that the one who deceives cannot be
considered as part of the Ummah of Islam. It is encumbent upon the seller to disclose the
faults of an item prior to its sale. Untrue declarations of the benefits or use of a particular
product is also reprehensible. It is not permissible to sell something that contains
delusion. The wool that is still on the back of a sheep cannot be sold. A preganant cow’s
unborn calf cannot be sold. Any merchandise, before seeing it, inspecting it, or testing it
if possible, should not be sold.

6
Reported in Sahih Al Bukhari, Hadith No. 8.116
7
Reported in Tirmidhi, Ibn Majah, Darimi
8
Qur’an Al Kareem Surah 11, Verse 85 (Translation from Pickthall)

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The Messenger (PBUH) of Allah is reported to have stated : “Do not buy fish in the
water, for verily it is deceitful (uncertain).”9

1.3. Avoid Selling Forbidden Items

A Muslim businessman may not engage in a transaction wherein impermissible items are
involved. The sale or purchase of alcohol, pork, casinos or even investing in insurance
companies or finance houses would not be permissible. Any industry that derives its
income from forbidden items becomes forbidden itself.
This is due to Allah’s Messenger (PBUH) having reported to have said :

“Verily, Allah has prohibited the trade of wine, dead animals, swine and idols.”10

1.4. Avoid Two Sales in One

The Noble Prophet Muhammad (PBUH) disallowed combining two sales in one
contract.

Amr bin Shuayb narrated on the authority of his father that his grandfather said that
Allah’s Messenger (PBUH) said :

“The following are not permitted : a loan and sale in one transaction, two conditions in
one sale, profits on goods that were not in our risk and selling that which you do not
have.”11

This means that where one sale in a contract is dependant upon a condition, the contract
would not be permissible, eg :

Combining a loan contract with the receipt of a gift

Combining the sale of an item on the condition of the use of another item :
9
Reported in Ahmad
10
Reported in Al Bukhari & Muslim
11
Narrated by Ahmad (3504) on the authority of Amr bin Shuayb on the authority of his father on the
authority of his grandfather (Amr bin Al Aas(RA)).

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o Ashraf states in a sale contract that he will sell his car to Rayhana on
condition that Rayhana will take over his furniture repayments as well.

Each trade should be separate in order to avoid confusion.

1.5.Avoid Back-to-back Sales

It is reported by Abu Huraira (RA) that Prophet Muhammad (PBUH) had disallowed
back-to-back sales of the same object between the same contracting parties, changing
roles in a contract, the second sale being dependent on the first. For example, a pre-
condition of a sale in another sale.

1.6. The sale of credit is prohibited (Bay al Inah)

It is not lawful for a Muslim to sell something on credit and then buy it back from the
person he sold it to at a lower price. This difference in price is a typical example of Riba
An Nasiyah as the difference is then agreed by the parties to be paid back on a deferred
basis. For example, Fatima wants a loan of R500 from Rayhana. Rayhana says that she
will sell her new designer wrist-watch to Fatima for R1,200 and then buys the wrist-
watch back immediately for R500. In this way, Fatima has R500 cash and agrees to pay
Rayhana the remaining R700 back over a deferred period of 6 months. This is interest
and is forbidden in Islam.

1.7. Selling a debt with a debt is prohibited

It is not permissible to sell something that does not exist (in terms of an asset or
commodity). A common example of the sale of debt in modern finance is the factoring of
debt. This is not permissible. While it is permissible for a debt to be transferred, it cannot
be sold at a discount, premium or at par. Allah’s Messenger (PBUH) forbade the sale of
a debt.

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There are of course many more principles in Islamic Commercial Ethics. We have
explained aspects that will be relevant to the Islamic Law of Contract and its application
in the development of Islamic Banking techniques.

2. Islamic Law of Contract

In order to understand the application of Islamic banking and finance techniques, a

familiarity with the Islamic Law of Contract must be gained. While it is understood that
the Law of Contract is an important part of commercial law, the Islamic Law of Contract
forms the basis of Islamic Commercial jurisprudence or ‘Fiqh al Muamalat’. The validity
of Islamic contracts is based on a set of rules. Agreements that fall out of these rules are
considered either void/invlaid transactions or not contractual obligations at all. Promises
have an interesting role to play in the application of modern Islamic banking. It would
therefore be prudent the begin with the types of commitments wherein the promise and
the contract would be a part.

2.1. Types of Commitments :

2.1.1. Wa’adah : Unilateral Promise / Undertaking (Promise made by one party)

This is a promise or undertaking by one person in which he offers to do something in the

future, Eg : Imran promises to buy his brother’s house after six months for
R1 million.
The Islamic Fiqh Academy of Jeddah has resolved in accordance with the Maliki
school that a unilateral promise is binding and enforceable, subject to the following
conditions :

It should be a one-sided promise

The promise must have caused the promisee to incur some liabilities for the
promisee to seek enforcement from the promisor

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A promise should not be taken as a concluded sale. If the promise is to

purchase something, the actual sale must take place by the exchange of an
offer & acceptance

If the promisor reneges on his promise, the court may force him to either
purchase the commodity or pay actual damages to the seller. Opportunity
cost will not be included in actual damages. 12

The promisor is not obliged to make good his promise where the lack of performance is
beyond his control. For example, Muhammad promises to sell his cattle to Rashid but his
cattle die in an accident and it is established that Muhammad did not act negligently. If he
did act negligently, he will be liable to fulfil the promise.

2.1.2. Muwa’adah : Bilateral Promise / Undertaking

This is a bilateral undertaking or two unilateral promises made by two parties on the
same subject matter. For example, Bilal promises to purchase Yusuf’s motor vehicle for
R50,000 at any time within six months and Yusuf promises to sell it to Bilal for R50,000
at any time within six months. This involves two unilateral promises on the same asset.

This unilateral undertaking will not be sufficient for ownership to transfer. A sale
contract would have to be established in order to conclude such a deal. According to the
majority of the scholars, Muwa’adah is not enforceable by law in situations where
contracts are not allowed, eg. Future contracts. According to AAOIFI standards, bilateral
undertakings can only be granted in situation where a contract can be validly executed. It
should be noted that there is difference of opinion amongst the scholars on this issue.

2.1.3. Aqd : Contract

A contract is a transaction that is executed between two or more parties for mutual
benefit.
The author of Al Inayah defines a contract as follows :

12
Resolution 302, Fifth Session, Kuwait

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“A legal relationship created by the conjunction of two declarations, from which flow
legal consequences with regard to the subject matter”.13
An aqd therefore implies an obligation arising out of mutual agreement.
Therefore, we can deduce from the above that there must be :

At least two independent parties

Material effect following the exchange of the item under consideration

Offer and acceptance relating to the item and the price of the item

2.1.3.1. Al Muawadha : With Consideration

Eg. Contract of Sale & Purchase, Ijarah (Leasing), Musharaka, Mudaraba

2.1.3.2. Tabarru or Ghair Muawadha :Without Consideration

Eg. Contract of loan, Aariyah, Wadiah

2.2. Conditional Contracts

Conditions in the contract are valid if they are not against the essence of that
particular type of contract.

Conditions that seem to be against the contract but are in accepted market
practice are not void unless proven against the Qur’an and Sunnah. Eg : Ahmed
buys a luxury car provided that the agent provides a 3 year free maintenance plan and
5 year warranty on the engine. This is a valid contract.

Conditions that are against the essence of the contract and not in market practice
but are in favour of one of the parties in the contract is rendered void. Eg : Amina
is required in the contract by the jeweller to wear the gold ring she purchased when
she attends any weddings.

13
Babarti, Inayah ala Fath al Qadir Vol 5, P 47 : as quoted in Mansuri (2006)

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A condition that is against the contract, not in market practice and not in favour of
any contractor, is not a void condition. Eg : Ismail and Bilal enter into a contract and
decide to donate a percentage of their profits to charity upon conclusion of the sale.

2.3. Elements of a valid contract

A contract has basically three elements for the existence of the contract to be declared :

2.3.1. Contracting Parties

The contracting parties must of course be sane and mature.

2.3.2. Subject Matter

The following conditions must be met for the subject matter of the contract to be
valid :

2.3.2.1. Existence : The object must be in existence. Things that do not

exist cannot
be sold. (Except in Salam & Istisna transactions)

2.3.2.2. Valuable : The object should hold value in the light of the shariah.
Alcoholic beverages or lottery cards hold no value in
shariah.

2.3.2.3. Ownership : The seller must have ownership of the object at the time
of
sale. The seller can have physical or constructive
possession
of the subject matter. This means that the object can be
under
the direct control of the seller or under the control of
someone
else appointed as and acting on behalf of the seller.

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2.3.2.4. Delivery :The subject matter must be able to be delivered at the time
of
the contract. Delivery of the subject matter is the
physical
delivery and the transfer of risk & liabilities of the
object to the
buyer.

2.3.2.5. Specific :The element of uncertainty must be removed by ensuring

that
the subject matter can be specifically determined. The
subject
matter should be inspected or described in sufficient
detail as to
avoid uncertainty and ambiguity.

2.3.3. Offer & Acceptance (Ijaab & Qabool)

The offer & acceptance relate to the mutual consent by both the buyer and seller. Allah
Most High states in the Noble Qur’an :

“O you who believe, do not consume one another’s wealth by unlawful means except
that it be trading by your mutual consent.” 14
The term ‘offer’ refers to one person’s intent to sell to another or an intent to buy from
another, a specific quantity at a specific price. An ‘acceptance’refers to the person that
has approved the ‘offer’ that was made at a known quantity and specified price.

Conditions for the Offer & Acceptance to be valid :

The acceptance should be unconditional and absolute. For example, if Bilal offers
to purchase Goolam’s house for R1 million while Goolam says that he wants R1,2

14
Qur’an Al Kareem Surah 4, Verse 29 (Translation from Pickthall)

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million, the offer and acceptance has resulted in a counter-offer which needs to be
accepted to be absoluted and unqualified. Both parties must agree on a sepcific
amount before the contract can become valid.

The offer and acceptance should take place at the same meeting (Majlisul Aqd).
For example, Bilal could not have made an offer and both parties had dispersed
from the initial meeting unless Goolam was given a time-frame in which to
respond. The Islamic Fiqh Academy has ruled that offer and acceptance via fax or
other electronic methods will be deemed permissible.15

The offer holds until it is withdrawn. Acceptance must take place on the offer that
is being upheld. For example, Rayhana offers to purchase a hand-bag for R100
from a street vendor. She revokes her offer and makes a new offer of R80. If the
vendor accepted her first offer before Rayhana made the second offer, the first is
valid.

2.4. Contracts of Exchange & Sale

Islamic banking techniques utilise sales contracts with specific characteristics as the
basis of their product offering. Contracts like Murabaha, Salam and Istisna are all sales
contracts. The sale contract involves the transfer of ownership or exchange of the subject
matter/object/asset from a willing seller to an interested buyer. Where goods or
commodities are exchanged for money, a sales contract can be established. Exchange
contracts differ from each other in terms of legal requirements, obligations created, roles
of parties to the contract and liabilities created. Different methods are used for the
exchange or transfer of ownership depending on the circumstances and requirements of
the parties.

2.5. The Agency Contract (Wakala)

15
Islamic Fiqh Academy Resolution No. 52/3/6

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The term ‘wakala’ literally means ‘preservation’. The term is also used to mean the
delegation of one’s affairs to another.
A fiduciary relationship is created when one person passes authority to another such that the
party can now act on behalf of or represent the one who has provided this authority.
Wakala or agency can therefore be understood as the substitution of an agent for the principal
to act on behalf of that principal.

Islamic banks have been widely applying the agency contract in services offered including :

Asset Management

Murabaha transactions

Takaful (Islamic alternative to insurance)

According to the majority of the scholars, the contract of agency has four cornerstones16,
namely :

Principal : Also known as the Asil

Agent : Also known as the Wakil

Wording of the contract

Subject Matter :

This refers to the act for the performance of which the agent has been appointed. The
subject matter should fulfil the following:

It should be known to the agent

It should be lawful

The agent must exercise due diligence in the performance of his responsibilities. Possession
in the hands of the agent is considered possession in the hands of the principal. In other
words, risk is transferred to the principal once the agent has taken possession of an asset in
the case of a purchase representation.

16
Al Fiqh Al Islami wa Adillatuh, Vol 5 (2003), Pg 632

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2.6. Security Contracts

2.6.1. Kafala (Suretyship or Guarantee Contract)

The word ‘kafala’ can be defined as the merging of one liability with another in respect
of the demand for the performance of an obligation.17
This type of contract simply makes a third party liable alongside the original debtor. One
party stands as a guarantor for a debtor and becomes liable for the debt if the original
debtor defaults on payment. Conventional banks that offer the service of providing letters
of guarantee on behalf of their clients to other banks, charge ‘Guarantee Fees’ that are
usually a percentage of the guarantee required. This charge is not considered permissible
as this type of contract is regarded as gratuitous in order to avoid riba. Islamic banks have
justified the fee by usually charging a fixed administrational fee for the preparation of the
guarantee.

2.6.2. Hawala (Transfer of Debt)

The word ‘hawala’ comes from ‘tahwil’ which means shifting something from one place
to another. In terms of law, hawala refers to the transfer of debt from the liability of the
original debtor to the liability of another person.18
According to Imam Abu Hanifa, the original debtor is free of all obligations of liability
once the debt is transferred.19 The hawala is also a gratuitous contract that is void of riba.
Islamic banks generally charge an administrational fee that is not proportionate to the
duration or the value of the contract.
The transfer of debt can only be concluded once an offer is made by the debtor and
acceptance is established by both the creditor and the one to whom the debt has been
transferred.

2.6.3. Rahn (Mortgage or Pledge)

17
Marghinani, (Al Hidayah) Pg 317/318
18
Zaylai, (Tabyin al Haqaiq), Vol 4, Pg 1717, as quoted in Mansuri (2006)
19
Kasani, (Badai al Sanai), Vol 6, Pg 17

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A rahn or pledge consists of setting aside property as a security that can be lawfully
employed to obtain payment or for satisfaction of a claim in respect of a debt.20 A debtor
pledges a security or property to a creditor as collateral and agrees that the collateral may
be sold if the debtor does not fulfil his contractual obligations or terms of payment.

While the pledge is in place, it is permissible for the owner of the security to continue to
benefit from it. The maintenance of the pledged property remains the responsibility of the
its owner.
For example, Harun acquires a motor vehicle through a financing transaction with an
Islamic bank. Harun can use the motor vehicle itself as the rahn (pledge / security) for the
financing transaction. He will also be liable for the maintenance and service of the motor
vehicle although it is offered as collateral to the bank. The bank in fact, is not allowed to
benefit from the use of the motor vehicle.

20
Al Majallah Al Ahkam Al Adaliyyah, Article 701

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Module Questions

1. Is it permissible to sell a debt in Islam ?

2. What is the difference between Mu’awadah and the Aqd ?
3. What elements are required for a valid contract of sale to exist ?
4. Name the types of security contracts that are valid in the shariah.
5. What can be used as a security in motor vehicle finance arrangement that would be
permissible in the shariah ?
6. What are the required elements for an Aqd to be valid ?
7. What is the opinion of the various scholars with regards to the bilateral promise ?
8. The sale of a camel with deferred payment for its unborn baby is considered
_________ ?
9. Describe some ethical practices that a Muslim trader must adopt in the market-place.
10. Can misrepresentation of an item render the offer and acceptance void ?
11. Which school of thought accepts the promise as binding and enforceable ?
12. Name two impermissible sales contracts.
13. ‘Offer and acceptance need not be verbal or in writing but can be a tacit approval as
well.’
True or False ?
14. ‘The price of an object can be confirmed at a later stage but it is important for the
purchaser
to take possession of the object for a sale to be valid.’ True or False ?
15. What are the conditions to be satisified regarding the subject matter ?
16. Can the owner of an asset that he has provided as security make use of the same asset
?
17. What is the basis for two sales in one to be considered impermissible ?
18. Is it permissible for a contract of loan to be combined with a contract of sale ?
19. What are the key elements required for a contract of agency to be valid ?

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Module 4 : Islamic Banking Techniques : Mudaraba

Learning Objectives :

• Demonstrate knowledge on the concept of Mudaraba as per the Shariah Standards

• Differentiate between Mudaraba & Musharaka
• Explain the roles of parties in a Mudaraba
• Demonstrate knowledge on profit distribution in a Mudaraba
• Demonstrate knowledge on Mudaraba in practical banking application

The detailed material for this module can be found in :

1. Recommended Text : “An Introduction to Islamic Finance” by Mufti Taqi

Usmani,
under the chapter called : “Mudarabah” – Page 47 to 81

2. Recommended Reading : “Mudaraba Based Investment Finance” by A L M

Abdul Gafoor (Available on the IFISA website under Resources :
http://www.ifisa.co.za/Resources/Resource_banking.htm in pdf format for
easy downloading)

 Literal Definition:

The word ‘Mudaraba’ is derived from the Arabic word ‘Darb’ meaning to strike or to
hit. If the word is used with a prefix (the ‘Mu’) then it means to walk or to go about.
One meaning is to strike out and earn a living. The derived form signifies that the
work must be done reciprocally. In other words, if one man provides the effort while
the other assists him reciprocally by providing the finance, it is termed ‘Mudaraba’.

 Shariah Definition: Mudaraba is a partnership in profit whereby one party provides

capital (Rabbul Maal) and the other party provides labour (mudarib).21

21
AAOIFI Shariah Standard No 13, Par 2 (2005)

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 Concept of Mudaraba (Silent Partnership) as used in Islamic Banking :

In the Islamic Banking scenario, the partnership of Mudaraba can be used as a

method of investment finance where one party provides capital or deposits or invests
with another. The other party or entrepreneur then utilises these funds to assist those
requiring finance for the purchase of assets like motor vehicles, property, trading
stock, etc. whereby both the parties share in the profits at a pre-agreed profit-
sharing ratio but only the provider of the capital / depositor / investor / Rabbul Maal
risks the loss of the funds.

Mudaraba in conventional legal terms is known as a ‘Silent Partnership’ or en commandita.

o Parties involved in the Mudaraba :

Rabbul Maal : Investor or provider of the capital

Mudarib : The worker or manager of the funds
Ra’ sul Maal : The funds that are invested

Two scenarios can exist :

1. Bank as Rabbul Maal

In case of a project financing initiative, an entrepreneur requires financing for an
investment venture that he is skilled in. The entrepreneur can obtain investment finance
for such a project via a financial institution. The financial institution will use depositors’
funds to finance this type of initiative. This can be graphically illustrated as follows :

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2.Figure 2 : TypicalasMudaraba
Entrepreneur with Islamic Bank as Rabbul Maal(Owner of the capital)
Rabbul Maal
In this case, the entrepreneur is the owner of capital or the Rabbul Maal. In most
instances, he is a depositor at an Islamic Financial Institution, agreeing to participate in
the profits that will be made upon investing the depositor’s/entrepreneur’s funds. The
bank now becomes the Mudarib

Depositor

o Qur’anic
Figure Proof
3 : Typical :
Mudaraba with entrepreneur as depositor & Rabbul Maal. The Bank
is now the Mudarib.

o Qur’an Proof:

“Striking out in the earth in search of the generosity of Allah.” [Surah 73, Verse 20].

This verse is interpreted to mean that those who travel for the purpose of trading and
seeking

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permissible income in order to provide for themselves and their family.

While this verse is not explicitly discussing the Mudaraba contract or silent partnership, it
does implicitly validate working with others’ capital in exchange for part of the profits.22
.
o Hadith Proof:

Prophet Muhammad used to do business with the capital of Lady Khadija (RA) in the
method of Mudaraba. In the hadith, two other words are used : Muqaradah & Qirad.

From the Sunnah is the tradition that says al-Abbas Ibn Abd al-Muttalib used to pay
money for Mudaraba and to stipulate to the mudarib that he should not travel by sea, pass
by valleys or trade in livestock, and that the mudarib would be liable for any losses if he
did so. These conditions were brought before the Prophet and he approved of this.23

Among the traditions regarding the validity of Mudaraba is the case that states that Umar
Ibn al-Khattab gave one man the funds belonging to an orphan for the purpose of
Mudaraba and the man was trading with these funds in Iraq.24

Al Qasim Ibn Muhammad (who together with his orphan nephews were under the
supervision of the Mother of the Believers, Lady 'A'ishah (RA)) says:
“We had funds in the custody of Lady 'A'ishah(RA) and she used to give them on
mudarabah basis.”25

Suhaib (RA) narrates that Prophet Muhammad (PBUH) mentioned that three transactions
have barakah. Amongst them is mudarabah.26

o Types of Mudaraba :
22
Al Fiqh Al Islami wa Adillatuh, Vol 5 (1997)
23
The hadith is reported by al-Bayhaqi Vol 6/111.
24
The hadith is reported by al-Bayhaqi in al-Ma'rifah (see al-Zailai, Nasb al-Raayah)

25
Al Mabsut, Vol 22, pp 18
26
Miskhat Al Masabih, Pg 254. Also narrated in Ibn Majah.

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 Muqayyad or Conditional also known as Restricted Mudaraba

 Mutlaq or Unconditional also known as Unrestricted Mudaraba

Muqayyad means a Mudaraba wherein the Rabbul Maal(Owner of the Capital) specifies
that the funds be used in a particular place or for a fixed time or for some specified
purpose.

Mutlaq means a Mudaraba wherein no conditions are made and everything is left to the
discretion of the Mudarib. It is this form of Mudaraba that is used extensively in Islamic
Banking operations (by way of deposit-taking) throughout the world.

o Why is Mudaraba permissible & why is it used in modern day Islamic Banking ?

o Mudaraba is an acceptable form of investment since :

Money cannot increase unless it is associated with work. It is also not permissible to
provide money in return for a periodic pre-agreed payment to a person who is willing
to invest it as this will constitute a debt with riba.27

o The Mudaraba contract facilitates investment cooperation between capital

providers who are not prepared to invest and manage their money themselves, and
competent business or investment experts who lack adequate capital.

In other words, there are some individuals who are rich but lack business or
investment know-how and others who have business or investment expertise but
lack money. This situation thus calls for the permissibility of the Mudaraba
contract so as to combine the interests of the two parties.28

27
AAOIFI Shariah Standard No 13, Appendix B, Pg 240.(2005)
28
Takmilat al-Majmu' 14/371 as quoted in Al Fiqh Al Islami wa Adillatuh, Vol 5 (1997)

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o Basic Principles for application of Mudaraba in Islamic Banking

 Mudaraba is not a method of advancing money. It is a means of participating

in a business venture that can yield profits. Therefore, there is no debt on the
Mudarib to the provider of capital.

 The provider of capital must share the loss incurred by the business to the
extent of his capital.
In the case of the Mudaraba, only the Rabbul Maal will lose his capital as the
Mudarib does not invest any capital. The Mudarib will not be liable for losses
on the condition that he has observed due diligence. If the Mudarib has been
negligent, he will then become liable.

 The partners must determine the profit-sharing ratio at the beginning. They are
at liberty to stipulate any ratio that is acceptable between the partners.

 The Mudarib is authorised to do anything that falls within the course of

business.
He is only allowed to do the following with the express permission of the
Rabbul Maal :

Accept another Mudarib or partner

Mix his own investment in the Mudaraba

 The Rabbul Maal is not authorised to be involved in the management of the

funds as this will hinder the investment scope of the Mudarib.

 All direct expenses to the Mudaraba will be a first charge to the Mudaraba
pool of funds.

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o Differences between Mudaraba & Musharaka

Musharakah Mudaraba

1. All partners invest. 1. One party, Rabbul Maal, invests.

2. Management of the business by 2. Management of business by Mudarib only.

any/all partners.

3. All partners share the loss to the extent 3. Only Rabbul Maal suffers the loss
of the ratio of their investment. provided that the Mudarib acted with due
care.

4. Unlimited liability of partners. 4. Liability of Rabbul Maal is limited to his

investment unless the Mudarib was
authorised to incur debts on the business.

5. All partners share in the ownership of 5. The assets are owned by the Rabbul Maal
the assets pro-rata to their investment. and no share is owned by the Mudarib.

 Roles of the parties in a Mudaraba

It has been explained in the basic principles above that the Mudarib and Rabbul Maal
have specific roles in the contract, viz. :

Rabbul Maal : Provider of capital

• Provides the capital & not the management of the funds

Mudarib : Worker : (Roles played by the Mudarib at various levels)

• Ameen (Trustee) :

o Obligated to look after the investment responsibly &

with due diligence that is within his control.

• Wakeel (Agent) :

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o To purchase from the funds provided by the Rabbul

Maal.

• Shareek (Partner) :

o Shares in the profit

• Dhamin (Liable) :

o To provide for the loss suffered by the Mudaraba if it

was due to negligence.

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o Distribution of profit in a Mudaraba

Example :

Mohamed invests $100,000 with Bilal. Bilal is well-known in the jewellery and bag
industry. He purchases $60,000 worth of jewellery and $40,000 worth of handbags with
the investment. He has already received orders from retailers for the jewellery and
handbags. Bilal has marked up the jewellery at 20% and the hand-bags at 50%.

The two have agreed that they will share the profits on a ratio of 50/50. Bilal successfully
sells all the stock in his possession. He receives a total turn-over of :

$72,000 Jewellery

$60,000 Handbags

Total $132,000

Gross Profit $32,000 ($132,000 less the initial investment of

$100,000)

Expenses ($12,000) (Travel costs, delivery charges, etc.)

Net Profit $20,000

Profit accruing to each partner $10,000

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o In the abovementioned example, note the following :

o The profit ratio or profit distribution must be determined at the beginning of the
arrangement : In this case : 50/50. They cannot make a condition that a specified
amount can be the share of the Mudarib or that a percentage of the capital will be
given to the Rabbul Maal or vice versa.

o Expenses borne in the normal course of business are deductible as an expense

from the Mudaraba.29

o The Rabbul Maal is allowed to stipulate that profits will be shared 50/50 for the
jewellery but 70/30 for the handbags.

o The Mudarib cannot claim an additional salary for his services unless a separate
agreement has been made outside the Mudaraba agreement and provided that
these were not the original Mudaraba responsibilities. 30

o The agreement can be terminated at any time by either of the two parties and the
distribution of any profits at the time of termination must be made according to
the pre-agreed profit-sharing ratio.

o If Bilal(the Mudarib) decided to include some of his own capital in the

investment, the agreement will now be a combination of Musharaka(Partnership)
and Mudaraba.

29
Shariah Standard No 13, Par 8/7 .(2005)
30
Sarakhsi, AlMabsut V.22 pp 149,150 as quoted in Al Fiqh Al Islami wa Adillatuh, Vol 5 (1997)

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Module 5 : Islamic Banking Techniques : Musharaka

Learning Objectives :

• Demonstrate knowledge on the concept of Musharaka as per the Shariah Standards

• Demonstrate knowledge on the nature of capital in a Musharaka
• Familiarity with the position of Musharaka financing in the concept of Shirkat
• Explain the application of Musharaka in contemporary banking practice
• Explain how a Musharaka can be terminated

The detailed material for this module can be found in :

1. Recommended Text : “An Introduction to Islamic Finance” by Mufti

Taqi Usmani, under the chapter called : “Musharaka” – Page 27 to 91

Key Points of the Module

 Literal Definition

Shirk or Shirkah in Arabic means Partnership or Participation. Musharaka is the act or

contract of initiating a partnership. The technical meaning refers to two or more persons
in enjoying a right or ownership of a property or asset.

Linguistically, the term for partnership (sharikah) signifies mixing of two properties in a
manner that makes it impossible to define the separate parts. The majority of the jurists
then generalised the term to all partnership contracts, even if the component properties
can still be individually identified.31

Musharaka’s are classified into two major categories :

o Shirkatul Amlaak / Shirkatul Milk : Partnership by Ownership or Joint ownership

31
Al Fiqh Al Islami wa Adillatuh, Vol 5, Chpter 21(2003)

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o Shirkatul Aqd / Shirkatul Uqud : Partnership by Contract or Joint Venture

The Shariah Standards as prepared by AAOIFI, define the latter : Shirkatul Aqd

 Shariah Definition of Shirkatul Aqd

Shirkatul Aqd or the partnership of contract means an agreement between two or more
parties to combine their assets, labour or liabilities for the purpose of making profits.32

 Concept of Shirkatul Aqd or Partnership of Contract :

This is a type of partnership which is effected by a mutual contract. It can also be

understood to be a joint commercial enterprise. The joint venture can be further
classified into two specific categories :
1. Classical Contracts of Partnership or Fiqh-Nominate partnerships
2. Modern Corporation Partnerships

Herewith follows an explanation for the abovementioned categories :

1. Classical Contracts of Partnership or Fiqh-Nominate partnership can be
further divided into the following categories :

o Sharikatul ‘lnan (contractual partnership)

This type of partnership is a joint venture in which capital is invested and the
profit that is earned by the partners is according to a pre-agreed, mutual
arrangement. The shares do not have to be equal to each other. Losses are borne
by the partners in the ratio of the capital that each had invested.
According to one story, the origin of the term ‘inan’ (reigns of horses) suggests
the equality of partners in legal rights in dealing with the joint capital of the
partnership. The metaphorical use to which this explanation refers is one of two

32
AAOIFI Shariah Standard No 12, Par 2/1 (2005)

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horsemen riding side-by-side, with the reigns of their horses also being side-by-
side.33

o Sharikatul Wujooh or Dhimam (liability partnership)

This partnership has no initial capital. The objective is to purchase goods on credit
and earning profit by their onward sales, profit is then distributed in an agreed
profit-sharing ratio.

o Sharikatul A'mal (vocational partnerships and partnerships for undertaking

work or accepting jobs)

This type of partnership is in the business of services. Two or more individuals

agree to embark on a joint labour project (eg Two hairdressers), sharing the wages
according to their stipulated conditions in the contract. The partners may be of
similar or different professions. (eg : a carpenter and a blacksmith). 34

2. Modern Corporation Partnerships :

o Stock Company
o Joint-liability Company
o Partnership in commendum
o Company limited by shares
o Allotment (muhassa) partnership
o Diminishing Partnership (A commonly practiced form of Musharaka
financing. In Arabic : Musharaka Mutanaqisa)

 Basic Principles of Shirkatul Aqd

33
Al Fiqh Al Islami wa Adillatuh, Vol 5, 22/1/1(2003)
34
Al Fiqh Al Islami wa Adillatuh, Vol 5, 22/3 (2003)

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o The ratio of profit/loss for all partners must be determined at the time of entering into
the contract
o Profit allocated to each partner must be a proportion of the actual profit earned and
not a proportion of the capital invested
o Any condition that results in any partner being deprived or a class of partners from
having a share in the actual profit, or in liquidation, is not valid. Preference shares are
therefore not allowed.
o Profit ratios do not have to be equal to the proportion of capital invested.
Exception : > If the contract expressly stipulates that a partner shall not work for the
business, his share of the profit cannot exceed the proportion of his investment.
o Losses must be suffered by all partners in proportion to their respective investments
o No partner can guarantee the principal or the profit to another partner, even by a
separate undertaking. However, if the loss was caused through negligence, the partner
can be held liable.
o No partner can ask another partner for security unless in the form of a trust to be
invested for the benefit of its owner.

 The Nature of Capital in a Musharaka

o In principle, the capital of Sharika should be contributed in the form of monetary

assets on which one can rely in order to determine the amount of the capital and to
recognise profit or loss.

o It is permissible, upon mutual agreement, to contribute capital in the form of tangible

assets or commodities, provided that the monetary value of the assets have been
included as a share.35

o If shares are contributed in different currencies, the currency of the partnership must
be determined and the value must be included at the current exchange rates

35
AAOIFI Shariah Standard No 12, Par 3/1/2/1 (2005)

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 Musharaka as an instrument of financing in Islamic banking operations

o Musharaka is considered the best possible method of financing in Islamic economics

o Businesses that are in need of capital can utilise this form of financing in order to
raise much needed capital by allowing investors to purchase a share of the business
for a monetary sum.

o An acceptable modern form of Musharaka is the Diminishing Musharaka method

for property financing :

 Diminishing Musharaka is a form of partnership in which one of the partners

promises to buy the equity share of the other partner gradually until the title
to the equity is completely transferred to him.

 This transaction starts with the formation of a partnership, after which buying
and selling of the equity take place between the two partners.

 It is therefore necessary that this buying and selling should not be stipulated in
the partnership contract. In other words, the buying partner is allowed to give
only a promise to buy. (This is because of the prohibition of joining two
conditions in one : Safqa fi Safqa).

 This promise should be independent of the partnership contract.

 In addition, the buying and selling agreement must be independent of the

partnership contract.

 It is not permitted that one contract be entered into as a condition

for concluding the other. (Safqa fi Safqa prohibition)

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 The rules of Shirkatul Inan must be applied to the partnership

 One partner cannot be liable for all the costs of insurance and maintenance of
the asset on the grounds that he will eventually own the asset

 Each partner should contribute part of the capital

 In the case of trade, the ratio of profit that each partner is entitled to should be
clearly determined. The ratios do not have to be equal to the ratio of
investment but they must be pre-agreed

 It is permissible for either of the partners to rent or to lease the share of the
other partner for a specified amount and for a specified duration 36

Figure 4 : Joint ownership(Shirkatul Milk) in property with the intention of equity

purchasing by the customer until he owns 100% of the property.

 Procedure in Diminishing Musharaka :

The proposed arrangement is composed of the following transactions:

36
AAOIFI Shariah Standard No 12, Par 5 (2005)

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1. To create joint ownership in the property (Shirkat-ul-Milk).

2. Giving the share of the financier to the client on rent.
3. Promise from the client to purchase the units of share of the financier.
4. Actual purchase of the units at different stages through a formal offer & acceptance
5. Adjustment of the rental according to the remaining share of the financier in the
property.37

 Termination of a Musharaka 38

o The termination of a partnership will not affect obligations and actions that took place
before it.

o A partner cannot purchase the assets of a partnership at face value. The purchase must
be at market value or a price agreed upon at the time of sale.

37
Mufti Usmani, Taqi,(1998)“An Introduction to Islamic Finance"
38
Ibid, Appendix B

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Module 6 : Murabaha Cost-Plus Financing

Learning Objectives :

• Demonstrate knowledge on the concept of Murabaha as per the Shariah Standards

• Explain the application of Murabaha in contemporary banking practice
• Explain the steps necessary for a valid Murabaha financing transaction
• Understand the concept of security or guarantee for Murabaha financing
• Know the differenes between Murabaha and a loan
• Explain the use of penalty for default of payment in contemporary Islamic banking

The detailed material for this module can be found in :

1. Recommended Text : “: “An Introduction to Islamic Finance” by Mufti

Taqi Usmani, under the chapter called : “Murabahah” – Page 95 to 151

2. Recommended Reading : “Murabaha” by Mufti Taqi Usmani

(Available on the IFISA website under Resources :
http://www.ifisa.co.za/Resources/Resources_Banking.htm in pdf format
for easy downloading)

Key Points of the Module

 Literal Definition

Murabaha literally means ‘to make a profit’. The technical meaning of Murabaha is a kind
of sale wherein the seller discloses the actual cost he has incurred in acquiring the
commodity and then adds some profit thereon. It is therefore a straight-forward sale on a
cost plus mark-up basis.

 Shariah Definition

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Murabaha is selling a commodity as per the purchasing price with a defined and agreed
profit mark-up. This mark-up may be a percentage of the selling price or a lump sum. This
transaction may be concluded either without a prior promise to buy, in which case it is
called an ‘Ordinary Murabaha’, or with a prior promise to buy submitted by a person
interested in acquiring goods through the institution, in which case it is called a ‘Banking
Murabaha’, i.e ‘Murabaha to the Purchase Orderer’ . This transaction is one of the
trust-based contracts that depends on transparency as to the actual purchasing price or cost
price in addition to common expenses. 39

 Banking Murabaha or Murabaha to the Purchase Orderer

It is must be understood that Murabaha is really a kind of sale and not a form of finance in
itself. The preferable mode of financing is the Mudaraba or Musharaka method of
finance.

Homoud (1982) quotes Ibn Qudamah who defines Murabaha as follows:

(murabahah is) Selling for the cost price plus a specified profit, provided that both the
seller and the buyer know the cost price. The seller says, my capital, or the cost price, is a
hundred, and I sell it to you for a profit of ten.' This is permitted and there is no doubt about
its legitimacy. No scholar is reported to have regarded it with legal 'dislike' (karahah).40

However, to incorporate a purchase order in this transaction, Homoud turns to Imam

Shafi'i:

“If a man shows, certain goods to another and says, 'buy this for me and I will give you so
much profit', and the second man buys it; then the transaction is permitted. However, the
one who has made the promise has the right of withdrawal. If he buys, it makes no
difference whether he pays immediately or at a later date. So, the first sale is valid but there
41
is no commitment as to the other; they are at liberty.” This example of Imam Shafi'i has
led Homoud to evolve the financing mode called bai' al murabahah lil 'amir bil shira (sale
with declared profit to the purchase order i.e, the mark-up).

39
AAOIFI Shariah Standard No 8, Appendix D(2005)
40
Homoud, 1982, p. 7
41
Al Shafi’I (Vol.3, p33)

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• The most popular method of financing at Islamic banks internationally is the credit sale
on a deferred basis commonly known as the Murabaha. In many cases, this type of
financing forms more than 70% of the total financing at an Islamic bank. A credit sale
coupled with a cost plus mark-up is also known in Malaysia & parts of Europe as a BBA
(Bai’ Bithaman Ajil).

The Murabaha component determines the profit-margin and the deferment ensures that
the profit is collected over a period of time.

Usually on
deferred basis

Figure 5 : Murabaha to the purchase orderer on a deferred basis. The vendor or supplier of
the asset transfers the title to the customer after the customer acts as an agent on behalf of
the bank, providing constructive possession to the Islamic Bank.

o Conditions for a valid Murabaha

The basic rules and conditions of a valid sale apply in order to make the Murabaha valid.
Some of the conditions of a valid sale include the following :

A person cannot sell a commodity unless:

o It has come into existence,

o It is owned by the seller,
o It is in the physical or constructive possession of the seller.

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In addition:

o The sale must be instant and absolute. Thus a sale attributed to a future date is void
o The sale must be unconditional. A conditional sale is invalid, unless the condition is
recognized as a part of the transaction according to the usage of trade.
o The certainty of price is a necessary condition for the validity of a sale. If the price is
uncertain, the sale is void.
o The deferred price may be more than the cash price, but it must be fixed at the time of
sale.

 Important Note with respect to the use of Murabaha

o It must always be noted that originally, Murabaha is not a mode of financing. It is only a
device to escape from “interest” and not an ideal instrument for carrying out the real
economic objectives of Islam. Therefore, this instrument should be used as a transitory
step taken in the process of Islamization of the economy, and its use should be restricted
only to those cases where mudarabah or musharakah are not practical.

o The second important point is that the Murabaha transaction does not come into
existence by merely replacing the word of “interest” by the words of “profit” or “mark-
up”. Actually, murabahah as a mode of finance, has been allowed by the

Shariah scholars with some conditions.

Unless these conditions are fully observed, murabahah is not permissible. In fact, it is the
observance of these conditions which can draw a clear line of distinction between an
interest bearing loan and a transaction of murabahah. If these conditions are neglected, the
transaction becomes invalid according to Shariah.42

 Procedure for Murabaha as a Mode of Financing

42
Mufti Usmani, T, Murabaha (2003)

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A financial institution can use the Murabaha as a mode of finance by adopting the
following procedure:
o The client and the institution sign an overall agreement whereby the institution
promises to sell and the client promises to buy the commodities/assets/motor
vehicle/property from time to time on an agreed ratio of profit added to the
cost. This agreement may specify the limit up to which the facility may be
availed.

o When a specific commodity is required by the customer, the institution may

appoint the client as his agent for purchasing the commodity on its behalf, and an
agreement of agency is signed by both the parties. The institution may
alternatively acquire the item for the client themselves or through a third party –
This would be the preferred method.

o The client purchases the commodity on behalf of the institution and takes its
possession as an agent of the institution.

o The client informs the institution that he has purchased the commodity on his
behalf, and at the same time, makes an offer to purchase it from the institution.
At this point, the goods are at the risk of the institution.

o The institution accepts the offer and the sale is concluded whereby the
ownership as well as the risk of the commodity is transferred to the client.

All these five stages are necessary to effect a valid Murabaha. If the institution
purchases the commodity directly from the supplier (which is preferable) it does
not
need any agency agreement. In this case, the second phase will be dropped and at
the
third stage the institution itself will purchase the commodity from the supplier and
take possession while the fourth phase will be restricted to making an offer by the
client.

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The most essential element of the transaction is that the commodity must
remain
in the risk of the institution during the period between the third and fifth
stage.43

The resulting payments are fixed instalments made to the financial institution over
a specified period.

It is the obligation of the financial institution to ensure that the two requirements
below are met :

o The institution itself must pay the supplier, and not pay the price of the item
into the account of the customer as agent

o The institution should obtain from the supplier the documents that confirm
that the sale has taken place. 44

 Providing a Security or Guarantee for Murabaha

It is permissible for the institution, in the case of a binding promise by the customer, to
take a security deposit (known as Hamish Jiddiyah). The deposit is kept in trust or
invested as per the choice of the customer. This is amount is paid for two key reasons :

• Determination of the financial capacity of the customer (purchase orderer)

• Compensation to the institution in the case of any breach of the customer’s
binding promise.45

 Differences between Murabaha and a loan

43
Ibid
44
AAOIFI Shariah Standard No 8, Par 3/1/4 (2005)
45
Ibid Par 2/5/3 (2005)

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• Ownership must pass to the financial institution, whether constructive or

physical

No form of penalty may be charged in the case of late payment, that will
benefit the creditor since this will be riba

• The date for the conclusion of the transaction can be set and even extended if
required. However, there should be no cost associated to the extension, eg
penalty fees or an increase in the profit mark-up

• Early payment discounts that are not preferred unless it is the decision of the
financier to offer the discount.

An important note regarding Murabaha is that the subject matter cannot be sold back to the
original seller at a different price. This will fall in the classification of prohibited transactions
or bay al inah.

 Charging a penalty for the default of payment

o The need for corrective measures for defaulters

If a client in Murabaha financing defaults in payment of the price at the due date, the
price cannot be increased. In interest-based loans, the amount of loan keeps on
increasing according to the period of default. But, in murabahah financing, once the
price is fixed, it cannot be increased.

This restriction is sometimes exploited by dishonest clients who deliberately avoid to

pay the price at its due date, because they know that they will not have to pay any
additional amount on account of default.

o Qur'anic Injunction :

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“And if he (the debtor) is short of funds, then he must be given respite until he is
well off.” 46

o Hadith Injunction :

Holy Prophet (PBUH)has condemned the person who delays the payment of his dues
without a valid cause. According to the well-known hadith he has said:
“The well off person who delays the payment of his debt, subjects himself to
punishment and disgrace.”

o Opinion of AAOFI :

It is permissible for the institution to encourage an undertaking whereby the defaulter

promises to donate a sum of money in addition to the amount owing, to be spent by
the institution to a charitable cause as this is considered as instance of the
commitment to
make a donation, established in the Maliki school of law. This is the opinion of Abi
AbdAllah Ibn Nafi’ & Muhammad Ibn Ebrahim Ibn Dinar among the Maliki jurists.47

o First Objection – Riba

This payment to charity is made on a debt (an amount of money) and therefore
appears to be in the nature of Riba.

o Response :

The first answer is that the amount is paid by the debtor to charity, and not to the
creditor, pursuant to a unilateral undertaking, in the form of a vow, taken by the
debtor. The bank as the creditor derives no direct or indirect benefit from the
payment, which is made to charity.

46
Qur’an, [Surah 2 Verse 280]
47
i. AAOIFI Shariah Standard Appendix D (2005). ii. Tahrir al Kalam fi al Iltizam by al Hattab. iii.
Resolution of the Fourth Fiqh Forum by Kuwait Finance House.

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The second answer is that Riba is a contractually agreed amount between

creditor and debtor, in respect of and against which no consideration
(recognized by Shariah) passes, such contractually agreed amount (Riba) accruing
exclusively to the creditor. In this case, the creditor receives no compensation
on the monetary amount of the debt in any form whatsoever, with the result that
there is no Riba.

o Second Objection – Gharar (Uncertainty)

This payment to charity is dependant on the occurrence of a future event,

(namely, non-performance by the debtor, which may, or, may not occur. This is
known as Gharar in Shariah, and is not permissible.

o Response

The answer to this is that Gharar is permissible in that class of contracts and
obligations, which are known as “Tabarru”. Examples of tabarru contracts are
contracts of donations and suretyship. They must be distinguished from purely
commercial contracts such as sale and lease in respect of which there is a
reciprocal exchange of consideration or actual performances (eg Price and thing:
rental and thing).

This unilateral obligation which the debtor assumes against himself, pursuant to a
vow, to pay an amount to charity is therefore a tabarru which is permissibly
dependant on the occurrence or non-occurrence of a future event (breach of
contract). The Muslim jurists are unanimous that a person may assume a tabarru
obligation and thereby become bound or obliged to perform it.

o Third Objection – Penalty

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This payment to charity amounts to a penalty for non-performance by the debtor

on due date.

o Response

The short answer to this is that the so-called “penalty” is non imposed by the
bank as the creditor. It is a “penalty” (if one could term it such) which is
imposed by the debtor upon himself, for the purposes of serving as a
deterrent for his own possible non-performance or breach of contract. This is
why it is described as a vow (Yameen). The amount of the so called “penalty”,
is not fixed to the amount of the profit lost, in proportion to the period of the
delay, but may be determined in any other manner, because it does not
constitute compensation to the bank.48

Important Note

It must be noted that while the objections and responses have been presented,
acceptance has been based on the permissibility from the Maliki school only and
not the majority of the scholars.

In addition, it is necessary that the debtor himself states that he is willing to pay
such a penalty in default. It cannot be imposed upon him.

 Providing a discount on early settlement

o Once the Murabaha agreement is in place, a fixed instalment is required as payment

for the
duration of the agreement.

48
Objections and response details taken from : “Contemporary Issues in Islamic Banking & Finance” by
MS Omar.(2005)

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Eg. Muhammad finances a motor vehicle using Murabaha. The agreement is that he will
pay for the asset over a four year period at a fixed instalment of R2,000 per month for a
total value of R96,000. However, at the end of year two, he acquires some inheritance
and wants to settle the debt he owes to the finance house for the motor vehicle. He has
already paid R48,000(24 months x R2,000). He technically still owes another R48,000.
At the discretion of the finance house, he is allowed a discount and only settles with a
payment of R42,000. But the mark-up was pre-agreed and the instalment fixed at the
beginning. Is this discount allowed ?

o The basis for the permissibility of a discount or rebate is because discount is a

form of
settlement between the creditor and the debtor. The proof is found in the case
of Ubay
Ibn Ka’ab (RA) and his debtor, whereby the Prophet (PBUH) suggested to him
:
“Write off a portion of your debt.” 49

o The International Islamic Fiqh Academy has issued a resolution in support of this
rule.50

49
Sahih al Bukhari, Vol 1/179, Vol 2/965
50
Islamic Fiqh Academy Resolution 64 (7/2)

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Module 7 : Ijara, Ijara-Wa Iktina, Ijara Muntahia Bittamleek

Learning Objectives

• Demonstrate knowledge on the concept of Ijara as per the Shariah Standards

• Explain the basic rules for the application of Ijara as a mode of financing
• Differentiate between Ijara and Murabahah
• Familiarity with the concept of residual & Ijara
• Demonstrate knowledge on the penalty for late payment in an Ijara
• Explain how an Ijara can be terminated

The detailed material for this module can be found in :

1. Recommended Text : “An Introduction to Islamic Finance” by Mufti Taqi

Usmani, under the chapter called : “Ijarah” – Page 157 to 180

Key Points of the Module

 Literal Definition

“Ijara” lexically means ‘to give something on rent’. This can be either the hiring of
employees for their services or the hiring of an asset. Islamic finance and banking uses the
latter method of Ijara or the leasing of an asset with the transfer of ownership at the end of
the lease agreement. This is known as Ijara Muntahia Bittamleek. For the purposes of
understanding Islamic banking concepts, this type of Ijara will be discussed.

 Shariah Definition

Ijara Muntahia Bittamleek is the transfer of the usufruct of a particular property or asset
to another party in exchange for a pre-agreed consideration or rental for an agreed period.
The ownership of the property or asset remains with the lessor but the usufruct of the

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asset is transferred to the lessee. At the end of the pre-agreed period, the ownership is
transferred to the lessee through a separate undertaking that should not be mentioned in
the lease agreement.

 Concept of Ijara Muntahia Bittamleek

The concept of Ijara and its permissibility is derived from the Qur’an & Sunnah.

o Qur’anic Proof :

“Allah Almighty says in the Qur’an : “said one of them :’Oh My Father, engage him
on wages.” 51

And Allah says : ‘if you had wished, surely you could have exacted some recompense
for it.’52

o Hadith Proof:

Prophet Muhammad (PBUH) said that whoever hired a worker must inform him of
his wages.53 The Messenger of Allah also said that give a worker his wages before
his sweat(body odour) is dried.54

o Ijmaa’ or Consensus

The validity of Ijara wherein the transfer of ownership takes place at the end of the
lease agreement has been approved in its legitimate form by all schools of thought.

• Parties involved in the Ijara :

51
Qur’an (Surah 28, Verse 26)
52
Qur’an [Surah 18, Verse 77]
53
This hadith is reported by Ibn Majah, Sunan Ibn Majah 2/817
54
This hadith is reported by Ibn Majah, Sunan Ibn Majah 2/817, and Al Tabrani in Al Awsat. (See al-
Haithamy Majam’ al Zawa’id 4/98) as cited in Al Fiqh Al Islami wa Adillatuh, Vol 5 (1997)

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Mu’jir / Lessor : Owner of the asset or property

Musta’jir / Lessee : The party who makes use of the asset or property at a pre-agreed
rental

Figure 6 : Ijara Muntahia Bittamleek if the asset is taken over by the lessee at the end
of the lease term through a unilateral “promissory agreement”(undertaking through
a separate document) signed by the Lessor.

 Basic Rules of Leasing

o Transferral of usufruct, not ownership of usufruct

In leasing an owner transfers its usufruct to another person for an agreed period, at
an agreed consideration.

o Subject of Lease

The subject should be valuable, identified and quantified.

o Consumables cannot be leased out

Anything which cannot be used without consuming it cannot be leased, eg. food,
ammunition, money, etc. since the corpus of the leased asset remains in the
ownership of the lessor or seller.

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o All liabilities of ownership are borne by the Lessor

The corpus of the leased asset remains in the ownership of the lessor. Therefore, the
lessor is responsible for liabilities emerging from his ownership whereas expenses
related to the use of the asset will be borne by the lessee.

o Period of Lease

The duration of the lease must be determined in clear terms.

o Lease for specific purpose only

The lessee cannot use the leased asset for any purpose other than the purpose
specified in the lease agreement. If there is no such specified purpose, the use of the
asset must be whatever the use of it is in the normal course.

o Lessee is the Ameen

The lessee has been entrusted with the responsibility of protecting the asset to
whatever is deemed reasonable.

o Lease of jointly owned property

It is permissible for rentals to be distributed between the joint partners/owners of an

asset in proportion to their ownership.

o Determination of rental

o Rental amounts can only be increased via mutual agreement and any
unilaterally decided increase is not permissible.

o The lease period commences on the date of delivery of the leased asset to the
lessee. The rental shall be charged when the leased asset is handed over to the

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lessee.55

o The rental must be determined at the time of the contract for the whole period
of the lease.

o It is permissible that different amounts of rent are agreed for different phases in
the period of the agreement.

o Urbun : Earnest Money

An advance payment in the form of an Urbun may be taken at the execution of the
lease contract. According to the Hanbali school of thought, if the lease contract is
not executed for a reason attributable to the lessee, the lessor may retain the
Urbun.56

• Definition of Urbun

According to Ibn Qudamah, the Hanbali jurist :

“Urbun in the context of sale means : the purchaser acquires a commodity and
pays an amount to the seller on the basis that if he (the purchaser) takes the
commodity, the amount paid by him will be offset against the price. If he
does
not take the commodity, the amount will accrue to the seller.”57

 Basic Differences between Ijara and Murabaha :

55
AAOIFI Shariah Standard No 9, Par 4/4/1
56
Ibid Par 4/1/4
57
Al Mughni, Vol 4, pp 289

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Murabaha Ijara

1. Sale wherein the cost and the 1. Lease wherein an agreement is

mark-up reached as
and known by both the buyer to the rental for the period
and seller

2. Ownership is with the client 2. Ownership is with the

throughout the financing institute/lessor
period throughout the lease period

 Residual payment in an Ijara

o At the expiry of a conventional or financial lease agreement, the asset ownership is

normally
transferred to the lessee at no cost or at a nominal cost.

o In order to ensure that the leased asset transfers to the lessee at the end of the contract,
a
clause is included in the agreement to this effect. Sometimes, the condition is implied
and not
expressed in writing.

This condition, whether expressed or implied is not permissible in Shariah as it is an

agreed rule that one transaction cannot be tied up with another transaction so as to
make the former a pre-condition for the other.

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o The contemporary scholars have proposed and the Islamic Banks have implemented
the
following to overcome this problem :

o No such implication, clause or condition is to be in the contract or the agreement.

o A separate unilateral promise that is binding only on the lessor can be concluded
wherein the lessor can promise to gift the asset to the lessee at the end of the
lease
period.

This type of lease wherein the ownership has been transferred at the end of the
lease via a unilateral promise binding on one party only is known as Ijara wa
Iktina or Ijara Muntahia Bittamleek.58 (Refer to the section on promises &
contracts in Module 3 for further understanding of promises and conditions in a
contract)

 Termination of the agreement of Ijara

• If the lessee contravenes any of the clauses in the agreement, the lessor has a
right to
terminate the agreement unilaterally.

• If there is no contravention, the lease can only be terminated with mutual

consent of both parties

• It is not permissible for the lessor to obtain rental for the entire duration of the
lease once the contract has been terminated prematurely. This is a common
practice in financial leases.

58
AAOIFI Shariah Standard No 9 Par 8/1 (2005)

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 Insurance or Asset Protection

The cost of asset protection must be borne by the lessor and not the lessee. It is
encumbent upon the lessor to use the Islamic mode of insurance, viz.Takafol as cover
for the asset or property, if it is available.

Module Questions :

1. ‘A murabaha contract has two contracts in one.’ Is this True or False ?

2. Is it permissible for the Islamic bank to sell an asset that they have not physically
received
possession of, in the case of Murabaha ?
3. Is the ‘promise to buy’ agreement enforceable by shariah with reference to the
Murabaha contract ?
4. In an unrestricted Mudaraba, can the Mudarib invest in conventional banks in
order to ensure that the capital of the Rabb ul Maal is guaranteed ?
5. Can the Mudarib guarantee a return to the provider of the capital ?
6. In a Mudaraba practised at an Islamic bank, can the bank co-invest with the
depositors ?
7. Does the Diminishing Musharaka contain a contract of agency ?
8. Is the sales contract necessary in a Diminishing Musharaka ?
9. Is the Mudarib / Islamic bank responsible for any losses incurred while investing
the funds legitimately, on behalf of the depositor ?
10. Can the bank appoint the client as agent to purchase the goods in a Murabaha
contract ?
11. Is the Murabaha a contract of finance ?
12. Who is responsible for the general maintenance of the asset in an Ijara contract ?
13. Does the lessor have standard ownership rights in an Ijara ?
14. When does the leased asset belong to the client in an Ijara ?
15. Can the lease agreement be adjusted for rental escalation during the Ijara contract
?
16. How does the partnership profit in a Diminishing Musharaka ?

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17. When does the lease period start in an Ijara contract ?

18. What happens in the case of total loss in an Ijara contract ?
19. Is the lessor obliged to sell the asset to the lessee at the end of the Ijara wa Iktina
contract ?
20. When does ownership transfer to the client in a Murabaha transaction ?

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Module 8 : Salam & Parallel Salam

Learning Objectives

• Demonstrate knowledge on the concept of Salam as per the Shariah Standards

• Explain the structure of the Salam contract
• Identify the conditions to be satisifed for the validity of a Salam contract
• Understand the concept of Parallel Salam and its structure

The detailed material for this module can be found in :

1. Recommended Text : “An Introduction to Islamic Finance” by Mufti Taqi

Usmani, under the chapter called : “Salam & Istisna” – Page 185 to 195

Key Points of the Module

 Literal Definition

Salam or salaf literally means to advance or forward. In the case of Islamic

economics,
Bai’ Salam is a contract of sale which involves a spot payment made in advance for a
deferred supply of goods.

 Shariah Definition

“A Salam transaction is the purchase of a commodity for deferred delivery in exchange for
immediate payment. It is a type of sale in which the price, known as the Salam capital, is
paid at the time of contracting while the delivery of the item to be sold, known as al-
Muslam fihi (the subject-matter of a Salam contract), is deferred. The seller and the buyer

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are known as al-Muslam ilaihi and al-Muslam or Rabb al Salam respectively. Salam is
also known as salaf.”59

 Legitimacy of Salam

o Qur’anic Proof :

Almighty Allah says :”Oh you who believe! When you deal with each other, in
transactions involving future obligations in a fixed period time, reduce them to writing.”
60

o Hadith Proof:

Ibn Abbas (RA) is reported to have said that the Prophet (PBUH)came to Madinah and
found that people were selling dates for a deferred delivery after a duration of one, two or
three years on a Salam basis. The Prophet (PBUH) said: ”Whoever pays for dates on a
deferred delivery basis (salam) should do so on the basis of a specified scale and weight.”

In another version of the hadith : ”Whoever pays on a deferred delivery basis should do
so on the basis of a specified scale, weight and date of delivery.” 61

The salam transaction was beneficial to both the buyer and the seller. The purchaser
benefitted as salam prices were generally lower than spot prices, while the seller
benefitted from an advance payment.

 The Salam Contract

Salam can be understood as ‘future delivery financing’. Although we learnt earlier that
the goods must be in the possession of the seller in order for a sale to be legitimate, there

59
AAOIFI Shariah Standard No 10 (2004), Appendix C, pg 174
60
Qur’an (Surah 2, Verse 282)
61
The hadith is reported by al-Bukhari, Muslim and others, See Sahih al-Bukhari (Damascus: Dar
alQalam) 2/781; Sahih Musllm (Beirut: Dar al-Fikr), 3/1226

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are two exceptions : the Salam transaction (discussed here) and the Istisna contract
(discussed later).
The salam transaction, with the fulfilment of conditions, allows the delivery of goods at a
future date.

In a murabaha transaction, goods are delivered immediately while the payment is

deferred over a specified period. In a salam transaction, payment is made immediately
while the specified goods are delivered within a pre-determined period.

For example, a farmer is currently harvesting oranges. The farmer can request financing
for the project and a bank may agree to finance the salam and receive payment once the
farmer has received payment. In this way, the farmer has sufficient financing for working
capital. The bank then purchases the oranges, of a known quantity, grade,etc. with
immediate payment for delivery on a specificied future date. The bank therefore becomes
the owner of the goods. Agricultural produce usually has a time lag for harvesting. In
order to assist the farmer with meeting his monthly expenses, financing can be arranged
via the salam contract.

 Conditions for the Validity of a Salam Contract

The cornerstone of the forward sale or salam contract is the offer and acceptance.

1. Conditions of the Forward Sale

Scholars insist that six conditions be satisified in order for the salam contract to be valid.
That the object of sale is of known :

Genus; (eg wheat, barley, rice,etc)

Characteristics (eg Grade A or Grade B quality)

Amount; (by means of volume, weight, number or size)

that the Term of Deferment be known;

that the Price be Known and

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that the Place of Delivery be specified if the object’s transportation is costly.62

This means that the exact date and place of delivery must be specified in the
wording of the contract.

2. Conditions for the Price of the Forward Sale

The price must be specified in monetary terms.

Payment must be made in full at the time of sale.(If payment is deferred for more
than three days, it is like the sale of a debt for a debt (Bay al Inah) which is not
permissible.

 Parallel Salam

Definition from the AAOIFI Shariah Standards :

“If the seller enters into another separate Salam contract with a third party to acquire
goods, the specification of which corresponds to that of the commodity specified in
the first salam contract, so that he (the seller) can fulfil his obligation under that
contract, then this second contract is called, in contemporary custom, parallel
Salam.”63

Continuing from the example used to explain Salam regarding the Orange Farmer, on
the other hand we have a buyer that is not a bank.
Muhammad is a green-grocer and wants to purchase 5 tons of oranges packed in 10
kg pockets of
1st grade quality. He wants the oranges to be delivered on the 2nd of next month at his
grocery store in central Durban. The bank has already entered into one salam contract
with the farmer as the purchaser or Muslam. In a SEPARATE CONTRACT, the
bank acts as a seller or Muslam Ilaihi and sells the oranges to Muhammad in a
Parallel Salam Contract.

62
Al Fiqh Al Islami wa Adillatuh, Vol 1, (6.3, pg 240) (2003)
63
AAOIFI Shariah Standard No 10 (2004), Appendix C, pg 174

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In practice, the bank will usually utilise the services of a trader who will act as an
agent on behalf of the bank to execute the sales and purchases. In order for the bank
to secure itself for the initial advance payment, it will require the trader/agent to
secure a sale transaction or a parallel salam so that the bank may exit the transaction
upon delivery of the commodity. It must be noted that the agent cannot be the buyer
and seller at the same time. He must be independent.

Through the parallel salam, a financing tool is recognised.

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Module 9 : Istisna & Parallel Istisna

Learning Objectives

• Understand the concept of Istisna according to the Shariah Standards

• Determine the nature of an Istisna contract
• Identify the conditions necessary for the validity if an Istisna contract
• Identify the differences between Istisna and Salam
• Familiarity with establishing a Parallel Istisna contract

The detailed material for this module can be found in :

1. Compulsory Text : “An Introduction to Islamic Finance” by Mufti Taqi

Usmani, under the chapter called : “Salam & Istisna” – Page 185 to 195

Key Points of the Module

 Shariah Definition

”Istisna is a contract of sale of specified items to be manufactured or constructed, with an

obligation on the part of the manufacturer or builder (contractor) to deliver them to the
customer upon completion.”64

 Legitimacy of Istisna

o Hadith Proof:

It is reported that Allah’s Messenger (PBUH) requested the manufacture of a ring65 and
the manufacture of a platform for preaching.66

64
AAOIFI Shariah Standard No 11 (2004), Appendix C, pg 195
65
Sahih al-Bukhari 5/220, Sahih Muslim 3/1655
66
Sahih al-Bukhari 2/908

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 Concept & Nature of an Istisna Contract

Istisna is a contract of sale that can be used for project financing, property development &
construction. It is one of two instances where the item sold has not come into existence at the
time of contract – the other being Salam. In order to avoid gharar (uncertainty) in a Salam
transaction, the object of sale must be a fungible or perishable item. In order to avoid gharar
in an Istisna transaction, the object of sale must be defined by a detailed specification.
Payment for an Istisna can be made either as a lump sum advance or in progress payments.

 Differences between Istisna & Salam

Istisna Salam (Forward Sale)

1. Object of Istisna is a non-fungible 1. Object of Salam is a liability on the seller

that can be identified or determined, & must be fungible/perishable measured
eg. Furniture, property,etc. by weight, volume or length, etc. eg.
Wheat, oranges, etc.

2. The Price in Istisna can be paid in 2. The Price in Salam must be paid in
advance or in progress payments advance

3. It is not a requirement that the time 3. The Time of Delivery in Salam is

of delivery is fixed. specified

4. The Istisna contract can be revoked 4. The Salam is a binding, irrevocable

unilaterally before work begins contract

 Conditions for the validity of an Istisna Contract

According to the Hanafi jurists, there are conditions that must be satisfied for a valid contract ;

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The subject of Istisna must be known and mentioned precisely in terms of its genus, type,
quality and quantity

There should be some work or performance involved in the delivery of the commodity

The price or consideration should be specified

The following is not permitted in an Istisna contract :

It is not permitted for the manufacturer to stipulate in the contract of Istisna'a that he is
not liable for defects

It is not permitted to use the Istisna contract as a legal device for a riba-based transaction,
for example : the person commissioning the manufacture or construction of the object is
the manufacturer himself

It is also important to note that the subject matter of the Istisna contract must be raw material
that will be manufactured and not an already existing, identifiable, capital asset, eg. A car or
a factory. 67

 Parallel Istisna

In the modern banking environment, an Islamic bank is not willing to keep the object of
manufacture after completion. In a similar way as salam, the bank will enter into two
mutually independent contracts with the same product specification. The difference that the
bank offers the completed product to the third party for, is the profit that the bank is entitled
to.

For example, IFISA is a private Islamic Finance College that requires 100 desks to be
manufactured for its students but does not have the capital for it. It requests a Parallel Istisna
from IB, an Islamic Bank. IB makes an agreement with the manufacturer and adds a profit

67
AAOIFI Shariah Standard No 11 (2004, Par 3/1/3, pg 180)

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margin on the cost of manufacture. IB agrees to manufacture and deliver the desks to IFISA
within 2 months.

IB will have to enter into an Istisna contract with the desk manufacturer wherein the price is
agreed, the same specification that was required by IFISA is agreed and that the delivery will
take place as promised in 2 months. The desk manufacturer agrees to the contract.
Hence, two mutually independent Istisna contracts are established. IFISA will make
payment to IB on a deferred basis.

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