This article was originally published in the International Company and Commercial Law Review
Islamic jurisprudence, the human understanding of the Sharia (the divine Islamic law), derives from two main sources of law, the legislation written in the Qur’an and the precedent “case law” recorded in the Hadith literatures. There are, however, further sources of Islamic jurisprudence; tertiary sources such as the works of prominent scholars.
Commercial law in Islam, fiqh al-mu’amalat, is regulated by Islamic jurisprudence with the principles of natural justice being at its foundation. The foundation of all commercial activity is through the formation of contracts; for Muslims this is no different. Contract law is pertinent to enhancing commercial activity. As the availability of Islamic Finance products become readily available across the globe it is important to understand the fundamentals of Islamic commercial contract law.
The Qur’an and the Hadith have laid down the contractual maxims which form the basis of Islamic contracts. The Qur’an mentions in over 40 verses a number of commercial contracts. The Hanafi school of Islamic jurisprudence, followed by roughly one-third of the world’s Muslims, was the first school to formulate contract rules for business transactions and payment for goods for future delivery.
Essential conditions of contractual validity
To enter into a valid contract there are certain conditions which have to be met. There are six elements which need to be fulfilled: (i) the offeror and the offeree; (ii) offer and acceptance; and (iii) the subject matter and consideration. To be legally competent to enter into a contract the parties have to have prudence of sound judgement and be at the age of puberty. Therefore, physical and intellectual maturity is of great importance to determine capacity. Contracts can be entered into orally, by writing or they can also be entered into by the conduct of the parties, through the exercise of the contract. What distinguishes Islamic contracts from its Western counterparts is that it insists on the session of contract (majlis al-‘aqd). Both the offer and the acceptance take place simultaneously in the same time and place. This is to avoid any ambiguity and disagreements taking place. As technology has advanced there is now a degree of flexibility in the session of contract, flexibility which has been introduced by the tertiary sources of Islamic jurisprudence.
An offeror is able to withdraw its offer before an offeree accepts it. In accordance with the principle of khiyar al-majlis, the right to revoke the concluded offer and acceptance.
The subject of the contract must be: (i) lawful; (ii) in existence, with the exception of both a deferred delivery sale (bay’ al-salam) and contract of manufacture/projects (istisna ’); (iii) not fabricated; (iv) deliverable; and (v) precisely determined in the contract.
The Qur’an prohibits dealing with alcohol, pork, gambling, and something which is a nuisance to public order or immoral such as pornography. The price must be pre-determined so as to not lead to uncertainty. As the only exception to the rules, the price can be paid in the future in certain contracts.
Principles of natural justice underpinning contracts
The primary objective of Islamic economics is social and economic justice, and the equitable distribution of income and wealth in the economy of humans and countries. To create equitable justice in the economy Islamic economics and banking should always, and indeed do strive to, create Islamic financial instruments with these underlying principles.
Contracts in Islam are underwritten by three salient injunctions which eliminate exploitation in transactions and prevent unjustified enrichment. These are the prohibition of Riba (interest), Gharar (uncertainty) and Maysir (speculation).
Common types of contracts in Islam
The most common type of commercial financing instruments used under Islamic financing activities are generally murabaha, musharakah and mudarabah contracts.
Murabaha is a short-term debt financing contract whereby a financial institution buys a specified product in accordance with a customer’s specification then sell the same to the customer at a price based on cost plus profit.
Musharakah and mudarabah are long term equity-finance contracts. Often described as the “real and ideal instruments of financing” in Islamic jurisprudence. They are based on profit and loss sharing between the parties. The parties involved in a transaction sharing the risk is at the heart of Islamic jurisprudence in order to not create inequality of justice and unnecessary suffering to one party over another.
In a musharakah contract the parties to it will share in the profit or loss of the business activity undertaken in accordance with their share in the capital or as otherwise specified in the contract.
In a mudarabah contract, or otherwise known as a joint venture contract, the financier (rabb-ul-mal) provides the capital and the working partner (mudarib) exclusively carries out the project and its management.
The inherent flexibility of musharakah and mudarabah structures allows for a wide range of innovative applications to meet the demands of the growing Islamic market. Concepts of musharakah and mudarabah are based on basic principles. As long as the basic principles are complied with, and Islamic law adhered to, their application can vary from different scales of project financing, securitisation, or financing a single transaction in order to fulfil the day-to-day needs of traders, or financing imports and exports.
Contracts in the UK
Over the last few years, the UK has seen a surge of Islamic Banks which are primarily public focused. For a long period of time the Islamic Financial system has been aligned to debt-financing instruments and neglected equity financing, such as mudarabah and musharakah instruments based on partnerships. The conventional banking system is more prudent towards equity-financing products and as such debt-financing instruments are not as readily available. The two primary products provided by these Islamic Banks in the UK have been Home Purchase Plans, based on a diminishing musharakah instrument, and revolving credit/overdraft facilities.
Penalty clauses and force majeure
Islamic law recognises penalty clauses for the delay in the performance of a contract and damages. In the interest of justice and equality the penalty should be proportionate to actual damage and should not be exaggerated as per se. However, in the case of a breach of a contractual condition and consequent effect of a penalty clause the recompensed party should receive the amount as stated in the contract. Although contracts may include a penalty clause if agreed by the two contracting parties, it is not allowed to have provision to cover instances of force majeure.
Basic legal injunctions in the Qur’an and Hadith provide us with the guidance on how to write contracts within the confinements of Islamic jurisprudence and the Sharia. Some principles of the validity of Islamic contracts are not too dissimilar to Western contracts. Then there are principles of ethics and natural justice which are not commonly seen in the Western economical sphere. The tertiary sources of law, and in particular past and present works of Islamic jurists provide us with the guidance and innovations to create contracts which are befitting to the global economy. Islamic financing was not just created for the purposes of micro-financing and charitable work but was also created for the complexities of macro-financing, innovation and differing commercial needs as “God has permitted trade and has forbidden interest [usury]”.