Shariah Investment Agreement

The Legal Tool for Risk-Sharing in Islamic Finance

Syed Adam Alhabshi, Abbas Mirakhor, Haji Mohd. Na'im Haji Mokhtar, Syed Othman Alhabshi

• Publisher: De Gruyter Oldenbourg
• Year: 2021
• ISBN:
  9783110559743
• Edition: 1
• Topic: Business
• Subtopic: Sistemi bancari e finanziari nei paesi islamici
• Index: Business

Risk-sharing investment is currently the buzz word in Islamic finance. However, there is an incongruence in applying multilayered and opaque Tijarah contracts for investment purposes. This has contributed to the divergence between Shariah and Common Law and caused tremendous problems and systemic legal risks to Islamic finance.

The authors of Shariah Investment Agreement introduce a legal tool in the form of a Shariah Investment Agreement carefully drafted to ensure that it is Shariah-compliant and can be applied in Common Law jurisdictions as well, so as to allow for the execution of risk-sharing investment in Islamic finance. It details the building blocks and key considerations that must be noted when drafting such agreements so the investor and investee will know what to expect when entering into such a contract.

Proper implementation of the Shariah Investment Agreement will pave a clear route to a harmonious convergence between Shariah and Common Law and lead to Islamic finance developing further to become a stronger, unstoppable force in the finance industry.

Chapter 1 Introduction

There is an incongruence or misfit in applying multilayered and opaque Tijarah contracts for investment purposes. Such disparity has contributed to the divergence between Shariah and Common Law and caused tremendous problems and systemic legal risks to Islamic finance. This book introduces the Shariah Investment Agreement, which is based on Bay’ and meant for investment purposes. It has been carefully drafted to ensure that it is Shariah-compliant and can be applied in Common Law jurisdictions as well. It is intended to pave a clear route to a harmonious convergence between Shariah and Common Law. With proper implementation of the Shariah Investment Agreement, Islamic finance will be able to develop further to become a stronger, unstoppable force in the finance industry leading towards investment using investment agreements instead of Tijarah contracts; and more importantly, towards a riba’ free financial industry – or at the very least a reduced dependency on riba’.

This book explores the development of the Shariah Investment Agreement Template as a risk-sharing contract to be used for Shariah-compliant investments, based on Bay’ as a risk-sharing investment principle. The template to be developed here is both Shariah and Common Law-compliant. It is noted that the origins of Common Law in the 12th century may have been founded on established principles of Shariah (Makdisi, 1999). There are many examples of Shariah principles that were adopted by Common Law, so much so that Makdisi (1999) concluded that Common Law could be the true offspring of Islamic law. Over time, both Shariah and Common Law continued to develop their own jurisprudence and principles particularly in relation to commerce. Common Law eventually diverged further away from Shariah as evidenced by the current cases being adjudicated before the courts involving Islamic finance.

Islamic finance, during its inception, faced tremendous challenges particularly regarding the introduction of Shariah-compliant products to the market. One of the main reasons for this was that market players wanted to develop Islamic finance products and contracts resembling those of conventional finance to make them more acceptable on a more general level. Bankers and lawyers were confident that only familiar products would sell in the market, whilst unfamiliar products may take longer to gain acceptability in the market. Hence most Islamic products were structured to mimic their conventional counterparts with appropriate adjustments to make them Shariah-compliant. One of the consequences of this practice was the widespread use of Tijarah (trade transaction) contracts and instruments originally meant for the trade industry. The resulting structures were then used for investment purposes.

For much of the economic history of Muslim countries, Tijarah and agriculture were the mainstay of economic activity. Industrial investment projects with long gestation periods were undertaken by the governments of these countries. However, in the 20th century, as the economies of these countries grew and private participation in industrial investment increased, Islamic finance practitioners, armed with the classical Fiqh on trade, had to resort to multiple Tijarah contracts to achieve their desired investment purposes. Unfortunately, multiple Tijarah contracts can not emulate investment schemes because trading contracts are not suitable for investment in industrial and manufacturing projects of significant size and long gestation periods. To finance such projects with Tijarah instruments, multilayered, opaque, cumbersome and costly contracts were structured. Above all, these contracts are also challenging to adjudicate. This has led to legal disputes, which are usually to the disadvantage of the banks and product owners acting as investors. There are Court of Appeal cases (in the United Kingdom as well as in Malaysia¹) where the courts were not able to see that the intention of the parties was a simple investment due to the use of multiple, layered and opaque Tijarah contracts.

The cost of litigation is also very expensive. According to the “Median Costs of Litigation by Case Type,” disputes related to contracts in the United States on average cost about US$91,000 (Hannaford-Agor, 2013). In Malaysia, solicitors’ fees for non-contentious matters would be charged according to the Solicitors Remuneration Order 2005. For example, the fees for a sale and transfer for consideration or adjudicated value of RM7.5 million (US$1.8 million) are fixed, but where the value is in excess of RM7.5 million, the fees can be negotiated between the parties. For contentious matters, there is no scale or limit as it depends on various factors such as the complexity of the facts of the case, the background of the lawyer, the firm, the level² at which the court it is adjudicated and other factors. This makes legal disputes very expensive.

This book proposes a draft Shariah Investment Agreement that is both Shariah-compliant and can be applied in Common Law jurisdictions. It anticipates paving a clear path towards the harmonious convergence between Shariah and Common Law.

In analysing Shariah and Common Law, this book premises itself on the basis of Shariah being a divine law and therefore extra care is required to ensure that the divine status of Shariah is preserved when compared with the man-made concept of Common Law. This care is taken even to the extent of mentioning Shariah ahead of Common Law when both are mentioned in the same breath. When explaining the understanding of Shariah within the realm of Common law, we intend to elevate Common Law to a certain level that would allow it to resonate congruently with the divine Shariah. This is why the title of The Shariah Investment Agreement: Compatibility with Common Law was chosen – to show that it is Common Law that needs to be able to resolve Shariah investment contracts and not the other way round.

In this book, Shariah only deals with the clear and acceptable principles based on Ayah³ (verses/evidence from the Qur’an) with clear rulings (Muhkamat) and Ayah, which are commonly agreed by the majority of Fiqh scholars. We avoid the usage of ambiguous rulings (Mutashabihat) unless necessary. This is to ensure that our analysis will not be challenged merely on the grounds that we had relied heavily on evidence where there are many differences of opinion among Fiqh scholars.

1.1 The Common Law Conflict

Legal systems are meant to promote economic efficiency of Exchange Contracts. Any conflicts either within the same legal system or between different legal systems will cause uncertainties in the application of the law. This topic is of interest because there is currently serious conflict in the application of Common Law in Shariah contracts of exchange. In 2004 the Court of Appeal of the United Kingdom in Beximco v Shamil Bank (2004) recognised that the principles of English Law are not always consistent with Shariah, and therefore the court can not apply both English Law and Shariah at the same time. Back in Malaysia, in one of the most current Islamic finance cases, the Court of Appeal of Malaysia in FLH ICT Services Sdn Bhd & Anor v Malaysian Debt Ventures Bhd (2016) decided that the failure to mention the asset in a Bay’ Al-Inah contract had violated the entrenched principles of Bay’ Al-Inah and is not Shariah-compliant. The Court of Appeal went on to say:

“As such it is not a Bay’ Al-Inah financing contract but something else unknown in the Shariah financing system. Hence the respondent’s remedy is also elsewhere and not under the Bay’ Al-Inah financing system. The respondent cannot take advantage of the system when the contract they entered into is unknown in the system.”

(FLH ICT Services Sdn Bhd & Anor v Malaysian Debt Ventures Bhd [2016] 1 CLJ 243 at para 35)

Therefore, the Respondent was not required to return the debt amounting to RM12.1 million (US$2.91 million). This poses a serious systemic risk to financial institutions as the failure to identify an asset in a sale contract – which is a Shariah non-compliance issue as well as an operational non-compliance issue, impedes the financial institution from recollecting its principal sum that it had initially disbursed to its customer. The matter was brought to the Federal Court and we were informed that the decision of the Court of Appeal was reversed, and the decision of the High Court was reinstated. However, there was no written judgement delivered by the Federal Court.

The cases cited earlier are appellate cases and according to the doctrine of precedent (Stare Decicis, which in Latin means “to stand by things decided”), would be adopted as a binding authority to lower courts. The fact that these were from two different jurisdictions (the former from the United Kingdom and the latter from Malaysia) exemplify that there are some serious issues in how Common Law addresses Shariah Contracts of Exchange. The possible issues in the application of an Exchange Contract, which is both Shariah and Common Law-compliant, are mainly due to:

• A lack of detailed comparative analysis
• The absence of an established framework involving the principles of exchange contracts that confirms the congruence of Shariah and Common Law

This has resulted in an enormous gap in the understanding of the similarities and differences in exchange contracts by both Shariah and Common Law practitioners.

A lack of understanding in comparative analysis and framework involving the principles of exchange contracts in both Shariah and Common Law would make it difficult for legal practitioners, regulators and law makers to comprehend the problem. The worst-case scenario is that it may lead to a regressive development of the law and in any event, all stakeholders would incur enormous transactional costs in resolving or rectifying the problem.

The divergence between Shariah and Common Law has caused tremendous problems and systemic legal risks to Islamic finance. Islamic finance practitioners are forced to use their ingenuity to innovate Shariah-compliant products, which mostly mimic conventional and mainstream products. For example, the Commodity Murabahah financing facility complies with Tijarah Fiqh in commodity trading to create liquidity and debt obligation to finance a disjunctive purpose. It is unfortunate that investment contracts do not use investment (Bay’) contracts but instead use Tijarah contracts. The incongruence of applying Tijarah contracts leads to legal disputes with exorbitant design and legal costs.

1.2 The Shariah Investment Agreement Template – A Practical Alternative

The Tijarah contract is covered in the longest Surah in the Qur’an, Surah Al-Baqarah (2:282). However, investment as a key commercial aspect in the current commercial world is not specifically mentioned. History has shown that there were no complicated investments at the time of the Prophet Muhammad (SAW) as most businesses were for trading purposes (even Musharakah and Mudarabah were used for trading). This begs a fundamental enquiry into the origin of investment in the Qur’an. One may ask, “Where is investment in the Qur’an?” There are two answers to this question. The first is that investment is not in the Qur’an. This leads to a blasphemous presumption that Allah SWT had not foreseen or realised the existence and importance of investment for mankind, thus it was omitted from the Qur’an. Naturally, that answer must be completely rejected as it dilutes the attributes of Allah SWT. The second answer is to say that investment is indeed mentioned in the Qur’an, but where?

Herein lies the main motivation of this book. We submit that investment is the refined meaning of Bay’ in Surah Al-Baqarah (2:275), An-Nur (24:37) and Al-Jum’ah (62:9–11) to name a few. We have dedicated subsections to establish that investment does indeed exist in the Qur’an in the form of Bay’. Furthermore, it does not make sense for Allah SWT to divinely state that Bay’ is the permissible (Halal) alternative to riba’ when in application, the result is similar. For example, the profit rate in a Tijarah product such as a Commodity Murabahah facility is almost similar to the interest rate in a loan transaction. When Allah SWT provides an alternative, the outcome of that alternative will produce a better outcome than the prohibited act. This will be evident if Bay’ as an investment is used as the alternative to riba’.

Once we have established that Bay’ is in fact an investment, then we will attempt to resolve the systemic legal risk by producing the Shariah Investment Agreement Template for Shariah investment purposes. The Shariah Investment Agreement Template is a straightforward and unambiguous document, which is applicable to any investment structure. Moreover, it is the much sought-after replacement to the multiple and opaque Tijarah contracts. The Shariah Investment Agreement Template will make it easy for solicitors to prepare, parties to execute, and in the event of a dispute, it would also bring clarity for judges to appreciate.

Pursuant to the findings of Makdisi (1999) that the origins of Common Law may be founded in Shariah, we begin with the basis that Common Law shares similar established principles with Shariah. With time, it appears that the principles of Common Law had diverged away from Shariah. This research uses “Exchange Contracts” as a subject matter to converge Common Law with Shariah law once more. This is done by using the Shariah Investment Agreement Template and by explaining how Common Law can be used to resolve its issues.

1.3 Developing the Template

We took a qualitative approach in exploring the position, opinions and understanding of various past and present Shariah and legal jurists (within the context of investment) to derive the proper synergy, whilst observing current trends to develop upon. In the development of the template, we used the Black Letter Method for both Shariah and Common Law references.

The Black Letter Method is a descriptive analysis of legal rules derived from primary sources of the Common Law (i.e., Statutes & Case Laws) and secondary sources (i.e....