While Islamic finance (LIF) may prima facie seem considerably limited and prohibitive in comparison to the laissez-faire capitalist system, the former has come up with financial products and services that are in substance (though not in form) almost identical to those found in the latter. This has chiefly been made possible through an ostensibly formalistic adherence to the classical nominate contractual system, which lies at the very heart of modern sharia arbitrage. It can therefore be argued that prohibitions in LIF is only really operate at a theoretical level and in practice these ‘prohibitions’ do little to curtail the process of mimicking practices in conventional finance (CF).
History and Development of the Law
In a nutshell, the classical jurists adopted a nominate contractual system for the purposes of avoiding the two canonical prohibitions in LIF: riba (usury) and gharar (excessive uncertainty). One was to choose from pre-established contractual headings which the jurists considered acceptable, as simply allowing parties to come up with novel contracts amongst themselves would run the risk of contravening the riba or gharar prohibitions. While the classical nominate contractual system provided legal certainty at the cost of substantially limiting one’s freedom to contract, exceptions to this system provided much needed flexibility in the law and hence broadened the contractual liberty in practice. Unsurprisingly, the nominate system did not work as intended in practice. Saleh remarks ‘from the outset numerous exceptions and qualifications were dictated by business exigencies and found accommodation with an evolving legal system.’ The rigidity inherent in the system inevitably forced the jurists to develop mechanisms through which innominate yet commercially necessary contract types could be given legal recognition, mainly those of salam (forward sale) and istisna (contract of manufacture). Salam is essentially a forward purchase whereby goods are purchased and paid for immediately (during the contractual session) but the delivery of the property is at a specified future date. As the object of sale does not exist at the time of contracting and hence not in the possession of the seller (both of which go against two quintessential requirements for a valid contract in LIF), there is significant gharar as the product may never come to be. However, jurists characterised this gharar to be minor in relation to the potential benefits arising from financing agricultural and other activities through salam. Thus salam was exceptionally allowed on the grounds of benefit analysis (maslahah), a tradition attributed to the Prophet (p.b.u.h.), consensus (ijma) and public need (darurah).
Istisna would, for example, entail an order of a personalised made-to-order pair of shoes to a shoemaker for a pre-agreed price to be paid upon delivery. From a sharia legal perspective not only is there a non-existent subject matter like salam but additionally the payment is also deferred thereby further contravening the quintessential contractual requirement of immediate exchange of counter values in LIF. Yet curiously enough, istisna was accepted as valid in fiqh on the grounds of a custom (urf) which has prevailed from the time of the Prophet (p.b.u.h.) himself and justified by equity (istihsan) and commercial necessity. A third exception worthy of mention is the assignment of debt (hawlat al-dayn) which is ‘the operation of substituting for the person of a debt the person of another’ which was incorporated in Art. 673 of the Ottoman Majalla. Thus it becomes evident that the apparent strictness of the nominate system was nuanced by juristic inference (analyses) which validated forms of contracts that go against the letter of the law but were commercially necessary and hence held to be substantively permissible.
Modern Sharia Arbitrage
It is a fact that Islamic banks today invest almost exclusively in interest-bearing debt instruments where the only material risks it is exposed to are the same as conventional banks. El-Gamal has sternly warned us of the abuse of the nominate system in modern LIF: classical contract forms ‘can be used as apparently legitimate means toward illegitimate ends’. This phenomenon is coined by El-Gamal as ‘shari’a arbitrage’ whereby a certain transaction is forbidden but then permitted in slightly modified form with unaltered substance. What is meant here is that modern LIF contracts which dominate the industry such as murabaha, tawarruq, sukuk etc are mere replicas of their ‘impermissible’ conventional counterparts rather than actually being ‘Islamic’ alternatives. While the contracts involved differ in form, they are almost identical in economic substance.
For instance, the price mark-up in murabaha financing tends to mimic conventional interest rates but the return on capital is rhetorically labelled as ‘profit’ or ‘price mark-up’ in a sale transactions rather interest on a loan. This is a clear violation of the riba prohibition in substance yet permissible in form. Sukuk is the most common vehicle for Islamic bond alternatives based on securitisation of the usufruct of an eligible property (such as land or machinery). A special purpose vehicle (SPV) is created to buy and lease back the property for the purposes of fulfilling the requirements of bay and ijarah. The practical reason for doing so is to minimise the Islamic financial institution’s exposure to risk and benefit from the SPV’s unique legal structure for the purposes of bankruptcy remoteness (much like CF). Although AOFI requires sukuk issuances to be asset-backed rather than asset based transactions, due to the repurchase agreement inherent in most sukuk-al-ijarah issuances (the most common type of sukuk) the true sale criteria is never met. Today, this practice remains largely unchanged despite a 2008 fatwa by Taqi Usmani decrying the current practice of sukuk. Currently there exist blended forms of sukuk whereby debt instruments (such as murabaha) can be in the asset mix so long as the majority (51%) constitutes tangible assets (‘ayn). They justify this novel creation on the juristic maxim ‘the majority determines the genus and characterisation of the total’. Perhaps even more remarkably, Malaysia has taken the bold step of recognising debt (dayn) as property outright, overruling the classical prohibition on bay’al-dayn (sale of debt) based on maslahah. Whether all of this is an outright derogation from the shari’a or a much-needed reinterpretation, one thing is clear: parties in LIF have the ‘freedom’ to contract in ways almost inconceivable in the past. This has been made possible through the selective and systematic usage of the classical nominate system of contracts by different market players to replicate products and services found in conventional finance (CF). At this stage it becomes quite clear that LIF has gone from being a jurists law in the past to a pluralist legal system wherein the voice of jurists are but a source of the law and no longer the source of law.
The abuse of nominate contracts in modern LIF only achieves an inefficient and costly system riddled with overly complex structures meant to create an ‘Islamic’ facade to sham the lay Muslim investor/consumer. Such an ostensibly formal adherence to the law vis-à-vis the nominate contractual system has curious effects on the freedom of contract. On the one hand, modern LIF allows parties the freedom to contract in transactions that are in substance un-Islamic but formally acceptable (eg murabaha, tawarruq, sukuk). Conversely, it limits the parties freedom of contract in transactions that are substantively Islamic but formally unacceptable (eg commercial insurance). This problem has been poignantly highlighted by Al-Misri:
‘I prefer permissibility of insurance, without hiyal (legal stratagems, or ruses); for there are jurists who forbid one thing, and then return to permit by various legal stratagems and means of circumvention, without worry or shame.’
In light of all of this, the need to jettison this form-oriented approach to sharia (via the nominate system) in favour of an approach more in line with the economic substance of the classical doctrines may be the best way forward for the LIF industry.