On The Permissibility of Contracts

The general rule for all contracts, and especially in sales, is validity. Unless something is found deficient then the contract remains valid, such as:

1- one of the contracting parties lacking legal capacity

2- one of the objects of contract containing Riba or Gharar

3- or the fact that the object of sale is expressing forbidden, such as alcohol or pork-derivatives,

4- or the fact that is has no real or nominal value, for example a grain of sand

5- or the time of contract is sacred and as such it is not permissible to contract during, such as after the call to prayer on Friday

If the previous are avoided, any contract is permissible regardless of its structure.

If this view was actually implemented in Islamic finance today, we would probably see a lot more innovation and creativity in financing solutions. However, the system currently in vogue is one that depends solely on medieval contract forms, and any new introduction must be related back to that small pool of medieval approved contracts.

While  reasoning behind this is that Umar, the second caliph of Islam, said “No one will contract business in our market unless he has learned the rulings surrounding sales.”Yet this, at face value, seems to run in the face of the hadith “The greatest of Muslims in sin is the one that asked about something that was permitted and is then forbidden because of his questioning.”

To reconcile the two, it can simply be said that the legislative weight of Umar’s statement is less than that of a statement of the Prophet. To understand this further, the circumstances behind Umar’s statement should be analyzed to see if it applied generally to all transactions or specifically to a certain type.

As a general principle, the statements of the Sahabah are not to be taken according to their general connotations, unlike the Hadith of the Prophet.

Additionaly, it is possible that Umar’s statement was an act of trade regulation, based on the general principle of “preventing harm”, thus a policy and not an expression of substantive law.

Thirdly, the base ruling of all transactions is that they are permissible; this fact is agreed upon by all scholars except for Ibn Hazm of the Dhahiri School. Ibn Hazm held that all contracts must be approved of by God and his Messenger in order for us to use them. Even though the majority of scholars differed with Ibn Hazm in principle, by insisting on medieval contract forms they seemingly agree with him in practice.

This can be seen as mainly the product of the normalization period of Islamic law, which occurred between the 6th to 8th centuries. While this process has benefits in providing a redundant system for litigation and judicial procedure, it had a negative effect on legal research and to some extent social norms and acceptable practice, as everything was relegated back to a era affected by different socio-economic constraints. This system caused even more problems in the pre-colonial period, not allowing the legal systems of Muslim lands to adapt to the challenges that it faced from the rising economic power of Europe.

In conclusion, when looking for the “islamicity” of any contract, we do not need to look far, and many stipulations that were mentioned in the books of Islamic Law were mentioned to help in decision making during dispute resolution, not for product validation and creation.

Price-Based Deferred Sales

Salam (السَلـَـم) is a form of contract that was found in pre-Islamic Arabia. At the time the Prophet arrived in Medina, he found people dealing in this form of trade.

In the Hadith of Ibn Abbas he reports:

The Messenger came to Medina and he found the people making deferred sales in fruit for one to two years, and sometimes. At this he said “Whoever makes a deferred sale, then let him do so according to a known volume or weight, and [for delivery at ] a known time.”

Generally, this form of contract was performed in the following way:

  1. Party A requests from Party B a certain product, specifying it in a descriptive manner in such a way that the price would differ (if in fact at delivery the product does not fit the description)
  2. Party B accepts to deliver the product for X amount of money on a specified date
  3. Party A pays Party B for the product, and waits for delivery on the agreed date
  4. On the agreed date, Party B delivers the product to Party A

This description of course barring circumstances such as inability to deliver, market failures, etc. and the product is deferred while the price is given up front. If delivery is not possible then the money is refunded.

An Example:

  1. Bill goes to the farm, and requests from Jake 100 kilos of grade A California raisins, to be delivered in six months time.
  2. Jake accepts for the price of 10 dollars a kilo, total being $1000 USD
  3. In six months, Jake delivers 100 kilos of Grade A raisins to Bill.

Price-Based Deferred Sales

Similar to this method, there is another method that may be effective for Microfinance which is known as “price-based deferred sales”, where the same structure is used but instead of the product being the object of contract the price is the object.

This is performed in the following manner:

  1. Bill goes to the farm, and requests from Jake 1000 Dollars worth of grade A California raisins, to be delivered in six months time.
  2. Jake accepts and receives $1000 USD from Bill.
  3. In six months, Jake delivers $1000 USD of Grade A California raisins to Bill

Differences between the two:

Price-based deferred sales are contracted by Party A (Bill) in hopes that prices go down per kilos, and the quantity received is more. Party B (Jake) hopes that prices go up, or stay the same.

Benefit here is reciprocal in that Party A benefits from the time value of the money increasing or remaining the same, thus reducing loss. Party B benefits from locking in a maximum that will be paid for the product, i.e. a fuzzy number estimated between (0-1) amounts of raisins.

Despite this presentation of various finance vehicles, it is important to remember that the general rule for all transactions is that they are permissible until a source for their invalidity is found (riba, gharar, sale of prohibited substance, invalid condition). If these are not found, or cannot be conclusively proven, then the transaction is valid.

Caveat Emptor and “As-is” sales

In terms of Islamic Law, defects in an object of sale are of two types:

1- Those that occur naturally, such as a home with a faulty foundation or a car with a cracked head.

2- Those that are initiated by a legislative prohibition; selling ground meat as chicken, when in fact it’s pork, or tying the udder of an animal so as to appear to give more milk.

Both types are considered when adjudicating a dispute. So someone who was sold a set of CD’s in which one was cracked or scratched may have the right to a replacement, but may not have the right to recover for damages, as the market price of the CD set is not adversely affected by one faulty CD and no ill intent can be determined in the sale of pre-packaged media.

The right of the buyer to recover for defects is considered when those defects were present before the period of sale. These are, by consensus, valid causes for litigation and recovery. Scholars differed as to those that appear during the period of sale and before the sale is finalized; Malik saw that the buyer has three days to claim defect after which the claim must be dropped. In cases where the defect does not appear except seasonally or over a long period of time he allotted one year. An example of this would be an animal with mange. If the disease was treated before the sales period and is known to reappear without re-treatment, selling the animal in this case would be cause for anullment of the contract or recovery of damages. The three day period was substantiated by a hadith (judged weak by the opposing opinion) and the period of one year substantiated by precedent found in the custom of the people of Medina. This application may be viewed as similar to the principle of Caveat Emptor in English Common Law although not synonymous.

The Majority (Abu Hanifah, al-Shafi, and Ahmad) saw no difference between the period of sale and that before it, allowing for a claim to res indefinitely. They cite the principle “Presumption of Continuity” (Arabic: istiS-Ha_b al-Ha_l استصحاب الحال). That is if a defect is found, we presume, in order to protect the rights of the contracting party that the defect was present before contractm until proven otherwise.

For “As is” sales scholars held three opinions. The first, held by the Hanafi and Hanbali schools, is that “As is” conditions are permissible, and liability can be disclaimed from every type of defect. The second opinion, held by scholars of the Maliki, Shafi, and Hanbali schools, is that liability can be disclaimed only from those defects that are unknown to the seller at that time. The third opinion, being an alternate opinion held by those mentioned in the second, is that liability can be disclaimed except in the case that they were known before hand. This third opinion is in reality a subset of the second, and as such consideration for only two opinions should be given.

Proponents of the first opinion cite a hadith collected by Ahmad that two men came to the Prophet having disagreed over inheritance that had since expired or dilapidated. After having been warned of the dangers of false litigation and the appropriation of another’s property wrongfully earning that person divine punishment in the next life, they agreed to forgive each other. At this the Prophet told them “Go then, divide your wealth, and be just to each other, then let each of you forgive the other.” The implied meaning of this hadith is that each of them after dividing the wealth in question would then forgive his partner for any defects found in his share, mutually disclaiming all liability.

Those that held the second opinion however countered that this hadith is applicable only to cases of inheritance, which in itself is not a commutative form of transaction. Proponents of the second opinion used case-precedent from the time of the Caliph Uthman, in which two men disagreed about a slave who had some defect that had been sold, the seller disclaiming all liability. When it became clear that the seller would not go under oath that he knew of this defect, the Caliph Uthman, acting as Judge in this case, ruled that the price paid must be refunded to the buyer by the seller and the slave returned.

Insurance Regulation

Classically, scholars categorized contracts as being from one of three types.

  1. Commutative exchange (Mu’awaDat معاوضات) – Involving the voluntary exchange of good, services, and/or both for the purpose of trade. Includes: cash sales, bartering, and currency exchange.
  2. Charitable exchange (Tabaru’at تبرعات) – Involving the voluntary not-for-profit exchange of good, services, and/or both out of the goodwill of the giver. Includes: monetary loans, material loans, gifts, and will & testament etc.
  3. Contracts of record/certification (Tawthiqat توثيقات) – The recording of a right or claim of one party against another. Includes: Liens, pawn certificates, debt records, Kafala, etc

When the question of insurance presented itself to the Muslim world, scholars generally took the position that commercial insurance was prohibited. They based this on the perceived obscurity (Gharar) and gambling (muqamarah) involved in the transaction. A small minority differed with this verdict, permitting all forms of insurance; this opinion however was built more on the permissibility of invalid contracts in certain circumstances rather than a full-fledged theory of insurance. Almost alone in his permitting commercial insurance was Mustafa al-Zarka, a premier Hanafi jurist of the last decade.

On the other hand, most allowed mutual insurance. Mutual companies are owned by the policyholders, while stockholders (who may or may not own policies) own stock insurance companies. A mutual company is, in the simplest terms, where all parties are members of an insurance ‘guild’ contributing to the ‘pot’. These contributions are charitable in nature and are seen as the the collective right of the guild, in which everyone agrees that if one member is faced with adversity or some loss that the money collected will be used to offset that loss.

Now for the problem

When scholars speak on the permissibility of insurance, they usually do so from the viewpoint of the insured. Hardly ever do you hear of criticism of the insurance industry as a whole, and the pricing schemes involved. We are told that commercial insurance is Haram, and that we should all go out and get mutual insurance.

This one-sided solution to the problem of insurance, if not obligated by the authorities, leaves many people high and dry with regards to protecting their personal and business interests.

As a quick side note, in classical Islamic legal discussions, compensation for losses accrued by an individual or a group of investors through natural disasters and unforeseen events beyond their control were usually compensated for by the institution known as “Bayt al Mal” or the state treasury, if not they were taken up by the persons tribal allegiances. The state had the responsibility to ensure the livelihood of its citizens, in that it is the authority which collects zakat, taxes, spoils of war, and is entrusted with the natural resources of the state and the revenue received from them.

Back to the issue of contracts, when we look at insurance practices, and if in fact insurance of any type was a commutative exchange, then if canceled or renewed there should be the option to receive back that money that was ‘contributed’ to the deal. As far as I know, you can not do this with most insurance packages. In this case, you are essentially giving away a portion of you wealth in hopes to receive compensation in the face of future losses without expecting the principle contribution back; exactly what is claimed in the case of Mutual insurance.

If this is the case, there would seem to be no difference between commercial and mutual insurance; in both you will end up receiving the same compensation and in both you will pay a similar amount. What does seem to be of consequence is the use of that money by the insurance company, their ability to cancel the policies of their clients, and their secondary investment of that money for their own profit.

The permissibility of insurance (or lack thereof) would seem to lie in regulation of the industry itself, not in the character of the end-user agreement.

Here’s an example that should bring it a little closer to home:

In silent partnerships (Mudaraba), partners are to share equally in the profit and loss of the partnership. If say, the silent partner specifies for himself some form of profit to the exclusion of the other (who here is performing the ‘work’ involved), then scholars held two opinions as to how the profits should be distributed in the face of this invalid condition (calling this MuDarabah Fasidah مضاربة فاسدة). Some said that this partner should be given salary commensurate to his work. Others said that he should receive the profit commensurate to that which a partner similar to him would receive. The point here is that the working party receives compensation for that which he entered the contract for initially, whether it be profit or salary.

If we were to characterize insurance contracts as a form of silent partnership, or at least hold them in the same light, then the contract is invalidated from one side only, not both. The main issue we should be concerned with then is regulation, and not one pertaining to the permissibility of the end-user entering into such as agreement.

In this case,  it shouldn’t matter to the end-user as to what type of insurance he buys, to what extent he insures his property, and to what extent he receives compensation for his losses. In the end of the day it is all the same, he will receive compensation commensurate to his losses; but will the Insurer receive compensation commesurate  to his effort? I suspect that in both commercial and Takaful structures some form of price gouging happens.

Just as the state should guarantee fair business practice and fair compensation, it should regulate the insurance industry accordingly.

Current Accounts… Current thoughts… on Islamic Banks

Current accounts in most Islamic banks have been conceptualized as loans, ergo it is impermissible – in the view of most modern jurists- to pay or charge an interest rate on the account. While most conventional banks do not provide any sort of interest payment unless a initial minimum deposit is made, most still provide free services for account holders, such as free checkbooks, with many offering discounted or free no-frills services to students and the elderly.

One of the main criticisms of Islamic banking has been the fact that instead of it meeting the needs of the lowest common denominator, it has largely served to enrich corporate interests and line the pockets of multi-national banks with “Islamic” windows.

Far be it from me to say seeking wealth is impermissible, but further inquiry into this issue is past due. It becomes particularly scandalizing to see an industry prided with claims of ethical behavior and divine preeminence used as an instrument of enrichment while neglecting the larger ethical principles involved in justifying the industry as a whole.

Discussing these larger ethical guidelines that Islamic law strives to ensure, Ibn ashour says:

As I mentioned in the previous chapter, the most important objective here is preservation and economization of this nation’s wealth. This nation’s wealth, whence viewed as a whole, is preserved through regulating the manners by which it is managed generally, in addition to the manners in which individual wealth is preserved and managed. Preservation of the whole depends on preservation of its components; the majority of Islamic legal principles dealing with wealth relate directly to the preservation of individual wealth, which in turn preserves the wealth of the nation; there being a direct correlation between the benefit of personal wealth and the benefit of public wealth in relation to the prosperity of the nation.

Key here to this discussion is his mention the “Preservation of the whole depends on preservation of its components“. While this may be true, it is evermore problematic to preserve components that serve the exact opposite of the whole they claim to maintain.

Back to current accounts. Considering current accounts to be loans, means account holders can neither receive nor ever expect to receive any return on their deposits, regardless of the amount. Fine. But when you take into account (no pun intended) the fact that most Islamic banks do not offer investment accounts for retail clients (at least for clients that have less than 10k US in their possession) the dilemma remains. Add to this that Islamic banks charge fees for accounts that do not maintain a minimum monthly balance, and your wealth will probably earn more under mattress than in a current account. To say the least you won’t earn enough to at least pay zakat with at the end of the year.

What to do? Either create an Islamically “viable” solution to offering a return on deposits, make the deposit holder a shareholder in the bank (much like a credit union), or uphold the status quo and support the current framework.

This is the premise of a paper I am working on, part of a larger research interest. The standing system has been veraciously defended (something to be fed up to the back teeth about), and arguments for mutuality have been made. Granted mutuality has not been researched in the relentless fashion that the current system has, I doubt that Islamic banks (and those that support them) will move anytime soon to converting to Credit Unions.

A more equitable solution is in line that would satisfy the needs of all parties involved, the larger ethical objectives of Islamic law, and the pre-modern legal precedents that are the mainstay of Islamic Financial product creation.

A tall order indeed!