Murabaha & Musawamah

LECTURE By Dr. Syed Zulfiqar Ali Shah Murabaha & Musawamah LECTURE By Dr. Syed Zulfiqar Ali Shah Murabaha & Musawamah

Summary of Last Lecture Introduction Conditions of Valid Bai Murabaha- A Bai Al Amanah Bai Murabaha in Classical Literature The Need for Murabaha Murabaha & Musawamah

Layout Specific Conditions of Murabaha Possible Structures of Murabaha Murabaha To Purchase Orderer (MPO) Issues in Murabaha Precautions in Murabaha Operations Musawamah (Bargaining on Price) Summary Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) There is no doubt that jurists have justified Murabaha on the grounds that it provides protection to the innocent, unskilled and inexperienced purchasers, but as we do not find any reference regarding its prohibition for experienced people or traders, it can therefore be adopted subject to the fulfilment of the juristic conditions, as an alternative to interest-bearing transactions for those activities which the Shar¯ı´ah boards of various banks may allow. Bai Murabaha & Credit Sale- (Murabaha Muajjal): Murabaha as an alternative to interest-based financial transactions assumes importance only when it is transacted on a deferred payment basis. This, therefore, calls for a study of the concept of postponement of payment in Murabaha. The terms of payment in the classical Murabaha did not necessarily involve credit; they could be either cash or credit. It may, however, be pointed out that the Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) postponement of payment is one of the general features of lawful sales – termed Bai‘ Mu’ajjal, which refers to sale of goods or property against deferred payment (either in a lump sum or instalments). Bunched with the Murabaha, Bai‘ Mu’ajjal would mean sale with an agreed profit margin over the cost price along with deferred payment. In Hidaya, permission for credit sale has been described thus: “A sale is valid either for ready money or for a future payment provided the period be fixed, because of the words of the Holy Qur’¯an ‘Trading is lawful’ and also because there is a tradition of the holy Prophet (peace be upon him) who purchased a garment from a Jew, and promised to pay the price at a fixed future date by pledging his iron breast-coat. It is indispensably a requisite of business but the period of payment should be fixed. Uncertainty in the period of repayment may occasion a dispute and jeopardize the Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) execution of the transaction since the seller would naturally like to demand the payment of the price as soon as possible, and the buyer would desire to defer it.” The substitution of prompt payment by deferred payment has been justified on the grounds that upon execution of the transaction, the receipt of the agreed price becomes the sole right of the seller. It is, therefore, within his discretion to postpone it for the convenience and ease of the purchaser. The fact is that he is empowered even to forego it altogether. Delay in payment under Murabaha is also allowed in other schools of Fiqh, including Shiaites. As described in detail, jurists slightly differ on the aspect of different cash and credit prices. The Hanafis, Shafi‘es and Hanbalis permit the difference between cash and credit prices provided one price is settled at the finalization of the contract. Although Imam Malik himself forbade it, some of the Malikis hold a different view Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) and allow it. Contemporary jurists are almost unanimous on the legality of this difference. The rationale behind this viewpoint is that exchange in respect of a loan wherein any excess is prohibited occurs between a commodity and its like, while in credit sale, one of the counter values is the money and the other any goods of trade. As, for example, in loan transactions, $100 can only be exchanged for $100 or a ton of wheat for a ton of wheat. Any increase in the mutual exchange, therefore, is Riba. In the case of credit sale, exchange has to take place between two different commodities. First, money is exchanged for goods and then goods are sold against money. Therefore, the difference between the purchase price and sale price does not amount to Riba. Further, interest charged on a loan is payable to the lender in any case. In a sale contract, this is not so because the prices are liable to change. Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) If the price rises, the purchaser gains because he purchased a good on a deferred payment basis at a cheaper price, but if the price drops, the seller gains because he succeeded in selling the item purchased on a deferred payment basis at a higher price. Bai‘ bi Thaman al-’Ajil or Bai‘ Mu‘ajjal is, therefore, in conformity with the Fiqhi principle “Al-Ghunm bil Ghurm”, i.e. profit goes with loss. However, the sale contract has to be finalized at one price so that the exact liability is known to the parties. This would practically imply that the whole price is in return of the sale item. However, it is not allowed to conduct Murabaha on a deferred payment basis in the case of gold, silver or currencies, because all monetary units are subject to the rules of Bai‘ al Sarf. Similarly, receivables or debt instruments cannot become the subject matter of Murabaha, as any profit over the principal of a debt is Riba. However, Murabaha of shares of joint stock companies eligible on Murabaha & Musawamah

Specific Conditions of Murabaha (Cont’d) the basis of screening criteria is allowed. Murabaha & Musawamah

POSSIBLE STRUCTURES OF MURABAHA Murabaha & Musawamah

Possible Structures of Murabaha trading and other real sector business activities require specific expertise, which bankers may or may not have. Further, it is not possible for banks to train all staff in trading, marketing and other real sector activities required for Islamic banking practices. One possible solution is that banks may establish specific purpose companies to undertake trading (and leasing) activities and the staff with relevant specialized expertise may be entrusted the job of trading in goods so as to fulfil the Shar¯ı´ah essentials of Murabaha–Mu’ajjal. Those companies would buy commodities and assets and sell them to their customers on the basis of deferred payment. Thus, the banks’ specialized entities could use their entrepreneurial expertise, like all other profit-seeking businesses, to earn profit. Otherwise, the trading activities may be conducted either through the client as agent or through a third party agency. The options for conducting Murabaha are briefly discussed that are: Murabaha & Musawamah

Possible Structures of Murabaha (Cont’d) Direct Trading by Bank Management: Direct trading by bank officials is the most ideal option with respect to fulfilment of the Murabaha essentials, but involving the bankers in retail trading business could lead to a lot of managerial problems and open the floodgates to corruption. This issue can be resolved through the introduction of effective internal controls. In the absence of such controls, this structure could be used only in cases of selected specific assets, wherein banks could purchase any high value asset or specific goods with trademarks in bulk for building inventory and sell to its clients on a cost-plus basis. For example, a bank’s subsidiary dealing with agricultural finance may purchase fertilizer/pesticides and provide them to farmers on the basis of Murabaha through dealers. In such wholesale business, an additional benefit would be that the bank’s sale price could be closer to the cash market price. Murabaha & Musawamah

Possible Structures of Murabaha (Cont’d) 2. Bank Purchases Through a Third Party/Agent: One option in many cases may be to purchase goods through a third party agent to maintain inventory or to purchase according to clients’ requests for Murabaha operations. This structure of Murabaha is most likely to accomplish the Shar¯ı´ah requirement of taking possession and commercial risk by the bank for the period between the purchase of the assets from the supplier and their sale to the client on Murabaha. After purchase from the supplier, banks stand liable if anything goes wrong until handing the asset over to the Murabaha clients. The customer cannot guarantee the risk of transportation of the goods because the safety of the goods is the responsibility of the owner, that is, the bank. Banks can mitigate this risk by stipulating to get delivery at their go downs. Banks may appoint qualified suppliers as agents for purchase according to their inventory creating plans or as and when required by their clients. Murabaha & Musawamah

Possible Structures of Murabaha (Cont’d) For the latter arrangement, the package would comprise (i) an MoU or agreement to sell – the client’s request and promise that he will purchase the specified commodity from the bank; it may also include a stipulation about the profit margin to be taken by the bank and, if possible, the sale price, that will include the cost price, the contract price and the payment date(s); for the profit margin, the bank may indicate at this stage any reference rate provided a definite price is stipulated at the time of execution of Murabaha; (ii) the sale deed executed at the time when the commodity is in the ownership and risk of the bank; and (iii) the “promissory note” signed by the client to the effect that he will pay the price of the goods purchased on a specified date. In addition to this, the agreement may include clauses about the security/collateral, description and quality of goods and the way out in case of defect in the goods and nonpayment by the client at the due date(s). According to the AAOIFI Standard, a promissory note or other guarantee can be Murabaha & Musawamah

Possible Structures of Murabaha (Cont’d) obtained from the customer at the promise stage also. Of course, it is better that promissory notes be obtained after execution of the sale, because these generally contain the wording “against value received”. 3. Murabaha Through the Client as Agent: The structure of trading through a client as the bank’s agent is the safest way for banks to avoid commodity-based risks and related problems. But this arrangement is more likely to make Murabaha transactions a back door to interest and, therefore, requires extra care to keep it Shar¯ı´ah-compliant. The foremost requirement is that goods come under the ownership and risk of the bank. Further, the customer should explain to the supplier about his agency status. If the bank does not purchase and own the items and only makes payment for any goods directly purchased and received by the client from the supplier/vendor under “Murabaha”, that will be a Murabaha & Musawamah

Possible Structures of Murabaha (Cont’d) remittance of the amount of money on behalf of the client, which shall be nothing but a loan to him and any profit on this amount shall be nothing but interest. As Islamic banks are normally using this structure, we discuss it in detail. Murabaha & Musawamah

MURABAHA TO PURCHASE ORDERER Murabaha & Musawamah

Murabaha to Purchase Orderer Modern Murabaha transactions by banks normally take the form of Murabaha to Purchase Orderer (MPO) (Murabaha lil ‘amri bil Shira or ‘Murabaha li Wa‘da bi Shira), which is an arrangement wherein the bank, upon request by the customer, purchases an asset from a third party and sells the same to the customer on a deferred payment basis. This variant is being widely used by almost all Islamic banks operating in various parts of the world and by the Islamic Development Bank for its foreign trade-financing operations. The need for MPO arises from the following factors: Commercial banks, and likewise Islamic banks, do not normally undertake business where they might be maintaining inventories of various goods; they do not want to become grocers or traders because inventory storage, space and holding costs might be expensive. 2. It may not be possible for Islamic banks to purchase all items in Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) advance for Murabaha to their clients because the list of goods could be very long and there could be continuous additions to the list. 3. The clients might be in need of specific quality goods and the banks might not be even aware of the source of their availability. If banks keep similar items in inventory, these might not be acceptable to the clients. 4. Regulators/central banks normally do not allow the banks to undertake trading as their core business, with the dual purpose of keeping them liquid/saving them from the asset and market risks related to goods and to avoid cartels and monopolies in the commodity market. As such, most of the Islamic banks purchase only those goods for which they receive requisition from their clients. On account of the above, Islamic banks have been allowed not necessarily to maintain inventory of goods to be sold through Murabaha. According to the AAOIFI Shar¯ı´ah Standard on Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) Murabaha, it is permissible for IFIs to purchase items only in response to their customers’ wish and application. But this wish may not be considered a promise or commitment by the client to purchase the items, except when the promise has been made in the due form. For practical purposes, the promise can be incorporated into the requisition form to be submitted by the client. The customer can also indicate the supplier from whom the items/goods are to be purchased by the bank. But the bank will have to ensure that the supplier is any third party and that the client has not already purchased the item from that supplier or made a firm commitment with him to purchase; otherwise it would be Bai‘ al ‘Inah and the transaction would be non-Shar¯ı´ah-compliant. The bank can obtain a performance bond from the client to ensure that the supplier identified by him will function in good faith and that the item provided by him will be acceptable to the client. Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) Similarly, the bank is not allowed to enter into a Musharakah arrangement with the client with the promise that one of the parties will buy the other’s share through Murabaha on either a spot or deferred payment basis. However, the promise can be made by a partner to buy the other’s share at the market price or at a mutually agreed price at the time of sale by means of a separate contract. The above permission for MPO does not imply that IFIs cannot be involved in the sale/purchase of goods or cannot create their inventories. Purchasing an item, taking its possession and ownership along with risk and reward is a major requirement of Shar¯ı´ah, without which the transaction would not be valid. Murabaha cannot be used as a substitute for a running finance facility, which provides cash for fulfilling various needs of the client. If a bank does not keep inventory, it can purchase a commodity on a client’s request and sell it to him on a cost-plus basis, but it will have to fulfil all the Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) necessary conditions of valid Bai‘ as well as additional conditions applicable to Murabaha. Merchant banking has become one of the functions of even conventional banks. Therefore, Islamic banks, in addition to conducting MPO, may like to establish specialized asset management and trading companies as non-bank financial subsidiaries to undertake active trading business by maintaining inventory of major items demanded by their clients. This way, their profit margin may be higher and the customers may also be offered such items at cheaper rates. Banks can purchase the goods through any third person/agent and possess the goods before resale. If the bank appoints the customer its agent to buy the commodity on its behalf, the customer will first purchase the commodity on behalf of the bank and take its possession as such But payment should be made by the bank Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) directly to the supplier. Double agency, i.e. for making payment and for purchasing and taking delivery, should be avoided because it may become a cause of misuse, making Murabaha a back door to interest. At this stage, the commodity must remain at the risk of the financier, who is the seller in this transaction. Thereafter, the client purchases the commodity from the financier for a deferred price. MPO- A Bunch Of Contracts: Modern Murabaha also involves an agency relationship between the bank and any third party or even the client. The Murabaha to Purchase Orderer in this form would comprise three distinct contracts: A master contract which defines the overall facility to be availed, followed by an agreement to purchase or promise by the client to purchase the article when offered by the bank. Instead of being a bilateral contract of forward sale, the “agreement to buy” is a Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) unilateral promise from the client which binds him and not the bank. b) An agency contract whereby the agent, who could be a client or any third party, has to purchase the item from the market or the supplier identified by the client and take its possession on behalf of the bank; this should be separate from the Murabaha agreement. The actual Murabaha contract. The actual Murabaha contract should be concluded when the bank owns the concerned commodity. Murabaha transactions that involve other contracts like promise, agency (Wakalah) and credit along with an agreed rate of return for IFIs over the cost price lead to a number of issues: should the promise be unilateral or bilateral, binding or nonbinding? What is the remedy if the client backs out? What should be the sequencing of the various actions of the bank and the client? When the actual Murabaha is to be executed, what happens if the client makes early payment or delays in making payment of the settled price? To what Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) extent can the bank’s loss be covered and mitigated? And last, but not least, what structure and modus operandi of Murabaha can be adopted to fulfil the needs of various stakeholders along with ensuring Shar¯ı´ah compliance? We discuss these matters in the following sections. Promise to Purchase in Murabaha: According to classical Fiqh rules, mere promises are not binding and cannot be compelled by the process of law. Although fulfilling a promise is advisable and violation reproachable, it is neither mandatory nor enforceable through the courts. However, to many other jurists, promise can be enforced through courts of law. The third view (of some Maliki jurists) is that promise is not binding in normal conditions, but if the promisor has caused the promisee to incur some expenses or undertake some labour or liability on the basis of a promise, it is mandatory on him to fulfil his promise for Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) which he may be compelled by the courts. Shaikh Muhammad Taqi Usmani, after detailed discussion on the subject, contends: “Therefore, it is evident from these injunctions that fulfilling promise is obligatory. However, the question whether or not a promise is enforceable in courts depends on the nature of the promise. But in commercial dealings, where a party has given an absolute promise to sell or purchase something and the other party has incurred liabilities on that basis, there is no reason why such a promise should not be enforced. Therefore, on the basis of the clear injunctions of Islam, if the parties have agreed that this particular promise will be binding on the promisor, it will be enforceable. If the promisor backs out of his promise, a court or any arbitration may force him either to purchase the commodity or pay actual damages to the promisee seller. The actual damages will include the actual monetary loss suffered by him, but will not include the opportunity cost” Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) This aspect has been discussed with the conclusion that if the parties agree that the promise should be binding, it will be legally enforceable; and if the promisee has incurred expenses as a result of the promise, the promisor will have to make up the loss incurred by the promisee. A client asks a bank to purchase certain goods on the basis of Murabaha according to his specifications from a supplier and promises that, after the bank acquires the goods, he will purchase them from the bank on a cost-plus basis. In a case of the breach of promise by the client, the bank may suffer loss while trying to return or to dispose of the purchased goods. To overcome this problem, scholars have issued a verdict that the promise of the customer to enter into the sale binds him, at least to the extent that he should pay any actual loss, excluding the loss on account of conventional “opportunity cost”, incurred by the bank as a consequence of its reliance on the promise. This is in line with Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) the AAOIFI’s Standard on Murabaha to Purchase Orderer. Even a mutual promise (involving two parties) is permissible in the case of a Murabaha sale provided the option (Khiyar) is given to one or both of the parties. Without such an option, it is not permissible, since in a Murabaha sale, a mutual and binding promise is like an ordinary sale contract, in which the prerequisite is that the seller should be in full possession of the goods to be sold in order to be in conformity with the tenets of the Shar¯ı´ah forbidding the sale of anything that is not in one’s possession. A bank can also obtain Hamish Jiddiyah (earnest money) from the client to ensure that the latter will buy the item when purchased. In response to a purchase request by a client, a bank can enter into a purchase agreement with the supplier, keeping for itself an option of return (Khiyaral-Shart) within a specified period. This option will expire with actual sale to the customer. Hence, an option (Khiyar) Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) can be used as a risk mitigation tool (asset risk) by an Islamic bank. It must be kept in mind, however, that an actual sale must take place at the proper time when the bank gets possession and ownership of the item by the exchange of offer and acceptance. Mere promise itself should not be taken as a concluded sale. 3. MPO – The Customer as the Bank’s Agent to Buy and Related Matters: The general structure of this variant of Murabaha is the following: 1. The customer approaches the bank with a request for the purchase of any commodity that can be legally sold on credit. 2. The bank appoints the client its agent to purchase the item(s). 3. The bank purchases the commodity through the client as agent. 4. The bank makes payment to the vendor/supplier. 5. The customer takes delivery of the item on behalf of the bank as Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) agent. 6. The customer makes an offer to purchase and the bank accepts the offer – the bank transfers the title over to the customer upon execution of Murabaha. The customer makes payment on a deferred basis without any rollover, discount or rebate. The above structure involves the following stages/steps: pre-promise understanding; promise stage; agency stage; acquiring possession; execution of Murabaha; post-execution of Murabaha. Each of these steps is crucial in its own right and neglecting essentials of any stage would render the whole arrangement unacceptable from the Shar¯ı´ah angle: The client and the bank sign an MoU or “agreement to sell”, whereby the bank undertakes to sell and the client promises to buy a Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) commodity for a purchase price plus a profit margin of X% that may or may not be tied with any benchmark, or a stipulated amount over the known cost. 2. The bank appoints the client as its agent for purchasing the commodity on its behalf, and both the parties sign an independent specific or general purpose agreement of agency. 3. The client purchases the commodity on behalf of the bank and takes its possession, for which the bank makes payment to the vendor/supplier. This is obligatory according to the AAOIFI Standard; however, some Islamic banks do not follow this instruction due to some procedural problems. The purchase order, material receiving report and delivery challan, under whatever title, should be in the name of the bank. 4. The client informs the bank that he has purchased the commodity on its behalf, has taken possession thereof, and makes an offer to Murabaha & Musawamah

Murabaha to Purchase Orderer (Cont’d) purchase it from the bank at a profit margin over the cost, as agreed to in the “agreement to sell”. This must be before the goods are consumed, otherwise the Murabaha will be invalid. 5. The bank accepts the offer and the sale is concluded, whereby the ownership as well as the risk of the commodity is transferred to the client. The nature of the relationship in the above arrangement would be: 1. Bank and client: principal and agent. 2. Bank and client: promisor and promisee. 3. Bank and supplier: buyer and seller. 4. Bank and client: seller and buyer. 5. Bank and client: creditor and debtor. Prerequisites of the various stages of MPO with the client working as agent are discussed below. Murabaha & Musawamah

Summary of Today’s Lecture Specific Conditions of Murabaha Possible Structures of Murabaha Murabaha To Purchase Orderer (MPO) Murabaha & Musawamah

Thank You…. Murabaha & Musawamah