The proposition at hand is an extract from Schacht’s book. This proposition is divided into two parts, both of which are inter-connected. The first part requires for us to discuss the extent of freedom in contracts provided within contracts construed under Islamic financial law, with an exception to few, whereas the second part of the question requires discussion regarding the point that within the ambit of ethical control of the legal transactions, liberty of contract will be incompatible.
To begin with, according to Schacht, Islamic legal system seems extremely reluctant to accommodate the concept of freedom to contract within the framework of Islamic financial contracts as under Islamic financial law (“IFL”) there is a scheme of unchangeable nominative contracts that is laid down for them to be followed. Secondly, due to religious constraints the contracts must be construed in a way by the parties that they should respect the moral provisions provided in the Shariah i.e.- Contracts must be made keeping in view the conditions that render a contract valid, avoid interest based contracts, reduction of uncertainty in contracts, usurious practices and other elements falling in the realm of Islamic practices. Analyzing Schact’s idea of liberty to contract, it is clear that Islamic legal system does not support the practice of liberty to contract which essentially is identified under Western law. This is the point of contention between the classical Islamic Financial Law and modern financial law practiced in today’s world.
The doctrine of Islamic Financial Contract is extremely rigid and does not provide a huge window of freedom towards contracts in order to bring them in line with the modern financial contracts. At the same time, it can be held that with the socio-economic and financial changes in the world, the need of the hour is to bring change to the approach of how Islamic financial contracts are construed. It can be said that liberty of contract is an ever evolving subject and with further changes to the financial world globally, the rules may be rearranged in a way again so as to fit in the requirements of the changing world.
According to the Maliki interpretation of Surah: 4 Verse: 28, the Quran states – O believers! Do not consume one another’s wealth through unlawful means; instead, do business with mutual consent; do not kill yourselves by adopting unlawful means. Indeed Allah is Merciful to you.
The religious scholars concede that Quran clearly states not to consume each other’s wealth through unlawful means ( Riba, Gharar, Usury etc which the Quran has forbidden in later verses) but to trade with each other with mutual consent (the parties are free to contract as they see fit as long as they do not add new effects to the contract1) is permissible under IFL.
With the ever changing world, modern scholars/ jurists have introduced tools to create contracts which render a contract valid/ permissible under Islamic law. Unlike nominate contracts, they grant some freedom of contract, to bring in line the Islamic financial contracts with modern western contracts. First and foremost, I will be discussing the conditions that render Islamic contracts valid, moving on to a few prohibitions under Islamic law in contrast with their exceptions to get a clearer picture of how Islamic law does not recognize freedom of contracts but at the same time due to the changing world modern scholars have construed contracts in a way that do give some space to create contracts without breaching the basic rules laid down under the Islamic legal system.
Under IFL, a contract is based on four elements that render a contract valid. These are the seller, the buyer, the form and the object of the contract. The form of the contract must include an offer and corresponding acceptance for a contract to be valid and must also include consideration which is not necessarily a monetary price but it may be in the form of another commodity. Secondly, the buyer and the seller must be legally competent to enter into a contract (meaning a person qualified for acquiring rights and undertaking duties and responsibilities). Thirdly, the object of the contract (mal) is defined as something which must be in existence, it must be owned and be temporarily non-perishable. It must also be legally owned by the party before selling it. Lastly, there must be immediate exchange of ownership of the object of sale and the price. Therefore, there should be no options, as a sale without options would transfer immediate ownership of the object of sale to the buyer and the price to the seller.2
Laying down the basic conditions that render a contract valid, the prohibitions will now be specified with a few exceptions to fit in within the parameters of modern financial law.
Just like under IFL there are conditions that must be satisfied to enter into a contract, there are prohibitions as well that render a contract illegal. The first one being Riba – (Riba – having interest based contracts) The Quran clearly quotes “But God has permitted the sale and forbidden the Riba”3 “God destroys/eliminates the Riba”4 It must also be taken into consideration that the same has been exempted under Prophet’s sayings. The Prophet mentions – “The Wrath of God is on the taker of Riba, its giver, its writer and its two witnesses.” To put it in simpler words Riba is an increase in the amount a debtor owes his creditor due to the passage of time, as is mentioned above interest based contracts. Consequently, once a debt is created, any payment above the principal of the debt is interest and is “Prohibited Riba” according to the terminology of the Qur’an. Notwithstanding the challenges made today, Riba has been a contentious issue since the Mamluk dynasty, when ibn-e-tahmiya first justified interest to earn back the principle amount. Similar notion of interest has resurfaced in the works of Rashid Rida, Mohommad Abdu and Al Afghani being the early Islamic reformers, who have differentiated between interest on a productive loan and interest on a loan for personal consumption basis. What they mean to say is that productive loan is essentially a public loan meant for social welfare and infrastructure thus allowing interest to a certain extent. Whereas interest on a loan for personal consumption must not be deemed to be valid. There are various other understandings towards how various legal scholars interpret the concept of Riba. Some consider charging exorbitant interest rates as non-permissible where as another alternative approach of Islamic modernists emphasizing more on the moral aspect of the prohibition believe that charging interest on loans to the poor and needy is not permissible as that is the exploitation of the needy which is the basic issue than the interest being itself.5 Therefore from what it seems, the classical approach may completely banish the concept of Riba and disregard charging any kind of interest, but Islamic modernists tend to focus more on the moral aspect of the concept of Riba and interpret God’s revelations in a way that basically repeal injustice and hardship from the system and not completely eradicate the concept of interest from financial contracts. Their rationale behind this kind of a reasoning is that in the Makkan society (Riba al jahiliya) was practiced, and those practices and the problems that they faced were different from the problems faced in the contemporary world. In Makkah, lending involved charging high interest rates from people of not a very high financial status, who borrowed money for the purposes of consumption, which in most of the cases led to financial slavery (as they were unable to return the money back) where as in the contemporary society money is usually loaned for commercial purposes which includes investments as well and such type of commercial transactions usually take place between people of the same background thereby reducing the economical gap between both the parties therefore justifying charging interest and providing a certain amount of liberty to contract. 6Thereby in an overall perspective, Schact’s view of rigidity in contracts under Islamic financial law is definitely present but in this ever changing world liberty to contract is always a concept that will evolve with time and presently as seen, modernist scholars have justified catering to the need of financial contracts having interest without breaching Islamic legal principles.
The second major prohibition under Islamic jurisprudence is of the concept of Gharar which plays a huge role in the Law of Islamic Finance. Gharar is a prohibition on any gain that is not clearly outlined at the time of making of the contract. If put in easier words Islam does not allow the element of uncertainty in any of its contracts whether it be with regards to the quality, quantity ownership or presence of the subject matter.
There are various hadith of the Prophet (pbuh) that indicate the need to avoid Gharar in contracts. Abu Hurairah (RAA) narrated: “The Messenger of Allah (pbuh) prohibited sales of ‘whatever a pebble thrown by the seller hits,’ and sales in which there is chance or risk (Gharar).” Sahih Muslim The Hadith is considered as one of the cardinal principles of sale’s law and the grundnorm of all rules governing Gharar contract7. In essence proving that the concept of uncertainty is strictly prohibited under IFL.
Gharar can also appear in a number of other forms. One of them would be to sell an asset that one does not own. It is pertinent under IFL that only the owner has a right to sell what he owns. Secondly one cannot sell something of uncertain quality or for that matter quantity, e.g. Something that one had promised to sell did not turn out to be of a specific quality that was required by the buyer or was not of the exact quantity that was required, that will give rise to a dispute and the underlying factor of that dispute would be uncertainty, therefore since one is not sure of the precise quality/quantity that will be sold to the buyer, one must not sell it. Some of the classical examples of Gharar are – Sale of fish in the sea – sale of birds in the air – sale of unborn animals. As it can be evidenced all of them have a certain level of uncertainty in them therefore they are prohibited.
Whereas on the other hand since many of the modern day transactions and contracts do have a certain element of uncertainty in them. This gives rise to the argument that with Gharar being prohibited there is rigidity in the matter of IFL contracts, now in order to create some flexibility modern world scholars/ jurists gave the concept of Gharar some freedom by creating a spectrum of minor to major Gharar. However, in the classical period, jurists distinguished between contracts containing minor Gharar (al Gharar- al yasir) which is acceptable and doesn’t render a contract invalid and contracts containing substantial Gharar/ excessive Gharar (al Gharar- al kathir) (which are prohibited and render a contract invalid). This debate continues until today where scholars such as Mahmasani differentiated between minor and major Gharar with regards to its legal implications whereas Al Sanhuri did not completely agree with the concept but rather gave his own view that a distinction should only be made between instances in which the subject matter of a transaction is non-existent but will come into existence with certainty – thus invoking Gharar. It can be seen that both the scholars recognized the need of flexibility in contracts in modern world commerce and found ways to accommodate degrees of Gharar.
In light of another concept of Bay as Salam, Gharar has been replaced to some extent and become permissible. Basically the scholars have granted freedom of contract in the contemporary world of Islamic contracts by introducing forward sale which is also known as Salam in which the non-existence of the commodity is permissible, and proceed with the exchange. Hence reducing the rigid formality of Gharar to a considerable extent, bringing about a certain amount of liberty to contract.
Having talked about the prohibitions in Islamic legal system, light will be shed upon how the modern jurists/ scholars have created exceptions and brought about some change in the certain fixed type of contracts and to what extent could they be valid. Shariah rulings, made over time, are found in the writings of Shariah specialists/scholars. This is why those seeking Shariah guidance or precedents must search for what is known as “nominate contracts” in Shariah literature; that is the contracts that are mentioned in the famous writings of Shariah scholars over the last twelve centuries or so.8 Under IFL, nominate contracts play a huge role in determining the basic financial structure of contracts. Nominate contracts have existed for centuries, their special conditions are derived from the practice of the Prophet Mohammad’s (PBUH) community in Madinah. They have set Islamic rules with its legal effects that are used in construing contracts. These rules restrict contracting parties’ freedom to choice of clauses, but many exceptions have been made and on the basis of the salient features of Islamic Financial Contracts, modern jurists along with contemporary Islamic banks in cooperation with Shariah scholars, have developed a scheme of hybrid financing contracts that suit the contemporary world of finance without completely transgressing rules laid down by the Islamic legal system.9 In short, the hybrid Islamic finance contracts are essentially the backbone of banking and financing contracts in the world today.
The hybrid finance contracts include –Equity sharing (Musharakah), equity sharing with a silent partner (Mudarabah), transactional based contracts (Murabaha) and crop-sharing (Muzara’ah). They also mention three sale-based financing contracts: deferred or installment payment sale (al bay’ al ‘ajil), forward sale with cash advance (Salam), and manufacturing financing sale (Istisna). Lastly, leasing (Ijarah) as a form of financing.10
In other words, the hybrid Islamic finance contracts constitute the empirical and practical backbone of Islamic banking and finance in the world today, an industry that started in the mid 1970s and has been growing at an average of over 14 percent annually over the last three decades.
A few of these will be discussed to shed light upon the understanding of how liberty to contract has subtly made its way into the once old rigid approach of classical Islamic finance.
According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Mudaraba is a partnership where one party provides capital whereas the other provides labour.11 E.g. – under a Mudarabah investment deposit, the bank (labor) invests the fund owners (party that provides capital) deposit in its financing business, and the profit gets divided between the fund owner and the bank, according to an agreed ratio. Mudarabah deposit contract can be differentiated from the Mudarabah contract known in the classical literature by adding three contractual elements. It mixes funds from all depositors together, it mixes funds of depositors with funds of the manager, and it provides certain procedures of early withdrawal.12 Mudarabah investment deposit is the Islamic alternative of the time deposit in conventional banks. It does not give a pre-fixed rate of return. Therefore, depositors choose between Islamic banks on the basis of past performance. In this regards, they are closer to investment in open mutual funds; a key difference, though, is Mudarabah deposits are usually set for an agreed period of time. Thereby justifying some freedom to contract within the Islamic legal system.
Murabaha, on the other hand, is a sale in which the cost and profit are fully known to the person who made a purchase order and they both agree on the cost plus price. The price is marked up in exchange for allowing the buyer to defer a payment. The bank owns the commodity for a very short period of time which legitimizes the banks profit from a Shariah point of view. The basic purpose of Murabaha is to avoid involving interest based payments in a manner which help the buyer to buy sometime before he makes payment. Thereby eradicating the rigidity in the contracts.
Various scholars have different views over it. Taqi Usmani, one of the noted scholars of Islam, claims that it may appear to a few scholars that allowing a buyer more time to pay for some product in exchange for them paying a higher price does amount to the concept of interest but that is incorrect.13 At the same time the scholar emphasizes on the fact that Murabaha should only be used as a structure of last resort where profit and loss sharing instruments are unavailable. He himself claims that the concept of Murabaha and interest based loan have a very slight distinction between them which must not be overlapped. Conclusively it can be seen that this situation is unanimously accepted by all the four Sunni schools of Islamic Law and majority of the jurists, these reports have been approved in the Islamic Republic of Pakistan as how to eliminate interest, therefore proving that liberty to contract within interest based contracts has also been devised under IFL and is practiced in the modern day world.
Musharakah is a joint enterprise or partnership structure in which one partner provides capital and the other management with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Furthermore, the net profit is shared according to the ratio provided in the agreement while losses are distributed only according to capital shares.
Buy back is essentially practiced by Islamic banks in Malaysia and Brunei for providing personal financing. It is a cash buy of goods owned by a customer and deferred sale of the same goods at a higher price to the same customer. A version of this contract is done as buy lease-to- own back. From the above discussion it is clear that in the modern world IFL has evolved over time and has adopted a more flexible approach to facilitate the parties entering into contract. While the Shariah counselors of most Islamic banks do not approve of this hybrid financing contract because it is merely a lending for interest hidden under a different name, some scholars argue that it may be the lesser of an evil when compared with interest lending. Therefore, they accept it in case of need for cash to pay off an interest- based loan.
Analyzing the above arguments, it is opined that Schacht may be right in completely negating liberty of contract in light of the classical Islamic approach but there is some capacity that the modern scholars have utilized to maneuver nominate contracts in a way that they are compatible with modern day financial contracts. Thereby Islamic finance has, to some extent gained foothold in the global financial market which interestingly is evidenced being adopted by the legal systems who are not based on Sharia principles only. With this ever changing world further changes are expected to take place in the modern financial world and thereby Islamic laws may also yield to the pressures of commerce but only with the condition of remaining within the Legal framework provided under Shariah.