Islamic Trade Finance in Practice: The Murabaha Contract
While many, if not all, of the nominate contractual forms available to Islamic finance prac- 15.29 titioners can be used as trade financing mechanisms, for reasons of space they cannot all be discussed here.
Instead, the most used contractual form in the Islamic finance industry— the murabaha, which according to most estimates accounts for over 80% of the Islamic banking business[1666]—will be examined.15.30 The murabaha has been defined as ‘a fiduciary credit sale with a fixed and disclosed profit margin over the cost of the subject matter of the sale’.[1667] It has a pre-Islamic origin and its original purpose appears to have been to assist less knowledgeable purchasers in determining a fair price for unfamiliar goods.[1668] Thus, it was more a form of trade rather than a method of trade finance.[1669] However, the inherent flexibility of the murabaha structure means that it can be used to approximate many conventional financial transactions, which makes it the perfect mode of finance for the acquisition of assets, goods, or commodities.[1670] As well as serving a trade-finance purpose, the murabaha can also be used for other purposes including liquidity and risk management and the raising of capital,[1671] which explains why it lies at the core of much of the current Islamic finance industry’s business. The basic features of the murabaha as a means of trade finance will now be discussed.[1672]
A. Structure, Profit, and Fees
15.31 Like many nominate contractual forms, the murabaha is based on the contract of sale, and therefore must first meet the requirements of a sale contract under Islamic law.
Those requirements can be summarised as being: a buyer and seller; an object—both the price of the contract and the consideration provided for this price; and an expression of offer and acceptance.[1673] Several shurut are also read into sale contracts, meaning that the contract will not be valid if one of the parties is a child, or is not sane, or if the offer and acceptance are not given during the same contract session.[1674]15.32 In its most basic form in relation to trade finance, the murabaha involves a financial institution and a customer. The customer wishes to purchase an asset from a third party and engages the financial institution to do this. The financial institution (seller) then acquires title to the asset from the third party before entering into a sales contract with the customer (purchaser) where the seller discloses the initial purchase price of the asset and both parties agree upon a profit margin which the purchaser agrees to pay to the seller in addition to the initial purchase price and in consideration for the asset. Deferred payment terms are agreed and then title to the asset is transferred from the seller to the purchaser.
15.33 The disclosure of the price of the asset and the agreement of a profit margin are fundamental to the murabaha structure, which is categorised as a type of trust sale (bay’ al- amanah). Without this step, the contract is a normal type of sale contract (musawamah). In addition to disclosing the initial price of the asset, the seller must also disclose whether
ISLAMIC TRADE FINANCE IN PRACTICE: THE MURABAHA CONTRACT 321
they obtained the asset in question on deferred payment terms.[1675] Once the price has been agreed it cannot be modified under any circumstances due to the prohibition on riba discussed above.
Similarly, there can be no uncertainty as to the price, for that would amount to gharar.There is debate between the schools as to how the cost price of the asset may be calculated. 15.34 For example, and importantly in the trade-finance context, can expenses such as insurance, transportation, and packing be included within the cost price? The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI'), a respected standard setting body for the industry, follows the Hanbali view that any expenses such as those mentioned above can be added to the cost price, if they are disclosed by the seller and both parties to the transaction agree to it.[1676] However, if such an expense is ‘customarily considered as normal' to the transaction at hand, then it can be included in the cost price without disclosure to the purchaser.[1677] The cost price must not include a conventional upfront fee or facility fee in consideration for the transaction,[1678] which is an important difference between the murabaha and conventional trade finance methods such as the letter of credit.
B. Payment Schedule
The pre-agreed price may be paid at any time on a deferred basis, either in instalments or 15.35 as a lump sum. There is no restriction as to the timing of the payments—parties are free to contract according to their commercial requirements—except that the payment timings be agreed as part of the sale transaction.[1679]
C. Title to the Asset
The seller must obtain the title to the asset before it can be transferred to the purchaser. The 15.36 ownership of the title to the asset must be real—although it can be actual or constructive depending on the nature of the asset[1680]—and the seller need not take physical possession of the goods prior to selling them.
size=2 color=black face="Times New Roman">D. Agency
It is permissible for the financial institution to authorise an agent, other than the purchase 15.37 orderer (customer), to carry out the purchase.
Only in ‘dire need' should the customer be appointed to act as an agent. The agent must not sell the asset to himself. Rather theinstitution must first acquire title to the asset and then sell it to the agent turned customer, by allowing ‘an interval of time between the performance of the agency contract and the execution of the contract of murabahah’.[1681]
E. Possible Syndication
15.38 Like a letter of credit, a murabaha may be bilateral (involving only the purchaser and the selling financial institution) or may be syndicated. In a syndicated murabaha the seller would act as a mudarib (partner) alongside other financial institutions.
F. Actual Sale
15.39 It is a requirement of the murabaha transaction that the sale between the seller and purchaser be a valid one. Hence, it is not permissible for a purchaser to use a murabaha transaction to raise funds over an asset which they already own.[1682] If there has been any dealing between the third- party supplier of the asset and the purchaser, that must be excluded from the murabaha,[1683] and it is not permissible for an existing contract between the third-party supplier and the purchaser to be assigned to the financial institution so that it can be used in a murabaha transaction.[1684] It is also not permissible to enter into a murabaha transaction if the customer wholly owns or owns a majority share of the supplier of the item.[1685] This restriction is meant to prevent the so- called bay’al-,inah (a legal stratagem in which a person sells an asset to another for a deferred payment.
Thereafter, the seller buys back the asset for a cash payment before having made full payment of the deferred price). AAOIFI forbids the contract as it views the stratagem as a means of avoiding the riba prohibition. However, the Sharia Advisory Council ofthe Malaysian Securities Commission and the National Sharia Advisory Council of Bank Negara Malaysia— the central bank—have made the bay’ al- ‘inah a lawful Islamic standard.[1686] Finally, the sale of the asset may not be concluded prior to the seller gaining title to it.[1687]G. Subject Matter and Liability for Defects
15.40 Regarding the subject matter of the murabaha, the rules on the nature of property discussed
above apply. For example, it would be impermissible to conduct a murabaha agreement in relation to pork products for they are considered haram. Cash is also not permitted to be the subject of a murabaha as that would amount to riba, meaning that the refinancing of an initial murabaha,[1688] or creating a murabaha over gold, silver, or other ribawi goods, is
ISLAMIC TRADE FINANCE IN PRACTICE: THE MURABAHA CONTRACT 323 not permitted.[1689] The seller may sell the goods without liability for defects provided that if the seller does not do so, liability remains for latent defects after the execution of the contract. This would entitle the buyer to sue the seller for any defects.[1690] In practice, Islamic financial institutions acting as sellers will allocate the risk of defects to the purchaser which would then preclude any such action.
Furthermore, the buyer is not able bring an action against the supplier as they are a third party to the supply of the goods. This latter aspect distinguishes the Letter of Credit from the murabaha for trade finance. However, in general, the murabaha approximates the balance of risks in the transaction that are found in a conventional letter of credit arrangement.[1691] The following section sets out the steps of the murabaha agreement, highlighting the contractual structure and the risks that this poses to the financier and the buyer.H. Phases of the Murabaha Agreement
There are five phases to a typical murabaha agreement. First, there is the documentation 15.41 phase where the seller and purchaser first enter into an agreement. This agreement will detail the seller's financial commitment under the murabaha and will include representations and warranties by the purchaser as to its credit and credit-related events, trading activity (as seen in a conventional financing facility), positive and negative undertakings as to its activities during the term of the murabaha, and events of default which would permit the termination and acceleration of the purchase price.[1692] Within this agreement, the mechanics of the other stages of the murabaha will be set out and perhaps specimen forms will be attached which represent the said phases.[1693]
The conditions precedent to the seller's obligations under the murabaha will also be set out 15.42 in this phase.[1694] They will be very similar to those found in an equivalent conventional finance transaction—for example they are likely to include legal opinions on the legality and enforceability of the murabaha, and copies of corporate authorisations and authority.[1695] An important condition precedent unique to Islamic finance in general is the requirement that a fatwa be delivered stating that the proposed murabaha is Sharia-compliant.[1696] Finally, this documentation phase will include information on the place and time of payment, clauses relating to the resolution of disputes and the governing jurisdiction of the agreement, and other clauses that operate in the same way as their conventional finance equivalents.[1697]
The second phase of the murabaha agreement is the request phase, when, after all conditions 15.43 precedent are met, the purchaser notifies the seller of the asset that it wishes to purchase.[1698]
The seller then arranges to purchase the said asset and notifies the purchaser of the cost price and the proposed profit. This is done in the form of an offer to sell which is conveyed to the purchaser.[1699]
15.44 Following receipt of this offer, the purchaser in turn delivers a ‘promise to purchase' the asset at a certain price.[1700] Traditionally a promise was not considered legally enforceable in Islamic law as the proto-typical sale contract is characterised as an immediate exchange of countervalues and therefore is not promissory. Known as wad in Arabic, the promise in Islamic law is unilateral and future-oriented and while the fulfilment of promises is commendable, only Allah determines whether it will happen. Therefore, the maj ority of classical jurists have deemed the wad as non-binding.[1701] However, as many modern Islamic financial structures depend on the wad to accommodate modern finance structures, albeit according to the form of classical Islamic rules, minority opinions that view the wad as legally binding have been appropriated. This is the case with the murabaha as a non-binding promise from the purchaser would be unacceptable to the selling financial institution which has to buy assets at the request of the purchaser. As a result, some jurists allow that the purchaser is liable to the seller for any losses caused by a failure to complete the murabaha, although this remains subject to debate among scholars and practitioners.[1702] If documented as a purchase undertaking, however, the promise is enforceable in modern municipal legal systems.
15.45 In the fourth phase of the murabaha, the seller purchases the asset detailed in the offer to sell and the promise to purchase and takes title to it. Then the asset is resold to the pur- chaser.[1703] Importantly, and as discussed above, the seller need not have actual possession of the goods. Constructive possession is satisfactory. The important element of possession is the assumption of risk that the asset may be lost or damaged between the purchase and resale. Of course, this is mitigated by having the period in which the seller possesses the asset in question be very small in duration.[1704] After the above phases are all complete, the sale transaction is regulated in its operation phase by the terms of the murabaha agreement.[1705]
I. Ensuring Performance
15.46 Prior to the completion of the transaction, the seller may take money in the form of a security
deposit known as hamish jiddiyyah which may be drawn upon if the customer breaches his/her binding promise to purchase the asset.[1706] In the case of breach, the institution is
ISLAMIC TRADE FINANCE IN PRACTICE: THE MURABAHA CONTRACT 325 limited to deducting only the amount of actual damage incurred as a result of the breach. A charge for the lost profit is not permissible.[1707] However, this security cannot cover loss or damage to the goods which is suffered whilst the goods are in the possession of the seller.[1708] The seller alone bears these risks which, according to sharia, cannot be offloaded to the buyer prior to the transfer of title. Moreover, according to sharia, the seller's liability extends to any defects of the goods as the seller must bear the responsibility of ownership. In practice, however, financial institutions regularly exclude liability for the risks of defects in Murabaha contracts despite the clear contravention of ownership responsibilities per the sharia. Notably, it is permissible for the financial institution to obtain a personal guarantee from the purchaser of the good performance of the supplier when the purchaser has suggested a particular source of supply for the item that is the subject matter of the contract.[1709] Ostensibly, ‘good performance' would exclude the risks of defective goods, thus providing a means of limiting risk in these circumstances. Regarding the security (hamish jiddiyyah), it cannot be used to cover loss or damage to the goods which is suffered while the goods are in the possession of the seller.[1710] During the operations phase, the seller can receive a third party guarantee of the purchaser's obligations which can be called upon if there is a default event or if the purchase price needs to be accelerated.[1711] It is also common practice to take security over the purchaser's other collateral to secure the purchaser's obligation under the murabaha agreement.[1712]
J. Default and Restructuring
As the purchase price is fixed in a murabaha agreement, there can be no penalty for late pay- 15.47
ment in the form of an increase to the amount due.[1713] However, AAOIFI Standards allow for such a late penalty if it is put to a charitable purpose.[1714] Non-penalty charges such as enforcement and recovery costs are recoverable from the purchaser.[1715]
The acceleration of charges in the event of a default is possible in a murabaha agreement.[1716] 15.48
In the event of a default, any security may be realised and the subject matter of the murabaha may be repossessed, although both of those remedies are subject to availability within the enforcement jurisdiction specified in the initial murabaha.[1717]
One of the limits of the nominate contractual system is the lack of freedom to amend con- 15.49 tractual terms, which severely limits the ability of defaulting murabaha purchasers to restructure their initial agreement through variation of terms.[1718] Such a restriction is not present in a conventional trade financing scenario.
V.