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Islamic Commercial Law

Commercial law in Islam, ‘fiqh al-mu’amalat’, is regulated by Islamic jurisprudence with the principles of natural justice being at its foundation. The foundation of all commercial activity is through the formation of contracts; in Islam it is no different. Contract law is pertinent to enhancing commercial activity. With the availability of Islamic financial products across the globe it is important to understand the fundamentals of Islamic commercial contract law.

The Qur’an and the Hadith (the sayings and living example of Prophet Muhammad) have laid down the contractual maxims which form the basis of Islamic contracts. The Qur’an mentions in over 40 verses a number of commercial contracts. The Hanafi school of Islamic jurisprudence, followed by roughly one-third of the world’s Muslims, was the first school to formulate contract rules for business transactions and payment for goods for future delivery.

Essential conditions of contractual validity

To enter into a valid contract there are certain conditions which have to be met. There are six elements which need to be fulfilled:

  1. the offeror and the offeree;
  2. offer and acceptance; and
  3. the subject matter and consideration.

To be legally competent to enter into a contract the parties have to have prudence of sound judgement and be at the age of puberty. Therefore, physical and intellectual maturity is of great importance to determine capacity.

Contracts can be entered into orally, by writing or they can also be entered into by the conduct of the parties, through the exercise of the contract. What distinguishes Islamic contracts from its Western counterparts is that it insists on the session of contract (majlis al-‘aqd). Both the offer and the acceptance take place simultaneously in the same time and place. This is to avoid any ambiguity and disagreements taking place. As technology has advanced there is now a degree of flexibility in the session of contract, flexibility which has been introduced by the third important source of Islamic jurisprudence and Shari’ah – Ijma, or agreement amongst Islamic scholars/Muslim jurists on a particular issue, is the third source.

An offeror is able to withdraw its offer before an offeree accepts it. In accordance with the principle of ‘khiyar al-majlis’, the right to revoke the concluded offer and acceptance.

The subject of the contract must be:

  1. lawful;
  2. in existence, with the exception of both a deferred delivery sale (bay’ al-salam) and contract of manufacture/projects (istisna ’a);
  3. not fabricated;
  4. deliverable; and
  5. precisely determined in the contract.

The Qur’an prohibits dealing in alcohol, pork, gambling, and any thing which is a against the public good or immoral such as pornography. The price must be pre-determined so as to not lead to uncertainty. As the only exception to the rules, the price can be paid in the future in certain contracts.

Principles of natural justice underpinning contracts

The primary objective of Islamic economics is social and economic justice, and the equitable distribution of income and wealth in the economy of humans and countries. To create equitable justice in the economy Islamic economics and banking should always, and indeed do strive to, create Islamic financial instruments with these underlying principles.

Contracts in Islam are underwritten by three salient injunctions which eliminate exploitation in transactions and prevent unjustified enrichment. These are the prohibition of Riba (interest), Gharar (excessive uncertainty) and Maysir (speculation) which is like gambling (Qimar).

Common types of financing contracts in Islam

The most common type of commercial financing instruments used under Islamic financing activities are generally Murabaha, Musharakah and Mudarabah contracts.

Murabaha is a short-term debt financing contract whereby a financial institution buys a specified product or goods in accordance with a customer’s specification then sell the same to the customer at a price based on cost plus profit agreed in advance. This arrangement does not involve direct lending by a financial institution to a customer to buy the product or goods hence no interest is paid.

Musharakah and Mudarabah are long term equity-finance contracts. Often described as the “real and ideal instruments of financing” in Islamic jurisprudence. They are based on profit and loss sharing between the parties. The parties involved in a transaction sharing the risk is at the heart of Islamic jurisprudence in order to not create inequality of justice and unnecessary suffering to one party over another.

In a Musharakah contract a financial institution will provide part of the investment required by a customer and will share in the profit or loss of the business activity undertaken by the customer. The profit or loss is shared in accordance with their share in the investment or as otherwise specified in the contract.

In a Mudarabah contract, or otherwise known as a joint venture contract, the financier (rabb-ul-mal) provides the capital and the working partner (mudarib) exclusively carries out the business venture or project and its management. The profit is shared according to the ratio agreed in advance while any loss is borne by the financier. The profit sharing arrangement no interest is paid on the investment of the financier.

The inherent flexibility of Musharakah and Mudarabah structures allows for a wide range of innovative applications to meet the demands of the growing Islamic market. Concepts of Musharakah and Mudarabah are based on basic principles. As long as the basic principles are complied with, and Islamic law adhered to, their application can vary from different scales of project financing, securitisation, or financing a single transaction in order to fulfil the day-to-day needs of traders, or financing imports and exports.

Reference: Islamic jurisprudence: the law of contracts and natural justice, article by Mohammad Awais Anwar, 2 Jun 2021.