Introduction to Islamic Commercial Law

Understanding Islamic Economic System

Comparative Understanding of Islamic Economic
System

• Capitalism
– Adam Smith

• Communism
– Karl Marx
 Capitalist System Communist System Islamic System

Private ownership of property Public ownership of property Private usufruct* of property

Free market economy State-controlled market Free but regulated market

economy economy. Zakat and Sadaqa for
the distribution of wealth.

Profit maximization at Profit maximization at Profit is not the ultimate goal;

individual level collective level The ultimate objective is to
submit to the Will of Allah
(S.W.T)

*a legal right to use and derive profit from property belonging to someone else
provided that the property itself is not injured in any way
Islamic Finance: Challenge for Scholars

• To avoid any possibility of riba (interest) in commercial

transactions.
• Condemnation of riba in the strongest terms in the Qur’an and
Hadith.
• Riba: The second most serious sin after Shirk and Kufr
• Strongest Condemnation of Riba: In Sura al-Baqara – Verses:
275 - 280
Sura al-Baqara: 275

َ ِ‫ان ِم َن ْال َمسِّ ۚ ٰ َذل‬

‫ك بَِأنَّهُ ْم قَالُوا‬ ُ ‫ط‬َ ‫ون ِإاَّل َك َما يَقُو ُم الَّ ِذي يَتَ َخبَّطُهُ ال َّش ْي‬ َ ‫ون الرِّ بَا اَل يَقُو ُم‬ َ ُ‫ين يَْأ ُكل‬ َ ‫الَّ ِذ‬
َ َ‫ظةٌ ِم ْن َربِّ ِه فَا ْنتَهَ ٰى فَلَهُ َما َسل‬
‫ف‬ ِّ ‫الربَا ۗ َوَأ َح َّل هَّللا ُ ْالبَ ْي َع َو َح َّر َم‬
َ ‫الربَا ۚ فَ َم ْن َجا َءهُ َم ْو ِع‬ ِّ ‫ِإنَّ َما ْالبَ ْي ُع ِم ْث ُل‬
َ ‫ار ۖ هُ ْم فِيهَا َخالِ ُد‬
‫ون‬ َّ ‫ن‬‫ال‬ ُ‫اب‬ ‫ح‬
َ ْ‫ص‬‫َأ‬ ‫ك‬
َ ‫ِئ‬َ ٰ ‫وَأ ْم ُرهُ لَى هَّللا ِ ۖ وم ْن َعا َد فَُأو‬
‫ل‬
ِ َ َ ‫ِإ‬ َ
Those who live on usury will not rise up before Allah except like those who are
driven to madness by the touch of Shaitan. That is because they claim: "Trading is
no different than usury, but Allah has made trading lawful and usury unlawful. He
who has received the admonition from his Rabb and has mended his way may keep
his previous gains; Allah will be his judge. Those who turn back (repeat this
crime), they shall be the inmates of hellfire wherein they will live for ever.
Sura al-Baqara: 276

‫ار َأثِ ٍيم‬

ٍ َّ‫ت ۗ َوهَّللا ُ اَل ي ُِحبُّ ُك َّل َكف‬ َّ ‫ق هَّللا ُ ال ِّربَا َويُرْ بِي ال‬
ِ ‫ص َدقَا‬ ُ ‫يَ ْم َح‬

Allah has laid His curse on usury and blessed charity to prosper.
Allah does not love any ungrateful sinner.
Sura al-Baqara: 277

‫ت َواَقَا ُموا الص َّٰلوةَ َو ٰاتَ ُوا ال َّز ٰكوةَ لَهُمۡ اَ ۡج ُرهُمۡ ِع ۡن َد َربِّ ِه ۚمۡ​ َواَل‬ ّ ٰ ‫اِ َّن الَّ ِذ ۡي َن ٰا َمنُ ۡوا َو َع ِملُوا ال‬
ِ ‫صلِ ٰح‬
‫ف َعلَ ۡي ِهمۡ َواَل هُمۡ يَ ۡح َزنُ ۡو َن‬
ٌ ‫َخ ۡو‬
Truly the reward of those who believe and do righteous deeds and
establish Prayer and pay Zakah is with their Lord; they have no
reason to entertain any fear or grief.
Sura al-Baqara: 278

َ ‫يَا َأيُّهَا الَّ ِذ‬

َ ِ‫ين آ َمنُوا اتَّقُوا هَّللا َ َو َذرُوا َما بَ ِق َي ِم َن ال ِّربَا ِإ ْن ُك ْنتُ ْم ُمْؤ ِمن‬
‫ين‬

O You who believe! Fear Allah and waive what is still due to you
from usury if you are indeed believers;
Sura al-Baqara: 279

‫ون‬
َ ‫ظ ِل ُم‬ ٍ ْ‫فَِإ ْن لَ ْم تَ ْف َعلُوا فَْأ َذنُوا بِ َحر‬
ْ َ‫ب ِم َن هَّللا ِ َو َرسُو ِل ِه ۖ َوِإ ْن تُ ْبتُ ْم فَلَ ُك ْم ُر ُءوسُ َأ ْم َوا ِل ُك ْم اَل ت‬
َ ‫ظلَ ُم‬
‫ون‬ ْ ُ‫َواَل ت‬

Or war shall be declared against you by Allah and His Rasool. If

you repent, you may retain your principal, causing no loss to
debtor and suffering no loss.
Sura al-Baqara: 280

‫ون‬ َ َ‫ان ُذو ُع ْس َر ٍة فَنَ ِظ َرةٌ ِإلَ ٰى َم ْي َس َر ٍة ۚ َوَأ ْن ت‬

َ ‫ص َّدقُوا َخ ْي ٌر لَ ُك ْم ۖ ِإ ْن ُك ْنتُ ْم تَ ْعلَ ُم‬ َ ‫َوِإ ْن َك‬

If the debtor is in a difficulty, grant him time till it is easy for him
to repay; but if you waive the sum by way of charity it will be
better for you, if you understand it.
Condemnation of Interest in Ahadith
• Narrated by Abu Hurairah: The Prophet (S.A.W) said: “Refrain
from seven deadly things.” The companions asked him: What
are these? He said: “To associate partners with Allah (S.W.T),
sorcery, to kill a soul without valid reason, to devour interest, to
devour the property of the orphan, to flee from the battlefield
and to falsely implicate chaste, innocent, believing women of
vulgarity.”
[Reported in: Bukhari, Muslim, Sunan Abu Dawood, Sunan Nisai]
(continued…)
• Narrated by Jabir bin Abdullah: The Prophet (S.A.W) cursed the
receiver of interest and the payer of interest, the one who
records it and the two witnesses of such agreement. He said:
“They are all alike.”
[Reported in: Muslim, Tirmidhi, Musnad Imam Ahmad]
What is Riba?

• Lexical Meaning: Excess, increase or addition

• Technical Meaning: Any compensation charged on monetary

loan.
Two Types of Riba
• Riba al-Nasee’ah (‫)ربا ا¬¬لنسيئة‬
– Also known as Riba al-Jahiliyya and Riba al-Qur’an
– To charge a specified increase or profit on a specific amount lent for a given period
– E.g. Lending Rs. 100 and demanding Rs. 120 in return

• Riba al-Fadhl (‫)ربا ا¬¬لفضل‬

– Also known as Riba al-Bay‘ and Riba al-Hadith
– Excess taken in the exchange of same type of commodities
– E.g. Exchanging 1 kg of rice with 2 kg of rice
– Applicable in ancient barter trade
What is Finance and What is Islamic Finance?
• Financing is the act of providing monetary funds for business
activities, making purchases or investing.

• Banks are actually financing institutions as they provide

monetary funds to businesses, consumers and investors to help
them achieve their goals.

• In conventional banking system the banks gain profit on the

monetary funds that they provide to the clients which is interest.
Distinguishing Feature of Islamic Finance
• Money is only a medium of exchange therefore no profit can be
earned solely on money.
• Islamic Finance is asset-backed finance.
• Profit can only and only be earned on real transactions which
are based on exchange or transfer of assets or the provision of
services.
• Other laws of sharia should also be taken into account.
Transactions used for Financing in Islam
1) Diminishing Musharaka NOTE:
2) Murabaha (‫)مرا¬بحة‬ (a) All the modes of financing are
asset-backed.
3) Musharaka (‫)مشاركة‬
(b) We will only cover 1) and 2) in
4) Mudharaba (‫)مضاربة‬ this course. You can read the rest on
5) Ijara (‫)ا¬جارة‬ your own from the slides below but
they wont come in exam.
6) Salam (¬‫)س¬¬لم‬
7) Istisna (‫)ا¬ستصناع‬
Diminishing Musharaka Contract
• The bank and the client together buy a house.
• The client pays rent to the bank which is proportional to share of the
bank in the ownership of the house.
• The client gradually buys the share of bank to become the full owner
of the house.
• The rent paid by the client keeps on decreasing corresponding to the
diminishing ownership of the bank.
Example of Diminishing Musharaka contract
• A person ‘A’ has bought a house for 10 million out of which 5 million are
provided by a bank ‘B’.
• A and B are therefore 50-50 % owners in the house.
• ‘A’ can start living in the house and therefore must pay rent, e.g. 10,000 to B
corresponding to the share of B.
• Gradually A buys the bank out by increasing his share. After 1 year A has 75 %
share in the ownership. Now A will pay 5000 as rent.
• In this way A can become the sole owner of the house and will cease to pay the
rent.
Murabaha (‫ )مرا¬بحة‬as a mode of financing
• Murabaha: A sale in which the seller adds his own margin of
profit on the original cost of a commodity.
• Murabaha is a sales contract and is not meant to be used for
financing.
• Islamic banks are now using Murabaha as replacement for
conventional financing mechanisms.
• Usually Islamic banks buy a commodity like car, etc. and sell it
to the client at a higher price for a deferred payment or a
payment in installments.
Example of a Murabaha contract
• A person ‘A’ wants to buy a car worth 1 million.
• A bank ‘B’ can buy the car for 1 million and sell it to A for 1.2
million on installments with mutual agreement.

• Conditions:
– The price can not be increased or decreased after the first agreement as
it will be counted as interest.
– The bank ‘B’ must take ownership and possession of the car before
selling it to the person ‘A’.
Musharaka (‫)مشاركة‬
• A joint business project in which two or more participants invest money and all of
them have a share in profit and loss.

• A bank can become partner to a business project by investing money and therefore
can share the profit and loss.

• Example: A person ‘A’ wants to establish a business and needs 100,000 but has got
only 50,000. So ‘A’ will go to a bank ‘B’ and ask it to become partner in the
business by providing 50,000. So person ‘A’ and bank ‘B’ will both be partners in
profit and loss.
Rules for a Valid Musharaka Contract
• In case of profit or loss, sharing should not be in fixed lump-sum amount. Rather
sharing of profit and loss should be proportional to the actual profit and loss in the
business. So, in the previous example the profit of the bank cannot be set at 10,000
per year.

• Ratio of profit is determined by mutual agreement and may differ from the ratio of
investment. So, in the previous example, the bank may get 10% of profit although
it has invested 50%.

• Ratio of loss should be exactly the same as the ratio of investment. So, in the
previous example, the bank will have to share 50% of the loss.
Mudharaba (‫)مضاربة‬
• A business project in which one participant invests all the money and
another participant manages the business. Both the participants have a
share in the profit.

• A bank can become the investor allowing the client to run the business as
manager. The bank can thus share the profit.

• Example: A person ‘A’ needs 100,000 for a business. The bank ‘B’
provides this amount. The bank will become the investor and ‘A’ will
become the manager of the business. Both ‘A’ and ‘B’ will have a share in
the profit.
Rules for a Valid Mudharaba Contract

• Ratio of profit is determined after mutual agreement. So, in the

previous example they can even agree on 50-50 % share in
profit.

• All loss is sustained by the investor. However if there is clear

evidence of negligence on the part of the manager then he can
be asked to give compensation.
Problems in using Musharaka and Mudharaba in
modern banking system
• Problems:
– The person ‘A’ may not show his profits accurately.
– The banks may not be willing to share the risk of loss.
• Solutions:
– Establishment of strict and fool-proof system of monitoring and checks
and balances along with an efficient system of justice.
– A system of black-listing of clients who continuously report losses.
– Proper assessment of business plan of the client and tracking the
performance of clients.
Ijara (‫ )ا¬جارة‬or Leasing as a mode of financing
• Ijara means:
– Hiring of services of a person in return for monetary compensation.
– Transferring usufruct of a commodity to someone in return for
monetary compensation. This type of ijara is used by Islamic banks as
a mode of financing.

• Example: Person ‘A’ wants to buy a car worth 1 million. Bank

‘B’ buys the car and gives it on lease to A for a monthly rent of
10,000. After 100 months (8 years and 4 months) the bank has
received the cost of the car in rentals. At that time the bank can
sell the car for 200,000 to A.
Salam (¬‫ )س¬¬لم‬as a mode of financing
• Salam: It is a type of sale in which the price of a commodity is
paid in advance and the delivery of the commodity is deferred to
a later date. Mostly farmers use this method of financing.

• Example of salam contract: A farmer ‘A’ wants financing for

growing wheat. He can get 100,000 from the bank with the
promise of deliver 10 tons of wheat to the ownership of the
bank after 6 months. The bank can sell the 10 tons of wheat in
the market for 120,000.
Istisna (‫ )ا¬ستصناع‬as a mode of financing
• Istisna: It is a type of sale in which a manufacturer takes
advance payment to manufacture something for a client and
delivers it later after manufacturing. Mostly industrialists use
this method of financing.

• Example: A factory owner ‘A’ needs financing to manufacture

sports equipment in his factory. He can get 100,000 from the
bank as advance payment to deliver some sports equipment 6
months later. The bank can sell the same equipment for 120,000
in the market.
A general problem facing Islamic Financial
Institutions
• How to make sure that the client will fulfill his promise?

• It can be done by taking something as security from the client.

• It can also be done by involving the law-enforcement agencies

in the agreement.