Shari’a Guidelines To Innovation In Sukuk Structure

Sukuk is one of the fastest-growing sectors in Islamic finance and is considered by many as the most innovative product of Islamic finance. The impressive development of the sukuk market has led to innovative combination of contracts and product structures to meet the current needs of business and trade especially in the age of electronic transactions. In practice, sukuk instrument brings about the inevitable combinations of contracts in one single transaction to serve variety needs of investors. This also implies that contracts used in sukuk instruments are likely to be more complicated.

On the back of this, there is an increasing need for a universally acceptable Shari’a guidelines and parameters for combination of contracts or hybrid contracts in sukuk structure, which is instrumental to ensure clarity and consistency in market practices. In Shari’a viewpoint, hybrid contracts are lawful provided that the combination follows Shari’a guidelines and parameters. Increased standardisation has the potential impact of stabilising the global Islamic debt capital market and safeguarding investors’ confidence.

HYBRID CONTRACTS

Most modern contracts are hybrid contracts in which more than one product and/or their basic terms and conditions, are incorporated. As standalone contracts, each component may be permissible. However, its combination in its entirety may have the end result similar to a prohibited contract In principle, Shari’a law does not object to combination of contracts. However, with hybrid contracts, all rights and obligations created when these contracts are combined must be viewed as inseparable obligations and one must apply Shari’a rule to the overall deal emerging from the combination of the contracts. Hence, what is disputed is not the validity of the combined contracts but the nature and form of the outcome of such combination.

There are a number of hybrid contracts that are prohibited in Islamic commercial law such as bay wa salaf (combination of sale and loan) and qard jarra manfa`ah (a loan with added benefit to the lender). The invalidity of bay wa salaf is based on the explicit hadith: “it is impermissible to combine a sale contract with a lending contract” as narrated by al-Tarmizi. The hadith explains clearly that it is illicit to combine a loan contract and sale contract in a single transaction. This is generally understood to mean that it is illegal to stipulate a sale contract in a qard contract. Imam Ibn Taymiyyah prohibits the combination between sale and loan in one transaction due to the contracting parties will benefit from sale instead from loan, unless there is return the loan at the same amount or return the goods at the same specification. An example of a combination of sale and loan occurs when a buyer, willing to purchase US$5,000 worth of wheat may require a seller to lend him US$3,000 in cash, for the transaction to conclude.

PERMISSIBILITY OF HYBRID CONTRACTS

The majority of Muslim scholars allow for hybrid contract as long as there is no evidence that expressly prohibits it in the Quran and by the Sunnah. However, a number of restrictions, parameters and criteria must be followed such as each contract is done separately (uqud mustaqillah) and not binding. Clear guidelines over the combination of contracts, which is expressly prohibited in the hadith is the combination between sale and loan contract in a single transaction.

In general, the Shari’a principle in respect to structure of contracts is that any form of contract structured for sukuk instrument is valid and acceptable in Islamic law unless explicitly prohibited and proclaimed as forbidden. The combination of contracts will be permissible if the subject matter, the price, and the time of transaction are known and clear to the contracting parties. If one of these elements are not clear, the contract becomes unlawful. However, there are certain types of contracts that cannot be combined. In such cases, any structure that involves such a combination becomes unacceptable.

THE COMBINATION MUST NOT CONTRADICT AN EXPLICIT TEXT

Ibn Qayyim argued that the Prophet (pbuh) forbids combination of contracts between contract of sale and loan (qard), even though each contract exists independently from one another. The prohibition of combining the contract of salaf (loan contract) and sale in the contract is to avoid the forbidden riba. This argument is strengthened by Hammad, who argued that any product in Islamic banking and finance structured on the basis of hybrid contract is unacceptable in Islamic law if it contradicts with an explicit source.

For example, it is unlawful in Shari’a to disburse loan to an investor and at the same time sells a particular asset to the investor. This transaction falls under the category of combining loan contract with sale in order to accrue benefit.  Therefore, it can be concluded that all combined contracts that contain any sales element is prohibited to be combined with qard contract in a single transaction. These include ijara contract with qard contract and salam contract with qard contract.

THE COMBINATION MUST NOT ATTEMPT TO CIRCUMVENT A PROHIBITION

Majority of Muslim scholars agreed that any product that is structured on the basis of a combination of contracts, which is intended to circumvent the unlawful transaction such as riba, gharar, and maysir is unacceptable. Such transactions are called hilah or manipulation to legalise riba, where in fact there is no real transaction done in the contract. In the case of bai’ ‘ina, for example, there is a combination of contract between deferred payments with cash payment, which leads to riba. Normally, this involves someone selling something with credit, with the condition that the buyer shall sell it back in cash at a lower price.

AAOIFI (No. 25/2008) laid down four Shari’a restrictions in combining contracts. The first is to combine sales with lending, or combining two sales in one deal, or combining two transactions in one transaction. Second, it is the prohibited to combine contract as a trick for practicing riba based on the directive of the Prophet (pbuh), which indicates the prohibition of bai’ ‘ina and riba fadhl. The Prophet disapproved of any transaction that is conditional upon another transaction. Contracts must exist independently from one another and cannot conceal a “hidden purpose” behind the contract.

Thirdly, it is prohibited to use the combination of contracts as an excuse for dealing in riba, based on the hadith of the Prophet which forbids combining lending with selling. The fourth restriction states that the combination of contracts should not contradict each other in terms of purpose or Shari’a rulings. Hence, contracts that are mutually contradicting cannot be combined.

COMBINATION OF CONTRACTS AS HILAH RIBAWI

Generally, the contemporary hybrid contracts that is commonly used by Islamic financial institutions as hilah ribawi occurs through the contracts of bai’ ‘ina and organised tawarruq when used as a backdoor to legalise riba. The below points highlight the combination of contracts that is commonly used for such instances.

A credit purchase of an asset which is later sold to the original owner or third party, either on cash or deferred, higher or lower than the original contract, or for an exchange of goods

Bai’ ‘ina

The contract of bai’‘ina is seen as something similar to riba-based financing by the majority of Islamic jurists. According to Imam Shafi’i, bai’ ‘ina is “a credit purchase of an asset which is later sold to the original owner or third party, either on cash or deferred, higher or lower than the original contract, or for an exchange of goods.” The contract involves loans and the difference between the two prices is considered as interest. Such contract is forbidden because a loan for interest is equivalent to usury or riba. Drawing upon the views of Imam Shafi’i, Maliki and Hanbali, bai’ ‘ina is said to be an illegal device to overcome the prohibition of riba and is not deemed to be an act of sale, as there is clear evidence that such act amounts, in effect, to a contract of loan.6 Practices of bai’ ‘ina in sukuk structure is normally to finance obligor who needs cash to finance their overhead expenses or to pay debt. In the ‘ina sukuk structure, the obligor will use a particular asset as the underlying sukuk asset. The obligor promises to purchase the sukuk asset more than the original price. The ownership of the underlying asset is not actually transferred to the investors, which means that investors do not own the sukuk asset. Similarly, reverse ‘ina is also forbidden as it tantamount to hilah (trick) to practice riba. Here, the buyer undertakes to buy a commodity at a spot price and then resell it to the former owner (from whom he has just bought the commodity) for a higher price on a deferred payment basis.

Organised Tawarruq

The term tawarruq refers to the purchase of an asset on deferred payment to a third party (other than the original seller) in cash; whereby the deferred price would be higher than the cash price. AAOIFI (No. 30/2008) defines tawarruq as “The process of purchasing a commodity for a deferred price determined through muswamah (bargaining) or murabaha (mark-up sale), and selling it to a third party for a spot price so as to obtain cash.” Majority of jurists forbid bai’ ‘ina and allow tawarruq except for Ibn Taymiyyah and Ibn al-Qayyim.

The OIC Islamic Fiqh Academy in its 15th session in September 1998 (Rajab 1419H) permitted tawarruq subject to the condition that the customer does not sell the commodity to its original seller so as to avoid bai’ ‘ina. However, in December 2003 during the 17th session, the Academy distinguishes and classifies between permissible (tawarruq hakiki or real tawarruq) and the forbidden tawarruq (tawarruq munazzam or organised tawarruq). The latter, which is widely practiced by Islamic banks, is deemed to be synthetic and fictitious as it resembles bai’ ‘ina and hence frowned upon as a form of hilah. In April 2009, at its 19th session the Academy prohibited the application of organised tawarruq transaction between sukuk issuer and investor as it is considered as a deception and resembles bai’ ‘ina.

Similarly, AAOIFI’s standard on tawarruq does not approve the fictitious trade transactions with cosmetic involvement of any third party. Nonetheless, AAOIFI’s Standard No. 30/2008 allows tawarruq transaction on certain parameters as follows:

1. The requirements of the contract for purchasing the commodity on deferred payment should be fulfilled where the commodity is real.
2. The commodity should be well-identified to distinct it from other assets.
3. If the commodity is not available at the time of contract, the customer should be given a full description over the commodity such as the quantity and the place.
4. The commodity should actually be received by the customer.
5. The commodity must be sold to a party other than the original seller to avoid bai’ ‘ina.
6. The contract for purchasing the commodity on deferred payment and the contract for selling it for a spot price should not be linked together in such a way that the client losses his right to receive the commodity.
7. The customer should not delegate the Islamic bank or its agent to sell the commodity on his behalf after he actually receives the commodity.
8. The Islamic bank should not arrange proxy to a third party to sell on behalf of the customer.
9. The customer should sell the commodity by himself.
10. The Islamic bank should provide the information to the customer where to sell the commodity.

SHARI’A PARAMETERS FOR COMBINATION OF CONTRACTS IN SUKUK STRUCTURE

In general, the amalgamation of several contracts in one transaction is a permissible structure. This legality however, is circumscribed with certain parameters, criteria and conditions that need to be followed. The discussion on parameters, criteria, restrictions and conditions of combination of contracts in Shari’a for sukuk structure are highlighted in the following discussion.

The validity of combination of contracts for the purpose of the development of sukuk instruments is required to structure sukuk in a way that does not conflict with an explicit source. Shari’a parameters or restrictions on the use of hybrid contracts have been applied by international Shari’a standard-setting bodies such as AAOIFI. AAOIFI in 2007 and 2008 provided resolution No. 25 that says that the entire hybrid contract agreement is permissible provided that the contract should be separated from one another and each contract is permissible on its own, with the exception of the combination of sale and loan contract. AAOIFI then laid down the regulations and Shari’a parameters governing hybrid contracts as follows:

1. The combination of contract agreements may not incorporate with the contract that has been clearly prohibited in Shari’a such as combination between of sale and loan in one transaction.
2. The combination of contract agreement may not be used as a trick or hilah to justify riba such as those in sale contracts and buy-back agreement between two parties (bai’ ‘ina) or riba fadl. 
3. The combination of contract agreement may not be used as a tool for riba such as creditor lends money in order to obtain a gift from a debtor or provides other benefits such as providing a ride or offering accommodation in his house.
4. The combination of contract agreement must not contradict the essence of the contract. For example, in mudaraba contract, there should be no profit guarantee using hibah agreement in the first place or a combination between currency exchange with ju’alah contract, or bay al-salam with ju’alah for the same contract value or leasing with selling.

The Shariah Advisory Council Kuwait Finance House during their meeting No. 23/2006 on September 19, 2006 in Kuwait, when evaluating Ijara Rental Swap based on unilateral binding promise contract in the musawamah transaction and tawarruq, laid down four main conditions needed for the product to comply with Shari’a.9 The conditions are:

1. Contract agreements in the transaction must be real, and not a fictitious contract.

2. Any contract that is being transacted has its own contractual effects. For example, once a sale contract has been transacted it has to transfer ownership of the asset from the seller to the buyer.

3. Contract agreements are separated.

4. Contract agreements are not conditional upon one another.

Pertaining to the Shari’a parameters, Vihajat (2012) augments several parameters for the transaction to comply with Shari’a rules and principles. These are:

1. The subject matter that is going to be transacted has to be real, not a fictitious asset, which will lead to dispute in the future.

2. The subject matter that is being transacted can be delivered to the buyer if the buyer wishes. This condition is to ensure the availability of the transacted subject matter.

3. The price of the subject matter has to be based on the market price, with no manipulation in terms of the price.

4. The place of the subject matter should be known among the parties.

5. The subject matter that is being transacted is halal according to Shari’a as stated in fatwa DSN -Iv U I No. 82 2011 concerning in endorsing the product of Commodity Syariah for the Islamic Money Market.

6. The objective of the transaction is for real sale and not for short-selling purposes.

7. The subject matter must be ready for use.

CONCLUSION

 As the sukuk market matures and becomes increasingly relevant to global investors, we have witnessed innovation in terms of sukuk structures with more and more innovative structures in the form of hybrid contracts. Hence, making it imperative to have globally recognized Shari’a parameters on hybrid contracts so as to ensure further development of the sukuk market. Here, the understanding of fiqh in commercial transaction to meet the challenges of growth that may further strengthen Islamic finance industry is a must toward exploring various effective sukuk issuance.