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Conflict of interest renders contracts ineffective

Fifth of several parts

Abdulazeem Abozaid – Conflict of interest- Abdulazeem Abozaid

In Islam, transactions and property deals are carried out through Sharia compliance known as ‘Ijarah Muntahia Bittamlik,’ and a general investigation of any contract in Islamic banks will prove consistency and full abidance.

However, some apparently valid clauses are added to this contract, leading to the deactivation of some of these basic rules and thus to the negligence and distortion of the Ijarah essence.

One clause relates to the division of lease rental into three elements: fixed, variable and complementary. The problem, however, lies with the complementary rent and to a certain extent with the variable rent. The complementary rent represents any cost the bank as owner has incurred in the past Ijarah period.

The cost includes taxes, insurance and major maintenance expenses. Although these are supposedly the responsibility of the bank as owner, the bank after paying them, claims the same from the client by adding it up to the next Ijarah rental under this clause.

Shifting risk

This paralyses and renders ineffective the basic contract Sharia rules pertaining to the liability of the owner in Ijarah for the property risks.

In fact, this practice of effectively shifting property risks to the lessee is especially critical in the application of Ijarah Muntahia Bittamlik since it brings this financing instrument closer to conventional financing after removing the justification for profiting, which is based on the notion of ‘Al Kharaj bid Daman’ (Liability justifies the Gain).

The core difference between Riba and trade is undertaking risk, which is normally embedded in trade. This risk is eliminated when the bank indirectly shifts the leased property liabilities to the client, and even in case of property partial or total damage, it is the client who bears it, as he is the one who effectively pays the insurance premiums.

Variable element

On the other hand, the problem with the variable element of Ijarah rental relates to the uncertainty this practice involves. Banks tie this element to an interest rate benchmark like LIBOR (London Inter-Bank Offered Rate).

The problem starts when the Islamic banks tend to set and cap only one end of this excessively volatile benchmark, i.e. its floor. However, a ceiling needs also to be set at a certain figure in order to minimize the gharar then involved and thus maintain the validity of the contract.

Unjust practice

Nevertheless, banks tend to only protect themselves from the undesirable movements of the interest rate benchmark by capping the minimum amounts payable by their clients, and they have no desire to cap the maximum amounts payable by their clients.

This practice creates excessive gharar and leads to breaching the Sharia requirement to determine the lease rental in any Ijarah contract, not to mention the injustice involved.

Moreover, the above deviation from Ijarah Muntahia Bittamlik rules manifests itself more blatantly in cases where the asset leased in Ijarah Muntahia Bittamlik has been originated from the same client.

A client needing cash or refinancing will be instructed by the bank to sell to it an asset or a common share thereof, then to lease it back from the bank through Ijarah Muntahia Bittamlik.

The bank frees itself from all asset liability in the manner described above and the client repays with a mark-up on the financed amount in form of rentals.

This transaction has been widely used recently to enable banks to restructure non-performing debts in the wake of the financial crisis.

Neutral effect

Thus, we see how the same clause in one contract can be neutralised by another, leading eventually to the distortion of the contract substance and thus to stripping the contract of its Sharia spirit and objective.

Although Islamic finance has developed Ijarah contract into a new model and helped maintain most Ijarah rules in this innovative instrument, it has however left a room for individual Islamic banks to twist the substance of contract and deprive it of its nature as a lease contract.

Abdulazeem Abozaid is Associate Professor of Islamic Finance Programme at Qatar Foundation, Qatar. The above is the fifth of several parts of the Paper that he presented at the 11th Conference of Western Economic Association International hosted by Victoria University and Massey University at Te Papa Museum, Wellington from January 8 to 11, 2015.

Emails: aabozaid@qfis.edu.qa; abozaid.abdulazeem@gmail.com

 

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