Islamic finance has suffered from accusations that its products and services are too similar to conventional offerings. APNIZAN ABDULLAH discusses how courts can contribute to the purity of the Shariah compliant offering by upholding substance (or intention) over form in court rulings.
The very reason for having a banking institution as an intermediary is to facilitate economic activities of society. Islamic financial institutions (IFIs) are no exception. While providing society with an alternative to the interest-based banking activities offered by their conventional counterpart, IFIs are still profit-making entities. To be competitive in the financial market, most of the products and services offered by IFIs generally seem to be more or less similar to its conventional counterparts, and it has been argued that Islamic financial products have failed to position themselves as different from conventional products and services.
The probable reason might be the attitude of IFIs, which tends to be risk averse, as is the case with conventional bankers. When IFIs choose to imitate conventional banking with slight modifications to suit Shariah, the notion of prohibition of Riba and the promotion of profit-making through trading and profit and loss sharing seem to be left behind as profit maximization requires them to carry on business for huge profit and minimum risk.
It is true that Islam does not prohibit profit making and risk mitigation. However, in realizing risk mitigation efforts, IFIs might be driven to craft products and services that minimize risk through, for example, debt or equity-based instruments or contracts. As debt is highly associated with Riba in conventional banking, the products and services are financially engineered with the involvement of instruments or contracts that become more complex. The innovation exercises could contribute to the complexity of documentations of the Islamic financial contracts. However complex the documents, instruments or contracts are, the nucleus of determination at the end of the day is the intention of the signatories of the contracts.
The essentials of Niyyah (intention) in Islamic financial contracts
Intention is the pivotal root of any contract entered into. Due to that, Islam vehemently emphasizes the importance of Niyyah, or intention, in every single deed a man does, including in Muamalat transactions. The holy prophet was reported to say that: “The reward of deeds depends upon the intention and every person will get the reward according to what he has intended.”
Similarly, it is trite that under the common law principles, intention is the key point of a contract. Hence, a contract is judged based on what is intended by the contracting parties. Labelling is immaterial, as in the case of L Schuler AG v Wickman Machine Tool Sales [1974] AC 235. In this case, the court stated that the court would look only into the intention of the parties regardless of what has been named in the contract. Intention on the other hand, is manifested by the written terms of the contract or from the circumstances of the case if there is no document to prove such intention. Thus, in a contract, if the intention of the contracting parties is A, but it is labelled as B in the contract documents, the court will adjudicate based on A not B. Hence both Islamic law and common law recognize the importance of intention in determining duties, rights and obligations of the parties involved especially in human transactions. This is a common ground between the two distinct legal systems.
Substance over form
It is worth noting that conventional finance has undergone many hundreds of years of evolution to stand on its current stage. With that vast experience, it is still evolving in parallel with the times, people and market changes. ‘Modern’ Islamic finance on the other hand, is still at infancy stage where it evolves according its paths and flows before it reaches a point of stability. Any shortcomings arising from this circle are expected. Both legal systems agree that Niyyah or intention of the parties is an important element to a contract or transaction. As Islamic financial products are supposed to be crafted distinctively according to the types of transaction the parties agree upon, the intention is the key point to be observed to distinguish the rights and liabilities arising from different types of contract. For instance, if an IFI chooses Mudharabah as the underlying contract between itself and the customer, the contract must portray the profit sharing aspect. If it is under the basis of Murabahah, it has to be a trade transaction. It is important that IFIs truly adopt the features of each contract according to its underlying concept.
What is seen in the market today is something else. Islamic financial products have been crafted mainly on debt-based contracts and named with various Arabic names, for instance Bay’ Bithaman Ajil, Inah, Murabahah, Mudharabah, Musharakah etc. By looking at the names, they connote product differentiation that should have been the selling points for Islamic products. Many studies have found however that Islamic finance has not reached its goal in positioning itself as distinctive from its conventional counterpart, and its products tend to mimic the conventional. It is contended that the rapid growth of Islamic finance is not due to its attributes and theoretical advantages but most likely spurred by the worldwide Islamic resurgence from the late 1960s until today that is closely associated with the increasing demand from Muslims worldwide for Shariah compliant financial products. Much research agrees that most of the Islamic financial products are debt-based and hence do not resemble the original concepts in term of underlying contracts.
There must be a reason for this dilemma. Is it due to the lack of competitiveness of the Islamic financial products? Or is the Islamic financial system still too immature? Or is it caused by the attitude of its players who are risk averse and greedy? One may argue that the scenario occurs due to Islamic finance products that tend to essentially replicate the conventional financial system. Or one may question the competency of the mandated players in crafting and drafting the products. The innovation process might contribute to the complexity of products and the documentation involved. In fact, there is a signal of increasing market understanding on the flows and movements of Islamic financial products and services. When the contracts become more complex and complicated, the climax of its peril is when there is a dispute between the parties involved.
Malaysian and international cases: How do the courts respond?
Close examination of reported cases in Malaysia and some other international cases reveals that in determining the disputes, the court essentially looked into the intention of the parties.
Domestic cases in Malaysia such as Dato’ Haji Nik Mahmud bin Daud v Bank Islam Malaysia [1998] 3 MLJ 393; Arab-Malaysian Merchant Bank v Silver Concept [2006] 8 CLJ 9; Bank Islam Malaysia V Pasaraya Peladang [2004] 1 LNS 280; Affin Bank v Zulkifli Abdullah [2006] 1 CLJ 438 and some other recent cases prove that the courts took the approach of looking into the intention of the parties at the time the contracts were made rather than the names or labels used in the contracts.
The substance of the contract over its forms paradigm has led the judges to arrive at different decisions. To illustrate this scenario, in the case of Dato’ Haji Nik Mahmud bin Daud v Bank Islam Malaysia [1998] 3 MLJ 393 for instance, the court analyzed the nature of the contract and held the BBA contract as valid and not in infringement of any provisions of state land enactment. In the case of Affin Bank v Zulkifli Abdullah [2006] 1 CLJ 438, the judge used the same approach and decided that the BBA contract was tainted with an element of Riba, and as such it contradicted with the Shariah law and principles. This case startled the Malaysian market and invited market chaos.
Similarly, at the international level the landmark case of Beximco Pharmaceutical v Shamil Bank of Bahrain E.C [2004] EWCA Civ 19 and the case IICG v Symphony Gems also proved to the world that the court took the same approach. The worst was, these two cases rejected the application of Shariah principles in determining the rights and liabilities of the parties and upheld that the matters were to be governed by the English law. Bearing in mind that Shariah stands on Tawhidic paths that are entirely different from the English law that is based on human reasoning, the court was nonetheless of the opinion that English law was the governing law for the dispute settlement. That was where intention played its important role, which eventually led the courts to decide on its basis.
Compared to the international treatment as mentioned above, the Malaysian courts seem to be gentler in determining Islamic financial disputes locally. The fact that the judges are mostly Muslims might have had a favorable impact on dispute resolution in favor of Shariah principles even though most of them are English-trained. Another bonus for Malaysia in this context is that the Malaysian court has allocated a special division, called the Muamalah division, for Islamic finance dispute settlement, although this is sadly available only at the High Court of Kuala Lumpur.
But still, looking at Islamic finance in the next 10-20 years, these cases (whether national or international) have prompted Islamic finance players to become more aware of the market changes and innovative processes involved along the way as Islamic finance progresses.
The rapid development nationally and internationally due to globalization has urged market players to look into this matter seriously. As the jurisdictional issues are still unsettled for Islamic finance disputes, international cases have alarmed all the stakeholders and market players in the sphere of Islamic finance and raised the importance of shifting to a substance over form paradigm rather than form over substance.
Studies and research undertakings are essential to spot any loopholes in the Islamic economic eco-system. Prior research has pointed out that Islamic financial products only look different based on their names. Their substances remain as debt-based instruments or contracts. This proves that the Islamic financial system has failed to promote the true concept of trading and profit and loss sharing, including other types of instruments or concepts that support the two main concepts.
Islamic financial products and their documentation must be crafted, drafted and documented based on these concepts. With regard to the importance of innovation in the progress of Islamic finance, innovation must be made in line and in good terms with this principle.
This is all due to the common ground of Shariah and English law or other civil laws that prevail the intention of the parties over the contracts’ names or labels. It is hoped that by adopting the substance over form paradigm, the Islamic finance industry will be both prosperous and successful in positioning itself as distinctive to its conventional counterparts.
Apnizan Abdullah is a researcher at International Shariah Research Academy for Islamic Finance. She can be contacted at
[email protected]
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