This article is the third (of four) addressing Shari`ah-compliant home financing products. It considers murabaha and tawarruq structures. These structures predominate in many areas of the world and their use has been increasing in recent years, particularly since the onset of the global financial crisis in 2007-2008. They are discussed in some detail because of their widespread use in other Shari`ah-compliant products.
Murabaha Definition and Principles
Bayu al-murabaha is a sale of venerable lineage under the Shari`ah; it is acceptable to all four of the main orthodox Sunni madhhahib. As originally conceived, it is a trade-based, “cost-plus” sale contract in which the cost is ascertained and expressly disclosed and has nothing to do with financing. Current conceptions are focused on financing transactions.
The murabaha, in any context, is a sale, and must conform to Sharī’ah requirements applicable to sales. It is essential to begin with some fundamental sales principles, including some specific to the murabaha. The following are general principles and may be subject to limited exceptions in different contexts.
Each of the object of the sale (mabi) and the price must be in existence, with certainty, have a determinable value, and be deliverable at the time of the contract and, absent certain destruction scenarios, at the time of the sale. The mabi must be precisely identified and not a haram object. A condition for conclusion of a sale is that the sale object be a valued good with legitimate uses. Valid consummation of the sale requires that the mabi be in the seller’s possession. A sale contract that does not name the price is defective and invalid (fasid); not naming the object of sale voids the contract. If the mabi perishes prior to delivery, the sale is void, which is not true of perishing of the price prior to delivery. The buyer must deliver the price before he, she or it has a right to receive the object of sale, unless the seller otherwise agrees.
The object must be in the actual or constructive possession of the seller (the initial buyer) at the time of the sale. Constructive possession here means that the seller has assumed all liabilities and obligations of ownership and possession, including in respect of destruction or “perishing”, even though the seller has not taken physical delivery of the object. The mabi must be deliverable at the conclusion of the sale. Delivery of the object must be certain and not contingent or dependent upon conditions, events or circumstances.
The sale must be immediate and not contingent on future conditions, events or circumstances. If not immediate, or if contingent, it is void as a present sale and will have to be renewed and reaffirmed at the specified future date or upon the occurrence of the contingency. Certain “customary trade usage” conditions are permissible (e.g., the validity of a warranty), and these should be determined with the advising Sharī’ah scholar.
The murabaha is a trust or fiduciary sale (bay al-amanah) requiring disclosure. Disclosure begins with the initial costs, but extends to all essential transactional elements. Disclosure to the second buyer of the cost to the first buyer/seller entails consideration of what constitutes the “cost” to the first buyer (i.e., initial cost), and thus what must be disclosed. This determination is important in ascertaining what is entitled to earn a profit. Certain normal costs and expenses associated with the object of sale which result in an increase in the value of the object or are “effective in the essence” of the object (such as tailoring or dyeing) may be included as part of the “cost”, even if not determinable at inception. Other includable expenses include non-recurring expenses incurred by the first buyer in effecting the transaction (e.g., freight and transportation charges, customs duties, sales intermediation fees, costs and expenses, feeding costs, and other normal and customary transactional costs). Recurring business costs and expenses of the seller are not permissible additions to the sale price (e.g., employee salaries, premises rent, normal storage and warehousing, veterinarian's costs, and the fees of herdsmen). Disclosure of the initial cost must include disclosure of any financing and deferred payment arrangements pertaining to the object or its initial purchase. Consultation with the advising Sharī’ah scholar is advisable in connection with determinations as to expenses which may be included.
If the object of the sale suffers damage or defect while in the possession or under the control of the first buyer (seller) or a third party, the damage or defect must be disclosed to the second buyer. If the mabi is increased whilst in the possession or control of the first buyer (seller) (such as by giving birth, creating milk, bearing fruit or growing wool), the sale may proceed, but only after disclosure of the increase. If the mabi was purchased by the first buyer (seller) in exchange for a debt owed by the initial third-party seller to the first buyer, that information need not be disclosed to the second buyer. However, if the mabi was accepted as compensation for an unpaid loan, then it may not be sold in a murabaha to the second buyer at a cost equal to the amount of the unpaid loan (this is a debt forgiveness arrangement rather than a negotiated sale).
Inability to determine the initial price, or unwillingness to fully disclose that price, voids the sale as a murabaha.
The profit may be a lump sum or a percentage. It may be higher if the date of payment is more distant: consideration of time in establishing price is permissible. The price need not reflect the current, or any future, market price. It may be different for cash and credit transactions, reflecting different risk assessments relating to each. One of the options must be chosen at inception, and the price then fixed.
Different prices for different maturities or payment dates, leaving an option to the second purchaser as to election, are impermissible. The due date for payment also must also be unambiguously fixed and determinable at inception. It is acceptable to make reference to a specific date or a specific period, but the date may not be fixed by reference to an unknown or uncertain event. In deferred payment transactions (bay mujajjal), including most murabaha financing transactions, additional rules apply.
Many Shari`ah scholars allow for late payment and default payment charges of some type. These are of two types: actual fees, costs and expenses (actual damages) of the seller resulting from late payment or default, which may be retained by the seller; and penalty charges, which may not be retained by the seller, but must be donated to charity. The latter, where permitted, are allowed as incentives for timely payment by the second buyer.
Acceleration of the entire purchase price upon a default is generally permissible. Collateral security for the payment and performance obligations is acceptable.
For a sale to be binding on both parties, there must not exist any options that allow one of the parties to void the contract. Examples of such options include options by condition (khiyār al-sharṭ), description (waṣf), price payment (naqd), identification (tayīn), inspection (ruya), defect (ayb) and deception (ghubn maa al-taghrīr).
Delivery and receipt of each of the mabi and the price are critical elements of a valid sale. Receipt, and thus possession, by the purchaser may be established in various ways. If the purchaser is provided full access and permission (al-takhliya) to the mabi, delivery and receipt will have occurred. Delivery and receipt also will have occurred if the purchaser shall have damaged the mabi while it is in the seller’s possession, as the precondition to such infliction of damage is the ability to affect the mabi and the related implication of access and permission. Similarly, delivery and receipt are concluded if the mabi suffers spoilage or a defect caused by the purchaser while the mabi is in the possession of the seller. Should the purchaser, or a third party at the suggestion or direction of a purchaser, take possession of the mabi for safekeeping or as a loan during the pendency of the sale contract, delivery and receipt will be presumed. There are differences of opinion among Shari’ah scholars as to whether delivery and receipt have been concluded in circumstances where the purchaser prosecutes a third party for damages or compensation caused by transgressions or acts or omissions of that third party.
Murabaha Home Financings
The financing of the purchase of a Property (a house and related land interests) is illustrated in FIGURE 1. This discussion of a pure murabaha transaction is illustrative only; it is never used in practice as a result of a wide range of bank regulatory, tax, real estate and other reasons.
The Purchaser desires to purchase a Property. The Purchaser requests the Bank to engage in a murabaha transaction pursuant to which the Bank purchases the Property from the Seller on a cash, spot-payment basis at an amount equal to the “Spot Cash Amount” and then immediately sells that Property to the Purchaser, on a deferred payment basis, at an amount equal to the sum of the Spot Cash Amount plus a Profit Amount. The Profit Amount may be at a variable or fixed rate. It is approximately equal to the interest rate used for conventional interest-based home loan mortgage financings on equivalent properties. Similarly, the payment structure often mimics that of a conventional interest-based home loan mortgage financing.
The Bank and the Purchaser execute the Murabaha Agreement (step 1) that governs the series of transactions, including the Property purchase by the Bank and the Property sale by the Bank to the Purchaser. The Murabaha Agreement contains customary financing provisions, such as conditions precedent to the Property purchase by the Bank, the Purchaser’s promise to purchase the Property from the Bank if the Bank purchases the Property, the Purchaser’s representations, warranties and covenants, the deferred payment terms pursuant to which the Purchaser will pay the Bank, events of default, remedies and other provisions. The Purchaser’s obligations pursuant to the Murabaha Agreement, including payment obligations, are secured by a first mortgage in favor of the Bank (and possibly other pledges, security interests and guarantees) (step 7). Title to, and ownership of, the Property is in the Purchaser from the time of the initial transfer of possession pursuant to the Murabaha Agreement.
The Purchaser negotiates the Property Purchase Contract with the Seller (step 2), but does not execute that contract. Instead, upon Bank approval of the Property Purchase Contract, the Bank executes the Property Purchase Contract (step 3) and purchases the Property pursuant to that Contract (steps 4 and 5) for a purchase price equal to the financed amount (the Spot Cash Amount) plus an equity contribution from the Purchaser. Thereafter, the Bank sells the Property to the Purchaser pursuant to the Murabaha Agreement (step 6). The Purchaser makes periodic deferred payments (step 8) of the financed amount, as set forth in the Murabaha Agreement.
Tawarruq Home Financings
The term “tawarruq” derives from tawarraqa, meaning “to eat leaves”. The term “wariq” refers to dirhams of silver (minted and unminted). The term tawarruq therefore referred, historically, to the seeking of silver money; it now refers to the seeking of paper money or money generally – to monetization. In the Islamic finance and investment realm, the term generally includes the concept of a person buying a commodity (other than gold, silver and other prohibited commodities) on a deferred payment basis and thereafter selling it to a third person for immediate cash. The purposes of the transaction are monetization of the commodity and acquisition of the cash.
There is a distinction between “organized” tawarruq (al-tawarruq al-munazzam) and unorganized or individual tawarruq (al-tawarruq al-farid). In organized tawarruq, the seller manages the process by which cash is acquired for the monetization beneficiary or mutawariq. The seller (a bank in a banking tawarruq), acting as an intermediary or agent, sells a commodity to the mutawariq on a delayed payment basis and then sells or arranges for the sale of the commodity on behalf of the mutawariq for an immediate cash payment. In an unorganized tawarruq that seller has no role in assisting the mutawariq in selling the commodity.
The permissibility of organized tawarruq is strenuously debated. Various tawarruq structures, including organized tawarruq structures, are widely used in the Islamic finance and investment industry, including in connection with home purchase financings transactions. The Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”), in the AAOIFI Monetization Standard, has provided parameters to ensure the appropriate implementation of organized tawarruq transactions. In addition to requirements pertaining to the nature of the commodity, its receipt by the mutawariq, and its sale by the mutawariq to a third party, the AAOIFI Monetization Standard:
- prohibits a linkage between the contract for the mutawariq’s purchase of the commodity on a deferred basis and the contract for the sale of the commodity by the mutawariq to a third party;
- prohibits the entity that sells the commodity to the mutawariq on a deferred payment basis from acting as, or arranging for, the sales agent for the mutawariq in its cash sale to a third party, unless required by law; and
- requires the mutawariq itself to sell the commodity it acquired on a deferred payment basis or to sell that commodity through an agent other than the entity that sold the commodity to the mutawariq on a deferred payment basis.
FIGURE 2 illustrates the use of a tawarruq structure to provide funds to the Purchaser to enable the Purchaser to purchase the Property.
The Purchaser (Mutawariq) requests the Bank to engage in a murabaha transaction to provide the Purchaser (Mutawariq) with cash to enable the Purchaser (Mutawariq) to purchase the Property. The Bank does not itself purchase the Property and sell it to the Purchaser. Instead, the Bank purchases a commodity – usually a permissible metal or palm oil – at the Spot Cash Amount and sells that commodity to the Purchaser on a deferred basis at an amount equal to the sum of the Spot Cash Amount plus the Profit Amount. Arrangements are made to enable the Purchaser to immediately sell that commodity, for cash on the spot market at the Spot Cash Amount, in order to obtain the cash to be used to purchase the Property. Frequently, this is structured as an organized tawarruq. The Profit Amount is a variable or fixed rate that is approximately equal to the interest rate used for conventional interest-based home loan mortgage financings on equivalent properties. Similarly, the payment structure often mimics that of a conventional interest-based home loan mortgage financing. In any event, it is clear that the commodity is a vector to arrange for the Purchaser (Mutawariq) to obtain cash; obtaining the commodity is not the substantive object of the transaction.
The Bank and the Purchaser (Mutawariq) execute the Murabaha Agreement (step 1) that governs the series of transactions, including the purchase of the commodity by the Bank and the sale of that commodity by the Bank to the Purchaser (Mutawariq). The Murabaha Agreement contains customary financing provisions, such as conditions precedent to the purchase of the commodity by the Bank, the promise of the Purchaser (Mutawariq) to purchase the commodity from the Bank if the Bank purchases the commodity from the Seller, the representations, warranties and covenants of the Purchaser (Mutawariq), the deferred payment terms pursuant to which the Purchaser (Mutawariq) will pay the Bank, events of default, remedies and other provisions. It also contains covenants and conditions precedent to ensure that the proceeds of the tawarruq transaction are used to purchase the Property and mortgage that property to the Bank to secure the deferred payment obligation under the Murabaha Agreement. The obligations of the Purchaser (Mutawariq) pursuant to the Murabaha Agreement, including payment obligations, are secured by a first mortgage on the Property in favor of the Bank (and may be secured by other pledges, security interests and guarantees) (step 6). Title to, and ownership of, the Property will be in the Purchaser (Mutawariq) pursuant to a direct sale from the Property Seller (rather than pursuant to a transfer of possession pursuant to the Murabaha Agreement).
The contracts for the purchase of the Metal by the Bank from the Commodity Seller and the sale of the Metal by the Purchaser (Mutawariq) to the Commodity Purchaser are standardized commodity purchase and sale contracts, rather than individually negotiated contracts. This emphasizes the fact that the commodity is a vector in this series of transactions, rather than the substantive object of the transactions. These contracts are not shown in Figure 2.
The Purchaser (Mutawariq) negotiates and executes a Property Purchase Contract with the Property Seller (step 2). The Bank approves, but does not execute, the Property Purchase Contract.
The Bank purchases the commodity (i.e., the Metal) from the Commodity Seller (steps 3 and 4) on a cash spot purchase basis. The amount of Metal purchased equals the amount of financing desired by the Purchaser (Mutawariq) in respect of the Property purchase. The Bank then immediately sells the Metal to the Purchaser (Mutawariq) on a deferred payment basis (step 11). The deferred payment terms are set forth in the Murabaha Agreement and are comparable to the terms of a conventional interest-based home purchase financing. The deferred payment obligation of the Purchaser (Mutawariq) is secured by a mortgage on the Property. Immediately after purchasing the Metal, the Purchaser (Mutawariq), or an agent on its behalf, sells the Metal to the Commodity Buyer on a cash spot market basis (steps 7 and 8).
The Purchaser (Mutawariq) now has sufficient cash to purchase the Property from the Property Seller. That is, it has cash equal to the amount financed (the Spot Cash Payment amount) plus the amount of equity contributed by the Purchaser (Mutawariq). The Purchaser (Mutawariq) purchases the Property from the Property Seller (steps 9 and 10) pursuant to the Property Purchase Contract.
The financed amount is repaid to the Bank over time as deferred payments in respect of the commodity murabaha for the Metal (step 11).
The next article will continue the discussion of Shari`ah-compliant home purchase financing products. It will address home purchase financings and will address bay bithaman ajil structures and istisnaa – parallel istisnaa structures.
As the Sultanate of Oman prepares to roll out its new legal and regulatory framework for Islamic banking in the coming months, we will be covering Islamic banking in the Client Alert as it is an important and growing field. This article is the fourth in a series by Curtis partner Michael J.T. McMillen, an Islamic finance specialist based in our New York office who provides support to our Islamic banking practice in Oman and throughout the Middle East region.