Conventional corporate finance requires the managers of a firm to manage the financial and other aspects of the business in a manner that increases the market value of the firm and therefore the value of a shareholder’s investment in the firm.[1] Apart from a few legal rules regarding wrongful trading and insolvency law, managers’ choices are not constrained by any other moral or ethical rules relating to the financing of their projects or investment of the firm’s funds. In contrast, Islamic finance is constrained by various mandatory ethical and moral standards. Therefore, managers of corporations will be required to avoid transactions which involve Riba (interest or usury), gambling, hoarding, dealing with unlawful (under Islamic law) goods and services, short sales and speculative transactions.[2]
In the following sections, a brief discussion of two features, which involve negative actions, i.e. the principle of avoiding usury/interest and the principle of avoiding Gharar/speculation will be provided, followed by a complete section dedicated to analysing the most significant features of Islamic finance, i.e. risk-sharing and asset-backed finance.
Avoiding Usury or Interest
In Islamic finance, a loan transaction is not an investment and therefore lender cannot expect to derive profits from such transactions. A lender has a claim only to the full principal amount that he had lent, but nothing else. Similarly, when exchanging money for money of the same currency/denomination, they will have to be equal and hand to hand. This is because any difference will result in Riba (usury) and any delay may lead to an increase or decrease in the value of any or both, which will also amount to Riba. Therefore, charging interest on receivables or other financial instruments is “alien” to Islamic banking and finance, whereas trading with real assets is encouraged and required.[3]
The rationale[4] behind the prohibition of Riba is argued to ensure an equitable and just distribution of wealth and prevent exploitation of vulnerable people through unfair exchanges. It is, therefore, also prohibited to bypass this prohibition through introducing mechanisms or financial devices that enable the entrance of Riba in a transaction by back doors, as it is enshrined in Shariah that anything that leads to committing of an unlawful act is also unlawful. For example, deceiving an inexperienced and naive trader or rigging the prices in an auction through the help of agents have also been labelled as Riba. In summary, the purpose of prohibiting Riba in Shariah is to stop people earning “black money” that has been derived from injustice to, or exploitation of, others.[5]
Avoiding Gharar or Speculation
The principle of avoiding Gharar in Islamic Finance deals with the problem of excessive risk-taking and uncertain transactions. Gharar is a concept that refers to entering into a contract which involves absolute risk or uncertainty about the ultimate result of the contract. This may be as a result of uncertainty regarding the nature or quality and specifications of the subject matter, price of the subject-matter or the rights and obligations of the parties.[6]
Gharar is also involved if a sale takes place before the subject-matter comes into existence. Other types of sales that involve Gharar are: two sales in one, down payment (‘Arbun) sale, suspended sales and future sales.[7] In order to prevent the element of Gharar in a sale contract, the following three situations have been prohibited under Islamic law:
- to sell a thing that does not exist at the time of sale;
- to sell a thing that is not in the actual or constructive possession of the seller; and
- to sell a thing on the basis of uncertain payment or delivery.[8]
An offshoot of the principle of avoiding Gharar is to avoid gambling and games of chance. Thus, IFIs cannot deploy instruments like prize bonds or lotteries in which coupons are given and inducement or incentives are provided by an uncertain and unknown event depending on chance.[9]
In summary, the principle of avoiding Gharar ensures that parties are certain about the most important aspects of their transactions and they are protected from all kinds of uncertainty that may lead to unnecessary disputes in the future.
A question arises regarding the prohibition of gambling and speculation, which is that it seems implausible to permit the payment of a return only if the capital is at risk while gambling and speculation are forbidden.[10] A straightforward answer to this question seems to be that in the former case the return is backed by an asset and in the latter case the return does not seem to correspond to any real asset and there is no genuine economic activity taking place.
*Prepared by Abdullah Fahim (as part of the LLM Dissertation)
Alimiyyah, (Jamia Islamia Birmingham), LLB (University of Birmingham), LLM in Corporate Law (University College London), Imam & Khateeb (Masjid Taqwa, Birmingham, United Kingdom)
References:
[1] Richard A Brealey, Stewart C Myers and Franklin Allen, Principles of Corporate Finance (McGraw Hill 2017) 7.
[2] Muhammad Taqi Usmani, An Introduction to Islamic Finance (Idara Isha’at India 2009)18.
[3] Muhammad Ayub, Understanding Islamic Finance (John Wiley & Sons 2007) 75.
[4] For an intriguing and informative discussion of the rationale behind the prohibition of usury or interest under Islamic law, see: Muhammad Taqi Usmani, The Historic Judgment on Interest Delivered in the Supreme Court of Pakistan, available at <https://ia802705.us.archive.org/3/items/Document1_201501/Document%201.pdf> accessed 30 August 2018
[5] M Umer Chapra, Towards a Just Monetary System (The Islamic Foundation UK 1985) 60-61
[6] ibid 57-58.
[7] ibid, 59-60.
[8] ibid, 60.
[9] ibid, 61-64.
[10] Elaine Housby, Islamic and Ethical Finance in the United Kingdom (Edinburgh University Press 2013) 4.