Islamic Banking — Bay Bithamin Ajil (“BBA”) and Istisna’a Structures

This is the fourth and final post in the series of articles addressing Shari`ah-compliant home financing products. It considers bay bithamin ajil (“BBA”) and istisna’a structures. Thereafter, it provides a few observations on the structures that are likely to be used in the Sultanate of Oman in light of the current draft of the proposed Islamic banking rules. BBA structures are used in Malaysia, Indonesia and Brunei, but are not encountered in the Middle East, the United States, Canada, the United Kingdom or Australia. Istisna’a structures (including istisna’a – parallel istisna’a structures), or construction financing structures, are used throughout the world.

Bay’u Bithamin Ajil Definition and Principles

The bay’u bithamin ajil or BBA contract is a contract of sale, utilizing deferred payment concepts. Importantly, it is not a separate kind of sale under the Shari’ah^[1]. The payment of the price is deferred and is payable at a particular time in the future, usually on an instalment basis. Elements of sale that have been previously discussed in these Client Alerts are applicable and must be satisfied. For example, the sale and purchase price must be agreed and fixed at the inception of the transaction – at the time the contract is made. Thus, the profit rate for a BBA transaction is fixed at the inception of the transaction for the entire period of the transaction.

The fixed rate nature of the BBA contractual transaction has led to various criticisms pertaining to its competitiveness and appropriateness as a banking tool. Addressing some of those criticisms, Bank Negara Malaysia introduced a rebate (ibra’) mechanism that use variable rate financing techniques.^[2] Using this mechanism, the sales price bears a fixed profit rate that is designated as the ‘ceiling profit rate’. The ceiling profit rate is set at a rate that is greater than the actual variable rate that will be charged to the home purchaser (which is referred to as the ‘effective rate’). The difference between the payment calculated at the ceiling profit rate and the payment calculated at the effective rate is the amount of the rebate to the home purchaser for the relevant period.

Different types of sale arrangements may be embedded in the BBA transaction. In Malaysia, Indonesia and Brunei, the bay’ al-‘inah (sale and buy-back) structure is frequently used. This type of structure is not used with any frequency outside Malaysia, Indonsesia and Brunei. Figure 1 provides a graphic depiction of a BBA transaction using this mechanism.
 

In this transaction, the Customer identifies the property that the Customer desires to acquire (say, from a developer), enters into a Property Purchase and Sale Agreement (step 1) and pays a Deposit amount to the Property Seller (step 2).

As a result of paying the Deposit amount to the Property Seller, the Purchaser is deemed to have become the beneficial owner of the property. The Purchaser then approaches the Bank to seek financing for the acquisition of the property in an amount equal to the balance of the purchase price over the amount of the Deposit (the “Financing Amount”). That is, the property purchase price is equal to the sum of the Deposit and the Financing Amount.

Upon arranging that financing, the Purchaser enters into a Property Sale Agreement (step 3) and sells the property to the Bank for an amount equal to the Financing Amount (step 4). The Bank will consummate the purchase of the property by making payment of the Financing Amount, which is usually disbursed directly to the Seller as shown in step 5.

Thereafter, pursuant to the Property Purchase Agreement (step 6), the Bank sells the property to the Purchaser at an amount equal to the sum of (a) the Financing Amount plus (b) a profit amount on the Financing Amount, which may be determined using either a fixed or floating rate (the “Total Purchase Amount”) (step 7). The Purchaser then makes installment payments of the Total Purchase Amount to the Bank, as illustrated in step 9. The obligation of the Purchaser to make the installment payments of the Total Purchase Amount will often be secured by a rahn (mortgage) on the property from the Purchaser to the Bank, as illustrated in step 8.

Istisna’a – Parallel Istisna’a Home Construction Financings  

The term “istisna’a” (or ‘istisnā’) means requesting a san’ah, which is the work of a small or large scale manufacturing worker. In jurisprudence and the modern Islamic finance and investment industry, the term is used to refer to a type of forward sale contract involving the request to manufacture (or construct) a specific item in a specific form for a specific price. The commission to manufacture contract is thus a contract to purchase the item to be manufactured by the worker, where the worker provides both the raw materials and the labor to produce the final product.^[3] Historically, the istisna’a contract is derived from situations in which the custom production was required or desired, although it now refers more broadly to both manufacturing and construction undertakings. The sāni’ or sane is the seller, the mustasni’ or mustasne is the purchaser, and the masnū’ or masnou is the object of the sale transaction.

The istisna’a is similar to the forward sale contract (salam) in that it involves the future delivery of a traded item, it is a sale of an object that is not existent at the time of the consummation of the sale and purchase contract, and the object of the sale is a liability of the seller. In the istisna’a contract, the sales price need not be paid immediately at the time of entering into the contract, in contrast to the salam contract.^[4]

The nature of the istisna’a contact in a situation where a purchaser desires to have a house constructed is seemingly straightforward. The purchaser/mustasne commissions the seller/sane to build a house (masnou) and sell it to the purchaser upon completion of construction, whereupon the purchaser will make payment in full. In the normal course, and classically, this arrangement does not involve instalment payments of the purchase price by the purchaser. The seller would have to be qualified to construct the house, or at least to cause the construction of the house (or the acquisition of the masnou in the markets).

The pure istisna’a contract does not seem well suited to situations in which the purchaser of the house is in need of financing to effect the purchase and the payment of the house purchase price. Additionally, the pure istisna’a does not seem well suited to situations in which the purchaser desires to make instalment payments of the purchase price, particularly instalment payments over an extended period of time. And construction contractors and manufacturers are not well positioned to provide long-term financing of house acquisitions. With respect to each of these matters, the introduction of banks and/or financial institutions into the equation seems both appropriate and beneficial.

This line of thought leads to the contemporary istisna’a – parallel istisna’a transactional form. This form involves two istisna’a contracts, one between the house purchaser as the mustasne (the “end mustanse”) and the bank as the sane, and one between the bank as the mustasne and the constructor as the sane (the “end sane”). Figure 2, overleaf, provides a graphic depiction of the overall transaction involving both istisna’a contracts.

The “First Contract” is comprised of the Istisna’a Agreement (step 1) between the Customer (Home Purchaser) as the End Mustasne and the Bank as the Sane. The Bank agrees to construct the House (Masnou) (which will be delivered in step 5) in accordance with the plans and specifications set forth in, and otherwise as agreed in, the Istisna’a Agreement and for a price (the “Istisna’a Amount”) set forth in the Istisna’a Agreement (which will be paid in instalment payments in step 6). The Istisna’a Amount is equal to the sum of (a) the cost to construct the House, which is the “Total Istisna’a Amount” referred to in step 4, plus (b) the financing costs to be paid to the Bank. Those financing costs may be calculated using either a fixed or a floating rate. The Bank is obligated to the Customer (Home Purchaser) in respect of the construction of the House. The Customer (Home Purchaser) agrees to purchase the House for the Istisna’a Amount on the instalment payment terms set forth in the Istisna’a Agreement.

Of course the Bank is not in the business of constructing houses. Thus, the Bank, as Mustasne, arranges for the “Second Contract”, being the “Parallel Istisna’a Agreement” (step 2), with the Construction Contractor as sane (or “End Sane” because it is the ultimate sane in the overall istisna’a – parallel istisna’a arrangement). Pursuant to the Parallel Istisna’a Agreement, the Construction Contractor agrees to the construct the House and deliver it to the Bank (step 3), which will make payment to the Construction Contractor in one or more spot market payments (step 4) during or at the end of the construction period. All construction terms pertaining to the House to be constructed pursuant to the Parallel Istisna’a Agreement (e.g., the plans and specifications) are identical to the construction terms set forth in the Istisna’a Agreement between the Customer (Home Purchaser) and the Bank. That is, the two contracts are “parallel” in all regards other than the price and the timing of the payment of the price. The price to be paid to the Construction Contractor under the Parallel Istisna’a Agreement is the “Total Istisna’a Cost” (step 4). It is the cost to construct the House without regard to any financing costs that are included in the Istisna’a Amount.

It is to be noted that the Istisna’a Agreement and the Parallel Istisna’a Agreement are, and must remain, totally independent obligations and arrangements, rather than interdependent obligations and arrangements. Thus, for example, pursuant to the Parallel Istisna’a Agreement, the Construction Contractor is obligated to the Bank, but not the Customer (Home Purchaser), in respect of the construction and delivery of the House. Pursuant to the Istisna’a Agreement, the Bank is separately and independently obligated to the Customer (Home Purchaser) in respect of the construction and delivery of the House. These obligations are independent and unrelated. Failure by the Construction Contractor to construct and deliver the House in accordance with the plans and specifications will not relieve the Bank of its obligation to the Customer (Home Purchaser) to deliver the House in accordance with the plans and specifications; the Bank will continue to be liable to the Customer (Home Purchaser).

Home Purchase Financings in the Sultanate of Oman

The four-part survey of Shari`ah-compliant home purchase financing products has considered a range of different structures and techniques for financing home purchases. These have included (i) the lease (ijara), which is discussed in Islamic Banking: Home Purchase Financings I: The Lease, (ii) the musharaka mutanaqisa (diminishing partnership), which is discussed in Islamic Banking: Home Purchase Financings II: Musharaka Mutanaqisa, (iii) the murabaha (cost-plus sale involving a commodity), which is discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq, (iv) the tawarruq (seeking of cash through the use of a murabaha in which the commodity purchased by the party needing financing is immediately sold by that party for cash), which is discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq, (v) the bay’u bithamin ajil or BBA contract, which is discussed in this client alert, and (vi) the istisna’a – parallel istisna’a, which is also discussed in this client alert. Each of these is discussed at https://omanlawblog.curtis.com.

While these discussions are indicative of the range of possibilities from a global perspective, it is clear that only a subset of these structures will be offered by Islamic banks or Islamic windows of conventional banks in the Sultanate of Oman. The current drafts of the proposed Islamic banking regulations for the Sultanate of Oman require that products be in accord with the standards and guidelines of the Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”). Thus, certain types of tawarruq structures (i.e., organized tawarruq) will not be permitted in Oman, as was discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq. In addition, BBA structures will not be permissible in Oman.

The structures that will be available for home financing products in the Sultanate of Oman are likely to be the ijara (lease) and the musharaka mutanaqisa (diminishing partnership). Generic transactions using these structures were discussed in Islamic Banking: Home Purchase Financings I: The Lease, and Islamic Banking: Home Purchase Financings II: Musharaka Mutanaqisa, respectively.

As the Sultanate of Oman prepares to roll out its new legal and regulatory framework for Islamic banking in the coming months, we continue to cover 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.




1This type of contract is also knows as a bay muajjal in Southeast Asia and is commonly referred to as a bay murabaha in the Middle East.

2See Introduction of Islamic Variable Rate Mechanism, in The Islamic Financial System, 187-89 (2003), BANK NEGARA MALAYSIA, available at http://www.bnm.gov.my/files/publication/ar/en/2003/cp05_003_whitebox_intro.pdf.

3If the raw materials were provided by the purchaser, the contract would be one of employment of the labour of the worker.

4See Wahbah Al-Zuhayli, Al-Fiqh Ali-lslami wa-Adillatuh (Islamic Jurisprudence and its Proofs), Financial Transactions in Islamic Jurisprudence, Mahmoud A. El-Gamal, translator (2002), at 267-79, for discussions of the jurisprudential positions regarding whether the istisna’a is a contract of sale or a promise to sell or a form of employment of the manufacturer, of appended conditions, of the legal status of the contract, and of legal characteristics of the contract, and for a detailed comparison of the istisna’a and the salam contracts.

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Taimur Malik Joins Curtis as Counsel in Oman

Muscat, Oman, November 1, 2012 - Curtis, Mallet-Prevost, Colt & Mosle LLP has announced that Taimur Malik has joined the international law firm as Counsel in its Corporate and Infrastructure Development groups. He will be based in Curtis’ Muscat office.

Mr. Malik moves to Curtis from Vale, the world’s second largest mining and metals group, where he was Head of Legal for the Middle East as well as responsible for providing support to the group’s business development, project and exploration work in Central Asia and South Asia. Prior to Vale, he worked at leading law firms in Oman and Pakistan.

He has counseled clients on a wide range of corporate transactions and projects, including government concessions, M&A and joint ventures in countries across Asia, the Middle East, Europe and Africa. He advised clients in matters involving Power, Water, and Infrastructure Projects, Commercial Agencies and Insolvency, Banking and Finance, Real Estate, Mining, Oil & Gas and Petrochemicals.

“We are delighted to welcome Taimur Malik to Curtis,” said Bruce Palmer, managing partner of Curtis in Oman. “He brings a wealth of international experience from the private sector in a wide range of matters that will help Curtis continue to expand both in Oman and around the world.”

In Oman, Mr. Malik has been actively involved in the development, project and operations phases of many of the largest government financed projects (such as the country’s first multi-billion dollar dry dock in Duqm) as well as foreign investment based projects (including Oman’s first multi-billion dollar iron ore pelletizing plant and distribution center in Sohar). He has also advised numerous Fortune 500 companies, leading Omani business groups and governmental entities on a broad range of legal matters related to doing business in Oman.

Mr. Malik has been recognized by several leading legal industry directories, including the Legal 500 and the IFLR 1000. The International Financing Review declared one of his deals as “Latin America Loan of the Year 2011.”

Mr. Malik regularly conducts international law training and capacity building sessions for public sector officials. His articles on legal issues appear regularly in leading publications and he has also contributed to books on joint ventures and mergers and acquisitions in the Middle East. He has also been a Research Scholar (International Commercial Contracts) at UNDROIT in Rome and a Visiting Fellow (WTO Dispute Resolution) at South Center in Geneva.

Mr. Malik was called to the Bar by the Honourable Society of Lincoln’s Inn, UK. He was educated at the University of London, University of Heidelberg, Hague Academy of International Law, Boston University School of Law, University of Dundee and the London School of Economics. He has also received a general management certificate of achievement from Judge Business School, University of Cambridge and is an Associate Member of the Chartered Institute of Arbitrators.

Curtis, Mallet-Prevost, Colt & Mosle LLP is a leading international law firm providing a broad range of services to clients around the world. Curtis has 16 offices in the United States, Latin America, Europe, the Middle East and Central Asia. The firm’s international orientation has been a hallmark of its practice for nearly two centuries. For more information about Curtis, please visit www.curtis.com or follow Curtis on Twitter (twitter.com/curtislawfirm) and Facebook (Facebook.com/Curtis.Careers).

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Real Estate Zoning

Zoning is a well-established method of land-use planning in many countries. Under this approach, specific parcels of land are designated as permissible for (i.e., “zoned for”) particular types of uses and activities, such as: residential, commercial, agricultural, industrial, or undeveloped open space. The fundamental purpose of zoning is to avoid undesired or incompatible combinations of land use within a community that would interfere with the community’s distinctive character or the land area’s overall intended purpose.

In some countries where zoning is actively practiced, the broader guidelines for a zoning regime would be set out by the central government and administered at the regional level by the local municipalities or governorates. In other countries, most zoning is spearheaded by local governments. Within each broad zoning category, there can be further subdivisions. For instance, a residential area could be divided into low-density housing with villas and single homes and high density housing with high-rise apartment buildings and an industrial area could be light and heavy industry zones. In urban zones, there could be residential, mixed residential-commercial, commercial, industrial and special zones (with power plants, airports, shopping malls, sports complex, etc.), and infrastructure for each zone is planned on the basis of its zoning designation.

Zoning is a relatively new concept in Oman; however, it could be poised to play a key role in the coming years as the Government increases its focus on sustainable real estate development. As the Sultanate features five regions subdivided into 61 districts and four governorates, this organizational structure could be a helpful starting point for giving Omani land, including property that is not yet developed or slated for development, zoning designations; this way, Government authorities and prospective property developers would be able to consider not only the applicable zoning for the particular lands they are contemplating for projects, but also the relevant zoning of the surrounding lands.

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Aquaculture in Oman: Key Considerations for Investors

With 3,165 kilometers of pristine coastline and a deep drop-off ocean shelf, Oman is a prime candidate for fish farming, also known as aquaculture. In recent years, the Omani Government has indicated a particular desire to grow aquaculture operations within the Sultanate, both as a means of diversifying the national economy away from hydrocarbons and as a way to ensure domestic food security needs. The Omani aquaculture sector thus offers an array of potential opportunities for investors.

There are several key considerations that investors would do well to bear in mind when pursuing aquaculture projects in Oman. First, as with any investment project in Oman, it is important to select the appropriate local entity type for forming a permanent Omani establishment. Previous posts discuss the most commonly used options, such as a limited liability company or a branch to service an Omani Government contract.

Second, it would be important for investors to work with the Omani Government authorities to clearly establish up front the land use rights that will pertain to the project. As land ownership in Oman is generally limited to Omani and GCC nationals, the best way for a foreign investor to obtain land rights for a long-term aquaculture project in Oman likely would be via a usufruct, which can be granted for a period of up to 50 years for projects that contribute to Oman economic or social development.

Finally, and perhaps most crucially, investors would do well do work with the Omani Government authorities early in the process of planning the aquaculture project to arrange the procurement of all licenses necessary to operate the project, and to ensure that the term of these licenses would be commensurate with the term of the aquaculture project.

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Debt Securities

Many companies use debt to fund their operations and investments. Broadly speaking, there are two main types of debt finance: bank loans and debt securities. We have discussed bank loans – such as overdrafts, term loans and revolving facilities – extensively in past posts. This month we provide a brief overview of debt securities.

Debt securities are financial instruments that borrowers (who are referred to as “issuers” in this context) sell to investors.

Typically, a debt security entitles its holder to receive periodic interest payments from the issuer during the term of the security, as well as repayment of the security’s principal amount at the end of the term. For example, if you hold a 20-year, RO 1,000 bond paying a fixed 5% annual interest, the issuer is obligated to pay you interest of RO 50 per year throughout the 20-year term and then to pay you RO 1,000 at the end of the term. There are, of course, other variations that a debt security can take. Some debt securities carry the right to receive a fixed periodic interest rate, others a floating interest rate. Convertible debt securities give the holder the right to tender the security to the issuer in exchange for a given number of shares of the issuer’s common stock. Zero-coupon debt securities pay no periodic interest and only repay the principal amount.

Debt securities are thus used by companies to borrow money from investors as an alternative to borrowing from a bank. Many governments also issue debt securities. In Oman, both the Government and large corporations issue debt securities.

The name used to describe a debt security is often based on the length of its term. Longer-term debt securities are usually called “bonds”, whereas short-term debt securities may be called “commercial paper” when issued by companies or “bills” when issued by a government entity.

While bank loans continue to meet most Omani companies’ debt finance needs, debt securities are often a viable alternative or complement for large companies. It is also important to note that other forms of debt, such as vendor financing (e.g., when a corporate customer buys heavy equipment using a loan provided by the equipment manufacturer), play an important role for many Omani companies, particularly small and medium-sized enterprises.

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Islamic Banking: Home Purchase Financings Part III- Murabaha and Tawarruq

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.[1] 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.[2]  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.[3] 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.[4]  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.[5]  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.[6]

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.[7]  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.[8]   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.[9]

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.[10]   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:

(a)               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; 

(b)               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

(c)                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).

Future articles

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.

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[1] See Michael J.T. McMillen, Trends in Islamic Project and Infrastructure Finance in the Middle East: Re-Emergence of the Murābaha, available at http://ssrn.com/abstract=1753252.

[2] Compare the musawamma, which is essentially identical to the murabaha except that cost and profit are not disclosed to the purchaser.

[3] This article does not address cornerstones (‘arkan) of a sale transaction, such as offer and acceptance, conditions of conclusion, conditions of validity, conditions of execution and bindingness conditions.  Those are all assumed to be satisfied.  Nor does this article address the six categories of conditions of validity relating to sales contracts generally: (i) ignorance or uncertainty (al-jahala); (ii) coercion; (iii) timing; (iv) deception and gharar (gharar al-waṣf); (v) harmful sales (al-ḍarar); and (vi) corruption (al-shuruṭ al-mufsida).

[4] Particularly to the Mālikīs, who discern three categories: (i) that which is permissibly appended to the cost and has a right to earn a profit; (ii) that which is appended to the cost but may not earn a profit; and (iii) that which may not be appended to the cost and may not earn a profit.  The Ḥanafīs tend to include in the capital or principal a broader range of costs associated with the purchase and sale of the mabi (essentially all such costs).

[5] There are differences of opinion where the mabi is damaged as a result of “natural causes”.

[6] There are various options available to the second buyer in cases of betrayal of trust, including non-disclosure or inaccurate disclosure of price and quality characteristics.

[7] In most cases, absent deferral or other consensual arrangements, delivery of the mabi and the price must be concurrent, except in the case of an exchange of non-fungibles for fungibles.  However, there are variations among the madhāhib, and variations in respect of specific exchanges.

[8] It is necessary to carefully distinguish agreed “trustee” and rahn arrangements in transactions where those elements are present.

[9] The discussion is a prelude to the tawarruq discussion and later discussions of equipment, asset, working capital, revolving credit facility and term financing structures.

[10] Shari`a Standard No. (30), Monetization (Tawarruq), SHARI`A STANDARDS FOR ISLAMIC FINANCIAL INSTITUTIONS 1432 H - 2010, AAOIFI (the “AAOIFI Monetization Standard”).  This standard applies to both deferred payment murabaha and deferred payment musawammatransactions.

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