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Insider Dealing: Fraud in Islam?: School of Accounting, Universiti Kebangsaan Malaysia, Bangi, Malaysia
Insider Dealing: Fraud in Islam?: School of Accounting, Universiti Kebangsaan Malaysia, Bangi, Malaysia
www.emeraldinsight.com/1359-0790.htm
JFC
19,2 Insider dealing: fraud in Islam?
Siti Faridah Abdul Jabbar
School of Accounting, Universiti Kebangsaan Malaysia, Bangi, Malaysia
140 Abstract
Purpose – The purpose of this paper is to examine whether insider dealing is fraud from the
perspective of Islam.
Design/methodology/approach – The paper uses analogy (qiyas) of the injunctions in the Qur’an
and Sunnah and critical analysis of literature on Islam.
Findings – The paper finds that insider dealing is fraud (taghrir) in Islam and the defrauded party
has the option to rescind the transaction for fraud (khiyar al-tadlis) as well as for latent defect (khiyar
al-‘aib).
Practical implications – The paper is practical as a source of reference in legislating laws relating
to insider dealing particularly where Shari’ah is the principal source of law.
Originality/value – The paper presents a novel attempt in establishing that insider dealing is fraud
from the perspective of Islam.
Keywords Crimes, Finance, Fraud, Insider dealing, Insider trading, Islam
Paper type Viewpoint
Introduction
In the US, insider dealing has long been regarded as fraud. Rule 10b-5[1], which was
promulgated by the Securities and Exchange Commission (SEC) in 1942 under
Section 10(b) of the Securities Exchange Act of 1934, imposes a duty to, inter alia,
disclose material information in connection with the purchase or sale of a security.
Courts in the US have decided that non-disclosure in such a situation is fraud. In the
UK, failure to disclose material information may tantamount to a criminal offence of
statutory fraud under the Fraud Act 2006[2] although mere non-disclosure is not fraud
under the common law. In South Africa, non-disclosure of material information in
securities transactions is similar to non-disclosure of latent defect in sale of goods, thus,
rendering insider dealing a prohibited conduct[3]. Jabbar (2010) argued that insider
dealing is prohibited in Islam and can be categorised as a criminal offence of ta’zir[4].
However, would Islam regard insider dealing as fraud as well? It is the latter question
that this paper seeks to answer. This paper, accordingly, scrutinises insider dealing as
fraud and the relationship between insider dealing and the law of latent defect from the
perspective of Islam.
Insider dealing and the law of latent defect from Islamic perspective
Another doctrine that is related to the topic in discussion is ‘aib khafii. ‘Aib khafii
refers to:
[. . .] a latent defect or fault which exists in the goods [. . .] at the time of the contract, is
material to the purpose of the contract and substantially impairs the value of the goods [. . .] to
the recipient, these criteria being determined by normal commercial usage (‘urf ) (Coulson,
1984).
Where there is ‘aib khafii, the purchaser is given the right to khiyar al-‘aib or khiyar
an-naqisat, namely an option to accept or reject the goods for defect because there is an
implied condition in every contract of sale of goods that the goods should be free from
any defect and that it should be of merchantable quality (Hamilton, 1985;
Comair-Obeid, 1996; Coulson, 1984; Rayner, 1991; Billah, 2006). Islam imposes a
duty upon every seller to fully disclose any defects, faults or unsuitability of the goods
for their declared intended purpose[16] as exemplified in the Sunnah of the Prophet
Muhammad where he was reported to have said:
[. . .] it is not permitted for a Muslim to sell to his brother a sale in which there is a defect,
unless he discloses it to him[17].
In Islam, any defect in goods, which is known only to the seller, must be disclosed to
the buyer although it is not enquired by the latter[18]. Further, the disclosure must
JFC mention the defect specifically and not indirectly or generally, or mentioning the real
19,2 defect among a list of imaginary defects so as to mislead the buyer into neglecting the
real defect upon finding the goods sound concerning the imaginary defects[19].
Where there is ‘aib khafii, the purchaser’s right to exercise khiyar al-‘aib rests on the
conditions that the purchaser was not aware of the latent defect before or during the
conclusion of the contract; the purchaser discovered the defect after taking possession
144 of the goods; and the defect proves contrary to the quality of the goods as stipulated in
the contract (Billah, 2006, p. 129; Comair-Obeid, 1996, p. 83). Where ‘aib khafii is
combined with fraud, the seller has committed taghrir bi al-‘aib (Rayner, 1991; Sanhuri,
p. 185 in Rayner, 1991). Intentionally concealing a defect in goods is fraudulent and
according to the Hanafi such concealment is haram; to the Maliki it constitutes tadlis;
and to the Shafi’i and Hanbali it is ghushsh (deception) (Rayner, 1991). All the
four schools of Islamic jurisprudence unanimously agree that in such a sale, the
right to khiyar al-tadlis is established for the buyer (Rayner, 1991). Accordingly,
it may be deduced that where there is a latent defect in the goods sold, the buyer
has a right to khiyar al-aib and where the latent defect is combined with fraud on
the part of the seller, the purchaser has a right to khiyar al-tadlis in addition to the
khiyar al-‘aib[20].
The application of the doctrine of ‘aib khafii is, however, not restricted to contracts
of sale of goods. The doctrine similarly applies to other contracts such as contracts of
hire, contracts of service and contracts of sale of property. In contracts of hire or
service, the doctrine of ‘aib khafii applies whereby there is an implied condition that the
hired property or service shall be suitable for the proposed purpose of the contracts
(Hamilton, 1985; Coulson, 1984; Rayner, 1991; Billah, 2006). Meanwhile, in contracts of
sale of property, any rights and liens held over the property, such as the existence of a
lease, must be disclosed by the seller to the buyer (Rayner, 1991). The concealment of
the rights and liens interferes with the absolute purpose of the sale, namely to obtain
the benefits of the object of sale and such concealment is considered as significant as a
concealment of a defect, thus, “affecting the severance of the bargain” (Sanhuri, p. 186
in Rayner, 1991). Likewise, it is submitted that the doctrine of ‘aib khafii may also be
applied to the sale and purchase of securities where only one party to the transaction
has knowledge of a materially adverse inside information regarding the securities.
Such a knowledge possessed by the person is analogously similar to knowledge of a
latent defect possessed exclusively by a seller of goods. If the seller is under an
obligation to disclose the latent defect in the sale of goods, so must the person in the
securities transaction in that he must disclose the materially adverse inside
information. Although “securities” was not an envisaged item when the doctrine of
‘aib khafii was first formulated, it is by no means an indication that the sale and
purchase of securities cannot be covered by the doctrine. Many Islamic principles and
their application may be extended from the precepts in the Qur’an and Sunnah to cover
an infinite number of cases by using various Islamic traditional legal methods.
Included in this is the doctrine of ‘aib khafii and its application. Therefore, applying the
doctrine of ‘aib khafii, an insider is under the duty to disclose a material inside
information in his securities transaction and his failure to do so gives the other
transacting party the right to khiyar al-‘aib and khiyar al-tadlis.
Related to the issue of disclosure is the question whether there is a duty to disclose if
the disclosure is detrimental to oneself, for example, where the premature disclosure
serves as the basis for the imposition of liability on the individual. Prior to answering Insider dealing:
that question, it is to be noted that Islam emphasises on utmost honesty on the part of a fraud in Islam?
Muslim where he must be honest and truthful at all times in all circumstances and
must put his faith over and above any worldly gain[21]. Thus, where there is a conflict
between disclosure and non-disclosure in that a disclosure would entail in self-harm
and non-disclosure would entail in a detriment to the other contracting party, a Muslim
is required to place the interest of the other party over and above his personal interest. 145
This is best exemplified in the practices of the earlier Muslims where they strictly
observed the practices of telling the truth and of exposing the defects in the items they
sold. One Ibn Sirin told a buyer that the sheep he was selling kicked its fodder
(Al-Qaradawi, 2003). Meanwhile, one al-Hasan ibn Salih told a buyer that the slave girl
he was selling spat up blood although she had done that only once, but al-Hasan’s
Muslim conscience made him mentioned the fact despite knowing that he bore the risk
of receiving a lower price for the slave girl (Al-Qaradawi, 2003). However, where a
premature disclosure is detrimental to a third party, for example, to the company to
which the information relates or is a disservice to the investing public, the individual
has to weigh between the detriment of the non-disclosure to the other contracting party
and the detriment of the premature disclosure to the third party and choose the one that
is less harmful. This position is based on a maxim of Islamic jurisprudence of “severe
harm is avoided by a lighter harm” (al-darara al-ashaddu yuzalu bi darari al-al-akhaffu)
or “choose between the lesser of two evils” (akhhaf al-dararyn) (Al-Suyuti, 2003 in
Dusuki, 2007). Nonetheless, in insider dealing where a premature disclosure would be
detrimental to a third party and non-disclosure would be detrimental to the other
contracting party, Islam would require the insider to abstain from disclosing the
material information and at the same time, abstain from trading.
Conclusion
In the US, non-disclosure of material information in connection with the purchase or
sale of a security is fraud. Likewise, in the UK, failure to disclose the information may
tantamount to a criminal offence of statutory fraud under the Fraud Act 2006 although
mere non-disclosure is not fraud under the common law. In South Africa,
non-disclosure of material information in securities transactions is similar to
non-disclosure of latent defect in sale of goods, thus, rendering the transaction as
insider dealing, which is a prohibited conduct. The concept of fraud in the temporal
laws finds its similarity in the Islamic doctrine of taghrir although the later covers a
very wide ambit of situations, which is much wider than that given under the temporal
laws. Taghrir also encompasses insider dealing since mere omission of material
information would be included in the definition of taghrir. This is similar to the
position under the US SEC Rule 10b-5 and the UK Fraud Act 2006, but dissimilar to the
common law fraud where simple reticence does not amount to a legal fraud.
Under taghrir, the defrauded party in insider dealing is given the option to either
ratify or rescind the contract (khiyar al-tadlis) provided he can prove materiality and
causation, although the exact application of the elements is subject to various
interpretations of the different schools of Islamic jurisprudence. Thus, it may be
surmised that there are some similarities between insider dealing as taghrir and insider
dealing as fraud under the US SEC Rule 10b-5. In both situations, the elements of
materiality and causation are to be proved although the exact extent of the application
JFC of the elements is uncertain in that they are to be adjusted according to the specific
19,2 circumstances of the particular case. Furthermore, the defrauded person in insider
dealing may also opt to rescind the transaction on the ground that there is a latent defect
(‘aib khafii and khiyar al-‘aib), similar to the position in South Africa as was decided in the
case of Pretorius & Anor. v Natal South Sea Investment Trust Ltd [22]. Finally, what is
interesting is that in Islam, a person is under an obligation to disclose a material
146 information to another even if the disclosure is detrimental to oneself. This is because in
Islam, the interest of another supersedes one’s self-interest.
Notes
1. 17 C.F.r. S 240.10b-5 (1977).
2. Ss.1-4.
3. Pretorius & Anor. v Natal South Sea Investment Trust Ltd. 1965 (3) SA 410 (W), see also
Rider (1977).
4. Ta’zir is one of the three categories of crime under the Shari’ah (Islamic law). It refers to an
act or omission, which has not been specifically prescribed as a crime by the primary sources
of Shari’ah, i.e. Qur’an and Sunnah, but which may be declared as one if public interest so
requires.
5. Words, conducts and implied approvals of the Prophet Muhammad, which are reported as
Hadith.
6. Hadith Bukhari, 3:358; 3:359; Sahih Muslim, Book 010, Nos. 3,634-3,637.
7. The practice is known as tasriyyah (Coulson, 1984).
8. The “measure of dates” mentioned in the Sunnah is merely a suggested example (Coulson,
1984).
9. Sanhuri, Masadir al-Haqq, II, 157 in Rayner (1991).
10. Sanhuri, Masadir al-Haqq, II, 159 in Rayner (1991).
11. In Islam, there are four Sunni schools of thought, namely the Maliki, Hanafi, Shafi’i and
Hanbali. While agreeing on basic concepts, principles and methodologies, they differ in their
opinion regarding certain specific rules and their application, but none of their differing
views can be considered wrong.
12. Ghabn juridically means an imbalance between the value of a subject-matter of a contract
and the consideration paid for it, for example, by paying a higher or lower price than the
market price. Ghabn can be divided into ghabn fahish and ghabn yaseer with the former
meaning excessive imbalance and the latter, small imbalance (Salameh, 1994 in Al-Rimawi,
2004; Taha, 1971 in Al-Rimawi, 2004).
13. Comair-Obeid (1996); Bellefonds, Traite, I, p. 355 in Rayner (1991).
14. Sanhuri, Masadir El-Haqq, Pt. 11, pp. 143-6, 160-89 and Mahmasani, General Theory, Pt. II,
p. 426 in Al-Rimawi (2004).
15. Some questions that have not been resolved are whether the proper focus is loss causation or
transaction causation; the relation of causation to materiality, reliance and privity; how
proximate the cause must be; the questions of foreseeability and intervening cause; and how
causation operates in stock exchange transactions. For further discussions on these
unresolved issues (Rider and Ffrench, 1979).
16. Unlike in English law where the duty is imposed in uberrimae fidei contracts only
(Coulson, 1984; Rayner, 1991).
17. As related by Ibn Majah and Ibn Hanbal in Zayla’i, Tabyin al-Haqa’iq: Sharh Kanz Insider dealing:
al-Daqa’iq (Bulaq, 1,313-15; Reprint Beirut, n.d.) Vol. IV, p. 31; Sanhuri, pp. 183-4;
Ibn Nujaym, al-Bahr al-Ra’iq, Vol. VI, p. 35; Ibn Juzayy, al-Qawanin al-Fiqhiyya, pp. 263-4; fraud in Islam?
and the Shafi’i author Shirazi, al-Muhadhdhab, Vol. I, pp. 283-4 in Rayner (1991).
18. Unlike the common law rules of caveat emptor and “mere silence is not fraud”.
19. Dardir, al-Sharh al-Saghir, in margin of al-Sawi, Vol. II, pp. 53-4 in Rayner (1991).
20. In khiyar al-‘aib, it matters not whether the concealment is deliberate or accidental, by act or
147
by omission. Sanhuri, p. 185 in Rayner (1991) and Coulson (1984).
21. See, for example, Surah Al-Ahzab (33): verse 70 of the Qur’an, which is translated thus:
“O you who believe! Keep your duty to Allah and fear Him and speak (always) the truth.”
Al-Qaradawi (2003).
22. 1965 (3) SA 410 (W).
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