Chapter 4: Introduction to

Islamic contract law and

financial contracts
Haniffa/Hudaib: Islamic Banking and Finance. An Introduction
Definitions of contract in Islamic law

‘Aqd’ is the two parties taking upon themselves an undertaking to do

something. It is composed of the combination of an offer (ijab) and acceptance
(qabul). The making of ‘aqd’ is connecting in a legal manner, one’s offer (ijab)
and acceptance (qabul) with the other, in a way which will be clear evidence of
being mutually connected.

• A precise definition of contract only emerged in the 19th century in the

Islamic Civil Law Codification of the Ottoman Empire, namely Majallah al-
ahkam al-adliyyah (also known as Mejelle) under Articles 103-104.
• For a contract to be valid under Islamic law certain conditions must be met
like consideration.

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Elements of a valid contract – offeror and offeree
For a valid contract parties must be:

• Legally competent
• physical puberty
• prudence in making sound judgement

• Have the capacity

• quality that qualifies a person in acquiring rights and undertaking duties and
responsibilities

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Elements of a valid contract – offer and acceptance
Offer (ijab)
• A specific action that reflects consent or willingness by one of the
contracting parties done either in writing or verbally

Acceptance (qabul)
• Represents a statement uttered indicating assent to the offer

Offer and acceptance may be concluded by representatives or modern

communication systems, e.g. telephone, telex, fax, email and letter.

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Elements of a valid contract – subject matter

Existence Lawfulness
• Object of the contract must exist, except
• Object of the contract must be lawful
in the case of deferred delivery sale and
and permitted for trading purposes as
manufacturing contracts.
per shari’ah.

Deliverability Precise determination

• Indicates that the object of the contract • Validity of contract depends on accuracy
can be certainly delivered as promised. of the object in terms of quantity, quality
and value.

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Elements of a valid contract – consideration

• Not restricted to only monetary price, may also be in the form of another
commodity
• Must be in existence and determined at the time of the contract
• Cannot be fixed at a later date with reference to the market price or be left
to the determination by a third party

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Legal consequences of contracts
• A deficient contract is lawful in substance but unlawful in description.
• A void contract is unlawful in both its substance and description.
• A binding contract is sound both in its substance and description, making it
binding on the parties as well as enforceable under the law.
• A revocable contract has an option to revoke the contract at any stage.
• An irrevocable binding contract cannot be revoked by either party at any stage.
• An enforceable contract is a valid and binding contract that can be enforced by
the law on the parties concerned without affecting a third party.
• A withheld contract is a binding contract that has been concluded by someone,
but is waiting for final approval by the real owner of the subject matter or final
ratification of the negotiated price.

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Classification of Islamic contracts

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Unilateral contracts - gift (hibah, hadiah)
Parties Hibah provider and Hibah recipient
ValidityProvider must have: Recipient must have:
• attained puberty and have the • capability to own, if not it can be
capacity given to a guardian or a trustee
• genuine ownership
Object • lawful (halal) and have value
• exists at the time the gift is made
• must be eligible for sale
• must be uncompensated
Example Used by Islamic banks to provide discretionary hibah to their savings depositors

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Unilateral contracts - off-setting debt (ibra’)
Parties Debtor and Creditor
Objective A person waives or drops a right that is established as a liability to another.
Subject Debt, right and claim over a non-fungible item
matter
Example A creditor drops the debt and releases the debtor. Ibra’ or a ‘reduce and
expedite’ clause can be incorporated in a finance agreement.

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Unilateral contracts - benevolence loan (qard hassan)
Parties Lender and Borrower
Objective Qard ul hasanah means ‘beautiful loan’.
Establish a relationship between lender and borrower without any accrued
tangible profits.
Validity • Concluded through the appropriate language of offer and acceptance.
• Both parties must be of legal age and have the mental faculties making them
eligible to give charity.
• The loan amount is known, in terms of volume, weight, number or size, so that
repayment of its equal is possible.
Example Known as interest free loans thus may be utilized as an overdraft facility.

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Unilateral contracts - endowment (waqf)
Parties Owner of the asset(s)
Objective Asset(s) given to be used for an assigned objective or cause that will benefit
others
Category • Charitable or public - includes any kind of benefit to the public
• Family or private - intended to benefit (a) specific person(s)
• Joint - part benefit assigned to private persons and the other part to the public
Aspects • Founder (waqif) - eligible to undertake the contract and the owner of the asset
• Asset held as waqf - permissible under shari’ah
• Proclamation for establishing the waqf - needs to be clearly stated
• Objective of the waqf - act of benevolence and righteousness

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Unilateral contracts - will (wasiyyat)
Definition Act of conferring a right in the substance or the usufruct of an asset after death.
The will can be either in written form, verbal or even by signs.
Validity The testator must:
• be of the age of maturity
• have full possession of their senses at the time of making the will
• not be acting under compulsion or under influence or in jest
• not be indebted to an extent that the debt is equivalent in value to the whole
asset.
Object of • May be of anything useful.
the will • Bequest can only be to the extent of a third of the testator’s assets.
• Any amount exceeding a third is not valid unless the heirs consent to it.

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Bilateral contracts – profit sharing or
partnership

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Bilateral contracts – profit sharing (Mudarabah)
Definition A partnership in profit whereby one party provides the capital (rabbul mal) and
the other party provides skill and labour (mudarib)
Objective Helps in facilitating investment cooperation
Validity • Contracting parties have the right to share the profit in an agreed ratio.
• Liability for losses is borne only by the capital provider or financier.
• Capital must be in absolute currency in the form of cash and not debt.
• Financier has no right to participate in the management of the project, which
is carried out by the entrepreneur only.
Types • Restricted
• time or period – void after the specified time or period
• place or location – bound business territory
• specific business – nature of the business specified by rabbul mal
• Unrestricted

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Example of two-tier mudarabah
Assume that the depositor deposits £100 000 which is used by the bank to provide capital to Adam, the
entrepreneur. The bank agrees to share profit with the depositor in the ratio of 30:70 and agrees to
share profit with Adam in the ratio 60:40.

If the business makes a profit of £40 000: If the business makes a loss of £20 000:
Adam’s share = 40% × £40 000 = £16 000 Both Adam and the banker would lose their efforts and
Bank’s share = £40 000 – £16 000 = £24 000 × 30% = £7200 will not receive anything. Depositor will lose £20 000
Depositor’s share = £24 000 × 70% = £16 800 + £100 000 and will only recover £80 000 of the capital.

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Bilateral contracts – partnership (musharakah)
Definition A partnership between two or more parties in which all partners contribute
capital, participate in the management, share the profit in proportion to their
capital contribution, or in the pre-agreed ratio, and bear the losses (if any) in
proportion to their capital ratio
Objective Commingling of funds for the purpose of sharing in profit
Validity • Contracting parties must all contribute capital to the project.
• All parties have right to executive powers in accord with an agreed formula.
• It is better for the partners to belong to the same trade and can participate in
actual work, with all the partners getting profit according to their work.
Risk • Entails lower risks since it involves risk sharing through partnership
Types • General – agree to joint ownership without formal agreement
• Contractual
• shirkat-ul-amal (partnership in services or labour)
• shirkat-ul-wujooh (goodwill partnership)
• shirkat-ul-amwal (equity participation partnership)
• shirkat-ul-amwal (Partnership by capital )

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Bilateral contracts – exchange or sale (al-
mu’awadad)
Cost-plus contract A contract between a buyer and a seller under which seller sells specific goods
(bay’ al-murabahah) allowed under shari’ah and the law of the land at a cost plus agreed profits
payable in cash on any fixed future date in a lump sum or by instalments.
Forward sale contract The purchase of a commodity for deferred delivery in exchange for immediate
(bay’ al-salam) payment according to specified conditions, or sale of a commodity for deferred
delivery in exchange for immediate payment.
Deferred instalment Through this contract, banks may finance customers who acquire an asset but
sale contract wish to defer the payment for a specific period (payment by instalments).
(bay’ bithaman ajil) Customers are allowed to settle the payment within a certain period of time.
Manufacturing This is a contract for the acquisition of goods by specification or by order.
contract
(bay’ al-istisna’a)
Sale of currency This is a contract of exchange of money for money or currency trading.
contract
(bay’ as-saraf)

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Bilateral contracts – usufruct contracts (al-
ijarah)
Definition A contract between two parties, the lessor and lessee, where the lessee enjoys
or reaps a specific service or benefit against a specified consideration or rent
from the asset owned by the lessor.
Validity • Object and purpose of the contract should be lawful.
• Risk of the leased asset shall remain with the lessor throughout the lease
period, lessee (customer) leases the goods from the owner or lessor (Islamic
bank) at an agreed rental over a specific period.
Types • Operating lease (ijarah tashgheeliah) is a lease contract where the lessee
benefits from the asset for a specific time period but it does not result in the
eventual transfer of ownership of the asset to the lessee.
• Financial lease is a lease contract which incorporates the option to transfer
ownership of the leased asset from the lessor to the lessee at the end of the
lease period.
• financial lease ending with sale (ijarah wa-iqtina)
• financial lease ending with ownership transfer (ijarah muntahiya bil tamlik)
• financial lease with sale option (al ijarah thumma al bay’)

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Bilateral contracts – safe custody (al-wadi’ah)
Definition A contract between the owner of goods and the custodian of goods whereby the
latter undertakes the responsibility to protect the goods from being stolen or
destroyed and to ensure safe custody.
Validity • Offer and acceptance between depositor and custodian (depository
institution).
• Deposited object must be a tangible asset that can be possessed physically.
Types • Safe custody trust (wadiah yad amanah) - the trustee or custodian has a duty
to safeguard the property held in trust by:
• not mixing or pooling the properties (money) under custody
• not using the properties
• not charging fees for safe custody.
• Guaranteed custody (wadiah yad dhamanah) allows the custodian to pool the
funds for utilization, with service charges being imposed and the custodians
guaranteeing the safety of money, returning the funds as and when requested
by the customer.

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Bilateral contracts – security contract (al-
tawthiqat)
Suretyship A contract between two parties whereby one party agrees to discharge the liability
contract of a third party in the case of default by the third party.
(al-kafalah) • May involve more than one guarantor or surety for a single obligation.
• Can take the form of being Immediate, Conditional and Contingent.
• Types of al-kafalah: surety for the person (kafalah bi al-nafs), surety for the claim
(kafalah bi al-mal)
Transfer of debt Transfer of debt from a debtor (transferor) to another party who accepts the transfer
(al-hawalah) (transferee) of debt, which releases the former from any obligation to pay the debt.
Types of al-hawalah: absolute hawalah (mutlaq), conditional hawalah (muqayyad).
Collateralization Is an arrangement whereby a valuable asset is placed as collateral for a debt.
or pledging • Pledged asset must be owned by the pledger or debtor.
(ar-rahn) • Reason for pledging is as security of debt and not investment and profitable use.
• Pledgee cannot dissolve the contract until the debt is paid by pledger.
• Pledger loses right of security and no liability will be incurred on the pledge if the
security damages itself.
• If either of the party dies, the contract will be dissolved automatically.

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Bilateral contracts – agency contract (wakalah and ju’alah)
Al-Wakalah A contract between two parties where one party (the principal) appoints
another party (agent) to act on his behalf.
• Principal should have full authority of disposing the matter being entrusted
to another person to perform on his behalf.
• Agent appointed should have the capacity, i.e. knowledge and experience, to
execute the trust given to him and to only act for what he is appointed for.
• Types of al-wakalah:
• absolute agency (al-wakalah mutlaqah),
• limited agency (al-wakalah al-muqaiyadah)
Commission Involves one party undertaking to pay another party a specified amount of
(al-Ju’alah) money as a fee for rendering a specific service in accordance to the terms of
the contract stipulated between the two parties.

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