Islamic finance is a branch of finance that raises capital and provides financial services in compliance with Islamic rules and principles. Islamic finance not only establishes rules for providing financial services, but also legal rules for commercial transactions, such as sales.
Seeing as Nasdaq Dubai is the largest exchange for sukuk globally, and since the Dubai Maritime Vision 2030 aims to “establish Dubai as a leading Global Islamic Maritime Economy,” Dubai is rapidly growing as a world Islamic financial hub.
This article briefly examines (I) the specific contractual rules required for a valid Islamic finance transaction and (II) the commonly used Islamic finance products in the maritime industry.
(I) Contractual rules specific to Islamic Finance
Islamic finance contractual rules
The purpose of Islamic finance contractual rules is (1) to encourage development and (2) to ensure that transactions between parties are sound and fair. Islamic finance requires that the parties to a contract be of sound mind, and that the contract be formed on the basis of offer and acceptance. Furthermore, the terms of the acceptance by one party must mirror the terms of the offer proposed. The basic contractual rules of Islamic finance transactions therefore reflect the same contract law rules of common-law jurisdictions, thus making the Islamic finance contracts enforceable in many western jurisdictions.
Like many of the rules throughout various jurisdictions that aim to protect consumers, Islamic finance requires the seller to fully disclose all known flaws of goods that may not be evident to a buyer. Parties must also avoid any misrepresentations, and a seller may not take advantage of a buyer’s ignorance.
Furthermore, the seller must disclose the profit made from the transaction by disclosing the actual cost incurred (i.e., the cost of acquiring, producing or manufacturing the good). A permissible exception to this requirement is a musawama transaction, whereby a buyer agrees not to know the profit earned by the seller.
Prohibitions in Islamic finance transactions
Islamic Finance transactions must be based on honesty and fair trade. Profiteering and cheating are therefore impermissible or haram. Furthermore, certain practices of the financial services industry of western jurisdictions are prohibited in Islamic finance. In addition to the prohibition on transactions concerning impermissible goods (i.e., investing in the production or sale of pork and alcohol), one of the absolute prohibitions in Islamic finance is the prohibition of riba.
There are two categories of Riba; The first is the act of charging interest on a loan (Riba al Nassiyah), and the second is the compensation received by one party which is in excess of the value of the underlying transaction (Riba al Fadl). The act of charging interest in addition to the principal on a loan is therefore impermissible in Islam. Islamic finance therefore provides alternatives to conventional financial products that use riba through various Islamic finance products.
Transactions must also avoid gharrar, or uncertainty. All terms of the contract, such as date of delivery in a sales contract, must be defined in order to avoid uncertainty. However, price need not be agreed upon in order for the contract to be valid if the price can be readily determined on the market. A seller must also own the property that is the object of the contract prior to the conclusion of the sale or transaction in order to avoid gharrar. Ownership can be either constructive or actual.
Finally, maysir, or speculation, is a major prohibition in Islamic finance. The interdiction therefore prohibits the use of derivatives in Islamic Finance transactions.
(II) Common Islamic finance products used in Ship Finance
Amongst the various Islamic finance products available, certain products are well-suited to the needs of the shipping industry. The following are the most popular Islamic finance products used in ship finance:
Ijara- Operating and Finance leases
Ijara is the Arabic word for “rent.” It is defined as a bilateral usufruct contract, or contract which grants one party the right to use the property of another party for a specific duration. In order to avoid gharrar, a lessor must therefore own the asset before entering into a lease contract with a leasee.
The ijara contract can be structured as either an operating lease or a finance lease known as ijara wa iqtina.
Ijara wa iqtina allows a leasee to pay periodic rental payments to the owner of the property with the promise to purchase the property at the end of the lease term. In the shipping industry, ijara wa iqtina is therefore used to finance the purchase of ships and other marine assets. Islamic finance also allows transactions to be structured with a security or mortgage in order to protect the lessor from the leasee’s default.
Istisna’a – Project finance
Istisna’a is a commonly used Islamic finance product which enables a bank to act as an intermediary between a customer and a manufacturer hired to produce or construct an asset. It is mainly used for project finance or working capital as an alternative to a loan.
In practice, a customer approaches a bank in order to construct property or manufacture goods. The bank pays for the construction of the project, and ownership of the finished product is transferred to the bank upon completion. In the maritime industry, istisna’a is predominately used in ship building. It enables a bank to exercise pre-delivery financing of ships under construction.
Upon completion of construction, ownership may be transferred from the bank to the customer. The customer has the right to pay for the property either (1) in installments, or (2) in whole at the end of the construction.
Murabaha – Cost-plus financing
Another commonly used Islamic finance product is murabaha, which is the Islamic finance equivalent of cost-plus financing in conventional banking.
Murabaha is often used for acquiring assets and working capital. In the maritime industry, murabaha would therefore be used to acquire ships and other marine assets.
In a murabaha transaction, the bank enters into a contract to acquire an asset on behalf of a customer. The bank acquires ownership of the asset in order to avoid gharrar. The rules of Islamic finance allow a bank to acquire the property in its name, or to appoint an agent to act on the bank’s behalf to acquire the asset. The bank may even appoint the customer as an agent.
After the bank acquires the asset, the asset is immediately transferred to the customer. The customer then pays for the asset by a deferred payment on a date that is pre-agreed upon between the two parties.
Like other Islamic finance transactions, banks may protect themselves from loss through mortgages, collateral (rahm), and/or guarantees (kafala).
Sukuk – Bond
Sukuk is considered the fastest growing and most popular Islamic finance product on the market. The growing popularity can be accredited to the fact that, like bonds and shares, sukuk certificates are securities that can be publically-traded on a secondary market (exchanges). The popularity is also due to a sukuk’s capability of raising large amounts of capital.
Sukuk can be defined as a beneficial interest or proof of ownership in an underlying asset whereby a sukuk holder receives periodic payments based on the performance of the underlying asset. Sukuk is often equated to bonds in conventional banking. However, many characteristics clearly distinguish sukuk from conventional bonds. For example, periodic payments based on performance of the underlying asset differ from coupons attached to a conventional bond, as coupons allow a bond holder to receive interest payments. Furthermore, due to the ownership interest a sukuk grants a holder of its certificates, a sukuk can be classified as a hybrid security that combines the characteristics of both bonds and shares (debt and equity).
There are various forms and structures of a sukuk, however ijara sukuk appears to be a popular form of sukuk in the maritime industry. In a typical sukuk transaction, the obligor, or the party who wishes to raise funds, approaches an Islamic bank for funding. The Islamic bank then establishes a special purpose vehicle (“SPV”). The SPV issues the sukuk certificates, which are title deeds of equal shares for leasing project, to shareholders in exchange for capital. The obligor transfers the property to the SPV in exchange for the capital provided by the sukuk holders. The obligor enters into a rental agreement with the SPV, and agrees to pay periodic rentals on the property, with a promise to purchase the property at a maturity date. The certificate shares are only issued once the obligor transfers the property to the SPV. Seeing as the certificates represent ownership, the certificates grant the holders the right to receive rental fees paid by the obligor and dispose of their property affecting the lessee’s rights.
Karbal & Co is an international law firm with offices in Dubai, UAE, and Libya that provides legal & arbitration services to the maritime industry.