Commercial Transaction Applicability of Shari’ah and Indian Commercial Law

Commercial Transaction Applicability of Shari’ah and Indian Commercial Law

Written by

K.A. NAJMI

Published on

August 12, 2022

The history of non-interest banking in its present day incarnation is of recent origin. In the second half of the 20th century, efforts were made to adopt Islamic Finance in Egypt. It slowly spread to the Middle East and then to other parts of the world. Today it is the world’s fastest growing financial sector and is becoming an increasingly important component of the international financial system. Assets under Islamic management have grown from US$150 billion in the mid-1990 to around US$700 billion in 2007. [Preferably under the Mutual Co-operative Credit Societies Act in States where such a Law is in place. Elsewhere under the Co-operative Societies Act.]

Islamic bank must abide by Shari’ah. It comprises a set of principles governing all aspects of day-to-day activities of a Muslim including the commercial and financial transactions undertaken by him.

 

PRINCIPLES OF ISLAMIC FINANCIAL FRAMEWORK

  • Interest is not justifiable: Money has no intrinsic value; it is merely a store of wealth and a medium of exchange. On its own it cannot beget money. Hence, there is no justification for payment or receipt of interest;
  • The business should be transparent: Those participating in a transaction must be adequately informed. Uncertainty or speculation has to be avoided;
  • No investment in unethical business: Investment in socially detrimental activities is forbidden;
  • No profit without business risk: The investor must share the business risk. Profit without risk of business is not acceptable;
  • Debt not a tradable commodity: Simple debt is not a tradable commodity; and
  • All financial transaction must have asset backing: Financial Transaction without asset-backing amounts to treating ‘money’ itself as a valuable commodity and the same is not permitted.

 

MONEY AND CAPITAL

A lender of the money is not entitled to anything more than what he lent. When ‘money’ joins hand with human labour, it gets transformed into “capital” and assists in the production of goods and services. An entrepreneur is required to convert ‘money’ into “capital”. The saheb-al-mal (owner or master of the fund) may himself be that entrepreneur or allow somebody else to act as such before expecting any return. By investing money or allowing it to be invested in business, the saheb-al-mal puts his capital at risk and in the process, becomes entitled for reward in the form of business profit. Production of (a) goods or services and (b) assumption of commercial risk are essential parts of Islamic Financing Technique.

 

ISLAMIC FINANCIAL TRANSACTION & LAW

Islam refuses to accept that ‘money’ per say deserves to be treated as ‘capital’. Such an approach towards ‘money’ has far reaching implication for all commercial and financial transactions. Shari’ah provides “substance” for a transaction and law gives it a “form”. It is desirable to align the Shari’ah compliant financial transactions, with the real world practice of law. One need not place too much emphasis on names. The terminology is not relevant. Since we cannot change the world, it is desirable to do the next best thing. While structuring a product, there is a need to learn using terminologies that others use so long as the terminologies so used reflect the meaning assigned by Shari’ah. This would avoid any conflict between the transaction and the statute and help bridge the gap between the Shari’ah scholars and the legal experts.

 

THE SUBSTANCE VS. FORM

i.      Under the conventional system “Legal Form” and “Economic Substance” match  each other because economic theories and legal theories both are products of the same system. Thus, there is unity in “form” and “substance”. None of these legislations were conceived with Shari’ah compliant products in mind. Hence, there is a mismatch between the extant laws and the transactions conceived under Shari’ah. The western scholars familiar with western economic theories have tried to fit in the “Economic Substance” of a Shari’ah compliant transaction, as understood by them, into a legal form known to them. There has been a marriage of convenience between English “Legal Form” and Islamic “Economic Substance”. As a result the product quite often highlights the mismatch rather than a smooth union of the two concepts.

ii. The conflict came out clearly when tax authorities in the UK were required to tax the Shari’ah compliant transactions. For them the “form” was important because tax is imposed on the basis of “form”. In a Shari’ah compliant transaction Economic theory is derived from Shari’ah but laws are largely Anglo-Saxons. Thus, the two are products of different systems. As a result, the ‘return’ in Mudaraba (profit sharing) contract is treated as “interest” for the investor and as expense for the “Borrower”.  Similarly, ‘Murabaha’ as single Islamic transaction is seen as involving two transactions namely (i) purchase, and (ii) resell. This may require payment of Stamp Duty on two occasions. ‘Musharaka’ or asset financing, extremely popular among Islamic banks as a means of financing is at times, seen as being hit by existing legal provision which prohibits banks from owning property without appreciating that a Musharaka transaction carried out by a banking or financial company is a “financial transaction” comparable to lending for the acquisition of underlying assets and was always treated as a financial transaction under Shari’ah. [There was a time, in 80s and early 90s when NBFC were not regulated by RBI. In fact RBI was of the opinion that the activities carried on by a large number of NBFCs were against Public interest and hence they need to be closed. The Supreme Court held that a Regulator has a right to regulate an activity to ensure that public interest does not suffer. It cannot direct closure (1987)1SCC424 and (1992)2SCC343. Thus, Chapter III B of the RBI Act was amended and in terms of the powers so vested, a number of directions were issued by RBI to regulate different types of NBFCs.] Till scholars of Shari’ah and Islamic Economics succeed in providing a “Form” known in law to the substance of the transaction thus aligning the substance with the form, the road to Islamic Finance is likely to be rough.

iii.   Shari’ah requires that a financial transaction must have an underlying asset. Once this is understood, it would be easy to appreciate that owning the assets by a banking company during the continuance of the Loan (Musharaka) or indulging in buying and selling of assets (Murabaha) or entering into a contract of joint ownership of assets till the loan is repaid (Mudarabah) are primarily “financial transactions” and hence deserve to be treated as such.

iv.   The challenge is to get all the financial transactions under Shari’ah recognised as a financial transaction in law. Given the provisions of the Contract Act, this is not an impossible task. Section 58 (e) of the Transfer of Property Act deals with English Mortgage. In English mortgage there is a transfer of ownership to the Mortgagee (lender), with a covenant to repay the debt on a certain date and a proviso that on this condition being performed the mortgagee will retransfer the property to the mortgagor (borrower). The ownership of the assets, in law, remains with the bank as lender, during the period of loan. Many a time the mortgaged assets are only those created with the loan amount, but nobody has ever argued that it is violative of Section 8 of the B.R. Act. Thus granting loan for acquiring an asset and getting ownership over the same as a security during the currency of loan is quite acceptable.

Mudaraba postulates placing fund with the entrepreneur for the purpose of sharing profit.  Musharaka is becoming partner in the production of goods and services. In Musharaka, the ownership in the assets of the business is shared between the bank and the borrower which is much less than transfer of full ownership in favour of the lender as in the case of English mortgage. Yet Musharaka is objected on the principle that it amounts to participating in manufacturing activity which a bank cannot do. Musharaka may be a partnership in manufacturing where Saheb-al-mal participates in the management and organisation of the partnership business. But, for a bank Musharaka is a financial transaction and not a partnership for manufacturing of goods / services. The bank as lender expects its investment to be paid back together with a small profit earned by the entrepreneur, just like any other conventional bank except that the return is not an assured amount as in the case of interest.

 

THE ANSWER

i. The answer lies in identifying a Shari’ah compliant transaction on the basis of its predominant character. The Indian judicial system has a long history of reconciling the conflicts in different legal systems. In the beginning of the British Raj, the courts were called upon to reconcile the Indian civil laws pertaining to Hindus and Muslims including their customary laws, with the concept of justice as understood under the Anglo-Saxon theories. That tradition has continued and is reflected in many a judgment of post-independence period.

In relation to charging of duties on instruments, Indian Courts have held that the substance has to be seen and not the form. [Unlike England, we are a country  of  “extremely Secular” people so I do not expect the RBI or any other Governmental agency  to do what FSA did in England. Hence in India, the onus to bring awareness among the masses will have to be shouldered by Shari’ah practitioners.] Thus under the existing legal system in India there are examples where the Courts gave precedent to “substance” over the “form”. This in fact is the correct approach to be adopted when dealing with the product of a different faith or belief.

ii.            There is another good reason to believe that that the Indian Legal system would be able to appreciate the nature of a Shari’ah compliant transaction much better than hitherto understood by British tax authorities or bankers. The Indian Contract Act though based on English common law principles, is so widely worded that it gives sufficient liberty to parties to the contract to reach a bargain in accordance with Islamic Economics / Shari’ah. Hence, it is possible to cover Shari’ah compliant contractual obligation under the Contract Act in most of the cases and decide the nature of the transaction based on its predominant character. Such an approach is likely to see MurabahaMusharaka etc. the way it is seen by Shari’ah. [Recent effort by an NRI to establish a Shari’ah Compliant NBFC as a joint venture with “KSIDC  having a minority holding” was challenged in a writ petition before the Kerala High Court by Mr. Subramanian Swami, former Union Law and Justice Minister and the Kerala High Court is now ceased with the matter. At times, Law is the expression of the policy goals of the dominant social group.]

The provision of Contract Act and Sales of Goods Act, the two basic statutes dealing with commercial transactions do not pose any serious hurdle in structuring a transaction in a manner that conforms to the principles of the Statutes as also the Shari’ah. Thus Murabaha can possibly be structured to make it a single financial-transaction under the Contract Act.   This would avoid its division into two distinct transactions known to English law viz. “purchase” and “resell”, which in a way is a clear distortion of the whole concept of Murabaha.

[The writer is Ex. Additional Legal Advisor of Reserve Bank of India.]