Khutba Message:

" Allah has permitted trade and forbidden usury. "

Al-Imran : 275

Types of Contracts in Islam

A brief classification of the major financing contracts adopted by the various modern-day Islamic banks, investment companies and other financial institutions is provided here. Practices and interpretations of Shari`ah law vary widely between these institutions, as well as between the various juristic schools in Islam, hence the acceptability of these techniques is not always agreed upon.

The various forms of commercial contract in Islam can be identified in the Qur'an, the recorded sayings of the Prophet Muhammad peace be upon him (the ahadith), and in the jurisprudence (or fiqh) of Islamic scholars both ancient and modern. Due to the detailed nature of Islamic law, institutions in the Islamic financial market will often appoint a shari`ah board in order to vet proposed transactions for acceptability.

Despite the various differences of interpretation that exist, three categories of Islamic contract of relevance to commercial and financial activity are widely recognised in both contemporary and classical literature. They are: a) contracts of exchange; b) contracts of charity; and c) contracts of investment partnership. Other forms of contract, contracts of guarantee for example, are not dealt with in the following outline.

It is generally agreed that commercial transactions should be concluded: a) at a price that is agreed mutually and not under duress; b) between parties that are sane, and that are old enough to understand the implications of their actions (in other words who are mumayiz); c) without uncertainty or deception (gharar) with regard, for example, to the quality of the goods or the seller's ability to deliver them. (Hence, short selling is widely and there is a general requirement that at the time of contracting the goods transacted should be in existence, under the ownership of the seller and in the seller's physical or constructive possession); d) the contract should not be based upon a countervalue that is itself prohibited under Islamic law (alcohol for consumption) for example.

Contracts that involve prohibited items or that are structured in a way that is prohibited may in certain circumstances be rectified by removal of the objectionable clause, or may result in the entire contract being annulled.

The Arabic word bay` refers to any transaction in which ownership of an asset is exchanged between a seller and buyer, in return for money or by barter. Bay` can be made as a musawamah, in which case the price of the item is stated and the buyer agrees or refuses to buy, or as a murabahah in which case the seller discloses the costs of the goods being offered for sale so that the buyer may agree the profit margin. Referring to the kinds of absolute sales, ibn Rushd derives the nine possible forms of sale, and highlights the prohibition of the general form of sale that involves the exchange of two liabilities:

Each transaction between two individuals is an exchange, either of corporeal property for corporeal property, or of corporeal property for a corresponding liability, or of a liability for another liability ... Each one of these three again is either immediate for both parties, or delayed for both, or is immediate for one party and delayed for the other. The kinds of sales (that emerge) are thus nine in number. Delay from both sides is not permitted by consensus either in corporeal property or in liabilities as it amounts to a proscribed exchange of a debt for a debt. ibn Rushd: Bidayat al-Mujtahid (p. 154, 1996)

Commenting further, ibn Rushd examines the three forms of sale that can arise in a market where goods and money are in existence: ... when two commodities are exchanged, one may serve as a currency and the other as a priced commodity, or both may be currencies. When a currency is exchanged for a currency the sale is called 'sarf', and when a currency is exchanged for a priced commodity, the transaction is sale proper ('bay`'). Similar is a the sale of a priced commodity for another priced commodity (barter) ...
ibn Rushd: Bidayat al-Mujtahid (p. 154, 1996)

Exchange transactions can be for immediate or deferred exchange.

O you who believe! When you deal with each other in transactions involving future obligations in a fixed period of time ... Qur'an 2: 282 It is recommended that future contracts be evidenced in writing.

O you who believe! When you deal with each other in transactions involving future obligations in a fixed period of time, reduce them into writing. Qur'an 2: 282 Spot transactions need not be evidenced in writing but witnesses are recommended. ... but if it be a transaction which you carry out on the spot among yourselves, there is no blame on you if you reduce it not to writing. But take witnesses whenever you make a commercial contract ... Qur'an 2 : 282

The item for sale should be under ownership of the seller and in his physical or constructive possession at the time of contracting the sale.

The messenger of Allah forbade me to sell a thing which is not my property Hadith : Tirmidhi

The messenger of Allah forbade me to sell a thing which is not my property or something that is not apparent and seen clearly. Hadith : Bukhari

The subject matter of an exchange contract must have value of some kind. According to the Shafi'i and Hanbali schools, the 'usufruct' of an asset (in other words, the benefit arising from the use of that asset) can be considered as property and thus can be subjected to an exchange transaction, whereas some in the Hanafi and Maliki schools do not share this view. According to Professor Hashim Kamali at the International Islamic University in Kuala Lumpur, most scholars of later periods side with the Shafi'i and Hanbali schools on this matter.

A sale by public auction (bay` muzayadah) in which an item is sold to the highest bidder, is disallowed by some jurists on the basis that auctions may be rigged by a small group of well informed 'insiders'. However, it is widely accepted that in the absence of manipulation, a public offer to sell an object at a given price is permitted. The Shari`ah permits making [a] public offer with fixed deadlines for acceptance, binding the offeror to abide by the deadline he has fixed. The Islamic Research and Training Institute (1990)

According to many jurists, a contract of sale must relate to only one transaction. Hence, rather than signing a single contract to cover more than one separately identifiable transaction, individuals should instead enter into each transaction under a separate contract. Here is an important condition. If followed strictly, it helps to prevent usurious agreements being constructed from a set of underlying contracts that may, in themselves, be quite acceptable.

The price agreed must be fixed at the time of contracting the exchange transaction, and ownership remains with the seller until delivery is made. In this respect, there should be a formal event that signifies the point at which a contract is concluded, for example a handshake or a signature.

Though a sale cannot be made conditional upon a future event, conditions may be imposed upon the sale, for example the implementation of a service contract on a manufactured item sold to a buyer, or the availability of a warranty against defective goods (daman).

Both the buyer and seller may be given an option, khiyar al-majlis, to cancel a transaction during a given period after conclusion of that transaction. The Hanafi school limits the period of this option to three days, whilst other scholars do not precisely define the period of time allowed. Some have used khiyar as the theoretical basis for modern day 'Islamic option' products whilst others have based arguments for the permissibility of options on the existence of the contract of bay` al-urban. Bay` al-urban involves a deposit that may be forfeited in the event that the depositor does not complete the purchase of the specified good by a specified date. However, it would seem that whilst khiyar is widely accepted as a valid contract under Islamic law, few jurists permit bay` al-urban.

Naturally, individuals will not always be in a position to conduct exchange transactions on the basis of a simultaneous exchange of cash for goods or services (in other words as spot transactions). Where one of the two countervalues to an exchange transaction (cash, goods or services on the other) is not exchanged simultaneously, certain rules, and some exceptions to those rules, apply. Thesetypes of contract are discussed under other headings in this section of the site.

It is important to note that Muslim scholars have traditionally prohibited the sale of a debt (bay` al-dayn) at anything other than face value. Thus, if person B lends person A £100, B cannot then sell this debt to person C for anything other than £100. (If B sold the debt to C for, say £90, then C would effectively be earning interest of £10 on a loan of £90 made to A). Among the achievements of the Islamic Fiqh Academy (affiliated to the OIC) was the issuing of a detailed decision ... for deeds based on debts, which shall be non-negotiable except where transfer is made with the exchange of the face value of that debt. If they are purchased for less than their face value this would be the same principle as is applied to discounting of bills of exchange which is prohibited.
al-Qardawi: Islamic Capital Market Conference, Malaysia (1996)

It should be noted that there is some disagreement on the matter of bay` al-dayn, in particular in Malaysia. There, Professor Kamali quotes ibn-Taimiyah and al-Darir as being in favour of bay` al-dayn, and argues in favour of the transaction on the basis that there is no clear and authentic prohibition to be found in the Qur'an or Sunnah. This is not a position adopted by most Middle Eastern scholars.