shari'ah non-compliance risk management and legal

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Sharı ah Non-Compliance Risk

Management and Legal

Documentation in Islamic

Finance

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Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offi ces in North America, Europe, Australia and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers’ profes-sional and personal knowledge and understanding.

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AHCENE LAHSASNA

Sharı ah Non-Compliance Risk

Management and Legal

Documentation in Islamic

Finance

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mailto:[email protected]

v

Contents

Foreword ix

Acknowledgments xi

About the Author xiii

Introduction 1

CHAPTER 1Fundamental Concept of Sharı ah and Sharı ah Non-Compliance Risk 51.0. Introduction 51.1. Concept of Sharīàh 51.2. Compliance in the Islamic Financial Institutions: An Overview 61.3. Concept of Risk 111.4. The Concept of Sharīàh Non-Compliance Risk 121.5. Review of the Concept of Sharīàh Non-Compliance Risk 171.6. Features of Sharīàh Non-Compliance Risk 191.7. Sharīàh Non-Compliance Risk Events 191.8. The Sharīàh Basis for Sharīàh Compliance 25

CHAPTER 2Sharı ah Compliance in IFSA 2013 and Classification of Sharı ah Non-Compliance Risk 292.0. Introduction 292.1. Provisions Unique to Islamic Banks in IFSA 2013 292.2. Sharīàh Compliance in IFSA 2013 312.3. Classification of Sharīàh Non-Compliance Risk 41

CHAPTER 3The Major Risk Elements of Sharı ah Non-Compliance Risk and Its Causes in Islamic Finance Operations 433.0. Introduction 433.1. The Major Risk Elements of Sharīàh Non-Compliance Risk 433.2. The Causes of Sharīàh Non-Compliance Risk in Islamic

Finance Operations 68

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vi CONTENTS

CHAPTER 4Tools and Techniques to Identify Incongruence in Sharı ah Compliance 734.0. Introduction 734.1. Tools 734.2. Techniques 83

CHAPTER 5Understanding the Sharı ah Requirements for Mitigating the Sharı ah Non-Compliance Risk in Islamic Finance 855.0. Introduction 855.1. The Fundamental Islamic Principles in Islamic Contracts 855.2. The Fundamental Islamic Financial Transactions

Used in Islamic Finance 90

CHAPTER 6Lines of Defences for Sharı ah Non-Compliance Risk Management 1016.0. Introduction 1016.1. The First Line of Defence: Product Owner 1016.2. The Second Line of Defence: Management of the IFI 1076.3. The Third Line of Defence: Sharīàh Risk Management 1096.4. The Fourth Line of Defence: Sharīàh Management 1126.5. The Fifth Line of Defence: Sharīàh Committee/Board 1126.6. The Sixth Line of Defence: Board of Directors 1236.7. The Seventh Line of Defence: Sharīàh Advisory Council

(SAC), Bank Negara Malaysia (BNM)/Authorities 1296.8. The Eighth Line of Defence: Sharīàh Review 1306.9. The Ninth Line of Defence: Sharīàh Audit 1446.10. The Tenth Line of Defence: Public 154

CHAPTER 7Sharı ah Non-Compliance Reporting 1577.0. Introduction 1577.1. Objective 1577.2. Applicability 1587.3. Legal Provisions 1587.4. Reporting Requirements 1597.5. Reported as Potential Sharīàh Non-Compliance Event 1597.6. Submission of Reports on Actual Sharīàh

Non-Compliance Events 1607.7. Timeline for Actual Sharīàh Non-Compliance Reporting 1607.8. Potential Sharīàh Non-Compliance Event 1617.9. Timeline for Potential Sharīàh Non-Compliance Reporting 161

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Contents vii

7.10. No Sharīàh Non-Compliance Event Is Detected 1627.11. Process Flow for Authentication or Confirmation of

Sharīàh Non-Compliance in the IFIS 163

CHAPTER 8Legal Documentations in Islamic Finance 1658.0. Introduction 1658.1. Introduction to Legal Documentation 1658.2. Law Related to Islamic Banking 1668.3. General Principles in Legal Documentation 1678.4. Legal Documentation: Definition and Sharīàh Concern 1678.5. Incorporation of Sharīàh Requirements into Legal

Documentation 1678.6. The Main Functions of the Legal Documentation 1698.7. Areas in Legal Documentation under Consideration

and Review 1698.8. Potential Area of Sharīàh Non-Compliance Risk 190

CHAPTER 9Drafting Legal Documents 2099.0. Introduction 2099.1. Structure of the Legal Agreement/Contract 2099.2. Tips for Drafting Text and Additional Clauses 2309.3. Legalistic Style 231

CHAPTER 10Useful Information and Samples of Legal Documentation 23310.0. Introduction 23310.1. Sample of an Agreement (Musharakah Agreement in

Sukuk Issuance) 23310.2. Sample of an Offer Letter 24110.3. Sample of Legal Document Structure 24310.4. Master Agency Agreement (AIBIM) 24610.5. Corporate Wakalah Placement Agreement (AIBIM) 25310.6. Corporate Murabahah Master Agreement 27210.7. List of the Top Common Audit Shortcomings in Sharīàh

Non-Compliance 300

APPENDIXThe Impact of Non-Sharı ah-Compliance Risk on the IFI, and Checklist 303A.1. The Impact of Non-Sharīàh-Compliance Risk

on the IFI 303

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viii CONTENTS

A.2. Major Aspects Governing the Checklist for Non-Sharī`ah-Compliant Risk 304

A.3. Checklist for Sharī`ah Non-Compliance Risk 305

List of Abbreviations 317

Glossary 321

Bibliography 327

Index 329

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ix

Foreword

First and foremost, I would like to seize this opportunity to extend my heartiest congratulations to Dr. Ahcene Lahsasna for writing this book.

The timing of this publication is all the more relevant as Dr. Lahsasna encap-sulates seismic past and present events, such as the 1997 Asian Financial Crisis and the 2008 global financial crisis.

We at Maybank Islamic are truly and deeply honored to be associated with this publication, which will prove to be instrumental in adding depth to the debate on Sharīàh advisory in Islamic finance.

Maybank Islamic’s aspiration to become a global player in the industry is backed by the Sharīàh Center of Excellence. The initiative aims to serve not only as a comprehensive and practical source of reference to the Islamic finance and banking industry but also to legal, regulatory, and academic institutions and contribute to the debate and development of the industry.

Islamic finance has made bold and progressive strides by endeavoring to reach beyond domestic and regional borders to become an increasingly important component of the global financial system. Consumers, sovereigns, and corporations at large are benefiting from the advantages of Sharīàh-compliant banking solutions. It is therefore imperative, given the industry’s broad appeal and increasing popularity, that Islamic financial institutions adhere to Sharīàh principles by virtue of a sound, consistent, and clear gov-ernance framework.

With the implementation of the Islamic Financial Services Act 2013 in May of that year in Malaysia, central governance has been consolidated into a single legislative framework. Such legal strength and certainty will surely allow Malaysia’s Islamic finance and banking sector to flourish in a respon-sible, ethical, and progressive manner while equipped with the tools to face the new complexities, uncertainties, and sophistication of the years to come.

—Muzaffar HishamChief Executive Officer

Maybank Islamic

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xi

Acknowledgments

I would like to express my profound praise and thanks to Allah Almighty the Merciful; the Compassionate, Who enabled me to finish this book. I

would like also to express my warmest greetings, appreciation, and thanks to Maybank Islamic for their kind support and co-collaboration in this research. A special thanks is extended to the chairman of the board of directors, Dato’ Seri Ismail Shahudin, for his wise direction and manage-ment, along with the other board of directors of Maybank Islamic. A spe-cial thanks to the CEO of Maybank Islamic, Mr. Muzaffar Hisham, for his strong support and commitment. A special thanks to the team of Maybank Islamic, who help me through their useful comments, advice, and support, especially Mr. Ramadhan Fitri Ellias, head of Sharīàh Management; Mr. Mod Rusdi Che Yusof, head of Compliance and Review; Mohd Fikri Abd Ghapar, head of SME/BB; Ezry Fahmy Eddy Yusof, from Sharīàh advisory; Rosmayati Ismail, head of Transaction Management; and others. I also would like to express my appreciation to the Association of Islamic Banking Institutions Malaysia for granting me the permission to publish its legal doc-uments in this book. I hope that this book will be a significant contribution to the Islamic finance industry in the area of Sharīàh compliance, Sharīàh audit, Sharīàh review, and legal documentation. I have to note here that the opinions expressed in this book represent the opinions of the author and not of Maybank Islamic.

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xiii

About the Author

Associate Professor Dr. Ahcene Lahsasna (PhD, CIFP, ACIP, RFP, Sharīàh RFP, Sharīàh Advisor) is cur-

rently a lecturer at the International Centre for Education in Islamic Finance (INCEIF) Malaysia, known as the Global University of Islamic Finance. He is also the Graduate Studies academic advisor at the same univer-sity. He received his bachelor’s degrees in Islamic law and Islamic jurisprudence from Algeria, and his Master’s and PhD degrees in Islamic law and Islamic jurisprudence

from IIUM (Malaysia). Dr. Lahsasna is equipped with industry qualifica-tions as follows: Certificate Islamic Capital Market Sharīàh Advisor (I Advisor), offered by the Securities Industry Development Corporation (SIDC), Securities Commission Malaysia; Certificate Islamic Capital Market (sukuk and structured products), offered by the SIDC, Securities Commission Malaysia; Chartered Islamic Finance Professional (CIFP), offered by INCEIF; Registered Financial Planner (RFP) and Sharīàh RFP, offered by MFPC. Dr. Lahsasna is also a member of the ACIFP, Association of Islamic Finance Professionals, and National Council of Malaysian Financial Planning. Currently, Dr. Lahsasna is a registered Sharīàh advisor at Bank Negara Malaysia and Securities Commission Malaysia; serves as Sharīàh board member of Maybank Islamic, Etiqa Takaful in Malaysia, and RGA Re-Takaful based in Labuan; is on the Sharīàh Advisory Council of MFPC; and is chairman of Takaful and Sharīàh RFP at MFPC, Malaysia. Dr. Lahsasna has been appointed by the Finance Agency Accreditation as FAP (FAA Accreditation Panel).

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1

Introduction

S harīàh non-compliance risk is a unique aspect of Islamic finance that deserves specific focus. Research and studies should be dedicated to this

topic in order to further expand its scope and depth, as it is still at its early stage and there is not much written about it. This book tries to lay down the first pillars and foundation in this emerging area of Islamic finance. Sharīàh non-compliance risk means that the terms, conditions, and other related aspects agreed on in the contract do not effectively comply with the Sharīàh rules and principles. In other words, the terms and conditions in the financial contract do not fulfill the Sharīàh requirement, hence mak-ing the existing contract concluded invalid, or in need of rectification. It is very important to note that the risk management cycle and process should start from this point, because Sharīàh non-compliance risk might be chal-lenged at any point of the Islamic banking business activities, which may lead to legal conflicts, disputes, or litigations. Sharīàh non-compliance risk may increase the risk portfolio of the Islamic Finance Industry (henceforth IFI), which may result in financial losses and reputational damages. In the context of this scenario, the present book tries to address this issue by dis-cussing a few aspects related to the subject of Sharīàh non- compliance risk management, which include but are not limited to the examination of legal documentations used in Islamic finance to make sure that they represent the Sharīàh in its form, substance, and spirit. The Sharīàh non-compliance risk and the methodology used within its process will identify the gaps between theory and practice.

1. PROBLEM STATEMENT

The main concern of this book is Sharīàh non-compliance risk; it addresses the issues for the following questions:

■■ What are the types of Sharīàh non-compliance risk in Islamic finance?■■ What are the causes of Sharīàh non-compliance risk in IFI?■■ What are the tools and techniques used to identify the Sharīàh non-

compliance risk in Islamic finance?

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2 SHARl ÀH NON-COMPLIANCE RISK MANAGEMENT IN ISLAMIC FINANCE

■■ What is the methodology and process used to address the Sharīàh non-compliance risk management in Islamic finance?

■■ What are the types of issues in the legal documentation used by IFI in offering Islamic facilities?

■■ What are the terms and conditions agreed on in the legal documenta-tions that may trigger Sharīàh non-compliance risk?

2. OBJECTIVES OF THE RESEARCH

This book aims to achieve the following objectives:

■■ Introduce the framework of Sharīàh non-compliance risk management in Islamic finance.

■■ Identify the Sharīàh non-compliance risk in Islamic finance.■■ Present the tools and techniques used to identify the Sharīàh non-

compliance risk management in Islamic finance.■■ Highlight the methodology used in Sharīàh non-compliance process.■■ Elaborate on the Sharīàh rules and principles required in mitigating the

Sharīàh non-compliance risk.■■ Identify the Sharīàh non-compliance risk in legal documentation and

operation.■■ Eliminate Sharīàh non-compliance risk pertaining to legal documenta-

tions in Islamic banking facilities.■■ Ensure Sharīàh compliance in legal documentation pertaining to

Islamic financial contracts implemented by the Islamic banks.

3. METHODOLOGY

This research will use the following methodology:

■■ Induction methodology through collecting and checking the available legal documents and practices of the Islamic facilities offered by Islamic Financial Institution (IFI) in Malaysia.

■■ Analysis and comparative study methodology through the examination of the legal documents of selected financial transactions implemented by the Islamic banks.

4. THEORETICAL FRAMEWORK

This book tries to identify the area of Sharīàh non-compliance in Islamic finance, by introducing the Sharīàh non-compliance risk management

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Introduction 3

framework particularly in legal documents/contracts and practices of Islamic banks in various banking applications.

In order to achieve the objectives mentioned, the study has adopted the following approach.

4.1. Platform/Foundation of the Research

This platform is demonstrated in a discussion on the concept of Sharīàh non-compliance risk, followed by the nature of Sharīàh non-compliance risk in Islamic banking and finance, along with the Islamic tools and instru-ments to identify incongruence in Sharīàh non-compliance. In addition, there are some major elements of Sharīàh non-compliance risk in Islamic banking and finance that have been observed, such as gharar (uncertainty), ghubn (inequality), and others. There are also other factors that can cause Sharīàh non-compliance risk, such as human error, concept of risk, features of Sharīàh non-compliance risk, Sharīàh non-compliance risk events, and the Sharīàh basis for Sharīàh compliance.

4.2. Fundamental Blocks of the Research

The fundamental blocks represent the major pillars of the research; they form the Sharīàh fundamental requirements in contracts and the legal framework of the Islamic finance facility. These blocks are as follows:

4.2.1. Sharı àh Building Block/ Sharı àh Rules Sharīàh rules are the first building block in this research; Sharīàh rules govern the fundamental Islamic prin-ciples and requirements in contracts and legal documentation in the Islamic finance facilities in the bank. The major elements of the contract are sighah of the contract (offer and acceptance), the contracting parties (seller and buyer), and the subject matter of a contract (goods and price). This Sharīàh building block enables the bank to structure the Islamic finance facility in a Sharīàh-compliant manner.

4.2.2. Legal Building Block/Legal Framework The legal framework is the second building block, which is based on the incorporation of Sharīàh requirements into the legal documentations. It includes the functions of the legal docu-mentations, determining the specific prohibitions that should be avoided in the terms and conditions of the legal documentation, and so forth. The purpose of incorporating Sharīàh requirements in legal documentation is to ensure Sharīàh compliance and monitor the Sharīàh non-compliance risk in the Islamic facilities. The critical areas in legal documentation are the terms and conditions (T&C) that affect the rights and liabilities of the

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parties in the Islamic financial contract. In addition to that, the T&C gov-ern the Islamic finance facility and represent a point of reference in case of dispute and litigation. The T&C include clauses such as right to recall, cross default, consolidation and set-off, prepayment clause, and others.

4.2.3. The Tools and Techniques Used for Sharı àh Non-Compliance Risk The tools include accounting, financial statements, and cash flow. The techniques include observation, sampling, interviewing, and testing. The tools and tech-niques are both important to identify Sharīàh non-compliance risk.

4.2.4. The Process of Risk Management and Lines of Defence This is related to the process and management of Sharīàh non-compliance risk, when the lines of defence have been used to screen Sharīàh non-compliance risk. The lines of defence, in order, are:

1. Product owner 2. Management of the IFI 3. Sharīàh risk management 4. Sharīàh management 5. Sharīàh committee/board 6. Board of directors 7. Sharīàh Advisory Council at the national level 8. Sharīàh review 9. Sharīàh audit 10. The public

These lines of defence play a crucial role in preserving the interest of Sharīàh in Islamic finance.

4.3. The Application of the Banking Facility

The Islamic finance application taken into consideration in this book rep-resents various Islamic banking facilities in deposit and financing and other banking products and services.

5. THE TERMS USED IN THIS BOOK

■■ Sharīàh committee, Sharīàh supervisory board, and advisory board are used interchangeably. Sharīàh Advisory Council (SAC) refers to the Sharīàh Advisory Council of Bank Negara Malaysia.

■■ Sharīàh non-compliance risk and Sharīàh risk are used interchangeably.■■ Sharīàh management, Sharīàh department, and Sharīàh advisory are

used interchangeably.

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5

CHAPTER 1Fundamental Concept of Sharı ah

and Sharı ah Non-Compliance Risk

1.0. INTRODUCTION

Sharīàh non-compliance risk in Islamic finance and legal documentations is a very vital topic due to the risk involved, which might lead to serious finan-cial implication rendering the financial contract invalid. This non-Sharīàh compliance status will trigger the legitimacy of the income generated by the Islamic financial institution. Hence, understanding the Sharīàh requirements in Islamic banking facilities and legal documentation is crucial. Sharīàh non-compliance risk consists of three important terms, namely: Sharīàh, risk, and compliance. A brief definition for each term is given below.

1.1. CONCEPT OF SHARl ÀH

The Arabic word Sharīàh refers in its literal meaning to the road to the watering place, the straight path to be followed,1 whereas the technical mean-ing refers to designating a rule of law, or a system of law, or the whole of the message of particular prophet.2 However, in the Islamic context Sharīàh refers to the laws and commandments and way of life prescribed by Allah to mankind.3 Another definition of Sharīàh is: “The sum total of Islamic teach-ing and system, which was revealed to prophet Muhammad (s.a.w) recorded in the Quran as well as deducible from the Prophet’s divinely guided lifestyle called the sunnah.”4 In other words, “Sharīàh refers to commands, prohibi-tions, guidance, and principles that God has addressed to mankind pertain-ing to their conduct in this world and salvation in the next.”5 It has also been defined as: “The body of those institutions that Allah has ordained in full or in essence to guide the individual in his relationship with God, his fellow

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Muslim, his fellow men and the rest of the universe.”6 Abdul Karim Zaidan defines Sharīàh by saying: “as the path of religion and the various aspects of laws (al-ahkam) which Allah provides for his servants, i.e. human.” In the context of the various definitions, Sharīàh basically is the knowledge of the laws relating to men’s acts and behavior, and the commands of Islam in par-ticular matters and application. Sharīàh is the code of life that consists of ideology, faith, behavior, and obligation in the practical daily matters; since it is a divine law, it is a legislation based on the totality of Allah’s commands revealed to Prophet Muhammad.

Fiqh is another term that has been used with a legal connotation within the concept and scope of Sharīàh. Fiqh means understanding al-fahm, or the absolute understanding Mutlaq al fahm.7 In its technical sense, fiqh means “knowledge of the legal rules, pertaining to conduct that have been derived from their specific evidences.”8

From the foregoing deliberation we conclude some points as follows:

■■ The word Sharīàh has a very wide meaning as compared to fiqh.■■ Sharīàh consists of law, rules, regulations, commands, obligations, guid-

ance, principles, ideology, faith, and behavior that govern the human being in every aspect of life.

■■ Sharīàh includes all aspects of human life in this world.■■ Sharīàh is meant for two different worlds, happiness in this life and in

the hereafter.■■ Sharīàh is the whole divine law and values as given by Allah, whereas

fiqh is the law extracted by Muslim jurists from the sources of Islamic law.

■■ Fiqh contains human involvement such as the involvement of jurists who perform a sort of ijtihad and interpretation.

■■ The term Islamic law refers to fiqh, which can also be used to describe Sharīàh.

1.2. COMPLIANCE IN THE ISLAMIC FINANCIAL INSTITUTIONS: AN OVERVIEW

1.2.1. Definition of Compliance

Compliance means to comply with all relevant laws, rules, regulations, and regulatory guidelines. Compliance refers to proper supervision and a com-petent system of internal controls within an organization to mitigate the risk and to preserve the Bank’s reputation as well as safeguarding of its assets and compliance with all relevant regulatory requirements.

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Fundamental Concept of Sharıàh and Sharıàh Non-Compliance Risk 7

1.2.2. Definition of Compliance Risk

Compliance risk can be defined as “The risk of legal or regulatory sanction, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory orga-nization standards, and codes of conduct applicable to its banking activities.”

1.2.3. Consequences of Non-Compliance

Failure to comply with all applicable laws, rules, regulations, and regulatory guidelines will constitute a breach. It may result not only in the imposition of disciplinary, civil, or criminal sanctions against the Islamic financial insti-tution, but also in damaging one of Islamic financial institution’s (IFI’s) most important assets, its reputation. In addition, it may also result in the banking license being suspended/withheld by the regulator.

1.2.4. Objective of Compliance Operation Manual

Every Islamic financial institution has a compliance operation manual. This compliance operation manual describes the guiding principles for managing compliance at the business/support sectors within the IFI. The business/sup-port sectors are responsible for ensuring that the activities of the department and its staff are conducted in accordance with all applicable laws, rules, regulations, Sharīàh rules and principles, and regulatory guidelines and the highest ethical standards.

1.2.5. General Objectives of Compliance Operation Manual

The compliance operation manual in the Islamic financial institution tries to achieve the following objectives:

1. Improve the quality and effectiveness of the compliance function. 2. Provide uniform practice guide on compliance, which would serve as a

basis for guidance and measurement of performance of the compliance function by the compliance officer.

3. Facilitate the understanding and correct implementation of compliance function and procedures.

4. Ensure that compliance officers meet the minimum job expectation level imposed by the Bank.

5. Minimize the non-compliance to laws, rules, regulations, Sharīàh rules and principles, and regulatory guidelines that may result not only in the imposition of penalties, rendering the contract null and void, and staff disciplinary action, but also damage the IFI’s reputation.

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Specific compliance responsibilities that compliance operation manual intends to convey is that compliance should be looked upon as an entire system of the following:

1. Compliance with laws, rules, regulations, Sharīàh rules and principles, regulatory guidelines, and standards.

2. The prompt reporting of any compliance incidents (including Sharīàh non-compliance).

3. Taking appropriate action if compliance incidents occur.

1.2.6. Process of the Compliance Operation Manual (COM)

The compliance operation manual normally applies to compliance officer and all staff of the IFI.

1.2.6.1. Scope of Coverage The scope of compliance operation manual is one of the general compliance standards and requirements that govern the over-all working and business within the IFI. It should neither be interpreted as an all-encompassing manual that has exhaustively and conclusively listed out all the laws, rules, and regulations that the IFI is subjected to, nor as a substitute to the regulations.

1.2.6.2. Areas of Compliance The areas of compliance for business/support sector shall cover all regulatory (including Sharīàh rules and principles) and statutory requirements.

1.2.6.3. Frequency of Review Normally the compliance operation manual of the IFI needs to be reviewed on an annual basis and as and when the follow-ing circumstances occur:

■■ Change of work process/procedures/structures■■ Computerization of work process■■ Circulars issued by group compliance■■ Regulatory requirements■■ Others

1.2.6.4. Compliance Responsibilities 1.2.6.4.1. Compliance Officer The responsibilities of a compliance officer are as follows:

1. To facilitate the business/support sector in complying with all applica-ble laws, rules, Sharīàh rules and principles, regulations, and regulatory guidelines related to the business/support sector including monitoring the

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changes in regulations affecting the respective business/support sector, and providing value-added feedback to relevant departments in the IFI.

2. To become the liaison officer and advice business/support sector on any compliance matters that they may face in the course of their work.

3. To ensure the establishment and proper/effective implementation of compliance program, which, amongst others, shall include submission of compliance reports, independent testing/checking, compliance educa-tion/training, and so on.

4. To proactively identify, measure, assess, and document the compliance risk related to the business/support sector. This shall include completing risk control self-assessment of the compliance functions and key risk indicators (KRI).

5. To conduct independent testing/checking/review in order to gauge the level of compliance with regulatory requirements (including Sharī`ah rules and principles) at business/support sector as well as to mitigate/minimize the compliance/ Sharī`ah non-compliance risk.

6. To promptly inform the relevant head of the compliance of any compli-ance incidents/breaches/potential breaches upon discovery of the inci-dents. Thereafter, to monitor, manage, review, and follow up on any non-compliance issues reported and detected until resolved.

7. To participate in providing feedback, comments, recommendations and sign-off for any product/project/outsourcing/policy review sign-off.

8. To facilitate business/support sector in complying with FATF 40 Recommendations pertaining to anti-money laundering and counter financing of terrorism as well as Bank Negara Malaysia (BNM) UPW/GP1 and UPW/GP1(1) and other related regulatory requirements.

9. To promote a culture of compliance awareness at business/support sec-tor by providing/arranging training/briefings, via regular/constant com-munications to all employees in the business/support sector.

10. To ensure proper record keeping on all the compliance activities/pro-gram conducted for future reference.

1.2.6.4.2. All Employees of the IFI The responsibilities of the compliance officer as well as the rest of the staff of the IFI all play a role in creating the compliance atmosphere in the IFI; hence, compliance is every staff member’s responsibility.

1.2.7. Compliance Standards

The compliance standards are to be observed and guided by all staff in respect to the various compliance fundamentals as follows:

1. High standards of compliance ensure good reputation, which in turn will attract more business and a larger customer base.

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2. Ensure that all applicable laws, rules, Sharī`ah rules, principles, regula-tions, and internal policies and practices are strictly complied with.

3. These compliance standards of strict adherence to external require-ments and the highest standards of ethical conduct must not, under any circumstances, be compromised in the name of commercialism or competition.

4. Identify and assess potential compliance issues (including Sharī`ah non-compliance), guide and educate staff on compliance laws, rules, and standards, and perform a monitoring and reporting role.

Compliance staff shall also keep abreast of sound compliance practices and, in particular, take into account the recommendations of the BNM and Basel Committee on Banking Supervision as well as other international best practices such as Australian Standards AS3806 on compliance-related issues. Failure to put in place compliance personnel with the right abilities, skills, and resources may increase the risk in performing the business to the bank.

1.2.8. Independence and Accountability

Compliance function is independent from the business activities of the bank and is managed by the head of IFI compliance, who reports directly to the IFI board. The head of IFI compliance shall also submit a compliance report to the IFI board on the compliance-related activities/matters. Compliance staff shall not be placed in a position in which there is a possible conflict between their compliance responsibilities and any other responsibilities they may have.

1.2.9. Authority

The following is a list of the necessary authority needed for the compliance officer to fulfill his responsibilities:

■■ Unrestricted and unlimited access to all information and records.■■ Authority to interview any employee regarding any conduct, business

practice, ethical matter, or any other issue that is relevant to the dis-charging of compliance duties.

■■ Ability to retain any resources, at the bank’s expenses including outside experts it deem necessary in the performance of its duties.

1.2.10. Termination/Resignation/Hand-Over of the Compliance Officer’s Task

The compliance officer shall ensure proper hand-over of the compliance function to the person taking over the compliance function in the event of

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transfer/termination/resignation/change of the compliance officer. The com-pliance officer shall hand over all documents and materials relating to work and ensure a smooth transition of duties and responsibilities.

1.3. CONCEPT OF RISK

Generally, risk is used as a synonym of hazard, danger, peril, jeopardy.9 However, as a noun the term risk is the possibility of loss or damage of money or property. If it is related to the stock exchange, for instance, it is the degree of possibility that an asset may increase or decrease in value. However, risk as a verb means to expose oneself or someone or something to danger, failure, or loss.10 There are a few definitions of risk that depend on the point of view of each particular discipline. Each particular area of knowledge will treat the term differently based on its background and area of specialization. In this regard, we may find various definitions according to the area of the knowledge as such economics, finance, or others. The defini-tion will reflect the concept of that particular discipline.

In order to understand the wider scope of risk, a few definitions are provided below in order to give a comprehensive understanding of the term risk in various fields of knowledge:

■■ “Risk is a condition in which there is a possibility of an adverse devia-tion from a desired outcome that is expected or hoped for.”11

■■ “The chance of making a loss, this could be making a loss on an asset sale or the possibility of machine failure.”12

■■ “The risk is amount one potentially stands to lose by a transaction.”13

■■ “Risk can be defined as the volatility of unexpected outcomes, which can represent the value of assets, equity, or earning.”14

From these definitions, there are different types of concepts provided under the purview of risk. It seems that the term risk has various classifica-tions, the two major parts most related to the business and financial transac-tions are: the business risk and the financial risk. The business risks are those that the corporation assumes willingly to create a competitive advantage and add value for shareholders. Business risk includes the business decision companies make and the business environment in which they operate.15 On the other hand, the financial risk is related to possible losses owing to finan-cial market activities.16

As a conclusion, risk includes some important points:

■■ Risk is the concept of a potential negative impact to valuable thing.■■ It may arise from some present process or future event.

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■■ It is often used synonymously with the probability of a known loss.■■ The probable loss in the risk can be uncertain.■■ Risk can be in business or finance or other classifications.■■ It has a bad implication on the financial institutions.■■ It can be managed in order to mitigate its impact, and avoid its implications.■■ Risk is a part of the business portfolio.

1.4. THE CONCEPT OF SHARl ÀH NON-COMPLIANCE RISK

1.4.1. Risk from an Islamic Perspective: The Islamic Financial Services Board/IFSB Point of View

According to the Islamic Financial Services Board (IFSB), there are six types of risks faced by the Islamic financial institution: credit risk, equity invest-ment risk, market risk, liquidity risk, rate of return risk, and operational risk. The Sharīàh non-compliance risk is discussed under the operational risk.

According to IFSB, there are two principles governing the operational risk:

Principle 1: Institutions offering Islamic Financial Services (IIFS) shall have in place adequate systems and controls, including Sharīàh board/ advisor, to ensure compliance with Sharīàh rules and principles.

Principle 2: IIFS shall have in place appropriate mechanisms to safe-guard the interests of all fund providers. When the Investment Account Holders (IAH) funds are commingled with IIFS’ own funds, IIFS shall ensure that the bases for asset, revenue, expense, and profit allocations are established, applied, and reported in a manner consistent with IIFS’ fiduciary responsibilities.17

The first principle is related to Sharīàh risk, whereas the second prin-ciple is related to safeguarding the interest of the IAH funds.

■■ The Islamic bank is responsible for curbing any occurrence of opera-tional risk; therefore, any losses resulting from this type of risk due to some inadequate or failed internal process will be borne by the Islamic financial institution. The possible cause of loss resulting from a Sharīàh non-compliance event and the failure in its fiduciary is the responsibility of the bank as well.

■■ According to IFSB, Sharīàh non-compliance risk is the risk that arises from IIFS’ failure to comply with the Sharīàh rules and principles, as determined by the Sharīàh board of the IIFS or the relevant body in

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the jurisdiction in which the IIFS operate.18 Sharīàh is highly appreci-ated in the Islamic bank operation, and failure to comply with Sharīàh rules may expose the Islamic financial institution to high financial risk due to the invalidity of the transactions. IFSB highlighted the relevant issue very clearly by stating that: “Sharīàh compliance is considered as falling within a higher priority category in relation to other identified risks. If IIFS do not comply with Sharīàh rules and principles, their transactions must be cancelled and income generated from them shall be considered as illegitimate.”19

Under principle 7.1 of Sharīàh non-compliance risk, IFSB highlighted the following clauses:

■■ IIFS shall ensure that they comply at all times with the Sharīàh rules and principles as determined by the relevant body in the jurisdiction in which they operate with respect to their products and activities. This means that Sharīàh compliance considerations are taken into account whenever the IIFS accept deposits and investment funds, provides finance, and carries out investment services for its customers.

■■ IIFS shall ensure that its contract documentation complies with Sharīàh rules and principles—with regard to formation, termination, and ele-ments possibly affecting contract performance, such as fraud, misrepre-sentation, duress, or any other rights and obligations.

■■ IIFS shall undertake a Sharīàh compliance review at least annually, per-formed either by a separate Sharīàh control department or as part of the existing internal and external audit function by persons having the required knowledge and expertise for the purpose.

■■ The objective is to ensure a. The nature of the IIFS’ financing and equity investment. b. Its operations are executed in adherence to the applicable Sharīàh

rules and principles as per the fatwa, policies, and procedures approved by the IIFS’ Sharīàh board.20

■■ IIFS shall keep track of income not recognized arising out of Sharīàh non-compliance and assess the probability of similar cases arising in the future. Based on historical reviews and potential areas of Sharīàh non-compliance, the IIFS may assess potential profits that cannot be recognized as eligible IIFS’ profits.

1.4.2. Sharı àh Compliance and Area of Coverage

Sharīàh non-compliance risk has a wider scope in Islamic banking and finance. It is an end-to-end process that consists of these important parts: structure of

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the facility/product/service, the terms and conditions of the facility/product/legal documentation, the execution of the legal documentations/product and implementation of the product or services in the market place, and the related IT system along with the related multimedia and broadcasting.

1.4.2.1. Structure of the Facility/Product/Service The structure of the product/service or the facility should be Sharīàh-compliant, whereby it should be structured in such a way that complies with the underlying contract used such as ijarah. This includes but is not limited to the flow and procedure of the product; the relationship between the parties in the facility; the source of the fund; the use of the fund; the profit generated; the nature of the relation-ship between the different contracts used in the facility; the nature of the combination of the contracts if applicable; how the product is built, struc-tured, and designed; and how it works and functions.

The aforementioned aspects should satisfy the Sharīàh requirements, and when there is a potential Sharīàh non-compliance risk, a Sharīàh justifi-cation should be provided in order to demonstrate the position of the Islamic financial institution, along with giving guidance to the team of Sharīàh review and audit when they conduct their function to avoid misunderstand-ing and confusion. The people responsible for the Sharīàh compliance in this area are the Sharīàh board and the supporting division from Sharīàh management/Sharīàh advisory and legal Sharīàh review and Sharīàh audit.

1.4.2.2. The Terms and Conditions of the Facility/Product/Service The terms and con-ditions (T&C) must be compliant with Sharīàh rules and principles, and the clauses in the T&C should reflect the underlying relevant contracts used in the facility (product or services). In addition, if the conventional documenta-tions are used, the conventional T&C, which are not allowed by Sharīàh, should be removed and replaced by relevant terminologies to reflect the spirit of Sharīàh and Islamic finance in the form and substance. The T&C should be free from any clause that may contradict the very nature of the contract applied. The careful stipulation of the T&C will result in accu-rate legal documentation that comply with Sharīàh rules and principles. The people responsible for Sharīàh compliance in this area are the Sharīàh board and the supporting division from Sharīàh management/Sharīàh advisory, legal, Sharīàh review, and Sharīàh audit.

1.4.2.3. The Execution of the Legal Documentations/Product/Service The other area of Sharīàh non-compliance risk that should be observed is the execution of the contracts along with the relevant legal documentation by looking at the sequence of the contracts according to the process and procedure required. The execution is looking at the way that the products and services have been

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implemented at the operational level. The people responsible for Sharīàh compliance in the execution and implementation are the relevant employees of the Islamic bank/the owner of the product. The people responsible to ensure that there is no discrepancy in the process of execution and imple-mentation are the Sharīàh review and Sharīàh audit employees.

1.4.2.4. The Information Technology Infrastructure and System The information technology infrastructure and system has great importance in the daily banking operation of the Islamic bank. The IT system represents a risky area of Sharīàh non-compliance risk. The Islamic financing facility, its execution, and its implementation are riding on the IT system. Hence, a proper consideration should be given to this area, which represents part of the Sharīàh compliance process. The IT infrastructure and system should reflect the Sharīàh requirements in the feature, information, sequence, and execution in such a way that helps the officers of the Islamic bank to Sharīàh non-compliance if it has happened even by mistake. The sys-tem should be resilient enough to block any attempt to transact any non-Sharīàh-compliance transaction. It should be understood that restruc-turing the IT infrastructure and system in a bank has a very huge cost; how-ever, progressive improvement in the system and gradual enhancement of the IT system should be part of the concern of the management. Meanwhile, the gaps that exist should be addressed in a timely and careful manner, and discrepancies should be rectified manually to ensure proper transactions that fulfill Sharīàh in its form and substance. The people responsible for Sharīàh compliance in this area are the Sharīàh board and the supporting division from Sharīàh management/Sharīàh advisory, and the IT team.

1.4.2.5. Marketing Collateral, Multimedia, and Broadcasting Marketing collateral and materials, multimedia, and broadcasting represent the image of the Islamic financial institution. These represent the means of communication between the Islamic bank and the public that build the reputation of the bank. The improper presentation of the Islamic financial bank will expose the bank to reputation risk. Therefore, a serious concern should be given to these tools to ensure that the IFI message is properly and clearly delivered without ambiguity or confusion.

The most important criteria that should be observed in the area of mar-keting collateral, multimedia, and broadcasting are as follows:

■■ Honesty and sincerity in advising the client when offering products, especially those related to some banking facilities or takaful products.

■■ Adequate disclosure on the information related to the product to the client, and no hidden cost.

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■■ Avoid deception and misrepresentation of the product.■■ Avoid convincing the client to buy the product or subscribe to it, if the

marketing officer knows that the product is not within the interest of the client. Therefore, it should be fair advice, neutral presentation of the product by explaining the features and the facts without exaggeration that may mislead the client.

■■ Balance between the key performance indicator (KPI), which is the self-interest of the marketing officer and his company and the interest of the client.

■■ Marketing and pushing the product should be governed by the public interest of the market and customers, and not by the private interest of the company.

■■ Consultancy and advice should be embedded in the process of market-ing and selling as a kind of mutual help and co-operation.

■■ Contentment is a valuable ethic that the seller should keep in mind when promoting its products in the market. Misunderstanding of this valuable ethic will lead to greed and self-interest without consideration of the interest of others, which may destroy the society.

■■ Contentment brings barakah, the blessing from God, whereas greed brings evil and leads to corruption.

■■ The profit maximization should be shifted to reasonable profit, because maximization does not give space to others who want to earn money and accumulate wealth. The concept of wealth and profit maximization will remove tolerance in the competition, and it will change the features of brotherhood and friendly competition to war and enmity, in which everyone wants to expel his competitor from the market. Maximization does not give space to sharing and cooperation. The thinking should change to bring the business community to a level of satisfaction on what they have in hand and avoid looking at the hand of others. Brotherhood is more important than wealth, living together with rea-sonable wealth is better than one person living alone with mountains of wealth while others serve him. The Prophet says: Who among you is safe in his house, healthy in body, he has a living for a day, he gathered him the whole world.

■■ Avoid any improper description about the products that belong to other competitors. This is because the objective of selling and earning money does not justify the non-permissible means such as downgrading the value of other products to convince the client of subscribe to one’s own product. This is unethical.

■■ Marketing collateral, multimedia, and broadcasting should be free from any Sharī`ah non-compliance feature, contents, or image.

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The people responsible for the Sharīàh compliance in this area are the Sharīàh board and the supporting division from Sharīàh management/Sharīàh advisory, and the marketing team.

1.5. REVIEW OF THE CONCEPT OF SHARl ÀH NON-COMPLIANCE RISK

According to IFSB’s definition, Sharīàh non-compliance risk is the risk that arises from IIFS’ failure to comply with the Sharīàh rules and principles determined by the Sharīàh board of the IIFS or the relevant body in the jurisdiction in which the IIFS operate.21 This definition puts the responsi-bility of Sharīàh non-compliance risk solely on the IFI, which means the failure of the IFI to comply with the resolutions of the Sharīàh board will lead to Sharīàh non-compliance risk. This definition does not address the possible failure of the Sharīàh board to provide a sound resolution in cases in which the Sharīàh board changes its positions or amends its resolution because of the lack of information provided, or due to other reasons.

Therefore, the appropriate definition of Sharīàh non-compliance risk should be as follows: “Sharīàh non-compliance risk is the risk that arises from (1) IIFS’ failure to comply with the Sharīàh rules and principles deter-mined by the SAC (in case of Malaysia, the Sharīàh Advisory Council is the high authority pertaining to Islamic finance matters, and their resolution are binding on the IFI) or, (2) IIFS’ failure to comply with the Sharīàh rules and principles determined by the Sharīàh board/committee or, (3) failure of the Sharīàh board to achieve a sound resolution due to the lack of informa-tion provided to them or due to other reasons.” In all cases, rectification is required to put the practice back on track according to Sharīàh status.

The preceding definition comprehensively addresses both types of risk and makes both parties responsible for Sharīàh non-compliance risk. Both types of Sharīàh non-compliance risk lead to the same results, so that, in some cases of non-Sharīàh compliance, the profit will not be recognized and the income will be disposed of and channeled to a charitable fund account. (See Figure 1.1)

Sharīàh non-compliance risk can arise either from the Islamic finan-cial institution or from the Sharīàh board. The concept of Sharīàh non- compliance risk here is based on the argument that the issue of Sharīàh non-compliance risk is about the failure to comply with the Sharīàh rules and principles, regardless of the entity responsible for this failure, and regardless of the reasons behind this failure, be it a genuine reason or oth-erwise. Therefore, the concern is to identify the Sharīàh non-compliance

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risk and apply a proper process to resolve it. The new definition widens the scope of Sharīàh non-compliance risk, respectively changing the shape of dealing with this type of risk; hence, additional risk-management tools will be addressed to cater to this type of risk. The attribution of the Sharīàh non-compliance risk to the Sharīàh board does not tarnish the board’s cred-ibility and reputation. It will not be held liable because, from an Islamic jurisprudence perspective, the scholar who performs ijtihad in a proper manner, as prescribed in Islamic jurisprudence, will be rewarded in both cases, irrespective of whether his ijtihad is right or wrong. In fact, when the resolution is issued based on the information provided by the Islamic bank or third party, it is deemed sound. However, if additional facts and informa-tion emerge later, the resolution that has been issued will not be relevant anymore and it might be totally revised. The potential risk in this case is that the bank may start the execution of the product or services based on the early resolution of the Sharīàh board. However, after the revision of the resolution based on the new information furnished, what has been executed and implemented by the IFI will be revised and rectified.

From a Sharīàh review and Sharīàh audit perspective there is no dis-crepancy in the process as far as their function is concern, because there is no Sharīàh risk that should be addressed since the practice is in line with the resolution of the Sharīàh committee (SC) of the IFI. But from the Sharīàh board’s perspective, there is a discrepancy due to the additional facts disclosed, which requires a revision of the resolution that may have a

Failure of the IFI to comply with the resolution of the SAC or SC

Failure of the Sharīàh board/committee to provide a sound resolution

Sharīàh non- compliance risk arises from IFI

Sharīàh non- compliance risk arises from SC

FIGURE 1.1 The Concept of Sharīàh Non-Compliance Risk

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major impact on the existing transactions executed. Therefore, Sharīàh non- compliance is triggered, and measurement rectification should take place.

1.6. FEATURES OF SHARl ÀH NON-COMPLIANCE RISK

Sharīàh non-compliance risk features and criteria can be summarized as follows:

■■ Sharīàh non-compliance risk is a major concern in the risk manage-ment framework.

■■ Sharīàh compliance is significantly considered the banking process, whether in the stage of fund mobilization in taking deposit or at the level of providing financing, services or investment (retail and/or cor-porate market).

■■ Sharīàh compliance is a consistent process which should be maintained at all times by the Islamic financial institutions.

■■ Sharīàh compliance is about ensuring that the financial transactions carried out by IFIs are in accordance with Sharīàh rules and princi-ples. It means that financing, investment and the entire banking busi-ness operations are executed in strict adherence to the applicability of Sharīàh rules and principles.

■■ Sharīàh non-compliance risk is understood within the resolutions, poli-cies and procedures approved by the IIFS’s Sharīàh board, meaning that if the IFI is executing some business operations that are against other resolutions issued by Sharīàh boards of other IFI, it does not trig-ger Sharīàh non-compliance risk.

■■ Sharīàh compliance risk should be observed in the legal documenta-tion, which includes offer, acceptance, and other clauses of the con-tractual agreement that demonstrate the rights and obligations of the contracting parties.

■■ The ex-post Sharīàh non-compliance risk can be assessed or detected during the Sharīàh review process, either internally or externally.

■■ The profit arising from Sharīàh non-compliant transactions are con-sidered illegitimate profit and should be disposed of by means that are acceptable from a Sharīàh perspective, such as channeling the funds to a charitable organization.

1.7. SHARl ÀH NON-COMPLIANCE RISK EVENTS

For Islamic banking purposes, Sharīàh non-compliance risk may occur as a result of non-compliance with resolution/guidelines issued by the regulatory

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bodies (BNM, SC), Sharīàh compliance framework issued by the bank and/or resolution and decisions made by the bank’s Sharīàh committee.

The following are examples of Sharīàh non-compliance risks events that may occur in a bank. The risk may be mapped to the scope of audit.

1.7.1. Audit of Financial Statement

■■ Income from an invalid transaction is not purified and channeled to charity.

■■ Ta`widh (compensation fee) amount was compounded.■■ Zakat is not accurately calculated and not distributed to the proper

recipients (asnaf).■■ Profit distribution calculation for mudarabah fund is not calculated

in accordance to Sharīàh where weightage was assigned for different types of deposits or deductions of ineligible expenses, for example, indi-rect expenses.

1.7.2. Compliance Audit on Organization Structure, People, Processes, and Information Technology

■■ Poor communication between the Sharīàh committee and management that leads to non-Sharīàh-compliance incidences.

■■ Failure to escalate Sharīàh non-compliance incidents to the Sharīàh committee.

■■ Fees/charges imposed to Islamic products and services not in accor-dance with Sharīàh principles.

■■ Uncertainty (gharar) in price/rebate/compensation/fee disputes versus Sharīàh non-compliance status of advertisement, illustration/materials/forms/documentation used in offering products and services.

■■ Acceptance of deposit from Sharīàh non-compliance sources.■■ Financing assets/goods that are non-compliant with Sharīàh

requirements.■■ Sequence of contract execution not in line with Sharīàh ruling/

requirement.■■ Non-existence of underlying asset during contract execution for Islamic

product non-execution or renewal of aqad (agreement) for Islamic contract.■■ Improper usage of Islamic terminology and definition.■■ Bundling of conventional products with Islamic products.■■ Inability of system to cater for the Sharīàh features of the contract, for

example, non-compounding of ta`widh, ceiling limit of selling price.■■ System error resulting in specific aqad not executed upon renewal or

disbursement, for example, commodity murabahah.

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1.7.3. Review of Adequacy of Sharı àh Governance

■■ Non-compliance to requirements outlined in the BNM Sharīàh gover-nance framework.

■■ Non-identification or incomplete identification of Sharīàh risk faced by the bank resulting in poor mitigation.

■■ Absence or irregular Sharīàh review function to conduct compliance review of operations to ensure Sharīàh compliance.

■■ Absence of Sharīàh research functions to conduct in-depth Sharīàh research before submission to the Sharīàh committee.

■■ Absence of measures by the Sharīàh secretariat to ensure that all Sharīàh committee’s resolutions are properly documented and disseminated.

■■ Lack of management of the Sharīàh committee’s interest and wel-fare, including remuneration that may result in difficulty in attracting Sharīàh scholars as SC members.

■■ Absence of proper documentation to support the Sharīàh commit-tee’s resolution or decision that may hamper defence in any case of dispute.

■■ Absence of a comprehensive Sharīàh policy manual to assist staff in ensuring Sharīàh compliance.

1.7.4. Sharı àh Governance Risk


■■ Irregular Sharīàh review function of operations to ensure Sharīàh compliance.


■■ Absence of control measures to ensure that all Sharīàh committee’s resolutions are documented and disseminated.

■■ Lack of management of the Sharīàh committee’s interest and welfare, including remuneration that may result in difficulty in attracting experi-enced Sharīàh scholars as Sharīàh committee members.

■■ Absence of proper documentation to support the Sharīàh committee’s resolution or decision that may hamper defence in any dispute cases.

■■ Absence of a comprehensive Sharīàh policy manual to assist staff in ensuring Sharīàh compliance.

■■ Lack of checking to ensure the board’s annual attestation is accurately reported to BNM.

■■ Poor communication between the Sharīàh committee and management that leads to non-Sharīàh-compliance incidences.

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■■ Non-compliance to requirement in the BNM Sharīàh governance framework (SGF).

■■ Failure by the management to identify and refer any Sharīàh issues to the Sharīàh committee for decision, views, and decisions.

■■ Failure to disclose sufficient information in the annual report on the state of compliance of the bank’s operation in conformity with Sharīàh principles.

1.7.5. Sharı àh Product-Approval Risk

■■ Failure to ensure the Islamic finance product being subject to the correct product-approval process.

■■ New product-approval/guidelines/campaign/process not endorsed by the Sharīàh committee (SC).

■■ Product features non-compliance to Sharīàh principles.■■ Failure to ensure that the contracts are in compliance with BNM’s

Sharīàh parameter reference guidelines, that is, murabahah, ijarah, mudharabahh, musharakah, and istisna.

■■ Lack of processes to ensure that a thorough research was conducted to review new products and business development prior to presentation the Sharīàh committee.

■■ Absence of records to show that a rigorous deliberation process was per-formed by the Sharīàh committee prior to their certification of new prod-ucts and backed by the relevant fiqh literature, evidence, and reasoning.

1.7.6. Sharı àh Documentation Risk

■■ Incorrect legal documentation of financing facilities.■■ Improper/Wrong usage of Islamic terminology and definition.■■ Bundling of conventional products with Islamic products.■■ Non-execution of aqad documentation.■■ Blank or incorrect information and aqad documentation, for example,

price, asset.■■ Failure to ensure that specific clauses in the product documentation, for

example, wadiah, mudharabah.■■ Failure to provide control and reasonable assurance that two different

contracts are concluded separately.

1.7.7. Sharı àh Operational Risk

■■ Incorrect sequencing of buy/sell transactions in BBA contents.■■ Fees/charges imposed to Islamic products and services not in accor-

dance with Sharīàh principles.■■ Uncertainly (gharar) in price/rebate/compensation/fee disputes.

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■■ Sharīàh non-compliance status of advertisement, illustration/materials/forms/documentation used in offering products and services.

■■ Failure to escalate Sharīàh non-compliance incidents to Sharīàh committee.■■ Acceptance of deposit from Sharīàh non-compliance sources.■■ Financing assets/goods that are non-compliant with Sharīàh requirements.■■ Disputes over performance or advisory activities (including Sharīàh

advisory).■■ Sequence of contract execution not in line with Sharīàh ruling/requirement.■■ Failure to ensure the availability and existence of underlying assets dur-

ing the execution or aqad contract for Islamic product.■■ Non-execution of new aqad upon extension or renewal of facility, for

example, MOD.■■ Sharīàh underlying asset used for transaction of specific contract is

non-Sharīàh compliant, for example, debt-based instrument used for debt-base sale.

■■ Non-execution of separate Aqad, for example, sale contract, after end of leasing in al-Ijarahthumma al-Bai (AITAB) products.

■■ Non-execution of supporting contract, for example, wakalah for com-modity Murabahah.

■■ Failure to identify and comply with purification process of business income arising from Sharīàh non-compliance business transaction activities, that is, donated to charity.

■■ Failure to ensure that the contract transaction is in conformity with the basic tenets (elements and conditions) of the contract used in, for example, sell-based leasing.

■■ Failure to observe and implement rulings decisions and resolutions made by the Sharīàh committee.

■■ Failure to comply with BMN Sharīàh advisory councils (SAC) resolutions.■■ Non-genuine sell and buy transaction by commodity vendors that may

lead to invalid contracts for commodity murabahah products.■■ Failure to ensure that any transaction involving payment of excesses by

the bank is supported by an Islamic contract to avoid riba.

1.7.8. Sharı àh Reputational Risk

■■ Lack of knowledge of Sharīàh/Islamic banking products and compe-tencies of staff.

■■ Lack of clarity/transparency in the Sharīàh product’s features, docu-mentation, and marketing materials.

■■ Excessive charge/compensation or penalty.■■ Corporate image with regards to perception by customers of staff dress

code and other Islamic-related matters in the operations of Islamic banking outlets.

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■■ Non-Sharīàh-compliant marketing material that may result in poor perceptions of Islamic banking.

■■ Concept used for product not globally accepted.■■ Non-restriction of Islamic credit-card facility to purchasing non-

permissible goods, services, or at non-permissible merchants and establishments.

1.7.9. Sharı àh Treasury Risk

■■ Sharīàh non-compliant instrument being used for treasury and hedging activities for the Islamic financial institutions.

■■ Investment staff did not monitor or divest from investment subsequently reclassified as non-compliant.

■■ Underlying asset used for issuance of the Islamic financial institution share certificate to branches for use during Bai` ìnah execution was not monitored and replaced upon expiry or trade.

1.7.10. Sharı àh IT Risk

■■ Inability of system to cater to the Sharīàh features of the contract, for example, non-compounding of tawith ceiling limit of selling price. System error resulting in specific aqad not executed upon renewal or disbursement, for example, commodity murabahah products.

1.7.11. Sharı àh Credit Risk

■■ Lack of checking resulting in Islamic credit facility granted to non-eli-gible customers.

■■ Lack of checking resulting in granting of financing facility for the pur-pose of financing asset that is not permissible under Sharīàh.

■■ Lack of checking resulting in granting of financing facility for the pur-pose of financing asset intended for a purpose that is not permitted under Sharīàh.

1.7.12. Sharı àh Investment Banking/Asset Management Risk

■■ Poor controls resulting in Sharīàh non-compliant securities allowed for trading using the Islamic stock broking facilities.

■■ Poor controls resulting in commingling of Sharīàh and conventional income.

■■ Lack of monitoring to ensure that the lease asset under Sukuk with ija-rah contract is insured with Takaful instead of conversional insurance.

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1.8. THE SHARl ÀH BASIS FOR SHARl ÀH COMPLIANCE

There are many provisions from Quran and sunnah that emphasize on adherence to Sharīàh compliance. These provisions are commands from the Lawgiver to ensure the status of Sharīàh compliance in human being activi-ties including Islamic finance activities.

A. Quran

Allah Says:

“And now have We set thee (O Muhammad) on a clear road of (Our) commandment; so follow it, and follow not the whims of those who know not.” (Al Jathiya: 18)

Allah Says:

“but help ye one another unto righteousness and pious duty. Help not one another unto sin and transgression, but keep your duty to Allah. Lo! Allah is severe in punishment.” (Al Maeda: 2)

Allah Says:

“O ye who believe! Obey Allah, and obey the messenger and those of you who are in authority; and if ye have a dispute concerning any matter, refer it to Allah and the messenger if ye are (in truth) believ-ers in Allah and the Last Day.” (AnNisa: 59)

Allah Says:

“But nay, by thy Lord, they will not believe (in truth) until they make thee judge of what is in dispute between them and find within themselves no dislike of that which thou decidest, and submit with full submission.” (AnNisa: 65)

Allah Says:

“Lo! We reveal unto thee the Scripture with the truth, that thou mayst judge between mankind by that which Allah showeth thee. And be not thou a pleader for the treacherous.” (AnNisa: 105)

Allah Says:

“And whoso opposeth the messenger after the guidance (of Allah) hath been manifested unto him, and followeth other than the

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believer’s way, We appoint for him that unto which he himself hath turned, and expose him unto hell—a hapless journey’s end!” (AnNisa: 115)

Allah Says:

“And unto thee have We revealed the Scripture with the truth, con-firming whatever Scripture was before it, and a watcher over it. So judge between them by that which Allah hath revealed, and follow not their desires away from the truth which hath come unto thee. For each We have appointed a divine law and a traced-out way. Had Allah willed He could have made you one community. But that He may try you by that which He hath given you (He hath made you as ye are). So vie one with another in good works. Unto Allah ye will all return, and He will then inform you of that wherein ye differ.” (Al Maeda: 48)

Allah Says:

“And it becometh not a believing man or a believing woman, when Allah and His messenger have decided an affair (for them), that they should (after that) claim any say in their affair; and whoso is rebellious to Allah and His messenger, he verily goeth astray in error manifest.” (Al Ahzab: 36)

Allah Says:

“The saying of (all true) believers when they are called unto Allah and His messenger to judge between them is only that they say: We hear and we obey. And such are the successful.” (Al Noor: 51)

B. Sunnah

Narrated Abu Huraira: Allah’s Apostle said,

“Whoever obeys me, obeys Allah, and whoever disobeys me, dis-obeys Allah.” (Bukhari: Book 9: Volume 89: Hadith 251)

“A’isha reported Allah’s Messenger (may peace be upon him) as saying: He who innovates things in our affairs for which there is no valid (reason) (commits sin) and these are to be rejected.” (Muslim: Book 18: Hadith 4266)

These provisions have been conveyed on different occasions by the Lawgiver, depending on the occasion of each provision. However, the

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provisions together convey the concept of compliance with the rules and commands of the Lawgiver that have been provided in Sharīàh.

NOTES

1. See: AhkamAli Al Kafif, Ahkam Al Muamalat Al Sharīàh (Cairo, Egypt: Dar Al Fikr Al Arabi, 1996),3; Muhammad AkramLaldin, Introduction to Sharīàh and Islamic Jurisprudence (Kuala Lumpur, Malaysia: CERT Publications, 2006), 2; Muhammad HashimKamali, An Introduction to Sharīàh (Kuala Lumpur, Malaysia: Ilmiah Publishers, 2006), 12.

2. The Encyclopaedia of Islam ed. S. Nurit and C. E. Bosworth, Vol. 9 (Leiden, Netherlands: Brill, 1997), 322; Al Kafif, Ahkam Al Muamalat, 3.

3. See: Al Kafif, Ahkam Al Muamalat, 3; Laldin, Introduction to Sharīàh and Islamic Jurisprudence, 3.

4. Ibid. 5. Ibid., 12. 6. Al Haj ad Ajijola, What Is Sharīàh? (Delhi, India: Adam Publishers &

Distributions, 2002), 14. 7. A. H. al-Ghazali, Al-Mustasfa min illm al-Usul (Karachi, Pakistan: Idarah

al-Quran, 1987/1407), vol. 1, 15. 8. Saàdi Abi Jib, Dictionary of Fiqh (Dar al Fikr, Damascus, 1988), 289. 9. See: Merriam-Webster’s Dictionary of Synonyms (Springfield, MA:

Merriam-Webster, 1984), 700. 10. See: Oxford Dictionary Business English (London: Oxford University Press,

1996), 366. 11. Emmett J. Vaughan and Therese Vaughan, Fundamentals of Risk and Insurance,

10th ed. (Hoboken, NJ: John Wiley & Sons, 2008), 3. 12. Alastair Day, Mastering Risk Modeling (Pearson Education Limited, Edinburgh:

2003), 65. 13. John Clark, Dictionary of Banking and Finance Terms (Prospect Media, Sydney:

1999), 286. 14. Philippe Jorion, Value at Risk (New York: McGraw-Hill, 2007), 3. 15. Ibid., 4. 16. Ibid. 17. IFSB, Islamic Financial Services Board (2005), Guiding Principles of Risk

Management for Institutions (other than insurance institutions) offering only Islamic Financial Services, 26.

18. Ibid., 26. 19. Ibid., 27. 20. Ibid.21. Ibid., 26.

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c01.indd 28 18-12-2013 22:34:02

29

CHAPTER 2Sharı ah Compliance in IFSA 2013

and Classification of Sharı ah Non-Compliance Risk

2.0. INTRODUCTION

The legal amendments in the law represent a milestone that takes Islamic finance in Malaysia to the next level. The new legislation emphasizes Sharī`ah compliance and establishes Sharī`ah certainty, responsibility, and account-ability. The Islamic Financial Services Act (IFSA) shall replace both Islamic Banking Act (IBA) 1983 and Takaful Act 1984 (Section 282). IBA, enacted in 1983 (30 years ago), was based on the old Banking Act of 1973. In 1989, the Banking Act 1973 for conventional banks was replaced with the more comprehensive BAFIA. However, IBA was never upgraded until the recent passing of the IFSB. Hence, most of the laws are new to the industry but largely already known in the form of regulations/guidelines from the central banks. IFSB is generally similar to the Financial Services Bill 2012 (FSB) but with specific sections unique to in catering to the Islamic banking business.

2.1. PROVISIONS UNIQUE TO ISLAMIC BANKS IN IFSA 2013

2.1.1. Islamic Banking Business

Previously, Islamic banking was defined by the IBA as “banking business whose aims and operations do not involve any element that is not approved by the religion of Islam.” Now under IFSA, it is defined as:

1. Accepting Islamic deposit with or without the business of paying or col-lecting cheques.

2. Accepting money under an investment account.

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3. Provision of finance. 4. Such other business as prescribed under Section 3 of IFSB (Section 2).

The aforementioned are the major banking business activities carried out by the Islamic financial institutions. However, Islamic banking business can be defined as the business banking activities such as accepting deposit, collecting cheques, investment, provision of finance; and other business related to the nature of the financial institution based on Sharīàh rules and legal requirements prescribed by the regulators.

2.1.2. Islamic Deposit and Investment (Section 2)

2.1.2.1. Islamic Deposit Money accepted or paid in accordance with Sharīàh will be repaid in full with or without any gains either on demand or at a time or circumstances agreed upon.

2.1.2.2. Islamic Investment Money paid and accepted for the purposes of investment in accordance with Sharīàh is without obligation to repay the money in full where the profits or losses are shared between the person paying the money and the person accepting the money with or without any return. In essence, deposit is principal guaranteed and investment is where principal is not guaranteed.

2.1.3. Finance and Other Business (Section 2)

2.1.3.1. Finance Finance includes entering into or making an arrangement for another person to enter into the business or activities that are in accor-dance with Sharīàh, including equity or partnership financing; lease-based financing; sale-based financing; currency-exchange contracts; fee-based activity; purchase of bills of exchange, certificates of Islamic deposit, or other negotiable instruments; and the acceptance or guarantee of any liabil-ity, obligation, or duty of any person.

2.1.3.2. Such Other Business under Section 3 This includes international Islamic banking business, Islamic financial intermediation activities, Islamic factor-ing business, Islamic derivatives, and Islamic leasing business.

2.1.4. Sharı àh (Section 29)

There is no specific definition on Sharīàh in Section 2, but under IFSA and read together with the Central Bank of Malaysia Act 2009, Sharīàh, under the context of Islamic finance and services will be the muamalah Sharīàh principles as determined by the Sharīàh Advisory Council (SAC) of Bank

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Sharıàh Compliance in IFSA 2013 and Classification of Sharıàh Non-Compliance Risk 31

Negara Malaysia (BNM). BNM is thereon empowered to give effect to the rulings of SAC and to specify the standards of Sharīàh governance or any other matter related to the business of an Islamic bank. The duty of the board, the Sharīàh committee, the CEO, and the senior officer is to ensure compliance to the standards specified by BNM.

2.1.5. Sharı àh -Related Provisions

A licensed bank and an investment bank under the Financial Services Bill (FSB) can still carry out Islamic banking business subject to written approval from BNM (Section 8 (1)). Breach of Sharīàh standards is one of the bases for revo-cation of banking license (Section 18). For any discovery of breach of Sharīàh:

1. Immediately notify BNM. 2. Immediately notify internal Sharīàh committee. 3. Immediately cease activities in breach. 4. Within 30 days, submit rectification plan to BNM (Section 28).

A financial group may apply to BNM for a single Sharīàh committee to oversees its Islamic financial services and banking business if BNM is satis-fied that the SC has the capability to ensure Sharīàh compliance (Section 30 (2)). Any appointment or termination of a Sharīàh committee member must be with prior written approval of BNM (Section 31 and 33). All information submitted to the Sharīàh committee shall be accurate, complete, and not false or misleading in any material particular (Section 35). Members of the commit-tee are not liable to defamation suit for any statement made in discharge of its duties without malice (Section 36). An external auditor may be appointed by BNM, or by the Islamic bank under directive of BNM, to perform a Sharīàh audit and to report to BNM on any findings and cost to be borne by the Islamic bank (Section 37 and 38). The definition of “Related Party Transactions” now includes Sharīàh committee members (Section 57). The board is obligated to give due regards to any Sharīàh committee decisions in relation to Islamic bank-ing business before making its final decision (Section 65). Maximum permis-sible holdings for Islamic banks may exceed 10 percent subject to prior written approval of BNM (Section 104). Islamic bank mergers are no longer via Section 176 of the Companies Act, because they are now provided for under IFSA.

2.2. SHARl ÀH COMPLIANCE IN IFSA 2013

IFSA has shifted the legal framework and legislation in Malaysia to the next level, which marks a new face in the history of the Islamic banking and finance legislation in Malaysia.

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The IFSA and the Sharīàh governance framework (SGF) represent milestones in promoting Sharīàh governance and Sharīàh compliance in Malaysia. The objectives of IFSA are as follows:

■■ To promote financial stability and Sharīàh compliance in the banking activities.

■■ To strengthen the foundations for the entire business banking model, such that the IFSA is end-to-end with Sharīàh governance and compliance.

■■ To support the Sharīàh compliance contracts in the Islamic financial products and services.

■■ To give strong warning followed by penalties in case there is a failure to comply with Sharīàh mandate.

■■ To align legal and regulatory principles with Sharīàh precepts, while promoting greater legal operational certainty.

■■ To emphasize the significant role of the central bank of Malaysia BNM as regulator.

■■ To entrench Sharīàh principles and the Sharīàh Advisory Council rul-ings in the Islamic finance industry.

■■ To enforce Sharīàh compliance status on the market, and drive the Islamic financial institution toward more Sharīàh compliance activities through a close monitoring and by imposing penalties.

■■ To appreciate the Sharīàh non-compliance risks, and manage them in a very effective manner, which compliments the Sharīàh non-compliance report-ing and other aspects as mentioned in the Sharīàh governance framework.

■■ To impose strict and severe offences and penalties as a result of failure to comply with Sharīàh compliance.

Section 28: Duty of Institution to Ensure Compliance with Sharı àh.

The IFSB Act 2012 highlights the duty of institutions to ensure compliance with Sharīàh.

In Section 28 (1), an institution shall at all times ensure that its aims and operations, business affairs, and activities are in compliance with Sharīàh. In Section 28 (2), for the purposes of this act, a compliance with any ruling of the Sharīàh Advisory Council with respect of any particular aim and operation, businesss affair, or activity shall be deemed to be in compliance with Sharīàh with respect to the aims and operations, business affairs, or activity.1

With regards to non-Sharīàh compliance and the process of rectifica-tion, the Act has highlighted that the non Sharīàh compliance cases should be reported to the regulators.

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According to Section 28 (3), where an institution becomes aware that it is carrying on any of its business affairs or activities in a manner that is not in compliance with Sharīàh or with the advice of its Sharīàh committee or the advice or ruling of the Sharīàh Advisory Council, the institution shall:

1. Immediately notify the bank and its Sharīàh committee of the fact. 2. Immediately cease from carrying on such business, affair, or activity and

from taking on any other similar business, affair, or activity. 3. Within 30 days of becoming aware of such non-compliance or such fur-

ther period as may be specified by the bank, submit to the bank a plan on the rectification of the non-compliance.

4. The bank may carry out an assessment as it thinks necessary to deter-mine whether the institution has rectified the non-compliance referred to in subsection (3).

5. Any person who contravenes subsection (1) or (3) commits an offence and shall, on conviction, be liable to imprisonment for a term not exceed-ing eight years or to a fine not exceeding 25 million ringgit or to both.2

As a summary of Section 28, which determines the duty of an institution to ensure compliance with Sharīàh rules and principles:

■■ An institution shall at all times ensure that its aims and operations, busi-ness affairs, and activities are in compliance with Sharīàh. This can be shown in the vision, mission, tag-line statement of the IFI, and demon-strated in their practices and operations.

■■ Compliance with the resolutions of SAC of BNM shall be deemed to be compliance with Sharīàh.

■■ In case the institution becomes aware that it is carrying on any of its business affairs or activity in a manner that is not in compliance with Sharīàh or the resolutions of its Sharīàh committee or the resolutions of SAC of BNM, the institution shall: a. Immediately notify BNM and its Sharīàh committee of the fact. b. Immediately cease from carrying on such business affairs or activ-

ity and refrain from taking on any other similar business affair or activity.

c. Within 30 days of becoming aware of such non-compliance or such further period as may be specified by BNM, submit to BNM a plan of rectification of the non-compliance.

■■ Plan on the rectification of the non-Sharīàh compliance.■■ Any person who contravenes this section commits an offence and shall,

on conviction, be liable to imprisonment for a term not exceeding eight years or to fine not exceeding 25 million ringgit or both.

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2.2.1. Section 29: Power of Bank to Specify Standards on Sharı àh Matters

1. The bank may, in accordance with the advice or ruling of the Sharīàh Advisory Council, specify standards— a. On Sharīàh matters with respect to the carrying on of business

affairs or activities by an institution that requires the ascertainment of Islamic law by the Sharīàh Advisory Council; and

b. To give effect to the advice or rulings of the Sharīàh Advisory Council. 2. In addition, the bank may also specify standards relating to any of the

following matters that do not require the ascertainment of Islamic law: a. Sharīàh governance including—

i. Functions and duties of the board of directors, senior officers, and members of the Sharīàh committee of an institution in relation to compliance with Sharīàh.

ii. Fit and proper requirements or disqualifications of a member of a Sharīàh committee.

iii. Internal Sharīàh compliance functions. b. Any other matter in relation to the business affairs and activity of

an institution for the purposes of compliance with Sharīàh. 3. Every institution, its director, chief executive officer, senior officer, or

member of a Sharīàh committee shall at all times comply with the stan-dards specified by the bank under subsections (1) and (2), which are applicable to such person.

4. Every institution shall at all times— a. Ensure that its internal policies and procedures on Sharīàh governance

are consistent with the standards specified by the Bank under this section. b. Regardless of whether standards have been specified by the bank

under this section, manage its business affairs and activities in a manner that is not contrary to Sharīàh.

5. Every director, officer, or a member of a Sharīàh committee of an insti-tution shall at all times comply with the internal policies and procedures adopted by such institution to implement the standards specified by the bank under subsection (1) or (2).

6. Any person who fails to comply with any standards specified under subsection (1), commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding 25 million ringgit or to both.3

As a summary of Section 29:

Power of the bank to specify standards on Sharīàh matters Bank Negara Malaysia will specify standards on:

■■ Sharīàh matters.■■ Sharīàh governance.

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■■ Any other matter in relation to the business affairs and activity of an institution for the purposes of compliance with Sharīàh.

■■ Every institution, its director, chief executive officer, senior officer, or member of a Sharīàh committee shall at all times comply with BNM standards applicable to such person.

■■ Every institution shall at all times—■■ Ensure that its internal policies and procedures on Sharīàh gover-

nance are consistent with the standards specified by BNM.■■ Manage its business affairs and activities in a manner that is not contrary

Sharīàh regardless of whether standards have been specified by BNM.■■ Every director, officer, or a member of Sharīàh committee of an institu-

tion shall at all times comply with the internal policies and procedures adopted by such institution to implement BNM standards.

■■ Any person who fails to comply with any BNM standard commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding 25 million ringgit or to both. (See Table 2.1.)

TABLE 2.1 Offences and Penalties under Sections 28 and 29

Offence Penalty

1 Failure to comply with BNM stan-dards on Sharīàh matters, that give effect to SAC rulings, ruling of BNM SAC, advice of Sharīàh committee, and Sharīàh principles.

On conviction, not exceeding 8 years imprisonment or fine of 25 million ringgit or both.

2 Failure to immediately report, or cease Sharīàh non-compliant activ-ity, or submit rectification plan in accordance with Act and Circular.

On conviction, not exceeding 8 years imprisonment or fine of 25 million ringgit or both.

3 Failure to comply with BNM stan-dards on Sharīàh governance.

Monetary penalty to be imposed by BNM: s.245 (3), or 247, Schedule 15 (3).

4 Failure to comply with BNM stan-dards in relation to the business affairs and activity of an institu-tion for the purpose of Sharīàh compliance.

■ Fine not exceeding 5 million ring-git if body corporate/1 million if individual.

■ Fine shall not exceed 3 times the gross amount of pecuniary gain made or loss avoided as a result of the breach.

■ Fine shall not exceed 3 times the amount of money that is the subject matter of the breach, whichever is greater, for each breach or failure to comply.

5 Failure to ensure that internal poli-cies and procedures are consistent with BNM standards.

6 Failure to comply with internal policies and procedures adopted to implement BNM standards.

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Section 35: Information to Be Provided to Sharı¯àh Committee

1. An institution and any director, officer, or controller of such institution shall— a. Provide any document or information within its or his knowledge, or

capable of being obtained by it or him, which the Sharīàh committee may require.

b. Ensure that such document or information provided under paragraph (a) is accurate, complete, not false or misleading in any material par-ticular, to enable the Sharīàh committee to carry out its duties or perform its functions under this Act.

2. Except as provided in Section 36, a member of a Sharīàh committee shall not disclose any document or information furnished under subsec-tion (1) to any other person.4

As summary of Section 35,

An institution and any director, officer, or controller of such institution shall:

■■ Provide the relevant documents or information to the Sharīàh com-mittee upon request, this cooperation to ensure a sound decision on Sharīàh matters for the IFI.

■■ Ensure the soundness and accuracy of the documents and informa-tion provided to the Sharīàh committee.

■■ Enable the Sharīàh committee to carry out its duties or perform its functions under this Act.

■■ Not disclose any document or information furnished to any other person (except for purposes of reporting to BNM, discharging his duties, in good faith and without malice).

Section 36: Qualified Privilege and Duty of Confidentiality

A member of a Sharīàh committee shall not be liable—

a. For a breach of a duty of confidentiality between such member and the institution in respect of— i. Any reporting to the bank. ii. The discharge of his duties and performance of his functions, pursu-

ant to any standards specified by the bank under subparagraph 29(2)(a)(i), which was done or made in good faith.

b. To be sued in any court for defamation in respect of any statement made by the member without malice in the discharge of his duties under this Act.5

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The members of a Sharīàh committee have been given the privilege to access some information and to deal with confidential matters in the IFI; however, in carrying out their duties, the Sharīàh commit-tee shall not be liable—

■■ For breach of a duty of confidentiality of the institution such as reporting to the bank; or the discharge of his duties.

■■ For breach of duty related to any standards specified by the bank under subparagraph 29(2)(a)(i), which was done or made in good faith.

■■ To be sued in any court for defamation with respect to any statement made by the member without malice in the discharge of his duties.

Section 37: Appointment of Person by Institution to Conduct Audit on Sharı àh Compliance

1. The bank may require an institution to appoint any person as the bank may approve, to carry out an audit on Sharīàh compliance by the institution.

2. The person appointed under subsection (1) shall have such duties and functions as may be specified by the bank and shall submit a report to the bank on the audit carried out pursuant to this section.

3. The remuneration and expenses of the person appointed under subsec-tion (1) relating to any audit on Sharīàh compliance under this section shall be borne by the institution.

4. A person appointed under subsection (1) shall not be liable for a breach of duty of confidentiality between such person and the institution with respect to matters reported to the bank pursuant to an audit on Sharīàh compliance under this section.


■■ Bank Negara may require an IFI to appoint any person of Bank Negara to carry out Sharīàh audit.

■■ The person appointed shall have such duties and functions as may be specified by Bank Negara and shall submit a report to BNM.

■■ The IFI will bear remuneration and expenses of the Sharīàh auditor.■■ The auditor shall not be liable for a breach of duty of confidentiality

between such person and the institution with respect to matters reported to Bank Negara.

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Section 38: Appointment of Person by Bank to Conduct Audit on Sharı àh Compliance

1. Without prejudice to Section 37, the bank may appoint for an institu-tion any person to conduct an audit on Sharīàh compliance— a. If the institution fails to appoint a person under subsection 37(1); b. In addition to the person appointed under subsection 37(1); or c. Under any other circumstances as the bank deems appropriate for

the purposes of compliance with Sharīàh by the institution, and the remuneration and expenses relating to such appointment shall be borne by the institution.6

As summary of Section 38

■■ If the IFI fails to appoint one under subsection (37)1.■■ In addition to the person appointed under subsection (37)1.■■ Under any other circumstances as the bank deems appropriate for the

purposes of compliance with Sharīàh by the IFI.■■ His remuneration and expenses shall be borne by the IFI.■■ Duties and functions may be specified by BNM and shall submit a

report to BNM.■■ He shall not be liable for a breach of duty of confidentiality with respect

to matters reported to BNM.

Some section in the IFSA Act mentioned that aspects of breach offence was committed without consent or connivance; the exercise of diligence is required to prevent the commission of the offence as he ought to have exer-cised, having regard to the nature of his function in that capacity and to the circumstances.

The following sections fall into some relevant and important aspects in Division 2, administrative actions.

Section 245: Power of Bank to Take Action

1. A person has committed a breach under this Act if the person fails to comply with or give effect to— a. Any provision of this Act. b. Any regulations made under this Act. c. Any order made or any direction issued under this Act by the Bank,

including an order made under Section 106 or a direction issued under Section 128 or 168, subsection 225(6) or Section 227.

d. Any standards, condition, restriction, specification, requirement, or code under this Act.

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2. The bank shall have regard to the following matters in determining the appropriate action to be taken in each case. a. The effectiveness of the enforcement action to be taken under this Act; b. The proportionality of the action to be taken with the breach

committed; c. Deterrence of future breaches of similar nature by other persons;

and d. Any other matter that is considered as relevant in the opinion of the

bank. 3. If the bank is of the opinion that a person has committed a breach and it

is appropriate to take action against that person, the bank may, subject to Section 273, take any one or more of the following actions: a. Make an order in writing requiring the person in breach—

i. To comply with or give effect to. ii. To do or not to do any act in order to ensure compliance with

such provisions, regulations, order, direction, standards, condi-tion, restriction, specification, requirement, or code referred to in subsection (1).

b. Subject to subsection (4), impose a monetary penalty— i. In accordance with the order published in the Federal

Government Gazette Act 759 made under Section 247, or if no such order has been made, such amount as the bank considers appropriate, but in any event not exceeding 5 million ringgit in the case of a breach that is committed by a body corporate run-incorporate or 1 million ringgit in the case of a breach that is committed by any individual, as the case may be.

ii. Which shall not exceed three times the gross amount of pecuni-ary gain made or loss avoided by such person as a result of the breach.

iii. Which shall not exceed three times the amount of money that is the subject matter of the breach, whichever is greater for each breach or failure to comply.

c. Reprimand in writing the person in breach or require the person in breach to issue a public statement in relation to such breach, if it is in the opinion of the bank that such breach is relevant for the information of the general public.

d. Make an order in writing requiring the person in breach to take such steps as the bank may direct to mitigate the effect of such breach.

e. Make an order in writing requiring an authorized person, operator of a designated payment system, or a market participant to rem-edy the breach, including making restitution to any other person aggrieved by such breach.

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4. The bank may impose a monetary penalty under paragraph (3)(b) only with respect to the following: a. Breach of any provision set out in Schedule 15. b. Breach of any requirement under any other provision of this

Act where no offence is provided for non-compliance of that requirement.

c. Failure to comply with any requirement imposed under regulations made under this Act where no provision for imposition of penalty is provided for in accordance with paragraph 271(2)(d).

d. Failure to comply with any standards, code, order, direction, requirement, condition, specification, restriction, or otherwise made or imposed pursuant to any provision set out in Schedule 15.

5. If a breach is committed by a body corporate or un-incorporate, any action under subsection (3) can be taken against a person— a. Who is its director, controller, officer, or partner, or was purporting

to act in any such capacity. b. Who is concerned in the management of its affairs, at the time of the

breach unless that person demonstrates that the breach was com-mitted without his consent or connivance and that he exercised such diligence to prevent the breach as he ought to have exercised, hav-ing regard to the nature of his function in that capacity and to the circumstances.

6. If a breach is committed by a person— a. Who is a director, controller, officer, or partner of a body corporate

or un-incorporate, or was purporting to act in any such capacity. b. Who is concerned in the management of the affairs of a body corpo-

rate or un-incorporate, an action under subsection (3) can be taken against the body corporate or un-incorporate.

7. For the purposes of paragraph (3)(e), in determining whether any amount is to be paid by a person in breach, the bank shall have regard to— a. Whether one or more persons have suffered loss or been otherwise

adversely affected as a result of the breach. b. The profits that have accrued to such person in breach.

8. Any monetary penalty paid by a person in accordance with paragraph (3)(b) shall be paid into and form part of the Federal Consolidated Fund.

9. Where a person fails to pay a monetary penalty imposed by the bank under paragraph (3)(b) within the period specified by the bank, the pen-alty imposed by the bank may be sued for and recovered as a civil debt due to the government.

10. Where a person fails to remedy the breach, including making restitu-tion to any other person aggrieved by the breach under paragraph (3)(e), notwithstanding any other written law, the bank may sue for and

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recover such sum as a civil debt due to the person aggrieved by the breach.

11. Nothing in this section shall preclude the bank from taking any of the actions that it is empowered to take under this Act, in particular, Sections 106, 128, or 168, or any written law.7

Section 250: Civil Actions under Civil Action by Bank

Where it appears to the bank that there is a reasonable likelihood that any person will contravene or has contravened or will breach or has breached or is likely to fail to comply with or has failed to comply with any—

a. Provisions of this Act. b. Provisions of any regulations made pursuant to this Act. c. Order made or direction issued by the bank under this Act including an

order made under Section 106 or a direction issued under Section 128 or 168, subsection 225(6) or Section 227.

d. Standards, condition, restriction, specification, requirement, or code made or issued pursuant to any provision of this Act.

e. Action taken by the bank under subsection 245(3), the bank may insti-tute civil proceedings in the court seeking any order specified under sub-section 251(1) against that person regardless of whether that person has been charged with an offence with respect to the contravention or breach or whether a contravention or breach has been proved in a prosecution.8

2.3. CLASSIFICATION OF SHARl ÀH NON-COMPLIANCE RISK

The risk level may be classified as high, medium, and low.

1. High. Sharīàh non-compliance risk may consist of risk that lead to the invalidation of the contracts without any option to rectify and/or non-recognition of profit. For example, a sale-based contract was entered into without specifically identifying the underlying asset transacted and it has matured.

2. Medium. Sharīàh non-compliance risk may consist of non-compliance of conditions of the contract, but it can be rectified and may not neces-sarily lead to the invalidation of the contract. However, the risk may result in non-recognition of profit. For example, late payment charges beyond the loss incurred or approved limit are channeled to charity.

3. Low. Sharīàh non-compliance risk consists of minimal risk other than high and medium. For example, marketing advertisement containing images of prohibited behavior, such as models not dressed decently, leading to reputational risk that may impact the business.

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NOTES

1. Islamic Financial Services Act 2012. Part IV, Sharī`ah requirements, Division 1, Sharī`ah compliance, 58–59.

2. Ibid.3. Ibid., 59–60.4. Ibid., 63.5. Ibid.6. Ibid., 64.7. Ibid., Section 245.8. Ibid., Section 250.

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43

CHAPTER 3The Major Risk Elements of Sharı ah Non-Compliance Risk and Its Causes

in Islamic Finance Operations

3.0. INTRODUCTION

If we look at the risk from the point of view of Sharīàh, we can identify a few elements or components of risk: riba, gharar, deception, inequality, duress, and others as explained briefly next.

3.1. THE MAJOR RISK ELEMENTS OF SHARl ÀH NON-COMPLIANCE RISK

3.1.1. Riba

Riba literally means increase, addition, expansion, or growth. However, not every increase or growth is prohibited by Islam. The increase in good deeds is encouraged by Sharīàh. Riba technically refers to the “premium” that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or for an extension in its maturity. Based on this connotation, riba has the meaning of “interest” in banking.

3.1.1.1. Types of Riba Riba is divided into two types: riba al duyun/al-nasiàh and riba al buyu/al-fadl.

3.1.1.2. Riba al Duyun/al-Nasiàh The term nasiàh comes from the root nasaà, which means to postpone, defer, or wait. It refers to the time that is allowed to the borrower to repay the loan in return for the “addition” or the “pre-mium.”1 In riba al-nasiàh there is a fixing rate or return in advance paid as

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precondition to grant the loan whereby the lender will get a reward against his waiting, which is not permitted by Shariàh. From a Sharīàh perspec-tive, the reward generated from the loan is not allowed, whether the rate obtained is small or big, fixed or variable. The prohibition also extends to the non-tangible reward generated as gift or service. This type of riba is also known as riba al duyun, which means interest related to debt.

3.1.1.3. Riba al Buyu/al-fadl Riba al-fadl is related to the barter trade in spe-cific commodities: gold, silver, wheat, barley, dates, and salt. There are some Sharīàh rules that should be observed in the exchange of specific commodities, as determined by the following provisions.

From Abu Sa‘id al-Khudri:

The Prophet, peace be on him, said: “Do not sell gold for gold except when it is like for like, and do not increase one over the other; do not sell silver for silver except when it is like for like, and do not increase one over the other; and do not sell what is away [from among these] for what is ready.” (Bukhari and Muslim)

From Ubadaibn al-Samit:

The Prophet, peace be on him, said: “Gold for gold, silver for sil-ver, wheat for wheat, barley for barley, dates for dates, and salt for salt—like for like, equal for equal, and hand-to-hand; if the com-modities differ, then you may sell as you wish, provided that the exchange is hand-to-hand.” (Muslim and Tirmidhi)

The preceding ahhadith govern the transactions of the mentioned com-modities. There are six rabawi items derived from such provisions, namely: gold, silver, wheat, barley, dates, and salt. When there is an exchange between these items, such as gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, Sharīàh rules should be observed.

Sharīàh rules in these commodities are as follows:

■■ Equality in the quantity in the exchange of the rabawi commodity if the subject matter is identical.

■■ If the six commodities are not identical, equality is not required.■■ However, spot transaction is required in the exchange of the six com-

modities, whether the subject matter is identical or not.■■ Therefore, the delay in their exchange is not permissible.

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The Major Elements of Sharıàh Non-Compliance Risk 45

3.1.2. Gharar (Uncertainty)

Gharar in the financial transaction may render the financial contract totally null and void, or it may lead in some cases to compensation. Therefore, it is important to highlight the concept of gharar in the financial transaction. The term gharar literally means danger or fraud, and the source term al-taghrir refers to exposure to danger. The linguistic origin of the term gharar refers to items with a likeable appearance and disliked reality2 or it refers to something that cannot be defined or specified.3 The word gharar has been used to mean risk, uncertainty, and hazard.4 In the technical meaning, the Muslim jurists provide various definitions that are related to the uncertainty and ignorance of one or both parties about the substance or attributes of the subject of sale, or doubt of subject matter’s existence at the time of contract.

The Maliki define gharar as: “what is not known to exist in the future, e.g. birds in the air and fish in the water.”5 Shafiis defines it as: “gharar is that which admits two possibilities, with the worse consequence being the more likely.”6 Shairazi said: “Gharar is that whose nature and consequences are hidden.”7 In this context, the sale of gharar is any sale that incorporates a risk that affects one or more of the parties to the contract and may result in loss of its property.8 The gharar is risk in the sense of lack of certainty regarding the existence of an object. The gharar sale is consequently the sale of that which is not known to exist or whose measure in not known to be large or small, or that which is undeliverable.9 The Muslim jurists agree that the gharar sale is not valid, and may easily render the transaction totally null and void. However, it is important to record that gharar in Islamic law is classified into three categories:

1. The substantial gharar (gharar kathir): This type of gharar is unani-mously prohibited and not accepted in Sharīàh, such as selling a bird in the sky. This is considering an excessive gharar, which renders the financial transaction invalid.

2. The minor gharar (gharar yasir): This type of gharar is unanimously allowed by Sharīàh, such as gharar about the foundation of a house to be bought/sold. The jurists are in agreement that this minor gharar is tolerable and permitted.10

3. The intermediate gharar: This is moderated gharar, which falls between the two previous categories. However, there are a few legal opinions from the Muslim jurists about this category, whether this gharar belongs to the first category or to the second one, depending on the nature of the gharar.

As for the minor gharar, the Maliki and Hanbali schools of law and other Muslim jurists are of the opinion that the minor gharar in sale is

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permitted and accepted in Sharīàh, and it does not affect the business trans-action. This legal Sharīàh approach will facilitate and smoothen the busi-ness transaction and trade in the market.

According to Imam al Nawawi, the minor accepted gharar can be observed in two major areas:

1. Items that are included as part of sale and that may not be sold sepa-rately (e.g., foundation of a house).

2. Items that are customarily tolerated, either due to its insignificance or the difficulty of identifying (e.g., the fees for using a bathroom when the amount of water used in the bath may vary).11

The wisdom behind allowing the minor uncertainty in business transac-tion is to facilitate the flow of cash/wealth in the market. Besides, it is very difficult to achieve zero gharar in business operation within the existing complex market. However, the major uncertainty is not accepted and it is strictly forbidden by Sharīàh in all kind of trade and business activities and is considered as one of the major components of risk.

In this regard, if a major defect is found in asset or commodity, the sale will be invalid based on the option of detecting a defect in the object sold. From the Sharīàh point of view, some business transactions are not allowed because of the substantial risk of uncertainty. One of the objectives of Sharīàh is to remove all kind of conflicts and arguments between the contractual parties. Furthermore, the substantial risk of uncertainty might result in harm or loss to one of the contractual parties. Hence, honesty and transparency with reasonable risk taking in business activities is very impor-tant to be considered in order to secure benefit for both parties through justice and fairness.

3.1.3. Conditions for the Legal Consequences of Gharar

In order for the gharar to take its legal consequences it should fulfill the fol-lowing conditions:

1. The gharar must be excessive. However, if it is trivial and ordinary, such gharar is negligible.

2. Gharar must occur in the financial transaction. However, it should be negligible if it occurs in donation transactions (Uqud al tabarruàt), meaning that gharar is observed only in uqudmuawadat/exchange contracts.

3. Gharar must affect the subject matter of the contract itself directly.12

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3.1.4. Taghrir (Deception, Fraud)

Taghrir (deception) is one of the major components of risk. It stands for inducing a contracting party to think that it is in his interest to take the subject matter whereas, in fact, it is not so.13 According to Majalla, taghrir is to cheat.14 The risk of deception is divided into two types: deception related to statements (taghrir qawli) and deception related to deeds (taghrir fi`li). Taghrir is alternatively called tadlis. Taghrir qawli occurs because of the deception of one of the two contracting parties or his representative in order to induce the other party to conclude a contract even if it happens with inequality. However, taghrir fi`li is deception that occurs through doing something on the subject matter to show it in a condition that contradicts its reality, such as selling a second-hand mobile phone represented by the seller as brand new with a new cover. The buyer will think that this is a new phone, whereas, in fact, it is not. Both deceptions are forbidden in Sharī`ah.15

3.1.4.1. Conditions of the Taghrir There are some conditions required in taghrir in order for it to take its legal consequences. These include:

1. The products or services are misrepresented to the client in the form of statement or in form of deed.

2. The decision made and the consent expressed is based on the misrepre-sentation of the counter party, whereby, upon concluding the contract, one party realizes that he has been cheated.

3. The contract results in financial damage and suffering.

3.1.5. Ghubn (Inequality)

Ghubn is also one of the major components of risk. In the literal sense, it is decrease or reduction.16 Technically, it is inequality of price and subject matter of a contract of exchange—that is, one of them becomes less or more than the other, which was not known at the time of contract.17Ghubn is divided into two types: insignificant inequality (ghubn yasir) and excessive inequality (ghubn fahish). According to Majalla, ghubn fahish means to be deceived with respect to goods.18

Jurists have different opinions about the standard of measuring what is insignificant inequality and what is excessive inequality; some jurists maintain that if this inequality falls within the jurisdiction of evaluators, it is considered insignificant inequality.19 Other jurists have determined a fixed amount for measuring what constitutes an insignificant or excessive inequality. All jurists unanimously agree that insignificant inequality does

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not affect most contracts. This is because it frequently occurs in financial transactions and people tend to forgive each other for this small amount of inequality. However, some contracts with even a small amount of inequality are deemed to be invalid because of the existence of accusation.20

3.1.6. Ikrah (Duress)

Ikrah (duress) in Islamic law is to force someone to do something that he dis-likes, but in order to remove the more harmful aspect, he does so against his consent.21 Or it is a situation in which one is forced to do something against his will.22 However, in order for the duress to be accepted by Sharī`ah and take its legal effect, three conditions must be fulfilled:

1. It should be from a person who is able to implement what he has threatened.

2. The compeller (mukrih) must be serious in his threat. 3. The consequences of the threat must be very difficult for the compelled

to bear.23

Duress is divided into two types: complete duress (ikrah mulji`) and incomplete duress (ikrah ghayr mulji`):

1. Complete duress/serious duress: This is the type in which a threat occurs for homicide, or destruction of an organ of the body, or serious beat-ing that causes fear of destruction of life or an organ, or the threat for destruction of the whole property of a person.

2. Incomplete duress/less serious duress: This type is a threat is for mat-ters other than those already mentioned. It is difficult to bear but not devastating, such as a beating that does not cause fear of destruction, or destruction of part of the wealth of a person.24 Furthermore, duress is divided into justified coercion and unjustified coercion. Regarding the justified coercion, it is like the order of a qadi/judge directing a debtor to pay his creditors, or his command to a man to divorce his wife after the passage of the period of ila. This kind of ikrah does not wrongfully affect the free will of a person, as this duty is imposed by the law-giver.25 On the other hand, the unjustified coercion is coercion without justification.26

According to Islamic law, the person who conducts a business transac-tion under duress or sells or buys under compulsion, his sale is nugatory and illegal.27 However, jurists have three different opinions on whether these contracts are valid under duress or otherwise:

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1. The majority of jurists maintain that duress causes nullification of these contracts if consent to the contract is withdrawn after the removal of duress.

2. Most Hanafi jurists maintain that duress causes nullification of these contracts, but if consent is given after the removal of duress, this con-tract is considered valid.

3. Zufar, a Hanafi jurist, opines that duress makes these contracts depen-dent on permission of the compelled contracting party. If he gives permission, it becomes a valid contract. In fact, the second and third opinions are almost the same.28

3.1.7. Ghalat (Mistake)

Mistake (ghalat) in Islamic law is an assumption about anything that comes into the mind of a person, but proves to be inaccurate.29 In other words, it is something that contradicts reality without intention. Mistake in a contract is that, following its formation, it becomes clear to a contracting party that the subject matter of the contract contradicts what has been contracted for. This mistake could either be in the very essence of a subject or in its attri-bute. In the case of a mistake in the very essence of a subject, a contract is considered invalid because the difference in genus makes the subject mat-ter non-existent and a contract for a non-existing thing is not valid. On the other hand, if a mistake occurs in the attribute, a distinction should be made between whether the subject matter was present in the session of the contract. If it was absent from the session of the contract, the purchaser will have the right to choose between retaining this contract as valid or canceling it. This is because he has purchased what he has not seen. This is called the option of seeing (khiyar al-ru`yah). But if the subject matter was present in the meeting of the contract, a distinction should be made between whether its attribute was possible to be observed due to its clear appearance, or it was not possible to be observed due to it being obscure and unclear.30

3.1.8. Combination of Contracts

Combination of contracts is a process that takes place between two parties or more and entails the simultaneous conclusion of more than one contract.

3.1.8.1. The Various Forms of Combinations of Contracts According to the Accounting and Auditing Organization for Islamic Financial Institutions, a combination of contracts may take any of the following forms:31

■■ Combining more than one contract without imposing any of them as a condition for the other and without prior agreement to do so.

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■■ Combining more than one contract while imposing some of them as conditions for the others without prior agreement to do so.

■■ Combining more than one contract subject to prior agreement but with-out imposing any of them as a condition for the others.

■■ Agreement to conclude the deal through any of different contractual forms as will be finally decided in the future.

3.1.8.2. The Forms of Combined Contracts According to AAOIFI, combined contracts are as follows:

■■ Combined contracts may have a single lump-sum countervalue. For instance, a party may sell his piece of land to the other and simultaneously rent his car to the same party for one month, both against 1,000 dinars.

■■ Combined contracts may be concluded for separate values. For instance, one party may sell his house to the other for 1,000 dinars, and rent his car to the same party for 100 dinars per month.

■■ Some of the combined contracts may be stipulated as conditions in the other contracts. One party, for instance, may say to the other party that “I will sell you my house for 10,000 dinars, on condition that you undertake to rent the house to me for two years for 1,000 dinars per year.” The sale of the house in this manner could also be concluded on the condition that the buyer of the house undertakes in return to sell his car to the seller for 2,000 dinars.

■■ Combined contracts may take the form of an exhaustive contractual statement comprising a number of successive parts and stages that finally lead to the realization of the desire of the two parties to conclude the deal in contract. A good example in this regard may be seen in a number of present-day financial transactions like ijarah ending with ownership, murabahah to the purchase order, and diminishing musharakah.32

3.1.8.3. The Shari’ah Position in Combined Contracts It is permissible in Shari’ah to combine more than one contract in one set, without imposing one contract as a condition for the other and provided that each contract is permissible on its own.

3.1.8.4. The Shari’ah Requirements in Combined Contracts Combined contracts should not include the cases that are prohibited by Shari’ah, such as com-bining sale and lending in one contract.

■■ It should not be used as a trick for committing riba, such as an agreement between two parties to conclude a transaction that is usurious in nature.

■■ It should not be used as an excuse for practicing riba. The two par-ties could misuse for instance, by combining contracts, where they con-clude a lending contract that, at the same time, facilitates some other compensatory gains to them. For example, they could stipulate in the

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contract that the borrower should offer accommodation in his house to the lender, or should grant him a present.

■■ Combined contracts should not reveal disparity or contradiction with regards to their underlying rulings and ultimate goals. Examples of con-tradictory contracts include granting an asset to somebody as a gift and selling/leasing it to him simultaneously, or combining mudarabah with lending the mudarabah capital to the mudarib, or currency exchange with juàlah, or salam with juàlah for the same contract value.33

3.1.9. Sequence in the Execution of the Contract

The Islamic financial transactions are based on some logical processes and procedures determined by Sharīàh where the sequence of the financial transaction executed by the IFI should follow some specific steps and order. Sequence in the execution of the contract is very crucial, which may trig-ger Sharīàh non-compliance risk in the banking operation. On the other hand, the ignorance of the sequence of the contract may render the financial transaction invalid and make the return generated by the IFI not legitimate.

We conclude that:

■■ The preceding elements represent the major risk factors that trigger Sharīàh non-compliance risk in Islamic finance.

■■ A careful consideration should be given to these risk elements to ensure that the Islamic financial transaction is concluded according to Sharīàh principles without any discrepancy.

■■ The major elements of risk in Sharīàh non-compliance are: uncertainty (gharar), deception (taggrir), inequality (ghubn), duress (ikrah), mistake (ghalat), and others as mentioned.

■■ These elements are very important to be considered in order to identify incongruence in Sharīàh compliance.

■■ The risk of non-Sharīàh compliance can be identified by some tools such as: account instruments, legal instrument, Islamic ruling that includes fatwa and resolutions, through a specific methodology of Sharīàh review and auditing process.

3.1.9.1. Consideration of the Sequence in the Legal Documents The objectives of the sequence details provided in the legal documents are to provide guide-lines in the correct sequence of documents to ensure the validity of the con-tract. Table 3.1 is a brief explanation of the documents involved in each type of products offered in Islamic banking.

We can conclude that Islamic law in its financial contracts and financial transactions always observes the element of risk in the business, finance, and

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Number Product Name Shar ī`ah Principle Agreement Used Sequence of the Agreement

1 Liquidity Product

Murabahah Master Facility Agreement Under a Master Facility Agreement, the mutually agreed terms and conditions for the Facility will be laid down.

Example: Home Financing

Letter of Hibah (LOH) 1 (where applicable)

Under LOH 1, the asset originally belongs to another party. The owner must execute LOH 1 to transfer the ownership to the customer prior to the execution of Asset Purchase Agreement.

Asset Purchase Agreement Under Asset Purchase Agreement, the cus-tomer sells the identifi ed asset and the bank purchases the asset at the bank ’s purchase price (fi nancing amount) upon the terms and conditions of the Asset Purchase Agreement.

Asset Sale Agreement Under the Asset Purchase Agreement, the bank then sells and the customer purchases the identifi ed asset at the bank ’s sale price (bank ’s purchase price + profi t margin).

LOH 2 (Where Applicable) Prior to the execution of security documents, the customer executes LOH 2 transferring back the ownership of the asset to the owner.

TABLE 3.1 All Business Segmentation

52

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Note Upon renewal of the facility, the parties shall execute the docu-ments (except for Master Facility Agreement) based on the under-lying Sharī`ah contract that has been used.

Retail Financing

2 Home Financing Bai` Bithaman Ajil

First Party Property Purchase Agreement

First Party Under the Property Purchase Agreement, the customer sells the property to the bank and the bank purchases the said property at the bank ’s purchase price.

Property Sale Agreement Under the Property Sale Agreement, the bank sells the property to the customer at the bank ’s selling price (bank ’s purchase price + profi t margin) to be paid at the agreed installment amount and period.

53

(Continued)

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Third Party Third Party Letter of Hibah 1 The execution under LOH 1 is required

when the property to be transacted is not owned or is only partially owned by the cus-tomer. In this case, the third party (owner) has to transfer his/her ownership or partial ownership to the customer via the execution of LOH 1. The reason is that the customer must have full ownership over the property before selling it to the bank.

Property Purchase Agreement Under Property Purchase Agreement, the customer sells the property to the bank and the bank purchases the said property at the bank ’s purchase price.

Property Sale Agreement Under a Property Sale Agreement, the bank sells the property to the customer at the bank ’s selling price (bank ’s purchase price + profi t margin) to be paid at the agreed installment amount and period.

Letter of Hibah 2 Prior to the execution of the security docu-ments, the customer transfers back the own-ership/partial ownership given by a third party to him orher via the execution of LOH 2.

TABLE 3.1 All Business Segmentation (Continued)

54

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3 Personal Financing

Bai` `inah Asset Sale Agreement For Bai` `inah , the underlying asset* for the transaction belongs to the bank; thus, under an Asset Sale Agreement, the bank shall fi rst sell its asset and the customer who shall pur-chase the asset at the bank ’s sale price (bank ’s purchase price + profi t margin) to be paid at the agreed installment amount and period.

Asset Purchase Agreement Under Asset Purchase Agreement, the cus-tomer sells the asset to the bank and the bank purchases the said asset at the bank ’s purchase price (fi nancing amount).

4 Home Equity– Based Financing

Mushara-kahMu-tanaqisah Ijarah

MusharakahMutanaqisah Co-Ownership Agreement

The customer agrees to jointly own the asset with the bank and agrees to lease the bank ’s share of asset at the agreed rental payment and duration. The bank ceases to be a co-owner of the asset with the customer at the end of the rental period.

5 Commodity Murabahah Home Financing

Commodity Murabahah

Commodity Murabahah Facility Agreement (CMFA)

CMFA lays down the mutually agreed terms and conditions for the facility.

55

(Continued)

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Purchase Request and Undertaking

Under a Purchase Request and Undertaking, the customer requests the bank to purchase the identifi ed commodity from the commod-ity supplier on spot basis and undertakes to purchase the said commodity from the bank thereafter.

Asset Sale Agreement Upon purchasing the commodity from the commodity supplier under an Asset Sale Agreement, the bank transfers the ownership of the commodity to the customer by sell-ing it at the bank ’s sale price (cost + profi t margin) payable to the bank at the agreed installment amount and period.

Letter of Appointment as Agent The customer appoints the bank as agent to sell the commodity to a commodity dealer on spot basis and credit the proceed into the customer ’s account.

6 Credit Card Qardh Ujrah

Application Form, T&C The Application form, the T&C, and the acceptance/usage of the card by the customer shall form the basis of contract.


56

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7 Stocking Murabahah Murabahah Floor Stocking Financing Facility Agreement

MFSFFA lays down the mutually agreed terms and conditions for the facility. The appointment of the customer as an agent to purchase the motor vehicle for the bank from the motor vehicle dealer is also embedded in this document.

Undertaking to Purchase Undertaking by the customer to purchase the motor vehicle from the bank after the bank purchases the motor vehicle from the autho-rized motor vehicle dealer.

Motor Vehicle Sale Agreement The sale contract for the sale of the motor vehicle by the bank to the customer.

8 Vehicle Financing

Murabahah Murabahah Vehicle Financing Facility Agreement

MVFFA lays down the mutually agreed terms and conditions for the facility.

Undertaking to Purchase Undertaking by the customer to purchase the vehicle from the bank after the bank pur-chases the vehicle from the dealer.

Asset Sale Agreement The sale contract for the sale of the vehicle by the bank to the customer.

9 Block Discounting

Bai` Al-Usul Bi Al-Khasm (Asset Sale with Discount)

Islamic Hire Purchase Block Financing Facility Agreement

Under Islamic Hire Purchase Block Financing Facility Agreement, the customer and the bank mutually agree on the terms and condi-tions of block discounting.

57

(Continued)

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Dealer ’s Offer to Sell and Declaration (appended to the Master Agreement as Schedule Two)

Dealer offers the bank his asset (compiled HP-I agreements) and guarantees that the information and disclosure to the bank are accurate and true and acknowledges the fact that the bank relies on the said information and disclosure in providing the fi nancing.

Trade Financing

10 Letter of Credit (without fi nancing)

Wakalah Letter Offer (LO)/ Facility Agreement

LO/Facility Agreement lays down the terms of fi nancing. The customer places 100% deposit with the bank.

Islamic Documentary Credit The customer shall appoint the bank as the payment agent via the application form.

Application Form Settlement via liquidation of deposit / cus-tomer ’s own funds.

11 Letter of Credit (with fi nancing)

Wakalah LO/ Facility Agreement LO/Facility Agreement lays down the terms of fi nancing and the bank appoints the cus-tomer as purchasing agent.

Islamic Documentary Credit The customer undertakes to purchase the goods from the bank via the LC-i application form.

Application Form (The settlement via fi nancing by the bank under Murabahah contract.)


58

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12 Trust Receipts Murabahah LO/ Facility Agreement LO/Facility Agreement lays down the terms of fi nancing and the bank appoints the cus-tomer as the purchasing agent and the cus-tomer undertakes purchasing the goods from the bank.

Murabahah Contract Note Upon delivery of the goods from the seller to the customer when the customer has acknowledged receipt of shipping documents issued by the seller/exporter, the bank pays the seller/exporter the invoice value and thereafter sells the goods to the buyer/cus-tomer at cost plus mark-up.

13 Accepted Bill (Purchase)

Murabahah LO/ Facility Agreement Murabahah Contract Note

The sequence and the explanations are simi-lar to Trust Receipts.

14 Accepted Bill (Sale)

Bai` Dayn LO/Facility Agreement LO/Facility Agreement lays down the terms of fi nancing.

Bai` Dayn Contract Note Under Bai` Dayn Contract Note, the cus-tomer sells Sale Invoice to the bank at a mutually agreed price on spot payment with recourse against the customer for the pay-ment of the Sale Invoice in the event of non-payment by the purchaser/importer.

59

(Continued)

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15 Export Credit Refi nancing (Pre-Shipment)

Murabahah The sequence and the explanations are similar to Trust Receipts.

16 Export Credit Refi nancing (Post-Shipment)

Bai` Dayn The sequence and the explanations are similar to Bills of Exchange Purchased-I (following).

17 Bills of Exchange Purchased

Bai` Dayn LO/Facility Agreement LO/Facility Agreement lays down the terms of fi nancing and the right of recourse against the customer for the payment of the Sale.

Invoice in the event of non-payment by the purchaser/importer.

Islamic Documentation Collection and/or Negotiation Form

Bai` Dayn Contract Note Under Bai` Dayn Contract Note, the cus-tomer sells Sale Invoice to the bank at a mutually agreed price on spot payment.

18 Bills of Exchange Purchased (Authority to Purchase)

Bai` Dayn The sequence and the explanations are similar to Bills of Exchange Purchased-i.

19 Bank Guarantee Kafalah LO/ Facility Agreement LO/Facility Agreement lays down the terms of fi nancing.

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Bank Guarantee Under a Bank Guarantee, the bank guaran-tees the performance or action of the cus-tomer to the benefi ciary

20 Shipping Guarantee

Kafalah LO/Facility Agreement LO/Facility Agreement lays down the terms of fi nancing.

Shipping Guarantee Under a Shipping Guarantee, the bank guar-antees the performance or action of the cus-tomer to the benefi ciary

21 Standby Letter of Credit

Kafalah LO/Facility Agreement LO/Facility Agreement lays down the terms of fi nancing.

Standby Letter of Credit The bank guarantees the performance or action of the customer to the benefi ciary.

22 Inward Bills for Collection

Wakalah Letter Offer LO lays down the terms of fi nancing and the customer shall appoint the bank as the pay-ment agent via the Letter Offer.

23 Outward Bills for Collection

Wakalah Letter Offer Islamic Documentary Collection and/or Negotiation Form

LO lays down the terms of fi nancing.

The customer shall appoint the bank as the payment agent via the applicable form.

61

(Continued)

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24 On-Shore Foreign Currency Financing (Import)

Murabahah LO/Facility Agreement

Murabahah Contract Note

The sequence and the explanations are simi-lar to Trust Receipt-i.

25 On-Shore Foreign Currency Financing (Export)

Bai` Dayn LO/Facility Agreement LO/ Facility Agreement lays down the terms of fi nancing.

Bai’ Dayn Contract Note Customer sells Sale Invoice to the bank at a mutually agreed price on spot payment with recourse against the customer for the pay-ment of the Sale Invoice in the event of non-payment by the purchaser/importer.

26 Promissory Foreign Exchange

Bai` Sarf LO/Facility Agreement LO/Facility Agreement lays down the terms of usage.

Wa`ad PFX Confi rmation Under PFX Confi rmation, parties shall agree to the currency, rate, and trading date via PFX Confi rmation.

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Corporate

27 Murabahah Financing

Murabahah (Purchase Orderer)

Murabahah Financing Facility Agreement

Facility Agreement lays down the mutually agreed terms and conditions for the facility.

Purchase Request Under Purchase Request, the customer requests the bank to purchase the Murabahah Asset.

Agency Letter Under an Agency Letter, the customer is appointed by the bank as its agent to pur-chase asset on its behalf.

Murabahah Sale Contract Under Murabahah Sale Contract, the bank sells and the customer purchases the Murabahah Asset at a sale price (cost plus profi t)

28 Commodity Murabahah Financing

Murabahah (Tawarruq)

Master CM Financing Agreement

A Master CM Financing Agreement lays down the mutually agreed terms and condi-tions for the facility.

Purchase Request To utilize the facility, the customer issues a Purchase Request to the bank requesting the bank to purchase the commodity from the commodity supplier.

63

(Continued)

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Bank ’s Acceptance and Offer for Sale

Upon purchasing the commodity from the commodity supplier, the bank will then sell the commodity to the customer at a Sale Price (cost plus profi t) by executing the Bank ’s Acceptance and Offer for Sale.

Customer ’s Acceptance The customer accepts by executing of cus-tomer ’s acceptance.

Agency Letter

The bank, upon receipt the Purchase Request from the cus-tomer, will purchase a commod-ity from a commodity supplier.

The customer then appoints the bank as its agent to sell the commodity on spot basis by the execution of Agency Letter.

29 Short-Term Revolving Credit

Murabahah BBA Facility Agreement A Facility Agreement lays down the mutually agreed terms and conditions for the facility.

If the asset originally belongs to another party, the owner must execute LOH 1 to transfer the ownership to the customer prior to the execution of the Asset Purchase Agreement.

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Letter of Hibah 1 (where applicable)

Under Asset Purchase Agreement, the cus-tomer sells the identifi ed asset and the bank purchases the asset at the bank ’s Purchase Price (fi nancing amount) upon the terms and conditions of the Asset Purchase Agreement.

Asset Purchase Agreement Under Asset Sale Agreement, the bank sells and the customer purchases the identifi ed asset at the bank ’s sale price (bank ’s purchase price + profi t margin).

Asset Sale Agreement Prior to the execution of security documents, the customer executes LOHH 2 transferring back the ownership of the asset to the owner.

Letter of Hibah 2 Facility Agreement lays down the mutually agreed terms and conditions for the facility.

Bai` `inah For Bai` `inah , the underlying asset* for the transaction belongs to the bank; thus the bank, under Asset Sale.

Facility Agreement Agreement shall fi rst sell its asset and the cus-tomer purchases the asset at the bank ’s sale price bank ’s purchase price + profi t margin) to be paid at the agreed installment amount and period.

65

(Continued)

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Asset Sale Agreement

Asset Purchase Agreement

Note: Upon renewal of the facil-ity, the parties shall execute the documents (except for Facility Agreement) based on the under-lying Sharī`ah contract that has been used

Under Asset Purchase Agreement, the cus-tomer sells the asset to the bank and the bank purchases the said asset at the bank ’s Purchase Price (fi nancing amount).

30 Ijarah Financing Ijarah-Muntahia Bi al-Tamlik

Asset Purchase Agreement Under an Asset Purchase Agreement, the customer sells to the bank the asset for cash consideration.

IMBT Term Financing Facility Agreement

Under IMBT Term Financing-i Facility Agreement, the bank as an owner to the asset leases the asset to the customer.

Asset Sale and Purchase Agreement

Upon expiration of the lease period/early termination and full settlement of the agreed total rent (total amount plus profi t) the bank sells the ijarah asset to the customer at an agreed price via Asset Sale and Purchase Agreement.

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31 Istisna WaIja-rahMuntahia Bi al-Tamlik

Istisna Ijarah-Muntahia Bi al-Tamlik

Master Facility Agreement A Master Facility Agreement lays down the mutually agreed terms and conditions for the facility.

Financing Istisna Purchase Agreement Under Istisna Purchase Agreement, the bank purchases the manufacturing/construction project from customer.

Ijarah Muntahia bi al-Tamlik Agreement

Under Ijarah Muntahia bi al-Tamlik , the bank as owner of the benefi cial interest of the ijarah asset will lease the ijarah asset to the customer.

Asset Sale and Purchase Agreement

Upon maturity of the lease period and full settlement of the agreed total rental (total fi nancing amount plus profi t), the bank sells the ijarah asset to the customer at a price agreed by both parties via Asset Sale and Purchase Agreement.

67

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trade, and that risk must be avoided or monitored at all time. This shows how Sharīàh is very concerned about risk, whether these elements of risk are observed in credit, market, liquidity, investment, and operation, or other aspects of business and finance that can expose one of the contracting par-ties to risk. However, some of the financial transaction can be concluded based on free risk.

3.2. THE CAUSES OF SHARl ÀH NON-COMPLIANCE RISK IN ISLAMIC FINANCE OPERATIONS

The Sharīàh non-compliance risk is a result of some causes that represent the main factors behind the failure of Sharīàh compliance in practice. They are as follows:

3.2.1. Lack of Knowledge, Skills, and Competency

Lack of knowledge and competency in the area of Islamic finance is a major cause of non-Sharīàh-compliance risk. If the officer in the Islamic financial institution who is responsible for the execution of the Islamic financial trans-actions is not equipped with the necessary knowledge in Sharīàh and related skills according to his job description, the risk of committing a Sharīàh non-compliance transaction is very high. Hence, proper knowledge according to some specific qualification in needed to perform Islamic banking activities according to Sharīàh rules and principles to ensure that the contract is valid and sound.

3.2.2. Lack of Training

Only knowledge is not a sufficient measurement to ensure Sharīàh compli-ance status. Proper training is needed to enhance the knowledge and uplift the competency level of the employee. The training and guidelines provided by senior officers who have more experience and knowledge is required on regu-lar basis to ensure that the skills and competency of the officer are adequate.

3.2.3. Lack of Close Monitoring and Proper Supervision

The knowledge and the training may help to improve the Sharīàh compliance status, but it is not sufficient, especially if the officer in charge of the execu-tion is still junior. Hence, a proper and close monitoring from a senior staff is needed to mitigate the Sharīàh non-compliance risk at the operation level.

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3.2.4. Weakness of the Internal Control System

In 1992, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) issued the Internal Control Integrated Framework. COSO defines internal control as “a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following catego-ries: effectiveness and efficiency of operations, reliability of financial report-ing [and] compliance with applicable laws and regulations.”

According to COSO, internal control consists of five interrelated components:

1. Control environment: The tone of the organization influences the con-trol consciousness of its people. Examples include the integrity, ethical values, and competence of employees; management’s philosophy; and input provided by the board of directors.

2. Risk assessment: Identification and analysis of risks relevant to achiev-ing corporate goals, determination, and implementation of how such risks should be managed.

3. Control activities: Policies, procedures, and processes that help ensure a company carries out management directives. Examples include approv-als, verifications, reconciliations, and reviews of operating performance.

4. Information and communication: Communication within the company and with external parties such as customers, regulators, and sharehold-ers. For example, reports that contain operational, compliance, or finan-cial data.

5. Monitoring: Assessing the quality of a company’s internal control sys-tems. As a result of this framework, internal audit approaches shift from compliance to risk-management approach.

If the preceding criteria are missing, we assume that the internal control system in the financial institution is not sound.

3.2.5. Weakness in the Information Technology and Infrastructure of the Banking System

The Islamic financial institution is riding on the infrastructure of the system of the information technology; hence the IT system should have a Sharīàh compliance status to ensure that it reflects the Sharīàh rules and princi-ples features and criteria pertaining to the contracts used by the bank. The Sharīàh non-compliance risk sometimes emerges from the IT system in cases where the software and IT infrastructure are not compatible with the

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Sharīàh features. Sometimes the rectification of the potential non-Sharīàh compliance feature is done manually, but sometimes they are overlooked which trigger the non-Sharīàh compliance risk. The Islamic financial insti-tution should put in place proper risk management tools to mitigate the non-Sharīàh compliance in case the IT system and its infrastructure is not fully complied with Sharīàh features. It is known that the full migration to fully IT infrastructure system is very costly; however, extra care should be taken of when using the IT system. At the same time, a proper plan-ning should be in place for full migration to a fully IT system that entirely removes the Sharīàh non-compliance risk from the system.

3.2.6. Human Error and Moral Hazard

The Islamic financial activities are carried out by people who are human beings by nature. Even the information and data are key in a system done manually by people. As human beings, error and mistakes are very possible that can happen anytime, anywhere. Work stress; sickness; physiological problems; family problems; financial needs; feeling rushed, angry, hungry, happy, sad; overloaded with work; disatisfaction; disappointment; and so on are some of the significant factors that cause human error in the function of the officer in the Islamic financial institution; hence the Islamic financial institution should provide a good environment convenient to perform work and duties at required standards of perfection. The human resource section should also take care of the different problems faced by the officers in the Islamic financial institution, including personal problems. Human resources can also provide motivation programmes to the staff to address these issues to mitigate the human error in performing works and duties. Unfortunately, sometimes errors are committed internally as a result of moral hazard due to revenge or some unknown reasons. To address this issue, a code of ethics should be provided by the Islamic financial institutions and circulated to the staff to provide guidelines for responsibility, accountability, reward, and punishment in committing such actions.

3.2.7. Dual Banking Business Activities

The structure of the Islamic financial institution can be a significant factor that causes Sharīàh non-compliance risk. If the Islamic financial institu-tion is subsidiary to a parent conventional bank, there will be a potential Sharīàh non-compliance risk in the business activities and operations. The Islamic financial institution will leverage on the infrastructure of the parent conventional institution. This includes but is not limited to the IT system, human capital, premises, shared services, marketing, accounting, auditing, training, risk management, and so on.

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If the hybrid structure of the IFI is not carefully observed and moni-tored, a non-Sharīàh-compliance risk will emerge very frequently. The most significant issues concerning the hybrid structures are as follows:

■■ The officer hired by the Islamic financial institution will perform con-ventional business activities of the conventional financial institution.

■■ The premises are owned by the Islamic financial institution but used or leased by the parent conventional institution.

■■ The infrastructure IT system is owned by the Islamic financial institu-tion but used or leased by the parent conventional institution.

■■ The business event, function, or celebration is not Sharīàh compliant, but the cost is shared according to a specific ratio, in which specific charges will be borne by the Islamic financial institution.

■■ Due to the integrated structure, marketing and compliance will be car-ried out together, and the team of the Islamic financial institution will participate directly or indirectly in selling, promoting, and executing the conventional products.

3.2.8. Miscommunication

When there is miscommunication between the officer in charge of the Islamic financial transaction executed and the different departments when passing information or exchanging communication, Sharīàh non-compliance risk can occur.

3.2.9. Logistics

Poor logistics can cause Sharīàh non-compliance risk. The concept of logistics is very broad, and it can heighten any gap that may exist in the entire system, mostly those related to communication, transportation, and the ability for business activities and operation to flow smoothly in Islamic financial institutions.

NOTES

1. See: Rafiq al Masri, al Jami fiusul al riba, 2nd ed. (Damascus, Syria: Dar al Qalam, 2001), 10.

2. See: Wahbah Al-Zuhayli, Financial Transactions in Islamic Jurisprudence, vol. 1 (Damascus, Syria: Dar al-Fikr al-Mouaser, 2003 [English ed.]), 82; Ali Al Kafif, Ahkam Al Muamalat Al Sharīàh (Cairo, Egypt: Dar Al Fikr Al Arabi, 1996), 6.

3. Ala’ Eddin Kharofa, Transactions in Islamic Law (Kuala Lumpur, Malaysia: A.S. Noordeen, 1997), 80.

4. Mohammad Hasim Kamali, Islamic Commercial Law (Kuala Lumpur, Malaysia: Ilmiah Publishers, 2002), 84.

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5. Al Qarafi, al furuq (Dar us Salam, Cairo 2001), vol. 3, 265.6. Al Isnawi, Al sulsharhminhaj al usul, vol. 2, 89.7. Al Shairazi, Al muhadab, vol. 1, 262.8. Al-Zuhayli, Financial Transactions in Islamic Jurisprudence, vol. 1, 83.9. Ibid., 84.

10. See: Al Kafif, AhkamAl Muamalat Al Sharīàh, 356.11. Al Nawawi, al Majmou’, (n.d. Jidda), vol. 9, 280.12. See: Kamali, Islamic Commercial Law, 85.13. Al Kafif, AhkamAl Muamalat Al Sharīàh, 356.14. Majalla el-Ahkam-I-Adliyah, Article 164 (Kuala Lumpur, Malaysia: The Other

Press, 2003), 20.15. For further reading on gharar, see: Inbn Rushd, bidayat al-mujtahidwanihawat

al-muqtasid, (Dar us Salam, Cairo: 1995), vol. 4, 534.16. Al Kafif, AhkamAl Muamalat Al Sharīàh, 356.17. See: Wahbah Al-Zuhayli, Financial Transactions in Islamic Jurisprudence, 3rd

ed., vol. 1 (Damascus, Syria: Dar al-Fikr al-Mouaser, 1989[Arabic ed.]), 221; Al Kafif, Ahkam Al Muamalat Al Sharīàh, 356.

18. Majalla, Article 165, 20.19. See: Al-Zuhayli, Financial Transactions in Islamic Jurisprudence (Arabic ed.),

221; Al Kafif, Ahkam Al Muamalat Al Sharīàh, 356.20. For further reading on ghubn, see: InbRushd, bidayat al-mujtahidwanihawat al-

muqtasid, vol. 4, 534; Al Kafif, AhkamAl Muamalat Al Sharīàh, 358.21. Al-Zuhayli, Financial Transactions in Islamic Jurisprudence (English ed.), 18.22. Imran Ahsan Khan Nyazee, Islamic Jurisprudence (Kuala Lumpur, Malaysia:

The Other Press, 2001), 134.23. See: Ahmad Ibrahim Biq, The Sharīàh Financial Transaction (Dar al Ansar,

Cairo: 1936), 87.24. Ibid., 86.25. Nyazee, Islamic Jurisprudence, 136.26. Ibid.27. See: Kharofa, Transactions in Islamic Law, 78.28. Al-Zuhayli, Financial Transactions in Islamic Jurisprudence (Arabic ed.), 360.29. Ibid., 216.30. Biq, The Sharīàh Financial Transactions, 88.31. AAOIFI, Sharīàh standards No. 25, English ed. (Bahrain: Accounting and

Auditing Organization for Islamic Financial Institutions, 2004), 445.32. Ibid.33. Ibid., 446.

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73

CHAPTER 4Tools and Techniques to I dentify

Incongruence in Sharı ah Compliance

4.0. INTRODUCTION

The nature of Sharīàh non-compliance risk refers to the structure of the product, the terms, the conditions governing the contracts/products/services, and the executions of the legal documentation/products that represent the stage of implementation. There are other related aspects that are within the Sharīàh non-compliance scope such as marketing collateral, telemarket-ing, broadcasting, information technology infrastructure, and systems.

With regards to the means and instruments, there are a few that can be used in order to identify incongruence in Sharīàh compliance.

4.1. TOOLS

4.1.1. Accounting/Islamic Financial Reporting Technique

Accounting is a very important instrument to identify incongruence with Sharīàh by using different accounting tools or techniques such as the financial data, balance sheet, and so forth. The prohibited elements in Sharīàh can be easily identified through this process. Accounting as an instrument along with the technique used can bring Sharīàh compliance to the entire financial transactions and business activities that cover areas as follows:

■■ Accounting represents an official record of a financial transaction and traces the movement of assets and the type of payment at each stage of a transaction.

■■ Tracing and recording the different lawful and legitimate business activities.

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■■ Allocating valid contracts and profit that exclude interest and uncer-tainty of contract conditions.

■■ Mutual consent with an ascertained degree of trust through transpar-ency, fairness of representation, and equity between parties in terms of counter value or distribution.

■■ The balance sheet will show the asset and liability of the contracting parties and classify them as financial and non-financial transactions along with the source of funds and their use in the proper category that enables a proper examination.

4.1.1.1. Financial Statement/Balance Sheet (Asset and Liability) The statement of net worth or balance sheet presents a snapshot of the client’s financial posi-tion at a particular date. It shows how the assets of the client are financed, which is either from his own savings and accumulations or from outside sources such as banks. The net worth section is the equity ownership the client possesses over his/her assets at that date. The balance sheet is divided into three broad sections as follows:

4.1.1.1.1. Assets The assets section shows what the client possesses. The assets include:

■■ Liquid assets (cash and marketable securities)■■ Certificates of deposit and Islamic bonds■■ Investment assets (stocks, stock mutual funds, real estate, gold)■■ Personal assets (auto, jewelry, art)■■ Deferred assets (pension plan, Takaful coverage, and inheritances)

Below are more details about the aforementioned types of assets:

A. Cash/cash equivalents: Cash and cash equivalents include savings account, current account, fixed-deposit accounts, and family Takaful cash values.

B. Investment assets: These are basically financial items that have been reserved for a specific purpose (e.g., retirement funds or funds to be accumulated for the purpose of increasing wealth). They are as follows:

■■ EPF account balance/Equities (stocks)■■ Fixed-income securities (Sukuk)/Real properties (those held for

investment purpose)■■ Unit trusts/managed funds■■ Business and business assets

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Tools and Techniques to Identify Incongruence in Sharıàh Compliance 75

■■ Jewelry/collectibles (those held for investment purpose)■■ Home contents (for sale at retirement)

C. Personal-use assets: These are valuable assets that are generally meant for personal use and not to be liquidated to finance other needs, (e.g., the client’s home and car). The following may be classified as investment assets:

■■ Residence house■■ Personal vehicles■■ Jewelry/collectibles (those meant for assets section or keeping)■■ Home contents (those meant for keeping)

D. Analyzing assets: Assets should be listed in the order of their liquidity at current market values. The list of the assets provides a clear image on the types of asset, along with their status. The proper listing and classification of the asset can easily determine the status of Sharīàh non-compliance.

■■ The listing of cash will show whether it is placed in Islamic bank or a conventional bank.

■■ The listing of securities will show whether they are on the Islamic counter or the conventional counter.

■■ The listing of assets like real estate will show their Sharīàh status according to the benchmark set by the Sharīàh Advisory Council of the Securities Commission.

■■ The listing of personal assets like cars and furniture, if they are still being financed, will show whether they are under an Islamic financ-ing facility.

■■ Listing deferred assets like retirement plans for an individual will show whether the scheme is under a Takaful operator or under a conventional scheme.

■■ Listing investment assets like stocks and bonds will show whether the stock and the bonds are Sharīàh compliant.

4.1.1.1.2. Liabilities The liabilities section shows what the client owes, which includes the following:

■■ Short-term debt-financing credit cards■■ Intermediate-term debt financing (car)■■ Lone-term debt financing (mortgages)

The liabilities section is the “minus side” of the client’s statement of net worth. It provides a listing of items that will result in an outflow of financial resources in the future.

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main categories of liabilities There are two main categories of liabilities:

1. Short-term liabilities: Those financial obligations that must be settled within one year are classified as short-term or current liabilities. These would include items like income tax payable and credit-card bills.

2. Long-term liabilities: Those financial obligations that can be settled out-side the realm of one year are called long-term liabilities. This could include items like house financing and education financing.

analyzing liabilities Liabilities show the debt or the future financial obligation. They determine the level of the debt and its Sharīàh compli-ance according to the tolerable level of debt. Debt financing due between one and five years, such as auto debts, and debt financing due in more than five years, such as mortgages, are long-term debt financing. The liabilities will show the portfolio of debt that one individual or entity may have. The analysis of the liability will show whether debt portfolio is Islamic debt or otherwise.

4.1.1.2. The Cash-Flow Statement The cash-flow statement provides informa-tion about the movement of cash. It provides inflows and outflows of cash.

1. Cash inflows: Cash inflows would include all the sources of cash tak-ings accorded, either in the form of actual cash receipts or credits to the account.

2. Cash outflows: Cash outflows would include all the cash disbursements. It provides a pattern of the spending, savings, and investment activities. Outflow can be further divided into committed or fixed outflows or variable outflows.

The cash inflow and outflow provide details about the source of income, that is, where the cash is coming from. This will help to determine the Sharīàh compliance status of the cash. The cash outflow also shows where the money is going in trading the process of spending and disbursement. This also helps to give the status of the Sharīàh compliance of the usage. In short, the cash flow traces the source of fund and the channel of spending, where Sharīàh compliance can be granted or Sharīàh non-compliance risks can be identified.

4.1.2. Legal Technique

Legal technique as a form of assessment and examination plays a very sig-nificant role in identifying incongruence with Sharīàh. The legal approach

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is based on the examination of the structure of the contract and the assess-ment of the product terms and conditions to ensure Sharīàh compliance status. The legal assessment includes the terms and conditions stipulated in the agreement and the way the contract is executed, respectively. The care-ful examination of the clauses in the contract will identify any potential violation of Sharīàh rules while providing an assurance that the process is consistent between Sharīàh and legal requirements.

Islamic finance rides on some acts, legal requirements, and guidelines. The non-compliance of the transaction with the legal acts and regulation will trigger Sharīàh non-compliance risk because those rules and regula-tions are integrated and based on Sharīàh requirements.

4.1.3. Sharı àh Technique

4.1.3.1. Sharı àh Parameter References (SPR) of Bank Negara The parameters issued by Bank Negara are regarded as the main reference for the Islamic financial institutions. These references are known as SPR, and they are used in structuring the products and services of the Islamic financial insti-tutions. The rules and principles along with the terms and conditions are derived from these principles endorsed by the Sharīàh Advisory Council of Bank Negara. The Sharīàh reference parameters as of now are as follows: Murabahah, Ijarah, Mudarabah, Musharakah, and Istisna. Any deviation from these references is an indication of Sharīàh non-compliance. However, these parameters are in the process to be converted into Sharīàh standards.

4.1.3.2. Resolutions of Sharı àh Advisory Council (SAC) of Bank Negara The resolu-tions of the Sharīàh advisory of Bank Negara along with their guidelines and circulars establish a status of Sharīàh compliance. Any deviation on their resolution will trigger a Sharīàh non-compliance risk.

4.1.3.3. Islamic Ruling (Resolutions of the Sharı àh Committee of the Bank) The reso-lutions of the Sharīàh committee of the IFI pertaining to products and ser-vices represent the Sharīàh compliance status that the IFI should subscribe to. The Islamic financial institution should carry out the banking activi-ties according to the resolutions of the Sharīàh committee. Failing to do so, Sharīàh non-compliance will be triggered. The resolutions can identify incongruence in legal documentation from Sharīàh perspective. This instru-ment is used by the Sharīàh board to examine the documents of the pres-ent product to eliminate any element that is not consistent with Sharīàh rules and principles. The resolutions will be the point of reference used by relevant division of Sharīàh audit and Sharīàh review in their audit and review through the whole process.

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4.1.3.4. AAOIFI Sharı àh Standards The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Sharīàh standards represent a benchmark for Sharīàh compliance because AAOIFI has a global represen-tation and most of the experts in Islamic finance are part of the global insti-tution that issue standards in Sharīàh, for accounting, auditing, governance, and code of ethics. The AAOIFI standards are not binding; hence every jurisdiction has the option to subscribe to the AAOIFI standards or not. However, when there is no resolution in specific jurisdiction on a particular issue in Islamic finance, or the jurisdiction is silent about it, AAOIFI becomes the benchmark and the proper reference to refer to. In some jurisdictions, such as Bahrain, Syria, Jordan, and Sudan, their respective authorities have enforced the AAOIFI standards in their market. Hence, any deviation from AAOIFO standards triggers the Sharīàh non-compliance risk.

4.1.3.5. Islamic Ruling (Fatwa and Resolutions at the International Level) The resolu-tions that have been issued at the international level such as resolution of the international fiqh academy represent a sound reference for Sharīàh compli-ance status because of the global acceptance and international endorsement. Hence, these resolutions and fatwa can guide the IFI toward a Sharīàh com-pliance status.

4.1.3.6. Sharı àh Screening In 1995, the SC’s SAC established the methodol-ogy to undertake Sharīàh screening process for listed companies. The meth-odology comprises quantitative and qualitative assessments. The Sharīàh screening is an appropriate tool to identify a Sharīàh non-compliance risk. The methodology of the Sharīàh Advisory Council of Malaysia on stock screening enables it to monitor the Sharīàh non-compliance risk within the specific tolerated benchmark.

According to the Securities Commission of Malaysia, the focus of the examination will be on the primary activities of a company with regard to the goods and services offered. This is because these primary activities bring returns for the companies that are subsequently distributed to its share-holders. Such activities need to be identified to see whether they are consis-tent with Sharīàh principles. If they are not, then that particular company’s securities are excluded from the list of Sharīàh-compliant securities.

■■ The criteria can be used to analyse whether securities of a particular company can be deemed Sharīàh compliant or not.

■■ The decision was made on four basic primary criteria to analyse listed securities.

■■ These criteria were established after referring to the sources of Sharīàh and general Sharīàh principles.

■■ The criteria were formulated according to the activities of a particular company.1

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First Criterion: Riba as the Primary Activity of the Company The primary activity of the company is based on riba as practised by conventional finan-cial institutions, including commercial banks, merchant banks, and finance companies. This criterion is based on the Quranic verses 275–276 in Surah al-Baqarah:

Those who devour riba will not stand except as one whom the evil one by his touch hath driven to madness. That is because they say: “Trade is like riba,” but God hath permitted trade and forbidden riba. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for God to judge; but those who repeat (the offence) are Companions of Fire: they will abide therein (forever). God will deprive riba of all blessing, but will give increase for deeds of charity: for He loveth not creatures ungrateful and wicked.

Second Criterion: A Company Whose Primary Activity Is Gambling This criterion will include companies running casinos, gaming, and others. This criterion is based on the Quranic verses:

O you who believe! Intoxicants, and gambling, (dedication of) stones, and (divination by) arrows, are an abomination of Satan’s handiwork: eschew such (abomination) that ye may prosper.

Third Criterion: The Primary Activity of a Company Is the Production and Sale of Goods and Services That Are Prohibited in Islam This criterion will include the following:

■■ Processing, producing, and marketing of alcoholic drinks.■■ Supplying non-halal meat like pork, and so forth.■■ Providing immoral services like prostitution, pubs, discos, and so forth.

Fourth Criterion: Gharar (Uncertainty) This criterion includes compa-nies whose primary activity is gharar (uncertainty), such as conventional insurance trading. The basis of the prohibition on gharar is a hadith of the Prophet s.a.w.:

Verily, the Prophet s.a.w. prohibits gharar transactions.

The Product Approval of Securities in Mixed Companies The methodol-ogy used in the approval of mixed securities is based on setting a specific benchmark to measure a certain degree of the prohibited elements. This

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Sharīàh position takes into consideration umum al balwa and ghararyasir, which can justify listing the company with a mix of permissible and prohib-ited elements. According to the Securities Commission Sharīàh Advisory Council, companies with a certain degree of prohibited elements that do not exceed the benchmark set by the SAC can be included in the list of Sharīàh-compliant securities.2

Quantitative and Qualitative Approach in the Screening Process in Capital Markets There are two methods used in the screening process: the quanti-tative approach and the qualitative approach.

1. Quantitative approach: By this method, the SAC’s decision is based on the percentage of contribution activities that do not comply with the group income and profit before tax set by the commission. The SAC will compare the percentage with the benchmark that has been fixed, such as 5 percent and 25 percent.

2. Qualitative approach: By this method, the SAC’s decision is based on several external factors of the company, such as image, maslahah, and others. This method does not refer to the benchmark for activities that do not comply with the Sharīàh in deciding the status of the listed company.3

Summary of Revised Screening Methodology of Securities Commission Malaysia In view of the current development and sophistication of the Islamic finance industry, the screening methodology has now been revised by adopting a two-tier approach to the quantitative assessment that applies the business activity benchmarks and the newly introduced financial ratio benchmarks while maintaining the qualitative assessment.

This revision is in line with the SC’s initiatives to further build scale in the Sharīàh-compliant equity and investment-management segments as well as expand the Islamic capital market’s (ICM) international reach, as outlined in the Capital Market Master plan.

Quantitative Assessment Business activity benchmarks: 5 percent and 20 percent.

■■ Financial ratio benchmarks: 33 percent.

Business Activity Benchmarks The 5 percent benchmark would be appli-cable to the following business activities:

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■■ Conventional banking■■ Conventional insurance■■ Gambling■■ Liquor and liquor-related activities■■ Pork and pork-related activities■■ Non-halal food and beverages■■ Sharīàh non-compliant entertainment■■ Interest income from conventional accounts and instruments■■ Tobacco and tobacco-related activities■■ Other activities deemed non-compliant according to Sharīàh

The 20 percent benchmark would be applicable to the following activities:

■■ Hotel and resort operations■■ Share trading■■ Stockbroking business■■ Rental received from Sharīàh non-compliant activities■■ Other activities deemed non-compliant according to Sharīàh

The contribution of Sharīàh non-compliant activities to the overall rev-enue and profit before tax of the company, will be calculated and compared against the relevant business activity benchmarks.

Financial Ratio Benchmarks The financial ratios applied are as follows.

cash over total assets Cash will only include cash placed in conven-tional accounts and instruments, whereas cash placed in Islamic accounts and instruments will be excluded from the calculation.

debt over total assets Debt will only include interest-bearing debt, whereas Islamic debt/financing or Sukuk will be excluded from the calcula-tion. Both ratios, which are intended to measure riba and riba-based ele-ments within a company’s balance sheet, must be lower than 33 percent.

The Sharīàh-compliant status of the company may be affected in the following manner:

■■ Companies with mixed activities in which are currently assessed under the 10 percent or 25 percent benchmarks may be affected because their activities are now assessed under the 5 percent or 20 percent benchmarks.

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An example is given next.

Revised Methodology [5% benchmark]

Current Methodology [10% benchmark]

Sharīàh Non-Compliant Activity

Company 1

Status: Sharīàh non-compliant

Status: Sharīàh-compliant

Tobacco’s revenue/Group rev-enue = 9%

Company A listed on Main Market, Bursa MalaysiaBusiness activities: Property development, trading of building materials and manu-facture and distribu-tion of cigarettes (tobacco)

■■ Companies with high level of conventional debt may be affected because currently there is no screening based on the total conventional debt of the company.

An example is given next.

Revised Methodology [33% benchmark]

Current Methodology [Not applicable]

Level of Conventional Debt

Company 1

Status: Sharīàh non-compliant

Status: Sharīàh-compliant

Total conven-tional debt/Group total asset = 36%

Company B listed on Main Market, Bursa MalaysiaBusiness activities: Property develop-ment, trading of building materials and construction works

Formula for Sharīàh Screening

Step 1: Determine the earnings (Total Income/Revenue) and profit before tax (PBT) of the company.

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Step 2: Identify and measure the income/earnings and profit before tax from the non-permissible activities.

Step 3: Determine the percentages as follows:

1. Earnings from non-halal activities × 100Total Earnings of Firm

2. PBT from non-halal activities × 100PBT all activities of firm

Step 4: Compare the percentage earnings and profit before tax with the benchmark.

4.2. TECHNIQUES

In addition to the preceding tools, there are other techniques that are used to identify the Sharīàh non-compliance risk in Islamic financial activities. These are as follows:

4.2.1. Observation

Observation is a methodology in data collection used in qualitative research. Its aim is to be close to the subject matter under observation and be familiar with it. It forces the person involved to have a clear understand-ing about the company’s behavior. Observation can be used in Sharīàh non-compliance risk.

4.2.2. Sampling

Sampling is used to examine the relevant legal documentations of the products and services used by the Islamic financial institution. The size of the sample is determined according to the soundness of the internal con-trol system of the Islamic financial institution: smaller sample size if the internal control system is sound; larger sample size if the internal control system is weak.

4.2.3. Interview

Interview is an effective technique that tests the level of competence, skill, and knowledge of the human capital in the Islamic financial institution. It can cover many areas related the Sharīàh non-compliance risk in the finan-cial activities of the Islamic financial institution.

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4.2.4. Testing

Testing can be applied on existing system software; it may have more than one objective. The first one is to test the skills of the officer in using the sys-tem in a competent manner. The second is to test the liability of the system itself, to ensure its Sharīàh compliance status.

NOTES

1. www.sc.com.my (official website of the Securities Commission Malaysia).2. Resolution of the Securities Commission Sharīàh Advisory Council, 2nd

ed. (Kuala Lumpur, Malaysia: Sharīàh Advisory Council of the Securities Commission, 2009), 145.

3. Ibid., 150.

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http://www.sc.com.my

85

CHAPTER 5Understanding the Sharı ah

Requirements for Mitigating the Sharı ah Non-Compliance Risk

in Islamic Finance

5.0. INTRODUCTION

It is important to have a good understanding of Sharīàh requirements in the financial transactions in order to appreciate the Sharīàh non-compliance risk in the Islamic banking activities. The fundamental Sharīàh requirements in formulating a financial contract are: the sigah/statement of the contract, the contracting parties, and the subject matter of the contract. These three pillars have to fulfill some specific requirements in order to be valid and accepted from Sharīàh perspective. These conditions are discussed briefly next.1

5.1. THE FUNDAMENTAL ISLAMIC PRINCIPLES IN ISLAMIC CONTRACTS

5.1.1. The Formation of the Financial Deal through Offer and Acceptance/Sighah

Sighah of the contract (offer and acceptance), known also as the statement of the contract, is the appropriate way to form the contract in Islamic commer-cial law; each financial transaction needs a specific formula in order to con-clude the transaction. In a sale, the offer and acceptance are the words used for concluding a sale by common usage and custom of the place.2 Therefore, sighah in contract reflects the consent of the parties in the contract and is considered as a primary condition of any contract. Obviously, the sighah is formulated through an offer (ijab) and acceptance (qabul). Sighah is an

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external proof of the contract that reflects the internal and intangible aspect of the consent. The ijab is the offer made by the first party (seller) who is giving the freedom of acceptance and confirmation to the second party, whereas qabul is the statement agreement made by the second party (buyer) to express his freedom by confirming the offer. By this confirmation, the con-tract is created.3Majalla states that with an offer and acceptance, the sale is complete.4 However, the offer and acceptance must fulfill some conditions.

5.1.1.1. The Tense of the Sighah Obviously the jurists prefer the past-tense expression for forming an offer and an acceptance in contract, such as “I sold” and “I bought.” The reason behind that is to reduce the degree of uncertainty in the contract. On the one hand, according to linguistic use, this tense is utilised for instant offer and acceptance. However, other tenses such as present, future, or the command form of a verb, could be utilised for forming a contract depending on the intention of both parties. On the other hand, the Hanafi School of Law has a different point of view. According to them, if the past tense is not used in the sighah, the sale is not concluded using words in the future tense, such as “I will take,” “I will sell,” which mean merely a promise.5 The sale is also not concluded by words in the imperative tense, such as: “sell” “buy.” But a sale is concluded by an impera-tive, which, of necessity, indicates the present.6

5.1.1.2. Conformation of the Offer to the Acceptance The acceptance and the offer must conform to each other. In case conformity does not exist, there will be no consent, and, therefore, no contract is concluded due to the absence of the conformation. However, the conformity is very flexible as long as it real-izes its objectives; it could either be explicit or implicit.7

5.1.1.3. Clarity of the Offer and Acceptance Both offer and acceptance must be firm and clear to avoid doubtfulness and ambiguity. The objective of this requirement is to materialize the full consent of both parties involved in the contract. However, to achieve that, both offer and acceptance must be clear in order for the other party to confirm what was issued by his counterpart. If the offer and acceptance are issued by word, they should be pronounced clearly; if it is issued in writing, it should be readable.

5.1.1.4. Connection of the Offer and Acceptance (Unity of the Contract Session) This is known in Islamic law as the session of the contract (majlis al-`aqd). According to the jurists, an acceptance must be connected with an offer. In a typical traditional context, the contracting parties should be present in the same session (majlis) of contract in order to formulate the contract.8 However, due to the innovation and development of the business environment because

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Understanding the Sharıàh Requirements in Mitigating the Sharıàh 87

of the advancement of the technology, Sharīàh accommodates other ways and means of meeting, where the session of the contract can be converted from physical meeting in specific location to a time environment in case the contract is concluded through video conference, or phone call, or other means of communication.

According to Majalla if one of two contracting parties makes an offer for something in any manner whatsoever, the other party’s acceptance of the contract must exactly correspond with the offer. The second party has no right to separate or divide either the price or subject matter of the sale.9 However, at the meeting for bargaining, after the offer until the end of the meeting, both parties have an option: after the offer and before the accep-tance, if one of the two parties gives an indication of dissent, whether by word or act, the offer becomes void, and there is no longer room for accep-tance.10 When one or two contracting parties make an offer, but one with-draws from it before the acceptance of the other, the offer become void, after which the sale cannot be concluded by an acceptance.11 In order to make the transaction smooth and flexible, the Islamic law allows many ways of offer and acceptance, by words, writing, and by conducts.12

Regarding the separation of ijab and qabul, the Maliki ruled that the separation between the ijab and qabul does not affect the sale transaction with the condition that the other party is not disengaged from the transac-tion. On the other hand, Shafi and Hanbalis ruled that acceptance must immediately follow the offer. However, the contract would be harmed if the two parties engage with a discussion that is outside the scope of the transaction.13

5.1.2. The Two Contracting Parties (Seller and Buyer)

The parties who are formulating the contract must have legal capacity in order to enter into a financial contract. The capacity is the quality that makes a person qualified for acquiring rights and undertaking duties and responsibilities.14 Both parties must fulfill the following attributes:

5.1.2.1. Puberty of the Contracting Parties (Male or Female) Both contracting parties—buyer and seller—must attain puberty, which is a sign that enables the parties to conclude the deal from Sharīàh perspective. This requirement is for both parties, whether they are male or female. A male attains puberty when he experiences wet dreams (starts to ejaculate sperms in his night dreams), while a female attains it at the onset of menstruation.15

5.1.2.2. Sanity of the Contracting Parties (Male or Female) Both parties, buyer and seller, whether male or female, must be sane and have the full mental

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capacity to conduct a business deal. If both or one of them is insane (maj-nun), the financial contract will be void and not valid from Sharīàh per-spective and the deal cannot take effect. However, there are some cases in which one of the contracting parties temporarily becomes insane, especially in hot weather, and later regains sanity when the weather get back to nor-mal. This person will be allowed to conclude his business deal and final-ize his financial contract agreement when he regains sanity, but he is not allowed to do so when he is insane. The effect of the contract will be subject to his status at the time of concluding the contract agreement.16

5.1.2.3. Maturity of the Contracting Parties (Male or Female) The two contracting parties, buyer and seller, male or female, must also attain maturity (rushd). According to scholars, maturity is: “Good and proper dealings with wealth from a worldly viewpoint.”17 However, if someone is dealing with the prop-erty in a wrong manner from Sharīàh point of view, such as misuse of the money, mismanagement of his wealth, improper spending of the wealth, wasting the property, the person will be considered as not mature from the Sharīàh perspective. Therefore, the person as result of that will not be allowed to deal with his wealth independently.18

5.1.3. The Subject Matter of a Contract (Goods and Price)

The subject matter of a contract (mahall al-àqd) can either be a tangible thing (such as money, wealth, goods, etc.), a utility, or a work. In all these cases, the subject matter must fulfill the following conditions.

5.1.3.1. Suitability and Legality of the Subject Matter for the Contract The subject matter of the contract is very important in financial business transactions; the jurists have agreed that the subject matter in the contract must be suit-able for concluding a contract. If the subject matter of the contract is not suitable, the contract will be void and invalid.

The following three conditions should be observed in the subject matter of the contract:

1. The subject matter should be considered property of value to one of the parties; if it is not suitable, the contract will be invalid.

2. The subject matter must be owned by one of the parties; therefore, if it is not owned by one party, such as fish in the sea or a bird in the air, the contract will be invalid.

3. The subject matter must be legal and permissible and not forbidden by the Sharīàh, otherwise the contract will be invalid.19

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5.1.3.2. The Subject Matter Must Be Known to Both Parties The subject matter of a contract must be known to both parties in order to engage in a particular contract; otherwise the contract will not be valid. According to Majalla it is necessary that the thing sold to be known to the buyer.20 The thing sold becomes known by a description of its quality, or quantity, which distin-guishes it from other things.21 Sharīàh imposes this requirement in order to avoid ambiguity and dispute.

5.1.3.3. Capability of the Subject Matter to Be Handed Over It must be possible to hand over the subject matter of the contract at the conclusion of the con-tract; otherwise the contract will be invalid. Therefore, it is not allowed to sell fish in the water, birds in the air, and milk in the udders of an animal.

5.1.3.4. Presence of the Subject Matter at the Time of Contract The subject matter of the contract must be present at the time of the contract if it is a tangible thing. The Prophet (peace be on him) forbade selling of a good that does not exist. The Majalla in Article: 205 states: The sale of a non-existing thing is invalid.22 However, there are some exceptions to this general rule such as salam, which is selling something that is not present during the time of the contract. The full price in salam to be paid on the spot during the session of the contract and the delivery of the goods will be in future date. The excep-tion for this particular transaction is prescribed by the Prophet (peace be on him).23

As a conclusion, we can note points as follows:

■■ The contract in Islamic law consists of three elements: the contract-ing parties (seller and buyer), the statement of the contract or sighah (offer and acceptance), and the subject matter of the contract (goods and price).

■■ Each element of these pillars has some terms and conditions to fulfill in order to validate the contract and the transaction accordingly.

■■ The offer or ijab shows the willingness of a party to engage in a trans-action; the offer also gives the option to the counterpart to express his consent toward the transaction whether by acceptance or rejection.

■■ The acceptance or qabul is confirmation of the offer and willingness to conclude the business transaction.

■■ By concluding the offer and acceptance, the contract is formulated.■■ The statement can be conveyed by words or writing or even by indi-

cation and conduct. This shows the flexibility of the Sharīàh in con-tract and illustrates the objective of Sharīàh in facilitating the business transaction.

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■■ There are some requirements in offer and acceptance to be fulfilled in order to have a valid contract.

■■ The session of contract is required to format a valid contract; however Sharīàh accommodates the various means for the unity of offer and acceptance of the contract according to modern communications.

■■ The subject matter of the contract must be legal in Sharīàh in order to validate the business transaction.

■■ The subject matter of the contract can be in actual existence during the time of the contract; however, Sharīàh has allowed the subject matter of the contract to be non-existent in some special contracts.

■■ The subject matter of the contract must be possible of being handed over at the conclusion of the contract.

■■ The subject matter of the contract must be precisely determined at the time of the contract; the termination can be done by full description of quality and quantity.

The contract in Islamic law should realize the objective of maqasid al Sharīàh in Islamic financial transaction.

5.2. THE FUNDAMENTAL ISLAMIC FINANCIAL TRANSACTIONS USED IN ISLAMIC FINANCE

There are some important principles in Islamic finance that should be under-stood to ensure a proper understanding regarding the norms of Islamic financial transactions carried out by Islamic financial institutions:24

■■ Profit-sharing-based transactions■■ Sales- and trade-based transactions■■ Lease-based transactions■■ Fee-based transactions■■ Free-interest-loan-based transactions■■ Security-based transactions■■ Support-based transactions■■ Voluntary/charitable-based transactions

5.2.1. Profit-Sharing-Based Transactions

The principles for profit-sharing-based transactions are guided by mushara-kah, mudarabah, Muuzaraah, and Muzaqah.

5.2.1.1. Musharakah Musharakah is derived from the word sharikah, which means “partnership.” Musharakah is defined as a partnership in which profits

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are shared as per an agreed ratio whereas the losses are shared in proportion to the capital or investment of each partner. All partners must provide capital and may participate in the management of business project. The capital as subject matter of Musharakah contract shall fulfil the following conditions:

■■ Capital contributed shall be in form of cash, gold, silver, or their equiva-lent in value.

■■ Capital may consist of trading assets such as goods, property, and equipment.

■■ Capital may also be in the form of intangible asset such as trademarks, pat-ents, and similar rights, provided they are valued at their cash equivalent.

5.2.1.2. Mudarabah Mudarabah is also known as qirad and muqaradah. It is defined as a contract between two parties whereby one party, the rabu al-mal (the provider of capital), entrusts the money to the other party called mudarib (managing trustee). The profits are distributed based on an agreed ratio, whereas the financial loss is borne by the provider of capital. There are some important rules that should be observed in mudarabah:

■■ The division of profit must be on a proportional basis and cannot be a lump sum or guaranteed return.

■■ The investor is not liable for losses beyond the capital he has contributed.■■ The mudarib does not share in the losses except for the loss of his time

and efforts.

5.2.1.3. Muuzara’ah (Crop Sharing) Muzara`ah is a contract of partnership on crop sharing whereby one partner will provide the land and the other party provides labour, and they share the crop according to their predetermined agreement. According to the Majalla, it is a kind of partnership where the land comes from one partner and the work from the other partner to culti-vate and divide the crop.

5.2.1.4. Musaqah Musaqah is a contract of giving trees to another so that he undertakes to water them and perform all associated work for a known part of their produce. According to Majalla it is a kind of partnership on the terms that the trees are to be owned by one and cultivated by the other and that the fruit produced is to be shared between them.

5.2.2. Sales and Trade-Based Transactions

This type of principle includes the following contracts: Bai` BithamanAjil (deferred-payment sale), Bai` `inah, istisna` (manufacturing contract),

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murabahah (mark-up), salam (future delivery), tawarruq, and ijarah (leasing).

5.2.2.1. Bai’ BithamanAjil (BBA) (Deferred-Payment Sale) BBA is a contract of sale whereby the commodity exchanged is delivered immediately and the deferred price is paid in installments. It is also called Bai` Muàjjal. In this contract, the price is higher than spot price due to the deferment in the payment. According to the majority of jurists, increasing the price in BBA due to the deferment in payment is allowed. The increment of price is allowed in case of deferment of price in a sale contract. Such an increase is permissible because it is against the commodity and not against money. An increase against deferred payment is only considered to be amounting to riba when the subject matter is money on both sides. Therefore, it is allowed for a seller to fix two prices of a commodity, that is, cash price and credit price, and give an option to the buyer to buy a commodity at either of the two prices.

5.2.2.2. Bai` ìnah Inah is a sale in which a commodity is sold for a deferred payment and then it is resold to the same seller on a cash basis. Normally the cash price is cheaper than the deferred payment price. For example: A sells asset X to B at a credit price, say 10,000 ringgit; then, immediately B sells it back to A for 9,000 ringgit on cash payment. It is called ìnah since the seller of the objects (àyn) takes it back again. There is a disagreement among Sharīàh scholars on the validity of this contract. The majority of scholars prohibit it, whereas Shafis allow it.

5.2.2.3. Bai’ wafa’ It is also known in other terms such as bai` thanaya (Maliki Mazhab), bai` ùhdah (SyafiìMazhab), bai` amanah (Hanbali Mazhab) or bai` toàh or bai` jaiz. The Hanafi book named it bai` muàmalah. Section 118 of Majallah al-Ahkam al-Àdliyyah defines it as a sale with a condition that, when the seller pays back the price of the goods sold, the buyer will return the goods to the seller. According to al-Zarqa`, it is àqdtauthiqiy (security contract) in the form of a sale, based on the fact that both parties to the contract have the right to reclaim the exchanged goods. This means that when there is a wafa` sale, the seller has the right to reclaim the goods sold by paying the buyer the full price of the goods sold. It is called wafa` because of the obligation to fulfill the condition in the contract, that is, returning the goods sold when the seller decides to reclaim the goods by paying back the amount. There is a disagreement among Sharīàh schol-ars on the validity of this contract; the majority of scholars don’t allow it whereas Hanafis allow it.

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5.2.2.4. Bai’ Muzayadah It is the offering of goods for sale in a market by a seller with a number of interested buyers who compete to offer the highest price. This process ends with the seller selling the goods to the highest bid-der. In other words, it is similar to an auction. Other names for this principle used by past Islamic jurists are bai` fuqara`, bai` man kasadatbidha`atuhu, bai` mahawij, and bai` mafalis. Bai` muzayadah is a form of trading that has existed and been applied in the muamalat for a long time.

5.2.2.5. Bai’ al Istijrar It is the practice of taking a certain amount of goods, such as bread, meat, and oil from the seller by the buyer every day and paying for them at market price at year-end or month-end without fixing the price at the inception of the `aqd. This practice will not give rise to any dispute between buyer and seller because they have agreed on the method of payment and price determination. It should be noted that there are different types of bai` al istijrar according to the different schools of law; the afore-mentioned is the Hanbali version, which is disputed. Bai` al istijrar, which is not disputed, is defined as a contract whereby the supplier agrees to supply a particular product on an ongoing basis, for example, monthly, at an agreed price and an agreed mode of payment.

5.2.2.6. Bai’ al-Dayn Bai` al-Dayn is a sale of payable right either to the debtor himself, or to any third party. The issue of bai` al-dayn arises when Islamic bonds are traded in the secondary market at a discount, because, among the conditions, if the debt is money, its price should be equal in terms of amount. There are some conditions that should be observed when dealing with bai` al dayn.

5.2.2.7. Istisna’ (Manufacturing Contract) Istisna` is derived from the root word sana`, which means “to manufacture or to construct something.” Istisna` is defined as a contract whereby a party undertakes to produce, construct, manufacture a specific thing according to certain agreed upon specifications at a determined price and for a fixed date of delivery. Istisna` is the second kind of sale, after salam, where a commodity is transacted before it comes into existence.

5.2.2.8. Murabahah (Mark-Up) Murabahah is the sale of a commodity for the price at which the seller has purchased it, with the addition of a stated profit known to the buyer. The only feature distinguishing murabahah from other kinds of sale is that the seller expressly tells the purchaser how much cost he has incurred and how much profit he is going to charge in addition to the cost. If a person sells a commodity without stating the cost and profit, then it is called musawamah.

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5.2.2.9. Salam (Future Delivery) Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price that is fully paid on the spot. The price is paid in cash, but the supply of the purchased goods is deferred. The subject matter of salam is normally agricultural products such as rice and natural resources such as gas.

5.2.2.10. Sarf (Currency Exchange) Sarf is the exchange of one monetary form for another in the same or different genre such as gold for gold coin, silver for silver, gold for silver, silver for gold, whether it is in the jewelry form or minted coins. There are rules to be observed in the exchange of this type of monetary form. These rules are applicable for today’s bank notes, which mean that, when there is a currency exchange, for instance Malaysian ring-gits with Algerian dinars, the rules of currency exchange will apply whereby a spot transaction is required without delay in the exchange.

5.2.2.11. Tawarruq Tawarruq is the purchase of a commodity, which is in the ownership and possession of the seller, against a deferred price, and its subsequent sale by the purchaser to a party other than the seller on cash for the purpose of obtaining cash. It is defined also as purchasing a commodity on credit and selling it to a person other than the initial seller for a lower price in cash.

5.2.3. Lease-Based Transactions

Ijarah (Leasing): Ijarah is defined as a contract of proposed or known usu-fruct with a specified return or compensation for the effort or work that has been expended or for the benefit derived from the use of a leased object. It is also called sale of the usufruct. Ijarah is divided into two types: Corporeal property (ijarah or manfaàt al-àyn), which includes immovable property (land) merchandise (machinery) and animals. Personal service (ijarah or manfaàt al- àmal) type of ijarah is the hiring of services or labour such as hiring an engineer or a tailor to undertake a specific task.

5.2.4. Fee-Based Transactions

This principle includes the following contracts: juàlah (commissioned transaction) and wakalah (agency).

5.2.4.1. Ju’alah Juàlah is an open promise by one party to pay whoever per-forms a particular task. It is a unilateral contract that is binding on the ini-tiator. In other words, juàlah is a contract in which one of the parties (jaìl)

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offers specific compensation (the ju`l) to anyone (amil) who will achieve a determined result in a known or unknown period. The forms of activities that both parties in ju`alah agree upon may include: an activity that is intended through the agreement to produce a result such as the extraction of miner-als; any information in which the offeror has an interest such as presenting a report or a study that realises a result but in which the extent of the work cannot be determined; and an activity that is intended through the agreement to return lost property to its seeker. The application of ju`alah is as follows:

■■ Exploration for minerals and extraction of water■■ Collection of debts■■ Securing permissible financing facilities■■ Brokerage■■ Discoveries, inventions, and designs

5.2.4.2. Wakalah Wakalah is the delegation of one party (the principal) for another (the agent) to be the representative in a known and permissible dealing. Wakalah includes three main elements: the principal (al muwak-kil), the agent (al wakil), and the subject matter (al muwakkalfih). There are some conditions that must be fulfilled in order to conclude valid wakalah contracts, which are:

■■ The contract agreement must be concluded based on the mutual con-sent of the contracting parties.

■■ The contracting parties must fulfill the requirements of the legal capac-ity to be able to conclude wakalah contract.

■■ The subject matter must be known to both parties.■■ The disposition must be permissible; therefore, it is not allowed to

appoint one agent to perform non-permissible action.■■ The subject matter accommodates representation such as sale, purchase,

and leasing.

5.2.5. Free-Interest-Loan-Based Transactions

5.2.5.1. Qard Hassan Qard hassan (free interest loan) is the lending of money to a borrower without imposing interest on his loan. The borrower is required to return the principal upon demand or according to the mutual agreement of the parties. Qard is the transfer of ownership in fungible wealth to a person on whom it is binding to return wealth similar to it. It is stipulated for the subject matter of the contract that it be known fungible (mithli) marketable wealth. The borrower comes to own the subject matter

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of qard (the wealth loaned) through possession, and he becomes liable for (the repayment of) a similar subject matter.

The applicable rule is the return of an amount similar to the loan amount at the place where it was delivered. The stipulation of an excess for the lender in loan is prohibited and it amounts to riba.

■■ Whether the excess is in terms of quality or quantity.■■ Whether the excess is a tangible thing or a benefit.■■ Whether the excess is stipulated at the time of the contract or while

determining the period of delay for satisfaction or during the period of delay.

■■ Whether the stipulation is in writing or is part of customary practice.

It is permitted to stipulate the satisfaction (repayment) of qard at a place other than that where the loan was made.

5.2.6. Security-Based Transactions

This principle includes the following contracts: Kafalah (suretyship) and rahn (pledges).

5.2.6.1. Kafalah Kafalah is adding obligation (of the guarantor) to the obli-gation of the principal debtor with respect to the demand for something (debt; compensation). For example, if someone has a debt, another person is willing to give guarantee of the debt; the first person is called asil (the prin-cipal debtor) and the second person is called kafil (guarantor). Jurists agree that in the surety-ship, the debt of guarantor is established, whereas the debt of the principal debtor remains as it is.

The types of the financial guarantee are as follows:

■■ Kafalah bi al-dayn (guarantee for debt). It means to guarantee the pay-ment of debt to the creditor owed by the principal debtor.

■■ Kafalah bi al-Taslim (guarantee for delivery). It is a guarantee to deliver property to its owner to be sure, on behalf of a lessee, to transfer the possession of a leased property to the lessor or his agent at the expira-tion of the lease period.

■■ Kafalah bi al-dark. It is a kind of guarantee given by a seller that he will return the price of the object if it is taken over by someone else in the exercise of his better right.

The majority of Muslim jurists view that it is non-permissible to take a fee for giving guarantee. Some contemporary scholars allow the taking of

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a fee in a kafalah contract by giving a different concept of kafalah within the modern business and finance.

5.2.6.2. Rahn Rahn is possession offered as security for a debt so that the debt will be paid from the security given, in case the debtor failed to pay back the debt. Other names of rahn are pledge, mortgage, pawn, collateral, but with Sharī`ah values and rulings. The mortgage does not automatically belong to the mortgagee if the mortgagor fails to pay the debt. There must be consent from the mortgagor to sell the mortgage, or by order of the court. The contract of rahn is a voluntary charitable contract (tabarru` ) because the pawned object is given without financial compensation. It is a contract of a non-fungible property, which is not considered totally binding until the object of contract is delivered.

5.2.7. Support-Based Transactions

This principle includes the following contracts: hawalah (transfer of debt) and muqassah (set-off), suftajah, and ibra`.

5.2.7.1. Hawalah Hawalah means transferring a debt from one debtor (transferor) to another party (transferee). Once the transferee has accepted the transfer of debt, the transferor would be released from any obligation.

5.2.7.2. Ibra Ibra` refers to the act of surrendering one’s claims and rights, such as a creditor writing off the debts of a debtor. Ibra` falls under uqudtabarru`at. Alternatively, it is an act by a person to withdraw his rights to collect payment from a person who has the obligation to repay the amount borrowed from him.

5.2.7.3. Muqasah Muqasah or set-off is a device used to discharge the obliga-tions or debts of a person in business and financial transactions. It is a form of a clearance of obligation and setting off debts of the debtor and creditor when the debts are identical in all aspects or when the debt is of different value, the smaller debt is reduced from the larger debt. Muqasah means discharge of debt receivable against debt payable. It is defined as the setting off of a debt that is due on the debtor by a creditor who is at the same time indebted to the debtor with certain specific conditions. Both debtor and creditor are indebted toward each other whereby the debts are of the same amount and value, and both parties have agreed to set off their debts and terminate their obligations accordingly. Muqasah means that the debtor and creditor have the rights (debt) that are of the same nature toward each other, and both parties have agreed to discharge their rights.

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5.2.7.4. Suftajah The word suftajah originated from the Persian language and has been adopted by the Arabs. It means a document written by a per-son to his representative or debtor instructing him to pay a certain sum of money to his creditor. There is little difference between its meaning in Arabic and its Islamic jurisprudence terminology, which is a credit instrument in the form of financial notes given to someone to enable the creditor to use it at another predetermined venue. The benefits given by the debtor using this method are from a risk-management aspect. A creditor does not run the risk of losing money during his journey as he is only carrying suftajah notes. Among the applications of suftajah in the modern financial world is the pro-cess of money transfer, that is, telegraphic transfer, traveller’s cheque, and money order. In the context of the capital market, it is related to financial notes.

5.2.8. Voluntary/Charitable-Based Transactions

5.2.8.1. Ariayh Ariayh means borrowing. It involves allowing a person to enjoy the benefit of an asset and have its beneficiary ownership without a consideration for a particular time to be returned to its owner. It is a kind of gratituous loan. In ariayh contract, the asset remains, whereas its benefit is used, such as a house, car, machine, and so forth. Ariayh does not involve lending of money or object to be used and consumed such as food. Ariayh is different than qard hasan, whereby qard hasan is related to money to be used and consumed and the borrower will have ownership of it and is required to provide a similar amount when it is returned, whereas in ariayh the borrower is not getting money but will benefit from an asset that belongs to the owner. Therefore, ariayh is a borrowing for use, whereas qard hasan is a borrowing for consumption. Ariayh can be against guarantee, and it will be ariayh with guarantee.

5.2.8.2. Hibah Hibah means a gift; it is awarding a person something with-out a consideration. The gift can be a kind of tangible asset or benefit; how-ever, the concept of awarding the benefit is confined to ariayh. The Maliki define hibah as “giving ownership by those who are entitled for donating things that are approved by Sharī`ah without counter value to those who are entitled to receive with the language or any that shows it.” Al-Dasuqi has defined hibah as “Giving ownership without counter value.” One of the most important conditions of the object in hibah is:

■■ The object exists at the time of hibah (Maliki accommodate the hibah of non-existent object).

■■ The object must be a permissible asset/item according to Sharī`ah.

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■■ The object belongs to the donor through a valid ownership.■■ The object can be delivered to the recipient.

5.2.8.3. Wadiàh Wadiàh is derived from the verb wadaà, which means “to leave.” The literal meaning of wadiàh is leaving something in someone’s custody. Hanafis defined it as empowering someone to keep the owner’s wealth explicitly or implicitly. According to Shafiìs and Malikis, it rep-resents keeping possession of respectable private good in a specific way. Majallah al-Ahkan al-Adliyyah defines it as an asset given to someone for safekeeping without any return.

5.2.8.4. Waqf Waqf means to stop, contain, or to preserve. According to Sharīàh, waqf is a voluntary, permanent, irrevocable dedication of a portion of one’s wealth in the form of cash or kind to Allah (s.w.t). Section 2 of the Enactment of Wakaf of Selangor 1999 defines wakaf as the dedication of any property from which its usufruct or benefit may be used for any chari-table purposes whether as wakaf am or wakaf khas, but it does not include a trust, which is defined under the Trustee Act 1949. Waqf cannot be given as a gift, inherited, or sold. It belongs to Allah (s.a.w.) and the corpus of the waqf always remains intact. The benefit of waqf may be utilised for a particular objective if it is stipulated by the waqif, or in different charitable objectives if there is no specific stipulation by the waqif.

5.2.8.5. Wasiyyah The word wasiyyah comes from the root word of wasa which means “to attach” or “to join.” Wasiyyah in its technical definition is “a transfer of ownership for no consideration to take effect after death.” It is a kind of tabarru`, which can be an asset, or benefit. It is recommended by Sharīàh to be a channel for the needy people.

5.2.8.6. Tabarru There are two main categories in Islamic law of contract, namely, uqud tabarru` (voluntary contract) and uqud muawadat (exchange contract). Tabarru` is not a specific contract but it is category or class in Islamic law of contracts. It is the opposite of an exchange contract. Tabarru` is a word derived from the Arabic word (tabarra` ), which means to give something voluntarily to others. If a person gives something (asset or ben-efit) to others (individual or group) in the present or in the future without consideration, we say that the person is making a tabarru`. It is regarded also as a kind of gift given to a person or an organization as a charitable deed for assistance purpose; the donation may take a different form such as cash, tangible asset, commodity, and the like. The donation does not gener-ate profit or benefit but is driven by love and care. It is categorized under voluntary transactions and not considered as an exchange contract. For

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instance, in the case of emergency cases, the donation will be in the form of medical care and provision such as blood donation and free food supplies.

NOTES

1. The fundamentals of the contract are discussed very briefly.2. Majalla el-Ahkam-I-Adliyah, Article 168 (Kuala Lumpur, Malaysia: The Other

Press, 2003), 21; Ali Al Kafif, Ahkam Al Muamalat Al Sharīàh (Cairo, Egypt: Dar Al Fikr Al Arabi, 1996), 203.

3. See: Ala’ EddinKharofa, Transactions in Islamic Law (Kuala Lumpur, Malaysia: A.S. Noordeen, 1997), 11.

4. Majalla, Article 167, 21.5. Ibid., Article 171, 21.6. Ibid., Article 172, 21; Al Kafif, Ahkam Al Muamalat Al Sharīàh, 204.7. AhceneLahsasna, Islamic Contract in Financial Services (Kuala Lumpur,

Malaysia: CERT, 2003), 26.8. See: Wahbah Al-Zuhayli, Financial Transactions in Islamic Jurisprudence, vol. 1

(Damascus, Syria: Dar al-Fikr al-Mouaser, 2003 [English ed.]), 19.9. Majalla, Article 177, 23.

10. Ibid., Article 183, 25.11. Ibid., Article 184, 25.12. See: Al-Zuhayli, Financial Transactions in Islamic Jurisprudence, 18.13. Ahmad Ibrahim Biq, The Sharīàh Financial Transactions (Dar al Ansar, Cairo,

1936), 111.14. Kharofa, Transaction in Islamic Law, 12; Al Kafif, Ahkam Al Muamalat Al

Sharīàh, 208.15. Al Kafif, Ahkam Al Muamalat Al Sharīàh, 236.16. Ibid., 236.17. Subhi Mahmasani, TheGeneral Theory of Obligation and Contract in Islamic

Law (Beirut, Dar ulIlm lil Malayin, 1983), vol. 2, 366.18. Al Kafif, Ahkam Al Muamalat Al Sharīàh, 269.19. See: M. Tahir Mansuri, Islamic Law of Contract and Business Transactions

(International Islamic University, Islamabad, Pakistan, 2011), 35; Biq, The Sharīàh Financial Transactions, 84.

20. Majalla, Article 200, 27.21. Ibid., Article 201, 27.22. Ibid., Article 205, 28.23. Biq, The Sharīàh Financial Transactions, 145; Mohamad Sulaiman Al Ashqar,

Murabahah, Salam and Istisna’, 92; Nazih Hamad, The Contract of Salam in Islamic Law (Beirut, Dar al Qalam, 1993), 7.

24. For more details see Lahsasna, Islamic Contract in Financial Services, 67.

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101

CHAPTER 6Lines of Defences for Sharı ah

Non-Compliance Risk Management

6.0. INTRODUCTION

To prevent a Sharīàh non-compliance risk event, there are some measure-ments and processes that have been carefully implemented in the IFI as part of risk management for non-Sharīàh compliance risk.

These represent the lines of defence that are shown in Figure 6.1.

6.1. THE FIRST LINE OF DEFENCE: PRODUCT OWNER

The product owner represents the first line of defence in Sharīàh non-com-pliance. The team that develops the product, instrument, or the facility is the first line that screens the product and ensure it compliance to the Sharīàh rules and principles. In structuring the product, the team in collaboration with the Sharīàh management should employ its best effort to make sure that the product structure is designed in such a way that it complies with the Sharīàh requirements and avoids any term or condition that may expose the product to Sharīàh non-compliance.

6.1.1. Guidelines on Sharı àh Compliance Product Development

Structuring the products in Islamic finance should be guided by some guide-lines. The development of the products should be governed by the following parameters in order to ensure Sharīàh compliance status:1

■■ Selection of niche product and niche market: The development process in product compliance starts by selecting an appropriate product for a niche market. The process of selection and design is easier for the

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Islamic banks that are subsidiary of conventional bank, whereby the Islamic bank will leverage on the mother bank for designing and devel-oping products. In some cases, the product development department in the bank will share the new product developed in order to produce a conventional version and Islamic version at the same time. In some cases, other financial institutions approach the Islamic bank to design a product for some particular needs such as product investment link for Takaful operator or structure product for some investment bank. This represents the first step toward introducing a Sharīàh compliance product.

■■ Understanding the product in its conventional framework: The starting point and initial stage in the product development in Sharīàh compli-ance product starts from understanding the product in its conventional framework. The understanding of the product includes the concept of the product, feature, function, applications, the parties involved, the mechanism of generating the profit, type of risk that exist in the prod-uct, and so on. This approach is applicable in case that the product is imported from the conventional finance.

■■ Analysis and examination of the product: The understanding of the product in its conventional environment will be respectively followed

FIGURE 6.1 The Lines of Defence in Islamic Financial Institutions

1

3

5

6

2

Product owner Product design and development

4

Pre-Sharīàh compliance process—risk mitigation

CEO/management IFI management

Sharīàh riskmanagement Risk management

Sharīàh management Sharīàh management

Sharīàh committee Approval and supervision/institutionlevel

Board of directors Management

SAC BNM & SAC SC Approval and supervision (national level)

Sharīàh review Examination and assessment/internal

Sharīàh audit Examination and assessment/internal

Public Public perception and judgment

7

8

9

10

Post-Sharīàh compliance process—Risk identi�cation and rati�cation

1st line of defence

2nd line of defence

3rd line of defence

4th line of defence

5th line of defence

6th line of defence

7th line of defence

8th line of defence

9th line of defence

10th line of defence

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Lines of Defences for Sharıàh Non-Compliance Risk Management 103

by a process of analysis by dismantling the product to its basic compo-nents. The process of examination is a very important stage in product development; the examination will include the following:

■■ Identify the process flow of the product.■■ Identify the parties involved in the transactions.■■ Understand how the profit is generated and calculated.■■ Identify if there is loan transaction in the product.■■ Trace the flow of fund in lending and borrowing.■■ Identify the nature of the transaction and the norm of the deal

whether it is investment, financing, deposit.■■ Identify the purpose of the product and its objective, which will help

to select the potential Islamic contract to serve the same purpose.■■ Listing the prohibited elements that may exist in the product.

■■ Elimination of prohibition elements in Sharīàh: In building a new product, it is a primary requirement to eliminate the prohibited ele-ments that have been identified in the product in order to ensure its Sharīàh compliance. The prohibited elements are but are not limited to riba, maisir, gharar, ghubn, deception, inequality, and duress.

■■ Identifying the Islamic commercial contract: Before making any devel-opment on the product, it is important to identify the underlying contract that governs that product. The reason behind this step is to understand the norm of the product in the first place and what type of rules and conditions should be observed in the development of the product.

■■ Understanding the rules governing the contract: The identification of the nature of the contract will enable the Sharīàh advisor to have a proper understanding of the product and will help to design a proper structure to develop the product. It should be understood that each contract has principles, rules, conditions, that must be preserved and protected from any potential violation during the development of the product.

■■ Maintaining the existing Islamic rules of the underlying contract when applying the contract in new applications: The contract that governs the application must maintain its rules, conditions, and nature. Even the application has changes from its origin form and takes different shape and serves different purposes and applications. For example, the devel-opment of leasing contract from its typical format to the financial leas-ing ending with the transfer of the ownership of the asset, which is used by the Islamic financial institutions in car financing and home financing, will not allow the financial leasing to depart from the basic rules and con-ditions of leasing contract. This parameter should be applied in all types of contracts that have developed from its typical format to new applica-tions depending on the need of the market. For example, salam has been

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developed from typical salam contract to parallel salam; istisna` has been developed from typical istisna` contract to parallel istisna`, and so on. However, sometimes the contract is subject to some enhancement to suit and fit the banking environment because it is a highly regulated market. This enhancement does not compromise of any Sharīàh rules or features of the contract, such as the enhancement of murabahah to murabahah to the purchase orderer, or enhancement of ijarah to ijarah muntahiah bittamlik (leasing ending with ownership), and so on.

■■ Maintaining the underlying contract and upgrading the application by designing a new feature according to the market demand: The develop-ment of the product is driven by the market demand to fulfill the need of the marketplace, that is, the customer in the retail market, and the corporation as well. Sometimes, some institutions request the bank to customize a particular product to suit their need such as Takaful opera-tor in a product link investment. Hence, the contract maintains its basic rules with some development in its features to suit particular need.

■■ Reassemble the product based on underlying contract in Sharīàh: The process of reassembling the product again takes place upon completion of the analysis and elimination of the prohibited elements, whereby the product is assumed to be free from potential Sharīàh non-compliance risk. This particular stage is a process of switching the product from its original format, which is based on an interest loan, to a new format by structuring it on the suitable Islamic commercial contract. The product may have flow of transactions involving few parties; the proper design of the flow in this stage will ensure Sharīàh compliance of the product. A careful procedure should be observed here especially when selecting the suitable contract.

■■ Careful observation in using contract combination: As it is known, most of the facilities consist of a series of transactions that means a series of contracts. This is a very crucial stage in product structuring and development. There is no issue of having a master document that gov-erns the entire facility process including the different transactions and the contract pertaining to the product. However, in the implementation and the execution of the product, the separation of the contract and the sequence is very important to ensure Sharīàh compliance. Each con-tract should stand by its own and has its obligations, conditions, and rules; the combination of the contract in product development with-out careful consideration of the conditions of the contract will lead to Sharīàh non-compliance risk.

■■ Consideration of the terms and conditions of the contract: The terms and conditions of the contract are rules governing the contract. The parties must always respect these terms and conditions and no party is

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allowed from Sharīàh perspective to violate any clause without prior consent of the counterparties. Product development should be distin-guished by two types of conditions. First, there are conditions that have been imposed by Sharīàh that must be implemented, whereby the con-tracting parties have no choice but to adhere to them. On the other hand, Sharīàh allows contracting parties to stipulate additional con-ditions whereby they have the freedom to include any condition that serves their interest, with the condition that the stipulated conditions in the contract agreement do not contradict the norm and nature of the contract and do not violate the Sharīàh rules and principles.

■■ Consideration of the risk exposure in the product: Consideration of the risk exposure is an important part in product development. There is no valid reason to spend a financial engineering effort on product that has a high risk and does not attract investors. In addition to that, it is prohibited to expose the capital to high risk that may damage the asset and lead to some financial crisis as an implication and result of that product. Allah says: “Spend your wealth for the cause of Allah, and be not cast by your own hands to ruin; and do good. Lo! Allah loveth the beneficent” (Al Baqara: 195).

Consideration of high risk is obviously observed by the Islamic financial institutions and the regulator, whereby sometimes the regulator, such as the central bank, rejects or holds some products if they are associated with high risk in case the regulator feels that the Islamic financial institution is unable to control or mitigate the risk due to lack of experience.

■■ Consideration of the commercial value of the product in the market and its profitability and contribution to the economy and finance (public interest of the ummah): Sharīàh gives equal consideration concerning the product development. The first concern is the Sharīàh aspect whereby the product should be free from all the prohibited ele-ments. This aspect represents the interest of the religion. The second aspect is the commercial value of the product in the form of its profit-ability, its benefit, and (manfa) the economic growth and prosperity to the ummah. The check and balance is an element integrated in the pro-cess of Sharīàh approval.

■■ Ensuring that the final product developed is in line with Sharīàh rules and principles: The flexibility of Sharīàh in product development and innovation cannot be extended to overrule Sharīàh principles. The free-dom of innovation is accommodated and encouraged within the norm of Sharīàh and its rules in business and finance. The developed product

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must be designed by taking into account the Sharīàh rules of the con-tract; at the end of the development process, the product should be in accordance with Sharīàh rules and principles. The violation of Sharīàh rules and principles will trigger Sharīàh non-compliance risk.

6.1.2. Product Development Process Based on Sharı àh Governance Framework (SGF)2

Sharīàh governance framework of Malaysia mentioned the product-devel-opment process as follows:

1. One of the major deliverables of every IFI is the introduction and offer-ing of financial products to the market that do not only need to meet the demand of the customers but also have to be fully Sharīàh compliant. The IFI must ensure that the product-development process is compre-hensive and robust to minimise the possibilities that the product will be nullified on Sharīàh grounds.

2. Generally, Sharīàh non-compliance occurrence during the product-development process originates from improper structuring of products, lack of internal research in understanding the appropriate Sharīàh con-cepts, and misrepresentation of the product at the issuance or marketing stage of the product.

3. The IFI must acknowledge that managing a Sharīàh-based institution has to be a continuous process that requires the IFI to have in place adequate and appropriate control and measures, including risk-mitigating instru-ments that could address or minimise Sharīàh non-compliance instances.

4. Therefore, the IFI must refer all Sharīàh issues in its product-devel-opment business operations to the Sharīàh committee for advice. The submission for advice or a decision must be made in a comprehensive manner for an effective deliberation by the Sharīàh committee. This will include explaining the process involved, documents to be used, and other necessary information.

5. All new products shall be endorsed by the Sharīàh committee to cer-tify Sharīàh compliance on the concept and the mechanism/structure, backed by the relevant fiqh literature, evidence, and reasoning. There shall be a rigorous deliberation process among the Sharīàh committee as well as detailed scrutiny of the legal contracts and other documents relevant to the products or transactions.

6. Product development covers both pre-product approval (i.e., process of product structuring and developing prior to the introduction to market) and post-product approval process (i.e., process after the product has been offered to the customers and transactions have been carried out).

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Pre-product approval

a. Pre-product approval process involves the issuance of Sharīàh decisions, product structuring, or design processes backed by comprehensive Sharīàh research, vetting of contracts and agree-ments, as well as compliance checks before the product is offered to customers.

b. There shall be a formal and transparent procedure for issuance of Sharīàh decisions, which are well documented and approved by the board and Sharīàh committee.

c. An IFI shall ensure that the pre-product approval process includes, among others, a review of the concept, structure, term sheet, doc-umentations, policies and procedures, pamphlets, brochures, and advertising materials. The documents shall be approved by the Sharīàh committee of the IFI.

Post-product approval

a. Post-product approval process involves monitoring product imple-mentation to ensure compliance with Sharīàh principles, identifying the area of potential Sharīàh non-compliance risks, and proposing the relevant remedial actions to senior management.

b. An IFI must ensure that post-product approval in its Sharīàh governance framework also includes internal Sharīàh review and Sharīàh governance reporting. Without such follow-up, the IFI would not be able to monitor the consistency of its Sharīàh compli-ance and effectively manage any Sharīàh compliance risk that may arise over time.3

6.2. THE SECOND LINE OF DEFENCE: MANAGEMENT OF THE IFI

Management is the second line of defence because management is respon-sible for delegating specific tasks to the appropriate staff members based on knowledge, experience, and competency to ensure the effectiveness of the tasks performed by the different units and divisions of the bank. Management is also responsible for providing the necessary measurement, platform, and environment to ensure Sharīàh compliance.

According to Sharīàh framework of Bank Negara Malaysia, manage-ment is responsible for observing and implementing Sharīàh decisions and rulings made by the Bank Negara Malaysia Sharīàh Advisory Council and Sharīàh committee, respectively. Management is also responsible

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for identifying and referring any Sharīàh issues to the Sharīàh committee for decisions, views, and opinions.

It is the responsibility of management to allocate adequate resources and manpower to support the Sharīàh governance that should be com-mensurate with the size, complexity, and nature of the IFI’s business. The infrastructure and resources provided shall include, among others budget allocation, reference and research materials, training and development, and so on.

Given that the accountability on Sharīàh decisions rests with the Sharīàh committee, management shall provide the necessary informa-tion and disclosures to Sharīàh committee in a true and fair manner and shall be transparent on any areas that need clarification by the Sharīàh committee to enable the Sharīàh committee to discharge its duties effectively.

Management is responsible for providing continuous learning and training programs for the key internal stakeholders including the board, the Sharīàh committee, Sharīàh officers and relevant staff in Sharīàh and finance matters. This is to ensure that every function in the Sharīàh gover-nance structure is sufficiently exposed to the latest development on Sharīàh related matters.

It is the responsibility of management to inculcate Sharīàh compliance culture within the organization. Sharīàh compliance culture refers to the compliance of the IFI to Sharīàh principles in its overall business opera-tions. For example, the management should consistently remind the front-line staff of the importance of Sharīàh and its impact to the IFI if Sharīàh principles and practices are not observed, and to always place Sharīàh as the overarching requirement in the formulation of any procedures and activ-ities. In addition, each staff member is expected to be conversant on the IFI’s Islamic products, the underlying Sharīàh concepts, and the similarities and differences with conventional concepts.

Management must ensure that Sharīàh policies and procedures are accessible to those involved in the implementation of Sharīàh governance at all times. The Sharīàh policies and procedures shall clarify matters related to the end-to-end process of Sharīàh governance in the IFI. The manage-ment shall also be responsible for ensuring that the operations are executed according to the policies and procedures and to constantly review and update the policies and procedures to reflect the current market practices and development.

In the event that management becomes aware that certain operations are found to be carrying business that is not in compliance with Sharīàh, or against the advice of its Sharīàh committee or the rulings of the Sharīàh Advisory Council, management shall:

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■■ Immediately notify the board and Sharīàh committee as well as the bank of the fact.

■■ Immediately cease to take on any new businesses related to the Sharīàh non-compliance business.

■■ Within 30 days of becoming aware of such non-compliance or such further period as may be permitted by the bank, furnish a plan to rectify the non-compliance with Sharīàh to be duly approved by the board and endorsed by the Sharīàh committee.

For cases in which the bank has reason to believe that an IFI is carry-ing on operations that is not in compliance with Sharīàh, it may direct and require remedial measures to be instituted by the IFI.

Management is responsible for establishing a Sharīàh risk management control function as part of the IFI integrated risk management framework. Sharīàh risk management control function refers to the identification, assessment, monitoring, and controlling of Sharīàh risks through a sys-tematic approach to mitigate any possible non-compliance events. Due to the technicality and complexity in identifying, measuring, controlling, and monitoring the risk of non-compliance with Sharīàh, the function shall be performed by risk officers who have suitable qualification or experience in the subject matter.

Apart from institutionalising a robust Sharīàh compliance function, management is also required to establish an internal unit consisting of quali-fied Sharīàh officers to conduct pre-product approval process, research, vet-ting of issues for submission, and undertake administrative and secretarial matters relating to the Sharīàh committee.

In the absence of an internationally accepted code of conduct, the man-agement shall develop a code of conduct for the Sharīàh committee to be duly approved by the board. The code of conduct may be developed in consultation with the Sharīàh committee and shall be reviewed from time to time.

6.3. THE THIRD LINE OF DEFENCE: SHARl ÀH RISK MANAGEMENT

According to Sharīàh governance framework of Bank Negara Malaysia, Sharīàh risk management is a function to systematically identify, measure, monitor, and control Sharīàh non-compliance risks to mitigate any pos-siblity of non-compliance events. The systematic approach of managing Sharīàh non-compliance risks will enable the IFI to continue its operations and activities effectively without exposing the IFI to unacceptable levels of

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risk.4 Hence, the Sharīàh will be integrated in the structure of the risk man-agement. However, will the Sharīàh risk management be running in parallel with the normal risk management as an independent body or will it be part of the whole risk management system in the Islamic financial institution? From the IFSB classification mentioned in the early chapters, Sharīàh non-compliance risk is part of the different risk management that the IFI is fac-ing. SGF said, “The Sharīàh risk management control function shall form a part of the IFI’s integrated risk management framework.”5 However, due to the technicality and complexity in managing the risk of non-compliance to the Sharīàh, the function shall be performed by risk officers that have suitable qualifications and/or experience in the subject matter.6 The skills and qualification required are most dominant by Sharīàh knowledge as the main issue address in this type of risk is Sharīàh non-compliance risk.

According to SGF Sharīàh risk management function involves:

■■ Facilitating the process of identifying, measuring, monitoring, and con-trolling Sharīàh non-compliance risks inherent in the IFI’s operations and activities:

■■ Identifying and understanding the inherent Sharīàh non-compliance risks in the IFI, taking into account existing controls that have been put in place and their effectiveness in mitigating such risks.

■■ Measuring the potential impact of such risks to the IFI, based on the historical and actual de-recognition of income derived from Sharīàh non-compliant activities.

■■ Monitoring of Sharīàh non-compliance risks to facilitate efficient and effective management of such risks. A report on the Sharīàh non-compliance risks indicators shall be escalated to the board, the Sharīàh committee, and management periodically.

■■ Control to avoid recurrences. This involves keeping track of income not recognised arising from Sharīàh non-compliance activities and assessing the probability of similar cases arising in the future. Based on historical reviews and potential areas of Sharīàh non-compli-ance, the IFI may assess potential profits that cannot be recognised as eligible.

■■ Formulating and recommending appropriate Sharīàh non-compliance risk management policies and guidelines.

■■ Developing and implementing processes for Sharīàh non-compliance risk awareness in the IFI.7

The Sharīàh risk management function is a pre-process function in the Sharīàh compliance procedure, where management is responsible for putting into place the necessary measurement, steps, and processes to

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mitigate all types of Sharīàh non-compliance risk. The Sharīàh risk man-agement represents the process of preventing the non-compliance from happening, not rectifying what has happened. However, such management benefits from the lesson of the incident to put further recommendation and processes from occurring in the future.

The IFI shall establish the best practice of risk management and report-ing process to avoid value destruction and reduce threats to value creation, to improve chances of meeting the IFI’s objectives and to maximize value cre-ation opportunities. The risk management activities include business continu-ity management, capital management, and stress-testing activities, and they are governed by the risk management framework and regulatory requirement governing the IFI business and Sharīàh compliant investment activities.

The risk management framework shall define the following:

■■ The governance structure of the risk management practice including the appropriate board, and senior management oversight.

■■ The overview of the risk management approach including to identify, measure, monitor, report, and control the relevant categories of risk.

■■ The general risk affecting the business and the potential threat to the company.

■■ Adequate risk reporting to the relevant committee and supervisory authority.

The company shall have in place adequate system and controls includ-ing Sharīàh committee/advisor to ensure the IFI business and Sharīàh compliant investment activities are in accordance to Sharīàh rules and prin-ciples. The company shall have in place the business continuity management framework to facilitate the company business continuity plan. The company business continuity framework serves as a guiding principle to enable the company to respond effectively to the business disruptions and to minimise impact to the company in the event of disaster.

The company shall establish the capital management framework to ensure the appropriate capital management is in place and consistent with the fiduciary duties of the Takaful operators toward its Takaful customers and in accordance to the objective of Sharīàh. The company shall design and develop the stress-testing guidelines to identify potential threats due to exceptional but adverse plausible events to the organization’s financial condition. The stress-test guidelines shall commensurate with the nature, complexity, and sophistication of the business activities of the company.

Risk management process shall undertake appropriate steps to comply with Sharīàh rules and principles. This is to ensure adequacy of relevant risk reporting to management and Sharīàh committee, where applicable.

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Risk management shall monitor and report any potential risk to the com-pany through a robust risk reporting to the risk management committee, Sharīàh committee, and the respective board. Risk management shall facil-itate the integration of risk awareness culture into business process with the aim to inculcate the risk awareness and risk ownership to company.

The company shall review the risk management approach and practices from time to time to adopt the best market practice in accordance to the ever-changing market climate and potential threat to the company. Other conditions related to Sharīàh risk management shall be referred to the risk management framework.

6.4. THE FOURTH LINE OF DEFENCE: SHARl ÀH MANAGEMENT

Sharīàh management is the in house Sharīàh advisory. They play a sig-nificant role to ensure Sharīàh compliance status in the Islamic financial institution. The role can further be extended as follows:

■■ Sharīàh division plays an imperative role in the company to ensure that all business activities and services offered by the company comply with Sharīàh rules and principles at all times. Besides, Sharīàh divi-sion is responsible for ensuring that company adheres to the regulatory requirements governing the Sharīàh-compliant investment and fund management activities.

■■ The roles of Sharīàh division among others include conducting Sharīàh review, carrying out in-depth research concerning Islamic finance, and providing required support and assistance to internal audit who will conduct Sharīàh audit. Furthermore, liaising with risk management on any potential risk related to Sharīàh issues for escalation to Sharīàh committee is also its duty.

■■ In addition, Sharīàh division is responsible for assisting the Sharīàh committee/Sharīàh advisor to execute their roles efficiently and effectively.

6.5. THE FIFTH LINE OF DEFENCE: SHARl ÀH COMMITTEE/BOARD

Sharīàh board is one of the most important corporate governance bod-ies in the structure of corporate governance in Islamic finance. They have the responsibility of the Sharīàh compliance status in the Islamic financial

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institution, where they advise, monitor, and decide on the different Sharīàh matters related to Islamic finance practices of the IFI.

6.5.1. Definition of Sharı àh Board

According to the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), Sharīàh board is defined as follows:

A Sharīàh Supervisory Board is an independent body of special-ised jurists in fiqh almua’malat (Islamic commercial jurisprudence). However, the Sharīàh Supervisory Board may include a member other than those specialised in fiqh almua’malat, but who should be experts in the field of Islamic financial institutions and with knowledge of fiqh almua’malat. The Sharīàh Supervisory Board is entrusted with the duty of directing, reviewing and supervising the activities of the Islamic financial institution in order to ensure that they are in compliance with Islamic Sharīàh rules and principles. The fatwas and rulings of the Sharīàh Supervisory Board shall be binding on the Islamic financial institution.8

From this definition, a few important points can be summarized as follows:

■■ Sharīàh Supervisory Board is an independent body, where the members are not regular/permanent staff of the IFI.

■■ The members of the Sharīàh board are major in fiqh almua’malat (Islamic commercial jurisprudence). This means that the members are expert in Sharīàh.

■■ The Sharīàh board is not restricted to the Sharīàh expert only but open to other members other than those specialised in fiqh almua’malat, but who should be expert in the field of Islamic financial institutions and with knowledge of fiqh almua’malat.

■■ The Sharīàh board is entrusted with the following functions:■■ Directing the Islamic financial institution in matters related to Sharīàh.■■ Reviewing the Islamic finance business activities.■■ Supervising the business activities of the Islamic financial institution

in order to ensure that they are in compliance with Islamic Sharīàh rules and principles.

■■ The resolution of the Sharīàh board is binding on the IFI.

The Sharīàh board function is within the collective ijtihad and not within the individual ijtihad. Sharīàh board has a great involvement in Islamic banking activities because it is considered to be part of its bank-ing structure and one of the important corporate governance organs in the

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Islamic financial institution. Within the context of fatwa, Sharīàh board is acting as a mufti whereas the Islamic bank is acting as mustafti.

6.5.2. Other Names of Sharı àh Board

This corporate governance organ uses the following names interchangeably.

■■ Sharīàh Advisory Board■■ Sharīàh Supervisory Board■■ Sharīàh Advisory Council■■ Sharīàh advisory committee■■ Sharīàh committee■■ Sharīàh board

There is no issue to name and describe the above council with any term as long it serve the purpose and distinguish it from other corporate gover-nance organs in the Islamic financial institution; normally each jurisdiction has its own terminology.

6.5.3. Resolution Issued by a Sharı àh Board

Normally each country has a different Sharīàh governance framework and different legal requirements that govern Sharīàh board. The Sharīàh board is a legitimate control and regulatory body consisting of selected members of jurists chosen on the basis of their background in Islamic jurisprudence, Islamic law, and Islamic finance. The principle duty of the Sharīàh board is to ensure that the current financial operations of the bank and its busi-ness transactions conform to Sharīàh rules, principles, and regulations. The outcome of deliberations of the Sharīàh board in their regular meeting is deemed to be a resolution. Hence, the resolution can be defined in a similar way to fatwa. It is a result of process of collective ijtihad among expert jurists in the area of Islamic finance to issue a ruling pertaining to Sharīàh matters that need clarification. From AAOIFI perspective, there is no dif-ference between fatwa and resolution and both are regarded as synonyms.

6.5.4. Function of Sharı àh Board and Scope of Its Duties

The Sharīàh advisory exercises ijtihad to issue resolutions in the area of Islamic finance based on the specific inquiries of their Islamic financial insti-tutions. Its main task is to issue Sharīàh ruling and advise their Islamic financing institutions when needed. Besides this task, it is involved in some other technical assignments and other tasks, such as:

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1. Revising the structure of the financial products. 2. Review, examination, and endorsement of the legal documentation. 3. Products designed to implement Sharīàh recommendations. 4. Sharing information between Sharīàh scholars, advisors, and other

institutions offering Islamic financial services.

In AAOIFI Sharīàh pronouncement of 2008 clause six (6), there is rec-ommendation to further foster the responsibility and the accountability of the Sharīàh board. Clause six (6) emphasized on the obligations and the functions of SSB in order to ensure the Sharīàh compliance in all stages. According to AAOIFI announcement, the obligations and functions should be as follows:

■■ SSB should not limit their role to the issuance of fatwa on the permis-sibility of the structure of sukuk only.

■■ The careful review of all relevant contracts and documents related to the actual transaction.

■■ Oversee the actual means of implementation in the IFI by taking into account all the parties involved in structuring sukuk.

■■ Ensure that the operation complies, at every stage, with Sharīàh guide-lines and requirements as specified in the Sharīàh standards.9

The recommendation of AAOIFI makes the duties and responsibilities of the SSB more involved in the whole process of sukuk, which include the following:

■■ Issuing fatwa of the permissibility of sukuk.■■ Structuring the sukuk products.■■ Checking the contracts agreement.■■ Checking all the relevant documentation.■■ Profit and loss distribution.■■ Oversee the means of implementation.■■ Oversee the various stages of the process.■■ Ensure the enforcement of Sharīàh rules and regulations in the process.

The main duties and responsibilities of the Sharīàh board can be briefly summarized as follows:

1. To advise the board of directors pertaining to Sharīàh matters of the banking business operation of the IFI.

The Sharīàh board plays a significant role in advising the board of directors on Sharīàh matters in order to ensure that the banking

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business operations and activities are in accordance with Sharīàh rules and principles. It is advisable that the chairman of the Sharīàh board or any other representative from Sharīàh board attend the meeting of the board of directors by invitation to give input on the issue discussed and express Sharīàh opinion on relevant Sharīàh matters when needed.

2. To review, examine, validate, and endorse the relevant documentations used in the IFI.

The Sharīàh board should review, examine, validate, and endorse, the following:

■■ Legal documentation used in the Islamic business activities by the IFI. This includes the principles, terms, and conditions of the con-tract agreements and related documents.

■■ Standard operating procedures (SOP), Sharīàh compliance and framework manual of the IFI, booklet, application form used in the IFI.

■■ The product manual, marketing advertisements, sales illustrations, and brochures used to describe the product.

■■ Media, clips, broadcasting, script of telemarketing, website informa-tion and contents, information in the IT systems, and related multi-media, communication, and marketing.

3. Ensuring the proper sequence of the legal documentation along with the execution of the contract agreement.

The Sharīàh board should ensure that adequate mechanism is in place to ensure that the transaction is executed in a Sharīàh-compliant manner. A proper sequence of the legal documentation is required to avoid a Sharīàh non-compliance risk.

4. To assist related parties on Sharīàh matters for advice upon request.The related parties of the Islamic financial institution, such as its

legal counsel, auditor, or consultant may seek advice on Sharīàh matters from the Sharīàh board/committee. The Sharīàh board/committee is expected to provide assistance to them so that compliance with Sharīàh principles can be assured completely.

5. To advise on matters to be referred to the authority.The Sharīàh board/committee must advise the Islamic financial

institution when they refer the matters to regulators and authorities. 6. To provide written Sharīàh opinions when needed.

The Sharīàh board/committee are required to provide written Sharīàh opinions when needed. Normally, the written opinions are pro-vided in the following cases:

■■ Where the Islamic financial institution makes submission applica-tions to the regulators such the central bank and the securities com-missions for new product approval.

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■■ When there are inquiries from the regulators or authority pertaining to any matter related to Sharīàh-compliant status in the products, facilities, services, and business activities of the IFI.

The Sharīàh board/committee should explain the Sharīàh issues, when recommendations or decision have been made. The decision should be sup-ported by relevant Sharīàh evidences.

6.5.5. Sharı àh Governance Framework and Criteria in Malaysia (Bank Negara)

The central bank of Malaysia has come out with the Sharīàh governance framework (SGF) that regulates the Sharīàh advisory in Islamic finance industry. Following are some aspects as mentioned by SGF.

Sharı àh Committee According to SGF, the Sharīàh committee shall be respon-sible and accountable for all its decisions, views, and opinions related to Sharīàh matters. Although the board bears the ultimate responsibility and accountability on the overall governance of the IFI, the board relies on the Sharīàh committee on all Sharīàh decisions, views, and opinions relating to the business of the IFI. As the Sharīàh decisions, views, and opinions bind the operations of the IFI, the Sharīàh committee shall ensure decisions are made after undergoing rigorous and robust research and deliberation exercise.

The Sharīàh committee shall perform an oversight role on Sharīàh matters related to the institution’s business operations and activities. This can be achieved through the Sharīàh review process and the Sharīàh audit functions. Regular Sharīàh review reports and the Sharīàh audit observa-tions should enable the Sharīàh committee to identify issues that require its attention and, where appropriate, to propose remedial measures.

In discharging its duties, there shall be sufficient disclosure by the Sharīàh committee in the annual financial report on the state of compliance of the IFIs, as per requirements under the Guidelines on Financial Reporting for Licensed Islamic Banks (GP8-i).10

Appointment of the Sharı àh Committee

1. The board shall, upon recommendation of its nomination committee, appoint the members of the Sharīàh committee.

2. The appointment and reappointment of a Sharīàh committee mem-ber shall obtain prior written approval of the bank and the Sharīàh Advisory Council.

3. In approving the appointment and reappointment, the Bank may impose necessary conditions it deems fit in addition to the requirements

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in this framework. Failure to comply with any conditions shall nullify the approval.

Resignation and Dismissal of the Sharı àh Committee

1. An IFI shall notify the bank of any resignation or dismissal of a member of the Sharīàh committee within 14 days of the date of resignation or dismissal, stating the reasons of such resignation or dismissal.

2. The resignation or dismissal will only take effect upon approval from the bank and the Sharīàh Advisory Council.

Qualifications There are different Sharīàh qualifications required for the Sharīàh board members based on different jurisdictions. The Sharīàh advi-sory is appointed to this position by an authorized committee that carefully selects them according to some criteria to ensure better performance by this committee.

According to SGF requirements:

■■ A member of a Sharīàh committee shall be a Muslim individual. A company, institution, or body shall not constitute a Sharīàh committee for the purpose of this framework.

■■ The proposed member of the Sharīàh committee shall at least hold a bachelor’s degree from a recognized university in Sharīàh, which includes study in Usul Fiqh (the origin of Islamic law) and Fiqh Muamalat (Islamic transaction/commercial law) and preferably special-ising in both areas.

■■ It is reasonable to expect a member of the Sharīàh committee to have good knowledge of written Arabic, and it is highly recommended that the member of the Sharīàh committee be able to converse in Bahasa Malaysia, English, and Arabic.

■■ The Sharīàh committee may have experts in relevant background such as finance and law. However, these members must not form the majority of the Sharīàh committee.11

Composition To ensure proper deliberation and effective function of Sharīàh committee on any Sharīàh related matters, Sharīàh committee shall com-prise of members of mixed background in terms of qualification, experi-ence and knowledge. Members of the Sharīàh committee shall be trained in Sharīàh and shall possess some exposure in the areas of commerce or finance, for example, in retail banking, Takaful operations, or capital mar-ket products.

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Experience The Sharīàh committee members should preferably have either some experience in making Sharīàh pronouncements/decisions, teaching, research in Islamic finance or involvement in the operations of Islamic finance.

Disqualifications

1. The members of the Sharīàh committee shall be persons of accept-able reputation, character, and integrity. The bank, together with the approval from Sharīàh Advisory Council, reserves the right to disqualify any member who fails to meet the requirements. In par-ticular, any member may be disqualified due to any of the following breaches:i. Acted in a manner that may cast doubt on his fitness to hold the posi-

tion as a Sharīàh committee member.ii. Failed to attend 75 percent of the Sharīàh committee meetings in a

year without reasonable excuse.iii. Declared bankruptcy or a petition under bankruptcy laws is filed

against him.iv. Found guilty for any serious criminal offence or any other offence

punishable with imprisonment of one year or more.v. Subject to any order of detention, supervision, restricted residence, or

banishment. 2. Upon the discovery that a Sharīàh committee member becomes subject

to any ground of disqualification or otherwise becomes unfit to hold such appointment as provided in this framework and/or in the letter of approval from the Bank and SAC, the IFI shall terminate the appoint-ment of the Sharīàh committee member.12

6.5.6. Sharı àh Governance Framework and Criteria According to the AAOIFI

There are some rules that have been stipulated by AAOIFI regarding the Sharīàh Supervisory Board, the rules, and standards, as follows:

6.5.6.1. Appointment of Sharı àh Supervisory Board and Fixing of Its Remuneration The Sharīàh Supersory Board is appointed by the shareholder of the IFI. AAOIFI mentions in governance standards 1 that:

1. Every IFI shall have a Sharīàh Supervisory Board to be appointed by the shareholders in their annual general meeting upon the recommendation of the board of directors taking into consideration the local legislation

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and regulations. Shareholders may authorise the board of directors to fix the remuneration of the Sharīàh Supervisory Board.

2. The Sharīàh Supervisory Board and the IFI should agree on the terms of the engagement. The agreed terms would need to be recorded in an appointment letter.

3. The Sharīàh Supervisory Board should ensure that the IFI documents and confirms the Sharīàh Supervisory Board’s acceptance of appoint-ment. The letter of appointment of Sharīàh Supervisory Boards should generally include reference to the compliance of the Islamic financial institution with Islamic Sharīàh rules and principles.

4. The Sharīàh Supervisory Board shall appoint from among its members or any other person a supervisor(s) to help it in performing its duties.13

Therefore, the letter of engagement constitutes the agreed terms and conditions that must be observed by both parties.

6.5.6.2. Composition, Selection, and Dismissal of the Sharı àh Supervisory Board According to AAOIFI, the composition and dismissal of the Sharīàh board should be according the following:

1. The Sharīàh Supervisory Board shall consist of at least three members. The Sharīàh Supervisory Board may seek the service of consultants who have expertise in business, economics, law, accounting, and/or oth-ers. The Sharīàh Supervisory Board should not include directors or sig-nificant shareholders of the IFI.

2. The dismissal of a member of the Sharīàh Supervisory Board shall require a recommendation by the board of directors and be subject to the approval of the shareholders in a general meeting.

6.5.6.3. Report of the Sharı àh Supervisory Board as Suggested by AAOIFI According to AAOIFI, there are basic elements of the Sharīàh Supervisory Board’s report to be observed:

The Sharīàh Supervisory Board’s report should contain the following basic elements:

1. Title. 2. Addressee. 3. Opening or introductory paragraph. 4. Scope paragraph describing the nature of the work performed. 5. Opinion paragraph containing an expression of opinion on the compli-

ance of the Islamic financial institution with Islamic Sharīàh Rules and Principles.

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6. Date of report. 7. Signature of the members of Sharīàh Supervisory Board.

A measure of uniformity in the form and content of the Sharīàh Supervisory Board’s report is desirable because it helps to promote the read-er’s understanding to identify unusual circumstances when they occur.

A: Title The Sharīàh Supervisory Board’s report should have an appropri-ate title.

B: The Addressee of the Sharīàh Supervisory Board’s Report The Sharīàh Supervisory Board’s report should appropriately address, as required by the circumstances, the engagement and local laws and regulations.

C: Opening or Introductory Paragraph The Sharīàh Supervisory Board’s report should identify the purpose of the engagement. Illustrative wording for an opening (introductory) paragraph is shown: “In compliance with the letter of appointment, we are required to submit the following report:”

A scope paragraph should describe the nature of the work performed.Illustrative wording for a scope paragraph is shown:

We have reviewed the principles and the contracts relating to the transactions and applications introduced by the Example Islamic Financial Institution during the period ended. We have also conducted our review to form an opinion about whether the Example Islamic Financial Institution has complied with Sharīàh rules and principles and also with the specific fatwas, rulings and guidelines issued by us.

D: Management’s Responsibility There should be a clear statement that the management of the IFI is responsible for properly complying with Islamic Sharīàh rules and principles. Illustrative wording for Sharīàh statement is shown next:

The Example Islamic Financial Institution’s management is respon-sible for ensuring that the financial institution conducts its business in accordance with Islamic Sharīàh rules and principles. It is our responsibility to form an independent opinion, based on our review of the operations of the Example Islamic Financial Institution, and to report to you.

E: Scope Paragraph Confirmation that the Sharīàh Supervisory Board has performed tests, procedures, and review work as appropriate.

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Where appropriate, examining, on a test basis of each type of trans-action, evidence to support that the transaction and dealings entered into by the respective IFI are in compliance with the Islamic Sharīàh rules and principles.

An illustrative wording to explain the review process is shown:

We conducted our review, which included examining, on a test basis of each type of transaction, the relevant documentation and proce-dures adopted by the example IFI.

We planned and performed our review so as to obtain all the information and explanations that we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the example IFI has not violated Islamic Sharīàh rules and principles.

Where appropriate, the report of the Sharīàh Supervisory Board should include a clear statement that the financial statements have been examined for the appropriateness of the Sharīàh basis of allocation of profit between the equity holders and the investment account holders.

Where appropriate, the report of the Sharīàh Supervisory Board should include a clear statement that all earnings that have been realized from sources or by means prohibited by Islamic Sharīàh rules and principles have been disposed of to charitable causes.

Where an Islamic financial institution prepares a statement of sources and uses of Zakah and charity funds, the Sharīàh Supervisory Board’s report should state whether the calculation of the Zakah is in compliance with Islamic Sharīàh rules and principles.

F: Opinion Paragraph The Sharīàh Supervisory Board’s report should state whether the example IFI’s contracts and related documentation are in compliance with the Islamic Sharīàh rules and principles.

An illustration of these matters in the opinion paragraph is shown:

In our opinion:

a. the contracts, transactions and dealings entered into by the Example Islamic Financial Institution during the year ended . . . that we have reviewed are in compliance with the Islamic Sharīàh Rules and Principles;

b. the allocation of profit and charging of losses relating to invest-ment accounts conform to the basis that had been approved by us in accordance with Islamic Sharīàh Rules and Principles;

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(where appropriate, the opinion paragraph shall also include the following matters:)

c. all earnings that have been realized from sources or by means prohibited by Islamic Sharīàh Rules and Principles have been disposed of to charitable causes; and

d. the calculation of Zakah is in compliance with Islamic Sharīàh Rules and Principles.

If the Shari’ah Supervisory Board has ascertained that the manage-ment of the Islamic financial institution has violated Islamic Sharīàh Rules and Principles or the fatwas, ruling and guidelines issued by its Shari’ah Supervisory Board, then the Sharīàh Supervisory Board has to report the violations in the opinion paragraph of its report.

G: Date of Report The Sharīàh Supervisory Board should state the period covered by its report and date the report as of the completion date of the review. The Sharīàh Supervisory Board should not date the report earlier than the date on which the financial statements are signed or approved by management.

Sharīàh Supervisory Board’s Signature The Sharīàh Supervisory Board’s report should be signed by all members of the board.14

6.6. THE SIXTH LINE OF DEFENCE: BOARD OF DIRECTORS

6.6.1. Definition and Selection of Members

A company’s or an organization’s board of directors is a group of individu-als that are elected to serve as representatives of the shareholders. They pro-vide the organization with direction and advice, and in doing so, ensure the fulfillment of the organization’s mission statement and set the overall policy objectives. Other names for the board of directors may include board of managers, board of governors, or board of trustees. It should be noted that every public company must have a board of directors, and this board acts as a top-level advisor of the organization; therefore, it is fiscally responsible for the performance of the organization.

The board members are elected according to different criteria and by different authorities depending on the type of the organization. Firstly, if the members of the organization are voting members, as is the case in a professional society, the organization’s full assembly elects the members, and the board acts on behalf of that full assembly. Secondly, in a non-stock

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organization, such as a university, the board acts as the highest authority in the organization and is sometimes elected by the members of the same board. Lastly, when the organization is stock based, the members of the board are selected by the stockholders and are also the highest and supreme authority of that organization.

6.6.2. Structure of the Board of Directors

The board of directors consists of men and women who are selected, or, more precisely, elected, by the shareholders of the organization. These men and women, known as “directors” are elected on a multiyear term basis that varies from one company to the other. The number of directors on the board also varies greatly between different organizations, depending on the size and the responsibilities assigned to them. There are three types of directors, depending on their role in the company:

1. The director is also an employee in the company, working in the upper management or an officer. This type of director is usually referred to as an “executive director.”

2. The director has an interest in the company, by either being a major shareholder or an investor in it.

3. The third type is different in that the director is not associated with the organization and is considered to be an “independent director” and is hired by the shareholders to ensure conflict of interest.

The numbers and percentages of each type of those directors in a board depends on various factors, such as the type of the organization and the laws and regulations of the country in which the organization is operat-ing in. Typically, one member of the board is assigned the responsibility of tracking and managing the day-to-day activities of the organization and serves as the communication medium between the board and the manage-ment of the corporation. This member is the chief executive officer (CEO) and is the highest-ranking manager in the company. Whether the CEO is also the chairman of the board depends on the laws and regulations of the country in which the organization is operating.

6.6.3. Duties and Responsibilities of the Board of Directors

The powers of the board of directors determine the activities and duties assigned to it. These powers and activities are usually conferred by an authority outside the body of the board in something called the “organization’s bylaws.” It is clear that the main goal of the board of directors is to act on the best interest of all the shareholders, including the employees of the organization.

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Typically duties of the board include many activities, such as:

■■ Establishing mission, vision, and values: The board is expected to set the pace for the current and future operation of the company, to determine and promote the values of the company, and to establish the company’s policies.

■■ Setting strategy and structure: The board has an ongoing process of always monitoring and evaluating the current and future risks facing the organization and assessing the weaknesses and strengths of the company. It also determines the strategic options and the business strat-egies to pursue them and to ensure that the company’s organizational structure and capabilities are appropriate for implementing the chosen strategies.

■■ Managing the organization’s financial issues: This broad task includes several activities, such as: ensuring the availability of adequate financial resources, approving the annual budget reports of the company, and setting the salaries of the company management.

■■ Acting as a medium of communication: The most important role of the board is to be the medium of communication between the stockholders (or the owners and investors) and the management of the organization. This task works in two directions. On the one hand, it works to delegate authority to management and monitor the implementation of policies, strategies, and business plans. On the other hand, it accounts to the stakeholders for the organization’s performance and communicates the needs of the employees and the company, in general, if needed.

6.6.4. Case of Malaysia

In order to improve the monitoring function of corporate governance mech-anisms in Malaysia, the Code of Corporate Governance was drafted in 1999 and subsequently approved in 2000 by the Ministry of Finance. The Code outlines some necessary conditions for the structure and functioning process of the board of directors, audit committee, and external auditors in safe-guarding the interest of shareholders.

The Finance Committee Report on Corporate Governance issued on March 25, 1999, sets out the Malaysian Code on Corporate Governance. The Code of Corporate Governance was gradually enforced on the listed firms by Bursa Malaysia in 2001 (Kuala Lumpur Stock Exchange changed its name to Bursa Malaysia in 2004).

The major component of the principles and best practices of good gov-ernance includes some benchmarks of board of directors’ characteristics. The five main characteristics of board of directors refer to board composi-tion, board size, directors’ ownership, number of directorships, and duality status of the chairman and CEOs.

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According to Malaysian Code on Corporate Governance 2012, there are eight principles and their corresponding 26 recommendations. The prin-ciples and recommendations focus on, amongst others, laying a strong foun-dation for the board and its committees to carry out their roles effectively, promote timely and balanced disclosure, safeguard the integrity of financial reporting, emphasise the importance of risk management and internal con-trols, and encourage shareholder participation in general meetings.

6.6.5. Principles and Recommendations in the Malaysian Code on Corporate Governance 201215

Principle 1—Establish clear roles and responsibilities: The responsibili-ties of the board, which should be set out in a Board Charter, include management oversight, setting strategic direction premised on sus-tainability and promoting ethical conduct in business dealings.

Recommendations:

1.1. The board should establish clear functions reserved for the board and those delegated to management.

1.2. The board should establish clear roles and responsibilities in dis-charging its fiduciary and leadership functions.

1.3. The board should formalize ethical standards through a code of conduct and ensure its compliance.

1.4. The board should ensure that the company’s strategies promote sustainability.

1.5. The board should have procedures to allow its members access to information and advice.

1.6. The board should ensure it is supported by a suitably qualified and competent company secretary.

1.7. The board should formalize, periodically review, and make public its board charter.

Principle 2—Strengthen composition: The board should have transpar-ent policies and procedures that will assist in the selection of board members. The board should comprise members who bring value to board deliberations.

Recommendations:

2.1. The board should establish a Nominating Committee which should comprise exclusively of non-executive directors, a majority of whom must be independent.

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2.2. The Nominating Committee should develop, maintain, and review the criteria to be used in the recruitment process and annual assess-ment of directors.

2.3. The board should establish formal and transparent remuneration policies and procedures to attract and retain directors.

Principle 3—Reinforce independence: The board should have policies and procedures to ensure effectiveness of independent directors.

Recommendations:

3.1. The board should undertake an assessment of its independent directors annually.

3.2. The tenure of an independent director should not exceed a cumu-lative term of nine years. Upon completion of the nine years, an independent director may continue to serve on the board subject to the director’s re-designation as a non-independent director.

3.3. The board must justify and seek shareholders’ approval in the event it retains as an independent director, a person who has served in that capacity for more than nine years.

3.4. The positions of chairman and CEO should be held by different individ-uals, and the chairman must be a non-executive member of the board.

3.5. The board must comprise a majority of independent directors where the chairman of the board is not an independent director.

Principle 4—Foster commitment: Directors should devote sufficient time to carry out their responsibilities, regularly update their knowledge, and enhance their skills.

Recommendations:

4.1. The board should set out expectations on time commitment for its members and protocols for accepting new directorships.

4.2. The board should ensure its members have access to appropriate continuing education programmes.

Principle 5—Uphold integrity in financial reporting: The board should ensure that financial statements are a reliable source of information.

Recommendations:

5.1. The Audit Committee should ensure financial statements comply with applicable financial reporting standards.

5.2. The Audit Committee should have policies and procedures to assess the suitability and independence of external auditors.

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Principle 6—Recognize and manage risks: The board should establish a sound risk management framework and internal controls system.

Recommendations:

6.1. The board should establish a sound framework to manage risks. 6.2. The board should establish an internal audit function that reports

directly to the Audit Committee.

Principle 7—Ensure timely and high quality disclosure: Companies should establish corporate disclosure policies and procedures to ensure comprehensive, accurate, and timely disclosures.

Recommendations:

7.1. The board should ensure the company has appropriate corporate disclosure policies and procedures.

7.2. The board should encourage the company to utilise information technology for effective dissemination of information.

Principle 8—Strengthen relationship between company and sharehold-ers: The board should facilitate the exercise of ownership rights by shareholders.

Recommendations:

8.1. The board should take reasonable steps to encourage shareholder participation at general meetings.

8.2. The board should encourage poll voting. 8.3. The board should promote effective communication and proactive

engagements with shareholders.

Board of Directors’ Responsibility and Accountability Based on SGF Sharīàh gover-nance framework of BNM has specifically highlighted the mandate of the board of directors of the Islamic financial institutions as follows:

1. The board is ultimately accountable and responsible for the overall Sharīàh governance structure and Sharīàh compliance of the IFI. The board must ensure that the Sharīàh governance structure adopted by the IFI commensurate with the size, complexity, and nature of its busi-ness. The board is also expected to perform diligent oversight of the effective functioning of the IFI’s Sharīàh governance structure.

2. The board, upon consultation with Sharīàh committee, shall approve all policies and procedures relating to Sharīàh matters and is expected to ensure that such policies and procedures are comprehensive and effective.

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3. The Sharīàh committee members shall be appointed by the board upon the recommendation of its nomination committee. The number of Sharīàh committee members to be appointed must not be less than five, of which the majority must possess strong knowledge in Sharīàh with qualification in Sharīàh jurisprudence. The board must be satisfied that the Sharīàh committee members are aware of the fiduciary responsibili-ties in discharging their duties.

4. The board is encouraged to consider appointing at least one member of the Sharīàh committee as a member of the board that could serve as a “bridge” between the board and the Sharīàh committee. The pres-ence of a director with sound Sharīàh knowledge would foster greater understanding and appreciation amongst the board members on the decisions made by the Sharīàh committee.

5. The board must ensure that effective communication policy among the key functions of IFI are observed in ensuring that all parties within the organization are aware of the role and responsibility of the Sharīàh committee. For example, there should be in place a mechanism that per-mits the reporting to the board on all Sharīàh issues that may affect the IFI, Sharīàh review process, and audit. The IFI’s communication policy could also serve as an additional tool to ensure that every party of the organization is fully aware on the need to observe the Sharīàh require-ments at all times.

6. The board shall remunerate the Sharīàh committee members appro-priately as advised by its remuneration committee. Such remuneration shall be commensurate with and reflect the accountability, duties, and responsibilities of the Sharīàh committee and the stature of the Sharīàh committee and its members.16

6.7. THE SEVENTH LINE OF DEFENCE: SHARl ÀH ADVISORY COUNCIL (SAC), BANK NEGARA MALAYSIA (BNM)/AUTHORITIES

6.7.1. Sharı àh Advisory Council (SAC) of BNM

The Sharīàh Advisory Council (SAC) of Bank Negara Malaysia (BNM) is a council at the national level to look at the Sharīàh matters in Islamic finance particularly on Takaful and banking matters.

The Sharīàh Advisory Council of Bank Negara Malaysia was estab-lished in May 1997 as the highest Sharīàh authority in Islamic finance in Malaysia. The SAC has been given the authority for the ascertainment of Islamic law for the purposes of Islamic banking business, Takaful business,

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Islamic financial business, Islamic financial-development business, or any other business, which is based on Sharīàh principles and is supervised and regulated by Bank Negara Malaysia. As the reference body and advisor to Bank Negara Malaysia on Sharīàh matters, the SAC is also responsible for validating all Islamic banking and Takaful products to ensure their com-patibility with the Sharīàh principles. In addition, it advises Bank Negara Malaysia on any Sharīàh issue relating to Islamic financial business or transactions of Bank Negara Malaysia as well as other related entities.

In the recent Central Bank of Malaysia Act 2009, the role and functions of the SAC was further reinforced whereby the SAC was accorded the sta-tus of the sole authoritative body on Sharīàh matters pertaining to Islamic banking, Takaful and Islamic finance. Although the rulings of the SAC shall prevail over any contradictory ruling given by a Sharīàh body or committee constituted in Malaysia, the court and arbitrator are also required to refer to the rulings of the SAC for any proceedings relating to Islamic financial business, and such rulings shall be binding.

Consisting of prominent Sharīàh scholars, jurists, and market practitio-ners, members of the SAC are qualified individuals and have vast experience in banking, finance, economics, law, and application of Sharīàh, particu-larly in the areas of Islamic economics and finance.17

6.7.2. Sharı àh Advisory Council (SAC) of Securities Commission (SC)

The SAC of the SC is a committee established by the SC in 1996 under sec-tion 18 of the Securities Commission Act 1993 (SCA). The SAC was given the mandate to ensure that the running of the Islamic capital market (ICM) complies with Sharīàh principles. Its scope of jurisdiction is to advise the SC on all matters related to the comprehensive development of the ICM, and functions as a reference centre for ICM-related issues. The members of the SAC consist of Islamic scholars/jurists and Islamic finance experts.18

6.8. THE EIGHTHLINE OF DEFENCE: SHARl ÀH REVIEW

6.8.1. Introduction

Sharīàh review is a post-Sharīàh compliance process focusing on identi-fication of discrepancies and non-Sharīàh compliance cases and events in the products and services offered by the IFI in order to be addressed and rectified.

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6.8.2. Overview

Sharīàh Governance Framework (SGF) for IFIs issued by Bank Negara Malaysia (BNM) has been enforced since January 1, 2011. The SGF puts a significant emphasis, amongst others, for the IFIs to undertake a Sharīàh review function. The Sharīàh review function refers to regular assessment on Sharīàh compliance in the activities and operations of the IFIs by quali-fied Sharīàh officer(s), with the objective of ensuring that the activities and operations carried out by the IFI do not violate Sharīàh.

Accordingly, the requirements of SGF have been incorporated into IFI Sharīàh Compliance Framework. Embracing the spirit of the SGF, the Sharīàh Division of IFI, via its Sharīàh review, is given the task of executing the Sharīàh review function from time to time.

To empower the execution of the Sharīàh review function (including to access records, personnel, and physical properties relevant to the Sharīàh review), the Sharīàh review charter identifies and outlines the purpose, authority, independence, responsibility, and ethical standards of Sharīàh reviewing conducting the same.

6.8.3. Sharı àh Review and Sharı àh Audit

As defined by the Sharīàh governance framework, Sharīàh review refers to “regular assessment on Sharīàh compliance in the activities and operations of the IFI by qualified Sharīàh officers, with the objective of ensuring that the activities and operations carried out by the IFI do not contravene with the Sharīàh.”Sharīàh review as required by these shall be performed by the designated internal Sharīàh review personnel, as appointed and assigned to the Sharīàh management of the IFI. Therefore, Sharīàh review is a process that involves obtaining and evaluating sufficient and reliable evidence to establish whether the IFI activities and operations are in accordance with established Sharīàh rules and principles.

On the other hand, the Sharīàh governance framework defines a Sharīàh audit as “the periodical assessment conducted from time to time, to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the IFI’s busi-ness operations, with the main objective of ensuring a sound and effective internal control system for Sharīàh compliance.”

Hence the differences between Sharīàh review and Sharīàh audit may be categorised as shown in Table 6.1.

Although the scope of Sharīàh review and Sharīàh audit may overlap, Sharīàh review compliments Sharīàh audit in a way that the continuous and regular nature of Sharīàh review fills in the gap period during which

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audit is not performed. Sharīàh review provides a timely evidence and assis-tance for the Sharīàh committee to form its opinion about the Sharīàh compliance level of the IFI in a financial year for the purpose of issuance of annual financial statement.

6.8.4. Sharı àh Review Objectives

Sharīàh review function shall provide an independent examination, evalua-tion and objective remedial rectification measures of the Sharīàh compliance of IFI activities and operations, including the internal control mechanism for Sharīàh compliance. The primary objective of Sharīàh review is to provide an independent examination, evaluation, and objective remedial rectifica-tion measures that IFI complies with the Sharīàh requirements in activi-ties and operations including the internal control mechanism for Sharīàh compliance.

TABLE 6.1 Sharīàh Review and Sharīàh Audit

Sharīàh Review Sharīàh Audit

Definition Regular assessment on Sharīàh compliance in the activities and operations of IFI by qualified Sharīàh officer(s).

Periodical assessment conducted from time to time, to provide an independent assessment and objec-tive assurance designed to add value and improve the degree of compli-ance in relation to the IFI’s business operations.

Objectives To ensure that the activities and operations carried out by the IFI do not contra-vene with the Sharīàh.

i. To provide an independent assess-ment and objective assurance.

ii. To ensure a sound and effec-tive internal control system for Sharīàh compliance.

Scope Overall business opera-tions, including the end-to-end product-development process.

All aspect of the IFI’s business opera-tions and activities including audit on financial statements, compliance audit on organisational structure, people, and information technology applica-tion systems, and review of adequacy of the Sharīàh governance process.

Personnel Sharīàh qualified officer(s) within the Sharīàh Division of an IFI.

Internal auditor.

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The Sharīàh review objectives in relation to Sharīàh compliance requirements shall include:

■■ To add value and improve IFI’s operations by providing regular and continuous assessment on IFI overall business operations and activi-ties which are designed to examine and evaluate IFI’s level of Sharīàh compliance.

■■ To provide remedial rectification measures, together with the necessary control mechanism thereof, thus enhancing the risk management con-trol and governance processes.

■■ To assist Sharīàh committee to form judgment on the Sharīàh compli-ance level at IFI, by providing the Sharīàh committee with the relevant information and explanation based on the finding of the Sharīàh review.

■■ Ultimately, to ensure IFI’s operations and activities are in compliance with established Sharīàh criteria and principles.

The established Sharīàh criteria shall include:

■■ The Sharīàh resolutions and decisions of the Sharīàh SAC of BNM.■■ The Sharīàh resolutions and decisions of the Sharīàh SAC of the

Securities Commission.■■ The resolutions and decisions of the Sharīàh committee.■■ The resolutions and the decisions of the Accounting and Auditing

Organisation for Islamic Financial Institutions (AAOIFI).■■ The resolutions and the decisions of the al-Majmaàl-Fiqhi al-Islami.■■ The approved product manuals and the SOPs of IFI.■■ Any other reputable and qualified bodies as acknowledged by the

Sharīàh Committee from time to time.

In the event(s) of conflict among or between any of the above criteria, the matters shall be referred to the Sharīàh Committee for their deliberation and resolution.

6.8.5. The Scope of Work of Sharı àh Review

The scope of work of the Sharīàh review function is to determine whether IFI’s operations, activities, and governance as designed and represented by the management, are adequate and functioning in the manner required by Sharīàh. These would include, but are not limited to:

■■ Adding value by providing regular assessment on the Sharīàh risk man-agement, internal control, and corporate governance processes relating

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to the conduct of the business in a planned, orderly, prudent, and cost-effective manner in adherence to sound established principles;

■■ Evaluating the adequacy of the Sharīàh risk management processes by reviewing the key objectives of those processes.

■■ Examining and evaluating the adequacy, effectiveness, and efficiency of financial and operating controls in relation to any Sharīàh risk identified and ensure that internal controls are recommended and implemented, including for the proper treatment of income and prevention of mixture of between Sharīàh-compliant and non-Sharīàh-compliant income.

■■ Determining that assets and resources are economically, effectively, and efficiently utilised in accordance with Sharīàh principles.

■■ Ascertaining that strategic, financial, operational, and management information related to Sharīàh matters is accurate, reliable, timely, and cost effective.

■■ Checking the implementation and compliance to regulatory require-ments and IFI’s policies, standards, procedures, and applicable laws and regulations pertaining to Sharīàh risks and issues.

■■ Reviewing existing and new Takaful products, covering end-to-end product-development processes, which start from product structuring to product offering.

■■ Determining that programmes, plans, and operations are consistent with established Sharīàh principles and are carried out as planned.

Opportunities for improving management control, profitability, and IFI’s image and reputation may be identified during Sharīàh review and will be communicated to the appropriate level of management.

Sharīàh review shall cover IFI’s overall operations and activities, prod-uct-development processes, and a review of adequacy of the Sharīàh gover-nance process of IFI with reference to the established Sharīàh criteria.

The scope of the Sharīàh review shall cover review on IFI’s overall busi-ness operations and activities and provide any rectification measures together with the control mechanism to avoid recurrences of Sharīàh non-compliance events. As required by the SGF, Sharīàh review requirements shall consist of all aspects of IFI’s operations and activities, including but not limited to review on:

■■ Business operations■■ Sharīàh risk management and internal control processes■■ Transactions and finances■■ IFI products and services■■ Trainings, marketing, and sales■■ Branches, agent, and business/support units■■ Entertainment and other related activities

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In the case of Sharīàh review on Sharīàh risk management and internal control processes, the scope of such review shall include legal, compliance, risk management as well as the review on the implementation of previous resolutions of the Sharīàh committee. In view of the technicality and com-plexity of risk management process, Sharīàh division will work hand in hand with the risk-management division to develop, identify, and control Sharīàh the risk-management programme.

In the case of Sharīàh review on transactions and finances, Sharīàh review personnel shall review and ensure that IFI transaction and finance matters are in compliance with Sharīàh requirements. These may include those related to contracts, agreements, deposits, investments, investment accounts, financings, accounting, recognition of income and expenses, income/profit distributions, purification of income, and zakat computation as per the decisions made by the established Sharīàh criteria.

In the case of Sharīàh review on Takaful products, it shall include the review of existing and new Takaful products, covering end-to-end the prod-uct-development process. This is to ensure the fulfillment of the contract requirements and conditions of the contracts according to Sharīàh and the proper application of fiqh muamalat principles.

In the case of Sharīàh review on training, marketing, and sales, the review shall cover the review on training materials, product brochures, and marketing materials. This is to ascertain that strategic, financial, opera-tional, and management information related to Sharīàh matters is accurate, reliable, and timely. Sharīàh review of IFI branches, agents, and business/support units is to ensure that their respective activities and operations are Sharīàh compliant.

The following are the possible Sharīàh review scope related to branch review:

■■ Ensure that all products offered are those approved by the Sharīàh committee.

■■ Assess for adequate numbers of qualified people to deal with the activi-ties and operations.

■■ Assure proper activities and operations of IFI products.■■ Assess employees’ understanding of Islamic financial products.

In relation to Sharīàh review on entertainment and other related activi-ties, this may cover the review on events and programmes organised by IFI. This is to ensure that such events are in compliance not only with ethical standards but also Sharīàh principles and that they do not contain any excessive level of entertainment. The Sharīàh review shall assess and rea-sonably assure that the formal reporting channel on Sharīàh matters is

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carried out effectively and in a timely manner. Sharīàh review shall be per-formed on a regular and continuous basis. However, Sharīàh review may be performed on an ad-hoc basis upon the request of the Sharīàh committee, the management, the regulators, and/or where any circumstances require.

6.8.6. Empowerment and Responsibility of Sharı àh Review

6.8.6.1. Accountability Sharīàh review is set up by the Sharīàh risk manage-ment to be staffed with adequate and qualified Sharīàh review personnel to perform the Sharīàh review function. The head of Sharīàh risk manage-ment shall head the Sharīàh review function, assisted by the designated Sharīàh review personnel (collectively “Sharīàh review members”). The Sharīàh review members shall, on a continuous basis, conduct the Sharīàh review, which is a review of processes and deliverables as well as deter-mine that such processes and outcomes satisfy the needs of the Sharīàh. The Sharīàh review members, in discharging their duties, shall, in-line with the “solid arrow” and “dotted arrow” reporting lines as depicted in the SGF, be accountable to the Sharīàh committee and the senior management commit-tee (SMC), respectively, to:

1. Prepare Sharīàh review guidelines detailing the scope of work, state-ment of purpose, authority, and responsibility that would enable the Sharīàh review to be performed comprehensively.

2. Provide annually, a Sharīàh review annual plan (SRAP) of the review-able area on Sharīàh compliance requirements together with the objec-tive, scope, reporting, rectification, and follow-up actions followed by the execution of the Sharīàh review, as guided by the SRG or any SOPs developed in relation to Sharīàh review function.

3. Conduct the Sharīàh review exercise, as principally outlined in the SRG and the SRAP, examining and evaluating IFI’s level of compliance to the Sharīàh.

4. Prepare written report(s) (Sharīàh review report), which shall report significant Sharīàh issues relating to the operation, activities, and pro-cesses of IFI, remedial rectification measures to resolve Sharīàh non-compliances, and to recommend control mechanism to avoid recurrences of the Sharīàh non-compliance.

5. Provide information periodically to the Sharīàh committee on the status and results of the SRAP, and the sufficiency of Sharīàh review resources.

6. Prepare a Sharīàh review annual plan report (SRAP report) to report on the Sharīàh review activity during the preceding financial year.

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6.8.6.2. Authority The Sharīàh review members are authorised to carry out comprehensive programme of Sharīàh review within IFI and initiate reviews, examinations, and inspections at such time as they may determine and without advance notice, with respect to any of IFI’s activities as deemed necessary.

The Sharīàh review members are authorised to:

1. Carry out comprehensive programme of Sharīàh review within IFI. 2. Have complete, unhindered, and unrestricted access to all functions,

records, property and personnel as may be required including obtaining copy of reference and documentary purposes.

3. Have full and free access to communicate with the Sharīàh committee and the SMC.

4. Allocate resources, select reviewable units, determine scope of work and apply the techniques required to accomplish Sharīàh review objectives.

5. Require the head of divisions, departments, or units where they perform Sharīàh review (target units) to appoint and/or assign representative(s) as a link to assist and provide technical guidance to the Sharīàh review members throughout the Sharīàh review exercise.

6. Obtain the necessary assistance of personnel in the target units, as well as other specialised services from within or outside IFI.

7. Follow up with the respective target units on the findings and recom-mendations made based on the Sharīàh review to ensure observance and execution of such recommendations.

8. Communicate and deliberate with the Sharīàh committee and SMC on actions taken in response to Sharīàh review findings and recommendations.

The head of the Sharīàh division may be required to participate as a member of selected committee in IFI as determined by SMC, but not with-standing such selection, the participations as a member of these commit-tees should not in any way affect the objectivity and independence of the Sharīàh review function.

6.8.6.3. Independence To provide for the independence of the Sharīàh review function, Sharīàh review personnel are placed under the direct authority and supervision of the head of the Sharīàh management. The head of the Sharīàh management in performing the Sharīàh review function reports directly to the Sharīàh committee.

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6.8.6.4. Responsibility The head of the Sharīàh management, assisted by the members of the Sharīàh review, has the responsibility to:

■■ Develop the Sharīàh review based on significant Sharīàh non-compli-ance risk and exposure, and submit the plan to the Sharīàh committee for review and approval.

■■ Implement the Sharīàh review as approved, including any ad hoc assign-ments, special tasks or projects assigned by the Sharīàh committee.

■■ Maintain a group of qualified Sharīàh review personnel with ade-quate knowledge, skills, and experience to conduct the Sharīàh review function.

■■ Evaluate and assess significant Sharīàh non-compliance risks and expo-sure to present and future processes, operations, and controls.

■■ Issue Sharīàh review report to Sharīàh committee and management committee summarizing the results of Sharīàh review exercise.

■■ Perform investigations on suspected Sharīàh non-compliant activities within IFI and report to Sharīàh committee and MC the results of such investigations.

6.8.7. Sharı àh Review and Governance

IFI ensures an effective structure and function of Sharīàh review and ensures that governance processes are in place. For effective implementation of Sharīàh review, IFI is required to establish Sharīàh review function as part of the Sharīàh division. The Sharīàh division ensures that it has adequate, qualified, and competent officers, and adequate funds to ensure the effective performance of Sharīàh review function. Sharīàh review members must be in consultation with and accountable to the Sharīàh committee in plan-ning, examining, and reporting of Sharīàh review. Such consultation may be made on an “as needed” basis and where circumstance requires so. The reporting structure of the Sharīàh review management unit is as illustrated in the appendix.

The Sharīàh committee determines the deliverables of the Sharīàh review and is expected to review and endorse the SRAP. The Sharīàh review findings are submitted for consideration and deliberation of the Sharīàh committee. The SMC acknowledges the finding and conclusion of the delib-eration made by the Sharīàh committee. The Sharīàh review is guided by the Sharīàh resolutions and decisions of the Sharīàh committee to effectively execute their review function. The Sharīàh review activity must be free from interference in determining the scope of reviewing, performing work, access-ing evidence, and communicating results. Sharīàh review personnel must have an impartial, unbiased attitude and avoid conflict of interest.

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Sharīàh review personnel maintain a high level of independence to pro-vide the Sharīàh review with an independent and objective assurance about the IFI level of Sharīàh compliance. Although Sharīàh review is responsible for assisting the Sharīàh committee to form an opinion on the extent of IFI level of Sharīàh compliance, the responsibility for compliance therewith lies with the respective business owner and the management. The Sharīàh review process does not relieve other business owners and the management of their responsibility assigned to them to perform their functions in accor-dance with Sharīàh.

6.8.8. Sharı àh Review Charter

IFI establishes a Sharīàh review charter that incorporates Sharīàh review function, which includes planning, implementation, and reporting of the Sharīàh review exercise. IFI must have a Sharīàh review charter, which is a mandated document for the proper execution of the Sharīàh review function.

The Sharīàh review charter specifies the Sharīàh review, which addresses the following aspects:

■■ The nature of Sharīàh reviewing.■■ The Sharīàh review objectives.■■ The scope of Sharīàh review work.■■ The responsibilities of Sharīàh review personnel.■■ The authority of Sharīàh review personnel.■■ The independence of Sharīàh review personnel.

The Sharīàh review charter should clearly specify the planning, exami-nation, and reporting of the Sharīàh review. The Sharīàh review personnel should have direct access to the Sharīàh committee and the SMC. There must not be any limitation of scope or restriction placed on the Sharīàh review personnel. This is to ensure efficiency and effectiveness of the Sharīàh review function.

6.8.9. Competency of Sharı àh Review Personnel

Sharīàh review personnel should be competent in reviewing knowledge and skills as well as Sharīàh knowledge relevant to the Sharīàh review function. The Sharīàh review personnel must possess adequate reviewing knowledge, skills, and competencies on the following:

■■ Adequate knowledge of the essentials of the Sharīàh.■■ Proficiencies in conducting review.

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■■ Understanding of management principles.■■ Appreciation of accounting, economics, commercial law, taxation, and

finance.■■ Skills in dealing with people and communicating.■■ Skills in oral and written communications.

The Sharīàh review personnel should have the ability to construct rele-vant and appropriate review methodology in line with the review objectives of any particular area of the review. This is to correctly verify evidence for different reviewable areas to ensure Sharīàh compliance.

The basic qualifications of the Sharīàh review personnel are as follows:

■■ Have a relevant degree or professional qualification.■■ Have adequate knowledge of Sharīàh.■■ Have adequate knowledge and understanding of the functions of IFI

and Islamic products and services.

The candidates who do not possess a bachelor degree qualification should have relevant working experience in reviewing or in IFIs for a mini-mum of two years, provided, however, that such person should not work independently in a Sharīàh review team without involvement of at least one member who has a Sharīàh degree. Adequate knowledge in Sharīàh means that the candidates have successfully undergone sufficient education and training in fiqh muamalat.

The knowledge of Sharīàh required of the Sharīàh review personnel should cover the following areas:

■■ Usul fiqh■■ Fiqh muamalat■■ Principles of Islamic financial contracts■■ Prohibited elements in Islamic financial contracts■■ Islamic financial contracts

Adequate knowledge and understanding on the functions of IFI, and the Islamic products and services means that the Sharīàh review personnel should be well versed in the Islamic principles underlying the Islamic finan-cial contracts and basic activities and operations of the IFI (in this particular case, Takaful products and services offered by the Takaful operator (TO). The TO vis-à-vis the Sharīàh division creates positions for qualified Sharīàh officers that function within the Sharīàh review. The Sharīàh review per-sonnel maintains their technical competence through continuous education. This can be achieved either through training, seminar, or muzakarah, in

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order to maintain their proficiency and keep them informed about improve-ments and current developments of Takaful business and operations.

The Sharīàh review personnel exercises professional due care in per-forming the Sharīàh review activity. Professional care should be appropri-ate to the complexities of the Sharīàh review being performed. In exercising due professional care, they personnel should be alert to the possibility of intentional wrongdoing, errors and omissions, inefficiency, waste, ineffec-tiveness, and conflicts of interest. They must also be alert to those conditions and activities where Sharīàh non-compliance is most likely to occur. Due professional care also denotes reasonable care and competence, not infal-libility or extraordinary performance. Due care requires the Sharīàh review personnel to conduct assessments, examinations, and verifications to a rea-sonable extent, but does not require detailed inspections of all transactions. Accordingly, the Sharīàh review personnel cannot give absolute assurance that Sharīàh non-compliance does not exist. Nevertheless, the possibility of material Sharīàh non-compliance should be considered whenever the Sharīàh review personnel undertake a Sharīàh review.

6.8.10. Sharı àh Review Process

Sharīàh review process consists of a comprehensive review process that includes planning, examination, and reporting by obtaining reliable and rel-evant evidence for Sharīàh assurance purposes.

The following are essential matters of the Sharīàh review process:

■■ Formulation of SRAP to include reviewable area on Sharīàh compli-ance requirements.

■■ Assessment of the adequacy of Sharīàh compliance review.■■ Establishment and implementation of risk-based review process and

procedures that evaluate the level of Sharīàh compliance.■■ Formulation of review opinion on the effectiveness of the internal

Sharīàh control system and production of a proper Sharīàh review report.

■■ Continuous assessment on the adequacy and completeness of Sharīàh compliance review practice.

Sharīàh review planning is adequately developed to include a complete understanding about IFI operations in terms of products, size of opera-tion, location, branches, subsidiaries, and divisions. The planning includes obtaining rulings made by the Sharīàh committee and other established Sharīàh criteria. Sharīàh review develops an SRAP. SRAP refers to a manual-based document that specifies the review control objectives and

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step-by-step procedures to execute a review for any concerned year. SRAP can be designed and developed based on products and services, operations, processes, policies, and branches as well as other areas that Sharīàh review (upon consultation with the Sharīàh committee) deemed necessary.

Sharīàh review personnel examine the following reviewable areas which normally include:

■■ Understanding the management awareness, commitment, and compli-ance-control procedures for adherence to the Sharīàh.

■■ Risk assessment of the Sharīàh non-compliance risks to assess the risk profile of IFI’s activities and operations in order to prioritise the review-able areas.

■■ Assessment of the adequacy of the internal control system for Sharīàh compliance.

■■ Review of contracts and agreements.■■ Review of product manuals and SOPs.■■ Review of information and reports such as circulars, minutes of meet-

ing, operating and financial reports, policies, and reports.■■ Relevant personnel.■■ Activities and operations.■■ Review of profit computation and distribution, zakat computation, pen-

alty computation and manner of distribution thereof.

The Sharīàh review activity assists IFI in maintaining effective controls by evaluating the effectiveness and efficiency of Sharīàh compliance control, and by promoting continuous improvement. The Sharīàh review activity evalu-ates the adequacy and effectiveness of controls encompassing IFI’s governance, operations, as well as marketing and information systems. These include:

■■ Reliability and integrity of financial and operational information.■■ Effectiveness and efficiency of activities and operations.■■ Safeguarding of assets.■■ Compliance with laws, regulations, and contracts.

Together with risk management division, Sharīàh review assesses the ade-quacy of the Sharīàh risk management processes, which includes the assur-ance of:

■■ Sharīàh non-compliance risk arising from activities and operations identified and prioritised.

■■ The level of Sharīàh non-compliance risks have been adequately deter-mined by the management committee and Sharīàh committee.

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■■ Risk mitigation activities are designed and implemented to reduce, or otherwise manage, risk at levels that were determined to be acceptable to the board and the management.

■■ On-going monitoring activities are conducted to periodically assess Sharīàh non-compliance risk and the effectiveness of controls to man-age the risk.

Together with the risk management division, Sharīàh review personnel plays a role in assisting with the initial establishment of Sharīàh risk man-agement and internal control for Sharīàh compliance. However, Sharīàh review personnel do not “own” or are responsible for the management of risks and internal control.

The Sharīàh review process involves the followings:

■■ Planning phase■■ Reviewing phase■■ Reporting phase■■ Post-reporting phase (following up)

The details of the Sharīàh review process implementation is docu-mented in an SOP, which lists the fundamental principles, policies, and procedures in relation to the implementation of Sharīàh review process. Annually, the head of risk management/Sharīàh management submits to the Sharīàh committee a written SRAP report on the Sharīàh review activity during the preceding financial year. IFI may appoint or employ an external party to conduct a Sharīàh review on the activities and operations of IFI, if IFI considers it is desirable or in the interest of IFI to do so.

6.8.11. Reporting Requirements for Sharı àh Review

Sharīàh review provides a Sharīàh review report that includes recommended rectifications to effectively communicate the findings of the Sharīàh review to the Sharīàh committee and the management committee, reporting the com-munications of the findings of the Sharīàh review conducted, which include recommended rectifications to improve Sharīàh assurance. The SGF requires that the Sharīàh review function communicate results of any assessment or findings arising from the Sharīàh review to the Sharīàh committee.

The objectives of the Sharīàh review report are:

■■ Report the findings of Sharīàh non-compliance (if any).■■ Assess the degree of recurring of non-compliance and its systematic

effect on IFI as a whole.

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■■ Recommend corrective actions, improvements, and rectifications neces-sary by identified persons charged with such rectifications, corrections, and improvements.

■■ Suggest timelines for such rectifications to be completed.■■ Track and monitor the progress of rectifications from past recommen-

dations of previous Sharīàh review report.

Sharīàh review report is undertaken and the report can also be made at regular intervals or on an ad-hoc basis. The report is approved by the Sharīàh committee and a copy of the report shall be made available to the management committee. Sharīàh review opinion is expressed in the report on whether IFI’s business operations and activities so reviewed are in line with Sharīàh requirements. The report of Sharīàh review contains the observations and the assessment of Sharīàh non-compliance risks and controls. The Sharīàh review report provides recommendations for poten-tial improvements and corrective actions where relevant, together with sug-gestions for control mechanism to avoid recurrences. The report should be objective, clear, constructive, and timely.

6.9. THE NINTH LINE OF DEFENCE: SHARI AH AUDIT

6.9.1. Definition of Sharı àh Audit

The BNM SGF defines the Sharīàh audit function as follows: “Sharīàh audit refers to the periodical assessment conducted from time to time, to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the Islamic financial institution’s (IFI) business operations, with the main objective of ensuring a sound and effective internal control system for Sharīàh compliance.”

6.9.2. Audit Objective and Criteria of Sharı àh Audit

It is important to note that unlike Sharīàh reviews by the Sharīàh board, which focus on Sharīàh compliance, auditors focus onthe true and fair view of the financial statements in accordance with the Sharīàh principles and requirements. In other words, financial audit is performed with consider-ation that financial activities and financial reporting of such activities com-ply with Sharīàh requirements and principles.

Para 2 of Auditing Standard for Islamic Financial Institutions (ASIFI) No. 1 states the objective as follows:

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The objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with Sharīàh rules and principles, the accounting standards of the Accounting and Auditing Organization of Islamic Financial Institutions and relevant national accounting standards and practices in the country in which the financial institution operates.

The Sharīàh rules and principles are established by the SSB or other bodies as specified or indicated by the financial authorities. Accounting and reporting standards promulgated by AAOIFI are the international standards that address specific reporting requirements for IFIs. Finally, the national accounting standards and practices may differ between countries and could be harmonised by international reporting standards issued by AAOIFI and IASB.

6.9.3. Essential Principles Governing the Auditor

In order to attain the audit objective, the auditor is expected to comply with the “Code of Ethics for Professional Accountants” issued by both AAOIFI and IFAC, which does not contravene Sharīàh rules and principles. This is to ensure that the accountants conduct themselves in a manner that is approved by Sharīàh. The auditor should also conduct the audit in accor-dance to ASIFI, which consists of basic principles and essential procedures together with related guidance in the form of explanatory and other material.

Having taken the aforementioned principles into consideration, the auditor should plan and perform the audit with professional competence and due care, recognising the circumstances that may exist that cause the financial statements to be materially misstated.

The professional knowledge, skills, and attitude of competence, due care, and diligence are expected of the auditor who conducts the audit for IFIs. Furthermore, the auditor is also expected to understand pertinent Sharīàh rules and principles that impact the professional knowledge, skills, and attitude. In terms of the audit plan and budget, proper training as well as recruitment of audit staff capable of the undertaking the audit assignment and fulfilling the Sharīàh requirements need to be addressed.

6.9.4. Scope of Audit

Another element that influences the annual audit budget is the scope of audit of Islamic financial institutions.

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Para 7 of ASIFI No.1 is stated as follows:

The “scope of audit” refers to audit procedures deemed necessary to achieve the audit objective. “The procedures required to conduct an audit having regard to the requirements of appropriate Islamic rules and principles, ASIFIs, relevant professional bodies, legisla-tion, regulations which do not contravene Islamic rules and prin-ciples, and where appropriate, the terms of audit engagement and reporting requirements. International Standards of Auditing (ISA) shall apply in respect of matters not covered in detail by ASIFI pro-vided that these do not contravene with Islamic principles.”

In formulating the audit procedures to accomplish specific audit objec-tives, the auditors need to define the scope of audit, taking into account various aspects such as the types of Islamic financial activities of IFIs and the relevant regulations and requirements on such activities. In addition, the scope of audit is governed by specific regulations, provisions, and guidelines that define the audit and the client relationship as specified in the terms of engagement. In return, the scope of the audit would then influence the annual audit budget. In most instances, with the establishment of need for new information relevant audit procedures to capture such information are designed. Thus, both the permanent and periodic audit working papers would increase, thus, increasing the setting-up cost for the audit. However, with the learning-curve effect, it is anticipated that average cost shall decline for subsequent periods.

The functions of the auditor that relate to the scope of the audit and that are mentioned in the letter of engagement include:

■■ Conducting the audit in accordance with the standards and require-ments as specified by the scope of audit.

■■ Understanding and assessing the adequacy of the accounting system as a basis of preparations of financial statements for IFIs.

■■ Obtaining relevant and reliable evidence to enable the auditors to draw reasonable conclusions therefrom.

■■ Determining the nature and extent of audit procedures to be adopted in lieu of the assessment of the internal control system.

■■ Planning an audit that allows reasonable expectation of detecting mate-rial misstatements or errors in the financial statements or accounting records resulting from fraud, for instance, non-compliance to Sharī`ah rules and principles.

■■ Providing for sampling error and level of confidence in testing the sam-pled information when conducting the audit.

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6.9.5. Sharı àh Audit Structure (Standard 1000—Purpose, Authority, and Responsibility)

In order to further enhance the internal audit department structure to per-form the Sharīàh audit function and serve the financial entities in the group, a separate unit, namely Sharīàh, Retail and Sharīàh, Audit (previously was named Star Bank, Regional Operations) was created in February 2010 and included in the group internal audit organisation chart. The unit is given the task of performing Sharīàh-related audits on the operations of Star Bank Islamic Star Bank’s network of Islamic branches and other business units and subsidiaries where Sharīàh products are offered and managed.

The Sharīàh audit forms part of the regular internal audit function. Hence, the Sharīàh audit leverages the internal audit’s strategy and struc-ture, including the audit committee of the board, audit charter, code of eth-ics; it also continues to leverage the audit’s mission and objectives where it does not contravene any of the BNM SGF’s policy and requirements.

The Sharīàh audit process also adopts the internal audit standard risk-based audit processes, which include audit planning, sampling, examina-tion, reporting, and monitoring.

The Sharīàh audit is required to develop a Sharīàh audit program to execute an audit. The coverage and scope of audit work must include exam-ining, evaluating, and reporting the compliance with the Sharīàh rules and principles as determined by BNM SAC and Star Bank Shariah committee in all aspects of the Islamic products, operations, and activities. For selected assignments, the Sharīàh work will be performed or jointly performed by auditors from the other audit departments. The arrangement will be deter-mined and documented in the annual audit plan.

6.9.6. Reporting Structure of Sharı àh Audit (Standard 1100—Independence and Objectivity)

Based on the BNM SGF, the Sharīàh audit function, in addition to the direct reporting line of the audit committee of the board, is also expected to have a dotted line to the Sharīàh committee. To operationalise this, the Sharīàh audit’s annual audit plan and Sharīàh audit’s reports shall also be submitted to the Sharīàh committee members to communicate coverage of the audit and results of any assessment or findings arising from the Sharīàh audit. This is to allow the members to assess the work carried out by Sharīàh audit in order to ensure compliance with Sharīàh matters, which forms part of their duties in providing their assessment of Sharīàh compliance and assurance information in the annual report. By being part of the internal

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audit set-up, the Sharīàh audit maintains its independence from the man-agement and Sharīàh department function.

Note: Figure 6.2 illustrates a model structure of roles, functions, and reporting relationships of key organs, including Sharīàh audit, in the IFI’s Sharīàh governance framework based on the BNM SGF.

6.9.7. Roles and Responsibilities of Sharı àh Auditor (Standard 1000—Purpose, Authority, and Responsibility)

The core function of the Sharīàh audit is to provide an independent assess-ment and reasonable/objective assurance designed to add value and improve the degree of compliance with Sharīàh principles in relation to the IFI’s business operations with the main objective of ensuring a sound and effec-tive internal control system for Sharīàh compliance. The primary objective is to ensure that the management of the bank discharges its responsibilities in relation to the implementation of the Sharīàh rules and principles as determined by the BNM SAC or Star Bank SC.

FIGURE 6.2 The Structure of Sharīàh Governance in Islamic Banking

BOARD RISKMANAGEMENT

COMMITTEE

BOARD AUDITCOMMITTEE

BOARD

SHARĪÀH COMMITTEE

MANAGEMENT

Sharīàh AuditFunctionProvide independentassessment & objectiveassurance designed tovalue add & improve IFI’scompliance with Sharīàh

Oversight accountability onSharīàh-related matters

Conduct in-depth Sharīàhresearch prior tosubmission to the Sharīàhcommittee

Review businessoperations on regular basisto ensure Sharīàhcompliance

• Ensure execution of business & operations are in accordance with Sharīàh principles• Provide necessary support to the Sharīàh committee

Overall oversight onSharīàh governcestructure & Sharīàhcompliance

Identify, measure, monitor,report & control Sharīàhnon-compliance risk

Sharīàh ResearchFunction

Sharīàh ReviewFunction

Sharīàh RiskManagement ControlFunction

Sharīàh Compliance and Research Functions

Sharīàhas overarching principle in Islamic nance

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This requirement is specifically outlined in the Bank Negara Malaysia’s SGF, which was issued in October 2010 and took effect on January 1, 2011. IFI was given six months from the effective date to comply with all the requirements.

The SGF expectation, at the minimum, consists of a regular Sharīàh audit, as part of Bank Negara’s thematic audit, at least on an annual basis, verifying that the IFI’s key functions and business operations comply with Sharīàh.

The Sharīàh audit scope was also included in the Bank Negara Malaysia’s Guidelines on Internal Audit Function of Licensed Institutions or previously known as GP10, which took effect July 1, 2010. The guideline requires the scope of audit work to include every activity and subsidiary that includes the evaluation of the compliance with Sharīàh rules and principles as determined by the Sharīàh committee of the licensed institution or other relevant bodies (for Islamic operations).

6.9.8. Sharı àh Audit Methodology and Framework

The Sharīàh audit methodology and framework is primarily guided by the SGF and Guidelines on Internal Audit Function of Licensed Institutions issued by Bank Negara Malaysia. In addition, the audit also adopts the Group audit’s (Star Bank Risk-Based Audit) methodology.

The methodology shall include, amongst others:

■■ Understanding the business and scope of the Sharīàh audit universe.■■ Identifying Sharīàh risk events that are inherent in the business.■■ Developing the Sharīàh audit planning procedure.■■ Establishing the audit sampling and testing policies.■■ Reporting and rating methodology.

6.9.9. Types of Sharı àh Audit

The different types of Sharīàh audit conducted may include one or a com-bination of the following:

1. Sharīàh audit of company or department: Sharīàh compliance audit over the operations at the head office departments of Islamic banking subsidiaries for example, Star bank Islamic, Sun Takaful, that is, assess-ment of the support function for Islamic Banking operations by the departments in Star Bank, for example, Sharīàh management, product management, risk and compliance, and so forth.

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2. Sharīàh audit of product development: Sharīàh compliance audit over the product design and development process, that is, assessment on the process of product structuring and developing prior to introduction to the market, covering approval process by the Sharīàh committee on the product concept, structure, documentation, policies, and advertising materials.

3. Sharīàh audit of delivery channel/support centers: Sharīàh-compliance audit over product implementation and execution, that is, assessment after the product has been offered to customers, covering the imple-mentation and execution of the products such as the aqad execution. The subject matter as well as the contracting parties must comply with Sharīàh principles.

6.9.10. Sharı àh Audit Process

The audit coverage of Sharīàh/Islamic Banking operations (similarly to the normal audit) can be determined using the following steps:

Phase 1: Audit engagement planning.

Phase 2: Audit execution/fieldwork.

Phase 3: Report audit results.

Phase 4: Audit monitoring/follow-up.

6.9.10.1. Audit Engagement Planning (Standard 2200—Engagement Planning) The planning stage is to identify significant areas and to design the audit work.

A. Determine the scope of responsibility of the activity or unit over the Islamic Banking’s business operation. This is to design the audit work to meet the objective of ensuring that specific operations of the unit are directly related to their objective of complying with Sharīàh requirements. Perform a Sharīàh risk profiling of the unit to be audited. The informa-tion required may be obtained from the manuals and policies governing its operations.

The letter of engagement (EL) is a formal contract that the auditor is engaged by IFIs according to specific and mutually agreed terms. AISIF No. 3 provides specific guidelines on the terms of audit engagement.

The basic contents EL specifies the following:

■■ The auditor’s acceptance of appointment.■■ The objectives and scope of audit.■■ Extent of auditor’s responsibilities to the client.■■ Forms of report to be provided by the auditor.

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Any variation in the terms of appointment as specified in the contents will influence the annual budget fees.

For example:

■■ Delivery channels—for example, branches, business centers, trade finance centers—are involved in the marketing and selling of Islamic Banking products and may be responsible for the execution of the Sharīàh contracts (aqad), for example, aqad for ASB-i.

■■ Support centers—for example, credit administration centers—are involved in the disbursement and may be responsible for the execution of the Sharīàh contracts (aqad), for example, aqad for STRC-i.

■■ Corporate banking and business centers are involved in processing and approval of corporate customers’ Islamic financing—for example, eligi-bility of corporate customer for Islamic facility.

■■ Star Bank Islamic, the Islamic Banking subsidiary, is involved in product design and development process and business operations and support functions of the Islamic Banking sector. Star Bank may be responsible for the execution of the Sharīàh contracts (aqad), for example, aqad for commodity murabahah.

■■ Sun Takaful, the Islamic insurance subsidiary, is involved in product design and development process and business operations and support functions of the Takaful sector. The IFI may be responsible for the re-Takaful, investment portfolio, and so forth.

■■ Investment banking, the investment arm of the group, is involved in Islamic stockbroking and Islamic debt market operations. Investment banking may be responsible for the product development of stockbrok-ing, sukuk, and other services.

B. Determine the extent of Sharīàh audit activities related to the activ-ity or unit, that is, in terms of product, size of operations, locations, by preparing the following:

■■ Listing of Islamic banking’s products or services and the Islamic con-tracts used, for example: deposits, wadiah; financing, murabahah; investment, mudharabah; treasury, murabahah.

■■ Listing of Islamic banking related operations/processes, for example, marketing and selling of products, execution of aqad, profit calculation.

C. Determine the Sharīàh principles that are applicable for the product and processes identified earlier. Prepare the listing of the established Sharīàh principles/criteria by making reference to relevant sources, including Sharīàh rulings published by BNM SAC, relevant pronouncement on Sharīàh matters

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by BNM, resolutions and decisions issued by Star Bank Sharīàh committees, approved product manuals and guidelines, the Sharīàh audit results, and the internal Sharīàh audit checklist. Note: In the event of conflict between the different sources, the matter shall be escalated to the SAC of BNM.

D. Determine if there were any Sharīàh review works performed on the area. If there were any, leverage the work performed by the Sharīàh review to determine the level of compliance and internal control.

E. Upon completion of the the preceding steps, the auditor shall pre-pare the audit plan and determine the scope of audit based on the risk-base approach. The type of audit will be based on the results from the opera-tional audit, product development or product execution, or a combination of the three types.

The individual audit plan is to be signed by the preparer (team leader), reviewer (project supervisor/head of section), and approver (head of depart-ment) before the commencement of the audit fieldwork.

6.9.10.2. Audit Execution/Fieldwork (Standard 2300—Performing the Engagement) F. Prepare the audit program, which includes audit procedures and

extent of testing, to be used to audit the key audit activities as approved in the audit plan. The audit work should be similar to the normal audit:

■■ Interview staff and other relevant counterparties, if necessary, to obtain feedback and to confirm the activity processes and risks involved.

■■ Determine from the documentation or interview the extent of controls implemented to mitigate the risks faced. There should be clearly speci-fied internal controls in relation to Sharīàh compliance requirements. Raise findings and suggest corrective actions.

■■ Examine the relevant documentations and procedures to provide evi-dence that the control is operating effectively. Perform sampling of products development to ensure compliance during the designing of the contracts and documents. Perform sampling of completed transactions to ensure that these transactions conform to Sharīàh rules and guide-lines as endorsed by the SC. The internal control system must be effec-tive in relation to Sharīàh compliance requirement. Raise findings and suggest corrective actions.

■■ Ascertain the extent of Sharīàh compliance of its operations, product, and transactions based on the applicable standards and resolutions.

6.9.10.3. Report Audit Results (Standard 2400—Communicating Results) G. Communicate the results of the findings and other observations aris-

ing from the Sharīàh audit to the auditee, internal audit committee (IAC), audit committee of the board (ACB), and Sharīàh committee (SC).

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6.9.10.4. Audit Monitoring/Follow-up (Standard 2500—Monitoring Progress) H. The Sharīàh audit shall work together with audit operations and qual-

ity department on the follow-up to ascertain that appropriate action is taken on the implementation of recommendation in relation to the audit report findings and any other resolutions made by the IAC, ACB, and/or SC. The management is responsible for rectification of noncompliance, prevention of recurrence of non-compliance, and ensuring that the agreed upon actions were carried out including their timing (deadline) and extent of follow-up.

I. In the event a conflict of opinion between senior management and audit on any audit issues is not resolved, the matter shall be escalated to the ACB for resolution.

J. On a quarterly basis, a “Status of Rectification of Audit Findings” report shall be submitted to the IAC, ACB, and SC.

6.9.11. Audit Report Rating

For specific Sharīàh compliance audit reports, the audit ratings are assigned based on the following:

1. Complied, that is, no material findings detected for high-risk category. 2. Gap(s) noted, that is, findings detected in the medium and high-risk

categories.

For the other audit reports, internal audit has adopted the following four categories of rating for audit report:

1. Satisfactory (meets standards) 2. Fair (needs improvement 3. Unsatisfactory 4. Poor

6.9.12. Qualified Audit Opinion

The magnitude of audit findings in terms of ability to provide reasonable assurance that the financial statements are true and fair in accordance with Sharīàh rules and principles, AAOIFI accounting, and reporting standards, as well as national and relevant international reporting standards, are cat-egorised according to opinions expressed by the auditor.

Audit opinions expressed as “the financial statements as a whole are free from material misstatements based on accumulated audit evidence” refers to the whole audit process and comply with Islamic Sharīàh rules and princi-ples. Four types of opinion are expressed in Table 6.2 (AAOIFI ASIFI No. 2).

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Generally, management representation and the degree of reliance that auditors place on such representation will significantly influence the type of opinion expressed. If audit rating is weak, this is an indicator that the sever-ity of audit findings can lead to a qualified disclaimer or adverse opinion.

6.10. THE TENTH LINE OF DEFENCE: PUBLIC

The public or the Muslim public and society is the last line of defence to ensure Sharīàh compliance. A society that feels confident in the Islamic banking activities and accepts its products and services is indication of the Sharīàh compliance status. However, by public acceptance, we mean the consensus of the majority of society; hence, the view of a group of people who do not have a major representation in the society does not represent a sound line of defence, but a view that can be heard. The condition of the total agreement of the society based on their consensus is that the Muslims are protected to agree on a mistake as mentioned by the Prophet (s.a.w). “My community (Umati) shall never agree upon error.”

NOTES

1. M. Kabir Hassan and Michael Mahlknecht, Islamic Capital Markets (Chichester: John Wiley & Sons, 2011), 41.

2. Sharīàh Advisory Council of Bank Negara Malaysia, Sharīàh Resolutions in Islamic Finance, 2nd ed. (Kuala Lumpur, Malaysia: Bank Negara Malaysia, 2010), 39.

TABLE 6.2 Types of Audit Opinion for Sharīàh Audit Process

Opinions Description

Unqualified Opinion

A true and fair view is expressed in accordance with Islamic Sharīàh rules and principles as determined by SSB and financial reporting standards and requirements.

Qualified Opinion

Opinion is qualified due to disagreement with management or limitation of scope but not material and pervasive to disclaim or reach an adverse opinion. Opinion is expressed with exception on specified matters.

Disclaimer Opinion

It is expressed due to the possible effect of such disagreement or limitation, which is material and pervasive, and the auditor is not able to obtain sufficient appropriate evidence.

Adverse Opinion

It is expressed due to the effect of disagreement, which is so mate-rial and pervasive that the qualification is not adequate to disclose the misleading or incomplete nature of the financial statements.

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3. Ibid., 40.4. Ibid., 27.5. Ibid.6. Ibid.7. Ibid., 28.8. AAOIFI, Governance, Standard No. 1, English ed. (Bahrain: Accounting and

Auditing Organization for Islamic Financial Institutions, 2004), 4.9. See: AAOIFI pronouncement, February 13 and 14, 2008.

10. Sharīàh Advisory Council of Bank Negara Malaysia, Sharīàh Resolutions, 12.11. Ibid., 30.12. Ibid., 31.13. AAOIFI, Governance, Standard No. 1, 4.14. Ibid., 7.15. Securities Commission Malaysia, Malaysia Code on corporate governance,

2012.16. Sharīàh Advisory Council of Bank Negara Malaysia, Sharīàh Resolutions, 10.17. Bank Negara Malaysia, “Learn about the Bank.” Retrieved June 18, 2013, from

www.bnm.gov.my/index.php?ch=7&pg=715&ac=802.18. Islamic Capital Market, “Frequently Asked Questions.” Retrieved June 18,

2013, from www.sc.com.my/main.asp?pageid=256&menuid=285&newsid=&linkid=&type=.

c06.indd 155 18-12-2013 22:35:20

http://www.bnm.gov.my/index.php?ch=7&pg=715&ac=802

c06.indd 156 18-12-2013 22:35:20

157

CHAPTER 7Sharı ah Non-Compliance Reporting

7.0. INTRODUCTION

Regarding Sharīàh non-compliance reporting, a circular was issued by the Central Bank of Malaysia on March 15, 2013. The effective date of the cir-cular was May 1, 2013.1

7.1. OBJECTIVE

Bank Negara Malaysia (the Bank) places great importance on ensuring that the Islamic financial system operates in accordance with Sharīàh. In meeting this objective, compliance with Sharīàh has become an integral aspect in the operations and business conduct of the Islamic financial insti-tutions (IFIs).

Paragraph 2.17 of the SGF for IFIs (the framework) stipulates that it is the duty of the IFIs to inform its board of directors (the board), the Sharīàh committee, and the Bank in the event that the IFIs have become aware that certain operation of the IFIs is found to be Sharīàh non-compliant:

In the event the management becomes aware that certain opera-tions are found to be carrying out business(es) which is(are) not in compliance with Sharīàh, or against the advice of its Sharīàh Committee or the rulings of the Sharīàh Advisory Council of the Bank (SAC), the management shall:

I. Immediately notify the board and Sharīàh Committee as well as the Bank of the fact;

II. Immediately cease to take any new business related to the Sharīàh non-compliant business; and

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III. Within thirty (30) days of becoming aware of such non-compliance or such further period as may be permitted by the Bank, furnish a plan to rectify the state of non-compli-ance with the Sharīàh, to be duly approved by the board and endorsed by the Sharīàh Committee.

Pursuant to the preceding requirement, the IFIs are obliged to notify the Bank on any Sharīàh non-compliance event of the IFIs business operations and activities. Although the IFIs have been notifying the Bank on Sharīàh non-compliance events from time to time, there is a need to develop a mech-anism to streamline the reporting template to enable effective monitoring and surveillance by the Bank. This circular is issued to facilitate the IFIs in meeting the foregoing requirement.

This circular provides a standard reporting mechanism for the IFI to inform the Bank of any Sharīàh non-compliance of IFI’s business opera-tions and activities as well as to provide guidance to the IFIs in preparing the reports on Sharīàh non-compliance events for submission to the Bank on a regular basis.

The circular shall be read together with the framework and other regu-lations, guidelines, or circulars that the Bank may issue from time to time.

7.2. APPLICABILITY

The circular is applicable to:

1. Islamic banks licensed under the Islamic Banking Act 1983 (IBA); 2. Takaful operators and re-Takaful operators registered under the Takaful

Act 1984 (TA); 3. Banking institutions carrying on Islamic banking or financial business

under the Banking and Financial Institutions Act 1989 (BAFIA). 4. Development financial institutions prescribed under the Development

Financial Institutions Act 2002 (DFIA) that carries on Islamic banking business or Islamic financial business.

(All institutions hereafter referred to as Islamic financial institutions (IFIs).)

7.3. LEGAL PROVISIONS

This circular is issued pursuant to Section 53A of the IBA, Section 69 of the TA, Section 126 of the BAFIA, Section 126 of the DFIA, and Section 59 of the Central Bank of Malaysia Act 2009 (CBA).

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Sharı ah Non-Compliance Reporting 159

7.4. REPORTING REQUIREMENTS

The IFIs are required to submit reports to the bank on the actual and poten-tial Sharīàh non-compliance events using the attached reporting forms in Attachment 1. The chart on the whole process flow of the Sharīàh non-compliance reporting is attached in Appendix 1 for reference.

In the event that the IFIs realised that they are engaging or have engaged in Sharīàh non-compliance activities, the IFIs are required to bring the non-compliance event to the attention of their respective Sharīàh committee for confirmation about whether the non-compliance event is either actual or potential Sharīàh non-compliance.

Upon the confirmation by the Sharīàh committee that the reported event is actual Sharīàh non-compliance, the IFIs are required to immedi-ately notify the board and subsequently to provide the Bank with sufficient information of the fact, together with the rectification plan that has been approved by the board.

In addition, the IFIs are also required to report to the Bank on potential Sharīàh non-compliance events specifically to serve as an alerting tool to the Bank of any potential Sharīàh non-compliances that may lead to other type of risk—for example, legal or reputational risk, especially when it comes to similar issues that occur across the industry. In addition, such reporting is also to ensure a level playing field when it comes to the treatment of Sharīàh non-compliance events. For example, Bank A may treat an incident as actual Sharīàh non-compliance that affected its income. However, similar cases might not be reported by other IFIs if it might not appear as an actual Sharīàh non-compliance event due to differences in Sharīàh interpretations by the respective Sharīàh committee.

An example of a potential Sharīàh non-compliance event (inclusive of financial and/or non-financial implications) is illustrated next:

Bank Z charges annual administrative fees on dormant savings and current accounts from the outstanding balance in these accounts, without obtaining consent from the customers. Bank Z recognised the fees as income to the bank. Following a Sharīàh audit con-ducted, the practise was discovered and brought to the attention of the Sharīàh committee of the bank.

7.5. REPORTED AS POTENTIAL SHARl ÀH NON-COMPLIANCE EVENT

The Sharīàh committee of the bank has not made any decision on the issue and needs to conduct further research and investigation. Due to the pending

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decision by the Sharīàh committee on the matter, it shall be reported as a potential Sharīàh non-compliance event to the Bank.

7.6. SUBMISSION OF REPORTS ON ACTUAL SHARl ÀH NON-COMPLIANCE EVENTS

Report on actual Sharīàh non-compliance event shall be submitted to the Bank on an “immediate” basis “as and when” necessary. The term “immedi-ate” is defined as within 14 days of realisation that the Sharīàh non-compli-ance event has occurred. During this period, the IFIs are required to obtain the confirmation from the Sharīàh committee. In addition, the IFIs are also required to submit to the Bank the rectification plan, to be approved by the board and the Sharīàh committee within 30 days. Figure 7.1 illustrates the timeline for actual Sharīàh non-compliance reporting to the Bank.

7.7. TIMELINE FOR ACTUAL SHARl ÀH NON-COMPLIANCE REPORTING

The timeline, shown in Figure 7.1, for Sharīàh non-compliance reporting, is very crucial and sensitive. Hence, the stakeholder of the Sharīàh non-compliance in the Islamic financial institution must act in timely manner through efficient coordination and communication with the Sharīàh board

FIGURE 7.1 Timeline for Actual Sharīàh Non-Compliance Reporting

Con�rmation by Sharīàh committee& necessary action by IFI

Day-1 Subsequently atreasonable date**. IFI mustledge report to the Bank Day-30 (05/2/2013)

Deadine reporting tothe Bank

IFI requires to furnishthe Bank on reti�cation& action plan approvedby the board

15/1/2013 Board meeting orspecial board meeting to approvesuch plans prior to or before theend of 30-day period

Screening process &detected by Sharīàhunit

1//1/2013 IFI uponreleasing that it isengaging in Sharīàhnon-compliance event

Illustration on actual Sharīàh non-compliance05/1/2013Sharīàhcommitteemeeting*

*Non-compliance event to be tabled on the nearest dated of Sharīàh committee meeting or IFI shall ensure that it must be laterthan 14 working days. whichever is earlier. To meet the requirement IFI may have to conduct special Sharīàh committee meeting.**Reasonable date is de�ned as no longer than 3 working days after Sharīàh committee meeting in this scenario. The immediatereporting to the Bank shall be on 06/01/13 (not later than 09/01/13).

Within 30 days

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and the board of directors to ensure compliance with the guidelines of the regulator in reporting the Sharīàh non-compliance matters.

In the event that no board meeting will be held within 30 days from the date of confirmation by the Sharīàh committee that an actual Sharīàh non-compliance event has occurred, the IFI is required to exhaust other means to obtain the board’s approval on the rectification plan prior to the submission to the Bank.

7.8. POTENTIAL SHARl ÀH NON-COMPLIANCE EVENT

Any pending decision by the Sharīàh committee on the identified issue shall be treated as a potential Sharīàh non-compliance event.

Report on potential Sharīàh non-compliance events to the Bank shall be made on a monthly basis based on a calendar year that is not later than two weeks after the end of each monthly period. Figure 7.2 illustrates the timeline for potential Sharīàh non-compliance reporting to the Bank.

7.9. TIMELINE FOR POTENTIAL SHARl ÀH NON-COMPLIANCE REPORTING

The timeline for potential Sharīàh non-compliance, shown in Figure 7.2, is different from the actual, where there is a flexible time frame for the poten-tial Sharīàh non-compliance.

Day-30 (05/2/2013)Deadine reporting tothe Bank

IFI requires tofurnish the Bank onrecti�cation & actionplan approved by theboard

15/1/2013 Boardmeeting or special boardmeeting to approve suchplans prior to or beforethe end of 30-day period

Screening process& detected bySharīàh unit

As at 31/1/2013Monthlyreportingto the Bank

06/2/2013Sharīàhcommitteemeeting

Requires furtherdeliberation andsubmission to the Bankas potential Sharīàhnon-compliance events dueto pending decision bySharīàh committee

Con�rmation by Sharīàhcommittee & necessaryaction by IFI

1//1/2013 IFIupon releasingthat it isengaging inSharīàh non-compliance event

Illustration on potential Sharīàh non-compliance

Day-1 Subsequently atreasonable date**. IFI mustledge report to the Bank

05/1/2013Sharīàhcommitteemeeting*

*Non-compliance event to be tabled on the nearest date of Sharīàh committee meeting.**Reasonable date is de�ned as no longer than 3 working days after Sharīàh committee meeting in this scenario. The immediate actual Sharīàh non-compliance reporting to the Bank shall be on 06/02/13 (not later than 08/02/13).

Within 30 days

FIGURE 7.2 Timeline for Potential Sharīàh Non-Compliance Reporting

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7.10. NO SHARl ÀH NON-COMPLIANCE EVENT IS DETECTED

When there is no Sharīàh non-compliance event in the IFIs for any par-ticular period, the IFIs are still required to submit the reports on a monthly basis, which serves as a declaration or official attestation on the status of Sharīàh compliance of the IFIs.

Submission of all the reports shall be made to the Bank within the stipu-lated deadline as specified in paragraphs 6.6.1, 6.7.2, and 6.8.1. The IFIs shall refer to Attachment 1 (Figure 7.3) for the reporting template forms on Sharīàh non-compliance event reporting to the Bank.

Sharīàh screening process conducted by Sharīàh compliance functions(e.g. Sharīàh risk, Sharīàh review, Sharīàh audit and or Sharīàh risk management)

Non-Sharīàh issuesTo be removed from list of Sharīàh issues**

Con�rmed by SC & to bereported to BNM

WhetherSharīàh or non-Sharīàh

related*

1st level screening process by Sharīàh compliance functions

No

Sharīàh issues Shall be tabled to Sharīàh committee (SC) for con�rmation

Yes

SC con�rmed &Decided the issue

Requires further deliberations/investigation & to be reported to BNM

2nd level con�rmation by Sharīàh Committee & to be reported to BNM

Implications Revalidatethe issue

Non-Sharīàh issueTo be removed from list

of Sharīàh issues

IFI must go through similar process as actual(refer to Actual)

Financial impact Income to be cleansed

Non-�nancial impact Corrective actions

Potential Actual

No

Actual

CleansingChanneled to charity***

Possible implicationsEmergence of other risk

3rd level for corrective measures

Note: Actual case should be recti�ed/ remedied (e.g., through a new contract) and thereafter shall be removed from the list and notreported to BNM. *Functions shall be performed by Sharīàh quali�ed of�cer. At this stage, the IFIs must maintain all submission on Sharīàhnon-compliance reporting for audit & supervisors assessment purpose. **The IFIs are required to report to BNM on monthly basis even though there is no Sharīàh non-compliance event is detected ***Charity funds refers to contribution to Baitulmal and other Islamic institutions, including contribution to non-pro�t.organizations approved by Sharīàh committee of IFI.

FIGURE 7.3 Process Flow for Sharīàh Non-Compliance Risk

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Submission of the reports constitutes an official attestation by the IFI based on the business operations and activities conducted. The officer-in-charge of IFI shall be prepared to respond to any query from the Bank about the details of their submission.

The chief risk officer/senior management in charge of statutory report-ing of the IFI is responsible and will be held accountable for the quality and accuracy of the information submitted to the Bank.

7.11. PROCESS FLOW FOR AUTHENTICATION OR CONFIRMATION OF SHARl ÀH NON-COMPLIANCE IN THE IFIS

The process flow shows the line of reporting through the three different levels of screening. (See Figure 7.3.) The first level is the screening process by Sharīàh compliance function, the second level is the confirmation by Sharīàh committee to be reported to the central bank, and the third level is the correction measures to be undertaken by the Islamic financial institu-tion. Actually, the Sharīàh non-compliance risk started by detecting the risk in the business banking operation, then it will be reported to the Sharīàh committee for decision about whether the risk is to be declared actual or potential. If actual, a possible financial impact may take place; in case of potential, a following decision is to be made, either to be removed from the list of Sharīàh issues or to be declared actual.

NOTE

1. Sharīàh non-compliance reporting issued by the Central Bank of Malaysia on March 15, 2013. The effective date of the circular was May 1, 2013.

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165

CHAPTER 8Legal Documentations in

Islamic Finance

8.0. INTRODUCTION

Legal documentation is an important aspect of Islamic finance industry. Islamic financial institutions use the legal documentation on a daily basis, each product is attached to legal documents, either in the stage of design and approval or in the stage of implementation and execution. Lawyers and legal firms are engaged in legal work that is needed to determine the rights, liabilities, and obligation of the contracting parties. By ensuring a sound legal documentation, a Sharīàh non-compliance risk will be mitigated and managed. Conversely, weak legal documentations that have gaps and loop holes will have a potential Sharīàh non-compliance risk.

8.1. INTRODUCTION TO LEGAL DOCUMENTATION

The first step in legal documentation is to understand Sharīàh requirements in contractual agreements, which are understood within the theory of con-tracts in Islamic commercial law. The Sharīàh requirements are presented in the form of legal documentation clauses in order to determine the rights and obligation of the contracting parties based on mutual consent. Sharīàh requirements will be incorporated in the agreement and presented to the contracting parties as legal documentation. After being documented, they will be implemented and enforced, and then they represent the point of reference in case of dispute.

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8.2. LAW RELATED TO ISLAMIC BANKING

Islamic banking in Malaysia is operating under a dual banking system in which the Islamic finance and conventional finance coexist together and operate in the same market place. In addition, both systems are governed by the same authority, common guidelines, and common standards, under the supervision of the central bank (Bank Negara Malaysia) and the Securities Commission of Malaysia. Hence, there are some similarities in laws that are applicable for both Islamic finance and conventional finance.

In general, Islamic banking in Malaysia falls under the federal juris-diction under the federal Constitution, unlike other Islamic matters, such as Muslim family laws and religious offences, which falls under the State jurisdiction. In short, any dispute in Islamic banking shall be referred to the civil courts instead of the state Sharīàh courts. It’s important to note that, currently, Islamic banks are governed under the Islamic Banking Act of 1983, which has now been replaced by the Islamic Financial Services Act in May 2013.

Under the Central Bank of Malaysia Act 2009, any Sharīàh issues in relation to financial transactions fall within the purview of Sharīàh advi-sory council of Bank Negara Malaysia whose rulings and resolutions will be binding upon the civil courts.

In order for the Islamic legal documentation to be effective, it should comply with the law of the land. On the other hand, whenever any application in banking or finance has civil law requirements and Sharīàh requirements, the civil law requirements should comply with the Sharīàh requirements. In case of conflict, the Sharīàh requirements prevail, and regulations and law requirements should be adjusted to suite Sharīàh rules and principles.

The case of Bank Islam Malaysia Berhad v Lim Kok Hoe & Anor and other appeals [2009] 6 CLJ 22 stipulates that, notwithstanding that Islamic financing is designed to comply with Sharīàh requirements, it is still subject to the same set of laws applicable to conventional banking.

The list that follows shows most of the important and relevant laws that are related to Islamic finance.

National land code Limitation Act, 1953

Companies Act, 1965 Civil Law Act, 1956

Stamp Act, 1949 Specific Relief Act, 1950

Contract Act, 1950 Evidence Act, 1950

Hire Purchase Act, 1967 Rules of Court, 2012

Sale of Goods Act, 1957 Islamic Financial Services Act 2013

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Legal Documentations in Islamic Finance 167

8.3. GENERAL PRINCIPLES IN LEGAL DOCUMENTATION

Generally speaking, there are some important principles in legal documenta-tion that should be observed to monitor the Sharīàh non-compliance risk as follows:

■■ Legal documentation should comply with Sharīàh law to ensure Sharīàh compliance.

■■ Legal documentation should comply with civil law (federal or state law) to ensure consistency and matching between positive law and Sharīàh.

■■ Legal documentation should be enforceable by the court to protect the terms and conditions agreed upon.

These principles play a significant role to ensure Sharīàh compliance, legal and Sharīàh consistency, preservation of the rights and liabilities of the parties involved in the banking facility.

8.4. LEGAL DOCUMENTATION: DEFINITION AND SHARl ÀH CONCERN

Legal documentation is a document based on a specific contract/agreement or set of contracts/agreements that reflect the rights and liabilities of the contracting parties as the result of entering into a particular contractual agreement. The rights and liabilities are consequences of terms and condi-tions stipulated and agreed upon in the contract. There are two requirements in legal documentation. From a Sharīàh perspective, legal documentation for an Islamic financial product must not contain any element or principle that is not in line with Sharīàh principles. From a legal perspective, the legal documentation must be valid and enforceable because this is the ultimate aim of this document.

8.5. INCORPORATION OF SHARl ÀH REQUIREMENTS INTO LEGAL DOCUMENTATION

Legal documentation is the most important and effective method to describe the legal relationship between the parties involved in the contract, the agreed terms and conditions subject to full agreement and consent of the parties. Normally when there is a dispute as a result of a conflict of interest, the legal documentation will be the key evidence for the court to refer to.

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Legal documentation should reflect Sharīàh rules in the relevant con-tract subject to that particular agreement. Sharīàh rules should be accom-modated and harmonised with the applicable civil law, market practice, and custom. Legal documentation should always demonstrate Sharīàh rules and regulations; therefore, the clauses and provisions of the contact should not violate any Sharīàh requirement. Conversely, legal documentation must incorporate all the rules governing the contract depending on the type of the financial transaction such as mudarabah, musharakah, murabah, or others.

The people behind the task of drafting the legal documentation should be equipped with the necessary knowledge and understanding of Sharīàh requirements to ensure that justice and fairness is reflected. In addition to that, ensuring Sharīàh compliance throughout the process is designed by the legal documentation that represents the main reference for any particu-lar transaction in Islamic finance.

There are some important aspects that must be taken into consideration when drafting the legal documentation:

■■ Avoid having any term, clause, or provision in legal documentation that is not consistent with Sharīàh principles.

■■ Avoid using conventional terms such as: interest, penalty payment, repayment, loan, penalization of early payment clause, and penalization for late payment, and so on. These terms should not be incorporated in the legal documentation, simply because they don’t belong to the Islamic finance terminology. Furthermore, these terms either confuse the contracting parties, the judge, the lawyer, or they are open to inter-pretation, which opens a terminology dispute.

■■ Implement Sharīàh terminology and terms in order to express the true meaning of the contract as described in Islamic law while avoiding all types of ambiguities that might arise.

■■ Streamline the terms and conditions by using the popular words/terms implemented in the Islamic market.

■■ Refer to Sharīàh standards and resolutions as the main reference for legal documentations.

■■ Establishing the rights and obligations of the contracting parties clearly.■■ Ensure equity and justice in the clauses and provisions of the contract.■■ Incorporate Sharīàh requirements in relevant legal documentation

according to the contract subject of the agreement.■■ Clearly describe the main Sharīàh principles in the relevant contract and

make provision to refer to other supporting principles when applicable.■■ The legal documentations should stipulate the general terms and condi-

tions of the financing facility.

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■■ There’s no necessity to use Arabic terms if the parties and the courts are not conversant with the language; accurate translation in the language of choice will suffice.

The challenges of the legal documentations is the responsibilities of the Sharīàh board and qualified lawyers whose thorough effectiveness and knowledge render the legal documentation sound, accurate, comprehensive, and Sharīàh compliant. The meaning of knowledge here is the understand-ing of Sharīàh rules and principles and also understanding the legal aspects and principles of Islamic finance practices.

8.6. THE MAIN FUNCTIONS OF THE LEGAL DOCUMENTATION

Legal documentation is designed to describe the contractual agreement between the different parties involved in the financial transaction. It con-tains T&C agreed upon that must be honored, respected, and executed. The terms and conditions stipulated can be changed and adjusted if both parties agree on that.

The function of the legal documentation can be described as follows:

■■ Determine the legal relationship between parties involved in the finan-cial transaction.

■■ Determine the rights and obligations of each party on the contract.■■ Express the mutual consent on the T&C agreed upon between the two

contracting parties.■■ Create a legal document that can be a reference in case of dispute,

whereby the T&C stipulated in the contract and agreed upon in the contract will be the final reference to resolve the conflict.

8.7. AREAS IN LEGAL DOCUMENTATION UNDER CONSIDERATION AND REVIEW

Islamic legal documentation covers areas as follows:

■■ T&C or clauses in legal documentation that are clearly prohibited by Sharīàh principles (riba).

■■ The combination of the contracts in the legal documentation (in case the facility requires combining a few contracts).

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■■ The execution of the legal documentation (the sequence).■■ The form and the structure of the legal rights and liabilities of the two

contracting parties in the legal documentation.■■ The T&C or clauses in legal documentation that have ambiguity and

may create confusion.

These aspects represent the main areas in legal documentations and are discussed briefly next:

8.7.1. Terms or Conditions (T&C) or Clauses in Legal Documentation That Are Clearly Not Approved by Sharı ah (Riba)

The T&C are the main contents of any legal documentation. They reflect the parameters to which all parties in a contract have agreed to subscribe. These T&C speak of respective rights, obligations and liabilities that all parties have agreed to adhere to. In the case of a dispute, default, or breach, these T&C will be the point of reference. Some of these T&C are quite standard in the financial market even before the introduction of Islamic finance.

Some may hold that these T&C are plain and neutral and, therefore, can be retained even in the case of Islamic financial legal documentations. Is that true statement? Why?

In answering this argument, we should bear in mind that the legal docu-mentations in conventional finance have been drafted based on two major underlying principles, namely loan and permissibility of interest. Hence, the T&C in banking or PTC (principles, terms, and conditions) in capital mar-ket documents reflect the two underlying principles: loan and interest.

T&C such as repayment, penalty interest, and right to recall the facil-ity upon demand, and so forth, are terms designed to suit the principles of the conventional finance. Therefore, if they are used in Islamic legal docu-mentation, very careful attention should be given to them. There is a risk of Sharīàh non-compliance if there is blind use and implementation of the conventional legal documentation in the Islamic banking and finance with-out prior careful review, examination, and assessment of the conventional legal documentation in form and substance.

A legal maxim says that everything is permissible unless it is proven otherwise by Sharīàh. Therefore, from Sharīàh perspective there is freedom in stipulating the T&C of a contractual agreement, provided they are in line with Sharīàh rules and principles. Any term or condition contradicting Sharīàh rules or principles will render the terms or conditions agreed upon null and void. The objectives of the terms and conditions should be heading to the same objectives of Sharīàh (Maqasid al Sharīàh).

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In legal documentation, the T&C of contracts are determined to estab-lish the firmness or legitimacy of the contract, and address specific needs or requirements of the counterparties.

It is very important to emphasize that legal documentation must not behave like a conventional loan, because the financier is neither a lender nor a borrower. Therefore, generally, terms such as loan, interest payment, and repayment are not relevant to Islamic finance, simply because the terms reflect the act of giving the money to someone after which there will be an interest payment in the form of the repayment of principal plus the payment of a premium on loan is not suitable for a transaction based on sale, equity, or services.

The most challenging part in Islamic finance is that the legal documen-tations are drafted from a perspective that the Islamic banking facilities are behaving exactly like a loan transaction in conventional finance. This is a serious issue that must be resolved and overcome gradually. Legal documen-tation should reflect the true meaning of the Islamic principles in financial transaction such as ijarah, murabahah, and so forth. These financial transac-tions are not loans.

Terms that have no relevancy to the spirit of Sharī`ah must be avoided and replaced with relevant terms. Their presence in legal documentation could dilute the very meaning of an Islamic finance perspective.

It should be noted that there are some terms that are clearly prohibited by Sharī`ah; therefore, they cannot be used in the legal documentation such as riba and others.

8.7.1.1. Riba (Usury) The term riba cannot be used in Islamic legal documen-tations because riba is not allowed; therefore, it should be removed from the legal documentation. Riba is equivalent to interest, and usury; therefore, both cannot be used in legal documentation as well.

One may say that every mention of interest should be removed from the legal documentation. Is this a true statement? Why?

To answer this question, we should know that in some jurisdictions, the term interest has taxation implications. Although interest payments are not taxable, the profits and dividends of Islamic products may be taxable as in sukuk ijarah or sukuk musharakah, thereby rendering them not competi-tive to the conventional products. Many jurisdictions have deemed profit or dividend paid under Islamic financing schemes as interest on the treatment of tax. This is to make Islamic products compatible to conventional products in terms of tax treatment. In some jurisdictions, there is no special treatment given to profit or dividends with regards to tax arising from Islamic finan-cial products like sukuk ijarah when it refers to coupons paid to investors or dividends paid under a mudarabah investment account. The issue arises

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whether the term interest can be used in these jurisdictions in all relevant legal documentation for a specific purpose, such as avoiding tax implications.

The only outstanding issue is whether it is possible to use the word interest (in the place of profit and dividend, as the case may be) for the specific purpose that it is simply to relieve investors/customers from paying a tax that is not paid under conventional products. Scholars have different views on this issue. Although some might approve the incorporation of the term interest in Islamic-approved products for tax purposes, others might find this objectionable. This incorporation could be deemed permissible pro-vided sufficient illustration or explanation is given to explain the position of this term and why such a term has been incorporated into an Islamic legal document. The term interest is not a feature in contract but incorporated to relieve involved parties from paying some taxes.

8.7.1.2. Loan The term loan is the second controversial term that cannot be used in Islamic legal documentation unless the loan refers to qard hasan. However, it should be understood that the concept of qard hasan is usually used in Islamic finance and incorporated in legal documentation accordingly. Knowing that will ensure that the term is used accurately in legal documentation.

Qard hasan can be used in Islamic finance area as follows:

■■ Qard hasan is not used in commercial banking in financing, but in a deposit account.

■■ In financing, qard hasan is used under micro financing. However, the commercial banks don’t provide this kind of financing normally; it is provided by the non-banking financial institutions that are supported by the government.

■■ Qard hasan is used as an instrument between the parent bank and its subsidiary when cash or liquidity is needed.

■■ Qard hasan is used as an instrument between the central bank and the Islamic bank in case the central bank grants a loan to an Islamic finan-cial institution.

■■ Qard hasan is used in the Takaful when there is a deficit in the risk fund.■■ Qard hasan is used in the investment account when the reserve is in deficit.■■ Qard hasan is used in profit distribution in sukuk, in case there is no

reserve.■■ Qard hasan is used in credit card transactions by some Islamic financial

institutions.

The concept of loan in legal documentation can be used accordingly, but it is recommended that the word qard hasan be used instead of loan to avoid ambiguity and misunderstanding. In financing, loan cannot be used

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because the facility in Islamic finance is not regarded as credit extended to the client; rather, it is a facility governed by a particular contract such as ijarah, mudarabah, or others.

As conclusion: Loan is not a financing facility in Islamic finance and legal documentation. Riba is not a profit in Islamic financing facility. Both cannot be used to describe the Islamic financing facility and both terms can-not be incorporated in the legal documentation.

It should be understood that the bank is not a lender but either:

■■ Seller (such as murabahah/parallel salam)■■ Buyer (such as BBA/murabahah/parallel istisna`)■■ Partner (such as musharakah)■■ Investor (such as mudarabah)■■ Capital provider (such as mudarabah)■■ Mudarib (such as mudabahah)■■ Intermediary (such as wakalah)■■ Broker (such as jualah)■■ Owner (such as ijarah)■■ Lessor (such as ijaraah)■■ Lessee (such as ijarah)■■ Custodian (such as wadiah)

Legal documentations should reflect the position of the bank and the client according to the nature of their relationship based on the underlying contract used in the banking facility; otherwise, a Sharī`ah non-compliant risk in the legal documentation will be triggered.

Other terms to be avoided in legal documentation are as follows:

■■ Late payment interest■■ Default interest■■ Borrower■■ Lender■■ Borrowed money■■ Base lending rate■■ Compounding■■ Others

8.7.2. The Combination of the Contracts in the Legal Documentation

Combination of contract is an important area in legal documentation; prod-uct should be structured in such a way that does not result in Sharī`ah non-compliance risk.

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8.7.2.1. The Concept of Combination of Contracts Combination of contracts is a process that takes place between two parties or more, and entails the simultaneous conclusion of more than one contract. Hence, combination of contracts may take any of the following forms:

■■ Combining more than one contract without imposing any of them as a condition for the other, and without prior agreement (muataàh) to do so.

■■ Combining more than one contract while imposing some of them as conditions in the others, without prior agreement to do so.

■■ Combining more than one contract subject to prior agreement (muataàh), but without imposing any of them as a condition in the others.

■■ Agreement to conclude the deal through any of different contractual forms as will be finally decided in the future.1

8.7.2.2. Forms of Combined Contracts There are different forms of combina-tion of contract as follows:

■■ Combined contracts may have a single lump-sum countervalue. For instance, a party may sell his piece of land to another party and simulta-neously rent his car to the same party for one month, both against one thousand ringgit.

■■ Combined contracts may be concluded for separate values. For instance, one party may sell his house to another for one thousand ringgit, and rent his car to the same party for one hundred ringgit per month.

■■ Some of the combined contracts may be stipulated as conditions in the other contracts. For instance, one party may say to the other party that I will sell you my house for 10,000 ringgit on condition that you under-take to rent the house to me for two years for 1,000 ringgit per year. The sale of the house in this manner could also be concluded on condition that the buyer of the house undertakes in return to sell his car to the seller for 2,000 ringgit.

■■ Combined contracts may take the form of an exhaustive contractual statement comprising a number of successive parts and stages, which finally lead to realization of the desire of the two parties to conclude the deal in question. For example, the transactions of ijarah ending with ownership, murabahah to the purchase order, and diminishing musharaka.2

8.7.2.3. Sharı àh Status of Combining Contracts It is permissible in Sharīàh to combine more than one contract in one set, without imposing one contract

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as a condition in the other, and provided that each contract is permissible on its own. Combining contracts in this manner is acceptable unless it encoun-ters a Sharīàh restriction that entails its prohibition on exceptional basis.

8.7.2.4. Sharı àh Parameters on Combining Contracts Sharīàh parameters in combination of contract are as follows:

■■ Contracts’ combination should not include the cases that are explicitly banned by Sharīàh like combining sale and lending in one contract.

■■ It should not be used as a trick for committing riba such as agreement between two parties to practice riba al fadhl.

■■ It should not be used as an excuse for practicing riba. The two parties could misuse, for instance, combining contracts when they conclude a lending contract that, at the same time, facilitates some other compensa-tory gains to them.

For example, they could stipulate in the contract that the borrower should offer accommodation in his house to the lender, or should grant him a present. Combination of on tracts could also be misused by impos-ing excess repayment in terms of quantity or quality on the borrower.

■■ Combined contracts should not reveal disparity or contradiction with regard to their underlying rulings and ultimate goals.

Examples of contradictory contracts include granting an asset to somebody as a gift and selling/leasing it to him simultaneously, or combin-ing mudarabah with lending the mudarabah capital to the mudarib, or currency exchange with jua`la, or salam with jua`la for the same contract value, or leasing with selling (i.e., hire purchase in its traditional form).3

8.7.2.5. Sharı àh Concessions for Contracts’ Combining In principle, the Sharīàh concessions that can be granted to implicit and subsidiary contracts at the time of combining contracts cannot be granted to the same contracts when concluded independently. Here, implicit and subsidiary contracts refer to contractual commitments that are not explicitly embodied in the deal agree-ment or those that succeed the original commitments of the transaction.

The concessions to be granted in this case should be judged in the light of traditions, practice, and professional experience, and they are subject to clearance by the Sharīàh supervisory board of the institution.

■■ Concessions granted to implicit and subsidiary contracts comprise relief from the following Sharīàh-banned acts:

■■ Gharar, which affects financial contracts, may be overlooked in implicit and subsidiary contracts.

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■■ Jahala, which also affects financial contracts, may be ignored with regard to the object of a subsidiary contract.

■■ Sale-based riba and violation of currency exchange rules (as when spot delivery is ignored in a contract that combines currency exchange with money transfer) are also forgivable in subsidiary and implicit contracts.

■■ Selling of a debt for another debt may be ignored when it comes in the context of a subsidiary contract. A fitting example here is pur-chasing (on debt) the shares of an indebted company.

■■ Subsidiary and implicit contracts may also be relieved from some prerequisites that underline the validity of contracts (such as offer and acceptance) when such relief is dictated by need or desire to achieve a Sharīàh-permitted interest.4

8.7.2.6. Pre-Arrangement (Muwathoah) for Combining Contracts Muwathoah or Tawatu` in fiqh terminology has several meanings, most important among are stated in the following list:

■■ Explicit or implicit intention of the parties to the contract to use a cer-tain trick for practicing riba through a Sharīàh-accepted contractual form.

■■ An unrevealed prior agreement between the two parties to perform a Sharīàh-permissible act or deal for the sake of finding a Sharīàh-accepted exit (acceptable trick).

■■ Coincidence of the intentions of parties to the contract at the stage of preparatory negotiations that precede the signing of the contract.

From fiqh perception, Muwathoah for combining contracts has three distinct characteristics:

1. It is an agreement between two parties to conclude contracts and fulfill pledges in the future.

2. When muwataàh is stipulated as part of the contract, it becomes a condition precedent to the conclusion of the contract, and the contract becomes subject to the relevant Sharīàh rulings with regard to permis-sibility, enforceability, and validity.

3. Enforceability of muwataàh in Sharīàh is similar to enforceability of conditions preceding the signing of contracts. A condition that precedes the signing of the contract has the same validity and binding nature as the normal conditions of the contract, since the former constitutes the bases of the contract that have been mutually agreed upon between the two parties.

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Muwataàh to combine contracts takes several forms, which may be grouped into the following four types:

1. Muwataàh to form riba tricks, in which the two parties agree to practice, for instance, Riba al fadhl. In this case, Sharīàh prohibits muwataàh and the contract so designed is invalid.

2. Muwataàh for riba excuses is prohibited by Sharīàh whereby the two parties agree to combine a loan with another transaction, or stipulate that the borrower has to present a gift to the lender, or make excess repayment in terms of quantity or quality.

3. Prohibition of muwataàh to do such tricks, which are permissible in principle, should be judged in the light of two conditions:

■■ The intention to use the permissible act as a means of concluding a prohibited deal should be obvious and beyond all doubts.

■■ There should be no obvious need or lawful interest that justifies resorting to such a trick.

4. Muwataàh for obtaining Sharīàh exits, which refers to tricks that nei-ther violate Sharīàh rules nor contradict Sharīàh objectives, nor result in any harm to others, is permissible.

5. Muwataàh for combining contracts that contradict or oppose each other is prohibited because it leads to performing of an act that has been strictly banned by Sharīàh.5

8.7.2.7. Contemporary Applications and General Rules for Combination of Contracts According to AAOIFI Sharīàh standards one of the most dis-tinguishable forms of contemporary financial transactions is the contrac-tual arrangements that comprise a number of contracts and pledges that the parties agree beforehand to execute in a specific manner and according to agreed number of successive stages. Such arrangements aim to achieve a given purpose or interest of the parties to the contract such as perform-ing murabaha on Order of Purchase, ijarah Ending with Ownership, or Declining musharakah.

■■ Muwathoah, when provided for in the contract and used for combina-tion of contracts, should be observed by, and remain binding to the parties to the contract, subject to Sharīàh-accepted commercial and banking conventions.

■■ The pledges contained in such combined contract sets are binding to their respective parties.

■■ These newly devised sets of combined contracts should observe the gen-eral rules of Sharīàh with regard to structure, rulings, requirements, and conditions in order to be Sharīàh compliant.

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■■ These contract sets should also observe the Sharīàh rulings pertaining to combining contracts and may make use of the Sharīàh concessions in this respect.

■■ Failure of any of the parties to combined contracts to honor its contrac-tual commitments gives the other party the right of claiming indemnity for the actual injury encountered.6

8.7.3. The Execution of the Legal Documentation

The execution of the contract looks at the sequences of the contracts execution.

8.7.3.1. The Importance of Sequencing Islamic financial products and services are based on certain contracts. These contracts, unlike a normal loan con-tract, are essentially based on some logical processes and procedures.

1. In some cases, a particular contract must take place prior to any sub-sequent contract. The failure to observe this sequencing will make the contract null and void because of the lack of the basic requirements of ownership and/or possession before one can proceed with the subsequent contract. A financier under a BBA cannot sell an asset to a customer unless the financier already owns the asset. The same also applies to other facilities. Likewise, under a sale and leaseback contract, the lessor cannot lease an asset to the lessee until and unless he owns the leased asset.

2. In some cases, the sequencing of signing the legal documents is a logical requirement. The two parties cannot simply sign a document on charge or guarantee unless they have created a kind of obligation between them whereby the charge or guarantee is to secure the interest of the creditor, that is, to receive a certain payment or delivery from the debtor. This sequencing is to reflect the logical processes of all contracts that are involved in one financial product.

3. The proper sequencing in legal documents is useful to facilitate not only the Sharīàh compliance aspect but also the viability of a certain financial product. Murabahah is a purchase order whereby the cus-tomer approaches the bank/financier requesting the bank/financier to purchase the asset from the supplier. The bank/financier will then require that the customer offers, under the principle of wa`d (unilateral binding promise), to purchase this asset from the bank/financier if the bank/financier were to sell this asset to the customer. This sequencing is important to address the Sharīàh compliance issue, which is to avoid selling something until and unless the seller (financier) has already owned that asset.7

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■■ The contract in Islamic law consists of three elements: the contracting parties (seller and buyer), the statement of the contract or sighah (offer and acceptance), and the subject matter of the contract (good and price).

■■ Each element of these pillars has some T&C to fulfill in order to validate the contract and the transaction accordingly.

■■ The offer or ijab is showing the willingness of a party to engage into a transaction. Meanwhile, the offer gives the option to the counter-part to express his consent toward the transaction, either by accep-tance or rejection.

■■ The acceptance or qabul is confirmation of the offer and willingness to conclude the business transaction. By concluding the offer and the acceptance, the contract in formulated.

■■ The statement can be conveyed by words or writing or even by indication and conduct. This shows the flexibility of the Sharīàh in contracts and illustrate the objective of Sharīàh in facilitating the business transaction.

■■ There are some requirements in offer and acceptance to be fulfilled in order to have a valid contract.

■■ The unity of the session of contract is required to format a valid contract; however, Sharīàh accommodates the various means for the unity of the contract according to modern communications.

■■ The subject matter of the contract must be legal in Sharīàh in order to valid the business transaction.

■■ The subject matter of the contract can be in actual existence during the time of the contract; however, Sharīàh has allowed the subject matter of the contract to be non-existent in some special contracts.

■■ The subject matter of the contract must be capable of being handed over at the conclusion of the contract.

■■ The subject matter of the contract must be precisely determined at the time of the contract; the termination can be done by full descrip-tion of quality and quantity.

■■ The contract in Islamic law should realize the objective of maqasid al Sharīàh in Islamic financial transaction.

8.7.4. The Form and the Structure of the Legal Rights and Liabilities of the Two Contracting Parties in the Legal Documentation

It should be noted that in some cases, the combination of a few T&C may impair the main objectives of the contract or lead to contradict the very nature of the contract, as a result of which the transaction will be regarded as non-Sharīàh compliant. The legal documentation along with the terms

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and condition should be consistent with the underlying contract used in the facility. If the T&C contain any clause that goes against the nature of the contract, the said contract will be defected.

Examples

■■ A contract of mudarabah or musharakah (equity-based contract) can-not stipulate a condition that the partner shall guarantee the profit, the capital, or both.

■■ Contract of mudarabah cannot be concluded when there is a condition that the capital will not be provided at the outset of the contract, or by assuming that the capital is in form of debt not due for collection.

■■ Contract of murabahah cannot be concluded without disclosing the original cost and profit.

■■ Contract of istisna` cannot be concluded on the conditions that the raw material will be supplied by the buyer, because it will be regarded as ijarah contract and not istisna`.

■■ Contract of salam cannot be concluded on the condition that the price will not be advanced in the contract and it will be provided through trench or installment.

■■ Contract of wadhiah cannot be concluded when there is a profit gener-ated, because there is an assumption that there is a discount provided.

■■ Contract of tawliyah cannot be concluded when there is a profit gener-ated because the contract supposes generating zero profit, because it is a transaction with non-profit.

■■ Contract of mudarabah cannot be concluded when there is a condition that the profit is fixed and predetermined upfront.

The preceding are some example of T&C that might be incorporated in the legal documentation that trigger Sharīàh non-compliance risk. These examples can be seen as clauses in the legal documentation that go against the very nature of the contract. Each contract in Sharīàh has basic rules and principles that should be complied with in order to ensure Sharīàh compli-ance status in the structure of the product and its legal documentation.

8.7.5. Terms or Clauses in Legal Documentation That Have Ambiguity and May Create Confusion

There are some T&C that may affect the rights and liabilities of the parties in a concluded contract. The following aspects are clauses that may appear in the legal documentation that need clarification to ensure consistency between Sharīàh and legal documents.

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8.7.5.1. Right to Recall the Facility Conventionally, this clause is incorporated into any loan contract documentation to enable the lender/financier to recall the facility by terminating the facility and requiring that the customer/bor-rower settle any outstanding payment on the spot. The clause is triggered when the customer/borrower defaults or breaches any of conditions imposed on him. The same clause is maintained in the Islamic legal documents. The clause is drafted as:

The facility granted herein shall be subject to the bank’s right to recall on demand and to be reviewed from time to time by the bank and nothing in these presents contained shall be deemed to render it obligatory upon the bank either at law or in equity to make any advances or to afford any other accommodation or facility whatso-ever to the customer and the bank shall have the right to withdraw the facility at any time it deems fit to do so.

Sometimes, the clause is drafted under recall and acceleration of pay-ment. The clause is drafted in a personal financing offer letter is as follows:

Notwithstanding any other provisions relating to the availability of the facility(s) or any part thereof, the Bank reserves the right to review periodically and accordingly to terminate the facilities or any part thereof, at any time it deems fit by giving written notice of the same, whereupon the facilities or such part thereof shall be terminated and the whole indebtedness or such part thereof shall be payable upon demand. Without prejudice to the generality of the foregoing, the Bank reserves the right to review periodically and accordingly to terminate the facility(s) or any part thereof if the facility(s) is utilised for any purpose which is in contravention of the Sharīàh.

From one perspective, this clause is acceptable to Sharīàh principles if the meaning of this clause is deemed to accelerate the outstanding pay-ment upon delay or default in payment. The basis for the condition is that all installments will become due if there is delay as in the hadith of the Prophet (pbuh), that is “Muslims are bound by the conditions they made.” Therefore, if the buyer under murabahah has agreed to this condition, he will be bound by this condition to make the entire payment once he has defaulted on the payment for even one installment.

However, from another perspective, the “right to recall” clause cannot be understood as the right to terminate a contract. This is because according to Sharīàh principles, a non-payment will not render the contract terminated.

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A delay in payment will not revoke the contract. Hence, this clause must only be understood as giving the right to the financier to request that the customer has to pay all outstanding payments once he has defaulted. It can-not be construed as a termination of contract.8

8.7.5.2. Repossession of the Asset The procedure of repossession of the asset, which is very close to the clause of right to recall, has a different procedure depending on the type of the facility offered by the Islamic bank. If it is a sale-base facility, the right of the bank to recall the facility as mentioned earlier will be applicable within the context explained. However, in the case that the facility offered is based on operating leasing or financial leasing, the physical repossession of the asset with its real meaning may take place, because the asset is owned by the IFI.

The clause is drafted also in banking documents of murabahah vehicle term financing facility agreement under the clause of Procedures for Taking Possession as follows:

a. Upon the happening of any of the events of default stipulated under this agreement the Bank shall be entitled to take possession of the vehicle without any further notice to the customer.

b. The Bank is entitled to appoint its own officers and/or manager and/or agents to take possession of the vehicle.

c. Upon taking possession, the Bank shall send a notice to the customer informing him about taking possession and giving him 14 days to rem-edy the breach. The Bank shall not, without the written consent of the customer sell or dispose or part with possession thereof until the expira-tion of the said notice.

d. Upon expiration of the said notice and the customer has refused/neglected/failed to remedy the breach, the Bank can without any further notice be entitled to sell and/or dispose the vehicle in the manner herein stated.

8.7.5.3. The Limit of the Right of the Bank There is limit of right for the bank toward the contract agreement such as bai` bithaman ajil (BBA) or other facilities offered, as long as the client honors the agreement and pays the outstanding amount due to him regularly. In this case, the bank has no right to foreclose the property and recall the BBA financing facility. Therefore, the documentation of the debt financing facilities such as BBA should not include any clause mentioning the right to the bank to recall back the facil-ity because the bank cannot repossess the property back. However, the bank will be entitled to this right and be in a position to terminate the scheme

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of the installment facility. In case the client is unable to pay the bank and settle the outstanding amount, the bank can claim the unpaid amount by using the collateral of the client, by selling it to settle the unpaid amount only, and release the balance to the client. Hence, the action of the bank is against the charged asset and not recourse on the contract itself.

8.7.5.4. Cross Default This clause in legal documentation is a term that gives the right to a financier to deem a particular financing facility in default because the customer has actually defaulted in another facility, even though this particular customer has not defaulted in that first facility. However, since both are related to each other under a cross-default term, any default in one of the facilities, the other facility, although still good, must be deemed to be equally in default.

An illustration of this case is as follows. A customer has already secured a house financing facility. He is later offered another facility by the same bank, for example, an ijarah car financing. A cross default clause may be incorporated into both financing facilities’ documents. Should this customer default on his house financing obligation by not paying a few installments, his car ijarah financing will be automatically deemed in default.

The clause is drafted in master facility agreement for murabahah over-draft as follows:

The customer herby expressly agrees that if any sums shall be due from the customer to the bank from time to time or at any time or if the customer maybe or become liable to the bank anywhere on banking account or any other account current or otherwise in any manner whatsoever or if default is made in any provisions of such account on any other banking facilities granted by the bank to the customer or in any provisions herein, then in any such event, the monies hereby secured together with all monies payable under such account or other banking facilities aforesaid shall immedi-ately become due and payable and the security herein shall become immediately enforceable.

It is drafted in other legal documentation such as murabahah vehicle term financing facility agreement as follows:

Notwithstanding the provisions relating to the payment of Bank’s Selling Price hereinbefore provided, the Customer hereby expressly agrees that if any sums shall become due and payable from the Customer to the Bank or with any of the institutions within the bank Group of companies from time to time or at any time or if

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the Customer become liable to the Bank or with any of the institu-tions within the bank Group of companies anywhere on banking account or any other account current or otherwise in any manner whatsoever or if default is made in any provisions of such accounts or in any other banking facilities granted by the Bank or with any of the institutions within the bank Group of companies to the Customer or in any of the provisions herein, then and in such event, the Facility together with all monies payable under such accounts or other banking facilities aforesaid shall immediately become due and payable and the security herein shall become immediately enforceable.

Based on the preceding clause, all legal consequences will follow such as a notice requiring an entire payment. Although some scholars may approve of this term on the basis of maslahah (public interest), other scholars may object to it because they view it as unfair to the customer.

The incorporation of this term must be subject to the approval of the financier’s Sharīàh board because there could be more than one opinion on this issue from a Sharīàh perspective. One of the opinions is that cross-default does not reflect the principle of Sharīàh in justice and equity, each financial facility should stand for its own, and they must be treated sepa-rately. The other opinion is based on cross-default as a mitigation tool to protect the interest of the bank from being financially harmed because of the financial distress of the customer and his potential bankruptcy where he will not be able to fulfill his future financial obligations.9

8.7.5.5. Consolidation and Set-Off This clause is common and standard in legal document and it means that the financier has the right to consolidate all the accounts that a customer has with the bank/financier such as savings and current and/or investment accounts, for the purpose of using these monies deposited with the bank to settle any payment outstanding to the bank under the principle of set-off or muqasah. A customer may have a few accounts with his bank and at the same time, he may have been granted a few financ-ing facilities such as murabahah house financing. By virtue of this term, if the customer defaults in making the regular installments under murabahah, the bank/financier is entitled to consolidate all the accounts of the customer to set-off the amount payable or owing to the bank/financier. Sometimes the clause is presented under (right of bank to consolidation). The clause is drafted in a master facility agreement for murabahah overdraft as follows:

The bank shall have the right to consolidate any or all accounts of the customer with the bank, such right to be exercised at the bank’s

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absolute discretion and it is hereby expressly agreed and declared that this agreement shall not be satisfied except on payment by the customer of not only all the MOD (murabahah overdraft) indebted-ness but also all monies secured by any other agreement or security created by the customer in favour of or vested in the bank to secure the facility.

The clause is drafted also in other banking documents such as murabahah vehicle term financing facility agreement under the clause of Consolidation and Combination of Accounts as follows:

It is hereby expressly agreed and declared that unless the Bank otherwise agrees, the Customer shall not be entitled to redeem or require the release or discharge of any security given by the Customer to the Bank and whether given now or hereafter except on payment by the Customer of all moneys referred to herein. It is hereby expressly agreed and declared that unless the Bank other-wise agrees in writing the Assignment created herein shall not be terminated except on payment:

i. of all the Indebtedness; and ii. of all moneys secured by any other security created by the

Customer or by any person through whom the Customer claims in favour of or vested in the Bank.

The objective of this clause is to protect the interest of the bank/finan-cier. It is valid practice to set off mutual rights and obligations between two parties, as long as there is an agreement between them.10 According to Bank Negara guidelines, the bank should give notification of 21 days before the preceding takes effect.

8.7.5.6. Right to Debit Account Sometimes, there is a clause drafted after the clause that gives the bank the right of consolidation. The clause focuses on the right to debit from the account of the customer. This clause is presented under the clause (of right to debit account) and is drafted as follows:

The customer agrees that without prejudice to any other rights and remedies of the bank, the bank shall have the right (without being obliged to) at any time without prior notice to debit the customer’s current or other account or accounts with the bank with the MOD (murabahah over draft) indebtedness provided that no such deb-iting shall be deemed to be a payment of any of the amount of

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the MOD indebtedness due (except to the extent of any amount in credit in the customer’s current account or other accounts or accounts with the bank) or waiver of an event of default under the security documents.

The preceding clause sometimes is drafted in different context in the letter offer of the facility as follows:

Any monies due and payable to the bank or advances by the bank on your behalf with regards to the facility(s) may be debited to such accounts as the bank deems fit.

8.7.5.6. Service Charge Relating to Employees Provident Fund Withdrawals The cli-ent should be aware that his consent gives the financial institution the right to debit from his account the service charge relating to employees provident fund (EPF) withdrawals. The clause is drafted as follows:

You shall be liable to pay the sum of RM10 as service charge for provision of information pertaining to you and/or your account by the bank to the Employees Provident Funds (EPF) in the event that any application for housing withdrawal is submitted by you to EPF and such information and/or verification of such information is sought by EPF. It is hereby agreed the bank shall be entitled to debit your account for the said sum without notice.

8.7.5.7. Penalty/Compensation/Late-Payment-Charges Clause Financial obliga-tions arising from Islamic debt financing modes such as murabahah, ija-rah, istisna`, and tawarruq, may not be fulfilled by the customer on time. Conventionally, the financier will impose a penalty on late payments based on a certain agreed formula. Also, this penalty may be compounding in nature. Obviously, this clause is not acceptable from the Sharīàh perspec-tive. According to respective AAOIFI Sharīàh standards, the financier is only entitled to charge the defaulting customer an amount of money that is commensurate with the actual cost incurred by the bank/financier. The bank/financier under Sharīàh principles may, however, request that when the customer delays a payment, he give his word, documented in relevant legal documents, that he will pay an amount of money to be donated to charitable causes.

This penalty clause is merely to deter the customer from defaulting and any money paid by the defaulting customers, other than a portion to com-pensate actual expenses, must not be regarded as an income to the bank, but must be disposed to charitable organisations.

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In Malaysia the bank/financier is allowed to charge the defaulting cus-tomer a certain percentage of his outstanding payments or installments to compensate the loss incurred by the bank/financier. There is a guideline by Bank Negara on this issue known as the late-payment charges, where the bank charges compensation (tawidh) of 1 percent from the amount in arrears and upon recall on the total outstanding amount and thereafter at Interbank Money Market Rate after maturity of the financing period, or the actual loss as compensation for default of payment on top of that banks are also allowed to charge penalty (gharamah) over and above the compensation. However, the penalty proceeds must be channeled to a charitable organization.

The clause is drafted in some banking legal documents as a murabahah vehicle term financing facility agreement under the clause of late-payment charges as follows:

a. The Bank shall have the right to be compensated on late install-ment and default payment based on the following mechanism: i. Overdue Installment or Scheduled Payment For failure to pay any installment or any payment due

from the date of the first disbursement of the Facility until its maturity date, a Late Payment Charges (“LPC”) sum equivalent to one per cent (1%) per annum of the overdue installments/payment or by any other method approved by Bank Negara Malaysia (BNM);

ii. Upon Maturity For failure to pay any installment or any payment due and

which failure continues beyond the maturity date of the Facility or upon judgment, whichever is earlier, at the LPC rate which shall be the prevailing daily overnight Islamic Interbank Money Market (IIMM) rate on the outstanding balance due and payable or any other method approved by Bank Negara Malaysia from time to time.

b. Notwithstanding the amount of the LPC charged, it is expressly acknowledged and agreed that the said amount of LPC shall not be further compounded.

c. The LPC referred to in Clause (a) above shall be applied to the judgment sum and shall be payable from the date of the judg-ment is made until the date of actual payment.

This issue can be solved within the Islamic financial institution where the regulator, through a policy, puts pressure on the defaulters by depriving them of obtaining any facility from any Islamic financial institution in the market. Furthermore, the penalty can be imposed only on the dishonest cli-ents who defaults in payment without any reason or reasonable excuse, so

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they will be liable to pay compensation to the Islamic bank for the loss and damage created by them.

8.7.5.8. Pre-Payment/Early Settlement Clause A pre-payment clause is related to the right of the customer to pre-pay or to settle outstanding payments early. Without this clause, the customer may not be able to settle early as the decision to allow prepayment will be ultimately vested with the financier. However, if the financier and the customer have agreed on this pre-payment practice according to some procedures, such as an up-front notice, the finan-cier is bound to allow pre-payment by the customer. The clause is drafted in the letter offer as follows:

you may at any time by giving the bank one (1) month notice in writing to pay the indebtedness due under the facility(s) or part thereof then due and payable to the bank

Some legal pre-payments are under the clause of Early Settlement. The clause is drafted in banking documents of murabahah vehicle term financing facility agreement under the clause of early settlement as follows:

a. The Customer may, at any time make an Early Settlement by giving an Early Settlement Notice.

b. All Early Settlements received by the Bank shall be applied by the Bank toward reduction of the number of Installment payable by the Customer in inverse order of maturity of the respective Installment Payment Dates and not towards reducing the quantum of any of the Installment unless otherwise agreed by the Bank in writing.

Conventionally, the clause will provide a formula of how the full payment will be calculated, which is normally based on deducting the outstanding interest portion from that total amount outstanding prior to a pre-payment date, that is, discounting. The Sharī`ah issue does not relate to the provision of pre-payment but relates to provision of rebate in this pre-payment clause.

8.7.5.9. Rebate on Early Payment This issue is related to the possibility of hav-ing discount in indebtedness in case the client wants to make an early settle-ment for his outstanding payment. The issue here is whether it is permissible by Sharī`ah to give rebate/ibra for the early payment.

According to the majority of jurists, the concept of rebate/ibra is based on the concept of da` wataajjal (give discount and receive soon),11 as it is known in Islamic legal literature. The majority of the jurists do not allow the discount to be stipulated as a condition in the contract for earlier payment

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settlement. According to AAOIFI Sharī`ah standards, the practice of rebate or ibra` is permissible provided this is not contractually agreed upon in the contract, that is, this form of pre-payment and rebate is not essentially valid to be incorporated. This term is incorporated by stating that, in the case of a pre-payment, the bank may give a rebate based on the bank’s sole discretion, and this is done without providing any formula of rebate.

On the other hand, it is permissible if the creditor gives a rebate or discount voluntarily without prior condition in the contract. Accordingly, the Islamic banks cannot stipulate in the document agreement clause of the rebate on early payment, nor can the client officially claim his right to receive discount upon early settlement.12

The practice in Malaysia is based on the guidelines of Bank Negara, which allows this clause to be incorporated in the legal documentation because of the uncertainty and ambiguity that should be removed in the legal agreement. The clause is drafted as follows:

The Bank shall grant rebate (Ibra`) to the Customer if, but not lim-ited to the following events:

a. The Customer makes early settlement or early redemption, including those arising from prepayments;

b. In the event of early commencement of Monthly Installment prior to the expiry of grace profit period (for properties under construction);

c. In the event the Effective Profit Rate is lower than the Ceiling Profit Rate; and

d. In the event the actual disbursed amount is less than the Bank’s Purchase Price.

For avoidance of doubt, it is hereby acknowledged and agreed that the rebates referred to herein shall not be construed in any manner whatsoever as cash rebate payable to the Customer, but shall be reflected as a reduction in the profit element of the installments of the Facility. The rebate shall only be deemed granted upon receipt of the settlement/redemption sum as determined by the Bank based on the following formula:

Outstanding Bank’s Selling Price (LESS) Outstanding Financing Amount (LESS) Other Amount Due to the Bank

The Sharī`ah Advisory Council of Bank Negara Malaysia has issued a resolution on ibra` in 2000, where IFIs may incorporate a clause on the under-taking to provide ibra` to customers who make early settlement in the financ-ing agreement on the basis of public interest (maslahah). With the inclusion

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of ibra` clause in the financing agreement an IFI is required to honour the undertaking or promise to grant ibra` to its customers. In line with the need to safeguard the maslahah (public interest) and to ensure that customer protec-tion is carried out consistently, the SAC in its 101st meeting on May 20, 2010, further resolved the following:

■■ The bank may obligate IFIs to grant ibra` to customers of sale-based financing.

■■ In order to eliminate uncertainties pertaining to customers’ rights in receiving ibra` from IFIs, the granting of ibra` must be included as a clause in the legal documentation of the financing.

■■ To enhance the transparency between contracting parties, IFIs shall provide a payment schedule that discloses the amount owed by the customer and the estimated ibra` that might be received at a certain date to its customers.13

8.8. POTENTIAL AREA OF SHARl `AH NON-COMPLIANCE RISK

8.8.1. Fixed Rate and Floating Rate in the Debt Financing Facilities

The nature of fixed-rate financing would enable the clients to plan their cash flow since monthly payment is fixed throughout the financing period. Some customers might prefer to have this kind of facility, instead of having equiva-lent conventional products, which are floating rate in nature, because the payment of the selling price will be fixed and settled by installment over a long-term period. The worker with fix income can plan his payment properly without affecting his other monthly budgets. It is argued by some that the fixed-rate method of financing might affect the competitiveness as well as the viability of Islamic banks, and sometimes it is not a preferred mode of financing to some clients.

The fluctuation of interest rate sometimes will affect the preference of the client if the interest rates are climbing. These clients would choose fixed rate financing facility, in which BBA is prominent to lock the payment price to protect themselves against the increasing trend of interest rates. But when the interest rates are in a decreasing mode, they will convert their financing to interest-based financing facilities for a relatively lower payment. So, the fluctu-ation of interest rates in the market will definitely affect the demand for BBA and other Islamic fixed-rate modes of financing. Besides, the fixed-rate modes of financing have also resulted in a funding mismatch to the Islamic financial institutions because their long-term financing was funded by short-term bank deposits, which can give variable returns. It is a disadvantage to Islamic banks

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as they have locked in their financing profit rates over a long period, while they have to give a competitive rate of return to their depositors; otherwise these depositors will shift their deposits to the conventional banks, which can offer a better rate of return. So, Islamic banks are placed in a very difficult situation. They have to maintain a competitive rate of return and, at the same time, they cannot change the profit rate of the concluded fixed-rate contracts. It is argued that this fixed-rate and price-rigidity factors have rendered Islamic banks to be very vulnerable to economic and interest-rate volatility.

Bank Negara Malaysia had come out with the first variable-rate financ-ing product based on the concept of BBA. Under this BBA financing with ibra` features, the selling price of the asset sold to the customer on deferred terms would be fixed at a profit rate known as the ceiling profit rate. Contrary to the BBA fixed rate, the periodical installments of this financing will fluctuate and vary depending on certain benchmarks and the spread on the customer for a particular period.14

8.8.1.1. Example To illustrate the aforementioned ibra` concept, consider the following example: If the original monthly installment was RM 1,000.00, but the financing payment plus profit rate of that month (calculated based on certain benchmarks such as BFR plus margin) is lower, certain ibra` will be given to the client, in order to reduce the monthly installments to match those of the current market level. If the interest rate increases beyond the monthly installment payment (BFR plus margin), the effective profit rate will remain at the ceiling rate. This means that the client will only have to pay the installment at not more than the ceiling price that has been agreed upon upfront. It means that the ibra` will be calculated on a monthly basis and will differ from one month to another. On the maturity of the financing, the total installments will be calculated and they should not exceed the original selling price. Any shortfall will be treated as an ibra` (rebate) given to the client. Such variable rate financing products will be able to reduce the vulnerabilities of Islamic banks, especially in a dual banking environment where the Islamic banking system operates in parallel with a conventional financial system. The flexibility of this financial instrument has also manifested the compatibility of the Sharī`ah in providing a necessary mechanism to manage and mitigate risk in the modern financial setting.15 (See Figure 8.1.)

As result of the structure of the floating rate just described, the payment in legal documentation is drafted as follows:

Since effective rate will change based on movement of BFR, the number of installments to fully settle the financing may as such be lesser or more than the prescribed number of installments. In circumstances where BFR continues to increase, the number of

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installments and/or installment amount may increase but the total installments to be collected shall not exceed the bank’s sale price.

The clause is drafted also in other banking documents such as muraba-hah vehicle term financing facility agreement under the clause variable-rate financing as follows:

a. For facility granted based on variable rate financing, the parties agree that the Bank’s selling price shall be calculated based on the ceiling profit rate; however, the actual payment of the Bank’s selling price as may be due and payable to the Bank shall be calculated based on the effective profit rate.

b. Notwithstanding the agreed ceiling profit rate, the Bank agrees that during the tenure of the facility, the customer will pay the Bank’s selling price to be calculated at the effective profit rate as may be advised by the Bank from time to time.

c. The effective profit rate may vary according to the changes of the Bank’s BFR.

d. The Bank may notify any change of the BFR in any manner as the Bank may deem fit, which may include by way of placing in one issue of a daily newspaper a general notice of change of the BFR addressed to public generally or by displaying at the prem-ises of the Bank a general notice of change of BFR addressed to its customers generally.

FIGURE 8.1 BBA Variable Rate Financing: Home Financing Is Fixed at 12 Percent, Variable between 4 and 12 Percent

Contractualagreement

Financing tenure (e.g., months) End of tenure

Ceiling rate

RM

2,000

1,700

1,500

Pro�tRate(%)

12

11

4

Monthly rebate given at each installment

Effective monthly installments

1 2 3 4 5…

Effective rate

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8.8.2. Variation of Installment or Tenure

Variation of installment or tenure is a result of the floating rate. There is a clause in the legal documentation that governs the variation of installment payment or tenure as a result of that. The clause is drafted in banking docu-ments such as murabahah vehicle term financing facility agreement under the clause of variation of installment or tenure as follows:

a. The customer agrees and acknowledges that the installment set out in this agreement has been based on the prevailing effective profit rate. The customer further agrees and acknowledges that the amount of the installment may change if and every time there is a change in the BFR.16

b. If and whenever the BFR changes, the Bank may at its dis-cretion make the necessary adjustment consequential to such change of BFR by either: i. varying the amount of installment; or ii. varying the number of installment payable under the facility; or iii. extending the tenure of the facility; or iv. all or any of the combination of the above.

c. For avoidance of doubt, the provision of this clause shall not be applicable if the facility is granted on a fixed rate basis.

d. The Bank will notify the customer of any change of rate or revision of terms of payment, at least twenty one (21) days prior to the effective date of implementation of the said change or revision.

8.8.3. Risk Taking in the Financial Transaction

The risk taking in the business transaction is one of the requirements for entitle-ment of the reward and profit. From Sharī`ah perspective, the profit is always associated with the risk, based on the legal maxim al kharaj bi dhaman, the profit should be accompanied by risk and responsibility. Hence, the reward is associated with risk taking. This concept is supported as well by the legal maxim al ghorm bi ghonm. Besides the risk, there are other important compo-nents for reward entitlement such as work and responsibility. In conventional banking, the issue is not addressed; risk taking is not considered as one of pre-requirement for the bank’s reward. In conventional banking, the return and profit is based on interest rate that is fixed, predetermined, and guaranteed, regardless of the type of risk element undertaken. The risk in the conventional system is transferred, whereas in Islamic banking it is often shared, whereby the Islamic bank and the client will share different types of risk in different capacity depending on the on-going process and progress of the contract agreed upon. Normally, each one is entitled for reward based on the type risk of taken.

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8.8.4. Third-Party Collateral

In some banking facility, the bank requests the applicant to provide col-lateral in order to grant the facility financing if the client has extra proper-ties to be charged to the bank. However, if the client has no property to be charged to the bank, a third party may get involved to pledge his property in favour of the bank to facilitate the grant of the facility to the client.

From Sharīàh point of view, it is permissible to create a legal charge over a property that belongs to a third party at his own responsibility and risk. If the collateral is charged through a letter of gift in favour of the applicant, where the hibah facilitates the charge process, the ownership is transferred to the applicant, to be then charged in favour of the bank. The third party must be aware of the consequences of his action in charging his property to the bank and the legal effect of the letter of gift issued to the applicant. The transaction of the letter of gift should be secured to protect the rights of both parties. Alternatively, a third party is given charge, with consent, whereby the owner of the asset will declare consent over his asset in favour to the bank. The hibah contract will be kept by the bank as security documents until the maturity of the financing tenor.

8.8.5. BBA Financing: Selling of the Nonexistent

BBA is one of the facilities in Islamic banking related in Malaysia to different applications. One of them is property business that includes the properties under construction as well. The banks offered BBA home financing as part of the facilities. The issue here arises from the nature of the subject matter of the contract, which is not in existence. This situation may trigger the Sharīàh non-compliant risk from the perspective of the majority of the scholars. Even though there is an agreement to deliver the property with full specification at a due date but still ambiguity and conflict may arise. Dispute is expected, especially when there is a delay in delivery. The convenient financing mode for property financing under construction is an istisna` contract, which is suitable for projects under construction and housing under development. The financing banking mode of the IFI will be based on the parallel istisna based on future delivery of the asset.

The BBA home financing under construction is a form of bay madu’m. However, it should be noted that in a typical sale contract, one of the condi-tions is that the mahal al-àqd or ma`qudalaih (objects of trade) to be traded must exist when the contract is being made. Purchase of an object that does not exist when the contract is being made is considered bai` ma`dum.

The issue was discussed by Islamic jurists when they were debating the condition of an object in a contract of sale. The Hanafi and SyafiÌ

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Mazhab pronounced that the object of sale must be in existence at the time the contract is made. Otherwise, the contract will be deemed invalid because anything that is ma`dum cannot be owned. However, exemption was made to the salam, ijarah, and istisna`contracts, based on the istih-san principle. The Maliki echoed the opinion of the Hanaf I and SyafiÌ regarding muàwadhat maliyah (exchange contract), whereas for the tabarruàt (ownership contract on voluntary basis) such as hibah, they did not impose any condition for an existing object. What was important was that it was expected to exist in the future. The Hanbali Mazhab, on the other hand, did not stipulate this condition. What was important was that a contract should not contain elements of gharar, which is forbidden by Sharīàh.

Ibnu Taimiyah and Ibnu al-Qayyim analysed the question of bai` ma`dum and concluded a sale was forbidden not because of ma`dum during the contract making, but rather because of the existence of gharar, which is a forbidden element.

This was based on the following arguments: Neither the Quran, the Sunnah nor the Prophet’s companions stated that bai` ma`dum was not permissible. However, a hadith prohibiting the sale of certain goods with features that did not exist. The prohibition was also for goods that are avail-able but simply did not exist at the point of trade. This showed that the pro-hibition was due to the existence of the gharar element in the trade. There are specific situations where bai` ma`dum is permissible by Sharīàh and considered valid. An example is the sale of fruits and grains that are about to mature. This is considered bai` ma`dum because the buyer cannot take delivery of the goods and has to wait until the fruits or grains mature. The salam, istisna`, and ijarah contracts are other examples of bai` ma`dum that are permissible based on the principle of istihsan.

All of these examples show that selling something that has not yet existed or is not yet in the seller’s possession at the point of the sale is not forbid-den merely because of its ma`dum nature.17 Hence drafting the legal docu-mentation in BBA home financing is based on the views of Ibn Taymiyyah if the Sharīàh board of the bank subscribe to that view to mitigate the Sharīàh non-compliance risk. However, istisna remain the best contract that suits the portfolio of selling assets to be manufactured or constructed in the future.

In fact, if we look at the housing development (control and licensing) ACT 1966. Schedule G, the third schedule clause 4 (1), the schedule of pay-ment of purchase price, can easily be adjusted to an istisna contract. See Table 8.1. We can see the payment progress moving passively along with the progress of the construction [Housing Development (control and licensing) ACT 1966, schedule G, the third schedule clause 4 (1)].

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TABLE 8.1 Payment Installments for Home Financing

Installments Payable % Amount

1 Immediately upon the signing of this agreement 10 RM

2 Within 21 working days after receipt by the purchaser of the vendor’s written notice of the completion of: a. The foundation and footing works of the said

building; b. The reinforced concrete framework of the said

building c. The walls of the said building with door and

window frames placed in position d. The roofing, electrical wiring, plumbing (without

fittings), gas piping (if any), and internal telephone trunking and cabling to the said building

e. The internal and external plastering of the said building

f. The sewerage works serving the said building g. The drains serving the said building h. The road serving the said building

10

15

10

10

10

555

RM

3 On the date the purchaser takes vacant possession of the said building, with water and electricity supply ready for connection

12.5 RM

4 Within 21 working days after receipt by the purchaser or the purchaser’s solicitors of the separate document of title to the said lot, together with a valid and registrable memorandum of transfer to the purchaser duly executed by the vendor or on the date the purchaser takes vacant possession of the said building, whichever is later

2.5 RM

5 On the date the purchaser takes vacant possession of the said building as in item 3 and to be held by the vendor’s solicitor as stakeholder for payment to the vendor as follows: a. 2.5% at the expiration of 6 months after the

date the purchaser takes vacant possession of the said building;

b. 2.5% at the expiration of 18 months after the date the purchaser takes vacant possession of the said building.

5 RM

Total 100 RM

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8.8.6. Bai` ìnah Transaction in BBA Home-Financing Legal Documentation

The transaction of inaah appears after acquiring beneficial ownership over the property. By concluding the S&P contract agreement, the client will sell the property to the bank, which will subsequently resell the property back to the client based on bay al Innah transaction. Innah concept in the transaction is part of the procedure in BBA facility home financing in Malaysia and the doc-umentations clearly reflect this transaction. BBA is based on combinations of few agreements; one of them is inna contract. Hence, the structure does not demon-strate BBA contract only; rather, it is a combination of more than one contract.

It should be noted that the SAC of BNM, at its fifth meeting on January 29, 1997, passed a resolution that Bai` ìnah is a principle that is permis-sible in the Islamic capital market in Malaysia. Bai` ìnah refers to trading whereby the seller sells his assets to the buyer at an agreed selling price to be paid by the buyer at a later date. After that, the buyer immediately sells back the assets to the seller at a cash price, lower than the agreed selling price.

The majority of Islamic jurists state that there are three forms of trading categorised as Bai` inah, whereby it can be concluded that all the assets sold come from the financier. The financier will sell a product to the buyer at an agreed price to be paid later. The financier then immediately buys back the asset at a cash price lower than the deferred selling price.

Past Islamic jurists had differing views on determining the hukm on Bai` ìnah. The following were their views: The majority of scholars were of the opinion that Bai` ìnah was not permissible because it was the zari’ah (way) or hilah (legal excuse) to legitimise riba (usury). The Hanafi was of the opinion that Bai` ìnah was permissible only if it involved a third party, which would act as an intermediary between the seller (creditor) and buyer (debtor). The Maliki and Hanbali on the other hand, rejected Bai` ìnah and considered it invalid. Their opinion was based on the principle of sadd zariàh, which aims to prevent practices that can lead to forbidden acts such as, in this case, riba.

The basis for the opinion of the majority of the Islamic jurists was the had-ith dialogue between Aishah and Zaid bin al-Arqam, which showed the prohi-bition of Bai` inah. They also held to the hadith of the Prophet (s.a.w) in which he warned that those who practised Bai` ìnah would suffer scorn. The Syafiì and Zahiri Mazhab viewed Bai` ìnah as permissible. A contract was valued by what is disclosed and one’s niyyah (intention) was up to Allah s.w.t. to judge.

They criticised the hadith used by the majority of the Islamic jurists as the basis for their argument, saying that it (the hadith) was weak and, therefore, could not be used as the basis for the hukm. The SAC decided to accept the opinions of the Syafiì and Zahiri Mazhab in permitting Bai` inah. Therefore, it can be developed into a product for the Islamic capital market in Malaysia. When institutions or individuals are in need

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of capital for a specific purpose they can utilise this method of payment, using their assets as mortgage. Because they still need the assets, this method allows them to liquidate without losing the asset.

Revisiting the Rulings on Bai ` ìnah The regional Sharīàh dialogue that was held on June 28–29, 2006, aims at harmonising and promoting understand-ing amongst the Sharīàh scholars who are involved in Islamic finance. The dialogue had specifically focused on finding the best solution to resolve the issue of the use of Bai` ìnah and tawarruq in Islamic financial system. The council and the participating Sharīàh scholars had taken a comprehensive approach with regard to Bai` ìnah and tawarruq transactions.

Resolution The council in the regional Sharīàh scholars dialogue on June 29, 2006, or JamadilAkhir3, 1427 resolved that:

1. The permissibility of Bai` ìnah and tawarruq is still a matter of juristic disagreement among the Sharīàh scholars backed by their own basis of justifications.

2. The basis relied on to justify the permissibility of tawarruq is similar to the basis to justify the permissibility of Bai` ìnah. Therefore, both concepts shall be ruled similarly.

3. Bai` inah concept is still necessary in the context of local Islamic finance development. However, the market players are required to strengthen and enhance the operational process and documentation to comply with the features of Bai` ìnah as permitted.

4. Since Bai` ìnah concept is still regarded as a matter of juristic disagree-ment among the Sharīàh scholars, it is more desirable that Islamic financial institutions limit its use in products that face difficulty in struc-turing them based on other consensually accepted contracts.18

The SAC, in its 16th meeting dated November 11, 2000, and 82nd meeting on February 17, 2009, has resolved that a valid Bai` ìnah contract shall fulfill the following conditions:

1. Consist of two clear and separate contracts, namely, a purchase contract and a sale contract.

2. Has no stipulated condition in the contract to repurchase the asset. 3. Both contracts are concluded at different times. 4. The sequence of each contract is correct, whereby the first sale con-

tract shall have been completed before the conclusion of the second sale contract.

5. The transfer of ownership of the asset and a valid possession (qabd) of the asset in accordance with Sharīàh and current business practice (urf tijari).19

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The SAC, in its 8th meeting on December 12, 1998, has resolved that the transaction based on Bai` ìnah in the Islamic Interbank Money Market is permissible, subject to the following conditions:

1. The Bai` ìnah transaction shall follow the methods acceptable by the Shafi’i school of law.

2. The transacted goods shall be non-ribawi items.

The SAC, in its 82nd meeting on February 17, 2009, has resolved that the stipulation to repurchase the asset in a Bai` ìnah contract will render the contract as void.

With regard to the issue of intercondionality of the ìnah contract, it is known in the resolution of the SAC as the Stipulation to Repurchase an Asset in a Bai` ìnah Contract. The SAC was referred to on the issue of whether the stipulation to repurchase the asset (interconditionality) may be incorporated into both agreements of bay bithamanajil (BBA) based on Bai` ìnah, namely, the property purchase agreement and the property sale agreement for home financing concluded between the Islamic financial insti-tution and the customer. This stipulation to repurchase is normally included in the document that indicates the seller’s undertaking to repurchase the asset from the buyer, especially in the recital of the agreement, marketing brochures, supplementary documents, appendixes, and others.

8.8.7. Transfer of Ownership

The BBA along with the other debt financing facilities is a contract of sale that requires the transfer of the ownership as a result of the financial transaction. It should be noted that BBA financing mode is a sale contract where the possession (al-qabd) of the subject matter should truly happen, because the BBA is not loan for financing but real financial transaction based on the exchange of the subject matter of the contract. This Sharīàh requirement was imposed in order to ensure that the seller is selling what he possesses. The possession can be proven according to the custom, whether it is a physical possession or constructive possession. The issue is how to prove ownership in an exchange contract. Is it through legal title as required by the law or through fulfillment of the pillars of the contract along with their conditions such as offer and acceptance as required by Sharīàh?

The issue is subject to different views and interpretations, which result in different practices. From a Sharīàh perspective, the transfer of the owner-ship of an asset is effected through offer and acceptance, which is expressed verbally or through others means that convey the consent of the contracting parties. The legal documentation is a process to document and record the

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transaction concluded through offer and acceptance in order to protect the rights and obligation of the contracting parties. This means that if the asset is sold through offer and acceptance, the buyer assumes the ownership of the asset even though the legal title belongs to someone else. In fact we should distinguish between two cases: The first case is trading with the objective of claiming permanent ownership over the asset. In this case, the offer and acceptance should be followed by the transfer of the legal title to secure the interest of the buyer. The second case is trading with the objective to resell the object of the trade or to recycle it in the market from hand to hand. In this case, the offer and acceptance will be sufficient to claim the ownership of the asset without a need to transfer the legal title as long as there is evidence that shows that the contract has been concluded and the asset belongs to the buyer (such deed of assignment in the property business). Hence, the transfer of the legal title, which is a legal requirement, is an option to the buyer from a Sharīàh perspective. Hence, the ownership is not necessary to be evidenced by the legal title but also through documented offer and acceptance.

8.8.8. Using LIBOR in Profit as Benchmark

There is no doubt that LIBOR (London Interbank Offered Rate) is interest-based, implemented by the conventional financial institutions; it is used widely and accepted internationally. The practice shows that murabahah profit is determined based on the current interest rate, and mark-up is determined by murabahah whether equal to LIBOR or above it. This implementation of LIBOR as benchmark in Islamic financial transaction has been debated among contemporary scholars.

The argument here is that using the conventional benchmark makes the Islamic financial transaction similar to conventional transaction and the financing mode based on an interest-based financing shows some appar-ent resemblance, which is not preferable. We have to take note that using LIBOR as benchmark and tying up the murabah transaction accordingly is not acceptable. However, using LIBOR as indication for profit rate is accepted and it does not make the transaction invalid. The important Sharīàh requirement here is that murabahah should fulfill all the terms and conditions imposed by the Sharīàh.

Example: A and B are two brothers. A trades in liquor, which is totally prohibited in Sharīàh. B starts a business of soft drinks, but he wants his business to earn as much profit as A earns through trading in liquor. Therefore, he resolves that he will charge the same rate of profit from his customers as A charges over the sale of liquor. Thus, he has tied up his rate of profit with the rate used by A in his prohibited business. One may

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question the propriety of his approach in determining the rate of his profit, but, obviously, no one can say that the profit charged by him in his halal business is haram, because he has used the rate of profit of the business of liquor as a benchmark.

However, using LIBOR as a benchmark is still a challenge for the Islamic banking industries in order to achieve a full Islamic process flow for any financial banking transaction, because the interest rate will be taken as an ideal for Islamic business transaction and flag for halal product. Furthermore, the non-halal product cannot survive and grow in the Islamic system and Islamic environment, due to the implication of the issue in the financial system. Usmani says:

The Islamic banks and the financial institutions should strive for developing their own benchmark. This can be done by creating their own inter-bank market base on Islamic principles. The pur-pose can be achieved by creating a common pool which invests in asset-backed instruments like musharakah, Ijarah etc. If majority of the assets of the pool is in tangible form, like leased property or equipment and shares in business concerns etc. its units can be sold and purchased on the basis of their net asset value determined on periodical basis. These units may be negotiable and may be used for overnight financing as well. The banks having surplus liquidity, they can purchase these units and when they need liquidity can sell them. This arrangement may create interbank market and the value of the units may serve as indicator for determining the profit in muraba-hah and leasing also.20

It is recommended that the Islamic banks should move away from LIBOR and have belief in the global Islamic banking industries so that they are able to create an Islamic system to replace LIBOR with the will and sup-port of the political decision of OIC countries, which represent the key of success for this shift.

Since the establishment of the first Islamic commercial bank in 1975, the Islamic finance industry has been searching for an indigenous benchmark that can be applicable to transactions compliant with Islamic law (Sharī`ah compliant).21 As an ethical financial system, Islamic finance prohibits inter-est and shuns all interest-related transactions and instruments as these are contradictory to the core principles of Islam. Despite this prohibition, in the absence of a reliable Islamic interbank benchmark, Islamic banks and financial institutions have continued to utilise conventional interest-based benchmarks to calculate their cost of funding with no reference to either

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their assets’ risk profile or the regional particularities of Islamic banks. The Islamic Interbank Benchmark Rate (IIBR) serves to address some of these concerns by developing a rate that is contributed by and is indigenous to a global panel of Islamic banks and Islamic Banking windows with fully seg-regated funds. (See Figure 8.2.)

Uses of the Benchmark

■■ Pricing of common overnight to short-term treasury investment and financing instruments such as murabaha, wakala, and mudaraba.

■■ Pricing of retail financing instruments such as property finance, car finance, and other asset financing.

■■ Pricing/benchmarking of corporate finance and investment assets.■■ Pricing of sukuk and other Sharīàh-compliant fixed income instruments.■■ Official incorporation possible for pricing onto confirmations/annexes

related to the Sharīàh-Compliant Hedging Master Agreements.

Methodology

■■ Rates for Sharīàh-compliant U.S. dollar (USD) funding in reasonable market size are contributed via Thomson Reuters systems each busi-ness day between 9:00 a.m. and 10:44 a.m. (Makkah time–GMT+3) by a panel of 16 Islamic banks or fully segregated Islamic banking windows.

FIGURE 8.2 Methodology of the IIBRSource: Thomson Reuters (http://thomsonreuters.com/site/islamic-interbank-bench mark-rate/definition-methodology-criteria/).

SelectedContributing

Banks

Islamic Benchmark Committee

ThomsonReuters

TerminalsRates Data

FixingIIBR

BY 11:00 a.m.Makkah time

BY 10:45 a.m.Makkah time

Sharīàh Compliance

Guidance and Supervision

Sharīàh Committee

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http://thomsonreuters.com/site/islamic-interbank-benchmark-rate/definition-methodology-criteria/

http://thomsonreuters.com/site/islamic-interbank-benchmark-rate/definition-methodology-criteria/


■■ The panel banks contribute their rate based on a pre-defined question specified by the Islamic benchmark committee and approved by the Sharīàh committee.

■■ The rates are snapped by Thomson Reuters at 10:45 a.m. Thomson Reuters undertakes both automated and manual audit and review procedures at this stage to ensure that the rates contributed are genuine.

■■ The rates are ranked from highest to lowest and the top and bottom quartiles (25 percent) of the rates are excluded to ensure that outliers do not influence the distribution (from 16 contributed rates, 8 rates are excluded—4 each of the highest and lowest rates).

■■ The arithmetic mean (average) of the remaining mid quartiles’ values is then calculated to produce the IIBR, rounded to 5 decimal places.

The calculation methodology is very similar to the calculation method-ology of interest-based benchmarks such as the LIBOR. If that is the case, then what’s the difference?

The fundamental difference is that benchmarks such as LIBOR measure interest, whereas IIBR measures profit. Thomson Reuters calculates hundreds of fixings in various markets globally. The methodology utilised represents a time-tested mechanism to calculate the average cost of funding for any market. A key maxim of Islamic jurisprudence suggests that, in the matter of commercial transactions, everything is deemed permissible unless explicitly stated otherwise. As long as the transacting parties adhere to the principles of Islamic jurisprudence while applying the benchmark to their transaction, it is acceptable to utilise a consensus methodology for the rate fixing.

The banks in conventional fixes are principally involved in interest-based borrowing and lending and are contributing quotes for how much interest they must pay were they to raise funding. The IIBR contributor banks are all either Islamic banks or banks with fully segregated Islamic banking windows and hence limited to only investing in Sharīàh-compliant assets.

Further, a critical difference between the IIBR and interest-based benchmarks is what exactly they are contributing when they are quoting their rates. The Islamic banks are contributing the rate they would have to distribute to an investor, if they were to raise Sharīàh-compliant funds, considering the risk profile of the Islamic banks’ underlying assets. The specific question asked to each contributing bank is: “What is the expected profit rate that you would distribute for an interbank Sharīàh-compliant funding transaction, were you to do so by asking for and then accepting interbank offers for a market amount of U.S. dollars for the tenors speci-fied below?”

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Finally, the IIBR is guided by a panel of major Islamic banks and approved by a Sharī`ah committee of internationally renowned scholars.

In treasury or money-market operations, banks expect to earn a return on their money or “interest” not necessarily linked to utilizing the funds for any productive activity. What’s the difference here?

Unlike conventional treasury operations, Islamic treasury transactions are always related to real Sharī`ah-compliant trade (bay`) and investment (istithmar) transactions such as murabahah (cost plus) or wakala (invest-ment agency) or mudarabah (investment management) that the bank under-takes either as a seller, an agent (wakil), or investment manager (mudarib), respectively. Hence, it is necessarily invested in assets that generate return either through sale or yields produced from the underlying investable assets.

Why not build a benchmark based on real economic indicators, for instance CPI, GDP growth, and the performance of the financial or other sectors of the economy?

The ultimate criterion for the industry-wide adoption of any bench-mark, particularly one that is published every business day, is the simplicity, reliability, and robustness of its methodology. Additionally, to engender the confidence of financial markets participants, an interbank benchmark must be calculated on every business day with a transparent and simple method-ology open to public scrutiny. Benchmarks such as CPI, GDP, growth, and performance are subject to much more volatility, less frequency, and are less opaque in the process by which the underlying metric is calculated. Further, these measures tend to lag far behind market conditions to the extent that they are rendered irrelevant by market participants by the time they are pub-lished. Instead, the IIBR will be a lead-indicator able to react to prevailing market conditions on a day-to-day basis.

If the IIBR is meant to be a global benchmark for the Islamic mar-kets, then why are most of the contributor banks in the Gulf Cooperation Council (GCC) countries?

To publish a reliable and realistic benchmark for any interbank transac-tion, the currency for the benchmark must be uniform across all contributors, as rate differentials are present and sometimes accentuated across currencies. The unique benefit of including GCC banks is that most, if not all, of these banks have substantial reserves/exposure in U.S. dollars, in addition to the fact that five out of the six countries peg their currencies to the U.S. dollar. This effectively allows for a broader representation of banks from various Islamic markets while still remaining within the risk parameters of one currency. In addition, the U.S. dollar still represents the most liquid currency, and most international sukuk continue to be issued in U.S. dollars. It is intended that going forward, other contributor banks in non-GCC countries will apply to participate in the U.S. dollar benchmark to make the benchmark more inclusive and global. On a more

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strategic level, the GCC-based benchmark can be considered one of the precur-sors of a truly global and economically integrated Islamic financial market.

8.8.9. Securities or Collateral in BBA and Debt Financing Facilities

The nature of murabahah financing is that the payment is settled later on installment bases, but the commodity is handed over to the client and the amount is practically paid. Due to this deferred payment arrangement, the bank may request a security for the payment of the transaction to mitigate the risk of the financing. In this regard, the bank will ask for some mortgage to be charged to satisfy the bank financing. At this stage, the relationship between the client and bank is creditor and debtor. It is allowed that the cli-ent provides a mortgage to the financial institution. According to the Islamic rules pertaining to mortgage, the rahn will remain at the bank risk if the charge is under bank custody. If the security remains with the customer for usage, the risk remains with the customer. The party that handles the asset physically will be responsible for any damage that may occur, until the full settlement of the debt, when the mortgage will be released accordingly. The practice shows that the sold property is given to the financier seller as a mort-gage. Under BBA, the property is sold to the customer and no longer belongs to the bank; what remains is the debt that is secured by the said property.

However, there are some rules pertaining to security that must be observed as follows:

■■ The security can be claimed rightfully where the transaction has created a liability or debt, and no security can be asked from a person who has not incurred a liability or debt. In case of third-party security and guar-antee, the security arrangement is between the client and the third party, not between the bank and third party.

■■ It is permissible that the sold commodity itself is given to the seller as security. Some scholars are of the opinion that this can be done only after the purchaser has taken its delivery and not before. It means that the purchaser shall take its delivery, either physical or constructive from the seller than give it back to him as mortgage in order to distinguish the transaction of sale from transaction of mortgage. According to Taqi Usmani, this condition is required in a cash sale transaction only and not in credit sales. Therefore, it is not necessary that the purchaser take the delivery of the sold property before he surrenders it as mortgage to the seller. The only requirement would be that the point of time when the property is held to be mortgaged should necessarily be specified because, from that point of time, the property will be held by the seller in a different capacity, which should be clearly earmarked.22

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8.8.10. Rescheduling of Payments in BBA and Debt Financing Facilities

Obviously, rescheduling of payment arises when the purchaser is not able to pay the debt of the financing according to the agreement with the bank or the financial institutions. However, the issue of rescheduling BBA financing has the same Sharīàh implication as rollover. Basically, BBA is a banking facility based on sale related to commodity with fixed price agreed upon upfront. The request of the client to reschedule the installment of BBA should not be treated as a loan. The practice of conventional bank in rescheduling the facility is based on the nature of treatment of the bank to the transaction, which is based on loan, and allows the bank to be entitled to additional interest accordingly. This financing treatment and banking approach trigger a Sharīàh non-compliance risk. If the bank wants to engage in rescheduling BBA, it should be without any additional charges to the original amount (selling price) agreed upon. The original selling price remains as it is by hav-ing the same amount in the same currency.23 However, the amount can be revised and the tenor can be extended within the amount predetermined in the contract agreement that represents the selling price.

8.8.11. Securitization of BBA Debt

This issue is related to the possibility of pulling BBA to the capital mar-ket as a major segment in Islamic finance by securitizing BBA and issuing sukuk, which is a negotiable instrument to be traded in the secondary mar-ket. According to the Sharīàh requirement in securitization, BBA cannot be securitized, because it represents monetary debt receivable; therefore, the monetary obligation arising out from BBA cannot be used to issue sukuk. The monetary debt of BBA should be treated and transferred at par value. The only possibility that BBA can be securitized is in the case of a mixed portfolio consisting of a number of transactions, such as BBA leasing. This mixed portfolio can be used to issue a negotiable instrument subject to some conditions.24

According to AAOIFI pronouncement, sukuk must not represent debt or receivables. Sukuk representing receivables or debt are not tradable; therefore, securitization must be purely based on assets, usufruct, or ser-vices, except in the case in which the financial institution is selling all its assets including the receivables as part of it. A mixed portfolio that con-sists of physical assets and debt or some receivable, whereby the debt and receivables are included incidental is in accordance with the AAOIFI stan-dard 21 regarding the financial papers in which it allows the trading of sukuk backed by a portfolio consisting of a hybrid asset made up of debts,

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receivables, and physical assets, where the later constitutes at least 30 per-cent of the portfolio.25

NOTES

1. AAOIFI, Sharīàh standards, English ed. (Bahrain: Accounting and Auditing Organization for Islamic Financial Institutions, 2004), 451.

2. Ibid., 452.3. Ibid.4. Ibid., 453.5. Ibid., 454.6. Ibid., 455.7. International Centre for Education in Islamic Finance, Applied Sharīàh Rules

in Financial Transactions, CIFP Module (Kuala Lumpur, Malaysia, 2006), 147.8. Ibid., 142.9. Ibid., 143.

10. Ibid., 144.11. “Da` wataajjal” (give discount and receive soon)—this Prophetic statement is

based on a hadith in which Abdullah ibnMasud was reported to have said that when the Jews belonging to the tribe of Banu Nadir were banished from Madinah (because of their conspiracies) some people came to the Prophet (pbuh) and said; “You have ordered them to be expelled, but some people owe them some debts which have not yet matured.” Thereupon the Prophet (pbuh) said to them (that is, the Jews who were the creditors), “Give discount and receive (your debts) soon.” The majority of the Muslim jurists, however, do not accept this Hadith as authentic. Even if the Hadith is held to be authentic, the exile of Banu Nadir was in the second year after hijrah, when riba was not prohibited yet.

12. See: Muhammad Taqi Usmani, An Introduction to Islamic Finance (Karachi: Maktaba Ma’ariful Quran, 2005), 141–143.

13. Guidelines of Bank Negara Malaysia on Ibra.14. International Centre for Education in Islamic Finance, Applied Sharīàh in

Financial Transaction, CIFP Module (Kuala Lumpur, Malaysia, 2006), 176.15. Ibid.16. BFR: Refer to the base financing rate published by the Central Bank (Bank

Negara Malaysia).17. Resolution of the Securities Commission Sharīàh Advisory Council, 2nd

ed. (Kuala Lumpur, Malaysia: Sharīàh Advisory Council of the Securities Commission, 2009), 24.

18. Sharīàh Advisory Council of Bank Negara, Sharīàh Resolutions in Islamic Finance, 1st ed. (Kuala Lumpur, Malaysia: Bank Negara Malaysia, 2010), 17.

19. Sharīàh Advisory Council of Bank Negara, Sharīàh Resolutions in Islamic Finance, 2nd ed. (Kuala Lumpur, Malaysia: Bank Negara Malaysia, 2010), 113.

20. Usmani, An Introduction to Islamic Finance, 120.21. http://thomsonreuters.com/products_services/financial/islamic_interbank_

benchmark_rate/definition_methodology_criteria, retrieved February 27, 2013.22. Usmani, An Introduction to Islamic Finance, 126–128.

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23. Ibid., 146.24. Usmani, An Introduction to Islamic Finance, 147.25. Ahcene Lahsasna and Umar Idris, “Examination of the AAOIFI Pronouncement

on Sukuk Issuance and Its Implication on the Future Sukuk Structure in the Islamic Capital Market.” Research paper presented at the 6th International Islamic Finance Conference, 2008, Innovation in Islamic Finance: A Fast Track to Global Acceptance, Monash University, October 13–14, 2008.

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209

CHAPTER 9Drafting Legal Documents

9.0. INTRODUCTION

Drafting a legal document is a skill of encapsulating rights, obligations, and liabilities of parties pertaining to a transaction. The drafting is a common word used by legal professionals such as lawyers. The legal draft presented is very precise wording that describes what the contracting parties want, their needs, desired, and objectives. Consent is expressed in legal terms to be made as reference in case of dispute.

9.1. STRUCTURE OF THE LEGAL AGREEMENT/CONTRACT

The following aspects are the most important terms found in the legal docu-ments. Some of them might not be necessarily found in every legal document, such as the preamble:

■■ Title■■ Date■■ Preamble■■ Recitals■■ Parties■■ Definition■■ Interpretation■■ Body of the agreement/contract■■ Boilerplate clauses■■ Miscellaneous■■ Signature■■ Schedule

These terms are explained briefly in the following sections.

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9.1.1. Title

The legal document has a title that describes the scope and the area of the agreement such as interbank wakalah placement agreement, corporate wakalah placement agreement, or master agency agreement, and so forth. The title is mentioned on the first page.

9.1.2. Date

The date of the agreement. The date is mentioned on the first page.

9.1.3. Preamble

The preamble is an introduction to a book or a written document; an introduc-tion to something you say. Normally the preamble is found at the beginning of the agreement. The preamble is an introduction to the legal agreement con-tents and its background. A preamble is an opening statement, introductory statement, preface, part of the statute related to legal documents that explain the purpose of the agreement and its underlying philosophy and history.

Here is a sample of preamble in the interbank murabahah master agree-ment of AIBIM.

THIS AGREEMENT is madeBETWEEN[Insert Name of Deposit Placing Entity] (Company No. •), a com-pany incorporated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Placing Entity] and business address at [Insert Business Address of Deposit Placing Entity] and includes its successors in title and permitted assigns (“the Principal”) of the one part;AND[Insert Name of Deposit Taking Entity] (Company No. •), a com-pany incorporated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Taking Entity] and business address at [Insert Business Address of Deposit Taking Entity] and includes its successors in title and per-mitted assigns (the “Bank”) of the other part.

9.1.4. Recitals

The recital comes after the preamble and before the definition and interpreta-tion. Sometimes it is mention as recital; sometimes it is expressed in different

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Drafting Legal Documents 211

words such as “background,” “introduction,” or “whereas.” Here is a sample of a recital in the inter-bank murabahah master agreement of AIBIM.

WHEREAS:

A. The Bank is carrying on the business of Murabahah activi-ties as part of its investment activities/Islamic banking busi-ness,1 which includes buying and selling of the Merchandise (as herein defined) by way of Murabahah.

B. By an agreement dated [Insert date of Master Agency Agreement](“Master Agency Agreement”) made between the Principal and the Bank, the Principal has agreed to appoint the Bank as its agent to do all acts as the Principal could do itself with respect to the purchase of the Merchandise on a cash basis (“Purchase Transactions”) and the Bank has agreed to accept such appointment on the terms and condi-tions set out therein.

C. The Bank will from time to time enter into arrangement with the Principal whereby, the Bank, upon the completion of each of the Purchase Transactions, may/will2 purchase from the Principal the Merchandise at an agreed sale price for a spot delivery date and a deferred cash consideration on terms and conditions set out in this Agreement (“Sale Transactions”). The Principal as the seller shall always ensure all elements of Murabahah are preserved where the Principal must disclose its profit and cost of the Merchandise to the Bank as the buyer upon the Parties’ (as herein defined) agreement to enter into this transaction.

In some legal documents, such as the asset sale agreement, the recital is spelled out in Article 1, which contains a few sections: Section 1 proj-ect, Section 2 application for financing facility, Section 3 purpose of the facility, Section 4 existing of the indebtedness.

The recital is further introduction to the legal agreement and the nature of the relationship between the contracting parties. Its provides information about the purpose of the agreement, and the parties who are involve in the agreement. There is no right or obligations in the recital but, rather, the fea-tures related to the contract.

9.1.5. Parties

The parties involved in the contract must be clearly identified and mentioned in the legal agreement. Normally the contracting parties will be mentioned on

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the front page and the preamble. The details of each contracting parties must be included such as name, company number, if the company is incor-porated in Malaysia under the Companies Act, 1965, registered office, and business address.

9.1.6. Definition

Definition and interpretation are combined in one section but presented into two subsections. The definition subsection defines specific terms used in the legal agreement. It provides meaning and concept of the key words and terms of the contract. The definition always starts with the word means and the term is always capitalized such as “Business Day,” “Insolvency Proceeding,” and so on.

Example of the definition in the interbank murabahah master agree-ment of AIBIM is as follows:

Incorporated DefinitionsIn this Agreement the following expression shall, unless the

context otherwise requires, have the following meanings:

Bank Means [Insert Name of Deposit Taking Entity] (Company No. •), a company incor-porated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Taking Entity] and business address at [Insert Business Address of Deposit Taking Entity] and includes its successors in title and per-mitted assigns;

Bank’s Confirmation Means the confirmation issued by the Bank to the Principal upon the completion of the Purchase Transaction in the form set out in Appendix 4 herein or in such other form mutually agreed;

Bank’s Offer Means the offer to purchase the Merchan-dise issued by the Bank to the Principal in the form set out in Appendix 5 herein or in such other form mutually agreed;

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Business Day Means a day (excluding Saturday and Sunday) on which commercial banks are open for business in Kuala Lumpur save that to the extent it refers to any payment, in which event the expression “Business Day” shall mean a day (excluding Saturday and Sunday) on which commercial banks are open for business in Kuala Lumpur and London, and, in relation to payments in (i) Dollars, New York; and (ii) any other currency, in the principal financial cen-tre for foreign exchange dealings in such currency;

Insolvency Proceeding

Means a case or proceeding or petition or resolution or any other steps be taken to seek a judgment of or arrangement for insolvency, bankruptcy, composition, reha-bilitation, reorganisation, administration, winding-up, liquidation or other similar relief with respect to a party or its debts or assets or seek the appointment of a trustee, receiver, liquidator, conservator, custodian or other similar official of a party or any substantial part of its assets, under any bank-ruptcy, insolvency or other similar law or any banking, insurance, or similar law governing the operation of a party and any analogous proceeding in any jurisdiction to which a party is subject to;

Master Agency Agreement

Means the Master Agency Agreement dated [Insert date of Master Agency Agreement] made between the Principal and the Bank upon the terms and conditions therein contained and includes any variation, mod-ification and supplement thereof;

Merchandise Means goods and commodities that are acceptable to the Principal and the Bank and valued according to Sharī`ah as set out in Appendix 1 hereto. The “Merchandise”

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shall be goods and commodities other than gold, silver or currency(s) and it also excludes pork, alcoholic drinks, tobacco, narcotics, or any other items which are not acceptable to Sharī`ah, the Principal and the Bank;

Parties or Party Means the parties or party to this Agreement;

Principal Means [Insert Name of Deposit Placing Entity] (Company No. •), a company incor-porated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Placing Entity] and business address at [Insert Business Address of Deposit Placing Entity] and includes its successors in title and permitted assigns;

Principal’s Acceptance Means the Principal’s acceptance of the Bank’s Offer to purchase the Merchandise from the Principal in the form set out in Appendix 6 herein or in such other form mutually agreed;

Purchase Order Means the notice to be issued by the Principal to the Bank as its agent in the form set out in Appendix 3 herein or in such other form mutually agreed indicating the Principal’s wish to pur-chase the Merchandise under the Purchase Transaction;

Purchase Transactions Means the purchases of the Merchandise by the Principal on a cash basis on terms and conditions set out in this Agreement, and “Purchase Transaction” shall refer to any one of them;

Sale Transactions Means the purchases of the Merchandise from the Principal for a spot delivery date and a deferred cash consideration on terms and conditions set out in this Agreement, and “Sale Transaction” shall refer to any one of them;

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Supplier Means the third party, including but not limited to commodity trading houses, com-modity brokers, industrial firms and/or their suppliers, from whom the Merchandise are purchased/to be purchased under the Purchase Transactions; and

Trade Transactions Means collectively the Purchase Transactions and the Sale Transactions.

9.1.7. Interpretation

The interpretation is an important section in the agreement. It provides clear meaning and rules pertaining to some major aspects in the legal agree-ment. The interpretation removes any room for ambiguity and uncertainty throughout the legal document.

Example of the interpretation in the interbank murabahah master agree-ment of AIBIM is as follows:

InterpretationThe headings in this Agreement are inserted for convenience

only and shall not be taken, read, and construed as essential parts of this Agreement.

i. References to clauses or schedules are to be construed as refer-ences to the clauses or schedules of this Agreement.

ii. All references to provisions of any legislation or statute include references to any amendments, any statutory modification and re-enactment thereof or regulations proclamations, by-laws, published rulings, statements of policy or guidelines issued under or in relation to that statute.

iii. References to this Agreement shall include all amendments and modifications to this Agreement as shall from time to time be in force.

iv. Words importing the singular number shall include the plural number and vice versa.

v. Where two or more persons or parties are included or comprised in any expression, agreements, covenants, terms, stipulations and undertakings expressed to be made by or on the part of such persons or parties shall be deemed to be made by and be binding upon such persons or parties jointly and severally.

vi. Words importing the masculine gender shall include the femi-nine and neuter gender and vice versa.

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vii. A reference to a document includes any amendment or supple-ment to, or replacement or novation of that document.

viii. A reference to ‘date’ or ‘time’ is a reference to that date or time in Malaysia.

ix. Any reference to ‘law of Malaysia’ shall be construed so as to include, without limitation, any act, ordinance, statutory or municipal, rule, regulation, ruling, decree, or order enacted, issued or decreed by the Parliament of Malaysia or any bureau, minister, instrument, agency, court, regulatory body, author-ity, legislative body or department thereof (including, without limitation, Bank Negara Malaysia or any taxing, fiscal or other monetary authority thereof) and Islamic law as administered by the courts of Malaysia.

x. Other parts of speech and grammatical forms of a word or phrase defined in this Agreement shall have a corresponding meaning.

In some other agreement such “cash line facility agreement” the interpretation includes statement as follows:

a. Words denoting the singular includes the plural number and vice versa.

b. Words importing the masculine gender include the feminine and neuter genders and vice versa.

c. The headings and sub-headings to articles and Sections in this Agreement are inserted for convenience only and shall be ignored in constructing the provisions of this Agreement.

d. References to Articles and Sections are to be construed as refer-ences to articles and sections of this Agreement, unless stated otherwise.

e. References to the provisions of any legislation include a refer-ence to any statutory modification or re-enactment thereof.

f. Words applicable to nature persons include any body, person, company, corporation, firm or partnership, corporate or other-wise and vice versa.

g. The word “herein,” “hereinafter,” “hereof,” “hereunder,” and other words of similar important shall refer to this Agreement as a whole and not to any particular provision.

h. The words “monies,” “Ringgit Malaysia” and the symbol “RM” shall be construed as Malaysian currency.

i. The schedules and annexure herein shall form an integral part of this Agreement and shall be taken, read and construed as an essential part hereof.

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9.1.8. Body of the Agreement/Contract

The body of the agreement is the core of the contract, it contains most of important clauses that determine the right and obligation of the contract-ing parties. In some financing facilities such as the Murabahah Tawarruq Facility Agreement it is labeled “Facility,” which contains a few sections. There are key terms covered in the body of the agreement such as consider-ation, rights, duties, responsibilities, and so forth.

The following sections are Purchase Transactions, Tax, Sale Transactions, Representations and Warranties, Termination and Notices, and represent the body of the agreement in the interbank murabahah master agreement of AIBIM. Details of these sections are as follows:

2. PURCHASE TRANSACTIONS

2.1. The Principal, pursuant to the Master Agency Agreement, has appointed the Bank to be its agent to purchase the Merchandise under the Purchase Transaction, subject to the terms and condi-tions of this Agreement in accordance with the guidelines detailed in Appendix 1 hereto.2.2. The Parties may proceed to undertake the Purchase Transaction in accordance with the procedure set out in Appendix 2 hereto.2.3. The Parties hereby agree that upon completion of the Purchase Transaction, the title, ownership, rights and interests of the Merchandise shall immediately be transferred to the Principal and the Bank shall immediately enable the Principal to take possession of the Merchandise.2.4. Each Party acknowledges that the Merchandise comprised in a Purchase Transaction shall be capable of physical delivery. The Principal may request for the physical delivery of the Merchandise provided that the Bank shall have received such instruction from the Principal in the Purchase Order.2.5. All costs associated with the physical delivery of the Merchandise as requested by the Principal in accordance with Clause 2.4 above, including the delivery costs, storage costs, and insurance, shall be borne by the Principal.

3. TAX

3.1. The Principal does not wish to enter into any Purchase Transaction with respect to which value added tax (“VAT”) or any other tax is payable and the Bank will not propose any purchase of this kind.

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3.2. All sums payable by the Principal under any Purchase Transaction shall be deemed to be exclusive of VAT and any other tax levied in respect thereof and all sums payable to the Principal under any Sale Transaction shall be inclusive of VAT and any other tax levied in respect thereof.3.3. If it is determined that, notwithstanding Clause 3.1 above, a tax and/or duty is payable with respect to any Trade Transaction by the Principal or the Bank, the Bank shall ensure that the Supplier shall pay to the Principal or the Bank the amount of such tax and any penalty, cost or expense incurred by the Principal or the Bank in relation thereto.3.4. For the purposes of the interpretation of this Clause 3:

a. Any reference to VAT or tax shall be a reference to value added tax charged under any United Kingdom VAT leg-islation or to any similar sales or turnover tax levied or imposed by the governments of the United Kingdom or Malaysia or government of any other jurisdiction where the Merchandise is traded.

b. In Clause 3.3, any reference to a tax shall be a reference to any tax imposed by the United Kingdom or Malaysia or any other jurisdiction where the Merchandise is traded on the income, profits or gains of the Principal arising out of a Trade Transaction, but excluding any tax payable by reason of the residence for tax purposes of the Principal in either the United Kingdom or Malaysia or any other juris-diction where the Merchandise is traded or by reason of the Principal carrying on activities in such jurisdictions other than as contemplated by this Agreement.

4. SALE TRANSACTIONS

4.1. Unless the Principal decides to have the physical delivery of the Merchandise as set out in the Purchase Order and Provided that the Principal shall have received the Bank’s Confirmation, the Bank may/will proceed to undertake any Sale Transaction whereby the Bank may/will purchase the Merchandise from the Principal upon like terms (save as to price) as the Bank purchased such Merchandise on behalf of the Principal from the Supplier under the Purchase Transaction.4.2. Each Sale Transaction shall be entered into by the Bank in accordance with the operational schedule in Appendix 2 hereto.4.3. With respect to each Sale Transaction title, ownership, rights and interests of the Merchandise shall pass to the Bank as purchaser thereof

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immediately following the passing of such title, ownership, rights and interests to the Principal under the relevant Purchase Transaction.4.4. Subject to clause 6.4, the Bank will/may purchase the Merchandise from the Principal on the basis that:

a. All payments to be made by the Bank as purchaser to the Principal pursuant to any Sale Transaction shall be made without any set-off or counterclaim, and in immediately available and transferable funds for good value on the due date thereof to the account of the Principal that the Principal shall from time to time notify the Bank; and

b. All payments to be made by the Bank as purchaser to the Principal shall be without deduction for and free from any present or future taxes, levies, imposts, duties, charges, fees, deductions, withholdings, restrictions or conditions of any nature imposed, levied, collected or assessed by any taxing authority unless the Bank is compelled by law to make any such deduction or withholding. In that event the Bank will ensure that such deduction or withholding does not exceed the minimum legal liability therefore and will pay to the appropriate authorities the amount deducted or withheld and supply a tax deduction certificate to the Principal.

4.5. If any payment due from the Bank as purchaser under any Sale Transaction falls on a day which is not a Business Day, the payment shall be made on the next succeeding Business Day save where the next succeeding Business Day falls in the next calendar month in which event the payment shall be due and made on the day imme-diately preceding the Business Day.4.6. Neither Party hereto shall be liable to the other in respect of a failure to make a delivery of the Merchandise or payment on the due date if such failure is caused (directly or indirectly) by an error or omission of an administrative or operational nature, and funds or the Merchandise (as the case may be) were available to such Party to enable it to make the relevant payment or delivery when due, provided that such error or omission is remedied within three (3) Business Days of receipt of a notice served by the non-defaulting party requiring the defaulting party to rectify such failure.4.7. Each Party hereby acknowledges that in the event the Principal decides not to accept the Bank’s Offer for any reason whatsoever, the Principal hereby agrees that all costs associated with the physi-cal delivery or the safe-keeping of the Merchandise by the Bank as requested by the Principal, including the delivery costs, storage costs and insurance, shall be borne by the Principal.

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5 REPRESENTATIONS AND WARRANTIES

5.1. Each Party hereto warrants and represents to the other Party that:

a. It has the legal capacity to enter into this Agreement and each Trade Transaction;

b. Its execution of this Agreement and each document delivered by it under this Agreement is and will be duly authorised;

c. Its obligations under this Agreement and each Trade Transaction will constitute its legal, valid and binding obli-gations in accordance with their respective terms (subject to generally applicable insolvency laws and principles of equity) and will not violate the terms of any agreement to which it is a party and it has waived any immunity that may be available to it, including sovereign immunity, to the fullest extent practicable;

d. It has and will at all times maintain all authorisations, approvals, licences and consents required to enable it to lawfully perform its obligations under this Agreement and each Trade Transaction;

e. (Save as otherwise disclosed prior thereto or in the case of a Purchase Transaction), it shall enter into this Agreement and each Trade Transaction pursuant to this Agreement as principal and not as agent, or in any other capacity, fidu-ciary or otherwise; and

f. It is duly incorporated and validly existing under the laws of its incorporation and, if relevant under such laws, is in good standing and no Insolvency Proceeding has been threatened or commenced against it (which is not frivolous or vexatious).

5.2. In respect of each Sale Transaction, the Principal hereby rep-resents and warrants to the Bank as purchaser of the Merchandise that:

a. The Principal has not created and shall not create any charge or encumbrance, and has not granted and shall not grant any third party rights, over its interest in the Merchandise which is the subject of a Sale Transaction; and

b. The Principal shall not take any steps which may impair the quiet possession of the purchaser of the Merchandise after completion of the sale without due cause.

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9.1.9. Boilerplate Clauses

Boilerplate clauses are standard clauses that appear in most of the legal doc-uments as provision at the end of the agreement. Boilerplate clauses clarify the nature of the relationship between the contracting parties. Its purpose is to provide how the agreement is to operate such as clauses dealing with applicable law, and jurisdiction clauses. Sometimes they are referred to as “Miscellaneous” provisions in the agreement.

The purpose of boilerplate provisions is to save the parties and drafters of contracts time with commonly used language. Boilerplate language is used to save time, but it is nevertheless important to understand the meaning and effect of these provisions in order to choose which ones are important for your particular contract. Although boilerplate provisions may seem “standard,” they can still be tailored to meet your specific contracting requirements.3

According to Andrew Whan, Tatsunhiko Kamiyama, and Natsuko Sugihara, boilerplate clauses are not only a common feature of many English law contracts but have also been adopted in many other juris-dictions’ contracts, including Japan. Such term refers to the relatively standardised clauses in contracts, which are often agreed on with little or no negotiation and found toward the end of an agreement.4 Boilerplate removes ambiguity and gharar from the agreement. By including boiler-plate clauses, the parties to a contract can better define the relationship between themselves, which provides certainty if terms in the contract are ever disputed. Omitting such boilerplate clauses may create uncertainty and expose certain elements of the relationship or agreement between the parties open to interpretation in a court of law, which is often an expensive and unpredictable exercise.5

The most commonly used boilerplate clauses are discussed next, along with an explanation of their purpose.

■■ Amendment: An amendment clause provides the means by which the parties are entitled to make changes to the contract.

■■ Assignment: This is a term used to refer to the rights and obligations of a party to a contract and the ability or not of that party to pass on those rights and obligations to a third party. Often contracts have a “no-assignment” clause, which prevents either party from subcontracting their duties under the contract.

■■ Arbitration: The purpose of arbitration is to provide an alternative to litigation. It is generally quicker, cheaper and is less formal than going to court. Arbitration can be particularly useful in resolving disputes that are of a highly sensitive or confidential nature. Often a contract will have

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an arbitration clause so that a dispute will be resolved by an impartial tri-bunal without either party having to resort to costly and lengthy litigation.

■■ Entire Agreement: This is a very useful clause that has the effect of lim-iting all the parties’ rights and obligations to only the provisions con-tained within the contract and any attached schedules. This means that neither party can claim to have acted based on any statement, discus-sion or document not expressly contained within the contract.

■■ Force Majeure: Force Majeure is a clause that prevents the parties to a contract from being liable in the event that circumstances outside their control stop them from being able to undertake their obligations under the contract. The theory behind this lies in the legal doctrine of “frustra-tion”—that parties should not be penalised for the actions or fault of another that they could not reasonably have foreseen.

■■ Law and Jurisdiction: This determines the law of the country (or state) that governs the contract. In the event of litigation the jurisdiction is the country that will hear any legal dispute.

■■ Notices: This provides the parties to a contract with an agreed method of communication upon the occurrence of specific events. It is a very important provision as it sets out the way in which parties should com-municate, and the timescales, thereby avoiding dispute later on. If par-ties are in different countries, this is likely to be by electronic means.

■■ Termination: This sets out the ways in which the contractual relation-ship can come to an end. This may be at the end of a fixed term, if the contract is breached by either party, by granting the other party notice of termination (e.g., 30 days’ notice and in writing) if one party becomes insolvent, bankrupt, or is liquidated, or a dispute arises between them that stops them from being able to continue with the contract. There will often be a further section in this clause that explains what happens when the contract is terminated.6

■■ Sometimes the force majeure and law and jurisdiction are not clauses in the boilerplate but incorporated in the Miscellaneous. This depends on each contract and the nature of the facility subject to the agreement. Example of the boilerplate in the interbank murabahah master agree-ment of AIBIM is as follows:

6. TERMINATION

6.1. This Agreement shall remain in force until and unless either Party has given at least Fourteen (14) days’ notice of termina-tion in writing to the other Party.

6.2. Either Party hereto shall be entitled to terminate this Agreement forthwith by giving written notice to the other if:

a. The other Party hereto becomes subject to Insolvency Proceedings; or

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b. The other Party hereto commits a breach of any of its obli-gations under this Agreement or any of its representations or warranties as stated in Clause 5 is false or incorrect in any material respect, and (if such breach shall be capable of rem-edy) shall not be remedied by such Party within Fourteen (14) days of receipt of a notice served by the first mentioned Party requiring it to make good such breach; or

c. The other Party is, or is deemed for the purposes of any law to be, unable to pay its indebtedness as they fall due or insolvent.

6.3. Termination of this Agreement will be without prejudice to any rights or obligations of a Party accrued up to the date of termina-tion and the completion of any Trade Transaction already executed, whichever is the later.6.4. Following any termination of this Agreement under the provi-sions hereof, each Party hereto may set off any obligation owed under this Agreement against any other obligation (whether or not matured) owed between the Parties hereto, regardless of place of payment, booking branch or currency of the obligation. Written notice is to be given to the other Party after such setting off.

7. NOTICES

7.1. Any notice to be given in relation to this Agreement shall, except where communication by telephone is expressly contemplated, be given in writing. All mail and notices are to be addressed to the Parties hereto at their respective addresses as set out in Clause 7.3 below and will be deemed to be received:.

a. If in writing and delivered in person or by courier on the date it is delivered;

b. If sent by telex, on the date the recipient’s answer back is received;

c. If sent by facsimile transmission, on the date that transmis-sion is received by the recipient in legible form and con-firmed by a transmission report generated by the sender’s facsimile machine;

d. If sent by ordinary or registered mail (unless there is evi-dence of earlier receipt), three (3) days after posting;

e. If sent by electronic messaging system (which shall include email exchanges), on the date that electronic message is received, unless the date of that delivery or that receipt as applicable is not a Business Day or that communication is

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delivered or received as applicable after the close of business on a Business Day, in which case that communication shall be deemed given on the first following day that is a Business Day.

7.2. a. Each Party (“Recipient”) is authorized, but not obliged, to rely upon and act on all instructions and correspondences (“Instructions”) from the other Party (“Sender”) commu-nicated by telephone or transmitted by facsimile or other electronic mode of communication as may be mutually agreed upon by the Parties.

b. The Sender releases the Recipient who has relied upon or acted on the Instructions from the Sender from and indem-nifies and holds the Recipient harmless from and against all actions, suits, proceedings, costs (including legal costs), claims, demands, charges, expenses, losses and liabilities however arising (unless due to the gross negligence or will-ful default of the Recipient) in consequence of, or in any way related to:

i. The Recipient having acted in good faith in accor-dance with the Sender’s Instruction, notwithstanding that such instruction(s), as above have been initiated or transmitted in error or fraudulently altered, misun-derstood or distorted in the lines of communication or transmission;

ii. The Recipient having refrained from acting in accor-dance with the Sender’s Instruction by reason of failure of either actual transmission thereof to the Recipient or receipt by the Recipient for whatever reason, whether connected to the fault or failure or other cause con-nected to the sending or receiving machine or other-wise; or

iii. The Sender’s failure to forward all original copies of Instruction to the Recipient within such period as the Recipient may specify.

7.3. Either Party hereto may, by notice to the other, change the address, telex, or facsimile number below:

PartyAddressTelephoneFacsimileTelexSwiftE-mail

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7.4. The Bank and the Principal shall be entitled to record all tele-phone conversations and instructions received from the other Party and such recordings and transcripts thereof shall be used by the Parties as evidence in any dispute. Each Party’s recordings shall be and remain the sole property of such Party.

9.1.10. Miscellaneous

Miscellaneous is a clause in the legal agreement consisting of numbers or elements of different aspects and kind that have mixed characters. Example of the Miscellaneous in the interbank murabahah master agreement of AIBIM is as follows:

MISCELLANEOUS

8.1. The contents of this Agreement and the transactions contem-plated by this Agreement shall be kept confidential by the Parties hereto during the currency of this Agreement and after it shall termi-nate, save to the extent that any such matter shall become a matter of public knowledge other than through the fault of either Party hereto and save as required by an order of court of competent jurisdiction or competent administrative authority. The foregoing prohibition shall not apply to disclosures (i) made to the legal or financial advisors of any Party; (ii) required by law or by any regulatory authorities; (iii) made in connection with the enforcement of this Agreement; (iv) made to the Affiliates and the group of companies of either Party and parties providing processing services for the Trade Transactions of either Party. For the purpose of this Clause, “Affiliates” are compa-nies controlled by a Party or any company that (i) controls the Party or (ii) is under common control with the Party.8.2. Unless in the event of reconstruction, amalgamation or merger in the constitution of the Parties, this Agreement and the Parties’ respective rights and obligations hereunder shall not be assignable or transferable except with the prior written consent of the other Party.8.3. This Agreement is intended to be Sharīàh-compliant. Both the Bank and the Principal hereby agree and acknowledge that their respective rights and obligations under this Agreement are intended to be subject to and in conformity with Sharīàh prin-ciples (such Sharīàh principles as are determined by the Sharīàh Committee/Sharīàh Supervisory Board of the Bank) (“Sharīàh Principles”). Both Parties further agree acknowledge and under-take that no proceeds from the sale of the Merchandise or any

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transactions contemplated by this Agreement shall be invested and/or utilised in any non-Sharīàh compliant securities or financial instruments.8.4. The illegality, invalidity, or unenforceability of any provision of this Agreement under the laws of any jurisdiction or under any Sharīàh Principles shall not affect the validity or enforceability of any other provision of this Agreement or other agreements and/or documents to be entered into pursuant hereto.8.5. If the fulfillment of the terms and conditions of this Agreement is rendered impossible due to force majeure events, i.e., extraordi-nary and unforeseen circumstances which are beyond the affected Party’s reasonable control, each Party shall not be liable to the other Party for any delay in performance of its obligation under the Trade Transaction but shall not be released from the obligations under this Agreement. The Party affected by such events shall promptly inform the other Party in writing of the circumstances and shall use all reasonable endeavours to comply with its obligations or provide alternate performance reasonably acceptable to the other Party. In the event such incapacitation continues for a period of fourteen (14) days from the date of the first such force majeure event, the Parties shall have the right to terminate the Trade Transaction fully or in part after making mutually agreeable reasonable settlements. For the avoidance of doubt, force majeure events shall include war, hostilities, any state of riots, civil commotion, earthquake, flood, fire, tempest and any other natural disaster or any event beyond the reasonable control of the Parties.8.6. Subject to Clause 8.3, this Agreement shall be governed by and construed in accordance with the laws of Malaysia in so far as it complies with the Sharīàh Principles and each of the Parties hereto irrevocably agrees that the Courts of Malaysia shall have exclusive jurisdiction for the purpose of any proceedings arising out of or in connection with this Agreement in so far as it complies with the Sharīàh principles, and, for such purposes, irrevocably submits to the jurisdiction of such courts.8.7. Notwithstanding the provisions of this Agreement, the Parties hereto recognise and agree that the principle of the payment of interest is repugnant to Sharīàh Principles and accordingly, to the extent that laws of Malaysia would but for the provisions of Clause 8.8 above impose whether by contract or by statute any obligation to pay interest, the Parties hereto hereby irrevocably, uncondition-ally and expressly waive and reject any entitlement to recover inter-est from each other.

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8.9. This Agreement may be executed in counterparts, each of which when executed and delivered shall constitute an original, but all the counterparts together shall be deemed to constitute one and the same instrument.8.10. It is agreed and acknowledged that this Agreement and each Trade Transaction is not intended to be, and shall not be, governed by the Rules of the London Metal Exchange or any other recog-nized exchanges on which the Merchandise is traded (as the same may be supplemented or amended from time to time) and is an OTC (over-the-counter) contract.8.11. Time wherever mentioned shall be of the essence.8.12. The Parties hereto hereby agreed that they shall also be subject to the additional terms and conditions as stipulated in Appendix 7.

9.1.11. Signature

Signature is a legal endorsement of the agreement executed by the contracting parties. The signature represents the stage of the execution of the offer and acceptance. It is an expression of the consent and declaration of the agreement on the contents of the legal documents that are in the contract. Example of the signature in the interbank murabahah master agreement of AIBIM is as follows:

AS WITNESS the hands of the duly authorised representatives of the parties hereto the day and year first before written.

PrincipalSigned byfor and on behalf of[Insert Name of Deposit Placing Entity](Company No. •)as its authorised signatoryin the presence of:BankSigned byfor and on behalf of[Insert Name of Deposit Taking Entity](Company No. •)as its authorised signatoryin the presence of:-

9.1.12. Schedule/Appendix (if applicable)

The schedule is an attachment to the legal agreement, it is not included in the main part of the contract but it is attached to it and executed after the

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main part of the contract. The schedule contains additional information and items that are considered part and parcel of the legal agreement. Usually the schedule or any other annexure will be captured in the interpretation section that normally reads as follows: “The schedules and annexure herein shall form an integral part of this Agreement and shall be taken, read, and construed as an essential part hereof.” This clause makes the schedule to be part of the legal agreement and cannot be ignored.

Example of the appendix in the interbank murabahah master agreement of AIBIM is as follows (there are seven appendixes; we include just two here for illustration purposes).

APPENDIX 1

(which shall be read, taken and construed as an integral part of this Agreement)

GUIDELINES

No Purchase Transaction may be entered into by the Bank or its agents, on behalf of the Principal without the Principal’s express confirmation in accordance with Paragraph 3 of Appendix 2 herein. The Purchase Transaction shall adhere to the following guidelines:

Eligible Instruments

A. The Bank may purchase for the Principal’s account non- precious commodities evidenced by London Metal Exchange (LME) Metal Warrants or any other recognized exchanges on which such non-precious commodities are traded (“the Merchandise”). Ownership of the Merchandise shall be evi-denced to the Principal by indicia documents of title made out in the name of the Principal or the Bank (as its agent) or by crediting and debiting a commodity account.

B. The Merchandise purchased should be items that are acceptable to the Principal and the Bank and valued according to Sharī`ah. No Trade Transaction can be made in any Merchandise that consists of pork, alcoholic drinks, tobacco, narcotics, gold, sil-ver or any other items which are not acceptable to the Principal and the Bank.

Maturity

Merchandise may be sold to the Bank as purchaser on deferred pay-ment for such period as mutually agreed by the Principal and the Bank.

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Currency

The proceeds from any Trade Transaction will be in Ringgit Malaysia or such other currencies as the Parties hereto may agree from time to time.

APPENDIX 2

(which shall be read, taken and construed as an integral part of this Agreement)

TRADE TRANSACTIONS

1. The Principal will communicate with the Bank on a recorded line or any other equivalent mode of communication the amount desired to be transacted and the payment period. The Principal will provide the details of its account into which the deferred sale proceeds are to be deposited into.

2. The Bank will advise the Principal on a recorded line or any other equivalent mode of communication the details of the pro-posed Purchase Transaction which may be entered into by the Principal.

3. Upon the Principal’s acceptance of the details of the proposed Purchase Transaction, the Principal may, on a Business Day, send to the Bank a Purchase Order in form set out in Appendix 3 hereto (“Purchase Order”).

4. Following the Bank’s receipt of the Purchase Order, the Bank will purchase the Merchandise held under [the LME Warrants] from the Supplier on the purchase date as set out in the Purchase Order or on the next Business Day following such purchase date.

5. On acquisition of the Merchandise, the Bank will send to the Principal by facsimile message the Bank’s Confirmation in form set out in Appendix 4 hereto (“Bank’s Confirmation”).

6. The Principal shall transfer to the account of the Bank for value not later than [insert time pm] on the relevant purchase date, such funds as may be necessary for the Bank to complete the agreed purchase on behalf of the Principal and to enable the Bank to effect payment of the relevant purchase price due on such purchase date as set out in the Bank’s Confirmation.

7. The Bank may/will7 subsequently thereafter offer to purchase the same from the Principal by way of offer by the Bank to the Principal in the form set out in Appendix 5 hereto (“Bank’s Offer”).

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8. Subject to Paragraph 9 below, the Principal may/will8 sell the Merchandise to the Bank in form set out in Appendix 6 hereto (“the Principal’s Acceptance”).

9. For Parties with tested telex/SWIFT: the Purchase Order, the Bank’s Confirmation, the Bank’s Offer and the Principal’s Acceptance may be sent via tested telex/authenticated SWIFT message.

10. It is agreed and acknowledged that the Parties hereto intend to be legally bound by the terms of each Trade Transaction from the moment they agree to those terms on any mode of com-munication. A confirmation(s) (as referred to in Paragraphs 6 and 8 above) shall be entered into as soon as practicable in the form set out in the Appendixes to this Agreement and may be executed and delivered in counterparts (including by facsimile transmission) or be created by an exchange of telexes or by an exchange of electronic messages on an electronic system, in each case thereby evidencing a binding agreement.

9.2. TIPS FOR DRAFTING TEXT AND ADDITIONAL CLAUSES

There are some tips in drafting the legal documentation and their clauses to be considered to ensure a proper presentation of the form and substance of the contract presented in the legal documents.9

■■ Order the additional clauses in a logical sequence. Generally, it is a good idea to keep sentences short but not cryptic. The intent of the text must be clear. If the clause is long, consider dividing the clause into sections.

■■ Review the text. Make sure your meaning is clear by having someone else review what you wrote to ensure the meaning is apparent. It is not unusual to rewrite a sentence or clause several times to ensure that it is simple and clear. The last thing you want is for a judge or arbitra-tor to discard an important clause because the meaning is unclear or ambiguous.

■■ Omit needless words. Do not use jargon/legalese such as hereto and the said item.

■■ Avoid making redundant clauses and ensure clauses do not contradict.■■ Read the document carefully to ensure that the additional clause is not

repeating or contradicting what has already been stated in the document.■■ Use numerals, not words, to denote amounts.■■ Refer to people and companies by name. If names have been defined by

a shorthand identifier within the document, then use that name instead.

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This is especially true of the parties to the agreement. These are usu-ally identified at the beginning of the contract. You should use these predefined terms throughout the rest of the document. Example: the Landlord, the Tenant, the Customer, the Service Provider, and so forth.

■■ Do not use multiple names or identifiers to refer to the same person or thing. It will appear to the reader that you are introducing new or dif-ferent objects.

■■ Do not use terms such as: they, us, we, our, you, me, and so forth. These terms are ambiguous and confusing.

■■ Do not abbreviate words.■■ Emphasize the positive and avoid using multiple negatives in sentences

(for example, change “Notice will not be effective unless it is delivered in person.” to “Notice will only be effective if it is delivered in person.”

■■ Do not use all capitals.■■ Spell-check your clause.

9.3. LEGALISTIC STYLE

Draft the clause in plain English. Plain English means language that is sim-ple and conveys ideas with the greatest possible clarity. The difference is illustrated in the list that follows:

Legal Language Plain English

at the present time now

due to the fact that because; since

during such time as while

for the duration of during

inasmuch as because; since

in the event that if

notwithstanding the fact that although; even if

prior to before

pursuant to under; in accordance with

subsequent to after

that certain a

with reference to about

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NOTES

1. To delete where appropriate subject to the requirements of the Bank.2. Subject to the requirement of the Bank.3. Boilerplate provision, Chartered Institute of Purchasing & Supply, www.cips

.org, retrieved July 27, 2013.4. A. Whan, T. Kamiyama, and N. Sugihara, “Boilerplate Clauses in English Law Con-

tracts,” Tokyo: Clifford Chance (September 2012), 1, www.cliffordchance.com/ publicationviews/publications/2012/09/boilerplate_clausesinenglishlawcontracts .html.

5. Ibid.6. Lorna Elliott, “What Are Boilerplate Clauses?” Contracts & Agreements, www

.contractsandagreements.co.uk/what-are-boilerplate-clauses.html, retrieved July 27, 2013.

7. Subject to the requirement of the Bank.8. Ibid.9. “Tips for Drafting Text and Additional Clauses,” Law Depot.com, www.lawdepot

.com/help/draftingtips, retrieved February 27, 2013.

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http://www.cips.org

http://www.cliffordchance.com/publicationviews/publications/2012/09/boilerplate_clausesinenglishlawcontracts.html

http://www.lawdepot.com/help/draftingtips

http://www.cips.org



http://www.contractsandagreements.co.uk/what-are-boilerplate-clauses.html

http://www.contractsandagreements.co.uk/what-are-boilerplate-clauses.html

http://www.lawdepot.com/help/draftingtips

http://LawDepot.com

233

CHAPTER 10Useful Information and Samples

of Legal Documentation

10.0. INTRODUCTION

This chapter includes various samples of contracts in different applications of Islamic finance. It also includes contracts of ABIM, the Association of Islamic Banking Institutions Malaysia, as approved by the AIBIM Sharī`ah Advisory Committee.

10.1. SAMPLE OF AN AGREEMENT (MUSHARAKAH AGREEMENT IN SUKUK ISSUANCE)

The following is a sample of a contract of management agreement in sukuk musharakah issuance.

THIS MANAGEMENT AGREEMENT is made on the_________ day of 2014

BETWEEN:

1. ABC bank Islamic Berhad (Company No. 11111), a company incor-porated in Malaysia with its registered office at Kuala Lumpur (the “Issuer”);

AND

2. XYZ Trustees Berhad (Company No. 22222), a company incorporated with limited liability under the laws of Malaysia and having its regis-tered office at Kuala Lumpur (as the “Sukuk Trustee”).

RECITALS

A. Pursuant to the resolutions of the Board of Directors of the Issuer passed on 19 June 2015, the Issuer has been empowered to undertake

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the issuance of Ringgit One Billion (RM1,000,000,000.00) in aggre-gate nominal value of redeemable unsecured subordinated sukuk based on the Sharī`ah principles of Musharakah (“Sukuk”). The Sukuk will mature on the Maturity Date with an option given to the Issuer (sub-ject to the fulfilment of the Redemption Conditions) to redeem all and not a part only of the Sukuk on the fifth (5th) anniversary of the Issue Date and every Periodic Distribution Date thereafter but prior to the Maturity Date.

B. The Sukuk are constituted by a Sukuk Trust Deed dated the___________ day of 2014 entered into between the Issuer and the Sukuk Trustee.

C. By a Sukuk Trust Deed made between the Issuer and the Sukuk Trustee acting on behalf of the Sukukholders, the Issuer has declared a trust of all its rights, title and interests in and to the Trust Assets in favour of the Sukukholders upon the terms and subject to the conditions contained therein.

D. The Sukuk shall represent the Sukukholders’ undivided proportionate interest in the Trust Assets as between the Sukukholders. Each Sukuk will constitute an undivided proportionate interest in the Trust Asset and shall rank paripassu, without discrimination, preference or priority among themselves.

E. Pursuant to the Musharakah Agreement, the Sukuk Trustee is desir-ous of appointing the Issuer to act as manager in connection with the Musharakah Venture (including managing the Trust Assets) to pro-vide the services and perform the duties set out in this Management Agreement on the terms and subject to the conditions of this Management Agreement.

THIS MANAGEMENT AGREEMENT WITNESSES as follows:

1. INTERPRETATION1.1 In this Management Agreement (including the recitals):

a. Words and expressions defined and the rules of construc-tion and interpretation set out in the Sukuk Trust Deed and the Musharakah Agreement, as such definitions and rules may be amended from time to time shall, unless otherwise pro-vided herein or the context otherwise requires, have the same meanings herein save that, in the event that there is a conflict between a definition in the Sukuk Trust Deed, the Musharakah Agreement and in this Management Agreement, the definition in this Management Agreement shall prevail; and

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Useful Information and Samples of Legal Documentation 235

b. Except so far as the context otherwise requires, “Agreement” means this Management Agreement as the same may be amended or supplemented from time to time.

2. APPOINTMENT OF THE MANAGER AND THE INCENTIVE FEE2.1 Pursuant to the Musharakah Agreement, the Sukuk Trustee, act-

ing on behalf of the Sukukholders, hereby appoints and gives the Issuer full authority to act as manager, subject to the terms of this Management Agreement, the Issuer has absolute discretion with respect to all the trusts, power, authorities and discretions vested in it, in relation to the Musharakah Venture (including the Trust Assets and the Business) and the Issuer hereby accepts such appointment.

2.2 The responsibilities of the Issuer (in its capacity as the manager) shall be to manage the Business as follows:a. To manage the Business in such manner it thinks fit, subject to

the provisions in the Musharakah Agreement;b. To distribute the income received from the Musharakah Venture

to the Sukuk Trustee (on behalf of the Sukukholders) and the Issuer being partners to the Musharakah Venture based on the pre-agreed profit sharing ratio set out in the Musharakah Agreement. The distribution to the Sukukholders shall be applied in the following manner and order of priority:i. All income distributable to the Sukuk Trustee (on behalf of

the Sukukholders) will be applied to pay the Sukuk Trustee (on behalf of the Sukukholders) up to the Expected Periodic Distribution generated from the Musyarakah Venture;

ii. In the event there is any excess after applying the above, such excess shall be retained by the Issuer (in its capacity as the manager) as an Incentive Fee. For the avoidance of doubt, the Issuer shall have no obligation to guarantee, pay, or distribute the income generated from the Musharakah Venture should there be no income generated except that in the event of any shortfall between the Expected Periodic Distribution and the actual income generated from the Musharakah Venture, the Issuer shall pay to the Sukuk Trustee (on behalf of the Sukukholders) the shortfall, and such payment shall constitute an Advance Part Payment of the Exercise Price.

2.3 a. The Musharakah Partners shall pay to the Issuer the Incentive Fee, if any, on each Periodic Distribution Date. Other than the Incentive Fee mentioned in Clause 2.3(b) or other fees or amounts payable to the Issuer under the other Transaction Documents, the Issuer is

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not entitled to any other fees under this Agreement or otherwise by virtue of its appointment as a manager hereunder.

b. Notwithstanding any other provisions in the Transaction Documents relating to the Sukuk and subject to Clause 2.3(c) below, payment of such Incentive Fee mentioned in Clause 2.3(a) above by the Sukukholders to the Issuer shall only be by way of the Sukukholders hereby agreeing that any amount of Income Entitlement that is over and above the Sukukholders’ respective Expected Periodic Distributions shall be retained by the Issuer as Incentive Fee.

c. The Incentive Fee mentioned in Clause 2.3(a) above shall belong to the Issuer immediately upon the determination and payment of Periodic Distributions in accordance with the provisions of the Sukuk Trust Deed in respect of the Sukuk.

3. OTHER DUTIES OF THE ISSUER AS THE MANAGER3.1 The Issuer hereby agrees and undertakes with the Sukuk Trustee that

in consideration of the agreement for payment of the Incentive Fee (as mentioned in Clause 2 above) from the Musharakah Partners, and as long as any Sukuk remain outstanding, the Issuer shall carry out the following duties and functions for and on behalf of the Sukukholders:a. Exercise reasonable degree of skill and diligence in carrying out

it business and affairs in a proper and efficient manner and in accordance with sound financial and commercial standards and practices;

b. Maintain in full force and effect all relevant and necessary authorisations, consents, rights, licences, approvals and permits (governmental and otherwise) and will promptly obtain any fur-ther authorisations, consents, rights, licences, approvals and per-mits (governmental and otherwise), the absence of which would give rise to a Material Adverse Effect on the Issuer and which are or may become necessary to enable it to own its assets, to carry on its business or for the Issuer to enter into or perform its obligations under this Agreement or to ensure the validity, enforceability, admissibility in evidence of the obligations of the Issuer or the priority or rights of the Sukuk Trustee and the Sukukholders under this Agreement and the Issuer shall comply with the same;

c. Obtain and maintain all Takaful or insurances with respect to its assets and business against all risk that a prudent company car-rying on a business similar to that of the Issuer would normally insure;

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d. Diligently manage and administer the Trust Assets;e. Maintain such records as are reasonably necessary to adequately

record and maintain the Trust Assets, the income and proceeds (including dividends) generated thereby and the reinvestment of such income/proceeds.

3.2 The Issuer shall have absolute control of the collections of the Trust Assets mentioned in Clause 2.1 above and shall continue to manage such collections for itself and the Sukukholders and if necessary, to outsource any management functions as it deems fit. All decisions pertaining to the collections of the Trust Assets and the exercise of such voting rights shall be made and implemented solely by the Issuer. Notwithstanding any outsourcing, sub-contract or delega-tion of the performance of its obligations under this Management Agreement, the Issuer shall not thereby be released or discharged from any liability under this Management Agreement and shall remain fully responsible for the performance of the obligations of the Issuer under this Management Agreement and the performance or non-performance or the manner of performance of any sub-con-tractor or delegate of any of the services shall not affect the Issuer’s obligations under this Management Agreement.

4. SUKUK TRUST DEED AND PURCHASE UNDERTAKING/SALE UNDERTAKING4.1 The Issuer hereby agrees and acknowledges that its obligations as

manager as set out under Clause 3 above shall be in addition to and shall not in any way prejudice or derogate from its substantive obli-gations as Issuer under the Sukuk Trust Deed and as Obligor under the Purchase Undertaking/Sale Undertaking.

5. RETIREMENT OR REMOVAL OF MANAGER5.1 The Issuer shall continue as the manager for the Sukuk holders for

as long as any of the Sukuk remains outstanding. Upon repurchase in full by the Issuer of the Sukuk, the appointment of the Issuer by the Sukuk holders hereunder shall forthwith come to an end and neither the Issuer, the Sukuk Trustee nor any of the Sukuk holders shall have any further rights or obligations in respect of each other save and except for antecedent breaches.

5.2 The Sukuk Trustee shall be entitled, upon the declaration of a Dissolution Event, to terminate the appointment of the Issuer herein by giving thirty (30) days’ notice in writing to the Issuer. For the avoidance of doubt, such termination shall not entitle the Sukuk Trustee to appoint a substitute entity to act as a replacement manager.

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6. THE SUKUK TRUSTEE6.1 Declaration of trust The Sukuk Trustee hereby declares itself to be

trustee for the Sukuk holders of the interests, covenants, undertak-ings and rights hereby created or conferred upon it for the Sukuk holders by the Issuer on the terms and conditions contained in the Sukuk Trust Deed.

6.2 Duties and powers The duties and powers of the Sukuk Trustee arising out of this Management Agreement shall be performed and exercised in accordance with the relevant provisions of the Sukuk Trust Deed, which provisions shall apply to this Management Agreement as if the same were expressly set out herein.

6.3 Retirement or removal The retirement or removal of the Sukuk Trustee as trustee hereof, and the appointment of any replacement or additional trustee hereof, shall be effected in accordance with the relevant provisions of the Sukuk Trust Deed as if the same were expressly set out herein.

7. INDEMNITY7.1 The Issuer hereby agrees to and shall indemnify and keep the Sukuk

Trustee and the Sukuk holders fully indemnified from and against all losses, charges, damage, costs, expenses and liabilities as may be incurred or suffered by them as a result of any breach or non-performance by the Issuer of its obligations hereunder.

8. OTHER PROVISIONS8.1 The other provisions of the Sukuk Trust Deed, to the extent that

they do not conflict with the provisions hereof, shall apply to this Management Agreement as if the same were expressly set out herein respectively in relation to the Sukuk, the Sukuk Trustee and the Sukuk holders.

9. MISCELLANEOUS9.1 This Management Agreement may not be supplemented or amended

in any manner except by an instrument in writing signed by the par-ties hereto.

9.2 In the event that any one or more of the provisions in this Management Agreement shall for any reason be held to be unen-forceable, illegal, or otherwise invalid in any respect under the law governing this Management Agreement or its performance, such unenforceability, illegality, or invalidity shall not affect any other provisions of this Management Agreement and this Management Agreement shall then be construed as if such unenforceable, illegal, or invalid provisions had never been contained herein.

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9.3 Each of the parties hereto undertakes with each other to do all things reasonably within their power that are necessary or desirable to give effect to the spirit and intent of this Management Agreement.

9.4 Time whenever mentioned shall be deemed to be of the essence of this Management Agreement.

9.5 The failure of a party to insist in any one or more instances upon the performance of any provision of this Management Agreement shall not be construed as a waiver or relinquishment of that party’s right to future performance of such provision and the other party’s or parties’ obligation with respect to such future performance shall continue in full force and effect.

9.6 This Management Agreement shall be governed by and be con-strued in accordance with the laws of Malaysia.

9.7 Each and every one of the agreements, indemnities, covenants, rep-resentations, warranties, and undertakings of any party contained in this Management Agreement shall survive the lawful termination of this Management Agreement and shall continue to be binding upon the defaulting party and shall take effect and enure for the benefit of the other party notwithstanding any lawful termination of this Management Agreement by such other party as a result of any breach by the defaulting party of any of the provisions of this Management Agreement.

10. STAMP DUTY10.1 The Issuer has obtained the approval of the SC on February 25,

2014, with respect to the issue of the Sukuk undertaken by the Issuer and for the purposes of the Stamp Duty (Exemption) (No. 23) Order 2000 (“Order”), IT IS HEREBY DECLARED THAT this Management Agreement constitutes one of the several instru-ments relating to the issue of the Sukuk and is, therefore, exempt from stamp duty pursuant to the Order.

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IN WITNESS WHEREOF the parties hereto have executed this Management Agreement.

The Issuer

The execution of this ManagementAgreement by the Issuer,

ABC Bank Islamic Berhad(Company No. 11111), was duly effectedin a manner authorised by its constitutionunder the Common Seal of the Issuerwhich said Seal was hereunto duly affixed on theday of___________ 2014 in the presence of:

______________________ ______________________Director Director/Secretary

Address: Kuala LumpurFacsimile No.: [.]Contact person(s): [.]

The Sukuk Trustee

The execution of this Management Agreementby the Sukuk Trustee,

XYZ Trustees Berhad(Company No. 22222) was duly executedin the manner authorised by its constitutionunder the Common Seal of the Sukuk Trusteewhich said Seal was hereunto duly affixed on theday of___________ 2014 in the presence of:

______________________ ______________________Director Director/Secretary

Address: Kuala LumpurFacsimile No.: 03-2032 1222Contact person(s): General Manager

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10.2. SAMPLE OF AN OFFER LETTER

MURABAHAH VEHICLE TERM FINANCING FACILITY (MVTF-i)

Our Ref. No.:Date:Customer’s NameAddress

Dear Sir/Madam,

RE: MURABAHAH VEHICLE FINANCING FACILITY

We are pleased to offer you the above Facility subject to the followings terms and conditions:

Purpose:

Method of Financing:

Bank’s Purchase Price:

Facility Amount:

Bank’s Selling Price:

Margin of Finance:

Financing Tenure:

Ceiling Profit Rate:

Effective Profit Rate:

Monthly Installment:

Payment Mode:

Security:

Late Payment Charges (Ta`widh):

Legal Cost and Expenses:

Disbursement:

Rebate:

Takaful:

Other Conditions:

This Letter of Offer shall be valid for a period of fourteen days (14) days from the date hereof or such other extended period as we may allow.

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In the event that it is not duly accepted, signed and returned to us within the aforesaid period, the offer herein contained shall lapse and be of no further effect.

Yours faithfully,For ISLAMIC BANK ABC

____________________________Managercc: The solicitor

ACKNOWLEDGMENT OF ACCEPTANCE

1 Subject to the terms and conditions of the legal documentation to be executed, I further agree that this letter embodies in writing all and the entire terms of our agreement and I hereby declare and con-firm that no warranties, promises, representations, collateral agree-ments have been made to me and if, which is denied, that any such warranties, promises, representations or collateral agreements were made they have now lapsed and are superseded by this letter and be of no effect whatsoever.

2 I hereby acknowledge receipt and I have read and understood the contents of this Letter of Offer including all its Appendices (if any) and [I further warrant that I have sought independent legal advice in relation to this letter and] acknowledge and understand the obli-gations arising therefrom. I hereby further confirm the acceptance of the above terms and conditions.

Name:_______________________________

NRIC No.:_______________________________

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10.3. SAMPLE OF LEGAL DOCUMENT STRUCTURE

MURABAHAH VEHICLE FINANCING FACILITY AGREEMENT THIS AGREEMENT is made this_________ day of______________, 20____.

BETWEENABC ISLAMIC BANK, a company incorporated in Malaysia and hav-

ing its registered office at XYZ Kuala Lumpur hereto and includes its suc-cessors in title and assigns, (“Bank”) of the one part;

ANDTHE PARTY named in Item 1 of First Schedule hereto (“Customer”)

of the other part.IT IS HEREBY AGREED as follows:

1.0 DEFINITION AND INTERPRETATION1.1 Definition1.2 Interpretation

2.0 RECITALS2.1 Application for Facility2.2 Purpose of the Facility2.3 Method of Financing2.4 Appointment of the Customer as The Bank’s Agent2.5 Dispute

3.0 REPRESENTATIONS AND WARRANTIES3.1 Representations and Warranties3.2 Continuing Nature of Representations and Warranties

4.0 CONDITIONS PRECEDENT4.1 Conditions Precedent to Disbursement4.2 Waiver of Conditions4.3 Discretion of the Bank on Disbursement

5.0 TENURE5.1 Tenure

6.0 PROFIT6.1 Fixed Rate Financing6.2 Variable Rate Financing

7.0 PAYMENT7.1 Payment for Bank’s Selling Price7.2 Variation of Dates for Payment7.3 Variation of Installment or Tenure7.4 Rebate

8.0 REGISTRATION OF OWNERSHIP CLAIM8.1 Endorsement of Ownership Claim8.2 Custody of the Vehicle Registration Card

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9.0 COVENANTS 9.1 Positive Covenants 9.2 Negative Covenants

10.0 MUTUAL COVENANTS10.1 Irrevocable Consent and Authorization

11.0 REMEDIES OF THE BANK11.1 Events of Default11.2 Rights of Bank on Default11.3 Procedures for Taking Possession11.4 Procedure for Sale11.5 Proceeds of Sale11.6 Deficiency in Proceeds of Sale11.7 Bank’s Right to Enforce This Agreement and Legal Proceedings

Concurrently11.8 Bank’s Right to Reinstate This Agreement

12.0 TAKAFUL12.1 Takaful on Vehicle12.2 Terms and Form of Takaful12.3 Assignment of Takaful12.4 Evidence of Takaful12.5 Bank’s Right to Collect Proceeds and covered under Takaful12.6 Compliance with Takaful Terms, Laws, Regulations, etc.12.7 Application of Takaful Money

13.0 ASSIGNMENT13.1 Absolute Assignment13.2 Licencee13.3 Peaceful Enjoyment

14.0 CUSTOMER’S OBLlGATIONS14.1 Customer’s Obligations14.2 Continuing Obligation to Pay Installment

15.0 MISCELLANEOUS15.1 Time15.2 Reconstruction of the Bank or Customer15.3 Late Payment Charges (Ta`widh)15.4 Stamp Duties15.5 Modifications and Indulgence15.6 Costs15.7 Cumulative Remedies15.8 Expenditure Incurred by the Bank for and on Behalf of the

Customer15.9 Severability

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15.10 Cross Default15.11 Suspense Account15.12 All Payments Received to be Payments in Gross15.13 Discharge of Indebtedness15.14 Consolidation and Combination of Accounts15.15 Extent of Agreement15.16 Certificate of Indebtedness15.17 Early Settlement15.18 General Indemnity15.19 Effective Date15.20 Disclosure15.21 Incorporation of the Provisions of Letter of Offer15.22 Assignment and Transfer

16.0 LAW AND LEGAL PROCESS16.1 Law16.2 Service of Legal Process16.3 Notices16.4 Changes in Law16.5 Place of Contract16.6 Termination by the Customer Prior to Disbursement16.7 Other Terms and Conditions of Approval (If Any)16.8 Principal and Secondary Instruments

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10.4. MASTER AGENCY AGREEMENT (AIBIM)

Association of Islamic Banking Institutions MalaysiaDated: March 23, 2014As approved by AIBIM Sharī`ah Advisory Committee on February 27,

2014.

DATED THIS________ DAY OF_______________________, 20____

___________________________________________________

MASTER AGENCY AGREEMENT___________________________________________________

BETWEEN

[ Insert Name of Deposit Placing Entity ]

(Company No. •)

(“Principal”)

AND

[ Insert Name of Deposit Taking Entity ]

(Company No. •)

(“Bank”)

• • •

THIS AGREEMENT is made BETWEEN

[Insert Name of Deposit Placing Entity ] (Company No. •), a company incorporated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Placing Entity] and business address at [Insert Business Address of Deposit Placing Entity] and includes its successors in title and permitted assigns (“the Principal”) of the one part;

AND

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[Insert Name of Deposit Taking Entity ] (Company No. •), a company incorporated in Malaysia under the Companies Act, 1965 and having its registered office at [Insert Registered Office of Deposit Taking Entity] and business address at [Insert Business Address of Deposit Taking Entity] and includes its successors in title and permitted assigns (the “Bank”) of the other part.

WHEREAS:

A. By the Interbank Murabahah Master Agreement dated [Insert date of Inter-bank Murabahah Master Agreement] (“Master Agreement”) made between the Principal and the Bank, at the request of the Principal, the parties agree, from time to time, to enter into a Murabahah arrangement whereby the Bank will, upon the Principal’s request, purchase the Merchandise on terms and conditions set out in the Master Agreement.

B. The Principal wishes to appoint the Bank as its agent to do all acts as the Principal could do itself with respect to the purchase of the Merchandise on a cash basis (“Purchase Transactions”) and the Bank is willing to accept such appointment on the terms and conditions set out in this Agreement.

NOW IT IS HEREBY AGREED as follows:

1. DEFINITIONS AND INTERPRETATION1.1 Incorporated Definitions and Interpretations

All terms, expressions and interpretations defined in the Master Agreement shall unless otherwise defined herein or repugnant to the context hereto have them eanings when used or referred to herein.

1.2 Further DefinitionsIn this Agreement the following expression shall, unless the context otherwise requires, have the following meanings:

Master Agreement Means the Interbank Murabahah Master Agreement dated [Insert date of Master Agency Agreement] made between the Principal and the Bank upon the terms and conditions therein contained and includes any variation, modification and supplement thereof; and

Parties or Party Means the parties or party to this Agreement.

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2. AGENCY2.1 The Principal hereby appoints the Bank to be its agent and the

Bank hereby accepts the appointment as the Principal’s agent to do and execute all acts with respect to the Purchase Transactions through purchase agreements, certificates, and other instruments as the Principal could do and execute itself and to negotiate with the Supplier and their clients on behalf of the Principal in relation thereto.

2.2 Each Purchase Transaction will be governed by the terms and con-ditions of the Master Agreement in accordance with the guidelines detailed in Appendix 1 hereto.

2.3 In consideration of the Bank undertaking the Purchase Transactions as the Principal’s agent, the Principal shall pay to the Bank such fees as agreed between the Principal and the Bank.

2.4 The Bank hereby agrees with the Principal that it will in perform-ing its activities under the Master Agreement protect the interests of the Principal and to act in good faith. The Bank shall not in any circumstances whatsoever be liable to the Principal for any con-sequential losses, even if informed in advance of the likelihood of them being incurred (including, without limitation, economic loss, loss of goodwill, loss of business opportunity or loss of profits). The Bank’s actions on behalf of the Principal hereunder and in connec-tion with any Purchase Transaction are for the Principal’s account and risk (save for any gross negligence or wilfull misconduct on the part of the Bank).

2.5 Subject to the Bank not being in breach of its obligations or neg-ligent, the Principal hereby undertakes to indemnify and keep the Bank indemnified on its first demand against all losses, claims, actions, proceedings, damage, costs and expenses whatsoever brought or claimed by any party and/or incurred or sustained by the Bank as a result of the purchase of Merchandise under any Purchase Transaction as agent of the Principal or any breach by the Principal of its obligations herein. The indemnity given herein shall survive termination of this Agreement and any sums payable under it shall not be subject to any deduction whether by way of set off, counter claim or otherwise.

2.6 The Bank shall not be obliged to enter into any Purchase Transaction, nor follow any instruction of the Principal, if in the opinion of the Bank by entering into such Purchase Transaction or following such instruction, the Bank and/or any of its affiliates would be in contra-vention of any law, policy, rule, or regulation.

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2.7 On execution of this Agreement, the Principal shall deliver to the Bank the following documents in form and substance satisfactory to the Bank:a. a list of signatories, with specimen signatures, of those persons

authorised by the Principal to give instructions to the Bank; andb. any other relevant documents as requested by the Bank.

3. TERMINATION3.1 This Agreement shall terminate upon termination of the Master

Agreement, and without prejudice to the foregoing, either Party may terminate this Agreement by giving at least Fourteen (14) days’ notice of termination in writing to the other Party.

3.2 No termination shall affect any rights and obligations of the Parties subsisting at the date of termination.

4. MISCELLANEOUS4.1 This Agreement is intended to be Sharīàh-compliant. Both the Bank

and the Principal hereby agree and acknowledge that their respec-tive rights and obligations under this Agreement are intended to be subject to and in conformity with Sharīàh principles (such Sharīàh principles as are determined by the Sharīàh Committee/Sharīàh Supervisory Board of the Bank) (“Sharīàh Principles”).

4.2 The illegality, invalidity, or unenforceability of any provision of this Agreement under the laws of any jurisdiction or under any Sharīàh principles shall not affect the validity or enforceability of any other provision of this Agreement or other agreements and/or documents to be entered into pursuant hereto.

4.3 Subject to Clause 4.1 above, this Agreement shall be governed by and construed in accordance with the laws of Malaysia in so far as it complies with the Sharīàh principles and each of the Parties hereto irrevocably agrees that the Courts of Malaysia shall have exclusive jurisdiction for the purpose of any proceedings arising out of or in connection with this Agreement in so far as it complies with the Sharīàh principles and, for such purposes, irrevocably submits to the jurisdiction of such courts.

4.4 Notwithstanding the provisions of this Agreement, the Parties hereto recognise and agree that the principle of the payment of interest is repugnant to Sharīàh Principles and accordingly, to the extent that laws of Malaysia would but for the provisions of Clause 4.3 above impose whether by contract or by statute any obligation to pay interest, the Parties hereto hereby irrevocably, uncondition-ally and expressly waive and reject any entitlement to recover inter-est from each other.

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4.5 This Agreement may be executed in counterparts, each of which when executed and delivered shall constitute an original, but all the counterparts together shall be deemed to constitute one and the same instrument.

4.6 Time wherever mentioned shall be of the essence.[The rest of this page has been intentionally left blank]

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Principal

Signed by:or and on behalf of:[Insert Name of Deposit Placing Entity ]:

(Company No. •):

as its authorised signatory:in the presence of:

Bank

Signed by:for and on behalf of:[Insert Name of Deposit Taking Entity]:

(Company No. •):

as its authorised signatory:in the presence of:

• • •

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APPENDIX 1

(which shall be read, taken, and construed as an integral part of this Agreement)

GUIDELINES

No Purchase Transaction may be entered into by the Bank or its agents, on behalf of the Principal without the Principal’s express confirmation in accordance with the provisions of the Master Agreement. The Purchase Transaction shall adhere to the following guidelines:


A. The Bank may purchase for the Principal’s account non-precious com-modities evidenced by London Metal Exchange (LME) Metal Warrants or any other recognized exchanges on which such non-precious com-modities are traded (“the Merchandise”). Ownership of the Merchandise shall be evidenced to the Principal by indicia documents of title made out in the name of the Principal or the Bank (as its agent) or by crediting and debiting a commodity account.

B. The Merchandise purchased should be items that are acceptable to the Principal and the Bank and valued according to Sharī`ah. No Trade Transaction can be made in any Merchandise that consists of pork, alcoholic drinks, tobacco, narcotics, gold, silver, or any other items that are not acceptable to the Principal and the Bank.

Currency

The proceeds of the Purchase Transactions will be in Ringgit Malaysia or such other currencies as the Parties hereto may agree from time to time.

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10.5. CORPORATE WAKALAH PLACEMENT AGREEMENT (AIBIM)

Association of Islamic Banking Institutions MalaysiaDated: November 24, 2014As approved by AIBIM Sharī`ah Advisory Committee on November 19, 2014

Dated

[-](1)

(as Muwakkil)

and

(2)

(as Wakil)

THIS AGREEMENT is made on the date set out in Section 1 of Schedule 1 hereto BETWEEN:

1. the party whose particulars are set out in Section 2 of Schedule 1 hereto (the “Muwakkil”); and

2. the party whose particulars are set out in Section 3 of Schedule 1 hereto (the “Wakil”),

(each a “Party” and together the “Parties”).

WHEREAS

The Muwakkil, as principal, wishes to appoint the Wakil as its agent in connection with the investment of the Muwakkil’s funds in transactions permitted under the Sharī`ah (as defined in Clause 1.1) upon the terms and subject to the conditions set out in this Agreement.

AND IT IS HEREBY AGREED as follows:

1. DEFINITIONS AND INTERPRETATION1.1 As used herein and in the preceding recitals, the following terms

shall have the meanings hereby assigned to them, unless the context expressly requires otherwise: “Actual Profit” means the realized profit from a Transaction; “Anticipated Profit” means the profit anticipated by the Wakil to

be made with the relevant Investment Amount from a Transaction and as specified in paragraph 4 of the relevant Wakil Offer;

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“Business Day” means a day on which the Muwakkil and the Wakil are open for business;

“Insolvency Proceedings” means, proceedings or a case or peti-tion or resolution or arrangement for insolvency, bankruptcy, composition, rehabilitation, reorganisation, administration, winding-up, liquidation or other similar relief with respect to a Party or its debts or assets or the appointment of a trustee, receiver, liquidator, conservator, custodian or other similar offi-cial of a Party or any substantial part of its assets, under any bankruptcy, insolvency or other similar law or any banking, insurance, or similar law governing the operation of a Party and any analogous proceedings in any jurisdiction to which a Party is subject. For avoidance of doubt, “Insolvency Proceedings” shall not include any contested proceedings until the outcome of such proceedings is determined by court;

“Investment Amount” means, in relation to a Transaction, the amount invested by the Muwakkil and as specified in paragraph 1 of the relevant Wakil Offer;

“Investment Date” means, in relation to a Transaction, the date on which the Muwakkil shall pay the relevant Investment Amount to the Wakil and as specified in paragraph 2 of the rel-evant Wakil Offer;

“Loss” means the loss incurred in a Transaction; “Maturity Date” means, in relation to a Transaction, the date

on which the relevant Maturity Proceeds shall be payable by the Wakil to the Muwakkil and as specified in paragraph 3 of the relevant Wakil Offer;

“Maturity Proceeds” means, in relation to a Transaction, the proceeds of such Transaction generated by the Wakil and due to the Muwakkil on the relevant Maturity Date and calculated in accordance with Clause 5.4.1;

“Muwakkil” means the Muwakkil in its capacity as the principal of the Wakil appointed in accordance with Clause 3;

“Muwakkil Acceptance” means, in relation to a Transaction, a written notice to be sent by the Muwakkil pursuant to Clause 5.2 and substantially in the form of Schedule 3 (Form of Muwakkil Acceptance);

“Sharī`ah” means the rules, principles, and parameters of Islamic law as interpreted, ascertained, determined, or pronounced by the Wakil’s Sharī`ah advisory body;

“Transaction” means an investment made by the Muwakkil through the Wakil, the terms of which are agreed by the Parties

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pursuant to the issuance of a Wakil Offer and a corresponding Muwakkil Acceptance, each in accordance with this Agreement;

“Wakalah” means a contract of agency under the Sharī`ah whereby a person appoints another to perform a certain task on his behalf;

“Wakil” means the Wakil in its capacity as agent for and on behalf of the Muwakkil pursuant to its appointment in accor-dance with Clause 3.1;

“Wakil Fee” means the agency fee chargeable by the Wakil under this Agreement and as specified in paragraph 7 of the relevant Wakil Offer; and

“Wakil Offer” means, in relation to a Transaction, a written notice to be sent by the Wakil to the Muwakkil pursuant to Clause 5.1 and substantially in the form of Schedule 2 (Form of Wakil Offer).

1.2 In this Agreement, unless the context otherwise requires:1.2.1 the recitals to this Agreement and all the schedules hereto

shall constitute integral parts of this Agreement and shall be read together with it for all their purposes and intents;

1.2.2 words importing the singular include the plural and vice versa;

1.2.3 words importing a gender include any gender;1.2.4 a reference to a part, clause, or Schedule is a reference to a

part and clause of, and schedule to, this Agreement and a ref-erence to this Agreement includes any schedule;

1.2.5 a reference to a document includes an amendment or supple-ment to, or replacement or novation of, that document;

1.2.6 where the day on or by which any action is to be done is not a Business Day, that thing must be done on or by the next Business Day;

1.2.7 a reference to an agreement includes an undertaking, agree-ment or legally enforceable arrangement or understanding whether or not in writing; and

1.2.8 an agreement, representation or warranty in favour of two or more persons is for the benefit of them jointly and severally.

2. CONDITIONS PRECEDENT The performance of the matters set out in Section 4 of Schedule 1 hereto prior to or on execution of this Agreement shall be a condition precedent to its effectiveness. The Muwakkil hereby expressly acknowledges and declares that the said matters are intended for the benefit of the Wakil and may, therefore, be waived wholly or in part by the Wakil at its discretion without preju-dicing the Wakil’s rights and such waiver shall not prejudice the Wakil

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from insisting on the Muwakkil’s compliance with any such waived matter at any subsequent period as the Wakil may deem fit.

3. TERMS APPLICABLE TO THE WAKALAH RELATIONSHIP3.1 In respect of each Transaction and in consideration of the Muwakkil

paying the Investment Amount to the Wakil in accordance with Clause 5.3, the Muwakkil appoints the Wakil as its agent and the Wakil accepts such appointment to invest the relevant Investment Amount in accordance with the terms of this Agreement.

3.2 Subject to Clause 9, the appointment of the Wakil pursuant to Clause 3.1 shall take effect from the relevant Investment Date and end on the relevant Maturity Date.

3.3 In respect of each Transaction, the Wakil shall invest the Investment Amount on a discretionary basis but, subject always to this Wakalah, shall be restricted to investments in transactions permitted under the Sharī`ah. The Parties agree that the Wakil may aggregate the Investment Amount with the Wakil’s pool of investments and with other amounts received by the Wakil pursuant to Transactions entered into with other counterparties from time to time such that the aggregate return of these investments achieves no less than the Anticipated Profit for such Transaction.

3.4 The Wakil shall arrange for payment and collection of funds on behalf of the Muwakkil and is hereby authorized to execute and deliver any instruments or transfers necessary in connection therewith.

3.5 In connection with its powers, discretions, authorities and duties under this Agreement, the Wakil shall act as the non-exclusive agent of the Muwakkil on a deal by deal basis to the extent expressly provided herein and in respect of Transactions from time to time entered hereunder and shall not otherwise be regarded as agent for and on behalf of the Muwakkil in any other respect whatsoever.

4. TERMS APPLICABLE TO TRANSACTIONS4.1 The Parties agree that there is no obligation on the part of either the

Wakil or the Muwakkil to enter into a Transaction except upon a binding agreement coming into effect in accordance with Clause 5.2.

4.2 The Muwakkil as principal shall bear and indemnify the Wakil against all the risks associated with the acts of the Wakil as agent for the Muwakkil including in the event the Loss exceeds the Investment Amount except those risks resulting from the Wakil’s misconduct, negligence, default, omission, or fraud.

4.3 The Muwakkil is entitled to seek from the Wakil, and the Wakil shall in such circumstances provide, the specifics of investments entered into by the Wakil on behalf of the Muwakkil pursuant to a Transaction.

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4.4 Unless provided for to the contrary in Section 5 of Schedule 1 hereto, the Muwakkil irrevocably agrees not to withdraw any Investment Amount prior to the relevant Maturity Date.

4.5 Investment Transactions shall be carried out for and on behalf of the Muwakkil but in the name of the Wakil, or in the name of such other person or persons as the Wakil appoints in its discretion. For the avoidance of doubt, the Wakil shall be entitled to appoint such subagent or agents as the Wakil in its discretion may deem necessary.

4.6 The Wakil shall be entitled to the Wakil Fee notwithstanding that the Actual Profit is less than, equal to or exceeds the Anticipated Profit and in the event of a Loss.

4.7 In the event the Actual Profit is equal to or exceeds the Anticipated Profit, the Muwakkil shall be entitled to receive the Anticipated Profit less the Wakil Fee and the Wakil shall be entitled to retain the difference between the Actual Profit and the Anticipated Profit as an incentive.

5. TRANSACTION ARRANGEMENTS5.1 Wakil Offer

On any Business Day, the Parties may by telephone or any other means such as facsimile or e-mail agree the terms of a proposed Transaction. As soon as reasonably practicable thereafter, the Wakil shall send to the Muwakkil a Wakil Offer setting out the terms of the proposed Transaction.

5.2 Muwakkil AcceptanceThe Muwakkil, if it is willing to accept the Wakil Offer made by the Wakil pursuant to Clause 5.1, shall confirm the terms of the Wakil Offer by sending a Muwakkil Acceptance to the Wakil no later than one (1) Business Day before the proposed Investment Date. Upon receipt by the Wakil of such Muwakkil Acceptance, a conditional Transaction shall be constituted incorporating the terms of the Wakil Offer and the Muwakkil Acceptance.

5.3 Payments by the Investment Date5.3.1 Pursuant to the agreement of a Transaction in accordance

with Clause 5.2, the Muwakkil shall be obliged to pay the Investment Amount to the account specified in the relevant Wakil Offer not later than the relevant Investment Date.

5.3.2 The Parties agree that the payment of the relevant Investment Amount by the Muwakkil to the Wakil shall constitute an unconditional Transaction.

5.3.3 Save in the event the matter set out in Section 6 of Schedule 1 hereto applies, in which case this Clause 5.3.3 shall not apply, if the Muwakkil shall for any reason whatsoever fail to

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comply with Clause 5.3.1, the Transaction shall thereupon be deemed automatically cancelled and of no further effect and the Parties shall have no further rights or obligations against each other in respect thereof.

5.4 Payments on the Maturity Date5.4.1 On the Maturity Date, if:

a. The Actual Profit is equal to or exceeds the Anticipated Profit, the Wakil shall pay to the Muwakkil an amount equal to the Investment Amount plus the Anticipated Profit less the Wakil Fee and shall retain the difference between the Actual Profit and the Anticipated Profit as its entitlement;

b. The Actual Profit is less than the Anticipated Profit, the Wakil shall pay to the Muwakkil an amount equal to the Investment Amount plus the Actual Profit less the Wakil Fee; or

c. The Transaction shall have suffered a Loss, the Wakil shall pay to the Muwakkil the Investment Amount less the Wakil Fee andthe Loss; in each case, the amount payable by the Wakil to the Muwakkil shall be the “Maturity Proceeds.”

5.4.2 All payments of the Maturity Proceeds made by the Wakil pursuant to Clause 5.4 shall be made to the account stated in the relevant Muwakkil Acceptance.

6. REPRESENTATIONS AND WARRANTIES6.1 Each Party represents and warrants for the benefit of the other

Party from the date of this Agreement that:6.1.1 It has and will at all times for the duration of this Agreement

have the legal capacity to enter into this Agreement and each Transaction thereby contemplated, and will cause all neces-sary corporate resolutions and authorities to be made and/or passed to ensure that the persons who purport to enter into Transactions on its behalf are able to commit it in accordance with terms of this Agreement; and

6.1.2 It has and will at all times maintain all authorisations, approvals, licences and consents required to enable it to perform its obligations under this Agreement and each Transaction.

6.2 The Muwakkil hereby represents and warrants to the Wakil that:6.2.1 It as acted, and will at all times for the duration of this

Agreement act, as a principal and not as a trustee for the purposes of entering into a Transaction contemplated by this Agreement;

6.2.2 It has entered into this Agreement and each Transaction and each transaction document after having reviewed them for

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the purposes of their permissibility under the law including the Sharīàh and with, to the extent it has considered this nec-essary taken, independent advice from advisors specialising in the law including the Sharīàh and:a. Is satisfied that the provisions of this Agreement and

each Transaction do not contravene the law including the Sharīàh; and

b. Confirms that it does not have any objection, nor will it raise any objections as to the legality or validity under the law including the Sharīàh of any provision of this Agreement or any Transaction; and

6.2.3 The source(s) of the Investment Amount will be legal and per-mitted under all applicable laws and regulations (including the laws and regulations relating to foreign exchange) and the Muwakkil will take all such necessary action to ensure that at all times such laws and regulations will be complied with and will not be contravened.

6.3 Neither the Wakil nor the Muwakkil has advised each other to enter into this Agreement or any Transaction entered into or to be entered into under this Agreement but that the Muwakkil has decided to enter into this Agreement and each such Transaction in reliance on its own expertise and/or after taking such third party advice as it saw or sees fit.

6.4 The above warranties shall be deemed to be repeated by:6.4.1 The Wakil each time a Wakil Offer is sent to the Muwakkil; and6.4.2 The Muwakkil each time a Muwakkil Acceptance is sent to

the Wakil. 7. LIABILITY AND INDEMNITY OF THE AGENT

7.1 The Wakil shall not be liable to the Muwakkil in contract or tort or otherwise for any direct or indirect financial or economic losses, costs, liabilities or expenses (including, without limitation, loss of profit, loss of savings or loss of goodwill) save for those directly aris-ing as a result of the Wakil’s misconduct, negligence, default, omis-sion or fraud. The liability of the Wakil for any losses arising directly as a result of the Wakil’s misconduct, negligence, default, omission or fraud shall not in any event exceed the Investment Amount. The Wakil shall not be liable in relation to the misconduct, negligence, default, omission or fraud of any person, firm or company with whom Transactions are effected for the account of the Muwakkil.

7.2 Neither Party shall be liable for any failure of the other Party to duly and punctually perform any of its respective duties or obliga-tions under this Agreement.

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8. PAYMENT8.1 All payments to be made by either Party shall be without deduction

for and free from any present or future taxes, levies, imposts, duties, charges, fees, deductions, withholdings, restrictions or conditions of any nature imposed, levied, collected, or assessed by any taxing authority unless that Party is compelled by law to make any such deduction or withholding. In that event that Party shall ensure that such deduction or withholding does not exceed the minimum legal liability therefor and shall pay to the appropriate authorities the amount deducted or withheld and supply a tax deduction certificate to the other party.

8.2 If the payment due falls on a day that is not a Business Day, the pay-ment shall be made on the next following Business Day.

9. TERMINATION9.1 This Agreement shall remain in force until and unless either Party

has given at least twenty-one (21) days’ notice of termination in writing to the other Party.

9.2 The Muwakkil or the Wakil, as the case may be, shall be entitled to terminate this Agreement forthwith by giving written notice to the other if:9.2.1 The other Party becomes subject to Insolvency Proceedings; or9.2.2 The other Party commits a breach of any of its obligations

under this Agreement or any of its representations or warran-ties as stated in Clause 6 is false or incorrect in any material respect, and (if such breach shall be capable of remedy) shall not be remedied by such Party within fourteen (14) days of receipt of a notice served by the first mentioned Party requir-ing it to make good such breach;

9.2.3 There is evidence of the Wakil’s misconduct, negligence, default, omission or fraud or insolvency; or

9.2.4 The other Party is, or is deemed for the purposes of any law to be, unable to pay its indebtedness as is due or insolvent.

9.3 Termination of this Agreement will be without prejudice to any rights or obligations of a Party accrued up to the date of termi-nation and the completion of any Transaction already executed, whichever is later.

9.4 Following any termination of this Agreement under the provi-sions hereof, each Party may set off any obligation owed under this Agreement against any other obligation (whether or not matured) owed between the Parties regardless of place of payment, booking branch or currency of the obligation. Written notice is to be given to the other Party after such setting off.

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10. CONFIDENTIALITYThe contents of this Agreement and the transactions contemplated by this Agreement shall be kept confidential by the Parties during the cur-rency of this Agreement and after it shall terminate save to the extent that any such matter shall become a matter of public knowledge other than through the fault of either Party and save as required by an order of court of competent jurisdiction or competent administrative author-ity. The foregoing prohibition shall not apply to disclosures (i) made to the legal or financial or any other professional advisors and service providers of any Party or its Affiliates; (ii) required by law or by any regulatory supervisory, governmental or quasi-governmental authorities or court or tribunal with jurisdiction over the Party or its Affiliates; (iii) made in connection with the enforcement of this Agreement; (iv) made to the Affiliates and the group of companies of either Party and par-ties providing processing services for the Transactions; (v) made to any actual or potential participant or sub-participant in relation to any of the Party’s rights and/or obligations under any agreement between the Parties or its assignee, novatee or transferee (and any agent or adviser of any of the foregoing); and (vi) made to any rating agency or any insurer or insurance broker of or direct or indirect provider of credit protection to any Party or its Affiliates on a need to know basis. For the purpose of this Clause, “Affiliates” are companies controlled by a Party or any company that (i) controls the Party or (ii) is under common control with the Party.

11. ASSIGNMENT11.1 Subject to Clause 11.2, this Agreement is personal to the Parties

and their respective rights and obligations hereunder shall not be assignable or transferable.

11.2 Notwithstanding Clause 11.1, either Party may assign or transfer its rights, benefits or obligations under this Agreement or under any Transaction to any company in the group of companies of which it is a member with the prior written consent of the other Party.

12. ENTIRE AGREEMENT This Agreement and the documents to be entered into pursuant to this Agreement, including any Wakil Offer and Muwakkil Acceptance, constitute the entire agreement and understand-ing between the Parties in relation to the subject matter hereof and the terms of this Agreement and such documents may not be rectified by reference to evidence of any prior oral agreement.

13. NOTICES13.1 Any notice to be given in relation to this Agreement shall, except

where communication by telephone is expressly agreed and

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contemplated, be given in writing. All mail and notices may be given by such modes and subject to such additional terms and con-ditions as may be agreed between the Parties at their respective addresses, telephone/facsimile/telex and e-mail addresses set out in Schedule 4 hereto and will be deemed to be received:

a. If in writing and delivered in person or by courier on the date it is delivered;

b. If sent by telex, on the date the recipient’s answer back is received;

c. If sent by facsimile transmission, on the date that transmission is received by the recipient in legible form and confirmed by a transmission report generated by the sender’s facsimile machine;

d. If sent by ordinary or registered mail, (unless there is evidence of earlier receipt) three (3) days after posting;

e. If sent by electronic messaging system (which shall include email exchanges), on the date that electronic message is received,unless the date of that delivery or that receipt as applicable is not a Business Day or that communication is delivered or received as applicable after the close of business on a Business Day, in which case that communication shall be deemed given on the first following day that is a Business Day.

13.2 a. Each Party (“Recipient”) is authorized, but not obliged, to rely upon and act on all instructions and correspondence (“Instructions”) from the other Party (“Sender”) communicated by telephone or transmitted by facsimile or other electronic mode of communication as may be mutually agreed upon by the Parties.

b. The Sender releases the Recipient which has relied upon or acted on the Instructions from the Sender and indemnifies and holds the Recipient harmless from and against all actions, suits, proceedings, costs (including legal costs), claims, demands, charges, expenses, losses and liabilities however arising (unless due to the gross negligence or wilfull default of the Recipient) in consequence of, or in any way related to:i. The Recipient having acted in good faith in accordance

with the Sender’s Instruction, notwithstanding that such instruction(s), as above have been initiated or transmitted in error or fraudulently altered, misunderstood or distorted in the lines of communication or transmission;

ii. The Recipient having refrained from acting in accordance with the Sender’s Instruction by reason of failure of either actual transmission thereof to the Recipient or receipt by

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the Recipient for whatever reason, whether connected to the fault or failure or other cause connected to the sending or receiving machine or otherwise; or


13.3 Each Party shall be entitled to record all telephone conversations and instructions received from the other Party and such recordings and transcripts thereof shall be used by the Parties as evidence in any dispute. Each Party’s recordings shall be and remain the sole property of such Party.

14. UNENFORCEABILITY The illegality, invalidity, or unenforceability of any provision of this Agreement under the laws of any jurisdiction shall not affect or impair the validity or enforceability of any other pro-vision of this Agreement or the other agreements and/or documents to be entered into pursuant to this Agreement, which shall be construed as if such illegal, invalid, or unenforceable provisions had never been con-tained in this Agreement and/the other agreements and/or documents to be entered into pursuant to this Agreement.

15. AMENDMENTS This Agreement shall not be capable of amendment or variation without the prior written agreement of both Parties to be signed by a duly authorised representative of each Party.

16. COUNTERPARTS This Agreement may be executed in any number of counterparts, and this has the same effect as if the signatures on the counterparts were on a single copy of the Agreement.

17. SHURA (CONSULTATION) In the event of any dispute, controversy, claim, or difference whatsoever arising between the Parties at any time hereafter whether during or the continuance in effect of this Agreement or upon or after its discharge or termination touching any Clause, mat-ter or thing herein contained or the operation or construction thereof or any matter or thing in any way connected with or relating to this Agreement or the rights, duties or liabilities of either Party under or in connection with this Agreement or any Transaction, the Parties shall first attempt to resolve them amicably through mutual consultation between them in the true spirit of Shura.

18. GOVERNING LAW AND JURISDICTION18.1 This Agreement and each Transaction shall be governed by and

construed, interpreted and applied in accordance with the laws of Malaysia provided always that in the event there is a conflict between the civil laws and the Sharī`ah on any matter whatsoever, the Sharī`ah shall prevail.

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18.2 In the event of a dispute or difference of opinion whatsoever between the Parties in respect of, relating to, or in connection with the Sharīàh, the Wakil shall seek the advice of the Sharīàh Advisory Council of Bank Negara Malaysia thereon and such advice shall bind the Parties.

18.3 The Parties irrevocably agree that the courts of Malaysia are to have jurisdiction to settle any disputes that may arise out of or in connection with this Agreement and each Transaction. The Parties hereby irrevocably submit to the jurisdiction of the Malaysian courts and waive any objection on the ground of venue or on the ground that the proceedings have been brought in an inconvenient forum provided that this Clause shall be without prejudice to the right to bring proceedings in any other jurisdiction for the purpose of enforcement or execution of any judgement or other settlement in any other courts.

18.4 The Parties to this Agreement recognise and agree that the pay-ment or the receipt of interest is prohibited under the Sharīàh and, accordingly, to the extent that any legal system would (but for the provisions of this Clause) impose (whether by contract or by stat-ute) any obligation to pay interest, the Parties hereby irrevocably and unconditionally expressly waive and reject any entitlement to recover interest from each other.

19. SUCCESSORS This Agreement shall ensure to the benefit of and bind the Parties and their respective permitted assigns and transferees.

20. RECONSTRUCTION The liabilities and or obligations created by this Agreement shall continue to be valid and binding for all purposes whatsoever notwithstanding any change by amalgamation, reconstruc-tion or otherwise, which may be made in the constitution of the other party.

21. RIGHTS CUMULATIVE21.1 The rights of each Party under this Agreement are cumulative and

are in addition to its rights under general law.21.2 The rights of each Party under this Agreement (whether arising

under this Agreement or under general law) are not:21.2.1 Capable of being waived or varied otherwise than by an

express waiver or variation in writing;21.2.2 Waived or varied by any failure to exercise or any delay in

exercising any of such rights; and21.2.3 Precluded from partial exercise of any of such rights.

22. FORCE MAJEURE If the fulfillment of the terms and conditions of this Agreement is rendered impossible due to force majeure events, that is extraordinary and unforeseen circumstances that are beyond the

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affected Party’s reasonable control, each Party shall not be liable to the other Party for any delay in performance of its obligations under the Transaction but shall not be released from the obligations under this Agreement. The Party affected by such events shall promptly inform the other Party in writing of the circumstances and shall use all reasonable endeavours to comply with its obligations or provide alternative perfor-mance reasonably acceptable to the other Party. In the event such inca-pacitation continues for a period of fourteen (14) days from the date of the first such force majeure event, the Parties shall have the right to terminate the Transaction fully or in part after making mutually agree-able reasonable settlements. For the avoidance of doubt, force majeure events shall include war, hostilities, any state of riots, civil commotion, earthquake, flood, fire, tempest and any other natural disaster or any event beyond the reasonable control of the Parties.

23. TIME Time wherever mentioned herein shall be of the essence. 24. ADDITIONAL TERMS The Parties hereby agree that they shall also

be subject to the additional terms and conditions as set out in Schedule 5 hereto.

THERE ARE NO FURTHER CLAUSES.SCHEDULES 1 TO 5 APPEAR IMMEDIATELY AFTER THIS PAGE.

• • •

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SCHEDULE 1Particulars

Section Item Particulars1. Date of this Agreement

2. Muwakkil Name:Registration No.:Registered Office:Business Address:

3. Wakil Name:Registration No.:Registered Office:Business Address:

4. Conditions Precedent The delivery of duly certified true cop-ies of the following documents by the Muwakkil to the Wakil prior to or on execution of this Agreement:a. its charter or constitutional

documents;b. a copy of the resolution of its board

of directors or equivalent manage-ment body, approving the execution, delivery and performance of this Agreement, the Transactions contem-plated by it and the documents in connection therewith;

c. a list of its authorised signatories con-taining their specimen signatures; and

d. such other documents as the Wakil may reasonably require.

5. Premature Withdrawal of Investment Amount

Notwithstanding Clause 4.4, the Muwakkil may withdraw the Investment Account prior to the Maturity Date in which event the provisions of Clause 5.4 shall apply mutatis mutandis save that “Actual Profit” therein shall be construed to be the profit from the Transaction accrued to the day of withdrawal as com-puted by the Wakil.

6. Effects of Muwakkil’s non-payment of the Investment Amount if the Wakil has entered into pre-order commitments

Clause 4.2 shall apply mutatis mutandis.

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SCHEDULE 2

Form of Wakil Offer

WAKIL OFFER

Deal No.:

Date: [ ]

To: [Muwakkil]

From: [Wakil]

Corporate Wakalah Placement Agreement dated [insert date of this Agreement] between ourselves and yourselves (the “Corporate Wakalah Placement Agreement”).

We refer to the Corporate Wakalah Placement Agreement (terms defined in which shall have the same meanings herein) and your instructions of today, in which you indicated your wish to place an amount with us for investment by us in transactions permitted under the Sharī`ah on your behalf:

1 Investment Amount: [ ] 2 Investment Date: [ ] 3 Maturity Date: [ ] 4 We will invest the Investment Amount in transactions expected to gen-

erate for you in aggregate an Anticipated Profit of [ ] % per annum. Any profit exceeding this will be retained by us as an incentive.

5 In respect of the Investment Amount, please authorize us to debit your account with us or credit the amount to our following account: [ ].

6 This offer is conditional upon receipt by us of the Investment Amount in cleared funds no later than the Investment Date.

7 We shall be entitled to a Wakil Fee in the sum of RM [insert amount] in accordance with the provisions of the Corporate Wakalah Placement Agreement.

________________________________

Signed for and on behalf of

________________________________[Wakil]

Name___________________________

Title___________________________

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SCHEDULE 3

Form of Muwakkil Acceptance

MUWAKKIL ACCEPTANCE

Deal No.:

Date: [ ]

To: [Wakil]

From: [Muwakkil]

Corporate Wakalah Placement Agreement dated [insert date of this Agreement] between ourselves and yourselves (the “Corporate Wakalah Placement Agreement”).

1. We refer to the Corporate Wakalah Placement Agreement (terms defined in which shall have the same meanings herein) and to your Wakil Offer dated [ ].

2. We accept your offer to enter into a Transaction and hereby enter into a Transaction with you under the terms of the Corporate Wakalah Placement Agreement and the above referenced Wakil Offer.

3. Please transfer any Maturity Proceeds on the Maturity Date to the fol-lowing Account: [ ]

________________________________Signed for and on behalf of

________________________________[Wakil]

Name___________________________

Title___________________________

• • •

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SCHEDULE 4

Particulars of Communication

The Wakil

Attention: [Name] – [Title]

Postal Address:

Telephone:

Fax:

SWIFT:

E-mail:

The Muwakkil

Attention:

Postal Address:

Telephone:

Fax:

SWIFT:

E-mail:

Or in accordance with such other contact details as one Party may from time to time notify in writing to the other.

• • •

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SCHEDULE 5

Additional Terms and Conditions

1 COMPENSATION (TA`WIDH)1.1 Any payment due to the Muwakkil under this Agreement that is

not paid on the due date by the Wakil shall be deemed to be a late payment. It is expressly agreed by the Parties that, in addition to the payments then due and payable, the Wakil shall pay a compensation on late payments, which shall be calculated based on the compensa-tion rate of one percent (1%) per annum of the overdue payment or by any other method approved by the Sharī`ah Advisory Council of Bank Negara Malaysia from time to time.

1.2 Any payment due to the Muwakkil under this Agreement that is not paid on the due date by the Wakil shall be deemed to be a late pay-ment. If any of the payments shall be required to be recovered by the Muwakkil from the Wakil through any process of law or other-wise, the Wakil shall pay (in addition to the payments then due and payable) all actual fees and expenses properly incurred in respect of such collection or recovery process including the Muwakkil’s solici-tors’ fees (on a solicitor and client basis) provided that the actual fees and expenses shall not exceed the amount of the compensation rate as approved by the Sharī`ah Advisory Council of Bank Negara Malaysia from time to time.

THERE ARE NO FURTHER SCHEDULES.THE TESTIMONIUM APPEARS IMMEDIATELY AFTER THIS PAGE.

• • •

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IN WITNESS WHEREOF, the Parties or their respective duly autho-rised representatives have caused this Agreement to be duly executed as of the date first above written.

SIGNATURES

THE MUWAKKIL

If under hand:

For and on behalf of

___________________________ ___________________________Authorised signatory Authorised signatory

Name______________________ Name______________________

Title_______________________ Title_______________________

If under seal:

The common seal of __________________________ was hereunto affixed in the presence of:

_______________________ _______________________Director Director/Secretary

Name______________________ Name______________________

Title_______________________ Title_______________________

The Wakil

For and on behalf of

___________________________

___________________________ ___________________________Authorised signatory Authorised signatory

Name______________________ Name______________________

Title_______________________ Title_______________________

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10.6. CORPORATE MURABAHAH MASTER AGREEMENT

Association of Islamic Banking Institutions MalaysiaAs approved by AIBIM Sharī`ah Advisory Committee

on December 11, 2014

DATED THIS_______ DAY OF_____________20__

__________________________________________________

CORPORATE MURABAHAH MASTER AGREEMENT

___________________________________________________

BETWEEN

<***>

(Company No. <***>)

(“Principal”)

AND

<***>

(Company No. <***>)

(“Bank”)

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THIS AGREEMENT is made

BETWEEN

The Party whose name and particulars are set out in Section 1 of Appendix 1 and includes its successors in title and permitted assigns (“Principal”) of the one part;

AND

The Party whose name and particulars are set out in Section 2 of Appendix 1 and includes its successors in title and assigns (“Bank”) of the other part.

WHEREAS:

A. The Bank is carrying on the business of Murabahah activities as part of its<***investment activities/Islamic banking business1>, which includes buying and selling of the Merchandise (as herein defined) by way of Murabahah.

B. By an agreement dated on the date specified in Section 3 of Appendix 1(“Master Agency Agreement”) made between the Principal and the Bank, the Principal has agreed to appoint the Bank as its agent to do all acts as the Principal could do itself with respect to the purchase of the Merchandise on a cash basis (“Purchase Transactions”) and the Bank has agreed to accept such appointment on the terms and conditions set out therein.

C. The Bank will from time to time enter into arrangement with the Principal whereby, the Bank, upon the completion of each of the Purchase Transactions, <***may/will2> purchase from the Principal the Merchandise at an agreed sale price for a spot delivery date and a deferred cash consideration on terms and conditions set out in this Agreement (“Sale Transactions”). The Principal as the seller shall always ensure all elements of Murabahah are preserved where the Principal must disclose its profit and cost of the Merchandise to the Bank as the buyer upon the Parties’ (as herein defined) agreement to enter into this transaction.

1 To delete where appropriate subject to the requirements of the Bank.2 Subject to the requirement of the Bank.

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NOW IT IS HEREBY AGREED as follows:

1. DEFINITIONS AND INTERPRETATION1.1 Incorporated Definitions

In this Agreement the following expression shall, unless the context otherwise requires, have the following meanings:

Bank Means the party whose name and particulars are set out in Section 2 of Appendix 1 and includes its suc-cessors in title and assigns;

Bank’s Confirmation

Means the confirmation issued by the Bank to the Principal upon the completion of the Purchase Transaction in the form set out in Appendix 5 herein or in such other form mutually agreed;

Bank’s Offer Means the offer to purchase the Merchandise issued by the Bank to the Principal in the form set out in Appendix 6 herein or in such other form mutually agreed;

Business Day Means a day (excluding Saturday, Sunday and public holiday) on which commercial banks are open for busi-ness in Kuala Lumpur save that to the extent it refers to any payment, in which event the expression “Business Day” shall mean a day (excluding Saturday, Sunday and public holiday) on which commercial banks are open for business in Kuala Lumpur and London, and, in relation to payments in (i) Dollars, New York; and (ii) any other currency, in the principal financial centre for foreign exchange dealings in such currency;

Insolvency Proceeding

Means a case or proceeding or petition or resolution or arrangement for insolvency, bankruptcy, composi-tion, rehabilitation, reorganisation, administration, winding-up, liquidation or other similar relief with respect to a party or its debts or assets or seek the appointment of a trustee, receiver, liquidator, conser-vator, custodian or other similar official of a party or any substantial part of its assets, under any bank-ruptcy, insolvency or other similar law or any bank-ing, insurance, or similar law governing the operation of a party and any analogous proceeding in any juris-diction to which a party is subject to. For avoidance of doubt, “Insolvency Proceeding” shall not include any contested proceeding until the outcome of the such proceeding is determined by court;

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Master Agency Agreement

Means the Master Agency Agreement dated on the date specified in Section 3 of Appendix 1 made between the Principal and the Bank upon the terms and conditions therein contained and includes any variation, modification and supplement thereof;

Merchandise Means goods and commodities that are acceptable to the Principal and the Bank and valued accord-ing to Sharīàh as set out in Appendix 2 hereto. The “Merchandise” shall be goods and commodities other than gold, silver or currency(s) and it also excludes pork, alcoholic drinks, tobacco, narcotics, or any other items that are not acceptable to Sharīàh, the Principal and the Bank;

Parties or Party Means the parties or party to this Agreement;

Principal Means the party whose name and particulars are set out in Section 1 of Appendix 1 and includes its suc-cessors in title and permitted assigns;

Principal’s Acceptance

Means the Principal’s acceptance of the Bank’s Offer to purchase the Merchandise from the Principal in the form set out in Appendix 7 herein or in such other form mutually agreed;

Purchase Order Means the notice to be issued by the Principal to the Bank as its agent in the form set out in Appendix 4 herein or in such other form mutually agreed indicat-ing the Principal’s wish to purchase the Merchandise under the Purchase Transaction;

Purchase Transactions

Means the purchases of the Merchandise by the Principal on a cash basis on terms and conditions set out in this Agreement, and “Purchase Transaction” shall refer to any one of them;

Sale Transactions Means the purchases of the Merchandise from the Principal for a spot delivery date and a deferred cash consideration on terms and conditions set out in this Agreement, and “Sale Transaction” shall refer to any one of them;

Sharīàh Principles

Means the Islamic principles of banking, trade and financing as adopted and approved by the Sharīàh Advisory Council of Bank Negara Malaysia and the Sharīàh Committee of the Bank;

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Supplier Means the third party, including but not limited to commodity trading houses, commodity brokers, industrial firms and/or their suppliers, from whom the Merchandise are purchased/to be purchased under the Purchase Transactions; and

Trade Transactions

Means collectively the Purchase Transactions and the Sale Transactions.

1.2 InterpretationThe headings in this Agreement are inserted for convenience only and shall not be taken, read, and construed as essential parts of this Agreement. i. References to clauses or schedules are to be construed as refer-

ences to the clauses or schedules of this Agreement. ii. All references to provisions of any legislation or statute include

references to any amendments, any statutory modification and re-enactment thereof or regulations proclamations, bylaws, published rulings, statements of policy or guidelines issued under or in relation to that statute.

iii. References to this Agreement shall include all amendments and modifications to this Agreement as shall from time to time be in force.

iv. Words importing the singular number shall include the plural number and vice versa.

v. Where two or more persons or parties are included or com-prised in any expression, agreements, covenants, terms, stipula-tions and undertakings expressed to be made by or on the part of such persons or parties shall be deemed to be made by and be binding upon such persons or parties jointly and severally.

vi. Words importing the masculine gender shall include the femi-nine and neuter gender and vice versa.

vii. A reference to a document includes any amendment or supple-ment to, or replacement or novation of that document.

viii. A reference to “date” or “time” is a reference to that date or time in Malaysia.

ix. Any reference to “law of Malaysia” shall be construed so as to include, without limitation, any act, ordinance, statutory or municipal, rule, regulation, ruling, decree, or order enacted, issued or decreed by the Parliament of Malaysia or any bureau, minister, instrument, agency, court, regulatory body, author-ity, legislative body, or department thereof (including, without

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limitation, Bank Negara Malaysia or any taxing, fiscal, or other monetary authority thereof) and Islamic law as administered by the courts of Malaysia.

x. Other parts of speech and grammatical forms of a word or phrase defined in this Agreement shall have a corresponding meaning.

1.3 LanguageEnglish is the governing language of this Agreement and shall pre-vail over any translations that shall be made of this Agreement. All correspondences, notices or other documents required or permitted hereunder may be drawn up in English and drawings and diagrams shall be annotated in English.

2. DOCUMENTS2.1 On execution of this Agreement, the Principal shall deliver to the

Bank the following documents in form and substance satisfactory to the Bank, where applicable: a. A certified true copy of the constitutional documents of the

Principal; b. A certified true copy of the resolution(s) of the Principal’s board

of directors or equivalent management body approving the execution, delivery and performance of this Agreement and the documents and arrangements contemplated by it;

c. A list of signatories, with specimen signatures, of those persons authorised by the Principal to give instructions to the Bank; and

d. Any other relevant documents as requested by the Bank.2.2 It is hereby expressly acknowledged and declared that the documents

contained herein in this Clause 2.2 are inserted for the benefit of the Bank and may therefore be waived wholly or in part by the Bank at its sole and absolute discretion without prejudicing the Bank’s rights and such waiver shall not prejudice the Bank from insisting on the Principal’s compliance with any such waived requirement at any subsequent period as the Bank may think fit and necessary.

3. PURCHASE TRANSACTIONS3.1 The Principal, pursuant to the Master Agency Agreement, has

appointed the Bank to be its agent to purchase the Merchandise under the Purchase Transaction, subject to the terms and condi-tions of this Agreement in accordance with the guidelines detailed in Appendix 2 hereto.

3.2 The Parties may proceed to undertake the Purchase Transaction in accordance with the procedure set out in Appendix 3 hereto.

3.3 The Parties hereby agree that upon completion of the Purchase Transaction, the title, ownership, rights, and interests of the

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Merchandise shall immediately be transferred to the Principal, and the Bank shall immediately enable the Principal to take possession of the Merchandise.

3.4 Each Party acknowledges that the Merchandise composed in a Purchase Transaction shall be capable of physical delivery. The Principal may request for the physical delivery of the Merchandise provided that the Bank shall have received such instruction from the Principal in the Purchase Order and the Bank has received pay-ment for the Merchandise. In the event the Bank does not receive payment for the Merchandise and/or instructions for physical deliv-ery of the Merchandise, the Bank is expressly authorized by the Principal to dispose of the Merchandise at such time and in such manner as the Bank may decide and the Principal shall pay the Bank all losses, damage, costs and expenses incurred or sustained by the Bank as a result of the purchase of Merchandise under any Purchase Transaction as agent of the Principal or as a result of the Principal’s failure to comply with the Principal’s obligations to effect the payment of the Merchandise to the Supplier.

3.5 All costs associated with the physical delivery of the Merchandise as requested by the Principal in accordance with Clause 3.4 above, including but not limited to the delivery costs, storage costs and insurance, shall be borne by the Principal.

4. TAX4.1 The Principal does not wish to enter into any Purchase Transaction

in respect of which value added tax (“VAT”) or any other tax is payable and the Bank will not propose any purchase of this kind.

4.2 All sums payable by the Principal under any Purchase Transaction shall be deemed to be exclusive of VAT and any other tax levied in respect thereof and all sums payable to the Principal under any Sale Transaction shall be inclusive of VAT and any other tax levied in respect thereof.

4.3 For the purposes of the interpretation of this Clause 4, any refer-ence to VAT or tax shall be a reference to value added tax charged under any United Kingdom VAT legislation or to any similar sales or turnover tax levied or imposed by the governments of the United Kingdom or Malaysia or government of any other jurisdiction where the Merchandise is traded.

5. SALE TRANSACTIONS5.1 Unless the Principal decides to have the physical delivery of the

Merchandise as set out in the Purchase Order and Provided that the Principal shall have received the Bank’s Confirmation, the Bank <***may/will3> proceed to undertake any Sale Transaction whereby

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the Bank <***may/will4> purchase the Merchandise from the Principal upon like terms (save as to price which shall be paid on deferred basis) as the Bank purchased such Merchandise on behalf of the Principal from the Supplier under the Purchase Transaction.

5.2 Each Sale Transaction shall be entered into by the Bank in accor-dance with the operational schedule in Appendix 3 hereto.

5.3 In respect of each Sale Transaction title, ownership, rights, and inter-ests of the Merchandise shall pass to the Bank as purchaser thereof immediately following the passing of such title, ownership, rights and interests to the Principal under the relevant Purchase Transaction.

5.4 Subject to Clause 7.4, the Bank <***may/will5> purchase the Merchandise from the Principal at a sale price and payable on the deferred payment date, as may be agreed between the Principal and the Bank and specified in the Principal’s Acceptance, on the basis that: a. All payments to be made by the Bank as purchaser to the

Principal pursuant to any Sale Transaction shall be made with-out any set-off or counterclaim, and in immediately available and transferable funds for good value on the due date thereof to the account of the Principal that the Principal shall from time to time notify the Bank; and

b. All payments to be made by the Bank as purchaser to the Principal shall be without deduction for and free from any pres-ent or future taxes, levies, imposts, duties, charges, fees, deduc-tions, withholdings, restrictions, or conditions of any nature imposed, levied, collected, or assessed by any taxing authority unless the Bank is compelled by law to make any such deduc-tion or withholding. In that event the Bank will ensure that such deduction or withholding does not exceed the minimum legal liability therefor and will pay to the appropriate authorities the amount deducted or withheld and supply a tax deduction cer-tificate to the Principal.

5.5 If any payment due from the Bank as purchaser under any Sale Transaction falls on a day which is not a Business Day, the payment shall be made on the next succeeding Business Day save where the next succeeding Business Day falls in the next calendar month in which event the payment shall be due and made on the day imme-diately preceding the Business Day.

3 Subject to the requirement of the Bank.4 Subject to the requirement of the Bank.5 Subject to the requirement of the Bank.

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5.6 Neither Party hereto shall be liable to the other in respect of a failure to make a delivery of the Merchandise or payment on the due date if such failure is caused (directly or indirectly) by an error or omission of an administrative or operational nature, and funds or the Merchandise (as the case may be) were available to such Party to enable it to make the relevant payment or deliv-ery when due, provided that such error or omission is remedied within <***three (3)> business days of receipt of a notice served by the nondefaulting party requiring the defaulting party to rec-tify such failure.

5.7 Each Party hereby acknowledges that in the event the Principal decides not to accept the Bank’s offer for any reason whatsoever, the Principal hereby agrees that all costs associated with the physi-cal delivery or the safe-keeping of the Merchandise by the Bank, including but not limited to the delivery costs, storage costs and insurance, shall be borne by the Principal.

6. REPRESENTATIONS AND WARRANTIES6.1 Each Party hereto warrants and represents to the other Party that:

a. It has the legal capacity to enter into this Agreement and each Trade Transaction;

b. Its execution of this Agreement and each document delivered by it under this Agreement is and will be duly authorised;

c. Its obligations under this Agreement and each Trade Transaction will constitute its legal, valid and binding obligations in accor-dance with their respective terms (subject to generally applicable insolvency laws and principles of equity) and will not violate the terms of any agreement to which it is a party and it has waived any immunity that may be available to it, including sovereign immunity, to the fullest extent practicable;

d. It has and will at all times maintain all authorisations, approv-als, licences and consents required to enable it to lawfully perform its obligations under this Agreement and each Trade Transaction;

e. (Save as otherwise disclosed prior thereto or in the case of a Purchase Transaction), it shall enter into this Agreement and each Trade Transaction pursuant to this Agreement as principal and not as agent, or in any other capacity, fiduciary or other-wise; and

f. It is duly incorporated and validly existing under the laws of its incorporation and, if relevant under such laws, is in good standing and no Insolvency Proceeding has been threatened or commenced against it (which is not frivolous or vexatious).

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6.2 In addition to Clause 6.1 above, a. The Principal hereby represents and warrants to the Bank that

the source(s) of funds paid to the Bank for the Bank’s purchase under a Purchase Transaction is lawful under the laws and regu-lations (including the foreign exchange administration laws and regulations) of the jurisdiction, binding upon or applicable on the Principal and the Principal will take all necessary actions to ensure that such laws or regulations will not be contravened and will be complied with at all times; and

b. In respect of each Sale Transaction, the Principal hereby represents and warrants to the Bank as purchaser of the Merchandise that:i. The Principal has not created and shall not create any charge

or encumbrance, and has not granted and shall not grant any third party rights, over its interest in the Merchandise which is the subject of a Sale Transaction; and

ii. The Principal shall not take any steps that may impair the quiet possession of the purchaser of the Merchandise after completion of the sale without due cause.

6.3 The representations and warranties set out in Clause 6.1 and Clause 6.2 shall be deemed repeated by the Principal on each date on which the Trade Transaction is executed under this Agreement.

6.4 The representations and warranties set out in Clause 6.1 shall be deemed repeated by the Bank on each date on which the Trade Transaction is executed under this Agreement.

7. TERMINATION7.1 This Agreement shall remain in force until and unless either Party

has given at least <***twenty one (21)>days’ notice of termination in writing to the other Party.

7.2 Either Party hereto shall be entitled to terminate this Agreement forthwith by giving written notice to the other if: a. The other Party hereto becomes subject to Insolvency

Proceedings; or b. The other Party hereto commits a breach of any of its obliga-

tions under this Agreement or any of its representations or war-ranties as stated in Clause 6 is false or incorrect in any material respect, and (if such breach shall be capable of remedy) shall not be remedied by such Party within <***fourteen (14)> days of receipt of a notice served by the first mentioned Party requiring it to make good such breach; or

c. The other Party is, or is deemed for the purposes of any law to be, unable to pay its indebtedness as they fall due or insolvent.

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7.3 Termination of this Agreement will be without prejudice to any rights or obligations of a Party accrued up to the date of termina-tion and the completion of any Trade Transaction already executed, whichever is the later.

7.4 Following any termination of this Agreement under the provisions hereof, each Party hereto may set off any obligation owed under this Agreement against any other obligation (whether or not matured) owed between the Parties hereto, regardless of place of payment, booking branch or currency of the obligation. Written notice is to be given to the other Party after such setting off.

8. NOTICES8.1 Any notice to be given in relation to this Agreement shall, except

where communication by telephone is expressly agreed and con-templated, be given in writing. All mail and notices may be given by such modes and subject to such additional terms and conditions as may be agreed between the Parties at their respective addresses, telephone/facsimile/telex and e-mail addresses set out in Section 4 of Appendix 1 and will be deemed to be received: a. If in writing and delivered in person or by courier on the date it

is delivered; b. If sent by telex, on the date the recipient’s answerback is received; c. If sent by facsimile transmission, on the date that transmission

is received by the recipient in legible form and confirmed by a transmission report generated by the sender’s facsimile machine;

d. If sent by ordinary or registered mail, (unless there is evidence of earlier receipt) <***three (3)> days after posting;

e. If sent by electronic messaging system (which shall include e-mail exchanges), on the date that electronic message is received, unless the date of that delivery or that receipt as appli-cable is not a Business Day or that communication is delivered or received as applicable after the close of business on a Business Day, in which case that communication shall be deemed given on the first following day that is a Business Day.

8.2 a. Each Party (“Recipient”) is authorized, but not obliged, to rely upon and act on all instructions and correspondences (“Instructions”) from the other Party (“Sender”) communicated by telephone or transmitted by facsimile or other electronic mode of communication as may be mutually agreed upon by the Parties.

b. The Sender releases the Recipient that has relied upon or acted on the Instructions from the Sender and indemnifies and holds the Recipient harmless from and against all actions, suits,

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proceedings, costs (including legal costs), claims, demands, charges, expenses, losses, and liabilities however arising (unless due to the gross negligence or willful default of the Recipient) in consequence of, or in any way related to:i. The Recipient having acted in good faith in accordance

with the Sender’s Instruction, notwithstanding that such instruction(s), as above have been initiated or transmitted in error or fraudulently altered, misunderstood or distorted in the lines of communication or transmission;

ii. The Recipient having refrained from acting in accordance with the Sender’s Instruction by reason of failure of either actual transmission thereof to the Recipient or receipt by the Recipient for whatever reason, whether connected to the fault or failure or other cause connected to the sending or receiving machine or otherwise; or


8.3 The Bank and the Principal shall be entitled to record all telephone conversations and instructions received from the other Party and such recordings and transcripts thereof shall be used by the Parties as evidence in any dispute. Each Party’s recordings shall be and remain the sole property of such Party.

9. MISCELLANEOUS9.1 The contents of this Agreement and the transactions contemplated

by this Agreement shall be kept confidential by the Parties hereto during the currency of this Agreement and after it shall terminate, save to the extent that any such matter shall become a matter of public knowledge other than through the fault of either Party hereto and save as required by an order of court of competent jurisdiction or competent administrative authority. The foregoing prohibition shall not apply to disclosures (i) made to the legal or financial or any other professional advisors and service providers of any Party or its Affiliates; (ii) required by law or by any regulatory supervi-sory, governmental or quasi-governmental authorities or court or tribunal with jurisdiction over the Party or its Affiliates; (iii) made in connection with the enforcement of this Agreement; (iv) made to the Affiliates and the group of companies of either Party and parties providing processing services for the Trade Transactions of either Party; (v) made to any actual or potential participant or sub- participant in relation to any of the Party’s rights and/or obligations under any agreement between the Parties, or assignee, novatee, or

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transferee (any agent or adviser of any of the foregoing); and (vi) made to any rating agency or any insurer or insurance broker of, or direct or indirect provider of credit protection to any Party or its Affiliates on a need to know basis. For the purpose of this Clause, “Affiliates” are companies controlled by a Party or any company that (i) controls the Party or (ii) is under common control with the Party.

9.2 Unless in the event of reconstruction, amalgamation or merger in the constitution of the Parties or sanctioned by court order, this Agreement and the Parties’ respective rights and obligations here-under shall not be assignable or transferable except with the prior written consent of the other Party.

9.3 This Agreement is intended to be Sharīàh-compliant. Both the Bank and the Principal hereby agree and acknowledge that their respective rights and obligations under this Agreement are intended to be subject to and in conformity with the Sharīàh Principles. Both Parties further agree acknowledge and undertake that no proceeds from the sale of the Merchandise or any transactions contemplated by this Agreement shall be invested and/or utilised in any non-Sharīàh compliant securities or financial instruments.

9.4 The illegality, invalidity, or unenforceability of any provision of this Agreement under the laws of any jurisdiction or under any Sharīàh Principles shall not affect the validity or enforceability of any other provision of this Agreement or other agreements and/or documents to be entered into pursuant hereto.

9.5 If the fulfillment of the terms and conditions of this Agreement is rendered impossible due to force majeure events, that is, extraordi-nary and unforeseen circumstances which are beyond the affected Party’s reasonable control, each Party shall not be liable to the other Party for any delay in performance of its obligation under the Trade Transaction but shall not be released from the obliga-tions under this Agreement. The Party affected by such events shall promptly inform the other Party in writing of the circumstances and shall use all reasonable endeavours to comply with its obli-gations or provide alternate performance reasonably acceptable to the other Party. In the event such incapacitation continues for a period of <***fourteen (14)> days from the date of the first such force majeure event, the Parties shall have the right to terminate the Trade Transaction fully or in part after making mutually agreeable reasonable settlements. For the avoidance of doubt, force majeure events shall include war, hostilities, any state of riots, civil commo-tion, earthquake, flood, fire, tempest and any other natural disaster or any event beyond the reasonable control of the Parties.

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9.6 Subject to Clause 9.3, this Agreement shall be governed by and construed in accordance with the laws of Malaysia and each of the Parties hereto irrevocably agrees that the Courts of Malaysia shall have exclusive jurisdiction for the purpose of any proceedings arising out of or in connection with this Agreement, and, for such purposes, irrevocably submits to the jurisdiction of such courts.

9.7 Notwithstanding the provisions of this Agreement, the Parties hereto recognise and agree that the principle of the payment of interest is repugnant to Sharī`ah Principles and accordingly, to the extent that laws of Malaysia would but for the provisions of Clause 9.6 above impose whether by contract or by statute any obligation to pay interest, the Parties hereto hereby irrevocably, unconditionally and expressly waive and reject any entitlement to recover interest from each other.

9.8 This Agreement may be executed in counterparts, each of which when executed and delivered shall constitute an original, but all the counterparts together shall be deemed to constitute one and the same instrument.

9.9 It is agreed and acknowledged that this Agreement and each Trade Transaction is not intended to be, and shall not be, governed by any recognized exchanges on which the Merchandise is traded (as the same may be supplemented or amended from time to time).

9.10 Time wherever mentioned shall be of the essence.9.11 The Parties hereto hereby agree that they shall also be subject to

the additional terms and conditions as stipulated in Appendix 8.

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Principal

Signed by:

for and on behalf of:

<***>

(Company No. )

as its authorised signatory:

in the presence of:

BANK

Signed by:

for and on behalf of:

<***>

(Company No. )

as its authorised signatory:

in the presence of:

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APPENDIX 1

(Which shall be read, taken, and construed as an integral part of this Agreement.)

Section Item Particulars

1. Principal Name:Company No.:Registered Office:Business Address:

2. Bank Name:Company No.:Registered Office:Business Address:

3. Master Agency Agreement

Date:

4. Address for Notices and other Communication

BankAddress:

For Attention of:

Telephone No.:Fascimile No.:E-mail Address:Telex No.:

PrincipalAddress:

For Attention of:

Telephone No.:Fascimile No.:E-mail Address:Telex No.:

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APPENDIX 2


Guidelines

No Purchase Transaction may be entered into by the Bank or its agents, on behalf of the Principal without the Principal’s express confirmation in accor-dance with Paragraph 3 of Appendix 3 herein. The Purchase Transaction shall adhere to the following guidelines:


A. The Bank may purchase for the Principal’s account commodities evi-denced by such documents or certificate of ownership from the Supplier (“the Merchandise”). Ownership of the Merchandise shall be evidenced to the Principal by indicia documents of title made out in the name of the Principal or the Bank (as its agent) or by crediting and debiting a commodity account.

B. The Merchandise purchased should be items that are acceptable to the Principal and the Bank and valued according to Sharī`ah Principles. No Trade Transaction can be made in any Merchandise that consists of pork, alcoholic drinks, tobacco, narcotics, gold, silver, or any other items that are not acceptable to the Principal and the Bank.

Maturity Merchandise may be sold to the Bank as purchaser on deferred payment term for such period as mutually agreed by the Principal and the Bank.

Currency The proceeds from any Trade Transaction will be in Ringgit Malaysia or such other currencies as the Parties hereto may agree from time to time. The Bank on best effort basis is hereby authorised to effect any necessary conversions at that Bank’s own rate of exchange then prevailing on the day the Bank purchases the Merchandise from the Supplier and the Principal hereby agrees to hold harmless the Bank from and against any loss suffered as a result of any discrepancy on the rate of exchange used for such conversion.

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APPENDIX 3


Trade Transactions

1. The Principal will communicate with the Bank on a recorded line or any other equivalent mode of communication the amount desired to be transacted and the payment period. The Principal will provide the details of its account into which the deferred sale proceeds are to be deposited into.

2. The Bank will advise the Principal on a recorded line or any other equivalent mode of communication the details of the proposed Purchase Transaction which may be entered into by the Principal.

3. Upon the Principal’s acceptance of the details of the proposed Purchase Transaction, the Principal shall, on a Business Day: a. send to the Bank a Purchase Order in form set out in Appendix 4

hereto (“Purchase Order”); and b. deposit into the account of the Bank such funds as may be neces-

sary for the Bank to complete the agreed purchase on behalf of the Principal and to enable the Bank to effect payment of the relevant purchase price due on such purchase date as set out in the Bank’s Confirmation.

4. Following the Bank’s receipt of the Purchase Order and the Bank’s con-firmation that the funds have been transferred into the account of the Bank in accordance with Paragraph 3 above, the Bank will purchase the Merchandise held under such documentary evidence or certificate of ownership from the Supplier on the purchase date as set out in the Purchase Order or on the next Business Day following such purchase date.

5. On acquisition of the Merchandise, the Bank will send to the Principal by facsimile message the Bank’s Confirmation in the form set out in Appendix 5 hereto (“Bank’s Confirmation”).

6. The Bank <***may/will6> subsequently thereafter offer to purchase the same from the Principal by way of offer by the Bank to the Principal in the form set out in Appendix 6 hereto (“Bank’s Offer”).

7. Subject to Paragraph 8 below, the Principal <***may/will> sell the Merchandise to the Bank in form set out in Appendix 7 hereto (“Principal’s Acceptance”).

6 Subject to the requirement of the Bank.

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8. For Parties with tested telex/SWIFT: the Purchase Order, the Bank’s Confirmation, the Bank’s Offer and the Principal’s Acceptance may be sent via tested telex/authenticated SWIFT message.

9. It is agreed and acknowledged that the Parties hereto intend to be legally bound by the terms of each Trade Transaction from the moment they agree to those terms on any mode of communication. A confirmation(s) (as referred to in Paragraphs 5 and 7 above) shall be entered into as soon as practicable in the form set out in the Appendixes to this Agreement and may be executed and delivered in counterparts (including by fac-simile transmission) or be created by an exchange of telexes or by an exchange of electronic messages on an electronic system, in each case thereby evidencing a binding agreement.

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APPENDIX 4


THE PURCHASE ORDER

(by facsimile or tested telex or authenticated SWIFT message)From: <***The Principal>To: <***BANK> (“the Bank”)Date: <***>Re: The Purchase Order Ref No.: <***>

We refer to the respective Master Agency Agreement and the Corporate Murabahah Master Agreement between ourselves and the Bank dated <***> (collectively, “the MasterAgreement”). Terms defined in the Master Agreement shall have the same meaning herein.

We hereby instruct you as our agent to purchase the Merchandise on our behalf in accordance with the provisions of the Master Agreement on the following terms:

a Merchandise: b Quantity: c Unit Price: d Purchase Price: e Purchase Date:

We hereby confirm that we have deposited the Purchase Price amount into your account no. <***>, and accordingly, we hereby authorize you to utilise the foregoing sum to pay to the relevant Supplier mentioning Reference <***>.

Upon completion of the purchase of the Merchandise, we wish *:

(1) to have the Merchandise physically delivered to us or any third party other than the Bank.

(2) to sell the Merchandise to the Bank upon our receipt of the Bank’s Offer.

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In acting as our agent, we hereby agree to pay you an agency fee of Ringgit Malaysia <***> (RM<***>) only.

Yours faithfully,<***The Principal>

_______________________

Duly Authorised Signatory

Name:

Title:

* To insert (√) where applicable.

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APPENDIX 5

(Which shall be read, taken, and construed as an integral part of this Agreement)

THE BANK’S CONFIRMATION(by facsimile or tested telex or authenticated SWIFT message)

From: <***BANK> (“the Bank”)To: <***The Principal>Date: <***>Re: The Bank’s Confirmation Ref No.: <***>We refer to the Corporate Murabahah Master Agreement between

the Principal and our goodselves dated <***> (“the Master Agreement”). Terms defined in the Master Agreement shall have the same meaning herein.

We also refer to the Purchase Order dated <***> (Ref No.: <***>).This is to confirm that the Bank has at your specific request entered

into the following Purchase Transaction as per the following details as your agent on your behalf:

a. Deal Date: b. Ref. Number: c. Origin: d. Merchandise: e. Quantity: f. Unit Price: g. Supplier’s Name: h. Purchase Price: i. Purchase Date:

*We will utilize the funds paid by you into our account no. <***> to pay the Purchase Price amount to the relevant Supplier mentioning Reference <***>.

In acting as your agent, we hereby agree to accept an agency fee of Ringgit Malaysia <***> (RM<***>) only.

*amend/complete as appropriate

Yours faithfully,<***BANK>___________________________________


Name:

Title:

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APPENDIX 6


THE BANK’S OFFER(by facsimile and tested telex or authenticated SWIFT message)

From: <***BANK> (“the Bank”)To: <***The Principal>Date: <***>Re: The Bank’s Offer Ref No.: <***>

We refer to the Corporate Murabahah Master Agreement between the Principal and our goodselves dated <***> (“the Master Agreement”). Terms defined in the Master Agreement shall have the same meaning herein.

We hereby offer to purchase the Merchandise from you on the follow-ing terms:

a. Deal Date: b. Ref Number: c. Merchandise and Origin: d. Quantity: e. Unit Price: f. Total Purchase Price: g. Supplier’s Name: h. Purchaser’s Name: i. Purchase Date: j. Deferred Sale Price: k. Deferred Payment Date: l. Profit Margin: m. <***m. Location7:>

7 May be deleted subject to the requirement of the Bank.

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If you accept our offer, we hereby purchase the Merchandise and uncon-ditionally and irrevocably undertake to pay the Deferred Sale Price to you on the Deferred Payment Date.

Yours faithfully,<***BANK>

___________________________________


Name:

Title:

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APPENDIX 7


THE PRINCIPAL’S ACCEPTANCE(by facsimile and tested telex or authenticated SWIFT message)

From: <***The Principal>To: <***BANK> (“the Bank”)Date: <***>Re: Principal’s Acceptance Ref No.: <***>

We refer to the Corporate Murabahah Master Agreement between our-selves and the Bank dated <***> (“the Master Agreement”). Terms defined in the Master Agreement shall have the same meaning herein.

We hereby acknowledge that you have entered into the Purchase Transaction referred to in the Bank’s Confirmation on our behalf as our agent pursuant to the terms of the Master Agreement.

We also refer to the Bank’s Offer dated <***> (Ref No.:<***>) by which you have offered to purchase the Merchandise on the following terms:

a. Deal Date: b. Ref Number: c. Merchandise and Origin: d. Quantity: e. Unit Price: f. Total Purchase Price: g. Supplier’s Name: h. Purchaser’s Name: i. Purchase Date: j. Deferred Sale Price: k. Deferred Payment Date: l. Profit Margin: m. <***m. Location:8>

8 May be deleted subject to the requirement of the Bank.

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We hereby sell the abovementioned Merchandise to you with the same terms specified in the Bank’s Offer abovementioned.

*Subject to the terms of the Master Agreement, please pay all sums realised for the purchase of the Merchandise to <***insert account details>.

*amend/complete as appropriate

Yours faithfully,

<***The Principal>

_____________________________________


Name:

Title:

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APPENDIX 8


OTHER TERMS AND CONDITIONS

1 <***EARLY SETTLEMENT1.1 Subject to the provisions of Sharī`ah law, the Principal may, at any

time prior to the deferred payment date, request the Bank to make early settlement of the sale price of the Merchandise to the Principal in full.

1.2 Upon receipt of an early settlement request from the Principal, the Bank may elect, in its sole discretion, whether to make such early settlement, and in any event, notify the Principal of its decision within <***seven (7)> Business Days from its receipt of such early settlement request, failing which such early settlement request shall be deemed to have been rejected by the Bank.

1.3 In the event the Bank agrees to make early settlement of the sale price of the Merchandise to the Principal, the Bank shall agree on the amount of early settlement to be paid by the Bank, whereby such amount shall be calculated in such manner as may be agreed between the Parties9.>

2 <***COMPENSATION (TA`WIDH)2.1 Any payment due to a Party (“Affected Party”) under this Agreement

which is not paid on the due date by the other Party (“Paying Party”) shall be a late payment. It is expressly agreed by the Parties that in addition to the payments then due and payable, the Paying Party shall pay (in addition to the payments then due and payable) a compensation on late payments, which shall be calculated based on the compensation rate of one percent (1%) per annum of the overdue payment or by any other method approved by the Sharī`ah Advisory Council of Bank Negara Malaysia from time to time.

2.2 Any payment due to a Party (“Affected Party”) under this Agreement which is not paid on the due date by the other Party (“Paying Party”) shall be a late payment. If any of the payment shall be required to be

9 The Bank has the option to delete Clause 1 or to amend the said Clause subject to the requirement of the Bank.

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recovered by the Affected Party from the Paying Party through any process of law or otherwise, the Paying Party shall pay (in addition to the payments then due and payable) all actual fees and expenses properly incurred in respect of such collection or recovery pro-cess, including the Bank’s solicitors’ fees (on a solicitor and client basis).10 Provided that the actual fees and expenses shall not exceed the amount of the compensation rate as approved by the Sharī`ah Advisory Council of Bank Negara Malaysia from time to time.

10 The Bank has the option to delete either Clause 2.1 or Clause 2.2 or to amend the said Clause subject to the requirement of the Bank.

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10.7. LIST OF THE TOP COMMON AUDIT SHORTCOMINGS IN SHARI ÀH NON-COMPLIANCE

No. Shortcoming Risk Implication

1. Incorrect T&C executed for Islamic Savings account.

The T&Cs executed are not rel-evant to the type of account opened and this could lead to disputes on hibah or profit to be paid to the accountholders.

2. Wakalah agreement not obtained for Islamic Deposit Accounts opened under Murabahah Contract.

The transaction is considered non-Sharīàh compliant.

3. Wakalah Agreements for the products not given to the customers as evi-dence of customers’ acceptance.

Any non-compliance with Sharīàh principles with regards to “Akad,” its documentations and execution, would render the contract between the Bank and customer to be incomplete.

4. Bank Branch had used the sample Bank’s Asset Certificate (BAC) obtained from the system instead of the original BAC supplied by the bank when performing the “Akad”for financing accounts.

The contracts are considered non-Sharīàh-compliant.

5. There were no indications that the T&C for Murabahah Deposit Accounts were accepted by the cus-tomer during the opening of MDA-i accounts as the signed T&C were not kept by Branch.

Non-compliance with Sharīàh prin-ciples with regards to “Akad” in the documentations and execution of Islamic products.

6. The Bank Investment Certificate was not made available to customers dur-ing the signing of Letter of Offer in order to facilitate the “Akad” process.

7. Bank Branch used conventional Fixed Deposit Application Form for open-ing of Islamic Term Deposit accounts.

Any non-compliance with Sharīàh with regard to “Akad,” its documen-tations and execution may render the contract between the Bank and cus-tomer to be disputed.

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No. Shortcoming Risk Implication

8. Profit Sharing Ratio (PSR) not stamped on the opening account documents to evidence that it was communicated to the customers.

Conduct of transactions is not consis-tent with Sharīàh principles.

9. Bank Branch did not print copies of the “T&C Governing Banking” to be given to customers during the open-ing of account.

Inadequate awareness of the Sharīàh Compliance may negate the Bank’s efforts in complying with Sharīàh compliance.

10. Bank Branch did not notify the customers on the “T&C Governing Banking Accounts for Islamic Banking” during the opening of Islamic Savings accounts.

The transactions are considered as non Sharīàh compliant.

11. Conventional terms used in the letter offer for Islamic Financing, that is, BLR instead of BFR.

The terms used are not consistent with the Sharīàh principles.

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c10.indd 302 18-12-2013 22:34:22

303

APPENDIX

The Impact of Non-Sharı ah -Compliance

Risk on the IFI, and Checklist

A.1. THE IMPACT OF NON-SHARl ÀH-COMPLIANCE RISK ON THE IFI

Islamic financial institutions are bound to carry out their business activi-ties in accordance with Sharīàh rules and principles by virtue of the license granted by the central bank. Hence, the existence of Sharīàh non-compli-ance risk in their business activities may affect the integrity and the cred-ibility of the IFI and may expose their business to high risk. The impact of Sharīàh compliance rating and audit findings can significantly affect the acceptability of the financial statements of Islamic financial Institutions as well as the expectations and confidence of the investor and stakeholders.

Prior to issuance of any opinion or report by the auditor, all relevant issues must be addressed and discussed with the parties concerned in order to take corrective actions and ensure that a reasonable assurance can be provided on Sharīàh compliance. Disclosing information to the public before remedial measures are taken by IFIs on Sharīàh non-compliance may lead to a crisis of confidence amongst investors and stakeholders as well. It may further lead to a crisis of liquidity where depositor’s cash out their deposits and investment account holders withdraw their investments. This confidence crisis may affect the IFI to suffer losses from the drastic decline on the value of their investments.

Non-compliance to specific processes and sequence that support a specific Sharīàh concept may potentially lead to contravention to provision of IFSA Act 2012 that upon conviction is liable to a fine and revocation of license

■■ Null and void (batil/fasid) contract■■ Non-recognition of income derived from the transaction

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■■ Inability to recover the financing■■ Legal action (including monetary losses) if sued by the customer■■ Reputation risk—perception of the stakeholders and public confidence

A.2. MAJOR ASPECTS GOVERNING THE CHECKLIST FOR NON-SHARl ÀH-COMPLIANT RISK

The checklist as shown here incorporates the main aspects to be referred to during the review exercise and ascertain Sharīàh non-compliance in the products and activities of IFIs.

No

1 Tools for Sharīàh non-compliance risk

1. Sharīàh ruling

■⃞ Resolutions of the Sharīàh advisory council of central bank (Bank Negara)

■⃞ Resolutions of the Sharīàh committee of the IFI

■⃞ AAOIFI Sharīàh Standards■⃞ IFSB Guidelines

2. Accounting ■⃞ Balance sheet■⃞ Islamic financial reporting/Accounting■⃞ Financial reporting

3. Legal instrument

■⃞ Terms and condition of the contract■⃞ Combination of the contract■⃞ Terminology of the contract

agreement■⃞ The sequencing of the execution of

the legal documentation

4. Sharīàh review

■⃞ Internal and external process

5. Rating agency ■⃞ Sharīàh compliance element

6. Sharīàh governance

■⃞ Internal process

7. Screening process

■⃞ Internal/external process

2 Risk elements ■⃞ Riba■⃞ Maisir■⃞ Gharar■⃞ Ghubn■⃞ Deception■⃞ Inequality

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The Impact of Non-Shar ı ah-Compliance Risk on the IFI, and Checklist 305

■⃞ Duress■⃞ Combination of contract■⃞ Sequence in the execution of the

contract

3 Sharīàh parameter for contract

1. Sighah (offer and acceptance)

■⃞ Use past tense in forming the contract (recommended)

■⃞ Conformation of offer and acceptance■⃞ Clarity of offer and acceptance

Connection of acceptance with offer

2. The two con-tracting parties (seller and buyer)

■⃞ Legal capacity/puberty of the con-tracting parties (male or female)

■⃞ Sanity of the contracting parties (male or female)

■⃞ Maturity of the contracting parties (male or female)

3. The subject matter of a contract (goods and price)

■⃞ Suitability and legality of the subject matter for the contract

■⃞ The subject matter must be known to both parties.

■⃞ Capability of the subject matter to be handed over

■⃞ Presence of the subject matter at the time of contract

■⃞ The price should be determined and known.

■⃞ The price should be defined in its types, nature, and norm, such as com-modities or cash.

A.3. CHECKLIST FOR SHARl ÀH NON-COMPLIANCE RISK

The following are examples of Sharīàh non-compliance risks events that may occur in a bank.

Terminology used is as follows:

SC: Sharīàh compliance

SNR (R): Sharīàh non-compliance risk (Rating)

L: Low

M: Medium

H: High

bapp.indd 305 18-12-2013 22:33:47


Area of Risk SC SNR (R)

Comment, Rectification,

and Action PlanBy

Whom

✓ L M H

1. Audit of financial statement■■ Income from invalid transac-tion is not purified and chan-neled to charity.

■■ Ta`widh (compensation fee) amount was compounded.

■■ Zakat not accurately calcu-lated and not distributed to the proper recipients (asnaf).

■■ Profit distribution calcula-tion for mudarabah fund not calculated in accordance to Sharīàh where weightage was assigned for different types of deposit or deduction of ineligible expenses (e.g., indirect expenses).

2. Compliance audit on organiza-tion structure, people, processes, and information technology

■■ Poor communication between Sharīàh committee and management that leads to non–Sharīàh-compliance incidences.

■■ Failure to escalate Sharīàh non-compliance incidents to Sharīàh committee

■■ Fees/charges imposed to Islamic products and ser-vices not in accordance with Sharīàh principles.

■■ Uncertainty (gharar) in price/rebate/compensation/fee disputes vs. Sharīàh non-compliance status of advertisement, illustration/materials/forms/documenta-tion used in offering prod-ucts and services.

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and Action PlanBy

Whom

✓ L M H

■■ Acceptance of deposit from Sharīàh non-compliance sources.

■■ Financing assets/goods that are non-compliant with Sharīàh requirements.

■■ Sequence of contract execution not in line with Sharīàh ruling/requirement.

■■ Non-existence of underlying asset during contract execu-tion for Islamic product non-execution or renewal of aqad (agreement) for Islamic contract.

■■ Improper usage of Islamic terminology and definition.

■■ Bundling of conventional products with Islamic products.

■■ Inability of system to cater to the Sharīàh features of the contract (e.g., noncompounding of ta’widh, ceiling limit of selling price).

■■ System error resulting in specific aqad not executed upon renewal or disburse-ment (e.g., commodity murabahah).

3. Review of adequacy of Sharīàh governance

■■ Non-compliance to require-ments outlined in the BNM Sharīàh governance framework.

bapp.indd 307 18-12-2013 22:33:47




and Action PlanBy

Whom

✓ L M H


■■ Absence or irregular Sharīàh review function to con-duct compliance review of operations to ensure Sharīàh compliance.


■■ Absence of measures by the Sharīàh secretariat to ensure that all Sharīàh committee’s resolutions are properly documented and disseminated.

■■ Lack of management of the Sharīàh committee’s (SC) interest and welfare, includ-ing remuneration that may result in difficulty in attract-ing Sharīàh scholars as SC members.

■■ Absence of proper docu-mentation to support the Sharīàh committee’s resolu-tion or decision that may hamper defence in any case of dispute.

■■ Absence of a comprehen-sive Sharīàh policy manual to assist staff in ensuring Sharīàh compliance.

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and Action PlanBy

Whom

✓ L M H

4. Sharīàh governance risk■■ Non-identification or incomplete identification of Sharīàh risk faced by the Bank, resulting in poor mitigation.

■■ Irregular Sharīàh review function of operations to ensure Sharīàh compliance.


■■ Absence of control mea-sures to ensure that all Sharīàh committee’s resolu-tions are documented and disseminated.

■■ Lack of management of the Sharīàh committee’s (SC) interest and welfare, includ-ing remuneration that may result in difficulty in attract-ing experienced Sharīàh scholars as SC members.

■■ Absence of proper docu-mentation to support the Sharīàh committee’s resolu-tion or decision that may hamper defence in any dis-pute cases.

■■ Absence of a comprehen-sive Sharīàh policy manual to assist staff in ensuring Sharīàh compliance.

■■ Lack of checking to ensure the Board’s Annual Attestation is accurately reported to BNM.

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and Action PlanBy

Whom

✓ L M H

■■ Poor communication between Sharīàh committee and management that lead to non-Sharīàh-compliance incidences.

■■ Non-compliance to require-ment in the BNM Sharīàh Governance Framework.

■■ Failure by the manage-ment to identify and refer any Sharīàh issues to the Sharīàh committee for deci-sion, views, and decisions.

■■ Failure to disclose sufficient information in the annual report on the state of com-pliance of the bank’s opera-tion in conformity with the Sharīàh principles.

5. Sharīàh product approval risk■■ Failure to ensure the Islamic finance product being sub-ject to the correct product approval process.

■■ New product approval/guidelines/campaign/process not endorsed by the Sharīàh committee.

■■ Product features not compli-ance to Sharīàh principles.

■■ Failure to ensure that the contracts are in compli-ance with BNM’s Sharīàh Parameter Reference guide-lines (i.e., murabahah, ijarah, mudharabahh, musharakah, and istisna).

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and Action PlanBy

Whom

✓ L M H

■■ Lack of processes to ensure that a thorough research was conducted to review new products and business development prior to presentation the Sharīàh committee.

■■ Absence of records to show that a rigorous deliberation process was performed by the Sharīàh committee prior to their certification of new products and backed by the relevant fiqh literature, evi-dence, and reasoning.

6. Sharīàh documentation risk■■ Incorrect legal documenta-tion of financing facilities.

■■ Improper/wrong usage of Islamic terminology and definition.

■■ Bundling of conventional products with Islamic products.

■■ Non-execution of aqad documentation.

■■ Blank or incorrect informa-tion and aqad documenta-tion (e.g., price, asset).

■■ Failure to ensure specific clauses in the product documentation (e.g., wadiah, mudharabah).

■■ Failure to provide control and reasonable assurance that two different contracts are concluded separately.

7. Sharīàh operational risk■■ Incorrect sequencing of buy/sell transactions in BBA contents.

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and Action PlanBy

Whom

✓ L M H

■■ Fees/charges imposed to Islamic products and ser-vices not in accordance with Sharīàh principles.

■■ Uncertainly (gharar) in price/rebate/compensation/fee disputes.

■■ Sharīàh non-compliance status of advertisement, illustration/materials/forms/documentation used in offer-ing products and services.

■■ Failure to escalate Sharīàh non-compliance incidents to Sharīàh committee.

■■ Acceptance of deposit from Sharīàh non-compliance sources.

■■ Financing assets/goods that are non-compliant with Sharīàh requirements.

■■ Disputes over performance or advisory activities (including Sharīàh advisory).

■■ Sequence of contract execu-tion not in line with Sharīàh rulings/requirements.

■■ Failure to ensure the avail-ability and existence of underlying assets during the execution or aqad contract for Islamic products.

■■ Non-execution of new aqad upon extension or renewal of facility (e.g., MOD).

■■ Underlying asset used for transaction of specific contract is non-Sharīàh-compliant (e.g., debt-based instrument used for debt-based sale).

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and Action PlanBy

Whom

✓ L M H

■■ Non-execution of separate aqad (e.g., sale contract after end of leasing in al-Ijarah thumma al-Bai products).

■■ Non-execution of supporting contract (e.g., wakalah for commodity murabahah).

■■ Failure to identify and com-ply with purification process of business income arising from Sharīàh non-compli-ance business transaction activities (i.e., donated to charity).

■■ Failure to ensure that the contract transaction is in conformity with the basic tenets (elements and condi-tions) of the contract used in, for example, sell-based leasing.

■■ Failure to observe and imple-ment rulings, decisions, and resolutions made by the Sharīàh committee.

■■ Failure to comply with BMN Sharīàh advisory councils resolutions.

■■ Non-genuine sell and buy transaction by commodity vendors that may lead to invalid contracts for commodity murabahah products.

■■ Failure to ensure that any transaction involving pay-ment of excesses by the bank is supported by an Islamic contract to avoid riba.

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and Action PlanBy

Whom

✓ L M H

8. Sharīàh reputational risk■■ Lack of knowledge of Sharīàh/Islamic banking prod-ucts and competencies of staff.

■■ Lack of clarity/transparency in the Sharīàh product’s features, documentation, and marketing materials.

■■ Excessive charge/compensa-tion or penalty.

■■ Corporate image with regards to perception by costumers of staff dress code and other Islamic-related matters in the operations of Islamic banking outlets.

■■ Non-Sharīàh-compliant marketing material may result in poor perceptions of Islamic banking.

■■ Concept used for product not globally accepted.

■■ Non-restriction of Islamic credit card facility to purchas-ing non-permissible goods services or at non-permissible merchants’ establishments.

9. Sharīàh treasury risk■■ Sharīàh non-compliant instruments being used for treasury and hedging activi-ties for MIB.

■■ Investment staff did not monitor or divest from investment subsequently reclassified as non-compliant.

■■ Underlying asset used for issuance of MIB share certifi-cate to branches for use dur-ing Bai` ìnah execution was not monitored and replaced upon expiry or trade.

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and Action PlanBy

Whom

✓ L M H

10. Sharīàh IT rise■■ Inability of system to cater for the Sharīàh features of the contract (e.g., non-compounding of tawith ceiling limit of selling price).

■■ System error resulting in spe-cific aqad not executed upon renewal or disbursement (e.g., commodity murabahah products).

11. Sharīàh credit risk■■ Lack of checking resulting in Islamic credit facility granted to non-eligible costumers.

■■ Lack of checking resulting in granting of financing facility for the purpose of financing asset that is not permissible under Sharīàh.

■■ Lack of checking resulting in granting of financing facility for the purpose of financing asset intended for a purpose that is not permitted under Sharīàh.

12. Sharīàh investment banking/asset management risk

■■ Poor controls resulting in Sharīàh non-compliant securities allowed for trad-ing using the Islamic stock broking facilities.

■■ Poor controls resulting in commingling of Sharīàh and conventional income.

■■ Lack of monitoring to ensure that the lease asset under sukuk with Ijarah contract is insured with Takaful instead of conversional insurance.

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bapp.indd 316 18-12-2013 22:33:49

317

List of Abbreviations

AAOIFI: Accounting and Auditing Organization for Islamic Financial Institutions

ABi: Accepted Bills-i

AHB: Amanah Hartanah Bumiputera

AITAB: Al-IjarahThumma Al-Bai

APA: asset purchase agreement

ASA: asset sales agreement

ASB: Amanah Saham Bumiputra

ATM: Automated teller machine

BB: business banking

BBA: Bai` bithaman ajil

BCBS: Basel Committee for Banking Supervision

BFR: base financing rate

BIA: basic indicator approach

BICC: building in construction cost

BIS: Bank for International Settlements

BNM: Bank Negara Malaysia

CA: capital arbitrage

CAMELS: capital, assets, management, earnings, liquidity, and sensi-tivity to risk

CAPM: capital asset pricing model

CDS: central repository system

CM: Commodity Murabahah

COF: cost of finance

DGAP: duration gap

EAD: exposure at default

EL: expected loss

FDR: fixed deposit rate

babbrv.indd 317 18-12-2013 22:33:53

318 LIST OF ABBREVIATIONS

FIs: financial institutions

FTSE: Financial Times Stock Exchange

GDP: gross domestic product

GLC: government-linked company

GPP: grace profit period

HBT: home-building Takaful

IAIB: International Association of Islamic Banks

IAIS: International Association of Insurance Supervisors

IASC: International Accounting Standards Committee

IDB: Islamic Development Bank

IFD-i: Islamic Fixed Deposit-i

IFIs: Islamic financial institutions

IFSA: Islamic Financial Services Act

IFSB: Islamic Financial Service Board

IILM: International Islamic Liquidity Management

IMA: internal management approach

IMF: International Monetary Fund

IOSCO: International Organization of Securities Commissioners

IRB: internal rating based

ISDA: International Swaps and Derivatives Association

JFFC: Joint Forum on Financial Conglomerates

LDA: loss distribution approach

LGD: loss given default

LIBOR: London Interbank Offered Rate

LLR: lender of last resort

LO: letter of offer

LPC: late payment charges

LR: leverage ratio

LTCM: Long Term Capital Management

MCM: Murabahah Clearing Market

MDB: Multilateral development banks

MIB: Maybank Islamic Berhad

M-M: Mudarabah–Musharakah

babbrv.indd 318 18-12-2013 22:33:53

List of Abbreviations 319

MM: Musharakah Mutanaqisah

MOF: maturity of facility

MRTA: mortgage-reducing term assurance

MRTT: mortgage-reducing term Takaful

OD: overdraft

ODS: object deferred sale

OECD: Organisation for Economic Co-operation and Development

OIC: Organization of Islamic Conference

OTC: over the counter

PA: personal accident

PD: probability of default

PLS: profit-and-loss sharing

PPFs: principal-protected funds

PSR: profit-sharing ratio

RAROC: risk-adjusted rate of return on capital

RSA: rate-sensitive assets

RSL: rate-sensitive liabilities

RWA: risk-weighted assets

SA: savings account

SA: standard approach

SAC: Sharīàh advisory council

SC: Sharīàh committee

SGF: Sharīàh governance framework

SME: small and medium enterprise

SOA: simplified process of opening an account

SPV: special purpose vehicle

SSB: Sharīàh supervisory board

STRC-i: short-term revolving credit-i

T&C: terms and conditions

TD: term deposit

TO: Takafal operator

TPD: total permanent disability

TR-i: Trust receipt-i

babbrv.indd 319 18-12-2013 22:33:54

320 LIST OF ABBREVIATIONS

TT: telegraphic transfer

UL: unexpected loss

VaR: value at risk

VRF: variable-rate financing

WL: worst loss

ASIFI: Auditing Standard for Islamic Financial Institutions

babbrv.indd 320 18-12-2013 22:33:54

321

Glossary

This glossary is according to the glossary of Sharīàh Advisory Council of BNM.

Akad istithaq Contract of guarantee.Akad isytirak Contract of partnership, such as mudarabah and musyarakah.Akhz al-ajr àla al-jah Charging fee for someone’s reputation.Akhz al-ju`l àlaruqyah min al-Quran Charging fee for treatment/medication using

verses of al-Quran.Al-àdah muhakkamah Common practice as basis of the ruling.Al-ajl Deferment.Al-bai` Sale contract.Al-bai` wa al-salaf Sale contract with credit term.Al-ijarah thumma al-bai` Lease contract followed by ownership of asset through

a sale contract.Al-jamùbaina àqd al-qardhwa àqd al-muàwadhah Combination of a loan con-

tract and an exchange contract.Al-muqasah al-ittifaqiyyah Offsetting by mutual agreement of contracting parties.Al-muqasah al-jabariyyah Offsetting by order of the authority.Al-naqdyalid al-naqd Money begets money.Al-wa`d bi al-tamlik Promise to own or acquire ownership.Bai` ìnah Sale contract followed by repurchase by the seller at a different price.Bai` dayn Sale of debt.Bai` al-dayn bi al-dayn Sale of debt with debt.Bai` sarf Sale of currency.Bai` al-usul bi al-khasm Sale of asset at discount.Bai` al-kali’ bi al-kali’ Refer to bai` al-dayn bi al-dayn.Bai` bithaman ajil Sale contract based on deferred payment at certain price.Bai` mu’ajjal Refer to bai` bithamanajil.Bai` muzayadah Sale contract based on bidding or auction.Bai` salam Sale contract based on order of a certain asset with certain specifica-

tions. Full payment is made in cash at the time of conclusion of the contract, whereas the delivery of the asset is deferred to a specified time.

Bai` wadhiàh Sale contract with a price lower than acquisition cost.Baiàtain fial-baiàh Two sales contracts within one sale contract.Dayn ghair thabit Debt that is not yet established.Dayn mustaqir Debt for which the liability to pay is established.Dayn thabit Debt that is fixed.Dhaman Guarantee.Dharar Harm.

bgloss.indd 321 18-12-2013 22:33:37

322 GLOSSARY

Dhawabit Guidelines.Dho` wataàjjal Reducing the amount of debt when the debtor makean early

settlement.Facultative Re-Takaful agreement executed between a Takaful company and

another Takaful company (including conventional insurance company), and the Takaful company that underwrites the risks is having the option to distribute or cede, whereas the latter or conventional insurance company has the option to receive or refuse the risks.

Faraid The knowledge or rules on estate distribution according to Islamic principles.Fasakh Termination.Fasid Defective, invalid.Fiqh muamalat A discipline of knowledge that discusses the rules relating to

human affairs.Fuqaha Fiqh scholars.Gharamah Fine/penalty.Gharar Uncertainty.Gharar yasir Minimal uncertainty.Ghasb Confiscation or unlawful seizure of property.Hajah Need.Hamish jiddiyyah Security deposit.Hibah ruqba A gift during the lifetime of the giver or recipient of hibah with a

condition that the death of a party (either the giver or recipient of hibah) is the effective condition for ownership of the property by the surviving party.

Hibah umra A gift during the lifetime of the recipient or giver of hibah on the condition that the property will be returned to the giver in case of death of the recipient.

Ibra` Rebate/waiver of partial or total claim against certain right or debt.Ibra` muàllaq Ibra` that is subject to certain condition and if the condition is satis-

fied, the ibra` will be given.Ibra` muqayyad Ibra` that is limited by certain conditions.Ijarah Lease or service contract that involves benefit/usufruct of certain asset or

work for an agreed payment or commission within an agreed period.Ijarah muntahia bi al-tamlik Lease contract that ends with acquisition of owner-

ship of the asset by the lessee.Ijtihad Rigorous thinking and efforts by scholars who have attained the degree of

mujtahid in order to issue certain Sharīàh ruling definitely in a matter that is not clearly provided in al-Quran or Sunnah.

Ìllah Effective cause.Isqatal-haq Waiving of right.Istiqrartaàmul Smooth running of market.Istisna Sale contract by way of order for certain product with certain specifications

and certain mode of delivery and payment (either in cash or deferred).Istisna` muwazi Parallel istisna.Ittifaqiyyah Mutual agreement.Ìwad Consideration.

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Glossary 323

Jumhur Majority.Kafalah Guarantee.Kafalah bi al-Ujr Guarantee with fee.Kafil Guarantor.Makful ànhu Guaranteed party.Makfullahu Recipient of guarantee or beneficiary.Mani` Syarìe Sharīàh impediment.Marhun Charged property.Maslahah Public interest.Masnu` Manufactured item.Maysir Gambling.Muàyyan bi al-zat Clearly identifiable and determinable in terms of location,

quantity, and quality.Mubara’ah Mutual waiving of right.Mudarabah Profit-sharing contract.Mudarib Entrepreneur of a mudarabah joint venture.Mulzimah Binding.Muqaradah Refer mudarabah.Muqasah Offsetting.Muqtada al-àqd Objective of the contract.Murabahah Sale contract with a disclosure of the asset cost price and profit margin

to the buyer.Murtahin A party who asks for collateral.Musahamah Mutual contribution.Musawamah Sale contract without the disclosure of the asset cost price and profit

margin to the buyer.Musya` A feature of a jointly owned asset that cannot be separated or divided.Musyarakah Profit and loss sharing.Musyarakah mutanaqisah A contract of partnership that allows one (or more)

partner(s) to give a right to gradually own his share of the asset to the remaining partners based on agreed terms.

Musyarik Partner.Mutaàrafan Becoming common practice.Muwaàdah mulzimah Binding promise of both parties.Nafaqah Cost of liability.Qabd Possession over a particular asset.Qard Loan contract.Qard hasan Benevolent loan.Qawl al-jadid New opinion.Qawl al-qadim Earlier opinion.Qimah ismiyyah Nominal price.Qimah suqiyyah Market price.Qiradh Refer to mudarabah.Qiyas Analogy.Rabbul mal Capital owner/investor.

bgloss.indd 323 18-12-2013 22:33:38

324 GLOSSARY

Rahin Chargor.Rahn Pledge/charge.Rahn al-musya` Charge on a jointly owned asset.Rahn rasmi Surrender of charge via formal record in the registry of the authority.Sadd zarai` Sharīàh approach in blocking the means that may lead to a person’s

involvement in forbidden matters.Sighah The pronunciation of offer and acceptance.Siyasah Syarìyyah Basis and approach taken by the ruler for the interest of the

nation and the people, which is in line with Sharīàh principles.Sukuk Islamic securities/bonds.Sukuk commodity murabahah Islamic securities based on tawarruq contract.Sukuk ijarah Islamic securities based on ijarah contract.Syahadah al-dayn Debt certificate.Syubhah Doubt.Taàwun Helping each other.Ta`widh Compensation.Tabarru` Voluntary donation/contribution.Takaful A scheme that is based on the spirit of cooperation and helping each other

by providing financial assistance to participants when needed and all partici-pants mutually agree to give contribution for the said purpose.

Outward Re-Takaful Distribution of underwritten risks by a Takaful company to another Takaful company or a conventional insurance company.

Inward Re-Takaful Acceptance of risks by a Takaful company from another Takaful company.

Taklufah Actual cost.Takyif Adaptation.Takyiffiqhi Fiqh adaptation.Tanazul Waive of the entitlement to claim.Taqyid Limiting.Tasarruf Dealing.Tawarruq/commodity murabahah Purchasing an asset with deferred price, either

on the basis of musawamah or murabahah, then selling it to a third party to obtain cash.

Tawatu’ Prearrangement.Treaty Re-Takaful agreement between a Takaful company and another Takaful

company (including conventional insurance company), which requires the Takaful company to distribute or cede its underwritten risks and the Takaful company or conventional insurance company that had concluded the agreement shall undertake the risks.

Ujr àlawakalah Agency fee.Ujrah Commission.Ùqud muàwadhat Contracts of exchange.Ùqud musamma Contracts that are known amongst the scholars, mentioned in

classical fiqh literature and precisely explained in the sources of rulings (such as al-Quran and Sunnah).

bgloss.indd 324 18-12-2013 22:33:38

Glossary 325

Ùqud mustajiddah Contemporary contracts.Ùrbun Down payment/deposit.Ùrf Common practice that is acceptable by the community and does not contra-

dict the Sharīàh rulings.Ùrftijari Common business practice that is acceptable by the community and does

not contradict the Sharīàh rulings.Wa`d Promise.Wa`d bi al-syira’ Promise to buy.Wa`d mulzim Binding promise.Wadiàh Safekeeping contract in which a party entrusted his property to another

party for safekeeping and to be returned upon request.Wadiàh yad amanah Safekeeping contract based on trust.Wadiàh yad dhamanah Safekeeping contract with guarantee.Wakaf A form of endowment by an owner of a property for public benefit and

well-being that is allowed by Sharīàh.Wakalah Agency contract.Wakalah bi al-istithmar Agency contract for investment.Wasi A person appointed to execute a will.Zariàh ila riba Means leading to riba.Zan al-ghalib Presumption that is closer to certainty.Zimmah Liability.

bgloss.indd 325 18-12-2013 22:33:38

bgloss.indd 326 18-12-2013 22:33:38

327

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al Bashir al Amine, Muhammad. “Istisna and Its Application in Islamic Banking.”Arab Law Quarterly, 2001.

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Majallah el-Ahkam-I-Adliyah. Kuala Lumpur: The Other Press, 2003.Merriam-Webster’s Dictionary of Synonyms. Springfield, MA: Merriam-Webster,

1984.Naser, Ahmed Ibrahim. The Islamic Ruling of Istisna Contract (Arabic ed.). Egypt:

Dar Al Jamiah Al Jadidah, 2005.Nawawi, Abu. Zakaria Rawdat al Talibin (3rd ed.). Beirut: Dar Al kutub Al Ilmiya,

2006.Nyazee, Imran Ahsan Khan, Islamic Jurisprudence. Kuala Lumpur: The Other Press,

2000.Oxford Dictionary Business English. London: Oxford University Press, 1996.Resolution of the Securities Commission Sharīàh Advisory Council (2nd ed.). Kuala

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bbiblio.indd 328 18-12-2013 22:33:43

329

AAccountability of compliance staff, 10Accounting and Auditing Organization

for Islamic Financial Institutions (AAOIFI), 49–50, 133

accounting and reporting standards, 145obligations and functions of Sharīàh

board, 115Sharīàh committee/board, definition of,

113Sharīàh governance framework (SGF),

119–123Sharīàh pronouncement of 2008 clause

six (6), 115Sharīàh standards, 78sukuk, 206–207

Adequacy, review in Sharīàh compliance, 21Agency Letter, 51Al-ahkam, 5–6Al-Khudri, Abu Sa’id, 44Al-Samit, Ubadaibn, 44Anti-money laundering, 9Application Form, T&C, 51Appointment or termination of a Sharīàh

committee member, 31, 117–118Ariayh contract, 98Asset Purchase Agreement, 51Asset Sale Agreement, 51Audit, 20–21

compliance audit on organization structure, people, processes, and information technology, 20–21

of financial statement, 20–21Sharīàh. See Sharīàh audit

Australian Standards AS3806, 10Authority of compliance staff, 10

BBai` al-dayn, 51, 93Bai` al istijrar, 93Bai` al-usul, 51Bai` amanah (Hanbali Mazhab), 92

Bai` bithamanajil (deferred-payment sale), 51, 91–92

legal documentation, 194–197Bai` fuqara`, 93Bai` ìnah, 51, 92Bai` ìnah contract, 198–199Bai` jaiz, 92Bai` ma`dum, 195Bai` mafalis, 93Bai` mahawij, 93Bai` man kasadatbidhaàtuhu, 93Bai` muzayadah, 93Bai` sarf, 51Bai` thanaya (Maliki Mazhab), 92Bai` ùhdah (SyafiìMazhab), 92Bai` wafa`, 92Bank Guarantee, 51Banking Act of 1973, 29Banking and Financial Institutions Act 1989

(BAFIA), 158Bank Negara Malaysia (BNM) UPW/GP1, 9Basel Committee on Banking Supervision, 10Bi al-khasm, 51Bills of exchange, 30Board of directors, 123–129

case of Malaysia, 125–126definition and selection of members,

123–124duties and responsibilities, 124–125responsibility and accountability based on

SGF, 128–129structure of, 124

Boilerplate clauses, 221–225Breach of duty of confidentiality,

36–37, 40Breach of Sharīàh, 31Business activity benchmarks, 80–81Business risk, 11

CCapital Market Master plan, 80Cash over total assets, 81

Index

Lahsasna.indb 329 21-12-2013 17:14:39

330 INDEX

Central Bank of Malaysia Act 2009, 30–31, 130, 166

Certificates of Islamic deposit, 30Combined contracts, 50. See also Contracts

Sharī’ah position in, 50Sharī’ah requirements, 50–51

Committee of Sponsoring Organizations of the Treadway Commission (COSO), 69

Companies Act, 31Compliance, 6–11

compliance officerauthority, 10role of, 8–9termination/resignation/hand-over,

10–11consequences of non-compliance, 7definition, 6independence and accountability, 10operation manual, 7

areas of, 8frequency of review, 8general objectives, 7–8job expectation level, 7process of, 8–9scope of, 8specific responsibilities, 8

risk, definition, 7Sharīàh

area of coverage, 13–17duty of an institution, 33–34information technology infrastructure

and system, 15marketing collateral and materials,

multimedia, and broadcasting, 15–17people responsible for, 14power of bank, 34–36Section 28 (2), 32Section 28 (3), 33structure of product/service/facility, 14terms and conditions (T&C), 14

staff member’s responsibility, 9standards, 9–10

Contractsariayh, 98bai` al istijrar, 93bai` bithamanajil (deferred-payment

sale), 92combination of, 49–51

forms, 49–50combined, 50

Sharīàh position in, 50

Sharīàh requirements, 50–51fundamental Islamic principles in, 85–90

clarity of offer and acceptance, 86conformation of offer to acceptance, 86contracting parties (buyer and seller),

87–88maturity of contracting parties, 88puberty of contracting parties, 87sanity of contracting parties, 87–88separation between the ijab and

qabul, 87session of contracts (majlis al-àqd),

86–87sighah, 85–87subject matter (mahall al-àqd), 88–90

ijarah, 94istisna`, 93juàlah (commissioned transaction),

94–95kafalah (suretyship), 96–97legal documentation of, 51, 173–178mudarabah, 91Musaqah, 91Musharakah, 90–91Muzaraàh, 91rahn (pledges), 97sequence in execution of, 51–68sigah/statement of, 85uqud muawadat (exchange contract),

99–100uqud tabarru` (voluntary contract),

99–100validity under ikrah (duress), 50wakalah, 95

Counter financing of terrorism, 9Credit risk, 24Currency-exchange contracts, 30Customer’s Acceptance, 51

DDealer’s Offer to Sell and Declaration, 51Debt over total assets, 81–82Deposit, Islamic, 30Development Financial Institutions Act 2002

(DFIA), 158Drafting of legal documentation

body of the agreement, 217–221boilerplate clauses, 221–225

amendment clause, 221arbitration, 221–222entire agreement, 222force majeure, 222

Lahsasna.indb 330 21-12-2013 17:16:25

Index 331

law and jurisdiction, 222“no-assignment” clause, 221notices, 222termination, 222

date, 210definition, 212–215interpretation, 215–217introduction, 209miscellaneous clause, 225–227parties involved, mentioning of, 211–212preamble, 210recitals, 210–211schedule/appendix (if applicable), 227–230signature, 227, 272–273structure of legal agreement/contract,

209–230tips for, 230–231title, 210use of legal language, 231

Dual banking activities, as cause of Sharīàh non-compliance risk, 70–71

EEarnings, 82Equity financing, 30Events, Sharīàh non-compliance risk,

19–25audit, 20–21credit risk, 24governance, 21–22investment banking/asset management

risk, 24–25IT risk, 24legal documentation, 22operational risk, 22–23product-approval process, 22reputational risk, 23–24review of adequacy, 21treasury risk, 24

External auditor, 31

FFATF 40 Recommendations, 9Federal Government Gazette Act 759, 39Fee-based activity, 30Fee-based transactions, 90, 94–95

juàlah (commissioned transaction), 94–95wakalah (agency), 94–95

Financial deal, formation of (sighah)according to Majalla, 85–87, 89clarity of offer and acceptance, 86conformation of offer to acceptance, 86

connection of offer and acceptance, 86–87contracting parties (buyer and seller), 87–88

maturity of contracting parties, 88puberty of contracting parties, 87sanity of contracting parties, 87–88

offer (ijab) and acceptance (qabul), 85–87subject matter of contract (mahall al-àqd),

88–90capability, 89knowledge, 89presence at time of contract, 89–90suitability and legality, 88–89

tense of, 86Financial guarantee, 96Financial ratio benchmarks, 80–83Financial risk, 11Financial Services Bill 2012 (FSB), 29Financial transactions in Islamic finance,

90–100fee-based transactions, 90, 94–95free-interest-loan-based transactions, 90,

95–96leased-based transactions, 90–94profit-sharing-based transactions, 90–91sales-and trade-based transactions, 90–94security-based transactions, 90, 96–97support-based transactions, 90voluntary/charitable-based transactions, 90

Fiqh, 6Free-interest-loan-based transactions, 90,

95–96qard hassan (free interest loan), 95–96

GGhalat (mistake), 49Gharar (uncertainty), 45–46, 79

conditions for the legal consequences of, 46–47

definition, 45intermediate gharar, 45minor gharar (gharar yasir), 45

major areas, 46Maliki and Hanbali schools of law, 45–46purpose, 46

sale of, 45Sharīàh point of view, 46substantial gharar (gharar kathir), 45technical meaning, 45

Ghubn (inequality), 47–48excessive inequality (ghubn fahish), 47–48insignificant inequality (ghubn yasir),

47–48

Lahsasna.indb 331 21-12-2013 17:18:14

332 INDEX

Governance, 21–22, 34–35Sharīàh governance framework,

106–107Guidelines on Internal Audit Function of

Licensed Institutions, 149

HHand-over of compliance functions, 10–11Hawalah (transfer of debt), 97Hibah, 98–99Hibah contract, 194High Sharīàh non-compliance risk, 41Housing Development (control and

licensing) ACT 1966, 195Human errors, as cause of Sharīàh

non-compliance risk, 70Huraira, Abu, 26

IIbra` , 97Ijarah, 14, 103–104, 183Ijarah (leasing), 94Ijarah-muntahia bi al-tamlik, 51Ikrah (duress), 48–49

complete duress (ikrah mulji`), 48conditions for, 48Hanafi jurists and, 49incomplete duress (ikrah ghayr mulji`), 48validity of contracts under, 50

Ila, period of, 48Independence of compliance staff, 10Information technology (IT) infrastructure

system, Sharīàh compliance status of, 69–70

Internal controlcomponents, 69definition, 69

Internal Control Integrated Framework, 69International Islamic banking business, 30Interview, 83Investment, Islamic, 30Investment Account Holders (IAH)

funds, 12Investment banking/asset management risk,

24–25Islamic Banking Act (IBA) 1983, 29Islamic Banking Act 1983 (IBA), 158Islamic Banking Act of 1983, 166Islamic banking business

defined, 29–30under the Financial Services Bill (FSB), 31

maximum permissible holdings for Islamic banks, 31

mergers, 31Islamic derivatives, 30Islamic Documentary Credit, 51Islamic factoring business, 30Islamic financial institution (IFI)

compliance concept, 6–11Sharīàh, concept of, 5. See also Sharīàh,

concept ofIslamic financial intermediation activities, 30Islamic Financial Services Act (IFSA), 29

apointment of a person (Section 37), 37–38

apointment of auditing person (Section 38), 38

businesses, 30definition of Sharīàh, 30–31financing, 30information furnished under Section 35, 36Islamic banking business, 29–30Islamic deposit and investment, 30objectives, 32offences and penalties under Sections 28

and 29, 36power of bank to take action

(Section 245), 38–41qualified privilege and duty of

confidentiality (Section 36), 36–37Sharīàh compliance, 31–41

duty of institution, 32–34process of rectification, 32Section 28 (1), 32Section 28 (2), 32

Sharīàh-related provisions, 31standards specified by banks, 34–36

Islamic Financial Services Board (IFSB), 12Sharīàh non-compliance risk, 12–13

Islamic Financial Services (IIFS)and principle 7.1 of Sharīàh non-

compliance risk, 13and Sharīàh non-compliance risk, 12–13

Islamic leasing business, 30Islamic principles in contracts

clarity of offer and acceptance, 86conformation of offer to acceptance, 86contracting parties (buyer and seller), 87–88maturity of contracting parties, 88puberty of contracting parties, 87sanity of contracting parties, 87–88separation between the ijab and qabul, 87

Lahsasna.indb 332 21-12-2013 17:19:43

Index 333

session of contracts (majlis al-àqd), 86–87sighah, 85–87subject matter (mahall al-àqd), 88–90

Istisna´, 103–104Istisna’ (manufacturing contract), 93Istisna Purchase Agreement, 51IT risk, 24IT system and IT infrastructure, consequences

of weakness of, 69–70

JJuàlah (commissioned transaction), 94–95Justified coercion, 48

KKafalah, 51Kafalah bi al-dark, 96Kafalah bi al-dayn (guarantee for debt), 96Kafalah bi al-taslim (guarantee for delivery), 96Kafalah (suretyship), 96–97

asil (the principal debtor), 96kafil (guarantor), 96

LLaw for Islamic banking, 166

important and relevant laws, 166Lease-based financing, 30Leased-based transactions, 90, 94Legal documentation, 22

ambiguity in terms or conditions (T&C) or clauses, 180–190

cross default, 183–184“da’ wataajjal” (give discount and

receive soon), 188–189limit of right of bank, 182–183penalty/compensation/late-payment-

charges clause, 186–188pre-payment/early settlement clause, 188rebate on early payment, 188–190,

191–193repossession of asset, 182right to consolidate and principle of

set-off, 184–185right to debit account, 185–186right to recall the facility, 181–182service charge relating to employees

provident fund (EPF) withdrawals, 186areas under consideration and review,

169–190loan, 172–173riba, 171–172

terms or conditions (T&C) or clauses, 170–173, 180–190

BBA home-financing, 194–197bay al Innah transaction, 197–199rescheduling of payments in, 206securities or collateral in, 205–206

combination of contracts, 173–178contemporary applications and general

rules for, 177–178forms of, 174pre-arrangement (Muwathoah) for,

176–177Sharīàh concessions, 175–176Sharīàh parameters in combination of

contract, 175Sharīàh status of, 174–175

debt financingrescheduling of payments in, 206securities or collateral in, 205–206

definition, 167drafting of

body of the agreement, 217–221boilerplate clauses, 221–225date, 210definition, 212–215interpretation, 215–217introduction, 209miscellaneous clause, 225–227parties involved, mentioning of, 211–212preamble, 210recitals, 210–211schedule/appendix (if applicable),

227–230signature, 227structure of legal agreement/contract,

209–230tips for, 230–231title, 210use of legal language, 231

execution of, 178–179sequencing, 178–179

fixed rate and floating rate, 190–193form and the structure of the legal rights

and liabilities, 179–180GCC-based benchmark, 204–205general principles in, 167introduction, 165Islamic Interbank Benchmark Rate

(IIBR), 201–202issuing sukuk, 206main functions of, 169

Lahsasna.indb 333 21-12-2013 17:21:13

334 INDEX

Legal documentation (continued)as a murabahah vehicle term financing

facility agreement, 187risk taking in business transaction, 193sample, 243–245schedule 1, 266–267schedule 2, 267–268schedule 3, 269–270schedule 4, 271schedule 5, 272securitization of BBA debt, 206–207Sharīàh perspective, 167

considerations while drafting, 168–169incorporation of Sharīàh requirements,

167–169terms to be avoided in, 173third party collateral, 194transfer of ownership, 199–200treasury transactions, 204using LIBOR in profit as benchmark,

200–205calculation methodology, 203

variation of installment or tenure, 193Legal documents in Islamic banking, 51Letter of Appointment as Agent, 51Letter Offer (LO)/ Facility Agreement, 51

sample, 241–242Letter of Hibah (LOH), 51Logistics, poor, consequences of, 71Low Sharīàh non-compliance risk, 41

MMajalla

financial deal, formation of (sighah), 89Musaqah, 91sale of a non-existing thing, 89subject matter of a contract, 89

Majallah al-Ahkam al-Àdliyyah, 92Malaysian Code on Corporate Governance,

125–126principles and recommendations in,

126–129Management of IFI, 107–109

accountability on Sharīàh decisions, 108allocation of resources and manpower, 108code of conduct for Sharīàh committee, 109continuous learning and training

programs, 108establishing a Sharīàh risk management

control function, 109implementation of Sharīàh governance, 108inculcating Sharīàh compliance culture, 108

in terms of Sharīàh framework of Bank Negara Malaysia, 107–108

Maslahah, 184Master Facility Agreement, 51Maximum permissible holdings for Islamic

banks, 31Medium Sharīàh non-compliance risk, 41Mergers in Islamic banking business, 31Miscommunication, as cause of Sharīàh

non-compliance risk, 71Moral hazard and Sharīàh non-compliance

risk, 70Muamalah Sharīàh principles, 30–31Mudarabah, 51, 90–91, 168

rules, 91Mudarib, 51Muntahiah bittamlik, 103–104Muqaradah. See MudarabahMuqassah (set-off), 97Murabah, 168Murabahah, 50–51, 93, 103–104, 182–183,

188, 192–193, 205corporate master agreement, 273–300interbank master agreement of AIBIM

definition, 212–215preamble in, 210sample, 246–252

Murabahah Contract Note, 51Musharakah, 50, 90–91, 168

conditions, 90–91sample of a contract of management

agreement in sukuk musharakah issuance, 233–240

Musharakah mutanaqisah ijarah, 51Muslim public and society and Sharīàh

compliance, 154Mutlaq al fahm, 6Muuzaraah (crop sharing), 90–91Muwakkil Acceptance, 269–270Muzaqah, 90–91

NNon-compliance, consequences of, 7

OObservation technique, 83Offences for non-compliance, 36Operational risk, 12, 22–23

PPartnership financing, 30Penalties for non-compliance, 40, 36

Lahsasna.indb 334 21-12-2013 17:22:45

Index 335

Post-product approval process, 107Power of bank

civil actions, 41to specify standards on Sharīàh matters,

34–36to take action, 38–41

Pre-product approval process, 107Product-approval process, 22Product development process, 106–107Product owner, 101–107

compliance to Sharīàh rules and principles, 101

analysis and examination of product, 102–103

contract combination, 104elimination of prohibition element, 103guidelines, 101–106identifying underlying contract, 103market demand, 104process of reassembling the product, 104in product development and innovation,

105–106public interest of ummah, 105risk exposure, 105rules of contract, 103selection of niche product and niche

market, 101–102terms and conditions of contract, 104–105understanding of product, 102

Profit before tax (PBT), 82Profit-sharing-based transactions, 90–91Property Purchase Agreement, 51Property Sale Agreement, 51Prophet Muhammad, 5–6Purchase Request, 51

QQard hasan, 172Qard hassan (free interest loan), 95–96Qardh ujrah, 51Qirad. See MudarabahQualified privileges, 36–37Quran, 5–6

provisions in Sharīàh compliance, 25–26

RRabawi commodity, 44Rahn (pledges), 97“Related Party Transactions,” 31Reputational risk, 23–24Rescheduling of payments, 206Review of adequacy, 21

Riba, 43–45, 50definition, 43legal documentation of, 170–173as primary activity of company, 79riba al buyu/al-fadl, 43–45riba al duyun/al-nasiàh, 43–44Sharīàh rules, 44–45spot transaction, 44technical meaning, 43

Riskbusiness, 11compliance, 7concept of, 11–12credit, 24financial, 11governance, 21–22investment banking/asset management,

24–25IT, 24legal documentation, 22operational, 12, 22–23reputational, 23–24Sharīàh non-compliance, 12–17treasury, 24in various fields of knowledge, 11

Risk management for non-Sharīàh compliance risk, 102

management, 107–109organization’s board of directors, 123–129product development process, 106–107product owner, 101–107public/Muslim public and society, 154Sharīàh Advisory Council (SAC) of Bank

Negara Malaysia (BNM), 129–130Sharīàh audit, 144–154Sharīàh committee/board, 112–123Sharīàh management, 112Sharīàh review, 130–144Sharīàh risk management, 109–112

SSalam (future delivery), 94, 103–104Sale-based financing, 30Sales-and trade-based transactions, 90–94

bai` al-dayn, 93bai` al istijrar, 93Bai` BithamanAjil (deferred-payment sale),

91–92Bai` ìnah, 92bai` muzayadah, 93bai` wafa`, 92istisna’ (manufacturing contract), 93

Lahsasna.indb 335 21-12-2013 17:24:22

336 INDEX

Security-based transactions (continued )murabahah (mark-up), 93salam (future delivery), 94sarf (currency exchange), 94tawarruq, 94

Sampling, 83Security-based transactions, 90, 96–97

kafalah (suretyship), 96–97rahn (pledges), 97

Security contract, 92Session of contracts (majlis al-àqd), 86–87Sharīàh, concept of, 5–6

Arabic meaning, 5–6breach of, 31definition of, 5–6fiqh, 6in Islamic context, 5–6Quran, provisions from, 25–26requirements in Islamic banking, 5sunnah, provisions from, 26–27tools to identify incongruence in, 73–83

Sharīàh Advisory Council (SAC) of Bank Negara Malaysia (BNM), 30–31, 33–34, 79–80, 129–130

authority of, 129–130definition, 129resolutions of, 33role and functions, 130of Securities Commission (SC), 130

Sharīàh auditaudit reports and audit ratings, 153of company or department, 149coverage and scope of, 147definition, 144of delivery channel/support centers, 150engagement planning, 150–152

letter of engagement (EL), 150execution/fieldwork, 152functions of auditor, 146–147methodology and framework, 149monitoring/follow-up, 153objective and criteria, 144–145opinions, 153–154principles governing auditor, 145process, 150–153of product development, 150reporting of audit results, 152reporting structure, 147–148roles and responsibilities of auditor, 148–149scope of, 145–147structure, 147types of, 149–150vs Sharīàh review, 131–132

Sharīàh committee/board, 18–19, 112–123appointment of auditor, 37–38corporate governance organs, 114decisions on banking, 31, 33–35definition, 113–114duty of confidentiality, 36–37functions of, 113information to be provided to, 36involvement in Islamic banking activities,

113–114main duties and responsibilities, 115–117

in advising related parties, 116ensuring sequence of legal

documentation, 116in process of sukuk, 115providing written opinions, 116–117review, examine, validate, and endorse

documentations, 116names of, 114qualified privileges, 36–37recommendation of AAOIFI, 115resolution issued by, 114scope of duties, 114–117

Sharīàh-compliant status of a company, 81–82Sharīàh governance framework (SGF), 32,

106–107, 117requirements, 118Sharīàh committee, 117

appointment of, 117–118composition, 118disqualifications, 119experience in Sharīàh pronouncements/

decisions, 119qualifications, 118resignation and dismissal of, 118

stipulated by AAOIFI, 119–123appointment of Supervisory Board and

fixing remuneration, 119–120composition and dismissal of Sharīàh

Board, 120Supervisory Board’s report, 120–123

Sharīàh management, 112role to ensure Sharīàh compliance status, 112

Sharīàh non-compliance reportingon actual Sharīàh non-compliance event,

160authentication or confirmation of Sharīàh

non-compliance risk, 163in case no Sharīàh non-compliance event

is detected, 162–163circular, 157–158

applicability of, 158legal provisions, 158

Lahsasna.indb 336 21-12-2013 17:26:16

Index 337

by Islamic financial institutions (IFIs), 157–158

objective, 157–158as a potential Sharīàh non-compliance

event, 159–161timeline for, 161–162

requirements, 159submission of reports, 163timeline, 160–161

Sharīàh non-compliance risk, 1, 12–17causes of, 68–71

dual banking activities, 70–71human errors, 70internal control system, weakness of, 69IT system and IT infrastructure,

weakness of, 69–70knowledge, skills, and competency, lack

of, 68logistics, poor, 71miscommunication, 71monitoring and supervision, lack of, 68sequence in execution of, 51training, lack of, 68

checklist for, A.2.-A.3.classification of, 41–42

high, 41low, 41medium, 41

elements, 43–68combination of contracts, 49–51execution of contract, 51–68ghalat (mistake), 49gharar (uncertainty), 45–46ghubn (inequality), 47–48ikrah (duress), 48–49riba, 43–45sequence of documents, 51–68taghrir (deception), 47

events, 19–25audit, 20–21credit risk, 24governance, 21–22investment banking/asset management

risk, 24–25IT risk, 24legal documentation, 22operational risk, 22–23product-approval process, 22reputational risk, 23–24review of adequacy, 21treasury risk, 24

execution of legal documentations/product/service, 14–15

features of, 19risk features and criteria, 19

on IFI, A.1.in information technology infrastructure

and system, 15in marketing collateral and materials,

multimedia, and broadcasting, 15–17

principle 7.1 of, 13principles governing operational risk, 12process flow, 162process of rectification, 32research

fundamental blocks, 3–4methodology, 2objectives of, 2platform/foundation, 3theoretical framework, 2–4

review of, 17–19safeguarding of IAH funds, 12techniques to identify, 83–84

interview, 83observations, 83sampling, 83testing, 84

uncertainty (gharar) in price/rebate/compensation/fee disputes vs, 20

Sharīàh reviewaccountability, 136–137adequacy of, 142–143authority, 137charter, 139competency of review personnel, 139–141empowerment and responsibility of,

136–138and governance processes, 138–139IFI and, 142independence of, 137introduction, 130objectives, 132–133

in relation to Sharīàh compliance requirements, 133

overview, 131planning, 141–142process, 141–143reporting requirements for, 143–144responsibilities, 138reviewable areas, 142of risk management processes, 142–143scope of work, 133–136Sharīàh governance framework

definition, 131vs Sharīàh audit, 131–132

Lahsasna.indb 337 21-12-2013 17:27:59

338 INDEX

Sharīàh risk management, 109–112business continuity management

framework, 111capital management framework, 111definition, 109–111framework, 111

Sharīàh risk management (continued )IFI, role of, 110–111risk awareness culture, 111–112SGF, 110

Sharīàh screening process, 78–83quantitative and qualitative approach, 80

Shipping Guarantee, 51Sigah/statement of contract, 85Sighah. See Financial deal, formation of (sighah)Suftajah, 98Sukuk, 81, 206–207Sukuk ijarah, 171–172Sukuk musharakah, 171–172Sunnah, 5–6

provisions in Sharīàh compliance, 26–27Supervisory Board’s report, 121–123

addressee of, 121date, 123management’s responsibility, 121opening (introductory) paragraph, 121opinion paragraph, 122–123scope paragraph, 121–122signature, 123title, 121

Support-based transactions, 90, 97–98hawalah (transfer of debt), 97ibra, 97muqassah (set-off), 97suftajah, 98

Surah al-Baqarah, 79Suretyship. See Kafalah (suretyship)

TTabarru`, 99–100Taghrir (deception), 47

conditions required in, 47deeds (taghrir fi`li), 47statements (taghrir qawli), 47

Takaful Act 1984 (Section 282), 29Takaful Act 1984 (TA), 158Tawarruq, 198Termination/resignation of compliance staff,

10–11Testing, 84Tools to identify incongruence in Sharīàh

compliance, 73–83AAOIFI Sharīàh standards, 78accounting, 73–76

criterionfor companies running casinos, gaming,

and others, 79gharar (uncertainty), 79product approval of securities in mixed

companies, 79–80production and sale of goods and

services prohibited in Islam, 79riba, 79

financial ratio benchmarks, 80–83international resolutions and

fatwa, 78legal technique, 76–77resolutions of Sharīàh advisory

council, 77resolutions of Sharīàh committee, 77Sharīàh Parameter References

(SPR), 77Sharīàh screening process, 78–83

formula for, 82–83quantitative and qualitative

approach, 80Transfer of ownership, 199–200Treasury risk, 24Trustee Act 1949, 99

UUnjustified coercion, 48Uqud muawadat (exchange contract),

99–100Uqud tabarru` (voluntary contract),

99–100

VVoluntary/charitable-based transactions, 90,

98–100ariayh contract, 98hibah, 98–99tabarru`, 99–100wadiàh, 99waqf, 99wasiyyah, 99

WWaàd, 51Wadiàh, 99Wakalah (agency), 51, 95

corporate wakalah placement agreement (AIBIM), 253–273

Waqf, 99Wasiyyah, 99

ZZaidan, Abdul Karim, 5–6

Lahsasna.indb 338 21-12-2013 17:29:31