MIF Monthly - Malaysia: The International Islamic Financial Centre

Kuala Lumpur High Court Justice Datuk Abdul Wahab Patail’s string of judgments on Islamic banking transactions on the 18th July 2008 is, as yet, the most severe judicial indictment of the bona fides of the practice of Islamic banking in Malaysia.

In Arab-Malaysian Finance Berhad v Taman Ihsan Jaya Sdn Bhd & 2 Others and 11 other cases, the learned judge pronounces the current rendering of Bai Bithaman Ajil (BBA) contracts to be contrary to the Islamic Banking Act 1983 (IBA) and the Banking and Financial Institutions Act 1989 (BAFIA). In Tahan Steel Corporation Sdn Bhd v Bank Islam Malaysia Berhad, he categorically rules that Istisna contracts are void ab initio (from inception).

The judgments call into question the very integrity of Islamic banking practitioners here, including Shariah advisers. The Taman Ihsan Jaya judgment is liberally peppered with choice words like “legal devices or trickery”, “pretense”, “sleight of hand” and “distortion” to describe the mechanics adopted by Islamic bankers to structure BBA contracts, and the judge implies that the main motivation of the industry has been money. He unreservedly holds that BBA and Istisna arrangements in Malaysia are not bona fide.

The affected banks are reported to be appealing the decisions. Pending the outcome of the appeals, one should expect a possibly strident riposte from Shariah experts, including the Shariah Advisory Council (SAC) of Bank Negara Malaysia, which, under the Central Bank Act 1958, is the accredited authority for the ascertainment of Islamic law for the purposes of Islamic banking business.

On the SAC, however, Justice Abdul Wahab rules in Arab-Malaysian Merchant Bank Berhad v Silver Concept Sdn Bhd (also decided on the 18th July 2008) that it is an organ of the executive branch of the government, and not a judicial authority.

I would like to share my thoughts on the following observations made by the learned judge in Taman Ihsan Jaya:

That the concepts of BBA, Istisna’, Inah, Murabahah, Ijarah and the like are, in principle, Islamic

His Lordship unequivocally accepts that financing schemes like the BBA, Istisna, Inah, Murabahah and Ijarah are Islamic in nature “since no interest is involved”. However, in a decision that is also remarkable for the judge’s assertion of his judicial prerogative (he expounds that the court is no “rubber stamp”), Justice Abdul Wahab leaves no doubt that he is not persuaded by the sanction accorded to these products by Malaysian Shariah specialists and states that he is obliged to exercise curial supervision to determine if the application and implementation of the concepts offend the religious tenets in any way.

While one may question if civil judges have the necessary qualifications and expertise in the Shariah to sit in judgment on the rulings and practices of acknowledged Shariah scholars — and, in the case at hand, the rulings of the learned judge in so far as they concern the Shariah may indeed be subject to some hard scrutiny — the premise that there must be judicial surveillance of what is basically banking business is surely a welcome idea.

That a BBA (or Istisna) arrangement involving a novation agreement between the original vendor of the property, the bank customer and the bank is a bona fide sale while a bilateral direct sale and purchase between the bank and its customer is not

Banks migrated from novation agreements to property purchase agreements (PPA) in the mid-1990s due to the reluctance of vendors and developers to become parties to novation agreements. Despite the Taman Ihsan Jaya judgment, banks should be cautioned against rushing to re-embrace the novation set-up.

The novation agreement structure is, arguably, beset with conceptual difficulties. The customer, having entered into an agreement (the original contract) to purchase a property from the vendor, applies to the bank for financing to enable him to settle the purchase price payable under the original contract.

The financing documentation involves, firstly, the bank entering into a novation agreement with the vendor and the customer, whereby the customer is replaced by the bank as a party to the original contract with the result that the bank assumes all the rights and obligations of the customer under the original contract, and the customer’s rights and obligations under the original contract come to an end simultaneously.

Immediately following the execution of the novation agreement, the bank enters into a bilateral property sale agreement (PSA), whereby it purportedly sells the property to the customer at a price that comprises the aggregate of the financing amount and the bank’s profit (the sale price), and the customer covenants to settle the sale price by periodic installments during the tenure of the facility.

The PSA also provides that following such sale, the customer reassumes all rights and obligations under the original contract and the bank shall thereafter have no rights or obligations in respect of the property. The PSA, as such, is intended to achieve the following two objectives, to:

Under the law, the effect of a novation is not to assign or transfer a right or liability, but rather to extinguish the original contract and to substitute it with another. By the novation agreement entered into by the vendor, the customer and the bank, therefore, the original contract between the vendor and the customer is substituted by the original contract between the vendor and the bank.

The questions that arise with the PSA are as follows:

With regard to (a), it would be clear that as at the material time the property has yet to be vested in the bank, it has no right to deal with it. This would be especially obvious in cases where the property has yet to be constructed or is under construction. The bank can only transact on its rights and obligations under the original contract.

As for (b), the answer is no because it is well established at law and in equity that a party’s burden under a contract cannot be shifted to another without the consent of the other parties to the contract. Therefore, any divestment by the bank of the rights and obligations under the original contract may be made only with the consent of the vendor. It would then follow that a second novation agreement involving all three parties should be executed whereby the customer replaces the bank as a party to the original contract and thereby assumes the bank’s rights and obligations under the original contract and such rights and obligations of the bank are extinguished. In short, a novation agreement can only be unmade by another novation agreement.

However, such second novation agreement would not create any debt constituted by the sale price unless the sale price (or more precisely the transfer price) is expressed as the consideration for the bank’s agreement to transfer its rights and obligations under the original contract to the customer, perhaps under the Shariah principle of Hawala (transfer). Whether such a prototype is Shariah compliant is a matter for Shariah experts to ponder.

If, indeed, the bilateral PPA/PSA structure is Hila (legal device or trickery), one wonders in what way the novation model is any better. Novation agreements provide that the only obligation of the bank thereunder is to release the facility to the vendor and that the customer, and not the bank, continues to be liable and responsible for his other obligations under the original contract. It is a nice question whether, in view of this disclaimer by the bank, the proposition is really a novation as recognized by the law. As stated above, a novation agreement is intended to substitute the original contract with another, including by substituting one party with another, such that the original party’s rights and obligations are extinguished and the same are assumed by the new party.

Besides, the determination and the documentation of the sale price are identical in both structures. It is, therefore, difficult to comprehend the court’s conclusion that the sale price in the novation mold does not involve riba (interest) but the one in the PPA/PSA does. The correctness of the court’s differentiation solely on the basis of whether the bank had purchased the property from a third party or from the customer is something that warrants deeper analysis.

Significantly, none of the said judgments deals with what the exact nature and characteristics of the property should be to form a valid Bai (sale) contract.

Further, the judge also does not acknowledge or comment on what is otherwise well known in the industry that what has been so far passed off as BBA transactions under the PPA/PSA structure are really Inah contracts.The financier in a BBA contract is not entitled to the portion of profit attributable to the unexpired tenure of the facility.

The learned judge reiterates in Taman Ihsan Jaya his holding in Affin Bank v Zulkifli Abdullah [2006] 3 MLJ 67 that a BBA financier is entitled to recover only the profit for the period up to the date of recovery.

In Affin Bank, the judge had pooh-poohed the bank’s stand that Ibra or rebate on the sale price payable by the customer is at the discretion of the bank. The majority opinion of the fuqaha (Shariah scholars) is that, as the price in a BBA contract is fixed and any change thereto will nullify the aqad (contract), the creditor cannot be compelled to grant a discount on the agreed price.

In neither decision does the court consider or refer to the Shariah scholars’ sentiment on the issue or the incongruous situation that in the event the tenure has expired, the banks cannot, under the Shariah, claim anything more than the agreed sale price, no matter the length of time between the tenure and the recovery.

Further, the key doctrinal difference between BBA (which is a sale transaction) and a conventional interest-based loan appears not to have made any impression on the judge, although in Silver Concept, he adverts to “the gulf of difference between the legal consequences of a sale and a loan”. If the sale price payable by the BBA customer is fixed, the tenure should be construed as an indulgence granted by the bank to the customer and such privilege may be revoked if the customer commits a breach under the financing.

All BBA agreements would provide that the entire balance of the sale price becomes due and payable upon the occurrence of an event of default. The judge makes short shrift of the “classic common law approach” that since the defendant signed the contract, he was bound. To the judge, while there is no question that the defendant is bound to the contract, the true issue is what sum he is bound to pay as the sale price.

It is hoped that the Court of Appeal will make a definitive ruling on the question whether the element of Ibra is discretionary or not at the option of the creditor. Justice Abdul Wahab’s pronouncements on Ibra will really have little financial impact on banks.

This is because it is a long-standing practice of banks to exclude such profit on early settlement or recovery although in cause papers, banks do claim the entire balance of the sale price.

If there is one constant dominant theme in the Affin Bank (which has been followed in two East Malaysia High Court decisions) and Tam an Ihsan Jaya cases, it is that the learned judge finds it completely unacceptable that a client of Islamic finance is liable to pay more than his conventional banking counterpart.

While one may challenge the judge’s basis for drawing such comparisons without taking into account the deep philosophical differences underpinning the two systems, the judge’s reasoning that the raison d’être for Islamic finance is to serve as a counterbalance and ethical alternative to the oppressive and exploitative nature of usurious loans is, with respect, compelling. As all concerned would admit, the discretionary aspect of Ibra is often the principal sticking point with customers.

To allay the concerns of the judiciary and customers, banks should seriously consider incorporating clear provisions in facility agreements and court documents that in the event of early settlement or recovery, they will forego the profit for the unexpired duration of the tenure.

There is no legal impediment to the banks voluntarily making this concession as Islamic law does not bar a party from giving up voluntarily and without consideration any of his contractual rights under the principle of tanazul (foresaking one’s rights).

In the case of litigation, the cause papers should ensure that the banks shall recover profit up to date of settlement and not the date of breach, demand, pleadings, affidavits or orders.

Such response by financiers would have a positive effect on the Islamic banking industry as it would reconcile the theory with the practice with regard to bank claims in respect of profit for the unexpired portion of tenure and demonstrate that Islamic banking is indeed transparent and fair and equitable in its application.

In order for a product to be regarded as Islamic, it must not contain elements not approved by the mazhabs.

The learned judge’s finding that in order for a matter to be considered Islamic, all the recognized mazhabs should endorse it is controversial. This pronouncement goes against the widely held view that all four mazhabs are mutually recognized and respected.

It is open to a follower of one school to adopt for a particular point of law the interpretation by the jurists of any other Sunnite school in preference to that of his own.

Professor Hashim Kamali, an expert on Islamic jurisprudence, said the Shariah has often been considered as “diversity within unity” and the differences of opinion among the mazhabs are different manifestations of the same divine will and may, therefore, be regarded as an essential unity.

Intriguingly, the learned judge holds that the BBA facility should conform to the precepts of all mazhabs because they are offered to all Muslims and not only to Muslims of a particular mazhab.
Neither IBA nor BAFIA mentions the targeted clientele of the banks offering Islamic facilities.

The proper construction of the two statutes is that the facilities are meant for all, Muslims and non-Muslims alike. This has been, as it should be, the reality since the very first day Islamic banking was introduced to Malaysians in 1983.

Justice Datuk Abdul Wahab’s judgments serve to highlight some of the recurring concerns with regard to Islamic banking in this country.

Patently, much work has yet to be done by the legislature, regulators, Shariah advisers and industry practitioners to make Islamic finance more understood and accepted.