Sunday, May 10, 2009

OIC Fiqh Academy issues fatwa ruling tawarruq is not Shari'ah-compliant

While the OIC Fiqh Academy does not have the force of law in its fatawa, the recent fatwa condemning tawaruq as a deception will have a significant impact on the Islamic finance industry, perhaps a greater one than the AAOIFI ruling on sukuk in February 2008. The tawaqrruq product is one where a bank buys metal on the spot market, sells it to the customer for the spot price plus a profit margiin and then acts as the customer's agent to sell the metal again on the spot market. The economic result of the transaction is that no physical commodity (metal in the most common cases) exchanges hands but the customer ends up with cash as well as a deferred liability (a debt) to the bank that equals the cash received plus a pre-agreed, fixed rate of profit. It has been frequently used in the Islamic finance industry but has always been rather controversial because the trades involved have been executed to synthesize a conventional loan with little other activity. Neither the bank nor the customer have a use for the metal involved in the transaction.

Beyond its direct effect on tawarruq, the OIC Fiqh Academy ruling could have a greater impact on the industry as a whole by questioning whether the means justify the ends: that is, whether ensuring that products are structured in a way that is Shari'ah-compliant provides sufficient justification for creating an outcome that looks very similar to conventional financial products. In many cases, products will continue to be viewed as necessary compromises that, although creating economic effects that look like interest, are used in a way that directly facilitates economic activity.

In contrast to the tawarruq transaction described above where neither the bank nor the customer plan on using the metals involved is an ijara transaction like the ones used in many sukuk. In this case, a company owns a property and sells it to an SPV that has raised money for the purchase from selling ownership interests to investors. Upon selling the property to the SPV, the company then leases back the property for use in its business. The company also retains an option to repurchase the property at the conclusion of the lease, although the price at which it will do so is not fixed at the outset to avoid falling afoul of the AAOIFI rules on sukuk issued last year. In the ijara transaction, the company receives money from investors, pays regular lease payments tied to LIBOR and at the conclusion of the lease redeems the certificates by repurchasing the property from the SPV.

In both cases, tawarruq and ijara sukuk, the economic outcome remains the same--financing is provided and repayment is made later at a higher value than the initial amount--but in the former case, the traded commodity is used only for effecting the transaction but in the latter case, the commodity is used in the underlying business for which the transaction is structured. This, I believe, will become a more frequently used test to determine whether Islamic financial products are structuring for sake of replicating interest-based transactions or transactions created to finance business activity. This does not seem like an overly tight restriction, although it has huge implications for the industry and could restrict the industry's growth. It will now be a test for the industry to come up with replacement products tawarruq (and commodity murabaha) to provide unsecured financing such as that used to start businesses, pay for education and offer Islamic banks short-term liquidity management.

The translation of the fatwa into English is below and was provided by the International Shari'ah Research Academy for Islamic Finance.
Resolution 179 (19/5)

in relation to

Tawarruq: its meaning and types (classical applications and organized tawarruq)

The International Council of Fiqh Academy, which is an initiative of the Organization of Islamic Conferences (OIC), in its 19th session which was held in Sharjah, United Arab Emirates, from 1 - 5 of Jamadil Ula 1430 AH, corresponding to 26 – 30 April 2009, decided on the following:

Having reviewed the research papers that were presented to the Council regarding the topic of tawarruq, its meaning and its type (classical applications and organized tawarruq), a resolution were passed. Furthermore, after listening to the discussions that revolved about the applications of tawarruq, the resolutions were presented at the International Council of Fiqh Academy, under auspices of the Muslim World League in Makkah.

The following were the resolutions:

First: Types of tawarruq and its juristic rulings:

Technically, according to the Fiqh jurists, tawarruq can be defined as: a person (mustawriq) who buys a merchandise at a deferred price, in order to sell it in cash at a lower price. Usually, he sells the merchandise to a third party, with the aim to obtain cash. This is the classical tawarruq, which is permissible, provided that it complies with the Shari’ah requirements on sale (bay’).
The contemporary definition on organized tawarruq is: when a person (mustawriq) buys a merchandise from a local or international market on deferred price basis. The financier arranges the sale agreement either himself or through his agent. Simultaneously, the mustawriq and the financier executes the transactions, usually at a lower spot price.

Reverse tawarruq: it is similar to organized tawarruq, but in this case, the (mustawriq) is the financial institution, and it acts as a client.

Second: It is not permissible to execute both tawarruq (organised and reversed) because simultaneous transactions occurs between the financier and the mustawriq, whether it is done explicitly or implicitly or based on common practice, in exchange for a financial obligation. This is considered a deception, i.e. in order to get the additional quick cash from the contract. Hence, the transaction is considered as containing the element of riba.

The recommendation is as follows:

To ensure that islamic banking and financial institutions adopt investment and financing techniques that are Shari’ah-compliant in all its activities, they should avoid all dubious and prohibited financial techniques, in order to conform to Shari’ah rules and so that the techniques will ensure the actualization of the Shari’ah objectives (maqasid Shari’ah). Furthermore, it will also ensure that the progress and actualization of the socioeconomic objectives of the Muslim world. If the current situation is not rectified, the Muslim world would continue to face serious challenges and economic imbalances that will never end.

To encourage the financial institutions to provide Qard Hasan (benevolent loans) to needy customers in order to discourage them from relying on Tawarruq instead of Qard Hasan. Again these institutions are encouraged to set up special Qard Hasan Fund.

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