A Framework for Islamic Financial Institutions to Deal With Shari'Ah Non-Compliant Transactions (ISRA Paper)

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A FRAMEWORK FOR ISLAMIC

FINANCIAL INSTITUTIONS TO

DEAL WITH SHARÔÑAH NON-COMPLIANT TRANSACTIONS

ASSOC. PROF. DR ASYRAF WAJDI DUSUKI

MOHAMMAD MAHBUBI ALI

LOKMANULHAKIM HUSSAIN

RESEARCH PAPER (No: 42/2012)



A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL

WITH SHARÔÑAH NON-COMPLIANT TRANSACTIONS

Assoc. Prof. Dr Asyraf Wajdi Dusuki*

Mohammad Mahbubi Ali**

Lokmanulhakim Hussain***

ABSTRACT

The concern over SharÊÑah-compliant transactions is firmly entrenched in the activities

and operations of Islamic financial institutions (IFIs). As a business entity established within the ambit of SharÊÑah, an IFI is expected to be guided by values, principles,

objectives and rulings of the SharÊÑah. However, ensuring effective SharÊÑah compliance

is not a straightforward matter. As financial markets become increasingly sophisticated,

heightened product innovations and engineering in Islamic finance entail genuine

concern over the need to strengthen SharÊÑah compliance throughout the product

life cycle. This means that, while a product may be deemed SharÊÑah compliant prior

to its launch (ex-ante), the IFI must also be cognizant of the need to ensure that the

entire ex-post process — including contract execution, utilization of funds, investment

activities, the audit and governance process — are all in place. This paper focuses on

the framework for dealing with SharÊÑah non-compliant transactions in Islamic finance.

The framework delineates the concept of illegitimate income and its sources from the

Islamic perspective in order to develop a coherent approach to dealing with diverse

non-compliance situations based on established principles of the SharÊÑah. Although it

is not expected that an IFI will deliberately involve itself in illegitimate activities, any

incident of non-compliance needs to be immediately addressed, rectified and reported.

This is not only to ensure the purity of the income earned but, more importantly, for

IFIs to put in place adequate systems and controls to ensure such that non-compliancewith SharÊÑah rules and principles can be averted.

Keywords: : SharÊÑah non-compliant, illegitimate income, fÉsid, bÉÏil, contract

rectification, income purification

* Assoc. Prof. Dr Asyraf Wajdi Dusuki is the Head Research Affairs at International SharÊÑah ResearchAcademy for Islamic Finance (ISRA). He is also a SharÊÑah Advisor to AIA AFG Takaful Bhd. He can becontacted at [email protected]

** Mohammad Mahbubi Ali is a Researcher at International SharÊÑah Research Academy for Islamic Finance(ISRA). He can be contacted at [email protected]

***

Lokmanulhakim Hussain is a Researcher at International SharÊÑah Research Academy for Islamic Finance(ISRA). He can be contacted at [email protected]





A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITHSHARÔÑAH NON-COMPLIANT TRANSACTIONS

3

Against this backdrop, this study focuses on the approach and methodology for dealing

with non-SharÊÑah compliant transactions or non-ÍalÉl income. Specifically, the paper sets out to provide answers to the following research questions:

• What is non-ÍalÉl income?

• What are the categories of non-ÍalÉl income?

• How should each category of non-ÍalÉl income be treated from a SharÊÑah

perspective?

It is hoped that, by providing the answers to these three fundamental questions, the paper can propose a framework for income purification for Islamic financial institutions

in line with the requirements set out in Bank Negara Malaysia’s SharÊÑah Governance

Framework.

Following this brief introduction, the paper is organized according to the following

structure: the next section examines the concept of illegitimate income (mÉl ÍarÉm)

from the SharÊÑah viewpoint. Various sources of illegitimate income are identified

and then organized into two major categories: ÍarÉm li dhÉtihi (prohibited due to its

essence) and ÍarÉm li ghayrihi (prohibited due to external reasons). The third sectionthen elaborates the approaches to dealing with various sources of illegitimate income.

The principle of income purification is deliberated in detail so as to construct a robust,

relevant and practical framework that can be adopted by Islamic financial institutions

in addressing various potential SharÊÑah non-compliant transactions. The fourth section

provides sample scenarios for how Islamic financial institutions could treat their tainted

income, while the final section concludes the study.

2. AN OVERVIEW OF MÓL HARÓM

2.1 The Concept of MÉl in the SharÊÑah

Literally, mÉl (wealth) is defined as everything that may be possessed by an individual

(Ibn ManÐËr, 1414AH, 11:635; al-ZabÊdÊ, n.d, 30:427). Technically, classical jurists

have provided various definitions of mÉl . Ibn ÑÓbidÊn of the ×anafÊ School defines

mÉl as anything human beings desire that can be stored to be utilized when needed

(Ibn ÑÓbidÊn, 1992, 4:501). Majallat al-AÍkÉm al-ÑAdliyyah, in Article 126, includes



ISRA RESEARCH PAPER (NO. 42/2012)

Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain4

movable and immovable items as forms of mÉl (HawÉwinÊ, n.d, 31). The ×anafÊ School,

however, excludes usufruct (manfaÑah) from its definition of mÉl as it cannot be stored.

Al-ShÉÏibÊ of the MÉliki School defines mÉl as anything that can be owned and

controlled exclusively by the owner and acquired by legitimate means (al-ShÉÏibÊ, 1997,

2:17). The MÉlikÊ definition of mÉl stipulates two criteria: first, it can be exclusively

possessed. Hence, everything that cannot be owned, such as a bird in the sky, cannot be

deemed mÉl . In contrast to the ×anafÊ view, the MÉlikÊ view recognizes usufruct as mÉl

since it can be owned. Second, the method by which the wealth is acquired should be

legitimate from the SharÊÑah perspective.

The ShÉfiÑÊ School defines mÉl as something of value that is exchangeable (al-ShÉfiÑÊ,

1990, 171). Al-BahËtÊ of the ×anbalÊ School reiterates Ibn al-NajjÉr’s definition of

mÉl as anything permissible to take benefit from and acquire. This definition excludes

items of no benefit or whose benefit is prohibited, such as alcohol (al-BahËtÊ, 1993,

2:7). Based on their definitions, the ShÉfiÑÊ and ×anbalÊ Schools argue that a Muslim

who spilled a person’s alcohol cannot be held liable for the value of the wine as it is

not recognized as mÉl and has no value from an Islamic point of view (al-QazwÊnÊ, n.d,

11:258; Ibn QudÉmah, n.d, 5:222-223). While the MÉlikÊ and ×anafÊ Schools agree

with the ShÉfiÑÊ and ×anbalÊ Schools that alcohol cannot be considered wealth for Muslims, they recognize that it does have value for non-Muslims; hence, a Muslim is

held liable if he spills alcohol belonging to a non-Muslim (al-QarÉfÊ, 1994, 8:277-278;

al-SarakhsÊ, 1993, 11:103).

Based on the various definitions given, there are two areas of controversy in defining

mÉl : 1) the majority of jurists include usufruct in the definition of mÉl while the ×anafÊs

exclude it; 2) there is disagreement whether items prohibited by the SharÊÑah, but which

non-Muslims recognize as having economic value, are subject to indemnification if

damaged or destroyed.

2.2 The Concept of MÉl ×arÉm

Al-GhazÉlÊ defined mÉl ÍarÉm as any property acquired by illegal means, such as

theft, ribÉ , hoarding, gambling, etc. (al-BÉz, 2004, 39). Some contemporary scholars

have defined mÉl ÍarÉm as anything that the SharÊÑah has prohibited a Muslim from

appropriating due to a preventive factor (al-BÉz, 2004, 39). Other scholars have defined

it as wealth that the SharÊÑah has prohibited the holder from utilizing in any way (Yasin,




5

1414AH). These definitions, thus, differ regarding the locus of the prohibition: Is it

utilization or appropriation?

Jurists categorized mÉl ÍarÉm into two major types: First, what is prohibited in it

essence (li-dhÉtihÊ) and second, what is prohibited due to external reasons (li-ghayrihi)

(al-BÉz, 2004, 39).

2.2.1 Prohibited in Essence (×arÉm li DhÉtihi)

Muslim jurists considered certain items to be prohibited in themselves if the prohibition

is due to their essence and nature. These include pork, wine and other impure items(al-SarakhsÊ, 1993, 11:102-103; Ibn Rushd, 1425/2004, 3:52; Ibn Rushd, 1408/1988,

18:492; al-NawÉwÊ, n.d, 6:37, 14:283-284; Ibn QudÉmah, 1388/1968, 9:162). Indeed,

the majority of jurists do not consider such items to be mÉl at all.

2.2.2 Prohibited Due to External Reasons (×arÉm li Ghayrihi)

Another type of mÉl ÍarÉm consists of items that are permitted in their essence (aÎl )

but become prohibited due to external reasons or an auxiliary attribute (waÎf ). For

instance, accumulating wealth is basically permissible, but if the method by which it is

accumulated is illegitimate, the wealth is non-ÍalÉl (Ibn ÑÓbidÊn, n.d, 2:292; al-QarÉfÊ,

n.d, 4:108; al-NawÉwÊ, n.d, 12:116; Ibn Taymiyyah, 1408/1987, 4:210). For example,

trading is permissible, but it is prohibited during the hour of JumuÑah prayers so any

profits are illegitimate. Similarly, paper money in its essence is permissible, but if it is

acquired from bribery or ribÉ , the way it was earned changes the status of the money

to unlawful.

2.3. Sources of Impermissible (Non- ×alÉl ) Income

The preceding discussion explored the fundamental concept of mÉl and mÉl ÍarÉm.

Essentially, income-generating or wealth-accumulation activities that involve money do

not invoke the issue of ÍarÉm li dhÉtihi since money in its essence (Ñayn) is permissible.

However, a particular sum of money may be deemed impermissible if it is derived

from ÍarÉm sources. As previously explained, this is known as ÍarÉm li ghayrihi. The

following discussion will shed further light on the possible sources of impermissible

income (mÉl ÍarÉm, hereafter referred to as non-ÍalÉl income) due to external reasons.





In general, there are two external factors that make income non-ÍalÉl (al-BÉz, 2004):

(1) The income is acquired without the consent (bi ghayr riÌÉ ) of the legal owner.

Examples are income realized through theft ( sariqah), usurpation ( ghaÎb)

and deception.

(2) The income is earned with the consent of the owner by a transaction that is

not approved by the SharÊÑah. In this regard, Ibn Taymiyyah further divided

this category into two possible scenarios; (i) non-ÍalÉl income possessed

through nominate contracts; and (ii) non-ÍalÉl income earned without having

any specific contractual forms, such as income from rashwah (bribery),

maysir (gambling), gifts to employees while executing their duties, etc.

(Ibn Taymiyyah, 2005, 593-594). While income earned without a specific

underlying contract is clear and easily understandable, the following

discussion will delineate non-ÍalÉl income sources through specific nominate

contracts.

2.3.1 Validity of the Contract

In an Islamic transaction, validity of the contract is important in determining whether a transaction can be considered permissible or impermissible. A valid contract from an

Islamic viewpoint is one in which all the essential pillars and conditions of the contract

are fulfilled. This provides a parameter for determining the status of income derived

from any transaction conducted.

According to the majority of jurists, there are only two possible rulings on the status

of a contract: valid ( ÎaÍÊÍ) and invalid ( ghayr ÎaÍÊÍ), and this latter category has other

names (bÉÏil and fÉsid ) which can be used interchangeably for it (Zuhaily, 2004). ØaÍÊÍ

is a contract that is good in its essence (aÎl ) and lawful in its external attributes (waÎ f )(al-RËmi, 2004, 1:75). It is a contract in which all the essential elements (arkÉn)—

such as the contracting parties, subject matter, and offer and acceptance—and all the

underlying conditions are fulfilled (al-MinyÉwÊ, 2010, 1:34).

For instance, fulfillment of all the contractual pillars that would make a sale contract

valid would include the following: the parties to the contract are legally eligible to

undertake contracts; i.e., they are sane, of the age of majority and of sensible conduct;

the offer and acceptance are clear and made at the same session (majlis al-Ñaqd ), either




7

actually or in a form recognized as such by the law; the acceptance is in conformity

with the offer; the offer remains effective until the issuance of the acceptance; theasset is completely owned by the seller; it has value (mutaqawwam) and is deliverable

(qudrah ÑalÉ taslÊm).

From a SharÊÑah point of view, a valid contract establishes all the legal implications

that the SharÊÑah has assigned to a contract of that type (al-Namlah, 1999, 1:412). For

example, the buyer attains the exclusive right to possess and utilize the asset while the

seller becomes entitled to the consideration. All income generated from this class of

contract is deemed legal (ÍalÉl ), and the contract becomes effective (nÉfidh) upon its

execution. The majority of jurists hold the view that the effectiveness of a valid contract( ÎaÍÊÍ) may be suspended until the occurrence of a future event. In contrast, the ShÉfiÑÊ

School and some ×anbalÊ jurists hold that a valid contract must become immediately

effective upon its execution (Ayyub, 2007, 118).

On the other hand, a contract that is invalid ( ghayr ÎaÍÊÍ) is one that violates the

pillars and SharÊÑah conditions of the contract (al-ShawkÉni, n.d, 539). The following

are examples of factors that render a contract invalid: the sold asset is an impure

or prohibited commodity such as blood, pork, wine, a carcass; the asset is not fully

possessed by the seller or is undeliverable; there is excessive uncertainty in the deliverydate or price; or the contract is performed by parties without legal eligibility to execute

contracts; i.e., one of the parties is insane, immature or not of sensible conduct. From

the SharÊÑah point of view, an invalid contract does not produce the legal effects of

that contract. There is no exchange of financial rights and responsibilities due to it; the

buyer does not have any right to dispose of the asset, while the seller cannot possess the

income realized. Such a contract must be properly re-executed, starting from scratch.

The majority of jurists do not distinguish between bÉÏil (void) and fÉsid (irregular)

except in certain non-financial issues such as ×ajj (pilgrimage), marriage and khuluÑ(Ibn QudÉmah, 2002, 1:183). With regard to financial transactions, both terms are the

opposite of ÎaÍÊÍ, having a single legal implication (al-Ramli, n.d, 25), and are often

used interchangeably. Al-JazÊrÊ stated:

� � � .....

.





“ FÉsid and bÉÏil share a single meaning in relation to sale contracts;

everything that is fÉsid is bÉÏil , and vice versa; i.e., one of the conditionsor pillars is breached…. FÉsid sales are all interdicted, and it is incumbent

upon people to avoid them” (al-Jaziri, 2003, 3:224-225).

The ×anafÊ School took a different position from the majority of classical jurists.

They classified contracts into three categories: ÎaÍÊÍ (valid), fÉsid (irregular) and bÉÏil

(void), and considered bÉÏil and fÉsid to be different in substance and ruling. FÉsid ,

according to the ×anafÊ School, is an intermediary class of contract between ÎaÍÊÍ

and bÉÏil (al-BukhÉrÊ, 1997, 1:379-380). The ×anafÊ position is premised upon the fact

that the defect in a defective contract is due either to a fundamental element (aÎl ) or an

accessory attribute (waÎf ). The ×anafÊ School agreed with the majority that a defect in a

contract’s fundamental element (aÎl ) renders the contract void (bÉÏil ) and that it cannot

be rectified. However, a defect in an external factor (waÎf ) will only make the contract

irregular ( fÉsid ) (al-BukhÉrÊ, 1997, 1:380). It does not necessarily render it void (bÉÏil ).

According to AbË ×anÊfah, a sale contract has four fundamental pillars: the two

contracting parties and the two counter-values. If the four pillars are satisfied and free

from any SharÊÑah prohibition, then the contract is valid. In contrast, if the contract is

defective in any of its fundamental pillars, it is void (bÉÏil ). However, if the defect is due

to external factors attached to the pillars, the contract is irregular ( fÉsid ). The following

are scenarios that elucidate the ×anafÊ view regarding the differences between ÎaÍÊÍ,

bÉÏil , and fÉsid (al-QarÉfÊ, n.d, 2:83):

(1) An insane person sells pork for a payment of wine to another insane person.

In this case, all the fundamental pillars are defective and, hence, the contract

is void (bÉÏil ).

(2) A legally competent person sells clothes for a payment of pork to another legally competent person. In this case, one of the fundamental elements

(pork) is defective, which renders the contract void (bÉÏil ).

(3) A legally competent person sells one gram of silver in exchange for another

gram of silver to another legally competent person. In this case all the pillars

of the contract are sound and, hence, the contract is valid.

(4) Based on Scenario No. 3 above, assuming that one gram of silver is exchanged

for two grams of silver, the contract is defective due to the existence of an




9

external factor, i.e., an increment ( ziyÉdah). Since the defect is not in its pillars

or fundamental elements (aÎl ), the contract is irregular ( fÉsid ) but rectifiable.Once the increment is removed, the contract becomes valid

Since the ×anafÊ School agrees with the majority regarding the definition and legal

implications of a ÎaÍÊÍ contract, the following discussion will further examine the

×anafÊ conceptualization of bÉÏil and fÉsid .

2.3.2 BÉÏil Contracts

According to the ×anafÊ School, bÉÏil is a contract that is invalid due to a defect in any of the essential elements (pillars) of the contract (al-KÉsÉnÊ, 1986, 5:305). The following

are examples of such defects: if the contract involves impure or prohibited items as the

subject matter; the subject matter has no value from the SharÊÑah perspective; the asset

is not fully owned by the seller; the acceptance is not in conformity with the offer; the

contracting parties have not reached the age of maturity; the contract contains fraud,

deceit, etc.

The ×anafÊs and other schools identified some particular forms of bÉÏil contracts, which

include (Zuhaily, 2004, 5: 3398-3431):

(1) Selling impure items. All the schools stated that sales of pork, wine, carcasses

or blood are void because these items are not considered to have value

(mutaqawwam) from an Islamic perspective.

(2) BayÑ gharar ; i.e., a sale contract that contain excessive uncertainty, which will

lead to probable loss to one of the contracting parties and, thus, to disputes.

Jurists unanimously agreed that bayÑ gharar is invalid. Some prominent

forms of bayÑ gharar are:

(a) Selling something nonexistent at the time of the contract, such as sale

of fruit before it begins to ripen, sale of sperm or a fetus, and sale of

the offspring of a fetus. Technically speaking, some of these items

may be existent at the time of the contract; however, they do not

have economic value at the time of the sale; their value is only

realized at some future date.





(b) Selling something undeliverable, such as fish in the water or birds in

the sky.

The ×anafÊ conception of a bÉÏil contract has the same implications as the majority’s

category, ghayr ÎaÍÊÍ (invalid). A bÉÏil contract does not give rise to any legal

consequences. The contract is treated as if it does not exist. Therefore, the buyer in a

sale contract is not entitled to the asset while the seller has no right to the consideration.

All income generated from a void contract is ruled as non-ÍalÉl ; hence, it cannot be

possessed or utilized (al-BÉz, 2004).

×ussain ×Émid ×assÉn said:

�

“A void contract has no existence in the eyes of the Lawgiver. It does not

confer a right, does not create obligations, and does not transfer property”

(×assÉn, in Niazi, L.K, n.d, 79).

2.3.3 FÉsid Contracts

A fÉsid (irregular) contract is a unique class of contract recognized in the ×anafÊ

School’s categorization scheme. Unlike a bÉtil contract, the essential elements of a

fÉsid are present, but the contract is tainted by a defect in an accessory attribute (waÎf )

(MahmËd, 2000, 8:139; al-ZaylaÑÊ, 1313AH, 4:12; al-BÉz, 2004, 94).

×anafÊ jurists identified various factors leading to a fÉsid contract, as highlighted below:

(1) A problem with the deliverability of the asset. As mentioned earlier, if an asset cannot be delivered because the seller does not possess it, all the

madhhabs agree that the contract is void (bÉÏil ) (MahmËd, 2000, 8:147). In

other cases, the seller owns the asset, but its delivery will cause him harm; for

example, selling wood from the roof of his dwelling. ×anafÊ jurists consider

such contracts to be irregular ( fÉsid ) because a contract does not justify harm

(WizÉrat al-AwqÉf wa al-Shu’Ën al-IslÉmiyyah, 1404-1427AH, 12:60).

(2) Ignorance ( jahÉlah); i.e., insufficient information. The jahÉlah may exist

with regard to four matters:




11

(a) the asset; e.g., the seller says, “I hereby sell you some of my cloth,” and

the parties disperse without the seller specifying which cloth is beingsold.

(b) the price; e.g., the seller says to the buyer, “I hereby sell this asset

to you for RM 100 spot payment or RM 200 deferred payment” and

the parties disperse without the buyer accepting one of the prices in

particular (al-ÑImrÉnÊ, 2006, 80).

(c) the time of delivery.

(d) the guarantee, surety or the pledge; e.g., a seller stipulates a guaranteeor pledge without specifying what it is (Zuhaily, 2004, 5:3444-3446).

According to the ×anafÊ School, insufficient information about any of these four

matters renders the contract irregular ( fÉsid ) because it will create a dispute between the

contracting parties (Zuhaily, 2004, 5:3441-3446). However, if the lack of information

entails excessive uncertainty about the delivery date—e.g., selling an asset for delivery

if rain falls or if a certain person comes—the contract is ruled bÉÏil according to all four

schools of thought, including the ×anafÊs (al-KÉsÉnÊ, 1986, 5:178).

(3) The existence of an invalid condition. The ×anafÊ School defined an invalid

condition ( shart mufsid ) as a condition that is neither consistent with the

nature and implication of the contract (muqtaÌÉ al-Ñaqd ), nor endorsed by

textual authority, nor admitted by customary practice. In fact, the condition

offers a benefit to only one of the contracting parties (or a third party) at the

expense of the other contracting party (Zuhaily, 2004, 5: 3471). One example

is tying a loan agreement to a sale contract; e.g., ÑAlÊ agrees to give a loan

to Zayd on the condition that Zayd sells his asset to ÑAlÊ. In this case, Zayd

may consider discounting the price in favour of ÑAlÊ due to the loan facility,

resulting in a loan that extracts profit (Arbouna, 2007, 346). Another example

is a purchase undertaking at par in a muÌÉrabah-based product; this gives the

capital providers a guarantee of their capital. Another example would be a

seller who sells a slave on the condition that the buyer will free him.

(4) The existence of duress (ikrÉh). Jurists classified duress in the contract into

two types: (i) mulji’ (ii) ghayr mulji’ . Mulji’ means that the duress comprises

a threat of death or extreme harm to part of the body. In this case, duress





renders the contract void (bÉÏil ) because it nullifies freedom of choice

(ikhtiyÉr ) and consent (riÌÉ ). Duress that is ghayr mulji’ entails a lower levelof harm than the former; for example, threat of imprisonment or a comparable

or lesser harm. In this case, according to the ×anafÊ School, the contract is

fÉsid because it does not totally annul freedom of choice; rather, it nullifies

consent (riÌÉ ). From a fiqh perspective, consent is not a contract pillar, rather

it is a condition for the validity of a contract (WizÉrat al-AwqÉf wa al-Shu’Ën

al-IslÉmiyyah, 1404-1427AH, 9:101).

(5) The existence of an element of ribÉ . The majority of jurists consider the

existence of ribÉ to invalidate the contract (make it bÉÏil ). However, the×anafÊ School holds that ribÉ does not make a contract void (bÉÏil ); rather,

it makes it irregular ( fÉsid ) and, hence, rectifiable (WizÉrat al-AwqÉf wa al-

Shu’Ën al-IslÉmiyyah, 1404-1427AH, 9:101).

Unlike a bÉÏil contract, the income from a fÉsid contract is not irretrievably illegal; it

is irregular but rectifiable. Once the intolerable elements are eliminated, the contract

becomes ÎaÍÊÍ; thus, the income becomes legal (ÍalÉl ).

Interestingly, while the ×anafÊ School clearly differentiates between bÉÏil and fÉsid

in financial contracts, they do not distinguish between them in other areas, such as

in marriage contracts and acts of devotional worship. It is stated in al-AshbÉh wa al-

NaÐÉ’ir :

� � “In our view, bÉÏil and fÉsid are synonymous with regard to acts of

devotional worship and marriage contracts” (Ibn Nujaim, 1999, 401).

Indeed, the ×anafÊ approach to invalid contracts in financial transactions is not limited

to them. It is also supported by some MÉlikÊ and ShÉfiÑÊ jurists. Al-QarÉfÊ, of the MÉlikÊ

School, acknowledged that the ×anafÊ approach is sound (al-QarÉfÊ, n.d, 2:83). Some

ShÉfiÑÊ scholars also differentiate between fÉsid and bÉÏil in certain contracts such as

wakÉlah, iÑÉrah, and ijÉrah. Some even follow the ×anafÊ view regarding all types of

contracts (al-Ramli, n.d, 25). Contemporary fiqh scholars have generally adopted the

×anafÊ view. Therefore, this paper has employed the ×anafÊ categorization of invalid

contracts as the approach to designing the income purification framework for Islamic




13

financial institutions. The authors view the ×anafÊ differentiation between bÉÏil and

fÉsid to be more practical and relevant to the current context and the needs of market players. There are a number of reasons for that judgement:

First, practically speaking, not every contractual defect is serious enough to warrant

re-execution. Some defects are minor and can easily be rectified by removing the

objectionable elements. Second, in the current context, re-execution of contracts creates

practical complexity as institutions tend to use boilerplate contracts to undertake the

same basic type of transaction with thousand of clients, and some contracts involve

cross-border transactions. Adopting the majority view will undoubtedly impose

hardship and difficulty on the market. Thirdly, the ×anafÊ categorization provides moreoptions to the market players to apply the Islamic law of contract in modern financial

operations.

Exhibit 1 depicts the summary of the discussion so far pertaining to the sources of

impermissible income. It is pertinent to be clear about the sources of impermissible

income before developing a holistic income-purification framework for Islamic

financial institutions. The following subsection shall delineate the approaches and

mechanisms for dealing with various sources of impermissible income as discussed

above

Exhibit 1: Potential Sources of Impermissible Income.

MÉl ×arÉm

(Prohibited

Income)

Li DhÉtihi

Li Ghayrihi

RiÌa (Consent)

'Adam Rida

(No Consent)

Non-Contract

Contract

Batil

(Void)

FÉsid

(Irregular)

Mahal aqd

(Subject Matter)

Khalal fi arkan

(Defect in Other Pillars)

Tas-hih

(Rectifiable)

No Tas-hih

(Cannot be rectified)





3. DEALING WITH NON-HALAL INCOME

3.1 Treatment of Non- ×alÉl Income

In Islam, a Muslim is not supposed to enter into any transaction that is in violation

of SharÊÑah rulings and principles. However, in the event that he does transgress the

boundary of SharÊÑah principles, the SharÊÑah requires the Muslim to repent and rectify

the wrongdoings immediately. Repentance means that one should feel regret for having

done the act, should stop doing it and resolve not to repeat it. In a financial or business

transaction, repentance is not sufficient if one still possesses the impermissible assets or

income. It is imperative that any income derived from impermissible sources undergo

an immediate process of rectification or purification.

However, the rectification and purification process may vary, depending upon sources

and scenarios. Some non-ÍalÉl income may have to be purified by channeling all of the

tainted money to charity while in some cases it may be required to return the wealth

to the original owner. In certain scenarios, rectification can be made without resorting

to channeling all the income to charity or the original owner. The following discussion

examines the treatment of non-ÍalÉl income from various sources and scenarios

identified in the preceding section.

3.1.1 Non-×alÉl Income Due to Its Essence (×arÉm li DhÉtihi)

As described in the foregoing discussion, ÍarÉm li dhÉtihi is what is prohibited due to

the intrinsic nature of the item, such as pork, wine and other impure items (Ibn Rushd

2004, 3:52; Ibn QudÉmah, 1968, 9:162). In this case, the SharÊÑah does not recognize

the items as assets having value that can be owned and treated as legal property by the

holder. Hence, the holder should immediately rectify the wrongdoing by destroying

the items (itlÉf ); they should neither be returned to the original owner nor channeled to

charity. It is narrated by Anas that AbË ÙalÍah asked the Prophet (peace be upon him)

about orphans who had inherited wine. Allah’s Messenger (peace be upon him) told

him:

» « : : » «“Pour it out.” AbË ÙalÍah asked if he could make vinegar of it. He replied,

“No.” (AbË DÉwËd, n.d, 3:326).”




15

Nevertheless, if the original owner is a non-Muslim, the recipient may return these items

to him, as these are recognized as property in the hand of a non-Muslim, according tothe MÉlikÊ and ×anafÊ viewpoint. However, generating income or accumulating wealth

through ownership or transacting items of this category of prohibition is completely

prohibited from the SharÊÑah viewpoint.

3.1.2 Non-×alÉl Income Derived from Elements Prohibited Due to

External Reasons (×arÉm li Ghayrihi)

Within this category, there are two possible scenarios: the prohibited income is derived

either with or without the original owner’s consent. The treatment of income for each

of these two scenarios shall be discussed in brief.

3.1.2.1 Non-×alÉl Income Acquired without the Owner’s Consent

(bi Ghayr RiÌÉ)

This type of prohibited income is realized without prior consent from the legal owner,

such as income derived from robbery, theft, etc. In this case, the income must be purified

by returning it to the owner. The obligation to return the income back to the original

owner is justified by a ÍadÊth in which RasulullÉh (peace be upon him) said:

�

“Whoever oppresses his brother with regard to his honor or any other

matter should seek his forgiveness today, before [repayment] is no longer

in dinars or dirhams” (BukhÉrÊ, 1422H, 3:129).

Obviously, a thief who asks his victim for forgiveness without returning what he stole

from him has slim chance of receiving it.

It is also premised upon another ÍadÊth:

“The hand (i.e., person) is liable for what it took until it returns it” (al-

TirmidhÊ, 1975, 3:558).





This ÍadÊth is referred to in discussions of liability for a borrowed object; however, the

generality of its wording makes it relevant to the issue of income generated withoutthe consent of the original owner. Imam al-BayhaqÊ in MaÑrifat al-Sunan wa al-ÓthÉr

mentioned it when discussing the issue of a thief’s liability to indemnify the stolen asset

(al-BayhaqÊ, 1425AH, 12:422). Jurists unanimously agreed that any asset acquired

without the owner’s consent must be given back to the owner. Ibn QudÉmah says:

“Whoever usurps something is obliged to return it as long as it remains

[existent]. We know of no disagreement [on this ruling]” (Ibn QudÉmah,1388AH, 5:177).

3.1.2.2 Non-×alÉl Income Acquired with the Owner’s Consent

As indicated in the previous section, the non-ÍalÉl income acquired with the consent of

the owner may be realized through either a nominate contract or a non-specific form of

contract. The following discussion delineates the treatment of each scenario.

3.1.2.2.1 Consent via a Nominate Contract

The ×anafÊ’s categorization of invalid contracts as bÉÏil or fÉsid is employed to deal

with this type of income. Each type of invalid contract has a different treatment.

3.1.2.2.1.1 Treatment of a BÉÏil Contract

As mentioned earlier, the SharÊÑah does not consider a void contract to be existent.

Therefore, the transaction does not have any legal effects or implications. Hence, any

income derived from this type of contract is unlawful and must be purified. A void

sale contract, for example, does not cause any transfer of ownership. The seller should

therefore refund the price while the buyer has to return the “purchased asset”. The

MÉlikÊ jurist Ibn Rushd states:

- � - � �




17

“Jurists unanimously agree that the ruling of an invalid sale—what the

×anafÊs call bÉÏil —when it has been concluded and [the opportunity toundo it] remains, is radd (return): the seller returns the price while the

buyer returns the asset” (Ibn Rushd, 2004, 2:193).

If the buyer sold the asset to another party after taking delivery, the first seller still has

the right to reclaim the asset. That is because a void contract does not have legal effect;

thus, no transfer of ownership occurred in the first sale (WizÉrat al-AwqÉf wa al-Shu’Ën

al-IslÉmiyyah, 1404-1427AH, 3:285). In the context of a void gift (hibah), the recipient

does not possess the granted item (al-ShÊrÉzÊ, n.d, 1:455). He must return it back to the

donor. Likewise, if a rahn contract is ruled void, the murtahin (pledgee) does not have

any right to keep the marhËn (security) (Ibn Nujaim,1999, 338); thus, it must be given

back to the rÉhin (debtor).

Notwithstanding the above ruling, in case the transacted asset is an item clearly

prohibited by the SharÊÑah, such as pork, wine or other impure items, the counter-value

of such asset must be channeled to public benefit (maÎÉliÍ ÑÉmmah) (Ibn Taymiyyah,

2005, 29:291) and is not to be returned to the original owner. This is in consideration of

the SharÊÑah principle that it is unlawful to assist others to commit sins.

It can thus be concluded that a process of purification must be undertaken for a void

contract (bÉÏil ). Neither party can recognize the income realized from this form of

contract. The process of purification may be divided into two scenarios: First, if the

contract is ruled null because it has failed to satisfy one or more pillars or conditions

of validity, purification is conducted by returning the income to its owner. A properly

structured contract has to be re-executed from the beginning in case all the contracting

parties want to continue with the transaction in a SharÊÑah-compliant manner. Second, if

the underlying asset employed in the contract is a substance prohibited by the SharÊÑah,

such as wine, pork, etc., the income acquired is purified by channeling it to public

benefit (maÎÉliÍ ÑÉmmah). In this scenario, re-execution is not possible as the subject

of the contract is prohibited by the SharÊÑah.

3.1.2.2.1.2 Treatment of a FÉsid Contract

Unlike a void (bÉÏil ) contract, a defective or irregular ( fÉsid) contract, as promulgated in

the ×anafÊ and contemporary fiqh approach, does not necessarily require re-execution

of the contract. In most cases, the rectification process can be done in one of two ways.





The first way is to eliminate objectionable elements that render the contract fÉsid . If

such elements are eliminated, the contract becomes valid. This is based on the ×anafÊlegal maxim:

. “When the impediment disappears while the reason for the ruling is

present, the [original] ruling returns” (WizÉrat al-AwqÉf wa al-Shu’Ën al-

IslÉmiyyah, 1404-1427AH, 12:60).

The following are examples of objectionable elements, mentioned in the previoussection, whose elimination may rectify their contracts (WizÉrat al-AwqÉf wa al-Shu’Ën

al-IslÉmiyyah, 1404-1427AH, 9:100, 9:101, 12:59):

(1) Delivery of the asset would cause harm to the seller, such as selling the

wood of his roof. ×anafÊ jurists consider such a contract irregular ( fÉsid ). If,

however, the seller chooses to remove the wood and delivers it to the buyer

before the contract is revoked, the contract becomes valid.

(2) Insufficient information about the asset, the price, or the time of delivery. Inthis case, according to ×anafÊ jurists, the contract is deemed fÉsid and may be

rectified by providing the missing information. The parties must specify the

asset to be transacted and determine the type of payment to be applied, either

spot or deferred. Insufficient information about the time of delivery can be

rectified by specifying the time.

(3) The existence of an invalid condition. The contract can be rectified by

removing the objectionable invalid conditions.

(4) The existence of the lesser level of duress (ikrÉh ghayr mulji’ ), such as a

threat of imprisonment. In this case, the contract is fÉsid but, according to the

×anafÊs, it can be rectified if the party under duress expresses his consent to it

after the duress has been removed. In contrast, if the party under duress does

not express his consent, the contract becomes void.

(5) The existence of a ribÉ element. In this case, the contract may be rectified

by removing the stipulation of ribÉ from the contract or by returning the ribÉ

element to the original owner.




19

The second method of rectification is to change the fÉsid contract into another suitable

nominate contract that makes the contract valid. This is accomplished by looking into thesubstance and essence of the transaction. ×anafÊ jurists have discussed many examples

of this process (WizÉrat al-AwqÉf wa al-Shu’Ën al-IslÉmiyyah, 1404-1427AH,12:61-

62). They include:

(1) A kafÉlah (guarantee) contract with the condition that the aÎÊl (debtor) shall

be free from any liability. The contract is fÉsid because this condition conflicts

with the nature and legal effects of kafÉlah. However, it can be rectified by

shifting the contract into ÍawÉlah (debt transfer) with all its rulings and legal

consequences. Once the contract is shifted to ÍawÉlah, the contract will bevalid.

(2) Shirkah mufÉwaÌah. It is required that each partner in this kind of partnership

provide equal contributions in the form of capital, work and liability. If the

contract of partnership is established using shirkah mufÉwaÌah but the

contributions are not equal, the contract is fÉsid , but it may be rectified

by turning the contract into shirkah ÑinÉn with all its legal rulings and

implications.

(3) MuÌÉrabah contract. The original ruling of a muÌÉrabah contract is that the

muÌÉrib is a trustee and is not held liable for any financial loss unless he

violates the agreed conditions or is negligent. Any profit is shared between

the muÌÉrib and the capital provider based on the profit-sharing ratio agreed

up-front. However, if it is stipulated in the contract that all profit belongs

to the muÌÉrib and is not to be shared with the rabb al-mÉl , the condition

makes the contract fÉsid . It may be rectified by turning the contract into qarÌ

with all the rulings and conditions of a loan. The reason is that, from a fiqh

perspective, a person has an exclusive right to get the entire profit if he is theowner of the capital. Therefore, when a muÌÉrib stipulates a condition that all

profit belongs to him, the implication of his condition is that he is the owner

of the capital. That means that he must treat the capital of the rabb al-mÉl as

a loan to be repaid in kind (qarÌ ).

(4) WadÊÑah, too, is a trust-based contract. A custodian is not entitled to utilize

the deposit in any way and is not held liable for any loss or damage except

in case of negligence or misconduct. However, if the custodian stipulates the





right to utilize or invest the deposit, the wadÊÑah contract becomes fÉsid . Like

muÌÉrabah, it can be rectified by recognizing that the transaction with thiscondition is in fact a qarÌ (loan to be repaid in kind). As a consequence, the

custodian is required to guarantee the sum of the deposit and indemnify it in

case of loss or damage.

It can be concluded that fÉsid factors do not necessarily nullify the contract in which

they appear. Since they do not, it is not required to completely re-execute the contract.

Rather, once the intolerable elements are corrected, the contract will then be valid.

However, if the objectionable elements persist and the contract is not shifted to another

contract that makes it valid, the contract becomes void, and all income generated andassets received must be returned to their original owner.

3.1.2.2.2 Existence of Consent without a Nominate Contract

There are instances in which illegal income is derived with the consent of the owner

from a transaction without using a specific nominate contract; for example, the income

generated from gambling (maysir ), bribery (rishwah), gifts to officeholders, etc. (Ibn

Taymiyyah, 2005, 28:593-594).

Jurists have different opinions with regard to the treatment of such income. Some

scholars held that the income derived by illegal means with the consent of the owner

must be returned to the original owner. This was the view of the ×anbalÊ and the ShÉfiÑÊ

Schools in their authentic opinion, based on qiyÉs (analogy) with an invalid contract

(Ibn Taymiyyah, 1995, 28:593-594). Under this view, one who receives a non-ÍalÉl gift

(rishwah) must return it to the donor (al-MÉwardÊ, n.d, 128; al-MardÉwÊ, n.d, 11:212).

Other scholars are of the view that the income should neither be returned to the original

owner nor be possessed (al-BalkhÊ, 1310AH, 3:236). It cannot be returned to the owner to avoid any form of assistance in committing sins (iÑÉnah ÑalÉ maÑÎiyah). Likewise,

the asset cannot be possessed by the recipient because a prohibited action cannot

legally justify transfer of ownership (al-BÉz, 2004, 351). Therefore, the income should

be channeled to the Bayt al-MÉl (the Public Treasury). This view was upheld by the

×anafÊ and MÉlikÊ Schools, and there is a narration attributing the same view to ImÉm

AÍmad ibn ×anbal. It is supported by the ÍadÊth of Ibn Lutbiyyah (al-BÉz, 2004, 245):




21

:- : - � : : :

“ : :

:

« : “ »The Prophet r employed a man from the tribe of Azd named Ibn Lutbiyyah

as a collector of zakÉh. When the employee returned (from his assignment),

he said, “(O Prophet!) This is for you, and this is for me; it was presented

to me as a gift.” The Messenger of Allah r rose upon the pulpit and praised

and extolled Allah. Then he said, “I employ a man to do a job, and then

he comes and says, ‘This is for you, and this has been presented to me as

gift.’ Why did he not remain in the house of his father or the house of hismother and see whether gifts would be given to him or not? By Allah in

Whose Hand is the life of Muhammad, if any one of you took anything

wrongfully, he will bring it on the Day of Resurrection, carrying it on (his

back): a grunting camel, or a bellowing cow, or a bleating ewe.” Then he

raised his hands till we could see the whiteness of his armpits. Then he said

thrice, “O Allah! Have I conveyed (Your commandments?” (Muslim, n.d,

3:1643).

In this ÍadÊth, the Prophet did not request Ibn Lutbiyyah to return the gifts he had

received. The ÍadÊth indicates two rulings: (i) non-ÍalÉl income acquired from

prohibited activities with the consent of owner is not to be returned to the owner; (ii)

the recipient cannot recognize the income as his wealth.

The authors prefer the second view. This view corresponds with the authentic and clear

ÍadÊth of Ibn Lutbiyyah and also acts to block the path that leads to sin ( sadd al-

dharÊÑah).





Exhibit 2 is a diagram that summarizes the proposed framework for Islamic financial

institutions to treat their non-ÍalÉl income based on the various scenarios mentioned inthe discussion above. The corresponding Table 1 below also provides brief descriptions

of the different treatments on income purification from various possible scenarios.

Exhibit 2: Framework of Income Purification

MÉl ×arÉm(Prohibited

Income)

Li DhÉtihi

Li Ghayrihi

RiÌa (Consent)

'Adam Rida

(No Consent)

Non-Contract

Contract

Batil

(Void)

FÉsid

(Irregular)

Mahal aqd

(Subject Matter)

Khalal fi arkan

(Defect in

Other Pillars)

Tas-hih

(Rectifiable)

No Tas-hih

(Cannot be

rectified)

Destroyed

Charity

Owner

No

Purification

Destroyed

Owner

(Shafie &

Hambali)

Charity

(Maliki &

Hanafi)

Owner

Source of Non- ×alÉl Income Purification




23

Table 1: Treatment of Non- ×alÉl Income

NoTypes of Non- ×alÉl

IncomeTreatments

1. ×arÉm li dhÉtihi The items must be disposed of (itlÉf ).

2. Without owner consent 1. Returned to the original owner

2. Channeled to Bayt al-MÉl if the owner isunknown

3. With owner consent by a bÉÏil contract

All income must be returned to the original owner (buyer) if the invalidity of the contract is caused bya defect in the pillars or conditions of validity.

All income must be channelled to charity if thecontracted asset is prohibited in its substance bythe SharÊÑah.

4. With owner consent by a fÉsid contract

All income generated is legal (ÍalÉl ) if theobjectionable elements are rectified, either byelimination of such elements or by turning thecontract into another contract.

All income must be returned to the original owner

if the objectionable elements persist or the contractis not turned into another contract.

5. With owner consent butnot contracted

1. MÉlikÊs and ×anafÊs - Channeled to charity

2. ShÉfiÑÊs and ×anbalÊs - Returned to the owner

Source: Authors’ Own

3.2 Principles of Income Purification

Jurists are of the view that a person cannot benefit from income derived by illegalmeans. Allah said:

�

“O you who believe, do not consume one another’s wealth wrongfully;

rather, let there be trade by mutual consent” (al-Qur’Én, 4:29).





Commenting on this verse, AbË JaÑfar al-ÙabarÊ stated that no one is allowed to consume

the property of another by a means prohibited by the Lawgiver; for example, incomegained from a ribÉ -based transaction or gambling-based activities (al-ÙabarÊ, 2000,

8:206). Therefore, any non-ÍalÉl income should be purified.

� :

MaÑmar asked al-ZuhrÊ about one who obtains illegal property. Al-ZuhrÊ

said: “If he wants to be absolved of it, he should get rid of it” (Ibn AbÊ

Shaybah, 5:380-381).

Al-SubkÊ provided a general guideline on how to purify non-ÍalÉl income. If a person

knows the original owner, he must return it to him or his representative (wakÊl ). If

the owner dies, he must give it to the owner’s heirs. If the owner is unknown and it

is impossible to find him, the wealth is channeled to the benefit of Muslims (maÎÉliÍ

ÑÉmmah). If not, it should be donated to the poor (al-NawawÊ/al-SubkÊ, n.d, 9:351).

Al-SubkÊ’s view on channeling the illegitimate property or income for public benefit

is supported by the majority of jurists. This was clearly mentioned by Ibn Taymiyyah:

....

.If property was taken without right and cannot be returned to its rightful

owners, as is the case with most of the rulers’ properties, then helping to

channel such property for the benefits of Muslims at large—for instance

construction of fortresses for defense of the frontiers, living expenses of

soldiers, etc.—is consider assistance in good deeds and piety....This is the

majority view amongst the jurists; for example, MÉlik, AbË ×anÊfah and

AÍmad. It was also narrated from some of the ØaÍÉbah and is supported by

the SharÊÑah evidence (Ibn Taymiyyah, 1418AH).




25

In Islam, the income that requires purification is only that which clearly originated

from non-ÍalÉl activities. An example is the income derived from an interest-basedinvestment. In this case, the amount that needs to be purified is the interest only. A

person still has a right to hold and benefit from the principal. This is the clear indication

of the relevant verse of SËrah al-Baqarah:

� “And if you repent, then you shall have your principal [without interest].

Wrong not, and you shall not be wronged” (al-Qur’Én, 2:279).

This verse indicates that a person who wants to repent from committing ribÉ is entitled

to get back his principal; no more and no less (al-JawzÊ, n.d, 3:257). In line with this

verse, Ibn Taymiyyah stated that a person who holds a mixture of ÍalÉl and non-ÍalÉl

income must purify the non-ÍalÉl portion only while the remainder is deemed ÍalÉl :

� “Whoever has mixed ÍarÉm wealth with ÍalÉl wealth should remove

the ÍarÉm portion; the rest is lawful for him” (Ibn Taymiyyah, 2005,

5:74).

Ibn Taymiyyah’s opinion is supported by his student, Ibn Qayyim al-JawzÊ:

�

If a person mixed his property with one or more ÍarÉm dirhams, let him

remove the ÍarÉm portion, and the remaining balance will be ÍalÉl for

him, without any reprehensibility. This is whether the dirham removed

is the particular dirham earned from ÍarÉm or its equivalent because the

prohibition is not associated with the substance of the dirham but, rather,

the method by which it was earned (al-JawzÊ, n.d, 3:257).





If the level of non-ÍalÉl is not precisely known, then ijtihÉd (exercise of personal

judgement) is necessary in order to measure and remove the portion that is not ÍalÉl .

“If someone knows that [his property] includes some ÍarÉm wealth, but he

is unsure of the amount, he should remove the ÍarÉm part by his ijtihÉd ”

(al-Nawawi/al-SubkÊ, n.d, 9:428).

Based on discussion above, it is clear that any income generated by illegal means must

be purified. However, it is important to note that the existence of non-ÍalÉl income doesnot affect the ÍalÉl portion. Table 2 below summarizes various scenarios of income

purification:

Table 2: Treatment of Income Purification

Scenarios Treatment1. All income is non-ÍalÉl (i.e., accumulated from

transactions involving substances that are impure

or prohibited).

All income must be purified.

2. Mixed income (some of the income is ÍarÉm

and the rest is ÍalÉl , e.g., investing in mixed

companies)

Only the non-ÍalÉl portion needs

to be purified.

3. The principal is ÍalÉl, but the profit is non-ÍalÉl

(i.e., interest-based activities)

Only the profit portion must be

purified.

4. Mixture of ÍalÉl and non-ÍalÉl profit (e.g.,

dividends from mixed companies)

Only the non-ÍalÉl profit must be

purified.

5. The principal and profit is ÍalÉl, but the profit

exceeds the actual cost (i.e., the late payment

charge exceeds the actual cost )

Only the excess amount must be

purified.




27

4. INCOME PURIFICATION FOR ISLAMIC FINANCIAL

INSTITUTIONS

The study on the principle of income purification together with the concept of mÉl

ÍarÉm (illegitimate wealth) has been a subject of wide discussion in the field of Islamic

jurisprudence. As discussed in the previous sections, different sources of illegitimate

wealth necessitate different treatments and purification processes. For the purpose

of this study, we simplify the discussion by providing a summary of its application

to Islamic financial institutions in Table 3. Examples of their application to various

Islamic finance operational issues are also provided in the corresponding column to

further illuminate our understanding of the concept and the various approaches todealing with illegitimate income.

Table 3: The Framework of Income Purification for Islamic Financial

Sources Description Treatment

×arÉm li DhÉtihi 1. In offering a trade facility based on

murÉbaÍah for the purchase orderer

(murÉbaÍah lil Émir bi shirÉ’ ), the IFI isfound to have imported a mixture of goods

(ÍalÉl and ÍarÉm). A portion of it is actually

alcoholic beverages, which was only

discovered after an audit was performed at

the port by the SharÊÑah auditor. Under the

facility agreement, the bank is supposed to

enter into a sale contract with a customer

who has undertaken to purchase once the

goods are possessed and owned by the IFI.

1. The IFI needs to exclude the

ÍarÉm portion of the imported

goods, i.e. the alcohol.

2. The IFI can only proceed with

the sale of the remaining ÍalÉl

portion of the imported goods.

3. The bank needs to dispose of the

alcohol at its own cost.






×arÉm li Ghayrihi A. ×arÉm income

derived from a void

(bÉÏil ) transaction

due to a defect in the

subject of the contract.

1. The IFI was found to have advanced

working capital financing to a wine

manufacturing company or to finance the

purchase of bottles for the wine.

1. The IFI must channel all profits

derived from the financing to

charity. The principal amount

can be retained.

2. Re-execution of the contract is

not allowed because the subject

matter is ÍarÉm.

2. In managing a portfolio, it is found that

one of the securities which was previously

classified by the Securities Commission

as SharÊÑah-compliant stock has been

reclassified as non-SharÊÑah-compliant.

1. The IFI must immediately

dispose of the non-SharÊÑah-

compliant stock.

2. Any capital gain derived from

the divestment process can be

retained if the disposal took

place on the announcement

date made by the Securities

Commission.

3. If the disposal took place

long after the announcement

made, then only the principalamount can be retained while

any capital gain from the

announcement date until the

date of actual divestment needs

to be channelled to charity.

3. In an Islamic debit card transaction based

on wakÉlah bil ujrah, the bank acts as an

agent (wakÊl ) to pay on behalf of the client

(muwakkil ) each time the client conducts

a transaction by swiping his debit card. Inthis form of transaction, the bank earns a

fee for each of the client’s transactions.

In reviewing a quarterly statement of the

client’s debit card transactions, the IFI

finds that the client used the Islamic debit

card to pay for gambling activities in a

casino.

1. The wakÉlah contract is void

for that transaction because the

subject matter is an illegitimate

activity.

2. Only the fee earned on thegambling transaction needs to

be channelled to charity.




29


B. ×arÉm incomederived from a void

(bÉÏil ) transaction

due to absence in one

of the pillars in the

contract.

1. In extending a credit line or cash financingto a company which previously enter

into a Letter of Credit (LC) murÉbaÍah

agreement with the IFI, it is found that the

second leg sales contract signed with the

company does not involve any asset, but

mere signing of a document.

1. The contract can be re-executed provided that the asset is still

available.

2. If the asset is no longer available

(e.g., it has been consumed) or

the transaction was completed

long ago, the IFI must return

to the client all profits earlier

recognized from the financing.

If the client cannot be traced, it

should be channelled to the Baytal-MÉl. The principal amount

can be retained.

2. In bayÑ bi thaman Éjil (BBA) for a cash

line facility to a corporation, as practised

by many Islamic banks in Malaysia, the

Asset Sales Agreement (ASA) must be

executed first, prior to executing the Asset

Purchase Agreement (APA). However, it

is found that the APA was executed prior

to the ASA, which effectively means theAPA was executed without an underlying

asset since the client had not become

owner of the asset before selling it to

the bank. Therefore, whatever amount of

financing disbursed by the bank is now

deemed a loan rather than originating

from a sale contract. Hence, any amount

repaid by client in excess of the principal

is deemed ribÉ .

1. The APA contract is void.

2. The profit derived from the

transaction is deemed to be ribÉ

and, hence, must be returned to

the client.

3. If the client cannot be traced, the

profit should be channelled tothe Bayt al-MÉl.

4. The principal portion of the

financing can be retained by the

bank.






C. ×arÉm incomederived from an

irregular ( fÉsid )

transaction due to

the presence of an

alien condition that is

rectifiable.

1. In reviewing a sale contract, it was foundthat a condition was imposed that the

buyer would not have the right to take

delivery of the asset purchased.

1. The clause in which thecondition is stated must be

removed, and the customer must

be notified of the rectification.

2. In a takÉful product, it was found that a

company introduced a structure which

invoked the issue of ribÉ . For example,

the contribution paid is treated like a

normal premium in an exchange contract

rather than hibah contributed for mutual

aid (i.e., there was no segregation of funds between the participants’ risk fund

(tabarruÑ) and the shareholder’s fund).

In addition, contracted monetary benefits

other than for mishaps and calamities

were taken from the participant’s risk

fund, which changes the whole structure

from a tabarruÑ concept to an exchange

contract and, thus, invokes ribÉ since it

involves unequal exchanges of money for

money (amount contributed and amount of

benefits).

1. The contribution should be

segregated into participants’

fund and participants’ risk fund.

2. Any surplus earned must be

returned to the participants’

fund.

3. In reviewing a bank guarantee (BG)

facility document based on the kafÉlah

contract, it is found that one of the clauses

contains a condition that the client (the

applicant for BG) shall be released from

his debt to the creditor (BG beneficiary).

This condition contradicts the nature of

kafÉlah, which does not release the client

from liability until debt settlement, either by the bank or the client himself.




31


D. ×arÉm incomederived from an

irregular ( fÉsid )

transaction due to the

presence of an alien

condition that is not

rectifiable.

1. In reviewing an inter-bank deposit- placement scheme based on the wakÉlah

bil istithmÉr contract, it was found that a

clause required the deficit bank (as agent or

wakÊl ) to guarantee a certain percentage of

return to the Islamic bank as the principal

(surplus bank). The contract has matured,

and payment of both principal and profit

has already been made and received by the

IFI.

1. The wakÉlah contract isirregular due to the presence of

the unwarranted condition.

2. The contract is deemed a loan.

3. The principal amount can be

retained.

4. The profit amount which was

previously recognized needs to

be clawed back and returned to

the counterparty.

2. In reviewing London Metal Exchange

(LME) procedures and policies, it is found

that physical delivery of commodities is

not allowed. This affects the status of the

murÉbaÍah sales contract signed with the

broker, which has a specific clause that

disallows taking delivery.

1. The sale contract is irregular due

to the presence of unwarranted

condition.

2. The contract is deemed a loan.

3. The principal amount can be

retained.

4. The profit amount which was

previously recognized needs to

be clawed back and returned tothe counterparty.

E. ×arÉm income

derived from a

transaction, albeit

with consent of the

owner, but without

a specific nominate

contract permitted by

the SharÊÑah.

1. A SharÊÑah auditor discovers that, in an

attempt to be selected as panel lawyers

for an Islamic bank, some law firms have

given gifts in the form of entertainment

packages to the regional managers of the

Islamic bank. This inevitably impairs the

bank’s integrity in the selection process of

panel lawyers.

1. Based on the ShÉfiÑÊ and ×anbalÊ

Schools: - All “gifts” given must

be returned to the client.

2. Based on the MÉlikÊ and ×anafÊ

Schools: - All “gifts” given must

be channelled to charity to avoid

invoking the issue of assisting

others to do evil.

2. The head of the commerce department

of an Islamic bank was found to have

received a cash inducement that influenced

his decision in approving a financing

facility to a potential corporate client. This

transaction is a bribe, which an Islamic

bank cannot tolerate, even though the bank

employee received the money without the

knowledge or sanction of the bank.

1. Based on the ShÉfiÑÊ and ×anbalÊ

Schools: - The entire amount of

cash received must be returned

to the client.

2. Based on the MÉlikÊ and ×anafÊ

Schools: - The entire amount

of cash received must be

channelled to charity to avoid

invoking the issue of assisting

others to do evil.





5. CONCLUSION

This paper has presented a framework of the income purification process for Islamic

financial institutions. It started by delineating the concept of illegitimate income

from the SharÊÑah viewpoint. This includes identifying the various possible sources

of illegitimate income derived from invalid and defective transactions from an

Islamic commercial law perspective. Incidences of SharÊÑah noncompliance should

be promptly, effectively and efficiently dealt with in the manner appropriate to each

type of noncompliance. The Islamic principles of income purification elucidated in this

paper shed light on how an IFI can immediately act to rectify and remedy the situation.

In a nutshell, as an organization based on God’s law, an IFI must adhere to the ethical

and moral principles outlined by the SharÊÑah at all times and in all places regardless

of the economic and financial consequences. This demands the internalisation of

SharÊÑah principles on Islamic financial transactions in their form, spirit and substance.

Furthermore, to truly promote the value propositions of Islamic finance, IFIs should

develop a holistic corporate culture embracing the principles outlined by the SharÊÑah.

God-consciousness (the taqwÉ paradigm) has to be instilled and reflected in all facets


F. ×arÉm incomederived from a

transaction done

without the consent of

the owner

1. An audit finds that the IFI charged a feefor early settlement of a deferred payment

sales agreement. The charge was never

mentioned in the contract signed with

the client. This transaction is akin to theft

by taking people’s money without their

consent or awareness.

1. The IFI needs to return theamount of the fee to the

customer.

2. The IFI is also required to send

a letter notifying the customer

of the mistake and offering its

apology.

1. An audit finds that the IFI imposed

a compensation (taÑwÊÌ ) charge on a

delinquent client that did not reflect the

actual cost incurred by the institution.

Moreover, the charge is higher than

the maximum allowable taÑwÊÌ charge

stipulated by Bank Negara Malaysia, which

currently stands at 1% of the outstanding

balance without compounding.

1. The IFI needs to return the

excess amount previously

charged to the customer

2. The IFI must also send a letter

notifying the customer of the

mistake and offering its apology.




33

of an IFI’s behavior including product structuring, documentation, contract execution,

system control, internal relations, dealings with customers and other organizations, policies and procedures, business practices through dress, décor, image, etc. The income

purification framework discussed here is also an integral part of the taqwÉ paradigm.

Overall the framework presented here may benefit the practitioners of Islamic financial

institutions, and even Muslim entrepreneurs in general, who need specific guidance to

improve their exercise of SharÊÑah-compliant practice and governance. The discussion

on the diverse approaches to income purification not only provides adequate guidance

to IFIs, who must decide which courses to take and how much to commit to them,

but more importantly, assists them in constructing a robust SharÊÑah-risk-managementframework to prevent noncompliant transactions from actually happening. It is crucial

that potential SharÊÑah noncompliance exposure be understood and efficiently managed

to ensure that IFIs continue providing Islamic financial services to their clients in a safe

and sound manner.

Such a framework can, therefore, be instrumental in enhancing stakeholders’ trust

and confidence in the operations of IFIs. It is now commonly acknowledged that the

consequences of a weak SharÊÑah governance and compliance process are not only

financial but also legal and reputational and can impact the economy as a whole.Hence, sound SharÊÑah governance and compliance practices have become essential

for the efficient, viable and sustainable growth of Islamic financial institutions. The

fact that Islamic finance has become an integral part of the financial system in many

countries means that the soundness of its operations is essential to maintaining the

overall robustness of those economies.





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37

APPENDIX

Illustration

Rectification of a FÉsid MuÌÉrabah Contract

MuÌÉrabah is a partnership contract in which one party (rabb al-mÉl ) provides capital

and another party (muÌÉrib) provides managerial skills. Profit, if any, will be shared

according to a ratio agreed up-front while any financial loss will be borne by the capital

provider. It is a trust-based contract, meaning the muÌÉrib is not held liable to guarantee

the capital or the profit.

Let us assume that a capital provider stipulates a condition in the agreement that the

muÌÉrib must guarantee the capital. According to the ×anafÊ School, the condition

will make the contract fÉsid because it will provide a benefit to only one party at the

expense of the other. From the SharÊÑah point of view, any benefit created at the expense

of another party is called ‘ribÉ ’. However, a fÉsid contract does not necessarily require

re-execution. ×anafÊ jurists held that it can be rectified. In this case, two forms of

rectification may be employed:

1.

Eliminating the guarantee clause. Once this objectionable element is eliminated,the contract becomes valid. The ruling of muÌÉrabah then re-emerges: themuÌÉrib is not held liable for any loss in the capital, and the profit is shared

based on the agreed ratio.

2. Turning the muÌÉrabah contract into a qarÌ (loan to be repaid in kind) with allits rulings and legal implications. In this case, the muÌÉrib becomes a debtor tothe rabb al-mÉl . He is liable for the capital under any circumstance. However,as a consequence of the loan contract, any profit generated from the capital will

belong exclusively to the muÌÉrib, who will also bear any financial loss.

Notwithstanding the above, if the guarantee clause is maintained and the contractclauses do not acknowledge that the transaction is a loan; i.e., the muÌÉrib is required

to guarantee the capital and at the same time the rabb al-mÉl stipulates a condition to

still enjoy a portion of the profit, then the contract remains invalid ( ghayr ÎaÍÊÍ). Once

the contract is void, a proper re-execution should be undertaken if the parties want to

continue the transaction.









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A Framework for Islamic Financial Institutions to Deal With Shari'Ah Non-Compliant Transactions (ISRA Paper)