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Selling Short as Ijarāh with Istiḥsān and Its Ethical Implication
Article in Arab Law Quarterly · August 2016
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Arab LawQuarterly
Selling Short as Ijarāh with Istiḥsān and Its Ethical Implication
Imtiaz Mohammad SifatPhD candidate in Business Administration, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia, Kuala Lumpur, Malaysia
Azhar MohamadDepartment of Finance, Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia, Kuala Lumpur, Malaysia
[email protected]; [email protected]
Abstract
For most scholars, the concept of selling short, where financial assets are sold without prior possession or ownership, transgresses Islamic principles. However, the Sharīʿah Advisory Council of the Securities Commission of Malaysia (SAC) went against the majority by permitting short selling in 2006. Conventional finance points out that short selling increases liquidity, facilitates price discovery, and enables informational efficiency. Muslim scholars are facing a dilemma: on the one hand, Sharīʿah principles dictate that Islamic capital market transactions and instruments should remain devoid of elements of ambiguity and prohibited characteristics, but on the other hand, the Sharīʿah also demands that the transactions be of social utility to the participating par-ties. It appears that the SAC allows regulated short selling on the basis of ijārah with istiḥsān. This article strives to highlight the jurisprudential issues regarding short sell-ing and contribute to an Islamic angle on the ethical implications affecting this phenomenon.
Keywords
short selling – Islamic finance – regulation – fiqh – ijārah
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1 Introduction
Short selling has a relatively long-standing tradition in the financial markets. However, in recent times, it has gained notoriety against the backdrop of global financial crises, stock market collapses and scandals. The issue is even more complicated and divisive for the Islamic community due to divergent views and the rigidity of scholarly opinions. In an Islamic market system, the mechanisms ought to be driven by Islamic morality and ethics.1 In reality, how-ever, the reluctance of many scholars regarding the permissibility of sophisti-cated derivatives, or in this particular case short selling, is motivated by their restrained understanding of the underlying mechanisms at work, coupled with constricted paradigm of thinking which has retarded an out-of-the-box mentality to circumvent the fiqh restrictions and facilitate an Islamically per-missible workaround essential to the liquidity and solvency of Sharīʿah-based2 financial institutions. There exists a mismatch of concurrent expertise in the understanding of fiqh3 vis-à-vis financial markets’ nuances. This article adopts an analytical narrative approach in highlighting the issues often overlooked by the opponents and proponents of short-selling permissibility. While this approach can appear overly critical at times, it strives to contribute to the existing knowledge base by offering trained readers the diversity of arguments and resultant opinions, without inclining towards either camp. As a starting point, this article will focus on the Malaysian context of the Sharīʿah Advisory Council (SAC) of the Securities Commission’s influential fatwā4 that ruled that short selling was permissible.
1.1 Definition of Short SellingBefore we delve into the legality of short selling, it is important to have a firm grasp of what it entails, its operational parameters and its practical implica-tions. This section is dedicated to explaining the concept of short selling and how it works.
Short selling reverses the age old aphorism: ‘buy low, sell high’. Anticipating that a stock’s price will drop, a short seller performs this action in reverse: first
1 M. Ariff, ‘The Role of Market in the Islamic Paradigm’, IIUM Journal of Economics & Management 5(2) (1997): 97-107.
2 Sharīʿah refers to the canon of Islamic law undergirded by the Holy Qurʾān, the prophetic Traditions and the consensus of the earliest generations of pious Muslims (Salaf) and the erudite latter-day scholars.
3 Fiqh refers to the corpus of Islamic jurisprudence.4 A fatwā is a non-binding legal verdict in fiqh parlance.
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they sell high, then they buy low. The tricky part is that the short seller does not actually own the shares they want to sell. Thus, it can be defined as the sale of a security not owned by a person, or a sale that is fulfilled by borrowing the asset in order to deliver it. The settlement of the transaction occurs through the delivery of an asset borrowed on behalf of the buyer, typically through an agent or broker. The buyer later closes the position by returning the borrowed asset to the lender, usually through open buying from the spot market.
Bearish investors typically short an asset because they are certain that its value will decline, with the hope of buying it back at a lower price and enjoy-ing a profit from the resultant spread. It is also used by market makers and regulators to provide liquidity in the event of unanticipated demand, or as a means for hedging a long position in the same underlying asset or an asset with related risk features (i.e., beta value). In the event of a rise in price, the investor suffers financial loss.
An investor who sells stock short borrows shares from a brokerage house and sells them to another buyer. Proceeds from the sale go into the short sell-er’s account. He must buy those shares back at some point in time and return them to the lender.
A famous example of short selling is George Soros’s taking down of the Bank of England in 1992.5 He bet $10 billion that the pound sterling would eventually falter. His prediction was proved right soon afterwards. The day the pound fell, Soros made $1 billion in profit, and his profit eventually surpassed $2 billion. To explain further, consider the following situation: If an investor believes that Stock A is overpriced at RM 10, he may think that a price fall is imminent. He may wish to sell the stock for RM 10 despite his not owning any units of it. If the price falls to RM 8, he will then buy it from the bourse at the spot rate to settle the trade and thus net a (10-8) = RM 2 profit per share. Conversely, if the price shoots up to RM 12 per share, he will succumb to a loss of (12-10) = RM 2 per share to settle his trade. Thus, short selling carries an inherent risk of unlimited losses.
1.2 Purpose of Short SellingSpeculative profiteering and risk hedging are traditionally touted as two primary motives behind short selling. In addition to that, perceived over- valuation of a company in regards to its fundamental intrinsic value, pessimis-tic outlook of the general market or a specific industry also trigger short sale
5 B. Murphy, ‘Finance: The Unifying Theme—A Profile of Financier George Soros (1993)’, online at: http://www.theatlantic.com/magazine/archive/1993/07/finance-the-unifying-theme/ 305148/.
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interest among savvy investors. Another purpose of short selling is an immi-nent merger or acquisition prospect.
We have seen from the definition and example of short selling that it essen-tially entails betting against the price of a financial asset. Surprisingly, this phenomenon is not exclusively the rationale behind a short position. Clunie and Ying have argued that a big chunk of short positions in reality stem from investment tactics not predicated on the outlook of the company in question.6 Rather, it is the short-sellers’ attempt to take advantage of relative movements between securities. As an example, they cite that in a market-neutral portfo-lio, the fund manager straddles both long and short positions on securities expected to be headed towards the same direction. Since the stocks’ returns are positively correlated, this tactic reduces the volatility of the portfolio through exploiting the inherent market inefficiencies. Apart from the purposes listed above, Lo and Mackinlay have also mentioned convertible arbitrage and index arbitrage amongst candidates of short-selling activities.7
2 Regulated Short Selling in Bursa Malaysia
2.1 Historical BackgroundThe regulation surrounding short selling in Malaysia was conceived in 1996. It was unique at the time within Asia, especially considering the emerging mar-ket climate in the ASEAN (Association of Southeast Asian Nations) region. It did not succeed in preventing the Asian crisis from spreading to Malaysia as the nub of the Asian crisis came less than one year later. As a result, the secu-rities borrowing and lending (SBL) process was put in abeyance for all stocks in Bursa Malaysia. More than a decade later, in 2007, Bursa Malaysia came up with the SBL system, which is described below.
2.2 SBL MechanismSBL activities in Malaysia must either be carried out through an approved clearing house acting as a central lending agency (CLA). Under the SBL-CLA model or directly over-the-counter, transaction takes place between the
6 J. Clunie & T. Ying, Developing Short-Selling on the Mainland Chinese Equity Markets, unpub-lished manuscript, University of Edinburgh, 2006.
7 A.W. Lo & A.C. MacKinlay, ‘When are contrarian profits due to stock market overreaction?’, Review of Financial Studies 3(2) (1990): 175-205.
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eligible participants and is facilitated by the approved clearing house under the SBL-negotiated transactions (SBL-NT) model.
Investors wishing to engage in regulated short selling (RSS) are required to open a designated RSS trading account with a participating organisation (PO). All short-selling transactions are to be carried out through this account. Before execution, however, investors have to borrow the stocks from a CLA through the approved PO. A fee is charged for this service.
Sometimes additional collateral is required in order for someone to borrow. Once the borrowing is complete, RSS is performed by dealers through the PO following the submission of a purchase order. An up-tick rule dictates that the investor’s order price must be greater than the last traded price of the stock in Bursa Malaysia. Not all stocks are approved by Bursa Malaysia for RSS. In order to qualify for RSS, the following requirements need to be fulfilled:
1. a minimum of 50 million outstanding shares (public float);2. median monthly trading volume should be more than RM 1,000,000; and3. median daily market capitalisation should be more than RM 500,000,000.
Stocks that meet these criteria make up the approved list, which is updated twice yearly. The total short position of an approved stock is limited to one-tenth of the total number of stocks outstanding. If the limit is reached, RSS facilities for that stock are halted for four trading days.
The regulation of short selling has led to a more organised and monitored actualisation of the practice. Although this has eased the practical application, there remain some legal issues surrounding the Islamic permissibility of this practice. Some of these issues are mentioned below.
2.2.1 Can Stock be the Subject of a Loan Contract?In answering this question, scholars have examined the characteristics of the objects that are used in lending. The fact that stocks are freely exchangeable or replaceable, i.e., they are fungible, constitutes the crux of arguments in favour of its legitimacy for short selling. Classically, all schools of fiqh, except for the Ḥanafī school, ruled that loans are permissible for all fungible goods and non-fungible goods that are fit for forward sale. Also, all jurists agree that a forward contract would be valid if the commodity used demonstrated mithli (homog-enous) properties, because if the commodity or item were damaged, a replace-ment could be easily found. Further, the majority of jurists agree that a loan contract would be valid if the object loaned possessed the same characteristics as an object used for a salam contract. This argument is based on a Ḥadīth that
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tells of a young camel being loaned. When the loan was repaid, an older, strong camel was given back, and the Prophet (PBUH) said, ‘The best among you is the one who is the best in repaying his debt’.8 From this Ḥadīth the jurists derived that both fungible and non-fungible goods could be used for loaning as they could be measured for repayment, meaning that when the loan was repaid an equivalent could be found. But the Ḥanafī school differs from the others, and argues that with non-homogeneous goods one cannot find an suit-able equivalent with which to repay the loan.
Even though the majority of Muslim jurists agree that stocks satisfy homo-geneous properties and can qualify as the subject of loans, one noteworthy point is that stocks that are borrowed and repaid will not have the same value at both times, which can be argued as not having homogeneous properties. This argument is put forward by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), which cites a two-pronged objection to the determination of homogeneity: (i) fluctuation of the stock price due to market dynamics, and (ii) the constant change in underlying assets of the busi-ness enterprise represented by the shorted stock. A workaround is often pro-posed to this by treating stocks as commercial paper regardless of what they represent, which obviates the debate on homogeneity. This, however, leads to other legal complications.
2.2.2 Selling What the Seller Does Not OwnTo make a trade contract valid, the fundamental condition is that the traded object should exist and the seller should be able to transfer ownership to the buyer. In short selling, the issue of not owing the shares arises. This contradicts the Ḥadīth of the Prophet (PBUH): ‘Do not sell what you do not possess’.9
According to Ḥanafīs, qabd (taking possession of the goods) is not an essen-tial requirement.10 Thus a sale that is undertaken in good faith by a person who does not own the good is deemed valid but defective. According to the Mālikīs, qabd is required only for food grains. Under the Shāfiʾī school, however, it is necessary for the seller to have possession of the goods, which is based on the Ḥadīth above. According to the Ḥanbalī scholars Ibn Taymiyyah and Ibn Qayyim, the Ḥadīth is understood as meaning that one should not sell a good that one cannot deliver. According to them, what the Ḥadīth states is that sales with excessive risk (maysir) and uncertainty (gharar) should be prohibited.
8 Translation of Ṣaḥīḥ al-Bukhārī, vol. 3, book 41, number 578.9 Narrated by Abū Dāwūd (3/768) and al-Tirmidhī (4/228).10 Ḥanafī scholar al-Kasani mentions in Badai al-Sanai (5/148) that possession is merely a
subsidiary condition for a bona fide sale but does not constitute a pre-requisite per se.
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To them, the understanding of qabd is determined based on local customs, and not the existence of the object.11
On 18 April 2006, the SAC of the Security Commission of Malaysia resolved in its 69th meeting that RSS is in line with the Sharīʿah. The essence of the short-selling transaction is selling shares that are not owned by the seller. Therefore, the transaction falls under the category of bayʿ ul-maʿdūm (buy-ing non-existent assets),12 primarily because of the element of uncertainty. Most modern scholars, when it comes to bayʿ ul-maʿdūm, tolerate a reason-able degree of uncertainty. Along this line, the Malaysia SAC argues that the issue of gharar can be overcome and eliminated through regulated short sell-ing (RSS) and the inclusion of SBL principles. This means that with the intro-duction of SBL, the probability that the borrowed shares will be delivered can be sufficiently increased. When this probability is high, the element of gharar becomes insignificant. When an obstacle that hinders the recognition of an activity as Sharīʿah compliant is overcome, then that activity can be classi-fied as Sharīʿah compliant.13 This argument is buttressed by the legal maxim: ‘When an issue that impedes is removed, then the activity which was initially forbidden becomes permissible’.14 Based on such arguments of eliminating gharar through RSS mechanism, experts such as Mohamad have propounded the legitimacy of short selling in an Islamic framework.15
2.2.3 Benefitting from LoansThe third issue raised with short selling is whether the person who lends the stock can benefit from a loan contract. Under the Malaysian short-selling rule, the owners of the shares will receive a 2% return on lending the shares, based on a minimum loan amount of 50,000 shares. Over the ages, Islamic jurists have ruled that under any condition any repayment amount above what was
11 Ibn al-Qayyim, ‘I’lam al-Muwaqqi’ in 2/19.12 This literally means the sales of the non-existent. This kind of sales is generally permitted
by all schools of fiqh in Sunni Islam, with the Shāfiʾī school being the strictest. However, noted expert Hashim Kamali and certain Syrian scholars reject this contract altogether on the grounds of unabated uncertainty and contingencies of dispute.
13 A.W. Dusuki & A. Abozaid, ‘Fiqh issues in short selling as implemented in the Islamic capital market in Malaysia’, Journal of King Abdul Azis University: Islamic Economics 21(2) (2008): 63-78.
14 A.R.A. Rahman, Sharīʿah Audit for Islamic Financial Services: The Needs and Challenges, unpublished manuscript, ISRA Islamic Finance Seminar, 2008, Kuala Lumpur, Malaysia.
15 A. Mohamad, ‘Creating a Two-Way Market via Short Selling and Its Potential Use in the Islamic Paradigm’, International Journal of Economics, Management and Accounting 21(2) (2013): 29-43.
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loaned is prohibited, whether the repayment object is of the same type as that which was loaned or of a different type. A jurist belonging to the literalist (Ẓāhirī) school of thought, Ibn Ḥazm, ruled that usury in loans may arise in both ribāwī 16 and non-ribāwī properties. Ibn Ḥazm added that it is illegal to disburse a loan and receive back a lower or higher amount or a different type of repayment. Based on these facts, the jurists have established a well-known maxim that reads, ‘any loan contract which benefits the lender is tantamount to ribā’.
With the exception of the Mālikī school, the jurists permit gifts or benefits derived from loan contracts as long as they are voluntary and not a condition of the loan. The Mālikīs, however, forbid any gift or benefit given by the debtor to defer the debt that cannot be explained by brotherly motives. In this case, the prohibition applies to both parties: the receiver and the giver. On the other hand, the Mālikīs allow unconditional repayment of debt with an increase in the amount repaid if the debt resulted in a trade or sale. However, based on the Ḥadīth about the young camel and the old camel, the Mālikī jurists do permit an increase in the quantity to be repaid, provided that it is not a pre-condition. According to the Ḥanafīs, any condition imposed by a creditor regarding any increase in the amount owed is void while the contract is valid, whereas in the Shāfi’ī school, both the condition and the contract are void.
3 Dissecting the SAC Permission for Short Selling
It would be biased to look at only one side of the story without investigating the other. Hence, we will now study the basis for the granting of permission for RSS in the Islamic capital markets. There are two different models practiced. The model proposed by the SAC is based on ijārah (lease) with istiḥsān (juristic approbation) and the other model, proposed by the International Islamic Fiqh Academy, is based on bayʿ arbūn.
3.1 The Resolution by SAC, the Securities Commission of MalaysiaThis resolution has two parts: arguments permitting RSS, and arguments permitting SBL. Short selling cannot be dealt with without considering
16 Islamic law considers six substances which are sold by weight and measure to be ribāwi items. These are gold, silver, dates, wheat, salt and barley. Any transaction of these items in kind must be in equal measure with immediate transfer of possession. Any unequal transfer amounts to ribā (usury) and is deemed ḥarām (impermissible).
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SBL. The SAC rationalises permitting RSS through the elimination of gharar (uncertainty). This was explained earlier and needs no further repetition. The only issue of contention in this line of logic was the 2% commission which benefits the lender of the securities, which the scholars claimed contains an element of ribā, effectively inviting a reconsideration of the resolution by the SAC. However, the justification of the 2% commission by the SAC was not over-looked by its board of scholars. Hence, there is a need to reiterate this part of the argument.
SAC permits SBL on the basis of ijārah with istiḥsān. The SAC claims that the securities are lent on the basis of ijārah, which enables the lender of the asset to benefit from the leasing (through the 2% commission). This model eliminates the problem of ribā. Even though there is no usufruct from the secu-rities to the borrower, the SAC permits it because of coupling ijārah principles with istiḥsān. At the risk of oversimplification, istiḥsān is an exception to a general rule. The general rule for ijārah is that there should be a usufruct, but SBL is an exception to it. The SAC buttresses its position through the following arguments:
1. Istiḥsān with maṣlaḥah: There is an advantage to the original shareholder and it can provide liquidity to the share market; and
2. Istiḥsān with ʿ urf -khāṣ: The SAC argues that SBL is a customary economic practice in the financial realm.
Further, in this model the leased asset is being sold (the essence of short selling is to sell the stocks that are borrowed). This issue can be overcome by obtain-ing consent to sell from the owner of the assets, and this what the SAC has done. In the following sections we further investigate some of the issues with regards to ijārah and istiḥsān.
3.1.1 Can Usufruct be Derived from the Leased Stocks?In principle, short selling can be argued to be ostensibly akin to ijārah, although the primary divergence occurs in the right to benefit (usufruct) and the trans-fer of benefits.
There are three pillars in ijārah: contract (offer and acceptance), rent, and usufruct (manfaʿah).17 The usufruct is the benefit derived from the leased asset. This benefit should be known and the ijārah contract will be terminated if the
17 Muḥammad ibn Aḥmad Sarakhsi,̆ Kitāb Al-Mabṣūṭ (Bayrūt: Dār al-Kutub al-ʿIlmiy̆ah, 2001).
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leased asset is not capable of giving usufruct.18 Imam Sarkhasy cites the exam-ple of a weak camel that is given in ijārah. A person borrows a camel for work that it cannot then perform. Hence, this contract is void. Further, he cites an example of infertile land, where farmer wants to use the land for agricultural purposes but cannot. Therefore, usufruct cannot be extracted from the land. Hence, ijārah is void.
These examples are an indication that when usufruct cannot be derived from the leased asset, it cannot be given as ijārah. However, can we derive usu-fruct from the leased assets? The simple answer is no. Umar Chapra states that the forward seller has no role to play, as the stocks are neither consumed nor used in business, and no work is performed to add value.19 The stocks traded in short selling are not used in the business by the borrower. He makes a specula-tive profit and clearly there is no usufruct, which nullifies the ijārah contract itself. Further, according to Aḥmad ibn Ḥanbal, rent is not given for the parts of the leased object but only for the usufruct. No claim can be made with regards to the ownership.20 However, this issue is resolved by infusing the ijārah con-tract with istiḥsān. Hence, the next issue is whether istiḥsān can be applied in short selling.
3.1.2 Can Istiḥsān Be Applied in Short Selling?Legitimacy of sources of the Sharīʿah other than the Qurʾān, Sunnah and ijmāʿ has never been unanimous in the history of Islamic Jurisprudence. Istiḥsān (juristic discretion), istishāb (continuity), maṣlaḥah al-mursalah (public wel-fare), ʿurf (social norms and customs), qawl al-sahabah (statements of the companions of the prophet) and sharaʿ man qablana (pre-Islamic laws) have brought about immense criticism and debate among classical scholars. Istiḥsān is rejected by ash-Shāfiʾī and this was also acknowledged by the SAC. The defi-nitions of istiḥsān among classical scholars contradict one another. However, the SAC has taken Imam al-Shatibi’s definition that istiḥsān is an exception to a general rule.
This article does not attempt to undermine the definition itself. Nevertheless, the example cited to explain this definition needs to be contemplated. Istiḥsān is known as an indirect analogy (qiyās khafiyy). The example is that a person
18 M.Y. Saleem, ‘Islamic Contract for Financing (Part 2)’, in: A. Trakic & H.H. Tajuddin (eds.), Islamic Banking and Finance: Principles, Instruments & Operations (Ampang: CLJ Publication, 2012), pp. 116-120.
19 M.U. Chapra, ‘Comments on M.M. Metwally: Role of the Stock Exchange in an Islamic Economy’, Journal of Research in Islamic Economics 3(1) (1985): 75-81.
20 Muhammad bin Salih ʿUthaymin, Al-Sharh Al-Mumtiʿ ʿAla Zad Al-Mustaqniʿ (Riyad: Mu’assasah Aʿsam, 2008).
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declares that his zakāt-able goods are for sadaqah (charity). There is an explicit difference between zakāt and sadaqah. Zakāt can be given to a certain class of people and it is a right of theirs. When someone declares this as sadaqah, the rights of those people who are eligible to receive zakāt will be breached as peo-ple may follow this declaration to reap benefits for themselves or their families. Hence, when confounded about drawing evidences from the primary sources, jurists resorted to istiḥsān to tackle the issue. Public interest (maṣlaḥah) is one major factor in istiḥsān. Scholars cite the following Qurʾānic verse to resolve this matter: ‘Take, [O, Muhammad], from their wealth a charity by which you purify them and cause them increase, and invoke [Allah’s blessings] upon them. Indeed, your invocations are reassurance for them. And Allah is hearing and knowing’.21
In spite of the textual use of the term ‘sadaqah’ scholars agree that this verse categorically explains the obligation of zakāt. As Allah has used the terms inter-changeably, scholars make an istiḥsān that the declaration of that person to give sadaqah on zakāt-able goods should be distributed following zakāt rules and not sadaqah. This resolution has set an example for the people to come.22
3.1.3 Does Short Selling Serve the Public Interest (Maṣlaḥah)?The SAC has validated the claim of istiḥsān as short selling serves the public interest. The benefits that the SAC has enumerated are that it is advantageous to the original shareholder and also provides liquidity to the market. This, how-ever, does not hold up to close scrutiny. The literature on short selling alludes to individual/trader benefits in terms of new avenues of profiteering. This is to be construed as micro-maṣlaḥah, and not macro-maṣlaḥah in the sense in which classical jurists understands public interest.
3.1.4 Could Short Selling be Categorised as ʿUrf-Khāṣ?ʿUrf is defined as ‘a long-standing tradition whereby the common man accepts it and it does not contradict Sharīʿah principles, and furthermore, the people rationally and emotionally believe it to be beneficial or good’.23 Plus, ʿurf will be rejected if it contradicts the naṣṣ shariʿ (explicit scriptural texts from the Qurʾān and Sunnah), the consensus of scholars (ijmāʿ), or when there is no benefit to society and the practice is harmful.24 It has already been argued that the issue of benefits is a grey area. The authors contend here that the benefits
21 Qurʾan: Chapter 9, Verse 103 (Surah Taubah: The Repentance).22 Ibn Aḥmad Sarakhsi,̆ supra note 17.23 Ahmad Fahmi and Abu Sanna, Urf Wa-l-Adafi Ray Al-Fuqahāʾ (n.p., 1992).24 Muhammad Amin Ibn Abidin, Majmuʾ Rasa ʾil, Muhammad ʾAbd al-Rahman al-Shaghul
(ed.), 1st ed., 2 vols. (Cairo: al-Maktabat al-Azhariyyah, 2012).
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brought about by short selling through avenues of market efficiencies, price discovery, liquidity, and risk hedging indicate a high level of benefits to be derived from the practice. This is not to undermine the harmful prospects of speculative and unscrupulous practices, however. Nonetheless, the pros far outweigh the cons and engender the positive advancement of public welfare and elevated market efficiencies. Below, we investigate further whether short selling fits into the principle of ʿurf -khāṣ.
ʿUrf can be divided into two parts: ʿurf -ʿamm and ʿurf-khāṣ. ʿUrf -ʿamm means that the majority of scholars agree upon a custom of society that fits the broad definition of ʿurf in general. ʿUrf -khāṣ, meanwhile, means that only some scholars agree upon the custom and deem it to be ʿ urf, while the majority do not agree, but it too fits the broad definition of ʿurf.25 For example, an act of the people of Medina was accepted as ʿurf by Mālikī scholars but not by others. Another example is that the term ‘dhabbah’ in literal Arabic means any ani-mal, which includes humans. However, according to ʿurf -ʿamm, this term only signifies four-legged animals, and therefore man does not fall under the scope of this definition. Interestingly, Egyptians use this term to only mean donkeys. This is an example of ʿurf -khāṣ only for the people of Egypt.26
The most important point is that neither ʿurf -ʿamm nor ʿurf -khāṣ contra-dicts the Sharīʿah, ijmāʿ and maṣlaḥah. In regards to short selling, a superficial case is made by its detractors that the act of short selling is not a long-standing tradition in Malaysia, and even more tenuously it is claimed that short sell-ing lacks a long history and is neither accepted nor practiced by the common man, which thereby extinguishes its candidacy for ʿ urf. We rebut this argument by pointing out that the definition of ʿurf here should preclude the common man and should include the industry practitioners. In today’s day and age, one would be hard-pressed to find financial industry professionals with at least a Bachelor’s level of education who is not aware of the practice of short selling. Its familiarity can now even be claimed to be ubiquitous. Its practice too is uni-versal in nearly all exchanges around the globe. This has to constitute a form of ʿurf for the financial industry. Therefore, to interdict short selling as ʿurf -khāṣ is a dubious argument.
25 Ali ibn Muhammad Jurjani and Al Sayyid Al-Sharif, Kitab Al-Ta ʾRifat (Beirut: Al-Hawkati, 2014).
26 M. al-Zarqa, Al-Madkhal Al-Fiqhi Al-ʿAamm: Al-Fiqh Al-Islami Fi Thawbihi Al-Jadid (Damascus: Dar al-Fikr, 1968).
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3.1.5 Vindicating Short Selling via Bayʿ ul-KhiyārKhiyār, in legal terms, denotes option. Thus, bayʿ ul-khiyār entails the seller’s choice and right to repay the price of a commodity already sold to the buyer, as well as the buyer’s duty to return the goods to the seller on a date pre-agreed by both parties. Although attempts have been made to legalise short selling through this analogy, they have failed due to the following:
1. The classical fiqh position on bayʿ contracts requires assets and all of their usufructs to be transferred to the buyer or his plenipotentiary. However, in short selling some parts of usufruct in the underlying assets are never transferred to the borrower/buyer/short-seller.
2. Classical bayʿ ul-khiyār requires the price to be fully settled and paid, with the added option of taking the asset back for a period of time. In short selling, however, only a margin (typically 10%) is paid, not the full price.
3.1.6 Vindicating through QardhQardh or debt is an ownership contract where the borrower takes possession of an asset as well as its usufructs, which is not achieved in a sale because a true sale contains transfer or ownership as well. The concept of qardh requires that an acceptable debt is uncompensated by anything more than the underlying asset itself (with the exception of a gift/charity when returning the borrowed asset). In contrast, in short selling, the lender receives more than the underly-ing asset, dissected earlier as the ribā element thus nullifies any possibility of the practice qualifying as a qardh contract.
3.1.7 Additional Risks Inherent to Short SellingFrom the lender’s perspective, the owner of the stock incurs three types of risk when lending a stock under the SBL mechanism:
1. Investment Risk This entails the risk that is undertaken by the owner or their plenipoten-
tiary as a result of investing in collateral. Many lenders around the world, especially in Bursa Malaysia, are unwilling to take risk in reinvesting col-lateral. As a result, they invest mainly in overnight repurchase agree-ments or financial instruments with a similar risk profile. Lenders with a higher risk appetite attempt to earn more by investing in longer instru-ments and shorter-term debt instruments with low ratings, i.e., junk bonds. Responsibility for monitoring the investment of collateral to man-age these risks lies squarely with the owner of the stock. In the event that
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a loss occurs through the investment of the borrower’s collateral, the owner remains legally obligated to settle the transaction.
2. Operational Risk This entails the risks rising from the unmet responsibilities of the lender
or borrower. Example of this include failure to procure dividend war-rants, crediting to the wrong account, failure to guide the client on corpo-rate actions leading to wasted opportunities to make a profit, failure to mark a loan to market, or failure to return an instrument when it is recalled. An accountable and transparent lending system that tracks divi-dends, corporate actions and the collateralisation of loans can help mini-mise operational risks.
3. Counterparty Risk This is the risk that the borrower will fail to provide additional collateral
or fail to return the stock. It is possible for the owner of the stock to mar-ginalise this risk by filtering less creditworthy borrowers and enforcing a stringent credit screening process. Additionally, marked-to-market daily collateral accounting enables lenders to buy stocks to cover the loan in the event of the borrower’s failure to return the original stocks.
From the borrower’s perspective, two types of risk are borne:
1. Loan Recall Risk This is the risk associated with a rise in the underlying stock’s price prior
to the borrower’s closing out of the position to settle the trade. Most bor-rowers would ideally like to acquire loans lasting the entire period of the short position, but in reality, such guaranteed term loans are seldom practical. Therefore, many borrowers hedge against this risk by finding a willing partner who is prepared to lend the asset for an elongated time window.
2. Rebate Price Volatility This is the risk that the borrower loses out on profit opportunities if the
market rate of rebates declines once he enters into a short position.
In addition to these risks, there is another inherent risk called the buy-in risk. In the event that the borrower is unable to return the stocks, the lender has the option to utilise the collateral to buy stocks to cover the loan. Therefore, recall notices can force borrowers to shuffle their trading strategies and adopt
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inferior positions, which potentially expose the borrowers to the possibility of large losses due to an ill-executed buy-in contingency.
4 Ethical Implications on Short Selling
The very tenet of short selling springs from a contrarian philosophy which facilitates profiting from a pessimistic stance on a financial asset. In practice, as discussed earlier, the prime motifs behind short selling are either specu-lation or seeking to hedge exposure in a long position. However, the contro-versial and ethically grey nexus of short selling derives from many investors’ perception that it is unethical to profit from troubled state of an enterprise, and scouting for weak or declining firms is tantamount to wishing ill of both the company as well its other stockholders. In fact, historical chronicles rang-ing from the collapse of Dutch East India Company to the South Sea bubble in the UK to the great American depression in 1930s until the recent financial collapse of 2007-2008 show that the act of short selling has been subjected to acerbic castigation from general investors, financial regulators, market observ-ers, and even media pundits. As per Paul Harrison’s commentary, Sir Barnard’s proposed law in 1734 described short selling as a pernicious and destructive practice directed at discouragement of industry and manifest detriment of trade and commerce.27 Lamont and Stein record short selling’s nefarious repu-tation in the 1920s as an act against God that is inhumane and un-American.28 Furthermore, less than two decades ago, in the backdrop of ASEAN crisis, at a time when the Malaysian Ringgit was in a free-fall, it was proposed by the Malaysian Finance Ministry officials that short sellers be subjected to physical punishment: e.g., caning. Although the proposal never materialised, it epito-mises the regulatory perception of this act across the globe. Historically, thus, it is not surprising that the act of short selling has been subjected to vitriol by the general populace. Despite such infamy, short selling has suffered over-whelmingly less notoriety among academics. Admittedly, the vast majority of academic works regarding the justification of short selling espouse an empiric approach, this section explicates some ethical arguments surrounding its justification.
27 P. Harrison, ‘The economic effects of innovation, regulation, and reputation on deriva-tives trading: some historical analysis of early 18th century stock markets’, (2004), online at: http://www.econ.tcu.edu/quinn/finhist/readings/paul_harrison.pdf.
28 O.A. Lamont & J.C. Stein, ‘Aggregate Short Interest and Market Valuations’, American Economic Review 94(2) (2004): 29-32.
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One of the foremost accusations hurled at short sellers is profiting at the expense of others’ misery. Irvine calls this the ‘Wishing Evil’ principle, and underlines that exponents of short positions are likely to entertain evil wishes that are potentially morally questionable.29 This moral objection can be rather easily squashed. A short seller naturally stands to gain from a negative turn of events affecting the asset he/she shorted. However, wishful thinking has no effect on reality. Just because someone wishes that Malaysian Airlines go bank-rupt and its stock value dwindle to zero does not necessarily mean that it is going to happen. Even if it does happen, it will not be because of this wish. Thus the age old post hoc, ergo propter hoc logical fallacy applies here. Interestingly, however, Irvine, while disregarding moral objection to such wishing of evil, also extends this argument by drawing inference to Immanuel Kant’s example where Kant posited although there is nothing wrong per se in being cruel to a dog, there remains a possibility that the person being cruel to dogs will grow crueller to people. Through logical inference, if one were to draw a corollary to the short selling issue at hand, at best it can be argued that the short seller, although in his/her own right committing no unethical act, by shorting a stock and wishing for it to decline in value, runs the risk of cultivating moral tenden-cies which may overstep acceptable boundaries and overlap into other aspects of investment. This in turn could lead to unethical or even illegal acts such as the spreading of false rumours, manipulation of markets, transacting insider deals, short and distort, etc.30 To be fair, though, the same is equally applicable to long position holders. In fact, unethical practices through pump and dump are common targets among market players, the majority of whom are com-prised of long positions, not short. Thus, it is reasonable to exonerate short selling on the count of ethically questionable profiteering.
Another common accusation against short selling is its perceived destruc-tion of enterprise value. This objection can be rebutted in multiple ways. First off, one of the primary objectives of a financial market is to facilitate price dis-covery and efficient trading.31 The price signal of a financial asset derived from a financial market represents a confluence of buyer and seller consensus and thereby constitutes an equilibrium price. Empirical studies by Boehmer and
29 W.B. Irvine, ‘Ill-Wind Investing: The Ethics of Wishing’, Journal of Business Ethics 35(1) (2002): 57-63.
30 J.J. Angel & D.M. McCabe, ‘The Business Ethics of Short Selling and Naked Short Selling’, Journal of Business Ethics 85(1) (2009): 239-249.
31 T. Chordia, R. Roll & A. Subrahmanyam, ‘Liquidity and Market Efficiency’, Journal of Financial Economics 87(2) (2008): 249-268.
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Wu32 also have shown through a large panel of NYSE-listed stocks that intraday informational efficiency of prices ameliorate as short flow increases, and the reversal of trading techniques by short sellers around extreme events enables price discovery and minimises discrepancy between market price and funda-mental values. The results of this study were robust and support related find-ings by Berkman and McKenzie and Boehmer and Kelley.33 Moreover, Chordia, Roll and Subrahmanyam claim that informed, sophisticated traders equipped with both short and long techniques observe the market with greater keenness and therefore contribute more information in pricing of stocks.34 This engen-ders transaction-based efficiency in the market. Secondly, a short position, once open, is contractually obligated to be closed which is possible only by buying back the assets. This represents future buying pressure, which stands to offset any immediate or short-term downward pressure on market capitalisa-tion. This argument was propounded by Epstein35 and received robust empiri-cal support from Curtis and Fargher.36 Although they found evidence that short selling exacerbates the price fall of a stock, when the same price decline is juxtaposed vis-a-vis intrinsic value, they find that those stocks were already being traded at a high rate unsupported by company fundamentals. They fur-ther note that short sellers divest (minimise) their short positions after a sig-nificant price decline, and shift their positions into other stocks which trade at rates much higher than their fundamental value. This not only lends credence to reports of Boehmer and Wu but also supports Epstein’s latent bull hypoth-esis as all the short positions are to be closed by subsequent long positions.37
Lastly, through an Islamic Sharīʿah lens, trade and commerce has been consecrated in Islamic traditions as containing nine out of ten good things, as supported by the prophetic narration: ‘Nine out of 10 sources of livelihood are to be found in the pursuit of trade, commerce and business’.38 This trade,
32 E. Boehmer & J.J. Wu, ‘Short Selling and the Price Discovery Process’, Review of Financial Studies 26(2) (2013): 287-322.
33 H. Berkman & M.D. McKenzie, ‘Earnings Announcements: Good News for Institutional Investors and Short Sellers’, Financial Review 47(1) (2012): 91-113; E. Boemer & E.K. Kelley, ‘Institutional investors and the informational efficiency of prices’, Review of Financial Studies 22(9) (2009): 3563-3594.
34 T. Chordia, R. Roll & A. Subrahmanyam, ‘Evidence on the speed of convergence to market efficiency’, Journal of Financial Economics 76(2) (2005): 271-292.
35 G. Epstein, Financialisation, Rentier Interests and Central Bank Policy, unpublished manu-script, Department of Economics, University of Massachusetts, Amherst, 2001.
36 A. Curtis & N.L. Fargher, ‘Does Short-Selling Amplify Price Declines or Align Stocks with Their Fundamental Values?’, Management Science 60(9) (2016) 2324-2340.
37 Boehmer & Wu, supra note 32. 38 Al-Hafidz al-Munāwī, Faidl al-Qadīr 3/220.
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by definition, requires assumption of risk and speculation. One of the ethical objections against short selling is its perceived widespread use in speculative activities. While it is true that Islam forbids maysir (excessive risk taking or gambling), it is quite possible to contain speculation in an acceptable range. Holbrook Working, a Stanford economist, devised a speculative T-Index which measures the adequacy (or excess) of speculation. In plain terms, the T-index is gauged by differentiating speculation from commercial hedging needs and commercial open interest.39 Here, a value of more than one (up to 1.2 in most markets) is considered acceptable according to industry norms, although tech-nically it qualifies as an excess. Nonetheless, it is considered a necessary excess because the opportunity to profit is what gives investors an incentive to trade and thus makes the market liquid. This article, while not dealing with the legit-imacy of speculation, does acknowledge its ill portents and hence advocates a cautionary approach towards speculation. It proposes an extensive use of the T-index in ensuring that the prevalent speculative activities owing to short sell-ing are at an agreeable extent. Perhaps Sharīʿah advisors and regulators could devise a framework to accommodate speculation in an Islamically acceptable and pragmatic way.
To summarise, not discounting the eminently controversial and polarising nature of short selling’s ethical boundaries, it is undeniable that in a bull mar-ket where asset prices are soaring and the traditional buy and hold strategies pay off, the bullish sentiment soon turns into euphoria and irrational opti-mism takes over. As inevitable, when the stock (or market) reverses and prices correct themselves it has understandably become fashionable for regulators to create a scapegoat in short selling. Keeping this in mind, it is noteworthy that it is ardent short sellers who inquisitively performed due diligence in finan-cial reports of overpriced and troubled com panies such as Enron, Worldcom, Tyco, Boston Chicken, etc., and exposed their phantom assets, shady account-ing practices, engineered vouchers, fictitious profits, and overall corporate frauds, while market participants and regulators were oblivious to it. In fact, in his 2006 meeting with shareholders of Berkshire Hathaway Warren Buffett famously called short sellers the ‘forensic accountants’ of the market. Clearly, with the absence of short selling, such investigative accounting holds little to no incentive due to absence of opportunity to profit from overpricing. It thus serves as a self-disciplinary whip to the market by reminding it that mispric-ing will be punished, whether overpriced or under-priced. Consequently, mar-ket efficiency must improve, and this utilitarian argument alone serves as a clincher as to the ethical justification in favour of short selling.
39 H. Working, ‘Speculation on Hedging Markets’, Food Research Institute Studies 1(2) (1960): 185-220.
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5 Broader Debate of Form vs Substance
A frequent and seemingly fashionable opposition subjected to short selling (and many other Islamic financial products for that matter), is whether short selling or any Islamised vehicle to replicate it are consistent with the spirit of law and economics. Some experts, of whom El-Gamal is a spearhead, have argued that short selling (and its similarly synthetic replicas of modern finan-cial instruments) are concordant to the letter of Islamic law but sacrifice its true essence. In fact, El-Gamal goes on to posit short selling as the archetypical problem with the present day Islamic financial industry; he even claims such practices make a mockery of Islam:
Every contract can be ‘Islamized’ in the age of financial engineering . . . It is a silly game. The distinction between contracts that are now ‘allowed in Islam’ and those that aren’t is only a function of who is willing to pay sufficient fees for the rent-a-jurists to certify an engineered product, and how high the transaction costs of the reengineering.40
We hold such views to be both cynical and vitriolic on several grounds. First, the alternative to the absence of such instruments leave Muslims to fully abandon the financial system altogether or embrace the conventional ribā-based system, neither of which is an appetising prospect. Besides, the first objective (maqāṣid) of the Sharīʿah is the preservation of faith. Being able to economically engage and transact in a non-ribā-based system is inextricably intertwined with this first objective of the Sharīʿah. If enabling short selling helps it inch towards that goal through availing the maṣlaḥah mursalah as iterated in this article, a campaign to abandon it betrays reason. Second, the status of the Islamic financial industry is akin to an intermediate good. The concept of tadarruj (gradualism) is ensconced in Islamic history and is consid-ered an acceptable (if not ideal) way of achieving the higher goals of Sharīʿah. As such, demurring innovations as short selling due to its ‘grey area’ status of permissibility despite the undeniable welfare to be achieved in exchange for a non-existent watertight alternative is dubious at best. To this extent, the SAC of Malaysia’s line of reasoning is difficult to rebuff analytically. Third, clear-cut evidence of short selling being outright banned in the Sharīʿah is yet to be established. An accepted axiom in Islamic law regarding matters of worship and transaction is that all matters of ʿibādah (worship) are forbidden except for those divinely sanctioned, whereas all matters of muʾamalah (transaction)
40 Mahmoud A. El-Gamal, Islamic Finance: Law, Economics, and Practice (Cambridge: Cambridge University Press, 2006).
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are mubāḥ (permissible) unless proven otherwise. In light of nebulous argu-ments against short selling’s legality, assumption of a permissible mindset yields more credence, especially given the way in which it makes life easier for Muslims, detracts speculative bubbles, and conveys a multitude of benefits to financial markets.
6 Conclusions
This article deals with the issue of the permissibility of short selling from an Islamic legal perspective with a special focus on the SAC’s fatwā of permitting RSS in the Malaysian market. The arguments put forward by the SAC are in contrast to the stance of the majority of clerics in other Muslim countries, especially the Persian Gulf nations. Despite an exhaustive analysis of SAC’s line of reasoning and that of their counterparts, some questions remained unan-swered. Whilst the SAC focuses primarily on the ribā issue, we dissect the issue with multifarious arguments such as superimposing an ijārah model, employ-ing istiḥsān, advocating maṣlaḥah h, examining the status of short selling as part of customaryʿurf, etc. An oft-overlooked facet of the short selling debate entails an apparent conflict between the jurisprudential legality of short selling versus the public welfare engendered through this practice. While academic positions invariably sway towards the benefits outweighing the demerits, a lack of scholarly consensus persists in the Islamic community due to a rigid framework of deriving decisions through application of juristic methods ema-nating from the classical fiqh ages. The point here is not to undermine such methodological practices, rather it is an invitation to accept the practicality that in many cases the two acts (literalist application of divine law vis-à-vis achieving public benefit) may appear mutually exclusive, and it is possible that one may not be achieved without sacrificing the other. In the event a common ground is found, it is rational to embrace it when it brings clear benefits for the Ummah. This article argues that such is the case in regards to short selling, and finds that arguments against the SAC’s decision to regulate and permit it hold up to scrutiny to a level deemed acceptable by the authors. A disclaimer is war-ranted here, however. We do concede the existence of a ‘grey area’ and appreci-ate that several analytical points can be construed one way or the other, which potentially swings the legality debate in the opposite direction. Hence, it is of paramount importance that more open-minded and solution-oriented aca-demic and industry-level debates be had to work cohesively towards ironing out the kinks and offer a plausible solution to the short selling issue—an issue that can doubtless serve the Islamic financial institutions and its clients well.
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In a nutshell, it is fair to say at this point that the issue is far from settled. Since Malaysia is considered to be at the forefront of innovation in the Islamic capital market and finance realm, this fatwā from an influential religious authority (SAC) sets a precedent for the Ummah with long-standing reper-cussions. Therefore, the SAC’s verdict requires further analysis from diverse perspectives, not only to achieve a more unified global stance among Muslim scholars but also to address the need for the Islamic capital markets to adopt more sophisticated and ethically congruent derivatives to keep up with their conventional counterpart, and enable superior risk minimisation tools to be introduced.
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