Islamic law principles applicable to the administration of trusts | LinkedIn
Introduction
Under English Law, a trustee who breaches any of the duties outlined below, and does not beforehand apply to the court for directions about the performance of his duties and the exercise of his powers, is exposed to a potential claim for:
- breach of trust;
- breach of fiduciary duty; and/or
- negligence, and if he is a professional trustee, e.g. a bank , accountant, or solicitor, will have professional indemnity insurance cover.
This is not an academic risk, and I expect that litigation involving Islamic fiduciaries is likely to increase, unless executors and trustees are rigorous.
If of course they do not know or understand, with crystal clear clarity, what their duties and powers are under the trust, or are blissfully unaware of their potential legal liability, executors and trustees are sitting ducks. Furthermore, unless an exemption clause is valid and exonerates the breach, or the court otherwise excuses the breach, the extent of their potential liability is unlimited, and compared with commercial litigation, the court issue fees in the English court (provided it has jurisdiction), in a will, trust, and inheritance dispute, are relatively nominal.
Furthermore,
‘Trustees who are donees of a mere power are not entitled to refuse to consider the desirability of exercising the power, whether it is a dispositive power or an administrative power. They cannot simply fold their hands and ignore it. Nor must they exercise it without consideration, as by doing whatever the settlor asks them to do. They must from time to time form a judgement bone fide as to whether they should exercise the power. It follows also that they cannot release it, unless (as is common) they are authorised to do so by the trust instrument. …
Under most trusts the subsistence of the power or duty will be dependent on the existence of a given state of facts. …
In principle, the trustees must be bound to give proper consideration to the question whether the requisite state of facts exists. Where the existence of the state of facts is the precondition to the exercise of a mere power, the power being fiduciary, the duty to form a judgement on the facts is simply part of the duty to consider the exercise of the power from time to time. …
When the trustees do give consideration to the state of facts, they are under certain further duties in forming a judgement about them. The duties are:
(i) To act honestly and in good faith;
(ii) To ask themselves the correct question;
(iii) To reach a decision open to a reasonable body of trustees; and
(iv) To take into account relevant matters and only those matters. …
[These duties] attach when the trustees are forming a judgement about the state of facts, as a precondition to the exercise of a power or duty. …
If they form a judgement in breach of those duties, the court will interfere. The grounds on which it does so are restricted: the court does not interfere merely because it would itself have reached a different decision and recognises that there may be a wide area within which trustees complying with their duties could form more than one judgement. Hence it is necessary to establish a breach of one of the [following] duties.’ [Lewin on Trusts, Twentieth Edition, Volume 11, Sweet & Maxwell (2020) paragraphs: 29-008; 29-014; and 29-016]:
(i) honesty and good faith;
(ii) correct question;
(iii) perversity and reasonableness; and
(iv) taking matters into account.
During a visit to Harvard University in 2002, I had the great honour to meet with Professor Frank Vogel (Harvard Law School) and Professor Samuel Hayes (Harvard Business School), who very kindly provided me with access to the Baker library.
Following my visit, I wrote an unpublished research note, which I last updated in 2012, and is set out below.
Between 1998 and 2002, I was one of the first two postgraduate students to ever research Islamic Finance at London University (King’s College London).
I am not a Sharia expert, and the Islamic Finance industry has grown exponentially since I had to abandon my research in the summer of 2002, in order to focus upon the demands of my law practice as a commercial solicitor in Leicester.
While I do not discuss Islamic law and trusts in my new book, the ‘Contentious Trusts Handbook’, which was published by the Law Society in July 2020 and is now in stock in bookshops and available to purchase online (see my recent post about the book), it struck me back in 2002, that very few academics and practitioners knew anything about the plethora of exacting equitable principles that govern the existence and performance of fiduciary duties, and the exercise of powers, in the context of Islamic finance products and structures.
Islamic Finance lawyers tended to be experts in the law of Islamic Contracts, and bankers and academics were usually expert economists.
However I could count on one hand, anybody I ever met, who had a thorough grasp of the equitable principles that are at the heart of the governance and administration of Islamic Finance funds involving trusts.
This must have changed since 2002. However, I doubt that the principles have yet been fully worked out, because literature on the subject appears to be slim. It therefore appears that the doctrinal foundations of fiduciary theory in Islamic law suffers from a paucity of analysis.
As Professor Mohammad Fadel concludes in chapter 28 of the Oxford Handbook of Fiduciary Law (2019) (‘Fiduciary principles in classical Islamic law systems’), at page 543:
‘[There is] a vast body of rules in classical Islamic law that were reflective of fiduciary principles. Equally interesting, however, was the interaction of express contractual stipulations alongside fiduciary principles in classical Islamic legal doctrine. … the origins of fiduciary duty in a strong sense of moral duty to the vulnerable cautions against taking the comparison of fiduciary duty to contract too far: an Islamic fiduciary, above all, is supposed to be motivated by a genuine sense of moral duty and is always aware that his or her discharge of that duty is subject to divine supervision. If fiduciary duties arise as a solution to incomplete contracting, it is a unique kind of contract insofar as the fiduciary is prevented from securing his own interests. It is rather an undertaking to do one’s best in furtherance of the interests of another. This altruistic dimension of fiduciary duties in Islamic law is ultimately its most crucial feature, distinguishing it from other legal relationships.’
Duties and powers
As explain in my new book, under English Law it is now almost pure rhetoric that:
‘Trustees enjoy a range of discretionary powers in relation to the selection and sale of investments. The paramount duty of the trustee is to exercise his investment powers in the best interests of both present and future beneficiaries. As a minimum, the trustee must preserve the capital value of the trust fund. When selecting investments, the trustee must have regard to the principles of portfolio theory (which are embodied in the standard investment criteria). According to this theory, investors should have regard to the composition of their investments as a whole (known as the ‘portfolio’), to determine whether they are balanced and suit the needs of the particular trust. A balanced portfolio of investments will have a mixture of different types of investments and in different sectors, including sectors that are in competition with each other. Another factor in ensuring that there is a balanced portfolio of investments is through careful management of the risk of loss.
The significance of portfolio theory to the management of risk is the emphasis placed on the risk level of the entire portfolio, rather than the risk attached to each investment in isolation. Consequently, an investment that might be considered too risky for the trust when examined in isolation, might be justified when considered in connection with other less risky investments of the trust. Part II of the TA 2000 makes provision for a general power of investment by trustees and confers extensive powers of investment on trustees. The general power is a power to make any kind of investment that the trustee could make if they were absolutely entitled to the trust property, save for investments in land other than loans that are secured on land.
The general power of investment does not apply to:
(a) trustees of pension schemes;
(b) authorised unit trusts; or
(c) charitable trusts.
In exercising the general power of investment or any power of investment, the trustee is under a duty to have regard to the so-called ‘standard investment criteria’. These criteria also apply when the trustee reviews investments. There are two criteria which reflect the key principles of portfolio theory:
(a) first, the trustee must consider the suitability to the trust of the particular investment, which requires consideration of various factors, including the:
(i) size of the trust fund;
(ii) anticipated length of the trust; and
(iii) degree of risk attaching to the investment;
(b) second, the trustee should consider the need to diversify the investments (as appropriate in the circumstances of the trust), which requires the trustee to;
(i) consider the relative risk of loss and gain; and
(ii) ensure that he invests in competing sectors (i.e. so that if one sector underperforms, another sector might yield a higher return).
Before:
(a) exercising any power of investment (under statute or under the terms of the trust); or
(b) reviewing trust investments,
a trustee is under a duty to obtain and consider proper advice about how his power should be exercised in accordance with the standard investment criteria. Advice is considered to be ‘proper’ where the trustee reasonably believes that a person is qualified to give advice because of their skill and knowledge of financial and other matters relating to the proposed investment.
Investment powers can be delegated to an agent, who will be bound by the same restrictions that constrain the trustee. An agent is not required to obtain investment advice if he is a person whom a trustee may properly consult, e.g. a financial adviser.
A trustee does not have any statutory power to acquire land abroad. When a trustee buys or sells trust property, he must obtain the best price, and not be influenced by ethical or moral considerations. There are also circumstances under which a trustee may have to act unscrupulously for the benefit of the trust, e.g. by ‘gazumping’ a buyer. The trustee’s duty to his beneficiaries outweighs his moral obligation to the purchaser.
In Buttle v. Saunders [1950] 2 All ER 193, [195], Wynn-Parry J. observed that, ‘It is true that persons who are not in the position of trustees are entitled, if they so desire, to accept a lesser price than that which they might obtain on the sale of property, and not infrequently a vendor, who has gone some lengths in negotiating with a prospective purchaser, decides to close the deal with that purchaser, notwithstanding that he is presented with a higher offer. It redounds to the credit of a man who acts like that in such circumstances. Trustees, however, are not vested with such complete freedom. They have an overriding duty to obtain the best price which they can for their beneficiaries. It would, however, be an unfortunate simplification of the problem if one were to take the view that the mere production of an increased offer at any stage, however late in the negotiations, should throw on the trustees a duty to accept the higher offer and resile from the existing offer. For myself, I think that trustees have such a discretion in the matter as will allow them to act with proper prudence. I can see no reason why trustees should not pray in aid the common-sense rule underlying the old proverb: “a bird in the hand is worth two in the bush”. I can imagine cases where trustees could properly refuse a higher offer and proceed with a lower offer. Each case must, of necessity, depend on its own facts.’
The following principles govern the selection of investments:
(a) the investment must be permitted by the terms of the trust;
(b) investments should be diversified;
(c) whilst the key aim is to obtain the best return for beneficiaries having regard to;
(i) risk;
(ii) potential income yield; and
(iii) potential capital appreciation,
high risk investments should be avoided;
(d) the trustee is not:
(i) generally required to consult beneficiaries about the selection of investments (except as required by the trust instrument); and
(ii) bound to act on the wishes of the beneficiaries, but should consider any comments of beneficiaries, and take them into account as and when appropriate;
(e) because different types of beneficiary will have different interests in the types of investment made, the trustee must ensure that they have regard to the interests of those who:
(i) are entitled to the income, such as the life tenant and
(ii) will take in the future, i.e. become entitled to the remainder, and
(f) therefore, the trustee is obliged to:
(i) exercise his investment powers in the best interests of both the present and future beneficiaries; and
(ii) to hold the scales impartially between different classes of beneficiary.
The trustee must act in the best interests of the beneficiaries as a whole. Where those interests conflict, the trustee must:
(a) maintain a fair balance between them; and
(b) not favour one beneficiary or class of beneficiary over another.
The duty to maintain a fair balance can be expressly or implicitly excluded by the trust instrument, i.e. where the trustee is given the power to choose between different beneficiaries or classes of beneficiary when exercising a power of appointment. Where there is a life interest, the distinction between capital and income is crucial, because the trustee has a discretion to choose whether to buy income producing investments or capital growth investments, and opting for an investment policy which lays too much stress on one objective or the other, would disproportionately favour the life tenant over the remainderman, or vice versa.
Before deciding whether a proposed course of action is for the benefit of the beneficiaries or in their best interests, the trustee must decide what:
(a) the purpose of the trust is; and
(b) benefits the settlor/testator intended the beneficiaries to receive.
Where trust property is capable of yielding an income, the trustee must obtain income. If the property is money, it should be:
(a) invested at interest; or
(b) be used to purchase income yielding assets, e.g. shares.
Where the property consists of business assets, it should be employed in the business. If the property is lettable land, it should be let for rent.
It is a breach of trust to offer a loan on soft, non-commercial terms to a person who is not a beneficiary. Therefore, when lending trust money the trustee must secure a commercial rate of interest. When selling trust property, the overriding duty of the trustee is to get the best possible price for the beneficiaries. In considering what investments to make, the trustee must disregard his own personal interests and opinions. Powers must always be exercised fairly and honestly for the purpose for which they were given, and not so as to further or accomplish an ulterior motive, whether for the benefit of the trustee, or anybody else.
When trustees find themselves in a situation of deadlock, unable to agree on how best to exercise their equitable discretion, they may make an application under CPR, Part 64, for directions.
The four main types of application that arise are:
‘i. an application concerning whether the proposed action is within the trustees’ powers. This is a question of the trust instrument, or a statute, or both;
ii. an application as to whether a proposed course of action is a proper exercise of the trustees’ powers. In this situation, there is no real doubt as to the nature of the trustees’ powers. Trustees agree as to how to exercise them, as the decision is particularly momentous, trustees wish to obtain the blessing of the court to the action. In this case, the trustees are not normally surrendering their discretion to the court, but frequently seeking to protect themselves from disgruntled beneficiaries;
iii. an application for directions where the trustees are deadlocked or disabled as a result of a conflict of interest and so cannot properly come to a decision. In this case, the trustees surrender their discretion to the court who makes the decision for them; and
iv. an application for a direction to, in effect, approve a course of action the trustees have already taken and which is being attacked.’
(Public Trustee v. Cooper [2001] W.T.L.R. 901, [923-924], per Walker J. (as he then was)).
“A trustee who is in genuine doubt about the propriety of any contemplated course of action in the exercise of his fiduciary duties and discretion is always entitled to take proper professional guidance and, if so advised, to protect his position by seeking guidance of the Court. If, however, he seeks the approval of the court to an exercise of his discretion and thus surrenders his discretion to the court, he has always to bear in mind that it is of the highest importance that the court should be put into possession of all the material necessary to enable the discretion to be exercised. It follows that, if the discretion which the court is now called upon to exercise in place of the trustee is one which involves for its proper execution the obtaining of expert advice or valuation, it is the trustee’s duty to obtain that advice and place it fully and fairly before the court, for it cannot be right to ask the judge in effect to assume the burdens of a trustee without the information which the trustee himself either has or ought to have to enable him to carry out his duties personally. The court ought not to be asked to act upon incomplete information and, if it is so asked, the proper course is either to dismiss the application or to adjourn it until full and proper information is provided.’” (Lord Oliver in Marley v. Mutual Security Merchant Bank [1991] 3 All ER 198 (PC) [201]).
An application for directions about the propriety of a particular course of action does not involve the Court determining any legal rights. The Court is solely concerned with the process by which the trustee reached the decision about whether their proposal is for the benefit of the beneficiaries.
In Cotton v. Earl of Cardigan [2014] EWCA Civ 1312 at [61] Vos L.J. said,
“In order to succeed in [a Public Trustee v. Cooper category 2 ‘blessing’] application, the trustees must, as Sir Andrew Morritt made clear in Tamlin v. Edgar … put the Court in possession of all relevant facts so that it may be satisfied that the decision of the trustees is proper and for the benefit of the beneficiaries. Moreover, it must be demonstrated that the exercise of their discretion is untainted by any collateral purpose. This process could be seen as one of “disclosure”, but I would prefer to regard it as an evidential exercise. The trustees have the burden of proof and must, therefore, give the Court all the information and disclosure that it requires to be satisfied that approval can be granted. If they fail to do so, they will not obtain the approval they seek. But the Court may, in such a case, send the trustees away to produce more evidence. Whilst the process is not inquisitorial, it is part of the inherent jurisdiction of the Court to supervise trustees. The Court would be unwilling, I think, to countenance the refusal to approve a proper, and momentous, transaction on some technical ground based upon an incidental failure to produce adequate material to the Court.”
The legal test for a Category 2 (‘Blessing’) application is, ‘would a proposed course of action be a proper exercise of the trustee’s powers?’ This involves a consideration of whether:
(a) the trustee has formed an opinion;
(b) the underlying conclusion is one which a reasonable body of trustees properly informed could properly have arrived at; and
(c) the opinion is vitiated by:
(i) any conflict of interest;
(ii) the application of the ‘fraud on a power’ doctrine; or
(iii) otherwise.
“In order for the court to perform its cautious, scrupulous and inquisitive review of a blessing application, the trustee must fully and frankly disclose all relevant materials. The case law is clear that it is of paramount importance that applicant trustees provide the court with all relevant facts, documents and information when making an application, and that the judge only decide after scrupulous consideration of the evidence… In certain cases , evidence of without prejudice communications might properly be adduced to assist the court to effectively exercise its blessing jurisdiction.” (‘Without prejudice privilege when seeking the court’s blessing’, by Andrew Butler and Nathaniel Walker, Trusts & Trustees, Vol 25, No.5, June 2019, pp. 539-551). Once approved by the court, the trustee’s conduct cannot be subsequently challenged by a beneficiary. The trustee is therefore, inoculated against later claims that their exercise of power was a breach of duty.
The legal test for a Category 3 (‘Surrender of discretion’) application is ‘what should the trustee do?’, i.e. what would be in the best interests of the trust. In order to prove that the decision was both proper, and for the benefit of’ the beneficiaries, a trustee should adduce evidence to show that it had:
(a) taken into account that which ought to have been taken into account; and
(b) not taken into account that which ought not to have been taken into account.
This is required, because:
(a) the overall question in a category 2 case, is whether the proposed course of action would be a proper exercise of the trustee’s power;
(b) if the propriety of the trustee’s decision-making process cannot be questioned, then a category 2 application can only be governed by the second condition (i.e. the rationality of the result) test, rendering the first and third conditions of the test virtually superfluous;
(c) if the trustees acted in breach of duty by:
(i) failing to take into account relevant considerations; or
(ii) taking account irrelevant considerations,
and failure would or might have affected the decision, then after the event (but for the blessing of the Court), the transaction may be set aside under the rule in Re Hastings-Bass as modified by Pitt v. Holt;
(d) if there has been sufficient disclosure to the Court, then the approval of the Court prevents a future challenge to the propriety of the transaction; and
(e) the Court should not bar such a challenge by approving the transaction if it knows that the trustee’s decision has not been properly taken.
The reasons for the decision made by the trustee needs to be specified and evidenced. Once that is recognised, the need to engage the Pitt v. Holt question is apparent. That logic then sheds light on what will frequently be the similarity in the evidence actually required as to the relevant considerations (in a Pitt v Holt sense) in category 2 and 3 applications.
The test in a category 3 application is stated in quite different terms to the conditions for a category 2 application. In a category 3 application, there is no decision to ‘bless’. The Court will require the applicant trustee to place before it, sufficient material for it to be able to make the decision as quasi-trustee. Yet, the Court will need to be put in a position, in that capacity to take into account that which a trustee ought to take into account. Therefore, unless there has been a subsequent change in circumstances or knowledge, the evidential exercise in respect of the considerations to be taken into account under a category 2 application is almost identical to that required in a category 3 application. (See further, ‘Evidence in trustees’ applications: reading Public Trustee v Cooper together with Pitt v. Holt’ by Will Henderson and Jonathan McDonagh, Trusts & Trustees, Vol 23, No.9, November 2017, pp 910-915).
The orders that the Court can make include:
(a) giving directions as to whether a power may properly be exercised;
(b) if the matter relates to an improper non-exercise of discretion, the Court may direct the trustee to consider exercising it;
(c) if the Court believes a past exercise of discretion was tainted, it will declare that the exercise was void from the outset and may then:
(i) require nothing further of the trustee (where an exercise of discretion has been overturned entirely); or
(ii) require the trustee to consider the discretion anew, or replace the trustee with another who can be relied upon to act properly.
Only in rare circumstances will the Court exercise the discretion in place of the trustee, i.e. where the trustee has:
(a) surrendered his discretion to the Court for a proper reason; or
(b) unreasonably refused to exercise his discretion.
In such a case, the Court may either on:
(a) the application of a beneficiary; or
(b) its own motion,
remove a trustee whom it believes is unlikely to exercise the discretion honestly and properly in the future.’
For the reasons set out at the top, I expect litigation involving Islamic fiduciaries to increase. In 2022, I will apply for rights of audience in the DIFC Courts in Dubai, and in Malaysia, in order to act for trustees and beneficiaries in Islamic Trust litigation.
RESEARCH NOTE
‘Islamic law principles applicable to the administration of trusts derived from the conduct of partnerships in classical Islam.’
Introduction
Discretionary trusts are prevalent in wealth planning for private clients in the Middle East and recently the issue of trust certificates (“sukuk”) has been widely applied as a technique in Islamic finance transactions on the basis of general Sharia guidelines approved by renowned Muslim jurists (“fuqaha”). By Royal Decree No.23 of 2006 Bahrain introduced a trust law, “aimed at providing a firm foundation for trust business, which is showing a potential for growth in the Middle East,[1]” and in July 2007 it was reported[2] that, “The Dubai International Financial Centre’s investment arm and Dubai Islamic Bank have joined forces to meet demand in the region for financial succession planning and other trust related-services that follow Islamic guidelines.”
Whilst Sharia scholars (the “Ulama”) have not achieved consensus upon a general theory of trust law principles worked through for Sharia compliance, Islamic law (comprising both Sharia and Fiqh) contains principles that equate to the English law concept of fiduciary relationships, and a doctrine of equity (“istishan”).
In this research note I briefly discuss the structure sources and methodologies underlying Islamic law and the innovation of estate planning products, and whether fiqh and the customary law that evolved out of partnerships in classical Islam, is potentially a rich vein of jurisprudence in relation to Islamic fiduciary duties. I also briefly consider whether a limited liability partnership constituted under English law can be used as a succession planning vehicle for muslims who are owner-managers and professionals.
The structure, sources, and methodologies underlying the interpretation of Islamic law, and the innovation of estate planning products
Islamic law must be understood to comprise the law that is revealed, the law which is taught by the different schools and sects, the law as established by customary practice, as well as law introducing an inevitable measure of foreign influence and alterations impelled by performance and the passage of time.
It has been carried down to the present not only through transmitted practice but, more importantly, embodied in a number of texts considered to be divinely revealed. Islamic law therefore sees itself as responding primarily to a discrete number of texts, that are understood as achieving religious, moral, and ideal ends, not only practical ones. As such Islamic law stands apart from the two major sources of contract law in the Western world, the Roman and common law, whose orientations are predominantly worldly and pragmatic.
Islamic law is not a unified system of law. Inpractice it is instanced by old decisions of Cairo Sharia courts, by official registers and private papers in places like Riyadh, Jeddah, Oman, Yemen, Damascus, and Baghdad and the much heralded manuscripts of the Cairo Geniza.
Custom and practice
Islamic Law recognises that commercial and contract customs prevailing in the Middle East in the years of its formation provided much of its content. It therefore has normative sources. Many of its legal rules and formulations bear strong family resemblance to Jewish, Roman, and Babylonian law.
Posing the question “What establishes a custom ?” Rayner states, that the Majella answers this question by stating that the custom must be ‘continuous’ or ‘preponderant’. “Preponderant”, means “commonly known”. She observes that this is the interpretation that has been adopted by the Civil Code of the UAE. She also notes that Fyzee states that the burden of proof lies heavily upon the party relying opon the validity of a custom as against the application of the general law. This party must firstly plead the custom. Secondly, he must clearly prove that the specific matter is governed by that custom, and not by the general law. Moreover, there is no presumption in favour, and the requirement that the custom be of long duration and not opposed to public policy, pertains to all accounts.[4]
According to tradition, the most prevalent means of merchant practice in Pre-Islamic Arabia were firstly, by partnership agreement (Musharaka), and secondly by receiving goods on the basis of a Commenda partnership (Qirad / Mudaraba). These methods provided unlimited scope for progress: potential investors would entrust capital or merchandise to the agent merchants on the understanding that the merchant would trade with it in foreign parts, and then return the principal sum to the investor along with a previously agreed share of the profits (or alternatively, the losses). The merchant retained the surplus profit in payment for his labour but did not participate in the material losses (other than having wasted his time and effort), which were borne exclusively by the investors. Alternatively, a merchant was able to combine his capital with that of the investors in a bilateral commenda. In such an enterprise, the merchant would enjoy the total profit from his own injected capital.
Innovation[5]
Legal rulings applied in contemporary Islamic banking and finance are generally developed using one or the other of the following techniques:
(1) Ijtihad
Derivation directly from the revealed texts of the Qur’an and the Prophet’s Sunna.
(2) Ikhtiyar –There are various sub-categories of this method according to the criteria of choice employed: the most ambitious reverts to the Qur’an and Sunna and to basic Fiqh principles to decide which view offers the best or strongest interpretation of the revealed texts; a second evaluates an opinion by the rules of decision internal to the school which espouses it, such as the degree of support from the school’s founder or its consistency with other school holdings; a third examines which view best serves the general welfare (maslaha, of a conception including religious welfare). Sometimes, because it conforms to prevailing practices or customs. This last method follows not from revelation but from changing temporal circumstances. Scholars are permitted to combine views of different schools on different parts or aspects of transactions.
(3) Rulings. The adoption of a ruling on a position, even one contravening a categorical Sharia rule, when one is compelled by stark necessity (darura ), which must be of great severity – usually one of life or death (Suras 2:173, and 2:286).
This exception applies only to the extent of, and for the duration of the necessity.
A version of the doctrine holds that a mere need (haja), if it affects many may be treated like a dire necessity affecting only one.
(4) Legal artifice (hila ). The foundation of this method is a formalistic approach to contract, in the sense of a concern for the external form of transactions instead of the parties’ substantive intentions.
Schools vigorously differ on subversive artifices, their views falling across a spectrum: the Hanafis and Shafi’s often declare them valid although immoral (and in many cases scholars declare them not even immoral), but the Maliki’s, and even more consistently the Hanbali’s condemn them altogether.
Clear departures from old rules are extremely rare.
Sharia Scholars rarely invent new terms, alter the definition of old ones, introduce new legal constructions, or criticize the methods or thought processes of the old scholars.
They do not systematically refer to specific intervening changes in technology, institutions, economics, or law as guides or motives to review, amend, or replace old rules.
They are mostly content to work with existing rules in ways that would be largely familiar to scholars of the past.
Devotion to basic “principles” (qawa’id) of the Islamic law lends further stability.
Qawai’id are general legal rulings, often stated as maxims, some found in Prophetic sayings, that classical scholars have identified by a process of induction from many fiqh rulings as sound generalizations about the law.
Scholars consider generalizations to be innate systematic characteristics of fiqh which can hardly be altered without changing the whole Islamic legal edifice.
By contrast, equity does not circumscribe the rights and remedies of its supplicants seemingly because it produces a neater taxonomy. It is therefore preferable not to restrict rights and remedies in equity, and instead to leave the mutual interplays of the doctrines open, particularly when they are germane.
The new contracts that emerged in classical times, which were few, did so not from scholarly theory but from popular custom or practice.
The scholars vetted them in the usual way by analogy to the standard types.
They were not named among the basic contract types. According to the received basic structure of the sources of Islamic law custom does not figure among the usual sources.
However, when one touches upon the great scholars of Islamic law – people like Sarakhsi (d. ca 1095), who wrote a 30-volume book in the eleventh century, or Kasani a century later, the importance of custom is there for all to see.
More recently, the study of the practice of medieval merchant families in Arabia was a source of innovation for the development of the Islamic Hedge Fund (which apparently bears close similarity with medieval Islamic merchant guilds and partnerships).[6]
Many new contracts can survive review against these various rules and principles: among them are various solutions to novel problems arising under modern social or economic conditions, combinations of earlier contracts under a single name, or more complex implementations of standard contractual relationships.
Examples are the modern corporation (sharika), a novel mechanism developed out of the laws of partnership; the modern construction contract (muqawala) combining the sale of materials and the hire of construction services with a fixed period of performance.
Islamic contract theory
The Islamic concept of contract is much wider than that of English law, as the former conveys not only mutual contracts, but also gratuitous dispositions as well as endowments and trusts. Contracts therefore can be nominate or otherwise, gratuitous or otherwise, formal or otherwise, conditional or otherwise, collective or otherwise, binding or otherwise, and unilateral, mutual, or multilateral.
In common with most legal systems prior to the 19th century, Islamic law has no general theory of contract, but rather a theory of contracts, or a system of nominate contracts (to use the Roman term). Nor is there any general theory of obligations such as one would find in Roman law or in French law. There are laws of sale, lease, pledge, and so forth, rather than a law of contract. But a number of principles and rules cut across all contract types, such as those pertaining to riba and gharar.
The 16 books of the Majella represents the earliest example of an official promulgation of the civil law principles of the Hanafi school of Islam by the authority of the Ottoman Empire. However even the Majella does not provide an explicit general theory governing obligations and contracts.
The early jurists were more inclined to exercise subtle analyses of specific contracts rather than to formulate broad principles of theory.
Rare attempts at a general theory are to be found among the early jurists, but they do not so much formulate watertight theories as to deduce several general principles from the libraries of commentaries and exegeses produced by their predecessors or contemporaries.
Only by combining and generalising the rules governing the conduct of various transactions do a number of general rules for the conclusion of a valid and binding contract emerge.
The development of Islamic contracts is the result of the method undertaken by Muslim jurists to elaborate the very broad and piecemeal doctrines of the Quran and Sunna, and to impose them on pre-Islamic norms of practice.
Every so often among the works of the early jurists it is possible to find a solution or a rule of a certain category which a priori seems restricted to that certain type, but which, if tested on other categories, allows a principle of a certain generality to emerge. The method followed by the jurists in the development of the system of nominate contracts (al-‘Uqud al-Mu’ayyana) was by applying the process of Qiyas to already existing contracts, and by authorising the resulting category with a Hadith or other legal sources. The Muslim psychology therefore tended to treat the law as paradigmatic made up of individual solutions handed down from day-to-day in relation to the specific needs of the moment, rather than of general principles set forth a priori from which the appropriate inference will be drawn for each fresh situation.
The system used by the jurists to categorise the nominate contracts was to determine whether, in any given contract, right passed in ownership or possession, and whether consideration passed or otherwise.
The basic nominate contracts number four:
(1) Bay’ (Sale): Where right of ownership passes for consideration (Tamlik al-‘Ayn biIwad).
(2) Hiba(Gift):Where right of ownership passes without consideration (Tamlik al’Ayn bila ‘Iwad).
(3) Ijara (Hire): Where transfers or possession occurs for consideration.
(4) Ariya (Loan) (which is only applicable to non-fungibles. Transfer of possession occurs without consideration).
Other nominate contracts include those of:
(5) Salam, (a contract for delivery with pre-payment).
(6) Mudaraba(already discussed).
(7) Sharika (Partnership).
(8) Rahn(Mortgage).
(9) Ju’ala, Wadi’a (Deposit).
(10) Al-Muzara’a (an agricultural contract where the landlord provides the land, seed and plants, and the worker provides the labour).
(11) Umra (an archaic form of an unconditional donation in perpetuity).
Freedom of contract
According to the Qur’an, property gained from a contract is presumptively lawful if the other party has freely consented to the transaction and the Qur’an supports this result by enjoining the other party to fulfil his contract even if he is disappointed with the outcome. These two provisions seem to complement each other: together they suggest freedom and sanctity of contract similar to modern Western systems. But two major exceptions loom, Riba and Gharrar, both largely undefined by the revelation.
In the overall result, whatever might be suggested by the Qur’an, the provisions of the Sunna create a climate inhospitable to freedom of contract, even more when the effect of such prohibitions is compounded with the revelations vehement, but irreducibly vague, prohibitions of riba and gharrar.
Classical fiqh rarely discussed the idea of contractual freedom outside the standard contract types. Indeed, it is possible that, apart from a few matters the sale of which is illicit (eg., wine, and pork), all the above restrictions on freedom of contract arise solely from a desire to defend contracts from riba and gharrar. This is the assertion of the great Andalucian jurist and philosopher Averroes or Ibn Rushd (d.1198), stating that that there are four causes for the invalidity of sale intrinsic to the concept of sale: illicitness of object of sale; riba; gharrar; and “those terms that conduce to one of the last two or some combination of them” [Ibn Rushd, Bidayat al-mujtahid II 125-6].
Under Islamic law, no contract can be validly concluded if it is in derogation of any Islamic principle. The application of this general rule runs contrary to the doctrine of freedom of contract. Thus the parties to a private contract are not absolutely free to choose the forms and the contents of their agreements.
Quite apart from such general limitations, Islamic law makes considerable room for intervention by the court in a contract. For instance, as provided in article 277 of the Iranian Civil Code 1983, under general principles of Islamic law the court can order a contractual debt to be paid either at a date later than the date it was originally contracted for, or to be paid by instalments. This is clearly an instance of judicial intervention in a private contract. Thus Islamic law disregards the arrangements agreed by the parties, if the court, by Islamic norms, is justified in setting aside the bargain concluded.
Formation
The following four principles are applicable to all commercial transactions: (1) Consent of the contracting parties; (2) Legal competence of the contracting parties; (3) A subject matter; (4) A consideration. For the purposes of evidence should litigation result, a fifth condition is added, namely the presence of qualified witnesses. No special formula is required, nor need the contract be embodied in any particular form.[7]
Documents (sakk, written contracts) fulfil no role whatsoever; there are no transactions for which a written format is prescribed.
In the past a written agreement and an agreement not committed to writing had exactly the same value with regard to probatory force. For both forms of agreement it was only the testimony of those who witnessed them which established their existence. Because writing was not convenient or possible during the first century of Islam, contracts were often concluded by a witnessed exchange of words and that was deemed sufficient to bind the contracting parties together.[8]
“A written agreement per se does not give rise to any obligation, nor does it constitute competent evidence in the event of litigation. Theoretically, a written document can acquire legal force only through the verification of its contents by the oral testimony of qualified witnesses. It is the oral testimony which is the decisive factor in determining the existence and nature of an obligation. The existence of documentary evidence constitutes at best, corroborative evidence only.”[9]
“Islamic legal theory, while persisting in its neglect of written documents, took cognisance, at a very early stage, of their indispensability and widespread use by creating a special branch of practical law, the ‘ilm ash-shurut, devoted exclusively to notarial science.”[10]
The absence of formalism is one of the characteristic features of Islamic contract law. No special words need be spoken and no specific forms or technicalities observed as a prerequisite to validity. In contracts, effect is given to intention and meaning, and not to words and phrases.
Forms of business organisation
The only type of business organisation historically found in an Islamic economy and discussed in detail by Islamic law is partnerships.
Under the Sharia, there is no single definition that covers the different types of partnerships.
The definition of each is based on the conditions and rules that govern their relationship.
Although Islamic law does not directly address the concept of commercial corporations, it does discuss in detail the different kinds of partnerships based on factors such as responsibility, restrictions, work-scope and profit.
The “Commenda”
“Pooling resources, whether in the form of cash, goods, skills, or a combination of these, is one of the indispensable components of any extended commercial activity. In Islamic law, the partnership and commenda contracts are the two basic legal instruments by which this can be accomplished.”[11]
Medieval long-distance trade, whether it traversed international boundaries, or whether it moved within the vast expanse of the medieval Islamic domain, required substantial investments of capital to cover the cost of acquiring goods at distant points, and of transporting them and caring for them until they were disposed of. The perilous conditions of both sea, and land travel, the arbitrariness of political and military authorities, and the unpredictable market conditions, exposed such investments to grave risks.
In Islam, it was the partnership and commenda contracts which were the two basic legal instruments through which the economic functions of the provision of capital resources for the formation of commercial investments, and the sharing of the risks of commercial ventures could be accomplished.
We possess no documents or actual contracts of commenda and partnership arrangements for the first three Islamic centuries.
Goitein states that in the Arabic papyri from Egypt, the term sharika-partnership-is mentioned only once, and no details concerning that particular case were furnished.
The various terms for the commenda – qirad, muqarada, mudaraba were as far he knew not mentioned at all in the papyri.
References to these arrangements in literary and historical writings of this period are scarce and sketchy.
He concludes that virtually our only source of information concerning these institutions for the early period, are the works of Islamic religious law.
“More often than not, informal co-operation was accompanied by one or more partnerships concluded between the correspondents, frequently with additional partners. Almost any larger accounts in the Geniza contain items such as “you personally,” “I personally,” “our partnership with so and so.” Merchants appear as managers or capitalists in commenda contracts concluded with their correspondents.[12] Correspondents were sometimes in doubt whether certain goods or sums were sent on their friend’s own account or on a partnership account.”[13]
The limited liability company
The closest approximation to corporate legal entities found in Islam have been bayt al-mal (public treasury), mosque property, waqf (trusts), and Muwafada.
However, it must be noted that institutions such as bay al-mal and awqaf are essentially non economic organisations, and their features are somewhat distant from those of business orientated corporations.
The OIC Academy has approved of share companies as long as they are not formed for Islamically invalid purposes.
Decision 65/1/7, seventh session (1992), Fiqh Academy Journal 1:711, 712 declares that owning shares in share companies formed for unlawful purposes is entirely improper. But owning shares in companies that only sometimes engage in forbidden activities like riba is unlawful only “in principle” a term that leaves open the availability of occasional excusing circumstances. Such circumstances are the basis on which fatwas have permitted Muslims to make investments in conventional equity funds.
This result, and apparent sea change, has required accepting two western legal concepts: artificial personality and the limited liability of investors. Finding affirmative proof for artificial personality among classical precedents is difficult. Objections stemming from religious-legal principles have proved weak and the innovation has come to be seen as little more than a practical convenience. It is now widely accepted. Limited Liability offers more serious problems. The chief argument supporting limited liability is that by law the names of such companies warn third parties of their limited capacity for liability, so that those who deal with them presumably consent to its character.[14]
That the stock company is so common in modern Islamic Finance bespeaks the potential of the industry to adapt modern institutions to its needs. It is an example of how a major institutional and contractual innovation in Islamic law can be accepted without extended debate when no conflict is detected with basic Islamic legal principles and rules.
Planning tools
The absence of formalism is one of the characteristic features of Islamic contract law. By synthesising Islamic and English contract law drafting and contracting principles and practice it becomes clear that when planning an Islamic business succession strategy the toolbox includes: (1) Corporate vehicles, and hence the creation of artificial and separate legal personality with limited liability (the limited liability company being the prime example); (2) various forms of Partnership, and by extension Limited Liability Partnerships; (3) Limited Liability Companies wholly owned by a Partnership, and under English law there does not appear to be any prohibition against the beneficial shares in a privately owned company being subscribed for and held by a partnership entity (with limited liability or otherwise); and (4) Trusts[15], and in certain circumstances under English law a partnership can hold property through a trustee; (5) the application of custom and practice; and (6) endorsement through common law precedent.
Islamic law broadly permits the intervention of the court in private contracts.
The English court becomes in effect the final arbiter of the meaning and enforcement of the parties bargain as evidenced by its written terms if the parties state that their contract is governed by English law and confer jurisdiction upon the English court.
Therefore, if a contract has been drafted following consultation with Sharia Scholars who have pronounced upon its conformity with Islamic law, whether any mention is made of this or not in the contract, it is arguable that if the English court enforce the contract on its terms as written, their decision must presumptively conform with Islamic law.
Consequently, if the parties formally subscribe to this process by executing a contract expressly stated to be governed by English Law which also states that the parties have submitted to the jurisdiction of the English court, there will be no space afterwards for arguing that the performance of the parties obligations in the manner specified by the contract is excused because the contract has stipulated the performance of obligations that do not conform with Islamic law.
Hence, any financing structure that involves any of the vehicles described above, would appear to be capable of being validly created under Islamic law, and of enforcement under English Law by the English court.
Provided that an investment / financing instrument has been approved by a recognised Sharia scholar, which of course would also be a quality (“Kite”) mark, and provided the contract is expressly governed by English law, two outcomes are certain. First, whether any reference is made or not to the importation of Islamic law concepts, for example a reference in the preamble to “the parties entering into a Mudaraba in conformity with the glorious Sharia for the purpose of carrying out the project”, the court will interpret and apply the contract in accordance with English law. Secondly, if a code of Islamic Law principles is properly drafted and set out in the contract or incorporated as terms of the contract by reference, the court will subject to its ability to enforce such terms as written, apply those terms robustly against a party in default. Unless any English law remedies that are capable of exclusion are expressly excluded, they will be fully available to the parties.
In the modern practice of Islamic finance[16], the modalities for equity finance are based on partnership modes (sharika). One the Modarabah, is similar to the medieval commenda. Its modalities are summarised below, one of the key drawbacks for the investor are that the entrepreneur as manager of the invested funds, is not liable for losses unless incompetent or negligent.
The Musharaka contract however, allocates risk and reward, ie sharing of profit and losses between the partners in accordance with their investment. This mode is more akin to venture capital financing, the main drawback being the need to establish at the earliest stages whether or not the investment is sound or whether the investor is going to lose their shirt. A further problem in practice being the limited duration of these investments. An exit strategy of at least 8 years would commonly be required for a venture capital investment. Musharakas are usually of no more than 3 to 6 years in duration.
In either case, if structured through a limited liability company, the concept of a preference share capital structure is prohibited. However, participation shares were legalised in the state of Bahrain in the late 1980’s, and on this basis, Professors Vogel and Hayes advance the argument in their book, that higher payout ratio structures are permissible. This may be a way of structuring Islamic venture capital financing through a Musharaka contract.
I recently asked a Sharia Scholar “Could an investor structure a financing in conformity with Islamic law without dressing it up so that on its face it conformed with one of the forms of nominate contracts, and then document an arrangement in a valid and enforceable contract under the law of the jurisdiction to provide for the transfer of title upon payment of the final instalment.” The answer was yes, and this in my opinion, confirms that a business succession planning arrangement is capable both of conforming with Islamic law and of being upheld by the English court (subject to the usual remedies and procedures available for challenge by a beneficiary), without making any reference to the underlying mode, or to the principles of the Sharia, if the substantive law governing the terms of the underlying agreements and instruments is English law.
Musharaka (Partnership / Joint-Venture)
These are appropriate to small ventures (as opposed to ventures eligible for capital market finance). They involve a partnership between two parties who contribute capital. Profits are shared on a pre-agreed ratio, and losses are borne pro-rata to equity participation. Each may participate in management.
BIBLIOGRAPHY
Edge, I. Islamic Law and Legal Theory, Dartmouth.1996.
Edwardes, W. Key Financial Instruments. Financial Times, Prentice Hall.2000.
Encyclopaedia of Islam (New Edition) edited by C,E.Bosworth, E.VAN. Donzel,W.P.Heinrichs and G.Lecompte, assisted by P.J.Bearman and Mme S.Nurit.
Goitein , S.D. A Mediterranean Society, The Jewish Communities of the Arab World As Portrayed in The Documents Of The Cairo Geniza, University of California Press, Berkley and Los Angeles. 1967.
Islamic Finance Innovation and Growth, Euromoney Books. 2002.
Karmali, M.H. Islamic Commercial law: An analysis of futures and options. Islamic Texts Society, Cambridge.
Karmali, M.H. Principles of Islamic Jurisprudence. Islamic Texts Society, Cambridge.2003.
McMillen, M. Islamic Sharia Compliant Project Finance: Collateral Security and Financing Structure Case Studies. Fordham International Law Journal, Vol 24, April 2001, at p.1184.
Rayner, S.E. The Theory of Contracts in Islamic Law, Graham & Trotman, London,Dordrecht,Boston. 1991.
Ruttley,Hilary and Chibli Mallat. Commercial Law in the Middle East, Kluwer Law International, London.1995.
Saleh, N. Unlawful Gain and Legitimate Profit in Islamic Law: Riba, Gharrar, and Islamic Banking (ed.2), London. 1992.
Schact,J. An Introduction to Islamic Law, Oxford. 1964.cf.N.J. Coulson, A History of Islamic Law , Edinburgh 1964.
Shorter Encyclopaedia of Islam. Edited by H.A.R.Gibb and J.H.Kramers (Leiden and London, 1961).
Udovich, Abraham L. Partnership and Profit in Medieval Islam, Princeton, NJ:Princepton University Press, Princeton, 1970.
Vogel, F and Samuel Hayes III. Islamic Law and Finance, Kluwer Law International, the Hague.1998.
Vogel, F. The Contract Law of Islam and of the Arab Middle East, Draft Chapter, the International Encyclopaedia of Comparative Law 1997.
[1] Abdul Rahman Al Baker, Executive director, Finacial Instituitons Supervision at the Bahrain Monetary Agency, reported www.ameinfo.com/93865.html
[2] “Dubai groups join forces to provide Shariah trusts”, by Simon Kerr in the Financial Times, July 18th 2007.
[3] To be written in 2021.
[4] Rayner (1991). P. 38
[5] this section is principally derived from Vogel and Hayes
[6] Based on a short conversation I had with Eric Meyer following his presentation at the Euromoney Annual Islamic Finance Summit in London in 2003.
[7] This rubric is common to all forms of Islamic partnership he discusses. NB Partnership and Commenda were the only forms of formal / quasi-formal business enterprises evolved by Muslim entrepreneurs in mediaeval times. Under English law a general partnership can be created with limited liability. Can a partnership per se or through a trustee be a sole member of a limited liability company? To be researched.
[8] ‘Aqada, the verbal route of ‘Aqd – contract or transaction – means to tie, to make a knot.
[9] Udovich (1970).P. 87 – In Footnote 115 he observes that by denying validity to documentary evidence and confining legal proof to oral testimony, Islamic law deviated from an express Qur’anic injunction (2:282) and from prevalent Near Eastern legal practice which, in so many other areas, influenced the development of Muslim legal institutions. As, yet, no satisfactory explanation has been offered for this seemingly strange development.
[10] Udovich (1970).P.88. Practitioners of this legal specialty (ahl ash-shurut, ashab ash-shurut) exercised two complimentary functions, that of notary public and that of professional witness. As notaries public, they drew up documents for a variety of transactions in accordance with the precepts of the Sharia; as professional witnesses of the documents they drew up, they could provide the oral testimony required to give the written contracts their evidential force.
[11] Udovich (1970).p.3-4
[12] Goitein (1967).p.167
[13] Goitein (1967).p. 167 Remarks to this effect are common [in the Geniza Papers] , and in general such questions were treated with a certain laxity.
[14] The OIC Fiqh Academy, in its brief and highly general statement approving of the conception, noted this as the justification.
[15] Equitable principles in Islamic law (Istihsan) is discussed in Chapter 12 of Kamali (2003).
[16] “Islamic finance is the provision of financial services on a basis that is compliant with the principles and rules of Islamic commercial jurisprudence (Fiqh Al Mu’amalat), a branch of Islamic Sharia jurisprudence.
The focus of Fiqh Al’Mu’amalat is on contract, and it lays down what types of contract are permissible or valid and what types are impermissible or invalid. In particular, contracts are impermissible if they involve riba (interest), gharar (uncertainty or ambiguity as to subject matter, terms or conditions) or maysir (gambling or speculation).
Islamic finance involves a specific set of legal issues within Fiqh Al’Mu’amalat. These are essentially issues of contract law, which govern the Sharia permissibility and validity of different contractual forms which may be used in Islamic financial services transactions. In addition, there is the issue of the enforceability of such contracts in secular courts.” Islamic Finance Innovation and Growth published by Euromoney Books p. 3.
