Promises have a peculiar treatment in Islamic law. Although reneging on promises is considered unethical in shari’a, there is no legal punishment for doing so. Unlike English law that makes no distinction between a contract and a promise, Islamic law traditionally has been more relaxed on promises. While a contract is bilateral and binding on the transacting parties, a promise in Islam is unilateral and becomes binding on the promisor only if and when the promisee calls upon it. This aspect of promises makes them very interesting for the purpose of structuring innovative Islamic financial products.
Nevertheless, discussions on promises in classical Islamic juristic literature have been scarce and it was only in the first decade of the twenty first century that promises got their recognition as an important tool for product development in Islamic banking and finance. Today, there is hardly any new product in the Islamic financial markets, which does not employ the concept of a promise in its structure. Given the exponential increase in the use of promises in Islamic banking and finance, the Bahrain-based umbrella organisation for Islamic finance, called the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), has recently issued a shari’a standard to guide the use of promises in Islamic financial product development.
The most common use of promises in Islamic banking and finance is in the form of sale and purchase undertakings. In retail banking, for example, financing for consumer items is based on murabaha – a contract that requires the seller to disclose its profit to the buyer. In murabaha-based financing, the financier must first buy an item (say a car) from the market to sell it on to a customer for a profit. The banks like to minimise some of the unnecessary risks, such as the risk of ending up having the car in its inventory when someone requests financing in the first instance and then changes their mind when the bank has actually bought the car from the market.
As “changing your mind” is acceptable in shari’a, the banks would like to get their customers committed before they actually buy an asset for selling it on to the customers. This is achieved through requiring the customer to sign a purchase undertaking wherein the customer promises to buy the item (eg, car) from the bank that discloses its procurement price and the profit it is earning from the customer. This is in effect a promise to buy on a murabaha basis. As the document is signed by the customer only, it is a unilateral promise given by the customer to the bank. The bank remains unbound to sell the item to the customer. However, the customer is bound to buy the asset for the already agreed price when the bank has bought it and wishes to sell it on to the customer.
There are some other more innovative uses of promises in Islamic banking, namely Islamic options, swaps and other derivative instruments that are allowed by contemporary jurists for the purpose of risk management and hedging. Conventional options are considered unacceptable in Islamic finance, because they involve trading in rights that are not recognised as tradable assets. Thus the “right to buy” (as in a conventional call option) and the “right to sell” (as in a conventional put option) are not tradable in shari’a.
Although there is significant discussion on options in the context of trading contracts, options in Islamic finance are based on promises. Thus, when a party A promises to buy an asset (eg, a stock) from another party B for a price of Rs12.00 on a future date, this gives rise to an option in favour of the promisee who has a right (but not an obligation) to sell the asset to the promisor for the promised price. For example, if on the future date, the market price of the stock happened to be Rs10.00, then party B will call upon party A to buy from him the stock for the promised price of Rs12.00.
As promises cannot be bought and sold, the above promissory arrangements make little sense for the promisor who “creates” an option against it, which may make it lose some money without having an opportunity to make some money in return. Therefore, Islamic options must be sold bundled with some assets and not without or before the actual sale of the assets. This requirement is evidenced in some of the more recent contractual arrangements in Islamic banking and finance. For example, the Malaysian Accounting Standards Board in its Islamic Financial Reporting Standard incorporates promises in the definition of ijarah muntahia bittamleek (Islamic hire purchase) as follows:
“Ijara muntahia bittamleek is an ijara [leasing] contract with an undertaking by the lessor to sell the ijara asset to the lessee and/or an undertaking by the lessee to purchase the ijara asset from the lessor by, or at, the end of the ijara period. The sale and purchase is effected by a separate contract. ‘Undertaking’ is translated from the Arabic word “wa’ad.”
Similar treatment of promises is found in the context of Islamic bonds, which are becoming popular once again in the aftermath of the financial crisis that hit the markets at the start of 2008.
The writer is a Shari’a advisor to a number of banks and financial institutions and can be contacted at humayon@humayondar.com