Tawarruq is a deception – OIC Fiqh Academy

Later last month, headlines somehow missed a significant ruling (if adhered to, in my humble opinion) regarding Islamic Finance. The Fiqh Academy and its range of scholars, some of whom have been advocates of abandoning the practice of reverse commodity murabaha (bai ajel or tawarruq), finally ruled against the practice.

In the backdrop of the sukuk utterances, and the uninhibited cynicism of a few outsiders directed at the select few Sharia’ scholars who, in the opinion of the same, have held the industry hostage to the same old products and stunted its growth (authenticity wise). They further allege that the use of mirrored Islamic products through various agency agreements and fancy structures are a subterfuge and the customer is no better with an Islamic product than with a conventional one. The ruling states that organised tawarruqbasically fails to deliver on the account of real economic value add and that it is a way of granting an interest-based loan to the client.

This ruling is significant and was given during the session in Sharjah between April 26-30, 2009. The text is reproduced below:

“Resolution 179 (19/5) in relation to Tawarruq: its meaning and types (classical applications and organised tawarruq)

The International Council of FiqhAcademy, which is an initiative of the Organisation of Islamic Conferences (OIC), in its 19^th session which was held in Sharjah, United Arab Emirates, from 1-5 of Jamadil Ula1430 AH, corresponding to 26–30 April 2009, decided on the following:

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

The following were the resolutions:

First:  Types of tawarruq and its juristic rulings:

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

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

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

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

This fatwa in my opinion should have a greater impact than the AAOIFI ruling on sukuk in February 2008 which raised a lot of furor especially from western-styled bankers who clamoured in their criticism and thought it was given in bad taste (with a view to kill a fledgling industry).

For the benefit of the few, tawarruq is a mode of finance where a financial institution (Sharia’ compliant or otherwise) buys metal at spot, sells it to the customer for the spot price plus a profit margin (which is allowed on a commodity rather than on money as such). The same institution subsequently acts as an agent for the customer and sells the metal on the spot market.

The economics of the transaction result in the customer being given cash (and an outstanding debt just like an interest-based loan in form of a deferred liability). It is to be noted that no physical commodity (metal in the most common cases) exchanges hands and its use is only to synthesise a loan into a purportedly Sharia’ compliant offering. The product has been frequently used in the Islamic finance industry (and is extremely popular in Arab jurisdictions because of its ease of use and similarity with interest based lending). It is controversial because the trades involved are only a subterfuge to Islamise a conventional loan with little other activity. Neither the bank nor the customer has a use for the metal involved in the transaction. The product is a quick-fix to urgent financing needs and is easily understood by practitioners in Islamic finance who, quite ironically, are products mostly of conventional set-ups and can not seem to think out of the interest-based straitjacket.

The Fiqh Academy ruling could have a greater impact on the Islamic industry by putting into question the justification of the means that reach a desired end. Thus, it is important to put products to the ‘real Sharia’ compliance test’ and question whether ensuring that products are structured in a way that is Sharia’ compliant provides sufficient justification for creating an outcome that mirrors conventional financial products. In many cases, products will continue to be viewed as necessary compromises that, although creating economic effects that look like interest, are used in a way that directly facilitates economic activity.

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

In both cases, tawarruq and ijarah sukuk, the economic outcome remains the same —financing is provided and repayment is made later at a higher value than the initial amount but, in the former case, the traded commodity is used only for effecting the transaction but in the latter case, the commodity is used in the underlying business for which the transaction is structured.

This, I believe, will become a more frequently used test to determine whether Islamic financial products are structuring for sake of replicating interest-based transactions or transactions created to finance business activity. This does not seem like an exacting restriction, though it has huge implications for the industry and could restrict the industry’s growth in the shorter run but, in my opinion, will help it pass the increasingly desired ‘authenticity tests’ by customers, humble and sincere practitioners, concerned public and academia alike.

It will now be a test for the industry to come up with notable replacement products to provide unsecured financing for start-ups, education and liquidity management. Time will tell if the aficionados of I-finance are up to it.

More power to authentic Islamic finance.