ISLAMIC REPUBLIC OF AFGHANISTAN

ISLAMIC REPUBLIC OF AFGHANISTAN Ministry of Rural Rehabilitation and Development Afghanistan Rural Enterprise Development Program Islamic Finance Product DevelopmentComponents A and B“The MushārakahMutanāqisahPartnership”for fixed-assets financingprepared by Alberto G Brugnoni – ASSAIF

CONTENTS • INTRODUCTION • SMEs’ REQUIREMENTS AND ISLAMIC FINANCING • DEFINITIONS • MUSHĀRAKAH • MUSHĀRAKAHAS SHIRKAT AL-MILK • MUSHĀRAKAHASSHIRKAT AL-’AQD • MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • ORIGIN & DEFINITIONS • THE FIQHPERSPECTIVE • WHY THE MMP FULFILLS THE MAQĀSID AL-SHARĪAH • GRAPHICAL REPRESENTATION • IMPLEMENTATION • THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • MECHANISM & FEATURES • REGISTRATION OF THE PROPERTY UNDER THE CUSTOMER’S NAME • REGISTRATION OF THE PROPERTY UNDER THE BANK’S NAME • PROPERTIES UNDER CONSTRUCTION: THE MMP CUM ISTISNA‘

CONTENTS • LEGAL FRAMEWORK AND DOCUMENTATION • TAKĀFULWRAPPING • THE IJĀRAH(LEASING) CONTRACT • MECHANISM & FEATURES • RENTING TO A THIRD PARTY • THE RENTAL RATE PEGGED TO INTEREST RATES • ACTUAL RENTAL RATE • VARIABLE RENTAL RATES • MISMATCHING ISSUE • DOCUMENTS • THE FORMULAS • THE BAY’ (SELLING) CONTRACT • MECHANISM & FEATURES • THE ALLOCATION OF UNITS • THE ISSUE OF PRICE

CONTENTS • THE WA’D (PURCHASE UNDERTAKING) • MECHANISM & FEATURES • THE EVENT OF DEFAULT • THE ISSUE OF THE SECOND PURCHASE UNDERTAKING • REDEMPTION & TERMINATION OF CONTRACT • RISK MANAGEMENT • ADVANTAGES OF MMP OVER BAY’ BI-THAMAN AJIL (BBA) • DIFFERENCES WITH A MORTGAGE LOAN • THE SECURITIZATION OF THE MMP’S FINANCIAL RECEIVABLES • SUKUK AL-WAKĀLA BIL-ISTITHMĀR (INVESTMENT AGENCY SUKUK) • BEST PRACTICES • BEST PRACTICE – MALAYSIA • BEST PRACTICE – PAKISTAN • BEST PRACTICE – AUSTRALIA • BEST PRACTICE – CANADA

SMEs’ REQUIREMENTS AND ISLAMIC FINANCING • TheMushārakahMutanāqisahPartnership (MMP), includes four relations (mushārakah, ijārah, bay’ and wa’d), and is a cutting-edge, hybrid product with identifiable Islamic features that set it aside from conventional financing products. These features, help overcome some hurdles sometimes associated with the Islamic Finance proposition, such as : • inertia • skepticism • doubt • fear • The MMP aims at financing the balance sheets of MSMEs and is in full compliance with recognized international Shariah norms and standards. If properly designed and implemented, it offers competitive services with a competitive pricing. • An important feature, is that the MMP lends itself particularly well to the securitization of its financial receivables based on ijārah, through the issuance of a sukuk al-wakāla bil-istithmār (investment agency sukuk) thus allowing the bank to shore-up its balance sheet and off-load its commitments

MUSHĀRAKAH • Beware: the following definitions are not a mere intellectual exercise as they may result in differences in classification and hence in the Sharīah rules pertaining to a given partnership and the contractual features of the ensuing product: • the term mushārakahis derived from the root word sharaka, meaning ‘one joining others’. It literally means mixing one’s assets with another person’s assets until they become unrecognizable • mushārakah(also: sharikahor shirkah) can be defined as a form of partnership where two or more persons combine either their capital or their labourtogether to share the profits, enjoying similar rights and liabilities • There is a consensus of opinion among jurists of all schools of thought (Ḥanafīs, Mālikīs, Shāfi’īs and Ḥanbalīs) that mushārakahis a valid and legitimate contract in Islam. However, they are in dispute on the types of permissible mushārakahcontracts • It is known to jurists that there are two types of shirkah: • shirkatal-milk or al-amlāk • shirkatal-’aqdor ‘uqūd

MUSHĀRAKAH ASSHIRKAT AL-MILK • Shirkat al-milk (al-amlāk) is a joint ownership on a non-contractual basis, or co-ownership. It is a state of diffused joint ownership with no contractual agreement between the parties. Each of the parties has an individual ownership contract, either voluntary or involuntary • Shirkat al-milk can be divided into two types: • shirkat al-milk al-ikhtiyārī(voluntary co-ownership). This is a joint ownership of something where two of more parties jointly purchase an asset, or someone gives the partners an asset, or someone disposes to them an asset through a will, or someone donates to them an asset. Thus if they accept the gift, or the will, or the donation, they become partners of the asset without any contractual partnership • shirkat al-milk without the partners’ willingness (ğabriyyah). This is a joint partnership between partners because of inheritance (mīrath) • Shirkat al-milk has the following features: • the intention is limited to the ownership and usufruct and not to gain a joint profit • all partners are independent and gain profits from their own portions only. Each partner shares in any income such as rent that is derived from the jointly owned property and this must be equal to his/her share in the ownership. Responsibility for losses is also distributed according to the shares in ownership

MUSHĀRAKAHASSHIRKAT AL-MILK • it is permissible for one partner to give a guarantee to the other partner because neither of them have any right of disposal in the other’s share • partners are independent in their transactions of their own portions. All agents are outsiders to other people’s portions • it is permissible for one partner to promise to buy the other partner’s share at its nominal value

MUSHĀRAKAHAS SHIRKAT AL-’AQD • Shirkat al-’aqd(‘uqūd) is a contractual partnership. It comes into existence by the enactment of a contract between two parties. It can be considered a proper partnership because the parties concerned have willingly entered into a contractual agreement for joint investment and the sharing of profits and risks • According to the ḤanafīsandḤanbalīs, shirkat al-’aqdcan be divided into four types: • al-’inān(restricted authority and obligation): it is a contract where two or more parties agree to become partners in the capital each has contributed and share their efforts in a business. The profit and loss from the business must be determined at the beginning of the contract. Therefore, al-’inānimplies that all partners need not be adults or have an equal share in the capital. Participation may either be on the basis of wealth or labor or credit-worthiness and equality of contribution or legal capacity is not necessary • al-mufāwaḍah(full authority and obligation): the partners are adults, equal in their capital contribution, their ability to undertake responsibility and their share of profits and losses • al-abdān (labour, skill and management): it is a contract among partners to share their efforts in a business and share the profits of the business by proportions agreed to before the commencement of the contract. Normally, without contributing to the capital

MUSHĀRAKAHAS SHIRKAT AL-’AQD • al-wujūh (goodwill, credit-worthiness and contracts): a contract between partners to purchase goods on credit and sell for a lump sum or by installments. Normally, the partners use their goodwill and their creditworthiness for promoting their business without contributing to the capital • Shirkat al-’aqdhas the following features: • the intention is to gain a joint profit • it is allowed for the partners’ share in any derived income or profit to be different from their ownership shares. The partners are free to decide a ratio of the profit • the loss shall be borne by the partners according to their capitals • every partner is an agent for the other partners in investment activities as all the partners benefit from the mushārakahbusiness. The condition of agency is automatically presumed to be in existence when a contract is made • it is not allowed for a partner to guarantee another partner’s profit or capital • it is not allowed for one partner to promise to buy the other partner’s share unless the promise to buy is executed at market value. This is because a promise to buy a partner’s share at its nominal value is the same as giving a guarantee, which is prohibited

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) ORIGIN & DEFINITIONS • Mushārakahmutanāqisahaka al-sharīkah al-mutānaqisahwa al-muntahiyah bi al-tamlīk aka diminishing mushārakahpartnership (MMP) it is not found in classical fiqhliterature as it is an innovative and a hybrid product consisting of three classical contracts: • implemented for the first time in Egypt by the Islamic banking division of a commercial bank in partnership with a tourism company in order to own a fleet of vehicles for transporting groups of tourists between Cairo and Aswan • implemented by Ansar Islamic Cooperative Housing Corporation in Toronto, Canada in 1980, as their home financing product • discussed by Abu Ghuddah at the 15thsession of the International Islamic FiqhAcademy of the OIC, held in Muscat, Oman • approved for house financing during the workshop organised by the IRTI, Jeddah, and the Sudanese Estates Bank, held in Khartoum in 1991 • gaining traction in the last few years as a viable Islamic alternative for financing

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • MMP is based on the classical mushārakahand is a partnership between the financier and the customer to acquire property under an arrangement where the customer agrees to rent the bank’s portion and pays rental on the bank’s share. Subsequently, the customer gradually purchases the bank’s share in the partnership. As the customer’s ownership in the property grows, the bank’s share diminishes until the customer has fully bought the bank’s equity in the property • MMP can be used for the purpose of financing fixed assets in many types of projects, such as real estate projects, industrial projects (plant and machinery), educational projects, agriculture land, cars, etc. • Definitions that are highlighting different features include the following: • apartnership or co-ownership culminating in legal ownership of the underlying asset by one of the partners, usually the customer (Bendjilali & Khan, 1995, p. 49) • apartnership in which one of the two partners promises to gradually buy the other partner’s stake until he owns the entire project (AAOIFI Sharī’ah Standard No. 12, 2008 pertaining to partnership and modern companies) • apartnership in which the bank gives its partner the right to acquire the bank’s stake in the company gradually or at one go, according to the terms agreed upon(Ezzedine Khojah, Adawat al-Istithmar al-Islami)

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • a partnership to which the bank contributes capital and promises to relinquish its rights by selling its share in the partnership to its partners. The partners, on the other hand, promise to buy the bank’s share in the partnership in one go or gradually, as per the terms agreed upon (‘Abdullāh ‘Abdul-Rahim al-’Abādī, The Academic and Practical Encyclopedia of Islamic Banks, Chapter 5, Sharī’ah Section, page 325) • an agreement between two parties to establish joint ownership (sharīkat al-milk) between them in a project, real estate or a manufacturing plant, etc., to be terminated by gradual transfer of one partner’s share in the partnership to the other through separate and successive sale contracts (Nazīh Hammād, MajallatMajma’ al-Fiqh al-Islāmī) • the involvement of the bank in a project with income-generating potential as a partner who provides all or part of the project’s capital. It is agreed that the bank will receive a percentage of the real net income and also have the right to hold the entire balance of the net income that belongs to its partner, or any part of it agreed to, as a payment by the bank’s partner to acquire the bank’s share in the partnership (my definition)

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • In a nutshell: MMP is a kind of contractual partnership in which the partners join together with their contributions for the common objective of undertaking business and trade in accordance with the principles of Sharī’ah. It has three main features: • joint ownership of the bank and customer • leasing of the share of the bank to the customer • gradual redemption of the share of the bank by the customer • MMP involves four relations (activities), each with its own documents and contracts carried out by the partners. To be noted that: • the four transactions cannot be combined in a single arrangement, they have to be executed independently and they cannot be the linked conditions for an enforceable contract • it is a well-settled rule of Islamic jurisprudence that one transaction cannot be made a precondition for another • instead of making the transactions a pre-condition for one another there can be one-sided promises from one party to another • however, the joint purchase and the contract of lease may be joined in one document whereby the financier agrees to lease his share, after joint purchase, to the customer. This is permitted because ijārah can be effected for a future date

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) THE FIQH PERSPECTIVE • The mushārakahmutanāqisahtransaction combines four relations that are permissible in Sharī’ah: hence there is nothing in it that violates any Sharī’ahrule or conflicts with any comprehensive principle in Islamic jurisprudence • Differences (that bear consequences in the structuring of products) may emerge in the classification of the contract: • in the financing of residential properties, mushārakahmutanāqisahappears to be a shirkat al-’aqd; although some researchers consider it to be a form of shirkat al-milk (Nazīh Hammād, MajallatMajma’ al-Fiqh al-Islāmī, Issue No. 13; 2:513-51) • other researchers consider it to be a form of shirkat al-milk for home financing and shirkat al-’aqdin the context of investments (Muhammad Taqī ‘Uthmānī) • still other researchers consider it to be an entirely new form of sharikah; i.e., it is neither a pure contractual partnership nor a pure joint-ownership partnership (‘Ujayl al-Nashmī, MajallatMajma’ al-Fiqh al-Islāmī, Issue No. 13, 2:568)

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • In particular, home financing cannot be considered permanently as shirkat al-milk as at some stages it shares the following features withshirkat al-’aqd: • the intention is not limited to the ownership and usufruct as the financier’s intention is not to own and use it, but to invest by leasing it in order to get a profit. Also, the client may lease back the property to another lessee, thus gaining profit from the property • the partners are not independent in their transactions as they are already tied to an earlier arrangement

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) WHY THE MMP FULFILLS THE MAQĀSID AL-SHARĪ’AH • The attention being paid to the different kinds of partnerships, including MMP, is consistent with the issued recommendations of the Islamic Fiqh Academy to reduce the use of murābahahlilāmir bi shira’ as much as possible, and expand the use of various risk-sharing investment methods such as mudhārabahand mushārakah • The importance of the MMP for both financing and investment by means of assets, lies in the fact that it epitomizes the nature of the Islamic economy, which is a ‘partnership-based economy’, in contrast to the conventional ‘interest-based economy’. In particular, it features: • the achievement of Sharī’ah-compliant returns and profits for both the financier and its clients through the investment of capital, assets and human efforts • the achievement for the financier of periodical real returns from the investment of its funds and throughout the investment period • the encouragement for the client to make halal investment • the realization of the client’s ambition to solely own the project in the medium run as the financier gradually gives up its share in the project • the search for new investment and development opportunities in medium to long-term projects that can benefit people and develop the community

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) • the balancing out of the economy by developing positive [risk-sharing] relationships rather than negative [risk-transferring] relationships, thus bringing about justice in distributing economic production

MUSHĀRAKAH MUTANĀQISAH PARTNERSHIP (MMP) GRAPHICAL REPRESENTATION

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • The customer enters into a partnership (mushārakah) agreement with the bank to co-own the asset being financed: • all schools of fiqh expressly allow the creation of a joint ownership in property • for home financing, it is considered a shirkat-al-milk • for investment projects, it is considered a contract of partnership based on agency (shirkat al-’inān) MECHANISM & FEATURES • customer identifies the property that he/she wants to purchase and signs a Sales and Purchase (S&P) agreement with the developer/seller and pays a deposit • customer approaches the bank for a MM financing facility. Inter alia, determines the duration of the contract • bank assesses the application and approve it (= feasibility study) • in case of an investment project: assessment of its implementation stages and related expenditures (including the appointment of a supervisor) • once approved, customer and bank will enter into a MMP arrangement where the purpose of the co-ownership is to acquire a property/fixed asset • the initial deposit/down payment made by the customer at this stage will be his/her contribution towards the MMP venture while the bank’s contribution will equal the financing amount. In this way both of them pay their respective shares to the seller of the asset

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • the client may have to give guarantees. The mortgage of the financed property is possible and any additional security as may be determined by the bank. This mortgage is not to guarantee the bank’s share in the partnership but to fulfill all the bank’s rights relating to this contract. In case of investment project, full pledge of a piece of land/asset is possible • the income tax (as well as start-up expenses, such as architectural and consultation fees, licensing fees and mortgage documentation fees, if any) will be paid by either the bank or the client, and whatever is paid will be considered as an additional contribution by that party to the partnership • in case of construction, costs in some instances may exceed the financing amount contributed by the bank. When faced with such a situation, the bank may increase its share in the partnership by covering the extra cost, or the client may cover the extra cost, as per previously stipulated conditions in the contract. In either case, the share of the payer [in the project] will be increased accordingly

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT REGISTRATION OF THE PROPERTY UNDER THE CUSTOMER’S NAME • The customer and bank are co-beneficial owners of the property but the customer becomes the registered proprietor of the property as well as a trustee for the two co-beneficial owners: • at this stage, the customer is a registered proprietor, a trustee for the customer and the bank (both as beneficiaries) and one of the two beneficiaries • the bank is the second beneficiary • the beneficial owner of an asset is the person for whose benefit it is being held. Beneficial ownership arises when an asset is owned by one person (the ‘legal owner’) who has a duty to use it on behalf of another; one person holds assets as trustee for another. Or: is a legal term where specific property rights (‘use and title’) in equity belong to a person even though legal title of the property belongs to another person • it is widely used by the industry • As security for the performance of its payment obligations (to protect the bank’s portion and to cover any expenses to dispose of the asset in the event of default) the customer pledges his/her share of the beneficial ownership of the property to the bank

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • However, given that the property is registered in the name of the customer in his/her capacity of trustee for the customer and bank (as beneficiaries), both beneficiaries agree that the customer in his/her capacity of trustee should register a charge over the whole property in favour of the bank as security: • a charge is defined as a security interest in property; it transfers neither title nor possession • registration confers upon chargee the power of foreclosure upon default of repayment of the debt and confers upon him/her a legal interest in the property. Thus, a legal charge is an encumbrance on the property which prevents any further dealings whether by way of sale and transfer of that land or the grant of a second charge without the consent of the first chargee • in theory, the trustee should only charge the customer’s portion of the property to the bank and not charge the bank’s portion as well • in practice, most National Land Codes only allow a charge on the whole, but not on a part only, of any alienated land. Hence, the trustee, with the consent of the bank, charges the whole property in favour of the bank

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • if the customer defaults and fails to remedy the default, the bank will sell the property through the charge provision under the National Land Code. If the sale leads to a surplus, the customer will get the surplus. If there is a shortfall, the customer will be liable to pay the shortfall amount to the bank, based on a wa’d obligation assumed by him/her. This position is also comparable to the charge foreclosure position under a conventional loan • In the rare case the charge is found to be invalid, the bank may have recourse to an equitable charge: • definition: “If an agreement be made to grant some interest in existing or future property for the purpose of securing the payment of a debt, that agreement to give the security confers an equitable security or charge, though all the formalities necessary to create the actual security have not been complied with” • hence: what is necessary for an equitable charge to exist is a valid contract that grants interest in existing property for the purpose of securing the payment of a debt • in addition: the bank can lodge a caveat which operates as notice to the entire world that the registered proprietor’s title is subject to the equitable interest alleged in the caveat • double check: what if the customer becomes a bankrupt? Can the official assignee challenge the Islamic bank’s equitable charge?

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT REGISTRATION OF THE PROPERTY UNDER THE BANK’S NAME • The Islamic bank is registered as the legal owner and holds the property on trust for itself and the customer: • at this stage, the bank is a registered proprietor, a trustee for the two co-beneficial owners and one of the two beneficiaries • the customer is the other beneficiary • currently practiced by Kuwait Finance House (KFH) • To evidence the trust, a trust deed is executed and stamped, and it is registered • If the customer defaults and fails to remedy the default, the underlying asset will be sold in the market and the proceeds will be shared between the co-partners according to the latest ownership share ratio - after all the outstanding costs and payments, such as outstanding rents and legal fees, are covered: • however, having the bank own the property may not be viewed favourably in the market as the customer’s perception is shaped by conventional mortgage practice where the customer is always the registered owner • also, there is the issue of the possible liability linked to the ownership of the property by the bank in the event there is a tortuous claim

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT PROPERTIES UNDER CONSTRUCTION: THE MMP CUM ISTISNA‘ • When it comes to properties under construction, the current practice is very similar to the MMP methods explained above. The only difference is that Islamic banks charge advance rental from the customer for the period during the construction. This advance rental is known as ijārah mawsūfahfīal-dhimmah(forward lease). See below. • however, if the property is abandoned (property yet to be constructed due, to say, the developer’s default) the bank has to pay back the advance rentals to the customer and bear the risk according to the financing • indeed, the bank cannot invoke the wa’d against the customer and ask the customer to pay the full amount disbursed by the bank as this mechanism would not be in compliance with the Sharī’ah • A possible solution to mitigate the construction risk is the use of a modified MMP with an istisna’structure: • the MMP venture will enter into an istisna’ agreement with the customer - whereby the customer will agree to procure the construction of the property for the MMP venture • the customer in turn will enter into a Sale and Purchase Agreement with a developer to contract the istisna’obligations to a developer of his choice

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • in this way, the customer is legally responsible to the MMP venture to procure the construction and delivery of the property. If the customer fails to deliver in accordance with the istisna’ agreement, then the MMP venture has a full right to claim the outstanding amount owed by the customer to the MMP venture • if the property is not completed under the istisna’, the bank will be required to repay to the customer the advance rentals paid by the customer (as lessee) to the bank (as lessor) during the construction stage. The bank can mitigate this risk by seeking compensation from the customer (as the procurement party) under the istisna’ for failing to deliver the property as per the istisna’ terms • for the sole purpose of computing this compensation, the quantum of compensation can be equal to the amount of advance rental repayable to the customer • Beware: • the MMP facility which does not expose the bank to the construction risk enjoys a 50% risk weight on capital requirements and consequently it is priced on par with a comparable conventional mortgage which does not expose the conventional bank to any construction risk • on the other hand, any construction risk exposure to the bank would increase the risk weight to 400% (allocate a higher percentage of the capital to back the MMP facility) and this would increase the overall cost to the customer by a manifold amount

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT Mushārakahmutanāqisahcum istisna'

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT • Please, refer to the presentation themed ‘The Bay’ Istisna’’ for details of this contractual relationship, including the following: WHAT IS MEANT BY ISTISNA’ THE LEGITIMACY OF THE ISTISNA‘ CONTRACT SHARI‘AH PARAMETERS - CONCLUSION OF CONTRACT SHARI‘AH PARAMETERS - ASSETS SHARI‘AH PARAMETERS - PRICE SHARI‘AH PARAMETERS - EXECUTION OF CONTRACT SHARI‘AH PARAMETERS - DELIVERY OF THE PRODUCT DIFFERENCES BETWEEN ISTISNA’ AND IJARAH DIFFERENCES BETWEEN ISTISNA’ AND SALAM APPLICATIONS OF ISTISNA’ IN ISLAMIC BANKS

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT LEGAL FRAMEWORK AND DOCUMENTATION • The modern business concerns being run on the basis of mushārakah may be a: • partnership: regulated either by rules framed by the government or business practices prevailing in the business community • limited company: regulated by the statutory rules framed by the government though its commercial activities are influenced by the business practices (‘urf) • co-operative society: governed by statutory rules. Its commercial activities are influenced by the practices prevailing in the business community • Documentation needed: • application form • documents from the client (address verification, personal information, income estimate, business information, property documents, etc.) • legal opinion • property valuation • credit approval & sanction letter • account opening • signing of house finance agreement

1. THE MUSHĀRAKAH (JOINT OWNERSHIP) CONTRACT TAKĀFUL WRAPPING The property buyer must take out an insurance (takāful) policy for the whole building with a clause covering the risk of the bank (the co-owner) as well. How the share of the bank in the premium will be adjusted to the installment payments isa matter of contractual agreement • Aim: to insure Islamically the property through a wakālah contract • Features: • insured amount is capped at a fixed rebuilding cost • the rebuilding costs are agreed upon by the chosen retakaful company. The market value is not taken into consideration, as it can be inflated • the takāfulpolicy insures Islamically the property (never the credit) against events such as: fire, explosions, lightening, falling parts of aircrafts (light and commercial), etc. • surplus refund mechanism for the product, but must get retakaful company to chip in the surplus to refund

2. THE IJĀRAH (LEASING) CONTRACT • The bank leases its share in the asset ownership to the customer under the contract of ijārah. The customer rents the bank’s undivided share or portion in the property and pays the rental payment (if he/she needs to make use of it during the period in which he is acquiring its ownership, which is usually the case): • all Muslim jurists agree on the permissibility for one party (even if it is the client) in mushārakahmutanāqisahto lease the other party’s share (even if it is the financier) for a known rental and for any specified period of time • there is difference of opinions only on leasing one’s share to a third part (AbūḤanīfavMālik, Shāfi’ī, AbūYūsuf) MECHANISM & FEATURES • the practice among the banks is to only lease their share in the property to the customer. In this case, all the rental payment goes to the bank • the bank’s portion of the rental income is similar to a financing profit earned by a conventional bank

2. THE IJĀRAH (LEASING) CONTRACT RENTING TO A THIRD PARTY • in case of a an investment project, the right to utilize the usufruct of the building (project) is delegated to the bank (the manager of the project, as per the conditions stipulated in the mushārakahcontract). Therefore, the bank has the right to conclude leasing contracts on the project and collect rentals. Leasing contracts that stipulate the agreed terms and conditions are to be signed by the bank and the lessees. However, the bank can discuss with the client/partner and get his opinion if the leasing contract is concluded with a person other than the bank’s client • it is also possible for the client to have his signature on these contracts too. The leasing contracts contain a special provision which extends the enforcement of the stipulated conditions after the bank exits the partnership • the bank will handle the follow-up with the tenants to collect the rentals on their due dates according to the agreed conditions and the rental amounts will be jointly shared between the customer and the bank according to the percentage share holding at the particular times which keeps changing as the customer purchases the financier’s share • the client’s share of the income will be determined and credited to a special account with the bank for the purpose of buying the bank’s share. It is also possible that the bank will give the client for his personal use part of his share in the income that has been saved in the special account

2. THE IJĀRAH (LEASING) CONTRACT • each partner will continue to be responsible for the basic maintenance of its share at all times THE RENTAL RATE PEGGED TO INTEREST RATES • The formula used for the MMP calculation is similar to the standard formula used in conventional financing for present value of annuities to compute for the monthly payments (see slides below): • an obvious advantage from this similarity is that the conventional formulas, and therefore the conventional financial calculators and spreadsheets like Excel can be used for the MMP computations and the preparation of amortization schedules thereof • Though scholars have argued that setting rental levels in line with market interest rates is not in itself haram: • this is the current practice by some Islamic banks in the UK whereas the rents are linked to LIBOR

2. THE IJĀRAH (LEASING) CONTRACT • ACTUAL RENTAL RATE • To be truly Sharī’ah-compliant, the interest rate in the MMP formula must be replaced with the actual rental rate. This may represent an hurdle for the bank as • the bank’s cost of funds is likely to be tied to market interest rates • the interest rate may be higher than the rental rate • tracking rentals can be cumbersome and impose additional costs particularly if services of independent valuers are sought, unless there are already national or regional rental indices • The use of actual rental value that reflects the real property value in the market as a benchmark is most suited for use in Islamic finance since it is measured from the true usufruct of the asset, unlike interest charges that are apparently not tied to the asset’s usufruct: • hence the rental rate can differ among houses within a same row of houses or among different floors within a condominium block and reflects the real property value in the market • the rental can be tied to some economic variables like Rental Index, House Price Index, etc. • If the customer cannot afford to pay the new rental and choose to continue paying the old rental, the duration of the remaining contract would be extended

2. THE IJĀRAH (LEASING) CONTRACT VARIABLE RENTAL RATE • A further improvement: (TaqiUsmani, An Introduction to Islamic Finance, 2004) Rental must be determined at the time of contract for the whole period of lease. It is permissible that different amounts of rent are fixed for different phases during the lease period, provided that the amount of rent for each phase is specifically agreed upon at the time of affecting a lease: • if the rent for a subsequent phase of the lease period has not been determined or has been left at the option of the lessor, the lease is not valid • to estimate the rental, some MMP operators use the services of independent real estate agents to provide them with the estimates; sometimes using average of as many as three agents’ estimates in order to be more just. But all these can impose additional cost on bank and the customer • the use of rental indices or house price indices in order to estimate the new rentals without having to bear the cost of using the services of real estate agents is admissible. If a particular index is used, it would be specified in the contract and acceptable to both the customer and bank to avoid gharar • nonetheless, using indices would cause the loss of some accuracy: while an index may give the average rental in a locality, specific factors should also be taken into consideration in order to get a better rental estimate fair to both sides

2. THE IJĀRAH (LEASING) CONTRACT • prices and rental of real estate properties are sensitive to many factors. Even within the same locality, particular location can affect prices and rentals. Other than characteristics of the property (floor size, number of rooms, single storey or double storey, corner or intermediate etc.) its location relative to school, shops, hospital, mosque, sewage etc. can also affect prices and rentals MISMATCHING ISSUE • If the cost of funds to the bank is based on variable rates while the MMP contract’s rental rate is fixed for the entire tenor, then the bank may face liquidity risk problems. The problem is matching the short duration deposit funds with long duration of the financings. The MMP can be made more flexible by requiring the review of rental periodically, say every five years DOCUMENTATION • Monthly payment agreement (rent agreement)

2. THE IJĀRAH (LEASING) CONTRACT THE FORMULAS • The standard formula for present value of annuities to compute for the monthly payments used by conventional financing is the following: Pmt1 PV = ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ 1- ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ i (1+ i )n which gives: i (1+i)nPV Pmt = ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ (1+i)n - 1 • PV = present value of the monthly or periodic installments, which is the loan amount itself • Pmt = the monthly or periodic installments (principal and interest) • i = the monthly or periodic interest rate • n = the number of months or periods

2. THE IJĀRAH (LEASING) CONTRACT • The formula used by the MMP is the following: x (1+x)n B0 M= ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ ̶̶ (1+x)n- 1 • M = the monthly or periodic payments to the bank, that comprises the rental amount and the additional amount being paid in order to redeem the asset early • x = rental rate, e.g. monthly rental divided by the original asset price • B0 = the initial contribution of the bank in the purchase price • n = the number of months or periods for the customer to fully own the asset

2. THE IJĀRAH (LEASING) CONTRACT • Please, refer to the presentation themed ‘The Ijarah muntahiya bi-tamleek’ for details of this contractual relationship, including: • ESSENTIALS OF IJARAH • ESSENTIALS OF IJARAH MUNTAHIYA BI-TAMLEEK • SHARIAH LEGITIMACY AND AAOIFI SHARIAH STANDARD • CONVENTIONAL V. IJARAH • DOCUMENTATION OF IJARAH • THE TRANSFER OF THE LEGAL TITLE OF THE ASSET • CURRENT APPLICATIONS OF IJARAH IN ISLAMIC BANKS • ACCOUNTING ISSUES • KEY DIFFERENCES BETWEEN IFRS AND AAOIFI

3. THE BAY’ (SELLING) CONTRACT • The customer has entered into a purchase undertaking to buy the financier’s share in stages: • he/she gradually and periodically buys through a sale contract (bay’) the units representing the bank’s share at an agreed upon portion until the asset is fully owned by the customer • the sale and purchase of the partnership’s share must not be stipulated as a condition in the mushārakah(partnership) contract. Indeed, a partner’s promise to sell or purchase must be separated from the partnership contract, and the transaction will be exercised through a separate contract. It is not permitted to link either contract with the other by a stipulated condition (AAOIFI, Sharī’ahStandard No. 12, clause 1/5) • it is not allowed to conclude any sale contract in advance because a sale cannot be concluded to take place in the future MECHANISM & FEATURES • throughout the tenure of the lease, at agreed time intervals, the customer will buy units representing the bank’s share in the property from the bank. This is implemented by the customer paying an additional amount in addition to the rental payment to purchase the bank’s share in the property

3. THE BAY’ (SELLING) CONTRACT • the share of the bank will be reduced by every purchase of the units by the customer, i.e.: ownership of the asset is gradually transferred to the customer upon payment of asset price • in case of an investment project: at the end of tenure of the lease, when the client has fully purchased the bank’s share by means of his share of the rental income, the MMP will be liquidated and the property will be wholly owned by the customer and the full ownership title will be transferred to him. In other worlds, the client undertakes to allocate his portion of the partnership’s profit or income to acquire a percentage of the bank’s share in the partnership • in case of an investment project: losses - if any - will be borne by each partner according to his/her share in the capital. In each period of the partnership, the loss-sharing ratio will be adjusted in proportion to any changes in the partners’ shares in the capital (AAOIFI, Sharī’ahStandard No. 12, Clause 5/4) • in case of an investment project: all leasing contracts and rights will be transferred to the client on that date. Thereafter, the client will be the only one authorized to collect rental fees

3. THE BAY’ (SELLING) CONTRACT THE ALLOCATION OF UNITS • It is fine to organize the acquisition of the bank’s share by its partner in any way that achieves the goals of both parties; for example: • the subject of the partnership is divided into shares (units), of which the bank’s partner periodically acquires a certain number until he manages to acquire the entire portion, which will make him the sole owner of the subject of the partnership • units may be worked out by dividing bank’s financed amount by the number of months financed • the client may purchases different units of the undivided share of the financier THE ISSUE OF PRICE • If two parties co-own the asset and share its rental income, they should also share the asset’s price appreciation (if any) • hence: there is no guaranteed rate of return on the investment of the financier • The Sharī’ah standards of AAOIFI prohibit the purchase of shares in a MMP at a price that is fixed in advance: • this is on the basis that partners in a contractual investment (in this case, a rental property) must share any losses on their investments in proportion to their capital contribution

3. THE BAY’ (SELLING) CONTRACT • “It will be preferable that the purchase of different units by the client is effected on the basis of the market value of the house as prevalent on the date of the unit, but it is also permissible that a particular price is agreed in the promise of purchase signed by the client” (Usmani 2005, p. 90) • “It is not permissible to the partners to agree with the price of another partner’s portion on the basis of its face value or premium value, but it is permissible to purchase the partner’s portion at the agreed price at dissolution day, or transaction day, or market price, or the price that is determined by experts” (Majmū’ah al-Barakah al-Maṣrafiyyah, 2007): • hence: the share is sold at its market value or at the price agreed upon at the time of the purchase or at the price that is determined by experts • it is not permissible to stipulate sale of a share at its nominal value because that is tantamount to guaranteeing the shares of the partnership by one of its partners • Beware: the sharing of the asset’s price appreciation involves few issues: • the MMP involves the gradual and constant redemption of the financier’s equity by the customer. Hence, by the end of the MMP financing the customer has already acquired the full ownership of the asset and any price appreciation at that moment fully belong to the customer

3. THE BAY’ (SELLING) CONTRACT • on the other hand, it is also true that an asset should be valued only when there is a sale of the property which would involve the full transfer of ownership. Otherwise the appreciation or depreciation of value would only be on paper • valuation of the asset within the duration of the MMP contract may not be appropriate since a full transfer does not take place at the moment of valuation as the MMP involves gradual transfer of ownership along the entire duration of the MMP • if periodic valuation of the asset, just like the rental, is agreed upon then it should involve both appreciation and depreciation and normally, banks do not want to take this risk • In practice: 1st way. Valuation of the property during the contract tenor done at the times agreed upon: • the capital appreciation (at the day of evaluation) is shared according to the ownership ratios of the customer and the bank (at the day of evaluation) • this will impact the equity of the customer and the bank that will increase accordingly • at the new equity value, the rental (which most probably will also have increase) will result in a different rental rate • a new amortization schedule will be drawn

3. THE BAY’ (SELLING) CONTRACT • In practice: 2nd way. Valuation of the property at the end of the contract tenor: • in a lump payment • sharing gains or losses in the capital value of the house in a pre-agreed ratio when the nominal partnership comes to an end

4. THE WA’D (PURCHASE UNDERTAKING) • The customer signs the wa’d(purchase undertaking) agreement whereby he/she agrees to buy the outstanding share from the bank on installments at a stipulated time MECHANISM & FEATURES • it is separate but concurrent with the previous contracts • the promise of the client to buy the share units of the financier is one-sided without any quid-pro-quo and should not be reciprocated with a binding promise from the other partner (who maintains the right not the obligation). This is to avoid a binding bilateral promise, which would cause the process to resemble a sale contract, for it is known that a sale contract cannot be concluded to take place in the future • it is also possible for the bank (though unusual) to make such a binding promise to the client; hence, it is permissible for one party to make a binding promise to allow the other party to gradually own his shares in the partnership through a sale contract concluded at the time of [each] purchase • in Sharī’ah, a promise to do something creates in general only a moral obligation on the promisor, which cannot be enforced through the courts of law, albeit there are juridical differences on the point. For example, the Ḥanafīposition is that promises can be enforced in cases/times of need on the principle of bay’ al-wafa’

4. THE WA’D (PURCHASE UNDERTAKING) THE EVENT OF DEFAULT • Where the customer has provided a wa’d (purchase undertaking) to the bank at the outset of the MMP (and the bank exercise it) the customer is obliged to acquire the bank’s remaining (outstanding)share: • this creates a debt to be paid by the customer to the bank equal to the amount of purchase price payable plus the amount of unpaid rental • if the customer fails to honour the wa’d (which is generally the case), the MMP will be terminated and the bank ends up selling the property under the charge at auction to obtain the capital • the selling price of the house could be higher, lower, or equal to the amount claimed and the bank would be able to claim any shortfall from the customer as an unsecured debt • the customer, however, would be entitled to any surplus from sale proceeds if the property price appreciates

4. THE WA’D (PURCHASE UNDERTAKING) • If no wa’d has been procured from the customer (or is not exercised by the bank) then the underlying asset will be sold in the market for the prevailing price and the proceeds will be shared between the partners according to the latest ownership share ratio: • after all the outstanding costs and payments, such as outstanding rents and legal fees, are covered • if there is a surplus, it will be shared between the parties based on the profit-sharing ratio. On the other hand, if there is a loss, it will be shared according to the capital share of each party in the property • The problem with the no-wa’dapproach is that if the value of the property has depreciated, the bank does not have recourse to the purchase price payable by the customer under the wa’d. In fact, if there is no wa’d, the only debt due and payable by the customer to the bank is the unpaid rental: • it is recommended that the bank choose one of the two options at the beginning of the contract and not be given freedom to decide whether to take the wa’d option or the direct sale option (without wa’d) at the time of default • in commercial practice most banks use the wa’d(purchase undertaking)

4. THE WA’D (PURCHASE UNDERTAKING) THE ISSUE OF THE SECOND UNDERTAKING • As an element of additional capital guarantee/protection, some banks have come to require the customer to sign a second wa’d to buy the financier’s share in the event of default. It has two features: • granting the right to the bank to oblige the customer to buy the bank’s share on credit in the event of default, or • granting the right to the bank to purchase the customer’s remaining share • In the first case, the customer shall buy the bank’s share on credit at the price that covers the bank’s remaining share and unpaid rental for the period before the imposing of the binding undertaking to purchase, and other expenses: • an indebtedness of the customer is created and the property is in the position of a collateral for the customer’s obligation • In the second case, the bank purchases the customer’s share at a pre-determined price and the payment of the price shall be set-off against the default rental fee: • the property will be solely under the bank’s ownership • the bank shall auction the asset to obtain the capital. The proceeds of the auction will be used to pay the default amount of rental and payment of the credit sale. If there is any balance, the bank shall return it to the customer

ISLAMIC REPUBLIC OF AFGHANISTAN