Mohamed Ismail Shariff explains the need for refinement in the documentation
MUSHARAKAH MUTANAQQISAH CONTRACT
In the last two years or so some Islamic financial institutions in Malaysia have introduced the Musharakah Mutanaqqisah (MM) contract for home ownership. This is a welcome development and will be a boon to intending homeowners and a boost for Islamic financing in this country. However there are certain aspects in the documentation of the contract that are of concern and if these are not rectified, could have adverse consequences. But before discussing those aspects it would be useful to take a brief look at the Bai Bithaman Ajil (BBA) contract which the MM seeks to replace.
BAI BITHAMAN AJIL CONTRACT
The BBA contract (deferred payment sale contract) has been the most common financing product used by Islamic banks (and conventional banks when they were allowed to carry on Islamic banking business through Islamic banking windows) since the introduction of Islamic banking in this country in 1983. This has been the principal mode of financing for home ownership in this country. But the BBA contract has also been used in other financing transactions, e.g. sukuk issuances.
The BBA contract is not recognized in some countries, notably the Gulf countries and Pakistan, as a valid Islamic contract. But in Malaysia it has been approved by the Shariah Advisory Councils (SAC) of the Islamic banks and subsequently endorsed by the SACs of Bank Negara Malaysia and the Securities Commission.
Nature of the BBA contract
The BBA contract is essentially a sale transaction. It is a debt financing product. In a typical case, the customer who requires a facility to purchase a house would first sell an asset to the bank. This is usually his beneficial rights to the house (which for illustrative purposes, is assumed to be under construction) that he has agreed to buy under the Sale and Purchase Agreement entered into between him and a housing developer. The price at which the bank will buy the asset will be the amount of financing that the customer requires to complete the purchase (termed the facility amount). The bank would release the facility amount to the developer progressively against architect’s certificates. The bank would immediately (i.e. on the same day as its purchase) sell the house to the customer at a sale price comprising the bank’s purchase price and its profit computed for the duration of the financing period. The customer would pay the selling price to the bank in instalments over the agreed period of the financing, e.g. 15 years.
As may be obvious this mode of financing bears considerable resemblance to a conventional loan transaction and many people have expressed the view that the BBA contract is in fact a loan transaction and the profit element is but the aggregated interest on the facility amount, which they argue is the loan amount. Whilst one can see the reasoning underlying this argument, it should be appreciated that the reasoning is flawed as it is based on appearances rather than the substance of the transaction.
Challenges to the BBA contract
The validity of the BBA contract has been questioned in a number of cases in the Malaysian courts. The first of these challenges was in the case of Adnan Bin Omar 1. The High Court dismissed the challenge. An appeal from that decision to the then Supreme Court was also dismissed. Thus the validity of the BBA contract was affirmed by the then highest court in the country.
The validity of the BBA contract was again challenged in the context of the sale and purchase of Malay reservation lands. That challenge was a more serious one; however, that was also met successfully: both the High Court and the Court of Appeal accepted and affirmed the validity of the BBA contract involving Malay reservation lands.2
The third and most serious challenge came from the High Court in two cases3. The judgments in the two cases (both by the same judge) caused great alarm among the Islamic banks as in those judgments the learned judge had ruled that the BBA contract was in fact a loan transaction. He said that the profit was, therefore, interest and since Islam prohibits interest the banks could not recover that element in the sale price but only the “principal sum” (i.e. the facility amount). If those decisions had stood, Islamic banks would have suffered huge losses which would have threatened their survival, given the vast amount of financing that had been provided under this contract. Those decisions were wholly reversed on appeal by the Court of Appeal and once again the validity of the BBA contract was re-affirmed.
THE MOVE TO THE MM CONTRACT
The Islamic banks had even before the last onslaught on the BBA contract begun to explore other modes of financing for home ownership. One of the modes developed was musharakah mutanaqqisah. MM is based on the musharakah concept, which is a partnership, more particularly on the diminishing partnership principle in which two (or more) parties invest in the acquisition of an asset (e.g. a house) with each contributing a portion of the acquisition price.
The asset (house) that is thus acquired is (preferably) registered in the name of a trustee that holds the asset on trust for the parties. The house is then leased to the customer by the trustee (or the other entity in whose name the house is registered). The rental received is apportioned between the two investors, with the customer’s portion also being paid to the bank every month. These amounts will go towards the gradual acquisition of additional amounts of the bank’s share in the venture by the customer. By the end of the partnership period the customer would have acquired 100% of the share in the asset and the bank would own 0%; hence, the diminishing nature of the partnership.
THE MM CONTRACT
In my view, MM is an eminently suitable mode of acquiring home ownership and it has many features that are far superior to a conventional loan transaction or the BBA contract. It is beyond the scope of this article to go into the details of this mode of home ownership. There could be several variations based on this concept but whilst there may be differences in detail, it is crucial to the validity of the product that certain essential elements of the musharakah concept are present in the product offered.
By far the most important element is the nature of the relationship between the parties, i.e. that it is one of partnership. A musharakah partnership requires that both parties should share the profits arising in the venture and also assume the risk of loss. The property purchased should be jointly owned by both parties or if it is registered in the name of a trustee, the trustee should hold it on trust for both parties. Neither party should claim a different or separate interest in the property from the other, save that their respective shareholdings will vary at any given time.
The MM contract as offered
I have had the opportunity to peruse the MM documentation currently being used by some financial institutions and in my respectful view they need to be modified in some important respects.4
The MM documentation treats the relationship between the bank and the customer as a debt financing relationship. What is supposed to be the bank’s investment in the asset is termed as a “facility” and is treated like a debt financing facility. The musharakah concept is not clearly reflected in the documents. This could be a ground for challenge in a court of law.
Some other features may be noted briefly here. Security documents are taken to secure the payment of monies payable by the customer and the security party under the facility. This is incorrect and not consonant with the musharakah principle. In a properly structured MM contract the only monies that would be payable by the customer will be the rentals due under the ijarah agreement pursuant to which the house is leased to the customer by the trustee.
The musharakah itself is not a legal entity and so has no legal personality but it has been given that status by the documents where it says that the musharakah shall lease the asset to the customer under the Islamic contract of ijarah. The musharakah cannot do this; it is the trustee or the registered owner who can do so.
The documents also refer to “undivided” shares in the musharakah which is perplexing since shares in a partnership are not undivided.
The agreements talk of full disbursement of the facility implying again that the transaction is one of debt financing and not a musharakah. It stipulates that the “profit” payable for a month shall be equivalent to the lease rental for the month. It is difficult to see how profit arises between the parties in a musharakah contract in which they are legally partners.
Land charge in favour of an equitable owner?
A land charge over the property that is being acquired is taken in favour of the bank by way of security “to secure the monies payable” to the bank. This security is of questionable validity as under the musharakah mutanaqqisah arrangement the bank is the major shareholder at the beginning of the relationship and the question will arise whether an owner of property, albeit an equitable owner, can take a charge over the same in its favour, though technically a land charge could be taken.
In my view these features written into the contract strike at the root of the musharakah principle. They are susceptible to challenge. The contract could fail the test of a musharakah contract. In such an event dire consequences could follow. I must emphasise that the deficiencies in the documentation arise not due to any shortcoming in the musharakah principle per se but by a lack of proper application of the features of that principle. The challenges that could be mounted would be more fundamental and different in nature from those raised in the BBA cases. The flaws in the documentation should be corrected to avoid any successful challenge.
MOHAMED ISMAIL SHARIFF (
1 Bank Islam Malaysia Berhad v Adnan Bin Omar  3 AMR 2291 (HC). No written judgment was delivered by the Supreme Court.
2 Datuk Haji Nik Mahmud Bin Daud v Bank Islam Malaysia Berhad  4 MLJ 295 (HC);  3 MLJ 393 (CA).
3 Affin Bank Berhad v Zulkifli Bin Abdullah  3 MLJ 67 (HC); and Arab-Malaysian Finance Bhd v Taman Ihsan Jaya Sdn Bhd  1 CLJ 419 (HC); and on appeal from the latter judgment, Bank Islam Malaysia Bhd v Lim Kok Hoe & Anor and Other Appeals  6 MLJ 839 (CA). The HC judgment was a joint judgment in 12 cases on BBA contracts involving different parties and banks dealt with jointly by the HC judge. 10 appeals from that judgment to the CA were heard together and the CA delivered one common judgment. The HC and CA decisions were reported in LEGAL INSIGHTS Issues No. 3/08 and 4/09 respectively.
4 The comments made herein are of a general nature and made in good faith. They do not refer, and are not intended to refer, to the documents being used by any financial institution in particular.
Editor's Note : The writer appeared as leading counsel for Bank Islam in the cases referred to in Notes 1 to 3 above.