Scope of Standard
An overview of AAOIFI Standard Number Five is presented. It should be noted only a summary and overview of the standard is presented, the full standard is available from AAOIFI.
This standard is issued on 29 Safar 1422 H corresponding to 23 May 2001.
This standard deals with guarantees that are intended to secure obligations and protect amount of debts, either from being uncollectible or from being in default. Such guarantees may take the form of written documents, attestations, personal guarantees, pledges, cheques and promissory notes. The standard also explains the permissible and prohibited forms of guarantees. It also deals with the distinctions between two types of recoverable liability, namely debts that are absolutely payable, either because of being contractually created, or because unjust enrichment has given rise to a liability for restitution and liabilities held on trust basis, i.e. obligations that are not subject to compensation for any loss suffered except in circumstances of misconduct, negligence or violation of the conditions agreed upon.
The standard does not deal with compensatory liability for the destruction of property and criminal acts.
General rulings on guarantees
Legitimacy of guarantees and their relevance to contracts
- A contract of guarantee is permissible in contracts of exchange, e.g. a contract of sale, or contract of rights, e.g. right of intellectual property.
- There is no objection in Shari’a to include a number of guarantees in one contract, such as incorporating a personal guarantee together with a pledge of security in the same contract.
Guarantees in trust (fiduciary) contracts
- It is not permissible to stipulate in trust (fiduciary) contracts. e.g. agency contracts or contracts of deposits, that a personal guarantee or pledge of security be produced, because such a stipulation is against the nature of trust (fiduciary) contracts, unless such a stipulation is intended to cover cases of misconduct, negligence or breach of contract.
- It is not permissible to combine agency and personal guarantees in one contract at the same time (i.e. the same party acting in the capacity of an agent on one hand and acting as a guarantor on the other hand), because such a combination conflicts with the nature of these contracts.
Guaranteeing existing leased properties
- The lessor bears the risk associated with the leased property and the lessee holds it on a trust basis. Hence, it is not permissible for the lessor to stipulate in the lease contract that the lessee provide a guarantee or pledge of security, etc., so that he may use it to recover the amount of the lease rental if the leased property is damaged, unless such a stipulation is restricted to cases of misconduct, negligence or breach of contract.
Written documentation and attestation
- Documentation in writing is recommended by Shari’a, whether such documentation is in the form of ordinary (private) or official documents.
- Attestation in financial transactions is recommended by Shari’a. On the other hand, perjury is prohibited and is one of the major sins.
- It is not permitted to scribe or witness acts prohibited by Shari’a, such as certifying or witnessing borrowing on the basis of interest.
Legitimacy and types of personal guarantee
- It is permissible for an institution to stipulate that a customer should provide one or more guarantors to secure the debts owed by the customer.
- Personal guarantees are divided into two types. One type is a guarantee where the guarantor has a right of recourse to the debtor, and this guarantee is offered at the request or with the consent of the debtor. The other type is a non-recourse guarantee, which is offered voluntarily by a third party without the debtor’s request or consent (voluntary guarantee).
- An institution is not entitled to guarantee financial commitments without a right of recourse to the debtor, i.e. to be a non-recourse guarantor, unless the institution is already authorised by its shareholders and investors to make donations or to perform acts of benevolence.
- It is permissible to fix the duration of a personal guarantee. It is also permissible to set a ceiling on the amount to be guaranteed and it is permissible that the personal guarantee be restricted by, or be contingent upon, a condition.
- It is not permissible to take any remuneration whatsoever for providing a personal guarantee per se, or to pay commission for obtaining such a guarantee.
Guaranteeing unknown (majhul) and future debts
A valid guarantee may be given for debts, the exact amount of which is unknown. Similarly, a valid guarantee may be given for a debt that will arise in the future. However, it is permissible for the guarantor to withdraw such a guarantee before a future debt is actually created, after notifying the person having interest in the guarantee.
The effect of a personal guarantee
- The creditor is entitled to claim the amount of his debt from either the debtor or the guarantor and he has the choice of claiming his right from either of them.
- If the creditor discharges the debtor from the debt, the guarantor is also discharged automatically from his liability. However, if the creditor discharges the guarantor from liability, the debtor remains in debt.
- It is permissible for a personal guarantee contract to be designated in a separate contract. It can also be concluded together with, or before, or after, the conclusion of the contract of a credit transaction.
- If an institution manages transactions on the basis of mudaraba or musharaka or investment agency, it is not permitted for it to guarantee the fluctuations of currency exchange rates so that the investors will recover their investment shares irrespective of the behaviour of the currency market.
- If the contract of a credit transaction stipulates that the debtor shall provide a guarantor and the debtor fails to provide one, the institution is entitled to initiate legal action to force him to provide a guarantor or to terminate the contract.
Legitimacy of pledges
- It is permissible for an institution to stipulate that at or before the conclusion of the contract of a credit transaction the customer shall provide a pledge of security to secure payment, and that possession of the asset so pledged will not prevent it from demanding payment when the payment of the debt falls due.
- The contract of pledge is binding on the debtor who provides it, even if the asset so pledged is not possessed by the creditor, and thus the debtor cannot revoke the contract. However, the acceptance of a pledge is not binding on the creditor as he is entitled to disclaim his right to pledge.
Conditions relating to a pledged asset
- A pledged asset must be a valuable asset that can be lawfully owned and sold. It should be subject to identification by sign, name or description, and capable of being delivered to the creditor. Hence, property held in common may be produced as a pledge provided the pledged percentage of it is specified, such as pledge of shares.
Possession and ownership of the pledged asset
- The pledged asset remains the property of the pledger so far as it continues to be subject of pledge.
- In principle, the pledged asset should be in the possession of the creditor (possessory pledge). However, it is permissible that it be left in the possession of the debtor (security or registered pledge) and all the rules governing pledges remain applicable to such a pledge. It is also permissible that the debtor pledge an asset of a third party with the permission of the owner (“borrowed pledge”). Possession of the documents of title to goods or equipment held in warehouses or at ports is considered to be possession of the assets they represent.
- All actual expenses relating to tangible pledges, excluding the expenses incurred for the safekeeping of the pledge, are to be borne by the pledger.
Enforcement of a pledge
- The effect of the pledge of security is that the creditor is entitled, if the debtor fail to pay the debt on time, to demand the sale of the pledged asset in order to recover the amount of the debt from the sale proceeds, and to return any surplus proceeds to the debtor.
- The creditor (the pledgee) is not entitled to obtain ownership of the pledged asset in consideration for his debt (i.e. to foreclose on the pledge), unless the debtor has agreed to sell the asset to the creditor and an agreement has been reached for the set-off of the sale proceeds and the amount of the debt.
- A seller is not entitled to stipulate, after conclusion of a sale contract, a right to retain an asset sold on a deferred sale basis, as security for payment. This is because the legal effect of a sale contract is the transfer of ownership of the asset sold. However, it is permissible for the seller to stipulate that the buyer should release the sold asset into the seller’s custody as a pledge of security so as to ensure recovery of the remaining deferred instalments.
- The creditor is entitled to stipulate that the debtor should authorise him to sell the pledged asset when the debt falls due in order to recover what is due to him from the sale proceeds, without recourse to the courts.
- The pledgor (the debtor) bears the expenses incurred for documentation, safekeeping, and any sale of the pledged asset.
Redemption of the pledge
- The creditor (the pledgee) is entitled to retain the entire pledge for any part of the debt, unless he has agreed to a partial redemption. However, the creditor is not entitled, after the payment of the relevant debt, to retain the pledge for another unsecured debt, if this was not agreed earlier.
Utilisation of a pledged asset
- It is permissible for the pledgor to use the pledged asset with the consent of the pledgee. However, the pledgee is not permitted to use the pledged asset at all, even if the pledgor has consented to this.
Destruction of (or loss of, or damage to) a pledged asset
- A pledged asset is held by the pledgee on a trust basis. Hence, its destruction, loss or damage while in the possession of the pledgee does not affect the debt obligation. If it is destroyed, lost or damaged without any misconduct or negligence on the part of the pledgee or a trustworthy third party holding the pledge for the parties (the ‘adl), then they are not liable for such destruction, loss or damage.
Insurance for a pledged asset
- It is permissible for the creditor at the conclusion of a credit transaction to request the debtor to take out an insurance protection on the pledged asset and to assign the insurance benefit to the creditor, so that in case the pledged asset is damaged (without misconduct or negligence), before payment of the amount of the debt, the indemnity amount or insurance benefit shall replace the pledged asset.
Bringing forward future instalments in case of default on payment
It is permissible to include a term in a debt contract to the effect that, if the debtor defaults on the payment of one or more instalments, some or all of the future instalments shall fall due immediately, provided the default was not caused by unforeseeable intervening events or force majeure.
Termination of a sale on deferred payment terms in case of failure to pay
- The seller is entitled, in a contract of sale on a deferred payment basis, to stipulate that if the buyer fails to pay the price within a certain period of time, the seller is entitled to revoke the contract and repossess the sold asset without recourse to the courts.
Guarantees and their modern applications
Letters of Guarantee
- It is not permissible to take remuneration for issuing a letter of guarantee, whether is with cover or without cover, if the remuneration is intended as consideration for the guarantee per se, since the amount guaranteed and the duration of the guarantee are usually taken into consideration in computing remuneration.
- Asking an applicant for a letter of guarantee to bear administrative expenses incurred in issuing a letter of guarantee of either type (i.e.preliminary or final) is permissible in Shari’a, provided the remuneration for such expenses do not exceed the commission that others would charge for such services.
- It is not permitted for the institution to issue a letter of guarantee in favour of an applicant who will use it to acquire an interest-based loan or to conclude a prohibited transaction.
- It is permissible for the institution to charge the actual expenses incurred in issuing documentary credits. It is also permissible for the institution to charge fees for providing the required services, whether such a fee is in the form of a lump sum or a certain percentage of the credit amount, provided the duration of the credit is not considered in determining the commission.
Use of cheques or promissory notes
- There is no Shari’a objection to obtaining cheques or promissory notes from the debtor as a means to force the debtor to make timely payment of instalments in cash, whereby if the debtor pays on time such cheques or promissory notes shall be returned to him, and in the event of default on payment they may be produced for recovery.
Insurance for doubtful or bad debts
- It is permissible to subscribe to an Islamic insurance coverage as security for debt obligations and it is not permissible that debts be insured a conventional insurance basis.
Freezing cash deposits (blocking withdrawals)
- In order to secure the future payment of debts on a single payment or an instalment basis, it is permissible for the institution to stipulation that it is entitled to freeze the customer’s investment account, or to revoke his right to withdraw money from such an account entirely or to block an amount in the account equivalent to the debt, which is the preferred option.
- In a credit transaction, it is not permitted for the institution to stipulate a right to freeze the customer’s current account.
Third party guarantees (voluntary undertakings to compensate an investment loss)
- It is permissible for a third party, other than the mudarib or investment agent or one of the partners, to undertake voluntarily that he will compensate the investment losses of the party to whom the undertaking is given, provided this guarantee is not linked in any manner to the mudaraba financing contract or investment agency contract.
- It is permissible for the institution to undertake that it will underwrite the remaining shares offered for subscription after the expiry of the offer period, provided the shares are underwritten at the offer value without any consideration for the underwriting per se.
- The underwriter is entitled to receive consideration for a service it provides other than the guarantee, such as conducting a feasibility study or marketing the shares.
Guarantees in tenders, security deposits in Murabaha transactions and earnest money (urbon)
- It is permissible to obtain guarantees for tenders and this includes both the amounts paid for participating in the bid (primary cash security for participating in the bid) and the amounts paid when the contract is awarded to the successful bidder (final cash security providing evidence of ability to complete the project).
- It is permissible for the institution, in the case of a unilateral binding promise, to take a sum of money called hamish jiddiyyah (i.e. security deposit) from the purchase orderer (customer) as security for his promise.
- It is permissible to take a urboun from a buyer or lessee when a sale or lease contract is concluded, on condition that, if the contract is not terminated within the specified period during which the option to terminate the contract remains valid, such an amount will be considered as part of the consideration for the contract and, if the buyer or lessee fails to perform the contract within this period, the seller or lessor is entitled to retain the amount.
Priority right of recovery and the right to follow up
- The institution is entitled to recover first its tangible items that were sold to or manufactured for a customer and have not been paid for and can be identified among the assets of the customer.
- The institution is entitled to protect the integrity of the subject of a guarantee, such as a pledged asset, and pursue a legal action against misusing it if it is established that the person holding it is using it in a manner that may lead to losses to be borne by the institution.
- The rights of the parties holding pledges of security shall be given priority over the rights of the parties who are unsecured
- In the event of bankruptcy or liquidation, the parties in charge of the liquidation have a preferential right or priority over other creditors in recovering their rights, (i.e. the cost of any services provided in the process of liquidation).