Murabaha - as a mode of finance

Originally, murabahah was a particular type of sale and not a mode of financing. The ideal mode of financing according to Shariah are mudarabah or musharakah. However in the perspective of the current economic circumstance there are certain practical difficulties in using mudarabah and musharakah as instruments in every type of financing. Therefore, the contemporary Shariah experts have allowed, subject to certain conditions, the use of murabahah on a deferred payment basis as a mode of financing. However, there are two important and essential points which must be remembered in this respect:

1. It should never be overlooked that originally murabaha was not a mode of
    financing. Murabahah is only a device to escape from "interest" and not an
    ideal instrument for carrying out the real economic objects of Islam.
    Therefore, Murabahah as an instrument of financing should be used as a
    transitory step taken in the process of the Islamization of the economy and
    its use should be restricted to those cases where mudarabah or musharakah
    are not practicable.

2. The murabahah transaction does not come into existence by merely
    replacing the word 'interest' by the words "profit" or "mark-up". Actually,
    murabahah as a mode of financing, has been allowed by the Shariah
    scholars with some conditions. Unless these conditions are fully observed,
    murabahah is not permissible. In fact it is the observance of these
    conditions which can draw a clear line of distinction between the
    interest-bearing loan and the transaction of murabahah. If these conditions
    are not observed, the transaction becomes invalid according to Shariah.

Basic features of Murabahah financing

1. Murabahah is not a loan given o interest. It is a sale of a commodity for a
    deferred price which includes an agreed profit added to the cost.

2. Being a sale and not a loan, murabahah should fulfill all the conditions
    necessary for a valid sale.

3. The financier must have a good title to the commodity before he sells it to
    his client.

4. The commodity must come into possession of the financier, whether
    physically or constructively, in the sense that the commodity must be in 
    the risk of the financier even though the risk may be for a short period.

5. The best way for murabahah according to Shariah is that financier himself
    purchases the commodity and keeps it in his own possession or purchases
    the commodity through a third person appointed by him as his agent before
    he sells it to the customer. However, it is also allowed that the financier
    may make the client himself his agent to buy the commodity on his behalf.
    In this case the client first purchases the commodity on behalf of his
    financier and takes possession as such. Thereafter, he purchases the
    commodity from the financier for a deferred price. His possession of the
    commodity in the first instance is in his capacity as an agent of the
    financier. In this capacity he is only a trustee while the ownership vests in
    the financier and the risk of the commodity is also borne by the financier as
    a logical consequence of the ownership. However, when the client
    purchases the commodity from the financier, the ownership as well as the
    risk is transferred to the client.

6. As mentioned earlier, the sale cannot take place unless the commodity
    comes into the possession of the seller but the seller can sign an 
    agreement to sell even when the commodity is not in his possession. The
    same rule is applicable to murabahah.

7. In the light of the aforementioned principles, a financial institution can use
    the Murabahah mode of financing by adopting the following procedure:

All the abovementioned five stages are necessary to effect a valid murabaha sale. The most essential element of the transaction is that the commodity must remain in the risk of the institution during the period between the third and the fifth stage. This is the only feature of murabahah which can distinguish it from an interest-based transaction. Therefore, it must be observed with due diligence otherwise the murabahah transaction becomes invalid according to Shariah.

8. It is also a necessary condition for the validity of murabahah that the
   commodity is purchased from a third party. The purchase of the commodity
   from the client himself on a buy back agreement is not allowed in the
   Shariah. Thus murabahah based on 'buy-back' agreement is nothing more
   than an interest-based transaction.

9. The abovementioned procedure of the murabahah financing is a complex
    transaction in which the parties involved have different capacities at
    different stages as follows:

(a) At the first stage, the institution and the client agree to sell and purchase
     a commodity in the future. This is not an actual sale. It is only a promise 
     to effect a sale in future on a murabahah basis. Therefore, at this stage
     the relationship between the institution and the client is that of a promisor
     and a promisee.

(b) At the second stage, the relationship between the parties is that of a
     principal and an agent.

(c) At the third stage, the relationship between the institution and the supplier
     is that of a buyer and seller.

(d) At the fourth and fifth stages, the relationship of buyer and seller comes
     into existence between the institution and the client and since the sale is
     affected on a deferred payment basis the relationship of a creditor and
     debtor also emerges between them simultaneously.

All these capacities must be kept in mind and must come into operation with all their consequential effects each at its relevant stage and these different capacities should never be mixed up or confused with each other.

10. The institution may ask the client to furnish security to its satisfaction for
     the prompt payment of the deferred price. It may also ask him to sign a
     promissory note or bill of exchange but it must be after the actual sale
     takes place i.e. at the fifth stage mentioned above. The reason is that the
     promissory note is signed by a debtor in favour of his creditor but the
     relationship of debtor and creditor between the institution and the client
     begins only at the fifth stage whereupon the actual sale takes place
     between them. 

11. In the event of default by the buyer (client) in respect of the payment of
     the purchase price on the due date, the purchase cannot be increased.
     However, if he has undertaken in the agreement to pay an amount for a
     charitable purpose, as mentioned in clause 7 of the rules of Bai'Mu'ajjal, he
     shall be liable to pay the amount undertaken to be paid by him. However,
     the amount so recovered from the buyer shall not form part of the income
     of the seller/ the financier. The financier is bound to spend it for a
     charitable purpose on behalf of the buyer (client).