Law and Practice of Islamic Banking and Finance

by Dr Nik Norzrul Thani Mohamed Ridza Mohamed Abdullah Megat Hizaini Hassan U-!.,

MALAYSIA • SINGAPORE • HONG KONG SWEET & MAXWELL ASIA 2003 Contents

Dedication vii Preface ix About the Authors xi Acknowledgment xiii Table of Cases xxiii Table of Statutes xxv

Chapter One The Islamic Financial System in Malaysia 1 1.0 Malaysia — In brief 1 2.0 The Malaysian financial system 1 2.1 The banking system 2 \ 2.2 The non-bank financial intermediaries 2 2.3 The financial markets 4 3.0 Regulatory framework of the Malaysian financial system 5 3.1 The financial system and BAFIA 7 3.2 Other regulatory authorities 8 4.0 Rationale for the establishment of an Islamic Bank in Malaysia 9 4.1 International perspective 9 4.2 Mobilisation of Muslim funds 11 4.3 Response to Islamic resurgence 12 5.0 Pioneering Islamic Banking - The establishment of Bank Islam Malaysia Berhad (BIMB) 13 5.1 Origin of the proposal 13 5.2 The National Steering Committee on Islamic Banking... 14 6.0 Requirements for an Islamic banking system 17 6.1 A broad variety of instruments 17 6.2 Large number of players 18 6.3 An Islamic inter-bank money market 19 7.0 The Malaysian Islamic financial system - related developments 20 7.1 companies (Islamic insurance) 20 7.2 Islamic capital market 20 7.3 Labuan - Islamic Offshore Financial Centre 22 8.0 International developments in Islamic finance 22 8.1 International Financial Services Board (IFSB) 22 8.2 International Islamic Financial Market (IIFM) 23 8.3 The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) 23 xvi Contents

8.4 Islamic Corporation for the Development of the Private Sector (ICD) 25 8.5 International Islamic Rating Agency (IIRA) 27 8.6 The Islamic Development Bank 28 8.7 General Council for Islamic Banks and Financial Institutions (GCIBFI) 28 8.8 The Institute of Islamic Banking and Insurance 29 8.9 Islamic Research and Training Institute (IRTI) 31 8.10 The Dow Jones Islamic Market Indexes 32 9.0 Conclusion 32

Chapter Two Islamic Financial Products: History and Concept 33 1.0 Financial products in Islam: Equity financing and debt financing 33 2.0 Equity financing and debt financing - Differences with conventional 35 3.0 Islamic financial products in Malaysia 37 3.1 Al-Bai' Bithaman Ajil (Credit sale) 38 3.2 Bai' Salam (Advance purchase) 39 3.3 Istisna' (Commissioned manufacture) 42 3.4 (Leasing) 44 3.5 Ijarah Thumma Bai' 48 3.6 MudharabahlMuqaradhah (Profit-sharing) 49 3.7 Musharakah (Partnership) 53 3.8 Musharakah Mutanaqisah {Musharakah Muntahiah Bi Al-Tamlik) 56 3.9 Murabahah (Set profit sale) 57 3.10 Rahn (Pledge/security) 59 3.11 Dhaman/kafalah (Guarantee) 61 3.12 Hawalah (Assignment) 64 3.13 Qardh al-Hasan 67 3.14 Bai'Al-'Inah 68 3.15 Bai'Al-Dayn 69 3.16 Bai'Muzayadah 71 3.17 Haq Tamalluk 71 3.18 Hibah 71 3.19 Ibra' 71 3.20 Ittifaq Dhimni 72 3.21 Sanadat 72 3.22 72 3.23 Ujrah/Ajr 72 3.24 Muqaradhah bonds an alternative for Islamic debt bonds 72 Contents xvii

4.0 Middle-East as a role model 74 5.0 Conclusion 75

Chapter Three Legal Framework of Islamic Banking 77 1.0 Licensing of Islamic banks 77 1.1 Islamic banking business 79 1.2 Government Investment Act 1983 83 2.0 Banking operations of Islamic banks 84 2.1 Customers' deposits , 84 2.2 Financing 86 2.3 Trade finance 87 2.4 Other services 89 2.5 Review of the banking operations of Islamic banks and IBS 90 2.6 Resolution of disputes for Islamic financial transactions.. 92 2.7 Implications of Islamic banking on current tax laws 94 3.0 The future of Islamic banking in Malaysia 96 4.0 Master Plan for Islamic banking 100 4.1 Master Plan — Vision and objectives for Islamic banking and Takaful 101 4.2 Recommendations of the Master Plan 102 4.3 Establishment of an effective legal sructure 104 5.0 Conclusion 104

Chapter Four Legal Framework of Islamic Capital Market 105 1.0 Development of the Islamic capital market 105 2.0 Main legislation and guidelines governing Islamic capital market 106 2.1 Securities Commission Act 1993 107 2.2 Guidelines on the Offering of Private Debt Securities... 111 2.3 Guidelines on the Offering of Asset Backed Debt Securities 114 2.4 Guidelines on the Minimum Contents Requirements for Trust Deeds 118 2.5 Guidelines on Contents of Prospectus for Debentures ..119 2.6 Controller of Foreign Exchange 120 2.7 Real Time Electronic Transfer of Funds and Securities ("RENTAS") 120 2.8 Fully Automated System for Tendering ("FAST") 124 2.9 Rules on Bond Information and Dissemination System (BIDS) 126 xviii Contents

Chapter Five Islamic Trade Finance 127 1.0 Introduction 127 2.0 Islamic trade financing 128 2.1 Letter of credit (Contract: Al-Wakalahl'Agency) 129 2.2 Letter of credit (Contract: Al-Murabahah/Dekrred lump-sum sale or cost plus) 131 2.3 Letter of credit (Contract: Al-Musharakah/]o'mt-ventu.re profit-sharing) 132 2.4 Letter of guarantee (Contract: Al-KafalahlGuarantee)... 133 2.5 Islamic accepted bill (Contract: Murabahah) 134 2.6 Securitisation and export financing (LAB-EXPORT) (Contract: Bai' Al-Dayn/Debt trading) 135

Chapter Six Practical Applications of Islamic Banking & Finance: Legal Documentation for (A) Islamic Banking (B) Islamic Private Debt Securities 137 1.0 Islamic banking 137 1.1 Bai' Inah 137 1.2 Ijarah 142 2.0 Islamic private debt securities (IPDS) 145 2.1 Al-Bai' Bithaman Ajil (Islamic debt securities) 145

Chapter Seven Legal Framework of Takaful 151 1.0 Introduction 151 2.0 Conventional vs Islamic insurance 154 3.0 Various schemes and products of Takaful insurance 158 3.1 Family solidarity business 158 3.2 General business 160 4.0 Legal documentation 161 5.0 Legal position...! 161 6.0 Conclusion 165

Chapter Eight Legal Aspects of Electronic Islamic Banking 167 1.0 Introduction 167 2.0 Definitions 168 2.1 E-Banking 168 3.0 Islamic bank and Islamic banking business 176 Contents xix

4.0 Malaysia's legal framework on e-banking 177 4.1 Law of contract and agency 177 5.0 The BAFIAon EFT 177 6.0 BNM guidelines 178 7.0 Code of good banking practice 180 8.0 Additional laws 180 9.0 Legality of e-Islamic banking under the Shari'ah 181 10.0 Legal issues on e-Islamic banking 182 10.1 Requirement of witness 182 11.0 Contract of further obligations 183 12.0 Management of accounts 184 13.0 Conclusion 185

Chapter Nine Labuan as an Islamic International Offshore Financial Centre 187 1.0 History of Labuan 187 2.0 Characteristics of an international offshore financial centre 188 3.0 Labuan Offshore Financial Services Authority (LOFSA) 190 4.0 Labuan as an Islamic IOFC 193 4.1 Development of Islamic finance in Labuan 193 4.2 The global Islamic financial market 197 4.3 Conceptual framework of the International Islamic Financial Market 199 4.4 New and innovative Islamic financial instruments 202 5.0 Legal framework 204 5.1 Offshore Banking Act 1990 204 5.2 Offshore Companies Act 1990 and the Labuan Trust Companies Act 1990 211 5.3 Tax structure 216 5.4 The Labuan Offshore Trusts Act 1996 219 5.5 The Labuan Offshore Limited Partnerships Act 1997... 219 5.6 The Labuan Offshore Securities Industry Act 1998 221 5.7 Regulatory changes to offshore legislation 223 6.0 Liberalisation of entry criteria for offshore banking 225 7.0 Infrastructure 226 8.0 Labuan International Financial Exchange (LFX) 227 8.1 Participants of the LFX 228 8.2 Benefits of the LFX 229 8.3 Opportunities at LFX 230 8.4 Opportunities for Shari'ah based investment at the LFX230 9.0 E-Commerce Gateway 231 10.0 Labuan and the master plan 232 10.1 Vision and objectives 233 Contents

10.2 Recommendations of master plan 233 10.3 Approach to implementation 238 11.0 Future prospects for Labuan as an Islamic financial centre 238

Chapter Ten Islamic Currency — Legal Aspects of Gold 241 1.0 Introduction 241 2.0 The need for an Islamic currency . 242 2.1 Features and characteristics of dinar 242 2.2 Not a 243 3.0 Malaysia's current monetary legal framework 244 3.1 Ringgit and sen as the Malaysian currency 244 3.2 Exchange control mechanisms 245 3.3 Limited application of gold dinar 246 4.0 Legal framework for gold dinar as a primary medium of exchange 248 4.1 The Shari'ah aspects of gold dinar 248 4.2 The legal framework for the use of gold dinar in Islamic business and banking 249 5.0 The legal effect of gold dinar 252 6.0 Conclusion 253

Chapter Eleven Conclusion 255 1.0 The global phenomenon of Islamic banking and finance 255 1.1 Bahrain 255 1.2 United Arab Emirates 256 1.3 Iran 257 1.4 Pakistan 257 1.5 Sudan 258 1.6 Indonesia 259 2.0 Recent developments in Islamic banking and finance - Proposed legislative amendments 260 2.1 Central Bank of Malaysia (Amendment) Bill 2003 [DR 25/2003] 262 2.2 Amendments to BAFIA - the Banking and Financial Institutions (Amendment) Bill 2003 [DR 23/2003].... 265 2.3 Amendments to the Islamic Banking Act - the Islamic Banking (Amendment) Bill 2003 [DR 24/2003] 265 2.4 Amendments to the Takaful Act - Takaful (Amendment) Bill 2003 [DR 22/2003] 266 3.0 Concluding remarks 266 Contents

Appendices

Islamic Banking Act 1983 271 Takaful Act 1984 313 Guidelines on the Offering of Private Debt Securities 373 Guidelines on the Offering of Assets-Backed Debt Securities 401 Guidelines on the Minimum Contents Requirements for Trust Deeds 423 Guidelines on Contents of Prospectus for Debentures 441 Guidelines on Bond Information and Dissemination System (BIDS) 469 Rules on Fully Automated System for Issuing/Tendering (FAST) 511 Rules on the Scripless Securities Under the Real Time Electronic Transfer of Funds and Securities (RENTAS) System 585

Subject Index 641 Bibliography 655