Research Paper (printed copy)

Critical Appraisal of the Letter of Guarantee (Khi?āb al-?amān) in Malaysian Islamic Finance Practices AUTHORS: Mohd Bahroddin Badri Assoc. Prof. Dr. Said Bouheraoua
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EXECUTIVE SUMMARY

 

A letter of guarantee is an indemnity letter issued by a guarantor under the principle of kafālah―the term used in Malaysia for a guarantee—to guarantee the payment obligation should the guaranteed party fail to fulfil its contractual obligations. In other words, the issuer commits itself to pay a specified amount to the beneficiary in the event of non-performance of obligation by the guaranteed party. In order to understand the application of kafālah in guarantee facilities, the paper examines some selected structures of kafālah-based guarantee products that exist in the market with special reference to Malaysian practice. This research examines the application of kafālah in guarantee facilities offered by Islamic financial institutions; i.e., Islamic Bank Guarantee and Islamic Shipping Guarantee. The paper also studies the guarantee facility offered by the Credit Guarantee Corporation Malaysia Berhad, which aims to assist small and medium enterprises (SMEs) in Malaysia to obtain financing from financial institutions, particularly for those with insufficient collateral. It includes a guarantee facility offered by Cagamas (The National Mortgage Corporation) SRP Berhad under the Malaysian Government initiative of Skim Rumah Pertamaku @ SRP (My First Home Scheme) to enable young Malaysian citizens to own their first house without having to pay a 10% down payment. Under this scheme, the applicant can get 100% financing from the financial institution with the 10% being guaranteed by Cagamas SRP.

 

Despite the increasing demand for this product, the instrument’s underlying structure, which is kafālah bi al-ajr (a guarantee with a fee), is still debated among jurists. The main Sharī?ah issue in guarantee facilities is the imposition of a fee on the client in exchange for the guarantee offered. The research shows that the majority of the classical texts consider charging a fee for a guarantee to be impermissible. On the other hand, some contemporary jurists hold that charging a fee for a credit guarantee is permissible. Realizing that there are several Sharī?ah issues arising from the imposition of a fee for a guarantee, this research explores the ruling on kafālah bi al-ajr. The arguments of both supporters and opponents of a guarantee with a fee are examined in order to understand the basis of their views.

 

The jurists who oppose charging a fee for a guarantee argue that, since a guarantee is characterized as a benevolent contract, it is not feasible to impose any charge for it. The objective of a guarantee is to assist those who are in need, based on generosity and benevolence, and it should not be used as a profit-making instrument. They further argue that in the event that the guaranteed party (makfūl ?anhu) manages to fulfil his financial obligation to the financier, which results in the financier-cum-beneficiary (makfūl lahu) getting the full amount of the debt, there is no justification for the guarantor (kafīl) taking a fee from the guaranteed party. As such, it can be considered as illegally taking the rights of others.

 

The biggest issue of charging a fee for the guarantee is that it leads to ribā al-qar?, especially when default takes place. In the event of default, the guarantor has to settle the debt that the guaranteed party owes to the beneficiary. This places the guaranteed party in a position of indebtedness to the guarantor, and thus the guarantor is entitled to reclaim the amount from the guaranteed party. Ribā comes into the picture when the guarantor is presumed to receive the fee imposed earlier over and above the full amount of the debt owed to him. This scenario triggers the issue of qar? jarra manfa?ah where any benefit derived from a loan is deemed as ribā. AAOIFI holds that charging a fee for a guarantee is only allowed when it involves the actual cost according to the standard market price, meaning that there should not be any profit-making element in the fee payment (AAOIFI, 2010). The actual cost comes into the picture when the guarantee involves costs such as legal fees, documentation, administrative costs and stamp duty.

 

On the other hand, the proponents argue that there is no clear textual evidence from the Qur’ān or the Sunnah that prohibits the charging of a fee for a guarantee. Even though the guarantee contract falls under the category of benevolent acts, it does not necessarily mean that charging a fee on such a contract is forbidden. Furthermore, they argue that a guarantee is not similar to a qar?. The issue of ribā does not arise as the fee for the guarantee is regarded as the price for the commitment. A guarantee should not be treated as debt; instead, it should be regarded as a commitment to pay the beneficiary in the event of default by the guaranteed party. Commitment is the counter-value in exchange for the fee. By contrast, a counter-value is absent in interest-based lending transactions. Some jurists affirm the permissibility of taking compensation for certain types of commitment. The guarantor deserves the fee for the risk factor, which is the guaranteed party’s inability to settle his debt. Some proponents argue that it is almost impossible currently to find a guarantor who is willing to give a guarantee without charging any fee, particularly when it involves a big amount of money. Therefore, permissibility should take place based on isti?sān (juristic preference) in order to realize public interest. Otherwise, the effect might be worse because the public would be forced into taking guarantees from conventional banks.

 

The research realises that the major concern regarding the prohibition of charging a fee for a guarantee is to avoid ribā. This is obvious because when the guaranteed party is indebted to the guarantor the fee over and above the debt is deemed as ribā. However, it is worth noting that the relationship between the guarantor and guaranteed party is not a creditor-debtor relationship in any circumstance except the occurrence of default.

 

The view favoured in this paper is that if the bank determines prior to issuing the guarantee that the customer (guaranteed party) will be unable to pay the debt, then taking compensation for the guarantee is prohibited from day one. However, if that is not the case, the authors favour the opinion that it is allowed to accept a fee for the guarantee, as long as there is no default by the customer. If the customer defaults and the guarantor settles the outstanding amount to the beneficiary, the guaranteed becomes indebted to the guarantor. In this case, the guarantor is not allowed to charge any additional fees besides the actual cost incurred.




Critical Appraisal of the Letter of Guarantee (Khi?āb al-?amān) in Malaysian Islamic Finance Practices
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