UK: Shar´ia Compliant Outsourcing: The Basics

Last Updated: 26 August 2008
Article by John Buyers

Islamic finance is rapidly becoming big business. The size of the market has been growing by 15% a year as the range of Shar'ia compliant financial products and structures has expanded to include everything from bank accounts and residential mortgages to syndicated corporate lending.

Given the extent of outsourcing in the financial services industry, it is one of the first of these areas to come under scrutiny and outsourcers will increasingly find that they will need to ensure that the outsourcing contracts for Islamic products are Shar'ia compliant too. This article examines what the Shar'ia driven consequences for these agreements may be.

Firstly however, we need to understand what Shar'ia is and what underpins it in order to get a feel for how it could impact on outsourcings in this sector.

In essence Shar'ia is an Islamic moral code which forbids investment in or association with certain unethical products and industries, such as pornography, alcohol and tobacco. Shar'ia also prohibits amongst other things, unjust enrichment without commensurate effort. This encompasses the earning or payment of interest, speculation or gambling (maysir), and contractual uncertainty (gharar). Traditional financing techniques fall foul of many of these strictures, so Islamic financing techniques seek to create the same outcomes as traditional products by different means, for example by replacing interest payments with rent, sharing in profits though an equity stake or by the lender buying and reselling an asset at a higher price on a deferred basis.

Inevitably the area is complex. It is also necessary to point out that it is subject to constant and differing interpretation and is a matter of active and often vigorous debate between Islamic scholars and clerics as to how it may be applied in any particular situation. To add a further dimension, different Islamic schools of thought (mazhab) will have different opinions on the legitimacy of any particular structure and what is permissible will depend to a degree on the level of theological conservatism (or indeed liberalism) in that particular mazhab . The lesson to bear in mind is that Shar'ia is not a codified set of "black and white" rules, but rather a series of principles and behaviours that can be interpreted in shades of grey.

So, what are the main areas to consider in a Shar'ia compliant outsourcing ?

Default Interest and Liquidated Damages

Firstly, and most obviously, any payments made under the outsourcing contract cannot be the subject of any interest or riba. There are a number of techniques that can be used if a payment analogous to interest is requested by the parties, again, the legitimacy of which will depend upon the chosen mazhab. So for example, these can be re-expressed as a 'management charge' which produces an equivalent sum or under a more rigorous interpretation, they must be donated to charity.

Similar considerations apply to liquidated damages. These are a favourite mainstay of outsourcings which have time-critical milestones, such as system integration "build and run" type deals. Shar'ia provides that these cannot be in excess of any actual damage incurred. Anything in accrued in excess of what the actual damage is will also need to be donated to charity.

Uncertainty

Shar'ia provides that parties may not enter into an agreement that contains excessive ambiguity and uncertainty or gharar. This has been described as "ignorance over the material attributes of the subject matter and also uncertainty as to its availability and existence". Given the constraints of this short article, this is a simplification of a principle which has evolved over several hundred years of Islamic jurisprudence. It is not unusual however to end up in an outsourcing scenario where either the customer does not know what they are buying or the supplier does not know what they are delivering !

The lesson to be drawn (and to avoid any accusation of gharar) must be to ensure that appropriate service descriptions and Service Level Agreements are sufficiently granular to enable the parties to understand what is being performed when and to what level. It also draws into question the current trend in the industry for results-based rather than service-based outsourcing agreements.

Governance Mechanisms

To ensure compliance with Shar'ia, outsourcing customers and suppliers will need an additional religious layer of governance – a Shar'ia Supervisory Board typically consisting of at least an Islamic finance consultant, an Islamic academic and a cleric who can take an informed position on whether the manner in which the services are performed (or indeed any conduct under the agreement) is halal (permissible) or haram (forbidden).

Given the susceptibility of Shar'ia to interpretation, a key issue here will be the ensure that the chosen experts concerned take a consistent view of what is and is not compliant. This usually means that you should ensure that all of the board's members belong to the same mazhab if their deliberations are not to become mired in interminable theological debate.

Aside from these considerations, thought should be given to ensuring that such a body is representative of both supplier and customer as an imbalance could lead to bias towards one or other of the contract counterparties.

Fatwa

As a "belt and braces" approach, many Islamic customers will insist prior to signature of an agreement on a fatwa or formal proclamation from a suitably qualified Shar'ia expert declaring that the agreement is in conformity with Shar'ia principles.

Basis of appointment

Finally, those advising outsourcing suppliers need to be mindful of the manner in which their client is appointed. In particular, they need to avoid the agreement being construed as wakala (akin to an agency agreement) which in Shar'ia terms makes the supplier a wakeel (or agent).

Within Shar'ia, being paid a fee as wakeel raises the fiduciary duty of the wakeel beyond a normal duty of care to the same level as he or she would apply to their own business. In addition, being considered a wakeel gives the customer (certainly in Shar'ia terms) the right to terminate the agreement at any time.

In summary, understanding Shar'ia philosophy as a whole rather than an attempt to apply a set of rules is the key to ensuring that your agreement is and remains compliant.

Agreements need to be flexible enough to achieve this aim, but should of course avoid straying too far into the area of uncertainty. As the Middle East becomes more willing to invest in European and US markets and Muslims in these regions increasingly demand products that do not conflict with Islam, these issues are set to become more and more commonplace.

An adapted version of this article appears in the Summer 2008 edition of Outsource Magazine.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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