Well informed.

The role of Shariah scholars Islamic Finance: Client Guidance Note 2

Introduction: We are often asked about the role of the Shariah scholars in Islamic financial transactions. This Client Guidance Note is intended to provide the reader with some brief insights into who the Shariah scholars are and what roles they perform. It also identifies some of the factors that may influence why there can be variations in opinions (or fatawa) issued by different scholars.

Who are the Shariah scholars? The Shariah scholars who support the Islamic financial services industry are individuals who have acquired a deep knowledge of the Shariah and Islamic jurisprudence. They have usually also attained varying degrees of knowledge of other subjects such as law (i.e. the secular law of various jurisdictions) economics, finance and banking. The ability of an individual to practice as a Shariah scholar generally requires the person concerned to gain acceptance by the Umma (i.e. the wider Muslim community). In effect an individual who holds himself (and in some cases herself) out as a Shariah scholar will only be successful in that role if he/she is accepted by the community to which he/she appeals and his/her opinions are considered as being properly formed and worthy of being followed. There is a large degree of personalisation based upon respecting the individual as a worthy, morale person, a ‘good Muslim’.

What is their role? The roles that Shariah scholars are required to perform can be divided into three essential elements, as follows:

> Advisory – this role encompasses ensuring that arrangements entered into between the parties to a transaction or the arrangements contemplated by a particular financial product do not violate Shariah; it also extends to ensuring that investments are not made against the injunctions of the Shariah or where the extent of prohibited activities is in excess of a tolerable level as set forth in Fatawa

> Approval – the approval role requires the Shariah scholar to look holistically at a transaction to ensure that investors are not directly or indirectly (i.e. through hiyal activities) making non-compliant investments and to ensure that any tainted income is not distributed to investors but is purified (e.g. given away to charity)

> Audit – the audit role involves the conduct of an ongoing Shariah compliance monitoring function (usually an internal function) and the provision of an ex post compliance verification exercise. The latter exercise might also be conducted internally but should ideally be undertaken by an independent external Shariah function

Conflicts of interest and role confusion: There are several important aspects of these various roles to be aware of. The three roles of advice provision, approval and subsequent audit do offer the potential for conflicts of interest to arise if they are performed by, for example, a single scholar or the same members of a Shariah Supervisory Board. The precise way in which Shariah scholars provide their inputs has evolved alongside the development of the industry and it is likely to continue doing so. It is generally considered important not to confuse the advisory role of the Shariah scholar with the executive role of the directors (i.e. the function is advisory and non executive) and seek to assume an executive capacity.

Qualifications and education: At the present time there is no generally accepted, globally binding understanding of precisely what Shariah, academic, jurisprudential and/or vocational experience a Shariah scholar should have. Some countries (e.g. Malaysia) have sought to outline basic standards as they endeavour to start professionalising the Shariah scholar community. The Shariah scholar community also lacks any form of professional body setting out such things as minimum educational requirements and what professional standard of care should apply to the work of practicing Shariah scholars.

The role of Shariah scholars.What is a Fatwa and how does it influence Islamic finance?

At its simplest a Fatwa (the plural of which is Fatawa) is an opinion issued by a Shariah scholar, or a group of Shariah scholars sitting as a Shariah Supervisory Board (see below), that indicates whether or not, in his, or their opinion, the transaction or product which is being opined upon is, or should be considered as being, Shariah-compliant. It is worth keeping mind that a Fatwa differs in several important respects from a juridical ruling (or Hukm) issued to end a dispute. Amongst the differences, a judgment is issued by a court or judge – a Fatwa is issued by a Shariah scholar (not acting in a judicial capacity); a judgment is mandatory/obligatory/binding – a Fatwa is not and a judgment is based on evidence provided to a judge, whilst a Fatwa is based on religious proscription as determined by the Shariah scholar.

Two processes are invariably involved in the delivery of a Fatwa: the first might be described as the ‘determinative’ process and the second as the ‘administrative’ procedure. The precise way in which these two elements will be delivered in any particular matter will vary on a case by case basis.

> The determinative process is concerned with the steps that the Shariah scholar should take in order to conduct the correct analysis of the fact pattern before him with a view to reaching his opinion on the permissibility of the arrangements being contemplated. This is the intellectual work that has to be performed by the Shariah scholar whether he is advising individually or as a member of a Shariah Supervisory Board. It involves the rigorous process of checking the sources of Shariah and has been described by a commentator as follows: “Fatwa in Islamic finance is a discovery of Shariah ruling by a competent Shariah scholar on unclear matters in Islamic finance by providing legal Shariah opinion extracted from Islamic sources through a process of Ijtihad on a particular religious matter after the demise of the Prophet (s.a.w.) in the light of the Shariah rules and Islamic jurisprudence principles.”

> The administrative process is concerned with the way in which the parties seeking the Fatwa engage with the Shariah scholar/Shariah Supervisory Board in order to obtain the Fatwa. In the early days of the Islamic finance industry this process of engagement was fairly ad hoc and would vary significantly from transaction to transaction. At the current time, there are still various ways in which Shariah scholars disseminate their advice either acting as an individual, through an advisory firm or as an appointed member of a Shariah Supervisory Board. Regardless of the capacity in which the Shariah scholar is operating, the industry has evolved the process illustrated in the diagram to the right, with a view to ensuring efficiency and cost effectiveness in the entire process. The concern is to avoid the sort of problems that were all too often encountered in the industry’s early days when documentation would be advanced without explicit prior Shariah scholar approval only to have to be re-written, or discarded, if the Shariah scholars subsequently disapproved what had been prepared. It is now common (and desirable) for a structure paper and/or detailed term sheet to be prepared and approved by the issue of an ‘interim’ Fatwa by the relevant Shariah scholars. This provides a secure platform for the transaction documentation to be developed and the remaining due diligence undertaken. Over the years, the bankers and their legal advisers have also become better as spotting potential Shariah issues and seeking their resolution before they have the potential to de-rail a transaction.

Shariah scholars: the Fatwa process.

What is a Shariah Supervisory Board?

A Shariah Supervisory Board (or SAB) is a formal committee that is established (most often by financial institutions) to consider, advise and provide guidance to the institution that has established it regarding matters of Shariah. The constitutional documents of a financial institution that seeks to operate as a wholly Shariah-compliant firm will usually require the Board of Directors to appoint an independent SAB that can advise the Board on matters of Shariah observance. In several jurisdictions in the Muslim world, in particular, the relevant financial regulator has made the establishment of such a function mandatory.

Other organisations such as conventional banks with Islamic windows and investment management firms or funds, may also establish SAB’s. The SAB’s formative document will set out its terms of reference, how often it should meet and generally how it should engage with and report to the Board.

Organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have also published guidance as to how Islamic financial institutions should manage the question of Shariah compliance and governance. In addition to the establishment of an external SAB, there are also guidelines available concerning the internal Shariah monitoring and compliance procedures that can be followed.

Preliminary Structure

Memorandum

Prepared by financiers, lawyers and accountants

Informal discussions with Shariah Scholars

Interim FatwaProvided by Shariah Supervisory Board based on the preliminary structure memorandum

Due DiligenceAnalysis of legal, commercial, tax and credit risk etc.

Draft Documentation

Prepared by lawyers with input from financiers and, if necessary accountants

Informal discussions with Shariah Scholars

Final FatwaProvided by Shariah Supervisory Board based on the documentation

The prominent Schools of Thought.

Why do Shariah opinions vary?

Shariah scholars are criticised, sometimes unfairly, for the variability of their opinions. It may be helpful to consider this in context. One of the important elements of the Muslim religion is that man has a direct nexus to God and he can read about that through the revelations contained in the Qur’an. Although there should be no intermediary between man and God, for reasons of literacy the religious men of the time would read the Qur’an and lead prayers. As scholars studied the sources of Shariah the four prominent Sunni Schools of Thought (or mahdabs) arose which reflected the thinking of the individuals after whom the schools were named (see box). The approaches of these Schools of Thought inform, to varying degrees, the thinking of Shariah scholars working in Islamic finance in the present time.

It is often argued by the Shariah scholar community that they are in agreement on the vast majority of questions they are asked to consider and it is only at the margins where they have major differences of opinion and further, without such differences, there would have been none of the evolution in products we are currently witnessing.

Perhaps the frustration for practitioners is when Shariah scholars appear to change their minds even when opining on a substantially identical fact pattern to a previous transaction. The challenge here is to identify whether the reason for the adjusted view is because the prior deal was approved on an exemplary basis or the previous decision has been forgotten because of poor administration or disregarded through a lack of professional consistency. Our experience suggests that despite occasional hiccups, the Shariah approval process has become more consistent and is generally less capricious than it was in the industry‘s formative years.

> Named after Iraqi scholar Abu Hanifa > Most prominent among all Sunni schools and has the most adherents in the Muslim world

> Reputed for putting greater emphasis on the role of reason and being more liberal

Hanafi

> Derived from the work of Malik Ibn Anas > Second-largest of the four madhabs, followed by approximately 25% of Muslims

> Sunnah includes not only what was recorded in hadiths, but the legal rulings of the four rightly guided caliphs, ijma’, qiyas & ‘urf

> When forced to rely upon conflicting authenticated hadiths to derive a ruling, Mālik īs would then choose the hadith that has a Medinan origin

Maliki

> Named after Imam Ash-Shafi’i > Emphasises proper derivation of laws through the rigorous application of legal principles as opposed to speculation or conjecture

> Adopt systematic methodology to religious science

Shafi’i

> Traced back to Imam Ahmad Ibn Hanbal but institutionalised by his students

> Considered very strict and conservative, especially regarding questions of dogma and cult

Hanbali

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