Shariah Issues in Penalty and Compensation in Financial Commitments

By Abdulazeem Abozaid, Professor at Qatar Foundation

Penalty provision relates to a breach of commitment whether in relation to work/labour or a debt. For example, when a contract obliges a property developer to pay a certain amount of money for every day of delay in delivering the project specified in the contract, or when the contract states that the debtor-buyer is committed to paying a specific amount or percentage of the debt instalment for every day of delay in repaying the debt instalment. 

Any investment company may have their fair share of defaults on payments. At Ethis, for example, they have opted for leniency and providing potential defaulters with more time to make the obligatory payments. However, certain customers could take advantage of this kind of gesture and this results in further delay, and cause serious repercussions in the company’s reputation as well as the business cash flow. 

The penalty provision has become commonplace in contracts today, especially in construction, supply and lease contracts, as well as in contracts that initiate debts, such as sale on a deferred payment basis. 

The reasons for the prevalence of the penalty provision nowadays are due to lack of transparency, the great financial harms that could result from breaching obligations, and the interdependence of contracts and obligations whereby a condition placed by one contracting party leads the other parties to reciprocate with similar conditions on the same or other contracting parties. 

For example, the purchaser in an istiṣnā‘ contract (mustaṣni‘) of a building places a penalty provision on the istiṣnā‘ seller (ṣāni‘), making the ṣāni‘ place a penalty provision on the contractor, and the latter in turn, places a penalty provision on the supplier of the building materials and so on. Ethis mainly uses Musharakah contracts however other contracts have been utilised as well including istiṣnā‘ for housing projects. 

Another reason for the prevalence of the penalty provision is to avoid or ease litigation proceedings in courts. The penalty provision comes to specify when compensation is required so that it is not left to the court, which could take months if not years to determine the basis and the amount of compensation if any. 

In fact, the idea of the penalty provision originally relates to harm; the party that could be harmed places it in case the other contracting party fails to fulfil his obligations. 

However, it has been expanded such that the contracting party conditions it on others—even if he is not actually harmed by the other failing on their obligations, and the amount of compensation is conditioned beforehand, and is not based on the degree of actual harm. 

However, the default position in Classical Shariah is to give compensation for the harm that has already occurred, and not beforehand, because the compensation is related to the size of the harm, which is only known after it occurs.

Thus, the penalty provision in its contemporary form includes novel matters that require attention to clarify the extent to which it is acceptable. 

The Shariah Stand on Penalty Provision

Here at Ethis we uphold Shariah to the highest degree. This is evident in how we carry multiple layers of Shariah screening, the first layer of screening is internal and carried out by Mufti Yousuf Sultan and his team. Mufti Yousuf Sultan is an AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) Master Trainer, experienced and Certified Shariah Advisor and Auditor (CSAA) from AAOIFI with over 10 years of experience, member of ASAS (Association of Shariah Advisors in Islamic Finance) & CIFE (Chartered Institute of Islamic Finance Executive), graduated as a Mufti in Shari’ah and Islamic jurisprudence and guest speaker all over the world. 

The second layer of screening is external and carried out by prestigious organizations such as ISRA (International Shari’ah Research Academy), AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) & IFSB (Islamic Financial Services Board) among others. 

According to Shariah, the wealth of people is protected and is prohibited to be used in non-legitimate ways or without the consent of both parties. The compensation for harm is one of the legitimate ways that is intended to overcome the harm that one of the contracting parties causes the other, whether intentionally or unintentionally. 

Whoever destroys the wealth of another person is obliged to compensate him or her for it, whether done intentionally or unintentionally. However, a question that can be raised in this context is whether it is permissible for the contracting parties to agree that in case of a breach of the contract, the one who is liable for the breach must pay the other a sum of money unrelated to the amount of harm caused by the breach.

At first look, we might find a resemblance for this in Islamic law in the so-called urbūn sale. This sale contains a condition that if the buyer rescinds the sale, the amount paid becomes the property of the seller regardless of whether the seller has been harmed by the cancellation of the contract and regardless also if the amount of ‘urbūn is higher than the amount required to alleviate the actual harm if any. 

However, to the majority of Islamic schools, urbūn is invalid simply because it represents earning for the seller without providing a counter-value, i.e. earning merely by means of stipulation. By contrast, Imam ‘Aḥmad b. Ḥanbal permits ‘urbūn based on some reports that some Sahaba (companions of the Prophet) dealt with it. 

OIC Fiqh Academy permits ‘urbūn (No 85) with no restriction on its amount or purpose, and it also acknowledges penalty provision in general but with conditions. First, the original obligation containing the penalty clause must not be a debt. Second, the penalty does not exceed the actual financial loss to the other contracting party. OIC resolution also restricts the implementation of the penalty provision to the inability of the party obliged by the condition to prove that the breach of the contract was due to a reason beyond his control. 

In fact, it is clear that the position permitting ‘urbūn sale implicitly contains the position of the permissibility of earning from a condition, i.e. the permissibility of earning from a penalty clause, because the ‘urbūn can realize earnings for the seller, and these earnings come from a condition. 

The seller is the one who conditions it and he is the one who determines the amount that the buyer pays in ‘urbūn, which is an amount that can achieve earning for him. Hence, the position taken by the Fiqh Academy in the two issues (‘urbūn and the penalty clause) contains a degree of contradiction because it permits ‘urbūn unconditionally; irrespective of the harm caused, while it restricts the penalty provision to the amount of actual harm, despite the fact that ‘urbūn, in reality, is nothing but a penalty clause.   

The more suitable position in the issue, and that which conforms to Shariah principles, is to not make the condition (penalty clause) a reason for earning, but for compensation for emphatic harm. Earning must be in return for a counter value, as the jurists state, whether it is work or investment of money in legitimate ways. In fact, ribā involves nothing but earning from a condition without a counter-value, and hence its prohibition. 

Therefore, the penalty provision must be restricted to compensation for the actual harm caused, and must not be a reason for earning. If the amount of harm cannot be precisely calculated, it can be approximated. It is no secret that permitting a penalty provision unconditionally without linking it to the actual loss opens the door to exploitation in contracts. 

The stronger party can exploit the weaker party and dictate his own conditions, especially in the modern so-called contracts of subjection (‘uqūd idh‘ān), where one of the parties has no choice but to accept the contract as it is, without having the power to adjust any clause. 

Critical Applications

1) Compensation for a delay in paying the instalments

A client of an Islamic bank could delay paying some instalments, which would harm the creditor. In this instance, the debtor/client is either insolvent (mu‘sir) and unable to repay the debt or a procrastinator (mumāṭil). 

According to Islamic law, an insolvent debtor cannot be penalized but rather should be given respite, as per the verse: “And if someone is in hardship, then [let there be] postponement until [a time of] ease” (Translation of the Holy Qur’ān 2:280). 

On the other hand, if the debtor is procrastinating, he is enforced to pay and should also be punished with a difference [of opinion] regarding the punishment; being prison or public exposure (tashhīr), based on the hadith: “.Who has money but does not pay, his honour and punishment are permissible” (Sahih Al-Bukhari 2/845).

However, the jurists never permitted the creditor to demand from the procrastinator to pay more money, because it would then turn into ribā, as it would lead to an increment in the debt in return for an extension that occurred in the time period. 

Nevertheless, some Islamic financial institutions do demand compensation from a procrastinating client, and they determine the amount based on the forgone earning whereby the client pays an average of what the bank would normally earn in the delay period. Such financial institutions attempt to justify this compensation on the basis of usurpation (ghaṣb), with the reasoning that the client has usurped the bank its right to the money and its profit.  Hence, it is incumbent upon him to return this money with the profit.

However, this position is controversial, because it supports the bank earning from a debt, which is the essence of ribā. If the justification of loss of earnings was sound, Islam would not have prohibited ribā, or would have restricted its prohibition to certain cases and not others. The bank must hedge its debt by taking adequate credit risk guarantees, and not enforce higher payments on the debtors-clients in case they delay repayment. 

2) Enforcing penalties for a delay [in payments] that the financing bank does not benefit from 

Islamic banks tend to enforce on their clients paying fines in case of default in debt payment. The bank deducts and keeps for itself an amount corresponding to the actual damages incurred due to a delay in repayment, such as the cost of following up with clients to pay their debts, and then donates the remaining amount, if any, to charitable causes. 

The aim of these fines is to make the debtor pay on time and avoid procrastination, not to earn and receive compensation. This matter seems acceptable and reasonable since it does not involve ribā on one hand, as the creditor (bank) does not earn from it, and it is necessary for the banking business on the other. If the Islamic banks do not do such, many of their clients would delay their repayments, causing the bank to lose its money and the money of depositors. 
However, it is necessary to restrict its permissibility by enforcing those fines on procrastinators only, not on the insolvent, because an insolvent person deserves charity and zakāt. It is improper to make him pay charity when he himself is in need of it. However, it is possible procedurally to enforce a fine on every defaulter, but that the money is returned to those who prove to be insolvent, such that the proof of insolvency rests on the client to have the fine retracted.

3) Annulment of a non-performing debt with another new debt

Some Islamic financial institutions invented ways of dealing with non-performing debts, which involve annulling a debt with another debt (faskh al-dayn bi al-dayn), i.e. restructuring the debt with an additional amount. 

The bank buys from the defaulting client an asset for an immediate payment that represents the value of the debt, with an agreement to lease that asset as an ijārah ending-in-ownership whereby the total instalments are increased above the amount of the purchase. Hence, the bank achieves annulment of the old debt with a newly increased debt, as the old debt is set off against the asset’s selling price, and the client will have to pay the new debt as ijārah instalments. 

This ijārah contract is a bogus contract, especially that the bank does not bear responsibility for any of the ownership liabilities as the new owner of that asset. Some banks instead use either tawarruq or ’īna contracts for the same aim of annulling previous debts with new ones. 

In the case of tawarruq, the bank would sell an asset to the client (whose debt liability is 100k for example) for 110k, and then sell it on his behalf in the market for 100k, using the latter amount to settle the old liability and creating a new debt with 10k increase to compensate for the foregone profit. In the case of ’īna, the bank would sell the client an asset for 110k and then buy it back for 100k, using the latter amount to settle the old liability and creating a new debt with 10k increase to compensate for the foregone profit.

In truth, using sale or ijārah contracts with the aim of restructuring debts, or to achieve for-profit cash financing, represents a misuse of these contracts, and contradicts an agreed-upon Shariah principle – the prohibition of providing money for a guaranteed profit as occurs with the riba-bearing loans, and the prohibition of annulling a debt with another debt. 

In conclusion, penalty or compensation provision in contracts is accepted as long as it is within the framework of removing the actual harm done and not gaining because gaining merely by virtue of stipulation is forbidden in Islam. Ribā is in fact nothing but gaining through stipulation. However, compensation must never include gaining from penalties imposed upon debtors, and the increase in debt, in this case, is unlawful regardless of the method used to achieve it. 

Ethis refuses to simply be a messenger of bad news in the case of defaults on payments. Therefore, initiatives are being taken to implement penalties & compensations through restructuring of contracts should default on payments happen in the future.

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