Penalty of Default

Another problem in murabahah financing is that if the client defaults in payment of the price at the due date, the price cannot be increased. In interest-based loans, the amount of loan keeps on increasing according to the period of default. But in murabahah financing, once the price is fixed, it cannot be increased. This restriction is sometimes exploited by dishonest clients who deliberately avoid to pay the price at its due date, because they know that they will not have to pay any additional amount on account of default.

This characteristic of murabahah should not create a big problem in a country where all the banks and financial institutions are run on Islamic principles, because the government or the central bank may develop a system where such defaultors may be penalized by depriving them from obtaining any facility from any financial institution. This system may serve a a deterrent against deliberate defaults. However, in the countries where the Islamic banks and financial institutions are working in isolation from the majority of financial institutions run on the basis of interest, this system can hardly work, because even if the client is deprived to avail of a facility from an Islamic bank, he can approach the conventional institutions.
In order to solve this problem, some contemporary scholars have suggested that the dishonest clients who default in payment deliberately should be made liable to pay compensation to the Islamic bank for the loss it may have suffered on account of default. They suggest that the amount of this compensation may be equal to the profit given by that bank to its depositors during the period of default. For example, the defaulter has paid the price three months after the due date. If the bank has given to its depositors a profit at the rate of 5%, the client has to pay 5% more as compensation for the loss of the bank. However, the scholars who allow this compensation make it subject to the folowing conditions:

(a) The defaulter should be given a grace period of at least one month after the maturity date during which he must be  given weekly notices warning him that he should pay the price, otherwise he will have to pay compensation.

(b) It is proved beyond doubt that the client is  defaulting without  valid excuse. If it appears that his default is due to poverty, no compensation can be claimed from him. Indeed, he must be given respite until he is able to pay, because the Holy Qur’an has expressly said:

And if he (the debtor) is short of funds, then he must be  given respite until he is well off. (2:280)

(c) The compensation is allowed only if the investment account of the Islamic bank has earned some profit to  be distributed to the depositors. If the investment account of the bank has not earned profit during the period of default, no compensation shall be claimed from the client.

This concept of compensation, however, is not accepted by the majority of the present day scholars. (including the author). It is the considered opinion of such scholars that this suggestion neither conforms to the principles of Shariah nor is it able to  solve the problem of default.

First of all, any additional amount charged from a debtor is riba. In the days of jahiliyyah (before Islam) the people used to  charge additional amounts from their debtors when they were not able to pay at the due date. they used to say. Either you pay off the debt or you increase the payable amount.

The aforementioned suggestion of paying compensation to the creditor/seller resembles the same attitude.
It can be argued that the above suggestion is theoretically different from the practice of jahilliyah in that the suggestion is to grant the debtor a grace period of one month to make sure that he is avoiding payment without a valid cause and to exempt him from compensation if it  appears that his non-payment is due to poverty or a hardship. But in practical application of the concept, these conditions are hardly fulfilled, because every debtor may claim that his default is due to his financial inability at the due date, and it is very difficult for a financial institution to hold an inquiry about the financial position of each client and to verify whether or not he was able to pay. What the banks normally do is that they presume that every client was able to pay unless he has been declared as bankrupt or insolvent. It means that the concession allowed in the suggestion can be enjoyed only by the insolvent people. Obviously, insolvency is a rare phenomenon, and in this rare situation, even the interest-based banks cannot normally recover interest from the borrower. Therefore, the suggestion leaves no practical and meaningful difference between an interest based financing and an Islamic financing.

So far as grace period is concerned, it is a minor concession which is sometimes given by the conventional banks as well. Once again, in practical terms, there is no material difference between interest and the late payment charged as compensation.

It is argued in favor of charging compensation that the Holy Prophet ? has condemned the person who delays the payment of his dues without a valid cause. According to the well-known hadith he has said:

"The well-off person who delays the payment of his debt, subjects himself to punishment and disgrace."

The argument runs that the Holy Prophet ? has permitted to inflict a punishment on such a person. The punishments may be of different kinds, including the imposition of a monetary penalty. But this argument overlooks the fact that even if it is assumed that imposing fine or a monetary penalty is allowed in Shariah,1 it is imposed by a court of law and is normally paid to the government. Nobody has allowed a situation where an aggrieved party imposes the fine on its own (and for its own benefit) without a judgment of a court, competent to decide the matter.

Moreover, had it been a recognized punishment, it should have been imposed even if the investment account has earned no profit during that period, because the guilt of the defaulter is established and it has no nexus with the profit of the investment account of the bank.

In fact, the suggestion of compensation equal to the rate of profit of the investment account is based on the concept of opportunity cost of money. This concept is foreign to the principles of Shariah. Islam does not recognize opportunity cost of money, because after the elimination of interest from the economy, money has no definite return. It  is always exposed to loss as well as it has the ability to earn a profit. And it is the risk of loss which makes it entitled to gain a return.

Another point is worth attention. The one who defaults in payment of  debt is, at the most, like a thief or a usurper. But the study of the rules prescribed for theft and usurpation would show that a thief has been subjected to very severe punishment of amputating his hands, but he was never asked to pay an additional mount to compensate the victim of theft. Similarly, if a person has usurped  the money of another person, he may be punished by way of ta‘zir, but no Muslim jurist has ever imposed on  him a financial penalty to compensate the owner.

Imam al-Shafi’i is of the view that if someone usurps the land of another person, he will have to pay the rent of the land according to the market rate. But if he has usurped money, he will return the equal amount of money and not more.

All these rules go a long way to prove that the opportunity cost of money is never recognized by the Islamic Shari‘ah, because, as explained above, money has no definite return, nor any intrinsic utility.
On the basis of what is stated above, the idea of compensation to be charged from a defaulter is not approved by most of the contemporary scholars. The question was thoroughly discussed in the annual session of Islamic Fiqh Academy, Jeddah, and it was resolved that no such compensation is allowed in Shariah.

All this discussion relates to the impermissibility of the proposed compensation in Shariah. Now  it is to be noted that this proposal does not solve the problem of default at all. To the contrary, it may encourage the debtors to commit as much default as they wish. The reason is that, according to this suggestion, the defaulter is asked to pay compensation equal to the return earned by the depositors during the period of default. It is evident that the rate of return earned by the depositors is always less than the rate of profit paid by the customer in a Murabahah transaction. Therefore, the customer will be paying after default, much less than he was paying before the default. Therefore, he would willingly accept to pay this amount and not pay the amount of price which he will invest in a more profitable activity. Suppose the rate of profit agreed in a murabahah transaction of six moths is 15% p.a. and the rate of profit declared to the depositors is 10%. p.a. It means that if the client withholds the price of murabahah after its maturity date and keeps it for another six months, he will have to pay the compensation at the rate of 10% p.a. which is much less than the rate of original murabahah (i.e. 15%). As such he will default and enjoy another facility for the next  six months at a lesser rate.

This proposal, therefore, is not only against Shariah, but also deficient in meeting the problem of default.

The Alternative suggestion
The question now arises as to how the banks and financial institutions may solve this problem. If nothing is charged from the defaulters, it may be a greater incentive for a dishonest person to default continuously. Here is the answer to this question:

We have already mentioned that the real solution to this problem is to develop a system where the defaulters are duly punished by depriving them from enjoying a financial facility in future. However, as commented earlier, this may be only where the whole banking system is based on Islamic principles, or the Islamic banks are given due protection against defaulters. Therefore, up to a time when this goal is reached, we may need some other alternative.

For this purpose it was suggested that the client, when entering into a murabahah transaction, should undertake that in case he defaults in payment at the due date, he will pay a specified amount to a charitable fund maintained by the bank. It must be ensured that no part of this amount shall form part of the income of the bank. However, the bank may establish a charitable fund for this purpose and all amounts credited therein shall be exclusively used for purely charitable purpose approved by the Shari‘ah. The bank may also advance interest-free loans to the needy persons from this charitable fund.

This proposal is based on a ruling given by some Maliki jurists who say that if a debtor is asked to pay an additional amount in case of default, it is not allowed by Shari'ah, because it amounts to charging interest. However, in order to assure the creditor of prompt payment, the debtor may undertake to give some amount in charity in case of default. This is, in fact, a sort of Yamin (vow) which is a self-imposed penalty to keep oneself away from default. Normally, such 'vows' create a moral or religious obligation and are not enforceable through courts. However, some Maliki jurists allow can be made it justiceable,1 and there is nothing in the Holy Qur'an or in the Sunnah of the Holy Prophet which forbids making this 'vow' enforceable through the courts of law. Therefore, in cases of genuine need, this view can be acted upon. But, while implementing this proposal, the following points must be kept in mind.

1. The proposal is meant only to pressurize the debtors on paying their dues promptly and not to increase the income of the creditor / financier, nor to compensate him for his opportunity cost. Therefore, it must be ensured that no part of the penalty forms part of the income of the bank in any case, nor can it be used to pay taxes or to set-off any liability of the financier.

2. Since the amount of penalty is not deserved by the financier as his income, but it goes to charity, it may be any amount willfully undertaken by the debtor. It can also be determined on per cent per annum basis. Therefore, it may serve as a real deterrent against deliberate default, unlike the former suggestion of compensation which, as explained earlier, may tend to encourage the defaults.
3. Since the penalty undertaken by the client is originally a self-undertaken vow, and not penalty charged by the financier, the agreement should reflect this concept. Therefore, the proper wording of the penalty clause would be on the following pattern,

"The client hereby undertakes that if he defaults in payment of any of his dues under this agreement, he shall pay to the charitable account/fund maintained by the Bank/Financier a sum calculated on the basis of ...% per annum for each day of default unless he establishes through the evidence satisfactory to the Bank/financier that his non-payment at the due date was caused due to poverty or some other factors beyond his control."

4. Being a vow of charitable act, it was originally permissible for the client to give the stipulated amount to  any charity of his own choice, but in order to ensure that he will pay, the charitable account or fund maintained by the financier/bank is specified in the proposed undertaking. This specific undertaking does not violate any principle of Shariah. However, it is necessary that the bank or the financial institution maintains a separate fund, or at least, a separate account for this purpose and the amounts credited to that account must be spent in well-defined charities known to the client/debtor.

This proposal has now been implemented successfully in a large number of Islamic financial institution.