Review of Regulation on Islamic Finance Services provided by Microfinance Organisations

The Central Bank of the Republic of Uzbekistan adopted the Regulation on the Procedure for Provision of Islamic Finance Services by Microfinance Organisations (reg. No. 3536 dated July 24, 2024) [https://lex.uz/uz/docs/-7036330] (hereinafter referred to as “Regulation”). The Regulation establishes the basic principles and requirements for rendering services in this area, providing or implementing a legal basis for Islamic financial mechanisms.

 INTRODUCTION

Islamic finance – a financial activity based on the principles of Shariah, Islamic law, one of the main features of which is the prohibition of riba (interest), which makes Islamic financial services unique and requires the use of instruments such as Murabaha, Musharaka, Salam, Ijarah, Sukuk, Istisna and others.

As main features, any Islamic financing practice must conform to the following basic principles of Islamic financing:

• Prohibition of interest (riba). Islamic financing is not directly lending money like banks, but unlike them, it is composed of purchasing the object by financing institutions and leasing or selling it on a deferred payment basis to their clients.
• Prohibition of uncertainty (gharar). Avoidance of any speculation or uncertainty in the transactions: there must be full disclosure of all terms (e.g. certainty about the subject and contract price).
• Risk Sharing. Risks and costs related to the maintenance of the financing object shall arise from the moment when the status of ownership is transferred to the Client.
• Sharia compliance of assets. The objects of financing must comply with Shariah rules as assets prohibited by Islamic law cannot be either sold or leased.

The Regulation requires the establishment of a Special Board on Islamic finance (hereinafter referred to as the “Board”), which plays a key role in ensuring compliance of the services provided with Shariah norms, consisting of at least five persons; the appointment and termination of the members of which is carried out by the general meeting of participants (shareholders) of the microfinance organization. At least one of the members of the Board must have a higher education in Islamic law, one must have a higher legal education, and the rest of the members must have an international certificate related to Islamic finance.

The main duties of the Board are:

• reviewing and approving model contracts, internal documents and reports on Islamic finance services.
• ensuring compliance of Islamic finance services with legal requirements and standards, and reporting compliance to the governing bodies.
• assisting in the implementation of the risk management and internal control system in Islamic finance through opinions and guidelines

 ISLAMIC FINANCIAL INSTRUMENTS

The Regulation details the rules and procedures for the use of various Islamic financial instruments. This chapter provides comprehensive guidance on the use of instruments that comply with the principles of Islamic finance, including:

• Murabaha: an Islamic form of trading in which a seller purchases goods and sells them to a buyer at a mark-up that is fixed in advance.
• Mudarabah: an instrument in which one party provides capital and the other party manages it in exchange for a share in the profits.
• Musharakah: a joint partnership in which all participants contribute capital and share profits and losses in proportion to their contribution.
• Ijarah (Ijarah Muntahia Bitamlik): an Islamic lease arrangement in which the Microfinance organisation purchases a property and leases it to a client, with an option to repurchase it at the end of the contract.
• Salam: an Islamic mechanism in which the buyer pays for goods in advance and the seller undertakes to deliver the goods at a future date.

The chapter also covers the Shariah compliance principles that must be considered when using these instruments, and defines internal control and audit procedures to ensure compliance with established standards.

 Murabaha

Paragraph 1 of Chapter 4 of the Regulations regulates the provision of Murabaha-based trade finance services by the Microfinance organisation. Murabaha is a form of Islamic finance whereby the Microfinance organisation purchases goods (hereinafter referred to as “Object”) at the request of a client and then resells them to the client at a pre-agreed markup.

1. Client’s application (clauses 17-18):

• Murabaha-based financing shall be provided on the basis of a written application from the client, in which the client may specify the desired object of purchase, its approximate price and the terms and conditions of purchase.
• The Client may also suggest a seller from whom the item can be purchased. However, the Microfinance organisation may choose another seller if it finds more favourable conditions.

2. Financial obligations and risks (clauses 19-20):

• The Microfinance organisation may require the client to make a down payment for the goods.
• All costs associated with the purchase and delivery of the goods shall be borne by the microfinance organisation. All risks associated with the purchase and delivery process are also borne by the microfinance organisation.
• The Microfinance organisation may not sell to a client an item that is not already in its possession.

3. Restrictions on sellers and buyers (clauses 21-22):

• It is prohibited to purchase the Object from the Client himself or organisations where the client has a significant shareholding.
• An item purchased by a microfinance organisation cannot be sold to a client on a commercial basis if contractual obligations already exist between them.

4. Pricing and transparency (clauses 23-25):

• The price of the Object and the amount of the mark-up must be clearly defined and spelt out in the contract. It is not allowed to set the price based on uncertain or future figures.
• All costs of purchase, delivery and insurance of the Object are borne by the microfinance organisation and these costs must be disclosed to the client.
• If the organisation receives a discount from the seller, it must proportionately reduce the price of the Object to the client.

5. Representation and additional terms and conditions (clauses 26-27):

• The Microfinance organisation may appoint the Client or a third party as its representative to purchase the Object. In such a case, the Microfinance organisation must pay directly to the seller and receive proof of sale.
• If the Client refuses the purchase, the Microfinance organisation has the right to sell the goods to a third party and recover from the Client the losses incurred in connection with such sale.

6. Additional restrictions (clauses 28-32):

• Additional fees may not be charged to the Client for extending the settlement period or for providing brokerage services.
• Certain assets such as cash, crypto-assets, gold and silver are not eligible for trading under the Murabaha.
• It is not allowed to sell (refinance) the same commodity to the same client on the basis of a new trading agreement.

Paragraph 2 of Chapter 4 of the Regulations regulates the provision of Islamic leasing services by the Microfinance organisation. Islamic leasing is a form of financing in which the Microfinance organisation grants a client the right to use the leased object (hereinafter referred to as “Object”) on terms and conditions agreed in advance in a contract and assumes responsibility for the compliance of the leased object with the terms and conditions of the contract.

1. Client’s application and down payment (clauses 33-34):

• The Islamic rental service is provided on the basis of the written client application that specifies the rental property and the associated real estate.
• The microfinance organisation may require an initial cash deposit for the rent. This fee may be an advance payment or compensation for losses incurred due to the Client’s cancellation of the rental.

2. Representation and responsibility (clauses 35-36):

• The Microfinance organisation may appoint the client or a third party as a representative to purchase the property. The Microfinance organisation is liable for any defects that may restrict the use of the Object.

3. Facility compliance and insurance (clauses 37-38):

• If the Object does not conform to the characteristics of the contract, the Client has the right to refuse to accept the property.
• The Microfinance organisation may ensure the lease item by paying all insurance costs that may be included in the lease payments.

4. Ownership and secondary leases (clauses 39-40):

• The ownership of the Object must be held by the Microfinance organisation. It may purchase the Object from the client and lease it back, but the purchase agreement must not provide for a secondary lease.
• The leased Object may be transferred to a secondary lease upon agreement only with the Microfinance organisation.

5. Lease term and payment schedule (clause 41):

• The contract and payment schedule must be clearly defined and lease payments may be set periodically or in a lump sum.

6. Security and losses (clauses 42-43):

• The Microfinance organisation may require collateral to mitigate risks. When recovering losses from collateral, future periods are prohibited from being charged.
• Lease payments are calculated from the date of delivery of the Object. It is prohibited to charge for a period before the delivery of the object.

7. Joint possession and late payment (clauses 44-46):

• The rental property may be acquired jointly with the client and payments are calculated on the basis of the share in the property.
• In the event of late payments, the Microfinance organisation may require a lump sum payment of the remaining amount. No increase in late payments is allowed, but a penalty may be imposed.

8. Transfer of ownership and repairs (clauses 47-49):

• The Microfinance organisation may transfer the rights to the facility to a third party by giving notice to the new party.
• Major repairs to the facility are paid for by the organisation, while current repairs are paid for by the client. Major repairs may be performed by the Client with the costs deducted from the payments.

9. Liability for damage and cancellation (clauses 50-53):

• The Client is liable for damage to the rental object and must compensate for the damage or replace the Object.
• If the rental object is partially damaged or destroyed, the Client may terminate the contract or agree to change the payments. If the Object is completely destroyed, the contract is cancelled, except in case of the Client’s negligence.
• If the Client returns the Object before the end of the rental period without consent, the Microfinance organisation can demand payment for the remaining period.

 IJARAH MUNTAHIA BITAMLIK

Paragraph 3 of Chapter 4 of the Regulations describes the provision of an Islamic lease service with the condition of subsequent purchase of the leased property (Ijarah muntahia bitamlik). This represents the Islamic analogue of conventional leasing, whereby the Client leases an object with an option to purchase it afterward.

1. Entering into a lease agreement (clause 54):

• the Microfinance organisation and a client may enter into an Ijarah muntahia bitamlik agreement with the condition that the object of the lease will be subsequently purchased by the client. This contract is the Islamic analogue of a conventional lease.

2. Application of requirements and rules and transfer of property rights (clauses 56-57):

• The same requirements and rules apply to an Ijarah muntahia bitamlik with a subsequent purchase condition as to a conventional Islamic lease.
• Transfer of property rights in the leased Object to the Client must be made under a separate contract. The transfer of ownership may be affected through the sale or gift of the leased object.

3. Recalculation of lease payments upon loss of the object (clause 57):

• If the Object is destroyed or rendered unusable through no fault of the Client, the payments, including those already made, shall be recalculated at the average market value and the positive difference shall be returned to the Client.

Paragraph 4 Chapter 4 of the Regulations describes the provision of a prepaid finance service, known as Salam, by the Microfinance organisation. Salam is a form of Islamic finance in which the client pays for an item in advance and the Microfinance organisation undertakes to provide that item at a future date.

1. Salam application and facility (clauses 58-60):

• The Salam service is provided on the basis of a Client’s application.
• Items that can be weighed, measured or counted and are easily identifiable may be used as the object of Salam (hereinafter referred to as “Object”), excluding money, crypto-assets, gold and silver.
• The Microfinance organisation is obliged to pay Salam to the client in full within three working days after the conclusion of the contract.

2. The terms and quality of the Salam facility (clauses 61-66):

• The contract should specify the terms and conditions for delivery of the Salam facility.
• If the client offers a better-quality item at no additional cost, the Microfinance organisation is obliged to accept it.
• If the Salam object does not meet the contract quality or is delivered before the deadline, the Microfinance organisation has the right to refuse to accept it.

3. Contract performance and cancellation (clauses 67-68):

• If the Client defaults, the Microfinance organisation may grant additional time for delivery or demand a refund.
• The contract may be canceled with a full refund of payments, or partially with a refund for the canceled part.

4. Penalties and ownership (clauses 69-70):

• The Microfinance organisation may impose a penalty for the late delivery of the Object.
• No contract of sale of the Object may be entered into until title to the facility has been acquired.

Paragraph 5 of Chapter 4 of the Regulations describes the provision of profit-sharing financial services, known as Mudarabah, by the Microfinance organisation. Mudarabah is a form of Islamic finance in which one party provides capital and the other party manages and shares the profits.

1. Application and capital (clauses 71-73):

• Mudarabah is provided by the Microfinance organisation on the basis of a Client’s application.
• The debt of the Client or a third party cannot be presented as capital.
• The Microfinance organisation may require collateral from the client in accordance with the law. Losses incurred due to the Client’s dishonest behaviour may be covered from the reserve account.
• If capital is provided in the form of tangible assets, their value must be clearly stated.

2. Distribution of profits (clause 74):

• Profits shall be distributed in accordance with the terms of the contract. No fixed amount of profit shall be allowed for the parties to the contract.

3. Contract cancellation and damages (clauses 75-77):

• On cancellation of the contract by mutual agreement of the parties, if the profits are equal to the total costs, the capital is returned.
• Recovery of losses from the client is only permissible in case of bad faith.
• The contract cannot be unilaterally terminated by the Microfinance organisation before the end of the term, unless it is stipulated by the terms of the contract.

Paragraph 6 Chapter 4 of the Regulations relates to the provision of financial services on a partnership basis known as Musharakah, where profits and losses are shared between the partners.

1. General provisions and governance (clauses 78-79):

• Musharakah is a financial partnership without establishing a legal entity whereby the parties contribute funds or assets on the basis of mutual agreement.
• The partners may agree to delegate management rights to more than one partner or to a single partner.

2. Contributions and shares (clauses 80-84):

• Tangible assets are contributed to capital, at a monetary value, and each Partner’s share is determined on the basis of that value. Receivables are not included in capital except as an integral part of additional capital.
• The contract may be concluded for a limited or unlimited term with the possibility of agreeing on termination terms.

3. Distribution of profits and losses (clauses 84-88):

• Profits are distributed according to shares in the capital and no fixed amount of profit is allowed. Distributions are based on actual financial results and may be made after deducting all expenses and returning the capital originally invested.
• Losses are allocated according to the capital shares and liability for losses cannot be assigned entirely to one party. Clients may voluntarily assume losses.

4. Rights and obligations of the parties (clauses 89-91):