SS 5 · Guarantees, documentary credit and Rahn

SS 5: Guarantees

What this standard is about

The standard covers guarantees (securities) meant to secure obligations and protect debts against delay and default. These can take the form of written documents, attestations, personal guarantees, mortgages, cheques, and promissory notes. It explains which forms are permissible and which are prohibited. It also draws a line between guarantees and assets held on trust. It does not cover guarantees against wrongful acts (torts).

Why it exists

Guarantees protect property, which is one of the objectives of Shariah. But guarantees have limits. A trustee holding someone's asset is not the same as a guarantor. The standard keeps these two roles apart, so a person trusted with an asset is not forced to guarantee it.

The key rules, simply put

Guarantees are permissible in exchange contracts, such as sales, and in rights contracts, such as intellectual property.
A guarantee can be written into the body of the original contract. It does not affect the permissibility of that contract.
Several guarantees can sit in one contract. A personal guarantee and a mortgage can be combined.
In trust contracts, such as agency or deposits, the bank cannot demand a guarantee from the trustee. A trustee is only liable for misconduct, negligence, or breach of the agreed conditions.
A partner, a mudarib (investment manager), or an investment agent cannot guarantee the capital of other partners or investors.
A third party may voluntarily promise to cover investment losses, as long as the promise is not linked to the mudaraba or agency contract.
Cheques and promissory notes may be taken as security to press a debtor to pay on time.

An everyday example

A bank financing a car sale asks the buyer's brother to act as guarantor. If the buyer defaults, the bank can claim from the brother. The guarantee sits inside the sale contract and both brothers know the terms from the start.

Words to know

Kafalah — a personal guarantee; one person joining their liability to another's.
Rahn — a mortgage or pledge; an asset tied to a debt.
Mudarib — the manager in a mudaraba (trustee partnership) who invests the capital.
Riba — interest; any guaranteed extra on a loan or debt. Not allowed in Islamic finance.

Source

AAOIFI Shariah Standard No. 5 — https://islamicmarkets.com/publications/guarantees-scope-of-the-standard