Rulings On Penalty Charges

The issue of legitimacy of penalty charges has been discussed by a group of international jurists at the seminar conducted and published by the Al Baraka Investment & Development Co as follows:-

Issue: Is the principle of holding a dilatory liable to pay damages to the creditor legitimate from the point of view of the Islamic law.

Answer: “In Islamic law it is permissible to hold responsible a financially capable debtor who delays payment of debt without any genuine reason, and to compensate the Financier for any loss resulting from late payment. Such a debtor is unjust as the Prophet said “A debtor who delays payment of debt is unjust. The case of such person is similar to that of an unjust decreed that besides returning the capital he should also be made to return any profi t made by him on the usurped penalty. This was the majority opinion. Some are of the view that the obligation to pay this amount is a sort of penalty clause based on the principle of public welfare provided any income obtained is spent on legitimate charitable works.”

Jumhur ulama’ has taken the view that a person who has the means to repay his debt but delays in doing so is actually committing an unjust act. The liability of the Customer is also subject to the proviso that he is unable to offer any genuine reasons for his delay. It may be constructed that the appropriate rate to be determined may be influenced by factors such as whether there was a willful intention on the part of the Customer to delay his payment or there are other extraneous factors beyond the  control of the Customer.

If we were to stretch the element of public welfare evident in the opinion, it is also possible to look at the culpability factor that contributes to the injury committed. Culpability factor occurs where the act of delaying the payment of the debt was due directly by the actions of the person committing the act and precipitated by extraneous factors. The culpability factor may be relevant at arriving at a fair rate of penalty; depending on the circumstances of the case to be weighed by the authority imposing the penalty rate. When the element of public welfare is taken into further consideration, any penalty charges imposed may be channeled through charitable institutions, subject always to the institution overseeing and supervising the collection and distribution of the penalty charges.

Stipulating a penalty clause (opinion published by international jurists)

Issue: Is it permissible to stipulate a penalty clause in the case of those who delay paying their debts while they are able to pay.

Answer: “It is permissible to stipulate a penalty clause as a deterrent against those who are well off and still delay paying their debts provided the money received from these penalties is spent on works of charity and special welfare. In case there is any taxes to be paid on the amount of penalty the Bank is entitled to deduct these expenses from the penalty for late payment”.

Jumhur ulama are of the opinion that it is permissible to stipulate a penalty clause in the contract between the Financier and the Customer. A valid contract is one that fulfils the conditions if a sahih (valid) contract namely; offer and acceptance, subject matter and the contracting parties. It is a fundamental Shariatic principle that consent/mutual agreement of both parties to the terms of contract are given effect to. Parties to the contract may stipulate their agreement to a penalty clause in the contract. This will effectively prevent any dispute between the parties in the future as to the rights of the Financier to impose a penalty charge on the Customer. Jumhur ulama nevertheless put a condition that any income received from the imposition of penalty charges should go to charitable purposes and welfare.

The rate of penalty charges

Jumhur ulama have left the question of the appropriate rate to be imposed to the experts; the Bankers and Financiers. They have provided some guidelines for consideration namely; whether the debtor is able to offer a genuine and reasonable explanation for their delay; whether willful intention was present at the time the wrongdoing was committed and whether there was a culpability factor.

The injured party may have to decide on what amounts to extraneous factors which gives rise to the culpability factor. Is high interest rate due to recession an extraneous factor or simply a business risk to be shared between the Customer and the Financier. It may be argued by the Financier, that they are the party more vulnerable as high interest rates directly affect its cost of fund. Islamic banking in Malaysia is based on a fixed rate mechanism and Islamic banking would have to absorb the gap between the cost of fund and the profit it has fixed for the Customers in a situation of interest hike.

The rate of the penalty charges to be imposed is dependent on many factors namely the Financier’s cost of fund, the administrative charges, expenses, legal costs, etc. The principle in charging penalty charges is to compensate the Financier for any loss or injury suffered by the Financier. The difficulty here would be to actually quantify the actual amount of the losses or injury suffered and determine what was the losses or injury suffered.

The Supreme Court of Pakistan in the case of Dr. M. Aslam Khaki v. Syed Muhammad Hashim 2000 Shariat Law Reports states that:-

“…a service charge based on the actual (eg. Secretarial) expenses incurred by the financier, in advancing a loan can be claimed by him from the Customer.

This principle is derived from the following Quranic verses:

Al Baqarah: 82

“And the indebted person shall dictate (the document evidencing the debt)”

Here the preparation of the document of loan has been held to be the responsibility of the Customer which naturally means that if this documentation involves some expenses, they will be borne by the Customer. It lays down the principle that the expenses of such nature in a transaction of loan can be claimed by the financier, on condition that they are really based on actual expenses.

It is submitted that a parallel reading of the word “service charge” to include charges incurred by the Financier as a result of the Customer’s default is not contrary to the Shariah, Further the Court were of the opinion that if some additional expenses were incurred after the default through sending reminders, they were not necessarily at the same rate the service charge was calculated. They can be less or more if the Financier has to take a legal action against the Customer. In qualifying the actual losses or injury suffered, the Financier shall have to be able to provide in detail the actual amount and to be able to justify the amount to be charged.

The dividing line between a ribawi (interest based) and non ribawi (noninterest based) transaction here depends to a large extent whether the Financier is able to justify the penalty charges imposed and it is fair and legitimate in the event the Customer challenges the penalty charges. The principle of determining a fair penalty charge therefore should be on the basis of justification.

In examining the concept of ribawi, we find that the majority jurists have unanimously agreed by way of ijma’ that ‘riba’ does not refer to an amount of money or its equivalent, but encapsulates elements of oppression, exploitation and uncertainty.

In the above stated case an opinion submitted by a representative of the Islamic economic scholars on the definitions or ‘riba’, states “…in order to come within the term ‘riba’, such return would have to reflect exploitation of the Customer by the Financier..’. It is submitted that the element of ‘exploitation’ or ‘uncertainty’ may be contained where the Financier is able to provide the correct information and such information has not been withheld or manipulated to serve their own interest.

By Fakihah Azahari

published in Islamic Finance News Asia dated 28^th July 2006 pg 9