Kafalah

Kafalah is the contract of guarantee or suretyship in Islamic commercial law. Under it, one party, the guarantor, adds its own liability to that of another party so that a creditor may claim against the guarantor if the principal debtor does not perform. It is used in Islamic finance as the basis for bank guarantees, for the guarantee element of trade instruments, and for assurances given in project finance and capital market transactions.

The contract serves the same commercial purpose as a conventional bank guarantee, but it is subject to the requirements of Sharia, most notably on whether the guarantor may be paid. The same Arabic root gives the name of the labour sponsorship system used in some Gulf countries and of the guardianship of orphans; these are separate subjects.

Classical jurists identify four elements.

• The guarantor, known as the kafil, who must have legal capacity and give the undertaking voluntarily.
• The principal, the party whose obligation is guaranteed.
• The beneficiary, the creditor in whose favour the guarantee is given.
• The guaranteed subject matter, which must be an obligation that is valid and capable of being fulfilled by the guarantor, such as a debt that is due or will become due, or the delivery of a specified asset.

A guarantee may be for a fixed amount or period, may be restricted by conditions, and may be made to take effect at a future time. Jurists differ on whether the creditor may pursue the guarantor at once or must first claim from the principal; the widely held view allows the creditor to claim from either, unless the contract says otherwise. A guarantor who pays is entitled to recover from the principal where the guarantee was given at the principal's request.

The main distinction is between a financial guarantee, under which the guarantor undertakes to pay a debt or other monetary claim, and a guarantee of the person, under which the guarantor undertakes to produce someone, for example before a court. The financial form is the one used in banking.

Guarantees are also classified as unrestricted or restricted, immediate or deferred. Kafalah is different from hawalah, in which a debt is transferred to a new debtor and the original debtor is released; under kafalah the original debtor remains liable.

Kafalah is traditionally classed as a benevolent contract, entered into to help another, like an interest-free loan. A guarantor who pays the debt becomes, in effect, a lender to the principal. The majority of classical scholars therefore held that charging a fee for the guarantee itself is not allowed, because if the guarantor has to pay, the fee would amount to a return on a loan, which is riba.

This creates a difficulty for banks, for which issuing guarantees is a business involving cost and risk. Contemporary practice takes several approaches. The Sharia standard on guarantees issued by AAOIFI does not permit remuneration for the guarantee as such but allows the guarantor to recover the actual expenses of issuing it. Many banks structure a guarantee facility with a wakalah element, charging a fee for the agency and administrative services they perform, and take a cash margin or collateral from the customer. Some scholars and national Sharia bodies, notably in Malaysia, accept a fee for the guarantee itself, a structure described as kafalah with a fee, on the grounds of public need and of the benefit the customer receives. Practice therefore differs between jurisdictions, and each institution follows the ruling of its own Sharia supervisory board.

• Letters of guarantee. Performance, bid, advance payment and financial guarantees issued for customers in construction and trade, corresponding to a conventional demand guarantee.
• Trade finance. The bank's undertaking in an Islamic letter of credit to pay the exporter is commonly analysed as kafalah, combined with agency or murabaha depending on whether the customer funds the purchase.
• Shipping guarantees. Undertakings given to carriers so that goods can be released before documents arrive.
• Sukuk and syndications. Third-party guarantees of payments under sukuk are permitted where the guarantor is independent of the issuer and manager. A manager or partner may not guarantee capital or profit in equity-based structures, since that would turn a risk-sharing investment into a debt.
• Deposit protection. Some Islamic deposit insurance schemes are structured on kafalah with a fee, with the scheme guaranteeing deposits in return for premiums paid by member banks; others use a takaful model.
• Personal and corporate guarantees. Guarantees taken by Islamic banks from shareholders or parent companies as security for financing.

The fee question remains the principal controversy: critics of fee-based structures argue that charging in proportion to the amount and duration of a guarantee is hard to distinguish from charging for credit, while supporters argue that the prohibition would prevent Islamic banks from offering an essential service. A second issue is the limit on guarantees within investment structures, which constrains credit enhancement in sukuk and has led to the use of purchase undertakings and third-party support in their place.

• Accounting and Auditing Organization for Islamic Financial Institutions
• Islamic Financial Services Board