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In August 2010 I wrote a detailed review of the book "Islamic Banking and Finance: What It Is and What It Could Be" edited by Tarek El Diwany.

One area where I was quite critical was the section "Attempts to shoehorn new contractual arrangements into the limited number of contracts found in the traditional Shariah law books" where I criticised the approach applied when analysing structures such as limited partnerships or corporations.

I returned to this theme in my monthly column in the 7 March 2018 issue of "Islamic Finance News." You can read it below.

In my opinion the mindset that I criticise is one of the main causes of the lack of progress in seen in many Muslim majority countries.

Shariah scholars should stop analysing corporations as if they were partnerships

In "Principles of Islamic Jurisprudence", Mohammad Hashim Kamali gives a brilliant account of the development of traditional Islamic law (“fiqh” in Arabic) from the original sources of the Quran and the Sunnah of the Prophet Muhammad (peace be upon him.)

Developing Islamic law over its first five centuries (the process continued afterwards) was an achievement of Islamic civilisation perhaps even more striking than its physical achievements such as the construction of major cities. Muslim scholars developed a system of law largely independently of the ruler, which in practice constrained his power, in a manner that contrasts extremely favourably with Christian Europe in that era.

For commerce Muslims developed a detailed law of partnerships such as musharaka (several partners contribute capital to a jointly run business) or mudarabah (one partner contributes capital and the other partner contributes his physical effort); a law still in use today.

However, the process of developing Islamic law gradually ran out of steam. Instead of radical innovation, legal development eventually petered away into small refinements of the existing doctrines of the major schools of Islamic law.

Probably Islamic law’s greatest historic failure is that it never invented the concept of a corporation. As anyone familiar with modern company law knows, by legal fiction a corporation is treated as a person in its own right, quite separate from the individuals (or other entities) who are shareholders in the corporation. The corporation has an infinite life (“perpetual succession”) and is unaffected by the death or departure of a shareholder; whereas the death of a partner terminates a partnership. Finally, the shareholders of a corporation have no liability for its debts which are the obligations of the corporation itself only.

The corporation was almost certainly the greatest innovation of European law. The reason is that it transformed the scale at which business operations could be conducted.

While Muslims failed to invent them, corporations entered Muslim majority regions along with European colonialism. They proved so useful that today, as far as I am aware, corporations can be formed under the law of every single Muslim majority country. This applies even in for countries such as Saudi Arabia which officially base their legal system on traditional Islamic law. They see no incongruity in also having corporations; something Islamic law has no provision for.

Despite corporations being a completely new concept, which has come entirely from outside Islamic law, many Shariah scholars still attempt to analyse corporations as if they were partnerships. This is despite the fact that the law of corporations is specifically designed to overcome the limitations of the law of partnerships.

For example, most Shariah scholars consider that preference shares are impermissible. The argument is not that a preference dividend is like loan interest, since preference dividends are not paid if the corporation makes no profit. Instead, the prohibition is normally based on the argument that all partners in a musharaka type partnership should share in profits in proportion to their contribution of capital. But corporations are not partnerships. (In passing, that argument also ignores the practice of modern professional partnerships where the partnership income is normally distributed by reference to the performance of the partners rather than in proportion to their shares of the partnership capital.)

What is needed is a “root and branch” reconstruction of Islamic law, based on the earlier sources, rather than being locked into a “path-dependent” approach of only seeking to refine what has been constructed before in the main schools of Islamic law.