Understanding Gharar: Why Excessive Uncertainty Invalidates Contracts in Islamic Jurisprudence

Prohibitions: Gharar

”On that London winter evening in 1996 Sheikh Nizam, his Arabic headdress pulled tight over his slight features, turned his attention to the second important prohibition: gharar, or uncertainty. Uncertainty in sales and other transactions is considered to void or invalidate a contract, and may indicate that the party practising it is deceiving or defrauding his counterparty, and indeed cheating and fraud are generally considered to be special cases of gharar. However, uncertainty does not have to be deliberately deceptive in nature. It arises when there is a lack of knowledge of the subject matter, such as the failure to identify the subject matter of the contract or the failure to determine the contract; lack of knowledge of the price of the subject matter, or the quantity, or the deferred period of delivery if there is one; lack of knowledge of the existence or the impossibility of its acquisition, including hindrances to its delivery; and lack of knowledge of its sound or continued existence.

Some examples might include agreeing to sell my house if Manchester United beats Liverpool (uncertainty due to conditionality); agreeing to sell my car that has been stolen (uncertainty due to existence or availability); selling one out of a herd of cows without specifying which cow (uncertainty due to quality or the nature of the object). Uncertainty does not apply to charitable contracts or gifts, so there is no prohibition in offering a gift that is not yet in one’s possession, or in making a charitable donation without specifying when delivery will take place.

Abu Hanifa deemed gharar to be so serious a matter that on one occasion when he heard that a sheep had been stolen in the town of Kufa, he enquired as to the lifespan of a sheep and was told it was seven years. Fearing to such an extent the purchase or consumption of stolen goods, he abstained from eating mutton for seven years.

Since no contract can be entirely free of uncertainty, minor gharar would not render a sales contract defective. For example, the sale of a pregnant cow would be deemed valid, despite the unknown status of the calf, and the higher price for a pregnant cow compared to one that is not would be considered acceptable. However, the sale of the unborn calf by itself would not be valid since it may be stillborn. In the case of the pregnant cow, the cow itself is the primary subject of the sale and therefore the uncertainty is deemed to be minor.16 Uncertainty must be excessive in order to invalidate a contract. It is this quantification of excess that, ironically, leads to some uncertainty in the analysis of gharar in contracts.

Many classical jurists recognized the legitimacy of the seller’s ability to deliver at the point of contracting as the overriding factor in a valid sales contract, almost irrespective of existence, ownership, availability and possession. It is a necessary condition of a sale contract that the seller must own the subject of the sale prior to selling, and that the seller has no right to sell something he does not own. As a result, almost all short selling as conventionally practised in the financial markets (that is, selling shares or other securities that one borrows but does not own) would not be valid in Sharia. However, the matter is less clear cut on whether the subject matter of the sale must exist at the time of contract conclusion.

Thus, whilst a farmer cannot enter into a contract to sell whatever crop is harvested in his fields without knowing the quantity or quality of the future harvest (since there is excessive uncertainty in such a contract), the farmer may instead sell a fixed quantity of a crop with specified quality to be delivered at a specified point in the future. This contract is quite simply a forward sale, as practised in the conventional financial world today, and does not demonstrate the characteristics of gharar. The analysis of some scholars leads them to conclude that the existence of the subject matter of the sale is not necessary at the time of entering into the sale agreement, but that the seller must have the ability to deliver the goods on the pre-specified delivery date. One condition sometimes applied by such scholars to ensuring uncertainty is minimized may include that the commodity being sold under such a contract should be readily available in the market throughout the term of the contract.

It is worth noting that the characteristic of risk itself is not necessarily so inherently uncertain that it invalidates a contract. After all, an investment partnership takes risk in deploying capital to a venture in the hope of making profit.
At what point does one reach the conclusion that a contract might have major and not minor gharar, and is therefore invalid? Some jurists would suggest that excessive uncertainty is a dominant feature of such a contract, overwhelming its potential outcome, whereas minor gharar outweighs a greater benefit, as in the case of the sale of a pregnant cow. Mahmoud El-Gamal, Professor of Economics and Statistics at Rice University, suggests that gharar is ‘trading in risk’, using the language of the modern financier.

He summarizes gharar as incorporating uncertainty regarding future events and qualities of goods, perhaps as the result of ‘one-sided or two-sided and intentional or unintentional incompleteness of information’. The key attribute that El-Gamal is seeking is significant (possibly unquantifiable) risk and uncertainty. If there is the possibility of unanticipated loss to at least one party, then the contract may be a form of gambling, and therefore invalid without any ambiguity. If the contract may lead to disputation between contracting parties, then there is also major uncertainty present. Interestingly, Professor El-Gamal likens the prohibition of uncertainty as equivalent to the prohibition of the ‘unbundled and unnecessary sale of risk’, which in its most extreme form is gambling.

He suggests that since modern finance – both conventional and Islamic – is primarily concerned with the allocation of credit or risk, particularly through advances in securitization and financial derivatives, that the two main prohibitions in Islamic commercial transactions, that is riba and gharar, are best characterized as trading in unbundled credit and trading in unbundled risk respectively.

I find the analogy to trading of unbundled credit and risk as an excellent pointer in applying a sense check to the degree of excess and uncertainty in a contract, and at a stroke, it renders a large swathe of the modern financial services industry to be in conflict with the basic principles of Sharia. Unbundled risk is where the risk that attaches to the ownership of an object is detached from that ownership and is sold in a separate contract. Some might argue that the modern insurance industry is riddled with uncertainty, since the risk of an accident that damages or writes off a car should belong to the owner of the car, and when he transfers that risk to an insurance company for a fee he has allowed the detachment of risk from his ownership. This does not, however, preclude the possibility of Islamic insurance contracts based on the principles of voluntary contribution and mutual cooperation.

Perhaps a more topical example in the investment banking industry is a credit default swap, or a CDS as it is more commonly known. This is a type of insurance contract bought by a party ostensibly to protect itself from the risk that a particular company or nation state might default on its debt obligations. For example, a financial institution may have lent significantly to the public sector in Greece and may be concerned with the deteriorating credit situation in the country, and therefore the increased risk of default by its debtors. It may therefore decide to partially ‘hedge’ itself by buying protection against the risk of default in the form of a contract – a ‘derivative’ contract – known as a CDS, usually issued by a large financial institution. If this insurance policy, the CDS, is linked to Greek sovereign debt, then in the event the sovereign defaults on its debt obligations, the ‘writer’ of the CDS (the large financial institution acting as an underwriter) will pay out a sum to compensate the holder for defaults that presumably will now trickle down through the rest of the Greek economy.

Thus the buyer of the CDS has been paid out in a manner similar to an insurance policy, and the risk of the subject matter is not attached to its ownership – a perfect example of the disintermediation of risk and reward.Imagine now that the buyer of the CDS has no intrinsic interest in the subject matter, in other words has no exposure to loans in Greece. He is taking out an insurance contract on something he doesn’t own. Is he merely seeking to take a speculative punt on Greek debt default? Is this therefore a form of gambling? We will come back to this point in Chapter 7 when we discuss derivatives in more detail.”

Heaven’s Bankers: Inside the Hidden World of Islamic Finance

Book by Harris Irfan