Islamic Forward Brief Introduction
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Brief Introduction
Islamic Forward Contract
Salam and Istisna
By: - Zia Ahmed www.hhrdevelopment.com www.ziaahmed.org zia@ziaahmed.org
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INDEX Salam And Istisna ´ Brief Comparison............................................................................................3 Rules for a Valid Salam Contract..................................................................................................4 Istisn’a ....................................................................................................................................................5 Risks Management in Salam-based Financing ................................................................................7 Parallel Salam to manage and mitigate risk....................................................................................8 Potential of Istisna´a ........................................................................................................................ 10 Istisn’a .............................................................................................................................................. 10 Parallel Salam and Disposal of Salam Goods ................................................................................ 12
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Salam And Istisna ´ Brief Comparison
Salam (Advance Payment against Deferred Delivery of Goods) Salam (also referred to as Bai Salam, Al-Salam, Bai al-Salam) is an ancient form of forward contract wherein the price is paid in advance at the time of making a contract of sale for goods to be delivered at a future date. What is given in exchange for the advance payment of the price should not in itself be in the nature of money. For the payment in advance, the contracting parties stipulate a future date for the supply of goods of specified quantity and quality Salam may be considered as a kind of debt, because the object of the salam contract is the liability of the seller, up to the agreed future date, to deliver the object for which advanced payment of the price has already been made. There is consensus among Muslim jurists on the permissibility of salam, because the object of the contract is that the goods are a recompense for the price paid in advance, just as the price is recompense paid for getting the goods in advance. Salam is permitted, notwithstanding the general principle of the Shari´ah that does not permit the sale of a commodity which is not in the possession of the seller. When Prophet Muhammad (pbuh) came to Madinah (the second holiest city in Islam, after Makkah), the people used to pay in advance the price of fruits (or dates) to be delivered within one, two or three years. But such a sale was carried out without specifying the measure, weight and the time of delivery. Prophet Muhammad (pbuh) said: "He who sells on Salam (money in advance) must sell a specific volume and a specific weight to a specific due date (to be delivered later)". The practice of salam, as ordained by the Prophet Muhammad (pbuh), continued during his life time and also in later periods. The list of items covered by salam suggests that it benefited the owners of farms and orchards. Barring a few exceptions, the Muslim jurists have now expanded the list of items which can be sold under salam to cover all homogeneous commodities that can be precisely determined in terms of quality and quantity.
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Rules for a Valid Salam Contract
Only those fungible (mithli) things which can be precisely determined in terms of quantity and quality can be contracted in salam. Besides, salam cannot take place between identical goods, e.g., wheat for wheat, Dollar for Dollar and potato for potato. All goods that can be categorised as belonging to the same species can be the subject of salam. For example, wheat, rice, barley or other grains of this type, motor cars of any trade mark, oil, iron and copper can all be sold through salam. Similarly, electricity measured in kilowatts can be considered a fungible commodity. In salam, it is necessary to fix precisely the time of delivery of the goods. The buyer must unambiguously specify the quality and the quantity of the goods and the specifications must be applicable to the generally available items of the goods of the contract. The specification of goods should particularly cover all those characteristics which could cause variation in price. Thus the general terms and conditions of salam should be binding in nature and Q2P2T be followed. The first Q stands for the quantity of the commodity to be supplied. The second Q stands for the quality or variety of the commodity. The first P stands for the price to be paid in advance by the buyer and the second P stands for place of delivery. Finally, T stands for the time of delivery. The buyer in salam should advance the price of the commodity at the time of making the contract
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Istisn’a
It is a contract culminating in a sale at an agreed price, paid in advance, whereby the buyer places an order for the manufacture, assembly or construction, items to be delivered at a future date. The object of an Istisna´a contract should not be an identified asset which is already in existence and immediately available. The items must be specified to the extent of removing any ignorance, doubt or lack of knowledge of their kind, type, quality and quantity. In istisn’a transactions the buyer cannot before taking possession (actual or constructive) of the goods, sell or transfer ownership of the goods to any other person or party. Istisna´a is invalid for natural things or products that are not manufactured, such as animals, corn, fruits, etc. Both unique and homogeneous types of goods are covered, provided their specifications are agreed at the time of contract. For example, items of unique description that have no regular market, have no substitute in the market and the value of each unit of this category of goods may be different and is covered by istisna´a. Where Istisna´a is used in manufacturing, the manufacturer will arrange the procurement of the materials for both manufacture and labour. If the materials for manufacture are supplied by the buyer and the manufacturer is required only to provide the labour and expertise, then it will be considered as a contract of ujrah (the financial charge, such as the agreed wage/remuneration, for using services and not of istisna´a where the material required also has to be provided by the manufacturer). The price of the object specified in the istisna’a contract should be known in advance to the extent of removing any ambiguity and the price, once settled, cannot be unilaterally increased or decreased. However, where the manufacturing process may involve a longer time, sometimes necessitating changes such as modification of the contracted item, or due to unforeseen contingencies or changes in prices of inputs such as materials need for production, the price can be readjusted with the mutual consent of the contracting parties. The time required for the manufacturing process should also be fixed. It is not always necessary in istisna´a for the full price to be paid in advance (unlike in salam,
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where spot payment of the price is necessaryHence, the istisna´a transaction would not be of the nature of ‘sale of debt for debt’, even if full pre-payment is not made by the buyer, as it could be in salam. As in salam, the buyer has the right to obtain collateral from the manufacturer for the amount paid in advance and, as regards delivery of the commodity, specifications and time of delivery. The buyer in istisna´a is not regarded as the owner of the materials in the possession of the manufacturer for the purpose of producing the object of istisna’a contract, unless the manufacturer has previously guaranteed that such materials will only be utilised to fulfil the contract with the buyer.
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Risks Management in Salam-based Financing
Islamic banks may face the following risks in salam-based financing: a) Counter-party Risk (the client may default after taking the payment in advance.) b) Commodity Price Risk (at the time the goods are received the price may be lower than the price that was originally expected). c) Quality Risk/ Low investment Return or Loss (goods received might not be of desired quality – unacceptable for the potential buyer) d) Asset-Holding Risk / possibility of extra expenses on storage and takaful (the bank might not be able to market the goods in time, resulting in possible asset loss for the unsold goods and locking funds in the goods until they are sold) e) Asset-Replacement Risk (in case the bank has to purchase goods from the market in parallel salam where the third party fails to supply the specified goods under the parallel contract. f) Fiduciary Risk in the case of parallel salam (original salam seller might not deliver). Islamic banks need to take proper measures for mitigation of the above risks. They should purchase only those goods which have good marketing potential; take proper security and a performance bond; insert a penalty clause in the contract as a deterrent against late delivery; obtain a binding promise from the prospective buyers along with a sufficient amount of earnest money in deposit; and fulfil the responsibility of parallel salam-purchase similar goods from the market on spot to supply these to the buyer and recover the loss, if any, from the seller in the original salam.
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Parallel Salam to manage and mitigate risk
For the disposal of goods purchased under salam, Islamic banks have a number of options, including: i) to enter into a parallel salam contract where the bank is involved as a buyer on one side and as a seller on another side, ii) an agency agreement with any third party or with the client (seller) to sell the goods on behalf of the bank and / or iii) a sale in the open market the bank itself by entering into a promise with any third party or direct selling upon taking the delivery. Where the bank (as buyer) enters into a parallel salam contract there cannot be any condition or linkage to the first salam contract. (Parallel Salam is allowed with a third party only. The seller in the first contract cannot be made purchaser in the parallel contract of salam, because it will be a buy-back contract, which is not permissible in the Shari’ah). Each one of the two contracts entered into by a bank should be independent of the other, but the bank (as seller) can sell the goods on parallel salam on similar conditions and specifications as previously purchased on the first salam contract without making one contract dependent on the other. This arrangement cannot be tied up in such a manner that the rights and obligations of one contract are dependant on the rights and obligations of the parallel contract. The period of parallel contract in the second transaction is usually shorter and the price may be a higher than the price of the first salam transaction. The difference between the two prices is the bank’s profit The parallel contract arrangement may not be an attractive mode of disposal of goods for banks, as the amount invested by the bank (the advance payment of the price in the first salam) would be disinvested when the buyer in the parallel contract made the advance payment to the bank for the purchase of the goods under the parallel contract. Under an agency agreement, the Islamic bank may appoint the seller its agent to sell the salam goods on its behalf at a given price which would include the bank’s profit. Some Islamic banks are, therefore, using salam for purchasing goods and appointing the sellers as their agent for subsequently marketing the goods at a price with a suitable profit margin for the
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bank. In the case of an agency, the salam contract and the agency agreement should be separate and independent of each other. The purchased goods cannot be sold back to the salam seller, hence a parallel salam cannot be entered into with the original seller in the salam contract as it would be considered as being a ‘buy-back’, which is prohibited under the Shari’ah rules. In the third option, the Islamic bank (as buyer under salam) may obtain a binding promise from a third party to purchase the goods from the bank. This promise should be unilateral from the prospective buyer. The bank (as buyer) will not have to pay the price in advance, as the prospective buyer is merely making a promise and it is not an actual sale. However, the bank can ask for earnest money (a security deposit as an act of good faith). As soon as the bank purchases the goods, they will be sold to the third party at the pre-agreed price, according to the terms of the promise. Banks may also wait until receipt of the goods and sell them in the open market, but they will be taking the asset-risk for the period the goods remain in the bank’s inventory. It is important to note again that the salam goods cannot be sold back to the original seller owing to the prohibition of the ‘buy-back’ arrangement.
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Potential of Istisna´a
Istisna’a for risk management in asset-based financing Islamic banks can use istisna´a for manufacturing high technology goods such as aircrafts, ships, buildings, dams, high ways, etc. It can also be used for housing, export financing and meeting working capital requirements in industries where sale orders are received in advance. The potential areas for the application of istisna’a are indicated below: • To finance the construction of buildings, factories, hospitals, schools and universities. • Housing finance schemes • To finance high technology industries such as the aircraft, locomotive and shipbuilding industries, and the various types of machines produced in big factories or workshops. • To finance various industries where their productions can be monitored by measurement and specifications, such as in the food processing industry.
Istisn’a
Istisna´a, is a special kind of sale contract where a sale is transacted before the goods come into existence. It is a contract culminating in a sale at an agreed price, paid in advance, whereby the buyer places an order for the manufacture, assembly or construction, items to be delivered at a future date. The object of an Istisna´a contract should not be an identified asset which is already in existence and immediately available. The items must be specified to the extent of removing any ignorance, doubt or lack of knowledge of their kind, type, quality and quantity. In istisn’a transactions the buyer cannot before taking possession (actual or constructive) of the goods, sell or transfer ownership of the goods to any other person or party. Istisna´a is invalid for natural things or products that are not manufactured, such as animals, corn, fruits, etc. It is not necessary that the seller should be the manufacturer of the goods. The seller may enter into a contract with a third party to manufacture the goods specified in the Istisna´a
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contract. On this basis, banks may undertake financing based on Istisna´a by getting the subject of istisna´a manufactured through another such contract. Thus, Islamic banks can serve both as manufacturers and purchasers (see section on parallel istisna’a). Istisna´a can be used to provide the facility for financing the manufacture of goods or the construction of houses, plants, projects, bridges, roads, and highways, etc. The istisna´a contract can also be drawn-up for real estate developments on designated land owned either by the purchaser or the contractor, or on land in which either of them owns the usufruct. It involves the construction of specified buildings that will be built and sold according to specifications and, in this case, the contract of istisna´a does not specify a particular, identified place. Where Istisna´a is used in manufacturing, the manufacturer will arrange the procurement of the materials for both manufacture and labour. If the materials for manufacture are supplied by the buyer and the manufacturer is required only to provide the labour and expertise, then it will be considered as a contract of ujrah (the financial charge, such as the agreed wage /remuneration, for using services and not of istisna´a where the material required also has to be provided by the manufacturer). It is not always necessary in istisna´a for the full price to be paid in advance (unlike in salam, where spot payment of the price is necessary). The price may be paid in instalments within a fixed time period. Against the general rule applicable for salam, the contemporary Islamic scholars have legalised instalment payments in istisna’a based on istihsan (juristic "preference” over strict analogy The buyer in istisna´a is not regarded as the owner of the materials in the possession of the manufacturer for the purpose of producing the object of istisna’a contract, unless the manufacturer has previously guaranteed that such materials will only be utilised to fulfil the contract with the buyer. This form of guarantee will only be enforced in the event that the manufacturer has requested the buyer to pay part of the price in advance for acquiring some of the materials needed.
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Parallel Salam and Disposal of Salam Goods
“Islamic law restricts the ways a party to a salam contract may avoid or undo his contractual obligation. It does not allow the buyer to sell to a third party his interest in the contract, i.e., in the seller’s obligation to deliver the goods. Most schools (of Islamic jurisprudence) do not permit the buyer to see the specific goods that he is purchasing under the salam contract before they are delivered. For the disposal of goods purchased under salam, Islamic banks have a number of options, including: a.) to enter into a parallel salam contract where the bank is involved as a buyer on one side and as a seller on another side, b) an agency agreement with any third party or with the client (seller) to sell the goods on behalf of the bank and c) a sale in the open market the bank itself by entering into a promise with any third party or direct selling upon taking the delivery. Where the bank (as buyer) enters into a parallel salam contract there cannot be any condition or linkage to the first salam contract. (Parallel Salam is allowed with a third party only. The seller in the first contract cannot be made purchaser in the parallel contract of salam, because it will be a buy-back contract, which is not permissible in the Shari’ah). Each one of the two contracts entered into by a bank should be independent of the other, but the bank (as seller) can sell the goods on parallel salam on similar conditions and specifications as previously purchased on the first salam contract without making one contract dependent on the other. This arrangement cannot be tied up in such a manner that the rights and obligations of one contract are dependant on the rights and obligations of the parallel contract. For example, if a bank (as buyer) has purchased from a farmer (seller) ‘A’ 50 tons of wheat by way of salam to be delivered to the bank on June 30, the bank can contract a parallel salam with a trader ‘B’ to deliver 50 tons of wheat to the trader ‘B’ (buyer in the parallel contract) also on June 30. While contracting the parallel salam with ‘B’, the delivery of wheat cannot be made conditional upon the bank taking delivery of the wheat from ‘A’. If ‘A’ fails to deliver the wheat on
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June 30, the bank will still be duty-bound to deliver the 50 tons of wheat to ‘B’. In that event, the bank can seek whatever recourse it has against ‘A’, but cannot back out from its liability to deliver the wheat to ‘B’, for which the bank will have to find an alternative supplier. Similarly, if the farmer ‘A’ delivers poor quality wheat, the bank will still be obliged to deliver wheat of the stipulated quality to ‘B’ according to the parallel salam contract. The period of parallel contract in the second transaction is usually shorter and the price may be a higher than the price of the first salam transaction. The difference between the two prices is the bank’s profit. The parallel contract arrangement may not be an attractive mode of disposal of goods for banks, as the amount invested by the bank (the advance payment of the price in the first salam) would be disinvested when the buyer in the parallel contract made the advance payment to the bank for the purchase of the goods under the parallel contract. Under an agency agreement, the Islamic bank may appoint the seller its agent to sell the salam goods on its behalf at a given price which would include the bank’s profit. In the third option, the Islamic bank (as buyer under salam) may obtain a binding promise from a third party to purchase the goods from the bank. This promise should be unilateral from the prospective buyer. The bank (as buyer) will not have to pay the price in advance, as the prospective buyer is merely making a promise and it is not an actual sale. However, the bank can ask for earnest money (a security deposit as an act of good faith). As soon as the bank purchases the goods, they will be sold to the third party at the pre-agreed price, according to the terms of the promise. Banks may also wait until receipt of the goods and sell them in the open market, but they will be taking the asset-risk for the period the goods remain in the bank’s inventory. It is important to note again that the salam goods cannot be sold back to the original seller owing to the prohibition of the ‘buy-back’ arrangement.
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