Islamic Finance - Introduction to Istisna Contract

 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 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.

Potential of Istisna´a

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.

 

Islamic Finance Different Methods

 

Mode of Financing by Islamic Banks

The selection of mode in Islamic financing depends upon the nature, purpose and size of the transactions involved, essentially these are:

a) Selling on profit: This mode implies the purchase of goods by banks and their sale to clients at appropriate mark-up in price on deferred payment basis, without levy of mark-up on mark-up; it encompasses the purchase of a property by banks from their clients with a buy-back agreement.

b) Shared-risk financing and sharing of profit and loss: This mode implies the sharing profit and the risk of loss among the investors, i.e. the bank on the one hand and the client on the other hand.

c) Renting of assets (leasing)

d) Benevolent Loans

The modes which are closest to the spirit of Islamic finance are Musharakah (shared risk partnership or joint venture) with Mudarabah (profit-and-loss-sharing, also a form of partnership). However, some practical difficulties which had sometimes hindered their application and adoption led Shari’ah scholars to allow the use of other modes such as ijarah (leasing), and murabaha (cost plus mark-up). These latter modes are comparatively easy to understand and apply, however the mark-up in murabaha and lease rental in ijara suffer from having a resemblance to some of the conventional banking interest-bearing products. Shari’ah advisors have expressed a desire to encourage the use of products based on the concepts of musharakah and mudarabah as early as possible.

Debt Type Instruments include:

o   Murabaha (cost-plus profit mark-up)

In its simplest form, murabaha, is a trading mode and refers to a purchase and resale transaction involving an asset whereby the cost of the purchase and profit margin (mark-up) on the resale is known and the mark-up agreed by the parties involved. Another general and regular kind of sale is musawamah, in which the price of goods to be traded is negotiated between seller and buyer. Musawamah is usually used where the seller is not in a position to ascertain precisely the costs of commodities offered for sale or does not want to disclose the cost price; all other conditions relevant to murabaha are valid for musawamah as well.

Under murabaha, the Islamic bank purchases, in its own name, goods from a third party (the supplier/seller) that are required by their clients, and then re-sells the goods to their clients, on spot or deferred payment, with an pre-determined mark-up.

The difference between the bank’s purchase cost and its sale price forms the profit available to the Islamic bank on this transaction. The ownership of the goods being sold to a client at a mark-up price on deferred payment terms remains with the bank.

o   Salam (advance payment for goods)

Salam is a trading mode allows a buyer to make payment in advance for goods to be delivered on a specified future date at an agreed price. Salam is also defined as a forward purchase of specified goods for assets or a full forward payment (i.e. a forward contract). In normal circumstances, a sale cannot be affected unless the goods / assets are in existence at the time of the bargain. However, this type of sale is an exception, provided the goods / assets are defined and the date of delivery is fixed. The objects of the sale must be tangible goods/ assets that can be defined as to quantity, quality and workmanship

 

o   Istisna’a (contract to manufacture)

Istisna’a is a trading mode where specific goods or an asset is made against a purchase order for delivery at a specified future date. An order to manufacture goods or assets requires various expenses including expenditures on raw materials, utilities, labour, and direct and indirect over-heads; these types of expenses may not be suited to murabaha financing which is primarily focused on the trade in commodities.

As a mode of finance, Islamic banks frequently use istisna'a to finance construction projects that may also involve the manufacturing of industrial equipment and various capital goods. Under this mode, the client will request and the bank will agree to construct and to sell the project to be constructed at the bank’s selling price (cost plus profit margin) on deferred payment terms and thereafter the bank will request another party (a contractor) to construct the project and the bank will purchase the project to be constructed at the bank’s purchase price (cost price/facility amount).

o   Tawarruq (Reverse Murabaha)  Bai Al Ajel

Tawarruq as an Islamic banking product is a recent introduction. It may be considered as a reverse form of commodity murabahah. Tawarruq is a debt instrument that many Shari’ah scholars have approved allowing Islamic banks another way financing individuals and businesses in need of cash or liquidity without contravening the rules of the Shari’ah. Under a tawarruq contract, Islamic banks sell any saleable goods or assets a client on deferred payment at cost plus profit, and the customer then sells the goods or the asset on a spot basis to a third party for cash.

There is a view that tawarruq is prohibited because the structuring resembles bai` `inah, a mode used in Malaysia, whereby an Islamic bank and a client (in need of cash) enter into a transaction between themselves involving a buy-back arrangement. It involves the bank buying goods or an asset from a client for immediate cash and then selling it back immediately same client for a higher amount on deferred payment.

o   Qard Hasan (Benevolent Loan)

Qard Hasan is a non-interest bearing loan or benevolent loan that may not collateralised. It refers to a loan given by a person (the lender) to another (the borrower) without any expectation of any return for the use of the funds. The borrower is obliged to only repay the original amount to the lender within the agreed stipulated period of time. The borrower can pay more than the amount borrowed so long as it is not required by the contract. Qard Hasan is granted on compassionate grounds free of interest and/or service charge. It is repayable as and when the borrower is able to repay. Under this mode of financing many Islamic banks are providing Qard Hasan to clients who are in need, for example for education and medical treatment. Other Islamic banks give interest-free loans only to the holders of investment accounts with them; some extend Qard Hasan to all the bank’s clients; some banks restrict the loans other economically weaker sections of society; and some provide interest-free loans to small producers, farmers and entrepreneurs who are unable to obtain finance from other sources. Qard Hasan is also in Islamic microfinance.

Quasi - Debt Type Instruments include:

o   Ijarah (leasing)

Ijarah is one of the simplest asset-based financial instruments. Under Islam, leasing began as a trading activity and then much later became a mode of finance. As a mode of finance, under an ijarah contract, the Islamic bank purchases an asset or equipment at the request of a client and leases / rents it to the client a price that includes a fair return for the bank. The lease contract specifies the leasing period, the amount and timing of lease payments and the responsibilities of both parties during the life of the lease. Lease can be simple rental or more elaborate contractual arrangements committing the parties to future action. The bank can, by agreement with the client, re-negotiate the quantum of the lease payment at agreed intervals.

The risk in Ijarah principally revolves around the fact that the Islamic bank is the owner of the asset / equipment being financed. This ownership is helpful from the point of view that there is comfort for the bank who may rely more on the high quality of an asset than the credit risk of the client, which allows a client of relatively weak credit rating to obtain Ijarah financing.

Under the standard ijarah contract, the client does not normally have the option to purchase the leased asset in instalments but may purchase the asset at the end of the lease period. Subject to fulfillment of certain condition, this object may be achieved by means similar to a hire purchase agreement, known as an ijara wa iqtina (equivalent to a leasing and instalment loan), whereby each lease rental payment includes a portion of the agreed asset price and can be made for a term covering the asset's expected life. The optional purchase price declines over the period of the lease agreement, but as the client is not obliged to purchase, the

Profit-And-Loss-Sharing Instruments include:

o   Musharakah | Diminishing Mushrakah (partnership or joint venture)

Musharakah implies an arrangement of business or its financing based on the concept of profit-and-loss sharing in which all parties contribute capital or labour skills or a combination of all three in a venture. The profit of the venture can be shared in any agreed proportion but any loss is shared in strict proportion to the capital contributed by each party. As a participatory mode with profit-and-loss sharing musharakah is considered to be the most desired mode of Islamic financing.

It a form on equity participation and also widely regarded as the purest form of an Islamic financial contract, conforming to the underlying partnership principles of sharing in, and benefiting from, risk. All key Shari’ah essentials are promoted in a musharakah contract, such as

(a) Absence of profit

(b) Sharing in the risk

(c) Sharing in the profit-and-loss (profits can be divided up in any agreed ratio, while losses must be shared in strict proportion the investment)

(d) Direct link between capital investment and underlying asset-backed transactions

As a form of financing, an Islamic bank enters into a partnership with a client in which both invest in the equity capital required to finance a transaction or project, perhaps even participate in the management ; both share in the profits according to a pre-determined basis or in losses according to their investment. As such, musharakah is an equity participation arrangement which works like a partnership, normally for a limited duration. It can be conveniently adopted by Islamic banks for single transactions. Musharakah may also be adopted to finance new projects, or to provide additional funding for existing ones.

A variant of the musharakah is Diminishing Musharakah (DM).

The DM arrangements, as in the case of musharakah, allow equity participation and sharing of profits on a pro-rata basis, but also provide a method through which the bank keeps on reducing its equity in an asset against periodical payments, ultimately transferring ownership of the asset to the client. Over and above the payment against the bank’s share in the equity held by the bank, the client also makes rental payments based on the level of equity held by the bank, with each payment, the bank’s equity reduces followed by a reduction in the rental calculated on the reducing equity. Thus, by the capital repayments the client purchases the bank’s equity, progressively increasing the client’s equity and reducing (diminishing) the bank’s equity until the bank has no equity and thus ceases to be a partner and the client has acquired complete ownership. Likewise, the rental payments to the bank reduce with the bank’s diminishing equity in the asset until no further rental payment has to be made. The real estate, housing and construction sectors increasingly use DM.

o   Mudarabah (profit-and-loss sharing partnership)

Mudarabah, also a participatory mode and a form of investment partnership, ranks alongside musharakah as one of Islamic finance’s preferred financing modes, musharakah being the most desired form of financing. Mudarabah also embodies the spirit of profit-and-loss sharing partnerships and the encouragement of trade, as well as an active management of capital linked to assets. Unlike musharakah, in mudarabah one party provides the capital while another other party, as the managing partner, provides the labour and skills to manage the venture. Profits are shared between the parties according to a pre-agreed ratio; however losses are borne by the capital provider only.

As a financing mode adopted by Islamic banks, it is a contract in which all the capital is provided by the Islamic bank and the business, or a project, is undertaken by the client. The profit is shared in pre-agreed ratios, and loss, if any, is borne by the bank only, except in the case of misconduct, negligence, or violation of the conditions agreed with the bank. While many banks are providing mudarabah financing for various business activities, they may also make mudarabah investments in the small budding entrepreneurs in the form of venture capital finance transactions.

Hybrid or Combination Modes

Frequently there are projects which call for the use of a variety of, or a combination of, modes within an Islamic financing transaction. In such a situation, the prudent Islamic banker basically describes the transaction and breaks the transaction into its constituent parts, using some modes as building blocks where it appears to be most appropriate, but they must all be independent of one another. Islamic banks may use these modes with accessory contracts, such as:

• Jua′alah (Wages, pay, stipend, or reward in exchange for a service provided by the bank)

• Wakalah (Whereby the bank acts on behalf of a client for a fee)

• Amanah (Trust)

• Hawalah (Assignment of debts)

• Kafalah (Whereby the bank acts as guarantor)

Combinations modes are allowed by Shari’ah scholars based on the general principle of necessity provided they “make something forbidden as permissible or something permissible as forbidden”. Some scholars have raised objections to certain types of modes being combined as in such cases all rights and obligations will be seen as inseparable and dependent on each other. “What is at dispute is not the validity of combination contracts in principle. The concern is with the nature and form of such combinations” (A Guide to Islamic Finance, by Munawar Iqbal, 2007).