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ISLAMIC BANKING AND FINANCIAL PRODUCTS

IB&F: 405: Trade Based Modes of Islamic Banking and Finance

POST GRADUATE DIPLOMA IN ISLAMIC BANKING & FINANCE

AlHuda CIBE

“If You Invest in Islamic Finance Products, You tend not to be sensitive to developments in interest rates.”

Fares Mourad, Credit Suisse

IB&F: 405

TRADE BASED MODES OFISLAMIC BANKING & FINANCE

C O N T E N T S

· Bai

· Murabaha

· Salam

www.alhudacibe.com/dlp

01

09

14

· Summary

· Discussion Questions

· Reference Material

33

33

34

· Istisna

34

BAI (BUYING/SELLING)

'Bai' is defined in Shari'ah as 'the exchange of a thing of value by another

thing of value with mutual consent'. Islamic jurisprudence has laid down

enormous rules governing the contract of sale, and the Muslim jurists have

written a large number of books, in a number of volumes, to elaborate them

in detail.

Some Basic Rules of Bai

What is meant here is to give a summary of only those rules which are more

relevant to the transactions of Murabaha as carried out by the financial

institutions:

The subject of sale must be existing at the time of sale:Thus, a thing which has not yet come into existence cannot be sold but if a

non-existent thing has been sold, though by mutual consent, the sale is void

according to Shari'ah.

Example: A sells the unborn calf of his cow to B. The sale is void.

The subject of sale must be in the ownership of the seller at the time of

sale:

Thus, what is not owned by the seller cannot be sold. If he sells something

before acquiring its ownership, the sale is void.

Example:

§A sells to B a car which is presently owned by C, but A is hopeful that he

will buy it from C and shall deliver it to B subsequently. The sale is

void, because the car was not owned by A at the time of sale.

01

Glossary:

Bai: The exchange of a thing of value by another thing of value with mutual consent is termed as Bai (Sale).


The subject of sale must be in the physical or constructive possession of

the seller when he sells it to another person:

"Constructive possession" means a situation where the possessor has not

taken the physical delivery of the commodity, yet the commodity has come

into his control, and all the rights and liabilities of the commodity are passed

on to him, including the risk of its destruction.

Examples:

§A has purchased a car from B. B has not yet delivered it to A or to his

agent. A cannot sell the car to C. If he sells it before taking its delivery

from B, the sale is void.

§A has purchased a car from B. B, after identifying the Car has placed it

in a garage to which A has free access and B has allowed him to take

the delivery from that place whenever he wishes. Thus the risk of the

Car has passed on to A. The car is in the constructive possession of A.

If A sells the car to C without acquiring physical possession, the sale is

valid.

Explanation 1:

The gist of the rules mentioned in paragraphs 1 to 3 is that a person cannot

sell a commodity unless:

§ It has come into existence.

§ It is owned by the seller.

§ It is in the physical or constructive possession of the seller.

Explanation 2:

There is a big difference between an actual sale and a mere promise to sell.

The actual sale cannot be effected unless the above three conditions are

fulfilled. However one can promise to sell something which is not yet owned

or possessed by him. This promise initially creates only a moral obligation on

the promisor to fulfill his promise, which is normally not justifiable.

Nevertheless, in certain situations, especially where such promise has

burdened the promise with some liability, it can be enforceable through the

courts of law. In such cases the court may force

02

There is a big

difference between

an actual sale and a

mere promise to

sell.

TIP


the promisor to fulfill his promise, i.e. to effect the sale, and if he fails to do

so, the court may order him to pay the promise the actual damages he has

incurred due to the default of the promisor.

But the actual sale will have to be effected after the commodity comes into

the possession of the seller. This will require separate offer and acceptance,

and unless the sale is affected in this manner, the legal consequences of the

sale shall not follow.

Exception:

The rules mentioned in paragraphs 1 to 3 are relaxed with respect to two

types of sale, namely:

§Bai' Salam

§ Istisna'

The rules of these two types will be discussed later in a separate chapter.

The sale must be instant and absolute:

Thus a sale attributed to a future date or a sale contingent on a future event

is void. If the parties wish to affect a valid sale, they will have to affect it

afresh when the future date comes or the contingency actually occurs.

03

Glossary:

Istisna: Istisna' is a contract to build, manufacture, construct or develop the object of sale at a definite price, over a defined period of time, according to agreed specifications between the parties.

Salam: Salam refers to the purchase of a commodity for deferred delivery in exchange for immediate payment.

Keep In Mind

The actual sale cannot be affected unless these three conditions are fulfilled:

first, it has come into existence. It is owned by the seller and it is in the

physical or constructive possession of the seller.

Thus a sale

attributed to a

future date or a sale

contingent on a

future event is void.

TIP


Examples:

§A says to B on the first of January: "I sell my car to you on the first of

February". The sale is void, because it is attributed to a future date.

§A says to B, "If party X wins the elections, my car stands sold to you".

The sale is void, because it is contingent on a future event.

The subject of sale must be a property of value:

Thus, a thing having no value according to the usage of trade cannot be sold

or purchased.

The subject of sale should not be a thing which is used for a Haram

purpose:

The subject of sale should not be for a thing which is used for Haram purpose

like pork, wine etc.

The subject of sale must be specifically known and identified to the buyer:

The subject of sale or a commodity for which sale is being conducted must

be in the knowledge of the buyer. All the specifications must be made known

to the buyer.

Example:

§There is a building comprising a number of apartments built in the

same pattern. A, the owner of the building says to B, "I sell one of

these apartments to you"; B accepts. The sale is void unless the

apartment intended to be sold is specifically identified or pointed

out to the buyer.

The delivery of the sold commodity to the buyer must be certain:

The delivery of the sold commodity to the buyer must be certain and should

not depend on a contingency or chance.

04

The subject of sale

should not be for a

thing which is used

for Haram purpose

like pork, wine etc.

TIP


05

Example:

§ A sells his car stolen by some anonymous person and the buyer purchases it under the hope that he will manage to take it back. The sale is void.

Price of the commodity must be certain:

The certainty of price is a necessary condition for the validity of a sale. If the price is uncertain, the sale is void.

Example:

§ A says to B, "If you pay within a month, the price is Rs. 50. But if you pay after two months, the price is Rs. 55". B agrees. The price is uncertain and the sale is void, unless anyone of the two alternatives is agreed upon by the parties at the time of sale.

The sale must be unconditional:

A conditional sale is invalid, unless the condition is recognized as a part of the transaction according to the usage of trade.

Example:

§ A buys a car from B with a condition that B will employ his son in his firm. The sale is conditional, hence invalid.

§ A buys a refrigerator from B, with a condition that B undertakes its free service for 2 years. The condition, being recognized as a part of the transaction, is valid and the sale is lawful.

Components of Valid Bai

The components which are necessary for a valid bai are as follows:

§ Contract

§ Subject matter

§ Price

§ Possession

In Islam, a

conditional sale is

invalid

TIP


The components are depicted in the following graphical diagram:

06

Muslim Trade Routes


07

Kinds of Bai

There are several kinds of Bai. Some of these are:

§ Bai Musawamah

§ Bai Murabaha

§ Bai Salam

§ Bai Istisna'

§ Bai Urboon

§ Bai Eenna

§ Bai Touliya

§ Bai Wadhia

§ Bai Tawaruq

Detail of all these kinds is given below:

Bai Musawamah: it is a negotiated sale, a general kind of sale in which the price of the commodity to be traded is bargained between the seller and the purchaser without any reference to the price paid or cost incurred by the seller.

Bai Murabaha: Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and the profit. This has been adopted by Islamic banks as a mode of financing. As a financing technique, it can involve a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost which is stipulated in advance.

Bai Salam: Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract. According to normal rules of the Shariah, no sale can be affected unless the goods are in existence at the time of the bargain, but Salam sale forms an exception given by the Holy Prophet (SAW) himself to the general rule provided the goods are defined and the date of delivery is fixed. It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute.

Murabaha is a

sale on mutually

agreed profit.

TIP


08

Bai Istisna: It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery. A manufacturer or builder agrees to produce or build a well described good or building at a given price on a given date in the future. Price can be paid in installments, step by step as agreed between the parties. Istisna can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, and building of bridges, roads and highways.

n resell an object between them, once for cash and once for a higher price on credit, with the net result of a loan with interest.

Bai Wadiah: safe-keeping/resale of goods with a discount on the original stated cost. It is a

Bai Urboon:

sale of goods at a discounted price.

It is essentially a down payment made by a buyer to a seller after both parties have entered into a valid contract. The down payment represents the commitment to purchase the goods. If the buyer is able or decides to pay the remaining outstanding payment during a prescribed period, the amount paid as down payment will be counted as part of the purchase price. Otherwise, the down payment will be forfeited by the seller.

Bai Eenna: Double sale by which the borrower and the lender sell and the

Bai Tawarruq: a transaction which generates cash now for more cash later through trade in goods, other than gold and silver. Usually it involves a deferred payment sale of goods by the financier to the customer at a higher price which the customer then sells to a third party for cash, thereby receiving cash now for more cash paid later to the financier.

Bai Wadiah is a sale

of goods at a

discounted price.

TIP

Bai Salam is ideal

for agricultural

financing.

TIP

Trade in Islamic Era


Murabaha is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit or mark-up thereon. The profit in Murabaha can be determined by mutual consent, either in lump sum or through an agreed

09

Keep In Mind

Murabaha is valid only where the exact cost of a commodity can be

ascertained. If the exact cost cannot be ascertained, the commodity cannot

be sold on Murabaha basis.

ratio of profit to be charged over the cost.

All the expenses incurred by the seller in acquiring the commodity like freight, custom duty etc. shall be included in the cost price and the mark-up can be applied on the aggregate cost. However, recurring expenses of the business like salaries of the staff, the rent of the premises etc. cannot be included in the cost of an individual transaction.

In fact, the profit claimed over the cost takes care of these expenses. Murabaha is valid only where the exact cost of a commodity can be ascertained. If the exact cost cannot be ascertained, the commodity cannot be sold on Murabaha basis. In this case the commodity must be sold on Musawamah (bargaining) basis i.e. without any reference to the cost or to the ratio of profit / mark-up. The price of the commodity in such cases shall be determined in lump sum by mutual consent.

Examples:

§ “A” purchased a pair of shoes for Rs. 100/-. He wants to sell it on Murabaha with 10% mark-up. The exact cost is known. The Murabaha sale is valid.

§ “A” purchased a ready - made suit with a pair of shoes in a single transaction, for a lump sum price of Rs. 500/-. A can sell the suit including shoes on Murabaha. But he cannot sell the shoes


separately on Murabaha, because the individual cost of the shoes is unknown. If he wants to sell the shoes separately, he must sell it at a lump sum price without reference to the cost or to the mark-up.

Murabaha as a Mode of Financing

Originally, Murabaha is a particular type of sale and not a mode of financing. The ideal mode of financing according to Shari'ah is Mudarabah or Musharaka which have been discussed in the first chapter. However, in the perspective of the current economic set up, there are certain practical difficulties in using Mudarabah and Musharaka instruments in some areas of financing. Therefore, the contemporary Shari'ah experts have allowed, subject to certain conditions, the use of the Murabaha on deferred payment basis as a mode of financing.

But there are two essential points which must be fully understood in this respect:

§ It should never be overlooked that, originally, Murabaha is not a mode of financing. It is only a device to escape from "interest" and not an ideal instrument for carrying out the real economic objectives of Islam. Therefore, this instrument should be used as a transitory step taken in the process of the Islamization of the economy, and its use should be restricted only to those cases where Mudarabah or Musharaka are not practicable.

§The second important point is that the Murabaha transaction does not come into existence by merely replacing the word of "interest" by the words of "profit" or "mark-up". Actually, Murabaha as a mode of finance has been allowed by the Shari'ah

10

Originally,

Murabaha is a

particular type of

sale and not a mode

of financing.

TIP

Keep In Mind

There are certain practical difficulties in using Mudarabah and Musharaka

instruments in some areas of financing. Therefore, the contemporary

Shari’ah experts have allowed, subject to certain conditions, the use of the

Murabaha on deferred payment basis as a mode of financing.


11

scholars with some conditions. Unless these conditions are fully observed, Murabaha is not permissible. In fact, it is the observance of these conditions which can draw a clear line of distinction between an interest-bearing loan and a transaction of Murabaha. If these conditions are neglected, the transaction becomes invalid according to Shari'ah.

Basic Features of Murabaha Financing

The basic features of Murabaha are as follows:

§ Murabaha is not a loan given on interest. It is the sale of a commodity for a deferred price which includes an agreed profit added to the cost.

§ Being a sale, and not a loan, the Murabaha should fulfill all the conditions necessary for a valid sale, especially those enumerated earlier in this chapter.

§ Murabaha cannot be used as a mode of financing except where the client needs funds to actually purchase some commodities. For example, if he wants funds to purchase cotton as a raw material for his ginning factory, the Bank can sell him the cotton on the basis of Murabaha. But where the funds are required for some other purposes, like paying the price of commodities already purchased by him, or the bills of electricity or other utilities or for paying the salaries of his staff, Murabaha cannot be affected, because Murabaha requires a real sale of some commodities, and not merely advancing a loan.

§ The financier must have owned the commodity before he sells it to his client.

§ The commodity must come into the possession of the financier, whether physical or constructive, in the sense that the commodity must be in his risk, though for a short period.

§ The best way for Murabaha, according to Shari'ah, is that the financier himself purchases the commodity and keeps it in his own possession, or purchases the commodity through a third person appointed by him as agent, before he sells it to the

Murabaha should

fulfill all the

conditions necessary

for a valid sale

TIP


customer. However, in exceptional cases, where direct purchase from the supplier is not practicable for some reason, it is also allowed that he makes the customer himself his agent to buy the commodity on his behalf. In this case the client first purchases the commodity on behalf of his financier and takes its possession as such. Thereafter, he purchases the commodity from the financier for a deferred price. His possession over the commodity in the first instance is in the capacity of an agent of his financier. In this capacity he is only a trustee, while the ownership vests in the financier and the risk of the commodity is also borne by him as a logical consequence of the ownership. But when the client purchases the commodity from his financier, the ownership, as well as the risk, is transferred to the client.

§As mentioned earlier, the sale cannot take place unless the commodity comes into the possession of the seller, but the seller can promise to sell even when the commodity is not in his possession. The same rule is applicable to Murabaha.

§ It is also a necessary condition for the validity of Murabaha that the commodity is purchased from a third party. The purchase of the commodity from the client himself on 'buy back' agreement is not allowed in Shari'ah. Thus Murabaha based on 'buy back' agreement is nothing more than an interest based transaction. The above mentioned procedure of the Murabaha financing is a complex transaction where the parties involved have different capacities at different stages.

Steps Involved in Murabaha

In the light of the aforementioned principles, a financial institution can use the Murabaha as a mode of finance by adopting the following procedure:

Firstly: The client and the institution sign an over-all agreement whereby the institution promises to sell and the client promises to buy the commodities from time to time on an agreed ratio of profit added to the cost. This agreement may specify the limit up to which the facility may be availed.

12

The sale cannot

take place unless

the commodity

comes into the

possession of the

seller

TIP


13

Secondly: When a specific commodity is required by the customer, the institution appoints the client as his agent for purchasing the commodity on its behalf, and an agreement of agency is signed by both the parties.

Thirdly: The client purchases the commodity on behalf of the institution and takes its possession 0s an agent of the institution.

Fourthly: The client informs the institution that he has purchased the commodity on his behalf, and at the same time, makes an offer to purchase it from the institution.

Fifthly: The institution accepts the offer and the sale is concluded whereby the ownership as well as the risk of the commodity is transferred to the client.

All these five stages are necessary to affect a valid Murabaha. If the institution purchases the commodity directly from the supplier (which is preferable) it does not need any agency agreement. In this case, the second phase will be dropped and at the third stage the institution itself will purchase the commodity from the supplier, and the fourth phase will be restricted to making an offer by the client. The most essential element of the transaction is that the commodity must remain in the risk of the institution during the period between the third and the fifth stage. This is the only feature of Murabaha which can distinguish it from an interest-based transaction. Therefore, it must be observed with due diligence at all costs, otherwise the Murabaha transaction becomes invalid according to Shari'ah.

The most essential

element of the

transaction is that

the commodity must

remain in the risk of

the institution

during the period

between the third

and the fifth stage.

TIP

Keep In Mind

The most essential element of the transaction is that the commodity must

remain in the risk of the institution during the period between the third and

the fifth stage. This is the only feature of Murabaha which can distinguish it

from an interest-based transaction.


Step By Step Murabaha Financing

Stage 1: Promise Stage

Stage 1 (A)

Client approach the bank for facility of Murabaha

Stage 1 (B)Client and bank sign an agreement to enter into Murabaha

Stage 1 (C)Client submits the purchase requisition to the bank

14

Facility Approved Islamic

Bank Client

Murabaha Facility

Agreement

MOU

Islamic

Bank

Client

Islamic Bank

Client Submission of Purchase

Requisition


Stage 2: Agency Stage

Stage 2 (A)

Client is appointed as agent to purchase goods on bank's behalf

Stage 2 (B)

Bank gives money to supplier through client's account for purchase of goods

15

Bank Client Agreement to

Murabaha

Agency Agreement

Agreement to Murabaha

Agency Agreement

Islamic

Bank Bank Client

Disbursement to the client


Stage 3: Acquiring Possession

Client purchases goods on bank's behalf and takes their possession.

Stage 4: Execution of MurabahaStage 4 (A)

Client makes an offer to purchase the goods from bank

Stage 4 (B)Bank accepts the offer and sale is concluded

16

Client purchases

goods and takes

possession Transfer of Risk Vendor

Bank Client

Offer to purchase

Bank Client

Murabaha

Agreement

+

Transfer of Title

Bank Client


Stage 4 (C)

Client pays agreed price to bank according to an agreed schedule, usually on a deferred payment basis (Bai Muajjal)

General Mechanism of Murabaha

CUSTOMER ISLAMIC BANK Agreement VENDOR



17

Bank Client Payment of Price



The above mentioned procedure of the Murabaha financing is a complex transaction where the parties involved have different capacities at different stages.

§At the first stage, the institution and the client promise to sell and purchase a commodity in future. This is not an actual sale. It is just a promise to affect a sale in future on Murabaha basis. Thus at this stage the relation between the institution and the client is that of a promisor and a promise.

§At the second stage, the relation between the parties is that of a principal and an agent.

§At the third stage, the relation between the institution and the supplier is that of a buyer and seller.

§At the fourth and fifth stage, the relation of buyer and seller comes into operation between the institution and the client, and since the sale is affected on deferred payment basis, the relation of a debtor and creditor also emerges between them simultaneously.

All these capacities must be kept in mind and must come into operation with all their consequential effects, each at its relevant stage, and these different capacities should never be mixed up or confused with each other.

The institution may ask the client to furnish a security to its satisfaction for the prompt payment of the deferred price. He may also ask him to sign a promissory note or a bill of exchange, but it must be after the actual sale takes place, i.e. at the fifth stage mentioned above. The reason is that the promissory note is signed by a debtor in favor of his creditor, but the relation of debtor and creditor between the institution and the client begins only at the fifth stage, whereupon the actual sale takes place between them.

In the case of default by the buyer in the payment of price at the due date, the price cannot be increased. However, if he has undertaken, in the agreement to pay an amount for a charitable purpose, he shall be liable to pay the amount undertaken by him. But the amount so recovered from the buyer shall not form part of the income of the seller or

18

Murabahah

financing is a

complex transaction

where the parties

involved have

different capacities

at different stages.

TIP


19

the financier. He is bound to spend it for a charitable purpose on behalf of the buyer, as will be explained later in detail.

Applications of Murabaha

Murabaha can be utilized for the following purposes:

§Purchase of raw material; for meeting working capital needs of trade and industry.

§Medium to long term requirements for purchase of land, building and equipment.

§Trade finance products including imports, exports and bill purchase.

Pricing of Murabaha


Risk Dimension of Murabaha

20

Risk

Dimension

s

Credit

Banking

Risks

Credit

Credit Liquidity

Interest Rate

Market

Foreign Exchange

Solvency

Operational

Islamic Banks also face

-Additional asset risk

-Greater fiduciary risks

-Greater legal risk


SALAM AND ISTISNA

Salam (Advance Payment – Deferred Delivery of Goods)

Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advance price fully paid on spot. Seller and the buyer can agree on any price at their free will. Price in Salam can be lower than the spot sale price.

The buyer should pay the price in full to the seller at the time of finalizing the sale. Otherwise, it will be tantamount to a sale of debt against debt, which is expressly prohibited by the Holy Prophet (Peace be upon him). The Islamic Fiqh Academy has resolved that the seller may give a concession of two or three days to the buyers but this concession should not form part of the agreement. Because of this consideration, a debt liability of the seller cannot be adjusted against price for Salam sale, in part or in full. Allama Ibn Qudama says “It is not permissible for a person to use (for instance) one Dinar owed to him by somebody else as Salam principal for purchasing a certain quantity of food from that person. Ibn al Monzer says: a consensus on prohibition of this (adjusting the debt in Salam price) had been reached by all the Ulama from whom I learned, including Malik, al Awza'i, al Thawri, Ahmad, Es'haq, As'hab al rai and al Shafi'e. However, Ibn al Qayyim and Ibn Taymiah allow that amount of debt can be subtracted from the price to be paid in Salam. (Umar, Haleem; 1995, pp. 32, 33).

21

Price in Salam can

be lower than the

spot sale price.

TIP

A debt liability of

the seller cannot be

adjusted against

price for Salam sale,

in part or in full

TIP

Keep In Mind

Allama Ibn Qudama says “It is not permissible for a person to use (for

instance) one D inar owed to him b y somebody else as Salam principal for

purchasing a certain quantity of food from that person.

Glossary:

Spot Sale Price: Spot Sale Price is usually the cash price for a product available for immediate delivery it also refers to the nearest contract month for delivery.


Although the buyer has to pay the price in full at the time the Salam contract is finalized, yet the payment of hard cash is not necessary; banks may credit the seller's account or issue a pay order, in favor of the seller, which will be encashable on demand. Salam borrower (seller) may deposit the amount or the price he receives with the same bank with which he had entered into a Salam deal. However, granting a line of credit in Salam will not be advisable because in that case it would be difficult to fulfill the Shari'ah conditions relevant to Salam.

Salam can be applied in those commodities only that are normally available in the market and whose quality and quantity can be specified exactly. It may include any marketable goods with definable features, like raw materials, agricultural produce or manufactured goods. The quality of the commodity that is intended to be purchased should be fully specified leaving no ambiguity leading to dispute. Date of delivery must be well set either by linking it to a specific date or to an event whose happening is an absolute certainty although the date of its occurrence may be subject to a slight variance, provided it does not result in a conflict.

The time of delivery should be long enough to affect prices. Preferably, it should be fifteen days or one month from the date of agreement. But as the Holy Prophet (SAWW) did not specify any minimum period for the validity of Salam, it is all right to have an earlier date of delivery if the seller consents to it and other conditions of Salam are fulfilled.

The banks will receive certain commodities, not money, from their clients. They cannot sell commodities purchased through Salam before they are actually delivered to them. The Islamic Fiqh Academy of the OIC in its Eighth session (21-27 June, 1993) resolved in respect of Salam that: “As Salam (forward buying) contract covers a wide scope considering its terms and conditions, it benefits the buyer in investing his surplus funds for profit, as well as the seller in securing adequate commodity prices.

22

Salam can be

applied in those

commodities only

that are normally

available in the

market and whose

quality and quantity

can be specified

exactly.

TIP

Glossary:

Pay Order: A cheque issued by a branch of a bank against consideration received. Pay

orders are valid for a certain period as indicated on the face of the cheque.


A commodity which is subject of a forward contract (purchased through Salam contract) cannot be sold until it is received” (Also see Mu'watta, No. 1352, P. 301).

A parallel contract of Salam, however, is possible with any third party. The bank (buyer in Salam) can enter into a parallel Salam contract without any condition or linkage with the original Salam contract. In one contract, the bank will be the buyer and in the second the seller. Each one of the two contracts shall be independent of the other. They cannot be tied up in a manner that the rights and obligations of one contract are dependant on the rights and obligations of the parallel contract. Further, parallel Salam is allowed with a third party only. For example, if a bank has purchased from farmer 'A' 50 tons of wheat by way of Salam to be delivered on June 30, the bank can contract a parallel Salam with a trader 'B' to deliver to him 50 tons of wheat on June 30. But while contracting parallel Salam with 'B', the delivery of wheat to him cannot be made conditional upon taking delivery from 'A'. Even if 'A' does not deliver wheat on June 30, bank will be duty bound to deliver 50 tons of wheat to 'B'. Bank can seek whatever recourse it has against 'A', but he cannot back out from his liability to deliver the wheat to 'B'. Similarly, if the farmer delivers poor quality wheat, the bank will be still obligated to deliver the wheat of stipulated quality to 'B' according to the original Salam contract.

23

Glossary:

Parallel Salam: Parallel Salam is based on two independent Salam contracts whereby the financier will be both the seller and the buyer in this arrangement

Parallel Salam is

allowed with a third

party only

TIP

Keep In Mind

A parallel contract of Salam , however, is possible with any third party. The

bank (buyer in Salam) can enter into a parallel Salam contract without any

condition or linkage with the original Salam contract. In one contract, the

bank will be the buyer and in the second the seller. Each one of the two

contracts shall be independent of the other. They cannot be tied up in a

manner that the rights and obligations of one contract are dependant on the

rights and obligations of the parallel contract.


In order to ensure that the seller shall deliver the commodity on the agreed date, bank can ask him to furnish a security, which may be in the form of a guaranty, mortgage or hypothecation.

The jurists disallow the operation of the Islamic law of option (Khiyar) in the case of Salam because this disturbs or delays the seller's right of ownership over the price of the goods. In case of multiple commodities, the amount and period of delivery for each item should be separately fixed. Salam was allowed by the Holy Prophet (Peace be upon him) to fulfill the needs of farmers and traders. Therefore, it is basically a mode of financing for small farmers and traders in agricultural goods. Banks can use this mode to finance the agricultural sector in particular and other trading activities in general. If a parallel contract of Salam is not feasible, banks can also obtain a promise from a third party to purchase the goods. This promise should be unilateral from the prospective buyer. The buyers will not have to pay the price in advance as they are merely making a promise. However, bank can ask for earnest money. As soon as the bank receives the commodity, it will be sold to the third party at a pre-agreed price, according to the terms of the promise.

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Glossary:

Mortgage: Mortgage is a written constructive pledge of property that is used as

security for the repayment of a loan.

Hypothecation: Hypothecation is a charge that is created on movable asset as

security for a debt. However, the ownership as well as possession of the asset is

retained with the borrower.

Salam is basically a

mode of financing

for small farmers

and traders in

agricultural goods.

TIP

Keep In Mind

Salam was allowed by the Holy Prophet (Peace be up on him) to fulfill the

needs of farmers and traders. Therefore, it is basically a mode of financing

for small farmers and traders in agricultural goods. Banks can use this mode

to finance the agricultural sector in particular and other trading activities in

general.


Regarding contemporary application of Salam, banks can use it for Agricultural Finance, Export Finance, Working Capital Finance, Inventory Finance, Operational Cost Management, Liquidity Management-Short term financing, etc. Islamic Fiqh Academy (pp: 185-187) has observed that the wide range of applications of Salam may include the following:

§A Salam contract may be used to finance various agricultural operations, in which case an Islamic bank may deal with farmers expected to have the commodity in the right season, either from their own crop or from that of others, which they may purchase and deliver in case of failure on their part to honor the delivery out of their own crops. The bank would thus have extended to them a benefit of great value and protected them against the failure to achieve their production targets on account of resource constraints.

§A Salam contract may be used to finance agricultural or industrial activities particularly for financing the stages before the production and export of the manufactured goods, by means of buying them under Salam and marketing them again at profitable prices.

§A Salam contract may be applied in financing handicraftsmen, small manufactures, farmers and industrialists by providing them with the necessary production needs in the form of tools, equipment, or raw material as a forward capital against access to some of their produce and remarketing them.

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Istisna

Istisna, like Salam, is a special kind of sale where sale of a commodity is transacted before it (the commodity) comes into existence. It is an agreement culminating into a sale at an agreed price whereby the purchaser places an order to manufacture, assemble or construct, or cause so to do, anything to be delivered at a future date. Istisna can be used for providing the facility of financing the manufacture or construction of houses, plants, projects, building of bridges, roads and highways, etc.

It is used in the field of manufacturing wherein Al-Saani (manufacturer) would arrange both the raw material and the labor. (If material is supplied by the purchaser and the manufacturer is required to use his labor and skill only, it will be the contract of Ujrah and not of Istisna.) The subject of Istisna (things to be manufactured or constructed) must be known and specified to the extent of removing any ignorance or lack of knowledge of its kind, type, quality, and quantity. The price should also be known in advance to the extent of removing ignorance or lack of knowledge, and price once settled, cannot be increased or decreased. However, it can be readjusted by the mutual consent of the contracting parties because of making material modification in the commodity (al-Masnoo) or due to unforeseen contingencies or changes in prices of inputs.

It is not necessary in Istisna that the price is paid in advance (unlike Salam in which spot payment of price is necessary). Price can be paid in installments within a fixed time period. Against the general rule set out for Salam, the contemporary scholars have legalized it on the basis of Istihsan as the construction of huge plants may require long gestation

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Istisna is an order to

manufacture and

construct anything.

TIP

The subject of

istisn’a must be

known and

specified.

TIP

Glossary:

Ujrah: Ujrah is a contract in which any work is done against stipulated wage or fee.

Istihsan: It is a doctrine of Islamic law that allows exception to strict legal reasoning,

or guiding choice among possible legal outcomes, when considerations of human

welfare so demand.


period and payment through installments according to the pace of implementation of such projects. In addition to these considerations, OIC Islamic Fiqh Academy recommends that time of manufacturing should be fixed.

It is not necessary for al-Sanii (seller) to manufacture the commodity himself. He may enter into a contract with a manufacturer to provide the subject matter of Istisna. On this basis, the banks may undertake financing based on Istisna by getting the subject of Istisna manufactured through another such contract.

Before a manufacturer starts the work, any one of the parties may cancel the contract by giving a notice to the other. However, after the manufacturer has started the work, the contract cannot be canceled by the buyer unilaterally. The Civil Law of some Muslim countries like Jordan and Sudan, the 'Unified Arab Law' proposed by the League of Arab Countries and the Fiqh Academy of the OIC treat Istisna a 'binding contract' provided that certain conditions are fulfilled. If the commodity conforms to the specifications agreed at the time of the Istisna contract, the purchaser is bound to accept the goods and he cannot exercise the option of inspection. Al-Mustasni (purchaser) has the right to obtain collateral from the al-Sanii for the amount he has paid and as regards delivery of the commodity with specifications and time.

The contract may also contain a penalty clause on account of breach of the contract. It can be agreed, in other words, between the parties that in the case of delay in delivery, the price shall be reduced by a specified amount. The scholars have contended this on the basis of analogy. The classical jurists have allowed such condition in Ijarah, e.g. if a person hires the services of a tailor, he may tell him that the wage would be Rs 100 in case he prepares the clothes within a week and Rs. 150 if within two

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Keep In Mind

If the commodity conforms to the specifications agreed at the time of the

Istisn’a contract, the p urchaser is bound to accept the goods and he cannot

exercise the option of inspection.


days. By analogy, experts allow a penalty clause in the Istisna agreement in case of delay in delivery of the subject of Istisna.

The Council of the Islamic Fiqh Academy of the OIC in its Seventh session (9-14-May, 1992) recommended the following in respect of Istisna:

§The Istisna (manufacture) contract is binding on both parties if it meets the basic requirements and conditions.

§The Istisna contract must stipulate the following:

o The nature, type, amount and required specifications of the product to be manufactured.

o The time limit should be specified.

§ In the Istisna contract, payment may be deferred in full or scheduled according to pre-determined installments and specific due dates.

§ It is permissible to include a penalty provision in the Istisna contract except for inevitable circumstances.

Differences between Istisna and Salam

The differences between Istisna and Salam are as follows:

§ Istisna deals with manufacturing items, but Salam could or could not be a manufacturing contract, but Salam is ideal for agriculture sector.

§ In Salam advance payment is necessary, but in Istisna' it is not a necessity.

§Date and time of delivery are necessary part of bai Salam, but in Istisna, it is not the part of the deal.

§ In bai Salam, it can be cancelled one sided, but in Istisna, it could be cancelled, if production is not started yet.

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Concluding Remarks

The following three basic rules are exceptional for Salam and Istisna:

§Existence of Product/Commodity

§Ownership of Product/Commodity

§Possession of Product/Commodity

Under Salam, 100% amount in paid in advance. The product must be quantified, identified and Measured with quality. Date of delivery, Time, Place must be mentioned clearly in advance and Salam is not valid for a specific farm/land/garden.

Under Istisna, it is not necessary to pay the 100% amount in advance like in Bai Salam. It is essential for the validity of Istisna that price must be decided in the beginning of the contract. Moreover, qualities, quantities and features of the products contracted must be identified.

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§ 'Bai' is defined in Shariah as 'the exchange of a thing of value by another thing of value with mutual consent'. Islamic jurisprudence has laid down enormous rules governing the contract of sale, and the Muslim jurists have written a large number of books, in a number of volumes, to elaborate them in detail.

§The subject of sale must be existing at the time of sale, the subject of sale must be in the ownership of the seller at the time of sale, the subject of sale must be in the physical or constructive possession of the seller when he sells it to another person.

§There is a big difference between an actual sale and a mere promise to sell. The actual sale cannot be effected unless the above three conditions are fulfilled. However one can promise to sell something which is not yet owned or possessed by him. This promise initially creates only a moral obligation on the promisor to fulfill his promise, which is normally not justifiable.

§Murabahah is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit or mark-up thereon. The profit in Murabahah can be determined by mutual consent, either in lump sum or through an agreed ratio of profit to be charged over the cost.

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Summary §The ideal mode of financing according to Shariah is mudarabah or musharakah which have been discussed in the first chapter. However, in the perspective of the current economic set up, there are certain practical difficulties in using mudarabah and musharakah instruments in some areas of financing. Therefore, the contemporary Shariah experts have allowed, subject to certain conditions, the use of the Murabahah on deferred payment basis as a mode of financing.

§ A parallel contract of Salam, however, is possible with any third party. The bank (buyer in Salam) can enter into a parallel Salam contract without any condition or linkage with the original Salam contract. In one contract, the bank will be the buyer and in the second the seller. Each one of the two contracts shall be independent of the other. They cannot be tied up in a manner that the rights and obligations of one contract are dependant on the rights and obligations of the parallel contract.

§ Salam was allowed by the Holy Prophet (Peace be upon him) to fulfill the needs of farmers and traders. Therefore, it is basically a mode of financing for small farmers and traders in agricultural goods


§What is bai? Explain some basic rules of Bai?

§What are the components and kinds of a valid bai?

§What is Murabaha? Explain Murabaha as a mode of financing?

§What are the basic features of Murabaha financing?

§What is Salam? Explain its basic rules?

§What is Istisna? Explain its basic rules? What are the differences between Salam and

Istisna?

§ Islamic financial services

§Contracts in Islamic commercial finance

§ Islamic modes of business and finance

§Books

§Articles

§Presentations

§Reports

For further study, you can consult our CD or e-library by getting log-in to your account. You

would get number of books, presentations, literature and reports on the following topics:

E-Library:

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Discussion Questions

Reference Material


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