Islamic Finance: An effective tool to finance construction

Istisna is another type of sale where a commodity or an asset is transacted before it comes into existence. However, as against Salam, the price in Istisna is not paid upfront but in phases, commensurate with the progress of the specified job. Istisna is widely used by the Islamic banks to finance the construction of buildings and industries.

It is essential for the validity of Istisna that the price and the complete specification of the asset (to be manufactured or constructed) are agreed to between the parties, at the outset.

An Istisna agreement creates an obligation on the seller to develop the required goods and for the buyer to take delivery upon completion. The parties do have an option to withdraw prior to commencement of work by giving written notice to the other. However, once the work has been started by the seller, the contract cannot be cancelled unilaterally.

Despite various similarities, following points define the different characteristics of Salam and Istisna:
* The subject of Istisna must be something, which requires manufacturing or construction from scratch whereas Salam could be utilised for all types of goods.

* It is necessary under Salam that the buyer pays full price upfront, while under Istisna the payment is released progressively or deferred for an agreed period.

* A Salam agreement, once entered, cannot be revoked unilaterally whereas a contract of Istisna could be cancelled by either party prior to commencement of work.

* Time and place of delivery is prefixed in Salam. Istisna does not impose any such condition.
In Istisna, the seller is required to manufacture or construct the agreed asset out of the material owned by him (pre-stored or purchased by him for the purpose).

However, if the buyer supplies the material and merely utilises the skills of the manufacturer or contractor, the transaction will be categorised under Ijara and not Istisna since the services are hired against an agreed fee.

When the seller has got the required goods or asset ready, he should invite the buyer for obtaining the delivery.

If all the agreed specifications have been complied with, the seller will be deemed to have fulfilled his obligation under the Istisna contract and the buyer will be bound to meet with his commitment to purchase the asset.

Most of the scholars agree that if the seller is found to have deviated from the agreed specifications, the Istisna agreement will become null and void and the buyer will have the right to walk out of the transaction.

In such situation, buyer will be entitled to reclaim any part payment made to the seller besides genuine damages, if any, incurred by the buyer due to seller's non-compliance to the Istisna specifications.

As discussed above, it is not the pre-requisite of Istisna to have a fixed delivery date, however, in order to remove uncertainty, buyer may want to assign a maximum time limit for completion of a certain Istisna job. If the seller delays the completion beyond such reasonable timeline, buyer will not be bound to continue with the transaction.

In order to protect buyer's interest and introduce certain degree of discipline towards timely delivery, Istisna contract may include a penalty clause whereby seller is liable to bear a form of daily charge from the maximum time limit till completion of the job. Total penalty amount is then deducted by the buyer from the agreed price.

Does Sharia approve of such practice which may be seen as akin to charging of penal interest on default by the conventional banks? Many Sharia scholars have permitted insertion of such clause provided both parties have given their consent and that the intention is to avoid complacency on seller's part and to curtail undue delay.

Though not a very popular mode of financing, some Islamic banks do use Salam primarily to finance the agricultural sector. This is done more as social obligation than to earn profits. An Islamic bank buys future agricultural produce from the farmer by making immediate payment to him.

The price at which the bank buys the produce is lower than the average market price of the same goods at the time of entering into Salam contract. This way, the difference between the two prices is regarded as profit for the bank.

To ensure fulfillment of commitment by the farmer, the bank can seek security in the form of a third-party guarantee or mortgage over an asset. In case of default, the guarantor may be asked by the bank to deliver the same commodity, or if there is a mortgage, the bank can sell the mortgaged property to recover its advance payment.

The reason for relatively low financing activity in Salam is the aspect of receiving a commodity as repayment instead of cash.

Modern day bankers are not very comfortable in dealing with goods and imagine a dandy banker taking delivery of various commodities in repayment of Salam financing. Not a very good sight.

Another discouraging aspect is the involvement of the process to sell the acquired commodities in order to realise the investment and profit. It may require large storage space in addition to the cost of inventory holding and other allied expenses.

While it may take some time for an Islamic bank to take initiative to develop a special cell to deal with commodities under Salam, one way out, which is currently available to banks, is the onward sale of the Salam goods to a third party by entering into a parallel Salam contract close to the delivery date.

This way, the bank will simply receive the goods from the seller under the first Salam contract at pre-agreed lower price and hand them over to the buyer against parallel Salam contract at higher price. The date and place of delivery for both contracts should be the same to avoid the bank from having to store the goods for re-sale.

While doing so, the bank must take care of the following parameters:
* Each of the Salam contracts must be independent of the other. They cannot be tied up in a manner that the rights and obligations of the parallel contract are dependent upon the rights and obligations of the master contract or vice versa.

* Each contract should have its own legality and effectiveness and its performance should not be contingent upon the other.

For example, even if the obligation under the master Salam contract remains unfulfilled, the bank must meet with its obligations under the parallel Salam contract from other sources.

* Parallel Salam is only allowed with a third party and not with the seller under the master Salam contract. It also excludes the subsidiaries of the seller under the master Salam contract.

The author is the head of risk management at Dubai Islamic Bank.