Risk mangement in Istithna transaction

We have examined various risks associated with the sale Istithna structure and how these can be mitigated from within the structure. Readers would recall that a sale Istithna transaction is where an Islamic Financial Institution (IFI) sells an asset to its customer which is non-existent and is required to be developed, built or manufactured.

Let us evaluate what risks are connected to a purchase Istithna transaction where an Islamic Financial Institution (IFI) contracts to purchase an asset from the customer.

The purchase Istithna transaction entails the purchase of a certain asset by the IFI from a customer that requires to be developed, built or manufactured and delivered by the customer to the IFI as per the specifications and delivery date agreed to between the parties.

Once delivered, the asset is leased by the IFI to the customer at a lease rent and for a term which would ensure that the IFI would be able to redeem its equity in the asset, along with the anticipated return.

The IFI would be exposed to the following risks in a purchase Istithna transaction:

How would an IFI safeguards its equity investment if the customer (the seller) fails to timely deliver the asset to the IFI, or does not deliver at all?

This situation may render the IFI to face another risk which is the rate of return risk since late delivery of the asset by the customer (as seller) will deny the IFI (as buyer) to lease the asset back to the client.

As per Sharia, the IFI would not be in a position to start earning the lease rent (which will ensure the return of its equity plus the anticipated profit) unless the asset is leased to the client.

Let us examine how these risks are mitigated in a purchase Istithna transaction.

In case of late delivery of the asset by the customer to IFI, the IFI would be entitled to receive compensation in shape of a pre-determined daily liquidated damage from the customer.

We have learned in a recently published article that Sharia allows the buyer under Istithna to claim liquidated damage from the seller if the seller fails to keep up with the agreed delivery deadline.

Unlike the compensation earned in Ijara, Murabaha and the other structures where it must be donated to charity by the recipient, the liquidated damage under Istithna is the right of the buyer and hence there is no need to donate it to charity.

As such, the compensation in shape of liquidated damage will alleviate the rate of return risk for the IFI under the purchase Istithna contract where the delivery of the asset takes place with certain delay. What if the asset is not delivered at all by the customer to IFI?

In such situation, the IFI has the right to terminate the Istithna contract and demand the return of the total amount paid by it to the customer on account of the purchase price of the asset.

Sharia allows the IFI (being the buyer under the Istithna contract) to also claim actual financial damages arising from the customer's failure to perform its obligation under the Istithna contract. However, unlike the liquidated damage, such additional compensation cannot be pre-agreed but will have to be proved by the IFI to the arbitration panel or the court of law.

Upon termination of the Istithna contract by the IFI, the incomplete asset will be retained by the customer and will not be passed to the IFI on account of refund of the purchase price by the customer to the IFI. The customer will have full ownership rights over such incomplete or undelivered asset.

There could be a situation where after having received the full payment and delivering the asset to IFI, the customer does not take the asset on lease from the IFI.

This apparent risk can easily be managed by the IFI by seeking the customer to sign a forward lease agreement with the IFI which will bind the customer to take the asset on lease immediately upon having delivered the same to IFI.

- The writer is head of risk management at Dubai Islamic Bank.