Salam can be used as tool of pre-shipment finance

A colleague associated with trade finance of the bank asked whether Salam could be adopted by an Islamic bank as a vehicle for pre-shipment financing of the goods covered under an export letter of credit.

Yes, Salam could be modified and improvised to serve as a tool of pre-shipment financing. The following procedure may provide broad guidelines in doing so:
* Bank receives an export letter of credit (LC) in favour of its client, covering certain goods.

* Client gives the letter of credit under bank's lien. Thus, allowing the bank to assume the role of seller to the foreign buyer.

* To comply with the LC requirement, bank agrees to buy the goods from its client under a Salam contract and makes upfront payment to him.

* Salam contract devised for this purpose should include specific delivery date and place. Delivery date should be reasonably ahead of the latest shipment date stated in the letter of credit.

* As for the place, it should be the port of destination mentioned in the LC. Submission of in-order shipping documents (viz. bill of lading and certificate of origin) by the client may be deemed equivalent to the satisfactory delivery.

* The agreed payment (pre-shipment finance) made by the bank to its client will be lower than the amount of the export LC, difference being bank's profit.

For the purpose of understanding in light of last week's column, the contract entered into by the bank with client should be regarded as the master Salam contract whereas the LC can be considered as parallel Salam contract.

It is advisable that an Islamic bank undertakes the following precautionary measures in extending pre-shipment finance to a client:
A) The letter of credit (to be regarded as parallel Salam contract) must be irrevocable.

B) Bank should extend the facility to its credible clients only who are highly likely to perform under the master Salam contract. This is to ensure fulfillment of bank's own obligations under the parallel Salam contract (LC).

C) In order to facilitate smooth negotiation of export LC and the recovery of its finance with profit, bank should include submission of commercial invoice, packing list, bill of exchange, and the other documents listed in the LC, as a condition of the master Salam contract.

D) Wherever possible, bank should also obtain third-party guarantee or any other suitable security to ensure recovery of its investment in the event of non-shipment by the client.

It may be noted that in case of subsequent extension in the shipment date, the bank will not be in a position to alter the price it paid for the goods covered under the LC.

While a foreign letter of credit can be assumed to be a parallel Salam contract for the above purpose, it may not be necessary that the documents utilised for negotiating the LC bear bank's name as principal seller.

However, the opening bank should be advised of their LC having been surrendered by the beneficiary to the Islamic bank's lien. It will not only prevent fraudulent negotiation of the LC but will also serve the purpose of informing the opening bank of the Islamic bank's financing against it.

Thus, an Islamic bank can promote Salam in the above manner as an effective tool of extending pre-shipment finance to clients without the need of receiving the physical possession of the goods as repayment. It will also eliminate the need to establish costly special cell to deal with purchase and re-sale of goods towards recovering an Islamic bank's investment and profit under Salam.

Like Salam, Istisna is another transaction where the asset (subject of the agreement) could be sold before it comes into physical existence.

However, under Istisna the asset is required to be developed or manufactured from the beginning. This condition stems from the literal meaning of the word Istisna, i.e. to manufacture or to develop.

Istisna is a contract whereby a financier agrees to construct or develop an asset according to certain specifications at a determined price, which includes financier's profit during the course of construction or development. It is not necessary that the financier accomplishes the specified job himself. He may assign it to the others under a Wakala (agency) arrangement.

A primary objective of the Istisna mode of financing is to stimulate developmental/manufacturing activities in an economy leading to creation of jobs. Istisna may include commercial or residential buildings, industries, roads, dams, aircraft, vessels, etc.

In the Gulf, Islamic banks usually adopt Istisna for financing real-estate activities. However, of late, it has also been used for building large vessels and aircrafts in some high profile international deals.

It is necessary under Istisna that the client undertakes to buy the completed asset from the bank under a separate Murabaha agreement.

In order to avoid ambiguity, it is preferable that the terms of Murabaha agreement should be agreed upon between the parties even prior to financing under Istisna takes place.

In case of construction, if the client owns the land, an Islamic bank may undertake to finance construction of the required building on the basis of Istisna contract entered into with the client which includes an undertaking to buy the asset from bank on completion.

However, it does not mean that the absence of land with client may prevent the bank from undertaking Istisna financing. Bank can agree to finance construction of the building under Istisna over a plot of land selected by the client. In that case, the Istisna amount will include the cost of land and construction beside bank's profit for the construction period.

Unlike Salam, in Istisna the bank does not release finance for developing the asset in advance. The financing remains tied up with the progress in developing the asset under an agreed upon mechanism whereby independent verification of progress is essential for payment.

Due to bank's obvious lack of expertise in construction of buildings or any other asset for that matter, Sharia allows it to nominate the client as an agent responsible for satisfactory completion of the job.

This is to eliminate any possibility of future argument as client knows best what it wants to build and for what purpose. If considered necessary, bank can hire the services of an independent surveyor to keep a close watch on the progress.

Upon satisfactory completion of the asset, bank transfers the Istisna amount to the Murabaha account on the basis of client's undertaking to buy the asset. The agreed repayment of bank's finance under Murabaha starts after the client has taken over the possession of asset.

To secure its finance, bank can take various measures such as mortgage on land on which the asset is being built, any other property or personal or third party guarantee.

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