Islamic Modes of Finance

Istisna Alfalah Institute of Banking and finance

Bahauddin Zakariya University Multan

MBA (Banking & Finance)

4th Semester

Submitted to: Mr. Umair Shahid Submitted by:

Muhammad Asif
MBK-11-03

MBA (B & F) 4th semester

Alfalah Institute of Banking and Finance

Abstract:
This paper examines the meaning and concepts of the Islamic mode of finance Istisna in Islamic banking. Different thoughts of Islamic scholars about Istisna are given. How the Istisna compliance with Islamic shariah. Two case studies are discussed that how the Istisna in Islamic banking work. It is shown that how Istisna can be used for export finance.

Introduction:
This paper will analytically explain the theory of the contract of Istisna ' and its practical application in Islamic banking and financial institutions operations. The topics to be discussed, among others, are the concept and definition of Istisna ', differences between Salam sale and Istisna ', legitimacy of Istisna ', the binding effect of istis.nii' contract, conditions for the legality of Istisna , penalties in Istisna ', termination of the contract of Istisna . In this article also two case studies are discussed. with the help of these case studies you will be able to understand the physical application of the Istisna in Islamic banking.

Istisna and its concepts and definition:

Definition: The word Istisna is derived from the word Sana'a which literally means "making, manufacturing or constructing something." Istisna a, is a special kind of Baiwhere the sale of a commodity is transacted before the commodity comes into existence. We can define Istisna in following way: "Istisna is an agreement in 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."

OR
In other word it is a contract ('aqd) made with a manufacturer pursuant to which the manufacturer agrees to produce a specific thing for a purchaser on certain agreed upon specifications at a determined price and for a fixed date of delivery.

Parties:
There are two parties in Istisna 1. Sani 2. Mustani

Sani: The person who makes it is called sani'. Mustani: person who causes it to be made called mustani.
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Masnu: the thing made called Masnu.

Subject Matter of Istisna :

This contract is valid only for those objects that have to be manufactured or constructed. But it is not necessary that the seller himself manufactures the item, unless stated in the contract. The subject of Istisna (the thing 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 sellers agree to provide the subject matter transformed from raw materials through manufacturing or goods manufactured by human hands. It is invalid for natural things or products like animals, corn, fruit, etc. Both unique and homogeneous types of assets are covered under Istisna provided their specifications are agreed at the time of the contract. For example, items of unique description that have no regular market, have no substitute in the market and where the value of each unit of that type of goods may be different are covered by Istisna. In Istisna, the manufacturer arranges 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, this is the contract of Ujrah (doing any job against an agreed wage/remuneration) and not of Istisna. It is not permissible that the subject matter of an Istisna contract be an existing and identified asset. For example, it is invalid for an Islamic bank to conclude a contract to sell a particular designated car from a factory on the basis of Istisna. But an asset that has already been produced by the seller or by another can become the subject matter of Istisna provided that it is not identified in the contract and the contract identifies speciation only. An Istisna contract may be drawn 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 is allowed because the contract involves the construction of specified buildings that will be built and sold according to specification and, in this case, the contract of Istisna does not specify a particular identified place.

Price in Istisna:
The price in Istisna can be in the form of cash, any tangible goods or usufruct of identified assets. The price should be known in advance to the extent of removing ignorance or lack of knowledge and dispute. It is permissible that the price of Istisna transactions varies in accordance with variations in

delivery date. There is also no objection to a number of offers being subject to negotiation, provided that eventually only one offer is chosen for concluding the Istisna contract. This is to avoid uncertainty and lack of knowledge that may lead to dispute. The price, once settled, cannot be unilaterally increased or decreased. However, as manufacturing of huge assets may involve more time, sometimes necessitating many changes, the price can be readjusted by the mutual consent of the contracting parties because of making material modifications to the item to be manufactured or due to unforeseen contingencies or changes in prices of the inputs. It is not necessary in Istisna price is paid in advance (unlike Salam, in which spot payment of price is necessary). The price can be paid in installments within the agreed time period and can also be linked with the completion stages.

Penalty Clause: Delay in Fulfilling the Obligations:

An Istisna contract may also contain a penalty clause stipulating an agreed amount of money for compensating the purchaser adequately if the manufacturer is late in delivering the asset. Such compensation is permissible only if the delay is not caused by intervening contingencies (force majeure). Further, it is not permitted to stipulate a penalty clause against the purchaser for default in any payment because this would be Riba. A voluntary rebate for prepayment is permissible, provided it is not agreed in 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 allowed such a condition in Ijarah, e.g. if a person hires the services of a tailor, he may tell him that the wage will be 10 dirham's if he prepares the clothes within a week and 12 if within two days. By analogy, experts allow a penalty clause in the Istisna construction of the subject of Istisna. 'an agreement in the case of a delay in delivery, supply or

In Fiqh, this principle is termed Shart-e-Jazai (penalty condition), or the condition of decreasing the price on account of a delay in delivery of the subject matter of Istisna. This reduction will enhance the income of the orderer (purchaser) and it will not go to charity, as in the case of all other modes. This special permission is on account of the fact that, in Istisna; timely completion of the work depends on labor and commitment of the manufacturer (seller). If he does not devote full time to completion of the job of a particular contract and engages in other contracts in his quest for more and more orders and maximum earnings, he can be fined. This benefit would go to the purchaser, who might suffer in the case of non delivery at the stipulated time. Any such undertaking by the manufacturer would be binding on him.

The Binding Nature of an Istisna Contract:

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The Hanafi jurists generally divide the binding effect of this kind of contract into three stages. Their views are mainly based on their position about the legal basis of this contract. At the first stage, where the work of manufacturing has not yet started, the Hanafi jurists are fully agreed that the contract is not binding ('aqd ghayr lazim) upon either of the parties and the manufacturer may refrain(stop) from making the commodity. On the other hand, both contracting parties have the right of revocation. At the second stage, the manufacturer may finish making the needed goods, but the purchaser has not seen the manufactured object yet. The manufacturer still has the right even to sell the commodity to a third party. The third stage is when the required goods have been manufactured and presented to the purchaser. In this case, Muslim jurists have different opinions whether the purchaser has the right to reject the commodity or not. AI-Imam Abu Hanifah is of the opinion that the purchaser can exercise his option of inspection (Khiyar-e-RoiyyaT) after seeing the goods, because Istisna is a sale and if somebody purchases a thing which he has not seen, he has the option to cancel the sale after seeing it. The same principle is also applicable to Istisna. Abu Yusuf, a follower of Abu Hanifah, opines that if the commodity was in conformity to the inspections agreed upon between the parties at the time of the 'contract, the purchaser is bound to accept the goods and he cannot exercise the option of inspection (khiyar al ru'yah). Finally, influenced by Abu Yusuf new opinion and the change of circumstances in the new and modem transactions, Majallah al-Ahkam al- 'Adliyyah considers the contract of Istisna as binding from the beginning. "After Istisna is concluded by an agreement, the parties cannot go back on the bargain. But if the thing does not agree with the description, the person who gives the order has an option". It is clear from the above mentioned of Majallah that the contract is binding from the beginning unless the recommended goods do not fulfill the prescriptions in the contract.

Conditions for the Legality of Istisna:

These conditions are divided into general conditions and specific conditions. In the case of general conditions, the Istisna sale must fulfill the requirement of a valid contract as discussed by the jurists, i.e. the capacity of the contracting parties, offer and acceptance, and the subject-matter should be a valuable thing. In addition to these general conditions, there are some specific conditions for the contract of Istisna' to be legal, as follows: 1. The object must be precisely determined both in its essence and quality. In other words, it is a condition in Istisna contract to state in the clear type, quality, quantity and all the

specifications required because it is a condition that the sold commodity must be known by the parties involved to avoid ignorance which may lead to dispute later on. 2. The recommended manufactured goods should be things that people customarily deal with in the field of manufacture. Otherwise, the contract of Istisna ' will be invalid. In this regard, Ibn 'Abidin, a Hanafi Jurist, is of the opinion that it is not permissible to practice Istisna in what is not familiar among people under this contract such as the manufacture of cloth. However, the example of cloth manufacture prohibited by the early Hanafis was undoubtedly different from the modem practice, as nowadays it has become very familiar. Perhaps what was said by the earlier jurist was just an example on reason the types of manufacture differ from age to age and for this reason the Majallah al-Ahkam al- 'Adliyyah cites new permissible things stating that: "or if there is a bargain with a ship-carpenter to make a ship or boat and its length, breadth, quality and things required are explained, the Istisna becomes a complete contract". 3. It is a condition that the time of delivery is specified whether it is short or long so as to avoid ignorance, which might lead to conflict between the two parties. Nevertheless, this is not the position in Abu Hanifah view where he says that the time of delivery must not be stipulated in the contract of Istisna', otherwise the contract will be a contract of Salam rather than Istisna . However, the two disciples of Abu Hanifah, namely, Abu Yusuf and al-Shaybaru hold that it is not a condition to stipulate a time of delivery. If the time of delivery stipulated, the contract would still be a contract of Istisna and would not be transformed to a contract of Salam. They argue that this is customarily practiced and people normally stipulate a time of delivery in the contract of Istisna. As Istisna itself is allowed, because of the need and practice of the people, the stipulation of time for delivery would be part of the practice and it would not transformed Istisna into a Salam contract. It is worth to mention here that the opinion of Abu Yusuf and Muhammad b. al-Hasan al-Shaybani is preferable to the view of Abu J:Ianifah and in line with the practice of the modem transaction which makes the stipulation of a time of delivery a necessary requirement. Moreover, in our time, the era of heavy industry and technology, when the manufacturing of some commodities may take years to complete, it is reasonable and rational to make the stipulation of delivery compulsory for the stability of transactions. 4. The materials should be supplied by makers, if they are supplied by the buyer,the contract is regarded as ujrah and not Istisna. 5. It is a condition that the place of delivery is stated if the commodity needs loading or transportation expenses.

Guarantees:
The bank, acting either in the capacity of the manufacturer or of the ultimate purchaser, can give or demand security, collateral or a performance bond to ensure that the work is performed within the

agreed time and as per specifications. It can also get Arbun, which will either be part of the price if the contract is fulfilled, or forfeited if the contract is rescinded. However, it is preferable that the amount forfeited be limited to an amount equivalent to the actual damage suffered.

Parallel Contract Subcontracting:

Istisna is not confined to what the manufacturer himself makes, and if the contract is silent or it expressly allows such, the seller/supplier can get it manufactured as per the specifications given in the contract from anyone else. Financial institutions, as sellers, would contract with someone else to manufacture the same. This could be a case of a Parallel Istisna a contract. An Istisna a contract shall be entered into, on the one hand, between the bank and a customer, while on the other hand, the bank may enter into a Parallel Istisna a with a third party (contractor) for preparation of the subject matter of the first Istisna a. The delivery date of the parallel contract must not precede the date of the original Istisna a contract. In one contract, the bank will be the buyer and in the second, the seller. Ownership related risks of the two contracts will remain separate and will have to be borne by the respective parties so long as the asset is not transferred to the other. Each of the two contracts shall be independent of the other. They cannot be tied up in a manner whereby the rights and obligations of one contract are dependent on the rights and obligations of the other contract. Further, Parallel Istisna is allowed with a third party only. It is permissible for the bank to buy items on the basis of a clear and unambiguous Specification and to pay, with the aim of providing liquidity to the manufacturer, the price in cash when the contract is concluded. Subsequently, the bank may enter into a contract with another party in order to sell, in the capacity of manufacturer or supplier, items whose specifications conform to the wishes of that other party, on the basis of Parallel Istisna a, and fulfill its contractual obligation accordingly.

Post Execution Scenario:

Work in Process:
Before the manufacturer starts work on the subject matter of Istisna, both of the parties have the right to rescind the contract. Once the seller/manufacturer initiates the work, the contract becomes binding and any change is possible only with mutual consent. The parties to the contract are inevitably bound by all obligations and consequences flowing from their agreement. The purchaser will make the payment as per the agreed schedule and the manufacturer/seller will supply the asset as per the specifications agreed. If the subject matter does not conform to the specifications agreed upon, the customer has the option to accept or to refuse the subject matter. The purchaser shall not be regarded as the owner of the materials in the possession of the manufacturer for the purpose of producing the asset. 8

If the actual cost incurred by the bank (as seller) on an asset sold on Istisna is less than the forecast cost, or the bank gets a discount from the subcontractor on a Parallel Istisna basis, the bank is not obliged to give a discount to the purchaser and any additional profit, or loss if any, pertains to the bank. The same rule adversely applies when the actual costs of production are greater than the forecast costs. If so desired by a customer, the Islamic bank (as purchaser) may replace an existing contractor to complete a project which has already been commenced by the previous contractor. For this purpose, the existing status of the project needs to be assessed, whereby the cost of such assessment and all liabilities as of that date shall remain the responsibility of the customer. The bank, working as a manufacturer (seller), must assume liability for ownership risk, maintenance and Takaful expenses prior to delivering the subject matter to the purchaser as well as the risk of theft or any abnormal damage. The manufacturer cannot stipulate in the contract of Istisna that he is not liable for defects. Therefore, if the bank is the manufacturer for the purpose of an Istisna contract, it cannot absolve itself from loss on this account. The orderer (purchaser) has the right to obtain collateral from the manufacturer for the amount he has paid and as regards delivery of the commodity with specifications and time of delivery. A voluntary rebate for prepayment is permissible, provided it is not agreed in the contract.

Delivery and Disposal of the Subject Matter:

1. Before delivery of the asset to the purchaser, it will remain at the risk of the seller; any loss to the raw material or to the item in the process of manufacturing will be borne by him. 2. After delivery, risk will be transferred to the purchaser. 3. Possession of goods can be physical or constructive, depending upon the nature of the asset and transfer of ownership/risk. Transferring risk and delegating authority of use and

utilization/consumption are the basic ingredients of constructive possession. For this, there should be a demarcation line between handing over and taking over of possession. 4. If a manufactured asset is delivered before the agreed date, the purchaser should accept it if the asset meets the stipulated specifications. He can refuse to accept the goods if these are not as per the agreed specifications or there is some other genuine justification for not accepting before the agreed date (Istisna Standard, clauses 6/1 to 6/3).

5. If the condition of the subject matter does not conform to the contractual specifications at the date
of delivery, the ultimate purchaser has the right to reject the subject matter or to accept it in its present condition, in which case the acceptance constitutes satisfactory performance of the contract.

The Potential of Istisna:

Islamic banks can use Istisna for manufacturing of high technology goods like aircrafts, ships, buildings, dams, highways, etc. It can also be used for housing and export financing, meeting working capital requirements in industries where sale orders are received in advance.

Potential areas are given below:

financing the construction industry apartment buildings, hospitals, schools and Universities; Development of residential/commercial areas and housing finance schemes; financing high technology industries such as the aircraft industry, locomotive and shipbuilding Industries.

Risk Management in Istisna:

Banks could face the following risks in Istisna based financing: Settlement risk; Price risk; Delivery risk; Possession risk; Market risk. As a whole, risks in Istisna would be mitigated by taking proper collateral, performance bonds, technical expertise in the relevant areas for timely and effective marketing and for ensuring cost effectiveness, by resorting to suitable Takaful policies, by choosing good clients and by adopting suitable capital budgeting and liquidity management policies. Mitigation for some of the risks is shown in Box 10.9. As little is available so far on the practical application of Istisna, we shall also give a number of hypothetical case studies.

Risk Mitigation in Istisna:

Ownership of material:
The Islamic bank is not the owner of the materials in the possession of the manufacturer for the purpose of producing the asset. It can have no claim on it in the case of any nonperformance. Security is available with the bank.

Delivery risk
The bank may be unable to complete the manufacturing of goods as scheduled due to late delivery of completed goods by the subcontractor in Parallel Istisna. On the basis of the rule of Shart-e-Jazai, the bank can put in the Istisna agreement a clause to reduce the Istisna price in the case of delay.

Sale not permissible before delivery

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Sale of Istisna goods is not allowed before taking physical possession. This may lead to asset, price and marketing risk The bank can take a promise to purchase from a third party and can make arrangements for sale through agency.

Quality risk
The Islamic bank gets delivery of inferior quality manufactured goods, which also may affect the original contract. The bank can obtain a guarantee of quality from the original supplier.

Termination of the Istisna Contract:

As one of the nominated contracts in Islamic Commercial Law, Istisna is terminated by the normal ways of termination of contracts, namely when manufacturer makes the commodity and presents it to the purchaser and receives the payment. Furthermore, the jurists are of the opinion that the contract of Istisna can be terminated by the death of one of the contracting parties. This rule is based on the analogy of Istisna ' to Ijarah in the Hanafi School due to the similarity between ijarah and Istisna .' However, due to the extensive application of the contract of Istisna ' now a days' transactions, the manufacturer is not a single person. It is rather a large corporation. Therefore, it is not applicable the contract will be ended by the death of one or two persons because this one or the other has signed the contract on behalf of the corporation. Thus, it must be differentiated between a contract of Istisna ' between individuals and one which involves corporations and companies. In the former case, it will be terminated by the death of one of the contracting parties, but in the second case, it will continue as long as the corporation or company is in existence and will not be affected by the death of its members.

Housing Finance through Istisna:

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Istisna -Housing Finance during Construction Phase

Rs. 5million+rent over a period Of 10 years

Deferred

Bank

Rs.5M

DIMINISHING MUSHARAKAH

Rs.2 M Spot

Customer

Istisna

Rs.7M

Spot

Contractor

Hypothetical Case Study:

The following could be the flow process:
1. Suppose a builder/contractor C has announced a scheme for the construction and sale of apartments costing Rs. 7 million each. (He demands cash and has no financial relationship with the bank.)

2. Client A decides to have an apartment; he has Rs. 2 million and needs financing from bank B of
Rs. 5 million for ten years. 3. A and B create a Musharakah pool of Rs. 7 million under the principle of Shirkat_ul_ milk and jointly enter into Istisna agreements with C for the construction and sale of an apartment of defined specifications and pay Rs. 7 million in four installments.

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4. C starts building the apartment as per the requirements of the Istisna contract. 5. The bank appoints A its agent to supervise the construction work. 6. C hands over the apartment to A; B leases out its part of ownership to A in rent. 7. A purchases one unit of the banks part every month; the rental starts decreasing after each payment and after ten years, the banks investment is redeemed and ownership is transferred to the client.

Istisna for Pre shipment Export Finance:

Istisna -Pre shipment -Export
Rs.110M (Export proceeds)
Deferred

Bank

Rs.100 M (Istisna)

Customer

Spot

Agent

EXPORT Rs.110 M

Hypothetical case study:

1. Client A gets an export order for the export of ready-made garments of value Rs.110 million. 2. A approaches bank B for financing and indicates that he has the expertise to prepare the consignment. 3. B enters into an Istisna agreement with A for the supply of garments of a specified nature for Rs. 100 million within a period of three months. This contract will be a sale; A will make delivery at the agreed time.

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4. 5.

B also appoints A its agent for export of the garments when they come under its ownership. A foreign importer opens an L/C of value Rs. 110 million in the name of B (the L/C can also be in the name of A but that would be under an agency agreement). If an L/C has already been opened, Istisna is not possible (avoiding Bai al Inah).

6.

A prepares the garments and informs B to take delivery; the bank takes actual/constructive delivery of the garments and henceforth the garments come under its risk/liability.

7.

A exports the consignment as agent of B, sending documents on behalf of B. B gets Rs. 110 million, as per the terms of the L/C.

Difference between Istisna and Salam:

Istisna 1.
The subject of Istisna is always a thing which needs manufacturing.

Salam
The Salam subject can be either natural products or manufactured goods.

2.

The

price

in

Istisna

does

not

The price has to be paid in full in advance.

necessarily need to be paid in full in advance.

3.

Penalty in the form of a reduction in price on account of a delay in delivery will reflect the income of the

Penalty for late delivery shall go to charity and the P&L Account of the purchaser (bank) will be unaffected.

purchaser (the principle of Shart-eJazai approved by the jurists.)

4.

As long as work has not started, Istisna is nonbinding; any of the parties can revoke the contract.

Salam is a binding contract; once executed, it cannot be rescinded without the consent of the other.

Difference between Istisna and Ijarah:

Istisna
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Ijarah

1.

The manufacturer uses his own materials and the sale price is fixed.

The manufacturer on an Ujrah basis uses the material provided by the buyer and he is paid the agreed wages.

2.

Istisna can be of anything that needs manufacturing.

Ijarah can be only on those assets the corpus of which is not consumed with use.

3.

In Istisna asset risk is transferred to

In Ijarah, asset risk remains with the

the purchaser soon after delivery of the owner (lessor) and the lessee has to give item to him and he has to pay the price rental only if the assets capable of being irrespective of what happens to the used as per normal market practice. asset.

Conclusion:
The above discussion can be safely concluded that Istisna contract in Islamic Commercial Laws is one of the important methods of investment in Islamic banking and can play an important role in economic development. It encourages the demand for manufacturing goods, financing economic activities, contributing to the stabilization of prices of manufactured goods, promoting industrial and technological advancement and making use of the available possibilities of the economy.

References:
1. Meezan Bank's Guide to Islamic Banking by Dr. Imran Ashraf Usmani. 2. Istisna in Islamic Banking: Concept and Application by Joni Tamkin Borhan. 3. Understanding Islamic Finance by Muhammad Ayub. 4. AAOIFI, 20045a, clauses. 5. Muhammad al-Bashir, op.cit, pp. 80-82.
6. Majallah al-Ahkam al- 'Adliyyah, Art. 388. 7. Draft Shariah Parameter Reference5:Istisna Contracts by Central Bank Of Malaysia 8. Istisna by Al Maali Islamic Finance Training & Consultancy 9. Islamic Banking and Finance By Mufti Muhammad Taqi Usmani.

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