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Thursday, August 12, 2010

Forward Sales and Manufacturing Contracts: Salam And Istisna

By Mufti Taqi Usmani

- Meaning of Salam
- Conditions of Salam
- Salam as a Mode of Financing
- Istisna
- Difference Between Istisna and Salam
- Difference Between Istisna and Ijarah
- Time of Delivery
- Istisna as a Mode of Financing

It is one of the basic conditions for the validity of sale in Shariah that the commodity intended to be sold must be in the physical or constructive possession of the seller. This condition has three implications:

First, the commodity must be existing; a commodity that does not exist at the time of sale cannot be sold.

Second, the seller should have acquired the ownership of that commodity. If the commodity exists but the seller does not own it, he cannot sell it to anybody.

Third, mere ownership is not enough. It should have come in the possession of the seller, either physically or constructively. If the seller owns a commodity, but he has not acquired its delivery by himself or through an agent, he cannot sell it.

There are only two exceptions to this general principle in Shariah. One is Salam and the other is Istisna. Both are sales of a special nature, and by the present article I want to explain the concept of these two kinds of sale and the extent to which they can be used for the purpose of financing.

Meaning of Salam

Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced price fully paid on the spot.

Here the price is paid in cash, but the supply of the purchased goods is deferred. The buyer is called "rabb-us-Salam", the seller is "Muslam ilaih", the cash price is "ra's-ul-mal", and the purchased commodity is termed as "muslam fih", but for the purpose of simplicity, I shall use the English synonyms of these terms.

The Holy Prophet, Sall-Allahu alayhi wa sallam, allowed Salam subject to certain conditions. The basic purpose of this sale was to meet the needs of the small farmers who needed money to grow their crops and to feed their family up to the time of their harvest. After the prohibition of riba they could not take usurious loans. Therefore, it was allowed for them to sell the agricultural products in advance.

Similarly, the traders of Arabia used to export goods to other places and to import other goods to their homeland. They needed money to undertake this type of business. They could not borrow from the usurers after the prohibition of riba. It was, therefore, allowed for them that they sell the goods in advance. After receiving their cash price, they could easily undertake the aforesaid business.

Salam was beneficial to the seller, because he received the price in advance, and it was beneficial to the buyer also, because normally, the price in Salam used to be lower than price in spot sales.

The permissibility of Salam was an exception to the general rule that prohibits the forward sales. Therefore it was subjected to some strict conditions. These conditions are summarized below:

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Conditions of Salam

  1. First of all, it is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale. It is necessary because in the absence of full payment by the buyer, it will be tantamount to a sale of debt against debt, which is expressly prohibited by the Holy Prophet, Sall-Allahu alayhi wa sallam. Moreover, the basic wisdom behind the permissibility of Salam is to fulfill the instant needs of the seller. If the price is not paid to him in full, the basic purpose of the transaction will be defeated. Therefore, all the Muslim jurists are unanimous on the point that the full payment of the price is necessary in Salam. However, Imam Malik is of the view that the seller may give a concession of two or three days to the buyers, but this concession should not form part of their agreement.
  2. Salam can be effected in those commodities only whose quality and quantity can be specified exactly. The things whose quality or quantity is not determined by the specification cannot be sold through the contract of Salam. For example, the precious stones cannot be sold on the basis of Salam, because every piece of precious stones is normally different from the other either in its quality or in its size or weight and their exact specification is not generally possible.
  3. Salam cannot be effected on a particular commodity or on a product of a particular field or farm. For example, if the seller undertakes to supply wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid, because there is a possibility that of that particular field or the fruit of that tree is destroyed before the delivery, and in the presence of this possibility the delivery remains uncertain. The same rule is applicable to every commodity whose supply is not certain.It is necessary that the quality of the commodity (intended to be purchased through Salam) be fully specified leaving no ambiguity that may lead to dispute. All the possible details in this respect must be expressly mentioned.
  4. It is also necessary that the quantity of the commodity be agreed upon in unequivocal terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it's quantified through measures, its exact measure should be known. What is normally weighed cannot be specified in measures and vice versa.
  5. The exact date and place of delivery must be specified in the contract.
  6. Salam cannot be effected in respect of those things that must be delivered at the spot. For example, if gold is purchased in exchange of silver, it is necessary, according to Shariah, that the delivery of both be simultaneous. Here, Salam cannot work. Similarly, if wheat is bartered for barley, the simultaneous delivery of both is necessary for the validity of sale, therefore, the contract of Salam in this case is not allowed.

All the Muslim jurists are unanimous on the principle that Salam will not be valid unless all these conditions are fully observed, because they are based on the express ahadith of the Holy Prophet, Sall-Allahu alayhi wa sallam. The most famous hadith in this context is the one in which the Holy Prophet, Sall-Allahu alayhi wa sallam has said: "Whoever wishes to enter into a contract of Salam, he must effect the Salam according to the specified measure and the specified weight and the specified date of delivery."

However, there are certain other conditions, which have been a point of difference between the different schools of the Islamic jurisprudence. Some of these conditions are discussed below:

  1. It is necessary, according to the Hanafi school, that the commodity (for which Salam is effected) remains available in the market right from the day of contract up to the date of delivery. Therefore, if a commodity is not available in the market at the time of the contract, Salam cannot be effected in respect of that commodity, even though it is expected it will be available in the markets at the date of the delivery. However, all the other three schools of Fiqh (i.e. Shafi'i, Maliki, and Hanbali) are of the view that the availability of the commodity at the time of the contract is not a condition for the validity of Salam. What is necessary, according to them, is that it should be available at the time of delivery, only. This latter view can be acted upon in the present circumstances.
  2. It is necessary, according to the Hanafi and Hanbali schools that the time of delivery is, at least, one month from the date of agreement. If the time of delivery is fixed earlier than one month, Salam is not valid. Their argument is that Salam has been allowed for the needs of small farmers and traders, therefore, they should be given enough opportunity to acquire the commodity, and they may not be able to supply the commodity before one month. Moreover, the price in Salam is normally lower than the price of spot sales. This concession in the price may be justified only when the commodities are delivered after a period that has a reasonable bearing on the prices. A period of less than one month does not normally effect the prices. Therefore, the minimum time of delivery should not be less than one month.

Imam Malik supports the view that there should be a minimum period for the contract of Salam. However, he is of the opinion that it should not be less than fifteen days, because the rates of the market may change within a fortnight.

The view is, however, opposed by some other jurists, like Imam Shafi'i and some Hanafi jurists also. They say that the Holy Prophet Sall-Allahu alayhi wa sallam has not specified a minimum for the validity of Salam. The only condition, according to hadith, is that the time of delivery must be clearly defined. Therefore, no minimum period can be prescribed. The parties may fix any date for delivery with mutual consent.

This view seems to be preferable in the present circumstances, because the Holy Prophet Sall-Allahu alayhi wa sallam has not prescribed a minimum period. The jurists have prescribed different periods that range between one day to one month. It is obvious that they have done so according to the expediency and keeping in view the interest of the poor sellers. But the expediency may differ from time to time and place to place. Likewise, sometimes it is more in the interest of the seller to fix an earlier date. As far as the price is concerned, it is not a necessary condition of Salam that the price is always lower than the market price on that day. The seller himself is the best judge of his interest, and if he accepts an earlier date of delivery with his free will and consent, there is no reason why he should be forbidden from doing so.

Certain contemporary jurists have adopted this view considering it more suitable for the modern transactions.

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Salam as a Mode of Financing

It is evident from the foregoing discussion that Shariah allowed Salam to fulfill the needs of farmers and traders, therefore, it is basically a mode of financing for small farmers and traders. The mode of financing can be used by modern banks and financial institution, especially to finance the agricultural sector. As pointed out earlier, the price in Salam may be fixed at a lower rate than the price of those commodities delivered at the spot. In this way, the difference between the two prices may be a valid profit for the banks or financial institutions. In order to ensure that the seller shall deliver the commodity on the agreed date, they also can ask him to furnish a security, which may be in the form of a guarantee or in the form of mortgage or hypothication. In case of default in delivery, the guarantor may be asked to deliver the same commodity by purchasing it from the market, or to recover the price advanced by him.

The only problem in Salam that may agitate the modern banks and financial institutions today is that they will receive certain commodities from their clients, and will not receive money. Being conversant with dealing in money only, it seems to be cumbersome for them to receive different commodities from different client and to sell them in the market. They cannot sell those commodities before they are actually delivered to them, because it is prohibited in Shariah.

But whenever we talk about the Islamic modes of financing, one basic point should never be ignored. The point is that the concept of the financial institutions dealing in money only is foreign to Islamic Shariah. If these institutions want to earn a halal profit, they shall have to deal in commodities in one way or the other, because no profit is allowed in Shariah on advancing loans only. Therefore, the establishment of an Islamic economy requires a basic change in the approach and in the outlook of the financial institutions. They shall have to establish a special cell for dealing in commodities. If such a special cell is established, it should not be difficult to purchase commodities through Salam and to sell in spot markets.

However, there are two other ways of benefiting from the contract of Salam.

First, after purchasing a commodity by way of Salam, the financial institutions may sell them through a parallel contract of Salam for the same date of delivery. The period of Salam in the second (parallel) transaction being shorter, the price may be a little higher than the price of the first transaction, and the difference between the two prices shall be the profit earned by the institution. The shorter the period of Salam, the higher the price, and the greater the profit. In this way the institutions may manage their short term financing portfolios.

Second, if a parallel contract of Salam is not feasible for one reason or another, they can enter into a promise to sell the commodity to a third party on the date of the delivery. Being merely a promise, and not the actual sale, their buyers will not have to pay the price in advance. Therefore, a higher price may be fixed and as soon as the commodity is received by the institution, it will be sold to the third party on a pre-agreed price, according to the terms of the promise.

A third option is sometimes proposed that at the date of the delivery, the commodity be sold back to the seller on a higher price. But this suggestion is not in line with the dictates of Shariah. It is never permitted by the Shariah that the purchased commodity be sold back to the seller before taking its delivery, and if it is done on a higher price it will tantamount to riba which is totally prohibited. Therefore, this proposal is not acceptable at all.

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Istisna is the second kind of sale where a commodity is transacted before it comes into existence. It means to order a manufacturer to manufacture a specific commodity for the purchaser. If the manufacture undertakes to manufacture the goods for him, the transaction of Istisna comes into existence. But it is necessary for the validity of Istisna that the price is fixed with the consent of the parties and that necessary specification of the commodity (intended to be manufactured) is fully settled between them.

The contract of Istisna creates a moral obligation on the manufacturer to manufacture the goods, but before he starts the work, any one of the parties may cancel the contract after giving a notice to the other. But after the manufacturer has started the work, the contract cannot be cancelled unilaterally.

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Difference between Istisna and Salam

Keeping in view this nature of Istisna there are several points of difference between Istisna and Salam which are summarized below:

  • The subject of Istisna is always a thing that needs manufacturing, while Salam can be effected on anything, no matter whether it needs manufacturing or not.
  • It is necessary for Salam that the price is paid in advance, while it is not necessary in Istisna.
  • The contract of Salam, once effected, cannot be cancelled unilaterally, while the contract of Istisna can be cancelled before the manufacturer starts the work.
  • The time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna that the time of the delivery is fixed.

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Difference Between Istisna and Ijarah

It should also be kept in mind that the manufacturer, in Istisna, undertakes to make the required goods with his own material. Therefore, this transaction implies that the manufacturer shall obtain the material, if it is not already with him, and shall undertake the work required for making the ordered goods with it. If the customer provides the material, and the manufacturer is required to use his labor and skill only, the transaction is not Istisna. In this case it will be a transaction of Ijarah whereby the services of a person are retained for a specified fee paid to him.

When the seller has manufactured the required goods, he should present them to the purchaser. But there is a difference of opinion among the Muslim jurists whether or not the purchaser has a right to reject the goods at this stage. Imam Abu Hanifah is of the view that he can exercise his "option of seeing" (Khiyar-ur-ru'yah) after seeing the goods, because Istisna is a sale and if somebody purchases a thing which is not seen by him, he has the option to cancel the sale after seeing it. The same principle is applicable to Istisna.

However, Imam Abu Yousuf says that if the commodity conforms to the specification 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 seeing.

This view has been preferred by the jurists of the Ottoman Empire, and the Hanafi law has been codified according to this view, because it is damaging in the context of modern trade and industry, that the manufacturer exerts all his resources to prepare the required goods, and the purchaser cancels the sale without assigning any reason, even though the goods are in full conformity with the required specifications.

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Time of Delivery

As pointed out earlier, it is not necessary in Istisna that the time of delivery is fixed. However, the purchaser may fix a maximum time for delivery that means that if the manufacturer delays the delivery after the appointed time, he will not be bound to accept the goods and pay the price.

In order to ensure that the goods will be delivered within the specified period, some modern agreements of this nature contain a penal clause to the effect that in case the manufacturer delays the delivery after the appointed time, he shall be liable to a penalty which shall be calculated on a daily basis. Can such a penal clause be inserted in a contract of Istisna according to Shariah? Although the classical jurists seem to be silent about this question while they discuss the contract of Istisna, yet they have allowed a similar condition in the case of Ijarah. They say, if a person hires the service of a tailor to tailor his clothes, the fee may be variable according to the time of delivery. The hirer may say that he will pay Rs. 100/- in case the tailor prepares the clothes within one day and Rs. 80/- in case he prepares it after two days.

On the same analogy, the price in Istisna may be tied with the time of delivery, and it will be permissible if it is agreed between the parties that in case of delay in delivery, the price shall be reduced by a specified amount per day.

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Istisna as a Mode of Financing

Istisna can be used for providing the facility of financing in certain transactions, especially in the sector of house financing.

If the client has his own land and he seeks financing for the construction of a house, the financier may undertake to construct the house on that open land, on the basis of Istisna, and if the client has no land and he wants to purchase the land also, the financier may undertake to provide him a constructed house on the specified piece of land.

Since it is not necessary in Istisna that the price is paid in advance, nor is it necessary that it is paid at the time of the delivery, rather, it may be deferred to any time according to the agreement of the parties, therefore, the time of payment may be fixed in whatever manner they wish. The payment may also be in installments.

On the other hand, it is not necessary that the financier himself construct the house. He can enter into a parallel contract of Istisna with a third party, or may hire the services of a contractor (other than the client). In both cases, he can calculate his cost and fix the price of Istisna with his client in a manner that may give him a reasonable profit over his cost. The payment of installments by the client may start, in this case, right from the day when the contract of Istisna is signed by the parties, and may continue during the construction of the house and after it is handed over to the client. In order to secure the payments of installments, the financier as a security may keep the title deeds of the house or land, or any other property, until the client pays the last installment.

The financier, in this case, will be responsible for the construction of the house in full conformity with the specifications detailed in the agreement. In case of discrepancy, the financier will undertake such alternation on his own cost as may be necessary for bringing it in harmony with the terms of the contract.

The instrument of Istisna may also be used for project financing on similar lines. If a client wants to install a machinery plant in his factory, and the plant needs to be manufactured, the financier may undertake to prepare the plant through the contract of Istisna according to the aforesaid procedure. The same principles will be fully applicable to the construction of a building for the industry.

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