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Islamic Modes of Finance

Alfalah Institute of Banking and finance

Bahauddin Zakariya University Multan

MBA (Banking & Finance)

4th Semester

Istisna

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Submitted to:

Mr. Umair Shahid

Submitted by:

Muhammad Asif

MBK-11-03

MBA (B & F) 4th semester

Alfalah Institute of Banking and Finance

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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 Bai‘where 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

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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 'an agreement in the case of a delay in delivery, supply or

construction of the subject of Istisna.

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

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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

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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.

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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:

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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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Rs. 5million+rent over a period

Of 10 years

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.

Bank Rs.5M DIMINISHING MUSHARAKAH Customer Rs.2 M

Spot

Deferred

Rs.7

M

Istisna

Spot

Contractor

Istisna -Housing Finance during Construction Phase

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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 bank’s part every month; the rental starts decreasing after each payment

and after ten years, the bank’s investment is redeemed and ownership is transferred to the client.

Istisna for Pre shipment Export Finance:

Rs.110M

(Export proceeds)

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.

Istisna -Pre shipment -Export

Bank Rs.100 M (Istisna)

Spot

Customer

Deferred

Agen

t

EXPORT Rs.110 M

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4. B also appoints A its agent for export of the garments when they come under its ownership.

5. 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 Salam

1. The subject of Istisna is always a thing

which needs manufacturing.

The Salam subject can be either natural

products or manufactured goods.

2. The price in Istisna does not

necessarily need to be paid in full in

advance.

The price has 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

purchaser (the principle of Shart-e-

Jazai approved by the jurists.)

Penalty for late delivery shall go to charity and

the P&L Account of the purchaser (bank) will

be unaffected.

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 Ijarah

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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

the purchaser soon after delivery of the

item to him and he has to pay the price

irrespective of what happens to the

asset.

In Ijarah, asset risk remains with the

owner (lessor) and the lessee has to give

rental only if the assets capable of being

used as per normal market practice.

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, 2004–5a, 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.