1. IB1005 DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONS CHAPTER 11 : SALAM FINANCING & ISTISNA FINANCING
COMPILED BY
HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance)
Certified Professional Trainer (MIM)
Industry Expert
INCEIF
PRESENTED BY
HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA)
Part-time Lecturer (INCEIF)
Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd

2. Chapter 11 : Salam & Istina’ Financing
Bai’ as-Salam is the sale of a deferred item in exchange for an immediate forward price.
A salam contract referred to a commodity for deferred delivery in exchange for an immediate cash payment.
The salam concept has been used by banks to hedge against inflation on other receivables due (on other assets such as murabahah); the forward income on salam being worth more.

3. In Sudan, one example of commercial financing is the application of salam for agricultural transactions (with funds utilized to pay for seeds, fertilizers and wages), but also to finance industrial and commercial activities.
Salam contracts can be developed between a farmer and IFIs, and a parallel salam between the IFI and a wholesaler/distributor whom in turn will generate retail income from the consumer.

4. AAOIFI stipulates that since the payment has been made in advance, the object matter of the salam contract (al-muslam fihi) is considered a debt, so no penalty clauses are permitted in salam “because it is not permitted to stipulate payment in excess of the principal amount of debts”.

5. Istina’ (Manfacturer’s contract)
The Majallah al-Ahkam al-Adliyyah (Ottoman code of Islamic civil law) defines istisna as “a contract with a skilled person to make something. The person who makes the thing is called sani, the person who causes it to be made mustasni, the thing made masnu.

6. The emphasis in istisna is the specificity of subject matter to avoid gharar (uncertainty) ensuring that the seller cannot transact with something that cannot be accurately described;
one can describe equipment, a factory or an industrial plant, but not fish in the sea prior catching them since their type and volume is unknown.

7. Malaysian Accounting Standards Board (MASB) in its Financial Reporting Standards (FRS) for Islamic Financial Institutions (IFI) defines the ististna contract as follows, “Bai al-istisna (lit. order sale) - A contract of exchange whereby an IFI, at the request of the customer, acquires an asset for purchase or construction based on specifications by the customer. The payment of acquisition price to manufacturer, developer or vendor of the asset is made up-front by determined future date.

8. Upon delivery, the IFI sells it to the customer at a prevailing market price comprising original acquisition price and a margin of profit.
The customer repays by instalments within a period and in the manner agreed between the IFI and the customer.”

9. AAOIFI also explains the differences between istisna and ijarah, a standard construction contract, and salam; Shari’a Standards ( ), Shari’a Standard No.11, Appendix (C), p.195. “The contract of istisna differs from the contract of ijarah in the sense that the latter is a contract of services without any commitment to supply materials whereas the former requires [the supply of] materials in the form of finished items.’’ Majallah al-Ahkam al-Adliyyah, Book II (Ijarah), Ch.1, Article 421.

10. Istisna differs from a salam contract [as an] istisna contract is applicable to materials that require transformation by a manufacturing or construction process.
The salam, on the other hand, is a contract of sale of specified goods, the validity of which is not attached to a condition that the goods must be manufactured or constructed.”

11. Companies and corporations may seek to obtain.
1. Housing projects
2. Construction of industrial/commercial building
3. Commercial projects
Under the Istisna’ principle, the bank will enter into an agreement to purchase from the project/ asset to be developed (Istisna Purchase by order) at an agreed Purchase Price.

12. Subsequently, the bank will immediately sell back the projects / assets (Sale by order), to the customer at a selling price which will include the original Purchase Price and the bank’s profit margin.
The customer is required to settle the selling price by instalments within the agreed period or by redemption exercise (if applicable). The Bank’s Purchase Price is normally released on a staggered basis i.e. upon the presentation of valid Architect’s Certificate and/or other acceptable documentary evidence.

13. The bank may also provide an end-financing package to the individual purchasers of housing/commercial building developed by the customer.
With a parallel `istisna, the main istisna’ contract between the customer and the bank involves deferred repayments, and subsequently, the bank enters into a parallel istisna’ with sub- contractor(s) for all or part of the project with cash released during the construction period.

14. Salam and Istina’ Financing
To protect public interest (maslahah al ammah), has the Islamic commercial law failed to recognize that not all objects of sale must be delivered on the spot in a physical form?
Certainly, the answer is a no, because both salam and istisna are exempted from this requirement.

15. The permissibility of salam and istisna’ in Islamic commercial law can make us realize that prevailing bai-bithaman-ajil contracts has been applied in a rather crude manner.
Basically, Salam and Istisna are sale contracts whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advance price fully or partially paid on the spot.
In other words, the price is paid cash (full or partial) while the supply of the goods is deferred to a future date.

16. It seems the bay' bithaman ajil contracts involving future delivery have violated the principle of mahallul 'aqdi violated, that " the subject matter must be in existence at the time of sale".
This is because the contract of al-bay, whether cash or deferred (bay’ bithaman ajil or bay 'murabahah) assumes that the goods are delivered on the spot

17. We see many instances today where in bay' bithaman ajil transactions, not all goods have been delivered on the spot.
Apparently, deferred delivery is only allowed in Salam and Istisna based transactions, but deferred sale products such as bay’ bithaman ajil tends to include deferred delivery as one of their prominent features.

18. This may not be accurate because in salam and istisna the main feature is deferred delivery while in bai-biithaman ajil, it is the deferred payment.
Salam usually involves agricultural products, while the subject of istisna is always a thing that needs manufacturing in which more attention is given to specifications of goods under order.

19. Workflow of Istina’ Financing
Each party has the option to rescind the contract before it is implementer but
binding once it has been constituted. Once constituted, if the Al-Masnoo does not conform to
specifications, the mustasni has the right to revoke the contract
Subject matter Al-Masnoo of certa
In specification ( can be manufactured
or obtained
from the market)
Kind
Type
Quality
Quantity
Payment in:
Spot Cash
Installment
Bullet
Al-Sani’
(The ultimate
Seller)
Price
Known
Cannot be increased
Decreased on account
Of increases or decreases
In price of inputs
Delivery :
a. Fixing delivery date is necessary
Al-Mustasni’
(The ultimate
Buyer)

20. In salam, the price is paid in advance while in Istisna it may be paid in cash or by installment.
This has a lot to do with the nature of agriculture production when most activities took place in the planting stage. It is important to release all capital during this critical stage after which less capital is required

21. In contrast, istisna’ production, unlike salam deals with production in stages all of which require capital injection
The time of delivery is an essential part of the sale of salam while it is not necessary in istisna' that the time of delivery be fixed.
Lastly, the contract of salam, once effected cannot be cancelled unilaterally, while the contract of istisna' can be cancelled before the manufacturer begins work.

22. The contract of istisna' can be more relevant relative to salam
The contract of istisna' can be more relevant relative to salam. But salam is also applicable to manufacturing. It is not accurate to say that salam is specially made for agriculture.
today, bay' bithaman ajil contract, seem to take advantage of the twin benefits of deferred payment sale and deferred delivery but are unable to allow the customer to exercise his right to cancel the order.

23. Have a good day 
May God bless you
Thank you & Wassalam