1. Revision of Chapter 12 - 16

2. Salam: Forward Purchase A salam transaction is the purchase of a commodity for deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while delivery of the item to be sold, known as subject matter of salam, is deferred. Uses: – Purchase of commodities (financing for production of agricultural commodities/ minerals) – Liquidity requirements of sugar mills, etc.

3. Salam: Forward Purchase Wisdom of allowing Salam Beneficial for both seller and purchaser: seller or the farmer can get capital to grow the crop and get better produce of the crop, while the buyer can be sure of its stocks and price. Three major problems 1.Risk of default by seller 2.Bank’s need to liquidate goods after delivery 3.Seller’s inability to produce or procure commodity

4. Principles of Salam An exception to the possession A contract opposite to Murabaha Payment of full price at spot - otherwise selling debt for debt Allowed in fungible commodities Product of a particular origin can't be specified Quality and quantity decided in unambiguous terms

5. Principles of Salam The commodity should remain in the market throughout the period of contract (different opinions). The time of delivery should be sufficient to allow use of Salam capital conveniently A security/guarantee is preferred as safeguard to the risk of default Only commodity is delivered and not the money

6. Parallel Salam The disposal of commodity at the end of Bank can be through: a.Parallel Salam: MFI may sell commodity, before the date of delivery, to some other purchaser for the date of original delivery. The period in second contract will be shorter than the original contract, but price will be higher than the original contract. b.Unilateral Promise: Promise of purchase can be obtained from third party for delivery on the date of original contract. Price in this promise is set higher than parallel salam because the promisor has to pay nothing.

7. Rules of Parallel Salam and Third Party Promise Both the contracts i.e. Salam and parallel Salam must be independent of each other Parallel Salam is allowed only with third parties The third party giving unilateral promise should not pay the price in advance as this is not allowed in Sharia.

8. Seller (Buyer) Bank (Seller) Buyer Deferred Delivery Price received Deferred Delivery Salam Parallel Salam Price paid

9. Istisna

10. Introduction Istisna is a sale transaction where commodity is transacted before it comes into existence. Definition It is an order to producer to manufacture a specific commodity for the purchaser.

11. Conditions of Istisna the subject of Istisna is always a thing which needs manufacturing Manufacturer use his own material Quality and Quantity should be agreed in absolute term Purchase price should be fixed with mutual consent

12. Price of Istisna Price of Istisna may be spot and deferred therefore Istisna is applicable where Salam is not applicable. Price of Istisna can be paid in installments. The installments may be tied up with different stages of manufacturing.

13. Right of Rejection When the required goods have been manufactured by the manufacturer, purchaser can exercise his right to reject the goods based on the defects in the manufactured goods

14. Cancellation of Istisna The contract of Istisna can be cancelled unilaterally before the manufacturer starts working. After starting the work, Istisna cannot be cancelled unilaterally.

15. Difference between Istisna & Salam Istisna The subject of Istisna is always a thing which needs manufacturing. The price in Istisna does not necessarily need to be paid in full in advance. Salam The subject can be any thing. The price has to be paid full in advance.

16. Difference between Salam and Istisna Istisna Time of Delivery does not have to be fixed, but the stages of manufacture might be time bound The contract can be cancelled before the manufacturer starts working. Salam Time of delivery is an essential part of the sale The contract cannot be cancelled unilaterally.

17. Security A security in the form of a guarantee, mortgage or hypothecation may be required for Istisna in order to ensure that the manufacturer shall deliver the commodity on the agreed date, In the case of default in delivery, the guarantor may be asked to deliver the same commodity, and if there is a mortgage, the buyer can sell the mortgaged property and the sale proceed can be used either to realize the required commodity by purchasing it from the market, or to recover the price advanced by him.

18. Time of Delivery It is not necessary in Istisna that the time of delivery is fixed. However, the purchaser my fix a maximum time for 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 agreement of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, the price shall be reduced by a specified amount per day.

19. Delivery of Manufacturing goods Before delivery, goods will remain at the risk of seller. After delivery, risk will be transferred to the purchaser. Possession of goods can be physical or constructive. Transferring of risk and authority of use and utilization/consumption are the basic ingredients of constructive possession. If manufactured goods are delivered before agreed date, purchaser can refuse to accept the goods.

20. Parallel Istisna and its Applications After the execution of Istisna agreement with one party, buyer as a seller executes another Istisna agreement with third party,

21. Conditions for Parallel Istisna a.There must be two different and independent contracts, these two contracts cannot be tied up and performance of one should not be subject to the other. b.Parallel Istisna is allowed with third party only.

22. BuyerBank Contractor Deferred Delivery Payment agreement Deferred Delivery Istisna Parallel Istisna Payment agreement

23. Potential of Istisna The client can get finance for raw material, working capital and other overhead expenses by the execution of Istisna agreement. House financing, import and export products can be easily designed on Istisna basis.

24. Istisna as Mode of Financing House Financing Project Financing BOT Arrangement Export Pre Shipment

25. Musharakah Definition Musharakah is a form of partnership which is based on profit and loss sharing. The origin of Musharakah is Shirkah which connotes engagement of two or more parties who have a common interest to form a partnership.

26. Musharakah Types of Shirkah 1.Shirkah ul Aqad (commercial partnership) 2.Shirkah ul Milk (joint-ownership). Shirkah ul Aqad refers to partnership with commercial objective, whereas, Shirkah ul Milk refers to joint-ownership in a particular asset.

27. Features of Musharakah Contract 1.Capital contribution by all partners 2.Management of Musharakah venture 3.Profit sharing 4.Loss sharing 5.Partnership venture

28. 1. Capital Contribution by all Partners 1.Monetary assets in different currencies shall be valued based on the currency agreed by the partners in the contract. 2.All forms of debts (accounts receivables) shall not qualify as Musharakah capital. 3.Non-monetary asset with an associated debt may be contributed as capital e.g. contribution of a partner in the form of building which is partly funded by 30% debt (debt should not be more than 50%).

29. 1. Capital Contribution by all Partners 4.The total amount of capital to be contributed by each partner shall be determined up front. The agreed capital may be contributed on lump sum or staged basis. 5.Additional capital may be injected by mutual agreement of the partners. 6.Failure to contribute capital by the capital provider as per the agreed schedule shall constitute a breach of promise. The partners will have the option to terminate the agreement or to revise the agreement based on actual capital contribution.

30. 1. Capital Contribution by all Partners 7.The capital invested shall not be guaranteed by any of the partners. 8.Any of the partners acting as agents shall be liable for misconduct or negligence to the partnership as a whole. 9.Any partner acting on his own or as agent who has caused the loss of capital due to misconduct or negligence shall be liable to refund the loss of capital to the other partners. 10.Any loss of capital in the course of the business shall be recognized as capital impairment and shall be borne proportionately.

31. 1. Capital Contribution by all Partners 11.Share of Musharakah capital may be transferred to existing or a third party as per the Musharakah contract. 12.The Musharakah agreement may impose a condition that compels a partner to offer the redemption of the partner’s share of capital to existing partners based on certain agreed terms and conditions. 13.Capital gains or losses will be shared by the partners.

32. 2. Management of Musharakah Venture Musharakah venture may be managed in the following ways 1.Management by all partners; or 2.Management by certain partners or single partner; or 3.Management by a third party.

33. Profit shall be measured as an amount exceeding capital after deducting the cost and expenses attributable to Musharakah venture. In cases where the Musharakah is specified and meant for a specified project or activities, only expenses that can be identified by the partners or deemed direct expenses to the project may be deductible. The profit sharing ratio may either be proportionate to the capital contribution or be based on a ratio or percentage which is agreed upon by all partners irrespective of their capital contribution. 3. Profit Sharing Rights

34. Illustration: Profit Sharing Ratio Basis ‘A’ and ‘B’ contributed Rs.20,000 and Rs.80,000 respectively to form a Musharakah partnership. While B has decided not to take part in the management of the business venture, A has committed to managing the business of the partnership. According to the first provision, the profit sharing ratio between A and B should be 20:80 or 1/5 and 4/5 respectively. The ratio could be of any ratio such as 80:20 or 50:50 or any other arrangement as agreed upon by both parties. 3. Profit Sharing Rights

35. It is not permissible to include a condition in Musharakah contract that stipulates a pre-determined fixed amount of profit to one partner which deprives the profit share of the other partner. However, a lump sum amount of profit may be permissible if the profits are more than a certain benchmark profit.

36. 3. Profit Sharing Rights It is not permissible to express profit in a Musharakah, in a form of percentage of capital only, that means a payment of fixed profit regardless of the actual profit realized. Partner(s) in Musharakah, shall not fully or partially guarantee the principal and profit of another partner(s).

37. A third party who is not related to any party in the Musharakah in terms of equity ownership and management control may guarantee the profit to the Musharakah venture subject to certain conditions. Illustration: Guaranteed Rental Income for Profit Distribution If a Musharakah financing agreement is signed to build and rent a property to an identified tenant. The partners can obtain an undertaking from the prospective tenant that upon completion of the property and its availability for occupancy, the tenant will lease the property for a specified period at an agreed rental rate. Profit to be shared between the partners is based on the guaranteed rental income by the lessee for the lease agreement. This guaranteed rental by a third party is permissible. 3. Profit Sharing Rights

38. Any unusual investment income from Shariah prohibited activities of a Musharakah venture due to unavoidable circumstances will be distributed to charity. Illustration: Non-Compliant Activities and Disposal of Shares Investors, through Musharakah participation, subscribe to an investment fund that invests in a portfolio of several large companies. During the investment period one of the companies shifted its core business to non Shariah compliant activities. The fund manager responded by disposing of the investments in the company. Gains from the disposal of the share for the period of non-compliant activities are to be identified and distributed to charity.

39. 4. Loss Sharing Capital loss incurs when a capital asset (investment or real estate) decreases in value. The loss is not realized until the asset is sold for a lower price than the purchase price. Loss shall be shared among the partners proportionate to their capital contribution. Preferential treatment to a particular partner over the others in the same Musharakah venture in absorbing the loss shall not be permissible. The loss to the partners shall be limited to the capital contribution of each partner.

40. 4. Loss Sharing A third party may undertake to bear the loss of a partner. In order to encourage public participation in the Musharakah investment the government may provide a guarantee on the capital of a Musharakah venture. This type of guarantee is permissible and valid as the government is an independent party to the Musharakah venture.

41. 4. Loss Sharing Upon realization of loss, a partner may agree, without any prior condition, to bear the loss of another partner at the time such a loss is realized. The loss due to misconduct, negligence and breach of terms and conditions by a managing partner shall be borne entirely by that partner.

42. 5. Partnership Venture Business ventures of Musharakah shall be Shariah compliant and may be conducted in various sectors such as trading, plantation, construction, manufacturing, investment and services. A Musharakah contract may be adopted for non commercial activities which are non-profit oriented. Pre contracting costs like feasibility study fee may be charged to the customer subject to his/her consent.

43. Mudarabah Definition This is a kind of partnership between the two parties where one partner contributes capital and the other one contributes efforts as manager or entrepreneur. The profit of the venture is share at an agreed ratio while the losses are borne by the capital provider. The investment comes from “Rabb-ul-Maal” (Investor) while the management and work is an exclusive responsibility of the working partner, who is called Mudarib.

44. Features of Mudaraba Contract There are number of principles governing the Mudaraba contract, e.g. 1.Nature of the contract 2.Capital 3.Management of the Mudaraba 4.Profit and loss sharing mechanism

45. 1. Nature of the Mudaraba Contract Generally Mudaraba contract allows anyone of the contracting parties to terminate the contract unilaterally. However, the contract shall not be terminated unilaterally if the manager has started the work or when both parties have agreed not to terminate the contract during a specified time.

46. 2. Capital 1.The capital shall be contributed by the capital provider and shall be managed by the manager to generate income. 2.The capital of Mudarabah may be in the form of monetary or non-monetary assets.

47. 2. Capital 3.Monetary assets of different currencies shall be valued according to an agreed currency at the time of signing the Mudarabah contract. 4.The mutually agreed currency shall be applicable throughout the Mudarabah business venture. For example, any capital investments after the initial investment shall be converted into the currency mentioned in the prospectus.

48. 2. Capital 5.Capital in the form of non-monetary assets which may include intangible assets shall be valued based on the valuation determined by a third party or as agreed upon by the contracting parties at the time of contract. 6. Upon termination or the expiry of the contract non-monetary Mudarabah capital contributed may be redeemed at its original value invested or otherwise at its market value.

49. 2. Capital Illustration: Non Monetary Mudarabah Capital Contribution A public transportation company, XYZ applied for Mudarabah- based financing from an Islamic Bank. The bank approves the application and agrees to provide five buses to the company as Mudarabah capital valued at Rs.10 million based on prevailing market value and the company should manage the operations of these buses. Upon the termination of the contract the Murabaha capital may be valued at its original value or the residual market value as agreed in the contract.

50. 2. Capital 7.Debts such as account receivables or loans due to a capital provider do not qualify as capital of Mudarabah. 8.The agreed capital shall be made available to the manager to commence the business activities. 9.The capital may be fully or partially disbursed or made available to the manager at the time of the contract or based on terms of the contract. 10.Capital provider and manager may agree for a gradual withdrawal of Mudarabah capital by the capital provider.

51. 2. Capital 11.Failure to provide capital by the capital provider as per the agreed schedule shall constitute a breach of promise according to specified terms and conditions of the contract. 12.The manager has an option to terminate the agreement or both parties may agree to revise the agreement based on actual capital contribution.

52. 2. Capital 13.Where the agreement is terminated the manager has to return the outstanding capital (if any). If the Mudarabah expenditure exceeds the actual capital contribution, such liability shall be borne by the capital provider up to the limit of the total amount committed under the contract.

53. 2. Capital 14.Upon liquidation or maturity of the Mudarabah contract, all outstanding capital shall be returned to the capital provider. 15.Any outstanding capital including the share of profit shall be deemed as debt due to the capital provider. 16.The manager shall not guarantee the Mudarabah capital.

54. 2. Capital 17.The capital provider may require the manager to arrange for an independent third party performance guarantee. 18.The guarantee shall be executed as a separate contract and be utilized to cover for any loss or depletion of capital in the event of misconduct, negligence, dishonesty, fraud or breach of the terms of the contract by the manager.

55. 3. Management of the Mudaraba 1.Mudarabah capital will be used only for the Sharia compliant activities. 2.Manger/Mudarib will have the exclusive rights to manage the contract. However, the capital provider has the right to information regarding the conduct of the business and manger. 3.Manager shall not be liable for any loss of capital unless it is due to any negligence, dishonesty, misconduct or breach of contract.

56. 3. Management of the Mudaraba Restricted Mudaraba The powers of the manger shall be provided under the terms and conditions of the contract. The contract may restrict the manager’s role/functions such as determination of location, period for investment, type of project and commingling of funds, provided it does not nullify the purpose/objective of the contract. However, the restrictions shall not unduly constrain the manager.

57. 3. Management of the Mudaraba Unrestricted Mudarabah Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he/she deems fit, this is called unrestricted Mudarabah. The manager has the discretion to use the capital in the best interest of the Mudaraba. However, Mudarib is not authorized to: Keep another Mudarib or a partner Mix his own investment in that particular Mudaraba without the consent of Rabb-ul Maal.

58. 3. Management of the Mudaraba Single tiered Mudaraba A Mudarabah contract shall require the manager to deploy the capital to a profitable venture. The manager shall be personally responsible to ensure the proper management of the capital is in the interest of the capital provider. Multi-tiered Mudaraba The manager of a Mudarabah contract may assign the capital to another manager in another Mudarabah contract with the consent of the primary capital provider.

59. Bank Mudarib Rabb ul Mal Mudarib Investment Depositor Profit/loss Rabb ul Mal Two Tier Mudarabah

60. 4. Distribution of Profit & Loss 1.It is necessary for the validity of Mudarabah that the parties agree right at the beginning on a definite proportion of the actual profit to which each one of them is entitled. 2.They can share the profit at any ratio they agree upon. 3.However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios. 4.Some incentives my be given to the Mudarib.

61. 4. Distribution of Profit & Loss 5.Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah. 6.The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

62. Termination of Mudarabah 1.Mudarabah can be terminated any time by either of the two parties by giving notice. 2.If Mudarabah was for a particular term, it will terminate at the end of the term. 3.Termination of Mudarabah means that the Mudarib cannot purchase new goods for the Mudarabah. However, he may sell the existing goods that were purchased before termination.

63. Collective Mudarabah 1.Collective Mudarabah means a joint pool created by many investors and handed over to a single Mudarib who is normally a juristic person. 2.Collective Mudarabah creates two different relationships: a.Relationship between investors themselves, which is Shirkah or Partnership. b.Relationship of all the investors with Mudarib, which is Mudaraba.

64. Running Mudarabah 1.Investors come in and go out at different dates 2.Profits are calculated on daily basis. 3.Redemption before maturity a.If the assets of Mudaraba are in illiquid form, an investor may redeem his share by selling it to the pool.. b.If the assets are in liquid form, a provisional amount may be given to him subject to final settlement

65. Diminishing Musharakah It is a type of Shirkah where one partner promises to purchase the other partner’s share gradually.

66. Type of Diminishing Musharakah Like Musharakah contract Diminishing Musharakah is also of two types; /Diminishing Musharakah Shirakat-ul-Milk Joint ownership Shirkat-ul-Aqd Joint Venture

67. Features of Diminishing Musharakah Shirkat-ul-aqd (joint venture) Two partners start business in Shirkah to earn profits. One of the partners undertakes to purchase the share of another partner gradually at regular intervals.

68. Rules of Diminishing Musharakah in Joint Venture There will be an agreement of joint venture between both partners where in investment of everyone and ratio of profit will be agreed. One partner undertakes to purchase the share of other partner, but three conditions should be considered in this undertaking. a) This promise will not be a part of Shirkah Agreement. b) The price of unit will not be agreed in this promise but promise to purchase should be on offer and acceptance basis for a valid sale contract. c) If promise is not fulfilled, then it can be forced by Court of law.

69. Rules of Diminishing Musharakah in Joint Venture At the time of purchase, the price of unit will be decided on the basis of market value of business. Conditions of valid sale transaction must be observed. Unit will be purchased through Offer & Acceptance.

70. Features of Diminishing Musharakah in Joint Ownership Two or more partners purchase any asset (machinery, property, etc.) and their intention is that one or both partners will use this asset or rent out their share and one partner undertakes to purchase the share of other gradually.

71. Rules of Diminishing Musharakah in Joint Ownership There will be an agreement of Shirkat ul Milk and it will be decided How much investment will be made by each partner. Asset will be purchased and everyone will be owner of this asset as per the ratio of his/her investment and all other rules of Shirkat-ul-Milk will be applicable.

72. Rules of Diminishing Musharakah in Joint Ownership One Partner can rent out his share to other partner or to a third party and Ijarah Agreement will be signed. Within period of Ijarah, Shariah rulings relating to Ijarah will be applicable.

73. Rules of Diminishing Musharakah in Joint Ownership One of the partners can promise to purchase the share of another partner and in this promise, the price of unit may be decided. Unit can be purchased on the basis of Offer & Acceptance. All the above mentioned agreements and undertaking should be independent and not linked up with each other.

74. Termination of Diminishing Musharakah 1.Subject to agreement or by mutual consent of joint owners, a joint owner may withdraw his share from the joint asset or property after serving a due notice to other joint owner(s). 2.The withdrawal can be affected by sale or gift to existing joint owner(s) or to any other person(s). In case of sale, the parties may agree on face value, book value, agreed value, or market value. 3.A withdrawal of one or more joint owner(s) shall not lead to the termination of the joint ownership among remaining joint owner(s). 4.It is also permissible for the joint owners to agree on termination of the joint ownership before the agreed period.

75. Use of Diminishing Musharakah in the Present Islamic Banking System

76. Use of Diminishing of Musharakah in Banking System Diminishing Musharakah is usually used for asset financing and particularly in House Financing for four purposes: 1.Purchase of House 2.Construction of House 3.Renovation of House 4.Balance Transfer Facility (BTF)

77. 1. Financing for Purchase of House 1.The Client in the approved area of the bank makes the choice of house. 2.Bank & client enter into Musharakah agreement. In this agreement it is decided to purchase the house jointly and ratio of investment by each other.

78. 1. Financing for Purchase of House 3.The property will be in the name of the client. 4.This is Shirkat-ul-Milk. 5.According to the ratio of ownership, each one is responsible for the loss. 6.Bank divides its own part of asset into units, which is promised by the client to purchase on pre-agreed price.

79. 1. Financing for Purchase of House 7.After taking possession of house, bank rent out its share to the client by execution of Ijarah Agreement. 8.Rent may be fixed on prevailing market rate or with mutual consent. 9.Bank’s monthly profit may also be decided, as monthly rent of the house and principal amount will be recovered in the unit price.

80. 1. Financing for Purchase of House 10.In Ijarah Agreement, a lump sum amount of rent is necessary to be fixed for a certain period. Rent for the rest of the period, may be linked with agreed Benchmark. 11.Each unit will be purchased on the basis of Offer & Acceptance.

81. Summary of the Lecture We revised the lectures from lecture number 12 to 16 and discussed the following topics. Salam and Istisna Musharakah Mudarabah Diminishing Musharakah