INTRODUCTION TO ISTISNA

Istisna is the second sales contract, in addition to Salam, that is an exception to the Shariah requirements for a valid sales contract. These Shariah requirements are that the asset being sold must exist at the time of the contract, the seller should be the owner of that asset and the asset should be in the possession or control of the seller, either physically or constructively. The word Istisna is derived from the Arabic word Sina'a, which means to manufacture a specific commodity. Shariah scholars allow the Istisna contract as an exception to a valid sales contract since it helps meet the needs and requirements of individuals and organizations which cannot be financed through standard sales contracts.

Istisna is a sales contract in which the buyer contracts with the seller to manufacture, produce, construct, fabricate, assemble or process any asset in accordance with given specifications, descriptions, quality and quantity identified, and within a specified period and at an agreed price. The asset is produced using the seller's raw materials and/or effort, labour. All these conditions and details are discussed and agreed in advance, with the mutual consent of both parties. Wherever possible, a sample or model needs to be provided to reduce ambiguity.

The parties in the Istisna contract are the buyer (al Mustasni) and the seller (al Musania), and the specific asset to be manufactured is the al Masnu. Istisna is the sale of an asset which does not exist yet, similar to a Salam contract. The main difference is that, in case of a Salam contract, the price is paid in advance at the time of the contract while delivery is made in the future, while in case of an Istisna contract the order is provided for a specific manufacture, with delivery in the future and the payment being at spot or deferred in the future.

Istisna is one of the most flexible Islamic finance contracts with regard to payment and delivery. The buyer has various options to pay in a lump sum or instalments during construction, at delivery, or deferred in the future, according to a pre-specified payment schedule or in payments linked to progress in the construction or manufacture of the asset. The contract cannot be cancelled unilaterally by either party once work on the asset has started. The flexible payment options make Istisna a suitable form of contract for construction and project financing, and it is applied to long-term projects involving building or manufacturing a capital item.

If the buyer does not specify it as a condition in the contract that the seller is required to manufacture the item itself, the seller has the right to contract with a third party to manufacture, produce, construct, fabricate, assemble or process the asset. In this case the seller enters into a second Istisna contract, as a buyer this time, and the manufacturer of the asset is the seller in this second Istisna, which is called the parallel Istisna. Usually, when an Islamic bank is involved as the seller in the Istisna contract, it enters the parallel Istisna as the buyer while the manufacturer is the seller.

SHARIAH RULES AND GENERAL PRINCIPLES GUIDING ISTISNA CONTRACTS AND THEIR CHARACTERISTICS

The Shariah rulings related to the Istisna contracts as identified by Sheikh Muhammad Taqi Usmani (Usmani, 1999) and other principles developing the characteristics of Istisna contracts being offered by the Islamic banking industry are discussed below.

1. Exception to valid sales contract. Istisna is an exception to the rules under Shariah that need to be met for a sales contract to be valid. These rules are that the asset involved in the sales should exist at the time of the contract, should be owned by the seller and should be in physical or constructive possession of the seller.
2. Specifications of the asset to be provided. To reduce or remove all ambiguities related to a yet-to-be-manufactured asset, significant specifications related to the asset's description, quality and quantity need to be included in the contract and be mutually agreed between the parties. This also serves the purpose of removing any uncertainty or Gharar in the contract.
3. Material sourcing. This is the responsibility of the manufacturer and should match the asset specifications as agreed.
4. Price. This is decided mutually between the two parties and included in the contract. Any change required later can only be made with mutual consent.
5. Delivery. A specific date of delivery is agreed in the contract and the seller is obliged to meet this delivery date. The buyer, on the other hand, is obliged to take delivery of the asset at the prescribed date, provided the asset matches the specifications in the contract. The buyer cannot refuse to accept the asset once it has been manufactured, unless it has an obvious defect.
6. Payment options. An Istisna contract can be designed with a variety of payment options. The buyer has the option to pay in full at the time of the contract, in instalments during the construction period, in full at the time of delivery, or deferred in the future either in a lump sum at a specific date in the future or in instalments over a defined period after delivery. The payments can also be made progressively in accordance with the progress in construction or manufacture of the asset.
7. Cancellation or termination of contract. The parties can cancel the contract unilaterally only prior to the start of work on the manufacture. Once work starts, no unilateral cancellation is allowed. The parties can mutually agree to cancel.
8. Default. Default can occur in four ways in the case of Istisna. It can happen before delivery or after delivery, by the buyer and by the seller.
   1. Default before delivery by seller. If the before-delivery default is caused by the seller, by not delivering on the due date or the delivered asset not matching the specification or being damaged, the buyer can terminate the contract and demand return of any payments already made, and even damages if due to the default the buyer would lose.
   2. Default before delivery by buyer. If the before-delivery default is caused by the buyer, for instance failing to or refusing to take delivery of the asset when the specifications are met by the seller, the seller can claim damages from the buyer. In case the buyer has already partially paid, and the value of the instalments paid by the buyer is greater than the damages, the seller will deduct its damages and return the excess to the buyer, but if the value is less than the damages, the buyer needs to pay the additional amount.
   3. Default after delivery by seller. If the after-delivery default is due to the seller, for example when the seller fails to meet commitments relating to post-construction or after-sales service, in such a manner that the asset cannot be used by the buyer as was intended, the buyer can terminate the Istisna and claim return of the purchase price from the seller as well as damages for any loss incurred.
   4. Default after delivery by buyer. On the other hand, if the default happens because the buyer fails to make repayments as they fall due, the seller cannot take the asset back since title has already passed to the buyer, but they can claim damages and recover their dues from the collateral or security or through a court procedure.
9. Penalty. If the seller fails to deliver the asset on the agreed delivery date, then the price of the item can be reduced by a specific amount each day. This is not the time value of money, but compensation to the buyer for loss of the benefit or value that the buyer could have derived from the asset if it was delivered on the due date. On the flip side, a penalty can also be applied to the buyer for delayed repayment. This penalty could be applied as per the contract specifications, as a percentage per day for delayed repayment or a fixed amount, but the seller cannot benefit from this penalty and it needs to be donated to charity.
10. Security or collateral. As seller, the bank often takes security or collateral from the buyer. In case of delayed payment or non-repayment, the asset provided as security or collateral can be sold to recover the payments and this can be done without the intervention of the courts.
11. Insurance of the Istisna asset. During the manufacture or construction of the asset the manufacturer, the seller of the parallel Istisna contract, is responsible for the insurance. After the delivery of the asset the customer, the buyer of the first Istisna contract, is responsible for insuring the asset.
12. Independence of Istisna and parallel Istisna contracts. The two Istisna contracts need to be completely independent of each other and the rights and obligations derived from each contract are in no way dependent on each other.

ROLE OF ISLAMIC BANKS IN ISTISNA AND PARALLEL ISTISNA

Theoretically, Istisna is a contract between a buyer and a seller, where the buyer requires the seller to construct, fabricate, assemble, produce or manufacture an item, equipment, building, etc. In modern Islamic banking, Istisna has three parties, consisting of two Istisna agreements. The buyer, being the customer, approaches the Islamic bank which acts as an intermediary. Banks are not in the business of manufacturing any item, but rather in the business of financing such a manufacture. The bank agrees to deliver the required asset as per the detailed specifications provided by the customer by entering into an Istisna contract with the customer playing the role of a seller but entering into a second back-to-back Istisna contract called the parallel Istisna. The bank acts as the buyer in the parallel Istisna and contracts with the manufacturer, producer, assembler, fabricator or constructor for the exact same item as required by its customer, providing the exact same specifications. The bank adds its profit margin to the price at which it contracts the manufacturer and sells the item to the customer at this higher price. The price difference between the two Istisna contracts is the spread or margin earned by the bank. The delivery date on both Istisna contracts is often the same. The physical delivery of the item is made directly to the customer, while ownership of the asset passes from the manufacturer to the bank. On the parallel Istisna contract, the bank pays the cash in advance at the time of entering the contract or in instalments during the manufacturing process. On the Istisna contract, the bank offers the customer a variety of payment options including spot or deferred, lump sum and instalments. Thus, the main role of the Islamic bank is to provide financing for the manufacture of the asset required by the customer.

The first Istisna contract is drawn up between bank and customer; the bank is the seller and the customer the buyer. The customer provides full specifications, description, quality and quantity of the item, including design details, material to be used, also maybe the raw material supplier and manufacturer to be assigned, the performance standards to be met, completion time and appropriate costing. The repayment period for this contract will usually be long term with a variety of options available to the customer to pay a lump sum on spot at delivery, or deferred to the future as a lump sum at an assigned period, or in regular instalments over an agreed repayment schedule.

The second Istisna contract is drawn up between the bank and the assigned manufacturer; the bank is the buyer and the manufacturer is the seller. The bank approaches the manufacturer with the exact same order and specifications that the customer has provided to the bank in the first Istisna. When the bank receives the quote from the manufacturer, it adds its own profit and quotes to the customer for the first Istisna. If the customer agrees, then the first Istisna is contracted. The bank then goes back to the manufacturer and enters the contract of the second Istisna agreement, the parallel Istisna. The bank makes the payment to the manufacturer either in full when signing the contract or in instalments during the manufacture, or sometimes in full at delivery. The parallel Istisna can be called a sub-contract, but to be Shariah complaint the two Istisna contracts must be completely independent of each other with respect to rights and obligations.

The term period of the parallel Istisna is much shorter than the first Istisna, since the manufacturer wants to be paid in advance, or during construction, or at delivery or soon after. On the contrary, the customer usually requires a longer period to make the payment and this is the main reason for having to approach the bank, to receive financing for purchase of the asset. Hence, the bank allows the customer a much longer payback period and various repayment options, including lump sum payment on spot at delivery, deferred lump sum or instalments. The price difference between the two Istisna contracts is the margin or profit made by the bank, basically by paying for the asset and providing the customer with the opportunity for delayed payment, thus in practice providing the financing for the asset.

Description of the Process

Figure 9.1 shows a diagram of the Istisna and parallel Istisna processes.

1. The Istisna process usually starts when the customer approaches the bank to finance any asset to be produced, manufactured, constructed, fabricated or assembled. For example, a new building. A conventional bank at this stage would offer a loan, while an Islamic bank could suggest an interest-free Shariah-compliant Istisna contract.
2. The customer would then provide the bank with a detailed description, specifications, quality, quantity, time to develop and expected cost estimate. In the case of the building example, the customer would provide other documents like the plan, layout and blueprints, as well as government permits. The customer may also identify the preferred construction contractor and preferred suppliers of materials.
3. The Islamic bank would then approach the manufacturer, builder or producer with the above specifications provided by the customer for a quote.
4. When the bank receives the quote for the development of the prescribed asset from the manufacturer, which is usually valid for a few months, the bank adds its own profit or margin to the price quoted and takes it to the customer.
5. If the quoted price and the delivery time are acceptable to the customer, then the bank and the customer would enter into the Istisna contract, the customer being the buyer and the bank being the seller.
6. Once the Istisna contract is completed, the bank goes back to the manufacturer, accepts its quote and enters the parallel Istisna, the bank being the buyer and the manufacturer being the seller.
7. The delivery time for both contracts is usually the same; the bank takes over the title from the manufacturer and the delivery is made directly to the customer.
8. Istisna allows a variety of payment options. In the parallel Istisna contract the bank may pay the manufacturer the full price at the time of the contract, or pay in instalments during the period of production (these payments could be tied up with progressive completion of the production), or pay in full on delivery, or pay deferred in full or in instalments after delivery. Usually in this contract the deferred payment is less common, and even if it is deferred the repayment period would be short. On the contrary, in the Istisna contract the buyer has the option to pay in full at delivery, or pay deferred in full or in instalments. Usually the deferred payments are more common in this contract, and the repayment period is much longer than in the first Istisna contract.
9. As such, it is evident that through the mechanism of Istisna and parallel Istisna contracts for the exact same asset and the same delivery period, the customer acquires the asset without having to pay for it immediately. In this case the customer is being financed by the Islamic bank, which pays the manufacturer upfront or within a shorter period and delivers the asset to the customer, allowing the customer a much longer deferred period to make payments.

PROBLEMS RELATED TO ISTISNA AND PARALLEL ISTISNA

Default risk of banks. Banks serve as an intermediary between the Istisna and the parallel Istisna contracts and they carry default risk from the counterparty on both contracts.

Credit risk of banks. In the Istisna contract the bank has the risk of non-payment by its customer, called credit risk. To deal with this, banks can ask for security or collateral from their customers, which can be used to recover any amounts that are not paid by the customer.

Performance risk. In the parallel Istisna contract the bank is exposed to the risk of the manufacturer not delivering the asset in the required specification, quality and quantity and at the designated time and price, called performance risk. To manage the manufacturer's performance risk, banks may demand performance bonds and warranties after delivery. Any delay due to negligence of the manufacturer allows the buyer, the bank, to claim compensation. The bank may reject the asset if it does not meet the Istisna specifications as detailed in the contract, and may also demand compensation from the performance bond. Any failure to provide after-delivery services can be compensated by the warranties. Shariah compliance requires the two Istisna contracts to always remain separate, however, and the liability of one cannot be related to the liability of the other.

COMPARISON OF ISTISNA WITH INTEREST-BASED FINANCE, SALAM AND IJARA

Istisna is one of the Shariah-compliant deferred sales contracts and can be compared with the standard interest-based financing provided by a conventional bank. The two forms of financing are compared in Table 9.1.

DIFFERENCE BETWEEN SALAM AND ISTISNA

Salam and Istisna are both Shariah-compliant deferred sales contracts. Both are exceptions to Shariah rulings for valid sales. That is, in both cases the asset does not exist at the time of the contract, and as such it is neither owned nor physically or constructively in the possession of the seller. In both Salam and Istisna, the possibility of Gharar is avoided by providing detailed specifications of the asset. Beyond these similarities Salam and Istisna contracts have the differences listed in Table 9.2.

COMPARISON OF ISTISNA WITH IJARA

In case of the Istisna contract, the manufacturer uses their own materials to produce, manufacture, construct, fabricate or assemble the asset. If the raw material is not already in the possession of the manufacturer, they are required to obtain it as per the specifications provided by the bank or buyer and develop the asset in accordance with the Istisna contract. If the raw material required for production is provided by the buyer and the manufacturer only applies their labour and/or skill, the transaction can no longer be termed Istisna but rather becomes Ijara, where the services of the manufacturer to produce the asset have been hired through the payment of a specific fee.

PRACTICAL APPLICATION OF ISTISNA

Istisna is a financing method offered by Islamic banks that is specifically designed to offer clients funding for assets that are yet to be constructed, manufactured, produced, fabricated or assembled. Unlike Murabaha, which is the purchase of an existing asset or Ijara, which is the renting of an existing asset, Istisna is the purchase of an asset that is yet to be developed. Thus, it allows the client to acquire an asset that has been tailor made to their requirements and built to detailed specifications. Istisna contracts are usually for the longer term and are for assets of significant value. Most commonly, Istisna financing is used for construction finance, project finance, trade finance, machinery for specific purposes and capital equipment such as aircraft, ships, oil rigs, etc. Due to its longer term, and since the asset will be built and delivered in the future, significant risk is involved in Istisna financing. Islamic banks have innovated various measures to minimize these risks. Two measures gaining a lot of popularity are described below, as detailed in Kettel (2011).

Parallel phased Istisna (PPI). This technique was first introduced by the ABC International Bank, based in the UK and a subsidiary of the Arab Banking Corporation of Bahrain. Construction projects with Istisna can be risky and expensive, as they are often drawn out over an extended period and subject to various kinds of delay. To reduce this risk ABC broke the construction period into multiple Istisna contracts, each linked to staggered financing, conditional on the completion of the previous phase.

Buy, operate, transfer (BOT). Istisna can also be used for projects in BOT mode. For example, a government may contract a manufacturer to build a bridge. Once the bridge is completed, the builder operates it, collecting toll, which in turn pays off the builder. Once the toll money repays the builder completely, it hands over the bridge and its operations to the government. In this way the asset pays for itself, moreover it is operated by the manufacturer during the early part of its lifetime to assist with any trouble-shooting required.

KEY TERMS AND CONCEPTS

• Al Masnu
• Al Musania
• Al Mustasni
• Credit risk
• Default after delivery
• Default before delivery
• Default risk
• Istisna
• Performance risk
• Parallel Istisna

CHAPTER SUMMARY

Istisna is the second exception to the Shariah-compliant sales contract, where the buyer contracts the seller to manufacture, produce, fabricate, assemble or process a specific item with descriptions, quality and quantity identified. A specific delivery period and price are also mutually decided. Istisna is the most flexible Islamic finance product with respect to repayment options.

The Shariah rules and general principles guiding the characteristics of the Istisna contract include the exception from the valid Shariah sales of the asset being in existence, owned and in possession of the seller, providing detailed specifications to avoid any Gharar, also rules related to material sourcing, price, delivery and payment options, cancellation and termination of contract, default and penalty, security, insurance and the independence of the Istisna and parallel Istisna contracts from each other.

The Islamic bank serves as an intermediary between the buyer and the seller by entering into the Istisna contract as seller with the client and into the parallel Istisna contract with the manufacturer as buyer for the same items, with the same delivery period. The price and payment options would differ in the two contracts, and the price difference is the profit made by the bank for providing the financing. Islamic banks face credit risk in the Istisna contract and performance risk in the parallel Istisna contract, and default risks in both contracts.

Istisna differs from conventional loans with respect to the type and number of contracts, the parties, the bank's relationship to the customer, the asset and the risks and penalty. The differences of Istisna from Salam, the other exception to the Shariah sales contract rulings, include the suitable type of subject matter, manufacturer, payment method, delivery, cancellation and bank involvement.

Istisna contracts usually involve larger funding and longer term. To minimize the risk, modern Islamic banks break the contract into phased smaller contracts with staggered financing conditional on completion of the previous phase; they also use the BOT mechanism of financing with Istisna contracts.

END OF CHAPTER QUESTIONS AND ACTIVITIES