1. Ministry of Rural Rehabilitation and Development Afghanistan Rural Enterprise Development Program Islamic Finance Product Development The Bay’ Istisnā’ for fixed-assets financing prepared by Alberto G Brugnoni - ASSAIF ISLAMIC REPUBLIC OF AFGHANISTAN

2. CONTENTS  WHAT IS MEANT BY ISTISNĀ’  THE LEGITIMACY OF THE ISTISNĀ’ CONTRACT  SHARI‘AH PARAMETERS - CONCLUSION OF CONTRACT  SHARI‘AH PARAMETERS - ASSETS  SHARI‘AH PARAMETERS - PRICE  SHARI‘AH PARAMETERS – EXECUTION OF CONTRACT  SHARI‘AH PARAMETERS - DELIVERY OF THE PRODUCT  DIFFERENCES BETWEEN ISTISNĀ’ AND IJARAH  DIFFERENCES BETWEEN ISTISNĀ’ AND SALAM  APPLICATIONS OF ISTISNĀ’ IN ISLAMIC BANKS

3. WHAT IS MEANT BY ISTISNĀ’  Istisnā’ means a production on order of specific items to be manufactured or constructed  Istisnā’ is a financial contract issued for manufacturing a product or erecting a building for instance. Using his own materials, the seller is committed to deliver the product of certain descriptions at a specific period of time  Istisnā’ financing is when the bank contracts with a manufacturer to finance an operation (hence, buys goods) for a customer  Technically, istisnā’ is an agreement to sell to a customer a non-existent asset that is to be manufactured or built according to the agreed specifications and delivered on a specified future date at a predetermined selling price  Istisnā’ is an important contractual formula because: →the sale transaction takes place before the commodity comes into existence →is distinguished from other sales contracts in that the contract combines material and work. I.e.: raw materials that can be transformed from their natural state by a manufacturing or construction process involving labor →there is flexibility of payment →the vitality of the areas in which this facility is used (industry and real estate)

4.  The contract of istisnā’ may be concluded with a condition that production shall be carried out by the Islamic bank using its own resources, and will have a right to assign the process of production to another entity  It is permitted for the manufacturer to fulfill his obligations in istisnā’ contract by the delivery of items produced by his own resources or items produced by other parties, even the items were in existence before the istisnā’ contract was concluded  It is permissible that istisnā’ contract be concluded for the production of subject matter having unique descriptions as well as for the production of subject matter that has perfect substitutes available in the market  Not every contract combines the material and work, qualifies as istisnā’. In fact, there are a variety of circumstances that accompany the combination of the two: →if the amount of labor is insignificant and the consideration is all focused on the material item, it is a regular sale (bay‘); for instance, buying an electric washing machine and having it installed in the buyer’s home →if the amount of material involved is insignificant and the consideration is all focused on the labor, it is a type of labor lease; for example, bringing cloth to a tailor to have him sew it, and he provides the thread and the buttons WHAT IS MEANT BY ISTISNĀ’

5. →If the proportions of both labor and materials are significant, the contract is istisnā’, and it is not necessary for the labor and the material to be of equal value WHAT IS MEANT BY ISTISNĀ’

6. THE LEGITIMACY OF THE ISTISNĀ’ CONTRACT  The legitimacy of the istisnā’ contract is founded on the basis of the Sunnah of the Prophet Muhammad Peace Be Upon Him (PBUH), and the consensus of the Muslim Jurists (ijma’)  Nafi’ reported that Abdullah b. ‘Umar has reported to him that the Prophet Muhammad (PBUH) has requested for the manufacturing of a golden ring for him. The narration provides basis for the permissibility of istisnā’. [Bukhari 5/220 and Muslim 3/1655]. Also the Prophet (PBUH) required that a pulpit (platform) be built for preaching [Bukhari 2/908]  Originally allowed by the Hanafi school, while other schools preferred the raw material to be provided through sale contract and manufacturer produce the final product on the basis of ijarah (contract of construction)  Now, it has received widespread acceptance. Istisnā’ is also legally recognized by established Shariah bodies such as the International Islamic Academy of Fiqh which is under the patronage of the Organisation of the Islamic Conference (OIC)

7. SHARI‘AH PARAMETERS - CONCLUSION OF CONTRACT  The istisnā’ contract is binding: it is entered by both seller and purchaser to manufacture or construct specific asset that conforms to the agreed specifications, price, place of delivery and payment modes shall be binding on both parties  It is not required that the product be present at the time of the contract, which makes it similar to salam. It does not matter if the product is manufactured before or after the contract session. Likewise, it is not required that the manufacturer possess the materials necessary for manufacturing the product before the contract session  The offer and acceptance actually occurs in an istisnā’ contract at the instant they are articulated. It is a complete contract, not just a promise. Thus there is no need for a new offer and acceptance at the time of delivery, which is one of the effects of the contract. This is a point of difference with the promise of a purchase undertaker to conduct a murabahah contract in the future  Formalism (suriyyah) should be avoided when concluding an istisnā’ contract. It is not permitted for the contracts in istisnā’ to be concluded in a form that turns the process into a stratagem to cover up riba’-based financing. Therefore, it is not permissible for a bank to finance its client by means of istisnā’ if it has already concluded a [similar] contract with another manufacturer, in order to avoid riba’ and purely formal transactions

8.  The contract of istisnā’ can be cancelled unilaterally before the manufacturer starts the work, however the seller may claim for compensation of the cost incurred. Once the work has been started, istisnā’ cannot be cancelled unilaterally  The contract may incorporate a clause to provide an option for the purchaser to take control of the project and the right to recourse to the seller for all expenses to complete the asset if the seller (contractor) failed to follow the schedule agreed upon in the contract  A third party may be appointed to provide additional professional services related to the project. The engagement of the additional services and fees are to be specified and mutually agreed in a separate contract SHARI‘AH PARAMETERS - CONCLUSION OF CONTRACT

9. SHARI‘AH PARAMETERS - ASSETS  The asset and the purpose of manufacturing and construction shall be Shariah- compliant  The manufacturing or constructing the istisnā’ assets shall be executed based on the detailed specification stipulated in the agreed contract in order to avoid any uncertainties  The istisnā’ assets may represent homogeneous assets which are commonly traded or a customized product, which will be manufactured by the seller  Both contracting parties may agree on certain degree of deviation or tolerance in terms of expected level of accuracy in meeting the agreed specification, which is in line with the acceptable market practice  The assets to be manufactured or constructed shall be specified but not identified with reference to the physical form of the intended assets

10. SHARI‘AH PARAMETERS - PRICE  It is required that the price of the product be known in absolute and un-ambiguous terms at the time the contract is concluded. The price concluded may take into consideration the warranty, after sales services and length of delivery period  Spot, progressive or deferred payment in the form of installments or bullet payments: it is permitted to link the payment installments to stages of the production process if the stages are clearly distinguishable in customary practice such that no dispute will arise about them. It is also permitted to set the price on the basis of a unit of measure  It is permitted to set the price in an istisnā’ contract on the basis of actual production costs plus a specified percentage as a mark-up. In this case, detailed documents must be provided to establish the cost →however, the requirement to disclose the production cost by the seller is not mandatory in istisnā’: the selling price may be determined based on the direct and/or indirect costs of istisnā’

11. SHARI‘AH PARAMETERS - PRICE  It is also permitted for the price to vary depending on variations in the delivery date. This does not render the price unknown, and the variation in price serves as an incentive for the manufacturer to finish production early: →the basis for this ruling of permissibility is qiyas (analogy) on the remuneration in a labor lease, for jurists have explicitly stated that it is permissible to stipulate in the contract that the worker will be paid two dirhams if he completes the required task in a day and one dirham if he completes it in two days  Price can also be usufruct of the related or not related to subject matter. The price of istisnā’ contract may be in the form of cash or tangible goods (in-kind) or the usufructs on an asset for a particular duration, whether such usufructs are related to an asset other than the subject matter or to the subject matter itself  The variation in the selling price shall not be associated with the extension of payment period  The purchaser shall not be entitled to claim from the seller any reduction of the istisnā’ sale price due to reduction of construction/manufacturing cost. However, the manufacturer may decide to waive (ibra’) part of the selling price based on its own discretion

12. SHARI‘AH PARAMETERS - PRICE  Additional costs and expenses arising from meeting any specific legal requirement which is not specified in the contract may be imposed on the purchaser provided that those expenses are not within the liabilities of the seller  The purchaser may promise to share with the seller some of the trading profits arising from the sale of an istisnā’ asset when it is sold to a third party

13. SHARI‘AH PARAMETERS – EXECUTION OF CONTRACT  Warranty terms may be specified by the parties in an istisnā’ contract to safeguard the interest of the purchaser against defects and to ensure necessary maintenance work is carried out after the asset is delivered  A down payment (‘urbun) may be paid subject to a mutual agreement. The seller may forfeit the down payment if the purchaser breaches or terminates the contract  The seller in the istisnā’ contract shall be liable for any defects of the istisnā’ assets as well as its merchantable quality. The seller shall not exempt himself from any defects liability during the construction and warranty period  It is permitted for the istisnā’ contract to include a reasonable penalty clause on the manufacturer in case he is late in delivering the product, as long as the delay is not due to circumstances beyond his control. Some Shariah supervisory boards have advised that an upper limit be fixed for such a penalty clause  In case the saani‘ enters into a deal with a subcontractor, the saani‘ is responsible for the subcontractor’s work, and all the responsibilities of the saani‘ toward the mustasni‘, as stated in the contract, remain in effect. This is allow only if the purchaser did not specifically require the istisnā’ work to be performed by the seller himself

14. SHARI‘AH PARAMETERS - EXECUTION OF CONTRACT  If the mustasni‘ agrees to cancel the contract due to the manufacturer’s inability to carry it out, he shall reclaim what he spent without any increase or demand for financial compensation. In such a case, it is not permitted to stipulate that the mustasni‘ has the right to then execute the istisnā’ contract at the expense of the manufacturer  It is permissible for the Islamic bank (when acting as the manufacturer) to draw-up an independent and separate contract of agency appointing the ultimate purchaser as an agent of the Islamic bank to supervise the manufacturing or construction process so as to ensure that the items produced conform to contractual specifications  It is permissible for the manufacturer and the ultimate purchaser to agree on the party who will bear the additional cost of supervision of an istisnā’ contract

15. SHARI‘AH PARAMETERS - DELIVERY OF THE PRODUCT  If, upon delivery, the product does not meet the contractual specifications, the mustasni‘ has the right to refuse to accept it, or to accept it as is, or to negotiate with the manufacturer to accept it on the condition that the price be reduced  If the mustasni‘ declines to take receipt of the product at the delivery date, it is a trust (amanah) in the keeping of the manufacturer, who is not responsible for it unless he is negligent or transgresses, and the mustasni‘ must bear the storage expenses. The manufacturer also has the right to sell it at the expense of the mustasni‘  It is permitted for the mustasni‘, after he has been given access to the product, to appoint the manufacturer to be his agent to sell it to one of the manufacturer’s clients, on the condition that no linkage is made between the istisnā’ contract and the agency contract  It is not permitted to sell the product before taking actual or constructive possession of it; however, it is permitted to sell something of the same specifications as that which has been purchased from the manufacturer, and this is what is known as parallel istisnā’

16. SHARI‘AH PARAMETERS - DELIVERY OF THE PRODUCT  It is permissible to state in the istisnā’ contract that the manufacturer will act as the agent of the ultimate purchaser to sell the subject matter if there is a delay on the part of the purchaser in taking delivery of the subject matter within a particular period of time. In this case the manufacturer will sell the subject matter on behalf of the ultimate purchaser and after deducting the agreed contract price, the balance, if any will be returned to the purchaser →if the price obtained is less than the contract price, the manufacturer shall have a right to of recourse to the ultimate purchaser for the recovery of the remaining balance. In addition, the ultimate purchaser, will bear the expenses incurred in selling the subject matter

17. DIFFERENCES BETWEEN ISTISNĀ’ AND IJARAH  The manufacturer either uses his own material and if it is not available with him, obtains it to make the ordered goods  The material is provided by the customer and the manufacturer uses only his labor and skill meaning that his services will be hired for a specified fee paid to him  The purchaser has a right to reject the goods after inspection as Shariah permits somebody who purchases a thing not seen by him, to cancel the sale after seeing it  The right of rejection only exists if the goods do not conform to the specifications agreed upon between the parties at the time of contract. Right of rejection of goods after inspection does not exist

18. DIFFERENCES BETWEEN ISTISNĀ’ AND SALAM  The subject matter on which transaction of ISTISNĀ’ is based, is always a thing which needs to be manufactured  The subject can be anything that need manufacturing or not  The price in istisnā’ does not necessarily need to be paid in full in advance. It is not even necessary to pay the full price at delivery. It can be deferred to any time according to the agreement of the parties. The payment may also be made in installments  The price has to be paid in full in advance  The time of delivery does not have to be fixed in istisnā’  The time of delivery is an essential part of the sale  The contract can be cancelled before the manufacturer starts the work  The contract cannot be cancelled unilaterally

19. APPLICATIONS OF ISTISNĀ’ IN ISLAMIC BANKS ISTISNĀ’ FINANCING IN REAL ESTATE  The customer has a land. He wants to build a house and approaches the bank for an istisnā’ financing contract: →the customer approaches the bank with a request →the bank agrees to finance the customer →the customer presents the project plan in details to the bank including (price, project details ) →the bank signs an istisnā’ contract to build a house based on the plan brought by the customer →the bank requests to order the construction of a house (parallel istisnā’) →the bank contracts with a supervisor office to control the work at different phases on behalf of the bank →the customer signs on each controlling phase →constructor hands over the completed house directly to the customer →customer pays the installments to the bank as agreed in the contract

20. APPLICATIONS OF ISTISNĀ’ IN ISLAMIC BANKS ISTISNĀ’ COUPLED WITH IJARAH →customer presents his request to the bank →customer gets the estimated cost of the project financing →partnership contract: bank signs a joint contract with the customer to build a building →istisnā’ contract: bank and the customer sign the contract with the constructer to build the unit at certain descriptions →delivering the building at the period agreed upon →installment sale contract: bank signs a contract of sale by installment of the property to the customer →ijarah muntahyia bi-tamleek contract: bank signs the contract of leasing at a different payment, customer finishes by owning the product after finishing all the installments  It is permissible to draw up an istisnā’ contract for real estate developments on designated land owned either by the ultimate purchase or the contractor/ manufacturer on land in which either of them own the usufruct