ISTISNA: A CLASSICAL CONCEPT IN A MODERN FRAMEWORK
MOHAMED EL-FATIH HAMID
The IDB (Islamic Development Bank) fosters the economic development and social progress of member countries and Muslim communities individually, as well as jointly, in accordance with the principles of the Sharia. As part of its functions, the IDB participates in the equity capital of projects and extends loans for productive projects and enterprises, besides providing financial assistance to member countries in other forms for economic and social development.
The IDB is also charged with the responsibility of assisting in the promotion of foreign trade, especially in capital goods, among member countries, providing technical assistance to member countries, extending training facilities for personnel engaged in development activities, and undertaking research to enable the economic, financial and banking activities in Muslim countries to conform to the Sharia. Th e present membership consists of 50 states.
It will be seen from the foregoing that the IDB combines a number of attributes which distinguish it from other major multilateral development financing institutions. The most important of these attributes are:
a) It is required by its Charter to conduct its activities in conformity with the principles of the Sharia.
b) Its primary mission of fostering economic and social development not only extends to its member countries but embraces Muslim communities in non-member countries.
c) It is an association of developing countries bound together by the Islamic principles of mutual co-operation.
d) Its task is much more wide-ranging than that of other multilateral development financing institutions in that, apart from its financing role, it is entrusted with the functions of promoting foreign trade and economic co-operation among member countries, as well as extending training facilities to personnel engaged in training activities and undertaking research to enable the economic, financial and banking activities in Muslim countries to conform to the principles of the Sharia.
The Articles of Agreement establishing the IDB, while mentioning only two modes of project financing – loan and participation in the equity capital of productive projects – has given the IDB a general mandate to “invest in economic and social infrastructure projects by way of participation or other financial arrangements”. Through this general mandate, the IDB was able to devise a number of modes of project financing, such as leasing, profit-sharing, instalment sale and, more recently, Istisna (a contract for financing the manufacture of goods).
The Need for Istisna
The question may then arise as to why an institution that has in its hands such diverse instruments of financing would want to adopt yet another instrument of financing. There are several reasons for this, the most important of which are the following:
a) One of the functions of the IDB, as stated in Article 2 (vii) of the Articles of Agreement, is “to assist in the promotion of foreign trade, specially in capital goods, among member countries”.
Though the IDB had made some headway in this regard through its export-orientated scheme (The Longer-term Trade Financing Scheme), IDB felt the need for supporting its efforts under that scheme through the extension of financing needed for the production of the goods. The need for foreign exchange financing has always been one of the bottlenecks that inhibited the development of the production capacity of the member countries.
Unlike leasing and instalment sale, which are suitable for financing the acquisition of finished goods, Istisna is an instrument that is well suited for pre-shipment financing. By contributing to the enhancement of the production capacity of its member countries through the extension of financing needed for the production of goods, IDB will not only be promoting trade through the production of goods in one member country to be sold to another but will also be fulfilling its development objective.
b) Because instalment sale and leasing are mostly suitable for financing finished goods, the working capital necessary to produce those goods falls outside the ambit of IDB’s financing. Istisna, on the other hand, is a mode of financing the production of the goods at the pre-shipment stage. It is, therefore, suitable for financing working capital which is badly needed in most of the IDB member countries.
c) Since its inception, IDB has been financing economic infrastructure projects through loans. The borrowers of these loans have always been member country governments. This is because financing of infrastructure has been the exclusive domain of the public sector. However, in recent years, the financing of economic infrastructure projects has witnessed a shift from the public to the private sector. It has, for several reasons, been realised that some infrastructure projects may be more efficiently financed and managed by the private sector.
The projects that have featured prominently in this shift are those that have regular and reliable cash flows, such as telecommunications, power generation, transmission and distribution, toll roads, airports, sea-ports, pipelines and water supply and sanitation.
Given that the development of infrastructure is a necessary prerequisite to general economic development, the IDB should not be less keen in its support of these projects because they have shifted from the public to the private sector. On the other hand, it will not be feasible for the IDB to extend financing to private sector projects through interest-free loans. Istisna will give the IDB a mode of financing infrastructure projects that cannot easily lend themselves to financing by way of instalment sale or leasing.
Legal Implications
The definition and legal nature of Istisna was the subject of divergent opinions among the classical jurists. However, there was no disagreement that the essential element in Istisna was the manufacturing of goods at the behest of the buyer, and of the specifications determined by him, and the delivery thereof to the buyer within an agreed period and at an agreed price.
I would like to highlight briefly three points because of their relevance to what will follow.
The first point is whether the seller in Istisna is required not only to deliver goods conforming to the specifications, but also to supply his own services in manufacturing the goods. To put it in other words, is the seller obliged to manufacture the goods himself?
The predominant view among the classical jurists, and all of the modern jurists, is that although the supply of services is an essential requirement of an Istisna contract, the services need not be supplied by the seller himself The obligation of the seller is to deliver goods conforming to specifications, no matter who had supplied the services necessary for the manufacturing of those goods.
The second point is whether Istisna is a contract that is binding on both parties from its inception. In other words, does the contract oblige the seller to manufacture and deliver the goods and oblige the buyer to take delivery of the goods and pay the price if the goods are manufactured in conformity with the specifications? The predominant view among the classical jurists is that the contract is revocable by either party at any time. Even after the goods have been manufactured in conformity with the specifications and delivered to the buyer, the latter can still revoke the contract and is not obliged to take delivery of the goods.
The minority view in this regard, which has been adopted by the Islamic Fiqh Academy of the Organisation of the Islamic Conference is that the contract is binding on both parties from the moment the contract is concluded by offer and acceptance. Either party will be in breach of his obligation if he fails to perform his part of the bargain. The only situation in which the buyer can revoke the contract is where the seller delivers goods that do not conform to the specifications.
The final point concerns the characterisation of an Istisna contract. This contract has been variously characterised as a pure sale of goods, as a contract of Salam (a sale of future goods in which the price is paid in advance), as a contract of hire of persons, and finally as a contract partaking both of sale of goods and hire of persons.
Each of these characterisations is based on one of the aspects of Istisna. While those who characterised the contract as a hire of persons relied on the fact that the substance of Istisna is the delivery of conforming goods to the buyer by the manufacturer, those who characterised it as a contract of Salam looked at the fact that at the time of the contract the goods which are the subject matter of the contract are not in existence and are known only by their specifications, and are to be produced within an agreed future time. Finally, those who characterised it as partaking both of a sale and hire looked at the fact that Istisna involves both the delivery of goods and the supply of services.
It appears that the contract of Istisna is a special type of sale which possesses some characteristics that distinguish it from a pure contract of the sale of goods. The attempts of the classical jurists to seek a characterisation for this contract by analogy with existing contracts, is more indicative of the manner in which the Islamic law of contract had evolved historically, than of a conscious desire to force this contract into the pigeon-hole of one of the existing nominate contracts.
The proper characterisation of a contract is an essential prerequisite for determining the rights and obligations of the parties under the contract.
The Fiqh Academy considered the contract of Istisna in its Seventh Session and adopted Resolution No. 67/3/7, in which it has decided that Istisna, which is a contract the subject matter of which is the goods identified by description and the provision of services, is binding on both parties if the constituent conditions and terms are satisfied. It further decided that:
(1) It is necessary for the validity of Istisna that:
(a) the nature, quality, quantity and description of the thing to be manufactured are known; and
(b) a time is fixed for manufacturing the goods.
(2) It is permissible in a contract of Istisna to defer the price or to pay it in instalments within a fixed time period.
(3) It is permissible to include in a contract of Istisna a penalty clause, if the parties so agree, save for cases of force majeure.
Structuring an Istisna Transaction
As has already been alluded to, a seller in an Istisna transaction need not itself supply the services necessary for the manufacturing of the goods, neither is it required by the rules of Islamic law pertaining to Istisna to do so. This makes it possible for financing institutions, like Islamic banks, to be the seller in an Istisna contract.
However, it is inevitable for a financial institution that assumes the role of a seller in an Istisna transaction to re-let the Istisna contract to an entity that will be able to provide the services necessary for manufacturing the goods (hereinafter “the manufacturer”). Within this context an Istisna transaction could be structured in one of two ways, both of which involve two contracts, one between the seller and the buyer and another between the seller and the manufacturer.
In the first structure, the contract between the seller and the buyer will provide for the manufacturing of goods conforming to the specifications required by the buyer and the delivery thereof to the buyer within the stipulated time for an agreed price to be paid by the buyer, normally, on a deferred basis.
The seller will then enter into another Istisna contract with the manufacturer to provide the same goods which are the subject of the first contract and to deliver them to the seller within a stipulated time that will coincide with the time for the delivery of the goods under the first contract, for a price which is less than the price under the first contract by a margin that represents the return to the seller under the first contract.
The price under the second contract will normally be paid in a manner that is commensurate with the progress of work under the contract. The manufacturer under the second contract will deliver the goods, either to the seller, who will in turn deliver them to the buyer, or directly to the buyer on the orders of the seller. If the manufacturer fails to deliver the goods or delivers non-conforming goods, the seller will equally be in default of his obligations under the first contract.
Under the second structure, the contract between the seller and the buyer, in addition to providing for the manufacturing of goods conforming to the specifications within a certain time for an agreed price, will also provide that the buyer agrees:
a) to take delivery of the goods from the manufacturer;
b) to supervise (through a consultant or other expert) the execution of the contract with the manufacturer in a manner that will ensure that no progress payment under the contract will be effected unless the buyer’s consultant certifies that the work for which payment is sought has been carried out in conformity with the contract; and
c) that the issuing, by the buyer’s consultant of the final payment certificate under the contract with the manufacturer will, ipso facto, operate as acceptance of the goods under the first contract.
On the other hand, the contract between the seller and the manufacturer will provide for the manufacturing of the goods in conformity with the specifications and the delivery thereof directly to the buyer. It will also provide that no progress payment under the contract will be made by the seller, unless the relevant invoices have been certified by the consultant (or other expert) of the buyer.
It will be noted, that while both structures are feasible and acceptable to Islamic law, the second structure has the advantage of ensuring that no progress payment will be made unless the buyer is satisfied that the execution of the work is progressing satisfactorily in conformity with the specifications required by him. Consequently, if all progress payments are released only on the certification of the buyer’s consultant, it will be extremely unlikely that the buyer will reject the goods on the ground of their non-conformity to the specifications.
The virtual elimination of the risk of rejection of the goods by the buyer through this structure saves the financial institution concerned the cost and embarrassment of finding in its hands goods which it had already paid for but which the buyer will not accept. This is not to say that the institution will not itself be able to reject the goods under its contract with the manufacturer, as long as it refrains from doing anything that could be construed as acceptance of the goods.
Risk Management
Istisna involves the manufacturing of goods or the construction of buildings or other assets (ships, aircraft, etc.). Consequently, all the risks associated with manufacturing or construction contracts are present in a contract of Istisna. Because these risks are inherent in these types of contracts, ways and means have been developed to alleviate or mitigate them.
In the following paragraphs, the major risks in this regard will be discussed and the ways and means of mitigating or alleviating them will be described. However, before doing so, it will be necessary to explain the risk factor relative to the nature of an Istisna transaction.
The major risks that have to be addressed in an Istisna transaction, as regards the relationship with the manufacturer, are the latter’s failure to deliver the goods in time or his failure to deliver conforming goods. We have already seen how this latter risk could virtually be eliminated by a proper structuring of the contract. The failure to deliver the goods in time could be due to:
i) delay in the execution of the works;
ii) the occurrence of a casualty risk, i.e., the goods are destroyed by fire or are otherwise lost;
iii) the occurrence of a force majeure; or
iv) the insolvency of the manufacturer.
Though liquidation, chronologically speaking, will be the last misfortune that can befall a company, it is being addressed here as the first risk in the context of Istisna as a salient reminder of the need to take utmost care in the selection of the manufacturer; and, in particular, the need to make a rigorous examination of its financial standing and technical and administrative capability.
If this exercise is carried out properly, the risk of liquidation will be remote. If liquidation nevertheless occurs, the financial institution concerned would need to recover the amounts it has paid to the manufacturer as progress payments. Therefore, if it has not taken any other security, its claim to recover the amounts it has paid will rank in pari passu with the claims of the other unsecured creditors of the manufacturer.
This will not be a position that a financial institution will be advised to take. The alternatives open to the financial institution will be:
i) to take a mortgage of or a charge on, the parts of the assets that have been executed;
ii) to take a charge over all the assets of the manufacturer; or
iii) to take a refundment bond guarantee.
It is, however, fair to point out that each of these securities has its own drawbacks. To begin with, a mortgage on the parts of the assets that have been executed will not be of much use if the execution is taking place in the yard of the manufacturer. This is because the buyer will not be able to complete the assets, and the unfinished assets are not likely to fetch a good price in the event of the foreclosure of the mortgage.
It will also be added that the enforcement of a mortgage or a charge, whether on the whole assets of the company or on the parts of the assets that have been executed, is a timeconsuming and costly process without any assurance that the mortgage (or charge) will be able to fully reimburse itself from the proceeds of a forced sale of the assets.
On the other hand, while a mortgage (or charge), in the context of an Istisna transaction, is a security that could be enforced only in the event of the liquidation of the manufacturer, a refundment bond guarantee could be made encashable in all cases where the manufacturer fails to deliver the goods or delivers non-conforming goods.
However, a refundment bond, being a bank guarantee, may be open to the objection that it is costly. As against this, it may be argued that a refundment bond, in the context of Istisna, is different because:
a) it is a guarantee against amounts actually paid by the seller to the Manufacturer and for which the seller has not yet received anything in return (quid pro quo);
b) the manufacturer expects to receive payment from the seller equal to the amount of each refundment bond it provides to the seller;
c) the amounts paid by the seller (being an Islamic financial institution) to the manufacturer do not carry any financial charges. If the manufacturer is to borrow the same amount from a commercial bank to finance the construction of the goods, it will have to pay interest on that amount in addition to any security which the lender may ask for. The cost of the refundment bond guarantee will, most probably, be far less than the interest charged on the loan;
d) it is not unusual in international financing to require a refundment bond guarantee. IDB had, in fact, asked for and obtained a refundment bond guarantee to secure its financing (more than 25 million US dollars) of the construction of vessels for one of its member countries.
Having said that, it will readily be admitted that asking for a refundment bond guarantee will not always be necessary. For instance, if the construction of the assets is being done on the land of the buyer, as in the case of a building, a power station or a toll road, it may be sufficient to rely on the usual performance bond and retention money particularly where suitable legal and contractual arrangements are reached regarding the ownership of the finished parts of the assets.
Since, under a contract of Istisna, there is an agreed time period for the manufacturing or the construction of the assets, the failure to complete this task within the agreed time period may result in a loss to the buyer. The normal way of minimising this risk is by obliging the manufacturer to pay liquidated damages for this delay.
As has already been alluded to, the imposition of a penalty clause for the payment of liquidated damages has been sanctioned by the Fiqh Academy. Where the delay is inordinate, the only remedy of the buyer is to terminate the contract and claim reimbursement of the amounts already advanced against the contract price. If there is a refundment or a performance bond, the prospective buyer will proceed to invoke it. Otherwise, it will have to be content with its claim against the manufacturer.
It is usual to deal with the risk of the loss of the assets or their destruction (totally or partially), during construction, by means of insurance. The manufacturer should therefore be obliged to take up the appropriate insurance policies and to assign the proceeds of these policies to the Islamic bank concerned.
In case of partial loss, the manufacturer may be allowed to use the proceeds of insurance to restore the asset to its condition before the occurrence of the loss. If as a result of events beyond the control of the parties, such as floods, earthquakes, volcanoes and other natural disasters, or adverse political actions, such as expropriation, change of law, war, etc., the manufacturer is unable to complete the work, a reasonable extension of time may be granted.
If, after this extension, the manufacturer cannot complete the construction (manufacturing) of the assets, the contract may be terminated and the buyer can claim a refund of the payments it has paid and compensation for any loss caused by such delay.
Liability of the Seller for Defective Goods
There is an implied condition in a contract of sale that the goods are free from defects. Thus, if the goods sold turned out to be defective, the buyer, in Islamic law, has the option of either rescinding the contract and recovering the price he has paid or accepting the defective goods without the right to compensation.
Only one school of jurisprudence gives the buyer the right to claim compensation (Arsh). The amount of the compensation will be the difference between the market price of the defective goods and the market price of the same goods when sold without defect. The other schools give the buyer this right only when restitute integrum is impossible, i.e., when it will not be possible for the buyer to return the goods to the seller in the state in which he has received them.
Exemption Clauses
The implied condition, in a contract of sale, that the goods are free from defects may be excluded by an express stipulation in the contract negating the responsibility of the seller for defects. To use modern legal terminology, it should be excluded by an exemption clause. While there is a consensus amongst the Islamic jurists in this matter, they differ on the circumstances under which such exemption will be effective and on the type of defects that may be excluded.
Financial institutions will not welcome the possibility of a buyer appearing some time after the delivery of the goods to return them on the ground that he has discovered a latent defect therein and to claim the return of the price or the part thereof which he had already paid. The question, therefore, arises whether, like the case of a seller in a pure sale contract, a seller in Istisna may cover himself against this eventuality by an exemption clause. The classical jurists were silent on this point.
It is, therefore, possible to argue that since Istisna is a contract of sale, albeit a special type of sale, what is permissible in sale should be permissible in Istisna, unless the very nature of Istisna makes it inapplicable. However, Professor Mustafa Al-Zarka – one of the most eminent and renowned contemporary jurists – marshalled cogent and persuasive arguments against this view.
He took the view that a stipulation in an Istisna contract which is designed to exclude the liability of the seller for latent defects should be void. He argued that if such exclusions are allowed, the seller may not feel the need to take utmost care in manufacturing the goods.
He further argues that although the seller in a pure sale may be excused if he excludes his liability for defects in the goods which he did not manufacture, the same logic will not obtain in Istisna, where the goods were not in existence at the time of the contract and it is the seller who brought them into existence. An exemption clause in this context will only serve to protect the seller against his own incompetence in manufacturing the goods and may promote bad faith in this important instrument of financing.
Though the views of a jurist of the stature and scholarship of Professor Al-Zarka command the utmost respect, this issue is of great practical importance for financial institutions using Istisna as an instrument of financing. It, therefore, needs to be submitted to the Islamic Fiqh Academy for a final opinion.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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