Islamic Sales Contracts Structure

ByMuhammad Ayub,

Director, Research & TrainingRiphah Center of Islamic BusinessRiphah International University

• Contracts for:• Intermediation• Financing

• Trade based – sale / purchase• Lease based• Service / agency based• Investment• Equity based• Debt based• Hybrid assets

AVOIDINGRiba, Gharar, Maysir / Qimar

andDoing Trade and Business as per Shariah

Rules

Mudaraba

Trade Financing

Takaful

Wakalah

Lease

Financing

Transactional Contracts

Wakala/ Jualah

Intermediation Contracts

Amanh / Wadhi

Kafalah

Jualah

QardInvestments

Ijara Financing

I.F Contracts / Structure

Mudaraba Wakalah

Sukuk

Murabaha

Collateralized Structures / Debt

Musharka

Funds / Unit Trusts

Asset Backed Investments

Asset Based Investments

Salam Istisna

Sukuk / Certificates

Stocks

Equity Participate

Classification of Contracts - 1

• If the classification is made by looking at the purpose and function

• of the contracts, Islamic contracts may be classified into:• – contracts of exchange,• – contracts of security,• – contracts of partnership,• – contracts of safe custody,• – contracts pertaining to the utilisation of usufruct.

Classification of Contracts-2

If the perspective of payment is to be looked at, these contracts can be divided into three kinds of contracts, namely:•– immediately enforceable contract (al ‘aqd al munjaz‐ ‐ ),•– contract that will become effective at a particular future time (al ‘aqd almudaf ila al mustaqbal‐ ‐ )•and contingent contract (al ‘aqd al mu’allaq‐ ‐ ).When the perspective of legality is considered, contracts can be•classified as:•– valid (sahih),•– voidable (fasid)•– and void (batil).

Classification of Contracts-3

These contracts can be broadly classified as follows:•– Sale based principles‐•– Profit sharing principles‐•– Lease based principles‐•– Benevolent loan principle‐•– Fee based principle‐•– Supporting principles

Classification of contracts -4

• Sales based on payment mode:– Normal-Bai al Mutliq; Bai al Muajjal, Bal al Salam

• Sales based on legitimacy:– Sale sahih, – Batil (by touching an article; bai’ al hasat (a transaction determined by‐

throwing stones )and– Fasid

• Sales transactions based on exchange Items:– Barter trade (bai almuqayadah)– General sale(bai’al mutlaq)‐– (forex) Bai al sarf‐

Barter trade(bai almuqayadah)

In case of ribawi items

•1: If commodities are of the same genus then immediate delivery and equality of the counter values have to be observed.

•2: If the items differ in kind then they should be exchanged in the same session of contract

Classification -Disclosure of Cost Price and Profit/Loss

• Normal bargaining Sale (Bay’ al musawamah‐ )– No reference is made as to the cost price and profit/loss

made by the seller of the object

• Fiduciary Sales - Buyu’ al amanah; the buyer ‐depends and relies totally on the integrity of the seller as regards to the cost and profit/loss that he discloses to the buyer– Bai’al murabahah - Cost plus sale‐– Tawliyyah - Resale at the stated original cost-no profit or

loss to the seller.– Wadiah: The seller resells the object at a discount from

the original cost at which the object was obtained

Commutative Contracts

• Exchange Contracts• Agency contracts• Partnership contracts• Investment contracts

Murabaha – Subject Matter• Goods to be traded: real, tangible goods or title to

such goods; papers of debt or credit documents ?• Existing• In ownership of Seller• In possession of Seller– Sale – promptly effective– Delivery of the sold goods - certain– Price– Unconditional

Banking Murabaha

• The Murabaha by Islamic banks as a mode of finance is something different from the traditional Murabaha used in normal trade.

• Comprises a number of contracts and processes for providing goods to the clients and fulfilling their financial needs.

• MPO (AAOIFI) - Murabaha conducted with a prior promise to buy, submitted by a person interested in acquiring goods through Islamic bank.

Exchange Value - Price

• Cash and Credit price• Certainty of Price upon execution• Treatment – In case of default– In case of early payment– Rescheduling– Roll-over

Sale Agreement – Actual SaleUse as a financing tool:

Promise to Sell – Agreement to SellTreatment – breach of binding promise

Murabaha MoU – Facility Agreement

Agency concept – Wakalah in Murabaha

Misc. Murabaha Rules

• Wakalah – Agency• Wa’ad – Promise• MPO (AAOIFI) - Murabaha conducted with a prior promise

to buy by the client• If the supplier is proposed by the client himself, guarantee

for good performance can be demanded;• Willful defaulter can be subjected to different

punishments • Penalty for charity purposes.• Penalty cannot be a source of further return to the seller /

bank.• Liquidated Damages - solatium - through court.

Misc. Murabaha Rules

• Physical / constructive possession.• Third party as agent – Payment to Supplier• The goods once sold by the bank are property of the client

No Roll-over• Bank must ensure that the Supplier – the party from whom

the item is bought is a third party and not the customer or his agent : Why-------?

• It is a fixed price sale and normally for short term, sometimes for medium term----------------- Why?

• The commodity must remain in the risk of the bank.• The sequence - extremely important for Shariah compliant.

Murabaha Process• Request• Master Murabaha or MFA• Agency - time of agency agreement important - Invoice dates• Specific request for Murabaha – Request Form• Promise• Ensuring that goods are not already owned by the • Ensuring that the supplier is completely distinct from the

client.• Purchase by agent• Declaration – reporting• Murabaha execution

Murabaha Process

• Customer to confirm that goods have been examined and are satisfactory in respect of quality as per the requisition given.

• Bank accepts the offer by stating the Murabaha Price- Cost price plus agreed profit

• Payment date / schedule agreed, liability created;

• Sale is concluded.

• Relationship of a debtor and creditor emerges.

• Changing Relationship : Five : Promise, agency, Seller / Buyer (2 separate sales); Debtor / Creditor

• Post execution: – Prepayment;

– Default - Penalty

Analysis required• Nature of goods• Pricing • Market• Client’s cash flow• Risk element• Commitment fee: Hamish Jiddiyah• In case of breach of promise, Hamish Jiddiyyah can be

used to recover actual damage; • Documentary evidence -before execution of

Murabaha: delivery challan, gate pass, sales tax invoices, etc.

• The point of time when the risk of the item is passed on by the bank to the customer, be clearly identified.

In case of Import• Bank will open the LC in its name or Customer’s

name under agency - .

• Price has to be fixed and properly recorded in Pak Rs.

• It could be in F. Currency – slight adjustment in price because of forex rate

• FOB or C&F cost can be fixed beforehand w. r. to fixed or forward rate of conversion or only foreign currency cost may be agreed initially.

Ijarah

Concept• Leasing• Hiring• ‘Ujrah• Sale of usufruct but not sale in normal sense• Different from Juaalah• Correct term: – Ijara Wal Iqtina’ or – Ijara Muntahee Bittamleek

• Lessee as Ameen• Lease of joint asset• A sale contract within the Ijarah contract effective

on a future date is not allowed.

Ijarah Rules

• Transferring right to usufruct against known rent.• Fixed and Floating Rate of rent• Lessor must retain title to the assets, and bear all risks and

rewards pertaining to ownership; • Loss caused to the asset by misuse/negligence to be borne

by the Lessee.• Lessee liable for wear & tear and operational charges

incurred to get the usufruct. • Transfer of asset to lessee under separate document• Securitisation on Ijarah basis: Lessor can sell the asset,

during the lease period, to anyone or to a number of individuals - Sukuk.

Rentals

• Flexibility:• If the asset being leased and amount of rent both are

clearly known to the parties at the time of the contract, Ijarah can be contracted or promise to Ijarah can be made on an asset or a building that is yet to be constructed, as long as it is fully described in the contract provided that the lessor should normally be able to acquire, construct or buy the asset being leased by the time set for its delivery to the lessee

• Rentals: When due; Fixed, Variable and Floating• Floating: a clear formula, ceiling and Floor• Advance rent

Ijarah Rules• Corpus of the asset should remain intact- its form should not

undergo a visibly major change. Anything which cannot be used without consuming its corpus cannot be leased out. e.g.. Money, Petrol, Wheat, etc.

• The Asset should be valuable, identified and quantified.• Ijarah be terminated if the lessee does not pay the rent or

fails to pay on time.• Partial destruction: Both the lessee and the lessor may also

agree to terminate, or amend the rental. • If the lessee stops using the leased asset or returns it to the

owner without the owner’s consent, the rental will continue to be due.

Ijarah Rules

• lessor is not entitled to rent for the period during which the lessee was not able to benefit, if the damage was not due to negligence of the lessee.

• The lease contract should be preceded by acquiring either the asset to be leased or usufruct of that asset.

• If a specified asset is to be acquired and leased, the Ijarah contract shall not be executed unless and until the institution has acquired that asset.

• A customer may jointly acquire an asset that he wishes to lease - DM

• The rental receivable by the bank should only be in proportion to its share in the ownership of the asset.

Who to bear Expenses / Risks

• Owner: Ownership related• Lessee: Normal expenses• How to decide?

Lease Process• Request form• promise to lease agreement.• Master agreement may or may not be - a number of Ijarah

transactions• Security Deposit - Hamish Jeddiah• Bank purchases the item and receives title of ownership

from the vendor• Bank makes payment to the vendor• Bank leases the asset to the customer after execution of

lease agreement.• Customer makes periodic payments as per the contract.• Title is transferred to the customer at the end of lease

term under a separate deal.

Sale and Lease back

• Permissible if the contracts are executed separately.• To avoid Bai al ‘inah a reasonable period of time, between

the purchase contract and the time of the sale of the asset to the lessee, must have expired.

• Generally, scholars don’t prefer this kind of lease and restrict its use to only those clients who intend to convert their borrowings to Islamic modes.

• Excessive use in case of Ijarah Sukuk

Rights and liabilities in case of premature termination

Theft / Total destructionAAOIFI’s advice

What IBs in Pakistan do?Clause 8/8

IBD Circular #1, 2010Application of AAOIFI Standards

Ownership Transfer

– A promise to sell for a token or other consideration, or by paying the market value of the leased property.

– A promise to give it as a gift (for no consideration).

– A promise to give it as a gift, contingent upon the payment of the remaining installments.

FORWARD SALESSALAM AND ISTISNAA’

2 exceptions to the general principles of sale:

Salam (which is also called as Salf); andIstisna.

Salam / Salf• The seller to supply specific goods to the buyer at a

future date in exchange of an advanced price fully paid at spot.

• Beneficial to both parties– To meet the need of small farmers and producers for W

? Capital and to look after their family up to the time of harvest.

– To meet the need of traders for import and export business.

• Acceptance of T. Value of Money through pricing of goods• Only Mithly (homogeneous commodities• Quality, quantity, price, delivery tome must be agreed.;

but not for a particular commodity or on a product of a particular field or farm.

Salam sale is impermissible on existing commodities or on land and real estates

Salam in Shares ?

Salam Rules

• To be ensured that the commodity is possible to be delivered when it is due.

• Only in such items which have a definite market known by way of counting and measuring.

• In the items in which variations in numbers make no difference.

• Zawatul Amsal • Not for Zawatul Qiyam• Salam not for Currencies• After taking delivery, the purchaser has the “option of

defect” (Khiyar-e-Aib).• But not “option of seeing” (Khiyar-e-ruyat).

Salam Rules

• The place of delivery should also be known. If it is not known, shall be decided according to customary practices.

• Once agreed upon, a Salam contract cannot be revoked unilaterally by any party.

• Risk before delivery• Risk after delivery• 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.

Disposal of Salam Goods

• Parallel Salam• Promise from the 3rd Party• Agency– 3rd party– Client

• Sale as and when received– To the client ?– In the market

Issues in case of Agency of the client / sellerAAOIFIPricing

Advising a priceRest for the client

Responsibility of the client / agent

Issues inLate Delivery

Replacement of the commodity(market value of such substituted goods shall not be higher than the market value of the originally agreed commodity, at the time

of delivery )

Failure in deliveryRecourse to collateral

Receivable Debt cannot become price in Salam

It is not permissible for the Bank to link the obligations under the original and parallel Salam

contracts

Salam for Agriculture

Commodity OperationsIndustry

Exports - preshipmentLocal trade financing

Pricing

• Banker to know:– Purchase Price– Profit– Sale Price

• EXAMPLE: PURCHASING FERTILIZER FROM A FIRM• Step 1: No. of bags to be purchased (at market rate)• Step 2: (20)% Margin• Step 3: Deciding the discounted Purchase Price• Step 4: No. of Bags to be purchased (at discounted rate)• Step 5: Profit• Step 6: Sale Price to be advised to the sale agent• Banks appoints the seller agent to sell the fertilizer at Rs. ------ per bag

and take whatever is over and above that price as firm’s bonus. Firm is asked to deposit the proceeds on the day of delivery followed by Wakalah agreement.

SBP Exposure Draft on Salam

Istisnaa

Istisna Concept

• An order to a manufacturer to manufacture a specific item for a purchaser.

• The manufacturer uses his own material to manufacture the required goods. Otherwise ?

• Price : Advance, deferred, installments Why ?• Uses of Istisnaa:• Financing high technology industries , e.g. aircraft industry,

locomotive and ship building industries.• Working capital and export financing.• To finance construction industry such as apartment

buildings, hospitals, schools and universities.• Housing finance.

Istisna Subject matter

• That has to be constructed, manufactured, prepared;

• Both Mithly and Qiyami• invalid for natural products• The price and mode of payment must be known at

the conclusion of the contract. • Istisna contract has a fixed price - any profit and

loss relates to the manufacturer. If any discount is received on the raw materials, the additional profits relates to the manufacturer.

Parallel Istisna

• Not necessary that manufacturer / seller himself prepares,

• Banks will enter into parallel istisnaa for supply to the client

Penalty & Shart e Jazai

• Importance of personal commitment by the seller / manufacturer

• If the manufacturer is late in delivering the asset, due to lack of commitment that is proved, providing a bonus to the manufacturer if he delivers the asset earlier

• It is not permitted to stipulate a penalty clause against the purchaser for default on payment.

Specific I. B. Risks• More credit risk

• Integrity risk

• Commodity risks

• Price risks

• Market Risks

• Process / Stage related risks

• Documentation / legal risks

• Post transaction risks – Counter party and risk related

• Mode-wise risks

• Fiduciary risk: failure to perform in accordance with explicit and implicit standards fiduciary responsibilities; more for Islamic banks

Risk Features in Finance

• Broad risk categories in finance:– Transaction, – Business, – Treasury, – Governance, and – Systemic risks

• Specific risks for IFIs • Displacement risk (risk of withdrawal of deposits); • Liquidity management• Counter-party risk, (inherent in some Islamic modes, combined with

credit and commodity risk• Governance related risks

• Quality of management (Combination of finance & Shariah knowledge; internal control processes; integrity;

• Harmonization of the institutional environment; like different Fiqh opinion, ineffective litigation and dispute resolution

Risk Features in Finance

Adverse Selection• Before transaction occurs– Potential clients most likely to produce adverse

outcomes are likely to seek finances and be selected

Moral Hazard• After transaction occurs: e.g. – Client has incentives to engage in undesirable activities

making it more likely that finance / loan won’t be paid back

Grey Areas • Sale of Debts• Sale and buy back (Al- ‘inah)• Organized Tawarruq – Commodity Murabaha, Reverse

Murabaha• Use of W’ad as an alternative to proscribed contracts /

exchanges – Undertakings integral part of the agreements

• Financial derivatives – Short selling, Notional / fictitious assets, separation and sale of risk

• Netting-of• Pre-payment rebate when stipulated as a prior

condition

Thanks!