Shari’ah Issues in Future Financing Contracts

Unit 6 | 1

Shari’ah Issues in Future

Financing Contracts Unit 6
(Madum, Salam and
Istisna’)
Topics in This Unit

6.1- Introduction

6.2- Bay madum

6.3- Salam contract

6.4- Istisna’ contract

Unit At the end of this unit, you should be able to:

Objective
• Determine the Shari’ah issues in a madum sale
• Assess the different argumentation of scholars pertaining
to the legitimacy of the madum contract
• Determine the Shari’ah issues in a salam contract
• Assess the different argumentation of scholars pertaining
to the legitimacy of the salam contract
• Determine the Shari’ah issues in an istisna’ contract
• Assess the different argumentation of scholars pertaining
to the legitimacy of the istisna’ contract

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
Shari’ah Issues in Future Financing Contracts
Unit 6 | 2

Key Terms

Ma’dum / non-existent

Salam

Parallel Salam

Istisna’

Parallel Istisna’

Future Delivery

MADUM, SALAM & ISTISNA’

The selling of a non-existent subject matter is an

issue in Shari’ah, where the majority of scholars do
not allow the selling of an asset which does not exist.
However, there is an exception to this rule where
some contracts have been granted the permissibility:
salam, istisna’ and ijarah. This unit will discuss the
sale of madum with special focus on salam and
istisna’, along with the Shar’iah issues related to each
contract.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 3

Unit 6.1 INTRODUCTION

One of the basic conditions for the validity of a sale in Shari’ah is that the commodity (intended
to be sold) must be in the physical or constructive possession of the seller. This condition has
three main features:

1. First, the commodity must be in existence during the contract; therefore, a commodity
which does not exist at the time of sale cannot be sold.
2. Second, the seller should have acquired the ownership of that commodity. Therefore, if
the commodity exists, but the seller does not own it, he cannot sell it to anyone.
3. Third, the commodity should have come into the possession of the seller, either
physically or constructively. If the seller owns a commodity, but he has not taken its
delivery himself or through an agent, he cannot sell it. There are only two exceptions
to this general principle in Shari‘ah. The first exception is in a salam contract defined
as a contract of sale of a commodity for deferred delivery in exchange for immediate
payment. The other exception is an istisna’ contract which will be explained later in this
unit.
The following discussion highlights some issues that arise through some selected contracts
related to the above criteria in a sale transaction, where normally the object sold should be in
existence.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 4

Unit 6.2 BAY MADUM

One of the conditions of sales is that the mahal al-‘aqd or ma’qud alaih (objects in trade) to be
traded must exist when the contract is made. Purchase of an object that does not exist when
the contract is made is considered bay ma’dum. The bay ma’dum issue was discussed by Islamic
jurists when they debated the condition of an object in a contract of sale.

Unit 6.2.1 OPINION OF THE JURISTS

The Hanafi and Syafi’i school of law pronounced that the object of sale must be in existence at
the time the contract is made. Otherwise, the contract will be deemed invalid because anything
that is ma’dum cannot be owned. The Prophet (p.b.u.h.) said: “Don’t sell what you don’t have.”

However, an exemption was made to the salam, ijarah and istisna’ contracts based on the istihsan
principle. The Maliki school of law echoed the opinions of the Hanafi and Shafi’i schools of law
regarding mu’awadhat maliyah (exchange contract), but for tabarru’at (ownership contract on
voluntary basis) such as hibah, they did not impose any condition for an existing object. What
was important was that it was expected to exist in the future. The Hanbali school of law, on
the other hand, did not stipulate this condition. What is important is that a contract did not
contain elements of gharar, which is forbidden by Shari’ah.

Ibnu Taymiyah and Ibnu Al-Qayyim analysed the question of bay ma’dum and concluded a sale
was forbidden not because of ma’dum during the contract was made, but rather because of the
existence of gharar, which is a forbidden element. This was based on the following arguments:

Neither the Al-Qur’an, the Sunnah nor the Prophet’s Companions stated that bay ma’dum
was impermissible. However, there exists a hadith prohibiting the sale of certain goods with
features that did not exist. The prohibition was also for goods that are available but simply did
not exist at the point of trade. This showed that the prohibition was due to the existence of the
gharar element in the trade.

There are specific situations where bay ma’dum is permissible by Shari’ah and considered valid.
One example is the sale of fruits and grains, which are about to mature. This is considered bay
ma’dum because the buyer cannot take delivery of the goods and has to wait until the fruits

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 5

or grains mature. The salam, istisna’, and ijarah contracts are other examples of bay ma’dum
which are permissible based on the principle of istihsan. From the perspective of Ibnu Al-
Qayyim, all these examples show that the sale of something that has not yet existed or is not yet
in the seller’s possession at the point of the sale is not forbidden merely because of its ma’dum
nature.

Unit 6.3 SALAM CONTRACT

Unit 6.3.1 DEFINITION OF SALAM

Salam or salaf is defined as the sale or purchase of a deferred item in exchange for an immediate
price. Thus, in the salam contract, the price is paid in advance while the commodity is deferred
to an agreed date in the future, such as, buying two tons of dates which will be delivered one
year later, while the price is paid on the spot. These features of the salam contract can be
observed in the definitions of Muslim scholars on salam. The Shafi’I scholars, for example,
provide a definition of salam as, “A sale of a well-defined commodity to be delivered by the seller
in the future”. On that same discourse, the Hanbali jurists defined salam as, “A sale whereby
the seller undertakes to supply some specific goods to the buyer at a future date in exchange for
an advanced price fully paid on the spot”. The Maliki jurists using the same expression defined
salam as, A sale in which the capital sum price is paid in advance, and the object of sale is
deferred to a specified term.”

From the above definitions, we can summarise that salam is a sale with advance payment for
future delivery. Thus, in the salam contract, the price is paid in cash, but the supply of the
purchased goods is deferred. The forward buyer is called rabb al-salam; the forward seller is
al-muslam ilayhi; the cash price is ra’s al-mal, and the purchased commodity is termed as al-
muslam fihi. In bay salam, the vendor has no title over the sale object but undertakes to make
it available to the purchaser.

Under the strict rules of contract in Shari’ah, this kind of sale would be unlawful, because the
seller deals with an article which is not in his possession.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 6

Nevertheless, salam is allowed on the basis of the tradition of the Prophet (p.b.u.h.) and on
the grounds of consensus (ijma) and because it conforms to the public’s needs. Salam was
allowed by the Prophet (p.b.u.h._. subject to certain conditions. The basic purpose of this sale
was to meet the needs of small farmers who needed money for their working capital as well
as living expenses. Similarly, the Arab traders used to undertake import and export business.
They exported goods to other places and imported some other goods to their homeland. They
needed money to undertake this type of business. It was therefore allowed for them that they
sell their goods in advance. When they received their cash price, they could easily undertake
the aforesaid business.

Unit 6.3.2 NOTION OF THE CONTRACT

According to the majority of the jurists, this contract is an exception to the general rules of
Shari’ah and against analogy. It is considered as ruksa inb hazm and ibn taymiay. Their view
is that this is an independent contract and it is not an exception to the general of Islamic
commercial law.

Unit 6.3.3 NATURE OF CAPITAL IN SALAM

The scholars have differed as to the permissibility of payment in the form of trading assets.
Some fuqaha have considered it permissible, as this is adopted by the AAOIFI. The Maliki
school of law allowed the payment to be in the form of benefits in kind such as the benefit of
living in a house.

Unit 6.3.4 MODES OF PAYMENT

With regards to the mode of payment of a salam sale, many jurists agree that the buyer must pay
the whole amount in cash or in the forms of goods at the time when concluding the contract.
The purpose is to ensure prompt payment and to evade the violation of the sale of debt for a
debt (bay al-dayn bi al-dayn) as prescribed in the hadith. In a bank’s financing mode, however,
the payment in cash is not done and moreover, it is not practical. Thus, it will not be desirable
for a bank to pay hard cash to the seller; the bank may credit the amount to the seller’s account,
or in the case of long term financing, the bank may grant a line of credit, or issue a pay order
(which may be cashable on demand) in favour of the seller. In all such cases, money remains in
the bank but is placed at the disposal of the seller.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 7

Another observation is that a salam contract normally involves the exchange of commodities
for price. Modern banks and financial institutions will receive certain commodities from their
clients, instead of money. This may pose two problems. First, is the problem of realising the
commodities into money. These institutions are conversant with dealing in money only, and
thus, it seems to be cumbersome for them to receive different commodities from different clients
and then sell the commodities in the market. The second problem is space and storage of the
goods received. The banks cannot sell these commodities before they are actually delivered
to them, because it is prohibited by Shari’ah. Therefore, a proper area is needed to store the
commodities, which may require different types of storage facilities. It would be a good trading
activity for banks and financial institutions to sell them in the spot market.

Unit 6.3.5 DELIVERY OF THE AL-MUSLAM FIHI

According to Muslim jurists, the delivery time of salam commodities may not be specifically
fixed. The approximate time for delivery is permissible; for example, the parties agree that
the delivery of the salam commodities should be during the next “harvest period”. However,
the approximate time for delivery of the goods may not be convenient to the bank. It may be
advisable, however, for the bank to stipulate the specific time and date for the delivery of the
goods, provided that the goods required are available in the market.

In order to prevent gharar and to enable the al-muslam ilayhi to discharge his obligation, the
future delivery should be fixed to match the time when the al-musalam fihi would likely be
commonly available. Hanafi jurists stipulate that the future availability of al-muslam fihi should
be known at the date of contracting to the date of delivery. The AAOIFI adopted the opinion of
the majority of the fuqaha.

Specifying the future delivery date of the al-muslam fihi is permissible because:

• The fuqaha have agreed that specifying the future date of delivery is considered
permissible. For example, the last day in the month of October 1996.
• The fuqaha have also agreed that the delivery should not be contingent on an
unknown event. For example, the solvency or the arrival of another person.
• The fuqaha have differing opinions on the issue of the lack of specificity that is
considered permissible with regard to the delivery date of al-muslam fihi. For
example, during the harvesting season or during the time of Hajj (pilgrimage).

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 8

• The majority of the fuqaha require a greater degree of specificity of the delivery
date, but the Maliki jurists consider a range of possible delivery dates as acceptable
and so did the Hanbali jurists in one of their versions. The latter view has been
adopted by the AAOIFI.

Unit 6.3.6 DELIVERY OF THE AL-MUSLAM FIHI ON ITS DUE

DATE

The al-muslam ilayhi should deliver the al-muslam fihi on its due date, according to the agreed
quality and quantity, and the al-muslam should accept it. If the al-muslam ilayhi delivers a
superior quality of al-muslam fihi, then the al-muslam should accept it on the condition that
the al-muslam ilayhi does not ask for a higher price in return for the extra quality because this
is considered as a form of satisfactory fulfilment. If the al-muslam ilayhi delivers an inferior
quality of al-muslam fihi, then the al-muslam has the option to accept the al-muslam fihi on
the condition that he does not ask for a lower price in return for the inferior quality because he
has accepted it as satisfactory fulfilment.

Unit 6.3.7 DELIVERY OF THE AL-MUSLAM FIHI BEFORE ITS

DUE DATE

It is considered permissible to deliver the al-muslam fihi before its due date on condition that
the following are satisfied:

1. The al-muslam fihi should be of the agreed upon quality and quantity.
2. The al-muslam fihi should be neither of superior quality nor in greater quantity.
3. The al-muslam fihi should be neither of an inferior quality nor in lesser quantity.

In the case where all or part of the al-musalam fihi is not available on its due date, the al-
muslam shall have the following options:

1. Cancel the contract and have his repayment refunded.

2. Wait until the al-musalam fihi is available.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 9

Unit 6.3.8 REVOCATION OF THE CONTRACT

Another interesting observation is the effect of the revocation of the salam contract. As a general
rule, the parties have the right to rescind the contract of salam before the delivery of the goods,
in which the seller is required to return the advance paid. However, a critical observation on
this requirement tells that the parties may be taking advantage of the price fluctuation of the
commodities. The seller may be inclined to withdraw from the contract if the market price of
the contracted goods is higher (at the time of delivery) than what the bank has paid to him.
Likewise, the bank may tend to rescind the contract if the price of the contracted goods goes
down at the time of delivery. Looking into the possible manipulation of the flexible revocation
right, it seems that it is preferable that the salam be made irrevocable by the agreement of
the parties concerned. The only exception which may be considered is unavailability of the
commodities in the market and inaccessibility of the commodities to the seller, in the case
where the bank refuses to extend the period of delivery. In the case of revocation of the contract,
the bank will charge the same amount that it had paid to the seller.

Unit 6.3.9 SECURITY FOR SALAM

Since the delivery of the goods in a salam contract occurs in the future, banks and financial
institutions are allowed to request the seller to furnish a security, which may be in the form
of a guarantee or in the form of a mortgage, to cover the risk of non-delivery. In the case of
default, the guarantor may be asked to deliver the same commodity; and if there is a mortgage,
the buyer or the financier may sell the mortgaged property and the sale proceeds can be used
either to realise the required commodity by purchasing it from the market, or to recover the
price advanced by him.

The issue of security in a salam transaction is also prevalent in situations where the seller supplies
goods that are inferior to what was agreed upon and then forcing the bank to accept them, or
to rescind the contract. This will put the bank in a difficult situation whereby acceptance of the
inferior goods may be harmful to it; and in the case where the bank rescinds the contract, the
price has to be returned back to the bank; in which this too will be unprofitable to the bank.
The fiqh provides a few solutions to this problem such as:

1. The bank may refuse to accept the goods and claim for the supply of the agreed goods
or its price;

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 10

2. In the case where the seller is not able to supply the stipulated goods, he may revise the
agreement to supply other goods; and
3. In the case where the seller can only supply part of the agreed goods, the bank may
accept the same and revise the purchase order to the extent of the remaining quantity,
or it may claim the refund of the balance.
Another possible solution to minimise the risk of non-delivery or incomplete delivery of
the salam commodities is by exercising the parallel contract of salam (salam muwazi). After
purchasing a commodity by way of salam, the bank may sell it through a parallel contract of
salam for the same date of delivery. The period of salam in the second (parallel) transaction is
shorter, and therefore, the price may be a little higher than the price of the first transaction and
the difference between the two prices shall be the profit earned by the financial institution. The
shorter the period of salam, the higher the price, and the greater the profit. In this way, financial
institutions may manage their short term financing portfolios. Another method a bank can use
to manage its short term portfolio is, it can obtain a promise to purchase from a third party. This
promise should be a unilateral promise from the expected buyer. Being merely a promise, and
not the actual sale, the buyer will not have to pay the price in advance. Therefore, a higher price
may be fixed and as soon as the commodity is received by the institution, it will be sold to the
third party at a pre-agreed price according to the terms of the promise.

In the arrangement of parallel salam, the bank enters into two different contracts. In the
first one, the bank is the buyer and in the second contract, the bank is the seller. Each one of
these contracts must be independent of the other. They cannot be tied up in a manner that
the rights and obligations of one contract are dependant on the rights and obligations of the
parallel contract. Each contract should have its own force and its performance should not be
contingent on the other. Parallel salam is only allowed with a third party. The seller in the first
contract cannot be made purchaser in the parallel contract of salam, because it will be a buy-
back contract, which is not permissible in Shari’ah. Even if the purchaser in the second contract
is a separate legal entity, but is fully owned by the seller in the first contract, the arrangement
will not be allowed, because in practical terms it will amount to a “buy-back” arrangement. For
example, A has purchased 1,000 bags of wheat by way of salam from B, a joint stock company.
B has a subsidiary C, which is a separate legal entity but is fully owned by B. A cannot contract
the parallel salam with C. However, if C is not wholly owned by B, A can have a parallel salam
contract with it, even if B and C have common shareholders between them.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 11

Unit 6.3.10 SALE OF AL-MUSLAM FIHI BEFORE RECEIVING

IT

This is not considered permissible by the majority of the fuqaha because of the rule that
prevents the sale of food, as well as all movable items, before it is received. This is because it is
not considered permissible to earn a profit without entering into an obligation to deliver.

Maliki jurists agreed with the majority of the fuqaha on the prohibition of selling al-muslam
fihi before it is received but only if the al-muslam fihi is food. Otherwise, they feel that it is
permitted, provided that the following conditions are satisfied:

1. In the case of a sale back to at-muslam ileihi, this is considered permissible either at the
contract price or lower.
2. In the case of a sale to a third party (not at-muslam ileihi) it is considered permissible
to sell al-muslam fihi at the contract price (which is required if the quality is similar to
that specified in the contract) or at a higher or lower price (if the quality is different from
that specified in the contract).

Unit 6.3.11 REPLACEMENT OF AL-MUSLAM FIHI WITH

ANOTHER KIND OF GOODS

The majority of the fuqaha have prohibited the replacement of the al-muslam fihi before it is
received except by substituting it another kind of similar goods. This is because substitution is
considered as a form of sale and according to the jurisprudence, an individual cannot sell what
he does not own. However, it is considered permissible to replace al-muslam fihi by substituting
similar goods that are of the same, lower or better quality as this is not considered as a sale, but
as a form of satisfactory fulfilment and out of necessity.

Maliki jurists have agreed with the majority of the fuqaha on the prohibition of replacing the
al-muslam fihi if it is food. However, they have made the replacement of the al-muslam fihi
by a substitution permissible if it is not food, based on the views of their school of fiqh, which
permits the sale of goods before they are received.

If the substitution is made with the al-muslam ilayhi, then it would be considered permissible
on the conditions that:

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 12

1. The substitute is similar to al-muslam fihi or of a lower quality, in order to negate the
suspicion of riba.
2. The al-muslam ilayhi should receive the delivery of the substitute, so that it does not
lead to the exchange of debt against debt.
3. The relation between the substitute and the price should be free of riba.
Some contemporary fuqaha are of the view that substitution is considered permissible whether
or not the al-muslam fihi is food, subject to the following two conditions:

1. With regard to kind (type), the suitability of the substitute to be considered as al-
muslam fihi is specified in the salam contract.
2. With regard to quantity, the substitute should not be more than the al-muslam fihi so
that the purchaser does not obtain additional benefit.

Unit 6.3.12 PARALLEL MUSLAM (SALAM MUWAZI)

After purchasing a commodity by way of salam, the bank may sell it through a parallel contract
of salam on the same date of delivery. The period of salam in the second (parallel) transaction
is shorter, and therefore, the price may be a little higher than the price of the first transaction,
and the difference between the two prices shall be the profit earned by the financial institution.
The shorter the period of salam, the higher the price, and the greater the profit. In this way,
financial institutions may manage their short term financing portfolios. Second, the bank can
obtain a promise to purchase from a third party. This promise should be a unilateral promise
from the expected buyer. Being merely a promise, and not the actual sale, the buyer will not
have to pay the price in advance. Therefore, a higher price may be fixed and as soon as the
commodity is received by the institution, it will be sold to the third party at a pre-agreed price
according to the terms of the promise.

In an arrangement of parallel salam, the bank enters into two different contracts. In the first
one, the bank is the buyer and in the second contract, the bank is the seller. Each one of these
contracts must be independent of the other. They cannot be tied up in a manner that the rights
and obligations of one contract are dependant on the rights and obligations of the parallel
contract. Each contract should have its own force and its performance should not be contingent
on the other.

Parallel salam is only allowed with a third party. The seller in the first contract cannot be
made the purchaser in the parallel contract of salam, because it will be a buy-back contract,

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 13

which is not permissible in Shari’ah. Even if the purchaser in the second contract is a separate
legal entity, but is fully owned by the seller in the first contract, the arrangement will not be
allowed because in practical terms, it will amount to a “buy-back” arrangement. For example,
A has purchased 1,000 bags of wheat by way of salam from B, a joint stock company. B has a
subsidiary, C, which is a separate legal entity but is fully owned by B. A cannot have the parallel
salam contract with C. However, if C is not wholly owned by B, A can have the parallel salam
contract with it, even if B and C share common shareholders.

Two independent contracts

Seller / maker Client / purchaser

Parallel
Salam Delivery of Delivery of
Salam
the subject the subject
2 matter of matter of
the contract the contract
to the client to the client

3 4
Banks / Financial institution
Buyer Seller

Figure 6.1 Function of parallel salam

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 14

Unit 6.4 ISTISNA’ CONTRACT

Istisna’ is a contract that involves the purchase of an asset to be manufactured or constructed

according to agreed upon specifications. The seller in an istisna’ contract is normally a
manufacturer or developer.

Unit 6.4.1 DEFINITION OF ISTISNA’

Literally, the word istisna’ is a derivative of the root word sana’, which means to manufacture
or to construct something. Istisna’ is an order or request to manufacture something, whereby
the requestor has invited, induced or caused another to make or manufacture some goods for
him.

Technically, it is a contract to purchase for a definite price, something that may be manufactured
later according to agreed specifications between the parties. In other words, it is a contract of
sale of specified items to be manufactured or constructed with an obligation on the part of the
manufacturer or contractor to deliver them to the customer upon completion.

As stated earlier, istisna’ is actually an exception to the general condition of a sale that states
the goods intended to be sold must be in the physical or constructive possession of the seller.
There are three types of sale by referenced to the availability of the subject matter of the sale at
the time of the contract:

1. Both the price and the goods are present at the time of contract; this is the common type
of sale.
2. The subject matter is present but the price will be paid later at an agreed period (known
as deferred payment sale).
3. The price is present (paid on the spot) but the goods will be delivered at a later agreed
period, this is known as a contract of salam.

The majority of jurists considered istisna’ as part of salam and therefore, the price must be paid
at the time of contract, as in the case of salam. However, according to the Hanafi jurists, istisna’
is another type of sale contract, different from the contract of salam, whereby the price can be

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 15

paid later, not at the time the contract is signed. This is because one of the most important
features of this contract is that it involves labour, either to transform the raw material or to
add value to it. Therefore, the transaction in this respect is similar to ijarah (leasing contract),
whereby it is permissible to pay the rentals on a deferred or instalment basis without being
considered as a sale of debt for debt which is prohibited in Islamic commercial law.

Unit 6.4.2 SHARI’AH CONDITIONS FOR ISTISNA’

1. It is a condition in the istisna’ contract to state in the clearest of terms, the type, dimensions
and all the specifications required because it is a condition in all commutative contracts
that the sold commodity must be known to avoid ignorance which can lead to dispute.
2. The istisna’ contract is valid for objects that can be made. It is invalid for corn, wheat,
barley or fruit, and all natural products whose sale on liability is a salam and not an
istisna’ contract.
3. The object sold in istisna’ is a fixed liability debt and therefore, it is permissible for it to
be a valuable asset made according to special specifications (there is nothing else like
it) as the customer wishes with the proviso that it can be monitored by description. For
this feature, istisna’ is different from salam which is permissible only for similar “assets”.
4. The materials should be supplied by the maker. If they are supplied by the buyer, the
contract becomes ijarah and not istisna’.
5. The istisna’ is not confined to what the seller makes after he contracts, but the maker will
be satisfying his obligation if he brings in an article conforming to all the specifications
irrespective whether it was manufactured by him prior to the contract or the article was
produced by some other parties. The specifications demanded by the buyer are the most
important element of the contract.
6. The istisna’ contract is binding on the two parties, and no party has the right to retract.
The buyer has the option to retract only if the asset does not conform to the specifications
demanded.
7. Once the contract is concluded, the ownership of the asset is affirmed to the buyer and
the ownership of the payment of the price is affirmed to the maker.
8. It is not a condition in the istisna’ contract to advance the payment of price, though it is
permissible to do so, to defer or install it. Usually, part of the price is paid in advance and
the remainder will be withheld to the time of delivery and receipt of the commodity.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 16

9. It is a condition of istisna’ that the period of delivery is specified, whether it is short or

long, so as to avoid ignorance which may lead to conflict between the two parties.
10. It is a condition that the place of delivery is stated (specified) if the commodity needs
loading or transportation expenses.

The buyer may stipulate in the istisna’ contract that the commodity shall be manufactured
or produced by a specific manufacturer, or manufactured from specific materials. This is not
permitted in the case of a salam sale.

Unit 6.4.3 THE PROHIBITED ELEMENTS IN IN ISTISNA’

There are several prohibited elements in istisna’ and it can be summarised as follows:

1. The presence of the element of gharar (uncertainty) is prohibited in any contract;

however in the case of istisna’ this prohibition is more significant especially with regard
to the subject matter of the contract. This is because the subject matter is not in existence
at the time of the contract, as it is to be manufactured in the future. The obligation of
the manufacturer is fully dependent upon the specification. Likewise, his compliance
or non-compliance with the obligation is based on the specified requirements of the
subject matter determined and agreed upon by the parties at the conclusion of the
contract. Therefore, a lack of knowledge on the specifications and the nature of subject
matter to be manufactured would render the contract null and void.
2. It is prohibited that the subject matter be already in existence at the time of the contract,
or identified by designation. The subject matter must be identified by specifications
only to be manufactured in the future. If the items to be sold are specific identified
items, the transaction then involves selling identified items that the seller does not own
at the time of the contract, which was prohibited by the Prophet (p.b.u.h.). On the other
hand, the non-existent item in istisna’ is by nature, to be produced and delivered later
which constitutes the non-monetary obligation of the manufacturer.
3. The price should not be increased or decreased on account of the normal increase or
decrease in commodity prices or the cost of labour. This is to avoid gharar (uncertainty)
in the price of the subject matter.
4. The raw material of the subject matter to be manufactured should not be supplied by
the buyer; otherwise the contract becomes an ijarah and not an istisna’contract.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 17

5. It is not permitted for the manufacturer to stipulate, in the contract of istisna’ that he
will not be liable for defects in the subject matter. The reason for this prohibition is that
istisna’ is a sale of specified goods to be delivered in future, and the exclusion of liability
as to defects is valid only in the sale of particular identified goods.
6. The contract of istisna’ cannot be drawn up on the basis of a murabahah sale or sale
by determining the price on the cost plus profit basis. This is because in a murabahah
sale, the subject matter must be something already in existence which is owned by the
seller and the cost of which is known prior to the conclusion of the murabahah sale. On
the other hand, istisna’ is concluded prior to the ownership of the subject matter to be
manufactured in future and therefore, the cost is essentially not known as required in
murabahah.
7. In a parallel istisna’ contract, the institution or bank cannot simply act as a financial
intermediary or the financier of the istisna’ between the ultimate buyer and the actual
manufacturer. This is to avoid the element of riba. Therefore, the two contracts must be
independently concluded.

Project Financing Based on Istisna’ with the Pledging of Conventional

Bond

This case was addressed in the resolution of the Shari’ah Advisory Council of BNM. According
to the SAC, an Islamic financial institution decided to offer project financing based on an
istisna’ contract to renovate and refurbish its customer’s business premise. The proposed
modus operandi for this istisna’ financing is as follows:

1. The customer awards a contract to renovate his business premise to the Islamic financial
institution at a price, for example, RM2 million which will be paid by instalments;
2. The Islamic financial institution subsequently appoints a contractor to undertake the
renovation works of the premise according to the specifications as stipulated in the
agreement at a price, for example, RM1 million to be paid in cash;
3. The customer will pledge a conventional bond as security to secure the financing. The
bond which has been pledged will be liquidated by the Islamic financial institution
(only up to the principal value of the bond without interest) if the customer fails to
honour the instalment due according to the terms and conditions of the agreement; and
4. In the case of failure to complete the renovation, the customer is not required to pay
the pre-agreed price and the Islamic financial institution will enforce the terms and
conditions of the agreement to claim compensation from the contractor.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 18

In this regard, the SAC was referred to on the following issues:

1. Whether the proposed project financing based on an istisna’ contract is permissible;

and
2. Whether the Islamic financial institution may accept a conventional bond as a security
for the Islamic financing.

Resolution

The SAC, in its 1st special meeting dated 13 April 2007, has resolved the following:

1. The proposed structure and mechanism for project financing based on an istisna’
contract is permissible. However, the usage of the renovated business premise shall
comply with Shari’ah; and
2. Conventional bond as a security for the Islamic financing is permissible.

Basis of the Ruling

The aforesaid resolution by the SAC on the permissibility of istisna’ is based on the following
hadith of Rasulullah (p.b.u.h.):

“Reported by Jabir bin Abdillah, a lady said: ‘Oh Rasulullah, may I make something
for you to sit on it, verily I own a slave who is good in carpentry.’ Rasulullah (p.b.u.h.)
replied: ‘As you wish.’ Then, she made a mimbar.”

Rasulullah (p.b.u.h.) had also applied the istisna’ contract in making an order to manufacture
a ring for him as narrated in the following hadith:

“Reported by Nafi’, Abdullah told him that Rasulullah (p.b.u.h.) had ordered a golden
ring. When he put on the ring, he will turn its stone towards the palm of his hand.
Later, there were a lot of people who also ordered the manufacture of golden ring
for themselves. Then Rasulullah (p.b.u.h.) stepped on the mimbar and praised Allah
(s.w.t.) and said: ‘I had once ordered a manufactured golden ring but now I am not
wearing it anymore.’ He then threw the ring and this was followed by the people.”

Majallah al-Ahkam al-‘Adliyyah also provides that istisna’ is permissible (article 389) provided
that the descriptions and features of the ordered subject matter have been mutually agreed
upon (article 390). Article 391 of the Majallah states that istisna’ payments need not be made at

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 19

the time of the contract. Istisna’ and istisna’ muwazi have also been allowed by the AAOIFI as
long as the relevant principles are being followed accordingly.

In relation to the permissibility of accepting a conventional bond as a security for Islamic

financing, some scholars recognise such practices since the pledge is not made for the purpose
of ownership, but merely as a security. A conventional bond is a type of liquid asset that fulfils
the requirements of chargeable items.

Two independent contracts

Seller / maker Client / purchaser

Delivery
Istisna’ of theof
Delivery Parallel
Delivery of
subject
the subject Istisna’
the subject
2 metterof
matter of matter of
the
the contract the contract
to contract
the client to the client
to the
client

3 4
Banks / Financial institution
Buyer Seller
Figure 6.2 Function of parallel istisna’

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
Shari’ah Issues in Future Financing Contracts
Unit 6 | 20

SUMMARY

• This unit discussed some relevant issues related to madum, salam and istisna’ sale as
prominent contracts used by Islamic financial institutions.

• Future contract is a form of bay madum: this type of contract includes salam and
istisna’.

• As a matter of principle, the sale of a commodity which is not in the possession of

the seller is unlawful. This is the general rule laid down by the Shari’ah based on the
hadith of the Prophet (p.b.u.h.). However, the practice of salam is permissible as an
exception to the general rule, on the basis of need (haji) and public interest. Since
salam is an exception to the general rule, the Shari’ah imposes strict conditions on
salam, especially on salam commodities (al-muslam fihi).

• Istisna’ is a contract of sale of a specified item to be manufactured or constructed with

an obligation on the part of the manufacturer or contractor to deliver them to the
customer upon completion.

• Hanafi jurists approved the legality of istisna’ as an independent type of contract on

the basis of istihsan or Islamic equity due to the needs of the buyers to obtain the goods
according to their specifications and needs. Contemporary scholars adopted this view,
to accommodate the needs of the contemporary developments of modern financial
transactions among the Muslims, and realising the general principles of Shari’ah.

• As a special type of contract, several conditions must be fulfilled in order to consider

a contract of istisna’ as valid, to avoid prohibited elements in Shari’ah either in the
subject matter or the nature of obligations and liabilities of the parties. The viability
of istisna’ as an instrument of modern financing could be further enhanced by the
operation of parallel istisna’. However, strict conditions must be observed in order to
avoid the element of riba.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 21

CASE STUDY

TRADE MISSION TO JAPAN

You have been appointed as an agent by Rapid Kl Sdn Bhd. The company intends to extend
its business transportation from the terminal of each city to a new rural destination as part
of the government’s to facilitate the communication and movement in the country. For
this, they require 100 additional buses. As an expert in the field, your company sent you
to Japan to look for buses to be imported in Malaysia. You have been escorted to factories
in Japan to finalise the order based on Islamic facilities using Islamic banks. Your mission
is to buy 100 buses. Unfortunately, you found only 20 buses available ready for collection.

Discuss the following scenarios:

1. What kind of contract would you use to buy the 20 buses which are ready in the
warehouse?
2. You know the financial status of your company is not that sound, and that,
financially, they are only able to buy another 30 buses. What type of contract would
you recommend for the order of the 30 buses to be delivered in 6 month’s time?
3. You need financing for another 50 buses. What type of Islamic financing would
you recommend to the Islamic bank to be used in financing the 50 buses?

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
Shari’ah Issues in Future Financing Contracts
Unit 6 | 22

CASE STUDY

TRADE MISSION TO THAILAND

Your first successful mission to Japan gained you a reputation as good agent that handles
international trade according to Shari’ah, and therefore, a commodity company calls you
for another mission to Thailand to buy rice for them to be sold in the Malaysian market.
Your trade mission is to buy 20,000 MT of rice for the country. Upon arriving to Bangkok,
you have been escorted to the factory to finalise the order based on Islamic facilities using
Islamic banks. Unfortunately, you found only 5,000 MT (metric tonne) of rice available
for collection.

Discuss the following scenarios:

1. What kind of contract you would you use to buy the 5,000 MT of rice ready in the
warehouse?
2. You know the financial status of your company is not that sound, and financially,
the company is only able to buy another 5,000 MT, what type of contract would you
recommend for the order of 5,000 MT to be delivered in 3 month’s time.
3. You need financing for the other 10,000 MT. What type of Islamic financing would
you recommend to the Islamic bank to be used in financing the 10,000 MT?

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 23

QUESTIONS AND PROBLEMS

Question 1.
How would you compare and contrast istisna’ and salam contracts?

Question 2.
What is the opinion of the scholars on the madum contract?

Question 3.
Discuss the major Shari’ah issues in a salam contract?

Question 4.
Discuss the important elements of istisna’ and the conditions for a valid istisna’.

Question 5.
Discuss the important elements of salam and the conditions for a valid salam.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
Shari’ah Issues in Future Financing Contracts
Unit 6 | 24

• al-Zuhayli, Mahmoud A. El-Gamal (tr), Financial

Transactions in Islamic Jurisprudence, Vol. 1, Dar al-Fikr al-
Mu’asir, Beirut, 2003.

• Muhammad Taqi Usmani, An Introduction to Islamic

Finance, Idaratul Ma’arif, Pakistan, 1999.

• Shari’ah Standards. Accounting and Auditing Organization

for Islamic Financial Institutions. 1425-6H/2004-5, Sharia
Standard No. 10, pp.159 – 174.

• Nabil A.Saleh, Unlawful Gain and Legitimate Profit in

Islamic Law, Riba, Gharar and Islamic Banking, Cambridge
University Press, 1986, pp.71 – 76.

• Muhammad Al-Bashir Muhammad Al-Amine, “Arbun, Risk

Management and Options”, Journal of Islamic Banking and
Finance, The International Association of Islamic Banks,
Karachi, Vol. 17, No. 4, pp. 7–32, at pp.19-20.

• Nazih Hammad, Aqd al-Salam fi al-Shariah al-Islamiyyah,

Dar al-Qalam, Damshiq, 1993.

• Razali Nawawi, Islamic Law on Commercial Transactions,

CT Publications, Malaysia, 1999, pp. 99-96.

• Abdullah Alwi Hassan, Sales and Contracts in Early Islamic

Commercial Law, Kitab Bhavan, New Delhi, 1997, pp. 66-73.

• Dr. Nik Norzrul Thani, Mohamed Ridza Mohamed

Abdullah, Megat Hizaini Hassan, Law and Practice of
Islamic Banking and Finance, Thomson Sweet & Maxwell
Asia, 2003, pp. 39–42.

• Mohammad Hashim Kamali, Islamic Commercial Law: An

Analysis of Futures and Options, Ilmiah Publisher, Kuala
Lumpur, 2002.

• Accounting, Auditing and Governance Standards for Islamic

Financial Institution, Financial Accounting Standard No.
10, Istisna’ and Parallel Istisna’, AAIOIFI, 1425-6H/ 2004-5.

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH
 Shari’ah Issues in Future Financing Contracts
Unit 6 | 25

• Frank E. Vogel, and Samuel L. Hayes, Islamic Law

and Finance, Religion, Risk and Return, Kluwer Law
International, Hague, 1999.

• Istisna’, http://www.barakaonline.com/product/Istisnaa.
htm

• Muhammad, al Bashir Muhammad, Istisnā’ (Manufacturing

Contract) in Islamic Banking and Finance: Law and Practice,
AS Noordeen, Kuala Lumpur, 2001.

• Muhammad, al Fatih Hamid, Istisna’, Classical Concept in a

Modern Framework, New Horizon, Feb 1996.

• Salam and Istisnā’ by Muhammad Taqi Usmani, http://

www.accountancy.com.pk

• Shari’ah Standard No. (11), Istisna’ and Parallel Istisna’,

Accounting and Auditing Organization for Islamic Financial
Institution (AAOIFI), 1425-6H/ 2004-5.

• Wahbah, Zuhaili, Financial Transactions in Islamic

Jurisprudence, Dar al Fikr, Syria, Translated by Mahmoud
A El Gamal, Vol. 1, p. 267-279

SH5023 Shariah Issues in Islamic Finance

© INTERNATIONAL CENTRE FOR EDUCATION IN ISLAMIC FINANCE 2014/1435 AH