revision of chapter 12 - 16. salam: forward purchase a salam transaction is the purchase of a...

Revision of Chapter 12 - 16

Salam: Forward Purchase• A salam transaction is the purchase of a commodity for

deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while delivery of the item to be sold, known as subject matter of salam, is deferred.

• Uses:– Purchase of commodities (financing for production of

agricultural commodities/ minerals) – Liquidity requirements of sugar mills, etc.

Salam: Forward Purchase

Wisdom of allowing Salam

• Beneficial for both seller and purchaser: seller or the farmer

can get capital to grow the crop and get better produce of the

crop, while the buyer can be sure of its stocks and price.

Three major problems

1. Risk of default by seller

2. Bank’s need to liquidate goods after delivery

3. Seller’s inability to produce or procure commodity

Principles of Salam

• An exception to the possession

• A contract opposite to Murabaha

• Payment of full price at spot - otherwise selling debt for

debt

• Allowed in fungible commodities

• Product of a particular origin can't be specified

• Quality and quantity decided in unambiguous terms

Principles of Salam

• The commodity should remain in the market throughout the

period of contract (different opinions).

• The time of delivery should be sufficient to allow use of Salam

capital conveniently

• A security/guarantee is preferred as safeguard to the risk of

default

• Only commodity is delivered and not the money

Parallel Salam

The disposal of commodity at the end of Bank can be through:

a. Parallel Salam: MFI may sell commodity, before the date of delivery, to some other purchaser for the date of original delivery. The period in second contract will be shorter than the original contract, but price will be higher than the original contract.

b. Unilateral Promise: Promise of purchase can be obtained from third party for delivery on the date of original contract. Price in this promise is set higher than parallel salam because the promisor has to pay nothing.

Rules of Parallel Salam and Third Party Promise

• Both the contracts i.e. Salam and parallel Salam must

be independent of each other

• Parallel Salam is allowed only with third parties

• The third party giving unilateral promise should not

pay the price in advance as this is not allowed in

Sharia.

Seller

(Buyer)Bank(Seller)

BuyerDeferred Delivery

Price received

Deferred Delivery

Salam

Parallel Salam

Price paid

Istisna

Istisna

Introduction• Istisna is a sale transaction where commodity is

transacted before it comes into existence.

Definition• It is an order to producer to manufacture a specific

commodity for the purchaser.

Conditions of Istisna

• the subject of Istisna is always a thing which needs

manufacturing

• Manufacturer use his own material

• Quality and Quantity should be agreed in absolute term

• Purchase price should be fixed with mutual consent

Price of Istisna

• Price of Istisna may be spot and deferred therefore

Istisna is applicable where Salam is not applicable.

• Price of Istisna can be paid in installments.

• The installments may be tied up with different stages

of manufacturing.

Right of Rejection

When the required goods have been manufactured

by the manufacturer, purchaser can exercise his

right to reject the goods based on the defects in

the manufactured goods

Cancellation of Istisna

• The contract of Istisna can be cancelled unilaterally

before the manufacturer starts working.

• After starting the work, Istisna cannot be cancelled

unilaterally.

Difference between Istisna & Salam

Istisna

• The subject of Istisna is always a thing which needs manufacturing.

• The price in Istisna does not necessarily need to be paid in full in advance.

Salam

• The subject can be any thing.

• The price has to be paid full in advance.

Difference between Salam and Istisna

Istisna• Time of Delivery does not

have to be fixed, but the stages of manufacture might be time bound

• The contract can be cancelled before the manufacturer starts working.

Salam• Time of delivery is an

essential part of the sale

• The contract cannot be cancelled unilaterally.

Security

• A security in the form of a guarantee, mortgage or hypothecation may be required for Istisna in order to ensure that the manufacturer shall deliver the commodity on the agreed date,

• In the case of default in delivery, the guarantor may be asked

to deliver the same commodity, and if there is a mortgage, the buyer can sell the mortgaged property and the sale proceed can be used either to realize the required commodity by purchasing it from the market, or to recover the price advanced by him.

Time of Delivery

• It is not necessary in Istisna that the time of delivery is fixed. However, the purchaser my fix a maximum time for delivery after the appointed time, he will not be bound to accept the goods and pay the price.

• In order to ensure that the goods will be delivered within the specified period, some modern agreement of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, the price shall be reduced by a specified amount per day.

Delivery of Manufacturing goods

• Before delivery, goods will remain at the risk of seller.

• After delivery, risk will be transferred to the purchaser.

• 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.

• If manufactured goods are delivered before agreed date,

purchaser can refuse to accept the goods.

Parallel Istisna and its Applications

• After the execution of Istisna agreement with one party, buyer as a seller executes another Istisna agreement with third party,

Conditions for Parallel Istisna

a. There must be two different and independent

contracts, these two contracts cannot be tied up

and performance of one should not be subject to

the other.

b. Parallel Istisna is allowed with third party only.

Buyer Bank ContractorDeferred Delivery

Payment agreement

Deferred Delivery

Istisna

Parallel Istisna

Payment agreement

Potential of Istisna

• The client can get finance for raw material, working

capital and other overhead expenses by the

execution of Istisna agreement.

• House financing, import and export products can be

easily designed on Istisna basis.

Istisna as Mode of Financing

• House Financing

• Project Financing

• BOT Arrangement

• Export Pre Shipment

Musharakah

Definition

Musharakah is a form of partnership which is based on

profit and loss sharing. The origin of Musharakah is

Shirkah which connotes engagement of two or more

parties who have a common interest to form a

partnership.

Musharakah

Types of Shirkah

1. Shirkah ul Aqad (commercial partnership)

2. Shirkah ul Milk (joint-ownership).

Shirkah ul Aqad refers to partnership with commercial objective,

whereas, Shirkah ul Milk refers to joint-ownership in a particular

asset.

Features of Musharakah Contract

1. Capital contribution by all partners

2. Management of Musharakah venture

3. Profit sharing

4. Loss sharing

5. Partnership venture

1. Capital Contribution by all Partners

1. Monetary assets in different currencies shall be valued based

on the currency agreed by the partners in the contract.

2. All forms of debts (accounts receivables) shall not qualify as

Musharakah capital.

3. Non-monetary asset with an associated debt may be

contributed as capital e.g. contribution of a partner in the

form of building which is partly funded by 30% debt (debt

should not be more than 50%).

1. Capital Contribution by all Partners

4. The total amount of capital to be contributed by each

partner shall be determined up front. The agreed capital may

be contributed on lump sum or staged basis.

5. Additional capital may be injected by mutual agreement of

the partners.

6. Failure to contribute capital by the capital provider as per the

agreed schedule shall constitute a breach of promise. The

partners will have the option to terminate the agreement or

to revise the agreement based on actual capital contribution.

1. Capital Contribution by all Partners

7. The capital invested shall not be guaranteed by any of the

partners.

8. Any of the partners acting as agents shall be liable for

misconduct or negligence to the partnership as a whole.

9. Any partner acting on his own or as agent who has caused the

loss of capital due to misconduct or negligence shall be liable to

refund the loss of capital to the other partners.

10. Any loss of capital in the course of the business shall be

recognized as capital impairment and shall be borne

proportionately.

1. Capital Contribution by all Partners

11. Share of Musharakah capital may be transferred to existing

or a third party as per the Musharakah contract.

12. The Musharakah agreement may impose a condition that

compels a partner to offer the redemption of the partner’s

share of capital to existing partners based on certain agreed

terms and conditions.

13. Capital gains or losses will be shared by the partners.

2. Management of Musharakah Venture

Musharakah venture may be managed in the following ways

1. Management by all partners; or

2. Management by certain partners or single partner; or

3. Management by a third party.

• Profit shall be measured as an amount exceeding capital after deducting the cost and expenses attributable to Musharakah venture.

• In cases where the Musharakah is specified and meant for a specified project or activities, only expenses that can be identified by the partners or deemed direct expenses to the project may be deductible.

• The profit sharing ratio may either be proportionate to the capital contribution or be based on a ratio or percentage which is agreed upon by all partners irrespective of their capital contribution.

3. Profit Sharing Rights

Illustration: Profit Sharing Ratio Basis

‘A’ and ‘B’ contributed Rs.20,000 and Rs.80,000 respectively to

form a Musharakah partnership. While B has decided not to take

part in the management of the business venture, A has

committed to managing the business of the partnership.

According to the first provision, the profit sharing ratio between

A and B should be 20:80 or 1/5 and 4/5 respectively. The ratio

could be of any ratio such as 80:20 or 50:50 or any other

arrangement as agreed upon by both parties.

3. Profit Sharing Rights

3. Profit Sharing Rights

• It is not permissible to include a condition in Musharakah contract that

stipulates a pre-determined fixed amount of profit to one partner which

deprives the profit share of the other partner.

• However, a lump sum amount of profit may be permissible if the profits

are more than a certain benchmark profit.

3. Profit Sharing Rights

• It is not permissible to express profit in a Musharakah, in a form of

percentage of capital only, that means a payment of fixed profit regardless

of the actual profit realized.

• Partner(s) in Musharakah, shall not fully or partially guarantee the

principal and profit of another partner(s).

• A third party who is not related to any party in the Musharakah in terms of equity ownership and management control may guarantee the profit to the Musharakah venture subject to certain conditions.

Illustration: Guaranteed Rental Income for Profit DistributionIf a Musharakah financing agreement is signed to build and rent a property to an identified tenant. The partners can obtain an undertaking from the prospective tenant that upon completion of the property and its availability for occupancy, the tenant will lease the property for a specified period at an agreed rental rate. Profit to be shared between the partners is based on the guaranteed rental income by the lessee for the lease agreement. This guaranteed rental by a third party is permissible.

3. Profit Sharing Rights

3. Profit Sharing Rights• Any unusual investment income from Shariah prohibited activities

of a Musharakah venture due to unavoidable circumstances will be distributed to charity.

Illustration: Non-Compliant Activities and Disposal of SharesInvestors, through Musharakah participation, subscribe to an investment fund that invests in a portfolio of several large companies. During the investment period one of the companies shifted its core business to non Shariah compliant activities. The fund manager responded by disposing of the investments in the company. Gains from the disposal of the share for the period of non-compliant activities are to be identified and distributed to charity.

4. Loss Sharing• Capital loss incurs when a capital asset (investment or real

estate) decreases in value. The loss is not realized until the asset

is sold for a lower price than the purchase price.

• Loss shall be shared among the partners proportionate to their

capital contribution.

• Preferential treatment to a particular partner over the others in

the same Musharakah venture in absorbing the loss shall not be

permissible.

• The loss to the partners shall be limited to the capital

contribution of each partner.

4. Loss Sharing

A third party may undertake to bear the loss of a partner. In

order to encourage public participation in the Musharakah

investment the government may provide a guarantee on the

capital of a Musharakah venture. This type of guarantee is

permissible and valid as the government is an independent party

to the Musharakah venture.

4. Loss Sharing

• Upon realization of loss, a partner may agree, without any

prior condition, to bear the loss of another partner at the

time such a loss is realized.

• The loss due to misconduct, negligence and breach of terms

and conditions by a managing partner shall be borne entirely

by that partner.

5. Partnership Venture

• Business ventures of Musharakah shall be Shariah compliant

and may be conducted in various sectors such as trading,

plantation, construction, manufacturing, investment and

services.

• A Musharakah contract may be adopted for non commercial

activities which are non-profit oriented.

• Pre contracting costs like feasibility study fee may be charged

to the customer subject to his/her consent.

Mudarabah

Definition

• This is a kind of partnership between the two parties where

one partner contributes capital and the other one contributes

efforts as manager or entrepreneur.

• The profit of the venture is share at an agreed ratio while the

losses are borne by the capital provider.

• The investment comes from “Rabb-ul-Maal” (Investor) while

the management and work is an exclusive responsibility of the

working partner, who is called Mudarib.

Features of Mudaraba Contract

There are number of principles governing the

Mudaraba contract, e.g.

1. Nature of the contract

2. Capital

3. Management of the Mudaraba

4. Profit and loss sharing mechanism

1. Nature of the Mudaraba Contract

• Generally Mudaraba contract allows anyone of the

contracting parties to terminate the contract unilaterally.

• However, the contract shall not be terminated unilaterally if

the manager has started the work or when both parties have

agreed not to terminate the contract during a specified time.

2. Capital

1. The capital shall be contributed by the capital provider and

shall be managed by the manager to generate income.

2. The capital of Mudarabah may be in the form of monetary or

non-monetary assets.

2. Capital

3. Monetary assets of different currencies shall be valued

according to an agreed currency at the time of signing the

Mudarabah contract.

4. The mutually agreed currency shall be applicable throughout

the Mudarabah business venture. For example, any capital

investments after the initial investment shall be converted

into the currency mentioned in the prospectus.

2. Capital

5. Capital in the form of non-monetary assets which may include

intangible assets shall be valued based on the valuation determined

by a third party or as agreed upon by the contracting parties at the

time of contract.

6. Upon termination or the expiry of the contract non-monetary

Mudarabah capital contributed may be redeemed at its original

value invested or otherwise at its market value.

2. CapitalIllustration: Non Monetary Mudarabah Capital Contribution

A public transportation company, XYZ applied for Mudarabah-

based financing from an Islamic Bank. The bank approves the

application and agrees to provide five buses to the company as

Mudarabah capital valued at Rs.10 million based on prevailing

market value and the company should manage the operations of

these buses.

Upon the termination of the contract the Murabaha capital may

be valued at its original value or the residual market value as

agreed in the contract.

2. Capital

7. Debts such as account receivables or loans due to a capital

provider do not qualify as capital of Mudarabah.

8. The agreed capital shall be made available to the manager to

commence the business activities.

9. The capital may be fully or partially disbursed or made

available to the manager at the time of the contract or based

on terms of the contract.

10. Capital provider and manager may agree for a gradual

withdrawal of Mudarabah capital by the capital provider.

2. Capital

11. Failure to provide capital by the capital provider as per the

agreed schedule shall constitute a breach of promise

according to specified terms and conditions of the contract.

12. The manager has an option to terminate the agreement or

both parties may agree to revise the agreement based on

actual capital contribution.

2. Capital

13. Where the agreement is terminated the manager has to

return the outstanding capital (if any). If the Mudarabah

expenditure exceeds the actual capital contribution, such

liability shall be borne by the capital provider up to the limit

of the total amount committed under the contract.

2. Capital

14. Upon liquidation or maturity of the Mudarabah contract, all

outstanding capital shall be returned to the capital provider.

15. Any outstanding capital including the share of profit shall be

deemed as debt due to the capital provider.

16. The manager shall not guarantee the Mudarabah capital.

2. Capital

17. The capital provider may require the manager to arrange for

an independent third party performance guarantee.

18. The guarantee shall be executed as a separate contract and

be utilized to cover for any loss or depletion of capital in the

event of misconduct, negligence, dishonesty, fraud or breach

of the terms of the contract by the manager.

3. Management of the Mudaraba

1. Mudarabah capital will be used only for the Sharia compliant

activities.

2. Manger/Mudarib will have the exclusive rights to manage

the contract. However, the capital provider has the right to

information regarding the conduct of the business and

manger.

3. Manager shall not be liable for any loss of capital unless it is

due to any negligence, dishonesty, misconduct or breach of

contract.

3. Management of the Mudaraba

Restricted MudarabaThe powers of the manger shall be provided under the terms and conditions of the contract.• The contract may restrict the manager’s role/functions such

as • determination of location, • period for investment, • type of project and • commingling of funds,

provided it does not nullify the purpose/objective of the contract. However, the restrictions shall not unduly constrain the manager.

3. Management of the Mudaraba

Unrestricted Mudarabah

Rabb-ul-maal gives full freedom to Mudarib to undertake

whatever business he/she deems fit, this is called unrestricted

Mudarabah. The manager has the discretion to use the capital in

the best interest of the Mudaraba.

However, Mudarib is not authorized to:

• Keep another Mudarib or a partner

• Mix his own investment in that particular Mudaraba

without the consent of Rabb-ul Maal.

3. Management of the Mudaraba

Single tiered Mudaraba• A Mudarabah contract shall require the manager to deploy

the capital to a profitable venture. The manager shall be personally responsible to ensure the proper management of the capital is in the interest of the capital provider.

Multi-tiered Mudaraba• The manager of a Mudarabah contract may assign the capital

to another manager in another Mudarabah contract with the consent of the primary capital provider.

Bank

Mudarib

Rabb ul Mal

Mudarib

Investment Investment Investment Investment

Depositor Depositor Depositor Depositor

Profit/loss

Profit/loss

Rabb ul Mal

Two Tier Mudarabah

4. Distribution of Profit & Loss

1. It is necessary for the validity of Mudarabah that the parties agree right at the beginning on a definite proportion of the actual profit to which each one of them is entitled.

2. They can share the profit at any ratio they agree upon. 3. However in case the parties have entered into Mudarabah

without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios.

4. Some incentives my be given to the Mudarib.

4. Distribution of Profit & Loss5. Apart from the agreed proportion of the profit, the

Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah.

6. The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

Termination of Mudarabah

1. Mudarabah can be terminated any time by either of the two

parties by giving notice.

2. If Mudarabah was for a particular term, it will terminate at

the end of the term.

3. Termination of Mudarabah means that the Mudarib cannot

purchase new goods for the Mudarabah. However, he may

sell the existing goods that were purchased before

termination.

Collective Mudarabah

1. Collective Mudarabah means a joint pool created by many investors and handed over to a single Mudarib who is normally a juristic person.

2. Collective Mudarabah creates two different relationships:

a. Relationship between investors themselves, which is Shirkah or Partnership.

b. Relationship of all the investors with Mudarib, which is Mudaraba.

Running Mudarabah1. Investors come in and go out at different dates

2. Profits are calculated on daily basis.

3. Redemption before maturity

a. If the assets of Mudaraba are in illiquid form, an

investor may redeem his share by selling it to the

pool..

b. If the assets are in liquid form, a provisional amount

may be given to him subject to final settlement

Diminishing Musharakah

It is a type of Shirkah where one partner promises to purchase the other partner’s share gradually.

Type of Diminishing Musharakah

Like Musharakah contract Diminishing Musharakah is also of two types;

/Diminishing Musharakah

Shirakat-ul-MilkJoint ownership

Shirkat-ul-AqdJoint Venture

Features of Diminishing Musharakah

Shirkat-ul-aqd (joint venture)

• Two partners start business in Shirkah to earn profits.

• One of the partners undertakes to purchase the share of

another partner gradually at regular intervals.

Rules of Diminishing Musharakah in Joint Venture

There will be an agreement of joint venture between both partners

where in investment of everyone and ratio of profit will be agreed.

One partner undertakes to purchase the share of other partner, but

three conditions should be considered in this undertaking.

a) This promise will not be a part of Shirkah Agreement.

b) The price of unit will not be agreed in this promise but

promise to purchase should be on offer and acceptance basis

for a valid sale contract.

c) If promise is not fulfilled, then it can be forced by Court of law.

Rules of Diminishing Musharakah in Joint Venture

• At the time of purchase, the price of unit will be decided

on the basis of market value of business.

• Conditions of valid sale transaction must be observed.

• Unit will be purchased through Offer & Acceptance.

Features of Diminishing Musharakah in Joint Ownership

• Two or more partners purchase any asset (machinery,

property, etc.) and their intention is that one or both partners

will use this asset or rent out their share and one partner

undertakes to purchase the share of other gradually.

Rules of Diminishing Musharakah in Joint Ownership

• There will be an agreement of Shirkat ul Milk and it will be

decided How much investment will be made by each partner.

• Asset will be purchased and everyone will be owner of this

asset as per the ratio of his/her investment and all other

rules of Shirkat-ul-Milk will be applicable.

Rules of Diminishing Musharakah in Joint Ownership

• One Partner can rent out his share to other partner or to a

third party and Ijarah Agreement will be signed.

• Within period of Ijarah, Shariah rulings relating to Ijarah will

be applicable.

Rules of Diminishing Musharakah in Joint Ownership

• One of the partners can promise to purchase the share of

another partner and in this promise, the price of unit may be

decided.

• Unit can be purchased on the basis of Offer & Acceptance.

• All the above mentioned agreements and undertaking should

be independent and not linked up with each other.

Termination of Diminishing Musharakah

1. Subject to agreement or by mutual consent of joint owners, a joint owner may withdraw his share from the joint asset or property after serving a due notice to other joint owner(s).

2. The withdrawal can be affected by sale or gift to existing joint owner(s) or to any other person(s). In case of sale, the parties may agree on face value, book value, agreed value, or market value.

3. A withdrawal of one or more joint owner(s) shall not lead to the termination of the joint ownership among remaining joint owner(s).

4. It is also permissible for the joint owners to agree on termination of the joint ownership before the agreed period.

Use of Diminishing Musharakah in the Present

Islamic Banking System

Use of Diminishing of Musharakah in Banking System

Diminishing Musharakah is usually used for asset financing

and particularly in House Financing for four purposes:

1. Purchase of House

2. Construction of House

3. Renovation of House

4. Balance Transfer Facility (BTF)

1. Financing for Purchase of House

1. The Client in the approved area of the bank makes the

choice of house.

2. Bank & client enter into Musharakah agreement. In

this agreement it is decided to purchase the house

jointly and ratio of investment by each other.

1. Financing for Purchase of House

3. The property will be in the name of the client.

4. This is Shirkat-ul-Milk.

5. According to the ratio of ownership, each one is responsible

for the loss.

6. Bank divides its own part of asset into units, which is

promised by the client to purchase on pre-agreed price.

1. Financing for Purchase of House

7. After taking possession of house, bank rent out its share to

the client by execution of Ijarah Agreement.

8. Rent may be fixed on prevailing market rate or with mutual

consent.

9. Bank’s monthly profit may also be decided, as monthly rent

of the house and principal amount will be recovered in the

unit price.

1. Financing for Purchase of House

10. In Ijarah Agreement, a lump sum amount of rent is

necessary to be fixed for a certain period. Rent for the

rest of the period, may be linked with agreed

Benchmark.

11. Each unit will be purchased on the basis of Offer &

Acceptance.

Summary of the Lecture

We revised the lectures from lecture number 12 to 16 and

discussed the following topics.

• Salam and Istisna

• Musharakah

• Mudarabah

• Diminishing Musharakah