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Istisna'a and Back-to-Back Istisna'a Finance

It is no more acceptable for Islamic banks to provide finance to government sponsored projects in forms abhorrent to their articles of associations nor is acceptable for an Islamic bank to finance private sector projects by way of interest free loans. Therefore, Istisna'a has been rendered to be the most appropriate Sharia and business form to finance infrastructure projects, manufacturing aircrafts, construction of power stations, buildings, and equipments, which have to be completed on need basis. Hence, there arises the importance of Istisna'a contract as a financing tool, which is a contract that allows the sale of a commodity that does not exist at the time of contracting, while payment can be made on spot or deferred basis.

Process of Istisna'a Sale

  • The process starts when a customer expresses to the bank its intention to purchase a commodity that has to be manufactured, built or assembled with certain specifications at a specified price.
  • The bank and the customer enter into an Istisna'a contract under which the bank undertakes to have the subject commodity manufactured and delivered to the customer within a certain period in return for a specified price payable on spot or on several installments or in one stroke on deferred basis.
  • The bank then enters into a back-to-back Istisna'a contract with a third party to have the subject commodity manufactured, built or assembled.

Purpose of Financing under Istisna'a and Back-to-Back Contracts

Given the mammoth changes in the volume and value of the projects necessitated by the development drives undertaken by governments or such other projects assigned to the private sector, and in view of the lack of liquidity and insufficient financing sources in addition to lack of expertise needed, a sore need has arisen for a new form of Islamic compliant financing. Thus, Istisna'a became one of the sale contracts which could be used by Islamic banks to meet the needs and requirements of individuals and organizations which can not be financed through other sale contracts; Under Istisna'a financing contract, the underlying commodity is manufactured and the price is paid on forward basis or on installments, depending on the Istisna'a requester (the customer) and the consent of the manufacturer (the bank).

Scope of Applications

Examples of Istisna'a contracts, which may be used for the community welfare, include infrastructure projects such as construction of roads, schools, hospital, buildings, power and other facilities, in addition to myriad contracts such as manufacturing of aircrafts, vehicles and ships. It would have been difficult for the sponsors/ owners of such projects to find other suitable financing alternatives.

Parties of Istisna'a Contract

  • Istisna'a requester: is the buyer (owner of the project)
  • Manufacturer: is the bank (seller/producer) which enters into contract with the Istisna' requester and commits itself to provide the subject commodity.
  • Contractor: is the seller, contractor or actual contractor, which concludes the back-to-back contract with the bank and starts manufacturing or construction of the subject commodity. It is the bank's sub-contractor or supplier.
  • Product: is the commodity defined and contracted to be manufactured.

The bank is considered to be the manufacturer and principal contractor vis-à-vis the Istisna'a requester who is the owner vis-à-vis the contractor in the second contract (back to back Istisna'a contract).

Sharia Controls of Istisna'a and back-to-back Istisna'a

  • The subject product must be precisely defined with details including:
    • Product (vehicle, aircraft, real estate etc.)
    • Type (brand and make)
    • Description (product schedule of specifications)
  • Permitted Deferment
    • The subject product is to be manufactured or procured form the market. Therefore, a maturity date must be specified in order to avoid risk.
    • The term depends on the nature of the product to be manufactured in accordance with the Istisna'a contract entered into by the two parties and subject to the conditions and specifications set out in the term sheet of the contracted commodity as agreed between the two parties.
  • Price
    • The price be precisely defined and known by the two parties.
    • The price should not be affected by any increase in market prices or labor in normal circumstances.
    • The price may be adjusted if amendments are made to the contracted product by mutual agreement of the two parties.
  • Shrinking Musharaka

In a shrinking Musharaka, the bank's interest share decreases by the payments received from the customer and the bank's share of the profit is calculated on the basis of the outstanding interest share.

Process of Istisna'a Sale

The bank agrees with the customer to finance a business transaction by entering into it as a partner. The terms of Musharaka provide that the bank shall sell its share interest to the customer at the end of the partnership. Each partner may sell its share interest to the other partner or to a third party by virtue of a separate contract pursuant to then mutually agreed terms between the two partners including the rate profit rate, method and terms of payment, guarantees, and other terms, subject to the Sharia applicable rules and controls.

Sharia Controls

  • The equity contribution must be paid in cash. Any form of equity may not be accepted unless liquidated and converted into cash.
  • The equity contribution should not necessarily be readily available at the time of signing the contract; it must be readily available when implementation of Musharaka commences.
  • Management could be undertaken by one or more of the parties in return for a percentage of the profits.
  • Any loss or damage sustained by the Musharaka based project, except as a result of gross negligence or transgression, shall be shared by the parties proportionately.
  • Profits shall be distributed as agreed by the partners provided that the share is predefined and known to them as a percentage, such as one quarter or one third or otherwise.
  • A partner's interest share of the capital must be converted into a commodity should it wish to sell it to another partner. A partner may sell its interest share at any profit margin of its discretion.
  • A share interest may not be sold before having been legally and duly possessed and owned.

Features of Musharaka

  • The customer may act as the bank's agent in performing the Musharaka process thereby allowing the customer, by virtue of its experience and expertise, sufficient flexibility to complete the formalities and custom duty requirements.
  • This type of finance is suitable for customers who wish to receive the commodity documents in their names whether to serve their relationship with their suppliers or because they have certain concessions (custom exemptions for example).
  • The bank's entry with customer as a financier partner to the purchase transaction, "commodity purchase", is an evidence of seriousness and commitment to the partnership.
  • Musharaka financing is one of the most Sharia flexible and comprehensive forms of finance by virtue of the fact that it befits all finance requirements of various economic activities.
  • Musharaka is an ideal instrument to finance fixed assets purchases in commensurate with the bank's credit policy, which is based on the customer participation in the financing transaction of such assets.
  • The bank may discontinue the partnership in one stroke so it becomes wholly owned by the customer.
  • The bank may sell its share interest to a third party should the customer withdraw and decides not to purchase the subject commodity.
  • Pre-maturity partnership termination option mitigates the risk related to investment term.

Scope of Musharaka Applications

Musharaka form is used for contingency financing (commodity, goods, equipments) requirements of bank corporate customers of different business sectors, for different maturities and multiple purposes including, in addition to working capital, purchase of fixed assets. The banks usually extends to customers special Musharaka credit facilities the of which is determined based on the type of business and the purpose of finance. Each customer is assigned certain credit line either in the form of Musharaka contract/ contracts which are used for one time or in the form of revolving Musharaka usable more than once during the terms of the facility.​