Islamic Sales Contracts Structure

By

Muhammad Ayub,
Director, Research & Training
Riphah Center of Islamic Business
Riphah International University

 Contracts for:
Intermediation
Financing

Trade based sale / purchase

Lease based
Service / agency based
Investment
Equity based
Debt based
Hybrid assets

AVOIDING
Riba, Gharar, Maysir / Qimar
and
Doing Trade and Business as per
Shariah Rules

I.F Contracts / Structure

Intermediation
Contracts
Mudaraba

Transactional
Contracts

Investments

Qard

Financing

Wakalah
Amanh / Wadhi

Trade Financing

Ijara Financing

Wakala/ Jualah

Kafalah
Murabaha

Takaful

Salam

Istisna

Lease

Jualah

Mudaraba

Musharka

Asset Based
Investments

Wakalah

Sukuk

Asset Backed
Investments

Collateralized
Structures / Debt

Funds / Unit Trusts

Equity Participate

Sukuk /
Certificates

Stocks

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 (alaqd al
munjaz),
contract that will become effective at a particular
future time (alaqd almudaf ila almustaqbal)
and contingent contract (alaqd almuallaq).
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:
Salebased principles
Profitsharing principles
Leasebased principles
Benevolentloan principle
Feebased 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 alhasat (a transaction
determined by
throwing stones )and
Fasid

Sales transactions based on exchange Items:

Barter trade (bai almuqayadah)
General sale(baialmutlaq)
(forex) Bai alsarf

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 almusawamah)

No reference is made as to the cost price and
profit/loss made by the seller of the object

Fiduciary Sales - Buyu alamanah; 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
Baial murabahah - Costplus 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 Sale

Use as a financing tool:
Promise to Sell Agreement to Sell
Treatment breach of binding promise
Murabaha MoU Facility Agreement
Agency concept Wakalah in
Murabaha

Misc. Murabaha Rules

Wakalah Agency
Waad 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 PriceCost 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
Clients 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
Customers 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 owners
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 dont 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 destruction
AAOIFIs advice
What IBs in Pakistan do?
Clause 8/8
IBD Circular #1, 2010
Application 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 SALES
SALAM AND ISTISNAA
2 exceptions to the general principles
of sale:
Salam (which is also called as Salf); and
Istisna.

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 /

seller
AAOIFI
Pricing
Advising a price
Rest for the client
Responsibility of the client / agent

Issues in
Late 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 delivery
Recourse 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 Operations
Industry
Exports - preshipment
Local 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 firms 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 wont be paid back

Grey Areas
Sale of Debts
Sale and buy back (Al- inah)
Organized Tawarruq Commodity Murabaha,
Reverse Murabaha
Use of Wad 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!