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Istisna'

Istisna’ means asking someone to construct, build or manufacture an asset. In Islamic finance, istisna' is generally a long-term contract whereby a party undertakes to manufacture, build or construct assets, with an obligation from the manufacturer or producer to deliver them to the customer upon completion. In practice, the key advantage of an istisna’ contract is that it can provide flexibility to the customer, where payments can be made in installments linked to project completion, at delivery or after project completion. In contrast to istisna', for salam contract the payment has to be made in full, in advance.

Istisna' Application: Examples


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Infrastructure projects are the main examples of istisna' application. This includes: construction of power plants, factories, roads, schools, hospitals, building and residential developments. The parties to an istisna' contract are: the Producer or Manufacturer; the Bank (i.e. the financier); and the Customer (i.e. purchaser of goods).

Figure 1: Istisna’ Structure

The below diagram shows istisna' structure:


Source: Islamic Banking and Finance, 2009 (Spiramus Press Ltd)

The above structure is also known as “simple istisna'”, where it is assumed that the buyer has the required financing to directly coordinate with the manufacturer on the project. If the buyer does not have the financing, then the below parallel istisna' structure can be used.    

Figure 2: Parallel Istisna’ Structure

The parallel istisna' involves: the customer (the buyer); the Islamic bank (the seller); and the manufacturer (in some cases it can also involve sub-contractors), where the buyer can obtain financing from the Islamic bank  The following diagram shows parallel istisna' structure:



Source: Islamic Banking and Finance, 2009 (Spiramus Press Ltd)


Istisna’ Validity, Amendments and Cancellations

In order for the istisna' to be valid, the price must be fixed from the outset. In the event of any unforeseen event that causes a delay in delivery the price of istisna' can be amended, if it is mutually agreed. After the manufacturer has started the work, the contract cannot be cancelled unilaterally.


Istisna’ Risk Mitigation

RiskDescriptionMitigation
Delivery RiskDelay in delivery of goods from the producer to the customer at maturity.Link pricing of the istisna' to delivery.
Non-PerformanceThe producer is either unable or is unwilling to manufacture the goods during assigned time.The price can be paid in installments.
Quality RiskThe producer delivers defected/inferior goods, which is realized by the customer only at the time of delivery.Quality assurance agreement, with producer to rectify defects.
Increased costs of ProductionCost incurred by the producer turns out to be higher than anticipated, which causes the producer to default on performance.Producer to handle increase in costs, unless it is due to an unforeseen event.
Storage RiskIn the case of parallel istisna’, the goods once delivered by the producer will be at the bank's risk before being sold to the customer.Insurance / Takaful.

Source: IslamicBanker.com; Meezan Bank.

Istisna' Documentation

There are three sets of documentation involved in istisna':

1. Master Istisna' Agreement

The agreement is signed between the Bank and the Customer, outlining the terms and conditions of the production of goods, including: cost price, delivery location, quantity and quality.

2. Agency Agreement

In the case of Agency Agreement, the Bank will appoint the producer of goods its Agenet to sell the goods. Generally, this documents also sets out the agency fees schedule (Notice of Appointment).

3. Corporate Guarantee

This agreement is between the Bank and the Customer, guaranteeing the payment obligation in the case of default. This can include a mortgage or pledges on receivables.

In practice Istisna' contracts can be arranged with other Sharia' compliant agreements including: kafalah, takaful; rahn; hamish gedyyah (security deposit), or arbun (down payment).

Istisna’: Hadith

The Islamic underpinning of istisna' can be found with the following two ahadith:

The Prophet (PBUH) required that a pulpit (platform) be built for preaching [Bukhari 2/908]

The Prophet (PBUH) required that a finger ring be manufactured for Him [Bukhari 5/220 and Muslim 3/1655]

 

References

1. Sheikh Muhammad Taqi Usmani, An Introduction to Islamic Finance.
1. Meezan Bank, Istisna'.
3. Istisna' in Islamic banking: Concept & Application.
4. Islamic Banking and Finance, 2009 (Spiramus Press Ltd).
5. Abdulkader Thomas et al, 2005, Structuring Islamic Finance Transactions, Euromoney Books.