Forward Sales – Salam and Istisna’a

Salam is a cash sales agreement where the seller promises to provide the buyer with an agreed product at a future date in exchange for an advanced payment at the time of contract. The goods do not exist at the time of contract but they have a market demand whenever they are produced. The goods to be delivered are free of ambiguity as specifications, quantity, and time of delivery are all defined in the contract. After the agreement, the delivery of goods becomes a debt on the seller until the promised goods are delivered.

The concept of Salam is allowed by Islam as this was practiced at the time of the Prophet (PBUH) and he had allowed it. Salam helps both seller and buyer by providing the necessary financing for business operations for the former, while the latter is guaranteed delivery of a product in future at a price which is usually lower than the spot price. Since the goods have a market demand, the buyer and seller are both protected against default by any contracting party. Salam is used by Islamic banks to finance agriculture, manufacturing, business operations, and securitization of Islamic bonds.

Salam can be illustrated with the following example of a cotton farmer seeking to forward sell 1,000 bales of cotton through a Salam contract to finance his operation through the grow and harvest season.

1. The farmer contacts an Islamic bank to go into the Salam contract and offers to sell 1,000 bales of cotton, which is commonly available in the market at the time of harvest. The delivery is scheduled for six months after the contract date.
2. The bank and the farmer agree on a Salam contract for current price of $50 a bale which is expected to be lower than the market price at the time of delivery. The quality of cotton is same as normally available in the area of operation. Necessary Islamic insurance (takaful) is also procured to protect both parties. Since the bank is not in the business of buying and selling cotton, they acquire services of an agent to handle the delivery and subsequent sale of cotton in the market.
3. The farmer also provides tangible security guarantees and agrees to penalties in case of non-compliance.
4. The bank provides $50,000 Salam financing to cover the purchase of 1,000 bales of cotton.
5. After the harvest, the farmer delivers bales of cotton to the bank’s agent as per the contract, hence completing his side of the contract. The bank assumes the market risk of owning the cotton until it is sold. The bank can exercise one of many options to sell the cotton.
6. The bank may sell the cotton in a Murabaha transaction (cost plus profit mark-up) with single or installment payments. Since the bank’s cost was $50 per bale and market price is higher, any price reasonably above $50 will fetch a profit for the bank.
7. Alternatively, the bank may sell the cotton to a manufacturer before taking delivery from the farmer on what is called Parallel Salam. Again, any price above $50 will be profitable for the bank. However, since this is another separate Salam contract, the bank is liable to deliver the goods at agreed upon time even if the farmer fails to deliver.
8. As a third alternative, the bank could secure a promise to buy from another customer at a price which is higher than $50 per bale. Since this is only a promise to buy, this customer does not pay any price until the actual delivery of cotton.

Istisna’a is a sale where a product is sold before it comes into existence usually applicable to construction or manufacturing financing. The payment amount or series of payment are fixed in the agreement. The manufacturer or the builder is paid for the raw material, production effort and a profit. The goods do not exist at the time of contract but are required to be manufactured. The goods do not need to be delivered at a certain time but rather there could be partial deliveries as payments are made. After the agreement, the deliveries of goods become a debt on the seller until all the promised goods are delivered. One main difference that distinguishes Istisna’a from Salam is that full payment is not required at the time of contract.

Istisna’a helps both seller and buyer by allowing the former to manufacture goods according to certain specifications and a guarantee of payment while allowing the latter to order goods to be manufactured against the business needs and not having to pay the full price in advance. Since the goods have a market demand, the buyer and seller are both protected against default by any contracting party. Istisna’a is used by Islamic banks to finance infrastructure projects or for manufacturing.

Istisna’a can be illustrated with the example of a power company which wants a bank to provide financing for construction of a power plant.

1. The power company requests an Islamic bank for an Istisna’a contractto have a power plant built over a five year period. The company agrees to pay the bank five annual payments of $20 million each starting from the end of first year of the contract.
2. The contract obligates the bank to deliver a completed power plant within the five year period and to assure that any parallel contract will meet this requirement.
3. The bank subsequently contracts (parallel Istisna’a) with an engineering and construction (E&C) firm to build and deliver the specified power plant within the five year period. The E&C firm is under contract obligation to complete the project on time. The bank provides the cash to the E&C firm as needed to acquire the engineering and construction services, facilities and materials. They assure that the total project cost will be reasonably under $100 million to make this a profitable project.
4. Upon completion of the plant, the E&C firm transfers the ownership to the bank or an agent who is qualified to check the quality of work before taking possession. The bank then transfers the plant to the power company, thus completing the two independent Istisna’a contracts.
5. The bank and the power company both as buyers in their own capacity, will verify that the completed power plant meets or exceeds all the requirements specified in the contract.
6. The power company will make payments annually regardless of when the actual plant is delivered. They may even make payments after delivery of the plant if the project is completed ahead of time.