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Among the many Islamic finance contracts that has grown in importance – particularly in the realm of project finance and manufacturing – is the istisna contract. Coming from the Arabic word for manufacturing,
istisna is an agreement that allows a buyer to commission the production or construction of an asset. Today, we breakdown the essentials of istisna, what its key features are, its basic structure and practical use cases.
In a standard istisna contract, a buyer commissions a seller to construct or develop a bespoke asset to agreed upon specifications, with an agreed upon schedule for the delivery of the asset set out in the contract.
In istisna (and its less flexible derivative salam) the price of the commissioned work is set ahead of time and is predetermined.
In this way, Istisna contracts are effectively a combination between a standard project development contract and a futures contract.
However, unlike a salam contract (which we’ll dive into at a later time), payments on an istisna contract can happen in stages. This could happen as certain milestones are achieved, or payment in full can be made upon delivery.
For an istisna contract to be valid, three main conditions must be met:
1- the contract must clearly state the specifications of the commissioned asset, including its design, function, quality, quantity, materials and along with a delivery schedule.
2- the specific asset must be newly constructed or manufactured and must be of new design. This is made to distinguish istisna from other contracts for existing assets such as Murabaha.
3- the price of the asset must be clearly specified at the time of the signing of the contract along with the payment schedule and delivery terms.
In the event of an unforeseen circumstance (a force majeure), the price can be amended by mutual agreement. After work has begun on the asset, the contract cannot be cancelled unilaterally.
As with any form of shariah-compliant contract, istisna contracts are designed to prevent the use of interest as a form of financing.
The contract must also avoid any excessive uncertainty (gharar) by clearly outlining the projects specifications and contractual terms. It goes without saying that the project involved must not be in service of any haram activities.
There are two generally held forms of an istisna contract.
it is assumed that the buyer has the prerequisite funding to pay for the project.
In this form the buyer agrees with the seller on the aforementioned conditions of the contract and pays according to the agreed upon schedule. It is in effect, a simple two-way transaction.
usually involves the presence of a third party in the transaction, usually to either cover the funding of the contract or to participate on the manufacturing and construction side as a sub-contractor or outsourcing agent.
In the case of funding, a master istisna contract is signed between the buyer and an Islamic bank, where the bank acts as the contractor, negotiating the price and factoring into it its profit or fees.
The bank then signs a separate agency agreement with the service provider that will actually construct or manufacture the asset in question. The bank will act as guarantor of funding for the construction of the asset in the event of default.
At the same time, conditions for default are set with the buyer to receive guarantees, which could include pledges on receivables.
In practice, istina contracts of this type are usually made with our forms of shariah-compliant financing, including down payments, security deposits, collateral, and takaful insurance.
If the original customer fails to make payments to the bank, it can retain ownership of the asset.
Read more about: The Main Islamic Financing Methods
Istisna contracts offer flexibility in terms of payments, making it easier for all parties to manage cashflows, as well as providing them with an element of shared risk.
Meanwhile, the specificity in an istina makes it ideal for projects that require customization, where specific materials and design are a requirement.
The aforementioned benefits, conditions and features make istisna contracts ideal for large scale projects of all sorts, including infrastructure construction and management, real estate development, and the manufacturing of custom products, such as machinery, equipment, or vehicles.
These projects tend to be costly, and require a great level of expertise and usually take a long time to complete. An istina may prove ideal with managing the risks involved in such projects.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
