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The flexibility offered in terms of payments in an istisna contract, as well the required specificity in the asset makes istisna ideal for large scale projects of all sorts, including infrastructure construction, real estate development, and the manufacturing of custom products.
However, due to the high risk associated with these projects, istisna contracts may not be enough to mitigate against them, especially as some of these risks are unforeseen. These challenges have solutions in conventional project development contracts, but istisna contracts are limited in how they deal with them.
Today, we look at some of these limitations and explore strategies to mitigate them.
Read more About : Your Basic Guide to Istisna contracts
Due to the niche nature, complexity and long duration of these types of projects, funding them tends to be more expensive and require the use of interest-bearing and other forms of non-halal financing.
As a shariah-compliant form of financing istisna forbids the use of more widely available conventional forms of funding. This limits the way the financing is structured, which could significantly increase the risk profile of the project.
While being touted as one of its biggest advantages, the flexibility in payment in an istisna could become its biggest hurdle.
Because the istisna does not require immediate payment on the buyer, the contractor may not be able to have the initial financial means to deliver the product up to the agreed upon standard.
On the flipside, the buyer may jump the gun and sign an istisna without having secured the full funds to complete the project.
The specificity of the product required in an istina may lead to unexpected operational issues.
This specificity may mean that standard, tried and true ways of managing the project may not be sufficient and new operational requirements may make it difficult to meet deadlines and achieve the required outcome.
In conventional development and construction contracts, delays may incur a penalty that could come in the form interest charges.
These are prohibited in istisna contracts, which may potentially increase the risk profile of the project.
Cost overruns are part of the nature of projects of the scale used in istina contracts.
This is in part due to the long duration of the projects, which may lead to price fluctuations in the price of materials.
Conventionally, there are financial tools that can be used to hedge against these. Islamic finance prohibits the use of speculation and instruments such as derivatives that might be used to hedge against these price fluctuations.
Projects of this kind may come across unanticipated circumstances that could trigger force majeure clauses, including natural disasters and political instability.
In istisna contracts, these events may be subject to Islamic law and interpretations, which could vary. Any potential disputes could lead to arbitration in an Islamic court that could set back the project even further.
Parallel istisna contracts are used to spread some of the risks to a third or even fourth party, whether that be on the production side (through the hiring more able sub-contractors), or in the case of funding, where a bank is roped in to help cover the financing of the project.
Read more about: Funding Options in Parallel istisna
Buyers can provide guarantees for their financial institution, which could include pledges on receivables (depending on the project). Buyers can also have their bank post a bond or guarantee to cover the initial payments.
If the original customer fails to make payments to the bank, it can retain ownership of the asset.
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.
Takaful insurance is particularly beneficial as it can cover operational delays, and damage to the project.
Read more about: Conventional Insurance and Takaful "Islamic Insurance"
An istisna contract should include provisions for dispute resolution and Islamic arbitration or any other shariah-compliant legal means.
The process should include the use of mediation. In general, setting about a process in contract tends to minimize lengthy legal disputes.
Clearly outlining penalties for late delivery and poor quality could incentivize the contractor to meet their obligations and can act as a deterrence for any mismanagement of the project.
These should also include definitions for force majeure events and the consequences for them.
Implementing a regular system of audits and quality assurance inspections during the manufacturing process could help the buyer monitor quality and compliance with the contract specifications in real time.
These should also be done with the assistance of third parties of experts and advisors.
Performing a rigorous due diligence on the contractor that includes clear and demonstrable prior capabilities to fulfill this type of work will mitigate much of the risks noted above right off the bat.
Disclamer
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
