Tuesday, November 6, 2012

Islamic Banking

This is the fourth and final post in the series of articles addressing Shari`ah-compliant home financing products. It considers bay bithamin ajil (“BBA”) and istisna’a structures. Thereafter, it provides a few observations on the structures that are likely to be used in the Sultanate of Oman in light of the current draft of the proposed Islamic banking rules. BBA structures are used in Malaysia, Indonesia and Brunei, but are not encountered in the Middle East, the United States, Canada, the United Kingdom or Australia. Istisna’a structures (including istisna’a – parallel istisna’a structures), or construction financing structures, are used throughout the world.

Bay’u Bithamin Ajil Definition and Principles

The bay’u bithamin ajil or BBA contract is a contract of sale, utilizing deferred payment concepts. Importantly, it is not a separate kind of sale under the Shari’ah[1]. The payment of the price is deferred and is payable at a particular time in the future, usually on an instalment basis. Elements of sale that have been previously discussed in these Client Alerts are applicable and must be satisfied. For example, the sale and purchase price must be agreed and fixed at the inception of the transaction – at the time the contract is made. Thus, the profit rate for a BBA transaction is fixed at the inception of the transaction for the entire period of the transaction.

The fixed rate nature of the BBA contractual transaction has led to various criticisms pertaining to its competitiveness and appropriateness as a banking tool. Addressing some of those criticisms, Bank Negara Malaysia introduced a rebate (ibra’) mechanism that use variable rate financing techniques.[2] Using this mechanism, the sales price bears a fixed profit rate that is designated as the ‘ceiling profit rate’. The ceiling profit rate is set at a rate that is greater than the actual variable rate that will be charged to the home purchaser (which is referred to as the ‘effective rate’). The difference between the payment calculated at the ceiling profit rate and the payment calculated at the effective rate is the amount of the rebate to the home purchaser for the relevant period.

Different types of sale arrangements may be embedded in the BBA transaction. In Malaysia, Indonesia and Brunei, the bay’ al-‘inah (sale and buy-back) structure is frequently used. This type of structure is not used with any frequency outside Malaysia, Indonsesia and Brunei. Figure 1 provides a graphic depiction of a BBA transaction using this mechanism.
 


In this transaction, the Customer identifies the property that the Customer desires to acquire (say, from a developer), enters into a Property Purchase and Sale Agreement (step 1) and pays a Deposit amount to the Property Seller (step 2).

As a result of paying the Deposit amount to the Property Seller, the Purchaser is deemed to have become the beneficial owner of the property. The Purchaser then approaches the Bank to seek financing for the acquisition of the property in an amount equal to the balance of the purchase price over the amount of the Deposit (the “Financing Amount”). That is, the property purchase price is equal to the sum of the Deposit and the Financing Amount.

Upon arranging that financing, the Purchaser enters into a Property Sale Agreement (step 3) and sells the property to the Bank for an amount equal to the Financing Amount (step 4). The Bank will consummate the purchase of the property by making payment of the Financing Amount, which is usually disbursed directly to the Seller as shown in step 5.

Thereafter, pursuant to the Property Purchase Agreement (step 6), the Bank sells the property to the Purchaser at an amount equal to the sum of (a) the Financing Amount plus (b) a profit amount on the Financing Amount, which may be determined using either a fixed or floating rate (the “Total Purchase Amount”) (step 7). The Purchaser then makes installment payments of the Total Purchase Amount to the Bank, as illustrated in step 9. The obligation of the Purchaser to make the installment payments of the Total Purchase Amount will often be secured by a rahn (mortgage) on the property from the Purchaser to the Bank, as illustrated in step 8.

Istisna’a – Parallel Istisna’a Home Construction Financings  

The term “istisna’a” (or ‘istisnā’) means requesting a san’ah, which is the work of a small or large scale manufacturing worker. In jurisprudence and the modern Islamic finance and investment industry, the term is used to refer to a type of forward sale contract involving the request to manufacture (or construct) a specific item in a specific form for a specific price. The commission to manufacture contract is thus a contract to purchase the item to be manufactured by the worker, where the worker provides both the raw materials and the labor to produce the final product.[3] Historically, the istisna’a contract is derived from situations in which the custom production was required or desired, although it now refers more broadly to both manufacturing and construction undertakings. The sāni’ or sane is the seller, the mustasni’ or mustasne is the purchaser, and the masnū’ or masnou is the object of the sale transaction.

The istisna’a is similar to the forward sale contract (salam) in that it involves the future delivery of a traded item, it is a sale of an object that is not existent at the time of the consummation of the sale and purchase contract, and the object of the sale is a liability of the seller. In the istisna’a contract, the sales price need not be paid immediately at the time of entering into the contract, in contrast to the salam contract.[4]

The nature of the istisna’a contact in a situation where a purchaser desires to have a house constructed is seemingly straightforward. The purchaser/mustasne commissions the seller/sane to build a house (masnou) and sell it to the purchaser upon completion of construction, whereupon the purchaser will make payment in full. In the normal course, and classically, this arrangement does not involve instalment payments of the purchase price by the purchaser. The seller would have to be qualified to construct the house, or at least to cause the construction of the house (or the acquisition of the masnou in the markets).

The pure istisna’a contract does not seem well suited to situations in which the purchaser of the house is in need of financing to effect the purchase and the payment of the house purchase price. Additionally, the pure istisna’a does not seem well suited to situations in which the purchaser desires to make instalment payments of the purchase price, particularly instalment payments over an extended period of time. And construction contractors and manufacturers are not well positioned to provide long-term financing of house acquisitions. With respect to each of these matters, the introduction of banks and/or financial institutions into the equation seems both appropriate and beneficial.

This line of thought leads to the contemporary istisna’a – parallel istisna’a transactional form. This form involves two istisna’a contracts, one between the house purchaser as the mustasne (the “end mustanse”) and the bank as the sane, and one between the bank as the mustasne and the constructor as the sane (the “end sane”). Figure 2, overleaf, provides a graphic depiction of the overall transaction involving both istisna’a contracts.

The “First Contract” is comprised of the Istisna’a Agreement (step 1) between the Customer (Home Purchaser) as the End Mustasne and the Bank as the Sane. The Bank agrees to construct the House (Masnou) (which will be delivered in step 5) in accordance with the plans and specifications set forth in, and otherwise as agreed in, the Istisna’a Agreement and for a price (the “Istisna’a Amount”) set forth in the Istisna’a Agreement (which will be paid in instalment payments in step 6). The Istisna’a Amount is equal to the sum of (a) the cost to construct the House, which is the “Total Istisna’a Amount” referred to in step 4, plus (b) the financing costs to be paid to the Bank. Those financing costs may be calculated using either a fixed or a floating rate. The Bank is obligated to the Customer (Home Purchaser) in respect of the construction of the House. The Customer (Home Purchaser) agrees to purchase the House for the Istisna’a Amount on the instalment payment terms set forth in the Istisna’a Agreement.


Of course the Bank is not in the business of constructing houses. Thus, the Bank, as Mustasne, arranges for the “Second Contract”, being the “Parallel Istisna’a Agreement” (step 2), with the Construction Contractor as sane (or “End Sane” because it is the ultimate sane in the overall istisna’a – parallel istisna’a arrangement). Pursuant to the Parallel Istisna’a Agreement, the Construction Contractor agrees to the construct the House and deliver it to the Bank (step 3), which will make payment to the Construction Contractor in one or more spot market payments (step 4) during or at the end of the construction period. All construction terms pertaining to the House to be constructed pursuant to the Parallel Istisna’a Agreement (e.g., the plans and specifications) are identical to the construction terms set forth in the Istisna’a Agreement between the Customer (Home Purchaser) and the Bank. That is, the two contracts are “parallel” in all regards other than the price and the timing of the payment of the price. The price to be paid to the Construction Contractor under the Parallel Istisna’a Agreement is the “Total Istisna’a Cost” (step 4). It is the cost to construct the House without regard to any financing costs that are included in the Istisna’a Amount.

It is to be noted that the Istisna’a Agreement and the Parallel Istisna’a Agreement are, and must remain, totally independent obligations and arrangements, rather than interdependent obligations and arrangements. Thus, for example, pursuant to the Parallel Istisna’a Agreement, the Construction Contractor is obligated to the Bank, but not the Customer (Home Purchaser), in respect of the construction and delivery of the House. Pursuant to the Istisna’a Agreement, the Bank is separately and independently obligated to the Customer (Home Purchaser) in respect of the construction and delivery of the House. These obligations are independent and unrelated. Failure by the Construction Contractor to construct and deliver the House in accordance with the plans and specifications will not relieve the Bank of its obligation to the Customer (Home Purchaser) to deliver the House in accordance with the plans and specifications; the Bank will continue to be liable to the Customer (Home Purchaser).

Home Purchase Financings in the Sultanate of Oman

The four-part survey of Shari`ah-compliant home purchase financing products has considered a range of different structures and techniques for financing home purchases. These have included (i) the lease (ijara), which is discussed in Islamic Banking: Home Purchase Financings I: The Lease, (ii) the musharaka mutanaqisa (diminishing partnership), which is discussed in Islamic Banking: Home Purchase Financings II: Musharaka Mutanaqisa, (iii) the murabaha (cost-plus sale involving a commodity), which is discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq, (iv) the tawarruq (seeking of cash through the use of a murabaha in which the commodity purchased by the party needing financing is immediately sold by that party for cash), which is discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq, (v) the bay’u bithamin ajil or BBA contract, which is discussed in this client alert, and (vi) the istisna’a – parallel istisna’a, which is also discussed in this client alert. Each of these is discussed at http://omanlawblog.curtis.com.

While these discussions are indicative of the range of possibilities from a global perspective, it is clear that only a subset of these structures will be offered by Islamic banks or Islamic windows of conventional banks in the Sultanate of Oman. The current drafts of the proposed Islamic banking regulations for the Sultanate of Oman require that products be in accord with the standards and guidelines of the Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”). Thus, certain types of tawarruq structures (i.e., organized tawarruq) will not be permitted in Oman, as was discussed in Islamic Banking: Home Purchase Financings III: Murabaha and Tawarruq. In addition, BBA structures will not be permissible in Oman.

The structures that will be available for home financing products in the Sultanate of Oman are likely to be the ijara (lease) and the musharaka mutanaqisa (diminishing partnership). Generic transactions using these structures were discussed in Islamic Banking: Home Purchase Financings I: The Lease, and Islamic Banking: Home Purchase Financings II: Musharaka Mutanaqisa, respectively.

As the Sultanate of Oman prepares to roll out its new legal and regulatory framework for Islamic banking in the coming months, we continue to cover Islamic banking in the Client Alert as it is an important and growing field. This article is the fourth in a series by Curtis partner Michael J.T. McMillen, an Islamic finance specialist based in our New York office who provides support to our Islamic banking practice in Oman and throughout the Middle East region.




1This type of contract is also knows as a bay muajjal in Southeast Asia and is commonly referred to as a bay murabaha in the Middle East.

2See Introduction of Islamic Variable Rate Mechanism, in The Islamic Financial System, 187-89 (2003), BANK NEGARA MALAYSIA, available at http://www.bnm.gov.my/files/publication/ar/en/2003/cp05_003_whitebox_intro.pdf.

3If the raw materials were provided by the purchaser, the contract would be one of employment of the labour of the worker.

4See Wahbah Al-Zuhayli, Al-Fiqh Ali-lslami wa-Adillatuh (Islamic Jurisprudence and its Proofs), Financial Transactions in Islamic Jurisprudence, Mahmoud A. El-Gamal, translator (2002), at 267-79, for discussions of the jurisprudential positions regarding whether the istisna’a is a contract of sale or a promise to sell or a form of employment of the manufacturer, of appended conditions, of the legal status of the contract, and of legal characteristics of the contract, and for a detailed comparison of the istisna’a and the salam contracts.