Financing Construction Projects or Purchase Orders (Istisna) in Islamic Finance
Istisna is a financial instrument in Islamic finance in which a manufacturer agrees to complete a construction project on a future date for a fixed, agreed-upon price and with product specifications that both parties agree to. If the project doesn’t fit the contract specifications, the buyer has the right to withdraw from it.
This financial instrument provides for payment flexibility between the manufacturer and the buyer. The contract doesn’t demand that the buyer pay in advance or that the manufacturer receive only a lump sum at the time of delivery. Instead, both parties can set a schedule of payment.
Istisna instruments are widely used in the construction industry or for project financing and trade financing. For example,
Kuwait Finance House (KFH) uses the istisna contract for home financing (properties under construction) and project financing.
Qatar Islamic Bank (QIB) signed an istisna agreement in late 2010 to finance a major residential complex in the north of Qatar.
Minimizing uncertainty (gharar) in istisna
Usually, a contract for a not-yet-manufactured product presents some uncertainty about the product. Islamic law prohibits finance institutions from being part of transactions that involve uncertainty (called gharar). To avoid uncertainty, the istisna contract is as detailed as possible regarding what the end product will be.
In the istisna contract, the customer approaches the bank with the desired asset’s specifications. Both the customer and the bank sign the istisna contract, and then the bank manufactures the product or the asset for the customer through its agent, such as a manufacturer.
Opting for parallel istisna
When the bank provides the customer with the istisna financial instrument, the customer signs the contract with the bank for the specified asset or project. Then the bank (via its manufacturing agent) manufactures the asset or project per the customer’s specifications.
However, in some circumstances the bank doesn’t want to produce the item for the customer. In this case, the bank opts to use two mutually independent istisna contracts called parallel istisna.
Here’s how this system works: The customer who wants the project or asset enters an istisna contract with the bank per the customer’s specifications. The bank then enters into a parallel istisna contract with a manufacturer (which is not the bank’s agent; it is a separate third party) to meet those same specifications.
In theory, when the manufacturer completes the asset or project, it delivers that product to the bank. (In practice, the manufacturer usually delivers the product directly to the customer.) The bank pays the manufacturer, and the customer pays the bank according to the agreed payment schedule. The bank marks up the manufacturer’s price in the contract with the customer to secure a profit.
Keep in mind that a separate istisna contract exists on both sides: between the customer and the bank, and between the bank and the manufacturer.
For example, fictional customer Acme, Inc., approaches the World’s Best Islamic Bank to manufacture a housing scheme with specifications for $1 million. Then the bank enters an agreement with A Construction Company to build the houses with the same specifications for $800,000.
When the construction project is complete, A Construction Company hands over the project to the bank, which verifies the specifications and delivers the product to Acme, Inc., on the payment basis agreed to in that part of the istisna.
The bank goes for a parallel contract in this scenario because it can’t produce the assets and doesn’t want to hold the produced assets after their completion. In a parallel contract, the bank has both a buyer for its products and a manufacturer.