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Ministry of Rural Rehabilitation and Development Ministry of Rural Rehabilitation and Development

Ministry of Rural Rehabilitation and Development - PowerPoint Presentation

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Ministry of Rural Rehabilitation and Development - PPT Presentation

Afghanistan Rural Enterprise Development Program Islamic Finance Product Development The Use of the Commercial Contract of Bay Salam to Finance Agricultural Production and Small Trade ID: 812682

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Slide1

Ministry of Rural Rehabilitation and Development Afghanistan Rural Enterprise Development Program Islamic Finance Product DevelopmentThe Use of the Commercial Contract of Bay’ Salamto Finance Agricultural Production and Small Tradeprepared by Alberto G Brugnoni - AREDP

ISLAMIC REPUBLIC OF AFGHANISTAN

Slide2

CONTENTSINTRODUCTIONDEFINITIONS OF THE COMMERCIAL CONTRACTTHE SHARIAH LEGITIMACYUNANIMOUS SHARIAH FEATURESDEBATED SHARIAH FEATURESSCOPE AND POTENTIAL OF SALAMRISK & RISK MANAGEMENTDIFFERENCES WITH SIMILAR CONTRACTSSALAM AS A SHORT TERM FINANCE TOOL

Slide3

INTRODUCTIONSalam is, at its origin, an agricultural product. The farmer normally needs financing for purchasing agricultural inputs like seed, fertilizers, pesticides, diesel for tractor, payment of water charges, labor, etc.Its versatility has allowed salam to become a diversified tool for liquidity management, monetary policy management, and tradeThe strong parallel that salam bears with either futures or forward sales has allowed for securities applications of salam

Slide4

DEFINITIONS OF THE COMMERCIAL CONTRACTSalam (also ‘ita’ = giving, taslif = advance, sales by order) is one of the two exceptions (rukhsa) to the three Shariah conditions of validity of sale:the commodity purchased must be in existence (bay’ ma’dum)the seller should have acquired the ownership of the commoditymere ownership is not enough, as the commodity must be in the physical or constructive possession of the sellerSalam

is a sale agreement whereby the seller receives the price

in advance while goods are delivered at a future specified dateAnother definition states that the seller

agrees to supply specific goods to the buyer at a future date in exchange of an advanced price fully paid at the time of contract

It is also a sale

contract over prescribed commodity sold as a deferred liability on one party, in exchange for a price that is received during the contract

session

It

is the sale of a liability whose characteristics are described in exchange for a price or capital-sum paid in

advance

Slide5

DEFINITIONS OF THE COMMERCIAL CONTRACTMaliki defined it as a sale in which capital sum (price) is paid in advance and the object of sale is deferred to a specified termAAOIFI defines salam as the purchase of commodity for deferred delivery in exchange for immediate paymentAll definitions entail that price is always in cash and the supply of goods always deferredhence: salam is, in its essence, a forward saleTERMINOLOGYsalam applies to the contract as a whole, and may also refer to the goods

which are to be delivered laterrabb

al-salam or al-musallim, refer to the owner of capital, the party purchasing the goods (the buyer)

al-

musallam

alayhi

,

refers

to the party who takes on

the obligation

to deliver the

goods

at a future

date (

the

seller

)

ra’s mal al-salam,

refers to the capital, the price paid in advance of delivery of the sale object (the price)a

l-

musallam

fihi refers to the subject of the contract, the object or goods to be delivered (the sale object)Ijàb (offer) and qabul (acceptance) are other terms of use

Slide6

SHARIAH LEGITIMACYQUR’ANSalam legitimacy is based on its concordance with the Qur’anic verse that forbids usury but permits/enjoins commerce:“Those who eat ribà will not stand (on the Day of Resurrection) except like the standing of a person struck by Satan leading him to insanity. That is because they say: “Trading is only like ribà” whereas God has permitted trading and forbidden ribà (Qur’an, 2:275)The salam contract also conforms to the Qur’anic instruction to write down/record any debt transactions:“O you who believe! When you contract a debt for a fixed period, write it down” (Qur’an, 2:282)one should note that ‘debt’ is comprehensive of whatever is owed and therefore may take the form not only of monetary loans but any objects like foodstuffs (e.g. wheat and barley), manufactured articles (paper, cars, machines, etc.) or raw materials (e.g. copper, iron, petroleum etc.) duly specified as to quantity and qualityaccording to the tafsir attributed to Ibn ‘Abbas, this verse “was revealed to address the salam in particular”

Slide7

SHARIAH LEGITIMACYHADITHThere are several hadiths and reports bearing witness that the salam contract was in use at the time of the Prophet (pbuh)Narrated by lbn ‘Abbas: the Messenger of Allah (pbuh) came to Medina and the society used to pay in advance the price of fruits to be delivered within one or two years. The Prophet (pbuh) said, “Whoever pays money in advance for dates (to be delivered later, i.e.: a contract of salam) should pay it for known specified weight and measure (of the dates) [and a specified date of delivery]”lbn ‘Abbas commented that: “I bears witness that

al-salaf (al-salam

) stipulated for a stated term had been made legal by Allah in His holy book and His permission is in it”IJMA’All Muslim jurists

have given their consensus to the permissibility of

bay’

al-salam

:

i

t is deemed a: “facilitation and

an extension that closes up the door against

usury”

p

articularly,

because the product in sale is one of

the counter-values

in

the contract

there

is also the need of the people in it. The owners of the agricultural products and

small businesses needed

some financing to support themselves or to fund their crops until the day of

harvesting

hence

, it is made permissible to

fulfill public needs

Slide8

UNANIMOUS SHARIAH FEATURESCONTRACT'S FEATURESThe salam contract is binding and is sealed by using the word ‘salam’ or ‘salaf’ and specifying terms:neither party has the right to annul it without the other’s satisfaction unless the sale object proves to be other than as specifiedthe seller is thus obliged to discharge his obligations towards the buyer with respect to the sale object, just as in any other sale contractthus, salam is not among those contracts in which either party is permitted to abrogate the contract without the other’s approval, such as musharakah, mudharabah or qirad, wakalah and wadiʼah contractsIt is permissible to cancel the contract of salam by mutual agreement, subject to no reduction and increase in original capital refundedAfter execution of the salam

agreement, the contract cannot be revoked unilaterally:nevertheless, the iqala

(recession of contract) is possible. In this occurrence, the parties freely consent to rescind it and each one gives back the consideration receivedthe Prophet (pbuh) has stated: “He who does the iqala with a Muslim who is not happy with his transaction, Allah will forgive his sins on the Day of

Judgment”

Slide9

UNANIMOUS SHARIAH FEATURESThe salam contract may be applied to all commodities, metals, animals and livestock, produce and manufactured goods:in the view of some scholars, it can even be applied to utilitiesThe subject matter of a salam contract must be different from mode of payment of price:ex.: if capital is provided in currency, then commodity in salam contract must not be currency

Slide10

UNANIMOUS SHARIAH FEATURESCASH PRICE OR SALAM CAPITALThe price to be paid at spot to receive the goods for future delivery should be known to both parties involved in the salam agreement:ideally it should be in cashhowever, it is permissible to pay the price in kind subject to the (i) specification and (ii) quantity of goods to be delivered as capital in salam contract. This could be commodity, food or livestockPrice should be paid in full immediately by the time contract is concluded:this condition is necessary because in the absence of full payment by the musallim, salam will become tantamount to sale of a debt against a debtmoreover, the basic wisdom behind the permissibility of salam is to fulfill the instant needs of the musallam ‘alayhi. If the price is not paid to him in full, the basic purpose of the transaction will be defeatedh

owever, the musallam ‘alayhi

may at its discretion give a concession of two, three days to the musallim (Imam Malik), but this concession should not form part of the agreement

in no case, payment period must

be

equal to or greater than the delivery time of goods purchased under

salam

it

is not a

necessary ingredient

of

salam

that the price

be

always

lower than the market

price on

that day

Slide11

UNANIMOUS SHARIAH FEATURESA debt receivable from the musallam ‘alayhi cannot be converted into salam capitalSUBJECT MATTERS Commodities involved in the salam contract must be clearly known to both parties involved at the time of contract:no ambiguity and uncertainty should be left unaddressed which may lead to a dispute. All the possible details with regards to quality, quantity, etc. must be expressly mentionedif the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, according to the usage of its traders, its exact measure should be knownas quantity and quality must be exactly specified precious stones cannot be sold on the basis of salam because each stone differs in quality, size, weight, etc.

Commodities must be fungible

goods that share common features, such as wheat, rice, fruits, etc.:

this, may include standardized products of companies

it is not permitted to stipulate

salam

for the products of a

specific

tree, land or farm (possibility of that particular fruit, crop to be destroyed before delivery).

The

same rule

is applicable

to every commodity the supply of which is not certain

t

he

things whose quality or quantity

is not

determined

by specification

cannot

be sold through the contract of salam as its supply may not be certain

Slide12

UNANIMOUS SHARIAH FEATURESDate/dates of delivery and place of delivery should be certain and unambiguous:scholars differ on the shortest duration of time of delivery: three days, fifteen day, thirty days or whatever the contracting parties may decideSalam cannot be effected in respect of items that are ribawi in nature and must be delivered on spot (gold, silver, barley, etc.):similarly, cross sales (practice of selling amongst or between clients, markets, traders) are not allowed .Disposal of commodities is not allowed prior to maturity of contract: however, replacement with other commodities, except with cash, is allowedSECURITYA security in the form of a guarantee, pledge, mortgage or hypothecation may be required for a salam

contract in order to ensure that the musallam ‘alayhi

shall deliver the commodity on the agreed date:in the case of default in delivery, the guarantor may be asked to deliver the same commodity

if there is a mortgage, the buyer can sell the mortgaged property and the sale proceeds can be used either to realize the required commodity by purchasing it from the market or to recover the price advanced by him

Slide13

UNANIMOUS SHARIAH FEATURESDELIVERY OF GOODS AT DUE DATEThe delivery of goods at due date is the responsibility of the musallam ‘alayhi, and the acceptance of goods by musallim is required if goods are meeting the contractual specifications in quantity and quality:possession of goods can be physical or constructive, i.e.: transfer of risk and authority of use and utilization/consumptionThe delivery of the sale object by installments at specified times is permittedIt is permitted to:settle the contract by supplying superior

goodssettle

the contract at discount if musallam ‘alayhi provides inferior goods

settle the salam contract earlier than due date,

if required commodities are supplied by

musallam

alayhi

replace the commodities (except with currency) and settle the contract as the case may

be

Slide14

UNANIMOUS SHARIAH FEATURESIt is not permitted to:stipulate penalty clause for delay in deliveryhowever, musallam ‘alayhi can undertake in the salam agreement that in case of late delivery of salam goods, it shall pay to the charity account maintained by the musallim a sum calculated on the basis of a percentage per annum for each day of defaultBefore delivery, goods remain at the risk of seller. After delivery, risk is transferred to the purchaser:transferring of risk and authority of use and utilization/consumption are the basic ingredients of constructive possessionAfter taking delivery, the purchaser has the ‘option of

defect’ (khiyar al-’

aib):whereas the goods can be returned if found defective. It is the responsibility of the seller to supply goods free of error/defect or point out the defect to the buyer. In no way is he allowed to cover the defect of the goods which constitutes a fraudin one hadith, the Prophet has stated “He is not amongst us who indulges in fraud”therefore, the buyer has the right to return the good in case of a defect which is considered a defect in the market and which depreciates the value of the goods

.

Slide15

UNANIMOUS SHARIAH FEATURESAfter taking delivery, the purchaser does not have the ‘option of inspection’ (khiyar al-ruyat):whereas the goods can be returned after inspectionAGENCY AGREEMENTIf the musallim has no expertise to sell the commodities received under the salam contract, it can appoint the musallam ‘alayhi as its agent to sell the commodity in the market/third party, on condition that:salam and the agency agreements are separate from each otherA price at which the agent will sell the commodity must be determined:but if the price increases, the benefit can be given to the agentOn the other hand, if the musallim has expertise in the relevant

commodity:it can sell the commodity in the market or to a third

partyIt can hold the commodity to fetch a better market price to maximize its profit

Slide16

UNANIMOUS SHARIAH FEATURESPROMISE TO PURCHASEBefore maturity, the musallim can take promise to purchase from a third party. After taking delivery, the musallim will sell the same commodity to the promissee which will be bound to purchase it according to the undertaking:this promise should be unilateralPENALTY FOR LATE DELIVERYMusallam ‘alayhi can undertake in the salam agreement that in case of late

delivery, it shall pay to the charity account maintained by the musallim

a sum calculated on the basis of a certain % per annum, for each day of

defaultmusallim will spend this amount in charity purpose on behalf of the

musallam

alayhi

this

is a

sort of self-imposed

penalty to keep oneself away from default

Slide17

DEBATED SHARIAH FEATURESAVAILABILITY OF COMMODITIESIt is required that commodities involved in salam contract remains available in the market right from the day of contract up to the date of delivery:if a commodity is not available in the market at the time of the contract, salam cannot be affected, even though it is expected that it will be available in the market at the date of the delivery (Hanafi school)However, the Shafi’, Maliki, and Hanbali schools are of the view that the availability of the commodity in the market is necessary at the time of delivery only (so that in any case the musallam ‘alayhi should be able to discharge its liability)this second approach should be preferred.TIME OF DELIVERYIt is necessary that the time of delivery is at least one month from the date of agreement (this is perhaps to restrict the sale concessions and drive it towards processing in agriculture, construction, or manufacture):if the time of delivery is shorter, salam is not

valid as small farmers and traders should be given enough time to acquire the commodity (Hanafi and HanbalI

)Imam Malik supports this view but put the period at not be less than fifteen dayssome other jurists, like Imam Shafi’ and some Hanafi jurists oppose it on the ground that the Holy Prophet (pbuh

) has not specified a minimum period for the validity of salam

Slide18

DEBATED SHARIAH FEATUREScontemporary and prevalent opinion is that this issue should be left to the bargaining of the contacting parties

Slide19

SCOPE AND POTENTIAL OF SALAMSalam has been applied in the agricultural sector since before the life of the Prophet (pbuh), when it was a documented business methodProvide Islamically accepted financing alternative and avoid any involvement in ribàSalam is beneficial:to the musallam ‘alayhi, because it receives the price in advance and may finance its business ventureto the musallim, because normally, the price in salam is lower than the price in spot sales (or: spot price agreed is lesser than future prices on the actual date of delivery)

The original purpose of

this sale by way of exception and the reason of its agreement by Shariah was to address the needs of two categories of people:

small farmers who needed money to grow their crops (purchase seeds and fertilizers) and feed their families up to the time of harvest without falling pray of shark

loaning

small traders or artisans in need

of capital to export goods to other places and to import goods to their

homeland

Slide20

SCOPE AND POTENTIAL OF SALAMThe salam sale is suitable to finance the agricultural operations where the musallim can transact with farmers who are expected to have the commodity penalized during harvest time:thus the musallim renders great services to the farmers in their way to achieve their production targetsit is a valuable tool with to provide agricultural finance to large community of unserved/underserved farmers’practically, it is used to finance the agricultural needs of farmerSalam sale may also be used to finance commercial and industrial activities, especially in phases prior to production and export of commodities:

goods are purchased on salam and

marketed for a profitThe musallim

may finance the craftsmen and small producers through the salam sale by supplying them with the material for production

as a salam capital

in exchange of some

of their commodities

Slide21

RISK & RISK MANAGEMENTCounter-party risk: the musallam ‘alayhi may default after taking the payment in advanceCommodity price risk: whereas at the time the goods are received the price may be lower than the price that was originally expectedQuality risk, low investment return or loss: occurs when goods received are not of desired quality or unacceptable for the potential buyerAsset-holding risk: the musallim might not be able to market the goods in time, resulting in possible asset loss for the unsold goods and locking funds in the goods until they are sold, this implies possible extra expenses on storage and TakafulAsset-replacement risk: in case the musallim has to purchase goods from the market where the third party fails to supply the specified goods

Slide22

RISK & RISK MANAGEMENTFiduciary risk: if the musallam ‘alayhi has not delivered the goods as expectedRisk management:purchase only goods that have good marketing potentialtake proper security and a performance bondrequire from the prospective buyers earnest money in deposit and a binding promise to purchasea penalty clause in the salam contract against late delivery from the supplierparallel salam by purchasing similar goods from the market on spot

Slide23

DIFFERENCES WITH SIMILAR CONTRACTSBAY’ AL-SALAMMURABAHAHPrice is paid on spotPrice is paid in full

Price is either paid on spot or deferred

Price is paid in full or installment

Not executed in a particular commodity but commodity has specifications

Can be executed in particular commodity

Cannot be effected in respect of things which must be delivered at spot

Can be executed in things

which

must

be delivered at spot

SALAM

v

MURABAHAH

Murabahah

,

ijarah

and

salam

are the three nominative contracts that involve either the sale of a good or the sale of the use of a good

Slide24

DIFFERENCES WITH SIMILAR CONTRACTSBAY’ AL-SALAMBAY’ AL-ISTISNA’Salam can be effected on anything, no matter whether it needs manufacturing or not

The subject of

istisna’ is always a thing which needs manufacturing

It is necessary for

salam

that the price is paid in full in advance

Payment for

istisna’

can be made in staggered basis

The contract of

salam

, once effected, cannot be cancelled unilaterally

The contract of

istisnà

can be cancelled before the manufacturer starts the work

SALAM

v

ISTISNA’

Istisna

is an offspring of the

salam

contract

Slide25

DIFFERENCES WITH SIMILAR CONTRACTSSALAM v FUTURES & FORWARDSThough close parallels can be found with futures contracts or even with options, fundamental differences exist:Salam sale can be affected only for halal fungible goods which are generally available in the market at the time of delivery. Physical delivery of goods forming the subject matter of salam contract is required by Islamic lawIn case of futures and forwards, physical delivery is not required as in most of the cases the contract is settled on margins by the parties involved:hence: goods are not sold and purchased rather claims are sold and purchased which create no utility for the society as a whole. It is zero sum game where certain individuals gain on the expense of othersthis practice of settling contracts on margins has led to short selling which creates imbalance in the market

Hence: two basic features of the salam

sale differentiate it from futures and forwards:immediate payment of total price (not a percentage as margin)definite

delivery of goods

Slide26

SALAM AS A SHORT TERM FINANCE TOOLOver the generations, commercial salam has expanded to meet the needs of trade financiers:it has also spawned a derivative: istisnà’When utilized in the financial markets, the salam sales contract effectively provides a means to finance:financial institutions and investors can make a return by paying funds in full to a trader for future delivery of commodities knowing there is a third-party buyer and a ready supply in the marketlike other Islamic commercial methods, it might be better characterized as a processThe salam has

the flexibility to cover the needs of various sectors of activities where farmers, industrialists, contractors, exporters or traders are involved:it can be used to meet the capital requirements as well as to meet the cost of

operationsSalam, as a short term financial tool, allows an

entreprise to limit its risks, define future profit opportunities with reasonable accuracy, and manage production timing to demand cycles

Slide27

SALAM AS A SHORT TERM FINANCE TOOLEXIT STRATEGYOff-take mechanism: before entering into a salam agreement, the musallim, who will be acquiring title to the commodities on deferred delivery and who is not a direct consumer of the goods, has to have in place a creditworthy pre-agreed on-sale (or other exit strategy) mechanism with the end-consumer/buyerAgency agreement: the musallam ‘alayhi negotiates terms and conditions (price, qualifications, quality, quantity, delivery, etc.) with the end-buyer (if it acts as agent of the musallim through an agency agreement)The musallim

and the end-consumer/buyer execute an agreement for sale of the commodities that will be acquired by the musallim

from the musallam ‘alayhi. This agreement represents an exit strategy and can be implemented via a number of mechanisms:

parallel salam

:

(

i

) receives

the payment and signs contract of

salam

with promise to deliver the goods at a point in time in

future

Slide28

SALAM AS A SHORT TERM FINANCE TOOLijarah wa iqtinà’letter of creditpurchase orderThe end-buyer may secure the musallim’s delivery commitment with a mortgage, guarantee or letter of credit

Slide29

SALAM AS A SHORT TERM FINANCE TOOLSTEPS OF THE PROCESS AND MAIN AGREEMENTSThe salam (deferred delivery) agreement is signed between the musallim and the musallam ‘alayhi in line with the above:optional associated security agreements (guarantee or mortgage) may be signed Musallam ‘alayhi draws up a Transaction Notice (communication) with terms reflecting the above agreementM

usallim confirms acceptance (if agreeable with the Transaction Notice) to the musallam

‘alayhi by sending a Purchase Order

Musallim pre-pays musallam ‘

alayhi

for the commodities for future delivery

Musallim

assumes titles to the commodities which are delivered by the

musallam

alayhi

to the end-buyer who signs off on acceptance

End-buyer pays

musallim

as per the off-take mechanism agreed upon

letter

of credit or promise to pay between producer and end-buyer

Slide30

SALAM AS A SHORT TERM FINANCE TOOLPARALLEL SALAMAfter the execution of the salam agreement with one party, musallim or musallam ‘alayhi may execute another salam agreement, for the same date of delivery, to sell the proceeds once taken over, under the following conditions:all rulings listed for the salam contract apply to the parallel salam agreementthere must be two different and independent contracts, these two contracts cannot be tied up and performance of one (rights and obligations) should not be contingent on the performance of the other. In other words, execution of the second contract is not conditional to the fulfillment of the first contract of salamparallel

salam is allowed with third party only. Otherwise, it will become a buy-back contract, which is not permissible in

Shariah

Slide31

PRACTICAL STEPSstep 3: musallam ‘alayhi in first salam contract delivers the goods to musallim on due date to discharge its liabilitystep 4: musallam ‘alayhi of the 2nd salam delivers the goods to 2nd musallim in parallel salam contract

Slide32

ISLAMIC BANKING PRODUCTSHybrid Salam FinancingSalam Financing Working CapitalParallel Salam Financing

Slide33

SALAM COMBINED WITH MURABAHAHMusallim can sell the salam commodity to the musallam ‘alayhi on murabahah, subject to the following terms:salam agreement and murabahah agreement should be independent, not contingent and with free will of the partiesmurabahah will be executed after taking the possession of salam goods musallim shall assume the risk of loss by taking delivery and execution of the murabahahmusallim

cannot take undertaking from the musallam

‘alayhi that it will purchase the salam commodity from bank on a murabahah

basis