Salam
Salam is a forward financing transaction, where the financial institution pays in advance for buying specified assets, which the seller will supply on a pre-agreed date. What is given in exchange for the advance payment of the price should not in itself be in the nature of money. For the payment in advance, the contracting parties stipulate a future date for the supply of goods of specified quantity and quality.
Salam may be considered as a kind of debt, because the object of the Salam contract is the liability of the seller, up to the agreed future date, to deliver the object for which advanced payment of the price has already been made. There is consensus among Muslim jurists on the permissibility of Salam, notwithstanding the general principle of the Shari´ah that does not permit the sale of a commodity which is not in the possession of the seller, because the object of the contract is that the goods are a recompense for the price paid in advance, just as the price is recompense paid for getting the goods in advance. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. Muslim jurists are unanimous that full payment of the purchase price is key for Salam to exist. However, Salam cannot take place in money or currencies as these are subject to rules relating to bai al-sarf, wherein exchange has to be simultaneous.
Because the Salam contract deals with the delivery of an asset which is not in existence, the Shari´ah highlights that strict rules must be adhered to in order to ensure that the right of all parties are protected. In fact, it is necessary that the quality of the commodity is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The commodity should be generally available in the market at the time of delivery. And all goods that can be categorized as belonging to the same species can be the subject of Salam. However, Salam cannot take place between identical goods. Besides, the time and place of delivery of the goods should be precisely fixed; and the quality and the quantity of the goods should be clearly specified. The specification of goods should particularly cover all those characteristics which could cause variation in price.
Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam contract can stipulate that that, in the event of late delivery of the goods, the supplier pays a certain amount as a penalty to the buyer, which amount must be used for a charitable purpose; it cannot be taken into the buyer’s income. The buyer has also the right to demand security or collateral from the seller to ensure that the seller delivers the goods on the agreed date, the buyer has the right to dispose of the security and purchase the specified goods from the market; the buyer is entitled to deduct the advance payment from the proceeds of the security realised and return any surplus to the seller.
Istisna´a, like salam, is a special kind of sale contract where a sale is transacted before the goods come into existence. However, there are several points of difference between Istisna’a and Salam. In fact, the subject of Istisna’a is always a thing which needs manufacturing, while Salam can be effected on anything, no matter whether it needs manufacturing or not. Also, it is necessary for Salam that the price is paid in full in advance, while it is not necessary in Istisna’a where payment can be made in staggered basis. And the object of the Salam is a liability on the seller to deliver, thus should be in the form of fungible. Under the Istisna’a, the asset manufactured must meet specification of the order and the buyer has the right not to take possession of the asset if the specifications are not met. In addition, the time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna’a that the time of delivery is fixed. Any penalty for charged late delivery can reduce the price of an Istisna’a contract but in a Salam, the penalty amount is paid should not be taken as benefit for the buyer.
Salam may be considered as a kind of debt, because the object of the Salam contract is the liability of the seller, up to the agreed future date, to deliver the object for which advanced payment of the price has already been made. There is consensus among Muslim jurists on the permissibility of Salam, notwithstanding the general principle of the Shari´ah that does not permit the sale of a commodity which is not in the possession of the seller, because the object of the contract is that the goods are a recompense for the price paid in advance, just as the price is recompense paid for getting the goods in advance. The transaction is considered Salam if the buyer has paid the purchase price to the seller in full at the time of sale. The idea of Salam is to provide a mechanism that ensures that the seller has the liquidity they expected from entering into the transaction in the first place. Muslim jurists are unanimous that full payment of the purchase price is key for Salam to exist. However, Salam cannot take place in money or currencies as these are subject to rules relating to bai al-sarf, wherein exchange has to be simultaneous.
Because the Salam contract deals with the delivery of an asset which is not in existence, the Shari´ah highlights that strict rules must be adhered to in order to ensure that the right of all parties are protected. In fact, it is necessary that the quality of the commodity is fully specified leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be expressly mentioned. Salam can be effected in those commodities only the quality and quantity of which can be specified exactly. The commodity should be generally available in the market at the time of delivery. And all goods that can be categorized as belonging to the same species can be the subject of Salam. However, Salam cannot take place between identical goods. Besides, the time and place of delivery of the goods should be precisely fixed; and the quality and the quantity of the goods should be clearly specified. The specification of goods should particularly cover all those characteristics which could cause variation in price.
Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam contract can stipulate that that, in the event of late delivery of the goods, the supplier pays a certain amount as a penalty to the buyer, which amount must be used for a charitable purpose; it cannot be taken into the buyer’s income. The buyer has also the right to demand security or collateral from the seller to ensure that the seller delivers the goods on the agreed date, the buyer has the right to dispose of the security and purchase the specified goods from the market; the buyer is entitled to deduct the advance payment from the proceeds of the security realised and return any surplus to the seller.
Istisna´a, like salam, is a special kind of sale contract where a sale is transacted before the goods come into existence. However, there are several points of difference between Istisna’a and Salam. In fact, the subject of Istisna’a is always a thing which needs manufacturing, while Salam can be effected on anything, no matter whether it needs manufacturing or not. Also, it is necessary for Salam that the price is paid in full in advance, while it is not necessary in Istisna’a where payment can be made in staggered basis. And the object of the Salam is a liability on the seller to deliver, thus should be in the form of fungible. Under the Istisna’a, the asset manufactured must meet specification of the order and the buyer has the right not to take possession of the asset if the specifications are not met. In addition, the time of delivery is an essential part of the sale in Salam while it is not necessary in Istisna’a that the time of delivery is fixed. Any penalty for charged late delivery can reduce the price of an Istisna’a contract but in a Salam, the penalty amount is paid should not be taken as benefit for the buyer.
Parallel Salam
Selling the goods purchased in a Salam contract prior to taking delivery is not generally allowed in Shari´ah. Instead, it is allowed for the Islamic bank to make parallel Salam contracts for the same goods to be delivered even at the date and time of delivery of the original Salam. In this an arrangement, there must be two different and independent contacts; one where the bank is a buyer and the other in which it is a seller. The two contracts cannot be tied up in a manner that the rights and obligations of one contact are dependent on the rights and obligations of the parallel contract. And each contract should have its own force and its performance should not be contingent on the other.
For Example, if A has purchased from B 100 tons of wheat by way of Salam to be delivered on 31st December, A can contract a parallel Salam with C to deliver to him 100 tons of wheat on the same date. But while contracting Parallel Salam with C, the delivery of wheat to C cannot be conditioned with taking delivery from B. Therefore, even if B did not deliver wheat on 31st December, A has the duty to deliver the agreed quantity of wheat to C. He can seek whatever recourse he has against B, but he cannot rid himself from his liability to deliver wheat to C. Similarly, if B has delivered defective goods which do not conform to the agreed specifications, A is still obliged to deliver the goods to C according to the specifications agreed with him.
After purchasing a commodity by way of Salam, the Islamic Bank may sell it through a parallel contract of Salam for the same date of delivery. The period of Salam in the parallel transaction being shorter, the price may be a little higher than the price of the first transaction, and the difference between the two prices shall be the profit earned by the institution. Generally, the shorter the period of Salam contract, the higher the price and the greater the profit.
Parallel Salam is allowed with a third party only. The seller in the first contract cannot be made purchaser in the parallel contract of Salam, because it will be a buy-back contract, which is not permissible in Shari´ah. Each one of the two contracts entered into by a bank should be independent of the other, but the bank, as seller, can sell the goods on parallel Salam on similar conditions and specifications as previously purchased on the first Salam contract without making one contract dependent on the other. If the purchaser in the second contract is a separate legal entity, but it is fully owned by the seller in the first contract the arrangement will not be allowed, because in practical terms it will amount to ‘buy-back’ arrangement. For example A has purchased W quantity of wheat by way of Salam from a company B. C is a subsidiary of B, which is a separate legal entity, but is fully owned by B, then A cannot contract the parallel Salam with C. However, if C is not wholly owned by B, A can contract parallel Salam with it, even if there are some common shareholders between B and C.
However, some parallel contract arrangements may not be an attractive mode of disposal of goods for Islamic banks, as the advance payment of the price in the first Salam contract would be disinvested when the buyer in the parallel contract made the advance payment to the bank for the purchase of the goods under the parallel contract.
For Example, if A has purchased from B 100 tons of wheat by way of Salam to be delivered on 31st December, A can contract a parallel Salam with C to deliver to him 100 tons of wheat on the same date. But while contracting Parallel Salam with C, the delivery of wheat to C cannot be conditioned with taking delivery from B. Therefore, even if B did not deliver wheat on 31st December, A has the duty to deliver the agreed quantity of wheat to C. He can seek whatever recourse he has against B, but he cannot rid himself from his liability to deliver wheat to C. Similarly, if B has delivered defective goods which do not conform to the agreed specifications, A is still obliged to deliver the goods to C according to the specifications agreed with him.
After purchasing a commodity by way of Salam, the Islamic Bank may sell it through a parallel contract of Salam for the same date of delivery. The period of Salam in the parallel transaction being shorter, the price may be a little higher than the price of the first transaction, and the difference between the two prices shall be the profit earned by the institution. Generally, the shorter the period of Salam contract, the higher the price and the greater the profit.
Parallel Salam is allowed with a third party only. The seller in the first contract cannot be made purchaser in the parallel contract of Salam, because it will be a buy-back contract, which is not permissible in Shari´ah. Each one of the two contracts entered into by a bank should be independent of the other, but the bank, as seller, can sell the goods on parallel Salam on similar conditions and specifications as previously purchased on the first Salam contract without making one contract dependent on the other. If the purchaser in the second contract is a separate legal entity, but it is fully owned by the seller in the first contract the arrangement will not be allowed, because in practical terms it will amount to ‘buy-back’ arrangement. For example A has purchased W quantity of wheat by way of Salam from a company B. C is a subsidiary of B, which is a separate legal entity, but is fully owned by B, then A cannot contract the parallel Salam with C. However, if C is not wholly owned by B, A can contract parallel Salam with it, even if there are some common shareholders between B and C.
However, some parallel contract arrangements may not be an attractive mode of disposal of goods for Islamic banks, as the advance payment of the price in the first Salam contract would be disinvested when the buyer in the parallel contract made the advance payment to the bank for the purchase of the goods under the parallel contract.
Risk management in Salam
Islamic banks need to take special care in Salam operations. They face a number of risks. Counter-party Risk is one of some common risks in Salam-based financing, in fact, the client may default after taking the payment in advance. Commodity Price Risk, where at the time the goods are received the price may be lower than the price that was originally expected, is another risk associated to Salam. There is also Quality Risk, low investment Return or Loss, which occurs when goods received are not of desired quality or unacceptable for the potential buyer. The bank might also 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 is Asset-Holding Risk that implies possible extra expenses on storage and Takaful. And in case the Islamic bank has to purchase goods from the market in parallel Salam, where the third party fails to supply the specified goods under the parallel contract, the bank faces an Asset-Replacement Risk. Finally, parallel Salam, if original Salam seller has not delivered the goods as expected, it is considered as Fiduciary Risk.
In order to manage and mitigate the above risks, Islamic banks need to take proper measures. In fact Islamic banks purchase only goods that have good marketing potential; they take proper security and a performance bond; they require from the prospective buyers a sufficient amount of earnest money in deposit and a binding promise to purchase these goods; they also insert a penalty clause in the Salam contract to protect themselves from a late delivery from the supplier; and they accomplish the responsibility of parallel Salam by purchasing similar goods from the market on spot to supply these to the buyer and recover the loss, if any, from the seller in the original Salam.
In order to manage and mitigate the above risks, Islamic banks need to take proper measures. In fact Islamic banks purchase only goods that have good marketing potential; they take proper security and a performance bond; they require from the prospective buyers a sufficient amount of earnest money in deposit and a binding promise to purchase these goods; they also insert a penalty clause in the Salam contract to protect themselves from a late delivery from the supplier; and they accomplish the responsibility of parallel Salam by purchasing similar goods from the market on spot to supply these to the buyer and recover the loss, if any, from the seller in the original Salam.