Istisnā' and Its Application in Islamic Banking

Brill
Istisnā' and Its Application in Islamic Banking

Author(s): Muhammad Al-Bashir Muhammad Al-Amine
Source: Arab Law Quarterly, Vol. 16, No. 1 (2001), pp. 22-48
Published by: Brill
Stable URL: http://www.jstor.org/stable/3381952
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ISTISNA' AND ITS APPLICATION IN
ISLAMIC BANKING
MuhammadAl-Bashir Muhammad Al-Amine*
INTRODUCTION
The emergence of Islamic banking represents one of the important characteristics

of Islamic resurgence in our time. Many Islamic commercial contracts such as
Muddrabah, Mushdrakah, and Murdbahah have been revived. Istisnd' in its own
right can play an important and, in many ways, a leading role in the Islamic
banking system, especially when the major parts of goods in a commercial
transaction are manufactured goods and notably due to the flexible legal nature of
Istisnd' and its secure aspect of investment.
Despite the scattered discussion about this contract in the classical juristic
works, especially the Hanafi jurists and the single detailed legal study of Kasib al-
Badran in the 1970s, followed in 1991 by the work of al-Tadamun Bank, the topic
did not receive much attention until recently. However, al-Badr5n's study is
somewhat impractical as it has endorsed some rules which are unacceptable
nowadays although it still has the merit of being the first detailed study on Istisnd'.
Meanwhile, al-Tadamfn Bank's study is good on some legal aspects even if it did
not touch certain other issues, yet it is shallow on the practical and economic
aspects of Istisnd'.
The first academic discussion of a modem type about the legal aspect of Istisnd'
and its possible application in Islamic banking was in the seventh session of the
Islamic Fiqh Academy,' where different papers were presented and an important
resolution was adopted. This was followed by another similar discussion held in
Qatar in conjunction with the twenty-second meeting of directors of investment in
Islamic banks.
But despite these welcome scholarly efforts, the topic is still in need of a detailed
study, which will relate the theoretical aspects with the practical position, and lay
down the legal basis for some of the new elements introduced in this contract due
to modem practice. Among the issues that call for further investigation must be
mentioned the clause about liquidated damage, the arbitration clause, the
* PhD student, Faculty of Laws, International Islamic University.

The session was held in Jeddah, Saudi Arabia, from 7 to 12 Zul-qa 'idah 1412H, March 1991.
Arab Law Quarterly, [2001] 22-48

? 2001 Kluwer Law International. Printed in the Netherlands.
22
ISTISNA' AND ISLAMIC BANKING 23
possibility of rebate for any customer who reimburses in time or before the due
date, or the problem of security and risk management in this contract.
Thus, since there is no specific Qur'5nic Ayah or Hadfth which establishes
clearly the legality of this contract, a brief study of the doctrine of freedom of
contract in Islamic law is necessary, because the specific evidence advanced by the
jurists is somewhat less than convincing. This article also addresses the legality of a
contract in which the subject-matter is non-existent and its relation to Istisnd'. As
well as this I will discuss the distinctive features of Istisnd' and its independence
from other contracts to avoid some of the confusing remarks advanced by some
scholars in this area.
Furthermore, since Istisnd' is a special kind of contract we need to look into its
relation with options (khiydrat); especially the option of defect (khiydr al-'ayb) and
the violation of the desired description (khiydr al-wasf). Closely related to the
study of options is stipulation by the seller (Islamic bank) to preclude his liability
for any defect in the commodity and its special consequences regarding the
contract of Istisnd'. The binding effect of this contract and its crucial effect in the
stability of transactions nowadays will be elaborated upon especially since the
majority of the classical jurists consider it as not binding. This opinion naturally
makes this contract of no use in our time.
The clause of liquidated damages and penalties in the contract of Istisnd'
deserves careful attention due to its practical consequences on the one hand, and its
modern academic discussion as a principle in Islamic commercial law on the other.
This is balanced by the effect of change of circumstances and its legal
consequences in the contract of Istisnda.On the other hand, as in any transaction,
the possibility of dispute in the application of Istisnd' is inevitable. Therefore, the
methods of dispute settlement need to be tackled. Arbitration as a way of dispute
settlement deserves special attention since Islamic banks include in their contract
an arbitration clause.
Moreover, we will examine the role of Istisnd' in economic development where
Istisnd' can play an important role by developing the manufacturing sector,
financing economic activities, stabilising the price of manufactured goods,
promoting the industrial and technological advancement and contributing to the
involvement of many streams of society in economic activities. Furthermore, we
will look into areas of application where Istisnd' is applicable to the various
industries as long as it can be monitored by measurement and specification and can
be manufactured or constructed at any stage of the process of its application. In
addition, we will explore the different modes of its application, either Istisnd' sale
or parallel Istisnd' and the legal status of the parties in the contract. Finally, the
criteria of project evaluation in Istisnd' will be elaborated upon covering the legal
or Shari' criterion, the commercial viability of the project, the financial situation of
the application or his management record, and the strategy of security and risk
management and insurance.
24 ARAB LAW QUARTERLY
CONCEPT AND DEFINITION
According to most authoritative Arabic dictionaries, the word Istisnd' is derived

from the word Sana'a which literally means "making,2 manufacturing, or
constructing something".3 Although the dictionary meaning of the word is to
make a thing, its juridical meaning is disputed among the jurists. Some jurists
define it by giving examples; others tackle it through its essence and attributes. For
instance, it is defined as "when one orders a craftsman to prepare a piece of
furniture for a determined price, to be delivered later, or one may engage a cobbler
to make a pair of shoes for a fixed price".4 It is also defined as "a contract with a
manufacturer to make something".5 However, al-Zarqa defined it as a contract of
selling a manufacturable thing with an undertaking by the seller to present it
manufactured from his own material, with specified descriptions and at a
determined price.6
ISTISNA' AND ITS RELATIONSHIP WITH

OTHER CONTRACTS
It is necessary to study the distinctive features of Istisnd' and its independence to

avoid some of the confusing expressions reported by some scholars in this area.
First, the Malikis, Shafi'is and Hanbalis consider Istisnd' as a variation of Salam,
then they subsume it under the definition of Salam. On the other hand, some of
the Hanafi scholars considered Istisnd' as a pure Ijdrah. Others considered it as
Ijdrah at the beginning and a sale at the end of the contract.7
First of all, despite the fact that Istisnd' and Salam have some points of
similarity, such as the non-existence of the subject-matter or the future delivery,
there are some points of differences as:
(1) The subject-matter in Istisnd' is always something that needs manufacturing
while Salam is possible in anything whose descriptive conditions can be
fulfilled;
2 Ibn Manzfr, Muhammad Ibn

Mukarram, Lisan al-'Arab, Dar Sadir, Beirut, Lubnan, 1955, Vol. 8,
pp. 208-212.
3 Ibn Yacoub al-Fayrozabadi, al-Qdmas al-Muhit, Mua'ssasat al-Risalah, Beirut, 1983, p. 54. See
also E. W. Lane's, Arabic English Lexicon, Islamic Book Centre, Lahore, Pakistan, 1982, Vol. 4,
p. 1733.
4 Al-Kasani, Abu Bakr Ibn Masud, Baddi' al-Sand'i Fi
Tartrb al-Shardi', Dar al-Kutub al-
'Ilmiyyah, Cairo, 1948, Vol. 6, p. 2677.
5 'Al a' al-Din al-Samarkhandi, Tuhfat al-Fuqaha', Mat ba'at Jdmiat Dimashq, Damascus, 1983, Vol.
2, p. 538.
6 Al-Zarqa, Mustapha Ahmad, 'Aqd al-Istisna' Wa madd Ahammiyyatuhu Fi al-Istithmardt al-
Islamiyyah al-Mu'dsira (Lecture Series of Renowned Scholars No. 12), Islamic Development Bank,
Jeddah, 1995, p. 21.
7 Ibn al-Humam, Muhammad Ibn'Abd al-Wahid, Fath al-Qadir, Maktabat al-Rashidiyyah,
Pakistan, 1985, Vol. 2, p. 32.
(2) It is necessary in a Salam contract that the price is paid in advance while in
Istisnd' it can be prompt, deferred or paid in instalments;8
(3) The classical jurists have also maintained that Salam is binding while
Istisnd' is not. However, this is not the modern approach;
(4) The classical jurists have also pointed out that the time of delivery is an
essential part in the contract of Salam while it is not necessary in Istisnd'.9
However, modern jurists reject this point of difference, as we shall see later.
Concerning the relation between Istisna' and Ijdrah it should be noted that the
manufacturer in Istisnd' undertakes to make the required goods with his own
material. However, if the customer provides the material, and the manufacturer is
required to use his labour and skill only, then, the transaction is not Istisnd' but
becomes Ijdrah instead.
Regarding the point of similarity between Istisndr and Ju'dlah is that in both
contracts the work or the labour is a condition, but they differ in the fact that Istisnd'
is only possible in manufactured goods while Ju'dlah applies to everything.
Furthermore, the labour can be well determined in Istisna"but this might not be
the case in Ju'dlah. In addition, they differ in their subject-matter which in the
contract of Istisna' is the labour and the material, but it is only the labour in Ju'dlah.10
With reference to the relation between Istisnd' and Murdbahah it should be
noted that Murdbahah is basically the sale of goods at a price covering the purchase
price plus a margin of profit agreed upon by both parties concerned1"while Istisnd'
is a contract where the deal can be referred to something not in existence at the
time of concluding the contract. However, Istisnd' has some more advantageous
characteristics as a method of investment by directly financing the manufacturing
of commodities, paying salaries to workers and bearing the administrative costs. In
Murdbahah, the role of the bank is restricted just to the act of selling. Moreover, in
Murdbahah, the transaction would not be considered as legal unless the Islamic
bank owns the commodity first before transferring it to the buyer. During this
period of ownership of the commodity by the Islamic bank, there is a possibility of
risk of damage or loss while in Istisnd' the commodity will be transferred only after
its completion.
Finally, the difference between sale and Istisnd' is more obvious since in absolute
sale there is no labour while in Istisndait represents the cornerstone of the contract.
Thus, it appears clear that the contract of Istisnda is not Salam, or Ju'dlah, Ijdrah,
or an ordinary contract of sale. It is an independent kind of contract with is own
conditions. Moreover, it combines the distinctive traits of some of these contracts,
such as:
8 Dunya, Shawkhi Ahmad, al-Ju'ala wa al-Istisna' Tahlil

Fiqhi wa Iqtisddi, al-Bank al-Islarnmi
Li al-
Tanmiyah, Jeddah Saudi Arabia, 1991, p. 30.
9 Ibn 'Abidin, Rad al-Mukhtar' ala Sarh al-Dur al-Mukhtar, al-Maktaba al-Tijariyyah, Makkah al-
Mukarramah, 1986, Vol. 5, p. 225.
10 Al-Qaradaghi,
"'Aqd al-Istisna' ", Majallat Majma' al-Fiqh al-Isami, No. 7, Vol. 2, 1992, pp.
336-344.
" Sudin
Haron, Islamic Banking Rules and Regulations, Pelanduk Publications, Selangor, Malaysia,
1997, p. 75.
(1) The distinctive traits of Salam as to its permissibilityeven though the

subject-matterof the contractis not in existenceat the time of the contract;
(2) In addition,the distinctivetraitof the ordinarysale wherebythe price can
be paid by instalmentsor deferredand it is not necessarilyto be advancedas
in Salam.
THE LEGAL BASIS OF ISTISNA'
Beforeproceedingwith the specificevidencesadvancedby the classicaljuristsfor

the legalityof this contract,it is necessaryto discuss brieflythe theoryof freedom
of contractin Islamiclaw andthe contractbasedupon a non-existentobjectdue to
their crucialimportancein the legalityof Istisnd'.
Freedom of contract in Islamic law

The relevanceof this theorywith Istisnd"lies in the fact that first of all, thereis no
explicit text from the Qur'dnand Sunnahto establishthe legalityof this contract
and the main basis for its legalityas advancedby the classicaljurists is Istihsdn
which is basedupon need andnecessity.It seems that the argumentof necessityor
need is less convincing since it implies that the possibility of admitting new
contracts is the exception and not the norm in Islamic law. However, by
elaboratingthe principleof freedomof contract,we will be able to demonstrate
that the possibilityof addinga new contractis normaland not exceptional.As a
result,the contractof Istisnd will be basedupon the wide principleof freedomof
contractand not the result of necessity.
In addition, the modem applicationof the contract of Istisnd witnessed a
fundamentalshiftfromthe conceptof Istisndas it was dealtwith in the classicallegal
discourseconcerningsuchsubjectsas the contractis bindingfromthe verybeginning,
recourseto the doctrineof unforeseencircumstances, or recourseto arbitration before
a judicialcourt, and especiallythe introductionof punitiveand liquidateddamage
clauseswhich lead somemodemwritersto contendthat such a clausewill drivethe
contractof Istisnd beyond the limits of what is allowedby the classicaljurists.12
However,these changesand otherchangesin the contractof Istisndcouldsafelybe
accommodated underthe broadprincipleof freedomof contract.
Muslim scholarshave advanceddivergentopinions with regardto the freedom
of the contractingpartiesto concludethe contractthey thinkfit or to stipulatethe
conditionsthat they desire.This diversityof opinionscan be summarisedinto two
categories:some hold that all contractsand the conditionsattachedto them are
consideredto be prohibitedexcept those permittedby the Shari'ah.The Zahiri
School championed this opinion. Likewise, rules formulated by Hanafiyyah,
Shafi'iyyah, and Malikiyyah are based on a similar opinion. However, jurists other
12
Al-Badran, Kasib, 'Aqd al-Istisnd' Fi al-Fiqh al-Islami Dirasah Muqcdranah,Dar al Da'wah al-
Islamiyyah, al-Iskandariyyah, 1980, p. 218.
than the Zahiri are relatively more liberal since they accept Qiyds and Maslahah
(Public Interest).
The opponents of freedom of contract cited a Hadith, where the Prophet is
reported to have said: "Whatever condition there be which is not in the Book of
God is void even if it were a hundred conditions. The judgment of God is truer
and His conditions are more binding. Patronage belongs only to the emancipa-
tor".13 Similarly, it is reported that the Messenger of God said: "if anyone does a
deed that we have not commanded, then it will be repudiated".14 Hence, they
concluded that all contracts and conditions are prima facie invalid unless their
making has been permitted by a rule of law.15
On the other hand, the advocates of freedom of contract in Islamic law held that
the non-restriction of nominated contracts represents the general rule, while any
restriction is considered to be exceptional. They based their argument on the
Qur'anic verses: "Oh you who believe fulfil all obligations" (Al-Ma'idah 5:1). This
stand is supported by the verse: "He hath explained unto you that which is
forbidden unto you except under compulsion or necessity" (al-An'dim 6:119),
which means that, in the natural state of things, there is a presumption of legality.
All acts and dispositions (including the making of contracts and conditions) are
valid (mubdh)unless they have been expressly prohibited.16 Besides, they cited the
saying of the prophet: "Every stipulation is lawful among the Muslims, except one,
which declares forbidden what is allowed or allows what is forbidden".17
It seems that it is right and logical to follow the second school. This is, first of
all, due to the strength of the evidence and arguments advanced, and on the other
hand, every age or country has contracts and transactions to which it is
accustomed, and it will amount to imposing hardship on people to require a legal
text from the Qur'in and Sunnah which authorises every contract or condition.
Thus, contracts and conditions that have expanded nowadays to an extent
unknown to early fuqaha' would be paralysed and people would be faced with
serious difficulties, whereas Allah (s.w.t.) has said: "Allah desires for you ease, He
does not desire for you difficulty" (al-Baqarah 2:185). Therefore, it could be
submitted that the contract of Istisnd' is legally based upon the theory of freedom
of contract and it is only under this theory that the drastic shift in the modern
concept of Istisnd' from its concept in the classical literature could be justified.
Sale of a non-existent object and its relationship to Istisni'

The importance of studying the existence of the subject-matter of a contract
during the conclusion of Istisnd' lies, first of all, in the fact that the contract of
13 Sahih al-Bukhdri with Fath al-Bdri (Book of Conditions), al-Matba'ah al-Salafiyyah, Vol. 4, p. 369.
14 Sahih Muslim (Book of Aqdiyah), Kitab al-'Aqdiyah, Hadith No. 1718.
's Ibn Hazam, al-Muhalla, Dar al-Kutub al-Islamiyyah, Beirut, Lubnan, 1988, Vol. 8, p. 412.
16 Abhath Hai'at Kibar al-'Ulama' Bi al-Mamlakah al-'Arabiayyah al-Saudiyyah, Matab'at Ibn
Khuzaimah, Riyad, 1991, Vol. 1, pp. 101-130.
17 Sahih Muslim, Kitab
al-Shurot, Hadrth No. 2876.
Istisnd' is basically a future trading contract where the subject-matter is non-

existent at the time of the contract. Secondly, due to the interpretations of the
Hadith: "Do not sell what is not with you",'8 three schools of law did not recognise
the contract of Istisnd' as an independent contract and subsumed it under Salam.
Moreover, some scholars went further and mentioned explicitly the illegality of the
contract of Istisnd'.19Besides, the Hanafis considered Istisnd' as an independent
contract, however, they maintain that it is legal on the basis of Istihsdn and not
under Qiyds or the general principles of contract, because it is a sale of what one
does not have.20 However, this opinion as we shall see is rejected by modern
scholars due to their endorsement of the broader interpretation of Ibn Taymiyah
and Ibn al-Qayyim. On the other hand, the Hanafis consider Istisnd' as not binding
and their main argument is that it is a sale of what has not been seen.21 For these
reasons and other matters, it seems necessary to elaborate briefly on the different
interpretations of this Hadith and its effect on the contract of Istisnd'. There are
different interpretations of the Hadith in question:
(1) "Do not sell what is not with you" means not to sell what one does not own
(la tabi'ma laisa 'indaka) at the time of sale;22
(2) Some other jurists and Hadith scholars hold that this Hadith applies only to
the sale of a specified object (al-'ayn) and not to fungible goods as these can
be substituted or replaced with ease;
(3) A third position is that a sale of "what is not with you" means the sale of
what is not present and what the seller cannot deliver. This is the view of
Ibn Taymiyah;23
(4) Finally, some contemporary legal writers have taken into consideration the
changes of market in the present circumstances compared to the time of the
Prophet.24Therefore, the possibility of gharar or dispute is not present here.
The specific legal basis of Istisni'

Muslim jurists have tried to establish the legality of this contract from different
legal sources: the Qur'5n, the Sunnah, Ijma', Qiyds, Istihsdn, and Maslahah.
However, Istihsdn seems to represent the first legal basis for this contract especially
in the literature of the classical schools of law. Al-Kdsdni in this regard said:
Concerningthe legalityof Istisnd',in principleit wouldnot be allowedon the basisof Qiyds
becauseit is a sale of what we do not have nor on the basis of Salamand the Prophethad
18s Abu Dawfid, Sunan, Hadith No. 2187.

19 Ibn Muflih, Kitab al-Fura', 'Alam al-Kutub, Beirut, Lubnan, 1984, Vol. 4, p. 24.
20
Al-Kasani, Baddi' al-Sandi', Vol. 6, p. 2678.
21
Ibid., p. 2680.
22
Muhammad Ibn Isma'il al-San'ani, Subul al-Salam Sharh Bulagh al-Maram, al-Maktabah al-
Tijariyyah, Cairo, Vol. 3, p. 17.
23 Al-Baghawi, Abu
Muhammad al-Husayn, Sharh al-Sunnah', al-Maktab al-Islami, Damascus,
n.d., Vol. 8, pp. 140-141.
24
For further details, see Kamali, "Islamic Commercial Law, An Analysis of Futures", The
American Journal of Islamic Social Sciences, Vol. 13, Summer 1996, No. 2, pp. 205-7.
prohibitedthe sale of what we do not have ... and it is allowed based on Istihsdnbecause
people are unanimousabout its need. They have used it throughthe ages and the Prophet
has said "My communityshallneveragreeon an error"25and "Whatis good for Muslimsis
good in the sight of Allah".26
It is also claimed that this contract is based on Ijma'.27 The claim of Ijma' by the
Hanafis is widespread among the major Hanafi works, such as al-Mabsut and al-
Badai'.
Regarding the basis of Istisnd' under public interest (Maslahah), which refers to
unrestricted public interest in the sense of not having been regulated by the lawgiver
and no textual authority can be found on its validity or vice versa,28al-Ashgar said:
"The use of this contract, for example: in building construction, shoes, furniture and
other items without objections from the scholars is a demonstration of the general
need. Therefore, it should be legal on the basis of public interest".29
On the other hand, Siddiq al-Darir maintains that Istisnd' is based on Qiyds and
not against it as it is claimed by the Hanafis. He argues that although the subject-
matter in this contract does not exist, its availability is certain, and there is no risk
(gharar) especially in the opinion that Istisnd' is a binding contract. Then it is a
legal contract, and any contract free from excessive risk (gharar) is a contract in
accordance with QZiyds.30
Besides, according to al-Ashgar the legality of this contract can be demonstrated
by the Qur'inic guidance in the story of Zulqarnain where some people requested
him to build a barrier between them and the Gog and Magog people (Surat al-Kahf
18:94). Commenting on this verse, Ibn Abbas said "kharajan" means big reward.
According to al-Ashgar, this verse represents a guidance in the Qur'an for the
legality of the contract of Istisnd'.31
But it seems that this agreement may have been concluded as a leasing contract
or any other type of contract or even a pure charity. Therefore, the claim of
considering it as evidence for the legality of Istisnd' is hard to accept. On the other
hand, this contract is also contended to be based on a Hadith that the Prophet had
ordered the manufacture of a ring32 and a pulpit33 for himself. However nothing
prove that the ring or the pulpit are made under Istisnd'.
25
Ibn Majah, Sunan Ibn Majah, Kitab al-Fitan, Hadith No. 3950.
26
This is not a genuine Hadith. It is just the saying of Ibn Mas'ud, reported by Ahmad, al-Bazzar and
al-Tabari, see Ahmad Shakir's comment on Musnad al-Imam Ahmad, Vol. 5, p. 211, Hadith No. 3600.
27
See al-Kifayah, Vol. 3, p. 222.
28
Kamali, Muhammad Hashim, Principles of Islamic Jurisprudence, Pelanduk Publications, Selangor
Darul Ehsan, Malaysia, 1995, p. 339.
29 Al-Ashgar, Muhammad
Sulayman, Bay' al-Murdbahah Kama tujrThal Bunak al Islamiyyah 'Aqd
al Salam Wa 'Aqd al-Istisnd' 'wa ImnquaniatIstifadat al-Bunak al Islamiyyah, Dar al-Nafa'is, Amman,
1995, p. 157.
30 See, al-Darir, Siddiq Muhammad
al-Amin, al-Gharar wa atharuhufi al'uqrid,Majmfi'at Dallah al-
Barakah, Jeddah, 1991, p. 457.
31 Al-Ashgar, Bay' al Bay' al-Murabahah, p. 157.
32 Malik Ibn Anas,
al-Mudawanah al-Kubra, Dar al-Fikr, Beirut, Lubnan, Vol. 2, p. 9; al-Nawawi,
Rawdat al- Talibin, Dar al-Kutub al-Ilmiyyah, Beirut, n.d., Vol. 4, p. 7; Ibn Qudamah, al-Mughni, al-
Maktabah al-Tijariyyah Makkah al-Mukarramah, 1985, Vol. 4, pp. 310-316.
33 Sahih al-Bukhdri, Kitab al-Salat, Hadith No. 965.
The bindingeffectof Istisnm

The classicalHanafijuristsgenerally dividethe bindingeffectof thiscontractinto
threestages.At thefirststagewheretheworkof manufacturing hasnotyetstarted,
theHanafijuristsareunanimous thatthecontractis notbinding(ldzim)uponeither
of the partiesandthe manufacturer mayrefrainfrommakingthe commodity and
both contracting partieshave the of
right revocation.34 At the secondstage,the
manufacturer mayfinishmakingthe neededgoods,but theclienthasnot seenthe
manufactured objectyet. The manufacturer still has the righteven to sell the
commodity to a thirdparty,The thirdstage whenthe required
is goodshavebeen
and to
manufactured presented the purchaser. Here,againthe Hanafijuristshave
difTerentopinionswhetherthepurchaser hasa rightto rejectthecommodity ornot."
However,it is reportedthatAbOYWisuf is of theopinionthatIstisne'is binding
fromthe firststagewherebyno one hasthe rightto revokethe contract,because
otherwisethe manufacturer will be harmedandit is possiblethathe willnot find
anyonewhowillbuythegoodsfromhimin timeor he maynotgeta similarprice
as agreeduponwiththe firstpurchaser.30
Moreover,Article392 of the Majcella endorsesthis opinionandconsidersthe
contractof Istisnt'as bindingfromthe beginning.In addition,if we referto the
opinionof thecontemporary Muslimjuristswe realisethattheyfollowtheMajella
Furthermore, the practicein the Islamicbanksis alsobasedon this
provision.-7
opinion. Thus,al-TadamOn Bankoptedforthisopinionby providingthat:"This
is the opinionwhichcango alongwith the circumstances andconditionsof the
moderntimeespeciallywiththe boomingindustries".3'
Theoptionof defectandtheoptionof desireddescription in Istisnrm

The twomajortypesof optionsrelatedto the contractof Istisnd'aretheoptionof
defect and the violationof the desired descriptionbecausea commodity
manufactured underIstisnt'mayturnout to be defective.
These two kindsof optionshave greatsimilaritiesand have the samelegal
The optionof defectis the rightof the buyerto cancelthecontractor to
bases.-39
confirmit if he discoversa defectin theobject,whichdiminishesits value.4"The
optionof theviolationof thedesireddescription is therightto rescindthecontract
due to the absenceor violationof the desireddescriptionstipulatedby the
contracting of the contract.41
partiesin the subject-matter
4' Al-Kasani,al-Badai'al-Saunii', Vol. 5, p. 2680.
Badai'al-Sanai',Vol. 6, p. 2680.
" Ibn al-Humam,Fath al-Qadir,Vol. 8, p. 116;Al-Kaosani,
SAl-Muhit al-Burhani(Manuscriptin Al-AwqafLibrary),Vol. 2, pp. 575-576.As reportedby Al-
Qnradfghi,'Aqdal-lstisna',p. 347.
" See,forinstance,Al-Zuhaili, WaAdillaruh,
al-Fiqhal-lslamti Daral-Fikr,Damacus,1989,Vol.4, p. 634.
"W Al-TadamonBank,'Aqdal-lstisrn',p. 51.
U Ibn Hazhm,'Ali Ibn Ahmad,al-Muhallaih, Dar al-Fikr,Beirut,n.d., Vol. 9, p. 41; Vol. 8, p. 314.
4OWafa, Muhammad,Bay' al-TaghrtrWatal-TadlisBay' al-Ma' yab fi al-Fiqi al-Islantiwa al-
Qa-in al-Wadi'al-Misri,Dar al-Tiba 'ah al-Muhamrmadiyyah, Cairo, 1987,p. 15.
4' 'Abd al-SatarAbu Ghudbah,alkhlivar W'aAthru/h Fi al- 'Uqild,p. 419.
These options are basedon some Hadtths,such as: "Do not tie up the udder of
female camelsand sheep;if one amongyou buys them with its uddertied up he has
two options after milkingit, whetherto retain it or to returnit with a measureof
dates".42"It is not lawfulfor a Muslim to sell anythingto his brotherand there is a
defect which he does not showhim (informhim about it)".43"Whocheatsus is not
from us".44
Conditionsfor valid exerciseof the optionof defect

(1) The defect should exist before the conclusion of the contract;
(2) The defect must still be in existencewhen the buyer takespossessionof the
object;
(3) The buyer must be unawareof the defect at the time of the contractand of
taking the object into his possession;
(4) The contract must not have been subject to an agreement excluding
guarantee;
(5) It must be general,in the sense that such goods are generallyfree from such
defect;
(6) The defect must still be in existence when the buyer wants to annul the
contract;
(7) The defect must not be so minor that it can be easily removed;
(8) The seller did not stipulatethat he is not liable for any defect.4'However,
this last conditionwill be discussed separatelylater due to its specialeffect
in the contractof Istisnd'.
The buyer who discovers a defect in the commodity in accordancewith the
conditions stated above is guaranteedthe right by law:
(1) Either to annulor to confirmthe contractwith the whole stipulatedprice as
far as the Hanafisand Shafis are concerned.As for the Malikisthis right is
given only if the defect is major;
(2) To annul the contractor to confirmit with a commensuratedamageto the
defect accordingto the Hanbalis.The Malikis view is the sameif the defect
is minor.
Concerningthe violationof the desireddescriptionthe generalrule is that as with
all the previous conditions,the buyerhas an option whetherto returnthe goods or
to take them at the full price without any compensationfor the violationof the
desired description.46The confinementinto these two alternativesis due to the fact
that what is violated is only a descriptionand the descriptionis not valuableand
has no special part or role in the price.
42 Sahthal-Bukhdri,Kitabal-ByQ,HadtthNo. 1340. SahlhMuslim,Kitabal-Iman,HadithNo. 164,
43 Ibn Majah,SunanIbn Majah,Kitab al-Bya', HadithNo. 2789.
44 SahthMuslim,KitAbal-Bya', HadithNo. 2987.
4" AI-Zuhaili, al-Fiqh al-Islami Wa Adillatuh,Vol. 4, p. 559; and Wafa, Mohammad,Bay' al-
Taghrlr,pp. 104-109; Baillee,Mohammadian Law of Sale, pp. 126-127,
Ibn al-Humam,Fath al-Qadir,Vol. 5, p. 136.
Istisnii' and stipulation by the seller to preclude liability from defects

in the commodity
Generally the Hanafi jurists give the seller the right to distance himself from any
liability for any defect in the commodity as far as the clause or condition is the
result of mutual consent between the contracting parties. Meanwhile, the majority
of other Muslim scholars held that, the seller is still responsible for any defect in
the commodity despite his stipulation to waive himself from any responsibility.
Moreover, this waiver could be accepted only if the defect is invisible because any
waiver of responsibility from any defect will protect fraud, dishonesty and
corruption. These arguments are taken into consideration when the seller is acting
in good faith. However, if he is acting in bad faith or misrepresentation, the
Muslim jurists are unanimous that the clause is void, and the seller is responsible
for any defect.47Nevertheless, what concerns us here is the legality of such a clause
in the contract of Istisnd. The classical jurists have not discussed the matter. But
al-Zarqa opines that among the points of difference between the ordinary sale and
Istisnd which must be adopted is that, any clause to waive the responsibility of the
seller from any defect in the commodity must be regarded as absolutely void
regardless of the difference about its legality among the classical scholars in the
ordinary sale. The logic of this opinion is clear where nowadays Istisna' is
concluded with large industries with sophisticated articles involving high
technology where any defect will lead to a huge financial loss.48
From the above, it is clear that the Islamic banks should bear responsibility for
any defective products that they have undertaken to manufacture. And they have
to sue their parallel contractors for damages instead and the Islamic banks should
not see this approach as an obstacle, but rather as one of the factors that
distinguishes between Ribawi' investment and Islamic investment.
Different conditions for the legality of Istisnd'

These conditions are divided into general conditions and specific conditions. As a
contract, Istisndamust fulfil the requirement of a valid contract i.e., the capacity of
the contracting parties, offer and acceptance, and the subject-matter should be a
valuable thing. In addition to these general conditions, there are some specific
conditions for the contract of Istisnd' itself.49
(1) The object must be precisely determined both in its essence and quality.50If
the commodity is of the modern sophisticated electronic kind, such as a
radio, television, etc., it can be determined by the design of a renowned
expert engineer or by a very well known sample;51
47 See Wazarat al-Awqaf al-Kuwaitiyyah, al-Mausaa' al-Fiqhiyyah, Vol. 20, p. 98.

48 Al-Zarqa, 'Aqd al-Istisna', pp. 37-49.
49 Al-Badran Kasib, 'Aqd al-Istisnd', p. 147.
50
Al-Kasani, al-Badai', Vol. 6, p. 2677.
51 Bank al-Tadaminn, 'Aqd al-Istisna', pp. 37-38.
(2) The early Hanafi jurists are of the opinion that it is not permissible to
practise Istisnd' in what is not familiar among people under this contract,
such as the manufacture of cloth.52 However, the example of cloth is very
familiar nowadays and the types of manufacture differ from age to age and
for this reason the Majella cited new permissible things such as a ship.53
According to al-Qaradaghi, it is possible to add to this all industrialised
things irrespective of whether they are from the heavy, medium and primary
industry as well as special items such as satellites. Al-Zarqa went further by
opining that as industrialisation booms in the world today, manufacture is
becoming common in almost everything. Then, there is no need for this
particular condition;54
(3) It is a condition that the time of delivery is specified, whether it is short or
long, so as to avoid ignorance, which might lead to conflict between the two
parties.55 This is to avoid dispute between the parties;56
(4) The materials should be supplied by the maker: if they are supplied by the
buyer the contract is Ijdrah and not Istisnd';57
(5) The place of delivery should be specified if the commodity needs loading or
transportation expenses.58
It is worth mentioning that it is not a condition in a Istisnd' contract to advance the
payment, though it is permissible to do so, or to defer it, or make the payment in
instalments. Also, it is not a condition that the seller should himself make the
commodity. He can fulfil his obligation by bringing a commodity with an exact
prescribed description although manufactured by a third person. Finally, it is not a
condition that the seller be an expert in manufacturing.59
The contract of Istisnd' and the clause of liquidated damages and

penalties
Al-Majma' al-Fiqhi al-Islami in its Resolution No. 66/3/7, 1992 concerning the
contract of Istisnd' includes a clause about liquidated damages and penalties.60 By
liquidated damages and penalties is meant a prior agreement between the parties to
a contract about what sum shall be payable in the event of one party failing to
complete or delaying his contractual obligation.
The basic source of legality of this concept lies in what is reported by al-
Bukhari, narrated by Ibn Sirin that:
52
Hashiyat Ibn 'Abidin, Vol. 5, p. 223; and Ibn al-Humam, Fath al-Qadir, Vol. 5, p. 355.
53 Majella, p. 388.
54 Al-Ashgar, Bay' al-Murabahah, p. 160.
55 Koja Ezzedine, Instrumentof Islamic Investment, p. 54.
56 Al-Qaradaghi, 'Aqd al-Istisna', pp. 354-356.
57 Koja, Ezzedine, Instrumentof Islamic Investment, p. 53.
58 Ibid., p. 54.
59 Al-Qaradaghi, 'Aqd al-Istisnd', pp. 347-548.
60 Al-Ashgar, Bay' al Murabahah, p. 183.
... a man said to a hirerof animals,prepareyour travellinganimalsand if I do not go with

you on suchandsuch day, I shallpayyou a hundreddirhams,but he did not go on thatday.
Shuraihsaid:"If anyoneimposesa conditionon himselfof his own free will withoutbeing
underduresshe has to abideby it". Also it is narratedby Ayyfb fromIbn Sirinthat"A man
sold food, and the buyertold the sellerthatif he did not come to him on Wednesday,then
his dealwouldbe cancelled,andhe did not turn up on that day". Shuraihsaidto the buyer
"You have brokenyour promise"and gave the verdictagainsthim.61
Also we have the Hadith of the Prophet (pbuh) "Muslims are bound by their
stipulations".62 It is clear that the clause of liquidated damages is in the interest of
the contract and it is a catalyst and an inducement for its fulfilment. Despite these
evidence from the Sunnah, the topic did not receive ample attention from the
classical jurists, but during the latter part of the Ottoman Empire, as pointed out
by al-Zarqa, the topic has been revived.63
One of the recent extensive and detailed studies on the legality of the liquidated
damages and punitive clause is the study of Hay'at Kibar al-' Ulamda'in Saudi Arabia
which analysed it through the general theory of contract and conditions. The council
concluded unanimously that the punitive condition on a contract is a legal condition
and must be taken into consideration unless there is an excuse for the non-fulfilment
of the obligation. However, it should not be used as a means of financial threat,
which in consequence will become incompatible with Shari'ah principles.64
However, the implementation of this principle may vary according to custom,
size and kind of transaction and the Islamic bank involved. Thus, in al-Rajihi
Banking and Investment for instance, if the Islamic bank fails to deliver the
manufactured goods in time and without any reason, it will be liable for damages
amounting to ten per cent of the total cost of the contract for every year. However,
if the delay is caused by the sub-contractor, he will be liable for damages
amounting to 15,000 Riyal for each day but the total amount of damages should not
exceed 10,000,000 Riyal. On the other hand, if the delay is from the customer who
fails to prepare his side of the project, he will be liable for damages of one per cent
for every week but the total amount of such damages should not exceed five per
cent of the total cost of the contract.65However, the clause of liquidated damages is
somewhat restricted by the effect of change of circumstances.
The effect of change of circumstances in the contract of Istisna'

In most legal systems, change in circumstances generates legal consequences that
are, in turn, governed by a number of defined legal principles and rules. The
61
Al-Bukhari, Sahib al-Bukhdri with Fath al-Bari (Book of Conditions) (Shurit), Vol. 5, p. 354.
62 See Sunan al-Tirmidhi with Sharh Tuhfat al-Ahwazi, Kitdb al-Ahkam, Vol. 4, p. 584; Sunan Abi
Dawad with 'Awn al-M'abat, Vol. 9, p. 516.
63 AI-Zarqa, al-Madkhal al-Fiqhi al-'Am, Vol. 3, p. 386.
64 Abhath Hay'at Kibar al-' Ulama', Vol. 1, pp. 101-264.
65 'Abd al-Bari Muhammad, 'Ali Mish 'al, "al-Dawabit
al-Shari'yyah li-'Aqd al-Istisna' bi Sharikat
al-Rajihi al-Masrifiyyah", al-Iqtisad al-Islami, No. 195, Year 17, June 1997, p. 140.
doctrineof changein circumstances means:"Occurrences whichradicallydisturb

the equilibriumof a contractual the
obligation,making performance excessively
onerousfor one of the contracting parties".66
It is possibleto findauthorityfor this doctrinein the followingQur'inicverses:
"Godcommands justiceandfairdealing(al-Nahl16:90),"0 ye whobelievelEatnot
upyourpropertyamongyourselves in vanities"(al-Nissa'4:29).It is possiblealsoto
the
prove authority of this doctrine by the followinglegalmaxims:"No harmmay
eitherbe inflictedor reciprocated". "Necessityis judgedaccordingto its merits"
(MajallaArt.22);"Harmmustbe eliminated to an end"(MajallaArt.20).
The relevanceof this doctrinein the contractof Isrisna'is likethe case in any
otherobligation;theperformance of theobligationof thepartiesto a validcontract
can be frustratedby events beyond their control. These events make the
performance of the contracteitherimpossibleor fundamentally differentfrom
thatwhichwasinitiallycontemplated by theparties.Sometimestheimpactof such
events is so considerablethat the performanceof the contractis completely
frustratedand the parties are thereforedischargedfrom their obligations.
However,it maybe thatthecontractonlyneedsreadjustment to enablereasonable
performance of theparties'obligation.The readjustment maybe contractual, if the
partiesagree,or judicial,if the partiesdisagree.
However,there is no agreedminimumlevel abovewhichthe buyermay be
entitledto a reductionin theprice.However,theMalikismaintainthattheconcept
of al-Jai'hawill be appliedonly whenat leastone-thirdor moreof the dropwas
affected.Thiswouldvalidatethebuyer'sclaimfora reductionin price.67 However,
it seemsthatlargelycustomandchangesof timeandplaceinfluencethisquestion.
It is worthmentioningthat al-Majma'al-Fiqhial-Islamihas a very important
resolution.It decidedthatin deferredcontractual obligations(suchas thecontracts
of importand construction)if the situationhas changeddrasticallyand the
fulfilmentof thecontractual obligationsbecomesveryhardforonepartyas a result
of pricefluctuationfor instanceandnot as a resultof negligenceor shortcoming
fromthe affectedparty,the courtcanintervene,if it hasbeennotified,to balance
the rightsandobligations,by dividingthe loss betweenthe parties.
It is alsopossibleto cancelthe contractregardingthe non-fulfilledpartof the
contractif it seems to the court to be the favourablesolutionwith just and
reasonable indemnitiesfortheaffectedparty.The courtshouldrelyon theopinion
of reliableand trustedexpertsin its assessment.The courtcouldalso deferthe
fulfilmentof the obligationsif it becomesobviousthatthe unforeseeneventwill
end soonandthe secondpartywill not be harmedby this deferment."6
However,for theapplication of thisdoctrineseveralconditionsmustbe fulfilled.
Thus, the eventshouldbe exceptional, unforeseeable, of a generalcharacter, and
mustoccurduringthetimeof performance of thecontractual obligationexcessively
66
AdnanAmkhan,"The Effectof Changeof Circumstances in ArabContractLaw"[1994]ALQ 258.,
67 See, e.g. al-Dirdir,al-Sharhal-Saghir, 1974, Vol. 4, pp. 241-247.
68 See QardratMajlis al-Majma' al-Fiqhi al-Islami li-R4bitat al-'Alam al-Islami, January 1985,
pp. 99-104.
onerousfor the contractingpartyinvokingthe doctrineof changeof circumstances.

There shouldalso be a directcausativelink betweenthe exceptional,unforeseeable,
and generalevent and the onerousnatureof the performance.69
But if the above-mentionedrequirementshave been shown to exist, the court
has the powerof interventionto adjustthe onerousobligation.Beforeintervening
in this way, the courtmay ask the contractingpartiesto re-negotiatethe contract
among them. Failingany agreementbetweenthe parties,the court'sintervention
will usuallybe affectedeitherby reducingthe aggrievedparty'sonerousobligation
or by increasingthe counterobligation.70
Arbitration and the contract of Istisni'

The studyof arbitrationin the contractof Istisna'is a new approach.It is the direct
result of the modern applicationof this contract in Islamic banks where an
arbitrationclause is always included in the contract. In addition, commercial
disputes do not fit into any particularmould, and, in internationalor domestic
contracts the parties often prefer to have disputes between them settled by
arbitration.Therefore,the availabilityof an effective, independentand impartial
mechanismfor the settlementof investmentdisputesis consideredto be one of the
crucialfactorswhich must be borne in mind in the assessmentof the investment
climate.
Regardingthe bindingeffect of Istisna-'and the legalityof an arbitrationclause
some writersclaim that an agreementto arbitratecan only strictlybe made after
the dispute arises. An arbitrationclause in the Western form would constitute
gharar because the natureor occurrenceof a future dispute is uncertain.7'The
Shari'ahdeterminesthat, in the interestsof fair and ethical dealing,elementsof
uncertaintyor risk (gharar)are to be avoided. What is non-existentnecessarily
involves a strong elementof gharar.72On the other hand, apartfrom the Maliki
School, the generalview is that such agreementsare not binding.Eachone of the
parties can revoke the agreementup until the time the award is made in the
absenceof priorauthorisationof a judge.This view is expressedin Article 1847of
the Majella.
However,these argumentsareunacceptable.It seems that any arbitrationclause
should be consideredas an ordinarycontractualcommitment,which is valid and
binding on the parties by virtue of the general theory of contracts already
discussed. Furthermore,the Maliki juristshave stated clearlythat an arbitration
agreementis irrevocable.73
69 Adnan Amkhan, "The Effect of Change of Circumstances in Arab Contract Law" [1994] ALQ
258 at 263-268.
70 Ibid., 269.
71 See Saleh, CommercialArbitration, pp. 49-50.
72 See Rayner, The Theory of Contract in Islamic Law, p. 366.
73 For more details see al-Baji, al-Muntaqa, Vol. 5, p. 227; Ibn Farhfin, Tabsiratal-Hukkam, Vol. 1,
p. 55.
Furthermore, all the different opinions advanced by the scholars are Ijtihadi
opinions, based on what they believe will secure the interest of the parties.
Therefore, there is no harm in adopting the Maliki's opinion based on Maslahah.
Moreover, it is well proven by the international practice nowadays that the interest
of the parties would not be secured unless we acknowledge the binding character of
arbitration clauses.
The scope of arbitration has given rise to a lot of discussion among Muslim
jurists.74 However, there is one area where there is general agreement that it falls
within the scope of arbitration, namely the area of commercial transaction.
Therefore, arbitration clauses in the contract of Istisnd' are without any doubt
within the scope of arbitration. It is stated in the Majella, Art. 1941: "It is
permissible to appoint an arbitrator in actions for property, dependent on the
rights of people".
Generally, an arbitrator must possess the quality of a judge (Qddi).75However,
these qualifications are more theoretical than practical since even the existing
judges did not fulfil these requirements. Thus, we find Article (4) of the Saudi
Arbitration Code stipulating that an arbitrator must be of experience, good
conduct and behaviour and full legal capacity, and the implementation rule in its
sub-section (3) provides that an arbitrator may be chosen from among
professionals (such as lawyers and accountants) and may be a government official,
provided approval of his department is obtained. As a rule, if a dispute is to be
heard by more than one arbitrator, the umpire must be knowledgeable in the
relevant principles of the Islamic Shari'ah commercial codes, customs and
traditions prevailing.
In practice, business persons tend to choose arbitrators who possess practical
experience and knowledge in business matters rather than those who are
knowledgeable in legal issues.76
Thus, the use of arbitration by the Islamic bank is legally based on strong
fundamentals in regard to its legality, binding effect (luziam) and award.
THE TERMINATION OF THE CONTRACT OF ISTISNA'
As one of the nominated contracts in Islamic law, Istisnd' is terminated by the

normal ways of termination of contracts, namely, when the manufacturer makes
the commodity and presents it to the buyer and receives payment.
On the other hand, classical jurists are of the opinion that the contract of Istisnd'
can be terminated by the death of one of the contracting parties.77Thus, due to the
74 See al-Dawri, 'Aqd al-Tahkim Fi al Fiqh al-Islami Wa al Qanan al-Wadi', Matba't al-Khulfd,
Baghdad, 1985, pp. 243-280.
75 Articles 1792, 1793, 1794, the Majella, translated by C.R. Tyser, Law Publishing Company,
Lahore.
76 Yahya al-Samaan, "The Settlement of Foreign Investment" [1994] ALQ 227-228.
77 Al-Kasani, al-Badai', Vol. 6, p. 2672.
similarity between Ijarah and Istisnd' it is argued that the contract of Istisnd'
should be terminated by the death of one of the contracting parties as in the case of
Ijarah.78However, this form of extinguishing the contract of Istisnd' is contested
by some modem scholars and restricted by others.
Due to the extensive application of the contract of Istisnd' nowadays, the
manufacturer is not a single person. It is rather a large corporation. Therefore, it is
not imaginable that the contract will be ended by the death of one or two persons.
Thus, we must differentiate between a contract of Istisna' between individuals and
one which involves corporations and industries.79 However, this opinion is less
convincing and the best solution is to refute the Hanafis arguments. This will be
expounded as follows:
(1) The Hanafis claimed that Ijarah is terminated by the death of any one of the
contracting parties and the contract of Istisnd' likewise will be governed by
the similarity between the two types of contracts. However, there is no
similarity according to the majority, namely, the Malikis,80the Shafis8' and
the Hambalis;82
(2) Nowadays the industrial corporations, and in our study the Islamic banks,
have a juristic personality which will continue as long as the corporation is in
existence and it will not be affected by the death of its members;
(3) The analogy of the Hanafis is a discrepant analogy because the subject-
matter in Ijdrah is the labour alone, while in Istisnd' it is the labour and the
material;
(4) We are not at all in need of Qijys since the contract of Istisna' is a contract in
its own right and should not be subjected to another contract.83
The role of Istisna' in economic development

As a mode of investment, Istisnd' can play an important role in economic
development. It encourages the demand for manufacturing goods; financing
economic activities, contributing to the stabilisation of prices of manufactured
goods, promoting industrial and technological advancement and making use of the
available possibilities of the economy.
The manufacturing sector represents the backbone of modern economies.
Istisnd' can play a role in strengthening this sector by increasing the demand for
manufactured goods. It is not a condition in Istisnd' that the price should be paid in
advance. Thus different bargains can be concluded and the price will be paid in the
future or in instalments. Moreover, there is no doubt that the increase of the
78 Ibn al-Humam, Fath al-Qadir, Vol. 5, p. 354.

79 Bank al-Tadamun, 'Aqd al-Istisna', pp. 60-61.
so Ibn Juzai, al-Qawanin al-Fiqhiyyah, p. 291.
81
Al-Nawawi, Rawdat al-Talibin, Vol. 5, p. 245.
82
Ibn Qudamah, al-Mughni, pp. 467-468.
83 Al-Qaradaghi, 'Aqd al-Istisna',
pp. 361 and 388.
ISTISNA ' AND ISLAMIC BANKING 39
demand has a great economic effect by expanding economic activities, opening new
areas of competitiveness, creating new jobs and enlarging the market.
Furthermore, if the buyer possesses the money during the conclusion of the
contract and pays in advance, the manufacturer will benefit from this payment to
finance the process of production or other investment projects. Moreover, it will
finance the expenses of manufacturing and stabilise the process of production.
Furthermore, the contract between the buyer and the seller before the
production of the commodity will be based on sound calculations. The buyer
would be aware that what he pays is commensurate to the right price. The
manufacturer on his side wants the market to continue its progress in a stable
manner to guarantee a regular demand for his merchandise. Thus, the agreed price
will be based on solid estimates, which will contribute to the prevalence of a
market price, which reflects the realities of supply and demand.
In addition, based on the production and trade of manufactured goods, and in
particular the need to take the utmost care in the selection of the manufacturer,
Istisnda increases competition and specialisation in the manufacturing field which
will, in turn, boost technological advancement in this area, a factor which is not
available in other modes of investment. Finally, a seller in an Istisnd"transaction
need not supply the necessary services for the manufacturing of the goods by
himself. This makes it possible for financial institutions, like Islamic banks, to be
the seller in Istisnd' contracts. Therefore, it is inevitable for a financial institution
that assumes the role of a seller in Istisndatransactions to relate the Istisnd"contract
to a third party that will be able to provide the necessary services for
manufacturing the goods. Furthermore, it is necessary sometimes to have a
consultant or supervisor to monitor the effective progress of the production. Thus,
Istisnd' allows the involvement of many parties in the production which will
contribute to the reduction of unemployment.84
Areas of application of Istisni'

Istisnd is applicable to the various industries as long as they can be monitored by
measurement and specifications and which could be manufactured or constructed at
any stage of the process of production. Thus, it can be used in the food processing,
drying, or canning industries or beverage manufacturing. The Istisndacontract is
applicable also in high technology industries, such as aircraftindustries, locomotives,
ships, cars, electronics and machines produced in big factories and workshops.85
It can also be used to finance intangible assets, such as electricity and gas. In
addition, Istisndacould be used as an international mode of investment (especially
among Muslims countries) in pre-shipment financing of the acquisition of capital
goods in projects for which no other suitable mode of financing is available.
84
Fayad 'Abd al-Mun'im, Bay' al-Istisnd' wa tatbiqdruhual-Masrifiyyah al-Mu'asirah (unpublished
paper), presented in the 22nd Meeting of Director of Investment in Islamic Banks, Qatar, 15-17 March,
under the auspices of the Islamic Development Bank.
85 Islamic Development Bank, "Operational Guidelines on
Istisna'" (unpublished material), pp. 3-4.
The Islamic development bank, for instance, has so far used instalment sale and
leasing mostly for financing finished goods. Working capital needed for the
production of such goods falls outside the ambit of the Islamic Development Bank
financing. With the introduction of Istisna' as a mode of financing, it has now
become possible for the Islamic Development Bank to finance working capital
needed for the production of capital goods.86 But the most common area of
financing through the contract of Istisndaup to now is in house building finance.
Perhaps this is due to the infancy of the manufacturing sector in most Muslim
countries or due to the general policy in Islamic banking where the goal of Islamic
financial institutions in an Islamic state should take into consideration the goal of
achieving the basic needs of the society, of which housing is one of paramount
importance.
In the Gulf states, for instance, where the establishment of Islamic banks,
synchronised with the galloping building expansion and increasing revenues of
these countries as "a result of the 1970s oil boom, a considerable part of investment
has gone into the housing sector"."7The construction industry was the field where
Istisnd' has played a prominent role and where the investment of a single Islamic
bank reached billions. Thus, Istisndahas contributed in solving one of the crucial
contemporary problems.88
On the other hand, the Islamic Development Bank has been generally financing
economic infrastructure through loans. This is because financing of infrastructure
has been the exclusive zone of the public sector. However, in recent years, the
financing of economic infrastructure projects has witnessed a shift from the public
to the private sector. It has, for several reasons, been realised that some
infrastructure projects may be more efficiently financed and managed by the
private sector. The projects that have featured prominently in this shift are those
that have regular and reliable cash flows, such as telecommunications, power
generation, transmission and distribution, toll roads, airports, seaports, pipelines
and water supply and sanitation. Given that the development of infrastructure is a
prerequisite of general economic development, the Islamic banks should not be
less keen in their support of these projects because they have shifted from the
public to the private sector. On the other hand, it will not be feasible for the
Islamic banks to extend financing to private sector projects through interest free
loans. Istisnd' will give the Islamic bank a mode of financing infrastructure projects
that cannot easily lend themselves to financing by way of instalment sale or
leasing."9
86 Ibid., p. 4.
87 Ahmed 'Ali Abdallah, "Forms of Investment in Real Estate in Islamic Perspectives", Islamic
Banking Modes for House Building Finance (Seminar proceeding Series No. 28), Islamic Development
Bank Publication, Jeddah, 1995, p. 43.
88 See Muhammad 'Abd al-Hakim Zi'ar, "al-Ijtihad al-Jama'i fi Majal al-Iqtisad
al-Islami al-
Istisna'", al-Iqtisad al-Islami, Markaz al-Tadrib wa al-Tatwirbi Bank Dubai al-Islami, No. 194, Year
17, April-May 1997.
89 See Mohammed El-Fatih Hamid, "Istisna' - Classical Concept in a Modem Framework", New
Horizon Islamic Banking and Insurance,published by the Institute of Islamic Banking and Insurance,
London, February 1997, No. 60, p. 4.
Modes of application of IstisnA'

The Islamic bank can use Istisnd' as a buyer by contracting with industrial and
manufacturing institutions, or with any artisan to manufacture or construct for it
some commodities with specific description. Then, it can sell them after receipt,
for cash, installed or deferred payment through Murdbahah or bay' bi al- Thaman
al-'ajil. Thus, the Islamic bank will be involved in direct investment. But this
method is related to some extent to the position of the Islamic bank where in
practice some Islamic banks are not allowed to be involved directly in commerce.90
It is also permissible for the bank to enter an Istisnd' contract in the capacity of
seller to those who demand the purchase of a particular commodity. Then, it will
draw a parallel Istisnd' contract in the capacity of a buyer with another party to
make or manufacture the commodity agreed upon in the first contract. This
method is more suitable to the practice of Islamic banks nowadays but in Malaysia
in particular, despite the very wide definition given to "Islamic banking business"
in the Islamic Banking Act, which can accommodate easily the concept of Istisnd'.
It is appreciated that Parliament intentionally gave Islamic banking business a
general and, therefore, a very wide definition so as to give as much flexibility and
scope as possible to Islamic banks to enable them to grow, expand their operations,
and to evolve into viable competitors to conventional institutions.91 Bank Islam
Malaysia unfortunately has not been involved up to now in this important mode of
investment as it should be.
The first Istisnd' can be immediate or deferred and the payment in the second
Istisndacan be cash or deferred as well. The parallel Istisnd' is the most applicable
form of Istisnd'. Accordingly, the deal may involve three parties: firstly, the
customer (the buyer); secondly, the Islamic bank (the seller); and finally, the
original manufacturer. Sometimes, especially in building construction, it may
involve four parties; the customer; the Islamic bank (contractor); the sub-
contractor; and a consultant or an expert to supervise the execution of the
construction contract.
It is worth noting that the contract between the Islamic bank and the customer
and the contract between the Islamic bank and the manufacturer or sub-contractor
should be separate and independent from each other. Moreover, the Islamic bank
should not wait for the coming together of two parties agreeing on the manufacture
or construction of something, and proposing that the bank finances the project
only because such a deal can no longer be an Istisnd' but rather a loan with interest
(qard bi alfai'dah). This is because in such a deal the Islamic bank is just lending
money to the seller for a determined profit.
It is necessary for the Islamic bank to set up its special unit on matters related to
Istisnd' having its own special relation with the manufacturers and constructors
90 Fayyad 'Abd al-Mun'im, Bay' al-Istisnd' wa Tatbiqdtuhu al-Masrifiyyah al-Mu'asirah (unpub-

lished paper presented in the 22nd Meeting of Directors of Investment of Islamic Banks, Qatar, 15-17
March 1997, p. 13.
91 Mohd Illias, "Islamic/Interest-Free Banking in Malaysia: Some Legal Considerations", The
Malayan Law Journal [1995] 3.
with whom it can bargain and contract on its own responsibility, sharing with them
the risk, benefit, and bearing the liability of any defect in the manufactured or
constructed commodity. Only in this way, it is possible to make the difference
between a usurious (Ribawi) and interest-free investment. Furthermore, Islamic
banks have their own objectives, which differ from the conventional bank; an
alteration therefore, in the structure of the bank is necessary to fulfil this objective
in a Shari' manner.
On the other hand, a correct implementation of Istisnd' can avoid the problems
and criticisms that are encountered in Murabahah in its application. Thus, in
Murdbahah the agreement between the Islamic bank and the customer must be an
ordinary promise according to the majority of Muslim scholars, and the customer
would not be liable for any misfortune which may face the specified commodity.
Moreover, the customer has a full option to accept the requested item or to reject it
even without reason. It is obvious that under such circumstances the use of
Murdbahah by the Islamic banks will be very limited due to the different risks
mentioned above. To avoid these problems, some scholars have adopted the view
that the promise between the customer and the Islamic bank should be considered
as binding which would mean that the customer will be under an obligation to
accept the commodity. But the legal bases of this opinion is controversial and for
these reasons even the proponents of this idea, such as al-Qaradawi, are
discouraging the Islamic banks from an excessive use of Murabahah.92
The second criticism advanced against Murabahah is that it involves a sale prior
to taking possession while it is a requirement of a valid sale in Islamic law that the
purchaser may not sell the goods purchased until they are in his possession. In
support of this ruling, jurists have referred to the authority of some ahadfth.
Although some scholars have tried to restrict this principle, it is far from being a
point of consensus of the majority and it is difficult in such conditions to gain the
confidence of the customers. In addition, the role of the Islamic bank is almost
negative in Murdbahah as practised nowadays just limited to the act of delivering
the various cheques and signing the documents.
On the other hand, the good performance of Istisnd' could be proven by the
following figures. Thus, in Dubai Islamic Bank, for instance, and in the field of
real estate activity in particular, Istisnd' jumped from zero in 1990 to 49 per cent in
1994 compared to Murdbahahwhich declined from 100 per cent to 51 per cent in
the same period.93 In addition, according to Ibrahim al-Ghafaly, the Deputy
General Manager of al-Rajihi Banking and Investment, Istisnd' represents a
vehicle which allows flexible payment options and now constitutes 27 per cent of
92 Ahmad 'Ali Abd Allah, al-Murabahah Usaluhawa Ahkamuhdwa Tatbiqrtuhdfi al-Masarifal-

Islamiyyah,al-Dar al-Sudaniyyahli al-Kutub,al-KhartQm,1987, p. 187.
93 See RichardThomas,"Is the Murabahahan overusedand abusedfacility?""A futureof Islamic
finance","AccessingIslamicfinance- Marketand InvestmentOpportunities",collectionof papers
deliveredat the IslamicBankConference,17-18 October1995, London.
al-Rajihi's portfolio. This constitutes such a major shift from Murdbahah that it is
likely to be mirrored throughout the Islamic-financing sector.94
Project evaluation in Istisnd' investment

There are some mechanisms and criteria governing the evaluation of projects in
Istisnd' investment. These will be looked at below.
The legal (Shari') criterion

The Shari' criterion in Istisnd' investment is similar to other investment activities
in Islamic banks governed by the principle of halal and haram. Therefore, the
subject-matter of Istisnd', for instance, must not be prohibited items such as the
manufacture of alcohol or its derivatives or the canning of pig meat or the
construction of gambling clubs, etc. Furthermore, the primary consideration for
the acceptability of a project is the non-existence of any element of interest or Riba.
It is obvious that the Shari' criterion will not be the subject of compromise or
concession as it constitutes the basis of acceptance of all other criteria concerning
Istisnd'.
Commercial viability of the project
'The second condition is that the project should be commercially viable, generating
enough cashflow to cover direct costs, and overhead expenses, and earn a
reasonable return for the investor. On the other hand, the project should
contribute to other socio-economic goals, such as the creation of jobs, growth of
the economy, and foreign exchange. Therefore, the Islamic bank will critically
review the feasibility of the project and judge the soundness of the venture from
the commercial standpoint.95 Islamic financial institutions therefore always ask for
audited financial statements for the latest three years in operation. These figures
give the bank an opportunity to analyse the financial trends and reasonably judge
their causes.96
Customerperformance and management

The process of evaluation of the customer includes detailed information about his
reputation, his financial situation, and his management capabilities. Thus, if the
applicant is suffering from certain financial strains resulting from poor
94 The American Journal of Islamic Finance, 1997, Greenwich Hills Drive, USA, Spring 1997, Vol.
VII, No. 1, p. 4.
95 'Abd Allah Sheikh Muhammad,"The Islamic Way of Finance and Investment",The Muslims
WorldLeagueJournal,March 1992,Vol. 19, No. 9, p. 47.
96 Suleiman A. Dualeh, "How to Apply for Islamic Financing", The Muslim World LeagueJournal,
January1992, Vol. 19, No. 7, p. 34.
44 ARABLAW QUARTERLY
performance of his other business, there is a possibility that it might also affect the
performance of the new proposal as well. That is why the Islamic banks should ask
for audited financial statements and business projections. In addition, the general
economic situation is analysed, especially the economic sectors to which the project
under study belongs because it may have a negative impact on the project.97
Furthermore, the Islamic bank may be interested to know whether the entity the
customer represents is a proprietorship, partnership or a limited liability company
to ascertain the legal set up. The Islamic bank may need to know the place and the
year of registration, number of years in operation and the line of the customer's
business. It is possible also to ask about the company's market, its size, and its
share in the market and the strategy to increase this share. Finally, the customer
may be asked to identify the names, addresses, and contact persons of banks he
deals with.98
The role of consultant or supervisor in the contract of Istisna' and

its legal status
Generally, as the customer is not an expert in construction or manufacturingand he
likes to receive a specified commodity according to his specifications, he may need
an expert or consultant to advise him to this effect. On the other hand, the Islamic
bank, on its side, wants to be sure that every part that it has financed is performed
according to the specifications desired by the customer. Moreover, the Islamic bank
will release no progress payment unless the beneficiary certifies that the work for
which payment is claimed is executed in conformity with the contract. For these
reasons a consultant or supervisor is needed in Istisna'. However, some practical
issues have been raised about the status of the consultant, especially his appointment
and payment. In principle, he should be appointed and paid by the customer
(buyer), since he is acting on his behalf and any approval by the consultant of any
executed part of the contract is considered as an acceptance by the buyer.
At the beginning of the implementation of the contract of Istisna"in Islamic
banking, the appointment and payment of the consultant was the responsibility of
the customer. Nevertheless, it was realised later that there is sometimes a lack of
co-operation between the consultant and the Islamic bank and the consultant
sometimes acts in a biased manner against the sub-contractor and the Islamic
bank. To solve this problem, the practice in some Islamic banks has been adjusted
so that the beneficiary (the buyer), in consultation with the Islamic bank, appoints
the consultant to supervise the execution of the work by the manufacturer/
contractor.99However, it should be noted that the Islamic bank should appoint its
97 Jamal Ahmad al-Asmar, "al-Istisna' baina al-Nazariyah wa al-tatbiq", p. 18; 'Abd Allah Sheikh
Muhammad, "The Islamic Way of Investment", p. 48.
98 Suleiman, A. Dualeh, "How to Apply for Islamic Financing", p. 34.
99 Jamal Ahmad al-Asmar and Khalid Mohammad al-Salamuni, al-Istisna' baina al-Nazariyah wa
al-tatbiq (unpublished paper presented in the 22nd Meeting of Directors of Investment in Islamic
Banks, Qatar, 15-17 March 1997, under the auspices of the Islamic Development Bank, p. 26.
own consultant besides the customer's supervisor, and any dispute which may
arise would be solved through the ordinary way of dispute settlement. This is
legally preferable rather than applying Istisna' through illegal practices.
Istisnd' and the possibility of rebate

Once again, this new subject in the study of Istisna' is the direct result of the
modern application of this contract. If the beneficiary (buyer) pays the instalment
of the price of the goods falling due in a particular year, on or before their due
dates, the beneficiary (buyer) shall be entitled to a rebate. In the practice of the
Islamic Development Bank, for instance, this rebate may amount to 15 per cent of
the rate of return of the Islamic Development Bank's investment in respect of
those instalments for that year.100
However, there is a difference of opinion among Muslim jurists concerning an
agreement between the debtor and the creditor as to if the debtor pays on time or
before the due time, whether the creditor should rebate part of the debt. The
legality of such a dealing is disputed. Some scholars maintain that it is an illegal
transaction, arguing that such a dealing is similar to what all scholars agreed about
its prohibition, namely to ask the debtor to add more money in exchange for a
relaxation in the time of payment. Thus, in both cases there is an exchange of time
with money. In contrast, some other jurists held that there is no problem in such a
deal. They assert that it is reported from the Prophet that he said to the Jews, after
the decision of their evacuation from Madinah and their claim of debt toward some
people, pay less for early settlement (dau' wa ta'ajjalu).1?1
The reason behind the jurists' disagreement is the interpretation of this Hadtth
and the previous analogy drawn by some others. However, it is suggested that:
(1) The Islamic bank may give rebate of a special amount of money to a
customer who pays on time or before the due time without a pre-determined
agreement;
(2) It is possible that the Islamic bank will make it a general policy pertaining
that all cases of payment prior to the due date without an antecedent
agreement are subject to rebate;
(3) In some cases it may be necessary for the Islamic bank to secure its interest
to make such a rebate for some of its customers who will not pay unless they
get such a reduction.102 It should be noted that the Islamic Fiqh Academy in
its resolution regarding bay' al-taqsft maintained that a rebate after an early
payment by a customer is legal if it is not the result of a prior agreement and
there is no intermediary or middle person between the two parties. In cases
100 Islamic Development Bank, "Operational Guidelines on Istisna', p. 5.

101
Ibn Rushd, Bidayat al-Mujtahid wa Nihdyat al-Muqtasid, Matb'at al-Baby al-Halaby, Cairo,
Egypt, Vol. 2, pp. 143-144.
102
Al-Masrif al-Isldmi al-Dawli li-al-Istithmdr wa al-Tanmiyah Markaz al-Iqtiscd al-Islami Idarat
al-Buhith, Dalil al-Fatwa al-Shari'yyahfi al-a'a mal al-Masrifiyyah ahammu ma Sadra min Fatwa al-
Riba wa al-Fawa'id, Cairo, 1987, pp. 131-134.
where bankruptcy, delay of payment, or death, debtor and the debt is

prompt, then, it could be rebated with mutual consent.'03
Furthermore, if we consider this transaction in a wider perspective, it is obvious
that it is in favour of the weaker party. It is totally the opposite of cases of Riba,
which will make the rich richer and the weak weaker. Having said this, it is better
to leave the matter to the Islamic bank assessment, on case-by-case basis, and not
to make it general policy. Otherwise, some opportunists may abuse it and this may
lead to instability in the market.
Security and risk management in the contract of Istisna'
Istisna-'involves the manufacturing of goods or the construction of buildings or

other assets (ships, aircraft, etc.). Consequently, all risks associated with
manufacturing or construction contracts are present in the contract of Istisna'.
The major risks that have to be addressed in an Istisna-'transaction, with regard to
the relationship with the manufacturer, is the latter's failure to deliver the
commodity in time, or his failure to deliver conforming goods. The failure to
deliver the goods on time could be due to delay in the execution of the works,
accident, or unforeseen events, the occurrence of a calamity (i.e. the goods are
destroyed by fire or otherwise lost), or the insolvency of the manufacturer.
I have already discussed how the first two issues can be addressed and the risk
can be eliminated under the principle of liquidated damages and the theory of
unforeseen events. In this part of the article I shall deal with two remaining issues.
Insolvency of the manufacturer

Though liquidation, chronologically speaking, will be the last misfortune that can
befall a company, it is being addressed here as the first risk in the context of Istisna".
This is to remind ourselves of the need to take the utmost care in the selection of the
manufacturerand the rigorous examinationof its financial standing and technical and
administrativecapability.'I There are some alternativemeasures for Islamic banks to
protect their investment, such as taking a mortgage, taking a charge over all the assets
of the manufacturer,taking a refunding bond guarantee, taking a personal guarantee,
taking a bank guarantee from another bank, or taking cheques for the instalment
equal in value to the remainder of the sale price after deducting any advance
payment, which is paid at the time of signing the contract to purchase.'05
103 See Majma' al-Fiqh al-Islami, Majallat Majmina'

al-Fiqh al-Islami, No. 7, Vol. 2, 1992, pp. 217-218.
104
Mohamed el-Fatih Hamid, "Istisna' - Classical Concept in a Modem Framework", New Horizon
Islamic Banking and Insurance, published by the Institute of Islamic Banking and Insurance, London,
No. 6, 1997, p. 6.
105 Jeremy Martin, "Security in Islamic Bank", New Horizon, London, No. 48, February 1996, p. 5.
Insurance and the contract of Istisnd'

It is usual to deal with the risk over the loss of assets or their destruction (totally or
partially) during construction or manufacturing by means of insurance. The
manufacturer should, therefore, be obliged to take out the appropriate insurance
policies and assign the proceeds of these policies to the Islamic bank concerned.
In case of partial loss, the manufacturer may be allowed to use the proceeds of
insurance to restore the asset to its condition before the occurrence of loss. If, as a
result of events beyond the control of the parties, such as floods, earthquakes,
volcanic eruptions, and other natural disasters, or adverse political actions, such as
expropriation, change of law, war, etc. the manufacturer is unable to complete the
construction or the manufacturing, a reasonable extension of time may be granted.
If, after this extension of time, the manufacturer could not complete the
manufacturing of the assets, the contract may be terminated and the buyer can
claim a refund of the payments, which he has paid and compensation for any loss
caused by such a delay.'06
Thus, the contract with the manufacturer shall require him to insure the assets
under manufacture and until their delivery for their full replacement value under a
contractor's all risk policy.'07
CONCLUSION
Our study of the contract of Istisnd' shows that it has witnessed a major shift from
its concept in the classical analysis as necessary transformations are required to
enable this important method of investment to play its role in the modern
framework of transactions.
However, in Malaysia in particular, as I have mentioned before, despite the wide
definition given to "Islamic banking business" in the Islamic Banking Act (1983)
and despite the fact that the area of application of Istisnd' is the fastest growing area
in the Malaysian economy,10s Bank Islam Malaysia has not yet benefited from this
golden opportunity. Other financial institutions are restricted by law to be
involved in trade and manufacturing.
From a practical point of view, as discussed earlier, Istisnd' has all the potential
to be one of the leading modes of investment in Islamic banks. However, despite
this attractive picture of Istisnd', some practical issues are still problematic. If the
Islamic banks do not tackle them in a forthright manner, they may lead to further
complications. Thus, the Islamic banks must be held liable for any defect in their
106
Mohammedel-Fatih Hamid, "Istisna'ClassicalConcept",p. 7.
107
IslamicDevelopmentBank,"OperationalGuidelines",p. 8.
108
Beforethe recent economicturmoilthe manufacturingand constructionsectorsare expectedto
providea strongbase for growthfor the Malaysianeconomy.The manufacturingsectoris expectedto
grow at between 11-13 per cent duringthe period 1996-1998,while growthin the constructionsector
will be at 8-9 per cent on averageduringthe sameperiod(see MalaysianEconomyOutlook,Vol. 9, No.
2, December 1996, MalaysianInstituteof EconomicResearch).
product, as I have alreadydiscussed while referringto al-Zarqa'sopinion. He

maintainedthat any clauseby the Islamicbanksto excludetheirliabilityfromany
defect in the manufactureditem shall be considered null and void due to the
special characterof Istisnd'.
But Mohamed el-Fatih Hamid is of the view that the problem should be
submittedto the IslamicFiqh Academy,saying that "thoughthe views of a jurist
of the statureand scholarshipof Professoral-Zarqacommandutmostrespect,this
issue is of great practicalimportancefor financialinstitutionsusing Istisnd'as an
instrumentof financing.It, therefore,needs to be submittedto the IslamicFiqh
Academyfor a final opinion".109
On the other hand, some Islamicbanks, keeping the structuralform of banks
inheritedfrom the conventionalbanks,areunableto deal with someof the rulesof
the Islamiclaw of transactions.Thus, some Islamic banksauthorisethe customer
to concludethe contractwith the sub-contractoron theirbehalf.Of course,wakdla
is valid but in such a sensitivearea it is better for the Islamic bank to set up a
special unit on Istisnd'to concludethe contract with the sub-contractor.They
ought also to have theirown specialteam of experts to supervisethe fulfilmentof
their obligations.
Finally,despitethe successfulimplementationof Istisnd'by some Islamicbanks,
it seems that the full potentials of this contract have not been totally used,
especiallywith regardto the possibilityof issuing Istisnd'certificatesto raisefunds
or to manageliquidity.Yet, this is an issue which needs separateinvestigation.
109 New Horizon, Islamic Banking and Insurance, London, February 1997, No. 60, p. 7.

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