ISLAMIC REPUBLIC OF AFGHANISTAN

ISLAMIC REPUBLIC OF AFGHANISTAN Ministry of Rural Rehabilitation and Development Afghanistan Rural Enterprise Development Program Islamic Finance Product DevelopmentThe Use of the Commercial Contract of Bay’Salamto Finance Agricultural Production and Small Tradeprepared by Alberto G Brugnoni - AREDP12 May 2013

CONTENTS • INTRODUCTION • DEFINITIONS OF THE COMMERCIAL CONTRACT • THE SHARIAH LEGITIMACY • UNANIMOUS SHARIAH FEATURES • DEBATED SHARIAH FEATURES • SCOPE AND POTENTIAL • ACCOUNTING • RISK & RISK MANAGEMENT • DIFFERENCES WITH SIMILAR CONTRACTS • SALAM AS A SHORT TERM FINANCE TOOL • PARALLEL SALAM

INTRODUCTION • Salam is, at its origin, an agricultural financialproduct: • it is usually used by farmers that needs financing for purchasing agricultural inputs like seeds, fertilizers, pesticides, diesel for tractor, payment of water charges, labor, etc. • Its versatility has allowed salam to become a diversified tool for liquidity management, monetary policy management, and trade • The strong parallel that salam bears with either futures contract or forward sales has allowed for securities applications of salam

DEFINITIONS OF THE COMMERCIAL CONTRACT • Salam(literally meaning ‘ita’ = givingandtaslīf= advance)also know as sales by order, is one of the two exceptions (rukhsa) to the three Shariah conditions of validity of sale: • the commodity purchased must be in existence (bay’ ma’dum) • the seller should have acquired the ownership of the commodity • mere ownership is not enough, as the commodity must be in the physical or constructive possession of the seller • * please, refer to the presentation on ‘The Contracts of Trade in IslamicLaw’ for further details • Salamis a sale agreement whereby the seller receives the price in advance while goods are delivered at a future specified date • Another definition states that the seller agrees to supply specific goods to the buyer at a future date in exchange of an advanced price fully paid at the time of contract • It is also a sale contract over prescribed commodity sold as a deferred liability on one party, in exchange for a price that is received during the contract session • It is the sale of a liability, whose characteristics are described, in exchange for a price or capital-sum paid in advance

DEFINITIONS OF THE COMMERCIAL CONTRACT • Maliki school defines salamas a sale in which capital sum (price) is paid in advance and the object of sale is deferred to a specified term • The Shafi’i and Hanbali school define the forward contract as a contract over described merchandise sold as a deferred liability on one party, in exchange for a price that is received during the contract session • AAOIFI defines salam as the purchase of commodity for deferred delivery in exchange for immediate payment • All definitions entail that price is alwaysin cash and the supply of goods alwaysdeferred • hence: salamis, in its essence, a forward sale

DEFINITIONS OF THE COMMERCIAL CONTRACT • TERMINOLOGY • salam applies to the contract as a whole, and may also refer to the goods which are to be delivered later • rabbal-salam or al-musallim, refer to the owner of capital, the party purchasing the goods (the buyer) • al-musallam‘alayhi,refers to the party who takes on the obligation to deliver the goods at a future date (the seller) • ra’s mal al-salam, refers to the capital, i.e.: the price paid in advance of delivery of the sale object (the price) • al-musallamfīhirefers to the subject of the contract, the object or goods to be delivered (the sale object) • Ijāb(offer) and qabūl (acceptance) are other terms (sighah) of use

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

SHARIAH LEGITIMACY HADĪTH • There are several hadiths and reports bearing witness that the salam contract was in use at the time of the Prophet (pbuh) • Narrated by lbn‘Abbas: the Messenger of Allah (pbuh) came to Medina and the society used to pay in advance the price of fruits to be delivered within one or two years. The Prophet (pbuh) said, “Whoever pays money in advance for dates (to be delivered later, i.e.: a contract of salam) should pay it for known specified weight and measure (of the dates) [and a specified date of delivery]” • lbn ‘Abbas commented that: “I bears witness that al-salaf (al-salam) stipulated for a stated term had been made legal by Allah in His holy book and His permission is in it” IJMĀ’ • AllMuslim jurists have given their consensus to the permissibility of bay’ al-salam: • it is deemed a: “facilitation and an extension that closes up the door against usury” • particularly, because the product in sale is one of the counter-values in the contract • there is also the need of the people in it. The owners of the agricultural products and small businesses needed some financing to support themselves or to fund their crops until the day of harvesting • hence, it is made permissible to fulfill public needs

UNANIMOUS SHARIAH FEATURES CONTRACT'S FEATURES • The salam contract is binding and is sealed by using the word ‘salam’ or ‘salaf’ and specifying terms: • neither party has the right to annul it without the other’s satisfaction unless the sale object proves to be other than as specified • the seller is thus obliged to discharge his obligations towards the buyer with respect to the sale object, just as in any other sale contract • thus, salam is not among those contracts in which either party is permitted to abrogate the contract without the other’s approval, such as musharakah, mudharabah or qirad, wakālahand wadiʼahcontracts • It is permissible to cancel the contract of salam by mutual agreement, subject to no reduction and increase in original capital refunded • After execution of the salam agreement, the contract cannot be revoked unilaterally: • nevertheless, the iqala(recession of contract) is possible. In this occurrence, the parties freely consent to rescind it and each one gives back the consideration received • the Prophet (pbuh) has stated: “He who does the iqala with a Muslim who is not happy with his transaction, Allah will forgive his sins on the Day of Judgment”

UNANIMOUS SHARIAH FEATURES • Thesalam contract may be applied to all commodities, metals, animals and livestock, produce and manufactured goods • Salam is permitted in the utility value of assets, like machinery and buildings: • utility value is a value assigned to an investment on the basis of anticipated performance • The subject matter of a salam contract must be different from mode of payment of price ex.: if capital is provided in currency, then commodity in salam contract must not be currency. Particularly: • if the price (the capital) and the sale object are of the same currency, a salam contract is invalid, because in such a transaction like-for-like and hand-to-hand are obligatory • if the price and the sale object are different currencies, salam is still not possible because sarfor exchange of this nature requires immediate transfer of both elements at the time of contract • if the price is in the form of a commodity while the sale object is ready money, Maliki jurisprudence allows a salam contract in this case

UNANIMOUS SHARIAH FEATURES CASH PRICE OR SALAM CAPITAL • The price to be paid at spot to receive the goods for future delivery should be known to both parties involved in the salam agreement: • ideally it should be in cash • however, it is permissible to pay the price in kind subject to the (i) specification and (ii) quantity of goods to be delivered as capital in salam contract. This could be commodity, food or livestock • Price should be paid in full immediately by the time contract is concluded: • this condition is necessary because in the absence of full payment by the musallim, salamwill become tantamount to sale of a debt against a debt • this is also necessary so that the musallimcan show that it is not entering into debt with a second party in order to eliminate the debt • moreover, the basic wisdom behind the permissibility of salam is to fulfill the instant needs of the musallam ‘alayhi. If the price is not paid to him in full, the basic purpose of the transaction will be defeated • however, the musallam ‘alayhi may at its discretion give a concession of two, three days to the musallim(imam Malik), but this concession should not form part of the agreement • in no case, payment period must be equal to or greater than the delivery time of goods purchased under salam

UNANIMOUS SHARIAH FEATURES • it is not a necessary ingredient of salam that the price be always lower than the market price on that day • A debt receivable from the musallam ‘alayhicannot be converted into salam capital SUBJECT MATTERS • Commodities involved in the salam contract must be clearly known to both parties involved at the time of contract: • no ambiguity and uncertainty should be left unaddressed which may lead to a dispute. All the possible details with regards to quality, quantity, etc. must be expressly mentioned. Also, the exact date and place of delivery must be specified in the contract • bay’ al-salam can be affected in those commodities only the quality and quantity of which can be specified exactly. As such, precious stones cannot be sold on the basis of salam because each stone differs in quality, size, weight, etc. • the things whose quality or quantity is not determined by specification cannot be sold through the contract of salam as its supply may not be certain • if the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, according to the usage of its traders, its exact measure should be known

UNANIMOUS SHARIAH FEATURES • Commodities must be fungible goodsthat share common features, such as wheat, rice, fruits, etc.: • bay’ al-salam cannot be stipulated for a particular commodity or for the products of a specific tree, a particular field or farm. This is because there is a possibility that the crop of that particular field or the fruit of that specific tree is destroyed before delivery, and given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain • this, may include standardized products of companies • By consensus, salam is improper in a concrete thing or commodity available to the seller as there is no sense in a postponement of delivery: • it is not permissible to apply the salam contract to real estate because of its material existence

UNANIMOUS SHARIAH FEATURES • Date/dates of delivery and place of delivery should be certain and unambiguous: • scholars differ on the shortest duration of time of delivery: three days, fifteen day, thirty days or whatever the contracting parties may decide • Salam cannot be effected in respect of items that are ribawi in nature and must be delivered on spot (gold, silver, barley, etc.): • similarly, cross sales (practice of selling amongst or between clients, markets, traders) are not allowed SECURITY • A security in the form of a guarantee, pledge, mortgage or hypothecation may be required for a salam contract in order to ensure that the musallam ‘alayhishall deliver the commodity on the agreed date: • in the case of default in delivery, the guarantor may be asked to deliver the same commodity • if there is a mortgage, the buyer can sell the mortgaged property and the sale proceeds can be used either to realize the required commodity by purchasing it from the market or to recover the price advanced by him

UNANIMOUS SHARIAH FEATURES DELIVERYOF GOODS AT DUE DATE • The deliveryof goods at due dateis the responsibility of the musallam ‘alayhi, and the acceptance of goods by musallimis required if goods are meeting the contractual specifications in quantity and quality: • possession of goods can be physical or constructive, i.e.: transfer of risk and authority of use and utilization/consumption • The delivery of the sale object by installments at specified times is permitted • Disposal of commodities is not allowed prior to maturity of contract: • however, replacement with other commodities, except with cash, is allowed • It is permitted to: • settle the contract by supplying superior goods • settle the contract at discount if musallam ‘alayhiprovides inferior goods • settle the salam contract earlier than due date, if required commodities are supplied by musallam ‘alayhi • replace the commodities (except with currency) and settle the contract as the case may be

UNANIMOUS SHARIAH FEATURES • It is not permitted to: • stipulate penalty clause for delay in delivery • however, musallam ‘alayhican undertake in the salam agreement that in case of late delivery of salam goods, it shall pay to the charity account maintained by the musallim a sum calculated on the basis of a percentage per annum for each day of default • Before delivery, goods remain at the risk of seller. After delivery, risk is transferred to the purchaser: • transferring of risk and authority of use and utilization/consumption are the basic ingredients of constructive possession • After taking delivery, the purchaser has the ‘option of defect’ (khiyar al-’ayb): • whereas the goods can be returned if found defective. It is the responsibility of the seller to supply goods free of error/defect or point out the defect to the buyer. In no way is he allowed to cover the defect of the goods which constitutes a fraud • in one hadith, the Prophet has stated: “He is not amongst us who indulges in fraud” • therefore, the buyer has the right to return the good in case of a defect which is considered a defect in the market and which depreciates the value of the goods • .

UNANIMOUS SHARIAH FEATURES • After taking delivery, the purchaser does not have the ‘option of inspection’ (khiyar al-ruyat): • whereas the goods can be returned after inspection • AGENCY AGREEMENT • If the musallim has no expertise to sell the commodities received under the salam contract, it can appoint the musallam ‘alayhi as its agent to sell the commodity in the market/third party, on condition that: • salam and the agency agreements are separate from each other • A price at which the agent will sell the commodity must be determined: • but if the price increases, the benefit can be given to the agent • On the other hand, if the musallim has expertise in the relevant commodity: • it can sell the commodity in the market or to a third party • It can hold the commodity to fetch a better market price to maximize its profit

UNANIMOUS SHARIAH FEATURES PROMISE TO PURCHASE • Before maturity, the musallimcan take promise to purchase from a third party. After taking delivery, the musallim will sell the same commodity to the promissee which will be bound to purchase it according to the undertaking: • this promise ought to be unilateral • PENALTY FOR LATE DELIVERY • Musallam‘alayhican undertake in the salamagreement that in case of late delivery, it shall pay to the charity account maintained by the musallima sum calculated on the basis ofa certain % per annum, for each day of default • musallimwill spend this amount in charity purpose on behalf of the musallam‘alayhi • this is a sort of self-imposed penalty to keep oneself away from default

DEBATED SHARIAH FEATURES • AVAILABILITY OF COMMODITIES • It is required that commodities involved in salam contract remains available in the market right from the day of contract up to the date of delivery: • if a commodity is not available in the market at the time of the contract, salam cannot be affected, even though it is expected that it will be available in the market at the date of the delivery (Hanafi school) • However, the Shafi’, Maliki, and Hanbali schools are of the view that the availability of the commodity in the market is necessary at the time of delivery only (so that in any case the musallam ‘alayhi should be able to discharge its liability) • this second approach should be preferred • . TIME OF DELIVERY • It is necessary that the time of delivery is at least one month from the date of agreement (this is perhaps to restrict the sale concessions and drive it towards processing in agriculture, construction, or manufacture): • if the time of delivery is shorter, salam is not valid as small farmers and traders should be given enough time to acquire the commodity (Hanafi and HanbalI) • Imam Malik supports this view but put the period at not be less than fifteen days • some other jurists, like Imam Shafi’ and some Hanafi jurists oppose it on the ground that the Holy Prophet (pbuh) has not specified a minimum period for the validity of salam

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

SCOPE AND POTENTIAL OF SALAM • Salamhas been applied in the agricultural sector since before the life of the Prophet (pbuh), when it was a documented business method • Provide Islamically accepted financing alternative and avoid any involvement in ribà • Salam is beneficial: • to the musallam ‘alayhi, because it receives the price in advance and may finance its business venture • to themusallim, because normally, the price in salam islower than the price in spot sales (or: spot price agreed is lesser than future prices on the actual date of delivery) • The original purpose of this sale by way of exceptionand the reason of its agreement by Shariah was to address the needs of two categories of people: • small farmers who needed money to grow their crops (purchase seeds and fertilizers) and feed their families up to the time of harvest without falling pray of shark loaning • small traders or artisans in need of capital to export goods to other places and to import goods to their homeland

SCOPE AND POTENTIAL OF SALAM • Thesalam sale is suitable to finance the agricultural operations where the musallimcan transact with farmers who are expected to have the commodity penalized during harvest time: • thus the musallimrenders great services to the farmers in their way to achieve their production targets • itis a valuable tool with to provide agricultural finance to large community of unserved/underserved farmers’ • practically, it is used to finance the agricultural needs of the farmers • Salam sale may also be used to finance commercial and industrial activities, especially in phases prior to production and export of commodities: • goods are purchased on salam and marketed for a profit • The musallim may finance the craftsmen and small producers through the salam sale by supplying them with the material for production as a salam capital in exchange of some of their commodities

ACCOUNTING • On January 01, 2013, Mr. A contacts the IFI to seek six-month financing of USD 15.000 for purchase of seeds and fertilizers. To be paid by delivery of 50 tons of wheat by July 30 2013 (USD 300 per ton) • IFI agrees to provide required financing in cash by opening current account for Mr. A and prepares salam sale contract duly signed by both parties on 5th January, 2013. At the same day account opening form is signed by Mr. A • This transaction has effect on both sides of the balance sheet. A current deposit is generated on the liabilities side and an investment under Salam Financing, of equal amount. His created on the assets side

ACCOUNTING • On 1 May, 2013 IFI enters into parallel Salam of wheat with Mr. B as potential buyer of 50 tons of wheat at USD 310 per ton for delivered on July 31, 2010. Impact of this transaction is as follow • On June 1, 2013 IFI comes to know that prices of wheat has fallen to USD 290 per ton, hence the commodity to be received has lost a portion of its book value. An immediate write off of loss is required as per accounting standard on Salam. This event affects equities as well as salamfinancing by equal amount, because loss in value is charged to equities of Islamic bank

ACCOUNTING • On July 30, 2010, Mr. A provides 50 tons of wheat which he hands over to Mr. B with shifting expenses (from fields of A to storage of B) incurred amounting to USD 50. This transaction affects parallel Salam account, Salam account, cash account (other assets) and retained earnings account (equities). In fact bank earned a profit of USD 500 and incurred expenses of USD 50. Cash decreased by .......... while salam financing account come to an end as well as parallel Salam account. Let us see the balance sheet as at July 31st 2010 • On

RISK & RISK MANAGEMENT • Counter-party risk: the musallam ‘alayhimay default after taking the payment in advance • Commodity price risk: whereas at the time the goods are received the price may be lower than the price that was originally expected • Quality risk, low investment return or loss: occurs when goods received are not of desired quality or unacceptable for the potential buyer • Asset-holding risk: the musallim might not be able to market the goods in time, resulting in possible asset loss for the unsold goods and locking funds in the goods until they are sold, this implies possible extra expenses on storage and Takaful • Asset-replacement risk: in case the musallimhas to purchase goods from the market where the third party fails to supply the specified goods • Fiduciary risk: if the musallam ‘alayhi has not delivered the goods as expected

RISK & RISK MANAGEMENT • Risk management: • purchase only goods that have good marketing potential • take proper security and a performance bond • require from the prospective buyers earnest money in deposit and a binding promise to purchase • a penalty clause in the salam contract against late delivery from the supplier • parallel salam by purchasing similar goods from the market on spot

DIFFERENCES WITH SIMILAR CONTRACTS SALAM v MURABAHAH Murabahah, ijarah and salam are the three nominative contracts that involve either the sale of a good or the sale of the use of a good

DIFFERENCES WITH SIMILAR CONTRACTS SALAM v ISTISNA’ Istisna’ is an offspring of the salam contract

DIFFERENCES WITH SIMILAR CONTRACTS • SALAM vFUTURES & FORWARDS • Though close parallels can be found with futures contracts or even with options, fundamental differences exist: • Salam sale can be affected only for halalfungible goods which are generally available in the market at the time of delivery. Physical delivery of goods forming the subject matter of salam contract is required by Islamic law • In case of futures and forwards, physical delivery is not required as in most of the cases the contract is settled on margins by the parties involved: • hence: goods are not sold and purchased rather claims are sold and purchased which create no utility for the society as a whole. It is zero sum game where certain individuals gain on the expense of others • this practice of settling contracts on margins has led to short selling which creates imbalance in the market • Hence: two basic features of the salam sale differentiate it from futures and forwards: • immediate payment of total price (not a percentage as margin) • definite delivery of goods

SALAM AS A SHORT TERM FINANCE TOOL • Over the generations, commercial salam has expanded to meet the needs of trade financiers: • it has also spawned a derivative: istisnà’ • When utilized in the financial markets, the salam sales contract effectively provides a means to finance: • financial institutions and investors can make a return by paying funds in full to a trader for future delivery of commodities knowing there is a third-party buyer and a ready supply in the market • like other Islamic commercial methods, it might be better characterized as a process • The salamhas the flexibility to cover the needs of various sectors of activities where farmers, industrialists, contractors, exporters or traders are involved: • it can be used to meet the capital requirements as well as to meet the cost of operations • Salam, as a short term financial tool, allows an entreprise to limit its risks, define future profit opportunities with reasonable accuracy, and manage production timing to demand cycles

SALAM AS A SHORT TERM FINANCE TOOL • EXIT STRATEGY • Off-take mechanism: before entering into a salam agreement, the musallim, who will be acquiring title to the commodities on deferred delivery and who is not a direct consumer of the goods, has to have in place a creditworthy pre-agreed on-sale (or other exit strategy) mechanism with the end-consumer/buyer • Agency agreement: the musallam ‘alayhinegotiates terms and conditions (price, qualifications, quality, quantity, delivery, etc.) with the end-buyer (if it acts as agent of the musallimthrough an agency agreement) • The musallimand the end-consumer/buyer execute an agreement for sale of the commodities that will be acquired by the musallimfrom the musallam ‘alayhi.This agreement represents an exit strategy and can be implemented via a number of mechanisms: • parallel salam: (i) receives the payment and signs contract of salam with promise to deliver the goods at a point in time in future

SALAM AS A SHORT TERM FINANCE TOOL • ijarahwaiqtinà’ • letter of credit • purchase order • The end-buyer may secure the musallim’s delivery commitment with a mortgage, guarantee or letter of credit

SALAM AS A SHORT TERM FINANCE TOOL • STEPS OF THE PROCESS AND MAIN AGREEMENTS • The salam (deferred delivery) agreement is signed between the musallimand the musallam ‘alayhi: • optional associated security agreements (guarantee or mortgage) may be signed • Musallam‘alayhidraws up a Transaction Notice (communication) with terms reflecting the above agreement • Musallim confirms acceptance (if agreeable with the Transaction Notice) to the musallam‘alayhiby sending a Purchase Order • Musallim pre-pays musallam ‘alayhifor the commodities for future delivery • Musallim assumes titles to the commodities which are delivered by the musallam ‘alayhito the end-buyer who signs off on acceptance • End-buyer pays musallimas per the off-take mechanism agreed upon • letter of credit or promise to pay between producer and end-buyer

PARALLEL SALAM • After the execution of the salam agreement with one party, musallim or musallam ‘alayhi may execute another salamagreement, for the same date of delivery, to sell the proceeds once taken over • CONDITIONS • All rulings listed for the salam contract apply to the parallel salamagreement • There must be two different and independent contracts, these two contracts cannot be tied up and performance of one (rights and obligations) should not be contingent on the performance of the other: • in other words, execution of the second contract is not conditional to the fulfillment of the first contract of salam • Parallel salam is allowed with third party only. Otherwise, it will become a buy-back contract, which is not permissible in Shariah

PRACTICAL STEPS • step 3: musallam ‘alayhiin first salam contract delivers the goods to musallimon due date to discharge its liability • step 4: musallam ‘alayhiof the 2ndsalamdelivers the goods to 2ndmusallimin parallel salamcontract

ISLAMIC BANKING PRODUCTS • Hybrid SalamFinancing • Salam Financing Working Capital • Parallel Salam Financing

SALAM COMBINED WITH MURABAHAH • Musallimcan sell the salam commodity to the musallam ‘alayhion murabahah, subject to the following terms: • salam agreement and murabahah agreement should be independent, not contingent and with free will of the parties • murabahah will be executed after taking possession of the salamgoods • musallimshall assume the risk of loss by taking delivery and execution of the murabahah • musallimcannot take undertaking from the musallam ‘alayhithat it will purchase the salam commodity from bank on a murabahah basis

ISLAMIC REPUBLIC OF AFGHANISTAN