27 Feb 2012 SALAM Contract in Shariah
Salam is a forward sale contract for future delivery of specified goods with up-front payment of price
It is also called Salaf or Taslif meaning a sale by advance payment. Salam has been permitted by the Holy Prophet (PBUH) notwithstanding the general principle of the Shariah that the sale of a commodity which is not in possession of the seller is not permitted.In Salam the seller undertakes to supply specific goods to the buyer at a future date, in exchange of an advanced price fully paid at the spot. The payment is made in cash, and the supply of purchased goods is deferred.
This publication provides a general overview on the Salam structure of finance.
PURPOSE OF SALAM CONTRACT
- To meet the needs of small farmers who need money to grow their crops and feed their family up to the time of harvest.
- To meet the need of working capital
- To meet the needs of liquidity problem.
- To meet the need of traders for import and export business.
- The Salam sale has the flexibility to cover the needs of various sectors of people such as farmers, industrialists, contractors, exporters or traders. It can be used to meet the capital requirements as well as to meet the cost of operations
- Salam sale is suitable to finance the agricultural operations where the bank can transact with farmers who are expected to have the commodity in penalty during harvest either from their own crops or crops of others, which they can buy and deliver in case their crops fail. Thus the bank renders great services to the farmers in their way to achieve their production targets.
- Salam sale is also used to finance the commercial and industrial activities, especially in phases prior to production and export of commodities and that is purchasing it on Salam and marketing them for lucrative prices.
- The bank in financing craftsman and small producers applies the Salam sale by supplying them with the inputs of production as a Salam capital in exchange of some for their commodities to market.
CONDITIONS OF SALAM CONTRACT
- The buyer must pay the full price to the seller at the time of affecting the sale. The basic idea behind the Salam agreement, is to satisfy the ‘instant need’ of the seller. If it is not paid in full, the latter purpose is not achieved.
- The quantity and the quality of the goods must be specified.
- Salam cannot be effected on a particular commodity or on a product of a particular field or farm.
- The contract must expressly state the quality of goods, thus leaving no room for ambiguities, which might lead to disputes later on. Same is the case as regards the quantity; it must be agreed upon in absolute terms.
- The exact date and place of the delivery must be specified.
- Salam cannot be effected in respect of things, which required them to be delivered at the spot.
- Since the price in the Salam agreements is generally lower than the price in spot sales, the difference between the two prices may be valid profit for the bank.
- A security in the form of guarantee, mortgage or hypothecation may be required in order to ensure the delivery from the seller.
- The seller must deliver to the buyer, the commodity, and not the money at the time of delivery.
Delivery of Salam goods/commdoties
Before delivery, goods will remain at the risk of the seller. After delivery, risk will be transferred to the purchaser. Possession of goods can be physical or constructive.
After taking delivery, the purchaser has the “option of defect” (Khiyar-e-Aib). Not the “option of seeing.”
RISKS INSALAM CONTRACT
Secondary or indirect liquidity risk
Secondary or indirect liquidity risk arises in salam contract when some other risk associated with this contract materializes. For example,
- the credit risk with this contract is that the seller may not be able to deliver the commodity on the specified date. If it does happen, then the liquidity problem of the bank extends beyond the maturity date.
- Having not received the commodity it cannot sell it in the market to convert it into a liquid asset.
Another example of indirect liquidity risk is if the commodity is delivered but the
- quality or
- quantity or
- some other attribute
of the purchased commodity is below the required specifications causing a legal dispute. The litigation risk which was a risk factor before the delivery now becomes a liquidity risk.
A way to mitigate the primary liquidity risk (as well as to avoid the delivery) in Salam contract is to use parallel Salam. The idea is to write a separate offsetting Salam contract.11 But the second Salam has to be
- an independent contract not contingent on the performance of the first Salam contract, and
- must be with a third party (i.e., not with the counter party in the first salam contract or its affiliates).
However, as long as the credit risk and the risk of dispute exist the secondary liquidity risk (or indirect liquidity risk) of salam still remains, and even increases now because of the two parallel contracts instead of one contract.
After the execution of Salam agreement with one party, buyer or seller executes another Salam agreement with third party.
Conditions for Parallel Salam
- There must be two different and independent contracts, these two contracts cannot be tied up and performance of one should not be contingent on the other.
- Parallel Salam is allowed with third party.
If the bank has no expertise to sell the commodities received under Salam contract, then the bank can appoint the customer as its agent to sell the commodity in the market/third party, subject to Salam agreement and Agency agreement, are separate from each other.
A price must be determined in an Agency agreement on which the agent will sell the commodity but if the price is increased, the benefit can be given to the agent.
Selling in the market
If the bank has expertise in the relevant commodity, it can sell the commodity in the market/third party, or hold the commodity to fetch a better market price to maximize its profit.
Promise to purchase
Before maturity bank can take promise to purchase from a third party, after taking delivery, bank will sell the same commodity to the promissee, and he will be bound to purchase the same according to his undertaking.
This promise should be unilateral
Salam combing with Murabahah
Bank can sell the Salam commodity to the seller of Salam on Murabaha subject to following terms:
- Salam agreement and Murabaha agreement should be independent, not contingent and with free will of the parties.
- Murabaha will be executed after taking the possession of Salam goods.
- Bank shall assume the risk of loss b/w taking delivery and execution of Murabaha.
- Bank cannot take undertaking from seller of Salam that he will purchase the Salam commodity from Bank on Murabaha basis.
PENALTY FOR NON PERFORMANCE
Seller can undertake in the Salam agreement that in case of late delivery of Salam goods, he shall pay to the charity account maintained by the bank a sum calculated on the basis of….% per annum for each day of default,bank will spend this amount in charity purpose on behalf of the client.
This undertaking is infact a sort of Yameen/Nazar which is a self-imposed penalty to keep oneself away from default.
The information contained herein is for informational purposes only and is not meant to serve and should not be relied upon as professional advice. Further information on the subject matter of this publication may be obtained from lecocqassociate.
lecocqassociate provides a full range of financial regulatory, corporate and commercial advice in relation to the structuring and incorporation of entities.
This newsletter is for information purposes only. It does not constitute professional advice or an opinion. Please contact Mr. Dominique Lecocq on email@example.com for any questions.
 Ibid at 11, pages 134-135 (Conditions of Salam).