What is Salam?
Bai‘Salam or deferred delivery sale is a forward contract wherein the price was paid in advance at the time of making the contract for the prescribed goods to be delivered at a later date. Unlike Murabaha (Cost plus Financing) and Ijarah (Lease), Salam was originally used as a financing mechanism for small farmers and traders.
Under a Salam agreement, a client needing short-term funds sells merchandise to the bank on the basis of deferred delivery. The bank receives the full price of the merchandise on the spot that serves its current financing needs. At a future date that has been pre-agreed, the client delivers the merchandise to the bank. The bank sells the merchandise at the prevailing price in the market. The bank thereby earns a profit on the transaction since the bank pays a lower spot price than the expected future price.
Essential Elements of a Salam Contract
The six elements required for a valid Salam contract are:
- Subject matter of Salam,
- Means of payment,
- Period and place of delivery,
- Khiyar or options,
- Conditions for amending or revoking the Salam contract
- Penalty for non-performance.
Subject Matter of Salam
The following types of goods are not permitted as subject matter of Salam:
- Goods that may not yield any produce for example, any general field,
- Goods that are prone to subjective evaluation, for example, landscapes or precious stones
- Paper currency, which is only a means of payment
The following rules apply to the subject matter of Salam:
- Goods for which the quality and quantity of the goods can be accurately established,
- Well-defined goods without specific units but with specifications that influence prices,
- Fungible (Mithli) things that do not differ significantly,
- Non-identical goods,
- Goods that can be measured in standard units and are available in the market at least at the time of delivery and
- Gold, silver and metallic money like Fulus of copper or other metals, which have functions other than as modes of payment and can be traded as metals.
Means of Payment
The following are permitted as means of payment because these are considered as immediate receipt of the amount due.
- Legal tender
- Goods in barter, if Ribâ is avoided
- Usufruct of assets
The following are not permitted as means of payment
- Outstanding loans on the seller or on a third party because that is debt for debt, which is prohibited to avoid Gharar (uncertainity).
- Payment delayed beyond three days as specified in the agreement and definitely not after delivery,
- Partial payment and
- In barter, advance payment in the form of the same species of goods in exchange of deferred delivery of similar goods
NB: Payment need not always be made through hard cash; it can be credited to a seller’s account.
Period and Place of Delivery
It is important to fix the time and place of delivery of goods. The nature of the goods decides the due date and delivery mode. If a place of delivery is not specified in the agreement, then the place where the contract was finalised will be regarded as the place of delivery. Goods are a responsibility of the seller before the delivery and of the buyer after the delivery.
Khiyar or Options
The Islamic law of option, or Khiyar al-Shart, is not permitted in Bai‘ Salam as it upsets or delays a seller’s ownership over the price of the goods. A buyer does not have the “option of seeing”, or Khiyar al-Ro’yat. A buyer has the “option of defect”, or Khiyar al-‘Aib, and the option of specified quality, after the delivery of goods. This means that a buyer can withdraw the sale if goods are found to be defective or fails to match the quality as agreed at the time of contract. In such cases, a buyer can only recover the price already paid and nothing more than that.
Conditions for Amending or Revoking the Salam Contract
A seller must deliver the goods as specified in the agreement. The following principles apply regarding amendment or revocation of the contract.
A buyer cannot independently change the conditions of the contract regarding the quality, quantity, or the period of delivery once payment is made to the seller.
Both parties have the right to withdraw the contract with mutual consent. In such cases, a buyer may recover the amount already paid, but nothing more than that.
If the market price of the goods seems higher, at the time of delivery, than what a buyer has paid, a seller may want to withdraw the contract. A bank may want to withdraw from purchase if the price of the item decreases at the time of delivery. To avoid such scenarios, it is advisable to make the contract binding on both the parties, with one exception, if the goods are absent from the market/inaccessible to the seller at the time of delivery.
Penalty for Non-Performance
- A seller may agree in the contract that he shall donate to the Charity Account, held by the bank, in case of a delay in delivery. This is a self-imposed penalty. Banks do not have rights to penalise. But if a seller fails due to bankruptcy, he may be granted additional time.
- Clause 5 of 7 of the AAOIFI’s Salam Standard says: “It is not permitted to stipulate a penalty clause in respect of delay in the delivery of the Muslam Fihi (Salam commodity).”
Application of Salam Contracts – in pre-shipment export finance
- The bank receives an export letter of credit in favour of its client for certain goods; the client gives the letter of credit under the bank’s lien. This allows the bank to act as a seller towards the foreign buyer.
- The bank agrees to buy the goods from its client under a Salam contract and makes advance payment to the client. The delivery date should be reasonably after the shipping date, and port of delivery should be the same mentioned in the Letter of Credit.
- Once the client submits the in-order shipping documents such as bill of lading or certificate of origin, delivery is deemed to be satisfactory.
- The bank’s profit is the difference between the agreed payment or pre-shipment finance made by the bank to its client and the amount of the export Letter of Credit.
There are two ways of using Parallel Salam for the purpose of financing:
1) After purchasing a commodity by way of Salam, the financial institution can sell it through a parallel contract of Salam for the same date of delivery. The period of Salam in the second parallel contract is shorter and the price is higher than the first contract. The difference between the two prices shall be the profit earned by the institution. The shorter the period of Salam, the higher the price and the greater the profit. In this way, institutions can manage their short term financing portfolios.
2) The institution can obtain a promise to purchase from a third party. This promise should be unilateral from the expected buyer. The buyer does not have to pay the price in advance. When the institution receives the commodity, it can sell it at a pre-determined price to a third party according to the terms of the promise.
Conditions of Parallel Salam
In Parallel Salam, there must be two different and independent contracts; one, where the bank is a buyer and the other in which it is a seller.
1) The two contracts cannot be tied up and performance of one should not be contingent on the other. For example, if ‘A’ has purchased from ‘B’ 1,000 bags of wheat by way of Salam to be delivered on 31 December, ‘A’ can contract a parallel Salam with ‘C’ to deliver to him 1,000 bags of wheat on 31 December. But while contracting Parallel Salam with ‘C’, the delivery of wheat to ‘C’ cannot be conditioned with taking delivery from ‘B’. Therefore, even if ‘B’ does not deliver wheat on 31 December, ‘A’ is duty bound to deliver 1,000 bags of wheat to ‘C’. He can seek whatever recourse he has against ‘B’, but he cannot free himself from his liability to deliver wheat to ‘C’. Similarly, if ‘B’ has delivered defective goods, which do not conform to the agreed specifications, ‘A’ is still obligated to deliver the goods to ‘C’ according to the specifications agreed with him
2) A Salam arrangement cannot be used as a buy back facility where the seller in the first contract is also the purchaser in the second contract. Even if the purchaser in the second contract is a separate legal entity, but owned by the seller in the first contract; it would not tantamount to a valid parallel Salam agreement. For example, ‘A’ has purchased 1,000 bags of wheat by way of Salam from ‘B’ – a joint stock company. ‘B’ has a subsidiary ‘C’, which is a separate legal entity but is fully owned by ‘B’. ‘A’ cannot contract the parallel Salam with ‘C’. However, if ‘C’ is not wholly owned by ‘B’, ‘A’ can contract parallel Salam with it, even if some share-holders are common between ‘B’ and ‘C’.