Is financial compensation in Istisnah allowed in Islam?

In-Depth Analysis

We are discussing why the Shariah principles permit paying liquidated damages or financial compensation to the buyer under an Istisna agreement in case of a delay in delivering the Istisna asset by the seller whereas in all other Islamic financing contracts we do not find such permission, instead there is strict prohibition. I assume readers are aware of the Shariah position of applying a penalty in case of a delay in meeting the financial commitment by customers of Islamic banks and financial institutions. First of all, originally there was no practice of charging a penalty on customers by Islamic banks on the past due amounts. It could not have been there as the Shariah principles do not have any mention of it since the 7th century AD. I am the witness to the fact that during the early 2000s when I switched sides from conventional to Islamic banking, this particular aspect was among various other differences that I spotted. At the time, my conventional banking mind became perplexed on the extension of such 'generosity' by my Islamic bank to customers who went scot-free for not paying on time. The learned Shariah scholars sitting on the Shariah board of the bank at the time were fairly accommodative to the trivial questions raised by a newly 'converted' staff member. I assume they must have gathered a lot of patience since the Islamic bank had recently opened its doors to conventional bankers. The explanation provided by the scholars was plain and simple. It was that an Islamic bank carries out trading transactions rather than lending money. Instead of earning interest on lending, the Islamic bank earns a profit on the buying and selling of permissible commodities, goods and assets. They further explained that if the Islamic bank sold something on a deferred payment basis to a customer and the customer does not pay the deferred price on time due to any reason, there is no permissibility in Shariah to increase the deferred sale price by an amount representing the delayed period. This is because what the bank signed is the fixed-price sale contract. Another gem which came out from the panel of learned scholars in the same Q&A session was that when a conventional bank loans the money and the customer repays it with interest, it is tantamount to money paid over and above the original money (or money over money) which becomes interest. In other words, money is on both sides in the lending practice of a conventional bank. Comparing it to an Islamic bank, the money is only on one side as the other side has either goods, commodities or an asset. The example given by the scholars was an easy-to-grasp car financing transaction carried out by an Islamic bank under the Murabahah contract where the bank pays the purchase price directly to the dealer, gets the car in its name and then sells the car under a Murabahah contract to the customer who becomes the car owner and pays the deferred purchase price in installments. So, here the money is only on one side, ie from the customer to the bank whereas the other side has the car from the bank to the customer. In case of a delay in payment of the deferred price by the customer, there is no room to re-open the subject of the sale price by the bank. In fact, in case of genuine difficulty, the Islamic bank will give more time to the customer without enhancing the Murabahah amount and should the bank find out that the customer is deliberately delaying the payment, the bank has the right to seek legal remedy. With the passage of time, the Islamic banks operating in the UAE and the Gulf gathered a long list of past due amounts since the corporate banking customers dealing with Islamic and conventional banks at the same time learned the Shariah ropes that the Islamic banks will keep their past due amounts static. Hence, they decided to divert funds first to keep their record clean with conventional banks in order to save paying the penalty interest on past due amounts to those banks. This undesirable situation was brought to the attention of the respective Shariah boards by the management of Islamic banks in the Gulf with a request to allow Islamic banks to also charge a similar penalty on past dues so as to discipline customers. This was granted by the scholars on the condition that this will be used as a deterrent and the penalty amount so collected shall be donated to charity and not taken as the bank's profit. The introduction of a penalty on late payment was thus introduced and purely aimed at disciplining customers and it resulted in the improvement in the asset portfolio of Islamic banks. Against this backdrop, we shall now discuss how Shariah principles permit an Istisna buyer to claim financial compensation from the Istisna seller in case of a delay in the delivery of the Istisna asset by the Istisna seller and that such compensation is Halal or permissible. Remember, the Shariah definition of interest is money over money — here, the Istisna seller's obligation to the Istisna buyer is not financial but in the shape of an Istisna asset. As such, any financial compensation paid over and above an asset does not make it interest, hence there is valid Shariah justification for the Istisna buyer to apply liquidated damages on the delay in receiving the Istisna asset.