Principles of Islamic banking and finance/PIBF201/Variable income Islamic modes of finance/Musharakah Mutanaqisah

Musharakah Mutanaqisa: An Updated Form of musharakah

The musharakah Mutanaqisa practiced by the Islamic banks and Islamic financial institutions today is a relatively recent development on the classical musharakah contract which is a PLS mode of finance available for project and business ventures. It is a partnership agreement whereby the customer and the financier share the cost of both the capital and the management of a project while the profits are distributed between them according to pre-determined ratios, usually but not necessarily based on their equity participation. Losses must be shared in proportion to the respective capital contributions.

In fact musharakah involves a financial institution obtaining an equity share in an asset or business as opposed to providing a conventional loan. Some basic rules of musharakah are discussed below: 1. Profits are shared as per the agreement of the partners whereas losses are shared on a pro-rata basis in the investment. 2. Contribution to the musharakah fund can be via liquid assets or illiquid assets. Once the assets are in the fund they are pooled for the benefit of all partners. 3. Silent partners must take a share of profits in direct proportion to their initial investment.

musharakah mutanaqisa, otherwise known as diminishing musharakah or diminishing partnership is a hybrid financing technique involving both ‘Ijara and musharakah elements. In the musharakah mutanaqisa the financier and the customer participate either in the joint ownership of an asset or in a joint commercial enterprise. It has been used mostly in house financing. The share of the financier is further divided into a number of units and it is understood that the customer will purchase these units one by one periodically, until he becomes the sole owner of the property, or the commercial enterprise, as the case may be.

A musharakah mutanaqisa is entered into by means of a number of different transactions. The first step that the customer takes in a home purchase is to bring in the financier as a co-owner of a home. This partnership is established by the use of a co-ownership agreement rather than conventional loan documentation. The rights and responsibilities of both parties while they own the home together are spelled out in this agreement. The customer and the financier are co-owners who own specific shares in the home. A customer finds a home that is priced to sell, for example, at $300,000. The customer can place 5%-20% ($15,000-60,000) into the transaction, while the financier provides the remaining 95%-80% ($285,000-240,000). The customer is 5%-20% owner; the financier is 95%-80% owner.

Although both co-owners would have the right to occupy the property in this transaction, the financier gives the customer the exclusive enjoyment and use of the whole property. After purchasing the property jointly, the customer uses the house as his residence. The customer’s monthly payment amount consists of two elements. The first portion is the ‘Rent Payment’ for exclusive use of the financier’s share of the property. The remaining portion is ‘Acquisition Payment’ which allows the customer to acquire an increasing share of ownership in the home. Together, these two amounts make up a predictable monthly amount. As the customer makes payments to acquire a further share in the property financier’s ownership share decreases. The rent payable to the financier is also reduced to that extent. This arrangement allows the financier to claim rent according to his proportion of ownership in the property and at the same time allows him periodical returns of a part of his principal through purchases of the shares of ownership in the home.

In order to achieve full home ownership over time, the customer commits to buy the financier’s share of the property over a period of say 15, 20 or 30 years. In the first example above, the financier obtains a share of the home of between 95% and 80% depending on the share allocation. The customer acquires the financier’s 95% or 80% share at the original price through a series of monthly acquisition payments. At any time, the customer also has the option to reschedule and expedite his acquisition of the financier’s remaining share in the property at a faster pace than the predetermined acquisition payments or even buy out the property entirely. There are no additional fees or penalties associated with this option. For instance, if the customer decides to move out of the property before the end of the financing period he can do so by first acquiring the financier’s remaining ownership share and then selling the property in the market. The second step normally takes place immediately after the first step during a single settlement, allowing the customer to use the proceeds of the sale to pay the amount owed to the financier for its remaining share. Naturally, because the customer fully owns the property at the point it is sold in the market, the customer will retain the full gain or loss resulting from this sale.

The above mentioned musharakah mutanaqisa model of Islamic finance enables home financing that honors the principles of the Shari`ah while benefiting from the best of what is available in the modern financial marketplace.

From an Islamic legal perspective, the contract of musharakah mutanaqisa is composed of the following transactions:

1. Creating co-ownership in the property.
2. Renting the financier’s share to the customer.
3. Promise from the customer to purchase financier’s shares.
4. Actual purchase of the shares at scheduled intervals.
5. Adjustment of the rental in proportion to the financier’s decreasing share in the property.

Looking into each part of the musharakah mutanaqisa model in a greater detail one finds that the first step which creates a co-ownership in the property can come into existence in different ways, including joint purchase by the parties. This has been expressly allowed by all Schools of Islamic law. Therefore, no objection can be raised against creating this co- ownership.

Relating to the financier leasing his share in the house to his customer and charging rent there has also been no difference of opinion among the scholars of the Shari`ah in the permissibility of leasing one’s undivided share in a property to one’s partner. However, the jurists have difference of opinions if the undivided share is leased out to a third party. Abu Hanifa and Zufar are of the view that the undivided share cannot be leased out to a third party, while Malik, Al-Shafi`i, Abu Yusuf and Muhammad opined that the undivided share can be leased out to any person.

The third step in the aforesaid transaction in which the customer purchases different units of the undivided share of the financier is also allowed according to all the Islamic Schools. If the undivided share relates to both land and building, the sale of both is also allowed. Similarly, if the undivided share of the building is intended to be sold to the partner, it is also allowed unanimously by all jurists. However, there is a difference of opinion if it is sold to a third party.

Although each one of the transactions mentioned above is allowed per se, the question arises whether this transaction may be combined in a single arrangement. The answer is that if all these transactions are combined by making each one of them a condition to the other, then this is not allowed in the Shari`ah, because it is a well settled rule in the Islamic legal system that one transaction cannot be made a pre-condition for another. However, the proposed scheme suggests that instead of making two transactions conditional to each other, there should be uniteral promise from the customer, firstly, to take out a lease on the financier’s share and pay the agreed rent, and secondly, to purchase units of the financier’s share of the house at different stages. This leads us to the fourth issue, which is the enforceability of such a promise.

It is generally believed that a uniteral promise to do something creates only a moral obligation on the promisor which cannot be enforced through the courts of law. However, there are a number of jurists who opine that uniteral promises are enforceable, and the courts of law can compel the promisor to fulfill his promise, especially, in the context of commercial activities. A short discussion of this juristic view is given below:

Some Maliki and Hanafi jurists are of the opinion that uniteral promises can be enforced through the courts of law in cases of need. The Hanafi jurists have adopted this view with regard to a particular sale called Bai`-bi al- Wafa (an agreement in which one party sells a security to another party and agrees to buy it back on a specified date for the same price as the initial sale price). This is a special arrangement for the sale of a house whereby the buyer promises to the seller that whenever the seller gives him back the price of the house, he will resell the house to him. This arrangement was in vogue in Central Asia. The Hanafi view is that if the resale of the house to the original seller is made a condition for the initial sale, it is not allowed. However, if the first sale is effected without any condition, but after effecting the sale, the buyer promises to resell the house whenever the seller offers him the same price, this promise is acceptable and it creates not only a moral obligation, but also a right enforceable by the original seller. The Muslim jurists allowing this arrangement have based their view on the principle that “a promise can be made enforceable at the time of need”. Even if the promise has been made before effecting the first sale, so long as it is not made a condition of the sale, it is also allowed by certain Hanafi jurists.

Conversely, if the sale is without any condition, but one of the two parties promises to do something separately, then the sale cannot be held to be contingent or conditional upon fulfillment of the promise made. It will take effect irrespective of whether or not the promisor fulfils his promise. Even if the promisor reneges on his promise, the sale will remain effective. The most the promise does is to create a right which the promisee can enforce through legal action. If the promisor is unable to fulfil the promise, the promisee can claim damages for loss suffered owing to the default.

This makes it clear that a separate and independent promise to purchase does not render the original contract conditional or contingent. Therefore, it can be enforced.

The following steps are involved in a musharakah mutanaqisa contract for home financing:

Step1. The vendor sells the property directly to the Islamic bank in whose the legal title to the property is vested. The IFSP pays the full purchase price of the property to the vendor.

Step 2. The Islamic bank and the customer enter into a partnership agreement to co-own the property. The Islamic bank and the customer agree at the start that their respective shares in the property shall be pro-rata in proportion to their contributions towards the purchase price paid to the vendor.

Step 3. Both parties also agree that during the course of their partnership, which has an agreed date of termination, the customer will purchase the Islamic bank’s share in the property in installments and for the price that the Islamic bank had paid for such share on the initial date of acquisition. As the customers increase their share in the property, the Islamic bank’s share correspondingly decreases by the same amount.

Step 4. Parallel to the musharakah mutanaqisa agreement, the Islamic bank grants to the customer a lease in respect of its share in the property. The lease is effective for as long as the Islamic bank has a share in the property.

Step 5. As security for the customer’s obligations to make payments of rent under the lease and acquire the Islamic bank’s share in the property at a fixed price under the musharakah mutanaqisa Agreement, the customer charges by way of security in favour of the Islamic bank, its interests in the property under the Lease and the musharakah mutanaqisa agreement.

On the basis of the above steps to be followed, musharakah mutanaqisa may be used for home financing so long as the following conditions are fulfilled:

1. The agreement of joint purchase, leasing and selling different units of the financier’s share should not be tied up together in one single contract. However, the joint purchase and the contract of lease may be joined in one document whereby the financier agrees to lease his share, after joint purchase, to the customer. This is permitted because ‘Ijara can be effected for a future date.
2. The customer may sign a unilateral promise to purchase different units of the financier’s share periodically and the financier may undertake that when the customer purchases a unit of his share, the rent for the remaining units will be reduced accordingly.
3. The purchase of each unit must be effected by the exchange of an offer and acceptance at that particular date.

It is preferable that units be priced according to the market value of the house prevalent on the date of purchase of that unit. However, it is permissible to agree a particular price in the promise of purchase signed by the customer.