Principles of Islamic banking and finance/PIBF202/Islamic banking products/Equity based-products

In this session, we will explore the equity-based Islamic financing products namely the mudarabah and musharakah, which falls under the category of profit-and-loss sharing (PLS). To this end, we examine the meanings and definitions of these two products and the relevant conditions to be met.

Mudarabah: Meaning and Definition

Muslim scholars have used different terminology for this Arabic word when translating into English such as ‘profit-sharing’, ‘trust financing’, ‘trustee profit-sharing’, ‘equity sharing’, ‘funds management’, ‘sleeping partnership’ and ‘commenda’.

The names for this kind of contract are themselves of some interest. The very word ‘mudarabah’ seems to come from an idiomatic phrase that appears in the Qur’an, meaning to beat the earth, or travel a great distance.

The mudarabah is defined as a contract between at least two parties whereby one party, the financier (known as rabb al-mal or sahib al-mal, i.e., owner of the property) entrusts funds to the other party, the entrepreneur (the mudharib or `amil), to undertake a business activity. The entrepreneurs return the principal to the financiers with a predetermined share of profit. In the case a loss occurs, the financiers lose some or all of their capital and the entrepreneurs do not receive any remuneration for their labour and effort. In Islamic Banking, the mudarabah contract has been extended to include three parties: the depositors as financiers, the bank as an intermediary, and the entrepreneurs who require fund. The bank acts as an entrepreneur when it receives funds from depositors and as financier when it provides the funds to entrepreneurs. For example, the Islamic banks, after receiving funds from their depositors, may enter into a contract with well-established commodity traders who have access to deals but lack capital to execute them. Profits from the deals will be split between the two parties, rewarding the banks for the provision of money and the traders for their expertise. This is called ‘two-tire mudarabah’ as the investors pool their funds with the banks that subsequently deal with entrepreneurs.

Conditions of mudarabah

The main conditions related to a mudarabah contract are as follows:

1. The banks receive funds from the financiers where no restriction can be imposed on the banks concerning the kind, the duration or the location of the business activity. However, in this contract, deposited funds cannot be invested in activities that are forbidden in Islam. Involvement with such activities would make the contract null and void.
2. The banks have the right to invest the funds directly in form of own investments or to offer them to other entrepreneurs.
3. The banks have the right to aggregate the profits from different investments, and share the net profit with the depositors according to a predetermined ratio. In the event of losses, the depositors lose a proportional share or the entire amount of their funds.
4. The banks have the right to determine the kind of activities, the duration, and the location of projects and supervise the investment when funds are provided to entrepreneurs, provided these are not formulated in a way that harms the performance of the entrepreneurs. However, when a project is undertaken, the banks may not interfere with the management of the investment.
5. The banks cannot seek any guarantee from entrepreneurs to secure their capital against an eventual loss. Such a condition makes the contract null and void.
6. The liability of financiers is exclusively limited to the amount provided, whereas entrepreneurs’ contribution is restricted solely to their labour and effort. If negligence or mismanagement of the entrepreneurs can be proven, they may be made liable for the financial loss and thus be obliged to compensate the financiers.
7. The entrepreneurs share the profit with the banks according to a previously agreed ratio. Until the investment yields a profit, the banks have the possibility of paying a salary to the entrepreneurs. The salary is determined based on the current job-market salary.

It should, however, be pointed out that mudarabah is of limited scope and risky for banking. Banks, even if they are nationalised, cannot work successfully under this financial instrument. Because, the entrepreneurs, being the skilled persons must be free to act within the authority, and as such, nobody not even the state can interfere in their activities. The funds as stated above must be completely made over to them so that they may handle it on their own. The financiers are not allowed to participate with them in work, nor are the entrepreneurs authorised to invest anything of their own to become financiers themselves. Entrepreneurs, as explained above, cannot be expected to furnish security for the capital made over to them. Even if they are made to furnish such security, it will be of no use to financiers because according to the rules of mudarabah, the entire loss attributed to financiers and they cannot fall back upon the security to recover it.

Meaning and Definition of Musharakah

The musharakah is normally translated in English as ‘partnership’. In the context of IB, however, the musharakah means ‘participating financing’ or ‘equity participation’. It is relatively new term in Islamic commercial law. Literally, it means a joint-venture agreement between two parties to engage in a specific business activity with an aim of making profit. In other words, it is a participative arrangement in which all partners contribute to capital. Unlike mudarabah, they are entitled to participate in management but not necessarily required to do so. Profit is to be distributed among the partners in ratio agreed to by the partners in advance, while loss is borne by each partner strictly in proportion to the capital contribution.

The musharakah corresponds in many ways to its conventional counterpart, but there are important differences. There are two kinds of musharakah - one is mufawada or universal partnership, in which complete equality of investment and profit and loss is obligatory; and the other is `inan or limited investment partnership into which all other types of partnership fall. Under an ‘inan arrangement, each partner is the agent but not the guarantor of the other, and the agency applies only to the field of business for which the partnership has been established, and to the extent of their joint capital. The `inan form of musharakah is the form used by the Islamic financial institutions today. The institutions usually translate musharakah as participation rather than partnership, and it is in the sense of participating in the borrower’s profits, in return for the provision of capital, that the musharakah has come into its own, rather than as a working partnership in which both sides contribute the same kind of input.

The Terms and Conditions of Musharakah

The generally agreed terms of the musharakah are as follows:

1. All partners must contribute capital to the partnership.
2. The contribution of capital can be made either in the form of cash or in material provided that its cash value can be established prior to employment in the partnership.
3. The contribution must be subject to profit sharing in any ratio agreed between the partners. A fixed amount of profit must not be agreed as part of the profit-sharing agreement.
4. The partners’ losses are to be shared according to the financing share of each partner and may not be limited to the value of their capital contributions.
5. The Partnership may be agreed for a particular period of time or be indefinite. It can be established as permanent musharakah in which invested funds are not subject to repayment in the short term, or as musharakah mutanaqisa or diminishing partnership where invested funds are repaid over time as profitability allows. Such divestment terms are agreed at the outset.
6. It may be agreed that the termination of the musharakah can only occur with the mutual agreement of all partners, though some jurists argue that one partner on his or her own may require the dissolution of the musharakah. Such a possibility seems to hold out rather dangerous implications for those partners wishing to continue with a business endeavour, especially in the early stages of the partnership and has therefore been rejected by many jurists as an unsound basis for partnership.
7. Partners must receive regular accounting and other information on business activity.
8. Permission from existing partners is required before raising capital from new partners.
9. Partners may negotiate fixed wages or salaries at the outset of the musharakah.