Principles of Islamic banking and finance/PIBF201/Variable income Islamic modes of finance/Mudarabah

Mudarabah is an agreement between two or more persons whereby one or more of them provide finance (Rab-Ul-Mal) and, while other provides entrepreneurship and management (Mudarib) to carry on any business venture with the objective of earning profits. The investment is called Ras-Ul-Mal. The profit is shared by them by an agreed proportion. The financial loss is borne only by financiers in proportion to their share in total capital. In case there is a loss, the Mudarib loses only his labor time. In Musharakah two or more parties pool their financial resources to start a business venture and share profit and loss with a predetermined ratio (Qaiser, 1990 )

In Pakistan, a financial firm can be registered as a Mudarabah company under the rules and regulations of Mudarabahs. Conceptually, a Mudarabah company is an investment fund for which resources are obtained through sale of certificates to subscribers. Commercial banks in Pakistan serve in this sector either as managers of a subsidiary Mudarabah or as subscribers of other Mudarabahs.

Traditional Interpretation of Mudarabah Finance
It is stated that the trade relation between the Holy prophet (P.B.U.H.) and his wife Khadija (R.A.A.), before his marriage, is an example of Mudarabah. The Holy prophet traveled for selling goods belonging to Khadija and got his share of profit. The most important thing to remember, which will be again emphasized elsewhere, is that Khadija (R.A.A.), the Rab-Ul-Mal, had approached the Prophet to become a Mudarib after she had heard about his competence, honesty and integrity. It is also important to note that this kind of business arrangement existed before the advent of Islam. When Islam prohibited all dealings in riba or interest, Mudarabah became a highly desirable form of business financing.

Specific features of a Mudarabah contract are that in this contract the financier and the Mudarib share the profit in an agreed upon ratio. The financier contributes his Ras-Ul-Mal. He does not contribute by way of labor or managerial skill. The Ras-Ul-Mal is expressed in monetary units, generally accepted in the market. The vital point in a Mudarabah is that the Rab-Ul-Mal bears all the financial risk. He cannot transfer any financial loss to Mudarib. Contract of Mudarabah is needed in those cases when one person has the financial capital but does not have trade skills or the time to use it productively while the other person has the trade skill, contacts and competence but lacks capital of his own to start a business.

In the contract of Mudarabah, profit cannot be expressed as fixed amount to a party. It has to be in the basis of agreed sharing ratio. Fixed amount of money is riba or remuneration. A Mudarabah involving compensation by way of a fixed amount is treated as invalid. If Rab-Ul-Mal and Mudarib incorporate a condition in the Mudarabah contract which makes the distribution of profit uncertain or subject to a condition which tends to make the distribution of profit uncertain, then the Mudarabah will remain intact but such condition will become invalid (Qaiser, 1990 ) In a contract of Mudarabah it is compulsory on the Rab-Ul-Mal to completely hand over the charge of relevant assets to the Mudarib. If he retains the assets (to be delivered in instalments etc.) the contract of Mudarabah is vitiated. In Mudarabah, Ras-Ul-Mal belonging to the financier is lodged with the Mudarib. When the assets are not available with Mudarib, the validity of Mudarabah is questionable. It is incumbent upon the financier to keep himself away from interfering with Mudarabah management. If the financier directly or indirectly, is in a position to interfere in the management, he practically has assets in his own hands. Mudarib is not allowed a free hand to take business decisions. Thus in all such cases where management remains directly or indirectly in the hands of Rab-Ul-Mal, the contract of Mudarabah becomes invalid.

The financier may provide broad policy package to the Mudarib. However, Mudarib is at liberty to decide on all the issues relating to the object of Mudarabah in the light of his own wisdom. Mudarib is, however, not empowered to create a subsequent Mudarabah or a sub-Mudarabah. Before entrusting Ras-Ul-Mal to a sub-Mudarabah, the Mudarib must acquire the consent of the Rab-Ul-Mal. Indeed the Mudarib can form a sub Mudarabah if he has empowered such discretionary power in the original contract.

While handing over Ras-Ul-Mal to Mudarib, the financier can impose some conditions such as trade or business should be done with a particular group of people or with a particular bank. The time period can also be specified by the financier.

Responsibility of Mudarib in a second Mudarabah
In case there were no provisions kept in the Mudarabah contract about formation of a second Mudarabah, there are two different opinion in this regard:

First opinion is that immediately after its commencement it will be treated as a deviation from the first Mudarabah and the first Mudarib will become responsible to the actual financier.

Second opinion is a bit more lenient. According to this opinion, second Mudarabah will only be treated as “deposit” unless the second Mudarib has commenced the trading or profit has occurred in the second Mudarabah. It is necessary that both Mudarabahs should be valid. In case any one of the Mudarabahs is invalid, secondary manager becomes hireling and is to be compensated accordingly by way of hire by the original Mudarib. As far as responsibility to the original financier is concerned, both the Mudaribs are responsible to him. The original financier is at liberty to sue any of the two Mudaribs; first Mudarib has violated the contract, and the second Mudarib is guilty of acquiring the stock from a person who had no valid title or authority to delegate. In case the subsequent Mudarabah is created with the consent of the financier, the second Mudarabah is valid. The Mudarib is in a position to execute a subsequent Mudarabah with third persons and share the profits in an agreed ratio. In case of a valid subsequent Mudarabah, profit will be shared in the light of agreement with the Rab-Ul-Mal. If the Rab-Ul-Mal had agreed to have 50% of the overall profit of the Mudarabah, and then the Mudarib also agrees to pay one third of the overall profits to the second Mudarib, then his own share would be only 17% (i.e. 1-0.50-0.33).

Alternatively, the Rab-Ul-Mal and the first Mudarib may agree to equally share the overall profit made by the first Mudarabah by forming a second Mudarabah with the second Mudarib on the basis of a 50% sharing ratio. In this case the second Mudarib gets 50% of the overall profit whereas Rab-Ul-Mal and the first Mudarib each gets 25% of the overall profit.