Month and Volume

Mudarabah and Musharakah

The Financial markets and the financial industry are witnessing the growth of Islamic

banking and finance. Although an Islamic banking and finance is a relatively new

force in the world of banking but it surely is a force to reckon with. Especially after

the recent financial doom which slumped markets world-wide and triggered the global

financial crisis. Islamic financial institutions have demonstrated significant resilience

and have been less affected compared to the conventional financial institutions

because of the prohibitions on excessive leverage. The growth, in both size and in

diversity in the Islamic finance industry has been especially robust over the past few

years. It is today a USD 1 trillion industry and is growing at a phenomenal pace of 15

percent annually. Apart from its traditional strong hold in the Middle Eastern

countries, it has spread its wings to Western countries as well. Islamic finance has a

significant presence in Europe and England is touted to be the Islamic finance hub of

the western world. Many leading and popular international banks have established

Islamic banking ‘units’ or ‘windows’ to provide financial services and products that

conform to shariah.

There are various modes of financing in Islamic finance and Mudharabah and

Musharakah fall within this ambit. They are essential modes of financing and are very

widely used by Islamic banking and financial institutions. It goes without saying that

all the modes of financing adhere to Shariah principles. The 4 basic elements

prohibited in Islamic mode of financing are Interest (Riba), Forbidden or

impermissible goods (Haram), Gambling (Maysir) and ambiguity (Gharar).

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Mudarabah financing: The term refers to a form of business contract in which one

party brings capital and the other personal effort. The proportionate share in profit is

determined by mutual agreement. But the loss, if any, is borne only by the owner of

the capital, in which case the entrepreneur gets nothing for his labour. The financier is

known as ‘rab-al-maal’ and the entrepreneur as ‘Mudarib’. As a financing technique

adopted by Islamic banks, it is a contract in which all the capital is provided by the

Islamic bank while the business is managed by the other party. The profit is shared in

pre-agreed ratios, and loss, if any, unless caused by negligence or violation of terms

of the contract by the ‘mudarib’, is borne by the Islamic bank. The profits in a

Mudarabah agreement may be shared in any proportion agreed between the parties

beforehand. However, the loss is to be completely borne by the owner of the capital.

In case of loss, the capital owner shall bear the monetary loss and entrepreneur shall

loose the reward of his effort. Mudarabah could be individual effort or a joint one.

Islamic banks practice Mudarabah in both its forms. In case of individual Mudarabah,

an Islamic bank provides finance to a commercial venture, run by a person or a

company on the basis of profit sharing. The joint Mudarabah may be between the

investors and the bank on a continuing basis whereby the investors keep their funds in

a special fund and share the profits. Many Islamic funds operate on the basis of joint

Mudarabah.

The basic tenets of a Mudarabah contract are:

• There are two contracting parties to a Mudarabah financing, i.e. the provider

of funds (rab-al-maal) and the entrepreneur (Mudarib). The latter does not

contribute any form of capital.

• Profit is shared between the capital provider and the entrepreneur according to

a pre-determined profit-sharing ratio. The profit-sharing ratio has to be

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 mutually consented upon and explicitly stated at the time of contracting (aqad

or agreement) and has to be a proportion/percentage of profits.

• In principal any financial loss under Mudarabah financing must be borne by

the Islamic banking institution. However, if the loss is caused by negligence,

mis-management or breach of contracted terms by the customer, then the

customer is liable for the loss.

Mudarabah financing can be divided into two main types, i.e. Restricted

Mudarabah (Mudarabah al muqayyadah) a n d Unrestricted Mudarabah

(Mudarabah Mutlaqah). Under restricted Mudarabah, the Islamic banking

institution may specify certain terms and conditions, for example stipulate a particular

business or particular place for the customer to invest the capital. The customer is

bound by all these restrictions and any violation of these restrictions may make the

customer liable for the loss, if any. This type of Mudarabah financing may be used for

contract financing of a specific project awarded to the customer. Under unrestricted

Mudarabah, an Islamic banking institution does not impose any limitation on the

customer/ partner, for example, on the type of business, place of business, methods of

payment from the customers and period of investment. In this case, the Islamic

banking institution will not have any recourse to the customer should the business

incur losses due to the investment policy as there would have been no such policy

prescribed by the Islamic banking institution in the first place. This type of

Mudarabah, for example, may be used towards financing a customer’s working

capital requirements.

The most important element of the Mudarabah contract is the distribution of profit.

At the inception of the Mudarabah contract the contracting parties should agree on a

definite proportion of the actual profit to which each of them is entitled. No particular

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proportion has been prescribed by the shariah; rather, it has been left to their mutual

consent.

They can share the profit in equal proportions, and they can also allocate different

proportions for the rab-al-maal and the mudarib. However, they cannot allocate a

lump sum amount of profit for any party, nor can they determine the share of any

party at a specific rate tied up with the capital. To cite an example, let’s say the rab-al-

mal provides a capital of Rs 800,000. On this capital they cannot agree on a condition

that Rs 60,000 out of the profit, if any, shall be the share of the mudarib, nor can they

say that 15 percent or more of the capital shall be given to rab-al-maal. However,

what can be agreed upon according to shariah is the profit-sharing ratio. Example, any

profit arising out of the business, i.e. 40 percent of the actual profit shall go to the

mudarib and 60 percent to the rab-al-maal or vice versa.

It is also allowed that different proportions of profit are agreed in different situations.

For example, the rab-al-maal may say to the mudarib at the beginning of the aqad that

if ‘you trade in gold, you will get 50 percent of the profit and if you trade in silver,

you will get 33 percent of the profit, the profit-sharing ratio can be anything in these

circumstances as agreed upon by the contracting parties. Similarly there can be a case

where the rab-al-maal can say to the mudarib that if he does business in his city or

town, he can be entitled to 30 percent of the profit, and if he does it in another town,

his share can be 50 percent of the profit.

It is important to cite, that apart from the agreed proportion of the profit, as

determined in the above manner, the mudarib cannot claim any periodical salary or a

fee or remuneration for the work done during the Mudarabah contract. On the other

hand, if the business has incurred loss in some transactions and has gained profit in

some others, the profit shall be used to offset the loss at the first instance then the

remainder, if any, shall be distributed between the parties according to the agreed

ratio.

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Termination of Mudarabah contract: The contract of the Mudarabah can be

terminated at any time by either of the two parties. The only condition is to give a

notice to the other party. If all assets are in cash form at the time of termination, and

some profit has been earned on the principle amount, it shall be distributed between

the parties according to the agreed ratio. However, if the assets are not in the cash

form, the mudarib shall be given an opportunity to sell or liquidate them, so that the

actual profit may be determined. There is a difference of opinion among the Muslim

jurists about the question whether the contract of Mudarabah can be in effect for a

specified period after which it terminates automatically. However, this difference of

opinion relates only to the maximum time limit of the Mudharabah. On the question

whether minimum time limit can be fixed by the parties before which Mudarabah

cannot be terminated? No express answer to this question is found in the books of the

Islamic Fiqh, but it appears from the general principles that no such limit can be

fixed, and each party is at liberty to terminate the contract whenever he wishes.

Therefore, if the parties agree, when entering into the Mudarabah, that no party shall

terminate it during a specified period, except in specified circumstances it does not

seem to violate any principle of shariah, particularly in the light of the famous hadith

which says:

“All the conditions agreed upon by the Muslims are upheld, except a condition which

allows what is prohibited or prohibits what is lawful.”

Musharakah financing: Musharakah is another popular technique of financing used

by Islamic banks. It could roughly be translated as partnership. In this technique two

or more financiers provide finance for a project. All partners are entitled to a share in

the profits resulting from the project in a ratio which is mutually agreed upon.

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However, the losses, if any, are to be shared exactly in the proportion of capital

proportion. All partners have a right to participate in the management of the project.

However, the partners also have a right to waive the right of participation in favour of

any specific partner or person. This equity financing arrangement is widely regarded

as the purest form of Islamic financing. There are two main forms of Musharakah:

Permanent Musharakah and Diminishing Musharakah

Permanent Musharakah: In this form of Musharakah an Islamic bank participates in

the equity of a project and receives a share of profit on a pro-rata basis. The period of

contract is not specified. So it can continue so long as the parties concerned wish it to

continue. This technique is suitable for financing projects of a longer life where funds

are committed over a long period and gestation period of the project may also be long.

Diminishing Musharakah: In this form of Musharakah equity participation and

sharing of profit on a pro-rata basis is allowed. It also includes a method by which the

bank keeps on reducing its equity in the project and ultimately transfers the ownership

of the asset to the participants. The contract provides for a payment over and above

the bank share in the profit for the equity of the project held by the bank. That is the

bank gets a dividend on its equity. At the same time the entrepreneur purchases some

of its equity. Thus, the equity held by the bank is progressively reduced. After a

certain time the equity held by the bank shall come to zero and it shall cease to be a

partner. Musharakah form of financing is being increasingly used the Islamic banks to

finance domestic trade, imports and to issue letters of credit. It could also be applied

in agriculture and industry.

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The basic tenets of a Musharakah contract:

• Both parties contribute a portion of capital which may not necessarily be

equal. The contributed capital can be either in the form of cash or assets with

an ascribed value.

• While both partners may undertake the management of the business, if a

partner chooses to withdraw from the management to become a sleeping

partner, such arrangement is allowed. The partner is also allowed to appoint a

third party to manage the business on behalf of the Musharakah partnership.

• The project or business must be permissible by shariah. The proportion of

profit to be distributed between the partners must be mutually pre-agreed upon

inception of the contract.

• Any losses shall be distributed between the partners according to the capital

contribution ratio. However, if the loss is due to the negligence of the

managing partner or management team, such losses shall be borne by the

respective partner or the management team.

Distribution of profit in Musharakah: The distribution of profit is a very crucial

issue in a Musharakah contract. The proportion of profit to be distributed between

the partners must be agreed upon at the time of inception of the contract. If there’s

no mention of the proportion of profit then the contract is not valid according to

shariah point of view. This is because the ratio of profit for each of the partner

must be determined in proportion to the actual profit accrued to the business, and

not in proportion to the capital invested by him. Also, it is not allowed to fix a

lump sum amount for any one of the contracting partners, or any rate of profit tied

up with his investment. Let us take an example to explain the distribution of profit

in light of the Musharakah contract. Suppose, A and B enter in to a partnership

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and it is agreed between them that A shall be given Rs 20,000 per month as his

share in the profit, and the remaining profit will go to B, this kind of partnership

will be rejected by shariah. Similarly, if they agree between them that ‘A’ will get

20 percent of his investment, the contract will still be pronounced as invalid by

shariah. According to shariah, the correct basis for the distribution of profit would

be an agreed percentage of the actual profit accrued to the business. If a lump sum

amount or a certain percentage of the investment has been agreed for any of the

partners, it must be expressly mentioned in the aqad (agreement) that it will be

subject to the final settlement at the end of the term, meaning thereby that any

amount so drawn by any partner shall be treated as ‘on account payment’ and it

will later on be adjusted to the actual profit he may deserve at the end of the term.

But in case if no profit is actually earned or is less than anticipated, the amount

drawn by the partner shall have to be returned.

Sharing of losses: The sharing of losses is done in proportion to the investment

made by each contracting partner in the venture. For example, if a partner has

invested 30 percent of the capital, he must suffer 30 percent of the loss, not more,

not less, and any condition to the contrary shall render the contract invalid.

According to Muslim scholars the ratio of the share of a partner in profit-loss both

must conform to the ratio of his investment. But some scholars differ on this

profit-loss ratio of investment. Some scholars assert that the ratio of the profit may

differ from the ratio of investment according to the agreement of the partners, but

the loss must be divided between them exactly in accordance with the ratio of

capital invested by each one of them. It is this principle that has been mentioned in

the famous maxim: ‘profit is based on the agreement of the parties, but loss is

always subject to the ratio of investment.

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Termination of Musharakah contract: A Musharakah contract can be

terminated in case of following events

• Every partner in the Musharakah contract has the right to terminate the

contract at anytime, provided the partner gives his other partner/partners

notice to this effect, upon which the contract will come to an end. In this

case, if the assets of the Musharakah contract are in cash form, all of them

will be distributed at pro-rata basis between the partners. But if the assets

are not liquidated, then the partners to the contract may agree either on the

liquidation of the assets, or on their distribution or partition between the

partners, as the case may be. In case of dispute between the partners in the

matter where one of the partner seeks liquidation while the other wants the

partition or distribution of the non-liquid assets themselves, the latter shall

be preferred, because after the termination of Musharakah, all the assets

are in joint ownership of the partners, and a co-owner has a right to seek

partition or separation, and no one can compel him on liquidation.

However, if the assets are such that they cannot be separated or

partitioned, i.e. Machinery, then they shall be sold and the sale proceeds

shall be distributed.

• If any one of the partners dies during the contract, the contract of

Musharakah with him stands terminated. His heirs in this case, will have

the option either to draw the share of the deceased from the business, or to

continue with the contract of the Musharakah.

• If any one of the partners becomes insane or otherwise becomes incapable

of effecting commercial transactions, the Musharakah stands terminated.

• If one of the partners wants termination of the Musharakah, while the other

partner or partners like to continue with the business, this purpose can be

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 achieved by mutual agreement. In this case, the partners who want to run

the business may purchase the share of the partner who wants to terminate

his partnership, because the termination of the Musharakah with one

partner does not imply its termination between other partners.

Conclusion on Mudarabah and Musharakah Financing: Financing through

Mudarabah and Musharakah does never mean the advancing of money. In Mudarabah

it means to participate in the business and in the case of Musharakah it means sharing

in the assets of the business to the extent of the ratio of financing. An

investor/financier must share the loss incurred by the business to the extent of

financing. The partners have the liberty to determine, with mutual consent, the ratio of

profit allocated to each one of them, which may differ from the ratio of investment.

However, in case a partner has expressly excluded himself from the responsibility of

work for the business, he cannot claim more than the ratio of his investment in the

project or business venture. In case of loss suffered in the project each partner must

bear the loss exactly in the proportion of his investment.

Benefits of Mudarabah/Musharakah financing on society: Both

Mudarabah/Musharakah financing are a part of the Islamic financial system which

rejects the concept that a borrower is liable for the repayment of the funds borrowed

and a predetermined return on those funds, regardless of the performance of the

borrower’s business. Under the Islamic system, this rejection of interest is replaced

with the concept that the lender is to assume the risks of the borrower’s business and

share in the profits and losses of that business. Interest or riba at the outset is strictly

prohibited in both Mudarabah/Musharakah or in any mode of Islamic financing. This

is because interest as human suffering has shown over centuries, causes much harm to

human beings. Its institutionalization, as in the secular/ western economies, causes

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wealth to be concentrated within the hands of the few, which is something Islam

clearly forbids.

Mudharabah/Musharakah financing are both based upon equity and profit-sharing.

This is due to the Islamic financial system which views equity capital, which is

productive in a real sense and the social and economic relationships that have to be

built, are not based on debt relationships, but upon equity and participation. Now this

is a very different concept of society from that of the contemporary capitalist society,

which is a society where human beings groan under the burden of debt, and the

individual is seen as a consumer. Islam says it has to be a participating, a profit-

sharing society, based on a different model, and in this model, freedom can be

ensured because every individual feels he is a participant in the drama of production

and not in any way subject to a debt situation. Islam encourages Muslims to invest

their money and to become partners in order to share profits and risks in the business

instead of becoming creditors.

By

Islami Tijara team

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