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Islamic Finance - Musharakah & Mudarabah
By Mufti Muhammad Taqi
Usmani
Combination
of Musharakah and Mudarabah
1)
Introduction.
2) Musharakah & Mudarabah as Modes of Financing.
3) Project Financing.
4) Securitization of musharakah.
5) Financing of a single transaction.
6) Financing of the working capital.
7) Sharing in the gross profit only.
8) Running Musharakah Account On the Basis of Daily Products.
9) Distribution of profit on daily product basis fulfills this
condition.
Introduction:
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A contract of
mudarabah normally presumes that the mudarib has not invested
anything to the mudarabah. He is responsible for the management
only, while all the investment comes from rabb-ul-mal. But there
may be situations where mudarib also wants to invest some of his
money into the business of mudarabah. In such cases, musharakah
and mudarabah are combined together. For example, A gave to B Rs.
100000/- in a contract of mudarabah. B added Rs. 50000/- from
his own pocket with the permission of A. This type of
partnership will be treated as a combination of musharakah and
mudarabah. Here the mudarib may allocate for himself a certain
percentage of profit on account of his investment as a sharik,
and at the same time he may allocate another percentage for his
management and work as a mudarib. The normal basis for
allocation of the profit in the above example would be that B
shall secure one third of the actual profit on account of his
investment, and the remaining two thirds of the profit shall be
distributed between them equally. However, the parties may agree
on any other proportion. The only condition is that the sleeping
partner should not get more percentage than the proportion of
his investment.
Therefore, in
the aforesaid example, A cannot allocate for himself more than
two thirds of the total profit, because he has not invested more
than two thirds of the total capital. Short of that, they can
agree on any proportion. If they have agreed on that the total
profit will be distributed equally, it means that one third of
the profit shall go to B as an investor, while one fourth of the
remaining two thirds will go to him as a mudarib. The rest will
be given to A as "rabb-ul-mal."
Musharakah
& Mudarabah as Modes of Financing
In the
foregoing sections, the traditional concept of musharakah and
mudarabah and the basic principles of Shari‘ah governing them
have been explained. It is pertinent now to discuss the way
these instruments may be used for the purpose of financing in
the context of modern trade and industry.
The concept of
musharakah and mudarabah envisaged in the books of Islamic Fiqh
generally presumes that these contracts are meant for initiating
a joint venture whereby all the partners participate in the
business right from its inception and continue to be partners
upto the end of the business when all the assets are liquidated.
One can hardly find in the traditional books of Islamic Fiqh the
concept of a running business where partners join and leave the
enterprise without affecting in any way the continuity of the
business. Obviously, the classical books of Islamic Fiqh were
written in an environment where the large scale commercial
enterprises were not in vogue and the commercial activities were
not so complex as they are today. Therefore, they did not
generally dwell upon the question of such a running business.
However, it
does not mean that the concept of musharakah and mudarabah
cannot be used for financing a running business. The concept of
musharakah and mudarabah is based on some basic principles. As
long as these principles are fully complied with, the details of
their application may vary from time to time. Let us have a look
at these basic principles before entering the details:
(1)
Financing through musharakah and mudarabah does never mean the
advancing of money. It means to participation in the business
and in the case of musharakah, sharing in the assets of the
business to the extent of the ratio of financing.
(2) An
investor / financier must share the loss incurred by the
business to the extent of his financing.
(3) The
partners are at 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, the partner who has
expressly excluded himself from the responsibility of work for
the business cannot claim more than the ratio of his investment.
(4) The
loss suffered by each partner must be exactly in the proportion
of his investment.
Keeping these
broad principles in view, we proceed to see how musharakah and
mudarabah can be used in different sectors of financing:
Project
Financing
In the case of
project financing, the traditional method of musharakah or
mudarabah can be easily adopted. If the financier wants to
finance the whole project, the form of mudarabah can come into
operation. If investment comes from both sides, the form of
musharakah can be adopted. In this case, if the management is
the sole responsibility of one party, while the investment comes
from both, a combination of musharakah and mudarabah can be
brought into play according to the rules already discussed.
Since
musharakah or mudarabah would have been effected from the very
inception of the project, no problem with regard to the
valuation of capital should arise. Similarly, the distribution
of profits according to the normal accounting standards should
not be difficult. However, if the financier wants to withdraw
from the musharakah, while the other party wants to continue the
business, the latter can purchase the share of the former at an
agreed price. In this way the financier may get back the amount
he has invested alongwith a profit, if the business has earned a
profit. The basis for determining the price of his share shall
be discussed in detail later on (while discussing the financing
of working capital).
On the other
hand, the businessman can continue with his project, either on
his own or by selling the first financier's share to some other
person who can substitute the financier.
Since financial
institutions do not normally want to remain partner of a
specific project for good, they can sell their share to other
partners of the project as aforesaid. If the sale of the share
on one time basis is not feasible for the lack of liquidity in
the project, the share of the financier can be divided into
smaller units and each unit can be sold after a suitable
interval. Whenever a unit is sold, the share of the financier in
the project is reduced to that extent, and when all the units
are sold, the financier comes out of the project totally.
Securitization
of musharakah
Musharakah is a
mode of financing which can be securitized easily, especially,
in the case of big projects where huge amounts are required
which a limited number of people cannot afford to subscribe.
Every subscriber can be given a musharakah certificate which
represents his proportionate ownership in the assets of the
musharakah, and after the project is started by acquiring
substantial non-liquid assets, these musharakah certificates can
be treated as negotiable instruments and can be bought and sold
in the secondary market. However, trading in these certificates
is not allowed when all the assets of the musharakah are still
in liquid form (i.e., in the shape of cash or receivables or
advances due from others).
For proper
understanding of this point, it must be noted that subscribing
to a musharakah is different from advancing a loan. A bond
issued to evidence a loan has nothing to do with the actual
business undertaken with the borrowed money. The bond stands for
a loan repayable to the holder in any case, and mostly with
interest. The musharakah certificate, on the contrary,
represents the direct pro rata ownership of the holder in the
assets of the project. If all the assets of the joint project
are in liquid form, the certificate will represent a certain
proportion of money owned by the project. For example, one
hundred certificates, having a value of Rs. one million each,
have been issued. It means that the total worth of the project
is Rs. 100 million. If nothing has been purchased by this money,
every certificate will represent Rs. one million. In this case,
this certificate cannot be sold in the market except at par
value, because if one certificate is sold for more than Rs. one
million, it will mean that Rs. one million are being sold in
exchange for more than Rs. one million, which is not allowed in
Shari‘ah, because where money is exchanged for money, both
must be equal. Any excess at either side is riba.
However, when
the subscribed money is employed in purchasing non-liquid assets
like land, building, machinery, raw material, furniture etc. the
musharakah certificates will represent the holders'
proportionate ownership in these assets. Thus, in the above
example, one certificate will stand for one hundredth share in
these assets. In this case it will be allowed by the Shari‘ah
to sell these certificates in the secondary market for any price
agreed upon between the parties which may be more than the face
value of the certificate, because the subject matter of the sale
is a share in the tangible assets and not in money only,
therefore the certificates may be taken as any other commodities
which may be sold with profit or at a loss.
In most cases,
the assets of the project are a mixture of liquid and non-liquid
assets. This comes to happen when the working partner has
converted a part of the subscribed money into fixed assets or
raw material, while rest of money is still liquid. Or, the
project, after converting all its money into non-liquid assets
may have sold some of them and has acquired their sale proceeds
in the form of money. In some cases the price of its sales may
have become due on its customers but may have not yet been
received. These receivable amounts, being a debt, are also
treated as liquid money. The question arises about the rule of
Shari‘ah in a situation where the assets of the project are a
mixture of liquid and non-liquid assets, whether the musharakah
certificates of such a project can be traded in? The opinions of
the contemporary Muslim jurists are different on this point.
According to the traditional Shafi‘i school, this type of
certificate cannot be sold. Their classic view is that whenever
there is a combination of liquid and non-liquid assets, it
cannot be sold unless the non-liquid part of the business is
separated and is sold independently.
The Hanafi
school, however, is of the opinion that whenever there is a
combination of liquid and non-liquid assets, it can be sold and
purchased for an amount greater than the amount of liquid assets
in the combination, in which case money will be taken as sold at
an equal amount and the excess will be taken as the price of the
non-liquid assets owned by the business.
Suppose, the
Musharakah project contains 40% non-liquid assets i.e.
machinery, fixtures etc. and 60% liquid assets, i.e. cash and
receivables. Now, each musharakah certificate having the face
value of Rs. 100/- represents Rs. 60/- worth of liquid assets,
and Rs. 40/- worth of non-liquid assets. This certificate may be
sold at any price more than Rs. 60. If it is sold at Rs. 110/-
it will mean that Rs. 60 of the price are against Rs. 60/-
contained in the certificate and Rs. 50/- is against the
proportionate share in the non-liquid assets. But it will never
be allowed to sell the certificate for a price of Rs. 60/- or
less, because in the case of Rs. 60/- it will not set off the
amount of Rs. 60, let alone the other assets.
According to
the Hanafi view, no specific proportion of non-liquid assets in
the whole is prescribed. Therefore, even if the non-liquid
assets represent less than 50% in the whole, its trading
according to the above formula is allowed.
However, most
of the contemporary scholars, including those of Shafi‘i
school, have allowed trading in the units of the whole only if
the non-liquid assets of the business are more than 50%.
Therefore, for a valid trading of the musharakah certificates
acceptable to all schools, it is necessary that the portfolio of
musharakah consists of non-liquid assets valuing more than 50%
of its total worth. However, if Hanafi view is adopted, trading
will be allowed even if the non-liquid assets are less than 50%,
but the size of the non-liquid assets should not be negligible.
Financing of
a single transaction
Musharakah and
mudarabah can be used more easily for financing a single
transaction. Apart from fulfilling the day to-day needs of small
traders, these instruments can be employed for financing imports
and exports. An importer can approach a financier to finance him
for that single transaction of import alone on the basis of
musharakah or mudarabah. The banks can also use these
instruments for import financing. If the letter of credit has
been opened without any margin, the form of mudarabah can be
adopted, and if the L/C is opened with some margin, the form of
musharakah or a combination of both will be relevant. After the
imported goods are cleared from the port, their sale proceeds
may be shared by the importer and the financier according to a
pre-agreed ratio.
In this case,
the ownership of the imported goods shall remain with the
financier to the extent of the ratio of his investment. This
musharakah can be restricted to an agreed term, and if the
imported goods are not sold in the market up to the expiry of
the term, the importer may himself purchase the share of the
financier, making himself the sole owner of the goods. However,
the sale in this case should take place at the market rate or at
a price agreed between the parties on the date of sale, and not
at pre-greed price at the time of entering into musharakah. If
the price is pre-agreed, the financier cannot compel the client
/ importer to purchase it.
Similarly,
musharakah will be even easier in the case of export financing.
The exporter has a specific order from abroad. The price on
which the goods will be exported is well-known before hand, and
the financier can easily calculate the expected profit. He may
finance him on the basis of musharakah or mudarabah, and may
share the amount of export bill on a pre-agreed percentage. In
order to secure himself from any negligence on the part of the
exporter, the financier may put a condition that it will be the
responsibility of the exporter to export the goods in full
conformity with the conditions of the L/C. In this case, if some
discrepancies are found, the exporter alone shall be
responsible, and the financier shall be immune from any loss due
to such discrepancies, because it is caused by the negligence of
the exporter. However, being a partner of the exporter, the
financier will be liable to bear any loss which may be caused
due to any reason other than the negligence or misconduct of the
exporter.
Financing of
the working capital
Where finances
are required for the working capital of a running business, the
instrument of musharakah may be used in the following manner:
(1) The
capital of the running business may be evaluated with mutual
consent. It is already mentioned while discussing the
traditional concept of musharakah that it is not necessary,
according to Imam Malik, that the capital of musharakah is
contributed in cash form. Non-liquid assets can also form part
of the capital on the basis of evaluation. This view can be
adopted here. In this way, the value of the business can be
treated as the investment of the person who seeks finance, while
the amount given by the financier can be treated as his share of
investment. The musharakah may be effected for a particular
period, like one year or six months or less. Both the parties
agree on a certain percentage of the profit to be given to the
financier, which should not exceed the percentage of his
investment, because he shall not work for the business. On the
expiry of the term, all liquid and non-liquid assets of the
business are again evaluated, and the profit may be distributed
on the basis of this evaluation.
Although,
according to the traditional concept, the profit cannot be
determined unless all the assets of the business are liquidated,
yet the valuation of the assets can be treated as
"constructive liquidation" with mutual consent of the
parties, because there is no specific prohibition in Shari‘ah
against it. It can also mean that the working partner has
purchased the share of the financier in the assets of the
business, and the price of his share has been determined on the
basis of valuation, keeping in view the ratio of profit
allocated for him according to the terms of musharakah.
For example,
the total value of the business of A is 30 units. B finances
another 20 units, raising the total worth to 50 units; 40%
having been contributed by B, and 60% by A. It is agreed that B
shall get 20% of the actual profit. At the end of the term, the
total worth of the business has increased to 100 units. Now, if
the share of B is purchased by A, he should have paid to him 40
units, because he owns 40% of the assets of the business. But in
order to reflect the agreed ratio of profit in the price of his
share, the formula of pricing will be different. Any increase in
the value of the business shall be divided between the parties
in the ratio of 20% and 80%, because this ratio was determined
in the contract for the purpose of distribution of profit.
Since the
increase in the value of the business is 50 units, these 50
units are divided at the ratio of 20-80, meaning thereby that 10
units will have been earned by B. These 10 units will be added
to his original 20 units, and the price of his share will be 30
units.
In the case of
loss, however, any decrease in the total value of the assets
should be divided between them exactly in the ratio of their
investment, i.e., in the ratio of 40/60. Therefore, if the value
of the business has decreased, in the above example, by 10 units
reducing the total number of units to 40, the loss of 4 units
shall be borne by B (being 40% of the loss). These 4 units shall
be deducted from his original 20 units, and the price of his
share shall be determined as 16 units.
Sharing in
the gross profit only
2. Financing on
the basis of musharakah according to the above procedure may be
difficult in a business having a large number of fixed assets,
particularly in a running industry, because the valuation of all
its assets and their depreciation or appreciation may create
accounting problems giving rise to disputes. In such cases,
musharakah may be applied in another way.
The major
difficulties in these cases arise in the calculation of indirect
expenses, like depreciation of the machinery, salaries of the
staff etc. In order to solve this problem, the parties may agree
on the principle that, instead of net profit, the gross profit
will be distributed between the parties, that is, the indirect
expenses shall not be deducted from the distribute able profit.
It will mean that all the indirect expenses shall be borne by
the industrialist voluntarily, and only direct expenses (like
those of raw material, direct labor, electricity etc.) shall be
borne by the musharakah. But since the industrialist is offering
his machinery, building and staff to the musharakah voluntarily,
the percentage of his profit may be increased to compensate him
to some extent.
This
arrangement may be justified on the ground that the clients of
financial institutions do not restrict themselves to the
operations for which they seek finance from the financial
institutions. Their machinery and staff etc. is, therefore,
engaged in some other business also which may not be subject to
musharakah, and in such a case the whole cost of these expenses
cannot be imposed on the musharakah.
Let us take a
practical example. Suppose a ginning factory has a building
worth Rs. 22 million, plant and machinery valuing Rs. 2 million
and the staff is paid Rs. 50,000/- per month. The factory sought
finance of Rs. 5,000,000/- from a bank on the basis of
musharakah for a term of one year. It means that after one year
the musharakah will be terminated, and the profits accrued up to
that point will be distributed between the parties according to
the agreed ratio. While determining the profit, all direct
expenses will be deducted from the income. The direct expenses
may include the following:
1. the
amount spent in purchasing raw material
2. the
wages of the labor directly involved in processing the raw
material
3. the
expenses for electricity consumed in the process of ginning
4. the
bills for other services directly rendered for the musharakah
So far as the
building, the machinery and the salary of other staff is
concerned, it is obvious that they are not meant for the
business of the musharakah alone, because the musharakah will
terminate within one year, while the building and the machinery
are purchased for a much longer term in which the ginning
factory will use them for its own business which is not subject
to this one-year musharakah. Therefore, the whole cost of the
building and the machinery cannot be borne by this short-term
musharakah. What can be done at the most is that the
depreciation caused to the building and the machinery during the
term of the musharakah is included in its expenses. But in
practical terms, it will be very difficult to determine the cost
of depreciation, and it may cause disputes also. Therefore,
there are two practical ways to solve this problem.
In the first
instance, the parties may agree that the musharakah portfolio
will pay an agreed rent to the client for the use of the
machinery and the building owned by him. This rent will be paid
to him from the musharakah fund irrespective of profit or loss
accruing to the business.
The second
option is that, instead of paying rent to the client, the ratio
of his profit is increased.
From the point
of view of Shari‘ah, it may be justified on the analogy of
mudarabah in services which is allowed in the view of Imam Ahmad
bin Hanbal 
Running
Musharakah Account On the Basis of Daily Products
3.
Many financial institutions finance the working capital of an
enterprise by opening a running account for them from where the
clients draw different amounts at different intervals, but at
the same time, they keep returning their surplus amounts. Thus
the process of debit and credit goes on up to the date of
maturity, and the interest is calculated on the basis of daily
products.
Can such an
arrangement be possible under the musharakah or mudarabah modes
of financing? Obviously, being a new phenomenon, no express
answer to this question can be found in the classical works of
Islamic Fiqh. However, keeping in view the basic principles of
musharakah the following procedure may be suggested for this
purpose:
(i) A
certain percentage of the actual profit must be allocated for
the management.
(ii) The
remaining percentage of the profit must be allocated for the
investors.
(iii)
The loss, if any, should be borne by the investors only in exact
proportion of their respective investments.
(iv) The
average balance of the contributions made to the musharakah
account calculated on the basis of daily products shall be
treated as the share capital of the financier.
(v) The
profit accruing at the end of the term shall be calculated on
daily product basis, and shall be distributed accordingly.
If such an
arrangement is agreed upon between the parties, it does not seem
to violate any basic principle of the musharakah. However, this
suggestion needs further consideration and research by the
experts of Islamic jurisprudence. Practically, it means that the
parties have agreed to the principle that the profit accrued to
the musharakah portfolio at the end of the term will be divided
on the capital utilized per day, which will lead to the average
of the profit earned by each rupee per day. The amount of this
average profit per rupee per day will be multiplied by the
number of the days each investor has put his money into the
business, which will determine his profit entitlement on daily
product basis.
Some
contemporary scholars do not allow this method of calculating
profits on the ground that it is just a conjectural method which
does not reflect the actual profits really earned by a partner
of the musharakah, because the business may have earned huge
profits during a period when a particular investor had no money
invested in the business at all, or had a very negligible amount
invested, still, he will be treated at par with other investors
who had huge amounts invested in the business during that
period. Conversely, the business may have suffered a great loss
during a period when a particular investor had huge amounts
invested in it. Still, he will pass on some of his loss to other
investors who had no investment in that period or their size of
investment was negligible.
This argument
can be refuted on the ground that it is not necessary in a
musharakah that a partner should earn profit on his own money
only. Once a musharakah pool comes into existence, the profits
accruing to the joint pool are earned by all the participants,
regardless of whether their money is or is not utilized in a
particular transaction. This is particularly true of the Hanafi
School which does not deem it necessary for a valid musharakah
that the monetary contributions of the partners are mixed up
together. It means that if A has entered into a musharakah
contract with B, but has not yet disbursed his money into the
joint pool, he will still be entitled to a share in the profit
of the transactions effected by B for the musharakah through his
own money. Although his entitlement to a share in the profit
will be subject to the disbursement of money undertaken by him,
yet the fact remains that the profit of this particular
transaction did not accrue to his money, because the money
disbursed by him at a later stage may be used for another
transaction. Suppose, A and B entered into a musharakah to
conduct a business of Rs. 100,000/-
They agreed
that each one of them shall contribute Rs. 50,000/- and the
profits will be distributed by them equally. A did not yet
invest his Rs. 50,000/- into the joint pool. B found a
profitable deal and purchased two air-conditions for the
musharakah for Rs. 50,000/- contributed by himself and sold them
for Rs. 60,000/-, thus earning a profit of Rs. 10000/-. A
contributed his share of Rs. 50,000/- after this deal. The
partners purchased two refrigerators through this contribution
which could not be sold at a greater price than Rs. 48000/-
meaning thereby that this deal resulted in a loss of Rs. 2000/-
Although the transaction effected by A's money brought loss of
Rs. 2000/- while the profitable deal of air-conditions was
financed entirely by B's money in which A had no contribution,
yet A will be entitled to a share in the profit of the first
deal. The loss of Rs. 2000/- in the second deal will be set off
from the profit of the first deal reducing the aggregate profit
to Rs. 8000/-. This profit of Rs. 8000/- will be shared by both
partners equally. It means that A will get Rs. 4000/-, even
though the transaction effected by his money has suffered loss.
The reason is
that once a musharakah contract is entered into by the parties,
all the subsequent transactions effected for musharakah belong
to the joint pool, regardless of whose individual money is
utilized in them. Each partner is a party to each transaction by
virtue of his entering into the contract of musharakah.
A possible
objection to the above explanation may be that in the above
example, A had undertaken to pay Rs. 50,000/- and it was known
before hand that he will contribute a specified amount to the
musharakah. But in the proposed running account of musharakah
where the partners are coming in and going out every day, nobody
has undertaken to contribute any specific amount. Therefore, the
capital contributed by each partner is unknown at the time of
entering into musharakah, which should render the musharakah
invalid.
The answer to
the above objection is that the classical scholars of Islamic
Fiqh have different views about whether it is necessary for a
valid musharakah that the capital is pre-known to the partners.
The Hanafi scholars are unanimous on the point that it is not a
pre-condition. Al-Kasani, the famous Hanafi jurist, writes:
According to
our Hanafi School, it is not a condition for the validity of
musharakah that the amount of capital is known, while it is a
condition according to Imam Shafi‘i. Our argument is that
Jahalah (uncertainty) in itself does not render a contract
invalid, unless it leads to disputes. And the uncertainty in the
capital at the time of musharakah does not lead to disputes,
because it is generally known when the commodities are purchased
for the musharakah, therefore it does not lead to uncertainty in
the profit at the time of distribution." (Badai‘-us-sanai‘
v.6 p.63)
It is,
therefore, clear from the above that even if the amount of the
capital is not known at the time of musharakah, the contract is
valid. The only condition is that it should not lead to the
uncertainty in the profit at the time of distribution.
Distribution
of profit on daily product basis fulfills this condition.
It is true that
the concept of a running musharakah where the partners at times
draw some amounts and at other times inject new money and the
profits are calculated on daily products basis is not found in
the classical books of Islamic Fiqh. But merely this fact cannot
render a new arrangement invalid in Shari‘ah, so far as it
does not violate any basic principle of musharakah. In the
proposed system, all the partners are treated at par. The profit
of each partner is calculated on the basis of the period for
which his money remained in the joint pool. There is no doubt in
the fact that the aggregate profits accrued to the pool are
generated by the joint utilization of different amounts
contributed by the participants at different times. Therefore,
if all of them agree with mutual consent to distribute the
profits on daily products basis, there is no injunction of
Shari‘ah which makes it impermissible; rather, it is covered
under the general guideline given by the Holy Prophet
in his famous hadith quoted in this book more than once:
Muslims are
bound by their mutual agreements unless they hold a permissible
thing as prohibited or a prohibited thing as permissible.
2.
If distribution on daily products basis is not accepted, it will
mean that no partner can draw any amount from, nor can he inject
new amounts to the joint pool. Similarly, nobody will be able to
subscribe to the joint pool except at the particular dates of
the commencement of a new term. This arrangement is totally
impracticable on the deposits side of the banks and financial
institutions where the accounts are debited and credited by the
depositors many times a day. The rejection of the concept of the
daily products will compel them to wait for months before they
deposit their surplus money in a profitable account. This will
hinder the utilization of savings for development of industry
and trade, and will keep the wheel of financial activities
jammed for long periods. There is no other solution for this
problem except to apply the method of daily products for the
calculation of profits, and since there is no specific
injunction of Shari‘ah against it, there is no reason why this
method should not be adopted.
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