Mudharabah and Muqharadah in Islamic Finance

BY: CAMILLE PALDICEO OF FAAIF

Mudharabah and Muqaradha in Islamic

Finance

Mudharabah

Mudharabah” is a kind of partnership where the investor partner gives money to another partner under a contract for the purpose of investing it in a commercial enterprise to generate profit and where the profit- sharing occurs according to the terms of the contract and the rules of Mudharabah and Shari’ah.

Mudharabah

The investment capital comes from the first partner who is called “rabb-ul-mal” or investor while the management and work is the exclusive responsibility of the other partner who is called the “mudharib” or the entrepreneur/manager.

Mudharabah

Therefore, the Mudharabah (Profit -Sharing) is a contract with one party generally providing 100 percent of the capital and the other party providing its specialist knowledge to invest the capital and manage the investment project with the goal of generating a profit.

Mudharabah

According to Bank Negara Malaysia, the capital may be fully or partially disbursed or made available to the manager at the time of the conclusion of the contract and based on the terms of the contract.

Managers and Restricted v Unrestricted Mudharabah

According to Bank Negara Malaysia, the powers of the manager shall be provided under the terms and conditions of the contract, which may include the scope and assignment of management of Mudharabah capital to a third- party.

According to Bank Negara Malaysia, the scope of the restricted Mudharabah contract may specify conditions restricting the manager’s role/functions such as determination of location, period for investment, type of project and co-mingling of funds, provided it does not nullify the purpose/objective of the contract.

Managers and Restricted v Unrestricted Mudharabah

However, the restrictions shall not unduly constrain the manager.

In contrast, according to Bank Negara Malaysia, unrestricted Mudharabah capital is the capital deployed in the Mudharabah contract, which does not specify any limiting conditions and where the manager is given the sole and wide -discretion to manage the investor’s capital provided that he or she acts in the best interest of the investor (fiduciary duty).

Two-Tiered Transaction

A bank may serve as intermediary and therefore create a two- tiered transaction with one transaction being between the depositor and the bank and the other transaction being between the bank and the entrepreneur or manager (Mudharib).

However, the contract may just exist between two parties, the investor and the entrepreneur, or may be multi-tiered.


Profits generated are shared between the parties according to a mutually pre-agreed ratio. Compared to a Musharakah, in a Mudharabah, when there is a loss, generally only the lender of the money (investor) suffers losses.

In a Musharakah (joint-venture), both parties incur loss according to the amount of capital contributed, similar to the limited- liability concept in an LLC. (Wikipedia)


Mudharabah is functionally adaptive in the area of general or specific investment, project financing, bridge financing, working capital and SME financing, inter-bank investment, structured products, investment deposits, etc. (Bank Negara Malaysia)


Mudharabah, otherwise known as Muqaradhah, Qirad, ‘trust-financing,’ ‘trustee profit-sharing,’ ‘equity-sharing,’ ‘sleeping- partnership,’ or ‘profit -sharing’ is the basis for re-organizing worldwide banking activity into an interest free framework.

The creditor does not earn interest on a fixed- rate in this system, but participates in the business risks and earns a share of the profit.

The difference between a conventional and an Islamic banking system is that in the conventional system, the cost of capital is expressed in terms of a pre-determined fixed rate while in Islamic banking it is expressed in an absolute amount, which may also be expressed as a ratio of profit.


(The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


Two -tier framework. The first tier of a Mudharabah agreement is between the

bank and the depositors who agree to put their money in the bank’s investment account and to share profits with it.

In this case, the depositors are the providers of capital and the bank functions as the manager of funds.

The second tier of the Mudharabah agreement is between the bank and the entrepreneurs who seek finance from the bank on the condition that profits accruing from their businesses will be shared between them and the bank in a previously agreed proportion, but the loss shall be borne by the financier only.


The bank functions as the provider of the capital and the entrepreneur works as the manager. In the case that there is more than one financier in the same project, profits are shared in a mutually agreed pre-determined proportion, but loss is shared according to the amount each investor has invested. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))

Profit-Sharing

According to Bank Negara Malaysia, the profit is always distributed on a proportional basis and may be based on a lump sum or guaranteed amount if it does not deprive the other partner from sharing in the profit. Furthermore, according to Bank Negara Malaysia, the profit- sharing ratio may be tiered to a target specific profit rate or threshold amount as per a specified benchmark.

Profit-Sharing

Thus, according to Bank Negara Malaysia, any profit rate or return that exceeds a specified benchmark may be allocated to the designated partners based on another formula of distribution such as the level of actual performance as long as this is mutually agreed upon and is included in the contract.

Profit-Sharing

In addition, according to Bank Negara Malaysia, a profit- sharing ratio may be ultimately translated into a fixed percentage based on the capital investment amount.

Furthermore, according to Bank Negara Malaysia, the ex-post performance profit amount based on the profit -sharing ratio (PSR), which is mutually agreed upon and contracted between the capital provider and the manager may be translated into a fixed percentage yield based on the capital investment amount.

Profit-Sharing

Bank Negara Malaysia also advocates that the agreed profit-sharing ratio may vary to correspond with different periods of investment or due to withdrawal of capital provided that such conditions are agreed upon at the conclusion of the Mudharabah contract.

Profit-Sharing

In addition, Bank Negara Malaysia states that a party may undertake (wa’d) to waive his right to the profits (if any), to another contracting party on the basis of Tanazul (waiver) at the inception of the contract. The waiver would be effective on the date of profit distribution.

Qu’ran and Sunnah

The origins of Mudharabah can be found in the Qu’ran and the Sunnah.

“…others travelling through the land, seeking of Allah’s bounty…”

(Al-Muzammil:20)ii. “And when the Prayer is finished, then may

ye disperse through the land, and seek of the Bounty of Allah; and celebrate the Praises of Allah often (and without stint): that ye may prosper.” (Al-Jumu`ah:10)

Qu’ran and Sunnah

According to Bank Negara Malaysia, these verses do not directly address the permissibility of Mudharabah, but are interpreted to imply Mudharabah by referring to those who travel for the purpose of trading and seeking permissible income including those who undertake labor with someone else’s capital in exchange for part of the profit.

Qu’ran and Sunnah

Sunnah:‘The Narration of Ibnu AbbasIbnu Abbas r.a. reported that: “When our leader Abbas

Ibn Abd al-Mutallib gives his property to someone for Mudharabah, he stipulated conditions for his partner not to bring the capital throughout the sea; and not to bring with him the capital crossing a valley; and not to buy animals with the capital; and if his partner violates the conditions, he should guarantee the loss occurred. These conditions have been brought to the attention of Prophet Muhammad (SAW) and he approved them.” (Mu’jam Al-Awsat; Al-Tabrani).

Qu’ran and Sunnah

The Narration of SuhaybSuhayb r.a. reported that the Prophet

Muhammad (SAW) said: “Three matters that have the blessing (of Allah): A deferred sale, Muqaradah (Mudharabah), mixing the wheat with barley for domestic use and not for sale.” (Sunan Ibn Majah).

The Tacit Approval of the Prophet Muhammad (SAW)

Mudharabah venture has been being practiced before the Prophet’s (SAW) first revelation and he did not raise or show any objections against the practice. This is considered a tacit approval by the Prophet Muhammad (SAW).

Ijma

The Muslim jurists have reached Ijma’ among them upon conducting Ijtihad on the permissibility of the Mudharabah contract. It has also been established that the companions of the Prophet Muhammad (SAW) such as Umar, Uthman, Ali, Abdullah Ibn Mas`ud, Abdullah Ibn Umar, and Ubaydullah Ibn Umar have placed the property of orphans under the Mudharabah contract with no objections from other companions.’ (Bank Negara Malaysia)

Profits, Losses, and Fiduciary Duty

In regards to profit- distribution, no profit can be recognized or claimed unless the capital of the Mudharabah is maintained intact.

Whenever a Mudharabah operation incurs losses, such losses stand to be compensated by the profits of future operations of the Mudharabah.

Therefore, the losses brought forward should be set against the future profits.

The distribution of profits depends on the final result of the operations at the time of liquidation of the Mudharabah contract.


If losses are greater than profits at the time of liquidation, the balance (net loss) must be deducted from the capital.

In this case, as she is a trustee, the Mudharib or entrepreneur or manager is not liable for the amount of this loss unless there is negligence, violation of specified conditions, or misconduct on her part. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


Hence, the loss is generally suffered wholly by the investor(s) except in the case of negligence, violation of specified terms and conditions, or misconduct on the part of the Mudharib.

In Islam as in Western finance, the Mudharib or entrepreneur/ manager also owes a duty of care to the investor similar to the trustee/fiduciary relationship found in the common law.


According to Bank Negara Malaysia, the manager is in the position of trustee and thus should act accordingly under a fiduciary duty to the investor to perform in the best manner possible in order to achieve the desired aim of the investor who has invested capital in the venture.


If there is a breach of any of the warranties given by the entrepreneur, which were relied upon by the investor, the investor may be entitled to a claim for damages. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


In fact, according to Bank Negara Malaysia, it is advisable for the investor to require the manager to arrange for an independent third- party performance guarantee, which would be executed as a separate contract and be utilized to cover for any loss or depletion of capital in the event of misconduct, negligence, dishonesty, fraud or breach of the terms of the contract by the manager.

Guarantees

According to Bank Negara Malaysia, specific conditions on third -party guarantees of the capital are as follows:-

i. The legal capacity and financial stability of such a third party as a guarantor shall be independent from the Mudharabah contract and partners;

ii. The third- party guarantor shall not hold the majority ownership of the guaranteed party; and

iii. The guaranteed party shall not hold the majority ownership of the third party guarantor.

Collateral

Furthermore, according to Bank Negara Malaysia, the investor may take collateral from the Mudharib, provided that the collateral could only be liquidated in the event of negligence or misconduct or violation of term of contract by the Mudharib.

Liquidated Damages/Indemnification

However, on the other hand, the entrepreneur may mitigate her liability in the event of negligence or misconduct by negotiating a cap on her liability akin to a liquidated damages or insert an indemnification clause. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))

Third Party Guarantees

According to Bank Negara Malaysia, in addition, a third- party may undertake to bear the loss of capital due to misconduct or negligence on the part of the manager.

Mudharabah

If the total Mudharabah expenses are equal to the total Mudharabah revenues, the investor will receive her capital back without either profit or loss and the Mudharib will not be entitled to a profit.

If profit is realized, it must be distributed between the parties as per the Mudharabah contract.

Mudharabah

The Mudharib or manager/entrepreneur becomes entitled to a share of profit at the point when the Mudharabah has generated profit. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))

Mudharabah

According to Bank Negara Malaysia, the profit may be measured based on the operating performance of the fund, gains realized from the disposal of ownership rights to the fund, or dissolution of the fund.

Also, according to Bank Negara Malaysia, the profit shall be recognized on a realization basis by selling the assets of the Mudharabah partnership (al-tandid al-haqiqi / al-fi’li) or on a constructive basis (altandid al-hukmi) by constructive valuation of the assets including accounts receivables.

Mudharabah

Bank Negara Malaysia states that in the case of constructive valuation, which is based on market valuation or a third party verification, the constructive profit reserve may be recorded. The reserve from the constructive valuation may be distributed when gains are realized at the time of disposal.

According to Bank Negara Malaysia, unrealized gains recognized during the financing shall be recognized as appreciation of capital and included in the profit and loss measurement/calculation for the Mudharabah contract.

Mudharabah

Bank Negara Malaysia states that the partners may mutually agree to set aside a portion of the profit to a third- party who is not involved in the partnership. Furthermore, Bank Negara Malaysia advocates that in a multi-tiered Mudharabah contract, two or more profit- sharing arrangements may be agreed between investor and IFI followed by IFI and the manager.

The profit generated by the manager shall be shared with IFI according to the agreed PSR, which then is redistributed between the IFI and the investor (rabb al-mal) based on the earlier pre-agreed ratio.

Mudharabah

The profit generated by the manager shall be shared with IFI according to the agreed PSR, which then is re-distributed between the IFI and the investor (rabb al-mal) based on the earlier pre-agreed ratio.

The Mudharabah Contract

In the Mudharabah contract, the parties may specify the terms of trade, require the inspection of the accounts, and determine the share in the profits according to a mutually agreed pre-agreed ratio between the investor(s) and the entrepreneur among other things.


The entrepreneur may conduct the business in her sole-discretion if unrestricted Mudharabah or with contractual restrictions if a restricted Mudharabah and she is obligated to perform business functions, which are ancillary to the enterprise without any additional charge.


However, if the entrepreneur performs additional services outside the normal scope of manager for the enterprise, she may be entitled to additional compensation, which should be accounted for in the Mudharabah contract. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


In a Mudharabah contract, it is not permitted to use a debt owed by the entrepreneur or another party to the investor as capital.

According to Bank Negara Malaysia, debts such as account receivables or loans due to a capital provider do not qualify as capital of Mudharabah.


For a Mudharabah contract to be valid and for the Mudharib to be considered as having control over the capital, the capital must be wholly or partially put at the disposal of the entrepreneur or the entrepreneur must have free access to the capital.


As per other Islamic joint- venture arrangements, the Mudharabah contract should stipulate the voluntary winding-up process after the termination of the contract and any issues related to insolvency and bankruptcy. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


If the joint profits of the business are re-invested into the business, the Mudharabah by default converts into a Musharakah by virtue of the use of joint funds, thereby converting the entire structure of the transaction.


The entrepreneur is then held liable for losses in proportion to her share in the capital and the investor is no longer solely liable for losses and both parties become liable according to their contributed share of capital. (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))


According to Bank Negara Malaysia, in general, any of the contracting parties may terminate the Mudharabah contract unilaterally.

However, according to Bank Negara Malaysia, the contract shall generally not be terminated unilaterally if the manager has commenced the work or when both parties have agreed not to terminate the contract during a specified time.

However, according to Bank Negara Malaysia, failure to provide capital by the investor as per the agreed contractual schedule shall constitute a breach of promise according to the specified terms and conditions of the contract.


In this case, the manager then has the option to terminate the Mudharabah agreement or both parties may agree to revise the agreement based on actual capital contribution.


According to Bank Negara Malaysia, where the agreement is terminated, the manager is obligated to return the outstanding capital (if any) to the investor and if the Mudharabah expenditure exceeds the actual capital contribution of the investor, such liability shall be borne by the investor up to the limit of the total amount committed under the contract.

Withdrawing the Capital Before Commencement of the Business Venture

Upon agreement to provide capital or disbursement of funds, the investor may withdraw the capital from the venture prior to commencement of the business venture subject to terms and conditions.

However, the investor may not be entitled to the profits on capital if the withdrawal is made before the maturity of the investment period in a restricted Mudharabah business venture. (Bank Negara Malaysia)

Way Out of the Contract with Limited Penalty/Liability and without Termination

According to Bank Negara Malaysia, a Mudharabah contract may incorporate Mubara’ah/Takharuj clause whereby:-

i. An existing capital provider agrees to forgo his right over certain profit if he exits the venture prior to its maturity date; and

ii. A new capital provider agrees to assume liability of the venture, which has commenced operation prior to his participation.


According to Bank Negara Malaysia, the Mudharabah contract shall be binding in the following events:

i. When the manager has commenced the business. In this event, the contract is binding up to the date of actual or constructive completion.

ii. When the duration or the termination date of the contract has been determined. However, the contract may be terminated earlier based on a mutual agreement by the parties.


In general and in sum, Bank Negara Malaysia states that the Mudharabah contract may be terminated due to the following circumstances:-

i. Unilateral termination by any of the parties when the Mudharabah does not constitute a binding Mudharabah.

ii. Mutual agreement to terminate between the parties.iii. The contract expires as at the maturity date agreed by

the parties.iv. The impairment of the Mudharabah fund does not

favor the continuity of the venture.v. The demise of the manager or the liquidation of the

managing institution.


The existence of one of these conditions would consequently render a Mudarabah contract invalid.

In this case, the Mudarib is deemed as the worker/agent who deserves fair and reasonable wages or fees only.


Based on Information from (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003)), Bank Negara Malaysia, and Wikipedia.

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Economy & Finance

Mudharabah and Muqharadah in Islamic Finance