Islamic Modes of Financing

Mudaraba

Summary of the Previous Lecture

We covered the following topics in the previous lecture,

1.The concept of Musharakah contract.

2.Features of the Musharakah contract:

•Capital contribution by all partners

•Management of Musharakah venture

•Profit sharing

•Loss sharing

•Partnership venture

Learning Outcomes

After this lecture you should be able to understand

1.One of the most important mode of financing

under Islamic financial system, i.e. Mudaraba.

2.Principles of Mudaraba

3.Uses of Mudaraba

Definition

• This is a kind of partnership between the two parties

where one partner contributes capital and the other one

contributes efforts as manager or entrepreneur. The

profit of the venture is share at an agreed ratio while the

losses are borne by the capital provider.

• The investment comes from “Rabb-ul-Maal” (Investor)

while the management and work is an exclusive

responsibility of the working partner, who is called

Mudarib.

Features of Mudaraba Contract

There are number of principles governing the

Mudaraba contract, e.g.

1.Nature of the contract

2.Capital

3.Management of the Mudaraba

4.Profit and loss sharing mechanism

1. Nature of the Mudaraba Contract

• Generally Mudaraba contract allows anyone of the

contracting parties to terminate the contract unilaterally.

• However, the contract shall 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.

2. Capital

• The capital shall be contributed by the capital

provider and shall be managed by the manager

to generate income.

• The capital of Mudarabah may be in the form of

monetary or non-monetary assets.

2. Capital• Monetary assets of different currencies shall be valued according

to an agreed currency at the time of signing the Mudarabah

contract.

Illustration: Multi Currency Mudarabah Fund

An Islamic Financial Institution has launched a global Mudarabah

fund. The fund accepts investment in various currencies such as

USD, Euro, Ringgit Malaysia, Saudi Riyal etc. However, the

prospectus has stated that the Mudarabah fund is denominated in

USD. Hence, all contributions by investors in non-USD currencies

will be converted into USD equivalent amount based on the

exchange rate on the day of subscription to the Mudarabah fund.

2. Capital

• The mutually agreed currency shall be

applicable throughout the Mudarabah business

venture. For example, any capital investments

after the initial investment shall be converted

into the currency mentioned in the prospectus.

2. Capital

• Capital in the form of non-monetary assets which may

include intangible assets shall be valued based on the

valuation determined by a third party which may include

authoritative bodies, experts, or as agreed upon by the

contracting parties at the time of conclusion of contract.

• Non-monetary Mudarabah capital contributed may be

redeemed at its original value invested should it be

possible or otherwise at its residual market value upon

termination or the expiry of the contract.

2. Capital

Illustration: Non Monetary Mudarabah Capital Contribution

A public transportation company, XYZ applied for

Mudarabah-based financing from an Islamic Bank. The

bank approves the application and agrees to provide five

buses to the company as Mudarabah capital valued at

Rs.10 million based on prevailing market value and the

company should manage the operations of these buses.

Upon the termination of the contract the Murabaha capital

may be valued at its original value or the residual market

value as agreed in the contract.

2. Capital

• Debts such as account receivables or loans due to a

capital provider do not qualify as capital of Mudarabah.

• The agreed capital shall be made available to the

manager to commence the business activities.

• The capital may be fully or partially disbursed or made

available to the manager at the time of the contract or

based on terms of the contract.

• Capital provider and manager may agree for a gradual

withdrawal of Mudarabah capital by the capital provider.

2. Capital

• Failure to provide capital by the capital provider as per

the agreed schedule shall constitute a breach of promise

according to specified terms and conditions of the

contract.

• The manager has an option to terminate the agreement

or both parties may agree to revise the agreement based

on actual capital contribution.

2. Capital

• Where the agreement is terminated the manager

has to return the outstanding capital (if any). If

the Mudarabah expenditure exceeds the actual

capital contribution, such liability shall be borne

by the capital provider up to the limit of the total

amount committed under the contract.

2. Capital

• Upon liquidation or maturity of the Mudarabah contract,

all outstanding capital shall be returned to the capital

provider.

• Any outstanding capital including the share of profit shall

be deemed as debt due to the capital provider.

• The manager shall not guarantee the Mudarabah capital.

2. Capital

• The capital provider may require the manager to arrange

for an independent third party performance guarantee.

• The guarantee shall 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.

2. Capital

The Mudarabah third party guarantee may be in

the form of performance guarantee of the

Mudarabah transactions or Mudarabah capital

itself. For example, capital employed to sell assets

or render services may be accompanied by a third

party guarantee on payment for such sales and

services.

3. Management of the Mudaraba

• Mudarabah capital will be used only for the Sharia

compliant activities.

• Manger/Mudarib will have the exclusive rights to manage

the contract. However, the capital provider has the right

to information regarding the conduct of the business and

manger.

• Manager shall not be liable for any loss of capital unless

it is due to any negligence, dishonesty, misconduct or

breach of contract.

3. Management of the Mudaraba

Negligence

Among the typical conditions specified in the Mudarabah

contract is that the managing partner is to exercise due

care and diligence. For example, the assets purchased for

sale was kept in the store without Takaful coverage against

fire and theft. As a result of fire some of the assets

perished. The manager is liable for the loss due to his

negligence of not obtaining necessary protection.

3. Management of the Mudaraba

Misconduct

The scope of the Mudarabah agreement specified that the

Mudarabah fund should be invested in securities with

investible grades and the securities should be from the list

agreed by the capital provider. During the course of

investments, in anticipation of huge profits the manager

invested in non-approved securities with lower ratings. If a

loss arises from such investment, the manager is liable for

the loss of capital.

3. Management of the MudarabaBreach of Terms

According to the terms of Mudarabah venture, the manager should disclose all relevant information that is significant for the capital provider to take a decision to participate in the venture.

If the manager concealed important information which is known to the manager to be material to the decision making process.

Upon engagement, losses on investment occurred and investigation reveals that such unfavorable information was not disclosed. This tantamount to the manager breaching the terms of engagement for willful non-disclosure and hence shall bear such loss of capital.

3. Management of the Mudaraba

Restricted MudarabaThe powers of the manger shall be provided under the terms and conditions of the contract.•The contract may restrict the manager’s role/functions such as •determination of location, •period for investment, •type of project and •commingling of funds,

provided it does not nullify the purpose/objective of the contract. However, the restrictions shall not unduly constrain the manager.

Unrestricted Mudarabah

Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he/she deems fit, this is called unrestricted Mudarabah. There are no limits and conditions specified and the manager has the discretion to use the capital in the best interest of the Mudaraba.

However, Mudarib is not authorized to:•Keep another Mudarib or a partner•Mix his own investment in that particular Mudaraba without the consent of Rabb-ul Maal.

3. Management of the Mudaraba

Different Capacities of the Mudarib

1. Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are held by him as a trust.

2. Wakeel (Agent): In purchasing goods for trade, he is an agent of Rabb-ul-maal.

3. Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rabb-ul-maal who shares the profit in agreed ratio.

Different Capacities of the Mudarib

4. Zamin (Liable): If the enterprise suffers a loss due to his negligence or misconduct, he is liable to compensate the loss.

5. Ajeer (Employee): If the Mudarabah becomes Void due to any reason, the Mudarib is entitled to get a fee for his services.

Distribution of Profit & Loss

1. It is necessary for the validity of Mudarabah that the parties agree right at the beginning on a definite proportion of the actual profit to which each one of them is entitled.

2. They can share the profit at any ratio they agree upon.

3. However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios.

4. Some incentives my be given to the Mudarib.

Distribution of Profit & Loss5. Apart from the agreed proportion of the profit,

the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah.

6. The Mudarib & Rabb-ul-Maal 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.

Distribution of Profit & Loss

EXAMPLE

If the capital is Rs.100,000/-, the partners in Mudarabah agreement cannot agree on a condition that Rs.10,000 out of the profit shall be the share of the Mudarib nor can they say that 20% of the capital shall be given to Rab-ul-Maal. However they can agree that 40% of the actual profit shall go to the Mudarib and 60% to the Rab-ul-Maal or vice versa.

Distribution of Profit & Loss

8. 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.

Termination of Mudarabah

1. Mudarabah can be terminated any time by either of the

two parties by giving notice.

2. If Mudarabah was for a particular term, it will terminate

at the end of the term.

3. Termination of Mudarabah means that the Mudarib

cannot purchase new goods for the Mudarabah.

However, he may sell the existing goods that were

purchased before termination.

Distribution at Termination

1. If all assets of the Mudarabah are in cash form at the time of termination, and some profit has been earned on the principal amount, it shall be distributed between the parties according to the agreed ratio.

2. If the assets of Mudarabah are not in cash form, they will be sold and liquidated so that the actual profit may be determined.

Distribution at Termination

3. If there is a profit, it will be distributed between Mudarib and Rab-ul-Maal.

4. If no profit is left, Mudarib will not get anything.

Collective Mudarabah

1. Collective Mudarabah means a joint pool created by many investors and handed over to a single Mudarib who is normally a juristic person.

2. Collective Mudarabah creates two different relationships:

a. Relationship between investors themselves, which is Shirkah or Partnership.

b. Relationship of all the investors with Mudarib, which is Mudaraba.

Running Mudarabah

1. Investors come in and go out at different dates

2. Profits are calculated on daily basis.

3. Redemption before maturity

a. If the assets of Mudaraba are in illiquid form, an

investor may redeem his share by selling it to the

pool..

b. If the assets are in liquid form, a provisional

amount may be given to him subject to final

settlement

Summary of the Lecture

In this lecture we studied the following concepts of Mudaraba financing;

1. Features of Mudaraba

1.Nature of the contract

2.Capital

3.Management of the Mudaraba

4.Profit and loss sharing mechanism

2. Termination of Mudaraba

3. Collective Mudaraba

3. Running Mudaraba