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Musharaka (Equity partnership)

Mudaraba (Investment Partnership)

How do you finance anything?

• Equity vs debt?

• How to decide?

• Availability, cost, tax structure...

• Conventional vs Islamic perspective

Trouble with debt

• 2008 GFC - households borrow more than they can pay back

• 2009 Dubai (Nakheel ) debt crisis - businesses borrow more than they can pay back

• 2010/11 Current Debt Crisis – governments borrow more than they can pay back

• Next???

Islam and debt

Bukhari, Volume 3, Book 41, Number 582:

"O Allah, I seek refuge with you from all sins, and from being in debt." Someone said, O Allah's Apostle! (I see you) very often you seek refuge with Allah from being in debt. He replied, "If a person is in debt, he tells lies when he speaks, and breaks his promises when he promises.“

Bukhari Volume 4, Book 52, Number 143:

"O Allah! I seek refuge with You from distress and sorrow, from helplessness and laziness, from miserliness and cowardice, from being heavily in debt and from being overcome by men."

Narrated by Abu Dawood Book 22, Number 3335 & 3336:

Prophet Muhammad (peace be upon him) linking debt with being in prison by saying “Your companion has been detained (from entering Paradise) on account of his debt.”

Also, The Prophet (peace be upon him) said: “After the grave sins which Allah has prohibited the greatest sin is that a man dies while he has debt due from him and does not leave anything to pay it off, and meets Him with it.”

“Whoever dies free from three things – arrogance, cheating and debt – will enter Paradise.”  Narrated by al-Tirmidhi (1572)

Umar ibn al-Khattaab r.a. said: Beware of debt, for it starts with worry and it ends with war. Narrated by Maalik in al-Muwatta’ (2/770). 

Scholars say: It is a disgrace and a humiliation because it preoccupies the mind and makes one worried about paying it off. (al-Qurtubi in al-Jaami’ li Ahkaam al-Qur’aan (3/417))

AAOIFI on equity based financing

• “the Shari'ah Board advises Islamic Financial Institutions to decrease their involvements in debt-related operations and to increase true partnerships based on profit and loss sharing in order to achieve the objectives of the Shari'ah.” (AAOIFI's Shari'a Board Resolutions on Sukuk)

Two basic modes of Islamic financing

Modes of Islamic Finance

Debt Based Financing (non-PLS* mode)

Eg. Murabaha, Ijarah, etc.

Equity Based Financing (PLS* mode)

Eg. Musharaka and Mudaraba

*profit-and-loss sharing (PLS)

Musharaka (Equity partnership, Joint Venture)

* Slides on Musharaka are based on AAOFI Sharia Standard No. (12) Sharika (Musharaka) and modern Corporations; and ‘Introduction to Islamic finance’ by T.

Usmani.

Derived from word shirkah or

sharing.

Sharika (partnership)

• AAOFI Sharia Standard No. (12) Sharika (Musharaka) and modern Corporations covers:

Applicable to all forms of traditional fiqh-nominated partnerships that operate on the basis of Sharika al-aqd (contractual partnership, (excluding ownership partnership sharika al-milk)

All modern forms of partnership including diminishing Musharaka

Definition

Sharika al-aqd (typical Musharaka)

“Sharika al-aqd (contractual partnership) means an agreement between two or more parties to combine their assets, labour or liabilities for the purpose of making profits” AAOIF sharia standard 12/2/1

Sharika al-aqd is classified into two main categories:

1. Traditional fiqh-nominated partnership

2. Modern corporations

Musharaka

A B

$/20% $/80%

Business Venture

Profit: 20/80 ratioOr any pre agreed ratio

(eg 30/70)

Loss: 20/80 ratio - Fixed! (according to capital

contribution)

Musharaka Calculation example (Pre agreed ratio 30/70)

Investor Capital Contribution

Outcome 1Profit

$10,000

Outcome 2Loss

-$10,000

A $40,000

B $60,000

Diminishing Musharaka• “Diminishing Musharaka is a form of partnership in

which one of the partners promises to buy the equity share of the other partner gradually until the title to the equity is completely transferred to him. “ AAOIFI 12/5/1

Bank Customer80% 20%75% 25%70% 30%65% 35%... ...0% 100%

Ownership %

Musharaka example

- A and B invest 50 (Capital contribution A: 30, B: 20)

- It is agreed that A will get 80% and B 20% of actual profits. (Profit ration 80/20)

- Total worth of the business has Increased to 100 units.

Q1: How will the profit be divided between the partners?

Q2: What would A have to pay to purchase B’s shares?

QIf A and B enter into a partnership and it is agreed between them that A shall be given $10,000/- per month as his share in the profit, and the rest will go to B, is the partnership valid?

AIt is invalid - The proportion of profit to be distributed between the partners must be agreed upon at the time of effecting the contract. If no such proportion has been determined, the contract is not valid in Shari‘ah.

The ratio of profit for each partner must be determined in proportion to the actual profit accrued to the business, and not in proportion to the capital invested by him. It is not allowed to fix a lump sum amount for any one of the partners, or any rate of profit tied up with his investment. The correct basis for distribution would be an agreed percentage of the actual profit accrued to the business.

What about shares?What are shares?

Shares represent units of ownership interest or a specific part of the total capital of a company.

Is it permissible to own shares?

In general there is nothing wrong with buying or selling shares as part of an investment strategy, as long as they pass Shariah compliancy test.

What about profits and dividends?

By purchasing shares in a company a person becomes a shareholder or partner in a business. As such, a shareholder is entitled to receive proportional profits that result from the company’s economic activities.

Mudaraba (Investment Partnership)

Mudaraba is a partnership in profit whereby one party provides capital (rab al-maal) and the other party provides labour (mudarib)

MudarabaMudari

bInvestor(one or group)

Labour Capital

Business Venture

Profit: Any pre agreed ratio

(eg 20/80)

Loss: Mudarib (labour), Investor (capital)

Mudaraba Calculation example (Pre agreed ratio 30/70)

Investor Capital Contribution

Outcome 1Profit

$10,000

Outcome 2Loss

-$10,000

Manager $0

Investor $100,000

Eg. Bank and MudarabaBank - definition and purpose

Take deposits/mobilize funds

Act as financial intermediary between lenders and borrowers

Connects savers to borrowers via various financial products

Islamic banks are less straightforward because Islam prohibits making money by money and thus all transactions must not involve any interest (riba). The Qur'anic verse "Allah has permitted trade and has forbidden interest (usury)" [2:275] is the main reason why Islamic banking derives its profit from real economic activities by means of trading, leasing or investment.

Bank accounts

BankSurplus units

Deficit units

Deposits

Financing

Q? If the capital is $100000/- can partners in Mudaraba agree on a condition that $10000/- out of the profit shall be the share of the mudarib?

NO

Can they say that 20% of the capital shall be given to rabb-ul-mal.

NO

Can agree on that 40% of the actual profit shall go to the mudarib and 60% to the rabb-ul-mal or vice versa.

YES

Is it allowed that different proportions are agreed in different situations?

For example the rabbul-mal say to mudarib, “If you trade in wheat, you will get 50% of the profit and if you trade in flour, you will have 33% of the profit”.

YES

What about: “If you do the business in your town, you will be entitled to 30% of the profit, and if you do it in another town, your share will be 50% of the profit”

YES.

Is it allowed that different proportions are agreed in different situations?

For example the rabbul-mal say to mudarib, “If you trade in wheat, you will get 50% of the profit and if you trade in flour, you will have 33% of the profit”.

YES

What about: “If you do the business in your town, you will be entitled to 30% of the profit, and if you do it in another town, your share will be 50% of the profit”

YES.

Can mudarib claim any periodical salary or a fee or remuneration for the work done by him for the mudarabah?

NO – what is the alternative?

d

Almir Colanalmir@auscif.comwww.AusCIF.com