UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Diminishing Musharakah in Islamic Finance

Diminishing Musharakah is just as it sounds.  It is a financing partnership, which diminishes as the money borrowed by the borrower from the financier to finance an asset or project is paid back in installments or other possible arrangements.  As soon as all the installments on the debt are completed, the partnership diminishes and the asset becomes completely owned by the borrower in the partnership.  The partnership then dissolves as the goal of the Diminishing Musharakah  has been achieved.

According to Norton Rose, ‘the financier and the client co-own the asset in question.  The portions of ownership at the start of the financing reflect the financial contributions of each party.  Each payment a client makes leads to the acquisition of a portion of the financier’s share in the asset.  As the client’s share increases, the financier’s share decreases – hence the term “Diminishing Musharakah.”

‘This structure is attractive to investors due to the fact that it is based on the principle of sharing risk.  The structure is appealing to financiers because it can incorporate a variable rate of return and has a credit profile that is acceptable  to most credit committees of conventional institutions.’  (Norton Rose)

“Under this contract, the investor, in her periodic profit distributions to the bank pays over to the bank not only the bank’s profit share, but also a pre-determined portion of his own profits, which goes towards reducing the bank’s capital share.  This is her profit, which goes towards reducing the bank’s capital share.   The additional funds are either held in an account to purchase the bank’s share in a lump sum at the end of the Musharakah period or they are applied progressively to reduce the bank’s capital share and thereby also reducing the bank’s claim on profits.”   (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003)) 

 

Asset Finance Using Diminishing Musharakah According to Norton Rose

1.     ‘The asset is acquired by the financier from a vendor at cost.  The asset is held either by the financer or by a third party on behalf of the financier and the client, each of whom retains a shared interest in the asset.

2.     The client agrees to buy the financier’s interest in the asset in installments and at cost (in accordance with a Purchase Undertaking).  Each time the client buys a share of the financier’s interest in the asset, the financier’s share in the asset decreases and the client’s share in the asset increases.

3.     At the same time, the financier leases their beneficial share in the asset to the client.  The rent payable by the client represents the profit due to the financier.  As the financier’s share in the asset decreases (based on payments by the client under the Purchase Undertaking), so too will the rent payable by the client.

4.     After the client has purchased the financier’s entire share in the asset, title to the asset is transferred to the client and the lease is terminated.’

Construction Finance Using Diminishing Musharakah According to Norton Rose

  1. ‘The financier and the client each contribute assets into a pool of Musharakah assets (In accordance with the Musharakah Agreement).  The financier generally contributes cash and the client contributes cash and/or assets by way of contribution-in-kind.
  2. The client (or a third party) holds the Musharakah assets as agent on behalf of financier and client (based on a Management Agreement) with the objective of the Musharakah (for example, the construction of the assets or the development of a site).
  3. The client agrees to buy the financier’s interest in the Musharakah asset in installments and at cost (in accordance with a Purchase Undertaking).  Each time the client buys a share of the financier’s interest in the Musharakah assets, the financier’s share in the Musharakah assets decreases and the client’s share in the Musharakah asset increases.
  4. The financier leases their share in the Musharakah assets to the client (in accordance with a lease).  The rent payable by the client represents the profit due to the financier.  As the financier’s share in the Musharakah assets decreases (following payments by the client under the Purchase Undertaking) so too will the rent payable by the client.
  5. After the client has purchased the financier’s entire share in the Musharakah assets, title to the assets is transferred to the client and the lease is terminated.’

Bank Negara Malaysia Sharia’h Parameters

“Musharakah Mutanaqisah (Diminishing Musharakah) technically is a partnership contract between two or more parties on a particular asset or venture, which allows one of the partners to gradually acquire the shareholding of the other partner through an agreed redemption method during the tenure of the contract.

An IFI may request its customer to give a binding promise (wa’d) to the IFI to purchase the Musharakah asset or IFI’s share either on a lump sum basis or gradually over an agreed period of time at market value or at a fair value or at any price to be agreed by the parties.

The execution of the promise shall not violate the element of profit- and- loss sharing in the Musharakah Mutanaqisah contract.

The transfer of Musharakah asset or share to the other party in a diminishing Musharakah may be executed in a single payment or on staggered basis.

Transfer of a Musharakah asset may also be made by way of conditional gift upon the full payment of the rental obligation.

In the event of a customer’s default to acquire the Musharakah asset or IFI’s share, the IFI may terminate the Musharakah contract and proceed with a recovery action.

The IFI may recover its capital from the proceeds of disposal of the jointly -owned asset to a third party.

Should the proceeds from the disposal be insufficient to cover the capital loss, the IFI may have recourse to the customer for the outstanding balance. In the case where the customer is insolvent, the IFI shall bear the loss of capital.

In the event of a surplus from the disposal of the proceeds, the surplus shall be distributed between the partners according to their respective ownership share.

ENHANCED FEATURES OF MUSHARAKAH CONTRACT

Origination and Execution of Musharakah Agreement

A valid Musharakah contract shall be concluded by an offer and acceptance between the partners and may be expressed by way of suitable documentation.

A party to a Musharakah contract shall conclude the contract personally or through an agent.

A party to a Musharakah contract shall have the legal capacity to enter into a contract provided that he is not restricted by any law.

Upon the disbursement of the capital by the Musharakah partners, all partners’ rights to the profit and liability to losses are established.

Any term or condition mutually agreed upon, which does not contravene Sharia’h shall be binding on the partners.

Termination and Dissolution of Musharakah Agreement

Partners may mutually agree to terminate the contract at any time unless stated otherwise in the Musharakah agreement.

Upon termination of Musharakah agreement, a partner may elect to acquire the entire asset of the Musharakah partnership.

The acquisition by one partner of the other partner’s entire asset may be satisfied as a debt due to the other partner, after taking into consideration the liabilities and determining profit and loss.

A Musharakah contract shall be terminated upon expiration of specified tenure of the contract, even though the venture is still in progress unless the partners mutually agree to extend the partnership.

Parties to a Musharakah contract may agree to end the partnership upon completion of business venture.

A Musharakah contract may be terminated if a considerable portion of the capital is impaired, subject to terms and conditions. Such impairment may arise from losses due to extenuating circumstances that hinder the partnership to continue for the remaining period or from being on going concern.

The demise or bankruptcy of one of the partners shall terminate the Musharakah contract. However, the partners may agree to continue with the contract according to the terms in the Musharakah deed or agreement.

Illustration:  Conditions for Termination of Musharakah Agreement

A Musharakah financing agreement between an IFI and a customer specifies that the agreement is terminated if any of the following conditions occurs:

(a) Both partners mutually agree to terminate after determining the liabilities of each partner;

(b) Upon demise of the customer;

(c) Court order to terminate the Musharakah is obtained by IFI;

(d) Significant loss of capital that incapacitates the partnership;

(e) Insolvency or bankruptcy of the customer; and

(f) Violation of conditions in the agreement by any partner.

In the event that any of these conditions are met, both partners need to settle any outstanding liabilities at the date of termination.  Upon the termination of the Musharakah contract, Musharakah assets shall be subjected to the liquidation process.

Liquidation

Musharakah assets may be liquidated through actual liquidation in which the assets are disposed to the markets or third parties. The proceeds of the disposal shall then be measured against the capital to recover the capital and to distribute the profit or to record a loss accordingly.

In the case of an actual liquidation, the assets shall be sold at market value and the proceeds of the sale shall be used as follows:-

i. Payment of liquidation expenses;

ii. Payment of financial liabilities that are owing to the partnership; and

iii. Distribution of the remaining assets, if any, among the partners in proportion to their capital contribution.

A constructive liquidation of the partnership asset may be effected in the case where the partners agree to dissolve existing partnership and venture into another new partnership by investing the initial asset as capital in kind.

Amendment and Variation of Musharakah Agreement

Amendments and variations to the Musharakah agreement may take effect at any time throughout the tenure of the contract on all issues provided such amendments and variations are mutually agreed upon by the partners.

Any amendment to the loss sharing ratio, which differs from the capital contribution ratio, is not permissible under all circumstances.

The Musharakah agreement may provide that any amendment to the agreement is valid by a specified approval process such as a majority vote or a decision by the management.

The Musharakah contract may enable the partner to withdraw capital throughout the agreed period unless stated otherwise in the Musharakah agreement.

Third Party Guarantee of Musharakah Capital

Specific conditions on third- party guarantee of the capital are as follows:-

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

ii. The guarantee shall neither be provided in consideration for nor linked in any manner to the Musharakah contract;

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

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

http://www.bnm.gov.my/guidelines/05_shariah/04_draft_shariah%20parameter_spr4.pdf

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))   and Bank Negara Malaysia.

Practical  Applications of Diminishing Musharakah

http://www.kantakji.com/fiqh/Files/Finance/N278.pdf

Guidelines for Musharakah and Mudharabah Contracts (See Page 18 for Diminishing Musharakah) Bank Negara Malaysia

http://www.bnm.gov.my/guidelines/01_banking/04_prudential_stds/15_mnm.pdf

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