UAE Laws and Islamic Finance

Laws of the UAE and Islamic Finance

Archive for Equity Finance

Equity versus Debt- Financing in Islamic Finance

In Islamic Finance, equity- financing is done primarily through the profit-sharing contracts (Uqud al-Ishtirak) of Al-Mudarabah and Al-Musharakah.

  1. Al-Mudharabah: (Origin)

“Al-Mudarabah for example can be traced back to Prophet Muhammad s.a.w. himself, who acted as a Mudharib (agent/entrepreneur) for his wife, Khadijah.  That was even before the first revelation was revealed to Prophet Muhammad s.a.w. by the Angel Jibril (Gabriel).  Such partnership performed an important economic function; they combined the three most important factors of production, namely: capital, labor, and entrepreneurship, the latter two factors being, usually, combined win one person.”  (*The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

Mudarabah” is partnership where one partner gives money to the other partner for investing it in a commercial enterprise. The investment money comes from the first partner who is called “rabb-ul-mal” while the management and work is the exclusive responsibility of the other partner who is called the “mudharib“.

Therefore, the Mudarabah (Profit -Sharing) is a contract where one party provides 100 percent of the capital and the other party invests the capital and manages the investment project. Profits generated from the business venture are shared between the parties according to a pre-agreed ratio. In contrast to the Musharakah structure, in the event of loss in the venture, the capital provider or the rabb-ul-mal bears all the losses of the business venture. (Wikipedia)

“In the contract of Al-Musharakah (joint-venture profit sharing) a few parties may invest in a business venture in agreed proportions and all the parties have the right to participate in the management of the business venture.  On the distribution of profits, it can be negotiated between the parties and such distribution of profits need not reflect the ratio of the participation in the business venture.  In the event of a loss, all parties bear the loss in proportion to their investment ratio.”  ((*The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

The main differences between Musharakah and Mudarabah includes that in Musharakah, each partner contributes some capital, whereas in Mudarabah, one partner provides all the capital and the other partner manages the investment.  In addition, in Musharakah, each partner is liable for loss in proportion to their investment while in Mudarabah, only the investing partner is liable for business loss.  Furthermore, in Mudarabah, only one party manages the investment while in Musharakah all partners are entitled to manage the business venture.

The equity-financing systems of Islamic and Conventional Finance are extremely similar.  However, the debt-financing systems in both modes of finance present more dissimilarities than similarities.

For example, conventional debt-financing is almost totally based on interest-based lending in complete contradiction to Islamic Finance where such lending is not allowed.  In Islamic debt-financing, as a contemporaneous underlying contract of buying and selling must be in place, there must be an underlying asset which is the subject- matter of the contract.  In addition, the Islamic debt-financing instrument of deferred contracts of exchange is not generally known in the conventional system.  ((*The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan.  (2003))

It is known that Islamic finance prohibits the charging of interest on loans, however, it does not reject the notion of time value of money.  Many people think that Islamic finance structures transactions in ways that just disguise interest in other forms, however, in Islamic Finance the capital provider is permitted an adequate return.  Therefore, when a structure appears to allow interest payments disguised in another form, it is actually not interest per se but time value for money.  Time Value for Money is allowed in the following situations.

  1. “If money is committed to another party to use for a period of time, compensation for the financing may not be a pre-determined amount guaranteed by the other party to the contract; instead, it should be a share in the actual profits of the venture.  Money is not treated as a commodity in the West, but as a bearer of risk, and therefore subject to the same uncertainties as those borne by other partners in the enterprise.
  2. If investors finance the acquisition of tangible goods by sale or lease, they may legitimately compensate themselves for foregone opportunities.  Profits deriving from lease payments or from credit sale may reflect, even explicitly, a time factor.”

In addition, new products should be monitored more carefully to ensure that they are in compliance with Sharia’h law.

“In the following Sunnah, Abu Sa’id al-Khudri said, “The Prophet, peace be upon him, said, Gold for Gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt – like for like, hand to hand.  Whoever pays more or takes more has indulged in Riba.  The take and the giver are alike (in guilt).”

Some of the Quranic revelations and the Sunnah relating to the prohibition of Riba are as follows:

God is with the debtor until he pays his debt, as long as it is not for something God disapproves. (Ibn Majah)

Devour not usury (Riba) doubled and re-doubled (Surah Ali-Imran (3) verse 130)

Lending is allowed in Islamic Finance but without interest.  This is known as Qard-al-Hassan or benevolent loan.”

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

Interesting Paper on Debt v Equity Financing in Islamic Finance In Light of the Maqasid Al-Sharia’h

Islamic Finance: Debt v Equity Financing in the Light of Maqasid al-Sharia’h by Eddy Yusof, Ezry Fahmy, Kashoogie, Jhordy and Anwar Kamal, Asim *International Islamic University Malaysia (IIUM) April 2009

http://www.iefpedia.com/english/wp-content/uploads/2010/09/MPRA_paper_20722.pdf

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