Archive for Islamic Finance
Bai Al Dayn [i] means the selling of debt in Arabic. Currently, products based on this concept are allowed in Malaysia, but not heavily practiced in the Middle East due to the differing opinions of the different schools of Islam on whether or not Bai Al Dayn is acceptable under the Sharia’h [ii]. In Malaysia, for example, Bai Al Dayn is the basis for the sale and purchase of Islamic securities, debt certificates, and various products. In the Middle East, the majority of scholars consider the trading of debt to be similar to the trading of money and therefore ribawi [iii] or riba [iv] (interest)-bearing.
According to several Malaysian scholars whom accept Bai Al Dayn as a valid instrument under the Sharia’h, “Bai Al Dayn means a sale and purchase transaction of a ‘quality debt’ i.e. the default risk of the debtor is low and the debt must be created from a business transaction that conforms with the Sharia’h and Bai Al Dayn can be either monetary or a commodity such as food or metal. Therefore, according to these certain scholars, “Bai Al Dayn can be defined as a sale of payable right either to the debtor himself or to any third party.” (The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan) This type of sale is usually for immediate payment.
The sale of such a payable right to a third party is a subject of disagreement amongst the scholars. “According to most of the Hanafi, Hanbali and Shafi jurists, the sale of debt to a non-debtor or third party is prohibited based on the forbidden sale of Gharar [v] (uncertain or obscure goods), sale of Al Kali Bil Kali[vi], and the sale of a thing which the seller does not possess. However, there are exceptions to this rule.” (The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan)
Exceptions to the Rule
1. “The pooling of assets with a minimum of 51% in tangible assets where trading at values other than par are permitted. (E.g. Ijara hybrid sukuk such as the hybrid sukuk issued by the Islamic Development Bank for $850 million in 2009 as part of its $1.5 billion sukuk program.
2. A legal trick (hiyal) could take advantage of this rule where a debt certificate is exchanged for a commodity, which in turn could be sold at market value. (Islamic Finance Wiki)”
Arguments Supporting Bai Al Dayn
I. Hanudin Amin restates several arguments as to why Bai Al Dayn is acceptable under the Sharia’h.
First, he recounts that, “The sale is allowed and fully permissible. According to the Hanafis, Malikis, Shafis, and Hanbalis, the creditor has the full right to sell his debt to the debtor at any price he likes as far as the debt is raised from the cost of damage, qard[vii], the price of a commodity, the cost of services, or the dowry of a woman.” Hanudin Amin recounts that, “This right is regardless of the type of debt in terms of the confirmation or time stipulation of the debt, but due to the reason that the creditor has the full right to waive or annul his debt at any point in time as he so desires. Therefore, he also has the same right to sell it to the debtor at any price he may like.”
Hanudin Amin states that “this opinion is based on the hadith narrated by Ibn Umar who reported that:
“One day he came to see the Prophet (pbuh) and told him: I sell camels in Baqi in dinars (debt) and accept dirhams (payment) and I sell in dirhams (debt) and accept dinars (payment). The Prophet said, ‘It is okay, but you should try to accept it at the day price for each before you conclude your contract.’”
Based on this hadith, Hanudin Amin restates that “selling a debt to the debtor is permissible provided that certain conditions are fulfilled.”
II. Hanudin Amin recounts a second argument in support of Bai Al Dayn.
“The sale is allowed. According to some Shafi and Hanbali’s like Ibn Al-Qayyim, the creditor has the right to sell only confirmed debt to the debtor or to a third party. This is based on the grounds that he is allowed to give it to the debtor and to a third party too.” Hanudin Amin recounts that this opinion is based on the following arguments:
“There is no authentic source that prohibits such kinds of selling or giving. Thus it should be allowed and permitted; The creditor has full right on possession and full right to sell it to a third party; and Based on a legal maxim, it is allowed, which states that all transactions are permissible until they are proven non-permissible by an authentic source. So, since there is no authentic source prohibiting this transaction, then, it should be allowed.”
III. Hanudin Amin recounts a third argument in favor of Bai Al Dayn.
“The sale is allowed on three conditions. According to some Shafi scholars namely Al-Shirazi, Al-Subki, and Al- Nawawi, the creditor has the right to sell his dayn or debt to a third party as well as to the debtor himself. Nevertheless, this permission is subjected to the following conditions:
The dayn must be a spot debt in nature, otherwise, it will not be allowed; The debtor must be a rich person and he has to accept the sale or there must be strong evidence to prove the existence of the debt in case of any denials from the debtor. Otherwise the sale should not take place; and The buyer must pay the price of the debt on spot basis, otherwise, the sale will be considered as invalid and illegal.
(Hanudin Amin, “An Analysis of the Classical and Contemporary Juristic Opinions on Bai Al Dayn, Labuan e-Journal of Muamalat and Society)
IV. Malaysian scholars write, according to the Maliki, Hanafi, and Shafi jurists, if certain conditions/requirements are fulfilled, such Bai Al Dayn sales are allowable under the Sharia’h. The certain Malaysian scholars recount the conditions as follows:
1. “It must be a confirmed debt (Dayn Mustaqir) and the contract must be performed at once and not deferred in order to avoid any relationship with the sale of a debt for a debt, which is prohibited under Islamic law. The sale should not be based on selling gold with silver or opposite because any exchange between these items necessitates the immediate possession, and if the debt is money, its price in another debt should be equal in terms of amount of quantity.
2. Selling of a debt by its equivalent in quantity and time of maturity by way of Hawalah[viii] is permitted in Islam. The debt must be paid in its full amount and bear no interest and give no benefit to the purchaser. Financial transactions involving debts should never allow for a payment against the length of the period of the loan because this would be tantamount to Riba(interest) or Bai Al Kilai Bil Kali [ix], which is clearly prohibited by the prophet in the Hadith: “Do not sell a debt for a debt”. Thus, Bai Al Dayn for deferred payment is not allowed.
3. Trading of debt on its face value is allowed in Islam. Where the price paid for a debt is not the same as the face value of that debt, the transaction would amount to Riba Al-Nasiah[x] (delay or deferred) and is therefore prohibited.
4. Islam strictly prohibits legal devices to be treated as a justification for transactions that Islam regards as unfair, unjust, and against the Islamic precepts.
5. In regards to the bonds, they would be acceptable if the financing is based on the legal maxim Al-Ghurmu Bil Ghurmi[xi], which means that no person is allowed to invest in a way that generates profit without exposing himself to the risk of loss. Both parties should be exposed to the outcome of the deal, whether profit or loss. (Avoiding usury)
6. This contract of Bai Al Dayn generally takes place in the secondary market where bonds are traded at a discount. Buyers do not intend to keep these bonds for long term purposes. They are usually speculators whose main target is to make fast and quick capital gains on the basis of market liquidity and interest rate movement. There are no controversies when the bonds are redeemed or sold at par value.” (The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan)
Malaysian Resolution and Regulation Concerning Bai Al Dayn
On August 21, 1996, the Malaysian Securities Commission Sharia’h Advisory Council passed a resolution confirming the acceptance of the principle of Bai Al Dayn as one of the concepts for developing the Islamic Capital Market Instruments in Malaysia. This decision was based on the views of the Islamic jurists who found Bai Al Dayn acceptable under the Sharia’h subject to conditions. Furthermore, the decision was implemented based on the knowledge that there is currently a well-developed and transparent regulatory system in the Malaysian capital market, which was set up to safeguard the maslahah (public interest) of the market participants. In Malaysia, Bai Al Dayn is regulated by the Bank Negara Malaysia (Central Bank of Malaysia) and the Securities Commission Sharia’h Advisory Council.
According to Hanudin Amin, “The Malaysian Securities Commission Sharia’h Advisory Council held that in the context of the sales of securitized debt, the characteristic of securities differentiates it from currency. It is not a legal tender and, therefore, it is not bound by the conditions of exchanging of goods. It is therefore not a ribawi[xii] item. (Hanudin Amin, “An Analysis of the Classical and Contemporary Juristic Opinions on Bai Al Dayn, Labuan e-Journal of Muamalat and Society)
[i] Means Debt. A Dayn comes into existence as a result of any contract or credit transaction. It is incurred either by way of rent or sale or purchase or in any other way which leaves it as a debt to another. http://aibim.com/content/view/151/126/
[ii] The term Sharia’h refers to divine guidance as given by the Holy Qur’an and the Sunnah of the Prophet Muhammad and embodies all aspects of the Islamic faith, including beliefs and practice. http://aibim.com/content/view/151/126/
[iii] Goods subject to Fiqh rules on Riba in sales, variously defined by the schools of Islamic Law: items sold by weight and by measure, foods, etc. http://aibim.com/content/view/151/126/
[iv] Means an excess or increase. Technically, it means an increase over the principal in a loan transaction or in exchange for a commodity accrued to the owner (lender) without giving an equivalent counter-value or recompense (‘iwad) in return to the other party; every increase, which is without an ‘iwad or equal counter-value. http://aibim.com/content/view/151/126/
[v] This means any element of absolute or excessive uncertainty in any business or a contract about the subject of contract or its price, or mere speculative risk. It has the potential to lead to undue loss to a party and unjustified enrichment of the other, which is prohibited. http://aibim.com/content/view/151/126/
[vi] The term Kali refers to something delayed. It appears in a maxim forbidding the sale of al-Kali bil-Kali i.e. the exchange of a delayed counter value for another delayed counter value. http://aibim.com/content/view/151/126/
[vii] (Loan of fungible objects): The literal meaning of Qard is ‘to cut.’ It is so called because the property is really cut off when it is given to the borrower. Legally, Qard means to give anything having value in the ownership of the other by way of virtue so that the latter could avail of the same for his benefit with the condition that same or similar amount of that thing would be paid back on demand or at the settled time. It is a loan, which a person gives to another as a help, charity or advance for a certain time. The repayment of the loan is obligatory. The Holy Prophet is reported to have said “…..Every loan must be paid……”. But if a debtor is in difficulty, the creditor is expected to extend time or even to voluntarily remit the whole or a part of the principal. Qard is, in fact, a particular kind of Salaf. Loans under Islamic law can be classified into Salaf and Qard, the former being loan for a fixed time and the latter payable on demand. (see Salaf) http://aibim.com/content/view/151/126/
[viii] Bill of exchange, promissory note, cheque, draft. Tech: A debtor passes on the responsibility of payment of his debt to a third party who owes the former a debt. Thus, the responsibility of payment is ultimately shifted to a third party.
Hawalah is a mechanism, which can be usefully employed for settling international accounts by book transfer. This obviates, to a large extent, the necessity of physical transfer of cash. The term was also used, historically, in the public finance during the Abbaside period to refer to cases where the state treasury could not meet the claims presented to it and it directed its claimants to occupy a certain region for a certain period and procure their claims themselves by taxing the people.
This method was also known as tasabbub. The taxes collected and transmitted to the central treasury were known as mahmul (i.e. carried to the treasury) while those assigned to the claimants or provinces were known as musabbab. http://actuary.my/pedia/tag/hawalah
[ix] The term Kali refers to something delayed. It appears in a maxim forbidding the sale of al-Kali bil-Kali i.e. the exchange of a delayed counter value for another delayed counter value. http://aibim.com/content/view/151/126/
[x] Riba Al-Nasiah or riba of delay is due to an exchange not being immediate with or without excess in one of the counter values. It is an increment on principal of a loan or debt payable. It refers to the practice of lending money for any length of time on the understanding that the borrower would return to the lender at the end of the period the amount originally lent together with an increase on it, in consideration of the lender having granted him time to pay. Interest, in all modern banking transactions, falls under the purview of Riba Al-Nasiah. As money in the present banking system is exchanged for money with excess and delay, it falls, under the definition of riba. http://aibim.com/content/view/151/126/
[xi] This provides the rationale and the principle of profit sharing in Shirkah arrangements. Earning a profit is legitimized only by engaging in an economic venture, applying risk sharing principles and thereby contributing to the economy. http://aibim.com/content/view/151/126/
[xii] Goods subject to Fiqh rules on Riba in sales, variously defined by the schools of Islamic Law: items sold by weight and by measure, foods, etc. http://aibim.com/content/view/151/126
“Bai’Al ‘Inah is a transaction which involves the sale and buyback of an asset by the seller:
1.The seller will sell the asset to the buyer on a deferred basis and later will buy back the same asset on a cash basis at a price, which is lower than the original selling price.
2. Alternatively, it could also be where a customer offers to sell some of his inventory to a bank for an immediate cash payment. He then buys back the inventory on an installment basis, but at a higher price than the price he sold to the bank earlier. The difference between the purchase price by the bank and the sale price by the bank is the bank’s profit.
It is generally known as a sale based on the transaction of Nasi’ah (delay):
- The prospective debtor will sell to the prospective creditor some object for cash, which is payable immediately, the debtor then immediately buys simultaneously the same object for a greater amount for a future date. The difference between the two prices represents the profit.” (The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan)
Government Sector (Bank Negara Malaysia)
According to Bank Negara Malaysia, “the Bai’ Al ‘Inah contract is defined as two transactions entered between two parties whereby one party (the Government) undertakes to sell an asset to successful participants on a cash basis and subsequently will purchase back the same asset at a higher price, which is normally at par on a credit basis.”
Private Sector (Bank Negara Malaysia)
“A contract, which involves selling and buying of an asset where a seller will sell the asset to a buyer on a cash basis and subsequently will buy the same asset on a deferred payment basis at mark up price. It can also be applied when a seller sells the asset to a buyer on a deferred basis and will later buy back the same asset on a cash basis with a price, which is lower than the deferred price.
1) Issuance of Bank Negara Negotiable Notes (BNNN).
2) Issuance of Profit-based GII.
1) Bai’ Al ‘Inah is not acceptable by the Middle Eastern countries, however, is practiced in Malaysia.
2) Some of the scholars regard Bai’ Al ‘Inah as part of Interest-based transactions and therefore, conclude that this is unacceptable under Sharia’h law.” (Bank Negara Malaysia)
According to Wikipedia, “Bai’ al ‘Inah is a financing facility with the underlying buy and sell transactions between the financier and the customer.
- The financier buys an asset from the customer on spot basis. The price paid by the financier constitutes the disbursement under the facility.
- Subsequently, the asset is sold to the customer on a deferred-payment basis and the price is payable in installments. The second sale serves to create the obligation on the part of the customer under the facility.
- There are differences of opinion amongst the scholars on the permissibility of Bai’ al ‘Inah, however, this type of sale is practised in Malaysia.” (Wikipedia)
‘The Maliki and Hanbali jurists feel that this method of sale is illegal as it constitutes a legal device to obtain a loan with interest, which is not allowed under the Sharia’h.’ They based their opinion on the Prophet’s Sunnah, in which he was reported to have said:
‘And when men become filled with greed towards money (Dinar and Dirhams) and transact through Ainah, and leave out jihad, remember that calamity will strike them until they turn back to their religion.’’
‘However, the Shafi jurists concluded that such transactions were allowed under the Sharia’h because according to them contracts are valid by the external evidence that they were properly concluded and that the unlawful intention of the parties is immaterial. It does not invalidate their act unless expressed in that act. The intention of the parties is, therefore, taken into account when the invalid intention is explicitly mentioned in the contract.’ (The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan)
* Based on Information from The Law and Practice of Islamic Banking and Finance (2003) by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; Megat Hizaini Hassan, Bank Negara Malaysia, and Wikipedia/
Types of Instruments on the Islamic Interbank Money Market (SBBA) (Bank Negara Malaysia)
Issuing Procedures for Islamic Treasury Bills – the Bai’ Al ‘Inah Concept (Bank Negara Malaysia)
Bai’ Al ‘Inah Downloads
Tawarruq means converting an asset into ‘wareq’ or money. It is a financial product structured to satisfy customer cash needs in accordance with Sharia’h. In this structure, the bank purchases certain goods on spot basis from local or international markets and sells them to the customer on credit on a cost plus basis. The customer in turn sells the goods to a third party for cash. Therefore, the customer has in effect turned an asset into cash using a bank as an intermediary and the bank has usually made a profit. In some instances, the bank will also act as agent in selling the asset for the customer.
In other words, the bank purchases commodity from a Trader (Trader A) in the commodity market on a cash basis. The bank then sells the commodity to the customer at a deferred price (cost price plus profit margin) payable in a lump sum or installment basis. The customer may appoint the bank as his agent to sell the commodity to another Trader (Trader B) on cash basis in the commodity market; and the bank then sells the commodity as agent of the customer to Trader B on a cash basis in the commodity market.
According to Mohammad Netajullah Siddiqi, in Tawarruq, ‘The client – the mutawwarriq – buys X on deferred payment from the International Financial Institution (IFI) and sells X for a cash amount less than the deferred price to a third party. Also, tawarruq enables the IFI to guarantee a pre-determined percentage rate of return to its term-depositer, buying XX from him/her on deferred payment then selling XX for cash, the deferred payment being larger than the cash price… therefore, allowing the bank to make a profit.’ (Mohammad Netajullah Siddiqi, The Economics Of Tawarruq, 2007)
According to http://finance.practicallaw.com/5-367-4016, Tawarruq is “a method where the financial institution either directly or indirectly will buy an asset and immediately sell it to a customer on a deferred payment basis. The customer then sells the same asset to a third party for immediate delivery and payment, the end result being that the customer receives a cash amount and has a deferred payment obligation for the marked-up price to the financial institution. The asset is typically a freely tradable commodity such as platinum or copper. Gold and silver are treated by Sharia’h as currency and cannot be used.”
According to Salah Al-Shahoob, “the bank specifies the market, which is the international market, and the type of commodity which is, normally, a metal. Then, the bank indicates the contract, which is offered to the client, which is a mark- up sales (bay‘ al-murabaha). This means that they indicate the cost of commodities to the client and the amount of profit and the price must be paid within a certain period of time. This transaction might be under the concept of deferred sales (al-bay‘ al-mu’ajjal) if the payment is a single transaction or installment sales (bay‘ al-taqsit) if the payment is by more than one installment. The role of the institution may not end after selling the product to the client, but the bank can also offer to the client their services as an agent to sell the commodity on his behalf and receive the price, which is credited to the client’s account.
Al-Mushaiqih defines the organized tawarruq as a contract where the financial institution arranges to sell a commodity to a client by deferred payment then becomes an agent on behalf of the client to sell the commodity to a third party whereupon the institution pays the price to the client. Then, al-Mushaiqih elaborates on the procedure. He says that the institutions buy commodities, normally minerals, specifically zinc, bronze, nickel, tin and copper, every week. They choose these minerals because they are common in daily exchange in the international market. In the contract, clients apply to buy a specific mineral, which they specify and the contract is based on installment sales. The commodities are normally in another country, such as Bahrain. Then, the institutions sell the minerals in many units according to the wishes of the clients. After the client buys a unit, he empowers the institution to receive and sell his commodity in the international market and credits the price of it to his account. The clients have the power to change the price, so they might sell their commodities for the same price or a different one. The clients also have the right to receive their commodities in the place where they are normally delivered. In addition, Al-Mushaiqih also indicates that the financial institutions engage in an agreement with some brokers to obtain the metals.”
Al-Shaloob concludes that “organised tawarruq is a sales contract, the purpose of which is to finance people in accordance with Islamic law.” He says that, “The process begins in the international or local market where the financial institutions buy commodities for immediate payment and obtains a certificate, which proves their ownership of the commodity. The financial institutions then offer the commodities to their clients and the clients buy the commodities as an installment sale. The financial institutions also often indicate the original price (al-thaman), which has been paid. The clients then enter into another agreement to empower the financial institutions or a third party to sell the commodities in the market, although they normally avoid selling the commodities to the traders who originally sold them to the financial institutions. However, in some cases the financial institutions and clients enter into the contract before the financial institutions obtain the commodities. At the end, the financial institution credits the price to the account of the client.”
According to Mohammad Netajullah Siddiqi, “the harmful effects (mafasid) of Tawarruq include:
• It leads to creation of debt the volume of which is likely to keep increasing.
• It results in exchange of money now with more money in the future, which is unfair in view of the risk and uncertainty involved.
• Through debt proliferation, it leads to gambling like speculation.
• Through debt finance, it leads to greater instability in the economy.
• In a debt-based economy, as the money supply is linked to debt, there will be a tendency towards inflationary expansion.
• It results in inequity in the distribution of income and wealth.
• Through debt finance, it results in the inefficient allocation of resources.
• By consolidating debt financing, it leads to the raising of anxiety levels and destruction of the environment.”
(Mohammad Netajullah Siddiqi – Economics of Tawarruq)
According to Saleh – Shaloob, “Tawarruq is not accepted by the Maliki School, however, is more accepted with the Hanbali, Hanafi, and Shafi Schools. According to Islamic Finance WIKI, the 5th decision of the Muslim World League on Tawarruq considered it permissible as the technique is derived on two sales contracts with the ultimate buyer being not the same as the initial seller. However, the OIC Fiqh Academy Ruled Organized Tawarruq Impermissible in 2009. Other Scholars believe that permission should be granted on a case-by-case basis.”
Saleh Al-Shaloob states that “The Islamic Fiqh Academy, which belongs to the Islamic World League, has issued two separate and different resolutions on the contract of tawarruq in the traditional form and the contract of organized tawarruq.
According to the Islamic fiqh academy, the traditional form of tawarruq is permissible (In the Circle 15th, Makka,1998) whereas the new form of tawarruq, which is called banking tawarruq (al-tawarruq al-masrafi) or organised tawarruq (al-tawarruq al-munazam) is prohibited (In the Circle 19th, Makka, 2003).
According to proponents of this view, there are three differences between the two forms;
The first difference is that the role of agency, which is played by the financial institutions changes the nature of the contract, bringing it close to the form of ‘ina sales, which is prohibited in Islamic law according to the majority scholars, whether the agency of the financial institution is indicated as a condition of the contract or is very common in this type of contract.
Secondly, this kind of contract, in many cases, does not reflect the concept of possession in Islamic law.
Thirdly, the reality of this type of contract is to finance the client (al-mustawriq) who applies for some money and to charge him extra;
The financial institute arranges the procedure of the contract by obtaining the commodity and selling it in the market on behalf of the client in order to achieve this purpose. However, that is not the real form of tawarruq, which has been indicated in the traditional fiqh and previously premised by the Islamic fiqh academy. The traditional form of tawarruq is a contract in which the seller sells a commodity, which is normally under his ownership and belongs to his business, to the buyer for deferred payment and the seller delivers the commodity to the buyer to be under his full possession and responsibility. Then, after the commodity is received by the buyer, he sells it to a third party who is not the seller for immediate payment.” (Salah Al- Shahoob)
Conditions of Organized Tawarruq
1- Ownership of the commodities.
The seller must own the commodity before selling it to the buyer.
2- Commodity is specified.
The seller has to explain the details of the commodity to the buyer.
3- Possession of commodities.
The commodities, which are normally used in the contract of organized tawarruq, can be transferred from place to place and this kind of commodity is called a transferable commodity (manqulat). Examples include metals, cement, rice and cars.
4-Avoiding ‘ina sales.
As has been mentioned, the majority of jurists consider that ‘ina sales are prohibited according to Islamic law. Therefore, financial institutions avoid buying the commodities again from the client because they have already sold them to the client by installment payments for more than what they normally pay to acquire the commodities. Consequently, if they were to buy the commodities from the clients for less than what the client had paid, the contract would be an ‘ina sale.
5- Details of the time of payments.
The contract between the financial institution as the seller and the client as the buyer is based on the contract of installment sales or deferred sales in general and one of the conditions of the both contracts is that it must explain in detail the manner of payment.
6- Avoiding usury.
The contracting parties have to be careful not to deal with commodities, which it is not permissible to exchange for deferment, otherwise, they would be involved in the usury by way of deferment (riba al-nasi’a).
7- Delivery is immediate.
As indicated previously, the contract of organized tawarruq is based on deferred or installment payment so if the delivery is deferred, the contract would then be a sale of debt –for- debt and this kind of sale is prohibited in Islamic law. “(Salah Al- Shaloob)
Murabahah is basically a sale-and-purchase agreement(s) for the financing of an asset or project for a cost plus a profit margin (mark-up), which is usually benchmarked against a conventional index such as LIBOR. Therefore, Murabahah is also known as ‘cost-plus financing and frequently appears as a form of trade finance based upon letters of credit.
Under this structure, banks can purchase goods from a third party at the request of a client and sell the goods to the client at cost plus a mark-up with the goal of making a profit. ‘Where a trader acts on behalf of another party in buying goods, the Murabahah mark-up may be seen as a payment for the trader’s service in locating, transporting and delivering the goods.’ (http://www.islamic-finance.com/item_murabaha_f.htm)
According to Islamicfinance.com, ‘The gain made by the seller is not seen as a reward for the use of his money capital, since it is not permissible to rent out money in Islam, but is instead seen as a profit on the sale of goods. However, this kind of sale of goods for money should be distinguished from a transaction in which a bank or financier buys an item and simultaneously sells it on at a profit to a customer. This operation is known as ‘Murabahah to the purchase-orderer’.’
According to Norton Rose, the original cost price of the asset is disclosed by the seller to the purchaser at the time of contracting and according to islamicfinance.com, the amount of the profit margin in money terms should be specified as well. In addition according to Norton Rose, although often referred to as a singular Murabahah contract, the cost-plus financing may be achieved through using two separate contracts. Norton Rose states that the way in which the two contracts are executed must be done carefully so as to be in compliance with the Sharia’h.
‘Islamic banks can engage in Murabahah because in contrast to conventional banks, trading is allowed. Murabahah is considered legal in Islam and is for the benefit of the contractors and the community as a whole. The concept is based on the fact that certain people are not skilled in buying and selling and enter into sale transactions with reliance on merchants to act in good faith and conduct a fair deal based on their duties as Muslims.’ (The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan)
Advantages of Murabahah
- Banks trading the goods ensure that there is a ready buyer.
- The buyer provides the bank information on the supplier of the goods.
- Banks have the chance to make a profit from cost-plus financing.
(The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003), islamicfinance.com, and Norton Rose)
A Murabahah Transaction Usually Involves the Following Steps
- The purchaser/client submits an order to the bank to purchase the goods.
- The bank agrees to finance the purchase of the goods.
- The bank sends an offer to the purchaser/client.
- The purchaser accepts the offer, which binds the purchaser contractually to purchase the goods. (Purchase Undertaking)
- The bank pays the supplier and purchases the goods using spot payment.
- The purchaser, acting for herself, enters into a contract to buy the goods from the bank.
- The purchaser purchases the goods from the bank for immediate delivery with deferred payment.
- On the due date, the purchaser pays the purchase price plus the mark-up.
(The Principles of Islamic Finance)
Terms of Murabahah
‘The subject matter of the Murabahah contract must be in existence, under the ownership, and in the physical or constructive possession of the seller at the time of contracting.
Where it is practiced in the modern financial market, Murabahah usually obeys the following terms:
- The end user settles the amount outstanding in one lump sum upon delivery or thereafter.
- The Settlement Date must be specified.
- The financier maintains ownership of the purchased items until delivery.
- The financier bears all the costs and risks of ownership until delivery.
- The end user and financier must pre-agree and specify the mark-up to be applied.
- The mark-up applies to all relevant costs incurred by the financier.
- The goods subject to the transaction must be specified.
- The cost of the required items and other relevant costs must be specified prior to contracting.
- In the event of default by the end user, the financier only has recourse to the items financed and no further mark-up or penalty may be applied to the sum outstanding although the seller may alternatively require the buyer to make a pre-specified donation to an agreed charity.
- The item purchased by the financier cannot be under the ownership of the financier, but must instead belong to a third party at the time of contracting.
- The seller may require the buyer to furnish security for the payment due, but only at the time when delivery of the purchased items to the buyer is made.’ (islamicfinance.com)
Risk Mitigation in Murabahah
1. The purchase from the supplier and sale to the buyer may be done at the same time in order to minimize risk of liability for damage to the goods or the goods not matching specifications or meeting delivery dates, etc.( This may be seen as a ‘Murabahah to the purchase-orderer’ ) (The payment of the marked-up price is usually done at a later date, which in addition to risk, involves the provision of credit).
Side Note: ‘Scholars accept a transaction in which the aggregate value of the deferred installments equals the spot price (since even if such a transaction is viewed as a combination of a sale of goods with a loan advanced by the seller to the buyer, the loan in this case would be interest-free)’. (islamicfinance.com)
2. The Bank can negotiate with the buyer to waive her rights to any claims against the bank for breach of warranty. (indemnification)
The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003),
Sharia’h Parameter Reference 1: Murabahah Contract Frequently Asked Questions (Bank Negara Malaysia)
Murabahah Contract by Malaysia International Islamic Finance Corporation/ Bank Negara Malaysia
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
- ‘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.
- 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).
- 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.
- 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.
- 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.
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.”
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
Guidelines for Musharakah and Mudharabah Contracts (See Page 18 for Diminishing Musharakah) Bank Negara Malaysia
Musharakah is rooted in the word shirkah or ‘partnership’ in English and refers to a joint-venture agreement between two or more parties to engage in a specified business activity based on profit -and- loss sharing.
According to Bank Negara Malaysia, Musharakah is a contract between the partners to contribute capital (monetary or non-monetary) to a venture (where in general debt cannot form the capital), whether existing or new, or to an owner of real estate or moveable asset, either on a temporary or permanent basis. Profits generated by that venture, real estate, or asset are shared in accordance with the terms of the Musharakah agreement, while losses are shared in proportion to each partner’s share of capital. Also according to Bank Negara Malaysia, it is not permissible to include a condition in a Musharakah contract that stipulates a predetermined fixed amount of profit to one partner, which deprives the profit share of the other partner.
Basically, in this financing structure, an Islamic investment company and the client(s) agree to partake in a joint-venture within a specified time period. Both parties to the joint-venture agree to contribute capital (in a lump-sum or staggered basis), which is agreed upon at execution of the contract and mutually amendable at a future date so as to allow the injection of new capital. In addition, new partners to the venture can be added after the initial execution of the agreement with mutual consent.
Each party’s net profit is determined in a pre-agreed ratio like the Mudharabah, however, the portion of profit due to a partner does not have to correspond to the amount invested.
For example, it can be agreed that a partner that contributes a large portion of labor receive a larger portion of the profit than a partner that contributed more capital. It is great to see a system of finance that recognizes the value of labor and does not see labor as just a person to squeeze profit out of in an exploitative formula of paying labor an hourly wage, which does not include the value added to the product or service by the laborer. A laborer should not just be an expendable input of production in a calculation of profit, however, a laborer should be increasingly viewed as a producer of profit where in which the laborer should be able to share in that profit to enhance the overall productivity and profitability of the venture. This system actually encourages higher productivity levels as laborers are paid their worth and given incentive to work harder instead of squeezed dry and tired by a capitalistic system that sees them as a valueless, expendable machine used in someone else’s quest for profit generation.
According to Bank Negara Malaysia:
“A partner who has agreed to a certain profit- sharing ratio may waive the rights to profits to be given to another partner on the basis of Tanazul (waiver) at the time of profit realization and distribution as well as at the time of the contract. However, a waiver of profit that takes place at the time of contract shall be by way of unilateral promise (wa’d).
The mechanism for estimating profit on Musharakah capital employed may be benchmarked to conventional benchmarks, such as but not limited to Base Lending Rate (BLR) in order to determine the indicative profit rate.
Profit may be distributed from actual or realized profits through the sale of assets of the Musharakah partnership (al-tandhid alhaqiqi / al-fi’li).
Profit distribution may also be on the basis of constructive valuation (al-tandhid al-hukmi) on the assets including accounts receivables.
In the case of constructive valuation based on market valuation or a third party verification, the unrealized profit shall be recorded as a reserve.”
According to Bank Negara Malaysia, ‘examples of Musharakah financing are structuring project financing, syndicated financing, asset financing, working capital financing, contract financing, trade financing and structured products based on securitization such as sukuk. One of the common Musharakah applications in asset financing is Musharakah Mutanaqisah (diminishing partnership). Musharakah may also be applied to acquire a stake in another entity in the form of Musharakah investment.’
Unlike the Mudharabah, both parties may participate in the management of the profit-making venture. However, according to Bank Negara Malaysia, it may be decided that one party may manage the venture or management may be outsourced to a third- party based on a relevant contract such as Wakalah, Ujrah or the Mudharabah contract.
Similar to the Mudharabah, in a Musharakah both parties may mutually pre-agree on the profit-distribution ratio, which may or may not correspond to the level of capital contribution. In a Musharakah, similar to an LLC, all parties bear loss in proportion to the amount of invested capital. This is in contrast to the Mudharabah structure where in general only the investor suffers the loss with exception to negligence, misconduct, or violation of certain terms and conditions by the Mudharib. However, in Musharakah as well, according to Bank Negara Malaysia, ‘any partner acting on his own or as agent who has caused the loss of capital due to misconduct or negligence shall be liable to refund the loss of capital to the other partners.’ In addition, according to Bank Negara Malaysia, upon realization of loss, a partner may agree, without any prior condition, to bear the loss of another partner at the time such a loss is realized.
Therefore, in a Musharakah, the profit may be distributed according to pre-agreed contributions not necessarily based on capital contribution, however, loss is spread in proportion to the capital contribution of each partner unless a partner has aggravated loss due to negligent conduct, in which case, the negligent partner may be liable for more than the proportion to his invested capital. Also, a partner may agree to bear the loss of another partner.
Similar to a Mudharabah, the provisions of the Musharakah contract must be written in a manner to avoid the possibility of dispute during the operation of business or at the time of distribution of profit, bearing loss, or winding down. A Musharakah contract can be terminated based on expiration of a time period, after fulfillment of certain conditions, or by the liquidation of the assets that constitute the subject-matter of the partnership. Furthermore, according to Bank Negara Malaysia, ‘failure to contribute 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 partners shall than have an option to terminate the agreement or may agree to revise the agreement based on actual capital contribution.’
Each partner is entitled to terminate the venture agreement after giving notice as per the contract. The withdrawing partner is then entitled to her share in the partnership. The remaining partners may then enter into a binding promise to continue the partnership for a specified period of time (after withdrawal of one or more of the partners). For the withdrawing partner, all obligations, which existed before termination under the Musharakah shall continue to exist after the partner’s withdrawal.
It may be the case, according to Bank Negara Malaysia, that ‘the Musharakah agreement may impose a condition that compels a partner to offer the redemption of the partner’s share of capital to existing partners based on certain agreed terms and conditions,’ for example before offering the shares to a third- party. According to Bank Negara Malaysia, a share of a Musharakah capital may be transferred to existing partners or a third -party according to the existing terms and conditions of the Musharakah contract.
‘Two Categories of Musharakah
- Sharikah Mulk (Property Partnership) – Involves the joint- ownership of a property without its joint- exploitation, such as the joint- ownership of a house transmitted by devolution to the heirs of a deceased person. According to Bank Negara Malaysia, ‘in general, it refers to joint-ownership in a particular asset.’
- Sharikah ‘Akd (contractual partnership) – It emphasizes the joint- exploration of capital and the joint- participation in profits and losses where joint ownership is a consequence of and not a prerequisite for the formation of the partnership. According to Bank Negara Malaysia, ‘it is generally a venture with a commercial objective.’
Three Different Methods in Establishing the Sharikah ‘Akd, which can be in the form of Mufawadha or an unlimited, unrestricted, and equal partnership or Sharikah ‘Inan or a limited investment partnership.
- Sharikah Mal (finance partnership) – Where money is the main criteria in the formation of the partnership;
- Sharikah A’mal (labor partnership) – Partnership based on a partner’s experience or skill;
- Sharikah Wujuh (credit partnership) – Where credit alone is used for the partnership investment.’
(The Law and Practice of Islamic Banking and Finance by Dr. Nik Norzrul Thani; Mohamed Ridza Mohamed Abdullah; and Megat Hizaini Hassan. (2003))
The Musharakah Contract
According to Bank Negara Malaysia, ‘the essential features attributable to a Musharakah contract are capital, management, profit- sharing, loss- sharing, and a joint- venture.
CAPITAL CONTRIBUTION BY ALL PARTNERS
The essential conditions of a valid Musharakah capital are as follows:-
i. Musharakah capital shall be readily available;
ii. Musharakah capital shall be contributed by all partners; and
iii. The capital may be in the form of monetary assets such as cash or non-monetary assets that includes tangible and intangible assets.’
Furthermore, according to Bank Negara Malaysia, business ventures of Musharakah shall be Sharia’h compliant and may be conducted in various sectors such as trading, plantation, construction, manufacturing, investment, and services.
A Musharakah contract may be adopted for non-commercial activities, which are non-profit oriented. Pre-contracting costs incurred to conclude Musharakah contracts such as the conduct of technical and feasibility studies of the financial viability of the Musharakah venture by the IFI may be charged to the customer subject to the latter’s consent.
Origin in the Qu’ran and Sunnah
According to Bank Negara Malaysia, ‘Musharakah has been practiced before the Prophet Muhammad’s Sallallahu `Alaihi Wasallam (SAW) first revelation and since then, the practice of Musharakah has been assimilated as part of Islamic jurisprudence by virtue of Sunnah of the Prophet Muhammad (SAW).
The legitimacy of the Musharakah contract is based on the Qur’an, the Sunnah of the Prophet Muhammad (SAW), and the consensus of Muslim jurists.
The following Qur’anic verses generally indicate the validity of Musharakah.
i. “…but if more than two, they share in a third…” (Al-Nisa’:12) The verse specifically underlines the rule of Islamic inheritance. However, in general context, Muslim jurists have regarded the text as containing general permissibility of any form of partnership.
ii. “Verily many are the partners (in business) who wrong each other, except those who believe and work deeds of righteousness and how few of them….” (Al-Sad: 24)
THE SUNNAH OF THE PROPHET MUHAMMAD (SAW)
The Narration of Abu Hurayrah
Abu Hurayrah said that: The Prophet SAW said: Allah says: I am the third [partner] of the two partners as long as they do not betray each other. When one of them betrays the other, I depart from them”. (Sunan Abu Daud)
The Narration of Abu al-Minhal
Abu al-Minhal narrated that Zayd Ibn Arqam and al-Barra’ Ibn ‘Azib were partners, and they bought silver in cash and credit. Their practices were brought to the Prophet SAW, and the Prophet SAW pronounced that what was bought on cash then they could benefit from it and what was bought on credit then they should reject it.”
It is learned from the narration that Prophet Muhammad SAW approved the partnership formed between Zayd Ibn Arqam and al- Barra’ Ibn ‘Azib but disapproved their venture into business activity of purchasing silver on credit.
THE CONSENSUS OF THE MUSLIM JURISTS
This type of partnership has been practiced throughout the history of Muslims without objection from the jurists.
Imam Ibn al-Munzir states in his book al-Ijma’: “And they (Muslim jurists) agree on the validity of partnership where each of the two partners contributes capital in dinar or dirham, and co-mingles the two capitals to form a single property, which is indistinguishable, and they would sell and buy what they see as (beneficial) for the business, and the surplus will be distributed between them whilst the deficit will be borne together by them, and when they really carry out [as prescribed], the partnership is valid.”’
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.
Introduction to Musharakah
Sharia’h Parameters for Musharakah by Bank Negara Malaysia
Musharakah and Mudharabah By Mufti Taqi Usmani
“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 Sharia’h. 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.
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. 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. 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).
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 predetermined 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))
This can be done through a 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 predetermined 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))
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. 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.
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.
Bank Negara Malaysia also advocates that the agreed profit-sharing ratio may vary to correspond with different periods of investment or due to pre-mature withdrawal of capital provided that such conditions are agreed upon at the conclusion of the Mudharabah contract.
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.
The origins of Mudharabah can be found in the Qu’ran and the Sunnah.
“…others travelling through the land, seeking of Allah’s bounty…”
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)
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.
‘The Narration of Ibnu Abbas
Ibnu 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 livestock 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).
The Narration of Suhayb
Suhayb 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).
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, Ubaydullah Ibn Umar and A`ishah 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 with integrity and 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 her capital without having any control in the management of the venture.
Negligence is an issue because an entrepreneur warrants to the investor of the entrepreneur’s skills in conducting the business among other things in the Mudharabah contract. Therefore, 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.
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.
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.
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))
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.
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. 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))
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.
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.
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.
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.
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.
Worthwhile Links Regarding Mudharabah
Musharakah and Mudharabah by Mufti Muhammad Taqi Usmani
Combining Musharakah with Mudharabah
Musharakah and Mudharabah
Some Economic Aspects of Mudharabah by Dr. Muhammad Nejatullah Siddiqi
Mudharabah by Dr. Muhammad Zubair Usmani
Sharia’h Parameters for Mudharabah by Bank Negara Malaysia