Islamic Modes of Financing

1. Islamic Modes of Financing Mudaraba

2. Summary of the Previous Lecture We covered the following topics in the previous lecture, • The concept of Musharakah contract. • Features of the Musharakah contract: • Capital contribution by all partners • Management of Musharakah venture • Profit sharing • Loss sharing • Partnership venture

3. Learning Outcomes After this lecture you should be able to understand • One of the most important mode of financing under Islamic financial system, i.e. Mudaraba. • Principles of Mudaraba • Uses of Mudaraba

4. Definition • This is a kind of partnership between the two parties where one partner contributes capital and the other one contributes efforts as manager or entrepreneur. The profit of the venture is share at an agreed ratio while the losses are borne by the capital provider. • The investment comes from “Rabb-ul-Maal” (Investor) while the management and work is an exclusive responsibility of the working partner, who is called Mudarib.

5. Features of Mudaraba Contract There are number of principles governing the Mudaraba contract, e.g. • Nature of the contract • Capital • Management of the Mudaraba • Profit and loss sharing mechanism

6. 1. Nature of the Mudaraba Contract • Generally Mudaraba contract allows anyone of the contracting parties to terminate the contract unilaterally. • However, the contract shall not be terminated unilaterally if the manager has commenced the work or when both parties have agreed not to terminate the contract during a specified time.

7. 2. Capital • The capital shall be contributed by the capital provider and shall be managed by the manager to generate income. • The capital of Mudarabah may be in the form of monetary or non-monetary assets.

8. 2. Capital • Monetary assets of different currencies shall be valued according to an agreed currency at the time of signing the Mudarabah contract. Illustration: Multi Currency Mudarabah Fund An Islamic Financial Institution has launched a global Mudarabah fund. The fund accepts investment in various currencies such as USD, Euro, Ringgit Malaysia, Saudi Riyal etc. However, the prospectus has stated that the Mudarabah fund is denominated in USD. Hence, all contributions by investors in non-USD currencies will be converted into USD equivalent amount based on the exchange rate on the day of subscription to the Mudarabah fund.

9. 2. Capital • The mutually agreed currency shall be applicable throughout the Mudarabah business venture. For example, any capital investments after the initial investment shall be converted into the currency mentioned in the prospectus.

10. 2. Capital • Capital in the form of non-monetary assets which may include intangible assets shall be valued based on the valuation determined by a third party which may include authoritative bodies, experts, or as agreed upon by the contracting parties at the time of conclusion of contract. • Non-monetary Mudarabah capital contributed may be redeemed at its original value invested should it be possible or otherwise at its residual market value upon termination or the expiry of the contract.

11. 2. Capital Illustration: Non Monetary Mudarabah Capital Contribution A public transportation company, XYZ applied for Mudarabah-based financing from an Islamic Bank. The bank approves the application and agrees to provide five buses to the company as Mudarabah capital valued at Rs.10 million based on prevailing market value and the company should manage the operations of these buses. Upon the termination of the contract the Murabaha capital may be valued at its original value or the residual market value as agreed in the contract.

12. 2. Capital • Debts such as account receivables or loans due to a capital provider do not qualify as capital of Mudarabah. • The agreed capital shall be made available to the manager to commence the business activities. • The capital may be fully or partially disbursed or made available to the manager at the time of the contract or based on terms of the contract. • Capital provider and manager may agree for a gradual withdrawal of Mudarabah capital by the capital provider.

13. 2. Capital • Failure to provide capital by the capital provider as per the agreed schedule shall constitute a breach of promise according to specified terms and conditions of the contract. • The manager has an option to terminate the agreement or both parties may agree to revise the agreement based on actual capital contribution.

14. 2. Capital • Where the agreement is terminated the manager has to return the outstanding capital (if any). If the Mudarabah expenditure exceeds the actual capital contribution, such liability shall be borne by the capital provider up to the limit of the total amount committed under the contract.

15. 2. Capital • Upon liquidation or maturity of the Mudarabah contract, all outstanding capital shall be returned to the capital provider. • Any outstanding capital including the share of profit shall be deemed as debt due to the capital provider. • The manager shall not guarantee the Mudarabah capital.

16. 2. Capital • The capital provider may require the manager to arrange for an independent third party performance guarantee. • The guarantee shall be executed as a separate contract and be utilized to cover for any loss or depletion of capital in the event of misconduct, negligence, dishonesty, fraud or breach of the terms of the contract by the manager.

17. 2. Capital The Mudarabah third party guarantee may be in the form of performance guarantee of the Mudarabah transactions or Mudarabah capital itself. For example, capital employed to sell assets or render services may be accompanied by a third party guarantee on payment for such sales and services.

18. 3. Management of the Mudaraba • Mudarabah capital will be used only for the Sharia compliant activities. • Manger/Mudarib will have the exclusive rights to manage the contract. However, the capital provider has the right to information regarding the conduct of the business and manger. • Manager shall not be liable for any loss of capital unless it is due to any negligence, dishonesty, misconduct or breach of contract.

19. 3. Management of the Mudaraba Negligence Among the typical conditions specified in the Mudarabah contract is that the managing partner is to exercise due care and diligence. For example, the assets purchased for sale was kept in the store without Takaful coverage against fire and theft. As a result of fire some of the assets perished. The manager is liable for the loss due to his negligence of not obtaining necessary protection.

20. 3. Management of the Mudaraba Misconduct The scope of the Mudarabah agreement specified that the Mudarabah fund should be invested in securities with investible grades and the securities should be from the list agreed by the capital provider. During the course of investments, in anticipation of huge profits the manager invested in non-approved securities with lower ratings. If a loss arises from such investment, the manager is liable for the loss of capital.

21. 3. Management of the Mudaraba Breach of Terms According to the terms of Mudarabah venture, the manager should disclose all relevant information that is significant for the capital provider to take a decision to participate in the venture. If the manager concealed important information which is known to the manager to be material to the decision making process. Upon engagement, losses on investment occurred and investigation reveals that such unfavorable information was not disclosed. This tantamount to the manager breaching the terms of engagement for willful non-disclosure and hence shall bear such loss of capital.

22. 3. Management of the Mudaraba Restricted Mudaraba The powers of the manger shall be provided under the terms and conditions of the contract. • The contract may restrict the manager’s role/functions such as • determination of location, • period for investment, • type of project and • commingling of funds, provided it does not nullify the purpose/objective of the contract. However, the restrictions shall not unduly constrain the manager.

23. 3. Management of the Mudaraba Unrestricted Mudarabah Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he/she deems fit, this is called unrestricted Mudarabah. There are no limits and conditions specified and the manager has the discretion to use the capital in the best interest of the Mudaraba. However, Mudarib is not authorized to: • Keep another Mudarib or a partner • Mix his own investment in that particular Mudaraba without the consent of Rabb-ul Maal.

24. Different Capacities of the Mudarib • Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are held by him as a trust. • Wakeel (Agent): In purchasing goods for trade, he is an agent of Rabb-ul-maal. • Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rabb-ul-maal who shares the profit in agreed ratio.

25. Different Capacities of the Mudarib 4. Zamin (Liable): If the enterprise suffers a loss due to his negligence or misconduct, he is liable to compensate the loss. 5. Ajeer (Employee): If the Mudarabah becomes Void due to any reason, the Mudarib is entitled to get a fee for his services.

26. Distribution of Profit & Loss • It is necessary for the validity of Mudarabah that the parties agree right at the beginning on a definite proportion of the actual profit to which each one of them is entitled. • They can share the profit at any ratio they agree upon. • However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios. • Some incentives my be given to the Mudarib.

27. Distribution of Profit & Loss • Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah. • The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

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

29. Distribution of Profit & Loss • If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed between the parties according to the agreed ratio.

30. Termination of Mudarabah • Mudarabah can be terminated any time by either of the two parties by giving notice. • If Mudarabah was for a particular term, it will terminate at the end of the term. • Termination of Mudarabah means that the Mudarib cannot purchase new goods for the Mudarabah. However, he may sell the existing goods that were purchased before termination.

31. Distribution at Termination • If all assets of the Mudarabah are in cash form at the time of termination, and some profit has been earned on the principal amount, it shall be distributed between the parties according to the agreed ratio. • If the assets of Mudarabah are not in cash form, they will be sold and liquidated so that the actual profit may be determined.

32. Distribution at Termination • If there is a profit, it will be distributed between Mudarib and Rab-ul-Maal. • If no profit is left, Mudarib will not get anything.

33. Collective Mudarabah • Collective Mudarabah means a joint pool created by many investors and handed over to a single Mudarib who is normally a juristic person. • Collective Mudarabah creates two different relationships: • Relationship between investors themselves, which is Shirkah or Partnership. • Relationship of all the investors with Mudarib, which is Mudaraba.

34. Running Mudarabah • Investors come in and go out at different dates • Profits are calculated on daily basis. • Redemption before maturity • If the assets of Mudaraba are in illiquid form, an investor may redeem his share by selling it to the pool.. • If the assets are in liquid form, a provisional amount may be given to him subject to final settlement

35. Summary of the Lecture In this lecture we studied the following concepts of Mudaraba financing; 1. Features of Mudaraba • Nature of the contract • Capital • Management of the Mudaraba • Profit and loss sharing mechanism 2. Termination of Mudaraba 3. Collective Mudaraba 3. Running Mudaraba