Musharakah & Mudarabah

The concepts of musharakah and mudarabah are an ideal alternative for the interest-based financing with far reaching effects on both production and distribution.

Lessons

Musharakah - Introduction

Musharakah or Musharaka is a word of Arabic origin which literally means sharing. In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. It is an ideal alternative for the interest-based financing with far reaching effects on both production and distribution. In the modern capitalist economy, interest is the sole instrument indiscriminately used in financing of every type. Since Islam has prohibited interest, this instrument cannot be used for providing funds of any kind. Therefore, musharakah can play a vital role in an economy based on Islamic principles.

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Mudarabah – Introduction

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

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Combination of Musharakah and Mudarabah

A contract of mudarabah normally presumes that the mudarib has not invested anything to the mudarabah. He is responsible for the management only, while all the investment comes from rabb-ul-mal. But there may be situations where mudarib also wants to invest some of his money into the business of mudarabah. In such cases, musharakah and mudarabah are combined together.

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Management of Musharakah

The normal principle of musharakah is that every partner has a right to take part in its management and to work for it. However, the partners may agree upon a condition that the management shall be carried out by one of them, and no other partner shall work for the musharakah. But in this case the sleeping partner shall be entitled to the profit only to the extent of his investment, and the ratio of profit allocated to him should not exceed the ratio of his investment, as discussed earlier.

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Diminishing Musharakah

Another form of musharakah, developed in the near past, is ‘diminishing musharakah’. According to this concept, a financier and his client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of the financier one by one periodically, thus increasing his own share till all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be.

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Mudarabah – Distribution of Profit

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. No particular proportion has been prescribed by the Shariah; rather, it has been left to their mutual consent.

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Musharakah - Distribution of Profit

The proportion of profit to be distributed between the partners must be agreed upon at the time of effecting the Musharakah contract. If no such proportion has been determined, the contract is not valid in Shariah. The ratio of profit for each partner must be determined in proportion to the actual profit accrued to the business, and not in proportion to the capital invested by him. It is not allowed to fix a lump sum amount for any one of the partners, or any rate of profit tied up with his investment.

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Shirkat-ul-Milk and Shirkat-ul-Aqd

Musharakah is a term frequently referred to in the context of Islamic modes of financing. The connotation of this term is a little limited than the term “shirkah” more commonly used in the Islamic jurisprudence. For the purpose of clarity in the basic concepts, it will be pertinent at the outset to explain the meaning of each term, as distinguished from the other.

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Nature of Capital

Most of the Muslim jurists are of the opinion that the capital invested by each partner must be in liquid form. It means that the contract of musharakah can be based only on money, and not on commodities. In other words, the share capital of a joint venture must be in monetary form. No part of it can be contributed in kind. However, there are different views in this respect.

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Ratio of Profit

Is it necessary that the ratio of profit of each partner conforms to the ratio of capital invested by him? There is a difference of opinion among the Muslim jurists about this question. In the view of Imam Malik and Imam Shafi’i, it is necessary for the validity of musharakah that each partner gets the profit exactly in the proportion of his investment. Therefore, if A has invested 40% of the total capital, he must get 40% of the profit. Any agreement to the contrary which makes him entitled to get more or less than 40% will render the musharakah invalid in Shariah.

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Sharing of Loss

In the case of loss in musharakah financing, all the Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of his investment. Therefore, if a partner has invested 40% of the capital, he must suffer 40% of the loss, not more, not less, and any condition to the contrary shall render the contract invalid. There is a complete consensus of jurists on this principle.

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Termination of Mudarabah

The contract of mudarabah can be terminated at any time by either of the two parties. The only condition is to give a notice to the other party. If all the 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. However, if the assets of the mudarabah are not in the cash form, the mudarib shall be given an opportunity to sell and liquidate them, so that the actual profit may be determined.

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Termination of Musharakah

Musharakah is deemed to be terminated in any one of the following events: (1) Every partner has a right to terminate the musharakah at any time after giving his partner a notice to this effect, whereby the musharakah will come to an end.

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Mudarabah as a Mode of Finance

Mudarabah is a sort of partnership. Both parties participate in the profit that is going to be generated by the financed activity. The parties are free to agree on the ratio of profit distribution (70% - 30% or 50% - 50% or any other). However, unless they agree at the initiation of the contract, the latter is, from Shari’ah point of view void. Furthermore, it is a Shari’ah requirement in mudarabah that all of the capital has to be paid at the signing of the contract. It is not allowed to pay it later or on installments basis. Rub-ul-mal can impose any (reasonable) instructions and conditions on the agent, if they are acceptable to the latter they become part of that contract. Once operation starts, the financier has no right to interfere in the day to day business. If agent fails to follow the instructions and satisfy the conditions, then he is liable for loss of capital. The mudarib don’t guarantee capital nor profit to the financier. Rather he or promises good conducted honesty. This is the source of moral hazard and adverse selection in mudarabah.

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Musharakah as substitute for regular overdraft

In the early writings on Islamic banking, Musharakah was supposed to be the basic mode of finance in the model of interest free banking. However, in contemporary Islamic banking, Musharakah is almost not existent. The reason for this is obvious, complexity and a relatively higher degree of moral hazards. In Shari’ah, the Musharakah is the simple partnership, where two parties participate in a venture providing capital. Developing “partnership” into a banking mode of finance is not easy. Firstly, it has to be temporary, as bank can not engage in ownership and operation of joint stock companies. Secondly, because Musharakah is the “mixing” of two capitals, whenever the Islamic bank gets into Musharakah by providing capital, it has to engage into an evaluation of the "worth" of the other party. This is because profit at the end of Musharakah are the difference in the value of the Musharakah between the two points. This is extremely complex.

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