Welcome to a new discussion in this educative series on Islamic finance. From today, we shall deliberate on the subject of the Musharakah contract — the second investment-based contract in Islamic banking and finance after Mudarabah.
A query was recently raised to which I could not respond earlier since I was in the middle of explaining Mudarabah but it is important that I address it before moving to the new topic. Someone had asked why we call the series ‘Back to Basics’?
Let us examine what this idiom means in the English language. The following few explanations may help:
a. Stressing simplicity and adherence to fundamental principles
b. A back-to-basics approach simplifies complicated matters
c. Self-discipline and respect for the law, and
d. Accepting responsibility for oneself, and not shuffling it off onto others.
In fact, when we were planning to launch the series way back in March 2018, different titles were under consideration but ‘Back to Basics’ won the vote simply because we wanted to present to readers the fundamental principles of Islamic finance in an easy and simplified manner.
Also, the way Shariah principles are structured, they provide a lot of self-discipline and a high level of adherence and finally, the odds are always evenly distributed between both parties as against lopsided loading seen in the case of conventional lending.
But the question remains: how is the title relevant to contents of the series? To answer that, it is common knowledge that being a new financial system taking roots in the face of a formidable conventional lending model, Islamic finance needed time to make practitioners completely understand its mechanics, boundaries and most of all, its objectives (Maqasid Shariah).
The lack of a clear understanding coupled with the influx of conventionally trained bankers (including myself) into Islamic banks and financial institutions during early 2000s led to the adoption of certain conventional practices while offering some products which could not have been classified as adhering to Shariah principles in either form or substance or both.
The start of the series in this backdrop was a bold initiative by IFN with the purpose to present to readers the original, pure and uncut picture of Islamic contracts based on which various genuine products can be developed by Islamic financial institutions.
Since I had the opportunity to work for about two decades in senior positions in conventional banks before switching to an Islamic bank, it helped me to develop scores of alternative Islamic banking products as the head of Dar Al Sharia which I founded for Dubai Islamic Bank in 2007.
The combination of conventional and Islamic banking experience together with the special qualifications in both financial systems proved helpful for me to be able to combine the theory and practice with a simple approach and basic understanding of how Islamic finance works, away from complicated offerings we commonly come across, hence the title ‘Back to Basics’. I hope this explanation would suffice.
Definition of a Musharakah contract
The literal meaning of the word ‘Musharakah’ is partnership, joint venture or sharing. When two (or more) parties join hands by contributing equity toward undertaking a commercial activity, they enter into a Musharakah contract.
A Musharakah contract can be entered into for one line of business activity or more at a time. This is suitable in a situation where the equity contributed could be utilized to develop and promote a set of activities (for example, general trading).
While entering into a Musharakah contract, the ratio for sharing of the actual profit must be pre-determined between the contributing parties. It is not necessary that such a ratio is a replica of the equity contribution percentage.
However, profit-sharing may depend upon the role played by each partner in developing the business and generating profit. Some partners may be passive whereas the others play a key role in running the business and generating profit. As such, the former’s right over the profit can be lower than the latter’s.
However, when it comes to sharing the liabilities, damages or losses, it must be done according to their equity contribution ratio, ie on a pro-rata basis.
Through a Musharakah contract, an interested party can invest provisionally in a running business without becoming a direct shareholder. In such a situation, the Musharakah contract should clearly spell out the role of the new equity and the period for which it is being deployed.
In such a situation, the responsibility for the existing liabilities on the running business will continue to rest with the actual shareholders. The interested party could seek to exit upon the completion of the Musharakah tenure or opt to continue through a renewed arrangement, which includes exercising the equity conversion option should that be granted by the existing owner(s).
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.