Last week’s article stemmed from a question posed by a student from Universiti Sultan Zainal Abidin, Malaysia.

The question is whether the risk mitigation in Islamic investment contracts, ie Musharakah and Mudarabah, could form the subject of academic research and if so what should be the areas to focus on.

Although I am at the fag end of the long discussion on Musharakah contracts, I had provided a few notions to readers in the last article (121), those that I shared with the student via e-mail, and shall sum up the remaining points in this write-up.

3. Return on equity risk
How can an Islamic financial institution mitigate the rate of return risk in a Musharakah or a Mudarabah transaction?

Risk mitigation
An Islamic financial institution can mitigate the rate of return risk by leasing its part of the ownership in the Musharakah asset to the other partner at an agreed lease rent. The institution can only do so provided the Musharakah asset is a movable or immovable completed asset, an undivided part of which can be leased by the institution to its partner. Such leasing could either be on an operating or financial basis.

Through leasing, the institution would also surrender its right of sharing the Musharakah profit as well as it will not be a party to any operating losses of the Musharakah. This means if the Musharakah entity is doing good, there will be no share in it for the institution, having leased its part of the asset at a fixed rent to the other partner.

For example; if the institution is an 80% owner of a Musharakah asset and has leased its part of the asset to the partner client at US$1,000 per month and in turn the partner client has leased the whole asset at US$5,000 per month, the institution will not have any share in that rent, having already leased its undivided ownership to the partner client at US$1,000.

Irrespective of leasing, the institution shall continue to carry the ownership risks in the Musharakah asset to the extent of its equity contribution ratio. As such, at the time of the occurrence of partial or full destruction to the Musharakah asset, the institution shall bear the same, prorated to its equity in the asset.

If the institution enters into the Musharakah contract with a customer for a trading entity, the institution will not be able to lease its part of the ownership in the business to the customer. This is because the Shariah conditions on leasing cannot be complied with in such a case. Hence, the institution cannot mitigate the return on equity investment risk in a running business.

There have been some efforts to achieve such mitigation in the co-mingling Musharakah or Mudarabah transactions by playing around with the ratio for distribution of profit in the agreement.

The approach seen by me in some transactions is to twist the ratio for profit distribution to 99% in favor of the institution and 1% for the customer. On top of that, a clause is inserted in the agreement stating that although the institution is entitled to 99% of the profit, it will be content if it can get a certain percentage (usually the prevalent market rate for such financing) from the profit and that anything over and above that threshold shall be granted by the institution to the customer as a performance bonus.

This clause protects the institution vis-a-vis the return on Musharakah and Mudarabah investments to a great extent since in the case of poor profit earnings, 99% can be attributed to the institution which may bring it closer to its anticipated return from such an investment. Nonetheless, this will not be effective if the Musharakah has suffered a loss. I will leave it to readers to decide how far such a practice complies with the spirit of Maqasid Shariah.

4. Operational risk (only in Musharakah)
Being the partner in a Musharakah transaction, how would an institution be able to mitigate the operational risk to the Musharakah asset?

Risk mitigation
If the institution has leased its part of the asset to the other partner, it will be appropriate for it to also appoint the customer as the service agent to maintain the entire asset on behalf of the Musharakah. By doing so, the institution would be in a position to mitigate the operational risk but would still be responsible to share the loss if caused to the asset due to no fault of the customer/service agent.

5. Shariah or non-compliance risk
Misuse/deployment of capital by the partner or Mudarib in other than the agreed business or in the non-compliant investments.

Partner misstatement; hiding actual profit and declaring the losses.

Risk mitigation
Such risks can be mitigated to a certain extent from the following:
• Submission of the all-encompassing feasibility study by the client making the partner or Mudarib responsible for the assumptions and cash flow projections

• Thorough due diligence and scrutiny of a partner’s performance prior to approving the Mudarabah or Musharakah facility

• Regular review of the partner’s business activities/requirement for submission of periodical performance report to the Rab Al Maal by the Mudarib,

• Surprise inspection by bank officials of the client’s premises to ensure that the institution’s interest is properly being safeguarded by the client, and

• Critical review/analysis of periodical financial statements submitted by the partner/Mudarib in compliance with the agreement terms.

So, you can see how perfectly the risk mitigation in Islamic financing and investment contracts emerges from within the contracts.

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.

Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].

Next week: Final few points on Musharakah contracts.