After having completed the exhaustive discussion on the sale-based contracts in Islamic finance, ie Murabahah, Salam, Istisnah and Ijarah (in the same sequence), I will now take up the explanation of investment-based contracts.
The difference between sale-based and investment-based contracts in Islamic finance is that in sale-based contracts, the seller is able to ascertain the profit (or loss) on the spot, ie at the time of concluding the sale transaction (irrespective of it being based on cash or deferred payment) whereas in an investment-based contract, the parties have to wait over a period of time for the outcome of the investment made by them. Only time will tell whether the new venture they are part of will yield a positive or negative outcome. So, let me commence the explanation of Mudarabah or fund management contracts from today. A glimpse of a Mudarabah contract was revealed to you earlier when I had explained the workings of an Islamic bank which accepts term deposits or savings account funds from customers on a Mudarabah contract basis. However, that was for the Islamic bank to act as the receiver of funds or Mudarib/fund manager. Our discussion now shall be centered on the Islamic bank’s reversed role as the provider of funds.
But before we start our excursion on the Mudarabah track, let me share an incident when a renowned Shariah scholar of our time was trying hard to explain a Sukuk Mudarabah transaction to a conventional corporate finance lawyer of western origin. Incidentally, I was present in the meeting (that’s how I can tell the tale) when the lawyer exhibited his utter frustration in clutching the Mudarabah ropes despite the explanation provided by the respected scholar.
The scholar resorted to an explanation which made the people attending the meeting amused and the lawyer was also able to understand the purpose of a Mudarabah contract. The scholar said that God Almighty has been kind to all people since He does justice in distributing wealth among them. To some people, God bestowed a lot of financial wealth and to others a lot of intellectual wealth. A person with financial wealth may lack the intellectual wealth and may not know how to make his or her money work. At the same time, a person with intellectual wealth may have brilliant business ideas but due to the absence of finance may not be able realize his or her dream.
To solve the handicap faced by both, the Shariah system has provided the Mudarabah structure where wealth meets with expertise. As such, a Mudarabah contract is simply a marriage of convenience resulting in the potential benefits for both parties, ie the investor and the entrepreneur. To refresh our memory from a previous discussion, kindly note that as against the ‘one size fits all’ phenomenon in conventional finance where all monetary needs are met with a single approach of lending money on interest, the Shariah principles have provided several solutions to match different situations faced by individuals and businesses; however, a loan with interest is not even one of them. Mudarabah provides a solution to one of those situations. It is also referred to as Qirad or Muamalat in Shariah terms.
Mudarabah can be defined as an investment contract where an investor (Rab Al Maal) and an entrepreneur (Mudarib – also known as Amil or Muqarid) join hands, with both parties having legal capacity or perfect capacity which means they are adults and of sane mind. The Mudarib invites the Rab Al Maal to invest his or her capital in a proposed business, project or a transaction to be managed by the Mudarib. Such an invitation could be verbal or written; however, Shariah principles prefer that it should be in writing. In present-day circumstances, the potential Mudarib submits a business plan or a feasibility study to a potential Rab Al Maal where it exhibits the expertise it holds, the required amount of the Mudarabah capital, the time period for which the Mudarabah capital needs to remain invested, the profit expected to be generated from the venture and the ratio of profit distribution between the Rab Al Maal and the Mudarib. It is to be noted that the underlined part refers to the distribution ratio of whatever actual profit is generated and not the rate of return which shall make it into interest.
It is also possible that the Rab Al Maal, looking for profitable investment avenues, approaches the Mudarib, asking it to accept being appointed as the Mudarib for the Rab Al Maal, and to invest the capital for and on behalf of the Rab Al Maal. Both ways are acceptable from the Shariah perspective.
A point comes to mind: who could be the people who are loaded with money but are looking out for a reliable Mudarib to deploy their funds instead of starting something on their own with the wealth they possess? Well, first of all, they could be the inheritors of wealth from parents or relatives. While as per Shariah, the inherited wealth is the purest form of fortune or highest type of Halal affluence, the biggest challenge for the inheritors is how to preserve or protect the new-found wealth and make it grow. This is precisely where the conniving people endeavor to bait the naive heirs to hand over the wealth and property against promised ‘lucrative’ returns which are never realized in most of the cases we have seen. Can the parameters of a Mudarabah contract ward off an investor from such perils? Come back next week to find out.
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: I have just started explaining Mudarabah and intend to take several weeks to complete it.