I hope my explanation by way of a little story in the last article on why an investor is not permitted to intervene in the routine running of a Mudarabah business has made a lot of sense to a lot of readers. I am available to explain if there is any remaining point in the mind of any reader on the subject.
On several occasions in this series, I have referred to the high point in Islamic finance which is that the ‘one-size-fits-all’ approach found in conventional banking cannot be applied here. What do I exactly mean by that? I think the time has arrived that I elaborate my rhetoric.
We had a long journey to cover the four sale-based contracts which are used in different situations. To refresh memories, the Murabahah contract is applied when there is the ready availability of goods or assets but payment needs to be deferred. Then comes the Salam contract where the situation is totally opposite since goods are absent, ie these are required to be delivered on a deferred basis; however, payment must be made upfront. Next is the Istisnah contract which is used for trading in ‘described assets’ which are required to be built, constructed or manufactured and payment made either on the spot or in stages. The last sale contract is actually a leasing (Ijarah) contract but because the usufruct of the asset is ‘sold’ for a defined period, it can be termed as a sale contract. So, you saw every situation of these sale contracts is diverse and has a dissimilar purpose.
In the same manner, there are different situations, objectives and aims when it comes to the three investment contracts and several Islamic banking and finance products were developed keeping in view the same. For example, have a look at the Mudarabah contract where one party is required to provide 100% funding but without permission to participate in managing the business whereas the other party who did not inject a penny is given full control. Then comes the Musharakah contract where both parties are investing capital (but that could be with any ratio) and are permitted to jointly run the day-to-day business affairs. The last one is the Wakalah (investment agency) contract where the full capital is provided by one party who also decides how, where and for how long it will remain invested and the other party has no say in it except to comply with the instruction.
When I analyze all of this, my conclusion is that the Mudarabah contract is the high-risk proposition, the Musharakah contract falls under a medium-risk venture whereas the Wakalah contract is the low-risk undertaking. To my understanding or as I perceive, these different risk levels are commensurate with the varied nature of people whereby some want to take high risk anticipating a high return, some are content with modest risk and want to remain involved so as to be sure of what is happening on the ground and the last ones do not want to take any risk on the counterparty for the investment decisions which they take themselves and merely instruct the agent to act upon them.
Moving on, let us examine the mechanism of how a Mudarabah contract is concluded after which I will have other Mudarabah-related points to explain.
At the end of the agreed Mudarabah tenure, the profit is determined and distributed between the parties according to the pre-agreed distribution ratio. This is very important to understand that the ratio of distribution of profit must be agreed between the Rab Al Maal and the Mudarib from the outset and clearly entered into the Mudarabah contract. This is because more than anything else, profit is the subject matter of a Mudarabah contract and a lack of clarity as to the subject matter renders a contract void in Shariah.
The basis for the requirement that the profit share of each party is stated in a percentage of the actually realized profit, and not a lump sum amount which may have no relevance to the actual profit, is because a Mudarabah contract is in essence a partnership in profit. Any condition that allocates a lump sum amount to one party would not be consistent with the paradigm of sharing the profit. There could be a possibility that the Mudarabah operation may not produce any profit whereas the payment of a lump sum amount to the capital provider may result in excluding the other party from a similar payment. Moreover, fixing a defined amount to be paid to the capital provider is equivalent to making an interest payment. Looking from another angle, such an amount will not be profit in nature but a part of capital, thus reducing the original capital on top of the loss the Mudarabah may have incurred.
On the other side, the Mudarib shall only be entitled to share the Mudarabah profit, and must not be paid any fee to manage the Mudarabah affairs. The basis for impermissibility of simultaneously receiving a share of the profit and a fee for managing a Mudarabah is because the fee is a known amount and the principle of Mudarabah is based on sharing the actual profit which is an unknown amount.
However, it is permissible that the Rab Al Maal voluntarily grants an incentive to the Mudarib out of the share of its own realized profit. But you will have to wait for the next article to learn how this complex arrangement can be achieved in a Shariah compliant manner.
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: Dealing with incentives in a Mudarabah contract.