CRITICAL ANALYSIS OF EQUITY LIKE ISLAMIC
FINANCIAL INSTRUMENTS
By:
QAISAR ZAMAN
Advocate High Court
LLM,
Muslims are unable to conduct their business activities
with conventional financial institutions because Quran and Prophet's teaching
prohibit them from paying and receiving interest. Islamic schools of thought
and scholars also argue that financial activities should be interest free. They
recommend Profit and Loss sharing system for Islamic banks. The Islamic banks
would provide its financial resources to the borrowers on a risk-sharing basis
unlike in the interest based financial system in which the borrower is
responsible for all risks. Most people understand that one of the fundamental
differences between Islamic and conventional finance is that Islamic banks
cannot charge (or receive) interest, there are other significant fundamental
differences in philosophy between Islamic and conventional banking.
Conventional banking involves employing funds on a time finance/cost basis and
charging interest.
In order to compete with conventional interest based
financial instruments, Islamic financial institutions developed products that
would fulfil the Shariah obligation and provide the same value as conventional
bank products. The main Islamic financial products include profit and loss
sharing (Mudaraba and Musharaka), Cost Plus Mark-up and Ijara. The focus of
this chapter is to critically analyze profit and loss sharing instruments.
1. Equity Like Financial Instruments
Mudaraba and Musharaka are two such financial instruments
based on the profit and loss sharing system, where the financier shares in the
venture's profits and losses.
The system is protective of the entrepreneur, who in a
capitalist economy would have to make fixed interest repayments even when the
venture is losing money.
a. Mudaraba Finance (Silent Partnership)
Mudaraba is a term that is derived from the expression
"ad-derbo-filard". It means journeying in the
Mudarabah is a contract between two parties in which one
party (Rab ul Mal) gives capital to the other party (Mudarib) for the purpose
of engaging in a business activity with the understanding that any profits will
be shared in a mutually agreed upon ratio. As for loss, it is to be borne by
the capital owner entirely unless it is proved that the Mudarib was neglectful
or incurred an infraction to the condition of the Mudarabah. Only then can the
Mudarib be made accountable for the loss.
Sharia'a law sets no particular proportion; rather, it is
left that to the agreement of both parties. They can share profit in equal
proportions, and they can also allocate different proportions for the
Rabb-ul-Mal and Mudarib. However, they cannot allocate a lump sum amount of
profit for any party, nor can they determine the share of any party at a
specific rate tied up with capital.
Aside from the agreed proportion of the profit or loss,
the Mudarib cannot claim any periodical salary or a fee or compensation for the
work done for him by the Mudarabah. If the investment has earned a loss in some
transactions but has gained a profit in others, the profit shall be used to
offset the loss at the first instance, and then the remainder, if any, shall be
distributed between the parties according to the agreed ratio.
Mudaraba is used for longer-term transactions of
substantial size. The funds provided by the Rabb ul-Mal may be unrestricted, or
restricted in terms of the commodities to be traded or the place of trade (two
of the main schools of thought on Islamic finance also allow restrictions on
the times of trade and on the persons that the working partner is allowed to
trade with).
There are five conditions which need to be satisfied in
order to have a valid or legitimate Mudarabah. First, parties should be
competent to be Mudarib and Rab ul Mal. Second, capital should be in monetary
form and must be present at the time of concluding the contract or at the time
of starting operation. Third, capital must be delivered to the Mudarib. Fourth,
capital must be known in quantitative form and ratio of profit must be fixed.
Fifth, if one of the above mentioned conditions are not fulfilled then the
contract is fasid (void).
Tarek S. Zaheer has compared Mudarabah with western
concept in these words:
"Mudarabah agreement is akin to western style
limited partnership, with one party contributing capital while the other runs
the business, and profit is distributed based on a negotiated
percentage of ownership. In case of a loss, the bank earns no return or a
negative return on its investment and the agent receives no compensation for
his efforts".
Bacha has argued that the concept of Mudarabah financing
in Islamic banking practice is hybrid. He says that it is neither equity nor
debt because on the one hand the financing that Mudarib receives from Islamic
bank is like conventional equity. There are four reasons for that: first,
unlike interest based conventional system there are no fixed annual payments
that are due. Second, Islamic bank receive payments from profits, it is similar
to dividends that are paid in case of profit accrued from the business. Third,
the Islamic financing institutions cannot take any legal action if there is no
profit gained from the venture. Fourth, Mudarabah financing like equity does
not increase a firm's risk. In fact debt financing does through increased
financial leverage.
On the other hand, Mudarabah financing acts as a
conventional debt. There are following reasons for that: first, Islamic bank
demands a "fixed" claim on his company, being the initial amount plus
whatever accrued profits (or losses) that are due to the bank. Second,
Mudarabah financing can be terminated like debt financing. It is done by mutual
agreement of the parties or Mudarib can end by repaying the principal and
accrued profits. "So, unlike equity which represents an unlimited and
perpetual claim on the company, Mudarabah, despite the features that make it
seem like equity, represents a fixed and terminable claim, much like debt,
hence the earlier, argument that Mudarabah is really a hybrid in the conventional
sense".
During the past few years venture capital finance has
become popular among western countries such as the
The Mudarib (entrepreneur) in a Mudarabah contract does
not share capital in the venture while in case of VC finance both the parties
(investor and entrepreneur) share capital in an agreed ratio. Profits in
Mudarabah contract are either paid continuously or on the completion of venture
whereas in VC finance, the capitalist draws profit through a sale of his shares
in the firm on an international stock exchange. Losses in Mudarabah are
entirely borne by the Rab ul Mal (investor) whereas in VC finance losses are
borne on the ratio of parties shared capital.
Mudaraba can also be used in a way similar to a
closed-end investment fund. In this structure, investors contribute to the
capital of an investment fund (managed by a specialized investment management
company or a bank). This could be organized, for example, by the sale of
"income notes" by the investment fund. The investment fund manager
can be paid a fixed fee, or a performance-related fee is essential for the
validity of a Mudarabah contract that the parties agree, from the beginning, on
a fixed proportion of the actual profit to which each of them is entitled.
The Mudarib is not allowed to guarantee either the
capital or the profits (but the Mudarib may be required to provide guarantees
or financial sureties). The sleeping partners could be investors and the
Mudarib a bank or investment fund manager. Alternatively, the sleeping partner
can be a bank and the Mudarib the operator of the project.
The major problem of this form of financing (venture
capital) is, of course, moral hazard: the investor/entrepreneur shares in the
profits, but not in the losses. In case it is the "sleeping partner",
close monitoring by the bank over the actual use of the funds (that is, the
investor's operations) is normally necessary.
b. Musharaka Finance (Partnership Finance)
Islamic jurists are of the opinion that Musharaka is a
valid and legitimate contract in Islam. The Islamic schools of thought,
however, differ over its form, conditions and other details.
Musharaka is a contract similar to joint venture in which
one party joins with another in contributing money to a venture and shares
profits and losses. Profits are to be distributed among the partners in
business on the basis of equity proportion settled by the parties in advance.
The share of every party in profit must be determined as a proportion or
percentage. Parties cannot settle the absolute amount of profit in advance.
Musharaka finance is suitable for long term financing and it is considered
closer to a traditional equity stake with rights of control. Every partner is
entitled to participate actively in the affairs of Musharaka if he desires to
do so. However, the partners may agree whether the management is carried out by
one of them. In such a case the "sleeping" (silent) partner shall be
entitled to the profit only to the extent of his investment.
According to Islamic principles, the intentions of a
financier must be determined prior to his engagement in a Musharakah contract.
If the financier is advancing a loan to the debtor for the sole purpose of
assistance, he may not receive any excess on the principle of his loan. On the
other hand, if he wants to share in the profits of his debtor, it is necessary
that he also share the losses that may be incurred. Thus the returns of the
financier in Musharakah are tied up with the actual profits accrued through the
venture. The greater the profits generated, the higher the rate of return for
the financier. If the venture earns enormous profits, the investor does not
have the right to all of it but must share it with the depositors at the bank.
In this way, Musharakah has a tendency to favour the common people rather than
the rich only.
This is why Islam has suggested Musharakah as an
alternative to the interest-based financing. In a similar manner to a Mudarabah
contract, with Musharakah, both parties have the right to end the contract at
any time as long as a notice is given to the other party involved. The assets
may be liquidated prior to their distribution among the parties involved or the
division could occur in asset format, depending on the preference of both
parties.
A Musharaka transaction comes into operation when either
a party contribute money to an existing venture in the
form of capital increase or as working capital or when parties join together
for a new venture and investor acquires an equity stake in the venture.
Musharaka may be compared to western partnerships,
limited partnerships or joint ventures. In conventional partnership interest
predetermines a fixed rate of return on a loan advanced by the financier
irrespective of the profit earned or loss suffered by the debtor, while
Musharaka does not envisage a fixed rate of return. Rather, the return in
Musharaka is based on the actual profit earned by the joint venture. The
presence of risk in Musharaka makes it acceptable as an Islamic financial
instrument. The financier in an interest bearing loan cannot suffer loss, while
the financier in Musharaka can suffer loss if the joint venture fails to
produce fruits.
Musharaka is quite similar with western capital venture
finance. In both financial instruments capital is shared by entrepreneur and
investor. Profit distribution and loss sharing is according to the equity
contribution of the parties. The main difference lies in the influence of
management, in Musharaka Islamic institution (investor) does not exercise
influence on entrepreneur whereas in venture capital finance, the capitalist
have influence on strategic decisions.
The most significant development in
The launch of the fund was a milestone on the long road
of implementing a true Islamic financial system. Many people thought that this
idea could never become reality. The critics proved wrong when Musharaka
declared a first annual dividend of 14.7%. The fund hopes to boost its size and
outreach over the next few years extending its operations to many Muslims.
Diminishing Musharaka:
A common form of Musharaka financing is diminishing or
declining Musharaka. In this type the partners finance jointly to acquire an
asset. The financier's share of the asset decreases through periodic payments.
It includes capital repayment and rent from the other partner. At the end, title
to the equity is completely transferred to the buying partner.
Diminishing Musharaka is used by people either buying
houses for owner occupation instead of a conventional mortgage or for the
purchase of investment property. It takes place when one party (eventual owner)
wants to buy an asset but cannot afford to pay for all of it. The bank buys 3/4
of the asset (e.g. building), while the eventual owner buys 1/4. According to
the contract the eventual owner has immediate rights to sole occupation of the
entire building. The eventual owner pays rent to the bank on the 3/4 of the
property that he doesn't own. According to the contractual arrangement, the
eventual owner pays the rent and will make additional payments to the bank to
purchase additional share of the asset. These purchases may be at the option of
the eventual owner, the bank will also have option to purchase the property at
some stage. The price for the additional shares of the asset will be set out in
the Diminishing Musharaka agreement. Any agreed price formula can be designed.
"Musharaka is the purest Islamic financial
instrument, since it conforms fully the principles of sharing in and benefiting
from risk. It remains rare, however, due to its obvious disadvantages. A
Musharaka venture exposes an investor to unlimited liability over a long period
of time. The returns on a venture are likely to be small or non-existent in the
short term, while a project is establishing itself. A further problem in some
countries is that accounting and auditing procedures are underdeveloped, making
independent assessments of losses, and especially profits, difficult. Faced
with an opportunity to make a long-term investment in a project, some Islamic
banks would try to structure long-term Mudarabas".
Standard Chartered Bank in
Almost all theoretical models of Islamic banking are
either based on Mudarabah or Musharaka or both, but to-date actual practice of
Islamic banking is far from these models. Nearly all Islamic banks, investment
companies, and investment funds offer trade and project finance on mark-up,
commissioned manufacturing, or on leasing bases. PLS features marginally in the
practice of Islamic banking and finance. Whatever is the degree of success of
individual Islamic banks, they have so far failed in adopting PLS-based modes
of financing in their business. Even specialised Islamic firms, like Mudaraba
Companies ... in