Contemporary Study in Islamic Economy

Brief Summary of Chapters Five & Six

Al Mudarabah Wel Musharaka Book

Contemporary Study in Islamic Economy

The following is a brief which provides some of the conclusions reached in the study, but for the full research together with its supporting reference and quotes, please read these two chapters in the book itself.

Islam forbid hoarding money and encourage investing it in various business activities, thus achieving prosperity to the society as a whole and profit to its owner. Islam encourages Muslims to invest their surplus money, either directly or by giving it to others who have the experience to invest it.

In convention economies, people –who have no experience or time to invest their surplus money, will simply deposit it in banks for a fixed return ‘interest’ earned after a specific period. The bank itself will loan this money to whoever need it, receiving higher interest rate, part of such loans will go to funding business and investment activities. This financial practice favours the party who owns the money over the party who actually invest the money and do the work, as the depositor receives a guaranteed return on its guaranteed deposit, while the business man who put the hard work and effort, is burdened with the high funding costs and suffer alone any possible losses. Both the depositor and the bank are always winners, the time the investor is left alone to take all the business risks in addition to the high funding cost, payable even if his business suffered a loss.

Islam strictly forbid usury, usury is defined as any increase on guaranteed money, given as loan or in a business transaction. When Islam forbad usury, Arabs used to fund their trade by two methods, the first was by charging usury payable after specific period (and for extending such period), the second by Qirad or more known as Mudarabah. Islam forbad Usury and left Mudarabah as the only lawful method of funding business transactions, as for loans needed to meet living expenses, Islam considered helping the needy as a charity highly rewarded, called it Al Qard Al Hassan (The good loan), which is due to be returned in the same amount, without any increase or interest.

Mudarabah serve the same purpose as interest funding, but is more just and fair to both parties. Al Mudarabah is a contract where a Money Owner –who does not have the knowledge, experience, time or ability to directly invest his money-, gives it to a person or a party or a company who have the knowledge, experience and capabilities to invest it the way it sees best. If at the end of the Mudarabah the business achieves profita, such profit will be divided between them in accordance to the ratio predetermined at the time of signing the contract, if the business incurred a loss, the owner of the money will receive whatever left of his capital, i.e. will bear the loss in the money, while the working partner will lose the value of his work and effort.

Although the basic idea is quite simple, the actual contract involve many controls and conditions which are necessary considering the changeable nature of this transaction, which differs from other business deals, because it is made up of many -in sequence- transactions, each have its rules and conditions. Mudarabah start as a deposit transaction, once the money owner hands the money to the working partner, the money become a deposit and the deposit transaction rules applies. Once the working partner start investing, i.e., use the money in the venture, he become an Agent ‘Wakeel’ of the Money Owner; who is fully authorised to do whatever he believes appropriate for investing the money. Once profit is achieved, the transaction becomes Partnership as they each own part of the profit. If no profit is achieved, it stays as Agency ‘Wikalah’ and as Agent does not bear any losses, the money owner shall bear all the loss in his capitalb. That is why there are many contract conditions and provisions in the Mudarabah contract, which details obligations and rights for each the two parties, in addition to the clauses of default, termination and other contractual provisions.

The idea behind the Mudarabah is that the Money Owner “MO” who gives his money to the Working Party “Mudareb”, aims to achieve profit, he have no interest in the work the Mudareb will put in this transaction, only as far as it benefit the Mudarabah, such benefit will only show if a profit is achieved, that is why the value of the Mudareb work is measured as portion of the profit.

Also that is why this transaction cannot be categorised as hiring. Hiring contract must be for a specific work and/or a specific period, here at the time of the contract, both the work and the duration are unknown.

Moreover, the MO has no interest or use for such work, nor he asked for it in the first place, so he should not be made responsible to pay for such work, as such work is put only to achieve growth to the capital, if the work succeeded in increasing the initial capital, then the work will have value which is quantified as part of the growth, if the work failed to cause the money to grow, then the work was of no use to the Mudarabah and accordingly will have no value.

In addition, the Mudareb himself entered the Mudarabah contract aiming to receive more than the rents and wages, by investing the value of his work in the transaction, hoping to receive part of the growth, which is in accordance to his calculations and studies, should be much higher than normal wages and rents. So in this Mudarabah, both parties invested their Capital, the first invested money, the second invested services and work (capital in kind), with objective of achieving growth. If achieved they share it, if not, each lose in kind of his participation, one from his money, the second from the value of his work.

The above is to explain the reasons why the Mudareb is not permitted to charge the Mudarabah for the wages and rents of his staff and assets, it could only be payable as portion of the profit when and if achieved.

Because 1) The Mudareb is the experienced knowledgeable capable party; on his sole actions depends the successes of the venture. And 2) The Mudareb will put effort and work, compensation for which is part of the profit, if there is no profit; then he will lose the value of his work and efforts. The Mudarabah contract provided the Mudareb with full authority and freedom to deal with the money as he wishes, without any interference from the MO. Because if the MO interfere and cause the Mudarabah to lose, the Mudareb will lose the value of his workc,

In Mudarabah, in case of loses, the value of work will be the first to be lost, followed by the cash capital. This is because if the revenues equalled the capital (the initial money provided by the MO), and as the Mudarabah Profit is what remains after returning the initial capital to the MO, nothing will remain, and the Mudareb will lose the value of his work and effort. That is why the condition of None Interference and giving the Mudareb the full freedom to act is a main condition of the contract. This condition is called Takhlia meaning to allow the Mudareb a full authority and freedom to do with the money whatever he sees fit.

From above, you may say that it is not fair that the Mudareb is the only one who lost in the mentioned example, but this is not exactly true, the MO also lost the potential growth of his Capital, and the Mudareb may bear some responsibility.

This essential condition of Takhlia, created difficulty in dealing with this contract in our time, as it is understood to mean that the contract is based on trust, which is far from that in real terms, as this research will show. Adding to that several misunderstandings about this contract. One of which allows the Mudareb to use the Mudarabah capital on himself (Nafaqah), and pay himself rents for his equipments, offices, stores and shops used in the transaction, he can also pay wages for himself and for his employees, also can take a management fee and yreat it as expenses.

If we take an example of a Mudarabah Contract between Money Owner and a Company. The company submit a feasibility study for a specific business investment, puts in the expenses the costs of its equipment, vehicles, stores, offices, staff and management, so when the Money owner put his capital, maybe quarter of it, if not more, will go to the company in paying for such services and works, if the Mudarabah achieve profit, it will be shared, if they lose, the company would have covered all its costs, and possibly made money of such rents and wages, the time the MO will lose alone part of his capital. when –considering the condition of Takhlia- The MO have no right to interfere or question how much the company paid it self for its services and assets mentioned above, clearly there are conflict of interest here, when we expect the company to negotiate with itself hoping to achieve the best price!

This is far from the Mudarabah which was practiced successfully for thirteen centuries in the Islamic world. You will not find a Money Owner who will give his money to be invested under such conditions, and no economical system can be based on such understanding, unless if we say that honesty, truthfulness, goodness and righteousness will govern the relation between the parties, and this does not work, not in this time nor in any other time. Some financial establishments tried to deal with this contradictions, sometimes it allowed the MO to supervise, interfere and have the right to approve or refuse, other times required the Mudareb to provide guarantees or guarantee results, none of which relate in any way to the Mudarabah Contract and should not be called so.

These wrong practices resulted from trying to apply the contract without understanding its real nature, what is offered by the parties, and how the profit should be divided between them. If it is a kind of a partnership, then of what, money and work, but if so, how can we sometimes divide the profit equally when the money could amount to ten times the work value. And in all cases the unknown value of the work cannot be considered as comparable to the MO paid in capital. As we mentioned before, the early Moslem Scholars referred the Mudarabah transaction to several transactions, namely deposit, Agency and partnership.  This explanation provides reasonable understanding of the transaction, but it does not answer our question: how we divide the profit? The early scholars left this issue to the agreement of the parties, which must be agreed upon before the contract, and they considered agreement of the parties as a proof of the fairness of the deal, and that each party will receive the fair returns on what it offered to the transaction, and that the market conditions will influence such agreements. All that is reasonable and logic, if they agreed on half, we should assume that the value of what they offered is equal, so the just balance which is the base of this transaction is achieved.

However, in such Mudarabah, where the parties agreed to equally divide the profit, we will be wrong if we say that the money (Mudarabah capital) equal the value of the work, we should try to find another equation to represent this transaction and provide equal input and returns. It appears that the capital ability to grow should equal the work value in order to reach equal division of the profit (money growth). Capital ability to grow (measured by growth) and work value although unknown in this Mudarabah transaction, can be quantified for comparison purpose and some percentages can be reached. We are interested to know comparable proportions not actual values.

Before we try to put the factors affecting the ratio’s of dividing the profit, we should first explain the correct meaning of three important Mudarabah definitions as mentioned in the old reference books:

Profit (Ribh Al Mudarabah):

It is generally understood today that the profit equals the revenue minus all expenses, this is true in all transactions except for Mudarabah. Profit in Mudarabah is the money remaining after paying back the initial capital to the MO.

Profit in Mudarabah is the increase above capital, such increase is attributed to the money and to the work, in other words, this increase consist of two parts, the first part is the growth of the capital that resulted from putting the capital into work, the second part is the value of the work which the Mudareb provided to the ventured.

If there was no profit –after returning the capital- this will mean that the Mudareb work have no value to the Mudarabah. As the value of his work is measured by its affect on increasing the capital, and quantified as part of such increase. If the increase is big, the value of the work will be a lot more than normal wages and rents, and if the increase is little, the value of the work is also little, and this is reasonable, as the MO have no interest in the work itself, he is seeking growth, and the Mudareb have no interest in wages and rents, he is seeking part of the profit and hoping it will be much more than the wages and rents.

Accordingly, the Mudarabah profit which is mentioned clearly in the early Muslim scholars writings, stated that the profit is what remains after returning the capital to its owner, and this includes the two parts 1) the growth of the initial capital and b) the value of the Mudareb’s work (valued as a part of the money remaining after repayment of the capital).

Al Mudareb’s Resources & Assets (Wages and Rents):

Contemporary understanding allows the Mudareb to pay himself from the Mudarabah capital for the work he provided (the wages and rents for his work, offices, stores, vehicles and equipment). It is said that as far as he have the right to hire a third party to do some work or to provide a service and as he pay them from the capital, he can pay himself if he executed the same work. This is not in accordance with what the early scholars have repeatedly said “If the Mudareb hired others to do part of his work he should pay them from his own money, and if he worked himself on what he normally hire others to do, he should not get paid from the Mudarabah money” meaning that the compensation for all the Mudareb’s intellectual and work input is only paid back to him as part of the profit. If there are no profit, then such contribution have no value as it failed to provide any growth to the Mudarabah capital.

Also, the Mudareb can negotiate best deals with third parties, but could not do the same if hiring from himself.

Al Nafaqah – Mudareb Personal Expenses:

It applies to a person who act as Mudareb. This should not be from the Mudarabah capital, the personal expenses should be from their own money, unless if agreed by the MO at the start of the contract.

According to above, the return of the Mudareb for his effort and work is form his share in the profit, and not from the Mudarabah capital. If a company approached a bank or Money Owner with an investing opportunity or Mudarabah funding, and showed in its feasibility study the cost of its main office, its salaries and wages, rents of its stores, equipments and other assets it owns, all this will form part of the work it is providing to the Mudarabah, for which it will receive a share in the profit. The bank will fund only the costs and expenses payable to third parties, and this should be the Bank Capital. However, if a company is a management company, and enter the Mudarabah offering only its experience and intellect, it is still valid as a Mudareb, and it can employ third parties to carry out the works paying them from the Mudarabah money, and the Mudarabah is correct. However, their share of the profit will be less than if they offered more. In summary, the Mudareb cannot pay himself for any work or service he provide to the Mudarabah.

In the example we mention above, the more the Mudareb provide work and use of its assets to the Mudarabah, the lower the risk the Money Owner will have, such understanding provide the owner with reasonable low risk investment which should encourage him to invest in Mudarabah contracts.

To put the above in prespective, if the Mudareb owns a factory, transport vehicles, stores and offices, valued in his study as 200,000 and he needs funding to buy raw materials delivered to his factory, including all costs payable to third parties which totals 800,000. And the study showed sales 1,200,000  The bank should pay him  only 800,000 as Mudarabah capital, and if all went to plan, revenue will be 1,200,000 and the Mudarabah profit is what remains after repaying the bank its capital, which will be 400,000. If at the start they agreed ¾ to the Mudarab and ¼ to the Bank, each will receive a good return on their investment.

But if the product was only sold for a million, profit here is only 200,000 divided 150,000 for the Mudareb and 50,000 for the bank. And this seems to show that the Mudareb lost the time the Bank have gained, and if true this will be unfair to the Mudareb. But it is not true, before we carry on here, we must define the nature of what each party provided to the Mudarabah, because if we say that the Mudareb shared with 200,000 and the Bank 800,000 then the profit division of ¾ to ¼ will not be correct, it should be then 1/5 to 4/5, but this transaction is not Musharaka, and it can not be, first because we can not mix cash, assets and services in capital, and even if we passed it as Musharaka, it will have different conditions and profit is what remains after paying both parties their capitals, all of this is not Mudarabah.

The fact is what they shared with is Manafa (the utility or the use of an asset, for example for a house, it is living in it and its value is the rent payable each month), the MO shared with Manfaat Al Mal, and the Mudareb shared with Manfaat Al Amal (work).

Manfaat Al Amale is the rents and wages should this work is directed into a simple rental or hire transaction, in our example it is estimated to be 200,000

Manfaat al Mal, is the estimated return if the money is invested in a low risk venture, in order to be comparable with Manfaat Al Amal mentioned above. This can be calculated assuming that we used the money to buy a building to rent it for the duration of the Mudarabah, assuming it is one year, and the rent net income was 66,660 (8.33% of the building value which is the capital), if we sum the two values 266,660 we got the Work share ¾ and the Money share ¼

So if we go back to our example and assume the product was sold for 1 million only, Mudarabah profit will be 200,000 out of which 150,000 to the Mudareb and 50,000 to the Bank, and they are both equal each loosing ¼ of expected return on their Assets, and if the product was sold less than 800,000 the Bank will start losing from its capital, (which is a condition of earning return on invested capital that it is exposed to loss, without it, the bank could not take the profit), while the Mudareb losses will stop at the maximum of the Manafaa of its assets, he can not lose more, and although his venture ended in losses, possibly disaster, he keeps all his assets intact and safe. Unlike if the transaction was with usury bank, he can lose his assets and more.

  1. Profit in Mudarabah, It is what remains after repaying the Money Owner his initial Capital at the end of the Mudarabah.  (back)
  2. The above is the traditional explanation of the Mudarabah phases, it is good but it does not answer basic questions such as: on what basis the partners agree the division of the profit? and as they are sharing in the profit, could it be categorised as a type of Musharaka? (kind of Partnership between Money and work). These issues are studied in depth in the book.  (back)
  3. Because it is valued as portion of the profit, and in the absence of the profit, his work will have no value.  (back)
  4. As the value of the Mudareb work is included in the Mudarabah profit, he should not be paid wages or rents.  (back)
  5. Detailed study with supporting early scholars writings is shown in this chapter of the Book.  (back)