Tag: Islamic Economy

Brief Summary of Chapters Five & Six

Al Mudarabah Wel Musharaka Book

Contemporary Study in Islamic Economy

The following is a brief summary 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 forbids hoarding money and encourages 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 conventional economies, people –who have no experience or time to invest their surplus money, will simply deposit it in a banks for a fixed ‘interest’ earned after a specific period. The bank itself will loan this money to whoever needs it, receiving a higher interest rate, and profiting from the difference. 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 businessman who put the hard work and effort in, 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 businessman is left alone to take all the business risks in addition to bearing the high funding cost, payable even if his business suffered a loss.

Mudarabah serves the same purpose as interest bearing 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, expertise, time or ability to directly invest his money, gives it to a person, party or a company who have the knowledge, expertise and capabilities to invest it the way it sees best. If at the end of the Mudarabah the business achieves profit((Profit in Mudarabah, It is what remains after repaying the Money Owner his initial Capital at the end of the Mudarabah.)), the 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 involves many controls and conditions which are necessary considering the changeable nature of this transaction. Mudarabah differs from other business ventures, because it is made up of many -in sequence- transactions, each have its rules and conditions. Mudarabah starts as a simple 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., uses the money in the venture, he becomes an Agent ‘Wakeel’ of the Money Owner; fully authorised to do whatever he believes appropriate for investing the money. When profit is achieved, the transaction becomes a Partnership as they each own part of the profit. If no profit is achieved, it stays as Agency ‘Wikalah’ and as an Agent does not bear any loss, the Money Owner shall bear all the loss in his capital((The above is the traditional explanation based on the Mudarabah phases, it is good but it does not answer basic questions such as: on what basis do 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.)). This is why there are many contract conditions and provisions in the Mudarabah contract, which details the obligations and the rights of 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 has no interest in the work the Mudareb will put in this transaction, only as far as it benefits 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 for 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 achieved growth. If the work failed to cause the money to grow, then the work was of no use to the Mudarabah and accordingly it 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 in accordance to his calculations and studies, should be much higher than the normal wages and rents. So in this Mudarabah, both parties invested their Capital, the first invested money, the second invested services and work (kind of capital in kind), with the 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 interferes and causes the Mudarabah to lose, the Mudareb will lose the value of his work((Because it is valued as portion of the profit, and in the absence of the profit, his work will have no value.)).

In Mudarabah, in case of loss, 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 Non 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 full authority and freedom to invest the money in whatever business he sees fit.

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

This essential condition of Takhlia, creates 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. There are also other several misunderstandings about this contract. One of which allows the Mudareb to use the Mudarabah capital to meet his own expenses (Nafaqah), paying himself rents for his equipment, offices, stores and shops used in the transaction. He can also pay wages for himself and for his employees, and can take a management fee and treat all such costs as Mudarabah expenses.

If we take an example of a Mudarabah Contract between Money Owner and a Company. The company submits a feasibility study for a specific business investment, include in the expenses ‘the cost 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 achieves profit, it will be shared, if they lose, the company would have covered all its costs, and possibly made profit of such rents and wages, the time the MO will lose alone part of his capital. When –considering the condition of Takhlia- The MO has no right to interfere or question how much the company paid itself for its services and assets mentioned above, clearly there is conflict of interest here, if we expect the company to negotiate with itself and we assume it will achieve the best deal for the Mudarabah!

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 successful economical system can be based on such understanding, unless if we say that honesty, truthfulness, goodness and righteousness will govern the relationship between the parties, and this does not work, not at the present 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 to 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 we sometimes divide the profit equally when the money could amount to ten times the work value. As we mentioned before, the early Muslim 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, they considered the agreement of the parties as a indication of the fairness of the deal and that each party will receive the fair returns on what it offered to the transaction, considering that the current market conditions will influence such agreements. All this is reasonable and logic, if they agreed on half, we should assume that the value of what they offered is equal, so the correct and just balance 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) equals 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 find the comparable values or percentages 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 in any transaction equals the revenue minus all expenses, this is true in all transactions except for Mudarabah. Profit in Mudarabah is the money remaining after repaying back the initial capital to the MO.

Profit in Mudarabah is the increase above its capital, such increase is attributed to the money and to the work, in other words, this increase consists 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 venture((As the value of the Mudareb work is included in the Mudarabah profit, he should not be paid wages or rents.)).

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, on the other hand if the increase is little, the value of the work will also be little. This conclusion is reasonable, the MO has no interest in the work itself as he is seeking growth and the Mudareb has no interest in wages and rents as 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 (measured as part of the profit, if any).

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 has the right to hire a third party to do a work or to provide a service and as he pays them from the capital then 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 hires 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 is no profit, then such contribution has 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:

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

According to above, the returns of the Mudareb for his effort and work is from his share in the profit, and not from the Mudarabah capital. If a company approached a bank or Money Owner with an investing opportunity seeking Mudarabah funding, showed in its feasibility study the cost of its main office, its salaries and wages, rents of its stores, equipment 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 of the profit. The bank will fund only the costs and expenses payable to third parties, and this will be the Bank Capital (The Mudarabah Capital). However, if a company is a management company, without any assets, enters the Mudarabah Contract offering only its experience and intellect, it is still valid as a Mudareb, and it can employ third parties to carry out the required works paying them from the Mudarabah capital, and in such case the Mudarabah is correct. However, the Mudareb share of the profit will be less than if it offered more in the way of work and assets. In conclusion, the Mudareb cannot pay himself from the capital for any work or service he provides to the Mudarabah, his compensation and reward for such, will come as part of the profit, such part to be predetermined and agreed prior to contracting.

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

To put the above in perspective, a Mudareb owns a factory, transport vehicles, stores and offices, valued in his study as 200,000. He needs funding to buy raw materials delivered to his factory, which totals cost of 800,000 including all amounts payable to third parties. The feasibility study he prepared and submitted to the bank showed sales revenue of 1,200,000. Based on this assumptions, the bank should pay him only 800,000 as a Mudarabah capital. If all went to plan, revenue will be 1,200,000 and the Mudarabah profit ((which is what remains after repaying the bank its capital)) 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 its investment. ((The bank will receive 100,000 returns on its 800,000 capital thus returning 12.5%. While the Mudareb will receive 300,000 for his work input, which was estimated at 200,000.))

 If the product was only sold for a million, profit then will only be 200,000, divided 150,000 for the Mudareb and 50,000 for the bank. This seems to show that the Mudareb lost, the same time the Bank gained, if true this will be unfair to the Mudareb, but this is not true. Before we continue here, we must define the nature of what each party provides to the Mudarabah, because if we say that the Mudareb provided 200,000 and the Bank 800,000 then the profit division of ¾ to ¼ will not be correct, it should then be 1/5 to 4/5, but this transaction is not Musharaka (Partnership), and it cannot be. Firstly because we cannot mix cash, assets and services in capital, and even if we passed it as Musharaka, it will have different conditions, one of which profit will be what remains after returning to each party its capital, all of this is not Mudarabah.

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

Manfaat Al Amal (Work)((Detailed study with supporting early scholars writings is shown in this chapter of the Book.)) is the rents and wages received if this work is provided under a simple rental and hire transaction, in our example it is estimated to be 200,000 as shown in the feasibility study.

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 returned in low risk renting and hiring contracts. This can be calculated assuming that we used the money to buy a building to rent it out for the duration of the Mudarabah. Assuming the Mudarabah duration 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 ((Manfaat Al Mal + Manfaat Al Amal))we reach total of 266,660. Accordingly we get the ‘Work’ share to be ¾ [ 200,000 ÷ 266,660 ] and the ‘Money’ share to be ¼ [ 66,660 ÷ 266,660 ].

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 will go to the Mudareb and 50,000 to the Bank, we will find that they are both loosing ¼ of their 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 for earning return on any invested capital that it is exposed to the possibility of incurring a loss, without such condition, 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. Although his venture ended in loss, he still keeps all his assets and property intact and safe. Unlike if this transaction was funded by interest bearing loan from a conventional bank, the Mudareb is exposed and can lose his assets, property and more.