Mudharabah and Muqharadah in Islamic Finance

B Y : C A M I L L E P A L D I
C E O O F F A A I F
Mudharabah and Muqaradha in
Islamic Finance

Mudharabah
 Mudharabah” is a kind of partnership where the
investor partner gives money to another partner
under a contract for the purpose of investing it in a
commercial enterprise to generate profit and where
the profit- sharing occurs according to the terms of
the contract and the rules of Mudharabah and
Shari’ah.

Mudharabah
 The investment capital comes from the first partner
who is called “rabb-ul-mal” or investor while the
management and work is the exclusive responsibility
of the other partner who is called the “mudharib” or
the entrepreneur/manager.

Mudharabah
 Therefore, the Mudharabah (Profit -Sharing) is a
contract with one party generally providing 100
percent of the capital and the other party providing
its specialist knowledge to invest the capital and
manage the investment project with the goal of
generating a profit.

Mudharabah
 According to Bank Negara Malaysia, the capital may
be fully or partially disbursed or made available to
the manager at the time of the conclusion of the
contract and based on the terms of the contract.

Managers and Restricted v Unrestricted
Mudharabah
 According to Bank Negara Malaysia, the powers of the
manager shall be provided under the terms and
conditions of the contract, which may include the scope
and assignment of management of Mudharabah capital
to a third- party.
 According to Bank Negara Malaysia, the scope of the
restricted Mudharabah contract may specify conditions
restricting the manager’s role/functions such as
determination of location, period for investment, type of
project and co-mingling of funds, provided it does not
nullify the purpose/objective of the contract.

Managers and Restricted v Unrestricted
Mudharabah
 However, the restrictions shall not unduly constrain
the manager.
 In contrast, according to Bank Negara Malaysia,
unrestricted Mudharabah capital is the capital
deployed in the Mudharabah contract, which does
not specify any limiting conditions and where the
manager is given the sole and wide -discretion to
manage the investor’s capital provided that he or she
acts in the best interest of the investor (fiduciary
duty).

Two-Tiered Transaction
 A bank may serve as intermediary and therefore
create a two- tiered transaction with one transaction
being between the depositor and the bank and the
other transaction being between the bank and the
entrepreneur or manager (Mudharib).
 However, the contract may just exist between two
parties, the investor and the entrepreneur, or may be
multi-tiered.

 Profits generated are shared between the parties
according to a mutually pre-agreed ratio. Compared
to a Musharakah, in a Mudharabah, when there is a
loss, generally only the lender of the money
(investor) suffers losses.
 In a Musharakah (joint-venture), both parties incur
loss according to the amount of capital contributed,
similar to the limited- liability concept in an
LLC. (Wikipedia)

 Mudharabah is functionally adaptive in the area of
general or specific investment, project financing,
bridge financing, working capital and SME
financing, inter-bank investment, structured
products, investment deposits, etc. (Bank Negara
Malaysia)

 Mudharabah, otherwise known as Muqaradhah, Qirad,
‘trust-financing,’ ‘trustee profit-sharing,’ ‘equity-sharing,’
‘sleeping- partnership,’ or ‘profit -sharing’ is the basis for
re-organizing worldwide banking activity into an interest
free framework.
 The creditor does not earn interest on a fixed- rate in this
system, but participates in the business risks and earns a
share of the profit.
 The difference between a conventional and an Islamic
banking system is that in the conventional system, the
cost of capital is expressed in terms of a pre-determined
fixed rate while in Islamic banking it is expressed in an
absolute amount, which may also be expressed as a ratio
of profit.

 (The Law and Practice of Islamic Banking and
Finance by Dr. Nik Norzrul Thani; Mohamed Ridza
Mohamed Abdullah; and Megat Hizaini
Hassan. (2003))

 Two -tier framework.
 The first tier of a Mudharabah agreement is between the
bank and the depositors who agree to put their money in
the bank’s investment account and to share profits with
it.
 In this case, the depositors are the providers of capital
and the bank functions as the manager of funds.
 The second tier of the Mudharabah agreement is
between the bank and the entrepreneurs who seek
finance from the bank on the condition that profits
accruing from their businesses will be shared between
them and the bank in a previously agreed proportion, but
the loss shall be borne by the financier only.

 The bank functions as the provider of the capital and
the entrepreneur works as the manager. In the case
that there is more than one financier in the same
project, profits are shared in a mutually agreed pre-
determined proportion, but loss is shared according
to the amount each investor has invested. (The Law
and Practice of Islamic Banking and Finance by Dr.
Nik Norzrul Thani; Mohamed Ridza Mohamed
Abdullah; and Megat Hizaini Hassan. (2003))

Profit-Sharing
 According to Bank Negara Malaysia, the profit is
always distributed on a proportional basis and may
be based on a lump sum or guaranteed amount if it
does not deprive the other partner from sharing in
the profit. Furthermore, according to Bank Negara
Malaysia, the profit- sharing ratio may be tiered to a
target specific profit rate or threshold amount as per
a specified benchmark.

Profit-Sharing
 Thus, according to Bank Negara Malaysia, any profit
rate or return that exceeds a specified benchmark
may be allocated to the designated partners based on
another formula of distribution such as the level of
actual performance as long as this is mutually agreed
upon and is included in the contract.

Profit-Sharing
 In addition, according to Bank Negara Malaysia, a
profit- sharing ratio may be ultimately translated
into a fixed percentage based on the capital
investment amount.
 Furthermore, according to Bank Negara Malaysia,
the ex-post performance profit amount based on the
profit -sharing ratio (PSR), which is mutually agreed
upon and contracted between the capital provider
and the manager may be translated into a fixed
percentage yield based on the capital investment
amount.

Profit-Sharing
 Bank Negara Malaysia also advocates that the agreed
profit-sharing ratio may vary to correspond with
different periods of investment or due to withdrawal
of capital provided that such conditions are agreed
upon at the conclusion of the Mudharabah contract.

Profit-Sharing
 In addition, Bank Negara Malaysia states that a party
may undertake (wa’d) to waive his right to the
profits (if any), to another contracting party on the
basis of Tanazul (waiver) at the inception of the
contract. The waiver would be effective on the date of
profit distribution.

Qu’ran and Sunnah
 The origins of Mudharabah can be found in the
Qu’ran and the Sunnah.
 “…others travelling through the land, seeking of
Allah’s bounty…”
 (Al-Muzammil:20)
 ii. “And when the Prayer is finished, then may ye
disperse through the land, and seek of the Bounty of
Allah; and celebrate the Praises of Allah often (and
without stint): that ye may prosper.” (Al-
Jumu`ah:10)

Qu’ran and Sunnah
 According to Bank Negara Malaysia, these verses do
not directly address the permissibility of
Mudharabah, but are interpreted to imply
Mudharabah by referring to those who travel for the
purpose of trading and seeking permissible income
including those who undertake labor with someone
else’s capital in exchange for part of the profit.

Qu’ran and Sunnah
 Sunnah:
 ‘The Narration of Ibnu Abbas
 Ibnu Abbas r.a. reported that: “When our leader Abbas
Ibn Abd al-Mutallib gives his property to someone for
Mudharabah, he stipulated conditions for his partner
not to bring the capital throughout the sea; and not to
bring with him the capital crossing a valley; and not to
buy animals with the capital; and if his partner violates
the conditions, he should guarantee the loss occurred.
These conditions have been brought to the attention of
Prophet Muhammad (SAW) and he approved them.”
(Mu’jam Al-Awsat; Al-Tabrani).

Qu’ran and Sunnah
 The Narration of Suhayb
 Suhayb r.a. reported that the Prophet Muhammad
(SAW) said: “Three matters that have the blessing (of
Allah): A deferred sale, Muqaradah (Mudharabah),
mixing the wheat with barley for domestic use and
not for sale.” (Sunan Ibn Majah).

The Tacit Approval of the Prophet Muhammad
(SAW)
 Mudharabah venture has been being practiced
before the Prophet’s (SAW) first revelation and he
did not raise or show any objections against the
practice. This is considered a tacit approval by the
Prophet Muhammad (SAW).

Ijma
 The Muslim jurists have reached Ijma’ among them
upon conducting Ijtihad on the permissibility of the
Mudharabah contract. It has also been established
that the companions of the Prophet Muhammad
(SAW) such as Umar, Uthman, Ali, Abdullah Ibn
Mas`ud, Abdullah Ibn Umar, and Ubaydullah Ibn
Umar have placed the property of orphans under
the Mudharabah contract with no objections from
other companions.’ (Bank Negara Malaysia)

Profits, Losses, and Fiduciary Duty
 In regards to profit- distribution, no profit can be
recognized or claimed unless the capital of the
Mudharabah is maintained intact.
 Whenever a Mudharabah operation incurs losses,
such losses stand to be compensated by the profits of
future operations of the Mudharabah.
 Therefore, the losses brought forward should be set
against the future profits.
 The distribution of profits depends on the final result
of the operations at the time of liquidation of the
Mudharabah contract.

 If losses are greater than profits at the time of
liquidation, the balance (net loss) must be deducted
from the capital.
 In this case, as she is a trustee, the Mudharib or
entrepreneur or manager is not liable for the
amount of this loss unless there is negligence,
violation of specified conditions, or misconduct on
her part. (The Law and Practice of Islamic Banking
and Finance by Dr. Nik Norzrul Thani; Mohamed
Ridza Mohamed Abdullah; and Megat Hizaini
Hassan. (2003))

 Hence, the loss is generally suffered wholly by the
investor(s) except in the case of negligence, violation
of specified terms and conditions, or misconduct on
the part of the Mudharib.
 In Islam as in Western finance, the Mudharib or
entrepreneur/ manager also owes a duty of care to
the investor similar to the trustee/fiduciary
relationship found in the common law.

 According to Bank Negara Malaysia, the manager is
in the position of trustee and thus should act
accordingly under a fiduciary duty to the investor to
perform in the best manner possible in order to
achieve the desired aim of the investor who has
invested capital in the venture.

 If there is a breach of any of the warranties given by
the entrepreneur, which were relied upon by the
investor, the investor may be entitled to a claim for
damages. (The Law and Practice of Islamic Banking
Hassan. (2003))

 In fact, according to Bank Negara Malaysia, it is
advisable for the investor to require the manager to
arrange for an independent third- party performance
guarantee, which would be executed as a separate
contract and be utilized to cover for any loss or
depletion of capital in the event of misconduct,
negligence, dishonesty, fraud or breach of the terms
of the contract by the manager.

Guarantees
 According to Bank Negara Malaysia, specific
conditions on third -party guarantees of the capital
are as follows:-
 i. The legal capacity and financial stability of such a
third party as a guarantor shall be independent from
the Mudharabah contract and partners;
 ii. The third- party guarantor shall not hold the
majority ownership of the guaranteed party; and
 iii. The guaranteed party shall not hold the majority
ownership of the third party guarantor.

Collateral
 Furthermore, according to Bank Negara Malaysia,
the investor may take collateral from the Mudharib,
provided that the collateral could only be liquidated
in the event of negligence or misconduct or violation
of term of contract by the Mudharib.

Liquidated Damages/Indemnification
 However, on the other hand, the entrepreneur may
mitigate her liability in the event of negligence or
misconduct by negotiating a cap on her liability akin
to a liquidated damages or insert an indemnification
clause. (The Law and Practice of Islamic Banking
Hassan. (2003))

Third Party Guarantees
 According to Bank Negara Malaysia, in addition, a
third- party may undertake to bear the loss of capital
due to misconduct or negligence on the part of the
manager.

Mudharabah
 If the total Mudharabah expenses are equal to the
total Mudharabah revenues, the investor will receive
her capital back without either profit or loss and the
Mudharib will not be entitled to a profit.
 If profit is realized, it must be distributed between
the parties as per the Mudharabah contract.

Mudharabah
 The Mudharib or manager/entrepreneur becomes
entitled to a share of profit at the point when the
Mudharabah has generated profit. (The Law and
Practice of Islamic Banking and Finance by Dr. Nik
Norzrul Thani; Mohamed Ridza Mohamed Abdullah;
and Megat Hizaini Hassan. (2003))

Mudharabah
 According to Bank Negara Malaysia, the profit may
be measured based on the operating performance of
the fund, gains realized from the disposal of
ownership rights to the fund, or dissolution of the
fund.
 Also, according to Bank Negara Malaysia, the profit
shall be recognized on a realization basis by selling
the assets of the Mudharabah partnership (al-tandid
al-haqiqi / al-fi’li) or on a constructive basis
(altandid al-hukmi) by constructive valuation of the
assets including accounts receivables.

Mudharabah
 Bank Negara Malaysia states that in the case of
constructive valuation, which is based on market
valuation or a third party verification, the constructive
profit reserve may be recorded. The reserve from the
constructive valuation may be distributed when gains are
realized at the time of disposal.
 According to Bank Negara Malaysia, unrealized gains
recognized during the financing shall be recognized as
appreciation of capital and included in the profit and loss
measurement/calculation for the Mudharabah contract.

Mudharabah
 Bank Negara Malaysia states that the partners may
mutually agree to set aside a portion of the profit to a
third- party who is not involved in the partnership.
Furthermore, Bank Negara Malaysia advocates that
in a multi-tiered Mudharabah contract, two or more
profit- sharing arrangements may be agreed between
investor and IFI followed by IFI and the manager.
 The profit generated by the manager shall be shared
with IFI according to the agreed PSR, which then is
redistributed between the IFI and the investor (rabb
al-mal) based on the earlier pre-agreed ratio.

Mudharabah
 The profit generated by the manager shall be shared
with IFI according to the agreed PSR, which then is
re-distributed between the IFI and the investor
(rabb al-mal) based on the earlier pre-agreed ratio.

The Mudharabah Contract
 In the Mudharabah contract, the parties may specify
the terms of trade, require the inspection of the
accounts, and determine the share in the profits
according to a mutually agreed pre-agreed ratio
between the investor(s) and the entrepreneur among
other things.

 The entrepreneur may conduct the business in her
sole-discretion if unrestricted Mudharabah or with
contractual restrictions if a restricted Mudharabah
and she is obligated to perform business functions,
which are ancillary to the enterprise without any
additional charge.

 However, if the entrepreneur performs additional
services outside the normal scope of manager for the
enterprise, she may be entitled to additional
compensation, which should be accounted for in the
Mudharabah contract. (The Law and Practice of
Islamic Banking and Finance by Dr. Nik Norzrul
Thani; Mohamed Ridza Mohamed Abdullah; and
Megat Hizaini Hassan. (2003))

 In a Mudharabah contract, it is not permitted to use
a debt owed by the entrepreneur or another party to
the investor as capital.
 According to Bank Negara Malaysia, debts such as
account receivables or loans due to a capital provider
do not qualify as capital of Mudharabah.

 For a Mudharabah contract to be valid and for the
Mudharib to be considered as having control over
the capital, the capital must be wholly or partially
put at the disposal of the entrepreneur or the
entrepreneur must have free access to the capital.

 As per other Islamic joint- venture arrangements,
the Mudharabah contract should stipulate the
voluntary winding-up process after the termination
of the contract and any issues related to insolvency
and bankruptcy. (The Law and Practice of Islamic
Banking and Finance by Dr. Nik Norzrul Thani;
Mohamed Ridza Mohamed Abdullah; and Megat
Hizaini Hassan. (2003))

 If the joint profits of the business are re-invested into
the business, the Mudharabah by default converts
into a Musharakah by virtue of the use of joint
funds, thereby converting the entire structure of the
transaction.

 The entrepreneur is then held liable for losses in
proportion to her share in the capital and the
investor is no longer solely liable for losses and both
parties become liable according to their contributed
share of capital. (The Law and Practice of Islamic
Banking and Finance by Dr. Nik Norzrul Thani;
Mohamed Ridza Mohamed Abdullah; and Megat
Hizaini Hassan. (2003))

 According to Bank Negara Malaysia, in general, any of
the contracting parties may terminate the Mudharabah
contract unilaterally.
 However, according to Bank Negara Malaysia, the
contract shall generally not be terminated unilaterally if
the manager has commenced the work or when both
parties have agreed not to terminate the contract during
a specified time.
 However, according to Bank Negara Malaysia, failure to
provide capital by the investor as per the agreed
contractual schedule shall constitute a breach of promise
according to the specified terms and conditions of the
contract.

 In this case, the manager then has the option to
terminate the Mudharabah agreement or both
parties may agree to revise the agreement based on
actual capital contribution.

 According to Bank Negara Malaysia, where the
agreement is terminated, the manager is obligated to
return the outstanding capital (if any) to the investor
and if the Mudharabah expenditure exceeds the
actual capital contribution of the investor, such
liability shall be borne by the investor up to the limit
of the total amount committed under the contract.

Withdrawing the Capital Before
Commencement of the Business Venture
 Upon agreement to provide capital or disbursement
of funds, the investor may withdraw the capital from
the venture prior to commencement of the business
venture subject to terms and conditions.
 However, the investor may not be entitled to the
profits on capital if the withdrawal is made before
the maturity of the investment period in a restricted
Mudharabah business venture. (Bank Negara
Malaysia)

Way Out of the Contract with Limited
Penalty/Liability and without Termination
 According to Bank Negara Malaysia, a Mudharabah
contract may incorporate Mubara’ah/Takharuj
clause whereby:-
 i. An existing capital provider agrees to forgo his
right over certain profit if he exits the venture prior
to its maturity date; and
 ii. A new capital provider agrees to assume liability of
the venture, which has commenced operation prior
to his participation.

 According to Bank Negara Malaysia, the
Mudharabah contract shall be binding in the
following events:
 i. When the manager has commenced the business.
In this event, the contract is binding up to the date of
actual or constructive completion.
 ii. When the duration or the termination date of the
contract has been determined. However, the contract
may be terminated earlier based on a mutual
agreement by the parties.

 In general and in sum, Bank Negara Malaysia states
that the Mudharabah contract may be terminated
due to the following circumstances:-
 i. Unilateral termination by any of the parties when the
Mudharabah does not constitute a binding Mudharabah.
 ii. Mutual agreement to terminate between the parties.
 iii. The contract expires as at the maturity date agreed by the
parties.
 iv. The impairment of the Mudharabah fund does not favor
the continuity of the venture.
 v. The demise of the manager or the liquidation of the
managing institution.

 The existence of one of these conditions would
consequently render a Mudarabah contract invalid.
 In this case, the Mudarib is deemed as the
worker/agent who deserves fair and reasonable
wages or fees only.

 Based on Information from (The Law and
Practice of Islamic Banking and Finance by Dr. Nik
Norzrul Thani; Mohamed Ridza Mohamed Abdullah;
and Megat Hizaini Hassan. (2003)), Bank Negara
Malaysia, and Wikipedia.

Thank You!
http://www.faaif.com
Franco-American Alliance for Islamic Finance

Mudharabah and Muqharadah in Islamic Finance

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