The Basic Rules of Musharakah

1. Musharakah or Shirkat-ul-amwal is a relationship established by the parties through a mutual contract. Therefore, it goes without saying that all the necessary ingredients of a valid contract must be present here also. For example, the parties should be capable of entering into a contract; the contract must take place with free consent of the parties without any duress, fraud or misrepresentation, etc., etc. But there are certain ingredients which are peculiar to the contract of "musharakah". They are summarized here: Distribution of Profit 2. The proportion of profit to be distributed between the partners must be agreed upon at the time of effecting the contract. If no such proportion has been determined, the contract is not valid in Shari'ah. 3. The ratio of profit for each partner must be determined in proportion to the actual profit accrued to the business, and not in proportion to the capital invested by him. It is not allowed to fix a lump sum amount for any one of the partners, or any rate of profit tied up with his investment. Therefore, if A and B enter into a partnership and it is agreed between them that A shall be given Rs 10,000/- per month as his share in the profit, and the rest will go to B, the partnership is invalid. Similarly, if it is agreed between them that A will get 15% of his investment, the contract is not valid. The correct basis for distribution would be an agreed percentage of the actual profit accrued to the business. If a lump sum amount or a certain percentage of the investment has been agreed for any one of the partners, it must be expressly mentioned in the agreement that it will be subject to the final settlement at the end of the term, meaning thereby that any amount so drawn by any partner shall be treated as 'on account payment' and will be adjusted to the actual profit he may deserve at the end of the term. But if no profit is actually earned or is less than anticipated, the amount drawn by the partner shall have to be returned. 4. Is it necessary that the ratio of profit of each partner conforms to the ratio of capital invested by him? There is a difference of opinion among the Muslim jurists about this question. In the view of Imam Malik and Imam Shafi'i, it is necessary for the validity of musharakah that each partner gets the profit exactly in the proportion of his investment. Therefore, if A has invested 40% of the total capital, he must get 40% of the profit. Any agreement to the contrary which makes him entitled to get more or less than 40% will render the musharakah invalid in Shari'ah. On the contrary, the view of Imam Ahmad is that the ratio of profit may differ from the ratio of investment if it is agreed between the partners with their free consent. Therefore, it is permissible that a partner with 40% of investment gets 60% or 70% of the profit, while the other partner with 60% of investment gets only 40% or 30%.' The third view is presented by Imam Abu Hanifah which can be taken as a via media between the two opinions mentioned above. He says that the ratio of profit may differ from the ratio of investment in normal conditions. However, if a partner has put an express condition in the agreement that he will never work for the musharakah and will remain a sleeping partner throughout the term of musharakah, then his share of profit cannot be more than the ratio of his investment. 2 Sharing of Loss But in the case of loss, all the Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of his investment. Therefore, if a partner has invested 40% of the capital, he must suffer 40% of the loss, not more, not less, and any condition to the contrary shall render the contract invalid. There is a complete consensus of jurists on this principle. 3 Therefore, according to Imam Shafi'i, the ratio of the share of a partner in profit and loss both must conform to the ratio of his investment. But according to Imam Abu Hanifah and Imam Ahmad, the ratio of the profit may differ from the ratio of investment according to the agreement of the partners, but the loss must be divided between them exactly in accordance with the ratio of capital invested by each one of them. It is this principle that has been mentioned in the famous maxim: Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment.

The Concept of Musharakah

The Concept of Musharakah Musharakah' is a term frequently referred to in the context of Islamic modes of financing. The connotation of this term is a little limited than the term "shirkah" more commonly used in the Islamic jurisprudence. For the purpose of clarity in the basic concepts, it will be pertinent at the outset to explain the meaning of each term, as distinguished from the other. "Shirkah" means "sharing" and in the terminology of Islamic Fiqh, it has been divided into two kinds: (1) Shirkat-ul-Milk: It means joint ownership of two or more persons in a particular property. This kind of "shirkah" may come into existence in two different ways: Sometimes it comes into operation at the option of the parties. For example, if two or more persons purchase an equipment, it will be owned jointly by both of them and the relationship between them with regard to that property is called "shirkat-ul-milk." Here this relationship has come into existence at their own option, as they themselves elected to purchase the equipment jointly. But there are cases where this kind of "shirkah" comes to operate automatically without any action taken by the parties. For example, after the death of a person, all his heirs inherit his property which comes into their joint ownership as an automatic consequence of the death of that person. (2) Shirkat-ul-'Aqd: This is the second type of Shirkah which means "a partnership effected by a mutual contract". For the purpose of brevity it may also be translated as "joint commercial enterprise." Shirkat-ul-'aqd is further divided into three kinds: (i) Shirkat-ul-Amwal where all the partners invest some capital into a commercial enterprise. (ii) Shirkat-ul-A'mal where all the partners jointly undertake to render some services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. For example, if two persons agree to undertake tailoring services for their customers on the condition that the wages so earned will go to a joint pool which shall be distributed between them irrespective of the size of work each partner has actually done, this partnership will be a shirkat-ul-a'mal which is also called Shirkat-ut-taqabbul or Shirkat-us-sana'i' or Shirkat-ul-abdan. (iii) The third kind of Shirkat-ul-'aqd is Shirkat-ul-wujooh. Here the partners have no investment at all. All they do is that they purchase the commodities on a deferred price and sell them at spot. The profit so earned is distributed between them at an agreed ratio. All these modes of "Sharing" or partnership are termed as "shirkah" in the terminology of Islamic Fiqh, while the term "musharakah" is not found in the books of Fiqh. This term (i.e. musharakah) has been introduced recently by those who have written on the subject of Islamic modes of financing and it is normally restricted to a particular type of "Shirkah", that is, the Shirkat-ul-amwal, where two or more persons invest some of their capital in a joint commercial venture. However, sometimes it includes Shirkat-ul-a'mal also where partnership takes place in the business of services. It is evident from this discussion that the term "Shirkah" has a much wider sense than the term "musharakah" as is being used today. The latter is limited to the "Shirkat-ul-amwal" only, while the former includes all types of joint ownership and those of partnership. Table 1 will show the different kinds of "Shirkah" and the two kinds which are called "musharakah" in the modern terminology. Since "musharakah" is more relevant for the purpose of our discussion, and it is almost analogous to "Shirkat-ul-amwal", we shall now dwell upon it, explaining at the first instance, the traditional concept of this type of Shirkah, then giving a brief account of its application to the concept of financing in the modern context.

MUSHARAKAH

Musharakah' is a word of Arabic origin which literally means sharing. In the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. It is an ideal alternative for the interest-based financing with far reaching effects on both production and distribution. In the modern capitalist economy, interest is the sole instrument indiscriminately used in financing of every type. Since Islam has prohibited interest, this instrument cannot be used for providing funds of any kind. Therefore, musharakah can play a vital role in an economy based on Islamic principles. '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 musharakah does not envisage a fixed rate of return. Rather, the return in musharakah is based on the actual profit earned by the joint venture. The financier in an interest-bearing loan cannot suffer loss while the financier in musharakah can suffer loss, if the joint venture fails to produce fruits. Islam has termed interest as an unjust instrument of financing because it results in injustice either to the creditor or to the debtor. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a fixed rate of return; and if the debtor earns a very high rate of profit, it is injustice to the creditor to give him only a small proportion of the profit leaving the rest for the debtor. In the modern economic system, it is the banks which advance depositors' money as loans to industrialists and traders. If industrialists having only ten million of their own, acquire 90 million from the banks and embark on a huge profitable project, it means that 90% of the project has been created by the money of the depositors while only 10% has been created by their own capital. If this huge project brings enormous profits, only a small proportion i.e. 14 or 15% will go to the depositors through the bank, while all the rest will be gained by the industrialists whose real contribution to the project is not more than 10%. Even this small proportion of 14 or 15% is taken back by the industrialists, because this proportion is included by them in the cost of their production. The net result is that all the profit of the enterprise is earned by the persons whose own capital does not exceed 10% of the total investment, while the people owning 90% of the investment get no more than the fixed rate of interest which is often repaid by them through the increased prices of the products. On the contrary, if in an extreme situation, the industrialists go insolvent, their own loss is no more than 10%, while the rest of 90% is totally borne by the bank, and in some cases, by the depositors. In this way, the rate of interest is the main cause for imbalances in the system of distribution, which has a constant tendency in favor of the rich and against the interests of the poor. Conversely, Islam has a clear cut principle for the financier. According to Islamic principles, a financier must determine whether he is advancing a loan to assist the debtor on humanitarian grounds or he desires to share his profits. If he wants to assist the debtor, he should resist from claiming any excess on the principal of his loan, because his aim is to assist him. However, if he wants to have a share in the profits of his debtor, it is necessary that he should also share him in his losses. Thus the returns of the financier in musharakah have been tied up with the actual profits accrued through the enterprise. The greater the profits of the enterprise, the higher the rate of return to the financier. If the enterprise earns enormous profits, all of it cannot be secured by the industrialist exclusively, but they will be shared by the common people as depositors in the bank. In this way, musharakah has a tendency to favor the common people rather than the rich only. This is the basic philosophy which explains why Islam has suggested musharakah as an alternative to the interest based financing. No doubt, musharakah embodies a number of practical problems in its full implementation as a universal mode of financing. It is sometimes presumed that musharakah is an old instrument which cannot keep pace with the ever-advancing need for speedy transactions. However, this presumption is due to the lack of proper knowledge concerning the principles of musharakah. In fact, Islam has not prescribed a specific form or procedure for musharakah. Rather, it has set some broad principles which can accommodate numerous forms and procedures. A new form or procedure in musharakah cannot be rejected merely because it has no precedent in the past. In fact, every new form can be acceptable to the Shari'ah in so far as it does not violate any basic principle laid down by the Holy Qur'an, the Sunnah or the consensus of the Muslim jurists. Therefore, it is not necessary that musharakah be implemented only in its traditional old form. The present chapter contains a discussion of the basic principles of musharakah and the way in which it can be implemented in the context of modern business and trade. This discussion is aimed at introducing musharakah as a modern mode of financing without violating its basic principles in any way. Musharakah has been introduced with reference to the books of Islamic jurisprudence, and basic problems which may be faced in implementing it in a modern situation. It is hoped that this brief discussion will open new horizons for the thinking of Muslim jurists and economists and may help implementing a true Islamic economy.

Present Practices of Islamic Banks

It is sometimes argued against the Islamic financial system that the Islamic banks and financial institutions, working since last three decades, did not bring any visible change in the economic set-up, not even in the field of financing. This indicates that the boastful claims of creating 'distributive justice' under the umbrella of Islamic banking are exaggerated. This criticism is not realistic, because it does not take into account the fact that, in proportion to the conventional banking, the Islamic banks and financial institutions are no more than a small drop in an ocean, and therefore, they cannot be supposed to revolutionise the economy in a short period. Secondly, these institutions are passing through their age of infancy. They have to work under a large number of constraints, therefore, some of them have not been able to comply with all the requirements of Shari'ah in all their transactions, therefore, each and every transaction carried out by them cannot be attributed to Shari'ah. Thirdly, the Islamic banks and financial institutions are not normally supported by the governments, legal and taxation system and the central banks of their respective countries. Under these circumstances, they have been given certain concessions, on the grounds of need or necessity, which are not based on the original and ideal principles of Shari'ah. Islam, being a practical way of life, has two sets of rules; one is based on the ideal objectives of Shari'ah which is applicable in normal conditions, and the second is based on some relaxations given in abnormal situations. The real Islamic order is based on the former set of principles, while the latter is a concession which can be availed at times of need, but it does not reflect the true picture of the real Islamic order. Living under constraints, the Islamic banks are mostly relying on the second set of rules, therefore, their activities could not bring a visible change even in the limited circle of their operations. However, if the whole financing system is based on the ideal Islamic principles, it will certainly bring a discernible impact on the economy. It is to be noted that the present book, being a guide book to the present day financial institutions, has dealt with both types of the Islamic rules. At the outset, the ideal Islamic principles of finance have been elaborated and later on we have discussed the best possible concessions that may be availed of in the transitory period where the Islamic institutions are working under pressure of the existing legal and fiscal system. Shari'ah has specific principles about such concessions as well, and their basic purpose is to avoid clear prohibitions by adopting a less preferable line of action. This may not serve the basic purpose of establishing a true Islamic order, yet it may help one refrain from a glaring sin and save him from the evil fate of disobedience, which, in itself, is a cherished goal of a Muslim, though at individual level. Moreover, this may help the society to advance gradually to the ideal target of establishing a total Islamic order

Capital and Entrepreneur

According to the capitalist theory, capital and entrepreneur are two separate factors of production. The former gets interest while the latter is entitled to profit. Interest is a fixed return for providing capital, while profit can be earned only when there is a surplus after distributing the fixed return to land, labour and capital (in the form of rent, wages and interest) . Islam, on the contrary, does not recognize capital and entrepreneur as two separate factors of production. Every person who contributes capital (in the form of money) to a commercial enterprise assumes the risk of loss and therefore is entitled to a proportionate share in the actual profit. In this manner 'capital' has an intrinsic element of 'entrepreneurship', so far as the risk of the business is concerned. Therefore, instead of a fixed return as interest, it derives profit. The more the profit of the business, the higher the return on capital. In this way the profits generated by the commercial activities in the society are equitably distributed to all those persons who have contributed capital to the enterprise, however little it may be. Since in the context of the modern practice, it is the banks and financial institutions who provide capital to the commercial activities, out of the deposits made with them, the flow of the actual profits earned by the society may be directed towards the depositors in equitable proportions which may distribute wealth in a wider circle and may hamper concentration of wealth in the hands of the few.

Five diference

1. In conventional financing, the financier gives money to his client as an interest-bearing loan, after which he has no concern as to how the money is used by the client. In the case of murabahah, on the contrary, no money is advanced by the financier. Instead, the financier himself purchases the commodity required by the client. Since this transaction cannot be completed unless the client assures the financier that he wishes to purchase a commodity, therefore, murabahah is not possible at all, unless the financier creates inventory. In this manner, financing is always backed by assets. 2. In the conventional financing system, loans may be advanced for any profitable purpose. A gambling casino can borrow money from a bank to develop its gambling business. A pornographic magazine or a company making nude films are as good customers of a conventional bank as a house-builder. Thus, conventional financing is not bound by any divine or religious restrictions. But the Islamic banks and financial institutions cannot remain indifferent about the nature of the activity for which the facility is required. They cannot effect murabahah for any purpose which is either prohibited in Shari'ah or is harmful to the moral health of the society. 3. It is one of the basic requirements for the validity of murabahah that the commodity is purchased by the financier which means that he assumes the risk of the commodity before selling it to the customer. The profit claimed by the financier is the reward of the risk he assumes. No such risk is assumed in an interest-based loan. 4. In an interest bearing loan, the amount to be repaid by the borrower keeps on increasing with the passage of time. In murabahah, on the other hand, a selling price once agreed becomes and remains fixed. As a result, even if the purchaser (client of the Bank) does not pay on time, the seller (Bank) cannot ask for a higher price, due to delay in settlement of dues. This is because in Shari'ah, there is no concept of time due of money. 5. In leasing too, financing is offered through providing an asset having usufruct. The risk of the leased property is assumed by the lessor / financier throughout the lease period in the sense that if the leased asset is totally destroyed without any misuse or negligence on the part of the lessee, it is the financier/lessor who will suffer the loss. It is evident from the above discussion that every financing in an Islamic system creates real assets. This is true even in the case of murabahah and leasing, despite the fact that they are not believed to be ideal modes of financing and are often criticized for their being close to the interest-based financing in their net results. It is known, on the other hand, that interest-based financing does not necessarily create real assets, therefore, the supply of money through the loans advanced by the financial institutions does not normally match with the real goods and services produced in the society, because the loans create artificial money through which the amount of money supply is increased, and sometimes multiplied without creating real assets in the same quantity. This gap between the supply of money and production of real assets creates or fuels inflation. Since financing in an Islamic system is backed by assets, it is always matched with corresponding goods and services.

Asset-backed Financing

One of the most important characteristics of Islamic financing is that it is an asset-backed financing. The conventional / capitalist concept of financing is that the banks and financial institutions deal in money and monetary papers only. That is why they are forbidden, in most countries, from trading in goods and making inventories. Islam, on the other hand, does not recognize money as a subject-matter of trade, except in some special cases. Money has no intrinsic utility; it is only a medium of exchange; Each unit of money is 100% equal to another unit of the same denomination, therefore, there is no room for making profit through the exchange of these units inter se. Profit is generated when something having intrinsic utility is sold for money or when different currencies are exchanged, one for another. The profit earned through dealing in money (of the same currency) or the papers representing them is interest, hence prohibited. Therefore, unlike conventional financial institutions, financing in Islam is always based on illiquid assets which creates real assets and inventories. The real and ideal instruments of financing in Shari'ah are musharakah and mudarabah. When a financier contributes money on the basis of these two instruments it is bound to be converted into the assets having intrinsic utility. Profits are generated through the sale of these real assets. Financing on the basis of salam and istisnd also creates real assets. The financier in the case of salam receives real goods and can make profit by selling them in the market. In the case of istisna, financing is effected through manufacturing some real assets, as a reward of which the financier earns profit. Financial leases and murabahah, as will be seen later in the relevant chapters, are not originally modes of financing. But, in order to meet some needs they have been reshaped in a manner that they can be used as modes of financing, subject to certain conditions, in those sectors where musharakah, mudarabah, salam or istisna' are not workable for some reasons. The instruments of leasing and murabahah are sometimes criticized on the ground that their net result is often the same as the net result of an interest- based borrowing. This criticism is justified to some extent, and that is why the Shari'ah supervisory Boards are unanimous on the point that they are not ideal modes of financing and they should be used only in cases of need with full observation of the conditions prescribed by Shari'ah. Despite all this, the instruments of leasing and murabahah, too, are fully backed by assets and financing through these instruments is clearly distinguishable from the interest-based financing on the following grounds.

The Basic Difference between Capitalist and Islamic

Economy Islam does not deny the market forces and market economy. Even the profit motive is acceptable to a reasonable extent. Private ownership is not totally negated. Yet, the basic difference between capitalist and Islamic economy is that in secular capitalism, the profit motive or private ownership are given unbridled power to make economic decisions. Their liberty is not controlled by any divine injunctions. If there are some restrictions, they are imposed by human beings and are always subject to change through democratic legislation, which accepts no authority of any super- human power. This attitude has allowed a number of practices which cause imbalances in the society. Interest, gambling, speculative transactions tend to concentrate wealth in the hands of the few. Unhealthy human instincts are exploited to make money through immoral and injurious products. Unbridled profit making creates monopolies which paralyse the market forces or, at least, hinder their natural operation. Thus the capitalist economy which claims to be based on market forces, practically stops the natural process of supply and demand, because these forces can properly work only in an atmosphere of free competition, and not in monopolies. It is sometimes appreciated in a secular capitalist economy that a certain economic activity is not in the interest of the society, yet, it is allowed to be continued because it goes against the interest of some influential circles who dominate the legislature on the strength of their majority. Since every authority beyond the democratic rule is totally denied and 'trust in God' (which is affirmed at the face of every U.S. dollar) has been practically expelled from the socio-economic domain, no divine guidance is recognized to control the economic activities. The evils emanating from this attitude can never be curbed unless humanity submits to the divine authority and obeys its commands by accepting them as absolute truth and super-human injunctions which should be followed in any case and at any price. This is exactly what Islam does. After recognizing private ownership, profit motive and market forces, Islam has put certain divine restrictions on the economic activities. These restrictions being imposed by Allah Almighty, Whose knowledge has no limits, cannot be removed by any human authority. The prohibition of rib a (usury or interest), gambling, hoarding, dealing in unlawful goods or services, short sales and speculative transactions are some examples of these divine restrictions. All these prohibitions combined together have a cumulative effect of maintaining balance, distributive justice and equality of opportunities.

AN INTRODUCTION TO ISLAMIC FINANCE

The fact behind this scheme is that human reason, despite its vast capabilities, cannot claim to have unlimited power to reach the truth. After all, it has some limits beyond which it either cannot properly work or may fall prey to errors. There are numerous domains of human life where 'reason' is often confused with 'desires' and where unhealthy instincts, under the disguise of rational arguments, misguide humanity to wrong and destructive decisions. All those theories of the past which are held today to be fallacious, claimed, in their respective times, to be 'rational' but it was after centuries that their fallacy was discovered and their absurdity was universally proved. It is thus evident that the sphere of work delegated to human 'reason' by its Creator is not unlimited. There are areas in which human reason cannot give proper guidance or, at least, is susceptible to errors. It is these areas in which Allah Almighty, the Creator of the universe, has provided guidance through His revelations sent down to His prophets. On the basis of this approach it is the firm belief of every Muslim that the commands given by the divine revelations through the last Messenger s|§ are to be followed in letter and spirit and cannot be violated or ignored on the basis of one's rational arguments or his inner desires. Therefore, all the human activities must always be subject to these commands and must work within the limits prescribed by them. Unlike other religions, Islam is not confined to some moral teachings, some rituals or some modes of worship. It rather contains guidance in every sphere of life including socio-economic fields. The obedience from servants of Allah is required not only in worship, but also in their economic activities, even though it is at the price of some apparent benefits, because these apparent benefits may go against the collective interest of the society.

Some Preliminary Points

Before the details of Islamic modes of financing are discussed, it seems necessary to explain some points concerning the basic principles that govern the whole economic set-up in an Islamic way of life. Belief in Divine Guidance The foremost belief around which all the Islamic concepts revolve is that the whole universe is created and controlled by One, the only One God. He has created man and appointed him as His vicegerent on the earth to fulfil certain objectives through obeying His commands. These commands are not restricted to some modes of worship or so-called religious rituals. They, on the contrary, cover a substantial area of almost every aspect of our life. These commands are neither so exhaustive that straiten the human activities within a narrow circle, leaving no role for human intellect to play, nor are they so little or ambiguous that they leave every sphere of life at the mercy of human perception and desire. Far from these two extremes, Islam has a balanced approach to govern the human life. On the one hand, it has left a very wide area of human activities to man's own rational judgment where he can take decisions on the basis of his reason, assessment of facts and expedience. On the other hand, Islam has subjected human activities to a set of principles which have eternal application and cannot be violated on superficial grounds of expediency based on human assessment.