MUDARABAH

DEFINITION

The Mudarabah contract is a form of partnership between one who contributes capital (Rabb-ul-maal)
and the other who contributes efforts in the form of managerial skills (Mudarib). Profit from the
outcome of the venture is shared between the capital provider and manager according to mutually
agreed profit sharing ratio whilst losses are borne solely by the capital provider, provided such loss is not
due to the Mudarib’s negligence or violation of specified conditions.

TYPES OF MUDARABAH

1. Al Mudarabah Al Muqayyadah (Restricted Mudarabah)

Rabb-ul-Maal may specify a particular business or a particular place for the mudarib, in which case he
shall invest the money in that particular business or place. This is called Al Mudarabah Al Muqayyadah
(restricted Mudarabah).

2. Al Mudarabah Al Mutlaqah (Unrestricted Mudarabah)

Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit, this is called
Al Mudarabah Al Mutlaqah (unrestricted Mudarabah)

However, he is not authorized to:

a) keep another Mudarib or a partner

b) mix his own investment in that particular Mudarabah without the consent of Rabb-ul Maal.

NATURE OF THE MUDARABAH CONTRACT

• Generally Mudarabah contract allows anyone of the contracting parties to terminate the contract
unilaterally.

• However, the contract shall 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.

MUDARABAH CAPITAL

• The capital shall be contributed by the capital provider and shall be managed by the manager to
generate income.

• The capital of Mudarabah may be in the form of monetary or non-monetary assets.

• Monetary assets of different currencies shall be valued according to an agreed currency at the time of
signing the Mudarabah contract.
Multi Currency Mudarabah Fund

The mutually agreed currency shall be applicable throughout the Mudarabah business venture.

For example, any capital investments after the initial investment shall be converted into the currency
mentioned in the prospectus.

• Capital in the form of non-monetary assets which may include intangible assets shall be valued based
on the valuation determined by a third party which may include authoritative bodies, experts, or as
agreed upon by the contracting parties at the time of conclusion of contract.

• Non-monetary Mudarabah capital contributed may be redeemed at its original value invested should
it be possible or otherwise at its residual market value upon termination or the expiry of the contract.

• Debts such as account receivables or loans due to acapital provider do not qualify as capital of
Mudarabah.

• The agreed capital shall be made available to the manager to commence the business activities.

• The capital may be fully or partially disbursed or made available to the manager at the time of the
contract or based on terms of the contract.

• Capital provider and manager may agree for a gradual withdrawal of Mudarabah capital by the capital
provider.

Where the agreement is terminated the manager has to return the outstanding capital (if any). If the
Mudarabah expenditure exceeds the actual capital contribution, such liability shall be borne by the
capital provider up to the limit of the total amount committed under the contract.

• Upon liquidation or maturity of the Mudarabah contract, all outstanding capital shall be returned to
the capital provider.

• Any outstanding capital including the share of profit shall be deemed as debt due to the capital
provider.

• The manager shall not guarantee the Mudarabah capital.

• The capital provider may require the manager to arrange for an independent third party performance
guarantee.

• The guarantee shall 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.

The Mudarabah third party guarantee may be in the form of performance guarantee of the Mudarabah
transactions or Mudarabah capital itself.

For example, capital employed to sell assets or render services may be accompanied by a third party
guarantee on payment for such sales and services.
MANAGEMENT OF THE MUDARABAH VENTURE

• Mudarabah capital will be used only for the Sharia compliant activities.

• Manger/Mudarib will have the exclusive rights to manage the contract. However, the capital provider
has the right to information regarding the conduct of the business and manger.

• Manager shall not be liable for any loss of capital unless it is due to any negligence, dishonesty,
misconduct or breach of contract Terms.

Breach of Terms

• According to the terms of Mudarabah venture, the manager should disclose all relevant information
that is significant for the capital provider to take a decision to participate in the venture.

• If the manager concealed important information which is known to the manager to be material to the
decision making process.

• Upon engagement, losses on investment occurred and investigation reveals that such unfavorable
information was not disclosed. This tantamount to the manager breaching the terms of engagement for
willful non-disclosure and hence shall bear such loss of capital.

Authority of Rabb-ul-Maal

1. Oversee the Mudarib’s activities and

2. Work with Mudarib if the Mudarib consents.

Different Capacities of the Mudarib

1. Ameen (Trustee): The money given by Rabb-ul-maal (investor) and the assets required therewith are
held by him as a trust.

2. Wakeel (Agent) : In purchasing goods for trade, he is an agent of Rabb-ul-maal.

3. Shareek (Partner): In case the enterprise earns a profit, he is a partner of Rabb-ul-maal who shares
the profit in agreed ratio.

4. Zamin (Liable): If the enterprise suffers a loss due to his negligence or misconduct, he is liable to
compensate the loss.

5. Ajeer (Employee): If the Mudarabah becomes Void due to any reason, the Mudarib is entitled to get a
fee for his services
PROFIT SHARING

• It is necessary for the validity of Mudarabah that the parties agree, right at the beginning, on a definite
proportion of the actual profit to which each one of them is entitled.

• They can share the profit at any ratio they agree upon.

• However in case the parties have entered into Mudarabah without mentioning the exact proportions
of the profit, it will be presumed that they will share the profit in equal ratios.

• Some incentives my be given to the Mudarib

• Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee
or remuneration for the work done by him for the Mudarabah.

• The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they
determine the share of any party at a specific rate tied up with the capital.

Distribution of Profit & Loss

• If the business has incurred loss in some transactions and has gained profit in some others, the profit
shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed
between the parties according to the agreed ratio.

Mudarabah Expenses:

• The Mudarib shares profit of the Mudarabah as per agreed rate with the investor but his expenses like
meals, clothing and medical are not borne by Mudarabah. However, if he is traveling on business and is
overstaying the night, then the above expenses shall be covered from capital.

Termination of Mudarabah

• Mudarabah can be terminated any time by either of the two parties by giving notice.

• If Mudarabah was for a particular term, it will terminate at the end of the term.

• Termination of Mudarabah means that the Mudarib cannot purchase new goods for the Mudarabah.
However, he may sell the existing goods that were purchased before termination.

Distribution at Termination

• If all assets of the Mudarabah are in cash form at the time of termination, and some profit has been
earned on the principal amount, it shall be distributed between the parties according to the agreed
ratio.
• If the assets of Mudarabah are not in cash form, they will be sold and liquidated so that the actual
profit may be determined.

• If there is a profit, it will be distributed between Mudarib and Rab-ul-Maal.

• If no profit is left, Mudarib will not get anything.

Collective Mudarabah

Collective Mudarabah” means a joint

Pool created by many investors and handled over to a single Mudarib who is normally a juristic
person.

Collective Mudarabah creates two different relationships:

Relationship between investors, which is Shirkah or Partnership.

Relationship of all the investors with Mudarib, which is Mudarabah.

PRACTICAL ASPECT

Mudarabah as Project Financing

In the case of project financing, the traditional method of Mudarabah can be easily adopted. If the
financier wants to finance the whole project, the form of Mudarabah can come into operation. In this
case, if the management is the sole responsibility of one party, while the investment comes from both, a
combination of musharakah and Mudarabah can be designed.

Investments - The Bank as the Rabb-ul-Maal

• Profit from the Mudaraba activity is shared between the Bank (as Rabb-ul-maal) and the Mudarib in a
pre-agreed ratio.

• The Bank will bear all the loss unless the Mudarib violates the agreement.

• The Bank will pay to the Mudarib, compensation (Mudarib fees) in return for management of its funds.

• The Mudarib is bound to return the capital to the Bank after deducting any losses or Mudarib fees at
the time winding up of the contract.
Process Flow Diagram

Activity:

1: Bank and Client discuss business plan; Bank provides funds to client towards capital investment;

2. Client sets up the business and manages its operations;

3. Business generates positive or negative profits;

4. Profits if positive are shared between Client and Bank as per a pre-agreed ratio;

5. Profits if negative are absorbed by Bank; effectively bringing down the value of the asset created with
its investments

RISKS IN MUDARABAH

To understand the risks Mudarabah based Financing , we look at:

• The risks at various stages of the transaction: beginning, during, and at the conclusion.

• Classify Credit Risk (CR) and Market Risk (MR) according to:

possession time (spot/future)

liquidity of asset/wealth (asset/cash).

MUDARABAH RISK & HEDGING

RISK CATEGORY HEDGING

Capital Risk Credit risk This can be mitigated by conducting proper
feasibility before entry
Sharia non compliance risk Operational risk Due attention to be given to all Sharia Aspects
during the stage of both pre and post approval
Liquidity risk Liquidity risk Only Long Terms Deposits Should be invested
Cancellation risk Market risk Collateral Should be obtained
Legal risk Operational risk To Secure legal position, the bank shall ensure
that all process is properly documented and it is
legally enforceable
Default risk Credit risk A Security in form of guarantee can be
obtained
Revenue risk Market risk Conducting proper feasibility Study of the
business before investment in project
DIFFERENCE BETWEEN MUSHARAKAH AND MUDARABAH

MUSHARAKAH
All partners invest.
All partners participate in the
management of the business and can
work for it.
All partners share the loss to the
extent of the ratio of their investment.
The liability of the partners is
normally unlimited. If the liabilities of
business exceed its assets and the
business goes in liquidation, all the
exceeding liabilities shall be borne pro
rata by all partners. But if the partners
agree that no partner shall incur any
debt during the course of business,
then the exceeding liabilities shall be
borne by that partner alone who has
incurred a debt on the business in
violation of the aforesaid condition.
As soon as the partners mix up their
capital in a joint pool, all the assets
become jointly owned by all of them
according to the proportion of their
respective investment. All partners
benefit from the appreciation in the
value of the assets even if profit has
not accrued through sales.
MUDARABAH
Only Rab-ul-Maal invests.
Rab-ul-maal has no right to participate
in the management which is carried
out by the Mudarib only.
Only Rab-ul-maal suffers loss because
the Mudarib does not invest anything.
However this is subject to a condition
that the Mudarib has worked with due
diligence.
The liability of Rab-ul-maal is limited
to his investment unless he has
permitted the Mudarib to incur debts
on his behalf.
The goods purchased by the Mudarib
are solely owned by Rab-ul-maal and
the Mudarib can earn his share in the
profit only in case he sells the goods
profitably.

Conclusion

• Risks in Islamic financial instruments are complex and change and evolve during the transaction

• It is important to know the underlying features of the contracts and risks arising in Mudarabah
Financing

• Risk management would require knowledge of Islamic contracts and also the appropriate skills to
mitigate risks arising in them