The mudarabah structure

A mudarabah is an arrangement where two or more parties collaborate for a common commercial purpose, while maintaining distinct roles. A unique element of a mudarabah structure is that the role of the provider of the funds (rabb-al-mal) is separate from that of the manager (mudarib). The rabb-al-mal is the provider of capital, while the mudarib, usually equipped with specialised know-how, manages the mudarabah funds with the intention of achieving a projected profit at the end of the mudarabah tenure. Once the investment objectives and parameters of the mudarabah have been laid out in the mudarabah contract, the typical mudarabah structure does not permit the rabb-al-mal to participate in the day-to-day administration of the mudarabah funds. This framework provides the mudarib with the ability to manage the funds without being hampered by the rabb-al-mal.

The mudarib is entitled to receive a fixed fee if the mudarabah investment yields a profit. The formula for the calculation of such fees is agreed at the outset. To incentivize the mudarib, it is common to allocate a bonus payment to the mudarib if the mudarabah investment yields profits beyond an agreed threshold. However, projection of the anticipated profits are not binding on the mudarib, as Shariah principles explicitly disallow any form of profit guarantee by the mudarib.

The mudarib is not liable for the loss of capital beyond the mudarib‘s capital contribution. Given that in a mudarabah arrangement, the rabb-al-mal provides an upward of 99% of the capital contribution to the mudarabah funds and that the mudarib‘s capital contribution is minimal (usually the fraction of one per cent), the rabb-al-mal bears almost the entire financial risk of a mudarabah investment, including the loss of capital. Barring negligence or misconduct, recourse to the mudarib is extremely limited even in a loss-making scenario.

Hence, the mudarabah structure is not suitable for all investment types, especially if the risk appetite calls for capital protection. The mudarabah structure is commonly used in Shariah bank deposit arrangements, where the bank is the mudarib and has the expertise and resources to invest the customer’s (rabb-al-mal‘s) deposits in ways not accessible to the average banking customer and in which capital losses can be controlled or mitigated by the bank. While mudarabah structures have commonly been employed in Shariah compliant funds in the past, the potential loss of capital coupled with the rabb-al-mal‘s inability to intervene in the day-to-day running of the mudarabah operations make it commercially unsuitable for many investment types which require more active involvement by the provider of the capital.

The musharakah structure

A musharakah is a form of Shariah-compliant partnership. A musharakah is akin to a conventional partnership under which two or more parties contribute towards the capital of a joint underlying commercial venture in the expectation of profits. It is a structure used for both financing and funds.

The musharakah partnership structure gives the partners more flexibility in administering the musharakah funds. A musharakah structure permits the musharakah partners to do one or more the following:

  1. participate in the operation of the musharakah partnership in a more representative and involved manner;
  2. agree how the profits are to be shared between the musharakah partners, which need not necessarily be in the same proportion to their capital contributions;
  3. delegate the management of the musharakah partnership to a specific partner or number of partners;
  4. elect a manager (not necessarily a partner) to administer the musharakah investment;
  5. agree on the procedures for partnership decisions; and
  6. by way of mutual agreement, vary the allocation of profit between the musharakah partners.

Should the partnership incur losses, such losses are borne in proportion to each partner’s capital contribution.

There are various types of musharakah structures and these are best selected based on the commercial intention sought. For example, the sharikat al aqd is a contractual partnership which is in line with the conventional understanding of partnerships or limited liability partnerships. A structure like the diminishing musharakah is often employed in real estate financing and is considered a type of financial product without the need to create a separate partnership entity.

Typical Shariah requirements in musharakah partnerships

A musharakah partnership entity can range from contractual partnerships to companies limited by shares. Depending on the structure being adopted, the musharakah must be in compliance with the applicable partnership or companies laws of the jurisdiction of establishment: this includes registration, reporting and taxation requirements.

While there are significant common attributes of musharakah and conventional partnership structures, a musharakah structure is subject to additional Shariah requirements and safeguards. Please note that Shariah requirements are not usually entrenched in statute, but must be observed in order for the musharakah to be certified as being Shariah-compliant. Hence it is important to engage both legal counsel and a Shariah advisor from the outset.

These Shariah requirements vary between jurisdictions, but commonly include the following:

  1. The musharakah capital must be derived from sources which are not forbidden under the Shariah (under Shariah principles, what is not expressly prohibited is assumed to be permitted). However, it is generally agreed that a partnership can be formed with a non-Islamic entity as long as the capital being provided to the musharakah partnership is not from sources which contravene Shariah principles.
  2. The musharakah activities must be in line with Shariah principles. Apart from its main commercial objectives, this requirement also includes its ancillary day-to-day activities. For example, it is preferred that the musharakah partnership maintains its bank account with an Islamic bank, and that it utilises takaful instead of conventional insurance where possible.
  3. A fatwa or a Shariah pronouncement on the Shariah compliance of the musharakah partnership, which is provided by Shariah advisors appointed by the partners, is required.
  4. Ongoing monitoring is required, including that of an annual Shariah audit to confirm that the operations of the musharakah continue to be in line with Shariah principles.
Conclusion

The above analysis has been simplified for the sake of brevity, to give a glimpse on the different types of popular Shariah-compliant partnership arrangements. Naturally there is a host of other legal and Shariah issues to consider for each structure. Shariah-compliant solutions are no longer confined to the banking and financing industry, and they continue to grow in popularity in other areas of investments as well.

 

For further information, please contact Azlin Ahmad, Senior Associate, Sophie Lenox, Senior Associate, or your usual Herbert Smith Freehills contact.

Disclaimer

Herbert Smith Freehills LLP is licensed to operate as a Qualified Foreign Law Firm in Malaysia. Where advice on Malaysian law is required, we will refer the matter to and work with licensed Malaysian law practices where necessary.

Peter Godwin
Peter Godwin
Managing Partner, Kuala Lumpur
+60 3-2777 5104
Azlin Ahmad
Azlin Ahmad
Senior Associate, Kuala Lumpur
+60 3-2777 5100
Sophie Lenox
Sophie Lenox
Senior Associate, Singapore
+65 6868 8036