In the name of Allah, the Compassionate, the Merciful

CHAPTER - 5

MUSHARAKAH AS AN INSTRUMENT OF FINANCING

CHAPTER- 5

Musharakah as an Instrument of Financing

The preceding chapters have explained the traditional concept of

Musharakah and the basic principles of Shari 'ah governing it. It is pertinent

how to discuss the way this instrument can be utilised for the purpose of

financing in the context of modem trade and industry. The books of Islamic

fiqh generally presume that Musharakah contract is “meant for initiating a

joint venture whereby all are partners until the end of the business whereby

all the assets are liquidated”1. Here we will briefly summarise the principles

on which the concept of Musharakah is based. As far as these principles are

fully compiled with, the details of their application may vary from time to

time and hence need to be looked into before entering into the details of its

application. These principles are:

i) Financing through Musharakah and Mudarabah never means

to advance money. It means to participate in the business and

share the assets of the business to the extent of the ratio of

financing.2

ii) An investor/financer must share the loss incurred by the

business to the extent of his financing.

iii) The partners are at liberty to determine with mutual consent,

the ratio of profit allocated for each one of them, which may

differ from the ratio of investment. However, the partner, who

has expressly excluded himself from the responsibility of work

1 M. T. Usmani, “The concept of Musharakah and its Application as an Islamic method of finance”, Arab Law Quartely, 1999, p. 217.

2 Idem.

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for the business cannot claim more than the ratio of his

investment.

iv) The loss suffered by each partner must be exactly in the

proportion on his investment1.

Keeping these broad principles in mind, let us now see how

Musharakah can be used in evolving a new system, that conforms to the

requirement of Shari‘ah and also fulfils the needs of trade and business.

5.1 Musharakah in Micro-Finance

Musharakah is observed to be potentially quite promising in the field

of microfinance or financing of small and medium enterprise1. It can be

developed as a micro-finance or scheme where Islamic bank will enter into

a partnership with micro-entrepreneurs. If there is profit, it will be shared

based on pre-agreed ratio and if there is loss, it will be then shared

according to capital contribution ratio. The most suitable technique of

Musharakah for micro-finance could be the concept diminishing

partnerships or Musharakah Mutanaqisah.

1 M. T. Usmani, op. cit., p 217.1 M. Obaidullah, Islamic Financial Services, p. 65.

90807060

1 50 o© 40Q.

30 20

10

0Islamic Bank Micro-entrepreneurship

Fig. 4: Diminishing Musharakah in micro financing

The above diagram shows that in the case of Musharakah

Mutanaqisah, capital is not permanent and every repayment of capital by

the entrepreneur will diminish the total capital provider. This will increase>

the total capital ratio for the entrepreneur until the entrepreneur becomes the

sole proprietor for the business. The repayment period is dependent upon

the pre-agreed period. This scheme is more suitable for the existing

business that need new or additional capital for expansion1.

5.2 Securitization of large projects based on Musharakah Sukuks

The traditional business model of financing institutions revolved

around originating an assets and holding it until maturity. But now, financial

1 Abdul Rahman, “Islamic Microfinance: A Mixing Component is Islamic Banking,” Kyoto Bulletin of Islamic Area of studies 1-2 (2007),pp 38-53.

institutions increasingly resort by securitization, which is a process of

pooling/repackaging the non-marketable and illiquid assets into tradable

certificates of investment. Securitization transforms the originator’s role

from being an accumulator to that of a distributor. In Islamic finance it has

become a stimulating factor, which refers to the process in which ownership

of the underlying assets is transferred to a large number of investors in the

form of instruments , presently termed Sukuk (the plural of the world Sak,

or Sanadat, meaning certificate of investment or simple certificates)1.

Musharakah is a mode which can serve as a basis for securitization

easily, especially in the case of big projects where huge amounts are

required. Every subscriber is given a Musharakah certificate, which

represents his proportionate ownership in the assets of the project. These

are certificates of equal value issued for mobilizing funds to be used on the

basis of partnership, so that their holders become owners of the relevant

project or the asset as per their respective shares that are the part for their

asset portfolios. Musharakah Sukuk can be issued as redeemable certificates

by or to the corporate sector or to individuals for their rehabilitations/

employment for the purchase of automobiles for their commercial use or for

the establishment of high-standard clinics, hospitals, factories, trading

centres, endowments etc .

Musharakah redeemable Sukuk are almost similar to Mudarabah

Sukuk. Therefore, basic Shari‘ah rules relating to Mudarabah also apply to

Musharakah certificates. The only major difference is that the intermediary

partly will be a partner of the group of subscribers represented by a body of

1 Ayub, op.cit., p. 392.2 Ibid., p. 399.

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Musharakah certificates holders, in a manner similar to a joint stock

company1.

After the project is started, these Musharakah certificates can be

treated as negotiable instruments certificates based on Musharakah/

Mudarabah can be bought and sold in the secondary market subject to the

condition that the portfolio of Mushrarahah comprises non-liquid assets

valuing more than 50 per cent. Profit earned by the Musharakah is shared

according to an agreed ratio. Loss is shared on a pro rata basis. Whenever

there is a combination of liquid and non liquid assets, it can be sold and

purchased for an amount greater than the amount of liquid assets in the

combination or in the pool.

Investment Sukuk can be issued on a Musharakah basis to mobilise

short-term deposits for the development of long term projects or for

investment in general financial activities or specific projects. The proceeds

of the Sukuk can be used to buy and lease certain equipment or for the

construction of projects and factories, the expansion of projects or for

working capital finance. The Musharakah structure is considered more>

equitable and also safer for the investor than the Mudarabah structure as it

involves both profit-and-loss sharing between the fund manger and the

Sukuk holders, not only profit-sharing . In addition, Musharakah Sukuk

holders will have added comfort and security from the cushion provided by

the manager’s participation in the Musharakah capital2.

In Sudan, a number of assets of the ministry of finance and the Bank

of Sudan, Bank of Khartoum, Nilain Bank and other public entities have

been identified for the purpose of securitization on a Musharakah basis.

1 Sami Hassan Homoud, “Islamic Banking”,Arabian Information London, 1985, p. 1998.2 Ayub, op. tit., p. 400.

Instruments known as Central Bank Musharakah Certificates (CMCs) and

Government Musharakah Certificates (GMCs) have been issued since 1998

for investors and are used in place of treasury bills and other interest

bearing securities for open market operations and monetary management by

the central bank. The CMCs are sold (or brought) by the central bank

through auctions and can be traded in the secondary inter bank market1.

A huge amount of funds is needed for infrastructure projects in the

Muslim world and if managed properly and carefully without comprising

on the Shari‘ah principles, this cannot only be arranged through the vehicle

of Musharakah Sukuk , but also it could be a stepping stone for broad

based development of these economies. This requires developing Islamic

countries to increasingly use the vehicle of Sukuk for financing their

infrastructure and other development projects.

5.3 Project Financing

This mode of financing serves the need of clients whose available

funds are not sufficient to defray the cost of awarded projects. Under this

scheme, both the Islamic bank and the client share the capital formation of

the venture according to the prearranged ratio. Both partners to the venture

also agree upon the ratio of profit sharing. This financing arrangement is

applicable to projects like real estate and housing development,

construction of public roads, ports, markets, buildings, corporate plants,

warehouses and other infrastructural concerns (the ratio of profit sharing in

1 Muhammad Ayub, Islamic Banking and Finance: Theory and Practice, State Bank of Pakistan, Karachi, December 2002; pp. 128-131; A. Ahmed Eltejani, Comments on paper by Adam, Nathif Jan on Sukuk. Papers presented at 6th International Conference in Islamic Economics and Finance, Jakarta, Indonesia, 21-24* Nov, pp 411-413.

this case is usually titled in favour of the active or managing partner who is

usually the client)1.

Fig. 5 : Musharakah in Project Financing*

i) Project shared according to agreed ratio or according to

ratio of capital contribution.

ii) Loss; shared according to ratio of capital contribution.

5.4 Long and short term projects

Musharakah financing is also frequently sought to provide credit for

long-term investment purposes. Such projects may exist in the housing

1 Source Alamanah Philippines; www.Islamicbank.com.ph

sector, or in the manufacturing and agricultural sectors, especially the agro­

business projects. In such cases, it is possible to include in the partnership

contract a provision, according to which at the end of the partnership period

and when profits (or losses) are realised, to evaluate the banks partnership

share and sell that share to the partner on cash or on installment basis1.

Investment while 60 per cent is contributed by B. the proportion of

profit allocated to each one of them is expressly agreed upon. But at the

same time B’s share in the business is divided into six equal units and A

keeps purchasing these units on gradual basis until after then of the two

years B comes out of the business leaving its exclusive ownership to A.

Apart from the periodical profits earned by B he gains the price of the units

of his share which in practical terms tends to repay in the original amount

invested by him.

5.5 Musharakah financing in public sector

Public sector financing needs are distinct from those of the private

sector in two respects:

• Funding requirement may be-sizeable and

• The maturity period of financing may be longer. Thus there

would be a need to work with divisible and tradable financial

instruments.

To the extent that a similar situation may arise in addressing the

private sector needs, a selected Musharakah arrangement can be developed

on the notion of Diminishing Musharakah for financing public sector

projects that also yield income flows. And rather than privatizing public

1 Ali Yasseri,o/?.c/7., p. 240.

sector enterprises, the government can enter into a Musharakah

arrangement with private parties who might play a role on the management

side1.

5.6 Musharakah Refinancing by the central bank

In order to promote investment in certain priority areas like

agriculture, exports or structural overhead projects, some central banks

provide to the commercial banks or NBFCs a refinance facility against their

disbursement to the priority areas. This refinance is normally based on

interest, but it is possible to provide such refinance in a Shari‘ah-

compliment manner. For example, the central bank in Pakistan (SBP)

provides an Islamic export refinance scheme (IERS) on the basis of

Musharakah; its main features are given below .

The frame work of the IERS is based on the concept of Shari‘ah.

The state bank shares in the actual profit of the Musharakah pool

maintained by the Islamic bank that provides export finance under various

Islamic modes. However, if the actual profit of the pool is more than

ongoing rates under a conventional export finance scheme (EFS), the excess

profit so received SBP is credited to the Takaful fund, a reserve fund to be

maintained by SBP for risk mitigation; the Takaful fund can be used to meet

future losses arising on implementation of the IERS. The salient features of

the scheme are:

> The facility initially is allowed only against as underlying

transaction, designed on the basis of Islamic modes of financing

approved by the Shari‘ah Board of the concerned bank.

1 Sayyid Tahir,“Islamic Banking at Systematic L evel: Issues and Approaches”, www.shp.org2 Ayub,op.cit., p. 377.

> An Islamic bank desirous of refinance has to create a Musharakah

pool (having a minimum of ten blue chip companies - to be achieved

in the first year of operation). Blue chip companies mean such

companies involved in the export business or other business or both,

or manufacturing concerns marketing their products in Pakistan or

abroad, who have (i) a good track record on the stock exchange or

(ii) a rating of minimum B+ or equivalent by the rating banks in

Pakistan, such a rating should be acceptable to the bank as per its

own lending policies for advancing loans or (iii) a return on equity

(ROE) during the last three years higher than the rates of finance

prescribed by the state bank during those years on its conventional

EFS. In the case of a company which has been in operation for less

than three years, the ROE of the available number of years shall be

considered. The Islamic bank has to ensure that companies selected

for Musharakah pool under the above criteria do not have adverse

“Credit Information Bureau” reports.

> The state bank shares the overall profit of the pool (gross income

less than any provision created linder prudential regulations during

the period plus any amount recovered against prior periods losses

and reversal of provision) earned by the Islamic bank on the

Musharakah pool under the provision of the IERS calculated on a

daily product basis.

> If, on the basis of the annual audited accounts of the Islamic bank,

the profit accruing to the SBP is more than the profit paid to the SBP

on a quarterly basis, as per the unaudited accounts of earnings of the

pool, the difference has to be deposited by the Islamic bank, within

seven days of its determination, in a special no remunerative reserve

fund, “Takaful fund,” to be maintained at the office of the state bank

where the head office/country office of the concerned bank is

situated.

> If, on the basis of annual audited accounts of the pool, the share of

the state bank in the profit works out to be less than the amount

already paid to the state bank on a provisional basis, the state bank

has to refund the excess amount involved out of balances held in the

Takaful fund, if any.

> In the event of loss suffered on the Musharakah pool on the basis of

the annual audited accounts, the Islamic bank and the state bank

shall have to share the loss in the proportion of their share of

investment in the pool expressed on a daily product basis. The share

of loss to the state bank will first be met out of the credit balance in

the Takaful fund, if any. Any loss not met from the Takaful fund shall

be borne by the state bank.

> In the case of loss, the Islamic bank is entitled to claim refund on

account of the share of profit paid by it to SBP on a provisional

basis, along with the SBP’s basis, along with the SBP’s share in the

loss of principal amount extended to the Musharakah pool1.

5.7 Musharakah Financing for International business

A customer wishing to enter into Musharakah partnership with an

Islamic bank to finance an international business transaction must provide

full information to the bank about his intended project or the goods to be

traded in. The bank studies all the documents presented by the customer

1 Ayub, op. cit., p. 378.

n io i

which must include the Municipality Certificate and Chamber of Commerce

Certificate, which are issued according to the law in the country where the

customer is doing business1.

Initially the Islamic bank looks to see if the business is permitted

according to Islamic Law and the law of the country. If this is the case then

studies feasibility of the project with regard to cost, returns and rate of

turnover in the business. The Islamic banks put great emphasis on the

viability of the commercial transaction, over and above the credit

worthiness of the customer, because the bank will be sharing in both the

profit and loss of the transaction2. In addition, efficient management,

commitment, trustworthiness and a good performance record are some of

the more important criteria on which a decision is normally taken.

However, in cases of new companies banks have to exercise their good

judgment3.

Upon approval of application by the authorised person in the bank a

Musharakah contract is signed between the bank and the customer. Each

contract specifies all the details relating to the contribution of each partner

in capital, management and profit as* well as the controls of regulating

relations between the bank and the customer. However, as the bank usually

waives its right to the management, to be given to the customer (partner)4.

This practice has been confirmed by the fatwa of Kuwait Finance

House Religious Committee, which has stated that the partners can agree on

a specified amount or an increase in the share of profits to be paid to the

1 Al Suwaidi, Finance o f International Trade in the Gulf, Brill, 20, p. 81.2 Mohammad Othaman Khaleefa, op. c//.p,213 Nawazish Ali Zaidi, op.cit, p. 15.4 Qasim M. Qasim, Paper on Collection forms Islamic Banking Practice, (In Aabid), (Qatar n.d)

p. 19, Quoted by Al- Suwaidi, op. cit., p. 81.

partner who manages the business1. The remaining profits are then divided

in proportion to the respective contribution of each party . As soon as the

contract is signed, a joint account in the name of the partnership is opened,

and the contribution of each partner in capital is paid to this account. In

addition to this the contract stipulates joint storage and Islamic insurance of

the commodity .

The partnership agreement normally includes a provision whereby

the bank promise to sell to the customer (partner) its share at a future date,

either as a lump sum or in installments, and the customer undertakes to

repurchase the same from the bank (partner) within an agreed period of

time4.

Another possibility is that the bank makes a capital contribution to

an already existing business but so that the partnership may be terminated

within a specified period of time or when certain conditions are met. A third

possibility is a decreasing participation on the part of the bank, whereby the

customer’s profits are kept in order to buy back the bank’s share of the

partnership5. The contract would allow an adjustment to the profits paid to>

each partner according to their changing share in the partnership6.

It is worth noting that from the Islamic point of view, no security can

be requested from the customer for such partnerships because, according to

1 Kuwait Finance House,” Shariah Legal Opinion in Economic Dealing” (in Arabic), 1st ed., vol. 2 (1987) p. 145.

2 Dubai Islamic Bank, “General Introduction of its objectives, Activities and investments”, (in Arabic), 2nd ed. (Dubai 1984), p. 23.

3 M. Othman Khaleefa, op. cit., p. 8.4 Barhain Monetary Agency, Bahrain, an International Financial Centre, p. 53.5 Trute Wholers Sharf, “Arab and Islamic Banks, New Business for developing countries”,

O.E.CD. France: Development centre studies, 1983 p. 846 Khaleefa, M. Othman, op. cit., p 911.

Islamic Law, capital and enterprises form a single factor of production in an

arrangement of profit and loss sharing1. However, in practice most Islamic

banks request security against the risk of negligence or wilful misconduct

of the customer or his non-compliance with the terms of the partnership

contract2.

5.8 Import financing

Musharakah can be used more easily in international trade in single

transaction as well as big projects. An importer can approach financers to

finance him for that single transaction of import alone on the basis of

Musharakah (and Mudarabah). The banks can also use these instruments

for import financing. If the letter of credit has been opened without any

margin, the form of Mudaradah can be adopted and if the letter of credit is

opened on some margin, the form of Musharakah or a combination of both

will be relevant .

A bank may enter into an Musharakah arrangement with a client

who intends to import; the bank may also appoint him as agent for

acquisition and disposal of the goods after the same are imported; an L/C>

could be opened in the bank’s or the client’s name. The net profit out of this

limited purpose Musharakah will be shared between the bank and the client

in an agreed ratio1. It is after the imported goods are cleared from the port,

their sale proceeds may be shared by the importer and the financer

according to a pre-agreed ratio .

1 Nawazish Al-Zaidi, op. cit., p. 151.2 Nabil A. Saleh, op. cit., p. 94.3 M. T. Usmani, op. cit., p. 218.1 Ayub, op. cit., p. 332.2 Usmani, Islamic Method o f Financial, op. cit., p. 218.

1 133 1

In this case, the title of the imported goods shall remain with the

financer to the agreed term and if the imported goods are not sold in the

market upto the expiry of the term, the importer may himself purchase the

share of the financer, making himself the sole owner of the goods .

Muhammad Ayub has discussed a practical application of a

transaction of import finance in the following finance case study.

A huge utility organization awards a contract to a local supplier

(ABC & Co) for the supply of equipment that has to be imported. ABC &

Co is interested in financing a transaction through a Musharakah

arrangement with an Islamic developed on a partnership by creditor/ lines

basis (Shirkatul Wujooh), in which the partners have no investment at all.

They purchase goods on credit and sell them on spot. The profit so earned is

distributed between them at an agreed ratio. The process of the transaction

consists of the following steps :

1. ABC & Co opens a Usanee L/C of Rs. 10 million, which is issued by

an Islamic bank (bank financing on a participation basis) in favour of

M/s XYZ Machines, Italy.

2. XYZ Machines agrees to give a credit period of 180 days.

3. Equipment is shipped to the importing country through air cargo due

to the sensitivity of the equipment.

4. ABC and Co inspects the goods and confirms its satisfaction to the

bank, upon which the Islamic bank conveys its acceptance of the

documents to the negotiating bank.

5. Customs take 30 days for the clearing of the equipment.

6. ABC and Co take around 50 days to install the equipment.

7. After the installation, the utility organization inspects and tests the

equipment for its performance.

8. As soon as the satisfaction certificate is issued, a bill is lodged for

payment.

9. Payment is received within 150 days of shipment.

10. Profit is distributed among the partners as per the agreed ratio.

11. The Islamic bank settles the L/C on the due date1.

5.9 Export financing

Musharakah can be applied in trade finance without complexities,

since the chances of fraud, negligence and other problems are relatively

lower in international trade than in other Musharakah-based projects. In

case of export finance under L/C, the goods will be acquired and made

ready for shipment on a Musharakah basis. The client will prepare the

export document a strictly in accordance with the terms of the L/C and

undertake to identify the bank for any loss in case of his failure to honour

his commitment. Export proceeds will be distributed according to the

agreed ratio. If there is no L/C involved, the merchandise will be made

ready for export under joint ownership of the bank and the client. However,

details of all such transactions will have to be worked out in consultation

with the commercial bankers who are actually involved in the business .

A possible procedure for export financing under Musharakah is

given below:

1 Muhammad Ayub, op. cit., p. 335.

1. The exporter receives and order from abroad to export a specific

commodity/good at a known price. He prepares estimated of cost and

his expected profit.

2. He needs financing for manufacturing/procurement of the goods and

asks the banks to provide finance on the basis of Shirakh. The bank

enters into an agreement, according to which profit will be shared on

a pre-agreed percentage.

3. The bank can get a guarantee/security to protect itself from

misconduct, breach of the contract or negligence on part of the

client. The financer may put a condition that it will be the

responsibility of the exporter to export the goods in full conformity

with the conditions of L/C. In this case, if some discrepancies are

found, the exporter alone shall be responsible, and the financer shall

be immune from any loss due to such discrepancies, because it is

caused by the negligence of the exporter. However, being a partner

of the exporter the bank will be liable to bear any loss which may be

caused due to any negligence or misconduct of the exporter1.>

However, in order to undertake such an operation, banks need to

understand the nature of the exported business and other requirements.

5.10 Letters of credit

In addition to financing of projects, Musharakah may also be

undertaken to finance a single transaction. A useful application of

Musharakah financing is the Islamic letter of credit2.

Letters of credit are essential banking services, particularly in the

1 Usmani, op. cit., p.218.2 Obaiduallh Muhammd, Islamic Financial Services, op. cit., p. 65.

area of international trade. In literature on Islamic banking, L/C’s are

covered under various contracts like Wakalah and Rafalah for businesses

under Musharakah and Murabah1.

Letters of credit may be opened for business on the basis of

Murabaha and Musharakah. As compared to Murabah, Musharakah is

more flexible, as the L/C may be in the name of the customer or the bank.

When the goods are received, the partner may sell them and the

Musharakah liquidated or the partner may buy the share of the bank. In the

case of Musharakah, either the bank or the customer can administer the

L/C; this gives more flexibility to both parties and solves some legal,

Sharika related and procedural problems which are encountered in

Murabaha L/Cs. It is also possible for the bank to act as an agent to the

beneficiary on behalf of the issuing bank and, in return, charge a fee against

the L/C2.

According to scholars, there is no objection to Islamic banks to add

their confirmation to a L/C opened on behalf of foreign suppliers to

importers. They would keep surplus in their accounts with the*

correspondent bank to cover their obligations to the third party (the

supplier). In this regard, there are certain considerations to be taken into

account3.

^ An Islamic bank should not delay the transfer of the value of the L/C

to the transfer of the value of the L/C to the correspondent abroad list

the correspondent bank should charge interest.

^ Import business conducted by an Islamic bank should not involve

1 Muhammad Ayub, op. cit., p. 385.2 Idem.3 Ibid., p. 285.

| 137 1

facilities for payment on the part of suppliers in return for interest.

This procedure often entails drawing drafts on importers, guaranteed

to be honoured for the benefit of the supplier, by the bank opening the

credit. Experience has shown that, in addition to the surplus

maintained by the Islamic banks, foreign banks have been accepting

dealing on the basis of mutual agreements by simple exchange of

letters, to enable by simple exchange of letters, to enable Islamic

banks to avail confirmation facilities upto an agreed ceiling without

charging interest if the accounts are overdrawn.

In consideration, Islamic banks undertake to abide by the following:

• To help a reasonable amount of cash in their current accounts with

confirming banks.

• To endeavour to cover any debit as soon as possible (it is part of the

understanding that the Islamic bank does not ask for any return on

any balance due to it, should the other bank utilize these funds

profitably). Therefore, there is no condition set by the other party if

the Islamic bank’s account remains overdrawn for sometime.

As partial security, the correspondent bank will, on adding its

confirmation, debit the Islamic bank with a certain “cash margin”, which it

will transfer immediately to its own account. Thus, Islamic banks need,

infact, correspondent bank’s account to cover the cash margins on the

letters of credit.

Transfer of funds in a specific currency to be paid in the same

currency is allowed with or without a fee. In traditional Islamic finance

literature, we come across the instrument of “Suftajah” for cash

transfer/payment, which involved the act of depositing a certain amount of

money with someone for settlement to the benefit of the depositor or his

representative at another place or in another country. In the transfer

involves payment in any other currency, the exchange operation at the

agreed rate is carried out before the transfer1.

In case study of Islamic letter of credit at Al-Ammanah Philippines,

the following steps are involved:

i) The customer informs the bank of his letter of credit

requirements and negotiates the terms and conditions of joint-

venture financing.

ii) The customer places a deposit which the bank under al-Wadiah

Principle towards his share of the cost of goods to be

purchased/imported as per Musharakah agreement.

iii) The bank establishes the letter of credit and pays the proceeds to

the negotiating bank utilizing the customer’s deposit together

with its own share of financing, and eventually releases the

pertinent papers to the customer concerned.

iv) The customer takes possession of the goods and disposes these

off in the manner agreed upon.

v) The bank and customer share in the profit from the venture as

provided for in the agreement .

5.11 Musharakah in the form of Term Finance Certificates (TFCs)Musharakah can also be used for financing through the purchase of

Musharakah certificates like Shirkah based Suhuk, Term Finance

Certificates (TFCs) or Participation Term Certificates (PTCs). Certificates

1 Muhammad Ayub, op. cit., p. 385.2 www.islamicbank.com.ph.

issued on the principle of ShirkahlMusharakah are negotiable instruments

issued by a company in consideration of any fund, money or

accommodation received or to be received by it whether in cash or in kind,

or against any promise, guarantee, undertaking or indemnity issued for its

benefit. The problem of moral hazard would be much less in the case of

TFCs/PTCs than in the case of direct Musharakah investments1.

An excellent example of Musharakah based financing through the

issuance of participatory instruments is that of the 5-year Term Finance

Certificates (TFCs) worth Pak Rupees 360 million issued by the Sitara

Chemical Industries, a public limited company in Pakistan, in June 2002.

The amount raised through the TFC issue was utilized to meet a part of the

cost of an expansion project of the company. The TFCs are based on the

mechanism of Shirkah and are tradable in the securities market. The

payment of profit or sharing of loss is linked to the operating profit or loss

of the company. The investors assume the risk of sustaining losses

proportionate to their principle amount in the case of any operating losses

incurred by Sitara. Changes in any government regulations may also affect

the profitability of the TFCs. By investing in the TFCs, an investor also

assumes the risk of not being able to sell the TFC without adversely

affecting the price.

Profit is paid on a six monthly basis. For the purpose of sharing

profit with the TFC holders, the level of yearly operating profit is divided

into two tiers as described below under the headings of Level I profit and

Level II profit.

Level I profit: On the first Rs. 100 million operating profit at 12 per cent

p.a. of the outstanding principal. The rate of 12 per cent has been taken as a

project rate by reverse accounting on the basis of a sharing ratio. The rate of

percentage profit entitlement shall be proportionally reduced if operating

profit is less than Rs. 100 million, as follows:

Actual operating profit/Rs. 100 million) x 12 % = Actual profit entitlement rate of level I profit

Level II profit: 2 per cent p.a of the outstanding principal on each

subsequent Rs. 100 million operating profit (over and above Rs. 100

million). One quarter of this profit will be transferred into the Fakaful

reserve and the balance will be distributed to the TFC holders. The rate of

profit entitlement shall be proportionately reduced if the actual figure of

subsequent operating profit falls in between two successive slabs of the Rs.

100 million of operating profit, as follows:

(Actual operating profit/Rs 100 million) x 2% = Actual profit entitlement rate of Level II profit

If the final profit payment of a year is in excess of the on-account

profit payments already paid to the TFC holders, the excess amount will be

paid along with the next six monthly on-account profit payment. However,

if the on-account payments that have already been made for the year are in

excess of the final profit share of the TFC holders, then the excess will be

adjusted as per predecided procedure. If the operating profit is more than

Level I profit, the profit-sharing arrangement applicable on Level II profit is

followed1.

If upon finalization of the annual audited accounts, a loss is incurred,

the on-account profit payment has to be adjusted. The loss attributable to

the TFC holders will be offset against the Takaful reserve created for the

purpose.

1 Ayub, op. cit., p. 336.

t 141 I

If the amount available in the Takaful reserve is insufficient to absorb

the entire loss attributable to the TFC holders, the unabsorbed losses will be

adjusted against the principal amount at the time of redemption of the

principal amount.

The face value of each TFC issued to the general public is Rs. 5000.

The principal amount has to be redeemed at the end of the third fourth and

fifth years from July 1, 2002. The amount of principal redemption at the

end of the third year may be Rs. 1650/- at the end of the fourth year Rs.

1650/- and at the end of the fifth year Rs. 1700/-. The principal redemption

in each above-mentioned year will be subject to profit/loss adjustments1.

5.12 Financing of working capital

Where funds are required for the working capital of a running

business, the instrument of Musharakah may be used in the following

manner:

1. The capital of the running business may be evaluated with the

mutual consent. It is already mentioned while discussing the

traditional concept of Musharakah that is not necessary, according to

Imam Malik, that the capital of the Musharakah is contributed in

cash form. Non-liquid assets can also form part of the capital on the

basis of evaluation. This view can be adopted here. In this way, the

value of the business can be treated as .the investment of the person

who seeks finance, while the amount given by the financer can be

treated as his share of investment. The Musharakah may be affected

for a particular period, like one year or six months or less. Both the

1 N.B: Sitara TFC’s Remained highly profitably: they gave a profit between 15 and 24% per annum. The IFC’s are not available in the secondary market as the holders locked in, keeping in mind the high profitability. Ayub.op.cit, p. 337.

f 142 1

parties agree on a certain percentage of the profit to be given to the

financer which should not exceed the percentage of his investment,

because he shall not work for the business. On the expiry of the term,

all liquid and non-liquid assets of the business are again evaluated

and the profit may be distributed on the basis of this evaluation1.

Although, according to the traditional concept, the profit cannot be

determined unless all the assets of the business are liquidated, yet the

valuation of the assets can be treated as “constructive liquidation” with

mutual consent of the parties, because there is no specific prohibition in

Shari ‘ah against it. It can also mean that the working partner has purchased

the share of the financer in the assets of his business, and the price of his

share can be determined on the basis of valuation, keeping in view the ratio

of the profit allocated for him according to the terms of the Musharakah.

For example, the total business of the value of A is 30 units. B

finances another 20 units, raising the total worth to 50 units; 40 per cent

having been contributed by B, and 60 per cent by A. It is agreed that B shall

get 20 per cent of the actual profit. At the end of the term, the total worth of

the business has increased 100 units. Now, if the share of B is purchased by

A, he should have paid to him 40 units, because he owns 40 per cent of the

assets of the business. But in order to reflect the agreed ratio of profit in the

price of his share, the formula of pricing will be different. Any increase in

the value of business shall be divided between the parties in the ratio of 20

and 80 per cent, because this ratio was determined in the contract for the

purpose of distribution of profit.

Since the increase in the value of the business is 50 units, these 50

1 M.T. Usmani, op. cit., 1998.

I 143 I

units are divided at the ratio of 20: 80, meaning thereby that 10 units will

have been earned by B. These 10 units will be added to his original 20

units, and the price of his share will be 30 units1.

In case of loss, however, any decrease in the total value of the assets

should be divided between them exactly in the ratio of their investment, i.e.,

in the ratio of 40/60. Therefore, if the value of the business has decreased,

in the above example, by 10 units reducing the total number of units to 40,

the loss of 4 units shall be borne by B (being 40% of the loss.). These 4

units shall be deducted from its original 20 units, and the price of his share

shall be determined as 16 units.

Financing on the basis of Musharakah according to the above

procedure may be difficult in a business having a large number of fixed

assets, particularly in a running industry, because the valuation of all its

assets and their depreciation or appreciation may create accounting

problems giving rise to disputes. In such cases, Musharakah may be applied

in another way.

The major difficulties in these cases arise in the calculation of>

indirect expenses, like the depreciation of the machinery, salaries of the

staff etc. In order to solve this problem, the parties may agree on the

principle that, instead of net profit, the gross profit will be distributed

between the parties, that is, the indirect expenses shall not be deducted from

the distributable profit. It will mean that all the indirect expenses shall be

borne by the industrialist voluntarily, and only direct expenses (like those of

raw material, direct labour, electricity etc.) shall be borne by the

Musharakah. But since the industrialist is offering his machinery, building

1 M.T. Usmani, op. cit., p. 219.

and staff to the Musharakah voluntarily, the percentage of his profit may be

increased to compensate him to some extent.

This arrangement may be justified on the ground that the clients of

financial institutions do not restrict themselves to the operations for which

they seek finance from the financial institutions. Their machinery and staff

etc. is, therefore, engaged in some other business also which may not be

subject to Musharakah, and in such a case the whole cost of these expenses

cannot be imposed on the Musharakah.

Usmani has given the following practical example. Suppose a

factory has a building worth Rs. 22 million, plant and machinery valuing

Rs. 2 million and the staff is paid Rs. 50,000/- per month. The factory

sought finance of Rs. 5,000,000/- from a bank on the basis of Musharakah

for a term of one year. It means that after one year the Musharakah will be

terminated, and the profits accrued upto that point will be distributed

between parties according to the agreed ratio. While determining the profit,

all direct expenses will be deducted from the income. The direct expenses

may include the following :

i) The amount spent on purchasing raw material.

ii) The wages of the labour directly involved in processing

the raw material.

iii) The expenses for electricity consumed in the process.

iv) The bills for other services directly rendered for the

Musharakah.

So far as the building, the machinery and the salary of other staff is

2 M.T.Usmani, op. tit., p. 220.

concerned, it is obvious that they are not meant for the business of

Musharakah alone, because Musharakah will terminate within one year,

while the building and the machinery are purchased for a much longer term

in which the factory will use them for its own business which is not subject

to this one-year Musharakah. Therefore, the whole cost of the building and

the machinery cannot be borne by this short-term Musharakah. What can be

done at the most is that the depreciation caused to the building and the

machinery during the term of the Musharakah is included in its expenses.

But in practical terms, it will be very difficult to determine the cost of

depreciation, and it may cause, disputes also. Therefore, there are two

practical ways to solve this problem1.

In the first instance, the parties may agree that the Musharakah

portfolio will pay an agreed rent to the client for the use of the machinery

and the building owned by him. This rent will be paid to him from the

Musharakah fund irrespective of profit or loss accruing to the business.

The second opinion is that, instead of paying rent to the client, ratio

of his profit is increased. The following may be the flow of transactions in

the case of Musharakah for running business :

i. A running Musharakah account for the client will be opened in the

books of the financing bank.

ii. The client’s proceeds from the sale of finished goods will be credited

in the running Musharakah account.

iii. The clients cash flows generated from investment activities (for

example, sales proceeds from the disposal of fixed assets) and cash

flows from long-term financing activities (for example, long term

1 M.T. Usmani, “Introduction to Islamic Finace”, Idaratul-Marif, Karachi, May 2000,p.49

1 146 I

finance availed for the project) cannot be credited in the running

Musharakah account.

iv. For determination of the period of running Musharakah limit, all the

clients of the bank will be divided into the following three categories

: seasonal, cyclical and continued operation.

v. At the end of each quarter or month, as the case many be, the profit

earned by the client in the Musharakah will be paid to the bank.

vi. The profit-sharing will be based on the computed operating profit for

the same period for which the running Musharakah limit was

awarded.2

5.13 Application of Diminishing Musharakah {Musharakah

Mutanaqisah) in financing

Diminishing Musharakah can be easily used for the purpose of

financing fixed assets by Islamic banks. It includes house financing, auto

financing, plant and machinery financing, factory/building financing and all

other fixed asset financing.

Financing by a bank on the basis of Diminishing Musharakah can

take different forms depending upon the assets involved. Some assets can

be leased out e.g., in case of house financing and the purchase of plant and

machinery, assets of a commercial nature would not involve leasing1.

5.14 Diminishing Musharakah in House Financing

Application of Musharakah in house financing could take many

forms. The customers/clients may for example, provide the land and part of

2 Muhammad Ayub , op. at., p. 333.1 Ibid., p. 339.

1 147 I

the finance or one of them and the bank provide the other. The house will

be jointly owned according to the percentage of finance provided by each

partner including the value of the land. When the unit is completed it can

either be used by the customer or let out. In all cases a rent will be

determined and the customer can either pay the share of the rent due to the

bank or use the premises or the premises can be let out and the rent shared

between the bank and the customer1. Let us see some practical examples of

house financing in different situation.

Construction of a house on a customer’s land or renovation of a houseConstruction of a house on land owned by the customer would

involve purchase/sale and lease-back. Suppose the plot of land is worth one

million Dirhams/Rupees and the customer needs 80,000 Drs. (Rs.) from the

Islamic bank. The bank would purchase a part of the land from the

customer (say 8 units of 100,000 Drs (Rs.) each out of the total of ten units

to form a joint ownership on the basis of Shirkatul milk. The customer

would undertake that he would pay rent on the bank’s part of ownership and

would periodically purchase the share of the bank according to a pre-agreed

schedule of price.

With the proceeds of the land (800,000 Drs. / (Rs.)) that could be

provided in four equal installments), the client would construct the house;

when the house was complete and habitable, the bank would lease its part

of ownership to the client at the agreed rental upto one year, the client

would pay only the rent on the bank’s part of the house. Accordingly, the

rent would not decrease during that period.

One year after the disbursement of the last installment, the bank

1 ‘Housing Finance in Islamic Countries, paper presented by Abdin-A-Salma, p. 29.

would start selling its units of ownership to the client as per the undertaking

of the customer; rent would decrease with every rental paid, and ultimately

the title of the house would transfer to the client. The period of one year has

been suggested by the Shari'ah scholars for sale of units by the bank to

avoid buyback (Bai ‘al-Inah ’), which is prohibited.

Renovation of a house owned by the customer would also involve

purchase/sale and lease-back. The client would sell, say, four units of his

ownership to the bank to create a joint ownership with the proceeds of the

sale, the client would renovate the house or make alternations to it. The

bank would start taking rent from the first month after disbursement of the

first tranche because the customer is already living in the house. The

process of the units’ sale back to the client would start one year after the

disbursement of the last tranche1.

Hypothetical case study on housing finance through Diminishing Musharakah (partnership by ownership) calculation of the monthly payment plan for home purchaseCost of house Drs or Rs. 1. Mm.

Bank Financing * 80%

Tenure 10 years

Rental (Return Rate Equivalent to): 7% p.a of investment

Purpose Home purchase from the market2.

Key structure: Monthly payment consists of unit purchase and rent

components. Unit purchase will remain constant over the entire tenure. Rent

1 Ayub, op. cit., p. 341.2 Idem

{1 4 9

is calculated based on the number of units outstanding. The rent component

will decrease every month with the purchase of units.

Construction o f a house on a plot o f land already

owned by the client, renovation/additions to a house

owned by him or a balance transfer facility (BTF) for

the payment o f an interest based mortgage loan on a

clients house are subject to a different procedure, as

discussed previously.

Working

Bank’s share : Rs. 800.000; full payment is madein one tranche

Client’s share Rs. 200.000

No. of bank’s units (equal to : 120number of months)

Price per unit (principal/number of : Rs. 6666.67units)

Rent per unit (annual) : ̂Rs. 466.67

[(outstanding investment* rate)/12) for monthly rent]

150 I

Month Unit Rent per month

Total Units Investment

0 - - - 120 800,000.0

1 6666.67 4666.67 11333.33 119 793,333.3

2 6666.67 4627.78 11294.44 118 786,666.7

3 6666.67 4588.89 11255.56 117 780,000.0

4 6666.67 4550.00 11216.67 116 773,333.3

5 6666.67 4511.11 11177.78 115 766,666.7

6-115 xxxxx XXX XXXXX XXX xxxx

116 6666.67 194.44 6861.11 4 26,666.7

117 6666.67 155.56 6822.22 3 20,000.0

118 6666.67 116.67 6783.33 2 13,333.3

119 6666.67 77.78 6744.44 1 6666.7

120 6666.67 38.89 67705.56 - 0.0

In all three above cases, i.e. the construction of a house, renovation>

of a house or purchase of a built house, if the client regularly pays the rental

and periodically purchases the bank’s share, the ownership is transferred to

him. If he delays the rental will not decrease and the bank’s loss in terms of

income will be far less than in the case of Murabaha or even simple

leasing, as the customer will go on paying rental on the units owned by the

bank.

The client can also purchase more than one unit of his cash flow

allows him to do so. In this case, Islamic banks normally conduct a

valuation of the house and share in the capital gain, if any, generally upto a

t 151 I

pre-stipulated rate. For example, if the client intends to purchase five units

at one time, the bank will conduct a valuation and will share the

appreciation upto 3 or 4 per cent on its part of the investment, giving the

remainder to the client. Thus, Musharakah Mutanaqisah on the basis of

Shirkatul-Milk has a built-in element of risk mitigation. The rental rates to

be taken by the banks can be fixed or floating; if floating they should be

subject to a proper “floor and cap” to avoid Gharar, which could render the

transaction non Shari‘ah Complaint1.

It is hence not without reason that the housing sector has witnessed

greater use of Musharakah Mutanaqisah than any other sector, since the

expected profits from this business would be sourced from rentals that are

predealable to a considerable degree.

Musharakah in building commercial building

The bank or an financial company undertakes this kind of project by

providing wholly or partially the necessary finance for constructing the

building, while the client provides the plot of land on which is to be

constructed, and perhaps part of the financing as well. As both the financer

the bank and the client are convinced of the feasibility of the project

according to the studies conducted on it, they proceed in its execution and

then its leasing, selling or exploiting in any firm that leads to achievement

of the required returns. The bank assumes (with authorization from the

client) the responsibility of managing the project and the revenue generated

there from is divided between the bank and the client as follows:

• 25 per cent of the revenue to be allocated as the bank’s share.

• The remainder (75%) of any proportion thereof agreed up will be

1 Ayub, op. cit., p. 343.

1 152 1

allocated for repayment of the principle provided by the bank after

which the whole project and its return is passed on to the hands of

the client.

• The does not require any guarantee in its favour in this type of

financing except the initial mortgage.

5.15 Musharakah in Auto Financing

With the increase demand of everyday life vehicle ownership has

shifted from a mere luxury to a vital necessity. Purchasing a car is often the

second most expensive yet important purchase, after buying a home. While

doing so an individual has two options available: either to make a hand on

hand (cash) purchase or to go for car financing. However, due to the

inebriant car price and lack of the funds available, many individuals prefer

the latter option. The current vehicle financing system is extensively

competitive with thousands of finance companies, banks, credit union and

dealership competing.

Standard Chartered Bank of Pakistan has introduced Islamic auto

finance product buying a car under the concept of diminishing Harakah and

has branded this product as Mushara car. Islamic auto finance by Standard

Chartered Bank Pakistan-based on Diminishing Musharakah1.

The product has been structured in the following manner:

The Shari‘ah 50 persons Committee has received the following

agreement (Auto finance agreement relating to SCB Islamic Auto Finance).

i. The bank will enter into a joint participation arrangement to invest in

the vehicle on the basis of Diminishing Musharakah. The title of the

1 Ox Musharakah Mutanaqisah

vehicle can remain with the customer.

ii. The bank will provide longer share of the purchase price of the

vehicle.

iii. The bank will rent out fallow usage of its share of the vehicle to the

customer. The customer will agree to make monthly payments as

rent for the use of the vehicle.

iv. The customer will also make regular scheduled payments in the

participation to increase its equity in the vehicle. Thus with each

payment the ownership of the customer in the partnership grows

increasing its share of the vehicle.

v. Once the customer has paid in full the customer will have free and

clear title to the vehicle.

In cases where the vehicle needs to be booked in advance the

following arrangements has been put in place:

1. Bank will make full payment to the manufacturer for purchase of

the car to be delivered after a few months.>

2. Till the time the car is delivered the Bank will receive advance

payments (both for rent and purchase of Bank’s share) from the

customer.

3. These payments will be received by the Bank as advance payment

and applied towards the diminishing Musharakah only after the

delivery of the vehicle.

4. If the vehicle is not delivered for any reason (not resulting the

customer’s negligence) the arrangement will be terminated and the

bank will refund all the advance payments to the customer.

LARIBA has the following model to offer for auto financing

They start by determining the monthly rental lease rate of the similar

auto by surveying the car dealers or rent-a-car agencies and request the

client to do the same. The client and company finance officer compares the

results of the survey and agrees on a monthly lease rental rate not on an

interest rate. They rather start form the utility value of the vehicle. This

concept is called “Marking the item to the market”. Interest rates are the

same through the USA regardless of the economic condition of the city,

locality or state.

The model calls for the financing entity to purchase the property

jointly with the client, and in a back-to-back agreement, the client purchases

the shares of the financing entity at cost. In doing so, there is no time value

of money. The client owns a title to the car, with the company holding a

first-position lien. This structure also confirms to requirements of the

banking regulators. The client agrees to buy back the company’s portion

over a period of time, called repayment of capital (RonC) to the company.

Return on capital (RonC) represents the property’s lease value as

explained above and is calculated based on a declining equity model based

on the property’s economic value (utility). Using this model we calculate

market value of the car, not to a predetermined interest rate like LIBOR or

prime rates.

The financing agreement consists of two part in which the client

returns the capital to the company (return on capital); the second is a lease

rate, calculated based on the declining equity stipulated by the retum-of-

capital payback agreement.

Based on the agreement detailed above, a promising note is drawn. It

I 155 1

details the monthly payment representing the repayment of capital (lease)

portion. To comply with the U.S regulatory requirements and U.S banking

system rules the monthly payments streams are plugged into a traditional

amortization programme to calculate an implied interest rate. This allows

LARIBA to satisfy the truth-in-lending and full and complete disclosure of

implied interest rate, laws as required by U.S banking and lending

requirements. This models and agreements used for all transactions are

exclusively developed by the company to provide services for the clients

seeking Islamic financing products. Thus we see that there is a good scope

of Musharakah being utilized in auto financing.

5.16 Musharakah in purchasing a taxi

Musharakah financing is a good option for a person, eager to

purchase a taxi to use for offering transport services to passengers and then

to earn income through fares recovered from them, but he is short of funds.

Let this person be ‘A’ another person ‘B’ agrees to participate in the

purchase of this taxi with 80 per cent of the price ‘A’ pays 20 per cent.

After the taxi is purchased, it is employed to provide transport to the

passengers, whereby the net income ot Rs. 5000 (plus or minus) is earned

on daily basis. Since ‘B’ has 80 per cent share in the taxi, it is agreed that

80 per cent of the fare will be given to him and the rest of 20 per cent share

will be retained by ‘A’ who has a 20 percent share in the taxi. It means that

Rs. 800 (plus or minus) is earned by ‘B’ and Rs. 200 (plus or minus) by ‘A’

on a daily basis. At the same time, the share of ‘B’ is further divided into

eight units. After three months ‘A’ purchases one unit from the share of

‘B \ Consequently, the share of ‘B’ is reduced to 70 per cent band the share

of ‘A’ is increased to 30 per cent, meaning that from that date ‘A’ will be

entitled to Rs. 300 (plus or minus) from the daily income of the taxi and ‘B’

will earn Rs. 700 (plus or minus). This process will go on until after the

expiry of two years, when the whole taxi will be owned by ‘A’ and ‘B’ will

take back his original investment, along with income distributed to them as

aforesaid.

However, taxi when used as a hired vehicle normally depreciates in

value overtime, therefore depreciation in value of taxi must be kept in mind

while determining the price of different units of the share of the finance.

5.17 Musharakah in construction of a plant

Construction or erection of a plant, for example a cement plant a

bank can provide finance on Musharakah basis and enter into an Istisnaa1

contract with any industrial concern by appointing the customer its agent

for supervision of the erection of the plant. The bank will enter into a

Musharakah contract with the client to operate the plant and get a periodic

profit payment in the form of rental on its part of ownership. Principal can

be recovered through selling of units to the client at market price with

proper offer and acceptance. The client may go on purchasing the bank’s

units until the bank’s investment is redeemed. Ownership transfer can also

be once, at the end of the investment period. Partnership can also be for

sharing of profits of plant when it goes into production1.

5.18 Musharakah Mu tan aqisahA) i m i n i s h i n g Musharakah in trade

If leasing is not involved and there is a simple partnership in which

two partners start a business, for example on a 40: 60 basis, they can agree

1 Order to manufacture (for purchase). It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in above and future delivery. Istisnaa can be used for providing the facility of financing the manufacture/construction of houses, plant, projects, bridges, roads and highways.

’ Ayub, op. cit., pp 373-374.

that the share units of one partner will be periodically sold to the other

partner, who will keep on purchasing them on a gradual basis until the

second party is out of the business. As this contract has been entered into

for profit-earning by the partners and also does not involve leasing, like the

case of a house or a vehicle, the purpose of share units cannot be fixed in

the promise to sell. One partner may agree to sell the units on the basis of

valuation of the business at the time of the purchase of each unit. Such

valuation may be carried out in accordance with the recognized principles

by experts, whose identity may be agreed upon between the parties when

the promise is signed. At the time of purchase, the sale should be executed

through offer and acceptance.

Although the entrepreneur partners in Diminishing Musharakah for

trade has an inherent motivation to acquire full ownership by purchasing

shares from the financer, the Shari ‘ah experts are not inclined to make the

purchase binding on him. According to Resolution No.2 of the Jeddah-

based OIC fiqh Academy, and also research undertaken by IRTI1, the sale

provision of the contract can be made binding only on the financer partner

and the sale will be effected at the prices prevailing in the market at the

time of actual sale. After creating joint ownership, the bank may sign a one­

sided promise to sell different units of the share of its ownership

periodically and may undertake that when the client purchase a unit of its

share, the rent of the remaining units will be reduced accordingly. Thus, an

Islamic bank will be making a binding promise to offer a specific part of its

ownership of the project for sale on a specified future date for a price that

will be determined at the time of the actual sale. The entrepreneur partner

may voluntarily buy the share of the financer at the prices prevailing at the

1 IRTI Islamic Research and Training Institute, Jeddah.

time of sale in the stock market or at a price determined with the free

consent of the parties1.

Property financing at Abu Dhabi Islamic Bank

The property is brought jointly by the bank and customer. This

structure is similar to Ijara in that the customer agrees to pay the cost price

over a time period to the bank, in return for acquiring the bank’s share in

the property and paying rent in the meantime for living in the property. The

rent element is determined by agreement between the parties based on

market rent for several properties. This structure assumes that, initially the

property will be bought at cost price from the seller jointly by the bank and

customer. The customer promises to purchase the bank’s share over a

period of time. The bank may authorize the customer to register title in his

own name and safeguard its interest by holding the title deeds and

registering a charge. Repayments are made up of the rent for the property

and repayment of a part of the bank’s share of the cost price. As more of the

property is being bought by the customer over time, the amount of rent

payable is reduced progressively2. Purchase or redeem the banks share on

specific dates in future - such promise(s) may also be binding on the

promisor3.

Redemption price of asset/property

However related issue is the pricing or valuation of such shares. In

this matter the general view is that the redemption should be undertaken at

the prevailing market price of the property. While the promise to redeem

the shares at “known” or predetermined prices is more convenient, it is

1 Ayub, op. cit., p. 340.2 Source: www. Adib.co.ae.

more controversial too. If prices are predetermined, this may involve a

“certain” return for the financier to or open the doors of Reba. The counter

view is that a promise to buy in future already involves uncertainty. A

promise to buy at an unknown (market) price involves still greater level of

uncertainty. Hence, a predetermined price such as cost price may be

desirable in the property financing product by Abu Dhabi Islamic Bank1,

the bank would stand to gain if property prices appreciate in future, as they

do in most cases instead of opts for sale of its stake at cost price. Clearly,

there is a trade-off between risk and reward.

5.19 Financing through Musharakah bonds

Musharakah Muntaraqisah bonds rank second in volume within the

Sukuk [Islamic bonds] market. Musharakah Muntaraqisah bonds mean that

the financiers (the issuer) regularly purchase his partners {Sukuk holders)

shares in the project until their full shares are purchased, which is called

Idfa al Sukuk (full acquisition of bonds). Such bonds are used to finance

real estate and infrastructure projects, which are characterised by flexibility

in issuance conditions. This means that the financing project need not>

already exist and the bonds may be issued to finance its construction or

develop an existing project. Moreover, the issuing company is capable of

using its assets as a share in these bonds, and the bonds are characterized by

flexibility in the distribution of profits between the issuer and the Sukuk

investors.

Musharakah bonds represent part-ownership of a particular project.

Although they are similar to shares, they are subjected to a limited duration

1 Muhammad Obaidullah, Islamic Financial Services, op. cit., p. 63.

of time and can also be adjusted to have a higher ceiling of profit for Sukuk

holders.

Though Musharakah Muntanaqisah bonds have recently come under

fire in jurist circles due to the presence of a commitment made by the issues

of some of these bonds to repurchase the bonds from holders using

historical cost or predetermined values. The origin of this controversy lies

in the fact that this commitment guarantees a given partners capital, which

is prohibited by Islamic Shari‘ah since Shari'ah provisions stipulate that

there are “no reward without risks” and that “profits must be accompanied

with liability” in accordance with the Islamic Hadith. Furthermore, under

this commitment, the partners capital is transformed into a loan and

therefore, any increase in the loan value falls under the type of interest that

is prohibited by Shari‘ah.

However, the presence of such non-compliant Shari‘ah elements

does not invalidate these bonds and nullify them from the structure of

Islamic bonds, rather the error must be rectified and Shari‘ah complaint

alternative must be sought to cover the risks that arise in the absence of

such commitment.

One of the alternatives is to raise the return on these Sukuk so that

there can be an even proportion between risks and retums.lt is unreasonable

that the return on these Sukuk is calculated according to SIBOR (Singapore

Interbank Offered Rate) and LIBOR (London Interbank Offered Rate),

where the risks are almost absent with the exception of the usual credit risks

entailed in this kind of finance.

The use of Musharakah Muntanaqisah bonds in financing the

establishment of the King Abdullah Financial District (KAFD) which is a

project owned by the public pensions agency, expecting to cost 30 billion

Saudi Riyals (US $8 billion) and is a proof to the subject matter, namely the

use of Musharakah bonds in financing.

The agency issues Musharakah Muntanaqisah bonds at each stage of

the project so that the assets at each point can be transferred to the company

that has been established for specific purposes. At a latter stage, the agency

acquires all these bonds by repurchasing them at a price that is specified in

the issuer’s prospectus. In the prospectus, the issuer (the agency) is not

obliged to purchase (the bonds). However, Sukuk holders will be obligated

to sell to the issuer at the price stated in the prospectus whenever the issue

wants, in this way, the agency guarantees that Sukuk holders will not be

able to dispose of the assets, and the profits will be calculated according to

the potential risks.

It is permissible to stipulate that the projects gained from Sukuk

holders should not exceed a certain rate that will be determined in the

prospectus. The agency appoints a bond assets Director who will be given

the profit surplus of Sukuk as an incentive for efficient management.

Following this method to finance the KAFD will accomplish the

following interests:

1. It will provide the project with the necessary finance for the

complications of bank finance.

2. It will contribute to absorbing part of the liquidity that exists

in the market as a result of the reduction in the interest.

3. This kind of finance and the financial and administrative

requirements and procedures such as disclosure, transpiring

and administrative governance that it entails, will remains

I 162 I

limited within the scope of this project and will not be used as

part of the agency’s other activities contrary to offering the

agency’s real estate branch as public company.

4. The bond holders ownership of the project is temporary,

which will expire when the issuer acquires the Sukuk in

contrast to finance as it is presented as public company.

5. It will allow both institutions and individuals of the private

sector to benefit from these massive projects.

6. It will contribute to the development of the Shari‘ah-

compliant capital market in Saudi Arabia1.

1 Lahem Al Nasser, “A Look at Musharakah Bonds”, http://knol. soosle. com. 28-05-2008.