INTRODUCTION TO MUSHARAKA

The term Musharaka is derived from the Arabic word Shirkah, and means partnership. Musharaka is a partnership of two or more, who put together their capital and labour based on mutual trust, share in the profit and loss of the joint venture and have similar rights and liabilities. It is the purest form of Islamic finance instrument. In Musharaka the risks and profit or loss are distributed more equitably between the investors, determined by the proportion of the investment of each partner, rather than in a conventional interest-based loan where interest is calculated based on the principal amount, the interest rate applied and the period of the loan, without any link to the risk or profit–loss scenario of the venture.

From the Shariah perspective, Musharaka is a simple partnership. But designing a banking product from it is not easy. Banks prefer to enter into a partnership for a limited period only. Yet Musharaka is considered the most viable Islamic banking product, with future growth potential. Islamic banks enter into a Musharaka contract with their clients, each contributing capital, in equal or varying quantities, and contributing their skills and expertise, also in varying quantities, to start a new joint venture or be part of an existing one. A partner may decide not to be involved in the day-to-day operations or management, thus becoming a silent partner. The profits of the venture do not have to be shared pro-rata to the capital contribution, but are shared according to a pre-agreed ratio which is decided at the initiation of the contract. Financial losses, though, are borne in proportion to the capital contribution of each partner. The return of the Musharaka venture cannot be guaranteed, like an interest-based loan, and may even lead to loss of the contributor's capital. As such, the product involves risk and since banks want to be involved for a limited period only, the product can be quite complex.

TYPES OF MUSHARAKA

Musharaka can be classified into diverse types. Based on the liability of the partners, it can be unlimited or limited. Based on the permanency of the Musharaka, it can be permanent or constant, temporary or diminishing. A special kind of Musharaka is Wujuh. As the industry is researching the potential of Musharaka as the purest form of Islamic finance, innovation continues and more varieties are expected in the future. The types currently in existence are discussed below, though all are not of equal popularity or use in the Islamic banking industry. Equity-based products like Mudaraba and Musharaka are challenging for Islamic banks to implement due to the problems of asymmetric information, where the fund user or customer has much more information about the operations and risks of the business venture than the Islamic bank and may decide not to disclose these to the provider of funds or the bank.

Mufawada or unlimited Musharaka. In this kind of Musharaka all the partners or participants rank equally in every respect – in their initial contributions of capital, in their privileges, in their rights and liabilities. The partners have equal roles in management, and equal rights in the profits and disposition of the assets of the venture. The liabilities of all the partners are unlimited, unrestricted and equal. They are all the agent and guarantor for each other. The Mufawada form of Musharaka is not very common or popular in the Islamic banking industry.

Inan or limited Musharaka. In this kind of Musharaka two or more partners contribute capital in varying amounts, which can be cash or kind, and may or may not contribute their labour, effort, skills and enterprise. Each partner is only the agent for all the others but is not a guarantor. The rights of the participants are different. In Inan Musharaka profit is shared according to a pre-agreed ratio, and the partners are at liberty to decide this ratio as they prefer; it may be different from the ratio of capital contributions. Any partner who is not involved in the management of the Musharaka business venture is not allowed a profit share that is more than their capital contribution. Inan or limited Musharaka is commonly used in the Islamic banking industry.

Constant or permanent Musharaka. In this kind of Musharaka the partners' shares in the capital remain constant or permanent throughout the contract period. The partners can sell their shares in the Musharaka capital to a third party. As in all Musharaka products, profit sharing is at a pre-agreed ratio and losses are borne in proportion to the capital contribution. Application of constant or permanent Musharaka amongst business partners is feasible and can be applied to other forms of partnership, like a law firm or a doctors' clinic, etc. Since Islamic banks want to finance projects for a limited period only, a constant form of Musharaka is not often applied.

Temporary Musharaka. This kind of Musharaka involves a single transaction or short-term financing, which concludes within one year. The Musharaka could be renewed each year if required. Common uses of temporary Musharaka are as working capital financing.

Wujuh Musharaka or partnership of goodwill. In this type of Musharaka one or more of the partners do not contribute financially but they contribute their goodwill, brand name or track record. Wujuh Musharaka is very suitable for financing franchising projects.

Musharaka Al Milk. This is a Musharaka partnership which involves ownership of common property that the partners may have acquired through a specific contract or via inheritance.

Musharaka Mutanaqisa, Musharaka Muntahiya Bittamleek or diminishing Musharaka. Diminishing Musharaka has widespread application in various financing contracts and its popularity is continuing to increase. This type of Musharaka is a joint-ownership contract at the very onset of which it is agreed that one party has the right to purchase the shares of the other partners over a prescribed contract period at a pre-agreed price. The repurchase can be at regular intervals or could be according to the financial convenience of the purchasing partner. Commonly, in Islamic banking, the borrower or entrepreneur is the party that gradually purchases the units in the Musharaka venture owned by the Islamic bank as partner. The result is that the Islamic bank's share in the Musharaka declines, finally becoming zero, while the other partner's share increases, reaching 100%, resulting in the latter owning all units of the venture and becoming the sole proprietor.

Musharaka Mutanaqisa is widely used by Islamic banks to provide long-term finance to retail customers for fixed assets like real estate, vehicles, etc. It is also used in corporate banking in the areas of project finance, trade finance and working capital finance. Profit is shared in a pre-agreed ratio and revised after each purchase instalment of the client that changes the ownership percentages. The liabilities and loss potential also change with the changes in ownership.

Diminishing Musharaka involves the parties entering into three contracts. The first contract is one of joint ownership between the client and the Islamic bank. The second contract is a lease contract between the bank and the client, where the bank agrees to lease its portion of the asset to the client. The third contract is a sales contract, which stipulates that the client would purchase the bank's share in the venture gradually and at pre-agreed intervals and price.

Figure 6.1 is an overview of a Musharaka Mutanaqisa.

SHARIAH RULES AND GENERAL PRINCIPLES GUIDING MUSHARAKA CONTRACTS

Important principles and Shariah rulings that define the Musharaka contracts are discussed below, a large part of which has been derived from the work of Sheikh Muhammad Taqi Usmani (Usmani, 1999) and discussed in Kettel (2011):

1. Musharaka venture and partners. As in the case of all Islamic finance contracts, partners in Musharaka ventures are required to be competent to enter a contract. Moreover, the project or business to be financed by Musharaka should be Halal and Shariah compliant.
2. Capital. The capital of the Musharaka venture needs to be specifically defined, should be in existence and immediately available. The partners may or may not contribute capital in equal proportions. Capital can be in the form of money and/or tangible assets like goods, machinery or real estate. Some scholars allow intangible assets like brand name, patents, etc. to be considered as capital. The value of any such tangible or intangible asset needs to be clearly defined and agreed upon.
3. Management and labour. All partners can work in the Musharaka venture and it is not permissible to forbid any partner from being involved in the management or operations of the business. On the other hand, if all partners agree then any one partner may manage the business alone.
4. Guarantee. Each partner serves as a trustee of the funds of all other partners but provides a guarantee for the funds only against negligence or mismanagement. The Musharaka venture may take a security or mortgage or guarantee against negligence and mismanagement, but Shariah does not allow a security to be taken to guarantee the capital or a certain amount of profit.
5. Profit and loss. At the onset of the Musharaka contract the profit-sharing ratio is agreed upon. Usually it is in proportion to the capital contribution, but according to some scholars it may be different from the capital contribution if all partners agree. Any one partner may singly manage the business, or may be more involved in the operations and management of the venture or may have greater relevant expertise for the business, thus justifying earning a ratio of profit greater than their capital contribution. On the other hand, a partner who does not participate in management cannot demand a profit ratio higher than their capital contribution. The return of the Musharaka partners is based on the actual profit earned by the Musharaka joint venture and Shariah insists that it is a ratio or percentage of the actual profit earned and not a lump sum. In the case of loss in the Musharaka venture, each partner bears losses proportional to their capital contribution in the joint venture.
6. Changes in partnership. Generally, partnership is a permissible and non-binding contract. As such, any partner may decide to leave the partnership if they so wish, but this needs to happen with the knowledge of the other partner or partners so that the partnership and the interest of the other partners is not harmed. Some scholars' opinion is that the Musharaka joint-venture contract is binding till the project agreed upon at the start of the contract is completed or if the venture is liquidated with the agreement of all partners. If any partner wishes to exchange or sell their share in the partnership to a partner within the Musharaka or to a new partner, the value of the share should not be based on the original capital contribution but be based on the fair value of the share at the time of sale. Moreover, any new partner can be introduced with the agreement of all other partners.
7. Termination. The Musharaka contract comes to an end either after completion of the prescribed project or if liquidation is executed, and this happens either if the project is declared bankrupt or if all partners wish to end the venture. At the termination of the Musharaka venture, a final profit and loss account is prepared and any amount held in the special reserve account is added to it. After paying off all creditors, the remaining balance is distributed amongst the partners pro-rata to their original capital contribution.

PROBLEMS RELATED TO MUSHARAKA

As discussed earlier, Musharaka is one of the purest forms of Islamic finance products but not easy to implement in Islamic banks. As such, in the initial years of Islamic banking Musharaka was rarely used by the banks. Though Musharaka is a simple partnership, with two or more parties contributing capital to a joint venture, developing it into a banking product is not easy since banks prefer to be involved in any kind of ownership, as in the case of a Musharaka, for only a temporary period. Moreover, the client partner has more information on the business than the bank, leading to asymmetric information and high moral hazard. Finally, the ownership role of the bank leads to the risk of bearing losses.

Other specific problems related to the product as discussed in Kettel (2011) are as follows.

Confidence of depositors. There is a risk that the managing partner in the Musharaka venture, in the event of loss of the venture, would pass the loss to the financing bank which usually has contributed the largest share of the capital. Any loss suffered by the Islamic bank would then pass on to its depositors. As such, depositors would be apprehensive about placing their funds with a bank that is involved in equity participation in products like Musharaka.

To avoid or reduce this problem, Islamic banks apply stringent due diligence by evaluating the business feasibility as well as the skills and character of the client in all Musharaka ventures they finance. Moreover, the Islamic banks do not finance just the one Musharaka but participate in a diversified portfolio of them, and it is unlikely that all or most of them will suffer a loss. Much more likely is that only a few of the Musharaka projects will suffer a loss. On the other hand, if the successful ventures make high profits as equity participants then the Islamic banks can benefit from this, unlike a conventional bank that only earns fixed interest no matter how much profit is made by the project it financed. As such, a well-chosen Musharaka project portfolio could yield higher returns than fixed interest.

Dishonesty of client. Another risk to the Islamic bank is that the managing partner of the Musharaka venture may not be honest in sharing business information and may ‘cook the books’ and falsely claim that the business has suffered a loss to deprive the Islamic bank of its profit, or may even claim such high losses that the original capital of the bank could be at risk.

To avoid or reduce this risk, Islamic banks need to efficiently monitor and audit all Musharaka ventures they contribute capital to, to prevent any misinformation or hiding of relevant information by clients. Moreover, the original Musharaka contracts should have measures built in that provide clear penalties and guarantees or security against any losses arising from negligence, misconduct or dishonesty of the client. Another protective measure Islamic banks can take is to provide Musharaka financing only to selective clients, especially those with whom the bank has a long-term relationship and whose integrity is beyond doubt. Finally, the Islamic bank may participate in Musharaka ventures in specific sectors only, which are easier to monitor and audit and which provide the client with less room for dishonesty. Export financing can be one such sector; since the exporter gets a specific order from abroad, specifying the final prices, costs are easy to determine, payments are secured by a letter of credit and made through the involved bank itself.

Secrecy of the business. Another risk related to Musharaka is from the perspective of the client. When the Islamic bank becomes a partner with the client in a joint venture, some business secrets of the client may have to be disclosed to the bank and sometimes from the bank to the investors whose funds the bank is applying. Such confidential business information may then reach the competitors and adversely affect the joint venture. To avoid this the client may introduce conditions to provide only necessary business secrets to the bank. Such information should be dealt with in the utmost confidence and not shared unnecessarily with investors or anyone else without the client's permission. Moreover, the bank should not interfere in the management of the venture and only a limited number of bank staff would be involved with the project, signing a confidentiality clause.

PRACTICAL USES OF MUSHARAKA

Despite the challenges and risks involved for an Islamic bank when it participates in the equity of its clients' ventures in Musharaka financing, this product is true to the principles of Islamic finance. In the early years of the development of modern Islamic banking very few Islamic banks applied Musharaka financing in their activities. In recent years, the Islamic banks globally are innovating in the area of Musharaka financing and using the product for various retail and business financing needs. Some of the common uses of Musharaka financing today are discussed below.

Working capital finance. The process of providing working capital finance by Islamic banks to their business customers using the Musharaka contract is similar to the working capital financing of conventional banks. Both types of bank deposit the agreed working capital funds into the client's account with the bank. The client uses the funds as and when needed. Conventional banks charge the amount with a predetermined interest rate, while Islamic banks charge the amount with a predetermined profit rate, based on the profit the client is expected to make and the pre-agreed profit ratio for the Musharaka financing, and this profit rate is subject to change (usually quarterly).

At the completion of the financial year, the actual profits earned by the client are calculated and the bank's share as per the pre-agreed ratio is calculated. If the amount already collected by the Islamic bank is less than the amount due to it, the client pays the difference into a special reserve account of the bank. On the other hand, if the amount taken by the Islamic bank is more, then the bank refunds the requisite amount into the client's account. If the client's business incurs a loss, the special reserve account is reduced by the amount of the loss. In case the reserve account amount is not sufficient to compensate for the loss, the bank would return part or all of the profit it had already collected during the year.

Domestic trade. Islamic banks finance domestic trade activities using the Musharaka contract. The bank enters into the Musharaka partnership agreement with the client for the purchase and sale of local goods whose specifications are provided by the client. The total cost of the goods purchased for domestic trade is divided between the client and the bank to contribute as capital. A special Musharaka account is opened at the bank into which the funds are deposited. After the goods are sold, each party receives their share of the profit as per a pre-agreed ratio; and if there is any loss, each partner bears the loss in proportion to their capital contribution.

Import finance. Islamic banks also finance imports using the Musharaka contract. Once the total cost of an import agreement is calculated, the bank provides part of the capital required to finance the import agreement. The cost of the import transaction is designated in the appropriate foreign currency.

The bank also opens a special Musharaka account and opens a letter of credit in favour of the importer or client. It is the responsibility of the Islamic bank to pay the exporter in full after receiving the shipment documents. The client or importer is responsible for arranging the import and the clearance and sale of goods. Once all operational costs (including shipment, insurance, etc.) are deducted from the sales revenue, the remaining profit is shared between the importer and the Islamic bank in the pre-agreed proportion. If any loss was incurred in the import contract, the loss would be shared between the importer and the bank according to the capital contributed by them.

Letters of credit. Musharaka is also used by Islamic banks to provide letter of credit facilities for trade finance. The process involves the customer informing the bank of their need for an L/C. Next, the terms of the Musharaka are negotiated. The customer's share of the capital contribution (which is part of the cost of goods to be imported) is deposited with the bank, based on the Wadia principle – that is, as keeper and trustee of the funds. The Islamic bank adds its own contribution of capital to the funds, issues the L/C and pays the proceeds to the negotiating bank and then provides the customer with the relevant documents. The customer uses the documents to release the goods and sells or disposes of them according to the Musharaka agreement. The profit earned from the transaction is divided between the bank and the customer as per a pre-agreed ratio. If any loss is incurred it would be borne by the partners pro-rata to their capital contribution.

Credit facilities. Islamic banks provide contingency financing for corporate customers as well as small and medium enterprises, for a variety of purposes and for different maturities using the Musharaka joint-venture contract. The client can use the Musharaka credit facility for working capital, or to purchase goods or equipment or other fixed assets. Each customer is assigned a certain credit line as a single or multiple Musharaka contract for various purposes and to be used once. Musharaka can also be designed as revolving credit, where it is used more than once during the period of the facility and could be renewed in the future.

Agriculture finance. Musharaka financing is progressively being used in agriculture financing around the world by Islamic banks. Under this scheme, the bank and the farmer become partners in a Musharaka joint venture. The bank contributes agricultural fixed assets to the venture (such as sprayers, ploughs, tractors, irrigation pumps, etc.) and may also contribute working capital in the form of seeds, pesticides, fertilizers, fuel, etc. The farmer's contribution to the venture would usually be land, actual labour, skills and management. The profits of the agricultural project are shared between the farmer and the bank according to the ratio agreed between them at the onset of the contract, while any loss would be shared proportional to the value of the capital contributed.

Diminishing Musharaka. Diminishing Musharaka is a special application of the Musharaka contract. In this type of Musharaka the bank or financier and the client contribute capital for the joint ownership of a property, which could be retail or commercial real estate, or could be equipment or a commercial enterprise. At the beginning of the contract the contribution of the bank is divided into equal units, and it is agreed that the client would purchase the units of the bank periodically. The number of units to be purchased at each period and the interval between any two periods are commonly the same, but the client and the bank could negotiate for intervals as well as units purchased to vary to match the ability and convenience of the client. Resultant to this process, at each interval the percentage ownership of the bank will decrease and that of the client will increase until finally the client purchases all units owned by the bank and becomes the sole owner of the property, equipment or enterprise. Diminishing Musharaka and its application to various financial needs of both retail and business clients of the bank is growing significantly.

COMPARISON OF MUSHARAKA WITH INTEREST-BASED FINANCING

The difference between Musharaka and an interest-based loan lies, to a significant extent, in the manner in which the two products are designed and operated and the products' relationship with the depositors and borrowers. The differences between the two instruments are highlighted in Table 6.3.

COMPARISON OF MUSHARAKA WITH MUDARABA FINANCING

Table 6.4 highlights the differences between Musharaka and Mudaraba financing.

KEY TERMS AND CONCEPTS

• Constant or permanent Musharaka
• Inan
• Mufawada
• Musharaka
• Musharaka Al Milk
• Musharaka Mutanaqisa, Musharaka Muntahiya Bittamleek or diminishing Musharaka
• Temporary Musharaka
• Wujuh

CHAPTER SUMMARY

Musharaka is a partnership of two or more parties based on mutual trust and is one of the equity-based products in Islamic finance. From the Shariah perspective it is one of the purest Islamic finance products. In modern Islamic banking various Musharaka contracts – Mufawada, Inan, constant and temporary – are used. Wujuh, Musharaka al Milk and diminishing Musharaka are other special types of Musharaka contracts.

Special Shariah compliance and general rules related to Musharaka involve the types of ventures and partners permissible, the contribution of capital and management of labour, the sharing of profit and loss, the guarantees of the partners, changes in the partnership and termination of the contract. Musharaka contracts are highly recommended by the Shariah but suffer from asymmetric information and moral hazard, as well as issues of depositor confidence due to risks, dishonesty of the client and lack of control over business secrets.

The major uses of Musharaka contracts by Islamic banks are in the areas of working capital, domestic trade, import finance, credit facilities for small and medium enterprises, agricultural finance and other financing of assets for both retail and corporate customers, especially using diminishing Musharaka. Musharaka contracts can raise finance through the mechanism of securitization.

Musharaka contracts differ from interest-based financing in the areas of profit versus interest payments, loss sharing, yield of the venture and the roles of security and guarantee. Mudaraba and Musharaka contracts differ in the sources of financing, partners' role in management, the preferred period of the venture, sharing of profit and loss, liabilities and ownership of assets by the partners.

END OF CHAPTER QUESTIONS AND ACTIVITIES