Mudarabah is a sort of partnership. Both parties participate in the profit that is going to be generated by the financed activity. The parties are free to agree on the ratio of profit distribution (70% - 30% or 50% - 50% or any other). However, unless they agree at the initiation of the contract, the latter is, from Shari’ah point of view, void. Furthermore, it is a Shari’ah requirement in mudarabah that all of the capital has to be paid at the signing of the contract. It is not allowed to pay it later or on installments basis. Rub-ul-mal can impose any (reasonable) instructions and conditions on the agent, if they are acceptable to the latter they become part of that contract. Once operation starts, the financier has no right to interfere in the day to day business. If an agent fails to follow the instructions and satisfy the conditions, then he is liable for loss of capital. The mudarib doesn't guarantee capital nor profit to the financier. Rather he or promises good conduct honesty. This is the source of moral hazard and adverse selection in mudarabah.
Profits are any amount in excess of capital. It is therefore imperative to liquidate the Mudarabah before declaring any profit. In recent years, many Shari’ah scholars have accepted what is called constructive liquidation constructive liquidation. Simply means that accounting procedures are applied to decide the profit and loss status of the operation. This liquidation process can be done periodically using accounting procedures and based on the outcome profit (loss) can be declared every quarter or year.
The agent in Mudarabah is entitled to nothing but his share of profits. If he (or the financier) receives any income before liquidation, it is always subject to adjustment when financial results are declared. Both parties are required to avoid any conditions in the contract that can fade away the particular nature of the mudarabah being a “company in profit”. For example, if one requested that he gets the first $ 500.00 of profits and the rest is for his partner then the contract is void. This is because it is quite possible that the whole profit will only be $ 500.00.
Before the advent of Islam, Mudarabah was the most common mode of finance in Makkah. The Makkan were the foremost traders in their area of the world in the 7th century, bringing goods from India and Yemen and selling to the Roman Empire. To finance this international commercial project, the majority of the merchants of Makkah presented themselves to the rest of the community as Mudaribs (agents), collecting Monies from men, women...etc. who become financiers.
Contemporary scholars were able to develop the Mudarabah contract to suit modern needs. In Pakistan, for example, a special Mudarabah law has been introduced which allows the floating of negotiable Mudarabah Certificates.
An attempt to introduce a similar scheme was tried in Jordan, and many Islamic banks are trying to go into special Mudarabah finance with major clients, where the problem of moral hazards is less severe.
Risks:
Mudarabah is a high-risk mode of finance. It is so risky that it is almost “Unthinkable” to any banker. This is because the bank advances capital to the client relying completely on his integrity, ability and good management. The bank is not only risking the expected return but also capital itself. This high degree of moral hazard and adverse selection is present in the classical form of Mudarabah. Recently, however, many Islamic banks were able to develop new, albeit Shariah based, forms of Mudarabah with significantly reduced degree of risks.
For example:
(a) Mudarabah is used only with public limited Companies, where a reasonable degree of transparency is possible i.e. audited accounts, and quarterly reported performance...etc.
(b) Securities and guarantees are introduced in the contract, but not against profit or payment of capital. Rather, only against loss due to negligence or mismanagement and delayed repayment of capital and profit after the end of mudarabah.
(c) Only those economic activities where the bank can easily see what the money is being used for can be financed on Mudarabah basis. For example, a car dealer who buys autos from manufacturers and then sells them on installments will be suitable for such mode of finance.
Mudarabah – Distribution of Profit:
It is necessary for the validity of mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. No particular proportion has been prescribed by the Shariah; rather, it has been left to their mutual consent. They can share the profit in equal proportions, and they can also allocate different proportions for the rabb-ul-mal and the mudarib.
However, they cannot allocate a lump sum amount of profit for any party, nor can they determine the share of any party at a specific rate tied up with the capital. For example, if the capital is Rs. 100000/- they cannot agree on a condition that Rs. 10000/- out of the profit shall be the share of the mudarib, nor can they say that 20% of the capital shall be given to rabb-ul-mal. However, they can agree that 40% of the actual profit shall go to the mudarib and 60% to the rabb-ul-mal or vice versa.
It is also allowed that different proportions are agreed in different situations. For example the rabbul-mal can say to mudarib, “If you trade in wheat, you will get 50% of the profit and if you trade in flour, you will have 33% of the profit”. Similarly, he can say “If you do the business in your town, you will be entitled to 30% of the profit, and if you do it in another town, your share will be 50% of the profit.”
Apart from the agreed proportion of the profit, as determined in the above manner, the mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the mudarabah.
All the schools of Islamic Fiqh are unanimous on this point. However, Imam Ahmad has allowed for the mudarib to draw his daily expenses of food only from the mudarabah account.
The Hanafi jurists restrict this right of the mudarib only to a situation when he is on a business trip outside his own city. In this case he can claim his personal expenses, accommodation, food, etc., but he is not entitled to get anything as daily allowances when he is in his own city.
If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder, if any, shall be distributed between the parties according to the agreed ratio.
Termination of Mudarabah:
The contract of mudarabah can be terminated at any time by either of the two parties. The only condition is to give a notice to the other party. If all the assets of the mudarabah are in cash form at the time of termination, and some profit has been earned on the principal amount, it shall be distributed between the parties according to the agreed ratio.
However, if the assets of the mudarabah are not in the cash form, the mudarib shall be given an opportunity to sell and liquidate them, so that the actual profit may be determined.
There is a difference of opinion among the Muslim jurists about the question whether the contract of mudarabah can be effected for a specified period after which it terminates automatically. The Hanafi and Hanbali schools are of the view that the mudarabah can be restricted to a particular term, like one year, six months, etc, after which it will come to an end without a notice.
On the contrary, Shafi’i and Maliki schools are of the opinion that the mudarabah cannot be restricted to a particular time. However, this difference of opinion relates only to the maximum time-limit of the mudarabah. Can a minimum time-limit also be fixed by the parties before which mudarabah cannot be terminated? No express answer to this question is found in the books of Islamic Fiqh, but it appears from the general principles enumerated therein that no such limit can be fixed, and each party is at liberty to terminate the contract whenever he wishes.
This unlimited power of the parties to terminate the mudarabah at their pleasure may create some difficulties in the context of the present circumstances, because most of the commercial enterprises today need time to bring fruits. They also demand constant and complex efforts. Therefore, it may be disastrous to the project, if the rabb-ul-mal terminates the mudarabah right in the beginning of the enterprise. Specially, it may bring a severe set-back to the mudarib who will earn nothing despite all his efforts.
Therefore, if the parties agree, when entering into the mudarabah, that no party shall terminate it during a specified period, except in specified circumstances, it does not seem to violate any principle of Shariah, particularly in the light of the famous hadith, already quoted, which says:
All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful.
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