SHIRKAH & ITS VARIANTS

SHIRKAH

SHIRKAH & ITS VARIANTS LECTURE By Dr. Syed Zulfiqar Ali Shah SHIRKAH

Summary of Last Lecture The Concept & Rules of Mudarabah Mudarabah Distinguished From Musharakah Modern Corporations: Joint Stock Companies SHIRKAH

Layout Modern Application of the Concept of Shirkah Diminishing Musharakah Diminishing Musharakah as an Islamic Mode of Finance Summary & Conclusion SHIRKAH

MODERN APPLICATION OF THE CONCEPT OF SHIRKAH SHIRKAH

Modern Application of The Concept of Shirkah Keeping in mind the broad principles and the concept of Shirkah, Musharakah and Mudarabah can be used for evolving a new system, both on the liabilities and assets sides of the financial system, that conforms to the requirements of Shar¯ı´ah and also fulfils the needs of trade and business. It may take the form of corporate firms, mutual funds, Mudarabah companies, individual or multi-investment portfolios by fund managers, business participation certificates, Musharakah agreements, project financing, running Musharakah and partnership businesses, certificates of investment or Diminishing Musharakah for facilitating financing fixed assets, trade and services. A combination of Shirkatulamwal and Shirkatula‘mal can be used for service firms of the modern age in medicine, law, IT, architecture and other fields. Use of Shirkah on the Deposits Side of the Banking System: According to the Shar¯ı´ah principles, whatever is permissible for an individual is also permissible for a group of people. Based on this principle, Shirkah, which conventionally was an individual contract SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) carried out by an owner of funds with a Mudarib, has now become a group activity. The main relationship between depositors and Islamic banks is that of financiers and Mudaribs. All deposits are pooled, the bank invests the pooled amount in business, all direct expenses are charged to the pool while expenses related to the general management or Head Office expenses are borne by the bank (Mudarib) itself, and the net proceeds are distributed among depositors according to the stipulated ratios. Different weightages can be assigned to different depositors depending upon their tenure and size, subject to the condition of sufficient disclosure to all depositors. For the purpose of profit distribution among partners, there is constructive liquidation after a tenure or accounting period and then the joint relationship starts afresh for the next accounting period. SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) 2. Use of Shirkah on the Assets Side: The best alternative to interest for financing by banks is considered to be a Shirkah arrangement that could be in the form of Mudarabah, Musharakah or investments through Shirkah based certificates or Sukuk. Mudarabah can be best used for financing of import trade on a single transaction or consignment basis in the case of a firm order and L/C without margin, where the whole investment has to be made by the bank. Its use is also possible for running businesses, project financing and for the purpose of securitization. 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. A bank may enter into a Musharakah arrangement with a client who intends to SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) 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 ratio. The above procedure can also be adopted in respect of bills drawn under inland L/Cs. SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) The following may be the flow of transactions in the case of Musharakah for running business: A running Musharakah Account for the client will be opened in the books of the financing bank. The client’s proceeds from the sale of finished of goods will be credited in the Running Musharakah Account. The client’s 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 finance availed for the project) cannot be credited in the Running Musharakah Account. For determination of the period of running Musharakah limit, all the SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) clients of the bank will be divided into the following three categories: seasonal, cyclical and continued operation. At the end of each quarter or month, as the case may be, the profit earned by the client in the Musharakah will be paid to the bank. The profit-sharing will be based on the computed operating profit for the same period for which the running Musharakah limit was awarded. Shirkah can also be used for financing through the purchase of Musharakah/Mudarabah certificates like Shirkah-based Sukuk, term finance certificates (TFCs) or participation term certificates (PTCs). Certificates issued on the principle of Shirkah 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 SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) case of TFCs/PTCs than in the case of direct Musharakah investments. However, banks indicate a number of risks and problems in the case of Shirkah-based financing. For example, the managing partner may manipulate the financial reporting in order to deceive the Islamic bank. They may be unwilling to disclose actual profits to the bank, exposing it to the risk of return on its investment. Guarantee/collateral can be taken only to safeguard against negligence and misconduct. The partners may allocate indirect and personal expenses in Musharakah operations. Legal capacity and financial stability of the guarantors have to be independent from the Musharakah contract. The Islamic bank, as the buying partner in a Diminishing Musharakah, may be exposed to fluctuations in unit price if it is not fixed at the beginning of the contract. The main obstacles in the way of widespread use of Musharakah stem from the lack of documentation, defective taxation systems and the lack of effort on the part of the bankers themselves. In the view of this author, Islamic banks have not made serious efforts to apply this system SHIRKAH

Modern Application of The Concept of Shirkah (Cont’d) simply because of the easy and less risky alternatives based on Murabaha and leasing. Musharakah could have been safely applied at least for trading and project financing if they had undertaken some research and taken initiatives to realize the potential of this most preferable mode of Islamic finance. In the following pages we shall give some case studies in this regard. 3. Securitization on a Shirkah Basis: A security, in financial terms, can be defined as an asset in the form of a paper whose cash flow is backed by a pool of liquid and tangible assets. Through securitization, tangible or nonliquid assts of joint business are made negotiable through the sale of shares/certificates in the financial market. SHIRKAH

DIMINISHING MUSHARAKAH SHIRKAH

Diminishing Musharakah The participatory contracts that may be more suitable for financing of fixed assets and present-day ongoing projects, particularly for financial intermediaries, can be based on the concept of “Diminishing Musharakah” (DM). In the Diminishing Musharakah contract, a party, after participation in ownership of any business/project, can liquidate his investment from the asset or the ongoing business. The jurists are unanimous on the permissibility of this arrangement. DM contracts contain a sale provision, according to which, one partner makes a promise to sell his part of ownership to the other party periodically. As discussed earlier, jurists have opined that promises are enforceable, and a court of law can compel a promisor to fulfil his promise, especially in the context of commercial activities. Diminishing Musharakah as a financing technique, however, is a new type of contract, suggested by contemporary jurists keeping in mind the problems perceived while discussing the traditional Musharakah/ Mudarabah principles in the broader economic perspective. SHIRKAH

Diminishing Musharakah (Cont’d) Diminishing Musharakah can be conducted both in respect of partnership in ownership (Shirkatulmilk) and contractual partnership (Shirkatul‘aqd). But some crucial differences between the two have to be taken into consideration to ensure Shar¯ı´ah compliance: SHIRKAH

Diminishing Musharakah (Cont’d) In Diminishing Musharakah through contractual partnership, the ratio of profit distribution for each partner should be clearly determined, this may be disproportionate to the ratio of equity of both parties. This ratio can be changed with mutual agreement due to a change in the ratio of equity share of the parties. A loss would necessarily be allocated in accordance with the ratio of equity at the time when the loss is incurred. No partner can be given a lump sum amount out of the profits. As regards partnership by ownership, the major objective of its forming is not profit earning through business; therefore, the ratio of profit distribution need not be stipulated in this arrangement. Each partner will own both risk and reward proportionate to his share. As one partner can lease his part to the co-partner, he can get rental on the leased part. The lessee, who is owner of a part of the asset, will get the reward of his part by using the asset without paying any rent. As the lessee partner goes on purchasing the share of the financier SHIRKAH

Diminishing Musharakah (Cont’d) partner, the rental goes on decreasing. Both parties will bear ownership-related expenses/liabilities and losses, if any in the case of sale, on a pro rata basis. 2. In Diminishing Musharakah through partnership by contract, the lessee partner can promise to buy periodically the share of the financier partner according to the market value or at a price to be agreed at the time of sale of units of the asset. It is not permitted to stipulate that the ownership units will be bought at a pre-agreed price or at their original or fair value, as this would constitute a guarantee of share capital of one partner by the other partner, which is prohibited by the Shar¯ı´ah. In Diminishing Musharakah through partnership by ownership, one partner can purchase ownership units of the co-partner at a pre-agreed price. This is a crucial difference between the two, particularly in respect of Shar¯ı´ah compliance of the procedure and the payment of price for transfer of ownership from the Islamic SHIRKAH

Diminishing Musharakah (Cont’d) financial institutions to their clients. The IFIs that provide housing finance on the basis of DM in Shirkatulmilk generally take promise from the clients that they will purchase the banks’ units of shares at pre-agreed prices, and this is permissible as per Shar¯ı´ah rules. Diminishing Musharakah in trade is conducted for the purpose of profit-earning; therefore, the price of units of the financial institution cannot be fixed in the promise to purchase by the other partner (client) because it would practically mean that the client has guaranteed the principal invested by the financier with or without profit. Therefore, the financial institution either has to agree to sell the units of his ownership on the basis of valuation at the time of the sale of each unit, or allow the client to sell these units to anybody else at whatever price he can, but at the same time it would offer a specific price to the client, meaning thereby that if he finds a purchaser of that unit at a higher price, he may sell it to him, but if he wants to sell it to the financier, the latter will be agreeable SHIRKAH

Diminishing Musharakah (Cont’d) to purchase it at the price fixed by him beforehand. However, this does not seem to be feasible as it does not serve the purpose of decreasing the equity in any business, as required under a Diminishing Musharakah arrangement. Therefore, Diminishing Musharakah is feasible only in respect of fixed or other assets that can be leased or given for use to the other partner. SHIRKAH

DIMINISHING MUSHARAKAH AS AN ISLAMIC MODE OF FINANCE SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance 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. In the case of housing finance, for example, a joint ownership is created for the purpose of Diminishing Musharakah. The financier partner gives his undivided share on lease to the partner using the house. The client gives rent on the part of the financier and periodically purchases the units of the partner’s ownership. The modus operandi approved by Shar¯ı´ah scholars is that three contracts are entered into separately, ensuring that each contract is independent of the other two contracts. The sequencing of contracts should be: A contract between partners to create a joint ownership. The client partner makes a promise, before or after the lease agreement is finalized, to purchase the share of the financier partner. SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance (Cont’d) The financing partner gives units of his share to the client on lease. The client partner goes on purchasing the units of ownership of the financing partner as per his promise. Accordingly, the rent goes on decreasing. 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 the case of house financing and financing the purchase of plant and machinery. Assets of a commercial nature would not involve leasing. Diminishing 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 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 SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance (Cont’d) into for profit-earning by the partners and also does not involve leasing, like the case of a house ora vehicle, the price 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 partner in DM for trade has an inherent motivation to acquire full ownership by purchasing shares from the financier, the Shar¯ı´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 the IRTI, the sale provision of the contract can be made binding only on the financier 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 SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance (Cont’d) 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 purchases 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 actual sale. The entrepreneur partner may voluntarily buy the share of the financier at the prices prevailing at the time of sale in the stock market or at a price determined with the free consent of the parties. 2. Procedure and Documentation in Diminishing Musharakah: The following is the sequence of documentation in a typical Diminishing Musharakah arrangement, as being used by Islamic financial institutions for housing finance business on the basis of partnership by ownership: Creation of joint ownership through a Musharakah agreement; the customer and the IFI become co-owners in a joint property. If legal SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance (Cont’d) title to the property is already with the customer, there can be an agreement to the effect that the IFI will acquire a certain share in the Musha‘a property and this would involve a sale and lease-back arrangement. Rent agreement. Both parties agree that the IFI will lease its undivided share to the client partner against a stipulated rental to be governed under the rules of Ijarah. This agreement is signed after the Musharakah agreement. It contains details about rent, the formula of its calculation and a schedule for the period of lease. Undertaking to purchase units of the bank’s share in the joint property. This is a unilateral promise binding on the promisor only. Either the client or the bank can make this promise. If the arrangement is based on Shirkatulmilk, it may contain a price schedule at which the client has to purchase the units from time to time. It also gives details about the situation if the client wants at any time, to purchase more shares than provided in the mutually SHIRKAH

Diminishing Musharakah as an Islamic Mode of Finance (Cont’d) agreed schedule. The arrangement also contains details about the nature of security/guarantee to be provided by the client. Normally it is the equitable mortgage of the financed property. The bank may require additional security to secure its interest, particularly in view of the financial position of the client. Thus, the customer pays rent for the use of the bank’s share in the property and goes on purchasing a part of the bank’s share periodically until the ownership of the asset is transferred to him. The facility can be provided for buying a house, building a house, renovation of a house and for replacing interest-based housing loans with a Shar¯ı´ah-compliant arrangement (balance transfer facility). Other fixed assets can also be financed through Diminishing Musharakah. SHIRKAH

SUMMARY & CONCLUSION SHIRKAH

Summary & Conclusion We may summarize the basic principles of Shirkah in the following way: Of the various kinds of Shirkah used in the books of Islamic jurisprudence, Shirkah al ‘Inan is of more relevance to partnership business by banks and financial institutions. There is a consensus of the jurists that Shirkah is not only a legitimate contract in Islam but is also preferable over the modes based on trade and leasing. The term “Musharakah” introduced by contemporary Shar¯ı´ah scholars also means joint commercial enterprise doing any economic activity by joint funds. Capital to be invested by the partners can be unequal and should preferably be in the nature of any prevalent currency. If it is in the shape of commodities, the market value should be determined with mutual consent to determine the share of each partner for sharing the profit or bearing the loss, if any. It may also be in the form of equal units representing currency, called shares in the case of perpetual Musharakah and certificates or Sukuk in the case of a SHIRKAH

Summary & Conclusion (Cont’d) redeemable partnership. The shares/Sukuk are negotiable and a shareholder can sell his shares to anyone in the market. Obtaining formal consent about the entry or exit of members into limited companies is not compulsory from an Islamic point of view. Power of appropriation in the property and participation in the affairs of the Musharakah may be disproportionate to the capital invested by the partners. In Musharakah (and also in Mudarabah), the ratio of profit distribution may differ from the ratio of investment, but the loss must be divided exactly in accordance with the ratio of capital invested by each of the partners. It is not allowed to fix a lump sum amount of profit for any of the partners, or any rate of profit tied up with his investment. Scholars have approved the concept of “projected profit”, but this is subject to final settlement at the end of the term, meaning that any SHIRKAH

Summary & Conclusion (Cont’d) any amount so drawn by any partner shall be treated as an “on-account payment” and will be adjusted to the actual profit he may deserve at the end of the term. If all the partners agree to work for the joint venture, each one of them shall be treated as an agent of the other in all the matters of the business and any work done by one of them in the normal course of business shall be deemed to be authorized by all the partners. The partners may agree upon a condition that the management shall be carried out by one of them, and no other partner shall work for the Musharakah. In this case, the ratio of profit allocated to a sleeping partner shall not exceed the ratio of his investment. In the case of running Shirkah business, the concept of “daily product” can be used for determining the share of each partner in the profit accrued. SHIRKAH

Summary & Conclusion (Cont’d) Musharakah or Mudarabah should never mean the advancing of money to get an ex ante return. It means participation in the business and sharing the actual results in the form of both profit and loss, subject to certain conditions. A financier on the basis of Shirkah must share the loss incurred by the business to the extent of his financing. The loss suffered by each partner must be exactly in the proportion of his investment. The basis of profit-sharing has to be defined beforehand without any pre-emptive right to any of the parties. Mudarabah is an essential mode for the establishment and operation of Islamic financial institutions. It serves as a basis of business to be conducted by combining funds and the expertise of different groups of people. For the assets side, however, Mudarabah is considered to be a very high-risk financing activity, mainly due to the moral hazard, adverse SHIRKAH

Summary & Conclusion (Cont’d) selection and lack of banks’ expertise in project evaluation and related technical matters. Islamic banks may use Mudarabah, albeit with proper care and risk management, to finance the business of those who are capable to work, whether they are professionals like physicians or engineers or traders and craftsmen. It can also be used without much risk of loss in foreign trade financing. Musharakah can be used for foreign and inland trade financing, project financing directly or through securitization. Mudarabah Sukuk can be issued to mobilize funds and strengthen trading and industrial activities. Asset management companies can manage such funds for conducting business for their benefit, and also that of the Sukuk holders. This could generate higher rates of return for the investors relative to the return realizable on any interest-based investment. In the case of big projects, the IFIs may form a consortium to issue certificates to the public for subscription. SHIRKAH

Summary & Conclusion (Cont’d) SHIRKAH

Summary of Today’s Lecture Modern Application of the Concept of Shirkah Diminishing Musharakah Diminishing Musharakah as an Islamic Mode of Finance Summary & Conclusion SHIRKAH

Thank You…. SHIRKAH

SHIRKAH & ITS VARIANTS