Investment-based contracts in Islamic finance: an overview

In-Depth Analysis

After completing an exhaustive discussion on sale-based contracts in Islamic finance — Murabahah, Salam, Istisnaa, and Ijarah — the author now turns to investment-based contracts, beginning with Mudarabah. The fundamental difference between sale-based and investment-based contracts is that in a sale-based contract the seller can ascertain the profit or loss at the time of concluding the transaction, whereas in an investment-based contract the parties must wait over a period of time for the outcome of the investment. Only time will tell whether the new venture will yield a positive or negative outcome. The author recounts an incident where a renowned Shariah scholar was trying to explain a Sukuk Mudarabah transaction to a conventional corporate finance lawyer of Western origin. The lawyer exhibited utter frustration in understanding the Mudarabah concept despite the scholar's explanation. The scholar resorted to an analogy that made the audience laugh: God bestowed a lot of financial wealth to some people and intellectual wealth to others. A person with financial wealth may lack the intellectual wealth and not know how to make money work, while a person with intellectual wealth may have brilliant business ideas but lack the finance to realize them. Mudarabah bridges this gap. Mudarabah can be defined as an investment contract between an investor (Rab Al Maal) and an entrepreneur (Mudarib — also known as Amil or Musaarib) joining hands, with both parties having legal capacity or perfect capability meaning they are adults and of same mind. The Mudarib invites the Rab Al Maal to invest capital in a proposed business, project, or transaction to be managed by the Mudarib. Such an invitation could be verbal or written; however, Shariah principles prefer that it should be in writing. The Mudarib submits a business plan or feasibility study to a potential Rab Al Maal where it exhibits the expertise it holds, the required amount of the Mudarabah capital, the time period for which the capital needs to remain invested, the profit expected to be generated, and the ratio of profit distribution between the Rab Al Maal and the Mudarib. It is also referred to as Qirad or Muamalat in Shariah terms. It is also possible that the Rab Al Maal, looking for profitable investment avenues, approaches the Mudarib, asking it to accept being appointed as the Mudarib for the Rab Al Maal, and to invest the capital for and on behalf of the Rab Al Maal. Both approaches are acceptable from the Shariah perspective. The article notes that Halal affluence — the purest form of fortune or highest type of Halal wealth — can be inherited, and the biggest challenge for inheritors is how to preserve or protect their newly found wealth and make it grow. This is precisely where the Mudarabah structure becomes relevant.