Profit Sharing – Mudarabah (Islamic Finance)
In Part I of our Islamic finance series, we will provide an overview of the profit-sharing arrangement known as mudarabah, the structure of such an arrangement and some key legal considerations that all parties must consider when engaging in such a transaction.
A mudarabah agreement has elements of a wakala and musharaka agreement (which are discussed during the later parts of the series). Essentially it is an agreement between two partners where one partner contributes capital to invest in some form of commercial enterprise, while another partner provides the expertise and management experience. The capital contributor is known as the ‘rabb-ul-mal’ while the managing partner is known as the ‘mudarib’.
Types of Mudarabah
A mudarabah can be classified into two types, a restricted mudarabah and an unrestricted mudarabah.
- Restricted mudarabah: an agreement where the investing partner specifies a particular enterprise for the managing partner of the agreement to invest the investing partner’s capital into.
- Unrestricted mudarabah: an agreement where the investing partner acts as a silent partner and the managing partner undertakes to invest the capital contribution into a business he or she chooses. The managing partner has full freedom to manage the investment apart from being able to:
- Use the capital in a venture with another partner; and
- Mix the investment in that particular mudarabah without the consent of the investor.
The profit ratios are agreed at the outset of the agreement and the investing partner usually receives the majority of the profits earned. The managing partner will receive the remaining profit share and may be entitled, depending on what is agreed, to a performance fee for providing the expertise and management skills if the profit generated exceeds projections. This performance fee would be calculated at the end of the mudarabah and upon liquidation of the mudarabah enterprise.
Upon liquidation of the mudaraba enterprise, the managing partner would buy the mudaraba interests from the investing partner at market value so that proceeds can be directed towards the investing partner. The Mudarib or managing partner will keep a profit share according to the agreed ratio.
The flow chart below is an example of a typical mudaraba structure:
Overview of structure
(1) The investing partner creates a special purpose vehicle and issues a sukuk (an Islamic bond), which is subscribed by investors for cash consideration.
(2) The investing partner enters into a mudarabah agreement with the managing partner to form a mudarabah enterprise with the purpose of generating profits on the principal amount.
(3) The investing partner contributes capital.
(4) The managing partner contributes management skill and experience.
(5) The investing partner takes a pre-agreed ratio of the profits, which are accrued until the end of the mudarabah;
(6) The managing partner takes the remaining profits which are accrued until the end of the mudarabah and potentially a performance fee;
(7) The investing partner can make periodic profit payments to the investors.
Key legal considerations
Set out below are some issues that need to be considered when entering into a mudarabah agreement:
- At least 33% of the mudarabah enterprise must comprise of tangible assets and all assets must be Shari’ah compliant;
- The underlying agreement should stipulate that the mudarib performs its obligations as managing partner with the same skill and care it would exercise in respect of its own assets;
- The profits are divided according to the agreed ratios but are accrued until the dissolution of the mudarabah enterprise. In the interim, investors may receive periodic profit payments which would be considered a constructive liquidation;
- Any losses of the mudarabah enterprise would be borne by the investing partner, limited to the capital investment, so investors would not be liable for more than what is invested;
- The risk of passing any losses of the mudarabah enterprise to investors may be mitigated through a purchase undertaking. The mudarib can undertake to purchase the mudarabah interests from the investing partner if proceeds from the enterprise are insufficient to pay the investors.
In continuation of Islamic Finance series, the Saracens commercial team will also be discussing the joint venture, Shari’ah loan and agency facilities in later segments.
Feel free to telephone our London office on +44 (0) 20 3588 3500 to speak directly to one of our lawyers on your investment needs.
Have you ever used a mudarabah arrangement? We would love to hear about your experience. Please leave a comment or any questions in the section below.