Mudharabah Transactions

Mudarabah, the most-widely known Islamic contract, is a profit sharing contract in which one party (the Rab al Maal) provides funds and the other (the managing trustee, the Mudarib or Ameel) management expertise. This contract is believed to come from the Arabic word darb, which means walking and traveling on the earth. (The Mudhrabah is sometimes known as Qirad).

While the literature extends this contract to include investment and launching a project, we confine ourselves here to trade activities. Profits are shared between the Rab al Maal and the Mudarib in a proportion agreed in advance. Losses, if any, are the liability of the former, and the latter loses his share in the expected profits. If, however, the Mudarib is proven to be guilty of willful negligence, fraud, or a breach of trust in handling the funds, he/she is totally responsible for the losses. Funds are to be used for Islamically permitted activities and, according to Khan:

The Rab-al-Maal has the option to restrict the Mudarib to a specific purpose, period, level of risk, and so on … The Mudarib is not allowed to buy or sell Mudarabah assets against or for his own possessions. The profit can be used again in another trade, but only after paying the share of the Mudarib in the profit. (Khan 2000:27)

Other characteristics of the Mudarabah contract are set out below:

1. Mudarabah is an optional contract, giving either of the parties the right to revoke the agreement unless a condition to the contrary has been included in the agreement;
2. It is a short-term contract of up to a maximum of one year and solely for the expansion of commercial activities. The Mudarib is either a real person or a legal entity;
3. Unlike the Principal-Agent theory, the roles of the Rab al Maal and the Mudarib are completely separate; and in this respect, the owner should only supply the capital and under no circumstances accept the responsibilities of the managing trustee, thus ruling out the possibility of Islamic banks acting as the Mudarib. Even if, at the signing of the contract, the Mudarib accepts responsibility for 8 some of the costs, this does not constitute playing the role of the owner of the funds.
4. The capital must definitely be in ready cash supplied in a lump sum or in parts, which means that a Mudarabah in profits and dues is not correct;
5. Except for those stipulated in the agreement, no other costs can be defrayed from the capital, and any such incidental costs are to borne by the Mudarib;
6. The responsibility of the Mudarib in safeguarding the Mudarabah capital is that of the trustee agent. Otherwise, the Mudarib cannot be held responsible for the safety of the capital or for damages suffered in the course of trading, except if it has been clearly stipulated in the agreement that the Mudarib will pass the ownership of his own property to the owner up to the extent of the damage or loss.

The Mudarabah contract has another characteristic that is peculiar to real persons. It is composed of three different contracts; namely: safe-depositary (Amanah); Trustee agency (Wakalah); and Partnership (Musharakah). The importance of each becomes evident if the Mudarib happens to die in the course of trading. If (s)he dies before the purchase is made, then the total capital is owned by the Rab al Maal. If s(he) dies after purchase of the goods, but before selling, the Mudarib is treated as the trustee agent and all costs incurred in the course of buying are the responsibility of the owner of the funds. Finally, if the Mudarib dies before selling the goods, but before reporting to the Rab al Maal, then (s)he has all the rights as if (s)he were alive and is considered to be a partner and his/her share is to be paid according to the conditions agreed at the outset. The capital of the Mudarabah contract should include one or more of the following: purchase price; packing; transportation, and forwarding costs; insurance and registration of orders; warehousing; bank costs; customs levies and commercial tax; and any other foreseeable costs. The payment of other costs not provided for in the contract is the responsibility of the Mudarib who, by signing a letter of understanding, accepts this responsibility against receipt of a compensation fee.

Source: Prof. Iraj Toutounchian, Thoughts from Iraj Toutounchian’s Islamic Money & Banking: Narrated by Camille Paldi. Republished with permission.