In this article, we will highlight one of the products in Islamic finance, Musharaka. In a previous article, we have explained the basic principles of Islamic finance. The article can be read here.
Musharaka is one of the most important products used as an alternative to interest-based financing in Islamic finance. The word musharaka comes from the Arabic word shirkah which means to share or to be a partner. According to Islamic law, the parties in musharaka must share both profits and any losses arising from the investment, which may be a house, a commercial building or a company.
Musharaka is an investment partnership that consists of a partnership between two or more investors. The terms for sharing profits and losses are clarified in advance between the parties. The Musharaka partnership can be compared to investors who will be allocated a profit if the investment makes a profit, and correspondingly will lose if the investment does not produce the desired result.
The following presentation will focus on the relationship between a lender, such as a financial institution, and a borrower, referred to as the "client". The terms "the parties" and "the investors" will be used to refer to both the lender and the borrower.
The following conditions must exist for a musharaka collaboration to be established:
Example of financing based on musharaka
Financing when starting a business
The financial institution and the client enter into an agreement on the financing of the enterprise for which the client needs capital. It is agreed how large a share of the profit each of the parties will be entitled to.
Where the financial institution is only to contribute as a capital contributor, and not to provide the company with input beyond the capital, Sharia law does not allow the financial institution to demand a higher share of the profit than its share of the contributed capital would indicate. If the financial institution contributes 50% of the paid-in capital, the institution cannot take more than 50% of any profit from the company.
Financial institutions will normally only take economic rights and not get involved in the company's organizational matters.
If the company makes a loss, the loss will be distributed pro rata between the parties, according to each party's share of the paid-in capital. If the financial institution has contributed 70% of the capital, 70% of the loss must therefore be borne by the financial institution itself, while the remaining 30% must be borne by the other investor (borrower).
Islamic finance is part of a larger financial sector known internationally as "Islamic finance". This financial sector mainly offers financial products within the banking, finance and insurance industries, and the products offered within these industries strive to be in line with Islamic principles.
The distinctive feature of Islamic finance is that its main purpose is to comply with the Islamic prohibition against paying and charging interest in financial transactions, and that the other elements of any transaction comply with Islamic rules, better known as "Sharia".
Particularly in connection with the financial crisis in 2008-2009, there has been an increase in awareness of the Islamic financial sector, and Islamic finance is on the rise in the major financial centers around the world, including Indonesia, Malaysia, Singapore, the Middle East, the UK, France and the USA. Islamic financial institutions are also likely to establish themselves in Norway. Housing finance is the field where the need for Islamic finance is likely to be most prominent once it is offered on a commercial basis in Norway.
Insa advokater has several articles on Islamic finance. This article deals with the basic principles of Islamic finance.
Islamic law is often referred to collectively as sharia. The word sharia comes from the Arabic word for "way". The idea is that sharia sets out the path that people should follow. This is reflected in the fact that sharia regulates every aspect of life: faith, worship, behavior, hygiene, family life, inheritance, criminal law, trade, economics, etc.
Islamic finance is based on principles expressed in the Islamic legal sources, the Koran and the hadiths. The Koran is considered by Muslims to be God's direct speech to mankind, and is the primary source of Islamic law. This is followed by the Sunnah of the Prophet Muhammad (pbuh). By sunnah is meant what the Prophet did, said or omitted. Writings of the sunnah are called hadith. The following is an overview of the basic principles of Islamic finance.
When lending money, sharia prescribes that one must make up one's mind whether the money is lent to help the borrower or whether it is done to share in the other person's profits. If a loan is made to help the borrower, the Shariah does not allow one to claim back more than the amount lent. This is related to the prohibition on interest, which is discussed below. If the loan is granted to share in the borrower's profit, the lender must also share in any loss.
Riba means interest. It is forbidden to pay or receive interest in Islam. The prohibition on interest applies to both the payment and receipt of interest, as well as any other obligation that has an element of interest in it. The prohibition of interest is one of the clearest prohibitions in Sharia, and is enshrined in several verses of the Quran. Riba includes any consideration given in return for the right to dispose of capital, and not only monetary benefits, but also benefits in kind. The Shariah imposes a total prohibition on agreeing such remuneration. Even if there is a delay on the part of the debtor, the creditor's monetary claim cannot be increased on the basis of default interest considerations.
Islam does not consider money to be a commodity or service that one can be paid to lend. It is only considered to be a means of exchanging goods and services. Therefore, one cannot charge for the sale of money. One krone cannot be exchanged or sold for an amount of money other than one krone. However, it is permitted to exchange money in other currencies based on fluctuating exchange rates. The economic consequence of the interest rate ban is that it operates according to a nominalist principle.
Maysir means gambling or gambling. The prohibition of gambling, like the prohibition of interest, is enshrined in several verses of the Koran. Gambling and gambling means any wagering of money based on an uncertain outcome, with the possibility of losing the amount wagered and with the intention of being rewarded more than the amount originally wagered.
Gharar means uncertainty and establishes a prohibition against agreeing on uncertain elements in contractual relationships. The word gharar is not mentioned in the Quran, but there are several hadiths that deal with gharar and support a prohibition on agreements where gharar is included in the agreement. For example, in one hadith the Prophet Mohammad (pbuh) forbade the sale of grapes until they were dark (ripe) and the sale of grain until they were ready for harvest, and in another he forbade the purchase of fish from the sea.
From these and other hadiths, Muslim scholars have deduced that gharar, uncertainty in contractual relationships, can as a starting point be defined as contracts where there is uncertainty with regard to the subject matter of the contract, delivery time, the existence of the performance, ignorance of the characteristics of the performance, the quantity of the performance or that the performance has not yet come within the party's sphere of control. Sharia requires that there must be certainty about the key elements of the transaction at the time the contract is entered into.
Sharia also does not permit agreements on sale where the performance of the debtor and creditor is to be exchanged in the future, even if the time of delivery, the characteristics of the goods sold, the quantity, the price and the subject matter of the sale are clear. Whether the asset sold will still exist at the agreed time of delivery is beyond the control of the parties, and Sharia considers this to be an uncertainty.
Sales where payment is made in advance, but delivery is not made until later, are nevertheless permitted for manufacturing purchases. The product salam under Islamic financing follows this exception in that borrowers engaged in manufacturing activities can increase their liquidity by receiving advance payment for goods. The repayment to the financial institutions consists of the borrower delivering finished products to the lender, who then sells the products on the market.
Gharar is also included as an element in the above-mentioned example of conventional insurance. The future event that may trigger liability for the insurer is uncertain and is thus considered to be gharar.
Sharia prohibits making two or more transactions conditional on each other. The reason for this is that conditional transactions create doubt and disruption (gharar) in contractual relationships. For example, it is not permitted for a lessor of an asset to enter into a lease agreement on the condition that the lessee will purchase the asset at the end of the lease term. The idea is that each transaction must stand on its own, independent of other transactions.
The prohibition of unjust enrichment and exploitation, the prohibition of interest and the nominalist principle in Sharia law mean that interest cannot be charged on late payments in the event of default. Claims for compensation for late payment are considered unjust enrichment at the expense of the defaulting party. The reason for this is both the prohibition of interest and the fact that it follows from Quran 2:280 that the debtor should be granted a postponement if he is in a difficult situation. However, Sharia allows a default in payment to be met with a claim for damages if the default is due to the debtor's fault. In order to put pressure on the debtor to pay, the solution in Islamic financing is that when the loan agreement is entered into, it is also agreed that a fee will be paid to the creditor in the event of default on the loan agreement, which the creditor will donate to charity. The fee can be set as a percentage of the amount owed for each day of default or as a predetermined sum.
Sharia does not allow investments in companies that are involved in actions that are illegal or unethical according to Sharia. It is not permitted under Islamic finance to invest in, for example, alcohol, pork, pornography, gambling, nightclubs, conventional banks and financial institutions (which base their operations on interest income), weapons, tobacco, etc.
Under Islamic financing, risk distribution is one of the basic prerequisites for being able to offer financing in line with Islam. Common to the products offered under Islamic financing is that the financial institutions bear part of the risk for a limited or unlimited period of time for the purpose for which financing is sought. The entire risk cannot be unconditionally passed on to the client. This would be contrary to the purpose of Islamic financing. In commercial Islamic housing finance, the financing company assumes the risk of the existence of the building, but it is also possible to allocate the risk of fluctuations in value.
The effect of contracting a term that is not permitted according to the Sharia criteria is that the term is considered null and void. In some cases, the effect of agreeing unlawful terms may be that the entire contract lapses, in other cases it is only the term that is considered a nullity.
However, the validity of a transaction under Islamic norms will be judged autonomously regardless of the legal status of the transaction under national law. For example, even if it is permitted under Norwegian law to agree on several interdependent transactions in one contract, this will not be permitted under Sharia law. A Sharia panel presented with this issue will therefore reject such a transaction.
If a Norwegian Islamic financial institution's sharia panel were to reject a transaction and declare it to be contrary to sharia, this would not in principle prevent a Norwegian court from ruling that the transaction is valid under Norwegian law. In addition to a request not to act contrary to Sharia, the solution in Sharia in such cases is that the party who has acted against the norms of Sharia must ask for forgiveness from God for their sin.
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