Islamic Finance Venture Investing

ISLAMIC FINANCE VENTURE INVESTING:

HOW ARE COMMUNITY PROJECTS AND MAJOR INFRASTRUCTURE  DEVELOPMENTS FUNDED WITHOUT CHARGING INTEREST?

You might be wondering how, with the embargo on the payment of interest, major infrastructure, construction and community projects are funded through the Islamic finance system. Below, I explain how Islamic finance venture investing protocols deal with the funding of major infrastructure, construction and community projects.

I also explain why major project funding based on the western system of interest-based finance is in reality an unjust instrument of financing. It is an unjust system because it can result in injustice to both the creditor company providing the bulk of the project funding and the debtor company that is bound to repay the project funds no matter what circumstances befall the debtor company. Initially, however, it may be useful if I explain why Islam rejects the concept of interest.

Warning: There is a considerable amount of information here concerning Islamic finance venture investing. Consequently, as the guide covers a lot of ground, expect a long read.

Background

First, let me set the stage. In my webpage Islamic finance: a primer, I drew attention to the fact that the major non-Islamic religions outlaw the charging and payment of interest but have never implemented any measures to seriously deal with the detrimental effects on individuals and families of an interest-based society. I ask why? In specific terms, why do they not seem to acknowledge any of the plainly evident adverse consequences of an interest-based economy on the members of their congregations; in particular the poorer members of their congregations.

Why is the story of Jesus & the moneylenders ignored by Christian leaders? Christians in particular appear to place great emphasis on the story of Jesus attacking the moneylenders who were allegedly causing trouble within his local community, although as I understand the story, the local situation being addressed by Jesus was essentially a microcosm and a symbol for the principle that interest was bad for individuals in particular and bad for society in general. So when Jesus made such a significant move against money lending and moneylenders, why hasn’t his message been accepted and acted upon down the centuries by subsequent Christian leaders. Why indeed!

Why is the charging and payment interest morally wrong, unjust and valueless in building an economy?

The conventional system of funding. In the western conventional finance system, an infrastructure construction project is funded by financial lenders who lend the funds required at a predetermined fixed rate of interest that will return a profit to the lender on the loan advanced to fund the project, irrespective of the profit earned or loss suffered by the debtor construction company as a result of the project.

Construction projects must be based on intrinsic value. On the other hand, in the Islamic finance venture investing system, the same project would be funded by a joint venture musharakah. This is because, as I said earlier, the infrastructure construction project has to be based on the intrinsic value in the project, and therefore cannot be hostage to a fixed rate of return for completion of the project. Rather, the return in musharakah is based on the actual profit earned by the project.

What is the fuss all about? Those of you brought up in the western conventional system may wonder what is actually in contention here, or put it more simply, what is the fuss all about? The contention is that the financier in an interest-bearing loan to an infrastructure construction project cannot suffer loss while the financier in musharakah can suffer loss, if the project fails to produce anticipated profits.

Funding an infrastructure construction project

Interest is unjust. From the shari’ah point of view, interest is an unjust instrument of financing because it can result in injustice to both the creditor and the debtor parties. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a fixed rate of return on capital contributed thus further exacerbating the loss; and if the debtor earns a very high rate of profit, it is unjust to the creditor to give him or her only a small proportion of the profit leaving the rest for the debtor, despite the fact that the high rate of profit would probably not have been possible without the creditor’s capital contribution.

Western conventional funding. In the western conventional financial system of today, banks and finance companies advance depositors’ and shareholders’ funds as loans to entrepreneurial companies. If an entrepreneurial company has only ten million dollars of its own funds available for a new infrastructure project with high community support that is expected to cost $100 million and generate a high rate of return thereafter, it obtains $90 million dollars from banks and finance companies to initiate the project.

The option of equity funding. Of course, it could be argued that the entrepreneurial company could seek equity capital for the project, but for various reasons, this may not be a viable option. For example, existing shareholders may not permit the dilution of their shareholding. The entrepreneurial company, after borrowing the funds, then simply repays the banks’ and finance companies’ capital contribution along with the interest over the life of the project. This is essentially the normal western business relationship.

Examine this financial arrangement from a different perspective to the traditional western view

Fairness 1. The reality of this situation is that 90% of the project has been created by money from the banks and finance companies while only 10% of the project has been created by entrepreneurial company’s own capital. If this project brings enormous profits, only a small proportion (i.e. the 8% to 12% interest component on the capital contribution, and none of the enormous profit) will go back to the banks and finance companies, while 100% of the enormous profit will be claimed by the entrepreneurial company whose real contribution to the project did not exceed 10% of the project cost.

Fairness 2. But it gets worse, because even the small interest proportion (the 8% to 12% interest component on the capital contribution) that accrues to the banks and finance companies is taken back by the entrepreneurial company, because this proportion is included by the entrepreneurial company in the cost of their production! The net result is that 100% of the profit of the infrastructure project is claimed by the entrepreneurial company whose own capital contribution did not exceed 10% of the total investment, while the people owning 90% of the capital contribution get no more than the fixed rate of interest which is more often than not repaid to them through increased prices of the project’s output.

Fairness 3. From the contrary perspective, if in an extreme situation the entrepreneurial company becomes insolvent because the project fails badly, the entrepreneurial company’s loss is no more than 10% or $10 million dollars, while the loss of 90% of the project, $90 million dollars, is totally borne by the banks and finance companies. I know business people like to say that business is business; but how fair is that?

Fairer 1. Under the Islamic finance venture investing system, in this situation the banks and finance companies would be more intimately involved in the management of the project and because of that may have been in a position to initiate early action to prevent the business failure. Of course the banks and finance companies would have a greater incentive to seek a more favourable outcome because their financial commitment is nine times greater than the company’s commitment. I make this point simply to illustrate the fact that everyone participating in the project is actively involved from day one.

This typical infrastructure project example shows in a practical way why interest on project capital, where the financier providing the capital is at arms’ length from the project being financed, is a major cause of imbalances in the western capitalist economic system.

Fairer 2. In this example, where an Islamic bank and an entrepreneurial company were to undertake the $100 million infrastructure project, the bank and the company would form a musharakah venture to jointly undertake the project. In normal Islamic finance venture circumstances, the profits and losses would be shared in proportion to the relative investments. In large projects, it would not be unusual for additional investors to join the musharakah as partners.

To conclude this brief description of the Islamic funding system for infrastructure construction projects, I would like to quickly review the managerial and administrative aspects of musharakah arrangements. After all, I did say earlier that ‘there is almost unanimous consensus amongst shari’ah scholars and other players in the Islamic finance industry that ‘musharakah is the purest form of Islamic financing’.

Musharakah: the rules of engagement

As is to be expected under shari’ah, there are rules and principles that guide and limit financing transactions.

1. The Rules About Profit

Profit distribution. The proportion of profit to be distributed between the musharakah partners must be agreed at the time the contract is concluded. If no such proportion is determined at the time the contract is concluded, the contract is not valid in shari‘ah.

Profit ratio. The ratio of profit for each partner must be determined in proportion to the actual profit accruing to the business, and not in proportion to the capital invested by particular partners. Moreover, it is not permitted to fix either a lump sum amount as a proportion of profit for any particular partners, or a specific rate of profit tied up with particular partners’ investment. The ratio of profit distribution is contentious, despite the principles just outlined. The question raised is this: Is it necessary that the ratio of profit of each partner conform to the ratio of capital invested by the partner? Interestingly, there is a difference of opinion among Muslim jurists on this question:

  • The first opinion suggests that it is necessary for the validity of musharakah that each partner gets the profit exactly in the proportion of each partner’s investment. Therefore, if Partner A has invested 40% of the total capital, he or she must get 40% of the profit. Any agreement to the contrary which leads to Partner A getting more or less than 40% will render the musharakah invalid in shari’ah.
  • The second opinion puts the view that the ratio of profit may differ from the ratio of investment if it is agreed between the partners with their free consent. Therefore, it is permissible that a partner with 40% of investment can receive say 65% of the profit, while the other partner with 60% of investment gets only 35% of the profit. This acknowledges that there may be other aspects in the deal that can influence the profit share.
  • The third opinion is somewhat of a middle ground compromise between the two foregoing opinions. That is, that the ratio of profit may differ from the ratio of investment in normal circumstances. However, where a partner has put an express condition in the agreement that the partner will never work for the musharakah and will always remain a sleeping or silent partner throughout the term of the musharakah, then the partner’s share of profit cannot be more than the ratio of the partner’s investment.

2. The Rules About Loss

Loss. In the case of loss, all Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of the partner’s investment. Therefore, if a partner has invested 40% of the capital, the partner must suffer 40% of the loss, not more, not less, and any condition to the contrary shall render the musharakah invalid.

3. The Rules About Capital Contribution

Liquidity. Most Muslim jurists are of the opinion that the capital invested by each partner in a musharakah must be in liquid form. This means that the contract of musharakah can only be based on a money contribution, and not be based on a commodity or in-kind contribution. In other words, the share capital of a joint venture must be in monetary form. No part of it can be contributed in kind. However, there are different views in this respect.

4. The Rules About Management

Modern management rules! The normal principle of musharakah is that every partner has a right to take part in its management and to work for it. This could prove unwieldy where there are many investor shareholder partners. Within the modern business context therefore, the musharakah partners may agree that the management of the musharakah shall be carried out by a number of them who will constitute a Board of Directors for the purposes of the musharakah.

Similarity with today’s corporate management. In the usual management process for a musharakah, each partner shall be treated as the agent of the other partners 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 authorised by all the partners. This principle of musharakah management accords with the management requirements of modern Australian companies under their constitutional arrangements and Corporations Act requirements, where directors are jointly and severally responsible for decisions made and implemented for and on behalf of the company.

5. The Rules About Terminations: traditional views

Historical background. Traditionally, a musharakah is deemed to be terminated when any one of the following events occur. However, these situations reflect a business life that existed in simpler times long before modern communications were generally available to all persons in business. They do not take into account the concept of the modern business corporation with many shareholder partners. Neither do they acknowledge the ongoing nature of modern business corporations, a criterion for business success today. More will be said about the integration of musharakah with modern business operations shortly, but for now, here are the historical grounds for terminating a musharakah.

All partners have a right to terminate. Conventionally, every partner in a musharakah has a right to terminate the musharakah at any time by giving all partners a notice to the effect that the partner desires to end the musharakah. In this case, where the assets of the musharakah are in cash, the cash assets will be distributed pro rata between the partners. But where the assets are not liquid, the partners may agree either on the liquidation of the assets or on their distribution or partition between the partners.

Partition & separation. If no agreement on liquidation can be reached between the partners, the latter option of distribution or partition shall be preferred, because after the termination of a musharakah, all the assets are in the joint ownership of the partners, and all of the co-owners have a right to seek partition or separation, and no partner can compel another partner into a liquidation. However, if the assets are such that they cannot be separated or partitioned, such as machinery, then they shall be sold and the sale proceeds shall be distributed pro rata.

Death or disablement of a partner.  If any one of the musharakah partners dies, the contract of musharakah with that partner is automatically terminated and the assets due to the deceased partner may pass to the deceased partner’s heirs. In this situation, the deceased partner’s heirs have the option of either withdrawing their inherited share from the business, or to continue with the contract of musharakah, in which case they become new partners within the musharakah. If any one of the partners becomes physically or mentally incapable of actively participating in commercial transactions, the musharakah is terminated.

6. The Rules About Terminations: modern views for modern corporations

One partner wants termination. If a musharakah partner wants termination of the musharakah, while the other partner or partners wish to continue with the business (in conformity with modern corporate practices), this is possible through mutual agreement. The partners who want to continue the business may purchase the share of the partner who wants to terminate his partnership, because the termination of musharakah with one partner does not imply that there is to be a termination between the other partners. However, in this case, the price of the share of the leaving partner must be determined by mutual consent, and if there is a dispute about the valuation of the share and the partners do not arrive at an agreed price, the leaving partner may compel other partners into liquidation or to a distribution of the musharakah assets.

One partner cannot hold others to ransom. Of course, the retiring partner cannot, under shari’ah principles, hold the remaining shareholders to ransom by holding out for an unreasonable valuation of the share to be acquired by the remaining partners. In such circumstances, the parties may seek mediation or judicial action to determine a suitable or adequate value for the retiring partner’s share. A typical question raised by investors considering participation in a musharakah is whether it is possible for the musharakah partners to agree and implement a condition that the musharakah cannot be liquidated or separated unless all the partners, or a majority of them want to do so, and that a single partner who wants to retire from the partnership shall have to sell his share to the other partners and shall not have the power to force them into liquidation or separation.

Islamic shari’ah scholars seem to be silent on this question; at least I have not been able to discover a learned text opposing the concept. Consequently, silence signifies approval so it appears that there is no bar from the shari‘ah point of view if the musharakah partners agree to such a condition at the commencement of the musharakah.

Modern business requires continuity. From a practical perspective, this condition may be justified, particularly in modern business situations, on grounds that the nature of business today requires continuity for success and the liquidation or separation of a musharakah at the instance of a single partner only may cause irreparable damage and harm to the other partners. The practical example here is where a specific long term infrastructure project has been initiated with an extremely large capital investment by a substantial number of musharakah partners and one of the partners seeks liquidation in the infancy or at an early stage of the project,

Partners’ powers now limited.  To liquidate or separate the musharakah at that point may be fatal to the commercial interests of the partners generally, and mortally wound one or more of the partners personally. Moreover, as very large infrastructure projects normally have significant community benefits, to liquidate or separate the musharakah at such a time may be detrimental to the growth of the local economy. It is therefore considered undesirable to imbue an individual partner with such arbitrary powers of liquidation or separation. Therefore, such a condition seems to be justified.

Yours sincerely,

Graham  Segal

Chiron! the business doctor.™ ... relieves business pain!™ 

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This website and the associated webpages content are produced by Graham Segal trading as Chiron! the business doctor.™. They are licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 3.0 Unported License based on Graham's work at http://chironthebusinessdoctor.com.

 

Date this webpage was last reviewed/updated: 4 May 2013

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