What is Modaraba

Introduction:
Modaraba is one of the prime modes of Islamic financial system. The concept of
Moradabad was given over 1400 years ago by our Holy Prophet Hazrat Muhammad
(SAWW). Modaraba can be simply defined as partnership between money and ability
Moradabad is a kind of partnership "where one party provides finance to other party for
the purpose of carrying on business. The party that provides the finance is called the
"Rab-ul-mal" (the providers of capital). Whereas the other party who puts in his
expertise and management skills is called the "Modarib" (manager)
History:
Concept of partnership between financer and worker was in practice in the medieval
period before the rise of Islam. Italian city of Rome, which was center of business in
Europe, had such partnership named Commenda. Traders from Europe reached
Baghdad. Business community of Iraq acknowledged this business practice and named it
Qarad. Through Iraqi caravans it reached to Arab and Persian areas, these areas were
first one to be enlightened by Islam.
Islam developed proper shape of the Concept of Commenda and covers the technique
of Qarad and named it as Modaraba. Islam put restriction to fixed return involvement in
Modaraba transaction and introduced profit and loss sharing.
Definitions:
i) General Definition;
It is a form of financial contract in which investor entrusts money to a financial manager
and any profits and losses are shared between them in an agreed manner.
ii) Fuqaha Definition;
It is a partnership contract between two parties, persons to person, organizations to
person or organization with organization in which one brings the capital, the other
shares his time, skill, experience and goodwill in respective business field for a specified
project or transaction.
On maturity, profit is divided according to the agreement, which will either be equal or
pre agreed ratio of net earned profit. In case of loss, financer loses capital investment
and manager loses time, efforts and reputation.
iii) Legal Definition;
According to Modaraba Companies and Modaraba Floatation and Control Ordinance
1980.
"A business in which a person participate with his money and another with his efforts or
skill or both his efforts and skill and shall include unit Trust and Mutual funds by
whatever name called"
Parties of Modaraba:
There are two parties in Modarabă agreement.
1. Rab-ul-mal;
The party which provides the finance, capital or money is called the Rab-ul-Mal. (owner)
2. Modarib
The other party who puts efforts, skill and experience is called Modarib.
Business Modal / Structure of Modaraba
The companies incorporated under the companies' Ordinance, 1984 and registered with
the registrar (Modaraba). SECP are eligible to undertake floatation and management of
Modaraba. The Modaraba or Modaraba fund (pool of funds) is created through public
subscription (IPO) and listed on stock exchange(s). Generally, a Modaraba can undertake
virtually any business activity that is not repugnant to Islam. The federal government
has constituted a Religious Board comprising two shariah scholars and a judge of high
court which certifies that the business to be undertaken by a Modaraba is not against
the tenets to Islam shariah and the Modaraba companies & Modaraba (floatation &
control) Ordinance 1980, Modaraba companies &Rules 1981.
How to Invest in Modaraba or Investment Schemes Issued by Modaraba
i) Investment in certificates of Modaraba;
a) Initial public offering the general public, after carrying out due diligence of
management and prospectus may subscribe to certificates of Modaraba when these are
first time offered by the Modaraba Company in primary market.
b) Direct buying from the Stock Market, One may also invest in the Modaraba
Certificates through buying them from registered stock broker (secondary market). The
Modaraba Certificates are quoted and traded on the stock exchange(s) like shares of
other listed companies.
II) Investment in non-interest bearing finance instruments/ schemes issued by Modarabas:
Modaraba offer various non-interest bearing certificates, i.e., Certificates of
Musharakah, certificates of Modaraba, term finance Certificates on Musharakah basis,
sukuk ete. approved by the Religious Board and the Registrar Modarabas. These
investment schemes are launched by Modarabas on profit and loss sharing basis and
rate of return varies based on the periodic profitability of the project / business of the
Modaraba. With the approval of Registrar (Modarabas), advertisements for such
investment schemes are published in which all the information about the scheme, the
mechanism of distribution of profit and loss and credit rating on the issuing Modaraba
etc. are disclosed. No Modaraba can offer such schemes unless it has obtained a
minimum investment grade rating i.e. 'BBB' from a registered credit rating agency.
Types of Modaraba:
Modaraba may be of two descriptions:
1. Multipurpose Modaraba: That is to say a modaraba having more than one specific
purpose or objective.
2. Specific purpose Modaraba: That is to say a modaraba having one specific purpose or
objective.
A modaraba may be either for a fixed period or for an indefinite period.
Religious Board:
The Federal Government shall, for the purpose of this Ordinance, constitute a Religious
Board which shall consist of such members and shall have such functions, terms and
conditions as may be prescribed.
Business of Modaraba:
No modaraba shall be a business which is opposed to the injunctions of Islam and the
Registrar shall not permit the floatation of a modaraba unless the Religious Board has
 certified in writing that the modaraba is not a business opposed to the injunctions of
Islam.
Working and Operational Issue of Modaraba in Pakistan
Background:
In Pakistan the process of offering Islamic financial products was initiated in 1980 when
the Government introduced the concept of modaraba as a legal entity for carrying out
business in the corporate and non-banking financial sector. According to the concept of
módaraba in Islam, it is a partnership, wherein one party provides finance for the
purpose of carrying on the business and the other party participates in the business
Venture with skills and efforts.
The party who provides the finance is called the "Rabb-ul-Mal" (the provider of capital)
i.e. Modaraba Fund, whereas the other party who puts in expertise and management
skills is called the "Modarib" (manager) i.e. Management Company.
The prevalent regulatory regime for Modarabas comprises of Modaraba Companies and
Modaraba (Floatation and Control) Ordinance, 1980 (the "Modaraba Ordinance") and
Modaraba Companies and Modarabas Rues 1981 (the "Modaraba Rules"), promulgated
in early 80s by the Government of Pakistan.
Modaraba Management Company:
The Modaraba law was designed keeping in mind the original concept of the modaraba.
The role of Mudarib was given to the Modaraba Management Company (MMC), a
corporate legal entity and the finance was to be arranged by another legal entity
licensed by the Registrar Modaraba called "Modaraba" which raises money through
public subscription (IPO). The persons who contribute in the pool of funds (the
Modaraba fund) are collectively called as the Rab-ul-Maal. Hence it is a two tier system.
Formation of MMC:
Firstly, the company is incorporated/ registered with the Registrar of Companies under
the Companies Ordinance, 1984 and then it is to be registered (licensed) with the
Registrar Modaraba of SECP as a Modaraba Management Company (MMC). The
Modaraba or Modaraba Fund (pool of funds) created through public subscription (IPO)
has to be listed on stock exchange(s).
Nature of Business:
The Modaraba can undertake only Shariah compliant businesses approved by the
Religious Board (the Board) duly appointed by the Federal Government for the
Modarabas by notification in the official Gazette. The Board has approved a number of
agreements for carrying out the business of Modarabas and the management
companies are bound to follow these agreements which include trading agreements
(Murabaha, Salam, Ijarah and Istisna), Financing Agreements (Modaraba, Musharikah)
etc. Except for commercial banking a modaraba can do every business in the financial
sector subject to compliance with Shariah principles.
One License Only
Unlike non-banking finance companies (NBFCs), a modaraba is not required to obtain
the license for each business activity in the non-banking financial sector and it can
undertake a number of businesses under one umbrella. Currently, Modarabas are
engaged in a wide range of business activities such as trading, import and export of
various permissible commodities, manufacturing, Ijarah, Murabaha Financing,
Musharikah Financing, Investment in equity market, brokerage house business, etc.
Raising of Funds
Primarily, the funds are raised by the Modaraba by issuance of modaraba certificates to
the general public. For generating further funds, the Religious Board has approved
various non-equity based instruments such as Certificate of Musharikah COM),
Certificate of Investment (Modaraba), TFCs (Musharikah based) & Sukuk etc.
Benefits Attached to Modaraba
Modaraba is very beneficial to the individuals' society and economy. Some of its
benefits have been discussed below:
1- Pleasure of Allah;
In Islam trade is most preferable activity and earning of just profit is allowed, Allah said
in Quran in Surah Al-baqarah verse no.275;
"Those who devour usury will not stand except as stands one whom the Satan by his
touch has driven to madness. That is because they say, "trade is like usury", but Allah
has permitted trade and has forbidden usury",
In case of partnership of money and efforts under modaraba interest will be replaced by
profit and loss sharing. Elimination of interest and profit sharing is an easy way to get
the pleasure of Allah and betterment of Akhirah.
2- Modaraba is Sunnah;
The Prophet Muhammad (SAWW) left on trading journey to Syria and used Modaraba
method for a participation contract with Hazrat Khadija (R.A) on pre-agreed terms and
conditions. Therefore, Modaraba is traded as Sunnah.
3- Business Opportunities;
One party has the funds but does not have the expertise and another party has the
expertise but does not have the funds. Modaraba gives opportunities to both the parties
(Modarib and Rab-ul-Mal) to join hands for the business under the shariah.
4- Halal Business;
Modaraba has a special and unique corporate identity as no such example is found in
the rest of the world. It is the only business model in the financial sector that is based on
two Islamic practices duly scrutinized and approved by the members of the religious
board appointed by the federal government. It provides profitable investment
opportunities according to the stakeholders who are looking for Halal profits in their
investments to the Islamic shariah.
5- Tax Benefit
Tax payment is normally not liked by the businessmen. Modaraba is blessing for
business community. The income earned by the Modaraba is fully exempt from income
pax provided if they distribute 90%of their profits among the certification holders.
6- Maximum Distribution of Profit
Above mentioned tax benefit results in maximum distribution of the profits. As investors
of a Modaraba you may expect getting maximum dividends as 90%of the income profits
of the Modaraba are distributed to the certificate holders in order to avail themselves of
the benefit of tax exemption.
7- Liquidity of Funds
Rab-ul-Mal can liquidate his investment anytime by selling Modaraba certificates
through Stock Market to any other person.
8- Circulation of Wealth
In countries like Pakistan wealthy people not having business experience hoard money
or invest it in real estate. Hoarding of money is negatively affecting economy. Modaraba
business model is best way to put money in circulation. It will help investors to use
funds more profitably, provide employment to other partner (Modarib). Money in
circulation will boost economy.
9- Increase in GDP
Modaraba increase trade and industrial activities resulting in production of goods and
services. Total value of goods and services produced in country in a year is called Gross
Domestic Product. Modaraba is best way to increase G.D.P and lead to country to
economic development.
10- Brotherhood
Prophet Muhammad (SAWW) said that all Muslims are brothers among themselves.
Once he said Muslims are like a body, pain of one part is felt by whole body.
In order to strengthen brotherhood among Muslim Modaraba is one of the most
effective means. Business partnership will bring Muslims closer. Rab-ul-mal will help
modarib by providing finance and in return modarib will increase his wealth through
profit.
Investment Risk Involved in Modaraba Business
Investment risk can be defined as:
i) The probability or likelihood of occurrence of losses relative to the expected return on
any particular investment".
ii) Probability that an actual return on an investment will be lower than the investors'
expectations all investment have some level of risk associated it due to the
unpredictability of the market's direction.
Like every other business Modaraba is also exposed to various risks that may have
impact on the operation and profitability of the Modaraba. These risks might be internal
and external including the markets operational credit or management risk. The potential
investors while making investment must keep in mind the above noted risks.
Following are the common risks involved in Modaraba business.
1. Management Risk
Main risk involved in modaraba business is of mismanagement. It is directly related to
the nature of Modaraba contract, where funds rest with manager and financer is not
participating in management. There is always objective possibility for loss due to
negligence; misfeasance or breach of contract on the part of management.
2. Variable rate of Return
It is a common practice among Islamic banks to offer variable percentage of profit. It is
done to smooth the financial returns to account holder and match with non
interest based banking. Sometimes this return may be lower than market rate. Share of
bank is also compared with an arrangement of agency fee.
3. Lower Rate on Investment
In Modaraba amount is generally invested in fixed assets. There is always risk of
mismatching between yield of assets and the expected rated return on investment user
of the asset and modarib gain more than financer.
4. Equity Investment Risk
Rab-ul-Mal of Modaraba certificate is owner /financer/ shareholder of the business.
Modaraba is equity investment. In this case, it is obvious that owner has to bear losses
as well as gaining profits. Owners also have to face other types of risks such as liquidity,
credit and market risk. In conventional banking depositors/ investor is not responsible of
loss.
5. Profit Rate Risk
Changes in the overall economic market affect specific types of investment, which result
in rate risk. If economic market is having positive trends rated of profit will be higher
and old investors will be discoursed. In opposite situation new investors will receive
lower returns.
6. Inflation Risk
Inflation is a situation where prices are rising. It reduces purchasing power of investors.
Modaraba investors will suffer on two sides; firstly they will purchase les investment,
Secondly, inflation will be eat away return on investment. To offset inflation risk,
investor will demand higher interest rate, which may create an imbalance in the
investment market.
7. Credit Risk
In Modaraba Rab-ul-Mal gives amount to Modarib. It is a form of credit. It leads to credit
risk, which occurs when companies are unable to repay investors. Although terms of
payments are settled at the time of investment, but still, sometimes companies are
unable to pay investors profit or principal at maturity dates,
8. Liquidity Risk:
Modaraba Certificate holders in accompany invest in cash, in expectation of setting
profits in cash. But it is a common practice in Pakistan that Modaraba companies pay
profits in the form of bonus shares. It affect liquidity of investors who gives cash but
receives certificates.
9.Changes in Law:
Modaraba business in corporate sector is governed by Government of Pakistan through
SECP. Following laws have been framed for smooth running of Modaraba;
i- The Modaraba companies and Modaraba (Floatation and Control) Ordinance 1980,
ii- Modaraba companies and Modaraba Rules 1981.
iii- Prudential Regulation
Government brings frequent changes in law, has added element of risk in Modarabas.
For example, in 1993 Government waived some tax exemption, which adversely hit
Modarabas business in Pakistan.
10. Market Risks:
In Modaraba, business is done in open market under competitive environment There
are many risks in market which can affect modaraba business. Like recession, wave of
pessimism natural calamities, wars, terrorism, and energy crises, political instability.