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Islamic Law of Transactions (Law 737)

Research Topic:

Mudharabah and Musyarakah are among the
products introduced in Islamic Law in order to
avoid the practice of riba (interest). Compare
and contrast these two contracts.



- Mudharabah : means that one party provides capital and the
other utilises it for business purposes under the agreement
that profit from the business will be shared according to a
specified proportion. (Partnership and Profit-Sharing in Islamic
Law, Muhamad Nejatullah Siddiqi, The Islamic Foundation,
London, U.K, 1985 pg15)

- Musyarakah : means participation of two or more persons in a
certain business with defined amount of capital according to a
contract for jointly carrying out a business and for sharing profit
and loss in specified proportions. (Partnership and Profit-
Sharing in Islamic Law, Muhamad Nejatullah Siddiqi, The
Islamic Foundation, London, U.K, 1985 pg15)

Definition (cont..)
Riba (interest): the extra money that you pay for borrowing
money from bank or the money that you earn when you keep
money in a bank. (Oxford Wordpower Dictionary, new 3

Prohibited in Islam through Al-Quran verse (3.130) You who
believe, devour not usury, double and multiplied; but fear God
that you may [really] prosper. (Article by Hussein Hassan;
Contracts in Islamic Law: The Principles of Commutative
Justice & Liberality (2002))
The Prophet p.b.u.h said: Gold for gold, silver for silver,
wheat for wheat, barley for barley, date for date, salt for salt, of
the same quantity and quality, from hand to hand. If there is a
surplus, this is usury. If the article are of different nature, sell
as you please, but from hand to hand. (from same article)
Furthermore, Al-Quran verse 2:275; Allah permitted
bay (sale and purchase) and prohibited riba (interest
or usury). [The Practices of Shariah Principles in
Instrument of Islamic Financial System : An
Overview by Fadillah Mansor)
In applying the above verse, muslim scholar as well
as the practitioners established principles of
mudharabah and musyarakah.

Agreement between at least 2 parties known as lender/investor (I)
(ras al-mal) & entrepreneur (E)(mudarib).
I entrust money to E who will manipulate for profit in the agreed
manner. If any, I will receive principles and profit on pre agreed
proportion and remaining balance will be kept by E.
Profit will be on proportional basis not on lump sum or guaranteed
return. It revealed no unfair terms to be shouldered by E.
Uncontrollable loss by E, I will face it consequence of financial losses
(tangible) but E only losses time, effort or may be reputation in the
eye of future investor (intangible).
I tend to act as sleeping partner.
Only I contribute the capital. (all from Fadillah Mansors article)

Ali bin Abi Talib empahsised that all losses must be paid for out of

If the profits are divided equally as per their agreement, no losses will
be charged to the mudarib.

If the investor has stipulates the conditions that the mudarib should
not enter into any transaction involving certain conditions and the
investor did not follow the instruction then the investor is not liable to
any repayment or replacement of the capital

2 broad categories:

Sharikah al-mulk i.e property partnership

Sharikah al-aqd i.e contractual partnership

5 types of Sharikah al-aqd:

Sharikah al-mal or finance partnership

Sharikah al-amal or labour partnership

Sharikah al-wujuh or credit partnership

Sharikah al-inan or limited investment partnership

Sharikah al mufawadah or unlimited investment
Joint-venture agreement involves 2 parties for specific business
activity for the sake of profit.

Timely based agreement or fulfillment of certain objective

Both parties will contribute capital and involve in the management of
that business activity. Capital can be in any form of immovable
property or cash.

Profit sharing based on specified agreed ratio.

Consequence of any loss, parties shoulder the loss in proportion to
their share of financing.

The origin of the partnership is the joint ownership of property.
Joint ownership is its only qualification, and no joint exploitation of
property is necessary.
It occurs when two or more people are partners in the possession of
The rule governing this type of sharikah is that any increase in the
property shall be shared by the co-owners in proportion with the
extent of their ownership.
Each of them is in the category of a stranger in regard to any action
on the part owned by his colleague.
It is unlawful for either partner to perform any act with respect to the
others share except with the latters express permission.
In terms of liability of the partners, they are quite independent of each
other, except for actions based on express authorizationby any of the
Their partnership is only in terms of ownership and potential sharing
of any profit or increase in the co-owned property, not in term of
sharing the liabilities arising from the partners actions.
This type of sharikah may not be known in the common law or
Malaysian law. In fact mere joint-ownership is generally insufficient to
constitute a partnership in common and Malaysian law

The origin of the partnership is the contract between the parties.
The structure of this type of sharikah may have more similarities with
the normal partnership in common law and Malaysian law.
For sharikah al `aqd, joint ownership is not an element necessary for
the establishment of the partnership.
The emphasis is rather on the joint exploitation of capital and the joint
participation in profits and losses, based on the terms of the
partnership contract.
Joint ownership is one possible consequence, and not a prerequisite
for the formation of sharikah al `aqd
The jurists further sub-divide Sharikah Al Aqd into various other
The subdivisions depend on a number of factors. If the underlying
factor is the subject matter of capital contribution, sharikah al `aqd
can be sub-divided into three main categories:-
(1) sharikah al amwal,
(2) sharikah al a`mal
(3) sharikah al wujuh.
When the subject matter of the capital is money, it becomes sharikah
al amwal (monetary partnership).
If the capital is in the form of labour, it becomes sharikah al a`mal
(labour partnership).
If the capital is in the form of reputation or creditworthiness, it
becomes sharikah al wujuh (reputation partnership).

The jurists also make further sub-divisions to sharikah al `aqd based
on the terms of the contract, i.e., whether the partners are required to
contribute equally to the capital and enjoy full equality in exploiting
the capital and sharing the profit or not.
Based on this consideration, sharikah can be divided into two types,
sharikah al mufawadah and sharikah al inan.
Sharikah al mufawadah means an unlimited investment partnership,
whereby each partner must contribute equally to the capital, and
enjoys full and equal authority to transact with the partnership capital
or property.
The Hanafis consider each partner as an agent (wakil) for the
partnership business and stands as surety (kafil) for the other
partners. Thus, the partners can be made jointly and severally
responsible for the liabilities of their partnership business provided
that such liabilities have been incurred in the ordinary course of

This type of sharikah clearly implies unlimited liability on the part of
partners since they are both agents and guarantors of each other.
Sharikah alinan can be defined as a limited investment partnership.
Whereby each partner may only transact with the partnership capital
according to the terms of the partnership agreement and to the
extent of the joint capital. Hence, their liability towards third parties is
several but not joint.
The liability of partners in Sharikah Al`inan resembles that of modern-
day limited liability partnerships.
Both Sharikah Al-Mufawadah and Sharikah Al`inan can occur in all
the three earlier types of sharikah, i.e., Sharikah Al Amwal (monetory
partnership), Sharikah Al A`mal (labour partnership) and Sharikah Al
Wujuh (reputation partnership).

Sharikah Al Mufawadah is rarely opted for due to the higher degree
of responsibility and the practical difficulty to achieve full equality
between the partners in all aspects of the partnership
Profit sharing.

It was narrated by Ibn Majah that
the Prophet was reported to
have said:

Three things done which have a
blessing in it, namely, credit sale,
Mudharabah, and a mixture of
flour and barley for the purpose
of invitation, and not for the
purpose of sale


Partnership. Literally it means a
joint venture agreements
between 2 parties to engage in
a specific business activity with
an aim making profit.

Mudharabah capital represents
savings for the owner or
investor but is generally a
source of livehood for the
working partner or


It the basis of reorganizing
banking activity in an interest
free framework. This can be
done by entering into 2 tier
Mudharabah Agreement.


The Islamic investment
company and the client agree
to participate in a joint venture
to be completed within an
agreed period of time.

First Tier

Between the bank and the
depositor who agrees to put
money in the banks investment
account and to share profit with

In this case, the Depositors are
the providers of the capital and
the Bank functions as the
Manager of funds.

Both parties contribute to the
capital of the operation in
varying degrees and agree to
divide the net profit in
proportion to the amounts
invested by each.

Second Tier

Between the bank and the
entrepreneurs who seek
finance from the Bank on the
conditions that profit accruing
from their business will be
shared between them and the
bank in previously agreed
proportion, but the lost shall be
borne by the financier only.

In this case, the Bank functions
as provider of capital and the
Entrepreneur work as the

In case there is more than one
financier of the same project i.e
one project is jointly financed
by several Banks, profits are to
be shared in mutually agreed
proportion previously
determined but lost is to be
shared in the proportion in
which the different financiers
have invested the capital.


As a basis of financial
intermediation in the Islamic
economy is offered as a viable
basis for an interest free
banking system.

The creditor does not earn
interest on the fixed rate in this
system but participate in the
business risks and earn the
share of the profit.

Thus, under an Islamic Banking
system, the cost of capital is
not zero, i.e, analogous to a
zero interest rate, as some
people assume it to be.


Both parties will provide capital
and the investor or lender may
also participate in the

The only difference between
Islamic banking and the
interest banking in this respect
is that the cost of capital in
interest based banking is
expressed in terms of a
predetermined fixed rate, while
in Islamic Banking, it is
expressed in absolute amount
which may also be expressed
as a ratio of profit.

The distribution of profit
between two parties must
necessarily be on a
proportional basis and cannot
be a lump sum or a guaranteed

In the case of loss as a result
of circumstances beyond the
control of the entrepreneur, the
investor will bear all the
financial risk and the
entrepreneur losses the time
and his effort s only.

Profit distribution

No profit can be recognized or
claimed unless the capital of
the Mudharabah is maintained

Profit distribution

Profit will be shared by two
parties in the agreed ratio and
the ratio not coincide with the
ratio of participation in the
financing activity.

Whenever the Mudharabah
incurred losses, such losses
stand to be compensated by
the profits of future operation
incurs losses, such losses
stand to be compensated by
the profits of future operations
of the Mudharabah.

The losses brought forward
should be set again the future

All in all, the distribution of
profit depends on the final
result of the operations at the
time of liquidation of the
Mudharabah contract.

If losses are greater than the
profits at the time of liquidation,
the balance (net loss) must be
deducted from the capital.

If the total Mudharabah
expenses are equal to the total
Mudharabah revenues, the
capital provider will receive his
capital back without either profit
or loss, and there will be no
profit in which the entrepreneur
is entitled to share. If profit
realized, it must be distributed
between parties as per


Entrepreneur shall not be liable
for any loss of the venture.

Thus, if the Mudharabah
business runs into a loss, only
the investor will have to bear
the loss.


In the event of loss, all parties
bear the loss in proportion to
the share of financing

Continues as such for as long
as the entrepreneur does not
contribute his own funds to the


Each partner is entitled to
terminate the partnership after
giving his partner(s) due notice to
the effect, in which the case he
shall be entitled to his share in the
partnership, and the withdrawal
would not necessitate the
termination of the partnership of
the remaining partners.

It come to an end at the expiry date
or before the expiry date if the
partners agree to terminate it
prematurely, or, in the case of
partnership in a particular
business, by actual liquidation of
the assets that constitute the
subject matter.


Although equity financing was not dealt with th Quran, the Sunnah affirmed that
Uqud al Ishtirak (profit sharing contracts of Al Mudharabah and Al- Musharakah
practised by pre-Islamic Arab society are allowed in Islam.

As stated earlier, this would extend to the profit sharing contracts practised by
Pre-Islamic Arab society. On this basis, equity financing was allowed in islam as

Surah An-Nisa(4), verse 32 :

Do not convert the bounties which God has bestowed more abundantly on
some of you than on others. Men are allowed what they earn, and women are
alloted what they earn. Ask God for something of His bounty.

- The above verse reiterates the principle that no one may claim more than he
has earned.