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Modaraba - Islamic Finance

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By Aamer Allauddin (FCCA), Member ACCA Pakistan Members


In the organized sector of Pakistan the concept of Modarabas emerged in 1979 as a result of the Government's initiatives towards Islamization of the economy. For this purpose a Council named the Council of Islamic Ideology was set-up. This Council was given the task of devising a blueprint for the Islamization of the economic and financial sectors. The promotion of Modarabas was an important component of this blueprint.

The Modaraba Concept

The term Modaraba is an Arabic term and implies a contract between two parties, whereby one party, the Rab-ul-mal entrusts money to the other party called the Mudarib, to put in his management expertise and utilize it in agreed manner. Profits of the Modaraba are shared in a pre agreed ratio and losses in the proportion of the capital invested. In other words, it is an arrangement between a capital provider and an entrepreneur, whereby the entrepreneur can mobilize the funds of the former for business activity. The entrepreneur provides expertise and management.

For example a bank would make Shariah compliant investments and share the profits with the customer, in effect charging for the time and effort. If no profit is made, the loss is borne by the customer and the bank takes no fee. The bank is compensated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits.

Legal Framework

Modaraba Companies and Modaraba (floatation & control) Ordinance was promulgated in 1980 to provide the statutory framework for organizing business enterprises according to the injunctions of Islam. This piece of legislation refined the Modaraba concept and brought it in conformity with the prevalent corporate structure. The Modaraba Companies and Modaraba Rules, 1981 have been framed under the Ordinance.

Types of Modaraba

The two types of modaraba practiced in Pakistan are:

1. multipurpose modaraba with more than one objective

2. specific purpose modaraba with a particular purpose

Modarabas can further be divided into two categories:

1. Modaraba al Muqayyadah (restricted Modaraba) is where the Rab-ul-mal specifies a particular business or place of business for the Mudarib.

2. Modaraba al Mutlaqah (non-restricted Modaraba) is where the Rab-ul-mal affords full freedom to the Mudarib to undertake any business the latter wishes. However, the Mudarib is not allowed to provide finance to anyone without the consent of the Rab-ul-mal. The Mudarib is authorized to do what is normal in the course of business, but anything beyond the normal routine of the business concerned will require permission from the Rab-ul-mal. The Mudarib is also forbidden to have another partnership or Mudarib, or mix his own investments in the modaraba concerned without having first obtained the Rab-ul-Mal's consent.

A modaraba may be either for a fixed period or for an indefinite period (perpetual modaraba). A modaraba floated for a fixed period or for a specific purpose shall be wound up by the Modaraba Management Company itself on the expiry of the period fixed for the modaraba or the accomplishment of the purpose of the modaraba, as the case may be.

Nature of Business

Majority of the modarabas in Pakistan are in the financial sector, although there is no restriction on the nature of business except that it should be according to the injunctions of Islam. The business / financing activities currently undertaken by modarabas in Pakistan are ijarah/leasing, morabaha, musharika, trading, equity/portfolio financing and manufacturing /distribution.

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.

Formation & Management

The Mudarib establishes a Modaraba Management Company (MMC) with the approval of the Registrar of Modarabas. No modaraba company shall operate without registration with the Registrar. Modaraba Management Company means a company engaged in the business of floating and managing a Modaraba. Essentially the MMC is the Mudarib and can establish a series of Modarabas for different business ventures with the approval of the Registrar and the Religious Board, bearing in mind that each modaraba is separate and distinct from the other and also from the MMC. The Registrar scrutinizes the application and after he is satisfied, submits it to the Religious Board for approval.

The Religious Board is constituted by the Federal Government and the role of its members shall be to examine and review the prospectus of a modaraba and certify that the business undertaken by the modaraba complies with Shariah principles, before the public offer is made.The Registrar may grant authorization certificate to float a modaraba only after clearance of the proposal by the Religious Board.

Following registration of the MMC, the Mudarib applies to make a public offer of modaraba funds through a prospectus. The Modaraba cannot commence business till the minimum amount stated in the prospectus has been raised, the modaraba certificates thereof have been allotted and a prescribed declaration in this regard signed by Chief Executive has been filed with the Registrar.

The Modaraba is a legal person and can sue and be sued in its own name through the MMC, and the assets and liabilities of each modaraba shall be separate and distinct from those of another modaraba as also from those of the MMC.

Profit and Loss sharing

Both parties i.e. the Mudarib and the Rab-ul-mal agree right at the outset on the proportion of profit that each is entitled to. This is based on mutual consent, as no specific proportion is defined under Shariah law. In the case of absence of a predetermined distribution ratio, the profit shall be shared equally.

Neither the Mudarib nor the Rab-ul-mal is allowed to allocate a specific amount of profit to any party, nor can profit be tied at specific rate to the capital. For example, they cannot agree to the Mudarib getting Rs. 10,000 of the profit or the Rab-ul-mal receiving a 15% share of the capital. However, proportionate sharing of the profit is allowed, such as 10% of profit to Mudarib and 90% of profit to Rab-ul-mal.

The law requires that the MMC subscribes at least 20% of the total amount of subscription in each modaraba floated by it. In order to compensate it, the MMC will get as remuneration, a fixed percentage of the net annual profit of the modaraba which shall not exceed 10% of such net annual profit as shown in the audited profit and loss account of the modaraba. The distribution of profit shall include distribution in cash or issue of bonus certificates out of the capitalized profit or any other security.

Tax Treatment of Modarabas

Under clause 100 of Part I of the Second Schedule to the Income Tax Ordinance, 2001, the income of non-trading modarabas is exempt from income tax, provided not less than 90% of its profits (as reduced by the amount transferred to a mandatory reserve) are distributed to the certificate holders. For the purpose of determining the distribution of ninety per cent, the profits distributed through bonus certificates to the certificate holders shall not be taken into account.

Future Outlook

Modarabas have a dynamic and progressive role to play in the Islamization of the financial system of the country. There is an appropriate infrastructure in place with nearly 30 years of practical experience. However, despite this, the modaraba sector has not performed as expected and their contribution in the financial sector has been insignificant. The total market capitalization of modarabas is still a tiny fraction of financial sector cap.

Modarabas have not been very successful in mobilization of savings or deposits or diversification of their products to differentiate from other market players such as leasing companies. Today the bulk of their business is primarily leasing which does not provide any market niche or comparative advantage to the sector. However, a point to note is that there have been a few successful models of modarabas engaged in manufacturing.

Modarabas need to innovate, improve their products and operational capabilities and at the same time become more competitive in their cost of funding. Reliance on banks would always place them at a cost disadvantage and there is a need to tap other sources which remain unrealized and do not flow to the banking sector. There are many savers who do not want to use the banking system and are looking for Shariah compliant products. In order for the equity base of Modarabas to expand, the Modaraba Association of Pakistan has been encouraging mergers and consolidations of the existing Modarabas. There is further room to grow and develop the sector given the increasing demand for Islamic products.

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