Introduction: Under the conventional concept, the term project financing is a phrase normally applied to the taking of the project performance (marketing) risk, where the principle repayments are generated by the revenues made from the sale of the products produced by the project for which financing has been arranged. However, there are projects, especially those owned by the governments or states that are mainly concerned with the countrys infrastructure and do not by them selves generate any revenue. But nevertheless they are classified as projects that need financial support to be completed. The financial support could be provided to either the projects owner or the contractor who requires a sort of bridge financing to allow him to complete the different stages of the project and receive payments for work completed. I shall try to provide you with a brief definition of mudaraba, main area of use, how to select your partner, its financial structuring, profit sharing, and securities/risk, shortcomings and some suggestions for a better contract. Mudaraba is an agreement between two partners where one party has the know-how, equipment and manpower, and the other has financial strength. They join together to form a temporary partnership to execute a specific project work, and agree on sharing the expected profit. Qatar Islamic Banks experience with mudaraba is mainly concentrated on agreements between it and local contractors that are awarded contracts by the government ministries and companies and semi-government companies in the oil and petrochemical industry These contracts are mainly for the development of the countrys infrastructure projects such as roads, drainage, sewage systems and administrative buildings QIB has financed trading activities such as imports and marketing of vehicles and fuel but on a very limited scale. Partner & Project Risk Analysis: In Mudaraba the Bank is taking the performance risk of its partner and as such it must ensure that the partner is capable of performing satisfactorily to complete the project. To do so there are some basic guidelines that the bank can follow to minimize the risk it is taking. Main areas to examine include, but are not limited to the following: About the contractor, the following things are to be examined; His financial standing; His technical and administrative capabilities; His past (historical) performance in similar projects, in terms of size and nature; Subcontractors and their capabilities and performance; and was he the lowest bidder and by how much? About the project to be undertaken, the areas to be examined include, but are not limited to the following: - Is it within the contractors technical abilities; - Is it within the contractors financial and administrative abilities (bearing in mind other ongoing projects executed by the contractor); and does it contain any provisions that are likely to be cancelled during the course of the projects. The project owner: - does he pay on time - length of administrative process; - is he strict on imposing penalties for delays; - does he issue orders as soon as decided upon or waits till end of contracts; and - does he honor agreements of assignments of proceeds. To examine the contractors capability, one should obtain at least the following: - 3 audited financial statements for the company executing the work and for the group if it is part of a group of companies; - Inquiry regarding the creditworthiness and facilities granted to the contractor; a complete pre-qualification documentation showing management and Organizational structure, equipment and machinery owned and other fixed assets; and - List of projects completed.
To examine the project, one should obtain: Mandate from the contractor requesting financing and suggested structure; The contract between the contractor and the project owner to include the B.O.Q; A copy of the offer submitted by the con tractor and accepted by the project owner and any correspondence related thereto; The list of companies who submitted tenders and their prices; and The contractors suggested cash flow and the projects bar-chart-schedule of completion of the main milestone of the To examine the project Owner, the bank needs to satisfy itself that the owner can and will pay the contractor the sums of money due under the contract. The Financial Structuring of the Mudaraba Agreement: Through its experience with local contractors over the past 4-5 years QIB has developed a mudaraba financing structure that allows it to have the desired level of control and flexibility in managing the agreement. The financing is aimed at covering the actual and true cost of the project and not the total contract value, QIB shares the profit expected from the project and does not finance that portion. Close and careful examination of the submitted tender documents and the contract will help in determining the actual project cost to the contractor. In any event we have developed the practice of financing 80-85 % of the contract price after deleting (ignoring) any provisions. The net 80-85% of contract value becomes the 100% of the mudaraba financing value which is divided into 3 main subheadings; Mobilization Payment, Materials Purchases, and Against Certificate of Partial Completion. (a) MOBILIZATION (ADVANCE) PAYMENT: This sub limit is given to facilitate the initial site preparation and mobilization of equipment and machinery and the establishment of the project site office. Normally, this sub-limit does not exceed 10% of the contract value. In case the project owner pays this advance payment to the contractor, its value is then deducted from the sub-limit. Based on our experience the amount of the sub-limit differs from one type of project to another. We have become accustomed to the following: Profit Sharing: Obviously QIB wishes to achieve a return on its investment that should be at least equal to the return offered by other investment opportunities available to it. We at QIB normally put a profit target which is stated in the mudaraba contract. The contract includes a profit distribution clause which normally states that the net profit will be distributed equally among the partners (50-50) and that in case the banks share of the profit exceeds the stated target of say 11% per annum, the bank has the option to award the other party for good performance a percent age of the amount that exceeds the target profit rate. This percentage is normally between 90% - 97% of the additional sum which will increase the contractor s share of the profit. No doubt each bank has or can develop its own practice depending on the market and its internal pricing and risk taking policies. To illustrate this concept the example below could help. To arrive at the US$ amount that is equivalent to the 11% profit we use a method known as the numerical cash flow calculations which multiply the deficit balance of the account by the number of days the balance has been since the last transaction. An example of this calculation is included as attachment to paper. Repayment: The main source of repayment is t payment provided by the projects owner to the Contractor as such it is imperative that this money comes directly to the bank and deposited into a separate ac count for the mudaraba. Direct access to such sum by the contractor could cause losses to the bank; Normally Assignment of Proceeds agreements are signed between the bank, the contractor and the projects owner to ensure commitment of the projects owner to transfer the money due to the contractor directly to the bank. Shortcomings and Risks: One of the major draw backs of the mudaraba is that there is no similar legal frame-work in the contemporary commercial laws of most countries, especially non-Islamic countries, that can be relied upon in case of dispute to complement Let us assume the following: - Main contract value
US $ 250,000 - Mudaraba value
.US $ 180,000 - Profit sharing is 50-50
50% - 50% - Profit target
...
..11% - 11% profit based on numerical calculation
..US $ 12,986 - The bank will award the contractor
.95% We can then calculate the profit amounts as follows: - Main contract value
US $ 250,000 - Mudaraba value
..
US $ 180,000 -Net profit
US $ 70,00 ============ - Banks Profit
.
US $ 35,000 - Contractors profit
US $ 35,000 - The bank will award the contractor
.. 35,000- 12,986 = US$22,014 - Banks share over 11%
US$1,101 - Banks overall profit
12,986+1,101 = US$ 14,087 - Contractors overall profit
35,000+20,913 = US$ 55,913 - Banks overall profit percentage
..20.2% - Contractors overall profit percentage
79.8% The agreement when there is uncertainty, except the mudaraba Agreement itself, and as such the agreement must be comprehensive and must cover all the details. The other shortcoming is that to specify a time limit (time frame) in the mudaraba makes it null and void because the principle of mudaraba is that it continues until the other partner completes the work for which the agreement has been established and its proceeds are collected. This, of course, leads the bank to difficulties of planning the actual cash flow and profit accrual and it would therefore be advisable to deal with mudaraba as either medium or long term investment even though it may be possible to conclude it before that. The Shariah ruling is that it is not permissible for the bank to interfere in the running of the work (to administer the execution of the project) which will lead to narrowing the use of the mudaraba among contractors that the bank has full confidence in their honesty and technical capabilities and this is difficult to achieve without examining all aspect of the contract and the contractor as I explained earlier. In addition, the bank must have or endeavor to establish the technical capability to carry out the necessary duties and to exercise due diligence and make the proper credit and technical follow-up to ensure that the project execution is going according to schedule. It is also advisable to have contingency plans and strategies to interfere in case the contractor fails to carry out its commitments. Wrong utilization of funds is a risk that banks need to be aware of and mitigate it by establishing a drawdown mechanism that will ensure the funds are spent on the project itself and not any other work that the contractor may be carrying out at the same time. Mismatch between the amount of money withdrawn and the completed work could happen which may lead to over spending at the end, specially if the contractor is either not using all the money for the specific project (the subject of the Mudaraba) or not properly managing his spending as he should, in either case the bank must step in to correct the situation as soon as it notices any indication of such mismatch. Project cancellation completely or partially may happen during the course of the project and to ensure that the banks investment is not lost, it should ensure that it is aware of all developments throughout the life of the project and has direct access to the project owner. In addition the careful spending will help in minimizing the banks losses. Project withdrawal may take place, especially when the contractor is accused of major negligence. In such case the mudaraba agreement must cover this possibility and be clear and specific in terms of how such situation be dealt with, bearing in mind that in the mudaraba Agreement the contractor is not responsible or accountable for losses or damaged that are beyond his control: in such case the bank loses its money unless it can prove that the contractor is negligent and responsible for such loss. Conclusion: We can conclude from the foregoing that the mudaraba can be used as a type or mode of finance that is dependent on the bank accepting the performance risk of the contractor to perform the work successfully within the projects budget and time- frame limitations. The agreement must be comprehensive and in detail to cover all aspects of the work and how to deal with each possible risk that may occur. The financial structuring should be appropriate to the type of project in hand to minimize the possibility of mismatch between spending and work completion and misappropriation of funds. The mudaraba is not without risk, and the success of the mudaraba largely depends on how well the bank manages this risk. Therefore, take your time in examining all matters that are either directly or indirectly related to the project; the contractor, the project owner and any matter of party that may have positive or negative influence on the project or the agreement. Ismail Zainal Mousa, an Executive Manager for Domestic Investment & Marketing at Qatar Islamic Bank presented this paper at a seminar sponsored by the Amiri Diwan in Kuwait on June 11, 1997.
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