State Bank of Pakistan made history in 1982 when it authorized commercial banks in Pakistan to finance their customers in trade and industry on the basis of profit and loss sharing in an arrangement which in Islamic phraseology is popularly known as Musharika. This arrangement is also known by another name of Shirkah. State Bank of Pakistan also issued detailed guidelines in their BCD Circular No. 21 of June 30, 1982 regarding the conduct of Musharika financing by banks. Some of the salient features of these guidelines are enumerated below:
1. A certain proportion of the profit in a venture will be payable to the client as 'management fee'. 2. The remaining profit will be distributable between the bank and the client on the basis of daily products of the funds employed by each of them. 3. 'Weightage' can be given to funds employed by the bank or the client where necessary.
4. Sharing ratio of the profit left after payment of the 'management fee', once determined, will not be alterable.
5. The portion of profit payable to the client by way of 'manage-ment fee' will be subject to achieving the level of profit projected by the client. 6. If the projected profit is exceeded by the client, the bank may use its discretion to enhance the 'management fee' and vice versa. 7. In case of loss, it shall be shared by the bank and the client strictly in the ratio of daily products of funds employed by each of them. 8. Musharika financing is optional for banks as well as for their clients. 9. Complete flexibility was allowed to banks for negotiating with their clients in matters pertaining to the proportion of 'management fee', sharing ratio of the remaining profit including 'weight- age' to the funds of banks or clients. This flexibility was modified and regulated subsequently when State Bank of Pakistan prescribed the minimum and the maximum annual rates of profit which could be earned by banks in Musharika financing. This range of profit is described elsewhere in this paper. Again in June 1984 when banks were authorized by State Bank (vide BCD Circular No. 13) to provide finance to their customers on the basis of twelve modes of financing, Musharika was retained as one of the permissible modes. Sufficient guidance was, however, not provided to banks in respect of other modes of financing in the same manner as was done in the case of Musharika in 1982, though the need for guidance from State Bank of Pakistan is being felt very acutely by banks.
The twelve modes of financing have been classified by State Bank in the following three categories: 1. Financing by lending
2. Trade-related modes
3. Investment-type modes A scrutiny of all modes of financing under investment-type (including Musharika) reveals a common characteristic that the return on the finances provided is variable and based on the principle of sharing. While no return is received on funds provided under financing by lending, the return under trade-related modes of financing is fixed and mutually agreed in advance between banks and their customers. Modaraba and Musharika Defined A legal definition of Musharika is not available as any specific law has so far been enacted in Pakistan to govern the conduct of Musharika. On the other hand, a Modaraba Companies and Modaraba (Floatation & Control) Ordinance 1980 was promulgated in Pakistan which defines a Modaraba in the following words:
"Modaraba means a business in which a person participates 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".
Since Modaraba and Musharika are the variants of the same principle of profit and loss sharing, Musharika as a mode of bank financing may be defined as an arrangement based on the principle of profit and loss sharing in which parties to the contract participate with their money or efforts or skills or a combination of them as may be provided for in the Musharika Investment Agreement. In Pakistan, any arrangement of bank financing based on the principle of profit and loss sharing which does not fall under the legal definition of Modaraba may be termed as Musharika. In Modaraba as well as in Musharika the basic principle regarding sharing of profit and loss is the same. That the profits may be shared in the proportion agreed to between the parties to the contract but a loss is always to be borne by the 'capital' alone in exact proportion of the capital of each of the contributors. For this reason where a party to the arrangement does not provide any capital it does not share in the financial loss of the business. In the absence of a specific law on the subject of Musharika, a Musharika arrangement between a bank and its customers is to be governed by the terms and conditions incorporated in the Musharika Investment Agreement. But the terms and conditions of the Agreement must remain in harmony with the instructions issued from time to time by State Bank of Pakistan.
To expressly exclude the financing by banks on the basis of profit and loss sharing from the ambit of the Partnership Act 1932 and to save them from incurring the liabilities of being a partner under the said Act, an amendment was made on December 31, 1984 and a new Sec-tion-6A was inserted in the Partnership Act which reads as under: Act not to apply to certain relationships - nothing contained in this Act shall apply to a relationship created by any agreement between a banking company and a person or group of persons providing for sharing of profits and losses arising from or relating to the provision by the banking company of finance to such person or group of persons. For the purpose of this Section, "banking company" and "finance" shall have the same meaning as in the Banking Tribunals Ordinance, 1984". This amendment became necessary in view of the fact that Section-4 of the Partnership Act, 1932 defines 'partnership' as the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Without the insertion of Section-6A in the Partnership Act, 1932, banks providing finance to their customers on the basis of profit and loss sharing could be implicated in liabilities for being a partner. Range of Profits Complete flexibility which was allowed to banks in negotiating the terms of Musharika arrangement was modified by State Bank of Pakistan at the end of 1984 by prescribing the minimum and maximum range of annual profits which could be earned by banks in Musharika financing. Where this financing was provided by banks out of their resources (i.e. banks' own capital and deposits mobilized from their account-holders) it was laid down by State Bank of Pakistan those banks could only enter into Musharika arrangements where the expected annual rate of profit on their funds was not less than 10%. This is the minimum rate, but there is no maximum prescribed. In case of priority sectors of the economy such as exports, etc. where it is intended to provide cheaper credit, State Bank provides refinance to commercial banks to enable them to finance their own customers on most favorable terms. From time to time State Bank prescribes concessionary
Table 1. Annual Range of Profits
Description Minimum Maximum
i) For exports under Export Finance Scheme. No minimum 6%
ii) For Part 1 (local sales) of the scheme
for financing locally manufactured machinery. No minimum 7 1/2%
iii) For Part 11 (export sales) of the scheme for
financing locally manufactured machinery:
a) Pre-shipment stage No minimum
b) Post-shipment stage 7% No maximum
iv) For other purposes for which specific
instructions have not been issued. 10.% No maximum
rates of profit for the priority sectors of the economy. The following range of annual profits was last laid down by State Bank of Pakistan vide their BCD Circular No. 24 dated May 25, 1985 pertaining to investment-type modes of financing. In cases falling under (iv) above, if the minimum rate of annual profit (i.e. 10% p.a.) is not earned by a bank, all such cases of financing of Rs. 10 million or above have to be reported to State Bank of Pakistan on half-yearly basis. This is a precaution adopted to safeguard the interest of banks' depositors who are the ultimate beneficiaries of banks' profits under the new system on non-interest banking, Selective Financing
Since the deposits received by banks in their PLS Accounts are to be employed in Musharika financing it is to be ensured by banks that the cases selected for financing on sharing basis are in a line of business which is prima facie not repugnant to 'Shariah'. This is essential to the concept of Islamic interest-free banking which rests on the premise that the income distributed by banks to their PLS depositors is free from the component of interest and the nature of the business financed by banks is also 'Halal' i.e. permissible in 'Shariah'. Multi - transaction Accounts The working capital financing by banks on the basis of Musharika is normally made available by banks in the form of a chequing multi-transaction account with facility for withdrawal and deposit of funds at the convenience of the customer. It is, therefore, obvious that in a Musharika financing arrangement the amount invested by the bank usually fluctuates on day-to-day basis. For this reason, profit and loss is shared by banks on the basis of daily closing balances (i.e. daily products) of the Musharika Investment Account of a customer and not on the basis of amount of the sanctioned limit or line of credit. There is no bar should a customer decide to avail of the Musharika finance in single-transaction Demand Finance Account. Likewise, customers' investment in their business is also reckoned on the basis of daily closing balances (i.e. daily products) of their capital employed. Customers' Capital State Bank of Pakistan has though not excluded any category of customers from being financed by banks on the basis of Musharika yet the banks are providing finance only to the corporate sector (i.e. limited companies) on this basis. For the purpose of sharing of profit and loss, the total of the credit balances in the following heads of accounts is treated as the capital of a company:
a) Paid-up Capital
b) All reserves
c) Unappropriated profits
d) Any other funds on which interest/return is not paid
Losses brought forward are deducted from the above total to arrive at the capital of a company. Participatory Redeemable Capital Outside finances obtained by a company for employment in business on the basis of profit and loss sharing have been collectively defined as the participatory redeemable capital in the Companies Ordinance 1984. Musharika financing provided by banks to limited companies is now termed as redeemable capital' to distinguish it from the permanent equity of the company. Some other amendments have also been made in the Companies Ordinance 1984 to support and accommodate some corollary issues emanating from the new concept of redeemable capital. Evaluation of Proposals In Musharika financing banks restrict their role to the monitoring of a company's performance without interfering in its management. The finance provided by banks is also not a part of the permanent equity of a company, though there is no legal bar for banks to finance the working capital needs of a company in the form of equity participation if it is mutually agreed between them. The decision whether to enter into a Musharika arrangement with a company is based on time-honored and prudent practices observed by banks all over the world. Efficient management, commitment-worthiness and a good performance record are some of the more important criteria on which a decision is normally taken. However, in cases of new companies banks have to exercise their good judgment. Banks may adopt different techniques in evaluating a Musharika financing proposal. To evaluate the profitability of a proposal with objectivity the under noted exercise will be found helpful in quantifying the profit performance of a company wishing to enter into a profit and loss sharing arrangement with a bank. Profit Projections and Sharing Profit sharing ratios are determined on the basis of profit projections made by a company in line with its past performance or in the light of its justifiable future plans and the economic climate in general. Banks do not claim share in the profits of a company on equal footing which would mean sharing of profits in strict proportion of the invested capital of the bank and the company. In Musharika, banks only provide funds whereas a company or its directors besides providing capital use their enterprise, energies, skills, expertise and connections in running the business and its affairs. This aspect is given due consideration in deciding the profit-sharing ratios. Legal Relationship The legal relationship of debtor and creditor has been retained in Musharika arrangements to meet the requirements of Banking Companies Ordinance 1962. As a result of amendments in the said Ordinance the definitions of debtor and creditor have been enlarged to include banking relationship based on profit and loss sharing. Obviously, the debtor and creditor relationship is applicable for-the recovery of bank's initial Musharika capital with necessary adjustments for the profit or loss due to the bank. Security Aspect Securities obtained in Musharika arrangements are similar to securities offered against advances allowed under the previous interest-based system such as pledge or hypothecation of goods or mortgage of property. Legal documents obtained to create bank's charge on securities have been suitably amended or entirely redrafted.
Guidelines
a) In the light of guidelines given in State Bank's BCD Circular No .21 dated June 30,1982 for sharing of profit in a arrangement, banks give due recognition to the quality of a company's management by setting apart a portion from the profits of the company as a reward for its managing the business. This portion is known as management bonus or management fee.
Table 2, Evaluating a Proposal: A Hypothetical Example
I. Capital of the Company (a) Actual Paid-up Capital Rs. 15,000 (b) All Reserves Rs. 5,000 (c) Unappropriated Profit (if any) Rs. 2.,00 (d) Any Other Funds on which Interest/Mark-up/ Hire/Rental is Not Paid
(Detailed Below): (i) Participation Term Certificates Rs. 5,000 (ii) From Directors Rs. 3,000 (iii) From Other Sources (i.e. Musharika Investment from Other Banks) Rs. 5,000
Total RS. RS.35,000 (e) Deduct Losses Brought Forward (if any) Rs. _
Net Capital Rs. 35,000
II. Net Return on the Capital of the Company
(a) Company's Net Capital Rs.35,000
(b) Pre-Tax Net Profit (Annual) Rs... 6,000
(c) Return on company's Capital Employed 17.14 % p.a
III. Profit Projection for the Next Year (a) Net Capital of the Company Rs. 35,000
(as per part I above)
(b) Musharika Investment Applied For Rs. 10,000
(Total a&b) Rs. 45,000
(c) Projected Pre-Tax Net Profit on Combined Capital Rs. 9,000 (d) Net Return on Combined Capital
u above 5 x 100 20 % P A
a + b
IV. Provisional Profit Sharing Ratio
(a) Projected Pre-Tax Profit Rate on Company t 20 % P.A. Bank's Combined Investment (b) Management Bonus/Fee 25% of the pre-tax profit at serial 1 in section IV. (c) Weightage of Bank's Investment, if any Nil % i.e. total of bank's product* shall be multiplied by Nil (weightage).
(d) After payment of the management bonus/fee (if any) the total products of bank's Musharika investment (with weightage, if any) and the total products of company's capital shall share the pre-tax profit as agreed to. This' expected return on bank's investment may be referred to as 'Provisional Profit'
b) After payment of the management bonus / fee (specified as a percentage of the projected pre-tax annual profits) the remaining profit is distributed between the company and the bank in the ratio of the totals of daily products of their funds employed. Companies with employment of similar amount of capital do earn different rates of return on their capital. It is the quality of the management which makes the difference. In all fairness, a company showing a better rate of profitability must be rewarded for the quality of its management. For this reason management bonus / fee at a higher rate is allowed to companies showing higher rate of profitability. a) If the projected profit is exceeded, banks in their sole discretion may allow management bonus or fee to the company at a higher rate than agreed to the management bonus / fee is payable to a company only on achieving the profits projected. This is a caution against exaggerated projection of profits. In genuine cases of shortfall, however, banks may allow the management bonus fee at a reduced rate instead of forfeiting it completely. Declaration of Profits. All companies in Pakistan usually prepare their final accounts once in a year. As such, banks' share in profits on their Musharika investment shall become receivable only once in a year whereas banks in Pakistan are following the practice of paying profits to their PLS depositors at the end of every half - year in June and December to enable banks to pay half - yearly profits to their PLS depositors, it is generally stipulated that companies pay to banks their share in profits on a provisional basis at the stipulated rate at end of each calendar quarter. The final adjustment is, however, made in the quarter following the end of a company's accounting year. If the actual profit earned by a company is more than the projected figures, a little more becomes payable to the bank in the said quarter. If the actual profit earned is less than projected figures a smaller amount is receivable by the bank in the said quarter. To encourage the prompt payment of bank's share in profit some banks allow a prompt - payment rebate to their clients. Situation of Loss A company financed on the basis of Musharika by a bank may also show a loss despite its projections of profits. The possibility of loss is, however, very remote for two reasons. Firstly, it indicates a serious misjudgment of risk on the part of the financing bank. Se-
condly, the amount of interest that a company used to pay previously to a bank on its interest-based borrowings, is not to be paid now. For instance, if a company used to borrow Rs. 10 million on interest from a bank, the reduction on account of interest alone amounts to about Rs. 1.4 million which amount is now added to the pre-tax profits of the company. Despite all this, if the company earns only rupee one as its pre-tax annual profit, it cannot be termed as a company in loss. Companies showing recurring losses stand no chance of being financed by banks on the basis of Musharika. Checks are also provided in the Musharika investment agreement to guard against a situation of manipulated loss. Accounting for Loss If a company suffers a loss, it is to be shared by the bank and the company in strict proportion of the daily-products total of bank's Musharika investment and company's own capital. The accounting for loss can be done in two ways. If a company has an existing reserve, the company's share in loss calculated in the above manner be debited to its reserves and the bank's share in loss debited to Musharika investment account of the bank in company's books and in turn, be debited by the bank to its PLS Income Account crediting the same to Musharika investment account of the company in books of the bank. The debit balance in company's Musharika investment account with the bank shall thus stand reduced by the amount of bank's share in the company's loss. If a company does not have reserves where the amount of company's share in loss is to be debited, the loss will have to be carried over in the balance-sheet as a 'fictitious asset' as this loss cannot be debited to the company's capital. If bank's share in loss is wiped off the company's balance sheet by debiting the amount to the bank while the company's share in loss is carried over as a 'fictitious asset' in the balance sheet, it amounts to an unequal treatment and also reflects not the true position of the company's financial affairs. In such case it may be preferable to carry over the total loss (including the bank's share) in the company's balance-sheet. Procedural Steps
a. On receipt of the sanction of the controlling authority, branch of the bank opens a 'PLS Musharika Investment Account' of the company. The account is maintained in a separate ledger meant for 'PLS Musharika Investment Accounts'. The company is allowed to make drawings from this account through cheques.
b. The drawings from the account are allowed after Bank's charge is registered with the Registrar, Joint Stock Companies and other documentation is complete.
c. The drawings are restricted to the maximum of the approved limit within the 'Drawing Power' of the account and the daily closing balances are treated as the 'daily products.'
d. The total of balances in all PLS Musharika Investment accounts with the branch are reflected in the General Ledger under 'PLS Musharika Investment.'
e. At the end of each calendar quarter, the 'daily products' are worked out by adding the daily closing balances. Bank's share in profit is provisionally paid by the company at the end of calendar quarter at the stipulated rate.
f. At the end of every calendar quarter, bank's share in profits is worked out. On March 31, June 30, September 30 and December 31 the bank is authorized to recover its share of profit by debiting the company's account subject to necessary adjustments as already described.
g. If by debiting the amount of provisional profit, the debit balance in the company's account remains within or equal to the drawing power and the sanctioned limit, some banks allow prompt payment rebate. If by debiting the company's account with the amount of bank's share of provisional profit drawing power and the sanctioned limit is exceeded, no prompt-payment rebate is allowed for the amount by which the account remains irregular. Revised Musharika Agreement In the preceding paragraphs elements of Musharika arrangement as adopted by some banks have been described in general terms. Now a revised Musharika Investment Agreement has been introduced which is yet to be implemented. In this agreement some new clauses have been incorporated which are based on the latest amendments made in the Companies Ordinance 1984. Salient features of the revised Musharika
Investment Agreement are described below:
a. Bank's investment in Musharika has been described as the 'redeem able capital' of the company.
b. All funds obtained by the company from various sources on the basis of profit and loss sharing have been collectively termed as 'Other Participating Funds.'
c. Projected pre-tax annual profit indicates the rate of expected re turn on the total investments of (i) the company (ii) the bank and (iii) other participating funds.
d. 'Provisional Profit' is the rate of return which is expected to be earned on bank's investment on the basis of profit sharing.
e. The company is required to open an additional account with the bank which is always to be kept in credit with an irrevocable authority in favor of the bank to debit this account at the end of each quarter with the amount of bank's provisional share in profit for the quarter calculated on the basis of daily products.
f. On preparation of the company's final annual accounts, if the bank's share in the actual profit of the company turns out to be more than the 'provisional profit' already received by the bank, the excess amount shall be credited to a special reserve called the 'Participation Reserve'. (Transfer to this reserve has been limited and further qualified through an amendment made on 31.12.84
in Section 23 of the Income Tax Ordinance 1979).
g. If the bank's share in the actual profit of company turns out to be less than the 'provisional profit' already received by the bank, the difference shall be debited to the Participation Reserve.
h. Upon termination of the Musharika arrangement a final account of profit or loss due to the bank shall be prepared. If there is a credit balance available in the 'Participation Reserve' the bank may permit the company to retain whole or any part of the credit balance by way of good management fee. (If the balance in the Participation Reserve is found to be in the debit at the end, its treatment has been left unspecified in the Agreement which needs attention. This shortfall is the result of reduced profits and not of loss).
Musharika Investment Agreement is initially for a period of one year, but is automatically renewed from year to year except where the bank or the company gives a notice for the termination of the Musharika.
j. If the bank's actual share in profit of the company is lower than the provisional rate of profit in any two of the preceding three years, the bank has the right to convert not more than twenty per cent of bank's investment into ordinary shares of the company at a break-up value in accordance with the rules prescribed under section 120 of the Companies Ordinance 1984. (The amended section 87 of the Companies Ordinance 1984 provides that such shares shall not be issued unless the return falls below the minimum rate of return laid down by State Bank for the said years and not the provisional rate, as mentioned).
k. If the company suffers a loss, the bank has the right to convert its investment or part of it or acquire ordinary shares of the company at its break-up value to the extent of bank's share in the company's loss. (Whereas the amended section 120 2(d) of Companies Ordinance 1984 makes it conditional on 'Net loss' on participating redeemable capital on the date of maturity).
1. In the event the company fails in performance of the covenants of the Agreement, the bank has the right to exercise voting rights pari passu with other shareholders of the company to the full extent of redeemable capital invested by the bank.
m. Losses suffered by the company due to various non-business reasons are to be borne by the company alone and in some cases of defaults 'liquidated damages' are also to be paid to the bank.
Conclusion
Though full of difficulties, Musharika financing is the central piece of Islamic system of non-interest banking. It is also technically adequate to cater for all the financing needs of banks' customers who are in a profit-oriented line of business. If used factually and extensively, Musharika financing shall instill flexibility and responsiveness in our banking system. It, therefore, needs to be promoted vigorously through official initiative as well as the combined marketing support of all the banks and the development financial institutions in Pakistan.
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