Mudaraba-based Investment and Finance

by
A.L.M. Abdul Gafoor∗
Groningen, the Netherlands

CONTENTS :

Brief history 2
Social context: past and present 3
Islamic banking 5
Participatory financing 6
Issues in implementation 8
Conclusion 9

Appendix 10
Terms and procedures relating to PF stocks and shares 10
1. PF Shares 10
2. PF Stocks 11
3. PF Projects, the PF “Company” and profit/loss sharing 11
3.1 PF Projects 11
3.2 PF “Company” 11
3.3 Profit/loss sharing 11
4. PF Dividends 12
4.1 Disbursement 12
4.2 Computation 13
5. Inflation and value erosion of capital 13
References 14

In any economy, private investment occurs in two different ways: active investment,
where one or more persons put their own capital into a project, manage it themselves
and enjoy the fruits of their labour and capital themselves; and passive investment,
where the investor provides the capital and receives a return but takes no further part in
the project. Broadly speaking, a passive investor has three options: one, buy shares in a
company and receive a dividend; two, buy bonds or securities and receive interest;
three, deposit in a bank and receive interest. In an Islamic economy, active investment
and the first option are permissible while the last two options would be regarded as riba

∗
The author is indebted to Dr. Saad Al-Harran and Tarek El-Diwany for reading through an earlier draft
and critically commenting on it. Author’s e-mail: abdul99@europe.com.
(interest) income and therefore prohibited. On the entrepreneur side, he may finance his
project using his own capital, by selling shares in his enterprise, or by borrowing on
interest (from a bank or by issuing bonds/securities). In an Islamic setting, the first two
methods are permissible while the last is not. For clarity the scena rios are depicted in
Tables 1 and 2.

Table 1. Investment options for capital-holders

Type of Mode of investment Type of return on capital Islamic

investment position
Active In own enterprise Profit or loss from the Allowed
investment enterprise
Passive Shares in a company Dividend (profit or loss) Allowed
investment from the company
Bonds/securities Fixed positive return (riba) Prohibited
Bank deposit Fixed positive return (riba) Prohibited

Table 2. Financing options for entrepreneurs

Type of Mode of financing Type of return on capital Islamic

financing position
Active finance Own funds Profit or loss from the Allowed
enterprise
Passive finance Share capital Dividend (profit or loss) Allowed
from the company
Bonds/securities Fixed positive return (riba) Prohibited
Bank loans Fixed positive return (riba) Prohibited

Both conventional and Islamic systems permit and encourage active investment, which
rewards labour and capital from realised profits. Both also permit and encourage
passive investment in shareholder companies, which too reward capital from realised
profits in the form of dividends. In both cases any realised loss is borne by the capital-
providers. But any investment that brings in riba income or financing that involves the
payment of riba is prohibited in an Islamic system. This leaves the Muslim passive
investors who cannot or will not buy shares in a company and Muslim entrepreneurs
who do not have their own capital or cannot raise share capital but need seed capital
and/or additional funds in a difficult situation. If not for their religious convictions,
they would resort to bonds and securities or fixed deposits and bank loans. Since this
category of investors and entrepreneurs form a large section of the Muslim investor-
entrepreneur community, it is necessary to address their difficulty. This essay explores
the options available to this group within an Islamic setting. Participatory Financing
explained in the following paragraphs is a system developed to address this special
concern of Muslims. It is based on the ancient concept of mudaraba.

Brief history
Mudaraba is an ancient form of financing practised by the Arabs since long before the
advent of Islam. It suited the Meccan Arabs because of their location at the cross roads
of the ancient trade caravans. They themselves were merchants carrying goods north to
Syria in the summer and south to the Yemen in winter. They took goods from their
homeport to sell at their destination, and with the proceeds bought other goods and
brought them back to sell at home and/or to re-export to another destination. When a
trading caravan is organised it was the practice of the Meccans either to join it with their
own goods and money or to send such through agents who did the business on their
behalf. When a caravan returned home and the goods were all sold, the mission was
complete and it was time to prepare the ‘balance sheet’ and calculate the profit/loss.
Traders who took their own money and goods assessed the success of the mission by the
profit/loss they made and enjoyed the fruits of their labour or mourned their loss on
their own. Those who combined their fortunes with that of one or more of their
colleagues and undertook the project together had to go one step further and divide the
fortune or loss among the partners, according to a pre-agreed pattern. The rules of this
pattern had long been established by custom and had been known by the name
musharaka. The agents who carried others’ goods and/or money had to give accounts
to their principals and claim their share of the profit/loss according to a pre-arranged
pattern. This too had rules assigned by custom and was known by the name mudaraba.
When Muhammad (Peace be upon him) began his prophetic mission he did one of three
things with regard to the practices of the Arabs: 1) if it involved the denial of the
existence or the uniqueness the one God (Allah) or associating anything or anyone with
Him or was against any command of God, he prohibited it outright; 2) if it did not
involve any such action he did not interfere with it; 3) if some useful or essential
practice involved some elements of the first, and if that could be removed, he removed
the offending elements and allowed the modified version to be practised. Mudaraba
and musharaka belonged to the second group.
Nabil A. Saleh in his authoritative and very readable book, Unlawful Gain and
Legitimate Profit in Islamic Law (1986), gives detailed descriptions of the rules relating
to mudaraba and musharaka, including the differences of opinion in the interpretation
of these rules by the later schools of Islamic Law. A recent (1999) publication by
Justice Taqi Usmani is a very useful contribution to Islamic finance. It is useful to
students and teachers of Islamic banking and finance on account of the authoritative
definitions given of the terms and concepts used in the field, and because of the detailed
explanations and background information provided. It also describes how these
concepts are currently implemented, and points out the shortcomings and gives
suggestions for improvements. Though the present author does not, with all respects,
agree with all the suggestions, the book is perhaps a must in the library of every student
of Islamic banking and finance. In it he singles out mudaraba and musharaka as the
only true modes of financing. The others such as murabaha, ijara, salam, istisna are
modes of trade which are presently being used as modes of financing.
Islamic financial institutions assume the role of traders and use the modes of trade but
remain financiers. This metamorphosis is achieved by ‘legal’ documentation and some
self-persuasion. It does not, however, convince many; and the root of the problems
faced by Islamic banking and finance today lies in this split personality. The theme of
this article is: let the financiers be financiers, and the traders and entrepreneurs be
traders and entrepreneurs.

Social context: past and present

The Mecca of 1400 years ago was a small city (of possibly a few thousand inhabitants),
practically everyone of any significance was known to everyone else, and the
assembling of a trade caravan was a great public event that took place twice a year. The
Who’s Who? of the financiers and the agents, their character and abilities, who took
what, what was sold for what price, what was bought for what price and the sale price
were all public knowledge. There was little room for misbehaviour and the price for it
in terms of social ostracism was very high.
Today, in the modern world, especially in large cities, practically everyone is a stranger
to his neighbour. Financial affairs are strictly private. Who has money, who needs it,
and to do what are all generally unknown to any other. But the bank has become privy
to this information, including the amounts, and has established itself as an intermediary
between the owner of funds and the entrepreneur who needs it.
The reality today is that there are many capital- holders who wish to earn an income
from their capital but have neither the time nor the skills necessary to embark on a
project. They may range from simple wage earners who have saved some money,
pensioners, widows or orphans who have received a lump sum payment, trusts and
institutions with whom some capital has been entrusted, to insurance companies and
individuals who have inherited a fortune. The size of their capital too may vary from
hundreds and thousands to millions. They need to invest their capital in a profitable
undertaking, but may not know any entrepreneurs who wish to embark on a project and
are looking for financiers. Even if they find one they may not have the necessary skills
to assess the viability of the project or the ability and integrity of the entrepreneur. On
the other hand, entrepreneurs who have viable project proposals may not know those
who have the required funds and are willing to invest in their projects.
This is where, in the context of the present-day, the need arises for a financial
intermediary who could bring the investor/financier and the entrepreneur together.
Conventional banks do perform this role very effectively and efficiently. Capital
holders deposit their funds with the bank, and entrepreneurs submit their project
proposals to the bank, the bank examines the business plan and if it is satisfied that the
project could bring in sufficient income to allow the repayment of the principal and
interest, and provided sufficient collateral is also available, the bank advances a loan.
The bank does not get involved in the project; whether the entrepreneur/borrower makes
a profit or loss he pays the principal and interest on due dates, or the bank has recourse
to the collateral. The bank accepts the depositor’s capital, guarantees its full return, and
pays him an interest (or return on his ‘investment’) at a fixed rate, and uses the capital to
grant loans to borrowers. But the interest rate given to the depositor is always smaller
than the rate the bank charges the borrower, and the difference goes to cover its own
expenses and profits.
This seems to work very well if people have no qualms about paying or receiving
interest, despite the built- in injustice to both the entrepreneurs and the depositors. 1 But
some people are beginning to have qualms, and Muslims are prohibited from earning an

1
The entrepreneurs must pay the pre-fixed interest even when they do not make that much profit, and
worse, even when the enterprise goes bankrupt. In the latter event, the bank confiscates the collateral and
the depositors/investors are guaranteed their capital. The entrepreneurs take this risk in exchange for
liquid capital, which they do not own. When the enterprise makes very good profit, the borrower still
pays the same fixed interest, and the depositors benefit nothing from this bounty. The depositors forego
this benefit for the certainty of their guaranteed capital and return. In either case the bank recovers all its
costs, and assures itself of a positive return. Each one’s expected return and commitment are known in
advance with certainty, and each can make forward plans accordingly. This certainty is considered an
important advantage.
income in this fashion. 2 Islamic banking is a response to their concern  an alternative
method to address the need, minus the injustice.

Islamic banking
Mudaraba is essentially an agreement between a financier and an entrepreneur — the
principals. However, taking account of the modern social structure and context, the
pioneers of Islamic banking brought in an intermediary between the principals and
created a two-tier mudaraba. This modified form of mudaraba was introduced into
conventional commercial banking in the form of profit-and- loss-sharing (PLS)
investment accounts and financing arrangements. The earned profit (which is an
uncertain and unpredictable return on capital) was to replace the interest (a pre-
determined fixed return) in the conventional setting. This, however, was not acceptable
to the conventional banking authorities. Therefore, except in a few countries where
rules were relaxed or special banking laws were enacted, it was not possible to establish
and operate Islamic banks in most countries of the world. In such countries Islamic
financial institutions, which did not come under deposit bank regulations, were
introduced. In both cases, while the deposit/investment side worked on mudaraba
basis, mudaraba was only one of several modes used for financing. Though a preferred
one in theory, in practice it became one of the least used. The most used forms are
modes of trade, and this has led to questions of morality and ethics. In addition, Islamic
banks are unable to provide all the financing services expected of a commercial bank. 3
One of the very serious consequences of using modes of trade as modes of financing is
that Islamic financial institutions are confined to financing short-term trade, and are
unable to finance long-term projects in industries, agriculture, services, etc. 4 The latter
are equally important, if not more, to any country except perhaps for some few raw
materials exporting countries which import all other products. But this situation too
cannot continue for long. Many, including Dr. Ali Yasseri in a recent (August 2000)
article, cry out for a new approach. The question is: is there a viable alternative
methodology? A comprehensive new methodology has been developed in a series of
three books published in the last few years, and an overview of the salient features of
the new approach is given in a recent publication. 5
The author argues that, “In Islam, there is a clear difference between lending and
investing  lending can be done only on the basis of zero interest and capital guarantee,
and investing only on the basis of mudaraba. Conventional banking does not  and
need not  make this differentiation.” But a system catering to Muslims “has to take
this into consideration” and “…provide for two sub-systems  one to cater to those
who would ‘lend’ and another for those who wish to invest.” The first sub-system
would cater to those who wish to put their money into a bank for safety and transaction
convenience; and the bank would provide all current account facilities and short-term
loans and advances. This is explained in a 1995 publication  Interest-free
Commercial Banking. The 1996 publication  Participatory Financing through
Investment Banks and Commercial Banks  describes the second sub-system, where
both investment and financing are strictly on the basis of mudaraba. Though the title

2
The consequences of the injustice becomes glaring only over long periods and when the amounts
involved are large, as in the case of national debts of many developing countries. But when the loans are
for consumption purposes, the ill effects are one-sided and they are seen much quicker, whether the
borrower is an individual or a country.
3
See Gafoor (1995) for details, pp. 44-77.
4
Ahmad (1994).
5
Gafoor (2000).
mentions only banks, the methodology can be used by investment companies as well.
In this article we propose to bring out the salient features of the second sub-system. 6
[In the present era inflation is an important consideration where money is involved, and
this has serious consequences in a riba- free system. An attempt at dealing with it in the
context of banking and finance is presented in the third book: Commercial Banking in
the presence of Inflation (1999).]

Participatory financing
The central idea in the concept of mudaraba is that two parties, one with capital and the
other with know-how, get together to carry out a project. The financier provides the
capital and plays no further part in the project; specifically, he does not interfere in its
execution, which is the exclusive province of the entrepreneur. If the project ends in
profit they share the profit in a pre-arranged proportion. If it results in loss the entire
loss is borne by the financier, and the entrepreneur gains no benefit out of his effort,
which was his part of the investment. There are many variations of this simple model
but this is the basic concept. Mudaraba is usually translated as profit-and-loss-sharing
but, as far as the financier is concerned, it is in fact profit-sharing-and- loss-absorbing.
In participatory financing, as envisaged in the present discussion, there are three
important additions to this basic concept. One, there are many investors and many
entrepreneurs. Two, an intermediary comes in with whom investors deposit their funds
and the intermediary finances projects put forward by entrepreneurs. In this investors-
intermediary-entrepreneurs triangle, the investor is essentially a sleeping partner. He
provides capital and then shares the profit or absorbs the loss. It is the responsibility of
the entrepreneur to present a good proposal, convince the financier that it is viable and
profitable, and provide proof that he is able, qualified and experienced to carry out the
project successfully. The intermediary is both an entrepreneur and a financier. When
he accepts funds from an investor, he is an entrepreneur; and when he finances a project
submitted by an entrepreneur, he is a financier.
Three, individual investors and individual entrepreneurs have no direct
contact/relationship with each other. The investor does not know which project is
financed by his capital, and the entrepreneur does not know whose money is financing
his project  a pool of funds from several investors finances a series of projects from
several entrepreneurs. When it comes to profit/loss sharing too it is the net profit/loss
from all the projects that is shared among the investors (and the intermediary). The
individual entrepreneur, however, shares with his financier (the intermediary, in the first
instance) the profit/loss from his own project only.
It is appropriate at this point to state that in the above scenario, the financiers  both
the investors and the intermediary  operate purely on the basis of mudaraba while the
entrepreneur is free to choose any mode of practice (such as murabaha, ijara, salam,
istisna, etc.) appropriate to his trade, business, industry, agriculture, etc. to run his
enterprise. Thus the proposed method simply avoids the need to devise dubious
“financial instruments” which have brought the very concept of Islamic banking and
finance into disrepute. This also nullifies the need for “Shari’a Boards” in these
institutions.
Another important characteristic of ancient mudaraba was that it was a one-project,
time- limited contract. That is, the contract (between the two principals) began with the
assembling of a particular caravan and ended with its return — each new caravan started

6
The salient features of the first sub-system are described in a companion article, RLED-free Commercial
Banking, also available on the author’s website.
with new contracts, whether with the same partners or with new ones. Today no trade
caravans ply between distant lands, assembling anew and dismantling each season; but
businesses, industries and all kinds of other enterprises are established and run on a
long-term basis. Therefore, in the modified version this time- limited, single-project
characteristic has also been removed. This enables the basic concept of mudaraba to be
applied to all kinds enterprises on a long-term basis.
The function of the intermediary is very important. He is responsible for identifying
good projects for financing as well as for monitoring their progress and ensuring proper
accounting and auditing. But he (the intermediary) plays no part in managing the
project or in making policy decisions — that is the exclusive domain of the
entrepreneur. The intermediary is a separate physical and legal entity, independent of
both the investors and the entrepreneurs. But he (she/it) is an equal partner in every
project he finances so that he has full legal right to the physical and financial assets of
all the projects and has full access to all the books. This is very important, and it is here
that participatory financing differs from conventional financing practices; in this respect
it differs from the current practices of Islamic banks too. This allows the intermediary
to have a true picture of the health of the projects at all times. He can then take any
preventive or corrective actio n (in extreme cases), and, in the event of failure of a
project, he can recover whatever is left of it. This possibility gives assurance to the
investors that their investment is safe, albeit within limits which they are aware of, and
that the profit and loss account given to them is reliable and transparent. The fact that
the investors’ confidence in the intermediary and the intermediary’s own profit depend
on the number and size of successful projects should ensure that the intermediary seeks
out good projects and closely monitors their progress.
One important feature of participatory financing is that the entrepreneur need not
provide security for the financing he receives. The project itself is the security, and the
intermediary, being an equal partner in the enterprise, is its guardian. This should play
a very constructive role in discovering and developing new entrepreneurial and other
talents in the society, especially at the micro level, otherwise unearthed on account of
the unavailability of collateral/security.
The proposed scheme provides for two types of investments: one called Participatory
Financing (PF) stocks and the other PF shares. These are essentially stocks and shares
in the intermediary’s PF scheme (which is a collection of all (or a group of) the projects
financed by the intermediary). PF shares correspond to unit shares because every PF
share contains a tiny portion of every project in the scheme. PF stocks roughly
correspond to fixed deposits in a bank. 7 The main difference between the conventional
fixed deposits and the PF stocks is that the return in the latter is computed from the
profit and loss statements of all the projects in the PF scheme (and the profit/loss shared
among the participants) at the end of the accounting period. Therefore the profit/loss is
a realised one, and not an anticipated or pre- fixed one. Thus neither speculation, nor
uncertainty, nor riba is involved in the operation. But the PF stockholders will have to
wait till the end of the accounting period to collect their returns.
The status of each of the three participants in this scheme is as follows. The
intermediary (an investment bank or an investment company) is a holding company
with the legal status of a (public) limited liability company. The investor may either
hold a PF Share or a PF Stock. The PF shareholders are like ordinary shareholders in
the holding company’s PF scheme. The PF stockholders are like the time-deposit
holders in a bank. Each project is a partnership limited liability company where the
entrepreneur and the holding company are the two partners. PF shares provide the

7
See appendix below for more explanatory definitions.
equity capital for the PF projects, while the PF stocks cater to the short-term cash
requirements (which are normally met by loans and advances from commercial banks).
In essence, participatory financing combines features of time deposits, business
organisations (partnerships, shareholder companies and holding companies), and unit
trusts on the one hand, and equity capital and commercial bank loans and advances on
the other. It makes use of well-known rules and techniques of financing, company laws
and accounting procedures. That makes it easy to implement, but the combination of all
these in one single system within an entrepreneurial environment is a new formulation.
That makes it a challenging one, requiring new attitudes and a comprehensive approach.
We will briefly touch on these issues in the next section.
The theory of participatory financing has been fully developed and presented in the
book. The depth of the theory can be gauged from the details given in the appendices,
one of which is reproduced below (with slight explanatory modifications to suit this
article) to help better understand the system.

Issues in implementation
The implementation of this system requires the cultivation of new attitudes on the part
of all the participants. This is a tall order but is an absolute necessity if we are to create
a truly riba- free economy. It requires more from each participant, but it also offers
more both to the individual and to the society as a whole. From the investor it requires
the full understanding that he/she/it may incur loss and that he will have to wait longer
to know the results, but it promises a truly riba-free income and possibly better profits.
From the entrepreneur it requires complete and accurate bookkeeping and full
disclosure of all his/her/its accounts and the sharing of his bounty with his financiers,
but it provides him with capital without collateral and the guarantee that in case there is
a loss he will not be required to make it up, provided he had been honest in his dealings
and his books will substantiate it. The intermediary is both a banker and an
entrepreneur. As an entrepreneur, he too is required to be honest in his dealings, and
accurate and transparent as to his bookkeeping and accounts.
Bankers are trained to be very cautious, because their first concern is to guarantee the
safety of the funds deposited with them. But in this system they are relieved of that
concern because the investors have agreed to take the risk, and therefore if they persist
with the banker’s attitude they will miss many opportunities at the investors’ expense.
On the other hand, too much adventurism can bring about low profits or even loss, and
that may lead to the loss of customers. They must have an entrepreneur’s natural talent
to spot profitable projects and to avoid bad ones, and should develop it into a
professional tool. The intermediary’s staff will have to be carefully picked and trained
to bring out inherent entrepreneurial talent. Such intermediaries will have ample
reward, as they will share in the profits. It requires a new culture, a culture of
entrepreneur- financiers and of professionally run partnership companies.
The system is heavily dependent on proper and accurate bookkeeping, accounting and
auditing. That requires the availability of trained bookkeepers and their wide use, as
well as professionally responsible and well-trained accountants and auditors. They are
the bedrock of the system. The system requires a high level of integrity from these
personnel, and it is in the interest of all the participants in the system to respect it.
Substantial investment is necessary in the training of such personnel, and legal
protection is necessary to safeguard the independence of the auditors.
The comprehensive system presented in the four books groups the entire spectrum of
business activities into three broad categories: at one end is the one- man-owned-and-
operated small enterprises, including the ones financed or supported by loans and
advances from commercial banks, and at the other end are the large enterprises financed
entirely by shareholders and managed by professionals. In between are the proposed
participatory-financed enterprises. The size of the enterprise is an important factor in
this categorisation, and the type of financing and the type of organisation must generally
match the size. Presently in all developing countries  to which group most of the
Muslim economies belong  the distribution is highly skewed towards the smaller end.
To achieve a better and stable economy, it is necessary to bring about a more even
distribution.
The mudaraba principle is applicable to a range of situations, from a simple local two-
person partnership to a multiparty international corporation. A shareholder company
works essentially on the mudaraba principle. But the participatory financing scheme
envisaged in this article aims at the middle section of this range. It brings in the
intermediary, and provides the investors with a unit trust type of investment
opportunity. The scheme is ideally suited to medium scale new enterprises. However,
it is possible to modify it slightly and bring in some of the running businesses too into
the participatory financing system. This will help expedite bringing about the even
distribution mentioned earlier.
This can be done as follows. There are two possibilities. One, the enterprise is a
running business and has no debts, and wishes to expand its activities. In this case, first
the present worth of the enterprise (property, equipment, stocks, receivables, etc.
including goodwill) must be determined. This is the capital of the enterprise in
monetary terms. The investment bank/company brings in the necessary additional
capital, and both go into a partnership (preferably by establishing a new private limited
liability company) as before. However, in the present instance the original enterprise
has two roles, as an entrepreneur and as a financ ier, while the investment bank/company
is only a financier. Accordingly, when the profit/loss is computed, the financiers (both
the enterprise in its role as a financier and the investment bank/company) will first share
the profit/loss with the “entrepreneur” on mudaraba terms. Next, the two financiers
will share the financiers’ share between themselves in proportion to their capital
contribution. Finally, the bank/company will credit its share from this project to the
bank/company’s PF pool of profit/loss. The procedure from here on is the same as
previously described.
Two, the enterprise is a running business and has debts owing to, say, a commercial
bank. In this case, the investment bank/company will pay up all the debts and go into
partnership with the enterprise, as in the first case, with this amount as its capital contribution.8
In establishing the new institution of mudaraba-based investment and finance, using the
participatory financing scheme as described above, it is preferable to start with medium
size running businesses. This will provide a stable base for the new institution to test
the theory and to gain experience.

Conclusion
In order to bring about a riba-free economy, the country’s banking system has to be
riba-free, its commercial enterprises have to be financed by equity capital, and its
investments have to be on a profit and loss sharing basis. This article has dealt with
investment and financing, and has introduced a mudaraba-based system called

8
Such partnerships will become necessary if the country’s banking system switches over to the riba-free
commercial banking system proposed in the first book. Because the fixed deposit holders whose
intention was to earn an income using their capital will move their funds from such commercial banks
into investment banks and companies. Consequently, the commercial banks will call in their medium-
and long-term loans, which are generally financed using such funds.
participatory financing that takes into account present-day realities. This is a new
institution specifically developed to address the concerns of Muslims. It has no parallel
in the conventional economy, but the individual tools and techniques it uses are ones
tested and proved in the conventional setting. Thus, while re- invention of the wheel has
been avoided, proving the viability of the new institution and benefiting from it are
challenges specific to Muslims. It is for the Muslim intellectuals, professionals,
investors, entrepreneurs, and other concerned individuals, institutions and organisations
to take up the challenge.
*******

Appendix
Terms and procedures relating to PF stocks and shares

In this appendix we present working definitions of some terms and procedures, which
can be used as a basis for the development of an operational model. The main purpose
here is to indicate the many issues that should be addressed in devising such a model.
The definitions of stocks and shares have not remained unchanged over time, the
distinctions have become blurred, and they have acquired different meanings and
connotations in different countries. For example, what were known as stocks in the UK
are now bonds in the USA, and shares have become stocks. The stocks and shares
under the PF scheme have much in common with the original British definitions of the
terms, but they have also some special characteristics of their own. Therefore we have
to define what we mean by PF shares and PF stocks.

1. PF Shares
Participatory Financing Shares are ordinary shares in the “company”, which consists of
all the PF projects the bank 9 is currently financing or hopes to finance in the near future.
Funds obtained by selling new PF shares are to be used as venture capital for new
projects. On account of the fact that every project will have a gestation period, the
“company” will not be able to post a profit or loss statement on these projects until they
become operational. Therefore PF shares cannot expect to earn a profit or loss during
this period. However, since different projects will have different gestation periods and
because the PF shares are not directly connected to any particular project, we have to
find a way of saying when a PF share begins to earn a profit or loss. One way of doing
it is for the bank to determine a common average gestation period for the projects
expected to come under the PF scheme and to announce this period when the PF shares
issue is advertised. The shares will not earn any profit or loss in this period of, say, one
to three years. The PF shares will mature at the end of this gestation period. And all
mature PF shares will be entitled to a share in the profit/loss of all the operational
projects of the “company”. The “dividend” on these shares is determined on the basis
of the net returns of all the PF projects of the “company” operational during the bank’s
accounting period, say, annually.
Profit and loss accounting is done at the end of the year. Therefore the final “dividend”
awarded to PF shareholders is a realised profit/loss and not an estimated or pre- fixed
one. Hence there is no room for uncertainty, speculation or riba. This is very
important.

9
Bank here means the intermediary (investment bank or investment company).
PF shares are transferable and have no termination points. PF shares will also have a
stake in the assets of the projects. However, since the investors have no direct
connection with any particular project, the claims of the PF shares are on all the projects
of the “company”. Thus, if, for example, a project ends and the assets are sold off or the
bank sells off its shares in a project (perhaps to the entrepreneur or to an outside
investor) the proceeds from such sales will accrue to all the PF shares of the “company”
(providing interim dividends, additional PF shares or increasing their value).
Whether the PF shares are issued periodically, as and when necessary or are available
throughout the year, are all operational concerns and are matters for individual bank’s
decision. The bank may also consider issuing separate shares to different groups of
projects. In this instance each group will come under the purview of a separate
“company”.

2. PF Stocks
Participatory Financing Stocks are funds deposited with the bank for a fixed period of
time, to be invested in their Participatory Financing projects. The return on these
investments are determined on the basis of the net returns of all the PF projects of the
bank operational during the bank’s accounting period, as computed at the end of that
period. And the bank will use these funds mainly to advance further credits to
operational projects. In effect, PF stocks are like fixed-term deposits except that neither
the capital nor the return are guaranteed or fixed in advance.
The special characteristics of the PF stocks would be that: 1) PF stocks will not bear any
fixed rate of return or interest, 2) the return will be determined at the end of each
accounting period, and no attempt will be made to make any estimates in advance, 3) PF
stocks are for a defined period, but they may be reinvested for another defined period,
4) PF stocks have no priority claims over PF shares, and 5) PF stocks share in profit and
loss, but they have no claims on the assets of the projects.

3. PF Projects, the PF “Company” and profit/loss sharing

Now we have to explain what we mean by projects and the “company” in the foregoing
paragraphs, in the context of participatory financing. Also how the profit/loss from the
projects is shared among the participants.
3.1 PF Projects
Each PF Project is an independent business entity whose legal status in the eyes of the
Company Law may be a private limited liability company. The project can be anything
from a large manufacturing concern to a small medical laboratory. There are two main
and essential partners in each project: the participate-financ ing bank and the concerned
entrepreneur. The entrepreneur is the active partner and the bank is the “sleeping”
partner.
3.2 PF “Company”
The PF “company” is an internal arrangement within the bank in order to keep PF funds
and profits separate from the bank’s own capital and profits. Thus the PF “company”
consists of all the PF projects of the bank and all the PF investors whose funds are
financing these projects. When the bank has more than one group of projects, each
group (with its own investors) will form a separate PF “company”.
3.3 Profit/loss sharing
The net profit/loss of each PF project operational during the accounting period is
obtained from its Profit and Loss accounting statement. Each PF project is a mudaraba
partnership with the bank as the financier. Therefore, if there is profit it is shared
between the bank and the entrepreneur according to the pre-agreed proportion. If there
is loss, the entrepreneur neither receives nor pays anything, while the bank takes the
entire loss. This is the first stage of the profit/loss sharing process.
The PF “company” consists of all the PF projects of the bank. Therefore the total net
profit/loss of the “company” is obtained by summing up the bank’s share of the net
profit/loss from all the individual projects.
Two observations need be made here. 1) All the projects – both profit- making and loss-
making – will have their capital investment intact, because the loss of the loss- making
ones would be made up by the financier (this is the meaning of loss absorbing) using the
profits accruing to the “company” from the profit- making projects. This means that the
value of the PF shares of the “company” will remain unaffected at this stage. 2) Since
fewer projects are expected to make loss, the net result for the “company” is likely to be
positive. However, there is always the possibility that the net result can turn out
negative.
The next stage is the sharing of the net profit/loss of the “company” between the bank
and the investors. Their relationship is also a mudaraba partnership. But here the
investors are the financiers and the bank is the entrepreneur. Hence when there is a
profit it is shared between the bank and the investors according to the pre-agreed ratio.
If there is loss it is absorbed entirely by the investors – PF shareholders and PF
stockholders – and the bank pays or receives nothing. The investors’ share of the
“company’s” profit/loss is the PF dividend, and it can be positive or negative.

4. PF Dividends
The “dividend” we have been talking about has one major difference as compared to
other conventional company dividends. Unlike them, as seen above, the PF dividend
can be positive or negative. This needs some explanation, but it is important to note the
difference. Its computation and disbursement are also different. Therefore we will
examine them below in some detail.
4.1 Disbursement
The entire net profit or loss of this “company” will be first distributed as “dividends” to
all mature PF shares and all the PF stocks immediately after the announcement of
accounts. If the outcome is a net profit, it will be credited to the account of the shares
and stocks. No part of this profit will be held back at this stage for future investment or
as buffer against future losses. That is, there is no retained profits or reserves at this
stage. If the outcome is negative, it will, similarly, be debited from the account of the
shares and stocks. This is necessary because in the PF scheme both the stocks and
shares participate in the profit/loss of the enterprises, unlike in the case of conventional
companies where only the shareholders participate in the company’s profit/loss while
the stockholders’ (preference shares, bonds, debentures, etc.) capital and return are
guaranteed. Otherwise, if, for example, some (or all) of the profits were held back, the
PF shares would rise in value at the expense of the profits of PF stocks. On the other
hand, if a loss is realised and it is compensated by previously held profits, the PF stocks
will escape loss at the expense of PF shares, which will fall in value.
However, while the PF shareholders and the PF stockholders will be treated equally in
the computation of their “dividends” they will find themselves in different situations
when it comes to the disbursement of it. If the “dividend” is positive the PF stockholder
will find his capital increased; but decreased if negative. He is free to do what he will
with his capital — reinvest it or take it away. On the other hand, the PF shareholders
may not be so free. For the bank may decide to retain all or part of the “dividend” due
to them. If the “dividend” was positive and part of it is held back, they will receive
some profit out of their investment and, at the same time, the value of their shares
would rise. If negative, they would receive no profits and, in addition, their shares
would fall in value.
4.2 Computation
The net profit/loss of each PF project operational during the accounting period is
obtained from its Profit and Loss account. The total net profit/loss of the “company” is
obtained by summing up the profit/loss of all the individual projects. So far so good.
The problem is how do we distribute the profits among the shareholders and
stockholders? Do the stocks and shares have equal standing? Suppose the answer is
yes, then what is the relationship between a stock and a share? Are they counted in
terms of units or in terms of currency? Some meaningful solution has to be found.
One way of doing it would be to first count the stocks in terms of units as we do of the
shares, and equate one unit of stock to one unit of share. Then every unit of stock will
earn profit/loss the same as one unit of share. Now how do they stand in terms of
currency? Is the price of a stock the same as that of a share? Which price are we
talking about? The nominal value of a share, its market value or its book value?
Without going into the details of why the former two are not quite suitable, let us settle
down for the third — the book value of a share — and see how this can be computed
and fixed in advance.
When the annual (or quarterly, half- yearly) account is made up and the “dividends” are
disbursed, the shares of the “company” will have a book value as at the beginning of the
next year. The price of one stock in that year can be fixed equal to this book value of
one share. Thus the stocks in the “company” will be sold in integer multiples, their unit
price will be the same throughout the current year (or accounting period), and every unit
of stock will earn the same “dividend” as a unit of share. The price of a stock, however,
may vary from year to year depending on the performance of the “company” but will be
equal to the book value of the share at the beginning of the year and will remain the
same throughout that year.
Consequently, as far as the computation of “dividend” is concerned, the company has a
total of this many units of “shares” and the “dividend” per unit is obtained by dividing
the total net profit/loss of the “company” by this number of “shares”. This “dividend”
per unit is then the same for both PF shares and PF stocks.

5. Inflation and value erosion of capital

Inflation is currently a fact of life and it erodes the value of capital as time passes.
Since the capital involved in Participatory Financing projects are long-term investments
we have to take into account the value erosion of capital in computing profit/loss.
Considering the space and time limitations, we need to mention here only that the value
loss of the project’s capital due to inflation will be separately computed (using the
methodology described in the third book, Gafoor (1999)) and deducted from the
project’s gross profit/loss and credited to the project, before the resulting net profit/loss
is shared between the financier (the bank) and the entrepreneur. Thus the capital of the
enterprise will be restored to its original real value at the end of each accounting period.
This also means that the paid out dividend would seem less, because it will no t include
the amount eroded from the value of capital, but the value of the PF shares will
appreciate in monetary terms. The rationale for this approach is presented in Chapter 5
of the second book, Gafoor (1996).
 *****

References

1. Ahmad, Ausaf, Contemporary experiences of Islamic banks: a survey. In: Elimination of

Riba from the Economy. Islamabad: Institute of Policy Studies, 1994. pp.369-393.
2. Gafoor, A.L.M. Abdul, Interest-free Commercial Banking. Groningen, the Netherlands:
Apptec Publications, 1995.
3.  , Participatory Financing through Investment Banks and Commercial Banks.
Groningen, the Netherlands: Apptec Publications, 1996.
4.  , Commercial Banking in the presence of Inflation. Groningen, the Netherlands:
Apptec Publications, 1999.
5.  , Islamic Banking and Finance: Another Approach. Groningen, the Netherlands:
Apptec Publications, 2000.
6. Saleh, Nabil A., Unlawful Gain and Legitimate Profit in Islamic Law. Cambridge, UK:
Cambridge University Press, 1986.
7. Usmani, Taqi M., An introduction to Islamic Finance. Karachi: Idaratul Ma’arif, 1999.
8. Yasseri, Ali, Islamic banking contracts as enforced in Iran: Implications for the Iranian
banking practices. Paper presented at the Fourth International Conference on Islamic
Economics and Banking, held at the Loughborough University, UK, August 13-15, 2000.

© A.L.M. Abdul Gafoor 2001

January 2001.
Revised October 2001

Note: 1. A shorter version of this article appears in New Horizon (the monthly publication of the
Institute of Islamic Banking & Insurance, London), Issue no. 119, July 2001.

Note: 2. A modified version of his article is also to be presented at The First International
Conference on: The Role of Islamic Banking & Finance in Socio-economic Development & The
Introduction of Innovative Financial Instruments, 29-30 October 2001, Kuala Lumpur, Malaysia.