Principles of Islamic banking and finance/PIBF203/Investment in stocks/Shari'ah compliant equity investment

Equity as Shari’ah Compliant Investment
In their seminal article Khatkhatay and Nisar pointed out that, in assessing whether a specific investment proposal is compliant with Shari’ah stipulations, it needs to be examined from two angles; the nature of the transaction and the nature of the contracting (counter) party. For instance, one should consider

a)	Whether there is gharar, riba or mysir involved in the structuring of the transaction, and

b)	The nature of the counter-party (business).

They note that while, examination of a transaction for riba, gharar etc. is done as a matter of course, the same extent of systematic attention is not devoted to examine whether it would be correct to deal with a particular counter-party. For example:

a)	Working for a conventional bank or a casino;

b)	Leasing premises to a conventional bank, casino, or insurance company for its business;

c)	Printing of propaganda tracts for an evangelical organization;

d)	Leasing of premises or equipment for holding pujas involving blatant idolworship;

e)	Providing commercial transportation or printing cartons or labels for liquor bottles etc.

“In all the above activities (transactions) there is an interface with (an organization or enterprise carrying on) a haram activity. The commercial transaction by itself is not unlawful. But it involves associating or providing goods or services at a price, to an individual or institution engaged in a haram activity. Such association in some of the instances cited above may not be a regular occurrence, but may comprise a varying proportion of the regular business activities engaged in, ranging from a minor or negligible portion to being the sole activity. Under such conditions, is it permissible under Shari[ah to transact with such a party, even if the structuring of the transaction itself is valid?”

According to Khatkhatay and Nisar, as far as the issue of investment in in equities is considered, the structuring of the transaction itself appears unobjectionable, as equities do not confer any assured benefits on the holder. Contrary to that, the shareholder could lose his entire capital in the event the company suffers massive losses (but they also note that, imitation of losses to the amount invested for the paid-up share is sometimes considered as violating the Shari’ah requirement that the investor bear his share of total losses.) Nor does equity investment necessarily involve the level of uncertainty that is associated with gambling and games of chance. The rights and obligations of the parties too are clearly defined and cannot be labelled as exploitation or injustice.

There could however be a problem as far as the nature of the company’s business is concerned. As holder of equity shares, the investor is the owner of the business – even if an extremely miniscule owner! As an owner, the holder of equity is responsible for any violation of Shari’ah by the company. However, it is not realistic to expect a small shareholder can have any effect on the policy of the company regarding the nature of the business or how the business is carried out.

“In the absence of sufficiently safe modes of genuine profit-sharing investment, equity markets represent an important investment alternative that is close to the Islamic profit-and-loss-sharing investment ideal. Ruling them out leads both individual investors as well as Islamic financial institutions to turn to other fixed return modes of investment and financial leases, which are close to the same old debt-financing methods, under a different terminology. In fact, this is an unfortunate development which has led to a shift of focus in Islamic banking from profit-based investment and stunted the emergence of profit-based financing and instruments.”

Listed companies and mutual funds are fairly closely monitored and regulated by the authorities with the objective of obviating accounting manipulation and financial malpractices, thereby assuring the ordinary investors of a reasonable protection against being cheated - something he cannot hope to assure for his investments on his own. There is therefore a strong element of maslahah (public good) in permitting equity investment under Shari[ah, provided the nature of the business and the way it is carried out are such that even in case there is a violation of Shari[ah stipulations, it is kept within certain limits. The permission could be conditioned on the absence of sufficiently prevalent and credible Islamic investment alternatives in the given environment.

“Equity funds or equity-based mutual funds are the financial institutions which mobilize investments from the public against the units of their fund and invest all these funds in listed equity shares. Thereafter, they calculate the NAV (Net Asset Value) of the fund units on a daily basis and may allow investors to exit or enter the fund at or around NAV. The fund may declare dividends periodically and even liquidate itself at a certain stage and pay off the investors on the basis of the final break-up value of the units. The expenses of this fund and the remuneration of the fund Manger are deducted from the earnings of the fund. A mutual fund unit thus closely resembles an equity share in that it too does not guarantee any fixed returns to the investors or an assurance of return of any part of the initial investment.” defray

“In addition, it gives the investors the benefit of a diversified investment portfolio and the services of expert investment advice, in spite of a modest investment outlay. The downside for him from an Islamic point of view is that his investment goes into shares of a large number of companies engaged in different businesses and with varying types of financials, over the selection of which he has no control, except to the extent the offer document of the fund defines the investment policy of the fund.”

“Thus, though the investor can normally ensure (by selection of the right fund) that his money is invested only or overwhelming in equities, he cannot be certain that all the companies in which his money goes are in permitted businesses or have financial structures which are Shari’ah compliant.”

“Islamic economists and financial experts agree that if certain conditions are met, it is lawful to invest in the stock market. Any earnings that result from such investments will be halal. The logic behind this argument is that when one purchases shares in a company he actually becomes a shareholder and thus becomes a partner in the business. Thus, this arrangement is akin to the Islamic concept of musharakah. However, there are a host of conditions that must be satisfied before one is allowed to invest in stocks. To start with, one must be sure that the business of the corporation/company offering the stock must be halal. Over and above this, shariah scholars have developed certain financial parameters for stocks selection. These are mainly related to the capital structure of the company. The purpose of these criteria is to determine the level of involvement of riba (interest) and gharar (uncertainty) in the overall business of the company.”

“One should keep in mind that these criteria are the results of modern fiqh scholarship (ijtihad) and therefore, should be seen to represent the current state of thinking on the issue. In that way, they represent the maximum tolerance levels and not the last word on the subject. In short, if a Muslim investor is contemplating investment in the stock market, he must not only be careful about the profitability but also about the compliance of shariah. These can be done by looking at the nature of business, percentage of income from interest and the financial soundness of the company. While there are a number of tools available to help understand the financial soundness of a company there are not many that can guide an investor in determining the shariah compliance of a stock. Following screening patterns may be helpful in determining the shariah compliance of stocks.”

According to Osmani and Abdullah:

“To establish an Islamic stock market, it is crucial to comprehend the role of stock market in the economic growth and respond to the demands of the Shari`ah. The universal rule of Islam for transactions reveal that trading is not only permitted but also entitled as Ibadah but with the condition that it is free from all forms of Riba, Al-Maysiri, Al-Gharar, price controlling, Al-Ihtikar, misinformation and coercion. The ethical behavior in Islamic market is assured with the quality of amanah, truthfulness, cooperation, and discarding Jealousy and cheating.

Generally, Share Company is legal in Islamic Shari`ah in a sense that it is same like partnership business or Mudarabah contracts which are permitted in Islam. The Traditional jurists agreed upon the permissibility of partnership business and Mudarabah contracts. Furthermore, there is no prohibition in the Shari`ah in forming a share company or a partnership company. While a common share is permitted in the Shari`ah, a preferred share is not allowed as it is not a partnership business because share holders do not have the right to vote. It means they are not the partners of the company. Besides, the extra money that the preferred shareholders get is just like Riba as they take it without sharing the risk of profit and loss.

Selling a common share is like selling a portion of a capital of the company. So, it is legal according to most of the scholars. They argue that a share is one's own property so he has the right to sell or lend as long as it does not cause harm to other share holders. It does not contain alGharar, as the price is determined according to the existing market during its purchase. (Mubarak, 2005, p. 184) Short selling is not valid in the Shari`ah as it is like gambling and cheating the buyer as the seller sells the product that he borrows but he does not own it. However, if the investor buys the stock from the broker and afterward sells it, then it is allowed in the Shari`ah. Though margin trading is not allowed apparently in Islam, as this contract comprises Riba, there is room to make this contract valid through giving loans to the investor without interest or if the broker agrees on Mudarabah [= profit and loss sharing] contract with the investor. “

According to El-Din & Hassan (2007) the very acquisition of company shares was open to question by many shari’a scholars during the greater part of the twentieth century. Early jurist controversy about the legitimacy of the modern corporation is reflected in the 1980s writings on the theory of an Islamic stock exchange when this concept was at an infant stage. The modern corporation differs from the received jurist concept of a company (sharika) or partnership in terms of two main features: limited liability of shareholders and the company’s assumed perpetuity which, at any point of time, makes its legal existence independent of any particular group of shareholders. Limited liability absolves shareholders from any obligation towards the company’s debts beyond the amount of their shares. It also provides for the possibility that a corporation continues indefinitely to survive while Islam and speculation in the stock exchange shares may constantly change hands. By contrast, the jurist form of company cannot exist independently of its originating partners, who must also bear total liability towards the company’s debt.

El-Din and Hassan note “This controversy had ultimately been resolved, or more accurately outmoded, by the early 1990s when an upsurge in internationally geared equity funds, carrying shari’a certification, entered Islamic financial markets. The late 1990s saw the creation of shari’aaudited international indices, namely Islamic Dow Jones and Islamic FTSE. Simply defined, international shari’a audit is a screening process aimed at the formation of investment portfolios from common stocks of listed international companies which ideally satisfy three basic criteria: legitimate field of economic activity, interest-free dealings in both assets and liabilities, and the dominance of real assets. Thus a company must not be engaged in the production of illegitimate goods like pork and alcoholic drinks; it must not deal with interest rate financing as a means to leverage its capital structure through fixed debt liabilities, or generate interest income from investment securities; and since a company’s shares represent equity rights in its assets, the latter should be real assets, not liquid money or receivable debt as they cannot be sold freely at a profit like real goods, real estate and machinery. But because interest-rate dealings are unavoidable in the usual practice of international companies, the strict criterion of interest-free finance has been relaxed to tolerate reasonably small percentages of debt/equity ratios (such as 30 per cent) and still smaller percentages of interest income in the companies’ income statements (such as 5 per cent). Liquid cash and receivable debt are tolerable so long as they constitute only a small percentage of a company’s assets (less than 50 per cent can do).”