Principles of Islamic banking and finance/PIBF203/Investment in stocks/Current Islamic rules of trading in shares

Ijtihad on Share trading
As we have seen in the previous page, trading in shares of public limited companies has some elements that are not compatible with the tenets of Islamic finance. Some of the issues relate to the nature of modern business corporations, such as them being independent identities in themselves, and limited liabilities of shareowners. However, the more important and basic problem is that they finance part of their investment requirements through debt instruments and, on the other hand, often earn income on debt based investments /securities. A different but related problem is the level of speculation present in trading of shares, which, for some, resemble to gambling.

Considering these problems, a strict ruling by religious scholars can prevent Muslims from trading in shares. However, as there are very few avenues for profit and loss sharing investment, shari’ah scholars have come up with a compromise solution. The fact that shares represent real ownership and do not receive fixed incomes has perhaps one of the two the key thing in their minds while making this ijtihad (juristic ruling). The other consideration was based on masalah mursalah (consideration of public interest), allowing a commercial activity that although not perfect but in essence somewhat permissible. They, however, did not give a blanket approval but formulated several rules that must be followed to make trading in shares acceptable, at least until a better alternative comes up. The rulings are, never the less, not without their critics.

In this session, we will look at the current rules and regulations that are followed in stock trading under Islamic finance. It must be kept in mind that we are only discussing the trading of shares and not their derivatives. That will be the taken up in the last session of this course.

==Screening Norms For Shari’ah Compliance == As mentioned earlier, different Islamic banks, investment companies and equity funds have their own norms for assessing Shari[ah compliance of companies in which they consider investing. Most such organizations do not publicize the norms they use for selection or screening of the companies. Organizations such as Islamic Development Bank, the Association of Islamic Banks, AAOIFI and the Fiqh Academy of the OIC also have not laid down any definite criteria in this regard. On the other hand, information is available on the screening criteria used by Dow Jones for inclusion and tracking of equities (listed at various stock exchanges) in its Islamic equity indices. Similarly, the screening criteria used by the Securities and Exchange Commission, Malaysia are also available as is the criteria used by Meezan, Pakistan. Unfortunately, the rationale for adopting a particular norm by each of them is not known. The criteria used by these organizations are described in the section below.

Screens for acceptable business activities
Activities of the companies should not be inconsistent with Shari’ah precepts. Therefore, based on revenue allocation, if any company has business activities in the Shari[ah inconsistent group or sub-group of industries it is excluded from the Islamic index universe. The DJIMI Shari[ah Supervisory Board established the following broad categories of industries as inconsistent with Shari[ah precepts: alcohol, pork related products, conventional financial services (banking, insurance, etc.), entertainment (hotels, casinos/gambling, cinema, pornography, music, etc.), tobacco, and weapons and defense industries.

Screens for acceptable financial ratios
After removing companies with unacceptable primary business activities, it removes companies with unacceptable levels of debt or impure interest income by applying the following screens:

Debt to assets
Exclude companies for which Total Debt divided by Trailing Twelve Month Average Market Capitalization (TTMAMC) is greater than or equal to 33%. (Note: Total Debt = Short-Term Debt + Current Portion of Long-Term Debt + Long-Term Debt).

Liquid assets to total assets
Exclude companies for which the sum of Cash and Interest-Bearing Securities divided by TTMAMC is greater than or equal to 33%.

Receivables to assets
Exclude companies if Accounts Receivables divided by TTMAMC is greater than or equal to 33%. (Note: Accounts Receivables = Current Receivables + LongTerm Receivables). Companies passing the above screens are included as components of the Dow Jones Islamic Market Index.

Screening Criteria of Securities and Exchange Commission (SEC), Malaysia
Screening for Shari[ah complaint stocks is done at central level by the Shari[ah Advisory Council (SAC) of the Securities and Exchange Commission (SEC). A list of permissible stocks is issued by the SAC twice a year. The screening criteria are mainly activity or income based. No debt or liquidity screens are used. Thus screening requires income statements but not the balance sheets of the companies. Individual funds or investment companies do not make their own Shari[ah screening criteria. Following screening criteria are used:

Core activities
The core activities of the companies should not be Shari[ah incompatible. Therefore companies with the following as their core business activities are excluded: Financial services based on riba (interest); gambling; manufacture or sale of non-halal products or related products; conventional insurance; entertainment activities that are non-permissible according to Shari[ah, manufacture or sale of tobacco-based products or related products; stock-broking or share trading in Shari[ah non-approved securities; and other activities deemed non-permissible according to Shari[ah.

Mixed activities
For companies with activities comprising both permissible and non-permissible elements, the SAC considers two additional criteria:

a)	The public perception or image of the company must be good; and

b)	The core activities of the company are important and considered maslahah (in the public interest) to the Muslim ummah (nation) and the country, and the non-permissible element is very small and involves matters such as umum balwa (common plight and difficult to avoid), uruf (custom) and the rights of the non-Muslim community which are accepted by Islam.

Benchmarks of tolerance
Applicable in case of mixed activities. If the contributions in turnover or profit before tax from non-permissible activities of a company exceed the benchmark, the securities of the company are classified as Shari[ah non-approved. The benchmarks are:

The five percent benchmark
Applied to assess the level of mixed contributions from the activities that are clearly prohibited such as riba (interest-based companies like conventional banks), gambling, liquor and pork.

The ten percent benchmark
Applied to assess the level of mixed contributions from the activities that involve the element of ‘umum balwa’ which is a prohibited element affecting most people and difficult to avoid. For example, interest income from fixed deposits in conventional banks.

The twenty-five percent benchmark
This benchmark is used to assess the level of mixed contributions from the activities that are generally permissible according to Shari[ah and have an element of maslahah (public interest), but there are other elements that may affect the Shari[ah status of these activities. For example, hotel and resort operations, share trading etc., as these activities may also involve other activities that are deemed non-permissible according to the Shari[ah.

Debt and liquidity
No restrictions on the proportion of debt or proportion of liquid assets in total assets.

Meezan Islamic Fund Criteria, Pakistan
It undertakes investment in equities, mudarabahs, Islamic sukuks, and other Shari[ah -compliant fixed income securities. The Shari’ah screening criteria for equities and other securities is given below:

Business of the investee company
The basic business of the Investee Company should be halal. Accordingly, investment in shares of conventional banks, insurance companies, leasing companies, companies dealing in alcohol, tobacco, pornography, etc. are not permissible.

Debt to total assets
The total interest-bearing debt of the Investee Company should not exceed 45% of the total assets.

Net Illiquid to total assets
The total illiquid assets of the Investee Company as a percentage of the total assets should be at least 10%.

Investment in Shari[ah non-compliant activities and income from Shari[ah non-compliant investments
The following two conditions are observed for screening purposes: The total investment of the Investee Company in Shari[ah non-compliant business should not exceed 33% of the total assets. The income from Shari[ah non-compliant investment should not exceed 5% of the gross revenue. (Gross revenue means net sales plus other income).

Net Liquid assets vs. share price
The net liquid assets (current assets minus current liabilities) per share should be less than the market price of the share.