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Hedge Fund Monthly

 

Shariah Screening and Islamic Equity Indices

Kamal M A Mian, Saudi Hollandi Bank

August 2008
 

Islam as a religion guides all aspects of the lives of its followers. Hence, Muslims are required to conduct their economic affairs in accordance with the teachings of Islam.

The concept of screening companies before making investments in them is derived from the Shariah principle that Muslims should not partake in an activity that does not comply with the teachings of Islam.

For centuries, it has been the practice to seek the guidance of Shariah scholars on the permissibility of an investment or business venture. The practice, however, has evolved from an informal consultation with a local mosque leader to the development of a methodology approved by renowned religious scholars and used by financial institutions around the globe.

Increased awareness of Muslim investors about opportunities offered by the foreign stock markets played an important role in the development of a coherent Shariah screening methodology.

Evolution of Shariah Screening Methodology

Under the Shariah, the ownership of shares in a company is considered a proportionate ownership of the companyfs business and assets. Muslim investors therefore cannot own a company that is involved in non-Shariah compliant activity.

Non-Shariah compliant activities range from having a line of business that is considered impermissible (like in the arms industry) to dealing with ginteresth while managing the financial affairs of a company (for example, taking interest-based loans).

Due to the prevalence of the interest-based conventional banking system, most of the companies today end up dealing with interest even though it is not part of their major business activities. These companies would not qualify for Shariah–compliant investments. Such a development kept the majority of Muslim investors away from the stock markets for a long time.

Cognisant of the situation and appreciating the important role of listed companies in an economy, a team of leading Shariah scholars came up with criteria in 1987 that would allow Muslim investors to own shares of listed joint stock companies. The team consisted of Muhammad Taqi Usmani of Pakistan, Professor Saleh Tug (Turkey) and Sheikh Mohammad Al-Tayyeb Al Najar (Egypt).

The premise behind the approach adopted by these scholars was that even for the companies whose line of business is permissible under the Shariah, it was almost impossible to conduct their financial activities and fully comply with the principles of the Shariah. This meant that Muslim investors could not participate in an important component of the global economy.

It was important to carefully study the non-compliant elements in a company and find the means and ways to avoid them or deal with them in a manner consistent with Shariah principles. The scholars presented the Shariah screening criteria and ruled that Muslim investors can purchase shares of the companies that fulfil the criteria.

The government of Malaysia, as part of its overall initiative to develop an Islamic banking and finance industry in the country, established a Shariah Advisory Council (SAC) in 1996.

The SACfs primary task is to advise the Securities Commission on all matters related to the development of the Islamic capital market and function as a reference body for issues related to the Shariah. Soon after its establishment, the SAC issued a Shariah–compliant securities selection methodology. The rationale and objectives of the methodology were similar to the one developed by scholars in the Middle East.

Over the past 20 years, a majority of Shariah scholars worldwide have accepted the screening methodology and its rationale. There is, however, a minority of such scholars who think that only companies that fully comply with Shariah principles are eligible for Shariah–compliant investments.

They contend that a shareholder of a company is considered a partner in the company. By becoming an owner/partner in the company, he/she indirectly consents to and authorises its non-Shariah compliant activities. These scholars do not find sufficient grounds to allow an exception in the well-established rule of Islamic law prohibiting participation in a non-Shariah compliant activity.

The proponents of a Shariah screening methodology argue that present-day joint stock companies are not similar to a traditional partnership where all the partners have an equal say in the business affairs. Hence, it is not appropriate to compare the two.

Moreover, the proposed screening methodology ensures that Muslim investors do not benefit from any non-compliant activity of the company. Given the opportunity, they are also required to express their disapproval of such activities. A Shariah–compliant investor never intends to either endorse or benefit from a non-compliant activity.

Shariah Screening Criteria

The Shariah screening criteria provide guidelines to screen companies conducting non-Shariah–compliant business activities. The criteria also exclude companies whose financials do not meet the minimum acceptable levels.

The criteria have been developed with the ultimate objective of excluding companies that do not comply with Shariah principles. We will first discuss in detail the screening criteria developed by the Shariah scholars in 1987. Subsequently, we will discuss the Shariah screening criteria of the Malaysian SAC.

A discussion on Shariah screening criteria would be incomplete without including the screening criteria endorsed by another important industry organisation, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

Business Activity Screens
The following business activities are not permissible under the Shariah. Hence the companies conducting these activities do not qualify for Shariah–compliant investments:

  • alcohol, tobacco and pork-related products;
  • entertainment (hotels, gambling, cinema/movie theatres, music, pornography and so on);
  • weapons and defence;
  • conventional financial services (ie banking, insurance and so on); and
  • biotechnology companies involved in human/animal genetic
  • engineering

The test a company must satisfy is that at least 95% of its gross revenues are generated by activities other than those mentioned above. Some Shariah scholars have also excluded the printing and media sector companies, excluding newspapers. Other sub-sectors that fall under gadvertising and mediah are reviewed on an individual basis to decide their acceptability.

A general reason for exclusion of companies from the abovementioned industries is that Muslims are commanded to participate in good things and work for righteousness. The products of many of the industries mentioned above have been specifically prohibited in Islamic teachings.

Financial Ratio Screens
Islamic teachings do not allow participation in or benefit from a transaction that involves interest in any form or shape. Hence, the companies that give or take interest do not qualify for Shariah–compliant investments.

The purpose of financial ratio screens is to exclude companies that do not comply with a minimum acceptable level of leverage, receivables and interest income. The financial ratio criteria have evolved over the period.

A company would be acceptable for Shariah–compliant investments if it meets the following criteria in terms of level of debt, receivables or impure interest income:

  • total debts (non-Shariah compliant) should be less than 33% of the equity;
  • account receivables should be less than 49% of total assets; and
  • interest income from cash and interest-bearing securities should not be more than 5% of the total income



Kamal M A Mian is head of Islamic banking at Saudi Hollandi Bank. The above article is an excerpt from a longer essay featured in the book, Islamic Finance: A Practical Guide published by Globe Law and Business. It features insightful chapters by leading practitioners in Islamic financing.


This article first appeared in Islamic Finance news (Volume 5, Issue 17).


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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