Shaykh Umer Khan
Originally published in Aghaz Insights.
History And Need
Founded in 1606, Virginia Company was one of the earliest joint-stock companies. The idea was to sell shares to investors, thereby raising a large amount of capital for the company, while establishing them as partners in the venture. Shares were eventually traded on exchanges; the first modern stock trading was created in Amsterdam in 1611, and Dutch East India Company was the first to be publicly traded. Fast forward almost 400 years and Islamic scholars started working on establishing a screening criteria to determine which joint stock companies were halal (permissible) for Muslims to invest in.
Stock companies can be divided into three broad types based on their business activity:
1. Stocks of companies with permissible purposes and operations: These companies engage entirely in activities that are compatible with Islamic law, and they deal with Islamically permissible products and services. They do not use interest-based debt as a part of their capital structure, they do not earn interest on their deposits, and they do not invest their money in unlawful ways. Scholars agree that the shares of these companies can be owned and traded.
2. Stocks of companies with forbidden purposes and operations, such as alcohol, gambling, pork products, conventional financial services (bank, insurance, etc), pornography, etc. Scholars agree that the shares of these companies cannot be owned nor traded.
3. Stocks of companies which have permissible purposes but perpetrate some impermissible transactions, such as having some interest deposits, borrowing using some interest-bearing loans. There have been differing opinions about this type, with scholars generally referring to principles of jurisprudence along with general jurisprudential rules (maxims) to formulate their views.
Most companies fall into the third type, where their primary business is compliant with Islamic principles but they have “mixed activities” due to the presence of prohibited transactions. This created the need for a “screen” to filter to separate permissible vs impermissible investments. The first fatwa on the topic (that I am aware of) was issued by the shariah supervisory board for the Dow Jones Islamic Market Index (DJIMI) in 1998, which consisted of:
- Shaykh Abdul Sattar Abu Ghudda, Syria
- Justice Muhammad Taqi Usmani, Pakistan
- Dr. Mohamed Elgari, Saudi Arabia
- Shaykh Nizam Yaquby, Bahrain
- Shaykh Yusuf Talal DeLorenzo, USA
- Mohd. Daud Bakar, Malaysia
This fatwa became the basis for many shariah standards, including the one established by the Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), which is perhaps the most widespread in use today. Here is how the screening works…
The first screening criterion was that a Muslim investor may not purchase fixed income securities, preferred shares, convertible notes, etc. That is because these types of securities fall within the prohibited scope of riba because they guarantee the principal and offer a predetermined rate of return. So even if the primary business of a company is deemed to be halal, such securities would not be in compliance with Islamic law.
A Muslim investor may not invest in a company whose primary business is haram (unlawful). This screen removes companies involved in (but are not limited to):
- Pork products
- Conventional financial services (banks, insurance, etc)
Companies that pass the business activity screen are further scrutinized with the final screen: financial ratios. While the primary business of the company has already been determined to be halal, this screen weeds out elements of haram that may incidentally become too large a part of the total company.
The current AAOIFI financial screening criteria (developed from the original Dow Jones fatwa) includes the following three ratios:
1) Interest-based debt: The total interest-based debt should not exceed 30% of the market cap of the total equity.
2) Interest-based deposit: The total interest-based deposits should not exceed 30% of the market cap of the total equity.
3) Income from impermissible activities: The total income generated should not exceed 5% of the total income of the company.
The establishment of these ratios is ijtihādī, i.e. they are a result of scholarly judgment/effort, and may vary somewhat based on specific fiqh schools and institutions. However they were initially established by a diverse group of scholars and have also been widely accepted and adopted by shariah scholars and boards globally. Similar criteria can be found by Morgan Stanley Capital International World Islamic Indices (MSCI), Financial Times Stock Exchange Shariah Global Equity Index (FTSE), and others.
Where Did the 30% Come From?
The famous incident of Saʻd is reported in all six canonical books of ḥadīth, including Ṣaḥīḥ al-Bukhārī [1295, 2742, 2743, 2744, 3936, 4409, 5354, 5659, 5668, 6373], Ṣaḥīḥ Muslim [1628, 1629]. It is narrated that the Messenger of Allah ﷺ was visiting Saʻd while he was very sick. He mentioned to Muḥammad ﷺ that he only had a single daughter as an heir and inquired if he could bequeath two-thirds of his wealth away as charity. The Messenger ﷺ objected and said no. He then asked if he could give half and again the response was no. Finally he asked “One third?”, which the Messenger ﷺ permitted and he added “والثلث كثير” and in another narration “والثلث كبير” — i.e. that one-third is “a lot” or “much” or “excessive” or “a large amount”.
The concept of taking one-third being “excessive”, as taken from ḥadīth, is not unique to financial screens, nor is it arbitrary. It has been used in several unrelated Islamic legal issues, particularly in the Mālikī and Ḥanbalī schools of fiqh. In fact, Ibn Qudāmah states in al-Mughnī that Imam Aḥmad bin Ḥanbal said that this concept of one-third was applied in seventeen different issues because one-third is considered excessive, and less than one-third is considered not excessive. Perhaps, the principle applied here was: العبرة بعموم اللفظ لا بخصوص السبب. The concept does not have to apply solely in the context of bequests, but rather can be used in a more general sense.
To keep some distance from “one-third” (33.33%) and stay below it, 30% was selected for the first two financial ratios.
Why Market Cap?
It is often asked why market capitalization was used rather than book value or assets. This was a subject of much thought and deliberation when the Dow Jones fatwa was issued. Market cap was selected because in many modern economic sectors such as technology, intellectual property (patents, copyrights, trademarks), brand, and other intangibles and goodwill are increasingly important to consider. Market cap is able to capture service sectors of the economy such as technology, biotech, healthcare, etc that assets do not. Market cap is also more sensitive to debt-incurring events such as credit agency downgrades, it is more transparent, and it is less vulnerable to manipulation than assets when valuing a company.
Where Did the 5% Come From?
While the one-third ratio is well-understood and documented, the 5% number has been harder to research. The fiqh maxim this is based on is that “little/trivial is forgiven/excused”. So how was it determined how much impermissible is little/trivial and can be excused and purified? The threshold too is ijtihādī, and may vary from scholar to scholar. Dr El Baaly proposes that the ratio should be proposed by finance researchers based on scientific justification and practice, and perhaps that is how this was established. Thank you Shaykh Joe Bradford for sharing the best explanation he had heard: that the ratio is related to segment reporting in accounting standards. After some research, I was able to determine that for a segment of a business to be considered “material” and thus be reported separately is defined by IFRS Standard number 8 (“Operating Segments”). The paper “Materiality Guidance of the Major Public Accounting Firms” states that out of the eight largest major public accounting firms, “six firms expect, suggest, or require the use of 5 percent of income before taxes while one firm allows 5-10 percent”, and the eighth did not use a percentage at all. One firm’s guidance stated “In our experience it appears the SEC Staff generally consider amounts over 5% of pre-tax income (loss) from continuing operations to be material.”
Ultimately, the permissibility of investing in stocks rests upon the established fiqh maxims المشقة تجلب التيسير (“hardship begets ease”) and الضرورات تبيح المحظورات (“Necessity renders prohibited things permissible”). As Muftī Taqi Usmani explains “Many Islamic investors have modest savings, and the opportunities for investing their money in ways that will prove both profitable to them and beneficial to humanity are limited. Investments are encouraged in companies that benefit the shareholder (through dividends and capital appreciation) and society (medical advances, technology, consumer products, services, etc).” Islamic scholars, looking at the bigger picture, have thus allowed investing in stocks halal stocks as long as they meet certain criteria. They have also defined a process of “purification” to cleanse one’s portfolio and wealth from the remaining elements of non-permissible income earned through dividends and appreciation.
The screens are not perfect and they are not free from critique:
– The financial ratios used are not perfect, and results of the screen can be highly sensitive to market prices of a company’s stock, particularly for stocks that are more volatile. Some argue that flow values (such as interest income and interest expense) may serve as better measures than stock values (such as total debt or deposits), or at least a secondary measure. Certainly, while it is extra effort, an individual investor (or an ethical/halal fund manager) can perform their own analysis before selecting which stocks to include in their portfolio/fund.
– A Muslim should invest in those companies that encourage the good; that will increase benefit in the world, and stay away from those companies that cause harm in the world. In addition to staying away from impermissible industries, products, and services, Environment, Social, and Governance (ESG) impacts should be taken into consideration. Companies that respect consumer privacy rights or strive to minimize their carbon footprint, for example, should be given preference and encouraged over those that do not. Fortunately, we are seeing an increasing trend to include ESG data in Islamic stock screeners.
– The criteria, while standardized and broad in its ability to screen publicly-traded companies, fails to provide answers for private and even public pre-revenue and early-revenue companies. As these ventures are early in their lifecycle, they tend to have very small revenues consisting entirely of interest earned on the capital they have raised, and zero to little revenue from the product or service the company was actually founded to deliver. This can act to discourage Muslims from investing in and supporting young start-ups that may encourage and promote Islamic values. However, alḥamdulillāh, the startup scene is currently thriving in Muslim markets as founders and investors often turn to Islamic scholars to get fatwas on early investments in such companies that may not strictly pass the AAOIFI standards in their early days.