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Investing in shares of companies: the Shariah way

By: Nathif J. Adam, CEO - First Community Bank

1) Introduction
With the forthcoming IPO of Safaricom, a large number of Muslims would, naturally, have liked to put some funds into what is regarded one of the most blue chip entities in this country. Like all other human beings, Muslim investors would like to have good shares and stock of mutual funds in their portfolios. Hence, Safaricom is certainly a tempting proposition which may not be shunned away easily and Muslims may, therefore, not be blamed for thinking in that direction.

However, like all the many other temptations that we deal with in our day-to-day lives, it is imperative that Sharia requirements are given due consideration when dealing with such matters. What, therefore, is the stand of the Sharia with regard to investing in the shares of joint stock companies?

Is it lawful investing in stock markets? This write-up is an attempt to clarify Islam’s stand on investment in shares and the Sharia backings that currently drive the practice.

2) Encouragement to investment
First we need to appreciate that Islam as a deen (way of life) has been distinguished by its continuing relevance to contemporary society in all facets of life including economical and financial undertakings of man which are not only meritorious but indeed regarded in many cases as obligatory and necessary.

The Qur’an is very explicit in its advocacy for trade and investing in various passages, such as in Sura 2:275 which reads “Allah has permitted trade…..”. Trade in this case involves all forms of legitimate commerce including investing and trading of company shares subject to any limitations that may have been laid down by applicable Islamic jurisprudence.

Similarly, financial investment activities have been given exceptional relevance by the prophet as can be seen, for instance, from the Hadith of `Amru bin Shuaib related from his grandfather that the Messenger of Allah said:

"Whoever is entrusted with money of an orphan should trade with it and should not leave it sitting to be used up by charity." (Tirmidhi)

The point of reference in this hadith is that the Messenger (PBUH) urged the trustee on the estate of people who due to age (or other reasons) cannot manage their own financial affairs, to invest it in a business that will yield a return and make it grow until they are in a position to do so themselves.

For, if proper investment is not made with such funds, the same will be depleted by Zakat, thus leaving the orphan with little or nothing.

Notwithstanding the above deep exhortations to investment, it is no less a truth that Muslims are required to put the tenets of their faith into practice in all their business transactions since Allah (SWT) Himself is witness to all their dealings. The Quran is categorical in this regard as can be seen from the following verse:

"In whatever business you may be, and whatever portion you may be reciting from the Qur'an and whatever deed you may be doing We are Witnesses thereof when you are deeply engrossed therein. [Al Qur'an 10:61]

And also:

“O you who believe! eat not up your (wealth) among yourselves in vanities: but let there be trade amongst you by mutual goodwill” (4:29).

Thus, while the sources of the Sharia (the Quran, Sunna and ijtihad) will continue to encourage the need for investment and commerce, such encouragement to invest is not meant to override the responsibility of the Muslim investor to abide by any limitations laid down for such activities.

3) Arguments for and against investing in the shares of joint stock companies
Even though the format of joint stock companies, as we know them conventionally, has no parallel in the Sharia, Muslim jurists, seem to agree that the overall legal structure of these institutions can be regarded compatible with the Sharia. This is so in view of the fact that the purchaser of a share in a joint stock company actually acquires an equity stake, which means that, as a shareholder, the investor is actually a partner in the business. Thus, as a partner, the investor’s equity is exposed to risk such that the investor actually shares in either the profits or the losses of the company. This, therefore, equates to the Islamic concept of Musharaka (Partnership) and is regarded acceptable.

However, whether Muslims can invest in present day stock market companies has been a matter of debate between Sharia experts for several years in the past largely for issues relating to the following matters:

• What line of business is the company engaged in and can its business activity (or activities) be regarded acceptable or unacceptable from a Sharia point of view?
• Does the company earn income from non-halal activities?
• Does the company earn interest income from its cash surpluses or from other sources?
• Does the company borrow money on interest basis?
• What percentage of the company’s assets is in cash (liquid) form and/or in debt form?

We will turn to the intricacies underlying the above issues in subsequent sections; however, what was obvious to most scholars is that if the main business of a company is not lawful from a Sharia perspective, it is not allowed for a Muslim to purchase, hold or sell its shares, because it will entail the direct involvement of the shareholder in that prohibited business.

Similarly, Sharia scholars are almost unanimous on the point that if a company is engaged in lawful business or businesses and does not borrow money on interest, or does not keep its surplus in an interest bearing account and deals only in limited cash holdings and receivables, then its shares can be purchased, held and sold without any hindrance from a sharia perspective.

But evidently, such companies are very rare in all contemporary stock markets and almost all the companies quoted in the present day stock markets are, in some way, involved in activities which tend to violate the injunctions of Sharia. Indeed, the typical joint stock corporation both pays and receives interest. Most companies are at least partially capitalized with debt and, therefore, pay interest to their creditors, who hold bonds and/or other liabilities. Companies also typically receive interest on cash which they hold in banks or from other market investments. A company may also charge its customers penalty interest on any overdue accounts receivable.

In view of the foregoing circumstances relating to modern day joint stock companies, a cross-section of Shari’ah experts in the Muslim world is of the view that it is not allowed for a Muslim to deal in the shares of such companies, even if its main business is halal. Their basic argument is that every share-holder of a company is a partner (sharik) of the company, and, according to the juristic rules of Musharaka, every partner is an agent for the other partners in the matters of the joint business. Therefore, the mere purchase of a share of a company embodies an authorization from the shareholder to the company to carry on its business in whatever manner the management deems fit. Accordingly, if it is known to the shareholder that the company is involved in an un-Islamic transaction, but decides to continue holding the shares of that company, then this means that the shareholder has authorized the management to proceed with the un-Islamic transaction. In this case, the shareholder will not only be responsible for giving his consent to an un-Islamic transaction, but that transaction will also be rightfully attributed to him because the management of the company is working under his tacit authorization.

Moreover, when a company is financed on the basis of interest, its funds employed in the business are impure. Similarly, when the company receives interest on its deposits an impure element is necessarily included in its income which will be distributed to the shareholders through dividends.

However, another large number of contemporary scholars do not endorse the above conservative view and argue that a joint stock company is basically different from a simple partnership (Musharaka). Their opinion is that in Musharaka partnership, all policy decisions are taken by the consensus of all the partners, and each one of them has a veto power with regard to the policy of the business. Therefore, all the actions of a partnership are rightfully attributed to each partner. Conversely, the policy decisions in a joint stock company are taken by the majority. Being composed of a large number of share-holders, a company cannot give a veto power to each shareholder. Hence, the opinions of individual shareholders can be overruled by a majority decision.

Therefore, each and every action taken by the company cannot be attributed to every share-holder in his individual capacity. Scholars note that, for instance, if a shareholder raises an objection against a particular transaction in an Annual General Meeting, but his objection is overruled by the majority, it will not be fair to conclude that he has given his consent to that transaction in his individual capacity.

Therefore, if a company is engaged in a halal business, but keeps its surplus money in an interest-bearing account where from some amount of interest is received as income, it does not render all the business of the company unlawful. In other words, if a person acquires the shares of such a company with clear intention that he will oppose this incidental transaction as much as possible and also intends not use that proportion of dividend that may accrue to him from this transaction, it will then be improper to conclude that he has approved the transaction of interest and that the transaction is attributable to him.

Meanwhile, with regard to the company’s borrowings on interest, the scholars argue that the above principle is equally relevant. If a shareholder is not personally agreeable to such borrowings, but has been overruled by the majority, such transactions cannot be attributed to him. Moreover, even though borrowing on interest is a grave sinful act from a Sharia perspective; the scholars, however, are of the view that a single act (or few acts) of borrowing should not render the whole business of the company as haram

Conditions for investing in the shares of joint stock companies

In view of the foregoing discussions, a large number of contemporary Muslim jurists have opined that dealings in the shares of joint stock companies can be acceptable provided a host of conditions are satisfied with regard to the relevant company before its stock can be acquired. The following is a summary of the conditions laid down by the scholars; however, one should keep in mind that these conditions have been arrived at as a result of modern fiqh scholarship (ijtihad) and represent, therefore, only the current state of juristic thinking but not the last word on the subject.

The first condition is that the main business of the company should not violate the Shariah. In this regard business activities may be broken down into acceptable and non acceptable as follows:

a) Acceptable Businesses
Industry sectors that don’t manufacture or market forbidden products are generally considered halal, and are acceptable for Muslim investors. Some classic examples of suitable industries are:
• Chemical manufacturers.
• Computers and computer software
• Energy
• Telecommunications
• Textiles
• Transportation
• Agricultural production
• Automobiles

However, even when considering such companies, it is important to look deeply into a company’s overall business nature to discover its core source of revenue/ or how it actually makes its money. Simply looking at the company’s industry sector, or part of the economy to which it belongs, may not always tell the whole story.

For example, a chemical manufacturing company may produce products used in explosives. A publishing company might print some works that are considered pornographic. Similarly, an agricultural producer might sell its products exclusively to breweries.

b) Unacceptable Businesses
Companies engaged in the following business activities are considered as haram and the shares cannot, therefore, be acquired and/or traded:

• Institutions engaged in interest-based financial products such as conventional banks, insurance companies and companies engaged in conventional hire purchase or factoring businesses.
• Companies that manufacture, sell or distribute liquor, narcotics etc.
• Companies engaged in the production, manufacture, sell or distribution of Pork and/or non-halal meat products
• Companies involved in and/or those which support gambling, night club activities, pornography, prostitution etc

Meanwhile, a number of other businesses, such as those that harm the environment, have poor track records with regard to labor or developing countries, or produce and market tobacco, weapons, or defense products have also been deemed as unacceptable by a cross-section of Muslim scholars.

On the understanding that the business activities of the company are confirmed as acceptable, scholars have outlined a set of criteria for any company whose shares are to be acquired. The criteria set by the scholars are largely of financial nature and tend to screen the capital structure of the company and the extent to which a company may be involved in riba (interest) dealings. In other words, these criteria represent tolerance levels for eligibility and companies that stay within the prescribed criteria, or screens, may be invested in by Muslim investors while those that cross the tolerance levels will be dropped off as not eligible for investment.

c) What is the level of income generated by a company from non-halal activities?
Scholars use several conventions to determine the core source of revenue for a company. In this regard they have opined that if a company earns some income from non-Halal activities, then the proportion of such income should not exceed 5% of the company’s total income. If such income exceeds 5%, then it is not permissible to invest in that company. The logic of this 5% rule is that a core business is one that accounts for at least 95% of a company’s gross revenue. For example, if the sale of explosives accounts for less than 5% of a chemical manufacturer’s revenue, explosives are not a core business and investing in that company’s stock is generally acceptable.

d) What is the level of Interest Income generated by the company?
It should be noted that the tolerance level discussed herein relates only to those companies which do not make earning interest their core business, but place some of their surplus funds in transactions that yield interest income. As in the previous case, ideally no income should come from interest-related sources. However, looking at the current situation Sharia scholars have permitted investments in shares of companies whose income from interest forms less than 5% of a company's total income. This could be calculated as interest income ÷ Total revenue (with a typical limit of 5%).

Thus, if upon analysis of the company’s financial information it is discovered that the company has interest -based income of more than 5%, then investing in the company is not allowed.

As expected, a large number of Muslims may want to question the rationale of this 5% non-halal (impermissible) income rule; however, the reality is that there is no specific basis derived from the Holy Quran or Sunnah and that this is only the collective outcome (consensus) or ijtihad of contemporary Shariah Scholars.

However, it is worth noting that even when the financials of a company abides by this 5% limit, a purification of earnings from such companies must be undertaken through a charity giving exercise. For example, if 4% of the whole income of a company has come out of interest-bearing deposits, then 4% of the dividend must be given away in charity and must not be retained by the investor.

e) What is the level of interest bearing debt that the company owes?
Ideally companies should not transact interest-based debt. However, as discussed earlier, such a situation is very rare with most stock market companies who tend to borrow for different purposes and from different sources. Of course, the concern here for the Muslim investor is that he will become a shareholder of a company that will be involved in promoting Riba activities. However, according to contemporary scholars if a shareholder is not personally agreeable to such borrowings, but has been overruled by the majority, these borrowing transactions cannot be attributed to him.

But even so, scholars would recommend restraint in terms of investing in the shares of companies that indulge in heavy borrowings. Nevertheless, the Muslim investor who is planning to become a shareholder in an enterprise is expected to appreciate the strong prohibition leveled by Islam against riba (interest dealings) and is required to be concerned about enterprises that that rely on excessive interest based debt.

Accordingly, the scholars have deliberated on the level of debt that a company may have on its balance sheet. For instance it was noted the level of borrowings may not be limited to 5% as applied to non-halal income. This is because, in the case of borrowings, this activity does not affect the income of the company and it is, therefore, less severe than interest based income. Hence, Shariah scholars and Islamic jurists have opined that the shares of a debtor company may be bought provided that its interest bearing debt does not exceed 33% of its capital. This could be calculated as Total Debt divided by Trailing 12-Month Average Market Capitalization (where Total Debt = Short-Term Debt + Current Portion of Long-Term Debt + Long-Term Debt).

Of course, the logic of this 33% rule as promulgated by the Sharia scholars has been questioned but the best that can be said about it is that it is a juristic viewpoint (ijtihad) which has been taken as acceptable by the Muslims who would like to abide by the same. Nevertheless, to explain the consensus of their ruling, the proponents of this rule cite the following saying of prophet (PBUH):

The prophet PBUH advised Abu Bakr RAA not to donate more than One-Third of his wealth, and commented that ‘’One Third is abundant (Al Thuluthu Wathuluth Katheer)’’ (Tirmizy).

They also make reference to the following common fiqhi rule in support of their juristic judgement:

‘’Whether a commodity that is part gold and part brass qualifies as gold for purposes of applying the rules of riba is resolved by the percentage of gold in the commodity, i.e., if greater than a third, it is ‘’gold’’.
Hence, the scholars opine that whatever is less than one third, may be regarded as not significant. This, they say, is also in accordance with the concept of “majority” or “abundance” as specified in the above hadith.
f) What is the level of cash and receivables (creditors) in the company’s balance sheet?

As a general rule, the Sharia advocates for taking of ownership stakes in real assets and not in debts or money. Hence, to be able to acquire the shares of a company, one has to be very careful about the level of liquid cash and receivables (creditors) in the company’s balance sheet. This consideration is important because, according to Islamic jurisprudence, the shares of a company can only be traded at a premium if the company owns a comfortable level of tangible fixed assets. If all the assets of a company are either in liquid form, i.e. in the form of money and/or in the form of receivables (Deyn), then such shares cannot be purchased or sold except at par value.

What, therefore, should be the exact proportion of tangible fixed assets of a company to warrant the negotiability of its shares? Despite, some generic differences, most contemporary scholars are of the view that the ratio of tangible fixed assets must be 51% in the least. They argue that if such assets are less than 50%, then the majority of assets would be regarded to be in liquid and/or receivables (Deyn) form, and therefore, all its assets should be treated as liquid on the basis of the juristic principle of “The majority deserves to be treated as the whole thing” (lii al-akthar hukm al-kul)" .

Hence, when analyzing a company’s financials for purchase of its shares, it is important that accounts receivables and liquid (cash) assets should be a maximum of 50% of the company’s total asset base (Accounts receivable and cash ÷ Total assets (with a typical limit of 50%).

g) Matters for consideration
It is worth noting that while a company may be meeting the laid Sharia criteria at the time of the purchase of its shares, (based on the company’s financials), the company may, however, decide immediately after buying the share or at a later date, to push its borrowing levels (and pay more interest) or earn more interest (for instance through depositing IPO monies in interest bearing accounts). When that happens, the Sharia criteria ratios may be crossed making the stock non-Sharia compliant. In such circumstances, the holding needs to be disposed (sold) off immediately.

However, given that financial information about the company may not always be readily available for the ordinary Muslim investor to analyze, then the Muslim investor is put to a situation whereby he/she continues to hold (and benefit) from an investment which is not Sharia compliant. But even where such information may be readily available, the correct analysis of the same on continuous basis is not an easy task for most people.

Meanwhile, the following other issues relating to investing in shares are worth considering:
a) Investible funds must be from a halal source. Hence, a Muslim investor cannot borrow on interest to finance the purchase of shares.

b) Prohibition of speculation: unlike conventional investors Muslims are generally discouraged from basing their investment decisions on short-term speculation but rather as medium/long term investors.

The Sharia, through its comprehensive sources of the Quran, the Sunna and Ijtihad shall continue to serve all the dynamic needs of Muslims at all times. This is exemplified by the interpretational efforts undertaken by learned Sharia scholars and jurists in coming up with various guidelines to identify what may be regarded as permissible stocks. However, it should be remembered that the matter under discussion is subjected to continuous scrutiny and change by the scholars in the light of new insights. Hence, these opinions should not, therefore, be taken as ‘’divine’’ rules of Sharia compliance.
Nevertheless, these parameters have not been set to allow Muslims the freedom to invest indiscriminately in the shares of listed joint stock companies. A Muslim investor interested in buying shares of a company is required to make every effort to measure the extent of the company’s use of riba and avoid companies whose involvement in the same exceeds the agreed thresholds. In addition, some scholars recommend that Muslim investors should exercise their right as shareholders and register their opposition to all non-Sharia compliant activities of the company either by explicitly writing to the company or by raising their voices at the company’s annual meetings.

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