Wednesday, 16th October 2019 Amanie Screening Solutions  

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The Shari'ah Stock Screening Process

Shariah Stock Screening Process – Background

Shariah stock screening process is a four-stage screening process that identifies active listed companies that are compliant with Shari'ah principles for the benefit of Muslim and ethically minded investors. The filtration procedure eliminates non-complying companies at each level of the process. The screening methodology is based on qualitative and quantitative parameters determined by a Shari'ah Board, where the companies' sources of income, from business activities, product lines and non-operational interest income, as well as their financial structures are assessed to ensure strict compliance with the requirements of Shari'ah. 

Assessment of Sources of Income from Business Activities

Firstly, an Islamic investor may not purchase preferred shared, convertible notes, and the like. The reason for this is that, in all of these cases, a pre-determined rate of return is stipulated, while the principal is guaranteed. This clearly falls within the prohibited area of riba, even if the primary business of the company (whose securities, shares, or notes are tendered) is halal or in compliance with the Shari'ah.

The first rule of Shari'ah compliant investing is that a Muslim may not purchase or hold shares in a company if the main business or activity of a company is not lawful in terms of Shari'ah. Even if the Muslim investor does make a monetary gain from these shares, the very act of his holding these shares signals his involvement in the prohibited line of business.

"O you who believe, do not consume your property among yourselves wrongfully, but let there be trade by mutual consent…." (4:29)

"Avoid the seven great destructive sins." The people enquire, "O Allah's Apostle! What are they? He said, "To join others in worship along with Allah, to practice sorcery, to kill the life which Allah has forbidden except for a just cause, (according to Islamic law), to eat up riba (usury), to eat up an orphan's wealth, to give back to the enemy and fleeing from the battlefield at the time of fighting, and to accuse chaste women, who never even think of anything touching chastity and are good believers." (Bukhari: 4.28)

There are investment restrictions in companies which are active or significantly involved in or related to industries and business activities that are not acceptable to the Shari'ah. Hence, the first step is to screen, identify and remove companies whose sources of revenue or income originate from core business activities or product lines that contravene Islamic principles.

"Core activity" is defined as business activity or a source, including non-operating interest income, that contributes 5% or more of the company's or the business grouping's total income ("the 5% rule"). If the core activity of the company contravenes Islamic Shari'ah principles (non-permissible), it is not lawful for a Muslim investor to purchase or hold the shares of such companies as it will entail the direct involvement of the investor, as a shareholder, in that prohibited line of business.

So all companies are likely to have some amount of non-Shari'ah compliant or "tainted" income. This being the case, most methodologies use the "5 percent rule". This is the maximum level of non-Shari'ah compliant activities or tainted income sources that are considered "tolerable".


What is the rationale behind the 5% limitation?

There is no specific basis derived from the Holy Qur’an or the Sunnah for the 5% rule of non-halal (impermissible) income. The 5% rule however is a collective consensus or ijtihad made between contemporary Shari’ah scholars.

To explain the ruling of the Shari'ah scholars, the basis of a company from the Shari'ah perspective would need to be explained. According to Shari'ah scholars, Shirkatul Inan is applicable to the company rule of the traditional Shirkah (partnership). However, if the rule of partnership were applied to a company, it would not be possible to permit any kind of impermissible activity or income. This is because every shareholder of a company is a sharik (partner), and every sharik, according to Islamic jurisprudence, is an agent of the other partner in a 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. If it were known to the shareholder that the company is involved in a non-Islamic transaction, and he still holds the shares of that company, this would mean that he has authorized the management to proceed with that non-Islamic transaction. In this case, he will not only be responsible for giving his consent to a non-Islamic transaction, but that transaction will also be rightfully attributed to himself, because the management of the company is working under his tacit authorization.

However, a large number of Shari'ah scholars are of the opinion that a joint stock company is in essence, different from a simple partnership. In a partnership, all the policy decisions are made by the consensus of all 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 majority will determine the policy decisions of a joint stock company. Being composed of a large number of shareholders, a company cannot however give veto power to each shareholder. 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 shareholder in his individual capacity. 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, especially when he intends to refrain from the income resulting from that transaction.

Therefore, if a company is engaged in "halal" (permissible) business, but also keeps its surplus money in an interest-bearing account, wherefrom a small incidental income of interest is received, not all of the company’s business is rendered unlawful. If a person acquires the shares of such a company with the clear intention that he will oppose this incidental transaction, and will not use that proportion of the dividend for his own benefit, then it cannot be said that he has approved the interest bearing transaction and that the transaction should be attributed to him.

In this context, a traditional partnership is different from the partnership of a company. Therefore if a small or negligible income were earned through these means despite his disapproval, then his investment in or trading of the shares would be permissible as long as the shareholder purifies that proportion of income by giving it to charity.

To what extent or to what limit should the income be forgone? Because this matter cannot be left to the decision of the lay-shareholder, the matter was resolved through the consensus of learned and experienced Shari’ah scholars, who after serious discourse resolved that the limit of impermissible income should not exceed 5% out of the total permissible income.

This does not mean that all investments and deposit activities that cause negligible haram income (that is less than 5%) is considered permissible because some large long-term investments may cause very negligible current income. Therefore, Shari'ah scholars have put another cap of one third to such impermissible investment (from total permissible investment activities) that produces anything less than 5% of haram income. In short, Muslim investors should not invest in companies if the interest income and other non-permissible sources of income are more than 5% of the company’s total income and/or the company’s total (long-term and short-term) interest-bearing financing. Nor should other non-permissible investments exceed one third of the company’s market capitalization.

An Islamic investor may not purchase the shares of companies whose primary or basic business is haram (unlawful). The business of such companies may include, but is not limited to:

• Conventional Financial Institutions based on Interest (Riba) or Gharar

This includes all interest-based conventional banks, finance houses, insurers, moneylenders, investment companies, leasing companies, stock brokerages, futures and options houses and other interest-related businesses. However, these do not include financial institutions which exclusively promote or provide Shari'ah based financial services. For financial institutions with Islamic banking windows or provide a mixture of both systems, the 5% rule would apply.

• Alcoholic Beverages

This includes the production, packaging, bottling, marketing, selling and/ or distribution of liquor and related products. Production facilities like breweries are automatically excluded.

• Gaming/ Gambling/ Casino/ Game of Chance

Provision of these services and betting or comparable activities as well as the production of the facilities and equipment shall be excluded from investable universe.

• Pork Production

The raising or selling of pork or pork-derived products and by-products. This includes the packaging, marketing and distribution of such products as well as slaughterhouses and livestock farms that are involved in the process in one form or another. If in doubt, most methodologies will exclude all meat producers, slaughterhouses and livestock farms, since clear segregation is not always possible at all times.

• Non-halal Food Products

Similar to pork production, the production, sale, packaging or distribution of non-halal food is not permissible. This shall include supermarkets and departmental stores with supermarket divisions. The 5% rule would normally apply, although most methodologies will exclude supermarkets due to the difficulty of clear segregation.

• Entertainment and Leisure related to Pornography or Adult content

This includes film-production, broadcasting companies, magazine publishers, cinemas, cable-TV companies, nightclubs and places of entertainment, record/ music companies that are related to pornographic, X-rated or adult contents or elements of it. This also includes the distributors and marketers of such contents. As clear segregation is not always possible, it is best to exclude any entertainment-related company if in doubt, unless proven otherwise.


Additionally, as a matter of policy, most methodologies would also be excluding companies whose major activities include the following industries:

• Arms, Defense and Military Equipment Manufacturers

• Tobacco: Includes manufacturers, distributors, wholesalers and retailers.

• Others: Prostitution, unisex massage parlors, escort and related-entertainment services as well as companies whose activities or image are deemed to be offensive or contrary to the principles of Islam. 

The majority of Shari'ah scholars and boards hold that the above-mentioned industries and their financial instruments are inconsistent with Shari'ah precepts and, hence, not suitable for Islamic investment purposes. 

In Qur'an, the Almighty, Exalted is He, said: "Partake of the good things and work righteousness". (23:51)

In this verse the command to partake of the good things was given before the command to work righteousness, or to do good deeds. As the order of the commands indicates precedence, it should be clear that one's partaking of the "good things" is even more important than one's doing good deeds. The great scholar of the letter and spirit of the Sari'ah, Imam Abu Hamid al Ghazali explained that the term "The good things" denotes those things that are halal. Clearly, the halal alluded to in the verse includes halal earnings.

From the forgoing it should be clear that halal earnings may have importance for Muslims that goes beyond their obvious, worldly benefits. On the other hand, the detriment to Muslims of prohibited earnings will be felt in this world and the next.

"As Shari’ah scholars, we are obligated both morally and ethically to inform Muslims of things that are good, decent, and beneficial not only for themselves, individually, but also for humankind. We therefore encourage Muslims to seek out and examine the merits of companies that have pro-environmental and pro-animal policies, that support their communities, that give voice to the disenfranchised, provide humanitarian services, and the like."

Assessment of Financial Ratios

The second level of screening involves scrutiny of the financial ratios of companies passing level one screening. At level two screening, the primary or basic business of the company has already been determined to be halal or in compliance with Shari’ah precepts. The concern of the second level of screening, however, is with elements of haram (unlawful) income that may incidentally become part of the total income of the company.

There are many situations in which corporations in Muslim and non-Muslim countries will generate, through an activity or activities unrelated to the primary business of the company, revenue that is haram. In such instances, when clearly unlawful revenue is combined with the lawful, the relevance and significance of such revenues must be subjected to examination.

Many companies that promote development through the provision of beneficial and humane services are based in non-Muslim countries where there are no laws that prohibit the giving and taking of interest. Nearly all companies in such countries routinely place excess corporate finds in interest bearing deposits, certificates of deposit (CDs), bonds, bills, notes, and other interest-bearing and principal guaranteed instruments. It should also be mentioned that companies would also invest in other companies. In these ways, income from interest will also form a part of the total earnings of companies that otherwise conform to Shari’ah precepts.

Many such companies will also have occasion to borrow money from banks and capital markets (bonds and preferred shares), and to issue convertible bonds (private placements), and the like, in which cases they will be paying out interest, which is also prohibited. Corporate borrowing may be undertaken for decidedly beneficial purposes, -like research and development, marketing and manufacturing, purchasing capital equipment, human resources, and so on. Additionally, in today’s corporate and capital market environment,’ companies are merged, acquired, consolidated, spun-oft split-off; and so on. Oftentimes, the result of such reconfigurations will be that a company engaged in a primary business activity that is clearly in conformance with Shari’ah precepts will acquire a division or a subsidiary engaged in business that is not in conformance with those precepts. 

Issues like those alluded to above, often related to the capital structure of businesses, require-the attention of Shari’ah Supervisory Boards. There is a growing body of accepted literature produced by established Shari’ah scholars that addresses the limits of tolerance for the haram. Some of the contemporary scholars who have commented on these issues include the undersigned and others.

The Shari’ah Supervisory Board and many eminent Shari’ah scholars are of the opinion that an Islamic investor may own shares of companies or investment vehicles whose primary business is consistent with Shari'ah precepts, even when a small part of their revenues include, within certain limits, haram income. As will be explained below, Islamic investors must use all available and necessary means to (1) estimate the extent of the haram income and (2) cleanse their holdings of that income.

The basic premises for allowing the purchase of, or investment in, such companies are as follows:

1st. The Islamic investor (a shareholder in the company) is not in fact a direct party to the haram or prohibited activities. This is owing to the nature of the company’s structure. As a shareholder in a corporation, and not a - full partner in a simple partnership, the enfranchised shareholder may vote (proxy) at a shareholders’ meeting and thereby make known his/her disapproval of haram activities or proposals. However, if the Muslim shareholder is out-voted by the majority, she/he cannot be held responsible for the resulting decision because that is determined by the majority.

2nd. The Board of Directors has a fiduciary duty of care and loyalty to examine, entertain, and implement decisions in the best interests of the company that will enhance shareholder value. When there is little or no ambiguity concerning the lawful nature of the primary business of the company, a negligible portion of income derived from a source other than the company’s main activity may be ignored, and the company’s shares may be purchased; but only if the purchaser intends to give in charity an amount proportionate to that negligible income. This is based on the Islamic juristic principle that a very small quantity may be ignored. This position is further consistent with the established juristic rule which states that what ‘is not permitted independently may be permitted subordinately.

Shari’ah scholars have also placed a one third cap on investments in non-permissible activities, even if revenues from these activities are lower than the 5% mark.

This does not mean that all investments and deposit activities that cause negligible haram income (that is less than 5%) is considered permissible because some large long-term investments may cause very negligible current income. Therefore, Shari'ah scholars have put another cap of one third to such impermissible investment (from total permissible investment activities) that produces anything less than 5% of haram income. In short, Muslim investors should not invest in companies if the interest income and other non-permissible sources of income are more than 5% of the company’s total income and/or the company’s total (long-term and short-term) interest-bearing financing and/or other non-permissible investments should not exceed one third of the company’s market capitalization.

3rd. 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.). When such investments contain elements, at a secondary level, of the haram, the Muslim shareholder must take steps to purify that haram income.

The scrutiny applied to the financial ratios or capital structure of companies in question may be accomplished by means of the following four criteria:

1. Percentage-wise comparison of other non-operating interest income to total 
revenues (Other non-halal income).

2. Pecentage-wise of cash plus interest bearing securities to market capitalization (Other sources of non-halal income).

3. Percentage-wise comparison of total debt to total market capitalization (Leverage ratio).

4. Percentage-wise comparison of cash plus accounts receivable to total assets (Liquidity ratio).

Assessment of Other Non-Halal Income (Interest Income) or Other Sources of Non-Halal Income

Contemporary Shari'ah opinion is almost unanimous on the point that if all the business activities of a company are in full conformity with Shari'ah, and the company neither borrows money on interest nor keeps its surplus cash in an interest bearing account or instrument, its shares can be purchased, held and sold without any hindrance from the Shari'ah viewpoint. Admittedly such companies are very rare in the real world. Many companies listed on major world bourses are involved in one way or another in an activity that violates the injunctions of Shari'ah. Even when the main business activity of a company is deemed permissible, its borrowings are likely to be based on conventional interest-based instruments and it would tend to keep its surplus cash in interest bearing accounts, or invest in bonds or securities. 

Moreover, it is further argued that when a company is financed on the basis of interest, the funds it employs to run the business are impure. Similarly, when the company receives interest on its deposits (interest income) an impure element is included in its total income that may be distributed to the shareholders in the form of dividends.

"But those who take riba (usury or interest) will not stand save as one driven insane by the touch of Shaytan. This is because they claim that usury is the same as sale. But Allah has made sales lawful (halal), whereas usury He has made unlawful (haram). Then, whoever, desists [from usurious transactions] when the teaching [about its prohibition] comes to him from his Lord, may keep whatever [he earned by means of it] in the past. His affair will be decided by Allah. But whoever returns to it, this will be the companions of the Fire, therein to reside forever. Allah renders all usury deficient, and increase charity. Allah does not love any immoral ingrate". (2:275-279)

"Devour not riba, doubled not redoubled. Heed Allah in the chance you may be successful". (3:130)

"Not exchange My signs for a paltry price. Those who do not judge on the basis of what Allah has revealed, those they are the disbeliever." (5:44)

"…and for their obstructing the way Allah for so many, and for their taking usury when they were ordered not to, and for their consuming the wealth of others without the right to do so. For the disbelievers among them have we prepared a painful torment". (4:160)

Assessment of Leverage Ratio

The total (long-term and short-term) interest-bearing debt liability must not exceed one third of the company’s total assets. Such a limit has been fixed because one third reflects less than 1/3rd of the total assets of a company and 1/3rd is considered abundant in the Qur'an.

The modern corporation often resorts to borrowing in order to raise funds for research and development, marketing and manufacturing, purchasing capital equipment, human resources, expansion, acquisitions, and the like. Corporate borrowing may take the form of loans, Lines of credit from banks, engaging the capital markets (bonds and preferred shares), issuing convertible bonds (private placements), and so on. In such cases, the corporation (debtor) pays the providers of those --funds (creditors) a pre-determined rate of interest on the funds that are borrowed. Even though the company is not directly profiting by making interest payments, such activity is still haram (because both earning and paying out riba are haram).

Contemporary Shari’ah scholars have allowed the acquisition of shares in a company with leverage that does not exceed one third.

What is the rationale behind the 30% ruling?

If a company borrows money on interest from financial institutions, the same aforementioned principle applies. If a shareholder does not personally agree to these loans, but has been overruled by the majority, than the loans cannot be attributed to him.

Moreover, even though the principles of Islamic jurisprudence state that borrowing on interest is a grave and sinful act, for which the borrower is responsible in the Hereafter; this sinful act does not render the whole business of the borrower as haram. Books on Islamic jurisprudence state that the contract of loan is among those contracts that are called “Uqood Ghair Muawadha” or non-compensatory contract – therefore, no void condition such as the condition of interest can be stipulated.

If such a void condition of interest has been stipulated, the condition will itself be void – this however will not invalidate the contract. Since the contract remains valid despite the annulled condition in this case, it is still permissible for the borrower to use the borrowed amount, and thus anything purchased in exchange for that money would not be unlawful. Nonetheless, the permissibility of investing in the shares of such companies is not limitless and can only be allowed to a certain degree. The limitation however is not the same as the limit placed on interest income, as this activity does not affect the income of the company. Shari’ah scholars have instead placed a limit of one third

The basis of this ruling is that one third is less than one third of the total asset of the company and one third is considered abundant by the following Hadith of the Holy Prophet (PBUH): “One third is big or abundant” (Tirmizi). This means that anything that is less than one third is considered small or little. Therefore to avoid being excessive, the limitation is fixed at less than one third of the company’s total asset.

It must be stated emphatically at this point that the above-mentioned formula is one that applies to investors interested in companies offering shares on the international market over which Muslims do not own or control. It should in no way be understood as an endorsement of the practice by Muslim-owned businesses that borrow on interest.

Assessment of Liquidity Ratio

For companies having receivables exceeding 70% of their total assets as per book value, a Muslim individual may only invest or deal in the shares of such companies if the shares are traded at par.

The shares of a company are negotiable only if the company’s receivables are below the 70% level. This is because if the majority (more than 70%)of the assets of a company are in liquid form, i.e. in the form of debt that cannot be purchased or sold, except on par value, then the share represents debt only and that debt cannot be traded in except at par.

The Shari'ah View on Realized Profits

The profits can accrue either through dividends distributed by the relevant companies or through the appreciation in the prices of the shares (that is termed as Capital Gain). In the first case, if the profits are earned through dividends, a certain proportion of the dividend, which corresponds to the proportion of interest earned by the company, must be given to charity. The contemporary Islamic funds have termed this process as "purification."

"O you who believe, fear Allah and give up what remains due to you of interest if you are indeed believers. And if you do not, then be warned of war (against you) by Allah and His Messenger, while if you repent you shall have your capital, Do not do wrong and you shall not be wronged. (2:278-279)"

The "purification" process is a process whereby all remaining elements of non-permissible income are removed or purged from one's portfolio through dividend cleansing.



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