fatwa in islamic finance

FATWA IN ISLAMIC FINANCE Monthly Publication – February, 2015 Edition

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SHARI’AH STOCK SCREENING: A BRIEF OUTLOOK INTRODUCTION

*ZIYAAT ISAACS & TAWFIK AZRAK Islamic law, the Shari’ah, stipulates that investors of Islamic funds can only invest in Shari’ah compliant business opportunities. Therefore, in respect of investing in stocks, investors of Islamic funds can only invest in Shari’ah compliant stocks. Generally, this means that the stocks should be free from riba (interest), maysir (gambling) and gharar (uncertainty). The essence of stock screening is to protect Muslim professionals and investors from falling into the pit of prohibitions in view of its grave consequences on them and the society. SHARI’AH STOCK SCREENING A majority of contemporary Sharīʿah scholars validate thShari’ah stock screening is a process that filters a pool of stocks from a particular database separating those stocks that conform to Shari’ah principles from those that do not. Shari’ah screening is a process of distinguishing between Shari’ah compliant and Shari’ah non-compliant investments; compliant investments conforming to the principles of the Shari’ah and non-compliant investments that are tainted, according to Shari’ah principles. Muslim scholars generally agree that the screening procedures comprise of two categories: qualitative sector screening, and quantitative financial screening. In order to obtain Shariah-compliant status, both categories’ criterion should be fulfilled. This is in line with the ruling issued in 1992 by the International Islamic Fiqh Academy, Jeddah that approved trading common stocks of companies that do not engage in activities which would violate Shari’ah principles. IFA-OIC in its resolution of 1992, asserts that: Participation in stock companies. a) Since the essential thing about transactions is their licit nature, the establishment of a joint stock company with unprohibited purposes and activities is permissible. b) There is no disagreement as to the prohibition of participation in joint stock companies whose main purpose is a prohibited activity such as transactions with (usury), production of, or traffic in, prohibited products.

companies that deal at times in prohibited things such as etc. even though their main activities are permissible.” (Source: Resolution of the OIC Fiqh Academy No 63. (1/7), 1992) Activity-based screens filter Shari’ah non-compliant activity based on thresholds that have been set by the Shari’ah Board of a particular institution or regulators’ stipulation for a particular market. The filtering separates stocks that contain elements opposing Shari’ah principles based on benchmarks set by Shari’ah authorities. Financial-based screens, on the other hand, are used to analyze how deeply an individual company is involved in financial practices that are not Shari’ah-compliant. The main cause is riba and the financial screen is used to select bestin-class companies considered tolerable due to necessity as companies fully free from such prohibited activities are the exception. THE MALAYSIAN PRACTICE The business activity benchmarks represent the first-tier of the quantitative assessment in the current Shariah screening methodology of the Shari’ah Advisory Council (SAC) of the Securities Commission (SC) of Malaysia. According to this methodology, the business activity benchmarks which previously consisted of four benchmarks had been reduced to only two benchmarks. The contribution of non-permissible activities had been reduced to 5% as opposed to its earlier benchmark of 10%. This means that the contributions from non-permissible activities that involve the element of ‘umum balwa’ “General Tribulation” should not be more than 5%. The other benchmark had been reduced from 25% to 20%. This entails that the contributions from non-permissible activities such as hotel and resort operations, share trading and stock broking should be lower than 20%. Therefore, the list of non-permissible activities under each benchmarks are as follows:

c) The basic principle is the prohibition of participating in * ISRA Shari’ah Management Trainee

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a) The Five Percent (5%) Benchmark

b) The Twenty Percent (20%) Benchmark

The contributions from the followings activities to the group turnover and profit before taxation should not exceed 5%:

The contributions from the followings activities to the group turnover and profit before taxation should not exceed 20%:

i. conventional banking;

i. hotel and resort operations;

ii. conventional insurance;

ii. share trading;

iii. gambling;

iii. stockbroking business;

iv. liquor and liquorrelated activities;

iv. rental received from Shariah non-compliant activities;

v. pork and pork-related activities;

v. other activities deemed non-compliant according to Shariah.

vi. non-halal food and beverages; vii. Shariah noncompliant entertainment; viii. interest income from conventional accounts and instruments, including dividends from investment in Shariah non-compliant instruments and interest income awarded arising from a judgement by a court or arbitrator; ix. tobacco and tobacco-related activities;

In the second-tier, a qualitative assessment is undertaken where each company who issues the securities should undergo the financial ratio screening. This is a recent addition by the SAC of SC which did not previously provide for the screening of financial ratios. Here, the SAC provides that the following ratio measures riba or riba-based elements in the company: a) Cash over total assets: cash to be included in the calculation includes cash placed in conventional accounts and instruments only. If the company placed the cash in the Islamic account, it should be excluded from the calculation.

b) Debt over total assets: debt to be included in the calculation includes interest-bearing debt only. If the company used Islamic financing such as sukuk, it should be excluded from the calculation.

* Source: Securities Commission Malaysia, 2013

To fulfil the requirement for this assessment, each ratio must be less than 33% and only securities issued by company that meet the requirement in all assessments will be classified as Shariah compliant securities (Securities Commission Malaysia, 2013c). The inclusion of financial ratio benchmarks has been the practice of global Shariah index providers such as Dow Jones, MSCI, and FTSE. Both SC’s and DJIM’s screenings incorporate a benchmark of less than 33% for financial ratios. In comparison, some other Shariah index providers may adopt slightly different benchmarks, for example, the Karachi-Meezan Index 30 (KMI-30) screening methodology incorporates a higher benchmark of less than 37% for interest bearing debt over total assets ratio while the S&P Shari’ah Indices methodology apply financial ratios on trailing 36-month average market value of equity while the benchmark for account receivables is set at less than 49% (Malaysian International Islamic Financial Centre, 2013).

x. other activities deemed non-compliant according to Shariah. * Source: Securities Commission Malaysia, 2013

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A GROWING CONCERN Ideally, untainted stocks are every Shari’ah investors’ desire; however, are Shari’ah compliant stocks compliant to the letter or are there some grey areas that remain shaded? The answer to this question is not as simple as it is posing the question as several considerations must be taken into account before answering it. Among these considerations are; business categorization, financial reporting, purification, uniformity and compatibility shifts. Firstly, business categorization of Shari’ah compliant stocks focusses on separating Shari’ah non-compliant activities from Shari’ah compliant activities. However, industry tools used to filter stocks; namely, the Global Industry Classification Benchmark (GICS) and the Industry Classification Benchmark (ICB), are one dimensional. The problem with this is that it only filters core business activities and disregards non-core activities that may indeed render the stock Shari’ah noncompliant. Secondly, accurate financial reporting of Shari’ah compliant stocks is essential to ensure that the stock is fully compatible. Issues in this area arise when financial statements are published inconsistently. Numerous companies report incomplete or erroneous financial disclosures on an interim and annual basis. Some companies do not report interest income as part of the financials and resulting in a disproportioned selection of compatible stocks. Similarly, there are companies that do not differentiate between cash and cash equivalents. This creates a distorted depiction of the actual projection and managers erroneously classify sticks as Shari’ah compliant.

Finally, compatibility shifts in stocks pose great challenges to fund managers. Compatibility shift here refers to when a Shari’ah non-compliant stock becomes compliant and vice versa. Among other challenges, issues of purification of newly compliant funds arise and re-compliance status is sort for those stocks that have lost its Shari’ah status. Currently, there are many advances that have been proposed by respective Shari’ah boards on a case by case basis; nevertheless, this has left the masses in a dilemma on how to respond to the issue. CONCLUSION There is still growing concern about Shari’ah stock screening and its application in the Islamic finance industry. There is a need to have a configured methodology that encompasses all of the issues that may hinder Shari’ah-compliant business conduct which will enable a compatible environment. Nevertheless, the need for innovative ideas in the industry is rampant. However, this will require committed collaboration between Shari’ah advisors, practitioners, authorities and service providers. The market is growing rapidly; however, innovation is still lacking in key areas. Harmonization is one of the ways that will spur progress for innovation.

Thirdly, purification of Shari’ah non-compliant earnings poses significant challenges as interest earned may not always be specified in the income account. In some instances, it could also be wrapped in disguise of set-offs against miscellaneous expenses. Therefore, it is almost impossible to obtain complete details of tainted income within a pool of 100 stocks that are provided from various platforms and are disclosed in different forms. Fourthly, Shari’ah compliant investments are considered taking into consideration the localized requirements. Two prominent exponents of Shari’ah compliance conducted a study to learn how different Sharia compliance strategies applied to the same asset universe could deliver differences among the sets of assets classified as compliant.

LEARN MORE For more information please email [email protected]. To learn more about Islamic markets on the Bloomberg Professional® service, go to ISLM or ISRA . The views expressed in this bulletin does not necessarily reflect those of International Shariah Research Academy for Islamic Finance (ISRA) and Bloomberg or its editors. Bloomberg and International Shariah Research Academy for Islamic Finance (ISRA) are not liable for errors or any consequences arising from the use of information contained in this bulletin. No information or opinion expressed herein constitutes a solicitation of the purchase or sale of securities or commodities.

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