Shariah screening parameters
I had ended the last article on the comment that the screening criteria for the inclusion of a listed company in the Islamic index do not stop merely at the activity being Shariah compliant, and that there are additional hurdles to be crossed.
Although Dow Jones first introduced the stock-screening parameters under the DJIM theme in 1999, AAOIFI launched its own criteria in May 2004 vide Shariah Standard No 21.
The AAOIFI criteria were approved by the greater assembly of Shariah scholars under AAOIFI’s Shariah board and widely accepted and used. The stock-screening parameters described below are derived from the AAOIFI standards.
The parameters are based on a listed company’s quarterly and the year-end financial position, required to be disclosed to the listing bourse within a certain defined number of days from the closing date of the financial period as a statutory requirement. Let me take you through them.
1. Conventional borrowing threshold
The total interest-bearing debt of the company should not exceed 30% of its trailing average market capitalization during the last 12 months.
The 12-month trailing average market capitalization is the average month-to-month market value of the stock over the last 12 months. Such an approach helps smooth out the fluctuating price of a stock to avoid any misrepresentation in its value when it may have momentarily jumped up due to any non-genuine reason.
If a company’s overall interest-based borrowings breach this limit based on the audited financials, the stock cannot remain part of the Islamic index and the index provider must take it out. Nevertheless, the stock can reenter the index in the next quarterly screening if such borrowings reduce to below the threshold.
An interesting question was raised by a delegate during a recent training workshop I conducted on the current subject for the apex bank officials from a Central Asian country. She pointed out that the screening is done based on the quarterly or annual financials but what if the company continued to breach the borrowing benchmark during the financial period but brought it under control for a day to avoid the stock from being ousted from the index? This is what is called ‘window-dressing’.
Well, my explanation was that if the company’s CFO plays around with the standards set by the renowned Shariah scholars pursuant to a lot of calculated wisdom aimed at not only safeguarding the investors’ interest but also to keep the company’s health at check, so be it.
As a famous quote describes, you can fool all the people some of the time and some of the people all the time, but you cannot fool all the people all the time. Therefore, if the company is habitually in breach of the borrowing threshold and does window-dressing for a day, a time will come that the CFO may not be able to continue with his unscrupulous practice.
Before I move on to the next threshold, it is important to explain that the scholars have excluded Islamic financing obtained by a company while ascertaining this ratio. This is because, as explained on many occasions in this column, Islamic financing cannot be classified as a ‘borrowing’ since it is not by nature clean lending in the same sense as the conventional banks indulge with customers.
To qualify for Islamic financing, a customer will either purchase a certain commodity or asset from the Islamic bank on a deferred basis under Murabahah or Istisnah or Salam. Similarly, it will lease an asset from the Islamic bank under Ijarah, or seek the Islamic bank to invest in its business through Mudarabah, Musharakah or Wakalah.
In none of the aforementioned situations can the funding extended by the Islamic bank to the customer be termed as a ‘borrowing’ as the market generally understands what borrowing and lending on interest is all about.
It is interesting to note that due to the exclusion of Islamic financing from this threshold by the scholars, many listed companies in the GCC and Southeast Asia regions have gone through a restructuring of their funding needs by carefully distributing the business between Islamic and conventional banks.
Some have since been completely relying on Islamic banks for their entire financial needs. This has enabled them to continue to remain in the Islamic index. By far, most publicly listed companies are unable to qualify for the Islamic index mainly due to not being able to meet this particular 30% threshold.
While on one hand this phenomenon has certainly helped to increase the size of the Islamic finance industry, on the other, it has enhanced the appeal for listed shares in the market. As such, not only would the individual investor buy and keep the stock, it would also enable the Islamic asset manager to continue to retain and increase the investment in the compliant stock in its portfolio.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at sazubairi1979@gmail.com.
Next week: Discussion on Shariah screening parameters to continue.
