The History and Rationale of the Screening Criteria

To determine the Sharia compliance of an equity investment, a company’s business and financials are screened. Investors commonly ask the nature and evidence behind the 30% and 5%. This article addresses the history and the rationale and of the financial screening as well as raises some questions on the future of the screening criteria.

The Brief History of the Screening Criteria

Research and discussions on Sharia-compliant investments in the equity markets began in the 1980s. In 1987, senior Sharia scholars such as Mufti Muhammad Taqi Usmani (Pakistan), Shaykh Saleh Tug (Turkey) and Shaykh Mohammad Al Tayyeb Al Najar (Egypt) formed a working group with an objective of finding a solution that would allow Muslim investor to own shares of listed joint stock companies.^[1] The International Islamic Fiqh Academy issued a ruling in 1992 that permitted investing in common stocks of Sharia-compliant companies. Shaykh Nizam Yaqubi, who issued the Fatwa for the Dow Jones Islamic Market Indexes (DJIMI) in 1998, it was instrumental in the Sharia compliant stocks screening.^[2] In an interview in 2015, Shaykh Nizam explained the historical motivation dating back to the 1990s’ Dot.com boom that attracted many Muslims around the world to make investments using their families’ wealth in expectation of high returns. These potential investors around the world inquired into the permissibility of investing in individual stocks. As it was impossible to respond thoroughly and individually to all inquiries due to the constraints of time and resources, Shaykh Nizam proposed that he issue a general criterion that can be applied to identify those companies operating within the acceptable range of Sharia principles.^[3] Since then, a number of Sharia boards and Sharia scholars have adopted variations of the Sharia screening criteria, giving it further Sharia strength and approval.

The Rationale of the Screening Criteria

Thirty-Three & Thirty Percent Debt (33% & 30%)

One goal of a Sharia-compliant portfolio is to have as little conventional debt as possible: the less conventional debt carried by the issuer, the better. Islamic financiers originally looked for issuers with zero debt, but that limited the universe of investment options too severely. Criteria had to develop over time and a 33% debt to total assets or total market capitalization ratio opened up greater opportunities for investment, while still limiting potential downsides. The stipulation for 33% or less debt within a portfolio was inspired by a conversation that the Prophet Muhammad had with Sa’ad ibn Abi Waqqas. When Sa’ad asked the Prophet whether he could give 33% of his inheritance away in charity, the Prophet stated, “You may do so, though one-third is also excessive.” (paraphrased from Sahih Bukhari: 80:725). Although 30% is not one-third, 30% was seen as a reasonable standard just below one-third to prevent the “excessiveness” from being within touching distance. And the majority of scholars have adopted this view and therefore the view has gained further strength and is now a standard based on widespread scholarly acceptance and approval including AAOIFI.As for the denominator – total assets versus market capitalization – opinions on how to best value a company have differed over time. Some analysts prefer using total assets and others prefer using market capitalization; the difference comes down to whether a company should be evaluated based on the value of its assets or based on the value another person is willing to pay. Most Sharia scholars have now agreed that a company’s value should be based on market capitalization. While the conversation between Sa'ad and the Prophet is seemingly not directly related to debt, it is common practice in Islamic law to find similarities in anecdotes like this that can be applied in situations not directly addressed in the text.

Five Percent Haram Revenue (5%)

This commonly accepted rule stipulates that any revenues a company receives from haram sources (selling alcoholic products, for example) must be limited to five percent or less of their total revenue. The threshold was established in the belief that any percentage of business activities above 5% changes the character of the company. When first determining this rule, scholars referred to the “smell test” that is used when making ablution. If a Muslim encounters a pond during a walk through the forest, he or she must determine whether it is pure enough for ablution. If the water has no detectable smell and no abnormal coloration or taste, it is enough to assume the pond is suitable. Although it is a somewhat arbitrary number, scholars settled on 5% of haram revenues as the way a company could also pass a “smell test.” It is important to note that though 5% of revenue from haram sources is a commonly accepted limit, generally the intention of Sharia-compliant investment managers is to avoid haram revenues altogether.

There are several questions raised against the screening criteria, which need further research and dialogue among senior Sharia advisors and Standard-setting bodies. Such as, although 30% has been deemed as a maximum according to AAOIFI, if necessity is the underpinning impetus for the ratios, should the percentages be elastic to contextual changes? Should investing in such listed equities be permitted if there are 100% Sharia compliant equities available in Islamic markets?

Reference____________________________________________________

[1] Mian, K. M. A. (2008). Shariah Screening and Islamic Equities Indices. Islamic Finance News, 5(17).

[2] Ilhan, B. & Yildirim,R. (2018). Shari’ah Screening Methodology – New Shari’ah Compliant Approach.

[3] Farid Gamaleldin (2015). Interview on “Background of Shariah Compliance Stocks Screening and Purification Fatwa”, interview conducted in person by Farid Gamaleldin on 2. February 2015.