Scope of the Financial Papers standard
Islamic finance standards No. 21 governs the investment in and trading of financial papers (securities): Shari'ah-compliant shares and bonds. Unlike Sukuk (which are issued by specific parties for specific purposes), shares represent ownership in joint-stock companies, and bonds represent debt obligations. the Financial Papers standard establishes screening criteria for which shares and bonds are permissible for Muslim investors.
Shari'ah-Compliant Shares: Definition and Screening
A share is a proportional ownership interest in a joint-stock company. For shares to be Shari'ah-compliant, the company must meet two conditions: (1) its primary business activity must be Shari'ah-permissible, and (2) its financial ratios must meet prescribed limits. Shares in prohibited industries are entirely haram (forbidden).
Permissible Business Activities
Companies engaged in the following are generally Shari'ah-compliant: manufacturing, trading, retail, agriculture, real estate, construction, telecommunications, media (excluding content that violates Shari'ah), transportation, utilities, and professional services. Companies engaged in the following are prohibited: conventional banking and interest-based lending, insurance (conventional), alcohol production/distribution, pork production, gambling, weapons manufacturing (unless for legitimate defense), entertainment (music, cinema), and adult services.
Financial Ratio Screening Criteria
Even if a company's primary business is permissible, shares are haram if the company relies heavily on haram (non-compliant) income sources or carries excessive haram debt. the Financial Papers standard establishes numeric thresholds:
- Debt Ratio: Riba-based debt should not exceed 33% of total assets (some scholars use 30%). A company financed more than one-third with interest-bearing debt is considered too debt-laden.
- Haram Income Ratio: Non-compliant income (interest, rental from haram businesses, etc.) should not exceed 5% of total revenue. Any significant haram income taints the entire company.
- Cash Ratio: Cash and cash equivalents should not exceed 33% of total assets. Excess cash is presumed to be earning interest and creates Riba exposure.
Practical Application Example
A technology company has: Total Assets = USD 1,000M. Interest-bearing debt = USD 300M. Riba-based interest income from idle cash = USD 10M. Total revenue = USD 500M. Assessment: Debt ratio = = 30% (acceptable, at the boundary). Haram income ratio = = 2% (acceptable). This company passes Shari'ah screening. However, if the company later took USD 400M in interest-based loans, the debt ratio would become 40%, exceeding the 33% threshold, and shares would become non-compliant.
Prohibited and Restricted Shares
Completely Prohibited Shares
- Companies in haram industries (conventional banking, alcohol, pork, gambling).
- Companies with haram income or debt exceeding limits.
- Companies whose primary shareholders are engaged in haram businesses.
Restricted Shares
- Companies close to the threshold (e.g., debt ratio 30–33%): Permissible for investment but carry heightened scrutiny.
- Companies with haram income near 5%: Permissible but may require purification of returns.
- Transitional companies: If a compliant company becomes non-compliant (e.g., takes excessive debt), investors may be required to divest within a grace period.
Islamic Bonds vs. Conventional Bonds
| Feature | Conventional Bond | Islamic Bond (Sukuk) |
|---|---|---|
| Return Mechanism | Fixed interest (coupon) | Asset-backed return or profit-sharing |
| Shari'ah Status | Non-compliant (Riba) | Compliant (if structured properly) |
| Asset Backing | Not required; backed by issuer credit | Required; must be tied to real assets |
| Investor Claim | Creditor right; senior claim | Proprietor right (ownership); junior to secured creditors |
| Default Risk | Credit risk; issuer must pay interest and principal | Credit + business risk; returns variable |
| Secondary Market Trading | Freely tradable | Subject to Shari'ah rules; some restrictions on tradability |
Purification of Returns
If an investor holds shares in a company that earns some haram income (but below the 5% threshold), the investor may need to purify returns by calculating the proportion of haram income and donating it to charity. For example, if a company's haram income is 2% of total revenue, the investor donates 2% of dividends received to specified charitable purposes. This purification is an investor responsibility, not the company's.