The Implication of Islamic Law for The Practices of Securities

In fact, there are many similarities between the conventional and Islamic securities.
Both securities apply the same portfolio theories in term of asset allocation, stock selection
and performance evaluation. The different between these two securities is, where the Islamic
securities have to comply and govern by Islamic principles. Differently with conventional
securities where these securities are not restricted to the Islamic law and make these securities
is more freedom.

In Islamic securities the restrictions to the Islamic law is to tight, this is because the
Islamic law is to protect the Muslim from doing the prohibited thing. Islamic securities are
more restrictive compare to the conventional securities. Before go more deeper for screening
criteria, Islamic law is concern with the ethical value of commercial transactions.

Muslim are governed by rules in respect for halal and haram which is permissible and
prohibited. However, muslim are encourage to participate in securities in respect of those
which shariah rules as halal. Trade transactions is permissible in Islam but they need to
followed the Shariah rules. So, this is the list where the company is classified as non shariah
compliant securities if that company involved in the following core activities:

1. Financial services based on interest

2. Gambling

3. Sales of non-halal products

4. Conventional insurance

5. Entertainment activities that are not permissible in shariah

6. Tobacco

7. Pornography

8. Pork related product

That all prohibited company securities is based on four major Islamic Indices Provider. I)
Islamic Dow Jones, II) Islamic FTSE, III) Islamic S&P and IV) Islamic MS
Shariah screening criteria

As a Muslim, to investing in something should into the shariah compliant instrument. That
can be done by investing in companies that pass shariah screening criteria approved by
shariah scholars. There have two categories of shariah screening criteria. I) Qualitative sector
screening and II) Quantitative financial screening. These two criteria must be met in order for
company pass the term of shariah compliant company.

I. Quantitative criteria

In these criteria, according to principle of Islam companies should not produce or sell the
impermissible product or services such as liquor, tobacco, alcohol, pornography, casino, pork
related product and also the conventional insurance because all that mention product is
containing the major prohibited element in that product such as riba, gharar and maysir. The
company if want to become the shariah compliant company should exclude all the prohibited
element in Islam. It will become the shariah compliant company if passes all the financial
screening criteria. In other word means qualitative criteria, in these criteria the company
should exclude the core prohibited activities from the company if to attract the Muslim
investor and to become shariah compliant company.

II. Qualitative criteria

Different between conventional securities and Islamic securities is, for Islamic securities
portfolio must have to comply with certain financial screening process. The purpose for the
financial screening process is to exclude the companies with the unacceptable level of
interest-based investment, conventional debt and impure income. Following the Islamic law
and principles, in Islamic investment must not to comply with or borrowing on the interest
rate nor invest in interest return instruments. According to Wilson, "such restrictions would
screen out the vast majority - if not all - of the stock that are available on the market, even
those listed in Islamic country". This is because the company tend to have exposure to
interest based finances for managing their working capital.
According to AAOIFI which is Accounting and Auditing Organisation for Islamic Financial
Institution, in order for company to be suitable for Muslim investors there are several
financial screening ratios that will be met the permissible for shariah compliant. That is the
percentage for not exceed to become shariah permissible companies:

 Interest based deposit - Total amount of interest taking deposit whether short or long
term should not exceed 30% of the market capitalization of the total equity.
 Interest based debt - The collective amounts of interest on loan must not exceed 30%
of the market capitalization of corporations.
 Earning from impermissible activities - The income generated from impermissible
activities should not exceed 5% of the total income of corporations.
 Tangible asset and benefit - The tangible asset must not less from 30% of the total
asset value of corporations.

For the additional in shariah screening securities, there have the financial ratios to avoid the
disagreement among the scholars.

Financial ratios

In financial ratios have four financial ratios that are commonly used are level of debt, level of
liquidity, interest bearing securities and impure involve.

Level of debt

In Islam it's clearly mentioned that interest-based debt is not acceptable. However, have some
debt is tolerated if the interest-based debt does not exceed the acceptable level of
conventional debt. According to Wilson, this is due to the impracticality of such a restriction
with contemporary companies, since the vast majority of company have exposure to interest-
based finance. For the shariah compliant companies, the interest-based debt shall not exceed
the excessive level.
Level of liquidity

From the some shariah view, the liquidity asset must be traded at par. But according to
shariah principles and law, the company with major asset cannot be traded. This requirement
of the liquidity screening is to avoid the Muslim investor to invest their money to the
company whose liquid their asset is traded at discounted value. Differently by AAOIFI, the
standard liquidity is not mentioned or not directly impose the restrictions the level of
liquidity. However, AAOIFI impose the conditions that the market value of tangible asset.

Interest bearing securities

The purpose of this financial ratios is to ensure that interest bearing securities are in
acceptable level. This is because many of this is not shariah compliant such as Government
bond and Preferred stocks. This is to minimize the investment in interest-based securities and
reducing the income that is generated interest or Riba.

Impermissible income

According to shariah law and principles, generated income from impermissible activities is
prohibited but SAC and shariah board have tolerated a small portion of impermissible income
as long as their main activities of the company is shariah permissible. However, this income
is permissible even have the small portion of prohibited, the investors are required to purify
their income portion.

Earnings purification

This is the impermissible income that generated from permissible business. The income just
only a small portion of the company income. For example, Tesco company selling the
permissible product but they have a small portion on selling the impermissible product for
non-Muslim such as alcohol and pork. According to Dolorenzo, for those who selling their
share before the company declared their financial period, they did not obligate to purify their
income and for those taking return on securities from the impermissible portion, it will be
purified by distributions of dividend. In other hand, the purification of earning in Islamic
mutual fund will be done by fund manager that be deduct by direct deduction before the
dividend be distribution.

For this earning purification, many muslim investor like to use the second method
compare with the first method that fund manager will do for it. The Muslim investor argue
that this method of purification makes the Islamic securities is more profitable.

Differently with conventional that the securities don't need to purification and didn't
give anything to the needy person like the capitalist thinking that your income that all yours.
According to AAOIFI, they indicated that the responsibility of purification falls upon
institutions. However, the zakat is the small portion in income or wealth that should pay to
the zakat institution to be distributed to the needed people, that’s like a charitable and
purification as well.

The four major Islamic indices applied to the earning purification process.

1.Islamic Dow Jones

 Does not apply the earning purification process.

2. Islamic FTSE

 Applied the approximately purification process.

3. Islamic MSCI

 Applied the dividend adjustment factor for all the reinvest dividend.

4. Islamic S&P

 The investor will get the dividend purification ratios for purification purposes. The
portion that investor get is the ratios of dividend that must to purified.