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2 Shariah Guidelines For ISLAMIC FUNDS By By Muhammad Najeeb Khan Sharia Advisor Habib Mertropolatin Bank Sharia Board Member UBL Islamic Fund

3 According to Shariah Standards of Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) a Stock Company has been defined as: “A stock company is a company of which the capital is partitioned into equal units of tradable shares and each shareholder’s liability is limited to his shares in the capital. It is a form of financing partnership. The rules of Sharikat al-Inan apply to this company except on the issue of the limited liability of the shareholders and the fact that this type of company cannot be unilaterally terminated by one party or a minority of its shareholders”

4 Scope Transactions in an Islamic Capital Market should be free from the involvement of prohibited activities by Islam as well as free from the elements such as usury (riba), gambling (maisir) and ambiguity (gharar)

5 Shariah Compliant Stocks Shariah Guide lines: Shariah Guide lines: Shariah based principle of equity participation is Shirkah Shariah based principle of equity participation is Shirkah Stocks are classified as Shariah compliant if their business activities do not fall in the prohibited list prescribed by Shariah Scholars Stocks are classified as Shariah compliant if their business activities do not fall in the prohibited list prescribed by Shariah Scholars Certain financial ratios are also applied for screening. Certain financial ratios are also applied for screening.

6 Shariah Compliant Stocks Prohibited activities: Alcohol Alcohol Gambling Gambling Pork related products Pork related products Pornography Pornography Conventional financial services Conventional financial services Conventional insurance Conventional insurance Tobacco, Tobacco, Indecent Entertainment Indecent Entertainment Financial Ratios: Main ratios applied are Main ratios applied are –Debt to equity ratio –Cash and interest bearing securities to equity ratio –Cash to asset ratio In Malaysia, the screening of listed stocks is undertaken by a centralised body- Shariah Advisory Council of SEC In Malaysia, the screening of listed stocks is undertaken by a centralised body- Shariah Advisory Council of SEC In other jurisdictions, screening services are performed by individual institutions In other jurisdictions, screening services are performed by individual institutions

7 Stock Market Business The stock exchange provides a market place where investors can buy and sell shares. The exchange’s role is to monitor the market to ensure that it is working efficiently, fairly and transparently. The stock exchange provides a market place where investors can buy and sell shares. The exchange’s role is to monitor the market to ensure that it is working efficiently, fairly and transparently. The trading system comprises four distinct segments: The trading system comprises four distinct segments: T+ (2) settlement T+ (2) settlement Spot transactions Spot transactions Provisionally listed counter Provisionally listed counter Futures contract Futures contract

8 Key components of Islamic Capital Markets Shariah Compliant Stocks Islamic Funds Islamic Bonds Islamic Capital Market

9 Shariah Related Issues in Stocks Trading Not permitted to purchase shares by raising interest bearing loans through a broker or someone else. Not permitted to purchase shares by raising interest bearing loans through a broker or someone else. Not permitted to pledge the shares for the interest bearing loan. Not permitted to pledge the shares for the interest bearing loan. It is not permitted to sell the shares that the seller does not own which is called short sale. The promise by the broker to lend these shares at the time of delivery is of no consequence. It is not permitted to sell the shares that the seller does not own which is called short sale. The promise by the broker to lend these shares at the time of delivery is of no consequence.

10 Issues in Stocks Trading (Contd) Not permitted to conclude futures contract for shares because according to Shariah only one thing either payment or delivery can be deferred. Not permitted to conclude futures contract for shares because according to Shariah only one thing either payment or delivery can be deferred. Not permitted to conclude the contracts of options for shares or to conclude swap contracts with respect to shares and their returns. Not permitted to conclude the contracts of options for shares or to conclude swap contracts with respect to shares and their returns. The contract of Salam is not permissible in shares – identified items. The contract of Salam is not permissible in shares – identified items.

Stock Screening Criteria Various Criterion have been developed by the Scholars to screen any scrip’s eligibility for investment. The major stock screening criterion followed are: Dow Jones Islamic Market Indices Criteria (DJIMI) Meezan Islamic Market Index Criteria (KMI 30 Index Criteria)

 Business of the Investee Company: The basic business of the investee company should be Halal.  Debt to Market Capitalization: Total debt divided by 12-month average market capitalization should be less than 33%.  Cash and Interest Bearing Securities: The sum of company’s cash and interest-bearing securities divided by trailing 12-month average market capitalization should be less than 33%.  Accounts Receivables: Accounts receivables divided trailing 12-month average market capitalization should be less than 33%. Dow Jones Islamic Market Index Criteria

 Business of the Investee Company: The basic business of the investee company should be Halal.  Debt to Total Assets: The interest bearing debt of the investee company should not exceed 37% of total assets.  Illiquid Assets to Total Assets: Total illiquid assets of the Investee company as a percentage of total assets should be at least 25%.  Investment in Shariah Non-Compliant Activities: Total investment of the investee company in Shariah non-compliant business should not exceed 33% of total assets.  Income from Shariah Non-Compliant Investments: The income from Shariah non-compliant investments should not exceed 5% of gross revenues of the investee company.  Net Liquid Assets vs. Share Price: The net liquid assets per share should be less than the market price of the share. Meezan Islamic Market Index Criteria

 It is necessary to purify the earnings by deducting from the returns on the investments those earnings emanating from an unacceptable source from a Shariah point of view.  In context of equity investment according to Shariah standards it is obligatory to eliminate prohibited income that is mixed up with the earnings of the company and this obligation is on the one who is the owner of the shares. Purification Requirement

 Elimination is not obligatory for the intermediary, agent or manager out of part of their commission or wages because this is their right in lieu of the work they have undertaken.  In case of Fund Management it is responsibility of the Management Company to eliminate the prohibited income.  According to Shariah Standards for the determination of the percentage of prohibited income the recourse should be the last verified financials position. Purification Requirement

 we calculate the percentage of non-compliant income to the gross revenue (sales + other income) for each investee company and this percentage is called as charity rate.  Charity rate for each investee company is multiplied with the dividend income from respective companies to get the charitable amount. This charitable amount is then transferred to a separate account.  Shariah advisor verifies the whole process of elimination of prohibited income and issues a certificate to be included in the annual accounts of the fund. Purification Requirement

17 Quantitative Screening Criteria The basic business of the investee company should not be non-Shariah compliant like conventional banks and insurance companies Total non-Shriah compliant debt of the Investee Company should not exceed 40% of the total assets. Total illiquid assets (which are not cash or cash equivalent) of the Investee Company as a percentage of the total assets should be at least 20%

18 Quantitative Screening Criteria Total investment of the investee company in Shariah non-compliant business (as a secondary source of income) should not exceed 33% of the total assets Investee Company’s interest income or any other non- Shariah compliant income should not exceed 5% of its gross revenues All the essential Shariah trading rules would be applied in case of trading; hence short sale or sale before settlement date would not be allowed

19 JAZAKALLAH