The following question and answer by Sheikh Yusuf Talal DeLorenzo attendees of the Dow Jones University Courses on Islamic Investement.
Question:: My question has to do with preferred stock and whether or not they are halal. In the lesson it mentioned that those that pay dividends are guaranteed, so it is not allowed. This is true of cumulative preferreds, but regularly "non-cumulative preferreds" only pay dividends when the company has earnings. My question is, the security haram if it is guaranteed, or is it haram if it pays a fixed dividend?
Answer: From Lesson One: Types of Stocks and Businesses:
Ownership shares issued by corporations and traded by investors include both common stock and preferred stock. While there are several ways in which the two types of stock differ, the most significant way, from an Islamic legal point of view, is that preferred stocks guarantee the amount of the dividend.
Such a predetermined and guaranteed rate of return is prohibited for the reason that it may be classified as riba. Thus, while an investor may share the risks of ownership with other investors, the preferred status of the preferred stock means that there is extra compensation for the owner for which the owner has not had to pay. This, in simplified terms, amounts to riba al fadl. In Lesson Two of this course, we will take a detailed look at riba and the forms it may take. For similar riba-based reasons, fixed-income securities, convertible notes, and the like are also prohibited.
As a general rule, then, Muslim investors may trade only in common stock.
In some cases, however, preferred stock may be offered without a fixed dividend or without a dividend at all. Even so, it is the right of the shareholders to change those terms through a vote at their shareholders? meetings. Thus, while a Muslim investor may purchase such stock, s/he may hold it only for as long as it carries no fixed dividend. If the status of the stock changes as a result of a vote, the Muslim investor will have to liquidate his/her interest in the company immediately. And if a fixed-amount dividend is received before the stock can be sold, the entire amount of the dividend will have to be given away as charity.