Shariah Screening

The following question and answer by Sheikh Yusuf Talal DeLorenzo attendees of the Dow Jones University Courses on Islamic Investement.Note: The course referred to in the answers is available only via the Dow Jones University. does not have access to this course material. Please contact the Dow Jones University directly for more information. Question 1: If you can, can you please explain to me how did the board of Shari`ah derive the debt/asset ratio, which is 30%, as a criteria to determine whether the company is an Islamic investment?Question 2: As we know, there are three additional shariah compliance screens imposed by DJIM on any company meeting the primary business requirement, such as its total debt and account receivables do not exceed 33% and 45% respectively of its total assets and its interest income doesn't exceed 5% of its revenues. my question are how these criteria are determined, what are the rationales behind such barometers?. Don't you think 33% or 45% is too much or too less? How are you sure that those percentages are optimalbarometers?Question 3: What is the rational for excluding businesses from the DJIM which have more than 33% debt or accounts receivable of less than 45%? Answer: As these three questions concern the same subject, I will attempt to answer all of them together. To begin with, however, four important points need to be kept in mind. Firstly, that the screens developed by our scholars are interim tolerance parameters, or preliminary attempts to deal with issues of interest as these effect corporations and should in no way be considered the final word on any of these matters. Secondly, that these apply only to non-Muslim owned/operated companies. Thirdly, that this is not to be understood as an endorsement of these corporate practices. And, fourthly, that all impermissible income must be calculated and cleansed. Then, with these points in mind,students are directed to Lesson Four: Shari`ah Aspects of Islamic Finance, and then tothe section entitled: Investment Guidelines for Private Equity. So, then, in answer to the question above at Q (2)? "How are you sure that thosepercentages are optimal barometers?" I must refer the questioner to the firstpreliminary point above, i.e., that these should in no way be understood as the finalword on the matter. This is because these ratios are the results of ijtihad or effortexpended by qualified scholars of fiqh in disciplined academic research. As you know,recourse may be had to ijtihad when there are no texts of direct relevance from theQur?an or the Sunnah to indicate a Shari`ah ruling on a particular issue. Under suchcircumstances, it was the instruction of the Prophet, upon him be peace, to "exerciseyour learned opinion," or use ijtihad to arrive at a ruling. The rules governing thepractice of ijtihad, the qualifications for practicing it, and the methodologies to beapplied were developed by the jurists of the classical period. Then, within the limitsof those rules, contemporary Islamic jurists have practiced ijtihad and arrived at theguidelines or screens for Shari`ah compliance of equities. It was explained in Lesson One that nearly all modern corporations are involved toone degree or another in interest. Now, remember from the four preliminary points listedabove that such interest would not be tolerated in a Muslim owned/operated company, andthat all income from interest must be calculated and cleansed (See Lesson Six for howthis may be calculated.) In order to place a limit on the amount of interest that maybe tolerated in an Islamically-acceptable investment, scholars turned to ijtihad becausethere are no clear guidelines on the subject in the Qur?an or the Sunnah. Rather, theycombed the texts of these revelational sources for something that might be considered ofrelevance, even if that something was mentioned in a different context. This is for thereason that evidence derived from the Qur?an or the Sunnah is stronger than the evidenceof reason alone. This is a well-established legal principle; and this is why certainjurists, Abu Hanifah for example, held evidence from even a weak hadith to be more validthan the evidence of reason (qiyas) alone.So, it is a clear legal principle that an insignificant amount of impurity will notcause, for example, an entire garment to be considered impure, or an entire water well.The same is true in regard to most transactions. If the basic elements of the transactionare valid from a Shari`ah standpoint, then a slight degree of impurity will not cancel thedeal. But measures will have to be taken to rid the deal of the "impure" orincorrect element. Now, there is a hadith in which the Prophet of Allah, upon him bepeace, speaks in terms of one third of something as "plenty" or, to use theAmerican vernacular, "a lot." Anything less than that amount, less than onethird, is spoken of as "trifling," or insignificant. So, even though thisparticular hadith was narrated in regard to an unrelated matter, it is nonethelessrelevant; and it is evidence from a revelational source, and thus stronger evidencethan reason alone. So the connection made by our contemporary scholars is that acompany?s interest-based loans may be considered insignificant if they total lessthan one third of that company?s total assets. This, then, is the basis for one of thescreens used by Islamic funds (and by the Dow Jones Islamic Market Indexes). Another of the screens prescribed by our scholars is that interest-based, non-operatingincome must be less than five percent of revenues. Now, it should be understood that theincome of which we speak here is incidental income, or income separate of the income derivedfrom the primary business of the company. The way this income comes about is that whencompanies receive payments for goods and services, they may not always be able to spend allof the money, and a cash reserve will begin to accumulate. Then, whether these reserves sitin bank accounts, or whether they are invested, short term, in interest-earning instrumentslike CDs, they will earn interest. It is this interest that we are concerned with. If itamounts to less than 5% of the company?s revenues, this too may be considered negligible.But, it must be calculated and cleansed. Fortunately, this sort of income is easily tracedon the balance sheets of corporations, and the matter of cleansing is relatively simple.(Again, see Lesson Six for instructions on how this may be accomplished.) Finally, in regard to the screen on accounts receivable, the Shari`ahallows investing in shares of companies in which the primary business activity is deemedlawful if the accounts receivable do not represent the majority (more than 50%) of thetotal assets. Thus, if the primary business of the company is halal, and the salemethodology for obtaining corporate revenue is through installment payments, which may bedeemed incidental or subordinate if the accounts receivable do not exceed 45% percent ofthe total assets, then investment in such a company will be permissible. It should be notedin this regard that if the receivables total more than fifty percent, the majority of thecompany?s dealings will actually be in money, and not in goods, services, and assets. This position is consistent with the established and recognized Islamic juristic rulestating that what is not permitted independently may be permitted subordinately, cited inmany contemporary fatwas. Therefore, if the accounts receivable do not exceed 45% of thetotal assets, consistent with the rule of majority determining ultimate judgment, an Islamicinvestor will not be prohibited from purchasing shares in such a company. .