Introduction
It is not uncommon for companies to issue preference shares for subscription by intending members of the public. Among other reasons, this happens usually in a bid to raise more capital for the company’s operation and expansion. Shares are broadly classified into ordinary shares and preference shares.
The most common share type is ordinary shares where shareholders all have equal rights and obligations and are regarded as owners of the business. More recently, there seems to be no major shariah concerns with regards to the permissibility of issuing and subscribing to this type of share.
On the other hand, preference shares, by virtue of certain features, have some legal violations (from a Shariah standpoint) which make them impermissible. This write-up seeks to explore the following:
a) shariah violation of preference shares;
b) possible structures or arrangements proposed by some scholars which could potentially make a preference share shariah-compliant;
c) my comments on point (b) above and residual concerns on the proposed structuring of preference share
Preference Shares
According to Investopedia, preference shares are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders.
Preference shares come in various forms ranging from redeemable, irredeemable, cumulative and non-cumulative preference shares. Preference shareholders generally do not have the right to vote. However, they benefit from fixed income and returns, low possibility of capital loss and sometimes guaranteed capital and priority in dividend distribution.
Shariah Violations of Preference Shares
a) Dividend Payment: Preference shareholders are required to be paid dividend before any other category of shareholders. In most cases, preference shareholders have a fixed dividend while the ordinary shareholders do not have a fixed dividend as their return is dependent on profit realisation and dividend declaration by the company.
This arrangement presents an issue from a shariah perspective. Most (if not all) contemporary scholars agree that the relationship between ordinary shareholders and preference shareholders (i.e tekyiiful l fiqhiy) is that of a partnership (Musharokah). This is why most rulings with regards to preference shares are established based on already known principles of Musharokah.
In a musharokah, the partners have equal priority (not to be confused with equal profit or profit in proportion of capital contribution) in profit distribution and no partner should guarantee income or profit for the other partner. Thus, ascribing fixed return/dividend to some partners is not in line with the shariah requirement of Musharokah as this potentially guarantees dividend for some partners.
Another implication of fixed dividend is that preference shareholders cannot benefit from a rise in profit above what has been agreed in the share offer. However, they tend to be protected when profit falls below expectation.
b) Cumulative Dividend: Equally, certain types of preference shares such as the cumulative preference shares may be entitled to claim back dividends from previous years when the company did not declare dividend in those years.
For example, if a company is not profitable for a few years, once it gets back on track to making profit, it may still have to pay those dividends from the previous years. These would then be regarded as dividend in arrears. Therefore, preference shares tend to combine both features of both equity and debt instrument.
c) Preferential Settlement: When a company goes into liquidation, the capital contributed by preference shareholders are returned before the ordinary shareholders are paid back their capital. With this, ordinary shareholders may not receive anything from their capital contribution unless there is sufficient fund available after preference shareholders have been settled.
This particularly contravenes the principle of Musharokah where members bear loss in proportion of their capital contribution.
d) Another notable feature of a musharokah is that a partner cannot guarantee the capital of the other partner. However, there is a category of preference shares called redeemable preference shares.
These shares are issued with an option to call them back by the company at a certain point in time. More often, they are called back at their initial purchase price thereby effectively guaranteeing the capital invested by a preference shareholder. AAOIFI Shariah Standard No. 12 (Article 3/1/4/1) clearly states that:
All partners in a Sharikah contract maintain the assets of the Sharikah on a trust basis. Therefore, no one is liable except in cases of misconduct, negligence or breach of contract. It is not permitted to stipulate that a partner in a Sharikah contract guarantees the capital of another partner.
In the light of the reasons mentioned above, preference shares are generally prohibited as they are very close in features to a debt instrument (i.e a conventional bond) where returns are fixed and pre-determined (regardless of business outcome) and capital is guaranteed.
It’s worth noting that section 4/1/2/14 of AAOIFI Shari’ah Standard No. (12) states:
It is not permitted to issue preference shares, i.e. shares that have special financial characteristics that give them a priority at the date of liquidation of the company or at the date of distribution of profit.
Shariah Compliant Preference Shares
Could preference shares be made shariah-compliant? Is there a way in which preference shares could be structured such that the Shariah violation would be expunged thereby making them permissible?
In order to give a balanced outlook to this discourse, it is perhaps useful to mention that there are scholars who have come up with propositions for a shariah-compliant preference share.
I have decided to summarise below major points in which preference shares could be made Shariah-compliant according to the majority of those who hold such view:
a) There is nothing in the Shariah that prohibits a business partner from voluntarily forfeiting some of his rights in favour of another partner. Ordinary shareholders will voluntarily waive their own rights to receive dividend until preference shareholders have received dividend.
This would be in the form of a mandate or agreement which would be ratified by the Board of Directors. With this, they waive their legal right to the preference shareholders based on the principle of tanazul ( تنازل ).
The same waiver of right could also be effected through a contract of wa’ad (bi-l-hibbah). In the same vein, the preference shareholders would agree to an undertaking to waive their right to receive any dividend that may be declared in excess of the agreed/expected dividend rate. This, to some extent seeks to address the concerns highlighted above in point (a) and (c) under the earlier section “ Shariah Violations of Preference Shares”
b) Also, the fixed rate of dividend offered to the preference shareholders is just an indicative rate and not binding. Thus, preference shareholders can receive dividend up to this rate to the extent that profit is actually available and the company is solvent.
c) Given the arrangement in (a) above under this section, there is no shariah breach if preference shareholders receive dividend before ordinary shareholders (even if the ordinary shareholders) end up receiving nothing as it is based on mutual consent and waiver of right between both. Mutual waiver of right does not go against the general principles of Musharokah.
d) Preference share could have a cumulative feature such that dividends not paid (e.g when dividend is not declared) in one financial year are carried forward to the following year and may continue to be carried forward as long as the share is not redeemed.
However, the final settlement that would be made should depend on profit availability and declaration of dividend in the financial year of payment. Therefore, if there is no profit upon maturity or redemption of the share, such accumulated profits would not be paid.
e) A redeemable preference share could be structured via a purchase and sale undertaking meeting certain conditions; the major condition being that it must not guarantee capital or profit for preference shareholders.
My comment and Further thoughts.
The above proposition on Shariah compliant preference share shows the level of effort and initiatives taken towards improving islamic product offering.
It also attests to the depth of innovative thinking demonstrated by contemporary scholars in a bid to meet the industry’s demand. While such an effort is commendable, there remains the following considerations in my opinion:
a) Firstly, for wa’ad bi Al-tanazul to have its intended effect, it must be executed at the beginning of the musharokah at the point of share issuance. By implication, the tanazul would thus involve a waiver or abortion of right to profit that is non-existing and which there is no guarantee that it (al-ma’quud alayhi) would later exist. As a result, there is a concern that this is similar to gharar which is a fundamental prohibition in Islam.
Even though tanazul is done through wa’ad which is generally a promise that relates to the future. However, in Islamic commercial jurisprudence, wa’ad is regarded as a binding promise. Therefore, once executed, it becomes a legitimate contract and bears immediate effect.
On the flip side, if it were possible to completely delay initiation of tanazul until after realisation of profit in each financial year, perhaps this shariah concern would be addressed. But then, how operationally feasible would that be?
As for the second alternative contract proposed (which is Al-wa’ad bil-Hibbah), I currently do not see any issue with that.
b) The specification of a fixed dividend rate (pre-determined in advance) in the preference share contract portends an issue from a Shariah perspective and somehow, the proponents of shariah-compliant preference share seem to agree with this reality.
However, their position is that such rate does not imply the company has guaranteed a dividend as the company is eventually paying dividends subject to actual profit realisation. In other words, such pre-determined dividend rate stated on the offer letter is only indicative.
A meticulous thought over this matter reveals that even if we agree with the above as claimed, there is still a residual matter to address which is: the effect of stipulating a potentially non-shariah compliant element in a contract while stipulating other conditions that make the non-shariah compliant element redundant and non-binding.
To understand what I mean here, let us consider this illustrative example:
Bank ABC (a hypothetical Islamic Bank) has specified in its loan terms and conditions that borrowers would be charged an interest of 2%. However, such interest charge is not binding on customers as they are free to opt-out and refuse payment of interest.
This loan contract, in my view, exemplifies a contract which has a prohibited component and at the same time, another component potentially nullifying or rendering the haram component ineffective.
Assuming all the loan customers opt-out of the interest element, Bank A’s product would by default operate like a` qardun-hasan (gratuitous loan or interest-free loan) which is allowed in Islam. Nevertheless, this would not mean that the 2% interest stipulation has not violated shariah requirement as it is a key term and condition within the contract.
The same scenario depicted above could be applicable to the case of “shariah-compliant” preference share. If for the sake of analysis, we assume the common shareholders are not guaranteeing the stated rate, having a dividend rate pre-determined (not determined based on profit) and stated in the share offer poses the same concern as that observed in this Bank ABC example.
c) Likewise, the principle underpinning musharokah requires that profit/dividend payout are dependent on the financial performance of the entity.
If we assume that the preference rate in (b) above is only indicative and it’s truly dependent on profit availability and solvency, then the ideal expectation is that once dividends are declared, the company’s liability and obligation for that performance cycle should be restricted (or limited) only to that amount which the Board of Directors has reasonably decided to declare as dividends to the share holders from the profit made; such decision supposedly taken in the best interest of the Company.
However, this is rarely or never the case with cumulative preference share. When a company could not or did not declare dividend on the specified dividend distribution date, the rate can be accumulated and carried forward.
Likewise, when a company, owing to its present financial condition, declares and pay an amount below the preference rate, it would be liable to carry forward the shortfall to the next financial year as a (liability) just as the practice in the case of conventional preference share. In other words, the company is constructively obliged (if not contractually) to pay accumulated dividends once it gets on the profit-making track.
This is why the majority of the scholars rule against the permissibility of a cumulative preference share. Therefore, carrying forward and accumulating dividends which the company is unable to pay due to its current financial performance could be seen as a subtle way of guaranteeing those dividends to preference shareholders.
d) Lastly, it is important that we do not forget the primary reason why a potential investor would opt to become a preference shareholder instead of an ordinary shareholder. From an investor perspective, the primary motive for choosing preference share is the potential to avert risk-sharing (be it partially or wholly) while earning some guaranteed return/dividend (or call it indicative dividend rate).
In the first place, this goes against fundamental principles of Islamic finance which emphasises risk sharing. For verily, a person is entitled to a gain if he/she also agrees to bear loss whenever it occurs (al-gunm bil gurm).
Thus, the fact that we are able to harness legally permissible structures, contracts or hiyal to come up with a preference share does not eliminate this breach of fundamental principle. In reality, the economic substance of preference share based on (wa’ad bi_t_tanazul or al_wa’ad bil_hibbah) is the same as that of the conventional preference share. This may also be indirectly passing the wrong message that only the legal form of a contract requires consideration in Islamic finance product structuring.
Conclusion
Preference shares are generally considered to be impermissible in many jurisdictions with a few exceptions. Verily, it is a subject matter regarding which scholars have discussed extensively.
The above discussions is my own personal attempt to give a high-level overview of the topic and to make us appreciate the extent of scholarly efforts that have gone into Islamic product structuring.
In addition, it’s essential to also state that even though my opinion above may align with certain scholarly positions, it’s not a ruling or judgement as to whether preference shares issued anywhere is Shariah-compliant or not. Rather, it was purely an expository and educational discourse. The judgement as to whether a product is Shariah-compliant lies within the exclusive jurisdiction of the Shariah scholars.
Lastly, while the Islamic finance industry continues to grow, it is very crucial to ensure that our end goal is not to ensure that the industry has an exact replica for every single form of conventional finance product. Rather, all our innovation should be driven by the fundamental principles of Islamic finance.
References/Further Readings
· Accounting and Auditing Organization for Islamic Financial Institutions. (2015). Sharī`ah Standards. Bahrain: AAOIFI.
· Shofian Ahmad & Marina Abu Bakar (2017) :The Status of Preference shares from Islamic Perspective
· Resolution of the SAC of the Securities Commission Malaysia
· Shofian Ahmad & Marina Abu Bakar (2022): The Application of Wa’d bi al-tanazul in Preference Shares from the Islamic Jurisprudence Perspective
· International Shariah Research Academy for Islamic Finance: Preference Shares from Shariah Perspective: Issues and Solutions_ Shamsiah Mohamad, Mezbah Uddin Ahmed and Mohd Bahroddin BADRI
· ISRA International Journal of Islamic Finance • Vol. 2 • Issue 2 • 2010: Shariah Parameters of Hiyal in Islamic Finance- Mohamed Fairooz Abdul Khir*
· Amanah Advisors Blog_https://amanahadvisors.com/the-shariah-breaches-f-preference-shares/
· Investopedia
Disclaimer:
The views and opinions expressed in this publication are mine and do not necessarily reflect the views or positions of any entities or organisations that I am affiliated with. Likewise, this article was first published on my Linkedin page in March 2023.