Participating in an IPO: the Halal Perspective
1/31/2014 2:44:58 PM
Bashar Qasem, CSAA
President and CEO
I wanted to take a moment to tell you about an important principle underpinning the practice of halal investing. It came up recently when a client asked me about the possibility of participating in a firm’s initial public offering, or IPO. After looking into the particulars of the company and the details of the arrangement, I had to inform him that participating would run afoul of Islamic principles. Let me explain.
There is a legal axiom from our scholars of fiqh (Islamic jurisprudence) that states:
“Matters that are prohibited may be allowed to continue, provided that they were done before the fact. However, the same rule is not allowed for its initiation.”
The implications of this statement in contract law are many. An example of its application in early Islamic history relates to marriage contracts. Many of the Prophet Muhammad’s companions were married prior to their acceptance of Islam. Even though Islam requires a contractual arrangement in order for a marriage to be valid, companions married prior to Islam were not required to “renew their vows” or to draft a contract. In other words, the matter was allowed to continue because it was done prior to the application of the relevant rule.
This axiom also applies to investing and financial contracts.
Unfortunately for my client, the issuance/purchase of shares of companies that have impermissible activities, no matter how little, are deemed by Standard No. 21 of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) to be unacceptable in the primary market. This is because the matter is at its point of initiation, as we saw in the axiom above. In order to discourage impermissible activities, participation in the IPO becomes a prohibited transaction.
Based on the legal axiom, AAOIFI makes a distinction between:
a) The issuer; and
b) Market participants who exchange shares that have already been issued.
In the secondary market—when market participants trade the stock of companies whose shares have already been issued—there are rules by which we are able to invest and benefit from these assets. The primary market, however, involves the actual structuring of the asset. Usually, there is some element of impermissibility in an IPO arrangement that would make it unacceptable. Often times, for example, an IPO will leveraged, or some other interest-based provision will apply. In these cases, zero tolerance applies. The AAOIFI thresholds for investing in the secondary market—debt ratios below 30%, accounts receivable ratios below 45%, and interest income below 5%--are reduced to zero in the primary market.
To put it simply, the AAOIFI guidelines we follow when trading shares of stock in the secondary market do not apply when transacting in the primary market. In the primary market, proceeds of the IPO go directly to the issuer, rather than to another investor, or market participant.
This is an example of the flexibility and pragmatism of Islamic financial and contract law. There is zero tolerance for violating Islamic prohibitions in the primary market because, as Muslims, we should not participate in the perpetuation of a practice that is by definition unjust (i.e., a transaction involving lending with interest). In the secondary market, however, the initial harm has already taken place. In this situation, investors are already in the market, so what should they do? They follow the guidelines that our scholars have outlined for us, based on the teachings of the Prophet Muhammad. In addition, we are encouraged to attempt to rectify the situation with other means such as shareholder advocacy (see the Seven Tenets of Halal Investing for more information).
I wanted to share this anecdote with you because it’s a subtle, though critical, concept that illustrates the depth and breadth of our guiding principles. It’s one example of the guidance that can lead the values-conscious individual through the sometimes murky world of modern investing. I hope you appreciate the lesson. I know I do.
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