Islamic Preference Shares – The Shari’ah Perspective

Preference shares and venture capital are bed mates, they’re with you whenever you do a deal in private equity. However, under Shari’ah (Islamic) principles, preference shares are not acceptable and by definition considered as debt, that a) gives you a priority and b) gives you a fixed coupon (interest).

Working with Venture Capital Bank, I’ve also had the honor of interacting with Sheikh (Dr) Nizam Yaquby. He is not only a businessman, but also a pre-eminent Shari’ah scholar who serves on over 40 boards. One of the things you learn immediately is that Islamic law does not allow the use of conventional debt and preference shares.

The answer is: No.

So what is the solution, well there is none. That’s not exactly what you might like to hear. The only alternative is to use convertible notes that allow you to convert your profit covered facility to equity at a point in time.

Under Shari’ah rule, the basic principle is that you should participate in the same risk as the owner of the company. By doing so, you will share in his profits and gains. However, with preference shares the risk is skewed, where preference shareholders have less risk compared to ordinary shareholders. There are two instances where preference have ‘preference’, and thus lead to the logic that it is not acceptable from a Shari’ah point of view.

Upon Liquidation…

If the company is liquidated or wound up, preference shareholders are given priority over ordinary shareholders to claims on company assets (just after bond holders). This could lead to situations where the preference shareholders receive the full par value of their shares.

Upon Profit / Dividend Distribution…

The second instance is when dividends / distributions are paid. Preferred shareholders generally receive better returns on their investment (think about Warren Buffet and his Goldman Sachs investment). Profits generated go to preference shareholders according to the specified coupon / dividend rate. After this, what remains, if any, will go to the ordinary shareholders. In some instances, when dividends are not paid out in a particular year, they will be paid later as a cumulative dividend (also called cumulative preference shares).

Now, what do you see as the advantage or disadvantage of dealing with Islamic investment institutions?