Islamic finance prohibits preference shares. But why?

My website makes it easy for people to contact me. Accordingly I often receive interesting questions related to Islamic finance.

A reader recently asked me to clarify the position of preference shares. This question gave me the idea for my April 2019 column in the magazine "Islamic Finance News." You can read it below.

One of my website readers recently asked whether preference shares were permitted in Islamic finance. I explained that almost all Shariah scholars who set down the rules for what is allowed in Islamic finance prohibit them.

As Timur Kuran has explained in depth, [in "The long divergence"] traditional Islamic law (fiqh) never developed the concept of the corporation. That is, an entity which is a legal person, distinct from its shareholders, which continues in existence irrespective of any changes amongst shareholders. As it had no concept of a corporation, traditional Islamic law had no concept of share capital, and therefore no concept of preference shares. Obviously, traditional Islamic law could not prohibit something which it had never conceptualised.

While all Muslim majority countries specify legal processes for creating and regulating corporations, this is new secular law and does not purport to be derived from traditional Islamic law.

Consequently, without even needing to check, one can be sure that all books of Islamic law written prior to contact with the modern Europeans who brought the concept of the corporation with them would have had nothing to say about preference shares.

When considering whether preference shares are permissible, modern Shariah scholars cannot simply cite earlier rulings from traditional Islamic law. Instead, they have to analogise from rulings about other situations. Of itself, there is nothing wrong with analogising since it has been a part of Islamic jurisprudence from the earliest days of Islamic legal scholarship.

Shariah scholars reached their decision about preference shares by analogising from the rules for partnerships. Under traditional Islamic law, in a commercial partnership, all capital providers (assuming for simplicity that none of them does any work for the partnership) are required to share in profits in proportion to the amount of capital that each has provided. No capital providing partner should have any priority over another.

In the case of partnerships, it would clearly be wrong for one partner to exploit other factors (for example that partner may have a government position with an implied threat of coercion against the other partners) to achieve a disproportionate profit share. Any form of coercion or exploitation of power in such manner is clearly wrong.

However, even in the case of partnerships, provided there is equality of information and bargaining power, there is no obvious reason why the capital providing partners could not agree to share the profits in a different way from straightforward proportionality to capital provided. For example, the partners could agree between them that one partner will have a higher share of the first $1 million of profits while taking a lower share of profits in excess of $1 million. There may be very good reasons for all of the partners to agree such an allocation.

One thing we need to remember is that the early books on traditional Islamic law were written at a time when commerce was much simpler than it is today, record-keeping systems were less sophisticated, and even mathematics was less well-developed, even though it was the Arabs who invented algebra.

Finally, one often-heard argument against preference shares, namely that preference share dividends are “riba”, is clearly invalid. In most jurisdictions, company law prohibits companies from paying dividends, both ordinary share dividends and preference share dividends, unless they have distributable profits from which those dividends are paid.