Definition of Preference Shares

Shares are where one entity has a stake over another entity, or multiple entities. Shares can generally be categorized into two types, namely ordinary shares (OS) and preference shares (PS). For PS, their holders do not have the rights similar to the ordinary shareholders. However, they are given preference or privilege where the dividends of the company will be paid in advance, at a fixed rate, regardless of the company’s financial performance. Hence, PS have been regarded as a less riskier investment instrument as maximal returns could be earned at a lower risk compared to OS.

Features of PS

The first feature of PS is the dividend rights, which could be non-cumulative, cumulative and participating. Non-cumulative dividend feature enables the company to stop dividend payments for a period of time and resumes dividend payments without carrying forward the missed dividend payments. Cumulative dividend is the opposite of non- cumulative dividend where the unpaid dividends will be carried forward to the following years. Zero dividend is where no dividends are paid, but instead are offered certain incentives. Participating PS could be categorized into three categories, namely non-participating where PS holders are not entitled to the surplus profit, partially-participating where PS holders are entitled to a limited rate established, and fully-participating where PS holders earn the surplus profit of the company on a pro-rata basis.

The next feature is conversion. PS could either be convertible or non-convertible. Convertible PS gives the holders right to convert the PS to OS and non-convertible PS holders have no right to convert their PS to OS.

Another feature of PS is the redemption feature where it is either redeemable or non- redeemable. This feature allows the company or PS holder to redeem the PS at a specified date, where the redemption method is determined by the redeemer. The opposite is true for non-redeemable PS.

The final feature of PS is where the holders are given preference to recover capital and distribution of profit in comparison to OS holders in the case of dissolution or winding-up and distributable earnings respectively.

Shariah Compliant PS

The suitable adaptation of fiqh (Takyif Fiqhi) for PS is the contract of musharakah. This is due to the OS and PS holders are considered to contribute capital to the company, hence making them a partner in the company. According to the Bank Negara Malaysia (2016) in Shariah Standards and Operational Requirements, musharakah is defined as “partnership between two or more parties whereby all parties will share the profit and bear the loss from the partnership”.

Shariah Advisory Council of Securities Commission Malaysia (SAC of SC) Resolution

The SAC of SC had series of meetings discussing the features of PS and its related Shariah issues. On 17th October 2022, in the 261st meeting, SAC had resolved the following resolutions. The Shariah contract applicable to PS is musharakah. The PS and OS holders are part of the contracting parties, where the PS is considered as new musharik (partner(s)) to an existing musharakah arrangement amongst OS and the issuing entity. Furthermore, the Muqtadha al-`aqd (objective of the contract) which is profit and loss sharing among musharik is to not be contravened, which certain conditions can be imposed should the objective of the contract is not contravened.

For the waiving of right issue, in the case of dividend distribution and dissolution, the concept of tanazul (waiving of right) and al-wa’d bi al hibah (undertaking to give) are applied. Both concepts assume the same effect as they lead to waiving the right of OS holders to (i) dividend after profit realization and (ii) amount pursuant to dissolution, to PS holders. Both concepts are considered as charity-based contracts. However, they require ratification by the Board of Directors (BoD) according to the mandate given by the OS holders.

For the issue of fixed profit rate, the SAC of SC resolved that it is permissible for the PS holders to receive dividend up to the declared profit by the issuing entity should both PS holders and issuing entity taradhi (mutually consent) such transaction.

On the issue of capital and profit guarantee, due to the nature of musharakah contract being a trust-based contract, such guarantees are impermissible. However, a concerned musharik is allowed to guarantee the realized profit and capital loss of other musharik in the event of misconduct, negligence, and breach of terms. Aside from that, capital and profit guarantees are no longer in the venture since there is risk of profit and loss in the venture, which is aligned with the hadith below:

الخراج ﺑﺎلﺿﻣﺎ ن

Meaning: Any profit goes to the one who bears responsibility.

(Narrated by Ibn Hibban (4928))

In a Shariah-compliant PS, the determined rate of dividend is only indicative, hence does not tantamount to capital or profit guarantee. Furthermore, dividend payouts are not regarded as debt of the issuing entity as it depends on the availability of profits.

Redeemable PS is considered permissible based on the terms and conditions that have been agreed upon subscription of PS. Redemption of PS can be done through sale and purchase undertaking as long as it is free from guarantee of profit and/or capital. For sale undertaking, any redemption method is to be based on the agreement. As for purchase undertaking, it is limited to redemption of PS according to market value, current performance of issuing entity and ratification by Board of Directors of issuing entity. As for convertible PS, conversion of PS to OS is permitted based on the concept of istibdal (substitution). The methods allowed, but not limited to:

• Conversion ratio;
• Conversion ratio and price; and
• Cash paid for the difference between PS surrendered and conversion ratio.

The conversion method used must be agreed by contracting parties with no capital guarantee included by issuing entity to PS holders, and the value is to be determined during the time of conversion of PS to OS.

As for the cumulative and non-cumulative dividend distribution feature of PS, the cumulative feature is subject to the profit availability, and when there is no profit, dividends will not be distributed. The same applies to the non-cumulative PS, where in the current year, the dividend will be distributed subject to profit availability.

Conclusion

In a nutshell, the conventional PS has features which go against Shariah principles, namely fixed profit and guaranteed profit and capital. There are several Shariah principles that have been identified as underlying principles for Shariah-compliant PS, namely musharakah, tanazul, and al-wa’d bi al hibah, hence eliminating the elements of fixed profits and guarantee of capitals and profits.