Quarterly Screening Review: Three Holdings and a Purification Error
A $75 million Islamic equity fund holds 38 stocks. At the quarterly review, three holdings raise issues. Company A: conventional banking revenue 4.9% of total revenue; interest-bearing debt 31% of market capitalization; accounts receivable 44% of total assets. Company B: alcohol revenue 6.2%; interest-bearing debt 24% of market cap; total assets $8.0 billion, market cap $2.1 billion. Company C: revenue from gambling 0%, but it earns 8.5% of revenue from interest on customer deposits and has 35% cash. The fund's policy says: 'Screen using AAOIFI thresholds; exclude any company with non-compliant revenue above 5%; purify using the market-cap denominator.' The manager uses a revenue screen only for A and B, excludes C, and calculates purification using net income. The client's Shariah board asks for a re-review and a written rationale. The fund has 3.2% in A, 2.7% in B, and 1.1% in C before review.
1. Apply the fund's stated policy to Companies A, B and C. State which are compliant, which are not, and explain the denominator and threshold issues.
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Company A passes the revenue test because 4.9% is below the 5% cap, but it fails on debt: interest-bearing debt at 31% of market capitalization exceeds the AAOIFI 30% threshold. A is therefore non-compliant on the balance-sheet test. The 44% receivables ratio should also be checked against the receivables-and-cash test; on the stated facts it does not by itself breach a 70% cap, but it signals balance-sheet risk and should be documented. Company B fails the revenue test because alcohol revenue is 6.2%, above 5%; the 24% debt ratio does not cure that breach. Company C fails because interest income is 8.5% of revenue, above 5%, even though gambling revenue is zero. The manager's revenue-only screen missed A's debt breach and C's interest income. The policy also says 'market-cap denominator' without specifying whether it governs the debt test, purification, or both; that ambiguity must be resolved by the Shariah board. Applying the stated policy, all three holdings should be excluded, with orderly sale and trade timing documented.
2. The manager purified using net income rather than market capitalization. Is that consistent with the policy, and what is the effect?
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It is not consistent with the stated policy. The policy says purification uses the market-cap denominator, and net income is not that denominator. Purification is normally calculated on the income actually received, such as dividends, using a defined ratio; alternatively, a holding-value method may use market capitalization, but the method must be stated and applied consistently. Using net income can overstate purification when profit margins are high and understate it when net income is low or negative. It also makes the calculation depend on accounting earnings rather than the non-compliant revenue ratio the policy intends to isolate. The manager should restate the purification calculation using the policy's denominator, show the formula, the holding value or dividend received, the non-compliant revenue ratio, and the resulting amount. If the policy is genuinely ambiguous, the manager should obtain a written interpretation from the Shariah board before recalculating. The correction should be disclosed to the client, and any over- or under-purification should be remedied through a compensating payment to charity or a client credit.
3. Draft the key elements of the written rationale to the Shariah board, including remediation.
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The rationale should open with the facts: the fund's policy, the three holdings, the ratios, the manager's original screen, and the purification method used. It should then apply the policy step by step: A fails the debt test at 31%; B fails the alcohol revenue test at 6.2%; C fails the interest-income test at 8.5%. It should explain that the revenue-only screen was incomplete because it did not test debt, receivables, cash, or interest income. Next, it should address purification: the net-income method was inconsistent with the policy, and the manager will restate the calculation using the market-cap denominator, showing the formula and amounts. Remediation should include orderly divestment of A, B and C; suspension of new purchases in those names; a look-back review of the prior quarter; a compensating charitable payment if purification was understated; and a control fix so that every holding is tested against revenue, debt, receivables and cash thresholds. The rationale should also request the board's written interpretation of the ambiguous denominator language and confirm that the fund will not rely on a single revenue screen in future.