In this article, ROBERT VYDRA provides a general overview of the legal and Shariah considerations relating to preferred shares in the Kingdom of Saudi Arabia (the Kingdom). The preferred shares in the Kingdom are regulated primarily by the Saudi Companies Law (issued pursuant to Royal Decree No M/3 dated 28/1/1437H, as amended) (the Companies Law) (see Articles 114 to 116).
Legal considerations under the Companies Law relating to preferred shares
The issuance and/or purchase of preferred shares, or the conversion of ordinary shares into preferred shares (and vice versa), by a Saudi Arabian joint stock company (JSC) are subject to the approval of the extraordinary general assembly of shareholders of the JSC which, under the Companies Law, requires a majority vote of two-thirds of the shares represented at the meeting (or 75% of such shares if it involves an increase or reduction of capital).
Preferred shares are non-voting shares and thus, do not carry any voting powers with respect to the resolutions of shareholders’ general assemblies and are disregarded in connection with calculating the quorum required for convening shareholders’ general assemblies. In exchange, the holders of preferred shares are entitled to receive a higher share in the net profits aft er setting aside the statutory reserve.
If a JSC fails to pay its preferred shareholders any dividends in any given year, the right of preferred shareholders to receive such dividends will be rolled over to the subsequent year(s) and the JSC may not distribute any profits in the subsequent year(s), except aft er the payment of such outstanding dividends.
If preferred shareholders are not paid for three consecutive years, they can (pursuant to a resolution of a special assembly consisting of preferred shareholders) in proportion to their share of the share capital either (i) appoint board members of the JSC to act on their behalf, or (ii) attend and vote at shareholders’ general assembly meetings for the duration of such non-payment.
The issuance of preferred shares is theoretically possible in the Kingdom for both private and listed JSCs.
Shariah considerations relating to preferred shares
Preferred shares with a fi xed dividend rate and liquidation preference can for various reasons be problematic from the perspective of Islamic law (Shariah). A fixed dividend rate or even priority in terms of profi t distribution is contrary to a fundamental principle of the Islamic partnership (Sharika) law, which is the basis of rules applied analogically by contemporary Muslim jurists to modern corporations. According to this principle, income must always be distributed in proportion to the actual profits rather than in proportion to the capital invested. Thus, a fixed amount or lump sum payment on preferred shares would be impermissible.
A guaranteed dividend payment would also be objectionable as Riba (unjust enrichment) because it would be the functional equivalent of interest.
Among classical Muslim jurists, divergent views were expressed about the ratio of capital to profit. While the Maliki and Shafi ’i position is that the ratio between capital invested and profit distributed must be exactly the same, Ahmad Ibn Hanbal, regarded as the founder of the Hanbali school of law (which is generally followed in the Kingdom), was of the opinion that this ratio could diff er so long as the parties agreed in advance of their own free will.
However, classical Muslim jurists are unanimous that losses may be suffered only in proportion to the capital invested.
It is for this reason that a liquidation preference would be invalid from a Shariah compliance perspective.
Classical Islamic legal doctrine is refl ected in a resolution prohibiting preferred shares exhibiting these characteristics published by the Council of the Islamic Fiqh Academy in 1992, a view confirmed in a subsequent resolution in 2003. This position was restated verbatim in Shariah Standard No 12 on Sharikah (Musharakah) and modern corporations adopted in 2002 by AAOIFI, prohibiting the issuance of preferred shares with a priority of liquidation or over distribution of profit. The AAOIFI standard also prohibited the issuance of non-voting shares, known as Tamatt u’ (enjoyment) shares, that grant the holder a right to participate in the net profi ts, with such shares to be redeemed over time through profit distributions.
However, both AAOIFI and the Islamic Fiqh Academy have approved the issuance of shares which enjoy certain “procedural and administrative privileges”, including the right to
vote, but which are otherwise similar to common shares (note the difference with the Saudi Arabian preferred shares legal framework discussed previously).
While AAOIFI and the Islamic Fiqh Academy are standard-sett ing bodies, their pronouncements are not legally binding unless incorporated into domestic Saudi Arabian legislation. That said, they are highly influential within the Islamic finance industry.
In this context and by way of international precedent, the Shariah Advisory Council of Securities Commission Malaysia has declared that non-cumulative preferred stock may be valid in accordance with Tanazul (waiver), whereby the right to profit is willingly conferred on the preferred shareholders by the ordinary shareholders. Under the Malaysian
Companies Act 2016, a preferred share is defined as a share by whatever name called, which does not entitle the holder to the right to vote on a resolution or to any right to participate beyond a specified amount in any distribution whether by way of a dividend, or on redemption, in a winding-up, or otherwise. Some modern academic commentators, notably Dr Muhammad Anas Zarqa, a prominent contemporary scholar, have in a similar vein argued that it would not be contrary to Islamic law to create a separate class of shares entitled to a higher percentage of the profi ts so long as this percentage does not exceed a stipulated dividend rate.
Finally, it should also be noted that pursuant to Article 121 of the Companies Law, a JSC shall observe the Shariah provisions for debts on issuing/ negotiating debt instruments. While interpretation of this article remains ambiguous, a narrower and more conservative view is that this Article restricts the issuance of conventional
bonds, requiring any Saudi JSC to structure debt instruments as Shariah compliant debt instruments (such as Sukuk). While there is no such explicit reference in the Companies Law in connection with the preferred shares, all enacted legislation in the Kingdom is subject to the Shariah. In the event of a conflict between the Shariah and enacted legislation, the Shariah will prevail.
Similarly, where enacted legislation is silent on any given matt er, reference should be made to the relevant rules under the Shariah and each Saudi Arabian court or other adjudicatory body is required to interpret and to apply enacted legislation accordingly (though the degree with which Shariah is applied varies among the different adjudicatory bodies).
In the light of the Shariah considerations relating to preferred shares discussed previously, it is not a surprise that there are no publicly known examples of JSCs in the Kingdom with preferred shares, despite the fact that their issuance is in theory possible pursuant to the Companies Law. A safe way from a Shariah compliance perspective would be to use some of the Sukuk structures to avoid the aforementioned Shariah compliance issues while allowing investors with different risk appetites and expectations (both in terms of economic returns and shareholders’ rights) to create investment structures that would fairly closely mimic a JSC with preferred shares.