Islamic Model of Corporate Governance

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Corporate governance is a broad theory concerned with the alignment of management and shareholder interest (Grant, 2003). Governance refers to the way in which something is governed and to the function of governing. Corporate governance can be interpreted as the process in which the company is administered and controlled by a few parties such as board of directors, management, auditors etc. These parties have the duty to ensure that the company is heading towards the mission as well as the vision of the company. At the same time, they are also accountable to the companies’ stakeholders (Abdul Rahman 1998; Shahul, 2000 u.p.).

According to Cadbury Report (1992);

“Corporate governance is the system by which companies are directed and controlled” (p. 4).

In Malaysia, the Finance Committee on Corporate Governance (1998) describes corporate governance as: “the process and structure used to direct and manage the business and affairs of the company towards enhancing business prosperity and corporate accountability with the ultimate objective of realizing long-term shareholder value, whilst taking into account the interest of other stakeholders”. It is basically the governing bodies which are responsible to the life of the institution as a whole. It takes into the consideration all the matters that affect feasibility, proficiency and ethical character of an enterprise.

Normally, responsibility and accountability are heaped onto director’s shoulder. Directors are responsible to increase the value of share by enhancing the company performance and in the same time are accountable with the decision that they have made. However, corporate governance is not simple. It is not just referring to the regulation and constraint that need to be complied by company but also concern with how powers are equitably shared and exercised by different group. Such powers need to be carefully used in the favor of various stakeholders and not merely based on the interests and wills of the power holders. Powers is delegated by investors to company’s directors, so that they have a control over the company. Hence, the control mechanisms are emphasizing the enhancement of stakeholders’ interest especially to the shareholders who have direct control on the company (Koh, 2001).

There are many definitions regarding corporate governance. However the definitions have been concluded that the essence of the corporate governance is the relationship between management of the company which included the directors, investors, and other interest stakeholders. Good corporate governance can be established if all of these groups can communicate effectively (Grant, 2003) and to achieve this, the conflict of interests need to be reduced among the groups.

The major concern of corporate governance is the conflict of interest between the board of directors and other stakeholders groups, especially shareholders and employees. Normally, directors take decisions that are in their personal best interests, and regardless of the interests of other stakeholders. Therefore good corporate governance at least can secure the interest of other stakeholders and directors be more accountable to decision that their take.

ISLAMIC WORLDVIEW

Worldview is “a set of implicit and explicit assumptions about the origin of the universe and the nature of human life” (p. 1). In other words, worldview is “the way in which a person sees and explains the world and his place in it” (Hamid, 1999, p. 1). As a building with its foundation, worldview serves as an essential base for man since the way he thinks, acts, behaves and his reflections towards everything are directly influenced by his worldview (Hamid, 1999; Chapra, 1992).

Meanwhile, the sources of worldview might vary. Some acquires it from religions (Hamid, 1999; Baydoun, Mamman and Mohmand, 1999), while others perhaps inherited from their ethnics who they belong to or maybe they just blindly follow others. As compared to the “materialist fundamental secularism” (Shahul, 2001, p. 19) of the Western worldview, Islam sees this world from dual perspectives. In essence, “Islamic ontology presents a dual worldview, this world (universe) and the hereafter” (Shahul, 2001, p. 9).

THE IMPORTANCE OF CORPORATE GOVERNANCE

A large company has a large number of stakeholders and has to balance the demand and the need of each and every one of them. Although some stakeholders have a power to influence or decide the action of the company, others who do not have much power need to rely on the information disclosed by company’s management which the main source is financial report. This is to ensure that the actions taken by the company are in their interest. Therefore, there are always conflicts between the stakeholder groups.

A major concern of corporate governance is to reduce the conflict between directors of the company and other stakeholders especially shareholders and employees as directors normally tend to take decision based on their interest. Furthermore, directors can assess more information therefore in a position to control or manipulate the information that is released to the stakeholders.

“In the absence of the protections that good governance supplies, asymmetries of information and difficulties of monitoring mean that capital providers who lack control over the corporation will find it risky and costly to protect themselves from the opportunistic behavior of managers and controlling shareholders” (p. 11)

Relationship between board of directors and shareholders is at the center of many problems that arise in corporate governance. Hence, the challenge of good corporate governance is to find a way in which the interest of shareholders, directors and other interest group can all be sufficiently satisfied. Good corporate governance will ensure the company survival for a long time. Directors should somehow or rather be more accountable and responsible to ensure this. They should not think of themselves at the expense of others.

In order to avoid a conflict of interest that may harm the interest of shareholders and other stakeholders, five issues need to be given high concern which are financial reporting and auditing, director remuneration, decision-making powers, risk taking and a lack of communication between the directors and shareholders.

THE EFFECTIVENESS OF CORPORATE GOVERNANCE

FROM WESTERN PERSPECTIVES

The collapse of big and well established companies was mainly due to the ineffective and lack of keen-eyed surveillance functions of the board of directors and audit functions. American Institute of Certified Public Accountants (AICPA) (1993) in their report states that good and effective corporate governance could be nurtured via strengthening the role of the board of directors.

The Blue Ribbon Committee (BRC 1999) has discovered three essentials facts pertaining to the oversight responsibility of corporate governance as well as the audit committee. Firstly, in order to produce a so called quality financial reporting, a collaborative working environment, two ways communications among management, board of directors, audit committee internal auditors and external must be well developed and established. Secondly, to reduce the fraud in the financial statement, the role of the corporate governance need to be strengthened. Thirdly, to enhance the confidence in the capital market, the elements of integrity, quality and transparency need to be cultivated in the financial reports. This confidence will be diminished if fraud is found to be existed in the financial statement.

According to Baker and Wallage (2000, p. 173-174) ‘an effective system of corporate governance requires an effective system of financial reporting and that an effective system of financial reporting requires a well-ordered system of financial accounting’. A look at financial reports will tell that it consist primarily of audited financial statements prepared in accordance with accepted accounting standards and must be audited by statutory auditors.

FROM ISLAMIC PERSPECTIVES

Any attempt to make corporate governance effective must incorporate Islamic concepts and values that have been discussed in the above section. Corporate activities might just be the interaction of two or more parties in business dealing using money as the medium of transaction but if it is done within Islamic Shari’ah without any intercession or association of partners to Allah and with the intention to please Him, then this will be a sign of worship to Allah (see Bilal Philips 1994).

Abdul Rahman (1998) applies the concept of tawhid, khilafah and taklif in his Islamic corporate governance framework. According to him an Islamic corporate governance framework should integrate both the regulatory aspect that is based on Shari’ah and Islamic moral precepts as its core structure. He claimed that the institution of shura, hisbah and religious audit can be used to achieve effective corporate governance.

Shura

Shura has been practiced since the time of the prophet Muhammad (pbuh) whereby he and his group of companion of highly knowledge discuss on certain issues. In the Holy Quran, there is one chapter entitled ‘Shura’ itself. Allah says;

Those who hearken to their Lord, and establish regular Prayer; who (conduct) their affairs by mutual consultation; who spend out of what We bestow on them for Sustenance (42: 38)

In worldly matters, the Prophet (pbuh) used to consult others and be consulted by them, while in religious matters; he referred to the revelation which took care of all matters related to faith. In the modern Islamic organization, a group of people comprising of representatives of shareholders, employees, customer can be formed acting as shura to assist corporate directors in the running of the business activities as well as to ensure consensus in decision arrived. To the Western, inviting all these groups in the decision making process might be unreasonable because their focus is mainly aiming at maximizing wealth for the shareholders and creditors (Kam, 1990; Shahul, 2001). However, Islam has a wider spectrum of users in which the overall organization’s objectives should take account off making the institution of shura applicable at this time of science and technology just as at the time of camel and desert of the prophet!

Hisbah

The Hisbah is essentially organized around safeguarding the limits of Allah from being violated, protecting the honour of the people, and ensuring public safety. It also includes monitoring the marketplace, craftsmanship, and manufacturing concerns to make sure that the laws of Islam are upheld by these entities. Allah states in the Holy Quran:

“Let there arise from you a group calling to all that is good, enjoining what is right and forbidding what is wrong. It is these who are successful” (3: 104)

In Islam, economic activities including business trading and its services are controlled by Shari’ah. Likewise, the system of Hisbah is an integral part of a just economy in a just society which also provides the same for non-Muslims as residents in an Islamic society. Off-hand, a Muslim should not cheat a non-Muslim in business whatsoever. Prophet Mohammad once said: "Who ever (a Muslim) causes harm to non-Muslim is also causing harm to me; and I shall be his opponent on the Day of Judgment". The Hisbah carries out these responsibilities which are he has the ability to ascertain right from wrong and the capability to distinguish the permissible (halal) from non-permissible (haram). He also should be wise, mature, pious, well-poised, sane, free, just, empathic and learned scholar in conjunction with the appropriate government agencies and other relevant establishments.

Religious Audit

Islamic religious auditing provides an institution to solicit advice and also to monitor performance so that the company operates as a strictly Islamic concern. The Islamic precepts highlighted the differences between Islamic and Western business practices. For example, the Islamic Shari’ah prohibits, among other things, the payment and receipt of riba or usury (Quran 2: 275-276), gambling (Quran 5:90), hoarding (Quran 9:34) and speculation (Qureshi, 1976). Besides that, Islam also forbids any investing or dealing in alcohol, pork and other activities which are considered unlawful from an Islamic perspective. The need for religious audit stem from the requirement that organization should comply with the Shari’ah. If religious auditors find any violation of the Islamic principles in the operation of organization, then this should be reported in the organization’s financial statement as in the case of external auditor reporting their opinion on the true and fair view of the organization’s financial position.

Malaysia ’s Move towards Effective Corporate Governance

In Malaysia laws has been reformed and amended to cater the issues in corporate governance. For example effective on September 1, 1998 new section 166A has been established. This provision has required the companies to prepare their accounts in accordance with approved accounting standards. It can be said that this provision has changed the look of the financial reporting in Malaysia. As a result, the companies would not be able to report their accounts

merely based on their hidden purposes and this may enhance the quality of financial reporting which has dropped recently.

The other changes is, under the provision of the Financial Reporting Act 1997, MASB is now responsible for promulgating accounting standards. Unlike what happen previously where the standards were promulgated by the accounting bodies. The Securities Industry Act 1983 also has been amended in the effort to strengthening the role of corporate governance. For instance, section 99B has now required the chief executive officers (CEOs) as well as directors of public listed companies to disclose their interest not only in the listed companies but also interest in any associated companies as well to the Securities Commission (SC). Besides, the increase in penalties for such failures to comply with this requirement and the lowering of the threshold for substantial shareholding reporting to 2%, clearly shows the seriousness of the government in handling governance issues towards better transparency in term of ownership disclosure.

Another endeavor to promote greater disclosure and transparency is by introducing new code pertaining to take over and mergers which take effects on January 1, 1999. The major reflection of this code is for those who involve in mergers and acquisitions; they will now need to follow much higher standards with regards to disclosure and corporate behavior. Such code is belief to be significantly needed in order to create an efficient, informed as well as competitive market. Also, the High Level Finance Committee on corporate governance comprising vast experience representation from public and private sectors and chaired by the secretary general of treasury has been established in early 1998. Then, through the comprehensive recommendation of this committee, the government in 1999 was able to release the Financial Committee report.

One of the important elements addressed in this report was the Malaysian code of corporate governance. First and foremost, it is a set of principles and best practices recommended for good governance. This recommendation focuses on four areas like principle, best practices, near best practices and exhortation to other participants. The summary of the code is provided in the table 2 below;

Table 4: A summary of Malaysian Code of Corporate Governance

All these efforts have shown to us on how concern the related parties to nurture a good corporate governance. A lot of recommendations and laws have been revised world wide to cater the malaise, yet none of them historically able to promote better governance in the company.

CORPORATE GOVERNANCE IN ISLAMIC BANKING

Islamic Banking represents a radical departure from conventional banking, and from the viewpoint of corporate governance, it embodies a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Because of the bank on interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the yield resulting from the use of funds. The depositors also share in the profits according to predetermined ratio, and are rewarded with profit returns for assuming risk. Unlike conventional bank which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors, on the one side, and also a partner with entrepreneurs, on the other side, when employing depositors’ funds in productive direct investment.

These financial arrangements imply quite different stockholder relationships, and by corollary governance structures, from the conventional model since depositors have a direct financial stake in the bank’s investment and equity participations. In addition, the Islamic bank is subject to an additional layer of governance since the suitability of its investment and financing must be in strict conformity with Islamic law and the expectations of the Muslim community. For this purpose, Islamic banks employ an individual sharia Advisor and/or Board.

CONCEPT

Governance structures are quite different from these under Islamic banking because the institution must obey a different set of rule which is from Al-Quran and meet the expectations of Muslim community by providing Islamically acceptable financing modes. These profit-and-loss sharing methods imply different relationships than under interest-based borrowing and lending.

There are two major differences from the conventional framework. Firstly, an Islamic organization must serve God. It must develop a distinctive corporate culture, the main purpose of which is to create a collective morality and spirituality which, when combined with the production of goods and services, sustains the growth and advancement of Islamic way of life.

Secondly, interest-free banking is based on the Islamic legal concepts of shirkah (partnership) and mudaraba (profit-sharing). An Islamic bank is conceived as financial intermediary mobilizing savings from the public on a mudaraba basis and advancing capital to entrepreneurs on the same basis.

There is a conceptual framework of corporate governance for Islamic bank. Central to such a framework is the Sharia Supervisory Board (SSB) and the internal controls which support it. There are three reasons why SSB play a significant role for banks which offer Islamic financing:

An Islamic bank is based on the Islamic faith and must stay within the limits of Islamic Law or the sharia in all of its actions and deeds. The original meaning of the Arabic word sharia was ‘the way of life ‘and it is now used to refer to legal system in keeping with the code of behavior called for by the Quran. There are four rules govern investment behavior;

Riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan.

It means buying the goods or shares at low and selling them for higher price in the future is considered to be illicit. Similarly an immediate sale in order to a void a loss in the future is condemned. The reason is that speculators generate their private gains at the expense of society at large.

A mechanism for the redistribution of income and wealth is inherent

in Islam, so that every Muslim is guaranteed a fair standard of living, nisab. An Islamic tax, zakat which derived from the Arabic zaka, meaning ‘pure’ is the most important instrument for the redistribution of wealth. This tax is a compulsory levy, one of the five basic tenets of Islam and the generally accepted amount of the zakat is 2.5% of Muslim’s annual income in cash or kind from all forms of assessed wealth exceeding nisab.

A strict code of ‘ethical investment’ operates. Hence it is forbidden for Islamic banks to finance activities or items forbidden in Islam, haram, such as trade of alcoholic beverage and pork meat.

In order to ensure that the practices and activities of Islamic banks do not contradict the Islamic ethical standards, Islamic banks are expected to establish a Sharia Supervisory Board, consisting of Muslim jurisprudence, who act as advisers to the banks.

CONCLUSION

Worldviews play a paramount role in the human being life. Its affect every single action of a man. Different worldviews will certainly shape different qualities of man kind which will eventually lead them to different end means of life as well. Western worldview and Christian worldview concern on secularism and religious respectively while Islamic worldview has dual worldviews which are in this world and in the hereafter. These remarkable and peculiar worldviews as compared to others have cultivated Islamic concepts, values and norms to the Muslims (assuming all Muslims adopt Islamic worldviews) at large.

The implications of these worldviews have nurtured positive contribution to the effectiveness of corporate governance. Although the Western have come out with a variety of connotations and recommendations pertaining to the effective corporate governance, the future of corporate governance globally still equivocal since none of them seems to be effective. Historically, such endeavors have shown failures. Hence, an important note to ponder is that the codes of upholding trust, maintaining integrity, exercising transparency and accountability, prudent management of resources, maximizing returns, caring and concern of the environment would remain as mere noble codes if the issues of man, his values, ethics and moral conduct are not tackled in the first instance. Corporate governance is basically the moral and ethical dimensions of managing a company’s business. For the Muslims, the ethical codes of conduct based on the tawhidic worldview and Quranic values are considered more elevating than those, which are detached from religious moorings.

As far as Islam is concerned, the Western solutions will resume to face failures as long as they are not able to cultivate a so called ‘true accountability’ (Islamic accountability) in their practitioners (i.e. accountants, auditors, board of directors, managers etc.). Islam believes that the dual accountability namely accountability to man to man as well as accountability to Allah are the best solution to attain good corporate governance.