Code of Ethics in Islamic Corporate Governance

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

INTRODUCTION

Corporate governance is a very important aspect for a corporation or business. In our understanding, corporate governance is concerned with the process of governing a corporation. It is the system by which companies are directed and controlled. In the corporate governance framework, the board of directors plays the main character. Therefore, when we discuss about the code of ethics in corporate governance, it is focusing more into the code of ethics for the board of directors.

In Islamic perspective, the code of ethics in corporate governance still is the same with other conventional perspectives. Furthermore, it has to be complied with shari’ah regulations and Islamic teachings. Here, in this assignment, we will divide the explanations into several sub-topics; (1) definition of corporate governance and the board of directors, (2) the concept and philosophy of corporate governance in Islam, (3) the role of the board of directors, (4) the scope of directors duties and responsibilities, and (5) the director code of conduct and ethics.

(1) Definition of corporate governance and the board of directors.

Corporate governance is defined by Malaysia 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.

Another definition is:

‘…Islam strongly advocates all forms of ‘…Islam strongly advocates all forms of

positive governance… Islamic corporate positive governance… Islamic corporate governance serves through its underlying governance serves through its underlying

principles of economic well being of the principles of economic well being of the

Ummah Ummah, universal brotherhood, justice, , universal brotherhood, justice,

accountability and equitable distribution accountability and equitable distribution

of income… of income… Islam advocate[s] good Islam advocate[s] good corporate governance, corporate governance, challenge to us lies challenge to us lies in its in its application…’

Generally, it is also defined in the literature as the overall supervision of the affair of the corporate. The qualification ‘corporate’ focuses attention on the governance of corporations rather than any other organization. In this context, the term ‘governance’ is preferred to the more common and familiar ‘management’ probably because it can stand for a higher authority with supervisory powers over the executive or management function. It is within the framework of a corporation that such a higher authority exists as a formal and distinctive feature of its hierarchy; the board of directors. Corporate governance, then, may be said to refer principally to the oversight function of the board of directors. (refer Appendix for the Corporate Governance Framework).

Company directors are so basic to companies that references to them necessarily pervade the entire subject area of company law. It is clear that in every modern company there is a central core of a quorum of directors who exercise the requisite duties and functions necessary to efficiently operate the company.

Section 4 of the Companies Act defines director:

“director” includes any person occupying the position of director of a corporation by whatever name called and includes a person in accordance with whose directions of instructions the directors of a corporation are accustomed to act and an alternate or substitute director.

Pennington states that in defining the nature of the office of a director, the courts have rarely made the essential distinction between the director as an official of the company appointed under its constitution and the director as an employee or agent of the company serving under a contract of employment, and the director suggests that the first relationship be referred to as status and the second as the directors’ contractual rights and obligations.

(2) The concept and philosophy of corporate governance in Islam.

The philosophy of corporate governance in Islam resides upon three aspects, namely (1) values, (2) knowledge or intellectual and, (3) competency. The fundamental of all these values lies in the concept of vicegerency (khalifah), or trusteeship. The underlying message in this concept is firstly, man’s position in relation to man (enjoining good deeds and forbidding evil doings), secondly, man’s position in relation to nature (to work, develop and exploit the natural resources of the earth in accordance with the principles), and thirdly and most importantly, man’s position in relation to Allah, his Creator.

In essence, the main objective inherent in its philosophy of managing the business is, to organize human society and its main systems and disciplines on the basis of social justice for all, irrespective of color, creed or race and to establish concepts of goodness, virtue and benevolence among people, so that they are able to enjoy a life of security, peace, prosperity and happiness on an individual as well as at social level.

The concept of managing life, governing a corporation, leading a community or society, rests upon the cardinal principle of submission to Allah. This notion has a deep and broad implications to Muslims for, the acceptance of Allah as their Lord implies a binding covenant and what follows is the submission to the rules, desires and the will of their Lord, hence the religion Islam which means submission.

The concept of corporate governance was put forward as a result of increasing awareness on the importance of the need to protect the rights of all stakeholders. While the term corporate governance is relatively new, the concept is actually is not alien to Islam.

The Holy Quran for instance, in a lengthy explanation in verse 282 and 283 of Surah al-Baqarah, states a detailed step-by-step process that should be taken when carrying out a transaction. This verse highlights the importance of proper record keeping so that no party will involve suffers injustice. The message behind this verse is the need for transparency and disclosure in business dealings. These in essence are two of the important underlying principles of ‘contemporary’ corporate governance.

Another important ingredient of corporate governance is accountability. On this matter, the Prophet Muhammad (PBUH) was reported in one hadith as saying that; “Each one of you is a guardian, and each guardian is accountable to everything under his care.” As such, if this tradition of the Prophet were to be translated into modern corporation dealings, all persons involved in the business transactions are indeed accountable for all their actions. In the practical sense, corporate governance involves the nuts and bolts of how corporations should fulfill their responsibilities to their shareholders as well as other stakeholders. A key factor in corporate governance is the monitoring of and the reporting on the internal control system. With a good internal control in an organisation, it will have less risk of having to face fraudulent acts by its members of the organization. A good internal control should be implemented as early as possible to prevent misconduct to minimize or eliminate the possible fraudulent acts by its members.

(3) The role of the board of directors.

A company director functions as an agent of the company. Although a company is a separate legal entity, it cannot conduct its business affairs on its own. It can only do so through its board of directors, or through those delegated and duly authorized by the board of directors. Under the Company’s Articles of Association, it is the board of directors, which has the power to manage the business of the company, except those powers that are expressed stated in the Articles of Association meant for the members of the company in a general meeting.

The board of directors plays a significant role in corporate governance. However, in practical terms, the board plays a variety of roles. Within the context of a fast-moving society, the board of which you are a member could execute three functional roles; directing, auditing of performance and legitimizing. These roles are even more significant today; in the view of the greater scrutiny many stakeholders place on a company.

As the board of directors, the director could help (1) to ensure compliance with the law governing corporation activities, and (2) involved in the selection of a competent managing director or chief executive officer. The director also could help in (3) promoting the efficiency of management succession. The director also could help (4) to assess the overall performance of the company, and (5) enhancing the company’s relationships with the outside society.

An important element of corporate governance seems to lie with the board of directors and the way management is run, with a sense a stewardship, responsibility and accountability to the shareholders, who are the legal owners of corporations. The board of directors is entrusted with the conduct and daily management of business activities and commercial feasibility of the venture by using the assets made available.

The boards of directors are therefore subjected to higher standards, which cover not only the technical efficiency of operations, but also the implementation of an efficient management system through the use of the ‘best practices’ developed from high ethical values.

Moral and ethical values have been much discussed but less seen practiced among the corporate leaders. Company directors are in fact leaders that play a significant role in shaping the color of their corporations. We have learned from the past, that a successful leader is one who builds core values in the people he leads. This requires him to have a sound moral education, including with spiritual values, which when combined with leadership, training and delegation, will result in his people being able to clearly and unhesitatingly differentiate between right and wrong, moral and immoral, ethical and unethical practices in their pursuit of achieving success.

(4) The scope of directors’ duties and responsibilities.

The responsibility of today’s board of directors is little different from what it was in previous time. Legally, most jurisdictions describe the director as having two duties, the duty of cure and the duty of loyalty. The directors’ conduct will be judge according to the ‘business judgment rule’.

Duty of loyalty means that the director must demonstrate unyielding loyalty to the company’s shareholders. Thus, if a director sat on the boards of two companies with conflicting interests (both trying to buy a third business), the director would be forced to resign from one board because clearly the director could not demonstrate loyalty to the shareholders of both companies at the same time.

Duty of care means that a director must exercise due diligence in making decisions. The director must discover as much information as possible on the question at issue and be able to show that, in reaching a decision, the director has considered all reasonable alternatives.

When a director demonstrate an action, with all due loyalty and exercised all possible care, the courts will not second-guess the director’s decision. In other words, the court will defer to the ‘business judgment’. Unless the decision made by directors and managers is clearly self-dealing or negligent, the court will not challenge it, whether or not it was a good decision in light of subsequent developments.

Laws offer only a general definition of the director’s role. The law, after all, must be sufficiently flexible to cope with ever changing business developments that are forever challenging directors with new issues and questions to resolve.

Many people have tried to step beyond the legal definitions of a board’s duties and develop more specific descriptions of the responsibilities of the directors. The Business Roundtable, representing the largest US corporations, describes the duties of the board as follows:

The board of directors has five primary functions;

Other groups have developed similar lists. The following, for instance, is the guide developed by the American Law Institute:

(5) The directors’ code of conduct and ethics.

The professional company director shall use his or her best endeavors to organize the resources available with the aim of optimizing the use in the attainment of the objectives of the organization. The director shall not misuse his or her authority of office for personal interest. In relation with the action of the director, it must comply with the laws of Malaysia relating to the direction of the organization with which he or she is connected and shall do the best to operate within the spirit of those laws.

In addition to the code of conduct, the director shall focus on corporate management relationships with shareholders, the environmental and the national vision. As the writer in “The Company Director’s Guidebook’ states that, as a professional company director, he or she should;

6) Corporate Governance In Islamic Banks

Corporate governance in banking has been analyzed almost exclusively in the context of conventional banking markets. For example, there has recently been some discussion of the role 'market discipline' exerted by bank shareholders and depositors in constraining the risk taking behavior of bank management.

Islamic banking represents a radical different approach from conventional banking, and from the viewpoint of corporate governance, it contains a number of interesting features since equity participation, risk and profit-and-loss sharing arrangements from the basis of Islamic financing. Due to the fact that Islam prohibits interest (riba), an Islamic bank cannot charge any fixed return in advance, but rather participates in the profit sharing resulting from the use of funds including from the depositors. The depositors also share in the profits according to predetermined ratio, and they are rewarded with profit returns for assuming risk. Unlike a conventional bank which is basically a borrower and lender of funds, an Islamic bank is essentially a partner with its depositors, and also a partner with entrepreneurs, when employing depositors' funds in productive investment.

These financial arrangements imply quite different stockholder relationships, and by different 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 shari’ah Advisor and or Board.

Corporate governance in Islamic banking begins with the comparing governance structures in the Islamic bank and will continue with the principles of Islamic banking. This study compares the Islamic banking, financial model and its implications for governance structures. The study intends to give a small picture on the principles of Islamic banking.

Governance structures are quite different from these under Islamic banking because the institution must obey a different set of rules - those of the Holy Qur'an - and meet the expectations of Muslim community by providing Islamically-acceptable financing modes. These profit-and-loss sharing methods imply diverse relationships than under interest-based borrowing and lending. There are two major differences from the conventional framework.

First and most significant is an Islamic organization must serve Allah (God). It must develop a unique 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 the Islamic way of life. To quote Janachi (1995):

'Islamic banks have a major responsibility to shoulder ....all the staff of such banks and customers dealing with them must be reformed Islamically and act within the framework of an Islamic formula, so that any person approaching an Islamic bank should be given the impression that he is entering a sacred place to perform a religious ritual, that is the use and employment of capital for what is acceptable and satisfactory to God.' (p.42).

There are equivalent obligations upon employees:

'The staff in an Islamic bank should, throughout their lives, be conducting in the Islamic way, whether at work or at leisure.' (p.28).

Further, obligations also extend to the Islamic community:

'Muslims who truly believe in their religion have a duty to prove, through their efforts in backing and supporting Islamic banks and financial institutions, that the Islamic economic system is an integral part of Islam and is indeed for all times ... through making legitimate and Halal profits.' (p.29).

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

7) Governance Structures and Principles of Islamic Banking

Islamic banks have a Sharia Supervisory Board (SSB) which is the central of conceptual frameworks in corporate governance for Islamic bank. There are also internal controls which support SSB as well. The SSB is essential for two reasons. First, people who deal with an Islamic bank require guarantee that it is transacting within Islamic law. Should the SSB report that the management of the bank has violated the sharia, it would quickly lose the confidence of the majority of its investors and clients. Second, some Islamic scholars argue that strict adherence to Islamic religious principles will act as a counter to the incentive problems outlined above. The argument is that the Islamic moral code will prevent Muslims from behaving in ways which are ethically unsound, so minimizing the transaction costs arising from incentive issues. The consequences are Islamic religious ideology acts as its own incentive mechanism to reduce the inefficiency that arises from inappropriate information and moral hazard. Matters stated above are generally basic criteria to the successful operation of Islamic modes of finance and these matters directly related to the Principles of Islamic Banking.

An Islamic bank is based on the Islamic faith and must stay within the restrictions of Islamic Law or the sharia in all of its actions and deeds. The meaning of the Arabic word sharia is 'the way to the source of life' and it is now used to refer to legal system in keeping with the code of behavior mentioned by Allah in the Holy Qur'an (Koran). Four most significant rules govern investment behaviour in Islamic banks:

CONCLUSION

In conclusion it must be good co-operations from all stakeholders to achieve good corporate governance. It covers all aspects from the roles and responsibilities until the code of ethics. The concept of corporate governance in actuality is a code of conduct of best practices. From the perspective of Islam, deeds are more important than words as highlighted in one verse if the Holy Quran; “Why do you say that which you do not do?”

In other words,, corporate governance should be practiced in the form of deeds and actions. Only when an action speaks louder than words, will a good corporate culture that looks after the welfare of all stakeholders materialize in today’s corporate world. In addition, Islamic banking system which applies Islamic corporate governance will soon be the mainstream of investments not only to the Muslim people but also for the non-Muslim as well. As an example, to quote a statement by Mokhtar Hanafiah in his article Big Boost For Islamic Banking ‘…when Islamic banking offers higher rates, many people will switch their deposits to Islamic banking from the conventional banking system..’

This said, it is possible that that one day, we will find every Islamic branch of non-Muslim banks offering the services of Islamic banking and therefore be practiced more commercially with a significant market share with potential 1.5 billion Muslims as customers worldwide.