Islamic finance corporate governance briefing

Publication | February 2009

Introduction

Shareholders increasingly expect companies to adhere to strict standards of corporate governance. In essence, corporate governance is the system by which companies are directed and controlled and involves adopting structures and processes which incorporate the values of fairness, transparency and accountability. The practical objective of corporate governance is to put in place a system which will deliver a company’s business objectives, i.e. increasing shareholder value, whilst managing risk. Islamic financial institutions (IFIs) share the same practical and business objectives, but are subject to an additional layer of compliance with Shariah rules and principles. An IFI does not only seek to make a profit, it seeks to make such profit in a socially responsible manner.

The Islamic Financial Services Board (IFSB): Exposure Drafts

The IFSB has recently released a number of exposure drafts providing ‘Guiding Principles’ specifically aimed at Islamic financial institutions. The aim is not thereby to establish an entirely new governance framework for the Islamic finance industry, but rather to build on and complement existing international standards and encourage institutions to view compliance as part of a general strengthening of good corporate governance culture.

Principles of good business conduct are desirable in terms of protecting investor interests and enhancing the integrity of the institutions concerned. It is also a requirement under Shariah that companies observe principles of ethical business conduct. Furthermore, the principles of certainty and transparency underpin the validity of a Shariah compliant contract.

Three recent exposure drafts, published in December 2008, offer ‘Guiding Principles’ on Conduct of Business for Institutions offering only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds) (the Guiding Principles on Conduct of Business), Shariah Governance System and Governance for Islamic Insurance (Takaful) Operations (the exposure drafts). These exposure drafts build on existing corporate governance and other IFSB standards. This briefing focuses on the first two.

Guiding Principles on Conduct of Business

The Guiding Principles on Conduct of Business adopt a principles-based rather than a purely rules-based approach. It is intended that the seven principles outlined in the exposure draft will form the basis of a code of business conduct which is observed by all IFIs, and which complements existing standards.

Principle 1

Honesty and Fairness - IFIs should treat all shareholders fairly and aspire to the highest standards of honesty and integrity in all their dealings with them.

Principle 2

Due Care and Diligence - IFIs should exercise due care, skill and diligence in their dealings with all categories of investors. An IFI will be expected to carry out proper evaluations of risk in relation to any investment activity and undertake appropriate reviews of the process of obtaining Shariah approval and of the Shariah compliance of asset portfolios.

Principle 3

Capabilities - an IFI must ensure that its senior management, staff and representatives are capable of discharging their duties competently. In particular, it is expected that those parties will have an appropriate understanding of Shariah and this principle must be continually kept under review.

Principle 4

Information about Clients - an IFI must undertake “know your customer” checks to ensure that an investor’s business and the purpose of any financing are consistent with Shariah rules and principles.

Principle 5

Information to Clients - reporting processes must be transparent and fair. An IFI must protect investors and potential investors by providing them with information that appropriately reflects the nature of its products and services, and the associated risks.

Principle 6

Conflicts of Interest and Duty - as far as possible, an IFI should avoid situations which create a conflict of interest. Where this cannot be avoided, the situation should be managed to ensure that all stakeholders are treated fairly and any issues are addressed in a transparent and open manner.

Principle 7

Shariah Compliance - an IFI must adopt and implement appropriate Shariah governance systems in order to monitor its Shariah compliance. Since Shariah compliance is of paramount importance in the context of IFIs, this issue is addressed more fully in a separate exposure draft as set out below.

Guiding Principles on Shariah Governance System

Previous IFSB publications highlighted a particular concern over the role and function of Shariah boards within the Islamic financial services industry. Shariah boards play a key role in advising institutions on their compliance with Shariah rules and principles. Whilst other IFSB publications have contained recommendations for ensuring appropriate Shariah governance systems are in place, the Guiding Principles on Shariah Governance System were a response to the industry’s need for greater clarity in this fundamental area.

‘Shariah Governance’ is defined as the set of institutional and organisational arrangements through which an IFI ensures that there is effective independent supervision of, in particular, the issue and dissemination of Shariah pronouncements, and internal and external Shariah compliance reviews.

Principle 1

General Approach - various different Shariah governance structures have been adopted in different jurisdictions, and systems adopted should be proportionate to the size, complexity and nature of the business. Shariah boards should have a clear mandate and be equipped with operative procedures and reporting lines to provide effective Shariah governance.

Principle 2

Competence - the choice of the scholars and other individuals whose role is to provide Shariah advice should be made on the basis of an individual’s honesty, good character and possession of the necessary qualifications to understand the technical requirements of the business. The need for ongoing professional development of such individuals is also crucial to ensure that they are kept up-to-date with legislative changes and industry-specific knowledge. Shariah boards should be regularly assessed in relation to objective performance criteria and be accountable to the board of directors.

Principle 3

Independence - no individual member of a Shariah board should be ‘connected’ with the company or serve another function within the company. Each member should be capable of exercising independent judgement. The management of the IFI should ensure that all relevant information is supplied to the Shariah board promptly and in such a manner that enables the board to discharge its duties properly. This will involve allowing the Shariah board independent access to senior management and providing for any further enquiries that may be made.

Principle 4

Confidentiality - members of the Shariah board will inevitably be exposed to commercially sensitive inside information in the discharge of their duties. As part of an IFI’s broader risk management processes therefore, it should ensure that adequate confidentiality clauses are included in each member’s service contract. There should also be an appropriate procedure for dealing with leaks of inside information, which may include some form of disciplinary action.

Principle 5

Consistency - decisions of Shariah boards should be consistent and, as far as possible, follow the pronouncements of the central Shariah authority in the relevant jurisdiction, where applicable. Where no such authority exists, it is recommended that the Shariah board uses best efforts to conform to any previous rulings and to publish its decisions so that they may be openly and transparently assessed.

Conclusion

As the Islamic finance industry develops further, there is a growing need for standardisation and professionalism across the industry. Coupled with this is the importance of adopting robust corporate governance systems of internationally recognised standards incorporating transparent, fair and ethical working practices. Islamic financial institutions are well-placed in this context, since at the heart of Islamic law is a vision of social development which requires all individuals and businesses to conduct themselves ethically and in a socially responsible manner. The Guiding Principles demonstrate how closely aligned are the basic principles of corporate governance with Shariah rules and doctrines, and consequently how IFIs are well-placed to offer shareholders opportunities to participate in a broader goal of corporate social responsibility.


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Contacts

Jane Clayton

Jane Clayton

Dubai