CORPORATE GOVERNANCE:

CONVENTIONAL VS ISLAMIC PERSPECTIVE

Rahmatina Awaliah Kasri

Department of Economics / Islamic Economics & Business Center

University of Indonesia

Kampus Baru Universitas Indonesia, Depok, Jawa Barat,Indonesia E-mail: rahmatina@fe.ui.ac.id /unirahma@yahoo.com

Abstract

Although Islam as a way of life has always promotedgood ethics, strong morals, unshakeable integrity and honesty of the highest order, it is not easy toincorporate such ethical values into an ‘Islamic’ corporate governance standard and implement it. Consequently, in practice, most of ‘Islamic’ companies use the conventional corporate governancestandard which may not be consistent with the Islamic values. This paper, therefore, compares thecorporate governance concepts in the conventional

and the Islamic perspective. Main differences are found with regard to philosophical aspects, including objectives of the company, types of contract involve, key players in the corporate governance practice as well as the relationships between the players. The difference rooted from thefact the Islamic perspective sees the corporate governance practice as Muslim’s obligation to God, thus leads to the existence and obedient of the ‘implicit’ contract with God and explicit contract with humans. In the end, these placed God and Islamitself as key players in the corporate governance practice. This is in contrast to the conventional point of view that focuses on the material aspects.In practical field, the differences are minor. The mechanism and tools for the effective implementation of corporate governance are relatively the same. Nevertheless, as Islamic financial institutions deal with more complicated financial transactions and must comply with Shari’ah rules, it requires relatively stronger internal control. Unfortunately, most of the tools are not being practiced yet by IFIs either because less supporting infrastructure or insufficient human resources are available. These constitute the main challenges for IFIs in the near future.

Keywords: Corporate governance; Islamic corporate governance; business ethics.

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Electronic copy available at: http://ssrn.com/abstract=1685222

1. Introduction

The issue of Corporate Governance is relatively new in literature and has gain popularity only during the last two decades. The issue has started to figure prominently in public domain in the wake of increasing scandals involving large corporations such as Enron, Worldcom and Parmalat. The scandals highlight the illegal actions, unethical practices and mismanagement that affect not only the value of the companies but also the wealth of millions of people who own shares in the companies. Other than that, it also affects society as a whole because, among others, it is usually followed by massive layoff of employees and changes or tightened corporate governance regulations applied to all companies.

Islamic financial institutions (IFIs) do not immune from such mishap. The collapse of Ihlas Finance House (IFH) of Turkey in 2001 provides an example on how weakness in corporate governancepractice entails negative repercussion for soundness and sustainability of an Islamic financial institution (Jang 2003, in Dusuki, 2007). Although Islam as a way of life has always promoted good ethics, strong morals, unshakeable integrity and honesty of the highest order, in practice it is not easy to incorporate such ethical values into an ‘Islamic’ corporate governance standard and then implement it. Thus, the current corporate governance practices of IFIs still rely on the conventional corporate governance standard, such as the OECD andthe BCBS standard, with adjustment to the shari'ah.

While the use of the conventional corporate governance standard is understandable, there is an urgency to define Islamic Corporate Governance standard. At the outset, this requires thatthe IFIs be able to distinguish the perspective of conventional

corporate governance with the Islamic point of view. This is themain concern of the paper. Afterwards, relevant policy

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makers should be able to incorporate the perspective into an ‘Islamic’ Corporate Governance Standard and encourage IFIs to adopt the standard in their daily business practice.

To address the issues, the rest of this paper is organized as follow. Section 2 discusses background and basic concepts of corporate governance as well as general view of Islam in the issue. Section 3 compares the aspects of conventional corporate governance with the Islamic perspective which include philosophical foundations, contracts involved, key player and their relationship, mechanism for corporate governance and toolsfor effective corporate governance. Finally, a brief summary andrecommendation is offered in the last section.

2. Background and Basic Concepts of Corporate Governance

OECD defines Corporate Governance as “a set of relationships between acompany’s management, its board, its shareholders and other stakeholders whichprovides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined” (in IFSB, 2006a). This definition is shared by IFSB, with additional to suit the context of Institutions offering only Islamic Financial Services (IIFS). According toIFSB, “in the context of IIFS, good corporate governance should encompass (i) aset of organizational arrangements whereby the actions of the management of IIFS are aligned, as far as possible, with the interests of its stakeholder, (ii) provision of proper incentives for the organs of governance such as the BOD, SSB and the management to pursue objectives that are in the interest of the stakeholders and facilitate effective monitoring, thereby encouraging IIFS to use resource more efficiently, and (iii) compliance with Islamic Shari’ah rules and principles” (IFSB, 2006a).

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While the OECD definition is rather broad in its term, the IFSB definition is more specific and contains main goals of the corporate governance in Islamic perspective, which is to align the actions of the IIFS management with the interest ofits stakeholder by providing proper incentives to the governance body and to comply with the shari’ah principles. Theclear objectives show that the major issue behind the corporate governance idea is the (possible) conflict of interest between the owner (principle) and the management (agent) in a corporation. This idea is known as “the principal-agent problem”.

In modern corporate literature, the principal-agent problem arises when ownership and managerial control are separated. The separation can be problematic if the management acts according to their best interest instead of doing the best interest to maximize the shareholders’ wealth. For instance, a manager might not be interested to spend much money in the company’s staff training, which will potentially increase operational cost and reduce profit - including his salary - in the short run. On the other hand, this type of investment has potential to increase profit for all shareholders in a longer run. Yet, the manager might not be in his position anymore in a long run. Therefore, it is obvious that conflictof interest potentially occurs between the owner and the management. This point of view represents the Shareholder Model or the Anglo-American Model of Corporate Governance largely used by manycorporations today, especially those in the US and the UK.

Another prominent corporate governance model is the Germany Model. In the model, owner and manager are often the same in a firm. Additionally, by regulation, German firms with more than 2,000 employees are required to have a two-tier board structure that separate the supervision of management from other normal duties of BOD including the nomination of new BOD members. Thus,private shareholders rarely have major ownership position in

German firms. Most corporate stocks are owned by public i.e. large institutional investors and

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insurance companies. Consequently, less emphasizes is given to shareholders’ value than the perspective of the US and theUK firms. In contrast, emphasizes is given more to other stakeholder, or stakeholders other than shareholders. This point of view represents the Stakeholder Model of Corporate Governance(Hit et al, 2005). Specifically, the stakeholder model proposesthat society is entitled to get positive contribution from firms, especially big firms that have great economic and social power, in return for ‘granting’ the firms their legal status in the marketplace. Nevertheless, some puzzles exist in the model. It is not clear who or what is a legitimate stakeholder, to what each stakeholder is entitled, or how managers should balance competing demands among a range of stakeholders (Steiner and Steiner, 2006).

Islamic perspective on corporate governance, to some extent, resembles to the stakeholder model. Indeed, it provides a more solid justification regarding who can qualify as a stakeholder and what are the rights and responsibilities thatboth firms and their various stakeholders may assume. This framework is firmly established in Islamic principles of property rights and contracts. According to Iqbal and Molyneux (2005), a stakeholder is defined as the one whose property rights are at stake or at risk due to voluntary or involuntary actions of the firm. This implies that a firm is expected to preserve property rights of not only the shareholders, but also those who have participated in the process of acquiring the firm’s property and those who could be threatened as a result of its operation. They also posit that any group/individuals with whom a firm has any explicit and ‘implicit’ contractual obligations qualifies as a stakeholder although the firm may not have formal contracts with them through mutual bargaining.

Islam also believe that a person’s daily activities and transaction should be based on the values of truthfulness,

firmness, fairness, respect for the law, kindness, forbearance, tolerance

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and uprightness, instead of deceit, haughtiness, class consciousness, ostentation, insubordination, envy, jealousy, backbiting and self-aggrandizement (M.K Hassan, 2002). These should also naturally be manifested in individuals’ involvement in business activities and operations as well as their relationships with all their respective stakeholders. Overall, the Islamic view of corporate governance is more comprehensive than the stakeholder view and closely related to the ethical values in Islam.

3. Conventional vs. Islamic Perspective on Corporate Governance

Previous section has briefly discussed the philosophical difference between the conventional corporate governance perspectives and the Islamic perspective. In this section, the issue is further explored. In addition to that, comparison between some specific issues is elaborated. Five important aspects - as reflected by the corporate governance definitions - are compared here, including (i) the philosophical objective, (ii) the types of contracts involve,(iii) the key players and their relationship (governance structure), (iv) the mechanism for corporate governance (means to attain the objectives), and (v) the tools (means tomonitor the performance) for effective corporate governance.

First, there is a major difference in philosophical objective between the conventional and Islamic point of view of corporate governance. In the conventional models, a company objectives canbe varied i.e. either to maximize the shareholders’ profit or tomaximize the stakeholders’ wealth. However, in Islamic perspective, the main goal is clearly stated: everyone has a

unity purpose in his/her that is to serve Allah SWT. One of the consequences would be, at least normatively, that the Islamic society will avoid having conflicting interest among member of the society. Ahmed (2003) further suggests that this will inevitably lead to a society whereby every member will cooperatewith each other rather than compete, as

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success in life is to obtain the ultimate happiness (falāh). Such philosophical considerations do not exist in the conventional literature.

The unity of purpose in Islamic point of view marks the existence of implicit contract, a type of contract unique to Islamic business transaction. Specifically, according to Attas (1984), the implicit contract is actually a Divine contract that requires man to manifest the covenant (al-mithaq)through his submission in absolute true willingness as prescribed by the Divine Law of Shari’ah. Indeed, the very foundation of the Shari’ah is covenant between God and man which imposes on man the duty of being faithful to his Lord. Failure to fulfill these obligations means he or she has breach the Divine contract, thus equivalent to betrayal with all the attending consequences in this world as well as in the hereafter.

Accordingly, both perspectives share the view that formal contracts are necessary to ensure effective corporate governance. The contracts are stipulated in forms of legal law and regulation. Nevertheless, because the western models are based on human perspective, they tend to change overtime dependson the situation. The Sarbanes-Oxley Act 2002 for instance, was enacted just after the Enron scandal discovered. It designs accounting practices to prevent financial misreporting and holdsmanagement more responsible for accurate financial reports and strengthen the power and responsibility of board audit committees (Steiner and Steiner, 2005). In contrast, the Islamicmodel is based on the Divine will and the Holy Quran that do notchange overtime. One verse of the Quran (QS 2:282), for instance, specifically mentioned the guideline for ethical accounting practices: “…let a scribe write down faithfully as between the parties…let him incurs the liability dictate, but let him fear his Lord God and not diminish aught of what he

owes…let neither the scribe nor witness suffer harm…and God is well acquainted with all things” (Abdul Rahman, 2007).

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Third, key players of different corporate governance practices are also different. As suggested in the previous section, the shareholder model believes that the major playerwhose interests are emphasized is the shareholder or capital provider. The stakeholder model, by contrast, places the sameamount of interests (at least in theory) on protecting the interests of other stakeholder. While Islamic perspective shares some similarity to the stakeholder’s view, i.e. to protect the interest of the stakeholder rather than the shareholder only, the primary stakeholder in the case of IFIsis the God and Islam itself. If the banks do not perform well, those who assume the Islamic system to be out of tune with the modern world may try to blame Islam and the Divine Will for the poor performance although they have nothing to do with that (Chapra and Ahmed, 2002).

Fourth, both perspectives recognize that mechanism for corporate governance constitutes of Board of Directors (BOD),Senior Management, and Shareholder. With respect to the firsttwo elements, the mechanisms are relatively the same in both cases. The boards have power to design the corporate governance policy frameworks, direct the affairs of the organization punish and rewards managers, and protect shareholders’ right and interests; the management’s responsibility is running the operation of the company (Hitt et al, 2005; Chapra and Ahmed, 2002).

However, the BOD of IFIs carries additional tasks. According to IFSB guidelines (2006a), the BOD of IIFS shall set up a Governance Committee (comprising at least three members), to coordinate and integrate the implementation of the governance policy framework. This Governance Committee may comprise of a member of the Audit Committee, a shari’ah scholar (possibly from the Shari’ah Supervisory Board of the IFIs) and a non-executive director (selected based on the director’s experience and

ability to contribute to the process). The existence of the shari’ah scholar highlights effort to comply with Islamic rules.

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Differences also occur with respect to shareholder position. According to the conventional model, depositor is not shareholder because their funds are insured and guaranteed. This implies that no corporate governance mechanism is required for them. However, in the Islamic perspective, the definition of shareholder should include the depositors’ role. In particular, Investment Account Holders (IAHs) that participate in PLS arrangements should act like the shareholder in the conventional practice. However, currently they neither have voice in the shareholder’s meeting nor haveguarantee for their funds, to comply with shari’ah rules (Chapraand Ahmed, 2002). Additionally, the fact that the IAHs are represented by the IFIs management for the PLS contracts leads to situation where tripartite conflict of interests between the common stockholder, the management, and the IAHs may happens. This remains unsolved by current corporate governance mechanism (Archer and Abdel Karim, 2007).

Fifth, effective corporate governance requires several tools to ensure confidence in such a system. Some important tools, among others, are internal control, accounting and external audit, andtransparency. Internal control, the most important tool, is basically a corporate governance framework designed to ensure the realization of organization’s goals and enhance its long runprofitability as well as to ensure management oversight and develop a healthy culture in the company. They are also necessary for recognizing and assessing risk, detecting problemsin the institution and correcting deficiencies. Important parts of internal control include accounting control and internal audit system, control environment1, risk assessment and

management2, and control activities3 (Sarji, 2007). In this respect, there is no significant difference between the conventional and Islamic model of corporate governance.

1 Control environment is the organizational structure and culture created by an organization for effective internal control.

2 For more discussion about risk management in conventional FIs see, among other, Ross

et al (2006), while for the IFIs please see Khan and Ahmed (2001).3 It includes policies procedures, and mechanism in place to help in ensuring that the

company’s objectives are met. Some examples include proper segregation of duties and appropriate documentation.

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The accounting and external audit, the second tool, are otherimportant element in corporate governance that appears in both corporate governance practises. Nevertheless, with the absent of sufficient number of shari’ah auditors, the function is often ‘neglected’ by IFIs. Current IFSB survey reveals that only a small minority of the IIFS have external ex-post shari’ah compliance reviews, even then mostly carried out by their governing central banks (IFSB, 2006a).

Other important aspect of corporate governance that increasingly popular nowadays is transparency. Conventionally, the standards used are the Basel Committee onBanking Supervision (BCBS) standard, the disclosure standards(Pillar 3) contained in the new Basel Capital Accord, and theinternational accounting standards. These standards are also used by IFIs, with addition to the transparency standard of IFSB and the Islamic accounting standard of AAOIFI. The use of those standards indicates that the need for transparency is, above all, an important shari’ah consideration. Any form ofconcealment, fraud or attempt at misrepresentation violates the principles of justice and fairness in shari’ah. The issues are mentioned by the Holy Quran in many places, including in Surah An-Nisa’ verse 135 and Surah Al-Mutaffifin verses 1-3 (IFSB, 2006b).

4. Conclusion

This paper compares the corporate governance concepts in the conventional and the Islamic perspective. Main differences are found with regard to philosophical aspects which include objectives of the company, types of contract involve, key players in the corporate governance practice as well as the

relationships between the players. The difference rooted from the fact the Islamic perspective sees the corporate governance practice as Muslim’s obligation to God, thus leads to the existence and obedient of the ‘implicit’ contract with God and explicit

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contract with humans. In the end, these placed God and Islam itself as key players in the corporate governance practice. This is in contrast to the conventional point of view that focuses on the material aspects.

In practical field, there are minor differences between the two perspectives. The mechanism and tools for the effective implementation of corporate governance are relatively the same. Nevertheless, as IFIs deal with more complicated financial transactions and must comply with Shari’ah rules, it requires relatively stronger internal control. Unfortunately,most of the tools are not being practiced yet by IFIs either because less supporting infrastructure or insufficient human resources are available. These constitute the main challengesfor IFIs in the near future.

References