The Legal Conflicts in Shari'ah Corporate Governance of

Islamic Financial Institutions in Malaysia

Aishath Muneeza & Rusni Hassan*

Corporate governance is a vital mechanism for the sustainable development of any

corporate entity. The smooth running of a corporate and the high returns a corporate
enjoy will always depend on the good and strong corporate governance structure of the
company. Shari'ah corporate governance is the Islamic version of corporate
governance which has stemmed from the developments of Islamic banking and finance
in the world. Malaysia can be dubbed as the cranium of Islamic banking, because of the
well developed and enhanced legal structure of the country. The Shari'ah governance
of Islamic Financial Institutions in Malaysia is regulated. However, this does not mean
that the Shari'ah corporate governance of Islamic Financial Institutions is problem free.
The objective of this legal research is to find out the legal conflicts facing Shari'ah
corporate governance of Islamic Financial Institutions in Malaysia.

Field of Research: Corporate governance, Islamic corporate governance

1- Introduction

Corporate governance is a globally debated interdisciplinary notion with numerous

attributes (Nobel cited in Krishnan, 2010, p.i). Shariah corporate governance is the
Islamic version of corporate governance. This is the simplest way to explain what
Shariah corporate governance is. Corporate governance is a vital aspect of managing
and directing a company. It helps to achieve the companys objectives without affecting
from the vagary of the weather. The company would have the strength to run the
organization smoothly. This is the main reason why the companies need to have good
corporate governance rules. In Malaysia the significance of corporate governance was
very much realized after the recent financial crisis that proved that good corporate
governance would be a shield to any kind of bad omen happening to the company. It
was after this that the Bank Negara of Malaysia came up with the set of corporate
governance rules which would be uniformly adopted by the Financial Institutions of
Malaysia.

Good corporate governance comprises of three major constituents; which are

transparency, disclosure and accountability. These components need to be successfully
implemented with clockwork relativity. When one fails, the rest exponentially fails to
achieve its targets. With broken strands, its hard to fathom the extent of damage until an
unpredicted catastrophe like the financial crisis hit the organization. And, then its too
late to prevent the disintegration of numerous functions of a corporation.

__________________

*International Islamic University Malaysia

Unlike the conventional corporate governance, Shariah corporate governance has a
much refined objective. The three major constituents of the conventional corporate
governance is owe to the shareholders and to the stakeholders of a corporation; where
as in shariah corporate governance the three main tenets of the corporate governance
are owed to the God and then to the shareholders and the stakeholders. The
fundamental objective of shariah corporate governance is to run the corporation
according to the principles of Islamic law. This is because the reason for creating
Islamic corporation is to distinguish itself from the convention rules of corporate
governance.

The objective of this research is to find out the legal conflicts facing Shari'ah corporate
governance of Islamic Financial Institutions in Malaysia. It is hoped that this research
would provide constructive recommendations for the existing problems in this area of
law.

2- Literature Review

The term corporate governance is reasonably new as it became the limelight of

corporate world within the last two decades and this conception is fundamentally not
eccentric to Islam (Fotiuh, 2010). Corporate governance has been defined in various
manners. The literatures on the shariah corporate governance are less compared to
that of conventional corporate governance (Siddiqi, and Haneef cited in Hassan, 2009).
The modern day scholars (like Lewis, 2005; Saroni, 2008; Hassan 2009; Malekian &
Daryaei, 2010; Salahudin, 2008; Choudhury and Hoque, 2006) have started writing on
this subject matter. Malekian & Daryaei (2010) defines corporate governance as the
way in which the boards oversee the running of a company by its managers, and how
board members are, in turn, accountable to shareholders, stakeholders and the
company. This definition does not cover the accountability of the Board of Directors to
God and the society, which are crucial factors in shariah corporate governance. Hence,
this is a good definition of conventional corporate governance.

According to Fotiuh (2010), concept of corporate governance was recommended as a

consequence of swelling consciousness on the significance of the want to guard the
rights of all stakeholders, including minority shareholders. And it has been s aid that
good corporate governance is more than an excellent thought as it promotes flow of
investments, lowers the cost of capital, and supports strong capital markets (Fotiuh,
2010).

It is hard to specify the person who coined the phrase Shariah corporate governance
and there is also no specific unified Arabic phrase formulated for this (Lewis, 2005, p.5).
However, Egyptian official translation has come up with the word for governance by
pronouncing it as hawkama and this has been approved by the Egyptian Linguistic
Department (Sourial, cited in Lewis, 2005, p.5). Malaysia has come up with several
guidelines on Shari'ah governance of Islamic Financial Institutions. But the effectiveness
of these guidelines is less spoken. Hence, it is hoped that this research would point out
the legal conflicts of Shari'ah corporate governance facing Islamic Financial Institutions
in Malaysia.

3- Methodology

This research with its novelty is among the first few to theoretically shed light on the
subjects discussed. Hence, the researchers co-objective was to explore and establish
the relations and findings within the conceptual, theoretical and foundational dynamics
of the subject. An exploratory research was conducted to identify and accumulate
existing literature and based on this information, further analysis and conceptual
proliferation was performed. Subsequently, the authors present the findings of this
comprehensive and meticulous research on a platter intelligible and graspable to all
stakeholders of Islamic corporate affairs.

4- Discussion and Findings

Under the Malaysian law, Islamic Financial Institutions established in the country are of
three kinds. There is need to understand the differences between these three
categories as the shariah corporate governance of each would differ in the eyes of law.
Following classified are the types of Islamic Financial Institutions in Malaysia;

1- Full-fledged Islamic banks operating under Islamic Banking Act 1983 or IBA (eg:
Bank Islam and Bank Muamalat)
2- Conventional banks offering Islamic banking business (Islamic window) under
Banking and Financial Institutions Act 1983 or BAFIA
3- Banks regulated under Development Financial Institutions Act 2002 or DFIA
offering Islamic banking products (eg: Bank Rakyat)

It should be observed here that apart from the respective statute applicable to the
Islamic Financial Institutions, for the matters related to corporate governance with
respect to establishment of shariah boards, the applicable guideline would be
Governance of Shariah Committee for the Islamic Financial Institutions (BNM/GPS 1).
Shariah corporate governance in Malaysia is not problem-free. This part of the paper
would examine the pertinent legal obstacles in shariah corporate governance in
Malaysia.

4.1 Shariah Corporate Governance Is Not Defined

The Guideline does not define what shariah corporate governance is and in fact
the phrase shariah corporate governance is alien to the Code. Hence, there is a
need to acknowledge in the Guideline that the corporate governance applicable
to Islamic Financial Institutions is shariah corporate governance and a precise
meaning of this need to be enacted. Some might think that this is not a problem
and there are many international guidelines like IFSB which defines this term. But
the truth is that Malaysia also needs to explicitly adopt a definition of this term to
avoid confusion between corporate governance and shariah corporate
governance.

4.2 The Position or The Rank of Shariah Committee Within the Islamic
Financial Institutions are Not Expressly Mentioned

A proper ranking of SC in an Islamic Financial Institution needs to be legislated

as for now the law only states that shariah Committee is an independent organ
in an Islamic Financial Institution. The current trend is that the law does not
specify where the SC ranks when compared with the Board of Directors (BOD) of
an institution. Furthermore, the functions of shariah committees are merely
advisory as the BOD has either the right to accept or reject the advice of them.
Hence, there is an imminent need to legally clarify the position or the rank of
shariah committee within an Islamic Financial Institution.

The current scenario in Malaysia with regard to this is that all of the shariah
committees are subordinate to BOD as BOD has the right either to reject or
accept their view. And in the organization charts of the most of the Islamic
Financial Institutions in Malaysia, shariah committee is under the Chief
Executive Officer of the Company and they are more like the non-executive
directors as they meet only when the need to do arise and sometimes it is
impossible to invite all the members of the shariah Committee as they have
other commitments.

Hence, in order to strengthen the position of shariah Committee within the

Islamic Financial Institutions, it is mandatory to state in the guidelines the rank of
the shariah Committee within the Islamic Financial Institutions.

4.3 Shariah Audit is Not Compulsory and the Qualification of Shariah

Auditors Need to be Enacted

Shariah audit is imperative to ensure and facilitate transparency and

accountability in the conduct of business before God. The existing guideline does
not mention the position of shariah audit and how importance it is to Islamic
financial institutions. This needs to be corrected as not only prudential audit is
vital for Islamic Financial Institutions. The following verse of Quran illustrates the
vitality of shariah audit:

Verily Allah commands that you should render back the trusts to those
whom they are due; and that when you judge between men, you judge
with justice. Verily, how excellent is the teaching which He (Allah) gives
you! Truly, Allah is Ever All-Hearer, All-Seer" (4:58).

Likewise the meaning of shariah audit needs to be specified too. The AAOIFIs
Governance standard No.2 (GSIFI) provides a precise view of Shariah audit as
defined below:
 Shariah review is an examination includes contracts, agreements,
policies, products, transactions, memorandum and articles of association,
financial statements, reports especially internal and central bank
inspection, circulars, and etc (Paragraph 3, GSIFI 2, AAOIFI Standards).

Furthermore, the qualification of shariah auditors also needs to be emphasized.

With regard to the requirement of Shariah auditors, they should not only possess
the knowledge of prudential accounting; but they shall be well versed in shariah
and preferably should have the knowledge of Islamic accounting.

4.4 The minimum requirements in Shariah reports need to be amended

Shariah reports are made by the shariah committee within the Islamic Financial
Institutions in accordance with Guidelines on the Specimen Reports and
Financial Statements for Licensed Islamic Banks (GP8-i). This report is made by
most of the Islamic Financial Institution for namesake as the only writing which
could be found in them is as follows:

We Encik D and Encik E being two members of the shariah committee of

Islamic Bank Bhd, do hereby confirm on behalf of the members of the
shariah committee, that in our opinion, the operations of the bank for the
year ended dd/mm/yy have been conducted in conformity with shariah
principles (Yusof, N/A).

The above mentioned few lines are the shariah reports made by the shariah
Committees in Malaysia to fulfill the legal requirement. Hence, it would be better
to change the minimum requirements mentioned in GP8-I, so that theses reports
would not be piece of papers made and signed for namesake. In order to
enhance the report the guideline could stipulate inter alia that the title of the
report shall begin with symbolic of Islamic salutation (Bismillah); the addressee
part that usually addressed to the shareholder of the Islamic Financial Institution
to portray a good image to the stakeholders; introductory/opening part of the
paragraph is vital in identifying the purpose of the engagement as well as
describing the nature of work performed; the date used may best suit using
Islamic date in addition to the Christian date; and all members of shariah
Committee shall sign in the report to stimulate to share the conscientiousness
and to shun free riders (Ibrahim, 2009).

4.5 Shariah Risk Management is not Emphasised

Shariah risk management methods need to be expressed too in the Guideline as

this is a vital aspect to shariah governance. Islamic Financial Institutions like the
conventional banks are susceptible to risks. The risks which a bank normally face
are credit risk (the possibility of counterparty failure to meet their commitment on
time), market risk (due to economic changes or external events, the common
risks faced to entire class of assets and liabilities), liquidity risk (risk that arises
from the complexity of trading on asset and difficulty in obtaining funding at a
rational cost), prepayment risk (risk of financing being prepaid before maturity
due to a plunge in interest rate and settlement risk (risk that a counterparty does
not deliver security or its value in cash as per agreement when the security is
traded after other counterparty have delivered security or cash as per
agreement) (Abdullah, 2007). According to Abdullah (2007), the risks which are
specific to Islamic banks are commodities and inventory risk which arise from
cleaving to items in inventory either for resale under a murabahah contract or
with a view to leasing under an ijarah contract; rate of return risk which is similar
to interest risk in the banking books; legal and compliance risk which is the risk
associated with the potential for system failure in a given market usually resulting
from inadequate internal processes and strategies; equity position risk which
arises from the equity exposures in mudharabah and musyarakah financing
contracts; and mark-up risk which is related with the variation to the benchmarks
rate as Islamic banks use market rates as benchmarks in pricing the products
instead of interest rates. There is need to emphasise on the guideline on the
utilization of Islamic risk management methods.

4.6 The Legal Liabilities of the Shariah Scholars are Unknown

The current position is that the law is silent on the consequence of malpractice
liability on the Shariah scholars presiding in the shariah committees, which
leads people to perceive that these scholars are immune from legal action.
Hence, there is need to mention the legal liabilities of shariah scholars. With this
regard it is vital to mention whether a shariah scholar could be sued for
negligence or not by the customers; and it would be prudent to mention to whom
the shariah scholars owe the duty of care.

It should be noted here if the law allows the clients to sue shariah scholars in all
types of negligence, then it would create practical problems in the availability of
scholars to sit in Boards as they would be reluctant and would feel fear when
making decisions. In the end this might inhibit the growth of the industry as
shariah scholars are the watchdogs and the main pillars of Islamic banking
industry. Hence it would be sensible and reasonable to mention that the clients
can sue shariah scholars only in extreme and serious cases (Hodgins, 2010).
Hodgins (2010) illustrates one instance which is serious enough to sue the
shariah scholars; that is where it could be demonstrated that the Shariah
scholar was focused on other concerns (for example, his relationship with the
product provider or his financial remuneration) and did not give any genuine
consideration to the Shariah compliance of the product.

Another practical problem which may arise from giving the clients of the Islamic
Financial Institutions to sue shariah scholars in cases would be that they might
not have enough money to compensate the parties. In order to guarantee that
availability of compensation in the event of malpractice it would be imperative to
ensure that the scholars purchased liability insurance (Hodgins, 2010).
 4.7 The Role of Shariah Committee is only Supervisory

The role of SC needs to be widened to make them physically take part in

watching and advising the real happening within the bank, rather than depending
on a report created by the staffs of the bank. The current trend is that the shariah
committee is treated as a part-time body, which meets when the Board or the
CEO needs them to meet. Hence, the law needs to enhance the role and
responsibility of the shariah Board to that of the function of a modern
Ombudsman or Muhtasib. Furthermore, the role of shariah Board can be both
supervisory and executive. The responsibilities of shariah Board put forth by
Malaysian Rating Corporation Bhd (MARC) are an exemplary one to follow. The
requirements quoted below are some of these requirements

1- To approve the shariah aspect in the memorandum of association, articles of

association regulation as well as the forms and policies used by the Islamic
Financial Institutions
2- To approve the standard agreements and contracts pertaining to the Islamic
Financial Institutions financial transactions
3- To give shariah opinion regarding the products introduced by the Islamic
Financial Institutions and issues fatwas on the questions and transactions
submitted to it
4- To study unprecedented situations not covered by fatwa with a view to
developing alternative products or procedures
5- To ensure shariah compliance in the implementation of all banking
transactions and to resolve any breaches
6- To write-off the profits earned through shariah non-permissible means and
donate the same to charity
7- To ensure that the distribution of the profit and bearing of loss are calculated
in accordance to shariah principles
8- To ensure that zakat is appropriately calculated and distributed in accordance
with the provisions of Islamic shariah

5- Conclusion
Shariah corporate governance is a vital mechanism for the smooth and effective
running of the Islamic corporate, especially the Islamic financial Institutions which are
numerous in Malaysia. Corporate governance is the mode by which a corporation is
directed, administered or controlled. The Shariah cooperate governance also has the
same objective, but the perspective and the modus operandi is different in the sense
that the basic tenets of Islam or the objectives of Shariah are considered in it in addition
to the interest of the directors and the stakeholders.

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Rusni Hassan, Assistant Professor, Faculty of Law, International Islamic University Malaysia, hrusni@gmail.com
Aishath Muneeza, Lecturer, School of Law, Nirwana College, munee_2@hotmail.com