CORPORATE GOVERNANCE AND ETHICS COMPLIANCE IN ISLAMIC FINANCIAL
INSTITUTIONS – LEGAL PERSPECTIVES
Dr. Osman Sacarcelik, M.A.
Research Assistant
University of Munster (Germany)
Institute of Corporate and Capital Markets Law
and
Cluster of Excellence “Religion and Politics”
Lecturer (Islamic Finance)
University of Marburg (Germany)
Center for Near and Middle Eastern Studies
Email:
osman@sacarcelik.com
osman.sacarcelik@uni-muenster.de
Phone: +49 176 854 95 397
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ABSTRACT
Corporate governance systems are continuously converging and inherently presuppose the
predominance of law. Strong emphasis is put on checks and balances and monitoring systems.
However, despite convergence tendencies there are also differences in corporate governance
systems that often stem from different commercial and legal cultures, the prevailing political
and economic conditions and the development of the macroeconomic model. Religious
traditions and moral aspects also come into play. Islamic financial institutions are
significantly subject to multi-level governance systems. They are not only required to comply
with applicable laws but also with Sharia and ethical principles. If legality is insufficient to
frame governance policies or where the law is silent, ethical norms can have a supplementary
regulative effect.
After inquiring the relationship between law and morals the paper will argue that the two
distinct spheres of law and morals can sometimes conflict with each other. The paper will
then go on to discuss the content and regulative character of codes of conduct applied in the
Islamic finance sector. In this context, the ethics standards of the AAOIFI and the IFSB will
be presented and critically reflected upon.
Because markets and individuals do not always sufficiently guarantee adherence to ethical
norms, ethical codes of conduct as instruments of self-regulation need to be implemented and
“reinforced” effectively. This article attempts to create a nexus between corporate governance
systems and ethics compliance taking into account the distinctive features of Islamic financial
institutions. It suggests integrated legal mechanisms for applying ethical norms within the
corporate governance framework of an Islamic financial institution. Formal organisational
systems that create incentives for ethical behaviour and ultimately enhance ethics compliance
will be discussed. The paper also shows the legal limits of implementing ethical norms and
sanctioning misconduct, particularly in European legal and regulatory settings.
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Key words: Islamic Finance; Law and Morals; Regulation; Corporate Governance; Ethics
Compliance; Code of Conduct; Sharia Compliance; Corporate Social Responsibility.
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CORPORATE GOVERNANCE AND ETHICS COMPLIANCE IN ISLAMIC FINANCIAL
INSTITUTIONS – LEGAL PERSPECTIVES
I.
Introduction
Corporate governance has received considerable attention in economic and legal literature as
well as in public policy debates of the recent past. Corporate governance can be defined as the
system by which companies are directed and controlled (Cadbury Report, 1992). It is a set of
relationships between a company’s management, its board, its shareholders and other
stakeholders. Current corporate governance structures are continuously converging. This
process is supported by joint regulatory efforts on international and EU-level. The prevalent
Western-type corporate governance system inherently presuppose the predominance of law
(Zetsche, 2007: 18). Strong emphasis is put on checks and balances and monitoring systems.
However, despite convergence tendencies there are still differences in corporate governance
systems that often stem from different commercial and legal cultures, the prevailing political
and economic conditions and the development of the macroeconomic model (Archer and
Abdel Karim, 2007: 297). Religious traditions and moral aspects also come into play
(Koslowski, 2009: 77; Zetsche, 2007). For example, some cultural and religious traditions put
less emphasis on external control but to a higher extent reliance on individual self-control and
self-restraint as well as moral notions such as honesty, personal integrity, thoughtfulness and
solidarity (see also Koslowski, 2009: 79). Islamic banks and financial institutions are subject
to a multi-level governance system where religious elements play a considerable role. They
do not only have to conform to national laws but additionally to principles of Islamic law.
Moreover, market participants and particularly clients expect them to adhere to ethics in their
daily business. While a number of governance problems and challenges are common to all
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financial institutions there are some issues which are specific to Islamic financial institutions.
These institutions have distinct structural features and risk characteristics that require greater
attention to the peculiarities of their business concepts and products as well as their specific
corporate governance structure (see Askari et al., 2010: 163; Archer and Abdel Karim, 2007:
295).
In the ultimate aftermath of large-scale corporate wrongdoings and frauds in the 2000s
corporate governance systems came under scrutiny internationally. There has been a shift
away from the traditional shareholder value centred view of corporate governance towards a
governance structure that takes a broader view on long-term stakeholders (e.g. clients, debtproviders and employees) and their rights. In the wake of the recent financial crisis, regulators
across the globe started once again reviewing company and capital markets laws in order to
improve the corporate governance architecture. Ethical codes of conduct also gained
increasing attraction. Some regulating bodies now require the adoption of codes of (business)
conduct.
The recent developments can be partly attributed to the fact that corporations and particularly
financial institutions face more and more pressure by investors, clients and the wider-public to
do the ‘ethical thing’ when they seek to make the ‘right choice’ (Chesterman, 2008). With
respect to the Islamic finance industry, ethics compliance is not only a voluntary choice but a
conceptional requirement. Thus, Islamic financial institutions are required not only to comply
with applicable laws and adhere to Sharia principles (e.g. not engaging in interest-based or
speculative transactions). They are also obliged to adhere to ethical principles which have
their basis in the teachings of Islam. The two standard setting bodies, the Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial
Services Board (IFSB) have formulated specific governance frameworks as well as codes of
conduct for Islamic financial institutions. These rules are based on ethical standards derived
from the Islamic faith.
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This article will first inquire the relationship between law and morals (II.). It will argue that
these two spheres are distinct and ethical rules and legal norms can sometimes conflict with
each other. The paper will then go on to discuss the regulative character and the content of
codes of conduct applied in the Islamic finance sector (III.). In this context, it will present and
critically reflect upon the governance and ethics standards adopted by the AAOIFI and the
IFSB. Finally, the crucial question, if and how ethical rules that are voluntary in nature can be
implemented and reinforced within existing corporate governance structures, will be
examined (IV.).
II.
Distinction between law and morals
Ethical norms can be defined as non-legal institutions that recommend concepts of “right” and
“wrong” behaviour and rely on consent among the respective social group. They constitute
guiding principles that can have both the form of individual ethics and institutional ethics, or
in the context of this paper, business or corporate ethics. Corporate ethics is sometimes used
interchangeably with the concept of corporate social responsibility. Generally, the latter is
wider than corporate ethics as it extends to social projects or philanthropic activities of a
company and the like. It can be seen as one of the reflections and practical dimensions of
ethical business conduct. Some ethical rules of Islam particularly refer to commercial
dealings. To simplify, this area of ethics is called here Islamic business ethics. It encompasses
individual, institutional and social perspectives. It is noteworthy that the term ‘Islamic’
business ethics is used to indicate that the respective ethical norms are derived from Qur’anic
revelation and prophetic tradition as well as the writings of Muslim scholars. Particularly,
Sufism can be seen as one driving element in the refinement of Islamic ethical concepts.
Secular ethics, in contrast to religious ethics, is based solely on human faculties such as
reason. Most ethical postulations of Islam in substance are supported in other religions as well
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as in secular ethics. This is because most ethical norms are of transcultural and universal
nature (Küng, 2010: 239) and come to similar conclusions.
The Qur’an addresses ethical and social awareness and behaviour in commercial dealings.
Breadwinning through legitimate means is associated with good deed. In this respect, there
are similarities between Islamic moral concepts and Protestant work ethics. Emphasis is put
on the importance of fulfilling promises and obligations (e.g. Qur’an 2:177; 16:92; 17:34),
enjoining ‘what is right’ (maʿrūf) and forbidding ‘what is wrong’ (munkar) (3:110), justice
(ʿadalah) and good social conduct (iḥsān) (16:91). An important commandment is giving full
measure and weight, with equity, and not depriving people of what is rightfully theirs (Qur’an
11:85; 83:1-3). The Qur’an commands not to deprive other’s property by unfair and dishonest
means (4:29). It recommends to grant a debtor who is in a difficulty time until it is easy for
him to repay. Waiving the sum by way of charity, is recommended (Qur’an 2:280).
Law is distinct from ethics in many respects. Among the different definitions of law (see
Dreier, 1986; Seelmann, 2010: 23) some emphasise the social efficiency, acceptance and
enforceability of norms as major elements. Others focus on the element of authoritative
positivity when they define what is law. According to Hart, for instance, legal systems are a
“combination of primary rules of obligations and secondary rules of recognition, change and
adjudication” (Hart, 1961: 95). The finding that law and morals are often identical in their
normative content and propositions implies that there is a difference between the two spheres.
Consequently, it leads to the assessment of the relationship between law and morals. Details
of this three-centuries-old debate will not be presented here, but the core distinction and the
different concepts are important for the further analysis with view to the interplay between
ethics and corporate governance.
Natural law is a system of law which is purportedly determined by nature, and thus universal.
It refers to the use of reason to analyse nature and deduce binding rules of moral behaviour.
According to the natural law theory, law and morals are an indivisible unity.
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Legal positivism as opposed to the concept of natural law is the thesis that the existence and
content of law depends on social facts and not on its merits. Whether a society has a legal
system depends on the presence of certain structures of governance, not on the extent to
which it satisfies ideals of justice, democracy, or the rule of law. What laws are in force in
that system depends on what social standards its officials recognize as authoritative (Stanford
Encyclopaedia of Philosophy: legal positivism). There are different strands of legal positivism
(e.g. Kelsen, Hart and Dworkin) which cannot be presented here (for the various definitions
see e.g. Dreier, 1986: 890, 892; Seelmann, 2010: 23). The critics of legal positivism argue that
it fails to give morality its due (see Stanford Encyclopaedia of Philosophy: legal positivism;
Radbruch, 1946, passim). However, even legal positivists acknowledge that moral reasons
shape the law (Finnis, 1996: 206). The design of laws often follows the ‘patterns’ of justice,
equity and normative maxims. Hence, law is not an entirely moral free sphere (see Dreier,
1986: 890, 892; Seelmann, 2010: 23). Moral norms on their part are often based on religious
foundations. Berman (2003: 373) argues that “contemporary scholars in all the relevant fields
[…] have largely neglected to consider the impact of belief systems generally on law”.
Similarly, Branson (2000: 691) states, that “the teaching of years of comparative study is that
it is the culture beneath the law and behind economic and other institutions that is as or more
important than law itself, legal structures, and good governance practices”.
Moral notions – often vested in constitutional norms and principles and human rights laws –
find their way through to law through ‘backdoors’ such as the blanket clauses in German civil
law. Blanket clauses generally define abstract rules and have a wide scope of application.
They are intended to provide some form of legal flexibility to accommodate and solve
problems which are not regulated by codified norms. These “open” clauses can help to avoid
results which are against the considerations of justice despite being compliant with written
rules. Blanket clauses are subject to interpretation and substantiation by the judge. Often there
is implicit or explicit reference to morals in these clauses. For example, according to the
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blanket clause in section 138 of the German Civil Code, legal transactions contrary to public
policy (sittenwidrig) or usurious transactions are void. The bona fides provision (Treu und
Glauben) is laid down in section 242 of the German Civil Code. Similarly, section 31 of the
German Securities Trading Act that implements Article 19 MiFID requires that an investment
firm must act honestly, fairly and professionally in accordance with the best interests of its
clients when it is providing investment services to them. Terms such as honesty, integrity and
fairness form an integral part of the ‘moral vocabulary’. The definition and adjudication of
these ‘general clauses’ therefore requires recourse to customary rules and consideration of
morals (Dreier, 1986: 891).
Islamic law, or more precisely the Sharia, is not only law in the narrow (or positivist) sense. It
does not only extend to the relationship between individuals (muʿāmalāt) but also between the
individual and God (ʿibādat). Thus, unlike secular systems, the legal system of Islam goes
beyond mere legal technicalities and into the realm of morality. While it is not the place here
to go into details about law theories in the context of Islamic law (see Emon, 2010; 2011) or
the classical theories on Sharia and human nature (fitra) (see e.g. March, 2009), it can be
claimed that the theoretical concept of Islamic law is quite close to natural law (see e.g.
Habib, 2011, pp. 3; for the definition of natural law see above). Islamic law is not “sacralised”
but in a sense “moralised” because the norms have a metaphysical reach and implication in
the hereafter. However, despite this overlap, there is still a formal distinction between law and
ethics in Islam. According to the “defining law” principle (ḥukm al-taklīfī) in Islamic
jurisprudence, any human act will fall under one of the five categories: obligatory (farḍ or
wājib), recommended (mandūb), reprehensible (makrūh), permissible (mubāḥ) and forbidden
(ḥarām). While the first and last categories (farḍ or wājib and ḥarām) have legal force, the
remaining three categories between them are not binding law and not justiciable in courts.
They fall in the domain of (non-obligatory) morals (Kamali, 2003: 413; Rohe, 2009: 10). The
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obligated person (mukallaf) earns spiritual reward (thawāb) for adherence to these moral
norms (Kamali, 2003: 413). Moreover, the distinction between act (‘amal) and intention
(niyah) reflects the existence of two distinct spheres. The dichotomy between law and morals
is also reflected in the hiyal (stratagem) controversy. Some Muslim jurists argue that formally
legitimate contracts may lead to unlawful ends and render the contract illegitimate (Hegazy,
2005: 143). These jurists argue that the teleological objectives (maqāṣid) of Sharia norms
have priority over the form (see for details Kamali, 2003: 351).
Legal norms and ethical norms, whether these be religiously grounded or not, are often
congruent, as mentioned before. However these two normative spheres can conflict with each
other in some situations. For example, structured instruments, collateralized debt obligations,
derivatives or naked short sales may be in conformity with legal provisions but problematic
from a moral perspective. In its judgment a German court called a certain interest swap a
“gambling constructed by the bank” (Oberlandesgericht Stuttgart, 26 February 2010 - 9 U
164/08). Thus, it might be perfectly legal to sell such financial products to customers provided
that the bank complies with its legal duties. Even if the customer is, let us say, an elderly
person who invests his or her pension savings into a high-risk instrument and suffers a total
loss, the bank will usually be on the safe side from a legal perspective. This is clearly an area
of conflict, most notably between freedom of contract and moral considerations, which is not
always easy to resolve (see also Schneider, 2010: 607). In such situations integrity rather than
mere legality can avoid frictions, loss of trust and other negative results. Legal loopholes and
gaps, for example with regard to financial innovations, can also make the assessment of
legality difficult. If legality is not sufficient to frame policy or when the law is silent, ethical
norms can have a regulative effect.
In the Islamic context, a conflict between law and morals can be demonstrated by the
following example: It is legitimate to demand back lended money when it is due. However,
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the creditor is advised to grant the debtor facing financial hardship an additional time to pay
or even forgive the debt (see Qur’an 2:280).
III.
Character and content of codes of conduct
1. Definition and character of codes of conduct
Codes of conduct are a modern form of self-regulation and as such a tool of private
governance and self-control. An ethics framework is often an expression of corporate culture.
Codes of conduct usually represent ethical postulations complementing legal regulation.
Codes of conduct generally contain provisions regarding confidentiality, conflicts of interest
management, limitation of direct competition, prohibition of corruption, restrictions on
trading in the company’s securities, whistleblowing rules etc. For financial institutions and
other corporation, these arrangements that are undertaken and implemented on a voluntary
basis offer the advantages of speed, consensus and flexibility, as opposed to formal rulemaking, which are usually lengthy processes (see also par. 8 of IFSB Guiding Principles on
Conduct of Business for Institutions offering Islamic Financial Services). A major advantage
of ethics codes is that they can take into account specifics of a certain market or industry as
well as religious or cultural characteristics in order to ensure broad acceptance by
stakeholders. This aspect is particularly important for Islamic financial institutions since they
base their operations on religious principles. It is also important for the application of ethics
codes within multinational financial institutions with operations in different countries and
cultural settings. The code may have the function of an umbrella covering all elements of a
global corporation. It can balance the gaps and disparities that can arise from the
fragmentation of national legal systems of various jurisdictions in which the corporation
operates (Arrigo 2006: 102).
Codes of conduct are generally not legally binding but instead accepted due to selfcommitment which can result from a moral or religious orientation.
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Despite their non-binding character codes of conduct have a regulative effect. Moreover, the
rules can be enforced (for more details see below IV.). They become usually de facto
mandatory due to the expectation of investors and other stake holders. Because reputational
damage can sometimes have more severe consequences for the affected company or its
managers than civil liability or criminal conviction. Thus, companies generally do not risk
being stigmatized as immoral.
2. Codes of conduct in Islamic banks and financial institutions
The AAOIFI and the IFSB have formulated specific governance frameworks and ethics
standards for Islamic financial institutions. The AAOIFI adopted in June 1998 a special code
of ethics for accountants and auditors of Islamic financial institutions. A similar standard was
adopted in April 2002 for the employees of Islamic financial institutions (code of ethics for
employees) which will be presented and analysed below. The IFSB adopted the “Guiding
Principles on Conduct of Business for Institutions offering Islamic Financial Services” in
December 2009.
Both the AAOIFI code of business conduct and the Guiding Principles postulate abstract
moral guidance. Some of the articles contained in the two standards are in an aspirative and
vague language. They draw idealistic objectives leaving much room for interpretation. The
code of ethics for employees of Islamic financial postulates for example as follows: “Loving
good for others, just as he would love it for himself, and avoiding envy [...]”.This can hardly
be subject to material evidence. In contrast, other postulations are more concrete. The IFSB
Guiding Principles contain explanations, best practise recommendations as well as
illustrations which help management and employees of an Islamic financial institution to
better understand and implement the principles. They also facilitate the interpretation of the
purpose and content of a provision. Some of the principles reiterate legal obligations which
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are generally already contained in labour laws or constitute contractual duties in employment
contracts.
a) AAOIFI Code of Ethics
The code of ethics for employees attempts to achieve the following objective which is laid
down in par. 3/1 of the code: “Developing the employee’s ethical and professional awareness
and, assuming the employee has ethical commitment, the code brings to his attention the
ethical issues involved in professional practice and provides guidance as to what is and is not
considered ethically acceptable behaviour from a Shari’a perspective”.
The code makes clear reference to the Sharia and follows from Sharia principles. Various
verses from the Qur’an are quoted. According to the code of ethics for employees of Islamic
financial institutions, the code is aimed at all employees of the institution at all levels. Hence,
it includes e.g. front-office staff as well as bank management. It lays down an ethics
framework which is “derived from the rules and principles of Islamic Sharia” as well as “the
provisions contained in man-made laws or contracts which do not conflict with the rules and
principles of Islamic Sharia” (par. 2). It is further based “on the codes of ethics currently in
use by the banking profession insofar as it does not conflict with the rules and principles of
Islamic Sharia” (par. 2). The code further states that the Sharia-based ethics “have a selfobligating force that is based on permanent religious motives which transcend, in their
objectives, other official or self-interest motives”. Moreover, it states that “since the banking
profession is an occupation that is affected by the values and ethics of society, it is imperative
that such values and ethics are those of an Islamic society. This should then be reflected in the
personal profiles as well as in the professional qualification and training of those working in
these institutions (par. 2).
The code explains what is meant by the objectives in terms of their practical implementation.
For example, the explanation of righteousness goes as follows: “Righteousness is one of the
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reasons for amity and brotherhood. Allah encourages us to co-operate in righteousness and
even associates it with piety. He says: Help ye one another in righteousness and piety (Qur’an
5:2). This is because in piety lies the pleasure of Allah, and in righteousness lies the pleasure
of people. The one who combines Allah’s pleasure with that of the people achieves complete
happiness. The Prophet, peace by upon him, said: Hearts are used to love the one who is kind
to them, and to dislike the one who is unkind to them” (par. 3/4).
The code requires for example the implementation of justice, even if oneself or one’s relatives
are involved, and exposing untruth even if doing so is contrary to personal interests and
preferences for relatives or friends. Avoiding all actions which may lead to situations that call
for apology (par. 6/1/3). This requirement is similar to whistle blowing rules.
Paragraph 7 of the code governs the enforcement of the code “which includes incentives and
disciplinary actions, either material or non-material, that are laid down by the relevant
bodies”.
b) IFSB Guiding Principles on Conduct of Business
The Guiding Principles on Conduct of Business for Institutions offering Islamic Financial
Services (“Guiding Principles”) is a framework that intends to “complement and “add value”
to other existing internationally recognised frameworks that set out sound principles and best
practices pertaining to the conduct of business by participants and institutions in the
conventional banking, insurance and capital market industry segments, by addressing the
specificities of the Islamic financial services industry” (par. 2). The Guiding Principles are
applicable to all institutions offering Islamic financial services in the banking, Takaful
(Islamic insurance) or capital market segments, including “windows” of conventional firms.
In accordance with the objectives of the IFSB, the Guiding Principles do not aim to “reinvent
the wheel”. Rather the objective is to reinforce the existing internationally recognised
frameworks or standards for the conduct of business taking into account the specificities of
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Islamic financial institutions. As such, the Guiding Principles seek to complement and
strengthen those codes of business conduct that are already in place (par. 4). Similar to the
AAOIFI code of ethics for employees, the IFSB Guiding Principles highlight that observing
principles of good business conduct is not only socially desirable for Islamic financial
institutions but also a Sharia obligation. Moreover, the Guiding Principles refer to the primary
sources of Sharia, the Qur’an and the Sunna. Appendix 1 indicates verses of the Qur’an and
Hadith addressing conduct of business.
Whereas some provisions of the IFSB Guiding Principles are directed to Islamic financial
institutions on an organisational or infrastructural level, most of the articles are addressed to
employees as institutional stakeholders and active members of the financial institution.
Principle 1 of the Guiding Principles requires that an Islamic financial institution shall aspire
to the highest standards of truthfulness, honesty and fairness in all its statements and dealings,
and must treat its customers fairly. It highlights that Islamic financial institutions should not,
either deliberately or through negligence, issue information that is potentially misleading to
stakeholders or the market, nor should it manipulate prices. Principle 2 of the Guiding
Principles provides that an Islamic financial institution “shall exercise due care and diligence
in all its operations, including the way it structures and offers its products and provides
financing, with particular regard to Sharia compliance, and to the thoroughness of research
and risk management”. Principle 3 requires that an Islamic financial institution shall ensure
that it has in place the necessary systems and procedures, and that its employees have the
necessary knowledge and skills, to comply with these principles and other IFSB standards.
Principle 4 stipulates that an Islamic financial institution shall take steps to ensure that it
understands the nature and circumstances of its clients, so that it offers those products most
suitable for their needs, as well as offering financing only for Sharia-compliant projects. The
principle states that the principle regarding information about clients obviously includes the
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principle “Know Your Customer”, already applied by banks, but has a broader import, as it
also includes having the capability of understanding a client’s needs in order to avoid misselling. In this context questionnaires and interviews with the clients as well as a written
record is required in paragraph 34. This provision is similar to the disclosure requirements in
most
jurisdictions
(e.g.
Article
19
MiFID
(Markets
in
Financial
Instruments
Directive 2004/39/EC); sec. 31 and 34 German Securities Trading Act). It also provides that
an Islamic financial institution needs to know that its customers’ businesses and the purpose
of any financing provided are consistent with the Sharia. Principle 5 requires that an Islamic
financial institution shall provide clear and truthful information both in any public document
issued and to its actual and prospective clients, both during the sales process and in
subsequent communications and reports. Article 6 stipulates that an Islamic financial
institution shall recognise the conflicts of interest between it and its clients that arise from the
type of products it offers, and either avoid them, or disclose and manage them, bearing in
mind its fiduciary duties to investment account holders as well as shareholders. The final
principle 7 provides that Islamic financial institution must be able to demonstrate that its
operations are governed by an effective system of Sharia governance and that it conducts its
business in a socially responsible manner, including appropriate charitable activities.
According to par. 3 of the Guiding Principles on Sharia Governance Systems for Institutions
offering Islamic Financial Services, the term “Sharia Governance System”, refers to the set of
institutional and organisational arrangements through which an institution offering Islamic
financial services ensures that there is effective independent oversight of Sharia compliance
[...]”.
IV.
Implementation, Monitoring and Enforcement
Market discipline plays an important role in making sure that fundamental ethical standards
are adhered to. Individuals usually have a good sense of what is meant by “ethical” behaviour
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and what is morally “right” or “wrong” in a certain situation. Most people are allegiant to the
Kantian categorical imperative which is also known as the “golden rule”. However, markets
and actors who are motivated by self-interest do not sufficiently guarantee ethical behaviour.
Commitment to Islamic moral principles cannot be taken for granted as well. Islamic financial
institutions may also suffer from breaches of fiduciary responsibilities or the consequences of
asymmetric information (see Grais/Pellegrini, 2006: 6). Therefore instruments of
implementing and monitoring ethical principles are required.
Some major ethical aspects and reflections are already contained in prevailing corporate
governance structures and risk management rules. However, in most jurisdictions compliance
with corporate governance codes is generally not mandatory. The UK, Germany and Bahrain,
for instance, apply the best practice standard “comply or explain” for listed stock corporations
(see e.g. section 161 of the German Stock Corporations Act). Compliance with the UK
Corporate Governance Code, for instance, is supervised by the Financial Services Authority.
Despite its non-mandatory nature, non-compliance with the Corporate Governance Code can
lead to sanctions and administrative fines. In Germany, failure to declare conformity with the
corporate governance code may trigger liability issues or the risk of contestation of general
assembly decisions. The same applies if the declaration of conformity is incorrect either
intentionally or negligently (see e.g. Hüffer, 2010: § 161 mn. 25 et seq.).
For ethical standards that are not already contained in corporate governance regimes, further
means of implementation and application need to be developed.
There are at least three instruments for the substantiation and implementation of ethics
frameworks. First, management could make use of its directive authority and give clear
instructions to their employees. This would enable management to act instantly on an ad-hoc
basis. The second instrument is the integration of the code into the employment contract. This
can be done by explicit reference to an external ethics framework. Finally, the code could also
be implemented through collective or work council agreement. This ensures the involvement
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of personnel as addressees of the code (bottom-up method). Another soft means of
implementation is creating continuous awareness and acceptance for ethics. Formal
organisational systems that measure and reward performance must be designed to encourage
value-adding, ethical behaviour. For example, incentives for moral behaviour could be
integrated into the remuneration and bonus systems (see Brickley; Smith; Zimmerman
2003:42).
In any case, the code of conduct has to clarify, for example, what a right decision and action
means. Consequently, the articles of the code need to be worded in a clear and simple manner
that is direct and comprehensible. Technical language should be avoided. In order to prevent
ambiguities and misunderstandings, it should contain definitions of important terms used in
the ethics framework. It should ideally explain the specific purpose of a rule. Uncertainties
would otherwise go at the expense of the employer.
Management should be subject to the same rules of the ethics framework and supervision by
the supervisory body of the company.
In Islamic financial institutions, Sharia boards could advise on ethical matters. The Sharia
certification process should not only be based on formal lawfulness of a transaction. Sharia
scholars should also have in view the ethical implications of a transaction. Investments should
be sustainable and socially responsible. Monitoring compliance could be entrusted to the
compliance officer or an ethics committee reporting directly to management. This committee
should revise and adapt the code of conduct where necessary, e.g. if shortcomings are
identified or new situations such as changes to the corporate structure occur. Clear
organisational structures, competences and reporting lines should be established where more
than one body supervises compliance with the code of ethics. The code of conduct should be
communicated inside and outside the financial institution. Management, employees and other
members of the company should be regularly trained about the purposes and postulations of
the financial institution’s ethics framework by the responsible body.
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One has to be aware that the applicability of the code is not unlimited. The ethical objectives
must not be turned into their opposite, e.g. by restricting employees’ or managements’
individual freedoms and rights. Especially ethical norms or moral practices should not limit
the freedom of thought, conscience and belief or non-belief as well as religious practice of the
employees or management. For example, there is a variety of court decisions by German
labour courts regarding the directive authority on the one hand and the rights of the employees
on the other limiting the scope of directive authority. The court cases involved for example
conflicts regarding dress codes, disputes about praying during working hours or political
activity within the company. These decisions can be taken as guidelines when formulating
codes of business conduct and defining management’s directive authority. While employees
and management should be expected to put a good example in their private life or outside
work, the code of conduct should only be applicable in the context work and in close
conjunction with the contractual duties. Extending the applicability of the code too much into
the private sphere or leisure time of staff can be problematic from a legal point of view. Only
in exceptional cases and with sufficient interconnection with work, adherence to the code
could also be expected in private settings.
Consequences and sanctioning mechanisms for misconduct should be sufficiently clear and
foreseeable for the addressee. The degree of sanctions should vary according to the type of
violation and respect the principle of proportionality. The sanctioning instruments could reach
from disapproval or warning letters to disciplinary measures, transfer or dismissal of an
employee (Arrigo 2006: 101). It is important to assess whether the misconduct was intentional
or negligent. The enforcement of the code should be in line with the basic rights and
particularly the fair trial principle. Accordingly, the person concerned should have as a
minimum the right to be heard – preferably by a competent and impartial body of the
company.
19
V.
Conclusion
The impact of religion and spirituality on economic behaviour has been the subject of
extensive academic research. In his renowned work “Die protestantische Ethik und der Geist
des Kapitalismus” Max Weber (1904) characterised the significant role of faith on economic
development. Similarly, behavioural economics and finance come to the conclusion that
people often make decisions based on approximate rules of thumb, not strict logic. The recent
financial crisis is not only a result of a lack of regulation and rules. It can be attributed to
failure of market discipline, weaknesses in corporate governance arrangements and to an
important extent to breach of trust and deteriorating business ethics. Warde, for instance,
criticises that the abundant literature on corporate governance has an ethnocentric character.
In his view, a one-size-fits-all approach that assumes Anglo-American practices and norms,
places heavy emphasis on checks and balances and monitoring compensation or conflicts of
interest and the like, is not always deemed to be the most adequate and effective response to
corporate governance challenges (see Warde, 2005: 15).
Religious foundations and the inherent ethical values provide an explanation for the
developmental path of corporate governance structures. However, despite their influence on
governance systems diverse cultural elements and moral aspect are still not sufficiently taken
into consideration when discussing new corporate governance frameworks. Codes of conduct
can integrate a values-based functional approach into the risk-based corporate governance
approach. These voluntary rules based on moral principles can also take into account the
specifics of a certain market or cultural differences. This is particularly true for Islamic
financial institutions which are not only obliged to Sharia principles but also have a specific
organisational and operational structure that requires special consideration. Most ethical
norms are of transcultural and universal nature (Küng, 2010: 239). Nevertheless, Islamic
moral principles are distinct from ‘secular’ ethics for they are based on faith. The religious
20
foundation of the ethics framework is clearly set out in the ethics standards designed by the
AAOIFI and the IFSB. Adopting a code of ethics is not sufficient to ensure ethical behaviour.
Consequently, monitoring systems need to be installed in order to ensure that the rules of the
ethics framework are adhered to. Various ways can be found to implement ethical norms
within existing corporate governance architectures. The rules can be implemented and
enforced by the use of management’s directive authority, the integration of the code into the
employment contract or through collective or work council agreements. When putting ethical
norms in place it is important to take market logic into account. It is also crucial that the code
is based on a broad consensus and acceptance by the stakeholders. Another crucial condition
for effective implementation is the respect for personal rights and freedoms of stakeholders.
Rules contained in codes of conduct should not be ‘imposed’ on the addressees. Sanctioning
instruments for violation of the code of conduct should be worded in a clear and foreseeable
manner.
Despite their non-compulsory character, ethical rules laid down in codes of conduct often
have a regulative effect due to market expectation and self-commitment by those who set
these rules. If ethical frameworks on the internal corporate level are well-designed, balanced
and functional and if they fit into the organisational architecture of the company, they can
create “strategic value” for the company and its stakeholders. The ethical is not the antithesis
of the efficient. Although it is difficult to assess the economic effects of ethics empirically,
there is general consensus about the optimising and value-creating effect of ethics in the long
run. Ethical behaviour regularly results in immaterial value. It fosters mutual trust and
establishes sustainability. However, a moral system which has continuously adverse impact
on individuals’ interests is not sustainable. Thus, moral values have to be brought in balance
with market logic in order to be applicable and viable in reality.
21
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