Wednesday, December 5, 2012

Islamic Banking: Shari'a Governance

One of the first matters to be addressed as the Sultanate of Oman moves to implement Islamic banking is Shari`a governance within Islamic banking institutions (i.e., full-fledged domestic Islamic banks, Islamic windows of conventional domestic banks and Islamic banking branches of foreign banks, which are referred to as “Licensees”). Shari`a governance is a subset of the general obligations and corporate governance framework and includes a range of topics that are particular to Islamic banking activities.

This article addresses a subset of those Shari`a governance matters, specifically certain matters pertaining to Shari`a supervisory boards (each an “SSB”) and related Shari`a governance entities and mechanisms. These topics are addressed in Title 2 (“Title 2”) of the proposed Islamic Banking Regulatory Framework of the Central Bank of Oman (the “CBO”), Version 2.0, of March 2012 (the “IB Framework”).

As a notable general position, the IB Framework makes reference to, and encourages (but does not seem to mandate) adoption of and adherence to, various guidelines of the Islamic Financial Services Board (“IFSB”). The explicitly referenced IFSB guidelines include the Basic Professional Ethics and Conduct for Members of the Shari 'a Board pursuant to the Guiding Principles on Shari 'a Governance Systems for Institutions Offering Islamic Financial Services (December 2009), the Guiding Principles on Conduct of Business for Institutions Offering Islamic Financial Services (December 2009), and the Guiding Principles on Corporate Governance for Institutions Offering Islamic Financial Services (December 2006).

Under the IB Framework, the required Shari`a governance structure is implemented by mandating each Licensee to (a) provide, in its memorandum and articles of association, for the conduct of its business in accordance with Islamic Shari`a principles, (b) establish and maintain systems and controls to ensure Shari`a compliance of its operations and business activities (in addition to the normal compliance requirements), (c) appoint an SSB to oversee operations from a Shari`a compliance perspective and prepare and present an annual Shari`a compliance report to the Licensee’s Board of Directors, and (d) implement a system of Shari`a governance as specified in Title 2.

The Shari`a governance system is the “hallmark and the differentiating factor for Islamic Banks and Islamic Windows which sets them apart from their conventional counterparts”. Its critical elements are (i) the SSB, (ii) the Internal Shari`a Reviewer, (iii) the Shari`a compliance unit and the Shari`a audit unit. The ultimate responsibility for ensuring Shari`a compliance, and the implementation of the required governance systems, lies with the Licensee’s Board of Directors (“Board”), although both the SSB and management have related responsibilities.

Constitution of SSBs

In other words, the restriction on the employee’s right to compete should be no greater than what is necessary and lawful to protect the employer’s business interests.

Licensees must establish their own independent SSBs, although there is a limited outsourcing exception for small institutions as approved by the CBO. Foreign banks must demonstrate to the CBO that their SSB satisfies the requirements of Title 2.

Each SSB must be comprised of at least three Shari`a scholars, and each scholar must be specialized in fiqh al-mu’amalat (Islamic commercial jurisprudence). An SSB may also include one or more non-voting members who are not specialized in fiqh al-mu’amalat but have expertise in Islamic banking or related areas, such as finance, economics, law, accounting or the like and possess basic knowledge of fiqh al-mu’amalat.Licensees are encourage to the use of Omanis on SSBs and to encourage the development of relevant Shari`a expertise among Omanis. These provisions are supplemented by provisions that allow the SSB to consult with outside experts in appropriate circumstances on a case-by-case basis. As a general admonition, the IB Framework indicates that SSB members should come from diverse backgrounds in terms of areas of expertise, qualifications and experience in order to enhance the depth and breadth of Shari`a deliberations and, additionally, should be familiar with the domestic legal and regulatory environment and sensitivities of the Sultanate of Oman.

The IB Framework contains a number of required qualifications (“fit and proper” standards) for SSB members. Most are stated as general requirements, without specific standards. All members must be of respectable character and be of good conduct, particularly in terms of honesty, integrity and reputation in their professional business and financial dealings. SSB members must be Muslim. It is unclear whether this applies to only Shari`a scholar members or also non-scholar members. The rationale for allowing non-scholar expertise with respect to professional matters to be brought into the SSB on a non-voting basis (as noted below, and subject to the conditions noted below) supports an interpretation that such expertise should be sought at the highest and most refined levels, without regard to affiliation restrictions. This matter will be left to future clarification.

SSB members with a Shari`a background must be holders of academic qualifications in the field of Shari`a (a minimum of a bachelor’s degree) that includes the study of usul al-fiqh and fiqh al-mu’amalat from “a recognized institution” (an undefined phrase). Those members must also demonstrate “an adequate understanding of finance / banking in general and Islamic finance / banking in particular” as well as an understanding of the legal and regulatory frameworks applicable to the functions of the Licensee. Shari`a scholars must have accumulated overall experience of ten years or more (in teaching, research, issuance of fatawa and similar matters). And they must demonstrate a strong proficiency in Arabic. It is also recommended that they have reasonable understanding of English.

SSB members other than Shari`a scholars must be individuals generally recognized for their expertise in their respective field (e.g., banking, finance, economics, law, accounting, etc.). They must hold at least a master’s degree. Non-scholar members must have accumulated relevant experience of 15 years or more in the relevant field. These non-scholar members should demonstrate reasonable proficiency in English, and it is recommended that they have some understanding of Arabic.

The IB Framework provides for disqualification of an individual from SSB participation for a range of “for cause” events, including (a) cessation of good character and reputation or a position of respect among one’s peers, (b) failure to attend a substantial number of meetings without reasonable excuse (currently, 75%), (c) association with any unethical or illegal activity, including contravention of any of the requirements and standards of the financial, banking or corporate regulatory system, (d) conviction of any criminal offense, including financial impropriety or moral turpitude (except misdemeanors), (e) dismissal as an employee or director from any entity on the grounds of fraud, misrepresentation or breach of trust, (f) use of confidential and privileged information about the Licensee or its clients obtained as a result of his position in a manner that is detriment to the competitive interests of the Licensee in the market place (but, apparently, not if otherwise in contravention of confidentiality requirements), or (g) assumption of membership in the SSBs of two or more competing financial institutions in Oman.

With regard to clause (g) of the next preceding paragraph, and as noted above, no SSB member can be on the SSBs of more than one competing institution in Oman. However, an SSB member can be on the SSBs of more than one non-competing institutions. The example provided in the IB Framework is that an Islamic bank SSB member can also sit on the SSB of a takaful company or an Islamic fund management company. However, no SSB member can be on the SSBs of more than four institutions in Oman.

The SSB is appointed by the Licensee’s shareholders upon the recommendation of its Board. The IB Framework does not address situations in which a foreign bank might have a different method of SSB appointment. An SSB member may be appointed for a maximum initial term of three years, and can serve one consecutive renewal term of three years on that SSB.

Roles and Responsibilities of SSBs

The SSB is entrusted with the duty of directing, reviewing and supervising the Licensee’s activities in order to ensure Shari`a compliance. The SSB is obliged to issue fatawa in respect of matters considered by it, which fatawa shall be determined by majority vote of the SSB’s Shari`a scholars and are binding on the Licensee.

The SSB’s scope of work is prepared by the Licensee and approved by its Board and is set forth in a charter. The charter must address a range of matters, including, at a minimum, (a) its purpose, (b) the membership and composition of the SSB, (c) the SSB’s chairperson and secretary, (d) grounds for removal and replacement of SSB members, (e) responsibilities and authority of the SSB, (f) meetings, agenda, quorum, voting, minutes and procedural requirements, and (g) amendment matters.

The responsibilities of the SSB include, without limitation: (i) advising the Board and management on Shari`a matters in the Licensee’s day-to-day business; (ii) review and approve all policies, procedures, products, processes, systems and contracts as to their Shari`a compliance, each to be subsequently ratified by the Board; (iii) review and approve products and related documentation, including structures, contracts, marketing and implementing materials; (iv) performance of follow-up to ensure compliant implementation of products; (v) review and approve Shari`a compliance and Shari`a audit functions; (vi) provision of guidance regarding Shari`a compliance to legal counsel, external auditors and other related parties; (vii) provision of written fatawa on relevant matters brought to it through the Internal Shari`a Reviewer or taken up by the SSB itself; (viii) submission to the Licensee’s Board of an annual Shari`a compliance report that addresses the rather detailed matters, and satisfies the standards (including the detailed opinion standards and requirements), set forth in the IB Framework, and (ix) development and implementation of annual training programs for SSB members regarding deficiencies in knowledge regarding banking, finance, economics or other related disciplines for SSB members with Shari`a background and Shari`a-related knowledge for SSB members who are experts in their respective fields but do not have adequate knowledge of Shari`a.

The report’s opinion paragraph included in its annual report (clause (viii) above) must address a variety of matters as specified in the IB Framework. These include whether the SSB has examined, “to a reasonable extent on a test-case basis, each class of transaction, the relevant documentation and procedures”. As one might expect, the opinion must also state, whether, in the SSB’s opinion, the affairs of the Licensee have been carried out in accordance with the rules and principles of Shari'a, the CBO's regulations and guidelines regarding Shari`a compliance and other rules as well as with specific fatawa and rulings issued by the SSB from time to time. The opinion must also address whether, in the SSB’s opinion, the allocation of funds, weightages, profit sharing ratios, profits and charging of losses (if any) relating to investment accounts conform to the basis given by the SSB in accordance with Shari`a rules and principles and whether there has been income from prohibited sources. Obviously, flesh will be put on these bones in the future.

The SSB is required to define the key elements to be evaluated while reviewing and approving a new product. These key elements establish the basis for developing the relevant product prior to its final presentation to the SSB for approval. Key elements pertain to, at a minimum, essential features of the product, processes, structure, documentation (including legal contracts), risk and compliance considerations, marketing, collateral and other necessary details. New product development must include an opportunity for the expression of views by, among others, internal and external auditors, lawyers and others involved in the process. The SSB will determine a product’s Shari`a compliance in the context of relevant fiqh literature, evidence and reasoning.

The IB Framework requires the SSB to report to the Board, non-compliant activities that it has “reason to believe” [are being] carried out in a systematic manner by the Licensee. If those activities shall continue, the SSB is required to inform the CBO and report such violations in its annual Shari`a compliance report. It is likely that the “reason to believe” and “systematic manner” qualifications will give rise to the need for further clarification in the future.

The SSB is required to issue fatawa and guidelines relating to products and bank functions. These are required to be maintained as central reference tools, be disseminated to Licensee employees, and be published in the annual Shari`a compliance report.

The IB Framework outlines a system for the protection of confidential, privileged and sensitive information made available to the SSB. This information may pertain to, among other matters, new product development and transactions, SSB and management decisions, matters presented to the SSB, discussions and deliberations of the SSB, Licensee client information under the banking laws, and matters so designated by management.

Fiduciary Duty and Conflict of Interest Provisions

A welcome development in the IB Framework, although one likely to give rise to some spirited discussion, relates to the considerable array of provisions that are designed to address fiduciary duties, conflicts of interest and related matters involving SSB members. These are defined as obligations to all of the Licensee and its stakeholders, the general public and the industry. Some of those have been previously discussed and relate to prohibitions on SSB members acting on the Shari`a boards of more than one competing institution or more than four institutions in Oman. Others require fairness, objectivity and independent functioning by the SSB members, in both substance and appearance, free from conflicts of interest, and the members are required to continually assess that status.

In a move toward the development of more stringent professional responsibility standards than are seen in most jurisdictions, the IB Framework addresses situations involving even the appearance of impropriety. For example, SSB members shall not have (a) any relationship with the Licensee that “could possibly be seen to interfere or reasonably be perceived to interfere” with the exercise of a member’s independent judgment when delivering fatawa and rulings or (b) any relationship that “could possibly be seen to interfere or reasonably be perceived to interfere” with the exercise of independent profession judgment. These are strong standards, and constitute a strong move toward a code of professional conduct and professional responsibility for SSB members. It will be interesting to see how these requirements are given definition. Some definition is provided by the IB Framework’s restrictions on employment, board positions, relationships (including those with family members of, and stakeholders of, the Licensee) and managerial and operation responsibilities that are expressly specified. More detail will undoubtedly be forthcoming as the framework is implemented.

The Board is required to undertake annual checks on the independence and conflicts of interest of SSB members as well as their annual performance and report the results to the Central Bank of Oman. The SSB members are made solely and personally responsible for their own work as members of the SSB. Notably, the SSB members are admonished to “appreciate the diversity of opinions among various mainstream schools of thought and differences in expertise among the fellow members” of the SSB.

In the event of an actual or potential issue of independence impairment, SSB members are obligated to document the issue, review and address the issue with the SSB, and, if the issue is unresolved, resign from the SSB and take the issue to the Licensee’s General Assembly. This is yet another step toward a strong professional conduct and responsibility framework. How it will be implemented is yet to be determined.

Management Responsibilities to SSBs

SSB members are required to enable and assist the Licensee’s management by providing advice and guidance regarding Shari`a compliance. Management, on the other hand, is responsible for observing and implementing SSB fatawa, rulings and decisions, and making them available to those who have implementation responsibilities and to other stakeholders. It is obligated, on a timely basis, to disclose information and provide necessary informational access to the SSB through the Internal Shari`a Reviewer (or risk Board penalties). Management is obligated to allocate adequate resources (including people, systems and processes) to support the Shari`a governance framework.

In instances of non-compliance with the Shari`a requirements, the management is obligated to take remedial action, including notification of the Internal Shari`a Reviewer and the SSB, cessation of new business relating to the non-compliance, and acting on the remedial and preventative advice of the Internal Shari`a Reviewer and/or the SSB. These are commendable steps toward strong professional conduct and a professional responsibility system, but these steps leave a broad range of unaddressed questions.


The Shari`a governance system that is to be implemented in the IB Framework is already the subject of considerable, and spirited discussion in the Islamic finance, banking and investment industry. It will certainly evolve as it is given greater form and substance. All are urged to participate in the on-going discussions as this is a fundamental, and forward looking, centerpiece of the Islamic banking governance package that the CBO desires to implement.