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Shariah in the spotlight III: Understanding governance in Shariah Law and ESG

Governance is perhaps the least talked about component of ‘ESG’, but is based on concepts of fairness, transparency and accountability that form the basis of good corporate governance.

By Emily Fuller, Deborah Low, Ellen McGinnis and Emma Russell, Haynes and Boone – Governance is perhaps the least talked about component of ‘ESG’, but is based on concepts of fairness, transparency and accountability that form the basis of good corporate governance.

Good corporate governance looks at the relationship among the company and its employees and shareholders, focusing on issues such as the balance of power among the managers, executives and directors of a company, compensation structures, quality control in product generation, transparency in decision making and accountability for corporate action. Good corporate governance structures have long been a factor that investors will consider when making investment decisions as poor corporate governance will expose the company and by extension, its investors to risks, such as shareholder, employee or consumer litigation, penalties for labor law or sanctions violations, lack of approval or authorisation for projects and investment schemes from governmental authorities and regulators, or other punitive actions for violations of applicable law.

However, while all companies may be subject to certain governance laws and regulations, such as accounting standards, mandated governance structures including independent directors, employee hiring and benefits and compliance with law, an ESG evaluation will seek to measure the effectiveness of a company’s protocols for compliance with these regulations, and whether the company is taking additional steps to promote fairness and transparency.

Similarly, Islamic financial institutions are subject to additional rules and regulations which have been developed to ensure good corporate governance and compliance with Shariah. For example, the Accounting and Auditing Organisation for Islamic Financial Institutions sets governance, accounting, and ethical standards for Islamic financial institutions, equivalent to the International Financial Reporting Standards. Islamic financial institutions themselves will also have a Shariah Supervisory Board (“SSB”) whose job it is to review transactions and report as to whether they are Shariah-compliant.

Other entities provide guidance to, and set standards for, the Islamic finance industry as a whole. The Islamic Financial Services Board issues guidance and international principles for the capital markets and banking industries and the Islamic International Rating Agency operates akin to other agencies like Moody’s or considering an entity’s level of compliance with Shariah law principles when assigning a rating.

Among the many similarities between ESG compliant investment criteria and Shariah-compliant investment criteria, there are also a number of differences. Fundamentally, Shariah compliant investing is driven by faith, and as such there may be additional faith-based prohibitions that have not been adopted beyond Islamic finance, such as prohibitions on interest as discussed above, and derivatives. The prohibition of investing in derivatives is based on the prohibition under Shariah law of deceptive uncertainty ‘gharar’, which is founded in the belief that one party should not benefit from taking a risk at the expense of another.

In this context shorting a stock would be viewed in the same negative way as gambling. Additionally, Shariah-compliant investors will be restricted from investing in entities which utilise a large amount of leverage. The specific percentage of permitted leverage will vary depending on the structure in question, but in general leverage which equates to over 33 per cent of the value of assets will be considered too high. Examples of other assets which will be available to ESG compliant investors but prohibited to Shariah-compliant investors include pork products and some forms of entertainment.

Additionally, though Shariah law is governed by a strict set of principles, it does include a legal maxim which is intended to ease and remove hardship. The intention of Shariah law is not to impose obligations on an Islamic financial institution that it is not able to meet. This legal maxim could be applied if a Shariah-compliant investor received a return in relation to an investment which has become non-Shariah-compliant, if, for instance, such investment signified a minor stake in the investor’s overall portfolio, eg less than 5 per cent. 

For example, a Shariah-compliant investor may hold investments in a real estate fund, which holds a hotel in its portfolio, even if such hotel derives some of its income through the sale of alcohol. Similarly, a private equity fund may hold a company in its portfolio which derives some of its profit through receiving interest. If the Shariah-compliant investor receives a distribution from such investments, the SSB could decide to ‘purify’ such a return by making a charitable donation in such an amount as determined by the SSB. 

Alternatively, if the institutional investor’s SSB decides, in its discretion, that purification is not appropriate, or if the haram asset is likely to continue to be part of the portfolio, the SSB may decide to divest from the fund completely. This concept of balancing out negative impacts of corporate action by way of ‘purification’ is not dissimilar to the growing practice of carbon offsetting which permits companies to compensate for their carbon emissions by making equivalent reductions in carbon output in other areas. 

For example, many airlines offer customers the ability to offset the carbon impact of their flight by charging an additional fee which is then donated and applied towards green projects such as tree planting or preventing deforestation. Similarly, funds which hold traditionally ‘non-green’ investments (such as companies which derive their profits from fossil fuels) are increasingly looking to ‘offset’ these investments by ensuring that a certain percentage of their overall portfolio does adhere to ESG parameters, rather than overhauling their entire investment strategy.

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