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«ABSTRACT This conceptual paper develops a discussion expounding the Islamic perspective of corporate governance as a special case of a broader ...»

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Appeared in Corporate Governance, 6:2, 2006

CORPORATE GOVERNANCE IN ISLAMIC PERSPECTIVE

Masudul Alam Choudhury* & Mohammad Ziaul Hoque**

ABSTRACT

This conceptual paper develops a discussion expounding the Islamic perspective of

corporate governance as a special case of a broader decision-making theory that uses the

premise of Islamic socio-scientific epistemology. Islamic epistemology is premised on

the divine oneness of God. The worldly explanation of divine unity is done by means of specific laws and instruments that make the Islamic epistemology functionally viable in developing, implementing and inferring from the application of the epistemological rules to different issues. In our present case the issue is of corporate governance.

The development and conclusions of this discursive paper as a conceptual one point out the possible application of a process-oriented epistemology of unity of knowledge to corporate governance. The underlying methodology of institutional discourse and integration with dynamic parameters is formalized.

The end result of the conceptual framework of this paper on corporate governance is contrasted with the approach to corporate governance in mainstream literature. Also the same Islamic theoretical and philosophical background of corporate governance is examined from the dual (mixed) Islamic economic and institutional perspectives.

The practical implications of the Islamic idea of corporate governance are immense for studying transaction cost minimization in decision-making environments. In this regard we argue that the theory of Islamic corporate governance presents a discursive process, transparency and institutional participation that altogether reduce transaction costs.

This paper contributes fresh knowledge in corporate governance theory in the light of two central issues. Firstly, the central issue is of organic preference formation studied systemically by process model. The second issue is of transaction cost minimization while pursuing such a discursive and participatory model of decisionmaking in an environment governed by a systemic meaning of unity of knowledge as its episteme. Relevant institutional policies are shown to be capable of formulation in the light of such systemic discursion under the episteme of unity of knowledge understood and applied in the systemic organic sense.

Keywords: corporate governance, Islamic economics and finance, epistemology, institutionalism.

-----------------------------------------------------------------------------------------------------------Professor of Economics, School of Business, University College of Cape Breton, Sydney, Nova Scotia, Canada.

** Assistant Professor of Finance, College of Commerce and Economics, Sultan Qaboos University, Muscat, Sultanate of Oman.

2 Corporate Governance In this comparative conceptual paper on corporate governance between Islamic and mainstream orientations on the topic we undertake an epistemological approach in establishing the foundational concepts of corporate governance in Islam. In undertaking the epistemological approach we derive the processoriented discursive methodology of perpetual learning in organizational and systems behavior that emanate from the premise of unity of knowledge. In the broadest Islamic precept the overarching episteme is that of oneness of God. In the systems methodology the emanating derivations from the precept of oneness of God is expressed as oneness of divine knowledge. It expresses itself and explains phenomena in the framework of perpetual knowledge production. This generates systemic learning by discursion and universally complementary relationships between the entities of world-systems and their embedded institutions. In our case the specific category of such an embedded polity and entity is corporate governance in Islam.

What is Corporate Governance?

What is Corporate Governance as conventionally understood? What is Corporate Governance in the Islamic perspective under the epistemological methodology of unity of divine knowledge on which all of Islamic scholarship is premised?

Answers to these questions are first divulged here.

Corporate Governance as a mainstream organizational concept

Corporate Governance has to do with those legal and organizational structures that look after the internal integrity of a corporation. The implication here is that a corporation is an organization and hence an institution. It is thereby a bundle of contracts and rules under which it functions, is legitimated by legal enactment and protected by the legal tenets of any government and state. The implications of such legal obligations and protection may be limited nationally or extended internationally under agreed upon globalization rules.

The latter case forms the extension of the legal statutes and conditions of property rights to the international venue by WTO governance policies such as TRIPS (Trade Related Investment Property Rights), TRIMS (Trade Related Investment Measures), Surveillance and Dispute Settlement Mechanisms, environmental protection, antidumping, corporate transparency, corporate responsibility, equitable distribution of wealth and income, labor laws and many others. As the complexity of the business environment in relation to property rights issues expands, the network of interrelationships among such diverse points of the complexity system grows. In the end there can hardly be anything left out of the extended meaning of corporate governance, though the discernible identification of such governance methods, tools, organization and acceptance go through an evolutionary learning process (Jensen, M.C. 1993).





Corporate Governance 3 Corporate governance as an organizational concept can be derived from the words

of Arrow who writes (1974, p.224):

An organization is a group of individuals seeking to achieve some common goals, or, in different language, to maximize an objective function. Each member has objectives of his own, in general not coincident with those of the organization. Each member also has some range of decisions to make within limits set partly by the environment external to the organization and partly by the decision of members. Finally, some but not all observations about the workings of the organization and about the external world are communicated from one member to another.

The Objective Function of Corporate Governance

The very first objective of corporate governance is to define and attain an objective criterion by means of understanding the relations between critical variables supported by policies, programs and strategic coalitions. The last point leads to the determination of rules of actions, policies and strategies by means of institutional consensus and the exercise of proper instruments as required by the kind of corporation in action. Thus there are three stages involved in the determination of the groundwork of corporate governance. Firstly, there is the collective formulation of objective criteria. In view of the complex nature of networking in corporate governance there must inevitably be multiple objective criteria interlinked in some explainable way.

We define such an objective criterion function as,

W = W(x,P; ≥(θ)) (1)

x = {x1, x2, x3, …, xn} denotes a vector of socio-economic variables between which interrelationships must be studied with respect to market and environing realities. For example, x1 can denote price of good 1, x2 as price of good 2; x3 as the quantity of good 1; x4 as the quantity of good 4. The relationships between these happen through the interaction between demand and supply of such goods in multimarkets (here two markets).

P = {P1, P2, …, Pm} denotes the vector of policy variables and instruments. An example is of P1 as competition policy, P2 as corporate transparency; P3 as a management contract with labor on wages and job security.

≥ denotes strategic preferences of corporate members either in management hierarchy or in co-operative mechanism within team work. The latter kind of strategy can be found in Japanese firms (Kobayashi, 1988). An example is that in order to determine right multimarket prices using the policies of corporate governance as mentioned above, the preferences of the corporate members would be different between competitive markets (the Taylor model of corporate governance) and co-operative strategies (Japanese case).

4 Corporate Governance θ denotes a consensual value of discursive mechanism existing within the corporate organization either in its hierarchical form or co-operative form to establish the preference ≥. Hence we write ≥ as being functionally determined by (θ). That is ≥(θ), which is a key epistemological indicator in the organizational theory of the firm. The structure, and thereby the nature of corporate interrelationship in the specific firm, will be determined by the kind of behavioral preferences formed by the discursive mechanism. In a neoclassical firm competitive behavior will rule foremost. In the co-operative firm complementary relations between multimarkets and the organizational strategies will prevail.

Comparison between Herbert Simon and Kenneth Arrow’s Organizational Theories in the Light of Corporate Governance Theory Herbert Simon (1957) referred to the above kind of simulative approach to decision making in a firm as satisfycing behavior. According to Simon there are three phases of decision making at the organizational level. The first phase is the intelligence activity. This accounts for setting up the favorable conditions for decision-making. The second phase is the design activity. This accounts for searching, discovering and analyzing possible sets of ways and means of interacting with the design activity. The third phase called the choice stage engages in selecting and implementing particular choices of actions that have been discovered and analyzed at the stage of design activity.

Simon’s characterization of an organizational conception of the firm is more process-oriented than Arrow’s. In Arrow’s characterization there is a particular conception of preferences that reside with competing individuals somehow molded together to form the preference of the organization as a whole.

Such a hierarchical preference formation then enters the criterion function of the organization. The maximization behavior along with the competing preferences of individual members makes the preferences those of self-centered individuals, whose individualistic preferences are then molded in ways unknown.

Firstly, such a molding results in lateral aggregation of individual preferences. Then this method of preference aggregation turns out to be simply an analytical nicety of civil libertarianism (Bentham, 1789) rather than a process that explains formation of consensus. The assumption underlying this kind of preference aggregation is that every individual behaves alike and unanimously concedes to a unique preference (Harsanyi, 1955). Despite accepting an argument sometime premised on the capacity for happiness in utilitarian ethics, a convergence to such a unique preference by the methodical rule of lateral aggregation raises the problem of idealism against political realism.

Secondly, such a convergence of preferences can happen by the hegemony of a dominant ruler. This is the kind of decision-making that takes place in any form of democracy where the will of a majority voter wields the power of convergence. The same kind of behavior when extended to international affairs would mean the reign of the will of a certain powerful group over the rest. In the Corporate Governance 5 economic scene the transnational companies have governance over the command of resources and investments in developing countries. Such policy governance is done by the WTO using the policy instruments of TRIPS, TRIMS, and capitalaccord in FDI movements and capital accounts liberalization. The technological dominance of the industrialized nations over the submissive will of the developing ones marks the return of Eurocentricity as a form of institutional governance in the globalization scene (Amin, 1989).

Selection of Corporate Strategies: the Social Wellbeing Criterion Function

Whether it is the maximization or the satisfycing nature of the criterion function, the corporation selects its strategies, and thus has a perspective of the relationships governing x and P. Here too the behavioral factor in preference formation is critical. If the preferences are of hedonism and methodological individualism governing individuals, institutions, organizational behavior and markets, then our earlier selection of the market variables for x1, x2, x3, x4 in multimarkets will show relationship between these markets by way of marginalist tradeoffs. Underlying this perspective of mainstream economics is the pervasive idea of resource allocation between competing ends. It stems from the neoclassical economic roots of the principle of marginal rate of substitution as the governing principle of competition linked with scarcity and both methodological individualism and independence between competing agents and alternatives.

Corporations adopt this principle to govern over alternatives that they assume are faced by the fundamental pre-condition of scarce resources in economic production. The bundle of policies that they adopt, namely intensifying competition (P1), evade competition policy (P2) and exercise control over international resources (P3) by taking protection of the trade and capital-flow liberalization instruments of the WTO and the IMF as mentioned earlier.

The following kinds of relationships will apply between the socio-economic and policy variables that we expect in the two cases of Arrow’s individualism and

Simon’s satisfycing behavior of agency:

1. Kenneth Arrow:

xi = fi(xi’,Pj), where xi’ denotes the xi variable without the ith one (2) i = 1,2,3,4; j = 1,2,3 In corporate governance a strategy to acquire oligopolistic control of market shares will cause xi as price or quantity variable to be determined by the price and quantity based collusion approach (Martin, 1988). Expression (2) forms a system of equations.



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