Chapter 19

Regulating the Islamic Capital Market

Nik Ramlah Mahmood

1. INTRODUCTION

In its formative years, the evolution of the Islamic financial services industry was largely driven by the growth of Islamic banking and takaful (insurance products based on Shari’ah principles). Over the last decade, the emergence of a vibrant Islamic capital market (ICM) in several Muslim countries is a significant milestone that denotes the coming to maturity of the global Islamic financial system. In this context, the growth of the ICM parallels the financial deepening process experienced in many emerging markets, most notably the large developing economies. As a reflection of this trend, the emerging markets’ share of global equity market capitalisation rose from 13 percent in 1990 to 24 percent in 2010.

The expanded role of markets in the Islamic financial intermediation process is already providing many benefits in relation to financing investments and catalysing the growth process in many Muslim countries. More importantly, it provides greater opportunities to shift from a developmental process that is based on replicating conventional finance towards an approach that facilitates financing based on structures and services that originate from risk-sharing concepts and that comply with the ethical principles that draw their roots from Islamic theology.

ICM offers a broad range of capital market products and services to meet the needs of issuers and investors, of which the most prominent currently are equities and sukuk. More recently, there has been considerable progress in expanding the range of Shari’ah-compliant products and services, including collective investment schemes such as unit trust and closed-end funds, investment banking, stockbroking, fund management, private equity, and venture capital, as well as funds and wealth management. To address the risk-management needs of banking and takaful products and operations, derivatives have also been developed, but their use is restricted for purpose of managing business exposures only.

The regulation of the ICM poses several unique challenges as compared to the regulation of Islamic banking and takaful. For example, the traditional products of the banking industry, such as deposits and loans, are effectively direct bilateral contracts between two parties, while capital market products such as sukuk and other investment-based products such as exchange traded funds involve standardised contracts, public disclosure of information, and tradability. Arising from this, markets tend to operate in highly unbounded environments and present regulatory challenges beyond credit and prudential risks. Typically, the regulation of markets would incorporate elements such as surveillance of markets and products and more importantly, from a Shari’ah-compliance standpoint, behavourial control systems such as for disclosures, conduct, and governance.

Development of new products and variants to product structures are also typically more prevalent within the ICM as compared to Islamic banking and takaful, thus requiring greater regulatory monitoring to ensure a sufficient level of investor protection while facilitating orderly growth of the market.

ICM products are also generally becoming more universal in that they are being offered and subscribed to in multiple jurisdictions, for example global sukuk and collective investment schemes. Such cross-border transactions and distributions require more intensive scrutiny from a regulatory perspective to address, inter alia, jurisdictional differences. This development has in recent years contributed to greater collaboration among regulators in order to mitigate the cross-border-related challenges.

2. THE APPLICABILITY OF UNIVERSAL PRINCIPLES OF SECURITIES REGULATION

Given that markets tend to operate in a more open environment, the fundamental challenge in regulating ICM is whether the objectives and requirements of Shari’ah are compatible with the underlying principles of securities regulation. A fact-finding study in 2004 by the International Organization of Securities Commissions (IOSCO)1 concluded that ICM constitutes a segment of the wider global securities market and therefore its regulation should comply with IOSCO’s Objectives and Principles of Securities Regulations (IOSCO Principles), which are intended to:

• Ensure fair and efficient securities markets.
• Protect investors.
• Reduce systemic risk.

According to the IOSCO study, a capital market with a sound regulatory framework and supporting infrastructure must first be present in order to nurture and support an Islamic component; thus ICM products and services may be introduced and developed within any existing well-structured securities market. The study also noted that the conventional securities regulation framework and principles equally apply to the ICM, with the addition of some form of a Shari’ah approval or certification process. The study further noted that formulation of separate regulation for the ICM is therefore unnecessary although it recognised that in certain instances individual jurisdictions may see the need for more specific guidelines to be introduced to ensure that the unique aspects of ICM are appropriately regulated.

The 2004 study was revisited by IOSCO in 2008 with the finding that no concerns were identified with respect to the compatibility of the IOSCO Core Principles with the Islamic securities market, although the implementation of the principles could benefit from further consideration in some specific areas.

The experience of several countries, including Malaysia, has borne out the IOSCO findings in that their ICMs do provide investors the same degree of clarity, certainty, and protection as those available in the conventional market. As in conventional capital markets, effective regulation of the ICM involves the effective interplay of regulatory discipline, market discipline, and self-discipline. In this regard, the process of financial deepening requires strong regulatory oversight accompanied by high governance standards to enable self- and market-disciplinary mechanisms to complement regulatory discipline. Regulations play an important role in defining the arrangements that reinforce investor trust and confidence in the markets. Nonetheless, the active involvement of market participants and other stakeholders is required to ensure that governance arrangements are effective and provide social benefits.

3. APPROACHES TO REGULATING ICM

There are various approaches that are adopted in the regulation of ICM. One approach is to limit the scope of compliance with Shari’ah or other ICM-specific requirements to being governed only by rules relating to disclosure, false information or misrepresentation, and other applicable existing laws. The drawback to this approach is that where ICM product structures or services do not fall within the realm of existing regulation, then there will be constraints in introducing such new products or services. Another approach is to introduce changes to existing laws to cater for specific Shari’ah requirements or to overlay the regulatory framework with an additional tier of ICM-specific regulations.

In fact, both approaches are complementary and useful in addressing various legal challenges. For instance in Malaysia, prior to 2004, all issuance of private debt securities including sukuk (or Islamic securities) was previously regulated under a single set of regulations that was applicable to both conventional and Islamic products, with certain Shari’ah requirements embedded specifically to govern the issuance of Islamic securities. However, since the term “debentures” was used, this had the effect that only sukuk that fit into the definition of debentures such as the bai’ bithaman ajil2 could be introduced. More widely accepted structures—which involve elements of profit and loss sharing (for example sukuk structures using principles such as musharakah3 and mudharabah,4 which are based on equity participation)—were inadvertently precluded.

This impediment was remedied in 2004 when the Securities Commission Malaysia decoupled sukuk from the definition of debentures and introduced a new legal definition for “Islamic Securities.”5 The 2004 Guidelines on the Offering of Islamic Securities6 was introduced specifically to facilitate sukuk issuance for both debt-based, and participatory or equity-type structures. The 2004 guidelines provided the opportunity to use a wider variety of Shari’ah contracts in structuring sukuk.

From a policy perspective, Malaysia has implemented a regulatory framework that considers ICM an integral and important segment of its overall capital market with specific regulation introduced to address impediments and gaps, to facilitate innovation, and to ensure as well continuous progress in raising governance and ethical standards. In this regard, the umbrella legislation for the capital market, namely the Capital Markets and Services Act 2007a (CMSA), regulates all activities, markets, and intermediaries in the Malaysian capital markets, and this extends to ICM. The CMSA provides for powers to make ICM-specific regulations—an example of this being the power of the minister to prescribe what are Islamic securities and to modify the provisions of the CMSA in respect of such securities to give effect to the Shari’ah (section 316). The CMSA also has specific provisions relating to the Shariah Advisory Council (SAC) for the ICM (sections 316A to 316H).

In this context, issuers of Islamic products must comply with the relevant disclosure requirements such as disclosure relating to prospectuses or trust deeds as expressly set out in sections 2327 and 2588of the CMSA, and in the Prospectus Guidelines dated 8 May 2009, and Trust Deeds Guidelines dated 12 July 2011. Additionally, ICM intermediaries are subject to the same requirements related to their activities—for example, disclosure of interests in the provision of investment advice and the segregation of client monies in trust accounts.

The capital market regulatory framework also extends to include subsidiary legislation, rules, and other legally binding guidelines. In this regard, additional ICM-specific requirements can be introduced in supporting legislation by providing other additional requirements, those applying only to ICM products and services. For instance, Malaysia’s Guidelines on Unit Trust Funds (issued on 3 March 2008) contain additional requirements that apply only to Islamic unit trust funds. These requirements include:

• The appointment of a Shari’ah adviser to advise on all aspects of unit trust and fund management business in accordance with Shari’ah principles.
• Specific reporting requirements by the Shari’ah adviser to be included in the fund’s annual and interim reports stating its opinion as to whether the fund has been operated and managed in accordance with Shari’ah principles for the financial period concerned.
• Appointment of a designated compliance officer.
• Appointment of two Muslims as members of the investment committee.

Yet another approach that can be considered for regulating ICM is to introduce complete stand-alone guidelines for Islamic products or securities. This approach is useful when there are significant differences between the requirements for conventional and for ICM products. Malaysia has taken this approach in regulating other ICM products and services, for example in introducing the Guidelines on Islamic Fund Management dated 3 December 2007, which sets out the Shari’ah principles and concepts for an Islamic fund management business. The guidelines also require an Islamic fund manager to maintain all accounts with Islamic financial institutions, or to maintain the accounts in other financial institutions provided they are maintained in accordance with Shari’ah principles and to segregate their accounts from those of conventional business.

4. THE SHARI’AH GOVERNANCE FRAMEWORK

An effective and robust Shari’ah governance framework that ensures strict observance of the Shari’ah compliance process is a critical factor that promotes investor confidence in the ICM. The approach adopted by different countries in establishing Shari’ah governance framework can vary between jurisdictions as each jurisdiction needs to take into consideration its own unique requirements and circumstances.

Generally, the Shari’ah governance framework operates at three levels; namely, at the company, national, and international levels. At the company level, there are governance requirements for the appointment of Shari’ah advisers to advise on the Shari’ah aspects of the products and services offered by the company. The roles of the Shari’ah advisers are often supported by the appointment of compliance officers with knowledge of Shari’ah and Islamic finance. At the national level, Shari’ah advisory boards or councils can be established to advise the regulator and to provide top-down rulings and guidance on any Shari’ah issues pertaining to ICM business and transactions. Internationally, there are global standard setting organisations such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)9 and the Islamic Financial Services Board (IFSB).10 The international standards issued by AAOIFI include Shari’ah standards that have been reviewed and approved by its Shari’ah board (comprising fiqh scholars). All the standards and pronouncements issued by AAOIFI are adopted by Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan, and Syria. As for IFSB, one of its many objectives is to promote the development of a prudent and transparent Islamic financial services industry through introducing new, or adapting existing, international standards consistent with Shari’ah principles, and recommending these for adoption. In this regard, IFSB has issued various standards, guiding principles, and technical notes for the Islamic financial services industry, each of which has been endorsed as compliant with the rules and principles of Shari’ah by the Shari’ah scholars (in this instance, the Shariah Advisory Committee of Islamic Development Bank). With respect to the ICM, these standards include, amongst others, Guiding Principles on Governance for Islamic Collective Investment Schemes (January 2009) and Guiding Principles on Conduct of Business for Institutions offering Islamic Financial Services (December 2009).

Malaysia has sought to ensure that its Shari’ah governance framework is comprehensive and effective. At the company level, only qualified and experienced individuals and corporations are allowed to act as Shari’ah advisers. This is reflected in the requirements set out in the Registration of Shariah Advisers Guidelines and other product regulation guidelines11 which establish fit and proper criteria for the appointment of Shari’ah advisers and as well as outlining their roles and responsibilities. To further raise professional standards, registered Shari’ah advisers are encouraged to keep abreast of developments in Islamic finance through requirements for continuous professional education. Various guidelines also specify the need for the appointment of compliance officers with basic knowledge of Shari’ah and Islamic finance.

At the national level, the Securities Commission Malaysia had in 2009 introduced amendments to its CMSA that included a specific provision for the establishment of national Shariah Advisory Council (SAC). Section 316A of the CMSA states that:

The Commission may establish a Shariah Advisory Council for Islamic capital market which shall be the authority for the ascertainment of the application of Shari’ah principles for the purposes of Islamic capital market business or transaction.

The functions of the SAC as set out under Section 316B of the CMSA are to:

One significant provision of the CMSA allows reference to the SAC for advice or ruling from industry participants or any person, the courts, or arbitrators, and the binding effect of such rulings on the person or entity concerned. Section 316E of the CMSA states that any licensed person, stock exchange, futures exchange, clearing house, central depository, listed corporation, or any other person may seek the advice or refer for a ruling of the SAC on any matter relating to its ICM business or transaction to ascertain whether such ICM business or transaction involves any element that is inconsistent with the Shari’ah. In addition, section 316F(1) of the CMSA states that where in any proceedings before any court or arbitrator concerning a Shari’ah matter in relation to ICM business or transaction, the court or the arbitrator, as the case may be, shall take into consideration any ruling of the SAC or refer such matter to the SAC for its ruling.

Any ruling made by the SAC under sections 316E or 316F shall be binding12 on the persons referred to in section 316E and the court or arbitrator referred to in section 316F, respectively. Further, section 316H states that where a ruling given by a registered Shari’ah adviser to a person engaging in any ICM business or transaction is different from the ruling given by the SAC, the ruling of the SAC shall prevail.

The SAC also plays its role in harmonising the decisions taken by the registered Shari’ah advisers. Whenever Shari’ah advisers are not able to give answers or clarifications on certain Shari’ah issues, they will refer to the SAC for final rulings. In the event that any inconsistency arises between the Shari’ah advisers’ views and the SAC’s rulings, the latter shall prevail.13 A similar framework is also adopted by Bank Negara Malaysia in regulating the Islamic banking and takaful business and transactions in Malaysia.14 This model of Shari’ah governance is also adopted in other countries like Pakistan, whereby the Shari’ah supervision mechanism consists of Shari’ah advisers for banks undertaking Islamic banking, a Shari’ah-compliance inspection, and a centralised Shari’ah board for the country.

The rulings made by the SAC of the Securities Commission Malaysia are published in the Resolution of the Securities Commission Shariah Advisory Council (2009). This book acts as the reference to guide and to deepen understanding of the Shari’ah products and concepts applied in Malaysia’s ICM. The SAC rulings are continuously incorporated into the relevant guidelines. For instance, the Securities Commission Malaysia revised the Islamic Securities Guidelines (Sukuk Guidelines) to provide greater clarity on the application of Shari’ah rulings and principles in relation to sukuk transactions as endorsed by the SAC.

As discussed earlier, Malaysia has made it mandatory for the court or arbitrators to refer any Shari’ah issues to the SAC and for the rulings made by the SAC to be binding on the courts or arbitrators. Tun Abdul Hamid Mohamed, the former chief justice of Malaysia, suggests that this approach is justified, as it ensures more thorough screening of Shari’ah products by well-known and highly reputable scholars. In addition, he points out that the establishment of a national SAC enables rulings on issues to be made more quickly as well as promoting greater consistency of rulings on Shari’ah issues. He further states that in Malaysia, the civil courts judges are in a position to look for the law but do not have the expertise to decide Shari’ah issues due to a lack of knowledge in Shari’ah and Islamic jurisprudence.

The case of Mohd Alias bin Ibrahim v RHB Bank Berhad and Another represents the first case on the legal effect of the SAC’s rulings in Malaysia. While this applies to a banking dispute, nonetheless the same issues apply to ICM. The case is about the constitutional validity of Sections 56(1)15 and 5716 of the Central Bank of Malaysia Act, 2009 (Act 701) (CBA) and in relation to this, the plaintiff raised three questions for the court’s determination:

The High Court subsequently decided as follows:

5. CONCLUSION

Capital markets play an effective role in connecting the vast pool of savings and investment opportunities and contribute towards higher economic growth. Therefore, greater efforts must be made to harness the capabilities of markets so that the benefits of productive wealth may be better utilised to advance Muslim society.

As the domestic financial landscape evolves with the emergence of ICM, there is a need to ensure that this is accompanied by the development of a sound and comprehensive regulatory architecture that takes into account the unique legal and socioeconomic circumstances of that jurisdiction, fully meets the needs of issuers, investors, and intermediaries and ensures sustained confidence in the country’s ICM.

NOTES

1. The International Organization of Securities Commission (IOSCO), which was established in 1983, is the international standard setter for securities market and is the primary international cooperative forum for securities market regulatory agencies.

2. Bai’ bithaman ajil (BBA) is defined as a contract that refers to the sale and purchase of assets on a deferred and installment basis with preagreed payment period. The tradability of BBA, and other debt instruments, tends to differ among jurisdictions.

3. Musharakah (profit and loss sharing) is defined as a partnership arrangement between two or more parties to finance a business venture whereby all parties contribute capital either in the form of cash or in kind for the purpose of financing the said venture. Any profit derived from the venture will be distributed based on a pre-agreed profit-sharing ratio, but a loss will be shared on the basis of capital contribution.

4. Mudharabah (profit sharing) is defined as a contract made between two parties to enter into a business venture. The parties consist of the rabb al-mal (capital provider) who shall contribute capital to finance the venture, and the mudarib (entrepreneur) who will manage the venture. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. In the event of a business loss, the loss shall be borne solely by the provider of the capital.

5. “Islamic Securities” is defined in Securities Commission (Prescription of Islamic Securities) Order 2004 as “(a) any product or instrument made available, offered for subscription or purchase, or issued pursuant to the Shariah principles of Mudharabah or Musharakah; or (b) any sukuk issued pursuant to any Shariah concept or principle; and which are specified as Islamic Securities under the Guidelines on the Offering of Islamic Securities issued by the Commission.”

6. The Guidelines on the Offering of Islamic Securities were superseded and replaced with Islamic Securities Guidelines (Sukuk Guidelines) dated 12 July 2011.

7. Section 232(1)—A person shall not issue, offer for subscription or purchase, make an invitation to subscribe for or purchase or in the case of an initial listing of securities, make an application for the quotation of the securities on a stock market of a stock exchange unless—(a) a prospectus in relation to the securities has been registered by the Commission under section 233; and (b) the prospectus complies with the requirements or provisions of this Act.

8. Section 258—(1) Every person issuing, offering for subscription or purchase, or making an invitation to subscribe for or purchase, any debenture shall—(a) enter into a trust deed that meets the requirements of section 259; (b) appoint a trustee who is a person eligible to be appointed or to act as trustee in accordance with section 260; and (c) comply with the requirements and provisions of this Division.

9. AAOIFI, which was formed in 1990, is an Islamic international autonomous not-for-profit corporate body that prepares accounting, auditing, governance, ethics, and Shari’ah standards for Islamic financial institutions and the industry.

10. IFSB was inaugurated in 2002, to serve as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market, and insurance.

11. Guidelines on Unit Trust Funds dated 3 March 2008; Guidelines on Islamic Fund Management dated 3 December 2007; Guidelines on Real Estate Investment Trusts dated 21 August 2008; Guidelines on Exchange-Traded Funds dated 11 June 2009.

12. Section 316G of the Capital Markets and Services Act 2007.

13. Section 316H of the Capital Markets and Services Act 2007.

14. Bank Negara Malaysia introduced Guidelines on Shariah Governance Framework for Islamic Financial Institutions in 2010 with the objective of enhancing the role of the board, Shari’ah committee, and the management in relation to Shari’ah matters. These guidelines provides guidance to the Shari’ah committee and Islamic financial institutions to discharge their duties in Shari’ah matters and the functions relating to Shari’ah review, Shari’ah audit, Shari’ah risk management, and Shari’ah research are also outlined in the guidelines. Further, Part VII Chapter 1 of the Central Bank of Malaysia Act 2009 provides the provisions for the establishment of Shariah Advisory Council at the national level, similar to the provisions as provided under the Capital Markets and Services Act 2007 for Islamic capital market business and transactions.

15. Where in any proceedings relating to Islamic financial business before any court or arbitrator any question arises concerning a Shariah matter, the court or the arbitrator, as the case may be, shall—(a) take into consideration any published rulings of the Shariah Advisory Council; or (b) refer such question to the Shariah Advisory Council for its ruling.

16. Any ruling made by the Shariah Advisory Council pursuant to a reference made under this Part shall be binding on the Islamic financial institutions under Section 55 and the court or arbitrator making a reference under Section 56.

REFERENCESb

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), www.aaoifi.com.

Akhtar, Shamshad, Governor of the State Bank of Pakistan, “Shariah Compliant Corporate Governance,” keynote address at the Annual Corporate Governance Conference, Dubai, (27 November 2006), www.bis.org/review/r070118b.pdf.

International Organization of Securities Commissions (IOSCO). 2008. Analysis of the Application of IOSCO’s Objectives and Principles of Securities Regulation for Islamic Securities Products (September). www.iosco.org/library/pubdocs/pdf/IOSCOPD280.pdf.

Islamic Capital Market Task Force of the International Organization of Securities Commissions (ICM-IOSCO). 2004. Islamic Capital Market Fact Finding Report. ICM (July). www.sc.com.my/eng/html/icm/ICM-IOSCOFact%20finding%20Report.pdf.

Islamic Financial Services Board, www.ifsb.org.

Mohamad, A.H. 2011. “Malaysia as an Islamic Finance Hub: Malaysian Law as the Law of Reference and Malaysian Courts as the Forum for Settlement of Disputes.” 12th Emeritus Prof. Ahmad Ibrahim Memorial Lecture, December.

Mohd Alias bin Ibrahim and RHB Bank Berhad (6171-M); RHB Islamic Bank Berhad (Company No. 680329-V), in the High Court of Malaya at Kuala Lumpur (Commercial Division), Suit No: D-22A-74–2010.

Securities Commission Malaysia. 2009. Resolutions of the Securities Commission Shariah Advisory Council, Revised Second Edition. www.sc.com.my/eng/html/icm/Resolutions_SAC_2ndedition.pdf

a Details and complete texts of the acts and guidelines referred to in this chapter can be found at the websites of the Securities Commission Malaysia (www.sc.com.my) under the “Legislation” column, the Central Bank of Malaysia (www.bnm.gov.my) under the “Law, Policy and Guidelines” column, and the Islamic Financial Services Board (www.ifsb.org).

b Details and complete texts of the acts and guidelines referred to in this chapter can be found at the websites of the Securities Commission Malaysia (www.sc.com.my) under the “Legislation” column, the Central Bank of Malaysia (www.bnm.gov.my) under the “Law, Policy and Guidelines” column, and the Islamic Financial Services Board (www.ifsb.org).