STAKEHOLDERS MODEL OF GOVERNANCE IN ISLAMIC ECONOMIC SYSTEM

Islamic Economic Studies,
Vol. 11, No. 2, March 2004





STAKEHOLDERS MODEL OF GOVERNANCE IN
ISLAMIC ECONOMIC SYSTEM

COMMENTS: MUHAMMAD UMER CHAPRA*

The main thrust of this valuable paper written by two highly qualified and
respected scholars is that “the stakeholder theory of corporate governance finds
strong roots in the Islamic economic system”. This leads the authors to argue that
all stakeholders should participate in corporate decisions; that managers have a
fiduciary duty to serve the interests of all stakeholders; and that the objective of the
firm ought to be promotion of the interests of all stakeholders rather than those of
just the shareholders. The paper then discusses property rights and contractual
obligations in Islam and the rules of behavior prescribed by Islam to ensure that
these rights and obligations are duly honored.


While the paper’s overall conclusion in favor of the stakeholders’ model and the
scholarly manner in which it is arrived at are highly commendable, the paper stops
far short of reaching the desired end. What is crucial is not just the defense of
stakeholders’ rights, because the Franco German model does the same1 and some
Muslim scholars have also defended these rights,2 but rather to show how to ensure
that these rights are protected. Here the authors rightly emphasize the role of rules
of behavior or what are now referred to as institutions in Institutional Economics.
This leads the reader to the more complex question of how these rules can be
enforced. Here the authors have taken an easy way out by assuming that “in an
Islamic system, the observance of rules of behavior guarantee internalization of
stakeholder rights (including those of the society at large). No other institutional
structure is needed”. This is where, I think, the principal weakness of the paper lies.

While the internalization of Islamic rules of behavior would help protect
stakeholders’ rights, it is not necessary that these rules would become
automatically internalized. The stark reality is that, while Islamic norms had
become internalized in the Muslim society in the Classical period of Islamic
history, they are no longer so. The question is: why? What is it that led to the

* Research Advisor, Islamic Research and Training Institute (IRTI) of the Islamic
Development Bank (IDB). Views expressed in these comments are the author’s own and do
not necessarily represent those of the IDB or IRTI.
1 Macey and O’hara (2001), pp. 1 and 5.
2 Chapra & Ahmed (2002).

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Islamic Economic Studies, Vol. 11. No. 2
internalization of rules of behavior in the Classical period and has led to their
general violation in modern times?

The answer lies in incentives and deterrents. Rules of behavior get observed
only if incentives and deterrents operate effectively in a society. While this
happened during the Classical period, it is not happening now. Islam has provided
two sets of incentives and deterrents. One of these is reward and punishment in this
world and the other is reward and punishment in the Hereafter. While the reward
and punishment in this world are missing because of the non-existence of an
enabling educational, socio-economic, political, legal and judicial environment, the
belief in accountability before the Almighty in the Hereafter has also become
weak.


A number of factors have dented the operation of incentives and deterrents in
modern times. The first of these is substantial erosion of the conscientious religious
environment which prevailed during the Classical period. This has weakened self-
enforcement of norms by individuals. Secondly, there prevailed in the Classical
period what Ibn Khaldun calls ‘asabiyyah or social solidarity. Anyone who tried to
violate the society’s norms became ostracized. This ensured honesty and fairness in
mutual dealings and acted as an informal contract enforcement mechanism.
Thirdly, the market system worked more effectively because the firms operating in
the market were generally small, being individual proprietorships and partnerships.
Separation of ownership and control did not, therefore, exist and the
principal/agent problem was not serious. Moreover, competition was tougher as a
result of the small size of firms and their large number. Market discipline,
therefore, played an important role in the effective enforcement of the rules of
behavior. Fourthly, what helped was the independence, honesty and promptness of
the judicial system. Courts as well as muhtasibs (ombudsmen) ensured that
property rights were honored and contractual obligations were honestly fulfilled.3
Lastly, honest, conscientious and legitimate governments ensured the observance
of the society’s rules of behavior by all, irrespective of their position in the society
or the power hierarchy. Therefore, it was not just the rules of behavior given by
Islam, but also the socio-economic and political environment which led to the
enforcement of property rights and contractual obligations.


Such an environment does not exist any more. As a result of the socio-economic
and political decline in the Muslim world, the family, the society, the courts and
the government, which are crucial elements of a proper enabling environment, do
not play their roles effectively in the enforcement of values. The effective
operation of incentives and deterrents has, therefore, become weak. The rules are
still there but they do not get enforced. Observance of these rules starts in the
family with the proper upbringing of children. Unfortunately, a majority of parents,

3 For a more detailed discussion of these factors see, Chapra and Ahmed (2002), pp.2-7.

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Stakeholder Model of Governance: Comments by M. Umer Chapra
67
and in particular mothers, are not well educated in Islamic norms. Institutional
arrangements needed for such education are also grossly inadequate. The stress in
religious education also seems to be, unfortunately, more on appearances and
trivialities than on the uplift of character. This has been one of the primary factors
which have contributed to an increase in the violation of Islamic norms. Those who
violate the norms do not only not get socially ostracized, but are rather able to get
prestige. The persistence of these violations over a long period has led to their
being locked-in in Muslim societies through the operation of path dependence and
self-reinforcing mechanisms. Courts have also become corrupt and governments
are generally illegitimate and not accountable before the people. It is, therefore,
crucially important to change the environment so that everyone is clear about what
the norms are and those who violate them do not only feel the pinch materially but
also get socially ostracized. This would reduce the principal/agent conflict of
interest by inducing individuals to do what is right and to abstain from doing what
is wrong. Without a change in environment and social, political and judicial
support, moral as well as legal norms are not likely to be effective.

Without the effective operation of incentives and deterrents even market
discipline will tend to be weak. Well-functioning competitive markets are
indispensable for effective market discipline as well as the protection of
stakeholders’ rights. It is competition which punishes those who cheat in quality
and quantity, do not give satisfactory dividends, and do not in general promote the
interest of the society. However, this is not happening because of a weak
competitive environment.

It is also necessary to have a proper legal framework for the protection of
stakeholders and its effective enforcement.4 Countries with properly regulated
markets have higher growth and are also less prone to economic crises.5
Consequently legal protection has become an important variable of policy in most
countries during the 1990s.

Legal protection may, however, be ineffective unless reinforced by
independent, honest and efficient courts to promptly redress the grievances of
stakeholders. It is also necessary to have effective internal controls, proper
accounting, independent audit, and adequate transparency, to reduce the
opportunity for mangers and directors to serve their vested interests. In spite of all
these measures protection of stakeholders’ right would tend to be weak if they are
themselves unable to have a say in corporate decisions. The authors have rightly
recognized this point. There is, however, no discussion in the paper of how to make
it possible for the diverse stakeholders to have a say in corporate decision making.


4 See Chapra and Ahmed (2002); see also Chapra and Khan (2000).
5 La Porta, et. al (1999).

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Islamic Economic Studies, Vol. 11. No. 2

All this does not deny the importance of moral values or rules of behavior on
which the authors have rightly laid great emphasis. The existence of legal and
institutional protection and stakeholder participation in decision making, though
necessary, will not be sufficient. There are so many clandestine ways of depriving
stakeholders of their rights that both market forces and legal protection may be
ineffective unless there is an inner urge on the part of agents themselves to fulfill
their commitments faithfully. In societies where there is no conflict between moral
norms and social behavior patterns, moral norms as well as laws get enforced
because, as Cooter has rightly put it, “officials lack the information and motivation
to enforce the law effectively on their own”.6 Legal protection tends to be ignored
when the law is inconsistent with ‘actually prevailing’ moral and social behavior
pattern. Consistency between moral and social norms and actual behavior is
considered to be indispensable ‘social capital’.

Such social capital does not seem to be adequate in Muslim countries.7
Therefore, new laws will not by themselves be able to provide the necessary
protection to stakeholders. Hence, while streamlining legal protection for
stakeholders, we should bear in mind the stark reality that, in the last analysis, it
may not be possible to ensure the honest and fair fulfillment of property rights and
contracts without the help of moral values and their implementation through an
enabling socioeconomic environment and impartial judiciary.

Within the framework of Ibn Khaldun’s analysis of the rise and fall of
civilizations, moral norms, which emanate in his analysis from the shari[ah in a
Muslim society, may not get reflected in laws, and the laws may not get
implemented effectively if the political authority does not attend to this task.8 It is
the responsibility of the political authority to check all morally objectionable
behavior – dishonesty, fraud and unfairness – that is harmful for socio-economic
development. It must also ensure the fulfillment of contracts and respect of
property rights, and inculcate in the people qualities that are necessary for
safeguarding the interests of all stakeholders.9 The governments generally fail to
perform these tasks if they are not accountable before the people, do not apply the
law equally and equitably on all the different strata of the population, and do not

6 Cooter (1997), p.191.
7 For a valuable discussion of social capital, see Dasgupta and Serageldin (1999).
8 Ibn Khaldun, Muqaddimah, pp.190-91.
9 It is only recently that the political dimension of economic reform and development has
started to receive analytical attention. Douglas North emphasized that the only way
economies can develop optimally is to keep ‘nasty’ behavior in check. Governments are
capable of doing this. If they do not, individuals may behave in ways that could undermine
the very foundation of the system and lead to social chaos and economic collapse (See the
Chapter, “Ideology and the Free Rider”, in North, 1981). John Williamson has also focused
on the political context of successful economic reform by analyzing 11 developed and
developing countries [See Williamson (1993)].

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Stakeholder Model of Governance: Comments by M. Umer Chapra
69
employ staff on the basis of character and competence.10


REFERENCES

Chapra, M. Umer, and Habib Ahmed (2002), Corporate Governance in Islamic
Financial Institutions, Jeddah: Islamic Research and Training Institute/Islamic
Development Bank (Occasional Paper No. 6).
Chapra, M. Umer, and Tariqullah Khan (2000), Regulation and Supervision of
Islamic Banks, Jeddah: Islamic Research and Training Institute/Islamic
Development Bank (Occasional Paper No. 3).
Cooter, Robert D. (1997), Annual World Bank Conference on Development
Economics, 1996, New York: World Bank.
Dasgupta, Partha and Ismail Serageldin (eds) (1999), Social Capital: A
Multifaceted Perspective, Washington DC: World Bank.
Dyck, Alexander (April 2000), ‘Ownership Structure, Legal Protections and
Corporate Governance’, adyck@hbs.edu
Ibn Khaldun, ‘Abd al-Rahman (d.808AH/1406AC), Muqaddimah, Cairo: Al-
Maktabah al-Tijariyyah al-Kubra, n.d.
La-Porta, R., F. Lopez-de-Salinas, A Schleifer, and R. W. Vishny (1999), ‘Investor
Protection: Origins, Consequences, Reform’, Harvard University, Manuscript,
cited by Dyck, 2000.
Macey, Jonathan R., and Maureen O’hara, ‘The Corporate Governance of Banks’,
irm29@cornell.edu. and mo19@cornell.edu
North, Douglas C. (1981), Structure and Change in Economic History; New York:
Norton.
Williamson, John (1993), The Political Economy of Policy Reform, Washington
DC: Institute for Institutional Economics.

10 Ibn Khaldun has devoted to this question a whole chapter entitled “Human Development
Requires Political Leadership for its Proper Ordering” in addition to substantial discussion
in several other chapters. See his Muqaddimah, pp.235-43.

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