Chapter 2

Sharī`ah Compliance in IFSA 2013 and Classification of Sharī`ah Non-Compliance Risk

2.0. INTRODUCTION

The legal amendments in the law represent a milestone that takes Islamic finance in Malaysia to the next level. The new legislation emphasizes Sharī`ah compliance and establishes Sharī`ah certainty, responsibility, and accountability. The Islamic Financial Services Act (IFSA) shall replace both Islamic Banking Act (IBA) 1983 and Takaful Act 1984 (Section 282). IBA, enacted in 1983 (30 years ago), was based on the old Banking Act of 1973. In 1989, the Banking Act 1973 for conventional banks was replaced with the more comprehensive BAFIA. However, IBA was never upgraded until the recent passing of the IFSB. Hence, most of the laws are new to the industry but largely already known in the form of regulations/guidelines from the central banks. IFSB is generally similar to the Financial Services Bill 2012 (FSB) but with specific sections unique to in catering to the Islamic banking business.

2.1. PROVISIONS UNIQUE TO ISLAMIC BANKS IN IFSA 2013

2.1.1. Islamic Banking Business

Previously, Islamic banking was defined by the IBA as “banking business whose aims and operations do not involve any element that is not approved by the religion of Islam.” Now under IFSA, it is defined as:

1. Accepting Islamic deposit with or without the business of paying or collecting cheques.
2. Accepting money under an investment account.
3. Provision of finance.
4. Such other business as prescribed under Section 3 of IFSB (Section 2).

The aforementioned are the major banking business activities carried out by the Islamic financial institutions. However, Islamic banking business can be defined as the business banking activities such as accepting deposit, collecting cheques, investment, provision of finance; and other business related to the nature of the financial institution based on Sharī`ah rules and legal requirements prescribed by the regulators.

2.1.2. Islamic Deposit and Investment (Section 2)

2.1.2.1. Islamic Deposit

Money accepted or paid in accordance with Sharī`ah will be repaid in full with or without any gains either on demand or at a time or circumstances agreed upon.

2.1.2.2. Islamic Investment

Money paid and accepted for the purposes of investment in accordance with Sharī`ah is without obligation to repay the money in full where the profits or losses are shared between the person paying the money and the person accepting the money with or without any return. In essence, deposit is principal guaranteed and investment is where principal is not guaranteed.

2.1.3. Finance and Other Business (Section 2)

2.1.3.1. Finance

Finance includes entering into or making an arrangement for another person to enter into the business or activities that are in accordance with Sharī`ah, including equity or partnership financing; lease-based financing; sale-based financing; currency-exchange contracts; fee-based activity; purchase of bills of exchange, certificates of Islamic deposit, or other negotiable instruments; and the acceptance or guarantee of any liability, obligation, or duty of any person.

2.1.3.2. Such Other Business under Section 3

This includes international Islamic banking business, Islamic financial intermediation activities, Islamic factoring business, Islamic derivatives, and Islamic leasing business.

2.1.4. Sharī`ah (Section 29)

There is no specific definition on Sharī`ah in Section 2, but under IFSA and read together with the Central Bank of Malaysia Act 2009, Sharī`ah, under the context of Islamic finance and services will be the muamalah Sharī`ah principles as determined by the Sharī`ah Advisory Council (SAC) of Bank Negara Malaysia (BNM). BNM is thereon empowered to give effect to the rulings of SAC and to specify the standards of Sharī`ah governance or any other matter related to the business of an Islamic bank. The duty of the board, the Sharī`ah committee, the CEO, and the senior officer is to ensure compliance to the standards specified by BNM.

2.1.5. Sharī`ah -Related Provisions

A licensed bank and an investment bank under the Financial Services Bill (FSB) can still carry out Islamic banking business subject to written approval from BNM (Section 8 (1)). Breach of Sharī`ah standards is one of the bases for revocation of banking license (Section 18). For any discovery of breach of Sharī`ah:

1. Immediately notify BNM.
2. Immediately notify internal Sharī`ah committee.
3. Immediately cease activities in breach.
4. Within 30 days, submit rectification plan to BNM (Section 28).

A financial group may apply to BNM for a single Sharī`ah committee to oversees its Islamic financial services and banking business if BNM is satisfied that the SC has the capability to ensure Sharī`ah compliance (Section 30 (2)). Any appointment or termination of a Sharī`ah committee member must be with prior written approval of BNM (Section 31 and 33). All information submitted to the Sharī`ah committee shall be accurate, complete, and not false or misleading in any material particular (Section 35). Members of the committee are not liable to defamation suit for any statement made in discharge of its duties without malice (Section 36). An external auditor may be appointed by BNM, or by the Islamic bank under directive of BNM, to perform a Sharī`ah audit and to report to BNM on any findings and cost to be borne by the Islamic bank (Section 37 and 38). The definition of “Related Party Transactions” now includes Sharī`ah committee members (Section 57). The board is obligated to give due regards to any Sharī`ah committee decisions in relation to Islamic banking business before making its final decision (Section 65). Maximum permissible holdings for Islamic banks may exceed 10 percent subject to prior written approval of BNM (Section 104). Islamic bank mergers are no longer via Section 176 of the Companies Act, because they are now provided for under IFSA.

2.2. SHARĪ`AH COMPLIANCE IN IFSA 2013

IFSA has shifted the legal framework and legislation in Malaysia to the next level, which marks a new face in the history of the Islamic banking and finance legislation in Malaysia.

The IFSA and the Sharī`ah governance framework (SGF) represent milestones in promoting Sharī`ah governance and Sharī`ah compliance in Malaysia. The objectives of IFSA are as follows:

  • To promote financial stability and Sharī`ah compliance in the banking activities.
  • To strengthen the foundations for the entire business banking model, such that the IFSA is end-to-end with Sharī`ah governance and compliance.
  • To support the Sharī`ah compliance contracts in the Islamic financial products and services.
  • To give strong warning followed by penalties in case there is a failure to comply with Sharī`ah mandate.
  • To align legal and regulatory principles with Sharī`ah precepts, while promoting greater legal operational certainty.
  • To emphasize the significant role of the central bank of Malaysia BNM as regulator.
  • To entrench Sharī`ah principles and the Sharī`ah Advisory Council rulings in the Islamic finance industry.
  • To enforce Sharī`ah compliance status on the market, and drive the Islamic financial institution toward more Sharī`ah compliance activities through a close monitoring and by imposing penalties.
  • To appreciate the Sharī`ah non-compliance risks, and manage them in a very effective manner, which compliments the Sharī`ah non-compliance reporting and other aspects as mentioned in the Sharī`ah governance framework.
  • To impose strict and severe offences and penalties as a result of failure to comply with Sharī`ah compliance.

Section 28: Duty of Institution to Ensure Compliance with Sharī`ah.

The IFSB Act 2012 highlights the duty of institutions to ensure compliance with Sharī`ah.

In Section 28 (1), an institution shall at all times ensure that its aims and operations, business affairs, and activities are in compliance with Sharī`ah. In Section 28 (2), for the purposes of this act, a compliance with any ruling of the Sharī`ah Advisory Council with respect of any particular aim and operation, businesss affair, or activity shall be deemed to be in compliance with Sharī`ah with respect to the aims and operations, business affairs, or activity.1

With regards to non-Sharī`ah compliance and the process of rectification, the Act has highlighted that the non Sharī`ah compliance cases should be reported to the regulators.

According to Section 28 (3), where an institution becomes aware that it is carrying on any of its business affairs or activities in a manner that is not in compliance with Sharī`ah or with the advice of its Sharī`ah committee or the advice or ruling of the Sharī`ah Advisory Council, the institution shall:

1. Immediately notify the bank and its Sharī`ah committee of the fact.
2. Immediately cease from carrying on such business, affair, or activity and from taking on any other similar business, affair, or activity.
3. Within 30 days of becoming aware of such non-compliance or such further period as may be specified by the bank, submit to the bank a plan on the rectification of the non-compliance.
4. The bank may carry out an assessment as it thinks necessary to determine whether the institution has rectified the non-compliance referred to in subsection (3).
5. Any person who contravenes subsection (1) or (3) commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding 25 million ringgit or to both.2

As a summary of Section 28, which determines the duty of an institution to ensure compliance with Sharī`ah rules and principles:

  • An institution shall at all times ensure that its aims and operations, business affairs, and activities are in compliance with Sharī`ah. This can be shown in the vision, mission, tag-line statement of the IFI, and demonstrated in their practices and operations.
  • Compliance with the resolutions of SAC of BNM shall be deemed to be compliance with Sharī`ah.
  • In case the institution becomes aware that it is carrying on any of its business affairs or activity in a manner that is not in compliance with Sharī`ah or the resolutions of its Sharī`ah committee or the resolutions of SAC of BNM, the institution shall:
a. Immediately notify BNM and its Sharī`ah committee of the fact.
b. Immediately cease from carrying on such business affairs or activity and refrain from taking on any other similar business affair or activity.
c. Within 30 days of becoming aware of such non-compliance or such further period as may be specified by BNM, submit to BNM a plan of rectification of the non-compliance.
  • Plan on the rectification of the non-Sharī`ah compliance.
  • Any person who contravenes this section commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to fine not exceeding 25 million ringgit or both.

2.2.1. Section 29: Power of Bank to Specify Standards on Sharī`ah Matters

1. The bank may, in accordance with the advice or ruling of the Sharī`ah Advisory Council, specify standards—
a. On Sharī`ah matters with respect to the carrying on of business affairs or activities by an institution that requires the ascertainment of Islamic law by the Sharī`ah Advisory Council; and
b. To give effect to the advice or rulings of the Sharī`ah Advisory Council.
2. In addition, the bank may also specify standards relating to any of the following matters that do not require the ascertainment of Islamic law:
a. Sharī`ah governance including—
i. Functions and duties of the board of directors, senior officers, and members of the Sharī`ah committee of an institution in relation to compliance with Sharī`ah.
ii. Fit and proper requirements or disqualifications of a member of a Sharī`ah committee.
iii. Internal Sharī`ah compliance functions.
b. Any other matter in relation to the business affairs and activity of an institution for the purposes of compliance with Sharī`ah.
3. Every institution, its director, chief executive officer, senior officer, or member of a Sharī`ah committee shall at all times comply with the standards specified by the bank under subsections (1) and (2), which are applicable to such person.
4. Every institution shall at all times—
a. Ensure that its internal policies and procedures on Sharī`ah governance are consistent with the standards specified by the Bank under this section.
b. Regardless of whether standards have been specified by the bank under this section, manage its business affairs and activities in a manner that is not contrary to Sharī`ah.
5. Every director, officer, or a member of a Sharī`ah committee of an institution shall at all times comply with the internal policies and procedures adopted by such institution to implement the standards specified by the bank under subsection (1) or (2).
6. Any person who fails to comply with any standards specified under subsection (1), commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding 25 million ringgit or to both.3

As a summary of Section 29:

Power of the bank to specify standards on Sharī`ah matters Bank Negara Malaysia will specify standards on:

  • Sharī`ah matters.
  • Sharī`ah governance.
  • Any other matter in relation to the business affairs and activity of an institution for the purposes of compliance with Sharī`ah.
  • Every institution, its director, chief executive officer, senior officer, or member of a Sharī`ah committee shall at all times comply with BNM standards applicable to such person.
  • Every institution shall at all times—
    • Ensure that its internal policies and procedures on Sharī`ah governance are consistent with the standards specified by BNM.
    • Manage its business affairs and activities in a manner that is not contrary Sharī`ah regardless of whether standards have been specified by BNM.
  • Every director, officer, or a member of Sharī`ah committee of an institution shall at all times comply with the internal policies and procedures adopted by such institution to implement BNM standards.
  • Any person who fails to comply with any BNM standard commits an offence and shall, on conviction, be liable to imprisonment for a term not exceeding eight years or to a fine not exceeding 25 million ringgit or to both. (See Table 2.1.)

    TABLE 2.1 Offences and Penalties under Sections 28 and 29

    Offence Penalty
    1 Failure to comply with BNM standards on Sharī`ah matters, that give effect to SAC rulings, ruling of BNM SAC, advice of Sharī`ah committee, and Sharī`ah principles. On conviction, not exceeding 8 years imprisonment or fine of 25 million ringgit or both.
    2 Failure to immediately report, or cease Sharī`ah non-compliant activity, or submit rectification plan in accordance with Act and Circular. On conviction, not exceeding 8 years imprisonment or fine of 25 million ringgit or both.
    3 Failure to comply with BNM standards on Sharī`ah governance. Monetary penalty to be imposed by BNM: s.245 (3), or 247, Schedule 15 (3).
    4 Failure to comply with BNM standards in relation to the business affairs and activity of an institution for the purpose of Sharī`ah compliance.
    • Fine not exceeding 5 million ringgit if body corporate/1 million if individual.
    5 Failure to ensure that internal policies and procedures are consistent with BNM standards.
    • Fine shall not exceed 3 times the gross amount of pecuniary gain made or loss avoided as a result of the breach.
    6 Failure to comply with internal policies and procedures adopted to implement BNM standards.
    • Fine shall not exceed 3 times the amount of money that is the subject matter of the breach, whichever is greater, for each breach or failure to comply.

Section 35: Information to Be Provided to Sharī`ah Committee

1. An institution and any director, officer, or controller of such institution shall—
a. Provide any document or information within its or his knowledge, or capable of being obtained by it or him, which the Sharī`ah committee may require.
b. Ensure that such document or information provided under paragraph (a) is accurate, complete, not false or misleading in any material particular, to enable the Sharī`ah committee to carry out its duties or perform its functions under this Act.
2. Except as provided in Section 36, a member of a Sharī`ah committee shall not disclose any document or information furnished under subsection (1) to any other person.4

As summary of Section 35,

An institution and any director, officer, or controller of such institution shall:

  • Provide the relevant documents or information to the Sharī`ah committee upon request, this cooperation to ensure a sound decision on Sharī`ah matters for the IFI.
  • Ensure the soundness and accuracy of the documents and information provided to the Sharī`ah committee.
  • Enable the Sharī`ah committee to carry out its duties or perform its functions under this Act.
  • Not disclose any document or information furnished to any other person (except for purposes of reporting to BNM, discharging his duties, in good faith and without malice).

Section 36: Qualified Privilege and Duty of Confidentiality

A member of a Sharī`ah committee shall not be liable—

a. For a breach of a duty of confidentiality between such member and the institution in respect of—
i. Any reporting to the bank.
ii. The discharge of his duties and performance of his functions, pursuant to any standards specified by the bank under subparagraph 29(2)(a)(i), which was done or made in good faith.
b. To be sued in any court for defamation in respect of any statement made by the member without malice in the discharge of his duties under this Act.5

As summary of Section 36,

The members of a Sharī`ah committee have been given the privilege to access some information and to deal with confidential matters in the IFI; however, in carrying out their duties, the Sharī`ah committee shall not be liable—

  • For breach of a duty of confidentiality of the institution such as reporting to the bank; or the discharge of his duties.
  • For breach of duty related to any standards specified by the bank under subparagraph 29(2)(a)(i), which was done or made in good faith.
  • To be sued in any court for defamation with respect to any statement made by the member without malice in the discharge of his duties.

Section 37: Appointment of Person by Institution to Conduct Audit on Sharī`ah Compliance

1. The bank may require an institution to appoint any person as the bank may approve, to carry out an audit on Sharī`ah compliance by the institution.
2. The person appointed under subsection (1) shall have such duties and functions as may be specified by the bank and shall submit a report to the bank on the audit carried out pursuant to this section.
3. The remuneration and expenses of the person appointed under subsection (1) relating to any audit on Sharī`ah compliance under this section shall be borne by the institution.
4. A person appointed under subsection (1) shall not be liable for a breach of duty of confidentiality between such person and the institution with respect to matters reported to the bank pursuant to an audit on Sharī`ah compliance under this section.

As summary of Section 37,

  • Bank Negara may require an IFI to appoint any person of Bank Negara to carry out Sharī`ah audit.
  • The person appointed shall have such duties and functions as may be specified by Bank Negara and shall submit a report to BNM.
  • The IFI will bear remuneration and expenses of the Sharī`ah auditor.
  • The auditor shall not be liable for a breach of duty of confidentiality between such person and the institution with respect to matters reported to Bank Negara.

Section 38: Appointment of Person by Bank to Conduct Audit on Sharī`ah Compliance

1. Without prejudice to Section 37, the bank may appoint for an institution any person to conduct an audit on Sharī`ah compliance—
a. If the institution fails to appoint a person under subsection 37(1);
b. In addition to the person appointed under subsection 37(1); or
c. Under any other circumstances as the bank deems appropriate for the purposes of compliance with Sharī`ah by the institution, and the remuneration and expenses relating to such appointment shall be borne by the institution.6

As summary of Section 38

  • If the IFI fails to appoint one under subsection (37)1.
  • In addition to the person appointed under subsection (37)1.
  • Under any other circumstances as the bank deems appropriate for the purposes of compliance with Sharī`ah by the IFI.
  • His remuneration and expenses shall be borne by the IFI.
  • Duties and functions may be specified by BNM and shall submit a report to BNM.
  • He shall not be liable for a breach of duty of confidentiality with respect to matters reported to BNM.

Some section in the IFSA Act mentioned that aspects of breach offence was committed without consent or connivance; the exercise of diligence is required to prevent the commission of the offence as he ought to have exercised, having regard to the nature of his function in that capacity and to the circumstances.

The following sections fall into some relevant and important aspects in Division 2, administrative actions.

Section 245: Power of Bank to Take Action

1. A person has committed a breach under this Act if the person fails to comply with or give effect to—
a. Any provision of this Act.
b. Any regulations made under this Act.
c. Any order made or any direction issued under this Act by the Bank, including an order made under Section 106 or a direction issued under Section 128 or 168, subsection 225(6) or Section 227.
d. Any standards, condition, restriction, specification, requirement, or code under this Act.
2. The bank shall have regard to the following matters in determining the appropriate action to be taken in each case.
a. The effectiveness of the enforcement action to be taken under this Act;
b. The proportionality of the action to be taken with the breach committed;
c. Deterrence of future breaches of similar nature by other persons; and
d. Any other matter that is considered as relevant in the opinion of the bank.
3. If the bank is of the opinion that a person has committed a breach and it is appropriate to take action against that person, the bank may, subject to Section 273, take any one or more of the following actions:
a. Make an order in writing requiring the person in breach—
i. To comply with or give effect to.
ii. To do or not to do any act in order to ensure compliance with such provisions, regulations, order, direction, standards, condition, restriction, specification, requirement, or code referred to in subsection (1).
b. Subject to subsection (4), impose a monetary penalty—
i. In accordance with the order published in the Federal Government Gazette Act 759 made under Section 247, or if no such order has been made, such amount as the bank considers appropriate, but in any event not exceeding 5 million ringgit in the case of a breach that is committed by a body corporate run-incorporate or 1 million ringgit in the case of a breach that is committed by any individual, as the case may be.
ii. Which shall not exceed three times the gross amount of pecuniary gain made or loss avoided by such person as a result of the breach.
iii. Which shall not exceed three times the amount of money that is the subject matter of the breach, whichever is greater for each breach or failure to comply.
c. Reprimand in writing the person in breach or require the person in breach to issue a public statement in relation to such breach, if it is in the opinion of the bank that such breach is relevant for the information of the general public.
d. Make an order in writing requiring the person in breach to take such steps as the bank may direct to mitigate the effect of such breach.
e. Make an order in writing requiring an authorized person, operator of a designated payment system, or a market participant to remedy the breach, including making restitution to any other person aggrieved by such breach.
4. The bank may impose a monetary penalty under paragraph (3)(b) only with respect to the following:
a. Breach of any provision set out in Schedule 15.
b. Breach of any requirement under any other provision of this Act where no offence is provided for non-compliance of that requirement.
c. Failure to comply with any requirement imposed under regulations made under this Act where no provision for imposition of penalty is provided for in accordance with paragraph 271(2)(d).
d. Failure to comply with any standards, code, order, direction, requirement, condition, specification, restriction, or otherwise made or imposed pursuant to any provision set out in Schedule 15.
5. If a breach is committed by a body corporate or un-incorporate, any action under subsection (3) can be taken against a person—
a. Who is its director, controller, officer, or partner, or was purporting to act in any such capacity.
b. Who is concerned in the management of its affairs, at the time of the breach unless that person demonstrates that the breach was committed without his consent or connivance and that he exercised such diligence to prevent the breach as he ought to have exercised, having regard to the nature of his function in that capacity and to the circumstances.
6. If a breach is committed by a person—
a. Who is a director, controller, officer, or partner of a body corporate or un-incorporate, or was purporting to act in any such capacity.
b. Who is concerned in the management of the affairs of a body corporate or un-incorporate, an action under subsection (3) can be taken against the body corporate or un-incorporate.
7. For the purposes of paragraph (3)(e), in determining whether any amount is to be paid by a person in breach, the bank shall have regard to—
a. Whether one or more persons have suffered loss or been otherwise adversely affected as a result of the breach.
b. The profits that have accrued to such person in breach.
8. Any monetary penalty paid by a person in accordance with paragraph (3)(b) shall be paid into and form part of the Federal Consolidated Fund.
9. Where a person fails to pay a monetary penalty imposed by the bank under paragraph (3)(b) within the period specified by the bank, the penalty imposed by the bank may be sued for and recovered as a civil debt due to the government.
10. Where a person fails to remedy the breach, including making restitution to any other person aggrieved by the breach under paragraph (3)(e), notwithstanding any other written law, the bank may sue for and recover such sum as a civil debt due to the person aggrieved by the breach.
11. Nothing in this section shall preclude the bank from taking any of the actions that it is empowered to take under this Act, in particular, Sections 106, 128, or 168, or any written law.7

Section 250: Civil Actions under Civil Action by Bank

Where it appears to the bank that there is a reasonable likelihood that any person will contravene or has contravened or will breach or has breached or is likely to fail to comply with or has failed to comply with any—

a. Provisions of this Act.
b. Provisions of any regulations made pursuant to this Act.
c. Order made or direction issued by the bank under this Act including an order made under Section 106 or a direction issued under Section 128 or 168, subsection 225(6) or Section 227.
d. Standards, condition, restriction, specification, requirement, or code made or issued pursuant to any provision of this Act.
e. Action taken by the bank under subsection 245(3), the bank may institute civil proceedings in the court seeking any order specified under subsection 251(1) against that person regardless of whether that person has been charged with an offence with respect to the contravention or breach or whether a contravention or breach has been proved in a prosecution.8

2.3. CLASSIFICATION OF SHARĪ`AH NON-COMPLIANCE RISK

The risk level may be classified as high, medium, and low.

1. High. Sharī`ah non-compliance risk may consist of risk that lead to the invalidation of the contracts without any option to rectify and/or non-recognition of profit. For example, a sale-based contract was entered into without specifically identifying the underlying asset transacted and it has matured.
2. Medium. Sharī`ah non-compliance risk may consist of non-compliance of conditions of the contract, but it can be rectified and may not necessarily lead to the invalidation of the contract. However, the risk may result in non-recognition of profit. For example, late payment charges beyond the loss incurred or approved limit are channeled to charity.
3. Low. Sharī`ah non-compliance risk consists of minimal risk other than high and medium. For example, marketing advertisement containing images of prohibited behavior, such as models not dressed decently, leading to reputational risk that may impact the business.

NOTES

1. Islamic Financial Services Act 2012. Part IV, Sharī`ah requirements, Division 1, Sharī`ah compliance, 58–59.

2. Ibid.

3. Ibid., 59–60.

4. Ibid., 63.

5. Ibid.

6. Ibid., 64.

7. Ibid., Section 245.

8. Ibid., Section 250.

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