Islamic finance hurt by its day in UK court

Sharia-compliant financial instruments face questions after a ruling by a UK court raised issues about how the securities stand up to legal review.

The English ruling has made it clear: Sharia has left the realm of opinion and entered the courtroom.

When the Islamic scholar Taqi Usmani in early 2008 questioned a large number of sukuk, his remarks caused a backlash across the Islamic finance industry and harmed the reputation of Sharia-compliant bonds. Two years on, it looks like a little noticed ruling by the high court in London could inflict more harm on Sharia-compliant loans and other financial deals.

This month an English judge ruled that The Investment Dar (TID), the troubled Kuwaiti investment house, did not have to stick to the terms of an Islamic loan because the contract did not comply with Sharia law, thus ultimately rendering it void. Scholars, lawyers and other experts say the ruling damages the reputation of Islamic finance. "The agreements put forward by Investment Dar's legal counsel could have a negative impact on the Islamic finance sector and increase so-called Sharia risk by several degrees," says Michael Rainey, a lawyer at King and Spalding, an international law firm. "The willingness [of the judge] to make such an argument damages the credibility of Islamic financial institutions generally."

The English court ruled that TID had made an "arguable case" that the Wakala agreement - effectively a type of loan for US$10 million (Dh36.72m) it entered with the Lebanon-based Blom Bank - was not in line with Sharia law. As a result, TID must repay only the principal, but not the profit, which is paid to the lender instead of interest under Sharia law. "This is a serious issue because, unlike the statements of Mr Usmani, it is not just one person giving his opinion," says Khalid Howladar, the senior credit officer for asset backed and Islamic finance at Moody's Investors Service. "It is, after all, a court of law."

In 2008, Blom had sued TID, seeking the principal plus a 5 per cent fixed return, as part of the deal it conducted with Investment Dar in 2007. But TID's lawyers said the fixed return constituted interest, which was prohibited under Sharia law. TID, which later defaulted on a $100m sukuk, is restructuring its debts. The London ruling comes as a double blow for the region. As bank financing dried up and Dubai World's debt troubles further depressed investor sentiment, companies are looking to Islamic finance to help meet their funding needs. But so far, only one sukuk has been issued in the Gulf this year, a $450m sukuk by Dar Al Arkan, one of Saudi Arabia's largest property company.

"Investors should be concerned because there is a material possibility of [Islamic] companies using this type of defence when in distress, adding to the operational risk of a sukuk or any other Sharia investment," says Mr Howladar. Experts are surprised, to put it politely, or shocked, to put it more bluntly, to see a UK court base its decision on Sharia principles. "Islamic and Sharia principles are not laws, they do not stand on their own. A court can only refer to a law of its country, for example a Swiss court would base its decisions on Swiss law," says a Sharia scholar, who did not want to be named.

The ruling marks a watershed: Sharia has left the realm of opinion of religious scholars and entered the courtroom. "In this case non-compliance with Sharia is being used as a means to escape an obligation that was mutually agreed at the outset of the contract," says Mr Howladar. Many of the complexities of Islamic finance can be explained by the lack of an overriding authority that rules whether something is in line with the belief. As a result, Islamic finance is consensual, resulting from several parties working out a joint decision.

It was one thing for Mr Usmani, who is the chairman of the board of up to 20 scholars at the Accounting and Auditing Organisation for Islamic Financial Institutions, to cause a storm across the industry when he said about 80 per cent of sukuk did not comply with Islamic principles. But it is an entirely different story once Sharia enters the courtroom. Although investors are generally aware that Islamic finance is complex, complexity does not necessarily mean more risk, experts say.

"But now, with this ruling, this could set a precedent for other cases," says Mr Howladar. Judges consider rulings on a case-by-case basis, but preceding rulings do set a certain measure. Ultimately the judge's decision for TID supports those who argue that Islamic finance often only complies with Sharia law as a formality, but not in their true substance. Take a sukuk, which must be backed by tangible assets. But in many cases no real asset transfer takes place, experts say, and the counterparty has no right to the asset because the transaction merely aims to give the impression of finance based on tangible assets. In reality it can turn out to be only an unsecured claim against debt.

Islam bans lending for interest as usury and demands that any loan arrangement is based on an underlying physical asset. "When you have an industry where 'form over substance' compliance is commonly accepted, you are exposed to a higher risk that a party may try to use Sharia non-compliance as a means to escape their obligation," says Mr Howladar. Interestingly, the most recent decision also contrasts with earlier rulings by UK courts.

In the case of Shamil Bank versus Beximco, a Bangladesh-based company, the high court in London decided in 2005 that it was not empowered to rule on the basis of Sharia. Instead, it cited standard practices and the fact that there could not be two different systems of law governing one contract. Even if Sharia was contradicted, it was not up to the court to decide that, it said. It ordered Beximco to repay what it owed.

A UK government spokesman said last year that Sharia could not be used as a justification for committing breaches of English law, nor should the principles of Sharia be included in a civil court for resolving contractual disputes. So the debate continues, and lenders wait. [e-mail]