The Islamic finance industry is seeking ways to safeguard deals against challenges to their religious permissibility, after a case in the UAE raised the risk that issuers of Islamic bonds could refuse to redeem them after such a challenge.
Bankers and lawyers say several mechanisms, new and old, could address the problem, though it may be impossible to remove the risk entirely.
Legal provisions in contracts for financial instruments could prevent their Shariah-compliance from being questioned after they are issued. Investors may also screen scholars who certify instruments as Shariah-compliant more carefully, and pay more attention to what mechanisms, such as courts, exist to rule on potential disputes.
Last month, Sharjah-based Dana Gas declared it would not make payments on $700mn of sukuk maturing this October because Islamic finance standards had changed since the instruments were issued four years ago.
The change in standards meant the instruments were no longer Shariah-compliant and had become “unlawful” in the UAE, Dana argued.
This raised concern across the Islamic finance industry that more companies could avoid redeeming sukuk by adopting the same argument as Dana.
The outcome of the Dana case, which is being fought in British and UAE courts, could hurt liquidity and growth in the global sukuk market, Moody’s said.
To try to avoid similar cases in future, investors may demand more detailed and restrictive language in sukuk documentation.
Such language already exists for some sukuk, but it is not used consistently and is not standardised.
“We foresee sukuk investors increasingly demanding Shariah assurances which could include a Shariah undertaking in the form of an explicit waiver of any defence of non-compliance,” said Mohammad Hasif Murad, investment manager at Aberdeen Islamic Asset Management in Malaysia.
Some issuers in Indonesia go further by stipulating that if their sukuk cease to be Shariah-compliant, they will be declared in default, mature immediately and become repayable to investors.
Sukuk issued by Maybank Indonesia, BRI Syariah and Bank Jambi include such clauses, according to Fitch Ratings.
They all used an investment management partnership structure known as mudaraba, the same format employed by Dana.
But early redemption is not fundamentally desirable for issuers or investors, which may limit wide use of such clauses in the Gulf region, said a Dubai-based partner of an international law firm.
Also, such clauses may not suffice against an issuer in financial distress seeking to force a restructuring aggressively or delay repayment, said the lawyer.
“This is part of the risk that investors run in our region. Such risk already tends to be priced into instruments issued out of the Middle East.”
Investors may therefore cast a more watchful eye on the groups of scholars who provide Shariah endorsements for sukuk.
“With this case, we will be more stringent when looking at what are the pledges made, who are the Shariah councils,” said Heddy Humaizi Hussain, director of institutional sales and marketing at Kuala Lumpur-based financial firm Saturna.
At present, sukuk issuers generally choose the scholars who certify their instruments.
Some analysts think that model could eventually change under pressure from investors, if that is necessary to maintain the credibility of Islamic finance.
Issuers could be required to have an independent Shariah board that answers to directors and shareholders rather than to management, said Sheikh Yusuf Talal DeLorenzo, a scholar with over three decades of experience in Islamic finance.
“Certainly in Muslim-majority jurisdictions this should be the case, whether it’s an airport authority, or a shipbuilder, or a real estate developer,” he said.
Malaysia has succeeded in limiting disputes over Shariah compliance partly because it has country-level Shariah boards within its central bank and capital markets regulator.
These boards tend to create a national consensus on standards.