Growth in sharia-compliant investing

International investors have become more aware of, and involved in, sharia-compliant financings over the past ten years or so.  This development is, in principle, good both for financial market participants whose actions are guided by the Koran and those whose actions aren’t necessarily sharia compliant.  The former gain access to a wider pool of potential investment capital, and very likely a lower cost of funds.  Institutional investors among the latter get greater diversification, plus the chance at differentiating their performance from that of peers unwilling/contractually unable to hold sharia-compliant securities.

Veteran investors know that you don’t really get to know the securities you own, or how well-crafted your portfolio is, until a time of trouble arises.  This has certainly proved true recently in the case of Islamic finance.

first sukuk…

In late November of last year, on the eve of a series of religious and secular holidays that would leave it incommunicado for the better part of a week, Dubai World made a surprise announcement that it wanted to restructure its debts.  These included a large sukuk issued by its real estate subsidiary Nakheel that was slated to mature three weeks later.  (See my series of posts on the Dubai World restructuring.)

As the situation unfolded, sukuk holders discovered to their dismay that there had been so few prior sukuk defaults that there was no history to use to make a judgment about what the possible outcomes of a restructuring might be.   This meant both the holders and the sharia compliance boards that would have to approve any settlement were going to have to break new ground.

The sukuk issuers also discovered an unanticipated vulnerability in their position.  Opportunistic hedge funds (reportedly mostly US- and UK-based) had bought the soon-to-mature Nakheel sukuk at a steep discount in the secondary market.  They announced that they would bring suit in the UK to force Dubai World into a western-style bankruptcy.   They could do this, they said, because the sukuk documents had been drawn up under UK law.

Again, there was no precedent to use in judging whether this action would be successful.  On a deeper level, however, the threatened lawsuit could potentially lead to a finding that the sukuk was really a Western-style interest-bearing debt instrument and not the equity-like sharing of profits and losses that the Koran requires.  What a mess!!

…now wakala

Sukuk is long-term financing.

The traditional equivalent of a CD is murabaha. This is an asset-based repurchase agreement (repo).  In the murabaha contract, one buys a certain amount of a commodity at an agreed-upon price and simultaneously commits to sell it for a higher price at a later date.

Wakala is a simpler alternative to murabaha.  It isn’t backed by a specific physical asset that the holder buys and sells.  Instead, it is backed by a general pool of assets that the issuer certifies to be sharia compliant.  So easier to handle logistically.  But it’s more like a mutual fund share than a repo.

Blom Development Bank v. TID

Here again, though, a conflict has arisen between the rules of English law, under which the documents are written and which presumably gives comfort to the non-Islamic parties to a deal, and the requirements of sharia.  The case in question, reported by the Financial Times, involves the Islamic finance subsidiary of the Blom Bank of Lebanon and the troubled The Investment Dar (TID) of Kuwait.

Blom gave TID $10 million to invest under a wakala agreement.  TID defaulted in 2009 and Blom sued in English court–this despite the fact both entities are sharia-compiant investors.  Where did the sharia compliance boards go?  Did the pair approach a sharia court, only to be rebuffed?

How could that be?  See below.

TID’s defense

TID had an ingenious (shameless might be a better word) defense.

Simplifying a bit, the parties in a sharia-compliant agreement are supposed to share in profits and losses.  Nevertheless, as a practical matter, a wakala commonly has a clause in it guaranteeing a minimum rate of return to the holder.  This makes it more like a Western CD than a true wakala. This one did, too.  And it presumably got the seal of approval not only from Blom but also from TID’s in-house sharia compliance board, or else the wakala would never have been issued.

TID argued that the contract should be declared null and void and that as a result it owed nothing to Blom.  Why?  –because the profit guarantee clause rendered the agreement out of compliance with sharia.  Since TID’s charter only permitted it to engage in sharia-compliant financing, it could never have entered into the contract in question.  Therefore, no contract–and no liability–existed.  (You can find more details here, in the interesting sharingrisk.org blog.)

Yes, TID lost.  But it didn’t get laughed out of court, as one might have expected.  Instead, although the judge said TID was unlikely to prevail on appeal, he conceded that the company had an arguable case.  He ordered TID to pay the original $10 million to Blom and left the profit element to be decided later.

So it turns out that maybe not in this case but potentially in some other, the “security blanket” of a wakala drawn up under English law with a guaranteed return may not act as expected.  Also, potential recourse to English courts may be a “secret weapon,”  but will it work for the issuer or the holder?  With a different judge or with a slightly different set of facts, the wakala might be declared null and void.

More troubling, if so what’s to stop a bank in difficulty from declaring after the fact that it had “discovered” its contract wasn’t sharia compliant after all?

What this means

You could make a persuasive (to me, anyway) argument that up until now that a lot of “Islamic finance” has been for most non-Muslims a bull market phenomenon, sort of like “hybrid bonds.”  That is, a half-baked idea that sounds good when uninvested funds are burning a hole in your pocket but where potential consequences haven’t been well thought through.

Unlike hybrid bonds, which I see as a contrivance by commercial banks and bond fund managers to allow them to exceed the limits of their investment mandates, and which therefore won’t resurface, I expect sharia-compliant investing to increase in importance as time goes on.  But the Dubai World restructuring and this, admittedly minor, wakala lawsuit have both exposed cultural and legal questions that buyers and sellers alike papered over in their zeal to get new issues of securities completed over the last few years.

These are teething pains.  Sellers of future sharia-compliant instruments will doubtless be compelled to be more transparent in disclosing the uses for the funds they want.  Buyers will have to do more due diligence on projects and become more involved in understanding the intricacies of sharia compliance.  And both sides will have to agree on a dispute resolution mechanism that doesn’t allow the parties to make the rules up on the fly.  This doesn’t necessarily help anyone involved in a sharia-related restructuring now.  But now that these issues are on the table, I’m sure they’ll all be addressed in the creation of future sharia-compliant securities.