This article deals with litigation related aspects of Islamic financing transactions. It focuses on those enforcement and litigation issues that arise specifically from the Sharia compliant nature of a certain transaction – so called "Sharia risk". It is based on an analysis of relevant court precedents, and provides concrete suggestions of what to bear in mind when drafting Sharia compliant agreements and capital market documents. It concludes with some reflections on whether it makes sense to set up specialized dispute review bodies for Islamic financing transactions.
When Things Go Wrong
Islamic finance litigation? Disputes arising out of Sharia compliant agreements were unheard of in the early days of Islamic finance. Banking transactions, by their very nature, are discrete, and as long as Islamic finance was confined to a small community, there was no need to enforce contractual arrangements in court. The growth of Islamic finance, however, and the globalization of the Islamic finance industry, has transformed the industry from a community based endeavour into a global business. In the global market, lenders default and banks sue and enforce. Islamic finance has become part of the global banking industry and Islamic finance litigation is a side effect thereof.
Litigation based on or relating to Islamic financing transactions can raise intricate issues, in particular if debtors defend invoking Sharia principles, in arguing that a contract or certain clauses are void as they do not comply with Islamic law (so-called "Sharia defences"). The spread and sophistication of the Islamic finance industry, as well as Islamic financial innovations, some of them based on controversial interpretations of the Sharia, have further contributed to uncertainty in the Islamic finance community. Over the last decade, however, the courts have developed certain principles of how to deal with Islamic finance cases.
Case Study: The Beximco Case
Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd. and others (known as the "Beximco Case"), heard by the London Court of Appeal in 2004, still is considered a landmark judgement in the field of Islamic finance litigation. The underlying facts can be summarized as follows: An Islamic bank based in Bahrain had entered into a murabaha financing agreement with a South Asian borrower. The borrower did not repay the loan as scheduled. The negotiations over restructuring of the debt all remained without success. The bank finally called the loan and brought a claim in the English courts, which the loan agreement determined as venue. The defendant inter alia argued that the transaction was altogether void, alleging it was only dressed up as an Islamic murabaha agreement, but was in fact an interest bearing loan. Thus it violated the Islamic prohibition of riba. The lack of Sharia compliance, the borrower argued, made the agreement altogether unenforceable, and liberated the borrower from his obligation to repay.
Assuming that the allegation was correct, and that the particular agreement in fact was contrary to Islamic law (what however is difficult to determine on basis of the facts as reported in the case), this raises the question of whether a state court will enforce the Sharia promise given by the Islamic bank, pursuant to which a particular transaction is compliant with Islamic principles. And if a state court should get involved with Sharia issues: who then will determine the content of Sharia rules? This is a difficult issue that touches fundamental questions, such as the competence of state courts to opine on religious matters and the protection of parties to contractual promises to the extent such promises are of non-pecuniary nature.
In the Beximco Case, the agreement provided that "Subject to the Principles of the Glorious Sharia, this Agreement shall be governed by and construed in accordance with the law of England." This clause ("Subject to") can well be read to imply that Sharia rules are meant to override principles of English law, at least to the extent the latter are not mandatory. Such an approach may be consistent with the intentions of the parties to enter into an Islamic transaction that is distinct from a conventional one. The Court of Appeals nevertheless declined to validate the Sharia rules referred to in the agreement: a choice of law, the Court held, only is valid if it refers to the law of a particular state or at least a body of black letter rules that are incorporated in the agreement The Principles of the Glorious Sharia, however, were to vague to be applied by a state court. The parties, the court continued, will not have intended to entrust a state court with the interpretation of religious principles, the Court continued. In view hereof, the Court ruled on basis of the provisions of the agreement and did not hear the Sharia arguments put forth by the defendant – altogether a pragmatic approach, one can say, upholding the validity of the agreement for the benefit of the lending bank.
Whether this approach is fully consistent with the spirit of Islamic finance, however, is a different matter. On the one hand, a customer chooses an Islamic bank also because of the Sharia promise, the compliance of the transactions with Islamic principles. This may suggest that the customer's expectation should be legally protected, too, and that the Sharia promise should, at least to a certain extent, also be enforceable in court. Moreover, Islamic law has been applied for centuries as the common law in North Africa, the Middle East and large parts of South Asia. This suggests that it cannot be impossible for a court to apply Islamic legal rules. On the other hand, however, in Islamic finance the reference to Sharia principles is more an ethical guideline that that these rules are "hard law." Whereas normally in financing transactions law has the function to make the agreement enforceable, the reference to Sharia principles in Islamic finance serves to express a religious orientation, to make the transaction compliant with a body of rules that in most jurisdictions, where Islamic banks operate, are not enforced by the state. Neither in the Islamic finance hubs Dubai or Kuala Lumpur, nor in London, New York, Luxemburg or Geneve, the prohibition of riba is part of state law
Dealing with it
The approach of the English courts is clear, and the principles established in the Beximco Case were upheld in subsequent cases, including most recently the decision of the London High Court in Investment Dar Company KSCC v. Blom Development Bank SAL, rendered in 2009 and concerning a wakala agreement. According to the settled law, the transaction is governed by what is agreed in the contract, supplemented by the state law applicable to the transaction. The compliance with Islamic legal principles – the "Sharia promise" – is not enforceable in court and any defences that a transaction is not compliant with Islamic legal principles, will not be heard. However, the mere fact that a debtor defends in an English court by referring to Sharia principles seriously troubled the industry. The talk of Sharia risk spread – and the discussion of how to deal with it.
It is customary in Islamic loan agreement to provide for a choice of law clause for the benefit of the law of a certain jurisdiction (England, US, UAE) and a jurisdiction or arbitration clause. In addition Islamic loan agreements regularly contain a "waiver of Sharia defence" clause, pursuant to which the borrower "waives all and any defences based on Sharia law." Effectively, through this clause the Sharia promise is reversed: while in the preamble, Islamic financing agreements regularly make reference to Sharia principles guiding the transaction, towards the end of the agreement, Sharia principles is explicitly denied the enforceability. Sharia principles are downgraded to non-.binding ethical principles that cannot be enforced in court.
Another way of addressing the issue of Sharia risk is to explicitly agree on the content of the rules of Sharia law. This may be seen to be more consistent with the tradition of Islamic law, where interpretative pluralism for centuries was an important source of legal development, and where the consensus, and the agreement on certain legal rules played an important counterbalancing role. Here, for example, a clause can be included in the agreement pursuant to which the "borrower has reviewed the fatwa rendered by the lender's Sharia board", that that "it had the opportunity to seek independent Sharia advice and discuss the opinion in the bank's fatwa with scholars of choice". The clause then would continue to provide that "the Borrower and the Lender agree on the interpretation of Sharia law as put forth in the fatwa of the Bank's Sharia board." This has the effect that the content of Sharia is contractually defined by the parties. It also would reflect that entering into the transaction, also as far as Sharia aspects are concerned, was based on an informed decision on the side of the borrower, who had the opportunity to seek professional advice. The rules of Islamic law, over history, have evolved in a discursive process and divergence of opinion always has been, and still is, one of the key sources of legal development and innovation. What however contributes to the development on the law as a system, what maintains its flexibility and allows for its adaption to the change of time and clime, can adversely affect the security of a specific transaction. Agreement, whether by way of contract or in the fashion of a consensus within the scholarly community, is an important source of law in Islamic jurisprudence that permits to determine rules in those areas where there are no definite prescriptions in the Quran and the Sunna. A contractual clause in which the parties to a certain transaction agree on their interpretation of Sharia can be seen in the context of this tradition.
Capital Market Documents
Whether the compliance of certain investments with non-economic guidelines impacts their valuation, and thus needs to be reflected in offer documents, is a long standing discussion in the investment and related industries. On the one hand, the classical view argues that an investment decision is based on risk and return. According to this approach, non-economic factors do not influence the investment decision. There, consequently, also is no need to make respective disclosures in an offer document relating to the respective investments. Whether an investment is Sharia compliant would be as irrelevant as if the respective investment certificate is printed in black, red or blue letters. Although for some investors this may actually play a role, and a certain colour may inform their investment decision, for the market at large this is completely irrelevant.
With regard to Sharia compliant securities, however, the situation is to a certain extent different. There are certain financial institutions, souvereign wealth funds, as well as influential private investors that would exclusively invest in Sharia compliant investments, and also under their constitutional documents would be prevented from entering into conventional transactions. As a result, a sub-market for Sharia compliant investments has emerged. It may be too early to speak of a separate (global) Islamic financial system, as one often would see that conventional investors would also invest in Sharia compliant investments (in particular Sukuk) and conventional banks, in turn, would offer Islamic products. Nevertheless Sharia compliance is more than black, red or blue letters. It defines whether a certain investment qualifies for a certain market, with a development of prices that may be decoupled from the general market.
All this supports the view that Sharia compliance can have an influence on the valuation of a certain investment and that thus a potential lack of Sharia compliance is a risk that must be disclosed and described in an offer document. Here, again the diversity in interpretation is a central challenge, as what may be permissible to some scholars, may be prohibited according to others. This "interpretation risk" normally is reflected in the section on "risk factors" in the offer document as follows: "The investment guidelines have been defined, and their observance is controlled by, a board of religious scholars (the 'Sharia Board') which the fund management company has carefully selected in consideration of their professional and academic credentials. The investment guidelines have been discussed in detail with, and are approved by, the Sharia board to comply with Sharia principles. There is no uniform interpretation of Sharia principles, however, and the fund management cannot exclude that other Sharia scholars take a different approach to interpretation of Sharia, and that in their view certain investment in the fund, or the investmen guidelines altogether, are not consisten with Sharia principles."
The Way Forward: Separate Dispute Resolution Bodies for Islamic Financing Transactions?
The ongoing debate on Sharia risk raises the question whether separate dispute resolutions bodies for Islamic financing transactions would be a solution. From the case law analysed above, one can see a certain unease of state courts to get involved in Sharia matters. This unease goes along with a dissatisfaction of many members of the Islamic finance community with how state courts have treated Sharia law. Moreover, there is a general tendency towards specialized dispute resolution bodies, for matters such as construction, shipping, commodity transactions, sports, IP, takeover rules and trade finance. So why not setting up dispute resolution bodies specializing in Islamic financing transactions, bringing together the perspectives of international finance and Sharia law?
At present, there are two dispute resolution bodies in Dubai and Kuala Lumpur specializing in Islamic finance disputes, with Bahrain expected to follow soon. The aim of these Islamic finance arbitration centres is to provide a specialist forum for Islamic financing disputes. And, as the rules of arbitration of the Dubai based International Islamic Center for Reconciliation and Arbitration( IICRA) provide: in rendering the arbitral decisions, "the Panel shall exclude any provisions in the law that should be applied if such provisions are not in conformity with the rules of Islamic Sharia." This means that Sharia rules, in the event the law determined as the proper law of the contract is in conflict with them, remain supreme. In the last instance, it is Sharia law that applies to the subject matter of the dispute. This is a very different approach from the "waiver of Sharia defence clauses" in standard Islamic loan agreements. At the same time, this inevitably puts enforceability of many Sharia compliant transactions at risk, as it allows for an independent review of the decision of the bank's Sharia board. It goes without saying that in many cases the arbitral body will share the board's interpretation of Sharia law. But this cannot be taken for granted, in particular when it comes to financial innovations, where opinions among Sharia scholars are divided, and as in the field of commodity murabaha or the sukuk with fixed return, the market practice is seen to conflict with an orthodox interpretation of the Sharia by many members of the Islamic scholarly community. Whether the market will accept specialised Sharia arbitration bodies in financial disputes remains to be awaited. The establishment of any specialised dispute resolution body takes years, if not decades, and for this reason it is far too early to come up with a definite assessment. A specialised dispute resolution panel, in any event, has the advantage that it can bring together different areas of expertise, and have arbitrators decide the cases that feel at home in the world of international banking and Sharia likewise.
An alternative approach, followed for example by the Malaysian central bank (Bank Negara), is to vest the financial services regulator also with the power to supervise Sharia boards or Sharia compliance. This model is based on the – correct – assumption that in an Islamic financing transaction Sharia compliance is part of the deal and must be subjected to supervision by the regulator, such as the observance of prudential rules and the compliance of consumer protection rules. This approach may be even more suited to build a coherent set of Sharia rules applicable to Islamic financing transactions.
Making it Happen: Sharia Compliant Agreements which can be Enforced in Court – a Checklist
- Determine a law as the proper law of the contract that is favourable to international lending and capital market transactions; avoid referring to the Islamic Sharia or principles of Islamic law in the choice of law clause.
- Provide for a venue (court or arbitration tribunal) that is familiar with international financing transactions and likely to uphold the contractual agreement among the parties. Avoid a venue where a court may apply Islamic legal principles in interpreting the contract.
- Determine in the contract what is meant by Sharia compliance and Islamic legal principles. Make reference to the view of the Sharia board or the fatwa approving the transaction. Let both sides seek independent Sharia advice.
- Include in capital market documents a risk factor dealing with divergent Sharia interpretations. There is no guarantee that scholars will follow the opinion of the issuer's Sharia board with regard to the permissibility of a certain transaction.
- Include a "waiver of Sharia defences" clause, pursuant to which the borrower waives all and any defences based on Sharia law.
Kilian Bälz, Islamic Financing Transactions in European Courts, in: Nazim Ali, Islamic Finance: Current Legal and Regulatory Issues, (Harvard Law School: The Islamic Finance Project, Cambridge/Mass. 2005), 61-75.
Kilian Bälz, Sharia Risk? How Islamic Finance has transformed Islamic Contract Law, ILSP Working Paper, Harvard Law School, Cambridge MA 2008.
Specialized Dispute Resolution Bodies
Shariah Advisory Council, Kuala Lumpur (http://www.bmthost.com/rcakl/islamic-banking)
International Islamic Center for Reconciliation and Arbitration( IICRA), Dubai (http://www.iicra.net)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.