With the combination of both the Shari’a and conventional law in Sukuk contracts, there were always going to be conflicts. This increases the risk facing potential investors. However, as Jhordy Kashoogie opines, there can be a harmonious relationship between the two systems of law.
There have been 21 sukuk defaults recently in the Islamic capital market space, with the Nakheel sukuk and the East Cameron Gas sukuk among the most publicized. These sukuk defaults reveal severe legal risks which are inherent in the sukuk contract. Specifically, the risk with regards to a sukuk contract’s enforceability i.e. whether or not the sukuk can be enforced in order to protect the rights of the sukuk holders in the event of a default.
Sukuk default cases are increasing with adverse impacts on the legal rights and compensation of the sukuk holders. Therefore, in this article, the issues sur- rounding the enforceability of sukuk contracts are discussed in an attempt to give possible legal and financial mitigations to the problem of sukuks legal risks in the Islamic capital market. Before as- sessing issues surrounding the enforceability of sukuk, it is imperative to highlight the kind of conflicts occurring in the Islamic finance sphere due to the dual law system that governs sukuk transactions.
Common law and civil law each present distinctive problems when they collide with the Shari’a. The national law always prevails over Shari’a law when there are disputes. In the case of Shamil Islamic Bank of Bahrain VS Pharmaceutical Company, the defendant was unable to repay his loan to the bank, and the court judged based on English law instead of Islamic law. The defendants argued that the contract was so worded with Shari’a principles as not to clash with English law. However, the judge ruled that there cannot be two separate law systems governing a contract and that English law will prevail especially since the parties had stated that the governing law of the contract was English law. The Courts will only look at the Shari’a so far as it adheres to the commercial purpose of the contract and will not look at it as the governing law. Furthermore, the conflict between common law and Shari’a leads to paradoxes. In the aforementioned case, the verdict was decided based on sale contract law, while the substance of the contract was
actually a conventional debt contract. With respect to sukuk structures in jurisdictions where Shari’a concepts are followed, this is, to a certain degree, more straightforward from a legal perspective, although the process does com- pose more layers since it requires compliance with Shari’a as well as local law. Realising that in most sukuk issuances there are cross-border transactions, there is a problem with which law would be enforced. This enforceability issue causes legal impediments due to the inability to obtain satisfactory legal opinions, which emanate from the sale of
assets between the originator and investors through the SPV, and also due to various bankruptcy law matters. Hence, there is confusion about which law can be enforced and to what extent that law can be enforced in some sukuk issuances.
There are two crucial aspects of sukuk operations that affect the enforceability of a sukuk contract. Firstly, true sale execution. Executing a true sale is a crucial element in a sukuk operation, as it constitutes a real transfer of ownership from the originator to the sukuk holders via the SPV. Nevertheless, some sukuk issuances do not execute a true sale, in the case of asset-based sukuk issuance, due to the absence of property law and bankruptcy law under civil law regimes. Secondly, an SPV is a bankruptcy remote firm, which is independent of the originator. The SPV is established based on trust law in which the sukuk’s originator (the transferor) transfers the assets to the sukuk holders (beneficiaries) via the SPV (a trustee) with good faith. Therefore, trust law plays an important role in governing the SPV’s establishment. These two aspects indicate that property law, bankruptcy law, and trust law are pivotal in governing rules to facilitate a true sale transaction in the eyes of both Western law and the Shari’a.
True sale execution and an independent SPV, however, are not in existence in most Sukuk structures, which eventually leads to a lack of legal protection for the sukuk holders. There are two identifiable legal mitigations arising from these sukuk enforceability issues. Firstly, the rating agency should incorporate additional proxies for sukuk rating, which take into account compliance as well as legal uncertainties of sukuk. Secondly, sukuk urgently need to be standardised and streamlined in terms of legal documentation and Shari’a standards. AAOIFI Shari’a standards for sukuk have been set properly, but the problem is that the standards are not binding among key players in the Islamic financial industry. Therefore, enforcement of the standards is critical to having Shari’a-compliant and jurisdictionally accepted sukuk in the market. Besides this, there should be uniformity of methods in resolving the issue of con- flicting legal systems that govern sukuk issuances across. The goal would be that, in a case of default, the case could be re- solved in pursuant to standardised legal documentation. Hence, there would be predictability, certainties, and Shari’a convergence through sukuk standardisation.
Alternatively, possible Shari’a-compliant financial innovations can be suggested in order to give financial protection to the sukuk holders from legal uncertainties. The following are suggestions made by scholars such as Mohammed Khnifer. Firstly, sukuk maturity extension in which the sukuk contract is extended until the issuer’s legal dispute is resolved by compensating sukuk holders through higher rental payments in the case of ijarah sukuk, and increasing the agreed profit sharing ratio in the case of musharakah sukuk. Secondly, sukuk refinancing in which sukuk are refinanced with another sukuk which have lower financing costs, in order to settle the sukuk holders’ residual payments. These two suggestions can be done only if the sukuk was in a strong financial position. Lastly, convertible equity sukuk in which sukuk’s assets values are converted into the issuer’s equity value based on a pre-determined formula in the event of default. These innovations would give assurances to the sukuk holders before the purchase undertaking is executed, and hence their financial rights would be fully protected from legal uncertainties.
Realising that in most sukuk issuances there are cross-border transactions, there is a problem with which law would be enforced. This enforceability issue causes legal impediments due to the inability to obtain satisfactory legal opinions, which emanate from the sale of assets between the originator and investors through the SPV, and also due to various bankruptcy law matters.
If key players in the Islamic capital market seriously consider these legal and financial mitigation tools, sukuk issuances can become more transparent and predictable enough so that sukuk can be enforced to protect the sukuk holders’ rights. Sukuk holders would have more valuable information as well as financial assurances in order to make an informed decision for sukuk investment. Thus, closer engagement between key players, regulators, Shari’a advisers, and scholars in the industry is urgently needed to discuss and improve the feasibility of these legal and financial mitigation tools.
