There have long been questions around the rigour of Islamic finance as practised in the Middle East.
Without an overarching regulatory body in place to establish the Shariah compliance standards used in every Islamic transaction, issuers of, and investors in, Islamic instruments rely on the determination made by individual Shariah scholars.
These are complex theological assessments that could, at least in theory, be contradicted at any time by any scholar.
That means the religious premises upon which each deal rests could be brought into question. This inherent flaw does not usually pose much of a problem. In the day-to-day workings of Islamic finance, investors and issuers simply agree to consider the contractual agreement they are entering as halal – on the determination of the Islamic scholars hired for the task – and, of course, as legally binding.
In a sense, it matters little whether a deal is truly Shariah-compliant or not, as long as all parties agree to consider that it is, and to fulfil their financial commitments by it.
Now a debt restructuring brought by Dana Gas, an Emirati gas company, looks set to expose issues with Islamic finance that had long been ignored.
This is the first time that somebody’s tried to restructure an obligation on the basis that actually it’s not religiously compliant, and to make it religiously compliant we have to restructure it, and by the way we’re going to give you less than we did before
- Khalid Howladar, Acreditus
Dana announced in early May that “due to continued challenges it faces around cash collections and resulting need to focus on short- to medium-term cash preservation”, it would begin restructuring negotiations with holders of its $700 million sukuk, which it issued in 2013 and which matures at the end of October.
But on June 13, the company explained the need to restructure its sukuk in a new and wholly different way. Rather than pursue the line of financial challenges – a common reason to restructure one’s debt – the company instead said that its sukuk was not “in its present form” Shariah-compliant.
It blamed non-compliance on “the evolution and continual development of Islamic financial instruments and their interpretation”, and said a restructuring of the sukuk was necessary, as the deal had become “unlawful under UAE law”. Dana said this view was based on “recently received legal advice”.
This explosive statement will have come as a shock to many participants in the region’s Islamic finance market.
Khalid Howladar, founder of advisory firm Acreditus and a long-term observer of Islamic finance, appears baffled by the legal justification put forward by Dana.
“UAE laws do not cover sukuks,” he tells Euromoney. “It’s not that there’s a law that can be changed. There’s actually no law that governs the Shariah structure of sukuk instruments.”
How then could a development in Islamic finance have made Dana’s sukuk “unlawful under UAE law”, as the company argues?
The bizarre claim raises the possibility that Dana is trying to overcome its debt challenges by using a religious argument, thereby avoiding the usual restructuring procedure.
The company has filed the claim at a court in Sharjah, where it is headquartered. Sharjah is considered one of the more conservative emirates in the UAE. If there is anywhere the claim could succeed, it is there, even though ultimately the sukuk should be governed by English law.
Howladar says: “This is the first time that somebody’s tried to restructure an obligation on the basis that actually it’s not religiously compliant, and to make it religiously compliant we have to restructure it, and by the way we’re going to give you less than we did before.
“Those two arguments don’t really gel. You could either restructure because it’s religious and give it the same sort of value, or if you’re doing it because you can’t afford it, call it what it is and say, ‘look, it’s a distressed exchange, we can’t pay you, and it’s actually got nothing to do with Shariah compliance’.”
This case could have consequences beyond simply the Dana Gas restructuring. If a sukuk issuer can bring into question the Shariah compliance of its own deals, and use that religious reassessment as a pressure point in restructuring negotiations, investors won’t know whether they can trust Shariah assessments any more.
If that trust is eroded, investors will simply turn away from Islamic finance in the Middle East.
Of Dana’s aggressive restructuring method, Hasnain Malik, head of frontier markets equity strategy at Exotix Partners, tells Euromoney: “If that’s possible, other sukuks in the same market must come into question.”
In Malaysia, where Islamic finance is large and innovative, such problems would not occur, because a central Shariah board is charged with setting the standards. The Dana Gas case might now force the UAE to seriously consider introducing such a board.
Some might push back, on the basis that ‘innovation’ would be stifled by such a move, but if investors are driven away by Dana’s restructuring, Emirati authorities will find themselves having to change the way they do things to halt the outflow.
Whatever the outcome of the Dana Gas case, it will serve as an important precedent for the entire market.
In 2010, the struggling Kuwaiti investment company Investment Dar brought a claim under a wakala agreement with Lebanon’s Blom Development Bank, on the basis that the arrangement was not in fact Shariah compliant, and should therefore be declared void.
The High Court in England told the Kuwaiti investment company it was allowed to run this argument at trial, but Investment Dar ended up dropping the claim after the pre-hearing, when it was told it would have to repay the principal either way. The Shariah-compliance argument was therefore never settled in court.
Now, with Dana Gas’s shock move, it might finally be.