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7/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions
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Islamic Finance: Due Diligence in Shariah-Compliant
TransactionsKalu Kalu
Santa Clara University School of Law
7/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions
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Kalu Kalu Santa Clara University School of Law, Class of Dec. 12
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Contents
Introduction .......................................................................................................................... 3
Background & Principles of Islamic Finance ............................................................................ 4
The Role of Shariah-Compliant Boards: Non-binding decisions .............................................................. 5
The Steps ............................................................................................................................................... 5
The Prohibition of Riba ............................................................................................................................. 6
Riba al-Fadl & Riba al-Nasiah ................................................................................................................ 7
The Time Value of Money: Prohibition of Money as a Commodity ...................................................... 7
Application of the Principles of Riba to Finance ................................................................................... 8
Islamic Financing Structures................................................................................................. 10
Murabaha (Cost-Plus Financing) ............................................................................................................. 10
Ijarah (Lease Financing) .......................................................................................................................... 11
Mudaraba (Venture Capitalism) ............................................................................................................. 12
Musharaka (Joint Venture) ..................................................................................................................... 13
Taxation of Islamic Financing Structures ................................................................................................ 13
Rahn (Security Interest or Pledge) .......................................................................................................... 15
The Sukuk: Islamic Bonds or Debt Securities ........................................................................ 15
Two Classes of Sukuk .............................................................................................................................. 18
Nakheel Sukuk: Case Study ..................................................................................................................... 19
Conclusion ........................................................................................................................... 24
Nakheel Structure Glossary.................................................................................................. 25
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Introduction
What is Islamic Finance? How does it differ from conventional finance? Islamic Finance
attempts to reach the same substantive outcomes as conventional finance but in forms that
comply with the concepts underlying the Shariah and the divine laws of Islam. Although
Shariah compliance prohibits many concepts integral to conventional finance, such as thecharging of interest and profit-making without commensurate risk, it is incorrect to assume that
Shariah-compliant projects are a radically different approach to finance. Islamic finance focuses
on structuring projects in ways that observe formal Islamic requirements, but still provide near
identical economic equivalents of conventional finance, including the aforementioned charging
of interest and profit-making without shared risk.1
Therefore, critics often opine that Islamic
Finance is the practice of form over substance. Salahs Islamic beerjoke is demonstrative of
critics points:
What's Islamic beer, you ask? Well, you first approach the Shari'ah scholar and ask Is it
all right if I tie a rope to this door? The scholar's response is, Yes. There's no issue
there. Go ahead and tie the rope to the door. Next you ask, Well, is it all right if I lie on
the floor? The scholar responds, I see no issue with that. You can lie on the floor. The
next question to the scholar: Is it all right if I tie a beer bottle to the end of the rope?
The scholar's response: I suppose that's all right. With that permission, you tie a beer
bottle to the end of the rope, you lie on the floor next to the beer bottle with your
mouth open, you wait for somebody to open the door, the bottle is pulled over and the
beer pours out into your mouth. That is Islamic beer.2
Others believe that critics are missing the point.3
When compared to religious dietary rules,people often refuse to eat food that is not halal or kosher, but may eat their closest
approximation.4
Thus sometimes the form itself can be of great significance to religious
observers. Regardless of critics points, Islamic Finance has the substantive benefit of allowing
greater market participation by Muslims across the world, which in turn can only lead to
greater global financial integration.5
All the same, because Shariah-compliant transactions may
1Mohammad H. Fadel, Riba, Efficiency, and Prudential Regulation: Preliminary Thoughts, 25 Wis. Int'l L.J. 655, 656
(2008).2
Isam Salah, Islamic Finance in the Current Financial Crisis, 2 Berk. J. Middle E. & Islamic L. 137, 154 (2009).3 PBS, Islamic Financing (2009), available athttp://www.pbs.org/wnet/religionandethics/episodes/april-10-
2009/islamic-financing/2629/(See Ibrahim Warde, professor of Islamic banking and finance at Tuft Fletcher School
of Law and Diplomacy, stating *t+he example I typically give is religiously inspired dietary rules, in that if some
people dont want to eat food that is not halal or kosher, then a nutritionist can come to them and say, Why are
you doing that? But for these people, for religiously minded people, how the food is prepared is quite
significant.).4Id.
5Blake Goud, Is Islamic Finance Beneficial for Non-Muslims?(2012), Sharing Risk Dot Org., available at
http://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.html.
http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/7/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions
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be described as the practice of form over substance, many risks inhere in their structure that
investors inexperienced with Shariah-compliant transactions may not appreciate.
This note explains what Islamic finance is by detailing the basic principles and commonly used
transaction structures. Additionally this note details some of the risks inherent but often hidden
in Shariah-compliant structures so that an investors may take due diligence when reviewing a
prospectus. Provided first is a description of the background and principles of Islamic finance,
most importantly the prohibition of riba and how to determine whether a transaction is
Shariah-compliant. Next the note will detail commonly used Shariah-compliant financing
structures such as musharaka (joint venture partnership), murabaha (cost-plus financing), and
ijarah (lease financing) followed by a short description of the tax implication of some these
structures.
The latter half of this note focuses exclusively on sukuk, Islamic trust certificates, in which an
originator securitizes a pool of assets usually comprising of Islamic financing structures (likemusharaka and ijarah). Thus investors, or sukuk-holders, by purchasing sukuk are given a
proportional ownership interest in the above-mentioned financing structures. After a
description of the basics of a sukuk structure the note will provide a case study of a Nakheel
Group (a Dubai-based real estate developer) ijarah-based sukuk offering. The case study will
describe the specifics of the sukuk offering, and what occurred after the sukuk went into
default. This Nakheel case study illustrates the complexity in identifying the Three Little
Enemies (TLE) to investors recourse in the event of default. Three Little Enemies is simply a
mnemonic to remind investors to identify whether they are transferred actual 1) Title that
would be of value after default, or if not, whether they perfected 2) Liens over said assets, andlastly whether these liens are 3) Enforceable in the pertinent jurisdiction.
Background & Principles of Islamic Finance
Finance in accordance with the concepts of Islamic laws is known as Islamic Finance.6Fiqh is
the direct source for Islamic Finance as opposed to the more commonly referred to Shariah-
law.7
While technically correct, Shariah-law refers to the divine laws of Islam as expressed in
the Quran and by Muhammad himself whereas Fiqh refers to the human interpretation of the
divine laws.8
Fiqh interpretations are abstracted from many sources - (1) the Quran (holy
book), (2) the Sunnah (what the prophet said & did), (3) Qiyas (new rules), and (4) Ijma
6McKean James Evans, The Future of Conflict Between Islamic and Western Financial Systems: Profit, Principle and
Pragmatism, 71 U. Pitt. L. Rev. 819, 821 (2010).7
Mushfique Shams Billah, Arab Money: Why Isn't the United States Getting Any?, 32 U. Pa. J. Int'l L. 1055, 1060
(2011).8Id.
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(scholarly consensus).9
Fiqh interpretations make up the main tenant of rules that must be
followed in Islamic Finance which are; a prohibition in transactions dealing with haram
(forbidden vices like alcohol, pork, gambling & pornography)10
, prohibition of riba (interest) and
a prohibition in gharar (transactions involving excessive uncertainty or risk). Only the
prohibition of riba, being the most abstract and difficult to comprehend concept to IslamicFinance, will be discussed in detail in this note.
The Role of Shariah-Compliant Boards: Non-binding decisions
How might an investor or a financial institution know iftheir transaction is Shariah-compliant?
Since much of Shariah law is based on human interpretations of the divine laws, there must be
a process for determining whether particular transactions are Shariah-compliant. This process
occurs through the issuances of legal opinions or fatwas by qualified Muslim scholars using
judicial consensus and analogical extensions.11
The StepsWhen an institution wishes to claim a financing structure as Shariah-compliant, it must confer
with a group of advisors comprised of Islamic scholars experienced in like-kind financial
transactions.12
These advisors are commonly known as a Shariah board.13
The Shariah boards
role is to work in close connection with the institution in order to issue a fatwa signaling that
the transaction is halal or Shariah-compliant.14
The fatwas produced by Shariah boards can
never be binding; they are more akin to legal commentaries by law professors.15
Moreover the
authority of a particular fatwa is largely dependent on the reputation of the issuing Shariah
board.16
It is important to understand that there is no universally accepted interpretation of Shariah
law; different jurisdictions in the Muslim world adopt different interpretations.17
Due to the
lack of binding precedent and the differing interpretations among Shariah boards there is an
absence of uniformity about what constitutes a Shariah compliant transaction.18
Often
institutions creating the financing transaction will seek Shariah boards with obscure minority
9Michael J.T. McMillen, Asset Securitization Sukuk and Islamic Capital Markets: Structural Issues in These
Formative Years, 25 Wis. Int'l L.J. 703, 772 n.1 (2008).10
Id. at 710.11
Rafel Mahmood, Islamic Governance, Capital Structure, and Equity Finance: Examining the Possibilities of
American Financial Shari'ah Boards, 37 Int'l J. Legal Info. 29, 33 (2009)12
Id.at 31.13
Id. at 31.14
Christine Walsh, Ethics: Inherent in Islamic Finance Through Shari'a Law; Resisted in American Business Despite
Sarbanes-Oxley, 12 Fordham J. Corp. & Fin. L. 753, 763 (2007).15
See Billah, supra note 7, at 1067.16
See Mahmood, supra note 11, at 37.17
Id.18
3F Sec. & Fed. Corp. Law 27:32.40 (2d ed.).
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views that observe liberal interpretations in order to allow transactions strikingly similar to
conventional finance.19
A prominent Islamic scholar has described the practice of board
shopping as Shariah arbitrage, stating that it amounts to none other than finding the closest
approximation to the conventional financial practice and then reengineering the product to
meet Islamic law, to be sold to an Islamic-finance-based captive market.
20
Adding furtherskepticism of a good faith adherence to fiqh, Shariah boards often act both as an independent
auditor and consultant for the institution seeking approval, leading to significant conflicts of
interest.21
For the aforementioned reasons, Islamic finance is often criticized as being driven by marketing
desires instead of a sincere desire to abide by the underlying principles of the divine laws of
Islam. Islamic investors want to know that their transactions are halal; however, regardless of
whether a Shariah board accepts a transaction as compliant, once created, the investors are
bound to the contractual agreement as with any conventionally structured financing
transaction. Ultimately, it is the responsibility of the investors and other participants, not the
issuer, to feel confident that they are conducting business in a manner that accords with their
religious beliefs.
The Prohibition of Riba
One of the more central and uniformly agreed upon necessities of Islamic Finance is adherence
to the Qurans express prohibition of riba. The Quran states; [t]hose who devour riba will not
stand [on the Day of Judgment] except like the standing of a person beaten by Satan leading to
madness. That is because they say: Trade is like riba, but Allah has permitted trade and
forbidden riba.
22
While it is uniformly agreed upon that riba is banned there is no precisedefinition of the term riba itself. Riba literally translated means increase
23and is generally
thought to be a prohibition on interest or usury.24
However, the concept of riba is far more
profound than can be captured only by notions of interest and usury. Abu Bakr ibn Ali al-
Bayhaqi, a prominent scholar of fiqh in the eleventh century, expansively defined riba as any
act which amounts to the financial exploitation of the poor by the rich.25
More modern
scholars define riba as any reward through passive use of money without commensurate risk.26
An illustration of profit without commensurate risk is a conventional interest-bearing loan
19See Sorenson, supra note 10, at 653.
20 Ali Adnan Ibrahim, The Rise of Customary Businesses in International Financial Markets: An Introduction to
Islamic Finance and the Challenges of International Integration, 23 Am. U. Int'l L. Rev. 661, 688 (2008).21
Id.22
Quran, 2: 275.23
See Billah, supra note 7 at 1061.24
Id. at 1062.25
Barbara L. Seniawski, Riba Today: Social Equity, the Economy, and Doing Business Under Islamic Law, 39 Colum.
J. Transnat'l L. 701, 706 (2001).26
See McMillen, supra note 9, at 714.
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where the lender is obligated to repayment plus interest regardless of whether the borrowers
investment of the loan is profitable. The concept of riba seeks to ban the lenders profit through
interest because it is both guaranteed and not dependent on the success of the borrowers
investment with the loan.
Another way to think of the prohibition of riba is by reference to the two modes of financial
participation in a transaction; through debt or equity. Equity participation involves an
ownership interest in the transaction, whereas debt participation involves only a loan of
property or money, usually with repayment including interest.27
Since profit making by the
charging of interest is banned, the prohibitions of riba encourages investors to make equity
structured transactions rather than debt-structured transactions.28
Riba al-Fadl & Riba al-Nasiah
There are two main categories of Riba; Riba al-Fadl and Riba al-Nasiah.29
Riba al-Nasiah,
roughly translated as deferred increase, deals with money-to-money exchanges where oneparty is charged a premium (or increase) for the right to receive the other partys money while
being allowed to repay at a deferred time.30
Therefore the ban of Riba al-Nasiah prohibits a
lender from fixing in advance a return on a loan based solely on the passive activity of waiting
for repayment. Riba al-Fadl prohibits hand-to-hand (bartering) exchanges that are not equal in
amount or quality.31
Riba al-Fadl is less relevant in modern finance as exchanges are monetary
in nature and less akin to bartering.32
However, it is clear that both qualitative and quantitative
increases during time delayed exchanges are barred.33
These doctrines of riba demonstrate the
Islamic view that lending should be a charitable activity and not a means of making profit.34
The Time Value of Money: Prohibition of Money as a Commodity
Since Riba al-Nasiah prohibits pre-determined fixed returns in reward for the lending of money,
an inductive extension also prohibits the guarantee of a return of capital. In other words,
money is viewed only as a means of exchange and not as a commodity.35
Therefore, it is
commonly said that the ban of riba prohibits the concept of making money from money.36
27Cal. Prac. Guide Corps. Ch. 3-B.
28See McMillen, supra note 9, at 714.
29See Ibrahim, supra note 20, at 694.
30Id.
31Id.32
Id.33
Id.34
Umar F. Moghul, Esq. & Arshad A. Ahmed, Esq., Contractual Forms in Islamic Finance Law and Islamic Inv. Co. of
the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & Ors.: A First Impression of Islamic Finance, 27 Fordham Int'l L.J.
150, 168 (2003).35
See McMillen, supra note 9, at 713.36
Alan J. Alexander, Shifting Title and Risk: Islamic Project Finance with Western Partners, 32 Mich. J. Int'l L. 571,
580 (2011).
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This is in stark contrast to Western methods of finance which treat money both as a commodity
and as a means of exchange.37
Riba prohibitions against increase (interest) are often
mischaracterized as an Islamic denouncement of the time value of money.38
However Ala
Adnan Ibrahim, Islamic scholar and vice president of the worlds largest Islamic banking
network, argues that the impreciseness of such a conclusion can be seen in the distinctionbetween lending and investment.
39Calculating the time value of money in a pure lending
transaction is clearly prohibited. However, it is permissible to calculate the time value of money
when it involves an economy activity such as an investment, and when the risk of loss is shared
by the investor.40
For example, in a shared partnership investment (musharaka) it is perfectly
permissible for one partner to receive a percentage of profits in excess of the proportion of
capital she contributed.41
Therefore one partner may receive 10% of the profit even though she
only contributed 7% to the musharaka. However, the losses must be shared to the extent of
capital contributed. In contrast to purely lending transaction such as a conventional loan, the
riba prohibition would preclude a lender from receiving any amount in excess of the loan given.
The riba principles of Islamic finance promotes the creation of goods and services rather than
mere passive lending. Investors are encouraged to take the role of an equity-holder rather than
a lender, which in turn supports the idea of sharing risk or in this context, sharing of losses and
profits.42
Application of the Principles of Riba to Finance
Ban on Interest
A consequence of a prohibition of Riba in the financial context is the ban against interest rates.
The ban against interest occurs when an interest rate (1) is tied to a time of deferred paymentfor a loan, (2) is fixed ex-ante, and (3) its payment is guaranteed regardless of the outcome or
the purposes for which the principal was borrowed.43
As alluded to earlier, though the riba
bans the charging of interest, there is a long-standing practice dating back to Ottoman times of
transactions authorized by both Hanafi and Shafil jurists that contravene the technical ban on
interest.44
In the Ottoman times this contrivance took the form of two separate transactions
where a lender would (1) lend the borrower money (i.e. $100) and (2) sell to the borrower on
37See McMillen, supra note 9, at 713.
38See Ibrahim, supra note 20, at 697-98.
39Id.40
Id.41
Shahzad Q. Qadri, Islamic Banking an Introduction, Bus. L. Today, July/August 2008, at 59, 60.42
Query how the tension between the Islamic concept of risk sharing and the general risk-averse nature of
traditional financers can be reconciled in a finance project with both western and Islamic financers. For an
extensive discussion of the sharing of risks with mixed Islamic and conventional lenders see generally Alexander,
supra nota 36.43
See Ibrahim, supra note 20, at 699.44
See Fadel, supra note 1, at 680.
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credit a nominally priced item (such as a hankerchief) at a price of the cost of the loan ($100)
plus desired interest rate of return (10%,).45
More modern forms of circumventing the ban on
interest that have also been approved by Islamic scholars are discussed in this note (i.e. a
murabaha or ijarah transaction).
Sharing of Profits & Losses: Retention of Title
Next, the prohibition of riba requires the sharing of risk or otherwise, profits and losses. This
requirement creates a general obligation for Islamic financers to retain title in the assets
underlying the financing project for at least an instant in time. *S+ince the assets are owned by
the Islamic financier it should assume the risk of total loss.46
Because all Shariah-compliant
deals must have assets at their core, some investors assume, incorrectly, that they have
recourse to the underlying assets in the event of a default (i.e. that it is asset-backed). Often
the lender will take title or a beneficial ownership in the assets.47
Whether there is recourse to
the underlying assets often depends on whether the transfer of the assets from the originatorto the issuer is classified as a true sale for bankruptcy purposes. If the transfer is not a true
sale, and the assets were transferred only for Shariah compliance purposes, then the lender
has no recourse to the underlying assets in the event of a default and therefore risks standing in
line with the originators creditors as an unsecured creditor.48
Keep in mind lenders in Shariah-
compliant transactions should maintain due diligence in understanding what the actual assets
are. Lenders should know if the actual assets are rights to real property which may be attached
and sold by the lenders in the event of default, or if they are merely rights to revenue stream
like leaseholds rights (ijarah) or oil and natural gas rights which may very well be worthless to
the lender in the event of default.
As you can see, whether the financers retain ownership of the underlying asset is one of the
main considerations in any Shariah-compliant finance project.49
As this note details the
different structures used in Shariah-compliant projects be cognizant of the various methods
used to observe the requirement for title retention. Also be cognizant of the possibility of
confusion on the part of lenders. Confusion can arise from determining what rights they
actually own, rights to a stream of revenue, or actual title in property.
45Id.
46John Inglis & Nadim Khan, Must Try Harder, Project Fin., 31 (2004).
47RAM Rating Services, Sukuk Investors Positions Amid Defaults, available at
http://biz.thestar.com.my/news/story.asp?file=/2009/10/3/business/4814754&sec=business (last visited Nov. 15,
2012).48
Id.49
See Alexander, supra note 36, at 576.
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Islamic Financing Structures
This next part describes the various types of commonly used Shariah-compliant transaction
structures. First, the most commonly used structure, mudaraba, is described. A mudaraba is
similar to a deferred payment or cost-plus profit transaction. Following is a description of the
second most commonly used, ijarah, a lease financing structure. Then the two differentpartnership structures musharaka (shared partnership) and mudaraba (silent partnership) are
described. A helpful mnemonic for distinguishing among the semantically similar mudaraba &
musharaka is to think of mudaraba as da guy with the money and da entrepreneur who
does the work, whereas musharaka is a shared partnership.50
These structures (with the
exception of murabaha51
) will be important in understanding the later discussion of sukuk,
Islamic bonds or trust certificates. Sukuk offerings are usually structured so the certificate-
holders own a beneficial interest in a pool of assets comprised of these financing structures. For
example, in the Nakheel sukuk case study, the sukuk-holders owned a beneficial interest in a
pool of ijarah leaseholds.
Thereafter will be a brief discussion of some of the tax implications customers should be aware
of in these structures. Although more complex transactions in Islamic jurisdictions have few tax
liability concerns, when they take place in the U.S. they can have unfavorable tax
consequences, especially in the home mortgage context. Lastly a rahn, or a security pledge, is
described. The enforceability issue of security pledges will come up under this rahn section and
again in the Nakheel case studies.
Murabaha (Cost-Plus Financing)
Murabaha, the most commonly used Shariah-compliant transaction structure, is a deferredpayment or cost-plus profit, debt-like transaction.
52In a Murabaha transaction, a financial
institution upon request by a borrower purchases an asset and sells it to the borrower at the
cost of the asset plus an additional fee (profit for the financial institution).53
The financial
institution can transfer title to the borrower at either the initial closing or a date later agreed
50Special thanks to Professor David Ball for passing on this mnemonic.
51Murabaha are impermissible in sukuk offerings because murabaha contracts involves the sale of debt, which is
generally prohibited in by Shariah law. Muhammad Taqi Usmani, Sukuk and their Contemporary Applications,
available athttp://www.failaka.com/downloads/Usmani_SukukApplications.pdf(last visited Nov. 15, 2012).52
Nickolas C. Jensen, CPA, Avoiding Another Subprime Mortgage Bust Through Greater Risk and Profit Sharing and
Social Equity in Home Financing: An Analysis of Islamic Finance and Its Potential As A Successful Alternative to
Traditional Mortgages I, 25 Ariz. J. Int'l & Comp. L. 825, 839(2008).53
Id.
http://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdf7/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions
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upon.54
The additional fee, or profit, may be benchmarked to standard interest rates, such as
LIBOR, giving the transaction the same economic effect as a traditional interest-bearing loan.55
Of course this fee isnt technically characterized as interest charged by the financial institution,
which is impermissible, but rather the permissible investment return on an asset purchase.56
Nevertheless, one might regard the profit as merely disguised interest, and wonder how to
reconcile these transactions with the prohibition of riba. Modern scholars argue the additional
cost-plus fee is distinguished from mere disguised interest because the financial institution
must own the asset before transferring title to the borrower, and therefore is forced to bear
risks associated with ownership.57
These risks include the possibility that the borrower will
refuse to purchase the asset and costs involved with maintaining the asset while it is in the
possession of the institution. However, the financial institution can easily minimize this risk by
conducting the resale to the borrower immediately after or simultaneous with the initial
purchase.58
To illustrate, consider the steps of a murabaha transaction in a home ownership context. Upon
request by the borrower, the financial institution purchases the home and sells it to the
borrower at a marked up purchase price which includes the cost of the home plus profit (built
in interest fees).59
The borrower, now homeowner, makes a down payment and purchases the
home from the financial institution and is transferred the full title in the home.60
Thereafter the
homeowner must make monthly payments to the financial institution on the balance of the
purchase price in order to fully pay off the home.61
Ijarah (Lease Financing)
An ijarah transaction shares many similarities with conventional lease financing. In an Ijarah
transaction a financial institution purchases an asset selected by the customer, leases it to a
customer, but retains title and ownership for the duration of the lease.62
The customer agrees
to purchase the asset and the financial institution agrees to sell the asset to the customer.63
The
customers rent payments are the sum of (1) the base amount, which includes the acquisition
cost for the assets and the amortization and cost obligations borne by the financial institution
during the term of the lease, and (2) a rental rate or LIBOR based interest rate on the
54Id.
55Michele O. Penzer, Melissa S. Alwang, Salman Al-Sudairi, Shari'ah-Compliant Financings: New Opportunities for
the U.S. Market, 126 Banking L.J. 59, 63 (2009). 56
See Jensen, supra note 52, at 839.57
Id.at 840.58
Id.59
Id.60
Id.61
Id.62
See Billah, supra note 7, at 1069.63
Id.
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remaining balance on the aforementioned base amount.64
The customer is entitled to
purchase the asset during or at the end of the lease through the provision of a call option.65
The
financial institution is granted a put option so it may force the customer, upon the occurrence
of certain events (such as a default on installment payments), to purchase the asset at the
remaining base amount.
66
The financial institution must retain title in the asset in order to comply with Shariah
requirements.67
Retention in title evinces the riba prohibition of profit without commensurate
risk because the financial institution bears the costs of maintenance and risk of asset
destruction during the lease term. In practice however, the customer will contract to repay all
costs of ownership borne by the financial institution such as maintenance, repair and insurance.68
Alternatively, and perhaps more ideal for Shariah compliance, the financial institution can
also take out insurance itself and build the costs into the lease rent.69
Mudaraba (Venture Capitalism)
A mudaraba is a silent partnership or venture capital financing structure involving two parties,
usually a financial institution as the capital owner and an entrepreneur as the investment
manager.70
The financial institution as the capital owner (rabb al-mal) provides all the capital
and bears all the risk of monetary loss.71
The financial institution is the silent partner and has no
control of the venture.72
On the other hand, the entrepreneur acting as the investment
manager (mudarib) provides sweat equity and management skills.73
The mudarib shares in
profit at a pre-determined ratio but bears no monetary loss, only the loss of wasted sweat.74
Alternatively a mudaraba can be structured with the financial institution or bank acting as the
investment manager and a customer as the capital owner.75
This structure functions similarly to
traditional savings accounts with two major exception; (1) the customer cannot charge interest,
and (2) the customers deposits are not secured because as a capital investor her deposits can
64See Penzer, supra note 55, at 62.
65Id.
66Id.
67Id.
68Id. at 65.69
See Billah, supra note 7, at 1069.70
Sulman A. Bhatti, The Shari'ah and the Challenge and Opportunity of Embracing Finance "Without Interest", 2010
Colum. Bus. L. Rev. 205, 220-21 (2010).71
Id.72
Id.73
Id.74
Id.75
Id. at 221.
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rise and fall depending on the banks (mudarib) investment activities.76
A customer may
nonetheless withdraw from the mudaraba and request that the bank merely maintain the
principal of her deposits.77
This arrangement is known as a Wadiah.78
The bank may use the
funds in its investment activities but must guarantee a refund of the entire deposit upon
demand by the customer.
79
Although the customer accrues no interest, the bank may rewardher with a monetary gift (hibah) in appreciation for the funds.
80The hibah serves a function
very similar to interest except it must be at the banks discretion and cannot be guaranteed or a
fixed amount.81
Musharaka (Joint Venture)
A musharaka is also a partnership similar to a mudaraba, without the explicit roles of capital
provider and manager.82
Here two entities jointly contribute labor and capital and share in
profits according to a pre-determined ratio.83
Although the profits may be pre-determined,
they must be shared according to a proportion or percentage as opposed to a fixed amount for
any one partner. 84The losses are shared to the extent of the capital invested.85 Each partner
has equal rights of control in the venture; however one partner may choose to relinquish the
right in respect to participation of in some activities.86
Taxation of Islamic Financing Structures
Another key source of confusion in Shariah compliance transactions is the tax treatment when
the deal is structured in a Western jurisdiction. Many Shariah-compliant transactions that in
substance are identical with their conventional counterparts may nevertheless have disparate
tax treatment in the U.S since the federal and state tax codes are predicated on the use of
conventional finance structures and the imposition of interest.
Islamic Finance transactions have many tax disadvantages under federal law in the United
States, most notably in the home financing context. While ijarah are recognized as being
equivalent to conventional mortgages for tax treatment, murabaha and musharaka are still at
great disadvantages.87
The first, but non-mortgage related, tax disadvantage relates to the
76Id.
77Id.
78Id.
79See Qadri, supra note 41.
80Id.81
Id.82
See Alexander, supra note 36, at 595.83
Id at 596.84
See Qadri, supra note 41.85
Id.86
Id.87
Shah M. Nizami, Islamic Finance: The United Kingdom's Drive to Become the Global Islamic Finance Hub and the
United States' Irrational Indifference to Islamic Finance., 34 Suffolk Transnat'l L. Rev. 219, 245 (2011)
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interest on business debt deduction which allows corporations and individuals to deduct the
interest paid on their business debt. Businesses financed through a murabaha would be unable
to classify the payments in excess of the financial institutions purchase price as interest and
therefore cannot get the business interest deduction. Similarly homeowners financing through
a murabaha are not eligible to deduct the interest paid from home indebtness of their primaryresidence.
88This is because the tax code does not view the additional fee paid by the buyer as
interest (even though it is calculated based on LIBOR-like rates).89
In contrast the United
Kingdom passed legislation which allowed profits in such situation to be given the same tax
treatment as interest.90
Lastly, the murabaha transaction is subjected to double taxation on the
real estate transfer tax since there is a tax on the initial purchase by the bank and again on the
transfer from the bank to the homeowner.91
Musharaka transactions receive even more unfavorable tax treatments. First, because a
musharaka is a shared equity partnership, a homeowner who purchases through such
partnership never accrues indebtedness to pay interest on and therefore cannot have a
deduction.92
Next, the Internal Revenue Code allows a partner to engage in a renting
transaction with the partnership, however since the ownership is with the partnership, the
rental income received from the homeowner must be included in the adjusted gross income of
the partnership. On the other hand, if the homeowner had a conventional mortgage, his
imputed income in living in the house would not be included.93
Lastly, the homeowner would
not be eligible for the normal exclusion from the gain derived from the sale of a principle
residence since ownership is in the partnership and not the homeowner.94
Taxpayers can seek to avoid disparate tax treatment on their Shariah-compliant investmentsthrough the substance over form doctrine. Taxpayers may petition the tax commissioner to
review to see whether the economic substance of a transaction does not deserve a different tax
treatment than those of similar forms.95
While such petitions are rarely won by taxpayers, the
Office of the Comptroller has found on at least one occasion that from a tax perspective, the
Murabaha financing transactions will be considered loans96
A taxpayer can therefore find
support for a substance over form, nevertheless this route of relief must be done on a case-
by-case basis and is therefore burdensome for taxpayers to get. A better route would be for
88Id. at 246.
89Id.90
Id.91
Id.92
Id .(stating that it is the partnership, not the homeowner who accrues the debt).93
Id.94
Id.95
Id. at 848.96
See Comptroller of the Currency Administrator of National Banks, Interpretive Letter #867
http://www.occ.gov/static/interpretations-and-precedents/nov99/int867.pdf(last visited Nov. 16, 2012), at 6.
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Congress to provide statutory relief through tax and regulatory rules modifications that provide
Islamic investments with equal tax treatment.97
The U.K. is a great example on how equal tax
treatment for Islamic Finance vehicles has been achieved through the legislature.
Rahn (Security Interest or Pledge)
A rahn or pledge is a means in which lenders or investors can secure themselves against the risk
of non-payment.98
In a rahn agreement the borrowers pledges a specific asset as collateral by
placing title in the asset with an agent or trustee (adl) who owes fiduciary duties to the lenders.99
If the borrower defaults then the lenders can force the agent or trustee to sell the assets for
the lenders benefit.100
According to riba principles the assets pledged must be in possession of
the lender.101
Constructive possession is permissible and can be achieved by recording the
security interest so other creditors are put on notice.102
Due to these possessory requirements
the perfection of a security interest may be particularly difficult in Islamic jurisdictions.103
For
instance to achieve perfection of a real property mortgage in Dubai, lenders are required to
record the mortgage at the Dubai Lands Department. 104 However only the interests of lenders
licensed by the central bank of Dubai can be registered.105
Lenders who are not licensed may
seek a structure using a licensed bank as a security agent.106
But, the enforceability of using a
licensed security agent when the lender itself is not licensed is untested in the UAE and
therefore cannot be guaranteed.107
Consequently lenders who do not take due diligence in
investigating security interests in a prospectus of an Islamic financing project may be exposed
to the hidden risk of having unenforceable security interests.
The Sukuk: Islamic Bonds or Debt SecuritiesSukuk is the plural form of Saak, which translates to investment certificate. They are
tradable securities that confer to the holder a beneficial interest in underlying assets or
Shariah-compliant ventures (i.e. most commonly Ijarah, mudaraba & musharaka) and the
profits arising from the assets.108
The Accounting and Auditing Organization for Islamic Financial
97See Jensen, supra note 32, at 851.
98See Evans, supra note 6 , at 830.
99Id.
100Id. at 830-831
101Id. at 831
102Id.103
Michael J.T. McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, 7 Chi. J. Int'l
L. 427, 455 (2007).104
Omar Salah, Dubai Debt Crisis: A Legal Analysis of the Nakheel Sukuk. Available at
http://bjil.typepad.com/Dubai%20Debt%20Crisis.pdfat 29.105
Id.106
Id.107
Id.108
See Ibrahim, supra note 20, at 719.
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Institutions (AAOIFI) issued the Standard for Investment Sukuk in an attempt to bring
uniformity to commonly accepted Sukuk Standards.109
A broad summary of the fourteen
eligible asset classes provided by the Standard for Investment Sukuk are as follows:
(a) of an existing or to-be-acquired tangible asset (ijara, or lease); (b) of an existing or to-
be-acquired leasehold estate (ijara); (c) of presales of services (ijara); (d) of presales of
the production of goods or commodities at a future date (salam, or forward sale); (e) to
fund construction (istisna'a, or construction contract); (f) to fund the acquisition of
goods for future sale (murabaha, or sale at a markup); (g) to fund capital participation in
a business or investment activity (mudaraba or musharaka, or types of joint ventures);
and (h) to fund various asset acquisition and agency management (wakala, or agency),
agricultural land cultivation, land management, and orchard management activities.110
The general consensus among Shariah scholars is that the pool of assets should be at least half
comprised of structures representing ownership interests in assets (like musharaka or Ijarah) asopposed to structures representing only an interest in a stream of payments (like Murabaha).
111
Although Sukuk are commonly referred to as Islamic bonds they are materially different from
traditional bonds112
and are closer in structure to a trust or investment certificates.113
A key
difference between the concept of Sukuk and traditional bonds are that theoretically Sukuk
represent only an ownership interest and not a right of return.114
This difference is best
summarized by Muhammad Taqi Usmani, president of the AAOIFI Shariah Council:
[T]he holders of [ conventional bond] certificates are no more than lenders to the
sponsors of such enterprises; and their earnings come from the interest on their loans in
a percentage that accords with the price of interest in the marketplace. The profits of
these enterprises after costs, including interest payments, return exclusively to the
sponsors. The basic concept behind issuing Islamic Sukuk, however, is for the holders of
the Sukuk to share in the profits of large enterprises or in their revenues.115
Therefore an investors return is derived through periodic payments of the profits from the
underlying asset and not an interest based percentage of capital as with conventional bonds.116
109 See McMillen, supra note 103, at 429.110
Id.111
Irina Marinescu, Where Does the Dirham Stop in A Sukuk Default?, 35 Hastings Int'l & Comp. L. Rev. 451, 458
(2012); See Usmani, supra note 51.112
See Alexander, supra note 36, at 596.113
See Marinescu, supra note 111, at 457.114
See Evans, supra note 6, at 828115
See Usmani, supra note 51, at 2.116
Id.
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An investors profits or capital cannot be guaranteed but must be based on the performance of
the underlying asset.117
Nevertheless Sukuk agreements in the past have been structured to reach the same function as
conventional bonds by including provisions (1) entitling the Sukuk-holder to loans from the
manager when actual profits from the underlying assets are less than prescribed percentages
(usually based on LIBOR or like interest rates) (2) directing actual profits in excess of the
prescribed percentages are to accrued by the manger alone and (3) guaranteeing a return of
capital through a manager pledge to repurchase the investors assets at a fixed or nominal price
upon maturity or a dissolution event of the transaction.118
The practical effect of Sukuk transactions structured in this matter led Usmani to admonish that
the Sukuk holders have no right other than the return of their principal, as is the case in
conventional bonds.119
Usmani later proclaimed that he believed up to eighty-five percent of
the worlds Sukuk were not Shariah-compliant due to these structures.
120
In a now infamous2007 clarification the AAOIFI prohibited the practices of manager loans to cover shortfalls in
asset profits, and also prohibited, with respect to only partnership based sukuk (like mudaraba
& musharaka) manager pledges to repurchase the underlying assets at a nominal value.121
Therefore it is clear that a manager pledge to repurchase at a nominal value is permissible with
the more common Ijarah-Sukuk.122
Furthermore it is also permissible in all sukuk structures for
a manager to pledge to repurchase at the cost of net value of assets, its market value, fair
market value, or a price agreed upon at the time of the actual repurchase.123
And in respect to
loans to cover shortfalls, the clarification made clear that it is only permissible to first
accumulate reserves from any excess of profits of the underlying assets, at which point anyfuture shortfalls with can be covered with the reserve.
124
In the aftermath of the clarifications some contended that the new guidelines wrecked the
*sukuk+ market by causing a reduction in overall issuances and a dramatic shift toward the now
less controversial ijarah-based sukuk structures.125
However others argue that evidence
117Id.
118Id.
119Id.at 8.120
See Marinescu, supra note 111, at 462.121
Accounting and Auditing Organization for Islamic Financial Institution, Sukuk Clarification, available at
http://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf, 2-4 (last visited Nov. 11, 2012).122
Id. at 3-4.123
Id. at 3.124
See McMillen, supra note 9, at 703.125
Scott R. Anderson, Forthcoming Changes in the Shari'ah Compliance Regime for Islamic Finance., 35 Yale J. Int'l
L. 237, 242 (2010).
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suggests that it was the current crisis and not the ruling that caused the overall reduction in
sukuk issuances in 2008.126
Two Classes of Sukuk
Sukuk come in two classes, asset-backed & asset-based. This terminology although
semantically similar has significant differences to the credit risks of the project and underlies
a key confusion to investors when it comes to understanding sukuk.127
The confusion is caused
by the form over substance trait of Islamic finance, where transactions with dissimilar forms
as their conventional counterparts provide significantly similar substance.128
The asset-
backed/asset-based distinction depends on whether, in the event of default, the sukuk-holders
have recourse to the underlying assets or recourse only to the credit of the issuer along with
other subordinated creditors.129
The sukuk is asset-based if the originator transfers only a
beneficial ownership to the SPV-issuer without the characterizations of a true sale or
recourse to the underlying assets. Upon insolvency of the originator, the assets will be
transferred to the originators bankruptcy estate and the sukuk-holders will not receive priority
over other unsecured creditors. Conversely, the sukuk is asset-backed if the transfer of the
assets from the originator to the SPV-issuer is characterized as a true sale with recourse to
the underlying asset.130
Upon default, the sukuk-holders as co-owners of the underlying asset
may sell the asset and recuperate their losses.131
In recap, if in the event of default the sukuk-holders have recourse to the cash-generating
asset, then it is an asset-backed transaction.132
If, however, in the event of default the sukuk-
holders cannotseek recourse to the cash-generating asset, then it is asset-based.133
Asset-
backed sukuk more easily harmonize with the values ofShariah compliance because the sukuk-holders actually do hold an undivided ownership interest in the underlying assets. The sukuk-
holders are therefore exposed to the risk of the asset because any losses on their cash flows
will be passed onto them. 134 Nevertheless, very few sukuk issued to date are in fact asset-
backed.135
Most sukuk are asset-based, with the cash-generating asset there chiefly to ensure
Shariah compliance. The presence of the assets however can potentially confuse investors as
126See Blake Goud, Sharing Risk Dot Org, available athttp://investhalal.blogspot.com/2009/03/ijara-sukuk-islamic-
finance-hurt-by.html(last visited Nov. 11, 2012).127
Moody Investors, The Future of Sukuk: Substance Over Form?, available at
http://www.kantakji.com/fiqh/Files/Markets/m170.pdf, 2 (last visited Nov. 11, 2012).128
Id.129
See Alexander, supra note 36, at 596130
Id. at 596-97131
Id.132
See Marinescu, supra note 111, at 462133
Id.134
See supra note 96, at 8.135
See Marinescu, supra note 111, at 462
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to their true means of recourse in event of a default.136
In fact, according to rating agency
Moodys, there are market participants who, without access to (or interest in) the legal detail,
sincerely [but incorrectly] believe there is asset security and that the investment/financing
provided is collateralized.137
Therefore Moodys suggests merely using a secured and
unsecured classification rather than the confusing asset-backed vs. asset-based distinction.
138
The asset-based and asset-backed distinctions reflect how the rating for the sukuk credit risk is
determined.139
In an asset-basedtransaction the rating will be determine by examining the
creditworthiness of the originator.140
Should the financial situation of the originator
deteriorate, so too will the investment rating. This was the exact scenario in an asset-based
sukuk issuance by Tamweel that saw its rating downgraded when Tamweels finances fell with
the declining market.141
The rating ofasset-backedsukuk is determined by examining the
performance and credit quality of the underlying assets.142
Therefore asset-backed securities
have the allure of receiving higher ratings than the originators credit alone could receive.
Indeed in a separate mortgage-backed securitization (MBS) by Tamweel, one of the few true
asset-backed or secured sukuk issuances, the project received substantially higher ratings
than both Tamweel and its parent company Dubai Islamic Bank was capable of receiving.143
However, Islamic finance blogger Blake Goud warns against the potential of secured sukuk
replicat*ing+ the ills of the MBS [mortgage-backed securities] market leading up to the crisis up
to the crisis where ratings schemes were gamed by originators to get higher ratings so they
could push out more and more issuance, the risk of which is largely transferred to investors.144
Nakheel Sukuk: Case Study
The following is a brief summary of the Nakheel structure. Nakheel, a Dubai-based developerand its various subsidiaries sought financing in order to develop land. The ultimate goal of the
transaction is to finance the development projects through issuance of sukuk where the sukuk-
holding-investors will act as the financers of the operation. To raise funds Nakheel chose the
securitization of its leasehold assets (ijarah) through a sukuk structure. These ijarah leaseholds
will be the Sukuk Assets, the assets underlying this transaction. The long leaseholds are for a
136Id.
137 See Moody Investors, supra note 96, at 5.138
Id.139
See RAM Rating Services, supra note 47.140
Id.141
Mohammed Khniferhttp://www.kantakji.com/fiqh/Files/Markets/575.pdfat 20.142
Id.143
Blake Goud The Potential for Growth in Islamic Mortgage-Backed Securities
http://investhalal.blogspot.com/2012/06/potential-for-growth-in-islamic.html(last visited Nov. 16, 2012).144
Id.
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term of 50 years and cover building, land and other property located in the Dubai Waterfront.145
A Special Purpose Vehicle (SPV) is created which will act as the Issuer of the Sukuk certificates
and holder of the ijarah assets (long leaseholds) as a trustee.146
The SPV, here Nakheel
Development 2, must raise funds through a Sukuk issuance before it can be transferred the
ijarah leaseholds. The SPV Issuer raises funds by issuing trust certificates (or sukuk) to sukuk-
holders (the investors) in exchange for cash. The SPV will then use these newly raised funds to
purchase from the Seller the entirety of the ijarah leaseholds assets (Sukuk Assets). The seller
now has the funds it can use for its land development projects, the purpose of the entire
financing transaction. The Issuer SPV creates a trust wherein the SPV holds legal title of the
Sukuk Assets for the benefit of the sukuk-holders.147
Now the Sukuk-holders have a title
interest as trustee beneficiaries in the assets underlying the transactions.
The SPV (as Lessor) then leases the newly acquired Sukuk Assets to a Nakheel group subsidiary,Nakheel PJSC (Lessee), for six consecutive lease periods of six months, or a total lease period of
three years.148
This short leasehold obligates the lessee to make bi-yearly payments to the
Lessor SPV for the benefit of the sukuk-holders. The annual sum of these lease payments is
equal to 5.5% of the entirety of the Sukuk Issue Amount plus Servicing Agency expenses.149
The
lease payments represent the interest paid for the financing, or more theoretically, the time
value of the sukuk-holding investors money. The Servicing Agency is made for the purposes of
allowing maintenance on the underlying property while it is being used in this transaction. The
lessee, Nakheel PJSC, is appointed as the lessors Service Agent, and tasked with conducting all
maintenance work and repair on the underlying property.
150
Of course, the costs of this agencyincurred by the SPV-Issuer (and therefore by the investors) is factored into the rent payments
as indicated above.
At maturity of the transaction or the occurrence of a dissolution event the sukuk-holders
(investors) will recoup their capital through the execution of a repurchase agreement.151
The
Purchase Undertaking Obligor (Nakheel PJSC) of the repurchase agreement will purchase the
sukuk from the original sukuk holders at the Sukuk Redemption Amount. The Sukuk
145See Nakheel Sukuk Offering Circular, Nakheel Deveopment Ltd., available at
http://www.nasdaqdubai.com/resources/2008/3/11/be8190d7-76fc-4f58-bf31-
669116537ca4/Offering%20Circular.pdfat 134.146
Id. at 8 (SPV-Issuer/Trustee/Lessor: Nakheel Development 2 Limited).147
Id. at 9.148
Id. at 12.149
Id; Sukuk Issue Amount: U.S.$750,000,000 the aggregate price sukuk-holders paid for their Certificates. Id at
91.150
Id. at 12.151
Id. at 13.
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Redemption Amount is the aggregate of the Sukuk Issue Amount and any due (but unpaid)
lease payments.
In order to secure payment obligations the sukuk-holders are granted a perfected mortgage
secured by the underlying physical properties with the Dubai Islamic Bank acting as security
agent.
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The Nakheel sukuk case study illustrates the complexity in identifying the Three Little Enemies
(TLE)152
to investor recourse in the event of default. Three Little Enemies is simply a mnemonic
to remind investors to identify whether they are transferred actual 1) Title that would be of
value after default, or if not, whether they perfected 2) Liens over said assets, and lastly
whether these liens are 3) Enforceable in the pertinent jurisdiction. To recap, the Nakheelstructure was a sukuk-manfaa-ijarah in which sukuk-holders owned as assets, leasehold rights
(ijarah), from which they derived their source of revenue.153
The leasehold was for 50 years
and covered property in the Dubai Waterfront.154
So how do we know whether investors are
secured in the event of default?
Title
First we must ascertain whether our sukuk-holder investors have title in valuable assets which
they can sell in order to recoup their loss. Here, the investors have title as beneficiaries in trust
to the Sukuk Assets. But the Sukuk Assets, here just leaseholds, are of little help. Since Nakheelis unable to make payments this means the lessee(s) under the leasehold also couldnt make
payments to Nakheel. What would be more useful is title in the actual property underlying the
leaseholds. But this title was never conferred and instead was retained by Nakheel Holdings 1.
Because there was no actual transfer of ownership of the physical property underlying the
revenue stream upon insolvency or default, unless the investors perfected a lien over the
assets, the assets would be transferred to the bankruptcy estate of the title owner, Nakheel
Holdings 1, for the equitable distribution to all its creditors.155
Lien
Consequently it may be tempting to classify this structure as asset-based and therefore
unsecured. However, regardless of an asset-based or asset-backed classification, what is
important is that the sukuk-holders are in fact secured creditors by obtainment of a mortgage
lien over the properties.156
However, as discussed above (rahn section), securing a lien is not
always assured due to the difficulty of achieving perfection of a security interest in Dubai.
To achieve perfection of a right to mortgage a lender must register the mortgage with the
Dubai Lands Department.157
However, only licensed lenders may register rights of mortgages
152 TLE -Title to valuable assets, Liens, and Enforceability153
See Salah, supra note 104, at 28.154
See Nakheel Sukuk Offering Circular, supra note 145155
Id.156
Although it is questionable whether these pledges are enforceable in the UAE. See Salah, supra note 84, at 29;
See Nakheel Sukuk Offering Circular, supra note 145, at 141 (stating In order to secure the payment obligations of
Nakheel under the Transaction Documents, Nakheel World LLC (the Mortgagor) shall grant a fully perfected
mortgage, free from any security interest and encumbrance.).157
See Salah, supra note 104.
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with the Dubai Lands Department.158
Here, although the Security Agent was a licensed bank,
the actual lender was not. Such a structure was untested in UAE courts and thereby called into
question the validity of the mortgage. Indeed, the prospectus cautioned that there can be no
assurance of the enforceability of a [m]ortgage by the Security Agent in the manner
contemplated by the Security Agency Agreement or any enforcement process or procedure.159
Enforceability
Sovereign immunity issues further complicate the enforceability of the mortgage since the
mortgagor, Nakheel World, is owned by the government of Dubai.160
Although Nakheel World
and its co-obligors agreed to waive immunity to the fullest extent allowed by law, due to an
absence of precedence the prospectus specifically warned there can be no assurance of the
enforceability of the waiver. Therefore, ultimately it may not be possible to enforce any
judgment [ ] against the properties and assets of any [c]o-obligor or Nakheel World.
161
In November of 2009, Dubai World and its subsidiaries notified the sukuk-holders that they
were unable to continue making their payment obligations and therefore would be in
default.162
The co-obligor guarantees by Dubai World and its subsidiaries and the purchase
undertaking agreement obligating repurchase at the Sukuk Redemption Amount could do little
to help the sukuk-holders since all parties involved were financially unable to fulfill their
payment obligations.163
The sukuk-holders only legal recourse, the mortgage, had daunting
enforceability challenges. Despite the very real possibility that the mortgage security could be
unenforceable, at least some Sukuk-holders were comforted by an assumption that the Gulf
emirate would guarantee repayment in the event of default. 164 This assumption was in-part
warranted due to the common practice of government support or bailouts for troubled Islamic
financial institutions within the UAE.165
However, the prospectus expressly warned the sukuk-
holders not to rely on the availability or assurance of a government bailout.166
158Id.
159See Nahkeel Offering Circular, supra note 145, at 45.
160Raisssa Kasolowsky, Amran Abocar, Legal Minefield Awaits Dubais Nakheel Bondholders. available at
http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203(last
visited Nov. 16, 2012); The prospectus clearly stated *u+nder applicable Dubai law, no debt or obligation owing
from the Ruler or the Government of Dubai may be recovered by laying hold, attachment, sale in auction, or taking
possession in any other legal action of the Rulers or the Governments properties and assets whether or not a
final judgment is issued in respect of such debt or obligation. See Nakheel Offering Circular, supra note 145, at 51.161
See Nakheel Offering Circular, supra note 145, at 46-47.162
See Salah, supra note 104, at 27.163
Id.164
See Kasolowsky, supra note 160.165
See Salah, supra note 2, at 148 (discussing trend of bailouts in the UAE).166
See Nakheel Sukuk Offering Circular, supra note 145, at 36 (stating *t+he Nakheel Group has traditionally relied
http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH200912037/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions
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Nevertheless, in the end neighboring Abu Dhabi did in fact come to the rescue with a $10 billion
loan which was used to refund the sukuk holders and redeem the sukuk upon maturity at the
agreed upon Sukuk Redemption Amount.167
Although the sukuk-holding investors were paid
out in this scenario it is often argued that sovereign bailouts like this add further confusion to
Islamic financing. A bailout here potentially prevented new precedent that could have added
clarity in the future. Future Sukuk-holders may again rely on a government bailout even though
the guarantee of which is expressly denied. Those future sukuk-holders may find themselves
without recourse in a similar event where no sovereign entity actually provides a bailout.
Moreover, lack of investor clarity could further be compounded by the controversial moral
hazard theory. The moral hazard theory refers to the greater tendency of people who are
protected from the consequences of risky behavior to engage in such behavior.168
Investors
shielded by such bailouts may have less reason to take a prudent economic course the next
time around and therefore may use less due diligence. 169
Conclusion
Investors need to be properly informed of the concepts of Islamic law in order to keep the
market safe. While Islamic Finance encourages the concept of risk-sharing, it also prohibits
investments that entail excessive riskiness. However, the foreign nature of Islamic finance,
compared to conventional finance structures, introduces risks inherent in novel structures
undertaken by inexperienced investors. Investors may often look at only the form of a Shari'ah-
compliant transaction and assume it provides the same substance as its traditional counterpartand thereby miscalculate their rights and liabilities. This risk is further compounded by two
likelihoods when the asset involved is located in an Islamic jurisdiction: 1) unpredictability of
judgments - a foreign judgment may not be upheld in an Arab country and 2) enforceability of
judgments - when dealing with sovereign entities, they may have immunity therefore
precluding recourse to assets. Finally sovereign entities in the UAE have shown a consistency to
bailout failing projects. This may psychologically make investors think they will always recoup
their capital regardless of the project's financial situation and therefore act as a disincentive to
conduct due diligence.
primarily upon capital contributions from the government of Dubai and retained earnings to
fund its capital expenditure requirements rather than seek internal financing. There can be no
assurance that these contributions will continue.). 167
See Kasolowsky, supra note 160.168
Steven L. Schwarcz, "Idiot's Guide" to Sovereign Debt Restructuring, 53 Emory L.J. 1189, 1194 (2004).169
Id.
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Nakheel Structure Glossary
Underlying Tangible Assets: Land, buildings and other property within the Dubai Waterfront170
Issuer assets: Leasehold interests in the underlying tangible Assets (property within the Dubai
Waterfront).171
Sukuk Assets:Trust certificates representing pro rata shares of the issuers assets. So the sukuk
holders hold ownership interests in the leasehold.172
Investors Fixed Return: Annual 5.5 per cent of total Sukuk Issue Amount173
Seller: Nakheel World LLC174
SPV-Issuer/Trustee/Lessor: Nakheel Development 2 Limited175
Obligor: Nakheel PJSC herein referred to as Nakheel.176
Purchase Undertaking Obligor: Nakheel177
Servicing Agent: Nakheel178
Lessee: Nakheel179
Mortgagor: Nakheel World LLC180
Security Agent: Dubai Islamic bank PJSC181
Sukuk Issue Amount: U.S.$750,000,000 the aggregate price sukuk-holders paid for their
Certificates.182
170See Nakheel Sukuk Offering Circular, supra note 145 at 10, 98.
171Id. at 1.
172Id. at 135.
173Id.
174Id. at 8.175
Id.176
Id. at 1.177
Id. at 9.178
Id.179
Id.180
Id. at 13.181
Id. at 9182
Id. at 91.
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Lease payments: 2 payments in one year equaling to 5.5% of the total Sukuk Issue Amount +
costs of the Servicing Agency Express (structural repair and maintenance of the property, etc).183
Dissolution Events: The principle dissolution events were (a) failure by the issuer to make anyPeriodic Distribution payments (b) nonperformance of material obligation by issuer in respect
to the lease interests (c) default of the lease agreements (d) insolvency, dissolution or
liquidation of the issuer.184
183Id. at135-36.
184Id. at 68-69.