Under Shariah, or traditional Islamic law, charging interest on a loan is taboo, but Muslim businessmen have created sukuk, which are financial instruments that can enable a return on principal. Less than a year ago, during the worst days of Dubai's financial crisis, it seemed likely that lawyers would turn Dubai into a laboratory for thrashing out the consequences of defaulting sukuk. Now, though, the worst of the financial crisis in Dubai has passed, with a minimum of such thrashing.
According to Mohammad Saeed Rahman, founder of Portland Oregon's Institute of Halal Investing, Dubai has turned the corner, and government-controlled company Dubai Holdings"will satisfy its bondholders with hybrid payments, 30% to 40% in cash, and issuing new securities for a longer period of time to restructure the remainder of the debt."
While the worst of the crisis may be past for the emirate, Dubai has highlighted some issues underlying the Islamic world's integration with worldwide finance. The rejection of riba (translated from the Arabic as "usury" or "interest") and the rejection of gharar (translated as "the sale of uncaught fish," which indicates risky trading) are among the defining principles of Shariah finance. So the question emerges: how can sukuk avoid riba or gharar?
According to Robert Michael, chairman of the New York City Bar Association's subcommittee on Islamic Law, "Sukuk are much more closely analogous to equipment trust certificates (ETCs)" than to interest-bearing bonds. Like ETCs, sukuk allow a company to hold and use tangible assets that continue to belong to the investors. The underlying asset serves as collateral, avoiding the charge of gharar. In other words, sukuk traders are dealing in fish that have already been caught.
According to Monzer Kahf, of the Qatar Faculty of Islamic Studies, if an institution that issues sukuk fails, its underlying assets must be handed over to the investors. While this can reduce risk, it does not imply that sukuk are risk-free: In a financial crisis, the underlying assets -- which may be land, mineral rights or automobiles -- may have lost value while in the possession of the enterprise. If so, Kahf said, the sukuk holders will lose part of their money.
Kahf notes that there is still some confusion about the safety of sukuk: "Unfortunately, some [sukuk] were issued with ambiguity that makes this point not clear." For example, after a 2008 bankruptcy filing by a East Cameron Gas, a U.S.-based resources exploration company, some parties to the proceedings disputed the claim of sukuk holders that their defined mineral rights were bankruptcy-remote. This was effectively resolved on March 31, 2010, when a judge authorized the sale of certain assets by the debtor and their purchase (at inexpensive prices) by the sukuk holders.
Michael summarized that ruling thus: "When the bondholders received clear ownership of those mineral rights for compensation that was apparently dramatically less than their value, they won a tactical victory as to their own economic situation. But by having to do so in the form of a purchase of something that under Shariah they already owned, it was a strategic defeat for Islamic finance overall."
Local Law Issues
Nabil Issa, a partner in the Middle East and Islamic finance group at international law firm King and Spalding, notes other issues can further complicate sukuk. For example, "There are a lot of local law issues that are separate from the Shariah-finance understanding of how sukuk should work." He cautions that as a result of these local law issues, a special-purpose vehicle that has issued sukuk may not properly own the assets on which it is based.
In Dubai, the Land Department documents all real estate transactions. Some sukuk structures are created as land sales and leasebacks, in which the certificate holders are said to "own" the land on which the issuer is conducting business, leasing it to a business in return for periodic cash payments. If there is a default on those payments, the owner's recourse is, in principle, to the land. But, Issa cautions, if the transfer of title of the land has not been registered, the asset-backed instruments may prove to be merely asset-based.
Enthusiasts of Islamic finance are inclined to get a bit starry-eyed. For example, Mohammad Nejatullah Siddiqi, professor emeritus at Aligarh Muslim University, has spoken of it as the financial application of a "holistic view of human personality" and clearly thinks it an antidote to much that troubles the world. Yet, much still troubles the proposed antidote, and potential investors may not want to exchange their green eye shades for rose-colored glasses.