Islamic capital markets: developments and issues (PDF Download ...

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Capital Markets Law Journal, Vol. 1, No. 2

Islamic capital markets: developments and issues Michael J. T. McMillen*

Key points As modern Islamic finance continues to develop, the development and growth of capital markets, including secondary markets, for securities and investments that are compliant with the principles and precepts of Islamic Shari’ah, is being witnessed. This article first considers the nature of Islamic finance, then looks at the primary factors influencing the development and growth of Islamic capital markets, before looking at the factors affecting risk assessment by transactional participants, particularly those pertaining to certainty, predictability and transparency of risk factors. Capital markets transactions involve both Shari’ah and secular jurisdictions, and legal opinions and choice of governing law for transactional documentation in each type of jurisdiction are critical factors in effecting these transactions and the growth of these markets. The article concludes with an overview of the state of the capital markets products.

1. Introduction As modern Islamic finance moves through the second decade of the period of ‘transformation and innovation’,1 we are witnessing the first stages of realization of the long-articulated admonition to develop capital markets, including secondary markets, for securities and investments that are compliant with the principles and precepts of Islamic Shari’ah (the ‘Shari’ah’). The purpose of this article is to examine some of the * Michael J.T. McMillen is a Partner of the law firm of Dechert LLP, working primarily in the New York and London offices ([email protected]). His practice concentrates on Islamic finance and project finance. He also teaches Islamic Finance at the University of Pennsylvania Law School and the Wharton School of Business. Copyright and all intellectual property rights retained by Michael J.T. McMillen. Views expressed are those of McMillen and not Dechert LLP or the University of Pennsylvania. Ideas addressed in this article have been developed by McMillen in a number of previous seminars, conferences and articles (including articles currently in printing for publications during 2006 or early 2007). Such articles include: Yusuf Talal DeLorenzo and Michael J.T. McMillen, Law and Islamic Finance: An Interactive Analysis, ch 7 of Islamic Finance: The Legal and Regulatory Challenge, Islamic Financial Services Board, 2006 (‘DeLorenzo and McMillen: Modern Islamic Finance’) (currently in printing for November 2006 publication); Michael J.T. McMillen, ‘Enforceable In Accordance With Its Terms’: A Proposal Pertaining to Islamic Shari’ah, Fourth Meeting of the Council and Second Meeting of the General Assembly of the Islamic Financial Services Board, Bali, Indonesia, 2 Raby’ al-awal 1425 HE, 2 April 2004 CE (‘McMillen: IFSB Enforceability Proposal’); Michael J.T. McMillen, ‘Sukuk issuances and the glimpse of a secondary market’ in Lori Nicholson (ed.), Islamic Finance Review 2006/2007, Euromoney Books (2006) pp. 10–16; Michael J.T. McMillen and Abradat Kamalpour, ‘An Innovation in Financing – Islamic CMBS’, in Andrew Petersen (ed.), Commercial Mortgage-Backed Securitisation: Developments in the European Market, (2006) Sweet & Maxwell (‘McMIllen and Kamalpour: Islamic CMBS’); Sukuk (Islamic Bonds and Securitizations): Toward a Viable Secondary Market, Integrating Islamic Finance in the Mainstream: Regulation Standardization and Transparency, The Proceedings of the Seventh Harvard University Forum on Islamic Finance, S. Nazim Ali (ed.), Islamic Finance Program, Islamic Legal Studies Program, Harvard Law School (currently in printing for late 2006 or early 2007) (‘McMillen: Sukuk and Secondary Markets’); and Michael J.T. McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, (2006) University of Chicago Journal of International Law, (‘McMillen: Contractual Enforceability’) (currently in printing). 1 See DeLorenzo and McMillen, Modern Islamic Finance, and see the discussion under the heading ‘Factors Influencing the Development of Islamic Capital Markets: Modern Islamic Finance’. ß The Author (2006). Published by Oxford University Press. All rights reserved. For Permissions, please email: [email protected]

Michael J.T. McMillen Islamic capital markets: developments and issues

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primary factors influencing, either as inducements or inhibitors, the development and growth of these Islamic capital markets. Before considering those factors, and by way of background, the articlefirst considers the nature of Islamic finance. What is Islamic finance? The answer requires more than definitional recitation; it requires an examination (at least in summary) of the nature, composition and role of Shari’ah supervisory boards that oversee the explication of the Shari’ah as it applies to the field of Islamic finance, including the issuance of fatawa or authoritative opinions as to the permissibility, under the Shari’ah, of structures and products. The final background discussion is a survey of a few rudimentary principles of the Shari’ah that are of particular import in considering Islamic capital markets. The article then turns to the consideration of the primary factors influencing the development and growth of Islamic capital markets. Historical trends in the development of modern Islamic finance provide the context, in terms of constraints and opportunities, based upon existing knowledge, available resources and methodology. Thereafter, the article summarizes some of the major multilateral organizations that are focused on the development of the Islamic capital markets, including their initiatives and capabilities in this area. Next, the article provides an overview of the expectations of transactional participants in order to increase sensitivity to issues that will need to be addressed in effectuating capital markets products in the Islamic finance field. Turning to more specific factors, the article examines a range of factors that affect risk assessment by transactional participants, particularly those pertaining to certainty, predictability and transparency of risk factors. The first such factors considered are systemic legal matters: the role of legal opinions and governing law choices. Particular attention is paid to the variations in the nature and composition of legal systems in which necessary legal opinions must be rendered. Some jurisdictions, particularly those within the Organization of the Islamic Conference (‘OIC’), incorporate the Shari’ah to some greater or lesser extent in the secular law of the jurisdictions (these are referred to as ‘Incorporated Jurisdictions’; jurisdictions that desire to use Shari’ah-compliant financing techniques as their primary economic form are referred to as the ‘Islamic Economic Sphere’ and jurisdictions that use primarily interest-based financing techniques are referred to as the ‘Western Economic Sphere’). Other jurisdictions do not incorporate the Shari’ah to any extent in the secular law of that jurisdiction (these are referred to as ‘Secular Jurisdictions’). Capital markets transactions involve both types of jurisdiction, and legal opinions and choice of governing law for transactional documentation in each type of jurisdiction are critical factors in effecting these transactions and the growth of these markets. Those factors, in turn, are dependent upon whether contractual arrangements, which embody risk allocations as agreed by the transactional participants, will be enforced in Secular Jurisdictions and Incorporated Jurisdictions. Case law and contractual drafting in Secular Jurisdictions are summarized. Thereafter, systemic issues and transactional practices in Incorporated Jurisdictions are examined. Sukuk (Islamic bond

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Capital Markets Law Journal, 2006, Vol. 1, No. 2

and securitization) issuance transactions, and related enforceability issues, are considered as a capital markets case study. The article closes with an overview of the state of the capital market products. There are summaries of equities and equity funds, real estate funds, private equity funds, hedge funds, derivatives and derivative funds, factoring and sukuk.

2. Islamic finance What is Islamic finance? Islamic finance is the conduct of commercial and financial activities in accordance with the Shari’ah. For present purposes, the Shari’ah is Islamic religious law as applied to commercial and financial activities.2 It is a combination of theology, religion and law. The Shari’ah is a guide to how a Muslim leads life (it means, literally, ‘the way’ or ‘the right path’). Thus, it is the perfect, immutable, divine law as revealed in the Quran and the sunna. Fiqh, literally, ‘understanding’, is the sum of human comprehension of that divine law, the practical rules of Shari’ah as determined by the Shari’ah scholars. The primary methodology used in this determinative and interpretive effort is ijtihad (literally, ‘effort’),3 or legal reasoning, using the ‘roots of the law’ (usul al-fiqh). The roots (usul) upon which Islamic jurisprudence are based are: (i) the Qur’an, being the holy book of Islam and the revealed word of Allah (notably, less than 3 percent of the Quran is legal in nature); (ii) the sunna of the Prophet Mohammed, which are the binding authority of his dicta and decisions; (iii) the ijma or ‘consensus’ of the community of scholars; and (iv) the qiyas or analogical deductions and reasoning. The Shari’ah is comprised of principles and precepts. In its explication and application, it is largely oral (there are a limited number of written compilations, such as the 1839 compilation for the Ottoman empire, the Majelle or Majalat al-Ahkam al-Adliyah).4 Further, there are a number of schools of Islamic jurisprudence (the four main Sunni schools, and those having the greatest impact on modern Islamic finance, are Hanafi, Hanbali, Maliki and Shafi). Historically, the different schools are frequently in conflict with respect to the application of the Shari’ah to different factual or structural situations. Even within a school there are variant interpretations with respect to any given matter. And there is considerable divergence between Southeast Asia (particularly Malaysia, Indonesia and Brunei), on the one hand, and the Middle East and Western Asia (particularly Pakistan), on the other hand. 2 The Shari’ah address two general categories of matters: (i) devotional material (ibadat), primarily cleanliness, ritual prayer, fasting, the Haj, zakat (legal alms) and jihad (holy struggle); and (ii) civil transactions (muamalat), primarily exchange of values, equity and trust, matrimonial law, civil litigation and administration of estates. Relatively little of the Shari’ah focuses on finance and commerce. 3 The meaning of this term, derived from the same root as hihad, is the expending of the utmost effort in the exercise of legal scholarship in order to interpret the law, fiqh. 4 The Majelle or Majalat al-Ahkam al-Adaliyah is a codification of civil law following a Western model that was originally prepared by Ottoman scholars of the Hanafi school of Islamic jurisprudence for use throughout the courts of the Ottoman Empire ca1839 CE/1285 AH. It was translated into the English language by the British jurist and scholar of Arabic, Judge CA Hooper, and was published in 1936. It was again published, in installments, by the Arab Law Quarterly in 1986.


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As explicated by Shari’ah scholars over the last 1400 years, and as applied to Islamic finance, the Shari’ah is a fulsome body of law. It covers virtually many aspects of commerce and finance that are addressed by a mature body of secular law. Thus, for example, it addresses contracts, concepts of consideration, legal capacity, mutuality, sales, leasing, construction activities, partnerships and joint ventures of various types, guarantees, estates, equity and trust, litigation, and many other activities and legal structures. Shari’ah supervisory boards Composition

How does an investor who desires to buy Shari’ah-compliant investments ensure that his or her investment is in fact compliant? Most individuals do not have the expertise to make that determination for themselves. Over the last few decades, the mechanism that has evolved to provide comfort with respect to Shari’ah compliant is the Shari’ah supervisory board (a ‘Shari’ah Board’ and a ‘Board’). Most Islamic banks and financial institutions, and many of the higher net worth families and individuals, have retained one or more Shari’ah scholars that comprise a Shari’ah Board. Each Board oversees the complete range of investment practices, and the principles, methodology and operational activities, of the entity or individual that has retained that particular Board. Each Board is comprised of a different group of individual scholars; no two Boards are identically comprised. And each Board renders determinations with respect to structures and undertakings that are confidential and proprietary to the entity that retains that Board, with the result that explication of the Shari’ah, as applied in competitive financial markets, has occurred in isolated pockets rather than a manner that is coordinated across markets or even schools of Islamic jurisprudence. The education of individual Shari’ah scholars is not centrally regulated or coordinated. There are no established curricula for the education of a Shari’ah scholar; it is largely a matter of self-selection and personal choice on the part of both the incipient scholar and that scholar’s teachers, including the school of Islamic jurisprudence and the substantive areas of study within the chosen school, and of peer recognition. Overwhelmingly, the education of any given scholar has been a process of ‘sitting and studying at the knee’ of another scholar. Until quite recently, many of the more learned scholars had little practical experience; their learning has been primarily academic. The lack of practical experience was, in part, the result of the domination of an interest-based economic system for a period of over five centuries and the concomitant interregnum in the development of Islamic finance. The practical effect of the foregoing and other factors, particularly the diversity of interpretation of the Shari’ah across and within the schools of Islamic jurisprudence, has been that the determinations of any one Shari’ah Board were fairly restricted and of narrow application—often being applicable to only a single entity. One investor or company would accept a new product as being compliant while others would determine

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that same product to be non-compliant. Obviously, few entrepreneurs were willing to invest heavily in product development in such an environment. As discussed in a later section,5 commencing in the 1970s, but particularly in the 1990s, and to the present, there were a number of developments that profoundly affected the field of Islamic finance. In summary, there was a sanctioned movement toward interpretive uniformity and harmony, with the concomitant decrease in entrepreneurial and transactional risks. An entrepreneur is now able to develop a new product with much greater certainty that it will be accepted by most investors and in most markets (although significant regional disparities remain). This, of itself, spurred the development of Shari’ah-compliant investment funds, many of which now retain their own Shari’ah Boards and investment products. This substantially increases the likelihood of agreed compliance and wider market acceptance. And, because many of the members of an investment fund’s Shari’ah Board are also members of investor Boards, the risk of market (investor) rejection of a given fund or product are minimized. The last point is worth considering a bit further as it has resulted in significant benefits to the industry, but is also the focus of conflict of interest concerns. Shari’ah Boards may be comprised of one scholar or a group of scholars. Frequently, a Board is comprised of one or more of the leading ‘internationalist’ scholars, some regional scholars and some local scholars. This brings international, regional and local expertise, experience and political sensitivity to bear on compliance issues. Frequently, the internationalist scholars (who most often populate the Boards of the investment funds) have expertise and experience in sophisticated financial transactions in a wide range of jurisdictions throughout the world, including variant secular tax, securities law and other legal and regulatory regimes and the interplay between those regimes and the Shari’ah as applied and considered by specific investors. Separate, and only informally coordinated, Shari’ah Boards for individual entities are the norm in the Middle East, North America and Europe. But numerous other developments exert pressure away from that model and toward uniformity, which is important for the development of a buoyant capital market. For example, certain jurisdictions have adopted approaches that are more centralizing or unifying, thus decreasing developmental and transactional risks. Malaysia is an example of a jurisdiction in which there is a central Shari’ah Board operating under the aegis of the government regulatory structure (via the central bank). The Accounting and Auditing Organization for Islamic Financial Institutions (‘AAOIFI’) and its Shari’ah Board, the Islamic Financial Services Board (‘IFSB’), the Islamic Development Bank (‘IDB’) and its Shari’ah Board and the Organization of the Islamic Conference (‘OIC’) Fiqh Academy, among other institutions, are also strong forces in promoting greater uniformity across the jurisprudential schools and across the divide between Southeast Asian jurisdictions, on the one hand, and Middle Eastern and Western Asian jurisdictions, on the other hand. As a greater number and variety of multinational conventional banks and investment 5

See the section entitled ‘Forces influencing the development of Islamic capital markets: Modern Islamic finance’.


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banks enter, and expand their range within, the Islamic finance field, there will be increased pressure towards uniformity, if only to facilitate the implementation of internal policies and procedures of these institutions. Roles and Fatawa

The role of a Shari’ah Board varies from fund to fund and entity to entity based upon the nature, extent and degree of Shari’ah compliance and monitoring desired by the target investors. The fund or other entity and the individual members of the Board will enter into a consulting agreement specifying the duties and standards to be applied in the performance of the Shari’ah consultation. Each individual Shari’ah scholar brings his unique perception to the relevant Shari’ah issues and interpretive matters although many scholars consult among themselves, both informally and through organizations such as the OIC Fiqh Academy. Thus, the relationship between each Shari’ah Board and its related fund or entity is unique, despite trends toward uniformity and convergence. In each case, however, the Board will perform a number of different roles, including, typically the following: (i) participation in product development and structuring activities; (ii) review and approval of the fund or entity structure and its objectives, criteria and guidelines and issuance of a fatwa in respect thereof; (iii) review and approval of disclosure and offering documents and issuance of a fatwa in respect thereof; (iv) review, approval and oversight of investment and business operational structures and methodology, and issuance of a fatwa in respect thereof; (v) on-going review, oversight and approval of transactional or operational variances or applications to unique or changing circumstances on an ongoing basis; and (vi) annual audit of the operations of the fund or entity and issuance of an annual certification of Shari’ah compliance. Decisions of the Board are usually unanimous and fatawa are almost always executed by all the Board members. Frequently, multimember Shari’ah Boards will appoint one of their members as the administrative member to be available for and address matters needing resolution prior to the next regularly scheduled meeting (which are periodic, often quarterly). That administrative member will exercise discretion as to whether to convene discussion with other members on operational or interpretive matters that arise from time to time. A fatwa (fatawa is the plural) is a written certification of a Shari’ah scholar or Board. It has no binding legal effect under secular law, unless the Shari’ah, as incorporated in the secular law of the land, were to give it binding effect (that is not presently true in any jurisdiction known to the author). Historically, a fatwa was a short, conclusory statement, providing only a summary of the reasoning behind the determination or a few salient Shari’ah precepts or precedents. More recently, and betraying the involvement of some Western lawyers, fatawa have been structured more like Anglo-American legal opinions, with discussion of the underlying Shari’ah precepts and a view towards its precedential value. It is common to see a copy of a more general fatwa reproduced in the offering circular of a sukuk issue.

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A few basic (and generalized) Shari’ah principles As noted above, the Shari’ah, in its currently enunciated state, addresses many matters addressed by a modern secular legal system. It also addresses a number of business matters that go beyond secular legal systems and into the realm of ethics. An example of the latter is the prohibition of involvement in certain types of businesses and business activities, in the same manner as other ethical investment funds. This section provides a rudimentary summary of some of the major Shari’ah principles pertaining to entities and instruments now in existence or that are likely to emerge in the near term. Some of these principles relate to entity (such as fund) structure, others relate to transactional structures underlying Shari’ah-compliant instruments. At the most general level, the Shari’ah prohibits investment in, or the conduct of, businesses whose core activities: (i) include manufacture or distribution of alcoholic beverages or pork products for human consumption and, in the case of certain Shari’ah Boards, tobacco and firearms; (ii) have a significant involvement in the businesses of gambling, brokerage, interest-based banking or impermissible insurance; (iii) include certain types of entertainment elements (particularly pornography); (iv) have impermissible amounts of interest-based indebtedness or interest income (these activities are referred to as ‘prohibited business activities’). Some Shari’ah Boards interpret the entertainment exclusion more broadly and include essentially all cinema and music because of pornography elements of these industries. Hotels are often included in prohibited business activities because of the presence of alcohol in the bars and minibars. Entities that have prohibited business activities may not be tenants in properties owned and leased by a Shari’ah-compliant investor. These prohibitions have a fundamental influence on the nature of a Shari’ah-compliant fund or product and the types of business objectives it may pursue. A fundamental Shari’ah principle is the prohibition of riba, which is commonly known for its prohibition on the payment or receipt of interest. This prohibition extends beyond mere prohibition to direct or indirect benefit concepts. It affects every aspect of the manner in which a Shari’ah-compliant business (including a fund) obtains and structures its financing. Consider the impact of these principles in the areas of equity and private equity investing as only one example. If these principles were strictly enforced, a Shari’ahcompliant investor would be prohibited from investing in all but a handful of companies in the world as almost all companies either pay interest or have interest-bearing investments of one type or another; Shari’ah-compliant investors would be eliminated from the global equity and private equity markets. As noted subsequently, the actual practice permits of some amount of interest income and expense in these markets. In the area of partnerships and joint ventures, there are numerous principles that address allocation of work, profits and losses as among the partners and joint venturers. For example, as a general statement: all distributions of profits and losses must be pro rata; and preferred stock is not permissible. In certain types of partnerships and joint ventures (mudaraba arrangements), one person contributes services and another person


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contributes capital. If the arrangement suffers a loss, only the capital provider may be monetarily penalized. In other types of partnerships or joint ventures (sharikat and musharaka arrangements), work and capital contribution may be allocated over all partners or venturers with concomitant loss sharing. Obviously, these rules have a profound effect not only on the structure of capital market products and participants. Shari’ah principles pertaining to leasing are of particular import because of the prevalence of leasing in the implementation of Shari’ah-compliant transactions. Examples of applicable leasing principles include the requirement that the lessor of property must maintain the integrity of the property being leased. This means that the lessor may not pass structural maintenance obligations, or correlative obligations such as the maintenance of casualty insurance, to a lessee. Thus, triple net leases that are pervasively used in Western finance are impermissible. These principles will have critical impact on a wide range of operating techniques, both financial and operational, of entities, including funds, participating in the capital markets as well as investments made by, and capital markets products used by, these entities. As one would expect in light of the development of the Shari’ah in Middle Eastern societies that were so heavily focused on trading activities, the Shari’ah principles applicable to all types of sales are especially well-refined and demarcated. Leasing, in fact, is treated as a type of sale—sale of the usufruct of property. With only limited exceptions, one can sell only tangible assets. Debt cannot be sold, nor can other financial instruments that do not represent an ownership interest in tangible assets. Further, one cannot sell property that one does not own and possess. These principles operate as the primary restrictions on the development of Shari’ah-compliant short sales, options trading and derivatives transactions. They also have a major influence on the structure of sukuk (Islamic bond and securitization) transactions and products. In addition, there are certain particular rules addressing delivery, receipt, ownership, allocation of risk, down payments and virtually all other aspects of sales transactions. These rules affect both the ability to create secondary markets, the tradability of equity, and the entire range of transactions conducted by a Shari’ah-compliant entity. Shari’ah principles that are preclusive of gambling and uncertainty preclude most types of insurance, although the unavailability of takaful (Shari’ah-compliant insurance) has led to some practical accommodations to this prohibition. In the view of many Shari’ah scholars, the Shari’ah also precludes the provision of guarantees for compensation; a guarantee must be a non-financial charitable transaction in the strictest sense. Obviously, these principles significantly affect both the structure and the investment methodology of entities structuring capital market products and their capital market transactions.

3. Forces influencing the development of Islamic capital markets The development of Shari’ah-compliant capital markets instruments, in its modern incarnation, began in approximately 2002 and has continuously accelerated since.

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This process is the result of a confluence of factors. Some of those factors are: (i) the evolution of modern Islamic finance, particularly since the mid-1990s; (ii) the efforts of multilateral institutions, such as AAOIFI, the IDB and the IFSB, among others; and (iii) transactional developments since the mid-1990s. Modern islamic finance Interregnum to ‘revival and recovery’

Islamic finance has evolved dramatically since the 1970s, but especially since the middle and late 1990s.6 Prior to the 1970s, the Shari’ah, particularly as it pertained to economic and financial matters, was marginalized during an interregnum when Islam’s social and economic institutions were displaced by Western models. Anglo-American legal systems were introduced into many predominantly Muslim jurisdictions in the Middle East, and continental European legal systems, often combined with elements from AngloAmerican legal systems, formed the models for many Southeast Asian jurisdictions. Application of the primary dynamic of Islamic jurisprudence (ijtihad) was diminished in application, and what application did survive occurred primarily in academic corridors rather than the marketplace. Independence of Muslim states in the 1950s and 1960s, conjoined with oil wealth in the 1970s, provided a marked impetus towards movement from academic and theoretical speculation as to the nature of an Islamic economy towards the establishment of a number of banks and investment houses with the mandate to operate in accordance with Shari’ah, although the focus of these banks was on deposits and savings, rather than investments.7 This marks the beginnings of modern Islamic finance. Islamic finance then moved into a period of ‘revival and recovery’. The Islamic banks looked to Shari’ah scholars for operational guidance and parameters. Most Shari’ah scholars of the time had little practical experience. They looked to the past, turning to the vast body of legal literature created by earlier generations, to the rules of commerce in the legal handbooks and glosses, and to the digests of case law or fatwa literature. In many cases, the sources they referenced were of their own particular legal schools of thought, madhahib, though there appears to have been, early in this process, a general understanding that consideration would have to be given to the opinions and methodologies of at least four major legal schools of Sunni Islam. Importantly, some banks established Shari’ah Boards comprised of a number of Shari’ah scholars, often from different schools of Islamic jurisprudence. Discourse and debate developed and the forum for discussion expanded. Importantly, Islamic jurisprudence had to deal with the resolution of practical problems, with the concepts of real markets and people’s money, and do so with expediency, efficiency and practicality. There was a pressing need to expand the number of qualified jurists as well as to educate all jurists 6 This section summarizes a more detailed discussion provided in DeLorenzo and McMillen: Modern Islamic finance. 7 See Nicholas Dylan Ray, Arab Islamic Banking and the Renewal of Islamic Law (1995) (‘Ray: Islamic Law’); and see Abdullah Saeed, Islamic Banking and Interest (1996), at pp 5–16, for a more detailed discussion of some of the early events in the development of Islamic banking and finance.


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in the realities of the markets, including international markets that were regulated by secular authorities, with respect to such matters as finance, banking, securities issuances, investment activities, capital market activities, entity structures and corporate governance. In addition, there was no code, not even an outdated one, towards which modern Shari’ah Boards might turn for guidance. The one exception was the Ottoman code known as the Majelle; but it was limited to only one school of jurisprudence. It is the nature of Islamic jurisprudence itself to insist on the freedom of qualified jurists to formulate and hold their own opinions. In fact, the inner dynamic for renewal, known as ijtihad, ensures the relevance of Islamic law to changing circumstances by empowering jurists to constantly revisit points of law and to improve upon them as necessary. In this regard, Islamic jurisprudence resembles Anglo-American common law as a type of judicial law based upon a precedential system and constrained by the principle of stare decisis or binding precedent. Thus, while there was no such code, there was also no requirement of the absolute immutability of previous determinations: the scholars were free to engage in a creatively reasoned consideration of existing precedents in the context of modern markets. The nominate contracts; custom; English language; practical experience

In this context, the early Shari’ah Boards sought help in the classical system of nominate contracts (’uqud musammat) and transactions (mu’amalat). These are contracts and transactional structures that are widely known by specific names, like murabaha, mudaraba, wakala and ijara. These were well-developed at the time, albeit primarily in the realm of trading, and have been the subject of an immense literature. They were relatively rigid in definition, in part because of the context in which they were developed and in part because of the desire that all parties to a transaction have a relatively clear understanding of that transaction and its implications. The use of these contracts and structures provided for a relatively high degree of certainty, predictability and transparency in risk allocation, risk management and transactional implementation as well as remedies and enforcement. They were recognized and, most importantly, upheld by Islamic courts from Spain to the Middle East to China, Indonesia, Malaysia and the Philippines. Thus, within the framework of the Islamic legal system that included a set of prescribed contracts, an Islamic legal system of finance and economics flourished in the Islamic East for centuries (at least prior to the interregnum). The scriptural foundations of this contractual system may be abbreviated, owing to their delineation of principles rather than specifics, but the dynamic of ijtahad inherent to fiqh has ensured that Muslim jurists, especially Shari’ah Boards, have continued to comment and build upon the theoretical constructs. The use of the nominate contracts during this period is of particular significance. It provided a common and accepted basis from which to analyse and resolve immediate practical problems. And, as scholars and bankers became more familiar with these contracts (or specified ways of transacting), they began coming to terms with how these

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might be applied in novel ways; how they must be adapted to the requirements and essential nature of new markets. Indeed, the facility of these scholars with the nominate contracts was the key to the next stage of development in modern Islamic finance. In addition, the use of these contracts and transactions provided the basis for the education of a new body of Shari’ah scholars. Practical application also reintroduced the Shari’ah scholars to the important role of custom (‘urf), an essential ingredient of classical Islamic jurisprudence. The Islamic legal maxim that ‘all transactions are to be considered lawful as long as they include nothing that is prohibited’ went hand in hand with custom and mercantile practice in clearing the way for innovation in trade and commerce. However, when the Shari’ah Boards of the modern Islamic banks began their work in the 1970s, there was no significant Shari’ahcompliant trade taking place, and thus no customary practice with regard to it. Further, members of the Shari’ah Boards, with no more than minimal exposure to modern finance, had little understanding of what was customary among modern financial practitioners. The early, conservative and tentative work of these Boards was conducted primarily, almost exclusively, in the Arabic language, particularly so given the influence of Egyptian scholars during this period. But even the early Islamic banks conducted much of their business in the English language, and English was clearly the predominant language in international transactions (particularly investment transactions). Although bank management often conversed and conducted business in English, Shari’ah supervision in the initial period was conducted almost exclusively in Arabic. This led to numerous misunderstandings and difficult practices. For example, the Shari’ah scholars (and Western business participants and lawyers) frequently had to rely on management representations as to documentary matters. The consequences of this state of affairs were sometimes unsatisfactory from the vantage of the transactional participants, particularly the Shari’ah scholars. The business and legal professionals who did not speak Arabic had to use secondary sources to learn about Islamic finance and, in particular, Islamic jurisprudence. This was a particularly inhibiting circumstance and a process rife with inaccuracy, especially so, given the absence of accurate secondary sources. These linguistic hurdles significantly hindered innovation and improvement in Islamic finance, created a perception of lack of transparency, led to a great deal of inaccuracy in understanding the Shari’ah imperatives, and contributed to the perception as well as the reality of uncertainty and lack of predictability. Until books on the subject began to appear in English and other languages, even the fundamentals were incomprehensible to all but the most dedicated and determined individuals. The situation began to change in the late 1980s and early 1990s. The growth of the Islamic finance industry continued beyond all expectations. A few international multinational banks and asset managers entered the field. Shari’ah scholars acquired greater practical experience, and the number of experienced scholars increased (however slightly in absolute terms). The foregoing two factors were synergistic; the multinationals


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and asset managers began involving the Shari’ah scholars earlier and earlier in the product development cycle, thus substantially increasing the level of understanding for both the groups. The perception, and reality, of greater transparency took hold, Shari’ah scholars gained experience in applying the nominate contracts to novel situations, significantly increasing their comfort level and willingness to expand their ijtihad, but even more importantly, transforming the view of the nominate contracts from static and rigid historical devices to ‘building blocks’ or constitutive structures that could be assembled in novel ways for transactional structures. The degree of discourse in the English language increased. And academic discourse on the subject had achieved a critical mass and many issues were moving towards consensus, the all important ijma’ or general acceptance of the juristic community considered a binding adjudicator (or indicator, dalil) in Islamic law. Innovation and transformation: nominates and consensus

It is these factors, but particularly the practice of reconfiguration of the nominate contracts as ‘building blocks’, that constituted the transition to a more proactive and participatory jurisprudence of ‘innovation and transformation’. Shari’ah scholars began to create not only variants of existing nominate contracts and structures, but also a host of hybrid nominates, using single nominate contract configurations and multiple nominate contract configurations. Many of the structures now so widely accepted in Islamic finance, including, in particular, for capital market products, are the result of these developments. A closely related development has been the development of consensus among the Shari’ah scholars, including scholars from different schools of Islamic jurisprudence, and among the Muslim business community and the scholars. Consensus, ijma’, as a legal indicator, dalil, carries very nearly the same authority as the revelational sources themselves. Despite questions, reservations and doubts among some critics of the process, a degree of ijma’ has been achieved, with profoundly beneficial impacts on the Islamic finance industry. Consider, for example, the beneficial impact on the Islamic finance industry of the deliberations and unifying and standardizing pronouncements and issuances of the OIC Fiqh Academy, AAOIFI and the IFSB, among many others. Multilateral organizations OIC Fiqh Academy

The OIC Fiqh Academy, located in Riyadh, The Kingdom of Saudi Arabia, has undoubtedly played a leading role in the development of Islamic finance in the modern era. It sponsors seminars and discussions, and debates issues of the moment to the Islamic finance industry. Of immediate relevance, the OIC Fiqh Academy plays a leading role in obtaining consensus as to applicable standards, transactional tests, transactional structures and contractual arrangements. Its influence on the thinking of Shari’ah scholars cannot be underestimated. However, for purposes of this article, attention is directed preferentially

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on three institutions that have had a particular impact on the growth and potential growth of the Islamic capital markets. These are AAOIFI, the IDB and the IFSB.8 AAOIFI: accounting and auditing organization for Islamic financial institutions

AAOIFI was formed on 1 Safar 1410 H, corresponding to 26 February 1990 CE, in Algiers and registered on 11 Ramadan 1411 H, corresponding to 27 March 1991 CE, in the State of Bahrain, where its corporate offices are now located.9 AAOIFI issues various international standards of relevance to the Islamic finance (including the Islamic banking) industry, each of which is reviewed and approved by both accounting and auditing professionals and an eminent and broadly based Shari’ah Board. In particular, it attempts to increase and harmonize practices within the Islamic finance industry pertaining to accounting, auditing, governance, ethical standards and Shari’ah standards. Since 1991, it has issued approximately 56 such standards. These standards address financial structures and products, such as murabaha (sale at a mark-up), salam (forward sale), ijara (lease), istisna’a (construction), mudaraba (services-capital partnerships) and many others. They also address investment funds, foreign currency transactions, asset transfer disclosure, investments, reserves, and surplus and deficit reporting, among other topics. Of particular relevance to the development of Islamic capital markets is Shari’a Standard No (17), Investment Sukuk (the ‘Sukuk Standard’), which became effective on 1 Muharram 1425 H, corresponding to 1 January 2004 CE.10 The Sukuk Standard addresses investments (direct or through funds or portfolios) in sukuk, which are a backbone element of the Islamic capital markets initiative. The Sukuk Standard is widely recognized as defining the essential form of, and parameters for, many capital markets instruments.11 IDB: Islamic Development Bank

The Islamic Development Bank (‘IDB’), headquartered in Jeddah, The Kingdom of Saudi Arabia, has been a leader in the field of Islamic finance since its formation on 15 Shawwal 1395 H, corresponding to 20 October 1975.12 The composition of this multinational development institution is approximately 56 governments, all of which are members of the OIC. Its Shari’ah Board is similarly diverse and is among the most eminent in the world. The IDB is itself an integrative and globalizing influence, allowing for cross-fertilization and exchange of ideas. In addition, this breadth and diversity 8 Although not discussed in this article, the central banks and financial regulatory authorities of a wide range of jurisdictions have been, are and will continue to be critical to the development of Islamic capital markets. Their influence is pervasive and is exercised through implementation of monetary policy, regulatory programmes, involvement in multilateral organizations (such as the IFSB, among others), and through conferences, seminars and educational efforts. 9 See the AAOIFI web site at www.aaoifi.com. 10 See also Financial Accounting Standard No. 17, Investments, which became effective 1 Muharram 1424 H, corresponding to 1 January 2003. 11 The Sukuk Standard is discussed under the heading ‘Sukuk: The Primary Vehicle for Capital (and Secondary) Market Developments’. 12 The declaration of intent for formation of the IDB was executed in December 1973 and the Inaugural Meeting of the Board of Directors was held in July 1975. The IDB formally opened in 1975. See the IDB web site at www.isdb.org.


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significantly enhance the acceptance of new products and structures that are responsive to a wide range of needs and circumstances. The objective of the IDB is to foster the economic development and social progress of member countries and Muslim communities (individually and jointly) in accordance with the principles of the Shari’ah. While its primary activities focus on project, infrastructure, trade and insurance, it is also involved in the development of standards for the Islamic finance industry. It has a wealth of economic knowledge that is unmatched, and its access to vital economic data give it a unique vantage in influencing market developments. The IDB includes an exceptionally broad range of functions. It engages in product development activities, consulting activities, economic analysis and forecasting. It conducts training programmes for institutions and individuals, within and outside the IDB. It acts as a grant provider. Importantly, it also serves as an equity investor and an external financier. It makes loans to member governments for infrastructure and agricultural projects. The IDB innovatively structures, makes available and administers a broad range of leasing, installment sale, and istisna’a programmes. It makes Shari’ahcompliant equity investments in start-up industries and in small and medium-sized companies, in each case exerting a significant influence on the direction of development in Islamic finance. It has a history of influencing market developments through the issuance of innovative securities. It has also pioneered the issuance of sukuk of different types.13 IFSB: Islamic Financial Services Board

Probably the most direct programmatic approach to assisting the development of Islamic capital markets, including secondary markets, is the initiative of the IFSB. The IFSB14 was inaugurated in 2002 and opened in 2003, and has been granted the immunities and privileges of an international organization and diplomatic mission by the government of Malaysia pursuant to the Financial Services Board Act of 2002. The IFSB is an international body comprised of regulatory and supervisory agencies of governments. The IFSB is comprised of three categories of membership: (i) full members (lead sovereign financial supervisory authorities for Islamic finance and certain intergovernmental international organizations); (ii) associate members, without voting rights (central banks, monetary authorities and financial supervisory organizations or international organizations involved in standards setting); and (iii) observer members, without voting rights, professional and industry associations, Islamic finance entities, professionals and ratings agencies). The objectives of the IFSB include: (i) establishing various standards pertaining to the soundness and stability of the Islamic financial sector and recommending these standards 13 See Mohamed Rafe Md. Haneef, ‘Recent Trends an Innovations in Islamic Debt Securities: Prospects for Islamic Profit and Loss Sharing Securities’ (2005) Harvard Islamic Finance (‘Haneef: Islamic Debt’), at pp 30–31; and ‘Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk’ in Nathif J. Adam and Abdulkader Thomas (eds) ‘Sukuk: Adam and Thomas’(2004) at pp 68–69. 14 See the IFSB web site at www.ifsb.org.

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for adoption by governments and other appropriate agencies and entities; (ii) providing supervisory and regulatory guidance for institutions offering Islamic financial products and developing industry criteria for identifying, managing and disclosing relevant international standards; (iii) encouraging cooperation among member jurisdictions in developing the financial services industry; (iv) facilitating training and personnel development of relevance to that industry; (v) undertaking research and publishing studies and surveys of relevance to the Islamic financial services industry; and (vi) establishing databases of participants in that industry. Recently, securities laws and capital markets initiatives have been added to the mandate of the IFSB. The capital markets initiative began with a study of factors influencing and inhibiting the development of capital markets in jurisdictions within the OIC using sukuk as a case study. As a result of these studies, the capital markets initiative was expanded to include comprehensive studies of different types of laws that have a particularly significant influence on the development of capital markets, including secondary markets. These include trust laws, securities and capital markets laws, bankruptcy laws and laws affecting enforcement of the Shari’ah in different jurisdictions. Proposals for legal reform will be made in the next year and thereafter. Risk allocation: expectations and responsibilities Risk assessment

Risk assessment is a first, and a continuing, process with respect to any transaction. The nature, level and degree of participation in the transaction is dependent upon the risk assessment, as is transactional pricing. The degree of certainty, predictability and transparency that exist with respect to each element of the transaction are important factors in any risk assessment. Even the most experienced capital market participants are given a pause when undertaking a risk assessment of Shari’ah-compliant transactions. This section attempts to provide some context for risk assessment issues in these transactions. Risk assessment considers factors at, and is subject to constraints imposed at, systemic, institutional, market, transactional and personal levels. Some of the systemic and transactional factors and constraints are noted elsewhere in this article. At the institutional and personal levels, there are policies and procedures with respect to, among other things, risk thresholds, risk allocation, risk coverage, underwriting criteria, acceptable legal risks and accounting treatment. At the market level, practices (often characterized as ‘best practices’ or ‘standard practices’) have evolved to address the market consensus as to risk allocations and concomitant transactional efficiencies. Systemic factors and constraints are essentially immutable in the transactional context. Institutional, market and personal factors are not literally immutable in the transactional context, but they are often so deeply embedded and ‘institutionalized’ as to be functionally immutable without rendering a transaction uneconomic.


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Standardization and contractual enforceability

The degree of structural and documentary standardization that is apparent in many capital market transactions within the Western Economic Sphere evidences a consensus on the coalescence of the positions of all transactional participants on all risk assessment matters. Each transactional participant has conducted its risk assessment (including systemic, institutional, market and personal analyses) and the market represents the accommodated positions of all transactional participants. A course of conduct and market custom has resulted in a degree of structural and documentary standardization with respect to a given type of transaction. This, of course, will vary from one type of transaction to another. But in each area, the markets attempt to achieve the greatest degree of standardization. Disclosure requirements under the securities laws attempt to standardize the definition and disclosure of risk-related factors and thereby facilitate comparative analysis. Securitizations, as an example of a capital market product, are highly standardized in the conventional markets. The standardization reflects: (i) the relative rights and remedies of the parties; (ii) the terms of many financial and commercial risk allocations; and (iii) the legal documentation. The same forms of financing documents are used with minimal change from one transaction to the next. These documents have been used for many years and have been the subject of considerable interpretive litigation over the years. Thus, there is great certainty, consistency, predictability and transparency regarding the interpretation and implementation of the transaction, any documentary provision, and the rights, obligations and remedies of all of the parties in a broad range of circumstances; ie with respect to risk allocations and responsibilities. Similar Shari’ah-compliant transactions have not yet obtained an equivalent degree of standardization or concomitant certainty, consistency, predictability or transparency, especially as to enforcement of the Sharia’h.15 Another example, relating more to the systemic and transactional levels, looks at the contractual enforceability in different legal systems. In Shari’ah-compliant transactions involving both Incorporated Jurisdictions and Secular Jurisdictions, there are issues that go directly to the critical concepts of transparency and the degree of certainty and predictability of contractual enforcement, particularly where, by definition, the contracts must be compliant with the Shari’ah. Each of the transactional participants will look to the ‘law’ governing this transaction to determine whether the agreed-upon rights and obligations of, and remedies available to, each of the parties (ie the agreed-upon allocations of risks) will be sustained and enforced in a predictable, consistent, certain and transparent manner. A primary function of law, including the Shari’ah, in the commercial 15 Variations among the different schools of Islamic jurisprudence with respect to specific matters are illustrative and are included in Frank E. Vogel and Samuel L. Hayes, III, ‘Islamic Law and Finance: Religion, Risk and Return’ (1998) and ‘Financial Transactions in Islamic Jurisprudence’ Dr Wahban Al-Zuhayli’s Al-Fiqh Al-Islami wa ‘Adillatuh (Islamic Jurisprudence and its Proofs), translated by Mahmoud A. El-Gammal (2003), which is a translation of vol 5 of Al-Fiqh Al-‘Islami wa ‘Adillatuh, (4th edn, 1997) and appears in two volumes. See also Scholastic Congestion, in Majid Dawood (ed.) Islamic Banking and Finance, 3, at pp 10–11.

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and financial realm is to provide the greatest degree of certainty, consistency, predictability and transparency and to sustain and enforce the determinations of the parties in a given transaction with respect to risk allocations and responsibilities. These matters are a primary focus in examining enforceability issues: whether, when and under what circumstances will the principles and precepts of the Shari’ah will be legally enforced in any given circumstance, with respect to any given structure, product or transaction and in any given jurisdiction. Answers to those questions are readily available in some jurisdictions.16 Answers are uncertain, at best, in many other jurisdictions. But from the vantage of risk assessment, the ability to arrive at answers is critical to the structuring and pricing of capital markets transactions.17 Market disequilibrium: the assumption of interest

Shari’ah-compliant capital markets transactions involve multiple parties from both the Islamic Economic Sphere and the Western Economic Sphere. They involve multiple jurisdictions, including both Incorporated Jurisdictions and Secular Jurisdictions.18 Each of the foregoing will be more pronounced during this current period of ‘transformation and adaptation’ in modern Islamic finance. This period is characterized by the factors previously described, and by increasing internationalization and globalization, a transactional base that entails conformity with both the Shari’ah and at least one body of secular law, diversification of Shari’ah-compliant products, and increased sophistication of those products.19 16 Jurisdictions that have a high degree of certainty, predictability and transparency, thus facilitating risk assessment as well as the perception of justice and fairness, such as the UK and the USA, are able to ‘export’ their law as the governing law for financial transactions. 17 See Peter L. Bernstein, ‘Against the Gods: The Remarkable Story of Risk’. Bernstein makes note of the importance of contracts in the reduction of risk. In summarizing the explanation developed by Kenneth Arrow and Frank Hahn of the relationship between money, contracts and uncertainty, he states, at p. 205: ‘. . . the past and the future are to the economy what warf and woof are to a fabric. We make no decision without reference to a past that we understand with some degree of certainty and to a future about which we have no certain knowledge. Contracts and liquidity protect us from unwelcome consequences . . .’. The essence of these explanations and arguments as to the importance of contracts is predicated on a series of presumptions as to the stability and predictability of enforcement of those contracts. 18 Sukuk issuances are good examples: they typically involve multiple jurisdictions, some being Incorporated Jurisdictions and some being Secular Jurisdictions. The asset originator and the assets may be located in a Incorporated Jurisdiction with the sukuk issuer being located in a Secular Jurisdiction that allows for the choice of applicable law for financial transactions. The sukuk will likely be sold to both Muslim and non-Muslim investors throughout the world. Other transactions are similarly constituted and examples are discussed in Michael J.T. McMillen, ‘Islamic Shari’ah-Compliant Project Finance: Collateral Security and Financing Structure Case Studies’, 24 Fordham International Law Journal, at pp 1237–1263 (‘McMillen: Fordham Project Finance Structures’), Michael J.T. McMillen, ‘Islamic Shari’ah-Compliant Project Finance: Collateral Security and Financing Structure Case Studies’, The Proceedings of the Third Harvard University Forum on Islamic Finance: Local Challenges, Global Opportunities, (Cambridge: Harvard Islamic Finance Information Program, Center for Middle Eastern Studies, Harvard University, 2000), at pp 111–131 (‘McMillen: Harvard Project Finance Structures’), Michael J.T. McMillen, ‘Shari’a-Compliant Finance Structures and the Development of an Islamic Economy’, The Proceedings of the Fifth Harvard University Forum on Islamic Finance: Islamic Finance: Dymanics and Development, at pp 89–102 (2003), Michael J.T. McMillen, Islamic Finance Review 2005/2006: a year of globalization and integration, Michael J.T. McMillen, ‘Raising the Game of Compliance: People and Organizations’, each in Euromoney Islamic Finance Year in Review 2005/2006 (2006), at pp 1–12 and 70–75, respectively, Michael J.T. McMillen, ‘Shari’ah-compliant real estate finance in Europe’, Euromoney 2006 Guide to Opportunities and Trends in Islamic Finance (2006), at pp 10–13, and Michael J.T. McMillen, Structuring Shari’ah-Compliant Transactions Involving Non-Compliant Elements: Use of the Nominate Contracts, a paper presented at the Islamic Financial Services Board conference, Islamic Financial Services Industry and the Global Regulatory Environment Summit 2004, May 18–19, 2004, in London. 19 DeLorenzo and McMillen, Modern Islamic Finance; McMillen, Sukuk and Secondary Structures; and McMillen, Contractual Enforceability. See also McMillen, Fordham Project Finance Structures, at pp 1237–1263 and McMillen, Harvard Project Finance Structures, at pp 111–131.


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Most systemic, institutional, market, transactional and personal factors and constraints, including, until quite recently, those in the Islamic Economic Sphere, were developed in, and have evolved within, a Western interest-based paradigm and reflect little, if any, sensitivity to the Shari’ah and its requirements. Standardized documentation and practices thus represent a Western interest-based set of risk allocations that take no cognizance of the quite different risk assessments made by Shari’ah-compliant participants. Enforcement will be in a legal system that has developed in response to the needs of an interest-based system. Nowhere are these observations more true than in the capital markets. Western transactional participants have little or no knowledge of or familiarity with the Shari’ah or its imperatives, and thus limited knowledge of or familiarity with the risk assessment considerations of Shari’ah-compliant transactional participants. There is thus considerable discomfort for the Western participant whose basic risk assessment paradigm, process and procedure is out of harmony with that of the Shari’ah-compliant investor. The Western participant does not possess the degree of certainty and predictability that is necessary to arrive at a comfort level in respect of its risk assessment. On the other hand, the Shari’ah-compliant investors are likely to be more comfortable with most elements considered in the risk assessment. They will have considerable experience with conventional capital market transactions of this type and they will also have a greater knowledge of and familiarity with at least some of the Shari’ah imperatives. In such a circumstance, the existing capital markets do not efficiently and adequately represent coalescence of the risk assessments of all transactional participants. The market will undergo a period of readjustment in order to reach the requisite equilibrium state once the standard practices have been restandardized in a process that will be, for a period, expensive in every respect. Structures, methodologies and documents are being, and will be, developed that allow both Muslim and non-Muslim, particularly Western, parties to operate within a sphere of certainty, consistency, predictability and transparency that is acceptable to those parties. Every element of the risk assessment process will have to be reconsidered in light of these modifications. The newly adjusted risk assessment will ultimately be reflected in a new market equilibrium point.

4. Transactional practice: legal opinions on enforceability A condition precedent to the closing of financing transactions, including Shari’ahcompliant transactions, is the requirement that legal counsel provide legal opinions as to: (i) due formation and valid existence of the participating entities under relevant applicable law (referred to as ‘entity authority’ opinions) and (ii) the validity, binding effect and enforceability of the relevant documents (the ‘enforceability’ or ‘remedies’ opinions). The latter opinions are of particular relevance, and difficul, in Shari’ahcompliant capital markets transactions.

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‘A remedies opinion deals with the question of whether the provisions of an agreement will be given effect by the courts.’20 The essence of this opinion is that each of the ‘undertakings’21 in the contracts is enforceable under the designated governing law, and the standard formulation is that ‘the agreements are valid and binding obligations of the Company, enforceable against the Company in accordance with their terms’.22 As described in the TriBar Report,23 the remedies opinion covers three distinct, but related, matters: (i) it confirms that an agreement has been formed; (ii) it confirms that the remedies provided in the agreement will be given effect by the courts; and (iii) it describes the extent to which the courts will enforce the provisions of the agreement that are unrelated to the concept of breach. Exceptions and exclusions to the opinion are appropriate in various circumstances, and these are set forth in the opinion. For example, one or more exceptions may be required in respect of the portion of the opinion described in clause (ii) above if either (a) under applicable law the opinion recipient will not have a remedy for a breach of any ‘undertaking’ by the other party to the agreement or (B) a remedy specified in the agreement will not be given effect by the courts under the circumstances contemplated. ‘Specific enforcement’ as a contractual remedy is an example of the latter circumstance. As noted in the TriBar Report,24 this means ‘as a practical matter, that a court will consider whether to provide specific performance as a remedy’ and not that the court will grant specific performance. The types of ‘undertakings’ to which the remedies opinion relates may be summarized into three groups: (1) the ‘obligations provisions’; (2) the ‘available remedies’ provisions; and (3) the ‘ground rules’ provisions. The ‘obligations provisions’ are those that obligate the company to perform an affirmative act, but say nothing about what will happen if the company fails to perform those acts. An example is the requirement in the ijara that the lessee pay the rent. As applied to these provisions, the enforceability opinion ‘means that a court will either require the company to fulfill its undertakings as written or grant damages or some other remedy in the event of a breach’.25 The ‘available remedies’ 20 Third Party ‘Closing’ Opinions: A Report of the TriBar Opinion Committee, 53 Business Lawyer 592 (1998) (the ‘TriBar Report’), at p 619. See also Special Report by the TriBar Opinion Committee: Use of the ABA Legal Opinion Accord in Specialized Financing Transactions, 47 Business Lawyer 1720 (1992) (the ‘TriBar Specialized Financing Report’). And, see, also, Third-Party Legal Opinion Report, including the Legal Opinion Accord, of the Section of Business Law, American Bar Association, 47 Business Lawyer 167 (1991) at s10, The Remedies Opinion, and the definition of ‘Remedies Opinion’ in the Glossary thereof. 21 The TriBar Report notes that all undertakings in the agreements with respect to which the enforceability opinion relates are covered by the opinion. TriBar Report, at 621. The TriBar Report, at fn 69, notes that coverage of all undertakings is based upon New York custom and practice, and that not all jurisdictions so interpret opinions. The variance noted in fn 69 is that of the 1989 Report of the Committee on Corporations of the Business Law Section of the State of California Regarding Legal Opinions in Business Transactions, 45 Business Lawyer 2169 (1990). That report endorses a narrower definition of the scope of the enforceability opinion, limiting the coverage of the opinion to only ‘material’ provisions of the agreements that are the subject of the enforceability opinion. It is important to be familiar with the scope of the enforceability opinion in the governing law jurisdiction. 22 References to the ‘company’ in this section are to the entity that is the subject of the opinion and against whom enforcement will be sought. 23 TriBar Report, at p 620. 24 TriBar Report, at p 620. 25 TriBar Report, at p 621. Note that a ‘representation’ in a contract is not an ‘undertaking’.


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provisions are those that specify a remedy if the company fails to perform particular undertakings. The remedies may be affirmatively stated (eg the requirement to pay liquidated damages) or, more frequently, set forth as the right of a party to take action (eg reduce the interest of a defaulting partner in a partnership, exercise a put option or sell certain property). ‘For those provisions, the remedies opinion means that a court will give effect to the specified remedies as written.’26 The ‘ground rules’ provisions are those establishing the basic rules for interpreting or administering an agreement and settling disputes under that agreement. Examples include the statements (which are actually undertakings of both parties) with respect to the choice of governing law, the forum for dispute resolution (eg New York or English courts or by arbitration), the manner in which notices are effectively given or binding amendments effected (eg by a writing), or the waiver of rights (eg the waiver of the right to jury trial). ‘Unless excepted from the opinion, these provisions are covered by the remedies opinion, which is understood to mean that a court will give effect to the provision as written and require the company to abide by its terms.’27 Enforceability or remedies opinions in specialized financing transactions are subject to considerations that are not applicable to other enforceability opinions.28 The TriBar Specialized Financing Report does not specify the types of transactions that are ‘specialized financing transactions’. The examples given are leveraged leases and sale–leaseback transactions, and other ‘reasoned’ transactions.29 It seems likely that many Shari’ah-compliant transactions in a Secular Jurisdiction should, and would, qualify as ‘specialized financing transactions’ for purposes of the TriBar Specialized Financing Report (and the ‘Accord’, as defined therein, of the American Bar Association). They involve a significant degree of structuring, the use of multiple agreements to effect the structure, the necessity of considering the entire set of documents as an entirety in order to clearly understand the agreement of the parties, the disregard of certain entities involved for the purposes of some laws (such as the disregard of entities for tax purposes), and multiple characterizations of the transaction (eg, different characterizations for tax and Shari’ah purposes). As a result, and in accordance with the TriBar Specialized Financing Report, various legal issues should be specifically addressed rather than being subsumed under the general, and customary, ‘enforceable in accordance with its terms’ language. Governing law The continuum from Shari’ah incorporation to purely secular

With respect to the degree to which the Shari’ah is incorporated into the secular law of a particular jurisdiction, there is a continuum running from total incorporation, 26 and 27 28 29

TriBar Report, at p 621. If the remedy is one that a court in the governing law jurisdiction will not enforce, the opinion will, must, take an exception for the enforcement of that remedy. TriBar Report at p 621. See the TriBar Specialized Financing Report. TriBar Specialized Financing Report, at p 1726.

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such that Shari’ah is paramount in all matters, to no incorporation whatsoever (Secular Jurisdictions). For purposes of this article, the term ‘Incorporated Jurisdiction’ refers to jurisdictions in which there is some degree of incorporation of the Shari’ah into the secular law. Parties to a capital markets transaction will write the ‘law’ for their transaction (in the form of their contracts, assuming those contracts do not violate public policy) and, frequently, have some freedom to choose the law that will govern enforcement of those contracts. That choice is heavily influenced by the degree of perceived certainty, predictability and transparency of outcome in the enforcement process. At the present time, most transactional participants choose English law or New York law as the governing law of capital market transactions because they perceive a high degree of certainty, predictability and transparency in those legal regimes and have little knowledge of, and a perception of significantly less certainty, predictability and transparency in, Incorporated Jurisdictions. This section attempts to lay a base for understanding choices as to governing law in capital markets transactions. Legal systems in the various countries of the Islamic Economic Sphere were, and are, primarily secular. However, there is usually some degree of incorporation of the Shari’ah into the secular law. The degree of incorporation varies widely and there are tensions and conflicts between the Shari’ah-compliant provisions and other provisions that conflict with, or are contrary to, the Shari’ah.30 Often, the Shari’ah is ‘a’ or ‘the’ paramount law or source of law.31 The provisions of the Shari’ah are either (i) literally incorporated into the text of the substantive law or (ii) incorporated as an interpretive matter by the courts or other enforcement bodies. In either case, a contract that is governed by the law of the Incorporated Jurisdiction will be enforced in accordance with the Shari’ah, to the extent that the Shari’ah is so incorporated and applicable, and whether or not the specific substantive legal provisions are referenced in the contract. Thus, in an Incorporated Jurisdiction the parties cannot alter the applicable Shari’ah provisions by contract, nor will it be necessary for the parties to specifically incorporate applicable Shari’ah provisions (they will be incorporated into the contract by operation of law). In a Secular Jurisdiction, on the other hand, the governing law, of itself, will not include any of the Shari’ah. However, the transactional participants may incorporate the Shari’ah into the contracts (the ‘law’) governing their relationships. Incorporation may be by referencing the Shari’ah, generally or specifically. Alternatively, incorporation may be effected by drafting the substantive terms of the contracts in accordance with the Shari’ah as determined by the Shari’ah Board involved in the transaction but without any express reference to the Shari’ah. Of course, contractual incorporation will be subject to legal limitations and requirements, such as those pertaining to illegal acts or acts contrary 30 See McMillen, ‘Fordham Project Finance Structures’, at pp 1195–1203, noting instances where enforcement mechanisms may allow enforcement of an agreement of the parties that is contrary to the Shari’ah despite the Shari’ah being recognized as the paramount law of the land. 31 See Nabil A. Saleh, Unlawful Gain and Legitimate Profit in Islamic Law (2nd edn, 1992), for a discussion of the extent of incorporation in various jurisdictions. For purposes of this article, the distinctions between the various Incorporated Jurisdictions are ignored unless otherwise indicated.


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to public policy, those pertaining to contravention of a paramount law, such as a constitution or, in certain Incorporated Jurisdictions, the Shari’ah itself, and those pertaining to unwaivable and mandatory legal provisions, such as certain consumer protection, environmental protection, landlord–tenant and public policy laws that may not be altered or waived by contract. Having incorporated the relevant Shari’ah principles in the contract, the parties will then choose a body of law pursuant to which the contract will be enforced. The choices are the law of a Secular Jurisdiction, such as New York or English law, or the law of an Incorporated Jurisdiction. If New York or English law is chosen, and the Shari’ah is explicitly referenced in the governing law provisions, the court may or may not enforce the portions of the contract that are subject to the Shari’ah, as discussed in the next section. If the Shari’ah is not referenced in the contract but the contract is in fact substantively compliant with the Shari’ah (as determined by the Shari’ah Board), the court will enforce the terms of the contract, and thus the Shari’ah. If the law of an Incorporated Jurisdiction is chosen, under choice of law or conflicts of laws principles in a Secular Jurisdiction, the court would apply and enforce the law of the chosen jurisdiction and, to the extent that such law itself incorporated the Shari’ah, the court in the Secular Jurisdiction would enforce the Shari’ah.32 Current transactional practice

The current transactional practice in international Shari’ah-compliant capital markets and investment transactions seems overwhelmingly to be that, first, the contracts are drafted without reference to the Shari’ah but in such a manner that the contracts themselves are substantively compliant with the Shari’ah as determined by the relevant Shari’ah Board, and, secondly, the parties chose English or New York law as the governing law of the contracts. The lawyers in these transactions have opined that the English or New York courts will enforce the undertakings in these contracts in accordance with their terms, and have taken no exceptions pertaining to Shari’ah matters. There have also been a number of recent international transactions emanating from the Middle East and Southeast Asia (particularly sukuk issuance transactions) where the governing law has been that of an Incorporated Jurisdiction. Most of the contracts for these transactions make no reference to the Shari’ah. The extent, if any, to which the Shari’ah might be applicable in the enforcement process is unclear and discussions with lawyers involved in those transactions reveals considerable discomfort with this lack of clarity.

5. Enforceability in secular jurisdictions: Shamil Bank v Beximco The opinion The question of whether and under what circumstances a court in a Secular Jurisdiction (England) will apply a governing law clause that includes the Shari’ah was recently 32 Assuming satisfaction of the other requirements of the choice of law doctrines, which are not addressed in this article. A future study will address the issue of whether a New York or English court would enforce the Shari’ah by virtue of enforcing a clause that chose the law of an Incorporated Jurisdiction as the governing law of a contract.

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considered by an English appellate court in Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco Pharmaceuticals Ltd and Others (‘Shamil Bank v Beximco’).33 The contractual governing law clause at issue read: ‘Subject to the principle of the Glorious Shari’ah, this Agreement shall be governed by and construed in accordance with the laws of England’. This case provides a good starting point for achieving an understanding of how enforceability issues are addressed in a Secular Jurisdiction. The facts of this case are not discussed in this article.34 However, a consideration of the court’s reasoning is of import to capital markets development considerations. The critical issue at the appellate court level, as well as at the lower court level, in Beximco was whether the quoted governing law clause required the consideration of the Shari’ah. The appellate court, like the lower court, determined that it did not. In addressing the governing law issues,35 the court noted that there can be only one law governing enforceability of the provisions of the contracts at issue. By concession in this case, that law is the law of England and not both English law and the Shari’ah. The opinion notes that the Rome Convention has the force of law in the United Kingdom,36 and that the Rome Convention allows the parties to a contract to choose the law applicable to that contract,37 but that the law so chosen must be the law of a country.38 The court also notes that Article 1.1 of the Rome Convention ‘is not on the face of it applicable to a choice between the law of a country and a non-national system of law, such as the lex mercatoria, or ‘‘general principles of law’’, or as in this case, the law of Shari’ah.39 Concurring with the lower court, the appellate court characterizes the Shari’ah as a set of ‘Islamic religious principles’40 and ‘religious and moral codes’,41 rather than laws of a nation. The opinion affirms the concept that the law of a nation (such as England) may govern a contract, but that contract may incorporate provisions of another foreign law or a set of rules as terms of the contract whose enforceability is to be determined by such 33 Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco Pharmaceuticals Ltd and Others [2004] EWCA Civ 19 [2004] All ER (D) 280 (Jan), 28 January 2004. 34 The case is discussed more fulsomely in McMillen, ‘Contractual enforceability’. 35 The appellate court opinion began by noting that an English court must interpret a contract in accordance with the commercial purpose of the parties and the contract. Beximco, at para 46. It noted that the purpose of the murabaha agreements and the ijara that are the focus of the transaction is the provision of a binding working capital facility with long-term repayment provisions. The court stated, at para 47, that ‘insofar as each of the clauses provides in clear terms that ‘‘this agreement shall be governed by and construed in accordance with the laws of England’’, the proviso that such provision shall be ‘‘subject to the principles of the Glorious Shari’ah’’ should be approached on a basis which is reconcilable with the purpose evident from the words which follow, rather than operating to defeat such purpose’. 36 Beximco, at paras 40 (relating to the lower court decision), 42 and 43 (noting that the Beximco companies accept the principle of a single governing law based upon the Rome Convention). The Rome Convention has the force of law in the UK by virtue of s 2(1) of the Contracts (Applicable Law) Act of 1990, as stated in para 40 of Beximco. 37 Beximco, at para 48, citing Art 3.1 of the Rome Convention (‘a contract shall be governed by the law chosen by the parties’). Para 40 summarizes the similar finding of the lower court. 38 Beximco, at para 48, citing Art 1.1 of the Rome Convention (‘the rules of this Convention shall apply to contractual obligations in any situation involving a choice between the laws of different countries’). Paras 40–43 summarize the lower court’s similar finding on this issue of interpretation. 39 Beximco, at paras 50–52, citing Dicey and Morris, The Conflict of Laws (13th edn), vol 2, at pp 32-086 and 32-087. 40 Beximco, at para 54. See also Beximco at para 40 with respect to the characterization of this matter by the lower court. 41 Beximco, at para 55. See also Beximco at para 40 with respect to the characterization of this matter by the lower court.


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national law, citing a leading text on conflicts of laws.42 Mere acceptance of that principle, however, is not found to be determinative of the instant case. The court held that the generality of the incorporation of contractual terms, if any, pursuant to the phrase ‘[s]ubject to the Glorious Sharia’a’ is insufficient to identify specific black letter provisions of the Shari’ah, and thus ineffective. The general reference to principles of Sharia in this case affords no reference to, or identification of, those aspects of Sharia law which are intended to be incorporated into the contract, let alone the terms in which they are framed. . . . [The] ‘basic rules’ [of the Sharia’a] are neither referred to nor identified. Thus the reference to the ‘principles of . . . Sharia’ stand unqualified as a reference to the body of Sharia law generally. As such, they are inevitably repugnant to the choice of English law as the law of the contract and render the clause self-contradictory and therefore meaningless.43 Finally, so far as the ‘principles of . . . Sharia’ are concerned, it was the evidence of both experts that there are indeed areas of considerable controversy and difficulty arising not only from the need to translate into propositions of modern law texts which centuries ago were set out as religious and moral codes, but because of the existence of a variety of schools of thought with which the court may have to concern itself in any given case before reaching a conclusion upon the principle or rule in dispute.

Some relevant principles A few principles from this decision are of particular import in considering the development of Islamic capital markets.44 The court affirms that the law governing a contract must be the law of a nation as precisely defined in that nation. This law will include both substantive legal principles, such as with respect to the nature of contracts and their interpretation, and procedural laws, such as with respect to how a given claim is brought in the courts of that nation or enforced under the laws of that nation. England, like many other jurisdictions, allows the parties to a contract to choose the law which will be applicable to the enforcement of that contract. The Rome Convention is one of the most significant embodiments of that principle. In most legal systems, there are ‘conflicts of laws’ and ‘choice of laws’ concepts that address the circumstances in which different governing laws may be chosen and enforced. Again, there are variations in this concept, especially as regards enforcement of foreign judgments obtained in foreign courts or under foreign law and as regards the concept of ‘public policy’ of a given nation as it relates to the structuring and enforcement of contracts.45 Further, as a general matter, 42 Beximco, at para 48, citing Dicey and Morris, The Conflict of Laws (13th edn), vol 2, at pp 32-086 and 32-087 (p 32-087 addresses the Harter Act and the Hague Rules): 32-086 . . . it is open to the parties to an English contract to agree e.g. that the liability of an agent to his principal shall be determined in accordance with the relevant articles of the French Civil Code. In such a case the foreign law becomes a source of law upon which the governing law may draw. The effect is not to make French law the governing law of the contract but rather to incorporate the French articles as contractual terms into an English contract. This is a convenient ‘shorthand’ alternative to setting out the French articles verbatim. The court will then have to construe the English contract, ‘reading into it as if they were written into the words’ of the French statute. 43 Beximco, at para 52. 44 Kilian Ba¨lz provides a summary of Shamil Bank v Beximco (and an earlier English case (Islamic Investment Company of the Gulf (Bahamas) Ltd v Symphony Gems N.V. and Others) and a discussion of how the issues of the Beximco case might be addressed under German law in Islamic Financing Transactions in European Courts, Islamic Finance: Current Legal and Regulatory Issues, S. Nazim Ali (ed.), Islamic Finance Project, Islamic Legal Studies Program, Harvard Law School (2005) (‘2005 Harvard Islamic Finance’). He notes that most of the incorporation principles are similar to those under English law, but that German law would likely be more sympathetic towards the incorporation of non-governmental rules as an appropriate governing law. 45 See eg McMillen, ‘Harvard Project Finance Structures’ at p 199 and the following pages and sources cited therein.

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many jurisdictions (including England) permit the incorporation of foreign laws, codes and rules into contracts governed by the laws of such jurisdiction. There are requirements as to the necessary degree of specificity for effectuation of that incorporation. Any such incorporation is usually considered to be an incorporation of specific contractual terms, rather than a modification of the governing law provision itself. There is an implication in the decision that the court would have no objection to the incorporation of specific aspects of the Shari’ah, analogously to the incorporation of the French Civil Code, the Hague Rules or the Harter Act, if there were adequate specificity of the terms to be incorporated. Applicable legal principles, as affirmed in this case, would seem to allow express incorporation of the Shari’ah into a contract governed by the national law of a Secular Jurisdiction if the incorporation is sufficiently specific and is structured as an incorporation of contractual terms rather than as a general governing law provision. At present, however, it is difficult (at best) to achieve an adequate degree of specificity with respect to the Shari’ah. There are no compilations of compilations of Shari’ah principles and precepts. The development of ‘model acts’ for each of the main nominate contracts and transactional structures would address the incorporation issue in terms of specificity.46 The proposal is that ‘model acts’ be developed for each of the primary areas of relevance to, or subjects of, Shari’ah-compliant banking, finance, commerce and securities regulation: essentially the model acts or codifications of the principles of the nominate contracts and widely accepted transactional forms. These acts would serve as basic guidelines, and would be amenable to modification for different purposes. They would be structured in a form that could be adopted by different nations as the substantive law of the land with respect to the area that is the subject of that model act, with such modifications as the adopting jurisdictions shall elect. They would also serve as the base source for text defining the law, and relevant structural principles and documentary text, for textual inclusion in enforceable contracts or as a referential basis for contractual interpretation. Again, the principles, as incorporated in any given contract, could be modified by the parties to give effect to desired variances, such as those to give effect to the position of a specific school of Islamic jurisprudence or the interpretive proclivities of specific parties. The proposal is that the model acts be structured similarly to the National Conference of Commissioners on Uniform State Laws in the United States. As noted earlier, the most frequently used alternative in current transactional practice is to avoid incorporation of, or direct reference to, the Shari’ah, but to draft the relevant contracts so that they are Shari’ah-compliant in the opinion of the relevant Shari’ah scholars and use secular national law governing law clauses for these contracts. 46 See McMillen, ‘IFSB enforceability proposal’; McMillen, ‘Sukuk and secondary markets’; and McMillen, ‘Contractual enforceability’.


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6. Enforceability in incorporated jurisdictions Systemic matters Although not developed in this article, it is necessary to make brief mention of a number of systemic matters that inhibit the development of Islamic capital markets as well as other international investment transactions. Some of these are market factors, some are human capital matters, and others are legal factors that influence the markets. As a generalization, markets within the Islamic Economic Sphere are underdeveloped and characterized by illiquidity, excessive concentration of risks and lack of specialization. They also lack critical market depth and scale. Issuance volume is limited. There are no programme issuers to generate volume on a consistent basis. For effective capital markets, it will be necessary to develop and sustain governmental, quasi-governmental and private programme issuers. The securitization markets in the United States are an example of how quasi-governmental programme issuers helped develop the capital markets. Consider, for example, the effect that institutions such as the Federal National Mortgage Association (FNMA or Fannie Mae), the Federal Home Loan Mortgage Association (FHLMA or Freddie Mac), the Government National Mortgage Association (GNMA or Ginnie Mae) and the Student Loan Marketing Association (SLMA or Sallie Mae), among others, have had on capital market development. They have influenced, even defined, the relevant legal and regulatory framework, they have fostered and overseen the development of standards and standardized documentation, and they have helped generate volume and depth of the markets. Governments and quasi-governmental agencies have acted as regulators, enablers, issuers and purchasers of securitized instruments and related securities, with profound effects on the capital markets and the effectuation of monetary policy. Market fragmentation in the Islamic Economic Sphere is another strong inhibitor to the capital markets development. Fragmentation exists with respect to, among other factors: (i) countries; (ii) currencies; (iii) the state of legal and regulatory development; (iv) the degree of elucidation of, and agreement on, applicable Shari’ah standards; (v) the degree of incorporation of the Shari’ah into applicable secular laws; and (vi) the operation of both Islamic and conventional interest-based markets in the same space. In terms of human capital, consider the dearth of qualified Shari’ah scholars. The interregnum in Islamic finance had the effect that relatively few scholars focused on commercial and financial aspects of the Shari’ah. It will take a generation or more to induce talented young scholars into the Islamic finance field and properly educated those scholars. Human capital shortages are also acute in terms of financial, legal, accounting and other professional disciplines. Again, there will be a generational period during which these professionals are educated, especially because they will need to be educated in both Western and Shari’ah structures and methodologies. And then there are a range of systemic legal issues, which reduce transparency and the adequacy of information dispersal resulting in significantly diminished certainty and predictability of enforcement of contractual risk allocations. Many, if not most,

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of these matters, are frequently referenced as ‘exceptions’ to the legal opinions that are rendered in capital markets and investment transactions within or involving these jurisdictions. One result has been that major international rating agencies have been unwilling to rate many of the capital market issuances that emanate from those jurisdictions. The legal and regulatory base in many jurisdictions within the Islamic Economic Sphere is a particularly vexing issue. Consider, as examples, the state of development of securities laws in many of the jurisdictions within the Islamic Economic Sphere as well as the enforceability issues referenced in this article and issues that arise as a result of the degree of variance in, and the lack of clarity of the extent and effect of, incorporation of the Shari’ah into the secular law of these jurisdictions. Consistency, predictability and transparency concerns, and thus a diminished ability to assess and allocate risk, also arise when inquiry is made as to: (i) whether the relevant legal system is based upon a system of binding precedents; (ii) whether legal and arbitral decisions, and the rationale for those decisions, are published and widely available; (iii) whether the judicial structure consistently applies judicial precedents; (iv) the time frame for enforcement of remedies within the system; (v) the degree of discretion afforded individual jurists; and (vi) conflicts of interest factors.47 As a generality, many of the structural elements necessary for affirmative answers to the foregoing questions are absent or insufficiently developed in jurisdictions within the Islamic Economic Sphere. The concept of binding precedent is often totally absent. Decisions are rarely published. In many jurisdictions, each case is considered de novo and without regard to other decisions that have been rendered in similar cases. Judges and other adjudicators are afforded wide and unfettered discretion in determining cases. There are few, if any, embodiments of standards as to how conflicts of interest are addressed, such as by recusal. The nature of the available remedies is not always clear, and the remedies vary markedly from case to case. And the time frame for enforcement is frequently so long that it precludes effective remedies. In many jurisdictions, the courts will not enforce foreign judgments and/or arbitral awards. There is also a lack of clarity as to whether a court that will enforce an arbitral award may infuse the Shari’ah into the enforcement (even the contractual interpretation) process pursuant to public policy doctrines.48 There are also a range of exceptions to remedies opinions that pertain to the Shari’ah itself. For example, there are exceptions that relate to: (i) the fact that the Shari’ah is comprised of general principles, rather than specific legal requirements, and, as such, it is difficult to ascertain how the Shari’ah will be applied in any specific transaction; (ii) the varying, inconsistent, interpretations of relevant Shari’ah principles and precepts by different schools of Islamic jurisprudence; and (iii) the lack of uniform statements of relevant Shari’ah principles and precepts. 47 Consider the general discussion of how such issues are addressed in the US legal system that is contained in David M. O’Brien, Storm Center: The Supreme Court in American Politics (7th edn, 2005). 48 See the discussion of enforcement of foreign judgments and awards at McMillen, ‘Fordham Project Finance Structures’, at pp 1199–1203, and the sources cited therein.


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Each of these factors is frequently cited by international capital market institutions as a reason for their reluctance to engage in capital markets initiatives in the Islamic Economic Sphere. Each of these factors is also cited by major international ratings agencies as problematic and among the primary reasons that sukuk and other capital markets transactions have not yet been rated. Sukuk and capital markets The most active area of the Islamic capital markets at the present time is sukuk issuance.49 It is an excellent case study of the capital markets instrument that has the greatest potential for forming a backbone of broader capital markets. It is also a good case study of some of the specific legal issues that are the largest impediments to development of those capital markets. Introduction to sukuk

In common parlance, sukuk are often referred to as ‘Islamic bonds’. In a Western conception, they are more akin to ‘pass-through certificates’,50 ‘equipment trust certificates’ or ‘investment certificates’51 due to ownership attributes. Thus, a sakk represents a proportional or undivided ownership interest in an asset or pool of assets. Sukuk are of two general types: Islamic bonds and Islamic asset securitizations. Islamic bonds are based, ultimately, upon the credit of an entity that is participating in the transaction (issuer, guarantor or other credit support provider) rather than on specific assets and cash flows derived from those specific assets. Securitizations involve asset transfers from an originator into a trust or similar special purpose vehicle with sukuk issuance by that trust or vehicle and payments on the sukuk derived from the payments received in respect of the transferred assets. Most sukuk offerings to date have been of the bond type, and the ultimate credit in most of those bond offerings has been a sovereign entity. There have been very few, if any, true securitizations, largely because of the inability to obtain ratings from major international ratings firms for the securitization sukuk issuances (ratings have been obtained for the sovereign bond issuances based upon the rating of the sovereign credit). The main impediments to obtaining ratings relate to the systemic legal factors noted in the previous section and specific enforceability and legal opinion issues, including in respect of true sales of assets and various bankruptcy law matters. Effective on 1 January 2005 CE, AAOIFI issued the Sukuk Standard. Under the Sukuk Standard, sukuk are defined as ‘certificates of equal value but representing undivided 49 Sakk (singlular; sukuk is the plural) means, in ancient Arabic, ‘to strike’ or ‘to hit’, as in to strike or imprint one’s mark on a document or tablet, and, as a derived term means ‘minting coins’. It is the term from which the English word ‘checque’ is derived. See Haneef, ‘Islamic debt’, at p 30; ‘Sukuk: Adam and Thomas’, at pp 42–46. While the sukuk concept has roots deep in the history of Islamic finance, the current structural formulations are a product of the ‘jurisprudence of transformation and adaptation’ of modern Islamic finance that has emerged since the 1990s. See DeLorenzo and McMillen, ‘Modern Islamic finance’ and sources cited therein. 50 Descriptions of various conventional securitization structures are contained in Frank J. Fabozzi (ed.), The Handbook of Mortgage-Backed Securities (2001). For an interesting comparison of the earliest securitizations with more recent securitization trends, compare the foregoing revised edition with Frank J. Fabozzi (ed.), The Handbook of Mortgage-Backed Securities (1985). Such a comparison is particularly poignant in considering existing sukuk structures. 51 See eg Rodney Wilson, Overview of the sukuk market, Sukuk: Adam and Thomas, at p 3.

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shares in the ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity. However, this is true after receipt of the value of the sukuk, the closing of subscription and the employment of funds received for the purpose for which the sukuk were issued’.52 An express distinction of sukuk from equity, notes and bonds is set forth. It emphasizes that sukuk are not debts of the issuer; they are fractional or proportional interests in underlying assets, usufructs, services, projects or investment activities. Sukuk may not be issued on a pool of receivables. Further, the underlying business or activity, and the underlying transactional structures (such as the underlying leases), must be Shari’ah-compliant (the business or activity cannot engage in Prohibited Business Activities, for example). The Sukuk Standard provides for 14 eligible assets classes. Broadly summarized, they are securitizations: (i) of an existing or to be acquired tangible asset (ijara); (ii) of an existing or to be acquired leasehold estate (ijara); (iii) of presales of services (ijara); (iv) of presales of the production of goods or commoditites in the future [salam (forward sale)]; (v) to fund construction costs [istisna’a (construction contract)]; (vi) to fund the acquisition of goods for future sale (murabaha); (vii) to fund capital participation in a business or investment activity (mudaraba or musharaka); and (viii) to fund activities in respect of asset acquisition, agency management [wakala (agency)], agricultural land cultivation, land management and orchard management.53 These can be divided into sukuk that bear predetermined returns and sukuk that allow for sharing of profit and, in some instances, loss. To date, most issued sukuk have been sukuk al-ijara bearing predetermined returns. The sukuk al-musharaka and the sukuk al-mudaraba are examples of profit and loss sharing sukuk and are thus far rarer. Legal infrastructure: specific legal issues

Development of an Islamic capital market will require the obtaining of ratings for capital market issuances from major international rating agencies. That, in turn, is dependent upon obtaining the requisite legal opinions from prominent law firms engaged in these issuance transactions. The ratings agencies have a well-developed analytical framework, which includes structural elements and legal opinion requirements on a defined group of matters. Consider a sukuk issuance as an example of a capital markets transaction.54 The securitized assets must be isolated for the benefit of the sukuk holders. In the simplest case, the critical elements are that: (i) all right, title, interest and estate in and to the securitized assets are transferred by the originator to a bankruptcy remote special purpose issuer and (ii) that issuer grants a first priority perfected (or perfectible) security 52 Sukuk Standard, s 2. 53 The parentheticals indicate the relevant Shari’ah structure. 54 A simple, generic, securitization involves: (i) an originator of assets; (ii) a special purpose issuer entity; (iii) a parent of the issuer; (iv) a payor or payors in respect of the assets being securitized; and (v) a purchaser—holder of the sukuk. The originator of the assets transfers, by sale, the assets to be securitized into the issuer. The issuer sells a sukuk to the purchaser and uses the proceeds of that sale to pay the originator for the transferred assets. Over time, the payor or payors make payments to the issuer who then transfers those payments to the sukuk holder. The issuer provides collateral security over the assets to the sukuk holders to secure the payment of the sukuk.


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interest over those assets to secure payments on the sukuk and other claims of the sukuk holders. The inquiry and legal opinions then focus on (a) the transfer of the assets from the originator to the issuer and (b) the priority, perfection and enforceability of the security interests granted in the securitized assets provided as collateral for the benefit of the sukuk holders. The following are the primary areas addressed by the remedies legal opinions: (1) true sale of the securitized assets [whether the sukuk issuer owns the transferred assets by virtue of valid sale that is not recharacterizable as a secured loan or avoidable in a bankruptcy or insolvency (such as pursuant to a fraudulent conveyance or preference payment) and whether the transfer is perfected or perfectible];55 (2) non-consolidation of the assets in bankruptcy (whether the securitized assets held in the issuer will be consolidated with the assets of the originator or the issuer parent in a bankruptcy or insolvency of either of those entities);56 (3) bankruptcy remoteness (minimization of the possibility of bankruptcy through restriction of business purpose and permissible business activities, covenants not to declare voluntary bankruptcy, non-competition provisions and legal devices such as ‘separateness’ covenants);57 (4) the collateral security structure [whether adequate first priority and perfected (or perfectible) security interests have been provided to the issuer and whether they are enforceable, including in a bankruptcy];58 (5) enforceability of the transactional documents; (6) choice of law (whether the chosen governing law, and related judgments, will be enforced in the various jurisdictions involved in the transaction); and (7) enforcement of judgments and awards (whether a court judgment or arbitral award will be enforced in each of the jurisdictions involved in the transaction).59

55 Related opinion issues pertain to whether the assets are transferred free of existing liens. This may also be a murky issue given variations among Incorporated Jurisdictions. From the Shari’ah vantage, which may include secular law in an Incorporated Jurisdiction, there are also issues as to the divisibility of legal and equitable title. 56 The ‘separateness’ covenants discussed further also pertain to the non-consolidation inquiry. 57 In many jurisdictions, contractual provisions with respect to asset distribution would be ignored or overridden by a court in a bankruptcy and certain provisions of law (such as mandatory stay provisions) will interfere with transactional payments. Discussion of separateness covenants and issues pertaining to their incorporation into Shari’ah-compliant structures are discussed in McMillen, Sukuk and Secondary Markets, and McMillen and Kamalpour, Islamic CMBS. 58 See McMillen, ‘Fordham Project Finance Structures’, at pp 1185–1232 with respect to some of the structural issues that impinge upon these determinations under Saudi Arabian law. Perfection and priority are particularly difficult issues in many jurisdictions within the Islamic Economic Sphere and lawyers have found it impossible to render satisfactory legal opinions. In Incorporated Jurisdictions, rahn (mortgage and pledge) concepts are frequently possessory and statutory modification is uncertain. 59 Some jurisdictions within the Islamic Economic Sphere will not enforce foreign judgments and arbitral awards. Some will enforce foreign arbitral awards, but not foreign judgments. Frequently, the extent and degree of enforcement of foreign judgments and awards is not entirely clear. A difficult, and open, question is whether the Shari’ah might itself constitute public policy in an Incorporated Jurisdiction and thus be applied as an exception to otherwise-agreed enforcement principles. See McMillen, ‘Fordham Project Finance Structures’, at pp 1195–1203, and the sources cited therein, for a discussion of enforcement mechanisms in The Kingdom of Saudi Arabia.

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In addition to bankruptcy remoteness provisions discussed in the text, there are also requirements for provisions limiting recourse for payments and indemnities to only the securitized assets (and applicable credit enhancements), provisions mandating that the payment priorities set forth in the documents shall govern in all cases, and provisions to the effect that, after full realization on all securitized assets (and credit enhancements), all payment and indemnity claims are extinguished. Without entering upon a discussion of the particular reasons in each jurisdiction, suffice it to say that lawyers in most jurisdictions within the Islamic Economic Sphere have had considerable uncertainty as to virtually every one of the foregoing opinion issues, and thus great difficulty in rendering the necessary legal opinions.

7. Transactional developments since the late 1990s In order to consider the future prospects for Islamic capital markets in light of the supports and inhibitors discussed in this article, it is helpful to summarize the current state of different elements of the Islamic capital markets and a bit of history as to how the markets achieved their current state. This generalized summary focuses on international investment transactions rather than local and regional transactions within the Middle East, Southeast Asia or Northern Africa. This is not to minimize the economic importance of those local and regional transactions. However, it is premised on the view that development of the capital markets will entail broad international participation, and thus, a consideration of issues that arise in the international transactional realm. Most, but certainly not all, international transactions have been effected through investment fund structures, and it is thus the primary focus of this summary. The main areas of transactional activity that are of relevance to capital market development have been: (i) equities and equity funds; (ii) real estate funds; (iii) private equity funds; (iv) hedge funds; (v) derivatives and derivative funds; (vi) factoring and refactoring; and (vii) sukuk (Islamic bonds and securitizations). Equities and equity funds The greatest enabler and impetus to the development of Shari’ah-compliant equity investing and equity funds was the origination of the Dow Jones Islamic Market (‘DJIM’) Index and the 1998 issuance by the DJIM Shari’ah Supervisory Board of a fatwa establishing the tests for Shari’ah-compliant equities investments.60 The DJIM Index was not the first Shari’ah-compliant equity index (Malaysia and Indonesia had earlier indices), but the fatwa that was issued to the DJIM was comprehensive and was the first to have been widely circulated and discussed, with approval, by members of the OIC Fiqh Academy based upon a previous decision of the OIC Fiqh Academy.61 Dow Jones now has numerous Islamic indices and various other index providers have entered the field (including the FTSE Group and Standard & Poor’s Corporation). 60 The tests have been somewhat revised since 1998, most notably in 2003. 61 The previous decision was set forth at Fiqh Academy Journal (1992) 1, 711–712 Decision 65/1/7.


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The making of Shari’ah-compliant equity investments was restricted by three Shari’ah principles. First, the entity in which a Shari’ah-compliant investment is made may not be engaged in Prohibited Investment Activities (as particularly modified for the DJIM). Secondly, the various Shari’ah principles relating to predetermined rates of return and guarantees of principal, which constitute riba, operate to preclude investment in fixed income securities, preferred shares, convertible notes and similar instruments. Thirdly, most businesses have impermissible interest income and interest-based debt. The DJIM fatwa stated that (footnotes omitted): the Shari’ah Board and other scholars, including members of the OIC Fiqh Academy, ‘are of the opinion that an Islamic investor may own shares of companies or investment vehicles whose primary business is consistent with the Shari’ah precepts, even when a small part of their revenues include, within certain limits, haram income.’ The Board then enunciated a set of tests to determine when a Shari’ah-compliant investor could make an equity investment in a company or investment vehicle that has impermissible interest income and expense in circumstances where the Shari’ah-compliant investor does not completely own or control the company or investment vehicle (different rules apply in complete ownership and control scenarios). Financial reporting and the availability of financial information have changed significantly since 1998. For example, operating statements are much more widely available for a greater number of companies. Further, there is now considerable experience with the operation of the DJIM tests under different market conditions, including the technology run-up and dot-com bust and a period of significant interest rate volatility. Without cataloguing all such developments, suffice it to say that various alternatives to the balance sheet tests of the DJIM fatwa have been considered, and some alternatives have been approved for testing Shari’ah-compliant investment in equities. Most of the alternatives focus on operating statement measurements (such as total interest expense and interest income and gross revenue)62 rather than balance sheet (such as total debt) and market capitalization measurements. Any capital market product that is based upon equity securities will entail performance of a series of tests as to Prohibited Business Activities and the financial ratio tests mandated by the relevant Shari’ah Board. Different entities are building software to assist in the screening process, but the process will always be somewhat labour intensive and involve a close working relationship with the Shari’ah Board, especially as regards the effective of acquisitions, mergers, divestitures, on-going financing arrangements and the dynamics of the individual business affect these test results. Real estate funds Shari’ah-compliant real estate funds emerged in the mid-1990s, and the number of such funds multiplied markedly after the dot-com slide in the late 1990s and early years of the 21st century CE. Most of these funds were, and are, domiciled in tax-favourable 62 Debt is not itself prohibited by the Shari’ah (a qard hassan, non-interest-bearing loan, is permissible); interest is prohibited.

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jurisdictions, particularly the Cayman Islands. The initial funds invested in residential real estate projects in the United States, beginning with multi-family housing and moved on to single-family developments, gated communities and golf course communities. Five primary factors drove the emphasis on the first residential funds: (i) first, the inapplicability to residential tenants of the Shari’ah rules prohibiting tenants of Shari’ah-compliant investments from engaging in Prohibited Business Activities; (ii) secondly, the development of workable Shari’ah-compliant istisna’a–ijara (construction–lease) financing structures in the United States; (iii) thirdly, the flexibility of the United States legal system in accommodating financing and investment structures that were both Shari’ah-compliant and used conventional interest-based financing in a manner that met the underwriting standards and criteria of conventional banks and allowed favourable tax treatment; (iv) fourthly, the short-term nature of construction financing was desirable to Middle Eastern investors who had little experience with, and appetite for, investments of more than two or two and one-half years; and (v) fifthly, the growth of the United States real estate markets during this period. Commencing in late 2002 and early 2003, real estate funds in the United States began investing in single tenant, credit tenant leased, commercial office properties and warehouse properties. These investments were ijara-based acquisition financings rather than new construction. These funds were designed to move into the strong United States commercial real estate markets during a growth period and in a manner that minimized the Shari’ah issues with respect to tenants that might be engaged in Prohibited Business Activities (only a single tenant and its lease need be reviewed). Often, the fund investments were designed so as to avoid both the Shari’ah issues pertaining to re-leasing and the economic issues of renovation for re-leasing. Shari’ah-compliant commercial real estate funds began to focus on Europe in late 2003 and 2004. The strongest funds retained an emphasis on single tenant properties, but also began to edge into investments in multi-tenant properties in both Europe and the United States. The movement to Europe was based upon the economics of European real estate investments and the increasing competition for similar properties in the United States, particularly because of the strength of the United States economy resulted in strong competition with conventional real estate investors for an ever more limited number of properties in a booming real estate market. The movement toward multi-tenant properties was driven by: (i) increased familiarity of fund managers and fund investors with the Shari’ah-compliance issues; (ii) increased sophistication of Shari’ah scholars in addressing complex multi-tenant issues; and (iii) the shrinking pool of single tenant properties. The increasing sophistication of the Shari’ah scholars with multi-tenant issues continues to grow and has spill-over effects into many aspects of real estate transactions, especially re-leasing issues. Resolution of those issues is opening the real estate funds


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markets to Shari’ah-compliant investments in multi-tenant properties where leases expire and are renewed or replaced by new leases. Many large office buildings and complexes include impermissible businesses such as retail branch banks, restaurants that serve alcohol and grocery stores that sell pork, wine and beer. In the purest case, the entire building would be an impermissible investment. However, the Shari’ah scholars have taken a pragmatic view of these investment opportunities, at least with respect to North American and European properties. Rules are now being developed that would allow Shari’ah-compliant investment in these properties for certain impermissible uses where the impermissible business or use is limited in scope and necessary to a defined community and there is no effective Shari’ah-compliant alternative to those businesses. The development of these rules as to de minimus impermissible tenancies is greatly expanding the universe of properties available for investment by Shari’ah-compliant funds and is likely to enhance the development of these funds. More recently, Shari’ah-compliant funds in the United States and, to a much lesser extent, in Europe are looking to new real estate asset classes. Examples include, in the health care field, outpatient treatment centers and, in the lodging sector, hotels that do not serve alcohol. Private equity funds International Shari’ah-compliant private equity funds have been predominantly focused on acquisitions in the United States using a Shari’ah-compliant ijara-based version of the leveraged buyout. European laws restricting the use of the assets of an acquired company to finance the acquisition of that company have limited the growth of Shari’ah-compliant private equity in Europe. The family-held and closely-held ownership patterns for Middle Eastern businesses have limited the number of Shari’ah-compliant private equity transactions in this region, although the number of transactions has been increasing over the last year. It is expected that this area of Shari’ah-compliant investment will increase, in both the private acquisition and the take-private realms, over the next ten years. Private equity investment transactions by Shari’ah-compliant investors are often structured as company-by-company transactions (the fund holding a single company), rather than funds holding multiple companies. The company to be acquired cannot have Prohibited Business Activities or, if it does have certain Prohibited Business Activities, those will have to be disposed of within such period as shall be specified by the Shari’ah Board. Although the equity investment rules previously mentioned may be applicable to the initial acquisition of the company, the acquisition may be permitted even if the company has much more interest-based income and expense than is permitted by the equity rules if the Shari’ah-compliant acquirer converts the interest-based loans to Shari’ah-compliant leverage and the interest-based income investments to Shari’ahcompliant investments. Because private equity is a complete ownership and control scenario, the acquirer will be obligated to convert all interest-based debt and interestbased income investments, and other management activities, to Shari’ah-compliant

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alternatives over time. The timing and method of conversion will be specified by the Shari’ah Board. Hedge funds It has long been assumed that a range of Shari’ah precepts will preclude the development of Shari’ah-compliant hedge funds (as well as many other derivatives). The principal precepts that give rise to these assumptions are: (i) that a person cannot sell something that is not owned by that person (thus precluding short sales) and (ii) that only tangible assets can be bought and sold (thus precluding the sale of options and derivatives). However, Shari’ah-compliant equivalents of short sales of securities and options trading have been developed and been approved pursuant to fatawa from eminent Shari’ah scholars. This is an area being intensively considered by numerous entities in the Islamic finance industry, particularly large international investment banks that have particular expertise in the hedge funds area. Complexities arise with respect to: (i) activities of the prime broker and regulatory supervision of the prime broker (particularly in respect of margin requirements) and (ii) the ability of the fund manager (or, in a fund of funds structure, the different prime brokers) to implement the Shari’ah tests for equity investments within trading periods. Prime brokers have been reluctant to modify any of their back office operations and experienced hedge fund managers have been reluctant to add a timesensitive screening layer to their investment operations. The increased presence of major international banks and investment banks in the field of Islamic finance, and the increased interest of Shari’ah-compliant investors in alternative investment vehicles such as hedge funds, are slowly overcoming these reluctances. The major international banks and investment banks already have large and sophisticated prime brokerage operations for conventional hedge funds. As they increase their level of their experience with Islamic finance, they are considering the establishment of prime brokerage operations for Shari’ah-compliant hedge funds. The location of both prime brokerage activities and the domiciliary jurisdiction for these funds will be primary considerations in the expansion of this portion of the markets. Derivatives and derivative funds Very few Shari’ah-compliant derivative instruments have been developed to date; essentially none with universal acceptance. The task of developing is assumed to be monumental, intellectually and financially, given the numerous applicable Shari’ah prohibitions and the widespread skepticism of Shari’ah scholars and investors. However, the International Swaps and Derivatives Association (‘ISDA’) has established a committee for the development of Shari’ah-compliant derivatives, which should assist in the development of this aspect of the markets.


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Factoring Factoring involves the sale of receivables, a debt instrument or claim. The sale and purchase of debt is prohibited by the Shari’ah. In 2006, a Shari’ah-compliant factoring and re-factoring structure was developed and Shari’ah Board approval was obtained for this structure. The development of this structure has opened an entirely new field for Islamic finance. This area of Islamic finance is likely to develop rapidly over the short-term. Sukuk

A primary vehicle for capital markets development is the sukuk. Offerings of sukuk have increased dramatically since 2003. Most sukuk offerings to date have been of the bond type, and the ultimate credit in most of those bond offerings has been a sovereign. There have been very few true asset securitizations thus far. It is clear that sukuk issuances will continue at an accelerating pace. It is also clear that the markets will move to asset securitization sukuk. The movement toward securitization sukuk in jurisdictions within the Islamic Economic Sphere is likely to be gradual given the necessity of considerable legal reform as a prerequisite to the issuance of satisfactory legal opinions. However, as noted earlier, there are organized efforts to define the necessary legal reforms, such as those of the IFSB noted previously. These efforts are in their initial stages and implementation will take considerable time. It seems more likely that the initial asset securitization sukuk issuances will emanate from United States and, possibly, European jurisdictions. These are likely to be securitizations of assets in those jurisdictions, rather than assets located in jurisdictions within the Islamic Economic Sphere (with possible exceptions for unrated issuances in respect of discrete asset classes). The reasons for this are that international banks and investment banks are entering the Islamic finance field. They have substantial Shari’ahcompliant assets (such as leased equipment and real estate) that are desirable investments for Shari’ah-compliant investors and extensive experience in securitization techniques, structures and requirements. Importantly, they can obtain ratings from the major international rating institutions due to their ability to structure the transactions entirely within jurisdictions where necessary legal opinions are readily obtainable. These developments should also result in the development of Shari’ah-compliant bond and securitization funds of various types.

8. Conclusion At present, the Islamic capital markets are small and in the very earliest stages of development. This article has attempted to suggest some of the factors that are supporting the growth and development of these markets as well as some of the factors that are inhibiting that growth and development. Given the inexorable growth of Islamic finance, the ingenuity and creativity of those involved in this field and those that will become involved in this field, and the potential for both economic and social benefit, it seems safe to say that the Islamic capital markets constitute, and for the foreseeable

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future will continue to constitute, one of the most exciting and challenging segments of capital markets activity. It is apparent that many of the critical factors influencing the growth of the Islamic capital markets are firmly within the field of law. Novel structural and transactional applications of the law, at the levels of principle and practice, will be required to integrate the Islamic capital markets with the broader conventional markets in a manner that serves people of all beliefs and preferences. doi:10.1093/cmlj/kml015