Chapter 9

Law and Islamic Finance: An Interactive Analysis

Yusuf Talal DeLorenzo and Michael J. T. McMillen

1. INTRODUCTION AND OVERVIEW

One of the most prominent features regarding the development of the Islamic economy in its “modern era” (which begins approximately 1390 AH, or 1971 CE) is the interactive influence of law and Islamic finance. Islamic finance is fertilising the development of law, particularly in its jurisprudential sense. And law, in both its jurisprudential and practical applications, is stimulating and shaping the growth of Islamic finance. This is the theme of this chapter. There is no pretense at comprehensive coverage of these interactive influences; the approach is to discuss only a handful of examples taken from both Islamic Shari’ah and secular law.

We begin with an historical analysis of how Islamic finance has influenced the development of Islamic jurisprudence. From little more than a concept in the first decades after most Muslim countries regained their independence following World War II, modern Islamic finance took the form of Islamic banks and investment houses in the 1970s and 1980s, and a growing body of scholarship was generated by the practical needs of those institutions as they began to proliferate, particularly as they accumulated more deposits and the demands for product diversity grew more insistent.

No legal system can remain viable without a subject, and without an object, for its application. In recent centuries, and until the 1970s and 1980s, throughout much of the Muslim world, the only significant finance available to Muslims was what Western commercial banks had to offer: primarily interest-based products. Without active commerce, the Shari’ah rules for transacting would become no more than a subject of academic concern, like a dead language. Without renewal, without constant attention on the part of qualified jurists to changing circumstances and realities, those rules, like any other system, would atrophy and eventually lose relevance. Islamic banking and finance in the 1970s and 1980s provided the living subject to which Islamic jurists turned their attention.

Given the inherent depth and breadth of classical Islamic commercial law, modern jurists found a veritable ocean of practical and theoretical jurisprudence upon which to draw while confronting the challenges of the modern marketplace. The first few decades of the modern era in Islamic finance may be characterised as a period of revival. The most recent decade has been a period of significant innovation. Using the nominate contracts for trade and exchange as their building blocks, modern Muslim jurists have provided Shari’ah-compliant solutions to an ever-expanding spectrum of needs.

Thus, Section 2 of this chapter moves from a consideration of the foundations of Islamic commercial law to the factors that have influenced the evolution of that law in modern times. The rise of modern Islamic banking is examined as a factor that has moved Islamic finance through a period of “revival and recovery” to a period of “transformation and adaptation.” The period of revival and recovery was characterised by the presence of relatively few Islamic banks, relatively few Shari’ah scholars with knowledge and practical experience in financial and commercial transactions, a focus primarily on the deposit side of Islamic banking, and discourse on Islamic finance primarily in the Arabic language. The current period of transformation and adaptation is characterised by various aspects and conditions: a significant number of Islamic and conventional multinational banks and financial institutions as participants; participation by Shari’ah-compliant and conventional asset managers; the development of significant practical experience by Muslim jurisprudents in an expanding range of financial and commercial transactions of increasing complexity; a growing discourse on Islamic finance in the English language; a movement toward consensus among Shari’ah scholars (ijma’); the acceptance and implementation of the concept that the nominate contracts may be thought of as building blocks, which may be constituted and constructed creatively for the achievement of all manner of objectives; and a transactional base that entails conformity with both the Shari’ah and at least one body of secular law. Other factors of particular importance include increasing internationalisation and globalisation as well as the rapid movement to greater breadth and sophistication of Islamic financial products.

Later sections of this chapter move the focus from a general historical review of jurisprudential trends to a detailed analysis of how the practical application of law influences the growth and development of Islamic finance and the Islamic economy. A primary function of law and legal systems is the provision of transparency certainty and predictability to market participants and the society at large. Contracts constitute a type of private law for individual transactions and groups of transactions.

Thus, the enforceability of contracts is an area of immediate relevance, and one that must be clearly understood. Modern Shari’ah-compliant transactions involve both the Shari’ah and secular law, with the contribution of each varying from jurisdiction to jurisdiction. Initial inquiry must focus on the issue of how to ensure that the provisions of a commercial or financing transaction that is structured in accordance with, and intended to be compliant with, the principles and precepts of the Shari’ah will be enforced by the courts and other enforcement bodies of different jurisdictions, and will be enforced in accordance with the terms of the contract as agreed by the parties to that contract. Consideration must be given to enforcement issues in both (a) those jurisdictions that incorporate the Shari’ah in their substantive law and thus will enforce contractual arrangements in accordance with the Shari’ah because the governing law will itself include the Shari’ah (“Shari’ah-incorporated jurisdictions”), and (b) those jurisdictions that take no cognisance of the Shari’ah and thus will not enforce it as a matter of governing law but may enforce it as a matter of enforcement of a contract under the governing law of that jurisdiction (“purely secular jurisdictions”).

Enforceability is a function of the law of the enforcing jurisdiction. Choice of law issues come to the fore in every jurisdiction given that Shari’ah-compliant transactions, and documents that are themselves compliant with the Shari’ah, must be enforced in purely secular jurisdictions. A recent English law case, Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco Pharmaceuticals Ltd. and Others, provides a framework for discussion and analysis of choice of law issues, particularly the choice of the Shari’ah as governing law. This case addressed issues of enforcement of the Shari’ah in a purely secular jurisdiction (England) where the contracts at issue specified the use of English law as the governing law, subject to the Shari’ah.

Thereafter, enforceability is considered in another, distinct analytical framework: the legal opinion on enforceability of transactional documents that is required in essentially every financing transaction. The nature and essential elements of these legal opinions are considered both generally and with respect to Shari’ah-compliant transactions. The focus is on the specific legal opinion that the relevant “agreements are valid and binding obligations, enforceable in accordance with their terms.”

The chapter closes with consideration of an example of an area in which law has a profound impact on the future of Islamic finance, both as to the structure of individual transactions and as to the shape of capital markets, particularly secondary markets, and thus the configuration of the entire Islamic finance industry and the Islamic economy. The example that is considered relates to sukuk issuances, current and future, and the nature of Islamic capital markets. Sukuk issuances can be bonds or securitisations. Both types of issuances access, and help to establish and build, the capital markets. Securitisations, however, have far broader implications. They allow for diversification and pooling of risks. They allow asset originators to manage their balance sheets and their capital structure and increase their productive capacity. And they have a special role in creating and sustaining capital markets—in particular, secondary markets.

Current sukuk issuances are primarily Islamic bonds, most frequently bonds that are based upon sovereign credits. As of this writing, true securitisations that are based solely upon the credit of the securitised assets are rare. If the benefits of securitisation are to be obtained for Islamic finance and the Islamic economy, there will have to be continuous issuances of asset-based securitisation sukuk by the private sector. That cannot be achieved without having those issuances rated by the major international rating agencies. Obtaining those ratings, in turn, is dependent, among other things, upon obtaining the requisite legal opinions from prominent law firms engaged in these issuance transactions. These legal opinions must address a broad range of critical issues focusing on sale, collateral security, and bankruptcy issues, among others. Thus there is discussion of true sales of assets, non-consolidation of assets, bankruptcy remoteness covenants, collateral security considerations, enforceability of contracts issues, choice of law doctrines, and issues pertaining to the enforcement of judgements and foreign awards. The ability of law firms to opine on these essential matters in many jurisdictions within the Islamic economic sphere (see below) is presently nonexistent or severely limited, with the consequence that capital market and secondary market growth is severely constrained. It will be necessary to address fundamental legal reforms and clarifications in the secular legal realm, as well as greater clarity of applicable Shari’ah principles and precepts, if these markets are to be fully developed.

For the purposes of this chapter, (1) there is reference to the jurisdictions and economies, without distinction as to cultural, political, and economic factors, of the Middle East, North Africa, and South and Southeast Asia that have predominantly Muslim populations as the Islamic economic sphere, and (2) the jurisdictions and economies, similarly without distinction, of the remainder of the world in which banking and finance is conducted primarily using an interest-based model are referred to as the Western economic sphere, as well as to Shari’ah-incorporated jurisdictions and purely secular jurisdictions.

2. ISLAMIC JURISPRUDENCE IN MODERN TIMES

“The Lawful is self evident and the Unlawful is self evident,” the Prophet of Islam (upon him be peace) said to his followers some 14 centuries ago. Then he added. “Yet between the two are matters that may give rise to confusion; not well understood by many people.”1

In making this statement, the Prophet laid the foundations for the legal system of Islam, generally known as the Shari’ah. Since that time, generations of jurists throughout the Muslim world have applied themselves to the explication and interpretation of Shari’ah rules. The role of the jurist in Islam has been to focus attention on what is less than self-evident, the gray areas between what is clearly lawful or unlawful, the areas of potential confusion.

2.1 Foundations of Islamic Commercial Law

The Shari’ah, literally “the way,” is the Muslim’s “way of life,” the rules that govern how Muslims conduct every aspect of their lives. When Islam is understood to mean “commitment,” that means that a life lived in accordance with Islamic norms is a life of commitment; and the Shari’ah may be said to be the divine delineation of the life of commitment.2 Then, if one is truly to live that life, one must come to terms with how that life is actually delineated by the Divine. It is precisely that “coming to terms” that is known in classical Muslim scholarship as fiqh, or Islamic jurisprudence.

The Shari’ah is also concerned with social justice. In the marketplace, the role of the Shari’ah is prominent because the business of earning a living concerns everyone, as individuals, as groups within society, and as citizens of nations and the world. The logic of the relevant Islamic teachings is that everyone will benefit when people earn their living in a wholesome and lawful manner; and social stability is supported by commercial society. Thus, at the core of Islamic finance are religious precepts governing what is good and permitted, or lawful, and what is harmful and forbidden, or unlawful. It is the responsibility of the jurist to help distinguish the one from the other. As markets grow in sophistication, and transactions become increasingly complex, that responsibility becomes more and more challenging.

It may also be helpful to think of the Shari’ah as a “shared endeavor.” It is shared, in the first place, between God and humankind. God is the Lawgiver, and humans have the responsibility to receive, understand, and observe the Divine law. Humans are also responsible for preserving it, and for endowing it with renewed relevance in changing times and in a variety of settings. So, in this sense, Shari’ah is an endeavor shared between jurists and the texts of revelation, through their understanding and interpretation of the meanings of these texts. The same endeavor is then shared by jurists among themselves, whether through applying themselves collectively to solve a particular problem or through reference to the works of distinguished jurists, both past and present. In the world of modern finance, this endeavour is shared with authorities and experts from the business world, with lawyers from numerous practice areas (often several for a single project), with regulators and their authorities, and, finally, with the investing, transacting, and consuming public.

2.2 Islamic Commercial Law in Modern Times

In recent centuries, over much of the Muslim world, the Shari’ah of Islam was marginalised during an interregnum when Islam’s social and economic institutions were displaced by Western models. For example, in the Indian subcontinent the British imported their own legal system, leaving little more than what amounted to “marrying and burying” as the legitimate concerns of what they termed “Muhammadan Law.”3 Under those circumstances it is hardly surprising that a century or two later, when Muslims finally gained independence, their own Islamic legal institutions were woefully unprepared to deal with twentieth-century realities. The same was true of Islamic political, educational, and economic institutions. Thus, during that interregnum, it is not surprising that Islamic jurisprudence, with no place to apply its dynamic of ijtihad, was relegated to a long confinement in exclusively academic settings. For it to break out of the confines of academia, Islamic jurisprudence required a real subject, a practical and living application, and practitioners who were not only conversant with the classical discipline but were also cognisant and appreciative of the changes the world had undergone in the intervening centuries.

Oil wealth may have provided the real impetus for the revival of the Islamic jurisprudence of commerce and finance. In the decades of the 1950s and 1960s, at a time when newly independent Muslim states were attempting to come to terms with their cultural and religious identities, a handful of Muslim thinkers began speculating on the theoretical foundations of an Islamic economic system, often as an afterthought to their musings about an ideal Islamic state. The state banks of a few Muslim countries held conferences to discuss the subject, a few scholars published papers in journals, and, in general, the interest in the subject was academic. But with the wealth from oil, the petrodollars of the 1970s, a number of banks and investment houses were established with the clear mandate to operate in accordance with Shari’ah.4 This marks the beginnings of modern Islamic finance.

At the time, to be candid, there was little that was clear in regard to banking operations conducted in accordance with the Shari’ah; in fact, Shari’ah and banking seemed particularly unsuited to any sort of collaboration. The Qur’anic prohibition of riba, equating in a general sense to interest and predicated on the understanding that money is a measure of value and possesses no intrinsic value of its own, precluded any sort of dealing with banks and banking. Indeed, throughout the Muslim world, the common understanding was that there was nothing lawful about banks. Even employment in banks was shunned in religious circles.

When the new Islamic banks were established, the first matters for consideration were deposits and savings accounts. How might these operate if no interest was to be paid? And, on the other side of the balance sheet, how would the Islamic banks invest and earn returns if no interest was to be earned . . . if interest was not even a part of earnings? How, finally, could the Islamic banks become profitable?5

2.3 The Jurisprudence of Revival and Recovery

It was then that the new Islamic banks called upon scholars of the Shari’ah for answers. In those early days, there were few scholars with knowledge of finance and banking. The handful of scholars that had published on related subjects were without practical experience, having had no exposure whatsoever to modern banks and financial markets. In many cases, banks retained scholars based solely on their reputations as authors and authorities on Islamic subjects in general; not as experts or authors of works on finance or related subjects.6 Thus, as in any fledgling industry, there was a period of adjustment and learning. The process was a rewarding one, however, and though there were difficulties, a good deal of progress was achieved. It is possible, and not unfair, to characterise the jurisprudence of this early period, perhaps the first two decades, as the jurisprudence of “revival and recovery.” During this period, scholars looked to the past and reestablished meaningful connections between the Shari’ah and the practical world of modern commerce and trade. In this undertaking they turned 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.

At this time, too, perhaps owing to the extraordinary demands placed upon individual scholars hired as advisers, and partially in order to bring to bear a wider range of legal opinion representing each of the four major schools of classical legal thought, as well as regional and cultural trends, Islamic banks began to establish Shari’ah supervisory boards, often with as many as six or eight members. A collective and inclusive approach such as this was not new to Islamic law, ever a shared endeavor. In fact, the classical schools of legal thought themselves grew out of academies. The Hanafi school, for example (named for an individual, Abu Hanifah), was developed over several decades during which regular assemblies in the city of Kufah were attended by a core group of about 40 scholars from a variety of disciplines. Much the same process took place in Madinah, where Imam Malik presided, in Baghdad and then Cairo where Imam Shafii led similar groups of the learned, and again in Baghdad, over a half-century later, where Imam Ahmad ibn Hanbal became the focal point of still another such academy.7

Throughout the formative period of the 1970s and 1980s, Shari’ah deliberations on issues related to modern banking were carried out collectively by formally constituted Shari’ah boards. Papers were written and discussed, both internally among Shari’ah supervisory boards and externally at conferences and seminars. The most important factor in everything that took place at the time, however, was that the jurisprudence had a real subject with which to deal and interact: the growing practice of Islamic finance. The deliberations of Shari’ah boards were more than speculation, or theoretical musings, or academic exercises. Real issues were involved and, perhaps more importantly, real people’s money—for from the day the Islamic banks first opened for business, they have attracted deposits from average Muslim consumers in addition to their high-net-worth and institutional clientele. For Muslims, the Islamic banks are a godsend, allowing them the opportunity to invest and transact in ways that leave their consciences clear. This has come as a great relief to Muslims the world over; the numbers speak for themselves.

Another factor was at work at the time the Islamic banks opened their doors for business. Shari’ah scholarship on financial matters had found a patron. Prior to that time, scholars engaged in the jurisprudence of finance did so on their own and generally as a purely academic pursuit. Orientalists such as Schacht, Udovitch, and Goitein made significant contributions to the knowledge of Islamic commercial law (in particular, with respect to the classical nominate contracts) in the two decades after World War II, and their work motivated and guided a handful of Muslim university students and professors who followed. But Islamic finance now constituted a practical industry, and a growing industry cannot progress if guidance is the result of the random output of a scattered and unassociated group of scholars. The demands of Islamic banks were specific and time-sensitive, and could not be allowed to depend on personal schedules and agendas of academics. Through the establishment of formal Shari’ah supervisory boards, whose members were compensated for their efforts, the Islamic banks brought scholarship to bear directly upon the issues of greatest concern to them and, by doing so, enabled a new generation of jurists to acquire expertise on the subjects of modern banking and finance through research and scholarly exchange.

Then, as a collectivity with incentives, the Shari’ah boards of the first Islamic banks set about developing ways and means to facilitate the unique and novel operations of those banks. Their first concern was, and remains, the issue of compliance, Shari’ah compliance. However, without a process in place for their deliberations, their beginnings were tentative at best, as the problems before them were complex and challenging.

2.4 Adjusting to Modern Trade and Commerce

To begin with, interest-based Western finance had advanced considerably during the interregnum, while Islamic jurisprudence had remained marginalised and inert. There were no ready solutions to be had from the classical legal literature because, for the most part, the classics never dealt with the sorts of issues facing the modern Islamic banks. Advances in technology facilitated commercial activity such as cross-border investing and correspondent banking on unprecedented scales, while regulatory environments and tax laws led to far greater complexity. The volume of commerce and the rapidity with which it may be accomplished were to have profound effects on legal systems worldwide. The same was true of modern phenomena such as the Industrial Revolution, the rise of consumerism, the proliferation of debt financing and unsecured lending, derivatives, fractional reserve banking, and the abandonment of the gold standard. By the time the modern Islamic banks commenced business in the 1970s, the financial community worldwide had already passed through several stages of legislation and regulatory reform focused on, ultimately, the protection of the consumer/investor. Modern reforms in the laws of the United States (especially in regards to finance, banking, securities issuances, investment activities, and business), for example, included matters restricting the nearly unlimited contracting power of the sort envisioned in the classical law of contract known as the “duties of the common calling.” Likewise, modern law had introduced relational torts and expanded understanding of bad faith breach.8 The complexities of today’s financial engineering, as exemplified in over-the-counter (OTC) derivatives, stress existing securities laws. Thus, if modern conventional finance is moving more quickly than the law, it should come as no surprise that modern Muslim jurists discovered themselves confronted by a very steep learning curve when attempting to make sense of the new commercial and financial practices proposed to them by the management of the new Islamic banks in those initial decades.

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 al-Majallah or the Majelle;9 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 constantly to revisit points of law and to improve upon them as necessary. However, while there was no such uniform code, there was also no requirement of the immutability of previous determinations. Indeed, Islamic law resembles in many ways the British and U.S. legal systems based on common law, a type of judicial law based upon the interpretations of judges as individual jurists, yet unconstrained by the principle of stare decisis, or binding precedent.10 Thus, while Shari’ah board members found themselves in the midst of new and uncharted legal territory, they at least had the freedom to think for themselves. This is a significant point, and one that has been ignored by many academics and others. For, despite all else, the fact remains that scholarship on the Shari’ah—however isolated, marginalised, and academic—continued to thrive in Muslim lands. Thus, when the time came to apply serious scholarship to Islamic banking and finance, there was no shortage of scholars with the ability and the training, albeit lacking practical financial experience, to take up the challenge.

In this context, the early Shari’ah boards sought help in the classical system of nominate contracts (‘uqud musammat). These are contracts that are widely known by specific names, such as murabahah, mudarabah, wakalah, and ijarah. Debates on the provenance of these contracts aside, it is well known that trade and commerce were highly developed in the Arabian peninsula before the advent of Islam.11 Then, even if the nominate contracts were based on earlier, pre-Islamic models, their real value was that they were widely known and accepted. By insisting that Muslims transact by means of a specific set of well-defined contracts, the Shari’ah ensures that all parties have every opportunity to understand their prospective transactions. The classical Islamic system of mu’amalat (transactions) is so highly articulated for precisely this reason. While the scriptural foundations of that system may be abbreviated, owing to their delineation of principles rather than specifics, the dynamic of ijtahad12 inherent to fiqh has ensured that Muslim jurists, especially Shari’ah boards, continue to comment and build upon the theoretical constructs.

2.5 The Significance of Contracts

A further important aspect to the nominate contracts, as with other contracts in sophisticated legal systems, is that they constitute a means for risk allocation and management. To understand this point, think of a contract as a device for stabilising the uncertainty of the future, risk, by connecting that future to the stability of a known past.

. . . the past and the future are to the economy what warp 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 . . .13

Relatively speaking, it may be asserted that the contracts defined by Islamic law represent solid ground. Indeed, it may also be asserted that the reason the institution of banking did not develop in Muslim lands is that it was simply not needed. The nominate contracts prescribed for trade and business by the Shari’ah were recognised and, most importantly, upheld by Islamic courts from Spain to China and the Philippines. Thus, within the framework of the Islamic legal system, held together as it were by a set of prescribed contracts, an Islamic legal system of finance and economics flourished in the Islamic East for centuries. To quote from the work of Nelly Hanna:

One aspect of trade in the Middle East that has often been emphasized is that there was no system for advancing funds to merchants—that is, there was no equivalent to the European banking system on which European merchants were heavily dependent—and the lack of such a system supposedly handicapped merchants of the Middle East . . . but the functions of this institution were in part fulfilled through the legal system, which provided a legal framework for the advancing of funds.14

Thus, the contracts upon which transacting in Islam is based function both to stabilize and to promote. By their very nature, these contracts act as a hedge against uncertainty. In addition, the circumstance of their standardization contributed significantly to the comfort level of investors and entrepreneurs, and allowed Muslims to finance huge projects and international trade without the need for intermediaries such as banks.15

The variety of purposes to which these contracts were put to use is worthy of special attention especially in view of the fact that so much has been written about the rigidity of Islamic law and its inability to adapt to various kinds of situations. The experience of seventeenth-century merchants who carried out a significant portion of their trade within the framework of the judiciary system gives an entirely different perspective on this matter. Rather than a rigid set of imposed laws that were supposed16 to have suffocated the business, the commercial documents show a legal system that was adaptable to various kinds of situations.17

2.6 The Nominate Contracts

Despite at least partial disuse of the classical system of Islamic finance during the interregnum, the foundations of that system, the nominate contracts upon which it was predicated, remained well defined. Thus, it was to these that the Shari’ah boards of the new Islamic banks turned for guidance. The corpus of classical legal literature on the subject of transactions, and particularly the nominate contracts, is immense. The published literature in Arabic alone runs into several thousands of volumes, and educated estimates gauge the size of the unpublished works preserved as manuscripts in libraries around the world as at least three to four times the size of the published works. It is impossible to know how much has been lost over the centuries. In any case, the important thing is that Shari’ah boards were able to reference hundreds of titles, and many thousands of fatawa, from earlier centuries. This availability facilitated the jurisprudence of revival and recovery alluded to earlier as characterising the early period of Islamic banking and finance during the decades of the 1970s and 1980s.

The most important factor in the transition from the jurisprudence of recovery and revival to a more proactive and participatory jurisprudence of transformation and innovation was the reconfiguration of the nominate contracts. This process began with the concept that the nominate contracts may be used as building blocks for the constructive and creative achievement of all manner of objectives.18 From the inception of Islamic banking in the 1970s it was apparent that a certain degree of adaptation was required for the successful application of the nominate contracts in modern finance. For example, in order to make the murabahah contract effective in the business of inventory or short-term trade financing, it was necessary to depart somewhat from the classical model by combining a promise to buy on the part of a client with the actual purchase by the bank of goods from third-party suppliers.19 Then, in addition to the actual murabahah contract, a further transaction is appended; the promise to purchase that is made by the client or prospective buyer.20 This arrangement, however innocent in appearance, actually brought up a host of issues for the early Shari’ah boards. Nonetheless, as the needs of modern trade were such that a Shari’ah-compliant alternative to trade financing by means of conventional, interest-based financing was required, the classical murabahah was transformed into the modern murabahah li’l-amir bi’sh-shira, murabahah with an order to purchase that has now become commonplace to Islamic banking. This is only one of scores, if not hundreds, of such examples of how simple nominates have been linked and reconfigured for the attainment of new objectives.21

Another result of the extended hiatus endured by the Islamic jurisprudence of finance is that it lost contact with custom and usage. In the classical system, custom (‘urf) played an important role. The 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’ah-compliant trade taking place, and thus no customary practice in regard to it. Second, 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. Thus, this all-important factor, too, was missing from the equation.

2.7 Academic and Linguistic Factors

The early work of the Shari’ah boards was tentative and, in keeping with the universal bias among jurists toward prudence, clearly conservative. Moreover, as the majority of the Shari’ah boards’ membership was drawn from the ranks of academics, their work tended toward the academic. Under the circumstances, this was for the best. Seminars and conferences were organised, and papers were presented and debated. Professors directed a handful of graduate students to write on subjects related to Shari’ah as it pertained to banking, finance, and commerce. Indeed, in the late 1970s, a team of primarily Egyptian academics began work on the production of a five-volume encyclopedia of Islamic banking that served as an important general introduction for the next decade.22 The work undertaken at this time, like the scholarly exchanges, was almost exclusively conducted in the Arabic language. The language factor was, and remains, significant, with consequences that are discussed later in this section.

During this initial period of recovery and revival, it is notable that scholars began to reacquaint themselves with the workings of the nominate contracts. The significance of this focus was two-fold. First, the nominate contracts, even in their classical forms (and in the forms they had attained before their development was interrupted), provided immediate solutions to several of the banks’ most pressing needs. Second, as scholars and bankers became more familiar with these contracts (or specified ways of transacting), they began coming to terms with how these might be applied in novel ways. Indeed, their facility with the nominate contracts was the key to the next stage of development in modern Islamic finance. Of course, there were other factors. But this single factor (facility with the nominate contracts), through regular exposure to the day-to-day business of the Islamic banks, is what provided the tools for the breakthroughs that would occur in the decade of the 1990s, and that continue until today.

Before discussing this breakthrough, consider for a moment the issue of language and what it has meant to Islamic finance. There is no denying the merits of the Arabic language or the advantages it brings to those who know it. Even so, from the day the first Islamic banks opened their doors for business, much of that business was conducted in the English language. After all, as the language of international finance, trade, and commerce, it was only natural that English be used in the Islamic banks. However, while management conversed with correspondent banks, counterparties, trading partners, regulators, and legal counsel in English, Shari’ah supervision in the initial period was conducted almost exclusively in Arabic. In several of the early fatawa, it is clear that the board had given its opinion on the basis of representations made by management; the Shari’ah board members themselves did not read the documentation, but relied upon summaries presented to them in translation. The reason for this situation was that Shari’ah board members, with a very few exceptions, had no English language capability. To a degree, this remains a problem even today.23 The important thing is that, in some cases at least, Shari’ah boards were simply unable to understand, and therefore unable to comment upon, the details of the subject transactions.

On the other hand, the business and legal professionals who did not speak Arabic had perforce to go to secondary sources to learn about Islamic finance and, in particular, to the jurisprudence of Islamic finance, a particularly inhibiting circumstance. For these professionals, even for those working in the Islamic banks themselves, such as non-Arabic-speaking expatriates, the lack of access to authoritative opinions presented difficulties, with the result that initiatives toward innovation and improvement were slow to come. Product development and process improvement, under such circumstances, became onerous and cumbersome tasks. Without direct access to the Shari’ah boards, legal counsel needed to rely on management to translate and summarise their work. Feedback from the Shari’ah boards under those circumstances was little better than hit or miss. None of this was conducive to progress. Instead, the Islamic banks appeared to most Western professionals, even to Western academics, to work behind a veil of mystery. If the fundamental principles were understood, the details were not. In fact, 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.

2.8 A New Stage in the Jurisprudence of Islamic Finance

Near the end of the decade of the 1980s, however, these situations had begun to change. By this time, Islamic banking and finance had grown far beyond the expectations of even the most fervent among its early supporters. In fact, Islamic finance became recognised as a growth industry; and a number of multinational banks and asset management companies were taking an interest in its development. Within the industry itself, significant developments were afoot. One of the main reasons for these developments was the progress made by Muslim jurisprudents in understanding the business of commerce and finance and in applying Shari’ah principles and precepts to it. Another reason was the facility developed by Shari’ah boards with the nominate contracts, such that they began to feel comfortable with novel configurations. Other reasons for development included the growing discourse on Islamic finance in the English language. Finally, the academic discourse on the subject had achieved a critical mass and many issues were moving toward consensus, the all-important ijma’ or general acceptance of the juristic community considered a binding adjudicator (or indicator, dalil) in Islamic law.

Undoubtedly, big players, in the form of financial institutions with their human and capital resources, did much to spur the development of Islamic finance. Their influence on the jurisprudence of Islamic finance, however, has been more subtle. Before discussing the innovations made by scholars with respect to the nominate contracts, it will be well to begin with a discussion of how the multinationals and global asset managers helped the jurisprudence of Islamic finance move into a significant new stage of creativity. Certainly a part of this involved the growing facility of Shari’ah scholars with English. To a degree, these two factors went hand in hand. Clearly it is true in any profession that it is one thing to acquire experience, and quite another to have exposure to the top echelons of that profession. Shari’ah scholars began working closely with Wall Street insiders, with some of the most knowledgeable and talented individuals in the business, and it was then that the exchange of ideas began in earnest. In some cases, a single member of a Shari’ah board would take part in such exchanges and report back, formally or figuratively, to his peers on the board. Exchanges of this nature provided Shari’ah scholars with valuable, and often key, insights into business procedures and practices that might otherwise have remained obscure and therefore suspect. Nor was this process of exchange a one-way street. On the contrary, as their own understanding of modern business concepts and practices increased, Shari’ah scholars were emboldened to make comments of their own, often pointing out parallels that exist between fundamental Shari’ah concepts of transacting and modern commercial law; and then moving on to extrapolate shared concepts and to consider their possible applications in modern situations. Through such exchanges many scholars acquired an insider’s grasp of the context of modern commerce. Clearly, such exposure added perspective and depth to the deliberations of Shari’ah boards on the jurisprudence of modern Islamic finance. While it may be difficult, if not impossible, to quantify or point directly to such intangibles, it is equally as difficult to deny their influence.

2.9 The Jurisprudence of Transformation and Innovation

As noted in Section 2.6, the most important factor in the transition from the jurisprudence of recovery and revival to a more proactive and participatory jurisprudence of innovation and transformation was the reconfiguration of the nominate contracts or, perhaps more exactly, the concept that the nominate contracts may be thought of as building blocks that may be constituted and constructed creatively for the achievement of all manner of objectives. Section 2.6 discusses the transformation of the classical murabahah into the modern murabahah li’l-amir bi’sh-shira, murabahah as an example of the application of this concept.

Following the success of this experience, Shari’ah boards went on to engineer and approve a host of hybrid nominates, using a single nominate such as murabahah in different configurations (such as parallel murabahah, reverse murabahah, back-to-back murabahah, and reverse parallel murabahah contracts), or using a plurality of nominate contracts in combination with one another. In this manner, the nominate mainstays of classical Islamic commercial law, musharakah, ijarah, salam, istisna’a, mudarabah, and others, were transformed and adapted in a variety of ways to modern needs and circumstances. A case in point is the adaptation of these contracts to bring about interest-free alternatives to conventional mortgages for the financing of homes;24 in other cases, these became key elements in investment funds, project finance, and, most recently, in sukuk.25 In fact, the contracts for the financing of homes by one U.S. company have recently been securitised and converted to sukuk issued by Freddie Mac with all the qualities of U.S. government–secured paper. It would be interesting, as an academic case study, to follow and analyze the transformation and adaptation of all the different nominates applied in that one instrument, as it includes the creative application of many disparate elements.

As discussed earlier, one of the factors in the development of a modern Islamic financial and commercial jurisprudence has been the ability of scholars to communicate their ideas among themselves and, through debate and discussion with colleagues and peers and, to an extent, through demonstrating by means of actual business applications, to bring about general agreement and approval throughout the scholarly community. The importance of this point, of this process itself, cannot be overemphasised because the concept of ijma’ as a legal indicator, dalil, carries very nearly the same authority as the revelational sources26 themselves. Whatever questions, reservations, or doubts the critics of modern scholarship may have on this subject, the fact that Shari’ah boards have been able to achieve consensus on so many key issues suffices to establish the legitimacy of modern Islamic finance and, more importantly from a practical perspective, sets the stage for the establishment of industry standards, which may, in turn, provide the impetus for real industry growth. Through the efforts of the various academies, especially those with international and regional representation, such as the OIC Fiqh Academy, and through the regular exchanges by scholars at seminars and conferences, particularly those like the annual Albaraka seminars in Jeddah, a serious process has been ongoing since the 1970s.

Finally, with the establishment of the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) in the early 1990s, the process for bringing scholarly attention to focus on particular issues was streamlined, with the result that consensus could be brought about through an institution, and then regular standards for a wide spectrum of Shari’ah-related issues could be approved and implemented. The transparency, thoroughness, and inclusiveness of the process employed by the AAOIFI have contributed in so many different ways to the growth of this industry that it would require a separate paper to do justice to each. Finally, the newly established Islamic Financial Services Board (IFSB) ensures that the efforts of Shari’ah scholars and financial and legal practitioners for the achievement of consensus and standardisation will find a place in legal and regulatory systems worldwide.

In the brief span of a few decades, Shari’ah scholars across the world have worked together and with others to bring about the revival of one of Islam’s most important institutions, its finance. In the process, Islamic jurisprudence has undergone significant development. Moreover, the revival of Islamic commercial energies has led to an expansion of cooperation and mutually beneficial exchanges between Muslims and the other peoples of the world. This can only lead to a better and brighter future for all.

3. ENFORCEABILITY OF THE SHARI’AH

As noted in the first sections of this chapter, Islamic finance in the modern era has passed through a period of “revival and recovery” to a period of “transformation and adaptation.” To summarise here, the current period of transformation and adaptation is characterised by various adherents and adherences to Shari’ah: by a significant number of Islamic and conventional multinational banks and financial institutions as participants; the participation by Shari’ah-compliant and conventional asset managers; the development of significant practical experience by Muslim jurisprudents in an expanding range of financial and commercial transactions of increasing complexity; a growing discourse on Islamic finance in the English language; a movement toward consensus among Shari’ah scholars (ijtna’); the acceptance and implementation of the concept that the nominate contracts may be thought of as building blocks that may be constituted and constructed creatively for the achievement of all manner of objectives; and a transactional base that entails conformity with both the Shari’ah and at least one body of secular law.

3.1 Trends in Islamic Finance and the Focus on Enforcing Islamic Shari’ah

Three trends during the period of transformation and adaptation are particularly notable: (1) “internationalisation” and “globalisation”; (2) diversification of Shari’ah-compliant financial products and structures; and (3) increasing sophistication of those products and structures. Each of these developments has the effect of focusing attention more immediately and more precisely on the issue of whether the principles and precepts of the Shari’ah will be legally enforced in any given circumstance, with respect of any given structure, product or transaction, and in any given jurisdiction. Of course, this is occasioned by the focus of all concerned with Shari’ah-compliant transactions, be they seeking such compliance or indifferent to such compliance, with the degree of certainty, predictability, and transparency of the Shari’ah-compliant structure, product, or transaction and with the functioning of the relevant legal regimes as risk allocators. Much of the history of commercial law in the United States, England, France, and many other countries that have been successful in promoting commercial interests (and, essentially “exporting” their law as a governing law of commercial and financial transactions) relates to the certainty, predictability, and transparency of the legal system and legal determinations in respect of commercial and financial matters, as well as the principles of risk allocation, fairness, and justice.

The transactional context that focuses on the enforceability of the Shari’ah is best examined by considering some illustrative examples of modern transactions. One type of transaction is a Shari’ah-compliant transaction in the United States involving the development of a real estate project by a non-Muslim U.S. developer with financing provided by a non-Islamic U.S. bank.27 A Muslim investor from the Middle East or Southeast Asia desires to invest in the construction and development of this project in compliance with the Shari’ah, and that investor’s Shari’ah supervisory board will review and pass upon the structure and documentation of the transaction. The investment in, and financing of, the project must comply with the secular law of the relevant state of the United States as well as applicable federal laws of the United States. The developer and the financing bank agree to participate in a Shari’ah-compliant transaction structured as an istisna’a-ijarah, although neither has any informed knowledge of what these structures entail and despite the fact that documents such as these are unknown, in this type of transaction, in the United States.

Another example is the issuance of sukuk, a Shari’ah-compliant pass-through securitisation of assets located in a Shari’ah-incorporated jurisdiction. The asset originator is located in that same jurisdiction. Assume that the sukuk issuer is a special purpose vehicle located in a purely secular jurisdiction that allows for the choice of applicable law for financial transactions. And assume that the sukuk are sold to both Muslim and non-Muslim investors throughout the world. The applicable laws will include those of the Shari’ah-incorporated jurisdiction, where the originator and the assets are located, particularly with respect to whether there has been a “true sale” of the assets by the originator to the special purpose issuer. The bankruptcy laws of both the jurisdiction where the originator and the assets are located and of the jurisdiction in which the issuer is located will be applicable to the transaction. Further, it is likely that the securities laws of the issuer’s jurisdiction as well as those of the various jurisdictions of the purchasers of the sukuk will be applicable in certain circumstances.

It is noteworthy that in each of the illustrative transactions, the profit margins are quite thin and, for the most part, non-Islamic transactions of these types are quite standardised in terms of (a) the relative rights and remedies of the parties, (b) the terms of many financial and commercial risk allocations, and (c) the legal documentation. For example, in non-Islamic transactions 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 many years. Thus, there is great certainty and predictability as to how any provision will be interpreted or implemented as well as with respect to the rights, obligations, and remedies of all of the parties in a broad range of circumstances.

In the Shari’ah-compliant configuration of these transactions, the Shari’ah-compliant investor and the Shari’ah supervisory board are (of course) not indifferent to the issue of compliance with the Shari’ah. In fact, they desire to know with certainty and predictability that the Shari’ah will be enforced in this, as in any similar, transaction. The other participants in the transaction (including developers and financing banks) may well be indifferent towards compliance with the Shari’ah, although they will undoubtedly not be indifferent to the effect that compliance with the Shari’ah will have on their respective rights, obligations, and remedies, and on the degree of certainty and predictability inherent in the Shari’ah-compliant transaction.

In these types of Shari’ah-compliant transactions in the United States or Europe, and at the commencement of the transaction, all parties to the transaction have moved away from the state of certainty and predictability to which they are accustomed, and the non-Muslim participants are not close to the degree of certainty and predictability that they must have to enable them to determine whether to consummate the transaction. The Shari’ah-compliant investors are likely to be more comfortable with the structure of the transaction at its inception. (It will be an istisna’a-ijarah or sukuk structure that he or she has worked with previously, and these investors may also be quite familiar and comfortable with the applicable secular law.) The non-Muslim participants will be notably uncomfortable at this time: they will likely not know more than a few material points about the Shari’ah, and they will be using a structure that is totally unique to their experience, that is nonstandard, and that is well outside their customary realm of certainty and predictability. Bankers, by nature and training being abhorrent of risks, particularly risks that they cannot control or understand, let alone risks that are unique to their experience, are usually the most uncomfortable participants in the transaction.

Each of the participants in this transaction 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 (that is, the agreed-upon allocations of risks) will be sustained and enforced in a transparent, predictable, and certain manner. A primary function of law, and we include the Shari’ah as “law” for the purposes of this chapter, in the commercial and financial realm is to provide certainty and predictability to the greatest possible extent and to sustain and enforce the determinations of the parties in a given transaction with respect to risk allocation and relative rights, obligations, and remedies. These matters are the focus in respect of the enforceability of the Shari’ah in Islamic finance.

Of course, predictability, stability, and uncertainty are matters of individual perception based upon the past experience of the individual participants. For a range of reasons, the perceptions of most participants will be based upon financing techniques and structures that have been developed in the Western interest-based economic and legal system. Some of those reasons include (a) the dominance of the Western interest-based economic system over the last few centuries, (b) the predominance of United States and European financial institutions, lawyers, and accountants in the development and refinement of the most widely used financing techniques, (c) the refinement and exportation of Anglo-American law, (d) the relative infancy of modern Islamic finance, (e) the lack of familiarity with the operation of legal systems in the jurisdictions of the Islamic economic sphere, and (f) the general lack of knowledge of, and familiarity with, the Shari’ah. Those perceptions are also influenced by the existence of “standardised” practices and structures, including “standardised” contracts, applicable to many of the activities that comprise a financing. Those standardised practices, structures, and contracts have evolved, have become “standardised,” because of the economic efficiencies that they facilitate, particularly with respect to risk allocation, risk coverage, and minimisation of transactional costs. Of course, most of those standardised practices, structures, and contracts were developed in, and have evolved within, a Western interest-based paradigm and reflect little, if any, sensitivity to the principles and precepts of the Shari’ah. Similarly, the contracts will be enforced in a legal system that has developed and evolved in response to the needs of an interest-based economic system.

Each of the participant parties will come to the financing transaction bound by their existing institutional perceptions and practices with respect to such matters as risk allocation, risk coverage, underwriting criteria, and accounting treatment. Each must continue to operate within an existing secular legal and regulatory framework, and that framework has probably shaped many of the embedded institutional practices. Each participant party will have strong expectations, based upon past “best practices” within its realm of experience, as to the enforceability of the many contracts that comprise the project financing. Frequently, this means that parties will desire to have the contracts governed by English or New York law, rather than the law of the host country.

Participants in Shari’ah-compliant transactions will include parties that proceed from, and are focused on, structures, methodologies, and documents that proceed from a Western interest–based perspective. However, almost by definition, these transactions will also include participants that proceed from a different set of principles and precepts: those embodied in the Shari’ah. Thus, in many cases, Shari’ah-compliant financings will utilise structures, methodologies, and documents that allow both Muslim and non-Muslim, particularly Western, parties to operate within a sphere of predictability, stability, and certainty that is acceptable to those parties.

Before examining issues pertaining to the enforceability of the Shari’ah in the context of modern Islamic banking and finance, it would serve us well to survey the aforementioned trends by way of sketching some recent developments that provide the context of discussion. In focusing on the issues pertaining to the enforceability of the provisions of a commercial or financial transaction that is structured in accordance with, and intended to be compliant with, the Shari’ah by the courts and other enforcement bodies of different jurisdictions, we need to consider (a) the types of jurisdictions in which such a transaction may occur and in which the related contracts may be enforced, (b) the state of the law in respect of enforcement and issues of governing law (particularly in purely secular jurisdictions), and (c) current practices in structuring and documenting such transactions. We examine each of these topics, and this examination includes consideration of the nature of legal opinions that are rendered in connection with such transactions.

3.2 Internationalisation and Globalisation

Prior to the commencement of the modern era of Islamic banking and finance, interest-based banking and finance was dominant throughout the world, including in the Islamic economic sphere. While that remains true to this day as a general statement, this chapter has outlined the post-1970s development of a system of banking and finance that is compliant with the Shari’ah. The establishment of these early Islamic banks and financial institutions occurred on an international, but largely regional, basis and focused primarily on transactions between an Islamic bank or financial institution and its local customer base.

Legal systems in the various countries of the Islamic economic sphere were, and are, primarily secular, with exceptions such as those noted later in this chapter. Often, economic and legal structures were and are the product of legislation or royal decree, and some, if not most, of those structures and that legislation is unclear under, or conflicts with, or is contrary to, the Shari’ah, even in Shari’ah-incorporated jurisdictions. However, most of those legal systems have some provision or conception that the Shari’ah is incorporated in the legal structure, frequently as “a” or “the” paramount law or source of law. Thus, there has been, and there remains, some question of whether, in what circumstances, and to what extent, the Shari’ah will be enforced in Shari’ah-incorporated jurisdictions within the Islamic economic sphere; the issue is joined, albeit quietly, and without the involvement of the Western economic sphere. Further developments during the modern era of Islamic banking and finance have ensured that the focus on enforceability is not now, and will not be, either quiet or isolated, and that the Western economic sphere will be forced to focus on the enforceability issue in tandem with the Islamic economic sphere.

In the mid- to late 1990s and the early years of this century, certain Middle Eastern investors sought to make investments in the Western economic sphere, particularly the United States, in accordance with the Shari’ah.28 Some of these investors were financial institutions and families that had long made investments in the United States, although many of those previous investments were not made in compliance with the Shari’ah, primarily because of the inability to effect, and perceived inability to enforce, Shari’ah-compliant transactions in the United States. Other investors were new to U.S. markets. And, as noted in the next section of this chapter, the products, structures, and transactions began rather simply and quickly became both more diverse and more sophisticated.

As an extension of this internationalisation and globalisation, and in response to political events during the period, the next major development began in late 2001, with acceleration in late 2002 and throughout 2003: Middle Eastern investors began to make Shari’ah-compliant investments in European jurisdictions on a significant scale. That trend continues to this day.

The salient point is that the making of Shari’ah-compliant investments in the United States and Europe was a broad international and more globalised trend. The transactions involved multiple jurisdictions and participants from a broad range of countries and religious, cultural, and legal systems. Many of the transactional participants, including the financing entities in the United States and Europe, had little or no familiarity with Islam or the Shari’ah. Yet, to give effect to the desires of the Muslim investors, the legal systems in the Western economic sphere had to address the issue of enforcing contracts in accordance with the Shari’ah, and, because of the structure of those legal systems, had to do so within the context of enforcement of conventional secular law, substantive and procedural, in those purely secular jurisdictions.

Of course, the question (a series of questions) is then dramatically posed: How can a Shari’ah-compliant investor or a Shari’ah supervisory board considering the structure of, or documentation for, a Shari’ah-compliant fund or transaction in the Western economic sphere be confident that the Shari’ah will be enforced? Can there be a truly Shari’ah-compliant transaction at all in the Western economic sphere if the relevant courts in the jurisdiction within the Western economic sphere will be applying the secular law of that jurisdiction in the interpretation and enforcement of the documentation for that transaction? Will a court in a Western economic sphere or a purely secular jurisdiction ever enforce the Shari’ah? How would a court in a purely secular jurisdiction within the Western economic sphere know what the Shari’ah is with respect to any matter or dispute? How does the injection of the Shari’ah into the secular law context affect the certainty and predictability of outcome that is essential to the effective operation of a legal system in a commercial world? Will financial institutions and non-Muslim transactional parties be willing to approve the enforceability of documents in accordance with the Shari’ah when they have essentially no knowledge of the Shari’ah and no confidence that there will be any contractual or economic certainty in a transaction where the Shari’ah is to be ascertained, interpreted, and enforced by a court in a purely secular jurisdiction within the Western economic sphere that likewise has no knowledge of the Shari’ah?

The questions quickly multiply, and are present in virtually every Shari’ah-compliant transaction in the international realm, and most particularly, but certainly not exclusively, in purely secular jurisdictions. These are critical questions to business people that desire minimisation of risk, where possible, and depend upon a legal system that supplies certainty and predictability in commercial and financial transactions. The issues raised by these and related questions are exacerbated by the increasing diversification and sophistication of Shari’ah-compliant structures and products, particularly in an environment, such as the present environment, in which Shari’ah scholars and others involved in Islamic banking and finance do not themselves agree on what is permissible under the Shari’ah in respect of innovative, novel, and sophisticated financial instruments.29

3.3 Diversification and Increased Sophistication of Products

Internationalisation or globalisation of Islamic banking and finance in the last 35 years has focused Shari’ah scholars, financial institutions, Muslim and Western business people, lawyers, accountants, and many others on the issue of the degree of certainty and predictability in Shari’ah-compliant transactions in comparison to the known degree of certainty and predictability in a conventional Shari’ah–non-compliant equivalent of that same transaction. The diversification of the base of Shari’ah-compliant products and the increasing sophistication of those products, all of which are highly “structured,” while both in their infancy, have sharpened the focus further and brought to the fore the question of whether potential participants in these transactions will be amenable to spending further significant amounts in the development of Shari’ah-compliant structures and products.

The late 1990s saw pioneering efforts in the area of Shari’ah-compliant private equity investments in the United States. Those investments continue to this date and in more refined form throughout the world, including in the United States and in Europe. In 1998, Dow Jones obtained a fatwa pertaining to the financial tests applicable to Shari’ah-compliant investments in equity securities. With the downturn of the equity markets in the late 1990s and early years of this century, various Shari’ah-compliant investors moved forcefully in the United States’ real estate markets. Investments were made in construction and development projects, first in the residential housing sector and later in commercial and mixed use projects.

During the period from 2001 to the present, there was a significant increase in Shari’ah-compliant investment in Europe, particularly pan-European real estate investments. There was also an increase in Shari’ah-compliant transactional activity in the United States during this period, although these transactions were done very discreetly, largely because of events in New York and Washington, D.C., in September 2001 and related developments. Shari’ah-compliant private equity funds also focused on both North America and Europe. Shari’ah-compliant structures for short sales of securities and options trading have been developed, and fatawa have been issued in respect of these structures. Efforts are under way to develop Shari’ah-compliant structures affecting the economic equivalencies of a range of derivatives. Shari’ah-compliant factoring and refactoring structures have been developed and approved by a Shari’ah supervisory board.

Notable aspects of developments in Islamic finance include: the increased involvement of conventional Western financial institutions; the expansion of English-language literature on Islamic finance and Islamic jurisprudence; the access of the Shari’ah scholars to the principal business participants in the Western economic sphere; and the involvement of the Shari’ah scholars, from the very initial stages onward, in the structuring of financial Shari’ah-compliant products, including in the Western economic sphere. Early transactions in the United States and Europe were initiated by Middle Eastern or, to a lesser extent, Southeast Asian institutions that desired Shari’ah-compliant investments of their own funds and those of their depositors and other customers. The economics of those transactions required the use of leverage. Conventional Western financial institutions were brought into the transactions to provide the necessary leverage. However, the structures and documentation had to be designed in a manner that made the use of that leverage compliant with the Shari’ah. For a range of commercial and legal reasons, the only financial institutions that could or would provide the requisite leverage were Western financial institutions, particularly conventional interest-based banks. Those banks rose to the challenge and implemented the Shari’ah-compliant structures and documentation, largely because of their relationships with the Western institutions that were involved as developers, equity investors, and fund managers.

As Islamic finance has grown and the number of transactions has both increased and become more visible, Western financial institutions have shifted their focus. In the context of increasing globalisation of their own businesses, they have recognised the size of the Islamic finance market and made a conscious decision to investigate participation in that market, not as a reflexive matter, but as an initiative matter. Their investigation has led them to the conclusion that it is possible, even practical, to develop structures that comply with, and meet the following desires, demands, and requirements: (a) the needs of their existing clients in the Islamic economic sphere; (b) their desire for global and international expansion and penetration of their own businesses; (c) their product strengths and capabilities; (d) the Shari’ah; and (e) local secular legal requirements. Thus, various conventional Western financial institutions are taking the initiative in developing their own Islamic finance programs, and some of these are at the forefront of Islamic finance. These banks desire to play to their own strengths, such as derivatives. Frequently, these strengths are in areas in which there are, at present, no Shari’ah-compliant structures. Additionally, these institutions desire products that compete in the conventional as well as the Islamic finance markets. The result is substantial pressure to create a broader range of much more sophisticated financial instruments and products.

3.4 Public Law and Private Law in Different Jurisdictions

Focusing on the concept of the application of the Shari’ah to contractual relationships between two or more sophisticated parties to a commercial or financial transaction, and as a general statement, there are two types of jurisdictions: the Shari’ah-incorporated jurisdictions and the purely secular jurisdictions. Examples of Shari’ah-incorporated jurisdictions include Egypt, Iraq, Jordan, Kuwait, Saudi Arabia, Syria, the United Arab Emirates, and Yemen. Examples of purely secular jurisdictions include the United States, the United Kingdom, France and most European jurisdictions, Japan, and South Korea.

The degree to which the Shari’ah has been incorporated into the substantive law of the various Shari’ah-incorporated jurisdictions varies considerably.30 Historically, the Ottoman Empire adopted many aspects of the French commercial code by 1830, and thereafter adopted many other French codes. Civil law remained largely untouched by this Westernisation process despite the compilation of the Majelle. The Majelle was a codification of civil law following a Western model, but the Majelle itself was comprised of, and based upon, the Shari’ah as interpreted by the Hanafi school of Islamic jurisprudence. Since 1949, Egypt and Syria have adopted Westernised codifications of certain laws, while retaining the influence of the Shari’ah in many substantive areas. In each of these jurisdictions, the Shari’ah is expressly designated as a source of law. In Egypt, the Shari’ah is to be consulted by a judge after considering the civil code and custom. In Syria, the Shari’ah is to be consulted prior to examination of custom, and is thus a true source of law. Similar concepts are found in the Civil Code of 1976 of Jordan. Kuwait and the United Arab Emirates are examples of nations that have incorporated significant portions of the Shari’ah into their codes. In certain jurisdictions, such as Saudi Arabia and Oman, there is no civil code and the role of the Shari’ah is predominant, including in respect of contracts.31

The distinction between Shari’ah-incorporated jurisdictions and purely secular jurisdictions is important in addressing the issue of when, and under what circumstances, the Shari’ah is an enforceable element of a contract under the laws of a specific nation or jurisdiction.32

In the Shari’ah-incorporated jurisdictions, provisions of the Shari’ah are either (a) literally incorporated into the text of the substantive law of the nation; or (b) 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 Shari’ah-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 a Shari’ah-incorporated jurisdiction the parties cannot by contract alter the applicable Shari’ah provisions, 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 purely secular jurisdiction, on the other hand, the governing law, of itself, will not include any of the Shari’ah. Sophisticated parties to a commercial financing transaction are permitted to write their own “law” for the transaction, in the form of the contract, and the contract itself is “the law of the land” with respect to that transaction.33 Thus, if the parties desire to implement the Shari’ah, they will have to draft the contract in accordance with, and incorporate, the relevant Shari’ah principles. If New York or English law, or the law of any other purely secular jurisdiction, is chosen as the governing law of a contract, the court will enforce that law, and the contract subject to that law, in accordance with its terms. If the contract in question is drafted in accordance with the Shari’ah (for example, to include, as text, the relevant Shari’ah principle), the New York or English court, applying New York or English law, will enforce the Shari’ah provisions. Alternatively, but with less certainty and predictability,34 the parties to a contract in a purely secular jurisdiction could choose to apply the law of a Shari’ah-incorporated jurisdiction, and thereby ensure that the contract would be enforced in accordance with the Shari’ah to the extent that the Shari’ah is incorporated in, or comprises a part of, the laws of such Shari’ah-incorporated jurisdiction.

4. ENFORCEABILITY OF THE SHARI’AH: CASE LAW AND TRANSACTIONAL PRACTICE

In analyzing the issues pertaining to enforceability, under the Shari’ah, of provisions of contracts in Shari’ah-compliant transactions, it is necessary to consider a number of factors, including: (a) existing law, including case law in common law jurisdictions; (b) current transactional practice relating to the construction and drafting of contracts in Shari’ah-compliant transactions in different jurisdictions; (c) current transactional practice with respect to legal opinions; and (d) the matters of certainty and predictability in Shari’ah-compliant transactions in different jurisdictions. In considering these factors, this chapter makes the assumptions that the transactions discussed have been structured and documented in accordance with the Shari’ah and that such structures and all documentation have been reviewed and approved by a Shari’ah supervisory board.

4.1 Shamil Bank v Beximco: A Recent English Court Decision

Focusing on enforceability issues in purely secular jurisdictions, such as England, other European jurisdictions, and the United States, litigation of a Shari’ah-compliant transaction using the law of the purely secular jurisdiction as the governing law will raise questions of whether, when, and under what circumstances a secular court will apply the Shari’ah in interpreting the contracts involved in that transaction. A recent appeals court decision in an English case, Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco Pharmaceuticals Ltd. and Others (“Shamil Bank v Beximco”),35 focuses on the enforceability issue in the context of a Shari’ah-compliant transaction in which the governing law provisions of the relevant legal contracts contained the following language: “Subject to the principle of the Glorious Sharia’a, 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 purely secular jurisdiction.

In 1995, two companies in the Beximco group of companies (the “Beximco Companies”) executed a murabahah agreement (the “1995 Murabahah Agreement”) with Shamil Bank pursuant to which Shamil Bank advanced funds to the Beximco Companies for the purchase of specified goods. The 1995 Murabahah Agreement was guaranteed by two directors of the Beximco Companies and by the parent company of the Beximco Companies (the “Guarantors”). One of the Beximco Companies made several payments under the 1995 Murabahah Agreement in accordance with a payment schedule to that agreement. In 1996, the Beximco Companies entered into a second murabahah agreement (the “1996 Murabahah Agreement”) with Shamil Bank, and funds were advanced pursuant to the 1996 Murabahah Agreement. The second of the Beximco Companies made various payments to Shamil Bank pursuant to the 1996 Murabahah Agreement and its related payment schedule.

By late 1999, both Beximco Companies were in admitted default under the 1995 Murabahah Agreement and the 1996 Murabahah Agreement (collectively, the “Murabahah Agreements”). In 1999, the Beximco Companies entered into two Exchange in Satisfaction and User Agreements with Shamil Bank, and these were later amended in 2001 and 2002 (as amended, the “Ijarah Agreements”). Pursuant to the Ijarah Agreements, certain assets of the Beximco Companies were transferred to Shamil Bank in satisfaction of the Murabahah Agreements, the Beximco Companies were granted the right to use those transferred assets, and the Beximco Companies agreed to make payments to Shamil Bank in respect of such use. Each of the Ijarah Agreements was guaranteed by the guarantors.

Pursuant to the constitutional documents of Shamil Bank,36 the Shari’ah supervisory board of Shamil Bank ascertains that the “investments and activities” of Shamil Bank conform to the Shari’ah. The Shamil Bank board of directors has the responsibility, pursuant to the constitutional documents, to “ensure that all the investments and other business transactions [of the Bank] have been referred” to the Shari’ah supervisory board. It is not clear from the reported decision whether or not the Shari’ah supervisory board of Shamil Bank reviewed the precise transactions, and related documentation, pertaining to the Murabahah Agreements, the Ijarah Agreements, and the related guarantees. This presumably would be a factual matter to be determined at a trial.

In mid-2002, both of the Beximco Companies were in default under the Ijarah Agreements and defined “termination events” had occurred thereunder. Shamil Bank provided notices of default and made claims for approximately US$49.7 million on the Ijarah Agreements and the guarantees provided by the guarantors. The lower court awarded judgement to Shamil Bank for approximately US$49.7 million. The lower court determined that it was not necessary to concern itself with Shari’ah principles.

The governing law provision of each of the Ijarah Agreements reads: “Subject to the Glorious Sharia’a, this Agreement shall be governed by and construed in accordance with the laws of England.” The governing law provision of each of the guarantees reads that such guarantee: “is governed by and shall be construed in accordance with English law” (there being no reference to the Shari’ah).

The critical issue at the appellate court level, as well as at the lower court level, in Shamil Bank v Beximco was whether the governing law clause in the Ijarah Agreements required the consideration of the Shari’ah. The appellate court, like the lower court, determined that the governing law clause did not require consideration of the Shari’ah.

The appellate court opinion begins by noting that an English court must interpret a contract in accordance with the commercial purpose of the parties and the contract, and must thus take cognisance of “the genesis of the transaction, the background, the context, the market in which the parties are operating” and similar factors.37 In the instant case, this requires recognition of the fact that the contracts at issue (that is, both the Murabahah Agreements and the Ijarah Agreements) were intended to provide working capital financing with long-term repayment provisions and were to be binding upon the parties to those contracts. Further, and in accordance with that same principle in respect of commercial purpose, the court noted 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 Sharia’a’ 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.”38

Turning to the governing law issues, 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,39 and that the Rome Convention allows the parties to a contract to choose the law applicable to that contract,40 but that the law so chosen must be the law of a country.41 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 Sharia.”42 Concurring with the lower court, the appellate court characterises the Shari’ah as a set of “Islamic religious principles”43 and “religious and moral codes,”44 rather than laws of a nation.

The opinion then addresses 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 national law. The opinion cites examples that are discussed in a leading text on conflicts of laws, Dicey & Morris, as put forth by the Beximco Companies:45

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.

32–087 It often happens that statutes governing the liability of a sea carrier, such as the former Harter Act in the United States, or statutes implementing the Hague Rules . . . are thus “incorporated” in a contract governed by a law other than that of which the statute forms a part. The statute then operates not as a statute but as a set of contractual terms agreed upon between the parties. The parties may make an express choice of one law (e.g., English law) and then incorporate terms of a foreign statute. In such a case the incorporation of a foreign statute would only have effect as a matter of contract.

While stating that the foregoing was of no assistance to the Beximco Companies, the court acknowledged the application of the principle that the governing law of a contract may be that of one nation (England or the United States), while “incorporated contractual terms” may come from another body of law or rules (such as the French Civil Code, the Hague Rules or, possibly, and by implication, the Shari’ah). However, as noted by the court,46 such an incorporation concept is only workable “where the parties have by the terms of their contract sufficiently identified specific ‘black letter’ provisions of a foreign law or an international code or set of rules apt to be incorporated as terms of the relevant contract such as a particular article or articles of the French Civil Code or the Hague Rules. By that method, English law is applied as the governing law to a contract into which the foreign rules have been incorporated.”

Turning to the instant case, the opinion finds 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. It is plainly insufficient for the defendants to contend that the basic rules of the Sharia applicable to this case are not controversial. Such “basic rules” are neither referred to nor identified. Thus the reference to the “principles of . . . Sharia” stands 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.47

4.2 Discussion

Before moving to other aspects of enforceability in the context of a Shari’ah-compliant transaction, it is worth noting a few aspects of the reasoning in the Shamil Bank v Beximco case.

First, in accordance with conceptions of national sovereignty and the concepts of nations, the near universal principle is that the law governing a contract (and most other matters) is 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. As noted in this chapter, certain jurisdictions—the Shari’ah-incorporated jurisdictions—do incorporate the Shari’ah into the national law, either generally or in specific instances. However, even in Shari’ah-incorporated jurisdictions, the degree of incorporation varies considerably and is often general rather than specific. As a general, and near universal matter, national law will govern the interpretation of contracts.

Second, the laws of many nations allow the parties to a contract to choose the law that will be applicable to the enforcement of that contract. The Rome Convention that is cited in the Shamil Bank v Beximco opinion 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.48 Again, there are variations in this concept, especially as regards enforcement of foreign judgements 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.49

Third, as a general matter, the laws of many nations allow the parties to a contract to incorporate foreign laws, codes, and rules into a contract governed by the laws of such nation, although they also require some degree of specificity to effect 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. The ruling in Shamil Bank v Beximco is consistent with those principles. The court in Shamil Bank v Beximco implied that it would have no objection to the incorporation of specific aspects of the Shari’ah, analogously to incorporation of the French Civil Code, The Hague Rules, or the Harter Act, if there were adequate specificity of the terms to be incorporated. This is consistent with the laws of the States of the United States and of most European jurisdictions.

Fourth, generally the laws of most nations allow the parties to a contract, particularly a commercial contract between sophisticated parties, to agree to such contractual terms and conditions as the parties determine appropriate. Of course, there are certain limitations, such as those pertaining to illegal acts or acts contrary to public policy, which cannot be the subject of a valid and enforceable contract. Another set of limitations relates to contractual contravention of a paramount law, such as a constitution or the Shari’ah itself. Similarly, there are unwaivable and mandatory legal provisions in the laws of most nations, particularly in respect of matters where the sophistication and bargaining power of the parties are disparate. Examples of the latter type of provisions include certain consumer protection, environmental protection, landlord–tenant, and public policy laws that may not be altered or waived by contract.

5. TRANSACTIONAL PRACTICE: LEGAL OPINIONS

Financial transactions are most often determined on the basis of legal opinions concerning parameters of existing laws, enforceability of laws, and certain specialised requirements. Section 5 sets forth three practical scenarios.

5.1 Legal Opinions in Financing Transactions Generally

In almost every financial transaction, including Shari’ah-compliant transactions, the parties will require that their counsel or opposing counsel provide a series of legal opinions. One set of legal opinions will address the due formation and valid existence of the participating entities under relevant applicable law. This threshold set of opinions is generally referred to as the “entity authority” set of opinions. Another set of opinions, and those that are the focus of this chapter, will address the validity and binding effect, and enforceability, of the relevant documents. This set of opinions is generally referred to as the “enforceability” or “remedies” set of opinions. An example of an enforceability opinion for a Shari’ah-compliant ijarah-based acquisition financing transaction in a purely secular jurisdiction (here, New York) is set forth as an Appendix at the end of the chapter.50

5.2 The “Enforceability” or “Remedies” Opinion

“A remedies opinion deals with the question of whether the provisions of an agreement will be given effect by the courts.”51 The essence of the enforceability or remedies opinion is that each of the “undertakings”52 in the contracts to which the client is a party is enforceable under the designated law governing the contracts, 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.”53 This opinion is customarily delivered at the closing of the transaction, and its delivery is usually a condition precedent to the closing of that transaction.

As noted in the TriBar Report,54 the remedies opinion covers three distinct, but related, matters:

Exceptions and exclusions to the opinion are appropriate in various circumstances, and those exceptions and exclusions are set forth in the opinion itself. (The Appendix provides examples of a wide range of exceptions and exclusions.) For example, one or more exceptions may be required in respect of the portion of the opinion described in clause (2) 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. An example of the latter circumstance is the concept of “specific enforcement” as being a remedy under a contract. As noted in the TriBar Report,55 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 summarised into three groups. The first group (the “obligations provisions”) includes those provisions of the agreement that obligate the company to perform an affirmative act, but say nothing about what will happen if it fails to perform those acts. An example from an ijarah-based transaction is the requirement in the ijarah that the lessee pay 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.”56

The second group (the “available remedies”) comprises those provisions that specify a remedy if the company fails to perform particular undertakings. The stated remedies may be affirmatively stated (for example, the requirement to pay liquidated damages) or, more frequently, set forth as the right of a party to take action (for example, reduce the interest of a defaulting partner in a partnership or 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.”57

The third group (the “ground rules provisions”) includes those provisions that establish 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 (for example, the New York courts or by arbitration), the manner in which notices are effectively given or binding amendments effected (for example, in writing), or the waiver of rights (for example, 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.”58

5.3 Enforceability Opinions in Specialised Financing Transactions

Enforceability or remedies opinions in specialised financing transactions are subject to considerations that are not applicable to other enforceability opinions.59 The types of transactions that are “specialised financing transactions” are not specified in the TriBar Specialized Financing Report. The examples given are leveraged leases and sale–leaseback transactions, and other transactions that are “reasoned.”60

A good argument can be made that many Shari’ah-compliant transactions in a purely 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). These transactions involve a significant degree of structuring, the use of multiple agreements to effect the structure, the necessity of considering the entire set of project documents and financing agreements as a totality to clearly understand the agreement of the parties, the disregard of certain of the entities involved for the purposes of some laws (such as the disregard of the funding company special purpose vehicle used in many of these transactions as a taxable entity), and multiple characterisations of the transaction. (For example, the tax matters agreement used in many of these transactions will state that the transaction as a whole is a loan transaction from the Facility Agent (lender) to the Project Company (into which the Shari’ah-compliant investment is made) for purposes of the federal income tax laws of the United States, and possibly for certain environmental laws allowing a lender a “safe harbor” in financing transactions.)

Because of the similarities of most Shari’ah-compliant transactions with the stated concept of “specialised financing transactions” in purely secular jurisdictions, various legal issues in respect of enforceability should be explicitly addressed as contemplated by the TriBar Specialized Financing Report.

6. SUKUK: CAPITAL MARKETS AND SECONDARY MARKETS

Section 6 examines various factors and functions of the area of Islamic finance called sukuk, classified in general as either bonds or securitisations.

6.1 Market Functions and Market Factors

Law, in its practical application, has a profound influence on the form of Islamic finance. Most obviously, the influence is felt at the level of individual contracts and the structure of individual transactions. The previous two sections of this chapter have summarised some of those effects. Of even greater significance are the influences of the law, direct and indirect, on the viability and structure of the capital markets, including secondary markets. A particularly poignant case in point relates to an area of Islamic finance that is in its earliest stages of development: the sukuk.

Sukuk are of two general types: Islamic bonds and securitisations. Islamic bonds are based upon the credit of an entity that is participating in the transaction, such as the issuer, a guarantor, or another provider of credit support. Securitisations involve a transfer of assets from an originator into a trust or similar special purpose vehicle (SPV) with the issuance of securities by that trust or SPV. Payments on the issued securities (the sukuk) are derived solely from the payments received in respect of those transferred assets, rather than any general credit of an issuer or participating party. Thus, securitisations are based upon the credit of the securitised assets. To date, most sukuk issuances have been Islamic bond issuances. True securitisation sukuk issues are rare, and issues of this type that have been rated by a major international rating agency are nonexistent.

While both types of issuances access the capital markets and are necessary for balanced growth of the capital markets, true securitisations have benefits that transcend those available from bond issuances alone. Securitisations allow, often require, broad diversification of the assets in the securitised pool. The originator of the transferred assets uses the securitisation to manage its balance sheet and capital structure. The originator transfers assets that generate deferred payments and receives an immediate cash payment from the capital markets in respect of that transfer. This enables the originator to immediately generate more assets and results in further diversification of the financing in respect of the transferred assets and access to a broader financing base. The securitisation process allows greater risk management and liquidity management for all market participants. It facilitates regulatory and conduit funding arbitrage. At a broader market level, the securitisation process has proven itself as a critical backbone of both the capital markets and, in particular, the development, existence, and functioning of secondary markets. Given the immaturity of capital markets and secondary markets in the Islamic economic sphere, and recent enthusiasm for sukuk issuances, securitisations, and the legal and structural support for securitisations, should be areas of primary focus for the entire Islamic finance industry.

To develop strong securitisation capability and related secondary markets, significant market depth must be obtained. Program issuers are a critical component, and those issuers must generate considerable volumes on a constant basis. Program issuers should include both governmental organisations and private financial institutions. Historically, governmental and quasi-governmental institutions have been critical to the development of securitisation markets and related viable secondary markets. In the United States, institutions such as FNMA or Fannie Mae (Federal National Market Association), Freddie Mac (Federal Home Loan Mortgage Association), GNMA or Ginnie Mae (Government National Mortgage Association), and SLMA or Sallie Mae (Student Loan Marketing Association), and similar quasi-governmental agencies, have been particularly effective in helping to establish broad secondary markets and in otherwise realising the benefits of securitisation. For example, the participation of these entities in the securitisation markets has helped to develop the relevant legal and regulatory framework, has fostered and overseen the development of standards and standardised documentation, and has helped to generate volume and depth of the markets. Governments and quasi-governmental agencies have acted as regulators, enablers, issuers, and purchasers of securitised instruments and related securities, with profound effects on the capital and secondary markets and the effectuation of monetary policy.

Securitisation in the field of Islamic finance is subject to a range of inhibitors that will need to be addressed and with respect to which structural accommodation is necessary. One such inhibitor is the considerable fragmentation of the relevant markets. These markets are fragmented with respect to, among other factors, (a) countries, (b) currencies, (c) the state of legal and regulatory development, (d) the degree of elucidation of, and agreement on, applicable Shari’ah standards, and (e) the operation of both Islamic and conventional interest-based markets in the same space. Another inhibiting factor is the lack of scale in the Islamic finance field at the present time. A third set of inhibitors relates to a range of uncertainties with respect to the legal and regulatory base for securitisations and capital markets generally. Consider, for example, the state of development of securities laws in many of the jurisdictions within the Islamic economic sphere. And, with respect to fundamental market criteria, the markets within those jurisdictions are underdeveloped and characterised by illiquidity, excessive concentration of risks, and lack of specialisation. Yet another inhibiting factor is the scarcity of human resources, such as qualified Shari’ah scholars and experienced financial, legal, accounting, and other professionals of all types.

6.2 Legal Infrastructure: Systemic Factors Pertaining to Enforcement

The general structure of each of the relevant legal systems is of primary relevance to the ability to effect securitisations and thus to the growth and development of capital markets and secondary markets within those capital markets.61 As noted elsewhere in this chapter, certainty and predictability are essential elements of any legal and financial system, as are transparency and consistency. As a systemic matter, some of the key structural elements that are of relevance are (a) whether the relevant legal system is based upon a system of binding precedents, (b) whether legal and arbitral decisions, and the rationale for those decisions, are published and widely available, (c) whether the judicial structure is responsive to continuity and consistency in the application of judicial precedents, and (d) the time frame for enforcement of remedies within the system.

While these systemic factors are not treated in detail in this chapter, suffice it to say that many of the key structural elements 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 discretion in determining cases. And the time frame for enforcement is frequently so long that it precludes effective remedies in fast-moving markets such as the capital markets. Each of these factors is frequently cited by international securitisation and capital markets institutions as a reason for their reluctance to engage in capital markets initiatives in the Islamic economic sphere. These are substantial impediments to growth of the securitisation markets (and thus the capital markets, including secondary markets) in these jurisdictions and there should be immediate focus on the removal, or a satisfactory alleviation, of these impediments.

6.3 Legal Infrastructure: Specific Legal Issues

Realisation of the benefits of securitisation for Islamic finance and the Islamic economy will require continuous issuances of asset-based sukuk by the private sector. This cannot be achieved without having those issuances rated by the major international rating agencies. Obtaining those ratings, in turn, is dependent upon obtaining the requisite legal opinions from prominent law firms engaged in these issuance transactions. These observations indicate that consideration of the ratings analysis used by the major ratings agencies is a useful paradigm for studying the legal issues that will affect the development and growth of the capital markets, particularly the secondary markets, insofar as those markets are influenced by sukuk issuances. The analytical framework and criteria used by the major ratings agencies are well developed and highly refined.62

As a generic matter, and in its simplest form, a securitisation involves (i) an originator of assets, (ii) an issuer of the sukuk or other instrument, which is a trust or SPV, (iii) a parent of the issuer, (iv) a payor or payors in respect of the assets being securitised, and (v) a purchaser/holder of the sukuk or other securities. The originator of the assets transfers, by sale, the assets to be securitised into the issuer. The issuer sells sukuk or other instruments 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 purchaser as the holder of the sukuk. The issuer provides collateral security over the assets to the sukuk holders to secure the payment of the sukuk.

In determining whether and how to rate a securitisation, rating agencies examine (i) the credit quality of the securitised assets (and, at least as a statistical and underwriting matter, the payors with respect to those assets) and any other available credit support, (ii) the structure of the securitisation transaction, and (iii) the legal opinion as to the structure and its key elements. As a general matter, the securitised assets must be isolated for the benefit of the sukuk holders. In the simplest case, the critical elements are: (a) that all rights, title, interest, and estate in and to the securitised assets are transferred by the originator to a bankruptcy remote SPV; and (b) that SPV grants a first priority perfected (or perfectible) security interest over those assets to secure payments on the sukuk and other claims of the sukuk holders.

The foregoing requires careful examination of (i) the transfer of the assets from the originator to the SPV, and (ii) the priority, perfection, and enforceability of the security interests granted in the securitised assets provided as collateral for the benefit of the sukuk holders. This examination is made through review of the documentation and through the obtaining of a legal opinion that addresses all of the transactional issues. Looking to the primary substantive legal opinions,63 the following are the primary areas addressed by the legal opinions:

6.4 True Sale

The true sale opinion addresses the issue of whether the SPV that is the issuer of the sukuk owns the transferred assets—that is, whether there was a valid transfer. The transfer must be such that it cannot be recharacterised by a court or other body as a secured loan or otherwise avoided in a bankruptcy or insolvency proceeding involving the originator of the assets (such as pursuant to a fraudulent transfer in anticipation of bankruptcy or a preference payment). The bankruptcy or insolvency of the originator should not affect the assets that have been transferred to the issuer SPV. This, in turn, means that the issuer will be able to enforce collection and other rights against the payor without hindrances resulting from the bankruptcy or insolvency of the originator.

Further aspects of the true sale doctrines relate to the nature of the title transferred to the issuer. Many securitisations involve an unperfected transfer of an equitable interest in the assets (in some cases, so as to avoid legal requirements pertaining to notification of the payor). The transfer must then be perfectible at the election of the issuer. Shari’ah scholars have differing views on the permissibility of separation of legal and equitable title to assets, and these raise impediments to effectuation of securitisations in certain unperfected transfer structures. If separation of legal and equitable title is not permissible, legal title would have to be transferred in a manner that satisfies all of the applicable perfection requirements (including notification of the payor).

Another aspect of the sale analysis (although technically not having an effect on whether a true sale exists) pertains to whether the assets are transferred free and clear of all prior overriding liens. This also will be considered in the relevant legal opinions and is a critical ratings criterion.

6.5 Non-Consolidation

A second legal opinion analysis focuses on the bankruptcy of two entities: the originator and the parent of the issuer SPV. In brief, the requirement is that the securitised assets held in the issuer will not be consolidated with the assets of the originator or the issuer parent in a bankruptcy or insolvency of either of those entities. The “separateness” covenants discussed in the next section pertain to the non-consolidation opinion as well as to bankruptcy remoteness.

6.6 Bankruptcy Remoteness

Another area of the ratings criteria relates to the remoteness of the bankruptcy of the issuer SPV. The focus is on reduction of the possibility of a bankruptcy of the issuer. The main reason for concern is that, in many jurisdictions, if there were a bankruptcy of the issuer the assets of the issuer would be distributed in accordance with law or a court order rather than in accordance with the contractual arrangements involving the issuer. Further, there would likely be mandatory stay provisions during the pendency of any issuer bankruptcy, which would interfere with timely payment of the sukuk. Therefore, the transaction is structured to make initiation of a bankruptcy proceeding against the issuer as unlikely as possible.64

The first set of documentary provisions relating to bankruptcy remoteness restricts the purpose and activities of the issuer SPV. This is accomplished by restricting the business purpose of the issuer exclusively to the sukuk transaction. Correlative provisions prohibit various activities. Rating agencies frequently require that these provisions be included in both the constitutive documents of the issuer and the transactional documents for the sukuk transaction. The required legal opinion will then have to indicate that the constitutive document provisions will be binding upon third parties.

Separateness covenants will be required to further ensure bankruptcy remoteness (as well as nonconsolidation). Most major rating agencies suggest covenants that require the issuer to:

Securitisation counsel often interprets rating agency guidelines to require that the foregoing covenants be included in the constitutive documents of the issuer as well as the transactional documents.

A number of issues arise with respect to the separateness covenants in a Shari’ah-compliant transaction. First, many law firms have taken the position that the separateness covenants should apply to, and be required of, the issuer and, where the securitised asset is an ijarah in a Shari’ah-compliant ijarah-based structure, the funding company lessor and the project company lessee. In such a structure, the funding company is, by intention, a disregarded entity for tax purposes and makes no decisions or determinations of its own accord—it is an entirely passive entity that undertakes a borrowing and acts as a lessor of the property in which a Shari’ah-compliant investment is made. In such a structure, many, if not most, of the separateness covenants are not true on their face. Assets of the funding company and the project company are commingled. Frequently, the financial statements of the project company (the entity of substance) are combined with those of the funding company. The funds of the project company are used to pay all liabilities, including those of the funding company. And the assets of the funding company and the project company are pledged to secure the obligations of each and both. Second,65 if these covenants are included in the constitutive documents, any breach (however minor or immaterial) of the covenants will constitute an ultra vires act and the members of the board of directors of the breaching company may be personally liable in respect of that breach. Given that bank officers and other primary market participants are frequently directors of the project company in Shari’ah-compliant transactions, there has been significant resistance to securitisation transactions if counsel requires inclusion of these covenants in the constitutive documents of the project company.

Yet another set of provisions to ensure bankruptcy remoteness relates to non-competition and bankruptcy declarations. The originator, investors, credit enhancers, and others agree in the transaction documents not to initiate involuntary bankruptcy proceedings against the issuer. The issuer also provides, in both its constitutive documents and the transaction documents, not to initiate voluntary bankruptcy proceedings.

6.7 Collateral Security Structure

Consideration of the collateral security structure is a critical factor under the ratings criteria, and the subject of legal opinions. The focus is on the security interests provided for the benefit of the sukuk holders. Those security interests must be the first priority (there can be no prior claims and no subsequent claims) and perfected (or perfectible). The legal opinions must address the nature of the security interest, the enforceability of the security interest against third parties, and perfection requirements (such as notices, registration, and recordation). The effects of bankruptcy on perfection must also be considered and opined upon.

A number of significant issues arise in jurisdictions within the Islamic economic sphere. First, rahn (mortgage and pledge) concepts in certain of these jurisdictions are possessory in nature (pursuant to the Shari’ah). This makes perfection a particularly difficult opinion issue in these jurisdictions. Second, in many jurisdictions, including those within the Islamic economic sphere, and without regard to rahn concepts, perfection and priority regimes are not well developed. Third, bankruptcy laws and regimes are not well developed in these jurisdictions. To date, law firms have found it impossible to render satisfactory opinions on the priority and perfection in most of these jurisdictions.

6.8 Enforceability of Documents

Ratings criteria require that enforceability opinions be rendered on all transactional documents. As discussed in Section 5, the form of such an opinion is that the transaction documents are valid and binding obligations of the relevant entities, enforceable against such entities in accordance with their respective terms. The nature of the exceptions and qualifications to enforceability opinions in New York are set forth in the Appendix. Those exceptions and qualifications are acceptable within the ratings criteria.

To date, legal opinions in jurisdictions within the Islamic economic sphere have included a number of other, much broader, exceptions and qualifications. These relate to the following:

To date, the rating agencies and the lawyers who have been asked to provide enforceability opinions have been of the opinion that there is insufficient predictability and certainty to permit the rendering of sufficient enforceability opinions in these jurisdictions.

6.9 Choice of Law

Choice of law opinions are also required in connection with the ratings review.69 The opinion must be to the effect that the choice of law will be upheld as valid by enforcing authorities in at least (a) the jurisdiction whose law has been chosen as governing the transactional documentation, (b) the jurisdiction(s) whose law governs the formation of each of the entities involved in the transaction, and (c) the jurisdiction in which the assets are located. These are complex legal opinions, and any analysis is beyond the scope of this chapter. It is sufficient to say, for present purposes, that the laws of many jurisdictions within the Islamic economic sphere are, at best, unclear as to choice of law principles. Thus, obtaining the choice of law opinions has been difficult and in some cases impossible.

6.10 Enforceability of Judgements and Awards

Another requirement of the ratings criteria is legal opinions to the effect that the judgement of each court or arbitral authority of relevance to the transaction, which will include foreign courts and arbitral bodies, will be enforced in each of the jurisdictions involved in the securitisation transaction. As noted in the previous section, there are numerous involved jurisdictions, and they will vary from transaction to transaction. Some jurisdictions within the Islamic economic sphere will not enforce foreign judgements and arbitral awards. Some will enforce foreign arbitral awards, but not foreign judgements. In some jurisdictions, the extent and degree of enforcement of foreign judgements and awards is not entirely clear.70

Particular difficulties arise in connection with Shari’ah-compliant transactions. Consider, for example, enforcement of a foreign judgement or award that was rendered or obtained in a purely secular jurisdiction in a Shari’ah-incorporated jurisdiction, and vice versa. Will the judgement or award be reviewed de novo in whole or in part upon attempted enforcement in the Shari’ah-incorporated jurisdiction? Will a purely secular jurisdiction decline to enforce a judgement or award rendered in a Shari’ah-incorporated jurisdiction where the basis of the judgement or award is a Shari’ah interpretation of terms not included in the relevant contract? Will a court in a Shari’ah-incorporated jurisdiction infuse the Shari’ah into the foreign arbitral award as a matter of public policy, and pursuant to the public policy exception of the relevant treaties?

Lawyers are uncertain as to the answers to the foregoing, and many other similar queries pertaining to the enforceability of judgements and awards, and the exceptions and exclusions proposed in legal opinions, have rendered those opinions insufficient for ratings criteria purposes.

6.11 Observations

If Islamic finance is to move beyond the issuance of Islamic bonds and into the widespread issuance of securitisation sukuk, with realisation of attendant macroeconomic and microeconomic benefits, it is imperative that the issuances be rated by major international rating agencies. Obtaining those ratings will turn on the availability of legal opinions on the various matters discussed in this section. Acceptable legal opinions from major law firms are not currently available due to the lack of transparency, certainty and predictability of legal parameters in jurisdictions included within the Islamic economic sphere. Initiatives should be, and are being, undertaken to examine critical legal parameters, such as the bankruptcy laws of these jurisdictions and the ability to utilise trust structures (particularly in civil code jurisdictions). The Islamic Financial Services Board is taking a lead in this area. Real progress, however, requires the effectuation of systemic legal reform in these jurisdictions, which will not be easily achieved. The composition of the IFSB is ideal for projects of this type as it includes as members a broad range of jurisdictions in which the uncertainties are particularly acute.

7. SUMMARY AND CONCLUSION

This chapter has reviewed some examples of the interaction between law (both the Shari’ah and secular law) and Islamic finance. It is clear that Islamic finance has had a profound effect on Islamic jurisprudence, facilitating the movement from a period of revival and recovery, commencing in the 1970s, to an innovative period of transformation and adaptation that commenced approximately a decade ago. The ability to use the nominate contracts, and hybrids of the nominate contracts, as well as other factors that comprise the current period, will now further drive the development of Islamic finance, particularly the development of a broader and more sophisticated range of products. Another key factor in the current period is the involvement of both conventional Western institutions and Shari’ah-compliant institutions in the developing Islamic economic sphere. This trend should result in a logarithmic increase in creativity and sophistication. More importantly, it should also result in enhanced understanding among the peoples of the world and a greater sensitivity to cultural, religious, social, and legal differences.

It is also clear that enforcement of the Shari’ah in both the Islamic economic sphere and the Western economic sphere, and in both Shari’ah-incorporated jurisdictions and purely secular jurisdictions, will be a matter of increased focus and relevance. An examination of the case law in a purely secular jurisdiction (Shamil Bank v Beximco) and of legal opinion practice indicates that the Shari’ah can be enforced in all relevant spheres and jurisdictions if (a) the relevant contracts used in the Shari’ah-compliant transaction are documented in such a manner as to be compliant with the Shari’ah (so as to enable enforcement under applicable secular law without any reference to the Shari’ah, whether as a governing law or otherwise), and (b) in other situations, model acts of relevant Shari’ah instruments, contracts, and structures are developed so as to allow sufficient specificity for incorporation in English or New York law documents.

While these developments give cause for optimism, the law presents significant hurdles to the further growth of Islamic finance in areas such as capital markets access. Realisation of the benefits of securitisation, macroeconomic and microeconomic, in the field of Islamic finance will depend in part upon obtaining ratings of sukuk issuances. Obtaining these ratings depends, in turn, upon obtaining acceptable legal opinions on a range of true sale, collateral security, bankruptcy, and other legal issues. It is clear that the requisite opinions cannot be obtained at the current time given the state of development of these legal areas in many jurisdictions within the Islamic economic sphere. A call for action and legal reform is in order. Hopefully, involved organisations (such as the IFSB and AAOIFI), governments, regulators, financial institutions, lawyers, accountants, and market participants will undertake a study of necessary modifications to these legal regimes and effect necessary reforms to enable the rendering of the legal opinions that will allow for an explosion in the issuance of rated sukuk transactions.

Much has been accomplished in the fields of Islamic finance and the jurisprudence of the Shari’ah, and in many areas the secular law is conducive to the continuing growth of Islamic finance. But these successes should not deflect attention from the tasks that lie ahead, in particular the reform of secular law in jurisdictions within the Islamic economic sphere in order to bring Islamic finance to the next level of development and sophistication and to allow explosive growth in the Islamic economy. Let us not shrink from this endeavor, as the game, the benefits within the field of Islamic finance, and throughout both the Islamic economic sphere and the Western economic sphere, will certainly be worth the candle.

APPENDIX

Form of Enforceability Opinion:

Shari’ah-Compliant Ijarah-Based Acquisition Financing in a Purely Secular Jurisdiction

We have acted as special New York counsel to [name of the “Project Company”], a [limited liability company] organized under the laws of the State of [Delaware], United States of America (the “Company”), in connection with the lease transaction evidenced by the documents listed in Schedule A hereto (the “Documents”).

This opinion letter is being delivered in connection with the execution and delivery of the Documents.

We have participated in the preparation, execution and delivery of the Documents. In rendering the opinion expressed herein, we have examined the Documents. In addition, to the extent relevant to our opinion expressed herein, we have examined the originals, or copies certified to our satisfaction, or electronic copies, of such other company records, certificates, resolutions, certificates of public officials and of directors, officers and other representatives of the Company, and agreements, documents and instruments, as we have deemed necessary as a basis for the opinion expressed herein. As to questions of fact material to such opinion, we have, when relevant facts were not independently established by us, relied upon certificates, representations and warranties of the Company and the other parties to the Documents or of their directors, officers or other representatives or of public officials and assumed the truth and accuracy of all such certificates, representations and warranties.

In our examination of the Documents, we have assumed, without independent investigation, and with your permission:

As used in this opinion letter, the phrases “to our knowledge” and “known to us” mean the actual knowledge (that is, the conscious awareness of fact or other information) of lawyers in the firm who have given substantive legal attention to representation of the Company in connection with the Documents. In addition, except to the extent expressly set forth in this opinion letter, we have not undertaken any independent investigation to determine the existence or absence of the matter in question, and no inference as to our knowledge of such existence or absence should be drawn from our representation of the Company.

We express no opinion as to the laws of any jurisdiction other than Applicable Law.

“Applicable Law” means those laws, rules and regulations of the State of New York and the federal laws of the United States of America currently in effect which in our experience are normally applicable to transactions of the type contemplated by any of the Documents, and does not include, and we express no opinion as to: (a) any New York or federal law, or any other law, relating to (i) title to any property (including the Property, as defined in the Lease (Ijara)), (ii) liens pursuant to any mortgage, deed of trust or security agreement or other security interests of any type, or the creation, validity, perfection or priority thereof, (iii) pollution or protection of the environment, (iv) zoning, land use, building or construction, (v) the construction, condition or use of such Property, (vi) labor, employee rights and benefits, or occupational safety and heath, or (vii) utility regulation; (b) antitrust laws; (c) tax laws, rules or regulations; (d) state, federal and other securities laws, including the Investment Company Act of 1940, as amended, and “blue sky” laws; or (e) any law, statute, ordinance, administrative decision, rule, regulation, ordinance, code or similar provision of law of any county, city, town, municipality or similar political subdivision or any agency or instrumentality thereof. “Government Approvals” means an order, consent, approval, license, authorization, or validation of, or filing, recording or registration with, or exemption by, any New York state court or federal court of the United States of America located in the State of New York, or any governmental body or authority in the State of New York or the United States of America, pursuant to Applicable Law.

Based upon the foregoing and subject to the limitations, qualifications, exceptions and assumptions set forth herein, we are of the opinion that:

Our opinion is also subject to the following qualifications:

We express no opinion herein as to:

Our opinion in paragraph 1 as it pertains to the choice of law provision in each Document is rendered in reliance upon the Act of July 19, 1984, ch. 421 McKinney’s Sess. Law of N.Y. 1406 (codified at N.Y. Gen. Oblig. Law 5–1401, 5–1402 (McKinney 2001) and N.Y. CPLR 327(b) (McKinney) (the “Act”), and is subject to the qualifications that such enforceability (1) may be limited by public policy considerations of any jurisdiction, other than the courts of the State of New York, in which enforcement of such provisions, or a judgement upon an agreement containing such provisions, is sought, and (2) as specified in the Act, does not apply to the extent provided to the contrary in subsection two of Section 1–105 of the New York Uniform Commercial Code (McKinney 1993 & Supp. 2001).

This opinion letter is being furnished only to you in connection with the transactions contemplated by the Documents and is solely for your benefit and is not to be used, circulated, quoted, published, relied upon or otherwise referred to by any other person or entity or for any other purpose or in any other connection without our prior written consent. This opinion letter is given on and as of the date hereof, and we assume no obligation to advise you after the date hereof of facts or circumstances that come to our attention, or changes in laws, rules or regulations that occur, after the date of this opinion letter which could affect the opinion contained herein.

Schedule A

NOTES

1. This hadith was related in nearly all of the major collections, including those of al-Bukharj, Muslim, Abu Daud, al-Tirmidhi, al-Nasa’i, Ahmad ibn Hanbal, Ibn al-Jarud, al-Tabarani, and Ibn Abi Shayhah.

2. Bernard Weiss, The Spirit of Islamic Law (Athens: University of Georgia Press, 1992), 18. Note the substitution of “commitment” for Weiss’s “submission.”

3. There is also the fact that for several centuries the contribution of the Ottoman Empire in the development of Islamic finance was quite limited.

4. The Mit Ghamr project in Egypt in 1963, the Nassar Social Bank in Egypt, the Organization of the Islamic Conference (formed in 1971), the multinational Islamic Development Bank (formed in 1975), and the Dubai Islamic Bank were early examples. See Nicholas Dylan Ray, Arab Islamic Banking and the Renewal of Islamic Law (London: Graham and Trotman, 1995); and see Abdullah Saeed, Islamic Banking and Interest (Leiden: Brill, 1996), 5–16, for a more detailed discussion of some of the early events in the development of Islamic banking and finance.

5. While the rate of growth of deposits and assets in the first 15 years was described as astounding, a study of this early period points to the “lack of profitable investment opportunities,” citing the reliance of the Islamic banks on projects and inventory finance. Ray, Islamic Law, 21.

6. Dr. Muhammad Adb al-Ghaffar al-Sharif, “The Shariah Supervision of Islamic Banks,” paper presented at the First Conference of Shari’ah Supervisory Boards for Islamic Financial Institutions, organized by the Auditing and Accounting Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain, October 2001.

7. Muhammad Zahid al-Kawthari, Fiqh Ahl al-’Iraq wa Hadithuhum (1970), 56–59.

8. W. D. Slawson, Binding Promises (Princeton, NJ: Princeton University Press, 1996), 9–19.

9. This is the well-known work entitled Majalat al-Ahkam al-Adaliyah, originally prepared by Ottoman scholars of the Hanafi school of jurisprudence for use throughout the courts of the Ottoman Empire circa 1839 CE/1285 AH. This work was translated into the English language by an accomplished British jurist and scholar of Arabic, Judge C. A. Hooper, and was published in 1936. Long out of print, the work was again published, in installments, by the Arab Law Quarterly in 1986.

10. The stories of how the early jurists, such as Abu Hanifa, Malik, Shafii, and Ibn Hanbal, resisted the efforts of the temporal authorities to codify their legal thought, and to impose those codes throughout their empires, are well known in Islamic history.

11. Many Orientalists, even those as recent as Schacht, went as far as to question the relationship of theory in Islamic financial transactions to historical practice. Recent inquiry has put such negativity to rest. In fact, the success of modern Islamic finance is probably the best of all arguments against such assertions. See Ray, Islamic Law, 35–36.

12. 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.

13. Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (New York: John Wiley & Sons, 1996), 205. In the passage quoted, Bernstein is summarizing the explanation developed by Kenneth Arrow and Frank Hahn of the relationship between money, contracts, and uncertainty.

14. Nelly Hanna, Making Big Money in 1600: The Life and Times of Ismail Abu Taqiyya, Egyptian Merchant (Syracuse, NY: Syracuse University Press, 1998), 54.

15. “. . . one fact is certain, the legal instruments necessary for the extensive use of mercantile credit were already available in the earliest Islamic period.” Abraham Udovitch, Partnership and Profit in Medieval Islam (Princeton, NJ: Princeton University Press, 1970), 78.

16. The authors refer here to criticism made by Orientalist scholarship.

17. Hanna, Making Big Money (1998), 59.

18. In this regard, it will be helpful to note the origins of the derivatives used in modern conventional finance. “In fact, the majority of financial instruments are not revolutionary new instruments. They are merely combinations of older generation derivatives and/or standard cash market instruments.” Warren Edwardes, Key Financial Instruments: Understanding & Innovating in the World of Derivatives (Upper Saddle River, NJ: Financial Times/Prentice Hall, 2000), 8.

19. While this has become commonplace today, it is interesting to note a reference in the first encyclopedia of Islamic banking, published in 1982, in which a description of a modem murabahah is based on a personal conversation with an officer of an Islamic bank. See al-Mausu at al-Ilmiyah wa’l-’Amaliyah li’l-Bunuk al-Islamiyah, Vol. V (Cairo: al-Ittibad al-Duwali li’l-Bunuk al-Islamiyah, 1982), 196.

20. In fact, there are two promises inherent to this transaction; the promise of the client to buy from the bank, and the promise of the bank to sell to the client. The entire matter became the subject of much discussion by the scholars at the First Conference of Islamic Banks in Dubai in 1979. Their collective fatawa approving this arrangement was a significant milestone in the jurisprudence of modern Islamic finance.

21. For a look at more examples, see Abdulkader Thomas, Stella Cox, and Bryan Kraty, Structuring Islamic Finance Transactions (London: Euromoney Books, 2005) and the sources cited at footnotes 25 and 27.

22. Mausu at al-Bunuk al-Islamiyah, al-Ittihad al-Duwali li al-Bunuk al-Islamiyah (1983). Several of the authors and contributors to that early work are still contributing to the development of the industry with their hard work, devotion, and invaluable experience.

23. For example, as Islamic investors move into the real estate markets of Asia and the European Union, asset managers, legal counsel, and Shari’ah scholars are challenged with documentation in several different languages, sometimes for a single transaction!

24. Brief descriptions of how all three of these nominates have been adapted to form the basis of different home financing programs may be found in Abdulkader S. Thomas and Virginia B. Morris, Guide to Understanding Islamic Home Finance (New York: Lightbulb Press, 2002).

25. See Nathif J. Adam and Abdulkader Thomas (eds.), Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk (London: Euromoney Books, 2004), Micheal J. T. McMillen, “Islamic Capital Markets: Developments and Issues,” Capital Markets Law Journal 10 (2006), 1093/cmlj/km/015, and Michael J. T. McMillen and Abradat Kamalpour, “An Innovation in Financing—Islamic CMBS,” in Commercial/Mortgage—Backed Securitization: Developments in the European Market, ed. Andrew V. Petersen (London: Sweet & Maxwell Ltd., 2006), 382–412. The material in Section 6.1 is addressed in detail in Commercial CMBS.

26. These, of course, are the texts of the Qur’an and the Sunnah.

27. See Michael J. T. McMillen, “Islamic Shari’ah-compliant Project Finance: Collateral Security and Financing Structure Case Studies,” Fordham International Law Journal 24 (1184): 1237–1263, describing the first such transactions in the United States [hereafter, McMillen, “Project Finance Structures”]. See, also, 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, pp. 111–131 (2000). Modifications of this type of structure and their use in various transactions is discussed in 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: Dynamics and Development, 89–102 (2003). Other illustrative developments are discussed in Michael J. T. McMillen, “Islamic Finance Review 2005/2006: A Year of Globalization and Integration,” and Michael J. T. McMillen, “Raising the Game of Compliance: People and Organizations,” each in Euromoney Islamic Finance Year in Review 2005/2006 (2006). Other transactions are discussed in Michael J. T. McMillen, “Structuring the Shari’ah-compliant Transaction Involving Non-compliant Elements,” paper currently in publication by Euromoney as a chapter in a forthcoming book, and in 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.

28. See, for example, McMillen, “Project Finance Structures,” 1237–63. These early transactions were described in the press: Michael J. T. McMillen, “Special Report U.S. Briefing: Islamic Finance: Breaking the Mould,” 38 Middle East Economic Digest (MEED), September 22, 2000, 28–29.

29. There is widespread, and spirited, debate regarding the “need” for standardization in the Islamic finance field. This is certainly not a new debate for Muslim jurisprudents: witness the intellectual rigor of the debate over the centuries among Islamic jurists of even the four main schools of Sunni Islam: the Hanafi, Han-bali, Shafi’i, and Maliki schools. Recent English-language works that highlight this debate, by way of a comparison of the positions of the different schools of Islamic jurisprudence with respect to specific matters, are Frank E. Vogel and Samuel L. Hayes, III, Islamic Law and Finance: Religion, Risk and Return (Leiden: Brill, 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 Volume 5 of Al-Fiqh Al-’Islami wa ‘Adillatuh, fourth edition (1997) and appears in two volumes. For examples of the current debate with respect to the need for standardization on a broader scale within the Islamic finance industry one need only attend any of the many Islamic finance conferences. See also Majid Dawood, “Scholastic Congestion,” Islamic Banking and Finance 3 (2004): 10–11.

30. For a review of the extent to which, and the manner in which, the laws of various Middle Eastern nations are composed of, or incorporate, the Shari’ah, and the extent to which other legal principles are incorporated in the laws of such nations, see Nayla Comair-Obeid, The Law of Business Contracts in the Arab Middle East (London: Kluwer Law International, 1996), particularly Chapter 3. The discussion in this section, to the extent that it addresses the integration of the Shari’ah into the law of the various nations, is based in part upon this secondary source. See Noel J. Coulson, Commercial Law in the Gulf States (London: Graham and Trotman Ltd., 1984). See also Noel J. Coulson, A History of Islamic Law (Edibirgh: University of Edinburgh Press, 1964) and Joseph Schacht, An Introduction to Islamic Law (Oxford: Clarendon Press, 1964), as general histories of Islamic law.

31. The Kingdom of Saudi Arabia recognizes the Shari’ah as the paramount law of the land. However, the various enforcement mechanisms that have been established with respect to the resolution of certain commercial disputes do influence the application of the Shari’ah to such disputes. One example is the settlement of disputes between a bank and its customer in Saudi Arabia. The “settlement” of such matters (other than in respect of negotiable instruments) is effected by the Banking Disputes Settlement Committee of the Saudi Arabian Monetary Agency (customarily known as the SAMA Committee), and the SAMA Committee generally attempts to settle a matter in accordance with the agreement of the parties. Another example in Saudi Arabia is indicated by the jurisdictional authority afforded to the Office of the Settlement of Negotiable Instruments Disputes (NIO), under the aegis of the Ministry of Commerce, which addresses and settles disputes involving negotiable instruments and generally looks only to the “four corners” of the instrument to which the dispute relates. See McMillen, “Project Finance Structures,” 1195–1203.

32. For the purposes of this chapter, the distinctions between the various Shari’ah-incorporated jurisdictions are ignored unless otherwise indicated.

33. Assuming, of course, that the contract does not violate public policy or fall foul of other mandatory legal requirements.

34. See, for example, some of the incorporation and choice of law requirements that are discussed or referred to in Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco, as discussed in Section 4 of this chapter.

35. Shamil Bank of Bahrain E.C. (Islamic Bankers) v Beximco Pharmaceuticals Ltd. and Others [2004] EWCA Civ 19, [2004] All ER (D) 280 (Jan), January 28, 2004.

36. Shamil Bank v Beximco, at para. 7, quoting clauses 35 and 36 of the Articles of Association of Shamil Bank.

37. Shamil Bank v Beximco, at para. 46, quoting Lord Wilberforce in Reardon Smith Line Ltd v Yngvar Hansen-Tangen [1976] WLR 989 at 996.

38. Shamil Bank v Beximco, at para. 47.

39. Shamil Bank v Beximco, at paras. 40 (relating to the lower court decision) and 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 United Kingdom by virtue of section 2(1) of the Contracts (Applicable Law) Act of 1990, as stated in para. 40 of Shamil Bank v Beximco.

40. Shamil Bank v Beximco, at para. 48, citing Article 3.1 of the Rome Convention (“a contract shall be governed by the law chosen by the parties”). Paragraph 40 summarizes the similar finding of the lower court.

41. Shamil Bank v Beximco, at para. 48, citing Article 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”). Paragraphs 40, 42, and 43 summarize the lower court’s similar finding on this issue of interpretation.

42. Shamil Bank v Beximco, at para. 48.

43. Shamil Bank v Beximco, at para. 54. See, also, Shamil Bank v Beximco at para. 40 with respect to the characterization of this matter by the lower court.

44. Shamil Bank v Beximco, at para. 55. See, also, Shamil Bank v Beximco at para. 40 with respect to the characterization of this matter by the lower court.

45. Shamil Bank v Beximco, at paras. 50–52, citing Dicey & Morris, The Conflict of Laws, thirteenth edition, Vol. 2, at 32–086 and 32–087.

46. Shamil Bank v Beximco, at para. 51.

47. Shamil Bank v Beximco, at para. 52.

48. The United States is a federal union, today comprising 50 separate states (including four commonwealths), a federal district (where the capital, Washington, DC, is located), and five major overseas territories, each having a separate and distinct legal system and set of substantive laws and which operate in a system of “parallel sovereignty” with the fedral government. Conflicts of laws issues are thus a daily matter of significant import and consequence in contractual matters in the United States or involving the law of any of the component jurisdictions of the United States. This governmental structure is one of the factors that led to the creation of the National Conference of Commissioners on Uniform State Laws in 1892, with a primary purpose of obtaining a degree of uniformity in the laws of the various states, thus enhancing commerce between and among the States and the certainty and predictability of legal enforcement in different state jurisdictions. Neither the National Conference of Commissioners on Uniform State Laws nor the federal government has the power or authority to prescribe uniform laws among the States; adoption of such laws is a matter of state discretion and prerogative. The success that has been achieved by the National Conference of Commissioners on Uniform State Laws in achieving a degree of uniformity, and in providing methods of defining and tracking differences where there is not uniformity, is an important basis for a proposal previously made by Mr. McMillen to the effect that “model laws” be prepared for each of the main contracts used in Islamic finance. See 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 H.E., April 2, 2004 C.E. (“McMillen, ‘IFSB Shari’ah Enforceability Proposal”’). The Government of Canada, which comprises 13 provinces and territories and a federal government, and the European Union, among others, grapple with similar, if less extensive and frequent, conflicts of laws issues.

49. See, for example, McMillen, “Project Finance Structures,” 199 et seq. and sources cited therein.

50. McMillen, “IFSB Shari’ah Enforceability Program,” addresses issues relating to legal opinions in Shari’ah-incorporated jurisdictions as well as those provided in purely secular jurisdictions. Discussions of the former have been omitted from this paper.

51. “Third Party ‘Closing’ Opinions: A Report of the TriBar Opinion Committee,” Business Lawyer 53 (1998): 619–621. This report is referred to in this paper as the “TriBar Report.” See, also, “Special Report by the TriBar Opinion Committee: Use of the ABA Legal Opinion Accord in Specialized Financing Transactions,” Business Lawyer 47 (August 1992): 1719–1730, which is referred to as the “TriBar Specialized Financing Report.” And see “Third-Party Legal Opinion Report, including the Legal Opinion Accord, of the Section of Business Law, American Bar Association,” Business Lawyer 47 (November 1991): 167, at Section 10, “The Remedies Opinion,” and the definition of “Remedies Opinion” in the glossary thereof.

52. 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,” 621. The TriBar Report, at footnote 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 such footnote 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,” Business Lawyer 45 (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.

53. See the relevant opinion language in the Appendix.

54. “TriBar Report,” 620.

55. Ibid.

56. Ibid., 621. Note that a “representation” in a contract is not an “undertaking.”

57. Ibid. If the remedy is one that a court in the governing law jurisdiction will not enforce, the opinion will, and must, make an exception for the enforcement of that remedy.

58. Ibid., 621.

59. See the TriBar Specialized Financing Report.

60. Ibid., 1726.

61. This chapter does not consider the important topic of the regulation of capital markets activities, such as securities issuance, standards applicable to investment companies, capital adequacy standards, prudential standards, trading activities, brokerage activities, and market manipulation regulations. See Commercial CMBS for a discussion of these topics.

62. Other areas of the legal infrastructure are not considered in this chapter, largely because of the tremendous diversity over different jurisdictions. These areas include tax law, real estate law, competition law, and corporate law, among many other areas of applicable law.

63. Entity organization opinions are critical, and are obtained, but are not discussed in this chapter. These opinions address formation of relevant entities, due authorization of the transaction by all entities, and due execution and delivery of all documentation.

64. In addition to bankruptcy remoteness provisions discussed in the text of this chapter, 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 priority of payments 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. These provisions are not further discussed.

65. And this is not specific to Shari’ah-compliant transactions.

66. Consider, for example, Section 4 and the Shamil Bank v Beximco case discussed in that section with respect to exceptions noted in clauses (a) through (c).

67. See McMillen, “IFSB Shari’ah Enforceability Proposal.”

68. See the discussion of enforcement of foreign judgements and awards at McMillen, “Project Finance Structures,” 1199–1203, and the sources cited therein.

69. Consider the discussion at Section 4 and the Shamil Bank v Beximco case discussed in that section.

70. See McMillen, “Project Finance Structures,” 1195–1203, and the sources cited therein, for a discussion of enforcement mechanisms in the Kingdom of Saudi Arabia.