islamic finance due diligence in shari’ah-compliant transactions

7/30/2019 Islamic Finance Due Diligence in Shariah-Compliant Transactions

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Islamic Finance: Due Diligence in Shariah-Compliant

TransactionsKalu Kalu

Santa Clara University School of Law


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Kalu Kalu Santa Clara University School of Law, Class of Dec. 12

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Contents

Introduction .......................................................................................................................... 3

Background & Principles of Islamic Finance ............................................................................ 4

The Role of Shariah-Compliant Boards: Non-binding decisions .............................................................. 5

The Steps ............................................................................................................................................... 5

The Prohibition of Riba ............................................................................................................................. 6

Riba al-Fadl & Riba al-Nasiah ................................................................................................................ 7

The Time Value of Money: Prohibition of Money as a Commodity ...................................................... 7

Application of the Principles of Riba to Finance ................................................................................... 8

Islamic Financing Structures................................................................................................. 10

Murabaha (Cost-Plus Financing) ............................................................................................................. 10

Ijarah (Lease Financing) .......................................................................................................................... 11

Mudaraba (Venture Capitalism) ............................................................................................................. 12

Musharaka (Joint Venture) ..................................................................................................................... 13

Taxation of Islamic Financing Structures ................................................................................................ 13

Rahn (Security Interest or Pledge) .......................................................................................................... 15

The Sukuk: Islamic Bonds or Debt Securities ........................................................................ 15

Two Classes of Sukuk .............................................................................................................................. 18

Nakheel Sukuk: Case Study ..................................................................................................................... 19

Conclusion ........................................................................................................................... 24

Nakheel Structure Glossary.................................................................................................. 25


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Introduction

What is Islamic Finance? How does it differ from conventional finance? Islamic Finance

attempts to reach the same substantive outcomes as conventional finance but in forms that

comply with the concepts underlying the Shariah and the divine laws of Islam. Although

Shariah compliance prohibits many concepts integral to conventional finance, such as thecharging of interest and profit-making without commensurate risk, it is incorrect to assume that

Shariah-compliant projects are a radically different approach to finance. Islamic finance focuses

on structuring projects in ways that observe formal Islamic requirements, but still provide near

identical economic equivalents of conventional finance, including the aforementioned charging

of interest and profit-making without shared risk.1

Therefore, critics often opine that Islamic

Finance is the practice of form over substance. Salahs Islamic beerjoke is demonstrative of

critics points:

What's Islamic beer, you ask? Well, you first approach the Shari'ah scholar and ask Is it

all right if I tie a rope to this door? The scholar's response is, Yes. There's no issue

there. Go ahead and tie the rope to the door. Next you ask, Well, is it all right if I lie on

the floor? The scholar responds, I see no issue with that. You can lie on the floor. The

next question to the scholar: Is it all right if I tie a beer bottle to the end of the rope?

The scholar's response: I suppose that's all right. With that permission, you tie a beer

bottle to the end of the rope, you lie on the floor next to the beer bottle with your

mouth open, you wait for somebody to open the door, the bottle is pulled over and the

beer pours out into your mouth. That is Islamic beer.2

Others believe that critics are missing the point.3

When compared to religious dietary rules,people often refuse to eat food that is not halal or kosher, but may eat their closest

approximation.4

Thus sometimes the form itself can be of great significance to religious

observers. Regardless of critics points, Islamic Finance has the substantive benefit of allowing

greater market participation by Muslims across the world, which in turn can only lead to

greater global financial integration.5

All the same, because Shariah-compliant transactions may

1Mohammad H. Fadel, Riba, Efficiency, and Prudential Regulation: Preliminary Thoughts, 25 Wis. Int'l L.J. 655, 656

(2008).2

Isam Salah, Islamic Finance in the Current Financial Crisis, 2 Berk. J. Middle E. & Islamic L. 137, 154 (2009).3 PBS, Islamic Financing (2009), available athttp://www.pbs.org/wnet/religionandethics/episodes/april-10-

2009/islamic-financing/2629/(See Ibrahim Warde, professor of Islamic banking and finance at Tuft Fletcher School

of Law and Diplomacy, stating *t+he example I typically give is religiously inspired dietary rules, in that if some

people dont want to eat food that is not halal or kosher, then a nutritionist can come to them and say, Why are

you doing that? But for these people, for religiously minded people, how the food is prepared is quite

significant.).4Id.

5Blake Goud, Is Islamic Finance Beneficial for Non-Muslims?(2012), Sharing Risk Dot Org., available at

http://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.html.
http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://investhalal.blogspot.com/2012/04/is-islamic-finance-beneficial-for-non.htmlhttp://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/http://www.pbs.org/wnet/religionandethics/episodes/april-10-2009/islamic-financing/2629/


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be described as the practice of form over substance, many risks inhere in their structure that

investors inexperienced with Shariah-compliant transactions may not appreciate.

This note explains what Islamic finance is by detailing the basic principles and commonly used

transaction structures. Additionally this note details some of the risks inherent but often hidden

in Shariah-compliant structures so that an investors may take due diligence when reviewing a

prospectus. Provided first is a description of the background and principles of Islamic finance,

most importantly the prohibition of riba and how to determine whether a transaction is

Shariah-compliant. Next the note will detail commonly used Shariah-compliant financing

structures such as musharaka (joint venture partnership), murabaha (cost-plus financing), and

ijarah (lease financing) followed by a short description of the tax implication of some these

structures.

The latter half of this note focuses exclusively on sukuk, Islamic trust certificates, in which an

originator securitizes a pool of assets usually comprising of Islamic financing structures (likemusharaka and ijarah). Thus investors, or sukuk-holders, by purchasing sukuk are given a

proportional ownership interest in the above-mentioned financing structures. After a

description of the basics of a sukuk structure the note will provide a case study of a Nakheel

Group (a Dubai-based real estate developer) ijarah-based sukuk offering. The case study will

describe the specifics of the sukuk offering, and what occurred after the sukuk went into

default. This Nakheel case study illustrates the complexity in identifying the Three Little

Enemies (TLE) to investors recourse in the event of default. Three Little Enemies is simply a

mnemonic to remind investors to identify whether they are transferred actual 1) Title that

would be of value after default, or if not, whether they perfected 2) Liens over said assets, andlastly whether these liens are 3) Enforceable in the pertinent jurisdiction.

Background & Principles of Islamic Finance

Finance in accordance with the concepts of Islamic laws is known as Islamic Finance.6Fiqh is

the direct source for Islamic Finance as opposed to the more commonly referred to Shariah-

law.7

While technically correct, Shariah-law refers to the divine laws of Islam as expressed in

the Quran and by Muhammad himself whereas Fiqh refers to the human interpretation of the

divine laws.8

Fiqh interpretations are abstracted from many sources - (1) the Quran (holy

book), (2) the Sunnah (what the prophet said & did), (3) Qiyas (new rules), and (4) Ijma

6McKean James Evans, The Future of Conflict Between Islamic and Western Financial Systems: Profit, Principle and

Pragmatism, 71 U. Pitt. L. Rev. 819, 821 (2010).7

Mushfique Shams Billah, Arab Money: Why Isn't the United States Getting Any?, 32 U. Pa. J. Int'l L. 1055, 1060

(2011).8Id.


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(scholarly consensus).9

Fiqh interpretations make up the main tenant of rules that must be

followed in Islamic Finance which are; a prohibition in transactions dealing with haram

(forbidden vices like alcohol, pork, gambling & pornography)10

, prohibition of riba (interest) and

a prohibition in gharar (transactions involving excessive uncertainty or risk). Only the

prohibition of riba, being the most abstract and difficult to comprehend concept to IslamicFinance, will be discussed in detail in this note.

The Role of Shariah-Compliant Boards: Non-binding decisions

How might an investor or a financial institution know iftheir transaction is Shariah-compliant?

Since much of Shariah law is based on human interpretations of the divine laws, there must be

a process for determining whether particular transactions are Shariah-compliant. This process

occurs through the issuances of legal opinions or fatwas by qualified Muslim scholars using

judicial consensus and analogical extensions.11

The StepsWhen an institution wishes to claim a financing structure as Shariah-compliant, it must confer

with a group of advisors comprised of Islamic scholars experienced in like-kind financial

transactions.12

These advisors are commonly known as a Shariah board.13

The Shariah boards

role is to work in close connection with the institution in order to issue a fatwa signaling that

the transaction is halal or Shariah-compliant.14

The fatwas produced by Shariah boards can

never be binding; they are more akin to legal commentaries by law professors.15

Moreover the

authority of a particular fatwa is largely dependent on the reputation of the issuing Shariah

board.16

It is important to understand that there is no universally accepted interpretation of Shariah

law; different jurisdictions in the Muslim world adopt different interpretations.17

Due to the

lack of binding precedent and the differing interpretations among Shariah boards there is an

absence of uniformity about what constitutes a Shariah compliant transaction.18

Often

institutions creating the financing transaction will seek Shariah boards with obscure minority

9Michael J.T. McMillen, Asset Securitization Sukuk and Islamic Capital Markets: Structural Issues in These

Formative Years, 25 Wis. Int'l L.J. 703, 772 n.1 (2008).10

Id. at 710.11

Rafel Mahmood, Islamic Governance, Capital Structure, and Equity Finance: Examining the Possibilities of

American Financial Shari'ah Boards, 37 Int'l J. Legal Info. 29, 33 (2009)12

Id.at 31.13

Id. at 31.14

Christine Walsh, Ethics: Inherent in Islamic Finance Through Shari'a Law; Resisted in American Business Despite

Sarbanes-Oxley, 12 Fordham J. Corp. & Fin. L. 753, 763 (2007).15

See Billah, supra note 7, at 1067.16

See Mahmood, supra note 11, at 37.17

Id.18

3F Sec. & Fed. Corp. Law 27:32.40 (2d ed.).


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views that observe liberal interpretations in order to allow transactions strikingly similar to

conventional finance.19

A prominent Islamic scholar has described the practice of board

shopping as Shariah arbitrage, stating that it amounts to none other than finding the closest

approximation to the conventional financial practice and then reengineering the product to

meet Islamic law, to be sold to an Islamic-finance-based captive market.

20

Adding furtherskepticism of a good faith adherence to fiqh, Shariah boards often act both as an independent

auditor and consultant for the institution seeking approval, leading to significant conflicts of

interest.21

For the aforementioned reasons, Islamic finance is often criticized as being driven by marketing

desires instead of a sincere desire to abide by the underlying principles of the divine laws of

Islam. Islamic investors want to know that their transactions are halal; however, regardless of

whether a Shariah board accepts a transaction as compliant, once created, the investors are

bound to the contractual agreement as with any conventionally structured financing

transaction. Ultimately, it is the responsibility of the investors and other participants, not the

issuer, to feel confident that they are conducting business in a manner that accords with their

religious beliefs.

The Prohibition of Riba

One of the more central and uniformly agreed upon necessities of Islamic Finance is adherence

to the Qurans express prohibition of riba. The Quran states; [t]hose who devour riba will not

stand [on the Day of Judgment] except like the standing of a person beaten by Satan leading to

madness. That is because they say: Trade is like riba, but Allah has permitted trade and

forbidden riba.

22

While it is uniformly agreed upon that riba is banned there is no precisedefinition of the term riba itself. Riba literally translated means increase

23and is generally

thought to be a prohibition on interest or usury.24

However, the concept of riba is far more

profound than can be captured only by notions of interest and usury. Abu Bakr ibn Ali al-

Bayhaqi, a prominent scholar of fiqh in the eleventh century, expansively defined riba as any

act which amounts to the financial exploitation of the poor by the rich.25

More modern

scholars define riba as any reward through passive use of money without commensurate risk.26

An illustration of profit without commensurate risk is a conventional interest-bearing loan

19See Sorenson, supra note 10, at 653.

20 Ali Adnan Ibrahim, The Rise of Customary Businesses in International Financial Markets: An Introduction to

Islamic Finance and the Challenges of International Integration, 23 Am. U. Int'l L. Rev. 661, 688 (2008).21

Id.22

Quran, 2: 275.23

See Billah, supra note 7 at 1061.24

Id. at 1062.25

Barbara L. Seniawski, Riba Today: Social Equity, the Economy, and Doing Business Under Islamic Law, 39 Colum.

J. Transnat'l L. 701, 706 (2001).26

See McMillen, supra note 9, at 714.


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where the lender is obligated to repayment plus interest regardless of whether the borrowers

investment of the loan is profitable. The concept of riba seeks to ban the lenders profit through

interest because it is both guaranteed and not dependent on the success of the borrowers

investment with the loan.

Another way to think of the prohibition of riba is by reference to the two modes of financial

participation in a transaction; through debt or equity. Equity participation involves an

ownership interest in the transaction, whereas debt participation involves only a loan of

property or money, usually with repayment including interest.27

Since profit making by the

charging of interest is banned, the prohibitions of riba encourages investors to make equity

structured transactions rather than debt-structured transactions.28

Riba al-Fadl & Riba al-Nasiah

There are two main categories of Riba; Riba al-Fadl and Riba al-Nasiah.29

Riba al-Nasiah,

roughly translated as deferred increase, deals with money-to-money exchanges where oneparty is charged a premium (or increase) for the right to receive the other partys money while

being allowed to repay at a deferred time.30

Therefore the ban of Riba al-Nasiah prohibits a

lender from fixing in advance a return on a loan based solely on the passive activity of waiting

for repayment. Riba al-Fadl prohibits hand-to-hand (bartering) exchanges that are not equal in

amount or quality.31

Riba al-Fadl is less relevant in modern finance as exchanges are monetary

in nature and less akin to bartering.32

However, it is clear that both qualitative and quantitative

increases during time delayed exchanges are barred.33

These doctrines of riba demonstrate the

Islamic view that lending should be a charitable activity and not a means of making profit.34

The Time Value of Money: Prohibition of Money as a Commodity

Since Riba al-Nasiah prohibits pre-determined fixed returns in reward for the lending of money,

an inductive extension also prohibits the guarantee of a return of capital. In other words,

money is viewed only as a means of exchange and not as a commodity.35

Therefore, it is

commonly said that the ban of riba prohibits the concept of making money from money.36

27Cal. Prac. Guide Corps. Ch. 3-B.

28See McMillen, supra note 9, at 714.

29See Ibrahim, supra note 20, at 694.

30Id.

31Id.32

Id.33

Id.34

Umar F. Moghul, Esq. & Arshad A. Ahmed, Esq., Contractual Forms in Islamic Finance Law and Islamic Inv. Co. of

the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & Ors.: A First Impression of Islamic Finance, 27 Fordham Int'l L.J.

150, 168 (2003).35

See McMillen, supra note 9, at 713.36

Alan J. Alexander, Shifting Title and Risk: Islamic Project Finance with Western Partners, 32 Mich. J. Int'l L. 571,

580 (2011).


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This is in stark contrast to Western methods of finance which treat money both as a commodity

and as a means of exchange.37

Riba prohibitions against increase (interest) are often

mischaracterized as an Islamic denouncement of the time value of money.38

However Ala

Adnan Ibrahim, Islamic scholar and vice president of the worlds largest Islamic banking

network, argues that the impreciseness of such a conclusion can be seen in the distinctionbetween lending and investment.

39Calculating the time value of money in a pure lending

transaction is clearly prohibited. However, it is permissible to calculate the time value of money

when it involves an economy activity such as an investment, and when the risk of loss is shared

by the investor.40

For example, in a shared partnership investment (musharaka) it is perfectly

permissible for one partner to receive a percentage of profits in excess of the proportion of

capital she contributed.41

Therefore one partner may receive 10% of the profit even though she

only contributed 7% to the musharaka. However, the losses must be shared to the extent of

capital contributed. In contrast to purely lending transaction such as a conventional loan, the

riba prohibition would preclude a lender from receiving any amount in excess of the loan given.

The riba principles of Islamic finance promotes the creation of goods and services rather than

mere passive lending. Investors are encouraged to take the role of an equity-holder rather than

a lender, which in turn supports the idea of sharing risk or in this context, sharing of losses and

profits.42

Application of the Principles of Riba to Finance

Ban on Interest

A consequence of a prohibition of Riba in the financial context is the ban against interest rates.

The ban against interest occurs when an interest rate (1) is tied to a time of deferred paymentfor a loan, (2) is fixed ex-ante, and (3) its payment is guaranteed regardless of the outcome or

the purposes for which the principal was borrowed.43

As alluded to earlier, though the riba

bans the charging of interest, there is a long-standing practice dating back to Ottoman times of

transactions authorized by both Hanafi and Shafil jurists that contravene the technical ban on

interest.44

In the Ottoman times this contrivance took the form of two separate transactions

where a lender would (1) lend the borrower money (i.e. $100) and (2) sell to the borrower on

37See McMillen, supra note 9, at 713.

38See Ibrahim, supra note 20, at 697-98.

39Id.40

Id.41

Shahzad Q. Qadri, Islamic Banking an Introduction, Bus. L. Today, July/August 2008, at 59, 60.42

Query how the tension between the Islamic concept of risk sharing and the general risk-averse nature of

traditional financers can be reconciled in a finance project with both western and Islamic financers. For an

extensive discussion of the sharing of risks with mixed Islamic and conventional lenders see generally Alexander,

supra nota 36.43

See Ibrahim, supra note 20, at 699.44

See Fadel, supra note 1, at 680.


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credit a nominally priced item (such as a hankerchief) at a price of the cost of the loan ($100)

plus desired interest rate of return (10%,).45

More modern forms of circumventing the ban on

interest that have also been approved by Islamic scholars are discussed in this note (i.e. a

murabaha or ijarah transaction).

Sharing of Profits & Losses: Retention of Title

Next, the prohibition of riba requires the sharing of risk or otherwise, profits and losses. This

requirement creates a general obligation for Islamic financers to retain title in the assets

underlying the financing project for at least an instant in time. *S+ince the assets are owned by

the Islamic financier it should assume the risk of total loss.46

Because all Shariah-compliant

deals must have assets at their core, some investors assume, incorrectly, that they have

recourse to the underlying assets in the event of a default (i.e. that it is asset-backed). Often

the lender will take title or a beneficial ownership in the assets.47

Whether there is recourse to

the underlying assets often depends on whether the transfer of the assets from the originatorto the issuer is classified as a true sale for bankruptcy purposes. If the transfer is not a true

sale, and the assets were transferred only for Shariah compliance purposes, then the lender

has no recourse to the underlying assets in the event of a default and therefore risks standing in

line with the originators creditors as an unsecured creditor.48

Keep in mind lenders in Shariah-

compliant transactions should maintain due diligence in understanding what the actual assets

are. Lenders should know if the actual assets are rights to real property which may be attached

and sold by the lenders in the event of default, or if they are merely rights to revenue stream

like leaseholds rights (ijarah) or oil and natural gas rights which may very well be worthless to

the lender in the event of default.

As you can see, whether the financers retain ownership of the underlying asset is one of the

main considerations in any Shariah-compliant finance project.49

As this note details the

different structures used in Shariah-compliant projects be cognizant of the various methods

used to observe the requirement for title retention. Also be cognizant of the possibility of

confusion on the part of lenders. Confusion can arise from determining what rights they

actually own, rights to a stream of revenue, or actual title in property.

45Id.

46John Inglis & Nadim Khan, Must Try Harder, Project Fin., 31 (2004).

47RAM Rating Services, Sukuk Investors Positions Amid Defaults, available at

http://biz.thestar.com.my/news/story.asp?file=/2009/10/3/business/4814754&sec=business (last visited Nov. 15,

2012).48

Id.49

See Alexander, supra note 36, at 576.


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Islamic Financing Structures

This next part describes the various types of commonly used Shariah-compliant transaction

structures. First, the most commonly used structure, mudaraba, is described. A mudaraba is

similar to a deferred payment or cost-plus profit transaction. Following is a description of the

second most commonly used, ijarah, a lease financing structure. Then the two differentpartnership structures musharaka (shared partnership) and mudaraba (silent partnership) are

described. A helpful mnemonic for distinguishing among the semantically similar mudaraba &

musharaka is to think of mudaraba as da guy with the money and da entrepreneur who

does the work, whereas musharaka is a shared partnership.50

These structures (with the

exception of murabaha51

) will be important in understanding the later discussion of sukuk,

Islamic bonds or trust certificates. Sukuk offerings are usually structured so the certificate-

holders own a beneficial interest in a pool of assets comprised of these financing structures. For

example, in the Nakheel sukuk case study, the sukuk-holders owned a beneficial interest in a

pool of ijarah leaseholds.

Thereafter will be a brief discussion of some of the tax implications customers should be aware

of in these structures. Although more complex transactions in Islamic jurisdictions have few tax

liability concerns, when they take place in the U.S. they can have unfavorable tax

consequences, especially in the home mortgage context. Lastly a rahn, or a security pledge, is

described. The enforceability issue of security pledges will come up under this rahn section and

again in the Nakheel case studies.

Murabaha (Cost-Plus Financing)

Murabaha, the most commonly used Shariah-compliant transaction structure, is a deferredpayment or cost-plus profit, debt-like transaction.

52In a Murabaha transaction, a financial

institution upon request by a borrower purchases an asset and sells it to the borrower at the

cost of the asset plus an additional fee (profit for the financial institution).53

The financial

institution can transfer title to the borrower at either the initial closing or a date later agreed

50Special thanks to Professor David Ball for passing on this mnemonic.

51Murabaha are impermissible in sukuk offerings because murabaha contracts involves the sale of debt, which is

generally prohibited in by Shariah law. Muhammad Taqi Usmani, Sukuk and their Contemporary Applications,

available athttp://www.failaka.com/downloads/Usmani_SukukApplications.pdf(last visited Nov. 15, 2012).52

Nickolas C. Jensen, CPA, Avoiding Another Subprime Mortgage Bust Through Greater Risk and Profit Sharing and

Social Equity in Home Financing: An Analysis of Islamic Finance and Its Potential As A Successful Alternative to

Traditional Mortgages I, 25 Ariz. J. Int'l & Comp. L. 825, 839(2008).53

Id.
http://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdfhttp://www.failaka.com/downloads/Usmani_SukukApplications.pdf


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upon.54

The additional fee, or profit, may be benchmarked to standard interest rates, such as

LIBOR, giving the transaction the same economic effect as a traditional interest-bearing loan.55

Of course this fee isnt technically characterized as interest charged by the financial institution,

which is impermissible, but rather the permissible investment return on an asset purchase.56

Nevertheless, one might regard the profit as merely disguised interest, and wonder how to

reconcile these transactions with the prohibition of riba. Modern scholars argue the additional

cost-plus fee is distinguished from mere disguised interest because the financial institution

must own the asset before transferring title to the borrower, and therefore is forced to bear

risks associated with ownership.57

These risks include the possibility that the borrower will

refuse to purchase the asset and costs involved with maintaining the asset while it is in the

possession of the institution. However, the financial institution can easily minimize this risk by

conducting the resale to the borrower immediately after or simultaneous with the initial

purchase.58

To illustrate, consider the steps of a murabaha transaction in a home ownership context. Upon

request by the borrower, the financial institution purchases the home and sells it to the

borrower at a marked up purchase price which includes the cost of the home plus profit (built

in interest fees).59

The borrower, now homeowner, makes a down payment and purchases the

home from the financial institution and is transferred the full title in the home.60

Thereafter the

homeowner must make monthly payments to the financial institution on the balance of the

purchase price in order to fully pay off the home.61

Ijarah (Lease Financing)

An ijarah transaction shares many similarities with conventional lease financing. In an Ijarah

transaction a financial institution purchases an asset selected by the customer, leases it to a

customer, but retains title and ownership for the duration of the lease.62

The customer agrees

to purchase the asset and the financial institution agrees to sell the asset to the customer.63

The

customers rent payments are the sum of (1) the base amount, which includes the acquisition

cost for the assets and the amortization and cost obligations borne by the financial institution

during the term of the lease, and (2) a rental rate or LIBOR based interest rate on the

54Id.

55Michele O. Penzer, Melissa S. Alwang, Salman Al-Sudairi, Shari'ah-Compliant Financings: New Opportunities for

the U.S. Market, 126 Banking L.J. 59, 63 (2009). 56

See Jensen, supra note 52, at 839.57

Id.at 840.58

Id.59

Id.60

Id.61

Id.62


Id.


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remaining balance on the aforementioned base amount.64

The customer is entitled to

purchase the asset during or at the end of the lease through the provision of a call option.65

The

financial institution is granted a put option so it may force the customer, upon the occurrence

of certain events (such as a default on installment payments), to purchase the asset at the

remaining base amount.

66

The financial institution must retain title in the asset in order to comply with Shariah

requirements.67

Retention in title evinces the riba prohibition of profit without commensurate

risk because the financial institution bears the costs of maintenance and risk of asset

destruction during the lease term. In practice however, the customer will contract to repay all

costs of ownership borne by the financial institution such as maintenance, repair and insurance.68

Alternatively, and perhaps more ideal for Shariah compliance, the financial institution can

also take out insurance itself and build the costs into the lease rent.69

Mudaraba (Venture Capitalism)

A mudaraba is a silent partnership or venture capital financing structure involving two parties,

usually a financial institution as the capital owner and an entrepreneur as the investment

manager.70

The financial institution as the capital owner (rabb al-mal) provides all the capital

and bears all the risk of monetary loss.71

The financial institution is the silent partner and has no

control of the venture.72

On the other hand, the entrepreneur acting as the investment

manager (mudarib) provides sweat equity and management skills.73

The mudarib shares in

profit at a pre-determined ratio but bears no monetary loss, only the loss of wasted sweat.74

Alternatively a mudaraba can be structured with the financial institution or bank acting as the

investment manager and a customer as the capital owner.75

This structure functions similarly to

traditional savings accounts with two major exception; (1) the customer cannot charge interest,

and (2) the customers deposits are not secured because as a capital investor her deposits can

64See Penzer, supra note 55, at 62.

65Id.

66Id.

67Id.

68Id. at 65.69


Sulman A. Bhatti, The Shari'ah and the Challenge and Opportunity of Embracing Finance "Without Interest", 2010

Colum. Bus. L. Rev. 205, 220-21 (2010).71

Id.72

Id.73

Id.74

Id.75

Id. at 221.


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rise and fall depending on the banks (mudarib) investment activities.76

A customer may

nonetheless withdraw from the mudaraba and request that the bank merely maintain the

principal of her deposits.77

This arrangement is known as a Wadiah.78

The bank may use the

funds in its investment activities but must guarantee a refund of the entire deposit upon

demand by the customer.

79

Although the customer accrues no interest, the bank may rewardher with a monetary gift (hibah) in appreciation for the funds.

80The hibah serves a function

very similar to interest except it must be at the banks discretion and cannot be guaranteed or a

fixed amount.81

Musharaka (Joint Venture)

A musharaka is also a partnership similar to a mudaraba, without the explicit roles of capital

provider and manager.82

Here two entities jointly contribute labor and capital and share in

profits according to a pre-determined ratio.83

Although the profits may be pre-determined,

they must be shared according to a proportion or percentage as opposed to a fixed amount for

any one partner. 84The losses are shared to the extent of the capital invested.85 Each partner

has equal rights of control in the venture; however one partner may choose to relinquish the

right in respect to participation of in some activities.86

Taxation of Islamic Financing Structures

Another key source of confusion in Shariah compliance transactions is the tax treatment when

the deal is structured in a Western jurisdiction. Many Shariah-compliant transactions that in

substance are identical with their conventional counterparts may nevertheless have disparate

tax treatment in the U.S since the federal and state tax codes are predicated on the use of

conventional finance structures and the imposition of interest.

Islamic Finance transactions have many tax disadvantages under federal law in the United

States, most notably in the home financing context. While ijarah are recognized as being

equivalent to conventional mortgages for tax treatment, murabaha and musharaka are still at

great disadvantages.87

The first, but non-mortgage related, tax disadvantage relates to the

76Id.

77Id.

78Id.

79See Qadri, supra note 41.

80Id.81

Id.82

See Alexander, supra note 36, at 595.83

Id at 596.84

See Qadri, supra note 41.85

Id.86

Id.87

Shah M. Nizami, Islamic Finance: The United Kingdom's Drive to Become the Global Islamic Finance Hub and the

United States' Irrational Indifference to Islamic Finance., 34 Suffolk Transnat'l L. Rev. 219, 245 (2011)


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interest on business debt deduction which allows corporations and individuals to deduct the

interest paid on their business debt. Businesses financed through a murabaha would be unable

to classify the payments in excess of the financial institutions purchase price as interest and

therefore cannot get the business interest deduction. Similarly homeowners financing through

a murabaha are not eligible to deduct the interest paid from home indebtness of their primaryresidence.

88This is because the tax code does not view the additional fee paid by the buyer as

interest (even though it is calculated based on LIBOR-like rates).89

In contrast the United

Kingdom passed legislation which allowed profits in such situation to be given the same tax

treatment as interest.90

Lastly, the murabaha transaction is subjected to double taxation on the

real estate transfer tax since there is a tax on the initial purchase by the bank and again on the

transfer from the bank to the homeowner.91

Musharaka transactions receive even more unfavorable tax treatments. First, because a

musharaka is a shared equity partnership, a homeowner who purchases through such

partnership never accrues indebtedness to pay interest on and therefore cannot have a

deduction.92

Next, the Internal Revenue Code allows a partner to engage in a renting

transaction with the partnership, however since the ownership is with the partnership, the

rental income received from the homeowner must be included in the adjusted gross income of

the partnership. On the other hand, if the homeowner had a conventional mortgage, his

imputed income in living in the house would not be included.93

Lastly, the homeowner would

not be eligible for the normal exclusion from the gain derived from the sale of a principle

residence since ownership is in the partnership and not the homeowner.94

Taxpayers can seek to avoid disparate tax treatment on their Shariah-compliant investmentsthrough the substance over form doctrine. Taxpayers may petition the tax commissioner to

review to see whether the economic substance of a transaction does not deserve a different tax

treatment than those of similar forms.95

While such petitions are rarely won by taxpayers, the

Office of the Comptroller has found on at least one occasion that from a tax perspective, the

Murabaha financing transactions will be considered loans96

A taxpayer can therefore find

support for a substance over form, nevertheless this route of relief must be done on a case-

by-case basis and is therefore burdensome for taxpayers to get. A better route would be for

88Id. at 246.

89Id.90

Id.91

Id.92

Id .(stating that it is the partnership, not the homeowner who accrues the debt).93

Id.94

Id.95

Id. at 848.96

See Comptroller of the Currency Administrator of National Banks, Interpretive Letter #867

http://www.occ.gov/static/interpretations-and-precedents/nov99/int867.pdf(last visited Nov. 16, 2012), at 6.
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Congress to provide statutory relief through tax and regulatory rules modifications that provide

Islamic investments with equal tax treatment.97

The U.K. is a great example on how equal tax

treatment for Islamic Finance vehicles has been achieved through the legislature.

Rahn (Security Interest or Pledge)

A rahn or pledge is a means in which lenders or investors can secure themselves against the risk

of non-payment.98

In a rahn agreement the borrowers pledges a specific asset as collateral by

placing title in the asset with an agent or trustee (adl) who owes fiduciary duties to the lenders.99

If the borrower defaults then the lenders can force the agent or trustee to sell the assets for

the lenders benefit.100

According to riba principles the assets pledged must be in possession of

the lender.101

Constructive possession is permissible and can be achieved by recording the

security interest so other creditors are put on notice.102

Due to these possessory requirements

the perfection of a security interest may be particularly difficult in Islamic jurisdictions.103

For

instance to achieve perfection of a real property mortgage in Dubai, lenders are required to

record the mortgage at the Dubai Lands Department. 104 However only the interests of lenders

licensed by the central bank of Dubai can be registered.105

Lenders who are not licensed may

seek a structure using a licensed bank as a security agent.106

But, the enforceability of using a

licensed security agent when the lender itself is not licensed is untested in the UAE and

therefore cannot be guaranteed.107

Consequently lenders who do not take due diligence in

investigating security interests in a prospectus of an Islamic financing project may be exposed

to the hidden risk of having unenforceable security interests.

The Sukuk: Islamic Bonds or Debt SecuritiesSukuk is the plural form of Saak, which translates to investment certificate. They are

tradable securities that confer to the holder a beneficial interest in underlying assets or

Shariah-compliant ventures (i.e. most commonly Ijarah, mudaraba & musharaka) and the

profits arising from the assets.108

The Accounting and Auditing Organization for Islamic Financial

97See Jensen, supra note 32, at 851.

98See Evans, supra note 6 , at 830.

99Id.

100Id. at 830-831

101Id. at 831

102Id.103

Michael J.T. McMillen, Contractual Enforceability Issues: Sukuk and Capital Markets Development, 7 Chi. J. Int'l

L. 427, 455 (2007).104

Omar Salah, Dubai Debt Crisis: A Legal Analysis of the Nakheel Sukuk. Available at

http://bjil.typepad.com/Dubai%20Debt%20Crisis.pdfat 29.105

Id.106

Id.107

Id.108

See Ibrahim, supra note 20, at 719.
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Institutions (AAOIFI) issued the Standard for Investment Sukuk in an attempt to bring

uniformity to commonly accepted Sukuk Standards.109

A broad summary of the fourteen

eligible asset classes provided by the Standard for Investment Sukuk are as follows:

(a) of an existing or to-be-acquired tangible asset (ijara, or lease); (b) of an existing or to-

be-acquired leasehold estate (ijara); (c) of presales of services (ijara); (d) of presales of

the production of goods or commodities at a future date (salam, or forward sale); (e) to

fund construction (istisna'a, or construction contract); (f) to fund the acquisition of

goods for future sale (murabaha, or sale at a markup); (g) to fund capital participation in

a business or investment activity (mudaraba or musharaka, or types of joint ventures);

and (h) to fund various asset acquisition and agency management (wakala, or agency),

agricultural land cultivation, land management, and orchard management activities.110

The general consensus among Shariah scholars is that the pool of assets should be at least half

comprised of structures representing ownership interests in assets (like musharaka or Ijarah) asopposed to structures representing only an interest in a stream of payments (like Murabaha).

111

Although Sukuk are commonly referred to as Islamic bonds they are materially different from

traditional bonds112

and are closer in structure to a trust or investment certificates.113

A key

difference between the concept of Sukuk and traditional bonds are that theoretically Sukuk

represent only an ownership interest and not a right of return.114

This difference is best

summarized by Muhammad Taqi Usmani, president of the AAOIFI Shariah Council:

[T]he holders of [ conventional bond] certificates are no more than lenders to the

sponsors of such enterprises; and their earnings come from the interest on their loans in

a percentage that accords with the price of interest in the marketplace. The profits of

these enterprises after costs, including interest payments, return exclusively to the

sponsors. The basic concept behind issuing Islamic Sukuk, however, is for the holders of

the Sukuk to share in the profits of large enterprises or in their revenues.115

Therefore an investors return is derived through periodic payments of the profits from the

underlying asset and not an interest based percentage of capital as with conventional bonds.116

109 See McMillen, supra note 103, at 429.110

Id.111

Irina Marinescu, Where Does the Dirham Stop in A Sukuk Default?, 35 Hastings Int'l & Comp. L. Rev. 451, 458

(2012); See Usmani, supra note 51.112

See Alexander, supra note 36, at 596.113

See Marinescu, supra note 111, at 457.114

See Evans, supra note 6, at 828115

See Usmani, supra note 51, at 2.116

Id.


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An investors profits or capital cannot be guaranteed but must be based on the performance of

the underlying asset.117

Nevertheless Sukuk agreements in the past have been structured to reach the same function as

conventional bonds by including provisions (1) entitling the Sukuk-holder to loans from the

manager when actual profits from the underlying assets are less than prescribed percentages

(usually based on LIBOR or like interest rates) (2) directing actual profits in excess of the

prescribed percentages are to accrued by the manger alone and (3) guaranteeing a return of

capital through a manager pledge to repurchase the investors assets at a fixed or nominal price

upon maturity or a dissolution event of the transaction.118

The practical effect of Sukuk transactions structured in this matter led Usmani to admonish that

the Sukuk holders have no right other than the return of their principal, as is the case in

conventional bonds.119

Usmani later proclaimed that he believed up to eighty-five percent of

the worlds Sukuk were not Shariah-compliant due to these structures.

120

In a now infamous2007 clarification the AAOIFI prohibited the practices of manager loans to cover shortfalls in

asset profits, and also prohibited, with respect to only partnership based sukuk (like mudaraba

& musharaka) manager pledges to repurchase the underlying assets at a nominal value.121

Therefore it is clear that a manager pledge to repurchase at a nominal value is permissible with

the more common Ijarah-Sukuk.122

Furthermore it is also permissible in all sukuk structures for

a manager to pledge to repurchase at the cost of net value of assets, its market value, fair

market value, or a price agreed upon at the time of the actual repurchase.123

And in respect to

loans to cover shortfalls, the clarification made clear that it is only permissible to first

accumulate reserves from any excess of profits of the underlying assets, at which point anyfuture shortfalls with can be covered with the reserve.

124

In the aftermath of the clarifications some contended that the new guidelines wrecked the

*sukuk+ market by causing a reduction in overall issuances and a dramatic shift toward the now

less controversial ijarah-based sukuk structures.125

However others argue that evidence

117Id.

118Id.

119Id.at 8.120

See Marinescu, supra note 111, at 462.121

Accounting and Auditing Organization for Islamic Financial Institution, Sukuk Clarification, available at

http://www.aaoifi.com/aaoifi_sb_sukuk_Feb2008_Eng.pdf, 2-4 (last visited Nov. 11, 2012).122

Id. at 3-4.123

Id. at 3.124

See McMillen, supra note 9, at 703.125

Scott R. Anderson, Forthcoming Changes in the Shari'ah Compliance Regime for Islamic Finance., 35 Yale J. Int'l

L. 237, 242 (2010).
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suggests that it was the current crisis and not the ruling that caused the overall reduction in

sukuk issuances in 2008.126

Two Classes of Sukuk

Sukuk come in two classes, asset-backed & asset-based. This terminology although

semantically similar has significant differences to the credit risks of the project and underlies

a key confusion to investors when it comes to understanding sukuk.127

The confusion is caused

by the form over substance trait of Islamic finance, where transactions with dissimilar forms

as their conventional counterparts provide significantly similar substance.128

The asset-

backed/asset-based distinction depends on whether, in the event of default, the sukuk-holders

have recourse to the underlying assets or recourse only to the credit of the issuer along with

other subordinated creditors.129

The sukuk is asset-based if the originator transfers only a

beneficial ownership to the SPV-issuer without the characterizations of a true sale or

recourse to the underlying assets. Upon insolvency of the originator, the assets will be

transferred to the originators bankruptcy estate and the sukuk-holders will not receive priority

over other unsecured creditors. Conversely, the sukuk is asset-backed if the transfer of the

assets from the originator to the SPV-issuer is characterized as a true sale with recourse to

the underlying asset.130

Upon default, the sukuk-holders as co-owners of the underlying asset

may sell the asset and recuperate their losses.131

In recap, if in the event of default the sukuk-holders have recourse to the cash-generating

asset, then it is an asset-backed transaction.132

If, however, in the event of default the sukuk-

holders cannotseek recourse to the cash-generating asset, then it is asset-based.133

Asset-

backed sukuk more easily harmonize with the values ofShariah compliance because the sukuk-holders actually do hold an undivided ownership interest in the underlying assets. The sukuk-

holders are therefore exposed to the risk of the asset because any losses on their cash flows

will be passed onto them. 134 Nevertheless, very few sukuk issued to date are in fact asset-

backed.135

Most sukuk are asset-based, with the cash-generating asset there chiefly to ensure

Shariah compliance. The presence of the assets however can potentially confuse investors as

126See Blake Goud, Sharing Risk Dot Org, available athttp://investhalal.blogspot.com/2009/03/ijara-sukuk-islamic-

finance-hurt-by.html(last visited Nov. 11, 2012).127

Moody Investors, The Future of Sukuk: Substance Over Form?, available at

http://www.kantakji.com/fiqh/Files/Markets/m170.pdf, 2 (last visited Nov. 11, 2012).128

Id.129

See Alexander, supra note 36, at 596130

Id. at 596-97131

Id.132

See Marinescu, supra note 111, at 462133

Id.134

See supra note 96, at 8.135

See Marinescu, supra note 111, at 462
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to their true means of recourse in event of a default.136

In fact, according to rating agency

Moodys, there are market participants who, without access to (or interest in) the legal detail,

sincerely [but incorrectly] believe there is asset security and that the investment/financing

provided is collateralized.137

Therefore Moodys suggests merely using a secured and

unsecured classification rather than the confusing asset-backed vs. asset-based distinction.

138

The asset-based and asset-backed distinctions reflect how the rating for the sukuk credit risk is

determined.139

In an asset-basedtransaction the rating will be determine by examining the

creditworthiness of the originator.140

Should the financial situation of the originator

deteriorate, so too will the investment rating. This was the exact scenario in an asset-based

sukuk issuance by Tamweel that saw its rating downgraded when Tamweels finances fell with

the declining market.141

The rating ofasset-backedsukuk is determined by examining the

performance and credit quality of the underlying assets.142

Therefore asset-backed securities

have the allure of receiving higher ratings than the originators credit alone could receive.

Indeed in a separate mortgage-backed securitization (MBS) by Tamweel, one of the few true

asset-backed or secured sukuk issuances, the project received substantially higher ratings

than both Tamweel and its parent company Dubai Islamic Bank was capable of receiving.143

However, Islamic finance blogger Blake Goud warns against the potential of secured sukuk

replicat*ing+ the ills of the MBS [mortgage-backed securities] market leading up to the crisis up

to the crisis where ratings schemes were gamed by originators to get higher ratings so they

could push out more and more issuance, the risk of which is largely transferred to investors.144

Nakheel Sukuk: Case Study

The following is a brief summary of the Nakheel structure. Nakheel, a Dubai-based developerand its various subsidiaries sought financing in order to develop land. The ultimate goal of the

transaction is to finance the development projects through issuance of sukuk where the sukuk-

holding-investors will act as the financers of the operation. To raise funds Nakheel chose the

securitization of its leasehold assets (ijarah) through a sukuk structure. These ijarah leaseholds

will be the Sukuk Assets, the assets underlying this transaction. The long leaseholds are for a

136Id.

137 See Moody Investors, supra note 96, at 5.138

Id.139

See RAM Rating Services, supra note 47.140

Id.141

Mohammed Khniferhttp://www.kantakji.com/fiqh/Files/Markets/575.pdfat 20.142

Id.143

Blake Goud The Potential for Growth in Islamic Mortgage-Backed Securities

http://investhalal.blogspot.com/2012/06/potential-for-growth-in-islamic.html(last visited Nov. 16, 2012).144

Id.
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term of 50 years and cover building, land and other property located in the Dubai Waterfront.145

A Special Purpose Vehicle (SPV) is created which will act as the Issuer of the Sukuk certificates

and holder of the ijarah assets (long leaseholds) as a trustee.146

The SPV, here Nakheel

Development 2, must raise funds through a Sukuk issuance before it can be transferred the

ijarah leaseholds. The SPV Issuer raises funds by issuing trust certificates (or sukuk) to sukuk-

holders (the investors) in exchange for cash. The SPV will then use these newly raised funds to

purchase from the Seller the entirety of the ijarah leaseholds assets (Sukuk Assets). The seller

now has the funds it can use for its land development projects, the purpose of the entire

financing transaction. The Issuer SPV creates a trust wherein the SPV holds legal title of the

Sukuk Assets for the benefit of the sukuk-holders.147

Now the Sukuk-holders have a title

interest as trustee beneficiaries in the assets underlying the transactions.

The SPV (as Lessor) then leases the newly acquired Sukuk Assets to a Nakheel group subsidiary,Nakheel PJSC (Lessee), for six consecutive lease periods of six months, or a total lease period of

three years.148

This short leasehold obligates the lessee to make bi-yearly payments to the

Lessor SPV for the benefit of the sukuk-holders. The annual sum of these lease payments is

equal to 5.5% of the entirety of the Sukuk Issue Amount plus Servicing Agency expenses.149

The

lease payments represent the interest paid for the financing, or more theoretically, the time

value of the sukuk-holding investors money. The Servicing Agency is made for the purposes of

allowing maintenance on the underlying property while it is being used in this transaction. The

lessee, Nakheel PJSC, is appointed as the lessors Service Agent, and tasked with conducting all

maintenance work and repair on the underlying property.

150

Of course, the costs of this agencyincurred by the SPV-Issuer (and therefore by the investors) is factored into the rent payments

as indicated above.

At maturity of the transaction or the occurrence of a dissolution event the sukuk-holders

(investors) will recoup their capital through the execution of a repurchase agreement.151

The

Purchase Undertaking Obligor (Nakheel PJSC) of the repurchase agreement will purchase the

sukuk from the original sukuk holders at the Sukuk Redemption Amount. The Sukuk

145See Nakheel Sukuk Offering Circular, Nakheel Deveopment Ltd., available at

http://www.nasdaqdubai.com/resources/2008/3/11/be8190d7-76fc-4f58-bf31-

669116537ca4/Offering%20Circular.pdfat 134.146

Id. at 8 (SPV-Issuer/Trustee/Lessor: Nakheel Development 2 Limited).147

Id. at 9.148

Id. at 12.149

Id; Sukuk Issue Amount: U.S.$750,000,000 the aggregate price sukuk-holders paid for their Certificates. Id at

91.150

Id. at 12.151

Id. at 13.
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Redemption Amount is the aggregate of the Sukuk Issue Amount and any due (but unpaid)

lease payments.

In order to secure payment obligations the sukuk-holders are granted a perfected mortgage

secured by the underlying physical properties with the Dubai Islamic Bank acting as security

agent.


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The Nakheel sukuk case study illustrates the complexity in identifying the Three Little Enemies

(TLE)152

to investor recourse in the event of default. Three Little Enemies is simply a mnemonic

to remind investors to identify whether they are transferred actual 1) Title that would be of

value after default, or if not, whether they perfected 2) Liens over said assets, and lastly

whether these liens are 3) Enforceable in the pertinent jurisdiction. To recap, the Nakheelstructure was a sukuk-manfaa-ijarah in which sukuk-holders owned as assets, leasehold rights

(ijarah), from which they derived their source of revenue.153

The leasehold was for 50 years

and covered property in the Dubai Waterfront.154

So how do we know whether investors are

secured in the event of default?

Title

First we must ascertain whether our sukuk-holder investors have title in valuable assets which

they can sell in order to recoup their loss. Here, the investors have title as beneficiaries in trust

to the Sukuk Assets. But the Sukuk Assets, here just leaseholds, are of little help. Since Nakheelis unable to make payments this means the lessee(s) under the leasehold also couldnt make

payments to Nakheel. What would be more useful is title in the actual property underlying the

leaseholds. But this title was never conferred and instead was retained by Nakheel Holdings 1.

Because there was no actual transfer of ownership of the physical property underlying the

revenue stream upon insolvency or default, unless the investors perfected a lien over the

assets, the assets would be transferred to the bankruptcy estate of the title owner, Nakheel

Holdings 1, for the equitable distribution to all its creditors.155

Lien

Consequently it may be tempting to classify this structure as asset-based and therefore

unsecured. However, regardless of an asset-based or asset-backed classification, what is

important is that the sukuk-holders are in fact secured creditors by obtainment of a mortgage

lien over the properties.156

However, as discussed above (rahn section), securing a lien is not

always assured due to the difficulty of achieving perfection of a security interest in Dubai.

To achieve perfection of a right to mortgage a lender must register the mortgage with the

Dubai Lands Department.157

However, only licensed lenders may register rights of mortgages

152 TLE -Title to valuable assets, Liens, and Enforceability153

See Salah, supra note 104, at 28.154

See Nakheel Sukuk Offering Circular, supra note 145155

Id.156

Although it is questionable whether these pledges are enforceable in the UAE. See Salah, supra note 84, at 29;

See Nakheel Sukuk Offering Circular, supra note 145, at 141 (stating In order to secure the payment obligations of

Nakheel under the Transaction Documents, Nakheel World LLC (the Mortgagor) shall grant a fully perfected

mortgage, free from any security interest and encumbrance.).157

See Salah, supra note 104.


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with the Dubai Lands Department.158

Here, although the Security Agent was a licensed bank,

the actual lender was not. Such a structure was untested in UAE courts and thereby called into

question the validity of the mortgage. Indeed, the prospectus cautioned that there can be no

assurance of the enforceability of a [m]ortgage by the Security Agent in the manner

contemplated by the Security Agency Agreement or any enforcement process or procedure.159

Enforceability

Sovereign immunity issues further complicate the enforceability of the mortgage since the

mortgagor, Nakheel World, is owned by the government of Dubai.160

Although Nakheel World

and its co-obligors agreed to waive immunity to the fullest extent allowed by law, due to an

absence of precedence the prospectus specifically warned there can be no assurance of the

enforceability of the waiver. Therefore, ultimately it may not be possible to enforce any

judgment [ ] against the properties and assets of any [c]o-obligor or Nakheel World.

161

In November of 2009, Dubai World and its subsidiaries notified the sukuk-holders that they

were unable to continue making their payment obligations and therefore would be in

default.162

The co-obligor guarantees by Dubai World and its subsidiaries and the purchase

undertaking agreement obligating repurchase at the Sukuk Redemption Amount could do little

to help the sukuk-holders since all parties involved were financially unable to fulfill their

payment obligations.163

The sukuk-holders only legal recourse, the mortgage, had daunting

enforceability challenges. Despite the very real possibility that the mortgage security could be

unenforceable, at least some Sukuk-holders were comforted by an assumption that the Gulf

emirate would guarantee repayment in the event of default. 164 This assumption was in-part

warranted due to the common practice of government support or bailouts for troubled Islamic

financial institutions within the UAE.165

However, the prospectus expressly warned the sukuk-

holders not to rely on the availability or assurance of a government bailout.166

158Id.

159See Nahkeel Offering Circular, supra note 145, at 45.

160Raisssa Kasolowsky, Amran Abocar, Legal Minefield Awaits Dubais Nakheel Bondholders. available at

http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203(last

visited Nov. 16, 2012); The prospectus clearly stated *u+nder applicable Dubai law, no debt or obligation owing

from the Ruler or the Government of Dubai may be recovered by laying hold, attachment, sale in auction, or taking

possession in any other legal action of the Rulers or the Governments properties and assets whether or not a

final judgment is issued in respect of such debt or obligation. See Nakheel Offering Circular, supra note 145, at 51.161

See Nakheel Offering Circular, supra note 145, at 46-47.162

See Salah, supra note 104, at 27.163

Id.164

See Kasolowsky, supra note 160.165

See Salah, supra note 2, at 148 (discussing trend of bailouts in the UAE).166

See Nakheel Sukuk Offering Circular, supra note 145, at 36 (stating *t+he Nakheel Group has traditionally relied
http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203http://www.reuters.com/article/2009/12/03/businesspro-us-dubai-debt-law-idUSTRE5B21YH20091203


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Nevertheless, in the end neighboring Abu Dhabi did in fact come to the rescue with a $10 billion

loan which was used to refund the sukuk holders and redeem the sukuk upon maturity at the

agreed upon Sukuk Redemption Amount.167

Although the sukuk-holding investors were paid

out in this scenario it is often argued that sovereign bailouts like this add further confusion to

Islamic financing. A bailout here potentially prevented new precedent that could have added

clarity in the future. Future Sukuk-holders may again rely on a government bailout even though

the guarantee of which is expressly denied. Those future sukuk-holders may find themselves

without recourse in a similar event where no sovereign entity actually provides a bailout.

Moreover, lack of investor clarity could further be compounded by the controversial moral

hazard theory. The moral hazard theory refers to the greater tendency of people who are

protected from the consequences of risky behavior to engage in such behavior.168

Investors

shielded by such bailouts may have less reason to take a prudent economic course the next

time around and therefore may use less due diligence. 169

Conclusion

Investors need to be properly informed of the concepts of Islamic law in order to keep the

market safe. While Islamic Finance encourages the concept of risk-sharing, it also prohibits

investments that entail excessive riskiness. However, the foreign nature of Islamic finance,

compared to conventional finance structures, introduces risks inherent in novel structures

undertaken by inexperienced investors. Investors may often look at only the form of a Shari'ah-

compliant transaction and assume it provides the same substance as its traditional counterpartand thereby miscalculate their rights and liabilities. This risk is further compounded by two

likelihoods when the asset involved is located in an Islamic jurisdiction: 1) unpredictability of

judgments - a foreign judgment may not be upheld in an Arab country and 2) enforceability of

judgments - when dealing with sovereign entities, they may have immunity therefore

precluding recourse to assets. Finally sovereign entities in the UAE have shown a consistency to

bailout failing projects. This may psychologically make investors think they will always recoup

their capital regardless of the project's financial situation and therefore act as a disincentive to

conduct due diligence.

primarily upon capital contributions from the government of Dubai and retained earnings to

fund its capital expenditure requirements rather than seek internal financing. There can be no

assurance that these contributions will continue.). 167

See Kasolowsky, supra note 160.168

Steven L. Schwarcz, "Idiot's Guide" to Sovereign Debt Restructuring, 53 Emory L.J. 1189, 1194 (2004).169

Id.


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Nakheel Structure Glossary

Underlying Tangible Assets: Land, buildings and other property within the Dubai Waterfront170

Issuer assets: Leasehold interests in the underlying tangible Assets (property within the Dubai

Waterfront).171

Sukuk Assets:Trust certificates representing pro rata shares of the issuers assets. So the sukuk

holders hold ownership interests in the leasehold.172

Investors Fixed Return: Annual 5.5 per cent of total Sukuk Issue Amount173

Seller: Nakheel World LLC174

SPV-Issuer/Trustee/Lessor: Nakheel Development 2 Limited175

Obligor: Nakheel PJSC herein referred to as Nakheel.176

Purchase Undertaking Obligor: Nakheel177

Servicing Agent: Nakheel178

Lessee: Nakheel179

Mortgagor: Nakheel World LLC180

Security Agent: Dubai Islamic bank PJSC181

Sukuk Issue Amount: U.S.$750,000,000 the aggregate price sukuk-holders paid for their

Certificates.182

170See Nakheel Sukuk Offering Circular, supra note 145 at 10, 98.

171Id. at 1.

172Id. at 135.

173Id.

174Id. at 8.175

Id.176

Id. at 1.177

Id. at 9.178

Id.179

Id.180

Id. at 13.181

Id. at 9182

Id. at 91.


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Lease payments: 2 payments in one year equaling to 5.5% of the total Sukuk Issue Amount +

costs of the Servicing Agency Express (structural repair and maintenance of the property, etc).183

Dissolution Events: The principle dissolution events were (a) failure by the issuer to make anyPeriodic Distribution payments (b) nonperformance of material obligation by issuer in respect

to the lease interests (c) default of the lease agreements (d) insolvency, dissolution or

liquidation of the issuer.184

183Id. at135-36.

184Id. at 68-69.