Are your Islamic bonds shariah compliant? Will they be tomorrow?

In the evolving world of Islamic finance, investors need to be especially cautious, as techniques for restructuring distressed debt can be just as surprising and exotic as the shariah-compliant investment instruments themselves. The recent saga of United Arab Emirates-based Dana Gas and its restructuring of $700 million in bond debt is a cautionary tale.

As is generally well known, Islamic law (shariah) bans interest-based lending (usury), while it allows profit sharing from the financed sale of goods and services. Consequently, to meet Western debt financers half-way (actually long before this), the Islamic finance industry developed long-term finance transaction structures that ride the razor’s edge between acceptable risk-and-profit sharing-based equity investment and prohibited fixed interest-based debt investment. The trick is to ensure regular, reliable returns for lenders but steer clear of toppling over into guaranteed interest-like returns.

Islamic law has no single judiciary, unlike secular legal systems, and so a complex evolutionary process has played out over the past 1,400 years by which various legal scholars have convinced others of the rightness of their interpretations of ambiguous source material, thereby rising to a position of authority within at least certain circles. These circles continue to disagree on the correct interpretation and application of many key precepts, including the line between prohibited usury and acceptable profit. Indeed, crucial to the Dana Gas story, authoritative opinions continue to evolve over time, much as secular courts’ opinions evolve on various matters of secular law. There is, unfortunately, no Supreme Court to resolve these differences authoritatively for the richly diverse and varied Islamic world.

For financial instrument issuers in many areas of the Islamic world, compliance with shariah is principally a private matter, a method of attracting funds from pious investors who prefer to conduct their financial affairs in a way that satisfies their religious tenets. Whether a particular transaction structure is shariah-compliant or not in such cases is simply a matter of the issuer persuading investors that a compelling authority on Islamic law has assessed the company’s arrangements as compliant. If investors regard the scholar or board who approved the company’s structure as compelling and authoritative, they feel comfortable investing, and that is that. The consequences of shortcomings in the shariah-compliance assessment process are largely limited to losing the confidence of present and perhaps future investors.

In some areas, however, particularly in the Arabian Gulf, Islamic law is incorporated into domestic law by royal decree or otherwise. Issuers and those dealing with them need to be concerned not only about their private view of the shariah-compliance of a transaction structure, but also about the public view of the government where the company’s assets and operations are located. Attempts to enforce a deal that such a government regards as non-compliant and hence illegal might undermine the ability to reach assets to satisfy the company’s obligations.

This state of affairs presented an opportunity for Dana Gas to forcibly restructure $700 million in bond (sukuk) debt, which as of May 2018 appeared to be on track to end successfully for Dana. Dana Gas began experiencing distress when buyers of its natural gas (Egypt and Iraqi Kurdistan) were slow to pay their substantial obligations to Dana. Looking for a way to reduce or restructure its own obligations, Dana Gas capitalized on a latent vulnerability in some of its shariah-compliant bonds.

The bond has been issued in a common shariah-compliant structure called mudarabah, a partnership arrangement in which investors were paid not fixed interest as a percentage of the loan, but rather a portion of the profit from management of Dana’s natural gas operations. The problem was that, though the deal had been called by the risk-sharing equity-investment title of partnership, at least part of the profit-sharing return had been guaranteed, effectively insulating the investors from risk. Practically if not nominally, this arrangement strained to the point of breaking the strict Islamic distinction between risk-based profit and guaranteed interest. Nonetheless, like any shariah-compliant investment vehicle, this one had been evaluated and declared valid by a reputable board of shariah scholar-specialists before issuance in 2007 and upon restructuring in 2012.

Though this vulnerable structure found widespread support in the Islamic finance world in 2007, at that same time the head of an influential Bahrain-based shariah-compliance body, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), had announced that debt instruments offering guaranteed returns were not shariah-compliant. Perhaps belatedly discovering this persuasive contrary opinion, or perhaps seizing on it, Dana Gas announced in mid-June 2017, shortly before the bonds were to mature in October 2017, that the $700 million obligations were illegal and unenforceable. Dana explained that it could make no further payments on these non-compliant bonds, inviting investors to exchange their instruments for compliant ones, offering a return less than half of that originally promised.

Even though the Dana bonds had been issued under English law, the conflict with the law of Dana’s home emirate of Sharjah would seriously complicate the situation. Investors enjoyed quick success in their efforts to have the bonds declared fully legal and valid under English law in London courts, but they faced a long, complicated, and uncertain future of litigating in Sharjah to find value against which a London pronouncement could be enforced. Any attempt to enforce a judgment against the company or its assets in the UAE would be stymied if the local courts viewed the obligations as invalid and unenforceable.

In light of this conflict, Dana Gas and its investors struck a deal that can only be viewed as an impressive victory for Dana’s shariah non-compliance gambit. Investors could choose to redeem their bonds at 90.5 percent of face value or roll them over for a combination of 20 percent immediate redemption and new, three-year bonds paying a future return of 4 percent, rather than the average 8 percent profit capitalized from the original bonds.

Dana asserted that the new bonds had been legally verified as unquestionably shariah-complaint, but one wonders if investors will be once bitten, twice shy. Are there no contrary opinions waiting to be discovered on the eve of these new bonds’ maturities, and might not new opinions be issued between now and then? It may be that Dana’s situation is unique, in that its assets were located in a jurisdiction that supported its retroactive reevaluation of Islamic law. The episode is a reminder in any event that risk evaluation in Islamic finance is a far more complex and multivariate question than many investors have perceived.

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Jason Kilborn

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

Jason Kilborn
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