The demand for Islamic financial products in the Middle East, led by the Arabian Gulf countries, is increasing. There is also a tremendous concentration of high-net-worth individuals and family businesses whose collective wealth in the Arabian Gulf countries (comprising of the GCC alone) is estimated by Moody's to be over $1.3 trillion (Moody's Investors Service special report entitled 2007 Review & 2008 Outlook: Islamic Finance).

The development of the Islamic finance market in the Middle East is therefore not only an integral part of the development of the international finance market but also an area of interest to international banks, especially after the subprime crisis in the US. According to Moody's, the Islamic finance market has grown by approximately 15% in each of the past three years, partly as a result of the increased wealth of Islamic countries, which was driven by high oil prices. Islamic assets under global management are reported by McKenzie to reach around $1 trillion by 2010. Therefore, it is not unexpected for large international conventional banks and financial institutions, mostly from Europe, to take the initiative in structuring new Islamic finance products to serve their Middle Eastern clients or to increase their market share in the Islamic finance industry, in both cases targeting profit.

Sukuk (Islamic notes or bonds) are the fastest-growing segment of the Islamic finance market. The sukuk market grew more than 12 times in the last seven years from less than $500 million in 2001 to more than $60 billion in 2007 (a 71% increase, by $32.65 billion, compared to 2006, according to Moody's).

Standard & Poor's ratings service, in its 2008 report, expects the growth of the sukuk market to top the symbolic $100 billion mark in the next few years, fuelled by significant investment and financing needs, notably in countries of the Gulf and Asia. Islamic finance has also expanded its presence on the world map in more than 75 Muslim and non-Muslim countries so far. While the Islamic sukuk industry expands, shariah scholars and lawyers have started to revisit their opinions on sukuks, shariah and legal frameworks, indicating that changes are required in the direction of the industry. Such changes are aimed at facilitating the growth of sukuk and enhancing the protection of investors.

New restrictions on GCC sukuk

There are 14 ways to structure sukuk, according to the Accounting and Auditing Organisation for Islamic Financial Institutions (Aaoifi). Sukuk al-musharaka (partnership sukuk) remains the dominant sukuk structure, with $12.9 billion issued in the first quarter of 2008, closely followed by sukuk al-ijarah (leasing sukuk), with $10.13 billion issued. However, ijarah structures were more frequently used, with 54 deals compared to 22 issued for musharaka structures. Mudaraba sukuk (investment management sukuk) are preferable in the GCC because they provide the obligor with the flexibility to allocate different assets to the sukuk transactions from time to time during the sukuk term. It also suits large institutions that are in the form of corporate holding companies where the only assets they have are shares in subsidiaries.

On February 14 2008, as a result of the increasing concerns of shariah scholars in the region regarding the shariah-compliance of existing sukuk transactions, the shariah committee of Aaoifi issued a new fatwa (Islamic shariah opinion) on tradable sukuk. The new fatwa applies to any new sukuk issued after the date of the fatwa in order not to disturb existing sukuk transactions (avoiding dharar or harm to investors in existing sukuk). The number of sukuk transactions in existence before Aaoifi's new fatwa exceeded 119. However, the need to correct direction in accordance with the fatwa requires the industry to realise that riba (usury) is a problem. Indeed, investment bankers have been able to secure approvals of shariah scholars on many sukuk structures that in reality defeat the merits of shariah: sharing the risk, losses and profit. However, it was believed that Islamic finance would not operate and function properly in a conventional world and would keep correcting itself in the future towards a true sharing of pain and gain, towards true transactions as opposed to debt financing.

Aaoifi's 2008 fatwa has been acknowledged in the GCC market as a step in the right direction to correct wrong practices in the market.

Musharaka and mudaraba sukuk assets must be off the balance sheets of the issuer and obligor

While Aaoifi confirmed its established position that tradable sukuk must represent an ownership by the sukuk-holders of real assets (real properties or other assets), usufructs or services that may be owned and disposed in accordance with the law and shariah, with all rights and obligations related thereto, it requires the issuer of the sukuk to evidence the transfer of ownership of such assets from its own books.

This effectively means that the transaction underlying the sukuk cannot be viewed as a method of structuring a debt financing transaction but as a true transaction where the assets used to structure the sukuk must be taken off the balance sheet of the issuer. If the sukuk are issued by an independent special purpose vehicle, the sukuk cannot be acknowledged in the books of the obligor as a debt financing but as a sale of assets. While most of the issuers and obligors are aware of this requirement of Aaoifi, accountants and auditors still acknowledge a sukuk transaction as a debt financing transaction to avoid the negative impact of taking the sukuk's underlying assets off-balance sheet in the financials of the issuer and the obligors. This is especially critical where the general activities of the obligor are conventional and not shariah-compliant.

Conditions for securitisation of sukuk

In order for sukuk to be traded, the underlying sukuk assets should not represent debts for more than 30% of the principal amount of the sukuk. Aaoifi's new fatwa allowed the issuance of tradable sukuk to represent either receivables or debts for more than 30% of the principal amount of the sukuk subject to two conditions: (i) a trading or financial institution is either selling all of its assets or an independent portfolio that has its own legal and financial independency; and (ii) the receivables or debts are incidental parts of the real assets or usufructs being sold.

This part of the fatwa should encourage the securitisation of consumer finance receivables through issue of tradable sukuk. The market will soon witness strong securitisation transactions within the parameters laid down by Aaoifi.

No soft loans or shariah-structured financing by the issuer or the obligor to finance shortfalls in periodic profit distribution. Building reserves and/or payment on account are acceptable

Islamic finance is part of the global financial market. Therefore, investors (Muslim and non-Muslim) expect an agreed rate of return on their investments. In sukuk issued before February 2008, obligors were either obliged to finance to sukuk-holders any shortfall in the profit below the agreed rate of return by extending soft loans from the obligors themselves or by undertaking to obtain a shariah financing from shariah lenders. Aaoifi's fatwa is that such obligations on the issuer or the obligor are not permissible under shariah regardless of the structure of the sukuk, whether mudarabah (investment management), musharakah (partnership), or wakalah (investment agency).

Aaoifi's fatwa, however, confirmed that it is permissible to either: (i) establish a reserve to which any surplus profit in access of the agreed rate of return is allocated and such reserve can be used to pay any shortfall in the future. The only condition required to establish such reserve is that it should be: (i) clearly agreed upon in the sukuk documents and declared in the sukuk offering circular; (ii) the obligor makes a distribution of profit on account (to be off-set from future profit); or (iii) to obtain a project finance on the account of the sukuk -holders and without recourse to the obligor itself.

In addition to the above, shariah scholars in the region approved structures where the obligor undertakes to sell part of the sukuk assets at the market price to a third party to secure the cash required to make profit payments at the agreed rate of return, failing which the obligor itself undertakes to purchase.

On maturity or redemption of sukuk, no purchase undertaking at nominal value or sukuk principal amount but net value, market value, fair value or agreed purchase price

Obligors of sukuk issued before February 2008 entered into a purchase undertaking to purchase the sukuk assets on maturity of the sukuk or on an early redemption or dissolution event at the principal amount of the sukuk. This was made to guarantee capital to investors. This is, in effect, against the general shariah investment principles, where investors should share the risk of depreciation or loss of the investment as well as participating in the appreciation and profit made. Aaoifi's fatwa is that the obligor's obligation to purchase sukuk assets at the nominal value or principal amount of the sukuk is against shariah. This prohibition applies to mudarabah sukuk (investment management), musharakah sukuk (partnership) and wakalah sukuk (investment agency).

Aaoifi's fatwa confirmed that it is permissible to agree to purchase the sukuk assets at their net value, market value, fair market value or for a price to be agreed upon at the time of the purchase by the obligor.

Aaoifi also confirmed that in circumstances in which the obligor breaches the terms and conditions of the sukuk, or if it commit a default or negligence, it should be liable to repay the principal amount of the sukuk to sukuk-holders. However, this should not be considered, from a legal standpoint, as a guarantee but as a compensation obligation for which the obligor is liable.

The foregoing limitation does not apply if the assets of sukuk al-musharakah, al-mudarabah or al-wwakalah are leased by way of hire purchase (ijarah muntahiya bi`t-tamlik). In such a case, it is permissible for the obligor to agree to purchase these assets on maturity, redemption or dissolution for a price equal to the remaining and unpaid rental installments on the basis that such rentals represent the net value of the assets.

This new limitation on the obligor's ability to purchase the sukuk assets at the principal amount of the sukuk represents a real concern for bankers and investors, even though it complies with the shariah principle of sharing in loss and profit. It seems that it would take the market a while to start adhering to this limitation, which has never been raised before. The market saw a few medium-sized sukuk transactions being launched after Aaoifi revised its fatwa without adhering to such restriction. This may be a result of lack of awareness of the essence of the fatwa or the bankers' desire to close transactions using structures that were approved in the past. Increasing awareness among scholars regarding the ban on obligors purchasing sukuk assets at a pre-agreed fixed price should influence adherence to the new shariah standard.

Structuring sukuk al-musharakah, al-udarabah or al-wakalah, therefore, will become more sophisticated. The first ever Kuwaiti sukuk, expected to be launched before the end of 2008, is intended mainly to be in the form of a mudarabah sukuk. However, as a result of the limitation laid down by Aaoifi, the structure was amended to add a stop loss condition to the mudarabah where the mudarabah terminates as a result of a loss in the market value of the mudarabah sukuk assets below a certain amount. Another element of ijarah was added to the structure so that the rental payments and the purchase price of the assets leased back by the obligor interact with the residual value of the mudarabah sukuk so that the expected rate of return on investment and also capital is realised by the investors.

Adherence to the new shariah standard would also represent an issue in both exchangeable and convertible sukuk using mudarabah structures. Setting the redemption price at the exchange or conversion price is acceptable to shariah scholars as such prices fluctuate according to the market price of the underlying shares or securities. The issue arises only when the exchange or conversion price is required to be a minimum amount equivalent to the principal amount of the sukuk. Again, a stop loss clause and an enhancement of the structure by adding an ijarah sukuk to the mudarabah sukuk could be a solution.

It should be noted that the above solutions are only to be used as temporary solutions until the Islamic finance market is mature enough to accept the full sharing of loss and profit as a result of investors' awareness of shariah needs and adherence to the ethics of Islam.

On maturity or redemption of ijarah sukuk, purchase undertaking can be at nominal value or sukuk principal amount

Aaoifi declared that it is permissible for the lessee in a sukuk al-ijarah to agree to purchase the leased assets on maturity, redemption or dissolution for the principal amount of the sukuk provided that the lessee is not also an investment partner (shareek), investment manager (mudarib) or agent (wakeel). This would maintain the ijarah sukuk as a traditional way of structuring sukuk, where the obligor has sufficient assets to be leased.

Pre and post closing review of sukuk transactions by shariah scholars are mandatory

The market practice in most Islamic transactions until now has been that shariah scholars only review transaction structures and main terms in shariah documents. Aaoifi required shariah scholars, in addition to reviewing and approving the structure of sukuk transactions, to review and edit the transaction documents and contracts and to review and approve the way the transaction is implemented in practice and how the sukuk proceeds are invested.

While this part of the fatwa is put in mandatory language by Aaoifi, the market has perceived it as only a recommendation, given the shortage in shariah advisory services and the lack of a sufficient number of shariah scholars.

Legal implications for the GCC sukuk market

The Islamic sukuk market has its own fundamentals which differ from those applicable to a conventional finance market, such as transparency and clarity of rights and obligations to avoid gharar, prohibition on shifting a natural obligation of a party to the counterparty, no interest being generated against money but income from sukuk assets, sukuk proceeds having to be related to the purpose for which the funding is used and sukuk having to be backed by real underlying assets rather than simply paper derivatives. These distinct features of the Islamic finance and capital market, therefore, require establishment of a robust, interactive and sound regulatory and legal framework, which has yet to mature in the GCC market compared to developed markets in the west. Therefore, the vast majority of GCC sukuk transactions are governed by English law and issued from issuers that took special purpose vehicles to tax haven jurisdictions in the west. This was because of local restrictions in GCC countries on the size of the sukuk if they were issued directly by the obligor and the time required for the licensing process. Many such GCC sukuk were also listed in western markets such as the Professional Securities Market of the LSE. However, sukuk have their own specificities with respect to: (i) nature of risks; (ii) structures; (iii) documentation; (iv) legal opinions; (v) accounting and auditing standards; (vi) corporate governance standards; and (vii) tax issues that the western developed markets have yet to have a full understanding of. In addition, enforcing Islamic shariah in non-Muslim jurisdictions is still unclear. In 2004, the English Court of Appeal refused to enforce Islamic shariah as a choice of law in Shamil Bank of Bahrain v Beximco Pharmaceutical.

False or untrue transaction

One of the most pressing concerns of lawyers in the GCC relates to whether or not the legal transactions underlying sukuk structures are true. There is also a lack of court precedents in this regard. Under a civil law system, from which many of the Middle Eastern countries have inherited their laws, influenced in particular by the French code de napoleon, a "false or untrue transaction" is recognised. A false or untrue transaction is a legal transaction that appears to be in compliance with all local laws and regulations but, in reality, there is a hidden transaction meant by the parties which differs from the declared transaction. For example, a murabaha transaction that appears in the form of a sale and purchase contract where the seller purchases commodities from the market for a spot price, sells to the purchaser for a deferred price and then the purchaser sells the commodities on the market for spot cash is likely to be viewed by civil law courts as a finance transaction and not a true sale and purchase transaction. This determination falls within the jurisdiction of the court after reviewing all facts and circumstances of the case.

Whether or not a transaction is true is meant to protect creditors or right holders from false transactions made by their debtor to defeat their rights or jeopardise their interests. An example of this would be if a borrower owns assets and transfers such assets to a creditor under a sale contract and leases back the assets with an option to purchase the assets back after a period of time. Even if title to such assets is officially transferred and registered in a central registration system of the jurisdiction, the court still has the power to rescind the asset transfer and order registration of a mortgage on the assets instead. This seems to be in contradiction of Aaofi's 2008 standard requesting sukuk assets to be transferred off the balance sheet of the issuer or the obligor. However, this is mitigated by an exception in civil law which provides that in cases of contracting interests among creditors as a result of a group of creditors requiring enforcement of the apparent contract and another group of creditors requiring the court to declare that the apparent transaction is false and untrue, the court is obliged to prefer the group of creditors requesting enforcement of the apparent contract (which is in reality is false and untrue) and would acknowledge the untrue transaction in such a case.

As such, lawyers in the GCC usually decline to provide any legal assessment of whether a shariah transaction is true and often provide a reservation that expressly excludes opinion on this specific point.

Recognition of shariah rules

Bankers and lawyers outside the GCC are often under the impression that laws in GCC countries, other than Saudi Arabia, fully apply shariah rules. While constitutions of GCC countries provide that Islam is the main source of legislation, legal systems in such GCC countries do not fully comply with Islamic shariah. There are provisions in local laws that permit the charging of interest in loans and interest delay. There are various court precedents issued by Egyptian courts and courts in the GCC influenced by Egyptian precedents which confirm that in order for the court to apply shariah rules, such court must have an authorisation either by law or by the agreement of the litigants, regardless of the general reference in the constitution that Islam is the main source of legislation.

For example, according to Article 1 of Kuwaiti Civil Law 67 of 1980, the court is required to apply the express and implied meanings of the laws. In the absence of such laws, the court should rule in accordance with the customs. Where there are no established customs, the court should apply justice at its own discretion, guided by the rules of Islamic shariah most consistent with the prevailing facts and interests of the State of Kuwait.

A key fact relating to the application of shariah rules is that the courts of the GCC, unlike western courts, interpret shariah without seeking the assistance of shariah scholars. In practice, they can rely upon scholars' published opinions in reference books and articles. A litigant may also ask the court to listen to a witness statement by a shariah expert, which is not binding in court.

Enforcement of foreign court judgments and arbitral awards

Due to the cross-border nature of sukuk issued for GCC obligors, most of the sukuk documents, following conventional financial documentation, provide for the choice of English law and English courts jurisdictions.

While the choice of English law does not represent an issue for GCC laws, most of the GCC countries, including Kuwait, require a treaty for the enforceability of a foreign court's judgment. There is no treaty between Kuwait and the UK that affords the reciprocal treatment. In 2005, the Kuwaiti Court of Cassation changed its position regarding enforcement in Kuwait of a monetary judgment awarded by the UK House of Lords. The Kuwait Court of Cassation refused to enforce an English court's judgment in Kuwait on the grounds that the English courts do not afford reciprocal treatment to judgments issued by the Courts of Kuwait, contrary to what was decided in a precedent from 2004.

It should be noted that most of the countries of the Middle East, including Kuwait, are signatories to the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards of 1958. The recent practice of the Kuwaiti Court is that it declines to accept jurisdiction to review any dispute that is agreed by the parties in a valid arbitration clause to be subject to arbitration unless the defendant accepts or submits to the jurisdiction of Kuwaiti Courts or, expressly or implicitly, waived its right to revert to arbitration. Declining jurisdiction by local courts in GCC countries in favour of arbitration does not exist in cases of agreement to revert to foreign courts. As such, it is recommended to agree to international arbitration or a default choice to arbitrate before a foreign international arbitration tribunal, with an option to litigate before a foreign court. In selecting jurisdiction or arbitration, bankers should take into consideration not only the enforceability of foreign judgment or foreign arbitral awards but also the location of the assets of the obligor. It might be preferable and less time consuming to agree to an institutional arbitration in accordance with the rules of a foreign arbitration tribunal. This should secure a quicker enforcement of the arbitral award against the assets of the obligor, rather than spending the time required to obtain a final award (not open to appeal) in a foreign jurisdiction and then attempt to enforce the award by a new enforcement action against the obligor in the jurisdiction where its assets are located.

Author biographies

Sam Habbas Sam Habbas is a senior managing partner in Al-Sarraf & Al-Ruwayeh who oversees the firm's international department. He was born in 1958 and received his education at the University of Santa Clara, California (BA Honours, 1980) and at Boston College Law School, Massachusetts (Juris Doctorate, 1983). Sam's core area of practice is consultancy on financial and commercial matters and developing aspects of Kuwaiti law for foreign firms seeking to conduct business in the Middle East. He acts as lead counsel for several large multinational companies, both foreign and domestic. Sam has developed the firm's international department to the point of being the largest of its kind in Kuwait and one of the largest in the region. Sam was recently selected by Best Lawyers publication as being among the best lawyers in Kuwait in various areas of expertise. Hossam Abdullah Hossam Abdullah is a member with Al Sarraf & Al Ruwayeh, Kuwait. He was born in 1971 and received his LLB (1992) and Diploma in International Trade Law and Investment (1993, with honours) at Cairo University, his Diploma in Private Law (1996) at IARS-ALESCO and his LLM (1998) in International Business Law at Manchester University, UK. He has been admitted to the Egyptian Bar Association since 1993. Hossam has over 15 years of extensive legal experience in the corporate, banking and finance sectors, with an emphasis on structuring and handling Islamic finance transactions, debt and equity, capital markets, investment funds and mergers and acquisitions. He also has an in-depth knowledge of shariah principles and has worked on leading Islamic and conventional transactions in Kuwait, the Gulf Cooperation Council region and the US. Hossam has been recently selected by Best Lawyers publication as among the best lawyers in Kuwait in various areas of expertise. He is fluent in English and Arabic.