A case will have far reaching consequences for future of Islamic finance industry.
Last week Abu Dhabi listed Dana Gas (symbol: DANA:UH) made the headlines by announcing that its own Islamic bonds are unlawful and tried to force the investors to exchange the existing bonds with a new lower coupon bond. I was debating with myself whether to title the post “Too cute by half” or “The Curious Case”. For now, I have decided to go with the latter as Dana Gas seems to have the upper hand at the moment.
I was a firm believer in Islamic Finance. I still am… but not in the manner it is practiced right now. Having worked in Islamic Finance for almost 10 years, I have come to the conclusion that Islamic Finance structure as prevalent today is far from its ethos. My manager at one of the previous institutions that I worked for used to call such structures as “wrapper structures” e.g. an investment bank would take a conventional banking transaction and will wrap it inside a Islamic legal structures. The underlying transaction remains the same but it has Arabic sounding entities. For the purpose of this post, I will use Islamic Finance and Sharia Compliant Finance interchangeably.
Islamic Finance is said to be a $2 trillion industry and everyone wants a piece of this action. All it takes for a transaction to qualify as shariah compliant is a fatwa from a scholar. The biggest culprits in getting most doubtful transactions certified as sharia compliant have been conventional banks and bankers who have made their careers in conventional banks. Having honed their skills in regulatory arbitrage, tax arbitrage and risk arbitrage, they approach sharia compliant transactions the same way__ what I like to call__ carry out “Sharia arbitrage” i.e. have enough pass through Special Purpose Entities (SPEs) and trust structures in the transaction and then shop for a scholar who will stamp the structure as sharia compliant. It is not that fatwa shopping started with Islamic Finance. Muslims have been doing fatwa shopping for centuries but with the arrival of Islamic finance, we have started pushing the envelope.
Sukuk as an instrument is considered a replacement of convention fixed income bonds. Technically speaking, Sukuks are equity instruments_ they provide the sukuk holder with an ownership right in underlying tangible asset / project which may provide a fixed income like return i.e. operating leases. Over a short span of time, they have come to be thought of as by wider public as well as Islamic bankers as debt instruments. But no one is investing in Sukuk to take on the equity risk. So a few scholars, investment bankers and lawyers banged their heads together to come up with innovations which would make the Sukuk a fixed income like instrument (may be sharia noncompliant now) but when seen through the convoluted eyes of lawyers and scholars who devised the structure, ticks all the boxes of being a sharia compliant instrument.
Initially Sukuk were thought up as Sukuk Al Ijara i.e. Sukuk subscriber buys ownership stake into the underlying asset and enjoys the Ijara (rental) stream from the asset. But to reach out to a global investor base that don’t want to be saddled with ownership risk or when the Sukuk issuer doesn’t want to transfer the underlying assets to Sukuk subscribers, creative investment bankers and sharia scholars are there to help . They came up with many a structures including the one known as Sukuk Al Mudaraba wherein the underlying is an asset management business (Mudaraba) and the asset manager (Mudarib) promises the Sukuk buyers a guaranteed return. The transaction is haram (non sharia compliant sounded too soft) but sharia scholars advising the issuer came with an argument that if some tangible assets are introduced in the underlying business (say around 30% issue size) the transaction will become sharia compliant. Banks issue Sukuk all the time backed by debt receivables on the bank’s balance sheet. As if sale of debt isn’t controversial enough in sharia, these Sukuk are traded at premium or a discount which is clearly prohibited. This is where those 30% tangible assets come into play. The banks and investors pretend that premium/discount reflects the change in the value of the tangible assets.
Everyone has their favorite scholar who they go to get a sharia fatwa. Malaysia is pretty lax in terms of sharia compliance standards. Sukuks certified by Malaysian scholars do not find acceptability in Middle East unless the local scholars have had seconded their fatwa. But it’s not as if Middle East has standardized sharia compliance. The transactions certified Sharia compliant in UAE aren’t automatically accepted by other GCC investors as UAE issuers are known to issue Sukuk against non-compliant businesses but would introduce certain “carve outs” in Sukuk documents that is supposed to “ring fence” sharia non-compliant income. When participating in sharia compliant syndicate transactions, we used to call banks in UAE as “Sharia Lite” as they were known to be paying lip service to sharia compliance. UAE banks were also the largest underwriters of conventional bank’s Sukuk issuances. We wondered how can a conventional bank issue Sukuk but lo and behold, UAE banks had structured the underlying assets in Sukuk to be assets of the Islamic financing operations of the conventional banks properly “ring fenced”. Yeah right.
Now coming to Dana Gas transaction, it is very surprising that it took this long for any issuer to take this way out. The transaction is based on Sukuk Al Mudaraba which was already called haram (prohibited) by Taqi Usmani in 2008 (google “Sukuk and Contemporary Applications” by Taqi Usmani). Yet most of the Sukuk issues continue to be based on Sukuk Al Mudaraba structure as they are closest to the conventional fixed income bonds and consequently as far away from sharia compliance as possible.
Dana Gas claims their Sukuk has become sharia noncompliant now. I am surprised as being a Sukuk Al Mudaraba, it was unislamic to begin with. Dana Gas has played it smart by taking the case to Sharjah Court and not DIFC or UK courts. I think the court has two options for judgment:
- that Sukuk is unislamic (I don’t whether that comes in Court’s jurisdiction) but since Dana Gas entered an agreement with the investors, it should abide by that agreement as it is per sharia to follow through an agreement if it was signed freely and openly.
- Sukuk is unislamic and thereby Dana Gas isn’t obligated to pay
It will take some time for the case to run through the court system. If investors don’t reach a settlement before that, my guess is court’s judgment will be nearer to the first option. Which is fine for conventional investors such as Blackrock (as it was reported that Blackrock is an investor). However, for Sharia compliant investors this will be troubling. As the income stream from Sukuk will now be deemed unislamic, they will no longer be able to record the future profit distributions as income. For them, the best option will be to sell it to conventional investors and recover their principal.
Will this change the market for future issues? Probably, conventional investors wouldn’t want to take on sharia risk anymore which depends on the whims of scholars and is impossible to quantify. Sukuk already had a hard time getting acceptance in the international market and as a result of this event, future Sukuk will only be marketed to local investors provided local investors have any more appetite for such a product.