Dana Gas’ ongoing ‘unlawful’ sukuk debate is not a first, or even the second such case for the Islamic finance industry but the good news is that cases like these are in the process of being addressed by changes to the Shariah governance system.
UAE’s Dana Gas is an oil and gas producer that has long struggled to generate cash from receivables owed to it in Egypt and Iraq. With an upcoming $700 million sukuk maturing on Oct 31, it is seeking to restructure the terms of its obligations to lower its costs, reduce the effect on shareholders and push out the maturity date.
This is not the first time Dana Gas is restructuring a sukuk, having been through the same process in 2013 for much the same reasons. During that time it refinanced its maturing sukuk privately with the sukuk holders.
Its current case, however, is different. The company began restructuring discussions with sukuk holders in May, then about a month later on Jun 13, it declared the sukuk was not Shariah-compliant. Dana Gas is now proposing to ‘swap’ its ‘unlawful’ sukuk with new instruments carrying lower profit rates for its investors.
This is not the first time the Islamic finance industry is faced with ‘unlawful’ sukuk.
TAQI USMANI ’85 PCT’
In late 2007, Sheikh Taqi Usmani, a prominent Shariah scholar, argued that about 85 percent of existing sukuk were not Shariah-compliant because they had a promise to pay back principal at maturity, when they should offer variable returns.
Following a period of uncertainty where sukuk issuance dropped, which was not helped by the oncoming global financial crisis, standards-setting body the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) clarified its position on redemption features.
AAOIFI’s position included a prohibition of the most controversial examples flagged by Sheikh Usmani and gave clarity around ijarah sukuk’s redemption feature.
The ijarah structure supplanted the mudarabah and musharakah structures, which were most affected by the AAOIFI ruling, as the go-to structure for issuers.
The outcome of the process was increased clarity about what was viewed as acceptable and what was not but the length of time needed to arrive at agreement left a gap from Nov 2007 to Mar 2008 when uncertainty ruled the market.
A year after the AAOIFI ruling on sukuk redemption features, another dispute emerged about the standards for Shariah compliance used by sukuk issuers. This time, it came from a market participant, not a Shariah scholar.
In 2009, Kuwaiti financial firm The Investment Dar faced repayment of a wakalah, or agency, deposit received from Beirut-based Blom Bank at the same time it defaulted on its sukuk (wrangling around the restructuring of obligations of The Investment Dar remains ongoing).
The Investment Dar’s inability to repay the wakalah led to a lawsuit that was heard in an English court. The transaction, like Dana Gas’ sukuk, was subject to English law.
The Investment Dar’s argument, mirroring what is reported about Dana Gas’ position, was that the transaction was not Shariah-compliant and thus was invalid.
The Investment Dar, unlike Dana Gas, was a financial institution and was specifically organized such that it could only undertake Shariah-compliant activities. Despite an appeal by The Investment Dar’s Shariah board to the company to not argue it had acted outside of its Shariah-compliant mandate, the company pressed its case. The court took a skeptical view on the defense but allowed The Investment Dar to move to a full hearing on the condition that it repaid the principal.
The English courts, in accordance with the previous rulings including a dispute about repayment of a murabahah financing by Beximo Pharmaceuticals, did not rule on the Shariah compliance of the transaction. The Beximo case included a ruling that an Islamic finance transaction that included language about being subject to both English law and Shariah would be judged in accordance only with English law.
HOW WILL DANA GAS’ SUKUK BE TREATED?
The experience in previous cases offers a guide to how Dana Gas’ sukuk could eventually be treated.
It would be likely, for example, that an English court would not overturn a financing arrangement agreed to by both parties for Shariah non-compliance.
However, this ruling would be unlikely to be useful to creditors trying to enforce it on a company headquartered in the UAE with assets in Egypt and Iraq.
For creditors, any victory would likely be hollow with an unenforceable judgment from an English court that the disclosures highlighted with reference both to the non-automatic recognition of foreign judgments by UAE courts and the potential for courts in the UAE to invalidate contracts that included interest.
All of what precedes is a dour assessment for legal predictability in Islamic finance.
If institutions can avoid payment by retroactively declaring transactions as non-Shariah-compliant—in this case it would require a UAE court endorsing the argument—it would undermine investor confidence.
Dana Gas’ ongoing case, and indeed harking back to Sheikh Usmani’s 2007 critique of sukuk structures, continues to underline the Islamic finance industry’s need for stronger Shariah governance.
AAOIFI is preparing standards to govern national Shariah boards for Islamic financial transactions, which have worked well where they are applied in establishing a consistent Shariah governance framework and aiding with dispute resolution.
Many jurisdictions are in the process of appointing central, national Shariah boards, and after two years since the idea was first (publicly) mooted in the UAE, the government at the end of May approved a Higher Sharia Board for Banking and Finance to increase consistency of rulings around Shariah compliance.
The main purpose of these higher Shariah boards is to set ex ante standards and issue fatawa about what contractual structures are Shariah-compliant and which are not and carry the risk, if not mitigated, of supporting claims of old structure becoming non-compliant.
One way to avoid this risk is to form the national Shariah board with a commitment that all previously approved contracts remain valid if they were approved in a proper way.
That is, so long as an independent board follows AAOIFI standards for Shariah board governance at the time the contract was concluded, the Shariah basis would not be subject to challenge to justify non-execution of the terms of that contract.
Ultimately investors will get over whatever hesitation the Dana Gas situation creates but the strength of the industry’s commitment to improving governance structures, which appears strong, will make this a learning opportunity for Islamic finance.
Dana Gas’ case is scheduled to be heard in a Sharjah court on Dec 25.
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