Islamic shari'a finance in trouble

Since the economic downturn, fans of Islamic shari'a-compatible investments have been touting that their financial institutions are immune to the problems that have plagued Western banks, and that their funds are inherently more secure.

Well, you can flush that idea down the toilet:

For the first time since the initial issuance of a Sukuk bond in Malaysia in 2001, cases of payments being defaulted on have occurred in the USA, Kuwait, and Malaysia. There are five legal cases that involve the default on payment of Sukuk [so far]. There are also some Sukuk cases that involve technical failures that are expected to develop into cases of legal default at any moment. Therefore the legal risk surrounding this type of [financial] bond – that falls under the provisions of Islamic Shariaa law – is beginning to become apparent.

And another article:

KUALA LUMPUR, July 16 — First defaults of sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the US$1 trillion (RM3.5 trillion) Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait’s Investment Dar said in May it had defaulted on a US$100 million sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

“Secular, non-Sharia courts upholding those structures are more likely to consider sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders,” said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

So the idea that investors in Islamic bonds have real assets in their name, as opposed to paper, is pretty much a fiction.(This also means that the idea that the investors in these bonds are not receiving interest is probably also a fiction, but I am neither a financial nor a shari'a expert.)