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Thursday, 14 May 2009

Legal wrangles to test Islamic banking

KUALA LUMPUR/MANAMA (Reuters) - A wave of debt defaults is set to hit Islamic banks as deals sour amid the global slowdown, testing the legal framework and stability of an industry already facing the biggest slump in its 30-year history.

The global economic downturn that punctured Islamic banking's growth bubble is also expected to bring many sharia financing structures under the legal microscope for the first time in centres such as Dubai, Bahrain and Malaysia.

But the expected increase in commercial disputes raises questions about whether conventional legal systems can deal with the highly specialised niche industry which has evolved into a $1 trillion industry handling government and corporate debt.

It could also test the foundations of the Islamic banking system, which the Asian Development Bank estimates is growing by 10-15 percent a year, but which some bankers and lawyers say still lacks a strong cohesive regulatory and legal framework.

Judges will have to weigh conventional law and sharia (Islamic law) used in contracts, and legal uncertainty over key contract provisions could hurt the industry's ability to bounce back when the global economy recovers.

"The industry will be watching to ensure any legal disputes are settled in a transparent manner which gives certainty to the contract terms entered into," said Davide Barzilai, a London-based Islamic finance lawyer with Norton Rose.

"If there a string of cases which result in contracts being overturned by the court for breach of sharia alone, then this could have a material impact on the growth of the industry."

Fuelled by a recent rush of oil money, Islamic bankers innovated on the basic financing model, taking it beyond sale and profit-sharing contracts to more complex derivatives which are harder for courts to deal with.

Islam's rules on transparency kept sharia banks from subprime mortgage loans that mauled Western banks, but their vast exposure to the property sector, especially in the Gulf, is taking a toll as global real estate markets slide.

Gulf Arab companies deemed most vulnerable to the downturn include large United Arab Emirates (UAE) real estate developers, such as Dubai-listed Islamic mortgage firms Amlak AMLK.DU and Tamweel TAML.DU.


Defaults and litigation are expected to jump as the ailing world economy, tough financial markets and stalled projects make it harder for firms to repay banks and asset values plummet.

Over half of the residential and commercial property projects due for completion in Dubai between 2009 and 2012 have been cancelled or suspended, Jones Lang LaSalle said in March.

But Islamic banking's legal framework is as fragmented as other aspects of the industry, with little case law to guide judges. Many judges are also unskilled in sharia, and the relationship between Islamic and secular law is unclear.

"It's a contest between sharia law and common law," said Islamic banking lawyer Mohamad Illiayas.

"Cases have gone to court where there is a problem of conflicts and inconsistencies but the English courts have always ruled in favour of common law."

He cited a 2004 case involving Shamil Bank of Bahrain where an English court refused to apply sharia law to a murabaha contract (a popular contract of sale). The court said two systems of law cannot govern one contract.

In Malaysia, home to the world's top Islamic bond market, only a handful of cases have come before the high courts in almost three decades, with most involving basic home loan cases.

Judges' expertise has been in focus after some courts questioned the validity of the bai bithaman ajil contract, a type of deferred payment sale, sowing confusion in the industry.

The contract was recently declared valid by an appellate court, but Malaysian authorities now plan to force judges to refer to national sharia advisers when handling Islamic finance cases.

"Looking purely at the formal qualifications and experience of judges, it would be hard to expect them to be fully aware of all the relevant intricacies of Islamic finance," said Megat Hizaini Hassan, an Islamic finance lawyer with Zaid Ibrahim.

In the Gulf Arab region, law firms have started to build up Islamic finance expertise but their skills is almost exclusively limited to consulting banks on deal structures and drafting contracts, and most have yet to see a court room from inside.

Islamic finance disputes can be referred to arbitration by specialists but many Malaysian cases still go court. In Bahrain, such cases have mostly gone to dispute resolution committees staffed by judges and specialised central bank officials.

But arbitration is not problem-free, either.

"We will still have to resort to common law at one stage or the other," said Illiayas. "Even after the arbitration award is given, if you want to enforce that award you still have to go to court."

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