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Operations Management Best Practice

Islamic Finance Litigation

by Kilian Bälz

Executive Summary

  • Islamic financing agreements raise particular issues in the field of litigation and enforcement, in particular if borrowers invoke shariah principles to argue that an agreement was contrary to shariah law and is void as a consequence.

  • English courts have heard several cases and developed the general principle that a contract should be governed by the contractual agreement and applicable state law; they are not prepared to validate a choice of shariah law, inasmuch as it is “too vague.”

  • Banks have reacted to the spread of Islamic finance litigation by including “waiver of shariah defense” clauses in loan agreements and specific risk factors on shariah-compliance in capital market documents.

  • The current situation where shariah-compliance cannot be enforced in court can be seen to contradict the spirit of Islamic finance, which is based on an application of shariah rules to financial transactions.

  • New centers for dispute resolution have emerged that specialize in Islamic financing transactions. These bring together expertise in alternative dispute resolution and shariah law.

  • In arbitration, shariah law may be given preference over state law. This means that an arbitration tribunal can be a suitable forum in which to enforce the shariah promise.

Introduction

This article deals with litigation-related aspects of Islamic financing transactions. It focuses on those enforcement and litigation issues that arise specifically from the shariah-compliant nature of a certain transaction—so-called shariah risk. It is based on an analysis of relevant court precedents, and provides concrete suggestions of what to bear in mind when drafting shariah-compliant agreements and capital market documents. It concludes with some reflections on whether it makes sense to set up specialized dispute review bodies for Islamic financing transactions.

When Things Go Wrong

Islamic finance litigation? Disputes arising out of shariah-compliant agreements were unheard of in the early days of Islamic finance. Banking transactions, by their very nature, are discrete, and as long as Islamic finance was confined to a small community there was no need to enforce contractual arrangements in court. The growth of Islamic finance, however, and the globalization of the Islamic finance industry, has transformed the industry from a community-based endeavor into a global business. In the global market, lenders default and banks sue and enforce. Islamic finance has become part of the global banking industry, and Islamic finance litigation is a side effect thereof.

Litigation based on or relating to Islamic financing transactions can raise intricate issues, in particular if debtors defend invoking shariah principles, in arguing that a contract or certain clauses are void as they do not comply with Islamic law (so-called shariah defenses). The spread and sophistication of the Islamic finance industry, as well as Islamic financial innovations, some of them based on controversial interpretations of the shariah, have further contributed to uncertainty in the Islamic finance community. Over the last decade, however, the courts have developed certain principles of how to deal with Islamic finance cases.

Case Study

The Beximco Case

Shamil Bank of Bahrain v Beximco Pharmaceuticals Ltd and Others (known as the Beximco Case), heard by the London Court of Appeal in 2004, is still considered to be a landmark judgment in the field of Islamic finance litigation. The underlying facts can be summarized as follows. An Islamic bank based in Bahrain had entered into a murabahah financing agreement with a South Asian borrower. The borrower did not repay the loan as scheduled. Negotiations over restructuring the debt all remained without success. The bank finally called in the loan and brought a claim in the English courts, which the loan agreement determined as venue. The defendant argued, inter alia, that the transaction was altogether void, alleging that it was only dressed up as an Islamic murabahah agreement, but was in fact an interest-bearing loan. Thus it violated the Islamic prohibition of riba. The lack of shariah compliance, the borrower argued, made the agreement altogether unenforceable, and freed the borrower from his obligation to repay.

Assuming that the allegation was correct, and that the particular agreement in fact was contrary to Islamic law (which, however, is difficult to determine on the basis of the facts as reported in the case), this raises the question of whether a state court will enforce the shariah promise given by an Islamic bank, pursuant to which a particular transaction is compliant with Islamic principles. In addition, if a state court should get involved with shariah issues, who then will determine the content of the shariah rules? This is a difficult issue that touches fundamental questions, such as the competence of state courts to opine on religious matters and the protection of parties to contractual promises to the extent that such promises are of a nonpecuniary nature.

In the Beximco Case the agreement provided that “Subject to the Principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with the law of England.” This clause (“Subject to”) can well be read to imply that shariah rules are meant to override principles of English law, at least to the extent that the latter are not mandatory. Such an approach may be consistent with the intentions of the parties to enter into an Islamic transaction that is distinct from a conventional one. The Court of Appeal nevertheless declined to validate the shariah rules referred to in the agreement: a choice of law, the Court held, is only valid if it refers to the law of a particular state, or at least a body of black letter rules that are incorporated in the agreement. The “Principles of the Glorious Shariah,” however, were too vague to be applied by a state court. The parties will not have intended to entrust a state court with the interpretation of religious principles, the Court continued. In view of this, the Court ruled on the basis of the provisions of the agreement and did not hear the shariah arguments put forth by the defendant—altogether a pragmatic approach, one can say, upholding the validity of the agreement for the benefit of the lending bank.

Whether this approach is fully consistent with the spirit of Islamic finance, however, is a different matter. On the one hand, a customer chooses an Islamic bank because of the shariah promise, meaning that he or she can expect transactions to comply with Islamic principles. This may suggest that the customer’s expectation should be legally protected too, and that the shariah promise should, at least to a certain extent, be enforceable in court. After all, Islamic law has been applied for centuries as the common law in North Africa, the Middle East, and large parts of South Asia. This suggests that it cannot be impossible for a court to apply Islamic legal rules. On the other hand, in Islamic finance the reference to shariah principles is more an ethical guideline than an undertaking that these rules are to be observed as hard law. Whereas normally in financing transactions the function of the law is to make an agreement enforceable, the reference to shariah principles in Islamic finance serves to express a religious orientation, to make the transaction compliant with a body of rules that, in most jurisdictions where Islamic banks operate, are not enforced by the state. Neither in the Islamic finance hubs of Dubai or Kuala Lumpur, nor in London, New York, Luxembourg, or Geneva, is the prohibition of riba part of state law.

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Further reading

Book:

  • Bälz, Kilian. “Islamic financing transactions in European courts.” In S. Nazim Ali (ed). Islamic Finance: Current Legal and Regulatory Issues. Cambridge, MA: Harvard Law School, Islamic Finance Project, 2005; pp. 61–75.

Report:

  • Bälz, Kilian. “Sharia risk? How Islamic finance has transformed Islamic contract law.” ILSP working paper. Harvard Law School, September 2008.

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