Islamic finance is at an interesting crossroad in its young history and is facing an array of new challenges. Several hot issues are occupying Islamic finance’s leadership, from contract interpretation to global dispute resolution to restructuring-related concerns. In concert with Reuters’ Islamic Finance Summit, Westlaw Business brought together a distinguished roundtable of leading lights in Islamic finance to discuss some of these legal issues driving the industry.

The themes discussed ran the gamut, with a spirited give-and-take covering (but not limited to): the causes and consequences of the Dubai World/Nakheel controversy; structuring challenges for Islamic finance instruments; regulatory limitations; the role of the Shariah within Islamic finance, and a great deal more.

A panel of eminent experts comprising the Roundtable included one regulator (Mr. Peter Casey, Director, Policy & Head of Islamic Finance for the Dubai Financial Services Authority, or DFSA); two Shariah scholars (Dr. Hussein Hamid Hasan (appearing in his private capacity) and Mr. Muddassir Siddiqui, who also heads the Islamic finance Middle East practice for the law firm of Denton, Wilde & Sapte); and four Islamic finance attorneys (in alphabetical order, Messrs. Jawad A. Ali of King & Spalding; Michael J.T. McMillen of Fulbright & Jaworski; Anzal Mohammed of Allen & Overy; and Richard O’Callaghan of Linklaters). Ms. Shaheen Pasha, a Reuters Islamic finance journalist, joined by Westlaw Business Legal Editor Jack Bunker, moderated the discussion.*

The discussion kicked off with a series of questions directed at the highest profile story in Islamic finance, the Dubai World restructuring and the underlying Nakheel sukuk at the epicenter of the controversy. Although a prima facie Islamic instrument, the sukuk’s risk stemmed only in part from its structure; manifold credit issues generally have dramatically compromised the issuance as well. Marketed as bonds (or Islamic bond equivalents), these sukuk (trust certificates) were issued using the ijara structure – the result of which was a complex, but Shariah-compliant securitization agreement.

In the case of Nakheel, the asset securitized was the revenue stream from leasehold rights for a 50 year term for various Dubai waterfront properties. Dubai World, as guarantor of Nakheel’s obligations, has endured an international public relations migraine since announcing in November 2009 that it would seek a debt standstill as part of a wider restructuring.

Excerpts of the Q&A follow:

“What was the confusion to the Nakheel deal? Was it an issue of the perception of Dubai rather than the reality of the offering?”

Jawad Ali: “I don’t think there was any misconception. If you look at the offering documents… if you look at the contracts I think it was clear that Nakheel was operating as a business enterprise, albeit owned by a holding company that is owned by the Dubai government.”

There may be “a number of people to blame… the government itself for not going out early when the debt was being incurred by Nakheel – and saying, ‘Hey, look, guys, the deal, just for the record, this is not backed by the government.’ That did not happen. The bankers … did not really go out of their way to say ‘legally speaking this is not backed by the government.’ They played with the impression. I think between the government, the people who were selling the instruments, [and] the sukuk, everybody kind of had a wink-wink understanding that this was backed by the government. Legally speaking, I don’t think that any of the law firms involved would have given an opinion saying that this is backed by the government.

Short of a contractual backing, or a guarantee of some sort, then it’s not backed by the government; the government is a shareholder and is liable to the extent of that shareholding, albeit also indirectly a second tier.”

Anzal Mohammed: “I don’t believe necessarily [the crisis] was an Islamic finance issue; in Nakheel, it’s very much a credit issue. Some of the concerns that were raised with that product would have been raised if Nakheel had issued a conventional bond with a guarantee from Dubai World. Because there were issues around sovereign immunity – to what extent could investors actually bring an action against Dubai World to the extent it failed.

[I]t’s unfortunate that because it was structured as a sukuk – there’ve been a number of other sukuk defaults . . . people have assumed the default is linked to the fact that it’s a Shariah-compliant product, when in all of those cases it was very much a credit issue.”

Richard O’Callaghan: “[T]here was an investor perception – at least previously – that [they would] have physical title to a saleable asset. But as we’ve recognized, the two worlds haven’t met yet in terms of real Shariah principles and what a typical debt capital markets investor would expect.”

Peter Casey: “I find it hard to believe [the investors] were not actually relying on [a whole set of cross-guarantees] rather than the underlying asset. Now perhaps they should have been relying; perhaps that is a lesson for the structuring, but in prudential terms, I think had some sukuk actually defaulted, I suspect most of the investors would have wanted to call the guarantees and those guarantees then translate into debt owed by the various entities including Dubai World itself…

[I]f you look at [various] sukuk, it was possible to count on your fingers and toes the number of investors who were holding those instruments and certainly initially, they were sold to large financial institutions for the most part and it doesn’t look as though they were much-traded thereafter—so they were not finding their way into the hands of small investors.

In that circumstance, I find it quite hard to believe that these institutions didn’t with their lawyers, read every page of the documentation.

Now I do believe that they probably put more weight on the various guarantees than they did on being able to take control of the assets—should that be necessary. But that they didn’t read it, well, I find that really hard to believe, given that they had all the resources to do so.”

As the discussion moved around the table, a more pointed question became: “What are the lessons learned after [Dubai World and other] high-profile defaults?”

Dr. Hussein H. Hasan: “When you buy sukuk you should be careful [of] what you are paying [for].” The relationship is “not creditor/debtor. What I am trying to [emphasize is] that the question of sukuk ijara, lease sukuk, is not a loan . . .”

Muddassir Siddiqui: “The dialogue between lawyers and the sheik and the perception in the market… debtors, creditors, and bankruptcies – this is at the heart of Islamic finance. In every dispute . . . there are documents and conditions that are used for issuing sukuk, mudaraba . . . and there is the pure Shariah concept that this must be an asset and they are really purchasing assets.

Yet “sometimes, there is a mismatch between all these things where we look at the real documentation. … People who bought these sukuk, they were really not, most of them, interested in the asset.” Some of them did not even know “what the assets are, and in the Nakheel case, they were an asset in the form of a lease, which was the asset which was subleased from one entity to another, but not the land on the ground.”

“In the Shariah view, declared in February 2008, . . . this should be a real asset” and “the ownership should really pass to sukuk holders.” What we are seeing is that “it doesn’t happen [that way], – and therefore everyone is relying on purchase undertaking which makes it like a debt instrument.”

Michael McMillen: The Dubai World/Nakheel publicity “is demystifying” Islamic finance instruments. “It’s getting people to look at the essence of that instrument. So in a way, I think this was good – we knew it was going to happen at some point.” In “any market you’re going to have bankruptcies; you’re going to have problems, and it was just a matter of time.”

We at Westlaw Business Currents look forward to bringing you more excerpts from this valuable inside look at the structures, concepts and personalities driving Islamic finance.

*Every attempt has been made to preserve the speakers’ quotes verbatim, save where indicated by brackets or ellipses. Because of the structure of the roundtable, some quotes originally followed in different sequence within the discussion.