Overcoming the Divergence Gap between Applicable State Law and Sharia Principles: Enhancing Clarity, Predictability and Enforceability in Islamic Finance Transactions Within Secular Jurisdictions

Abstract

With the emergence of Islamic finance, legal precepts of Islam gained momentum through voluntary adherence by market participants. Transactions are not governed by Islamic law as such. Rather they are structured within the framework of freedom of contract in a way that is coherent with Sharia principles. In absence of an authoritative judicial institution deciding on the Sharia conformity of a commercial transaction, individual Sharia scholars fill this gap. They interpret Islamic legal principles and exercise oversight of the products and operations of the Islamic finance industry. In Islamic finance transactions, there is frequently a dichotomy and tension between Sharia principles and perceptions underlying contractual agreements and their de jure qualification and treatment in secular jurisdictions. This paper investigates the divergence gap between Sharia precepts and the contractual design of Sukuk transactions as well as transparency issues under the German legal regime. Sukuk is taken pars pro toto for Islamic finance products. German law is chosen as case example within the circle of European civil law systems. One of the problematic issues is ownership status of Sukuk holders in sale-and-lease-back based Sukuk. Although, asset linkage is a major characteristic that distinguishes Sukuk from conventional bonds, the transfer of ownership in some sale based Sukuk structures is highly controversial not only from a Sharia perspective but also from a legal perspective. This is particularly the case when Sukuk transactions are structured in civil law legal systems where the common law concepts of trust and beneficial ownership are not recognized. The disengagement of Sukuk transactions from their underlying originating assets can be problematic for Sukuk holders in the event of a bankruptcy of the Obligor. The asymmetrical risk allocation between Sukuk issuer/obligor on the one side and the investor on the other may not only be problematic from an inner-Islamic point of view. In some cases this situation may also cause legal liability issues. Besides the issue of ownership status, some other terms and conditions of widespread Sukuk issues appear to be problematic with respect to legal transparency requirements on national and EU level. This paper suggests solutions to bridge the gap.

Keywords: Sukuk, ownership issues, trust, insolvency, transparency, legal enforcement, conflict of laws

JEL Classification: K11, K39, G33, G24