Amongst the gamut of issues revolving around the incorporation of Islamic finance into the mainstream economy, the question of jurisdictional law - whether civil or common - has cropped up more than once. NAZNEEN HALIM speaks to market experts who have structured transactions in various jurisdictions, and learns why some jurisdictions encounter more roadblocks than others.
You don’t have to be a legal expert to know that countries such as Indonesia and Saudi Arabia, which have been dubbed everything from sleeping giants to the next big thing, have had more difficulty issuing Sukuk than other jurisdictions such as Malaysia. Although market demand and business viability play a crucial role in the uptake and issuance of such structures, there is a more nagging reason behind the lag: and that is the law.
Aside from Malaysia, Singapore and the UK, amongst the countries which are dubbed as Islamic finance hotspots, most other booming Islamic finance markets are subject to the civil law code. Tax issues aside (which are quickly being remedied by regulators across the board) what makes civil law jurisdictions more complicated when dealing with Islamic finance transactions is the issue of trust.
The separation of legal title and beneficial title, which is recognized under the English common law code, does not exist in a civil system, and this has caused a stymieing of Sukuk issuances originating from civil jurisdictions such as Indonesia. Hanim Hamzah (caricature below), partner at ZICOlaw (Zaid Ibrahim & Co) Indonesia explains: “In a typical Sukuk transaction, there is a transfer of the beneficial/equitable title (rather than a legal one). Issues such as tax, filing and registration do not crop up because you are only dealing with the beneficial title of the asset, resulting in the legal title staying with the owner.
But as civil law does not recognize trust structures and the separation of legal and beneficial interests, it makes the requirement to have tax neutralization even more important, because it is considered as a buy and sell or actual transfer. Indonesia needs to address this issue as a civil law country. For example in Japan, although it is a civil law jurisdiction, it is unique because it recognizes special purpose trusts. Japan has last year, passed the necessary laws to allow for Sukuk transactions using their special purpose trusts structures.”
Megat Hizaini Hassan (caricature right), Islamic finance partner at Allen & Gledhill, further elucidated that structures such as Sukuk Ijarah are harder to execute in civil legal systems due to the lack of distinction between legal and equitable interest ownership. “For Sukuk and risk-based structured financing, part of the structure involves the division between beneficial and legal ownership. In an Ijarah structure for instance, there needs to be an acquisition of the asset by the financier, and the leasing of the asset to the customer. And for Sukuk, it will be an acquisition of the asset by the Sukukholders and the leasing of the asset to the issuer or obligor. Although the financier acquires the asset for the purpose of the transaction, the legal title ownership remains with either the originator, customer or obligor, depending on the structure. If there is no concept of equitable interest or ownership, and there needs to be a transfer of the title to the financier, there may be an issue. This is especially true when dealing with real estate investment trusts and real estate properties.”
He added: “For Sukuk, regardless of structure, there has to be a trustee to act on behalf of the Sukukholders via an SPV, and there must be recognition of trust or otherwise it may be difficult to structure it based on the conventional method of structuring, for Islamic bonds.”
As an emerging market, the case of Islamic finance is constantly being evaluated and re-evaluated according to Shariah requirements, jurisdictional regulations, tax allowances and most of all, experience. Far from being infallible, the practice and structure of Islamic finance has seen its fair share of hiccups along the way, ranging from structures being dubbed unacceptable to the issue of asset-backed and asset-based securitization and its arguments in the court of law to ensure stakeholder protection.
Hanim reveals that for Islamic finance in particular, due to its constantly evolving nature, common law is perhaps more suitable due to its flexibility. Common law which allows Case law precedent where a decision is made on a case by case basis and based on the latest judgements on a particular issue bodes well for the Islamic finance cause. However, in civil law, statutes and regulations are the ultimate point of reference. “In civil law jurisdictions, case law are not automatically binding and so you have to really look at the statutes and regulations. There is no central registry or easily available information on what is decided in courts. Laws also need to change with time, and usually through the latest arguments and decisions made with circumstances and time. But with civil law, you have to submit new guidelines, amend the statute, and pass a new law to accommodate the business requirements and market conditions.”
Common law also allows for the inference to different tests, such as a reasonableness test, as opposed to civil law where everything is based on the agreement and what the parties have agreed to in the contract. In a profit sharing deal done under civil law for instance, there is hardly any flexibility in terms of allowances towards market conditions, which makes it all the more important for the contracts to be water-tight, and accommodative of circumstances, changes and market conditions and for the necessary amendments to be made at the time of its issuance.
Like any other transaction, although a deal may be governed by English law, and crosses into a civil law jurisdiction, it is affected by the rules of these multiple countries. The transaction, as contemplated by the contracts that are being entered into, is not just honored but enforced; and it is imperative to ensure that the deal does not violate the laws of different jurisdictions, as it will not be enforceable in the respective local courts if a violation occurs.
According to Jawad Ali, the managing partner of King & Spalding Middle East Offices and global deputy head of the firm’s Islamic finance practice, although most deals in the Gulf are governed by English law, they are also subject to the laws of the country where the investment or project is located. “If the transaction is in Saudi Arabia, or Kuwait or Abu Dhabi, in addition to it being governed by English law, it needs to be compliant with, and not in violation of the law of the land. For a Shariah compliant transaction, we need to adhere to the compliance aspect as well. Meaning in addition to the contracts being governed by the law that regulates them and not in violation with the laws of the land (if different than the governing law) , such contracts have to also be compliant with Islamic Shariah in accordance with the Fatwa that have been issued in connection with that particular transaction.”
Islamic finance lawyers, he adds, in particular those dealing with cross-border financings, need to constantly balance between Shariah compliance, the governing law and the law of the jurisdiction where the investment/project is located. In some jurisdictions, we also have to worry about and navigate the tax codes of these jurisdictions to make sure that the Shariah compliant structure didn’t render the transaction tax inefficient. “For instance, a deal could be legal pursuant to the laws of the jurisdictions and Shariah compliant but prohibitive from a tax point of view. Every international cross-border lawyer who is doing a Shariah compliant transactions needs to worry about Shariah compliance, and the law governing the contract, and the laws of each and every jurisdiction that the transaction crosses through. For instance, if part of the security package or assets is in Malaysia or Singapore, we need to consider the implication of these countries’ laws on the transaction and the security documents covering the Malaysian or Singaporean assets will likely be governed by the laws of these countries.
“Although you are opting to have the contracts governed by English law rather than the law of the particular country in the Gulf, it is important to ensure that the laws of the land are not violated. If there is a dispute, the judge will in most instances apply the law that governs the contrac , but judges will likely disregard clauses that violate the law of the land and not enforce these provisions. Lawyers need to ensure that the provisions of that contract that are governed by a law other than the law of the land does not specifically violate the regulation in that jurisdiction. Additionally, in the GCC countries, it’s not only about not violating the letter of the law, but if it is against public policy of that country, such provisions will be stricken off and disregarded or worse cause the entire contract to be null and void.”
In some cases with civil law, foreign ownership could also become an issue, and this is particularly prevalent in GCC countries, industry experts reveal: which is not exactly an ideal situation for jurisdictions looking to entice foreign investors and new issuers. Megat elucidates: “Over and above the issue of recognition of the trust concept, equitable interest, in many of the civil law jurisdictions, there are some issues with foreign ownership of the asset. If they want to enforce certain rights, securities, located in the civil law jurisdiction, they may have an issue with respect to such enforcement. Dubai in particular is governed by common law, while Saudi Arabia and most other GCC countries are governed by civil law. This will have an impact on the type of structure you want to do, and if the underlying assets involved might be caught by these restrictions, it will not work, such in the case of Sukuk.”
Jurisdictions such as Qatar, which are governed by civil law, have developed various methods of circumventing the issue in order to grow their Islamic finance industry. Qatar has done this by creating a hub which recognizes common law principles: the Qatar Financial Center. Indonesia has also passed a sovereign Sukuk law which recognizes separation of title. However, this currently only applies to sovereign issuances and not corporate - the market segment Islamic finance players in the country are looking to tap.
According to Hanim, the Indonesian Sovereign Sukuk law itself is not watertight and is subject to some disparity and arguments. “The Sovereign Sukuk Law introduces the concepts of SPV, separation of equitable interests, amongst others, without amending other laws of the country. Although a sovereign issuance, the risk of default is minimal, we need to look at how some of these concepts can be defended in a legal dispute or court action.”
Japan, also a unique case, passed its laws and regulations in November last year, to pave the way for Sukuk issuance by way of special purpose trust vehicles; but is relatively coy with its tactics. The regulators, including the tax authority, have allowed for tax exemptions on Sukuk within a two-year window closing in March 2013. According to market players, the reason behind this is to observe market appetite and demand for such structures before making it permanent.
Ultimately, it is the question of education and familiarity, and how governments intend to resolve these issues to successfully tap into the growing Islamic finance market. Once the regulators are familiar with these structures and see their viability from a business point of view, there is no doubt that the laws will evolve accordingly.