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Borrowers seeking to avoid repayment by asserting Shariah non-compliance make Islamic finance more risky, thereby raising its cost, and also damage its reputation.

Sadly, people who have borrowed money often seek to avoid paying it back.

The most common reason is that the borrower has fallen on hard times and cannot pay it back. Ultimately, in most countries this will lead to formal bankruptcy proceeings. However some countries have insolvency systems that operate very slowly, and can be very favourable to borrowers.

The other common excuse for refusing to pay back is to assert that there is some defect in the financial contract, and that this defect obviates the need to make repayment.

Such contractual defect claims happen from time to time in conventional finance.

In Islamic finance, as well as the many categories of defect asserted in conventional finance, there is another type of defect that the receiver of finance (most conveiently referred to as a "borrower" although contractually Islamic finance normally does not involve loans as such) may assert.

That is to contend that the arrangements are not Shariah compliant, and that this precludes the borrower making the payments the contract requires.

I always consider such late assertions of Shariah non-compliance to be disingenuous, since in all cases the borrower will have originally satisfied itself, when entering into the contracts, that the arrangements were Shariah compliant. Non-compliance is only asserted when the borrower does not want to pay.

I made this the theme of my July column in Islamic Finance News, which can be read below.

To grow Islamic finance, we need to minimise contractual uncertainty

Reliable and efficient contract enforcement is essential for a successful economy. When you compare countries, those which have courts with independent, well trained, and non-corrupt judiciaries are on average much more successful economically than those countries which do not. That is why the World Bank in its annual "Doing Business" report has a section on enforcing contracts, and gives a score for every country covered in the survey.

Obviously, anything which creates uncertainty regarding the enforceability of contracts is undesirable. Sadly, one of the factors which from time to time creates uncertainty in the enforceability of Islamic finance contracts is the assertion of non-compliance with Shariah.

The 2004 case of Beximco Pharmaceuticals Ltd and others v Shamil Bank of Bahrain EC illustrates the issues very well. The Bangladesh based company Beximco obtained finance of over $40 million from a bank in Bahrain using murabaha contracts. However, when the time came for Beximco to pay, it asserted that the contracts used were not Shariah compliant and that accordingly it was not required to pay Shamil Bank.

Fortunately, the contracts were written under English law. The English courts had no difficulty concluding that Beximco should pay.

The case is famous because the precise words used in the clause which specified the applicable law were “Subject to the principles of the Glorious Sharia’a, this Agreement shall be governed by and construed in accordance with the laws of England.”

The High Court and the Court of Appeal concluded that Shariah was not a separate system of law applicable to this contract and that the reference to Shariah should properly be ignored. The key point is that without the words referring to Shariah, the matter would probably never have gone to court since Beximco would have had no case to argue to seek to avoid payment.

Last month, Islamic Finance News reported that the Sharjah based company Dana Gas was asserting that its sukuk, governed by UAE law, was no longer Shariah compliant and therefore it did not have to pay the sukuk holders. Instead, it would restructure the sukuk. (The proposed restructured terms are significantly worse for sukuk investors than the original terms.)

This article of course cannot comment on the merits of the Dana Gas case.

However, I believe that Islamic finance practice should seek to maximise contractual certainty and seek to eliminate the risk of either party subsequently asserting Shariah non-compliance. The following would help:

1. For international contracts, such as cross-border sukuk, always using English law as this is much better developed than the law of most if not all Muslim majority countries. (Obviously, purely domestic transactions will normally be governed by the domestic law of the country concerned.)
2. To avoid Beximco type arguments, the contractual documents should not refer to compliance with Shariah, except as indicated below.
3. Each party to the contract should affirm in the contract that it has taken appropriate Shariah advice, is satisfied that the contract is Shariah compliant, and explicitly waive any future right to assert Shariah non-compliance.
4. To the extent that either party is concerned that the future conduct of the other party may cause the contract to become Shariah non-compliant, it should ask for explicit undertakings in the contract regarding the other party’s conduct. (e.g. “the other party will not sell alcohol.”) However, these undertakings should be drafted in normal legal language, and should not mention Shariah.

If this can become standard practice, arguments in cases such as Beximco and Dana Gas should disappear.