Islamic banking and finance disputes: the case for semi-secular arbitration (Part 1)

This blog discusses the resolution of Islamic banking and finance disputes in a modern world of dispute resolution, in which litigation and arbitration as the main contentious forms of dispute resolution contend for taking prime position before any other form of dispute resolution. Given the high degree of specialty required in the resolution of disputes arising from more modern complex financial products, arbitration has more recently moved to the fore in this area of practice. This trend has also been strengthened by an increased offering of Islamic finance products, which in turn has spurred the need for Shari’a-compliant dispute resolution.

This blog is divided into two parts. Part 1 provides some background to dispute resolution in the banking and finance sector, highlighting in particular the apparent inaptitude of conventional dispute fora, such as the courts, to deal with Islamic finance disputes adequately. Part 2 will address how arbitration as an alternative form of dispute resolution can assist in providing Shari’a-compliant solutions where conventional dispute resolution through the courts fails. In doing so, it makes the case for semi-secular arbitration, a form of arbitration that combines Islamic and secular elements to ensure a Shari’a-compliant outcome.

Islamic finance versus conventional banking

Islamic finance as an alternative to conventional banking and finance has grown exponentially over the past two to three decades. The Islamic finance market measures multiple trillions of USD today. It offers crisis-proof investment products that appeal to both Muslims and non-Muslims alike and have a significant non-Muslim take-up. Some jurisdictions (for example, the UAE, UK, France, Malaysia and Singapore) have been trying to attract Islamic finance investments on a grander scale, through adaptation of their banking facilities and by advertising themselves as global or regional centers for Islamic finance. Western jurisdictions in particular (for example, UK/London and US/New York) have been trying to extend their existing dominance as a jurisdiction of choice for conventional banking disputes to disputes arising from Islamic finance products, English and New York law being the preferred governing law of international banking and finance contracts.

The compliance problem and the Shari’a risk

Islamic finance products must be halal (permissible and in compliance with the Islamic Shari’a), as opposed to haram (prohibited). As such, they must not violate prohibitions of riba (interest or excessive gain), gharar (uncertainty) and maysir (gambling or speculation) and are based on the axiom of profit and loss sharing. Standard products that are Shari’a-compliant include morabaha (cost-plus financing), mudaraba (trust financing) and ijara (leasing).

To preserve their compatibility with the Shari’a, Islamic finance products must comply with the basic Islamic law requirements and hence remain Shari’a-compliant over their entire life-cycle. To ensure compliance at the beginning of an investment cycle, Islamic finance contracts are routinely examined and approved as Shari’a-compliant by a corporate Shari’a board. The compliance requirement extends to any dispute resolution process that ensues from a dispute arising from an Islamic finance agreement in that both the process itself and the outcome must be Shari’a-compliant.

Non-compliance poses a Shari’a risk, that is, the risk that one of the parties to the Islamic finance contract or to the dispute arising from it argues the invalidity of the contract or dispute resolution process by virtue of its failure to comply with the Shari’a, a risk that is aggravated by the absence of a codified body of Islamic Shari’a. This, in turn, may raise enforcement issues with respect to:

  • The disputed Islamic finance contract.
  • The resultant court judgment or arbitral award (where, for example, the enforcing court in the target jurisdiction equates a violation of the Islamic Shari’a to a violation of public policy, for example, Article 37, Riyadh Convention; Article 2, GCC Convention; Article V, New York Convention), combined with a risk of nullification.

To mitigate the Shari’a risk, parties are free to contract into:

  • Shari’a-compliant dispute resolution.
  • A dispute resolution forum that is likely to comply with Shari’a law requirements (in both substance and form/procedure).
  • An enforceable governing law clause that ensures application of the Islamic Shari’a.
  • A waiver of the Shari’a defence (albeit possibly not enforceable).

Litigating Islamic finance disputes: the problem

Internationally, the courts of a few regionally and globally leading jurisdictions have been the common forum for dispute resolution for conventional banking and by extension for Islamic finance disputes (compare, in particular, the availability of summary judgments and legal certainty, lowering credit risk for financial institutions). Historically, the London and New York courts have developed a reputation as neutral fora for conventional finance litigation, having built considerable expertise in the application of English and New York law to banking and finance disputes, but other than that, being Shari’a inexperienced.

That said, even in Muslim jurisdictions, such as Malaysia, the civil courts are separate from the Shari’a courts (whose competence is limited to family/status matters and disputes between Muslims) and judges lack knowledge or specialism in the application of the Islamic Shari’a. Therefore, court litigation is unlikely to assist in managing the Shari’a risk responsibly: both the English and the Malaysian courts have relied on English law and more specifically conventional banking practice in the interpretation of Islamic finance contracts (for example, BKRM Bhd v Emcee Corporation). The English courts, in particular, have refused to give full effect to the enforcement of governing law clauses providing for the application of English law subject to the Islamic Shari’a.

The governing law paradox: the English law example

On a number of occasions to date, the English courts have been asked to consider the scope of a governing law clause in an English law contract within an Islamic context and in particular whether it contained sufficiently precise wording to encompass the Islamic Shari’a. The courts’ findings on the subject have been diverse, some finding in favour of the incorporation of the Islamic Shari’a, others against.

By way of example, in Shamil Bank of Bahrain EC v Beximco Pharmaceuticals Ltd, the English Court of Appeal held that a blanket reference to the Islamic Shari’a did not amount to the law of a country within the meaning of Articles 1.1 and 3.1 of the Rome Convention; on that basis, English law only applied to the underlying transaction (although the revised wording at Rectial 13, Rome I, may no longer support this conclusion as it no longer refers to the “law of a country”, but more generically refers to “rules”). But principles of Islamic Shari’a could be incorporated provided that there is a sufficiently precise reference (even though such a proposition poses challenges given the absence of a codified body of Islamic Shari’a). By contrast, in Halpern v Halpern, the English Court of Appeal recognised that parties can resort to a non-national system of law in arbitration. Finally, in The Investment Dar Company KSCC v Blom Development Bank SAL, the Chancery Division of the English High Court examined Shari’a compliance of the underlying wikala (agency) contract and held it was Shari’a non-compliant. Evidently, Chancery judges, routinely dealing with principles of equity in English common law, are more familiar with, and therefore accommodating, of Shari’a as an applicable body of law.

Taking guidance in particular from the English courts’ approach in Halpern, arbitration may well be the solution to resolving Islamic finance disputes in a way that gives full effect to the Islamic Shari’a as the governing law.

To be continued…

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