Shariah Compliance , Is Islamic Finance Ready

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Dr. Zia Ahmed Khan www.ventureart.biz whatsapp: +96567086552
Sharah Compliance

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Sharah Compliance
The Issues and Challenges Of Shariah Compliance Those Are Applicable To
Islamic Financial Institutions
Contents
Shariah Compliance 1
Islamic Capital Market 3
Challenges and Opportunities 4
Sukuk 5
Bibliography 10

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Sharah Compliance
Shariah Compliance
Shariah compliance of financial products is essential to ensure credibility of the products and institutions. It
is, at the end of the day, what differentiates conventional from Islamic financial products.
We have already seen the statistics on the potential of Islamic Finance. The number of Muslim investors is
increasing. They are becoming more sophisticated and will demand more from their bankers. Investors will
not only look at investment performance or Shariah compatibility alone. They will demand both Shariah
compliance and good returns.
In fact, using the label ‘Islamic’ or ‘Shariah Compliant’ would suggest that the product is already adhering to
the principles of Shariah. Any violation of this rule would mean a loss of confidence in the product, firm or
even the system itself. Investors will vote with their feet. Therefore, it is in the industry’s interest to ensure
that the Shariah supervision systems in the Islamic financial institutions are managed well.
However, ensuring effective Shariah compliance is not a straightforward matter. There are many issues
that confront it. For example, one of the more pertinent problems is the lack of standardisation in
addressing Shariah issues. A lack of standardisation may result in problems such as increased transaction
costs, lack of recognition of legal rights and marketability problems across borders. It may even impede the
development of the industry.
New Product Development
Aside from Shariah compliance, another factor that is crucial to the development of the industry is the
constant innovation and development of new products. Financial markets are increasing in sophistication;
the environment is constantly changing and competition is increasing. Muslim investors need a range of
products to meet their desire for diversification of their investments, based on their unique individual needs.
There have been many talks about the need to attract the Middle Eastern investors to this region. However,
we have yet to see different asset classes of investment being created to attract these investors.
The ijarah sukuk that we issued five years back is still the only available sukuk in Singapore. We hope to
contribute further in generating new products.
Current Improvements

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Sharah Compliance
Hence, there are some very important issues that face the Islamic Finance industry. And two of the more
crucial ones, as we have seen, are regarding Shariah compliance and new product development.
Nevertheless, it is heartening to note that much effort is being made to address these challenges.
For example, institutions such as the Islamic Financial Services Board (IFSB) and the Accounting and
Auditing Organisation for Islamic Financial Institutions (AAOIFI) have made great progress in developing
standards, including on Shariah compliance. I am glad to note that the Monetary Authority of Singapore is a
full member of IFSB, and is taking part in some of the standard setting projects.
Developing Talents
But at the end of the day, in order to address these challenges and to achieve further improvements, we
cannot run away from the fact that we need talented people. Shariah scholars, in particular, have to play a
greater role. Shariah Boards may have to operate differently in order to facilitate the innovation process,
without compromising Islamic principles.
They have to be involved in the new product development process at the onset. They have to integrate
Shariah considerations early and fully in any development or strategy.
They have to provide constant supervision and work in close partnership with management to ensure
innovative yet shariah compliant products.
They have to understand customers’ needs, safeguard their interests and represent them to the
management of the organizations.
They have to develop Shariah compliance systems that adhere to the standards developed by AAOIFI and
IFSB. And all of these procedures will have to be transparent in order to avoid problems of information
asymmetry and to gain the trust of potential investors.
Ultimately, both customers and Islamic financial institutions benefit. Investors will have a range of products
to choose from. Institutions will gain greater credibility and an increase in potential customers.
To play this new role, Boards have to be staffed by qualified individuals who understand both the intricacies
of modern finance and the rigour of Shariah laws. Unfortunately, finding such scholars is a problem for
many financial institutions.

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Sharah Compliance
Islamic Capital Market
The first is that Islamic capital market products must be durable, reliable and replicable. This means that
there is a need to balance product origination and innovation with efforts to ensure product sustainability.
While issues that are commonly faced at the product development or market build-up stage must be dealt
with, it is equally important to address issues that arise after the products have been introduced and
marketed to ensure that they remain attractive and sustainable in the longer run. I call these ‘after-sales’
issues. We do not want to have products that are offered with a lot of hype and fanfare to falter and fail.
This will result in a loss of confidence not only in the specific product but in the Islamic capital market as a
whole.
These so-called ‘after-sales’ issues include the need for continuous disclosure and clarification of
accountabilities to ensure adequate levels of investor protection and to help build a market that is credible
and transparent.
The second is that products must be backed by clear legal protection. There must be sound legal
documentation to protect the interest of all parties and appropriate sanctions which are enforceable in the
ordinary courts of law. In addition, the legal mechanism should work in a manner to resolve all disputes
effectively and expeditiously.
Thirdly there is a need to ensure that Islamic accounting rules and standards are consistent with
international practices. Given that existing accounting standards, whether based on IAS or GAAP were
developed based on conventional institutions, products and practices they are often inadequate or
inappropriate for Islamic products. Yet, in order to be acceptable world-wide, Islamic products are expected
to address issues such as comparability and reliability of information. In this regard, the efforts undertaken
by AAOFII (Accounting and Auditing Organisation for Islamic Financial Institutions) are significant in
accommodating the need for some level of compatibility with conventional accounting standards.
Challenges And Opportunities
• Shari'ah 'arbitrage' - Currently, there is a diversity of opinion regarding whether certain products or
practices comply with Shari'ah law. While regulators will not be in a position to assess the compliance
of products with Islamic principles, regulators will need to ensure that transparency of the Shari'ah
compliance process is appropriately communicated to the financial consumer. Further, the FSA

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Sharah Compliance
believes that common Shari'ah standards would be beneficial, and it is currently supporting the
development of such standards by various organizations, which would make it easier for bankers and
investors to assess, and access, the market;
• Shari'ah compliance throughout the product life cycle - While a product may be deemed Shari'ah
compliant prior to its launch, firms must also be cognizant of the need to maintain compliance after
launch by monitoring their products and services. Compliance must be considered an ongoing
obligation, as a breach of Shari'ah rules could undermine investor confidence in the products and
threaten the firm's solvency;
• Issues for Shari'ah scholars - As there is currently a shortage of Shari'ah scholars to certify that
products conform to Islamic law, it is currently not uncommon for scholars to hold consulting positions
within more than one financial firm. This raises concerns regarding the ability of scholars to apply a
high level of oversight to the various products and services at different firms, as well as concerns of
potential conflicts where scholars are both approving products and auditing existing products and
processes within the same firm or at different firms;
• Human resources - Like the shortage of Shari'ah scholars with relevant financial experience, there is
also a shortage of experienced professionals in the Islamic finance field. Education and professional
training programs will be required to address this ongoing need;
• Contract and documentation risk - While the structures of such transactions are designed to comply
with Islamic law, the agreements are governed by local law or, often, English or New York law. The
U.K. courts have refused to apply Shari'ah law in disputes, and the debate regarding the interpretation
of Shari'ah principles to certain financial products would add further uncertainty. Thus, particular
consideration must be given to the drafting of contracts to minimize the potential for disputes, and to
identify the governing law;
• Risk of contagion - As the Islamic finance industry is relatively young and limited in breadth, its
various business models remain untested on the scale enjoyed by more established financial products
and services. The FSA recognized that a failure in this nascent industry could affect the future
development of Islamic finance.

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Sharah Compliance
SUKUK
Nonetheless, in my presentation I will focus on the practical problems a lawyer can face in assisting his
clients to structure Sukuk in UAE, leaving the financial aspect to the financial experts, as well as the
technicality of Sukuk from a Sharia point of view to our learned Islamic scholars.
PART I: Practical Problems
A. Introduction
The evolution of Islamic finance is based on the concept of developing new financing techniques and
instruments which are compatible with market acceptable banking and securities products.
In doing so, the central idea is to ensure that newly developed products are in compliance with Sharia.
As a lawyer dealing with this issue, my major question is how can I ensure that the proposed product is in
compliance with Sharia, hence avoiding any challenges in this respect?
In my attempt to find an answer, obviously the big question is what are the requirements necessary to
consider a product as Sharia compliant?
As you might be aware, Sharia comprises various schools of thoughts that can be broadly classified into
Sunnite and Shiite, and in turn these two schools of thoughts are comprised of several sub-schools, for
example in the Sunnite tradition there are the Hanafi, Shaafi, Maaliki, and Humbali traditions.
Furthermore, for each of these sub-schools, when it comes to transactional issues, jurisprudence
developed over the past 1,500 years by the followers of these schools has departed from the original ideas,
although commonly recognized basic principles may have been retained.
Therefore it is extremely difficult to determine whether a product is Sharia compliant or not, under the
multiple schools of thought.
B. Practical Aspects
Before I elaborate further on the challenges facing lawyers in addressing the big question, I will just
mention certain examples of problems facing the construction of Sukuk, in particular Ijara Sukuk, being the
most common instrument that is used for medium and long term financing.
The technique of Ijara Sukuk, in a simplified description, is based on four major steps/transactions:

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Sharah Compliance
1. Issuing Ijara Sukuk by the SPV to raise funds to purchase the asset from the corporate seeking finance
("project company").
2. Purchase of the asset by the SPV from the project company.
3. Lease of the asset by the SPV to the project company.
4. Finally, sale back of the asset to the project company at the end of the Ijara term by the SPV.
These steps/transactions must meet certain conditions to qualify as being Sharia compliant, according to
the widely respected bodies such as Fiqh Academy of the OIC. However the engineering of Sukuk to meet
these requirements faces practical problems, and the market has developed certain approaches to
overcome such hurdles that can vary from case to case, or jurisdiction to jurisdiction.
I would like to share some of these with you:
1. Sequence
One of the conditions is that the issue of the Sukuk must take place before the lease agreement by and
between the SPV and the project company is entered into.
The practical techniques developed to overcome these conditions include:
a) The purchase of the assets as well as its lease agreement is dated on the same closing date as the
issue of Sukuk.
b) Furthermore, for transactions that cannot take place on the closing date, for example the sales back
agreement; the parties rely on promise from the SPV to sell the asset back at the end of the Ijara term,
dated for the closing date.
2. No Guarantee
Another condition is that the issuer of Sukuk (often an SPV), or the arranger may not guarantee the return
on the Sukuk.
This condition is surmounted by the arranger issuing the "Confidential Offering Circular" to potential
underwriters, by relying on the Engagement Letter executed beforehand by the project company in favor of
the arranger, and promises by the project company, inter alia, to:

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Sharah Compliance
a) Sell the asset to the issuer (SPV) upon receipt of the agreed sale price from the Sukuk proceeds.
b) Take on lease the asset for the agreed period and the agreed lease rental.
c) Obtain a rating for the Sukuk by internationally recognized rating agencies.
d) Sometimes, obtain a bank guarantee from a conventional bank, securing the Ijara rental payments.
Such assurances can be viewed as an implied guarantee.
3. Independent Entities
At times the Islamic scholars require that the SPV and the project company must be independent entities.
To circumvent this condition, the SPV that is formed in practice is totally or partially owned by the project
company, but this raises concerns about piercing of the corporate veil in event of a dispute.
4. Residual Value of the Asset
A major feature of the Sukuk is that the asset needs to be returned to the project company. To realize this
end, various mechanisms are applied:
a) The title of the asset may be returned to the project company as a gift without consideration.
b) The project company is required to pay fair market value of the asset at the end of the lease period,
which is established by an expert selected in advance.
c) The lessee acquires the asset against a nominal residual amount that is agreed in advance.
5. Valid Acquisition of the Asset
The technique of Sukuk relies heavily on the SPV having acquired ownership of the asset to be leased to
the project company, through a valid and enforceable sales agreement.
However such sales face two problems in practice, specially when the asset is real estate:
a) Registration Requirement: According to UAE laws the sale of real estate is not a consensual agreement,
but rather a formal one that requires registration before the Land Department.
b) Foreign Ownership: UAE law imposes restrictions on foreign ownership of real estate, and whereas most
of the SPVs are established as offshore companies in foreign jurisdiction (mainly to protect the asset from
claims by creditors or liquidators by the project company).

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Sharah Compliance
Even if the SPV is registered in UAE and has full UAE citizenship, still the parties are reluctant to go
through the registration process due to the high cost of registration for the initial sale, and then the sale
back.
6. Default and Security
Since transfer of the title pursuant to the sales agreement is questionable, the chances of realizing such a
security in the event of default are also questionable.
C. Prime Concern: Sham Agreement
These are some examples of the many practical issues facing structuring Sukuk that can be generally
grouped into one prime concern:
The risk that the various layers of transaction utilized in Sukuk may be viewed as a façade or a sham aimed
at disguising the conventional asset backed bond, which is prohibited under Sharia principles.
As you might be aware, UAE courts in dealing with such a transaction have the right and the duty to
examine features of the transaction through discovering the intention of the parties on the basis of
documentation used, and thus may recharacterize the transaction into a legal form they find most
appropriate, regardless of the title of the agreement, or language used by the parties.
Furthermore, given the nascent nature of Islamic finance, the products have not been tested sufficiently
before the courts of law, and the current economic boom gives rise to few disputes arising out of Islamic
finance products. Therefore there is little basis to predict how the UAE courts will treat disputes arising from
Sukuk transactions.
While some may view these concerns as theoretical, and an attempt by the lawyer to unnecessarily
complicate the issues, but any adverse trends in the markets will bring these problems to the forefront.
PART II: Challenges
A lawyer may not be able to address all these issues in a clear cut manner due to the various challenges
he would face in finding an answer, which can be summarized as follows:
A. Major Challenges

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Sharah Compliance
1. Legal Vacuum
One of the major challenges in addressing these issues is the lack of national legislation, as mentioned
earlier Sharia is not a codified body of law, but rather a set of practices based on various interpretations.
It may be noted that the first attempt to codify the Sharia into a binding legislation was by the Ottoman
Empire in the (known as Majalah Al Ahkam Al Adlia), and to a great extent civil laws in most of the GCC
countries are influenced by this first code.
Although the countries in the region do have certain legislation governing Islamic financial institutions, for
example in UAE's case:
- Federal Law No. 6 for 1985 concerning Islamic Financial Institution;
- Emirates Securities and Commodities Authorities ("ESCA") Resolution No. 93/2005 concerning listing of
Islamic Sukuk; and
- DIFC Law No. 13 for 2003 Regulating Islamic Financial Business.
However, these laws are more regulatory in nature, and do not deal with the substance of the product
introduced by the Islamic financial institution, leaving a legal vacuum.
2. Lack of Precedents
Although UAE legal system can be classified as a civil law system, but court precedents still play a major
role by supplementing the legislation, and help plug the gaps left by codified law.
Issues relating to Islamic finance, however, present an unusual problem because there is neither specific
legislation regulating it, nor is there sufficient relevant case law to address these issues.
Under this context, we would like to mention the ruling of the English Court of Appeal in the famous case of
Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd. et al. (2004).
To those who are not already aware of this case, we can briefly mention that Beximco entered into a
Murahaba arrangement with Shamil Bank and defaulted in its obligation, where Beximco challenged that
the transaction was not Sharia compliant as the agreement stipulated that the transaction was subject to
the principles of “Glorious Sharia" and was to be construed in accordance with the laws of England.
The Court found Beximco’s defense to be a “lawyers’ construct” and that it was not in a position to deal with
the Sharia principles unless these were precisely provided for in the contract itself.

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However, if the issue arises before a court in one of the Muslim countries, particularly those countries which
consider Sharia a main source of their legislation, the reasoning of English court may not be applicable, as
courts in such countries are under obligation to review the contract to ensure that it is Sharia compliant, as
the matter will be a public order issue.
3. Standardization
Although there are certain organizations that enjoy a great deal of recognition in the region, such as Fiqh
Academy of the Organization of Islamic Countries, based in Jeddah and the International Islamic Financial
Markets ("IIFM") in Bahrain, or the Accounting and Auditing Organization for Islamic Financial Institute
("AAOIFI") also in Bahrain, that lay down certain guidelines about the requirement of Sharia for the various
products, and issue an explanatory note, that can be viewed as setters of standards. These guidelines
however have not been officially adopted as national laws in the region.
In this context we can mention an advanced attempt by International Swap & Derivatives Association
("ISDA") to develop a "Master Agreement for Islamic Derivatives" for consideration by IIFM for adoption.
B. Other Challenges
In addition to the difficulties mentioned above, other factors contribute to the uncertainty surrounding Sukuk
transactions:
1. Absence of Centralized Sharia Compliance Board
Unlike some countries, such as Malaysia, the UAE does not have a central sharia compliance board.
The existing regulatory legislation simply requires that the activities of the institutions be Sharia compliant,
and the only requirement for assurance of such compliance is that it should be approved by a Sharia
Supervisory Board to be established by each institution that is itself introducing the product, for instance:
Article 6 of Federal Law No. 6 of 1985 requires each Islamic financial institution to have their own Sharia
Supervisory Board, and the Articles of Association of the financial institution itself will regulate the formation
of this board, their function and their competence. Nonetheless, the names of the members of the board
should be approved by the Central Sharia Compliance Board to be formed pursuant to a UAE Cabinet
resolution. However to the best of our knowledge, such a governmental body has not been set up yet.

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Sharah Compliance
However, under this regulation the approval by financial institution's Sharia Supervisory Board is only
binding on the institution itself, and is not binding on others.
2. Lack of Models
In spite of the fact that the Sukuk has experienced tremendous growth over the last few years in UAE, the
majority of these transactions relate to infrastructure development projects launched by government itself or
government backed companies, and have their own unique structure that cannot be considered as a model
for the private sector.
For example, one of the major Sukuk issues in UAE was for the second phase of expansion of Dubai
International Airport which involved building Terminal 2 for the Dubai Aviation Department, and was
arranged by Dubai Islamic Bank for USD 750,000,000.00.
For this particular issue, a specific law, Law No. 8/2004, was passed by the Ruler of Dubai Emirate by
virtue of which Dubai Civil Aviation Department, the party seeking financing for this project, was allowed to
secure the financing through Islamic products, and establish a company in Dubai Airport Free Zone,
majority of which was owned by Dubai government, to act as the SPV where Dubai Civil Aviation was
authorized to enter with the said SPV into all necessary agreements to secure the financing.
3. Multiple Jurisdictions
The structure of Sukuk involves various transactions that might take place in different transactions,
especially in cross border transactions which are quite common. For example, the engagement letter to be
issued by the project company in favor of the arranger may be subject to a jurisdiction, while the sale of the
asset and its lease may take place in another jurisdiction. Such a circumstance will just aggravate the
above mentioned problems.
Conclusion
• In conclusion, I believe that the future of Islamic finance depend very much on the core fundamentals
of Shariah compliance and new product development. Customers will demand from the institutions
more choices of products, better returns and Shariah compatibility. To meet their customers’ needs,
Shariah Boards will have to play a more active role in product development and work in close

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Sharah Compliance
partnership with management. And because of the increasingly complex role that they have to play,
Shariah Boards should be staffed by scholars who are trained in both modern finance and Shariah law.
• On its part, Muis will continue to develop such scholars. We are also committed to contribute to the
development of new and innovative products, just like what we had innovated five years ago. We hope
that the other players in the industry will also do likewise. With such efforts, we will see a more exciting
future ahead for the Islamic finance industry.
• Let me conclude by reiterating my view that to enable the Islamic capital market to develop further and
to tap the tremendous opportunities world-wide, we must move beyond trying to merely cater to the
investment needs of Muslim investors to introducing products that are acceptable to all in the global
financial arena. Hence our efforts must not be focussed merely on ensuring Shariah compliance but
also in ensuring international compatibility and acceptability. Negative differentials, whether in the form
of different legal, tax or accounting framework must be removed to ensure that Islamic capital market
products and services are competitive with the best in the conventional market. At the end of the day,
the pursuit of value is a common denominator amongst all investors and therefore the value proposition
that Islamic capital market products and services can offer will make all the difference.
• From a practicing lawyer’s point of view, we feel there is a serious and pressing need to enact
legislation regulating the various Islamic financial products, in order to maintain the growth and stability
in the market, and there is no harm if such legislation would adopt the most liberal views of the various
schools to structure new financing techniques and instruments which are compatible with the market
acceptable banking and securities products.
• Preferably, passing of national legislation adopting the standards issued by widely respected
organizations such as the Fiqh Academy and IIFM, will help in creating a unified international standard
for determining Sharia compliance of Islamic financing products.
Bibliography
Keynote Address By Mr Mohd Alami Musa, President Of The Islamic Religious Council Of Singapore
(Muis), At The International Islamic Finance Forum Tuesday 13 June 2006

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Sharah Compliance
Yang Berbahagia Tan Sri Dato’ Sri Dr. Zeti Akhtar Aziz, Governor Of Bank Negara And Chairman Of The
Labuan Offshore Financial Services Authority (Lofsa), Tan Sri-Tan Sri, Datuk-Datuk,
Conference On Islamic Finance In The Middle East Jointly Organized By: International Bar Association's
(Iba) Banking Law Committee And Arab Regional Forum On 14th January 2008
Problems With Structuring Ijara Sukuk Transactions In The Uae
Presented By: Advocate Ali Al Aidarous

Shariah Compliance , Is Islamic Finance Ready

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