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Islamic finance disputes: Arbitration options

Arab Hall, Leighton House, London.
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Arab Hall, Leighton House, London. Photo: AFIS

Disputes involving Sharia-compliant financing agreements can be complex and require an appropriate form of dispute resolution. Sarah Walker and Tom Childs from King & Spalding explain that arbitration may provide an answer.

Islamic finance has entered the mainstream. Around $2 trillion-worth of assets were estimated to be managed in accordance with Islamic law, or Sharia, globally at the end of last year (2014) while western institutions now embrace Sharia-compliant financings, including GE Capital, which issued $500 million in Islamic bonds (sukuk) in 2009 and the UK government, which issued a £200 million sovereign sukuk in 2014.

Islamic finance has to be structured in accordance with Sharia, but there is substantial diversity of opinion among Sharia scholars regarding the relevant legal rules. The six main schools of Islamic law (four within the Sunni branch of Islam and two within the Shia branch) agree on certain rules, such as the prohibition on the payment or acceptance of interest, but disagree on others. For example, some schools prohibit the use of conditions precedent in a contract, while others do not. All of the schools prohibit speculative transactions but they disagree as to the point on the spectrum at which a transaction becomes too speculative or uncertain to pass muster. Moreover, even within each school the law is often uncertain, given the absence of authoritative modern texts.

Because most Muslim-majority countries have primarily secular legal systems (especially as regards commercial law), Islamic Sharia has not been codified or modernised.

As such, while the Islamic finance industry has developed a flexible system for determining whether a particular financial product or service complies with Sharia, the topic can become more complex should disputes arise from Islamic finance transactions.

Sharia risk

With the recent growth and globalisation of the industry, however, comes an increased likelihood of cross-border disputes. Managing the risk of such disputes involves choices at the contracting stage with respect to both the law governing the contract and the forum in which any dispute arising out of the contract will be resolved.

Islamic finance institutions face all the traditional risks involved in a conventional financing but also deal with the additional factor of so-called Sharia risk. This is the risk that a defaulting customer may claim that the parties’ agreement fails to comply with Sharia and is therefore void and unenforceable. Even if a bank’s Sharia supervisory board – which it is required to have in order to offer Islamic finance products under the governance standards issued by the Accounting and Auditing Organization for Islamic Financial Institutions – sanctioned the agreement, the customer should have little difficulty finding authority to support its claim, given the doctrinal diversity and uncertainty of Sharia.

To mitigate Sharia risk, Islamic financial institutions in the Middle East generally stipulate in their customer contracts that the contract is governed by English or New York law and that the courts of England or New York shall have exclusive jurisdiction to resolve any disputes arising out of the contract. While most Middle Eastern countries have secular commercial codes that do not require compliance with Sharia, their constitutions generally refer to Sharia as a source of law, or even the paramount source of law. This creates the risk that a national court in a Middle Eastern country, applying national law, could invalidate an Islamic finance contract on the ground that it is not, in the opinion of the court, Sharia-compliant. Moreover, a bank may be unable to enforce an English or US judgment against the customer’s assets located in a jurisdiction that incorporates Sharia into its legal system.

Arbitration angle

Some observers believe the practice of extracting Islamic finance disputes from the Middle Eastern legal landscape is contrary to the spirit of Islamic finance. While the evidence is only anecdotal, dissatisfaction with this practice may be having a negative impact on the Islamic finance industry’s growth.

These critics generally favour arbitration by a panel of independent arbitrators who are called upon to adjudicate the dispute in accordance with Sharia in addition to national law – an example would be where an Islamic finance agreement provides for arbitration of any dispute in London and stipulates that the agreement is governed by English law and Shari’ah, which shall prevail in the event of a conflict between the two.

Recently, two arbitral institutions have promoted themselves as venues for the arbitration of Islamic finance disputes in accordance with Sharia and national law. In 2007, several Islamic financial institutions located mainly in the Middle East established the International Islamic Centre for Reconciliation and Arbitration (IICRA), which is based in Dubai. The IICRA’s Arbitration Procedures require the arbitral tribunal to exclude any provisions of the law chosen by the parties that are not in conformity with Sharia. According to the Procedures, the tribunal “may invoke for the disputed issue whatever it deems appropriate from among the viewpoints of various schools of Islamic thought, rulings of Islamic Fiqh academies, and opinions of Sharia supervisory boards at Islamic financial institutions.” The IICRA has administered a small number of cases but has not achieved widespread acceptance in the Islamic finance community.

In 2013, the Kuala Lumpur Regional Centre for Arbitration (KLRCA) published a revised version of its “i-Arbitration” Rules for disputes arising out of commercial agreements based on Sharia principles. Rule 11 of the i-Arbitration Rules provides that the arbitral tribunal may refer any “dispute arising from the Sharia aspect of the contract” to a Sharia expert agreed upon by the parties or appointed by the tribunal. The Rules allow the parties to designate any country as the seat of the arbitration. As a practical matter, however, the KLRCA’s Rules are unlikely to hold much appeal to market participants outside Southeast Asia.

Despite the initiatives of the IICRA and the KLRCA, arbitration of Islamic finance disputes in accordance with Sharia is unlikely to take off until the Sharia principles applicable to Islamic financing transactions are codified in some manner. Most banks (whether conventional or Islamic) require a high degree of certainty regarding the enforceability of their contracts before they are willing to part with large sums of money.

Secular solution

An alternative to the prevailing practice of conferring jurisdiction on the English or New York courts is to refer any dispute to arbitration but to require that the arbitrators apply only English or New York law but to the exclusion of Sharia. This “secular” arbitration option has a number of advantages, including:

  • The parties can agree to arbitrate in an arbitration-friendly jurisdiction that is geographically convenient to them. Good options in the Middle East and Asia include the Bahrain ‘Free Arbitration Zone,’ the Dubai International Financial Centre (a free zone located in Dubai), Hong Kong and Singapore.
  • Quality of decision-making. The parties can select an arbitrator or arbitrators (in the case of a three-member tribunal) with expertise in the applicable law and financial disputes. While the arbitrator need not have any expertise in Sharia (because it is not applicable), familiarity with Islamic finance may also be desirable. If the parties cannot agree on the sole arbitrator or the chairman of a three-member tribunal, the arbitral institution will make the appointment. For this reason, it is essential that the parties specify a reputable institution in their arbitration clause.
  • Enforcement. An arbitral award can be easier to enforce internationally than a court judgment, depending on the countries involved. For example, an award issued in Bahrain by an arbitral tribunal applying New York law should be easier to enforce against a customer’s assets in India than a judgment of a New York court.
  • Flexibility and expedition. Arbitration is a flexible process that can be adapted to the circumstances of the dispute. The parties can agree to arbitrate in English. If they select an arbitration-friendly jurisdiction and an expeditious arbitral tribunal, it may be possible to obtain an award within six months of the dispute arising.

In 2010, the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM) promoted the secular arbitration option when they launched the ISDA/IIFM Tahawwut (Hedging) Master Agreement. This framework agreement is intended to be Sharia-compliant and was developed under the guidance and with the approval of the IIFM’s Sharia Advisory Panel. Section 13(c) of the agreement gives the parties the option to choose ICC arbitration with a London or New York seat and English or New York law as the governing law. For the avoidance of any doubt, Section 1(d) specifically provides that the governing law does not include Sharia.

Despite its many advantages, the secular arbitration option has yet to receive widespread acceptance in the Islamic finance community. This may owe more to history than anything else as – unlike energy and mining companies – financial institutions have traditionally preferred litigation over arbitration. The recent uptick in the use of arbitration to resolve cross-border, conventional finance disputes thus may bode well for the future of secular arbitration of Islamic finance disputes.

Sarah Walker is a partner and Tom Childs is a counsel at King & Spalding


Sarah Walker specialises in dispute evaluation and resolution by English Court litigation, arbitration and mediation. Among other specialisms, her practice focuses on the Financial Services sector and she advises a broad spectrum of clients. Her recent experience includes claims in respect of complex financial instruments, claims for recovery of assets and enforcement of security, large scale project disputes and fraud claims.  Sarah has spent time during her career at the in-house litigation department of one of the UK’s major retail banks and is familiar with the regulatory, compliance and contentious issues which financial institutions regularly face. Sarah has worked on a wide range of arbitration matters, under the auspices of most of the institutional rules, as well as on a number of London based ad-hoc arbitrations.  She is admitted as a full member of the Chartered Institute of Arbitrators for a period serving as a committee member for the London Branch of the Chartered Institute.  Sarah has been a speaker at conferences for various arbitral institutions, including the Hong Kong International Arbitration Centre (HKIAC), Singapore International Arbitration Centre (SIAC) and the London Court of International Arbitration (LCIA).

Tom Childs is counsel in King & Spalding’s New York office and specialises in international investment and commercial arbitration.  He represents companies in commercial arbitrations with their business partners and in court proceedings in the U.S. and England to enforce arbitration agreements, foreign arbitral awards and foreign judgments. Tom has represented clients from many business sectors, including oil and gas, mining, pharmaceuticals, financial services and automobile manufacturing.  He is experienced with the rules of all major arbitral institutions (including ICSID, the ICC, the AAA/ICDR and UNCITRAL) and with claims arising under public international law, New York law, English law, French law and Indian law.




Author: Editor

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