Islamic finance has not escaped the financial crisis unscathed, whose ramifications have been amplified by the recent controversy surrounding the debt restructuring of Dubai World in tandem with a generally diminished investor confidence in the Gulf region. Tremors in the sukuk market serve as poignant reminders of the many governance issues that have beset financial innovation in Islamic finance. In particular, the Nakheel case in late 2009 has fuelled groundswell concern about the interaction of shari'ah compliance and commonly accepted principles of investor protection and bankruptcy workouts.
The potential of litigation following the announcement of a debt standstill on the Nakheel sukuk illustrated the importance of recognizing whether Islamic law governs sukuk by substance or form. If shari'ah compliance were treated as matter of form – and the jurisdiction of UAE courts over the issuer suggests that this would have been the case – then the opinion of shari'ah courts could potentially override the opinion of commercial courts on perfected security interest (or agency agreements) as defined by commercial law. Such legal uncertainty has been accompanied by considerable heterogeneity of scholastic opinion, which continues to hamper the creation of a consistent regulatory framework and corporate governance principles.
Going forward, the current controversy will raise expectations of legal governance in shari'ah-compliant instruments as key requirement for the general acceptance of Islamic finance. The Nakheel bond issue was the first real test case for shari'ah compliant bonds, and this episode will hopefully spur greater legal certainty, transparency and a more robust sukuk infrastructure. The fundamental factors support a strong recovery of sukuk markets, but without resolving these teething issues, Islamic capital markets will not reach a critical mass.