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Opalesque Islamic Finance Intelligence

Lex Islamicus: The Blame Game
by Khalil Jarrar, J.D.

Thursday, December 17, 2009

While contemplating the various topics to cover for Lex Islamicus for this month’s edition, the only thing that came to mind is the financial wreck that has been depicted in the press and the implications of this impending collapse for Dubai, the region and the Islamic finance industry as a whole.

In the wake of the economic concerns surrounding Dubai one wonders what exactly has gone astray, is it that the guiding principles of Islamic finance have led to such instability or is it the lack of observance to such guidance? Should we expect more investments borne out of Islamic finance to follow the same destiny?

Not long ago voices were blaming the worldwide meltdown of the financial system on Capitalism and similar calls for Islamic financial institutions to assert their weight in the global capital markets.

Then again, capitalism was never the cause of the financial crisis to begin with, nor has Islamic finance been an accomplice; it all boils down to simple human greed and overlooking the basic principles of a sound investment (whether these are contained in Islamic finance guidelines is besides the point).

Both Islamic finance and capitalism have profound investment principles that seek to protect the invested capital and avoid the exploitation of the investors and the weaker party. On the other hand, exotic financial instruments have been introduced into the marketplace (and blessed by Shari’a boards) with the aid of crafty service providers that were sure enough to not only structure a complex instrument but also to create a veil that could not be pierced by the average investor or even the most prudent ones. This has been documented extensively in structured products across the US and Europe and the issue is equally relevant for Islamic finance contracts and documentation.

A recent inquiry involved reviewing a contract for a real estate investment in the Gulf region. The contract ellaborated over 180 pages long. Most tellingly, special attention was given to specific clauses that would protect the investment company of any liability whatsoever. Even the arbitration clause, which should be the first resort to resolve a dispute amicably and which was discussed in the previous Lex Islamicus, was drafted in such a way that was limited to residents of London and Paris. To add insult to injury the jurisdiction for such arbitration was in one of the many offshore jurisdictions creating a forum of no- convenience even for the wealthiest of investors. Whether this particular offering circular referred to a Shariah compliant investment should be irrelevant, the essence of the contract should be fair and (hopefully) favourable for both parties for it to be feasible.

The courts in the past have resorted to restricting forum shopping sought by plaintiffs to claim the highest damages by plaintiffs, a decision that should be revisited today and impose exemplary damages to large companies disclaiming all liabilities in bad faith to deprive investors of all available remedies. After all, good faith and fair dealing is an implied covenant in every contract and cannot be abrogated (once again this is not exclusive to Islamic finance but is part of various best practices when mitigating legal or litigation risk).

“We have our own economic philosophy and system which others do not have,” Sheikh Yusuf al-Qaradawi told a conference in Doha, Qatar. ”The collapse of the capitalist system, which is based on usury and securities rather than commodities in markets, shows us that it is undergoing a crisis and that our integrated Islamic philosophy – if properly understood and applied – can replace the Western capitalism,” Qatar’s Gulf Times quoted him as saying. The operative word in his statement is ‘if properly understood and applied’ and it is here that the principals and agents in an Islamic finance contract need to understand and properly apply their knowledge and interpretation of Shari’ah. Effectively a duty of care should lean towards investors/consumers, and again this is part of well-documented agency risk (a substantial body of work has been devoted in conventional finance to this topic).

Nevertheless, not for the lack of knowledge it is at times for the loose-fitting generalities in compliance and the tailored fatwa’s to appease the highest bidders. The rapid growth of Islamic financial instruments has created an industry that I term fatwa incorporated, which only answers to a few but tends to neglect the majority. Even before applying the proper financial instruments, one must recall that subject matter knowledge and diversification is imperative. Many have argued repeatedly that certain Islamic finance instruments of today are lacking on both accounts.

In December 1863, H. McCulloch, U.S. Comptroller of the Currency and later Secretary of the Treasury, wrote to all national banks (quoting relevant excerpts):

“Let no loans be made that are not secured beyond a reasonable contingency. Do nothing to encourage speculation. Give facilities only to legitimate and prudent transactions.”

“Distribute your loans rather than concentrate them in a few hands. Large loans to a single individual or firm, although sometimes proper and necessary, are generally injudicious, and frequently unsafe. Large borrowers are apt to control the bank.” “Extravagance, if not a crime, very naturally leads to crime.” “Pursue a straightforward, upright, legitimate banking business. ‘Splendid financing’ is not legitimate banking, and ‘splendid financiers’ in banking are generally either humbugs or rascals.”

Effectively, gamblers must not manage society’s saving. McCulloch would have argued that central banks should institute qualifying psychological testing to bar bank lenders with gambling propensity from wheeling and dealing in customers’ deposits and shareholders’ equity. The again, if the remuneration structure in Islamic finance is so closely tied to engineering the next marvel, should there be a test of competency for these instruments or a best-practice approach towards ensuring investors are educated of the various aspects of Islamic finance contracts (some rather untested in courts of law).

He further asserted other principles that are closely aligned with Islamic principles prohibiting Gharar and encouraging the circulation of loans and wealth. These basic principles are faith-neutral and independent of being labeled as capitalist or religious principles. Hence, before financial structures are created an entity should always shore up the foundations and not let greed and quick profit blind it from common sense and prudent investing. It is time to stop the blame game and stick to the basic principles of investment, Islamic finance or otherwise. Nomenclature should always be reflective of the principles behind it not just a packaging to preserve the status quo or a new embroidery on an old garment.

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