Defaults Pose Latest Snag In Islamic-Bond Market

By STEPHEN FIDLER LONDON -- The once-booming market for Islamic-friendly bonds, having suffered a contraction amid the credit crisis, now faces a new challenge: default. The fledgling market in recent months experienced its first two defaults, and they aren't expected to be the last as issuers like Saad Group hit financial difficulties. This is taking investors and courts into uncharted territory as they seek to apply Western laws to bonds that were designed to comply with Islamic law, or Shariah. Agence France-Presse/Getty Images RELIGION AND FINANCE: Indonesian women outside the Sharia Finance Exhibition in Jakarta in February. In what could prove to be a test case, a bankruptcy judge in Louisiana is deciding the fate of holders of bonds tied to bankrupt energy firm East Cameron Partners LP, which in 2006 became the first U.S. company to issue the most popular type of Islamic-friendly instrument, known as a sukuk. One question: whether the bondholders actually own a portion of the company's oil and gas. As such cases work their way through courts, or are resolved without court intervention, "they may give some guidance to investors on the default of sukuk and how this would be resolved," says Mohamed Damak, an analyst with ratings firm Standard & Poor's in Paris. Sukuk bonds get around the Islamic ban on speculation and paying interest by using devices such as sale-repurchase deals. Although based on centuries-old religious law, the sukuk market has been a 21st-century phenomenon. More than $115 billion of such bonds have been issued since the turn of the century, buoyed by money from oil-rich Middle Eastern investors and non-Islamic players such as hedge funds, which accounted for as much as 80% of some issues. In 2007 alone, issuers of sukuk raised some $46.6 billion, according to figures from the London-based Islamic Finance Information Service, or IFIS. Then, says Muneer Khan, Dubai-based partner with the Simmons & Simmons law firm, there was "a double whammy for the sukuk market." Even as the global financial crisis and falling oil prices took a severe toll, investors had to digest the implications of a "back to basics" movement among some scholars in Shariah law. The recent defaults are only the latest twist for a market that has seen its fair share of growing pains over the past two years. In 2007, respected Pakistani scholar Muhammad Taqi Usmani delivered a bombshell, suggesting that the most popular type of sukuk structures, responsible for up to 85% of issues, were unlawful according to Islam. The problem: They offered partial or total guarantees of repayments or of annual distributions, which ran counter to the Islamic principle that parties to a financial transaction must share in the risks and rewards attached to it. Last year, the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions formally ruled such structures weren't Shariah-compliant. The ruling wasn't retrospective, so Muslims didn't have to unload past investments. But it had a chilling effect: In all of 2008, only $15.8 billion in sukuk were issued, according to IFIS. Mr. Taqi Usmani "didn't realize how much his views mattered," says Dawood Ahmedji, director of Islamic Finance at Deloitte LLP. Then came the defaults. In October, East Cameron Gas Co. filed for bankruptcy protection after its offshore Louisiana oil and gas wells failed to yield the expected returns, partly because of hurricane damage. Some $167.8 million of sukuk bonds were affected. And last month, Investment Dar Co., a Kuwaiti investment company that owns a 50% stake in luxury-car maker Aston Martin Lagonda Ltd., missed a payment on a $100 million sukuk, becoming the first company from the Middle East to default on Islamic bonds. Such defaults have the potential to be complicated. Many bonds were issued under Western law, which can conflict with Islamic principles. In a 2004 case relating to the enforceability of a contract, the U.K. Appeals Court ruled that when Shariah and English law conflict, English law takes precedence. The structure of sukuk bonds can invite challenges and delays as Western bankruptcy judges accustomed to traditional bonds try to figure out where sukuk holders belong in the line of creditors, and even whether they are creditors or owners. In the East Cameron case, for example, the company argued that there had been no real transfer of ownership of production revenues, known as royalties, into a "special-purpose vehicle" formed to issue the sukuk. Instead, they claimed the transaction was really a loan secured on those royalties. That would mean the sukuk holders would have to share the royalties with other creditors in the event of a liquidation. The bankruptcy judge, Robert Summerhays, has so far rejected this contention. He ruled, according to court records, that "holders invested in the sukuk certificates in reliance of the characterization of the transfer of the royalty interest as a true sale." He gave East Cameron leave to find further arguments to support its case, but if he maintains his position, the sukuk holders' rights will be strengthened. Mr. Damak says the sukuk market has the potential to rebound once such issues are resolved. He estimates there are more than $50 billion of sukuk in the pipeline awaiting the right market opportunity. The market has in fact managed to come back modestly -- but only for higher quality issuers. So far this year, more than $7.6 billion of sukuk have been issued, IFIS data show. Almost all this year's fund-raisers have been governments or government-related, the overwhelming majority from southeast Asian countries such as Indonesia. The Middle Eastern market that drove the pre-2007 boom has also sprung into life this month with a $500 million issue for the government of Bahrain, which was boosted to $750 million because of strong demand. According to a 2007 study by economists from the International Monetary Fund, sukuk have delivered lower returns to investors than conventional bonds and are more often illiquid, meaning they are hard to buy and sell in the secondary market. Write to Stephen Fidler at stephen.fidler@wsj.com