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Islamic Legal Studies ProgramHarvard Law School

ILSP

Occasional Publications 9September 2008

8 by the President and Fellows o Harvard CollegeAll rights reservedPrinted in the United States o America

ISBN -8886-65-

Sharia Risk?

How Islamic Finance Has

Transformed Islamic Contract Law

by

Kilian Blz

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ii

The Islamic Legal Studies Program is dedicated

to achieving excellence in the study o Islamic law

through objective and comparative methods. It seeks

to oster an atmosphere o open inquiry which em-

braces many perspectives, both Muslim and non-Mus-

lim, and to promote a deep appreciation o Islamic law

as one o the worlds major legal systems. The main

ocus o work at the Program is on Islamic law in the

contemporary world. This ocus accommodates the

many interests and disciplines that contribute to the

study o Islamic law, including the study o its writ-

ings and history.

Baber Johansen Acting Director

Peri Bearman Associate Director

Islamic Legal Studies Program

Harvard Law SchoolCambridge, MA 8, USA

Tel:6-6-Fax:6-6-

E-mail: ilsp@law.harvard.edu

Website: http://www.law.harvard.edu/programs/ilsp

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iii

Table of Contents

Preace v

Text, byKilian Blz

Endnotes

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iv

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v

Preface

This booklet was frst oered as a lecture at Harvard

Law School, in May8, while Dr. Blz was a Visiting

Fellow at the Islamic Legal Studies Program during

the spring o8. Dr Blz is a well-known scholar o

Islamic fnance and banking, as well as an attorney,

and his insights stem rom both a vast experience in

law, most recently as a partner in Gleiss Lutz, one o

Germanys leading law frms, where he specialized in

corporate fnance in the markets o the Middle East

and North Arica (MENA), and rom a solid edu-

cational background in Middle Eastern Studies. He

presently is International Co-Director o the Regional

Centre or Renewable Energy and Energy Efciency

(RCREEE), an international organization with ten

member states rom the MENA region, which is sup-

ported by Germany, Denmark, and the EU, and is

based in Cairo.

Islamic fnance is a burgeoning feld, growing at a pace

exceeding ten percent a year. Its basic tenet is that it

must conorm to Sharia rules, which have a strong

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vi

basis in equitableness and social justice. Sharia strongly

proscribes exploitative and unethical practices, includ-

ing most amously making money without compensa-

tion, which underlies the prohibition o interest. The

ethical nature o Sharia underpins the business o

Islamic fnance, yet ethics, along with legal rules, are

subject to interpretation. The exact role the ethics o

Sharia play in Islamic fnance, the risk or those who

bank in the sector, and the change that Islamic law has

undergone through the practice o Islamic fnance in

todays global market are some o the points Dr. Blz

discusses in this probing paper.

It gives us great pleasure to publish this study as the

ninth booklet o ILSPs Occasional Publications series,

launched in . For previous booklets, including

Moving Toward an Islamic Financial Regime in Paki-

stan, please access our website.

Peri Bearman

Associate Director, Islamic Legal Studies Program

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Sharia Risk?How Islamic Finance Has Transormed

Islamic Contract Law

Kilian Blz

This paper is about Islamic fnance and Islamic law.

Islamic law normally is defned as the body o legal rules

developed by Muslim scholars in interpreting the Quran

and the Sunna, the religious texts o Islam. Islamic f-

nance (or Sharia fnance, as American practitioners

like to call it) denotes fnancial transactions conorm-

ing to Islamic legal principles. Islamic fnance, since its

inception nearly fty years ago, has developed into one

o the most signifcant growth areas in international

banking. In addition Islamic fnancearguablyis the

most important area o the application o Islamic con-

tract law. What this entails is the subject-matter o the

below text, most fttingly researched at Harvard, which

was one o the frst universities to set up a specialized

research program in Islamic fnance, producing some

standard-setting publications in the feld.2

Over the last decade, the Islamic nance industry

has continuously evolved and developed. A recent

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2

study3 suggests that some USD 500 billion are man-

aged according to Islamic principles, with an annual

growth rate o5 to20percent. Today, Islamic nancing

transactions are not only oered by Islamic banks (-

nancial institutions that claim to transact only Sharia-

compliant business) but also by many, i not most, in-

ternational banks which either have established Islamic

banking subsidiaries (such as Noriba o UBS) or oer

an Islamic product line through an Islamic window

(such as Deutsche Bank, or example). Moreover,

in geographical terms Islamic nance is no longer

conned to the original strongholds in the Arab Gul

and Southeast Asia. Sharia-compliant transactions

have spread across the globe, with multiple regional

hubs including Dubai, Bahrain, and Kuala Lumpur. In

addition, Islamic nance has spread to international

nancial centers such as New York and London (with

the latter making substantial eorts to attract Sharia-

compliant transactions4).

My aim is to show how the global success o Is-

lamic nance has transormed Islamic contract law.

Islamic law is undamental to Islamic nance and

Islamic nance hascorrectlybeen described as an

application o Islamic law in modern nancial transac-

tions.5 Today, however, the developments in the law o

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3

Islamic nance are no longer conned to an adapta-

tion, amendment, and revision o traditional Islamic

legal concepts that are then applied to modern nance.

Insteadand this is the argument o my paperthe

changes must be seen as a by-product o the global-

ization o Islamic nance; they also must be analyzed

and understood in the context o the jurisdictions in

which Islamic nancing transactions are implemented

and, maybe more importantly, in the context o the

law o international nance. Put dierently, the un-

derlying assumption o this paper is that Islamic law

must be studied in the context in which it is applied,

and with regard to Islamic nance the context cannot

be reduced to the discourse among Islamic scholars.

Instead, any analysis must also pay close attention to

the global practices o international nance and to

developments such as the rise o proessional service

rms (investment banks, accountancy rms, and mul-

tinational law rms) that ormulate and administer

these practices.

The developments in the eld o Islamic nance,

moreover, may also be relevant or debates o interest

beyond the Islamic nance industry, taking the ol-

lowing into consideration.

. The adaptation o Islamic law to changing politi-

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cal, economic, and social conditions has been a central

research topic in the scholarship o Islamic law, both

with regard to pre-modern and modern times. As ar

as the developments since the mid-nineteenth cen-

tury are concerned, however, most studies (including

the seminal work o Anderson on Law Reorm in the

Muslim World6) emphasize the state and the courts

as drivers o change. I want to add that in the area o

Islamic nance there is also a signicant infuence rom

the globalization o business practices and rom private

actors, such as multinational investment banks, law

rms, and accountancy rms. Legal change is brought

about through the reception o contractual practices

that evolve in the market and is not dependent on

governmental intervention. The law o Islamic nance,

thus, can add an important new aspect to the debate

on how Islamic law has changed.

2. In recent years, globalization has challenged the

traditional paradigm o comparative law, which has

been occupied with comparing dierent legal insti-

tutions o dierent national legal orders (which, ol-

lowing Ulrich Beck, can be termed container theory,

according to which the nation state and its legal system

are enshrined in a box7). Instead, the ocus has shited

to transnational legal practices, rules produced in in-

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ternational business (and not promulgated, but only

supported by the state). From this perspective, inter-

national business law essentially consists o the rules

dened by contract and standardized in business.8

This perspective, I argue, is also o help when seeking

to explain the law o Islamic nance. It allows a move

away rom the state-centered paradigm o legal change

underpinning the traditional paradigm o law reorm

in the Muslim world. Possibly, however, some assump-

tions predominant in the debate on transnational law

need to be revised as well (in particular the belie that

transnational law is uniorm and not susceptible to

cultural pluralism).

3. The question o how the study o Islamic law can

be integrated into the broader ramework ocompara-

tive lawhas yet to be resolved. Mainstream comparative

legal scholarship9 is not genuinely interested in hosting

Islamic law, or two reasons. First, ollowing a certain

tradition o European scholarship that can be traced

back to Max Weber, Islamic law, labeled as a religious

law, is used as an antipode to Western legal develop-

ment. The emphasis on the sacred nature o Islamic law

and theallegedlypeculiar way justice is dispensed

(culminating in the catchphrase o Kadi Justiz) only

works i and to the extent the dierences, and not the

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commonalities, between Western and Middle Eastern

legal orders are emphasized. Second, comparative legal

studies are dominated by the idea o unctionalism,

i.e., the search or a unctional equivalent between

normative appearances in dierent legal orders; this

makes a comparison o European and Middle Eastern

laws dicult, as the social, economic, and political

conditions are oten quite dissimilar. I suggest that

using a paradigm such as transnational law, which

is oriented towards a certain normative appearance

as opposed to a unction, may help to overcome this

deadlock.

But let me or the time being return to Islamic nance

and my proposition that Islamic nance cannot be

explained exclusively as an application o Islamic law.

Instead, it must be seen as a contractual practice that

evolved in international nance.

In my paper I want to ocus on the ollowing ve

points:

. The context in which Islamic fnance operates.

Since the call to enact Islamic legislation and to set

up Islamic interest-ree banks emerged in the 970s,

Islamic nance oten is discussed in the context o

an Islamization o the law.0 Paradoxical as it may

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seem, I believe that the contrary is correct. Islamic

nance is part o a revival o Islamic religious ethics

in international business that thrives in jurisdictions

where law and religion are separated (such as Dubai,

London, Kuala Lumpur), whereas in those jurisdic-

tions that pledge to abide by Islamic legal principles

(such as Saudi Arabia, Sudan, Iran, Pakistan), Islamic

nance did not really take o.

2. The way Islamic legal rules are applied in Islamic

fnance. In Islamic nance, Sharia principles are ap-

plied as ethical principles and not as legal principles.

Whereas the so-called Islamization o the law normally

results in a secularization o Islamic legal rules, that is,

they are codied in state-enacted laws, with regard to

Islamic nance the contrary holds true: Islamic ethics

are applied to nancial transactions governed by some

other law.

3. In Islamic fnance, Islamic law no longer is applied

by Islamic scholars. Islamic law can be dened as legal

rules ormulated by Muslim jurists on the basis o the

Islamic legal tradition. In Islamic nance, however,

the so-called Sharia process, in which a transaction

is certied as conorming to Islamic legal rules, is

increasingly institutionalized. This also has an impact

on legal rules.

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4. In Islamic fnance, a new system o precedent has

emerged, consistent with the practices o international

fnance. The system o precedent marks a clear depar-

ture rom how Islamic law was administered in the

past, drawing on new orms o standardization and

other practices borrowed rom the law o international

nance.

5. From a legal perspective Islamic law is no longer

perceived as law but as risk.In nancial transac-

tions, law has the unction to provide transaction

security, that is, to saeguard that the transaction, i

need be, can be enorced in court. In Islamic nance,

the role o Islamic law is essentially dierent, as reer-

ence to Sharia rules can endanger the enorceability

o the transaction.

. Islamic Finance: The Global Context

Islamic nance has oten been treated as one aspect o

a broader Islamization o the law in the Middle East,

which in turn is seen as a key aspect o Islamic resur-

gence. The evolution o a powerul Islamic nance

industry since the 970s is taken as an indicator that

the call to implement Islamic law, raised by political

parties and groups o dierent Islamic orientation,

not only resulted in the implementation o Islamic

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codes and legislation, but was also successul in the

area o business transactions.

From todays perspective, this statement needs to

be qualied. Although the call to Islamize the law and

the nancial system can possibly be traced back to

the same historic roots, both trends have since devel-

oped independently. The civil and commercial codes

enacted since the mid-970s in the Arab Middle East

(starting with the enactment o the Jordanian civil

code in 976 and ollowed by the Civil Code o the

United Arab Emirates in 985) arguably incorporate

more Sharia elements than their predecessors. Islamic

nance, however, has developed independently rom

legislative trends. This becomes obvious i one looks at

the oundation o Islamic nance, namely, the ban on

interest (interest-ree banking is a popular denition

o Islamic nance).2 I commercial law had been suc-

cessully Islamized, there would be no need or Islamic

banks oering Sharia-compliant transactions as an

Islamic alternative to conventional banking. Islamic

banking, as it is practiced in international nance

today, thereore, thrives on providing an Islamic al-

ternative in a non-Islamic environment.

In addition, rom an empirical perspective, Islamic

nance hubs tend to emerge in either Muslim jurisdic-

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tions that do not ban interest, such as Dubai or Bahrain,

or in international nancial centers, like London, that

are actively promoting Islamic nance. The Islamic -

nance industry, thereore, seems to be attracted by nan-

cial centers that provide a reasonably liberal and stable

regulatory ramework, and not by jurisdictions that

enorce Islamic legal rules in the area o business law,

such as Saudi Arabia, Sudan, and Pakistan. Although an

Islamic nance industry exists in these countries, too,

it denitely lacks an appeal to international players.

This tendency, moreover, is underpinned by the more

recent wave o reception o English common law in the

Arab Gul states: the new international nancial centers in

Dubai and Qatar (Dubai International Financial Centre,

DIFC, and Qatar Financial Centre, QFC), or instance,

were set up as oshore nancial centers and operate on

common law-based legal orders.3 Eectively, most laws

and regulations are based on English models, with some

infuence rom the Far East (Hong Kong, Singapore)

and other common law jurisdictions (e.g., Ireland). This

development is accompanied by a large-scale move o

proessional services rms (law rms, accountants, nan-

cial advisors) to the new nancial centers in the Middle

East with the intention to make Western-style advisory

services available to Middle Eastern clients. Investment

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banks advise clients on structuring transactions the way

they are structured in the cities o London and New York;

international law rms drat contracts conorming to

global market practice; and accountants apply interna-

tional nancial reporting standards to local companies

in order to prepare them or the international capital

market. All these proessional services rms operate on

a business model based on transplanting international

practices rom New York and London to the emerging

nancial centers o the Middle East.

The global context o Islamic nance, thereore,

cannot be reduced to the implementation o Islamic

law. To the contrary, the recent Islamic nance boom

has coincided with a globalization o contractual

practices and their spread to the Middle East. In the

Arab Gul states, in particular, Islamic nance is thriv-

ing in an increasingly westernized business and legal

environment.

2. Islamic Finance Does Not Mean

to Apply Islamic Law

As mentioned at the outset, Islamic nance has oten

been described as an application o Islamic legal rules

to modern nance. Compliance with Sharia principles

is what makes Islamic nancial transactions dierent

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rom conventional transactions and Islamic transac-

tions are underpinned by the Sharia promise, the

banks pledge to the customer that the transaction

entered into is lawul also rom an Islamic perspective.

I argue, however, that this is dierent rom the call to

apply Islamic law that underpins the promulgation

o Islamized laws and codes. Whereas under ocial

Islamization policies, Islamic legal principles are

transormed into state law (and codied in Islamic

codes and legislation), in Islamic nance, Islamic legal

principles are introduced as a corrective ethical layer,

which implies that Islamic law is in eect reduced to

its ethical component.

Pre-modern Islamic law, in broad terms, employed

two categories to rate human acts. One concerned

its legal validity (ranging rom sahih valid to batil

null and void) and the other its ethical or religious

assessment (ranging rom wajib obligatory to haram

orbidden).4 Where Islamic legal rules have been

enacted as state law, as is the case with Islamic codes,

the rating normally is reduced to questions o legal

validity. State law is only concerned with the legal

dimension o the act in question and abstains rom a

value judgmentits the law. In Islamic nance, on

the other hand, Islamic law is employed exclusively to

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nd out about the permissibility o a certain transac-

tion: the decisive question is whether the transaction

is halalpermissible (as opposed to haram prohib-

ited). Legal validity (or transaction security, in the

words o the practicing lawyer) would normally be

provided by another legal order. In most Islamic -

nancing transactions English law is determined as the

proper law o the contract, the preerred law to govern

international nancial transactions. Hardly ever, i

at all, does a choice o law clause make reerence to

Islamic legal principles.

The reduction o Islamic law to a system o busi-

ness ethics has ar-reaching consequences or the

development o contract law, which becomes obvious

upon comparison o a traditional restatement o Is-

lamic legal principles, (such as theMurshid al-hayran

o the Egyptian lawyer Muhammad Qadri Basha, rst

published in 875) with the AAOIFI Sharia Principles

as applied in Islamic nance. A restatement o contract

law basically ulls two unctions: it provides rules that

supplement incomplete contractual arrangements and

it sets out remedies in the event things go wrong, e.g.,

i unoreseen events occur or one party does not ulll

its obligations. The law o Islamic nance, however,

normally does not address these issues. The Account-

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4

ing and Auditing Organisation or Islamic Financial

Institutions (AAOIFI)6 is a non-governmental orga-

nization based in Bahrain which, inter alia, is active in

ormulating Sharia standards, guidelines or Islamic

nancing transactions. The AAOIFI Sharia standards

are widely acknowledged in the industry. They dier,

however, in an important point rom a restatement o

Islamic contract law: they do not provide secondary

rules or unoreseen circumstances or non-peror-

mance o either party to the transaction, but only set

out criteria that must be met by Islamic nancing

transactions so that they meet Sharia requirements.

They only provide very limited guidance in case an

agreement is incomplete and virtually none when

things go wrong.

Islamic nance, thus, has the eect o reducing

Islamic law to business ethics. The Sharia turns into a

body o corporate social responsibility principles (al-

though Sharia rules in Islamic nance are oten applied

in a more rigid and ormalistic manner than CSR prin-

ciples). In very blunt terms one could say that in Islamic

nance, Islamic law is no longer applied as law.

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3. Islamic Finance Does Not Mean that

Islamic Law is Applied by Islamic Scholars

Sharia scholars play a central role in Islamic nance.

They certiy transactions with a atwa conrming that

it conorms to Islamic legal principles. In addition,

as members o Sharia boards they advise the banks

management on Sharia matters and ensure the institu-

tions compliance with Islamic principles. Complaints

about scholars in the industry are plentiul: there are

too ew o them, not all o them are adequately trained

in nancial matters, they are too expensive, and they

at times issue contradicting atwas. In view hereo, it

does not come as a surprise that issues o Sharia com-

pliance are increasingly taken out o the hands o the

scholars and transerred to other institutions. Let me

give you an example:

Among the most controversial issues in Islamic

nance are xed income products. On the one hand,

the prohibition o interest is the legal and economic

oundation o Islamic nance. Islamic nance, as men-

tioned above, is oten described as interest-ree bank-

ing (although there may be other more adequate ways

o characterizing Islamic nance, e.g., prot banking,

because a return is only justied i the investor takes a

risk in the nanced venture beyond the borrowers credit

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risk; or asset-based nance, as there is no trade in debt,

so that securitization structures need to be underpinned

by assets). These principles, however, are all at odds with

xed income products, where the investor receives a pre-

determined return. On the other hand, most investment

managers would be keen to invest a large portion o a

portolio (up to 90%) in xed income investments. To

balance risk and return requires a limitation o venture

capital-like investments (where the investor participates

in the business risk) to a certain portion o the portolio.

Last year, Deutsche Bank came up with a new xed in-

come capital protected und, based on the promise to sell

and buy certain Sharia compliant securities.7 I will not

go into the details o the structure, the debate surround-

ing its permissibility or the legal aspects (the structure

depends on the enorceability o unilateral promises,

which is controversial rom a Sharia point o view), but

I will highlight instead how this innovation was brought

about: One, it was developed by a consultancy, a subsid-

iary o Deutsche Bank (Dar al-Istithmar),8 specializing

in structuring Islamic transactions; two, the atwathat

is, the argumentation why the product is permissible

(although in obvious confict with one central tenet o

Islamic nance)was produced by and large by the

consultancy and later approved by the consultancys

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Sharia board; and, three, the atwa was published in the

orm o a research paper and put on the Internet, with

the aim o generating authority through transparency

(the success o which in the concrete case is question-

able). In eect, the Sharia process was taken out o the

hands o the Sharia scholars. In addition, in orm and

substance, the atwa process was rephrased to conorm

to a modern research paper. From the perspective o

traditional Islamic law, this was a rather unusual atwa.

Even urther reaching are the proposals to entrust the

regulator with ensuring Sharia compliance. This marks

a distinct break with the traditional division o labor in

Islamic nance, wherealso as ar as Islamic nancial in-

stitutions are concernedthe regulator would scrutinize

compliance with the law and regulatory principles (com-

pliance with consumer protection rules, maintaining

o adequate reserves, application o proper accounting

standards, etc.), but would not look into Sharia matters,

which would be let to the scholars. More recently, several

actors invite a revisiting o the issue: Sharia scholars

oten render advice to the institutions they supervise,

which can result in a confict o interest (comparable to

the one that brought down the accountancy rm Arthur

Anderson); the Sharia process is not always transparent,

as there is no requirement to disclose the reasons and

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legal argumentation underlying a certain Sharia judg-

ment; and the scholars are selected by the institution,

which may endanger their independence. Taken together,

these actors make it dicult or an outsider to evaluate

the Sharia promise (which is o particular concern in

the retail sector, because it is very burdensomei pos-

sible at allor the average consumer to obtain Sharia

advice o his or her own). In view hereo, it does not

come as a surprise that some regulators in countries with

substantial Islamic markets more recently have moved

towards enlarging their competencies to also comprise

Sharia supervision or at least certain aspects o it (most

notably Malaysia).9 In these markets, Sharia compliance

is deemed as one aspect o general compliance, alling

into the responsibility o the regulator. The transer o

Sharia supervision to the regulator materially alters the

division o laborand powerbetween state and civil

society in Islamic nance.

4. The Role of Global

Investment Banks and Law Firms

Modern banking depends on standardized transac-

tions. Standardized contractual practices acilitate

the comparison o a transactions nancial terms. The

absence o rmly established market practices has been

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9

perceived or a long time as one o the faws o the

law o Islamic nance. Islamic nance is at odds with

developing market practices, and this or two reasons:

Islamic nancial transactions are implemented in

many dierent, oten less mature jurisdictions, some

o which are civil law-based, like the UAE, and some

o which are common law-based, like Malaysia; and

the transactions are guided by dierent interpretations

o the Sharia (in particular, scholars in Malaysia, In-

donesia, and India tend to be much more liberal than

their counterparts rom the Arab Gul or Pakistan).

This has resulted in Middle Eastern and South-

east Asian market practices, which, in turn, are not

unanimously accepted rom the Sharia perspective

(this became obvious earlier this year when a debate

broke out regarding the question o whether the mar-

ket practice osukukIslamic bondsare consistent

with Islamic law).

In view o this, standardization eorts are a central

concern in Islamic nance. In addition to ormulat-

ing Sharia standardssuch as the AAOIFI Principles

mentioned abovewhich harmonize divergent in-

terpretations o the Sharia, there are ongoing eorts

to standardize transaction documents themselves. A

system o precedent, as well as a more or less system-

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20

atic collection o contractual orms (shurut), is not

alien to the tradition o Islamic law at all. However,

standardization in the Islamic nance industry today

marks a clear break with the traditional administra-

tion o Islamic law. I want to exempliy this using the

practice guide o the London Loan Market Association

(LMA), arguably the most signicant standard-setting

organization in international nance (at least as ar as

Europe and the Middle East are concerned).20 Last year,

in response to the increasing importance o Islamic

nance, the LMA published guidelines on how to use

the standard LMA orm when structuring Islamic

loan agreements. It is intended to urther develop the

practice guide into an Islamic LMA orm.

What is noticeable about this development are the

ollowing: (i) The Islamic model loan agreement will

be based on the standard LMA orm, which is widely

used in international nance and will thereore be

based on conventional loan documentation. (ii) The

practice guide was drated by lawyers rom law rms

active in international nance, not by Sharia scholars

(most o whom would not possess the drating skills

or such a job) or a standard-setting institution owned

by the Islamic nance industry (such as, or instance,

AAOIFI or the Islamic Development). As a result (iii),

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2

the practice guide conorms in terms o style to the

standard in international nance (which, in act, holds

true or most agreements in Islamic nance, at least as

ar as big ticket transactions are concerned).

In international nance, the law consists o con-

tractual practices and the market practice, at times,

can even prevail over mandatory legal provisions. The

background to this development is the business model

o London-based law rms, which essentially live o

o exporting drating services around the globe. Law,

rom this perspective, is what is written in the contract

and Islamic nance, in this respect, is not dierent.

5. The Role of the Courts and the Emergence

of the Doctrine of Sharia Risk

The globalization o Islamic nance had one unwanted

side eect: the emergence o Islamic nance litigation.

Once Islamic nance was no longer conned to a small

like-minded community, borrowers deaulted and

banks sued and enorced. A typical Islamic nance case

is the Beximco case wherein a company entered into

an Islamic murabaha loan agreement with an Islamic

bank. When the bank asked or repayment, the bor-

rower declined to settle the balance and claimed that

the contract was in act an interest-bearing loan that

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22

was only dressed up as an Islamic transaction. In view

hereo, the borrower argued, the contract was void and

there was no obligation to repay.2

This is not the right place to discuss the merits o

the legal argumentation in detail.22 Considering the

waymurabaha structures have developed over the last

decades, there is, however, an issue o how to discern

them rom a conventional loan. Under a murabaha,

the bank acquires a certain asset speciied by the

customer and sells it on to the customer with a prot

(mark-up) on deerred terms. Instead o granting

a loan in money, the bank engages in trade, as it sells

the customer an asset on deerred terms. From the

Sharia perspective, the bank is required to acquire

ownership o the asset and the risks attached to own-

ership in transit. In Islamic nance practice, however,

the risks attached to ownership in transit o the bank

are minimal i existent at all. First, the contracts nor-

mally provide or an allocation o risk that is similar

to the one under a conventional loan agreement. And,

second, instead o acquiring a specic asset, the bank

oten sells certain commodities to the customer, who

immediately turns them into cash on the commodities

exchange. This structurecalled tawarruqprovides

the customer with liquid unds and is thus even closer

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to a conventional loan structure. Permissibility o these

structures rom a Sharia perspective is not uncontro-

versial, to say the leastwith the eect that there is

always a chance that a atwa will be issued according

to which the transaction is not permissible.

The chance that an Islamic nancing transaction

is challenged on grounds that it does not comply with

Islamic law is called Sharia risk. Since the emergence

o the rst Islamic nance cases, the issue has attracted

a lot o attention. Sharia risk illustrates the changed

role o Islamic law in Islamic nance. In the world o

nance, law (and lawyers) normally serve to make the

transaction enorceable in court. Law provides transac-

tion security. In Islamic nance, in contrast, the role

o the Sharia is reversed. Sharia is a risk, which allows

the transaction to be attacked on the basis that it did

not conorm to Islamic legal principles.

In order to mitigate Sharia risk, Islamic nancing

transactions normally contain a so-called waiver o

Sharia deense clause. In this clause, although worded

slightly dierent rom one transaction to the other,23

the borrower normally waives the right to bring any

deense based on the non-compliance o the transac-

tion with Sharia principles. In addition, the clause may

also provide or an explicit statement on Sharia com-

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24

pliance, pursuant to which the parties agree to ollow

the interpretation o the banks own Sharia board as

ar as the transaction is concerned. Oten the borrower

will acknowledge that s/he had the opportunity to seek

Sharia advice o his/her own and is comortable with

the transaction rom an Islamic-ethical perspective. As

a result, Islamic nancing transactions are no longer

governed by Islamic law, but only by a conviction o the

parties (not necessarily a shared one) that the transac-

tion is compliant with Islamic business ethics.

Conclusion

The globalization o Islamic nance has transormed

Islamic contract law. While most observersin par-

ticular rom the viewpoint o the conventional nance

industryare puzzled by the return o ethical or reli-

gious principles to the world o international nance,

normally governed by the considerations o risk and

return, in act, globalized legal practices have secretly

hijacked Islamic contract law: Islamic nancing trans-

actions are no longer governed by Islamic law and

Islamic law is no longer applied by Islamic jurists. In

the medium term, I expect the law o Islamic nance

to develop into a semi-autonomous eld o Islamic

law such as the Anglo-Muhammadan law, which is

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25

based on certain Sharia concepts, but was transormed

through its application by English-trained judges. As

ar as law reorm in the Muslim world is concerned,

Islamic nance has established a new category o

modern Islamic contract law, where traditional Is-

lamic legal concepts have been transormed through

the practices o international nance and are phrased

in the language o international commercial law.

This transormation, notably, has not been brought

about by the state or the courts, but has gradually

evolved through the practice o international nance.

Whereas law reorm in the Muslim world and Islam-

ization policies alike are primarily state-driven, the

development o the law o Islamic nance is market-

driven and led by private actors: international invest-

ment banks, multinational law rms, and accountants.

This brings me to the debate in legal studies regarding

transnational law. The law o Islamic nance is a kind

o transnational law. In contrast to other legal orders,

in Islamic law the role o civil society in the law-making

process has always been paramount and only more

recently has the nation state claimed the monopoly to

determine legal rules in the Muslim world. However,

in Islamic nance this is merged with the modern

appearances o transnational law, namely, that law is

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26

made through business practices. As a result, a global

lex mercatoria o Islamic nancial transactions has

evolved.

From the perspective o comparative legal studies

this nding is intriguing. Normally it is argued that

law that is based on business practices and not on leg-

islative activity o the nation state results in uniorm

global standards. There is a strong belie, in particular

in the business community, that where contract is king

and governmental intervention absent, the law will

become harmonized (which, rom the perspective o

international business, is a desirable outcome). The law

o Islamic nance, however, demonstrates that this is

not the only and natural outcome, but that transna-

tional law can produce divergencies o its own.

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27

Endnotes

1 The paper is based on a public lecture delivered at the Is-lamic Legal Studies Program o Harvard Law School onMay, 2008. Some reerences have been added. I grateullyacknowledge the institutional support o the Islamic LegalStudies Program in hosting me as visiting ellow in spring2008 as well as the personal support and encouragement othe directors o the program, Baber Johansen and Peri Bear-man.

2 Most notably Frank E. Vogel and Samuel L. Hayes, Islamic Lawand Finance: Religion, Risk and Return (The Hague: KluwerLaw International, 998). The book is still the leading publica-tion in the eld.

3 KPMG, Growth and Diversifcation in Islamic Finance, oundat http://www.us.kpmg.com/microsite/FSLibraryDotCom/docs/Growth%20and%20Diversication%20in%20Islam-ic-%20Finance.pd (last visited May5, 2008).

4 City o London, Press Release January30, 2007, City wel-comes Government moves to promote Islamic nance,ound at http://www.cityofondon.gov.uk/Corporation/me-dia_centre/les2007/5_07.htm (last visited May6, 2008).

5 Islamic banking and nance seek to apply the Islamic reli-gious law (sharia) to a sector o modern commerce. Vogeland Hayes, Islamic Law and Finance, p. 23.

6 London: Athlone Press, 976.7 Ulrich Beck, What is Globalization?(Cambridge, UK: Polity

Press, 2000).8 See, e.g., the contributions in Richard P. Appelbaum, Wil-

liam L. F. Felstiner, and Volkmar Gessner (eds.), Rules andNetworks: The Legal Culture o Global Business Transactions(Oxord and Portland: Hart Publishing, 200).

9 See, e.g., the chapter on Islamic law in Konrad Zweigert andHein Ktz, Einhrung in die Rechtsvergleichung(3rd ed., T-bingen: J. C. B. Mohr, 996), pp. 296-305.

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28

10 This does not mean that both concepts, the call to imple-

ment Islamic law and to establish Islamic interest-ree banks,had not been around beore. However, only in the 970s and980s did these concepts, or the rst time, start to dominatethe legal and policy discourse and were actually put intopractice.

See, e.g., the chapter Muhammad Baqer as-Sadr and IslamicBanking, in Chibli Mallat, The Renewal o Islamic Law:Muhammad Baqer as-Sadr, Naja and the Shii International(Cambridge, UK: Cambridge University Press, 993), pp. 58-

87.2 This is not the right place to unold the debate whether the

Quranic prohibition oriba is correctly interpreted as a banon interest. Although this question continues to be debatedamong Islamic scholars, and historical precedents suggestthat interest-bearing loans have, at least at times, been prac-ticed in the earlier centuries o Islam, there is a broad con-sensus among practitioners o Islamic nance that Islamiclaw prohibits interest. Islamic nancial products thus share

the eature that they are interest-ree. One can thereore saythat the prohibition o interest is the ethical and economicoundation o Islamic nance.

3 See http://www.dic.ae/laws_regulations/laws/enacted_laws.html and http://www.qccourt.com/ (both pages last visitedMay2, 2008).

4 See, e.g., the discussion in Baber Johansen, Contingency in aSacred Law: Legal and Ethical Norms in the Muslim Fiqh (Lei-den: Brill, 999) pp. 69-70.

5

Muhammad Qadri [Basha], Kitab Murshid al-hayran ilamaaria ahwal al-insan f l muamalat al-shariyya (2nd ed.,Cairo 89).

6 See http://www.aaoi.com (last visited May5, 2008).7 See http://www.deutsche-bank.de/presse/en/content/press_

releases_2007_3347.htm (last visited May5, 2008).8 See http://www.daralistithmar.com/ (last visited May5,

2008).

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29

9 See http://www.bnm.gov.my/guidelines/0_banking/04_pru-

dential_stds/07_shariah_resolution.pd (last visited May5,2008).

20 See http://www.loan-market-assoc.com/ (last visited May5,2008).

2 Shamil Bank o Bahrain v. Beximco [2004] EWCA Civ99.22 For a discussion o the case and related cases, see Kilian Blz,

Islamic Financing Transactions in European Courts, in S.Nazim Ali (ed.), Islamic Finance: Current Legal and Regula-tory Issues (Cambridge, MA: Islamic Finance Project, 2005),

pp. 6-75.23 A (concise) typical clause would read: The transaction con-

templated in this Agreement has been approved by [ShariaBoard], whose ruling with regard to Sharia matters shall benal and binding or the Parties. Neither Party shall be en-titled to raise any objections or deenses based on the basisthat the agreement, the transaction envisaged therein or cer-tain clauses contained therein, is not in compliance with theprinciples o the Islamic Sharia (Waiver o Sharia Deense).

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