On balance, arbitration including Shari'ah experts is positive for Islamic finance

The Kuala Lumpur Regional Centre for Arbitration (LKRCA) announced new rules for arbitration that would allow for the arbitration panel to "outsource Shariah issues to a specialist council or expert agreed by the parties".  This is an important move for Islamic finance because it will provide a process for dispute resolution that incorporates a process for deciding differences of opinion between parties on the Shari'ah-compliance of contractual arrangements.

There will also be a significant ability to enforce arbitration decisions as well since, as the director of KLRCA Sundra Rajoo described in an article (pdf), "Awards under the i-arbitration rules will be enforceable in the 146 countries that are signatories to the New York Convention."  These countries include most of the countries with significant Islamic finance industry presence, including all 6 GCC countries.

In the past, Islamic finance contracts have been subject to either English or New York law, which has little room to incorporate disputes about Shari'ah-compliance.  One of the most widely cited cases was one between Shamil Bank of Bahrain and Beximo Pharmaceuticals, which received financing through a murabaha that included language that "Subject to the principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with the laws of England."

The English courts declined to decide on the Shari'ah-compliance of the transaction saying that only one law could be selected, and that Shari'ah was "merely intended to reflect the Islamic religious principles according to which the Bank held itself out as doing business[, and] not a system of law designed to trump the application of English law as the governing law." (see a description here as a PDF). 

In another case between The Investment Dar and Blom Bank, TID claimed that it was not obligated to repay a wakala facility because the contract was not Shari'ah-compliant (here was my summary).  The courts again declined to hear arguments about whether the contract was void because of Shari'ah-compliance concerns (TID was at the time in financial distress), and the Investment Dar's Shari'ah board, which had approved the transaction when it was signed requested that TID stop pursuing its claims that the transaction was not Shari'ah-compliant.

In July, I was predicting that it might be a long time for something like the KLCRA arbitration to develop the credibility needed to see much movement away from using English or New York law, and there remain some hurdles to be overcome before Islamic finance companies will adopt binding arbitration through the KLCRA rather than litigation in English and New York courts. 

Besides the difficulty of convincing large banks with Islamic windows that they will preserve their rights equally through an arbitration proceeding, I think there will be resistance within the banks based in regions like the GCC to using the KLRCA.  The biggest source of resistance will be the choice of what Shari'ah boards to use to decide on the Shari'ah-compliance of products.  The article linked above as a pdf describes:

"Parties who adopt the i-arbitration rules can opt for one of the two Malaysian councils, as named by the KLRCA – either the council of Bank Negara Malaysia, established by the Central Bank Act 2009 or the council established by the Securities Commission under the Securities Commission Act 1993."

The composition of the Bank Negara Shari'ah Board is overwhelmingly composed of Malaysian Shari'ah scholars, and while several of them are widely regarded and work globally, there is likely to be concern that the BNM Shari'ah Board will adopt Shari'ah standards used in Malaysia which are not all accepted by GCC-based Shari'ah scholars. 

For example, what would happen if a GCC-based Islamic bank with a Malaysian subsidiary was taken to arbitration by a counterparty in Malaysia, and the arbitration panel found that the GCC-based bank had to pay compensation to the counterparty that the GCC-based Shari'ah board said would fall afoul of Shari'ah.  It would not be possible (as it would be if the two parties were in reverse position in the arbitration) for the GCC-based bank to purify the settlement by donating the proceeds to charity since in this case it is being required to make a payment.  Likely it would be regarded as a de minimis item and allowed as a one-off occurrence.

But, if that happened, the Shari'ah board and boards of other Islamic financial institutions outside of Malaysia might make a push to require that future arbitration clauses specify that the Shari'ah board not be the BNM Shari'ah board, which would require additional arbitration centers in different regions.  This could limit the adoption of the KLRCA standards from then on.  It is likely that this will be the end result regardless, and the development of the KLRCA as an arbitration center will hasten this process, so it might be a good long-term development even if it could cause angst in the short-run. 

The development of an arbitration process for Islamic finance is on balance good, in my opinion, for the industry's long-term development and it is not surprising that it originates in Malaysia, where there is a national Shari'ah board.  In order for other arbitration panels to develop, I think there will have to be some standardization of Shari'ah opinion, whether on a national or regional basis.

The one concern that could arise is that arbitration (which would include an ex post review of the Shari'ah-compliance of a transaction) could lead to "Shari'ah risk".  Generally speaking, Shari'ah risk is the risk that a transaction that is approved by a Shari'ah board today could be ruled later as non-Shari'ah-compliant.  With the exception of the unsuccessful challenges by Beximo and The Investment Dar, there has been a general trend that a transaction that was approved by the Shari'ah board will not be challenged later on Shari'ah-compliance grounds.  Incorporating Shari'ah review into arbitration processes would change that and increase Shari'ah risk, which could slow the growth of Islamic finance, or increase costs.