By Robin Wigglesworth

The default of two prominent Middle Eastern investment companies is shaping up to be a test case for the $1,000bn Islamic finance industry on how Islamic bonds, or sukuk, are settled. Until recently, the market for bonds that comply with Islamic law, or sharia, was one of the fastest growing niches of the international financial industry, with issuance soaring from virtually nothing less than a decade ago to about $100bn of sukuk bonds outstanding this year.

However, like many of the complex financial products conjured up during the past decade, Islamic bonds are facing their sternest test yet. The defaults of Kuwait’s Investment Dar and Saudi Arabia’s Saad Group earlier this year have raised uncertainty on how sukuk-holders will be treated compared with more conventional creditors. “It’s a real legal battleground,” says Mohieddine Kronfol, managing director of Algebra Capital, a Dubai-based asset manager that has invested in Saad’s sukuk. “It will set an important precedent.”

Sukuk skirt round Islam’s ban on interest by allowing investors to profit from the income of an underlying asset, such as rental income on land or real estate placed in a special purpose vehicle for the duration of the bond, rather than receive a fixed interest rate.

Lawyers and bankers are now poring over the legal documentation of Investment Dar’s $100m sukuk, which defaulted in May, and Saad’s $650m “Golden Belt” Islamic bond to find out whether sukuk-holders have recourse to the assets. Saad’s Golden Belt sukuk is secured by land in Saudi Arabia — valued at about 40 percent of the bond’s principal, according to Kronfol — and some investors are trying to get the sukuk dissolved so they can gain recourse to the property. A ruling is expected later this month.

However, experts say that the issue may not be clear-cut. Lawyers say confusion has arisen on the difference between “asset-based” and “asset-backed”, and they stress that not all Islamic bonds are secured by an underlying asset. Moreover, sukuk are usually structured according to UK law to adhere to Islamic principles, raising concern over how courts will rule in a liquidation.

Even the Muslim clerics that have to approve all Islamic financial products often disagree on how closely Islamic bonds can mimic conventional paper and what happens in the case of a default.

“The Shariah view is that they [sukuk-holders] are the owners [of the assets], but it depends on how [the sukuk] is structured. If someone has purchased a sukuk assuming that they automatically have recourse to the assets, they might be unpleasantly surprised,” says Muddassir Siddiqui, a former Shariah scholar and head of Islamic finance at DentonWildeSapte. While received wisdom holds that sukuk-holders would be better protected than conventional bond-holders in the case of liquidation, assets are primarily put in place to facilitate the Islamic structure rather than protect creditors, according to Raphael de Ricaud, head of Islamic finance at Rothschild.

“At the core of this confusion lies the subtle - some would say ‘fictitious’ - distinction between ‘beneficial right’ and ‘legal right’ to the asset,” he says. “In a liquidation case, the court is very likely to look only at with whom the legal title of the asset resides to sanction who owns the particular asset.” The future of the Islamic debt markets could be at stake on what eventually happens in the restructurings, some bankers say. “Sukuk have never been tested like this,” says Nish Popat, head of fixed income at ING Investment Management in Dubai. “This will be an important test case to see if the market continues to evolve and improve or if the market starts to splutter.”

Total global issuance of Islamic debt has reached almost $18bn so far this year, according to Zawya, a data provider, with much of this issuance by sovereign or quasi-sovereign entities. Abu Dhabi’s Tourism Development & Investment Company recently sold a $1bn sukuk that was seven times subscribed. Among private sector issuers, the Islamic debt market is still difficult and bankers warn that investors are likely to be sceptical of any sukuk sales until the Investment Dar and Golden Belt sukuk issues are settled.

“Sukuk are no different from any new financial product that hasn’t been tested in stress situations before,” says an Islamic lawyer. “It’s a young market, and this is its first major test; lessons will be learnt, and practitioners will hope that investors and regulators learn from the outcomes.”