Arbitration: the ‘Bench mark’ for disputes?

MUSHTAK PARKER reports on 
a ‘man with a mission’, whose aim is to promote arbitration

Sundra Rajoo is a man with a mission. As director of the Kuala Lumpur Regional Centre for Arbitration (KLRCA) he has been mandated by Bank Negara Malaysia, the central bank, to promote arbitration in Islamic finance both in the region and beyond.

Consistent with the overall objectives of the Malaysia International Islamic Finance Centre (MIFC) initiative, the strategy is also now to make Kuala Lumpur the international hub for dispute resolution and arbitration in Islamic banking, finance and insurance contracts and transactions.

Rajoo’s dream is that down the line more countries especially from the Middle East and North Africa (MENA) region would offer Islamic banking arbitration services, which would enable them to enter into a convention for the enforcement of arbitral awards much like the New York Convention, which was established in 1958 as the Convention on the Recognition and Enforcement of Foreign Arbitral Awards. This Convention provides common legislative standards for the recognition of arbitration agreements and court recognition and enforcement of foreign and non-domestic arbitral awards.

Malaysia, like several MENA countries, including Bahrain, UAE and Egypt, is one of the 145 signatories to the New York Convention. Therefore, technically awards rendered in arbitral proceedings conducted in KLRCA and other centres in the MENA countries are enforceable in any one of the contracting states to the New York Convention.

KLRCA is one of the first arbitration centres to provide institutionalised arbitration based on specialised Islamic Banking and Financial Services Arbitration Rules introduced in 2007. But, equally important, Rajoo wants to go one step further. He aspires for the centre to come up with a uniform set of Islamic banking arbitration rules that can be used across the globe.

In fact, the Council of the Makkah-based Islamic Fiqh Academy of the Organisation for Islamic Cooperation (OIC) in a meeting in Abu Dhabi way back in 1995 called on member countries to establish an International Islamic Arbitration Court to hear disputes in the Islamic banking industry. The council emphasised that “in the absence of any such court, Islamic states or institutions may seek arbitration from non-Islamic courts in a quest for a Shariah-compatible settlement”.

KLRCA is positioning itself as the go-to centre for Islamic Banking Arbitration and is expanding its pool of Islamic banking arbitrators. It has also initiated negotiations with Bank Negara with the aim of revising the above rules to cater for the current needs of the industry and society; and is working with Shariah scholars from both the region and the Middle East and eminent arbitrators to revise the rules to ensure that the awards rendered are in compliance with the New York Convention.

Arbitration is fast becoming the preferred method of dispute resolution as opposed to litigation. It forms an integral part of financial and business culture especially for those dealing with transnational companies. There is also growing recognition that arbitration is the most effective way of resolving international commercial disputes. Not surprisingly, the demand for international commercial arbitration as a mode of dispute resolution is growing year by year in line with the expansion of transnational commerce, trade and the rapid globalisation of the world economy.

Despite this, in general arbitration, says Neil Miller, global head of Islamic finance at KPMG in Dubai, is not “well entrenched” but has become more common than in the past. Historically, under English law, “financial” contracts and the disputes that arise from them have tended to be dealt with by the judicial system, whilst “commercial” contracts and the disputes that arise from them, are often dealt with by arbitral means.  Again, historically, a perception that the judicial system handled disputes too slowly witnessed some migration towards arbitration but the courts have fought back by changing procedures and becoming more efficient, at least in the UK.

A current trend is the growing number of cases involving the Islamic finance industry and “the number is increasing on a yearly basis”, according to Rajoo. In fact, he maintains that the Islamic banking industry “would prefer arbitration due to the confidentiality of the proceedings, as goodwill means an awful lot to the financial and business sector as well as the expertise and knowledge of the arbitrator”.

At KLRCA, the panel of Islamic banking arbitrators are the crème de la crème of the arbitral fraternity – prominent Shariah scholars with experience in arbitration or lawyers who have experience in Islamic banking legal contracts. The arbitrator need not be a Muslim as long as he or she is experienced, qualified and knowledgeable about Islamic arbitration principles and ensures that awards are in compliance with Shariah rules. Arbitrators in general, of course, should also have first-class writing skills.

Over the last few years the Islamic finance industry has witnessed a number of high profile litigation cases especially in the High Court in London and in the Shariah Division of the Supreme Court in Kuala Lumpur involving disputes over commodity Murabaha contracts and other financing and investment contracts offered by Islamic financial institutions.

While these cases have courted negative publicity about the Islamic finance industry, they remain relatively few. However, the legal architecture and infrastructure governing Islamic financial transactions and contracts remain largely underdeveloped in many jurisdictions whether in the MENA countries or in Asia and elsewhere, save Malaysia, giving the impression that there is not enough legal protection and certainty for Islamic finance transactions especially in the MENA countries, where such transactions remain on the whole untried and tested by the local courts.

In June 2011, The Investment Dar (TID), the Kuwait based Islamic investment firm that owes its creditors more than $3.5bn  and which defaulted on periodic payments on its $100m Sukuk, finally won Chapter 11 protection under the emirate’s Financial Stability Law (FSL), when the Special Circuit Court of Appeal ruled that the company can be admitted to the scheme.

The FSL provides the necessary legal framework under which TID can implement a court-approved restructuring plan in which full repayment of all of its banks and investors is incorporated. But it has taken TID almost three years to be admitted to the scheme. A Kuwaiti court earlier refused to allow a number of small creditors to force TID into administration, emphasising that it would give the company a chance to restructure its debt and devise a repayment plan.

TID was also involved in a separate litigation in the High Court in London brought by Blom Bank of Lebanon, which invested an amount of funds with TID under the Wakala (agency) contract. Following the financial crisis at TID, Blom Bank demanded its principal investment plus the promised profit rate. Once again the governing law of the transaction was English Law.

In Kuwait, too, The International Investor (TII), another local Islamic investment company, and the Bahrain-based Albaraka Banking Group (ABG), one of the pioneer Islamic banking groups, headed by Saudi Sheikh Saleh Kamel, were locked in a dispute for several years following a failed merger between the two entities which involved a share swap arrangement plus a lump sum payment. After initial court proceedings in Kuwait, the two parties finally settled out of court.

But the two most “notorious” cases in the High Court in London involved Shamil Bank of Bahrain and Beximco Pharmaceuticals Ltd in a case in 2004; and Islamic Investment Company of the Gulf (Bahamas), a sister company of Shamil Bank, which was later merged with the latter, and Symphony Gems NV & Ors. Both cases involved commodity Murabaha (cost-plus financing) contracts in which the parties were said to have reneged on repayments after a period. The governing law clause for the contracts under the Murabaha Agreement was: “Subject to the principles of the Glorious Shariah, this Agreement shall be governed by and construed in accordance with the laws of England.”

Most of the major international transactions especially commodity Murabaha contracts and Sukuk transactions are done under the preferred English Law. But in both cases the High Court judges in London were explicit that the contracts were valid based on the law of contract within the context of the English law and that they had no competence to rule on the Shariah aspects of the agreement.

In the case of Beximco v Shamil Bank, there were two appeals by Beximco against the High Court judgement, the last one going to the wire to the House of Lords. In both cases the original judgement was upheld, which raises the question whether this costly litigation could have been pre-empted had an arbitration clause been included in the contracts?

The issue of litigation v arbitration especially in today’s financial environment is not as clear cut as it may seem. “I believe that many of the judgments that have touched upon contracts that were entered into on the basis that they would be Shariah compliant have been properly decided: Shamil v Beximco being the prime example.  Although I think that arbitration is a perfectly acceptable means of resolving disputes between parties to Shariah-compliant contracts and has an appeal that is supported by certain Surahs in the Quran, the judicial system is still a valid way of resolving such disputes,” explains KPMG’s Neil D Miller, himself a prominent lawyer with more than two decades of experience in structuring Islamic finance transactions.

Where the issue becomes more complicated is if a secular court is asked to provide a religious judgment. In most contractual situations this should not arise if the financial institutions have adopted the right approach to ensuring that the contractual arrangement was considered to be Shariah-compliant at the time it was entered into.  This means, according to Miller, “that the critical part of the process should be the initial product design, approval and rollout. Establishing Shariah compliance should be a ‘risk and compliance’ function; this is the message implicit in the Shamil v Beximco case”.

His suggestion is that rather than confine dispute resolution to a single forum of a particular type, a more acceptable approach would be to permit disputes to be heard as at present but provide higher forum than can opine on matters of Islamic jurisprudence if technical points arise. This may be feasible in Muslim countries along the lines of the KLRCA scheme which is endorsed by Bank Negara’s Shariah Advisory Council, although it would be harder to replicate in secular countries.

Traditionally, arbitration has been viewed as a speedier and less costly form of dispute resolution when compared with court litigation. However, according to City-based international law firm Trowers & Hamlins, which has considerable experience in the Islamic finance sector, this is no longer the case.

“In some jurisdictions, such as England, the courts have been alive to the costs of litigation for some time and have made it a requirement that the parties at least attempt to resolve disputes through alternative dispute resolution prior to issuing proceedings. Even when litigation has been commenced, parties are required to consider mediation at an early stage of the proceedings and those parties who unreasonably refuse mediation can face severe costs consequences. In fact, when one considers the costs of arbitrators’ fees, particularly in cases where there is a panel of arbitrators, court litigation can often be the less expensive alternative for resolving commercial disputes,” says the firm.

In other jurisdictions steps have been taken to increase the speed of court litigation. For example, in Bahrain, where parties are required to have any dispute over BD500,000 heard in the Bahrain Centre for Dispute Resolution, the statutory period in which the claim must be dealt with is four months. Litigation has other benefits as well – the judge is not paid by the parties and a litigant who is unhappy with a decision has a greater possibility of appealing it.

However, arbitration encompasses flexibility; specialist expertise in particular in complexes issues; confidentiality; the finality of the award; and its enforceability.

In relation to Islamic finance, according to Trowers & Hamlins, “while in our experience large banks would often wish to avoid arbitrations with small local obligors some of the advantages of arbitration are of paramount importance to the parties to a dispute”.

The good news is that many of the MENA states – including Bahrain, the UAE and Saudi Arabia – and many other developing economies, are signatories to the New York Convention, thus (at least in principle) making enforcement of an arbitral award obtained by an international financier against a borrower/obligor in this region relatively speaking “easier” than seeking to have a judgment recognised and then seeking enforcement of that judgment.

In the larger deals such as the multi-billion dollar, complex, multi-sourced financings it is not at all uncommon for the big borrowers to demand that disputes be settled by arbitration where suitable arbitrators with experience in the field can be appointed.

Dispute resolution whether through mediation or arbitration is nascent in the Islamic financial services industry. This despite the fact that the legitimacy of Arbitration in the Shariah is implicit in several verses of the Quran (Surah An-Nisa verses 35,58,65,128 etc) and in the Hadith (sayings of the Prophet Muhammed) and the Sunnah (the practices of the Prophet Muhammed).

In 1995, the Islamic Fiqh Academy in a meeting in Abu Dhabi issued Resolution 91/8/9 “Concerning The Principles of Arbitration in Islamic Fiqh” in which it outlined the Shariah rationale and rubrics of the Islamic Arbitration process. The Shariah advocates Tahkim (Arbitration) or Sulh (Mediation) in civil cases. In the Ottoman Mejelle, Article 1850 emphasises that the concept of arbitration can be used to settle financial and trade disputes akin to conciliation.

There have been several attempts to establish dedicated arbitration centres relating to the Islamic finance industry to deal with commercial and investment arbitration cases. In 2007, for instance, there were reports that Bahrain was establishing the Islamic Financial Mediator Council in Manama, which never materialised.

In 2005, the Jeddah-based Islamic Development Bank (IDB) launched the International Islamic Centre for Reconciliation and Commercial Arbitration (IICRCA) –  based in Dubai – “to conduct mediation of disputes and to adjudicate on financial and commercial disputes which can arise between Islamic financial institutions, and between these institutions and/or third parties” in accordance with Shariah principles.

It took two years for the centre, whose secretary general is Dr Abdul Sattar Khuwaildi, to actually start operations in 2007. Because of a lack of transparency and disclosure, it is not even clear how many arbitration awards were made under this IICRCA scheme; to what type of companies; from which jurisdictions; and whether there were any cross-border cases.

IICRCA has even issued a “Sharia Standard on Arbitration” relating to financial transactions and relations, and defines arbitration as “an accord reached by two or more parties to appoint some one to settle a dispute between them by a binding ruling” and in the specific case of Islamic Arbitration “the rulings and the principles of  the Shariah will be implemented”.

The drawbacks of the IICRCA Convention is that the main language of arbitrations undertaken by the Centre is Arabic, which makes it difficult for foreign parties with non-Shariah-compliant contractual arrangements in place with Middle Eastern counterparts submitting to use IICRA as an arbitration body. The awards made are supposed to be binding on the parties, but the centre does not go further to ensure enforcement.

These institutions should, however, not be confused with the surfeit of general regional arbitration centres that have sprung up over the last few years in the Middle East and North Africa (MENA) countries, including Bahrain, Abu Dhabi, Egypt, UAE, Iran and so on. They are not equipped or necessarily qualified to deal with cases relating to disputes in Islamic finance contracts and transactions, which is very specialised given that mediators or arbitrators need to satisfy both the provisions of relevant arbitral conventions and of Shariah compliance relating to conciliation or arbitration.

The Bahrain Chamber for Dispute Resolution (BCDR), which is an initiative between the Bahrain Ministry of Justice and the American Arbitration Association (AAA), for instance, mentions nothing about dispute resolution relating to the Islamic finance industry. Yet Bahrain is a major international Islamic financial centre, second only to Kuala Lumpur in terms of financial architecture and infrastructure.

In contrast, KLRCA has recently been enhanced to serve as a platform to deal with cases involving Islamic finance pursuant to provisions under Section 56 (1) and 57 of the Central Bank of Malaysia Act 2009, which refer to the central bank’s Shariah Advisory Council for ruling from a court or arbitrator.

KLRCA was the first arbitration centre established in Asia by the Asian African Consultative Legal Organisation (AALCO) to provide institutional support for domestic and international arbitration. It was also the first centre to adopt the United Nations Commission on International Trade Law (UNCITRAL) Arbitration Rules in August 2010, and offers speedier settlements relative to the court’s process and freedom to choose governing laws. Its legal basis is underpinned by the Malaysian Arbitration Act, 2005 which is based on the UNCITRAL Model Law.

KLRCA has three sets of rules as far as arbitration is concerned. They include The Rules for Arbitration of the KLRCA 2010; The Fast Track Arbitration Rules 2010; and Islamic Banking and Financial Services Rules for Arbitration 2007. The latter is drafted to cater for disputes arising out of business arrangement or transactions which are premised on Shariah principles.

In line with the rapid progress of Islamic banking in Malaysia, a comprehensive legal infrastructure has been developed to govern the regulatory regime for Islamic financial institutions and products. This has been reinforced by the establishment of a dedicated High Court Bench to provide a comprehensive adjudicative system to deal with disputes involving Islamic banking, whilst the Rules for Arbitration (Islamic Banking and Financial Services) 2007 provides a customised mechanism for the alternative dispute resolution in the Islamic financial services sector.

Last year, the centre registered 50 arbitration cases, of which 10 were foreign cases and which excludes ad hoc cases wherein parties administer their own cases but use the centre’s premises. In the first half of 2011, there has been a steady increase in the number of arbitration cases registered with the centre.

The most glaring difference between conventional and Islamic Banking Arbitration, says Sundra Rajoo, is that in the latter, whenever an arbitrator has to form an opinion on a point related to Shariah principles and decide on a dispute arising from the Shariah aspect of an Islamic financial services business, transaction or product, which is based on Shariah principles, the arbitrator shall refer the matter to the relevant council for its decision.

This is in line with the requirements of with the provisions of Sections 56 and 57 of the Central Bank Act 2009, which stipulate that any ruling made by the Shariah Advisory Council shall be binding on the Islamic financial institutions and the court or arbitrator; and reinforces this by effectively making the SAC the Shariah Authority of Last Resort.

The most important lesson that Islamic arbitration can learn from its conventional variant, according to KPMG’s Neil Miller, is that parties to financial contracts want certainty and predictability in outcomes.  In some respects the desire to avoid Gharar (deception through non-disclosure), which is proscribed by the Shariah, is as strong in conventional financial contracts as it is in Islamic financial contracts. This does mean slightly different things as the certainty conventional banks are concerned about is the methodology for unwinding deals that go wrong: a different concern to that of an Islamic financier, who is more worried about the speculative character of the transaction in the first place.

There have been suggestions that the inclusion of arbitration clauses in all Islamic trade finance contracts and other transactions be made mandatory, because it will add value and give greater legal certainty to the Islamic finance proposition. In Malaysia, for instance, the government has issued a directive to state entities and government linked companies (GLCs) to incorporate the KLRCA arbitration clause in their contracts. “We certainly believe that the government should encourage the inclusion of mandatory arbitration clauses for contracts involving Islamic financial and investment matters for the simple reason that it would be beneficial to the parties,” maintains Sundra Rajoo.

However, others are more sceptical about imposing mandatory dispute resolution procedures in contracts. Miller, for example, advises caution. “When working out how to resolve civil disputes between contracting parties,” he emphasises, “it seems to me that the crucial considerations are two-fold: first, what method will most likely result in the right outcome (and here we are concerned about adherence to the terms of the contract and/or notions of equity and fairness generally being imported where the contract is unclear, the facts are uncertain, or there is uncertainty and ambiguity about intentions etc); and, secondly, how will the outcome be best enforced? There is little merit having a dispute resolved if the ‘losing’ party cannot then be compelled to perform his obligation in accordance with the directions of the body that has resolved the dispute.”

The most appropriate way to ensure that these two characteristics are achieved will vary significantly depending upon the factual matrix surrounding the particular contract concerned.  What works for a domestic dispute in the retail market may not be appropriate for a major cross-border financing between multi-national organisations.

Imposing dispute resolution procedures that may not necessarily address the concerns of the parties regarding things like the competence of the arbitrators on the panel or the enforceability of the award itself, has the potential to jeopardise the flow of capital, warns Miller.

“Another problem with this is that it does seem to remove the element of choice from the contracting parties, which is usually the defining characteristic in selecting arbitration. By this I mean that the ‘default’ assumption would be that disputes should be resolved through the judicial system but the parties always have (and have always had) the contractual freedom to choose an alternative approach if they mutually agree that this would be a better avenue for them to follow. As a matter of law, an arbitration clause takes effect as a ‘contract within a contract’.”

Interestingly, the Islamic Fiqh Academy in its Resolution on Arbitration ruled that “arbitration is not mandatory for the two conflicting parties nor is it for the arbitrator. Either of the parties may decline it as long as the arbitration has not started, and the arbitrator may dissociate himself from the matter- even after consenting once – as long as he has not initiated issuing any verdict”.