|
CAVEAT
Throughout this memorandum, the term Shari’ah is used to denote the authoritative and authoritarian corpus juris of Islamic law as it has been articulated by the recognized Shari’ah authorities over more than a millennium. The specifics of this body of law and jurisprudence are discussed more fully in the text and accompanying footnotes herein. The term Shari’ah as used herein, therefore, does not refer to a personal, subjective, pietistic understanding of the word or concept of Shari’ah. This latter understanding of the word Shari’ah is closer to its literal meaning in Arabic without any of the legalistic connotations it has developed as an authoritative institution in Islamic history, as it is currently practiced in such countries as Iran, Saudi Arabia, and Sudan, and as it is meant when referred to in the various laws and constitutions of most Muslim countries.
Research Memorandum-Article:
Civil Liability and Criminal Exposure
for U.S. Financial Institutions and Businesses
Engaged in Shari’ah-Compliant Finance
Prepared for:
Shari’ah Risk Due Diligence Project
Center for Security Policy, Washington, D.C.
Prepared by:
Law Offices of David Yerushalmi
Washington, D.C., California, Arizona
Lead Author: David Yerushalmi, Esq.
© Copyright 2008. All rights reserved to the Law Offices of David Yerushalmi. No reproduction, publication, or distribution of all or
any part of this memorandum/article is authorized without the expressed written permission of the copyright holder.
1
Purpose:
The purpose of this memorandum is to examine Shari’ah-compliant finance
(“SCF”) in light of existing U.S. law. The result of this examination will be to
highlight and to examine areas of civil liability and criminal exposure unique to
SCF investments and transactions1 in the U.S. as they have been developed and
utilized by various financial institutions and facilitated and promoted by legal,
accounting, and financial professionals.2
This analysis is a first of its kind in the published literature. To date, there has
been no focused effort to identify and analyze the implications for civil liability
and criminal exposure for U.S. financial institutions and other businesses engaged
in any of the various manifestations of SCF from a legal and regulatory
framework. While some of the SCF professional and scholarly writings published
conventionally in professional journals and books and increasingly on the Internet
address broad regulatory concerns3, economic risks4, and transactional5 and
market-related hurdles6, scant attention has been paid to the specific civil and
criminal liability implications of SCF. Necessarily, this is an introductory and
preliminary effort.7 Each specific area identified in this memorandum, and quite
likely many others, require and deserve a detailed treatment by academics and
legal professionals, including government attorneys involved in financial
regulation and compliance, policy specialists, and most importantly practitioners
advising their clients on the advisability and the logistics of SCF.
All too often the legal or accounting professional acting as a facilitator, driven by
complex legal- or accounting-intensive tasks and further motivated by exorbitant
professional fees and the desire to develop a specialized expertise for yet future
marketing of services, loses sight of the fundamental threshold issues for any new
and novel market transaction: Does the transaction or business model comply
with existing civil and criminal statutory and regulatory frameworks? Does the
2
transaction expose the client to unique and elevated civil liability and criminal
exposure or regulatory intervention?8
Unfortunately, the history of the legal and accounting professions in properly
guiding clients involved in finance-intensive industries through the legal hazards
of complex and novel transactions has not been good. In just the past three
decades, problematic transactions were structured and manipulated by financial
institutions and finance-driven businesses and facilitated almost unimaginably by
their attorneys, accountants and financial advisors.9 The lesson professionals
should have learned -- but appear not to have, given what can only be described as
the blind exuberance driving SCF -- is that huge profits and explosive growth,
massive public relations and marketing efforts, and popular appeal in the financial
industry does not establish even a minimal baseline for legal compliance.
Whether a new financial product or an innovative structure for an existing
business is compliant with the civil, criminal, and regulatory frameworks imposed
on a lightning fast and fully reticulated finance-driven economy is no longer a
question for a single professional. Careful analysis and due diligence across
several disciplines conducted in a fully-informed, interactive environment is not a
luxury of the prudent but a necessity for all but the reckless.
The watchword ought to be: Transparency. Any new financing technique or fad
driven by huge profits or enormous liquidity without absolute transparency should
automatically raise red flags for the financial institutions exploiting them and the
professional facilitators structuring them.
Conclusion:
SCF exposes the financial institutions and other businesses which attempt to
exploit this new industry to a whole host of disclosure, due diligence, and
compliance issues, all of which elevate substantially the civil liability and
criminal exposure such companies otherwise factor into their business risk
profiles.10 What is clear from this preliminary legal analysis of what might be
called the SCF industry is that very little of this increased civil and criminal
exposure has been recognized, analyzed, or guarded against in any meaningful
way.11
The salient points of this analysis are:
• The Shari’ah black box syndrome: U.S. financial institutions and
businesses involved in SCF risk grave consequences by willfully ignoring
the endogenous elements of Shari’ah. Ignoring what Shari’ah is -- both in
theory and in practice -- and its intimate connection to Islamic terror and
holy war against the non-Muslim world amounts to corporate recklessness.
• Putting Shari’ah in a black box and treating its prohibitions as if they were
benign secular and objective “screens” ignores the duty of disclosure of
3
the most important elements of Shari’ah: its purposes and its ultimate
methods.
• Undoubtedly, a reasonable post-9/11 investor contemplating an SCF
investment would consider (a) the goal of establishing Shari’ah as the law
of the land and (b) the promulgation of the Law of Jihad to establish this
goal material to the investment decision.
• To the extent that U.S. Shari’ah authorities or foreign Shari’ah authorities
retained by U.S. businesses advocate the implementation of historical and
traditional Shari’ah, they risk being charged with a violation of 18 U.S.C.
§ 2385.
• U.S. financial institutions and businesses have a duty to conduct
reasonable due diligence investigations to be certain that their respective
Shari’ah authorities are neither advocating crimes in the name of Shari’ah
nor promoting the material support of terror, either through legal rulings or
through the funneling of “purification” funds to terrorists. Failure to
conduct such due diligence might very well lead to civil liability, if not
criminal exposure.
• The Shari’ah black box is yet another financial fad like the sub-prime
market where transparency is shrouded in opacity in the mad rush to
market-share and quick profits. U.S. mutual funds are poised to embrace
SCF without a word about the risks associated specifically with Shari’ah.
U.S. banks are cavalierly promoting Shari’ah-compliant loans as “interestfree”
when in fact they are merely repackaged loans at standard interest
rates. This violates any number of consumer protection statutes. Financial
institutions are underwriting Shari’ah-compliant loans and bond issuances
without really understanding the risks associated with default and
bankruptcy treatment.
• Insofar as U.S. financial institutions participate in and cooperate with the
Shari’ah authorities’ efforts to establish the rules and regulations for the
SCF industry, antitrust issues such as rules collusion are likely to present
yet additional issues of exposure for those embracing this new industry.
• The current structure of the SCF industry in which two dozen of the most
influential Shari’ah authorities control the way funds go in and out of the
largest financial enterprises in the world creates the paradigmatic pattern
of predicate racketeering activity any aggressive prosecutor or plaintiff’s
lawyer looks for in a RICO cause of action.
The failure by corporate management and their legal advisors to confront these issues in
any serious fashion is not surprising given the wholesale failure of the participants and
facilitators in this industry to have undertaken a serious analysis of these risks. The extant
legal academic and professional literature reads more like promotional material and not
serious legal analysis conducted by men and women trained to protect clients from their
own blind enthusiasm. The legal industry has gone down this road too many times in the
past. The difference this time is that the risk is not simply financial; it is potentially
existential.
4
I. Overview of Shari’ah-Compliant Finance
A. What is SCF?
According to the disclosures and representations of the financial institutions currently
promoting SCF12, and the Shari’ah authorities they employ, Shari’ah compliance means
that a particular investment or financial transaction has been conducted or structured in a
way considered “legal” or “authorized”13 pursuant to Islamic law.14 Compliance with
Shari’ah is generally achieved by having a Shari’ah authority – either an individual or
group of individuals who has achieved an authoritative status in matters relating to SCF15
– approve of the particular investment or type of transaction. Most financial institutions
employ or retain16 in some fashion what is called a Shari’ah advisory board, which
typically consists of three or more “Shari’ah scholars” who profess to be generally
recognized as an authority in SCF.17
According to most financial institutions, SCF is achieved by the avoidance of interest18,
risk (typically understood as uncertainty or speculation)19, and certain types of prohibited
industries (relating to activities considered haram or forbidden, such as the pork and
alcohol-beverage industries, pornography, gambling, and interest-based financing).20 In
addition, SCF also is said to include a focus on “purification” which has two separate
elements. One, is a form of obligatory charitable contribution called zakat where the act
of supporting the less fortunate is considered a spiritual purification21; and the other is the
purification of a Shari’ah-compliant investment or financial transaction that has been
tainted with forbidden revenue, whether from interest, illicit speculation such as trading
in commodity futures, or a forbidden commercial enterprise such as the pork industry.22
In the latter meaning of purification, the forbidden funds must be disgorged by donating
the money to an acceptable charity but this charitable gift will not count towards a
Muslim investor’s zakat requirement.23
It is quite evident from even a cursory review of these most basic concepts of SCF that at
least a rudimentary understanding of Shari’ah is required to grasp the implications of
SCF relative to U.S. law. Per force, this discussion will be elementary yet true to the
understanding of Shari’ah by contemporary and classical Shari’ah authorities. To begin,
Shari’ah, or the ‘proper way’, is considered the divine will of Allah as articulated in two
canonical sources. The first is the Qur’an, which is considered the perfect expression of
Allah’s will for man. Every word is perfect and unalterable except and unless altered by
some subsequent word of Allah.24 While most of the Qur’an’s 6,236 verses25 are not
considered legal text, there are 80 to 500 verses26 considered instructional or sources for
normative law. But the Qur’an is only one source of Allah’s instruction for Shari’ah. The
Hadith27, or stories of Mohammed’s life and behavior, are also considered legal and
binding authority for how a Muslim in any place at any time must live. The Hadith were
collected by various authors in the early period after Mohammed’s death. Over time,
Islamic legal scholars vetted the authors for trustworthiness and their Hadith for
authenticity and there is general consensus across all Sunni schools that there are six
canonical Hadith.28 The legal or instructional portions of the Hadith together make up the
Sunna.29 While the Shari’ah authorities from the Shi’a Muslim world also accept the
5
Hadith as authoritative, they differ on the selection of the authors accepted as
authoritative based upon mostly theological grounds.30 For all Shari’ah authorities,
however, the Qur’an is considered the direct revelation of Allah’s will and therefore
primary, while the Sunna is the indirect expression of that will and secondary. Both
sources are considered absolutely infallible and authoritative.
In order to divine the detailed laws, norms, and customs for a Muslim in all matters of
life, the Shari’ah authorities over time developed schools of legal jurisprudence adhering
to certain theological and jurisprudential rules to guide their interpretations of the Qur’an
and Sunna. While there is broad agreement among the schools about the rules, there are
important distinctions and these differences do result in different legal interpretations and
rulings, albeit typically differences of degree not of principle.31 The rules of interpretation
and their application to finite factual settings in the form of legal rulings are collectively
termed al fiqh (literally “understanding”). Usul al fiqh, or the ‘sources of the law’, is what
is normally referred to as jurisprudence. Technically, Shari’ah is the overarching divine
law and fiqh is the way Shari’ah authorities have interpreted that divine law in finite
ways.32 It is important to note, however, that the word Shari’ah appears only once in the
Qur’an in this context33 yet it has gained the currency it has institutionally in the Islamic
world only by virtue of the Shari’ah authorities over more than a millennium creating a
corpus juris (i.e., al fiqh) based upon their interpretative understandings of the Qur’an
and Sunna. As such, this memorandum uses the word Shari’ah to mean all of Islamic
jurisprudence, doctrine, and legal rulings, much as it is used in the vernacular by the
typical Shari’ah-adherent Muslim.
Prior to the twentieth century, there was no discipline termed Shari’ah-compliant
financing or even a Shari’ah sub-code relative to commercial transactions per se.34 There
are rulings by Shari’ah authorities authorizing certain contract forms dating back
hundreds of years, but as late as the 1900s, there was still some debate among Shari’ah
authorities whether the prohibition against interest was absolute or just against usurious
interest. When contemporary Islamic political thinkers began to confront the collapse of
the Ottoman Empire after the First World War and the intrusion of Western modes of
social, political, and commercial life into the heart of the Muslim world, Shari’ah
authorities followed their lead and began to issue legal rulings to confront this new
reality.35 Beginning with the early political-theological writings of men such as Maulana
Abul Ala Mawdudi who argued for an Islamic political resurgence and a unique Islamic
political economy, Shari’ah authorities followed suit by issuing authoritative legal
rulings forbidding interest on deposits and calling for the establishment of “Islamic
banks”. Over time, these rulings have incorporated prohibitions against transactions
considered too uncertain or speculative and also rulings to prevent Muslims from
investing in businesses engaged in un-Islamic behavior.36 The development of these rules
and the formalization of SCF have matured over the past three decades so that today there
are entire university departments in the Middle East, Asia, and even in Western
universities dedicated to the study of SCF.37 Most observers connect this recent
development to the emphasis of Shari’ah in the oil-producing Arab states and their
wealth-driven influence throughout the Muslim world and the West.38
6
Effectively, SCF is an attempt to embrace modern interest-based commerce and finance,
but to do so within a framework of Shari’ah-approved structures. For example, while
almost all Shari’ah authorities forbid any transaction or investment which provides for
interest income, SCF rules allow for interest in two ways. One way is to rule that a
Muslim can invest in a permitted business that earns or pays interest but only if the
amount is below a maximum level.39 Any profit earned by the Muslim from that interest
component, however, must be purified by contributing that portion to a Shari’ahapproved
charity.40 A second way to accommodate modern commercial transactions is to
structure the forbidden transaction within Shari’ah-approved contract forms. These
nominate contracts are based upon contract forms found in the classical rulings of the
Shari’ah authorities prior to the advent of contemporary finance. Thus, a loan might be
structured as a “cost-plus sale” where the lender buys the property and immediately sells
it back to the borrower for a “profit”. This profit is the interest component in the typical
loan transaction. The purchase price with the profit component included can be paid over
time to resemble an amortized loan repayment schedule. A host of other forms are
available to deal with interest and also with unduly speculative transactions including
sale-lease back contracts, and partnerships with variations and combinations. For the
more complex transactions, these Shari’ah approved nominate contracts are often pieced
together and used in combination to arrive at a Shari’ah-compliant modern commercial
deal.41
B. Why is SCF important?
As a burgeoning industry, SCF is touted as one of the fastest growing sectors in what has
been termed the global financial markets.42 Estimates for total funds committed to some
kind of SCF investment or transaction is $800 billion worldwide43 with $200 billion of
assets under management in Shari’ah-compliant banks.44 Annual growth in this industry
sector is estimated at between 15-20%45 based upon current trends fueled mainly by
profits and liquidity in the Muslim oil- and gas-producing countries and by a worldwide
Muslim population reported to be the fastest growing among the world’s major
religions.46
Within the SCF market, Shari’ah-compliant bonds, known in Arabic as sukuk47, are the
most explosive segment driven by huge petro-dollar profits creating enormous sovereign
wealth and liquidity. As of the end of the second quarter 2007, outstanding Shari’ahcompliant
bonds totaled $80 billion with another $37.3 billion worth issued in the third
quarter, which is double the amount issued during the same period the previous year.48
All of this growth, underwritten in the main by the mobile, highly liquid capital flowing
out of the GCC states49, has generated an entire industry of financial institutions, law
firms, accounting firms, financial advisors and money managers establishing domestic
and international links with the key investment figures in the GCC states in an effort to
exploit the opportunities for substantial profits.50 This enthusiasm has been translated to
domestic U.S. financial industries in many ways.51 U.S. financial institutions seek to
underwrite Shari’ah-compliant bond issuances domestically and globally;52 Dow Jones
and Company53 and Standard & Poor’s54 have both established Shari’ah-compliant
7
indexes that screen equities based upon software filters meant to eliminate Shari’ah-noncompliant
businesses; Shari’ah-compliant U.S.-based managed equity funds55 and offshore
hedge funds56 managed or advised by entities related to U.S. financial institutions
have been established and can now peg their performances against these indexes; and
U.S. banks have begun to offer Shari’ah-compliant home loans and other credit
facilities57 with federal banking authorities opining about their legality and at least one
state tax authority issuing a ruling on the tax implications of a Shari’ah-compliant
transaction58.
C. Why should SCF come under special scrutiny for civil and criminal
liability exposure?
A preliminary question must be asked: When making financial investments or entering
into financial transactions, why should adherence to the normative principles of Shari’ah
require any special or heightened scrutiny in relation to civil or criminal liability
exposure? The most immediate answer is that, according to the proponents and
practitioners of SCF, Shari’ah is not simply an approach to interest-free, ethical investing
-- although it has been described in promotional literature as such. Instead, SCF is
invariably described by SCF proponents, practitioners, and scholars, as the contemporary
Islamic legal, normative, and communal response to the demands of modern day finance
and commerce.59
As understood on its own terms or by the many constituencies who interpret it, Shari’ah
is not predicated upon a personal or subjective understanding of what it means to be a
Muslim. Neither is it simply an objective formal law or behavioral code regulating
finance and commercial transactions. Shari’ah has been described as “holistic”60, as
“designating good order, much like nomos”61, and definitively by Joseph Schacht, the
founding father of modern scholarship treating Islamic jurisprudence as a distinct
academic discipline, as “[t]he sacred law of Islam [which] is an all-embracing body of
religious duties rather than a legal system proper; it comprises on an equal footing
ordinances regarding cult and ritual, as well as political and (in the narrow sense) legal
rules.” 62
In one of the first and still important academic presentations of this new industry,
Professors Frank Vogel and Samuel Hayes, both distinguished professors at Harvard
University and proponents of SCF, explain that Shari’ah is not some personalized,
subjective, pietistic approach to Islam but an institutionalized legal-political-normative
doctrine and system:
Islamic legal rules encompass both ethics and law, this world and the next,
church and state. The law does not separate rules enforced by individual
conscience from rules enforced by a judge or by the state. Since scholars
alone are capable of knowing the law directly from revelation, laypeople
are expected to seek an opinion (fatwa) from a qualified scholar on any
point in doubt; if they follow that opinion sincerely, they are blameless
even if the opinion is in error.63
8
This classical understanding of Shari’ah has been echoed by almost all of the scholars
who have written on the subject. Two prominent advocates of SCF, one a leading
professor of finance in Australia and the other a senior official in the Bahrain Ministry of
Finance and National Economy, describe the all-encompassing nature of Shari’ah in their
way:
Since Islamic law reflects the will of God rather than the will of a human
lawmaker, it covers all areas of life and not simply those which are of
interest to a secular state or society. It is not limited to questions of belief
and religious practice, but also deals with criminal and constitution
matters, as well as many other fields which in other societies would be
regarded as the concern of the secular authorities. In an Islamic context
there is no such thing as a separate secular authority and secular law, since
religion and state are one. Essentially, the Islamic state as conceived by
orthodox Muslims is a religious entity established under divine law.64
Shari’ah is therefore not strictly speaking a religious legal code where offending or
offensive subdivisions or specific areas of law can be isolated and removed from a
cauterized corpus juris. Instead, Shari’ah is understood by the authorities and scholars
who interpret it as an indivisible “way of life”65 which informs a Shari’ah-adherent
Muslim’s entire being and identity as a Muslim66, including his relationship to his family,
the poor, the stranger, the visitor, national political life, the Muslim Umma (or nation),
religious ritual, business and financial dealings, and the enemy.67 While Shari’ah most
certainly includes more than a millennium of legal decisions developed through Islamic
jurisprudence and informal code-like compilations developed by the different “schools of
jurisprudence”68, Shari’ah proper is the overarching authoritative architecture for all
Islamic jurisprudence and the specific legal decisions which make up the corpus of what
amounts to a juristic body of Islamic dictates and norms.
Understood in its proper context then, anything deemed Shari’ah-compliant by generally
recognized Islamic legal authorities must first and foremost be within the gestalt of
Shari’ah. It is not enough, according to Shari’ah, that a Muslim conducts his own affairs
and business according to some narrow definition of “Islamic ethical business practices.”
For a Shari’ah-adherent Muslim to conduct his business and financial affairs properly, he
must not knowingly promote through his business dealings any forbidden action or
violation of a fundamental precept of Shari’ah or the legal rulings promulgated
thereunder. This is what the scholars mean when they describe Shari’ah as “holistic” or a
fully integrated religious, moral, and legal code.69
Thus, an interest-free and non-speculative commercial transaction which complies with
Shari’ah dictates in these strictly financial and economic areas might nonetheless be
forbidden because the subject matter of the business (i.e., the manufacture or sale of
alcohol) is forbidden. This would be the case even though the Muslim is neither
consuming the alcohol he manufacturers nor selling it to other Muslims. Similarly,
leasing a building to a restaurant or bar which serves forbidden foods such as pork and
9
alcoholic beverages, even though no Muslims frequent the establishment, would
nonetheless be forbidden because pork products and alcohol are forbidden by Shari’ah
independent of its economic or financial implications. Finally, leasing a building to a
church consisting wholly of non-Muslims would also violate the dictates of Shari’ah
because Christian worship and theological doctrine violate several tenets of Shari’ah.70
In other words, SCF is not about just finance, economics, or business ethics. To be
Shari’ah-compliant in financial matters means to be Shari’ah-compliant in theological,
moral, and political matters as well. From a legal or jurisprudential analytical framework,
there is no Shari’ah sub-code or segregated legal doctrine applicable only to financial
matters per se. To be sure, there are specific Shari’ah precepts relating to interest and
uncertainty and the legal decisions promulgated in accordance with those precepts. But
these Shari’ah precepts and the authoritative legal rulings flowing from them are not
divisible or segregable from the rest of Shari’ah and its jurisprudence. Thus, Islamic legal
rulings on apostates, holy war (Jihad), or forbidden sexual relations, are no less relevant
to SCF than rulings on forbidden interest.71
It has been the duty of the Shari’ah legal scholars over the ages to understand these
precepts and to apply them to new and changing circumstances. The degree to which
individual Muslims or the political powers ruling over them have adhered to Shari’ah as
determined by the generally accepted authoritative Islamic jurists has varied
tremendously. It can be said with some historical confidence that Shari’ah has been
honored more in the breach than in its observance.72 But the breaches have not
diminished the absolute authority of Shari’ah and its jurisprudence, as articulated by
Islamic legal scholars and the institutions they have established over the past 1200 years,
to define the legal limits of permitted and proscribed behavior among the hundreds of
millions of Muslims worldwide who consider Shari’ah a way of life, as much religion
and moral guide as civil and criminal legal code.73
This monopolistic institutional control over the legal doctrine of Shari’ah by the
recognized Shari’ah authorities is no better evidenced than in the world of SCF. Whether
one is reading from the Islamic legal treatises themselves, the academic studies of SCF
produced by Muslim and non-Muslim university professors, the lawyers who publish
legal journals on the subject, the media, or the myriad of Internet sites which are
dedicated to the subject, no one seriously contests the exclusive role of the accepted
Shari’ah authorities to divine what is permitted in SCF and what is not.74
This is more than just convention. Islamic jurisprudence codifies the important role
played by Shari’ah authorities to reach consensus (ijma) among themselves on areas not
previously established by the classical Shari’ah jurists as fixed law and immutable.75
Thus, as new financial transactions are fitted to Shari’ah and its immutable “principles
and rules”, the only way for a Muslim concerned with Shari’ah to know that he is not
violating Shari’ah is to rely upon the Shari’ah authorities and the level of consensus they
have reached on the particular matter.
1 0
The quite obvious implication of this fuller understanding of Shari’ah is that one cannot
speak of Shari’ah-compliant finance, business, or economics in the U.S. without
understanding Shari’ah as articulated by the Shari’ah authorities and its ramifications for
the U.S. investor. This is especially true given the legal implications in the areas of the
duty to disclose for financial institutions contemplating a SCF transaction. For example, a
mutual fund promotes itself as Shari’ah-compliant. Having licensed the use of the Dow
Jones Islamic Index (“DJII”)76, which utilizes a software filtering protocol determined to
be Shari’ah-compliant by the Shari’ah advisory board retained by Dow Jones &
Company, the mutual fund selects a subset of the indexed listed equities for its portfolio.
After a careful reading of the marketing material of the DJII and the registration
statement of the mutual funds utilizing the DJII, it should be obvious to any moderately
competent attorney that disclosure issues abound.77
Specifically, in the registration statement filed with the Securities and Exchange
Commission (“SEC”) for one of the first such funds, the Dow Jones Islamic Market
Index Portfolio78 (“Dow Jones Islamic Portfolio Fund”), other than a reference to certain
“Shari’ah screens” or “filters” limiting the universe of acceptable investments, nothing is
said of Shari’ah. For the investing public, all it learns about Shari’ah in the context of
this Shari’ah-compliant mutual fund is that equities of companies involved in interestdriven
profits, companies dealing with commodities such as alcohol or pork, or
companies engaged in the “vice” industries such as entertainment and gambling, are
prohibited. In addition, the standard disclosures also include references to various
financial ratios that work to eliminate companies that might generate too much interest
income on its cash reserves or pay too much interest on its debt. In other words, the DJII
and the mutual funds utilizing such an index appear in many ways like other “socially
responsible investing” or customized “values-based” and “faith-based” indexes.
But this is hardly the case. In a “secular” or even “ideologically” driven values-based
index, a screen that filters out all tobacco and weapons businesses is just that. Even if the
background social or political activism animating the screen is a “smoke-free
environment” and “pacifism,” the screen is marketed only as a screen that filters out
tobacco and weapons industries. It does not purport to be based upon some universal
theological-moral-legal system existing independently of the filters.79
When the mutual fund, however, markets its product as “Islamic” or “Shari’ahcompliant”,
it is making a claim that goes well beyond the disclosed screens or filters,
even if all that is applied to make it “Islamic” or “Shari’ah-compliant” is the use of the
disclosed filters. A cursory reading of the registration statement filed pursuant to the
Investment Act of 194080 for the Dow Jones Islamic Portfolio Fund suggests that the
lawyers tasked with writing the risk section of the document understood this reality, at
least at some rudimentary level81, and sought to eliminate the problem with one broad
brush stroke:
The investment objective of the Dow Jones Islamic Market Index Portfolio
(the "Portfolio") is to seek long-term capital gains by matching the
performance of the Dow Jones Islamic Market Index(SM) (the "Index") – a
1 1
globally diversified compilation of equity securities considered by Dow
Jones' Shari’ah Supervisory Board to be in compliance with Shari’ah
principles. (Emphasis added.)82
Notwithstanding representations throughout the registration statement that various
practices of the fund will comply with “Shari’ah principles”, which are nowhere
articulated in any remotely material way, the language in this section intends to sweep
Shari’ah under the rug by reducing “Shari’ah principles” to whatever the Dow Jones
Shari’ah Supervisory Board says they are. There are, however, a plethora of risk factors
specifically associated with anything pegged to Shari’ah compliance that such a
statement fails to capture. Fundamental disclosure issues for a reasonable investor would
be: What is Shari’ah? Does applying Shari’ah “principles” pose any unique reputational
or financial risks for the investment or might it actually pose a risk for the physical safety
of the U.S. investor? In other words, if Shari’ah is hostile to Western political and
financial institutions, would that not be important for a U.S. investor to know prior to
investing in a business which promotes Shari’ah-compliant investing?
A still more common example of a risk that appears to have been ignored in this
registration statement would apply with special emphasis to a closed-ended fund but
could also affect an open-ended fund’s investors. What would be the effect of a more
authoritative Shari’ah advisory board ruling asserting that the Dow Jones Shari’ah
Supervisory Board was gravely mistaken about Shari’ah principles resulting in a number
of forbidden companies being improperly listed by the DJII as Shari’ah-compliant?83
Precisely because the SCF industry generally represents that only authoritative Shari’ah
scholars can divine legitimate legal rulings of Shari’ah, a contradictory ruling by a more
austere body could pose grave financial risks. Investors who care about “Shari’ah
principles” and who had invested in the fund, and possibly others who had invested in the
underlying equities directly in reliance on the DJII, would likely feel obliged to sell their
interests. The Dow Jones portfolio fund managers would likely also liquidate those
equities so as not to get caught in the cross-fire between competing Shari’ah authorities
and to thereby mitigate claims for damages arising out an allegation that the fund
manager knew or should have known that the Dow Jones Shari’ah advisory board did not
properly adhere to authoritative Shari’ah principles. The end result, given enough sale
orders, would be a material reduction in the share price of the forbidden companies or, in
the case of a close-ended fund, the fund itself. Class action lawsuits brought by investors
caught “holding the bag” and predicated on failure to disclose and misrepresentation
would be inevitable.84
The point of this one, narrowly scripted example is not to analyze the liability exposure
of the registration statement of the now defunct Dow Jones Islamic Portfolio Fund, but
rather to illustrate how marketing an investment product as Shari’ah-compliant
incorporates a whole set of factual predicates, many of which are material to the
investment decision. According to the Shari’ah authorities themselves, Shari’ah -- of
which SCF is only a small, integrated component -- is more than just a half-dozen filters
operating in the background to eliminate interest, speculation, and vice. Rather it is a
motivating force and mark of Muslim identification for hundreds of millions of Muslims
1 2
throughout the world, a corpus juris that incorporates a 1200-year old history of
jurisprudence, of institutionalized legal schools with published legal decisions and other
scholarly writings, together with a millennium of religious and political implications, all
of which has generated in modern times a whole body of literature and scholarship on the
import of Shari’ah in the ancient and contemporary world.
These realities comprise a dangerous minefield for the naïve or willfully ignorant
financial institution seeking to capitalize on the alluringly profitable new universe of
investment vehicles marketed to Shari’ah adherents. This minefield includes questions
which these financial institutions and their professional facilitators have not even begun
to ask, much less answer.85 It is the purpose of this memorandum to begin this analysis
and the necessary discussion of its implications for the U.S. financial industry, the
professionals advising their financial clients on SCF, and the policy-makers in and out of
government. This latter group especially has an obligation to consider the ominous
implications for U.S. national and financial security of a fully integrated Shari’ahcompliant
financial industry.
II. Analysis: Toward an Analytical Taxonomy
A. How to analyze SCF: the lawyer’s role in SCF
As indicated above, Shari’ah-compliant financing is nomenclature describing the
contemporary Islamic legal, normative, and communal response to the demands of
modern day finance and commerce.86 Shari’ah-adherent Muslims desire to maintain their
commitment to the normative demands of Shari’ah. At the same time, they wish to
participate in the benefits and opportunities afforded by investment in international and
Western financial and commercial structures that are neither Shari’ah-centric nor
Shari’ah-compliant, at least according to the overwhelming majority of Shari’ah
authorities called upon in their institutional or personal roles to pass judgment.87
In many instances, both related and unrelated to SCF, transactional lawyers are required
by the parties to a transaction to opine on the transaction’s compliance with existing law
and the enforceability of the underlying agreements in a court of law or, in some cases,
before an arbitrator.88 These legal opinions serve the purpose of assuring the parties to the
transaction that there are no hidden issues that might create obstacles to enforcement. In
addition, although not necessarily part of a formal legal opinion, lawyers are required by
the ethics of professional responsibility to investigate compliance, disclosure, and due
diligence issues in order to understand their client’s legal exposure when a new and
innovative approach to existing financial or commercial transactions is contemplated.89
Lawyers and accountants themselves have direct exposure for documents submitted by a
client to the Securities and Exchange Commission (“SEC”) under several laws, the most
recent and well-known example of which is the Sarbanes-Oxley Act of 2002.
A fundamental predicate of a lawyer’s opinion and indeed the confidence of the parties to
engage in large complex financial deals is the knowledge that the basic transactional
building blocks of the deal are well-known, predictable, and do not pose any significant
1 3
risk that a court will refuse to enforce them as intended by the parties. In simple terms,
this means that the deal is structured in a way that has certainty, consistency,
predictability, and transparency (what shall be referred to hereinafter simply as
“Transparency”)90.
The problems legal counsel face when attempting to analyze a specific SCF transaction
and to opine on compliance and enforceability issues are often directly related to the
Shari’ah “black box” phenomenon. Attorneys, accountants, and financial advisors who
wish to structure a transaction to be Shari’ah-compliant do so by treating Shari’ah
precisely as Shari’ah demands by its own terms. For the Shari’ah faithful, Shari’ah is
first and foremost the divine and perfect will of the ultimate lawgiver and necessarily
there are strictures and obligations imposed on its adherents which are not subject to
reasoned critique or discourse. As to the part of Shari’ah open to human analysis, it is
reserved for Shari’ah authorities who cannot be challenged except by other equally
authoritative Shari’ah authorities.91 Further, because Shari’ah is understood as divine and
the Shari’ah authorities are considered the trustees of its authority, integrity, and
interpretation, the application of Shari’ah’s well-established and ancient doctrines to the
quite modern practice of SCF necessarily lacks Transparency.
The inability of Shari’ah as a jurisprudence and positive law to provide Transparency is
systemic. Any legal or normative system which is not articulated and enforced within a
political structure of codified laws, procedures, courts, binding legal opinions providing
precedence, and effective enforcement mechanisms will, by definition, lack
Transparency. Shari’ah is at its essential core by its own terms a divinely ordained law
which can never be subordinated to a secular political, legal, or regulatory system.92 SCF
is an attempt by the participants – financiers, businessmen, facilitators, and Shari’ah
authorities – to fit the divine law within a modern secular political, legal, and financial
system. But should a secular court or legislature attempt to codify Shari’ah’s precepts as
they apply to SCF in an effort to establish Transparency, aside from the constitutional
issues this would raise in the U.S., it would fail its fundamental purpose because Shari’ah
cannot be rendered subservient to secular law.93
In stark contrast, domestic finance and commerce in the U.S., and indeed international
financial transactions, are based upon Western legal financial structures which provide
Transparency. It is Transparency which renders a complex transaction quite manageable
and viable. When the parties to a transaction and the professionals facilitating it know
that a given transaction format has been used before successfully after being stress tested
and enforced in many forums under various circumstances, the risks of the deal are then
limited to the specific business terms and market conditions rather than the formalities of
the documents and their enforcement. In these transactions, the lawyer can opine safely
and with confidence because he knows the rules of the game and knows they are not
subject to fiat or challenge.94
This is not the case when a lawyer confronts a high-stakes, complex SCF transaction. In
order to render a legal opinion that will satisfy the parties and necessary third-parties such
as a rating agency for a bond securitization, a whole host of issues arise that cannot be
1 4
rationally addressed for at least two reasons: One, certain transaction restrictions
applicable to SCF are considered divine and unalterable. Two, those aspects of a
transaction subject to human reason are not subject to any human reason, but to the
reason of a Shari’ah authority. For example, interest income is understood by most
Shari’ah authorities today to be forbidden. The result has been that SCF utilizes all sorts
of Shari’ah-compliant transactional structures to convert the exact same income stream
(including its variability by pegging it to an index such as the LIBOR) from interest to
something else, such as lease payments. In legal parlance, this is the application of “form
over substance”.95
The use of legal fictions to change the form or the consequence of a transaction without
changing its substance is certainly not new to the secular law. Liability is often
determined by the form rather than the substance of a transaction.96 But the fundamental
difference between a secular use of a legal fiction to convert a problematical “form” to an
acceptable one is that the problem itself and the mechanisms to overcome it can be
understood, challenged openly, debated, and ultimately modified by smart lawyers,
judges, and legislatures to fit changing circumstances. Moreover, if a secular court rules
that a given legal fiction fails its purpose, the participants are free to return to the drafting
table and restructure the deal.
The debate within Shari’ah, however, is in effect closed. Its principles remain divine and
unalterable97 and the application of these principles to changing circumstances are subject
only to what the Shari’ah authorities acting independently of a secular legal and political
system determine to be permitted and forbidden. Thus, Shari’ah informs the Shari’ahadherent
participants in a finance transaction involving interest that interest is divinely
forbidden. The participants are also told it is forbidden because it is evil and causes the
destruction of society.98 Somehow though, interest, wrapped up in a different form where
all of the elements of interest exist but for the name, exits the black box of Shari’ah as
permissible and presumably good for society.99
Thus, a lawyer involved in a complex SCF transaction responsible for shepherding the
participants through the process confronts serious challenges at many different levels. In
this effort the diligent lawyer would likely focus on four distinct phases of a SCF
transaction: (1) determining if the generic investment or type of transaction is prohibited;
(2) developing an alternative (i.e., Shari’ah-compliant) transactional structure necessary
to achieve the financial or commercial goal of the “secular” or Shari’ah non-compliant
investment or transaction; (3) drafting the necessary legal agreements and documents to
implement the alternative transaction; and (4) preparing the filing of any regulatory and
compliance documents with government agencies.
At each stage of this effort, the lawyer is in effect wrapping the Shari’ah component of
SCF in what appears from the casual observer to be a secular black box. This process
begins at the first level when the lawyer turns to the Shari’ah authorities chosen by the
client to determine whether a given investment or transaction is Shari’ah-compliant. In
most cases, the Shari’ah authority issues a fatwa or legal determination in the form of a
terse answer to a fact situation, oftentimes but not always with some rationale. For
1 5
example, a client may wish to invest in a trucking business that hauls alcoholic beverages
along with other commodities. While the consumption of alcohol is generally understood
to be forbidden by Shari’ah, the question arises whether owning a business that transports
alcohol which is not owned or specifically destined for a Muslim is also forbidden. Also,
is there a percentage threshold of profits from the transportation of the alcohol which is
relevant to the determination whether the investment is permitted or proscribed?
At this level, the attorney invariably treats the Shari’ah jurisprudential analysis as a black
box and relies on what his client considers to be a determinative Shari’ah ruling from
someone the client determines to be a Shari’ah authority.100 In the case of a client making
an investment on its own behalf and not representing that the Shari’ah ruling is
authoritative to any third-party, and assuming there are no grounds for third-party
reliance on the authoritativeness of the Shari’ah ruling, the lawyer’s acquiescence to the
black box appears reasonable.101
But the professional’s reliance on the black box of Shari’ah might give rise to serious
problems precisely where there is a duty of care relative to the propriety of the ruling and
the legitimacy or authoritativeness of the Shari’ah authority issuing the ruling. The legal
exposure for a breach of such a duty, as discussed above in the illustration of the
registration statement of the mutual fund, will depend on the kinds of representations
made and the ability to insulate the client with disclosures of the risks and with warranty
and representational disclaimers.
After an investment or transaction is determined to be forbidden by Shari’ah, legal
counsel must address the second phase of the transaction. Here the attorney must be
certain that the client properly explains to the Shari’ah authority what the investment or
transaction involves in its secular or Shari’ah non-compliant structure and ask the
Shari’ah authority to suggest a structure. SCF as it has developed to date includes a range
of legal structures generally acceptable in Shari’ah commercial transactions to bring
otherwise forbidden investments into Shari’ah compliance. Most of these transactional
structures are meant to avoid the prohibition against interest.102
Once the Shari’ah authority solves the Shari’ah compliance problem by suggesting an
alternative structure to “rid” the transaction of the offending elements, be it interest or
uncertainty, the client’s legal counsel must now determine if the new structure changes
the substance of the deal or merely camouflages the problem identified by Shari’ah
through a change in the form of the deal. This analysis is fundamental in many areas,
including disclosure, compliance, taxation, and notably assessing enforceability in the
event of default.103
After having fully assessed the requirements of the Shari’ah-sanctioned deal structure,
legal counsel begins the third phase by drafting the “secular” contracts and various other
agreements to fit the demands of Shari’ah to conventional legal and regulatory
frameworks. This process can require the drafting of certain collateral agreements which
in themselves contradict the principal agreements and transactional documents and
potentially violate Shari’ah precepts. One such example occurs when an SCF transaction
1 6
is structured as a joint-venture leasing arrangement. While the intent of the parties as
reflected in all of the transactional documents is to create a joint-venture leasing
arrangement precisely because they do not wish to run afoul of the prohibition against
interest, the parties still desire to allocate the tax burdens and benefits as if the transaction
were a straightforward financing with interest.104
Lawyers skilled in SCF utilize what are called “tax matters agreements”105 to have the
parties decide for themselves that while the deal might look, feel, and smell like a leasing
duck, it in fact is a loan turkey for purposes of tax characterizations and allocations.106 In
other words, the “form” of the deal is a joint-venture-leasing arrangement (and Shari’ahcompliant),
but the “substance” of the deal for tax purposes is a loan with interest. While
tax matters agreements are not a recent innovation of SCF lawyers, and indeed are often
used for tax purposes in off-balance sheet “synthetic lease” transactions, their
applicability in SCF transactions is not self-evident.107 It is one thing for parties to a
secular transaction to establish dual and even contradictory characterizations depending
on whether the impact of the characterization is on the party’s balance sheet or tax
liability. In such dual-purpose transactions, arguably the standards are different between
tax accountability and balance sheet accounting and the parties’ primary intent is to
achieve off-balance sheet financing without any concern for the specifics of the
structure.108 In other words, the parties are agnostic as to structure and seek only to
achieve both tax and financial accounting benefits.
It is quite another matter, however, when the parties are not agnostic regarding the
structure of the deal and where their true intent is to avoid the payment of interest and to
establish real indices of ownership as required by SCF. In this case, the cognitive
dissonance adds enormous peril to an agreement where all of the documents describe a
joint-venture-lease agreement and the parties presume to tell the Internal Revenue
Service (“IRS”) that what looks to be the case on the surface and what the parties’
actually intended is not in fact the case. While the IRS might continue to apply the
economic reality test109 and wholly ignore the intent as manifested in the Shari’ahcompliant
transaction documents, it is also quite possible that an IRS or tax court ruling
would determine that the tax matters agreement is a ruse or “form” attempting to achieve
tax allocations and benefits inappropriate for the true “substance” of the deal: a Shari’ahcompliant
joint-venture-lease agreement.110
The final step for the transactional lawyer dealing with the intricacies of SCF involves the
various filing requirements of government agencies for reporting and compliance matters.
The registration statement or prospectus of a mutual fund is but one of many such
requirements where the attorney is asked to opine on the adequacy and compliance of
such statements. As described above in the case of the Dow Jones Islamic Portfolio Fund,
the Shari’ah black box exposes both client and counsel to a myriad of issues that do not
otherwise exist.
B. How to analyze the civil and criminal liability exposure in SCF
1. A suggested analytical taxonomy
1 7
The challenges described above for the SCF transactional lawyer and other professionals
advising clients on the intricacies of legal compliance are not inconsequential. In
agreements and in law, words matter but they are given context by the intent of the
parties. The inherent problem of SCF is that the intent of the parties is to comply with
Shari’ah but the intent of Shari’ah generally and in any particular transaction is typically
lost on the secular SCF advisors.111 The latter, especially the lawyers, are very good at
solving problems by re-structuring a transaction through word-smithing, thereby arriving
at the same result in different form. But their approach necessarily is to deal only with the
trees hindering the client’s path to the goal within the landscape of the transaction itself.
For the typical, secular financial transaction, this is sufficient because there is no dark
forest in which to get lost. An obstacle in the path can be safely circumvented because the
problem is transparent for what it is and thus all of its ramifications for disclosure and
compliance are understood. When the trees, however, grow out of the forest known as
Shari’ah, it is not at all clear to these professionals why they are where they are, what
dangers might lurk there, and where the forest might lead. This is so as the examples have
suggested because Shari’ah is not essentially accessible to the secular professionals. As a
consequence, the forest is packaged as a black box and effectively ignored. It is no
surprise then that there has been very little attention paid by legal professionals in the
published literature dealing with the civil liability and criminal exposure issues unique to
a financial or business transaction fitted to Shari’ah.112
Some of the professional literature does grudgingly recognize that SCF lacks the
certainty, consistency, predictability and transparency necessary to allow the legal and
other professionals to treat it as one would any other secular business transaction. But
because this literature is typically geared toward those fully committed to SCF, there has
been very little in the way of critical analysis of the inherent contradiction or dangers in
the effort to apply Shari’ah precepts, rooted in what one critical observer terms a
“Medieval obscurantism,” to Western financial transactions.113 The potential dangers are
exacerbated by the fact that finance and commerce cannot be separated in practice from
the law and its institutions built on certainty, consistency, predictability, and
transparency. This brings the secular Western legal institutions, understandings, and
duties face-to-face with a sectarian normative legal system rooted in a world bound by
the dictates of a god as determined by Shari’ah scholars fully wedded to the purposes of
Shari’ah.114
What this analysis suggests by implication is that the first order of business for the legal
practitioner advising a client on a SCF transaction is to ask what, if any, legal exposure
might the client have by fitting the desired secular financial transaction to a sectarian,
political, and legal institutional framework predicated upon Shari’ah?
2. Exposure arising out of endogenous elements
SCF is first and foremost a modality to structure modern secular financial activity in a
way to comply with Shari’ah. While legal practitioners, for the reasons discussed above,
1 8
are inclined to leave well enough alone and allow the Shari’ah scholars and authorities
sole access to this black box, professional and fiduciary duties and responsibilities do not
permit such a hands-off approach. The lawyer has an absolute duty to his client to warn
of civil and criminal liability exposure when such exposure exists. This is true even when
the client is not inclined to ask any questions beyond, “How do we get this deal done?”115
Competent legal counsel understands that when the client’s competitors are rushing to
cash-in on the newest fad in the international financial markets with literally trillions of
dollars flowing out of the ground and looking for an investment to land on, prudence
tends to take a back seat to following the herd. As noted earlier, very high-priced lawyers
and accountants with sterling reputations have on more that one occasion in recent
history failed to brake the blind enthusiasm and excesses of their clients as they rushed
head-long into exotic and innovative transactions. The criminal failure in these debacles
has been the fact that without the professional facilitators’ own version of blind
enthusiasm – a willful acceptance of their clients’ blind enthusiasm -- and with just a
modicum of prudent and analytical scrutiny, the U.S. financial and legal systems would
not have suffered as they have.
So it is with SCF. If the Shari’ah in SCF actually means something, the lawyer
representing a U.S. financial institution desiring to enter this new arena needs to find out
what that something is. This inquiry can be termed an analysis of the endogenous
elements or aspects of Shari’ah.116 To understand the risks and exposure for a financial
institution contemplating SCF, the lawyer first must understand what Shari’ah itself says
it is – that is, what the Shari’ah authorities understand it to be, without reference to how
SCF attempts to navigate the demands of modern finance. While this inquiry will only be
relevant to part of the analysis of the client’s potential exposure, it will most certainly be
relevant to many fundamental issues of SCF. Moreover, to the extent that Shari’ah
compliance is determined by Shari’ah authorities, presumably there is something in the
institution of Shari’ah itself that will inform the lawyer about who qualifies for such a
role and how. Finally, to the extent that Shari’ah is in fact what its proponents say it is –
a way of life combining authoritative Islamic legal, moral, theological, and normative
social constructs – the attorney will likely have a responsibility to be certain that his
client has conducted the necessary due diligence to be certain that these structures are not
in and of themselves violations of U.S. law.
Some preliminary questions would be: What is the purpose of Shari’ah? Is there a
Shari’ah with a purpose or are there many? If there are many, how are they distinguished
and how are they similar so that they are all called Shari’ah? Who determines what
Shari’ah is? Who determines what is permitted and what is forbidden in Shari’ah at any
time? Is Shari’ah finance or economics a separate and distinct discipline within Shari’ah?
Does Shari’ah recognize a SCF transaction even if it is utilized to undermine or destroy
Shari’ah? Does Shari’ah include theological purposes? Does it incorporate the purposes
or designs of any one political system over another? The answers to these and many
questions like them must be part of a knowledge base available to the lawyer as he begins
his analysis of specific legal duties in the context of U.S. law.
3. Exposure arising out of exogenous elements
1 9
As discussed above, SCF is a term of art used to describe the contemporary Islamic legal,
normative, and communal response to the demands of modern day finance and
commerce. As such, the rules and norms of Shari’ah are being forced to attend to the
demands of a Muslim demographic which desires to exploit the opportunities available in
Western financial and legal structures yet at the same time to remain faithful to a system
which rejects as unlawful and evil much of the Western financial premises about political
economies and structures. To achieve this seemingly impossible goal, Shari’ah
authorities have developed a whole range of transactional structures and legal-definitional
parameters to guide them in their ultimate determination whether a given transaction or
investment is permitted or prohibited.
In this part of the analysis, the lawyer should begin to address the features of SCF which
might raise liability exposure issues that are not inherent to Shari’ah principles but are
adaptations of Shari’ah principles to fit Western financial structures and institutions. An
example of a transactional structure to deal with this collision between a Shari’ah world
and a Western one built on the time-value of money in the form of interest is the salelease
back agreement.117 While sale-lease back agreements are not unique to SCF and in
fact are a popular vehicle in contemporary finance, in the two contexts they are not
identical in structure and worlds apart in their purposes.118 An example of the legaldefinitional
parameters set out by Shari’ah authorities to deal with the doctrinal conflicts
between the two systems would be the ruling that while interest income is absolutely
forbidden in Shari’ah, it is not forbidden to invest in a company that earns less than
X%119 from interest income which is not a core business of the company (i.e., interest
earned on liquid assets or accounts receivables).
In addition to the exogenous structural and definitional efforts to fit Shari’ah into modern
finance, another example would be the make up and structure of a Shari’ah advisory
board and how it plays some authoritative role in the financial institution with which it is
associated. Thus, while Shari’ah authorities have been an endogenous element within
Shari’ah for over a millennium, private Shari’ah advisory boards sitting together in the
capacity of something akin to an independent audit committee within the structure of a
financial institution is an innovation to respond to a financial landscape understood to be
exogenous to Shari’ah.120 Thus, for example, the lawyer might try to understand what
kind of organization Shari’ah requires for a Shari’ah advisory board and are there
implications for the client or for the Shari’ah advisory board itself relating to the very
real possibility of competing loyalties.
C. The legal analysis: overview
The legal practitioner’s job is typically not theoretical; it is fact-based. The lawyer’s work
by its nature is to take a specific set of facts and to apply the law. At some early point in
the analysis, the practitioner would be confronted by the client’s desire to engage in some
form of SCF. First, the lawyer would attempt to understand all of the factual elements of
the business, transaction, or investment. Part of the early discussions would include the
following questions: what is the client trying to achieve; how does the client wish to
2 0
achieve these goals; what does the client expect if these goals are not met; who are the
players; how are they involved; what decisions need to be made by the various parties;
and how are the decisions implemented?
With the facts of the investment or transaction understood, the transactional lawyer must
then map out not merely the transactional documents, but also the legal and regulatory
issues to be dealt with to achieve the desired end. Thus, in a typical analysis, the lawyer is
focused on a fact-specific transaction and would analyze each and every duty or
obligation imposed by law and determine what must be done to comply and what must be
avoided so as not to breach some duty imposed by statute, regulation, common law, or
the contractual obligations underlying the transaction itself.
For purposes of the analysis, rather than examine any particular fact situation, and to
avoid an overbroad, far-ranging analysis of the plethora of compliance issues relative to
the various SCF investments and transactions, this analysis will begin instead with those
specific duties and obligations that might give rise to civil and criminal liability exposure
implicated in SCF. The analysis will attempt to track the endogenous-exogenous
taxonomy described above. The particular duties examined are certainly not exhaustive
but have been chosen because they appear to give rise to the greatest areas of civil
liability and criminal exposure. Furthermore, this analysis will limit the examination of
the various kinds of businesses and transactions incorporating SCF to those used most
prominently in the U.S. market today.
1. Overview of the SCF markets analyzed
The nubile SCF market migrated from the GCC states via London looking for additional
legitimation in the dynamic U.S. financial markets. As much as London seeks to be the
SCF capital of the Western world121, New York is still the “go-to place” for capital
markets.122 The SCF industry has already taken hold in the imagination of many, but
certainly not all of the leading U.S. financial institutions, yet it is permeating into wider
and deeper audiences in the industry. To date, U.S. financial institutions are engaged in
Shari’ah-compliant stock indexes, publicly traded mutual funds, hedge funds or the socalled
“fund of funds” market for sophisticated fund managers and well-heeled clients,
sovereign wealth and private corporate bond issuances, consumer and commercial bank
loans such as home mortgages -- including participation by Fannie Mae and Freddie Mac,
car loans, residential and commercial real estate financing, and even some construction
financing.123 The analysis which follows will focus on the most common SCF products
utilized in the U.S. today. The specifics of the SCF product will be discussed in greater
detail within the analysis.
2. Overview of the legal analysis
The legal analysis of the SCF products to follow will examine civil and criminal liability
issues relating specifically to the duty to disclose, due diligence, and other compliance
issues raised by specific statutes. The examination will not be exhaustive nor will it focus
on the myriad of regulatory compliance issues where there is no manifest issue of civil or
2 1
criminal liability exposure.124 Specifically, in the disclosure discussion, the analysis
focuses on exposure to claims of securities fraud and various statutory and common law
regimens to protect against consumer fraud. The analysis of the requirements to conduct
due diligence and to meet other compliance mandates will focus primarily on the antiterrorism
statutes, which implicate the anti-money laundering statutes and the antiracketeering
statutes as amended by the USA Patriot Act (“the Patriot Act”).125 Finally,
the other compliance issues will discuss antitrust issues and exposure to tort claims for
aiding and abetting terrorism and the violation of internationally recognized norms of the
law of nations.
D. The legal landscape
1. Common law tort action for deceit or fraud
The regulation of disclosures by businesses, and by the financial industry in particular,
has a long and storied history in U.S. jurisprudence. Most of this regulation began in a
way not normally considered regulatory but its effect was and continues to be most
certainly to regulate. The common law of most states incorporated the tort action of
deceit, commonly referred to as fraud, to allow private rights of action for
misrepresentation in the context of what is now referred to as commercial speech.126 The
essential elements of a common law fraud action are: (1) a false representation (2) of a
material fact (3) which the defendant knew to be false and (4) with the intent to induce
the plaintiff to rely upon it and (5) the plaintiff in fact justifiably relied upon the
representation (6) thereby suffering damages as a result.127
Most states have relaxed or altered many of the elements of common law fraud. For
example, certain relationships under the common law, such as a fiduciary, might also
give rise to a claim for constructive fraud which allows recovery for an omission of
material fact. The scienter elements have also been relaxed. Thus, the intent elements
noted above in (3) and (4), has been “variously defined to mean everything from knowing
falsity with an implication of mens rea, through various gradations of recklessness, down
to such nonaction as is virtually equivalent to negligence or even liability without fault
(and would be better treated as creating a distinct species of liability not based on
intent).”128
2. Federal securities laws
In addition to common law actions for fraud or misrepresentation, there are federal and
state statutory regimes designed to govern disclosures in a myriad of business and
financial contexts, including the sale of goods and the provision of loans; investments
such as the formation of partnerships; and the sale of intangibles such as the offering of
securities. In the world of SCF, the disclosure statutes most obviously implicated in civil
and criminal liability issues are the federal and state securities laws.
In the main, the securities law relating to fraud and misrepresentation were modeled after
common law fraud. Having said this, it is just as true to say that Congress intended the
2 2
securities fraud statutes to have a far broader reach than the common law. As a result,
securities laws sought to include within its enforcement orbit misrepresentations,
omissions, schemes, and artifices that would not otherwise be captured by traditional
common law fraud. In addition, many of the specific elements of common law fraud were
relaxed or in some cases eliminated. While recent federal legislation aimed at curbing
abusive class action litigation and subsequent Supreme Court case law suggest a serious
trimming of the broad reach previously granted federal securities laws, the securities bar
knows full well that this is counterbalanced by a concomitant movement at the state level
to extend the reach of the state securities laws and to interpret them more liberally than
the federal counterparts.129
There are principally seven federal statutes that govern securities transactions: the
Securities Act of 1933; the Securities Act of 1934; the Trust Indenture Act of 1939; the
Investment Company Act of 1940; the Investment Advisors Act of 1940; the Securities
Investor Protection Act of 1970; and the Sarbanes-Oxley Act of 2002.130 Civil and
criminal liability under the federal securities statutes for failure to disclose, what is
broadly referred to as securities fraud, is regulated by the SEC and its principal weapons
are the Securities Act of 1933 ("1933 Act") and the Securities Exchange Act of 1934
("1934 Act").131 The 1933 and 1934 Acts target different markets. The 1933 Act regulates
initial offerings and the 1934 Act regulates all subsequent trading, but the overriding
public policy is the same: “full disclosure of every essentially important element
attending the issue of a new security” and a “demand that persons, whether they be
directors, experts, or underwriters, who sponsor the investment of other people’s money
should be held to the high standards of trusteeship.”132
Although both the 1933 and the 1934 Acts proscribe various types of conduct, including
incomplete or inaccurate disclosure of material information, as an administrative matter
the SEC, through its rule-making authority and its regulatory responsibilities, dictates the
specific kinds of minimal (and in some cases maximal) disclosure required by the
specific provisions. Beyond the routine administration functions granted the SEC, the
main weapons against securities fraud are the civil and criminal remedies. Thus, the SEC,
in addition to administrative sanctions, has access to the civil courts to seek injunctive
relief, disgorgement, and even civil fines, in addition to other ancillary equity-like relief.
In addition, the Department of Justice (“DOJ”), often as a result of an SEC administrative
investigation and criminal referral, is authorized to file criminal charges for violations of
the federal securities laws when it appears the offending party had the requisite intent.133
Finally, private plaintiffs have expressed and implied rights of action under several
provisions. The most used and abused of all such provisions is Rule 10b-5134,
promulgated under the 1934 Act135, which provides for civil litigation136 and criminal
prosecutions.137 When you add the class-action club to the civil claims brought under
Rule 10b-5, although reduced mightily by recent legislation138, the weapons available to
prosecute claims for misstatements and omissions of material fact in SEC filings and
elsewhere in the public domain are considerable.
3. State securities laws
2 3
State securities laws, usually referred to as blue sky laws, essentially track the
development of securities disclosure law and securities fraud liability in federal securities
law. As noted above, as a result of Congress’ efforts to curb private securities fraud
litigation and recent Supreme Court rulings regarding the new pleadings requirements,
the state securities laws will take on ever greater importance in the securities plaintiff’s
arsenal of litigation weapons.139
4. Federal and State consumer protection and anti-fraud laws
Further important weapons in the arsenal for fraud now available in most states are the
consumer protection statutes. While the Federal Trace Commission Act (“FTC Act”)140
does not apply to securities, it might well be implicated where businesses market
consumer products and represent that their business is run according to Shari’ah. Further,
modeled in part after the FTC Act, the “little FTC Acts” enacted by most states are often
more broadly interpreted than the FTC Act and many have an explicit or implied private
right of action allowing the consumers themselves to battle fraud in the marketplace.141
In California, for example, a private plaintiff sued Nike, Inc., an Oregon corporation, on
behalf of all California residents under the California Unfair Competition Law142 for
fraud and failure to disclose. The suit was filed after Nike had made false and misleading
public statements in the wake of media reports suggesting abuse at its foreign factories.
Nike claimed its speech was protected under the First Amendment. The case went to the
U.S. Supreme Court after Nike’s arguments to get the case dismissed on First
Amendment grounds did not persuade the California Supreme Court. But the U.S.
Supreme Court sent it back down to the California courts after it determined that
certiorari had been improvidently granted.143 Nike settled the case.144 The implications of
this type of state action for the SCF industry will be addressed below. Also, at least three
states allow their respective consumer protection statutes to be used for securities fraud,
which would bring the entire SCF industry under consumer fraud scrutiny.145
Additional statutes implicated are the federal Lanham Act, which regulates inter alia
fraud in the description of goods, services, or commercial activities,146 and laws
governing consumer finance. Consumer finance in the U.S. falls within the ambit of the
federal Truth-in-Lending Act (“TILA”)147 and the myriad of regulations promulgated
thereunder referred to collectively as Regulation Z.148 Banks and other lenders
advertising “zero interest loans” or “riba free loans” might in fact run afoul of the TILA
disclosure requirements and the restrictions on deceptive advertising. The Home
Ownership and Equity Protection Act (“HOEPA”)149, which is part of TILA, or the state
versions of HOEPA might also apply to what amounts to predatory lending to Shari’ahadherent
Muslims to the extent that the fees and costs are almost always higher than
conventional loans.
5. Due diligence and compliance statutes
The federal securities laws in several instances incorporate due diligence as defenses to
the anti-fraud provisions and as such are an integral part of any legal analysis for civil or
2 4
criminal exposure.150 In addition, due diligence is incorporated into several compliance
regimes such as the Bank Secrecy Act151 and the anti-money laundering statutes152, many
of which were modified by the Patriot Act. Insofar as SCF incorporates the Shari’ah
obligation to tithe and also requires the “purification” of profits earned in violation of
Shari’ah, the question for the legal practitioner is who decides what happens to the
monies gifted to charities and which charities are selected. Given the historical
connection between some of the largest and well-known Muslim charities and the
funding of terrorist groups153, these questions take on added focus in the context of
material support of terrorism. Finally, the structure of the Shari’ah authority boards and
their professional membership organizations also raise antitrust issues which must be
addressed.
E. The endogenous elements: disclosure of Shari’ah in SCF
1. The preliminary analysis
The first order of business for the attorney providing advice in the context of disclosure
laws to a U.S. financial institution interested in SCF should be the following question:
How intimate is the connection between SCF and Shari’ah itself? In legal terms, how
material is Shari’ah to SCF? If Shari’ah is a material part of SCF, the attorney must
confront the very real likelihood that it is a material fact of SCF in the context of
disclosure laws. While the answer to the question might appear self evident – that is,
Shari’ah has everything to do with SCF – all of the extant literature by legal scholars and
practitioners suggest that even if Shari’ah is a material component of SCF it is not
material to any of the disclosure laws because Shari’ah is treated as a black box that
merely turns out rules requiring objective filters to be coded into a software program and
specific kinds of contractual arrangements to avoid non-Shari’ah-compliant interest and
uncertainty.
But as the preceding pages have already suggested, when secular lawyers treat Shari’ah
as a black box that does not much concern them, except in the specific rulings relative to
a given investment or transaction, this amounts to a willful avoidance of material facts.
Those willfully avoided material facts are the endogenous elements of Shari’ah that
result in the “rules and principles” of SCF.154 Indeed, as indicated above, according to the
proponents and practitioners of SCF -- Shari’ah is not simply an approach to interestfree,
ethical Islamic business practices or investing. Invariably, SCF is described by its
proponents, practitioners, and scholars, as the contemporary Islamic legal, normative, and
communal response to the demands of modern day finance and commerce. What makes
the response “Islamic” or one pursued almost exclusively by Muslims155 is the fact that
this legal, normative, and communal response to modern finance is framed and regulated
by Shari’ah authorities ruling on what Shari’ah permits and what it prohibits. Thus,
whether called Shari’ah-compliant finance, Islamic economics and finance, or even
“ethical” investing, the one unifying characteristic of SCF in all of its ramifications is the
appearance of authoritative Muslim Shari’ah scholars who, individually and collectively
through various manifestations of consensus156, define the “rules and principles” of SCF
2 5
and set out how a Shari’ah-adherent Muslim may “lawfully” engage in commerce,
investing, and finance.
Further, the Shari’ah authorities are clear: SCF is not some discreet or segregable
component of Shari’ah. It is by all accounts a fully integrated discipline within the
corpus juris of Shari’ah which, in turn, is a holistic, all-encompassing way of life that
sets out legal mandates, norms, custom, and preferences to guide the Shari’ah-adherent
Muslim in every single aspect of life -- be it religious ritual, charity, business matters,
family issues and inheritance, war against the infidel, political life, or the afterlife.
Shari’ah is not divisible, moreover, in the sense that one might extract the SCF
“commercial legal code” from Shari’ah and end up with a body of laws articulating a
secular code of business conduct. This is demonstrated quite clearly by the prohibitions
against businesses that trade in pork products (seemingly a strictly dietary code issue) or
the leasing of a building to a church (quite obviously a theological consideration
informing a business law issue).157 Even in the legal rulings relating to whether a Muslim
bank or individual may receive interest from deposit accounts, the decision turns in large
part on whether the deposits reside in a jurisdiction called the “abode of war” where non-
Muslims predominate or the “abode of peace” where Muslims predominate.158
The inclusiveness, universality, and indivisibility of Shari’ah are not just evidenced by
the published work of the classical and contemporary Shari’ah authorities on the one
hand and the secular academic scholars who treat Shari’ah and its jurisprudence as a
discipline for study on the other. Especially important for the lawyer attempting to
determine what if anything the “Shari’ah” of SCF is in the context of disclosure laws,
and what if anything of this “Shari’ah” is material and subject to the duty to disclose, is
what Shari’ah actually is in practice. An attorney in search of the actual presentation of
Shari’ah as an extant and authoritative basis for law in modern times has the opportunity
to examine several Muslim regimes which have implemented Shari’ah as the law of the
land. The best examples of such implementation are Iran, Saudi Arabia, and Sudan.159
The Taliban of Afghanistan had also imposed a fully authoritative Shari’ah and many
other Muslim regimes have utilized aspects of Shari’ah to complement a non-Shari’ah
secular code. Obviously, the more a country’s laws are based upon Shari’ah, the better
the evidence of what Shari’ah is in actual practice devoid of all the academic theorizing
and parsing.160
It is not within the scope of this memorandum to determine what Shari’ah is in fact or
what it means to the contemporary Shari’ah authorities sitting as the final arbiters of
SCF. Examining the literature of Shari’ah over the course of its history, determining
what Shari’ah is in Muslim countries which apply traditional Shari’ah rules and
principles and, importantly, studying the published rulings by contemporary Shari’ah
authorities on what Shari’ah is161, what its purposes are, and what Shari’ah considers the
appropriate means to achieve those ends, are, however, all part of any essential inquiry
into the material endogenous elements of Shari’ah subject to disclosure.
2. The hypothetical: not so hypothetical
2 6
Notwithstanding a reluctance based on practical considerations to engage in a full
analysis of the material endogenous elements of Shari’ah, in order to provide a factual
predicate for the analysis of the disclosure (and other) laws that follow it will be helpful
to assume a fact or two about Shari’ah. Therefore, by way of example and for purposes
of the analysis, this memorandum assumes that after a good faith investigation, the
lawyer advising the financial institution desiring to enter the lucrative SCF industry will
determine that there is a reasonable basis to conclude that a consensus exists among
Shari’ah authorities on the fundamental purpose and methodologies of Shari’ah: The
purpose is submission. Shari’ah seeks to establish that Allah is the divine lawgiver and
that no other law may properly exist but Allah’s law. Shari’ah seeks to achieve this goal
through persuasion and other non-violent means. But when necessary and under certain
prescribed circumstances the use of force and even full-scale war to achieve the
dominance of Shari’ah worldwide is not only permissible, but obligatory.
While this memorandum poses these conclusions as a hypothetical, they are hardly
conjectural. In fact, they reflect the rulings of the classical Shari’ah authorities dating
back almost a millennium and include the most contemporary of Shari’ah authorities
issuing authoritative legal rulings today. Although post-9/11 scholarship on Islamic
terrorism has made the point that the terrorists almost always base their actions on legal
rulings by Shari’ah authorities,162 a wholesale confusion remains because policy-makers
and lawyers have not approached the doctrinal basis for Jihad or Islamic holy war
objectively or analytically. Indeed, other than the reflexive, “Islam is a noble religion of
peace,” no government agency or department, including the Departments of Homeland
Security and Defense, has undertaken a public analysis of the doctrines driving the
Islamic terrorists who seek the destruction of the U.S. and its constitutional
government.163 The result has been that, until recently, no scholar from any discipline
connected to this field of study has systematically examined the strategic doctrines which
provide the theoretical, legal, spiritual, and traditional motivations underpinning the war
on the U.S. and Western interests by the Islamic terrorist combatants.
In what amounts to a strategic and analytical tour de force, Major Stephen Collins
Coughlin, assigned to Military Intelligence in the U.S. Army Reserves, has produced a
study on Shari’ah and its foundational role as controlling doctrine for Shari’ah-adherent
terrorists in their holy war against the infidel.164 The unpublished study has been accepted
by the faculty of the National Defense Intelligence College in partial fulfillment of the
requirement for Coughlin’s Master of Science degree in Strategic Intelligence. The
strength of the study is that it examines meticulously Shari’ah as law as it is defined and
interpreted by Shari’ah authorities themselves. Further, the analysis surveys the binding
rulings of Shari’ah authorities from the classical periods dating back to the early days
after Mohammed’s death, including also the so-called Golden Era of Islamic
enlightenment, through the chaotic period around the fall of the Ottoman Empire and the
establishment of the secular-based military autocracies which continue to dominate most
of the Muslim world today, right through to the present. The contemporary survey also
includes a best-selling 7th grade text book used in Islamic day schools throughout the
U.S. to validate the study’s choice of authorities and to confirm that their legal rulings are
used pedagogically as the foundation for understanding traditional, Shari’ah-centered
2 7
Islam.165 Further, Coughlin carefully authenticates the authorities so that one is not
misled into accepting either a weak authority or an “extremist” view point. Finally, the
work is by far the best of any such scholarship attempted because it treats doctrinal
Shari’ah as Shari’ah expects to be treated and as evidenced by the published rulings of
the Shari’ah authorities: as a sectarian legal-political-military normative social construct
sourced in divine and immutable law.
What the study demonstrates beyond any reasonable doubt is that Shari’ah and the
doctrines of war articulated as the Law of Jihad are valid today as they were one
thousand years ago. Jihad should be implemented as circumstances permit, and the
contemporary authoritative Shari’ah scholars continue to teach, preach and issue legal
rulings to this effect. What Coughlin’s investigation further explicates is that, per
Shari’ah, once the Shari’ah authorities reach a consensus on a legal ruling or doctrine
which is based on the Qur’an and Hadith, that ruling or doctrine is considered immutable
and irrevocable.166 This adds yet further concretization to the rulings on Jihad because
the purpose of Islam and the methodologies to achieve those ends per Shari’ah are
universally accepted by the Shari’ah authorities with but relatively minor exceptions as to
specifics.167
Based upon a consensus of legal authorities, which Coughlin carefully documents by
traversing the full history of Shari’ah’s development across all extant legal schools, this
study places the Law of Jihad in a milieu permeated by the consequences of the
jurisprudential rule of consensus and indisputably establishes three fundamental points
relevant to this memorandum’s analysis:
[1] The goal of Jihad to convert or conquer the entire world and the
methodology to achieve this end by persuasion, by force and subjugation,
or by murder is extant doctrine and valid law by virtue of a universal
consensus among the authoritative Shari’ah scholars throughout Islamic
history.
[2] The doctrine of Jihad is foundational because it is based upon explicit
verses in the Qur’an and the most authentic of canonical Sunna and it is
considered a cornerstone of justice: until the infidels and polytheists are
converted, subjugated, or murdered, their mischief and domination will
continue to harm the Muslim nation. And,
[3] Jihad is conducted primarily through kinetic warfare but it includes
other modalities such as propaganda and psychological warfare.
These three points will serve as the background for the analysis below but will be stresstested
when the factual case studies are examined in Section III. If Coughlin’s thesis is
correct, there should be immediate evidence that contemporary Shari’ah authorities both
embrace the Law of Jihad as an extant doctrine for action by Shari’ah-adherent Muslims
and base their rulings on the classical Shari’ah authorities who fully embraced the
consensus on the Law of Jihad.
2 8
3. The legal analysis: applying the endogenous elements of Shari’ah to
the specific duty to disclose
As noted previously, the SCF industry in the U.S. includes a panoply of businesses which
fall within the regulatory sphere of the securities laws. Mutual funds tracking one of the
Islamic indexes, publicly traded bond issuances and the trading of securitized bond
issuances on a secondary market, and even U.S. public companies announcing their
commitment to conducting their business according to the principles of Shari’ah are
some of the more obvious examples. Do the facts of Shari’ah – representing the
overriding purposes of Shari’ah and the methods authorized to achieve those purposes –
require disclosure under the securities laws?
Failure to disclose a material fact (or the material misrepresentation of an asserted fact) is
the basis for administrative, civil, and criminal actions under all of the securities laws
requiring disclosure. The breach of this duty might arise in a registration, prospectus or
other required filing with the SEC or far more broadly “in connection with” a purchase or
sale of securities. For example, the 1933 Act imposes a number of requirements upon
issuers, underwriters, and dealers to make full and fair disclosures in securities
offerings.168 Section 11 of the 1933 Act (“Section 11”) provides that purchasers of
securities may sue for material misrepresentations or omissions in registration statements
as long as they did not know of the misrepresentation or omission at the time of
purchase.169 The dragnet under Section 11 for potential defendants is fairly wide and
includes: (1) any person who signed the registration statement; (2) any person who was a
director or partner of the issuer at the time of the filing of the registration statement; (3)
any person listed in the registration statement as a soon-to-be director or partner; (4)
every accountant, engineer, appraiser, or other expert named in the statement after having
consented, but only as to any liability arising from the portion of the statement attributed
to the specific expert; or (5) any underwriter of the securities.170 In addition, Section 12
of the 1933 Act (“Section 12”) authorizes a purchaser of securities to sue the offeror or
seller for any material misrepresentation or omission in a prospectus and adds “oral
communications” to the landscape.171 The depth of the exposure for both of these
provisions is the fact that a private plaintiff need not allege or show actual reliance on the
misrepresentation or show that the absence of the material omission was in fact a
contributing element.172
The pre-eminent statutory authority for civil and criminal liability exposure for failure to
disclose in securities transactions is Section 10(b) of the 1934 Act and its regulatory
offspring Rule 10b-5. This is so partly because it has been the source for most of the
litigation due to its breadth and the fact that it includes an implied private right of action
thereby adding private plaintiff and class action claims to the enforcement suits by the
SEC and by DOJ criminal prosecutions.173 The essential elements of a Rule 10b-5 action
are:
2 9
(1) a misstatement or omission; (2) of material fact; (3) with scienter; (4) in connection
with the purchase or the sale of a security; (5) upon which the plaintiff reasonably relied;
and (6) that the plaintiff's reliance was the proximate cause of his or her injury. 174
Once these elements of the Rule 10b-5 cause of action are established, a criminal penalty
can be imposed under section 32(a) if the government satisfactorily proves a willful
violation of the 1934 Act.175
While a thorough analysis of each of the fraud elements relative to the particulars of the
situation176 would be critical for the practitioner to undertake, this memorandum will
examine two of the unique elements to most fraud claims based upon allegations that the
defendant omitted material information about Shari’ah in various public filings and
representations: materiality and scienter. Because the discussion regarding materiality in
a federal securities fraud action are also applicable in the main to fraud claims alleged
under the common law, the state blue sky laws, or other anti-fraud federal and state
statutes, the discussion of materiality will not treat the latter separately. These two
elements of the fraud action are carved out for special attention in this memorandum
because a failure to consider these particular elements properly will likely contribute to
the conclusion that the Shari’ah black box poses no great risk to U.S. companies involved
in SCF. This conclusion, if reached without due consideration of the matters raised
herein, would be faulty and quite likely very costly. There will be a natural tendency by
practitioners to treat materiality and scienter as high hurdles for a government
prosecution, an SEC enforcement action, or a private civil claim because these lawyers
have treated Shari’ah as a black box into which they have refused to peer. They will then
consider the contents of that black box either immaterial in and of itself or irrelevant
since they will insist that there was no requisite intent on the part of their clients to
embrace the endogenous elements of Shari’ah.
a. Materiality
i. The Supreme Court’s standards
Materiality is a fundamental element for an action alleging a failure to disclose under the
securities laws and this is certainly the case for a plaintiff alleging that a defendant
violated such duty by not properly disclosing the real nature, purpose, and scope of
Shari’ah. The essential elements of such a claim might be, in addition to those set forth
above in the hypothetical factual predicate for this discussion, as follows:
(1) Plaintiff bought shares in a closed-end mutual fund which represented
itself to be Shari’ah-compliant.
(2) An important part of these representations was the high-repute of the
Shari’ah advisory board members who were to watch over the fund’s
Shari’ah compliance.
3 0
(3) Various representations by the defendant financial institution and its
agents and representatives spoke of the ethical and socially responsible
nature of Shari’ah.
(4) It was subsequently discovered and made public that the Shari’ah
advisory board members all treated the rulings and pronouncements of Ibn
Taymiyyah, a fourteenth-century Hanbali Shari’ah authority and scholar
“with strikingly modern-sounding views” on commerce and finance177, as
authoritative. It was also discovered and made public that Ibn Taymiyyah
was a key Shari’ah authority for most of the terrorists associated with al
Qaeda. Ibn Taymiyyah, it turns out, was a leading advocate of a Shari’ah
centered political organization for Muslims which would declare holy war
against infidels and Muslims who rejected Shari’ah. In fact, all sorts of
“Islamists” who have declared war on the U.S. and seek the establishment
of a worldwide Caliphate are students and followers of the Shari’ah “rules
and principles” espoused by Ibn Taymiyyah insofar as he advocates
Muslims to war against infidels.178
(5) There is a consensus among Shari’ah authorities from all schools of
Shari’ah jurisprudence that forced subjugation or Jihad against non-
Muslims is obligatory when efforts to peacefully convert the non-Muslims
fail and war is a viable option.
In addition to these allegations which would support an SEC enforcement action or a
private right of action for rescission, a plaintiff might opt to pursue damages. In such a
case, one might anticipate the following: When the information alleged above became
public knowledge, the fund suffered irreparable reputational damage and many of the
U.S. investors sold their shares in the mutual fund causing the value of the traded shares
to plummet. The complaint would also allege that the plaintiff purchased shares in the
mutual fund without knowing anything about Shari’ah other than what the defendants
represented to the public. Since the defendants promoted their Shari’ah authority board
members as highly respected scholars and authorities in their field and since these
authorities ruled that Shari’ah forbade interest and excessive speculation in investments,
and also prohibited investing in various “vice” industries, the plaintiff reasonably relied
on these representations in the belief that Shari’ah was a “socially responsible” business
practice and worth utilizing as an investment “screen”. Had the plaintiff known the facts
about Shari’ah as they have now come to light, plaintiff would never have invested in a
Shari’ah-compliant mutual fund. In addition to damages, the plaintiff would likely apply
to certify the class of similarly situated investors.
The first issue confronting the plaintiffs under Rule 10b-5, the broadest of the federal
securities anti-fraud statutes, will be whether the omissions of fact relating to Shari’ah
doctrine relative to the treatment of apostates (both non-Muslims and Muslims) were
material. Insofar as this question of materiality as phrased would be one of first
impression for an appellate court, legal counsel advising a U.S. financial institution on
the liability exposure for SCF would turn to the courts’ general pronouncements for
3 1
guidance. The leading decision in this area is TSC Industries, Inc. v. Northway, Inc.,179
where the Supreme Court was asked to wade into the question of whether a failure to
disclose in the context of a proxy solicitation was material. The case involved the
acquisition of the target company TSC Industries by National Industries through the
purchase of a controlling interest. After the acquisition, National Industries sought to
acquire all of the assets of TSC Industries and to liquidate the corporate shell. To
accomplish this, TSC Industries issued a proxy statement to its shareholders soliciting
their approval. The vote passed. A shareholder of TSC Industries, Northway, Inc., sued
under section 14(a) of the 1934 Act (“Section 14(a)”) and the SEC rules promulgated
thereunder, Rules 14a-3 and 14a-9. 180 The essential material fact at issue was who was
really |
