First defaults of sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the $1 trillion Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait's Investment Dar said in May it had defaulted on a $100 million sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

"Secular, non-Sharia courts upholding those structures are more likely to consider sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders," said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

A $650 million sukuk issued by troubled Saudi group Saad, which is undergoing debt restructuring, for example is seen as an asset-based, rather than an asset-backed, sukuk. Yields of the sukuk jumped to above 70 percent in mid-June, as investors feared a default of the issue.

Most sukuk are structured as asset-based instruments, rather than asset-backed securitisation where "you always have a claim for that particular asset that has been sold to you as the investor", said Megat Hizaini Hassan, an Islamic banking lawyer in Kuala Lumpur.

"Everybody is chasing the same assets if they have not been transferred to the name of the sukuk holders," said Samer Amro, senior associate at law firm Dewey LeBoef.

Other uncertainties are likely to arise from sukuk defaults, including a debate about how courts will interpret repurchase clauses which are structured to follow a controversial ruling by prominent jurist Sheikh Muhammad Taqi Usmani in late 2007.

Taqi had ruled that repurchase guarantees found in most sukuk contradict Islamic laws, as they violate the principle of sharing risks and returns.

"If you're looking at the newer structures where the repurchase obligations are left to be determined at the time of repurchase, there may be some issues there," said Megat Hizaini.

"You don't really know how the courts will treat it in the situation," he said.

Islamic finance is governed by scholars' rulings, national regulators and its own standard-settings bodies such as Bahrain-based AAOIFI, the Accounting and Auditing Organization for Islamic Financial Institutions.

"In the Middle East, it's going to put to the test many of the legal protections that were originally built into the sukuk," said Mohammad Faiz Azmi, global Islamic finance leader at PriceWaterhouseCoopers, adding that countries in the region typically do not have bankruptcy laws as sophisticated as in Europe.

"When these sukuk start to default, it would be very apparent which jurisdiction has a more robust system than others," he said.

Corporates with perceived higher risks that are facing high borrowing costs and a sluggish regional IPO market could use true sukuk sales with full ownership transfers as an avenue to the capital markets.

"It adds some credit-enhancement, it adds credit-worthiness," said Rizwan Khan, a senior associate at law firm Norton Rose.

But the paperwork involved in registering ownership transfers in the Gulf Arab region and restrictions on foreign ownership of land make true sukuk sales difficult.

Issuers have to register the SPVs, to which asset ownership would have to be transferred, in Bahrain or the Cayman Islands, as regulatory frameworks in other Gulf countries like Saudi Arabia and Kuwait do not fully cover sukuk structures.

This turns the SPV into a foreign buyer, limiting the pool of assets.

"This is not going to change unless laws are enacted, in particular on the ownership issues," Khan said. (Reuters)