Dana Gas plans to replace the current sukuk with four-year bonds paying “less than half of the current profit rates and without a conversion feature,” it said this week. The new profit payments will comprise a cash and payment-in-kind element, and the sukuk may be repaid either in whole, or in part at par, prior to its maturity without any penalty, the company said.

An ad hoc committee representing holders of the $700 million Islamic bonds said it won't exchange the sukuk for new instruments at the proposed terms, which are “materially less favorable,” according to two people with knowledge of the matter and a statement seen by Bloomberg.

What's Unlawful?

“Due to the evolution and continual development of Islamic financial instruments and their interpretation, the company has recently received legal advice that the sukuk in its present form is not Shariah-compliant and is therefore unlawful under U.A.E. law,” Dana Gas said earlier this week.

A so-called mudarabah contract was used to structure the sukuk, which stipulates that the capital provider agrees to share the profits between themselves and the entrepreneur at an agreed ratio or percentage.

A person familiar with the arguments the company will present said the structure isn't legally sound because of the following characteristics:

• The purchase price is pre-fixed
• Profit payment is guaranteed regardless of the company's performance
• Distributions are based on interest and not profit-based calculations

Dana Gas's sukuk structure was approved by Dar Al Shariah, a U.A.E.-based firm that has also advised companies such as Citigroup Inc. and Emaar Properties PJSC, according to its website. Dar Al Shariah didn't respond to emailed questions.

In the absence of a centralized national Shariah board, such as the regulatory body in Malaysia, Islamic borrowers seek the advice of trained scholars to approve contracts. Shariah law prohibits interest-based financial products and forbids investments in companies involved in activities considered unethical, such as gambling, prostitution and alcohol- and pork-related businesses.

What's at Risk?

Other than Dana Gas's sukuk, there are seven outstanding Islamic bonds issued by U.A.E. borrowers that are based on mudarabah contracts, according to data compiled by Bloomberg. All are perpetual bonds, with the exception of DP World's securities.

• Abu Dhabi Islamic Bank's 6.375% bonds
• Dubai Islamic Bank's 6.75% and 6.25% bonds
• Al- Hilal Bank's 5.5% bonds
• Noor Islamic Bank's 6.25% bonds
• GEMs Education's 12% bonds
• DP World's 6.25% bonds

If the legal issue “is somehow contractual and specific to Dana, it shows how excessive sukuk complexity can expose inexperienced investors to additional risks upon default and argues strongly for regulated central Shariah boards to both build market confidence and transparency around this immature industry,” said Acreditus's Howladar.

“Irrespective, the legal and Shariah opinions that are supporting this view should be made public by the regulators in the interests of market transparency,” he said.

Is This a First?

This isn't the first time a company has sought to discredit its own Islamic facility. Investment Dar, a Kuwaiti company that was restructuring debt, contradicted its own scholars' assessment and argued a transaction with Beirut-based BLOM Bank SAL breached the religion's Shariah principles because Dar “was taking deposits at interest,” it said in a court filing in 2009.

Not only was Investment Dar's appeal thrown out of a U.K. court, but its own Shariah Supervisory Board barred it from using arguments based on Islamic law.

Now What?

The Sharjah Federal Court of First Instance has issued an injunction while it considers Dana Gas's application to have its Islamic bonds issued in 2013 “declared unlawful and unenforceable,” according to a company statement on Wednesday.

The injunction restrains institutions associated with the sukuk from taking any action inside or outside the U.A.E. to enforce against any of the securities of the company and its affiliates until a final determination is made by the court, it said. Dana Gas was also granted an additional injunction from the commercial division of the High Court of Justice in the British Virgin Islands on June 13, and has filed a pre-emptive lawsuit in the English High Court of Justice in London “to protect its interests against any hostile action,” it said in separate statements.

Initial hearing in the case in Sharjah has been scheduled for Dec. 25. But the gas producer's two securities, the $350 million 9% ordinary certificates and the $350 million of 7% bonds, mature in October.

Dana Gas said it won't pay its next two profit distributions, on July 31 and Oct. 31, and that they will be accounted for as part of the new instrument.

Not paying coupons because the instrument is not Shariah-compliant is “something that has a much wider implication for the sukuk market in general,” said Hussain of Arqaam.

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