In conventional finance, those who default on their payments or that consistently pay late are usually penalized by altering their interest rates, usually connected to their credit rating.

In conventional finance, those who default on their payments or that consistently pay late are usually penalized by altering their interest rates, usually connected to their credit rating. This is problematic when it comes to sukuk because, unlike conventional banking, Islamic banking operates under Shariah compliant principles, which prohibit interest. Issues of defaults on loans, late payments, and how to deal with them are problematic for both conventional and Islamic banking. To ensure that the system works, affected parties need to be compensated somehow, and those that default should be penalized. Otherwise, the potential for abuse is too great. In this article we’ll take a look at cases in the last few years where these situations occurred and how they were handled.

In 2009, the entire Islamic debt market froze. This was due to a near default on a sukuk by Nakheel, a government owned property developer in Dubai. This sukuk was worth $3.5 billion USD. The main reason for the market freeze was the uncertainty about how the default would be handled if it happened. This is due to the fact that the Islamic financial market is still quite young, and many of these cases had no precedent. In the end, the sukuk was repaid thanks to intervention at the last minute by the government of Abu Dhabi.

Two important cases of sukuk default occurred in Kuwait in 2009. Investment Dar and International Investment Group (IIG), both based in Kuwait, had to default on sukuk worth $100 million USD and $200 million USD respectively. Investment Dar restructured the sukuk in 2011, converting the debt into equity in the company’s assets. IIG restructured its sukuk in order to alter its payments to a more manageable format. Dana Gas, in the United Arab Emirates, missed a payment on a $920 million USD sukuk. This case is being followed closely due to the way in which the restructuring of the sukuk is being handled consensually among the parties involved. This case could provide a model for futures defaulters in the area.

In general, Malaysian sukuk defaults have had better luck dealing with defaults. Several have defaulted since early 2009 without causing too many problems to the market. Fortunately, Malaysia has a developed legal framework in regard to Islamic finance that lets banks handle defaults in a manner similar to conventional bonds.