A decision by a Middle Eastern gas producer to declare its ownShariah-compliant bonds unlawful has baffled investors in the $2trillion Islamic finance industry.

Sharjah-based Dana Gas PJSC said Tuesday it no longer consideredits two Islamic bonds totaling $700 million issued four years agoas Shariah compliant under the United Arab Emirates' law. A courtin Sharjah has since barred bondholders from taking any actionagainst the company's securities until it reviews Dana Gas'sapplication to declare its debt “unlawful and unenforceable.”

“As creditors we understand that this is a liquidity and apayment issue, not a solvency issue — but clearly the company istrying to squeeze sukukholders to the benefit of shareholders andthat is a strategy that will end up hurting everybody down theroad,” said Abdul Kadir Hussain, the head of fixed-income assetmanagement at Arqaam Capital. Even if there were potentialdevelopments in Islamic finance that raised questions on thestructure, “it is still a debt instrument and money they haveborrowed,” he said.

The move comes after Dana Gas, which produces most of its energyin Egypt and Iraq, announced plans in May to restructure the debt,saying it needed to “focus on short to medium-term cashpreservation.” The company is owed about $1 billion from Egypt andthe self-governed Kurdish region in northern Iraq. Dana Gas hadabout $298 million of cash on hand at the end of March.

What About the Bondholders?

“This is pretty bad news for all sukuk investors as Dana Gasseeks to apply Shariah non-compliance as a rationale forrestructuring discussions,” said Khalid Howladar, the founder ofAcreditus, a risk and ratings advisory firm.

Dana Gas plans to replace the current sukuk with four-year bondspaying “less than half of the current profit rates and without aconversion feature,” it said this week. The new profit paymentswill comprise a cash and payment-in-kind element, and the sukuk maybe repaid either in whole, or in part at par, prior to its maturitywithout any penalty, the company said.

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

What's Unlawful?

“Due to the evolution and continual development of Islamicfinancial instruments and their interpretation, the company hasrecently received legal advice that the sukuk in its present formis 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 theprofits between themselves and the entrepreneur at an agreedratio or percentage.

A person familiar with the arguments the company will presentsaid the structure isn't legally sound because of the followingcharacteristics:

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

Dana Gas's sukuk structure was approved by Dar Al Shariah,a U.A.E.-based firm that has also advised companies such asCitigroup 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 asthe regulatory body in Malaysia, Islamic borrowers seek the adviceof trained scholars to approve contracts. Shariah law prohibitsinterest-based financial products and forbids investments incompanies involved in activities considered unethical, such asgambling, prostitution and alcohol- and pork-relatedbusinesses.

What's at Risk?

Other than Dana Gas's sukuk, there are seven outstanding Islamicbonds issued by U.A.E. borrowers that are based on mudarabahcontracts, according to data compiled by Bloomberg. All areperpetual 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 inexperiencedinvestors to additional risks upon default and argues strongly forregulated central Shariah boards to both build market confidenceand transparency around this immature industry,” saidAcreditus's Howladar.

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

Is This a First?

This isn't the first time a company has sought to discredit itsown Islamic facility. Investment Dar, a Kuwaiti company that wasrestructuring debt, contradicted its own scholars' assessment andargued a transaction with Beirut-based BLOM Bank SAL breached thereligion's Shariah principles because Dar “was taking deposits atinterest,” 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 usingarguments based on Islamic law.

Now What?

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

The injunction restrains institutions associated with the sukukfrom taking any action inside or outside the U.A.E. to enforceagainst any of the securities of the company and its affiliatesuntil a final determination is made by the court, it said. Dana Gaswas also granted an additional injunction from the commercialdivision of the High Court of Justice in the British Virgin Islandson June 13, and has filed a pre-emptive lawsuit in the English HighCourt of Justice in London “to protect its interests against anyhostile action,” it said in separate statements.

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

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

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

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