National and Global Islamic Financial Architecture:
Prolems and Possible Solutions for the OIC Member Countries
45
contract and returns payable on sukuk are treated as interest for tax purposes (PWC 2012:
102-103).
3.1.3. Dispute Settlement/Conflict Resolution Framework and Institutions
Sustainable development of any financial industry must have a suitable legal framework which
includes an effective dispute resolution mechanism (Grais, Iqbal, and El-Hawary, 2004). Courts
and other dispute settlement institutions ensure ex post implementation of contracts and
enforcement of property rights in case of any breach of contracts or exercise of rights (Pistor
and Xu 2003). As the contracts used in Islamic banking products are derived from the Shariah
and the Islamic financial contracts' legitimacy should be judged by the principles of Islamic
law, the ideal situation would be to use Shariah as the governing law to settle disputes. Thus,
the dispute resolution issue becomes complicated due to the duality of laws in play in Islamic
finance transactions. While the contracts use Islamic law, the courts in most jurisdictions use
some variant of Western commercial law to adjudicate. This would mean using non-Islamic
legal system to resolve disputes involving Islamic financial contracts. The outcome of these
disputes will partly depend on the legal system and whether supporting Islamic banking law
exists or not.
One way to resolve the problem of adjudicating disputes in courts using non-Islamic civil laws
is to include choice-of-law and dispute settlement clauses (Vogel and Hayes, 1998). If Islamic
law is chosen as the law of choice to settle disputes, the contracts can opt for commercial
arbitration and be shielded from the national legal environment. While some Islamic
arbitration centers exist, parties are reluctant to take disputes to these institutions due to the
lack of precedence that creates legal risks. There is uncertainty regarding outcomes due to the
differences of opinion among different scholars and schools and the absence of a standardized
codified Islamic law. As such, partners in transactions avoid using Islamic law as they want to
avoid the "impracticalities or the uncertainty of applying classical Islamic law" (Vogel and
Hayes, 1998: 51).
3.1.4. Bankruptcy and Resolution of Banks
Bankruptcy law addresses defaults and restructuring by enforcing property rights of different
stakeholders in an appropriate way when firms become bankrupt (Moskow 2002). Bankruptcy
law along with insolvency systems entail the rules and regulations that govern access,
protection, risk management, and recovery of dues by providers of debt. Insolvency systems
include elements such as requiring creditor consent to file for reorganization, imposing an
automatic stay on the assets of the firm on filing reorganizing, requiring secured creditors to
be ranked first among distribution of proceeds resulting from the disposition of assets of the
firm, and requiring the appointment of an official by the court or by the creditors to operate
the firm during reorganization (La Porta et al. 1998). An important factor determining the
rights of investors in bankruptcies is to have a sound insolvency system that has an efficient
enforcement process of the claims arising from bankruptcy proceedings (World Bank 2005:
230). Inefficient bankruptcy regimes create uncertainty about creditor rights and can
adversely affect the growth of the financial sector.
Certain specific issues arise in bankruptcies related to financial sector. A key factor is the
quality of the collateral and the rights of the creditor on it after a bankruptcy. This is relevant
in financial securities where their structure will determine the nature of risks the investors