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Insolvency & Debt Restructuring In Islamic Finance

The skyrocketing uncertainties in the global economy have rekindled the need to examine issues relating to insolvency and debt restructuring. With a focus on Islamic financial transactions and Islamic financial institutions, this article examines the inter play between three related concepts of insolvency, bankruptcy and debt restructuring.

As Islamic finance products and Islamic financial institutions expand into new jurisdictions across the world, there is a consequential risk of the rise of defaults, insolvency and finally bankruptcy which require some sort of standards to regulate the entire industry. Protecting the interests of creditors, investors or certificate holders is as important as consumer protection. Hence,the need for proper regulation of issues relating to defaults in the Islamic finance industry, both at the individual and institutional levels (Hassan and Kholid, 2010).

The classical Islamic jurisprudence recognises the concept of insolvency in debt-relatedtransactions. Though some scholars have tried to distinguish between iflas (insolvency) and taflis (bankruptcy), linguistically, they mean the same thing (Cowan, 1974: 726). However, the common term for an insolvent person in the prophetic precedents is muflis. While the condition of being unable to pay one’s debt is iflas(insolvency) official act or procedure of declaring the person as such is taflis (bankruptcy). For convenience sake, the terms are interchangeably used in this article except where it is other wise clarified.

One must not shy away from the fact that the classical fiqh does not have a clear-cut procedure for bankruptcy proceedings. But there are some fine principles that can be gleaned from fiqh based on prophetic precedents and developed by the earlier scholars.After all, it is the duty of scholars to piece together such fine rules and apply them to new issues. Some of these rules could contribute significantly to modern bankruptcy laws.Even though the traditional conception of bankruptcy relates to individual bankruptcy since there was no clear cut distinction between commercial and non-commercial entities, the concept ofifl as is known to the classical Islamic law (fiqh).

The recent issuance of AAOIFI Shari’a Standard No. 43 on bankruptcy hasfurther brought to the limelight the need to protect investors inthe Islamic finance industry. Furthermore, since the legal aspects of the Shari’a are inclusionary in nature based on the principles of ibahah (permissibility), one may arguably observe that whiles scholars are encouraged to come up with relevant  principles on bankruptcy from the classical fiqh, they should be understood in the light of modern realities. Areas that are not specifically covered in fiqh may be adopted from modern bankruptcy laws in so far as they are not inconsistent with the maqasid al-Shari’a and do not violate any explicit principle of the Shari’a.

A Conceptual Framework of Insolvency & Financial Distress in Islamic Law

There are incidences which are used by both the proto-jurists and modern scholars to establish certain basic rules of bankruptcy. Just as in the modern laws, insolvency leads to bankruptcy eventhough the latter may be preceded by the process of debt restructuring. Hence, there are historical precedents in the Sunnah detailing some practices among the proto-Muslims during theprophetic era. For instance, it was reported that the Prophet prevented Mu’adh from disposing his property because his debts outweighed his assets. Since he was insolvent, the Prophet, being the head of state who also exercised judicial powers, sold Mu’adhb Jabal’s property and paid off the creditors.

Muslim jurists have endeavoured to differentiate between financial distress (i’sar) and bankruptcy (iflas), and insolvency (taflis). WhileAl-Qurtubi defines financial distress as a situation where one finds himself in a difficult situation due to lack of funds, Abu Jayib(1408) describes bankruptcy as a situation where one’s debt outweighs his assets and there is no way the latter can settle the former. Furthermore, there is a sharp line of distinction between insolvency (taflis) and bankruptcy (iflas). Once someone has become insolvent, he may be declared bankrupt and the creditor scan get relief from the entire of all his properties. This is done through an interdiction (hajar) on his properties by the creditors.The bankruptcy proceedings should ordinarily be managed by a constituted authority, usually the qadi. All the properties of the bankrupt person are sold with the exception of some necessaries such as food, drink and clothing. The proceeds of such sale are divided among the creditors. If the debt of any of the creditors is something concrete and recognisable among the properties of the bankrupt person, it is restored immediately without selling it.

Though there are different of opinions among the Muslim jurists on some of the issues, the general Shari’a principles on bankruptcy are summarised thus:

  1. A debtor may be deemed bankrupt if he has no wealth or he has wealth but it will not cover the debt that is currently due. With regard to debts that are not yet due, the one who owes them cannot be deemed bankrupt.
  1. The bankrupt individual may have his assets frozen if his creditors or some of them request that, so that he will not harm them by that.
  2. If his assets are frozen, then any transaction he does,whether buying or selling, establishing a waqf or giving agift, is not valid.


  1. The ruler or qadi (judge) may sell his property in order to pay off his debts and leave him nothing except what is necessary for him, such as his dwelling, his books, his clothing, the tools of his trade, and the capital of his business; he may sell everything apart from that (Al-Munajjid, 2013).

National & Cross-Border Bankruptcy And InsolvencyLegislations

Most of the GCC countries do not have adequate bankruptcy laws even though some Islamic financial transactions and indeed institutions are vulnerable to financial distress. These uncertainties have further complicated issues involving sukuk defaults. It is unfortunate that the skyrocketing interest in developing the Islamic finance industry does not have any meaningful impact on bankruptcy laws of most Muslim countries and insolvency is a cardinal aspect of financing regimes. Hamoudi (2011) has earlier made this concern which, up till now, has not been given the much needed attention by regulatory authorities in jurisdictions operating Islamic financial services:

The interest in reforming bankruptcy laws is in fact astonishingly low, and bankruptcy is among the broad gamut of once Islamic legal regimes that have been, as a general matter, “totally replaced” by transplanted counterparts. To take one salient example, Qatar, which has begun a serious Islamisation of its finance sector through issuing bank directives designed to expand Islamic banking within the country, initiated a bankruptcy regime in a 2006 law that bears all the hallmarks of a Western transplant(Hamoudi, 2011: 509).

Apart from Qatar, other Muslim countries with good regulatory frameworks for Islamic finance such as Malaysia, Saudi Arabia and Indonesia have similar experiences. Their bankruptcy laws are western transplants neglecting the fine Islamic principles that could add value to their laws. One is therefore not surprised why Hamoudi (2011) is flabbergasted about the conspicuous irrelevance of Islamic bankruptcy in the modern Muslim world.There is no doubt that legislation or simply put, law plays a significant role in enhancing the original value proposition of Islamic financial intermediation (Oseni, et al. 2012).

Islamic principles of bankruptcy cannot be relevant in the modern era without some sort of codification. While the bankruptcy regimes of Muslim countries have preferred the legal transplant approach from western laws, it is time for experts to come up with Islamic bankruptcy rules for the modern Islamic finance industry. It is doubtful whether the new AAOIFI Shariah Standard No. 43 on bankruptcy will have any impact on existing laws in Muslim countries.

Conclusion & Recommendations

This short paper has attempted to highlight some current trends in insolvency and debt restructuring in the Islamic finance industry with a view to propose future directions for the industry. This is necessary to ensure the Shari’a compliance of the process as well as coming up with a conventionally viable Islamic bankruptcy law. It is needless to say that most of the Muslim countries have been complacent about the need to ensure that the laws regulating insolvency and bankruptcy issues is Shari’a compliant. While significant strides have been recorded in the regulation of Islamic finance industry, there has not been much development in the Islamic insolvency law.

One may conclude by re-echoing McMillen’s (2012) concerns on the need for fundamental research and indeed discussions on some relevant issues with a view to understanding the Shari’a position on some contemporary practices.

If, in line with international trends, the system will incorporatere organisation concepts and principles, what is the Shari’a basis for this regime? Even the fundamental questions are daunting. For example, consideration will need to be given to debt rescheduling concepts, debt forgiveness concepts, delayed debt payment concepts, equity conversion concepts, asset sale concepts, and differential equity conceptions. There will have to be consideration of whether voluntary bankruptcies can and will be permissible.And after agreement is reached on the basic nature and parameters of the system, the long road of discovery and elucidation of specific Shariah principles will have to be addressed. That undertaking will wind through a great deal of new territory, from the Shariah perspective, and will entail a comparative laws analyses (sic), and a systemic comparison, unlike any in history(McMillen, 2012: 29).

At this juncture, it is pertinent to emphasis that the process of coming up with a model law starts from a joint deliberation among Shari’a scholars, economists, financial experts, lawyers and even the consumers of Islamic finance products. Perhaps, the process an start from a one-day workshop to come up with the major highlights of a modern Islamic bankruptcy law. Subsequently, a committee comprising experts from all the groups concerned should be set up to come up with a draft which should, as a matter of necessity, be subject to further deliberations. Therefore,rather than waiting for the OIC Islamic Fiqh Academy to come up with a model law, the initial draft may be prepared and forwarded to it for ratification.

Against the above backdrop, the following recommendations should be taken into consideration while formulating the fine principles of a model Islamic bankruptcy law:

  1. Identifying the unique Islamic principles on financial distress,insolvency and debt restructuring. These may form the subject of a preliminary discussion from which a skeletal draft may emerge as a working outline for the special committee on the model Islamic bankruptcy law to be set up;


  1. Coming up with model rules or laws on bankruptcy and debt restructuring that can be domesticated in Muslim countries which are specifically applicable in the Islamic finance industry.Such a model law should consist of both the enabling laws and subsidiary legislations, ie, both the substantive and procedural aspects;


  • The proposed Islamic bankruptcy law should be developed at the level of OIC for wider acceptance among member countries. The International Islamic Fiqh Academy (‘IIFA’) ofthe OIC should constitute a high-powered committee comprising of leading experts in bankruptcy law in the modern world, leading Muslim lawyers from different member countries,representatives of IIFA, academicians, economists and financial experts, and some notable Shari’a scholars in the Islamic finance industry. This committee should be saddled with the responsibility of coming up with a model Islamic bankruptcy law to be proposed to the OIC member countries. In the interim, such committee may only need to ratify a draft law if such has been prepared by a team of experts;


  1. Structuring sukuk according to Islamic rules with specific reference to insolvency rules in Islamic law. The proposed Islamic bankruptcy law should be able to take case of issues of sukuk defaults. Since sukuk largely involve debts, insolvency issues should naturally be anticipated; hence, the need to specifically provide for sukuk transactions, particularly cases involving cross-border bankruptcy and insolvency cases;


  1. Emphasising an outcome-oriented and conciliatory approach in managing bankruptcy issues in the Islamic finance industry.This should form the bedrock of dispute management in cases involving insolvency; and


  1. Setting up Shari’a-compliant tribunals for the resolution of bankruptcy cases. Specialized arbitration tribunals may be utilized. This should be provided for under the model Islamic bankruptcy law.

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