Shariah’s Black Box

When the mutual fund, however, markets its product as “Islamic” or “Shariah-compliant”, it is making a claim that goes well beyond the disclosed screens or filters, even if all that is applied to make it “Islamic” or “Shariah-compliant” is the use of the disclosed filters. A cursory reading of the registration statement filed pursuant to the Investment Act of 1940[80] for the Dow Jones Islamic Portfolio Fund suggests that the lawyers tasked with writing the risk section of the document understood this reality, at least at some rudimentary level[81], and sought to eliminate the problem with one broad brush stroke:

The investment objective of the Dow Jones Islamic Market Index Portfolio (the “Portfolio”) is to seek long-term capital gains by matching the performance of the Dow Jones Islamic Market Index^(SM) (the “Index”) – a globally diversified compilation of equity securities considered by Dow Jones’ Shariah Supervisory Board to be in compliance with Shariah principles. (Emphasis added.)[82]

Notwithstanding representations throughout the registration statement that various practices of the fund will comply with “Shariah principles”, which are nowhere articulated in any remotely material way, the language in this section intends to sweep Shariah under the rug by reducing “Shariah principles” to whatever the Dow Jones Shariah Supervisory Board says they are. There are, however, a plethora of risk factors specifically associated with anything pegged to Shariah compliance that such a statement fails to capture. Fundamental disclosure issues for a reasonable investor would be: What is Shariah? Does applying Shariah “principles” pose any unique reputational or financial risks for the investment or might it actually pose a risk for the physical safety of the U.S. investor? In other words, if Shariah is hostile to Western political and financial institutions, would that not be important for a U.S. investor to know prior to investing in a business which promotes Shariah-compliant investing?

A still more common example of a risk that appears to have been ignored in this registration statement would apply with special emphasis to a closed-ended fund but could also affect an open-ended fund’s investors. What would be the effect of a more authoritative Shariah advisory board ruling asserting that the Dow Jones Shariah Supervisory Board was gravely mistaken about Shariah principles resulting in a number of forbidden companies being improperly listed by the DJII as Shariah-compliant?[83] Precisely because the SCF industry generally represents that only authoritative Shariah scholars can divine legitimate legal rulings of Shariah, a contradictory ruling by a more austere body could pose grave financial risks. Investors who care about “Shariah principles” and who had invested in the fund, and possibly others who had invested in the underlying equities directly in reliance on the DJII, would likely feel obliged to sell their interests. The Dow Jones portfolio fund managers would likely also liquidate those equities so as not to get caught in the cross-fire between competing Shariah authorities and to thereby mitigate claims for damages arising out an allegation that the fund manager knew or should have known that the Dow Jones Shariah advisory board did not properly adhere to authoritative Shariah principles. The end result, given enough sale orders, would be a material reduction in the share price of the forbidden companies or, in the case of a close-ended fund, the fund itself. Class action lawsuits brought by investors caught “holding the bag” and predicated on failure to disclose and misrepresentation would be inevitable.[84]

The point of this one, narrowly scripted example is not to analyze the liability exposure of the registration statement of the now defunct Dow Jones Islamic Portfolio Fund, but rather to illustrate how marketing an investment product as Shariah-compliant incorporates a whole set of factual predicates, many of which are material to the investment decision. According to the Shariah authorities themselves, Shariah — of which SCF is only a small, integrated component — is more than just a half-dozen filters operating in the background to eliminate interest, speculation, and vice. Rather it is a motivating force and mark of Muslim identification for hundreds of millions of Muslims throughout the world, a corpus juris that incorporates a 1200-year old history of jurisprudence, of institutionalized legal schools with published legal decisions and other scholarly writings, together with a millennium of religious and political implications, all of which has generated in modern times a whole body of literature and scholarship on the import of Shariah in the ancient and contemporary world.

These realities comprise a dangerous minefield for the naïve or willfully ignorant financial institution seeking to capitalize on the alluringly profitable new universe of investment vehicles marketed to Shariah adherents. This minefield includes questions which these financial institutions and their professional facilitators have not even begun to ask, much less answer.[85] It is the purpose of this memorandum to begin this analysis and the necessary discussion of its implications for the U.S. financial industry, the professionals advising their financial clients on SCF, and the policy-makers in and out of government. This latter group especially has an obligation to consider the ominous implications for U.S. national and financial security of a fully integrated Shariah-compliant financial industry.