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Legislative and regulatory framework

i Legislative and regulatory regime

The United Arab Emirates (UAE) has always provided an attractive environment from which to provide Islamic finance services and products into the Gulf Cooperation Council (GCC) and beyond. In addition to being an established and vibrant global financial centre and its geographical location in the centre of the Asian and Western financial markets, the UAE also provides a legal system and a judiciary that is familiar with the principles of shariah. The UAE's Constitution identifies shariah as a principle source of law and UAE Federal Law No. 5 of 1985 Concerning Civil Transactions (the UAE Civil Code), which is deeply anchored in shariah, recognises the basic Islamic financing contracts, including:

  1. Murabahah (cost-plus financing): Article 506 of the UAE Civil Code defines a murabahah sale as:

    1. A sale may be by way of resale with a profit, a loss or at cost price if the capital value of the thing sold is known at the time of the contract, and the amount of the profit or loss is specified.

    2. If it appears that the seller has exaggerated in declaring the amount of the capital value, the purchaser may reduce (the amount) by the amount of the excess.

    3. If the capital value of the thing sold is not known when the contract is made, the purchaser may rescind the contract when he learns of it, and the same shall apply if the seller conceals a matter affecting the thing sold or the capital value, and he shall lose his right to elect if the goods are sold or consumed or pass out of his ownership after delivery.

  2. Mudarabah (trust financing): Article 693 of the UAE Civil Code states that a mudarabah is 'a contract whereby the person owning property puts in the capital, and the mudarib puts in effort or work, with a view to making a profit'.
  3. Musharakah (partnership financing): Article 654 of the UAE Civil Code identifies musharakah generally in the following statement: 'A company is a contract whereby two or more persons are bound each to participate in a financial project by providing a share of property or work for the exploitation of that project and the division of any profit or loss which may arise thereout.'
  4. Ijarah (leasing): Article 742 of the UAE Civil Code defines ijarah as 'the conferring by the lessor on the lessee of the right of use intended for the thing hired for a specified period in consideration of an ascertained rent'.
  5. While there is no specific article in UAE law that expressly refers to and deals with istisnah, the official commentary to the UAE Civil Code stipulates that the shariah principles of istisnah are applicable in the case of construction contracts (muqawala), which are defined in Article 872 as 'a contact whereby one of the parties thereto undertakes to make a thing or to perform work in consideration which the other undertakes to provide'.

While the emirate of Dubai has established itself as a major centre for business and commerce, the UAE is a relatively young country and the laws and regulations applicable to financial products and services (including Islamic finance) are rudimentary – often just providing a mandate for the formation of regulatory authorities to govern the provision of the relevant financial products and services in the UAE. Consequently, the detailed rules, regulation and policies relating to financial products and services are left to the discretion of the relevant regulatory authorities. The internal rules, policies and guidelines implemented by the authorities relating to the relevant financial products are not always made public. The laws relevant to Islamic financial services are in many cases diffused in multiple pieces of legislation and the coverage of issues (including consumer protection) is general rather than comprehensive.

Islamic banking

The UAE is one of the largest Islamic banking markets in the world, after Saudi Arabia and Malaysia. According to the UAE Central Bank's annual report for 2018, as at December 2018, 20.3 per cent (583 billion UAE dirhams or approximately US$158.72 billion) of all banking assets and credit in the UAE are shariah-compliant, which represents a steeper growth rate for Islamic finance than that for conventional bank loans.

The principal governmental and regulatory policies that govern the UAE banking sector, including Islamic banks (except in the Dubai International Financial Centre (DIFC), where the regulatory authority is the Dubai Financial Services Authority), are UAE Federal Law No. 14 concerning the Central Bank and Organisation of Financial Institutions and Banking (the Banking Law), which came into force on 30 September 2018 and repealed UAE Federal Law No. 10 of 1980 concerning the UAE Central Bank, the Monetary System and the Organisation of Banking and UAE Federal Law No. 6 of 1985 concerning Islamic Banks, Financial Establishments and Investment Companies), UAE Federal Law No. 18 of 1993 as amended (the Commercial Code) and the various circulars, decisions, notices and resolutions issued by the board of governors of the UAE Central Bank, from time to time, and which deal with various aspects of banking, including bank accounts, maintaining of certain reserve ratios, capital adequacy norms and reporting requirements to the UAE Central Bank. (Under the Banking Law, all existing UAE Central Bank circulars, decisions, notices and resolutions will remain in full force for a period of three years, unless replaced by new circulars, decisions notices or resolutions).

The Banking Law is the primary legislation giving the UAE Central Bank the authority to regulate financial services (including Islamic financial services) in the UAE. According to the Banking Law, the UAE Central Bank has the power to license and regulate a wide variety of financial institutions operating in the banking and financial sector in the UAE. In particular, the following institutions are regulated:

  1. banks, which are defined to include institutions licensed primarily to carry on the activity of accepting deposits and other licensed financial activities, such as granting loans, issuing and collecting cheques, placing bonds, trading in foreign exchange and precious metals or carrying on other operations allowed by law or by customary banking practice;
  2. exchange houses and money intermediaries (i.e., foreign exchange dealers who purchase and sell currency);
  3. Islamic financial institutions; and
  4. other financial institutions.

With respect to Islamic financial institutions, permissible activities are not specified in the Banking Law, which provides that 'Islamic financial institutions' means financial institutions licensed to undertake all the activities of a commercial bank but in accordance with the principles of Islamic shariah. The Banking Law provides that licensed Islamic financial institutions may undertake any of the following activities, provided they are done in a shariah-compliant manner:

  1. taking deposits of all types, including shariah-compliant deposits;
  2. providing credit facilities of all types;
  3. providing funding facilities of all types, including shariah-complaint funding facilities;
  4. providing currency exchange and money transfer services;
  5. providing monetary intermediating services;
  6. providing stored values services, electronic retail payments and digital money services;
  7. providing virtual banking services;
  8. arranging or marketing licensed financial activities; and
  9. acting as a principal in financial products that affect the financial position of the licensed financial institution, including but not limited to foreign exchange, financial derivatives, bonds and sukuk, equities, commodities and any other financial products approved by the UAE Central Bank.

The concept of a higher shariah authority was first contemplated under Article 5 of UAE Federal Law No. 6 of 1985 concerning Islamic Banks, Financial Establishments and Investment Companies, which provided that this authority should incorporate 'legal and banking personnel to undertake higher supervision over Islamic banks, financial institutions and investment companies to ensure legitimacy of their transactions according to the provisions of Islamic shariah law, and also to offer opinion on matters that these agencies may come across while conducting their activities. The opinion of the said higher shariah authority shall be binding on the said agencies'.

In 2017, the UAE cabinet approved the formation of the board of the higher shariah authority to strengthen consistency in the Islamic finance industry across the UAE. At its first meeting, the board identified a number of core objectives for the higher shariah authority, in particular (1) issuing fatawa (opinions) and ensuring the legitimacy of the products, services and activities of institutions providing Islamic services; (2) introducing and approving new and existing shariah standards and uniform documents relating to best practices for global Islamic financial services; (3) notifying the UAE Central Bank of shariah matters concerning preventive systems related to global Islamic financial services, as well as shariah-compliant instruments and ways to develop these; (4) conducting shariah research regarding Islamic financing and ways of supporting it; and (5) communicating and cooperating with other international organisations that currently set shariah regulations and standards for the Islamic financial industry.

The Banking Law seems to have formalised the establishment, and expanded the mandate, of the existing higher shariah authority (the Higher Authority). The Higher Authority shall consist of at least five members (but not more than seven) with sufficient knowledge and experience in shariah and Islamic financial transactions. The Higher Authority will, among other things, determine the rules, standards and general principles applicable to Islamic financial institutions and will undertake supervision and oversight of the shariah committees (see below). The fatawa issued by the Higher Authority shall be binding on both shariah committees and all Islamic financial institutions undertaking part or all of their business in accordance with the principles of shariah. As the Higher Authority is a recent development, it remains to be seen how its role will develop and how it will interact with, and impact, other key stakeholders, in particular the shariah committees overseeing shariah compliance at financial institutions (see below).

Each Islamic financial institution must appoint and maintain a shariah committee, called the 'internal shariah supervision committee' (the shariah committee); these committees mirror the activities of shariah supervisory boards (SSBs) under the earlier banking regime, consisting of experienced experts in Islamic finance jurisprudence. The shariah committee shall undertake shariah supervision of all business, products, services and the business conduct of the Islamic financial institution, to ensure that its operations and products comply with the rules and principles of shariah, as set by the Higher Authority. The shariah committee will review all proposed financial products and related documents and issue a fatwa on their shariah compliance. Once a financial product has received the approval of the shariah committee, it can be offered by the Islamic financial institution to the public in the UAE. In the event that there is any disagreement, either between the members of the shariah committee or between the shariah committee and the board of the Islamic financial institution in connection with compliance with principles of shariah, the dispute shall be referred to the Higher Authority, whose ruling shall be final.

Capital markets

The capital markets in the UAE are still in their infancy and there are very few Islamic products listed on the local exchanges. While the UAE Central Bank is the principal financial services regulator for banks and financial institutions in the UAE, these entities are also subject to additional registration and licensing requirements at the federal and emirate levels. The Emirates Securities and Commodities Authority (ESCA) is the regulator in relation to listed securities (including sukuk). As with other jurisdictions in the GCC, the laws and regulation relating to the provision of financial products on the local capital markets are supplemented to a large extent by the regulatory regime implemented on the individual exchanges. In the UAE, while the regulators will provide the broad requirements for issuing securities, it is the individual regulators of the exchanges (such as in the Abu Dhabi Stock Exchange and the Dubai Financial Market) that will provide the detailed framework for the listing of the relevant financial products on these exchanges. A detailed review of the rules and regulations of the individual stock exchanges in the UAE and the DIFC is beyond the scope of this chapter.

While the UAE equity capital markets have been near inactive in the past few years, with only a handful of primary listings on the local exchanges, sukuk (or Islamic bonds) have bucked the trend and emerged as the fastest-growing segment of the UAE Islamic capital markets. The UAE is also a popular destination for listing sukuk. At the end of 2018, the total value of sukuk listed on NASDAQ Dubai stood at US$51.2 billion, with 14 new sukuk listings with an aggregate value of US$11.99 billion in 2018.

Decision No. 16 of ESCA's Board of Directors of 2014 Concerning the Regulation of Sukuk (the Sukuk Regulations) provides specific guidelines for the issuance of sukuk in the UAE and the listing of sukuk on the local capital markets. In particular, the Sukuk Regulations provide that:

  1. all retail sukuk (i.e., sukuk where the maximum value of each sukuk certificate is 100,000 UAE dirhams and is offered to the public through a public subscription) shall only be issued in the UAE through public subscription and shall be listed on a local market;
  2. the obligor (i.e., the company that will receive the funds from the issuance of the sukuk certificates) must obtain ESCA's approval before issuing or listing sukuk on a regulated market;
  3. for a primary listing of a sukuk, the obligor must ensure that the sukuk has been approved by its SSB. If the obligor does not have an SSB, the sukuk must be approved by a shariah committee approved by ESCA;
  4. unless ESCA provides otherwise, the nominal value of a listed sukuk must be above 10 million UAE dirhams or its equivalent in any foreign currency accepted by ESCA and the relevant capital market;
  5. the issuer must appoint a UAE licensed bank to act as the paying agent in the UAE;
  6. the obligor must provide a prospectus (prepared in accordance with the guidelines in the Sukuk Regulations) for a primary listing of a sukuk;
  7. the obligor must comply with detailed continuing obligations in connection with a listed sukuk, including notifying ESCA and the relevant market of any information that may be expected to materially affect market activity, the price of the listed sukuk, or the ability of the obligor or issuer to meet its commitments under the sukuk; and
  8. ESCA shall respond to any application for the listing of a sukuk within five business days. If no response is received in this time frame, the application shall be considered rejected. ESCA shall have the right to attach any conditions, to any listing approval, that it deems necessary to protect the public interest.

ESCA's Board of Directors Decision No. 20 of 2018 Concerning the Offering or Issuance of Islamic Securities (the Offering Regulations) also imposes various obligations in relation to the issuance or offering of any shariah-compliant securities in the UAE (including by foreign entities) or outside the UAE by UAE-based issuers. In particular, the Offering Regulations set out the minimum information that an issuer wishing to offer or issue an Islamic security inside or outside the UAE (as well as a foreign issuer wishing to offer an Islamic security in the UAE) will have to incorporate in the offering document or prospectus and the information that must be disclosed to ESCA and the market in connection with such an issuance or offering.

Takaful insurance

The growth in takaful is far outstripping that of conventional insurance. In the wider Middle East, the takaful market segment is growing by 20 per cent a year. Currently, there are more than 60 takaful companies operating in 23 countries worldwide, generating takaful premiums estimated to be in excess of US$2 billion.

Under Federal Law No. 6 of 2007 regarding the Establishment of the Insurance Authority and Organisation of its Operations (the Insurance Law), the UAE Insurance Authority (the Insurance Authority) was appointed as the regulator for the insurance industry in the UAE (outside the free zones), including takaful insurance, and tasked with promoting the role of the insurance industry to indemnify persons, property and liabilities against risks to ultimately protect the national economy; to accumulate and grow national savings and invest them to support economic development in the UAE; to encourage fair and effective competition; to provide the best insurance services with appropriate coverage at a affordable rates; and to achieve job emiratisation (i.e., job creation for Emiratis) in the UAE insurance market.

Takaful insurance companies are required to comply with the provisions of the Insurance Law, and the takaful regulations (below) must be read in conjunction with the Insurance Law.

The Insurance Authority issued Board of Directors Resolution No. 4 of 2010 concerning the Takaful Insurance Regulations, which outlined rules designed to regulate the work of takaful insurance companies and can be summarised as follows:

  1. All insurance and investment transactions by the takaful insurance company must be compliant with the provisions of shariah. Pursuant to the 2010 Regulations, all premiums should be invested in accordance with shariah. We are not aware of any instance where this is not the case. We are not aware of takaful companies investing takaful funds with conventional insurers or using conventional insurers for reinsurance purposes.
  2. Takaful products may not be offered through an 'Islamic window' of a conventional insurance company.
  3. Risk management operations and investment business shall be conducted by the company on wakalah or wakalah and mudarabah together.
  4. Family takaful insurance and general insurance may not be combined in one takaful insurance company. The existing takaful insurance companies currently engaged in both types were given a specific deadline to adjust their positions.
  5. The insurance company is committed to provide a qard hasan to the participants' fund in the event of a deficit in the assets of this fund.
  6. The maximum amount of qard hasan is the sum of the shareholders' equity.
  7. The amount of wakalah fees and how it is calculated, as well as the takaful insurance company's share of mudarabah, must be stated in advance.
  8. An SSB must be formed in each takaful insurance company.
  9. The Supreme Committee for Fatwa and Sharia Oversight was formed within the Insurance Authority.
  10. It is necessary to appoint a shariah controller within each takaful insurance company.

The Insurance Authority's Board of Directors' Decision No. 26 of 2014 Pertinent to Financial Regulations for Takaful Insurance Companies (the 2014 Regulations), which was largely inspired by the EU's Solvency II standards, outlined various financial standards required for takaful insurance companies, including the following:

  1. The introduction of solvency margins and a guarantee fund. The previous minimum capital requirements (MCR) of 100 million and 250 million UAE dirhams, required for insurers and reinsurers respectively, have been supplemented with the following capital requirements:
    • a minimum guarantee fund (MGF), comprising an amount that is the higher of (1) not less than one-third of the solvency capital requirement (SCR); or (2) the higher of a minimum amount to be specified by the Insurance Authority for each type of business and a specified percentage of the net earned premium for each type of business; and
    • an SCR, which is a risk-based capital calculation that utilises the solvency template published by the Insurance Authority. The SCR introduces, for the first time in the UAE, a risk-based capital component for insurers.
  2. The requirement for takaful operators to maintain the higher of the MCR, the MGF and the SCR. In practice, it is likely that the MCR will remain the key requirement for much of the takaful industry given the relative youth and lack of scale of the takaful operators in the UAE.
  3. The basis for calculating the financial provisions required by takaful insurance companies to meet their obligations towards participants and their beneficiaries, including unearned contribution reserves, outstanding loss reserves and unexpired risk reserves (all as defined in the 2014 Regulations);
  4. A determination as to the takaful operator's assets that meet the accrued insurance policies. The takaful operator must develop investment and risk management policies, including strict limitations on each class of asset that may be held by a single counterparty, to address concentration risk. For example, maximum limits set by law include (1) a 30 per cent limit on real estate assets; (2) a 30 per cent limit on equities – only one-third of this may be invested in a particular class of assets; and (3) a 20 per cent limit on mutual fund investment – only half of this may be invested in a particular asset class;
  5. The accounting standards to be adopted by takaful operators.
  6. The records and documents to be maintained by takaful operators, which shall be made available to the Insurance Authority upon request.

While the above developments will enhance consumer protection, they will also cause some hardship for takaful operators, particularly for the smaller operators who may find it difficult to meet the extensive reporting requirements and limitations on the types of assets in which they may invest. It is expected that these requirements will encourage smaller takaful operators to merge and consolidate their business, to manage the new solvency and reporting requirements.

Investment funds

The vast majority of funds (including Islamic investment funds) marketed in the UAE (whether to retail customers, high net worth individuals or institutional investors) are organised offshore and the number of onshore funds is extremely low.

There are no laws in the UAE that deal specifically with Islamic investment funds. Therefore, the legal and regulatory regime applicable to investments in general will also apply to Islamic investment funds.

The principal financial services regulator in the UAE is the UAE Central Bank. Important UAE legislation applicable to investment funds includes:

  1. the Banking Law;
  2. UAE Central Bank Resolution 164/A/94 (regarding the regulation of financial companies and banking, and financial and investment consultation establishments or companies);
  3. UAE Central Bank Resolution 89/3/2000 (regarding amendment to regulation of investment companies and banking and financial investment consultation establishment of companies);
  4. UAE Central Bank Resolution 58/3/96 (regarding the regulation of finance companies);
  5. UAE Central Bank Resolution 21/2/88 (regarding the system of investment banks in the state);
  6. ESCA Resolution 3 of 2000 (concerning regulations on disclosure and transparency);
  7. ESCA Resolution 4 of 2000 (concerning the Emirates securities and commodities authority and market);
  8. ESCA Resolution 48 of 2008 (concerning financial advice and analysis); and
  9. ESCA Board of Directors Decision No. 9 of 2016 (concerning the regulation of mutual funds) (the Investment Funds Regulation).

The Investment Funds Regulation further confirmed the transfer from the UAE Central Bank to ESCA of responsibility for the licensing and marketing of mutual funds (including any Islamic investment funds), which are defined as financial pools engaged in the activity of accumulating investors' assets for the purpose of investment against the issue of fund units of equal value, and a number of related activities. ESCA approval is required for the sale, marketing and promotion of foreign securities and funds in the UAE and the establishment of domestic funds. In particular, the Investment Funds Regulation provides that:

  1. all foreign mutual funds (which are the most common type of investment fund in the UAE) must be approved by ESCA to be marketed in the UAE. The fact that a foreign fund may only be offered to institutional investors does not provide an exemption from the requirement to obtain ESCA approval;
  2. a foreign mutual fund may not be marketed to the public in the UAE unless the foreign fund is (1) subject to the supervision of an authority equivalent to ESCA in its jurisdiction of incorporation and (2) authorised to make offers to the public in its jurisdiction of incorporation;
  3. all approved foreign mutual funds, whether public or private, must be promoted by a local promoter, which includes (1) banks and investment companies licensed by the UAE Central Bank and (2) companies licensed to be local promoters by ESCA. The local promoter will act as an intermediary between the foreign fund and the persons to whom units in the fund are promoted in the UAE. The local promoter will also be responsible for a broad range of issues, including:
    • continuous monitoring of the operations of funds to safeguard the investment of the unitholders;
    • keeping records of the units distributed by the fund;
    • providing subscribers with copies of the foreign fund's offering document;
    • ensuring timely disclosure of material information and financial statements relating to the foreign fund to investors in the UAE; and
    • distributing dividends and redemption proceeds to the unit holders in accordance with the foreign fund's documents; and
  4. an entity establishing a local fund must be a UAE joint-stock company or a UAE branch of a foreign company. The company or branch must have a minimum capital of 5 million UAE dirhams.

The investment policy of the investment fund must specify, among other things, proposed investment instruments, investment risks relevant to the proposed investment instruments, restrictions on types of investments and borrowing controls. The Investment Funds Regulation also prescribes certain restrictions on investment of the fund's assets, in line with the investment nature of the fund, covering:

  1. investment in tradable securities (stocks, bonds and cash instruments) or high liquid non-tradable securities;
  2. financial derivatives on tradable securities to control the level of risk set out in the fund's prospectus or for hedging in an amount not greater than the total net asset value and subject to disclosure;
  3. declared indexes or bank deposits to ensure liquidity with a maximum maturity of 12 months with licensed banks;
  4. open-ended mutual funds, subject to determining the investment ratio (such funds must be licensed by an entity similar to ESCA); and
  5. immovable assets of high liquidity.

Any application for a licence from ESCA for either the establishment of a fund or the establishment of a local promoter company requires the submission of a letter of application, various constitutional documents from the applicant and a business plan of some sort. The exact documents are not prescribed by the relevant authority; rather, the normal practice is for ESCA to notify the applicant of such additional documents as it might require on an ad hoc basis. ESCA requires an applicant seeking approval for promotion of a foreign mutual fund to submit the fund's key information, an undertaking from the local promoter, a signed promotion agreement, the fund offering document and the constitutional documents, and the applicant's previous two years' audited financial statements (although additional documents may be requested).

ii Regulatory and supervisory authorities

While the authorities identified in Section I.i have the power to regulate the provision of financial services in and from the UAE, in practice, day-to-day shariah supervision and compliance is still left to the individual Islamic financial institution. Currently in the UAE, shariah compliance is achieved in various ways, including by way of adopting national regulation, voluntary shariah-compliant standards and fatawa, and directives and resolutions of the Islamic financial institution's internal shariah committee. However, it is anticipated that the decisions and regulations issued by the Higher Authority will soon become the dominant authority in the regulatory regime governing Islamic financial institutions.

Previously, the adherence to the voluntary standards issued by standard setting bodies such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board varied among individual Islamic banks and financial institutions in the UAE. However, this has changed following the recommendation by the higher shariah authority (now the Higher Authority) that all banks and financial institutions offering shariah-compliant products in the UAE comply with the requirements of the AAOIFI's standards with effect from 1 September 2018. For now, Islamic financial institutions continue to seek guidance from their internal shariah committee; this can be problematic when arranging syndicates of Islamic banks or financial institutions, as there may be differences of opinion between the different committees on the application of shariah principles to the financing structure.

In determining whether an Islamic financial instrument is shariah-compliant, the shariah scholars generally adhere to the following process:

  1. review the product concept description created by the product development team;
  2. review the market conditions identified by the product development team;
  3. review the product development team's views on the Islamic principles on which the transactions will be based; and
  4. review the product development team's proposals and issue fatawa.

The scholars' resulting fatwa is then reviewed by the product development team and can be followed by a discussion between the scholars and the product development team to finalise the product. The need for a constant dialogue between the product development team and the scholars throughout this process should be stressed. In line with the majority of countries where shariah-compliant financial services are offered, each financial institution in the UAE has its own shariah committee, making individual decisions for the institution. It remains to be seen whether the establishment of the Higher Authority will ultimately result in the UAE becoming the latest country to adopt a fully centralised shariah compliance regime, like those in place in other jurisdictions, such as Malaysia and Sudan, where shariah compliance is centralised within the central bank.

Originally pioneered by the Malaysian Central Bank (Bank Negara Malaysia), other central banks (e.g., in Oman, Nigeria and Pakistan) have more recently established a centralised SSB within their central bank or financial regulator. The central SSB is responsible for the approval of all shariah-compliant financial transaction structures in the country. The responsibility of the SSB of the individual financial institutions is to ensure the transactions undertaken by the institution are compliant with these rules. Any amendments requested by individual institutions will have to be presented to the central SSB for ratification. The centralised SSB and Bank Negara Malaysia maintain a register of approved scholars. Scholars cannot be a member of more than one board per type of financial institution. As a result, a scholar could, for example, be a member of the SSB of a retail bank and an investment bank, but not of two retail banks.