SCF Journal Entry – AIG – Black Box Shariah – Yerushalmi Notes

The following notes are derived from an unpublished paper by David Yerushalmi.

The following website has the complete paper – The final 20 pages have not been boiled down, because they are important to read in full.  The case against AIG & Paulson/Co. on the basis of the Establishment Clause due to the Shariah Compliant aspects of the business begin with the following paper by David Yerushalmi.  No one is talking about the Shariah Compliant Finance activity of AIG, but David Yerushalmi has a case that we might all need to pay attention to, especially considering the fact that Marine Takaful and other Takaful divisions of AIG are literally creating the precedent for a Takaful World body and regulatory system in bed with the US Government.
http://works.bepress.com/david_yerushalmi/1

Shari’ah’s Black Box: Civil Liability and Criminal
Exposure Surrounding Shari’ah-Compliant Finance
by: David Yerushalmi, Esq.

This Article examines Shari’ah-compliant finance in light of existing U.S. law. It
highlights and examines areas of civil liability and criminal exposure unique to SCF
investments and transactions3 in the U.S. as they have been developed and utilized by
various financial institutions and facilitated and promoted by legal, accounting, and
financial professionals.4 Part I provides an introduction to SCF and explains why it
should be subject to special scrutiny by lawyers, accountants, and other professional
advisers. Part II discusses the role of the professional in SCF transactions and suggests an analytical framework for approaching the legal issues surrounding SCF in the U.S. This framework divides the world of potential liability into two groups: liability arising
out of elements endogenous to SCF, involving issues about what Shari’ah actually is and
requires; and liability arising out of elements exogenous to SCF, such as the impact of
Western-adaptions of Shari’ah principles. Part III focuses in detail on the former, while
Part IV examines legal concerns related to the latter.

p.2
Footnote

[3]The distinction made throughout between a SCF “investment” and “transaction” is intended and important in this context. SCF expresses itself in fundamentally two ways: (a) “the investment”
refers to the kind of investment or business Shari’ah is understood to permit (i.e., equity versus
debt with interest; asset-based versus intangibles such as derivatives or hedging transactions
based upon future contingencies; and commerce in permitted versus prohibited industries) and (b)
“the transaction” refers to the way in which a permitted investment or business transaction is
structured typically through the use of nominate contracts (i.e., an “interest-free” loan may be
structured as a cost-plus sale or sale/lease back). See infra notes 124-126.

[4] http://www.arabbankers.org/shared/layouts/section.jsp?_event=view&_id=120130_U127360__13
2301

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I. Introduction
This analysis is a first of its kind in the published literature. To date, there has been no
focused effort to identify and analyze the implications for civil liability and criminal
exposure for U.S. financial institutions and other businesses engaged in any of the
various manifestations of SCF from a legal and regulatory framework.While some of the
SCF professional and scholarly writings address broad regulatory concerns7

p.3
Footnote…

[7]ISLAMIC FINANCE: THE REGULATORY CHALLENGE (Simon Archer & Rifaat Ahmed
Abdel Karim eds., 2007); Ayman H Abdel-Khaleq, Offering Islamic funds in the US and Europe,
INTERNATIONAL FINANCIAL LAW REVIEW, available at
http://www.iflr.com/?Page=17&ISS=16434&SID=515350 (last visited Jan. 24, 2008).

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II.  Overview of Shari’ah-Compliant Finance:

A. What is SCF?
According to the disclosures and representations of the financial institutions currently
promoting SCF12, Shari’ah compliance means that a particular investment or financial
transaction has been conducted or structured in a way considered “legal” or
“authorized”13 pursuant to Islamic law.14 Compliance with Shari’ah is achieved by
having a Shari’ah authority – either an individual or group of individuals possessing
authoritative status in matters relating to SCF15 – approve the particular investment or
type of transaction. Most financial institutions retain16 a Shari’ah advisory board, which
typically consists of three or more “Shari’ah scholars” who profess to be recognized as
authorities in SCF.17
According to most financial institutions, SCF is achieved by the avoidance of interest18

pp.4-5
Footnotes…

[13]In classical and traditional Islamic law, extant and in use to this day by the recognized Shari’ah
authorities, there are essentially five categories of normative assessments: obligatory,
recommended, permitted, discouraged, and forbidden. ENCYCLOPEDIA OF ISLAMIC LAW: A
COMPENDIUM OF THE MAJOR SCHOOLS xxxvii-xxxviii (Laleh Bakhtar ed., 1996).

[15]An examination of these issues can be found in Wafik Grais & Matteo Pelligrini, Corporate Governance and Shariah Compliance in Institutions Offering Islamic Financial Services (World Bank Policy Research Working Paper No. 4054, 2006), available at
http://wwwwds.worldbank.org/servlet/WDSContentServer/WDSP/IB/2006/11/08/000016406_20061108095535/Rendered/PDF/wps4054.pdf (last visited Jan. 24, 2008).

[17]The number of Shari’ah scholars sufficiently versed in the disciplines necessary to be gainfully employed by a “blue chip” financial institution engaged in SCF is quite limited. It is generally represented that there are only about 20-25 competent Shari’ah scholars who have mastered
Shari’ah, finance, and English well enough to be considered both an SCF scholar and
employable. Richard C. Morais, Don’t Call It Interest, Forbes.com,
http://www.forbes.com/business/global/2007/0723/104.html (last visited Jan. 24, 2008). For the
general problem of the dearth of qualified Shari’ah scholars, see Grais & Pellgrini, supra note 15,
at [page number here] & n.18

[18]In Arabic, the term used is riba, which literally means “increase.” In the past, there has been
debate among Shari’ah authorities and Islamic academic scholars over the prohibition against
riba in financial and commercial transactions. Some scholars point to the fact that the prohibition
against interest in the Qur’an is not simple interest but usurious interest and specifically a default
interest prevalent in pagan pre-Islamic Arabia. Today, the debate is academic because there is
broad consensus that interest of all kinds is forbidden by Shari’ah. For the consensus view of the
prohibition against interest, see FRANK E. VOGEL & SAMUEL L. HAYES, III, ISLAMIC LAW AND
FINANCE: RELIGION, RISK, AND RETURN 71-87 (1998). For a contrarian position, see TIMUR
KURAN, ISLAM & MAMMON: THE ECONOMIC PREDICAMENTS OF ISLAMISM 14 (2004); see also
Alex Alexiev, Islamic Finance or Financing Islamism? 6-7 (The Center for Security Policy,
Occasional Papers Series No. 29, 2007). For a general discussion of how contemporary SCF has
perverted the “intent” of an “authentic” Islamic political economy, see Mahmoud Amin El-
Gamal, “Interest” and the Paradox of the Contemporary Islamic Law and Finance, 27 FORDHAM
INT’L L.J. 108 (2003); Chibli Mallat, The Debate on Riba and Interest in Twentieth Century
Jurisprudence, in ISLAMIC LAW AND FINANCE (Chibli Mallat ed., 1988).

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SCF also includes a focus on “purification”, which has two separate elements.
One is a form of obligatory charitable contribution called zakat, where the act of
supporting the less fortunate is considered a spiritual purification21; the other is the
purification of a Shari’ah-compliant investment or financial transaction that has been
tainted with forbidden revenue, whether from interest, illicit speculation, or a forbidden
commercial enterprise such as the pork industry.22

A rudimentary understanding of Shari’ah is required to grasp the implications of SCF
relative to U.S. law. To begin, Shari’ah, or the ‘proper way’, is considered the divine will
of Allah as articulated in two canonical sources. The first is the Qur’an, which is
considered the perfect expression of Allah’s will for man. Every word is perfect and
unalterable except and unless altered by some subsequent word of Allah.24

p.6
Footnotes…

[21]Zakah (sometimes referred to as zakat), which literally means purification, is a form of
religious tax for assisting the less fortunate and those that “struggle for Allah.” The amount is
between 2.5% and 20%, depending upon the source of the wealth, but it is typically on the lower
end (2.5%) of the scale. The amounts also vary based upon which of the four Sunni schools of
jurisprudence one follows. Shi’a Muslims also follow their own jurisprudence which also
accounts for some of the variation. For a fuller discussion of this religious tax and its use to
support those who “struggle for Allah” or fight against non-Muslims in holy war (i.e., Jihad), see
John D.G. Waszak, The Obstacles to Suppressing Radical Islamic Terrorist Financing, 37 CASE
W. RES. J. INT’L L. 673 (2005).

[22]See the extended discussion on purification by a well-known American Shari’ah authority, in
Yusuf Talal DeLorenzo, Shari’ah Supervision of Islamic Mutual Funds, available at
http://www.djindexes.com/mdsidx/downloads/delorenzo.pdf (last visited Jan. 24, 2008).

[24]For a thorough discussion from a “moderate” Shari’ah authority on the full theological and
jurisprudential analysis of Shari’ah, see MOHAMMAD HASHIM KAMALI, PRINCIPLES OF ISLAMIC
JURISPRUDENCE (2003). For the specific discussion of “abrogration”, which is the juridical view
of latter Qur’anic verses which contradict earlier ones, see id. at 202-227. For an analytical and
objective analysis of Islamic jurisprudence and its implications for Muslim-non-Muslim relations,
see Stephen Collins Coughlin, “To Our Great Detriment”: Ignoring What Extremists Say About
Jihad (with appendices) 83-133 (July 2007) (unpublished thesis, National Defense Intelligence
College).
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pp.7-8 Plugging in the Footnote Research line of Yerushalmi

[29]The debate over the role the Hadith should play as the secondary basis for Shari’ah is in fact
the debate between the traditionalists who follow the millennium-old doctrine of the Islamic legal
schools versus the progressives, typically in academia. The former account for the “Shari’ah
authorities” and the latter for university professors who wish to distance themselves and Islam
from the quite bellicose legal-military doctrines derived from the Hadith. The subject is
fascinating and rich with drama but not one this memorandum can take up. The interested reader
should begin with Coughlin, supra note 24{Stephen Collins Coughlin, “To Our Great Detriment”: Ignoring What Extremists Say About Jihad (with appendices) 83-133 (July 2007) (unpublished thesis, National Defense Intelligence College).}, at 83 et seq., and then turn to one of the founders of
the academic study of Shari’ah and Islamic jurisprudence, Joseph Schacht. Must reading would
be JOSEPH SCHACHT, AN INTRODUCTION TO ISLAMIC LAW (1982), and JOSEPH SCHACHT,
MUHAMMADAN JURISPRUDENCE (1950). Revisionists abound and two interesting versions are
WAEL B. HALLAQ, A HISTORY OF ISLAMIC LEGAL THEORIES (1997) and WAEL B. HALLAQ, THE
ORIGINS AND EVOLUTION OF ISLAMIC LAW (2005) on the one hand; and M. MUSTAFA ALAZAMI,
ON SCHACHT’S ORIGINS OF MUHAMMADAN JURISPRUDENCE (1996) on the other hand.
Useful also would be KAMALI, supra note 24{For a thorough discussion from a “moderate” Shari’ah authority on the full theological and jurisprudential analysis of Shari’ah, see MOHAMMAD HASHIM KAMALI, PRINCIPLES OF ISLAMIC JURISPRUDENCE (2003). For the specific discussion of “abrogration”, which is the juridical view of latter Qur’anic verses which contradict earlier ones, see id. at 202-227.}

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The rules of interpretation and their application to finite factual settings in the
form of legal rulings are collectively termed al fiqh (literally “understanding”). Usul al
fiqh, or the “sources of the law”, is what is normally referred to as jurisprudence.
Technically, Shari’ah is the overarching divine law and fiqh is the way Shari’ah
authorities have interpreted that divine law in finite ways.32

p.8
Footnotes…

[32]Furu’ is the Arabic word most often associated with positive law or the particular rulings in any
given case. See VOGEL & HAYES, supra note 18, at 23-24; see also M. Cherif Bassiouni & Gamal
M. Badr, The Shari’ah: Sources, Interpretation, and Rule-Making, 1 UCLA J. ISLAMIC & NEAR
E.L. 135 (2002). For a discussion of furu’ and usul al-fiqh, see Wael B. Hallaq, Usul Al-Fiqh:
Beyond Tradition, 3:2 J. ISLAMIC STUD. 172-202 (1992), reprinted in Law and Legal Theory.

*******
Prior to the twentieth century, there was no discipline termed Shari’ah-compliant
financing or even a Shari’ah sub-code regarding commercial transactions.34 There are
rulings by Shari’ah authorities authorizing certain contract forms dating back hundreds of
years, but as late as the 1900s there was still some debate among Shari’ah authorities
whether the prohibition against interest was absolute or just against usurious interest.
When contemporary Islamic political thinkers began to confront the collapse of the
Ottoman Empire after the First World War and the intrusion of Western modes of social,
political, and commercial life into the heart of the Muslim world, Shari’ah authorities
followed their lead and began to issue legal rulings to confront this new reality.35

When contemporary Islamic political thinkers began to confront the collapse of the
Ottoman Empire after the First World War and the intrusion of Western modes of social,
political, and commercial life into the heart of the Muslim world, Shari’ah authorities
followed their lead and began to issue legal rulings to confront this new reality.35
Beginning with the early political-theological writings of men such as Maulana Abul Ala
Mawdudi—who argued for an Islamic political resurgence and a unique Islamic political
economy—Shari’ah authorities followed suit by issuing authoritative legal rulings
forbidding interest on deposits and calling for the establishment of “Islamic banks”. Over
time, these rulings have incorporated prohibitions against transactions considered too
uncertain or speculative and also rulings to prevent Muslims from investing in businesses
engaged in un-Islamic behavior.36

p.9
Footnote…

[34]The legal verses of the Qur’an are typically broken down into those verses dealing with
religious rites and worship (ibadat) and those dealing with civil relations including commerce,
political life, and the Law of Jihad (mu’amalat). KAMALI, supra note 24, at 26. What is confusing
to many is that most academics writing on the subject of SCF define mu’amalat as civil or
commercial relations giving the impression that there is in fact some sub-code of strictly
commercial matters devoid of broader implications. See, e.g., Yusuf Talal DeLorenzo & Michael
J.T. McMillen, Law and Islamic Finance: An Interactive Analysis, in ISLAMIC FINANCE, supra
note 7, at 142. But cf. VOGEL & HAYES, supra note 18, at 301
*******

Effectively, SCF is an attempt to embrace modern interest-based commerce and finance,
but to do so within a framework of Shari’ah-approved structures. For example, while
almost all Shari’ah authorities forbid any transaction or investment which provides for
interest income, SCF rules allow for interest in two ways. One way is to rule that a
Muslim can invest in a permitted business that earns or pays interest but only if the
amount is below a maximum level.39 Any profit earned by the Muslim from that interest
component, however, must be purified by contributing that portion to a Shari’ah approved charity.40

p.10
Footnotes…

[37]http://muslim-investor.com/mi/education.phtml

[38]http://www.iht.com/articles/2007/11/22/business/islamic.php

[39]The first order of business for determining whether a business is Shari’ah compliant is to make
certain that it is not involved in a “vice” industry such as interest-based financing, the pork
industry, various forms of the entertainment industry, and gambling. The question for Shari’ah
authorities is how much “involvement” in a prohibited business amounts to a violation of
Shari’ah such that an investor must not invest in that company. The same question applies to a
permitted business that might earn interest on deposits or accounts payable and pay interest on
debt: How much interest is too much interest? For a discussion of the Shari’ah authority opinions
on this matter by one of the leading Shari’ah authorities, see Nizam Yaquby, Participation and
Trading In Equities of Companies Which Main Business Is Primarily Lawful but Fraught with
Some Prohibited Transactions, Address at the Fourth Harvard Islamic Finance Forum, Harvard
University (Sept. 30-Oct 1, 2000), available at
http://www.djindexes.com/mdsidx/downloads/yaquby.pdf (last visited Jan. 25, 2008).

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Why is SCF important?
As a burgeoning industry, SCF is touted as one of the fastest growing sectors in the
global financial markets.42 Total funds committed to SCF investments is estimated to be
$800 billion worldwide43, with $200 billion of assets under management in Shari’ahcompliant
banks.44

p.11
Footnotes…
[42]Drake Bennett, The Zero Percent Solution, BOSTON GLOBE, Nov. 4, 2007, available at
http://www.boston.com/news/education/higher/articles/2007/11/04/the_zero_percent_solution/
(last visited Jan. 25, 2008).

[44]Islamic Banking—Status of Islamic Banking, Institute of Islamic Banking and Insurance,
available at http://www.islamic-banking.com/ibanking/statusib.php (last visited Jan. 25, 2008).

[45]http://www.imf.org/external/pubs/ft/fandd/2005/12/qorchi.htm
http://www.iht.com/articles/2007/11/05/business/bankcol06.php

[46]http://www.cnn.com/WORLD/9704/14/egypt.islam/
http://www.newyorkfed.org/newsevents/speeches/2005/bax050301.html

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All of this growth, underwritten mostly by the mobile, highly liquid capital flowing out of
the GCC states49, has generated an industry of financial institutions, law firms,
accounting firms, financial advisors, and money managers establishing domestic and
international links with the key investment figures in the GCC states in an effort to
exploit the opportunity for substantial profits.50 This enthusiasm has been translated to
domestic U.S. financial industries in many ways.51

p.12
Footnotes…

[49]The principal oil-producing Muslim states are located in and around the Persian Gulf: Bahrain,
Kuwait, Quatar, Oman, Saudi Arabia, the United Arab Emirates, Iraq, and Iran. These countries,
sans Iraq and Iran, formed the Gulf Cooperation Council in February 1981. See Council Charter
of the Secretariat General of the Cooperation Council for the Arab States of the Gulf, available at
http://www.gcc-sg.org/eng/index.php?action=Sec-Show&ID=1 (last visited Jan. 25, 2007).

[50]For some of the promotional literature naming several of the “facilitators,” see, e.g., John
Butcher, Shariah Funds Inc Introduces the First Islamic Hedge Fund Aided by Scholars, HEDGE
FUNDS REV., available at http://www.shariahfunds.com/news/images/Hedge_Funds-Rev.pdf.
For specifically offices of such international law firms as Patton Boggs in Qatar, see the firm’s
Internet site, http://www.pattonboggs.com/Locations/Office.aspx?office=4 (last visited Feb. 28,
2008). For Patton Boggs promotional material indicating the law firm is also a registered agent
for lobbying on behalf of the Saudi Arabian government, see Patton Boggs LLP, Attorneys at
Law, http://www.pattonboggs.com/middleeast/ (last visited Feb. 28, 2008). The law firm of King
and Spaulding also highlights its activities in the area on its Internet site. See King & Spaulding,
http://www.kslaw.com/portal/server.pt?space=KSPublicRedirect&control=KSPublicRedirect&Pr
acticeAreaId=141&us_more=0 (last visited [date]); see also Brian O’Connell, Wealth
Management: Gulf’s Super Rich Return Home, Meed, Dec. 21, 2007 (updated Jan. 9, 2008),
available at
http://www.meed.com/bankingandfinance/specialreport/2007/12/gulfs_superrich_return_home.ht
ml.

[51]GCC sovereign wealth funds purchasing U.S. assets,Oct. 22, 2007, available at http://www.zawya.com/story.cfm/sidDN20070920015851
Nov. 22, 2007, available at
http://www.nytimes.com/2007/11/22/business/worldbusiness/22islamic.html?ei=5087&em=&en=
d6f0821c05a1d02f&ex=1195880400&pagewanted=all

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U.S. financial institutions seek to underwrite Shari’ah-compliant bond issuances domestically and globally;52 Dow Jones and Company53 and Standard & Poor’s54 have both established Shari’ah-compliant indexes that screen equities based upon software filters meant to eliminate Shari’ah-noncompliant businesses; Shari’ah-compliant U.S.-based managed equity funds55 and offshore hedge funds56 managed or advised by entities related to U.S. financial institutions have been established and can now peg their performances against these indexes; and U.S. banks have begun to offer Shari’ah-compliant home loans and other credit
facilities57 with federal banking authorities opining about their legality and at least one
state tax authority issuing a ruling on the tax implications of a Shari’ah-compliant
transaction58.

C. The Need for Heightened Scrutiny

When investing or entering into financial transactions, why should adherence to the
normative principles of Shari’ah require any special or heightened scrutiny in relation to
civil liability or criminal exposure? The most immediate answer is that, according to the
proponents and practitioners of SCF, Shari’ah is not simply an approach to interest-free,
ethical investing. Instead, SCF is invariably described by SCF proponents, practitioners,

p.13
Footnotes…

[52]Karen Lane, WSJ, Nov. 16, 2006 http://online.wsj.com/article/SB116361223362324035.html
Dow Jones Indexes and Citigroup To Launch First Islamic Bond Index (Mar. 6, 2006), available at
http://www.dj.com/Pressroom/PressReleases/Other/US/2006/0306_US_DowJonesIndexes_1095.
htm

[54]STANDARD & POOR’S, S & P SHARIAH INDICES, available at
http://www2.standardandpoors.com/spf/pdf/index/SP_Shariah_Indices_Methodology_Web.pdf

[55]Index Comparisons, Dow Jones Islamic Fund, http://www.investaaa.com/cgibin/
client_product.cgi?member=55&product_id=527

[57]Islamic Finance, Devon Bank, http://www.devonbank.com/Islamic/ (last visited Jan.
25, 2008) (Chicago-based Devon Bank internet site promoting its Islamic finance products).

[58]See, e.g., Shirley Chieu, Islamic Finance in the United States: A Small But Growing Industry,
Chicago Fed Letter No. 214, May 2005, available at
http://www.chicagofed.org/publications/fedletter/cflmay2005_214.pdf (last visited Jan. 25, 2008);
Office of the Comptroller of the Currency, Interpretive Letter No. 806, Oct. 17, 1997, available at
http://www.occ.treas.gov/interp/dec97/int806.pdf; Office of the Comptroller of the Currency,
Interpretive Letter No.867, June 1, 1999, available at
http://www.occ.treas.gov/interp/nov99/int867.pdf; see also State of New York Commissioner of
Taxation and Finance Advisory Opinion Petition No. M010821A, Jul. 26, 2002, available at
http://www.tax.state.ny.us/pdf/advisory_opinions/real_estate/a02_4r.pdf

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and scholars as the contemporary Islamic legal, normative, and communal response to the demands of modern finance and commerce.59

Shari’ah is not predicated upon a personal or subjective understanding of what it means to be a Muslim. Neither is it simply an objective formal law or behavioral code regulating
finance and commercial transactions. Shari’ah has been described as “holistic”60, as
“designating good order, much like nomos”61, and definitively by Joseph Schacht, the
founding father of modern scholarship regarding Islamic jurisprudence, as “[t]he sacred
law of Islam [which] is an all-embracing body of religious duties rather than a legal
system proper…

In one of the first academic presentations of this new industry, Professors Frank Vogel
and Samuel Hayes explain that Shari’ah is not a personalized, subjective, pietistic
approach to Islam, but an institutionalized legal-political-normative doctrine and
system.63 This classical understanding of Shari’ah has been echoed by a leading
professor of finance in Australia and a senior official in the Bahrain Ministry of Finance
and National Economy.64
p.14
Footnotes…
[59]See generally VOGEL & HAYES, supra note 18. SCF is “legal” in the sense it includes aspects
of binding law, especially in Muslim countries where Shari’ah is considered both constitutional
and statutory, such as Saudi Arabia, Iran, and Sudan; “normative” in the sense that Shari’ah is
considered an all-encompassing way of life; and “communal” in the sense that communities of
Muslims have in fact embraced Shari’ah as authoritative at some level.

[64]MERVYN K. LEWIS & LATIFA M. ALGAOUD, ISLAMIC BANKING 24 (Edward Elgar ed., 2001).
While the authors attempt to “tone down” this absolute statement of Shari’ah by suggesting that
as a practical matter Shari’ah has in fact lived side-by-side with secular law and in some cases
even incorporated it into Shari’ah, they honestly but almost unnoticeably add the following to
their effort to soften Shari’ah: “The continuation of a custom of a particular place or community
is allowable under Islamic law, and may in fact be assimilated into the law, as were many of the
customs of the Arabs. To be permissible a custom must not be contrary to revealed
injunctions, and this point remains highly controversial in some areas, for example the treatment
of women.” Id. at 25. What the authors mean by “revealed injunctions” means any legal ruling of
Shari’ah authorities where there is consensus among the authorities that the ruling is based on an explicit verse in the Qur’an or Sunna.

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Understood in its proper context, anything deemed Shari’ah-compliant by Islamic legal
authorities must first and foremost be within the gestalt of Shari’ah. It is not enough,
according to Shari’ah, that a Muslim conducts his own affairs and business according to
some narrow definition of “Islamic ethical business practices.” For a Shari’ah-adherent
Muslim to conduct his business and financial affairs properly, he must not knowingly
promote through his business dealings any forbidden action or violation of a fundamental
precept of Shari’ah or the legal rulings promulgated thereunder. This is what the scholars
mean when they describe Shari’ah as “holistic” or a fully integrated religious, moral, and
legal code.69

p.15
Footnotes…

[69]See generally DeLorenzo, supra note 22.

[70]There is no shortage of academic literature on the political and religious turmoil that existed in
the Muslim empires from soon after the death of Mohammed and the battles between the
“traditionalists” who sought a Shari’ah-centered political world and those who opposed it for one
reason or another. A good, deep history of Islam may be found in MARSHALL G. S. HODGSON,
THE VENTURE OF ISLAM: CONSCIENCE AND HISTORY IN A WORLD CIVILIZATION, 3 vols. (1974).
And, of course, the required reference to BERNARD LEWIS, THE MIDDLE EAST: A BRIEF HISTORY
OF THE LAST 2,000 YEARS (1995). For the narrative of the failures in Islamic history for the
political leaders to abide by Shari’ah from the “traditionalist” vantage, see SAYYID QUTB,
SOCIAL JUSTICE IN ISLAM (2000). For the classic statement on this “theory” versus “practice” and
the dominant role of Shari’ah authorities to determine the theory and even the practice when
Shari’ah is put into practice, see Joseph Schacht, supra note 62.

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The implication of this fuller understanding of Shari’ah is that one cannot speak of
Shari’ah-compliant finance, business, or economics in the U.S. without understanding
Shari’ah as articulated by the Shari’ah authorities and its ramifications for the U.S.
investor. This is especially true given the legal implications surrounding the duty to
disclose for financial institutions contemplating an SCF transaction. Consider, for
example, a mutual fund that promotes itself as Shari’ah-compliant. Having licensed the
use of the Dow Jones Islamic Index (“DJII”), which utilizes a software filtering protocol
determined to be Shari’ah-compliant by the Shari’ah advisory board retained by Dow
Jones & Company, the mutual fund selects a subset of the indexed listed equities for its
portfolio. A careful reading of the DJII’s marketing material, and of the registration
statements filed by DJII-utilizing funds, indicates that disclosure issues abound.72

Specifically, in the registration statement filed with the Securities and Exchange
Commission for one of the first such funds, the Dow Jones Islamic Market Index
Portfolio73 (“Dow Jones Islamic Portfolio Fund”), other than a reference to certain
“Shari’ah screens” or “filters” limiting the universe of acceptable investments, nothing is
said of Shari’ah.For the investing public, all it learns about Shari’ah in the context of
this Shari’ah-compliant mutual fund is that equities of companies involved in interestdriven
profits, companies dealing with commodities such as alcohol or pork, or
companies engaged in the “vice” industries such as entertainment and gambling, are
prohibited. In addition, the standard disclosures include references to various financial
ratios that work to eliminate companies that might generate too much interest income on
its cash reserves or pay too much interest on its debt. In other words, the DJII and the
mutual funds utilizing such an index appear in many ways like other “socially responsible
investing” or customized “values-based” and “faith-based” indexes.
p.16
Footnotes

[71]Whatever criticism some critics might have of the “Islamist” bent of SCF, there is no serious
challenge to the absolute authority of the traditionalists in this discipline. See, e.g., VOGEL &
HAYES, supra note 18, at 9-10, 23.

[73]This fund was begun in 1999 and liquidated in 2002. For access to its SEC filings, see
http://www.sec.gov/cgi-bin/browseedgar?
action=getcompany&CIK=0001088654&owner=include&count=40 (last visited Feb. 4,
2008).

******
A cursory reading of the registration statement filed pursuant to the
Investment Act of 194075

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’ Shari’ah Supervisory Board to be in compliance with Shari’ah
principles. (Emphasis added.)77

p.17
Footnotes

[75]Investment Company Act of 1940, Pub. L. No. 76-768, 54 Stat. 789.

[77]For the Dow Jones Islamic Market Index Portfolio’s Registration Statement filed pursuant to
the Investment Company Act of 1940, Part B, Item 12, see Dow Jones Islamic Market Index
Portfolio, Registration Statement (Form N-1A), available at
http://www.sec.gov/Archives/edgar/data/1088654/0000935489-99-000014.txt
Warranty Disclaimers For Dow Jones
Although Dow Jones uses reasonable efforts to comply with its guidelines regarding the
selection of components in the Dow Jones Islamic Market Index, Dow Jones disclaims
any warranty of compliance with Shariah law or other Islamic principles . . . .
While this might insulate Dow Jones from a claim of breach of warranty, it does not address the
failure to disclose material risks relative to the very real problem of competing Shari’ah
authorities.
******
Fundamental disclosure issues for a reasonable investor would
be: What is Shari’ah? Does applying Shari’ah “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 Shari’ah is hostile to Western political and
financial institutions, would that be important for a U.S. investor to know prior to
investing in a business which promotes Shari’ah-compliant investing?

According to the Shari’ah authorities themselves, Shari’ah — 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 more than a millennium of religious and political implications, all of which
have generated a body of literature on the import of Shari’ah 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 alluring new universe of investment
vehicles marketed to Shari’ah adherents. This minefield includes questions these
financial institutions and their professional facilitators have not even begun to ask, much
less answer.78 This Article begins the analysis and the necessary discussion of SCF’s
implications for the U.S. financial industry, the professionals advising their clients on
SCF, and the policy-makers in and out of government.

p.18
Footnotes

[78]Is a company that otherwise passes the publicly-disclosed filters remain Shari’ah compliant even if it is owned by or domiciled in the territory of the enemies of the Muslim nation (i.e., an Israeli-owned or domiciled company)? When the Dow Jones Islamic Index publicizes that weapons manufacturers are
forbidden, does Shari’ah in fact forbid weapons manufacturing by Muslims for Muslim nations?
Would it be material to a reasonable U.S. investor to know if the answers to any of these
questions is “no”? What would happen if the U.S. went to war against a major Shari’ahcompliant
Muslim nation and, as a result, the GCC states together with most of the authoritative
Shari’ah scholars in the world declare the war an act of war against the entire Muslim nation?
Will this declaration of war affect the Dow Jones’ Islamic Index filters? Would any company
owned by non-Muslim U.S. citizens be Shari’ah-compliant under those circumstances?
******
III. Toward an Analytical Taxonomy
A. The Lawyer’s Role in SCF
As indicated above, Shari’ah-compliant financing is nomenclature describing the
contemporary Islamic legal, normative, and communal response to the demands of
modern day finance and commerce.79 Shari’ah-adherent Muslims desire to maintain their
commitment to the normative demands of Shari’ah. At the same time, they wish to
participate in the benefits and opportunities afforded by investment in international and
Western financial structures that are neither Shari’ah-centric nor Shari’ah-compliant, at
least according to the overwhelming majority of Shari’ah authorities.80

Transactional lawyers are often required to opine on the transaction’s compliance with
existing law and the enforceability of the underlying agreements in a court of law or, in
some cases, before an arbitrator.81 These legal opinions assure the parties that there are no
hidden issues that might create obstacles to enforcement. In addition, lawyers are
required by professional ethics to investigate compliance, disclosure, and due diligence
issues in order to understand their clients’ legal exposure when an innovative approach to
existing financial or commercial transactions is contemplated.82 Lawyers and accountants
themselves have direct exposure for documents submitted by a client to the Securities and
Exchange Commission under several laws, including the Sarbanes-Oxley Act of 2002.

A fundamental predicate of a lawyer’s opinion is the knowledge that the basic
transactional building blocks of the deal are well-known, predictable, and do not pose any
significant risk that a court will refuse to enforce them as intended by the parties. In
simple terms, this means that the deal is structured in a way that has certainty,
consistency, predictability, and transparency.83

p.19
Footnotes

[80]VOGEL & HAYES, supra note 18, at 24-28. Vogel and Hayes note especially the minority
view that interest is not prohibited: “But such Muslims, though numerous, appear to be in the
minority. A much larger number, supported by a near-unanimity of traditional scholars, seem
certain that modern bank-interest falls within the revealed prohibitions and entails a major sin,
tolerable only in the throes of necessity.”

******
For the Shari’ah faithful, Shari’ah is first and foremost the divine and
perfect will of the ultimate lawgiver and there are strictures and obligations imposed on
its adherents which are not subject to reasoned critique or discourse. As to the part of
Shari’ah open to human analysis, it is reserved for Shari’ah authorities who cannot be
challenged except by other equally authoritative Shari’ah authorities.84

Shari’ah’s inability to provide transparency is systemic. Any legal or normative system
that is not articulated and enforced within a political structure of codified laws,
procedures, courts, binding legal opinions, and effective enforcement mechanisms will,
by definition, lack transparency. Shari’ah is at its core a divinely ordained law which can
never be subordinated to a secular political, legal, or regulatory system.85

p.20
Footnote

[86]According to Shari’ah doctrine rooted directly and firmly in the Qur’an, and agreed upon by all
legal schools, no secular law can take precedence over Allah’s divine law: “Whoever does not
follow the revealed law and does not judge according to it is counted an unbeliever.” See, e.g.,
AL-AZAMI, supra note 29, at 12; see also Coughlin, supra note 24, at 90
The blending of secular law and Shari’ah as it has unfolded in many Muslim countries would
appear to be ipso facto evidence of the failure to tame Shari’ah since there are no Muslim
dominated countries that one might call “mostly free” with real representative government except
possibly Turkey and Indonesia. Most observers recognize Turkey’s success has come at the
expense of “religious freedom” since the Kemalists and their use of the army to suppress the
public expression of Islam and Shari’ah is well documented. Indonesia is changing for the worse
due in large part to the growing violence against non-Muslims which in turn is due in large part to
the increasing influence of Shari’ah. See, e.g., Freedom House, Country Reports, available at
http://www.freedomhouse.org/template.cfm?page=21&year=2007
For a careful analysis of the extent to which Shari’ah is codified as the law of the land in Muslim countries, http://www.uscirf.gov/countries/global/comparative_constitutions/03082005/Study0305.pdf
For an examination of “religious freedom” in such Muslim countries as
Indonesia, Egypt, Iran, Saudi Arabia, see
http://www.uscirf.gov/countries/publications/currentreport/2005annualRpt.pdf#page=71

******
In order to render a legal opinion that will satisfy the parties and necessary third parties such
as a rating agency for a bond securitization, a number of issues arise that cannot be
rationally addressed for at least two reasons: Certain transaction restrictions applicable to
SCF are considered divine and unalterable; and those aspects of a transaction subject to
human reason are not subject to any human reason, but to the reason of a Shari’ah
authority.

p.21

******
The debate within Shari’ah, however, is effectively closed. Its principles remain divine
and unalterable90 and the application of these principles to changing circumstances are
subject only to what the Shari’ah authorities acting independently of a secular legal and
political system determine to be permitted and forbidden. Thus, Shari’ah informs the
Shari’ah-adherent participants in a finance transaction that interest is divinely forbidden.
The participants are also told it is forbidden because it is evil and causes the destruction
of society.91 Somehow though, interest, wrapped up in a different form where all of the
elements of interest exist but the name, exits the black box of Shari’ah as permissible and
presumably good for society.92

p.22
Footnotes

[91]Text of the Historic Judgment on Interest Given by the Supreme Court of Pakistan,
ALBALAGH, http://www.albalagh.net/Islamic_economics/riba_judgement.shtml

[92]Islamic scholars in academia have given this issue much attention. See, e.g., Mahmoud A. El-
Gamal, An Economic Explication of the Prohibitions of Riba in Classical Islamic Jurisprudence,
in THE PROCEEDINGS OF THE THIRD HARVARD UNIVERSITY FORUM ON ISLAMIC FINANCE:
LOCAL CHALLENGES, GLOBAL OPPORTUNITIES 29-40 available at
http://www.ruf.rice.edu/~elgamal/files/riba.pdf (last visited Jan. 28, 2008); see also KURAN,
Timur Kuran, The Genesis Of Islamic Economics; A Chapter In The Politics Of Muslim Identity,(Summer 1997), available at http://findarticles.com/p/articles/mi_m2267/is_n2_v64/ai_19652892/pg_1
******

At each stage, the lawyer is in effect wrapping the Shari’ah component of SCF in what
appears to be a secular black box. By doing so, the lawyer exposes herself and her client
to substantial civil and criminal liability. Part III.B below discusses various areas of legal
risk, and Part III.C suggests an analytical taxonomy for evaluating these risks in the SCF
context.
B. The legal landscape
1. Common law tort action for deceit or fraud

In most states, the common law incorporated the tort action of deceit, commonly referred to as fraud, to allow private rights of action for misrepresentation in the context of what is now referred to as commercial speech.93 The essential elements of a common law fraud action are: (1) a false representation (2) of a material fact (3) which the defendant knew to be false and (4)with the intent to induce the plaintiff to rely upon it and (5) the plaintiff in fact justifiably
relied upon the representation (6) thereby suffering damages as a result.94

[94]While it is not the purpose of this memorandum to detail the legal risks for the professional
facilitators, there is substantial legal exposure for the legal, accounting, and financial
professionals who provide the knowledge and expertise to develop the financial and legal
instrumentalities of SCF. While “scheme liability” under a Rule 10b-5 private right of action has
been put to rest by Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761
(2008), to the extent that the lawyers get involved in drafting the “representations”, liability will
still apply. See LOUIS LOSS & JOEL SELIGMAN, FUNDAMENTALS OF SECURITIES REGULATION
1329-1332 (2004) (for a discussion on “primary liability” for lawyers under Rule 10b-5); id. at
1465-1469 (for a discussion of the “duty to report evidence of a material violation” under Part
205 to Title 17 of the Code of Federal Regulations promulgated by the SEC pursuant to Section
307 of the Sarbanes-Oxley Act of 2002).

{original article notation of Seligman – After examining the multitude of liability issues surrounding Shari’ah-compliant financing, this Article concludes that SCF exposes the financial institutions and other businesses which attempt to exploit this new industry to a host of disclosure, due diligence, and compliance issues, all of which elevate the civil liability and criminal exposure such companies otherwise factor into their business risk profiles.}
******
In the main, the securities laws relating to fraud and misrepresentation were modeled
after common law fraud. But it is equally true that Congress intended the securities fraud
statutes to have a broader reach than the common law. As a result, securities law sought
to include within its enforcement orbit misrepresentations, omissions, schemes, and
artifices that would not otherwise be captured by traditional common law fraud.

There are principally seven federal statutes that govern securities transactions: the
Securities Act of 1933; the Securities Act of 1934; the Trust Indenture Act of 1939; the
Investment Company Act of 1940; the Investment Advisors Act of 1940; the Securities
Investor Protection Act of 1970; and the Sarbanes-Oxley Act of 2002.97Civil and
criminal liability under the federal securities statutes for failure to disclose is regulated by
the SEC and its principal weapons are the Securities Act of 1933 (“1933 Act”) and the
Securities Exchange Act of 1934 (“1934 Act”).98 The 1933 and 1934 Acts target different
markets. The 1933 Act regulates initial offerings and the 1934 Act regulates all
subsequent trading
p.24
Footnotes

[97]Securities Act of 1933 (Truth in Securities Act), 15 U.S.C. §§ 77a to 77aa (2006) (focuses on
initial distribution of securities); Securities Exchange Act of 1934, 15 U.S.C. §§ 78a to 78mm
(focuses on ongoing post-distribution trading of trading); Trust Indenture Act of 1939, 15 U.S.C.
§§ 77aaa to 77bbbb (supplements the 1933 Act and focuses on distribution of debt securities);
Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to 80a-64 (governs activity of publicly
owned companies that invest in and trade securities); Investment Advisers Act of 1940, 15 U.S.C.
§§ 80b-1 to 80b-21 (requires regulation and registration of those in business of advising others on
securities investments); Securities Investor Protection Act of 1970, 15 U.S.C. §§ 78aaa to 78111
(creates nonprofit membership corporation designed to cover customer losses when broker-dealer
firms cannot cover their customer accounts); Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204,
116 Stat. 745 (codified as amended in scattered sections of 11, 15, 18, 28, and 29 U.S.C.) (adds
several additional lawyers of corporate reporting and ethics oversight). The Public Utility
Holding Company Act of 1935, 15 U.S.C. §§ 79 to 79z-6, which governed public utilities, was
repealed by the Energy Policy Act of 2005, Pub. L. No. 109-58, 119 Stat. 594.

[98]No analysis of the current SCF industry in the U.S. would be complete without an examination
of the Investment Company Act of 1940 and the Investment Advisors Act of 1940. This is
because much of the SCF investments are being propelled by mutual funds tracking the DJII and
the S&P’s version of the same thing. In addition, with the huge sovereign wealth in the GCC
looking for sophisticated investment strategies, Shari’ah compliant hedge funds are right around
the corner. The analysis which follows will examine these two acts to the extent they implicate
these types of SCF investments and require a different analysis of the liability exposure for
securities fraud.

******
Although both the 1933 and the 1934 Acts proscribe various types of conduct, including
incomplete or inaccurate disclosure of material information, as an administrative matter
the SEC dictates the specific kinds of minimal (and in some cases maximal) disclosure
required by the specific provisions. Beyond the routine administrative functions granted
the SEC, the main weapons against securities fraud are the civil and criminal remedies.
Thus, the SEC has access to civil courts to seek injunctive relief, disgorgement, and even
civil fines, in addition to ancillary equity-like relief. In addition, the Department of
Justice, often as a result of an SEC administrative investigation and criminal referral, is
authorized to file criminal charges for violations of the federal securities laws when it
appears the offending party had the requisite intent.100

The most used and abused of all such provisions is Rule 10b-5101, promulgated under the 1934 Act102, which provides for civil litigation103 and criminal prosecutions.104 Considering that the class action mechanism, although limited by recent legislation105, is available to Rule 10b-5 claimants, the weapons available to prosecute claims for misstatements and omissions of material fact in SEC filings and elsewhere in the public domain are considerable.
3. State securities laws
State securities laws, usually referred to as blue sky laws, essentially track the
development of securities disclosure law and securities fraud liability in federal securities
law. As noted above, as a result of Congress’ efforts to curb private securities fraud
litigation and recent Supreme Court rulings regarding the new pleadings requirements,
the state securities laws will take on ever greater importance in the securities plaintiff’s
arsenal of litigation weapons.106

p.25
Footnotes

[101-106] Loss & Seligman, various case readings.

******

4. Federal and State consumer protection and anti-fraud laws
Consumer protection statutes, which exist in most states, provide additional weapons to
combat fraud. While the Federal Trade Commission Act (“FTC Act”)107 does not apply to
securities, it might be implicated where businesses market consumer products and
represent that their businesses are run according to Shari’ah.
Further, modeled in part after the FTC Act, the “little FTC Acts” enacted by most states are often more broadly interpreted than the FTC Act and many have an express or implied private right of action allowing the consumers themselves to battle fraud in the marketplace.108

Also, at least three states allow their respective consumer protection statutes to be used for securities fraud, which would bring the entire SCF industry under consumer fraud scrutiny.112

Additional statutes implicated are the federal Lanham Act, which regulates inter alia
fraud in the description of goods, services, or commercial activities,113 and laws
governing consumer finance. Consumer finance in the U.S. falls within the ambit of the
federal Truth-in-Lending Act (“TILA”)114 and the myriad of regulations promulgated
thereunder referred to collectively as Regulation Z.115

p.26
Footnotes

[108]For a discussion of the broad sweep of state consumer fraud statutes, see Victor E. Schwartz &
Cary Silverman, Common-Sense Construction of Consumer Protection Acts, 54 KAN. L. REV. 1
(2005).

[112]For Pennsylvania, see Denison v. Kelly, 759 F. Supp. 199, 202 (D. Pa. 1991) (referencing 73
PA. CONS. STAT. §§ 201-1-202-9.3 (2007)). For Illinois, see Onesti v. Thomson McKinnon
Secur., Inc., 619 F. Supp. 1262, 1267 (D. Ill. 1985) (referencing ILL. REV. STAT. ch. 121 1/2, §
262, et seq. (1985), now 815 ILL. COMP. STAT. 505/2 (2007)). For Arizona, see State ex rel.
Corbin v. Pickrell, 136 Ariz. 589, 592 (Ariz. 1983) (referencing ARIZ. REV. STAT. ANN. §§ 44-
1522 – 1531 (2007)).
113 15 U.S.C § 1125 (2006

******
Banks and other lenders advertising “zero interest loans” or “riba free loans” might in fact run afoul of the TILA disclosure requirements and the restrictions on deceptive advertising. The Home Ownership and Equity Protection Act (“HOEPA”)116, which is part of TILA, or the state
versions of HOEPA might also apply to what amounts to predatory lending to Shari’ahadherent Muslims to the extent that the fees and costs are almost always higher than
conventional loans.

5. Due diligence and compliance statutes
The federal securities laws in several instances incorporate due diligence as defenses to
the anti-fraud provisions and as such are an integral part of any legal analysis for civil or
criminal exposure.117 In addition, due diligence is incorporated into several compliance
regimes such as the Bank Secrecy Act118 and the anti-money laundering statutes119, many
of which were modified by the Patriot Act. Insofar as SCF incorporates the Shari’ah
obligation to tithe and also requires the “purification” of profits earned in violation of
Shari’ah, the question for the legal practitioner is who decides what happens to the
monies gifted to charities and which charities are selected. Given the historical
connection between some of the largest and well-known Muslim charities and the
funding of terrorist groups120, these questions take on added focus in the context of
material support of terrorism. Finally, the structure of the Shari’ah authority boards and
their professional membership organizations raise antitrust issues.

C. A Suggested Analytical Taxonomy
The challenges described above for the SCF transactional lawyer and other professionals
advising clients on the intricacies of legal compliance are not inconsequential. In
agreements and in law, words are given context by the intent of the parties. The inherent
problem of SCF is that the intent of the parties is to comply with Shari’ah but the intent
of Shari’ah generally and in any particular transaction is typically lost on the secular SCF
advisors.121

p.27
Footnote

[121]It is not enough to refute this proposition by stating that the intent of Shari’ah is known: the
avoidance of interest, speculation, and vice. If the refutation were both true and meaningful, it
would suggest that the speaker knows what Shari’ah means by interest, speculation, and vice.
And, if that were true, the speaker could devise his own legal structures without reference to or
assistance from Shari’ah scholars and authorities. But this is not the case.

******

This Article seeks to facilitate academic and professional scrutiny of SCF by suggesting
an analytical taxonomy separating SCF-related legal exposure in to two elements: that
arising of out endogenous elements, and that arising out of exogenous elements.

1. Exposure arising out of endogenous elements
This inquiry can be termed an analysis of the endogenous
elements or aspects of Shari’ah123, and it will be relevant to many fundamental issues of
SCF. Moreover, to the extent that Shari’ah compliance is determined by Shari’ah
authorities, presumably there is something in the institution of Shari’ah itself that will
inform a lawyer who qualifies for such a role and how.

p.28
Footnote

[123]Borrowed term from ENCYCLOPEDIA OF SOCIAL SCIENCE RESEARCH 308-309 (Michael
Lewis-Beck, Alan Bryman & Tim Futing Liao eds., 2003), available at http://wwwpersonal.
umd.umich.edu/~delittle/Encyclopedia%20entries/endogeneous%20variable.pdf (last
visited Jan. 28, 2008). The endogenous/exogenous taxonomy for analyzing disclosure has an
ancient pedigree. In standard common law fraud, commentators such as Judge Story distinguished
between the heightened duty to disclose for intrinsic elements of a deal versus the extrinsic:
Intrinsic circumstances are properly those which belong to the nature, character,
condition, title, safety, use, or enjoyment, &c., of the subject-matter of the contract, such
as natural or artificial defects in the subject-matter. Extrinsic circumstances are properly
those which are accidentally connected with it, or rather bear upon it at the time of the
contract, and may enhance or diminish its value or price, or operate as a motive to make
or decline the contract; such as facts respecting the occurrence of peace or war, the rise or
fall of markets, the character of the neighborhood, the increase or diminution of duties, or
the like circumstances.

******

Finally, to the extent that Shari’ah is in fact what its proponents say it is – a way of life combining authoritative Islamic legal, moral, theological, and normative social constructs – an attorney has a responsibility to ensure that her client has conducted the necessary due diligence to be certain that these structures do not violate U.S. law.

2. Exposure arising out of exogenous elements
As discussed above, SCF is a term of art used to describe the contemporary Islamic
response to the demands of modern finance and commerce. As such, the rules and norms
of Shari’ah are being forced to attend to the demands of a Muslim demographic which
desires to exploit the opportunities available in Western financial and legal structures yet
at the same time to remain faithful to a system which rejects as unlawful and evil much of
the Western financial premises about political economies and structures. To achieve this
seemingly impossible goal, Shari’ah authorities have developed a range of transactional
structures and legal-definitional parameters to guide them in their determination whether
a given transaction or investment is permitted or prohibited.

In this part of the analysis, a lawyer should address the features of SCF that might raise
liability exposure issues that are not inherent to Shari’ah principles but are adaptations of
Shari’ah principles to fit Western financial structures and institutions. An example of a
transactional structure to deal with this collision between a Shari’ah world and a Western
one built on the time-value of money is the sale-lease back agreement.124 While sale-lease
back agreements are not unique to SCF and in fact are a popular vehicle in contemporary
finance, in the two contexts they are not identical in structure and worlds apart in their
purposes.125 An example of the legal-definitional parameters set out by Shari’ah
authorities to deal with the doctrinal conflicts between the two systems would be the
ruling that, while interest income is absolutely forbidden in Shari’ah, it is not forbidden
to invest in a company that earns less than X%126
p.29 Footnotes

[124]One such Shari’ah-based nominate lease contract is called Ijara. VOGEL & HAYES, supra note
18, at 143-145.

[125]Typically, a sale-lease back financing transaction is a way for a company to gain liquidity and
to move a capital asset off the balance sheet to avoid the burdens to the company’s debt ratios if
standard capital asset financing is used. at http://www.nysscpa.org/cpajournal/old/10691657.htm
The motivation for a Shari’ah sale-lease back, however, is to avoid interest and to accommodate
Shari’ah fixed rules relative to the actual transfer of ownership of the property, who is
responsible for repairs (lessor), who can cancel the contract under changed circumstances
(lessee), and how the parties will treat future sale and option terms.

[126]INfo on Screening at DJII – Paper Presented at the Int’l Conference on Islamic Capital Markets (Aug. 27-29, 2007), available at
http://www.djindexes.com/mdsidx/downloads/Islamic/articles/DowJonesShariahScreeningNorms
.pdf

******
IV. The Endogenous Elements: Disclosure of Shari’ah in SCF
A. The preliminary analysis
The first order of business for an attorney providing advice in the context of disclosure
laws to a U.S. financial institution interested in SCF should be answering the following
question: How intimate is the connection between SCF and Shari’ah itself? (In legal
terms, how material is Shari’ah to SCF?) If Shari’ah is a material part of SCF, the
attorney must confront the likelihood that it is a material fact of SCF in the context of
disclosure laws. While the answer to the question might appear self evident – that is,
Shari’ah has everything to do with SCF – extant literature by legal scholars and
practitioners suggests that, even if Shari’ah is a material component of SCF, it is not
material to any of the disclosure laws because Shari’ah is treated as a black box that
merely turns out rules requiring specific kinds of contractual arrangements.

Those facts are the endogenous elements of Shari’ah
that result in the “rules and principles” of SCF.127 Indeed, according to the proponents
and practitioners of SCF, Shari’ah is not just an approach to interest-free, ethical Islamic
business practices or investing. Invariably, SCF is described by its proponents,
practitioners, and scholars as the contemporary Islamic legal, normative, and communal
response to the demands of modern day finance and commerce. What makes the response
“Islamic” or one pursued almost exclusively by Muslims128 is the fact that this legal,
normative, and communal response to modern finance is framed and regulated by
Shari’ah authorities ruling on what Shari’ah permits and prohibits.

p.30
Footnotes

[127]Various standards publications are available to the public through the Islamic Financial Services Board (“IFSB”), one of the premier standards institutes of SCF. See IFSB Published Standards, Islamic Financial Services Board,, http://www.ifsb.org/index.php?ch=4&pg=140

******

Further, the Shari’ah authorities are clear: SCF is not a discreet or segregable component
of Shari’ah. It is a fully integrated discipline within the corpus juris of Shari’ah which, in
turn, is a holistic, all-encompassing way of life. Shari’ah is not divisible, moreover, in the
sense that one might extract the SCF “commercial legal code” from Shari’ah and end up
with a body of laws articulating a secular code of business conduct. This is demonstrated
by the prohibitions against businesses that trade in pork products (seemingly a strictly
dietary code issue) or the leasing of a building to a church (quite obviously a theological
consideration informing a business law issue).130 Even in the legal rulings relating to
whether a Muslim bank or individual may receive interest from deposit accounts, the
decision turns in large part on whether the deposits reside in a jurisdiction called the
“abode of war”, where non-Muslims predominate, or the “abode of peace”, where
Muslims predominate.131

The inclusiveness, universality, and indivisibility of Shari’ah are not just evidenced by
the published work of Shari’ah authorities on the one hand and secular academic scholars
on the other. Especially important for a lawyer attempting to determine what the
“Shari’ah” of SCF is in the context of disclosure laws, and what if anything of this
“Shari’ah” is material and subject to the duty to disclose, is what Shari’ah actually is in
practice. An attorney in search of the actual presentation of Shari’ah as an extant and
authoritative basis for law in modern times has the opportunity to examine several
Muslim regimes which have implemented Shari’ah as the law of the land. The best
examples of such implementation are Iran, Saudi Arabia, and Sudan.132 The Taliban of
Afghanistan had also imposed a fully authoritative Shari’ah and many other Muslim
regimes have utilized aspects of Shari’ah to complement a non-Shari’ah secular code.
The more a country’s laws are based upon Shari’ah, the better the evidence of what
Shari’ah is in actual practice devoid of all the academic theorizing and parsing.133
p.31
Footnotes

[129]http://www.ifsb.org/view.php?ch=4&pg=257&ac=36&fname=file&dbIndex=0&ex=1201533270
&md=%C1h%D5%BB%AA%B9zc%C3%9E%7CV%29%0A%BA%3C

[132]See, e.g., STAHNKE & BLITT, RELIGIOUS FREEDOM SHARI’AH REPORT, supra note 86.
Recently, northern Nigeria has been added to this list. See Nigeria Turns From Harsher Side of
Islamic Law, N.Y. TIMES, Dec. 1, 2007, available at
http://www.nytimes.com/2007/12/01/world/africa/01shariah.html?_r=1&oref=login

******
It is beyond this Article’s scope to determine what Shari’ah is in fact or what it means to
the contemporary Shari’ah authorities sitting as the final arbiters of SCF.

B. The hypothetical: not so hypothetical

Therefore, by way of example and for purposes of the analysis, this Article assumes that, after a good faith investigation, a lawyer advising a financial institution desiring to enter the SCF industry will determine that there is a reasonable basis to conclude that a consensus exists among Shari’ah authorities on the fundamental purpose and methodologies of Shari’ah: submission. Shari’ah seeks to establish that Allah is the divine lawgiver and that no other law may properly exist but Allah’s law. Shari’ah seeks to achieve this goal through persuasion and other non-violent means. But when necessary and under certain prescribed circumstances the use of force and even full-scale war to achieve the dominance of Shari’ah worldwide is not only permissible, but obligatory.

p.32
Footnotes

[134]An integral part of this inquiry is a study of the extant rulings of the classical Shari’ah
authorities considered to be authoritative by contemporary Shari’ah authorities.

******
Coughlin’s study demonstrates that Shari’ah and the doctrines of war articulated as the
Law of Jihad are as valid today as they were one thousand years ago. Jihad should be
implemented as circumstances permit, and the contemporary authoritative Shari’ah
scholars continue to teach, preach, and issue legal rulings to this effect. Coughlin’s
investigation further explicates that, once the Shari’ah authorities reach a consensus on a
legal ruling based on the Qur’an and Hadith, that ruling is considered immutable and
irrevocable.137 This adds yet further concretization to the rulings on Jihad because the
purpose of Islam and the methodologies to achieve those ends per Shari’ah are
universally accepted by the Shari’ah authorities with but relatively minor exceptions as to
specifics.138

Based upon a consensus of legal authorities, this study places the Law of Jihad in a
milieu permeated by the consequences of the jurisprudential rule of consensus and
establishes three fundamental points:

[1] The goal of Jihad to convert or conquer the entire world and the
methodology to achieve this end by persuasion, by force and subjugation,
or by murder is extant doctrine and valid law by virtue of a universal
consensus among the authoritative Shari’ah scholars throughout Islamic
history.
[2] The doctrine of Jihad is foundational because it is based upon explicit
verses in the Qur’an and the most authentic of canonical Sunna, and it is
considered a cornerstone of justice: until the infidels and polytheists are
converted, subjugated, or murdered, their mischief and domination will
continue to harm the Muslim nation. And,
[3] Jihad is conducted primarily through kinetic warfare but it includes
other modalities such as propaganda and psychological warfare.

******
Coughlin’s thesis is supported by the rulings of at least one prominent contempory
Shari’ah authority. In a recent book, Mufti M. Taqi Usmani—a member of numerous
Shari’ah advisory boards and one of the most respected Shari’ah authorities in the world-
–advocates violent and aggressive Jihad even against peaceful non-Muslims if they don’t
heed the call to Islam.139 He bases his ruling explicitly on legal verses in the Qur’an, the
actions of Mohammed and the successor Caliphates, and a consensus among Shari’ah
authorities. If Coughlin is correct, then Usmani is but one example of a Shari’ah
authority who both embraces the Law of Jihad as an extant doctrine for action by
Shari’ah-adherent Muslims and bases his rulings on the classical Shari’ah authorities
who fully embraced the consensus on the Law of Jihad.

C. Applying the endogenous elements of Shari’ah to the specific duty to
disclose
As noted previously, the SCF industry in the U.S. includes a panoply of businesses
regulated by the securities laws.

Do the facts of Shari’ah – representing the overriding purposes of
Shari’ah and the methods authorized to achieve those purposes – require disclosure under
the securities laws?

Failure to disclose a material fact (or the material misrepresentation of an asserted fact) is
the basis for administrative, civil, and criminal actions under all of the securities laws
requiring disclosure. The breach of this duty might arise in a registration, prospectus or
other required filing with the SEC or “in connection with” a purchase or sale of
securities.

p.34
Footnote

[139]MUFTI M. TAQI USMANI, ISLAM AND MODERNISM 123-39 (2006).

******
The preeminent statutory authority regarding disclosure in securities transactions is
Section 10(b) of the 1934 Act and its regulatory offspring Rule 10b-5. It has been the
source for much litigation due to its breadth and the fact that it includes an implied
private right of action, thereby adding private plaintiff and class action claims to the
enforcement suits by the SEC and DOJ criminal prosecutions.145 The essential elements
of a Rule 10b-5 action are:

(1) a misstatement or omission; (2) of material fact; (3) with scienter; (4) in connection
with the purchase or the sale of a security; (5) upon which the plaintiff reasonably relied;
and (6) that the plaintiff’s reliance was the proximate cause of his or her injury. 146

Once these elements of the Rule 10b-5 cause of action are established, a criminal penalty
can be imposed under section 32(a) if the government satisfactorily proves a willful
violation of the 1934 Act.147

This Article examines two unique elements to most fraud claims based upon allegations
that the defendant omitted material information about Shari’ah in public filings and
representations: materiality and scienter.

These two elements of the fraud action are carved out for special attention because a failure to consider them properly will contribute to the conclusion that the Shari’ah black box poses no great risk to U.S. companies involved in SCF. This conclusion, if reached without due consideration of the matters raised herein,would be faulty and very costly.

1. Materiality
a. The Supreme Court’s standards

Materiality is a fundamental element for an action alleging a failure to disclose under the
securities laws. The essential elements of such a claim might be, in addition to those set
forth above in the hypothetical, as follows:

{Notes – Loss & Seligman}

******

(1) Plaintiff bought shares in a closed-end mutual fund which represented
itself to be Shari’ah-compliant.

(2) An important part of these representations was the high-repute of the
Shari’ah advisory board members who were to watch over the fund’s
Shari’ah compliance.

(3) Various representations by the defendant financial institution and its
agents and representatives spoke of the ethical and socially responsible
nature of Shari’ah.

(4) It was subsequently discovered and made public that the Shari’ah
advisory board members all treated the rulings and pronouncements of Ibn
Taymiyyah, a fourteenth-century Hanbali Shari’ah authority and scholar
“with strikingly modern-sounding views” on commerce and finance148, as
authoritative. It was also discovered and made public that Ibn Taymiyyah
was a key Shari’ah authority for most of the terrorists associated with al
Qaeda. Ibn Taymiyyah, it turns out, was a leading advocate of a Shari’ah
centered political organization for Muslims which would declare holy war
against infidels and Muslims who rejected Shari’ah.

(5) There is a consensus among Shari’ah authorities from all schools of
Shari’ah jurisprudence that forced subjugation or Jihad against non-
Muslims is obligatory when efforts to peacefully convert the non-Muslims
fail and war is a viable option.

In addition to these allegations, which would support an SEC enforcement action or a
private right of action for rescission, a plaintiff might opt to pursue damages. In such a
case, one might anticipate the following: When the information alleged above became
public knowledge, the fund suffered irreparable reputational damage and many of the
U.S. investors sold their shares in the mutual fund, causing the value of the traded shares
to plummet. The complaint would also allege that the plaintiff purchased shares in the
mutual fund without knowing anything about Shari’ah other than what the defendants
represented to the public. Since the defendants promoted their Shari’ah authority board
members as highly respected scholars and authorities in their field, and since these
authorities ruled that Shari’ah forbade interest and excessive speculation in investments,
and also prohibited investing in various “vice” industries, the plaintiff reasonably relied
on these representations in the belief that Shari’ah was a “socially responsible” business
practice and worth utilizing as an investment “screen”.

p.36
Footnote

[148]Vogel & Hayes…

******
An omitted fact is material if there is a substantial likelihood that a
reasonable shareholder would consider it important in deciding how to
vote. . . . Put another way, there must be a substantial likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the “total mix” of information
made available.153

Arguably, the question whether the Shari’ah in SCF is a material fact that ought to be
disclosed will rest on one of two analytical approaches, or possibly both. The first
approach seeks to determine the materiality of Shari’ah in principle. It asks: Would a
reasonable post-9/11 investor consider the connection between Shari’ah and SCF
important to his or her decision to invest? In other words, would a reasonable investor
looking to invest in something promoted as “Shari’ah-compliant” want to know what
Shari’ah and its “rules and principles” say about constitutional government, treatment of
infidels, the Law of Jihad, and the use of suicide-homicide bombers, and other acts of
terrorism? Would the reasonable investor want to know about the published statements
by international terrorist leaders citing Shari’ah authorities as justification for their holy
war against the U.S. and other Western nations? These and similarly phrased questions
all attempt to get at the associational link between Shari’ah in principle as an
authoritative set of rules and principles advocating violence and SCF. If in fact such an
association exists, would it be material information to a reasonable investor?154

p.37
Footnote

[154]A related question would be who decides and how does one decide what Shari’ah is? This is
not specific to the query of materiality. As noted supra, if a financial institution relies upon
specific Shari’ah authorities, the question might be as simple as determining what these specific
Shari’ah authorities consider to be authentic and authoritative Shari’ah rulings on Jihad,
terrorism, and violence against non-Muslims and non-Shari’ah-compliant Muslims. Aside from a
careful examination of the rulings on these subjects issued by the relevant Shari’ah authorities, a
problem in any event if they have not published rulings in these areas, one would be well-advised
to look to the classical Shari’ah authorities upon which these contemporary Shari’ah authorities
rely as authoritative in their SCF rulings. While such a reliance might not be dispositive (i.e., a
Shari’ah authority might rely on Ibn Taymiyyah for purposes of determining what kind of
nominate contract Shari’ah allows for any given transaction, but in fact reject Ibn Taymiyyah’s
rulings on Jihad and war against the infidels). But at the very least, it raises an important fact
question for the reasonable investor that might very well rise to the level of materiality: Do the
Shari’ah authorities of the particular financial institution consider Ibn Taymiyyah’s Shari’ahbased
rulings on war against non-Muslims and non-Shari’ah compliant Muslims authoritative? If
not Ibn Taymiyyah’s, whose?

******
The second analysis relevant to materiality goes beyond the association in principle of
SCF with Shari’ah and its call to violence and asks whether there is enough evidence of
association in fact. This analysis asks: Is the nexus between Shari’ah and violence so
contingent or speculative that it would render any theoretical association between
Shari’ah and violence immaterial?
In the context of Shari’ah, the argument is made that Shari’ah can be interpreted in peaceful ways or in violent ways, and that those Shari’ah authorities who interpret Shari’ah violently and in ways that would shock the conscience of a reasonable U.S. investor are the extremists and represent such a small percentage of the recognized Shari’ah authorities that it would render any theoretical link between Shari’ah and violence against non-Muslims and non-Shari’ah-compliant Muslims so tenuous as to be immaterial to a reasonable investor. In
short, this is an argument that accepts that violence is associated in principle with
Shari’ah,155 but argues that the association is less than material because it is not
representative of Shari’ah as espoused by the vast majority of contemporary Shari’ah
authorities.

As the Court opined in TSC Industries, “[t]he issue of materiality may be characterized as a mixed question of law and fact, involving as it does the application of a legal standard to a particular set of facts.”156 In addition to a simple factual showing that Islamic terrorists base their raison d’être for violence on the dictates of Shari’ah as expressed by the classical Shari’ah authorities and some contemporary ones, the fact question as presented might also be addressed by introducing evidence establishing what the contemporary Shari’ah authorities consider to be the purposes and authorized methods of Shari’ah.

p.38
Footnote

[155]This is procedurally akin to a defendant’s position on a motion to dismiss or for summary
judgment. Assuming all the allegations are true, as a matter of law, there is no actual evidence
that Shari’ah is the cause of violence rather than its excuse.

******
This question might be presented to a jury by introducing evidence (i) of the rulings of the contemporary Shari’ah authorities, (ii) of the rulings of classical Shari’ah authorities upon which the contemporary authorities have relied, and (iii) of Shari’ah in actu, which would include a brief on Muslimdominated regimes generally recognized as following Shari’ah, including their Shari’ah-based criminal codes and punishments and their track record for violations of the basic norms of the Law of Nations and human decency.157

Quantitative materiality requires companies only to disclose hard, empirical facts such as financial data and any criminal convictions of management personnel. Qualitative materiality
requires a fuller disclosure of behavior that might be considered unethical or even illegal
but which has not yet resulted in an actual conviction.158

Disclosure remains a significant legal issue for the company looking to promote its SCF business (or simply to disclose publicly the involvement in SCF) because of the difference between whether a duty to disclose exists in the first instance and what must be disclosed to make a partial disclosure not misleading to the reasonable investor.159 Thus, to the extent an SCF business actively promotes its SCF business or includes SCF within the risk factors in its SEC filings, this disclosure opens the door to a full and accurate disclosure of all facts which a reasonable investor would find material.

The fact of Shari’ah compliance would likely be sufficiently material for the duty of disclosure to exist independently of any partial representation.160

p.39
Footnotes

[159]Common law fraud did not originally impose a duty to disclose; rather, once a statement
represented something as fact, it had to be truthful. Materiality gets at “truthfulness” in that “halftruths”
can be as misleading as false statements. The development of the law on the disclosure of
omitted facts has always lagged behind the duty to disclose the whole of a truth partially told. For
a discussion in this development relative to securities fraud cases, see LOSS & SELIGMAN,

[160]This would be the case whether a company made no disclosure at all or represented itself as
focused on “socially responsible” or “ethical” investing without any mention of Shari’ah. If the
business model was in fact based upon Shari’ah, this would remain a material fact.

******
The confusion at a procedural level for the legal advisor attempting to weigh the
materiality issue within the overall analysis of liability exposure might be the existence of
counterfactual claims suggesting that Shari’ah has a peaceful face in addition to its
connection to Islamic terror. But these “counter-facts” would simply create a fact
question. This suggests that a well-pled complaint alleging a sufficient nexus between
SCF, Shari’ah, terror, and violence would survive a motion for summary judgment.

b. Global Security Risk: a material fact?
The close nexus in the hypothetical factual predicate for this discussion between Shari’ah
and global terrorism is, as explained above, more than just theoretical. Efforts by
corporate legal counsel to dismiss these concerns will invariably run up against the wall
of common understanding linking in material ways the violent and oppressive world of
Shari’ah one hears about in the public media161, terrorism committed in the name of
Shari’ah162, Shari’ah itself163, and something calling itself SCF.

In at least two instances, the New York City Comptroller, as the custodian and trustee of
several major New York City employee pension funds which had acquired substantial
stock in Halliburton Company and General Electric, demanded that these two U.S. multinational corporations doing business in Iran approve a shareholder proposal at their
respective annual meetings to examine the “potential financial and reputational risks”
associated with doing business in terror-sponsoring countries.164

p.40
Footnote

[164]The SEC documents from which this narration is drawn can be found through a Lexis search:
for the Halliburton “No Action Letter” file, see 2003 SEC No-Act. LEXIS 433 [hereinafter
Halliburton No-Action File]. For General Electric, see 2005 SEC No-Act. LEXIS 137
[hereinafter GE No-Action File]. For a broader article discussing these cases in some detail in the
context of compliance by foreign subsidiaries of U.S. corporations, see Terence J. Lau,
Triggering Parent Company Liability Under United States Sanctions Regimes: The Troubling
Implications Of Prohibiting Approval And Facilitation, 41 AM. BUS. L.J. 413 (2004).

******

In its correspondence in opposition to GE’s request, the Comptroller quoted at length from the Congressional Conference Report on the 2004 Budget, which requested that the SEC
establish an Office of Global Security Risk to evaluate the risks caused by the conduct of
business operations in terrorist states.167The SEC denied GE’s no-action letter and
ultimately established an Office of Global Security Risk, the purpose of which is to
“monitor whether the documents public companies file with the SEC include disclosure
of material information regarding global security risk-related issues.” 168

p.41
Footnote

[168]U.S. Securities and Exchange Commission, Office of Global Security Risk,
http://www.sec.gov/divisions/corpfin/globalsecrisk.htm (last visited Jan. 30, 2008). In this
context, the SEC proposed the following:
II. Disclosure of Business Activities in or With Countries Designated as State
Sponsors of Terrorism
The federal securities laws do not impose a specific disclosure requirement that
addresses business activities in or with a country based upon its designation as a State
Sponsor of Terrorism. However, the federal securities laws do require disclosure of
business activities in or with a State Sponsor of Terrorism if this constitutes material
information that is necessary to make a company’s statements, in the light of the
circumstances under which they are made, not misleading. [Note 6 citation appears here
in the text. See below.] The term “material” is not defined in the federal securities laws.
Rather, the Supreme Court has determined information to be material if there is a
substantial likelihood that a reasonable investor would consider the information important
in making an investment decision or if the information would significantly alter the total
mix of available information. [Note 7 citation appears here in the text. See below.]
The materiality standard applicable to a company’s activities in or with State
Sponsors of Terrorism is the same materiality standard applicable to all other corporate
activities. Any such material information not covered by a specific rule or regulation
must be disclosed if necessary to make the required statements, in the light of the
circumstances under which they are made, not misleading. The materiality standard’s
extensive regulatory and judicial history helps companies and their counsel to interpret
and apply it consistently, and we remain committed to employing this standard to
company disclosure regarding business activities in or with State Sponsors of Terrorism.

******

It is clear that U.S. companies can no longer consider their associations with countries or
entities tainted by terror a private, non-material, or irrelevant matter. While the courts
have not yet entered the fray, the executive and legislative branches have laid down some
markers. This suggests that the closer a company gets to a “state sponsor of terror”, the
more it has to disclose. Prudent counsel suggests that the closer a company gets to any
association with terror, the more it has to disclose. The obvious question raised by the
two proxy examples above would be: If a shareholder submits a proxy proposal to a
publicly reporting financial institution involved in SCF requiring a full study of the risks
associated with Shari’ah, will the company have legitimate grounds to argue that the
risks of Shari’ah and its connection to terror are not relevant? Outside of the proxy arena,
if a company engages in SCF and represents to the public that Shari’ah is a standard set
by Shari’ah authorities relied upon by the company, has the company disclosed enough
about Shari’ah to tell the whole story? Given the hypothetical this analysis has been
working with, the answer appears to be “no”.

2. Scienter
Unlike materiality, which is an element in any type of fraud action, scienter, or intent, is a
critical element of the common law and of most statutory provisions imposing liability on
a wrongdoer.169 As understood by the common law, a plaintiff’s claim for deceit could
only survive a motion to dismiss if the pleadings alleged that the defendant knew the
falsity of the representation and that the false representation was made in an effort to
induce reliance by the plaintiff. Over time, this standard has been relaxed to include not
merely false representations but also half-truths. This means that having opened the door
to a representation, the putative defendant must be certain to have told the whole truth, or
at least the whole material truth.170

******
But the question remains: Having omitted some important part of the story, and assuming
that the omitted part was material, did the defendant withhold the omitted part (a)
knowingly and (b) with intent to deceive? Successful civil and criminal fraud litigation is
as much about properly alleging scienter as it is proving it.171 Judges will decide the
former; jurors are most likely to decide the latter172.

p.43
Footnote

[171]This is especially true after the passage of the Private Securities Litigation Reform Act of 1995
(PSLRA), which ratcheted up the scienter pleadings requirements and froze discovery during a
defendant’s motion to dismiss to eliminate frivolous suits and to eliminate the “leverage”
plaintiffs use by propounding reams of discovery requests early on to tie-up company
management and extort a settlement. For a good discussion of the pleadings requirements post-
PSLRA, see Ray J. Grzebielski & Brian O. O’Mara, Whether Alleging “Motive and Opportunity”
Can Satisfy the Heightened Pleading Standards of the Private Securities Litigation Reform Act of
1995:Much Ado About Nothing, 1 DEPAUL BUS. & COM. L.J. 313 (2003).

******

Another serious avenue for enforcement that avoids the scienter issue arises under the
Investment Advisors Act of 1940 (“Investment Advisors Act”). Fund managers who
embrace SCF while ignoring Shari’ah as a material part of the disclosure will likely face
serious scrutiny as the SEC and large institutional investors come to understand the
intimacy between the terms “Shari’ah-compliant”, “Islamic finance”, and even “socially
responsible Islamic investing” and the Shari’ah witnessed in Iran, Saudi Arabia, and
Sudan. Indeed, an SCF investment or business which attempts to disguise the “Shari’ah”
and utilize a less emotionally charged term has added to its exposure, since that would be
circumstantial evidence that the putative defendants knew of the dangers of Shari’ah and
sought to minimize them by using a more acceptable public relations-sensitive
nomenclature.

Thus, under Rule 206(4)-1:
a. It shall constitute a fraudulent, deceptive, or manipulative act, practice,
or course of business within the meaning of section 206(4) of the Act for
any investment adviser registered or required to be registered under
section 203 of the Act, directly or indirectly, to publish, circulate, or
distribute any advertisement:

5. Which contains any untrue statement of a material fact, or which
is otherwise false or misleading.179

Rule 206(4)-8, captures the pooled investment fund advisors:
a. Prohibition. It shall constitute a fraudulent, deceptive, or manipulative
act, practice, or course of business within the meaning of section 206(4) of
the Act for any investment adviser to a pooled investment vehicle to:
1. Make any untrue statement of a material fact or to omit to state a
material fact necessary to make the statements made, in the light of
the circumstances under which they were made, not misleading, to
any investor or prospective investor in the pooled investment
vehicle; or
2. Otherwise engage in any act, practice, or course of business that
is fraudulent, deceptive, or manipulative with respect to any
investor or prospective investor in the pooled investment
vehicle.180

 

 

 

What the Court did was to
limit the Smith Act to cases where the advocacy for the overthrow of the government was
more than merely theoretical and to require a nexus between the advocacy and some
action that was being urged to achieve the treasonous goal.
p.47