Kuwait's troubled shareholding company Investment Dar is refusing to pay Lebanon's Blom Bank $10.7 million, saying that their original deal did not comply with Islamic law, in a move that could pressure the Islamic finance industry.

Dar's charter prohibits it from entering into non-Islamic transactions.

According to a legal brief circulated this week and obtained by Reuters, Blom sued the company in a British court last year, asking for the principal it invested plus a 5 per cent return, as structured in a deal it conducted with Dar in 2007.

But Dar, in a legal move experts say will get much attention, argued that the deal -- which was approved by its sharia board -- ultimately did not comply with sharia law and was therefore void.

A judge upheld that while Dar should repay the principal sum, it had an arguable defence regarding the extra profit. Legal experts have reacted to the case, saying that allowing companies to go back and argue that a deal is non-compliant will ultimately hurt the Islamic finance industry.   

"This is a very dangerous defence," said Sheikh Muddassir Siddiqui, sharia scholar and partner at law firm Denton Wilde Sapte. "For people dealing with Islamic financial organisations, it adds sharia risk to all the other common risks out there."    

The issue revolves around the concept of interest and risk-sharing. Under the deal, known as a wakala, Dar served as an agent and accepted funds from Blom that it would invest in a sharia-compliant manner.

But the contract called for the company to return the principal investment plus a fixed profit -- a deal Dar's attorneys now say constitutes interest, which is prohibited under sharia law.

Dar defaulted on a $100 million sukuk last year and is restructuring its debts.

Experts said that the latest defence from Dar will raise fears among potential investors over the long-term risks associated with entering a sharia-compliant deal.

"The timing is unfortunate," said one attorney who asked not to be named. "The company is clearly in financial difficulties and clutching at straws to get out of paying but it may cause concern for conventional institutions considering entering into a sharia transaction."    

He added that financial institutions that are already nervous over Islamic finance may view the move as a reason to steer clear of the industry.   

Islamic finance was once considered a safe haven given its prohibitions against speculative dealing. That was particularly attractive as financial companies suffered from the economic crisis. But a declaration by prominent sharia scholar Sheikh Usman Taqi calling into question the legitimacy of the majority of sharia-compliant deals, followed by a mounting number of high-profile defaults in the region, has tarnished the industry.

And experts say that Dar's defence just adds to the industry's worries. Michael Rainey, partner in the London office of King & Spalding, said the move appeared to be a way to discourage some of Dar's creditors from seeking independent redress in the courts and force them to participate in its restructuring.

Dar announced in November that two-thirds of its creditors had agreed to a standstill as part of its restructuring. "At minimum it creates more uncertainty which isn't good for our industry," Rainey said.   

And for potential investors, it may not be a risk worth taking, experts said.   

Spokesmen for Investment Dar and Blom Bank said they could not comment on an ongoing legal matter. - Reuters