Like with so many other things, when Dubai's credit-crazed corporations decided to tap the global sukuk market to raise funds few investors thought twice about the Shar'iah-compliant bonds. It's taken the threat of default to shake investors out of their complacency with regard to these structures.

Dubai World property developer Nakheel, best known for its Palms development in the Gulf, has $5.25 billion in outstanding sukuk subject to the standstill agreement that the government asked creditors for on November 25, including $3.5 billion due on December 14. While the rest of the $26 billion debt restructuring looks to be contained, such a restructuring is unprecedented in the nascent Islamic finance industry.

"This will mark the first test of the legal framework underpinning sukuk in general, and it could therefore have implications for Islamic fundraising globally," said Fahd Iqbal, an analyst at Middle Eastern investment bank EFG Hermes, in a report.

According to Kuwait Finance House Research, the yield on the Nakheel Development Sukuk 2, which matures in 2011, spiked to 80% on November 30 from 22.3% on November 24, the day before markets closed for the Eid holiday. The instrument's price simultaneously fell 40% to Dh53 ($14.43).

At issue with Nakheel's sukuk is how a court will handle the restructuring, note observers familiar with Islamic finance. Much depends on the structure of the instrument. A court could declare the instrument the equivalent of a conventional bond with repayment terms comparable to international norms, or it could find the sukuk to be structured as either a mudharabah (profit-sharing) product or a musyarakah (a partnership involving profit- and loss-sharing) product, both of which would likely involve the creditors sharing some of the issuer's losses.

Creditors stand to benefit if a sukuk is declared essentially the same as a conventional bond, whereas the issuer stands to benefit if it is defined first and foremost as an instrument that is compliant with Shar'iah (Islamic law) -- and thus subject to the idea of profit-sharing.

"The whole presentation of the structure is one where investors are meant to receive a share of the profits and not interest on debts - two very different obligations," said Khalid Howladar, a senior credit officer at Moody's. "It could be argued that, because an issuer is not generating profits, it should not have to pay sukuk investors."

Not everyone agrees: "This is a credit issue, not an Islamic issue," said Raja Teh Maimunah, global head of Islamic markets at Bursa Malaysia. "A sukuk is a bond and issuers need to pay back the money they borrowed."

She noted that this is not the first time an Islamic finance instrument has had to be restructured to avoid default. She would not discuss the details but said there were a few sukuk in Malaysia that had to be restructured during the 1997-1998 Asian financial crisis.

The full impact of Nakheel's debt restructuring on global sukuk issuance is unlikely to be known for some time, but at this point it looks minimal. During the first 10 months of the year, issuance was up 40% annually according to Moody's, and banks report robust pipelines. But investors may come out of this event wiser (if not wealthier) than before.

"Dubai World has created confusion over what a sukuk is," says one banker. "This will likely somewhat delay the revival of the market [after the decline in 2008] but it won't kill it. Demand won't change but people will be more cautious."

Maimunah agrees that investors will learn from Dubai World. "Cashflow was completely ignored in sukuk coming out of the Gulf. Markets will learn from this and they'll [know to] look at credit," she said.