The concept of odious debt and its relevance to Indonesia

(February 23, 2001) For creditors to expect any protection for their loans to foreign states, their loans must be utilized for the needs and interests of the state; otherwise the loans belonged to the power which contracted them, and were therefore, debts of the regime.

I first learned of the doctrine of odious debts years ago when I was writing my book about the Third World’s debt crisis. I was heartened. Here was a principle, published in 1927 by Alexander Sack, then the world’s preeminent legal scholar on the treatment of public debts, that offered a just way of resolving the current Third World debt crisis and of ensuring that another debt crisis would not be recreated in future.

Let me explain what the doctrine of odious debts is, how its principles have been used to resolve sovereign debt disputes in the past and, finally, why it is so relevant to Indonesia’s debt crisis today.

First, a little history. Professor Sack, a Russian professor of law teaching in Paris, wrote his doctrine in the 1920s – in a time when colonial territories were becoming independent nation states, when monarchies were being replaced by republics and when military rulers were being replaced by civilians. Borders were constantly changing and new ideologies of socialism, communism and fascism were overthrowing old orders. Sack’s theories about the treatment of state debts dealt with the practical problems created by such transformations of state. But he was no radical. So that international commerce and trade did not break down, Sack believed that liability for public debts – or government debts – should remain intact when a new government or new sovereign came to power. His argument? Sack believed that these debts represent obligations of the state. He defined the state to be the territory, rather than a specific governmental structure.

But there was one exception. Sack believed that debts not created in the interests of the state, should not be bound to this general rule. Some debts, he said, were odious.

And he defined an odious debt this way: “If a despotic power incurs a debt not for the needs or in the interest of the State, but to strengthen its despotic regime, to repress the population that fights against it, etc., this debt is odious for the population of all the State.”

He went on. “This debt is not an obligation for the nation; it is a regime’s debt.” Sack called it “a personal debt of the power that has incurred it.” When this power falls, that debt “consequently … falls with the fall of this power.”

According to Alexander Sack, these “odious” debts could not encumber the territory of the State, because such debts do not fulfill one of the conditions that determine the legality of the debts of the State. And here is the pivotal point of Sack’s doctrine: “the debts of the state must be incurred and the funds from it employed for the needs and in the interests of the State,” in order to be considered legal.

Professor Sack gave a few examples of what he would deem an “odious debt.”

First, and as I just mentioned, he said “If a despotic power incurs a debt … to strengthen its despotic regime, to repress the population that fights against it, etc., this debt is odious for the population of all the State.”

Professor Sack was also more specific. “When a government incurs debts to subjugate the population of a part of its territory or to colonize it with members of the dominant nationality, etc., these debts are odious to the indigenous population of that part of the territory of the debtor State.”

Lastly, Professor Sack considered a debt odious when, “the loans incurred by members of the government or by persons or groups associated with the government to serve interests manifestly personal – interests that are unrelated to the interests of the State.” A bribe is an example of a manifestly personal interest.

For a debt to be odious, the lender must be aware that the loan is “contrary to the interests of the nation.” In this case, Professor Sack said, a loan would be odious and would not compromise the nation, unless, he added, “that real advantages were obtained from these debts.”

“The creditors,” he continued, “have committed a hostile act with regard to the people; they can’t therefore expect that a nation freed from a despotic power assume the ‘odious’ debts, which are personal debts of that power.”

Even if a despotic power is replaced by another despotic power, the “odious” debts of the eliminated power are not obligations for the new power, he added.

Therefore, for creditors to expect any protection for their loans to foreign states, their loans must be utilized for the needs and interests of the state; otherwise the loans belonged to the power which contracted them, and were therefore, debts of the regime.

Now, to avoid abuse of the doctrine by self-serving interpretation, Sack proposed that a new government be required to prove that the debts it inherited from a previous regime did not serve the public interest and that the creditors were aware of this. Following these proofs, the onus would be upon the creditors to show that the funds were utilized for the benefit of the territory. If the creditors could not do so, before an international tribunal, or “in the opinion of competent and impartial representatives of the family of nations,” the debt would be unenforceable.

Some of you may be thinking, “great theory, but difficult to put into practice.”

I urge you, don’t despair. The principles have been applied in the past and exist in the jurisprudence.

Among the cases that Sack cited in formulating his doctrine was the case of the Cuban debts. After the Americans won Cuba from Spain in the Spanish-American War of 1898, the Spanish argued in the peace negotiations that the Cuban debts should be assumed by the Americans. The Spanish argued the prevailing principle of international law: that state obligations belong to a land and its people, not to a regime.

The Americans replied that the so-called “Cuban debt,” “imposed upon the people of Cuba without their consent and by force of arms, was one of the principal wrongs for the termination of which the struggles for Cuban independence were undertaken.”

Furthermore, the Americans added, much of the borrowing was designed to crush attempts by the Cuban population to revolt against Spanish domination, and was spent in a manner contrary to Cuba’s interest. “They are debts created by the Government of Spain, for its own purposes and through its own agents, in whose creation Cuba had no voice.”

“The debt was contracted by Spain for national purposes, which in some cases were alien and in others actually adverse to the interest of Cuba … in reality the greater part of it was contracted for the purpose of supporting a Spanish army in Cuba.”

As for the lenders, the Americans said, “the creditors, from the beginning, took the chances of the investment.”

In the end, the United States never acknowledged liability for the Cuban debt, nor assumed any Spanish debts. The holders of the so-called “Cuban debt” never collected fully on their claims.

About 20 years later, and still before Alexander Sack defined the Doctrine of Odious Debts, another very important case occurred. This case involved the Royal Bank of Canada, a private commercial bank from my country, which made a loan to the outgoing dictator of Costa Rica, President Tinoco. The new Costa Rican government challenged the debt before Chief Justice Taft of the U.S. Supreme Court who was asked to sit as arbitrator.

In his 1923 ruling, Chief Justice Taft noted that the transactions in question were “full of irregularities.” They were also “made at a time when the popularity of the Tinoco Government had disappeared, and when the political and military movement aiming at the overthrow of that Government was gaining strength.”

The payments, Justice Taft discovered, were made to cover either Federico Tinoco’s expenses “in his approaching trip abroad,” or his brother’s salary and expenses in a diplomatic post to which Tinoco appointed him.

The Royal Bank, Justice Taft ruled, cannot simply base its case for repayment on “the mere form of the transaction” but must prove its good faith in lending the money “for the real use of the Costa Rican Government under the Tinoco régime … for its legitimate use.”

“It has not done so.” Justice Taft ruled. “The bank knew that this money was to be used by the retiring president, F. Tinoco, for his personal support after he had taken refuge in a foreign country. It could not hold his own government for the money paid to him for this purpose. The position was essentially the same in respect to the payments made to Tinoco’s brother.”

In conclusion, Justice Taft ruled, “The Royal Bank of Canada cannot be deemed to have proved that the payments were made for legitimate governmental use. Its claim must fail.”

To my knowledge, the Doctrine of Odious Debts has not been invoked since it was drafted, some 70 years ago. But it has nagged the minds of lenders. In 1982, lawyers at The First National Bank of Chicago wrote in a professional journal, “The consequences of a change of sovereignty for loan agreements may depend in part on the use of the loan proceeds by the predecessor state. If the debt of the predecessor is deemed to be “odious,” i.e., the debt proceeds are used against the interests of the local populace, then the debt may not be chargeable to the successor.”

Although the intended use of proceeds is usually spelled out in bank loan agreements, the lawyers went on, the use described is often too general to ensure that the loan benefitted the people and so too general to guarantee loan enforcement. Moreover, the loan documents rarely restrict the money’s use.

“Commercial banks should be alert to the dangers of such doctrines,” the First National Bank lawyers warned. “Because successor governments have invoked doctrines based on an ‘odious’ or ‘hostile’ use of proceeds, lenders should describe with specificity the uses of the loan proceeds and, if possible, bind the borrower by representation, warranty, and covenant to those uses.”

We know that for years, bankers did not exercise this kind of due diligence. Without that due diligence, banks cannot ensure that their loans were used for the needs and interests of the state. Perhaps the most spectacular example of that is the case of the World Bank in Indonesia.

Thanks to the marvelous research of concerned citizens here in Indonesia and around the world, and of academics such as Jeffrey Winters, you have excellent evidence that the World Bank lent $30 billion to the Suharto government between 1966 and 1998 in the full knowledge that as much as $10 billion of that served, what Alexander Sack would have called, “manifestly personal” interests.

I think you have a strong case to launch odious debt arbitration proceedings not only against the World Bank, but against most if not all creditors, and on all counts. Did the government of President Suharto use the proceeds of the borrowed funds to “strengthen its despotic regime,” “to subjugate the population of a part of its territory,” and for “interests manifestly personal.”

But why not start with the World Bank.

How to do it? I would recommend that, in order to show good faith and to reassure the financial world that Indonesia is not a deadbeat, the Indonesian government place all debt and principal repayments due on outstanding World Bank loans into a trust fund managed by a respected and independent body, to be released only once the legitimacy of World Bank loans is determined. The government of Indonesia should then, together with the World Bank, select an arbitrator or panel. Indonesia should then conduct forensic audits of past loans, going through discovery procedures, and submitting arguments and evidence for determination by the arbitrators.

It is important to recognize that the World Bank has a financial moral authority that it doesn’t deserve. In the current debt negotiations, be they through the Paris Club or HIPC, the World Bank is the apparent defender of the pacta sunt servanda – the principle that contracts must be honoured. Many countries are too poor to honour their debt contracts, the World Bank implies, so it offers to organize charitable contributions to help relieve their burden. But if those countries repudiate their debts – for whatever reason – the World Bank threatens to banish them from the world of international finance and commerce.

It is time to tell the World Bank, and other creditors, that pacta sunt servanda works both ways. According to the principles of international law laid out by Alexander Sack, the World Bank had a contract with the Indonesian people that the money it lent to the people’s representative would indeed be spent in the interest of the people. If the World Bank failed to honour its side of the contract, then the people of Indonesia cannot be held responsible for those debts.

You must understand that the World Bank is determined not to admit culpability on this count. Let there be no mistake. The World Bank and other multilateral agencies, and the export credit agencies – the main creditors of the poorest countries – want no-fault debt relief in order to avoid financial accountability for their odious loans.

You may think the World Bank and the export credit agencies are the most powerful financial institutions in the world, but they are extremely vulnerable to the bad loans they made. Their survival depends on maintaining a facade of financial solvency. HIPC, Paris Club work-outs, and bilateral debt cancellation help them hide their losses. They must get bad loans off their books, and they must do it in such a way that does not look like write-offs or debt repudiation. If the debt retirements look like write-offs, their triple-A credit ratings will be threatened. If the World Bank and other public agencies faced arbitration panels that could deem their loans to have been odious, the outcome could bankrupt them. They know they are financially vulnerable. They also know they are legally culpable. More than anything, they want to avoid odious debt investigations so a dangerous financial chain reaction is not set in motion.

But, what might be dangerous for the World Bank, would be good for Indonesia.

Proving some of the World Bank’s loans to Indonesia were odious would relieve the Indonesian public of an unjust debt burden. It would also leave the World Bank with only one choice to recover its lost billions – that is to sue, pursue and, where possible, seize the assets of government leaders who illegally took those funds. This would be a just and elegant end to a decade’s long debt debacle: the lenders and the borrowers deserve each other, and they should settle their financial disputes on their own.

Today, the citizens of many countries, including Argentina, Brazil, Nigeria, and South Africa are challenging the legitimacy of their countries’ foreign debts. You, the citizens of Indonesia, are not alone. When I wrote my book, Odious Debts, I merely reviewed legal thought and history. I believe the citizens of the South will now start making history. Challenging just one foreign loan as odious would send shock waves through the financial industry. It would help eliminate the moral hazard that has dominated public borrowing for the past 50 years, and that has so damaged the economic, political, and social fabric of the Third World. It would, I believe, shift the balance of power in debt negotiations in favor of citizens. Creditors, fearing scrutiny of their own loans for odiousness, would likely become more sympathetic to debt write-offs. Lenders would take greater care to lend to governments with real authority, and not just apparent authority, and to exercise due diligence to make sure that the money is used for legitimate governmental purposes. It would probably be the fastest way to secure the measures for accountable public finance that citizens throughout the South have so thoughtfully articulated. Lenders would soon demand evidence that the borrowing public knows about, and consents to, government borrowing before extending credit.

I don’t know exactly how much of Indonesia’s debt burden today could be canceled if it were challenged as odious. I suspect the majority. But, whether it is that much, or less, the course of financial history would be altered if the Doctrine of Odious Debts became the standard for determining legitimate uses for governmental borrowing. Odious lenders of the past must pay for their recklessness and negligence; otherwise we will be here again in 20 years time, seeking relief from the next generation of debt. I am sure that recourse to odious debt arbitration, would protect future generations from living through more debt crises. In that, I think we have a duty to advance these principles to the best of our ability.

Thank you.

Patricia Adams, Speech to INFID Seminar on Indonesian Debt, February 23, 2001

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s