This provocative paper is sure to raise the ire of a civil society that wants Third World debts canceled because of their illegitimacy. But it won’t make the lenders who want “no fault” debt forgiveness (courtesy of Northern taxpayers) happy either. Instead, authors Ben-Shahar and Gulati push the legal envelope of “how to” resolve the Third World debt quagmire and in doing so, empower odious debt advocates with more legal fight than ever before.

Drawing on the economic analysis of private law to assign liability for odious debts, the authors argue that lenders should bear partial responsibility for odious debts because that will induce them to exercise greater care in future and because they have more tools at their disposal to prevent odious debts. Creditors are comparatively more blameworthy than the populace who often risk jail, or worse, if they try to stop the accumulation of their dictators’ odious debts. But, the authors say that the portion of debt used by the borrowing government in legitimate ways and to benefit the people should remain the public’s responsibility to repay.

“The populace continues to be strictly liable for the national debt, but it now has a defense of contributory negligence against the creditors. If the successor government can show that the creditors were at fault, the component of the debt that served ill purposes is discharged. The more the populace benefited from the debt, the more they have to pay back.”

What can creditors do to protect themselves under this partial liability regime?

Many things, say Ben-Shahar and Gulati. They can observe and exit by refusing dictators’ demands for secrecy and refusing to deposit funds into personal bank accounts (lenders typically do this in their non-sovereign lending). They can disclose and empower by making public disclosures of the loans, as well as publicizing their purpose and their results. They can exercise a good governance voice by demanding covenants, engaging external monitors to evaluate whether milestones for the project are being met, and accelerating the debt if they aren’t. They can also demand adequate assurance and proof that the funds are used in legitimate ways, and make this information public. Sensible suggestions all.

But why stop there? If creditors can take this kind of care, can’t other important “contributory actors” working with odious regimes, such as weapons manufacturers and consultants do the same, ask the authors? “It may well be that a cause of action ought to lie against such parties, shifting the cost of the harm done with their contribution or complacence from the populace that suffered it to them. To the extent that cheap prevention and precautionary actions can be taken, the same argument that we develop here would justify liability on these actors.” (The role of consultants in promoting the Three Gorges dam on China’s Yangtze River is a good example of this. See Damming the Three Gorges: What Dam Builders Don’t Want You To Know, Earthscan, 1993 )

The authors are quick to point out that the purpose here is not to hold creditors and contributors strictly liable for the entire debt, but only for the portion of the loans for which the creditors were negligent and failed to take due care. The purpose is to induce care.

Smart creditors would begin to avoid loans to projects famous as vehicles for corruption and lean towards projects that have more easily verifiable and obvious benefits. The more a creditor could demonstrate the population benefited from a loan, the more protection it would get against an odious debts defense.

But wouldn’t this heightened level of scrutiny on sovereign loans only push dictators to steal from other sources of revenue such as taxes? Herein lies a crucial point that has major implications for all sources of foreign funds to democratically challenged leaders: tax revenues tend to be relatively visible and therefore harder to steal without raising the public’s attention and ire. Plus they arrive in local currency – not as useful to the dictator who wants to buy a chateau in France. External borrowing, on the other hand, comes in foreign currency, directly to the dictator, and is therefore “easy to pilfer.” Moreover, when tax revenues are skimmed, it is the current generation that pays. But, when debt revenues are skimmed, it is the future generation that will have to pay the debt and therefore bear the burden. Natural resource revenues are also “susceptible to stealing,” a problem which groups like Revenue Watch and Publish What You Pay are trying to fix.

“So long as the current generation does not feel its pocket directly picked, it might not be as likely to revolt. Indeed, the clever despot will borrow on behalf of later generations and spend some of the proceeds of that borrowing to the current generation and steal the remainder.”

What about bonds as a source of foreign funding for dictators? Most despotic borrowing, say the authors, is rarely in the form of bonds. And “even if sovereign bonds are to be issued by a despotic regime, information about the liability risk would be reflected in the price of the security.” Indeed, the authors can imagine sophisticated intermediaries ascertaining the odious debt liability risk of sovereign bond issues (such as underwriters and rating agencies do for municipal bonds), collecting the necessary information to certify bonds as “free of odious debt liability,” and even bundling them with liability insurance.

So this creditor liability regime proposed by Ben-Shahar and Gulati begins to resemble the ex-ante certification mechanism proposed by Kremer and Jayachandran (where sovereigns are in effect licensed ahead of time in terms of their odiousness) but without an official international institution that would make error prone political decisions about odious regimes still in place. Instead of a centralized political body making this decision and facing controversy and legitimacy concerns, the authors propose a decentralized assessment made by the market.

Though they hope that the multilateral development banks could contribute to this monitoring function, I think their confidence is misplaced given MDBs are likely the largest lenders of odious debts

The creditor liability regime proposed by Ben-Shahar and Gulati is likely to make some sovereign debt more difficult to collect, but only if there is a true fundamental problem with the loan. “If credit becomes unaffordable to some dictators, let it be so,” say the authors. The benefit is that, in order to secure lower interest rates and more ready finance, borrowers (and lenders) will favor good borrowing and projects that clearly benefit the populace over those that are more suspect. This scheme will also help order the comparative fault of different creditors, providing a hierarchy of claims for repayment and protecting creditors who exercised greater diligence.

Creditors may try to circumvent the creditor liability regime in a variety of ways, warn Ben-Shahar and Gulati: they may switch their “choice-of-law” jurisdiction to one more likely to shelter them from an odious debt defense, but such a move would give creditors and the choice-of law regime bad press (as creditors to kleptocrats and oppressors, so to speak) and would likely to be prohibitively expensive. They might try round-tripping loans (extending new loans to repay old ones), but that gets expensive after awhile, as does bribing new governments to repay old governments’ odious debts. Ultimately, say the authors, their proposed partial liability regime will not make it impossible for creditors to engage in such circumvention but that getting around odious debt liability will likely be more expensive than the alternative of simply taking due care.