What are Illicit Financial Flows?
Illicit Financial Flows (IFFs) describe the movement of money that is illegally acquired, transferred or spent across borders. There are various definitions of illicit financial flows, but essentially they are generated by methods, practices and crimes aiming to transfer financial capital out of a country in contravention of national or international laws. These illegal cross-border transfers typically involve money laundering, bribery by international companies, tax evasion and trade mispricing. These practices, however, don’t tell us anything about the origin or intent of such funds.
IFFs can arise from illegal or corrupt practices such as smuggling, fraud or counterfeiting. The source of these funds may be legal, but their transfer may be illegal, such as in the case of tax evasion by individuals and companies. Additionally, IFFs may be intended for other illegal activities too, such as terrorist financing, bribery, or illegal consumption of goods.
Illicit financial flows vary by origin, complexity and intent, but they all have the same eroding effect on a country’s tax base, particularly for resource-rich developing countries which do not have the means to invest in public health, education, and sustainable development. These assets represent vast untapped wealth in the form of civil claims arising from historic grand corruption and fraud which belong to governments and their people.
The Cost of Illicit Financial Flows
Every year huge sums of money are transferred out of countries illegally, stripping resources that could be used to finance much-needed public services, from security and justice to basic social services such as health and education. Such practices occur in all countries – and are damaging everywhere – but the social and economic impact on developing countries is more severe given their smaller resource base and markets.
Although the exact scale of the problem is unknown, illicit financial flows are estimated to cost developing nations $1 trillion per year. The potential scale of this loss is illustrated by Nigeria, which was estimated to have lost $400 billion to IFFs between 1960 and 1990. Had this money been invested in a sovereign wealth fund, that fund could have been worth approximately $2 trillion today, larger even than Norway Government Pension Fund Global, the world’s largest sovereign wealth fund.
As illustrated above, the most immediate impact of IFFs is a significant reduction in capital available for domestic expenditure and investment, both public and private. This translates to fewer hospitals and schools, fewer police officers on the street, fewer roads and bridges – and ultimately fewer jobs.
Securing the recovery of wealth lost through IFFs has the potential not only to bridge gaps in country finances but also to create a virtuous circle of transparency, potentially unlocking financial support and helping to build vibrant and stable local economies.
What Is Being Done To Combat Illicit Financial Flows?
Recognizing the damaging effects of illicit financial flows, leaders meeting at the Fourth High Level Forum on Aid Effectiveness in Busan in 2011 agreed to “accelerate individual efforts to combat illicit financial flows by strengthening anti-money laundering measures, addressing tax evasion, and strengthening national and international policies, legal frameworks and institutional arrangements for the tracing, freezing and recovery of illegal assets.”
Below is a brief overview of the ongoing global efforts to combat illicit financial flows.
Anti-Money Laundering Policies
Individuals from developing countries whose wealth is of an illicit nature often seek to place it outside their own countries to avoid scrutiny and diversify risk. For this reason, they are likely to choose countries with stable and predictable financial systems, with low risk of detection due to weak anti-money laundering regimes.
In response, anti-money laundering (AML) and counter-terrorist financing (CTF) policies have proven to be some of the most effective tools for combating financial crime and illicit financial flows. Several conventions have been put in place to criminalize these acts, and the commitments in these conventions have been incorporated into the Recommendations of the Financial Action Task Force (FATF) – the most comprehensive instrument for tackling money laundering to date.
Exchange of Information Agreements for Tax Evasion
Effective exchange of information between tax authorities is critical for combating all forms of international tax evasion and avoidance. While developed countries are generally compliant on standards for the effective exchange of tax information, developing countries face many constraints to building more effective domestic tax systems and ensuring compliance. Since 2000, developed countries have signed approximately 1,300 bilateral exchange of information agreements (EOIs) with developing countries to combat cross-border tax evasion.
Developing countries need to continue to expand their network of agreements with relevant jurisdictions and they will need the technical capacity and political will to actively pursue international tax evasion through exchanging information. While the existing standard is based on exchange on request, the G-20 is committed to automatic exchange of information (AEOI) and significant capacity building support for developing countries is needed.
An estimated USD 1 trillion is paid each year in bribes, and bribery in the developing world may amount to the equivalent of 15-30% of all official development assistance. Reducing corruption and bribery reduces the opportunities for illicit gains and hence illicit financial flows.
The OECD Anti-Bribery Convention establishes legally binding standards to criminalize bribery of foreign public officials in international business transactions and provides for a host of related measures that make this effective. It is the first and only international anti-corruption instrument focused on the ‘supply side’ of the bribery transaction. All signatories should continue to provide effective protection for whistleblowers, and penalties should be harsh enough to form an effective deterrent and signal to the entire business community that bribery is no longer an option.
Asset Recovery Efforts
Any government that can recover illicit financial flows for its people will not only dramatically improve its fiscal revenues but also create a powerful disincentive for future state corruption.
Developed countries typically adopt adequately resourced and trained units for international asset recovery, adhering to international legal best practices for the rapid tracing, freezing and return of stolen assets. They also typically permit authorities to freeze funds based on a request from a foreign jurisdiction and allow foreign countries to initiate civil actions in their courts. Civil courts are able to order compensation, restitution or damages to the benefit of a foreign jurisdiction.
Developing countries on the other hand have a harder time demonstrating visible commitment to combating corruption. That is because most of these countries lack the capital and resources available to engage legal assistance and recover assets.
Litigation Funding: Asset Recovery for Developing Countries
One option is for sovereigns to self-fund and pursue the claims on their own. Unfortunately, most sovereigns are outgunned and outmanned for this, and recovery rates have historically been less than 15%.
Third-party litigation funding, however, is becoming a popular approach for asset recovery, especially for developing countries that lack the resources to go after bad actors. The model works like this: third party litigation funders agree to pay the legal fees incurred to pursue a claim for a sovereign. This finance is non-recourse, which means if the sovereign loses the litigation, it bears no cost. In return, if the sovereign is successful, it pays a percentage of the asset recovery to the funder. However, not all funders are equal on this point, and sovereign clients are advised to shop around, as litigation funders typically take a large share of the recovered assets (45%+), and are sometimes seen as “vulture funds.”
Finally, privatization models are now emerging that provide similar success rates to traditional third-party litigators, while also providing end-to-end support to their sovereign clients, and ensuring that returned monies are used in alignment with each country’s national priorities, and breaking the cycle of corruption.
Litigation Funding in Africa
The funding of litigation and arbitration is permissible (or unregulated) in many African jurisdictions. The market is growing at a rapid rate, and funding is increasingly a topic for discussion. While funders have traditionally focused on markets such as the US, Europe and Australia due to their size and the perceived predictability of their legal systems and enforcement, they have recently become more interested in Africa. A few of the reasons being:
- The volume and value of many of the disputes in Africa
- Improved perceptions of many African courts
- Reliable legal systems based either on English law, or harmonized by the likes of the Organization for the Harmonization of Business Law in Africa (OHADA)
- A developing track record of successful enforcement
- The exponential growth of arbitration as a means of resolving disputes
Rising litigation costs on the African continent, particularly in large, complex or cross-border matters, often compel sovereigns to abandon or settle good claims at a major discount. Funding provides these countries the opportunity to access first-class legal services and pursue good claims without the cash flow constraints and downside risk of a potentially unsuccessful outcome. It frees up capital for domestic expenditure and investment, both public and private.
Lastly, and relatedly, every African economy has been adversely affected by COVID-19 – some African countries were entering a recession before the first local COVID-19 infection. These countries are seeking opportunities to manage cost while maintaining the upside of a potential inflow of cash.