The London School of Economics rarely finds itself in the same company as Nelly Furtado. However, like the Canadian singer, its relationship with Libya has given rise to controversy. The LSE quickly moved to suspend its links with the Gaddafi International Charity and Development Foundation, run by Saif Gaddafi, son of Muammar Gaddafi. But this swift action failed to protect it from a torrent of criticism, including from David Cameron, and, last week, its director, Howard Davies, resigned. "I advised the council that it was reasonable to accept the money and that has turned out to be a mistake," he said. He had previously said: "I don't accept that the decision was taken without due consideration at the time," pointing out that the British government had encouraged him to engage with the Libyans on financial reform. An independent inquiry led by Lord Woolf will now examine the LSE's links with Libya and will establish guidelines for international donations to the university. But the LSE is not the only university to face criticism over links with Tripoli. Liverpool John Moores is facing questions from, among others, Robert Halfon MP, who tabled an early day motion criticising both institutions. The Liverpool Echo reported claims that the university signed research contracts amounting to just under £1.3m, but Professor Michael Brown, its vice-chancellor, told the paper that the partnership with Libya never got off the ground. "We've nothing to be embarrassed of whatsoever and our work in Libya was about improving medical facilities, which are woeful," he said. "You have to differentiate between a government you don't approve of and helping the people." It's not the first time donations have stirred up controversy. Professor Anthony Glees of the University of Buckingham claimed three years ago in a report for the Centre for Social Cohesion that the Saudi government and other private sources had been systematically focusing funding on Islamic and Middle Eastern studies departments that were most critical of western foreign policy, distorting scholarship. In the US, the foundation of a chair in economics by the former Enron boss Ken Lay at his alma mater turned into a nightmare for the University of Missouri. It was unable to find an appropriate candidate to fill the chair for several years, during which time it became a standing joke: the head of the economics department at the time said "It's not like it's the Osama bin Laden chair." In fact, other members of the Bin Laden family donated substantial sums to Harvard and Tufts University in the 1990s. So how can universities avoid embarrassment? One answer is of course to be extremely cautious about whom they deal with. But that is easier said than done when global politics changes fast and when austerity requires ever more fundraising from external sources. The LSE student union has called for "changes in the transparency" of future dealings and suggests establishing "a set of standards and a process of democratic decision-making, with student representation, that determines whether the school accepts money from controversial donors". Dr Sally Hunt, general secretary of the University and College Union, says all universities should sign up to institutional codes on ethics and accountability. "A committee with student and staff representation could then be tasked with vetting substantial donations". Nicola Dandridge, chief executive of Universities UK, says: "Of course universities will take into account political and ethical implications when they make decisions." However, she warns: "There are established academic, cultural and business links between the UK and countries overseas and it is essential we continue to engage with them." Retired fundraiser Mike Smithson points out that many institutions have already developed effective mechanisms to examine donations. In the 1990s, Oxford established a committee, which included Lord Butler, the former head of the home civil service, to scrutinise donors. Smithson points out that this group consulted with external bodies, including the Foreign and Commonwealth Office. "Oxford decided to turn down several gifts, based on their advice," he says. However, refusing donations can be difficult. First, donors' reputations are constantly changing in ways impossible to predict. When Lay endowed the chair that bears his name, Enron was voted America's most admired company in a Fortune magazine survey. Gaddafi's decision to end Tripoli's isolation meant that he was no longer viewed as a pariah by the international community, with his son, Saif, seen as a potential moderating influence. Fundraising consultant Adrian Beney, of Iain More Associates, contends that "most of those now complaining about the LSE have been happy to drive around with Libyan oil in their cars". There is also the argument that engaging with donors in countries governed by authoritarian regimes may encourage political reform in those countries. John Sexton, the president of New York University, has defended his institution's decision to establish a satellite campus in Abu Dhabi with $50m (£31m) in funding from the United Arab Emirates on the grounds that NYU will be a "positive change agent". In a recent statement the LSE wryly noted that in 2009 the student union welcomed the donation from Gaddafi's son's charity, stating that: "This is exactly the kind of organisation the school should be associated with – a group struggling for justice under what continues to be, despite reforms, a repressive and brutal regime." Smithson believes that effective fundraising relies on development teams having an entrepreneurial outlook. Consequently, the more conditions imposed on those involved, the less effective any efforts will be. But he says: "The promise of funding can be extremely tempting for cash-strapped university departments. For example, there has been a long and acrimonious debate over whether those involved in cancer research should accept donations from the tobacco industry." Many worry that cuts in university funding are forcing institutions to fundraise more aggressively, and to play down ethical concerns. Glees suggests that any money raised from sources the government considers unacceptable should be deducted from state funding. "I'm thinking in terms of the government saying 'if you accept money from despots, that money will be removed from what the state pays you, ie there will be no financial advantage in accepting money from tainted sources'." He says: "The cuts will make the problem even worse unless the government steps in and stops sharp fundraising practices." It is clear that recent events will lead to soul searching in universities. However, many will say this should not be confined to academia, and that although the LSE's decision to accept Libyan money was a mistake, Whitehall must share some responsibility.