Out-Law Legal Update
Director's attempt to defraud bankrupt's creditors was fraudulent trading: High Court
Out-Law Analysis | 20 Aug 2018 | 10:27 am | 13 min. read
Northamptonshire County Council has recently faced exactly this question, declaring itself to be facing unlawful overspend meaning that it is, in effect, insolvent. Other local authorities are reducing services to avoid a similar fate.
According to the National Audit Office (NAO) there has been a real-term reduction in government funding for local authorities of 49.1% since 2010/2011. Even the richest county, Surrey, is more than £100 million in debt, having used up its financial reserves and with no viable plan for the future. Social care continues to be the main drain on resources as 66.2% of local authorities with social care responsibilities were forced to use their financial reserves in 2016/17.
An NHS Digital study found that annual spending by local authorities on social care rose by £556m in 2016/17 to £17.5 billion. This constitutes a 1% increase in real terms and a 3.3% increase in cash terms, showing that the cost of care has soared far higher than the rate of inflation. Not only are more families having to fund social care themselves, but local authorities received 1.8 million requests for help in 2016, a figure which keeps rising.
This pressure is unlikely to be alleviated. A report by the King’s Fund found that the combination of increasing life expectancy and the ageing of those born in the baby boom means that the population aged over 65 is growing at a much faster rate than those under 65. Over the next 20 years the population aged 65-84 will rise by approximately 39% and those over 85 by approximately 106%.
It has also been estimated by the NAO that if local authorities keep draining their reserves at the current rate, one in 10 will have exhausted these reserves in three years’ time. Councils have expressed their need for more money as they face a 'cliff edge' which could culminate in a funding gap of £5 billion by 2020.
An example of the pressure felt by local authorities is demonstrated by Northamptonshire County Council (NCC). In February 2018 NCC declared that it faced an unlawful overspend and was, in effect, insolvent. For the first time in nearly 20 years all new spending, except on vulnerable people, was put on hold. This led to the recommendation that NCC should be dissolved and prompted the resignation of the council leader. NCC has since been criticised and a government-commissioned report has described its approach as “sloppy, lacking in rigour and without challenge”.
NCC’s chief finance officer prepared a report under Section 114 of the Local Government Finance Act 1988 (s114 Notice). The report confirmed that NCC had faced serious financial problems for some years and provided an indication to central government that it was at risk of breaking the law by spending more than its income. The report highlighted that NCC faced an overspend of £21.1m for the 2017/18 financial year and that the new purpose-built council headquarters should be sold in order to raise vital funds. In July 2018 a second s114 Notice was issued and emergency spending controls imposed once again with an updated action plan to fund a revised estimated £60-70m budget shortfall. NCC's new budget recovery plan includes extended controls on spending, property rationalisation and the creation of a transformation task force to identify cost reductions in line with the council’s agreed priorities.
Although NCC is the only council reported to have considered a s114 Notice during the current funding crisis, it seems unlikely to be the last.The NAO has warned that as many as 15 councils could become effectively insolvent over the course of the next few years. Whilst Torbay council has not issued a section 114 notice this August it called a stop to non-urgent spending in light of financial pressures forecasting an overspend of more than £2.8m.
Local authorities in England and Wales are divided between billing local authorities, which bill and collect council tax, and precepting authorities such as county councils, which issue a precept to a billing authority to collect council tax on their behalf.
Authorities have traditionally had five main sources of funding:
There have been calls from within local government for central government to issue more advice for councils in financial hardship, specifically on the reorganisation of councils. The chief executive for Dorset, who is responsible for the restructuring of its local councils, has urged more of his colleagues to be “brave” and drive debate about restructuring.
An obvious move, available to all local authorities, is to cut costs. In a Local Government Information Unit survey of England and Wales more than 40% of all councils anticipated making “cuts in frontline services, which will be evident to the public” – rising to 71% among social care authorities. The Local Government Association has said that despite the increases to council tax, councils will continue to reduce or close services such as children’s centres, libraries, leisure centres, parks, museums and road repairs in order to plug growing gaps in adult and children’s social care and homelessness services.
The British Medical Journal said that local authorities in England are being forced to prioritise adult social care over other vital services such as housing because of extreme central budget cuts. “The current trajectory for local government is towards a narrow core offer increasingly centred on social care,” said the NAO.
There are also trends for councils to share services. The latest statistics published by the Local Government Association found there are 555 individual shared service arrangements across the UK saving £840m. The most common services pooled include community safety, environmental protection, waste, finance, management, property and IT. This has been particularly evident in Somerset, with a number of councils merging a variety of services.
The leader of the Dorset restructuring process has also encouraged councils to develop technology as the sector is “starting to lag behind” commercial partners. If councils fail to invest in developing the skills and knowledge required to make the most of technology the councils could face an uphill battle. Although advancements in technology may have a large initial outlay they could result in substantial savings in the long run.
Another option available to councils is to follow the Dorset merger model. In February 2018, it was confirmed that the secretary of state for communities and local government had approved the proposal to create two unitary authorities out of the nine local councils. The decision to merge was largely supported by the councils; however, it will be likely to lead to significant job losses.
The new structure aims to save £108m over six years and could come into effect in April 2019, assuming that parliamentary approval is granted. It has been suggested by consultancy Ernst & Young that creating 27 unitary authorities in England could save up to £2.9bn.
However, there is debate over the wisdom of this action. It could distract authorities from delivering savings and ambitious devolution deals; councils could be split differently from their local policing unit and NHS trusts; it could result in friction and tension between councils, and it could lead to confusion for service users. Following the Dorset proposal the government has also suggested that similar plans might be put forward for Buckinghamshire and Northamptonshire. However, it will not be plain sailing – as can be seen by Christchurch’s plans to challenge the Dorset decision.
Councils also might try to focus on commercial solutions. The London Borough of Hammersmith and Fulham has taken a strategic approach to commercialisation and now has a director of customer and business development to lead this work across the authority. The new model aims to grow the external income streams at the lowest cost possible.
In order to save money, staff at the council have been encouraged to think about how income can be grown by thinking more commercially, rather than constantly focusing on cost cutting. The council has now implemented a sales and marketing plan and has a greater understanding of the profit and loss made by each service offered. The new approach has also involved staff being trained and encouraged to cross-sell other services to customers. For example, the registrar taking requests from people to get married is now offering details of the ceremonial rooms at the council to hold the ceremony as well. The director started in 2010 and in her first year the external income base was grown by 18%, or £800,000.
Before now local authorities have typically turned to the PWLB for long-term financing. PWLB will inevitably continue to play a significant role in providing capital sums; however, it has been suggested that local authorities may now be able to consider alternative sources.
One of the most useful sources of finance are bonds. Bonds have a number of advantages over PWLB finance, which is characterised by being a basic, vanilla product in which authorities borrow at a given rate and repay over a given profile. Alternatively, bonds can be designed to more closely meet the issuing authority’s financing needs. A bond’s repayment profile can better fit the capital project’s income profile. For instance in large infrastructure projects it could require making initial repayments low, then raising them as income from the project started flowing in.
However, the speed and ease of raising finance should also be considered. PWLB is far simpler, cheaper and quicker than listing a bond. Additionally, the credit rating of the local authority would be considered when attempting to issue bonds, which might not be suitable for local authorities in financial difficulties.
There are currently four councils ready to become the first to borrow from the UK Municipal Bonds Agency through a bond issue. The agency is hopeful that a larger second issue might follow, but there are no details available of which authorities are involved in the first issue, the size of the issue, the rates or when it will take place.
Bonds are not the only financing option. Banks have lent to local authorities, typically under long-term loans. Direct arrangements with pension and insurance funds may also be possible, particularly to finance infrastructure in a region. As well as helping the financial longevity of local authorities, it could work well on a localised level, matching the investor and the investee to fund projects that can generate economic opportunities and better meet local needs in the area.
However, any means of raising funds by borrowing or issuing debt instruments must be backed by an authority’s ongoing ability to service and repay such debts. The restriction on local authorities providing security for borrowings, in section 13 of the Local Government Act 2003, also potentially places a limit on how much private finance will be provided.
So what would happen to a local authority which becomes unable to meet its commitments? Is there a prospect of a bankruptcy occurring in the UK, such as happened in Detroit?
In 2013, Detroit filed for protection under Chapter 9 of the US Bankruptcy Code with an estimated US $18-20bn of debt. The governor appointed an emergency manager to help the city negotiate with creditors, insurers, unions and pensioners in order to develop a suitable plan. $7bn in costs was cut and a plan of adjustment was ordered by the court. Five years later Detroit is in the midst of resurgence and significant investment is evident; however, substantial restructuring is still required.
Might this happen in the UK? Should lenders and other creditors of local authorities be concerned and looking to protect themselves?
There is currently no legal framework for the insolvency of a local authority. Local authorities are required by law to balance their budgets and, in theory, can always reduce expenditure and/ or raise additional council tax so they cannot, technically, become insolvent.
However, whilst there is no insolvency procedure, there are a number of measures available where financial difficulties arise. First, once a local authority gets into a position where they believe expenditure is likely to exceed income or a decision or course of action is about to be made leading to unlawful expenditure then, like NCC, they can report to all the authority’s members and notify the external auditors. If no means can be found to finance the expenditure, the chief financial officer (CFO) is required to issue a s114 Notice which bars all new expenditure, except for that which safeguards vulnerable people and statutory services.
Before issuing a s114 Notice the CFO is likely to have formed the view that future expenditure cannot be brought under control, that the authority is projected to end the financial year with a deficit, and that there is no way of brokering a solution without issuing the s114 Notice. Once the s114 Notice is issued, local authorities have a 21 day breathing space, where all new expenditure ceases except that required to deliver statutory responsibilities. A full meeting must be held within that period to consider the notice and council members and auditors should work together to come up with an alternative balanced budget. In the case of NCC the secretary of state for local government appointed independent commissioners to take over the council’s functions associated with governance and scrutiny, appointment of statutory officers and strategic finance.
In addition to the s114 procedure the local auditor also has the power to serve an advisory notice on the local authority if they consider a course of action has been taken which is likely to give rise to a contravention of law or maladministration. This procedure was also followed with NCC when, in February 2018, the council was about to set a budget which the auditor considered would be unlawful.
Any person with a sufficient interest, including tax payers or the secretary of state, could independently seek a judicial review of the decision of a local authority in setting its council tax or refusal to do so.
The secretary of state also has a number of powers to give direction or intervene. These include power under the Local Government Act 1999 (LGA99) which imposes a “best value duty” on local authorities. Failure to set a balanced budget or allowing failure of a service would likely breach that duty, allowing the secretary of state to appoint a person to inspect the local authority’s compliance. Section 15 of the LGA99 allows the secretary of state to impose a range of measures, including directing the authority to take action necessary to meet its best value requirements. Exercise of such powers may also be accompanied by financial assistance from central government. This power was used for NCC leading to the inspection report recommending creation of two unitary authorities in place of the existing structure and imposing commissioners to oversee the running of the Council. Similarly, commissioners have previously been appointed to Doncaster Metropolitan Council in 2010 and Tower Hamlets London Borough Council more recently.
Are these measures of any comfort to lenders or should they be seeking additional protections? To date where authorities have merged or unified into unitary authorities the outstanding obligations and liabilities have transferred to the new body and not been reduced or restricted as part of the process. Comfort can also be drawn from the ability of a lender to appoint a receiver where a debt in excess of £10,000 remains unpaid for two months, even though security cannot be provided by local authorities. The High Court has the power under the Local Government Act 2003 to confer on the receiver power to collect revenues of the local authority or to issue levies or precepts or set and collect council tax.
Local authority members (and officers) are considered to be in a similar position to trustees in respect of the authority’s assets. So in an extreme case, such as a loss being caused to the authority through the wilful misconduct of an officer or member such as a refusal to set a lawful budget, that person might be found to be personally liable to the authority for damages for breach of trust.
Beyond the preventative measures highlighted above and ultimately intervention of central government to appoint others to monitor and supervise, is there a real risk of a local authority becoming in practical if not legal terms insolvent and creditors being left behind? The lack of statutory provision for an insolvency of a local authority and the importance of continuity of local services suggest that ultimately central government would provide funding if required. However, the current crisis may lead to new legislation or new precedents.
Nick Gavin-Brown is a restructuring expert at Pinsent Masons, the law firm behind Out-Law.com
Editor's note 20/08/18: This story previously claimed that Torbay council had stripped its services back to the statutory minimum, which Torbay council has said is not the case. We apologise for the error.
Out-Law Legal Update
Director's attempt to defraud bankrupt's creditors was fraudulent trading: High Court