Helen Randall: Spin-outs and the legal lessons for success

Spin-outs have become a popular option for councils looking to cut costs and boost income. Helen Randall explains that care needs to be taken to avoid legal pitfalls.

Most public authorities are considering spin-outs, to generate revenue and make savings. A warning: whilst every politician likes success, the media are quick to criticise when the public sector has to bail out a failing enterprise using taxpayers’ money.

A  spin-out is where an organisation decides to externalise part of its operations into a separate legal entity to make profits from services and insulate itself from risk.

Although local authority spin-outs began in the nineteenth century, they re-emerged in the 1980s to address compulsory competitive tendering and then the austerity drive. Abolition of revenue support grant gave them fresh impetus as an option to generate income and save money.

An enormous range of services have been transferred into spin outs including adult social care (Tricuro and Optalis); leisure (Greenwich Leisure trading as Better); education (3BM, EPIC and Octavo), property development and housing (Breckland Bridge and Red Door); regulatory services (Broste Rivers); regeneration (RE Limited). Some long established spin-outs like Capita, Prospects Services and QinetiQ are now major companies.

Minimise failure

As public sector spin-outs are not a new phenomenon, there are some useful lessons to apply to maximise success and minimise the possibility of failure.

When designing a spin-out, do consider upfront what return on investment (ROI) you want. From a legal perspective, this is an essential Wednesbury consideration and informs what type of entity to establish.

The ROI is influenced by the funding source. This should be detailed in the business case forming the basis underlying the decision to spin out.

If the authority intends to invest its own funds, or use PWLB funding, then it must stay within state aid rules to prevent legal challenge resulting in a fine for the local authority and mandatory clawback of the aid with interest potentially resulting in insolvency.  Do consider state aid at the outset of funding options to deploy any exemptions to their full advantage.

If the spin-out is to have free rein outside the procurement rules, then it should be carefully constituted and operated to have an entirely commercial character.  If the spin-out is a body governed by public law, it will need to comply with the procurement rules when purchasing.  The spin-out can benefit from the Teckal exemption so it does not have to tender for work from its shareholding parent authority.

Although the Teckal turnover threshold on trading with external customers is below 20%, it is a mistake to let the “Teckal tail wag the spin-out dog”.  The spin out should be a viable business proposition without having to rely totally on dowry contracts from its shareholding authorities.

Although many public sector spin-out models trade under the Teckal exemption do not be complacent.  Soon an over-confident public sector trading company will be challenged for flouting the procurement or state aid rules and you do not want to be the test case.

There are now clear powers for local authorities to form companies and to invest.  Powers to form other vehicles such as limited liability partnerships are less clear, albeit there are potential tax advantages. Getting the power right will give the spin out a solid legal foundation able to withstand an investor’s or customer’s due diligence

There are numerous types of entity for a spin out: companies limited by shares or guarantee, community interest companies, community benefit societies, mutuals, charitable incorporated organisations, trusts, LLPs, limited partnerships and unincorporated associations.

People can understandably be attracted by names but each vehicle has distinct legal and operational constraints. So, do think about function including the business plan and desired ROI, before choosing the form. An unsuitable legal structure will frustrate your objectives and hamper future growth. It is tricky to dissolve a company limited by guarantee and re-establish as a company limited by shares.

Boardroom

Before deciding who should be on the board, the individuals should understand the full extent of their personal legal and operational responsibilities.

How will they reconcile potential conflicts of interest between the duty to their authority and their duty to act in the interests of the company and all its shareholders (or its creditors should the company get into financial difficulties)? As directors they will need to keep abreast of the spin out’s financial status and its operations including compliance with health and safety, environmental, employment and other legislation and how business risks are being managed. Board training can be invaluable.

Staff motivation is key to a spin-out’s future success but even if TUPE applies, modernising terms may help profitability and safeguard their future. If so, ensure the business case does not inadvertently provoke employee claims. Assess the pensions liability early to consider appropriate risk-sharing.

You can protect the business through registering intellectual property rights but an insufficient trademark will not work so get expert advice.

But the good news is that many spin-outs from the public sector have been very successful because the set-up was sound, the management was astute and the staff passionate about keeping customers happy. It can be done.

Helen Randall is a partner at Trowers & Hamlins LLP.