Loans: The legal checklist for supporting enterprise
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Photo: MorganK, Pixabay.
Loans from local authorities to big companies recently made national newspaper headlines. They don’t happen without plenty of checks. Neil Waller and Paul McDermott offers a guide through the legalities.
So, what are the legal issues to consider on any proposed loan to finance private sector activities?
It’s worth reviewing a checklist of the key legal points.
In most cases, any such loans will be funded by the council taking out borrowings, probably from PWLB. Any checklist needs to consider any linked borrowing issues as well.
Does the council have the capacity to borrow and lend?
The introduction of the general power of competence under the Localism Act 2011 gives councils all the same powers that an individual generally has. Was the making of large scale loans to the private sector something Parliament had in mind when introducing this power? Arguably, yes.
The explanatory notes to the Act state that the power may be used in innovative ways, that is, in doing things that are unlike anything that a local authority—or any other public body—has done before, or may currently do.
Further, there is reference in the government’s impact assessment to giving local authorities the power to explore innovative solutions.
Of relevance is whether a council’s purpose was policy driven (i.e. supporting local economic growth) or merely profit driven. If the council’s primary purpose was to profit from the arrangement then arguably the council should have used a subsidiary company as is required by section 4 of the Localism Act.
Has the Council exercised its power to lend for a proper purpose?
The purpose of the proposed loan and the policy reasons underpinning it should be clearly documented. Simply wanting to make a financial return is unlikely to be sufficient.
MHCLG’s statutory local authority investment guidance applies to loans to third parties and permits a loan if the council’s proper purpose was to further local economic growth and other requirements in the guidance— including the security, liquidity and yield principles—are complied with.
Is the proposed transaction prudent?
In carrying out their duties, local authorities are required to have regard to The Prudential Code.
The Code provides that treasury management decisions should be “taken in accordance with good professional practice and in full understanding of the risks involved”, risks should be “managed to levels that are acceptable to the organisation” and councils should “avoid exposing public funds to inappropriate or unqualified risk”.
The Code also provides that local authorities should not enter into financial arrangements which serve no direct policy or treasury management purpose.
Could a council be in breach of its fiduciary duty to taxpayers?
A local authority has a fiduciary duty to look after the funds entrusted to it and to ensure that their taxpayer’s money is spent appropriately.
A council may be in breach of this duty if it makes an unduly risky lending decision.
Is the proposed lending irrational or wholly unreasonably?
According to the leading case in this area, this concept applies to any decision taken by a local authority which is “…so outrageous in its defiance of logic, or of accepted moral standards, that no sensible person who had applied his mind to the question to be decided could have arrived at it.”
Whilst this is generally regarded as a pretty high bar, it should be borne in mind that a review of an authority’s decision to lend will be undertaken with the benefit of hindsight, and if a loan investment has gone badly wrong then this concept may come into play.
This is particularly the case if a council can be shown to have taken into account irrelevant matters and, or, failed to consider relevant matters when making its lending decision.
Have the proper procedures been observed?
A local authority must follow its own procedures. Any relevant procedures of the council’s constitution must be observed and, if relevant decision-making powers are delegated to a particular officer, most obviously the section 151 officer in this context, a decision made under those powers must be taken by that officer.
Is the related borrowing within PWLB criteria?
As a result of last year’s changes, PWLB borrowing is no longer available to support the financing of an investment asset bought primarily for yield. In our view, the making of a long-term loan financed by PWLB borrowing would likely be viewed in the same way if it were made primarily for reasons of financial return.
There may be similar issues even if the proposed loan is funded by borrowing from other sources as PWLB have recently clarified that they will not refinance loans taken out after 26 November 2020 which are used to acquire assets primarily for yield.
Furthermore, if any such loans are taken out, this will restrict the authority’s ability to access PWLB lending during the then current financial year.
Has the council done its “due diligence”?
Whilst not a separate legal ground for challenge, if a council has not taken steps to satisfy itself as to the creditworthiness of the proposed borrower and, or, the viability of the proposed project, it lays itself open to a claim of irrationality or breach of fiduciary duty and may be in breach of the Prudential Code.
A council should be able to demonstrate that it has taken the same sort of steps that a reasonably prudent lender would have done.
There should be a robust business case approved in accordance with proper procedures and the progress of the council’s investment should be kept under regular review.
If the Council does not have the requisite expertise to do all this itself then external advice should be obtained.
Subsidy
It should be clear whether or not any proposed loan is to be made on market terms and, if it isn’t, the basis on which the council is making a subsidy available. If lending on market terms, external advice on the proposed interest rate and other key commercial terms is likely to be required.
Neil Waller and Paul McDermott are partners at law firm Trowers and Hamlins.
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