Prudential Code brings ‘clarity’ to investment strategies

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New guidance from CIPFA has been hotly debated. Scott Dorling offers a lawyer’s guide through the new Prudential Code.

The revised CIPFA Prudential Code for Capital Finance in Local Authorities was issued on 20 December 2021. It has provided clarity on a number of matters, and assuages concerns about the potential forced sale of local authority commercial investment properties.

Section 2 of The Local Authorities (Capital Finance and Accounting) (England) Regulations 2003 requires local authorities to have regard to the Prudential Code when complying with the duty under section 3 of the Local Government Act 2003—the duty to keep under review how much it can afford to borrow.

Prohibition

For many years the code has suggested a prohibition on borrowing by reference to the terminology of borrowing “in advance of need”. There was some potential confusion arising from statements in the previous code and other relevant guidance.

The previous version of the code provided that local authorities must not borrow more than, or in advance of, their needs purely in order to profit from the investment of the extra sums borrowed.

However, the code acknowledged that borrowing in advance of need could take place as it suggested that authorities should also consider carefully whether they could demonstrate value for money in borrowing in advance of need and could ensure the security of such funds.

The current Statutory Guidance on Local Authority Investments, issued pursuant to section 15 of the Local Government Act 2003, similarly “prohibits” borrowing “in advance of need” purely in order to profit from the investment of the extra sums borrowed.

As the code and the guidance are not themselves legislative prohibitions – they are matters that local authorities “must have regard to”. The statutory guidance acknowledges that some local authorities may nonetheless borrow in advance of need purely to profit from the investment. If they do so, their investment strategy should explain why the local authority has taken the course of action and the local authority’s policies on risk management.

The 2021 version of the code does not introduce any new prohibitions in relation to borrowing. But, helpfully, it removes the “advance of need” terminology and emphasises the legislative basis for borrowing, namely that a local authority can borrow and invest for any legislative function and/or for the prudent management of their financial affairs.

The examples listed in the Code of legitimate prudential borrowing are:

• Financing capital expenditure primarily related to the delivery of a local authority’s functions;
• Temporary management of cash flow within the context of a balanced budget;
• Securing affordability by removing exposure to future interest rate rises; or
• Refinancing current borrowing, including replacing internal borrowing, to manage risk or reflect changing cash flow circumstances.

Investing for return

The new code includes a clear and unqualified statement that a local authority must not borrow to invest primarily for financial return.

Most local authority borrowing will be via the Public Works Loan Board (PWLB, or more accurately the UK Debt Management Office). The rules for accessing PWLB borrowing were changed in 2020 to require a chief finance officer’s certification that their local authority’s capital spending plans do not include the acquisition of assets primarily for yield.

While the code refers to investments primarily for a “financial return” and the PWLB access rules refer to investments primarily “for yield”, we believe this is a distinction without a difference.

22 March 2022
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What does this mean for local authorities who have borrowed to invest in yield bearing commercial assets? The code sets out some very useful guidance in this regard:

53. Authorities with existing commercial investments (including property) are not required by this Code to immediately sell these investments. However, Authorities which have an expected need to borrow should review options for exiting their financial investments for commercial purposes in their annual treasury management or investment strategies. The options should include using the sale proceeds to repay debt or reduce new borrowing requirements. They should not take new borrowing if financial investments for commercial purposes can reasonably be realised instead, based on a financial appraisal which takes account of financial implications and risk reduction benefits. Authorities with commercial property may also invest in the repair, renewal and updating of their existing commercial properties.

The code does not require the sale of commercial assets. As one would expect, it suggests that commercial investments (presumably only those acquired primarily for yield) should, where the local authority has a need to borrow, be subject to an on-going review to consider exit arrangement, taking into account the financial implications and risk implications of doing so. That would be what a prudent investment strategy should consider in any event.

Scott Dorling is a partner and head of public sector at law firm Trowers & Hamlins.

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