The BBC News website recently publish an article with the headline "Council facing bankruptcy over £33.6m funding gap" (Worcestershire County Council facing bankruptcy over £33.6m gap - BBC News). The article concerned the issue of a section 114 report by a local authority with the first line of the article stating that "a council facing a £33.6m funding gap will effectively declare itself bankrupt unless the government allows it exceptional financial support".
Such headlines undoubtedly cause concern not only for local authorities and their residents but also for commercial entities contracting with them – particularly those companies that may be delivering services on their behalf as well as those undertaking major regeneration and development projects.
The headlines could, therefore, serve to stymy economic growth at the local level if, indeed, there is a legitimate concern that local enterprises may be at risk of not getting paid by local authorities for delivering their end of the bargain.
The issue of section 114 reports are also now becoming a common feature of default clauses in commercial contracts featuring local authorities with the consequence that the other party is entitled to terminate the arrangement or require the local authority to transfer its shareholding in a joint venture company where it is the subject of such a report.
Such clauses treat the issue of a section 114 report as tantamount to corporate insolvency but as we have set out below, that is simply not the case.
What is section 114?
A report under section 114(3) of the Local Government Finance Act 1988 is required to be made by a local authority's chief finance officer (CFO) if it appears that the expenditure for the authority (including expenditure it proposes to incur) in a financial year is likely to exceed the resources (including sums borrowed) available to it to meet that expenditure.
It derives from the legal requirement to set and maintain a balanced budget and to provide central government with awareness of whether any intervention may be required.
What are the implications of a section 114 Report?
Where a report is issued under section 114(3) of the 1988 Act, section 115(6) and (6A) of the same Act makes provision prohibiting the authority from entering into any new agreement involving the incurring of expenditure unless the CFO authorises it to do so (and they may only do so to prevent the situation which led to the report being made from getting worse; to improve the situation or prevent the situation from recurring) until such time as the report has been considered by the authority at a meeting of the Full Council and decided what action to take (a 21 day period)).
Is this analogous to bankruptcy or insolvency?
No. The issue of a section 114 report does not, in any way, relieve a local authority from the requirement to fulfil its statutory obligations. It also does not relieve it from any contractual commitments it has already entered into before the report is issued or from the duty to make payments which are due or may become due under that contractual commitment.
A section 114 report is not therefore analogous to bankruptcy or insolvency. Bankruptcy is the term applying to individuals where they have insufficient funds to pay their debts while insolvency occurs in respect of a company where it has insufficient funds to pay its debts as they fall due (or it has more liabilities than assets on its balance sheet). Insolvency processes then create risks for third parties as the company can be liquidated, contracts set aside and any debts not fully repaid.
Local authorities are not subject to these processes and a section 114 report is only an indication that a local authority's expenditure may exceed the income with the aim of ensuring that it can still fulfil all of the statutory services it is required to provide.
If anything then, the issue of a section 114 report is more analogous to a profits warning for a listed company rather than a bankruptcy or insolvency process. It is a sign that a local authority's expenditure is going to exceed its income for that financial year and that it needs to take lawful steps to address this. Such steps do not include choosing not to pay for the supply of goods, services or works that it has already received or choosing not to fulfil its contractual obligations to receive these going forward (although it may seek to renegotiate them).
Proceeding on a sensible basis
It is important that all parties deal with section 114 reports on the correct factual and legal understanding. Interestingly, despite the headline, the aforementioned BBC article later comments that "local authorities technically cannot go bankrupt".
We recommend that both local authorities and commercial enterprises dealing with local authorities think carefully before incorporating provisions into their contracts which treat a section 114 report in the same way as bankruptcy or an insolvency event. These could have unintended consequences and be to the detriment of the interests of all parties. Instead the parties should carefully consider what harm they want to guard against and the steps that can be taken to prevent them occurring. A section 114 report, by itself, should not cause any harm to pre-existing contracts and third parties can take comfort from the fact that local authorities cannot be declared bankrupt or insolvent while taking steps to consider possible impacts of future budget restrictions. It is, however, a sign that a local authority may face difficulty balancing its budget.
Devolution note
Section 114 of the 1988 Act extends only to England and Wales and not to Scotland and there is no duty on a CFO of a Scottish local authority to issue an equivalent report, however there is the ability to produce a similar report which should be treated with respect.
Further reading: https://researchbriefings.files.parliament.uk/documents/CBP-8520/CBP-8520.pdf
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