Council and external auditors at loggerheads over lawfulness of commercial property investment spree

A borough council and its external auditors are in an extraordinary stand-off over the lawfulness of property investments worth hundreds of millions of pounds.

Spelthorne described its external auditor's report as "disingenuous" and "speculative" in a bristling response from the local authority's senior management prepared for a meeting of full council next week (8 December).

In 2016, Spelthorne began pursuing a policy of borrowing money from the Public Works Loans Board (PWLB) to invest in commercial real estate. According to KPMG, by the end of the 2017/18 financial year, the local authority's portfolio was worth over £1 billion.

After auditing the activity, KPMG published a public interest report claiming that Spelthorne's decision to borrow £225m from the PWLB in the 2017/18 financial year to purchase three Heathrow properties situated outside the borough boundary was unlawful because the council did not "possess the necessary legal powers to borrow to then purchase the particular properties".

The public interest report said this was because:

1. Spelthorne could not rely on the “general power of competence” in the Localism Act 2011 “because local authorities acting for a commercial purpose must do so through a company. It did not purchase the properties through a company, rather in its own name.”
2. The council could not rely on the power to acquire land (section 120 Local Government Act 1972), because the purchase of the properties was not for "the benefit, improvement or development of [the authority's] area"; the purchases were simply made for investment purposes (i.e., to make a profit). “Any benefit to the Council’s area (through an increased income) was, and is, too indirect.”
3. The powers to borrow and invest in sections 1 and 12 of the Local Government Act 2003 must be exercised for purposes relevant to the council’s functions (“not relevant here as none were specified or are identifiable”) or for “the purposes of the prudent management of its financial affairs”. “Borrowing in order to invest in the hope of achieving a profit is by its nature a different exercise from the prudent management of financial affairs.”

Additionally, KPMG stated that, even if the council did have the power to borrow and purchase the properties, "it exercised this power unlawfully by failing to have regard to relevant statutory guidance" in the Local Government Act 2003 and the Chartered Institute of Public Finance & Accountancy's Prudential Code for Capital Finance in Local Authorities.

The 2003 Act's guidance recommends the preparation of an annual investment strategy containing policies for the management of the authority's investments. "The Council's 2017/18 investment strategy did not address investments in commercial property or acknowledge it was departing from that guidance, though the Council did adopt Strategic Property Investment Parameters in December 2017 at the same meeting at which it agreed to acquire the third of the three properties in question," KPMG's report stated.

The prudential code states that councils "must not borrow more than or in advance of their needs purely in order to profit from the investment of the extra sums borrowed".

KPMG said: "In our view, this is what the Council did (in this case borrowing more than was required), without any acknowledgement that it was departing from that Code."

According to KPMG, its conclusions were supported by the advice of King's Counsel. However, the auditing firm said that it decided to issue the PIR rather than seek a declaration from the court as the council has since brought its policy of borrowing to invest in commercial property to an end.

KPMG noted that updates to guidance making it clear that local authorities should not borrow more than they need to make a profit, and changes to the terms of borrowing from the PWLB were also factors which led it to decide against court action.

Spelthorne's Chief Executive, Daniel Mouawad, Chief Finance Officer, Terry Collier, and Group Head Corporate Governance, Farida Hussain, have co-authored a report for next week’s council meeting encouraging councillors to agree to KPMG's recommendations.

But the trio pushed back against the claims concerning the lawfulness of the property purchases, noting that the local authority relied on legal advice from James Goudie KC before taking the decisions.

The senior management’s report said the council proceeded with its acquisition of the properties outside the borough on advice from Goudie "to the effect that the acquisition was intra vires".

It continued: "The council's position is that in so doing, it acted wholly reasonably and conscientiously in any event.

"It is somewhat disingenuous and inappropriate that the PIR report only refers to the Auditors King's Counsel's advice at the outset and refrains from referencing the Council's similarly authoritative advice from James Goudie KC, until considerably later in the document."

Spelthorne stated that it has since sought further advice from Goudie on the legal matters raised within the PIR and reported that the KC maintains that he considers the investments made in 2017/18 were lawful and said he is "unpersuaded by the legal arguments made by KPMG in the PIR".

The council also denied KPMG's claim that it did not seek legal advice as to whether the advice applicable to purchases in the previous financial year was equally applicable to the 2017/18 transactions.

Responding to the assertion that Spelthorne's investments were unlawful, the council report said: "To the extent that the legislation and statutory guidance over the intervening four year may lead to more than one interpretation, as appears to be the case here, the Council feels that where the auditors have been provided with the legal advice supporting the Council's interpretation it is not open to the auditors to resolve and declare whether summarily or otherwise, that the Council has acted unlawfully."

In addition, Spelthorne highlighted that KPMG did not raise concerns over the lawfulness of similar transactions in its 2016/17 audit.

Alongside concerns over the lawfulness of Spelthorne's investments, the report also raised concerns over the overall investment approach. The PIR claimed the council lacked a defined investment strategy, its portfolio lacks diversification and has a high asset concentration (with four investments exceeding 80% of the value of the 2017/18 portfolio). It also claimed inconsistencies between the time horizon in the council's financial model, among other issues.

In light of this, KPMG concluded that there are "significant failings" in the council's governance arrangements in making the investment purchases.

In its report, Spelthorne challenged these claims noting that the council has been able to meet its loan repayment commitments from the rental income and has made an average contribution of £10m towards the council's revenue budget as well as making an annual setting aside averaging £7m per annum into Sinking Fund Reserves.

According to Spelthorne, the PIR also "outrightly fails to acknowledge" that the council has put aside £34 million of its rental income into reserves as part of a risk mitigation strategy.

Despite these disagreements, the Spelthorne report agreed with all of KMPG's recommendations. Making a "general point" on the recommendations, the Spelthorne report said: "[This] report has been released more than 4 years after the audit year in question and consequently, we are able to confirm that we accept the recommendations wholeheartedly as we have already been attending to these very matters for some years!"

Adam Carey