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Why the revised Prudential Code matters to monitoring officers

Monitoring officers need to make sure they are fully aware of the changes being introduced through the revised 2022 Prudential Code for Capital Finance in Local Authorities, writes Paul Feild.

In an article for Local Government Lawyer in May 2021, I covered the implications for local government practitioners of two recent Public Interest Reports (PIR) under section 24 and Schedule 7 of the Local Audit and Accountability Act 2014 (2014 Act) relating to Croydon Council and York City Council.

I made the point that Schedule 7 Paragraph 1 places a duty on a local auditor to consider whether in the public interest, they should make a report on any matter coming to their attention during the audit. It is a very wide scope for the local auditor; a sympathetic view is that effectively if a matter crops up in the audit, then the auditor can write about it. Schedule 7 Paragraph 2 enables a local auditor to issue written recommendations to the authority relating to the authority or entity connected with it, so that the recommendation may be considered. Publicity must be given and as well as sending a copy to the authority a copy must be sent to the Secretary of State. Furthermore, the auditor’s reasonable costs in preparing the report must be paid for by the authority.

I further observed that the legal advisor is coming under closer examination by auditors, for example as happened in York City Council. Financial regularity is also a matter of legality.

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The Prudential Code

The Chartered Institute for Public Finance (CIPFA) is the recognised accountancy professional body for public finance. Their guidance on local authority accounting practice goes beyond suggested best practice, it effectively takes the form of being obligatory. CIPFA have produced a practice guidance being the Prudential Code for Capital Finance in Local Authorities (the Prudential Code) 2017. This underpins the system of local authority capital finance. It has just been revised and after consultation which finished in November 2021 is expected to be issued sometime in December 2021 or January 2022.

The Prudential Code matters because local authorities are required by regulations to have regard to the Prudential Code when carrying out their duties in England and Wales under Part 1 of the Local Government Act 2003 (2003 Act) and by regulations 2 and 24 of the Local Authorities (Capital Finance and Accounting) (England) Regulations 2003 No 3146 as amended.

We also need to take note of section 15(1) of the 2003 Act. This provides that the Secretary of State for Levelling up, Housing and Communities regarding capital finance may issue guidance which the Local Authority shall have regard to. Guidance has been issued and the key document is the 2018 Statutory Guidance on Local Government Investments (3rd Edition) and is effective for financial years commencing on or after 1 April 2018. It is also worth noting that the section 12 (b) power to Invest in the 2003 Act refers to the ‘prudent management’ of its financial affairs.

So there is an established framework set out in legislation backed by regulations and guidance which inter alia requires the local government financial administration to have regard to their accountancy professional body. In addition, what the professional accounting guidance says about prudential capital finance is clearly part of defining what would be a prudent management of local authority financial affairs.

It is also to note that the CIPFA accountants e.g., Chief Finance Officers (section 151 Local Government Act 1972) as regulated professionals, must by law, ensure compliance with the duty to have regard to CIPFA’s codes. CIPFA observes that departure could be grounds for concerns to be raised with the institute’s independent regulation and disciplinary scheme.

What’s new about the new 2021/22 Prudential Code?

The proposed changes have caused concern for some authorities. It has not received universal approval as for example in the finance officer’s forum Room 151 [i]. The Chief Executive of CIPFA has written in Public Finance about the changes and I set out what the implications are, more of shortly.

Why this matters, is that the new Prudential Code will shortly be issued, and some current capital finance practices operated by some local authorities may be acting contrary to it.

Furthermore, as the 2018 guidance makes clear the Investment / Capital Management Strategy must be approved by full Council on an annual basis before the start of the financial year to which it applies. So local government lawyers across the land can look forward to the draft reports soon. As mentioned above the local auditors are empowered to make a report in the public interest and if there are items of concern they are bound to ask to look at a local authority’s current and proposed Capital Management / investment Strategy.

We have already seen this happen with Croydon Council under the current Prudential Code. Grant Thornton (GT) [ii] on 23 October 2020 published a Public Interest Report regarding the London Borough of Croydon.

GT said Croydon had increased the level of borrowing (£545m in three years) and used the monies to invest in its own companies and to purchase investment properties. The auditor noted that the investment strategy for investing in properties while it was approved at full Council had been subject to a form of guillotine procedures meaning there was insufficient time to discuss and challenge the strategy. GT considered that Croydon Council’s approach to borrowing, and investments exposed the Council and its taxpayers to significant financial risk. Their opinion was there had not been appropriate governance over the significant capital spending and the strategy to finance that spending.

Croydon Council’s Public Interest Report happened under the 2017 Prudential Code, so what changes in the proposed Prudential Code? Let’s look at the change:

The 2017 Prudential Code says:

(Para 45)

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. Authorities should also consider carefully whether they can demonstrate value for money in borrowing in advance of need and can ensure the security of such funds.

The Revised 2021 Prudential Code says:

[Para 45 is now Para 49 and onwards]

Authorities under legislation can borrow and invest for the following purposes:

  • Any function of the authority under any enactment.
  • For prudential financial management.

[now Para 50]

The Prudential Code considers legitimate examples of prudent borrowing to include:

a) financing capital expenditure primarily related to the delivery of a local authority’s functions

b) temporary management of cash flow within the context of a balanced budget

c) securing affordability by removing exposure to future interest rate rises

d) refinancing current borrowing, including replacing internal borrowing, to manage risk or reflect changing cash flow circumstances.

[now Para 50]

The Prudential Code determines certain acts or practices that are not prudent activity for a local authority and incurs risk to the affordability of local authority investment:

  • An authority must not borrow to invest for the primary purpose of commercial return.
  • It is not prudent for local authorities to make any investment or spending decision that will increase the CFR, and so may lead to new borrowing, unless directly and primarily related to the functions of the authority and where any commercial returns are related to the financial viability of the project in question.
  • These principles apply to prudential borrowing for capital financing, such as externalising internal borrowing for the primary purpose of commercial return.

[Now Para 51]

The UK government’s rules for access to PWLB [Public Works and Loan Board] lending require statutory chief finance officers to certify that their local authority’s capital spending plans do not include the acquisition of assets primarily for yield. This reflects a view that local authorities’ borrowing powers are granted to finance direct investment in local service delivery (including housing, regeneration and local infrastructure) and for cash flow management rather than to add gearing to return-seeking investment activity. Since:

a) access to the PWLB is important to ensure local authorities’ liquidity in the long term, and

b) gearing investment always increases downside risks

local authorities should not borrow to finance acquisitions where obtaining commercial returns is a primary aim.

So, the revised Code at Para 50 says no borrowing to fund commercial investments is permitted. The use of ‘must not’ is unequivocal. Most local authorities don’t borrow to acquire income producing assets, but what about those that do?

Well, it will no longer be capable of being prudent and clearly any fresh activity will not be prudent and contrary to the 2003 Act because it will be contrary to the revised Prudential Code. This activity is likely to be picked up by the local audit. They are bound to highlight it because of the risk.

This raises the question as to what do authorities do about current investments which have been funded by borrowing for the purpose of yield?

If the authority can prove by a robust audit trail that the borrowing was primarily rooted in the function of the function it was borrowed for, then there is a defendable position i.e., section 12(a) 2003 Act and Para 49 of the new Prudential Code.

The Chief Executive of CIPFA Rob Whiteman in Public Finance explained the new code will be introduced softly and that there is therefore no need to rip up existing strategies for 2022-23. Nevertheless, CIPFA suggests priority should be given to implementation of key risk management tools. CIPFA will expect full implementation by 2023-24.

The reality is CIPFA is making a subtle nudge to local authorities to move out of such investments and if possible, asap. Of course, this is easier said than done. Say everyone wanted to leave at the same time then it would hit the residual value of the holdings even if there is the possibility of exit. Furthermore there may be a cost in penalty fees for early termination. Worse still, rapid removal of funding may jeopardise the investment itself if is in a pooled fund for example.

It is suggested that the Prudential Code can be supplemented by ensuring that all the risks are considered within a Liability Benchmark. However, this tool is set for the local authority by itself and is not an inter-authority measure. Evidence would be needed that the Liability Benchmark was objective. In any event a Liability Benchmark cannot make an investment made from borrowed funds prudent unless it is compliant with section 12(a). The best it can do is provide some accountability for retaining as it were ‘a non-compliant to paragraph 49 investment’ from which the local authority cannot exit.

What to do

The first step is to ensure that an accurate picture is established regarding local authority investments and ensure that they continue to be compliant with the revised Prudential Code. The local authority’s Investment and Capital Management Strategy must be reviewed and amended to ensure compliance. If the revised code comes out in this December 2021 or January 2022 an attempt should be made to update the strategies for the 2022 financial year.

With regard to the existing investments which would appear contrary to the revised Prudential Code, then advice must be sought as to the exit options.

There are further considerations. What if a local authority has a portfolio of income producing investments which were acquired through a loan? It could be said that this was (tentatively) permitted by section 12 (b) 2003 Act. The wording is:

12 Power to invest E+W

This section has no associated Explanatory Notes

A local authority may invest—

(a) for any purpose relevant to its functions under any enactment, or

(b) for the purposes of the prudent management of its financial affairs.

Looking at the new paragraph 49 of the revised code it reflects section 12 of the 2003 Act. Further the existence of section 12 (b) implies that there is an investment power wider than section 12 (a) but that it should be for the prudent management of its financial affairs. But it is hard to see what CIPFA says is not prudent, can be prudent for the purpose of section 12 (b) 2003 Act. The implication is the revised Prudent Code has changed the interpretation of the ability to use the section 12 (b) power.

The message about giving some latitude for financial year 2022-23 is no more than common sense in that the capital management / investment strategy is expected to be agreed before the year it comes into effect and as the code has not been published, this means that 2023-24 is effectively the first year of the new Prudential Code for investments.

But once the revised Prudential Code is published, local authorities with non-compliant investments will be under pressure to divest themselves on the said investments. For some authorities that investment will have been producing income which may be necessary to balance the finances. If that stops then some authorities will find themselves in a double crisis in that the investments which help bridge their income gap may have to be sold at under value or may not be alienable at all and their income goes down too.

Section 114 (3) Local Government Finance Act 1988 (1988 Act), provides:

“The chief finance officer of a relevant authority shall make a report under this section if it appears to him that the expenditure of the authority incurred (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”.

Closing down the borrowing to invest option may push more authorities toward a section 114 1988 Act notice being issued. Furthermore there is the intriguing possibility that if contrary to the Prudential Code the authority kept hold of the investment then either section 114 (2) / 114A(2) could apply in that holding the investment could be imprudent and thus unlawful.

Summary

In this feature I have shown that the CIPFA Prudential Code is effectively applied by law and that the somewhat fluid question regarding legality of borrowing solely to invest in income producing assets is no longer equivocal, it is now outlawed and will be contrary to the Prudential Code and thus imprudent.

Investments funded by borrowing unconnected with a local authority’s functions can have no place in authorities' Investment Plans or Capital Management Strategies. These policies must be approved on an annual basis by full Council.

Borrowing and investment strategies and practice are liable to be picked up by the local auditor because they will all be out looking for them. As compliance with the Prudential Code is a legal requirement, non-compliance will be the business of the Monitoring Officer as well as the Chief Finance Officer.

Merry Christmas and a Happy Municipal Financial New Year.

Dr Paul Feild is Senior Standards Solicitor working in the Barking & Dagenham Legal Practice Governance Team. He has been a deputy Monitoring Officer on and off for various public authorities for twenty years. His 2015 Doctor of Business Administration thesis was ‘How does Localism for Standards Work in Practice? The Practitioner’s View of Local Standards Post Localism Act 2011’. He researches and writes on governance issues and can be contacted by email.

References

Local Government Act 1999

Local Government Act 2003

Local Government Finance Act 1988

Localism Act 2011

Local Audit and Accountability Act 2014

Statutory Intervention and Inspection- A guide for local authorities 2020 - Ministry of Housing, Local Government and Communities

London Borough of Croydon - Report in the Public Interest concerning the Council’s financial position and related governance arrangements - Grant Thornton 2020

CIPFA – Draft Prudential Code for Capital Finance in Local Authorities 2021

Rob Whiteman – Public Finance 16 November 2021

Room 151

[i] A Joke on room 101 in the novel 1984 – For S.151 officers their greatest fear was?

[ii] Who were the Auditors for Nottingham City Council (Robin Hood Energy)

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