The effects of a s.114 notice on third party contractors

Tom Knox looks at the potential impact on contractors where a local authority issues a section 114 notice.

On 19 September 2023, Michael Gove, the Secretary of State for Levelling Up, Housing and Communities, announced in Parliament that he was satisfied that Birmingham City Council was failing to comply with its ‘best value duty’ in accordance with the Local Government Act 1999. This came as a result of the severe financial issues raised in the Council’s section 144 notice (issued under the Local Government Finance Act 1988 (the ‘Act’)).

As part of the intervention package, Gove announced that the government proposed to:

• issue statutory directions to the Council;
• appoint commissioners to oversee the Council’s financial recovery plan; and
• launch an inquiry to determine how the Council came to acquire such a significant budgetary deficit and explore how the Council could become more financially stable.

On 5 September 2023, Birmingham City Council’s Chief Finance Officer issued the s.114 report under section 114(3) of the Act because they were of the opinion that it appeared that the expenditure of the authority in the 2023/24 financial year exceeded the resources available to the Council. More particularly, the Chief Finance Officer was of the view that the Council’s current projected deficit was £87 million for the 2023/2024 financial year and projected that the Council’s potential liabilities from its obligation to pay equal pay claims was in the region of £650 million to £760 million.

Birmingham City Council is by no means the first local authority to issue a s.114 report in recent years, however, its reasons are more specific to its current situation (equal pay claims and mass IT failures). There is more on this at the article at here.

Local authorities have come under heightened financial pressure from an increase in the costs of fulfilling their statutory and contractual obligations as well as a reduction in their real term spending power. This has come about as a result of many factors, including but not limited to: the Covid-19 pandemic; inflation; a rise in demand for local services; a reduction in government funding that local authorities receive; and increasing energy costs. Due to this enhanced financial pressure, there has been a substantial increase in the number of local authorities issuing s.114 reports including Nottingham City Council and Thurrock Council.

On the face of it, the above situation might be construed as Birmingham City Council declaring insolvency and/or bankruptcy. However, local authorities, unlike companies or individuals, are not subject to general bankruptcy or insolvency rules (such as the insolvency regime under the Insolvency Act 1986). The issuing of a s.114 report is not a declaration of insolvency – it is instead more akin to a ‘warning’ that the local authority expects it will not have sufficient funds to meet its legal obligations. A s.114 report obliges the local authority to take certain actions to rectify its poor financial situation.

So what happens when a local authority is struggling to meet its financial obligations?

What effect does a s.114 report have on a local authority’s ongoing expenditure and actions?

Where a s.114 report is issued pursuant to s.114(3) of the Act, s.115(6) of the Act prevents the authority from entering into any new agreement which may involve the incurring of expenditure (at any time) by the authority unless it is to fulfil a statutory obligation or the chief finance officer authorises the local authority to do so (and can only give such authority in limited situations conferred by section 115(6A)).

As well as a spending freeze, a s.114 report acts to encourage the local authority to reduce liabilities where possible. S.115(2) and s.115(3) of the Act require a local authority to hold a meeting within 21 days of the issuance to discuss the actions that it will need to take and agree a response to the issues raised in the s.114 report.

How do local authorities escape the spending freeze imposed by the s.114 report?

There are a number of ways in which a local authority may try to ‘re-balance the books’ to escape the s.114 payment freeze. A local authority may, amongst other things:

• choose to implement effective spending control measures;
• reduce or cut some of its non-essential services to reduce its level of expenditure;
• sell off some of its assets; and/or
• increase income tax to raise additional funds.

Whilst speculative at the time of publishing this article, it is possible that Birmingham City Council will have to implement all of the above, including a sale of substantial assets in order to fund its liabilities under its equal pay claims.

What about financial assistance?

A local authority may also receive financial support or a ‘bailout’ from the government, particularly where its liabilities are substantial. As a previous example, Thurrock Council, who issued a s.114 report on 19 December 2022, have been given provisional financial support from the government on the condition that, amongst other things, Thurrock Council develop an improvement and recovery plan and make progress in ensuring that the Council’s capital, investment and treasury management strategies are sustainable and affordable.

Gove’s recent announcement concerning Birmingham City Council suggests that a combination of statutory directions and the use of appointed commissioners to oversee Birmingham City Council’s financial recovery will be implemented before any such bailout is considered.

Does a s.114 report have an effect on a local authority’s obligations under existing contracts?

There is no requirement under statute for a local authority to terminate or amend existing contracts in order to avoid expenditure. The prohibition on entering into agreements is limited to entering into ‘new agreements’ that may incur expenditure. As such, a s.114 report does not affect or impact upon a local authority’s obligations to pay its liabilities to third parties under existing agreements in contractual arrangements.

Are contractors’ rights under existing agreements with a local authority that has issued a s.114 report reasonably well protected?

There is no statutory provision that allows a local authority that has been issued with a s.114 report to modify contractual terms of existing obligations and a local authority will be bound by its contractual obligations.

However, where a s.114 report has been issued, a local authority may look to exercise any unilateral suspension or termination rights under the existing terms of a contract where said termination or suspension will save costs.

Where an existing contract provides a local authority with rights under a contract (for example, a renewal of term provision or an additional purchase of services), the s.114 report will prevent the local authority from exercising that right during the freeze period.

Further, whilst a local authority is not subject to the insolvency rules, a wholly owned company of the local authority will be subject to the normal insolvency rules. This is a company like any other. This company would only be subject to the insolvency rules if it (itself) became insolvent. Contractors who have existing contracts with such wholly owned companies should therefore keep those contracts under close review and consider their rights under the contract should the wholly owned company become insolvent. Further cash injections into a wholly owned company are unlikely to be made where an authority is struggling to make ends meet.

How does central government intervene when a s.114 report is issued? And how might this affect contractors’ rights under existing contracts?

As made clear above, the Secretary of State for Levelling Up, Housing and Communities) has certain powers under sections 15(5) and 15(6) of the Local Government Act 1999 to instruct local authorities to undertake certain actions where the Secretary of State considers it necessary or expedient for the local authority to comply with its ‘best value duty’ under Part I of the Local Government Act 1999.

These powers have not been used frequently in the past highlighting the gravity of Birmingham City Council’s financial situation. The powers are very wide in nature and allow the Secretary of State to direct a local authority to undertake any action they see fit.

Whilst there is no previous precedent of such an occurrence, in theory, the Secretary of State could order the local authority to undergo a restructuring and not transfer the local authority’s liabilities to the newly structured entity. This is of course theoretical and very unlikely, however, given the increasing number of local authorities that are issuing section 114 reports, it is possible that such an action might be taken in future.

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