The Local Government (Contracts) Act 1997 has been awaited with some interest by financiers who wish to fund projects under the private finance initiative which involve local authorities. A review of what the Act does (and does not) do.

United Kingdom
by Christopher St John Smith

This piece of legislation has been awaited with some interest by those financiers who wish to fund projects under the private finance initiative, which involve local authorities. The Act became law on 27 November and the main sections of the Act, namely Sections 2 to 9, came into force on 30 December.

Although the terms of Section 1 of the Act have tended to attract less comment from the banking community than the certification provisions, and the protection accorded by them, sub-sections (1) and (2) provide a useful clarification and reminder of the purposes and limitations of this piece of legislation. Sub-section (1) provides that every statutory provision that confers or imposes a function on a local authority also confers power on that authority to enter into a contract with another party for the provision of assets or services to that local authority for the purpose of enabling the relevant local authority to discharge such function. Accordingly where, for example, a statutory provision imposes a waste disposal function on a local authority this provision now makes it clear that this confers on the local authority power to enter into a contract with some other party for the provision of, dust carts or incineration equipment or a package of waste collection or disposal equipment and collection and disposal services. This express extension of council powers applies to the discharge of all of its functions including education, recreation, public health and even local tax collection.

Sub-section (2) then goes on to make it clear that where a local authority enters into a contract for the provision of assets or services of the type previously described and, in connection with the relevant provision contract, a financier makes a loan, or some other form of finance, available to enable a party (other than the relevant local authority) to finance these arrangements then the local authority can enter into direct contractual arrangements with the financier. A common example of this would be some form of direct agreement giving the financier step-in rights if its borrower should fail to perform adequately under the provision contract. In the view of certain local authorities (and their legal advisors) these sections were not necessary since they believe that existing legislation made it sufficiently clear when local authorities had the requisite power to enter into transactions of this nature. However many within the banking community have not been so sanguine about this issue, especially since the Allerdale and the Waltham Forest judgments in the Court of Appeal. Whatever the merits of the local authorities views on their existing powers, the clarification provided by this Act on this point is helpful. It should however be noted that the terms of Section 1 also effectively describe the type of contract that is protected by the certification and other provisions set out in the rest of the Act. This Act does not therefore apply to all contracts that the parties may enter into with local authorities, but only to contracts for the provision of assets or services that fit within the express terms of the Act as described above and which operate, or are intended to operate, for a period of least 5 years.

Accordingly, this Act does not affect the powers of local authorities to enter into any kind of arrangement other than one expressly referred to in the Act.

In addition, this does not alter the legal regime relating to the power of local authorities to borrow or enter into guarantees or any other type of financial support. It does not alter the position with regards to their basic power to enter into leasing arrangements or any limitations on that power. All of these arrangements are the subject of existing legislative arrangements that are not altered or superseded by this Act. In addition, whilst the terms of the Act are helpful in clarifying the capacity of local authorities to enter into certain types of contractual arrangements that are associated with the private finance initiative, the Act does not avoid the need for careful consideration of a local authority's statutory power to enter into a transaction. That will still need to be considered in order to ensure that a relevant contract does fall within the scheme of this Act and that it will obtain the full benefit of the Act.

Sections 2, 3 and 4 of the Act then go on to set out the terms of a certification procedure for provision contracts of the type already described. Where a contract is certified in accordance with the terms of the Act, then the Act raises a presumption that the contract is within the powers of the local authority and that the local authority properly exercised its power in entering into such contract. In order to obtain the benefit of this presumption, the certification requirements prescribed in Section 3 of the Act must be satisfied within six weeks from the day on which the local authority enters into the relevant contract. The certification process is to be dealt with and controlled by the relevant local authority and satisfaction of the requirements should be easily achieved by that authority provided that it has properly considered the terms of the transaction that it is entering into.

As I have indicated, the certification procedure raises a presumption regarding the local authority's power to enter into a provision contract. It does not conclusively determine the point. In Section 5 of the Act it is made clear that this presumption does not prevent the local authority's power to enter into the relevant contract from being challenged on an application to the courts for judicial review of the local authority's conduct or on an audit review. However, sub-section (3) of Section 5 does now expressly provide that where it is determined that a local authority did not have the relevant power to enter into a certified contract, the court has a clear power to allow the contract to remain in effect if it wishes to do so, having regard to the likely consequences for the financial position of the local authority and for the provision of services to the public by that authority. This is a very useful provision, since in the Allerdale and Waltham Forest decisions, the view was taken by the Court of Appeal that the courts did not otherwise have any discretion as to whether to keep a contract in effect if it was considered to be outside the powers of the local authority. Some commentators have doubted this absolute view of the effect of a lack of capacity and this legislative provision

has now put this issue beyond doubt in the limited circumstances where the courts are dealing with a certified contract.

Section 6 of the Act then goes on to raise a further presumption regarding the enforceability of what are termed "relevant discharge terms" in a certified contract. This applies even in circumstances where on an application for judicial review or an audit review it has been determined that all of the other provisions of a certified contract were outside the capacity of the local authority. "Relevant discharge terms" are essentially terms providing for compensation as between the parties in the form either of compensatory damages or some adjustment of rights and liabilities in respect of the assets or goods to which the provision contract applied. An example of this might be to provide for the payment of certain sums on any early termination of the relevant contract combined with the local authority agreeing to relinquish any further claims in respect of assets provided to it under the terms of the contract. The Act provides that where a local authority has agreed such terms in an identifiable form, those terms (as opposed to any other terms within the contract) shall have effect as if the local authority had power to agree them and had properly exercised that power. However despite the strong terms in which the presumption regarding the effectiveness of relevant discharge terms is put in Section 6(4) of the Act it appears from the terms of Section 7(3) that there still may be circumstances in which a successful challenge may be made to the capacity of a local authority to enter into such terms.

Section 7 sets out what happens if a court on an application for judicial review or an audit review determines that a certified contract should not have effect, due to lack of capacity on the part of the local authority and if such a contract does not contain any relevant discharge terms. Section 7(3) effectively provides that such a contract may not have relevant discharge terms if the court determines that any purported relevant discharge terms do not have effect. Whilst it is not entirely clear when such circumstances would arise some guidance on this was provided in the discussion of this provision in the House of Lords. Certain Law Lords indicated that the circumstances where both the contract and purported relevant discharge terms would both be struck down would be rare and extreme. The examples that they gave included where there had been fraud or corruption used in order to induce the parties to enter into the contract or where the terms of the contract were "outrageous". Various attempts were made to define the latter circumstance, including references to gross unreasonableness, but the general consensus appeared to be that "outrageous" conveyed the right sense. In any event where such a contract is struck down in this fashion and there are no relevant discharge terms, Section 7(2) provides that the other party to the contract shall still be entitled to be paid by the local authority such sums as he would have been entitled to if the contract had been effective up until the time when the relevant court ruling was made but had then been terminated by the local authority by a repudiatory breach of the contract by the local authority. In essence the normal contractual measure of damages will then apply to compensate the aggrieved party to a contract. Although this is not the complete "safe harbour" provision that some have sought, this does represent a substantial improvement for any financier dealing with a local authority in PFI and other types of project finance structures. It could also be argued that the process of setting up rebuttable presumptions that is followed in the Act is nearer to the true protection afforded by the terms of Section 44(6) of the Local Government and Housing Act 1989 in connection with local authority borrowing.

In all such cases, this serves to underline the fact that although this legislation provides financiers with a significantly greater degree of protection than was previously available, it does not remove the need to proceed with caution when dealing with local authorities and to check, independently, that the financier is satisfied with the capacity of the relevant authority. The difference is that if it subsequently proves that the local authority did not have the relevant capacity, a bank that is involved in such a transaction is likely to obtain a significant level of compensation rather than being left without remedy. The residual risk is that if the termination or compensation terms that are set out in the contracts are not considered by the courts to be a proper measure of contractual damage suffered by the bank, then the court will impose its own terms. This may mean that whilst a bank may recover its principal and some interest, default interest may not be recoverable to the extent that it may be regarded as a penalty. The same test may also be applied to other standard provisions in loan documents.

This would appear to bring the legal risk associated with contracts of this type more into line with the usual corporate customer. However care still needs to be taken to ensure that the provisions of this Act apply in any given set of circumstances and that the local authority involved can and should be entering into a transaction of the type envisaged.