The failure of local audit

Dr Paul Feild discusses changes to the local audit process and how the issues at Spelthorne Council have highlighted the weaknesses in local audits.

Over recent years we have seen a number of Reports in the Public Interest (RPI’s) made under Schedule 7 of the Local Audit and Accountability Act 2014 (the 2014 Act). Once a rarity, now we are likely to see a great deal more. The problem is that the Local Audits RPI’s are identifying serious legal issues some years after the event. We will look at Spelthorne Council’s recent RPI as a case study.

The 2014 Act requires relevant authorities to appoint an external and independent auditor on the advice of an independent auditor panel.

While the external audit of a local authority is being carried out by local auditors, under Schedule 7 they are empowered to make a report in the public interest on any matter coming to their attention during the audit and relating to the authority or connected entity to the authority so that the recommendation can be considered by the relevant authority or brought to the attention of the public. Auditors can be expected to ask to look at the local authority’s current and proposed Capital Management / Investment Strategy simply because it carries so much risk.

Spelthorne’s Local Auditor (KPMG) in its audit of the financial year 2018 published an RPI. Its subject matter was the acquisition of three properties, being 3 Roundwood Avenue, Stockley Park in July 2017 for £21.4 million, the World Business Centre 4, Heathrow in September 2017 for £47.2 million and Hammersmith Grove in January 2018 for £160 million. All three properties were funded through loans from the Public Works Loan Board.

KPMG said:

"In our view, supported by the advice of King's Counsel, the Council acted unlawfully in borrowing and then purchasing the three properties in 2017/18."

What makes it interesting is the Local Auditor commissioned a KC’s advice to support the RPI. Spelthorne equally challenged the Local Auditors' view with their own KC’s advice. As I have mentioned before, Local Auditors are looking at legal aspects as well as financial aspects of an authority’s governance and so Monitoring Officers should take a keen interest in local audits.

This RPI has similarity with Croydon Council’s Local Auditor Grant Thornton (GT) [1] RPI on 23 October 2020 https://www.croydon.gov.uk/council-and-elections/budgets-and-spending/reports-and-reviews/report-public-interest.

In Croydon, GT said that the council had increased the level of borrowing (£545 million in three years) and used the monies to invest in its own companies and to purchase investment properties. 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.

So why have some authorities chosen to take this approach of investment in income generating property?

The reason for this is manyfold but I suggest several reasons which may run in parallel.

Firstly, as local government finances are pressurised there is a need to generate more income. There is after all a stark choice either make cuts and create efficiencies or get more income. Secondly, the need for income has led to the appetite of taking on more risk. Thirdly, for some activities such as borrowing to purchase an income stream was made possible by lenders and Fourthly, and this is not insignificant, the role of Members in wanting to avoid taking politically toxic decisions to make cuts. So, when a scheme which apparently generates an income stream, which officers then assure Members will carry a relatively small risk, it is hardly surprising that it is at least contemplated. This is seen as innovative financing and a favourable alternative to as it were, the old school warnings of threats of S.114(3) Local Government Finance Act 1988 Notices by the Chief Finance Officer and the cuts would have followed. Indeed, some schemes were not so much about the purpose of, say, stimulation of the local economy as about staving off hard-nosed business decisions. Furthermore, where the authority had a three out of four years, one-third election cycle then there would be pay-back at the polls for deep cuts in a way that the authority on a four-year cycle could avoid.

The fourth reason in particular relates to the prevailing culture in the organisation, where a sense of unreality can set in such that bad news and tough decision making are avoided. The consequence of this tends to be ever-increasing risk of a serious event occurring because risk mitigation measures had not been actioned.

The most fascinating aspect of the culture of denial is that those who follow these matters could see literally for years the inevitability of catastrophic failure. In local government circles, we knew who was going to get into trouble, indeed it was a mystery how one council went on as long as it did.

Thankfully things have changed over the last couple of years in that the Public Loan and Works Board has given guidance on what will be loaned upon and the Guidance on the Prudential Code from CIPFA was changed in December 2021.

The Prudential Code matters because local authorities are required by regulations to have regard to the Prudential Code when carrying out their finance 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, is borrowing to make investments to generate income ‘prudent management’? The answer today is no. Paragraph 50 of the 2021 Prudential Code states:” An authority must not borrow to invest for the primary purpose of commercial return”.

But what about those councils which borrowed before the revised 2021 Prudential Code? The Code at Paragraph 53 says:

53. Authorities with existing commercial investments (including property) are not required by this Code to immediately sell these investments. However, Authorities which have an expected need to borrow should review options for exiting their financial investments for commercial purposes in their annual treasury management or investment strategies. The options should include using the sale proceeds to repay debt or reduce new borrowing requirements. They should not take new borrowing if financial investments for commercial purposes can reasonably be realised instead, based on a financial appraisal which takes account of financial implications and risk reduction benefits. Authorities with commercial property may also invest in the repair, renewal and updating of their existing commercial properties…

So, there is the paradox of investments which a council may continue to hold but may not acquire. Does that mean such investments are part of prudent management of an authority’s affairs and are they lawful? Well yes and no.

Now back to Spelthorne’s Local Auditors' RPI. The first point is it is about the financial year ending March 2018, that’s over four years ago. So, under the 2003 Regs the CIPFA 2017 Prudential Code applied. KPMG said in the RPI that the council acted unlawfully in borrowing and then purchasing three outside the borough properties in 2017/18 in two respects.

Firstly, while KPMG acknowledged Spelthorne Council does, in a general sense, have powers to borrow and acquire properties but the KPMG position is that the lawfulness of exercise of those powers were dependent on the reason for their use.

KPMG says Spelthorne could not rely on the “general power of competence” in the Localism Act 2011 (which allows local authorities to do anything which an individual may do) 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. In other words, the general power could only be exercised if a company was used because the transaction was in the view of KPMG “commercial”.

So, what about the power to acquire land under section 120 Local Government Act 1972?

Section 120 LGA 1972:

“(1) For the purposes of—

(a) any of their functions under this or any other enactment, or

(b) the benefit, improvement or development of their area,

a principal council may acquire by agreement any land, whether situated inside or outside their area.

(2) A principal council may acquire by agreement any land for any purpose for which they are authorised by this or any other enactment to acquire land, notwithstanding that the land is not immediately required for that purpose; and, until it is required for the purpose for which it was acquired, any land acquired under this subsection may be used for the purpose of any of the council's functions. …”  

One view is that section 120(1)(a) needs a function to be supported by the acquisition of land, not dissimilar to the historic Audit Commission's argument in the past over the meaning of section 111 LGA.

But if this argument is right then you would not need section 120(1)(a) because section 111(1) means the same thing. That being so, a more liberal interpretation is that by its existence it is more permissive. KPMG then argues that section 120(1)(b) to acquire a property for yield is not for the benefit, improvement, or development of Spelthorne’s area so ruling out. It says:

“…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...”

Spelthorne disagrees. In paragraph 2.6 of the officer’s report to Council they argue:

The Council’s King’s Counsel maintains that the Council acted lawfully in relying on section 120(1)(b) of the Local Government Act which specifically authorises acquisition of land, including expressly outside the authority’s area for the “benefit” of the authority’s area. There is a difference of opinion between the Council's and Auditors' King Counsel on the interpretation of “benefit”.

There is something in this argument. Clearly, if the land is being bought as an investment, then the section 120 power is being used as part of the section 12 power to invest. Now granted in 2017 /2018 there was a different CIPFA prudential code, which was less forthright than in 2021 which now makes it clear that borrowing for yield is not prudential. As Spelthorne had acquired income producing assets that were making a contribution to the council’s finances which can fairly be seen as a benefit, then their officer’s argument that section 120(1)(b) was lawfully exercised carries weight.

So, what has this argument got to do with 2022? Well, as explained the 2003 Regulations make clear that CIPFA’s 2021 Prudential Code must be observed, plus the PWLB will not be lending on borrowing for yield. However, this RPI has raised the question about the province of section 120 Local Government Act 1972 and the complication of sections 1 and 4 of the Localism Act 2011.

Here is the question: let’s take as read that any acquisition for open market value inside a borough can probably be justified as being for the benefit, improvement or development of their area, is it being said that properties acquired outside a borough (unless adjacent or neighbouring) have to be held by a company because that would be commercial? If that were right, then really this limitation ought to be in section 120 LGA 1972.

In conclusion, this is an unsatisfactory state of affairs, because there are two big issues that need to be addressed.

Firstly, the CIPFA Prudential Code and Guidance, valuable though it is, is brought to bear by virtue of the Local Government Act 2003 and Regulations made together with the Secretary of State’s Guidance. My issue with that is the CIPFA Prudential Code and Guidance is behind a paywall, and really everybody should have access to such important accounting guidance for free if as is the case, it is a vital component to sound financial governance – perhaps one for Lawyers in Local Government to campaign for?

Secondly – local audit is a complete failure. Local Auditors are not meeting their target of producing the audit by the statutory date only 12% did this year [2]. Auditors do need to be paid a fair renumeration to make sure it is done thoroughly. The section 151 officer and the monitoring officer do need to know what is going on in their authority and they simply cannot rely on the local audit to give them any reassurance that the finances are sound if they are waiting for years for the said local audit to be completed.

Conclusion

As argued in this paper, an external audit is vital in setting standards and identifying risk. But it is failing, and as the financial pressures increase, the failure of the local audit regime as an alerting mechanism to councils taking on too much risk really matters. Combine that with those authorities where there is a culture of denial means there is little warning before critical failures occur. In the case of Spelthorne, it does no one any favours to debate the question of vires in an RPI about a financial year ending in 2018 in December 2022. But it’s not the fault of either the local auditor or that council. It’s quite simple in 2020, Sir Tony Redmond reported that radical changes need to be done to local audit. When Sir Tony reported 40% of audits were late. Now it’s 88% which are late. Nothing effective has been done and many local audits are not one year but two years behind.

Would timely local audits make any difference? Yes, they would, because the plain fact is the 2014 Act’s Local Audit is a vital part of governance because it is independent, those firms doing it do need to be paid a fair price for doing so and in return, their audits must be thorough and timely.

Until then it may be the only practical solution is for local authorities through their officers to carry out their own peer review shadow local audits perhaps with neighbouring boroughs or pool a fund together in the case of districts to commission a health check, looking at the key risk performance indicators and reporting accordingly. Yes, it would carry a cost but would it not be better to find out what’s not right before a formal RPI?

Dr Paul Feild is the Principal Standards & Governance Solicitor working in Barking & Dagenham Legal Services. He researches and writes on finance and governance issues and can be contacted by email.

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

[2] Only 12% of local government audits for 2021-22 were completed by the end of November, according to figures published 9 Dec 2022 by Public Sector Audit Appointments