In light of a recent deal involving a city council, Neil Waller and Scott Dorling look at the thorny issues around local authorities entering into interest rate swaps.
The news that Plymouth City Council has recently undertaken an interest rate swap transaction raises a number of immediate questions.
First and foremost, how come they were able to do this when famously the House of Lords in Hammersmith & Fulham ruled that doing so was beyond the powers of a local authority?
What can have changed since then?
By way of brief reminder, Hazell v Hammersmith and Fulham LBC  2 A.C. 1 (1991) decided that the Council did not have power to enter into an interest rate swap and specifically that such transactions were not "calculated to facilitate" or "conducive or incidental to the discharge of" the Council's power to borrow for the purposes of section 111 of the Local Government Act 1972.
So what's different now?
The introduction of the general power of competence under the Localism Act 2011 gives councils all the same powers that an individual generally has.
Were interest rate swaps part of what Parliament had in mind when introducing this power? Arguably, yes.
The explanatory notes to the Localism Act 2011 state that the power may be used in innovative ways, that is, in doing things that are unlike anything that a local authority - or any other public body - has done before, or may currently do.
In the Government's impact assessment there is reference to giving local authorities the power to explore innovative solutions and specifically to be able to give guarantees and indemnities (which, like interest rate swaps, are financial transactions that have caused similar vires headaches for councils in the past).
But there are limits on how a council's powers may be exercised.
Most obviously in this context, the power to enter into financial transactions must be exercised for a proper purpose. In exercising any borrowing power, Part 1 of the Local Government Act 2003 requires that local authorities must have regard to The Prudential Code. The Code provides that treasury management decisions should be "taken in accordance with good professional practice and in full understanding of the risks involved", risks should be "managed to levels that are acceptable to the organisation" and councils should "avoid exposing public funds to inappropriate or unqualified risk".
The Council's behaviour in Hammersmith and Fulham looks to have fallen far short of these standards. Though it was not the stated reason for the decision, it is doubtful that the Council in that case was exercising its powers for a proper purpose as it looked to have been motivated at least in part by financial gain. The Council was exposed to significant losses when the markets turned. This was not an example of good professional practice or an exercise in risk management.
Contrast this with the recent Plymouth transaction, where a swap is clearly being used as a risk mitigation tool. The Council has exposure to floating rate interest rates both now and in the foreseeable future which it has sought to mitigate by "swapping" obligations to pay interest on a specified floating rate with an obligation to pay a fixed rate instead. The net effect of borrowing at floating rates and swapping for a fix is that the Council now has a long term fixed rate borrowing arrangement in place at a rate reported to be considerably below those currently available from the Public Works Loan Board.
So as long as the swap is a proper exercise in mitigating interest exposure then it's all fine? Sadly, not quite.
When acting for banks or other swap counterparties, finance lawyers are programmed (no doubt partly as a result of Hammersmith & Fulham) to require that a swap counterparty has an express power to undertake derivatives, such as interest rate swaps. There is a marked reluctance to rely upon general competence type wording in the constitution of any corporate body.
For example, the Companies Act 2006 provides at section 31 (1) that a company's objects are unrestricted, unless its articles specifically provide otherwise. Despite this, finance lawyers typically insist that where a company wishes to enter into an interest rate swap then an express power to that effect must be included in the company's articles.
It's a similar position with housing associations, whose constitutions typically contain general power of competence wording similar to that which applies to local authorities. However, if an association wants to enter into a swap then an express power is typically required.
So whilst there are sound legal arguments to suggest that a council should be able to enter into interest rate swaps, the picture is not entirely clear - and is made even less clear with the public statement from the chief executive of CIPFA criticising Plymouth for the transaction and opining that it acted outside its legal powers. Banks are naturally risk averse and have long memories. Hammersmith & Fulham will always come to mind when these transactions are proposed with a local authority. Lawyers acting for finance parties will take some persuading that the general power of competence gives a sufficiently clear and unambiguous power to a local authority, particularly given market practice in other sectors and the potential sums of money at stake.