Staying alive

The credit crunch has led many important development projects to grind to a halt. Steve Manson and Judith Barnes look at whether prudential borrowing can come to the rescue.

Many development and regeneration projects are currently stalling in the face of a shortage of available funding as the economy and the banking sector continue to struggle with the credit crunch.

One way for local authorities to support their development projects and keep them on track is to self-fund projects wholly or partially using their borrowing powers, governed by the Local Government Act 2003 and the Prudential Code (CIPFA: The Prudential Code for Capital Finance in Local Authorities 2003). Development agreements can be restructured so that a project is not reliant wholly on third party funding but is paid for at least in part by local authorities.  This enables developments to be progressed in the time scale required by a local authority, for example to stimulate regeneration and provide housing stock, rather than waiting for any existing agreements to run up to their long stop dates and then risk failing.

To enable projects to stay alive there are several factors to consider:

1. Does a local authority have the requisite borrowing powers and can it pass the "affordability" test for the level of borrowing required ?

The Prudential Code sets out guidelines on the level of borrowing that each public body can incur.  The objective of the Code is to help ensure that:

• capital expenditure by the local authority is affordable;
• borrowing and long term liabilities are within prudent and sustainable levels; and
• the local authority’s treasury management is consistent with good practice.

Prudential borrowing is typically a loan from the Public Works Loan Board or commercial banks.  Where a local authority is already utilising its borrowing powers to fund projects, the cost of funding a stalled development may reduce the total amount of capital monies available to be spent in other areas.

2.  Can commercial terms be agreed with an existing developer to vary an existing agreement ?

With this way of structuring a development project, typically a local authority would pay a fixed development management fee to the developer for their services, as opposed to the developer getting any profit payment from the sale of the land to a third party.  A local authority retains an investment interest that can be sold and leased-back in the future.

We are seeing agreements where the whole development is to be carried out for a fixed price, minimising a local authority's potential risk in self-funding.  A benefit to the developer can be the certainty of monthly payments being made (based on valuations of work done) throughout the build period - and the certainty of the project proceeding.

Proper consideration would need to be given on each project as to whether a variation may result in a “material variation” - as to which please see point 3 below.

3.  Can the risk of a challenge to a variation of an existing contract be minimised ?

A challenge can be brought against a local authority either for judicial review of their actions in varying the contract or under the Procurement Rules where the variation to the existing contract is a "material variation".  This would effectively give rise to a "new" contract which should have been tendered following those rules.

Whether or not a variation is "material" will depend on the facts of each project, although there was some guidance on this from the European Courts in the recent Pressetext case (Case C454/06).

4.  Does the financial model allow for any increase in the rate of borrowing over the period of the project ?

A lead-in period for obtaining planning permission / satisfying conditions or a major development with a longer build period would introduce an element of cost uncertainty for the local authority which would need to be factored into the appraisal.  Now may be a good time to borrow with interest rates lower than they have been for many years - perhaps full funding could be drawn down to increase certainty on rates even if the development is phased.  Monies can be invested in the interim.

5.  Does the payment of VAT on the development costs result in a local authority not being able to recover the VAT it has paid in that financial year because it has breached the 5% limit of its total VAT expenditure ?

This issue is likely to only be of importance to local authorities embarking on a large, costly development project.

Local authorities can inject money into schemes where they are either landowners or prospective tenants of the development, or where they have no ownership of the land being developed, but the scheme will bring economic, social or environmental wellbeing benefits to the area.  

Public sector funding has the potential to be unlawful state aid and local authorities will need to be consider, for example, ensuring investment with a developer is pari passu or that any loans to partners are on commercial terms and at more commercial rates.

By varying existing traditional development agreements that depend on a land transfer to a third party for funding, local authorities can use Prudential borrowing to take control of delivering key regeneration projects in the timescales originally anticipated and using their existing partner and their expertise.  In addition, by keeping the land in their ownership, they also have the option of dealing with the completed development to secure capital funds when the market recovers.  

Steve Manson and Judith Barnes are partners of Eversheds LLP