In depth: what happens when a council gets into financial difficulties?

Lending money to a council is a low risk investment option because a council cannot be declared bankrupt, even in challenging economic conditions. But you may have seen stories in the media over recent months about the financial difficulties faced by some councils across the country, with some saying they are on the verge of ‘bankruptcy’. But what does that mean in reality, and what would it mean for a council investment if a council was struggling financially?

Why is lending to a council a low risk option?

Our council loans are an investment and you are lending money to a council so there are risks, however the risk of a council never paying back you back is very low as a council can’t be declared bankrupt. Therefore the only way for a council to remove a debt from its books is to repay it.

A council must always make its interest and capital repayments on its debt ahead of other spending as the loan is secured against the council’s revenues. There is a legal framework which requires councils to run a balanced budget and if they are unable to do so there is a process which allows the council to take additional actions to adjust its spending and costs until it can return to a sustainable financial position.

Why can’t a council be declared bankrupt?

Councils are the bedrock of our society. They have close to 1,300 statutory responsibilities (services they are legally required to deliver), passed down from central government, as well as delivering discretionary services which have been voted for by their electorate.

Through their adult and child social services they provide front line support to the most vulnerable members of our local communities, while at the same time maintaining our roads, collecting our bins and providing education facilities, parks, monuments and green spaces.

It is because of this critical role in society that the way councils manage their budgets is tightly controlled and regulated and why they have a unique legal structure which makes bankruptcy impossible in a technical sense.

Why are some councils in financial difficulties?

Councils across the UK are facing an increasingly challenging financial future, with some councils struggling more than others. This is due to both lower funding and the increasing scale and cost of delivering their statutory responsibilities.

The funding for councils comes from a range of sources including income from council tax and other activities such as operating leisure centres, as well as a significant proportion from a grant from central government. Over the past decade of austerity, councils have seen their funding cut significantly — according to the Local Government Association, councils have seen a 27 per cent real-terms cut in their core spending power since 2010.

More recently inflation has increased council costs and there has been rising demand for services like social care, in particular to tackle homelessness and children services. This combination of factors is leading to financial stress for many councils across the UK.

So when the media talks about councils ‘going bankrupt’, what do they mean?

When the media talk about a council ‘being bankrupt’ they typically mean it in a more general financial difficulties sense as the legal concept of bankruptcy does not exist for councils, as it does for a company or an individual.

It is illegal for a council to operate an unbalanced budget, where its costs exceed its income. If the council’s finance director believes there is a risk of the council incurring expenditure which will result in an unbalanced budget they are legally obliged to issue what is called a Section 114 notice. This is typically what is being referred to when a council is described as ‘bankrupt’. In recent times, Birmingham City Council, Working Borough Council and Thurrock Council have issued one.

A Section 114 notice is a statutory tool which gives the council’s finance director additional powers to avoid them operating an unbalanced budget. It gives the finance director control over all decisions regarding expenditure, essentially overriding the democratic control by which councils normally operate. In certain cases, they are allowed to increase council tax by more than the normal limit of 5% and that was the case for Thurrock Council which increased council tax by 10% as part of its plan to avoid an unbalanced budget.

So a Section 114 notice gives the council additional tools to try and bring their finances back under control. If that’s not possible, in extreme cases central government can also then step in and take control of the council.

How many councils have issued a Section 114 notice?

In the last five years, seven councils have issued a section 114 notice. Since the mechanism was introduced in 1989 it has only been used by 13 authorities. During this current period of reduced funding and stretched budgets, unexpected costs can unbalance a council’s budgets and lead to the need for a Section 114 notice. For example, Birmingham City Council has struggled to get to grips with equal pay claims and had to issue a Section 114 notice in 2023 as a result.

Does a Section 114 notice mean a council will not repay its debt?

In short, no. Unlike companies, the only way a council can remove debt from its balance sheet is to pay it back. Therefore even when it has issued a Section 114, a council is still obligated to repay its debt, including any loans through Abundance, ahead of other spending as its debt is secured against the council’s revenues. In the history of local government, no council has ever defaulted on a loan.

This is different to a company in that if it is unable to repay its debt, it risks being insolvent and closing down. If there is no value to be recovered from the company and its assets, creditors of the company may not be repaid in full or at all.

There is a risk that if a council issues a Section 114 notice it will need to adjust its spending which might mean it can no longer put the money it raised on Abundance towards the green projects it set out to. If this is the case, the loan on Abundance may no longer be Green Loan Compliant, and for this reason Abundance assesses whether the council is likely to issue a Section 114 notice before offering the loan on Abundance.

Does this mean there is no risk to lending money to a council?

No, it is important to understand that there are still risks when lending money to a council. While the council can’t be declared bankrupt and therefore it should repay its loans in full, it’s possible that the council’s financial difficulties may result in a delay to repayment or the interest owed. This would however result in a default, and no council has defaulted on a loan to date.

As a fixed term investment, it’s also important to consider that your money is tied up in the investment for a number of years, and you may not be able to get your money back earlier if you need.

RISK WARNING

As with any investment, there are risks when investing on Abundance. Your invested capital is at risk and any return on your investment depends on the ability of the company or council you have invested in to pay your returns. Investments on Abundance are generally long term and you should be prepared to hold them to maturity. The investments are illiquid and you may not be able to sell them if you need your money back earlier, and their value can rise or fall. Some investments may be secured, but this does not guarantee repayment or your return.

Quoted returns are no guarantee of future returns and past performance is not a guide to future performance. Specific risks will apply in relation to each investment. Please consider all risks before investing. The investments on Abundance include debentures or bonds and peer to peer loans — Abundance’s service in relation to loans is not covered by the Financial Services Compensation Scheme (FSCS).