Counterparty Due Diligence
It is no secret that the UK economy is really suffering from the impacts of the coronavirus pandemic and resulting lockdowns. Earlier this month the Office for National Statistics reported what we expected; UK headline GDP had fallen substantially in 2020. In fact, the 9.9% contraction was the largest annual fall in output since the Great Frost of 1709. The first quarter of 2021 is likely to continue in this vein. The Bank of England forecasts that the economy will shrink by a further 4% in this period.
Local authorities can play a role in supporting their local economies and one such way of doing so would be by providing loans to local businesses. These investments could provide an income return to local authorities, which can then in turn be used to fund other vital services in the area. This, however, does not come without risks.
There can be substantial risks to local authorities when lending money to struggling businesses, not just in terms of lost money but credibility as well. Companies can go bust. It has happened before and will certainly happen again. For an example of this please read my insight from September 2020, “What Happened to Carillion?”, the private contractor who entered into compulsory liquidation in 2018 after suffering significant financial troubles. At the time of going bust Carillion was working on around 420 public contracts and its collapse had significant consequences to many local authorities. This example specifically underlines the importance in undertaking ongoing financial analysis on contractors, to assess whether their financial situation has deteriorated to levels where they may struggle to complete work and to make necessary contingency plans. The financial strength should be reviewed on a regular basis.
It is therefore vital that local authorities perform detailed due diligence on counterparties to assess their credit risk and suitability for financial support before making these loans. A loan to a company in financial distress may incur substantial loss of capital to the authority.
Arlingclose has the required expertise and experience in performing these due diligence reports on the prospective borrower. We can analyse the whole company covering historic financial statements, company and sector news events, and business plans, just to name a few. This thorough analysis allows us to come to a conclusion about the financial health of the company. From this we can then assess the likelihood of default and probable loss on default, allowing for the calculation of a suitable interest rate to be charged on the loan, that will compensate for the risks being taken, and a recommendation of the level of security that should be implemented. This will be in line with a market-rate of interest and therefore will satisfy any State Aid (or equivalent) rules.
Sometimes the outcomes of our analysis do not yield the answers the potential borrower wants to hear but this demonstrates that we are always acting in the best interests of the local authority being asked to make the loan.
What is happening with State Aid?
The UK formally withdrew from the EU on the 31st January 2020, over four years after voting to leave in the referendum of the summer of 2016. However, the UK was required to continue applying EU state aid rules until the end of 2020.
On Christmas Eve 2020, the European Union and the United Kingdom concluded the Trade and Cooperation Agreement (TCA). This is still subject to formal ratification by the EU but has been provisionally applied since the 1st January 2021. Now, EU state aid rules no longer apply in the UK (except for measures that impact trade between Northern Ireland and the EU). Even though we do not follow EU rules any longer, we do still have international subsidy control commitments. For example, there are commitments on subsidies arising from the UK’s continued membership of the World Trade Organisation (WTO). These are not new commitments - the UK was subject to WTO rules when it was a member state of the EU.
In the near future little is likely to change, however there will certainly be a period of uncertainty whilst the UK regime is still being designed. In the interim, local authorities are required to assess whether they fall within the definition of a “subsidy” under the TCA.
On 3rd February 2021, the Business Secretary, Kwasi Kwarteng, set out plans for a new UK-wide subsidy control system, for providing more flexible and tailored financial support to businesses. A public consultation was launched seeking views from businesses and public authorities on how the new UK subsidy control regime should be designed. This will run until the end of March. This consultation can be found here.
Please contact me at firstname.lastname@example.org for more information on how we can assist you or for any queries around this insight.