So, the striking down of the lease is no small matter. And only recently we heard more from the Government about seeking to encourage funding of the public sector by leasing. These two threads are inconsistent and it's my view that the current legal position of the ultra vires doctrine in relation to the public sector is unsustainable. The willingness of funders to participate in public sector business will inevitably be much compromised by this case.
The case in question involved the Christ the King College on the Isle of Wight (School Facility Management Ltd and others v Governing Body of Christ the King College and Isle of Wight Council). The lease contract was for the build and letting of a sixth form college for the school, which the school urgently required as it had run out of space. As is common with such operating lease arrangements, the lessor obtained its funding for the building of the new premises by selling the lease receivables to a funder. Once the lease expired, the lessor would then hope to cover the residual value not amortised by the lease payments and obtain its profit from managing the subsequent use of the building either by the school or, on removal of the building (which was in modular form) and its re-erection somewhere else, by a subsequent lessee.
The Limits on Public Sector Borrowing (other than by central government)
To understand the problem, we need to consider two things: the limits on local authority borrowing promulgated by central government, and, second, what constitutes an operating lease under public sector finance rules. Since the 1980s central government has sought to constrain the powers of local government to borrow money, using "borrow" in a wide sense. For present purposes the significant rule is, and has been for a long time now, that local government and its offshoots, such as schools, have power to obtain assets by operating lease but not by finance lease or hire purchase. If they want to do the latter, they require Secretary of State consent. Over many years I've used this operating lease capability on behalf of clients to fund all sorts of things for local government organisations: from council house windows and central heating systems to school computers, books, catering systems and even teaspoons, to street lighting, and even, in one signal case, to a town by-pass. In short, the non-central government sector makes copious use of operating leasing to fund the necessities of its functions.
The second issue referred to above concerns the rules for establishing in public sector finance whether a lease is an operating or finance lease. This used to be relatively straightforward but has for some years become more complex by virtue of what is now accounting standard IAS17 and its adoption by the CIPFA Code of Practice on Local Authority Accounts, under which it's largely a matter for the relevant accountants to interpret and thus determine the categorisation of the lease, using the CIPFA guidelines. It's hard to render these rules concisely, but in essence there are five tests, and if any one of these is failed the lease may be categorised as a finance lease. They are:
(a) does the lease transfer ownership of the asset to the lessee
(b) does the lessee have the option at the end of the lease to buy the asset for less than market value
(c) is the lease term for the major part of the asset's economic life
(d) does the present value of the minimum lease payments (the PVMLP) at the start of the lease amount to substantially all of the fair value of the asset
(e) is the asset so specialised that only the lessee can use it without major modification.
Applying the Operating Lease Tests
These are fairly straightforward to deal with in structuring the deal, with the exception of (d), which was the central part of the discussion in this case. It used to be that a simple 90% rule was used for the PVMLP test, though it was shown that the Isle of Wight Council itself used a 70% test, which must mean that in reality they only intended using leasing for vehicle acquisition. In any event, the court focused on 90% in deciding the case. Lessors and their funders of course are well aware of the fluidity of this accounting definition and so it's common practice in such deals to obtain letters from the public sector body confirming that they have fully reviewed the transaction, that in their view it is an operating lease, that it will be so treated in their accounts, that the asset is to be used for one of their proper functions and that they have power to enter into the transaction. The lessor obtained such a letter from the school in this case and further comfort from Isle of Wight Council itself. These were regarded by the court as irrelevant to the question of whether they actually had the requisite power; they couldn't at their own hand confer on themselves powers they didn't have even if third parties relied on those assurances. The judge heard detailed conflicting evidence from accounting experts on whether the PVMLP test had been met and determined which expert he preferred, a sort of judgment of Solomon. Test (d) in his view had not been met and so the lease was void.
There are two major problems in the assessment of this test. The first is that lessors are entitled to make a profit. As indicated above, the lessor's profit from a public sector operating lease deal such as this comes in two places: first, any turn on the difference between the actual rental paid and the funding cost on sale of that rental as a receivable to the funder; second, the management of the residual value. So, it is a moot point how much of each rental amortises what cost of the asset, as this is never specified in the lease. And then we come to how the court assesses the residual value of the asset - and here I think, with respect, that the judge's decision does go quite badly astray. This issue needs some focus to itself.
The building here was a modular building; so, it could be dismantled and re-erected elsewhere, admittedly with considerable effort and expense. So, at the end of the lease it had in effect two possible values: one if it stayed where it was and one if it didn't. The difference was considerable and the judge decided it had no real value if dismantled and removed, given the cost of doing so. This is the point where I believe the decision cannot be supported. The judge concludes that, as the building had no value if removed but considerable value if it stayed, then the lessor was relying on it staying and, if it stayed, the only party who would be paying for it would be the lessee, the school. So, it was a finance lease. But that is entirely circular. Surely, the point is that the lessor is taking a real risk in the residual value. It has no comfort at all that at the end of the 15 year term of the lease, the school will still want the building. Maybe if the world doesn't change in 15 years it is likely to, but digital technology, new social norms and views in relation to religious schools, pandemics and all sorts of other possible issues mean that a real risk is being taken here. The judge was far more sanguine about this than any funder would be. It follows, in my view, that the decision taken on test (d) is entirely questionable.
So What Happens Now - and the Need for a Solution
We then come to the consequences of the decision. The lease is void. But the school has had the use of the building, so on unjust enrichment principles it should pay something for it. And the judgment so provides, the judge refusing to order repayment of rentals already paid. However, he only takes things up to judgment. His logic for doing so is that it is now up to the parties to decide what to do. If the lessor seeks to recover the building and the lessee fails to comply, then further unjust enrichment ensues and further payment should be made by the school; if the lessor fails to try to recover the building, then no further transfer of value has been made to the school, it has not been enriched and nothing falls to be paid. The parties were left to sort this out and a shambles is in the offing. On the one hand, the lessor may demur from risking the expense of the cost of repossession (one consequence of the lease being void is that its provisions for the cost of dismantling falling on the school are void too) and just give up. On the other hand, to protect its position and gambling on the school really needing the building it may seek to repossess, at which point, if the lessor has gambled correctly, the school will desperately try to retain the building and come to some sort of continued leasing and payment arrangement. And how is the lessor to get comfortable that the school will not then challenge its own powers to enter into that new arrangement?
While one might understand the current desire of central government to rein in local government spending, this situation is hopeless. In the case of companies, the ultra vires doctrine has been emasculated by statute; it is only in the public sector that it retains full effect. The lessor and its funder here, despite taking careful legal precaution, have ended up seriously out of pocket despite the public sector authorities having a real need to procure the building and certifying that they had power to do so. This is not an isolated case, though it is the first major court decision on this issue in relation to equipment leasing. It is unacceptable for the law to leave the private sector entirely at risk as to whether or not the public sector has power to do something when the private sector has not been cavalier in approaching the issue. The public sector needs access to private sector funds. This decision will deter that, except in simple cases like vehicle acquisition, where the residual value and amortisation issues are easily ascertainable. It may well be that the entire removal of the ultra vires rule from public sector contracts would be undesirable, but some simple and readily accessible method of contract certification is needed on which both the public and private sector bodies to a contract can rely - and the consent of the Secretary of State is not such a method.