School’s Lease Agreement held to be Ultra Vires

The High Court has held in School Facility Management Ltd and others v Governing Body of Christ the King College [2020] EWHC 1118 (Comm), among other findings, that a contract between a school and a construction company constituted a finance lease and was void because of the school’s lack of capacity under the Education Act 2002.

This case represents the first reported decision on a subject which has been kicking around the asset finance industry for many years, and is of great interest to lawyers. The judgement runs to 508 paragraphs and is extremely complex so we will concentrate on the main issues of principle which are likely to be of general application to asset financiers dealing with schools and local authorities.

Background – the legislation

Suffice it to say for present purposes that there is some complex legislation governing the ability of schools to enter into finance agreements, the general effect of which is understood to be that the power to borrow money and grant security (such as a mortgage or charge) may only be exercised with the written consent of the Secretary of State in England.

The Government has for some time taken the view that a finance lease equates for these purposes to borrowing money, so unless it can be demonstrated that a Lease Agreement properly qualifies as an operating lease it will be vulnerable to challenge by a school on the basis that in the absence of the required written consent of the Secretary of State the school purported to contract outside its powers (“Ultra vires”).

The court observed in this judgment that public bodies have increasingly resorted to structured transactions that allow the cost of equipment and buildings to be met from periodic payments. This trend results from limitations on the monies made available to those public bodies for capital expenditure, and allows them to treat the expenditure as revenue expenditure for regulatory and accounting purposes. Several factors will influence whether such a structure will constitute a finance lease or an operating lease and whether the public body will, accordingly, be treated as having borrowed money.

Common law duties

In addition to the legislative background, case law from as long ago as 1925 has established the principle that:

“[A] local authority owes a fiduciary duty to the ratepayers from whom it obtains moneys needed to carry out its statutory functions, and …this includes a duty not to expend those moneys thriftlessly but to deploy the full financial resources available to it to the best advantage”.

A decision to spend money that breaches this duty will be void as a matter of public law.

Compliance with this duty may overlap with a public authority’s wider duties to act “reasonably” and not irrationally, in the sense established in Associated Provincial Picture Houses Ltd v Wednesbury Corporation [1947] EWCA Civ 1 (a failure to do so is commonly known as Wednesbury unreasonableness).

Does the school contract as agent of the local authority?

Section 22 of School Standards Framework Act 1998 (SSFA 1998) establishes a local authority’s duty to fund the maintained schools in its area, and section 49(5) provides that any spending by the governing body of a maintained school from its delegated budget will be deemed to be spent by it as the local authority’s agent, subject to certain exceptions.

The Department for Education (DfE) has issued Statutory guidance on Schemes for financing local authority maintained schools, which explicitly states that a scheme should make it clear that although governing bodies may enter contracts under the relevant legislation, in most cases they do so on behalf of the local authority.

This has been regarded as critical by asset financiers since if the school were held to be contracting purely on its own behalf and not as agent of the local authority, it would mean that credit decisions would have to be taken on the basis of the individual school’s continuing ability to make repayments, sometimes far into the future, rather than on the common assumption that in the event of any financial difficulties with the school, its local authority would step in and accept liability for repayments.

Facts

The college, a voluntary aided school maintained by the second defendant council, obtained permission from the council to expand its age range and open a sixth form. It subsequently entered into a hire contract for the construction and hire of a building and associated equipment to accommodate the additional numbers. The building was provided and assembled by B, which subsequently sold the building to the second claimant BOSHire, which in turn entered into the contract to lease the building to the college. Subsequent assignments led to the first claimant (“SFM”) and then the third claimant obtaining the right to payments made by the college under the contract. The college failed to pay an annual instalment under the contract when it fell due, and the claimants commenced proceedings against the governing body of the council, the first defendant, and the second defendant for debt and damages under the contract.

They contended that the contract was binding on both the college and the council as the college’s principal, agency being established as a matter of fact and/or by application of regulation 22 of the School and Early Years Finance (England) Regulations 2012, containing the council’s duty to fund maintained schools in its area, and/or by application of section 49(5) and (6) of the SSFA.

Negotiations

During negotiations between BOS and the college, the parties referred to the contract as an “operating lease”, and the contract was termed (on its face) in such a way. At no stage was it apparently understood that or questioned whether the college was borrowing money and that the contract comprised a finance lease. The consent of the Secretary of the State was not sought by the college’s governing body as required by the relevant legislation.

Before negotiations had completed, in order to gain the assurance of its financial backers, BOSHire drafted two letters with input from its solicitors, which were intended for:

(1) The college to sign and return to BOSHire. This letter stated that the college had the power and capacity to enter into the contract, and that the governing body had taken all necessary legal steps to authorise the execution and performance of the contract. It also stated that the college was satisfied that the contract constituted an operating lease.

(2) The college to send to the council and for the council to sign and return to the college. The council understood that this letter would be seen by BOSHire. In it, the council agreed to the college’s expenditure under the contract. It also stated that it fell within the delegated budget and was not the council’s responsibility, and comprised an operating lease.

The college and the council signed their respective letters in February 2013. In September 2017, the college was unable to pay the annual instalment of nearly £668,000 under the contract

In November 2017, SFM sent the college a formal Notice of Default under the contract. In April 2018, the college stated that it had no intention of paying any further amounts. The contract was terminated in April 2018, and SFM informed the college that it was no longer in lawful possession of the building and should cease using it. It appears that the college continued to use the building until trial.

Decision

The High Court (Foxton J) held that:

(1) The claimants’ claims against the council under the contract failed because the college made the contract on its own behalf and not as agent of the council.

(2) The contract was ultra vires on the part of the college, and the claimants’ claims against the college under the contract failed.

(3) The claimants’ claims for misrepresentation and misstatement against the college and the council failed.

(4) The college’s counterclaim against the claimant for unjust enrichment failed.

(6) SFM’s claim in unjust enrichment against the college succeeded in respect of the period from September 2017, when the college failed to pay an annual instalment that gave rise to these proceedings, to the date of the judgment.

Did the college contact as agent of the council?

The court first considered whether, if a valid contract had been concluded, who the contracting parties were. The court concluded that the college, and not the council, had contracted with BOSHire. It rejected the college’s argument that it had acted as the council’s agent, which would have meant that the council was liable under the contract (if the contract was valid). The court’s reasoning included that:

(1) The contract identified the college as the contracting party, and did not refer to the council. This was consistent with documents and correspondence generated during negotiations, including the council’s letter to the college of February 2013 which would act as an assurance to BOSHire. This stated explicitly that the contract was “not the responsibility of the council under [the SSFA 1998] or otherwise”.

(2) There was no legal authority to support an implication that maintained schools acted as agents of local authorities by virtue of local authorities’ duties to fund maintained schools under section 22(1) of the SSFA 1998.

(3) Section 49(5) of the SSFA 1998 provided only limited support for the view that a maintained school contracted as the agent of the relevant local authority; the “deemed character” of a payment did not necessarily determine who the contracting parties were. As well as various practical problems that would arise if section 49(5) meant that the council were liable, the court also observed that local authorities would be exposed to liabilities that significantly exceeded the funding they had been allocated. This would subvert the regulatory and financial control systems for education funding.

(4) Because the payments related to a finance lease, they in any event fell under sections 49(6)(a) (repayment of borrowing) and 49(6)(b) (capital expenditure by a voluntary aided school) of the SSFA 1998 and constituted exceptions to the general rule that spending by the governing body of a maintained school from its delegated budget will be deemed to be spent by it as the local authority’s agent.

(5) The DfE statutory guidance issued under section 48 of the SSFA 1998, which provided that a scheme should contain a provision that makes clear that governing bodies enter contracts on behalf of the local authority, did not correctly reflect the law.

The defendants’ ultra vires defence based on borrowing

Both the council and the college argued that the contract was void because it involved borrowing for the purposes of the legislation without the consent of the Secretary of State. This argument framed the contract as a “finance lease”, which amounted to borrowing. The court accepted that the contract constituted a finance lease and it followed that the college’s decision to enter the contract was ultra vires and the contract was void.

Examining the economic substance of the transaction, the court held that the contract did amount to a loan. In particular, the substance of the transaction was the same as if the college had purchased the asset and financed this by taking out a loan; the lease payments (under the contract) were treated in a similar way to loan repayments. This was consistent with the Code of Practice on local authority accounting published by the Chartered Institute of Public Finance & Accountancy (CIFPA), the DfE statutory guidance, and the council’s scheme.

Using the CIPFA Code of Practice accounting standard IAS 17, in particular, and its indicators of the characteristics of a finance lease, the court examined the parties’ expert accountancy and valuation evidence to find that the following primary indicators of a finance lease were met:

(d) “whether at the inception of the lease the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset”;

(e) the leased assets were of such a specialised nature that only the lessee could use them without major modifications.

Two further indicators were not present relating respectively to ownership of the asset passing to the lessee at the end of the lease term and the lessee having the option to purchase the asset at a price that made it reasonably certain at inception of the contract (when the lease was entered into) the option would be exercised. BOSHire’s side letter concerning the prospect of an option to buy the building did not have legal effect.

The court noted that the college had simply taken BOSHire’s assertions that the contract was an operating lease on trust, and it appeared that the claimants did not give consideration to this issue at the time (they relied instead on retrospective calculations by their experts to support this assertion in these proceedings).

The court stated that the parties’ own descriptions of the contract (they routinely referred to it during negotiations as an “operating lease”, and the contract was termed as such) were not decisive.

The ultra vires defence based on the contravention of the council’s scheme

The court did however hold that council’s scheme, issued under section 48 of the SSFA 1998, did not impose limitations on the college’s contractual capacity. The court observed that the college had not complied with the scheme in several respects, but these failures to comply with the scheme did not amount to limits on the college’s capacity to contract. This meant that the contract was not void on the additional basis that the college had not complied with the council’s scheme.

Common law irrationality

It was clear to the court that although those acting for the college considered that it was essential for the college to have a sixth form centre, it was inappropriate for the college to have entered into the contract (a “very significant legal commitment”) without determining whether it would have the resources to fund it (the college’s approach was that it had a hope or conviction that “something would turn up”). There was “almost no effort” by the college to ascertain whether the price quoted by BOSHire represented good value. In addition, it did not reconsider whether the proposition remained viable when funding alternatives fell away or revisit the earlier, cheaper quotes for the project it had received. The college’s selection of BOSHire’s proposal appeared to have been driven by the relative speed at which the works would be completed.

The college’s decision to enter into and later agree to vary the contract in this context, therefore, was not within the range of reasonable decisions which a public body in its position might take. The college had breached the Roberts v Hopwood duty and had also acted unreasonably in the Wednesbury sense. This did not mean, however, that the college lacked capacity to enter into the contract, and it was not necessary for the court to determine the private law consequences of these particular public law breaches.

Misrepresentation and misstatement claims

The claimants argued that if the college and council had not made purported misrepresentations and misstatements in their respective letters in February 2013, they would have entered into an equivalent contract with a counterparty which did have capacity. This meant, the claimants argued, that there would have been a valid hire contract in place for, at least, the minimum term. This would have amounted to a sum of over £6.6 million.

The court held that because it had already found that entering the contract was ultra vires on the part of the college, the claim that the college’s misstatement in its letter (where it stated, for example, that all relevant provisions of the legislation had been complied with) failed. The college could not confer on itself a power that it did not have (citing Rhyl Urban District Council v Rhyl Amusements Ltd [1959] 1 WLR 465) and this meant that any representation that the transaction was valid and any assumption to the same effect was also void. The ultra vires finding that the court had made precluded the misrepresentation claim against the college.

The council had not acted ultra vires in the same sense as the college on the basis of its letter, but the fact that there was no contract and the council was not the contracting party were both fatal to a claim for damages for misrepresentation.

The court also rejected the claimants’ argument that the council and the college’s letters breached the negligent misstatement duty, which applies to statements made by an advisor with special skill. BOSHire was not, the court considered, looking to the college or council for advice, and neither would have assumed that BOSHire would have relied on their letters without independent inquiry (it would not have been reasonable for BOSHire to have done so). BOSHire formed its own view. The court considered that in fact BOSHire knew a “good deal more” about the issues that the letters addressed than either the college or the council.

Unjust enrichment -claimants’ claims

The claimants brought an alternative claim in unjust enrichment against the college on the basis that the college had been unjustly enriched at the claimants’ expense by the college’s retention and use of the building. The court held that SFM would have suffered loss from September 2013 because at that stage it became the owner and, since then, would otherwise have enjoyed the rights to possession and use of the building if the college had not done so. SFM did, however, receive payments under the contract from September 2013 until September 2017. The college began to use the building to accommodate its sixth formers from September 2013.

The court did not accept that SFM could be said to have known of and chosen to take the risk that the contract was not valid because of the “ultra vires risk”. It was not a condition of the contract that the contract was not void: the contract was conditional in the sense (only) that the college would pay the sums due under the contract and would, in return, be able to use the building. The court was also satisfied that the college could never have understood that if it was found to lack capacity to enter into the contract then SFM would have been expected to let it use the building without payment.

Unjust enrichment – college’s claim

The college made a counterclaim for unjust enrichment which sought to recover the payments it had made under the contracts. The basis for the claim could be analysed in different ways, either that:

(1) The payments were made under a mistake of law or subject to a condition (which failed) that the college was acquiring legal rights; or

(2) Under the principle that ultra vires payments by a public body are recoverable in unjust enrichment.

The claimants’ defence to the counterclaim was based on a change of position, that is that the proceeds under the contract had been spent (in good faith) on the acquisition and construction of the building.

“… SFM has, in good faith, changed its position. In particular, it is averred that such sums as were received as hire charges pursuant to the terms of the Hire Contract have been spent, in good faith and in the honest belief that the Hire Contract was not ultra vires, on servicing its financial obligations arising out of the manufacture, commissioning, transportation, and construction costs involved at the beginning of the Hire Contract”.

The court accepted this defence. It observed that a party could raise a change of position defence in respect of an ultra vires payment from a public body. The court did not accept the college’s argument that the claimants could not raise the defence in respect of action taken before and in anticipation of the receipt of payments under the contract.

The combined effect of the court’s findings that SFM conferred a benefit on the college from September 2013 to trial and that the college’s payments for this benefit were not recoverable from SFM between September 2013 and September 2017 was that:

(1) SFM could make no further recovery of payments beyond the amounts that the college had paid between September 2013 and September 2017 and which the court held the college could not recover; and

(2) Between September 2017 and the trial, SFM could recover in unjust enrichment at the market rate.

Comment

One of the striking features of this case is the clear ruling to the effect that the college did not contract as agent of the council. Whilst to a degree each case in this regard will turn on the precise terms of the documentation involved, it is a matter of some concern to asset financiers that the judge took the view that the DfE’s own statutory guidance issued under section 48 of the SSFA 1998, which provided that a scheme should contain a provision that makes clear that governing bodies enter contracts on behalf of the local authority, did not correctly reflect the law.

The elements of the decision dealing with ultra vires, restitution for unjust enrichment and the defence of change of position available to the financier are very much in line with the analysis which we have expressed in the pages of Briefings over recent years and elsewhere.

It is interesting that Foxton J cited a comment in an earlier case which identified that banks and other lenders that deal with local authorities are exposed to the “major risk of finding that their contracts are unenforceable in circumstances not encountered when dealing with the directors and officers of companies“, and that this case showed that this was equally true of those who leased equipment, goods or buildings to local authorities or the schools they maintain.