The London Borough of Croydon's issuance of an s114 notice may have come as a shock to some observers, but S&P Global Ratings highlights that it is a necessary and effective control mechanism that should help prevent further financial distress. Nevertheless, Croydon's issues are publicly noted to go deeper than those caused by the outbreak of COVID-19, and whether it can rebalance its budget will depend on the timely actions of its management, and potential central government intervention. Furthermore, while previously rare, s114 notices may become more common if other authorities' budgets succumb to the increasingly adverse effects of the pandemic.

Last week, the London Borough of Croydon's Director of Finance formally issued an s114 notice to councillors in relation to the authority's inability to balance its budget for the 2020/2021 financial year. It is only the third entity in the past 20 years to issue such a notice (the London Borough of Hackney issued one in 2000; Northamptonshire County Council issued two in 2018).

An s114 notice is a legal declaration that an authority will not be able to balance its budget (that is, planned expenditures exceed available resources on an accruals basis) or that is has experienced a critical depletion of reserves, as stipulated under the Local Government Finance Act 1988. In Croydon's case, a public interest report issued by its external auditors highlighted fundamental issues with financial management and performance. These have been exacerbated by unsuccessful savings programs and ineffective spending controls, all of which has resulted in an unfunded budget shortfall of close to £66 million in 2020/2021.

We highlight that the incremental costs and forgone revenues resulting from the ongoing COVID-19 pandemic are not the primary cause of Croydon's distressed position. The pandemic has increased financial stresses and strains, but by the authority's own admission, a number of issues were already at play within the council that would have led to an s114 notice, regardless of the coronavirus outbreak.

Issuing an s114 notice is often labelled as a bankruptcy. However, as far as the effect on credit risk is concerned, we see it as a preventative control mechanism that represents a fundamental strength of the U.K. local government finance system. An s114 notice does not in itself trigger a default. It is a step toward addressing an issue before it materializes. If an authority were to delay external (non-Public Works Loan Board [PWLB]) debt service as a result of an s114 notice, or seek to restructure its external debt, then we may consider that a default event had occurred. The actions taken under an s114 notice--including the halt on non-essential spending and the rebalancing of the budget--are designed to return an authority to a financially stable position. However, timeliness is critical for these actions to take effect before it is too late.

Despite an s114 notice indicating proactive financial management of a council, our analysis does not overlook the performance of an authority's councillors and senior officers in the preceding months and years. We also consider the internal policies, procedures, monitoring, and reporting, as the lack of effective financial management invariably plays a role in the deterioration of financial performance and resilience. Consideration of the level of reserves an authority maintains, and its track record of execution against budgets, are vital to our analysis. Our forecast assumptions around income and expenditure levels, and the ability to weather financial performance and liquidity shocks, are also key factors.

For investors in local authorities that have issued an s114 notice, we would not expect to see any effect on payments of interest or principal. The legal, contractual obligations of existing lending agreements should protect lenders as debt service remains a permitted expenditure item under statute. Furthermore, the general principle of local government debt security against all revenue sources provides additional assurances against the risk of default. As a lender of last resort, the PWLB remains available to authorities if the need exists to quickly and flexibly refinance external debt as part of any remedial actions in response to an s114 notice.

Croydon's councillors now have 21 days to respond to the notice, and we expect central government will also issue a statement before the end of the calendar year. In the case of Northamptonshire, the government appointed commissioners to help run the authority. The issues leading to its s114 also contributed to the planned dissolution and restructuring of the authority, due in April 2021. Croydon has issued its s114 amid unprecedented economic, constitutional, devolutionary, and public health upheaval. Clear parallels with previous cases are therefore difficult to draw.

We do not expect a contagion of notices being issued this year as most authorities are already taking steps to manage their pandemic-related financial difficulties. However, we note that in recent months entities such as Transport for London and Leeds City Council have publicly alluded to potential s114s of their own. Furthermore, we cannot ignore the possible structural issues amid uncertain future funding arrangements, tax reform, and social care pressures, and the cumulative effect this can have on an authority's ability to balance its budget. With the single-year Comprehensive Spending Review due to be published on Nov. 25, we believe that the local government funding settlement will be critical in determining whether more s114 notices may be on the horizon.