2.8 Inherited liabilities, Kenya counties total, 2013 and 2018

• Commence detailed analysis of financial performance of these investments, accounting for dividends and other financial gains, if any, and for financial supports the counties may have provided to these entities. • Clarify and analyze the explicit and implicit contingent liabilities the counties inherited from DLAs in association with these shareholdings. • Properly account for the book value and the fair market value of these investments. • Make policy decisions about divestiture of seriously underperforming investments, especially those found to have negative net present value. • There is a need for an urgent national program led by the National Treasury via NALM and the Ministry of Water and Sanitation to finalize outstanding issues and disputes regarding transfer of water companies’ assets to full and unambiguous county ownership with pragmatic resolution of attached liabilities.

Fixed deposits. DLAs had deposited fixed deposits into commercial banks or various other financial entities (for example, building societies). The total amount of fixed deposits appears to be small, less than K Sh 90 million (as of March 2013). The CALC reports do not show the present value of fixed deposits but suggest that some entities had gone bankrupt and thus the investments are presumably lost. These cases suggest that DLAs and present counties manage fixed deposits without a strategy and keep anecdotal and unverified data. Corrective measures may include (1) revisiting the list of fixed deposits and segregating performing and nonperforming items; (2) verifying with partner entities the status and present value of each fixed deposit; (3) establishing clear records and a reliable inventory of fixed deposits; (4) adopting a strategy to hold, change, and manage these fixed deposits; and (5) writing off deposits accounted as held in entities that had moved out of business.

Inherited liabilities

Counties had inherited K Sh 53.8 billion in liabilities as of March 27, 2013, and NCC inherited over two-thirds of these (table 2.8). The broad categories of liabilities include domestic and foreign loans, unpaid staff emoluments, unremitted statutory deductions and insurance dues, unpaid trade creditors, and legal fees. CALC teams made little attempt to estimate the present value of inherited liabilities and failed to estimate the volume of nonperforming liabilities at the virtual

TABLE 2.8 Inherited liabilities, Kenya counties total, 2013 and 2018

LIABILITY CLASSES

Loans

of which overdrafts

of which foreign Staff emoluments

Statutory deductions Trade or commercial creditors

Legal fees Total

MARCH 27, 2013 NONPERFORMING, AUGUST 31, 2018

K Sh (BILLIONS) % OF TOTAL K Sh (BILLIONS)

25.4 47.3 19.4

% OF TOTAL

45.6

2.1 3.9 0.0 0.0

15.3 28.5 15.3 35.9

6.3 11.7 2.2 5.2

11.6 21.7 11.2 26.3

7.8 14.5 7.2 17.0

2.6 4.8 2.6 6.0

valuation date of August 31, 2018. Instead, they commented on some of the liabilities and challenges. CALC reports and interviews suggest that three major changes happened between 2013 and 2018: (1) counties have paid out some liabilities, such as short overdrafts and the bulk of staff emoluments; (2) counties continued performing several domestic loans, so those loans are inherited liabilities but performing; and finally, (3) counties failed to work out overdue statutory deductions and face increasing penalties, so the present value of statutory deductions with interest and penalties is estimated to have doubled by 2019.

In sum, despite repaying over K Sh 5.4 billion of liabilities and performing another K Sh 5 billion of debt, the present value of liabilities roughly remained the same amount (K Sh 53 billion) as the initial inherited volume in 2013. The IGRTC report indicates a K Sh 5.9 billion variation between TA and IGRTC/ CALC inventories, but lower estimates by counties are presumably due to the inconsistent accounting of subsequent changes—repayment is reported to be about K Sh 5.4 billion (IGRTC 2018, 75). Counties should revise their inherited liabilities to precisely account the present value of inherited dues after several subsequent transactions and focus on the nonperforming liabilities for workout.

Loans. Counties inherited domestic commercial loans (K Sh 4 billion) and have been performing most repayments. NCC has inherited a foreign loan DLA borrowed for the NCWSC that is nonperforming, and Nairobi City County Government (NCCG) has failed verification of loan documents, even though the National Treasury keeps performing this loan from the foreign creditor and presumably has in its files the initial loan and on-lending agreement. NCCG simply accounts it in the balance sheet among liabilities regardless of unclear and nonperforming status. Furthermore, field interviews with managers suggest that NCWSC has no cash flow to serve this loan. Counties also inherited K Sh 2 billion bank overdrafts listed in the IGRTC report as nonperforming, although interviews suggest that many counties do repay and use overdrafts nowadays. Finally, there were some minor loans from the National Housing Corporation, and a K Sh 3.8 billion guaranteed loan from the Local Governments Loans Authority, which should have absorbed this loan based on the guarantee, but it is still accounted in the IGRTC inventory.

Unremitted deductions. Counties inherited K Sh 7.8 billion in unpaid statutory deductions and K Sh 2.4 billion in unpaid staff deductions. Unremitted deductions are not only the second largest item in the list of inherited liabilities, but they are disputed and the most poisonous liabilities, because this initial volume is growing fast daily with applied high penalties, some with over 30 percent annual interest. As a result, the present value of these dues is estimated to have doubled by 2019.

Many counties have attempted to work out inherited unremitted deductions. For example, Mombasa handed over 600 dwellings in three compounds to eliminate statutory health and social security insurance liabilities. (It is unclear if these unremitted deductions are still included in the IGRTC list of liabilities, because Mombasa’s repaid deductions reflect a small number in the IGRTC list.) Nairobi has tried to negotiate repayment of the deductions’ principals if creditors eliminate the high penalties, but negotiations failed. High-level national government actions are required to open this gridlock and seek pragmatic resolution on inherited deductions.

Staff emoluments. Counties paid out two-thirds of unpaid staff emoluments soon after the transition as part of the restructuring of staff and dues, and thus

reduced the inherited K Sh 6.3 billion to K Sh 2.2 billion. Reports do not indicate the reason or plans toward further resolving issues on unpaid emoluments.

Trade and commercial creditors. The total volume of inherited liabilities vis-àvis commercial creditors was estimated at K Sh 7.8 billion in 2013 value. Field interviews suggest that many counties had negotiated and revised commercial claims and compensated some trade creditors, sometimes by swapping assets and claims (maybe land). For instance, in 2018 NCC’s commercial claims reached K Sh 11 billion, but the NCC government advertised that trade creditors should present supporting evidence of their claims and they would be paid after validation. As a result, the validated volume of claims after the K Sh 3 billion settlement dropped to K Sh 4.7 billion. These claims may coincide with the list of inherited projects or works in progress that had been completed and presumably paid subsequently. Thus, a double accounting may distort information on trade creditors. The IGRTC report is very brief about trade creditors and presents the estimated value as of March 27, 2013, without providing any update by 2018. A fair update of the trade creditor portfolio and a cross-check with the projects portfolio is an urgent corrective measure.

Legal fees. Both the IGRTC report and field information remain very brief about the nature, verified volume (K Sh 2.6 billion), and present value of legal fees, some of which also may have triggered penalty interest, and thus they may have expanded by 2019.

Corrective measures for inherited liabilities may include the following:

• Carefully (re)validate and update the portfolio of inherited liabilities to determine the legality of claims and the amount repaid or worked out in other ways. • Segregate performing and nonperforming claims and loans and estimate the present values of the claims at the date of revision. • Commence a national program to work out inherited unremitted deductions by drastically reducing penalties, seeking swap options, and encouraging parties to reach final solutions. Further rolling of these poisonous claims is unhealthy and should be avoided. • High-level political support is needed, and intervention by the National

Treasury, Summit, and other ministries is required to commence and implement a workout program aiming at full elimination of inherited nonperforming liabilities, because counties alone are unable to resolve these disputes and eliminate claims, either legally or financially.

IGRTC has elaborated these issues, defined options, and presented a list of proposals.

Liquidation options for inherited liabilities

IGRTC has analyzed and recommended liquidation options based on detailed consultations with key stakeholders in accordance with Section 2(2) of Gazette Notice no. 4370. The broad liquidation options include a combination of the following:

• Counties offset liabilities from their revenues (equitable shares and/or ownsource revenues [OSR]). • The national government sets up and populates a strategic intervention pool to allocate conditional grants for payment of some liabilities.

• National and county governments agree on joint payment of liabilities in agreed proportions. • National government entities (OAG) rule to enable writing-off some liabilities and/or waiving penalties binding to both creditors and debtors. • Use current assets to offset some liabilities, based on county-by-county analyses. • Enable swapping third-party collectibles for liabilities to liquidate both debts and liabilities.

IGRTC has accomplished detailed negotiations with key stakeholders and listed resolution options for 17 liability categories with specific recommendations that reflect the options listed. IGRTC also lists entities that should play a role in resolving specific liability categories. The report is unclear, however, if the listed national or commercial entities (sometimes a dozen to participate in the workout of an item) have agreed and are able and willing to perform the expected roles, such as setting aside a substantial amount of money (for example, by the National Treasury) to support elimination of inherited liabilities.

Furthermore, the list of resolution options includes the face value of the inherited liabilities as of March 27, 2013. Instead, for a pragmatic resolution the portfolio of inherited liabilities should be restructured to reflect (1) the nonperforming liabilities that should be worked out and (2) the present value of nonperforming liabilities. This would indicate the magnitude of the problem and inform resolution seekers with realistic numbers and needs for restructuring. These can support a summary table of resolution options structured by key stakeholders to indicate the magnitude of their estimated willing contributions, without which no solid commitment can be considered, since without a specific contribution volume it would be a blank check for them to sign a list. The summary list with estimated specific contributions may include the following:

• Creditors with the magnitude of principal value and the penalties proposed to be written off • Banks with interest to write off or capitalize, and the volume or principal of restructured loans • National Treasury/NALM-projected magnitude of contribution on behalf of the national government • Auditor General rule for writing off inherited overdue audit fees • Statutory creditors with amount of forgiven penalties and a capitalized net volume of demands to be converted to long-term, 5- to 10-year maturity loans (The IGRTC report suggests giving a maximum 3 years for counties to pay out all dues, but counties simply have no free cash flow with a magnitude that would be required for fast repayment—for example, it would eat up over half of NCC’s total annual budget for 3 years.)

This is a vicious circle because the amounts are imprecisely known before hard negotiations. Attaching amounts to options can be approached as an elaboration of options to inform hard negotiations, instead of being final results set by IGRTC or the national government. In short, there is a need to attach specific numbers to resolution options to provide solid ground to start an iterative process that would lead to final resolution and elimination of inherited nonperforming liabilities. Such elimination will include restructuring liabilities and converting immediate dues to long-term loans and moving nonperforming liabilities to performing ones, because, as noted, many counties cannot pay