Raising finance for Formula 1 teams: pros and cons of a Resource Restriction Agreement

Published 09 April 2014 | Authored by: Cassian Goode

On 9 December 2013, the worldwide governing body for motorsports, the Fédération Internationale de l'Automobile (“FIA”), published a press release which may change the future of Formula One (“F1”):

"The principle of a global cost cap has been adopted. The limit will be applied from January 2015.

A working group will be established within the coming days comprising the FIA, representatives of the Commercial Rights Holder and Team representatives.

The objective of the working group will be to have regulations approved by the end of June 2014."1

This is, of course, not the first time the FIA has sought to cap the expenditure of F1 teams. However, unlike the apparently unilateral decision of the FIA to impose a cost cap of £40m in 2008 (which led to Ferrari seeking an injunction, and when this was unsuccessful, threatening to lead a breakaway series)2, the FIA’s recent press release was published following a meeting of the F1 Strategy Group and the Formula One Commission, where it was ‘unanimously approved’3. This detail is crucial, as given the F1 Strategy Group comprises Ferrari, Red Bull, McLaren and Mercedes, it would seem the sport’s most powerful and prosperous teams agree there must be a limit to teams’ expenditure.

 

Is the cost cap necessary?

There have always been teams which are well financed and teams which are poorly financed. However, whilst teams like Tyrrell and Lotus were once able to compete with better financed rivals by virtue of their engineering nous, the age of the garagistas has well and truly ended. The average amount spent by each of the twelve teams during the 2012 season was $220m4. This level of expenditure has, however, led to numerous concerns.

Firstly, competing in modern F1 requires money, and lots of it. Caterham, for instance, are likely to have spent more than $400m to participate in seventy seven grands prix, yet have failed to score a single point in the Constructors’ Championship. This recently led the team’s owner, Tony Fernandes, to articulate widespread fears regarding the continued participation of the smaller teams: "If we're not competing then we have to seriously examine ourselves and ask ‘does this make sense’?"5.  

Secondly, with advertising rate cards down6, the threat of insolvency has hung menacingly over many of the teams. During the 2013 season, reports emerged suggesting that Lotus and Sauber were unable to pay debts owed to both their suppliers and their drivers as they fell due, with Peter Sauber admitting that "we might not be able to drive if suppliers begin to stop supplying us"7. It seemed that, even for established teams, the cost of operating a competitive car was simply too high. 

Thirdly, as a result of the above, the sustainability of the sport has been called into question. According to the Chairman of Lotus, Gerard Lopez, "it is simply not possible to make a profit from F1 at the moment"8, a situation which led Martin Whitmarsh, ex-Team Principal at McLaren, to conclude he could not "see in their shoes [the seven smaller teams] how you can construct a sustainable business model"9.

It is hoped that the imposition of a cost cap will address these concerns. By reducing the amount the larger teams can spend, the smaller teams would be incentivised to remain in the sport, as the possibility of becoming competitive would seem more realistic. Furthermore, by forcing the teams to spend less, their endeavours to become competitive would not force them to spend beyond their means, and thereby risk insolvency. Lastly, by limiting their competitors’ expenditure, it would be possible for all teams to operate at a profit and attain commercial viability in the future. The overriding objective appears to be the creation of a competition where there is a competitive balance between the teams and where the teams’ future participation is sustainable.  

 

What will the regulations need to address?

There will need to be a significant amount of negotiation before any agreement could be reached.  Indeed, despite the FIA’s press release indicating the larger teams have agreed to a costs cap, it should be noted that they have only agreed to it in ‘principle10. Given the participants of the working group tasked with approving the cost cap regulations may well be opposed to one another’s agendas, it could be difficult to find a compromise position that is acceptable to all.  

The key will be finding a solution which can be applied fairly and which does not give any unintentional advantage to one team over another.  However, there is a concern that, even if a cost cap were to be introduced, it would be impossible for the FIA to financially evaluate each team’s expenditure, as the different corporate structures adopted by the teams would inevitably give rise to loopholes.11  According to Christian Horner, Team Principal at Red Bull, a cost cap would be "impossible to police" because "there are so many different structures, so many different entities"12.  

The first apparent loophole concerns intra-group transfers of assets at an undervalue between subsidiary companies.  It is believed, for instance, that if research performed at McLaren Applied Technologies Limited led to the development of a new technology, it could be transferred to McLaren Racing Limited for substantially less than the true value of the asset.  

The second apparent loophole concerns intra-group transfers of assets at an undervalue between a subsidiary company and their parent company.  It is also believed that, for teams backed by manufacturers, such as, for instance, Ferrari, it would be possible for assets developed by the parent company, Fiat SpA, to be transferred to the subsidiary company, Ferrari SpA, for substantially less than the true value of the asset.       

The third apparent loophole concerns transfers of assets for non-cash consideration between companies which are part of the same group.  It is also believed that it would be possible for companies to offer benefits-in-kind in lieu of cash consideration for assets and accordingly circumvent any limit on expenditure by attributing false valuations to such benefits.  This has recently been an issue in football, with the ability of UEFA to police the Financial Fair Play Regulations (“FFPRs”) likely to be soon tested by Manchester City FC, amidst reports alleging that the club may have only adhered to the FFPRs by entering into inflated image rights and intellectual property transaction with related parties13

It is clear that, if cost cap regulations are to be agreed, it will be necessary that they are carefully drafted to provide the FIA with the ability to financially evaluate each team’s expenditure regardless of their corporate structure or contractual arrangements.   

 

Could expenditure be financially evaluated?

The teams were similarly concerned about the ability of the FIA to financially evaluate each team’s expenditure during the failed attempt to introduce a cost cap in 200814.  Indeed, as a result of these concerns, the Formula One Teams’ Association (“FOTA”) proposed nominating independent accountants to devise an audit methodology which could then be used to evaluate each team’s expenditure15.  This would appear to be a logical solution to the issues outlined above.  

The ability to order an audit of each team would allow the FIA to determine the true value of assets which have been transferred between two entities.  Indeed, accountants will already be familiar with valuing assets which have been the subject of an intra-group transfer from a parent company or sister company at an undervalue, as they are already required to do so whenever a company makes a distribution of assets by virtue of Part 23 of the Companies Act 200616. Furthermore, accountants will also be familiar with valuing assets which have been the subject of a transfer to any person for non-cash consideration, as they are also already required to do so when determining if a company has transferred an asset at an undervalue by virtue of s.238 Insolvency Act 198617.  It would therefore seem that, contrary to Christian Horner’s concerns, it would be possible to police a cost cap as, despite the different corporate structures, there is the potential to ensure that any transaction at an undervalue or for benefits-in-kind could be financially evaluated and notionally added to a team’s expenditure to determine whether that team has adhered to any costs cap.  This is particularly so as given all the teams are involved in the same industry, it would be possible to develop a methodology which allows for a consistent and objective analysis regarding the value of expenditure related to F1.    

It is worth noting that other legislation has successfully dealt with similar issues.  Under Article 107(1) Treaty of the Functioning of the European Union, there is a prohibition on member states granting any form of aid to undertakings which would have the effect of distorting competition within the European Union.  This will often require an asset to be valued by reference to a notional market value were there to have been a sale between a willing seller and an arm’s length buyer.  On this basis, the European Commission conducted a valuation of land which the UK had sold to the Toyota Motor Corporation, concluding that the UK had provided illegal state aid by selling the asset at an undervalue of £4.2m.  Furthermore, there have also been sporting regulations that have already attempted to deal with similar issues, with the FFPRs allowing transactions made between related parties (essentially a person or company with a significant interest over the football club) to be notionally adjusted were the transfer deemed to have been made for anything other than fair value.  Importantly, in determining what constitutes a ‘related party’, the focus is on the substance of the relationship rather than the legal form of the entities involved (Annex X (E) FFPRs)18.  The outcome of UEFA’s Club Financial Control Body’s investigation into possible breaches of the FFPRs ought to provide valuable guidance to the working group tasked with approving F1’s cost cap19

(As an aside, if a company operating a football team or F1 team enters into a transaction with another company at an undervalue, it is difficult to see how the directors of that other company are prima facie complying with their duties as directors, particularly their duty to promote the success of that other company (s.172 Companies Act 200620).)    

 

Will there be agreement to implement a cost cap?

Although it is likely that the regulations would need to be somewhat extensive to account for all the possible variables, the complexities of drafting legislation to impose an effective limit on expenditure should not, in and of itself, prove fatal.  Indeed, other sports, such as American Football, have successfully implemented rules to limit expenditure through complex and sizeable legislation, with the NFL’s Collective Bargaining Agreement running beyond three hundred pages21.  

The objective of the FIA is to have regulations approved by the end of June 2014.  They have, therefore, provided six months for an agreement to be reached, although there must be doubts about whether this is achievable.  Even during the time it has taken to write this article, the position of the various teams appears to have changed, with McLaren, who recently appeared to be in favour of a cost cap, now apparently against one22. The reality is that, for those teams with healthy balance sheets, their financial advantage off the track will ensure they remain competitive on it, and they are unlikely to accept anything which would substantially change this position.  

 

Update

At the Bahrain Grand Prix on Sunday 6 April 2014, the FIA President Jean Todt announced that plans to agree a cost cap have now been abandoned: 

"I didn't believe we could really control through a cost cap. It was demonstrated to me that you could, so I said 'OK, if you can then I'm happy to put that on board'.  Most of the teams were in favour of the cost cap. I understand that all of the teams that are part of the Strategy Group are against the cost cap now. So clearly, if the commercial rights holder and [the F1 Strategy Group] are against it I can't impose it, it's mathematics. So in this case there is no more cost cap.  In a way, I am disappointed because it may be more difficult to achieve the [cost] reduction which I feel is needed.  But everyone says we are all in favour of reducing the cost, [but] through sporting regulation."23

Perhaps as a result of Sunday’s thrilling race, this story has not received much media attention.  However, the failure to reach an agreement is likely to have a severe impact on the smaller teams, particularly as previous efforts to limit expenditure by technical regulations have simply led teams to switch development into gaps between the regulations (merely "squeezing the balloon into another shape", according to Adam Parr, ex-CEO at Williams Grand Prix Holdings PLC24).   It will be interesting to see the reaction of the smaller teams, who spend a vast amount to compete in F1 yet appear to have no say in the sport’s future, particularly given Todt’s acknowledgment that it would be possible to control a cost cap.   

  

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About the Author

Cassian Goode

Cassian Goode

Cassian Goode is an Associate Solicitor at Clyde & Co. Cassian enjoys both watching and playing many sports and represented his county in both rugby union and hockey.

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