I am unable to take a call at the moment but I can do this evening if that works for you.
Unfortunately, it is irrelevant what condition the property is and if you had obtained consent from your mortgage to rent the property. The issue here is you are carrying out an activity that requires a licence which you do not have.
When the council came to visit and gave you the two options, did they mention to you that it was possible the exemption may not be granted?
The changes they have listed are part of the regulations for a HMO property so if you do continue to operate the HMO, you will need to ensure these works are carried out otherwise you may face further fines.
The council do have rights to issue a penalty, if you refer to the government website it does set out the regulations:
Fines and penalties can in some instances be unlimited as you will see on the link.
If you do not apply for the licences, the council are probably likely to issue a fine.
If you pay the additional fees for the licences and carry out the works they have suggested, I cannot see how they can justify applying a penalty on top of that aswell.
The tenants are able to apply for rent repayments regardless of whether they feel look afteer