Appellate Court Allows Lease-Leaseback Challenge to Proceed

June 2015

On June 1, 2015, the California Court of Appeal issued a decision that may force many public school districts to reevaluate the manner in which they utilize the lease-leaseback method of facilities construction.  (Davis v. Fresno Unified School Dist. (06/01/15, No. F068477).)  The court found that the plaintiff in the case adequately alleged three grounds for why the exception to competitive bidding found in Education Code section 17406 did not apply to the lease-leaseback arrangement between Fresno Unified School District (“District”) and its contractor.

The plaintiff, Stephen Davis, challenged a noncompetitive bid contract between the District and Harris Construction Co., Inc. (“Contractor”) for the construction of a middle school for $36.7 million.  The construction was completed in 2014 pursuant to a lease-leaseback arrangement that the District and the Contractor contended was exempt from competitive bidding under Education Code section 17406.  

Under the Site Lease—the “lease” in the lease-leaseback arrangement—the District leased the project site to the Contractor for $1 in rent.  The Facilities Lease—the “leaseback”—was structured so that the Contractor would build the project and sublease the site and project to the District in exchange for payments under a “Schedule of Lease Payments.”  Once the project was completed and the final lease payment made, the Facilities Lease terminated.  

Davis alleged the school construction project should have been competitively bid because the lease-leaseback arrangement did not create a true lease or satisfy the criteria for the exception from competitive bidding contained in section 17406.   

The court acknowledged another appellate court’s decision in Los Alamitos Unified School District v. Howard Contracting, Inc. (2014) holding that the exemption from competitive bidding under section 17406 can apply to lease-leaseback contracts, but extended the analysis of Los Alamitos by enumerating three additional factors that must be present for the exemption to be satisfied.

1.    The leases in the lease-leaseback arrangement must be “genuine.” The court concluded that for the statutory exemption from competitive bidding to apply, the underlying leases must be “genuine,” stating that the word “lease” refers “to the substance of the transaction and means more than a document designated a lease by the parties.”  It examined the Facilities Lease and found that its terms regarding the construction, payment, use, occupancy, possession and ownership of the new facilities supported Davis’s allegation that the arrangement was not a true lease that provided financing for the project.  The court found that the provisions about use, occupancy and title—and the fact that the District never occupied and used the project before making its final payment—provided sufficient support for Davis’s legal theory that the substance of the transaction “was a traditional construction contract and not a true lease that included a financing component.”

2.    The transaction must include a financing component.  To fulfill the primary statutory purpose of providing financing for school construction, the court determined that a lease-leaseback arrangement must include a financing component.  It observed that when a school district pays for the construction (using local bond funds) as it progresses—with final payment being made when construction is completed—such approach “cannot be characterized as a method of financing construction of new school facilities.”

3.    The leaseback agreement must provide for a district’s use of the facility during the term of the lease.  The court stated that “ a lease-leaseback arrangement qualifies for the exception to competitive bidding created by section 17406(a)(1) only if the instrument containing the leaseback requires the construction firm ‘to construct on the demised premises . . . a building or buildings for the use of the school district during the term of the lease.’ We interpret this statutory language to mean the leaseback must have a term during which the school district uses the new buildings.”  Here, the court found that Davis adequately alleged the Facilities Lease did not satisfy a criterion of section 17406(a)(1) because it did not provide for the District to use the newly constructed buildings during the term of the lease.

Addressing several other allegations in Davis’s complaint, the court rejected the argument that “the statutory scheme restricts the use of lease-leaseback arrangements to situations where the school district does not have sufficient available funds to cover the cost of building the new facilities.”  It also determined there was no violation of the Political Reform Act.  However, the court found the Davis adequately alleged a claim for conflict of interest under both Government Code section 1090 and common law based on allegations that the Contractor served as a professional consultant to the District and had a hand in designing and developing the plans and specifications for the project.

There is a possibility that the Legislature will revise or clarify the law in response to Davis in future legislation.  It is also possible that Davis will be appealed. However, districts should not rely on either possibility when considering the lease-leaseback method of construction for the foreseeable future.

Future lease-leaseback projects may be structured to comply with Davis.  Although there are certain, obvious drawbacks to this development, it should be noted that some changes may be of benefit to school districts.  For example, a recast facilities lease with a tenancy extending past the completion date for the project may aid in resolving some of troublesome issues associated with completion of traditional  construction projects, such as responsibility for completing punchlists, and commissioning and initial servicing of equipment. 

Yet, for lease-leaseback projects currently underway, the issues are considerably more complicated and will depend on a number of factors, including the language of the particular agreement, when the Board approved the agreement and the current status of construction.  Districts are strongly encouraged to consult their legal counsel for individualized issues that may arise from the Davis decision.

If you have any questions regarding this matter or for additional information contact one of F3’s many Business, Facilities and Real Property attorneys located throughout our six offices.

F3 NewsFlash prepared by Kathleen J. McKee, Paul G. Thompson, Mark S. Williams and James R. Traber.
Kathy is a partner in the F3 San Diego office.
Paul is a partner in the F3 Sacramento office.
Mark is a partner in the F3 Oakland, Los Angeles and Sacramento offices.
Jim is a senior associate in the F3 Sacramento office.

 Keep up to the minute on the latest updates, NewsFlashes, and legal news by following F3 on Twitter:@F3Law.

© 2015 Fagen Friedman & Fulfrost, LLP

All rights reserved, except that the Managing Partner of Fagen Friedman & Fulfrost, LLP hereby grants permission to any client of Fagen Friedman & Fulfrost, LLP to use, reproduce and distribute this NewsFlash intact and solely for the internal, noncommercial purposes of such client.