Orange County Branch Newsletter

September 2015

Law and CE News

Creativity Can Only Go So Far: Recent Case Creates Uncertainty Regarding Lease-Leaseback Arrangements

For many years, public school construction in California has had the use of an alternate financing tool: the lease-leaseback contract. In its pure form under a lease-leaseback arrangement, the district leases a piece of land to a contractor for a nominal sum (usually $1). The contractor then finances and builds a project on the land. Once completed, the contractor leases the land (with the completed project on it) back to the district for a period of time not more than 40 years. That period of time, and the lease payments made by the District during that period of time, is designed to be sufficient to compensate the contractor for building the project. At the end of that lease, the building vests back to the school district. In the last ten years, several districts have gotten very creative about how those contracts and transactions were structured. We have seen a shift to many of these transactions involving lease terms that equal the construction period, lease payments that just coincidentally equal the construction payments, and other various contract terms in an attempt to employ the lease-lease back concept. However, the California Court of Appeal in Fresno recently clarified the requirements and appropriate use of lease-leaseback arrangements in the case of Davis v. Fresno Unified School District.

In Davis, the Plaintiff, an individual, challenged these creative contracting practices. The District initially filed a demurrer, which is a request to the court that the case be dismissed because the Plaintiff has not stated a valid legal claim. The District won on that demurrer, and the Plaintiff appealed the decision to the Court of Appeal. After an extensive review of the legislative history of lease-leaseback contracts, the Court of Appeal determined that the Plaintiff did in fact state a valid claim and may proceed with litigation. While a final ruling regarding the validity of the contract in Fresno has not been issued, this case confirms that the provisions of the lease, method of financing, and structuring of payment is crucial to establishing a valid lease-leaseback arrangement.

Lease-leaseback arrangements were originally authorized in the 1950’s to provide school districts with an alternative means of financing facilities projects. Today, however, lease-leaseback arrangements are also commonly utilized for school district projects to avoid the competitive bidding requirements imposed on public entities. The original impetus for the adoption of this method was a legal issue that prohibited school districts from incurring indebtedness that exceeded the amount of one year’s income without first obtaining a two-thirds voter approval. With the cost of construction where it is (and was in the post-World War II era when the law waspassed), this essentially means that without voter approved local bonds, school districts would not be able to undertake any significant construction. 

In 1957, the Legislature authorized lease-leaseback arrangements in Education Code section 17406 as an alternative method for financing and delivering a project. The end result of this contract structure (described above) is that the construction cost is financed privately through the contractor, who in turn receives compensation through payments over the term of the lease. The school district enjoys the benefit of paying for the project over time and avoids the legal limitations on indebtedness.

To encourage use of this new method of financing, the Legislature included an exemption to the competitive bidding process. Under that exemption, districts are not required to go through the public bid process and award the construction contract to the lowest responsible bidder. This has made lease-leaseback a popular method of project delivery to this day.

In recent years, school districts and contractors have utilized the lease-leaseback process on publicly funded projects in order to avoid the competitive bidding requirements applicable to traditional methods of delivery. In Davis v. Fresno Unified School District, the School District funded construction through local bond funds and entered into a lease-leaseback arrangement. The land was leased to the contractor only for the duration of construction, with the lease expiring at the time of final payment and occupancy by the District.

On June 1, 2015, the Court of Appeal (5th District which covers the Fresno/Central Valley area) issued a ruling that this specific form of lease-leaseback arrangement may violate the provisions of Section 17406. Specifically, the court examined whether a genuine lease had been created which would qualify for the benefits of the lease-leaseback arrangement. Section 17406 explicitly requires the new facilities to be “for the use of the school district during the term of the lease.” In reviewing a lease, the Court examined: “(1) who holds property rights and when those rights and interests are transferred between the parties, and (2) the amount and timing of payments.” In Davis, payments under the lease were based upon progress of construction rather than the period of time the lessee occupies and uses the property. As a result, the Court viewed these payments as compensation for construction rather than a lease for use of the facilities. And because those payments were coming from the bond revenue the District had raised, the element of having the contractor secure the private financing to pay for construction was missing. This was one of the hallmarks that lead to the creation of lease-leaseback – the contractor would finance the construction and then be repaid over the life of the lease. Those lease payments, the Court held, should be structured as a traditional lease or rent payments, not construction progress payments. In other words, the District should be paying a fixed amount for the use of the facilities over a period of time. That amount, in turn, should be enough to compensate the contractor for securing the financing for the original construction.  Additionally, the Court found the actual term of the lease to be vital to this analysis. In Davis, the lease expired upon completion of construction. As a result, the contractor never acted as a landlord and the School District never occupied and used the premises as a true tenant. The Court of Appeal determined there must be a period during which the school district makes use of the facilities as a tenant for there to be a genuine lease which would qualify for the competitive bidding process exception. In light of this analysis, the Court of Appeal reversed the decision of the trial court that granted the District’s attack on the pleading which is known as a demurrer. In doing so, the Court of Appeal held that the Plaintiff had at least stated a legally cognizable claim and that the case could proceed to trial. It is important to note that while this decision on its face does not invalidate the particular lease-leaseback contract at issue, the strong language used by the Court of Appeal certainly seems to foretell that this particular arrangement may be problematic under the law.

The Future of Lease-Leaseback Arrangements
This case did not end lease-leaseback arrangements in the State. However, it has presented serious questions regarding the validity of lease-leaseback arrangements in which the lease expires upon completion of the project, payments are based upon progress of construction, and financing is secured through public funds. But, if structured properly, the lease-leaseback should be alive and well as an alternative means for districts to build their projects. The real issue the Court had was with the creative nuances that have worked their way into the lease-leaseback structure over the last decade or so. The outcome of this case will be monitored closely. The analysis presented by the Court of Appeal suggests that lease-leaseback contracts will soon become much stricter in terms of complying with the letter of the law.

Please contact us to discuss further.

David E. Barker | dbarker@ccmslaw.com  

Ryan E. Palumbo  | rpalumbo@ccmslaw.com 

Collins Collins Muir + Stewart LLP

Nothing contained in this article should be considered legal advice. Anyone who reads this article should consult with an attorney before acting on anything contained in this or any other article on legal matters, as facts and circumstances will vary from case to case.