The lease-leaseback structure permits builder-financed construction. A school district leases real estate it owns to a construction firm for $1.00 per year and the contractor agrees to build new facilities on that real estate. This gives the contractor sufficient property rights to “leaseback” the property, and serves as collateral the construction firm can use to obtain third-party financing. Under the financing method, the school can pay the builder back, via the terms of a lease, which can last up to forty years. Under Education Code section 17406(a)(1), a school district is exempt from the competitive bidding process otherwise required by Education Code section 17417 and the Public Contract Code.
Relying on Education Code section 17406(a)(1), the Fresno USD leased its project site to a contractor for $1 in rent with the contractor agreeing to construct facilities in accordance with the District’s plans and specifications in exchange for payments under a “Schedule of Lease Payments.” The lease set out scheduled lease payments as “monthly progress payments” until project completion, at which point the District made final payment for all work, and the term of the lease ended. The lease was in effect only during the construction of the school facilities; and the funds Fresno USD paid were solely for the construction services performed by the Contractor.
In November 2012, Davis, a local taxpayer, filed a lawsuit challenging Fresno USD’s lease-leaseback process. In his lawsuit, he alleged failure to comply with the competitive bidding requirements. He also alleged a conflict of interest by Contractor based on its participation in the planning and design of the project as a consultant to Fresno USD before the District awarded contracts for the project’s construction, and related legal theories.
Fresno USD and the Contractor filed demurrers, arguing that actions by other school districts to validate other, similar arrangements were routinely unopposed. Courts in similar cases found that site leases, subleases, and pre-construction services agreements entered into by school districts pursuant to section 17460 were not subject to Public Contract Code requirements for award of construction contracts to the lowest responsible bidder. The trial court sustained the demurrers, dismissed the suit, and entered judgment in favor of Fresno USD and the Contractor.
On appeal, the Court determined that the terms of Fresno USD’s contract with its builder was more akin to a traditional construction contract, and not a lease. The payment schedule aligned with progress for construction services; whereas under a lease, payments are for a set time, such as monthly, during which the lessee occupies and uses the real property. Not only was “leaseback” in effect only during the course of the construction, the school district did not occupy and use the new facilities as a “rent-paying tenant” for any set length of time. Because the contractual arrangement was for “construction services” and not a true lease-leaseback as a method of financing, the Court determined that Davis had sufficiently alleged that Fresno USD had violated the competitive bidding requirements. (Davis v. Fresno Unified School District)
In drawing this conclusion, the Court explained that the legislature’s primary purpose in enacting Section 17406(a)(1) was “to create a way for school districts to pay for construction over time and avoid the constitutional limitation on debt.” (Davis) The Legislature created the lease-leaseback exception to the competitive bidding process to encourage a new source of financing, and allow school districts, contractors, and third-party lenders to enter into “earnest negotiations” of the construction and financing arrangements “without the concern that the deal would be subsequently derailed by the competitive bidding process.” (Id. at p. 12)
With these underlying alternate-financing principles in mind, the Davis Court determined that Section 17406 applies only to “genuine or true leases,” though it did not go further in agreeing with the plaintiff that lease-leaseback arrangement should be restricted to situations where a school district does not otherwise have sufficient funds available to cover the cost of building. (Id. at p. 17.)
To determine whether a lease-leaseback contract is a “true lease,” and not simply a traditional construction contract the Court will look to: (1) provisions in the contract that define who holds what property rights, and when those rights and interests are transferred between parties; and (2) the amount and timing of payments. (Id. at 20) To be a “true” lease in compliance with Section 17406(a)(1), a school district must actually use the newly constructed premises, as a tenant, “during the term of the lease.” (Davis – emphasis original) The school district must use the building, and not another entity.
In addressing the conflict of interest claim, the Court found that Davis had alleged sufficient facts to allow the case to proceed on the conflict of interest claim. The Court stated that whether Davis will prove this claim will depend on the evidence presented in the trial court.
In Los Alamitos Unified School District v. Howard Contracting, Inc., a different Court of Appeal determined that a public agency could “indirectly but effectively” self-validate an action (under Code of Civil Procedure sections 863, 860) by refraining from initiating a validation action. The Court explained that an interested person may bring an action to determine the validity of the matter, but they must do so within 60 days. (Code of Civil Procedure, sections 863, 860.) If no interested person commences such action, and if the public agency does not initiate such action, within the 60-day period, the action becomes immune from attack. (Los Alamitos)Thus, the agency could “self-validate” an action, simply by doing nothing.
In a footnote to the Fifth District’s June 1, 2015 decision in Davis, the Court noted that Defendants “could have avoided this post-completion taxpayer challenge by bringing a validation action under Code of Civil Procedure section 860 prior to the construction of the project.” (Davis at p. 5) This conflicts with the holding in Los Alamitos, which did not require a validation action to commence “prior to  construction,” but within 60 days of the underlying action – in that case entry into the lease-leaseback agreement.
Because of the potential conflict between the 60-day inaction and resultant self-validation period described by Los Alamitos, and the “prior to [ ] construction” language articulated in Davis, this issue may be ripe for review by the California Supreme Court.
Davis v. Fresno Unified School District (2015) — Cal.App.4th —- [2015 WL 3454720]
For a discussion of the Los Alamitos case, please see our October 2014 Education Matters article. We will follow this issue closely and keep you informed of further developments.