Lease/Leaseback Transactions Under Fire

On August 26, 2015, the California Supreme Court refused to review the Fifth Appellate District’s decision in Davis v. Fresno Unified School District, allowing the case to return to the Superior Court for a trial on the merits. In addition, the Supreme Court refused to depublish the Davis Court’s decision, which means that parties involved in other litigation involving lease/leaseback contracts or conflict of interest claims are entitled to cite the Davis decision as authority.

The Supreme Court’s actions leave California school districts in a precarious position with respect to the use of lease/leaseback contracts. Consequently, California school districts are cautioned to either avoid utilizing the lease/leaseback delivery method or to tailor their lease/leaseback contracts so that they avoid the criticisms raised by the Davis Court.

In analyzing whether a particular lease/leaseback contract would comply with the dictates of the Davis decision, a brief summary of the case is helpful. On June 1, 2015, the Fifth Appellate District Court of Appeal of California held that a taxpayer properly alleged a claim that the particular lease-leaseback contract entered into between Fresno Unified School District (“FUSD”) and Harris Construction Co., Inc. (“Harris”) did not comply with the provisions of Education Code § 17406 and, as a result, such lease/leaseback contract was not exempt from the competitive bidding requirements. The Court gave three reasons for its holding:

1. The Facilities Lease was, in fact, just a traditional construction contact. Section 17406 requires that the school district and the builder enter into a true lease, not simply a traditional construction contract designated as a “lease” by the parties.

2. The FUSD/Harris lease-leaseback arrangement did not include a financing component for the construction of the project.

3. The FUSD/Harris lease-leaseback arrangement did not provide for FUSD to use the newly built facilities “during the term of the lease,” as required by § 17406.

The Court stated that the Legislature’s primary purpose in adopting the lease-leaseback arrangement “was to provide a new source of financing for the construction of schools.” That is, rather than financing a construction project with its own funds or funds obtained from the issuance of bonds, “the builder finances the project (probably with assistance from a third party lender) and is paid over the term of the lease, which can last 40 years.” The builder is to be repaid, not through normal construction progress payments, but “with a stream of payments spread over a specified period – namely, the term of the lease.” Specifically, the Court rejected the argument that the Legislature intended the lease-leaseback arrangement to create a broad or easily satisfied exception to the competitive bidding process.

The Court further stated the lease from the builder to the school district must have a term during which the school district uses the newly constructed buildings. The Court noted that both the Site Lease and the Facilities Lease between FUSD and Harris terminated at the completion of the construction; that is, at no time during the term of the lease would FUSD use the newly constructed buildings.

School districts going forward with the lease/leaseback delivery method must be mindful of the Davis Court’s criticisms of the particular lease/leaseback contract at issue in that case, and adjust their own lease/leaseback contracts to avoid those issues. Unfortunately, while the Davis Court made its criticisms clear, it provided little guidance on how a lease/leaseback contract can be amended to avoid these problems.

For example, the Davis Court stated that a lease/leaseback contract must contain a financing provision. What exactly does this require? Must the contractor finance 100% of the project? Will 10% satisfy this requirement? The answer is unclear. In addition, the Davis Court, in support of its finding that there was no true financing on the part of the contractor, noted that the monthly payments to the contractor “were based on the progress of the construction.” Does this mean that the monthly payments to the contractor must be more akin to a typical lease (i.e. a stream of payments in an equal amount)? Again, there is little guidance given.

The Davis Court stated that the school district must occupy the facilities during the term of the lease. That is, the lease cannot end upon the completion of construction. How long must the lease continue beyond the completion of construction? One year? Five years? Twenty years? Again, the answer is unclear.

In addition to the lease/leaseback issues, the Davis Court also addressed an issue resulting from Harris providing preconstruction services in connection with the project. The allegation was that the preconstruction services included the development of the plans, specifications and other construction documents. Based upon these preconstruction services, the plaintiff in Davis alleged that Harris had a conflict of interest and, therefore, should have been precluded from entering into the lease-leaseback contracts. The Davis Court held that based upon these allegations, the plaintiff was able to state both a common law cause of action for conflict of interest as well as a conflict of interest claim based on Government Code § 1090.

For any questions regarding this decision or lease/leaseback transactions, please contact Al Erkel.