For the past several years, school districts throughout the State of California have increasingly utilized the lease-leaseback contracting method to complete their new construction and modernization projects. Since 1957, the Legislature has provided an exemption to the normal design-bid-build competitive bidding process under Education Code section 17406(a)(1) which permits a lease-leaseback structure for builder-financed construction.
Using this contracting structure, 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.
School Districts utilizing the lease-leaseback structure have claimed significant monetary and time savings on their public works projects by using a competitive best value selection process rather than awarding strictly on the basis of the lowest responsive and responsible bid. Since the awarded lease-leaseback contractor must build the project for a Guaranteed Maximum Price (“GMP”), with limited exceptions, contractors are incentivized to work closely with the district to minimize change orders and delays in the completion of the project.
Fresno Unified School District's Project
Relying on Education Code section 17406(a)(1), the Fresno Unified School District's governing board in 2012 authorized the execution of a contract for the construction of buildings and facilities at a middle school. Under the contracts associated with the project, Fresno Unified was to lease the project site to Harris Construction Co., Inc. (Contractor). The Contractor would then build the project and lease the improvements and site back to Fresno Unified.
The Site Lease made the project site available to the Contractor for $1 in rent. The Facilities Lease provided that the Contractor would build the project in keeping with lengthy “Construction Provisions” and then sublease the site and project back to Fresno Unified in exchange for payments under a “Schedule of Lease Payments.”
The Schedule of Lease Payments was keyed to payments set out in the Construction Provisions, so that, in effect, the funds paid by Fresno Unified under the Facilities Lease were based solely on the construction services performed by the Contractor. The Facilities Lease was scheduled to terminate when the construction project was completed and the final lease payment was made. Construction was completed in 2014.
Fresno Unified was not scheduled to, and did not occupy the school facility until the lease was terminated. Stephen Davis, a local taxpayer and principal at Fresno-based Davis Moreno Construction, challenged Fresno Unified's arrangement with the Contractor as in violation of the Public Contract Code's competitive bidding requirements. Davis alleged the school construction project should have been competitively bid because the lease-leaseback arrangement did not create a true leaseback or satisfy the criteria for a statutory exception in §17406.
Davis also alleged Fresno Unified's board breached its fiduciary duties by approving the costly arrangement, and that the Contractor had an impermissible conflict of interest that rendered the lease-leaseback agreement void.
The District filed a demurrer, which was sustained by the trial court, claiming that courts in similar cases found that site leases, subleases, and pre-construction services agreements entered into by school districts pursuant to Section 17406 were not subject to the competitive bidding requirement to award to the lowest responsible bidder.
On appeal, the Fifth Appellate District reversed the trial court decision notwithstanding that there have been approximately 10 appellate court decisions prior to the Davis opinion which have validated the use of the lease-leaseback documents and structure similar to what the District has been using.
The court held that Davis stated a claim for violation of the requirement for competitive bidding on a public works project by alleging that a statutory exception for school construction did not apply where a school district's lease-leaseback arrangement with a construction contractor was merely a subterfuge that disguised a traditional construction agreement. Davis construed the competitive bidding exception of §17406(a)(1) to apply only to genuine leases.
The court agreed. By referring to buildings for use of the school district during the term of the “lease,” the Legislature meant an agreement that had the real substance of a lease, and not merely something the parties called a lease. In addition,to meet the primary statutory purpose of providing financing for school construction, the arrangement had to include a financing component.
In this case, Davis sufficiently alleged that the lease at issue was a subterfuge that did not provide financing for the project. Compensation paid to the Contractor was for construction, not for a period of use of the project facilities. In addition, the arrangement did not contemplate that the Contractor and Fresno Unified would proceed under a true landlord- tenant relationship. Instead, Fresno Unified simply paid for construction and took title when that was completed. Davis therefore stated a cause of action for a violation of the competitive bidding requirements normally in place for such a project.
The court clarified, as well, that a qualifying lease-leaseback arrangement must have a term during which the school district uses the new buildings constructed under the arrangement.
Finally, Davis alleged sufficient facts to state a cause of action for a violation of Government Code §1090's conflict of interest provisions, which also meant he stated a common law claim for a conflict of interest.
Davis's allegation that the Contractor provided services to Fresno Unified as a paid consultant under the pre-construction services agreement and that this fact was sufficient to raise the possibility that the Contractor was a “public official” subject to conflicts of interest in Government Code §87100.
It is important to note that the appellate court did not determine that the District had improperly used the lease-leaseback structure, only that Davis had alleged sufficient facts to state a cause of action and therefore sent the case back to the trial court for further litigation on the above issues.
Petition for Review of Court of Appeal Decision
Once the Court of Appeal decision becomes final on July 1, 2015, trial courts will be required to follow the Davis decision. On Friday, June 12, 2015, the Board of Trustees for Fresno Unified voted to file a petition for review of the case before the California Supreme Court. The District has until July 10th to file the petition. Once filed, the California Supreme Court has 60 days in which to makes its decision whether to accept review of the case. If the high court accepts review of the case, the appellate court holding in Davis v. Fresno Unified School District will be set aside until the court makes a final decision, which may take more than a year. If either the California Supreme Court declines to accept review of the case or sustains the holding of the appellate court, the appellate court decision will be reinstated retroactively to the June 1, 2015 decision.
Revision of Lease-leaseback Documents
At the June 12, 2015 C.A.S.H. Legislative Advisory Committee meeting held at Long Beach Unified School District in which the Davis opinion was discussed, it was agreed that the lease-leaseback is still a practical and useful tool for school districts and the Davis decision did not change that.
It was the consensus from attendees that pending final resolution of the Davis decision, that school districts revise their existing lease-leaseback documents, as needed: (1) to ensure that a genuine lease is entered into by the parties; (2) that a financing component is included in the lease-leaseback arrangement; and (3) that the school district use the facilities constructed during the term of the lease.
There was no consensus regarding the potential conflict of interest claim other than to avoid if possible from entering into pre-construction services agreements until it is ultimately determined whether a contractor entering into a preconstruction services agreement with the District should be considered an officer or employee of the District subject to Government Code section 1090 and its prohibition from being “financially interested in any contract made by them in their official capacity.”
To comply with these recommendations, our office has revised its standard form of lease-leaseback documents to provide that the lease of completed facilities continue for a period of 6 months following the school district's acceptance of the project as complete, and that 15% of the project cost be financed by the contractor during this extended 6 month period. Unfortunately, until a final decision is reached, it will not be known whether these fixes are necessary, and if so, whether they are sufficient.
Our office will continue to closely monitor the status of the Davis case as well as any other similar cases and will advise the District accordingly.
Should you have any questions, please do not hesitate to contact Douglas N. Yeoman at (714) 573-0900, or via the contact form on the menu above.