Is it the End of Lease-Leasebacks as We Know it?

[This article was written by Wendel Rosen’s Construction Practice and appeared in The Wendel Report: Construction and Infrastructure Update, August 2016.]

TEOTWAWKI.

The end of the world as we know it.

For K-12 school construction contractors it could well be.

Although their acronym would likely be TEOLLAWKI. The end of lease-leasebacks as we know it.

Lease-leasebacks, an alternative form of project delivery in which a school district leases property it owns to a builder-developer for as little as $1 and the builder-developer in turn builds a school facility on the property and leases the facility back to the school district – and which does not require competitive bidding – has come under fire.

One of the most talked-about cases of this past year – Davis v. Fresno Unified School District (2015) 237 Cal.App.4^th 261 – has sparked state-wide debate and has created uncertainty for many school districts and school construction contractors over the future of lease-leaseback projects in California and the legality of billions of dollars in lease-leaseback contracts which have already been entered.

Background

In 2012, the Fresno Unified School District (“District”) entered into a lease-leaseback arrangement with Harris Construction Company, Inc. (“Harris”) for the construction of the Rutherford B. Gaston Sr. Middle School, a $37 million project, in Fresno, California. Under the arrangement, the District was to pay Harris monthly progress payments during the course of construction, up to 95 percent of the total value of the work performed, with 5 percent retention held until acceptance of the project and recordation a notice of completion. Once the project was completed and the final “lease” payment was made, the facility and site reverted back to the District.

Stephen Davis, a taxpayer, later filed a taxpayer suit challenging the lease-leaseback – which, by law, does not require competitive bidding – as not being a lease-leaseback project at all, but rather, an ordinary design-bid-build project subject to competitive bidding requirements. Specifically, Davis alleged that, while the District leased the site to Harris while the project was being constructed, there was no genuine leaseback back to the District because the District did not use and occupy the facility during the leaseback period, which was during construction, but only after the leaseback period ended, when the project was completed.

The District and Harris challenged the lawsuit and the trial court agreed. Davis then appealed.

The Court of Appeals Decision

On appeal, the California Court of Appeals examined Education Code section 17406 which authorizes the use of lease-leasebacks by school districts, and which provides, in pertinent part:

(a)(1) Notwithstanding Section 17417, the governing board of a school district, without advertising for bids, may let, for a minimum rental of one dollar ($1) a year, to any person, firm, or corporation any real property that belongs to the district if the instrument by which this property is let requires the lessee therein to construct on the demised premises, or provide for the construction thereon of, a building or buildings for the use of the school district during the term of the lease, and provides that title to that building shall vest in the school district at the expiration of that term. The instrument may provide for the means or methods by which that title shall vest in the school district prior to the expiration of that term, and shall contain other terms and conditions as the governing board may deem to be in the best interest of the school district.

Focusing on the phrase “a building or buildings for the use of the school district during the term of the lease” as used in Section 17406, the Court of Appeals explained, that “the Legislature uses words to indicate substance, not merely as labels” and thus “the word ‘lease’ used in Section 17406(a)(1) . . . means something more than a document designated by the parties as a lease.” Thus, explained the Court, a lease-leaseback must be a true “lease” to satisfy Section 14706 not merely a document labeled as one.

Looking at the arrangement between the District and Harris, the Court held that the purported lease-leaseback arrangement did not have the indicia of a true “lease” under Section 17406 which would exempt the project from the state’s competitive bidding requirements, namely:

• The payments made by the District to Harris, which varied based on Harris’ progress on the project, and which included a holdback for retention, had the earmarks of a construction contract not a lease.
• The payments made by the District to Harris were for the actual work performed by Harris and its subcontractors, suggesting a construction contract, not for payments under a construction loan obtained by Harris, which would occur in a lease-leaseback arrangement.
• Because the leaseback period ended when the project was completed, Harris never acted in the capacity of a landlord and the District never used the facilities as a tenant, the sine qua non of a lease-leaseback.

Furthermore, held the Court of Appeals, a plain reading of the phrase a building or buildings for the use of the school district during the term of the lease, means that there must be a lease term during which a school district, as a tenant, makes use of newly built facilities built by a construction firm. Thus, if there is no term during which a school district leases newly built facilities from a construction firm, the arrangement is not a lease-leaseback, and the project is subject to competitive bidding.

However, the Court of Appeals rejected Davis’ argument that lease-leaseback arrangements are only available to a school district if a school district has no other means of financing a project, finding no express provision in the statutes providing for such a limitation.

Conclusion

For school districts and school construction contractors Davis is a cautionary tale. If you are going to try to avoid the competitive bidding laws (there’s also a discussion in the case about Harris having served as a “consultant” to the District with a hand in designing and developing plans for the project which it later constructed) through a lease-leaseback project, it better truly be a lease-leaseback project, and not just a typical design-bid-build project sans competitive bidding. The question in the minds of many school districts and school construction contractors, however, is where the line between a valid and invalid lease-leaseback project lies.