On June 1, 2015, a California Court of Appeal held that in order for a lease-leaseback arrangement to be enforceable, the lease must be “genuine”, containing both a financing component and a lease term that extends beyond the construction period (Davis v. Fresno Unified School District, et al. (2015) __CalRptr.3d__ [2015 WL 3454720].)
In 2012, the Fresno Unified School District (District) entered into a negotiated agreement utilizing the lease-leaseback project delivery method for the construction of improvements at a District middle school. The District leased the project site to the contractor for a nominal amount through a site lease (the lease). The contractor then constructed the project on the site and, during the construction period, purported to lease the site back to the District through a facilities lease (the leaseback). The total of the facilities lease payments equaled the cost of construction, and were paid monthly based of the progress of the construction work. Once the construction was complete, both leases terminated, and the facilities were handed over to the District. Plaintiff Stephen Davis, a taxpayer, filed a lawsuit against the District and the contractor, challenging the noncompetitive contractual arrangement and contending, in relevant part, that the arrangement was invalid because it did not satisfy the statutory criteria for a lease-leaseback.
The Court of Appeal held that the exception to the competitive bidding requirement in section 17406(a) of the California Education Code only applies if a lease-leaseback is “genuine,” meaning that it includes both a financing component and a lease term during which the District uses the improvement (that is, a lease term beyond the construction period). The rationale offered by the court was that the primary legislative intent behind the exception to competitive bidding is to provide a source of financing for the construction of public schools, enabling school districts to avoid the constitutional debt limit while making payments over an extended period.
In addition, the court noted that the performance of preconstruction (e.g., consulting) services may disqualify a contractor from securing the lease-leaseback contract itself on conflict of interest grounds.
Lease-leasebacks should include provisions which would avoid the result in the Davis case, specifically, by employing a lease as a tool to finance the project (rather than a tool to merely pay for construction), and by providing for a lease term that extends beyond the construction period. Providing for an extended lease term may aid districts in resolving some troublesome issues associated with the completion of traditional construction projects, such as repair of defects and performance of warranty work generally. However, it may be that the upshot of the Davis case is that districts will look to other delivery methods, such as the design-build delivery method, rather than lease-leaseback, when they want to select a contractor on factors other than low price.