A common method of California Public School Districts to award contracts for new construction and improvements to existing facilities is the lease-leaseback method. Education Code Section 17406 provides a contracting methodology for school districts to avoid the competitive bidding process. The contracting method provides that the district lease land that it owns to the general contractor for a nominal amount; the contractor agrees to build facilities on that site and then leases the facilities back to this district for a specified time at a specified rental amount. At the end of the lease, title reverts back to the District. This method of contracting envisions the contractor financing the construction (often through a third party) and being paid over the term of the lease, which is generally for a significant period of time.
In Davis v. Fresno Unified School District, Fifth Appellate District Appeal No. F068477 (June 15, 2015), plaintiff, a taxpayer, challenged the use of the lease-leaseback method for the construction at a middle school campus for the Fresno Unified School District. Plaintiff alleged that the lease-leaseback exception to the competitive bidding requirement did not apply to the project because (1) the exception is only available for true lease-leasebacks, (2) the contract did not include a financing component, and (3) the contract did not provide for the District’s use of the facilities during the term of the lease as required by Section 17406. Plaintiff also alleged that the contractor had a conflict of interest because it participated in the pre-award planning and design of the project as a consultant to the District.
The construction contract in question provided that the District would pay progress payments to the contractor for services performed during construction. Once the project was complete, the contractor’s lease terminated and title reverted to the District. The lease was in effect only during the construction of the facilities and the funds the District paid to the contractor were only for services performed by the contractor.
The District and general contractor demurred to the operative first amended complaint. The demurrers asserted that other courts had found similar site leases, subleases, and pre-construction services agreements entered into by school districts were not subject to the competitive bidding requirements of Education Code Section 17417. The trial court sustained the demurrers and entered judgment in favor of the district and contractor. Plaintiff appealed.
On appeal, however, the Fifth Appellate District found that Plaintiff had stated viable claims against the district and the contractor. The appellate court noted that there were apparent irregularities with respect to the contract, most notably in its financing and lease terms. The appellate court stated that Section 17406 applied only when the parties could show that there was a true or genuine lease as opposed to a conventional construction contract. To determine if the proposed lease – lease back contract contains a true or genuine lease, the appellate court stated that courts should examine whether there are provisions in the contract that identify who holds the property rights, when those rights transfer between the contracting parties, the amount of payments, and the timing of payments. To be a true or genuine lease, the court further noted that the district must use the constructed facilities as a tenant during the term of the lease. With respect to the contract in question, the court found that the contract did not provide for the district’s use of the constructed facilities during the term of the lease and did not include a financing component, but rather was like a traditional construction contract with progress payments.
The appellate court reversed the trial court’s decision to all claims but Plaintiff’s claims for breach of fiduciary duty, violation of the Political Reform Act of 1974, and Plaintiff’s claim based upon alternative available sources of funding.
The Fifth Appellate District’s ruling calls into question this type of contracting method. School districts and contractors who wish to use this type of contracting must be certain to include a financing component with a schedule of lease payments and a provision permitting the district to use the facilities during the term of the lease after construction has completed. If a school district intends to use the lease – lease back method, a footnote in the Davis case suggests that the school district consider filing a validation action under Code of Civil Procedure Section 860 prior to the commencement of construction to avoid this type of challenge to the contracting method. Alternatively, and particularly in those cases where the school district provides financing during the construction process and obtains title to the improvements immediately after the completion of construction, the school district should consider awarding the construction contract through the competitive bidding process.