A lease-leaseback agreement in California historically allows a school to lease land it owns to a contractor for a nominal amount in return for the contractor’s agreement to build school facilities on that site. In the aftermath of the Fifth Appellate District of California’s ruling in the 2015 decision Davis v. Fresno Unified School District, 237 Cal. App. 4th 261 (2015), rev. denied (Aug. 26, 2015), regarding the validity of lease-leaseback agreements, the climate surrounding the issuing and maintaining of these agreements has drastically shifted. The Davis court stated that the purpose of the lease-leaseback agreement as an exception to competitive bidding established in California Education Code Section 17406 was “to provide a new source of financing for the construction of schools” and that lease-leaseback agreements “allow a school to acquire facilities that it might not be able to pay for using other financing methods.” The court ruled that the exception to the competitive bidding statute under Section 17406 must be strictly construed such that a “true lease” is required for a lease-leaseback agreement. A lease cannot be deemed a “true lease” if: (1) it provides financing for a nominal amount; (2) the payments are for construction rather than for use; and (3) the government owner does not occupy the school before issuing the final payment. Specifically the court held that the agreement in Davis: (1) was not a true lease-leaseback because the contract was found to be a traditional construction contract, rather than a true lease as defined by the court; (2) there was no financing component in the contract; and (3) the government did not occupy the school during the lease term. The court nullified the agreement and ordered a complete disgorgement of funds.
The California Supreme Court declined to issue a ruling in Davis in August 2015. Thereafter, in April 2016 these issues were brought to the attention of the Second Appellate District of California in McGee v. Balfour Beatty Construction, LLC, 247 Cal. App. 4th 235, reh’g denied (May 23, 2016). The McGee court, citing the then-current language of Section 17406, expressly rejected Davis, holding that the “plain language of Section 17406 does not require a competitive bid process, and although the Legislature has amended the statute, it has not amended it to require competitive bidding in lease-leaseback agreements.” Id. at 239. Therefore, even if the school districts funded the projects themselves and regardless of whether the leases were site leases or subleases, the districts were exempt from having to obtain competitive bids when entering into lease-leaseback agreements to improve school property. Id. Notwithstanding the ruling in McGee, however, Davis has yet to be overturned.
In response to these decisions, the California Assembly passed Bill 2316 in April 2016 by a 66-4 vote, which reformed the lease-leaseback exception to bidding and amended Section 17406. The current version of the Code requires a competitive bidding process prior to entering into any lease-leaseback agreement. “[B]efore awarding an instrument, the governing board of the school district shall adopt and publish required procedures and guidelines for evaluating the qualifications of proposers that ensure the best value selections by the school district are conducted in a fair and impartial manner.” Educ. Code §17406.
Even if a lease-leaseback agreement under the amended statute is held invalid by a court, the statute prescribes that the contractor can still be paid the reasonable cost of labor, equipment, materials and services furnished if the contract was entered into prior to July 1, 2015 and certain conditions are met. Specifically: (1) the contractor proceeded with the work based on a good faith belief that the agreement was valid; (2) the district reasonably determined that the work performed is satisfactory; (3) no contractor fraud occurred in relation to the agreement; and (4) the lease-leaseback doesn’t otherwise violate state law. Educ. Code § 17406(d)(1). A contractor meeting these requirements will nonetheless not be paid in excess of the contractor’s costs under the agreement plus approved change orders or lease payments made, less profits, at the time the agreement is deemed invalid. Id. The Davis and McGee decisions as well as the amendments to Section 17406 beg the question: What does this mean for current and future lease-leaseback agreements?
Contractors And Owners Already Engaged In A Lease-Leaseback Agreement
If the agreement is not compliant with the Davis terms and/or the current statue, it should be amended as much as possible to fit within the Davis parameters. If construction has not begun on the project, the owner should consider letting the contract out for competitive bidding to prevent the contract being nullified by a later court ruling. Without competitive bidding, there is a chance a ruling of disgorgement will be upheld.
Disgorgement is undoubtedly one of the biggest blowbacks from the Davis decision. Rather than forcing the contractor to pay back all of its earnings on the project, the amended statute allows contractors to recover their reasonable costs even if there is a determination of invalidity. Despite this safety net, school districts and contractors should tread lightly when entering into lease-leaseback agreements and should attempt to avoid public works projects that do not involve a competitive solicitation process. Consideration should also be given as to whether the lease-leaseback agreements entered into contain a financing component as that was one of the cornerstones of the Davis decision. Although the McGee court held that this financing element was not necessary, that decision was based on the old statutory language.
When faced with a challenge to the validity of your existing lease-leaseback arrangement, a potential course of action is self-validation. In Los Alamitos Unified School District v. Howard Contracting, Co., 229 Cal. App. 4th 1222 (2014), the court ruled that if no action is brought against a contract within 60 days, the agreement self-validates itself, making it “immune from attack whether it is legally valid or not.” However, validation statutes may not apply to contracts that lack a financing component. According to Government Code Section 53511, a local agency is authorized to bring an action to determine validity of its bonds, warrants, contracts, obligations, or evidences of indebtedness. Looking to case law, in Kaatz v. City of Seaside, 143 Cal. App. 4th 13 (2006) the court ruled that the term “contracts” referenced in Section 53511 should be strictly interpreted to mean contracts constituting a financial obligation of a public agency. Thus, the contracts that can be validated under that Section can only be those that directly relate to the bonds, warrants, or other evidences of indebtedness of a public agency. One should be wary that in an agreement without a financial component such as that seen in Davis, self-validation as outlined by Section 53511 may not apply.
Owners And Contractors Looking To Enter Into Lease-Leaseback Agreements In The Future
When drawing up a contract of the lease-leaseback variety, it is important to take into account the terms set forth in Davis and the current version of Education Code Section 17406. A lease-leaseback agreement that is compliant with Section 17406 will have certain characteristics:
- The Contract Will Be Open To A Competitive Bidding Process
As outlined by Section 17406, the school district will: (1) provide a description of the project, including an estimate, an example of how the proposals should look, and the rubric they will use to evaluate the proposals; (2) announce the request for sealed bids at least ten days prior to the deadline; (3) prequalify the contractor and any anticipated subcontractors pursuant to state standards; (4) release a request for bids that identifies all criteria used to evaluate the proposals; (5) identify the rating system used to evaluate the proposals and a minimum acceptable score; (6) evaluate the proposals based on the standards outlined in Section 17406(a)(2)(F); and (7) have the right to deny all proposals and request new ones. The selected proposal will contain the best value, as defined by the Code.
- The Contract May Or May Not Have A Financing Component
One of the chief criticisms handed down from the Davis court was that “to fulfill the primary statutory purpose of providing financing for school construction, the arrangement must include a financing component” and the contract in question did not include one. Yet the McGee court expressly held that “additional requirements – such as the timing of the lease payments, the duration of the lease, and the financing – are not based on the plain language of the statute.” McGee, 247 Cal. App. 4th at 244. Neither the prior nor the current version of Section 17406 contains language that states the bidding exception only applies when a contractor funds the project. Thus, although a Davis compliant lease-leaseback will contain some type of financing component, under the current statute, a lease-leaseback that is school district funded will not be invalidated on that ground.
- The Contract May Or May Not Include An Extended Payment Plan With Timed Installments
The Davis court cited a 15-year period as an example of a good lease but again, the McGee court declined to opine on a required lease duration or the timing of lease payments in light of the statutory language. Just as the current version of Education Code Section 17406 is devoid of any financing restrictions, it is silent on lease terms.
- The Public Agency May Or May Not Be Required To Occupy The Facilities As A Tenant
In Davis, there was never a time when the district was occupying the new facilities as a rent-paying tenant. Once the final installment was paid, the district no longer owed “rent” and thus did not abide by the leaseback regulations. McGee held that it did not matter whether the leases were site leases or subleases. This requirement may not be necessary under the current statute.
Contractors, sureties and school boards should diligently watch this ever-evolving statute to make sure their lease-leaseback agreement is compliant with current law. Notably, the current version of Education Code Section 17406 will be repealed in 2022. The amended version effective July 2022 contains no language regarding competitive bidding, lease terms, owner occupancy or pre-2015 lease-leaseback agreements. Given the changing landscape involving lease-leaseback agreements, and with the Davis decision still standing, it is in all construction professionals’ best interests to be aware of current precedent. It is also worthwhile to keep close tabs on cases subsequent to Davis interpreting Education Code Section 17406 that may provide further clarifications on the terms necessary for a legally viable lease-leaseback agreement. In order to minimize the chances of a judicially ordered nullification of a contract or a total disgorgement of funds, as seen in Davis, owners and contractors should henceforth draft all contractual agreements with a prior competitive solicitation process and compare lease or occupancy requirements with the existing case law and statutes. Owners can then take the necessary steps to preclude possible legal issues down the line.