The Lease Leaseback Procurement Process for Public Works (K-12) - School & College Legal Services of California

The purpose of this legal update is to discuss the “lease leaseback” (“LLB”) process in light of the recent Fifth Appellate District Court decision entitled Davis v. Fresno Unified School District (2015) 237 Cal. App. 4th 261.

LEGAL UPDATE

August 3, 2015

To: Superintendents, Member School Districts (K-12)

From: Patrick C. Wilson, Senior Associate General Counsel

Loren W. Soukup, Associate General Counsel

Subject: The Lease Leaseback Procurement Process for Public Works

Memo No. 17-2015

The purpose of this legal update is to discuss the “lease leaseback” (“LLB”) process in light of the recent Fifth Appellate District Court decision entitled Davis v. Fresno Unified School District (2015) 237 Cal. App. 4^th 261.

Summary of the Lease Leaseback Process

• Education Code section 17406 authorizes a school district governing board, without advertising for bids, to lease real property currently owned by the District to any person, firm, or corporation for a minimum of $1 per year so long as such lease requires the other party to construct (or provide for the construction of) a building or buildings upon the subject property and that title to the subject property and the buildings vests in the school district at the expiration of the lease.

• There are no specific requirements regarding the selection of the LLB contractor; however, districts often use a request for proposals (“RFP”) process. In any event, the District must ensure that the contractor who is selected is competent and that the price to be paid to the contractor is reasonable under the circumstances.

• Mandatory prequalification procedures apply to LLB projects in some circumstances.

• The District enters into two separate leases with the chosen LLB contractor:

Site Lease. The Site Lease is the document by which the District will lease the real property to the builder for $1 per year.

Facilities Lease. The Facilities Lease is the document the parties will utilize to lease back the real property for construction of the facility and for the District’s use and occupancy of the completed facility for the term of the lease. It includes the fixed price to be paid for the construction of the project (the “Guaranteed Maximum Price”) and the rent to be paid by the District for the use and occupancy of the completed facilities. The two leases are approved at the same time and they expire at the end of the term of the Facilities Lease.

Other Considerations

• The District must have selected and approved the site, adopted the design development documents, and DSA must have approved the plans if otherwise required prior to the Board approving the LLB contract. Education Code §17402.

• The LLB process is subject to any State approvals otherwise required by law.

• The lease term cannot exceed forty (40) years.

• The LLB documents must include the standard construction requirements, including that the contractor must pay the prevailing wage, provide bonds, insurance, and retention, and provide other safeguards to the District (e.g. fingerprinting).

• The LLB contract documents are subject to negotiation.

• The Contractor and all subcontractors must be registered with the Department of Industrial Relations prior to the commencement of work.

• If State funding is utilized, we recommend consultation with the State to assure no risk to State funding by use of this method.

• The District should determine its indebtedness in accordance with Education Code §17423 prior to proceeding with LLB.

The Fresno Unified LLB decision

In the Fresno Unified case, a lawsuit was filed against the Fresno Unified School District and its contractor, Harris Construction, by a taxpayer and contractor named Davis, who alleged that the District and Harris had failed to competitively bid the $36.7 million middle school construction project. In particular, Davis claimed that the District and contractor failed to comply with the LLB process in Education Code § 17406. Therefore, Davis argued, the LLB contract was a sham lease and the contract was illegal due to a lack of competitive bidding.

The lawsuit also asserted that the preconstruction service agreement entered into between the District and its contractor constituted a conflict of interest in violation of Government Code §1090, since the contractor, Harris, as a consultant to the District, allegedly influenced the design of the project in which Harris later obtained a financial interest through the facilities lease.

In the Fresno Unified case, the leases terminated when the construction was complete; accordingly, there was no time period during the lease when the District actually used the premises as required by Education Code § 17406. As a result, the Court found that the “lease” was not a true lease within the meaning of Education Code § 17406 since the “lease” payments were variable progress payments based on work completed. A true lease typically involves fixed rental payments over time to pay for the use and occupancy of the premises, which was lacking in the Fresno Unified case.

Thus, for a LLB to comply with Education Code § 17406, the Court held that the following criteria must be met:

A genuine lease agreement is entered into by the parties;
A financing component is included in the lease-leaseback arrangement; and
The District uses the completed facilities at some point during the term of the facilities lease.

The Court declined to offer an opinion regarding how long the lease term for use of the premises must be or what level of fixed lease payments is sufficient under the lease.

The Court held that the District need not demonstrate a lack of other available funds prior to using LLB as a financing mechanism.

In light of the Fresno Unified case, we recommend that the facilities lease for the use of the premises be for a term of at least eighteen (18) months after completion of the project, and that the total lease payments to the contractor under the second lease equal or exceed 5% of the overall project price. In any event, total lease payments under the second lease must be of sufficient value to constitute financing by the contractor.

If a LLB contract is determined to be illegal, the primary risk is to the general contractor, who may be ordered to “disgorge” all sums received for work on the project. We do not recommend that the District agree to indemnify the contractor for such losses or risks.

Pre-construction Agreements

It has been common for school districts to enter into pre-construction agreements with the LLB contractor prior to signing the LLB contract, usually because DSA has not approved the construction plans and the District wants the LLB contractor to begin a review of the plans pending DSA approval. The Fresno Unified opinion held that such agreements potentially violate Government Code § 1090 to the extent that the contractor is influencing the design of the project. While the Court’s reasoning is subject to debate, districts must now be cautious about entering into a preconstruction services agreement with the LLB contractor.

Validation Actions

Code of Civil Procedure §§ 860 through 870 are the so-called validation statutes, which authorize a public agency to bring a lawsuit in Superior Court to request that the Court “validate” the legality of certain public agency financial matters.

The fact of a validation lawsuit is disclosed to the public by the requirement that the district publish in a local newspaper a copy of the summons issued in the case. Any person who wishes to intervene is required to file an answer to the complaint as specified in the summons.

The 60-day period to file the validating lawsuit begins “upon the existence of any matter” that is subject to validation. The Fresno Unified decision is the first to hold that LLB contracts are subject to validation. Thus, a validation action must be filed if at all within the sixty (60) day period after the district approved the LLB contract.

If a timely validation lawsuit is filed, there is no guarantee that the Court will decide the case within the sixty (60) days and it is likely that it could take much longer if there is any opposition.

If the School District does not file a validation action, any interested person may bring an action within sixty (60) days to determine the validity of the LLB documents. A validation action by an interested person is called a “reverse validation action.” This is what the plaintiff in Fresno Unified filed within the 60-day time limit.

Significantly, under the validation process, a public agency may indirectly but effectively “validate” its action by doing nothing to validate it. Unless an interested person brings an action under § 863 within the 60-day time period, the school district’s action will become immune from attack whether it is legally valid or not. See McLeod v. Vista Unified School District (2008) 158 Cal. App. 4^th 1156. Note: an action can be filed within sixty (60) days, but not served on the District for weeks or months later. Thus, a court check after sixty (60) days may be prudent.

General Comments re LLB

While the Fresno Unified Court found that the LLB process remains a viable procurement method so long as the District complies with the above procedures, the Court also observed that “school construction contracts are a type of public works contract subject to the competitive bidding process unless an exception applies.” Thus, competitively bidding public works remains the general rule; procurement methods like lease leaseback should be reserved for the exceptional projects.

We have updated our LLB documents in light of the Fresno Unified case.

Please contact our office with questions regarding this Legal Update or any other legal matter.

The information in this Legal Update is provided as a summary of law and is not intended as legal advice. Application of the law may vary depending on the particular facts and circumstances at issue. We, therefore, recommend that you consult legal counsel to advise you on how the law applies to your specific situation.

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