Lease-Leaseback Battle Continues as First District Court of Appeals Sides with Contractor and School District

“For Lease” by Scott Hingst/flickr.com (CC BY 2.0)

Earlier, we wrote about Davis v. Fresno United School District (2015) 237 Cal.App.4th 261, a Fifth District California Court of Appeals decision that sent shock waves through the school construction industry and raised questions regarding the use of California’s lease-leaseback method of project delivery (Education Code sections 17400 et seq.).

California’s lease-leaseback method of project delivery provides an alternative project delivery method for public school districts than the usual design-bid-build method of project delivery. Under the lease-leaseback method of project delivery, a school district leases its property to a developer, who in turn builds a school facility on the property and leases it back to the school district. One of the benefits of the lease-leaseback method of project delivery is that school districts do not need to come up with construction funds to build school facilities since they pay for the construction over time through their lease payments to the developer. Critics, however, argue that because lease-leaseback projects do not need to be competitively bid, they are ripe for cronyism between developers and school districts.

In Davis, a taxpayer successfully brought suit against the Fresno Unified School District challenging the propriety of a lease-leaseback project because the entirety of the District’s “lease payments” occurred while the project was being constructed and thus, successfully argued the taxpayer, there was no “true” lease of a facility since it was under construction.

California Taxpayers Action Network v. Taber Construction, Inc.

The Davis case caused a panic in the school construction industry, culminating in Governor Brown signing AB 2316, which requires school districts to use a competitive solicitation process for lease-leaseback projects based on best value. However, the Davis case also left open a number of unanswered questions including how long a lease-leaseback lease has to be for it to be considered “true” lease and whether any payments can be made during construction.  The California Court of Appeals for the First District has stepped in to answer this question, although, not quite in the way the Fifth District likely thought it would.

In California Taxpayers Action Network v. Taber Construction, Inc. (May 2, 2017), Case No. A145078, the Mount Diablo Unified School District entered into a lease-leaseback agreement with Taber Construction, Inc. for the modernization of five elementary schools and three middle schools. The agreement was comprised of a master site lease and a master facilities lease. Under the master site lease, the District agreed to lease the sites to Taber for one dollar. Under the master facilities lease, Taber agreed to modernize the eight schools for the “guaranteed project cost” of $14,743,395. The master facilities lease included construction provisions and construction schedules for each project site. Under the master facilities lease, the District agreed to pay Taber $13,269,057 in “tenant improvement payments” prior to taking delivery of the project, and six “lease payment amount[s]” of $245,723 plus interest paid at 30-day intervals starting 35 days after the filing of a notice of completion.

The California Taxpayers Action Network filed a reverse validation action against Taber and the District under Code of Civil Procedure section 863 asserting seven causes of action for: (1) failure to comply with Education Code sections 17400 et seq. (2) breach of fiduciary duty; (3) failure to comply with Education Code section 17417; (4) contractor conflict of interest; (5) improper use of Education Code sections 17400 et seq.; (6) improper delegation of discretion; and (7) declaratory relief.  Among other things, Taxpayers argued that the lease-leaseback provisions of the Education Code required “genuine lease-leaseback agreements” that “provide for financing of the school facility project over time” and that the master site lease and master facilities lease were “sham leasesd” because they were not genuine lease-leaseback agreements.

The District and Taber filed demurrers to the complaint which were granted without leave to amend by the trial court.

Taxpayers appealed.

The Court of Appeals Decision

The Court of Appeals, noting that while the Davis court had focused on whether the lease-leaseback transaction in that case was a “true” lease, Education Code section 17406 has three requirements for a leases in lease-leaseback transactions:

1. The real property belongs to the school district;
2. The lease is for the purpose of construction; and
3. The title shall vest in the school district at the end of the lease term.

And, here, explained the Court of Appeals, the District owns the project site, the agreement required Taber to complete the project and title vested with the District at the end of the lease term. “Nothing more is required,” held the Court.

Specifically addressing the Davis decision, the Court of Appeals explained that the Davis court looked at two factors in determining whether a lease-leaseback lease was a true “lease” including: “(1) who holds what property rights and when those rights and interests are transferred between the parties and (2) the amount and timing of the payments,” but held: “We decline to follow Davis, which went far beyond the language of section 17406 in adopting ill-defined additional factors to determine whether the leaseback portion of a lease-leaseback agreement is a “true” lease and imposing requirements that the contractor provide financing for the project.”

While disagreeing with the Davis court’s analysis of lease-leaseback arrangements, the Court of Appeals did agree with Davis, as well as with McGee v. Balfour Beatty Construction, LLC (2016) 247 Cal.App.4th 235, that an independent contractor providing pre-construction services to a school district could be deemed an “employee” of the district under Government Code section 1090 for purposes of evaluating conflicts of interest. While the Court did not find that Taber, which provided pre-construction services to the District, was an “employee” of the District, it reversed the trial court’s decision on this issue.

Conclusion

Taber Construction sets up an appellate court split between the Fifth District (Davis), on one hand, and the First (Taber) and Second Districts (McGee), on the other hand, with no clear indication that this split will be resolved anytime soon by the California Supreme Court. In the meantime, school districts, developer/contractors and critics of the lease-leaseback program have their choice of appellate court cases that they can argue support of their positions.