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California Supreme Court: Lease-Leaseback Construction Contract Without Financing Component Not Protected By Limited Challenge Period

May 2, 2023 | Legal Developments and News

Last week, the California Supreme Court in Davis v. Fresno Unified School District (April 27, 2023, S266344) (“Davis II”) held that lease-leaseback construction contracts that do not contain a “financing” component are not protected by the legal validation procedures. This means that lease-leaseback construction contracts that do not extend the term of the facilities lease beyond the completion of construction, with lease payments due during that extended period, may be challenged in court more than 60 days after entering into the agreement. A long-awaited decision, Davis II did not resolve all open issues regarding lease-leaseback agreements; however, it nevertheless provided critical guidance with respect to such arrangements as they relate to construction contracting and general obligation bonds.

Background

In October 2011, the Fresno Unified School District (“District”) issued approximately $108 million in voter-approved tax-exempt general obligation bonds.

In September 2012, almost one year after issuing the bonds, the District entered into a $36.7 million “lease-leaseback” construction arrangement under Education Code section 17406 with Harris Construction Company (“Contractor”) for construction of a new middle school in Fresno. Under the terms, the District leased to the Contractor for a nominal amount the site where the school would be constructed. Simultaneously, the Contractor leased the new facilities, still under construction, back to the District pursuant to a “facilities lease.” The facilities lease included construction provisions for the completion of the middle school, which, among other obligations, required the Contractor to complete work within 595 days and the District to make monthly lease payments reflecting the value of the construction work performed during each monthly period. The lease payments were paid using the bond proceeds of the District’s bonds issued in October 2011. However, the leases did not contain a “financing” provision that required the District to continue to pay the Contractor for the cost of the site improvements after the Contractor completed construction. The middle school was completed in November 2014.

In November 2012, Plaintiff and Appellant Steven K. Davis (“Plaintiff”), a Fresno-based contractor, filed suit against the District and the Contractor. Plaintiff alleged that the lease-leaseback arrangement was invalid and sought, among other remedies, disgorgement of the lease payments made by the District. One of the District’s arguments was that the contract was immune from attack because “validation statutes” require a challenge to certain public agency actions within 60 days, or else, the action is presumptively valid.

After two rulings by the trial court and appeals to the Court of Appeal, the issue left for the Supreme Court was whether a lease-leaseback arrangement, in which construction is funded by bond proceeds, rather than by or through a builder, constitute a “contract” within the meaning of Government Code section 53511 (“Section 53511”) and therefore subject to the validation statutes.

Decision

The Supreme Court held a local agency contract comes within the protection of the validation statutes only if a contract is “inextricably bound up with” governmental indebtedness or with debt financing guaranteed by the agency. The Supreme Court suggested that, to meet this standard, the contract must be one on which the debt financing directly depends. The Court concluded that the District’s lease-leaseback arrangement was not such an arrangement. The Court noted that a financing component of a lease-leaseback contract typically requires the district to continue to pay the contractor for the cost of the work under a lease for a period of a year or more after the contractor completes construction.

If a district’s lease-leaseback agreement is subject to validation, it is only open to challenge for 60 days, after which it is immune from legal challenge. Accordingly, if districts wish to invoke the significant protection of the validation statutes for their lease-leaseback agreements, including such a financing component may be important.

While the Davis II decision resolved the issue of whether lease-leaseback contracts without a financing component are subject to the validation statutes, Davis II left a number of other issues regarding lease-leaseback contracts unresolved. For example, the Davis II Court noted that it was not specifically deciding whether lease-leaseback contracts that do have a financing component are subject to the validation statutes, only that lease-leaseback contracts that do not have a financing component are not subject to the validation statutes.

Finally, as the decision more generally relates to general obligation bonds and related contracts subject to validation under Section 53511, the Court has given additional guidance on what is meant by a contract that is “inextricably bound up” with the agency’s indebtedness. Specifically, the Court noted it would not find this agreement within the scope of Section 53511 because it did not guarantee the indebtedness or provide a source of revenue securing the indebtedness. The Court also flatly rejected the suggestion that merely paying lease payments using bond proceeds qualified as a financing component sufficient to bring a contract within the protections of the validation statutes.

Impact

Standard DWK lease-leaseback agreements have long contained a financing component, typically extending the term of the facilities lease beyond the completion of the site improvements. Because DWK agreements provide for lease payments to the contractor after construction is completed, the Davis II decision does not preclude these kinds of agreements from being subject to the validation statutes. Davis II, however, does not provide minimum requirements for a compliant financing component so you should work with your attorney on the terms of financing.

Separate from the validation issue decided by Davis II, there remains a split in authority amongst the appellate courts as to the legality of lease-leaseback agreements that do not include a financing component. Davis II only addresses when financing is necessary to invoke the validation statutes and does not resolve whether financing is necessary for the agreement itself to be valid. However, at this time, the advisable route to using lease-leaseback includes a financing component which avoids this potential issue and also provides the added protection of validation.

If you have questions about your district’s lease-leaseback agreements or bond finance program, please contact an attorney in Dannis Woliver Kelley’s Business, Property and Construction group or Public Finance group.

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