(Shutterstock)

(Shutterstock)

Deal or no Deal

After critical court decision, future California lease-leaseback contracts stand on shaky ground.

Back Article Jan 26, 2016 By Russell Nichols

For the past four years, Star Academy in Natomas didn’t look like a regular school. Due to overcrowding,  elementary kids went to class in a commercial building that faced a major street and had warehouse space in the back. The district wanted a new facility, but in 2008 the city enforced a building moratorium on Natomas pending levee improvements. Last year, when the moratorium was lifted, the district considered building the new charter school through a lease-leaseback deal. But the method, once a popular way for struggling districts to acquire new facilities, has come under legal fire in recent years.

In this state-approved method, school districts lease property they own to a contractor for a minimum of $1 per year through a site lease. The contractor builds a school on the land, then leases the building (which they own) to the district through a facilities lease. The district then occupies the facility while paying off the lease. After repaying, the contract ends and the district officially owns the school. This method was created in the 1950s to avoid the traditional competitive bidding process, offering cash-strapped institutions longer financing terms and overcrowded districts the chance to build facilities faster.

But the law is short on specifics for lease-leaseback contracts, which gave districts tons of leeway, says Dave Walrath, president and legislative advocate for the Coalition for Adequate School Housing. In some cases, districts didn’t pay contractors based on a construction schedule. Some districts moved into the new building without any financing in place. Others had the financing piece worked out but no lease terms.

“It was unclear,” Walrath says. “There was no specificity in the law. Different districts did different things. In many cases, those were validated. In many cases, they didn’t go through the validation process. In general, there has been a tremendous amount of flexibility allowed by courts.”

All that legal wiggle room led to a critical lawsuit in 2012. A Fresno contractor sued his local district (Davis v. Fresno Unified School District), claiming a lease-leaseback contract to build a $37-million middle school was illegal. An appellate court agreed last year that the contract violated state competitive bidding and conflict-of-interest laws — pointing out that the district had enough money to pay for the project upfront, and also awarded the job to a firm that had actually provided consulting services during the planning stage. Opponents pleaded with the state Supreme Court to appeal the opinion, but the high court refused in October. The fallout in Fresno is ongoing, but the court decision was a shockwave felt all over the state and in the Capital Region, as local contractors scramble for answers to unsettling questions.

Is this a sign of things to come? Will previous lease-leaseback deals be reviewed by the courts? Most importantly: Could construction firms involved with such contracts be forced to repay hundreds of millions of dollars? To avoid such legal pitfalls, some firms are changing their entire business strategy. For example, Clark/Sullivan Construction is aiming to diversify its contracts since 65 percent of the company’s $75-million revenue currently comes from lease-leaseback deals, says Ted Foor, vice president and regional manager for the firm’s California office.

“The contractor has been paid for this. The school district has the school. The district is not going to give the school back to the contractor. But if it turns out the contracts were illegal, the contractor is on the hook to repay everything — not just the profit, everything.” >Dave Walrath, president and legislative advocate, Coalition for Adequate School Housing

Clark/Sullivan was pursuing the Star Academy project with Natomas. But following the Davis decision, Natomas administrators decided not to pursue a lease-leaseback deal and to put all such contracts on hold while the legal dust settled, says Jim Sanders, communications director for the Natomas Unified School District.

“We’re not doing any lease-leaseback right now,” says Sanders. “The Davis decision did not end lease-leaseback. It made it clear it has to be done correctly. We’re reserving that as an option in the future. In terms of alternatives, we’re willing to look into all options that will serve our facility needs. Currently, all our bidding is hard bidding.”

BIG PAYBACK

The traditional method (also known as the hard bid or design-bid-build) is the primary process for construction projects. But for districts to get funding this way, school boards must ask voters to tax themselves to approve bonds. After that, the boards solicit bids separately from designers and builders in a competitive process. Disadvantages of this method include multiple points of contact, potential construction delays and cost overruns.

For school construction, many administrators saw lease-leaseback contracts as a viable workaround. They don’t require voter approval or competitive bidding — not to mention the fact that cash-strapped districts didn’t need all the funds for the project upfront; the lease could be paid back to the contractor in increments, for a term up to 40 years.

This lease-leaseback concept dates back to the decade after World War II, when baby boomers flooded California’s public schools, overwhelming the districts. Without funds or voter permission, districts could still get projects done fast. But the ruling casts a shadow of doubt over the process, thrusting such deals into a negative spotlight. In the aftermath, the debate continues on: Is the lease-leaseback deal a smart investment or a shady business practice?

The problem is a lack of clarity on the court’s end, writes Albert Erkel, an attorney with Garcia, Hernandez, Sawhney & Bermudez. In a post on the firm’s website, he writes that the Davis decision was clear in its criticisms but offered little guidance for contractors and districts looking to avoid these problems.

“For example, the Davis Court stated that a lease-leaseback contract must contain a financing provision. What exactly does this require? Must the contractor finance 100 percent of the project? Will 10 percent satisfy this requirement? The answer is unclear,” Erkel writes. “How long must the lease continue beyond the completion of construction? One year? Five years? Twenty years? Again, the answer is unclear.”

One thing the law clearly states is that a lease-leaseback deal must be a true lease. That means that during the lease term, the contractor must be the landlord and the district the tenant. If the district doesn’t use or occupy the facility during the term, the contract doesn’t qualify as a lease-leaseback. In southwest Fresno, the district paid off the project when the construction was done, effectively ending the lease term before even moving in. Since the district never used the new Rutherford B. Gaston Middle School facility during the term, as the law requires, the court found the arrangement was not a lease-leaseback, but a traditional contract in disguise — which should have been subject to competitive bidding.

In the Capital Region, most school districts don’t use the lease-leaseback these days, Walrath says. Most use the more traditional method or go the design-build route, which bypasses the bidding process and contracts with a single entity to oversee the design and construction. With the lease-leaseback delivery method under fire, it remains unclear what type of reconciliation the court will enforce should any more contracts be red-flagged.

“The contractor has been paid for this,” Walrath says of completed projects. “The school district has the school. The district is not going to give the school back to the contractor. But if it turns out the contracts were illegal, the contractor is on the hook to repay everything — not just the profit, everything. For a number of contractors, if this has occurred, they could go bankrupt.”

DECISIONS, DECISIONS

For Clark/Sullivan Construction, the decision comes as a tough blow. The firm has deals with Sacramento City College and school districts in Chico, Lincoln and Stockton (with the San Juan Unified School District being one of the biggest). Clark/Sullivan never violated conflict-of-interest laws by helping districts develop plans or draft a request for proposals before the project went out to bid, Foor says.

“We compete, provide qualifications, usually our fees: markups, bonds, profits,” he says. “The district takes that into consideration. It’s not like we’re involved in shaping the decision to choose us. When they put out a request for proposals, we respond and we’re selected at that time.”

When Natomas went instead with a traditional method, Clark/Sullivan opted not to submit a bid. Landmark Construction broke ground on the project in October on Gloster Way, marking the first school to begin construction in Natomas since the moratorium was lifted.

This could be the start of a trend, with more districts choosing to avoid lease-leaseback deals, which could severely impact many firms, says Thomas T. Holsman, CEO of the Associated General Contractors of California. Moving forward, Holsman says, districts will want to validate contractors through the local courts to avoid any issues.

“We know there’s a large number of contractors that perform school construction work and public construction using lease-leaseback,” he says. “It’s a much greater dollar value than we thought. It is a project delivery method that has proved to be effective.”

But with the future of lease-leaseback deals so cloudy right now, contractors that specialize in them may be wise to branch out. At Clark/Sullivan, Foor is widening his pursuits to contracts in a variety of markets. Fortunately, he says, the company is unique with a presence not only in California, but also a small office in Wyoming and its headquarters in Reno. The wider scope offers a chance for more diverse clients, which Foor hopes will increase Clark/Sullivan’s annual revenue to between $100 and $120 million.

“We’ve been making sure we’re chasing county work, federal work and community colleges to do design-build projects,” Foor says. “We’ve been chasing some of that higher ed to make sure we have some backlog. We do hard bids too. We’re just trying to diversify our market.”

None of the company’s existing clients have reneged on contracts, Foor says, but the Davis ruling created a stigma around lease-leaseback deals that he doesn’t see clearing up soon.

“I don’t know what’s going to happen,” he says. “The scarier piece for us as a general contractor is the conflict-of-interest part. If they prove a conflict, that means the contract is void, which could trigger recoupment, giving money back for all the improvements made. We know there’s a legislative remedy coming soon and we’d rather wait.”  

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