Fresno Unified School District is enmeshed in litigation over Rutherford B. Gaston Middle School, built using a lease-leaseback method of financing. Photo provided by FUSD.

LOS ANGELES — California school districts may have hundreds of millions of dollars at stake after an appeals court ruled against Fresno Unified School District's financing for a school that opened last fall.

The Fifth District Court of Appeal ruled June 1 in favor of contractor Davis Moreno Construction Inc., which alleged in a lawsuit that Fresno USD improperly used a method of financing called lease-leaseback when it built the Rutherford B. Gaston Middle School.

Lease-leaseback differs from the competitive process that public agencies typically use to bid out big construction projects. In a lease-leaseback the district picks a general contractor based on qualifications other than just the lowest bid, in a process similar to design-build construction.

The intent was to give cash-poor school districts a way to finance school construction, using certificates of participation or bonds backed by voter-approved bond measures to make lease payments to the contractor, who has agreed to lease the land for a nominal fee.

Fresno School districts up and down California have used a similar approach to fund construction, and an adverse ruling from the Supreme Court could be costly to them, according to Patrick Harder, a partner with the law firm, Nossaman LLP.

"The worst-case scenario is that those who are under contract could have the contract canceled or face financial exposure for any money raised," he said.

Fresno USD officials said Thursday that they plan to take the case to the California Supreme Court. The district has until July 13 to file documents with the higher court.

Fresno USD officials dispute that they acted improperly in using the lease-leaseback method. A spokeswoman pointed to page 31 of the Appellate Court ruling, where the appellate court judges wrote that "the second cause of action failed to allege facts sufficient to state a claim for breach of fiduciary duty."

"The recent court of appeal decision said that the Board of Education conducted itself in a legal manner," said Amy Idsvoog, a Fresno USD spokeswoman. "There was no claim of a breach of fiduciary duties. We agree with that."

It's the areas that the district disagrees with — or where the appellate judges stated the Education Code doesn't give school districts clear direction — that Fresno USD officials plan to counter when they take the case to the Supreme Court, Idsvoog said.

The appellate court recognized in its decision that the state Education Code has been silent in key areas involving financing on lease-leaseback. And those areas are the ones that Fresno USD will be addressing when it files the appeal to the state Supreme Court, Idsvoog said.

Harding said there is no way to know exactly how much money is involved without reviewing all the school districts that have used the lease-leaseback financing method the same way Fresno USD did. The issue for the Appellate Court judges was that the leases didn't extend beyond completion of the school building, according to Harder. The way lease-leaseback was originally structured, the leases would have extended out 10 to 30 years, he said.

Stephen Davis, a principal at Fresno-based Davis Moreno Construction Inc., also alleged in the lawsuit that Richard Spencer, owner of Harris Construction, had a conflict of interest when he took the bid on the $36.7 million project.

Davis further contended in his lawsuit that Spencer was hired by Fresno Unified as a consultant on the school-building project before he was actually awarded the construction bid.

The appellate court didn't rule on the conflict of interest question, but said that Davis had grounds to return to the Fresno County Superior Court on that issue.

The court also ruled that consultants such as Spencer, not just elected officials, are subject to state conflict-of-interest laws.

The case is really more about competitive bidding than an attack on lease-leaseback, said Lew Feldman, a partner in law firm Goodwin Procter's Real Estate Capital Markets Group.

"I have seen a number of these deals over the past 10 years," Harder said. "They all have the same characteristics. It is rare to see one of these deals that has a true lease feature. Almost always the lease payments are in effect construction payments."

The lease terms are commensurate with the construction period in the Fresno USD case and in the way many other school districts structured their financing, Harder said, when payments for the so-called lease are paid, based on the progress of construction.

"They aren't leases in the way you think of leases, in which you lease property and pay rent over a 10-year period," Harder said. "It is not like that at all."

The appellate judge took issue with the fact that the contractor never acted as a true landlord after construction was completed and the school district occupied the building.

The potential monetary hit to school districts would occur if they had to pay the contractor that was actually the lowest bidder an award, Feldman said.

It could cost school districts money if contracts already signed with developers are unwound as a result of the lawsuit, Harder said.

If the developer not awarded the contract gets a ruling that the district was not authorized to do what it did, then the contract is invalid, Harder said. If the contract is invalid; than the contractor selected has to go through a disgorgement process, he said.

Feldman said the financings wasn't a true "design-build," which does allow a school district to not put it out for a competitive bid.

"The school district wasn't using the property like you would in a certificate of participation situation, or when it is financed for a full 30 years," Feldman said.

The most common approach to lease-leaseback is for the district to issue COPs or bonds to pay back the lease over a 30-year time frame, Feldman said.

But that wasn't the case for Fresno, which was able to repay the developer by the time the building was constructed. The court found that the developer was never a real "landlord" as a result.

Fresno USD, however, is not alone in using lease-leaseback in this manner, according to Harder.

The appellate court raised questions about the structure of the deal involving Gaston Middle School, because the term of lease only extended to the amount of time it took to construct the building, Harder said.

The middle school construction was funded through the $280 million Measure Q bond. The district never "leased" out the building, after it was built, but had cash in hand to pay back the developer right away, Feldman said.

Davis's attorneys argued in court documents that the financing was really structured as a traditional design-bid-build project, although the school district called it a lease-leaseback.

In a design-bid-build scenario, first, the school district hires an architect to design the project. Second, the district uses the design in its request for competitive bids from construction firms. Third, the winning builder builds the project.

School districts are allowed to use design-build, where a contractor designs and builds the project, allowing the steps to run simultaneously. The legal framework under design-build also allows district's to choose a contractor, who doesn't submit the lowest bid, based on superior technical aspects meeting a request for proposal, Harder said.

Typically, attorneys have recommended school districts file a validation lawsuit in a lease-leaseback situation in which anyone wishing to challenge the financial structure comes forth. If the district wins the suit, it discourages future lawsuits.

With the appellate court ruling, it will make it harder to win a validation suit under a similar structure. He said it's more likely that school districts will veer to a design-build model in the future.

"I think the validation action solution has lost its power with this opinion," Harder said.

The use of lease-leaseback, he said, has become a bit "wild west."

The structure has been around for a long time, and Harding said there isn't anything inherently wrong or bad with the structure.

A traditional lease-leaseback is essentially a way to spread payments for improvements out over a 10-year period or more through a lease. "And that is where the school district went a little bit rogue," he added.

While the option can be used for school districts that have low credit ratings, and may not be able to access the market, he said many with solid credit ratings are using it so they can pick the contractor they want for the job.

The statute allowing lease-leasebacks traces back to the 1970s, but the use of the structure as tool to finance construction only during the construction period is something that has only been used over the past decade, he said.

Fresno USD and other school districts have used lease-leaseback in that way over the past several years to lock down a maximum price and streamline work.

But they may have taken the structure a step too far from its original intent, according to the appellate court.

"We conclude the terms in the facilities lease regarding the construction, payment, use, occupancy, possession and ownership of the new facilities adequately support Davis' allegation that the arrangement is not a true lease that provided financing for the project," the court wrote.

The appellate court ruled that the terms of the lease agreement were really just a list of construction costs, while Harris Construction never acted as a true landlord.

"Truth be told, the reason that districts have used this tool is that it has allowed them to award contracts on the basis of something other than a low bid," Harder said. "If that is the objective, it makes sense for them to pivot toward design-build."

He gave an example of a contractor didn't submit the lowest bid, but was the best one for the job.

"The real value in (design-build) is the district can get real innovation in the design, which might save the district money," said Harder, whose firm works on design-build projects frequently for public agencies.

Design-build can unleash creativity that results in solutions the district may not have considered -- ideas that reduce costs, Harder said.



Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.