News & Insights

A Look at the Offner-Dean Exception

With rising costs and competing uses for shrinking available resources, municipalities may opt to lease rather than purchase real estate assets, freeing up capital to fund public services and more. However, there are nuances and pitfalls for landlords to be aware of when negotiating a traditional lease with a municipality, especially in California.

When a California commercial landlord or tenant finds themselves leasing or subleasing, respectively, to a city or other municipality, they should be aware of the ways this type of lease differs from a typical commercial lease.

Of particular significance is the California Constitution’s prohibition — and possibly a prohibition by the charter or governing documents of the municipality — against incurring certain types of indebtedness or liability by a municipality. Municipal governing documents frequently will mirror the California Constitution’s prohibition.

Ironically, the costly and complicated process for issuing lease revenue bonds is based upon established case law exempting traditional leases from the indebtedness and liability restrictions of the California Constitution. A direct lease of property by a municipality from a private party, therefore, fills the void between buying property and financing costly projects through the use of lease revenue bonds. Article 16, Section 18(a), of the California Constitution states that

No county, city, town, township, board of education, or school district, shall incur any indebtedness or liability in any manner or for any purpose exceeding in any year the income and revenue provided for such year, without the assent of two-thirds of the voters of the public entity voting at an election to be held for that purpose.

Obviously, it is unlikely that a municipality would submit a typical lease obligation to voters for approval. Therefore, the underlying question is whether a municipality’s obligation to pay future rent will be treated as a current indebtedness or liability.

While a municipality may take the position that Section 18(a) requires conditioning of a multiyear lease upon annual reauthorizations in its future budget, that position effectively would treat a multiyear lease like a one-year lease with annual renewal options for the benefit of the municipality. Based on that position, the municipality arguably could avoid its future rent obligations and terminate the lease by not reauthorizing the lease in subsequent years.

Exemptions From Section 18(a)

There is ample case law, however, that exempts a lease from the requirements of Section 18(a), so long as certain conditions are satisfied. The exceptions created by case law are often referred to as the Offner-Dean exception, which provides that a long-term lease obligation entered into by a municipality will not be considered an indebtedness or liability under Section 18(a) if the lease meets certain criteria.

In City of Los Angeles v. Offner in 1942, the California Supreme Court held that “[provided] the amount of rentals that the city may be required to pay in any single fiscal year, together with its other debts and liabilities will not exceed its income and revenue for such year,” the debt limitation of Section 18(a) is not violated.

In addition, an option to purchase the premises at the end of a lease term does not create a violation. In contrast, the court noted that an installment purchase contract may violate the California Constitution if the sum of (1) the total amount of future installment payments, and (2) the total amount of city expenditures in the first lease year exceeds the city’s income in the acquisition year, the purchase may violate Section 18(a).

Any such violation is avoided by obtaining the requisite level of voter approval. It does not matter what an agreement is called, e.g. whether named a mortgage, lease or sale, the analysis is the same. Therefore, in a lease lasting more than one year and that is not approved by the voters, the amount of rent paid during each fiscal year of the lease term cannot cause the financial obligations of the municipality to exceed its income and revenue in that fiscal year.

In Dean v. Kuchel in 1950, the California Supreme Court applied the Offner analysis to an analogous restriction on debts and liabilities of the state pursuant to Article 16, Section 1, of the California Constitution.

The court held that property owned by the state, ground-leased to a developer to construct a building on the property, then leased back to the state after completion of the building, with a reversion of the property and the building to the state at the end of the ground lease term, was not a violation of the California Constitution.

The holding largely was based on the fact that the state paid monthly rent during the multiyear term of the developer’s lease, and the state did not make payments to purchase the building as might be found in an installment sale.

The Implications of Offner-Dean

Subsequent to Offner and Dean, more recent cases have used the same analysis to evaluate the financing of large municipal improvement projects when the municipality had a leasehold interest in a portion of the project, even when the financing authorities or the special districts had been created by the municipality.

While cases addressing lease revenue bonds are too involved to address in an article of this length, there are general lessons and implications to take away from Offner, Dean and those modern cases, as well as positions taken by municipalities in reliance upon those cases, which will need to be further clarified by case law in the future.

Municipalities may require that rent be paid on a monthly basis, and the monthly rent should be in exchange for the use of the premises during the corresponding period. However, rent payments could arguably be quarterly or annually so long as the Offner-Dean exception applies.

Expect that municipalities will require that rent be fair market or less than fair market rent. Ironically, in Rider v. City of San Diego in 1998, the California Supreme Court’s analysis concluded that the right to purchase equipment at the end of the lease at fair market value meant that the lease rent was not a subterfuge for purchasing the equipment on an installment plan, which itself would have violated Section 18(a).

Section 18(a) itself, however, does not appear to prohibit above-market rent, if end-of-lease purchase rights do not exist.

Common area expenses payable by the municipality for actual expenses incurred by the landlord within each fiscal year should not be a violation of Section 18(a), so long as the common area maintenance charges to the municipality are incurred in the same fiscal year, and are proportional to the municipality’s interest in the building or project, as applicable.

If a municipality enters into a lease for the use of a premises, but later chooses not to use it, so long as the municipality continues to have access and the ability to use the premises pursuant to the lease, the municipality should be required to continue to pay rent. The municipality should not be able to unilaterally decide that it has no further use of the leased premises and argue that rent is not due or payable simply due to its decision to cease use of the premises.

A municipality should be liable for damages due to the acts or omissions of the municipality that give rise to third-party claims against the landlord, e.g. indemnity obligations under the lease, which should be considered contingent liabilities. As the California Supreme Court stated in Rider v. San Diego (1998), “A sum payable upon a contingency is not a debt, nor does it become a debt until the contingency happens.”

Expect municipalities to argue that the landlord should not be able to accelerate future rent due to the default of a municipality, since the municipality would be paying rent that may fall outside of the current fiscal year.

Interestingly, even based on that position, it is arguable that if the municipality defaults, then rent payable for the balance of that same fiscal year may be subject to acceleration, since it does not violate Section 18(a) on its face. However, negotiating terms to that effect may be difficult without clear case law supporting that approach, and without a willingness of both parties to agree.

So long as a municipality’s obligations to a financing authority or special district are limited to the payment of rent, it is unlikely that those rent payments violate the state constitution’s prohibition on future indebtedness or liabilities, even if the financing authority or special district was formed by the municipality.

Conclusion

Each situation must be evaluated based on its individual facts, as well as the governing documents of the municipality and the then-current case law.

However, under current case law, if the representative of a municipality argues that the California Constitution prohibits the payment of rent on a multiyear lease without the contingency of annual appropriations, then it is not an issue of “cannot,” but an issue of “does not want to.” Those are two entirely different things.

The case law clearly supports the multiyear leasing of premises by a municipality, without conditions for future budget appropriations.

Steven Otto is a partner at Crosbie Gliner Schiffman Southard & Swanson LLP. The article was published in Law360 (subscriber only).