Can a Virginia city avoid its constitutional debt limit by financing a new school through a lease that depends on annual appropriations?

Plain-English summary

Delegate Israel O'Quinn and Senator Bill Carrico (representing the Bristol area) asked the AG whether a specific financing structure that the Bristol Virginia School Board was considering for a new elementary school would count as the City of Bristol's "debt" under article VII, § 10 of the Virginia Constitution. That section caps city indebtedness at 10% of the assessed value of real estate in the city.

The proposed structure had several moving pieces: a third-party entity ("the entity") issues tax-exempt bonds and uses the proceeds to build the school. Either the School Board or the City leases the underlying land to the entity (the "Ground Lease"). The entity owns and leases the new school building back to the School Board on a 30-year triple-net lease (the "School Lease") at $1,254,500 a year. Crucially, the School Board has to pay only if and to the extent the City appropriates money each year, and the City has no obligation to do so. If the City stops appropriating, the School Board defaults, has to vacate, and the entity can re-lease the building. The Ground Lease keeps running, and on bond payoff, the building transfers back to the School Board.

AG Mark Herring concluded the structure does not create debt for constitutional purposes. The key tests were:

1. No legal obligation on the City to pay or appropriate. Under Dykes v. Northern Virginia Transp. Dist. Comm. (1991) and Baliles v. Mazur (1982), discretionary appropriations do not pledge the locality's full faith and credit and so do not count as debt.
2. No surrender of City real property on default. The opinion was explicit that the analysis would flip if the City had to give up an ownership interest in the Ground Lease land on a payment default. That kind of forfeiture provision would convert the structure into a constitutionally-limited indebtedness.

The opinion was a green light for the proposed structure as described, with that important caveat about default remedies on the land.

Currency note

This opinion was issued in 2018. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

Background and statutory framework

The Virginia Constitution at article VII, § 10(a) prohibits cities from issuing "any bonds or other interest-bearing obligations which, including existing indebtedness, shall at any time exceed ten per centum of the assessed valuation of the real estate in the city." A lease for more than one year, where the locality is the lessee, generally counts as indebtedness, with statutory exceptions.

The Virginia Supreme Court's debt-limit jurisprudence allows so-called "non-appropriation" or "appropriation-subject-to-annual-appropriation" structures to escape the debt cap. The leading cases are:

• Button v. Day, 205 Va. 629 (1964), which set out the general framework for lease-as-debt analysis.
• Dykes v. Northern Virginia Transp. Dist. Comm., 242 Va. 357 (1991), holding that no debt is created where no legal obligation runs against the city.
• Baliles v. Mazur, 224 Va. 462 (1982), holding that payments based on discretionary appropriations do not pledge full faith and credit.

(Note: all three are Virginia Supreme Court decisions; the "Va." reporter is the Virginia state reporter, not the U.S. Supreme Court.)

School boards in Virginia are bodies corporate with their own powers (§ 22.1-71). They have express duties to erect and furnish school buildings (§ 22.1-79(3)) and may lease real or personal property either as lessor or lessee subject to applicable law (§ 22.1-129(B)).

The Public-Private Education Facilities and Infrastructure Act of 2002 ("PPEA") authorizes a "qualifying entity" to enter into a comprehensive agreement with a public body for the design, construction, finance, or operation of a public facility. The Bristol school project sat inside that framework.

Common questions

Q: Why doesn't a 30-year, $1.25 million-a-year lease count as debt for a Virginia city?
A: Because the City of Bristol was not legally obligated under the lease. The School Board, not the City, was the lessee. The City had to appropriate to the School Board only if it chose to, and a discretionary appropriation does not pledge full faith and credit. That's the rule from Baliles and Dykes.

Q: What would have flipped the analysis?
A: A forfeiture provision tied to the City's failure to appropriate. The AG was emphatic that if the City had to surrender any ownership interest in the Ground Lease property on default, that would constitute a legal obligation subject to the constitutional debt cap.

Q: What protections did the bondholders have?
A: The bonds were secured by the lease revenues and by the school facility itself. The Ground Lease and the underlying real property were not used as security. So a default routed the bondholders to the building (which the entity could re-lease) without any claim on city land.

Q: Was the analysis specific to Bristol, or generally applicable?
A: The AG's analysis turned on the specific structure described. Two facts mattered: (a) the City was not unconditionally obligated to fund the lease, and (b) the City's real property was not forfeitable on default. Any Virginia city contemplating an appropriation-dependent PPEA school finance should pay attention to both.

Q: What does "triple-net" mean here?
A: A lease in which the lessee pays the property's operating expenses, including maintenance, insurance, and taxes, on top of the base rent. The School Lease was structured that way so the entity received clean lease revenue to service the bonds.

Q: What's the trade-off for the City?
A: The City avoids hitting its 10% debt cap, but in exchange the project pays higher interest because lenders treat appropriation-dependent debt as less secure than full-faith-and-credit debt. The City also has no enforceable obligation to fund, which means political risk if a future council declines to appropriate.

Q: Could the School Board itself be in "debt" even if the City isn't?
A: The opinion focused on the City's debt-cap question because that was what was asked. School boards in Virginia are separate corporate bodies; their borrowing capacity is a different analysis and was not addressed.

Citations

The opinion cites Va. Const. art. VII, § 10(a) (city debt limit); § 22.1-71, § 22.1-79(3), and § 22.1-129(B) (school board powers); the PPEA of 2002; and the Virginia Supreme Court trilogy of Button, Dykes, and Baliles, along with earlier Virginia AG opinions from 1972-1973, 1974-1975, 1984-1985, 1985-1986, 1986-1987, 1989, 1990, and 1995-1996.

Source

• Landing page: https://www.oag.state.va.us/annual-reports-opinions/official-opinions
• Original PDF: https://www.oag.state.va.us/files/opinions/2018/DelOQuinn-SenCarrico-issued-opinion18-055.pdf

Original opinion text

COMMONWEALTH of VIRGINIA
Office of the Attorney General
Mark R. Herring

202 North Ninth Street
Richmond, Virginia 23219
804-786-2071
Fax 804-786-1991
Virginia Relay Services
800-828-1120
7-1-1

Attorney General

November 2, 2018

The Honorable Israel O'Quinn
Member, House of Delegates
Post Office Box 16325
Bristol, Virginia 24209

The Honorable Charles W. Carrico Sr.
Member, Senate of Virginia
Post Office Box 1100
Galax, Virginia 24333

Dear Delegate O'Quinn and Senator Carrico:

I am responding to your request for an official advisory opinion in accordance with § 2.2-505 of the Code of Virginia.

Issue Presented
You ask whether the Bristol Virginia School Board's potential lease of a school facility in connection with the financing of the school's construction pursuant to the Public-Private Education Facilities and Infrastructure Act of 2002, would be considered a debt of the City of Bristol subject to the limitations of Article VII, § 10 of the Constitution of Virginia.

Background
The Board of Bristol Virginia Public Schools (the "School Board") currently seeks to construct a new elementary school. You relate that a qualifying entity (the "entity") will fund the construction of the school with proceeds from a tax-exempt bond issuance pursuant to a proposed comprehensive agreement as authorized by the Public-Private Education Facilities and Infrastructure Act of 2002.

To facilitate the project, the landowner, whether it be the School Board or the City of Bristol, would lease the land on which the school will be constructed to the entity (the "Ground Lease"). The School Board or the City will at all times retain title to the land. The entity will fund and oversee construction of the new school. Upon completion, the entity, as lessor, will lease the school facility to the School Board, as lessee, pursuant to a lease agreement (the "School Lease").

The School Lease will be a 30-year, triple-net lease[1] with annual payments due from the School Board totaling $1,254,500. The total anticipated payments under the School Lease will be equal to the debt service on the bonds plus any operating, maintenance, or bond costs not otherwise paid by the School Board. The School Board, however, will be obligated to make payments to the entity only if and to the extent the City makes annual appropriations to the School Board in each year of the School Lease that enable the School Board to make the lease payments. Neither the financing structure nor the School Lease will require any commitment by the City of Bristol to make appropriations. Simply put, payments under the School Lease will not be due to the entity unless and until the City of Bristol makes an annual appropriation that will enable the School Board to make those payments.

The entity will utilize the School Lease revenues to pay for the bond debt it incurs. The bonds will be secured by the revenues and assets of the project, including a pledge of the School Lease revenue and the school facility. Neither the real property nor the Ground Lease will be used in any way as security for the bond debt or the school facility. The Ground Lease also will not be subordinated to the bond debt. Once the bond debt is repaid, no further payments will be due under the School Lease, the Ground Lease will terminate, and the entity will convey the school facility to the School Board.

It is my further understanding that if the City of Bristol declines to make an annual appropriation or the anticipated School Lease payments are not remitted, the School Board will be considered to be in default of the School Lease. Upon such an occurrence, the School Board would be required to vacate the school and the entity could relet the school facility. Upon a nonpayment or nonappropriation, the underlying Ground Lease would continue. Nothing in the proposed transaction would require the City of Bristol or the School Board to surrender the real property on which the school is built upon a nonpayment or nonappropriation. The analysis and conclusions herein are based on these facts you have related.

Applicable Law and Discussion
As a preliminary matter, a public school board is a separate body corporate vested with all powers and charged with all duties imposed by law.[2] Among their powers, school boards may contract and take, lease and convey school property, both real and personal.[3] The duties of a school board include providing for the erecting and furnishing of necessary school buildings by purchase, lease, or other contracts.[4] A school board is authorized to lease real and personal property, either as lessor or lessee, subject to applicable law.[5]

You inquire whether the School Lease will have an impact on the debt limitation of the City set forth in Article VII, § 10 of the Constitution of Virginia. The Constitution of Virginia prohibits cities from issuing "any bonds or other interest-bearing obligations which, including existing indebtedness, shall at any time exceed ten per centum of the assessed valuation of the real estate in the city ...."[6] A lease for a term of more than one year under which a locality is the lessee constitutes indebtedness, unless the lease falls within one of the exceptions to the limitation set forth in Article VII, § 10(a) of the Constitution of Virginia.[7] In general, no debt is created for constitutional purposes if there is no legal obligation created on the part of the city.[8]

In the described transaction, the City of Bristol is not legally obligated to make payments under the School Lease. Payments under the School Lease by the School Board are conditioned upon the City of Bristol making sufficient annual appropriations to the School Board to fund the School Lease; however, the City of Bristol will not be unconditionally obligated to make any appropriations or commit revenues to the project or to pay the School Lease. Virginia law establishes that payments based upon discretionary appropriations do not pledge or commit the full faith and credit of the locality and, therefore, are not indebtedness for purposes of debt limitations.[9] Because no revenues are directly committed by the City of Bristol, and no legal obligation binds the City to make sufficient annual appropriations to enable the School Board to make payments under the School Lease, the Lease does not constitute municipal debt under the Constitution of Virginia.[10]

Based upon the structure of the transaction described, the School Lease between the School Board and the entity would not constitute indebtedness of the City of Bristol.[11] This determination would not apply, however, if the City's failure to make an annual appropriation would result in the forfeiture of valuable real property in which the City of Bristol has an interest. A security arrangement whereby the City of Bristol would be required to surrender any ownership interest it may have in the Ground Lease property upon the School Board's default in the School Lease payments would establish a legal obligation subject to the constitutional limitation on indebtedness.[12]

Conclusion
It is my opinion that the School Lease proposed in the financing structure described above will not constitute a debt of the City of Bristol for purposes of the constitutional limitation on its indebtedness.

With kindest regards, I am,

Very truly yours,

Mark R. Herring
Attorney General

1. A "triple-net" lease is one in which the lessee pays the ongoing expenses of the property, including maintenance, insurance, and applicable taxes, in addition to the agreed periodic rental payments.

2. VA. CODE ANN. § 22.1-71 (2016).

3. Id.

4. VA. CODE ANN. § 22.1-79(3) (2016).

5. VA. CODE ANN. § 22.1-129(B) (2016).

6. VA. CONST. art. VII, § 10(a).

7. Button v. Day, 205 Va. 629, 643 (1964); 1984-1985 Op. Va. Att'y Gen. 95; 1972-1973 Op. Va. Att'y Gen. 37; 1970-1971 Op. Va. Att'y Gen. 398.

8. Dykes v. Northern Virginia Transp. Dist. Comm., 242 Va. 357, 375 (1991).

9. Dykes, 242 Va. at 374-75; Baliles v. Mazur, 224 Va. 462, 469 (1982); 1995-1996 Op. Va. Att'y Gen. 86; 1985-1986 Op. Att'y Gen. 70; 1974-1975 Op. Att'y Gen. 28.

10. Dykes, 242 Va. at 375.

11. Baliles, 224 Va. at 469; 1995-1996 Op. Va. Att'y Gen. 86; 1985-1986 Op. Att'y Gen. 70; 1974-1975 Op. Att'y Gen. 28.

12. 1990 Op. Va. Att'y Gen. 51; 1989 Op. Va. Att'y Gen. 55; 1986-1987 Op. Va. Att'y Gen. 106.