Issue By: Rachel R. Ostrander

Russell City Energy Co. LLC v. City of Hayward

Court of Appeal, First District (August 7, 2017)

In Russell City Energy Co. LLC v. City of Hayward, the California Court of Appeals held that a payments clause in a contract between the City and an electric company was unconstitutional because it suspended the City’s ability to tax.

Article VIII, section 6 of the 1879 California Constitution provided, “The power of taxation shall never be surrendered or suspended by any grant or contract to which the State shall be a party.” In 1974, section 6 was replaced with Section 31, which provides “[t]he power to tax may not be surrendered or suspended by grant or contract.” Section 31 applies to local governments, including cities. It expresses the principle that governments cannot divest themselves by contract of the right to exert their governmental authority. To restrain its exercise by contract would be a renunciation of power to legislate for the preservation of society or to secure the performance of essential governmental duties. The power to tax is a sovereign power, and wherever it exists may be exercised at the will and discretion of the sovereign.

Section 31 does not define the terms “surrendered” or “suspended,” and therefore those terms have been interpreted in their ordinary and usual meaning, to be “to give up completely or agree to forgo especially in favor of another.” (Merriam-Webster’s Collegiate Dict. (11th Ed. 2014) p. 1258.) There is no question that a contract that surrenders or impairs a governmental power is invalid, but the question of whether a contract actually surrenders or impairs a governmental power largely depends on the language and intent of the contract.

In October, 2005, Russell City Energy Co. and the City of Hayward entered into a Cooperation and Option Agreement (“Agreement”). The purpose of the agreement was to facilitate Russell’s construction and operation of an Energy facility in the City. In the agreement, the City granted Russell an option to purchase 12.5 acres of City-owned land as the site for the facility. The Payments Clause provides in relevant part: “In the interest of clarity, the Parties acknowledge that payments to be made by [Russell] as contemplated in this Agreement comprise all payments to be made to the City by [Russell], its parents or affiliates in connection with the development, construction, ownership and operation of [the facility] and the City shall not impose any other levies, fees, taxes, contributions, or charges on [Russell], its parents or affiliates other than such levies, fees, taxes, contributions, or charges generally applicable to similarly situated owners of real property located in the City.” The agreement also contained a severability provision.

Four years later, in June, 2009, City of Hayward voters approved a utility tax on the usage of electricity and gas, which imposed a tax upon every person using electricity in the City at the rate of five and one-half percent (5.5%) of the charges made for such electricity, to be collected from the service user. The utility tax also included a provision regarding gas usage which is substantially similar. Russell filed suit against the City, and the City demurred. The trial court granted the demurrer without leave to amend.

The trial court found that the Payments Clause violated Section 31, and the Appellate Court agreed. Russell’s interpretation of the Payments Clause – that the City contractually promised not to impose any taxes other than real property related taxes – violated Section 31 because it surrenders and suspends the City’s power to tax the power plant. The Appellate Court held that the trial court properly determined the Payments Clause was unenforceable. In its holding, the appellate court rejected Russell’s argument that the Payments Clause was an exercise of the City’s taxing power, rather than a surrender. The Court did not agree that the language of the Payments Clause provided for an upfront payment in lieu of future taxes (which is also known as a PILOT agreement). The appellate court noted that by the language of the Payments Clause, the City unquestionably suspended its power to tax. The Payments Clause rendered the City’s power to tax “‘temporarily inactive’” for the life of the facility. The Appellate Court sustained the trial courts grant of demurrer, but reversed the order in order to allow Russell leave to amend to state a claim on any other grounds.

COMMENT

Russell City Energy Co. LLC v. City of Hayward is unambiguous that a municipality’s sovereign right to tax cannot be diminished by contract terms, regardless of the intention of the parties at the time of contracting. Parties to contracts with a public entities, and their counsel, must use explicit and clear contract language to address prospective issues, and must anticipate future conditions which may lead to contract terms running afoul of the entities superseding rights. Similarly, public entities that want to provide attractive contract terms to private parties in order to encourage growth and productivity, will need to be mindful of the concerns of private parties and emerging case law on prospective issues to provide meaningful incentives to contract.

For a copy of the complete decision, see: Russell v. City of Hayward

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