Economic Development Opportunity Deals With Public Entities and Their Constitutional Hurdles: What Can Be Learned from Schires v. Carlat

By Tracy A. Olson, Brett W. Johnson, Colin P. Ahler and Nicholas J. Wood

In recent years, courts have seen an increasing amount of cases challenging Arizona economic development deal opportunities between public and private parties under the “Gift Clause” of article IX, section 7 of the Arizona Constitution. Generally speaking, the Gift Clause prohibits a public entity from offering donations, grants, or subsidies to private entities. In an economic development setting, the Gift Clause prohibits an agreement between a public and private entity that is so lopsided (i.e., the public entity is giving much more than it is receiving) that it constitutes a gift from the public entity. Companies and economic development departments will need to continue to consider the application of the Gift Clause to a transaction as there is increased competition across the nation for economic growth opportunities.

In 1984, the Court adopted a two-pronged test to evaluate if an arrangement between a public and private entity violated the Gift Clause.¹ First, the arrangement must serve a “public purpose.”² Second, the arrangement must be supported by consideration that is “not so inequitable and unreasonable that it amounts to an abuse of discretion.”³ If the agreement fails to satisfy either prong of the test, the public entity has provided an illegal subsidy to a private party and violated the Gift Clause.⁴

On February 8, 2021, the Arizona Supreme Court weighed in again on the developing Gift Clause jurisprudence by issuing its opinion in Schires v. Carlat.⁵ In this case, the Court clarified the two-pronged Gift Clause test to “provide guidance to public entities entering into development agreements.”⁶ Most importantly, following Schires, Arizona courts may no longer give as much deference to public officials on the actual value of the benefits of a deal and will likely take a narrow view of the type of “direct” benefits that may be considered in evaluating the sufficiency of consideration.

Schires concerned a taxpayer challenge to an “economic development” arrangement between the City of Peoria and a private institution, Huntington University (“HU”), under the Gift Clause.⁷ By way of background, the City had begun implementing “strategies to spur economic development” including “paying money to businesses in desirable fields, [such as] higher education and technology, in return for their expansion” or relocation in Peoria and “partially reimbursing eligible property owners for making tenant improvements to vacant commercial buildings in an underused area . . . known as the ‘P83 District.’”⁸ To further this goal, the City entered into a 2015 Agreement with HU containing the following salient terms:

• HU agreed to enter into a leasing agreement with Arrowhead Equities, LLC for a building in the P83 District.
• HU agreed to spend a minimum of “$2.5 million to open its Peoria campus.”
• HU agreed to develop an undergraduate program in digital media and “to refrain from offering similar programs” in any other Arizona city for seven years.
• HU agreed to partake in “economic development activities” to help the City implement its other economic development strategies.
• In consideration for these promises, the City agreed to pay HU up to $1,875,000 over the span of three years if certain “performance thresholds” were met.
• The City also agreed to pay HU’s landlord, Arrowhead, $737,596 to renovate the P83 District building, subject to the satisfaction of “performance criteria.”⁹

The Court applied the two-pronged test and held that although the agreement served a public purpose (prong one), it was not accompanied by sufficient consideration (prong two), and thus violated the Gift Clause.¹⁰

Public Purpose. Generally, “a public purpose promotes the public welfare or enjoyment” and can be established through “both direct and indirect benefits of a government expenditure.”¹¹ Courts interpret the term public purpose broadly and, in regard to this prong, will defer to the judgment of City officials, unless the public entity “unquestionably abused” their discretion.¹² As a result, courts usually will not second guess whether the expenditure was necessary or even a good idea.¹³

In Schires, the Court concluded that the City did not “unquestionably abuse” its discretion in determining that the deal with HU served a public purpose because it worked to develop the city’s economy and revitalize the P83 District.¹⁴ In doing so, the Court rejected a request from the taxpayers to not consider “secondary, intangible, and indirect benefit[s]” in the public purpose inquiry.¹⁵ Instead, the Court reinforced its broad lens, concluding that the public purposes inquiry includes indirect and secondary benefits.¹⁶

Sufficient Consideration. To avoid a Gift Clause violation, an agreement with a public entity requires a greater degree of consideration than what is required for the formation of a valid contract.¹⁷ However, in determining whether there is sufficient consideration, the court may only consider the “direct benefits that are ‘bargained for as a part of the contracting party’s promised performance,’ and [will] not include ‘anticipated indirect benefits.’”¹⁸

Although the Schires Court took a broad view on the public purpose prong, the Court expanded the review to include whether a deal lacks sufficient consideration. Namely, in a departure from its 2016 decision in Cheatham v. DiCiccio,¹⁹ the Court held that “courts should not give deference to the public entity’s assessment of value but should instead identify the fair market value of the benefit provided to the entity and then determine proportionality.”²⁰ Accordingly, the inquiry is an objective one based on the agreed fair market value of the direct benefits.²¹ The value of the indirect benefits, including the economic impact of an agreement, is arguably irrelevant under this second prong.²²

Applying this new framework and relying on the expert testimony, the Court held that the arrangement did not possess sufficient consideration. The Court reasoned that the economic impact of the City’s agreement with HU was not a bargained for benefit because none of the agreement’s terms created an “enforceable promise to provide the City with any particular economic impact.”²³ Accordingly, even though the agreement would result in tax income and otherwise stimulate the City’s economy (as demonstrated through a fair market valuation), the value of the indirect benefits was found by the Court to be irrelevant.²⁴ Because the City did not derive any value from the agreement other than its “economic impact,” the Court found there was nothing to offset the value of its public expenditure.²⁵

Takeaways. Public and private entities will need to consider the Court’s direction in structuring economic development agreements. Although negotiating parties may still rely on economic development as a valid public purpose, to count as consideration for Gift Clause purposes, consideration should be given to whether the direct economic development benefits to the entity now needs to be (a) incorporated into the terms of the agreement as a direct benefit to the public entity; and (b) given a fair market value. Once the parties agree upon the fair market value of the benefit provided to the entity, the City and the entity may then apply the proportionality test. In addition, parties may want to continue to consider the entirety of the transaction terms in determining what constitutes a “direct” benefit that may be factored in the sufficient consideration analysis. Objective data and/or third-party expert guidance also may be useful given the potential lack of deference to a public entity’s determination of value.

Being aware of the constitutional hurdles to economic development incentive deals with public entities is important.   The Court’s reiteration that it was not going to take a position as to what is in the public interest from an economic development perspective may provide some latitude to parties negotiating economic development opportunity deals so long as the “direct” benefits are negotiated, articulated, and supported by objective analysis.