The county agency in charge of creating new agencies will not recover the $211,000 it spent to process the incorporation application submitted - and now abandoned - by the town of San Martin.

At a regular meeting last week, the Santa Clara County Local Agency Formation Commission board voted in closed session to settle a lawsuit filed by the San Martin Neighborhood Alliance. The alliance filed the lawsuit - which made numerous allegations related to corruption and other improper conduct on the part of LAFCO and the county in the processing the incorporation - shortly after the board voted to deny the incorporation in November 2008. The suit was filed against both LAFCO and its executive officer, Neelima Palacherla.

Incorporation proponents claimed LAFCO had a conflict of interest as its staff and board members are all county employees, and they avoided seeking a review of the application by an independent party such as the state, according to alliance attorney Richard van't Rood. The lawsuit also said LAFCO presented false information in its financial analysis of a potentially incorporated San Martin, which determined the town-turned-city would not be able to sustain itself.

Van't Rood said the $211,677.24 in fees that LAFCO billed to the alliance for staff time and resources to process the incorporation were "outrageous."

As part of the settlement, LAFCO agreed to drop its claim for fees and the alliance agreed to drop the lawsuit and its incorporation application.

Palacherla confirmed that the agreement, voted on in closed session, was approved and signed by county and alliance officials.

Without recovering staff wages and time expended in the nearly two-year incorporation process, those costs will be picked up by the county and its 13 cities, who split the cost of LAFCO's annual budget, she said.

"Those costs are factored into the operating costs that cities then have to pay for LAFCO's time and expenses," Palacherla said. "If we recovered (the fees from San Martin), then those costs would have gone down."

The settlement means the effort to incorporate the town is "dead," van't Rood said. He maintains the county tried to "ransom" San Martinians by presenting a financial analysis that said the only way the town could support itself is by imposing a utility tax on residents.

"I think the citizens of San Martin will re-apply for incorporation," said van't Rood, who said he would not be involved in the process again. "I have no confidence that San Martin will be run in a reasonable manner by the board of supervisors. The board does not perceive San Martin as being a town or a distinct community."

The alliance strove for incorporation because they want more local control over land use issues and they felt they could manage public services and local tax dollars more efficiently than the county does now.

The town's residents were divided on incorporation. Numerous residents attended public hearings and LAFCO meetings in the run-up to the November vote to voice their opposition to another layer of government.

Though LAFCO voted in November to stop work on the incorporation process, which began in early 2007, van't Rood and the alliance maintained the agency's financial analysis should be forwarded to the state controller's office for further review.

"Even today, nobody other than county employees have reviewed this information," van't Rood said.

The county's analysis concluded that a cityhood initiative should be voted on by San Martin residents, along with a utility tax initiative to address a shortfall of revenues from existing sources, such as property and sales tax.

Van't Rood said such a tax is illegal, and the county's analysis used false and outdated information. He believes the state would have felt the same way.

The alliance initially offered to settle the lawsuit by dropping its claims if LAFCO agreed to ask the state to review the town's application, van't Rood said. But LAFCO staff rejected that offer, he said.

Alliance President Sylvia Hamilton said that shows LAFCO "would rather eat the costs" than request a controller's review. "I guess they didn't want the state controller looking at it," she said.

LAFCO Commissioner Don Gage said the agency learned a lesson with the San Martin incorporation effort and subsequent legal action, as it was LAFCO's first attempt to create a city since the body was formed by county officials. To avoid future losses of fee revenues, he said the board will likely require up-front payment when incorporation proponents file applications.