Meet Sam, an Orange County business owner who was just named as a defendant in a lawsuit. Sam is 50 years old. He has spent the last few years thinking about his future retirement and his desire to establish a Private Retirement Trust, but, like many people, he never got around to formalizing a retirement plan. Now, with litigation pending, Sam wants to move fast to establish a Private Retirement Trust (“PRT”) and capture the exemption protection of California Code of Civil Procedure § 704.115(b).
Can he? Does the pending lawsuit preclude him from retirement planning altogether? Or is there a responsible path that allows Sam to fund a PRT even with a contingent liability hanging over his balance sheet?
1. Why Solvency Matters Before Funding a PRT
A significant part of determining whether a client is a proper candidate for a PRT is verifying that the client is solvent and financially — as well as legally — able to fund it. If a client is not solvent and the exemption protection of the PRT is later challenged, any assets transferred to the PRT could be voidable under the Uniform Voidable Transactions Act (“UVTA”).
Under California Civil Code § 3439.02(a), a debtor is insolvent if, at a fair valuation, the sum of the debtor’s debts is greater than the sum of the debtor’s assets. The rule of thumb is that the client’s glass needs to be more full than empty before pouring funds into a PRT. If the glass is near empty, transfers to the PRT may not benefit from the CCP § 704.115(b) exemption and will be open to attack under the UVTA — attacks that are expensive to defend even when they ultimately fail.
2. When Solvency Is Not Cut and Dry: Sam’s Balance Sheet
For some clients, determining solvency is straightforward. For clients who face potential personal liability from pending or threatened litigation, claims, or guarantor agreements that have not yet been called upon, it is not.
Assume Sam has assets worth $2 million, liabilities of $1 million, and damages sought in the lawsuit against him of $1 million. Two ways to read his balance sheet:
- If the lawsuit is ignored, Sam’s glass is half full — $2 million in assets against $1 million in liabilities leaves $1 million in net worth.
- If the full $1 million potential lawsuit liability is counted at face value, Sam’s glass is empty: $2 million in assets against $2 million in combined liabilities leaves $0 in net worth.
Which valuation is correct? The UVTA does not directly answer that question. To find the answer, we have to look at how the law treats contingent liabilities — obligations that only become actual liabilities upon the happening of a future event.
3. Why a Pending Lawsuit Is a Contingent Liability
The Legislative Committee Comment (7) to California Civil Code § 3439.02 addresses the valuation of an obligation incurred by a debtor as surety for another. In assessing solvency for a surety, the comment instructs that appropriate weight should be given to the prospective likelihood, and the extent thereof, that the debtor will be called upon to perform under the suretyship agreement, with appropriate value also placed on the surety’s rights to subrogation, exoneration, and indemnification.
A surety and a pending litigation case share the common trait of being a contingent liability. A contingent liability only results in actual liability upon the happening of an event — for a surety, the debtor being called upon to perform; for a pending lawsuit, the entry of a judgment against the debtor. The valuation logic that applies to one is logically applicable to the other.
Because the UVTA itself provides no detailed guidance on valuing contingent liabilities, and because the Legislative Committee notes that subdivision (a) of § 3439.02 is derived from the definition of “insolvent” in Section 101(29)(A) of the Bankruptcy Code, federal case law becomes a useful (though not controlling) source of guidance.
4. The Discounting Formula: Xonics and Covey
In the corporate bankruptcy context, the valuation of contingent liabilities is well settled. Contingent liabilities must be taken into account when determining solvency, but they are not counted at face value. They must be discounted by the probability that the liability will actually materialize.
In Matter of Xonics Photochemical, Inc. (7th Cir. 1988) 841 F.2d 198, 200, the court explained that a contingent liability is, by definition, not certain — and often is highly unlikely — to become an actual liability. To value it properly, the court must discount it by the probability that the contingency will occur and the liability will become real.
The Xonics decision was later criticized for applying the probability percentage to the company’s net book value rather than to the face amount of the contingent liability. In Covey v. Commercial Nat. Bank of Peoria (7th Cir. 1992) 960 F.2d 657, 660, the court corrected that approach. From the debtor’s perspective, the amount of the debt guaranteed — the face value of the liability — should be used as the multiplicand, not net book value.
The Covey court illustrated the point: a $5 million note issued by a firm with $4 million in assets propels the firm into insolvency, but a $5 billion guarantee by the same firm — on which the beneficiary is 99% certain to draw — should not yield a smaller liability than the $5 million note. Multiplying $5 billion by 0.99 is the correct approach, not multiplying $4 million by 0.99.
5. Applying the Formula: In re R.M.L., Inc.
In In re R.M.L., Inc. (3d Cir. 1996) 92 F.3d 139, 156, a court looks at the circumstances as they appeared to the debtor and determines whether the debtor’s belief that a future event would occur was reasonable. The less reasonable the belief, the more justified the court is in adjusting the assets or liabilities to reflect the debtor’s true financial condition at the time of the alleged transfers.
6. The State-Law Question: Can an Individual Use the Discounting Formula?
The Xonics and Covey formula was developed in the bankruptcy context for corporate debtors. No California state-court decision has directly authorized an individual subject to state law to use it. There is also no direct authority preventing the application.
This exact question was raised in In re Ponce Nicasio Broadcasting, LP (Bankr. E.D. Cal. Feb. 7, 2008) No. 04-26256-B-7, 2008 WL 361081. The debtors argued that the value of the debt owed to the plaintiff should be discounted by 50% because the liability was only contingent at the time of the disputed transfers. They pointed to an earlier Superior Court order that vacated an order of examination and stayed collection attempts pending an evidentiary hearing, arguing that the stay could only have been imposed if the Superior Court found that the relevant entities had demonstrated a probability of success on the merits.
The bankruptcy court rejected the application of the discount on the facts, finding that the debtors had not presented sufficient evidence to justify it. The court noted specifically that the debtors had presented no California state authority on the method by which contingent liabilities should be valued for purposes of an insolvency analysis, and that the federal cases they cited — including Xonics — were interesting but not controlling, because the plaintiff was proceeding under a cause of action created by state law.
Critically, the Ponce court did not reject the discounting method itself. It rejected the application on those facts because the debtors had not set forth an adequate basis on which to discount the contingent liability. The court’s conclusion was that, because the debtors had not set forth an adequate basis on which to discount, there was a genuine issue of material fact as to whether the entity was insolvent at the time of the transfers.
7. What Counts as an “Adequate Basis” to Discount?
Based on Ponce, application of the discounting formula to an individual debtor under California law appears to be a viable option — if the debtor can set forth an adequate basis on which to discount the contingent liability. “Adequate basis” is fact-driven and subject to interpretation by the trier of fact. It will vary from case to case based on the particular circumstances.
In practice, building that adequate basis means documenting the discount with the kind of evidence a court would accept: an objective assessment of the strength of the underlying claim, the viability of identified defenses, the typical outcomes of comparable cases, and any procedural history that genuinely supports a reduced probability of an adverse judgment. A self-serving estimate without supporting analysis is the type of evidence the Ponce court found inadequate.
Before relying on the discounting formula in a state-law solvency analysis, the client and counsel should be confident that the supporting record will hold up under scrutiny. If it will, even a client whose glass is more than half empty on a face-value analysis may be able to legally fund a PRT and capture the exemption protection of CCP § 704.115(b).
How a Properly Designed PRT Protects Retirement Assets
A pending lawsuit does not automatically foreclose retirement planning. The key to legally funding a PRT in the face of contingent liability is to make sure all liabilities are taken into account — whether matured or unmatured, liquidated or unliquidated, absolute, fixed, or contingent — and that enough is set aside to cover potential future liability. When the solvency analysis is done carefully, with appropriate documentation of any discount applied to contingent liabilities, the path to a legally defensible PRT funding strategy can be cleared.
Work With a Private Retirement Trust Attorney
Solvency analysis with contingent liability is one of the most fact-intensive parts of PRT planning, and one of the riskiest places to get the analysis wrong. A transfer made by an insolvent debtor — or one a court later concludes was insolvent — can be unwound under the UVTA, and the exemption protection that funding was meant to capture can disappear with it.
Dustin I. Nichols, creator of the Private Retirement Trust®, has spent over 30 years designing integrated exemption strategies for California clients. If you are considering a PRT with pending or threatened litigation in the background, schedule a free consultation, contact the Law Office of Dustin I. Nichols, APC in Newport Beach, California or call (949) 240-1101 to walk through your specific situation with an attorney who has been doing this work for decades. You can also reach us through our contact page.
Frequently Asked Questions About Funding a PRT With Pending Litigation
Can I Fund a Private Retirement Trust While I Am Being Sued?
Possibly. Pending litigation does not automatically prevent funding a PRT, but it does require a careful solvency analysis under California Civil Code § 3439.02. If the contingent liability from the lawsuit, properly valued, leaves the debtor solvent, funding may be permissible. If it leaves the debtor insolvent, transfers to the PRT can be voidable under the Uniform Voidable Transactions Act.
What Does “Insolvent” Mean Under California Law?
Under California Civil Code § 3439.02(a), a debtor is insolvent if, at a fair valuation, the sum of the debtor’s debts is greater than the sum of the debtor’s assets. The phrase “fair valuation” is important — contingent liabilities are not necessarily valued at face value.
What Is a Contingent Liability?
A contingent liability is a potential obligation that only becomes an actual liability upon the happening of a future event. For a surety, that event is the principal debtor being called upon to perform. For a pending lawsuit, it is the entry of a judgment against the debtor.
How Are Contingent Liabilities Valued for a Solvency Analysis?
Under federal bankruptcy case law in Xonics and Covey, the value of a contingent liability is the face value of the liability multiplied by the probability that the contingency will occur. The probability must be reasonable based on the underlying facts.
Does California State Law Use the Same Discounting Formula?
No California state-court decision has directly authorized application of the federal discounting formula to an individual debtor under state law. However, in In re Ponce Nicasio Broadcasting, LP, the court did not reject the formula. It rejected the debtor’s application of it because the debtor had not set forth an adequate basis on which to discount. Whether the formula can be applied in a given state-law case depends on the strength of the supporting record.
What Is an “Adequate Basis” to Discount a Contingent Liability?
Adequate basis is fact-driven. It typically requires an objective assessment of the strength of the underlying claim, the viability of available defenses, comparable outcomes, and any procedural history that supports a reduced probability of an adverse judgment. A self-serving estimate without supporting analysis is unlikely to satisfy a court.
What Happens If a Transfer to a PRT Is Found to Be Voidable Under the UVTA?
If a court determines that the debtor was insolvent at the time of transfer and the transfer is voidable under the UVTA, the assets transferred can be clawed back — and the exemption protection that funding was meant to capture is lost. Defending a UVTA claim is also costly even when the ultimate outcome is favorable.
Is It Better to Plan a PRT Before Any Litigation Arises?
Yes. The cleanest path to PRT funding is to establish and fund the plan well before any contingent liability emerges. When that is not possible, careful solvency analysis with documented discounting of contingent liabilities provides the next-best alternative, but it is more vulnerable to challenge than pre-liability planning.
LEGAL DISCLAIMER: This article is for informational purposes only and does not constitute legal advice. The information provided is general in nature and may not apply to your specific circumstances. No attorney-client relationship is formed by reading this content. For advice tailored to your situation, please consult with a qualified attorney. The Law Office of Dustin I. Nichols, APC serves clients throughout California.
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