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Spouses, Beware: Your Partner's Creditors Might Sue You, Too

When a wealthy man (it's usually a man) has creditors on his trail, he'll probably try to protect some assets by transferring them to his wife. If it works, his wife will be richer than she was before. On the downside, the law might come after her, too -- wanting the money back.

That's what's happening to the wives of two top executives of the failed Washington Mutual Bank, which was seized by the government in September, 2008. The Federal Deposit Insurance Corporation sued their husbands -- former CEO Kerry Killinger and former COO Stephen Rotella -- in federal court in Seattle last week, for negligence and breach of fiduciary duty in their management of the bank. WaMu's Home Loan President David Schneider was also charged. The government reportedly seeks to recover $900 million from the execs, for the bank's bondholders and other creditors.

Killinger and Rotella switched valuable property into their wives' names, directly or in trust -- an action that, potentially, could protect it from any judgments against them. So the FDIC slapped the wives -- Linda Killinger and Esther Rotella -- with a lawsuit, too. It also asked the court to freeze the transferred assets, so they couldn't be disbursed while the case is going on.

Seattle-based Washington Mutual was among the most reckless of the subprime mortgage lenders during the real estate bubble. The three execs took what the FDIC called, in court filings, "historically unprecedented risks" to drive up the price of WaMu's stock. They did it to enhance their own compensation, the FDIC alleged. In June, 2008, the bank listed $307 billion in assets, making it the largest failure in U.S. history.

Killinger and Rotella vigorously disputed the FDIC's claims in public statements (Schneider didn't release a statement). Killinger called the charges "baseless and unworthy of the government." Rotella described himself as a "hard working bank manager who performed well under extraordinary circumstances in an effort to save an important financial institution."

Before the wives will be called on to defend themselves, the FDIC has to prove its claims against their husbands. If a jury decides that they made reasonable banking decisions during a confusing housing boom, the case against the wives is moot. If the jury concludes, instead, that the men violated their legal "duty of care," and bring a money judgment against them, the argument over the property will begin. Was it a legal transfer and therefore safe from creditors? Or can the creditors seize the property out of the trusts? Lawyers I spoke with last week were betting against the wives, if their husbands lose the case.

In court filings, the FDIC alleges that in August, 2008 -- about a month before the seizure of the bank -- the Killingers transferred their home in Palm Desert, CA, to two irrevocable qualified personal residence trusts (QPRTs, pronounced CUE-perts in legalese). Kerry Killinger also transferred his half-interest in a Shoreline, WA, home to Linda, and another two QPRTs were created.

As for the Rotellas, the complaint alleges that, in about March or April, 2008, they transferred their home in Orient, NY, to two QPRTs. In addition, Stephen transferred "in excess of $1 million" directly to Esther after WaMu failed in September, 2008, the court filing claims.

Neither man addressed the transfers in their public statements. In an interview with the Wall Street Journal, Rotella said the transfers to his wife were for "typical financial planning purposes."

When you put assets into an irrevocable trust, you cannot change the terms of the trust or take the value back, even to pay creditors. But it's illegal to put assets in trust to "hinder, delay or, defraud" present or future creditors. That's called "fraudulent conveyance," which is what the FDIC is alleging here. The court papers say that, at the time the trusts were set up, both Killinger and Rotella had been named as defendants in "numerous lawsuits," which "posed a potential exposure far in excess of [their] means."

If a jury finds against them, the FDIC "will presumably try to unwind the house transfers as a fraudulent conveyance," says estate planning attorney and author Martin Shenkman. The cash that was transferred at the last minute might be recovered for the creditors, too. A court would have to find that the trusts were set up to evade these creditors, not for normal estate planning, as Rotella asserts.

QPRTs are indeed one of the tricks of estate planning used by wealthy couples. You can transfer a home to your children at a discounted value, which saves on gift taxes. Any appreciation in value is out of your estate. You continue to live in the house, paying all the expenses, for a certain number of years -- say, 10. Then the trust terminates, the kids (or a trust for the kids) own the house, and you pay them rent -- another way of getting money out of a large estate. (The only catch is that, if you die before the end of the term, the trust continues but the house is back in your estate, so you lose the tax savings.)

Irrevocable trusts, or transfers to spouse, can be an effective shield against creditors only if you make them early enough. If you wait until you have a major lawsuit against you, or expect a lawsuit, it's generally too late. That's why Ruth Madoff had to return most of the money she received from her husband, Ponzi schemer Bernard Madoff. Richard Fuld, head of Lehman Brothers, transferred a $13.75 million estate to his wife less than two months after his investment banking firm collapsed (he hasn't been sued).

What is the cost, if the WaMu execs lose their case and the court breaks the trusts? Not much, says Lawrence Waggoner, professor of law at the University of Michigan. "The worst that can happen is that they have to transfer the money back." Waggoner hastens to add that he doesn't advocate the strategy, in the face of fraud. But here's the hard truth: If you lose in a case like this, all you're out are the legal fees.

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