COLBERT M. MATSUMOTO 2276-0
Suite 2000, Amfac Tower
700 Bishop Street
Honolulu, Hawaii 96813
Telephone No. 523-2999
IN THE CIRCUIT COURT OF THE FIRST CIRCUIT
STATE OF HAWAII
In the Matter of the Estate
BERNICE P. BISHOP,
EQUITY NO. 2048 MASTERíS CONSOLIDATED REPORT ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES
TABLE OF CONTENTS
II. THE 109th MASTER'S REPORT AND THE STIPULATED ORDER CONCERNING MASTER'S RECOMMENDATIONS
IV. SCOPE OF REVIEW
V. HISTORICAL CONTEXT
VI. FINANCIAL REPORTING AND MONITORING
A. The Trustees Must Provide Meaningful
Financial Information In Connection With
The Annual Review
RECOMMENDATION NO. 1: NEW FINANCIAL
STATEMENT PRESENTATION SHOULD BE
B. Highlights Of The Audited Financial
Statements For FY 1994, FY 1995,
And FY 1996
C. Valuation of the Trust Estate's Assets
VII. ACCUMULATION OF INCOME
A. The Distinction Between Corpus And Income
Is Fundamental To Fulfillment Of The Will
Of Princess Pauahi
B. The Annual Accounts Filed With The Court
Do Not Adequately Disclose The Status of
the Corpus and Revenue Accounts
RECOMMENDATION NO. 2: CORPUS AND
REVENUE ACTIVITY SHOULD BE
C. Income Has Been Inappropriately
Reclassified As Corpus.
RECOMMENDATION NO. 3: ACCUMULATED
INCOME SHOULD BE RESTORED TO THE
D. The Accumulated Income Balance May
Violate The Express Direction Of The
Will And Prior Court Orders
RECOMMENDATION NO. 4: AN ACCOUNTING
OF ACCUMULATED INCOME AND INDEPENDENT
VERIFICATION SHOULD BE CONDUCTED
E. Past And Current Trustees Have Been Under
Court Orders To Plan For The Expenditure
Of Accumulated Income But Failed To Comply
With Those Orders
RECOMMENDATION NO. 5: STRATEGIC
PLANNING SHOULD INCORPORATE EXPENDITURE
OF ACCUMULATED INCOME
F. The Trustees Should Adopt, With Court
Approval, An Appropriate Spending Policy
RECOMMENDATION NO. 6: NO FUTURE
RECLASSIFICATION OF ACCUMULATED
INCOME SHOULD BE PERMITTED WITHOUT
PRIOR COURT APPROVAL
G. A Replacement Cost Reserve Has Been
Established Without Court Approval And
May Violate The Will.
RECOMMENDATION NO. 7: THE
APPROPRIATENESS OF THE REPLACEMENT
COST RESERVE SHOULD BE DETERMINED
BY THE COURT
VIII. EVALUATION OF THE INVESTMENT AND MANAGEMENT OF
ASSETS UNDER THE PRUDENT INVESTOR RULE
A. The Will Requires Annual Judicial And
Public Review Of Investments
B. The Trustees Are Subject To The Prudent
C. Appropriate Information Must Be Furnished
To Allow Evaluation Of Compliance With The
Prudent Investor Rule
D. Investment Performance Should Be
Appropriately Monitored, Benchmarked,
RECOMMENDATION NO. 8: INVESTMENT
PERFORMANCE SCHEDULES SHOULD BE
REGULARLY PREPARED AND INCORPORATED
AS SUPPLEMENTAL SCHEDULES TO THE
RECOMMENDATION NO. 9: INVESTMENT
RETURN ANALYSIS SHOULD USE
APPROPRIATE PERFORMANCE MEASURES
E. Substantial Losses And Loss Reserves
Were Established For Various Troubled
F. The Prudent Investor Rule Requires
Strategic Planning To Guide Investment
G. Prudent Investment Requires Diversification
Of The Investment Portfolio
RECOMMENDATION NO. 10: INVESTMENT
POLICIES SHOULD BE REVIEWED AS
RECOMMENDED IN THE ANDERSEN REPORT
H. The Due Diligence Review Process Needs
RECOMMENDATION NO. 11: DUE DILIGENCE
AND INVESTMENT MONITORING POLICIES,
PRACTICES, AND PROCEDURES SHOULD BE
I. Documentation Of Investment And Management Decisions Must Be Significantly Improved And Consistently Maintained
RECOMMENDATION NO. 12: INVESTMENT
AND MANAGEMENT DECISIONS SHOULD BE
J. Investment Costs And Management Expenses
Should Be Evaluated To Determine Compliance
With The Prudent Investor Rule
K. The Real Estate Portfolio Of The Trust
(a) The Andersen Report Recommends
Several Reforms For The Hawaii
Real Estate Operations
(a) The Non-Hawaii Real Estate
Investments Are Not Linked
To An Asset Allocation Strategy
For The Trust Estate
(b) Pooled Real Estate Investments
IX. STRATEGIC PLANNING
A. Appropriate Strategic Planning Remains Lacking
RECOMMENDATION NO. 13: COURT MONITORED
STRATEGIC PLANNING SHOULD BE INITIATED
BY THE TRUST ESTATE
B. A Historical Note Regarding Past Strategic
Planning By The Trust Estate
C. Caution Should Be Exercised In Undertaking
The Strategic Planning Process To Avoid
A Detrimental Impact on the Education
X. TRUST ADMINISTRATION 99
A. The Need For Organizational Reform In The
RECOMMENDATION NO. 14: THE LEAD
TRUSTEE SYSTEM SHOULD BE ABOLISHED
AND A NEW CEO BASED MANAGEMENT
SYSTEM SHOULD BE INSTITUTED AS
RECOMMENDED BY THE ANDERSEN REPORT 111
B. The Need For Judicial Intervention Is
Exemplified By The Conditions At The
XI. TRUSTEE COMPENSATION
A. Trustee Compensation During The Periods
Reviewed Were Consistent With State Law
B. Trustee Compensation May Be A Factor
Impeding Management Reform
C. The Intermediate Sanctions Law And Act 310
of 1998 Require Changes In The Procedure For
Determining Trustee Commissions.
RECOMMENDATION NO. 15: COMPLIANCE
PLAN FOR DETERMINING REASONABLE
TRUSTEE COMPENSATION SHOULD BE
XII. DUTY OF LOYALTY -- CONFLICT OF INTEREST 123
A. Trustees Are Subject To A Duty of
Loyalty Which Demands The Avoidance
Of Conflicts Of Interest
B. Issues Related To The Co-Investment By
Trustees In The McKenzie Methane
Investments Have Not Been Appropriately
C. Issues Related To The Receipt Of
Director's Fees By A Trustee While
Serving As A Director Of A Corporation
In Which The Trust Estate Has A
Substantial Investment Require Proper
D. Issues Arising From A Trustee Of The
Trust Estate Assuming A Position As A
Trustee Of The Robert Trent Jones Golf
Club During Negotiations Between The Two
Entities Were Not Adequately Reviewed.
E. Trustees Are Under A Duty To Act To
Prevent Or Redress A Breach Of Trust
RECOMMENDATION NO. 16: STRICTER
CONFLICT OF INTEREST POLICIES AND
PROCEDURES SHOULD BE ADOPTED
F. Expenses Related To The Enactment Of
The Intermediate Sanctions Law Were
RECOMMENDATION NO. 17: TRUSTEES
SHOULD SHOW CAUSE WHY THEY SHOULD
NOT BE SURCHARGED FOR EXPENSES
INCURRED IN OPPOSING INTERMEDIATE
XIII. THE TAX EXEMPT STATUS OF
THE TRUST ESTATE
A. Report By Arthur Andersen LLP Regarding
Matters Related To The Tax Exempt Status
B. The IRS Audit And Potential Conflicts
Of Interest 140
RECOMMENDATION NO. 18: NEGOTIATION
AND RESOLUTION OF IRS AUDIT SHOULD
BE SUBJECT TO COURT MONITORING AND
XIV. CERTIFICATION TO THE COURT BY TRUSTEES AND KEY EMPLOYEES AND AGENTS
RECOMMENDATION NO. 19: APPROVAL
OF THE ANNUAL ACCOUNTS TO BE
WITHHELD UNTIL THE CONCLUSION OF
THE PROCEEDINGS UPON WHICH THE
CERTIFICATION LETTERS ARE QUALIFIED
XV. REVISION OF THE RESTATED GUIDELINES
XVI. REQUESTS TO THE COURT
MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH,
ONE HUNDRED TENTH,
AND THE ONE HUNDRED ELEVENTH
ANNUAL ACCOUNTS OF THE TRUSTEES
Princess Bernice Pauahi Bishop mandated disclosure and accountability by the Trustees of her Trust Estate through the direction in the Will that:
[M]y said trustees shall annually make a full and complete report of all receipts and expenditures, and of the condition of said schools to the chief justice of the Supreme Court, or other highest judicial officer in this country; and shall also file before him annually an inventory of the property in their hands and how invested, and to publish the same in some Newspaper published in said Honolulu;
See Exhibit A.
In accordance with this express direction in the Will, Hawaii Revised Statutes ("HRS") 560:7-201(a), and the Hawaii Probate Court Rules, the Trustees of the Trust Estate have submitted three separate petitions for approval of the annual accounts covering three fiscal year periods: July 1, 1993 to June 30, 1994 ("109th Annual Account"); July 1, 1994 to June 30, 1995 ("110th Annual Account"); and July 1, 1995 to June 30, 1996 ("111th Annual Account").1
Pursuant to HRS 635-14 and Rule 28 of the Hawaii Probate Court Rules, by three Orders of Reference to Master filed herein on January 18, 1996, June 6, 1996, and May 19, 1997, the undersigned was appointed as the Court's Master to review the three petitions for approval of the annual accounts and to report his findings and recommendations to the Court.
In accordance with Rule 29 of the Hawaii Probate Court Rules your Master has undertaken to "review the operations of the fiduciary in light of the terms of the controlling document, as well as the financial transactions of the trust or estate." Haw. Prob. Ct. R. 28. It is pursuant to this charge that your Master has undertaken to review the 109th, 110th, and 111th Annual Accounts of the Trustees.
1 HRS § 554-4 also requires that a trustee file an annual account with the court showing in detail all receipts and disbursements, together with a full and detailed inventory of all property in the trustee's possession or under the trustee's control.
II. THE 109th MASTER'S REPORT AND THE STIPULATED ORDER CONCERNING MASTER'S RECOMMENDATIONS
On November 17, 1997, your Master filed the Master's Report on the One Hundred Ninth Annual Account of the Trustees ("109th Master's Report "). Rather than repeat its content, your Master incorporates by reference the text of, including, but not limited to, the discussion regarding the applicable principles of law and the pertinent legal authorities cited therein.
The Trustees' Response to Master's Report on the One Hundred Ninth Annual Account (Fiscal Year 1993-1994) ("Trustees' Response ") and the Report of the Attorney General on the Petition of the Trustees for Approval of the One Hundred Ninth Annual Account were both filed herein on December 3, 1997. The Trustees, Attorney General, and your Master thereafter entered into a Stipulation Concerning Master's Recommendations (109th Annual Account) filed herein on December 19, 1997 which was approved and entered as an Order by the Court on the same day ("Stipulated Order "). That Stipulated Order , in large part, provided for the implementation of the recommendations made in the 109thMaster's Report ; prescribed that an international accounting firm be retained to conduct a full financial and management audit; and directed that the 109th, 110th, and 111th Annual Accounts be consolidated for hearing.
On January 9, 1998, a Stipulation Concerning Financial and Management Audit ("Audit Stipulation ") was entered into among the Trustees, the Attorney General, and your Master describing the scope of the ordered financial and management audit. Pursuant to the Audit Stipulation , proposals from various international CPA firms were solicited. As a result of that process the firm of Arthur Andersen LLP was selected and engaged by your Master to conduct an independent financial and management audit of the Trust Estate.
Since their engagement, Arthur Andersen LLP has undertaken a broad review and analysis of the financial affairs of the Trust Estate for FY 1994, FY 1995, and FY 1996. In addition, they have also reviewed the management operations and structure of the Trust Estate in accordance with the Audit Stipulation . Your Master also requested that Arthur Andersen LLP review various specific transactions and matters related to the Trust Estate to assist your Master in the preparation of this Report.
On August 27, 1998, the team of professionals from Arthur Andersen LLP presented their findings and recommendations in connection with the management audit to the Trustees and key employees from the Trust Estate during an all-day briefing. Those findings and recommendations are contained in a 336 page report prepared by Arthur Andersen LLP entitled Kamehameha Schools Bernice Pauahi Bishop Estate Management Audit Findings dated July 1998 ("Andersen Report "). Copies of the Andersen Report were provided to your Master, the Trustees, and the Attorney General pursuant to the Stipulated Order and Audit Stipulation. A copy is submitted to the Court under initial court seal in accordance with the Stipulated Order .
Your Master believes that the full copy of the Andersen Report is a sensitive internal management document which should remain under court seal and not be made public. The Andersen Report is a useful management tool for the Trust Estate because of its comprehensiveness and its frank discussion of issues identified by the team of professionals from Arthur Andersen LLP. Your Master therefore believes that Court should limit review, reference, and use of the sealed copy of the Andersen Report to the Court, your Master, and the Court's future appointed masters in connection with the annual accounts under review and subsequent annual accounts filed by the Trustees.
Despite the sensitivity related to public release of the full Andersen Report , the Trustees have agreed to allow your Master to make public the Executive Summary of the Andersen Report . See Exhibit B. That Executive Summary represents a fair summary of the content of the Andersen Report.
Your Master wishes to acknowledge the work of several individuals who provided specialized expertise which assisted your Master in reviewing the accounts.
Paul Sachs, as the engagement partner, and Eric Yeaman, as the engagement manager, provided the leadership for the Arthur Andersen LLP team of professionals who undertook the financial audit and management review of the Trust Estate's operations. Their team was comprised of experts in financial reporting and consulting services related to financial market investment, real estate investment and management, not-for-profit organizations, information technology, compensation and benefits, and other areas of management operation expertise.
Edward C. Halbach, professor emeritus and former dean of the University of California at Berkeley School of Law (Boalt Hall) provided advice and guidance regarding the principles of trust law applicable to the Trust Estate.
Steven Sakamaki, CPA and the staff of the firm of Shigemura & Sakamaki, CPA, Inc. assisted in the initial review of the 109th and 110th Annual Accounts which provided much of the basis for the earlier 109th Master's Report .
In addition, your Master wishes to acknowledge the staff of the Trust Estate for their assistance in facilitating the completion of this report. At all levels of the Trust Estate: from the Kamehameha Schools; the staff at Kawaiahao Plaza; Royal Hawaiian Shopping Center, Inc.; and other subsidiaries of the Trust Estate; your Master found the staff to be dedicated and loyal to the legacy of Princess Pauahi. They are working under extremely stressful conditions because of the current controversy swirling around the Trust Estate. However, despite the difficult working conditions, your Master found them to be uniformly courteous and very professional in their conduct.
Finally, your Master wishes to acknowledge and commend the Trustees for agreeing to allow an independent financial audit and management review of the Trust Estate to be conducted by an international accounting firm such as Arthur Andersen LLP. As a result of that audit and review, the Trust Estate has the benefit of an independent, objective, and expert review and analysis of its operations. The recommendations derived from that process will provide valuable assistance to the Trustees in making improvements to the operations of the Trust Estate and strengthening their management of the Trust Estate's assets. Your Master thanks the Trustees for making themselves available for many hours of interviews and also for directing staff of the Trust Estate to cooperate with the team from Arthur Andersen LLP and your Master in providing requested information and interviews.
Your Master thanks all of these individuals along with the many unidentified persons who provided your Master with additional pertinent information for their contributions toward the preparation of this Report.
IV. SCOPE OF REVIEW
The scope of your Master's review of the Trustees' Petition was limited to the 109th, 110th, and 111th Annual Accounts filed by the Trustees covering FY 1994, FY 1995, and FY 1996.
The Trustees provided your Master with information required by the Minimum Guidelines Concerning the Annual Accounts of the Trustees of the Kamehameha Schools Bernice Pauahi Bishop Estate and the Reports of Future Masters as amended and restated as of September 30, 1995 ("Restated Guidelines ") as well as the Stipulated Order . Your Master has accepted and relied upon the information furnished by the Trustees as true, correct, and complete in preparing this Report.
Among the information provided by the Trustees to your Master and/or Arthur Andersen LLP were various responses of the Trustees to Information Document Requests ("IDRs") from the Internal Revenue Service in connection with an ongoing audit of the Trust Estate2; various responses to subpoenas served upon the Trust Estate by the Attorney General in connection with her current investigation of the Trust Estate; work papers of the independent auditors of the Trust Estate; and additional financial records specifically requested from the Trust Estate pertaining to investments and other matters within the scope of the Master's review.
All of the individuals who served as Trustees during the periods reviewed were interviewed by your Master and Arthur Andersen LLP. Several current and former staff members of the Trust Estate and various subsidiaries were also interviewed. In addition, various consultants who have serviced the Trust Estate in different subject matter areas were interviewed by your Master and/or Arthur Andersen LLP to gain some insight into the professional advice being provided to the Trustees.
The Restated Guidelines and Stipulated Order also require the Trustees to each make certain written statements and representations concerning the accounting period. As of the date of this Report your Master has received qualified certification letters dated November 14, 1997, signed by all of the Trustees covering each of the three years reviewed. See Exhibit O. In addition, your Master received additional letters from Trustees containing qualified certifications. See Discussion at Part XVI of this Report. Your Master has also received a number of responses from the Trustees to specific issues and information requests by your Master. Your Master has relied upon these statements and representations by the Trustees, as well as the responses from the Trustees through their counsel, as being true, correct, and complete responses to the matters addressed in the certification letters and otherwise inquired of them.
Pursuant to the Stipulated Order your Master has also received certifications from key Trust Estate employees designated by the Trustees. See Discussion at Part XVI of this Report. These employees are the principal executives of the various administrative groups of the Trust Estate. Your Master has likewise relied upon these statements and representations by these employees as being true, correct, and complete responses to the matters addressed in the certification letters and otherwise inquired of them.
Based upon the foregoing, your Master makes the following report and findings.
2At the time the IDRs were reviewed in early May 1998, the Trustees had not yet responded to over 50 IDRs which had recently been served upon the Trust Estate.
V. HISTORICAL CONTEXT
During the lifetime of Princess Pauahi, Hawaii was an independent nation which was undergoing radical social, economic, cultural, and demographic changes.
Princess Pauahi was born on December 19, 1831, only twelve years after her great-grandfather, King Kamehameha the Great, had died. At the time of her birth the indigenous population of Hawaii had declined to 124,449 from 300,000 estimated at the time of Captain Cook's arrival in 1778. By the time she was 41 years old in 1872, the total population of the Hawaiian Kingdom had further dwindled to 56,897 of which 51,531 were native Hawaiians. Twelve years later, when Princess Pauahi died in 1884, the overall population of the Hawaiian Kingdom had increased dramatically to 80,578 (as a result of in-migration related to the sugar industry), but the native Hawaiian population had further declined to 44,232. Native Hawaiian Data Book 1996 , Office of Hawaiian Affairs (1996).
Concerned for the future of the native Hawaiian people in an environment that was undergoing such drastic change, Princess Pauahi sought to leave a legacy of educational opportunity to assist native Hawaiians in coping with hostile social, economic, and cultural forces which were taking hold in Hawaiian society. With no universal public education system in place in 1884, that educational legacy was an important one to the native Hawaiian people.
Today, that legacy is no less important. While the decline in the native Hawaiian population has reversed itself through an increase in the population of part-Hawaiians and a universal public education system is in place, native Hawaiians continue to face social, economic, and cultural challenges of a different but nonetheless significant nature.
According to the 1990 United States Census, the school- aged population of native Hawaiians in the State of Hawaii was comprised of 39,439 children between the ages of 5 and 18 years. By the 1995-96 school year it was reported that there were 45,325 school-aged native Hawaiians. By the 2005-06 school year, it is predicted that there will be a school-aged population of 54,145 native Hawaiians. As a percentage of the total population of school-aged children, native Hawaiians constitute one of the fastest growing groups. Native Hawaiian Data Book 1996 , Office of Hawaiian Affairs (1996).
Correspondingly, the endowment left by Princess Pauahi has grown dramatically in recent years. At the time of her death, the lands comprising the corpus of her Trust Estate were appraised as having a value of $300,000. Today, that endowment has mushroomed to a total corpus value of more than $6 billion.
The number of students serviced by the schools established as Princess Pauahi's legacy has also expanded. During the first school year of Kamehameha Schools in 1887-88, the campus enrollment was comprised of only 37 students. By 1995-96, campus enrollment at the Kapalama campus of Kamehameha Schools from K through 12 reached a peak of 3,092. One Hundred and Ninth Annual Report from the President, Kamehameha Schools to the Board of Trustees, School Year 1995-1996 at 7-10. In addition, the Trust Estate provided Center-Based Preschool services throughout the state to 780 four-year old children in 1995-96. See Id. Moreover, over 1,800 college-enrolled students benefitted from over $12 million in scholarships funded by the Trust Estate.
The nature of the business operations of the Trust Estate has also evolved so that it is no longer just a real property landlord passively collecting lease rents from tenants on its Hawaiian land holdings. Instead, the infusion of enormous amounts of cash, resulting from the liquidation of residential land holdings under threat of public condemnation, has transformed the Trust Estate within the last 15 years into a complex business organization with wide-ranging and sophisticated domestic and international financial investments. Its financial resources and strength now make it a much sought after source of capital for investment.
In light of these historical changes, the challenges facing the Trustees today in fulfilling the legacy of Princess Pauahi are daunting. Likewise the responsibility of the Court in exercising proper oversight over the Trustees and the performance of their fiduciary duties has grown in magnitude.
Recognizing the historical significance of the legacy of Princess Pauahi, this Report attempts to review and report on the financial condition and operations of the Trust Estate with a view to ensuring that the integrity of her Will is maintained and her legacy fulfilled.
VI. FINANCIAL REPORTING AND MONITORING
A. The Trustees Must Provide Meaningful Financial Information In Connection With The Annual Review.
The duty to account required of the Trustees by the Will can only be discharged if they provide meaningful financial information when they submit their annual account to the Court.
With the Trust Estate's growing complexity and diversity of investments, appropriate financial reporting is critical to sound analysis of its financial condition. The financial reports of the Trust Estate must provide the kinds of information which will allow the Court to readily evaluate whether the Trustees have discharged their duties in governing the affairs of the Trust Estate and its assets prudently and in accordance with the dictates of the Will.
The Andersen Report makes several recommendations for a financial statement presentation different than that which the Trustees have heretofore provided to the Court. These changes also reflect recommendations from the Trust Estate staff who worked with Arthur Andersen LLP in developing an improved financial reporting format. The new financial statement presentation will provide the Court with a more comprehensive and meaningful overview of the Trust Estate as the complex business entity into which it has been transformed.
Among the principal changes recommended by Arthur Andersen LLP in the financial statement presentation are the following:
RECOMMENDATION NO. 1: NEW FINANCIAL STATEMENT PRESENTATION SHOULD BE ADOPTED.
Your Master recommends that the Trustees be ordered to adopt the financial statement and supplemental schedules presentation as proposed by Arthur Andersen LLP and recommended in the Andersen Report in all respects, with the same level of detail, and regularly filed with their annual account beginning with the 112th Annual Account.
B. Highlights Of The Audited Financial Statements For FY 1994, FY 1995, And FY 1996.
The past practice of not consolidating the Trust Estate's financial statement with those of its wholly owned and majority owned subsidiaries made it difficult to obtain an overview of the financial status of the Trust Estate and its subsidiaries. For this reason, the 109th Master's Report urged the Court to require the Trustees to consolidate the financial statements of the Trust Estate and its subsidiaries in accordance with GAAP.3
In accordance with the Stipulated Order , Arthur Andersen LLP has prepared audited financial statements for the Trust Estate and its majority-owned subsidiaries4 on a consolidated basis for each of the three fiscal years being reviewed5 ("Financial Statements ").
The format of the Financial Statements is also different from the historical financial statements previously filed with the Court in that it separately reports the Revenue Fund and Corpus Fund activity of the Trust Estate.
The Revenue Fund is the primary operating fund of the Trust Estate. Income generated from the corpus assets and from other sources is accounted for in the Revenue Fund and is used to provide for operations and maintenance of the Trust Estate and its assets. The Corpus Fund is comprised of the original assets provided for in the Will and other assets which have been subsequently acquired from the proceeds of sale of such original assets. Gain or losses on the sale of any assets as well as fluctuations in the fair value of certain assets are reflected in the Corpus Fund. As discussed further in Part VII, Sections A and B of this Report, the segregation of this activity allows the Court to better evaluate the relative compliance with the provisions of the Will.
The Financial Statements prepared by Arthur Andersen LLP comprise Exhibit C to this Report. The following abbreviated discussion highlights some of the noteworthy items contained in those Financial Statements :
1. Statements of Financial Condition. The Statement of Financial Condition presents the assets, liabilities, and net assets of the Trust Estate as of the end of each fiscal year. See Financial Statements at 3-7. Some of the significant changes in the account balances between fiscal years relate to:
(a) Cash and Cash Equivalents. The Trust Estate maintained significant cash balances for all three fiscal years ranging from $169,325,000 at June 30, 1994 to $89,391,000 at June 30, 1996. The Trust Estate's significant cash levels are due in part to its liquidity requirements related to its commercial paper program. The liquidity requirements under this program amounted to approximately $68,500,000 as of June 30, 1996.
(b) Privately Placed Debt and Equity Securities. The Trust Estate's investments in privately placed debt and equity securities increased substantially during the three years reviewed. The balance increased from $716,286,000 at June 30, 1994 to $932,536,000 at June 30, 1996. The increase is primarily a result of re-deploying cash proceeds received from the Trust Estate's residential fee sales program to special situation and venture capital type investments (including Goldman Sachs & Co.).
(c) Notes Payable. Total consolidated notes payable increased from $450,143,000 at June 30, 1994 to $608,453,000 at June 30, 1996. The increase was primarily related to financing the Trust Estate's $21 million acquisition of land in Hamakua; the acquisition of Shelter Bay timberlands for $60 million; and $75 million of the Trust Estate's second investment tranche in Goldman Sachs & Co. The increase in debt resulted in an approximately $9.9 million increase in consolidated interest expense between FY 1994 and FY 1996.
2. Statements of Activity . The Statement of Activity presents the revenues and expenses of the Trust Estate for the fiscal year and the increase or decrease in net assets experiences by the Trust Estate during that period. See Financial Statements at 8-11. In summary, the Statements of Activity present the following results:
(a) Education Programs. Although the Trust Estate enjoyed significant increases in net assets over the three fiscal years, Education Program Expenses remained relatively level:
Expenses6FY 1994: $ 91,141,305 FY 1995: $102,408,296 FY 1996: $ 99,819,224
See Statement of Activity FY 1994-1996; and Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
3Coopers & Lybrand LLP, the Trust Estateís independent auditor, in its Report of Independent Accountants with respect to the financial statement for FY 1996, declared that GAAP requires the Trust Estateís investments in its wholly owned and majority owned subsidiaries be accounted for on a consolidated basis. Accordingly, it qualified its auditorís report for the effect of not consolidating wholly owned and majority owned subsidiaries.
4Those subsidiaries include Pauahi Holdings Corporation (which in turn owns Royal Hawaiian Shopping Center, Inc. [îRHSCIî]; Kamehameha Investment Corporation; and P&C Insurance Company, Inc.); Socal Holdings, Inc.; Southern Nevada Income Properties (ìSNIPî); and Meridian Associates. RHSCI owns Kukui, Inc. and has substantial interests in a number of real estate partnerships which were also consolidated.
5Because the Trust Estate acquired a majority interest in a savings bank during 1995, the Financial Statements for FY 1995 and FY 1996 include financial information related to the savings bank. However, because financial reporting associated with a savings bank is somewhat incongruous with the other holdings of the Trust Estate, Arthur Andersen LLP has presented that information in a manner which allows the reader to view the consolidated holdings and operations of the Trust Estate with or without the impact of the information related to the savings bank.
6Includes both ìdirectî and ìindirectî education expenses for all education programs, including scholarships and financial aid.
The Trust Estate provides a substantial amount of scholarship assistance for students attending post-secondary educational institutions. It also provides financial aid to students attending the Kamehameha Schools. The total amount of such assistance was significantly increased from FY 1994:
& ScholarshipsFY 1994: $15,145,270 FY 1995: $17,034,074 FY 1996: $17,725,260
See Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
(b) Rental Operations. Historically, the financial statements filed with the Court presented the Trust Estate's rental operations on a "net" basis (i.e., rental operations revenues net of rental operations expenses). Also, interest expense for certain properties was netted with the results of these rental operations. The Financial Statements prepared by Arthur Andersen LLP separately report the revenues and expenses from rental operations. They also separately report total interest expense for the Trust Estate, a portion of which relates to rental properties. This presentation allowed your Master to better compare the results of these operations for the three years reviewed. During the three-year period, gross rental operations revenues fluctuated between years while rental operations expenses consistently increased resulting in a decline in net rental revenues:Rental Rental Net Rental Operations Operations Operations Revenue Expense Revenue FY 1994: $159,220,000 $60,981,000 $98,239,000 FY 1995: $158,587,000 $71,569,000 $87,018,000 FY 1996: $160,012,000 $68,798,000 $91,214,000
See Statement of Activity FY 1994-1996.
(c) Investment Income. Investment income fluctuated significantly during the three years reviewed. This is primarily a result of the volatility of the income attributable to the Trust Estate's investment in Goldman Sachs & Co. and certain of its real estate equity investments. It is also important to note that the investment income related to Goldman Sachs & Co. comprised a greater proportion of investment income than all other investment sources for each of the three fiscal years.FY 1994 FY 1995 FY 1996 Goldman Sachs & Co.: $ 49,953,000 $38,729,000 $ 74,451,000 All other sources: 23,858,000 6,039,000 34,527,000 Investment income: $ 73,811,000 $44,768,000 $108,978,000
See Notes , Financial Statements at 29; Statement of Activity FY 1994-1996.
The Court should also be aware that the income from Goldman Sachs & Co. was misreported on the audited financial statements submitted by the Trustees for FY 1994, FY 1995, and FY 1996. The Trust Estate holds a 9.5% interest in Goldman Sachs & Co. and, as a result, is required to account for the investment on the cost basis method of accounting. Instead, the investment was accounted for using a hybrid (cost and equity) method that is not in accordance with GAAP. This resulted in an overstatement or understatement of the Trust Estate's income in the following amounts:
(Understatement)FY 1994: $29,739,000 FY 1995: ($33,563,000) FY 1996: $17,058,000
The amounts reported in the Financial Statements prepared by Arthur Andersen LLP have been appropriately adjusted for this accounting error.7
(d) Net Gains (Losses) From Long-Term Investments. Revenues from long-term investments also fluctuated widely during the three years reviewed. In FY 1994, the Trust Estate recognized a net loss from long-term investments of ($50,016,000). This loss was primarily attributable to loss reserves or write-offs recorded during that period that related to the Trust Estate's investments in loans and subordinated debentures. In FY 1995, the Trust Estate again failed to enjoy any net gain on long-term investments but instead suffered a net loss of ($954,000). In FY 1996, the Trust Estate enjoyed a $21,269,000 net gain on its long-term investments. However, approximately $28,386,000 of the gains recognized in FY 1996 were unrealized gains from marketable debt and equity securities.
(e) Net Gains on Land Sales. During the three years reviewed, the Trust Estate realized net gains primarily associated with the residential fee sales program of approximately $334,372,000.8 However, revenue from such sales is rapidly declining:
Net Gains On
Land SalesFY 1994: $199,563,000 FY 1995: $83,125,000 FY 1996: $51,684,000
See Statement of Activity FY 1994-1996.
7The Trust Estateís staff and its independent auditor became aware of this error after extensive analysis in FY 1997 and a cumulative adjustment was made in that year.
8This is in addition to previously realized gains of $123 million in FY 1992 and $105.9 million in FY 1993 from lease-fee conversion sales reported in the Matsubara Report and Matsubara Report 2.
(f) Management and General Expenses. Management and general expenses rose considerably over the three fiscal years:
General ExpenseFY 1994: $41,934,000 FY 1995: $52,136,000 FY 1996: $61,147,000
See Statement of Activity FY 1994-1996.
A large portion of the increase was attributable to professional service expense which increased from approximately $6,901,000 in FY 1994, to $11,335,000 in FY 1995, and $12,520,000 in FY 1996.
(g) Inter-Fund Transfers. Accumulated income included in the Revenue Fund less any reserve balances is transferred annually to the Corpus Fund.9 For FY 1994 and FY 1995, this transfer amounted to $27,671,000 and $12,004,000, respectively. However, for the fiscal year ended June 30, 1995, the Trust Estate sustained a deficit in the Revenue Fund because operating expenses exceeded revenues for that year. Accordingly, a $20,518,000 transfer was made from the Corpus Fund to fund this deficit.
9This practice is criticized in Section VII of this Report.
3. Notes to the Consolidated Financial Statements . The Notes provide for a discussion of the significant accounting principles of the Trust Estate and more detailed information regarding amounts in the Financial Statements along with other explanatory information. The Notes also highlight other material facts to enable the reader to better understand the financial information presented in the Financial Statements .
The Notes prepared by Arthur Andersen LLP include expanded information designed to be more meaningful to the Court in facilitating future reviews of the Trust Estate. The expanded financial disclosures include:
(a) Net assets designated by the Trustees. See Notes, Financial Statements at 24.
(b) Investment income by type of investment. See Notes, Financial Statements at 29.
(c) Net gains (losses) on long-term investments by type of investment. See Notes, Financial Statements at 29.
(d) Inherent risks in the investment portfolio:
(i) Amount of loss reserves related to privately placed debt and equity investments. See Notes, Financial Statements at 27.
(ii) Risks associated with the Trust Estate's investment in Goldman Sachs & Co. See Notes, Financial Statements at 28-29.
(iii) Risks associated with the Trust Estate's investment in the savings bank. See Notes, Financial Statements at 40-71.
(e) Certain significant commitments and contingencies:
(i) Future rental income from long-term ground lease arrangements. See Notes, Financial Statements at 38.
(ii) Status of the IRS Audit. See Notes, Financial Statements at 39.
(f) Supplemental Schedules.
(i) Educational program revenues by source and expenses by object for FY 1994, FY 1995, and FY 1996. See Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
(ii) Income yield and total return for FY 1994, FY 1995, FY 1996 and the 3-years annualized (including notes thereto). See Financial Statements at 77-84.
C. Valuation of the Trust Estate's Assets.
Obviously, one of the basic measures of the financial condition of the Trust Estate is its worth. This has been the subject of considerable speculation due to the extent of the Trust Estate's real estate holdings. While it is impossible to exactly determine the fair market value of the Trust Estate's assets, a reasonable attempt to establish a value is important to measure its financial status. Such information is also critical to measuring investment performance and evaluating whether the Trustees have productively utilized the assets to further the purposes of the Trust Estate. See Ahuna v. Dept. of Hawaiian Home Lands, 64 Haw. 327, 640 P.2d 1161 (1982) (trustee is obligated to use reasonable skill and care to make trust property productive).
While the Financial Statement contains a Statement of Financial Condition (balance sheet) which shows the book value of the assets of the Trust Estate, it does not give an accurate view of the worth of the assets of the Trust Estate. This is because the majority of the assets is reflected in the Financial Statement at historical values rather than current values. In the case of the Trust Estate, by prior order of this Court, the value of the Hawaii real estate is shown at adjusted real property tax assessed values as of January 1, 1965. See Notes , Financial Statements at 22. Consequently, the Statement of Financial Condition materially understates the value of substantial assets owned by the Trust Estate.
The Statement of Financial Condition for each of the three annual account periods reviewed show the following results:10ASSETS LIABILITIES NET ASSETS FY 1994: $2,050,952,000 $ 555,150,000 $1,495,802,000 FY 1995: $2,249,396,000 $ 710,397,000 $1,539,000,000 $4,032,052,000 $2,441,569,000 $1,590,483,000 FY 1996: $2,383,670,000 $ 731,342,000 $1,652,329,000 $3,963,430,000 $2,267,314,000 $1,696,116,000
10In FY 1995, the Trustees acquired a majority interest in SoCal Holdings, Inc. (ìSoCalî), a savings bank company. The amounts on the first tier for FY 1995 and FY 1996 exclude the accounts of SoCal while the italicized amounts on the second tier reflect the effect of consolidating the Trust Estateís balance sheet with that of SoCal.
Pursuant to the Stipulated Order , the Trustees agreed to file with the Court a list of the assets of the Estate at the end of the accounting period, including the current fair market value of all assets. The Trustees filed such a list of assets on March 31, 1998. See Exhibit F.
In contrast to the numbers in the Financial Statement , the Concerning Supplemental List of Assets (111th Account) filed herein on March 31, 1998 ("List of Assets"), show the Trust Estate's assets as having an aggregate value of $5,714,142,590 as of June 30, 1996. The difference between this amount and the materially smaller amount reflected in the Statement of Financial Activity is principally due to the difference in value attributed to Hawaii real estate as explained above.
The aggregate value reflected in the List of Assets provides a closer approximation of the total value of the assets of the Trust Estate except in certain respects. First, real property values are reported based upon current adjusted real property tax assessed values and may not reflect "fair market value". Second, the assets held by Pauahi Holdings Corporation are not listed. Instead, the Trust Estate's ownership of Pauahi Holdings Corporation is reported "at equity" which reflects the "book value" of Pauahi Holdings Corporation and not necessarily the sum of the fair market value of its assets. Finally, Pauahi Holdings Corporation reports the ownership interest in Goldman Sachs & Co. at cost rather than fair value. As a result, the value of that asset may be substantially understated on Pauahi Holdings Corporation's financial statement. See Notes , Financial Statements at 37. To that extent, the Trust Estate's valuation of its interest in Pauahi Holdings Corporation is also understated.
VII. ACCUMULATION OF INCOME
A. The Distinction Between Corpus And Income Is Fundamental To Fulfillment Of The Will Of Princess Pauahi.
Maintaining the distinction between the corpus account11 and the income account12 is critical to the fulfillment of the express directions of Princess Pauahi as set forth in her Will.
In establishing the Trust Estate, Princess Pauahi bequeathed all of her residual estate to her designated Trustees to hold in trust, to erect the Kamehameha Schools. In Paragraph Thirteen of the Will, she specifically instructed them to utilize the residual estate as follows:
I direct my trustees to expend such amount as they may deem best, not to exceed however one-half of the fund which may come into their hands, in the purchase of suitable premises, the erection of school buildings, and in furnishing the same with the necessary and appropriate fixtures furniture and apparatus. I direct my trustees to invest the remainder of my estate in such manner as they think best, and to expend the annual income in the maintenance of said schools; meaning thereby the salaries of teachers, the repairing of buildings and other incidental expenses; and to devote a portion of each years income to the support and education of orphans, and others in indigent circumstances, giving the preference to Hawaiians of pure or part aboriginal blood; the proportion in which said annual income is to be divided among the various objects above mentioned to be determined solely by my said trustees, they to have full discretion . [emphases added]
This provision of the Will directs that expenditures for the erection of school buildings and for furnishing them with "fixtures, furniture and apparatus" be charged against the corpus account. On the other hand, expenditures from the income account are restricted to the "maintenance of [the] schools" and may not be used for other purposes such as the erection of school buildings. Collins v. Hodgson, 36 Haw. 334 (1943).
For this reason, it is important that the Trust Estate's financial statement separately account for corpus and income to ensure that the directions of the Will regarding how corpus and income are to be expended are properly fulfilled.13
The importance of such an accounting distinction was explicitly raised in 1970 by Richard S. Sasaki, Esq., Master for the 81st Annual Account. See Report to the Attorney General on the Petition of the Trustees for Approval of the Eighty-First Annual Report ("Sasaki Report ") which is appended to the Report of the Attorney General With Respect to the 81st Annual Account of Bernice Pauahi Bishop, Deceased for the Period Covering July 1, 1965 Through June 30, 1966, filed herein on February 10, 1970.
The Sasaki Report noted that the Trustees then failed to adequately segregate income from corpus in their accounting. The Sasaki Report critically observed that:
The propriety of various expenditures from the standpoint of income expenditures or corpus expenditures cannot be determined by a review of these schedules. It is also difficult to determine capital expenditures from expenses without tracing each expenditure to a chart of accounts.
Sasaki Report at 4.
The Sasaki Report also disclosed that the Trustees, for a number of years previously, had improperly charged against the income account a total of $4,984,906 for capital items. However, in response to concerns regarding the legality of the practice, the Trustees made adjusting entries to the corpus account to restore the amounts previously charged against the income account. This restored the accumulated income account balance as of the end of FY 1966 to $5,693,985.14
As a result of the Sasaki Report , the Trustees entered into a stipulation with the Attorney General, which was approved and ordered by the Court, wherein they agreed to institute a number of reforms. Those included reforms in accounting practices such as segregating the corpus and income accounts. See Stipulation filed herein on July 22, 1970 in connection with the 81st Annual Account; Report of the Attorney General With Respect to the 81st Annual Account of Bernice Pauahi Bishop, Deceased for the Period Covering July 1, 1965 Through June 30, 1966, filed herein on February 10, 1970; and Order Approving 81st Annual Account, filed herein on July 30, 1970.
11The ìcorpus accountî is sometimes referred to as the ìprincipal account.î Both terms refer to the same account.
12The ìincome accountî is sometimes referred to as the ìrevenue account.î Both terms refer to the same account.
13The Revised Uniform Principal and Income Act, HRS Chapter 557 classifies what constitutes ìincomeî and ìprincipalî. HRS § 557-3 defines ìincomeî as the ìreturn in money or property derived from the use of principalî and generally includes rent, interest, cash dividends, receipts from business operations, receipts from disposition of natural resources and underproductive property. ìPrincipalî generally includes proceeds from the sale of property, stock dividends, capital gains from the sale of corporate securities, and certain royalties, and receipts from the disposition of other property.
14To put this amount into perspective, during FY 1966, the Trustees spent a total of $4,137,892 for the operation of the Kamehameha Schools.
B. The Annual Accounts Filed With The Court Do Not Adequately Disclose The Status of the Corpus and Revenue Accounts.
The annual accounts filed by the Trustees since the Sasaki Report have included financial statements which segregated the corpus account from the revenue account and specifically indicated the status of the accumulated income account. However, beginning with the 103rd Annual Account (FY 1988), the Trustees unilaterally altered that practice and submitted financial statements to the Court which no longer disclosed the status of the corpus account and revenue account. As a result, since that time it has been impossible for the Court to determine the extent of the accumulation of income from the financial statements provided by the Trustees.
Your Master could find no authorization for the Trustees to alter the financial statement presentation in this manner. The consequence of the change was that the Court no longer was given the necessary information upon which to determine the status of the corpus and revenue accounts.
The Andersen Report recommends a financial statement presentation which will require that the corpus account and revenue account be separately reported. This will facilitate determining whether or not the dictates of the Will have been complied with. Such information is essential to maintaining the integrity of the Trust Estate created by Princess Pauahi. As the Supreme Court declared in Collins v. Hodgson, the appropriate expenditure (as opposed to the accumulation) of income by the Trust Estate is fundamental to the fulfillment of Princess Pauahi's intent as expressed in her Will. Compliance with the Will's directives can only be evaluated if appropriate information is furnished by the Trustees.
RECOMMENDATION NO. 2: CORPUS AND REVENUE ACTIVITY SHOULD BE SPECIFICALLY REPORTED.
Your Master recommends that the Trustees provide an explanation to the Court in their response to this Report why the prior order of the Court requiring segregation of the corpus account and the revenue account was not complied with.
Your Master further recommends that the Trustees be ordered to annually submit financial statements which conform to the trust accounting format as prescribed in the Andersen Report beginning with the 112th Annual Account.
C. Income Has Been Inappropriately Reclassified As Corpus.
Adoption of the financial statement presentation as recommended by Arthur Andersen LLP alone will not adequately ensure a proper accounting by the Trustees.
Your Master has learned that on repeated occasions, the Trustees approved reclassification of the entire accumulated income balance in the revenue account to corpus. This procedure basically involved depleting any unexpended income in the revenue account.
The procedure was first initiated by the Trustees15 by their action on June 30, 1988, to be effective as of July 1, 1987, when $65,629,805 in unexpended income from the revenue account was reclassified to corpus. This resulted in the revenue account being left with a zero balance as of July 1, 1987. Again in 1991, the Trustees16 approved the reclassification of $135,576,108 in unexpended income from the revenue account to the corpus account. This resulted in the revenue account being left with a zero balance as of July 1, 1991. This process of depleting the revenue account as of the end of the fiscal year was repeated annually from 1992 until 1997. During that period, the Trustees would apparently annually direct the transfer of the unexpended income balance in the revenue account to the corpus account,17 thereby maintaining a zero unrestricted income balance in the revenue account at the end of each fiscal year.
These transfers were done without judicial sanction, although ostensibly upon the advice of legal counsel and the independent auditor of the Trust Estate. Moreover, the conversion of unexpended income from the revenue account to the corpus account was never affirmatively disclosed to the Court.18
Although the Trustees contend that the transfers were done with the funds being "earmarked specifically for maintenance, or operations, of the schools" as advised by legal counsel, Arthur Andersen LLP found no evidence of such earmarking in the Trust Estate's general ledger accounts. Instead, it appears that the Trustees converted income into corpus without proper authority. Coupled with a change in financial statement presentation, that action was not readily discernable since the true level of accumulated income could no longer be identified in the financial records of the Trust Estate presented to the Court.
The method of accounting purported to be employed by the Trustees is suspect and undermined the ability of the Court to properly exercise its oversight function over the Trust Estate. Moreover, the actions of the Trustees in transferring funds from the revenue account to the corpus account were unauthorized, improperly documented, and inadequately disclosed to the Court.
15A different group of Trustees from the current group of incumbent Trustees were involved in that action.
16Not all of the incumbent Trustees were members of the Board of Trustees at that time.
17There are no minutes of the meetings of the Board of Trustees which reflect such action.
18The audited financial statements submitted to the Court make no mention of the reclassification of income to corpus although the amounts involved were material.
D. The Accumulated Income Balance May Violate The Express Direction Of The Will And Prior Court Orders.
Because Arthur Andersen LLP could not determine the status of the accumulated income account balance from the financial records provided by the Trustees, it was only upon inquiry by your Master regarding the status of the corpus and revenue accounts that the Trustees disclosed specific information regarding the accumulation of income by the Trust Estate. That information revealed that the Trust Estate had aggregated the following accumulated income amounts in each year since 1985:Year End Accumulated Unexpended Income Income as of as of June 30 June 30 Beginning Balance on July 1, 1985: $ 48,850,349 1986: $ 7,394,247 $ 56,244,596 1987: $ 9,385,209 $ 65,629,805 1988: $ 11,123,200 $ 76,753,005 1989: $ 47,763,508 $124,516,513 1990: $ 35,599,907 $160,116,420 1991: $ 41,089,493 $201,205,913 1992: $ 15,866,113 $217,072,026 1993: $ 17,072,621 $234,144,647 1994: $ 82,294,368 $316,439,015 1995: ($30,174,365) $286,264,650 1996: $ 2,018,180 $288,282,830 1997: $ 61,036,302 $349,319,132
To put the accumulated income amount into perspective, in FY 1996, the expense related to operating the schools-related educational programs (net of program revenues) was $69,886,775. See Notes; Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
The extent of accumulation of income disclosed raises a grave question regarding compliance with the dictates of the Will. An identical concern regarding compliance with the Will was raised by the Hawaii Supreme Court in Collins v. Hodgson, supra. In 1943, the Trustees had accumulated an income account balance so large as to cause the Supreme Court to remark with concern, in dicta , as follows:
Although the question of the propriety of the action of the trustees in accumulating so large a surplus of income is not an issue in this appeal, we feel impelled to comment upon it. The fact that more than one million dollars of income has accumulated makes it apparent that the expressed intention of the testatrix has not been complied with.
Collins v. Hodgson, 36 Haw. at 339 (emphasis added).
- The concern expressed in Collins v. Hodgson is equally, if not more, applicable to the circumstance today. Moreover, as discussed below in Part VII, Section E of this Report, the Trustees have apparently failed to satisfy prior Court Orders attempting to address this very issue.
E. Past And Current Trustees Have Been Under Court Orders To Plan For The Expenditure Of Accumulated Income But Failed To Comply With Those Orders.
In the early years of the Trust Estate, sufficient income was not always generated to meet the annual operating expenses of the schools. However, as years passed, the Trust Estate began to realize surplus annual income not expended "in the maintenance" of the schools. This led to an accumulated income account balance as surplus income from succeeding years continued to remain unexpended.
By 1943, that amount had reached a level which raised questions regarding satisfactory compliance by the Trustees with the dictates of the Will -- causing the Supreme Court to comment on the impropriety of such accumulation of income. See Collins v. Hodgson, 36 Haw. at 339 (accumulation of more than one million dollars of income was not in compliance with the expressed intent of the Will).
Concerns regarding the accumulation of income have repeatedly been raised with the Court over the history of the Trust Estate. For example, in 1985, George S. W. Hong, the Master for the 99th Annual Account (FY 1984) raised a concern over the extent of the accumulation of income which by June 30, 1984, had reached an amount of $43,253,003. Report of the Master on the Petition of the Trustees of the 99th Annual Report, filed herein on August 2, 1985, at 11. Hong noted that the large accumulated income balance reflected the conservative manner in which the Trustees had expended income in the operation of the schools. However, he explained:
While your Master is sympathetic to this conservative and prudent approach in expending monies in the operation of the Schools, your Master, nonetheless, is concerned that the plain language of Paragraph Thirteen of the Will does not permit accumulating income per se ; the Will appears to require the expenditure of all annual income earned by the Estate for educationally related functions, and any activity which would not implement this objective would appear to be proscribed by a plain reading of the Will. Your Master is aware that the prudent administration of the Schools would not lend itself to the careless expenditure of funds merely to comply with the Will's stated direction to expend all of the annual income for the maintenance of the Schools. However, your Master is of the opinion that it would appear to be within the ambit of Mrs. Bishop's directive if the Trustees were to provide a plan of future expenditures for fulfillment of Mrs. Bishop's charitable objectives by assuring that accumulated income be expended for designated educational purposes.
Id. at 18-19.
In response to Hong's concern and recommendation, the Court ordered that:
The Trustees are directed that they shall continue to prepare, implement and from time to time amend and revise their Ten-Year Plan, incorporating therein long-range planning for the expenditure of accumulated income for educational purposes consistent with said Will.
Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, filed herein on October 8, 1985, at 6.
Since at least 1985, the Trustees have been under specific direction from the Court to plan for the expenditure of accumulated income for educational purposes consistent with the Will. Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, filed herein on October 8, 1985. See also, Findings of Fact, Conclusions of Law and Order Approving the 103rd Annual Report, filed herein on October 16, 1990; Findings of Fact, Conclusions of Law and Order Approving the 107th Annual Report and the 108th Annual Report, filed herein on February 9, 1996.
Court masters subsequent to George Hong have also repeatedly urged appropriate planning by the Trustees for the expenditure of growing financial resources available for the educational mission of the Trust Estate. See Master's Report on the One Hundred Third Annual Report of the Trustees, filed herein on May 30, 1990, at 19 ("Dodd Report "); Master's Report on the One Hundred Fifth Annual Report of the Trustees, filed herein on April 21, 1992, at 36 ("Duffy Report "); Master's Report on the One Hundred Sixth Annual Report of the Trustees, filed herein on September 8, 1993 ("Duffy Report 2 "); Master's Report on the One- Hundred Seventh Annual Report of the Trustees, filed herein on September 15, 1995 ("Matsubara Report "); Master's Report on the One-Hundred Seventh Annual Report of the Trustees, filed herein on September 15, 1995 ("Matsubara Report 2 ").
Moreover, this Court has repeatedly relied upon representations by the Trustees that appropriate strategic planning was in progress. See, e.g., Findings of Fact, Conclusions of Law and Order Approving the 105th Annual Report, filed herein on June 8, 1992 (noting that the Trustees concurred with the Master's recommendations regarding a strategic plan and assured the Court that an effort was in progress to prepare such a plan); Findings of Fact, Conclusions of Law and Order Approving the 106th Annual Report, filed herein on December 27, 1993 (noting that the Trustees had represented to the Court that the recommended strategic planning effort was ongoing).
Despite this lengthy history (which is discussed in greater detail in the 109th Master's Report at 39-43), the Ten- Year Projections provided to your Master, including that provided in connection with the Strategic Plan adopted by the Trustees in August 1997, all reveal a complete disregard of the existence of the substantial accumulated income balance held by the Trust Estate. None of the Ten-Year Projections even hints of the existence of the large accumulated income balance, let alone plan for its expenditure.19
In fact, if the beginning revenue account balance for the Ten-Year Projection for FY 1996 reflected the actual accumulated income balance of $288,282,830, then the projected accumulated income balance by FY 2006, would be close to $1.5 billion--after expenses associated with the GoFoward initiative! 20
This failure to properly plan for the expenditure of the accumulated income is contrary to the prior Orders of the Court which have required past and current Trustees to plan for expenditure of accumulated income for educational purposes consistent with the Will.
19Even without taking into account the undisclosed accumulated income balance, the Ten-Year Projections forecast an accumulated income balance by the year 2006 in excess of one billion dollars after GoFoward expenses.
20After your Master raised concerns regarding this issue, the Trustees presented a Ten-Year Projection for the period from FY 1997 to FY 2007, which was prepared on June 17, 1998, showing a 70% reduction in the previously projected accumulated income balance as of June 30, 2007. That reduction is primarily due to future transfers of surplus income to the corpus account of over $741 million.
F. The Trustees Should Adopt, With Court Approval, An Appropriate Spending Policy.
Currently, there is no policy to guide the Trustees on expending its resources on Trust Estate purposes. Such a policy is fundamental to the development of a strategic plan for investments and educational expenditures.
The Andersen Report recommends that the Trustees incorporate the "Total Investment Return Spending " concept in its overall strategic planning. This is consistent with the past recommendations of Cambridge Associates, Inc. which, the Andersen Report observes, have been ignored.
Arthur Andersen LLP explains Total Investment Return Spending as follows:
Most charitable funds with perpetual spending mandates traditionally treat annual net income as the spendable income pool. Corpus was generally not considered available for distribution to beneficiaries, except for "capital expenditures."
In the mid-20th century, the Ford Foundation promulgated a concept, which is now almost universally accepted: Total Investment Return Spending :
- It permits trustees to invest in a greater proportion of growth assets versus income producing assets, and to recognize and spend (on average) the total return from both types of investments.
- Its primary driver behind this concept is preservation of corpus, by protecting its future spending power against the deteriorating effect of inflation.
- Only equity-type investments will accomplish this growth/protection goal, over long periods of time.
Total Return Spending Policy is typically established as a long-range plan, expressed in annual terms, as a percentage of the value of earning assets, e.g., 5%.
Because under Total Investment Return Spending , spending increases correspondingly as the value of the assets grows, adopting such a policy could help ensure that spending remains at an appropriate level based upon the growth of the value of the Trust Estate's assets. It could also provide greater flexibility to the Trustees in making investment choices since they would be less subject to criticism for too heavily weighting the Trust Estate's investments toward long-term capital appreciation at the expense of current income.
This is a concept employed by many large non-profit entities to ensure that appropriate levels of expenditures are spent in furtherance of their programs. For example, Yale University employs Total Investment Return Spending and established a 5.0% target spending rate from its endowment in FY 1996. Harvard College's spending policy distributes an annual average of between 4.5% and 5% of its endowment's market value. See Exhibit E at 25 and Exhibit D at 15.
In undertaking the strategic planning recommended in Part IX, Section A of this Report, the Trustees should give serious consideration to adopting a spending policy which appropriately incorporates the Total Investment Return Spending concept.
The Legislature has also enacted legislation in 1995 which facilitates adoption of the Total Investment Return Spending concept through the adoption of the Uniform Management of Institutional Funds Act ("UMIFA"), HRS Chapter 517D. However, it should be noted that the UMIFA legislation enacted as HRS Chapter 517D is a materially altered version of the uniform law. For some reason, the Legislature modified the uniform law to incorporate provisions which, in the cases of trusts, arguably allows a trustee to disregard restrictions in the trust instrument and also arguably allows reclassification of accumulated income to corpus. Such provisions are not part of the uniform law promulgated by the National Conference of Commissioners on Uniform State Laws, yet for some reason the Legislature failed to note that it was actually enacting a "Revised Uniform Management of Institutional Funds Act ."
In any event, during the periods reviewed, the Trustees have not attempted to avail themselves of the provisions of that statute which seemingly permits a disregard of the trust instrument and the reclassification of income to corpus.
G. A Replacement Cost Reserve Has Been Established Without Court Approval And May Violate The Will.
On November 29, 1990, without seeking instructions from the Court, the then incumbent Trustees established a reserve for major maintenance, renewals and replacements of educational buildings and facilities "based on an annual provision at a rate of 2.5% of estimated replacement costs" ("Replacement Cost Reserve "). Since that time, the Trustees have annually reserved within the revenue account amounts earmarked for the Replacement Cost Reserve . The effect of this has been to restrict the amount of unrestricted income available for "maintenance of the schools."
The purpose of the Replacement Cost Reserve is not limited to maintenance and repairs of the schools, an expense specifically permitted to be charged to income. Instead, the reserve also allocates amounts for the "replacement cost" of facilities. New facilities are capital expenses which should be charged to corpus. Therefore, charging the revenue account for the "replacement cost" of existing facilities is inappropriate absent specific instructions from the Court allowing the practice.22
21The Trust Estateís most recent Ten-Year Projection (FY 1997 to FY 2007) anticipates future transfers will be authorized by the Trustees from the revenue account to the corpus account totaling $741 million beginning in FY 2002.
22HRS §557-13(a)(2) of the Revised Uniform Principal and Income Act provides that a charge against income is allowed for:
A reasonable allowance for depreciation on property subject to depreciation under generally accepted accounting principles, but no allowance shall be made . . . for depreciation of any property held by the trustee on May 29, 1973, for which the trustee is not then making an allowance for depreciation.
On the other hand, HRS §557-13(c)(2) prescribes that the following charge shall be made against principal:
Extraordinary repairs or expenses incurred in making a capital improvement to principal including special assessments, but, a trustee may establish an allowance for depreciation out of income to the extent permitted by subsection (a)(2) and by section 557-8.
VIII. EVALUATION OF THE INVESTMENT AND MANAGEMENT OF ASSETS UNDER THE PRUDENT INVESTOR RULE
A. The Will Requires Annual Judicial And Public Review Of Investments.
The Will of Princess Pauahi directs the Trustees to annually file with the Court "an inventory of the property in their hands and how invested." Moreover, she directed that the inventory of investments be published in a newspaper for public review. The language of the Will reveals Princess Pauahi's belief that maintaining the integrity of her Trust Estate's investments and operations required annual judicial scrutiny and public review.
B. The Trustees Are Subject To The Prudent Investor Rule.
The basic legal standard by which the Trustees' management and investment of the assets of the Trust Estate is measured is the "prudent investor standard." See HRS 560:7-302 ("the trustee shall observe the standards in dealing with the trust assets that would be observed by a prudent person dealing with the property of another"); HRS 554A-1 (definition of "prudent person"). Cf. Brown v. Brown, 22 Haw. 715 (1915) (the trustee must act with honesty, prudence, and faithfulness, and exercise such sound discretion as prudent businessmen exercise in the investment of their own moneys, having regard not only to the income, but to the security of the principal and to the permanency of the investment); Bishop v. Kemp, 35 Haw. 1 (1939) (every investment of trust funds must be made with honesty, prudence, and fidelity).
Accordingly, the Trustees have a general duty to hold, manage, and invest trust property so that the trust estate can produce a reasonable return appropriate to the particular trust purposes, requirements, and circumstances. See Ahuna v. Dept. of Hawaiian Home Lands, 64 Haw. 327, 640 P.2d 1161 (1982) (trustee is obligated to use reasonable skill and care to make trust property productive); HRS 554A-3(a) (a trustee has the power to perform every act which a prudent person would perform for the purposes of the trust).
On April 14, 1997, Hawaii enacted the Hawaii Uniform Prudent Investor Act , HRS Chapter 554C, which codified the "Prudent Investor Rule" as the applicable standard by which the Trustees are bound to invest and manage the assets of the Trust Estate. HRS 554C-1(a). The statutory standard is now prescribed at HRS 554C-2:
HRS 554C-2. Standard of care; portfolio strategy; risk and return objectives.
(a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
(b) A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:
(1) General economic conditions;
(2) The possible effect of inflation or deflation;
(3) The expected tax consequences of investment decisions or strategies;
(4) The role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
(5) The expected total return from income and the appreciation of capital;
(6) Other resources of the beneficiaries;
(7) Needs for liquidity, regularity of income, and preservation or appreciation of capital; and
(8) An asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.
(d) A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.
(e) A trustee may invest in any kind of property or type of investment consistent with the standards of this chapter.
(f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee's representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.
The investment and management decisions of the Trustees must therefore be viewed in light of this fundamental legal duty. Cf. Restatement (Third) of Trusts 227 (1992) (setting forth the Prudent Investor Rule).
The Prudent Investor Rule reflects the "modern portfolio theory" of investment and abrogates categoric restrictions on types of investments. It is intended to provide a greater degree of flexibility to a trustee in selecting appropriate investments. Nonetheless, it still specifies factors which should be taken into account by a trustee in making investment and management decisions.
In evaluating those decisions, the Prudent Investor Rule prescribes that individual assets should not be evaluated in isolation. This is not to suggest that a trustee's decision to invest in a particular investment is not subject to scrutiny. Instead, the Rule clearly specifies that such a decision should be evaluated "in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust." HRS 554C-2(b). Cf. In re Cooper, 81 Wash. App. 79, 913 P.2d 393 (1996) (Court may evaluate performance of trustee by looking at specific assets or groups of assets rather than by considering performance of the trust as a whole). The Rule therefore identifies a non-exclusive list of factors which should have been considered by the trustee in making a decision, to the extent they are relevant. HRS 554C-2(c).
A failure to comply with the Prudent Investor Rule is not to be lightly regarded. As the Hawaii Supreme Court explained in Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964), the "mere violation of the prudent investment statute governing trust investments" may constitute "a breach of trust upon which liability by way of surcharge could be predicated." Id. at 576. Furthermore, good faith or a mistake in judgment will not provide any shelter to a trustee found to have violated the Prudent Investor Rule. Id.
C. Appropriate Information Must Be Furnished To Allow Evaluation Of Compliance With The Prudent Investor Rule.
Evaluating the Trustees' compliance with the terms of the Will and the Prudent Investor Rule requires that appropriate information be furnished in connection with the annual account review. In this regard, the Andersen Report identifies a number of areas where management information should be generated or improved and better documented.
In a nutshell, the Andersen Report recommends:
1. Appropriate monitoring of investment performance.
2. Identifying appropriate benchmarks for evaluation of investment performance.
3. Development of an appropriate investment policy.
4. Improving due diligence procedures.
5. Strengthening the documentation of investment and management decisions.
6. Identification of investment and management related expenses.
These recommendations proposed by Arthur Andersen LLP constitute best management practices aimed at strengthening the management of the Trust Estate. As discussed in more detail herein, implementation of these recommendations will enhance the ability of both the Trustees and the Court to evaluate whether the Trustees' investment and management decisions are in compliance with the Prudent Investor Rule.
D. Investment Performance Should Be Appropriately Monitored, Benchmarked, And Disclosed.
While a review of the financial statements provides an overview of the financial condition of the Trust Estate, the information it provides as part of the annual account review is inadequate to meaningfully evaluate the performance of the Trustees in managing and investing the Trust Estate's assets.
Unlike earlier periods in its history, the Trust Estate now regularly enjoys substantial income sufficient to meet the cost of its educational endeavors. However, the mere fact that gross revenues of the Trust Estate may total in the hundreds of millions of dollars is not a sufficient basis upon which to evaluate performance. In this regard, it is essential that the investment performance of the Trust Estate's portfolio be properly determined and measured.
The Hawaii Uniform Prudent Investor Act recognizes the importance of monitoring investments.23 Thus, a key consideration in evaluating compliance by the Trustees with the Prudent Investor Rule in their investment and management of assets of the Trust Estate is the measurement of investment return. HRS 554C-2(c)(5).
The Andersen Report notes that the Trust Estate does not currently have a satisfactory system of monitoring investment performance. There is also no procedure for evaluating investment performance against appropriate benchmarks. As a consequence, without reasonably frequent measurement and appropriate benchmarks, the Trustees are disabled from making informed investment management decisions.
The Andersen Report therefore makes a number of specific recommendations aimed at strengthening the monitoring and evaluation of investment performance at the Trust Estate. The Andersen Report also recommends that the Trust Estate's financial statements incorporate a supplemental investment performance schedule. See Exhibit H.
Implementation of the recommendations in the Andersen Report by the Trustees will be of utility in the annual account review since it will provide the Court with the necessary performance measures and benchmarks to better evaluate compliance with the Prudent Investor Rule.
23The commentary to the Uniform Prudent Investor Act explains:
ìManagingî embraces monitoring, that is, the trusteeís continuing responsibility for oversight of the suitability of investments already made as well as the trusteeís decisions respecting new investments.
Comment to Uniform Prudent Investor Act § 2 [HRS § 554C-2].
1. Internal Rate Of Return ("IRR") vs. Time Weighted Return.
In response to a concern raised in the 109th Master's Report , the Trustees claimed that between 1980 and 1994, the Trust Estate enjoyed an average annual total return for all asset classes on a compound basis of 17.3% which they contended compared favorably against various investment benchmarks and returns reported by other institutions. Closer scrutiny, however, reveals that the formula by which that rate of return was calculated was not comparable to the formula used for the benchmarks.
In calculating a 17.3% total return, the Trustees employed an Internal Rate of Return ("IRR") measurement. Arthur Andersen LLP indicates that IRR is normally applied to a single investment rather than a mixed portfolio of investments, except when a group of investments have similar characteristics. IRR is also not the basis for most investment indexes and other endowment fund performance analyses. Instead, the Andersen Report states that the Time Weighted Return ("TWR") is the generally accepted standard in the investment industry for measuring total return and the basis upon which most published investment benchmarks are calculated.
2. The Trustees' Investment Return Analysis.
Under the Stipulated Order the Trustees agreed to provide your Master with revised analyses of income yield24 and total return for the five fiscal years beginning with FY 1992 through FY 1996. The supplemental information was provided and reviewed by your Master and Arthur Andersen LLP. See Exhibit G. The analyses provided by the Trustees, utilizing TWR rather than IRR, revealed the following income yield and total return25 on the overall portfolio of the Trust Estate:Income Yield Total Return FY 1992: 1.9% 10.2% FY 1993: 2.0% 4.4% FY 1994: 2.1% -2.7% FY 1995: 2.2% 0.3% FY 1996: 2.0% -0.6%
Based upon the rate of return analysis provided by the Trustees, the three-year and five-year average income yield and average total return26 are as follows:Income Yield Total Return 3-Year Period FY 1994-1996: 2.1% -1.0% 5-Year Period FY 1992-1996: 2.0% 2.4%
The overall income yield and total return for the Trust Estate's portfolio provides useful information but the numbers should be put in perspective. The bulk of the Trust Estate's assets is Hawaii real estate which comprised the original trust corpus. Because the Will restrains the Trustees from freely selling those lands, the ability of the Trustees to fully maximize the return on the overall portfolio is limited.
This is why the Andersen Report recommends that the investments of the Trust Estate be categorized when examining investment performance. Grouping the investments will enable the investment performance of the portfolio to be evaluated according to appropriate investment categories. Income yield and total return related to Hawaii real estate could thereby be isolated from other investments. Adopting such a format will ensure that investment performance information is presented in a meaningful and useful manner. The Andersen Report incorporates a return analysis along the lines recommended by Arthur Andersen LLP. See Exhibit H.
24Over the years, various court masters have attempted to report the Trust Estate's income yield. Those reports have been based upon analyses by the masters themselves utilizing the best available information. Income yield has been reported to range over the years from 1% to 2%. However, the methodology by which such income yield calculations were performed by past masters is unknown and cannot be assumed to have been consistent.
25The analysis uses book value rather than market value for the Trust Estate's interest in Pauahi Holdings Corporation and the underlying investment in Goldman Sachs & Co. is carried on Pauahi Holdings Corporationís books at cost rather than fair market value.
26While three-year, five-year, and ten-year annualized performance analyses would be helpful in putting investment return in perspective, a ten-year annualized rate of return analysis was not provided.
E. Substantial Losses And Loss Reserves Were Established For Various Troubled Investments .
In addition to performance measures such as income yield and total return, investment loss experience is an important indicator of potential problems faced by the investment portfolio. For this reason, the 109th Master's Report disclosed that a significant number of the investments comprising the Trust Estate's overall investment portfolio recognized substantial losses and loss reserves in FY 1994.
The Trustees' Response disputed the figures contained in the 109th Master's Report and claimed that it distorted the true financial results. Instead, they claimed that the Trust Estate's "realized capital losses in FY 1993-94 were about $23 million, not $264 million." They also contended that the Trust Estate's corpus increased in FY 1994 "by more than $222 million, of which almost $39 million represents realized capital gains from sources other than Hawai'i land sales."
In the Stipulated Order , the Trustees agreed to provide a supplemental report concerning the performance of the Trust Estate's portfolio, including any realized capital losses or valuation losses and any loss reserves established during the accounting periods.
The 109th Master's Report indicated that the $264,090,257 reported represented "combined losses and loss reserves" recognized in FY 1994. These losses and loss reserves were highlighted not to suggest that the Trust Estate suffered a net loss during FY 1994. Clearly your Master reported otherwise in the 109th Master's Report . However, your Master viewed this record of losses and loss reserves recognized in a single fiscal year to be significant and suggested a need to examine the investment program of the Trust Estate to determine whether appropriate safeguards to avoid such adverse consequences were in place.
Arthur Andersen LLP has reviewed the extent of the losses and loss reserves recognized during FY 1994 and determined that the actual total was $135,518,139. The principal reasons for the discrepancy in the total amount of losses and loss reserves previously reported are:
For the three fiscal years under review, Arthur Andersen LLP has identified loss and loss reserves totaling ($135,518,139) in FY 1994; ($51,645,991) in FY 1995; and ($55,205,242) in FY 1996. Those losses and loss reserves were offset by realized and unrealized gains as reflecting in the following chart:Description FY 1994 FY 1995 FY 1996 Loss reserves and investment write- offs not previously reserved for: ($113,554,941) ($15,756,237) ($16,446,678) Realized and unrealized investment gains: $63,538,941 $14,802,237 $37,715,678 Net gain (loss) on long-term investments: ($50,016,000) ($954,000) ($21,269,000) Equity losses of investments in partnerships: ($18,047,982) ($25,865,184) ($16,194,097) Operating losses of subsidiaries: ($3,915,216) ($10,024,570) ($22,564,467) SUBTOTAL: ($71,979,198) ($36,843,754) ($17,489,564) Net gains on land sales: $199,563,000 $83,125,000 $51,684,000 Other net operating activities: $65,231,198 $48,399,754 $71,438,564 Increase in Net Assets: $192,815,000 $94,681,000 $105,633,000
Despite the discrepancy in the numbers reported in the 109th Master's Report , the significance of these investment losses and loss reserves is not to be diminished. While they may not all be attributed to FY 1994, they nevertheless aggregate to a significant amounts of losses and loss reserves established during all three periods.27
The investment portfolio (excluding Hawaii real estate) had an estimated value of approximately $850 million at the time the losses and loss reserves were booked. Proportionately, the losses and loss reserves are sufficient to warrant concern. Moreover, the losses and loss reserves are dispersed among several different private equity investments -- most of which are classified by the Trust Estate as "special situation" investments and North American real estate. This suggests that a careful review of the investment practices of the Trustees in selecting the Trust Estate's investments is appropriate in light of such losses and loss reserves.
Indeed, the Andersen Report recommends a number of improvements to the Trust Estate's investment policies and practices as discussed in more detail herein.
27 Prior Master Benjamin Matsubara reported "$107 million of write-offs and reserves for troubled investments" in FY 1992 and "$44 million of write-offs and reserves for troubled investments" in FY 1993. Matsubara Report at 23; Matsubara Report 2 at 22.
F. The Prudent Investor Rule Requires Strategic Planning To Guide Investment Decisions.
The Prudent Investor Rule does not restrict the types of investments in which a trustee may invest trust assets so long as they are consistent with the standards prescribed by the Hawaii Uniform Prudent Investor Act . HRS 554C-2(e). Fundamental among those standards governing investment and management decisions is that articulated at HRS 554C-2(b):
A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust. [emphasis added]
This standard requires that the Trustees have a carefully developed "overall investment strategy" when making investment and management decisions.28
The Andersen Report is repeatedly critical in its observations and recommendations in this regard. In virtually all areas of investment and management decision-making by the Trustees, the Andersen Report notes a lack of appropriate investment planning. Even more problematic, the Andersen Report observes that even to the extent that there may be a semblance of an investment plan, there is a weak commitment to abide by the plan.
Among the noteworthy observations made in the Andersen Report concerning investment planning for the "non-core assets"28 of the Trust Estate are the following:
(a) Although previous court masters have reported that the Trustees had engaged the services of a nationally known educational endowment investment consulting firm, Cambridge Associates, Inc., the Andersen Report indicates that the recommendations of Cambridge Associates, Inc. have been selectively applied by the Trustees. Notably, the Trustees failed to pursue investment categories recommended by Cambridge which would have provided more diversification and liquidity in the portfolio.
(b) In February 1995, the staff of the Asset Management Group of the Trust Estate presented the Trustees with 11 individual strategic planning reports which provided key recommendations aimed at establishing overall strategic planning objectives for the Trust Estate. Although these recommendations did not constitute a strategic plan, they laid out the framework for development of an overall investment strategy appropriate for the Trust Estate. However, the Andersen Report notes that those recommendations have been left unimplemented.
(c) The Trust Estate has engaged in investment practices which are opportunistic and highly unusual for a perpetual endowment. Many of the investments have required extensive allocations of human resources to unique individual investments which, among other things, have significant exposures to permanent principal impairment and liquidity risks. Such characteristics make it almost impossible for staff, no matter how competent, to develop realistic and moderately dependable expectations for investment return. Hence, there is a severe limitation on any attempt to arrange an orderly diversification program, in addition to causing undependable cash flow forecasts.
(d) The Andersen Report notes that there is no clear asset allocation policy which incorporates appropriate risk and return objectives. In particular, it notes that since 1983, there has been a tremendous infusion of cash into the Trust Estate coffers from the sale of leasehold fee interests. However, contrary to the recommendations of Cambridge Associates, Inc., the bulk of that money has been invested in illiquid private equity investments. While the portfolio mix between real estate and non-real estate assets has improved since 1983, most of the new investments since that date are of an illiquid nature.
In summary, the Andersen Report recommends that the Trustees undertake the development of an appropriate investment plan. It also urges the Trustees to adopt almost all of the 1995 staff proposals for development of a comprehensive investment strategy.
Your Master makes recommendations which address this matter in Part IX, Section A of this Report.
28 ìInvestment and management decisionsî are not limited to the initial investment decision but also includes all subsequent decisions relating thereto. Thus, a decision to invest additional capital or a decision involving a work-out program for a bad investment is subject to the same standard.
29 The term ìnon-core assetsî refers to the financial and non-Hawaii real estate investments entered into by the Trust Estate, largely as a result of the cash infusion from the sale of residential leasehold fee interests since 1983. ìCore assetsî on the other hand refers to the original corpus lands in Hawaii which initially established the Trust Estate and of which the Trustees are restricted by the Will from selling.
G. Prudent Investment Requires Diversification Of The Investment Portfolio.
Trustees are generally required to diversify the investments which they manage. See Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964) (it is the specific investment duty of a trustee to diversify trust investments unless absolved from so doing by express direction in the trust instrument).
HRS 554C-3 of the Hawaii Uniform Prudent Investor Act sets forth the applicable standard regarding diversification:
A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances or directives of the trust, the purposes of the trust are better served without diversifying.
Cf. Restatement (Third) of Trusts 227(b) (1992) (substantially identical standard).
The Hawaii Supreme Court in Steiner explained the reason for this requirement:
This duty is imposed in the expectation that it will minimize the possibility of large losses of capital through the failure of only one of the investments in the entire portfolio. Prudence requires a careful and cautious balance between the quantity and quality of the securities being held in trust so as to spread the risks of investments, bearing in mind "both probable income and probable safety of capital."
47 Haw. at 562. See also Dowsett v. Hawaiian Trust Company, 47 Haw. 577, 393 P.2d 89 (1945) (the risks of concentration and the benefits of diversification are accepted rules of prudent trust management under the "prudent investor rule").
Failure to comply with this duty to diversify may subject a trustee to surcharge. In Steiner, the Hawaii Supreme Court affirmed a judgment of the trial court which surcharged a corporate trustee for having failed to satisfy its duty to diversify the trust's investments. As a consequence, the trust suffered losses for which the corporate trustee was held liable.
The opinion in Steiner explained that there is no need for a finding of an "abuse of discretion" by a trustee for liability to attach for a failure to diversify. The Supreme Court explained:
Any deviation from the terms of the trust instrument or the statute regulating investments, such as the prudent investment statute, would constitute a breach of trust even though the trustee was acting in good faith and his deviation was merely a mistake in judgment. As stated in 2 Scott on Trusts at Section 209 (2d ed. 1956):
"A very common type of breach of trust is that which occurs where the trustee fails to sell or improperly delays in selling trust property which it is his duty to sell. The duty to sell may be imposed by express directions in the trust instrument. Even though the trust instrument is silent on the matter, the trustee may be under a duty to sell because the property is not a proper trust investment. The trustee is under a duty within a reasonable time after the creation of the trust to dispose of any part of the trust estate included in it at the time of the creation of the trust which would not be a proper investment for the trustee to make, unless it is otherwise provided by the terms of the trust or by statute."
Thus it was not necessary for the chancellor to find here that the defendant, as trustee, abused its discretion. The case does not fall in that area. The mere violation of the prudent investment statute governing trust investments constituted a breach of trust upon which liability by way of surcharge could be predicated, in the absence of investment directions expressed in the trust instrument which relieved the trustee of the duty of diversification.
Steiner v. Hawaiian Trust Co., supra at 576-577.
In the case of the Trust Estate, individual Trustees have contended that they are limited in their ability to diversify the investments of the Trust Estate because of the terms of the Will. They point to the fact that the bulk of the inception assets of the Trust Estate was comprised of lands which were owned by Princess Pauahi. In Codicil No. 1 to her Will Princess Pauahi gave her Trustees the power to sell and dispose of lands and to make "such investments as they consider best." However, she further directed that those lands were not to be sold except as necessary for the establishment or maintenance of the schools or "the best interest of [her] estate."
I give unto the trustees named in my will the most ample power to sell and dispose of any lands or other portion of my estate, and to exchange lands and otherwise dispose of the same; and to purchase land, and to take leases of land whenever they think it expedient, and generally to make such investments as they consider best . . . and I further direct that my said trustees shall not sell any real estate, cattle ranches, or other property, but to continue and manage the same, unless in their opinion a sale may be necessary for the establishment or maintenance of said schools, or for the best interest of my estate. [emphasis added].
See Exhibit "A".
This restriction on the sale of lands from the corpus is not absolute. The Trustees are granted discretion to sell if they deem it in the best interest of the Trust Estate. Hyde v. Smith, 11 Haw. 535 (1898). As a result, the Trustees are bound by the Prudent Investor Rule to consider diversification strategies which are in the "best interest of the Trust Estate." Cf. Steiner v. Hawaiian Trust Company, supra (corporate trustee held liable for breach of the duty to diversify under the prudent investor rule notwithstanding restrictions in the trust document regarding sale of the inception assets).
The Andersen Report makes no recommendation that the Trustees sell any Hawaii real estate comprising the core assets of the Trust Estate to achieve further diversification. However, it does recommend that to the extent funds become available, the Trustees should endeavor to better diversify the non-core assets of the Trust Estate.
The Trust Estate was able to realize considerable revenue from the forced lease-fee sale of residential lands from 1983 to the present. Utilizing that revenue, the Trust Estate has been able to make limited progress in diversifying away from real estate as its principal investment asset. Despite such progress, the Andersen Report recommends that the asset allocation of the investment portfolio of the Trust Estate be improved through further diversification, increased liquidity, and moving away from investments which are high risk and require intensive monitoring.
The Andersen Report observes that while the Trustees have invested substantial amounts in investments other than Hawaii real estate, the portion not invested in Hawaii real estate remains inadequately diversified. Despite the fact that the Trust Estate already has a disproportionately large real estate component, the Trustees have continued to invest substantial amounts in real estate investments both inside and outside of Hawaii. Such investments further detract from the desired goals of diversification and liquidity.
Moreover, the Andersen Report reports that private equity investments comprise a major component of the overall non-core investment portfolio of the Trust Estate. While such investments have helped improve the overall level of diversification, the Andersen Report notes that the proportion of such investments is substantially higher than the norm for comparable educational endowments. Although private equity investments promise a high rate of return, that promise is usually fueled by a high risk exposure.
The Andersen Report also observes that the investments outside of Hawaii real estate are largely illiquid rather than liquid investments. This is contrary to repeated recommendations from Cambridge Associates, Inc. and is also contrary to best practices for entities such as the Trust Estate with a defined social mission.
H. The Due Diligence Review Process Needs Strengthening.
Compliance with the Prudent Investor Rule makes it incumbent upon the Trustees to conduct an appropriate due diligence review or underwriting evaluation when making investment and management decisions. HRS 554C-2(d) demands that:
A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.
The necessity for appropriate investigation, analysis, and risk and return evaluation when making investment and management decisions is further reinforced by HRS 554C-8 which explains how compliance with the Prudent Investor Rule is to be determined:
Compliance with the prudent investor rule is determined in light of the facts and circumstances existing at the time of a trustee's decision or action and not by hindsight.
Thus, when evaluating whether the Trustees acted in accordance with the Prudent Investor Rule in entering into an investment, examination of the investment review and evaluation process is one of the critical elements.
The Matsubara Report recognized the importance of appropriate evaluation of proposed investments and therefore recommended that the Trustees formalize the due diligence process. The Court accordingly issued an order that:
[T]he Trustees formalize due diligence procedures by providing a check list of required steps for investment decision making as well as post acquisition monitoring, review and exit strategies;
Findings of Fact, Conclusions of Law and Order Approving the 107th Annual Report and the 108th Annual Report, filed herein on February 9, 1996, at 6.
Although the Trustees have adopted formal due diligence policies, the Andersen Report notes the inconsistent and sometimes deficient manner in which due diligence evaluation has been conducted. It also identifies several specific recommendations for strengthening the due diligence process. The Andersen Report recommends that better investment monitoring procedures be established and practices implemented.
I. Documentation Of Investment And Management Decisions Must Be Significantly Improved And Consistently Maintained.
An implicit requirement of the Prudent Investor Rule is that the reasons underlying investment and management decisions be properly documented to allow subsequent review. For example, HRS 554C-8 prescribes that compliance with the Prudent Investor Rule is to be "determined in light of the facts and circumstances existing at the time of a trustee's decision or action and not by hindsight." This can only be meaningfully accomplished if an adequate record is maintained of the basis for the decisions or actions by the Trustees.
The Andersen Report notes a number of areas where documentation of investment and management decisions could be improved and makes recommendations in that regard.
Moreover, your Master has noted that on a number of occasions significant decisions made by the Trustees have not been properly recorded, thereby leaving the basis for the decision unclear and open to subsequent debate. For example:
J. Investment Costs And Management Expenses Should Be Evaluated To Determine Compliance With The Prudent Investor Rule.
In connection with their duty to invest prudently, the Trustees must ensure that only reasonable investment expenses are incurred. HRS 554C-7 requires:
In investing and managing trust assets, a trustee may only incur costs that are appropriate and reasonable in relation to the assets, the purposes of the trust, and the skills of the trustee.
See also Restatement (Third) of Trusts 227(c)(3) (1992) (a trustee must "incur only costs that are reasonable in amount and appropriate to the investment responsibilities of the trusteeship.")
Because income yield analysis is based upon net investment income, i.e., gross investment income less expenses related to generating the investment income, compliance with this requirement can be more readily evaluated. The income yield and total return schedules prepared by Arthur Andersen LLP show the expenses related to each class of investment. Coupled with performance benchmarking as recommended by the Andersen Report , investment costs incurred by the Trustees can be put in perspective and gauged for their appropriateness and reasonableness.
It should be noted that the Trustees' Response to the 109th Master's Report also claimed that the total investment related expenses of the Trust Estate in FY 1994 were only $1.2 million which they describe as a "favorably modest amount."
Trustees' Response at 37. The rate of return analysis later provided to your Master pursuant to the Stipulated Order indicated that investment-related expenses for FY 1994 were $9,560,344 by the Trustees' own account. Those expenses grew to $13,105,041 by FY 1996 based upon the Trustees' figures.
In reviewing overall management and general expenses, Arthur Andersen LLP noted significant growth in professional expenses. In FY 1994, the Trust Estate expended $6,100,000 on professional services. In FY 1995, that amount grew to $11,300,000. During FY 1996, professional service expense increased further to $12,500,000.
The growth in expenses impacts investment performance. With the level of income yield and total return for various categories of investments falling below benchmark standards, the Trustees would be well advised to closely monitor increases in operating expenses. In addition, the Trustees should also exercise care in maintaining an appropriate ratio between direct education expenses and non-education expenses.
K. The Real Estate Portfolio Of The Trust Estate.
The real estate holdings of the Trust Estate are comprised of essentially three categories of assets:
1. Hawaii real estate--most of which are part of the original corpus establishing the Trust Estate.
2. Non-Hawaii real estate investments--which mostly fall into two categories:
(a) Direct investments--where the Trust Estate is the sole or lead equity stakeholder and/or developer of a real estate asset.
(b) Pooled investments--where the Trust Estate is one of several equity investors in a real estate investment pool.
The Andersen Report summarizes that based upon their review of the Trust Estate's real estate investments and operations the following areas need strengthening:
1. Strategic planning on both overall and segmented basis.
2. Improving due diligence procedures both with respect to direct and pooled real estate investments and ground lease analysis.
3. Strengthening the documentation of investment and management decisions.
4. Improvements in management organization, including a centralized planning department. Identification of investment and management related expenses.
5. Better performance monitoring of all segments of the real estate assets and investments.
6. Identifying appropriate benchmarks for evaluation of performance.
1. The Hawaii Real Estate Assets.
The Trust Estate's primary and most substantial asset is its Hawaii real estate holdings. The Trust Estate holds fee title to 365,123 acres of land in the State of Hawaii as of FY 1996. Conservation lands comprised 187,635 acres and agricultural lands constituted 172,630 acres. The conservation lands produced no revenue. Agricultural land leases generated about 2% of the total revenue from the Hawaii lands. Residential land holdings (single- and multi-family improved and unimproved) comprised 4,219 acres and generated 6% of the Trust Estate's total income from Hawaii lands. Although commercially zoned lands (commercial, industrial, hotel and resort) comprised only 639 acres or 0.17% of the Trust Estate's total land holdings in Hawaii, its rental income generated 92% of the total income from real estate in Hawaii. 1996 Annual Report of the Kamehameha Schools Bernice Pauahi Bishop Estate at 22-23.
The Hawaii real estate constitutes the core of the Trust Estate's assets, both as to total value (estimated at $4.03 billion in FY 1996 based upon adjusted real property tax assessment values) and amount of rental income (approximately $123 million in gross revenue in FY 1996). The Trust Estate constitutes one of the largest landowners in the Kakaako Redevelopment District and had its conceptual master plan for its holdings approved in September 1994 by the Hawaii Community Development Authority. In addition, the Trust Estate also acquired during FY 1995 approximately 30,000 acres of land which formerly comprised the Hamakua Sugar Plantation on the island of Hawaii.
The Trust Estate manages its real estate holdings through its Asset Management Group and its wholly owned taxable subsidiaries, Royal Hawaiian Shopping Center, Inc. and Kamehameha Investment Corporation.
(a) The Andersen Report Recommends Several Reforms For The Hawaii Real Estate Operations.
The Andersen Report identifies a number of strengths associated with the real property management activities, especially in the areas of residential fee conversions and commercial property management. However, the Andersen Report also makes several critical observations and recommendations.
With respect to the Hawaii real estate, the Andersen Report repeatedly cites a lack of appropriate overall strategic planning for the Hawaii real estate assets. The Andersen Report states that in 1995, staff of the Asset Management Group prepared a planning document titled Land Use Inventory -- Management Strategies ("LUI") which summarized the Trust Estate's real estate strategies for Hawaii real estate. The LUI was comprised of plans prepared by the regional land managers of the Trust Estate for their respective regions. The LUI has not been formally adopted or utilized as a strategic plan for the management of Hawaii real estate. Moreover, there is no evidence that those regional plans have been integrated into a comprehensive overall investment strategy for the Trust Estate.
The Andersen Report also discloses deficiencies in the due diligence processes. It cites one ground lease transaction in particular where: (a) not all of the economic aspects of the lease were analyzed and objectively quantified; and (b) a flawed present value methodology was used to compare alternative lease terms. This inaccurate analysis resulted in the ground lease being approved based upon an inappropriate analysis of the transaction.
Two recommendations made in the Andersen Report regarding Hawaii real estate are particularly significant. The first is that a comprehensive strategic plan for all real estate assets at the Trust Estate level and subsidiary level should be developed. The plan should be aligned with the Trust Estate's mission and overall strategic objectives. It should be linked to the Trust Estate's overall asset allocation strategy. It needs to be integrated with the Trust Estate's medium-term and long-term financial plan (5-year and 10-year plans). The plan should incorporate and articulate the Trustees' vision and the Trustees' expectations regarding the role of the Trust Estate in planning, development, and management of its real estate holdings.
The second key recommendation is that management should benchmark the financial performance of the commercial properties, by individual property and property types (i.e., shopping centers, office buildings, warehouses, etc.) on at least an annual basis. Variation explanations and remedial action steps should be developed in response to any unfavorable benchmark variations.
The Andersen Report also raises issues regarding strategic planning and management of the development of the Trust Estate's Kakaako land holdings. It questions whether the Trust Estate is adequately exploiting the economic potential of its Kakaako land holdings through such planning. It also highlights a need for the Trust Estate to more effectively deal with the market forces and competitive factors which may adversely impact the Trust Estate's highest and best use development plans for Kakaako.
2. Non-Hawaii Real Estate.
The Trust Estate currently owns substantial real estate holdings on the mainland. In FY 1996, those holdings consisted of both direct investments and participation in pooled investments which had a combined estimated value of $425 million at June 30, 1996.
The Trust Estate's investments in several directly held real estate investments did not begin as an equity investment. Instead, the Trust Estate initially assumed a lender position to minimize its risk exposure and provide for more predictable income flow. However, as some of these real estate developments became troubled, the Trust Estate converted its loans into equity and assumed ownership of the developments. Other investments were entered into by the Trust Estate on a partnership basis with the Trust Estate acquiring an increased equity interest through buy-out of the partners' interests or by default under a partnership agreement.
(a) The Non-Hawaii Real Estate Investments Are Not Linked To An Asset Allocation Strategy For The Trust Estate.
Arthur Andersen LLP reviewed a sampling of the files related to seven mainland real estate investments. Based upon their review they render a number of critical observations in the Andersen Report :
(a) There is no linkage between investment decisions and the Trust Estate's asset allocation strategy. In other words, investments are evaluated and considered based on opportunities presented from various sources rather than being "targeted" to fit within an approved portfolio strategy.
(b) The quality of due diligence performed is inconsistent, ranging from inadequate to relatively comprehensive.
(c) Documentation in staff reports is not standardized and often inconsistent. Information is sometimes insufficient to make and support prudent investment decisions.
(d) The justification for investment decisions made by Trustees contrary to recommendations included in staff reports was not adequately documented and supported.
The Andersen Report recommends that:
(a) Only those investment opportunities which satisfy the investment criteria defined by an approved portfolio strategy that is linked to the overall asset allocation model should be evaluated for potential investment. Such a portfolio strategy for real estate investments should define the Trust Estate's targeted investment criteria.
(b) Currently approved standard due diligence guidelines should be revised to include additional elements.
(c) Due diligence results and underwriting review should be fully documented in a standard reporting template.
(d) Trustees' decisions which are contrary to staff recommendations and analysis should be documented.
The Andersen Report observes that there is no well- defined strategy for the direct real estate investments located on the mainland. The Report also notes that these properties are primarily handled by third-party management companies or consultants which makes oversight by the Trust Estate more crucial. Some of the investments involve large-scale projects with very complex issues. Because Trust Estate staff rely heavily on consultants, their ability to effectively control and direct the management of the projects is impaired. As a consequence Trust Estate staff become more reactive rather than pro-active in managing the projects. In particular, with respect to direct investments which were acquired through workout situations, development of a well-defined strategy for each of the investments is recommended. Finally, the Andersen Report urges that management demonstrate a commitment to execute the approved strategy.
(b) Pooled Real Estate Investments.
The real estate pooled investments are comprised of over 20 investments in both single property and portfolio real estate pools. Those investments had an estimated fair value of approximately $150 million as of June 30, 1996.
The Andersen Report identifies weaknesses in the Trust Estate's policies and procedures for monitoring its pooled investments. It also is critical of the failure to perform monitoring in a disciplined and structured manner. Accordingly, the Andersen Report recommends that comprehensive investment monitoring procedures be developed, documented and performed on a routine basis.
3. The Hamakua Land Purchase .
In September 1994, the Trustees authorized the purchase at a bankruptcy auction of approximately 30,000 acres of land which formerly comprised the Hamakua Sugar Company for a bid of $21 million. This investment decision to purchase the Hamakua lands is indicative, in many ways, of the deficiencies noted by the Andersen Report .
1. Despite the magnitude of the transaction, there is no record of Trustee approval
of that transaction in the minutes of the meetings of the Board of Trustees. As a
result, your Master first obtained information regarding the transaction on June
30, 1998, in response to inquiries by your Master.30
2. Although the written staff analysis only supported a purchase at a substantially lower price and upon specific financial terms, the Trustees authorized acquisition at a price which varied from the written staff analysis and on a debt-financed basis despite staff's recommendation against debt financing.
3. The Trustees say that the $21 million purchase price was authorized based upon further staff analysis and a subsequent oral staff presentation. However, your Master has seen no documentation justifying the higher purchase price and the use of borrowed money to finance the purchase.
4. There is no documentation which your Master has seen which explains the reasons which justify and support the Trustees' authorization of the $21 million purchase.
5. There is no indication in the staff report or any other documentation provided to your Master which suggests that the acquisition was part of a broader investment strategy, i.e., what role the investment was expected to play within the overall portfolio of the Trust Estate.
6. There is very little documentation to reflect economic analysis of the expected income yield and total return.
7. There is nothing which evidences consideration of the impact the $21 million investment would have on the Trust Estate's liquidity, regularity of income, and preservation or appreciation of capital.
8. Although the Trust Estate already owns huge amounts of agricultural and conservation zoned lands, your Master is unaware of why the expenditure of such a large amount to acquire 30,000 more acres of such land would benefit the Trust Estate.
This example readily demonstrates the need for the Trustees to adopt the recommendations of the Andersen Report and incorporate appropriate investment policies and procedures to guide its real estate operations and investment decisions.
30 Your Master is still seeking additional information from the Trust Estate regarding this transaction.
4. Kahala Mandarin Lease.
In the 109th Master's Report a concern was raised regarding the lease transaction related to the Kahala Mandarin Hotel property. In particular your Master noted that the Trustees had failed to specifically disclose the transaction in the schedule of real estate transactions or mention it in any of the minutes of the meetings of the Board of Trustees. As discussed in Part VIII, Section I, appropriate disclosure of such a transaction in the minutes of the Trustees' meetings, at the very least, is essential to the integrity of the account review process.
The Trustees have indicated that they are cognizant of the need for appropriate recording in their minutes of their meetings and have represented to your Master that they have instituted new practices to avoid similar omissions in the future.
With regard to the Kahala Mandarin lease transaction, the Trustees have provided your Master with a supplemental report which disclosed the pertinent facts related to the transaction. In addition, your Master requested that Arthur Andersen LLP review the underlying due diligence documents and file related to the transaction.
Based upon the results of the review conducted by Arthur Andersen LLP, your Master is satisfied that: (a) the Trustees caused a proper due diligence investigation and lease analysis to be prepared; and (b) they negotiated the terms of the Kahala Mandarin Hotel lease in a commercially reasonable manner.
IX. STRATEGIC PLANNING
A. Appropriate Strategic Planning Remains Lacking.
In the 109th Master's Report , your Master expressed criticism of the strategic planning efforts of the Trustees. The Trustees' Response rejected the criticism and contended that the Trust Estate's strategic planning process is a "continuing" one. In the Stipulated Order , the Trustees agreed that a strategic plan would continue to be developed and adopted by the Trustees and provided to the court-appointed master and Attorney General prior to the first scheduled hearing on the 112th Annual Account.
Despite such assurances by the Trustees, your Master has found that the Trustees have failed to conduct appropriate strategic planning and that recent strategic planning efforts by the Trustees have been fundamentally flawed. Succinctly stated, the deficiencies in the strategic planning efforts are as follows:
The following discussion elaborates upon these points.
1. Strategic Planning By The Trustees Has Failed To Take Into Account The Available Financial Resources.
While there are many aspects of recent strategic planning efforts by the Trustees which your Master and Arthur Andersen LLP found to be deficient, all of those shortcomings pale in the face of the failure by the Trustees to properly deal with the issue of accumulated income.
All strategic planning efforts conducted by the Trustees have been done so without appropriate regard to the fact that the Trust Estate currently has an enormous accumulated income balance and is projected in the future to accumulate an income balance which will exceed a billion dollars by FY 2006. That projected accumulated income balance in excess of a billion dollars is after taking into account the operating costs related to the four new satellite schools scheduled to be developed on Maui, Hawaii, and Oahu and the expanded center-based pre-school program.
The extent to which such planning is flawed is amply demonstrated by the decision-making process employed by the Trustees in adopting the GoFoward initiative and dismantling a number of longstanding extension and outreach programs. The planning process was undertaken on a "budget neutral" basis. That is, all planned programs, both old and new, had to fit within the then current annual direct educational expense budget of $55 million. This meant that choices had to be made to eliminate or scale back existing programs in order to add new ones. This is despite the fact that the Trust Estate had an accumulated income balance of more than $316 million in FY 1994 and the 10-Year Projections showed considerable additional surplus income projected during the initial 10-year period in which GoForward was to be implemented.
2. The Investment Strategy Undertaken By The Trustees Has Resulted In An Illiquid Portfolio Which Makes Expenditure Planning Difficult.
The Andersen Report indicates that there is no investment strategy which is focused upon the liquidity requirements needed to expand education-related spending. It notes that because the bulk of investments made by the Trustees is illiquid, their ability to plan for future educational expenditures is hampered because of the uncertainty connected with such investments and the income they generate.
Financial planning for the GoForward satellite schools and center-based preschool expansion programs was not a simple undertaking. This difficulty was not because the Trust Estate lacks the necessary resources, but rather, because of the illiquidity of its portfolio.
Similarly, although the Trust Estate had an estimated accumulated income balance of $349 million as of June 30, 1997, it lacks the necessary liquidity to currently expend a significant portion of that amount because its assets are largely tied up in long-term investments. Of course, this is why planning is required to responsibly expend that accumulated income over a reasonable period of time. However, such expenditure planning needs to also be tied to an investment plan which ensures an appropriate level of liquidity to facilitate such spending.
The Andersen Report notes this flaw in the strategic planning of the Trust Estate. It also notes that Cambridge Associates, Inc. had recommended in 1983 that the Trustees allocate a substantial portion of the cash realized from the sale of corpus lands to a permanent endowment fund which would be invested in substantially liquid investments such as stocks, bonds, and other readily marketable investments. However, this recommendation was ignored and the bulk of the unexpended income of the Trust Estate has instead been invested in illiquid capital appreciation oriented investments.
3. The Educational Strategic Plan Must Be Coordinated With The Investment Plan To Ensure Appropriate Expenditure of Trust Assets.
As discussed in detail in the 109th Master's Report , there remains a need for a strategic plan involving the development of an educational plan in conjunction with an investment plan. Both must be developed hand-in-hand. The educational plan must take into account the future potential financial resources available. The investment plan must be fashioned around the projected educational program needs. The selection and mix of future investments by the Trustees should be accordingly guided. The development of a strategic plan in that manner will best ensure that the focal point of the Trust Estate's planning process will be its educational mission.
4. Intervention By The Court In The Strategic Planning Process Is Necessary.
Based upon the repeated efforts by past Masters and the Court to have the Trustees properly deal with this issue and the failure of the Trustees to follow through with appropriate strategic planning, your Master recommends that direct and specific intervention by the Court be immediately taken.
B. A Historical Note Regarding Past Strategic Planning By The Trust Estate.
1. The 1961 Strategic Planning Initiative: The Booz Allen Report.
During the course of your Master's research regarding the Trust Estate, he learned of a major strategic planning effort previously undertaken by the Trustees in August 1960. In your Master's view, that effort represented a "model" for strategic planning and revolutionized the Kamehameha Schools and shaped much of the educational direction of the Trust Estate during the past 37 years.
The Trustees at that time engaged the highly regarded strategic planning firm of Booz, Allen & Hamilton to conduct a "planning survey." A team of national experts in the field of education and education administration was assembled to conduct the survey and generate recommendations to the Trustees. The four volume report issued by Booz, Allen & Hamilton on September 25, 1961 ("Booz Allen Report ") basically defined a strategic vision for the Trustees to adopt to move the Trust Estate to a new level of delivering educational benefits to children of Hawaiian descent.
The Booz Allen Report is a document of remarkable foresight. The principles and vision described in it are as relevant today as they were almost 37 years ago when it was prepared. The strategic vision of the Booz Allen Report was aimed at meeting the challenges which the imminent growth and expansion of Hawaii would pose to its native Hawaiian population.
Accordingly, the authors of the Booz Allen Report cited the role of educational leadership which Kamehameha Schools was particularly well-suited to fulfill and recommended that it:
(a) Provide educational programs designed to achieve the maximum of educational results with young people of (1) a broad range and reasonably normal distribution of academic ability and (2) a full range of career goals.
(b) Demonstrate the results that can be achieved through instructional methods and with instructional materials and equipment selected to achieve educational results of particular importance in Hawaii.
(c) Provide a quality of education that will establish a standard toward which public and private schools in the state can strive.
The Booz Allen Report made several recommendations to develop and strengthen programs aimed at increasing the skill level of graduates to better prepare them for rapid changes occurring in Hawaii.
The Booz Allen Report also anticipated increased growth and stability in the financial circumstances of the Trust Estate. It therefore recommended undertaking two major new programs to expand the delivery of educational benefits to a growing school-aged Hawaiian population. The two programs were an Extension Program and a Scholarship Program. Because there would be limited fixed costs associated with the programs (as opposed to the "core" programs), they could be adjusted as financial circumstances dictated.
Over the last 37 years, the influence of the strategic vision described by the Booz Allen Report was apparent in the educational programs of the Kamehameha Schools.
2. The GoFoward Stategic Planning Initiative.
Following the public announcement of GoForward , over the course of the next year, the Trustees commissioned several other studies on a disparate variety of topics to be prepared by Ernst & Young LLP and staff. Curiously, among those studies prepared by Ernst & Young LLP was a financial model to estimate the operating and capital costs for the proposed satellite schools which was not developed until April 16, 1996--almost one year after GoForward was announced.
The preparation of these various studies was eventually followed by the drafting and approval by the Trustees on August 12, 1997 of the Kamehameha Schools Educational Strategic Plan: 1997-2005 which was reported in the 109th Master's Report .
Your Master is unable to determine the reasons why GoForward was announced in such a hurried manner with limited involvement of key personnel and educational expertise. Moreover, fundamental questions regarding the implications of the major program objectives of GoForward appear to have been left without scrutiny. Your Master has been unable to identify any documents which reveal that the Trustees obtained the benefit of critical analysis of the strategic direction GoForward represents by experts in educational planning.
Although the opening of the satellite schools is an exciting venture for the Trust Estate, there was no documentation evidencing analysis of the potential problems associated with the establishment of satellite schools comprised of only 20 students at each grade level from K through 6 and 40 students at grades 7 and 8.34
Such a small school population poses problems related to lost efficiencies in it operations. It also raises serious questions regarding whether each school is sufficiently large to enable an educational program of the desired breadth and quality to be offered economically and effectively. Furthermore, with only 20 students at each grade level, it is questionable whether the size of the school population will allow instruction to be organized on a sound basis, i.e., to attain a desirable class size and pupil grouping at each grade level. Moreover, since these schools will be located in communities with large Hawaiian populations, the social ramifications of having such a small group of students attending a satellite school to the exclusion of others does not appear to have been considered. Your Master is unaware of any specific planning for expansion of the satellite schools beyond currently planned enrollment levels.
The Trustees are entrusted with the discretion and authority to set the direction of the educational programs of the Trust Estate. However, because those programs represent the single largest investment of the Trust Estate, the Trustees are bound to act prudently in exercising that discretion. The exercise of prudence requires proper planning, thoughtful study, and analysis. While your Master believes the GoForward initiative is a commendable effort on the part of the Trustees, he is not satisfied that critical and fundamental planning considerations have been adequately analyzed.
32 Dr. Ahr explains that he had previously performed work for the Trust Estate related to human resource management since he is a mental health professional (clinical psychologist) by training. His work on personnel issues drew the attention of the Trustees and they engaged him to assist them with their strategic planning effort. Your Master notes that Dr. Ahr was formerly the Director of the Missouri Department of Mental Health; there doesnít appear to be anything in his resume which suggests he has expertise in educational strategic planning.
33 A more detailed description of the GoForward initiative as described by the Trustees is attached hereto as Exhibit I.
34 The strategic plan proposed by Dr. Chun in 1992, suggested satellite schools with a significantly larger student population at each school.
C. Caution Should Be Exercised In Undertaking The Strategic Planning Process To Avoid A Detrimental Impact on the Education Division.
Any evaluation of the internal turmoil and decline in staff morale at the Kamehameha Schools would be largely incomplete without examining the impact of the "strategic planning" process which was undertaken from 1993.
The GoForward strategic planning process is in stark contrast to the process undertaken by the authors of the Booz Allen Report and the Trustees at that time. The Booz Allen Report was developed after considerable research and input from an extensive number of stakeholders. Moreover, after the Booz Allen Report was issued, comments on the report were solicited by the Trustees from the professional staff at the Kamehameha Schools. Working groups were set up to review the Booz Allen Report and offered comments which were compiled in a responsive report presented to the Trustees.
The strategic planning process which led to the GoForward initiative falls short in having invited such input and comment. Your Master found that both professional staff and key management employees at the Kamehameha Schools, as well as key management personnel at the Trust Estate, were unaware of the many key details of the GoForward initiative until it was publicly announced by the Trustees. This understandably resulted in misunderstanding, confusion, loss of confidence, and a decline in morale. While acknowledging that the ultimate policy decision rested with the Trustees, numerous professional staff members expressed frustration and disappointment that they were not given the opportunity to comment on the plan before the Trustees committed themselves to undertake it.
Your Master notes that the anxiety surrounding the strategic planning process undertaken by the Trustees existed early on in that process. In fact, on August 23, 1994, former Trustee Myron Thompson, then the Chairman of the Board of Trustees, was so concerned about it that he gave a speech to the faculty and staff of Kamehameha Schools at a special assembly aimed at allaying such anxieties. Trustee Thompson at that time attempted to address concerns that "people are feeling left out of the planning and decision-making"; that "there's a lot of confusion, anxiety and discomfort" and "even some fright" among the staff and faculty. He assured them that "this is not an exercise in slash and burn" and "[the Trustees] are not out to dismantle programs or cut services."
Despite these assurances, programs were eliminated and services reduced less than a year later. Moreover, Trustee Thompson had suggested that if staff reductions were called for, they would be handled through consideration of "attrition, voluntary transfers and other non-layoff alternatives." Despite his remarks, over a hundred positions were eliminated and employees terminated as part of the GoFoward initiative. While the Trustees provided generous severance packages and employed mitigative measures to alleviate the impact on terminated employees, many former employees were nonetheless left embittered.
Your Master is troubled by the turmoil that was engendered by the strategic planning and implementation of the GoForward initiative. What should have been welcomed as the most significant and ambitious educational venture for the Trust Estate in decades, turned into an episode clouded by mistrust, misunderstanding, and antagonism that continues till today. Future planning efforts should be conducted in a manner which will minimize, if not avoid such controversy.
X. TRUST ADMINISTRATION
A. The Need For Organizational Reform In The Management Structure.
The 109th Master's Report was critical of the Trustees employing a "lead trustee" system of management. In the Stipulated Order , the Trustees acknowledged the legal principles applicable to delegation of investment and management functions. It was also stipulated and ordered that:
The Trustees shall ensure that the "board" system of administration and a hierarchical scheme of management formally established by them through the hiring of properly selected and supervised agents is kept intact and uncircumvented.
Accordingly, the Trustees agree to review and act upon the organizational structure and governance of the Trust Estate in light of applicable principles of law and their individual and collective fiduciary obligations. The Trustees will do so in connection with the financial and management audit hereinbelow described in Part II and shall report their decision and action to the Court prior to the hearing on the approval of the 109th, 110th, and 111th Annual Accounts as provided hereinbelow in Part III.
Stipulated Order at 11-14.
The Andersen Report has recommended significant reforms in the management structure and operations of the Trust Estate. These reforms largely center around the creation of a more traditional business hierarchical structure. See Exhibit K. This new regime would retain the overall governance and policymaking role of the Board of Trustees. However, the Trustees themselves would not be involved in management operations of the Trust Estate. Lower level management employees would not report to individual Trustees. Instead, the chief interaction between the Trustees and management would be through the new Chief Executive Officer ("CEO") and his or her team of senior executives. The Anderson Report also recommends the return of a strong internal audit function within the Trust Estate which reports directly to the Board of Trustees so that it maintains its independence.
Prior court masters have recommended establishment of a CEO-headed organization at the Trust Estate. However, the Court previously declined to impose such a recommendation upon the Trustees.
This Court previously addressed a recommendation by Michael D. Hong, Esq., Master for the 100th Annual Account (FY 1985), that the Trustees appoint a CEO to manage the Trust Estate and report to the Trustees. In his report, Hong made the following observations:
In examining the Estate's organizational charts and structure with regard to the Trustees relationship to the staff and the various divisions and departments, there appears to be lacking within the organizational framework a single central managing officer charged with the duties, responsibilities and obligations of supervising and coordinating the day-to-day operations, activities and affairs of the Estate and its various divisions and departments, its subsidiary corporations, and in implementing the policies and directives of the Board of Trustees. At the present time, the five Trustees, who are the sole policymakers of this complex billion dollar Estate, appear to be mixed in with the management team which can cause and create confusion among the staff, its Divisions and Departments. The Master, therefore, recommends that the Estate streamline and reorganize its management structure in at least one specific area that appears to be lacking, that is, the appointment of a single chief executive officer (CEO) who is experienced in education, land and financial matters. The appointment of a CEO would greatly improve the flow of the Estate's business, activities and communications to and from the Board of Trustees, the various staff members in the divisions and departments and the general public. The staff should report to the CEO on their assignments and projects and the CEO, in turn, should report to the Board of Trustees. The CEO would be in complete charge of implementing the policies and directives of the Board of Trustees and would among other things, coordinate and manage the Estate's Education, Land and Finance divisions and its other departments. The proposed CEO should be directly accountable to the Board of Trustees who should speak as a single voice.
If such a reorganization is adopted and implemented by the Estate and a CEO is appointed, the Trustees of this Estate can and should spend their time and efforts on more important matters, such as planning, evaluation of programs, operations and performances, development of assets, investment of funds, accountability of the funds and assets, policymaking for the Estate, its Land, Finance and Education Divisions, and leave the implementation of their directives and policies to the CEO. Such a reorganization would draw distinct lines of responsibility within the organizational framework, would permit a smoother functioning of the Estate's businesses, and would be of enormous value to the Estate in meeting the challenges in future years.
Master's Report on the One Hundredth Annual Report of the Trustees, filed herein on November 17, 1986 ("M. Hong Report ") at 15-17.
In the order approving the 102nd Annual Report, the Court declined to adopt the recommendation of the M. Hong Report that a CEO be appointed:
[T]he Court will not interfere in the administration of the Trust by the Trustees absent an abuse of discretion or breach of fiduciary duties. Staffing is a matter of trust administration. Therefore, possible creation and appointment of a chief executive officer for the Estate is not an appropriate matter for judicial action at this time.
Findings of Fact, Conclusions of Law and Order Approving 102nd Annual Report, filed herein on October 16, 1990, at 9 [emphasis added].
Despite this Court's prior determination in 1990 in connection with the 100th Annual Account, your Master recommends that the issue be revisited in light of the observations and recommendations of Arthur Andersen LLP.
Moreover, your Master firmly believes that the Court can no longer leave the matter of the establishment of such a business organization structure to the unfettered discretion of the Trustees. Your Master makes the following findings which warrant action in this regard by the Court:
1. Since the 100th Annual Account (FY 1985), the Trust Estate has undergone a metamorphosis. Not only have its assets multiplied in value, the nature of its holdings and investments have grown exceedingly sophisticated and complex. It is no longer merely a landlord of Hawaiian real estate, but has become a significant investor in diverse investments both domestically and internationally.
2. The high level of sophistication required to evaluate the investment opportunities available to the Trust Estate and to properly monitor such investments cannot be emphasized enough. In addition, the ability to fully comprehend and integrate investment planning with complex financing and tax considerations is essential to management of the Trust Estate's portfolio.
3. There is no indication that in reviewing the 100th Annual Account the Court considered the existence of a management system comprised of "five CEOs" or "five lead Trustees" as described in the 109th Master's Report and the manner in which that system might violate the governance structure dictated by the Will.
4. The Five CEOs/Lead Trustee management system in place at the Trust Estate has no basis in trust law and business theory or practice. Efforts to identify a comparable management structure within any major business organization of note turned up nothing.
5. In utilizing a Five CEO/Lead Trustee management system, your Master found the following:
(a) The Trustees have failed to identify qualification requirements for the various positions;
(b) They have not screened and selected candidates based upon qualifications and whether the person selected is best able to carry out the duties and responsibilities involved;
(c) They have not defined the duties and responsibilities of the positions and integrated them into the formal organizational hierarchy of the Trust Estate and its divisions;
(d) There is no procedure for monitoring and reviewing performance;
(e) There is no procedure for exercising oversight and holding individuals accountable;
(f) No governing policies or guidelines have been developed.
6. Other fact-finders who have examined aspects of the operations of the Education Division of the Trust Estate have noted the negative consequences and adverse impact of the Five CEOs/Lead Trustee management structure. These include:
(a) Final Report of Fact Finder prepared by Judge Patrick K.S.L. Yim, Ret'd., filed herein on December 4, 1997 ("Yim Report ").
(b) Western Association of Schools and Colleges Visiting Committee Report for Kamehameha Secondary School , March 9-12, 1998 ("WASC Report ").
(c) Kamehameha Schools Bishop Estate Evaluation as of June 30, 1998 prepared by Peterson Consulting LLC ("Peterson Report").
7. The Yim Report makes specific factual findings addressing the Five CEO/Lead Trustee management system, which include the following:
(a) The Board of Trustees has failed to adopt any guidelines or criteria in order to provide the Lead Trustee(s) with guidance on how the specific oversight is to be conducted and allowed the Lead Trustee(s) to carry out his/her responsibilities in the given area in a highly individualistic manner.
(b) The Board has not articulated what decisions are reserved to the Board, so that, in fact, the Lead Trustee exercises broad decision-making power over his/her area.
(c) The "Lead Trustee" practice and the lack of guidelines relating thereto have created confusion among the Board and among the impacted subordinates. This Lead Trustee managerial style and level of decision-making exercised on an ad hoc basis is, at best, confusing. It is often unclear as to whether the actions of an individual Trustee in his/her role as Lead Trustee, are in fact individual Trustee action or full Board action. This situation is exacerbated by the fact that Board minutes, as they address the specific subject matter, reflect little historical guidance and/or direction.
(d) When clarification of requested or demanded action is sought of the Lead Trustee or middle management, there is a reluctance and/or refusal to put responses in writing. Directives, for the most part, are issued verbally. This management style exacerbates the climate of confusion and has often lead to misunderstandings and misperceptions. This lack of clear-cut direction is fundamental to the frustration experienced by the persons charged with the responsibility of implementing the Board's actions. Rather than being guided by clear instruction in writing, requests for clarification are often met with rejection with no specific explanation as to why. The Fact Finder finds that the foregoing action demonstrates that the Lead Trustee system is fraught with inherent systemic flaws.
Your Master adopts and incorporates these finding by reference to the Yim Report .
8. The Peterson Report noted that the Trustees very much see their role as the "CEO" of the Trust Estate. Despite this, the Peterson Report states that principles of good educational governance practices dictate that the Trustees should be active in formulating policy and establishing objectives, but individual Trustees should not become involved in specific management, personnel or curricular matters at the Kamehameha Schools. The Peterson Report found that:
[R]elying on an expansive interpretation of their powers under the Will of Pauahi, the Trustees have attempted to manage the day-to-day operations of the Schools and exercise control over educational and financial matters instead of delegating the authority to the President and his staff.
Peterson Report at 18.
9. Both the Andersen Report and your Master's own inquiry identified
significant morale problems created by the Five CEO/Lead Trustee management system.
Both management and staff morale are aversely impacted as they are placed in circumstances
when they have been required to do the bidding of one Trustee; withholding information
from other Trustees; revising staff reports or recommendations to the Board of Trustees
at the behest of a single Trustee; being subjected to conflicting demands from two
or more Trustees; and being directed by a single Trustee outside of established lines
of authority and communication. Management and staff face considerable confusion
and stress as they find themselves accountable to five individual Trustees who may
not always agree, in addition to their direct supervisors in the formal management
10. Continuation of the Five CEO/Lead Trustee management system would likely violate the Hawaii Uniform Prudent Investor Act . That statute articulates standards for delegation of the investment and management functions of trustees to an "agent" (other than a trustee) which are not satisfied by the current Five CEO/Lead Trustee management system. In particular, HRS 554C-9 of the Hawaii Uniform Prudent Investor Act provides as follows:
554C-9. Delegation of investment and management functions.
(a) A trustee may delegate investment and management functions that a prudent trustee of comparable skills could properly delegate under the circumstances. The trustee shall exercise reasonable care, skill, and caution in:
(1) Selecting an agent;
(2) Establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust; and
(3) Periodically reviewing the agent's actions in order to monitor the agent's performance and compliance with the terms of the delegation.
(b) In performing a delegated function, an agent owes a duty to the trust to exercise reasonable care to comply with the terms of the delegation.
(c) A trustee who complies with the requirements of subsection (a) is not liable to the beneficiaries or to the trust for the decisions or actions of the agent to whom the function was delegated.
(d) By accepting the delegation of a trust function from the trustee of a trust that is subject to the law of this State, an agent submits to the jurisdiction of the courts of this State.
See also, HRS 554A-3(c)(23) (specifying the power of a trustee to act as a prudent person would in appointing agents).
11. There have been instances under the Five CEO/Lead Trustee system of management where Trustees have deferred to the judgment of a lead Trustee with respect to matters falling within that Trustee's subject matter area; Trust Estate employees who work within a lead Trustee's area have been expected to obey the directions of the lead Trustee even in matters upon which the full Board of Trustees has not deliberated or acted; a lead Trustee has caused information to be filtered before being presented to the full Board of Trustees for their consideration; the Trustees have been reluctant to review performance of lead Trustees in an objective and appropriate manner. And the current controversy among the Trustees can be directly tied to the difficulty engendered when Trustees must evaluate whether a lead Trustee has properly carried out his or her delegated responsibility.
12. The Trustees have an inherent conflict of interest in making the decision to establish a CEO-based management structure since the establishment of such a structure may be materially adverse to their personal pecuniary interests. As discussed in more detail in Part XI, Section B of this Report, the establishment of a CEO-based management structure would directly impact on the level of reasonable compensation for the Trustees. Accordingly, the Trustees face a significant conflict of interest. In the face of such a conflict, it is difficult to conclude that their impartial and objective judgment would not be clouded.
Although your Master believes that the Court should be circumspect in involving itself in a management decision such as that involving the establishment of a management structure for the Trust Estate, your Master concludes, based upon the foregoing reasons and the current circumstances facing the Trust Estate, that decision should not be left solely to the Trustees.
35 Prior Master Benjamin Matsubara also noted that the five "CEO" system could create "logistical problems" with staff having to deal with and respond to five CEOs as opposed to one. Matsubara Report at 16; Matsubara Report 2, at 16.
B. The Need For Judicial Intervention Is Exemplified By The Conditions At The Kamehameha Schools.
The management structure of the Kamehameha Schools is intended to be a hierarchical one with a President heading the Kamehameha Schools who reports directly to the Board of Trustees. This governance structure, however, was undermined by the "lead Trustee" system which usurped the traditional powers reserved to the President and others in the management hierarchy at the Kamehameha Schools. This is extensively documented in the Yim Report, the WASC Report, and the Peterson Report . The Yim Report succinctly concludes:
The Lead Trustee system itself is inappropriate for a Board of Trustees to adopt as a means of oversight for the Education Group.
Yim Report at 22.
During the three fiscal years under review, your Master found that administration of the Kamehameha Schools fell into disarray. In 1993, the Trustees initiated a process aimed at establishing standards of performance and accountability for the administration of the Schools and the educational programs. While this was an appropriate governance process embarked upon by the Trustees, it quickly sprang offshoots, one of which was direct involvement by the Trustees in the day-to-day operations of the Schools.
Independent of the Yim Report's findings, your Master found, through numerous interviews of personnel, that the management system at Kamehameha Schools was undermined because of efforts by the Trustees to exercise direct management control over various aspects of the operations of the Kamehameha Schools. As a result, the authority of both the President and Vice President was subverted. Confusion was created regarding the channels of communication for approvals and supervision. Morale of management and staff deteriorated.
The degree of Trustee involvement in the day-to-day operations of the Kamehameha Schools reached an unprecedented level. Trustees engaged in comprehensive and detailed review of operational budgets for the Kamehamemeha Schools; intervened in student disciplinary actions; reviewed the hiring of professional staff and employees; became directly involved with the purchases of services and contracting on the campus; commissioned a study by Ernst & Young LLP to evaluate the numbers of landscape workers and custodial employees to support cuts in positions directed by them; exercised prior review authority with respect to all publications issued from the campus; involved themselves with screening tee-shirt designs; exercised oversight regarding the Hawaiian language curriculum; and promulgated policies regarding student-teacher ratios intended to deter expulsion of students.
Clearly, the governance structure and relationship between the Trustees and the management of the Kamehameha Schools needs to be better defined and put back in order.
Concerns regarding the governance and administration of the Kamehameha Schools were addressed in 1961 by the Booz Allen Report . After a comprehensive study of the Schools and their governance, the team of education experts made recommendations regarding governance of the Kamehameha Schools which are equally applicable in today's factual context. Your Master has therefore attached that portion of the Booz Allen Report as Exhibit J and recommends that the Trustees review and consider the principles set forth in it in their addressing of issues related to the governance of the Kamehameha Schools and the Trust Estate.
XI. TRUSTEE COMPENSATION
A. Trustee Compensation During The Periods Reviewed Were Consistent With State Law.
Trustee compensation has long been a lightning rod for criticism of the Trustees. Even in the earliest years of the history of the Trust Estate, the level of compensation paid to former Trustees was a source of controversy since relatively large amounts were paid to them during a time when the Trust Estate was cash poor and forced to liquidate land holdings to operate. The Hawaii Supreme Court has been called upon on numerous occasions to address various issues involving Trustee compensation. See, e.g., In re Bishop, 53 Haw. 604, 499 P.2d 670 (1972) (trustee commission on real property tax payments by lessees); In re Bishop, 37 Haw. 111 (1945) (trustee commissions on income from rental of school facilities); In re Bishop Estate, 36 Haw. 403 (1943) (recovery of reasonable expenses); Smith v. Lymer, 29 Haw. 169 (1926) (trustee commissions on final payments of principal).
Over the years, various legislative initiatives have been enacted attempting to control compensation paid to trustees of all charitable trusts, largely because of concerns over the level of compensation paid to the Trustees. In more recent times, as Trustee commissions have become inflated by an unprecedented growth of revenues enjoyed by the Trust Estate, the compensation of the Trustees has continued to be the subject of annual public scrutiny and controversy.
The Will of Princess Pauahi makes no provision for compensation of the Trustees. Instead, Trustee compensation has always been determined in accordance with whatever law governed compensation for trustees of charitable trusts.36
During the three years under review, compensation of the Trustees was governed by two statutory sections. HRS 607-20 sets forth a percentage schedule which prescribes the maximum commissions payable to Trustees based upon varying percentages of revenue or income during a calculation period of not less than one year. HRS 607-18(b) provides for the payment of commissions based upon a percentage of the "cash principal received after the inception of the trust" and "final payments" of cash principal. In accordance with the Stipulated Order, the Trustees have provided a description of the methodology used to calculate Trustee commissions for the 109th, 110th, and 111th accounting periods (FY 1994, FY 1995, and FY 1996). See Exhibit L.
Because of the major growth in revenues enjoyed by the Trust Estate since the early 1980s, the statutory formula has consistently yielded a maximum permitted commission substantially in excess of what the Trustees actually receive. For many years, the Trustees have "waived" commissions and have paid themselves amounts less than the maximum permitted by statute. This practice presumably reflects an attempt by the Trustees to pay themselves a "reasonable" compensation, notwithstanding what the statutory formula may permit.
Applying the statutory schedule of percentages to the relevant amounts during each fiscal year, the Trustees were entitled to and in fact paid as a group, after waiver of commissions, the following amounts during each fiscal year:Statutory Maximum Amounts Paid FY 1994: $11,377,484 $4,576,192 FY 1995: $7,514,218 $4,690,236 FY 1996: $5,810,214 $4,215,546
These amounts were audited by Coopers & Lybrand LLP the independent auditors for the Trust Estate and reported to be fairly stated, in all material respects, in relation to the basic financial statements taken as a whole.
Your Master, relying upon the reports of Coopers & Lybrand LLP, is satisfied and finds that the commissions payable to the Trustees in FY 1994, FY 1995, and FY 1996, were calculated and paid in a manner consistent with the Trust Estate's interpretation of statutory authority as reflected in Exhibit L.38
36 At the time the Will was prepared, there was no statutory provision for the payment of fees to trustees. It was not until 1928 that legislation was enacted which specified a schedule for trustee fees. See generally In re Estate of Bishop, 37 Haw. 111 (1945) (discussing the history of trustee compensation); Smith v. Lymer, 29 Haw. 169, 179 (1926)(explaining how, in the absence of specific statutory authority, by judicial construction compensation for trustees was determined by analogy to the statute providing for compensation of executors, administrators, and guardians).
37 The 1998 Legislature enacted Act 310 which becomes effective on January 1, 1999, and amends HRS § 607-20 to now provide as follows:
§ 607-20 Charitable trusts, special provision.
(a) Notwithstanding any other provisions, in the case of a charitable trust, the compensation of the trustees shall be limited to an amount that is reasonable under the circumstances.
(b) This section shall apply to existing and new charitable trusts established after the effective date of this Act; provided that any provisions in existing trust agreements regarding trustee compensation shall supersede this section.
38 Your Master makes no finding as to the "reasonableness" of the compensation. His review was limited to determining whether the compensation paid was consistent with HRS § 607-20 and HRS § 607-18(b).
B. Trustee Compensation May Be A Factor Impeding Management Reform.
In connection with the 105th Annual Account, the Court ordered that:
The Trustees are instructed that they are authorized to commission a comprehensive study of the matter of trustees' commissions by one or more nationally recognized experts in the fields of executive compensation and trustee compensation. Any such study shall be provided to this Court's master appointed for the accounting period in which the study is presented.
Findings of Fact, Conclusions of Law and Order Approving 105th Annual Report, filed herein on June 8, 1992, at 7.
Pursuant to that order, the Trustees then commissioned an assessment of trustee compensation by Strategic Compensation Associates which resulted in a report entitled An Assessment of Trustee Compensation for Kamehameha Schools/Bernice Pauahi Bishop Estate , dated April 30, 1993, appended to the Master's Report on the One Hundred Sixth Annual Report of the Trustees, filed herein on September 8, 1993.
In accordance with the Order Approving the 105th Annual Account, the Trustees were required to commission compensation studies every third fiscal year thereafter. During FY 1996, the Trustees caused two Trustee compensation studies to be prepared and presented to your Master for review. The two studies were a study titled Kamehameha Schools Bernice Pauahi Bishop Estate -- Trustee Compensation , dated March 15, 1996, prepared by Towers Perrin ("Towers Perrin Report ") and a study titled An Assessment of Trustee Compensation for Kamehameha Schools Bishop Estate , dated June 1996, prepared by SCA Consulting, LLC ("SCA Consulting Report "), whose principals are the same as those of Strategic Compensation Associates which prepared the trustee compensation study dated April 30, 1993.39
Your Master notes that the Towers Perrin Report rendered an opinion that the "competitive annual compensation for KSBE Trustees" was within a range of $683,000 to $758,000 at the median or 50th percentile and $921,000 to $1,021,000 at the 75th percentile for each of five Trustees. The SCA Consulting Report concluded that "a cumulative annual compensation range of $3.5 million to $5.5 million [for the five trustees as a group] appears reasonable and appropriate."
In reviewing the methodology utilized, your Master notes that both studies employed measures based upon an aggregation of governance and management functions by the Trustees. The SCA Consulting Report is premised upon the Trustees functioning as "both senior operating executives and as a Board of Directors." The Towers Perrin Report is premised upon the Trustees collectively performing "what would be five distinct and separate roles in other organizations: Board of Directors; Chief Executive Officer (CEO); Chief Operating Officer (COO); Chief Financial Officer (CFO); and Treasurer (investment function)." Each study compares the total compensation paid to the Trustees as a group with the total compensation paid in other comparison organizations to their combined senior management staff and board of directors.40
Based upon this methodology the two studies essentially conclude that the compensation paid to the Trustees is comparable to the total compensation paid in other organizations to the combined group of executives and directors performing the comparable functions of the Trustees.41
Your Master notes that the conclusion of each study is premised upon the assumption that the Trustees actually perform comparable roles as those of the CEO, COO, CFO, and Corporate Treasurer of large and complex business organizations. It is apparent that in the absence of that premise, the conclusion reached by the two studies would be different.
This raises a serious issue from an organizational standpoint for the Trust Estate. Can the Trustees be expected to exercise appropriate discretion when the decision required of them puts their interests in direct conflict with those of the Trust Estate? In other words, can the Trustees be expected to establish an organizational structure and hire the best qualified executives to assist them in managing the assets and operations of the Trust Estate, if doing so would significantly impact the basis upon which their current level of reasonable compensation is premised?
The SCA Consulting Report notes that the total compensation cost of the top five administrators of the Trust Estate was $875,226.42 This was less than the total amount paid to a single Trustee during the period studied. Moreover, the SCA Consulting Report also noted that the total cost of the 14 senior management employees comprising the asset management staff of the Trust Estate was $1,320,055. This means that the combined cost of the five top administrators of the Trust Estate and the senior asset management staff of the Trust Estate was less than 50% of the total amount paid to the five Trustees as a group. Combined with the fundamental premise upon which each compensation study is based, this fact supports an inference that the issue of compensation may influence decision-making by the Trustees regarding organizational structure and compensation of management employees of the Trust Estate.43
Your Master believes that the Trustees of the Trust Estate should be highly compensated individuals. The Trust Estate is a $6 billion entity with a significant social mission. The role of Trustee should command the focused attention of someone entrusted with that responsibility. Accordingly, the Trust Estate should reasonably compensate Trustees in amounts which will ensure the most capable and qualified individuals serving in that capacity will be fully committed to overseeing the accomplishment of its mission.
The issue of Trustee compensation, however, should be addressed by the Court in a manner which will ensure that sound organizational decisions affecting the management and operation of the Trust Estate will not be tainted by concerns over the impact such decisions may have on Trustee compensation. Currently, it would appear that the Trustees are faced with that dilemma and probably cannot objectively and impartially make those decisions free from the inherent conflict of interest involved.
39 Your Master has not determined why two compensation studies were commissioned and paid for at considerable expense by the Trust Estate during FY 1996. In the future, the Trust Estate should not be required to pay for more than one study performed by qualified and independent compensation consultants.
40 Neither report examined qualifications, experience, or performance as criteria for compensation.
41 An earlier study dated November 30, 1990, performed by the Hay Group utilized a similar method of analysis and reached a similar conclusion. However, the Hay Group Report only focused on compensation paid to top executives in comparison entities and not the combined compensation paid to executives and directors.
42 Includes salary, benefits and car allowance for the principal executives of the Education Group, Asset Management Group, Legal Group, Administration Group, and Budget & Review Group.
43 Currently, the Trustees are the only individuals who receive compensation, in part, based upon the investment performance of the Trust Estate. Investment professionals within the Asset Management Group receive no performance-based compensation despite the fact that their peers in other tax-exempt organizations and taxable entities performing similar functions receive performance-based compensation. If the Trust Estate is to internally manage investments, it must utilize competitive compensation packages to recruit and retain the best qualified and most competent investment professionals. Your Master believes the current lack of such incentives is, in part, attributable to the potential impact such costs would have on the "reasonable" compensation analysis as performed by consultants such as SCA Consulting and Towers Perrin.
C. The Intermediate Sanctions Law And Act 310 of 1998 Require Changes In The Procedure For Determining Trustee Commissions.
As discussed in detail in the 109th Master's Report the enactment of Internal Revenue Code section 4958 ("Intermediate Sanctions Law") requires that an appropriate compliance process be established. The Intermediate Sanctions Law is applicable to compensation paid the Trustees from and after September 14, 1995.
Currently, the Trustees determine their own level of compensation within the parameters set by state statute. However, in light of the Intermediate Sanctions Law, that procedure no longer is appropriate. For this reason, the 109th Master's Report recommended that the Trustees be required to develop procedures to ensure the Trust Estate is in full compliance with the Intermediate Sanctions Law.
In the Stipulated Order , the Trustees agreed that they would comply with the Intermediate Sanctions Law and adopt appropriate procedures and a compliance plan which they would provide to the court-appointed master and the Attorney General prior to the first scheduled hearing for the 112th Annual Account.
Since that time, the Legislature has enacted Act 310 of 1998 which has likewise established compensation that is "reasonable under the circumstances" as the state statutory standard. HRS 607-20, as amended (effective January 1, 1999).
XII. DUTY OF LOYALTY -- CONFLICT OF INTEREST
A. Trustees Are Subject To A Duty of Loyalty Which Demands The Avoidance Of Conflicts Of Interest.
The paramount duty of a trustee is the duty of loyalty, which requires the trustee to administer the trust solely in the interest of the beneficiary. This duty is imposed on a trustee not because of any express provision in the trust instrument but because of the fiduciary nature of the relationship that arises from the creation of the trust. 7 Scott, The Law of Trusts 170 at 311 (4th ed. 1987).
The Hawaii Uniform Prudent Investor Act specifies this duty at HRS 554C-5 where it states:
A trustee shall invest and manage the trust assets solely in the interest of the beneficiaries.
See also Restatement (Third) of Trusts 170(1)(1992) (The trustee is under a duty to administer the trust solely in the interest of the beneficiaries); Ahuna v. Dept. of Hawaiian Home Lands, 64 Haw. 327, 640 P.2d 1161 (1982) (approvingly citing 170 of the Restatement (Second) of Trusts ); Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964) (approvingly citing 170 of the Restatement (Second) of Trusts ); In re Estate of Campbell, 36 Haw. 631, 653 (1944) (approvingly citing 170 of the Restatement of Trusts ).
This rule recognizes the fiduciary relationship between the trustee and the beneficiary and the special duties that relationship imposes upon the trustee. As a result of the duty of loyalty, a trustee is prohibited from engaging in certain acts which might otherwise be lawful and permitted outside of the context of a trust relationship.
This strict standard has repeatedly been acknowledged by the Hawaii Supreme Court. For example, in Estate of Isenberg, 28 Haw. 590 (1925) the Supreme Court declared:
Courts cannot emphasize too strongly the duty of trustees to accept or hold no office or position imposing upon them interests or duties in conflict with their duties to the beneficiaries whom they represent as trustees or which will in any wise embarrass them in the performance of such duties as trustees.
Id., at 672. Accord In re Estate of Smart, 32 Haw. 943 (1934).
In Mid-Pacific Dress Mfg. Co. v. Cadinha, 36 Haw. 732 (1944) the Supreme Court stated:
[T]here is nothing in the law of fiduciary trusts that is more firmly settled than that a fiduciary shall not be allowed to thus serve himself while ostensibly serving the beneficiaries. . . . "The rule stands on the moral obligation to refrain from placing one's self in positions which ordinarily excite conflicts between self-interest and integrity. It seeks to remove the temptation that might arise out of such a relation to serve one's self-interest at the expense of one's integrity and duty to another, by making it impossible to profit by yielding to temptation. It applies universally to all who come within its principle." [citation omitted]. It is a salutary rule, designed to protect the weak and incompetent from the encroachment of the strong and artful. It rests upon two principles. One is that a trustee or other fiduciary has no right to speculate upon the confidence in him imposed or derive any personal advantage from his confidential relationship, since all his skill and labor is required to be directed toward the advancement of the purposes of the trust and the best interests of the beneficiaries. The second is that he is not permitted to create in himself an interest opposite to that of the party for whom he must act, for no man can faithfully serve two masters whose interests are in conflict. [citations omitted].
Id., at 742-743. See also In re Parker, 14 Haw. 347 (1902).
During the course of your Master's review of the three annual accounts submitted by the Trustees for approval, a number of allegations have been reported by the press raising issues of potential breaches of the duty of loyalty by one or more Trustees. Your Master has also noted from a review of subpoenas issued by the Office of the Attorney General that many of those allegations are the subject of an intensive investigation being undertaken by the Attorney General in her capacity as parens patriae. The Trustees have likewise noted the scope of the Attorney General's investigation by qualifying the certification letter provided to your Master pursuant to the Restated Guidelines .
Rather than undertake a duplicative inquiry into these allegations as being undertaken by the Attorney General, your Master has left that task to be completed by the Attorney General in her capacity as parens patriae. Instead, three specific allegations of conflict of interest have been examined by your Master to determine the manner in which the Trustees address and dispose of such issues. The objective of your Master's inquiry was to identify if an appropriate process is in place to ensure that such issues are properly examined by the Trustees to eliminate any cloud of doubt which may be cast regarding their conduct.
In this regard, your Master finds that appropriate procedures have not been followed to address potential conflicts of interest and to the extent conflict of interest policies have been adopted, the policies are inadequately administered.
B. Issues Related To The Co-Investment By Trustees In The McKenzie Methane Investments Have Not Been Appropriately Reviewed.
In the 109th Master's Report , it was noted that in March 1995, a news article in the Honolulu Advertiser reported on the McKenzie Methane investments of the Trust Estate raised a question of whether the personal investments of various Trustees and employees of the Trust Estate gave rise to a conflict of interest.
Your Master makes no finding of whether any Trustee or employee violated the duty of loyalty owed to the Trust Estate in connection with the McKenzie Methane investment. Your Master does find, however, that despite the fact that the co-investment by Trustees and subsequent actions by them related to the investment raised serious issues of potential conflict of interest, the manner in which the Trustees addressed the issue was inadequate and unsatisfactory.
1. Your Master notes that in entering into the McKenzie Methane investment, the
Trustees recognized the potential conflict of interest posed by their co-investment.
They contend, however, that their personal investment was in an investment interest
which differed from that in which the Trust Estate had invested. They also claim
that the Trust Estate was "precluded" from entering into the same investment
interest which they had invested in. Consequently, they concluded that there was
no legal obstacle to their co-investment. That conclusion may or may not be true.
However, your Master found no attempt by the Trustees to obtain a specific legal
opinion regarding the appropriateness of their co-investment. Instead, in defense
of the propriety of the co-investment the Trustees presented your Master with a legal
memorandum prepared by outside counsel which addressed an unrelated fact pattern
and which offered no conclusive advice or recommendation. There is no indication
that the outside counsel was attempting to offer any legal advice or guidance regarding
the specific circumstances involving the co-investment sought to be entered into
by the Trustees.
2. Your Master is also concerned about the failure of the Trustees to conduct an appropriate examination of the issue of conflict of interest after a serious question was publicly raised by the press. Your Master likewise raised questions in correspondence with the Trust Estate in August 1997 and in the 109th Master's Report regarding a number of issues. Despite the concerns raised by the press and your Master, the Trustees failed to initiate an appropriate process to review the legal issues raised. While the Trustees provided your Master with a boxful of documents related to the McKenzie Methane investment, missing from all the thousands of pages of documents was any legal review and analysis. It was only after prodding by your Master that legal memoranda prepared by outside litigation counsel involved in McKenzie Methane related litigation was furnished. Your Master found the legal memorandum addressing the conflict of interest issues to be incomplete in its analysis.
C. Issues Related To The Receipt Of Director's Fees By A Trustee While Serving As A Director Of A Corporation In Which The Trust Estate Has A Substantial Investment Require Proper Review.
In August 1997, your Master raised questions regarding the compensation paid Trustees as directors of corporations in which the Trust Estate held a material financial stake. This inquiry was likewise raised as a result of press reports regarding compensation allegedly paid by Mid-Ocean Limited to certain Trustees who served on its board of directors during periods when the Trust Estate owned a major investment stake in the corporation.44
Your Master notes that the mere service by a Trustee as a director of a corporation of which the Trust Estate is a shareholder is not per se prohibited or inappropriate. Nevertheless, the Mid-Ocean Limited situation presented a useful opportunity to examine the policies and procedures of the Trust Estate to deal with such circumstances and ensure that the potential pitfalls were addressed.
In late June 1998, your Master was furnished access to materials in response to his inquiry. The documents reviewed included a memorandum outlining various facts investigated and identified by outside legal counsel "A". There was also a separate legal memorandum prepared by a different outside legal counsel "B" reflecting the product of extensive legal research and generally discussing the law with respect to situations where a trustee also serves as a director of a corporation in which a trust has an investment. There was nothing to indicate that any legal counsel was charged with investigating the pertinent facts, the applicable law, and rendering an opinion as to the appropriateness of the particular conduct involved from the standpoint of the Trust Estate.
Your Master finds this procedure to be inadequate and unsatisfactory to ensure that the interests of the Trust Estate are properly protected. While a legal memorandum which generally discusses the law applicable to such situations in the abstract is helpful to develop policies and procedures for prospective use, it is not a substitute for a specific legal analysis of a concrete factual situation. Without a focused inquiry, it cannot be said that a proper analysis has been undertaken to ensure that the pertinent conflict issues have been identified in the context of the specific circumstances involved.
Again, your Master emphasizes that he makes no findings regarding the propriety of the payment of director fees to the Trustees in the specific factual context involving Mid-Ocean Limited. Rather your Master is more concerned about the failure of the Trustees to institute and employ a satisfactory procedure to ensure that a timely examination is made, independent legal guidance obtained, and action taken by the Trustees on behalf of the Trust Estate, if appropriate.
44 Two Trustees served on the Board of Directors of Mid- Ocean. Trustee Matsuo Takabuki served as a director between November 1992 and November 1993. He was succeeded by Trustee Henry Peters who served from November 2, 1993 until 1998 when his term expired.
D. Issues Arising From A Trustee Of The Trust Estate Assuming A Position As A Trustee Of The Robert Trent Jones Golf Club During Negotiations Between The Two Entities Were Not Adequately Reviewed.
In September 1997, your Master raised questions regarding press reports related to Trustee Peters being in a position of conflict when he served as a Trustee of the Robert Trent Jones Golf Club, Inc. ("RTJ Golf Club") which was then negotiating with the Trust Estate.
In response to those inquiries, the Trustees provided your Master with hundreds of pages of documents. More recently, on June 30, 1998, they furnished a copy of a legal memorandum prepared by litigation counsel who represented Trustee Peters, in his capacity as a Trustee of the RTJ Golf Club. That legal memorandum only reviewed the issue of conflict from the standpoint of the RTJ Golf Club and not the Trust Estate. The Trustees apparently elected to rely upon this legal opinion to dispense with the need for any further review of the issue.
Your Master finds this procedure to be inappropriate and inadequate. First, legal analysis regarding the potential conflict of interest should have been conducted before Trustee Peters was placed in the position where he would be involved in negotiating a transaction which involved adverse interests between the Club and the Trust Estate. As a consequence, the Trust Estate became embroiled in litigation and later rescinded and restructured a transaction with the RTJ Golf Club.
Second, it was inappropriate for the other Trustees to rely upon a legal opinion rendered by the defense attorney for Trustee Peters to dispense with any concerns regarding the fiduciary issues involved. Your Master believes it should have been obvious to the other Trustees that legal counsel retained by the Trust Estate should have conducted an independent analysis with preservation of the interests of the Trust Estate foremost in mind. There is no indication that such analysis was conducted at any time.
E. Trustees Are Under A Duty To Act To Prevent Or Redress A Breach Of Trust .
The failure of the Trustees to act appropriately in the face of serious questions regarding a breach of the duty of loyalty or any other breach of fiduciary duty could itself constitute a breach of duty as a trustee. See Restatement (Third) of Trusts (1992) 184 (duty to use reasonable care to prevent a co-trustee from committing a breach of trust or to compel a co-trustee to redress a breach of trust); Richards v. Midkiff, 48 Haw. 32, 396 P.2d 49 (1964) (approvingly citing Restatement (Second) of Trusts 184) (trustee who fails to act to prevent a fellow trustee from committing a breach of trust may also be guilty of a breach of trust). Cf. HRS 554A-6(c) (a co- trustee is not excused from liability by either failing to participate in the administration of the trust or failing to attempt to prevent a breach of trust). See 109th Master's Report at 86-88 (discussion of the duty of the Trustees to prevent a co- trustee from engaging in a breach of trust).
Implicit in that duty is the obligation to conduct an appropriate inquiry into any significant issues raised. Trustees should not hide behind a lack of specific knowledge of the facts which might constitute a breach. The Trustees must be vigilant in identifying situations which pose a potential for conflict of interests or other breaches of fiduciary duties. If sufficient facts are identified to raise a reasonable question of a potential breach, then the Trustees should act to ensure that the interests of the Trust Estate are protected. The Trustees should take appropriate measures to verify the facts and circumstances involved, identify the applicable legal standards, determine whether proposed or past conduct constitutes a violation of those standards, and determine if the Trust Estate has been injured45 or prejudiced by the acts or omissions, and take appropriate steps to seek redress for the Trust Estate.
Presented with a specific circumstance which poses a risk of a future conflict of interest between Trustees and the Trust Estate, the Trustees are duty-bound to seek appropriate legal guidance before acting.
In In re Isenberg, supra, the Hawaii Supreme Court reviewed a situation where a corporate trustee had accepted an appointment which eventually placed it in conflicting position with a pre-existing trustee position it held. The Court criticized the failure of the trust company to seek appropriate legal guidance to address the potential conflict of interest:
The evidence shows that advice of counsel was not sought by the Trent Trust Company, Limited, in the days when the transactions in question were being carried out, as to the legal effect of any of the steps that were being taken or proposed to be taken or as to its duty in the premises. In this respect, also, it failed in its duty, in a matter of such importance.
28 Haw. at 672-673.
Upon charging legal counsel with the task of evaluating a potential conflict of interest or compliance with some other fiduciary duty, legal counsel is himself or herself duty-bound to render an opinion based upon a diligent investigation and analysis of all pertinent facts and law and consistent with the interest of the Trust Estate. See Haw. Probate Rules 42 and Commentary.
In each of the three examples discussed above, to the extent that issues of potential conflict of interest were identified and examined, no conclusive determination of those issues was made by the Trustees. Despite the inconclusive result of the inquiry, the matter was left unresolved. Instead of leaving the issue open, the Trustees should have sought specific guidance from the Court by seeking instructions or some other relief.
The Uniform Trustees' Powers Act (HRS Chapter 554A) prescribes at HRS 554A-5(b) a statutory procedure with which is aimed to assist a trustee in situations involving a conflict of interest:
554A-5. Power of court to permit deviation or to approve transactions involving conflict of interest.
* * *
(b) If the duty of the trustee and the trustee's individual interest or the trustee's interest as trustee of another trust, conflict in the exercise of a trust power, the power may be exercised only by court authorization (except as provided in section 554A-3(c)(1), (5), (17), and (23)) upon petition of the trustee. Under this section, personal profit or advantage to an affiliated or subsidiary company or association is personal profit to any corporate trustee.
To ensure compliance with the duty of loyalty and HRS 554A-5(b), where there is any doubt as to a particular situation, the Trustees should exercise caution and seek instructions from the Court before acting. As the Hawaii Supreme Court has previously declared in an earlier case involving previous Trustees of the Trust Estate:
Equity has jurisdiction over all matters relating to trust property and in the execution and administration of the trust and in all cases of doubt as to their rights and liabilities and what their conduct should be trustees are entitled to and should seek instruction and direction from the court so as to prevent them from committing an innocent breach of trust.
Bishop v. Pittman, 33 Haw. 647, 653 (1935). Accord In re Allen, 35 Haw. 501, 538 (1940).
Situations involving potential conflict of interest, whether real or perceived, are matters of great sensitivity. While Trustees may act with the highest level of good faith and without any adverse financial consequence to the Trust Estate, a conflict of interest casts doubt on the integrity of their actions and the confidence placed in them. It is for this reason that the Trustees must be circumspect in avoiding conflict of interest situations and uncompromising in enforcing appropriate policies to rectify them when they occur.
The Anderson Report makes several recommendations for strengthening the Trust Estate's policies regarding Trustee conflict of interest and its procedures for reviewing fiduciary issues. The Trustees should give those recommendations serious consideration in addressing the concerns raised in this Report.
45 It should be noted that even if a trustee acts in good faith or if no injury to the trust results, the trustee might not be shielded from liability. In re Parker, 14 Haw. 347 (1902); See also Steiner v. Hawaiian Trust Co., supra (good faith or mistake in judgment is not a defense to a breach of trust).
F. Expenses Related To The Enactment Of The Intermediate Sanctions Law Were Inappropriate.
One particular situation where the individual interests of the Trustees and that of the Trust Estate were in conflict involved the expenditure of a substantial amount of Trust Estate funds in an attempt to influence Congress with respect to the enactment of the Intermediate Sanctions Law, IRC 4958.
The 109th Master's Report described that legislation as having been aimed at making principals of tax-exempts more accountable; improving compliance with the tax law; and providing the public with more information about tax-exempt organizations through disclosure requirements. It also incorporated the effort by Congress to mitigate the extreme penalty of the loss of tax-exempt status which a tax-exempt organization might face because of misconduct by its principals. The legislation provided for intermediate sanctions which would penalize the principals but save the tax-exempt organization itself from loss of its tax exemption. The legislation was beneficial for the Trust Estate since it would better insulate its tax-exempt status from the consequences of any improper actions by its Trustees.
A key component of Intermediate Sanctions Law is that for an organization to maintain its tax-exempt status it must not allow any of its earnings to "inure" to the benefit of a private shareholder or individual. " Inurement" is the improper diversion of an organization's net earnings by persons with substantial influence over the organization for their private benefit or that of related parties (such as family members). This would include excessive salaries, interest-free loans, use of resources of the tax-exempt for a private benefit, and other instances of self-dealing. Compensation of "disqualified persons" is an area of potential private inurement which is subject to close scrutiny. Whether compensation results in private inurement depends on its reasonableness.
Your Master has determined that without prior Court approval, the Trustees engaged the services of lobbyists during the periods reviewed and otherwise expended Trust Estate's funds and resources to initially oppose enactment of the Intermediate Sanctions Law. Their position was later modified to opposing certain aspects of the proposed Intermediate Sanctions Law. More specifically, the Trustees sought to influence the drafting of the legislative history of the Intermediate Sanctions Law through changes in the Committee Report which described elements of the proposed law.
The first involved an unsuccessful attempt to eliminate language in the Committee Report which clarified that the mere "fact that a State or local legislative or agency body may have authorized or approved of a particular compensation package paid to a disqualified person would not be determinative of the reasonableness of compensation paid" for purposes of determining private inurement.
Second, they unsuccessfully sought to add language to the Committee Report which established a rebuttable presumption of reasonableness with respect to a compensation arrangement with a disqualified person if such arrangement was approved by an independent board of directors. The Trustees sought to add language which would have established the rebuttable presumption of reasonableness if the compensation arrangement was approved by a "comparable entity"--apparently with the procedure of Probate Court approval of their annual account in mind.
Finally, they were apparently successful in suggesting language in the Committee Report which would allow the reasonableness of compensation to be measured against compensation levels paid by similarly situated "taxable entities" as well as tax-exempt organizations for functionally comparable positions.
Your Master finds that the expenditure of funds and other Trust Estate resources for the purposes of initially opposing enactment of the Intermediate Sanctions Law and later seeking the described modifications of the Committee Report to be expenditures which raise a serious question of whether such expenditures were necessary or appropriate and reasonable to carrying out the purposes of the Trust Estate. See In re Bishop Estate, 36 Haw. 403, 410-413 (1943). See also Bishop v. Pittman, supra at 654 (trustee has duty to preserve and protect trust property for the beneficiary).
Your Master also finds that the exercise of authority by the Trustees in expending Trust Estate assets for the purpose as described, involved a circumstance where their duty as a Trustee and their personal pecuniary interest were in conflict. They were therefore required to exercise their power over the Trust Estate assets, in incurring such expenditures, only by first obtaining court authorization upon a proper petition. HRS 554A-5(b).
XIII. THE TAX EXEMPT STATUS OF THE TRUST ESTATE
A. Report By Arthur Andersen LLP Regarding Matters Related To The Tax Exempt Status.
The Trust Estate enjoys the status of a charitable non- profit entity and as such under Internal Revenue Code 501(c)(3), it is exempt from most federal, state, and local taxes. This exemption from taxation is of considerable financial benefit to the Trust Estate and is granted by law because of the public benefit provided by such charitable entities.
The importance of the tax-exempt status makes the Trustees duty-bound to protect it. In addition to the general fiduciary duty under the Prudent Investor Rule,47 HRS 554A-3(b) of the Uniform Trustees' Powers Act mandates that:
[A] trustee has a duty to act with due regard to the trustee's obligation as a fiduciary, including a duty not to exercise any power under this chapter in such a way as to deprive the trust of an otherwise available tax exemption, deduction, or credit for tax purposes or deprive a donor of a trust asset of a tax exemption, deduction, or credit or operate to impose a tax upon a donor or other person as owner of any portion of the trust. "Tax" includes, but is not limited to, any federal, state, or local income, gift, estate, or inheritance tax.
As such, compliance with the regulations of the Internal Revenue Service is therefore essential to ensuring the maintenance of the tax-exempt status of the Trust Estate.
Arthur Andersen LLP has reviewed information related to the non-profit status of the Trust Estate and consulted with your Master regarding such matters. Because some of those matters are apparently the subject of the pending IRS Audit , your Master has not discussed them in this Report. Instead, your Master requests leave of the Court to conduct a confidential in camera conference to advise the Court of some of those pending matters.
B. The IRS Audit And Potential Conflicts Of Interest .
Your Master has determined that the IRS is engaged in a wide-ranging audit of the Trust Estate. That audit covers activities of the Trust Estate and Trustees during the three fiscal years under review. The scope of the audit appears to be very broad based upon the nature of Information Document Requests ("IDRs") served upon the Trust Estate. Those IDRs are very specific in identifying particular transactions, events, and records which are the subject of scrutiny.
Based upon the IDRs, it would appear that issues related to the individual Trustees and their conduct as well as the Trust Estate may become subjects of the audit. As such, negotiations between the IRS and the Trust Estate through the Trustees may involve situations of conflicting interests. Consequently, your Master believes that it may become necessary for the Court to exercise oversight in connection with such negotiations to ensure that any conflicts of interest are dealt with appropriately and that the interests of the Trust Estate properly protected.
46 Your Master received on August 3, 1998, a response from one of the firms involved in the legislative effort. This was in response to an earlier inquiry by your Master to the Trustees seeking information regarding this issue. As of the date of this Report, he has not had an adequate opportunity to thoroughly review the response and obtain additional pertinent information.
47 HRS § 554C-2(c)(3) requires that a trustee consider the ìexpected tax consequences of investment decisions or strategiesî.
XIV. CERTIFICATION TO THE COURT BY TRUSTEES AND KEY EMPLOYEES AND AGENTS
Currently, the Restated Guidelines require the Trustees to provide a certification of certain facts regarding the Trust Estate upon which the court's master and the Court may rely in reviewing the annual account. Findings of Fact, Conclusions of Law and Order Approving the 103rd Annual Report, filed herein on October 16, 1990, at 8. The 109th Master's Report recommended that the form of that certification be modified and improved.
In the Stipulated Order , it was agreed that the Restated Guidelines would be amended and the form of the certification would be modified to broaden the representations made by the Trustees and to require that certain key employees and agents of the Trust Estate be also required to provide certifications. Stipulated Order , Part I, Section T.2.b.
Pursuant to the Restated Guidelines , your Master was provided on December 27, 1997, with a qualified certification letter dated November 17, 1997, for each of the three fiscal years signed by all of the Trustees. See Exhibit O.
In accordance with the Restated Guidelines and the Stipulated Order , your Master has received the following additional certifications from the following individuals:
1. Certification letter of Trustee Richard Sung Hong Wong dated July 20, 1998, received by your Master on July 24, 1998.
2. Certification letter of Trustee Oswald Kofoad Stender dated July 20, 1998, received by your Master on July 24, 1998.
3. Certification letter of Trustee Gerard Aulama Jervis dated July 22, 1998, received by your Master on July 27, 1998.
4. Certification letter of Trustee Marion Mae Lokelani Lindsey dated July 20, 1998, received by your Master on August 6, 1998.
5. Certification letter of Trustee Henry Haalilio Peters dated July 20, 1998, received by your Master on August 6, 1998.
The Stipulated Order also required that the Trustees identify key employees and independent agents of the Trust Estate who are in a fiduciary relationship with the Trust Estate and authorize such persons to deliver certifications to the Court. The Trustees have identified the principal executives of the Trust Estate as such persons. Your Master has accordingly received certification letters from the following individuals:
1. Certification letter dated July 31, 1998, from Nathan T. K. Aipa, General Counsel of the Trust Estate, received by your Master on August 4, 1998.
2. Certification letter dated July 31, 1998, from Rodney J. Park, Director of the Administration Group of the Trust Estate received by your Master on August 4, 1998.
3. Certification letter dated July 31, 1998, from Yukio Takemoto, Principal Executive of the Budget and Review Group of the Trust Estate received by your Master on August 4, 1998.
4. Certification letter dated July 31, 1998, from Michael J. Chun, President of the Kamehameha Schools received by your Master on August 6, 1998.
Your Master notes that all of the certification letters are qualified based upon the outcome of various proceedings and other matters identified in the letters. Because of the late date on which the certification letters were provided to your Master, matters disclosed along with the qualified aspects of the letters have not been specifically investigated or reviewed by your Master. The certification letters will be filed with the Court by your Master in a separate filing at a future date.
Because of the qualified nature of the certification letters, your Master is unable to fully and adequately rely upon the statements and representations contained therein in reviewing the annual accounts of the Trustees. Your Master is therefore unable to recommend that the annual accounts be approved and closed at this time.
XV. REVISION OF THE RESTATED GUIDELINES
In the Stipulated Order , it was agreed that the Restated Guidelines should be amended. It was agreed that your Master, the Trustees, and the Attorney General should cooperatively work to develop amended guidelines which would strengthen, improve, and make clearer the current Restated Guidelines . The work related to developing amendments to the Restated Guidelines has not yet been initiated by the designated parties and therefore no recommendations related thereto are included in this Report. Instead, your Master anticipates that the parties will hereafter work on a separate submission for approval by the Court independent of the Court's action on the 109th, 110th, and 111th Annual Accounts.
XVI. REQUESTS TO THE COURT
Based upon the foregoing Report and recommendations, your Master respectfully requests that this Court accept this Report and after due hearing and consideration issue an Order which:
A. Directs the Trustees to fully comply with and implement the recommendations of your Master as set forth herein within the time frames specified unless otherwise ordered by the Court; and
B. Suspend further consideration and approval of the Annual Accounts of the Trustees for FY 1994, FY 1995, and FY 1996, until the conclusion of the proceedings referred to in the certification letters of the Trustees.
DATED at Honolulu, Hawaii, August 7, 1998.
COLBERT M. MATSUMOTO