September 12, 1998
ROBERT BRUCE GRAHAM, JR. 1305-0
ASHFORD & WRISTON
Ali_i Place, Suite 1400
1099 Alakea Street
Honolulu, Hawaii 96813
Telephone No. 539-0400
Attorney for The Trustees under the Will
and of the Estate of Bernice Pauahi Bishop,
IN THE CIRCUIT COURT OF THE FIRST CIRCUIT
STATE OF HAWAII
In the Matter of the Estate
|EQUITY NO. 2048
TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES; EXHIBITS "A" TO "D"; CERTIFICATE OF SERVICE
TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH,
AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS
OF THE TRUSTEES; EXHIBITS "A" TO "D";
CERTIFICATE OF SERVICE
TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND
THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS
OF THE TRUSTEES
II. THE OPENING SECTIONS OF THE
III. NEW ACCOUNTING FORMAT
IV. CONCERNING REPORTED INCOME
VII. UNIFORM PRUDENT INVESTOR ACT
VIII. STRATEGIC PLANNING
IX. THE "LEAD TRUSTEE" SYSTEM
X. TRUSTEE COMPENSATION
XI. DUTY OF LOYALTY AND CONFLICT OF INTEREST
XII. INTERMEDIATE SANCTIONS
XIII. TAX ISSUES
XIV. REVISION OF THE RESTATED GUIDELINES
XV. THESE ACCOUNTS SHOULD BE CLOSED
XVI. THE ROLES OF THE MASTER AND THE COURT
TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND
THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES
This is the Response of the Trustees Under the Will and of the Estate of Bernice
Pauahi Bishop, Deceased, to the Master's Consolidated Report On the One Hundred
Ninth, One Hundred Tenth, And The One Hundred Eleventh Annual Accounts Of The Trustees
filed herein on August 7, 1998.1
A. Procedural Background
The Master's Consolidated Report concerns the Trustees' Accounts for three fiscal years, from July 1, 1993 to June 30, 1996. The Consolidated Report follows upon the Master's earlier report as to the Trustees' 109th Annual Account (FY 1994), filed herein on November 17, 1997 (hereinafter, the "First Report"). In their Response to the First Report, filed herein on December 3, 1997 (hereinafter, the "First Response"), the Trustees accepted the Master's recommendations while rejecting or disputing much of his narrative. The Trustees observed that the narrative was based upon a flawed analysis of their financial records and urged that the Master revisit the issues with the assistance of an international accounting firm. They invited a full financial and management audit of the Estate, to be conducted by such a firm under the auspices of the Master. Pursuant to a Stipulation Concerning Master's Recommendations (109th Account) between the Master and the Trustees, in which the Attorney General joined as to most but not all issues, the substance of the Master's recommendations was adopted and it was agreed that the Master would commission the financial and management audit the Trustees had proposed. The Stipulation was approved by this Court and filed herein on December 19, 1997. (The Stipulation is hereinafter referred to as the "December 19 Stipulation".) Subsequently, the Master selected Arthur Andersen, LLP to undertake the audit.
B. Financial Audit
The Trustees were not obliged to undergo a full financial and management audit and the fact that they invited one is compelling evidence of their good faith and their confidence in their record. Significantly, the financial audit has found no irregularity or impropriety in the audited financial statements previously submitted to this Court. As is discussed below, Arthur Andersen's revised format of financial statements has been prepared in cooperation with the Estate's staff and is consistent with the Estate's own reports.
C. Management Audit
The management audit is a statement of opinion and offers advice to the Trustees
concerning management issues. Such audits are expected to be critical and to recommend
change. They are merely opinions, however, and carry no guarantees. While they offer
insights and professional advice, they do not have the benefit of the long term experience
of the institutions they examine. Boards to whom such reports are presented must
review and consider the consultant's observations and recommendations in light of
the board's own knowledge of the organization. Blind implementation of a management
consultant's report would be no better than blind disregard of it. Thus, Arthur Andersen's
management audit is a management tool for use by the Trustees in the prudent exercise
of their discretion.
In some areas, Arthur Andersen's comments represent popular and current investment management theory and practice. In other areas, the comments represent the views of consultants who do not fully comprehend the Trustees' policy of retaining the Estate's core assets - the lands endowed to it by Bernice Pauahi Bishop - despite the current low productivity of lands now designated for agricultural and conservation uses. Arthur Andersen's comments concerning the Estate's landholdings in Kakaako suggest a lack of understanding of the current economic climate in Hawaii and the realities of the Honolulu real estate marketplace.
The three years currently under review were a period of resolution. The incumbent
Board of Trustees was constituted in December, 1994, when Trustee Jervis succeeded
Trustee Thompson, and has turned around a number of previously troubled investments,
making them productive assets of an enhanced and increasingly diversified portfolio.
Many of the Board's efforts came to fruition outside the accounting period and are
not reported by the Master. This results from a procedure which looks at the Accounts
on a fiscal year basis and not necessarily in context. The system is such that the
product of the Trustees' efforts will not be reported to the Court for another several
The Trustees' Accounts cover a three-year window in the 113 year history of the Estate. The Master is supposed to comment upon events occurring during the period under review. In fact, the Consolidated Report is not wholly confined to the period under review. It reaches into other years, before and after, to emphasize its theme. Unfortunately, the actual accounting period includes the establishment of loss reserves (and the recognition of some actual losses) resulting from troubled pre-existing investments. It generally does not include the "rest of the story": the time when troubled investments became winners, privately held investments went public, and the Estate and its subsidiaries began reaping hundreds of millions, even billions, of dollars in gains.
E. Theme of the Consolidated Report
The theme of the Consolidated Report is that the Estate needs more and better documentation, planning and internal procedures, and systems reorganization. The Master recognizes that the Estate has been transformed into "a complex business organization with wide-ranging and sophisticated domestic and international financial investments" and that the challenges facing the Trustees are "daunting." C.R. at 11.2 He observes that internal procedures have not always kept pace with the Estate's rapid evolution and his Consolidated Report chronicles certain deficiencies in process and procedure which he and Arthur Andersen perceive. Various specific transactions are used to demonstrate the Master's views. Significantly, with the sole exception of expenses incident to the Estate's efforts concerning Intermediate Sanctions legislation, the Master recommends no surcharge or other sanction of the Trustees; his recommendations are forward looking and he makes no findings of malfeasance or breach of duty.
F. The Master's Recommendations
The Master makes nineteen specific recommendations within an extensive narrative. The Trustees find most of the Master's recommendations helpful and have undertaken to work in good faith with the Master to achieve stipulated agreements concerning them. The product of that effort will be separately reported to this Court at or prior to hearing of the Trustees' 109th, 110th and 111th Accounts.
G. This Response
This Response will focus primarily on issues raised by the narrative portions of the Master's Consolidated Report. The Trustees are distressed by its negative tone and implications and believe that further discussion is necessary in order that the Court may have a more complete picture of the matters presented. Inasmuch as the Master uses specifics primarily as support for his underlying theme of the need for systemic changes, point by point discussion or rebuttal is neither necessary nor appropriate. Instead, this Response is intended to address those matters which the Master suggests need further explanation and to respond generally to the balance of the Master's narrative. Should the Court require further information concerning any matters raised by the Master, the Trustees will be pleased to respond.
II.THE OPENING SECTIONS OF THE CONSOLIDATED REPORT
The Master urges that Bernice Pauahi Bishop mandated disclosure and accountability and quotes a provision of her Will requiring an annual report to the Court of receipts and expenditures and publication of an inventory of properties. C.R. at 1. The Trustees are familiar with the requirements of the Will. They note that their annual reports are also subject to provisions of Hawaii law, the Rules of the Probate Court, and the much-amended and restated Minimum Guidelines specifically applicable to the Estate. These authorities are not always in harmony, are sometimes amended after filings have been made but before hearings are held, and, in the case of the Probate Court Rules, are ill-suited to a trust estate as large and complex as the Kamehameha Schools Bernice Pauahi Bishop Estate.3
B. The First Report and the Trustees' First Response
The Master's Consolidated Report incorporates by reference his First Report. C.R. at 2. Likewise, the Trustees incorporate by reference their First Response thereto. The Trustees submit, however, that much of the Master's First Report was the product of a flawed analysis, largely attributable to a failure of communication between the Estate staff and the Master's accountant. The Master's First Report and the Trustees' forceful First Response to it are not representative of the professional environment in which the Master's further review has been made.
C. The Arthur Andersen Report Should Remain Sealed
The Trustees concur with the Master's view that the Arthur Andersen report is a sensitive internal management document which should remain under court seal and not be made public. C.R. at 4. Nothing in the Will, the statutes or the rules of court requires publication of the financial and management audit. With the Trustees' consent, the Master has published an executive summary by attaching it as Exhibit "B" to his Consolidated Report. All persons who have any legitimate need to review the full report, including this Court, the Master and the Attorney General, have full and unredacted copies of it. Further publication is unnecessary and inappropriate.
D. Trustees' Compliance With Guidelines
The Master commends the Trustees for enabling the financial and management audit
conducted by Arthur Andersen and acknowledges that the Trustees provided him with
information required by the Minimum Guidelines, as amended, and by the December 19
Stipulation. C.R. at 6 & 7. These acknowledgements should lay to rest any question
concerning the Trustees' willingness to cooperate with the Master and open the Estate's
records to his review and inspection.
Another amendment of the Guidelines is contemplated by the December 19 Stipulation. (December 19 Stipulation at 29) The Guidelines have proved unsatisfactory to everyone involved. Almost every master since their promulgation has requested amendments to them. As a result, the Guidelines have failed to provide either the Estate's staff or the masters with any certainty as to what constitutes appropriate initial production and acceptable formatting. As more fully shown in Part of this Response, it is time to redesign the Guidelines rather than merely restate them.
III. NEW ACCOUNTING FORMAT
A. The Master's Recommendations
The Master's first and second recommendations are as follows:
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.
C.R. at 14.
Recommendation No. 2:
Corpus And Revenue Activity Should Be Specifically Reported.
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.
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.
C.R. at 31.
These recommendations concern the format of the Estate's annual financial statements and supplemental schedules submitted to this Court. The Master recommends the form of financial statements developed by Arthur Andersen in consultation with the Estate's staff. The Trustees are willing to make reasonable changes in the format of their reports to this Court. In the December 19 Stipulation, they agreed to file special financial statements for comparison purposes. They are willing to prepare and file special purpose financial statements hereafter. The format of those statements must be developed, however.
(The second part of the Master's second recommendation is discussed in Section
The financial statements envisioned by the Master's first and second recommendations cannot be permanently based upon a particular form. Not only does GAAP (Generally Accepted Accounting Principles) change from time to time but much of the information presented in the Arthur Andersen format of the Estate's financial statements is outside or beyond GAAP and subject to a wide latitude of discretion and opinion. Where there are no rules, reasonable judgment must prevail. With this caution, the Trustees accept the spirit of the Master's first and second recommendations concerning the form of the financial statements and the accompanying notes and schedules.
B. GAAP Accounting
GAAP is not a matter of law and GAAP changes from time to time. The Estate's financial statements for the 109th and 110th Annual Accounts followed accounting principles consistent with provisions of the Will of Bernice Pauahi Bishop and applicable state and federal laws. Where the Will is silent on accounting matters, GAAP was followed. In 1996, GAAP changed to require consolidation of wholly and majority owned subsidiaries. The Trustees chose not to adopt this change in the belief that accounting for these investments on a consolidated basis was not appropriate because the business operations of the subsidiaries were unrelated to those of the Estate. This is so noted in the report by the Estate's independent accountants, Coopers & Lybrand.
It is not unlawful for trustees or others to employ a "modified" GAAP approach, using accounting principles that are not in full compliance with GAAP. GAAP accounting is not required by law or rule of court. The official Commentary to Rule 26 of the Probate Rules says that a committee of accountants, attorneys, masters, the Attorney General and all trust companies reached no agreement concerning the form of trust accounts, and concludes "This rule does not mandate any form of detailed accounting, leaving that to the fiduciary's discretion." 4
The Master objected, however, to the Trustees' use of modified GAAP and the Trustees agreed to file financial statements in accordance with GAAP for comparison purposes . (December 19 Stipulation at 4) Ultimately, Arthur Andersen prepared financial statements for all three accounting years.
The December 19 Stipulation did not contemplate that Arthur Andersen would re-audit the Estate's three previously audited financial statements. Nonetheless, this was done at the Master's request in order that the three years under review would be presented in a uniform manner. As a result, the Estate's financial statements for FY 1994, 1995 and 1996 have been independently audited twice, once by Coopers & Lybrand (now know as PricewaterhouseCoopers) and once by Arthur Andersen. It is important to note that GAAP accounting and the format recommended by Arthur Andersen have not changed the underlying numbers. The Estate's financial statements reported on by Arthur Andersen (full GAAP) and those reported on by Coopers & Lybrand (Modified GAAP) have been fully reconciled.
The Master expresses his preference for full GAAP financial reports for purposes of the Trustees' annual accounts to the Court. While the Trustees have no objection to filing such special purpose financial statements for use in connection with their annual accounts, they are not convinced that full GAAP financial statements are appropriate for all purposes. Specifically, the Trustees are not convinced that it is helpful for less than wholly-owned Estate investments to be consolidated with the Estate's own financial information. They believe that modified GAAP, in which these investments are not consolidated, is a more accurate reflection of the core financial status of the Estate. They may continue to have general purpose financial statements prepared according to modified GAAP for other users of the Estate's financial statements while filing special purpose financial statements for the use of the masters.
The consolidation issue presented by GAAP versus Modified GAAP accounting concerns the consolidation of the financial statements of less than wholly-owned subsidiaries with the Estate's financial statements. GAAP generally requires consolidation if the "parent" owns more than 50% of an entity. This may be useful information to investors thinking of buying shares in a publicly traded parent and who may not have access to the subsidiaries' financial statements. It is less clear how such consolidation benefits the Master or the Court, who have access to all of the financial statements of the Estate and its subsidiaries.
On page 25 of his Consolidated Report, the Master shows the impact of consolidating the Estate's balance sheet with that of SoCal, a California savings bank company, in which the Estate held a majority interest. SoCal operates in a highly regulated industry and the inclusion of SoCal's assets, which the Estate could not reach nor use, drove the consolidated total of assets up by about $1.8 billion in FY 1995 (from $2.2 to $4.0 billion) and $1.6 billion in FY 1996 (from $2.4 to $4.0 billion). Including SoCal's liabilities, which were not the Estate's direct liabilities, drove the total of liabilities up by about $1.7 billion in FY 1995 (from $0.7 to $2.4 billion) and $1.5 billion in 1996 (from $0.7 to $2.3 billion).5 These are tremendous distortions, considering that while the GAAP format consolidates the entities for accounting purposes, the Estate at no time had any direct right to utilize SoCal's actual assets nor any direct obligation for its liabilities. GAAP consolidation is an accounting device that does not necessarily reflect the core operations of the Estate from a financial perspective.
The information upon which Arthur Andersen developed the "full GAAP" financial statements was at all times available to the Master at the Estate's offices. The issue was always one of format, not availability. GAAP will continue to change. Inevitably, the format recently devised by Arthur Andersen will become obsolete. The primary concern of standing orders of this Court should be the availability of the information to the Master. The formatting, which is ephemeral, should be of secondary concern and should be designed to assure that useful and accurate information is readily available to the Court and its masters.
C. Segregation of Revenue and Corpus Accounts
The Master urges adoption of a format of reporting that segregates the revenue
account and the corpus account. C.R. at 13 & 16.
The Master's recommendation really concerns the form of the financial statements filed with the Court and the accumulation of income. These are discussed below in Part of this Response. The Trustees do not object to segregating the two accounts in the reports filed with this Court and will do so in the future.
Three important point must be made: (1) The Estate already segregates the revenue and corpus accounts. Segregated revenue and corpus accounts are maintained in regular internal reports. These reports were provided to and acknowledged by Arthur Andersen. They have always been available to the masters. (2) Segregation of the revenue and corpus accounts is not required by GAAP in reporting on general purpose financial statements and there is no statute or rule that requires any particular form of trust accounting. The Guidelines do not require segregation of the two accounts. (3) The Trustees are not in violation of a prior court order. (This issue is discussed in detail in Section of this Response.)
D. Notes To Consolidated Financial Statements
The Master states that the Notes to the consolidated financial statements provide a better understanding of the Estate's financial condition. C.R. at 13. The Notes provided by Arthur Andersen go well beyond the requirements of GAAP, which establishes minimum disclosure requirements. This is another example of a format change which is not required by GAAP, statute, rule or Guideline and reflects merely a personal preference. For example, the SoCal information contained in the Notes is taken directly from a subsidiary's audited financial statements that were at all times available to the Master. Since the Notes will vary from year to year and can be in excess of GAAP minimum requirements, there can be no permanent agreement concerning their content. Notes to an entity's financial statements are matters within the discretion and opinion of management and the professional judgment of the independent auditor.
E. Supplemental Schedules
The supplemental schedules attached to the financial statements are wholly outside
any requirements of GAAP. Arthur Andersen conceded that the schedules were not required
and was prepared to issue its certification of the financial statements without them.
The content of the schedules of Trustee commissions is identical to that previously
filed by the Trustees as Exhibit "I" to the petitions for approval of each
of the three accounts. Nonetheless, the Trustees acceded to the Master's request
that the schedules be published and are willing to have similar schedules prepared
in connection with future accounts. It will, however, be necessary to develop benchmarks
more appropriate to the Estate's portfolio. The Estate's staff is reviewing this
issue. Benchmarking is discussed below in Section .
IV.CONCERNING REPORTED INCOME FROM GOLDMAN SACHS
The Master remarks that income from Goldman Sachs was "misreported" on the Trustees' financial statements. C.R. at 20. The Master also acknowledges that the Estate's own staff and independent auditor (Coopers & Lybrand) discovered the matter and rectified it. C.R. at 20, fn. 7. The Master does not explain, however, that the "misreporting" arose when certain assumptions concerning the Goldman Sachs investment changed. The accounting method originally employed was not improper based upon the accounting assumptions that had been made at that time. When the assumptions changed, the Estate and Coopers & Lybrand did an extensive analysis and a cumulative adjustment was made for the fiscal year ending June 30, 1997, outside the current accounting period. Arthur Andersen had the benefit of the Estate's analysis and of hindsight when it recast the financial statements for FY 1994, 1995 and 1996. There was no purposeful "misreporting" and Coopers & Lybrand had already discovered the issue. Investments evolve, assumptions change and adjustments are made when necessary.6
V.CONCERNING ASSET VALUATION
The Master notes that the Trustees' List of Assets shows the Estate having an aggregate value in excess of $5.7 billion as of June 30, 1996. C.R. at 26. The Master correctly notes that the value includes adjusted Hawaii real estate values, previously reported by the Estate pursuant to prior order of this Court at 1965 values and now reported at current adjusted tax assessed values. The Master also correctly notes that the market value of the Estate's landholdings may be different from the adjusted tax assessed values and that the Estate is carrying its investments through Pauahi Holdings at "book value." For example, the Estate's interest in Goldman Sachs is carried at its cost (about $500 million) despite current press reports that it may now be worth $3 billion.
While comparatively modest losses and loss reserves are reported in detail, the Trustees have reported some of the Estate's significant investments at cost even though significant appreciation in value may have occurred. This reflects a conservative accounting posture consistent with GAAP. The Estate's gains will be reported when they are realized in a subsequent accounting year. Unfortunately for the incumbent Trustees, this means that their reports reflect losses and loss reserves arising out of past activities, often of prior boards, without showing gains that likely outstrip the performance of virtually all other portfolios in Honolulu.
Inclusion of estimates of the value of the Estate's many highly successful investments would make the pending accounts look better. Many have advised the Trustees that they should take the opportunity to advertise their successes. They choose not to do so in order that public offerings and other events concerning those investments not be affected by an insider's published estimates of value. The Trustees' circumspection in this regard is prudent but results in an under-reporting of the Estate's successes.
VI.ACCUMULATION OF INCOME
Part VII of the Master's Consolidated Report concerns the issue of accumulated income and contains six of the Master's nineteen recommendations. The degree of the Master's apparent concern with accumulated income is disproportionate to the magnitude of the actual issue. The accumulated income exists unimpaired and is being held solely for the benefit of the Kamehameha Schools. There has been no misappropriation, misapplication or misuse of funds. The question is primarily one of documentation and will be resolved promptly by the preparation of special purpose financial statements for the use of the Court and its masters.
B. Explanation Concerning Segregation of Corpus and Revenue Accounts
In his second recommendation, the 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." C.R. at 31. Accordingly, the Trustees offer the following explanation to the Court. Some of the history is relevant to other matters discussed in this Response and is included here for the sake of context and completeness. As will be seen, no prior order of the Court has been violated.
Richard S. Sasaki, master as to the Trustees' Eighty-first Annual Report (FY 1966) was critical of Trustees Midkiff, Murray, Richards, Lyman and Keppler. The Estate's assets at the time were reported to be about $217 million. About $4 million had been spent for the operations of the Kamehameha Schools. Mr. Sasaki was dissatisfied with the form of the Trustees' accounts, the bookkeeping system employed, the methods for valuation of Estate assets, the quality of investments, the degree and quality of planning, the rate of return, operating expenses and the quality of the Estate's due diligence.
Mr. Sasaki, however, recognized the unique nature of the Estate and his words concerning its income producing operations are insightful:
Report to the Attorney General On the Petition of the Trustees
For Approval of the Eighty-first Annual Report at 25-26 (emphasis added).
Among Mr. Sasaki's concerns was the treatment of accumulated income. He objected
to the Trustees' treatment of recoveries of off-site development costs as income
rather than corpus. He urged that "the Court should insist upon a program
of the maintenance of corpus values." Id. at § 36.
He noted that the there had been four years of deficit operations and that the trend was worsening, saying "[t]he result of the deficiency in revenues for so many years has been the curtailment of Kamehameha School's enrollment and programs." Id. at § 39. He criticized the Trustees' low revenues from leasing activities and questioned whether a $1.3 million investment in stocks and bonds was "justified in light of the low returns derived from these investments." Id. at § 42.
He concluded with three questions: whether recoveries of development costs should continue to be credited to income rather than corpus, whether fixed assets could be paid for out of accumulated income and "Whether or not the Trustees should be required to segregate all accounts as between income and corpus and not only in the equity accounts as previously done." Id. at § 43
Upon this, the Attorney General recommended that recoveries of development costs be credited to income and said "The Trustees should be required to segregate accounts as between income and corpus and not only in equity accounts as previously done." Report of the Attorney General With Respect To The 81st Annual Account ..., filed herein on February 10, 1970, at 6.
In their Exceptions to the Attorney General's Report, the Trustees disputed the
Attorney General's position concerning segregation of accounts. This Exception was
item number 14 in their response.8 Exceptions To
The Report Of The Attorney General On The 81st Report Of the Trustees, filed herein
on June 2, 1970.
On July 21, 1970, a one page pre-hearing stipulation was filed in the First Circuit Court. It was signed on behalf of the Trustees and the Attorney General and was approved by the presiding judge. A true copy of the stipulation is attached hereto as Exhibit "A". It provides is relevant part as follows:
Pursuant to the informal conference had July 15, 1970 on the Exceptions of the Trustees to the report of the Attorney General on the 81st Account,
IT IS HEREBY STIPULATED:
The 1970 Stipulation was not a Court order and did not memorialize the terms of the "arrangement" between the Trustees and the Attorney General. While it was approved by Judge Fukushima, its function was merely to record an agreement between the Trustees and the Attorney General concerning which of the Trustees' Exceptions would require further hearing. The Trustees were entitled to a determination by the Court concerning each of their fourteen Exceptions. By the Stipulation, ten of them, including Exception No. 14 concerning the segregation of accounts between income and corpus, were withdrawn from hearing.
There is no Court Order concerning the undisclosed arrangement. The Order Approving the 81st Annual Account, a true copy of which is attached hereto as Exhibit "B", recites that the Attorney General recommended approval of the Account subject to the Stipulation. It orders that the Account be approved and allowed. Thus, the Court record concerning the disposition of Mr. Sasaki's concern about segregated accounting is, at best, murky. The Master's categorical statements concerning the matter are simply inaccurate.
For the next eighteen years, the Estate's financial statements segregated the income and corpus accounts. In 1988, however, the Estate's Controller requested advice from the Estate's General Counsel regarding the transfer of accumulated income to corpus. The Controller's inquiry arose out of concerns about the presentation of the Estate's financial reports to "corporate America."
As the Estate embarked upon its process of diversification and redeployment of the proceeds of forced sales under so-called "fee conversion" programs, it was asked for its financial reports by prospective lenders, credit agencies, investment partners and others, all of whom were accustomed to corporate balance sheets and financial reports. The form employed by the Estate may have been useful to the masters but it was confusing to persons unfamiliar with trust accounting. As Mr. Sasaki had observed in 1970, the "conglomeration" of trust and business accounting reflected the inherent problem of conducting the Estate's business in the forms customarily employed for trusts. Retained earnings, capital, equity, and similar nomenclature were familiar to corporate America. "Accumulated Income" was not.
The Controller advised General Counsel that the aggregation of accumulated income with corpus was permitted by GAAP. He asked whether trust law permitted the transfer.
The Office of General Counsel researched the question, gathering copies of prior court orders, masters' reports, relevant provisions of the Will of Bernice Pauahi Bishop, the opinion of the Court in Collins v. Hodgson, 36 Haw. 334 (1943), and other pertinent information.
General Counsel advised the Controller that accumulated income could be transferred to corpus. General Counsel based this conclusion in part on (i) a 1977 order of this Court authorizing commingled investment and reinvestment of accumulated income and corpus in income-producing property; (ii) the recommendation of the master of the 99th Account that long range expenditure of accumulated income be reflected in the Ten Year Plan; and (iii) the fact that the Will of Bernice Pauahi Bishop contemplates the use of both income and corpus to cover maintenance expenses at the Kamehameha Schools.
General Counsel's view was that since income and corpus may be commingled for investment and used for the same purpose of maintenance, it was not important that a separate income account be reflected on the Estate's financial reports. General Counsel recommended that the income so transferred to corpus be "earmarked" and noted that any uncertainties could be addressed to the Court in a petition for instructions.
It is clear that General Counsel was not aware of the unspecified arrangement between the Trustees and the Attorney General. The research file contains numerous documentary extracts and General Counsel's opinion to the Controller refers to many of them. The 1970 Stipulation and its uninformative reference to an off-record arrangement as to Exception 14 is not among the research materials.
In turn, the Controller reported to the Trustees that staff recommended reclassification of accumulated income to corpus. The staff report states in relevant part as follows:
Kamehameha Schools/Bernice P. Bishop Estate has maintained and reported its Fund Balance in two separate fund categories: Corpus and Accumulated Income.
The Corpus Account originally represented the initial appraised value of all the lands and other property inventoried upon the death of Bernice Pauahi Bishop. Over the years, net adjustments based on the State Tax Assessor's valuations were made periodically to the initial appraised value of the lands. These adjustments were recorded in the Corpus Fund and this action, in effect, destroyed the identity of the original Corpus....
The Accumulated Income Fund records the cumulative net income/expense after the cost of operating The Kamehameha Schools. This Fund represents the cumulative excess of operations that together with Corpus is available for the support and maintenance of the Kamehameha Schools.
In effect, both the Corpus and Accumulated Income Funds are wholly and solely restricted for the support of the Kamehameha Schools.
General Counsel's opinion (to be submitted separately) in support of the recommendation made in this report, indicates that terms of Pauahi's Will and Codicils allows the use of Corpus as well as the annual income for the maintenance and operations of the Kamehameha Schools. Discussions with Coopers & Lybrand, CPAs indicates that the proposed reclassification of Accumulated Income to Corpus does not violate generally accepted accounting principles.
Staff Report, June 30, 1988 (emphasis in the original).
The board of trustees approved the recommendation and the June 30, 1987 balance of accumulated income was reclassified for accounting purposes as Corpus as of July 1, 1987.
Thus, where the Estate's audited financial statements for FY 1987 included separate entries for Corpus ($477,872,269) and Accumulated Income ($65,629,805), the audited financial statements for FY 1988 contained a single new entry, "Kamehameha Schools/Bernice P. Bishop Estate equity" in the amount of $761,699,677. The accompanying restated entry for the prior year (FY 1987) was $543,502,074, which was the total of the previous year's separate entries for Corpus and Accumulated Income. Copies of the pages showing these entries are attached as Exhibits "C" and "D". The 1988 financial statements also contained an entry for the "Excess of income over cost of operating The Schools" in the amount of $11,123,200. This amount became accumulated income on the first day of the ensuing fiscal year.
Significantly, neither the next master nor the Attorney General complained of this change in format. If either were concerned about the segregation of income and corpus accounts, the 1988 financial reports which reported a combined "equity" rather than separate corpus and accumulated income figures, should have triggered some response. In all likelihood, the Attorney General in 1988 was as unaware of the 1970 "arrangement" as was the staff of the Estate, and the master did not find the presentation in the audited financials improper.
This is not to say that a separate record of accumulated income cannot be maintained nor to dispute that there may have been, in 1970, some agreed arrangement concerning the matter. But the incumbent Master's characterization of the Trustees's 1988 action as a 'unilateral alteration' suggests a degree of bad faith or wrongful intention that was simply not present. Eighteen years later, personnel had changed and memories had faded (including, apparently, the Attorney General's). A change in format was recommended to the Trustees and approved by them. The Estate's financial report now was more consistent with the format familiar to its lenders and business partners.
Thereafter, accumulated income again was transferred to corpus in 1992 and in subsequent years. In 1995, expenditures of more than $30 million in excess of revenues were funded out of the consolidated account, consistent with the Controller's 1988 recognition that "[i]n effect, both the Corpus and Accumulated Income Funds are wholly and solely restricted for the support of the Kamehameha Schools."
The accumulated income fund can be readily segregated. The funds exist and can be traced from one audited financial report to the next. The report for each year after 1988 contains an entry for the excess (or deficit) of revenue over expenses. The total of these amounts is the total of accumulated income after 1988.
In 1988, General Counsel recommended that the accumulated income be "earmarked." The word is not a term of art. The Controller and other staff members concerned with keeping the books considered that the annual report of excess revenue and the Ten Year Plans accomplished sufficient "earmarking."
The Master complains that this change was not affirmatively disclosed to the Court, was unauthorized, and undermined the ability of the Court to exercise its function properly. C.R. at 32 & 33. The action may have been mistaken but it was not duplicitous. Anyone reviewing the Estate's audited financial statements for the periods after 1988 could readily see that accumulated income was not separately reported in them. Four masters have reported on six accountings since 1988. None objected to the change.
C. Accounting For Accumulated Income
The Master's third and fourth recommendations are as follows:
Recommendation No. 3:
Accumulated Income Should Be Restored To The Revenue Account.
Your Master recommends that the Trustees be ordered to: (a) immediately cease and desist from continuing these practices; (b) restore to the revenue account all accumulated income which has been reclassified to corpus; and (c) provide a compliance report to your Master within 30 days from the date upon which the Court issues its order adopting this recommendation.
C.R. at 33.
Recommendation No. 4:
An Accounting Of Accumulated Income And Independent Verification Should Be Conducted.
Your Master recommends that the Trustees be ordered to provide an accounting to your Master within 60 days regarding the full extent of the accumulation of income by the Trust Estate and that such accounting be subject to independent review and verification by Arthur Andersen LLP.
C.R. at 35.
The Trustees will restore to the revenue account all accumulated income reclassified as corpus, will cease any further reclassification of accumulated income to corpus, and will provide the Master with the requested accounting and compliance report for review and verification by Arthur Andersen.
D. Disposition of Accumulated Income
The Master's fifth, sixth and seventh recommendations are as follows:
Recommendation No. 5:
Strategic Planning Should Incorporate Expenditure Of Accumulated Income.
Your Master recommends that the Court order the Trustees to undertake an appropriate strategic planning process under the supervision of the Court (as described in more detail in Part IX, Section A of this Report) which incorporates planning for the expenditure of the accumulated income.
C.R. at 40.
Recommendation No. 6:
No Future Reclassification Of Accumulated Income Should Be Permitted Without Prior Court Approval.
Your Master recommends that the Trustees be instructed that should they choose to rely upon the provisions of HRS Chapter 517D to reclassify accumulated or unexpended income to corpus in the future, that they shall do so only upon notice to the Attorney General as parens patriae of the Trust Estate and approval by the Court upon a proper petition for instruction.
C.R. at 43.
Recommendation No. 7:
The Appropriateness Of The Replacement Cost Reserve Should Be Determined By The Court.
Your Master recommends that the Trustees explain in their response to this Report why the Replacement Cost Reserve is not contrary to the terms of the Will and the Revised Uniform Principal and Income Act. Otherwise, should the Trustees desire to continue the practice of charging the revenue account for future additions to the Replacement Cost Reserve they should seek appropriate instructions from the Court.
C.R. at 44.
The appropriate disposition of accumulated income is an important issue for the long term interests of the Estate and the Master does not recommend that the accumulation should be liquidated. His emphasis, as in other matters, is on long range planning, and the Trustees have no objection to planning for the use of accumulated income. They do so regularly in the formulation of the Estate's Ten Year Plans.
As the Master observes, the Estate has not always generated sufficient income to meet the operating expenses of the Kamehameha Schools. There were times within recent memory when the Estate had trouble meeting payroll. The Trustees also are ever-mindful of the fate of the Estate of King Lunalilo. Had its trustees been permitted to preserve its corpus, many estimate the value of that estate would have surpassed the value of the Bernice Pauahi Bishop Estate. Instead, its value is reported to this Court in Equity No. 2414-A at less than $8 million.
Recognizing that preservation of corpus is vital if the Estate is to continue
to serve its educational purposes in perpetuity, the Trustees have acted conservatively
to assure that all maintenance can be funded out of income without resort to corpus.
This has been accomplished through the establishment of reserves for maintenance,
depreciation and replacement costs and by a concerted effort to restore corpus to
replace value lost through forced sales incident to fee conversion.9
Accumulated income is a vital component of this process of preservation and restoration of corpus. It should go without saying that it would not be prudent for the Trustees to expend all revenues received every year. This, however, requires discussion of the opinion in Collins v. Hodgson, 36 Haw. 334 (1943).
E. Collins v. Hodgson: Accumulation May Be Inevitable
Collins v. Hodgson was an appeal by the Attorney General from an order concerning the right of the Bishop Estate trustees to use accumulated income to defray the cost of erecting new school buildings. In 1941, the trustees had petitioned for instructions whether to charge income or corpus for such construction costs. In response, the Attorney General first argued that the costs should be charged to income but later amended his pleadings to assert that the costs should be charged to corpus. The circuit judge agreed with the Attorney's General's first position and concluded that accumulated income could be used to pay the construction costs. The Attorney General appealed and the Supreme Court held that only corpus could be used to pay the construction costs of new buildings. That is all the opinion in Collins v. Hodgson really holds.
By way of dictum, the Court added, however:
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. The record does not disclose why the trustees have failed or have been unable to comply with the expressed intention of the testatrix in that regard....
The record before us does not disclose over what period or why the income has been in excess of the expenditures. Neither does it disclose facts from which it could be determined whether or not a continual increase in the surplus income is or may become inevitable. Our decision that under the terms of the will income as such cannot be used to defray the cost of buildings is not to be understood as having any reference to the power of the chancellor, on a proper bill and showing, to apply the doctrine of cy pres and authorize an inevitable surplus, if any, to be applied to some other use within the purview of that doctrine.
Collins v. Hodgson, 36 Haw. at 339-40 (emphasis added).
From this dictum hangs the view that the accumulation of income is a violation of the Will, notwithstanding the fact that the Supreme Court itself acknowledged that accumulation may be "inevitable."10
The Will of Bernice Pauahi Bishop is not as certain as the Supreme Court's remarks might suggest. Article Thirteen directs the Trustees to expend up to half of the corpus in the purchase of a school site and the erection and furnishing of buildings. As to the balance remaining, it provides:
I direct my trustees to invest the remainder of my estate in such manner as they may 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 year's 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.
Will of Bernice Pauahi Bishop, Article Thirteen (emphasis added).
The seventeenth paragraph of the First Codicil to the Will provides:
I give unto the trustees named in my will the most ample power to sell and dispose of any lands or other portions of my estate, and to exchange lands and otherwise dispose of the same; and to purchase land, and to take leases of land wherever they think it expedient, and generally to make such investments as they consider best; but I direct that my said trustees shall not purchase land for said schools if any lands come into their possession under my will which in their opinion may be suitable for such purpose; 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.
First Codicil to the Will of Bernice Pauahi Bishop, seventeenth paragraph (emphasis added).
With all respect to the dictum of the Supreme Court in Collins v. Hodgson, the foregoing provisions do not necessarily mandate the annual expenditure of all income received. Even if Article Thirteen of the Will is read as a direction to expend all of the annual income, the First Codicil, which amends the Will, empowers the Trustees to purchase land, "take leases" (and therefore pay rents), and to make investments. The First Codicil does not require that such purchases and investments be made with corpus or only upon sale of lands.
Consistent with the provisions of the First Codicil, this Court has determined that the Trustees have power to reinvest cash, including accumulated surplus income, in income producing property:
10. Power To Invest Cash in Income Producing Property. The Trustees have power and are authorized to invest and reinvest cash proceeds from the sale of corpus, and any accumulated cash surplus income, in income producing real property whenever they determine it is for the benefit of the Estate.
Findings of Fact, Conclusions of Law, And Order Approving Eighty-fifth Annual Report, entered herein on February 3, 1977, at 5.
Certainly, if accumulated income may be reinvested in income producing property, it does not have to be fully expended annually.
In 1985, George S. W. Hong, master on the Trustees' 99th Annual Report (FY 1984) devoted most of his report to the issue of accumulated income. Mr. Hong did not advocate a spending spree, however:
Recognizing that the immediate expenditure of the accumulated income merely for the purpose of spending may not be in the best interest of either the Schools or the Estate, your master recommends that the Trustees examine the future needs of the Schools and the non-campus activities and periodically prepare a long-range plan for the expenditure of accumulated income for the educational purposes set forth in the Will and from time to time amend such plan as may be appropriate under the circumstances. Such plan should be subject to periodic examination by this Court.
Report of the Master on the Petition Of the Trustees of the 99th Annual Report, filed herein on August 2, 1985, at 24 (emphasis added).
Upon this recommendation, the Court decreed:
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 the educational purposes consistent with said Will.
Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, entered herein on October 8, 1985, at 6.
The incumbent Master's conclusion that there is no satisfactory plan for the expenditure of the accumulated income derives from his dissatisfaction with the Trustees' strategic planning process and the fact that the Ten Year Plans do not refer specifically to accumulated income. Strategic planning is discussed below in Part and the Trustees' agreement to segregate income and corpus and to report accumulated income separately will result in changes to the format of the Ten Year Plans.
G. Establishment Of Reserves Is Permitted
That brings the discussion to the real substance of the matter: What reserves and corpus protections are permitted to the Trustees to protect the long term interests of the Kamehameha Schools Bernice Pauahi Bishop Estate?
This Court has previously determined that the Trustees may maintain a depreciation reserve:
6. Depreciation Or Amortization of Depreciable Assets of the Trust Estate. The Trustees are authorized to set up reserves for depreciation for all depreciable assets held or acquired by them, and for all depreciable improvements to Trust property. Such depreciation should be charged to income, and corpus should be replenished over the estimated useful life of the assets, as set forth in the recommendations of Coopers & Lybrand, Certified Public Accountants, its letter of advice of October 29, 1976 ....
Findings of Fact, Conclusions of Law, And Order Approving Eighty-fifth Annual Report, entered herein on February 3, 1977, at 4.
This determination is consistent with H.R.S. § § 557-13(a)(2) (the Revised Uniform Principal and Income Act ) which allows a charge against income for a reasonable depreciation allowance taken in accordance with GAAP.
The Master recognizes the effect of the statute but suggests that a replacement cost reserve established by the Trustees in 1990 cannot be charged against income. In support of this view, he quotes H.R.S. § 557-13(c)(2) which provides that extraordinary repairs and expenses incurred in making capital improvements are to be charged against principal (corpus). The Master misinterprets the section. Replacement costs are neither extraordinary repairs nor expenses for capital improvements. They are, instead, a form of depreciation reserve permitted by Section 557-13(a)(2). Indeed, Section 557-13(c)(2), which mandates that extraordinary repairs and capital improvements be paid out of corpus, also provides that "a trustee may establish an allowance for depreciation out of income to the extent permitted by subsection (a)(2) and by section 557-8."11
Depreciation reserves and replacement reserves are nothing more than an accountant's recognition that things wear out and must be replaced. By charging an annual amount against income each year, a reserve has been established to provide for such costs when they arise. The Master says this has the effect of restricting the income available for expenditure. C.R. at 43. This is only partially true.
If the generation that uses the depreciating facility also spends the unrestricted income, it is burning the candle at both ends, at the cost of future generations. It has been noted that "[t]he basic policy of section 13 [of the Uniform Act, being H.R.S. § 557-13] is to allocate all trust expenses among the interests which receive the expense's particular benefit." Carl J. Sinder, Note, The Revised Uniform Principal and Income Act - Progress, But Not Perfection, U. Ill. L.F. 473, 492 (1963). This is exactly what the Trustees have endeavored to do by establishing reserves out of income for assets that are being used currently and will have to be repaired or replaced for the use of future generations. In a year in which maintenance and repair of facilities is funded from the reserve account, the annual income otherwise available for expenditure that year is not reduced by the costs so funded.
The Trustees' establishment of a replacement cost reserve is, therefore, both
prudent and consistent with the directions of the Will and the opinions of the Supreme
Court that both corpus and income may be used for the maintenance of the Kamehameha
Schools. The opinion in Collins v. Hodgson, has it that income may not be used to
defray the costs of erecting entirely new buildings. It says nothing about maintenance,
repair and renovation of existing facilities and cannot be interpreted as precluding
the establishment of a reserve for the replacement of existing facilities.12
In summary, there is considerably more to the issue of accumulated income than a 1970 pre-trial stipulation. A court order clarifying the matter would be helpful to all concerned, whether based upon a stipulation among the Trustees, the Master and the Attorney General, or entered after hearing of a special petition for instructions.
VII.UNIFORM PRUDENT INVESTOR ACT
Part VIII of the Master's Consolidated Report relies heavily upon the Hawaii Uniform Prudent Investor Act , H.R.S. § Ch. 554C ("HUPIA"), which was enacted in 1997. The Master characterizes this as a codification of the Prudent Investor Rule. C.R. at 46. A "non-exclusive list of factors" identified by the Master as arising under the Prudent Investor Rule provides the outline upon which Part VIII is based. C.R. at. 48.
The Trustees believe this analysis of their performance is flawed by the mixture of HUPIA and its non-exclusive list of standards with numerous decisions of the Hawaii Court that antedate HUPIA by several years, including (in the order mentioned by the Master in Part VIII) Brown v. Brown, 22 Haw. 715 (1915); Bishop v. Kemp, 35 Haw. 1 (1939); Ahuna v. Department of Hawaiian Homelands, 64 Haw. 327, 640 P.2d 1161 (1982) amended, 64 Haw. 688; Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964); and Dowsett v. Hawaiian Trust Co., 47 Haw. 577, 393 P.2d 89 (1964) reh'g denied, 47 Haw. 628, 393 P.2d 648.
The following discussion will show in some detail that, prior to HUPIA, there were two so-called "prudent man" rules. One was applicable to dynastic trusts such as the Kamehameha Schools Bernice Pauahi Bishop Estate, which are designed to perpetuate substantial holdings in trust for as many years as the law allows (in the case of the Estate, in perpetuity). The other was appropriate to caretaker trusts, which are designed to serve the needs of specific beneficiaries, usually a surviving spouse and minor children, for a comparatively shorter period of time. The considerations driving a dynastic trust and those driving a caretaker trust are very different but courts, including the Hawaii Supreme Court, and commentators have not always recognized the distinction.
B. HUPIA and the Third Restatement
The Restatement (Third) of the Law on Trusts (the "Third Restatement"), from which HUPIA and its "prudent investor" rule is derived, was intended in part to resolve the conflict in rules and to establish a new standard. It is hardly appropriate to employ the "non-exclusive list of factors" enunciated in HUPIA in 1997 while quoting from earlier case law which the framers of HUPIA intended to clarify and, in some cases, supersede.
HUPIA became law on April 14, 1997. H.R.S. § 554C-11 is clear that the statute is entirely prospective and applies only to decisions or actions occurring after that date. The periods of the Master's Consolidated Report are from July 1, 1993 to June 30, 1996, and HUPIA is not applicable to these accounting periods.
HUPIA is not a mere codification of pre-existing common law. In fact, only a few elements of pre-existing statutory and case law were incorporated into HUPIA. Adding to the confusion is the fact that HUPIA repealed former H.R.S. § 406-22(a) which had been called the "Prudent Investment Rule". See Matter of Estate of Dwight, 67 Haw. 139, 144-45, 681 P.2d 563, 567 (1984) recon. denied, 67 Haw. 683, 744 P.2d 779; and Steiner v. Hawaiian Trust Co., 47 Haw. 548, 561, 393 P.2d 96 (1964).
HUPIA is not based on common law but on provisions of the Third Restatement , which was adopted and promulgated by the American Law Institute in 1990. The Reporter for the Third Restatement was Professor Edward C. Halbach, Jr. whom the Master acknowledges as one of his consultants. C.R. at 5. Professor Halbach has said of the Third Restatement: "It attempts to restate the common law of trust investment and also makes changes in Restatement Second sections that affect or are affected by new sections 227, 228 and 229, which constitute the prudent investor rule."
Edward C. Halbach, Redefining the "Prudent Investor Rule", 129 Tr. & Est. 14 (1990) (hereinafter cited as "Halbach"). In reply to a question as to how the new concept of the Third Restatement varies from the "prudent man" rule, Prof. Halbach said:
Some of the changes we have made in Restatement doctrine will not be brand new to some prudent man states. But the overall thrust is to restore the originally intended flexibility of the Harvard College dictum. Flexibility is needed not just for the widely varied objectives and circumstances of different trusteeships but also to adapt over time to changes in the operation of financial markets, in the investment products available and in the practices of fund managers, as well as in the theories and knowledge underlying those practices. Thus, we have sought both to modernize trust investment law and to restore its flexibility.
There are some rather clear-cut differences between the new rule and that of the prior Restatement, which was fairly typical of the prudent man rules of the various states. Other differences involve mainly changes in emphasis or rationale.
Illustrative of the latter is the principle of diversification, the trustee's general duty to diversify. The prudent investor rule recognizes the nature and important role of asset allocation, which was not mentioned in the earlier Restatement, and it is more flexible than the old rule in ways that reflect the underlying reasons for diversification. To convey a better understanding of the relationship between this duty and risk, the new book discusses the different types of risk involved in investing--especially "compensated" and "uncompensated" risk. The objective is to have the role and the nature of diversification better explained and understood. This all represents mainly a change of emphasis and rationale, with associated adjustments in application. Certainly there has been a duty to diversify under prior Restatements and in most prudent man jurisdictions.
Another example of changed emphasis is the effort to enhance understanding of expense problems in fiduciary investing, with greater attention to management and transaction costs and to reasons why. Between change of emphasis and change of direction is our revision of the duty of impartiality, calling for reasonable effort in most cases to protect purchasing power.
Illustrative of clear cut change is our quite different view of the propriety and role of delegation by trustees. Maybe even more fundamental, however, and probably our most important reversal of direction, was the elimination of arbitrary prohibitions categorizing investments in the abstract as "speculative," or as permissible or impermissible per se. Under the traditional rule in most states, venture capital would not be a permissible investment, and in many real estate would similarly be excluded as involving too much risk and difficulty of management. Subrules like these usually applied to trusts generally, and without allowing for the tremendous variety that exists in trusts and trusteeships. The prudent investor rule says than no investment or course of action is per se prohibited. Significant differences follow from stressing that investments are to be judged by their portfolio role and context.
Id. at § 14-15.
C. The Two "Prudent Man" Rules
The so-called "prudent man" rule derives from the landmark decision of the Massachusetts Court in Harvard College v. Amory, 26 Mass. (9 Pick.) 446 (1830), which considered the power of fiduciaries to invest in insurance and manufacturing stocks. In that case, the court discarded the English common law, which restricted fiduciary investments to government securities, and enunciated what became known as the "prudent man" rule governing the conduct of a trustee:
[H]e shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
26 Mass. at 461.
As noted in Lawrence W. Friedman, The Dynastic Trust, 73 Yale L.J. 547 (1964):
The test laid down was carefully stated, for all its apparent vagueness. The "prudent investor" rule has been so often quoted, cited, and repeated, that the eye is apt to pass over it without noticing the precision of its phrasing. The ideal trustee must "observe how men of prudence, discretion and intelligence manage their own affairs." This presupposes a certain class of trustees: men of business ability, whose social and economic position allows them easily to observe how their peers manage large estates for themselves or others. The test was more appropriate to the professional than to the amateur trustee who assumed trusteeship out of friendship or blood ties with the settlor. The court also spoke of a "permanent disposition of funds." This might mean nothing more than the trustee's duty to avoid speculative investment; but in another sense "permanent disposition" implied investment for the long run. This phrasing was more appropriate to the dynastic than the caretaker trust.
73 Yale L.J. at 554.
For a variety of reasons, the prudent man rule, which was well-established in the United States at the turn of the century, went into eclipse in many jurisdictions for a number of years. At least one of the reasons was the paucity of dynastic trusts designed to last as long as legally possible. Dynastic trusts required administrative flexibility and it was such a dynastic trust that was considered in the Harvard College case.
At the opposite end of the spectrum is the caretaker trust, which is a short-term trust designed to serve the needs of limited group of beneficiaries for a relatively short period of time. The caretaker trust could tolerate only a very conservative and liquid portfolio. Since the caretaker trust was by far the more common form of trust, Harvard College, involving a dynastic trust, was perceived by many courts to be somewhat too expansive. As Professor Friedman puts it, "[most] states ..., lacking dynastic trusts in any significant numbers, lacking Boston's institution of professional trust-managers, and face to face with a wide, dangerous and complicated investment market, were not ready for Harvard College." Id. at § 561.
Thus, a different prudent man rule was enunciated in King v. Talbot, 40 N.Y. 76 (1869), a case involving a caretaker trust, the principal of which was to be paid to the decedent's children when they reached majority. While the New York court described a prudent man rule which superficially resembled the Massachusetts rule of Harvard College, it had key differences which, while suitable to caretaker trusts, were wholly unsuitable to the dynastic trust for which the original prudent man rule had been formulated. The court in the King case held that "the trustee is bound to employ such diligence and prudence ... as in general, prudent men of discretion and intelligence in such matters, employ in their own like affairs." Id. at § 85-86. The New York court saw that trustees had three basic investment duties: First, to place the money in a "state of security" ; second, to make it "productive of interest" ; and third, "to keep the fund, that it should always be subject to future recall for the benefit of the cestui que trust." Id. at § 88.
When the King court stressed that the income should be "without exposure to the uncertainties or fluctuations of adventures of any kind," it was saying, in effect, that the investment must be as utterly free of risk as it can possibly be. Thus emerged the beginnings of an alternative branch in American trust law, a counterpoint to the original "prudent man" rule but still calling itself the "prudent man" rule.
It is more accurately termed the "legal lists" rule. After King, courts began to narrow the rule laid down in Harvard College and legislatures began adopting lists of what were regarded as relatively risk-free investments to which fiduciaries would be restricted.
The differing legal approaches to trust investments are really different approaches to the regulation of risk and the risk of loss. Note, The Regulation of Risky Investments, 83 Harv. L. Rev. 603, 616 (1970) (hereinafter cited as "Investments"). There are several consequences to this. First, risk cannot be treated in isolation from the return in investment it contributes to a portfolio. There is a trade-off between risk and return and if each investment is evaluated solely from the point of view of risk of loss, the least risky investment will always be chosen. Perhaps because the law does not operate in the marketplace, the complementary concepts of risk and return are not commonly seen together from the bench. However, no prudent investor weighs one without the other and neither should the law. To do otherwise is to harm the trust beneficiary "either by being denied a worthwhile investment or by being exposed to the dangers of a poor one." Id. at § 618.
The risk factor most frequently overlooked is the inflation risk in any investment or portfolio. The danger to a dynastic trust today is less likely to be that the fiduciary will invest too aggressively than that the trustee will not invest aggressively enough to offset the effects of inflation. A failure to invest in such a manner as to offset the effects of inflation results in a radical diminution in corpus as inflation takes its yearly toll. The commentator in Investments notes the peculiar logic that this may entail:
The return on a portfolio means nothing unless it means the production and conservation of real, and not monetary, wealth. Accordingly, the risk of inflation and decline in purchasing power is at least as important as the risk of monetary loss. Inflation risk is the probability that, over the investment horizon of the portfolio, monetary inflation will decrease the real value of the portfolio. It is another type of uncertainty risk that current regulation fails to reflect.
... In overlooking possible inflationary conditions the law of trusts does not attach the same importance to risks of lessened purchasing power as it does to risks of monetary loss. Since both have the same economic impact trustees should have a legal duty to consider both risks, and the standard of prudence should be broadened to allow both to be anticipated.
Id. at § 622-624 (footnotes omitted).
Multiple editions of the treatise of Professor Scott, one of the leading commentators on trust law, also acted to inhibit development. As Professor Jeffrey N. Gordon observed in The Puzzling Persistence of the Constrained Prudent Man Rule, 62 N.Y.U. L. Rev. 52, 58 (1987), Scott was the leading commentator and the reporter of the First and Second Restatements. Most case law and commentaries quoted him. But his treatise had become moribund. "Scott's teachings on investment management by trustees have remained virtually unmodified over a fifty-year period." Id.
... Scott's rules and examples are more constraining, and less flexible, than Harvard College required. Perhaps initially useful, these rules and examples no longer conform to our best understanding of prudent investment strategy and thus unwisely restrict trustees. ... In a sense Scott has become "Scott," too authoritative to revise. Since the publications of the last editions of the Treatise and the second Restatement there has been an explosion of theoretical and empirical work by financial economists, leading to new conceptions of investor and market behavior. None of this progress is reflected in "Scott"; indeed, what has been learned contradicts much of what "Scott" states on investment management. ...
Three key decisions in the Treatise and the Restatement transformed the flexible standard of Harvard College into what has become the constrained Prudent Man Rule. First, Scott altered the Rule to require a more conservative benchmark of prudence than Harvard College. Instead of the prudence of persons seeking "permanent disposition of their funds," Scott prescribed the prudence of one seeking primarily the "preservation of the estate". An investment strategy designed to preserve principal will presumably be more cautious than one aimed at permanent disposition, which could include a buy-and-hold portfolio of common stocks at a higher level of risk and expected return. Moreover, in inflationary times, a mandate to preserve the estate becomes confounding; to preserve the estate in nominal terms may well defeat the testator's objective of transferring wealth to the next generation, but to preserve the estate in real terms requires investment that may risk the loss of principal.
Second, instead of an investment standard based on how prudent men conduct their own affairs, Scott prescribed the more constraining norm of "men who are safeguarding property for others." Thus, instead of the prudent man test, we have the prudent trustee test. The implication is that a trustee must use especially safe means to attain the desired level of investment safety, rather than ordinarily prudent means. So, making the debatable assumption that preservation of capital ought to be the trustee's primary goal, Scott tells us that a prudent trustee may not pursue this goal in ways acceptable to a prudent investor. Scott's dubious distinction confuses the setting of appropriately safe investment objectives with the process of investing. The confusion creates a special problem for a financial model like portfolio theory, in which investments (and investment techniques) designed to achieve greater safety may nevertheless appear risky viewed in isolation.
Third, and most serious, Scott, in separating "prudence" from "speculation," set hard and fast rules that now stymie the trustee's ability to adapt to prevailing circumstances in the financial markets. On the forbidden investment list are, for example, margin purchases of securities, "speculative" stock, discount bonds, securities in new and untried enterprises, and second mortgages. "Speculative stock" seems to refer to all companies except those "with regular earnings and paying regular dividends which may reasonably be expected to continue."
Id. at § 58-61 (footnotes omitted).
Professor Gordon's observation that Scott had become too authoritative to revise is borne out by the words of the Preface to the most recent (1987) edition of Professor Scott's treatise. "The Fourth Edition is a deliberately conservative revision of a monumental treatise written by a distinguished scholar and teacher." I Austin W. Scott & Wm. F. Frachter, The Law of Trusts, Introduction, at xxii (4th ed. 1987) (hereinafter cited as "Scott").
Frustration with the situation of a body of law that had not grown with the times gave impetus to the Third Restatement. Trust law had become bound up in rules and subrules, tending to drive trustees (especially trustees of dynastic trusts) in a direction which was at variance with what the marketplace regarded as good investment practice. The result was a legal revolution resulting in the Third Restatement, which enunciated the law of trusts not so much as it existed, but as the American Law Institute believed it should be. See Halbach at 21-22, Lyman W. Welch, How The Prudent Investor Rule May Affect Trustees, 130 Tr. & Est. 15 (1991) and Robert T. Willis, Prudent Investor Rule Gives Trustees New Guidelines, 19 Est. Plan. (1992).
D. Hawaii's Experience
The Supreme Court of Hawaii first specifically considered the standards by which a fiduciary's investments should be governed in the case of In Re Estate of Banning, 9 Haw. 453 (1894). The Court adopted the Harvard College standard, holding that a trustee's discretion must be accorded wide latitude. "The discretion confided in such matters to the trustee is one that is founded upon sound reasoning and conformity to established business principles ..." Id. at § 462 (citing Harvard College).
The Court held to the rule announced in Banning despite "much unpleasant criticism" and defended the rule as the law of many states. Guardianship of Parker, 14 Haw. 347, 351 (1902). It recognized that in some jurisdictions, "the [trustee's] discretion has been confined." Id. at § 352. But the Court adhered to the rule stated in Banning. See Brown v. Brown, 22 Haw. 715 (1915), fully restating and adopting the Harvard College prudent man rule.
Nonetheless, Hawaii became a "legal list" jurisdiction by act of the Legislature in 1933. See 1933 Haw. Sp. Sess. L. ch. 47. The Hawaii Court remarked that it was unable to comprehend the necessity for the legislation and noted that "even the legislature is powerless by subsequent enactment to vary any of the terms of a trust deed previously executed." Bishop v. Kemp, 35 Haw. 1, 8 (1939). In 1947, the 1933 Act was amended to adopt as statutory law the prudent man rule of Harvard College. See 1947 Haw. Sess. L. ch. 125.
In 1984, the Supreme Court of Hawaii decided Matter of the Estate of Dwight, which may be regarded as a classic failure of fiduciary due diligence. The trial court had found that First Hawaiian Bank, the successor trustee, invested trust assets in a decaying fifty-two year old building in a deteriorated and depressed area of Honolulu surrounded by bars and porno shops, which was designated for condemnation and urban renewal. The building was not in conformity with the applicable building codes and was termite infested. The successor trustee had made the investment on the strength of a short term lease to The Salvation Army. The successor trustee neglected to read the lease, which specifically disclosed some of the repair and damage problems, or to question the tenant about the condition of the building. The successor trustee "neither knew nor attempted to determine whether the building conformed to applicable building, health, safety and fire code requirements. The Trustee also did not secure any structural or termite inspections." 67 Haw. at 567, 681 P.2d at 143-44.
The Supreme Court observed:
In the absence of specific directions in the trust instrument concerning the investment of trust funds, our court has held that the trustee's duties to the beneficiaries are controlled by statute. Steiner v. Hawaiian Trust Co., 47 Haw. 548, 561-562, 393 P.2d 96, 105 (1964). The statute applicable in this case, Hawaii Revised Statutes (HRS) § 406-22(a) (1968), codified the generally accepted "prudent investment rule."
Id. at § 144-45, 681 P.2d at 567.
The statute which the Court called the "prudent investment rule" was former H.R.S. § 406-22(a), made applicable to trustees generally by the provisions of H.R.S. § 554-6. It provided for the exercise of:
... the judgment and care which, under the circumstances then prevailing, men of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds and property considering both probable income and probable safety of capital.
This is a classic formulation of the Harvard College prudent man rule.
Section 406-22(a) was superseded in 1976 by the Uniform Probate Code, which brought with it a revised formulation of the prudent man rule, this time as H.R.S. § 560:7-302. H.R.S. § 560:7-302 provides that 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, and if the trustees has special skills or is named trustee on the basis of representations of special skills or expertise, the trustee is under a duty to use those skills.
This is what Professor Gordon, quoted above, calls the "prudent trustee"
rule and lays at the doorstep of Professor Scott's moribund analysis.
Then, in 1997, the Legislature enacted HUPIA. As shown above, HUPIA was designed to revise and restate the "prudent man" rule as the "prudent investor" rule. Section 560:7-302 is still on the books, however.
While HUPIA and its "non-exclusive list of factors" is a valuable tool for the future, it must be understood as an intentionally revolutionary restatement of the law of trusts. It was designed by its framers to make into law what, in their view, the courts and the commentators had failed to develop in the years since Harvard College v. Amory. As a legislative statement, HUPIA supersedes prior Hawaii case law which is inconsistent with it. At this time, there are no reported Hawaii decisions construing HUPIA or its non-exclusive list of factors. And, for the period of the three Accounts now under review, HUPIA was not the law and the law was a confusion of standards, including two "prudent man" rules and a "prudent trustee" rule. This is especially clear in the Steiner decision, discussed next.
F. Steiner v. Hawaiian Trust Co.
The Master refers to the decision in Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964) several times. C.R. at 49, 63-66 & 123. The factual situation of that case is important to understanding the tone of the Court's statements. Steiner is less about diversification than it is about a careless corporate fiduciary. The case involved three identical revocable personal trusts established in 1931 by former Supreme Court Chief Justice E. C. Peters and his wife for the benefit of their children. Hawaiian Trust Company was the trustee. Each trust was endowed with 100 shares of Hawaiian Pineapple Company stock. The Trustee was prohibited from making any change in investments without the written consent of Judge Peters. When Mrs. Peters died in 1944, more assets were added to the trusts and they were amended to make them irrevocable. The added assets included several shares in various plantations and in Hawaiian Trust, with the result that each trust was worth about $35,610, with 99% of the stock in plantations, and over 80% of the stock being in Hawaiian Pineapple Company. In 1951, Hawaiian Pineapple stopped paying dividends. In 1955, Hawaiian Trust began a program of diversification. Hawaiian Trust sold the plantation stocks and invested the proceeds in Hawaiian Trust's own common trust fund. It never obtained Judge Peter's consent. In 1956, Judge Peters removed Hawaiian Trust as trustee and appointed Ernest Steiner as successor trustee. Steiner sued Hawaiian Trust.
The Court found three breaches: Hawaiian Trust's sale of Judge Peters' Hawaiian Trust stock to the president of Hawaiian Trust; Hawaiian Trust's sale of stocks without Judge Peter's consent; and Hawaiian Trust's failure to diversify sooner by advising Judge Peters to sell the stocks of declining plantations.
The Court emphasized that Hawaiian Trust was "bound to use the higher degree of skill that it possessed as an expert professional fiduciary." Steiner, 47 Haw. at 562, 393 P.2d at 105. The Court relied heavily on the Restatement (Second) of Trusts (the "Second Restatement") and Professor Scott's treatise, both of which were quoted at length. The Court reviewed in detail the erratic history of Hawaiian Pineapple, its instability, unpredictability and varying performance. Id. at § 571. It noted that the chancellor was not so much concerned with the concentration in local plantation stocks as he was in the quality of the investments. Pepeekeo Sugar had a history of deficits, dividend omissions, losses, low yields and insecurity. Id. at § 573.
From this, it is clear that Steiner involved a caretaker trust (established by parents for their children), a corporate fiduciary that held itself out as an expert, and an egregious factual situation, including sale of trust assets in violation of the terms of the trust and a dilatory approach to disposition of stocks that suffered badly in the postwar economy. Although not mentioned in the reported opinion, it is common knowledge that the wartime and postwar economies devastated Hawaii's plantation system.
Significantly, the Court's legal analysis includes the view that the trustee was obliged:
... "to make such investments as a prudent man would make of his own property having primarily in view the preservation of the estate and the amount and regularity of the income to be derived. *** It involves three elements, namely care and skill and caution." 3 Scott, Trusts, § 227 (2d ed. 1956). This is nothing more than a statement of the statutory "prudent investment rule."
Id. at § 573.
The Court's quotation from Section 227 of Scott is significant. Scott's formulation is not the Harvard College v. Amory prudent man rule. Instead, it is a direct descendant of the narrower New York standard enunciated in King v. Talbot. Thus, the Hawaii Supreme Court's statement that Scott's formulation is "nothing more" than a statement of the Hawaii rule was entirely mistaken. Hawaii's statute was the broader rule of Harvard College and Scott's formulation, appropriate to a caretaker trust, was not a statement of the Hawaii statutory rule.
It is apparent from the opinion that the Court was unaware of the distinction between the two rules. Earlier in the same opinion, it had correctly concluded that the Hawaii statute, R.L.H. § 179-14(a) [which later became H.R.S. § 406-22(a)] was a codification of the prudent investment rule set forth in Harvard College. Steiner, 47 Haw. at 562, 393 P.2d at 105. The Court's conclusion eleven pages later that Scott's narrower formulation was an accurate reflection of Hawaii statutory law was therefore plainly mistaken.13
The Hawaii Court's failure to distinguish the Harvard College "prudent man" rule from the prudent man of King v. Talbot is also clear in Ahuna v. Department of Hawaiian Home Lands, 64 Haw. at 340, 640 P.2d at 1169, (1982), wherein the Court quotes Mainland authority which itself confuses the two standards.
Thus, the law of Hawaii has been a confusion of the two prudent man rules, with
legislative dabbling in the "legal list" and "prudent trustee"
rules as well. HUPIA's emergence in 1997 as the "new" rule for prudent
investors may bring clarity to the situation. For purposes of the present accounts,
however, the Master cannot apply HUPIA's standards retroactively nor can HUPIA's
standards be considered as a mere codification of pre-existing law. HUPIA's standards
are intentionally new. They reflect a conscious effort to effect a rapid evolution
of the law of trusts. Moreover, given the confusion of the case law and statutes,
it is hard to say what standard did apply during the period of FY 1994 through FY
G. Hawaii Chronology
The following chronology shows the evolution of Hawaii law from the Harvard "prudent man" rule to HUPIA's prudent investor rule:
1894 Banning: Harvard prudent man rule adopted by the Hawaii Court 1919 Brown v. Brown: Harvard prudent man rule confirmed by the Hawaii Court. 1933 Act 47: "Legal List" enacted. 1939 Bishop v. Kemp: Hawaii Court questions need for "Legal List." 1947 Act 125: "Legal List" repealed and Harvard prudent man rule enacted. [R.L.H. § § 179-14(a) and H.R.S. § 406-22(a)]. 1964 Steiner: Hawaii Court's analysis confuses Harvard prudent man rule with King v. Talbot prudent man rule. 1976 Uniform Probate Code: "Prudent trustee" rule enacted (H.R.S. § 560:7-302) and Harvard prudent man rule [H.R.S. § 406-22(a)] repealed. 1982 Ahuna: Hawaii Court continues to confuse the two prudent man rules. 1997 Hawaii Uniform Prudent Investor Act (HUPIA) enacted.
H. Losses And Loss Reserves
The Master previously reported that the Estate had suffered more than $264 million in "combined losses and loss reserves" during FY 1994. The Trustees vehemently disputed the figure and the terminology. The Master now reports a revised calculation of about $135.5 million in losses, and explains the sources of the prior misstatement. C.R. at 56-58. Because this issue has attracted so much attention, further comment is necessary. The Master's conceded errors include:
a. Over $34 million previously reported as a loss or loss reserve was attributable not to the Estate but to an entity (SoCal) in which it made an investment. SoCal was a troubled savings bank. The Estate invested in it and the bank was turned around. It is now known as the Peoples Bank of California and has become a publicly traded entity. Not only was there no loss or loss reserve attributable to the Estate in FY 1994 for its SoCal investment but the investment has since proved itself handsomely profitable.
b. Almost $46 million previously reported as a loss or loss reserve proved to be an arithmetic error on the part of the Master or persons advising him.
c. Over $52 million previously reported as a loss or loss reserve for FY 1994 in fact arose in other years.
The $135 million figure now reported by the Master for FY 1994 is a combination of realized losses, equity losses and loss reserves established that year. As noted in the Trustees' First Response, loss reserves are a conservative and prudent accounting device. When circumstances arise which suggest that there is a potential impairment of value in an investment, which may be temporary or permanent, conservative practice is to establish loss reserves. An equity loss reflects the proportionate share of an investor's operating loss for that accounting period.
There also is a difference between a realized loss and a loss in value. A realized loss represents a permanent loss, as when an investment fails or is disposed of at less than what was paid for it. Valuation losses are experienced by investors every time the stock market dips or land values decline. Such losses are realized and become permanent only if the stock or the land is sold while its price is depressed.
The perception that the Estate "lost" $135 million in FY 1994 needs clarification. It fails to distinguish equity losses (operating losses) from reserves for potential losses, which may not occur if management is successful in rehabilitating the investment, as happened in the case of SoCal. It fails to recognize that operating losses may be offset in another year by operating income as an investment's fortunes improve. Most important, it leaves in the mind of many members of the Kamehameha ohana and the general public the mistaken idea that the Estate was poorer at the end of 1994 than it was at the beginning. To the extent that the Estate suffered losses in FY 1994, such losses were dwarfed by the Estate's reported gains.
The Master acknowledges this fact at page 58 of his Consolidated Report where he summarizes the Estate's financial statements, showing the various categories of gains and losses for each of the three years under review. The Master's table reveals the following significant facts: Equity losses amounted to only $18 million in FY 1994, $25.8 million in FY 1995, and $16.2 million in FY 1996. In those same years, the net gains on operating activities other than the sale of land were $65.2 million, $48.4 million and $71.4 million. Land sales in those same years added another $199.6 million, $83.1 million and $51.7 million. Even when the loss reserves are added to the calculations, the Master's table shows that the Estate enjoyed net increases in its assets in each of the three years, as follows: $192,815,000; $94,681,000; and $105,633,000. If the 1996 figures included the market value of various investments such as Goldman Sachs, the net increase would be substantially higher. (As discussed above in this Response, such investments are carried at their cost.) No fair minded person can conclude from these facts that the Estate is losing money or that land sales are covering losses.14
At page 76 of his Consolidated Report, the Master notes that Arthur Andersen:
... 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.
The Trustees consider that this question, perhaps more than any other, demonstrates the firm's lack of familiarity with Hawaii, existing economic conditions and the long term interests of the Kamehameha Schools Bernice Pauahi Bishop Estate.
Kakaako is the Estate's sleeping giant. Ten years ago, its redevelopment appeared certain. Government poured money into infrastructure and developers bulldozed entire blocks in anticipation of imminent highrise construction. Today, the bulldozed blocks are idle and Waterfront Plaza (Restaurant Row), one of the first developments in the new Kakaako, is about to be auctioned. The Estate is holding its land and biding its time. When the Hawaii economy revives and the Honolulu real estate market improves, the Estate's Kakaako holdings will benefit. For the time being, it is apparent to the Trustees, if not to others, that this is not a good time to master lease, develop or sell land in Kakaako.
J. Non-Hawaii Real Estate
The Master comments briefly concerning the Estate's non-Hawaii real estate. He
observes correctly that several of the Estate's directly held real estate investments
outside Hawaii did not begin that way. That is, prior boards made equity investments
for the Estate "to minimize its risk exposure and provide for more predictable
income flow." C.R. at 78. The previously troubled Mainland real estate
market and other business considerations required the Trustees to step in and become
owners in some cases. Prudent management and improvements in the Mainland real estate
market have seen many of these troubled investments turn around and they are now
valuable assets in their own right.
The balance of the Master's comments in this section concern documentation and targeted investing. The Trustees have acknowledged the value of greater documentation. Targeted investing is an aspect of strategic planning which is discussed below.
K. Hamakua Land Purchase
The Master's comments concerning the Estate's acquisition of approximately 30,000 acres of land on the Hamakua Coast of Hawaii do not present a complete picture of that transaction. C.R. at 81-82. While the Trustees have conceded that documentation practices can be improved upon, the Trustees submit that the purchase of the Hamakua properties is an example of their prudent and responsive administration of the Estate. The following discussion is presented to afford the Court a more balanced perspective.
The economic woes of the Hamakua Sugar Company are well known. Faced with foreclosure and bankruptcy, that company made efforts to save itself by offering to sell its lands. The Trustees were approached by the Company and offered a fraction of its properties for several millions of dollars. They declined the proposal.
Unable to meet its obligations, Hamakua Sugar went into bankruptcy in 1993. Its primary creditor was the Western Farm Credit Bank which held an $85 million first mortgage. The court authorized bulk sale of most of Hamakua Sugar's lands, approximately 30,000 acres. A public auction was scheduled for September 7, 1994. The bank let it be known that a pre-auction private sale might be considered at a price of about $35 million.
The property to be offered at auction comprised more than 600 separate lots covered by 273 tax parcel numbers. It included buildings, including a post office, homes and a commercial building, 50 miles of paved roads, several hundred miles of cane haul roads, water lines, bridges, ditches, pumps and reservoirs. 24,000 acres of the property was zoned for agriculture. Almost all of it had been used for growing sugar cane. The lands extended along 40 miles of coastline, from sea level to 2,700 feet.
Estate staff recognized and reported to the Trustees that the "Hamakua Coast provides some of the most productive growing conditions for timber/fiber production anywhere in the world." (Staff Report, Acquisition of Hamakua Sugar Lands, at 4.) Staff reported on an anticipated 21st century shortage of timber and fiber pulp for the Asian market. It noted that the Hawaii State Division of Forestry and Wildlife and the Department of Business, Economic Development and Tourism were promoting the forestry potential of the Hamakua Coast. Staff concluded that a "preliminary estimate of value" of the Hamakua lands was $15 million. Id. § Significantly, it based this estimate upon a review of prior land sales, the bulk sale aspect of the auction, continued pasture and agricultural use of large portions of the property with lease rents merely covering the real property taxes, and an assumption that management would be "passive" rather than "active" because of tax considerations. Staff specifically recognized that other investors who would directly acquire and manage the property for forestry operations "could afford to finance a higher initial purchase price that would be recovered through more substantial cash flows." Id. at § 5.
At their meeting on September 1, 1994, the Trustees instructed staff to gather more information and report back. The auction was then six days off. At the auction, Western Farm Credit Bank bid the property in at $20 million. That bid was subject to confirmation by the court on September 26, 1994. To reopen bidding, a 5% increase over the successful bid was required. Thus, the minimum bid at the confirmation hearing would be $21 million.
At their meeting on September 22, 1994, four days before the confirmation hearing, the Trustees heard an oral report from their staff concerning the property and, after deliberation, authorized staff to bid $21 million at the hearing. The Estate was the successful bidder and acquired the property for $21 million. Closing occurred on October 14, 1994.
All of the foregoing facts are reflected in contemporaneous Estate records.
At the meeting on September 22, 1994, staff presented oral reports and analyses of the proposed purchase. In its initial report wherein it recommended that the Estate bid $15 million while conceding that others could afford to go higher, staff had not considered the favorable interest rates available to the Estate and had made a number of other conservative assumptions about the Estate's use of the property. Subsequent review by the staff and discussion among the Trustees and staff on September 22 demonstrated that the staff's "preliminary estimate" was unnecessarily low.
The Trustees were also cognizant of the fact that, in 1994, Hamakua Sugar had surrendered its leaseholds of Estate lands and that Mauna Kea Agribusiness had done the same in 1993. Acquisition of Hamakua Sugar's fee titles gave the Estate a critical mass of prime Big Island properties to be converted from sugar agriculture to forestry operations.
Of the approximately 30,000 acres acquired from Hamakua Sugar, about 17,000 acres (together with other Estate lands) are now leased to PruTimber for forestry and about 7,500 acres are leased for other purposes. Another 4,470 acres of former Hamakua Sugar watershed lands are to be leased to the State of Hawaii in connection with the Lower Hamakua Ditch. When this is completed, over 99% of the lands acquired from Hamakua Sugar will be leased. In 2002, the Estate will begin to participate in percentage rents due from the first timber harvests.
The Hamakua land is a long-term investment in Hawaii. The Estate did not enter
upon it with the intention of quick turnover and immediate profit. As a perpetual
charitable trust, it can and should take the long view. With the purchase, the Estate
controls some of the best forestry lands in the world, has consolidated its pre-existing
holdings, and is positioned to benefit from the predicted worldwide shortage of pulp
and timber. In this, the Trustees have honored the Hawaii land-based traditions of
the Estate and have exercised the discretion granted them by Bernice Pauahi Bishop
"to purchase land ... whenever they think it expedient." (Will,
First Codicil, seventeenth paragraph)
While in retrospect, the documentation of the Trustees' decisions concerning Hamakua could have been more detailed, it is significant that the court-imposed deadlines were such that oral staff presentations and prompt Trustee action were required. Cumbersome procedures that might typically be required of a public agency are not conducive to the conduct of business in the "real world." An opportunity presented itself, the staff reported it to the Trustees, and the Trustees acted upon it.
L. Master's Request For Information
The Master states that there was an outstanding request by him for information concerning Hamakua. C.R. at 81. It should be noted that the Master's request was made on August 3, 1998, just four days before the Consolidated Report was filed.
The Estate has responded to numerous inquiries from the Master and Arthur Andersen. During the process of the financial and management audit, weekly meetings were held to assure the flow of information and the adequacy of responses. Arthur Andersen provided regularly updated schedules and lists of outstanding and new requests for information and documentation. The Master and the Trustees made every effort to avoid a repetition of the misunderstandings and miscommunications that occurred in connection with the First Report.
During the course of his review, the Master also requested specific information about various subjects referred to in his Consolidated Report. Responses have been made as quickly as counsel has obtained the information and, in some instances, the Master requested follow-up information. Hamakua is one of these. Estate Counsel replied to the Master's August 3 inquiry on August 24. The substance of that response appears above.
This cooperative process will continue as the Master undertakes his review of
the Trustees' 112th Annual Account (FY 1997).
M. Kahala Mandarin
In the First Report, the Master questioned the Trustees' handling of the renegotiation of the lease underlying the former Kahala Hilton Hotel and requested supplemental information concerning the transaction. The Estate provided that information and the Master now reports that he is satisfied that the Trustees caused proper due diligence and analysis to be performed and that they negotiated the terms of the new lease in a commercially reasonable manner. C.R. at 83.
Despite this, and the statement at page 76 of the Consolidated Report that the Arthur Andersen report "identifies a number of strengths associated with the real property management activities" , the Master's narrative focuses on perceived documentary shortcomings and there results a mistaken inference that the Estate's management of its real estate is deficient. The Trustees have conceded that documentation can be improved upon. They are justifiably proud of their record in land management, however, and remind the Court that the examples in the Master's Consolidated Report have been chosen by him to illustrate a documentary concern, not a failure of effective property management.
The Master's overriding concern is with perceived weaknesses in process and documentation. The Consolidated Report does not challenge the substance of any particular real property transactions. In this regard, it is important to note that the incumbent Master and Arthur Andersen have undertaken a more comprehensive and detailed analysis of the Estate's operations than has anyone in recent memory, if ever. A management audit is not intended to applaud the status quo. It is supposed to identify shortcomings in operations and to suggest areas for improvement. The Trustees take the Master's comments about the Estate's processes seriously. But they urge the Court and others to take them in context.
The Master remarks that the Kahala Mandarin transaction was not specifically disclosed in a schedule of real estate transactions nor referred to in the minutes of Trustees' meetings. C.R. at 82. The failure of the minutes is a fact and the Trustees acknowledged it in their First Response. First Response at 61. The Trustees recognize that the minutes must be kept more carefully than they were in 1993. The transaction was not included on the schedule of real estate transactions provided pursuant to the Guidelines simply because lease transactions never had been. The schedule had always been limited to purchases and sales of real estate and no one thought to add lease renegotiations to it. Pursuant to the December 19 Stipulation, the schedule now includes all significant lease transactions. (December 19 Stipulation at 19)
The Master's eighth recommendation is as follows:
Recommendation No. 8:
Investment Performance Schedules Should Be Regularly Prepared And Incorporated As Supplemental Schedules To The Financial Statements.
Your Master recommends that the Trustees be ordered to, at least annually, prepare benchmarked investment performance schedules as recommended by Arthur Andersen LLP beginning with the 112th Annual Account. The presentation of this information should evolve to include one-year, five-year, and ten-year annualized income yield and total return analyzes. The schedules should be incorporated as supplemental schedules to the Financial Statements filed with the annual account beginning with the 112th Annual Account.
C.R. at 52.
The Trustees accept the substance of the recommendation. The issue is the choice of appropriate benchmarks. Arthur Andersen concedes that benchmarking is a matter of judgment and that the benchmarks it has employed may not be the most appropriate choices for the Estate:
There were no applicable indices available to evaluate and benchmark the performance of the Hawaii landholdings. The commercial properties and marketable securities income yield and total return indices were derived by taking the weighed average of the indices described above. The weight applied to each index was based on the average fair value of each sub-asset class to the average fair value for the asset class.
The Estate's special situation, venture capital and oil & gas investments are private equity type investments. The indices used to benchmark these investments are based primarily on publicly traded data. The Estate's management is currently working with its investment consultant to develop performance benchmarks that are more appropriate given the nature and type of investments made by the Estate in these areas.
C.R. at Exhibit "H", n.4 [Schedule of Income Yield and Total Return].
Benchmarking is a means by which the performance of actual investments is compared to the performance of hypothetical investments. If appropriate benchmarks are used, the comparison yields information upon which investment decisions may be made. Benchmarking is not a science, however, and its comparisons are merely tools. The failure of an investment to meet a given benchmark in any given period is not necessarily cause to liquidate the investment. There may be circumstances that justify holding an investment that is performing poorly against a given benchmark, just as there may be reasons to sell an investment that is performing well against the benchmark. The benchmark, after all, is itself derived from data that includes investments that did better and worse that the resulting benchmark.
Benchmarking is also only as valid as the values to which the benchmark is compared. Where the Trustees have reported non-publicly traded investments at acquisition costs rather than at more speculative current values, benchmark analysis is of little practical use. As Arthur Andersen's quoted comment acknowledges, there are no indices available to benchmark the Estate's Hawaii landholdings. Benchmarking of its vast agricultural and conservation lands, which form the core of the Estate's original endowment but produce little or no current revenue, is impossible.
GAAP accounting does not require benchmarking and neither does any statute or rule of Court. The Guidelines do not mention it. Benchmarking is a management device that may have some informational value to the Court and the masters as well. But it is not pure science, nor a litmus test, nor an essential part of a financial report. Arthur Andersen's benchmarked schedules are not a part of the financial statements it certified. They are supplements prepared at the Master's request and filed by him with the prior consent of the Trustees.
In their First Response, the Trustees used benchmark analysis to demonstrate the long term performance of the Estate's total portfolio against the performance of the S&P 500 Index, Treasury Bills, the Consumer Price Index, Yale University, and other standards. (First Response, Exhibit "D") By those measures, the Estate's portfolio has performed remarkably well. Arthur Andersen's tables, each of which covers discrete years, are less enthusiastic as to some of the subcategories and are unable to draw conclusions as to the whole portfolio because appropriate benchmarks were not located.
As Arthur Andersen reports, the Estate is working with its investment consultant to determine appropriate benchmarks for future use.
O. Performance Measures
The Master's ninth recommendation is as follows:
Recommendation No. 9:
Investment Return Analysis Should Use Appropriate Performance Measures.
Your Master recommends that in preparing performance return analyses, the Trustees be ordered to utilize appropriate measures such as TWR and IRR for various time spans to allow meaningful comparisons against performance benchmarks.
C.R. at 53.
Like benchmarks, performance measures are also a matter of discretion and choice. Generally, Arthur Andersen favors the use of TWR (time weighed return) analysis. Estate staff believes that IRR (internal rate of return) analysis is more appropriate. Within TWR analysis, there are a variety of methods to compute the return. Commentators urge TWR analysis for certain investment categories and situations and IRR analysis in others.
Also like benchmarks, return analysis is not a matter of GAAP accounting, statute or rule. It is another management tool.
The Estate is working with its investment consultant to determine appropriate performance measures for future use.
The Master's tenth recommendation is as follows:
Recommendation No. 10:
Investment Policies Should Be Reviewed As Recommended In The Andersen Report.
Your Master recommends that the Trustees be ordered to undertake a comprehensive review of their investment policies as recommended by the Andersen Report in conjunction with the overall strategic planning recommendation in Part IX, Section A of this Report.
C.R. at 68.
This recommendation is made in connection with the Master's discussion of the Estate's diversification. The Master recognizes that the Estate "has been able to make limited progress in diversifying away from real estate" but urges that the diversification achieved to date is inadequate. C.R. at 66. The Master asserts that the Estate's private equity investments are higher than the proportion of such investments "than is the norm for comparable educational endowments." C.R. at 67.
The Trustees agree that greater diversification is desirable. The Estate has continued to diversify its holdings and recent conversions of some of its substantial private equity holdings into publicly traded entities should resolve concerns expressed about liquidity, risk, exposure and the level of private placement holdings. Again, it is important to remember that the years under review are a snapshot of the process whereby the Estate has evolved from being almost entirely invested in Hawaii real estate to holding hundreds of millions or billions of dollars in equity investments.
The core assets of the Estate will always be its Hawaii real estate, however, and, as explained in the Trustees First Response, the surge in Hawaii land values in and after 1989 distorts the Trustees' diversification efforts. First Response at 55. In 1992, the Estate's investment consultant, Cambridge Associates, recommended a target range of 60-80% real estate, with a 70/30 ratio of real estate to non real estate as a long-range objective. This was based upon 1989 asset valuations. By 1994, the Estate had achieved an 83/17 ratio, despite the tremendous increase in Hawaii land values since 1989. Id. § In October, 1997, the Trustees approved a new target of 66/34, to be achieved by 2006.
Since then, the Estate's private equity investments have soared in value and gone public while the Hawaiian real estate market remains in a slump. Investment ratios are goals and cannot be treated as absolutes.
As discussed above, the subject years were years of resolution in which prior troubled investments were turned around or losses recognized, and many successful investments were positioned for public offerings. Anticipated realizations on its private equity investments will now enable the Estate to become more diversified. The Estate is working with its investment consultant to clarify its investment objectives in light of its present circumstances.
Q. Due Diligence
Recommendation No. 11:
Due Diligence And Investment Monitoring Policies, Practices, And Procedures Should Be Strengthened.
Your Master recommends that the Trustees be ordered to undertake steps to improve and strengthen the due diligence and investment monitoring policies, practices, and procedures as recommended in the Andersen Report. Your Master further recommends that the Trustees be ordered to report their implementation plan relating to this recommendation to your Master within 60 days from the date on which the Court issues its order adopting this recommendation.
C.R. at 69.
The Trustees concede that the Estate's records with respect to due diligence are uneven. In his First Report, the Master recommended that asset lists with summary descriptions and other relevant facts should be assembled. (First Report at 62) The Trustees accepted and acted upon the recommendation. Thirteen- point investment summaries were completed and financial status reports were compiled. Arthur Andersen reviewed these and other records and has made specific recommendations to strengthen the Estate's due diligence and investment monitoring processes. The Trustees accept the consultant's recommendations concerning these matters and will implement them.
R. Documentation of Decisions
Recommendation No. 12:
Investment And Management Decisions Should Be Properly Documented.
Your Master accordingly recommends that the Trustees be ordered to ensure that appropriate documentation of their investment and management decisions be prepared and maintained as recommended in the Andersen Report. Such documentation should regularly be made available for review by the court's master in connection with the annual account review process. Your Master further recommends that the Trustees be required to report their implementation plan relating to this recommendation to your Master within 60 days from the date on which the Court issues an order adopting this recommendation.
C.R. at 72.
The Trustees have conceded that documentation, which is one of the Master's principal themes, is uneven and can be improved upon. However, as shown above in connection with the Hamakua land acquisition and below in connection with Strategic Planning, deficiencies in the minutes and other formal reports does not mean that discussions were not held or that the Trustees acted without adequate information. Oral reports and decisions made at scheduled Trustee retreats have not always been properly recorded. Often, there are other contemporaneous records, including staff notes and memoranda, which report the substance of staff and Trustee action. Documentary practices have been upgraded and the Trustees intend that Arthur Andersen's recommendations in this regard will be implemented. All such documentation has been and will continue to be available to the Court's masters.
VIII. STRATEGIC PLANNING
A. The Master's Recommendations
Part IX of the Master's Consolidated Report concerns strategic planning. The Master's thirteenth recommendation is as follows:
Recommendation No. 13:
Court Monitored Strategic Planning Should Be Initiated By The Trust Estate.
Your Master reiterates the recommendation made in the 109th Master's Report that the Trustees be ordered to complete the strategic planning process aimed at preparing a strategic plan which will lay out a road map for the Trust Estate's future.
Your Master recommends that within 180 days from the date on which the Court issues an order adopting this recommendation the Trustees be required to engage, subject to review and approval by the Court, one or more qualified strategic planning firms with specialized expertise in education, investment, and financial planning, to prepare a comprehensive educational and financial strategic plan for consideration by the Trustees. Your Master further recommends that within 90 days from the date on which the Court issues an order adopting this recommendation the Trustees be directed to prepare a request for proposals, subject to review and approval by the Court, which defines the scope of the strategic planning project to be undertaken and to establish the criteria for qualifying the strategic planning firms from which proposals are to be solicited. The scope of the project should involve the development of an educational plan in conjunction with an investment plan. The educational plan should take into account the future potential of the financial resources available. The investment plan should be fashioned to meet projected educational program needs. The investment plan should take into full account diversification (including thoughtful goal-oriented asset allocation), risk (especially income volatility), and cost-conscious administration. The principal focus of this interrelated planning process should be the educational mission of the Trust Estate.
The strategic planning firm(s) should begin its work no later than 30 days from the date of its engagement. The strategic plan should be completed and presented to the Trustees, the Court, and the Attorney General within twelve months from the date of engagement of the strategic planning firm(s).
The Trustees shall solicit input from appropriate stakeholders on the educational plan component of the strategic plan before adopting a final strategic plan. The Trustees shall exercise their discretion and by considering and acting upon the proposed strategic plan within 90 days after it is presented to them and present a report to the Court regarding their decision.
C.R. at 88.
B. The Trustees Will Complete The Strategic Planning Process
The Trustees previously agreed that they will complete the ongoing strategic planning process initiated by them in 1993. (December 19 Stipulation at 8-9). In so doing, they will implement the foregoing recommendations concerning the strategic planning process, while incorporating as much of their past strategic planning efforts as may be useful and appropriate. The Trustees intend that the details of their schedule and procedures for future strategic planning will be set forth in the stipulated agreements expected to filed herein at or before hearing.
The Master reports his dissatisfaction with the planning the Trustees have undertaken and, in an extraordinary leap of reasoning, concludes that the Court should intervene to compel, monitor, review and approve a new strategic plan. As shown in Part of this Response, the Court has no authority to assume such a role. As set forth above, the Trustees will promptly embark upon a new strategic planning process and will report their decisions to the Court. Nonetheless, the Trustees differ with the Master's remarks and the basis upon which he makes his extraordinary recommendation.
The incumbent Board of Trustees has undertaken more planning activity than any Board in memory. What the Master dismisses as a flawed process is an evolving work in progress. What the Master summarily rejects as a disparate assortment of forty studies, surveys and reports is the product of many months of systematic work by the Trustees and by professional staff among all divisions of the Estate.
The Master states plainly that he has a preferred model: the four volume Booz Allen Hamilton Report issued in 1961. C.R. at 89. His comments imply that the Booz Allen Report was the cornerstone of Estate planning and policy for thirty-seven years and he is plainly unhappy that this model was apparently abandoned by the planning process undertaken in 1993. The Trustees disagree. The Booz Allen Report, which concerned the Kamehameha Schools more than other divisions of the Estate, was drafted and its impact felt more than a generation ago, when Hawaii's population, economy and society and the Estate's financial position were very different. By 1993, the Booz Allen Report had become four volumes on the library shelves.
C. The Trustees Have Undertaken Strategic Planning
In July, 1993, the Trustees initiated a new strategic planning process that was
to encompass all divisions of the Estate. An essentially new board initiated a fresh
look at the Kamehameha Schools Bernice Pauahi Bishop Estate. At that time, the Board
of Trustees consisted of Trustees Peters (appointed 1984), Stender (appointed 1990),
Wong (appointed 1993), Lindsey (appointed 1993) and Thompson, whose term expired
December 1, 1994, when he was succeeded by Trustee Jervis.
From July, 1993 to March 1994, the Trustees and principal executives met in a series of strategic planning retreats and work sessions. By March, 1994, the participants produced a preliminary plan which contained statements of Mission and Values, Vision, Goals and Strategic Objectives.
Forty specialized issue papers were to be developed over the ensuing fifteen months.
The topics were wide-ranging, addressing educational and investment issues, Hawaiian
values, and existing programs at the Schools, among other things. Concerning the
investments, topics included were "Diversification of Assets", "Measuring,
Forecasting and Monitoring Performance of Assets", "Strategic Investment
Plan", "Asset and Income Growth Analysis" , and "Review
of Liquid Assets."
A fact-finding analysis of the Kamehameha Schools by Ernst & Young was commissioned, which analyzed the cost of existing programs. It was found that program costs varied widely from site to site and that Kamehameha Schools seemed to operate best, as measured against its own internal performance measures, when Kamehameha Schools' students were taught the Kamehameha Schools' curriculum by Kamehameha Schools' teachers in Kamehameha Schools' facilities. The final report was issued on April 17, 1994, and was titled "A Policy and Operationally Oriented Review of the Kamehameha Schools Bishop Estate Educational Programs."
Based upon the final report, the Trustees directed that several programs at the Schools be re-engineered or otherwise improved. Two authorities in the educational field were retained: James Yountiss, Ph.D., Director of the Life Cycle Institute at Catholic University in Washington, D.C., and Dr. William Damon of Brown University. Dr. Yountiss had over thirty years of research and teaching experience in the area of early child development. Dr. Damon is a recognized authority on after school programs for disadvantaged children.
From May through September, 1994, re-engineering teams comprised of School personnel were assisted by Ernst & Young in preparing reports to the Trustees on preliminary proposals for re-engineering of programs.
In the meantime, the forty reports on all aspects of Estate operations previously commissioned were being completed. Twenty-four were finished in time for a retreat in September, 1994. On the investment side, these included discussions of strategic investments, asset diversification, performance monitoring, and management of liquidity.
At the October, 1994 retreat, the Schools' President outlined his vision for the Schools, based in part upon the plans and strategies developed in the re-engineering process. The Trustees requested that additional financial estimates be developed for the programs the President presented to them. More of the forty reports were presented at this same retreat.
The next retreat was in February, 1995. It was the first retreat in which all members of the present board of Trustees participated. The President of the Schools identified his priorities among the then-current Schools' programs. Presentations were made concerning the re-engineered educational programs and the Asset Management Group's strategic issues and revenue projections.
The presentations made by both the Asset Management Group and the Schools were inconclusive. Despite months of effort at re-engineering certain of the Schools' programs, the Schools presented both re-engineered programs and arguments in favor of maintaining the status quo. Asset Management's report was preliminary and incomplete.
The Trustees' retreats had been facilitated by Paul Ahr, Ph.D. A clinical psychologist with experience in human resource management, Dr. Ahr was not called upon to determine educational programs but to facilitate Trustee discussion of reports received from the Schools' staff. Similarly, Dr. Ahr was not called upon to develop financial plans or investment strategies for the Estate, but to facilitate Trustee review of staff reports concerning them.
When the February, 1995 retreat proved inconclusive, Dr. Ahr was asked to consider the information the Trustees had received to date and to suggest alternative scenarios based upon the President's list of priorities, Trustee discussion and preferences articulated at the retreats, and other information received by and developed for the Trustees during the planning process. This included input from "Talk Story" sessions the Trustees had conducted and suggestions derived from surveys of the staff of the Estate, including the Schools.
Dr. Ahr developed five options. These included the re-engineered models presented at the February, 1995 retreat, a school and early intervention model, a "virtual school" model, a core school model, and a statewide schools model (Model V). In March, 1995, the Trustees discussed these five models and variations of them. Ultimately, a Core Planning Group was appointed to study the feasibility of Model V (the statewide schools model), to include center-based preschools and scholarships.
The Core Planning Group reported to the Trustees in April, 1995 and the Trustees approved Model V, with an expansion of the center-based preschools, and gave approval in concept to a ten-year initiative, known as "GoForward" . Its goal was to make the Kamehameha Schools the best and biggest private school in America. Ultimately, GoForward incorporated the top six of the President's eleven priorities and recast his eleventh priority. The off-campus programs, including Alternative Education, Continuing Education, Kamehameha Early Education and other federally funded programs, the President's seventh through tenth priorities, were not included.
It is clear from the tone of the Master's Consolidated Report that this process of strategic planning did not yield the results he thinks it should have. It is also clear that the Master prefers the tenor of the Booz Allen Report to that of the Trustees' planning process.
However, as the Master acknowledges, "The Trustees are entrusted with the discretion and authority to set the direction of the educational programs of the Trust Estate." C.R. at 97. The Will of Bernice Pauahi Bishop provides succinctly:
I also give unto my said trustees full power to make all rules and regulations as they may deem necessary for the government of said schools and to regulate the admission of pupils, and the same to alter, amend and publish upon a vote of a majority of said trustees.
Will, Article Thirteen
D. Acceptance of the GoForward Initiative
The Master finds that the GoForward initiative is a "commendable effort on the part of the Trustees." C.R. at 97. A summary of the GoFoward initiative provided to the Master is Exhibit "I" to the Consolidated Report. The Master objects, however, that the process stands in contrast to the Booz Allen process. He finds that staff members expressed frustration and disappointment that they were not given an opportunity to comment on the GoForward initiative. C.R. at 98. The Master concedes that the Trustees provided generous severance packages and employed other measures to mitigate the impact on terminated employees. C.R. at 99. He says, however, that "What should have been welcomed as the most significant and ambitious educational venture for the Trust in decades, turned into an episode clouded by mistrust, misunderstanding, and antagonism ...." C.R. at 99.
The Masters' sympathy for those employees who were terminated is understandable but the unhappiness of former employees should not be the measure by which a decision is judged. The Master's expectations are utopian if he believes that personnel whose positions were eliminated when the off-campus programs were terminated would be anything other than disappointed. For many of the people involved, the off-campus programs had been a career and they, no doubt, considered that the programs were successful and worthy of continuation. They apparently felt this so strongly that, when asked to re-engineer them to be more effective within the standards of the programs themselves, they delivered both re-engineered models and a plea for the status quo.
The Trustees have represented to this Court that they have been engaged in strategic planning and it is clear from the facts that they have been so engaged. The Master's own narrative concedes the fact that strategic planning has occurred. In fact, the process the Trustees employed was textbook strategic planning. The Master would have preferred a different process and, apparently, a different result. The Master is entitled to his opinions but he should not be heard to deny the process itself. Planning does not always yield an expected result. Perhaps Booz Allen Hamilton would have arrived at the point of the GoForward initiative had it been asked to conduct the work for the Trustees. Perhaps not. In either event, the GoForward initiative is, as the Master states, a commendable effort that should have been welcomed as the most significant and ambitious educational venture for the Trust Estate in decades.
The following events occurring outside the accounting period should be noted: In the summer of 1996, the post high scholarship program was increased by $3.1 million to $13.9 million; in August, 1996, pilot Neighbor Island satellite schools opened on Maui and East Hawaii; the Ho_aliku Drake Preschool, designed as a model for other permanent preschools, opened in Waianae in September, 1996; and in August, 1997, the Education Strategic Plan for 1997-2005 was approved and the Maui School Master Plan was completed.
The planning process is not ended. In June, 1998, the Trustees agreed to review
the GoForward initiative and possible program enhancements. This review
will enable the Trustees to assess the progress of the GoForward initiative,
review updated cost estimates, assess the reaction of the Kamehameha ohana and the
community, consider programs that were phased out, re-engineered programs, and new
and enhanced programs in light of the current and projected financial situation.
An accelerated rollout of GoForward and possible enhancements of it
are distinct possibilities.
In addition to an accelerated rollout, possible enhancements that have emerged include extending the preschools downward to age 2 and younger; adding remedial reading and language arts; establishment of specialized programs for Kamehameha Schools students who are not able to benefit from the standard curriculum; and various enhancements of the scholarship program to reach more young adults pursuing post high school education and more students requiring specialized educational services.
IX. THE "LEAD TRUSTEE" SYSTEM AND CEO-BASED MANAGEMENT
The Master's fourteenth recommendation is as follows:
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.
Your Master recommends that the Trustees be ordered to cease administering the Trust Estate based upon the "lead trustee" system of management. The Trustees should be further required to show cause in their response to this Report of why they should not be ordered by the Court to adopt and implement a CEO-based system of management for the Trust Estate as recommended in the Andersen Report within 180 days after the date on which the Court issues an order adopting this recommendation. Such a system should incorporate a formal governance policy which more clearly defines the roles of the Board of Trustees and that of the CEO.
C.R. at 111.
A. The "Lead Trustee" System Has Been Terminated
The Master again raises the specter of the so-called "Lead Trustee" system. C.R. at 104 ff. He discussed the same matter in his First Report and the Trustees replied to it in their First Response. First Response at 66 - 69.
The so-called "Lead Trustee" system has already been terminated. The
Trustees have stated that Trustee Lokelani Lindsey relinquished her role as the so-called
"Lead Trustee" for the Education Group in August, 1997. Trustees' Response
To Final Report Of Fact Finder, Filed Under Seal On December 4, 1997, filed herein
on December 10, 1997, at 7. "Trustee Lindsey has formally withdrawn as
Lead Trustee for the Education Group." Id. at § 8. On August 3,
1998, Randall O. Chang became the new General Manager of the Estate's Asset Management
Group and Trustee Henry Peters withdrew as the Interim General Manager of that Group.
Other Trustees also have already given up any direct supervision of specific groups
or departments of the Estate.
While the Trustees do not necessarily agree with the Master's observations concerning the functioning of the system, the relevant fact is that it has been dropped. The Trustees previously stated that the system was embarked upon in good faith for the purpose of capitalizing upon each individual Trustee's interests and specialized experiences, while maintaining a collective decision making process within the Board of Trustees. (First Response at 66) The system, as it was perceived, was criticized by the Master and others. It no longer exists.
B. CEO-Based Management
The Trustees have undertaken to complete the strategic planning process. See Section above. That process is expected to assist the Trustees in defining the future administrative structure of the Estate and, in conjunction with that process, the Trustees will study and plan for their implementation of an Estate CEO-based structure. In the interim, the Trustees intend to implement a pilot Estate CEO-based system whereby an Estate CEO will be charged with (i) shepherding the strategic planning process, (ii) being a communications bridge between the Trustees and the Estate's staff and management, and (iii) handling general administrative issues. The Trustees intend that relevant details concerning these matters will be set forth in the stipulated agreements expected to filed herein at or before hearing.
C. Implementation of CEO-Based Management Is Discretionary
The Master correctly reports that this Court has previously declined to adopt a recommendation that a CEO be appointed. C.R. at 102. It did so in recognition of the fact that the staffing and administration of the Estate lie within the discretion of the Trustees, not the Court. The Master seeks to overcome the rule against Court interference in the administration of trusts by suggesting that the Trustees have a conflict of interest that authorizes the Court to act. C.R. at 110. This speculation on the Master's part does not warrant an invasion of the Trustees' inherent authority to manage the Estate. If the Court assumes control of the management structure and administration of the Estate, the Court will have usurped the Trustees' duties and responsibilities.
The role of the Court and the limitation on its authority to interfere or intervene in the administration of trust estates is discussed elsewhere in Part of this Response. It is clear that the Court cannot lightly interfere with the administration of a charitable trust and that the fact that the Court would have exercised a discretionary power differently is not a sufficient reason for judicial interference in trust administration. Takabuki v. Ching, 67 Haw. 515, 530, 695 P.2d. 319, 328 (1985).
The Master's speculation that the Trustees are conflicted because of they receive compensation is too facile to withstand scrutiny. If trustees were disqualified by reason of their compensation from making discretionary decisions concerning trust management and administrative structures, it would follow that the courts, not the duly appointed trustees, would be called upon to determine the structure and operation of all trusts other than those in which the trustees are uncompensated. This has never been the law.
D. Discussion Concerning Delegation to a "CEO"
In his fourteenth recommendation, the Master asks that the Trustees show cause why they should not be compelled to adopt a CEO structure. C.R. at 111. While the Trustees are willing to implement a pilot Estate CEO-based system and to engage in strategic planning that will enable them to define the role of an Estate CEO, the Master must recognize that the organization of the Estate is a matter within the discretion of the Trustees and that traditional trust law absolutely forbade delegation of a trustee's discretionary authority to another. The law at the time of Bernice Pauahi Bishop's death was clear:
... "Wherever power is given, ... if the power repose a personal trust and confidence in the donee of it, to exercise his own judgment and discretion, he cannot refer the power to the execution of another, for delegatus non potest delegare [a delegate cannot delegate]."
Any infraction of this rule will usually result not only in the invalidity of the act done under the delegated power, but also in the liability of the original donee of the power for all damages resulting from his breach of trust.
A. H. Marsh, Delegation of Powers and Trusts, 21 Am. L. Rev. 936, 937 (1887).
This prohibition against delegation of a trustee's discretion is reflected in Professor's Bogert's current edition of The Law of Trusts & Trustees wherein he states:
The cases and texts sometimes state that a trustee cannot delegate to another a power the use of which involves discretion, but may permit another to perform for him merely "ministerial" acts. ... It would appear that the difference is rather between acts which demand a large amount of prudence and judgment and involve important decisions, and other acts which require relatively little discretion and experience and include only the making of unimportant decisions.
George G. Bogert & George T. Bogert, The Law of Trusts & Trustees, § 555 at 114-115 (rev'd 2d ed. 1980) (footnotes omitted) (hereinafter cited as "Bogert").
From this, Bogert concludes that prudent trustees may hire brokers and lawyers to secure offers and negotiate terms because "[t]he performance of such acts does not entail the making of vital decisions." Id. § 556 at 135. But discretionary powers, such as the power to enter into leases, terminate leases and remodel buildings cannot be delegated because:
... when the trustee accepts the trust, he does so with the implied understanding that he will discharge the duties incumbent upon him, by reason of the trust, according to the his own best judgment, and, hence, unless the grantor expressly provides that the trustee may delegate the powers conferred, he cannot do so.
Id. § 556 at 138 (emphasis added).
Professor Scott's treatise is concise and unequivocal:
Another fundamental duty owed by the trustee to the beneficiaries of the trust is the duty not to delegate to others the administration of the trust or the performance of acts in the administration of the trust that the trustee ought personally to perform. This duty is imposed on the trustee not because of any provision in the terms of the trust but because of the relationship that arises from the creation of the trust. This does not mean, of course, that the trustee must perform every act that may be necessary or proper in the execution of the trust. He can properly permit others to perform acts he cannot reasonably be required personally to perform.
IIA Scott § 171 at 437-38 (emphasis added).
"So too, even though the trustee continues to be trustee, it is a breach of trust to commit the whole management of the trust estate to another, unless he is permitted to do so by the terms of the trust. "
Id. § 171.1 at 439 (emphasis added).
Pauahi's Will is clear on the point. She did not envision the delegation of the Trustees' discretionary authority to persons other than her Trustees. In addition to the grant of "full power" to her Trustees under Article Thirteen of her Will, she also provided as follows:
I direct that a majority of my said trustees may act in all cases and may convey real estate and perform all of the duties and powers hereby conferred; but three of them at least must join in all acts. I further direct that the number of my said trustees shall be kept at five; ....
Will, Article Fourteen.
On the law as uniformly stated in Scott and Bogert, in the case authorities and the Second Restatement, § the Trustees would have been liable for surcharge had they taken it upon themselves to delegate their discretionary responsibilities to a CEO and the actions of the delegate would have been void or voidable. See IIA Scott § 171.2 at 442-44. While some limited delegation of acts involving "little discretion and experience" would have been allowed, it would have been a flagrant violation of the Trustees' fiduciary responsibilities for them to have appointed a true CEO with responsibility for the major affairs of the Estate.
This view is demonstrated in the case In re Bernice P. Bishop Estate, 36 Haw. 403 (1943), wherein the Supreme Court of Hawaii held that the Bishop Estate trustees might employ administrative assistants to perform delegable duties because "[I]n the case of large estates, it has been held not improper to employ an accountant or other agent to perform services which in the case of a smaller estate the trustee would be expected personally to perform." Id. at § 414.
This long-standing view changed somewhat in 1985 when the Hawaii Legislature adopted the Uniform Trustees' Powers Act, H.R.S. § Ch. 554A. That Act permitted delegation by trustees to specialized service providers, such as investment advisors. Section 554A-3(c)(23) provides that a trustee may employ attorneys, auditors, investment advisors and agents "to advise or assist the trustee in performance of the trustee's administrative duties" and authorizes the employment of agents to perform particularized acts of administration, including discretionary acts. Section 554A-4 of that Act provides, however:
The trustee shall not transfer the trustee's office to another or delegate the entire administration of the trust to a co-trustee or another.
In 1997, the Legislature enacted HUPIA, the Hawaii Uniform Prudent Investor Act. HUPIA and its origins are discussed in detail above. As shown, HUPIA is not a codification of prior law but is a conscious and deliberately revolutionary change in trust law derived from the Third Restatement, which was intended not merely to restate but to actually rewrite the law of trusts.
In a reversal of long established trust law but consistent with the direction of the Uniform Trustees' Powers Act, HUPIA provides that a trustee may delegate certain investment and management functions. HUPIA, however, does not provide for the employment of CEOs to take over the entire management and administration of trusts. Section 554A-4, quoted above, remains the law: a trustee shall not delegate the entire administration of the trust to another. In fact, HUPIA (the Hawaii Uniform Prudent Investor Act) is concerned with enabling trustees to employ professional investment managers. HUPIA is not carte-blanche for the employment of someone to actually run the affairs of an estate while its trustees merely assemble quarterly to establish policy.
The term "CEO" is derived from corporate practice and has no current definition in trust law. Referring to CEOs, a leading commentator on corporate law states:
This section discusses the powers of the officer in charge of the entire corporation who answers directly to the board of directors. This type of officer is called either the general manager or the chief executive officer. The general manager of a corporation has general charge, direction, and control of the affairs of the company for the carrying on of which it was incorporated. ... Some corporations give the title "general manager" to persons at intermediate managerial levels, reserving the title "chief executive officer" for the person at the top.
Fletcher Cyc. Corp. § 667 at 22 (Cum. Supp. 1997).
This corporate model is not directly applicable to a trust estate. Trustees are not merely directors to whom some employee having "general charge, direction, and control of the affairs" of the estate reports periodically. Unlike a corporate director, a trustee is the legal owner of the estate entrusted to him and he is expected to administer that estate to the best of his ability. He does not merely fix policies and leave the business to another to run. HUPIA enables trustees to hire and delegate certain authority to investment experts but it has not abolished the concept of trusteeship nor repealed the special fiduciary obligations assumed by a trustee upon acceptance of appointment. Its concern is with investment activity and its scope is far more limited that the Master's narrative implies.
Yale law professor John H. Langbein was the reporter for the drafting committee of the Uniform Prudent Investor Act. In his law review article, Reversing the Nondelegation Rule of Trust-Investment Law, 59 Mo. L. Rev. 105 (1994), he explained that the text of subsection (a) of the Act, which permits delegation by trustees, "closely follows the Restatement (Third) in treating the decision of whether and how to delegate as part of the trustee's overall responsibility for prudent investing." Id. at § 117 (emphasis added). He noted that the Third Restatement was drafted by Professor Halbach and arose from Halbach's larger project which was to update the prudent investing standard to accommodate developments in fiduciary investment practice under the influence of Modern Portfolio Theory, which treats the trust portfolio as a whole. "For larger trusts that continue to do individualized investing, investment professionals will increasingly be in command. And thus the decision to reverse the former nondelegation rule of Restatement (Second) and to incorporate within the new prudent investor rule of Restatement (Third) the duty to decide "whether and how to delegate ...." Id. at § 116 (emphasis added, footnotes omitted).
Arthur Andersen's comment in its Executive Summary that most sizeable estates in Hawaii function under a CEO structure (C.R., Exhibit "B" at 28) is inaccurate unless the term "CEO" is given some specialized meaning in a trust estate context that is different from its meaning in the corporate world. Other large Hawaii trusts have a variety of management structures, including reliance on a co-trustee which also is a licensed trust company; employment of an executive secretary to the trustees; and employment of individuals who have broad authority with respect to ministerial acts but whose limited authority over discretionary acts may only be exercised in conjunction with trustee approval.
In summary, the Kamehameha Schools Bernice Pauahi Bishop Estate could be reorganized to include an individual who would exercise a spectrum of authority ranging from a high degree of control over ministerial activity (routine consents to assignments of lease, for example) to a duty to implement specific decisions of the Trustees (investment in Goldman Sachs and acquisition of the Hamakua lands are current examples).
Under HUPIA and the Uniform Trustees' Powers Act, the Trustees also are authorized to delegate investment decisions provided that they select the agent, establish the scope and terms of the delegation consistent with the purposes and terms of the trust, and periodically review the agent's actions in order to monitor his performance and compliance with the terms of the delegation. H.R.S. § 554C-9(a)(1), (2) and (3).
As discussed above, HUPIA and the Third Restatement are primarily concerned with granting trustees the authority to hire and rely upon experts in the increasingly sophisticated world of finance and investments. It does not follow, however, that the person or persons best able to assist the Estate and the Trustees in such investments is necessarily the best person to administer the ministerial activities of the Estate and to implement the Trustees decisions as to matters which cannot be delegated. Put differently, it may not be a prudent use of an investment professional's talents to place him in charge of real estate management, personnel, legal affairs, accounting and the educational functions of Kamehameha Schools Bernice Pauahi Bishop Estate.
E. The Kamehameha Schools
In Section B of Part X of the Consolidated Report, the Master comments on the administration of the Kamehameha Schools and remarks that the governance structure and relationship between the Trustees and the management of the Schools "needs to be better defined and put back in order." C.R. at 113.
The Trustees have acted to do exactly this. They acknowledged the existence of controversy surrounding the Schools and, on May 14, 1997, petitioned this Court for instructions concerning the appointment of Patrick K.S.L. Yim as a fact finder. The Court's order on the petition was entered on July 10, 1997. Judge Yim's report was filed herein December 4, 1997. On December 10, 1997, the Trustees stated their intention to engage an independent expert to perform a specialized management audit of the educational programs and organization within the Estate's Educational Group. Thereafter, they selected Peterson Consulting, LLC, to perform that audit.
The Peterson Report is a comprehensive evaluation of the management, organization and education programs of the Estate's Education Group and the Kamehameha Schools. (Peterson Consulting, Kamehameha Schools Bishop Estate Evaluation as of June 1, 1998, filed herein on July 28, 1998.) The 190 page report contains 99 findings and makes 151 recommendations in response to those findings. Separate sections of the report are devoted to Governance and Management, School Planning, Academics and Educational Performance, Student Support Services, and Operations and Facilities. The report cautions that it should be read in its entirety to obtain a complete understanding of its analysis (Id. at § 1) and no summary or interpretation of the Peterson Report will be presented here.
It is significant, however, that Section VIII of the Peterson Report summarizes the recommendations, identifies the departments and functions responsible for implementing them and offers a suggested timetable for each implementation. The timetable, beginning at page 168 and concluding at page 190, identifies three timeframes: By January, 1999; by June, 1999; and by January 2000.
With respect to the controversy at the Schools, the Trustees have done the very things that the Master urges them to do with respect to other matters. They sought this Court's instructions. They obtained information from a fact finder. They commissioned a professional consultant's report. They are considering a twenty-two page timetable for further action recommended to them by the consultant. They are endeavoring to better define the governance structure and the relationship between the Trustees and the management of the Schools. They will also review and consider the principles set forth in the extract from the Booz Allen Report marked as Exhibit "J" to the Master's Consolidated Report.
The Master's fifteenth recommendation is as follows:
Recommendation No. 15:
Compliance Plan For Determining Reasonable Trustee Compensation Should Be Prepared.
In light of the new standard for compensation under state law in addition to the requirements of the Intermediate Sanctions Law, your Master recommends that the Trustees be ordered to present to your Master a compliance plan for determining their compensation which will satisfy both statutory requirements for the review and approval by the Court prior to November 13, 1998, the date of the first scheduled hearing for the 112th Annual Account.
Your Master further recommends that the Court issue a standing order that in the future, should compliance with the statutory requirements necessitate the preparation of a study regarding the reasonableness of Trustee compensation, such compensation study should be an independent study, utilizing relevant and appropriate criteria, commissioned by the court's master as part of the annual account review process. If the Trustees wish to prepare a compensation study of their own, they should do so at their own expense and not at the further expense of the Trust Estate.
C.R. at 122.
The Master's recommendation suggests an unprecedented involvement of future masters in the management of the Estate by putting the masters in charge of the process by which the Trustees' compensation will be determined. Some background is necessary to put the recommendation in perspective.
B. Trustees Have Always Been Entitled To Compensation
It has long been recognized that Trustees are entitled to receive compensation for their services. Even before trustee compensation was expressly covered by statutory law, the Hawaii Court said:
The trustee must also be allowed a reasonable price for his services. He was placed in possession as manager of an estate. As such, he should be allowed all proper expenses to keep up the estate, and his personal work was constantly required. The better rule now is that trustees should be allowed reasonable compensation for their time and trouble.
Hart v. Kapu, 5 Haw. 196, 199 (1884).
From the earliest times in Hawaii, it was the practice of the probate court to
allow trustees commissions based upon the statutory schedule applicable to executors,
administrators and guardians which was set out in the Civil Code of 1859. Estate
of Wichman, 27 Haw. 780, 783 (1924) ("Emoluments have always been attached
to the office of fiduciary in this jurisdiction." )
Trustees were added to the list of persons entitled to statutory commissions in 1928. 1927 Haw. Sess. L. ch. 183. There were at least six subsequent amendments to the law applicable to charitable trustees. During the period of the three accounts under review, the Trustees' compensation was based upon a commission schedule established by H.R.S. §§ 607-18 and 20. The Master correctly notes that "the statutory formula has consistently yielded a maximum commission substantially in excess of what the Trustees actually receive." C.R. at 115. In other words, the Trustees have not taken the full commission allowed them by the statute. During the accounting period, the Trustees have accepted less than 55% of the commission due them under the schedule. C.R. at 116. No commissions were taken on land sales and commissions were waived as to other capital receipts and disbursements as well.
Act 310 of the 1998 State Legislature amended the law applicable to compensation of charitable trustees. It abandoned the practice of 140 years whereby trustees receive a commission based upon their performance, in favor of a general statement that "the compensation of the trustees shall be limited to an amount that is reasonable under the circumstances." This provision becomes effective January 1, 1999. This law still recognizes that the Trustees are entitled to compensation. The Master acknowledges that the Estate's Trustees "should be highly compensated individuals" in order to ensure that capable and qualified persons are fully committed to the responsibilities of the trusteeship. C.R. at 121.18
C. Intermediate Sanctions Law Preempts State Law
State law concerning charitable trustee compensation is, for practical purposes, irrelevant. The Internal Revenue Code was amended on July 30, 1996 by the Taxpayer Bill of Rights 2, which included provisions applicable to tax exempt entities. Known as Intermediate Sanctions, these provisions are retroactive to September 14, 1995. Under Intermediate Sanctions, the Internal Revenue Service will be the ultimate authority as to whether the total compensation paid to the Trustees is reasonable. State law on the issue is effectively preempted.
D. The Estate Will Comply With The Intermediate Sanctions Law
In his First Report, the Master recommended that the Trustees develop procedures to ensure that the Estate is in full compliance with the Intermediate Sanctions Law. (First Report at 102) In their First Response, the Trustees stated that they will comply fully and completely with the Intermediate Sanctions Law but noted that Treasury regulations implementing the Law had not been published. (First Response at 79)
In the December 19 Stipulation, it was agreed as follows:
The Trustees will comply with the Intermediate Sanctions Law. The Trustees will consult with professional staff and consultants concerning such compliance. The Trustees will adopt appropriate procedures and a compliance plan. Such procedures and compliance plan will be provided to the court-appointed master and the Attorney General pursuant to the Restated Guidelines prior to the first scheduled hearing for the 112th Annual Account. The parties recognize that, depending upon the text of the final Treasury regulations, review and approval by other agencies, including the Court and the Internal Revenue Service, also may be required.
December 19 Stipulation at 18 (emphasis added).
The IRS unveiled its proposed regulations on July 30, 1998. These regulations explain the documentation that will be required to satisfy the IRS and the nature of the independent body whose compensation determinations will enjoy a presumption of reasonableness. The Estate's tax advisors delivered a copy of the proposed regulations to the Estate the day they were released and are working now to formulate a compliance plan. As previously agreed in the December 19 Stipulation, the Trustees will provide that plan to the Master and the Attorney General. The Trustees may seek an order of this Court assuring them that their compliance with federal law will be sufficient for State law purposes as well.
E. No Further Orders Are Appropriate At This Time
For the time being, this Court should make no order concerning what now is essentially a matter of federal law. Compliance with the Intermediate Sanctions Law likely will entail use of an independent entity to determine Trustee compensation. That entity will be obliged to obtain comparability data and to document its decision. Whether or not the Court's masters are appropriate persons to commission necessary studies is not clear at this time. The Trustees will present a compliance plan.
When they do so, further orders of this Court then may be appropriate.
F. The Cost of Compensation Studies Is An Estate Expense
The Master objects that the Trustees commissioned two compensation studies during FY 1996 and argues that, in the future, the Estate should not be required to pay for more than one such study. C.R. at 117, fn 39. This is another example of how each master views the same issues differently. In response to a previous master's concerns, this Court approved the Trustees' retention of "one or more nationally recognized experts ...." to make compensation studies. Findings of Fact, Conclusions of Law and Order Approving 105th Annual Report, entered herein on June 8, 1992, at 7. The following year, at the urging of the master, this Court directed the Trustees to commission periodic reviews "by one or more nationally recognized experts" at least every three years. Findings of Fact, Conclusions of Law and Order Approving 106th Annual Report, entered herein on December 27, 1993, at 6.
Accordingly, the Trustees commissioned two studies in FY 1996, one from SCA Consulting, LLC, which had prepared the 1993 study (under its prior name "Strategic Compensation Associates"), and the other from Towers Perrin. Both entities are nationally recognized experts in the field of compensation. The studies, which are attached as Exhibits "M" and "N" to the Consolidated Report, corroborate each other. The total compensation of the Trustees in FY 1996 is in the middle of the ranges reported by both studies.
Under the terms of the 1993 Order, the next compensation studies would be due not later than FY 1999. In the future, however, such compensation studies as may be conducted will be performed pursuant to requirements of the Intermediate Sanctions Law and a process by which reasonable Trustee compensation will be determined must be developed in light of the proposed regulations just published.
If that process reasonably requires reports from more than one recognized expert,
the cost should be borne by the Estate. The Trustees are entitled to reimbursement
for necessary expenses and costs reasonably incurred in the administration of the
Estate. Bogert § 975. Just as they are entitled to be reimbursed for their surety
bonds, which protect the Estate, so are they entitled to be reimbursed for such compensation
studies as are reasonably required to assure the Estate's compliance with the Intermediate
Sanctions Law. As shown above, the Trustees are entitled to their compensation. Federal
law requires that their compensation (and possibly that of other Estate executives)
be established with reference to comparability data. The cost of securing that data
is properly an expense of the Estate.
XI. DUTY OF LOYALTY AND CONFLICT OF INTEREST
Part XII of the Consolidated Report concerns the Trustees' duty of loyalty and the included duty to avoid conflicts of interest. The Master specifically states that he makes no finding that any Trustee or Estate employee breached any duty of loyalty. C.R. at 126 & 129. Instead, as elsewhere in the Consolidated Report, the Master uses examples to illustrate his view that stricter internal guidelines and procedures should be adopted. The Master's sixteenth recommendation is as follows:
Recommendation No. 16:
Stricter Conflict Of Interest Policies And Procedures Should Be Adopted.
Your Master recommends that the Court order the Trustees to develop and adopt stricter guidelines and procedures to ensure appropriate compliance with fiduciary standards. Your Master also recommends that future compliance with such guidelines and procedures be specifically monitored in connection with the annual account review. Your Master recommends that a compliance report regarding this recommendation be provided to your Master within 90 days from the date on which the Court issues an order adopting this recommendation.
C.R. at 135.
The Trustees accept the Master's recommendation that stricter conflicts policies should be adopted and they will do so. They note, however, that the three examples narrated by the Master (McKenzie Methane, Mid-Ocean Limited, and RTJ Golf Course) all arose in prior years and that they have adopted a conflicts policy and a fiduciary handbook since then. Specifically, the McKenzie Methane investments were made in FY 1989; the Mid-Ocean investment in FY 1993; and RTJ in FY 1995. The Trustees' Conflicts of Interest Policy was adopted on August 22, 1996 and is incorporated in a Trust Administration And Fiduciary Guidelines Handbook containing numerous fiduciary policies, which was approved on August 12, 1997.
The Master's concern is prospective and his recommendation concerns policies, not past events.
Nonetheless, the Trustees note briefly the following:
The Trustees discussed the McKenzie Methane investment in their First Response at pages 70 and 71. Thereafter, pursuant to the December 19 Stipulation, the Trustees delivered a supplemental report to the Master and the Attorney General. The individual investments in McKenzie Methane were made in 1989, after the Estate had made its investment. The individual investors acquired a different kind of interest that was not appropriate for a tax exempt entity.
Mid-Ocean Limited has recently become a publicly traded entity and the Estate has enjoyed significant appreciation of its investment. The Estate has suffered no loss or detriment by reason of the service of Trustees Takabuki and Peters as directors of Mid-Ocean. The director's compensation paid them was standard and did not belong to the Estate. As the Master notes, service by a Trustee as a director of an Estate investment is not per se prohibited or inappropriate. C.R. at 128. Trustee Peters' term of office has expired.
The Estate's involvement in the Robert Trent Jones Golf Club traces back to an equity investment made in 1986. In 1994, when the developer defaulted on a note, the Estate acquired the deed of trust (a mortgage) of the property and thus the right to appoint the trustees of the club. Trustee Peters became a club trustee. Thereafter, he and other club trustees acted to restructure the debt and proceed with the development. It is not inappropriate for the Trustees to appoint one of their number to serve on the board of a troubled investment. Trustee Peters' actions did not compromise his fiduciary obligations to the Estate. He recused himself from all Estate action concerning the club. In fact, two disgruntled members of the club later brought suit (later settled) wherein they alleged, inter alia, that Trustee Peters had ceded control of the club to the Estate and had variously acted to favor the interests of the Estate over those of the club.
The Master makes the point several times that he would prefer that the Trustees had obtained legal opinions and possibly instructions from the court concerning their involvement in these investments. The August 1996 Conflicts Policy provides for review by legal counsel and acknowledges that judicial instructions may be obtained in doubtful cases. The Trustees will further address these concerns in an expanded conflicts policy.
The Master's seventeenth recommendation is as follows:
Recommendation No. 17:
Trustees Should Show Cause Why They Should Not Be Surcharged For Expenses Incurred In Opposing Intermediate Sanctions Legislation.
Your Master recommends that the Trustees show cause in their response to this Report of why they should not be required to account for and be surcharged for all Trust Estate funds and resources expended on such activity.
C.R. at 138.
In a footnote, the Master states that on August 3, 1998, he received a response from one of the law firms involved in the legislative effort and that, "As of the date of this Report, he has not had an adequate opportunity to thoroughly review the response and obtain additional pertinent information." C.R. at 138 fn. 46. Subsequently, the Master requested additional information from the Estate's law firm, Verneer, Liipfert, Berhard, McPherson & Hand, in Washington, D.C. A reply to the Master is pending as of the date of this Response.
The Trustees believe that when the Master has had an opportunity to review the relevant materials and the actual efforts of the Estate in connection with Intermediate Sanctions, he will conclude that his recommendation of surcharge is mistaken and should be withdrawn. Accordingly, they ask the Court to defer action as to Recommendation No. 17, pending the Master's completion of his review. If the Master then remains dissatisfied, the Trustees will promptly submit a petition placing the matter before the Court for its determination.
In the meantime, the Trustees make the following points: Tax exempt entities, including the Estate, are entitled by law to conduct a limited amount of lobbying activity. The Estate's lobbying activity was within allowable limits. As originally drafted, the Intermediate Sanctions safe harbor provisions did not necessarily include charitable trusts. The Trustees sought clarity in the provisions and, with other charitable organizations, endeavored to have them amended before they became law. Among provisions eliminated from the final version of the bill was a potentially devastating penalty "exit tax" which, if ever enforced against a charity, would have required the charity to pay an amount equal to the lesser of (i) the total of all tax benefits ever enjoyed by it or (ii) its net assets.
The brevity of the Trustees' response to this issue should not be mistaken as conceding the Master's recommendation. The facts and the issues involved are complex and, if further review does not satisfy the Master, a hearing involving out of state witnesses likely will be necessary.
XIII. TAX ISSUES
Part XIII of the Consolidated Report concerns the tax exempt status of the Estate and an ongoing audit of the Estate by the Internal Revenue Service. C.R. at 138-141. The Master's eighteenth recommendation is as follows:
Recommendation No. 18:
Negotiation And Resolution Of IRS Audit Should Be Subject To Court Monitoring And Approval.
Your Master recommends that the Trustees be ordered to: (1) immediately notify your Master of any Notices of Proposed Adjustment (Form 5701) or Revenue Agent Report (whether in draft or final form) issued by the IRS or any other communication from the IRS which describes the issues raised by the pending audit; and (2) provide your Master with timely confidential reports regarding the status of the IRS Audit, including any issue which may raise a potential conflict between the interests of any Trustee personally and the interests of the Trust Estate and any negotiations between the Trustees and the IRS related to a resolution of issues affecting the Trust Estate.
Your Master further recommends that should the overall resolution of issues between the Trust Estate and the IRS include the proposed resolution of any issue in which one or more Trustees may face a conflict of interest, the Trustees shall neither negotiate nor enter into any Closing Agreement or other agreement relating to the proposed resolution without notice to, review by, and approval of the Court pursuant to a proper petition in accordance with HRS 554A-5(b) or such other procedure as the Court may order.
C.R. at 141.
If a conflict of interest arises in connection with the Trustees' resolution of issues with the Internal Revenue Service, the Trustees will bring the matter to the Court for instructions. If no conflict arises, no instructions will be appropriate.
The Trustees are cognizant of their obligation under H.R.S. § 554A-5(b) to seek this Court's instructions "[i]f the duty of the trustee and the trustee's individual interest ... conflict in the exercise of a trust power." Unless that "if" arises, it is not the place of the Master or the Court to oversee the Trustees' handling of an IRS audit. Their decisions, including any adjustments accepted by them or imposed upon them by the IRS, will be disclosed to this Court's master incident to the annual account of the year in which they occur. The Court (and the Master) must resist the temptation to undertake the exercise the of the Trustees' discretion for them in the meantime. See Takabuki v. Ching, 67 Haw. 515, 530, 695 P.2d. 319, 328 (1985).
The Master also requests an in camera conference to advise the Court. C.R. at 140. The Trustees agree that any presentation to the Court concerning tax matters should be in camera . With all due respect to this Court, however, the Trustees submit that these matters are essentially issues of federal law as to which this Court has no authority. As stated in the Trustees' First Response, this Court's jurisdiction is concurrent with that of the IRS and its action is not contingent upon that of the IRS. The Estate has been audited before and will be audited again. All large businesses must accept IRS audits as a fact of life. The Master's effort to insert himself and this Court in the resolution of any adjustment is inappropriate.
Most often, tax adjustments are a matter of business judgment well within the scope of the Trustees' discretion. By way of hypothetical example, if a tax paying subsidiary of a tax exempt charitable entity has suffered losses and the IRS disallows deductions for those losses, an adjustment may have to be made. The fact that the trustee of the charity and the IRS disagree about the treatment of the loss does not mean that the trustee has done anything wrong. Instead, one might question whether a trustee who adopts the most conservative course resulting in the payment of the most taxes is doing his job.
XIV. REVISION OF THE RESTATED GUIDELINES
In Part XV of the Consolidated Report, the Master correctly reports that the Trustees, the Master and the Attorney General have agreed to work cooperatively to develop amended Guidelines and that work on the amended Guidelines has not yet begun. C.R. at 144. The Trustees urge that the Guidelines need to be redesigned rather than merely restated.
B. History of the Guidelines
The Guidelines developed out of a recommendation made by Michael David Hong in his Master's Report On The One Hundredth Annual Report Of The Trustees, filed herein on November 17, 1986 and covering FY 1985. He envisioned guidelines which would establish the scope of the Master's work. His entire comment and recommendation reads as follows:
Presently there are no specific guidelines for the court-appointed Master in examining and reporting on the Estate's accounts, assets and finances in the 100th Accounting. The scope of examination of the Master in reviewing an examining the affairs of this diversified and complex Estate is presently unlimited and is as broad as the Master determines it to be within a specified fiscal year. The Master could have continued on and on in examining each and every phase of the Estate's business and activities, its goals and objectives but limited himself to what he considered to be priority issues to examine and report on. Therefore, the Master recommends that the court consider establishing some guidelines for future Masters to determine their scope of examination and to set certain standards and procedures for future Masters to follow to assist them (and the Estate) in fulfilling their duties and responsibilities.
Id. at § 17-18 (emphasis added).
Judge Philip Chun directed the Mr. Hong to work with the Trustees and their counsel to develop proposed Guidelines. Mr. Hong prepared and submitted his Proposed Minimum Guidelines For Future Masters on January 22, 1988. His draft acknowledged the inadequacies of a mastering system which obliged each new master to become familiar with the complexities of the Estate and had become a "time-consuming and frequently an unorganized undertaking sometimes repetitive of the review made by preceding Masters and by the Estate's Auditor." Id. at § 3 In order to minimize the downtime to the Estate's staff and make the mastering process more organized, he provided that certain enumerated information would be routinely provided to the masters "which the Masters may then reasonably accept and rely upon in formulating their reports to this Court." Id. at § 3-4.
The entire thrust of the recommended guidelines was to define a table of information and certifications that would be provided to the masters and upon which they might rely. While the draft specifically reserved the authority of the Masters to inquire beyond the outlined materials, its sole purpose was to facilitate a more efficient mastering process.
The Trustees concurred with the draft guidelines except in one respect. They requested that the master's review of the Estate's "affiliates" be limited to entities wholly owned by the Estate or as to which the Trustees had practical control. Trustees Response To Proposed Minimum Guidelines For Future Masters, filed herein on February 3, 1988.
Judge Chun accepted the Trustees' position and promulgated Minimum Guidelines for future masters by Order entered on May 4, 1988, with the requested change concerning affiliates. It is important to note that nothing in these original Minimum Guidelines required publication of any internal business records of the Estate. The information and certifications enumerated were a list of information to be provided to the Master, not the public.
A year later, the Attorney General urged that the Guidelines be amended to require the Trustees file a schedule of their commissions and a copy of the Estate's Federal Form 990 with their annual report and to expand the information contained in the annual publication of an inventory of assets. The Trustees agreed and the Court so ordered. Findings Of Fact, Conclusions Of Law And Order Approving 102nd Annual Account, entered herein on July 12, 1989, at 6, 10. The Guidelines were amended and restated in full to incorporate these additions. Amended Order Establishing Minimum Guidelines For Future Masters And Instructing Trustees Concerning Future Annual Reports, entered herein on July 12, 1989.
These Amended Guidelines were amended the following year. The list of information to be routinely provided to the masters was expanded and the form of the Trustees' certifications to the masters was clarified. Among the materials to be provided to the Master was the Trustees' strategic plan. The Order specifically provided that, in view of its sensitive nature, the strategic plan was not to be copied or published except where necessary to the master's review, and then only after a judicial determination of reasonable necessity. Findings Of Fact, Conclusions Of Law And Order Approving 103rd Annual Account, entered herein on October 16, 1990, at 8 - 10.
The Amended Guidelines were again amended in 1992 to extend the date by which the annual accounts were to be filed. The same Order tacitly amended the Guidelines by requiring that any compensation studies commissioned by the Trustees be provided to the masters. Findings Of Fact, Conclusions Of Law And Order Approving 105th Annual Account, entered herein on June 8, 1992, at 7.
The Findings Of Fact, Conclusions Of Law And Order Approving 106th Annual Account, entered herein on September 8, 1993, again tacitly amended the Amended Guidelines by requiring that any compensation studies commissioned by the Trustees be provided to the Court and its masters. Id. at § 7.
The Amended Guidelines were restated in full in 1995. A Stipulation For Amendment And Restatement Of Amended Guidelines was filed herein on October 4, 1995. This restatement grew out of discussions initiated by Benjamin M. Matsubara, master on the Trustees' 107th and 108th Accounts. See Master's Report On The One Hundred Seventh Annual Report Of The Trustees, filed herein on September 15, 1995, at 8. The restatement significantly altered the purpose of the Guidelines, so that they now required an extensive list of materials to be filed in connection with each account, effectively making these materials public records. Much of the additional information was driven by provisions of the newly adopted Probate Rules, which had become effective March 1, 1995. The Attorney General's office was actively involved in the preparation of the restatement, particularly the sections concerning the process for preserving the seal of confidentiality with respect to sensitive or confidential information. The burden of preserving the seal was shifted to the Trustees.
In his First Report, the incumbent Master stated that the information provided pursuant to the Restated Guidelines was inadequate and recommended further substantial revisions. First Report at 107. By the terms of the December 19 Stipulation, the Restated Guidelines were amended on an interim basis, again expanding and redefining the materials to be provided. December 19 Stipulation at 19-24, 28.
C. The Guidelines Need To Be Redesigned
The foregoing history demonstrates that the Guidelines are no longer serving the purpose for which they were intended. Instead of making the mastering process more efficient and enabling the masters to accept and rely upon a schedule of Estate information provided to them, the Guidelines have become another issue for review, with most masters seeking to alter them according to their own notions.
More important, what began as an agreed procedure for the sake of efficient mastering has become a means by which confidential and sensitive Estate information may be made a public record. The process for preserving the seal of confidential and sensitive information has been twisted such that the Estate's internal records are perceived by some as public information, subject only to the Trustees' opportunity to seek court orders restraining publication. The logic for this perversion is not stated in the Guidelines but it clearly arises out of a misguided belief that because the Estate is a charitable institution, its business records and other sensitive information should be less secure than are the records of such publicly regulated institutions as banks and insurance companies.
Federal regulations require charitable institutions to make their Federal Form 990 available to the public. The Trustees do so. Bernice Pauahi Bishop's Will requires that certain Estate information be published. The Trustees do so. The Probate Rules, designed for caretaker trusts and for the convenience of the trust companies, are vague and ill-suited to the legitimate needs and concerns of a dynastic trust such as the Estate but the Trustees comply with them. And the Guidelines are being misused to feed the insatiable curiosity of the media.
Thus, the Guidelines should be wholly redesigned with the purpose of developing a reasonably permanent list of information that will be available to future masters in order to assure an efficient and orderly mastering process. The Guidelines should preserve the Estate's business information from publication unless the person wishing to cause publication can show a compelling reason why, in the interest of the Estate, such publication is necessary.
Finally, any revision of the Guidelines should be made with advice from the accounting professionals who must produce the required schedules. As they now exist, the Guidelines are the work of lawyers, not CPAs, and the CPAs find them confusing because much of the operative terminology has no precise meaning to accountants.
XV.THESE ACCOUNTS SHOULD BE CLOSED
The Master's nineteenth recommendation is as follows:
Recommendation No. 19:
Approval Of The Annual Accounts To Be Withheld Until The Conclusion Of The Proceedings Upon Which The Certification Letters Are Qualified.
Your Master recommends that final approval of the annual accounts for FY 1994, FY 1995, and FY 1996 be withheld until such time as the outcome of the proceedings upon which the certification letters are qualified are concluded and the required certification letters are re-submitted without qualification or in some other form satisfactory to the Court. Should the outcome of the various proceedings referred to in the qualified certification letters warrant further review and action by the Court with respect to the pending annual accounts, then your Master recommends that a further report and recommendations to the Court be submitted by your Master and/or that the Court take such further action as may be appropriate under the circumstances.
C.R. at 144.
This recommendation is restated in the concluding paragraph of the Consolidated Report, which urges that this Court issue an Order which: "Suspend[s] 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." C.R. at 145.
The concluding paragraph is enigmatic. The content of the Trustees' certification letters is dictated by the Restated Guidelines, as amended by the December 19 Stipulation. It includes a series of affirmative statements and representations to the effect that there are no adverse circumstances concerning the Estate known to the Trustees, including no breach of duty by any Trustee. In the present circumstances, where among other things, an Attorney's General's investigation of undisclosed focus and scope is pending and two Trustees have filed a petition seeking removal of another Trustee, the Trustees have delivered qualified certifications to the Master. Simply stated, the Trustees have made their certifications subject to the outcome of various proceedings already known to the Master. Until the proceedings are resolved, no Trustee can say with certainty what will happen in connection with them.
Disclosure statements in any forum and for any use are routinely qualified by notes disclosing the existence of litigation and other events affecting the disclosure. Typically, there is an effort to quantify the issues and assess the probability they will affect the disclosures made, whether to auditors, securities exchange officials, shareholders, courts or others. This is impossible to do, however, where the focus of the Attorney General's investigation is undisclosed and where the outcome of other pending matters is unknown. The Trustees cannot ignore the existence of the matters which may affect their certifications but neither can they assess them.
The Master's suggestion that this Court defer further consideration and approval of the 1994 - 1996 Accounts pending conclusion of all of the proceedings referred to in the Trustees' certifications raises the possibility that the Trustees' Accounts will remain pending for an indefinite time for reasons wholly beyond the control of the Trustees. There is no cause for this. The pending accounts should be closed. The outcome of the proceedings referred to in the certification letters will be known in due course and should be dealt with as appropriate in conjunction with the accounts for the years in which such results become known.
There also is a practical consideration. To the extent that various proceedings
are deemed to be interdependent, it becomes impossible to close any of them without
closing the rest. It must be recognized that the proceedings, whether in this Court
or elsewhere, are concurrent and that these Accounts can be closed without prejudicing
the disposition of others proceedings.
XVI. THE ROLES OF THE MASTER AND THE COURT
Several of the Master's recommendations state the Trustees "should be ordered" to take various actions recommended by the Master. While the Trustees do not find the substance of most of the recommendations unacceptable, the Master is in error when he urges this Court to "order" the Trustees to undertake discretionary activity. This section addresses the roles of the Master and the Court.
In their First Response, the Trustees addressed the role of the master. First Response at 6. As noted there, in In re Estate of Bishop, 53 Haw. 604, 499 P.2d 670 (1972), the Supreme Court of Hawaii said:
The coverage of a Master's report should properly be limited to the matters which may be dealt with by an equity court in an accounting proceeding. Such a court may interfere with the trustees' administration of a trust only when it finds an abuse of the trustees' discretion or a violation of law. Restatement, Trusts (Second) §§ 187 and 382 (1959).
Id. at § 607, 499 P.2d at 673.
A master's report concerning the Estate authored by Frank W. Hustace, Jr. contains an authoritative statement of the respective roles of the Court, the Master and the Attorney General in the annual review of the Trustees' accounts and of the powers and limitations of each. Mr. Hustace stated that "[T]he master is the agent of the court and aids and assists the court in the performance of its specific judicial duties by clarifying the issues and making tentative findings." Master's Report On
The Eight-Fifth Annual Report Of The Trustees, filed herein on June 10, 1976, at 4. (Hereinafter cited as the "Hustace Report".)
The problems of trust administration most frequently arise in connection with the exercise of discretionary acts by the trustees. And it is here that the attorney general may disagree, the court, and even the legislature with the decision of the trustees. One of the two cardinal rules, and one which is frequently lost sight of is that "[w]here discretion is conferred upon the trustees of a charitable trust, the court will not interfere with the exercise of their discretion, except to prevent an abuse of discretion. ... If the trustees act within the bounds of reasonable judgment in the exercise of the discretion conferred upon them, the court will not interfere." 4 Scott, Trusts, supra, § 382, 2989 (emphasis added). And neither can the legislature. Trustees of Dartmouth College v. Woodward, 4 Wheat. 518, 4 L. ed. 629 (U.S. 1819).
Id. at § 8 (emphasis in the original).
[N]o matter the feelings of a master in respect of what he would have personally chosen to do were he in the shoes of the trustees and permitted to exercise the discretion which is given them, it serves no purpose to comment in any report to this Court of his differing views upon their administration unless he is of the opinion that the trustees in the exercise of their chosen course abused their discretion.
Id. at § 9 (emphasis added).
Rule 29 of the Hawaii Probate Rules also addresses the role of the Master, noting that, "[w]hile there is a presumption of good faith and regularity that applies to accountings, ... the master serves as the eyes and ears of the court." As such, the court's master enjoys broad access to trust records for the purpose of review. The Rules do not make the court's master a supervisor of the trustees nor an administrator of the trust.
Although written some years before the decision of the Supreme Court in Takabuki v. Ching, 67 Haw. 515, 695 P.2d 319 (1985), the Hustace Report proved correct in its analysis. When a rancorous dispute between Trustees concerning the Estate's acquisition of its Kawaiahao Plaza offices reached the Circuit Court, the Circuit Judge determined that the Court should have been involved and chastised the Trustees for not bringing the matter to the Court sooner. The Circuit Court invoked its "equitable supervisory powers of Trusts" to direct the Attorney General to convey the Court's instructions to the Trustees and to obtain compliance with those instructions by "appropriate legal action." Among the Circuit Court's instructions were directives to enter into a settlement with the developer of the building, to seek a formal opinion from the Internal Revenue Service concerning impact upon the Estate's tax exempt status, and to restructure the acquisition in a manner that would not jeopardize that status. Id. at § 525-26, 695 P.2d at 326.
The Supreme Court opened its analysis with a review of the powers of the Circuit Court. It recognized that while the Trustees may seek the order of the court, they are not obliged to do so in matters of trust administration:
That the Trustees of the Estate of Bernice Pauahi Bishop may seek instructions from the court, of course, is beyond cavil. ....
But it is settled too that "[t]he administration of charitable trusts is governed by majority rule." Richards v. Midkiff, 48 Haw. 32, 40, 396 P.2d 49, 55 (1964) "If there are several trustees ..., the powers conferred upon them can properly be exercised by a majority ..., unless it is otherwise provided by the terms of the trust." Restatement (Second) of Trusts § 383 (1957); see also 4 Scott, supra § 383. Here, the Will of Princess Bernice Pauahi Bishop declared that "three of them at least must join in all acts." Thus "[t]he determination of whether the [Bishop Estate] should maintain a legal action require[d] the requisite concurrence of the trustees just as the exercise of any other power." Richards v. Midkiff, 48 Haw. at 41, 396 P.2d at 55.
Id. at § 527, 695 P.2d at 327 (footnotes omitted).
The Supreme Court continued, making very clear that judicial interference in the exercise of the Trustees' discretion is inappropriate:
"Where discretion is conferred upon the trustee with respect to the exercise of a power, its exercise is not subject to control by the court, except to prevent an abuse by the trustee of his discretion." Restatement (Second) of Trusts, § 187 (1959); see also Miller v. First Hawaiian Bank, 61 Haw. 346 351, 604 P.2d 39, 43 (1979) (citing § 187); Dowsett v. Hawaiian Trust Co., 47 Haw. 577, 581, 393 P.2d 89, 93 (1964) (quoting § 187); In re Estate of Campbell, 42 Haw. 586, 603-04 (1958) (also quoting § 187). The rule is no different for charitable trusts. "Where discretion is conferred upon the trustees of a charitable trust, the court will not interfere with the exercise of their discretion, except to prevent an abuse of discretion." 4 Scott, supra, § 382; see also In re Estate of Bishop, 53 Haw. 604, 607, 499 P.2d 670, 673 (1972). And the "fact that if the discretion had been conferred upon the court, the court would have exercised the power differently, is not a sufficient reason for interfering with the exercise of the power by the trustee." Restatement (Second) of Trusts, § 187 comment e (1959).
Id. at § 530, 695 P.2d at 328.
In its review of the Trustees' annual accounts, this Court and its Master are properly limited to matters concerning the propriety of the accounts. This Court "may interfere with the trustees' administration of a trust only when it finds an abuse of the trustees' discretion or a violation of law." In re Estate of Bishop, 53 Haw. 604, 607, 499 P.2d 670, 673 (1972), citing the Second Restatement, § 187 and 382 (1959).
The Hawaii Supreme Court has quoted Professor Scott for the rule that "To
the extent to which the trustee has discretion, the court will not control his exercise
of it as long as he does not exceed the limits of the discretion conferred upon him.
The court will not substitute its own judgment for his." Estate of Campbell,
42 Haw. 586, 603-04 (1958) (quoting II Scott, Trusts, § 187 (2d ed. 1956)).
In Takabuki v. Ching, 67 Haw. at 530, 695 P.2d at 328, the Court cited (without quoting) Professor Scott's additional observation that "[i]f the trustees act within the bounds of a reasonable judgment in the exercise of the discretion conferred upon them, the court will not interfere." IV
Austin W. Scott, The Law of Trusts, § 382 at 2989 (3d ed. 1967)
Following the Second Restatement, § 187, comment e (1959), the Supreme Court
has said that a trustee's exercise of his discretion is not subject to "interference"
by the court except to prevent an abuse of discretion. Miller v. First Hawaiian Bank,
61 Haw. 346, 351, 604 P.2d 39, 43 (1979).
The fundamental error of the Circuit Court in Takabuki v. Ching was the Court's attempted substitution of its own judgment for that of the trustees. Although the Circuit Court there found that the trustees had discretionary authority to invest in commercial property and concluded that neither of the litigating trustees had breached a fiduciary duty in the exercise of the discretionary power; "[y]et it proceeded to issue instructions for the Trustees to follow." Id. at § 530, 695 P.2d at 328.
This Court should not yield to the Master's invitation to commit the same error.
DATED: Honolulu, Hawaii, September 9, 1998.
ROBERT BRUCE GRAHAM, JR.
Attorney for The Trustees under the Will and of the Estate of Bernice Pauahi Bishop, Deceased
Trustee Oswald K. Stender concurs in the foregoing Response only insofar as the Trustees' Response accepts the Master's Recommendations. To the extent the acceptance of any Recommendation may be qualified by the Trustees, Trustee Stender does not necessarily concur with any such qualification. Trustee Stender shall be filing a separate Response.