September 29, 1998

COLBERT M. MATSUMOTO 2276-0
Suite 2000, Amfac Tower
700 Bishop Street
Honolulu, Hawaii 96813
Telephone No. 523-2999

Master

IN THE CIRCUIT COURT OF THE FIRST CIRCUIT

STATE OF HAWAII

In the Matter of the Estate of BERNICE P. BISHOP, Deceased.

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EQUITY NO. 2048 MASTER'S FIRST SUPPLEMENTAL REPORT ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES; CERTIFICATE OF SERVICE

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MASTER'S FIRST SUPPLEMENTAL REPORT ON THE
ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE
ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES

TABLE OF CONTENTS

		Page
I. INTRODUCTION II. THE 109TH MASTER'S REPORT III. THE MASTER'S CONSOLIDATED REPORT IV. NEW ACCOUNTING FORMAT V. ERRORS IN REPORTING INCOME FROM GOLDMAN SACHS & COMPANY VI. ASSET VALUATION VII. ACCUMULATION OF INCOME A. The Trustees Fail To Comprehend Their Duty To Properly Account For Accumulated Income B. The Trustees Have A Duty To Account For Accumulated Income Irrespective Of Any Court Order Or Agreement With The Attorney General C. The Trustees Should Not Pass The Buck To Prior Masters For Failing To Detect Their Concealment Of Accumulated Income. D. The Trustees Have Yet To Adequately Explain Why The Reclassification Of Accumulated Income Was Not Disclosed To This Court E. The Trustees' Suggestion That The Will Should Not Be Read To Require The Expenditure Of The Annual Income Of The Trust In The Maintenance Of The Schools Should Be Rejected VIII. THE INVESTMENT IN HAMAKUA LANDS RECOMMENDATION NO. 20: THE TRUSTEES SHOULD ACCOUNT FOR AND HOLD THE TRUST ESTATE HARMLESS FROM THE HAMAKUA INVESTMENT IX. THE TRUST ESTATE'S LOSSES AND LOSS RESERVES X. STRATEGIC PLANNING XI. THE LEAD TRUSTEE SYSTEM XII. TRUSTEE COMPENSATION A. The Alleged Violation Of A Prior Agreement With The Attorney General Should Be Reviewed By Your Master B. State Law Has Not Been Preempted By The Intermediate Sanctions Law C. Multiple Compensation Studies At Trust Estate Expense Were Unwarranted RECOMMENDATION NO. 21: THE TRUSTEES SHOULD BE SURCHARGED FOR THE COST OF THE SCA CONSULTING REPORT XIII. CONFLICTS OF INTEREST A. McKenzie Methane B. Mid-Ocean Limited C. Robert Trent Jones Golf Club XIV. EXPENSES RELATED TO THE ENACTMENT OF THE INTERMEDIATE SANCTIONS LAW AMENDED RECOMMENDATION NO. 17: THE TRUSTEES SHOULD BE SURCHARGED FOR TRUST FUNDS AND RESOURCES EXPENDED IN OPPOSING INTERMEDIATE SANCTIONS LEGISLATION XV. IRS TAX AUDIT XVI. CLOSURE OF THE 109th, 110th, and 111th ANNUAL ACCOUNTS		1 2 3 4 4 5 5 5 6 7 8 14 15 24 24 27 28 29 29 30 31 34 34 34 35 35 37 39 39 40

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MASTER'S FIRST SUPPLEMENTAL REPORT ON THE
ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE
ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES

I. INTRODUCTION

On August 7, 1998, your Master filed the Master's Consolidated Report on the One Hundred Ninth, One Hundred Tenth, and One Hundred Eleventh Annual Accounts of the Trustees ("Master's Consolidated Report ").
On September 9, 1998, responses to the Master's Consolidated Report were filed by Trustees HENRY HAALILIO PETERS, RICHARD SUNG HONG WONG, MARION MAE LOKELANI LINDSEY and GERARD AULAMA JERVIS who filed the Trustees' Response to Master's Consolidated Report on the One Hundred Ninth, One Hundred Tenth, and One Hundred Eleventh Annual Accounts of the Trustees ("Trustees' Response ")¹; Trustee OSWALD KOFOAD STENDER who filed a separate response entitled Trustee Oswald Kofoad Stender's Response to Master's Report ("Stender Response")²; and the Attorney General who filed the Attorney General's Response to the Master's Consolidated Report on the 109th, 110th, and 111th Annual Accounts ("AG's Response") .
The following day on September 10, 1998, the Attorney General caused to be filed herein a Petition of the Attorney General on Behalf of the Trust Beneficiaries to Remove and Surcharge Trustees, for Accounting, and for Other Equitable Relief ("AG Petition").
In light of the matters set forth in the Trustees' Response, the Stender Response, the AG Response, and the AG Petition, your Master believes a reply to those responses and a supplement to the Master's Consolidated Report is required and accordingly submits this supplemental report.

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¹ Trustee OSWALD KOFOAD STENDER concurred in the Trustees’ Response only to the extent it accepts the recommendations in the Master’s Consolidated Report.
² On September 28, 1998, your Master received a communication from counsel for Trustee Stender along with various exhibits which further clarify Trustee Stender’s role in connection with a number of issues raised in the Master’s Consolidated Report. That communication contains significant information impacting on the issues raised which your Master has not had a chance to study before submitting this Supplemental Report.

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II. THE 109TH MASTER'S REPORT

The Trustees' Response asserts that the Master's Report on the One Hundred Ninth Annual Account of the Trustees ("109th Master's Report ") filed herein on November 17, 1997, was the "product of a flawed analysis, largely attributable to a failure of communication between the Estate staff and the Master's accountant." Trustees' Response at 6.
To suggest that the difficulties encountered by your Master and his accountant in initially reviewing and reporting on the 109th Annual Account were the result of a "failure of communication" is a gross mis-characterization of what transpired. Your Master has previously documented in the 109th Master's Report the difficulties he and his accountant encountered in obtaining access to information in connection with the 109th Annual Account review and he stands by those statements.

III. THE MASTER'S CONSOLIDATED REPORT

The Trustees' Response suggests that the theme of the Master's Consolidated Report is that "the Estate needs more and better documentation, planning and internal procedures, and systems reorganization." Trustee's Response at 4. While it is true that both the Master's Consolidated Report and the Andersen Report noted the need to improve its policies and practices in those areas, the Master's Consolidated Report attempts to emphasize the need for more fundamental reforms by the Trustees.
As indicated in the Master's Consolidated Report , the Trustees need to better fulfill their obligation to provide meaningful disclosure of the financial condition of the Trust Estate both to the Court and the public. They also need to be more cognizant of their accountability to the Court and the beneficiaries of the Trust Estate.
The Trustees' Response believes it is significant that your Master did not render a "finding" of a breach of duty by the Trustees. Trustees' Response at 4. Nothing remarkable should be read into such an omission. Your Master did not make such findings since in your Master's view, a determination that the Trustees have breached their legal duty is a legal conclusion reserved to the Court and not its Master.

IV. NEW ACCOUNTING FORMAT

The reason the accounting profession has adopted Generally Accepted Accounting Principles ("GAAP") is to have standard principles for financial reporting which are generally understood by readers and are consistent among different entities. Once a financial statement departs from GAAP, it becomes more difficult for readers to understand the basis upon which it was prepared and to compare them to those of other entities. In essence, deviation from GAAP allows for manipulation.
The Court should not be tempted by the Trustees' desire to continue to indulge in "modified GAAP" financial reporting. Requiring the Trust Estate's financials to fully conform to GAAP in the format recommended by the Andersen Report will materially aid future masters and the Court in efficiently and properly reviewing the annual accounts.

V. ERRORS IN REPORTING INCOME FROM GOLDMAN SACHS & COMPANY

Arthur Andersen LLP informed your Master that there were errors in the audited financial statements of the Trust Estate for FY 1994, FY 1995, and FY 1996, attributable to an incorrect application of accounting principles. This resulted in a material misstatement of income between the three years. The Trust Estate first corrected for this error in its financial statement for FY 1997.
Contrary to the inference one might derive from the Trustees' Response at 14-15, Arthur Andersen LLP discovered this error on its own. The existence of the error was not disclosed by the Trust Estate staff or its independent auditor (Coopers & Lybrand) to your Master or Arthur Andersen LLP until Arthur Andersen LLP revealed that it had discovered the error.

VI. ASSET VALUATION

Prior to the issuance of the audited financial statements prepared by Arthur Andersen LLP, the Trustees were adamant that Arthur Andersen LLP not disclose anything related to the fair value of their investment in Goldman Sachs & Company. It is therefore particularly curious that in the Trustees' Response at 16, as well as in comments to the press immediately after issuance of the Master's Consolidated Report , they had no qualms about claiming a $3 billion value for their interest in Goldman Sachs & Company. Unfortunately, it would appear that the Trustees are inclined to disclose financial information only when and to the extent that it serves "their own" purposes.

VII. ACCUMULATION OF INCOME

A. The Trustees Fail To Comprehend Their Duty To Properly Account For Accumulated Income.

It is troubling that the Trustees' Response minimizes the significance of their failure to properly account for and expend accumulated income. They remark that your Master's concern is "disproportionate to the magnitude of the actual issue." Trustees' Response at 17.
The inability of the Trustees to comprehend the gravity of their failure to properly account for and expend accumulated income betrays a lack of sensitivity to one of their most fundamental duties as trustees.
The Trustees' Response contention that the "accumulated income exists unimpaired" is erroneous and misleading. Trustees' Response at 17. The fact is, the income account has been impaired because it has been invaded with each reclassification of income to corpus by the Trustees. By reclassifying income to corpus, the Trustees converted income funds which should have been regularly expended upon the "maintenance of said schools" into corpus funds, the expenditure of which is restricted by both the Will and by law.
This is not merely a question of "documentation" as they assert. Trustees' Response at 17. If one believes that accounting is just numbers in columns on paper without legal significance then one might make light of the reclassification of income to corpus. But obviously proper accounting of trust assets is essential to maintaining the integrity of a trust. If the accounts submitted by the Trustees do not disclose the true status of the assets held by them in trust, then their annual account is meaningless and the Court is unable to exercise proper oversight.

B. The Trustees Have A Duty To Account For Accumulated Income Irrespective Of Any Court Order Or Agreement With The Attorney General.
The Trustees' Response attempts to split hairs by suggesting that they have only been subject to a stipulation to distinguish between corpus and income in their accounts which was "approved" rather than "ordered" by the Probate Court. Trustees' Response at 17-21. They ignore the fact that in the Order Approving 81st Annual Account the Court clearly intended and ordered that the account be approved subject to the stipulation between the Trustees and the Attorney General.
This particular stipulation has long been acknowledged to have the force and effect of a court order. Thus, the Master's Report on the Eighty-Fifth Annual Report of the Trustees ("Hustace Report ") which provides a historical summary of past orders of the Circuit Court specifically notes that the Order Approving 81st Annual Account required the Trustees to identify "corpus from income in cash transactions". Hustace Report at 17.
In either event, the Trustees' argument is really just a "red herring". Irrespective of whether the Trustees were subject to a court order or a stipulation, they have a duty under the Will of Princess Pauahi to properly account for accumulated income.
The Will is explicit in its direction that the Trustees:

[E]xpend the annual income in the maintenance of said schools; meaning thereby the salaries of teachers, the repairing of buildings and other incidental expenses....

To ensure compliance with the Will, clearly the Trustees are required to maintain the distinction between corpus and income as well as account for the accumulation of income from year to year. They have failed to do so.

C. The Trustees Should Not Pass The Buck To Prior Masters For Failing To Detect Their Concealment Of Accumulated Income.

The contention in the Trustees' Response that the reclassification of accumulated income to corpus was not deceptive because the information necessary to figure out how much income had been accumulated was always available for past masters to uncover is outrageous. Sidestepping the real issues, the Trustees' Response asserts:

The Master complains that this change [in accounting] was not affirmatively disclosed to the Court, was unauthorized, and undermined the ability of the Court to exercise its function properly. [citation omitted]. 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 reporting on six accounting since 1988. None objected to the change.

Trustees' Response at 25-26.

To blame past masters for failing to discern the Trustees' concealment of the true level of accumulated income is nothing less than a diversionary attempt to shift responsibility to others.
The fundamental duty to properly account for and expend income of the Trust Estate is that of the Trustees. In this regard they have failed and the responsibility for their malfeasance should not be laid at the doorstep of past masters appointed by this Court.

D. The Trustees Have Yet To Adequately Explain Why The Reclassification Of Accumulated Income Was Not Disclosed To This Court.

Indeed the question of whether the true level of accumulated income of the Trust Estate was intentionally concealed from the Probate Court and others remains unanswered by the Trustees' Response. For example:

1. The Trustees contend that the reason for the change in the financial statement to eliminate disclosure of the income account and corpus account balance was to achieve a format more "familiar to its lenders and business partners" and less "confusing to persons unfamiliar with trust accounting." Trustees' Response at 21-25. This justification for changing the accounting format is so pathetic as to border on the ludicrous. Do the Trustees really expect anyone to believe that their sophisticated lenders and business partners could not readily comprehend trust accounting entries in their financial statements without being confused? Such a specious rationale should be rejected by the Court.
   
   
2. Until FY 1987, the financial statement format readily allowed one to discern the true level of accumulated income. It wasn't until FY 1998 that the financial statement format was changed so that accumulated income was no longer disclosed in the Trust Estate's balance sheet. See Trustees' Response at 24.

   While the Trustees' Response admits that the balance sheet presentation was changed, it neglects to also disclose that another schedule in the financial statement was also omitted after FY 1987. A separate one-page schedule entitled the Combined Statement of Changes in Corpus and Accumulated Income clearly sets forth the status of the corpus and income accounts and the changes in the accumulated income balance from the prior year. See Exhibit P. Alleged confusion of sophisticated business readers of the financial statements could neither credibly nor reasonably have been the basis for eliminating that schedule from the financial statement.

3. The reclassification of accumulated income to corpus involved material accounting transactions. For example, in 1987, over $65 million was reclassified; in 1991, over $135 million was reclassified; in 1994, another $82 million was reclassified; and in 1995, over $59 million was reclassified. Despite the magnitude of these reclassifications, no mention is made at all in the financial statements for those years of these significant actions by the Trustees. See Letter dated June 16, 1998 from Robert Bruce Graham, Jr. to Colbert M. Matsumoto with enclosures at Exhibit S.
   
   
4. In response to your Master's inquiry about the apparent failure of the audited financial statements to note the Trustees' disposition of accumulated income, the Trust Estate's independent auditor, PriceWaterhouseCoopers disclaimed responsibility for the financial statements and asserted that the financial statements are the "representation and responsibility of management." See Letter dated July 23, 1998 from Arthur C. Tokin to Colbert M. Matsumoto at Exhibit W. When asked why the reclassification of income to corpus was not mentioned in the notes to the audited financial statement, again PriceWaterhouseCoopers attributes responsibility for that omission to "management". See Letter dated August 26, 1998 from Arthur C. Tokin to Colbert M. Matsumoto at Exhibit BB.
   
   
5. The actions of the Trustees in annually reclassifying accumulated income to corpus from 1991 through 1997 have never been disclosed in the minutes of Trustee meetings. See Letter dated July 1, 1998 from Robert Bruce Graham, Jr. to Colbert M. Matsumoto with enclosures at Exhibit U.
   
   
6. There is only a single reference to such action having been taken by the Trustees in an abbreviated reference to reclassification contained in the Confidential Minutes of the Trustees Meeting dated June 30, 1988.³ Exhibit Q. See also Exhibit U. The fact that the Trustees cloaked their decision to reclassify income to corpus as being "confidential" and "privileged" speaks volumes regarding the forthrightness of their action.
   
   
7. The Stender Response evidences that at least since 1994, the Trustees have knowingly and intentionally reclassified accumulated income rather than appropriate such funds for educational purposes as required by the Will.⁴ He states, in relevant part, as follows:

   Trustee Stender was aware that the Estate had accumulated income during the fiscal years of 1994, 1995 and 1996 (109th, 110th and 111th Annual Accounts) and has consistently questioned and raised with the other Trustees why those accumulated funds were not being appropriated for educational purposes Stender Response at 2.

8. The Trustees Response alludes to the existence of Quarterly and Year End Variance Reports prepared for the Trustees by the staff which distinguish between the corpus and income accounts.⁵ However, contrary to the implication intended by the Trustees Response, the Quarterly and Year End Variance Reports do not disclose the true level of accumulated income. In addition, Arthur Andersen LLP reviewed those variance reports and noted significant misclassifications between the income and corpus accounts.
   
   
9. The Trustees Response suggests that the true level of accumulated income could be discerned from the 10-year financial plan. This is simply not so. The 10-year financial plans give no hint as to the true level of accumulated income. As pointed out in the Master's Consolidated Report , that is the key flaw in the "strategic planning" of the Trustees. They failed to take into account the true level of accumulated income in conducting their planning. Despite this, the Trustees offer no explanation of why their 10-year financial plans and their strategic planning efforts all neglected to take into account the true level of accumulated income.
   
   
10. Indeed, if the true level of accumulated income was so readily apparent as the Trustees' Response suggests, then your Master questions why after he inquired of the Trustees about the accumulated income balance on April 15, 1998, it wasn't until June 16, 1998, that he received a response identifying the true level of accumulated income. See Exhibit S. Moreover, the amount represented to be the accumulated income balance in that letter was subsequently corrected by letter dated July 28, 1998. See Letter dated July 28, 1998 from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit Y. The only way that the Trustees were able to determine the accumulated income balance was through a time-consuming compilation process which required review of financial records extending all the way back to 1986.
    
    
11. Even Arthur Andersen LLP has verified for your Master that the true level of accumulated income is not reflected in the financial records of the Trust Estate. In fact, the Consolidated Financial Statement prepared by Arthur Andersen LLP based upon records from the Trust Estate, although formatted to set forth the corpus and income accounts, shows only a $9,241,000 balance in the income account as of June 30, 1996, when the true level of accumulated income was $288,282,830 as of that date. See Consolidated Statement of Financial Position - June 30, 1996, Financial Statement at 3 (Exhibit C) and Notes to the Consolidated Financial Statements, Note 1.m., Financial Statement at 24 (Exhibit C).

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³ The Trustees from time-to-time prepare “confidential” minutes which they claim are privileged. Items discussed during their meetings which they choose to treat as confidential therefore are not included in the “regular” minutes and instead are supposed to be included in the “confidential” minutes. On occasion items acted upon are not even mentioned in either sets of minutes. There are apparently no clear standards for distinguishing between those items which are included in the “confidential” minutes as opposed to the “regular” minutes.
⁴ Your Master has received a communication from counsel for Trustee Gerard Jervis on September 25, 1998, in which he points out that Trustee Jervis first became a Trustee on December 1, 1994, and therefore did not know about or participate in the antecedent decisions to reclassify accumulated or unexpended income to corpus. He also states that it is Trustee Jervis’ position that accumulated income “should be spent on education over a reasonable period pursuant to strategic planning and prudent fiscal practice.”
⁵ It should be noted that the existence of such reports was not volunteered to your Master by the Trustees. He only learned of their existence as a result of the comprehensive management audit conducted by Arthur Andersen LLP.

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E. The Trustees' Suggestion That The Will Should Not Be Read To Require The Expenditure Of The Annual Income Of The Trust In The Maintenance Of The Schools Should Be Rejected.

The effort in the Trustees' Response to minimize the significance of the Supreme Court's discussion regarding accumulated income in Collins v. Hodgson, 36 Haw. 334 (1943) by emphasizing its character as dicta mirrors the cavalier attitude the Trustees have about their failure to properly account for and expend accumulated income. The Supreme Court's discussion in Collins, although dicta , is not to be lightly regarded.

Although the question of the propriety of the action of the trustees in accumulating so large a surplus of income is not an issue in this appeal, we feel impelled to comment upon it. The fact that more than one million dollars of income has accumulated makes it apparent that the expressed intention of the testatrix has not been complied with.

Collins v. Hodgson, 36 Haw. at 339 (emphases added).

Until the Trustees' Response , there has never been any doubt cast on the interpretation of the Will and its requirement:

[T]o expend the annual income in the maintenance of said schools; meaning thereby the salaries of teachers, the repairing of buildings and other incidental expenses . . . .

There have been occasions on which the wisdom of implementing this express requirement of the Will has been questioned and prior orders of this Court have attempted to grant the Trustees reasonable flexibility in meeting the spirit and intent of this provision of the Will. However, there has never been an instance in which prior Trustees have attempted to undermine this express language of the Will.
Upon the flimsiest of arguments, the Trustees' Response would now render a revisionist reading of the Will to allow the Trustees to totally disregard the express intent of Princess Pauahi. Essentially, the Trustees argue that the Will should be read in a manner which would allow them to spend whatever amount of income on the educational mission of the Trust Estate whenever they deem it appropriate in their unfettered discretion. The Court should reject such an alarming attempt by the Trustees to eviscerate a fundamental underpinning of the Trust Estate.

VIII. THE INVESTMENT IN HAMAKUA LANDS

The Trustees' Response extensively discusses the Trustees' investment in lands formerly comprising the Hamakua Sugar Company plantation. In the Master's Consolidated Report , your Master only briefly commented upon that investment acquisition because he did not have sufficient information at that time to report to the Court. Having since received additional information regarding the investment, your Master believes that investment by the Trustees warrants review by the Court under the prudent investment standard.
During the Spring of 1998, your Master made an oral inquiry about the Hamakua investment since he recalled press reports about the acquisition occurring during the account periods under review but had seen no mention of it in materials provided to him by the Trustees. The oral inquiry was followed by a series of correspondence between the Trustees and your Master between June 22, 1998 and August 24, 1998.
Based upon the information he has been now able to compile your Master reports his finding that the Trustees' investment in Hamakua lands fails to meet the standards of prudent investment.
Although the Hamakua land transaction had a cost of $21 million, the decision by the Trustees to make the investment was not reflected in the minutes of the meetings of the Trustees nor was it listed in the schedule of real estate transactions appended to the annual account for FY 1995.
The pertinent facts as found by your Master are as follows:

1. From June 1, 1994, the Trust Estate Staff was directed by the Trustees to investigate a potential bid to acquire 30,500 acres of former Hamakua Sugar Co. lands ("Hamakua Lands") at a bankruptcy foreclosure auction. See Staff Report prepared by J. Melrose for August 30, 1994 Trustee Meeting ("Melrose Staff Report ") at Exhibit CC.
   
   
2. The Melrose Staff Report reported the Trust Estate Staff's investment analysis which supported a purchase at a price of $15 million:

   The Real Estate Investment and Appraisal Division [of the Trust Estate] has made a preliminary estimate of value based on a review of prior land sales and consideration for the unique nature of this bulk foreclosure sale. REIAD estimate the value of the property at $500/acre or roughly $15,000,000. See Exhibit CC.

3. The Melrose Staff Report stated that staff's analysis indicated that the purchase of the Hamakua Lands should be a cash acquisition rather than a debt financed purchase:
   
   

   Staff has reviewed the issue of debt verses [sic] equity financing for this acquisition. Due to the low cash returns for forestry . . . and agriculture . . . a debt financing approach would not return adequate revenues to cover debt service. The purchase of [the Hamakua Lands] to lease for forestry and agriculture is best dealt with as a cash acquisition. Exhibit CC.

   
   
   
4. The Melrose Staff Report observed that:
   
   

   The only advantage to KSBE of buying [the Hamakua Lands] is that at the end of 20 years the investment would pay for itself and we would continue to hold 28,000 more acres of land in Hamakua. The economics of a direct land purchase would argue against bidding more than $500.00 per acre since the lease income from forestry and pasture uses is insufficient to justify more up-front investment. So long as our investment is passive, even with debt financing, the acquisition should not result in negative tax consequences. Exhibit CC.

   
   
   
5. On September 1, 1994, the Trustees held a meeting at which the Melrose Staff Report was presented. The Minutes of the Trustees' Meeting reflect discussion of the potential acquisition of the Hamakua Lands. The Trustees did not act at that time but rather:
   
   

   The Trustees instructed staff to discuss investment strategies and alternatives for this land with Peter Savio and to report back to the board with these findings. Trustees instructed staff to determine what the carrying costs would be for this land. Minutes of the Trustees Meeting of September 1, 1998 at Exhibit DD.

   
   
   
6. The Trustees claim that on an unspecified date between September 1, 1994 and September 7, 1994, staff made an oral presentation to the Trustees of their further analysis which allegedly showed a profitable return could be obtained on a purchase price as high as $25 million. See Letter dated July 16, 1998, from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit HH. The spreadsheet program and a series of analyses of the financial feasibility of purchasing the Hamakua lands using different assumptions was purportedly developed by KSBE staff members Doyle Davis and Peter Simmons. No hard copies of each spreadsheet scenario were retained. See Letter dated July 31, 1998, from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit JJ. Staff did not prepare written reports or a formal staff report but only made an oral presentation based on those analyses. See Exhibit HH.
   
   
7. Based upon this oral presentation, the Trustees then authorized a bid of $20 million at the bankruptcy auction despite the earlier Melrose Staff Report recommending a bid of not more than $15 million. See Exhibit HH. No minutes of the Trustee meeting at which the oral presentation and vote of the Trustees to authorize the bid of up to $20 million exist. See Letter dated June 29, 1998, from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit FF.
   
   
8. The bankruptcy auction was held on September 7, 1994. The Western Farm Credit Bank ("WFCB") which was the principal bankruptcy creditor (holding a mortgage for $85 million) made the only bid for $20 million and was successful. A confirmation hearing was scheduled for September 26, 1994 at which time the foreclosure bidding could be reopened if a minimum reopening bid 5% greater or $1 million more than the $20 million bid by WFCB was received. See Exhibit HH.
   
   
9. On September 22, 1994, the Trustees allegedly held another meeting at which they heard another oral report from Staff and then voted to authorize the KSBE Staff to bid $21 million to reopen the bidding and purchase the Hamakua land. See Exhibit FF and Exhibit HH. No minutes of such a Trustee meeting exist, only a memo to file from Doyle Davis which is signed by Trustee Henry Peters. See Exhibit FF.
   
   
10. The Trustees successfully bid $21 million at the reopened foreclosure auction conducted by the Commissioner of the Bankruptcy Court on September 26, 1994. See Exhibit HH. Despite its unpaid $85 million mortgage, WFCB did not increase its prior bid of $20 million to acquire the 30,500 acres of land.
    
    
11. On September 27, 1994, the Trustees approved a 9-month budget of the projected carrying cost of the Hamakua Lands prepared by the KSBE staff for the Trustees which anticipated a 9-month operating cost of $1,432,045 without debt financing, including $318,750 for a security service contract. See Exhibit HH.
    
    
12. The acquisition of the Hamakua Lands was closed on October 14, 1994, at which time the transaction was disclosed to the media by the Trustees' press release. See Exhibit FF.
    
    
13. The decision to debt finance 90% of the acquisition price of the Hamakua Lands through the Trust Estate's commercial paper facility was made by the Trustees sometime during 1995 despite Staff comments advising against such financing in the Melrose Staff Report. That decision is not reflected in any minutes of Trustee meetings. See Exhibit HH and Letter dated August 24, 1998, from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit MM.
    
    
14. The carrying cost of the commercial paper debt incurred to finance the investment in the Hamakua Lands were:
    
    

    Fiscal Year	Interest Cost
    1995	$ 708,862.00
    1996	$1,096,662.00
    1997	$1,226,447.00

    
    
    See Exhibit JJ and Exhibit MM.
    
    
15. No supporting documentation exists, which was considered by the Trustees, justifying and supporting their decision to authorize the expenditure of $21 million for the purchase or their decision to use borrowed money to finance the purchase. See Exhibit JJ.
    
    
16. The Trustees explain their investment objectives and strategy in acquiring the Hamakua Lands as representing:
    
    

    [A]n opportunity to increase and further diversify its Hawaii land holdings. From a strategic perspective, KSBE viewed the Hamakua lands as being in the most fertile and productive region of the island of Hawaii. These lands had been described by State consultants in a study released in August 1994 as the base for the potential development of a commercial forestry industry in Hawaii. KSBE also desired to confirm its commitment to support Hawaiian agriculture. Trustees and staff were also cognizant of community sentiment to keep control of Hawaii's lands in Hawaiian [hands]. Exhibit JJ.

    
    
    
17. The 30,500 acres of Hamakua Land acquired are principally comprised of agriculture and conservation zoned lands. See Exhibit CC. Rather than diversify its asset portfolio, the acquisition increased the more than 330,000 acres of agriculture and conservation lands already owned by the Trust Estate which comprise more than 98% of the Trust Estate's land holdings in Hawaii.
    
    
18. Despite the apparent inconsistency of the acquisition with the Trust Estate's goal of investment asset diversification, the Trustees defend the purchase by explaining:
    
    

    The Hamakua acquisition was consistent with the asset allocation strategy KSBE has pursued since the late 1980's. As stated above, KSBE considers itself a Hawaiian land based organization. In the early 1990's, KSBE undertook a voluntary sales program of divesting substantially all of its condominium leased fee properties from its multi-billion dollar real estate endowment. Viewed in that context, the Hamakua lands may be considered a replacement of existing Hawaiian real estate assets and a diversification into corporate agribusiness. The relatively low price of these lands (On average, less than $1,000 per acre), the productivity of these lands and the ability to participate in new agriculture ventures led staff and Trustees to view this acquisition as a unique opportunity. These lands would not be encumbered by existing sugar leases characterized by low agricultural yields. Exhibit JJ.

    
    
    This response by the Trustees fails to clearly articulate a valid investment purpose, premised upon specific and rational investment projections, which would justify committing such a large amount of Trust Estate assets to such a venture.
    
    
19. Contrary to the suggestion by the Trustees, the acquisition of more agriculture and conservation zoned real property in Hawaii is inconsistent with the Cambridge Group's recommendations and the Trust Estate's own stated asset allocation goals of decreasing the Trust Estate's concentration in real property assets.
    
    
20. The Cambridge Group also previously discouraged investment in timber (along with oil & gas and foreign bonds) primarily because of its inherent illiquidity. Andersen Report at 163.
    
    
21. The investment in Hamakua Lands is not a timber or commercial forestry investment since the Trust Estate's role is merely that of a passive landlord which has made large acreage available to a commercial forestry operator, Prudential Timber. The Melrose Staff Report aptly pointed out the economic implications of this distinction to the Trustees. See Exhibit CC.
    
    
22. The Trustees defend their acquisition of the Hamakua Lands by asserting that the Trust Estate is a "land based institution." See Exhibit JJ. The fact that the original trust was composed almost entirely of land has nothing to do with the purpose and objective of the Trust Estate. The purpose of the Trust Estate is to establish and maintain the Kamehameha Schools, not to amass large amounts of Hawaii land with inadequate regard to the investment consequences of such a use of Trust Estate assets.
    
    
23. The decision to invest in the Hamakua Lands was made without any economic analysis of the expected income yield and total return objective.
    
    
24. When questioned about their specific investment return objectives and projections upon which the investment was made, the Trustees replied:
    
    

    KSBE did not approach the Hamakua investment based upon a predetermined rate of return. The financial feasibility of the investment was analyzed utilizing assumptions concerning various sales and leasing scenarios. The projected income from these alternative scenarios was then compared to determine the rate of return that could be achieved at different purchase price assumptions. Establishing the purchase price involved balancing between consideration of Western Farm Credit Bank's asking price and the price that could be supported by the differing sales and leasing scenarios. See Letter dated August 24, 1998, from Robert Bruce Graham, Jr. to Colbert M. Matsumoto at Exhibit MM.

    
    
    
25. There is insufficient evidence to find that the Trustees carefully analyzed and evaluated their investment of $21 million into acquisition of the Hamakua Lands in light of considerations of the Trust Estate's liquidity, regularity of income, and preservation or appreciation of capital.
    
    
26. Since the acquisition of the Hamakua Lands, the Trust Estate has sustained operating losses of approximately $4.8 million during FY 1995, FY 1996, and FY 1997. Exhibit MM.
    
    Based upon the principles of prudent investment applicable to the Trustees and the foregoing facts, your Master finds that the investment of $21 million to acquire the Hamakua Lands was not made by the Trustees in a prudent manner.
    
    

RECOMMENDATION NO. 20: THE TRUSTEES SHOULD ACCOUNT FOR AND HOLD THE TRUST ESTATE HARMLESS FROM THE HAMAKUA INVESTMENT. Accordingly, your Master recommends that the Court order the Trustees to account for and be surcharged for such amounts as required to hold the Trust Estate harmless from losses associated with the investment in the Hamakua Lands.

IX. THE TRUST ESTATE'S LOSSES AND LOSS RESERVES

As indicated in the Master's Consolidated Report , during the five years from FY 1991 through FY 1996, it has been reported that the Trust Estate suffered almost $400 million in losses and loss reserves on its investments.⁶ Your Master remains chagrin at the inability of the Trustees to focus on your Master's point for discussing the losses and loss reserve experience of the Trust Estate. The losses and loss reserve experience cries out for an examination of the investment program of the Trust Estate to determine whether appropriate safeguards to avoid such adverse consequences are in place.
Instead, the Trustees' Response attempts to defend their financial performance by crediting themselves with obtaining positive returns in each fiscal year. The Trustees either miss the point or don't want to deal with it.
The Trustees' Response attempts to raise a diversionary smokescreen in discussing the loss and loss reserve experience of the Trust Estate. While they attempt to highlight the discrepancies in the loss and loss reserve figures for FY 1994 as explained in the Master's Consolidated Report, they neglect to explain the reason why they themselves erroneously represented to the Court in their Trustees' Response to Master's Report on the One Hundred Ninth Annual Account (Fiscal Year 1993-1994) filed herein on December 3, 1997 ("Trustees' 109th Response") , that the level of losses in FY 1994 only amounted to $23 million. Trustees' 109th Response at 40.⁷
At the request of the Trustees, your Master included a chart which provided more detail regarding the financial experience related to the losses and loss reserves as offset by realized and unrealized gains. See Master's Consolidated Report at 58. Unfortunately, the Trustees' Response now describes that chart as though it was prepared by your Master as his work product and attempts to utilize it to make various points disparaging of the Master's Consolidated Report . See Trustees' Response at 52-54.
To set the record straight, your Master wishes to make clear that the chart is the work product of the Trustees. While the figures in the chart are not inaccurate, their interpretation in the Trustees' Response requires clarification.
The fact is, in FY 1994, without the benefit of gains from land sales of $199,563,000 and accounting adjustments due to change in accounting principles of $35,607,000⁸, the Trust Estate would have sustained an operating loss of $42,355,000. For the three fiscal years combined (FY 1994, FY 1995, and FY 1996), without the benefit of gains from land sales of $334,372,000 and changes in accounting principles of $77,287,000, the Trust Estate would have actually sustained a net operating loss of $18,530,000⁹.
A more meaningful discussion and analysis of the investment performance of the Trust Estate would focus on its rate of return on investments. However, the Trustees' Response is silent in that regard.

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⁶ The Master’s Consolidated Report reported that for the three fiscal years under review, Arthur Andersen LLP had identified loss and loss reserves totaling $135,518,139 in FY 1994, $51,645,991 in FY 1995, and $55,205,242 in FY 1996. In addition, prior Master Benjamin Matsubara had reported $107,000,000 of write-offs and reserves for troubled investments in FY 1992 and $44,000,000 of write-offs and reserves for troubled investments in FY 1993.
⁷ The Trustees’ 109th Response also contended that the Trust Estate's assets increased in FY 1994 by more than $222 million, however, they now concede that the increase in net assets was $192,815,000.
⁸ Both gains on land sales and changes in accounting principle have little or nothing to do with any value created through the efforts of the Trustees.
⁹ Following the filing of the Master’s Consolidated Report, the Trustees embarked upon an advertising campaign in the newspapers and on the radio where they purported to represent “The True Bottom Line On KSBE’s Financial Performance”. That advertising gave an incomplete picture since it failed to note that most of the income claimed by the Trustees during the periods mentioned were attributable to gains from land sales and changes in accounting principles. The advertisement also erroneously claimed that the Trust Estate had increased post-high school financial aid awards by $12 million since 1994.

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X. STRATEGIC PLANNING

The Trustees' Response defends the strategic planning efforts of the Trustees and rejects the recommendation in the Master's Consolidated Report which would require that they engage in Court monitored strategic planning. Trustees' Response at 70.
Devoid of any explanation in the Trustees' Response is their failure to plan taking into account the financial resources available. As indicated in the Master's Consolidated Report , this failure by the Trustees is the most glaring and alone compels Court intervention. Master's Consolidated Report at 84-85.
Furthermore, the Court should note that while the Trustees' Response at page 72 touts the involvement of "two authorities in the educational field" in connection with the development of one of the studies prepared for the Trustees by Ernst & Young LLP, neither played a role of any significance in the strategic planning process. In fact, Dr. James Yountiss and Dr. William Damon produced no written work product. Your Master found that both of them only made themselves available to provide consulting advice to some administrators at the Kamehameha Schools and at no time did they generate any written reports in connection with any strategic planning process.

XI. THE LEAD TRUSTEE SYSTEM

In the Stipulation Concerning Master's Recommendations (109th Annual Account) ("Stipulated Order") filed herein on December 19, 1997, the Trustees agreed and were subject to this Court's order that:

The Trustees shall ensure that the "board" system of administration and a hierarchical scheme of management formally established by them through the hiring of properly selected and supervised agents is kept intact and uncircumvented.

Accordingly, the Trustees agree to review and act upon the organizational structure and governance of the Trust Estate in light of applicable principles of law and their individual and collective fiduciary obligations. The Trustees will do so in connection with the financial and management audit hereinbelow described in Part II and shall report their decision and action to the Court prior to [July 10, 1998].

The Trustees Response declares that "[t]he so-called "Lead Trustee" system has already been terminated" as though it was a historical relic. The fact is despite the Stipulated Order , the Lead Trustee system was still intact at least eight months later. As the Trustees' Response admits, Trustee Peters continued to function as the "interim general manager" or "lead trustee" of the Asset Management Group until August 3, 1998, just four days before the Master's Consolidated Report was filed. Trustees' Response at 78.
This demonstrated lack of diligence in implementing the objectives of a prior stipulation and order evidences the need for the Court to take an active role in monitoring the implementation of CEO-based management system as recommended in the Master's Consolidated Report .

XII. TRUSTEE COMPENSATION

A. The Alleged Violation Of A Prior Agreement With The Attorney General Should Be Reviewed By Your Master.

In the Master's Consolidated Report , your Master reported:

Your Master, relying upon the reports of Coopers & Lybrand LLP, is satisfied and finds that the commissions payable to the Trustees in FY 1994, FY 1995, and FY 1996, were calculated and paid in a manner consistent with the Trust Estate's interpretation of statutory authority as reflected in Exhibit L.

The AG Response challenges this finding by your Master on the basis that the Trustees violated a 1966 agreement with the Attorney General in which the Trustees had agreed to waive all commissions on final distributions of capital.¹⁰ AG Response at 12-13.
Your Master was previously unaware of the existence of this agreement between the Trustees and the Attorney General and did not consider it in rendering his Master's Consolidated Report . Consequently, based upon the assertions in the AG Response , your Master is compelled to withdraw his finding regarding the propriety of the manner in which the commissions payable to the Trustees have been determined. Your Master has made inquiry of the Trustees and their independent auditor PriceWaterhouseCoopers regarding the contentions raised by the AG Response and will provide a further report to the Court upon completion of such inquiry. See Letter dated September 21, 1998 from Colbert M. Matsumoto to Robert Bruce Graham, Jr. at Exhibit PP and Letter dated September 21, 1998 from Colbert M. Matsumoto to Arthur C. Tokin at Exhibit QQ.

B. State Law Has Not Been Preempted By The Intermediate Sanctions Law.

The Trustees' Response suggests a desire to be unyoked from the burden of annually having to publicly report to this Court regarding matters concerning their compensation. They declare that "State law on the issue [of Trustee compensation] is effectively preempted." Trustees' Response at 92. This statement is erroneous and misleading.
The Intermediate Sanctions Law is the federal government's effort to ensure that entities, such as the Trust Estate, which enjoy federal tax exemption and other tax benefits are not engaged in "excess benefit transactions" with "disqualified persons". It is meant to provide the IRS with an enforcement mechanism to ensure that the public policy objectives for allowing tax-exempt organizations to enjoy tax benefits are being properly furthered.
Nothing in the law suggests that Congress was seeking to pre-empt the ability of the states to regulate charitable trusts or the compensation received by trustees of such trusts. Rather than pre-empt state law, the Intermediate Sanctions Law gives the IRS concurrent jurisdiction with the states in reviewing the reasonableness of compensation paid to individuals such as the Trustees. The IRS is not necessarily bound by a state court or state law determination of the reasonableness of compensation and likewise the state court is not bound by the IRS's standards.
The Court should not be misled by the Trustees' suggestion that "the Internal Revenue Service will be the ultimate authority as to whether the total compensation paid to the Trustees is reasonable." Trustees' Response at 92. The requirement that the Trustees annually account to the Court for their compensation should be maintained intact and unimpeded.

C. Multiple Compensation Studies At Trust Estate Expense Were Unwarranted.

The Trustees' Response rejects your Master's recommendation that any future study regarding the reasonableness of Trustee compensation should be commissioned by the court's master as part of the annual account review process. Trustees' Response at 93. They also reject the notion that if they wish to prepare a compensation study of their own, they should do so at their own expense. They argue that such a study should be at the expense of the Trust Estate. Trustees' Response at 93-95.
The Trustees' Response contends that the Court had previously authorized them to conduct as many compensation studies as they choose at the expense of the Trust Estate. Trustees' Response at 94. This is simply not so. While the Trustees' Response recites a portion of this Court's earlier Findings of Fact, Conclusions of Law and Order Approving 105th Annual Report , filed herein on June 8, 1992 ("Order Approving 105th Annual Report"), it takes the language out of context. See Trustees' Response at 93-94. The actual language of the Order reads as follows:

The Trustees are instructed that they are authorized to commission a comprehensive study of the matter of trustees' commissions by one or more nationally recognized experts in the fields of executive compensation and trustee compensation. Any such study shall be provided to this Court's master appointed for the accounting period in which the study is presented. [emphases added]

Order Approving 105th Annual Report at 7.

Reading the language of the Order Approving 105th Annual Report in its entirety it is clear that the Court had contemplated a single study to be done by one or more experts. To construe that order as allowing the Trustees to commission multiple studies is not reasonable since it invites waste and potential abuse. Furthermore, such expenditures on multiple studies at the expense of the Trust Estate cannot be reasonably said to be necessary or appropriate and reasonable to carrying out the purposes of the Trust Estate. See In re Bishop Estate, 36 Haw. 403, 410-413 (1943). See also Bishop v. Pittman, 33 Haw. 647, 654 (1935) (trustee has duty to preserve and protect trust property for the beneficiary).
For example, the two compensation studies, commissioned by the Trustees within months of each other, cost the Trust Estate a total of $169,296. The study entitled Kamehameha Schools Bernice Pauahi Bishop Estate - Trustee Compensation , dated March 15, 1996, prepared by Towers Perrin ("Towers Perrin Report ") cost the Trust Estate $64,075. The study titled An Assessment of Trustee Compensation for Kamehameha Schools Bishop Estate , dated June 1996, prepared by SCA Consulting, LLC ("SCA Consulting Report ") cost the Trust Estate $105,221.
Your Master inquired of the Trustees the reason for having commissioned two compensation studies prepared within three months of each other. See Exhibit NN. In a letter dated August 5, 1998 from Robert Bruce Graham, Jr., attorney for the Trustees, to your Master, they replied:

Recognizing the existence of sometimes heated controversy surrounding the issue of compensation, there was concern that use of only one or the same expert would be questioned by some persons. That is, despite the integrity and reputation of the expert, the fact that the Estate commissioned the study was bound to raise questions concerning the independence of the report. By ordering two studies, each independent of the other, each study could substantiate the other.

See Exhibit OO.

Such a reason is inadequate to justify such a duplicative expense to the Trust Estate. The Order Approving 105th Annual Report contemplated that the Trustees would retain one or more reputable and competent experts to conduct an independent study using appropriate methodology and measures. Such a reputable study should speak for itself. Its credibility should not be dependent upon substantiation through redundant studies.
As such, your Master finds that the expense incurred in connection with the preparation of the SCA Consulting Report, at a cost to the Trust Estate of $105,221, was not a necessary or appropriate expense reasonably incurred by the Trustees to carry out the purposes of the Trust Estate.

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¹⁰ The period during which commissions on final disbursements of capital were taken by the Trustees is August 26, 1993 through July 1, 1994. Trustee Jervis was not a Trustee during this period of time and therefore did not receive any of the disputed commission compensation.

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RECOMMENDATION NO. 21: THE TRUSTEES SHOULD BE SURCHARGED FOR THE COST OF THE SCA CONSULTING REPORT. Accordingly, your Master recommends that the Trustees be surcharged in the amount of $105,221 together with interest thereon at the statutory rate.

XIII. CONFLICTS OF INTEREST

The Trustees' Response makes various factual assertions regarding the three conflict of interest examples referred to in the Master's Consolidated Report which your Master would be remiss in not clarifying:

A. McKenzie Methane.

Although it is true the personal investments by the Trustees and other employees of the Trust Estate in the McKenzie Methane investment were in a different investment interest than that of the Trust Estate, two facts are relevant;

1. The interest they acquired would benefit if the interest acquired by the Trust Estate was successful. Likewise costs borne by the Trust Estate in litigating issues surrounding its investment and infusion of further capital to salvage the troubled investment also accrued to the benefit of the personal investment interests acquired by the Trustees and the employees of the Trust Estate.
   
   
2. The Trustees' Response claims that the interest acquired by the individual investors was "not appropriate for a tax exempt entity". Trustees' Response at 96. The only reason why that was the case was the income derived would not have been tax-exempt income. There was no legal impediment preventing the Trust Estate from also acquiring the interest acquired by the individual investors even if it would have generated taxable income.¹¹

B. Mid-Ocean Limited.

The Trustees' Response states that the "Estate has suffered no loss or detriment by reason of the service of Trustees Takabuki and Peters as directors of Mid-Ocean." Trustees' Response at 96. It neglects to disclose that Trustee Peters did utilize the services of Trust Estate staff to assist him in reviewing various issues related to his service as a director of Mid-Ocean Limited.

C. Robert Trent Jones Golf Club.

The Trustees' Response contends that:

Trustee Peter's 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.

Trustees' Response at 97.

Your Master is unable to agree with the facile manner in which the Trustees' Response dismisses the conflict of interest issues raised by this investment. In light of such comments, your Master is compelled to note the following:

1. Trustee Peters did not recuse himself from "all Estate action concerning the club." Rather, the Trust Estate records indicate that he recused himself only for a very limited span of time while he served as a trustee of the Robert Trent Jones Golf Club ("RTJ Golf Club"). By the time he became a trustee of the RTJ Golf Club, he already had extensive involvement managing the Trust Estate's investment interest and possessed intimate knowledge of the Trust Estate's investment strategy and objectives with respect to the golf course investment.
   
   
2. The settlement of the Bashram lawsuit to which the Trustees' Response refers, resulted in a financial arrangement with the RTJ Golf Club which was less advantageous to the Trust Estate that the financial arrangement upon which the suit was based. The reasons for such a result merit further inquiry and analysis by the Attorney General in her capacity as parens patriae. Master's Consolidated Report at 125.

The Trustees' Response further reinforces the view expressed in the Master's Consolidated Report that the manner in which the Trustees investigate, analyze, and deal with issues of conflict of interest is inadequate, unsatisfactory, and demonstrates a lack of sensitivity to the importance of such issues.

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¹¹ For example, the investment in Goldman Sachs & Company generates income which is not tax-exempt.

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XIV. EXPENSES RELATED TO THE ENACTMENT OF THE INTERMEDIATE SANCTIONS LAW

In the Master's Consolidated Report , your Master noted that the Trustees had expended a substantial amount of Trust Estate funds and resources in an attempt to influence Congress with respect to the enactment of the Intermediate Sanctions Law, IRC 4958.
Prior to and subsequent to filing the Master's Consolidated Report , your Master sought information from the Trustees to evaluate whether the expenditure of funds and other Trust Estate resources for the purposes of initially opposing enactment of the Intermediate Sanctions Law and later seeking the described modifications of the Congressional Committee Report were necessary or appropriate and reasonable to carrying out the purposes of the Trust Estate. See, Letter dated June 10, 1998 from Colbert M. Matsumoto to Robert Bruce Graham, Jr. at Exhibit RR; Letter dated August 6, 1998 from Colbert M. Matsumoto to Sue Tempkin at Exhibit TT; Letter dated August 17, 1998 from Colbert M. Matsumoto to Sue Tempkin at Exhibit UU; Letter dated August 25, 1998 from Colbert M. Matsumoto to Robert Bruce Graham, Jr. at Exhibit VV.
Your Master has received two letters purporting to respond to his inquiry. See Letter dated August 3, 1998 from Susan Tempkin to Colbert M. Matsumoto at Exhibit SS; Letter dated September 18, 1998 from Susan Tempkin to Colbert M. Matsumoto at Exhibit WW. However, your Master has been unsuccessful in obtaining the pertinent documents related to the legislative effort of the Trustees.
Based upon the responses received by your Master as well as other information he has obtained, your Master finds that the legislative effort by the Trustees with respect to the enactment of the Intermediate Sanctions Law by Congress, while in part was focused upon seeking legislative modifications which would be of general benefit to the Trust Estate, was nonetheless predominantly directed at preserving the historical procedure for determining compensation of the Trustees under state statutory law and minimizing the potentially adverse impact that the Intermediate Sanctions Law would have on their continued ability to receive compensation in accordance with and at the levels permitted under state law.
Your Master therefore finds that the expenditure of such funds and other Trust resources, to that extent, were not necessary or appropriate and reasonable to carrying out the purposes of the Trust Estate. See In re Bishop Estate, 36 Haw. 403, 410-413 (1943). See also Bishop v. Pittman, 33 Haw. 647, 654 (1935) (trustee has duty to preserve and protect trust property for the beneficiary).
Your Master also finds that the exercise of authority by the Trustees in expending Trust Estate assets for the purposes as described, involved a circumstance where their duty as a Trustee and their personal pecuniary interest were in conflict. They were therefore required to exercise their power over the Trust Estate assets, in incurring such expenditures, only by first obtaining court authorization upon a proper petition. HRS 554A-5(b).
Your Master has been unable to obtain the information necessary to make a determination of the total amounts expended by the Trustees in the legislative effort as well as what portion of that expenditure related to Trustee compensation as opposed to other more general issues of relevance to the Trust Estate. Your Master therefore recommends that the Trustees be required to provide an accounting in this regard.
Your Master therefore modifies Recommendation No. 17 of the Master's Consolidated Report as follows:

AMENDED RECOMMENDATION NO. 17: THE TRUSTEES SHOULD BE SURCHARGED FOR TRUST FUNDS AND RESOURCES EXPENDED IN OPPOSING INTERMEDIATE SANCTIONS LEGISLATION. Your Master recommends that the Trustees be ordered to account for and be surcharged for all Trust Estate funds and resources expended in attempting to influence Congress with respect to its enactment of the Intermediate Sanctions Law, IRC 4958, to the extent that such expenditures were related to seeking legislative modifications which would impact upon their compensation.

XV. IRS TAX AUDIT

Despite the unprecedented scope and gravity of the current IRS review of the Trust Estate, the Trustees' Response dismisses your Master's recommendation that the negotiation and resolution of the IRS audit be subject to Court monitoring and approval. The Trustees submit that tax matters "are essentially issues of federal law as to which this Court has no authority." Trustees' Response at 100.
Contrary to the Trustees' contention, tax issues could materially impact the financial status of the Trust Estate. It is therefore appropriate for the Court to review the impact adverse rulings by the IRS may have on the Trust Estate. The Court's authority to review tax issues affecting the Trust Estate is implicit in HRS 554A-3(b) which imposes a specific duty upon trustees:

[N]ot to exercise any power under [the Uniform Trustee Powers Act] in such a way as to deprive the trust of an otherwise available tax exemption, deduction, or credit for tax purposes or deprive a donor of a trust asset of a tax exemption, deduction, or credit or operate to impose a tax upon a donor or other person as owner of any portion of the trust. "Tax" includes, but is not limited to, any federal, state, or local income, gift, estate, or inheritance tax.

The Trustees' Response also asserts that "The Master's effort to insert himself and this Court in the resolution of any adjustment is inappropriate." Trustees' Response at 100. Although the Trustees claim that they are "cognizant of their obligation under HRS 554A-5(b) to seek this Court's instructions" in instances of conflict of interests, recent history suggests otherwise.
It is for this reason that your Master has recommended, in the shadow of an alarmingly broad IRS audit, that the Court issue a cautionary order instructing the Trustees to provide notice and report to the Court on the status of attempts to resolve the pending IRS audit.

XVI. CLOSURE OF THE 109th, 110th, and 111th ANNUAL ACCOUNTS

The AG Petition makes a number of allegations involving financial matters within the period of the three annual accounts reviewed by the Master's Consolidated Report . Several of these allegations alleged by the Attorney General have not been specifically reviewed by your Master. In light of such egregious allegations, it would be premature for the Court to approve and thereby close the three annual accounts until such time that the issues raised by the AG Petition are adjudicated or otherwise resolved.
At the request of the Trustees, your Master has not submitted the qualified certification letters he has received from them and various employees of the Trust Estate because of a concern raised by the Trustees regarding a public-disclosure sensitive matter referred to in the letters. On August 13, 1998, your Master requested that the Trustees provide redacted versions of the letter for submission to the Court. The Trustees have not yet provided the redacted letters and therefore your Master has not yet submitted the certification letters to this Court as exhibits.
Your Master again submits that because of the qualified nature of the certification letters, your Master is unable to fully and adequately rely upon the statements and representations contained therein in reviewing the annual accounts. For this reason also, your Master recommends that the annual accounts not be approved at and closed at this time.
DATED at Honolulu, Hawaii, September 29, 1998.

______________________________
COLBERT M. MATSUMOTO
Master

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IN THE CIRCUIT COURT OF THE FIRST CIRCUIT

STATE OF HAWAII

In the Matter of the Estate of BERNICE P. BISHOP, Deceased.

) ) ) ) ) ) ) ) ) )

EQUITY NO. 2048 CERTIFICATE OF SERVICE

CERTIFICATE OF SERVICE

I hereby certify that two (2) copies of the foregoing document were duly served upon the following parties listed below, in the manner described thereto, at their last-known address, on the date of filing.

	By U.S. Mail	By Hand Delivery
ROBERT B. GRAHAM, JR., ESQ. Ashford & Wriston Alii Place, Suite 1400 1099 Alakea Street Honolulu, Hawaii 96813 (Attorney for BISHOP ESTATE)		X
KEVIN T. WAKAYAMA, ESQ. Dept. of the Attorney General 830 Punchbowl Street, #219 Honolulu, Hawaii 96813 (Attorney for STATE OF HAWAII)		X

DATED at Honolulu, Hawaii, September 29, 1998.

______________________________
COLBERT M. MATSUMOTO
Master

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