COLBERT M. MATSUMOTO 2276-0
Suite 2000, Amfac Tower
700 Bishop Street
Honolulu, Hawaii 96813
Telephone No. 523-2999
MasterIN 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 MASTERíS CONSOLIDATED REPORT ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES
TABLE OF CONTENTS
Page
I. INTRODUCTION1
II. THE 109th MASTER'S REPORT AND THE STIPULATED ORDER CONCERNING MASTER'S RECOMMENDATIONS2
III. ACKNOWLEDGMENTS5
IV. SCOPE OF REVIEW6
V. HISTORICAL CONTEXT9
VI. FINANCIAL REPORTING AND MONITORING12
A. The Trustees Must Provide Meaningful
Financial Information In Connection With
The Annual Review12
RECOMMENDATION NO. 1: NEW FINANCIAL
STATEMENT PRESENTATION SHOULD BE
ADOPTED14
B. Highlights Of The Audited Financial
Statements For FY 1994, FY 1995,
And FY 199614
C. Valuation of the Trust Estate's Assets24
VII. ACCUMULATION OF INCOME27
A. The Distinction Between Corpus And Income
Is Fundamental To Fulfillment Of The Will
Of Princess Pauahi27
B. The Annual Accounts Filed With The Court
Do Not Adequately Disclose The Status of
the Corpus and Revenue Accounts30
Page
RECOMMENDATION NO. 2: CORPUS AND
REVENUE ACTIVITY SHOULD BE
SPECIFICALLY REPORTED31
C. Income Has Been Inappropriately
Reclassified As Corpus.31
RECOMMENDATION NO. 3: ACCUMULATED
INCOME SHOULD BE RESTORED TO THE
REVENUE ACCOUNT33
D. The Accumulated Income Balance May
Violate The Express Direction Of The
Will And Prior Court Orders33
RECOMMENDATION NO. 4: AN ACCOUNTING
OF ACCUMULATED INCOME AND INDEPENDENT
VERIFICATION SHOULD BE CONDUCTED35
E. Past And Current Trustees Have Been Under
Court Orders To Plan For The Expenditure
Of Accumulated Income But Failed To Comply
With Those Orders35
RECOMMENDATION NO. 5: STRATEGIC
PLANNING SHOULD INCORPORATE EXPENDITURE
OF ACCUMULATED INCOME40
F. The Trustees Should Adopt, With Court
Approval, An Appropriate Spending Policy40
RECOMMENDATION NO. 6: NO FUTURE
RECLASSIFICATION OF ACCUMULATED
INCOME SHOULD BE PERMITTED WITHOUT
PRIOR COURT APPROVAL43
G. A Replacement Cost Reserve Has Been
Established Without Court Approval And
May Violate The Will.43
Page
RECOMMENDATION NO. 7: THE
APPROPRIATENESS OF THE REPLACEMENT
COST RESERVE SHOULD BE DETERMINED
BY THE COURT44
VIII. EVALUATION OF THE INVESTMENT AND MANAGEMENT OF
ASSETS UNDER THE PRUDENT INVESTOR RULE45
A. The Will Requires Annual Judicial And
Public Review Of Investments45
B. The Trustees Are Subject To The Prudent
Investor Rule45
C. Appropriate Information Must Be Furnished
To Allow Evaluation Of Compliance With The
Prudent Investor Rule49
D. Investment Performance Should Be
Appropriately Monitored, Benchmarked,
And Disclosed50
RECOMMENDATION NO. 8: INVESTMENT
PERFORMANCE SCHEDULES SHOULD BE
REGULARLY PREPARED AND INCORPORATED
AS SUPPLEMENTAL SCHEDULES TO THE
FINANCIAL STATEMENTS52
RECOMMENDATION NO. 9: INVESTMENT
RETURN ANALYSIS SHOULD USE
APPROPRIATE PERFORMANCE MEASURES53
E. Substantial Losses And Loss Reserves
Were Established For Various Troubled
Investments55
Page
F. The Prudent Investor Rule Requires
Strategic Planning To Guide Investment
Decisions59
G. Prudent Investment Requires Diversification
Of The Investment Portfolio63
RECOMMENDATION NO. 10: INVESTMENT
POLICIES SHOULD BE REVIEWED AS
RECOMMENDED IN THE ANDERSEN REPORT68
H. The Due Diligence Review Process Needs
Strengthening68
RECOMMENDATION NO. 11: DUE DILIGENCE
AND INVESTMENT MONITORING POLICIES,
PRACTICES, AND PROCEDURES SHOULD BE
STRENGTHENED69
I. Documentation Of Investment And Management Decisions Must Be Significantly Improved And Consistently Maintained70
RECOMMENDATION NO. 12: INVESTMENT
AND MANAGEMENT DECISIONS SHOULD BE
PROPERLY DOCUMENTED72
J. Investment Costs And Management Expenses
Should Be Evaluated To Determine Compliance
With The Prudent Investor Rule72
K. The Real Estate Portfolio Of The Trust
Estate74
(a) The Andersen Report Recommends
Several Reforms For The Hawaii
Real Estate Operations76
(a) The Non-Hawaii Real Estate
Investments Are Not Linked
To An Asset Allocation Strategy
For The Trust Estate78
(b) Pooled Real Estate Investments80
IX. STRATEGIC PLANNING
83
A. Appropriate Strategic Planning Remains Lacking83
RECOMMENDATION NO. 13: COURT MONITORED
STRATEGIC PLANNING SHOULD BE INITIATED
BY THE TRUST ESTATE88
B. A Historical Note Regarding Past Strategic
Planning By The Trust Estate89
Page
C. Caution Should Be Exercised In Undertaking
The Strategic Planning Process To Avoid
A Detrimental Impact on the Education
Division97
X. TRUST ADMINISTRATION 99
A. The Need For Organizational Reform In The
Management Structure99
RECOMMENDATION NO. 14: THE LEAD
TRUSTEE SYSTEM SHOULD BE ABOLISHED
AND A NEW CEO BASED MANAGEMENT
SYSTEM SHOULD BE INSTITUTED AS
RECOMMENDED BY THE ANDERSEN REPORT 111
B. The Need For Judicial Intervention Is
Exemplified By The Conditions At The
Kamehameha Schools111
XI. TRUSTEE COMPENSATION113
A. Trustee Compensation During The Periods
Reviewed Were Consistent With State Law113
B. Trustee Compensation May Be A Factor
Impeding Management Reform116
C. The Intermediate Sanctions Law And Act 310
of 1998 Require Changes In The Procedure For
Determining Trustee Commissions.121
Page
RECOMMENDATION NO. 15: COMPLIANCE
PLAN FOR DETERMINING REASONABLE
TRUSTEE COMPENSATION SHOULD BE
PREPARED122
XII. DUTY OF LOYALTY -- CONFLICT OF INTEREST 123
A. Trustees Are Subject To A Duty of
Loyalty Which Demands The Avoidance
Of Conflicts Of Interest123
B. Issues Related To The Co-Investment By
Trustees In The McKenzie Methane
Investments Have Not Been Appropriately
Reviewed126
C. Issues Related To The Receipt Of
Director's Fees By A Trustee While
Serving As A Director Of A Corporation
In Which The Trust Estate Has A
Substantial Investment Require Proper
Review128
D. Issues Arising From A Trustee Of The
Trust Estate Assuming A Position As A
Trustee Of The Robert Trent Jones Golf
Club During Negotiations Between The Two
Entities Were Not Adequately Reviewed.130
E. Trustees Are Under A Duty To Act To
Prevent Or Redress A Breach Of Trust131
RECOMMENDATION NO. 16: STRICTER
CONFLICT OF INTEREST POLICIES AND
PROCEDURES SHOULD BE ADOPTED135
F. Expenses Related To The Enactment Of
The Intermediate Sanctions Law Were
Inappropriate135
Page
RECOMMENDATION NO. 17: TRUSTEES
SHOULD SHOW CAUSE WHY THEY SHOULD
NOT BE SURCHARGED FOR EXPENSES
INCURRED IN OPPOSING INTERMEDIATE
SANCTIONS LEGISLATION138
XIII. THE TAX EXEMPT STATUS OF
THE TRUST ESTATE138
A. Report By Arthur Andersen LLP Regarding
Matters Related To The Tax Exempt Status138
B. The IRS Audit And Potential Conflicts
Of Interest 140
RECOMMENDATION NO. 18: NEGOTIATION
AND RESOLUTION OF IRS AUDIT SHOULD
BE SUBJECT TO COURT MONITORING AND
APPROVAL141
XIV. CERTIFICATION TO THE COURT BY TRUSTEES AND KEY EMPLOYEES AND AGENTS141
RECOMMENDATION NO. 19: APPROVAL
OF THE ANNUAL ACCOUNTS TO BE
WITHHELD UNTIL THE CONCLUSION OF
THE PROCEEDINGS UPON WHICH THE
CERTIFICATION LETTERS ARE QUALIFIED144
XV. REVISION OF THE RESTATED GUIDELINES144
XVI. REQUESTS TO THE COURT144
MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH,
ONE HUNDRED TENTH,
AND THE ONE HUNDRED ELEVENTH
ANNUAL ACCOUNTS OF THE TRUSTEES
I. INTRODUCTION
Princess Bernice Pauahi Bishop mandated disclosure and accountability by the Trustees of her Trust Estate through the direction in the Will that:[M]y said trustees shall annually make a full and complete report of all receipts and expenditures, and of the condition of said schools to the chief justice of the Supreme Court, or other highest judicial officer in this country; and shall also file before him annually an inventory of the property in their hands and how invested, and to publish the same in some Newspaper published in said Honolulu;
See Exhibit A.
In accordance with this express direction in the Will, Hawaii Revised Statutes ("HRS") 560:7-201(a), and the Hawaii Probate Court Rules, the Trustees of the Trust Estate have submitted three separate petitions for approval of the annual accounts covering three fiscal year periods: July 1, 1993 to June 30, 1994 ("109th Annual Account"); July 1, 1994 to June 30, 1995 ("110th Annual Account"); and July 1, 1995 to June 30, 1996 ("111th Annual Account").1
Pursuant to HRS 635-14 and Rule 28 of the Hawaii Probate Court Rules, by three Orders of Reference to Master filed herein on January 18, 1996, June 6, 1996, and May 19, 1997, the undersigned was appointed as the Court's Master to review the three petitions for approval of the annual accounts and to report his findings and recommendations to the Court.
In accordance with Rule 29 of the Hawaii Probate Court Rules your Master has undertaken to "review the operations of the fiduciary in light of the terms of the controlling document, as well as the financial transactions of the trust or estate." Haw. Prob. Ct. R. 28. It is pursuant to this charge that your Master has undertaken to review the 109th, 110th, and 111th Annual Accounts of the Trustees.
1 HRS § 554-4 also requires that a trustee file an annual account with the court showing in detail all receipts and disbursements, together with a full and detailed inventory of all property in the trustee's possession or under the trustee's control.
II. THE 109th MASTER'S REPORT AND THE STIPULATED ORDER CONCERNING MASTER'S RECOMMENDATIONS
On November 17, 1997, your Master filed the Master's Report on the One Hundred Ninth Annual Account of the Trustees ("109th Master's Report "). Rather than repeat its content, your Master incorporates by reference the text of, including, but not limited to, the discussion regarding the applicable principles of law and the pertinent legal authorities cited therein.
The Trustees' Response to Master's Report on the One Hundred Ninth Annual Account (Fiscal Year 1993-1994) ("Trustees' Response ") and the Report of the Attorney General on the Petition of the Trustees for Approval of the One Hundred Ninth Annual Account were both filed herein on December 3, 1997. The Trustees, Attorney General, and your Master thereafter entered into a Stipulation Concerning Master's Recommendations (109th Annual Account) filed herein on December 19, 1997 which was approved and entered as an Order by the Court on the same day ("Stipulated Order "). That Stipulated Order , in large part, provided for the implementation of the recommendations made in the 109thMaster's Report ; prescribed that an international accounting firm be retained to conduct a full financial and management audit; and directed that the 109th, 110th, and 111th Annual Accounts be consolidated for hearing.
On January 9, 1998, a Stipulation Concerning Financial and Management Audit ("Audit Stipulation ") was entered into among the Trustees, the Attorney General, and your Master describing the scope of the ordered financial and management audit. Pursuant to the Audit Stipulation , proposals from various international CPA firms were solicited. As a result of that process the firm of Arthur Andersen LLP was selected and engaged by your Master to conduct an independent financial and management audit of the Trust Estate.
Since their engagement, Arthur Andersen LLP has undertaken a broad review and analysis of the financial affairs of the Trust Estate for FY 1994, FY 1995, and FY 1996. In addition, they have also reviewed the management operations and structure of the Trust Estate in accordance with the Audit Stipulation . Your Master also requested that Arthur Andersen LLP review various specific transactions and matters related to the Trust Estate to assist your Master in the preparation of this Report.
On August 27, 1998, the team of professionals from Arthur Andersen LLP presented their findings and recommendations in connection with the management audit to the Trustees and key employees from the Trust Estate during an all-day briefing. Those findings and recommendations are contained in a 336 page report prepared by Arthur Andersen LLP entitled Kamehameha Schools Bernice Pauahi Bishop Estate Management Audit Findings dated July 1998 ("Andersen Report "). Copies of the Andersen Report were provided to your Master, the Trustees, and the Attorney General pursuant to the Stipulated Order and Audit Stipulation. A copy is submitted to the Court under initial court seal in accordance with the Stipulated Order .
Your Master believes that the full copy of the Andersen Report is a sensitive internal management document which should remain under court seal and not be made public. The Andersen Report is a useful management tool for the Trust Estate because of its comprehensiveness and its frank discussion of issues identified by the team of professionals from Arthur Andersen LLP. Your Master therefore believes that Court should limit review, reference, and use of the sealed copy of the Andersen Report to the Court, your Master, and the Court's future appointed masters in connection with the annual accounts under review and subsequent annual accounts filed by the Trustees.
Despite the sensitivity related to public release of the full Andersen Report , the Trustees have agreed to allow your Master to make public the Executive Summary of the Andersen Report . See Exhibit B. That Executive Summary represents a fair summary of the content of the Andersen Report.
III. ACKNOWLEDGMENTS
Your Master wishes to acknowledge the work of several individuals who provided specialized expertise which assisted your Master in reviewing the accounts.
Paul Sachs, as the engagement partner, and Eric Yeaman, as the engagement manager, provided the leadership for the Arthur Andersen LLP team of professionals who undertook the financial audit and management review of the Trust Estate's operations. Their team was comprised of experts in financial reporting and consulting services related to financial market investment, real estate investment and management, not-for-profit organizations, information technology, compensation and benefits, and other areas of management operation expertise.
Edward C. Halbach, professor emeritus and former dean of the University of California at Berkeley School of Law (Boalt Hall) provided advice and guidance regarding the principles of trust law applicable to the Trust Estate.
Steven Sakamaki, CPA and the staff of the firm of Shigemura & Sakamaki, CPA, Inc. assisted in the initial review of the 109th and 110th Annual Accounts which provided much of the basis for the earlier 109th Master's Report .
In addition, your Master wishes to acknowledge the staff of the Trust Estate for their assistance in facilitating the completion of this report. At all levels of the Trust Estate: from the Kamehameha Schools; the staff at Kawaiahao Plaza; Royal Hawaiian Shopping Center, Inc.; and other subsidiaries of the Trust Estate; your Master found the staff to be dedicated and loyal to the legacy of Princess Pauahi. They are working under extremely stressful conditions because of the current controversy swirling around the Trust Estate. However, despite the difficult working conditions, your Master found them to be uniformly courteous and very professional in their conduct.
Finally, your Master wishes to acknowledge and commend the Trustees for agreeing to allow an independent financial audit and management review of the Trust Estate to be conducted by an international accounting firm such as Arthur Andersen LLP. As a result of that audit and review, the Trust Estate has the benefit of an independent, objective, and expert review and analysis of its operations. The recommendations derived from that process will provide valuable assistance to the Trustees in making improvements to the operations of the Trust Estate and strengthening their management of the Trust Estate's assets. Your Master thanks the Trustees for making themselves available for many hours of interviews and also for directing staff of the Trust Estate to cooperate with the team from Arthur Andersen LLP and your Master in providing requested information and interviews.
Your Master thanks all of these individuals along with the many unidentified persons who provided your Master with additional pertinent information for their contributions toward the preparation of this Report.
IV. SCOPE OF REVIEW
The scope of your Master's review of the Trustees' Petition was limited to the 109th, 110th, and 111th Annual Accounts filed by the Trustees covering FY 1994, FY 1995, and FY 1996.
The Trustees provided your Master with information required by the Minimum Guidelines Concerning the Annual Accounts of the Trustees of the Kamehameha Schools Bernice Pauahi Bishop Estate and the Reports of Future Masters as amended and restated as of September 30, 1995 ("Restated Guidelines ") as well as the Stipulated Order . Your Master has accepted and relied upon the information furnished by the Trustees as true, correct, and complete in preparing this Report.
Among the information provided by the Trustees to your Master and/or Arthur Andersen LLP were various responses of the Trustees to Information Document Requests ("IDRs") from the Internal Revenue Service in connection with an ongoing audit of the Trust Estate2; various responses to subpoenas served upon the Trust Estate by the Attorney General in connection with her current investigation of the Trust Estate; work papers of the independent auditors of the Trust Estate; and additional financial records specifically requested from the Trust Estate pertaining to investments and other matters within the scope of the Master's review.
All of the individuals who served as Trustees during the periods reviewed were interviewed by your Master and Arthur Andersen LLP. Several current and former staff members of the Trust Estate and various subsidiaries were also interviewed. In addition, various consultants who have serviced the Trust Estate in different subject matter areas were interviewed by your Master and/or Arthur Andersen LLP to gain some insight into the professional advice being provided to the Trustees.
The Restated Guidelines and Stipulated Order also require the Trustees to each make certain written statements and representations concerning the accounting period. As of the date of this Report your Master has received qualified certification letters dated November 14, 1997, signed by all of the Trustees covering each of the three years reviewed. See Exhibit O. In addition, your Master received additional letters from Trustees containing qualified certifications. See Discussion at Part XVI of this Report. Your Master has also received a number of responses from the Trustees to specific issues and information requests by your Master. Your Master has relied upon these statements and representations by the Trustees, as well as the responses from the Trustees through their counsel, as being true, correct, and complete responses to the matters addressed in the certification letters and otherwise inquired of them.
Pursuant to the Stipulated Order your Master has also received certifications from key Trust Estate employees designated by the Trustees. See Discussion at Part XVI of this Report. These employees are the principal executives of the various administrative groups of the Trust Estate. Your Master has likewise relied upon these statements and representations by these employees as being true, correct, and complete responses to the matters addressed in the certification letters and otherwise inquired of them.
Based upon the foregoing, your Master makes the following report and findings.
2At the time the IDRs were reviewed in early May 1998, the Trustees had not yet responded to over 50 IDRs which had recently been served upon the Trust Estate.
V. HISTORICAL CONTEXT
During the lifetime of Princess Pauahi, Hawaii was an independent nation which was undergoing radical social, economic, cultural, and demographic changes.
Princess Pauahi was born on December 19, 1831, only twelve years after her great-grandfather, King Kamehameha the Great, had died. At the time of her birth the indigenous population of Hawaii had declined to 124,449 from 300,000 estimated at the time of Captain Cook's arrival in 1778. By the time she was 41 years old in 1872, the total population of the Hawaiian Kingdom had further dwindled to 56,897 of which 51,531 were native Hawaiians. Twelve years later, when Princess Pauahi died in 1884, the overall population of the Hawaiian Kingdom had increased dramatically to 80,578 (as a result of in-migration related to the sugar industry), but the native Hawaiian population had further declined to 44,232. Native Hawaiian Data Book 1996 , Office of Hawaiian Affairs (1996).
Concerned for the future of the native Hawaiian people in an environment that was undergoing such drastic change, Princess Pauahi sought to leave a legacy of educational opportunity to assist native Hawaiians in coping with hostile social, economic, and cultural forces which were taking hold in Hawaiian society. With no universal public education system in place in 1884, that educational legacy was an important one to the native Hawaiian people.
Today, that legacy is no less important. While the decline in the native Hawaiian population has reversed itself through an increase in the population of part-Hawaiians and a universal public education system is in place, native Hawaiians continue to face social, economic, and cultural challenges of a different but nonetheless significant nature.
According to the 1990 United States Census, the school- aged population of native Hawaiians in the State of Hawaii was comprised of 39,439 children between the ages of 5 and 18 years. By the 1995-96 school year it was reported that there were 45,325 school-aged native Hawaiians. By the 2005-06 school year, it is predicted that there will be a school-aged population of 54,145 native Hawaiians. As a percentage of the total population of school-aged children, native Hawaiians constitute one of the fastest growing groups. Native Hawaiian Data Book 1996 , Office of Hawaiian Affairs (1996).
Correspondingly, the endowment left by Princess Pauahi has grown dramatically in recent years. At the time of her death, the lands comprising the corpus of her Trust Estate were appraised as having a value of $300,000. Today, that endowment has mushroomed to a total corpus value of more than $6 billion.
The number of students serviced by the schools established as Princess Pauahi's legacy has also expanded. During the first school year of Kamehameha Schools in 1887-88, the campus enrollment was comprised of only 37 students. By 1995-96, campus enrollment at the Kapalama campus of Kamehameha Schools from K through 12 reached a peak of 3,092. One Hundred and Ninth Annual Report from the President, Kamehameha Schools to the Board of Trustees, School Year 1995-1996 at 7-10. In addition, the Trust Estate provided Center-Based Preschool services throughout the state to 780 four-year old children in 1995-96. See Id. Moreover, over 1,800 college-enrolled students benefitted from over $12 million in scholarships funded by the Trust Estate.
The nature of the business operations of the Trust Estate has also evolved so that it is no longer just a real property landlord passively collecting lease rents from tenants on its Hawaiian land holdings. Instead, the infusion of enormous amounts of cash, resulting from the liquidation of residential land holdings under threat of public condemnation, has transformed the Trust Estate within the last 15 years into a complex business organization with wide-ranging and sophisticated domestic and international financial investments. Its financial resources and strength now make it a much sought after source of capital for investment.
In light of these historical changes, the challenges facing the Trustees today in fulfilling the legacy of Princess Pauahi are daunting. Likewise the responsibility of the Court in exercising proper oversight over the Trustees and the performance of their fiduciary duties has grown in magnitude.
Recognizing the historical significance of the legacy of Princess Pauahi, this Report attempts to review and report on the financial condition and operations of the Trust Estate with a view to ensuring that the integrity of her Will is maintained and her legacy fulfilled.
VI. FINANCIAL REPORTING AND MONITORING
A. The Trustees Must Provide Meaningful Financial Information In Connection With The Annual Review.
The duty to account required of the Trustees by the Will can only be discharged if they provide meaningful financial information when they submit their annual account to the Court.
With the Trust Estate's growing complexity and diversity of investments, appropriate financial reporting is critical to sound analysis of its financial condition. The financial reports of the Trust Estate must provide the kinds of information which will allow the Court to readily evaluate whether the Trustees have discharged their duties in governing the affairs of the Trust Estate and its assets prudently and in accordance with the dictates of the Will.
The Andersen Report makes several recommendations for a financial statement presentation different than that which the Trustees have heretofore provided to the Court. These changes also reflect recommendations from the Trust Estate staff who worked with Arthur Andersen LLP in developing an improved financial reporting format. The new financial statement presentation will provide the Court with a more comprehensive and meaningful overview of the Trust Estate as the complex business entity into which it has been transformed.
Among the principal changes recommended by Arthur Andersen LLP in the financial statement presentation are the following:
RECOMMENDATION NO. 1: NEW FINANCIAL STATEMENT PRESENTATION SHOULD BE ADOPTED.
Your Master recommends that the Trustees be ordered to adopt the financial statement and supplemental schedules presentation as proposed by Arthur Andersen LLP and recommended in the Andersen Report in all respects, with the same level of detail, and regularly filed with their annual account beginning with the 112th Annual Account.
B. Highlights Of The Audited Financial Statements For FY 1994, FY 1995, And FY 1996.
The past practice of not consolidating the Trust Estate's financial statement with those of its wholly owned and majority owned subsidiaries made it difficult to obtain an overview of the financial status of the Trust Estate and its subsidiaries. For this reason, the 109th Master's Report urged the Court to require the Trustees to consolidate the financial statements of the Trust Estate and its subsidiaries in accordance with GAAP.3
In accordance with the Stipulated Order , Arthur Andersen LLP has prepared audited financial statements for the Trust Estate and its majority-owned subsidiaries4 on a consolidated basis for each of the three fiscal years being reviewed5 ("Financial Statements ").
The format of the Financial Statements is also different from the historical financial statements previously filed with the Court in that it separately reports the Revenue Fund and Corpus Fund activity of the Trust Estate.
The Revenue Fund is the primary operating fund of the Trust Estate. Income generated from the corpus assets and from other sources is accounted for in the Revenue Fund and is used to provide for operations and maintenance of the Trust Estate and its assets. The Corpus Fund is comprised of the original assets provided for in the Will and other assets which have been subsequently acquired from the proceeds of sale of such original assets. Gain or losses on the sale of any assets as well as fluctuations in the fair value of certain assets are reflected in the Corpus Fund. As discussed further in Part VII, Sections A and B of this Report, the segregation of this activity allows the Court to better evaluate the relative compliance with the provisions of the Will.
The Financial Statements prepared by Arthur Andersen LLP comprise Exhibit C to this Report. The following abbreviated discussion highlights some of the noteworthy items contained in those Financial Statements :
1. Statements of Financial Condition. The Statement of Financial Condition presents the assets, liabilities, and net assets of the Trust Estate as of the end of each fiscal year. See Financial Statements at 3-7. Some of the significant changes in the account balances between fiscal years relate to:(a) Cash and Cash Equivalents. The Trust Estate maintained significant cash balances for all three fiscal years ranging from $169,325,000 at June 30, 1994 to $89,391,000 at June 30, 1996. The Trust Estate's significant cash levels are due in part to its liquidity requirements related to its commercial paper program. The liquidity requirements under this program amounted to approximately $68,500,000 as of June 30, 1996.
(b) Privately Placed Debt and Equity Securities. The Trust Estate's investments in privately placed debt and equity securities increased substantially during the three years reviewed. The balance increased from $716,286,000 at June 30, 1994 to $932,536,000 at June 30, 1996. The increase is primarily a result of re-deploying cash proceeds received from the Trust Estate's residential fee sales program to special situation and venture capital type investments (including Goldman Sachs & Co.).
(c) Notes Payable. Total consolidated notes payable increased from $450,143,000 at June 30, 1994 to $608,453,000 at June 30, 1996. The increase was primarily related to financing the Trust Estate's $21 million acquisition of land in Hamakua; the acquisition of Shelter Bay timberlands for $60 million; and $75 million of the Trust Estate's second investment tranche in Goldman Sachs & Co. The increase in debt resulted in an approximately $9.9 million increase in consolidated interest expense between FY 1994 and FY 1996.
2. Statements of Activity . The Statement of Activity presents the revenues and expenses of the Trust Estate for the fiscal year and the increase or decrease in net assets experiences by the Trust Estate during that period. See Financial Statements at 8-11. In summary, the Statements of Activity present the following results:(a) Education Programs. Although the Trust Estate enjoyed significant increases in net assets over the three fiscal years, Education Program Expenses remained relatively level:
Education Program
Expenses6FY 1994: $ 91,141,305 FY 1995: $102,408,296 FY 1996: $ 99,819,224
See Statement of Activity FY 1994-1996; and Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
3Coopers & Lybrand LLP, the Trust Estateís independent auditor, in its Report of Independent Accountants with respect to the financial statement for FY 1996, declared that GAAP requires the Trust Estateís investments in its wholly owned and majority owned subsidiaries be accounted for on a consolidated basis. Accordingly, it qualified its auditorís report for the effect of not consolidating wholly owned and majority owned subsidiaries.
4Those subsidiaries include Pauahi Holdings Corporation (which in turn owns Royal Hawaiian Shopping Center, Inc. [îRHSCIî]; Kamehameha Investment Corporation; and P&C Insurance Company, Inc.); Socal Holdings, Inc.; Southern Nevada Income Properties (ìSNIPî); and Meridian Associates. RHSCI owns Kukui, Inc. and has substantial interests in a number of real estate partnerships which were also consolidated.
5Because the Trust Estate acquired a majority interest in a savings bank during 1995, the Financial Statements for FY 1995 and FY 1996 include financial information related to the savings bank. However, because financial reporting associated with a savings bank is somewhat incongruous with the other holdings of the Trust Estate, Arthur Andersen LLP has presented that information in a manner which allows the reader to view the consolidated holdings and operations of the Trust Estate with or without the impact of the information related to the savings bank.
6Includes both ìdirectî and ìindirectî education expenses for all education programs, including scholarships and financial aid.
The Trust Estate provides a substantial amount of scholarship assistance for students attending post-secondary educational institutions. It also provides financial aid to students attending the Kamehameha Schools. The total amount of such assistance was significantly increased from FY 1994:
Financial Aid
& ScholarshipsFY 1994: $15,145,270 FY 1995: $17,034,074 FY 1996: $17,725,260
See Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
(b) Rental Operations. Historically, the financial statements filed with the Court presented the Trust Estate's rental operations on a "net" basis (i.e., rental operations revenues net of rental operations expenses). Also, interest expense for certain properties was netted with the results of these rental operations. The Financial Statements prepared by Arthur Andersen LLP separately report the revenues and expenses from rental operations. They also separately report total interest expense for the Trust Estate, a portion of which relates to rental properties. This presentation allowed your Master to better compare the results of these operations for the three years reviewed. During the three-year period, gross rental operations revenues fluctuated between years while rental operations expenses consistently increased resulting in a decline in net rental revenues:Rental Rental Net Rental Operations Operations Operations Revenue Expense Revenue FY 1994: $159,220,000 $60,981,000 $98,239,000 FY 1995: $158,587,000 $71,569,000 $87,018,000 FY 1996: $160,012,000 $68,798,000 $91,214,000See Statement of Activity FY 1994-1996.
(c) Investment Income. Investment income fluctuated significantly during the three years reviewed. This is primarily a result of the volatility of the income attributable to the Trust Estate's investment in Goldman Sachs & Co. and certain of its real estate equity investments. It is also important to note that the investment income related to Goldman Sachs & Co. comprised a greater proportion of investment income than all other investment sources for each of the three fiscal years.FY 1994 FY 1995 FY 1996 Goldman Sachs & Co.: $ 49,953,000 $38,729,000 $ 74,451,000 All other sources: 23,858,000 6,039,000 34,527,000 Investment income: $ 73,811,000 $44,768,000 $108,978,000
See Notes , Financial Statements at 29; Statement of Activity FY 1994-1996.
The Court should also be aware that the income from Goldman Sachs & Co. was misreported on the audited financial statements submitted by the Trustees for FY 1994, FY 1995, and FY 1996. The Trust Estate holds a 9.5% interest in Goldman Sachs & Co. and, as a result, is required to account for the investment on the cost basis method of accounting. Instead, the investment was accounted for using a hybrid (cost and equity) method that is not in accordance with GAAP. This resulted in an overstatement or understatement of the Trust Estate's income in the following amounts:Overstatement or
(Understatement)FY 1994: $29,739,000 FY 1995: ($33,563,000) FY 1996: $17,058,000The amounts reported in the Financial Statements prepared by Arthur Andersen LLP have been appropriately adjusted for this accounting error.7
(d) Net Gains (Losses) From Long-Term Investments. Revenues from long-term investments also fluctuated widely during the three years reviewed. In FY 1994, the Trust Estate recognized a net loss from long-term investments of ($50,016,000). This loss was primarily attributable to loss reserves or write-offs recorded during that period that related to the Trust Estate's investments in loans and subordinated debentures. In FY 1995, the Trust Estate again failed to enjoy any net gain on long-term investments but instead suffered a net loss of ($954,000). In FY 1996, the Trust Estate enjoyed a $21,269,000 net gain on its long-term investments. However, approximately $28,386,000 of the gains recognized in FY 1996 were unrealized gains from marketable debt and equity securities.
(e) Net Gains on Land Sales. During the three years reviewed, the Trust Estate realized net gains primarily associated with the residential fee sales program of approximately $334,372,000.8 However, revenue from such sales is rapidly declining:Net Gains On
Land SalesFY 1994: $199,563,000 FY 1995: $83,125,000 FY 1996: $51,684,000
See Statement of Activity FY 1994-1996.
7The Trust Estateís staff and its independent auditor became aware of this error after extensive analysis in FY 1997 and a cumulative adjustment was made in that year.
8This is in addition to previously realized gains of $123 million in FY 1992 and $105.9 million in FY 1993 from lease-fee conversion sales reported in the Matsubara Report and Matsubara Report 2.
(f) Management and General Expenses. Management and general expenses rose considerably over the three fiscal years:
Management &
General ExpenseFY 1994: $41,934,000 FY 1995: $52,136,000 FY 1996: $61,147,000
See Statement of Activity FY 1994-1996.
A large portion of the increase was attributable to professional service expense which increased from approximately $6,901,000 in FY 1994, to $11,335,000 in FY 1995, and $12,520,000 in FY 1996.
(g) Inter-Fund Transfers. Accumulated income included in the Revenue Fund less any reserve balances is transferred annually to the Corpus Fund.9 For FY 1994 and FY 1995, this transfer amounted to $27,671,000 and $12,004,000, respectively. However, for the fiscal year ended June 30, 1995, the Trust Estate sustained a deficit in the Revenue Fund because operating expenses exceeded revenues for that year. Accordingly, a $20,518,000 transfer was made from the Corpus Fund to fund this deficit.
9This practice is criticized in Section VII of this Report.
3. Notes to the Consolidated Financial Statements . The Notes provide for a discussion of the significant accounting principles of the Trust Estate and more detailed information regarding amounts in the Financial Statements along with other explanatory information. The Notes also highlight other material facts to enable the reader to better understand the financial information presented in the Financial Statements .The Notes prepared by Arthur Andersen LLP include expanded information designed to be more meaningful to the Court in facilitating future reviews of the Trust Estate. The expanded financial disclosures include:
(a) Net assets designated by the Trustees. See Notes, Financial Statements at 24.
(b) Investment income by type of investment. See Notes, Financial Statements at 29.
(c) Net gains (losses) on long-term investments by type of investment. See Notes, Financial Statements at 29.
(d) Inherent risks in the investment portfolio:(i) Amount of loss reserves related to privately placed debt and equity investments. See Notes, Financial Statements at 27.
(ii) Risks associated with the Trust Estate's investment in Goldman Sachs & Co. See Notes, Financial Statements at 28-29.
(iii) Risks associated with the Trust Estate's investment in the savings bank. See Notes, Financial Statements at 40-71.(e) Certain significant commitments and contingencies:
(i) Future rental income from long-term ground lease arrangements. See Notes, Financial Statements at 38.
(ii) Status of the IRS Audit. See Notes, Financial Statements at 39.(f) Supplemental Schedules.
(i) Educational program revenues by source and expenses by object for FY 1994, FY 1995, and FY 1996. See Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
(ii) Income yield and total return for FY 1994, FY 1995, FY 1996 and the 3-years annualized (including notes thereto). See Financial Statements at 77-84.C. Valuation of the Trust Estate's Assets.
Obviously, one of the basic measures of the financial condition of the Trust Estate is its worth. This has been the subject of considerable speculation due to the extent of the Trust Estate's real estate holdings. While it is impossible to exactly determine the fair market value of the Trust Estate's assets, a reasonable attempt to establish a value is important to measure its financial status. Such information is also critical to measuring investment performance and evaluating whether the Trustees have productively utilized the assets to further the purposes of the Trust Estate. See Ahuna v. Dept. of Hawaiian Home Lands, 64 Haw. 327, 640 P.2d 1161 (1982) (trustee is obligated to use reasonable skill and care to make trust property productive).
While the Financial Statement contains a Statement of Financial Condition (balance sheet) which shows the book value of the assets of the Trust Estate, it does not give an accurate view of the worth of the assets of the Trust Estate. This is because the majority of the assets is reflected in the Financial Statement at historical values rather than current values. In the case of the Trust Estate, by prior order of this Court, the value of the Hawaii real estate is shown at adjusted real property tax assessed values as of January 1, 1965. See Notes , Financial Statements at 22. Consequently, the Statement of Financial Condition materially understates the value of substantial assets owned by the Trust Estate.
The Statement of Financial Condition for each of the three annual account periods reviewed show the following results:10ASSETS LIABILITIES NET ASSETS FY 1994: $2,050,952,000 $ 555,150,000 $1,495,802,000 FY 1995: $2,249,396,000 $ 710,397,000 $1,539,000,000 $4,032,052,000 $2,441,569,000 $1,590,483,000 FY 1996: $2,383,670,000 $ 731,342,000 $1,652,329,000 $3,963,430,000 $2,267,314,000 $1,696,116,000
10In FY 1995, the Trustees acquired a majority interest in SoCal Holdings, Inc. (ìSoCalî), a savings bank company. The amounts on the first tier for FY 1995 and FY 1996 exclude the accounts of SoCal while the italicized amounts on the second tier reflect the effect of consolidating the Trust Estateís balance sheet with that of SoCal.
Pursuant to the Stipulated Order , the Trustees agreed to file with the Court a list of the assets of the Estate at the end of the accounting period, including the current fair market value of all assets. The Trustees filed such a list of assets on March 31, 1998. See Exhibit F.
In contrast to the numbers in the Financial Statement , the Concerning Supplemental List of Assets (111th Account) filed herein on March 31, 1998 ("List of Assets"), show the Trust Estate's assets as having an aggregate value of $5,714,142,590 as of June 30, 1996. The difference between this amount and the materially smaller amount reflected in the Statement of Financial Activity is principally due to the difference in value attributed to Hawaii real estate as explained above.
The aggregate value reflected in the List of Assets provides a closer approximation of the total value of the assets of the Trust Estate except in certain respects. First, real property values are reported based upon current adjusted real property tax assessed values and may not reflect "fair market value". Second, the assets held by Pauahi Holdings Corporation are not listed. Instead, the Trust Estate's ownership of Pauahi Holdings Corporation is reported "at equity" which reflects the "book value" of Pauahi Holdings Corporation and not necessarily the sum of the fair market value of its assets. Finally, Pauahi Holdings Corporation reports the ownership interest in Goldman Sachs & Co. at cost rather than fair value. As a result, the value of that asset may be substantially understated on Pauahi Holdings Corporation's financial statement. See Notes , Financial Statements at 37. To that extent, the Trust Estate's valuation of its interest in Pauahi Holdings Corporation is also understated.
VII. ACCUMULATION OF INCOME
A. The Distinction Between Corpus And Income Is Fundamental To Fulfillment Of The Will Of Princess Pauahi.
Maintaining the distinction between the corpus account11 and the income account12 is critical to the fulfillment of the express directions of Princess Pauahi as set forth in her Will.
In establishing the Trust Estate, Princess Pauahi bequeathed all of her residual estate to her designated Trustees to hold in trust, to erect the Kamehameha Schools. In Paragraph Thirteen of the Will, she specifically instructed them to utilize the residual estate as follows:I direct my trustees to expend such amount as they may deem best, not to exceed however one-half of the fund which may come into their hands, in the purchase of suitable premises, the erection of school buildings, and in furnishing the same with the necessary and appropriate fixtures furniture and apparatus. I direct my trustees to invest the remainder of my estate in such manner as they think best, and to expend the annual income in the maintenance of said schools; meaning thereby the salaries of teachers, the repairing of buildings and other incidental expenses; and to devote a portion of each years income to the support and education of orphans, and others in indigent circumstances, giving the preference to Hawaiians of pure or part aboriginal blood; the proportion in which said annual income is to be divided among the various objects above mentioned to be determined solely by my said trustees, they to have full discretion . [emphases added]
This provision of the Will directs that expenditures for the erection of school buildings and for furnishing them with "fixtures, furniture and apparatus" be charged against the corpus account. On the other hand, expenditures from the income account are restricted to the "maintenance of [the] schools" and may not be used for other purposes such as the erection of school buildings. Collins v. Hodgson, 36 Haw. 334 (1943).
For this reason, it is important that the Trust Estate's financial statement separately account for corpus and income to ensure that the directions of the Will regarding how corpus and income are to be expended are properly fulfilled.13
The importance of such an accounting distinction was explicitly raised in 1970 by Richard S. Sasaki, Esq., Master for the 81st Annual Account. See Report to the Attorney General on the Petition of the Trustees for Approval of the Eighty-First Annual Report ("Sasaki Report ") which is appended to the Report of the Attorney General With Respect to the 81st Annual Account of Bernice Pauahi Bishop, Deceased for the Period Covering July 1, 1965 Through June 30, 1966, filed herein on February 10, 1970.
The Sasaki Report noted that the Trustees then failed to adequately segregate income from corpus in their accounting. The Sasaki Report critically observed that:The propriety of various expenditures from the standpoint of income expenditures or corpus expenditures cannot be determined by a review of these schedules. It is also difficult to determine capital expenditures from expenses without tracing each expenditure to a chart of accounts.
Sasaki Report at 4.
The Sasaki Report also disclosed that the Trustees, for a number of years previously, had improperly charged against the income account a total of $4,984,906 for capital items. However, in response to concerns regarding the legality of the practice, the Trustees made adjusting entries to the corpus account to restore the amounts previously charged against the income account. This restored the accumulated income account balance as of the end of FY 1966 to $5,693,985.14
As a result of the Sasaki Report , the Trustees entered into a stipulation with the Attorney General, which was approved and ordered by the Court, wherein they agreed to institute a number of reforms. Those included reforms in accounting practices such as segregating the corpus and income accounts. See Stipulation filed herein on July 22, 1970 in connection with the 81st Annual Account; Report of the Attorney General With Respect to the 81st Annual Account of Bernice Pauahi Bishop, Deceased for the Period Covering July 1, 1965 Through June 30, 1966, filed herein on February 10, 1970; and Order Approving 81st Annual Account, filed herein on July 30, 1970.
11The ìcorpus accountî is sometimes referred to as the ìprincipal account.î Both terms refer to the same account.
12The ìincome accountî is sometimes referred to as the ìrevenue account.î Both terms refer to the same account.
13The Revised Uniform Principal and Income Act, HRS Chapter 557 classifies what constitutes ìincomeî and ìprincipalî. HRS § 557-3 defines ìincomeî as the ìreturn in money or property derived from the use of principalî and generally includes rent, interest, cash dividends, receipts from business operations, receipts from disposition of natural resources and underproductive property. ìPrincipalî generally includes proceeds from the sale of property, stock dividends, capital gains from the sale of corporate securities, and certain royalties, and receipts from the disposition of other property.
14To put this amount into perspective, during FY 1966, the Trustees spent a total of $4,137,892 for the operation of the Kamehameha Schools.
B. The Annual Accounts Filed With The Court Do Not Adequately Disclose The Status of the Corpus and Revenue Accounts.
The annual accounts filed by the Trustees since the Sasaki Report have included financial statements which segregated the corpus account from the revenue account and specifically indicated the status of the accumulated income account. However, beginning with the 103rd Annual Account (FY 1988), the Trustees unilaterally altered that practice and submitted financial statements to the Court which no longer disclosed the status of the corpus account and revenue account. As a result, since that time it has been impossible for the Court to determine the extent of the accumulation of income from the financial statements provided by the Trustees.
Your Master could find no authorization for the Trustees to alter the financial statement presentation in this manner. The consequence of the change was that the Court no longer was given the necessary information upon which to determine the status of the corpus and revenue accounts.
The Andersen Report recommends a financial statement presentation which will require that the corpus account and revenue account be separately reported. This will facilitate determining whether or not the dictates of the Will have been complied with. Such information is essential to maintaining the integrity of the Trust Estate created by Princess Pauahi. As the Supreme Court declared in Collins v. Hodgson, the appropriate expenditure (as opposed to the accumulation) of income by the Trust Estate is fundamental to the fulfillment of Princess Pauahi's intent as expressed in her Will. Compliance with the Will's directives can only be evaluated if appropriate information is furnished by the Trustees.
RECOMMENDATION NO. 2: CORPUS AND REVENUE ACTIVITY SHOULD BE SPECIFICALLY REPORTED.
Your Master recommends that the Trustees provide an explanation to the Court in their response to this Report why the prior order of the Court requiring segregation of the corpus account and the revenue account was not complied with.
Your Master further recommends that the Trustees be ordered to annually submit financial statements which conform to the trust accounting format as prescribed in the Andersen Report beginning with the 112th Annual Account.C. Income Has Been Inappropriately Reclassified As Corpus.
Adoption of the financial statement presentation as recommended by Arthur Andersen LLP alone will not adequately ensure a proper accounting by the Trustees.
Your Master has learned that on repeated occasions, the Trustees approved reclassification of the entire accumulated income balance in the revenue account to corpus. This procedure basically involved depleting any unexpended income in the revenue account.
The procedure was first initiated by the Trustees15 by their action on June 30, 1988, to be effective as of July 1, 1987, when $65,629,805 in unexpended income from the revenue account was reclassified to corpus. This resulted in the revenue account being left with a zero balance as of July 1, 1987. Again in 1991, the Trustees16 approved the reclassification of $135,576,108 in unexpended income from the revenue account to the corpus account. This resulted in the revenue account being left with a zero balance as of July 1, 1991. This process of depleting the revenue account as of the end of the fiscal year was repeated annually from 1992 until 1997. During that period, the Trustees would apparently annually direct the transfer of the unexpended income balance in the revenue account to the corpus account,17 thereby maintaining a zero unrestricted income balance in the revenue account at the end of each fiscal year.
These transfers were done without judicial sanction, although ostensibly upon the advice of legal counsel and the independent auditor of the Trust Estate. Moreover, the conversion of unexpended income from the revenue account to the corpus account was never affirmatively disclosed to the Court.18
Although the Trustees contend that the transfers were done with the funds being "earmarked specifically for maintenance, or operations, of the schools" as advised by legal counsel, Arthur Andersen LLP found no evidence of such earmarking in the Trust Estate's general ledger accounts. Instead, it appears that the Trustees converted income into corpus without proper authority. Coupled with a change in financial statement presentation, that action was not readily discernable since the true level of accumulated income could no longer be identified in the financial records of the Trust Estate presented to the Court.
The method of accounting purported to be employed by the Trustees is suspect and undermined the ability of the Court to properly exercise its oversight function over the Trust Estate. Moreover, the actions of the Trustees in transferring funds from the revenue account to the corpus account were unauthorized, improperly documented, and inadequately disclosed to the Court.
15A different group of Trustees from the current group of incumbent Trustees were involved in that action.
16Not all of the incumbent Trustees were members of the Board of Trustees at that time.
17There are no minutes of the meetings of the Board of Trustees which reflect such action.
18The audited financial statements submitted to the Court make no mention of the reclassification of income to corpus although the amounts involved were material.
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D. The Accumulated Income Balance May Violate The Express Direction Of The Will And Prior Court Orders.
Because Arthur Andersen LLP could not determine the status of the accumulated income account balance from the financial records provided by the Trustees, it was only upon inquiry by your Master regarding the status of the corpus and revenue accounts that the Trustees disclosed specific information regarding the accumulation of income by the Trust Estate. That information revealed that the Trust Estate had aggregated the following accumulated income amounts in each year since 1985:Year End Accumulated Unexpended Income Income as of as of June 30 June 30 Beginning Balance on July 1, 1985: $ 48,850,349 1986: $ 7,394,247 $ 56,244,596 1987: $ 9,385,209 $ 65,629,805 1988: $ 11,123,200 $ 76,753,005 1989: $ 47,763,508 $124,516,513 1990: $ 35,599,907 $160,116,420 1991: $ 41,089,493 $201,205,913 1992: $ 15,866,113 $217,072,026 1993: $ 17,072,621 $234,144,647 1994: $ 82,294,368 $316,439,015 1995: ($30,174,365) $286,264,650 1996: $ 2,018,180 $288,282,830 1997: $ 61,036,302 $349,319,132
To put the accumulated income amount into perspective, in FY 1996, the expense related to operating the schools-related educational programs (net of program revenues) was $69,886,775. See Notes; Schedule of Educational Program Revenue and Expense, Financial Statements at 73.
The extent of accumulation of income disclosed raises a grave question regarding compliance with the dictates of the Will. An identical concern regarding compliance with the Will was raised by the Hawaii Supreme Court in Collins v. Hodgson, supra. In 1943, the Trustees had accumulated an income account balance so large as to cause the Supreme Court to remark with concern, in dicta , as follows:Although the question of the propriety of the action of the trustees in accumulating so large a surplus of income is not an issue in this appeal, we feel impelled to comment upon it. The fact that more than one million dollars of income has accumulated makes it apparent that the expressed intention of the testatrix has not been complied with.
Collins v. Hodgson, 36 Haw. at 339 (emphasis added).
- The concern expressed in Collins v. Hodgson is equally, if not more, applicable to the circumstance today. Moreover, as discussed below in Part VII, Section E of this Report, the Trustees have apparently failed to satisfy prior Court Orders attempting to address this very issue.
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E. Past And Current Trustees Have Been Under Court Orders To Plan For The Expenditure Of Accumulated Income But Failed To Comply With Those Orders.
In the early years of the Trust Estate, sufficient income was not always generated to meet the annual operating expenses of the schools. However, as years passed, the Trust Estate began to realize surplus annual income not expended "in the maintenance" of the schools. This led to an accumulated income account balance as surplus income from succeeding years continued to remain unexpended.
By 1943, that amount had reached a level which raised questions regarding satisfactory compliance by the Trustees with the dictates of the Will -- causing the Supreme Court to comment on the impropriety of such accumulation of income. See Collins v. Hodgson, 36 Haw. at 339 (accumulation of more than one million dollars of income was not in compliance with the expressed intent of the Will).
Concerns regarding the accumulation of income have repeatedly been raised with the Court over the history of the Trust Estate. For example, in 1985, George S. W. Hong, the Master for the 99th Annual Account (FY 1984) raised a concern over the extent of the accumulation of income which by June 30, 1984, had reached an amount of $43,253,003. Report of the Master on the Petition of the Trustees of the 99th Annual Report, filed herein on August 2, 1985, at 11. Hong noted that the large accumulated income balance reflected the conservative manner in which the Trustees had expended income in the operation of the schools. However, he explained:While your Master is sympathetic to this conservative and prudent approach in expending monies in the operation of the Schools, your Master, nonetheless, is concerned that the plain language of Paragraph Thirteen of the Will does not permit accumulating income per se ; the Will appears to require the expenditure of all annual income earned by the Estate for educationally related functions, and any activity which would not implement this objective would appear to be proscribed by a plain reading of the Will. Your Master is aware that the prudent administration of the Schools would not lend itself to the careless expenditure of funds merely to comply with the Will's stated direction to expend all of the annual income for the maintenance of the Schools. However, your Master is of the opinion that it would appear to be within the ambit of Mrs. Bishop's directive if the Trustees were to provide a plan of future expenditures for fulfillment of Mrs. Bishop's charitable objectives by assuring that accumulated income be expended for designated educational purposes.
Id. at 18-19.
In response to Hong's concern and recommendation, the Court ordered that:The Trustees are directed that they shall continue to prepare, implement and from time to time amend and revise their Ten-Year Plan, incorporating therein long-range planning for the expenditure of accumulated income for educational purposes consistent with said Will.
Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, filed herein on October 8, 1985, at 6.
Since at least 1985, the Trustees have been under specific direction from the Court to plan for the expenditure of accumulated income for educational purposes consistent with the Will. Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, filed herein on October 8, 1985. See also, Findings of Fact, Conclusions of Law and Order Approving the 103rd Annual Report, filed herein on October 16, 1990; Findings of Fact, Conclusions of Law and Order Approving the 107th Annual Report and the 108th Annual Report, filed herein on February 9, 1996.
Court masters subsequent to George Hong have also repeatedly urged appropriate planning by the Trustees for the expenditure of growing financial resources available for the educational mission of the Trust Estate. See Master's Report on the One Hundred Third Annual Report of the Trustees, filed herein on May 30, 1990, at 19 ("Dodd Report "); Master's Report on the One Hundred Fifth Annual Report of the Trustees, filed herein on April 21, 1992, at 36 ("Duffy Report "); Master's Report on the One Hundred Sixth Annual Report of the Trustees, filed herein on September 8, 1993 ("Duffy Report 2 "); Master's Report on the One- Hundred Seventh Annual Report of the Trustees, filed herein on September 15, 1995 ("Matsubara Report "); Master's Report on the One-Hundred Seventh Annual Report of the Trustees, filed herein on September 15, 1995 ("Matsubara Report 2 ").
Moreover, this Court has repeatedly relied upon representations by the Trustees that appropriate strategic planning was in progress. See, e.g., Findings of Fact, Conclusions of Law and Order Approving the 105th Annual Report, filed herein on June 8, 1992 (noting that the Trustees concurred with the Master's recommendations regarding a strategic plan and assured the Court that an effort was in progress to prepare such a plan); Findings of Fact, Conclusions of Law and Order Approving the 106th Annual Report, filed herein on December 27, 1993 (noting that the Trustees had represented to the Court that the recommended strategic planning effort was ongoing).
Despite this lengthy history (which is discussed in greater detail in the 109th Master's Report at 39-43), the Ten- Year Projections provided to your Master, including that provided in connection with the Strategic Plan adopted by the Trustees in August 1997, all reveal a complete disregard of the existence of the substantial accumulated income balance held by the Trust Estate. None of the Ten-Year Projections even hints of the existence of the large accumulated income balance, let alone plan for its expenditure.19
In fact, if the beginning revenue account balance for the Ten-Year Projection for FY 1996 reflected the actual accumulated income balance of $288,282,830, then the projected accumulated income balance by FY 2006, would be close to $1.5 billion--after expenses associated with the GoFoward initiative! 20
This failure to properly plan for the expenditure of the accumulated income is contrary to the prior Orders of the Court which have required past and current Trustees to plan for expenditure of accumulated income for educational purposes consistent with the Will.
19Even without taking into account the undisclosed accumulated income balance, the Ten-Year Projections forecast an accumulated income balance by the year 2006 in excess of one billion dollars after GoFoward expenses.
20After your Master raised concerns regarding this issue, the Trustees presented a Ten-Year Projection for the period from FY 1997 to FY 2007, which was prepared on June 17, 1998, showing a 70% reduction in the previously projected accumulated income balance as of June 30, 2007. That reduction is primarily due to future transfers of surplus income to the corpus account of over $741 million.
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F. The Trustees Should Adopt, With Court Approval, An Appropriate Spending Policy.
Currently, there is no policy to guide the Trustees on expending its resources on Trust Estate purposes. Such a policy is fundamental to the development of a strategic plan for investments and educational expenditures.
The Andersen Report recommends that the Trustees incorporate the "Total Investment Return Spending " concept in its overall strategic planning. This is consistent with the past recommendations of Cambridge Associates, Inc. which, the Andersen Report observes, have been ignored.
Arthur Andersen LLP explains Total Investment Return Spending as follows:Most charitable funds with perpetual spending mandates traditionally treat annual net income as the spendable income pool. Corpus was generally not considered available for distribution to beneficiaries, except for "capital expenditures."
In the mid-20th century, the Ford Foundation promulgated a concept, which is now almost universally accepted: Total Investment Return Spending :- It permits trustees to invest in a greater proportion of growth assets versus income producing assets, and to recognize and spend (on average) the total return from both types of investments.
- Its primary driver behind this concept is preservation of corpus, by protecting its future spending power against the deteriorating effect of inflation.
- Only equity-type investments will accomplish this growth/protection goal, over long periods of time.Total Return Spending Policy is typically established as a long-range plan, expressed in annual terms, as a percentage of the value of earning assets, e.g., 5%.
Because under Total Investment Return Spending , spending increases correspondingly as the value of the assets grows, adopting such a policy could help ensure that spending remains at an appropriate level based upon the growth of the value of the Trust Estate's assets. It could also provide greater flexibility to the Trustees in making investment choices since they would be less subject to criticism for too heavily weighting the Trust Estate's investments toward long-term capital appreciation at the expense of current income.
This is a concept employed by many large non-profit entities to ensure that appropriate levels of expenditures are spent in furtherance of their programs. For example, Yale University employs Total Investment Return Spending and established a 5.0% target spending rate from its endowment in FY 1996. Harvard College's spending policy distributes an annual average of between 4.5% and 5% of its endowment's market value. See Exhibit E at 25 and Exhibit D at 15.
In undertaking the strategic planning recommended in Part IX, Section A of this Report, the Trustees should give serious consideration to adopting a spending policy which appropriately incorporates the Total Investment Return Spending concept.
The Legislature has also enacted legislation in 1995 which facilitates adoption of the Total Investment Return Spending concept through the adoption of the Uniform Management of Institutional Funds Act ("UMIFA"), HRS Chapter 517D. However, it should be noted that the UMIFA legislation enacted as HRS Chapter 517D is a materially altered version of the uniform law. For some reason, the Legislature modified the uniform law to incorporate provisions which, in the cases of trusts, arguably allows a trustee to disregard restrictions in the trust instrument and also arguably allows reclassification of accumulated income to corpus. Such provisions are not part of the uniform law promulgated by the National Conference of Commissioners on Uniform State Laws, yet for some reason the Legislature failed to note that it was actually enacting a "Revised Uniform Management of Institutional Funds Act ."
In any event, during the periods reviewed, the Trustees have not attempted to avail themselves of the provisions of that statute which seemingly permits a disregard of the trust instrument and the reclassification of income to corpus.
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G. A Replacement Cost Reserve Has Been Established Without Court Approval And May Violate The Will.
On November 29, 1990, without seeking instructions from the Court, the then incumbent Trustees established a reserve for major maintenance, renewals and replacements of educational buildings and facilities "based on an annual provision at a rate of 2.5% of estimated replacement costs" ("Replacement Cost Reserve "). Since that time, the Trustees have annually reserved within the revenue account amounts earmarked for the Replacement Cost Reserve . The effect of this has been to restrict the amount of unrestricted income available for "maintenance of the schools."
The purpose of the Replacement Cost Reserve is not limited to maintenance and repairs of the schools, an expense specifically permitted to be charged to income. Instead, the reserve also allocates amounts for the "replacement cost" of facilities. New facilities are capital expenses which should be charged to corpus. Therefore, charging the revenue account for the "replacement cost" of existing facilities is inappropriate absent specific instructions from the Court allowing the practice.22
21The Trust Estateís most recent Ten-Year Projection (FY 1997 to FY 2007) anticipates future transfers will be authorized by the Trustees from the revenue account to the corpus account totaling $741 million beginning in FY 2002.
22HRS §557-13(a)(2) of the Revised Uniform Principal and Income Act provides that a charge against income is allowed for:A reasonable allowance for depreciation on property subject to depreciation under generally accepted accounting principles, but no allowance shall be made . . . for depreciation of any property held by the trustee on May 29, 1973, for which the trustee is not then making an allowance for depreciation.
On the other hand, HRS §557-13(c)(2) prescribes that the following charge shall be made against principal:
Extraordinary repairs or expenses incurred in making a capital improvement to principal including special assessments, but, a trustee may establish an allowance for depreciation out of income to the extent permitted by subsection (a)(2) and by section 557-8.
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VIII. EVALUATION OF THE INVESTMENT AND MANAGEMENT OF ASSETS UNDER THE PRUDENT INVESTOR RULE
A. The Will Requires Annual Judicial And Public Review Of Investments.
The Will of Princess Pauahi directs the Trustees to annually file with the Court "an inventory of the property in their hands and how invested." Moreover, she directed that the inventory of investments be published in a newspaper for public review. The language of the Will reveals Princess Pauahi's belief that maintaining the integrity of her Trust Estate's investments and operations required annual judicial scrutiny and public review.
B. The Trustees Are Subject To The Prudent Investor Rule.
The basic legal standard by which the Trustees' management and investment of the assets of the Trust Estate is measured is the "prudent investor standard." See HRS 560:7-302 ("the trustee shall observe the standards in dealing with the trust assets that would be observed by a prudent person dealing with the property of another"); HRS 554A-1 (definition of "prudent person"). Cf. Brown v. Brown, 22 Haw. 715 (1915) (the trustee must act with honesty, prudence, and faithfulness, and exercise such sound discretion as prudent businessmen exercise in the investment of their own moneys, having regard not only to the income, but to the security of the principal and to the permanency of the investment); Bishop v. Kemp, 35 Haw. 1 (1939) (every investment of trust funds must be made with honesty, prudence, and fidelity).
Accordingly, the Trustees have a general duty to hold, manage, and invest trust property so that the trust estate can produce a reasonable return appropriate to the particular trust purposes, requirements, and circumstances. See Ahuna v. Dept. of Hawaiian Home Lands, 64 Haw. 327, 640 P.2d 1161 (1982) (trustee is obligated to use reasonable skill and care to make trust property productive); HRS 554A-3(a) (a trustee has the power to perform every act which a prudent person would perform for the purposes of the trust).
On April 14, 1997, Hawaii enacted the Hawaii Uniform Prudent Investor Act , HRS Chapter 554C, which codified the "Prudent Investor Rule" as the applicable standard by which the Trustees are bound to invest and manage the assets of the Trust Estate. HRS 554C-1(a). The statutory standard is now prescribed at HRS 554C-2:HRS 554C-2. Standard of care; portfolio strategy; risk and return objectives.
(a) A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.
(b) A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.
(c) Among circumstances that a trustee shall consider in investing and managing trust assets are such of the following as are relevant to the trust or its beneficiaries:(1) General economic conditions;
(2) The possible effect of inflation or deflation;
(3) The expected tax consequences of investment decisions or strategies;
(4) The role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property;
(5) The expected total return from income and the appreciation of capital;
(6) Other resources of the beneficiaries;
(7) Needs for liquidity, regularity of income, and preservation or appreciation of capital; and
(8) An asset's special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.(d) A trustee shall make a reasonable effort to verify facts relevant to the investment and management of trust assets.
(e) A trustee may invest in any kind of property or type of investment consistent with the standards of this chapter.
(f) A trustee who has special skills or expertise, or is named trustee in reliance upon the trustee's representation that the trustee has special skills or expertise, has a duty to use those special skills or expertise.
The investment and management decisions of the Trustees must therefore be viewed in light of this fundamental legal duty. Cf. Restatement (Third) of Trusts 227 (1992) (setting forth the Prudent Investor Rule).
The Prudent Investor Rule reflects the "modern portfolio theory" of investment and abrogates categoric restrictions on types of investments. It is intended to provide a greater degree of flexibility to a trustee in selecting appropriate investments. Nonetheless, it still specifies factors which should be taken into account by a trustee in making investment and management decisions.
In evaluating those decisions, the Prudent Investor Rule prescribes that individual assets should not be evaluated in isolation. This is not to suggest that a trustee's decision to invest in a particular investment is not subject to scrutiny. Instead, the Rule clearly specifies that such a decision should be evaluated "in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust." HRS 554C-2(b). Cf. In re Cooper, 81 Wash. App. 79, 913 P.2d 393 (1996) (Court may evaluate performance of trustee by looking at specific assets or groups of assets rather than by considering performance of the trust as a whole). The Rule therefore identifies a non-exclusive list of factors which should have been considered by the trustee in making a decision, to the extent they are relevant. HRS 554C-2(c).
A failure to comply with the Prudent Investor Rule is not to be lightly regarded. As the Hawaii Supreme Court explained in Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964), the "mere violation of the prudent investment statute governing trust investments" may constitute "a breach of trust upon which liability by way of surcharge could be predicated." Id. at 576. Furthermore, good faith or a mistake in judgment will not provide any shelter to a trustee found to have violated the Prudent Investor Rule. Id.
C. Appropriate Information Must Be Furnished To Allow Evaluation Of Compliance With The Prudent Investor Rule.
Evaluating the Trustees' compliance with the terms of the Will and the Prudent Investor Rule requires that appropriate information be furnished in connection with the annual account review. In this regard, the Andersen Report identifies a number of areas where management information should be generated or improved and better documented.
In a nutshell, the Andersen Report recommends:
1. Appropriate monitoring of investment performance.
2. Identifying appropriate benchmarks for evaluation of investment performance.
3. Development of an appropriate investment policy.
4. Improving due diligence procedures.
5. Strengthening the documentation of investment and management decisions.
6. Identification of investment and management related expenses.
These recommendations proposed by Arthur Andersen LLP constitute best management practices aimed at strengthening the management of the Trust Estate. As discussed in more detail herein, implementation of these recommendations will enhance the ability of both the Trustees and the Court to evaluate whether the Trustees' investment and management decisions are in compliance with the Prudent Investor Rule.
D. Investment Performance Should Be Appropriately Monitored, Benchmarked, And Disclosed.
While a review of the financial statements provides an overview of the financial condition of the Trust Estate, the information it provides as part of the annual account review is inadequate to meaningfully evaluate the performance of the Trustees in managing and investing the Trust Estate's assets.
Unlike earlier periods in its history, the Trust Estate now regularly enjoys substantial income sufficient to meet the cost of its educational endeavors. However, the mere fact that gross revenues of the Trust Estate may total in the hundreds of millions of dollars is not a sufficient basis upon which to evaluate performance. In this regard, it is essential that the investment performance of the Trust Estate's portfolio be properly determined and measured.
The Hawaii Uniform Prudent Investor Act recognizes the importance of monitoring investments.23 Thus, a key consideration in evaluating compliance by the Trustees with the Prudent Investor Rule in their investment and management of assets of the Trust Estate is the measurement of investment return. HRS 554C-2(c)(5).
The Andersen Report notes that the Trust Estate does not currently have a satisfactory system of monitoring investment performance. There is also no procedure for evaluating investment performance against appropriate benchmarks. As a consequence, without reasonably frequent measurement and appropriate benchmarks, the Trustees are disabled from making informed investment management decisions.
The Andersen Report therefore makes a number of specific recommendations aimed at strengthening the monitoring and evaluation of investment performance at the Trust Estate. The Andersen Report also recommends that the Trust Estate's financial statements incorporate a supplemental investment performance schedule. See Exhibit H.
Implementation of the recommendations in the Andersen Report by the Trustees will be of utility in the annual account review since it will provide the Court with the necessary performance measures and benchmarks to better evaluate compliance with the Prudent Investor Rule.
23The commentary to the Uniform Prudent Investor Act explains:ìManagingî embraces monitoring, that is, the trusteeís continuing responsibility for oversight of the suitability of investments already made as well as the trusteeís decisions respecting new investments.
Comment to Uniform Prudent Investor Act § 2 [HRS § 554C-2].
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1. Internal Rate Of Return ("IRR") vs. Time Weighted Return.
In response to a concern raised in the 109th Master's Report , the Trustees claimed that between 1980 and 1994, the Trust Estate enjoyed an average annual total return for all asset classes on a compound basis of 17.3% which they contended compared favorably against various investment benchmarks and returns reported by other institutions. Closer scrutiny, however, reveals that the formula by which that rate of return was calculated was not comparable to the formula used for the benchmarks.
In calculating a 17.3% total return, the Trustees employed an Internal Rate of Return ("IRR") measurement. Arthur Andersen LLP indicates that IRR is normally applied to a single investment rather than a mixed portfolio of investments, except when a group of investments have similar characteristics. IRR is also not the basis for most investment indexes and other endowment fund performance analyses. Instead, the Andersen Report states that the Time Weighted Return ("TWR") is the generally accepted standard in the investment industry for measuring total return and the basis upon which most published investment benchmarks are calculated.
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2. The Trustees' Investment Return Analysis.
Under the Stipulated Order the Trustees agreed to provide your Master with revised analyses of income yield24 and total return for the five fiscal years beginning with FY 1992 through FY 1996. The supplemental information was provided and reviewed by your Master and Arthur Andersen LLP. See Exhibit G. The analyses provided by the Trustees, utilizing TWR rather than IRR, revealed the following income yield and total return25 on the overall portfolio of the Trust Estate:Income Yield Total Return FY 1992: 1.9% 10.2% FY 1993: 2.0% 4.4% FY 1994: 2.1% -2.7% FY 1995: 2.2% 0.3% FY 1996: 2.0% -0.6%
Based upon the rate of return analysis provided by the Trustees, the three-year and five-year average income yield and average total return26 are as follows:Income Yield Total Return 3-Year Period FY 1994-1996: 2.1% -1.0% 5-Year Period FY 1992-1996: 2.0% 2.4%
The overall income yield and total return for the Trust Estate's portfolio provides useful information but the numbers should be put in perspective. The bulk of the Trust Estate's assets is Hawaii real estate which comprised the original trust corpus. Because the Will restrains the Trustees from freely selling those lands, the ability of the Trustees to fully maximize the return on the overall portfolio is limited.
This is why the Andersen Report recommends that the investments of the Trust Estate be categorized when examining investment performance. Grouping the investments will enable the investment performance of the portfolio to be evaluated according to appropriate investment categories. Income yield and total return related to Hawaii real estate could thereby be isolated from other investments. Adopting such a format will ensure that investment performance information is presented in a meaningful and useful manner. The Andersen Report incorporates a return analysis along the lines recommended by Arthur Andersen LLP. See Exhibit H.
24Over the years, various court masters have attempted to report the Trust Estate's income yield. Those reports have been based upon analyses by the masters themselves utilizing the best available information. Income yield has been reported to range over the years from 1% to 2%. However, the methodology by which such income yield calculations were performed by past masters is unknown and cannot be assumed to have been consistent.
25The analysis uses book value rather than market value for the Trust Estate's interest in Pauahi Holdings Corporation and the underlying investment in Goldman Sachs & Co. is carried on Pauahi Holdings Corporationís books at cost rather than fair market value.
26While three-year, five-year, and ten-year annualized performance analyses would be helpful in putting investment return in perspective, a ten-year annualized rate of return analysis was not provided.
E. Substantial Losses And Loss Reserves Were Established For Various Troubled Investments .
In addition to performance measures such as income yield and total return, investment loss experience is an important indicator of potential problems faced by the investment portfolio. For this reason, the 109th Master's Report disclosed that a significant number of the investments comprising the Trust Estate's overall investment portfolio recognized substantial losses and loss reserves in FY 1994.
The Trustees' Response disputed the figures contained in the 109th Master's Report and claimed that it distorted the true financial results. Instead, they claimed that the Trust Estate's "realized capital losses in FY 1993-94 were about $23 million, not $264 million." They also contended that the Trust Estate's corpus increased in FY 1994 "by more than $222 million, of which almost $39 million represents realized capital gains from sources other than Hawai'i land sales."
In the Stipulated Order , the Trustees agreed to provide a supplemental report concerning the performance of the Trust Estate's portfolio, including any realized capital losses or valuation losses and any loss reserves established during the accounting periods.
The 109th Master's Report indicated that the $264,090,257 reported represented "combined losses and loss reserves" recognized in FY 1994. These losses and loss reserves were highlighted not to suggest that the Trust Estate suffered a net loss during FY 1994. Clearly your Master reported otherwise in the 109th Master's Report . However, your Master viewed this record of losses and loss reserves recognized in a single fiscal year to be significant and suggested a need to examine the investment program of the Trust Estate to determine whether appropriate safeguards to avoid such adverse consequences were in place.
Arthur Andersen LLP has reviewed the extent of the losses and loss reserves recognized during FY 1994 and determined that the actual total was $135,518,139. The principal reasons for the discrepancy in the total amount of losses and loss reserves previously reported are:
For the three fiscal years under review, Arthur Andersen LLP has identified loss and loss reserves totaling ($135,518,139) in FY 1994; ($51,645,991) in FY 1995; and ($55,205,242) in FY 1996. Those losses and loss reserves were offset by realized and unrealized gains as reflecting in the following chart:
Description FY 1994 FY 1995 FY 1996 Loss reserves and investment write- offs not previously reserved for: ($113,554,941) ($15,756,237) ($16,446,678) Realized and unrealized investment gains: $63,538,941 $14,802,237 $37,715,678 Net gain (loss) on long-term investments: ($50,016,000) ($954,000) ($21,269,000) Equity losses of investments in partnerships: ($18,047,982) ($25,865,184) ($16,194,097) Operating losses of subsidiaries: ($3,915,216) ($10,024,570) ($22,564,467) SUBTOTAL: ($71,979,198) ($36,843,754) ($17,489,564) Net gains on land sales: $199,563,000 $83,125,000 $51,684,000 Other net operating activities: $65,231,198 $48,399,754 $71,438,564 Increase in Net Assets: $192,815,000 $94,681,000 $105,633,000Despite the discrepancy in the numbers reported in the 109th Master's Report , the significance of these investment losses and loss reserves is not to be diminished. While they may not all be attributed to FY 1994, they nevertheless aggregate to a significant amounts of losses and loss reserves established during all three periods.27
The investment portfolio (excluding Hawaii real estate) had an estimated value of approximately $850 million at the time the losses and loss reserves were booked. Proportionately, the losses and loss reserves are sufficient to warrant concern. Moreover, the losses and loss reserves are dispersed among several different private equity investments -- most of which are classified by the Trust Estate as "special situation" investments and North American real estate. This suggests that a careful review of the investment practices of the Trustees in selecting the Trust Estate's investments is appropriate in light of such losses and loss reserves.
Indeed, the Andersen Report recommends a number of improvements to the Trust Estate's investment policies and practices as discussed in more detail herein.
27 Prior Master Benjamin Matsubara reported "$107 million of write-offs and reserves for troubled investments" in FY 1992 and "$44 million of write-offs and reserves for troubled investments" in FY 1993. Matsubara Report at 23; Matsubara Report 2 at 22.
F. The Prudent Investor Rule Requires Strategic Planning To Guide Investment Decisions.
The Prudent Investor Rule does not restrict the types of investments in which a trustee may invest trust assets so long as they are consistent with the standards prescribed by the Hawaii Uniform Prudent Investor Act . HRS 554C-2(e). Fundamental among those standards governing investment and management decisions is that articulated at HRS 554C-2(b):A trustee's investment and management decisions respecting individual assets must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust. [emphasis added]
This standard requires that the Trustees have a carefully developed "overall investment strategy" when making investment and management decisions.28
The Andersen Report is repeatedly critical in its observations and recommendations in this regard. In virtually all areas of investment and management decision-making by the Trustees, the Andersen Report notes a lack of appropriate investment planning. Even more problematic, the Andersen Report observes that even to the extent that there may be a semblance of an investment plan, there is a weak commitment to abide by the plan.
Among the noteworthy observations made in the Andersen Report concerning investment planning for the "non-core assets"28 of the Trust Estate are the following:(a) Although previous court masters have reported that the Trustees had engaged the services of a nationally known educational endowment investment consulting firm, Cambridge Associates, Inc., the Andersen Report indicates that the recommendations of Cambridge Associates, Inc. have been selectively applied by the Trustees. Notably, the Trustees failed to pursue investment categories recommended by Cambridge which would have provided more diversification and liquidity in the portfolio.
(b) In February 1995, the staff of the Asset Management Group of the Trust Estate presented the Trustees with 11 individual strategic planning reports which provided key recommendations aimed at establishing overall strategic planning objectives for the Trust Estate. Although these recommendations did not constitute a strategic plan, they laid out the framework for development of an overall investment strategy appropriate for the Trust Estate. However, the Andersen Report notes that those recommendations have been left unimplemented.
(c) The Trust Estate has engaged in investment practices which are opportunistic and highly unusual for a perpetual endowment. Many of the investments have required extensive allocations of human resources to unique individual investments which, among other things, have significant exposures to permanent principal impairment and liquidity risks. Such characteristics make it almost impossible for staff, no matter how competent, to develop realistic and moderately dependable expectations for investment return. Hence, there is a severe limitation on any attempt to arrange an orderly diversification program, in addition to causing undependable cash flow forecasts.
(d) The Andersen Report notes that there is no clear asset allocation policy which incorporates appropriate risk and return objectives. In particular, it notes that since 1983, there has been a tremendous infusion of cash into the Trust Estate coffers from the sale of leasehold fee interests. However, contrary to the recommendations of Cambridge Associates, Inc., the bulk of that money has been invested in illiquid private equity investments. While the portfolio mix between real estate and non-real estate assets has improved since 1983, most of the new investments since that date are of an illiquid nature.In summary, the Andersen Report recommends that the Trustees undertake the development of an appropriate investment plan. It also urges the Trustees to adopt almost all of the 1995 staff proposals for development of a comprehensive investment strategy.
Your Master makes recommendations which address this matter in Part IX, Section A of this Report.
28 ìInvestment and management decisionsî are not limited to the initial investment decision but also includes all subsequent decisions relating thereto. Thus, a decision to invest additional capital or a decision involving a work-out program for a bad investment is subject to the same standard.
29 The term ìnon-core assetsî refers to the financial and non-Hawaii real estate investments entered into by the Trust Estate, largely as a result of the cash infusion from the sale of residential leasehold fee interests since 1983. ìCore assetsî on the other hand refers to the original corpus lands in Hawaii which initially established the Trust Estate and of which the Trustees are restricted by the Will from selling.
G. Prudent Investment Requires Diversification Of The Investment Portfolio.
Trustees are generally required to diversify the investments which they manage. See Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964) (it is the specific investment duty of a trustee to diversify trust investments unless absolved from so doing by express direction in the trust instrument).
HRS 554C-3 of the Hawaii Uniform Prudent Investor Act sets forth the applicable standard regarding diversification:A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances or directives of the trust, the purposes of the trust are better served without diversifying.
Cf. Restatement (Third) of Trusts 227(b) (1992) (substantially identical standard).
The Hawaii Supreme Court in Steiner explained the reason for this requirement:This duty is imposed in the expectation that it will minimize the possibility of large losses of capital through the failure of only one of the investments in the entire portfolio. Prudence requires a careful and cautious balance between the quantity and quality of the securities being held in trust so as to spread the risks of investments, bearing in mind "both probable income and probable safety of capital."
47 Haw. at 562. See also Dowsett v. Hawaiian Trust Company, 47 Haw. 577, 393 P.2d 89 (1945) (the risks of concentration and the benefits of diversification are accepted rules of prudent trust management under the "prudent investor rule").
Failure to comply with this duty to diversify may subject a trustee to surcharge. In Steiner, the Hawaii Supreme Court affirmed a judgment of the trial court which surcharged a corporate trustee for having failed to satisfy its duty to diversify the trust's investments. As a consequence, the trust suffered losses for which the corporate trustee was held liable.
The opinion in Steiner explained that there is no need for a finding of an "abuse of discretion" by a trustee for liability to attach for a failure to diversify. The Supreme Court explained:Any deviation from the terms of the trust instrument or the statute regulating investments, such as the prudent investment statute, would constitute a breach of trust even though the trustee was acting in good faith and his deviation was merely a mistake in judgment. As stated in 2 Scott on Trusts at Section 209 (2d ed. 1956):
"A very common type of breach of trust is that which occurs where the trustee fails to sell or improperly delays in selling trust property which it is his duty to sell. The duty to sell may be imposed by express directions in the trust instrument. Even though the trust instrument is silent on the matter, the trustee may be under a duty to sell because the property is not a proper trust investment. The trustee is under a duty within a reasonable time after the creation of the trust to dispose of any part of the trust estate included in it at the time of the creation of the trust which would not be a proper investment for the trustee to make, unless it is otherwise provided by the terms of the trust or by statute."
Thus it was not necessary for the chancellor to find here that the defendant, as trustee, abused its discretion. The case does not fall in that area. The mere violation of the prudent investment statute governing trust investments constituted a breach of trust upon which liability by way of surcharge could be predicated, in the absence of investment directions expressed in the trust instrument which relieved the trustee of the duty of diversification.
Steiner v. Hawaiian Trust Co., supra at 576-577.
In the case of the Trust Estate, individual Trustees have contended that they are limited in their ability to diversify the investments of the Trust Estate because of the terms of the Will. They point to the fact that the bulk of the inception assets of the Trust Estate was comprised of lands which were owned by Princess Pauahi. In Codicil No. 1 to her Will Princess Pauahi gave her Trustees the power to sell and dispose of lands and to make "such investments as they consider best." However, she further directed that those lands were not to be sold except as necessary for the establishment or maintenance of the schools or "the best interest of [her] estate."I give unto the trustees named in my will the most ample power to sell and dispose of any lands or other portion of my estate, and to exchange lands and otherwise dispose of the same; and to purchase land, and to take leases of land whenever they think it expedient, and generally to make such investments as they consider best . . . and I further direct that my said trustees shall not sell any real estate, cattle ranches, or other property, but to continue and manage the same, unless in their opinion a sale may be necessary for the establishment or maintenance of said schools, or for the best interest of my estate. [emphasis added].
See Exhibit "A".
This restriction on the sale of lands from the corpus is not absolute. The Trustees are granted discretion to sell if they deem it in the best interest of the Trust Estate. Hyde v. Smith, 11 Haw. 535 (1898). As a result, the Trustees are bound by the Prudent Investor Rule to consider diversification strategies which are in the "best interest of the Trust Estate." Cf. Steiner v. Hawaiian Trust Company, supra (corporate trustee held liable for breach of the duty to diversify under the prudent investor rule notwithstanding restrictions in the trust document regarding sale of the inception assets).
The Andersen Report makes no recommendation that the Trustees sell any Hawaii real estate comprising the core assets of the Trust Estate to achieve further diversification. However, it does recommend that to the extent funds become available, the Trustees should endeavor to better diversify the non-core assets of the Trust Estate.
The Trust Estate was able to realize considerable revenue from the forced lease-fee sale of residential lands from 1983 to the present. Utilizing that revenue, the Trust Estate has been able to make limited progress in diversifying away from real estate as its principal investment asset. Despite such progress, the Andersen Report recommends that the asset allocation of the investment portfolio of the Trust Estate be improved through further diversification, increased liquidity, and moving away from investments which are high risk and require intensive monitoring.
The Andersen Report observes that while the Trustees have invested substantial amounts in investments other than Hawaii real estate, the portion not invested in Hawaii real estate remains inadequately diversified. Despite the fact that the Trust Estate already has a disproportionately large real estate component, the Trustees have continued to invest substantial amounts in real estate investments both inside and outside of Hawaii. Such investments further detract from the desired goals of diversification and liquidity.
Moreover, the Andersen Report reports that private equity investments comprise a major component of the overall non-core investment portfolio of the Trust Estate. While such investments have helped improve