September 12, 1998

ROBERT BRUCE GRAHAM, JR. 1305-0
ASHFORD & WRISTON
Ali_i Place, Suite 1400
1099 Alakea Street
Honolulu, Hawaii 96813
Telephone No. 539-0400

Attorney for The Trustees under the Will
and of the Estate of Bernice Pauahi Bishop,
Deceased

IN THE CIRCUIT COURT OF THE FIRST CIRCUIT

STATE OF HAWAII

______________________________
RBG/0208183.

TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH,
AND THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS
OF THE TRUSTEES; EXHIBITS "A" TO "D";
CERTIFICATE OF SERVICE

TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND
THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS
OF THE TRUSTEES

TABLE OF CONTENTS

TRUSTEES' RESPONSE TO MASTER'S CONSOLIDATED REPORT
ON THE ONE HUNDRED NINTH, ONE HUNDRED TENTH, AND
THE ONE HUNDRED ELEVENTH ANNUAL ACCOUNTS OF THE TRUSTEES

This is the Response of the Trustees Under the Will and of the Estate of Bernice Pauahi Bishop, Deceased, to the Master's Consolidated Report On the One Hundred Ninth, One Hundred Tenth, And The One Hundred Eleventh Annual Accounts Of The Trustees filed herein on August 7, 1998.¹

I. INTRODUCTION

A. Procedural Background

The Master's Consolidated Report concerns the Trustees' Accounts for three fiscal years, from July 1, 1993 to June 30, 1996. The Consolidated Report follows upon the Master's earlier report as to the Trustees' 109th Annual Account (FY 1994), filed herein on November 17, 1997 (hereinafter, the "First Report"). In their Response to the First Report, filed herein on December 3, 1997 (hereinafter, the "First Response"), the Trustees accepted the Master's recommendations while rejecting or disputing much of his narrative. The Trustees observed that the narrative was based upon a flawed analysis of their financial records and urged that the Master revisit the issues with the assistance of an international accounting firm. They invited a full financial and management audit of the Estate, to be conducted by such a firm under the auspices of the Master. Pursuant to a Stipulation Concerning Master's Recommendations (109th Account) between the Master and the Trustees, in which the Attorney General joined as to most but not all issues, the substance of the Master's recommendations was adopted and it was agreed that the Master would commission the financial and management audit the Trustees had proposed. The Stipulation was approved by this Court and filed herein on December 19, 1997. (The Stipulation is hereinafter referred to as the "December 19 Stipulation".) Subsequently, the Master selected Arthur Andersen, LLP to undertake the audit.

B. Financial Audit

The Trustees were not obliged to undergo a full financial and management audit and the fact that they invited one is compelling evidence of their good faith and their confidence in their record. Significantly, the financial audit has found no irregularity or impropriety in the audited financial statements previously submitted to this Court. As is discussed below, Arthur Andersen's revised format of financial statements has been prepared in cooperation with the Estate's staff and is consistent with the Estate's own reports.

C. Management Audit

The management audit is a statement of opinion and offers advice to the Trustees concerning management issues. Such audits are expected to be critical and to recommend change. They are merely opinions, however, and carry no guarantees. While they offer insights and professional advice, they do not have the benefit of the long term experience of the institutions they examine. Boards to whom such reports are presented must review and consider the consultant's observations and recommendations in light of the board's own knowledge of the organization. Blind implementation of a management consultant's report would be no better than blind disregard of it. Thus, Arthur Andersen's management audit is a management tool for use by the Trustees in the prudent exercise of their discretion.
In some areas, Arthur Andersen's comments represent popular and current investment management theory and practice. In other areas, the comments represent the views of consultants who do not fully comprehend the Trustees' policy of retaining the Estate's core assets - the lands endowed to it by Bernice Pauahi Bishop - despite the current low productivity of lands now designated for agricultural and conservation uses. Arthur Andersen's comments concerning the Estate's landholdings in Kakaako suggest a lack of understanding of the current economic climate in Hawaii and the realities of the Honolulu real estate marketplace.

D. Context

The three years currently under review were a period of resolution. The incumbent Board of Trustees was constituted in December, 1994, when Trustee Jervis succeeded Trustee Thompson, and has turned around a number of previously troubled investments, making them productive assets of an enhanced and increasingly diversified portfolio. Many of the Board's efforts came to fruition outside the accounting period and are not reported by the Master. This results from a procedure which looks at the Accounts on a fiscal year basis and not necessarily in context. The system is such that the product of the Trustees' efforts will not be reported to the Court for another several months.
The Trustees' Accounts cover a three-year window in the 113 year history of the Estate. The Master is supposed to comment upon events occurring during the period under review. In fact, the Consolidated Report is not wholly confined to the period under review. It reaches into other years, before and after, to emphasize its theme. Unfortunately, the actual accounting period includes the establishment of loss reserves (and the recognition of some actual losses) resulting from troubled pre-existing investments. It generally does not include the "rest of the story": the time when troubled investments became winners, privately held investments went public, and the Estate and its subsidiaries began reaping hundreds of millions, even billions, of dollars in gains.

E. Theme of the Consolidated Report

The theme of the Consolidated Report is that the Estate needs more and better documentation, planning and internal procedures, and systems reorganization. The Master recognizes that the Estate has been transformed into "a complex business organization with wide-ranging and sophisticated domestic and international financial investments" and that the challenges facing the Trustees are "daunting." C.R. at 11.² He observes that internal procedures have not always kept pace with the Estate's rapid evolution and his Consolidated Report chronicles certain deficiencies in process and procedure which he and Arthur Andersen perceive. Various specific transactions are used to demonstrate the Master's views. Significantly, with the sole exception of expenses incident to the Estate's efforts concerning Intermediate Sanctions legislation, the Master recommends no surcharge or other sanction of the Trustees; his recommendations are forward looking and he makes no findings of malfeasance or breach of duty.

F. The Master's Recommendations

The Master makes nineteen specific recommendations within an extensive narrative. The Trustees find most of the Master's recommendations helpful and have undertaken to work in good faith with the Master to achieve stipulated agreements concerning them. The product of that effort will be separately reported to this Court at or prior to hearing of the Trustees' 109th, 110th and 111th Accounts.

G. This Response

This Response will focus primarily on issues raised by the narrative portions of the Master's Consolidated Report. The Trustees are distressed by its negative tone and implications and believe that further discussion is necessary in order that the Court may have a more complete picture of the matters presented. Inasmuch as the Master uses specifics primarily as support for his underlying theme of the need for systemic changes, point by point discussion or rebuttal is neither necessary nor appropriate. Instead, this Response is intended to address those matters which the Master suggests need further explanation and to respond generally to the balance of the Master's narrative. Should the Court require further information concerning any matters raised by the Master, the Trustees will be pleased to respond.

II.THE OPENING SECTIONS OF THE CONSOLIDATED REPORT

A. Disclosure
The Master urges that Bernice Pauahi Bishop mandated disclosure and accountability and quotes a provision of her Will requiring an annual report to the Court of receipts and expenditures and publication of an inventory of properties. C.R. at 1. The Trustees are familiar with the requirements of the Will. They note that their annual reports are also subject to provisions of Hawaii law, the Rules of the Probate Court, and the much-amended and restated Minimum Guidelines specifically applicable to the Estate. These authorities are not always in harmony, are sometimes amended after filings have been made but before hearings are held, and, in the case of the Probate Court Rules, are ill-suited to a trust estate as large and complex as the Kamehameha Schools Bernice Pauahi Bishop Estate.³

B. The First Report and the Trustees' First Response

The Master's Consolidated Report incorporates by reference his First Report. C.R. at 2. Likewise, the Trustees incorporate by reference their First Response thereto. The Trustees submit, however, that much of the Master's First Report was the product of a flawed analysis, largely attributable to a failure of communication between the Estate staff and the Master's accountant. The Master's First Report and the Trustees' forceful First Response to it are not representative of the professional environment in which the Master's further review has been made.

C. The Arthur Andersen Report Should Remain Sealed

The Trustees concur with the Master's view that the Arthur Andersen report is a sensitive internal management document which should remain under court seal and not be made public. C.R. at 4. Nothing in the Will, the statutes or the rules of court requires publication of the financial and management audit. With the Trustees' consent, the Master has published an executive summary by attaching it as Exhibit "B" to his Consolidated Report. All persons who have any legitimate need to review the full report, including this Court, the Master and the Attorney General, have full and unredacted copies of it. Further publication is unnecessary and inappropriate.

D. Trustees' Compliance With Guidelines

The Master commends the Trustees for enabling the financial and management audit conducted by Arthur Andersen and acknowledges that the Trustees provided him with information required by the Minimum Guidelines, as amended, and by the December 19 Stipulation. C.R. at 6 & 7. These acknowledgements should lay to rest any question concerning the Trustees' willingness to cooperate with the Master and open the Estate's records to his review and inspection.
Another amendment of the Guidelines is contemplated by the December 19 Stipulation. (December 19 Stipulation at 29) The Guidelines have proved unsatisfactory to everyone involved. Almost every master since their promulgation has requested amendments to them. As a result, the Guidelines have failed to provide either the Estate's staff or the masters with any certainty as to what constitutes appropriate initial production and acceptable formatting. As more fully shown in Part of this Response, it is time to redesign the Guidelines rather than merely restate them.

III. NEW ACCOUNTING FORMAT

A. The Master's Recommendations

The Master's first and second recommendations are as follows:

Recommendation No. 1:

New Financial Statement Presentation Should Be Adopted.

Your Master recommends that the Trustees be ordered to adopt the financial statement and supplemental schedules presentation as proposed by Arthur Andersen LLP and recommended in the Andersen Report in all respects, with the same level of detail, and regularly filed with their annual account beginning with the 112th Annual Account.

C.R. at 14.

Recommendation No. 2:

Corpus And Revenue Activity Should Be Specifically Reported.

Your Master further recommends that the Trustees be ordered to annually submit financial statements which conform to the trust accounting format as prescribed in the Andersen Report beginning with the 112th Annual Account.

Your Master recommends that the Trustees provide an explanation to the Court in their response to this Report why the prior order of the Court requiring segregation of the corpus account and the revenue account was not complied with.

C.R. at 31.

These recommendations concern the format of the Estate's annual financial statements and supplemental schedules submitted to this Court. The Master recommends the form of financial statements developed by Arthur Andersen in consultation with the Estate's staff. The Trustees are willing to make reasonable changes in the format of their reports to this Court. In the December 19 Stipulation, they agreed to file special financial statements for comparison purposes. They are willing to prepare and file special purpose financial statements hereafter. The format of those statements must be developed, however.

(The second part of the Master's second recommendation is discussed in Section below.)
The financial statements envisioned by the Master's first and second recommendations cannot be permanently based upon a particular form. Not only does GAAP (Generally Accepted Accounting Principles) change from time to time but much of the information presented in the Arthur Andersen format of the Estate's financial statements is outside or beyond GAAP and subject to a wide latitude of discretion and opinion. Where there are no rules, reasonable judgment must prevail. With this caution, the Trustees accept the spirit of the Master's first and second recommendations concerning the form of the financial statements and the accompanying notes and schedules.

B. GAAP Accounting

GAAP is not a matter of law and GAAP changes from time to time. The Estate's financial statements for the 109th and 110th Annual Accounts followed accounting principles consistent with provisions of the Will of Bernice Pauahi Bishop and applicable state and federal laws. Where the Will is silent on accounting matters, GAAP was followed. In 1996, GAAP changed to require consolidation of wholly and majority owned subsidiaries. The Trustees chose not to adopt this change in the belief that accounting for these investments on a consolidated basis was not appropriate because the business operations of the subsidiaries were unrelated to those of the Estate. This is so noted in the report by the Estate's independent accountants, Coopers & Lybrand.

It is not unlawful for trustees or others to employ a "modified" GAAP approach, using accounting principles that are not in full compliance with GAAP. GAAP accounting is not required by law or rule of court. The official Commentary to Rule 26 of the Probate Rules says that a committee of accountants, attorneys, masters, the Attorney General and all trust companies reached no agreement concerning the form of trust accounts, and concludes "This rule does not mandate any form of detailed accounting, leaving that to the fiduciary's discretion." ⁴

The Master objected, however, to the Trustees' use of modified GAAP and the Trustees agreed to file financial statements in accordance with GAAP for comparison purposes . (December 19 Stipulation at 4) Ultimately, Arthur Andersen prepared financial statements for all three accounting years.

The December 19 Stipulation did not contemplate that Arthur Andersen would re-audit the Estate's three previously audited financial statements. Nonetheless, this was done at the Master's request in order that the three years under review would be presented in a uniform manner. As a result, the Estate's financial statements for FY 1994, 1995 and 1996 have been independently audited twice, once by Coopers & Lybrand (now know as PricewaterhouseCoopers) and once by Arthur Andersen. It is important to note that GAAP accounting and the format recommended by Arthur Andersen have not changed the underlying numbers. The Estate's financial statements reported on by Arthur Andersen (full GAAP) and those reported on by Coopers & Lybrand (Modified GAAP) have been fully reconciled.

The Master expresses his preference for full GAAP financial reports for purposes of the Trustees' annual accounts to the Court. While the Trustees have no objection to filing such special purpose financial statements for use in connection with their annual accounts, they are not convinced that full GAAP financial statements are appropriate for all purposes. Specifically, the Trustees are not convinced that it is helpful for less than wholly-owned Estate investments to be consolidated with the Estate's own financial information. They believe that modified GAAP, in which these investments are not consolidated, is a more accurate reflection of the core financial status of the Estate. They may continue to have general purpose financial statements prepared according to modified GAAP for other users of the Estate's financial statements while filing special purpose financial statements for the use of the masters.

The consolidation issue presented by GAAP versus Modified GAAP accounting concerns the consolidation of the financial statements of less than wholly-owned subsidiaries with the Estate's financial statements. GAAP generally requires consolidation if the "parent" owns more than 50% of an entity. This may be useful information to investors thinking of buying shares in a publicly traded parent and who may not have access to the subsidiaries' financial statements. It is less clear how such consolidation benefits the Master or the Court, who have access to all of the financial statements of the Estate and its subsidiaries.

On page 25 of his Consolidated Report, the Master shows the impact of consolidating the Estate's balance sheet with that of SoCal, a California savings bank company, in which the Estate held a majority interest. SoCal operates in a highly regulated industry and the inclusion of SoCal's assets, which the Estate could not reach nor use, drove the consolidated total of assets up by about $1.8 billion in FY 1995 (from $2.2 to $4.0 billion) and $1.6 billion in FY 1996 (from $2.4 to $4.0 billion). Including SoCal's liabilities, which were not the Estate's direct liabilities, drove the total of liabilities up by about $1.7 billion in FY 1995 (from $0.7 to $2.4 billion) and $1.5 billion in 1996 (from $0.7 to $2.3 billion).⁵ These are tremendous distortions, considering that while the GAAP format consolidates the entities for accounting purposes, the Estate at no time had any direct right to utilize SoCal's actual assets nor any direct obligation for its liabilities. GAAP consolidation is an accounting device that does not necessarily reflect the core operations of the Estate from a financial perspective.

The information upon which Arthur Andersen developed the "full GAAP" financial statements was at all times available to the Master at the Estate's offices. The issue was always one of format, not availability. GAAP will continue to change. Inevitably, the format recently devised by Arthur Andersen will become obsolete. The primary concern of standing orders of this Court should be the availability of the information to the Master. The formatting, which is ephemeral, should be of secondary concern and should be designed to assure that useful and accurate information is readily available to the Court and its masters.

C. Segregation of Revenue and Corpus Accounts

The Master urges adoption of a format of reporting that segregates the revenue account and the corpus account. C.R. at 13 & 16.

The Master's recommendation really concerns the form of the financial statements filed with the Court and the accumulation of income. These are discussed below in Part of this Response. The Trustees do not object to segregating the two accounts in the reports filed with this Court and will do so in the future.

Three important point must be made: (1) The Estate already segregates the revenue and corpus accounts. Segregated revenue and corpus accounts are maintained in regular internal reports. These reports were provided to and acknowledged by Arthur Andersen. They have always been available to the masters. (2) Segregation of the revenue and corpus accounts is not required by GAAP in reporting on general purpose financial statements and there is no statute or rule that requires any particular form of trust accounting. The Guidelines do not require segregation of the two accounts. (3) The Trustees are not in violation of a prior court order. (This issue is discussed in detail in Section of this Response.)

D. Notes To Consolidated Financial Statements

The Master states that the Notes to the consolidated financial statements provide a better understanding of the Estate's financial condition. C.R. at 13. The Notes provided by Arthur Andersen go well beyond the requirements of GAAP, which establishes minimum disclosure requirements. This is another example of a format change which is not required by GAAP, statute, rule or Guideline and reflects merely a personal preference. For example, the SoCal information contained in the Notes is taken directly from a subsidiary's audited financial statements that were at all times available to the Master. Since the Notes will vary from year to year and can be in excess of GAAP minimum requirements, there can be no permanent agreement concerning their content. Notes to an entity's financial statements are matters within the discretion and opinion of management and the professional judgment of the independent auditor.

E. Supplemental Schedules

The supplemental schedules attached to the financial statements are wholly outside any requirements of GAAP. Arthur Andersen conceded that the schedules were not required and was prepared to issue its certification of the financial statements without them. The content of the schedules of Trustee commissions is identical to that previously filed by the Trustees as Exhibit "I" to the petitions for approval of each of the three accounts. Nonetheless, the Trustees acceded to the Master's request that the schedules be published and are willing to have similar schedules prepared in connection with future accounts. It will, however, be necessary to develop benchmarks more appropriate to the Estate's portfolio. The Estate's staff is reviewing this issue. Benchmarking is discussed below in Section .

IV.CONCERNING REPORTED INCOME FROM GOLDMAN SACHS

The Master remarks that income from Goldman Sachs was "misreported" on the Trustees' financial statements. C.R. at 20. The Master also acknowledges that the Estate's own staff and independent auditor (Coopers & Lybrand) discovered the matter and rectified it. C.R. at 20, fn. 7. The Master does not explain, however, that the "misreporting" arose when certain assumptions concerning the Goldman Sachs investment changed. The accounting method originally employed was not improper based upon the accounting assumptions that had been made at that time. When the assumptions changed, the Estate and Coopers & Lybrand did an extensive analysis and a cumulative adjustment was made for the fiscal year ending June 30, 1997, outside the current accounting period. Arthur Andersen had the benefit of the Estate's analysis and of hindsight when it recast the financial statements for FY 1994, 1995 and 1996. There was no purposeful "misreporting" and Coopers & Lybrand had already discovered the issue. Investments evolve, assumptions change and adjustments are made when necessary.⁶

V.CONCERNING ASSET VALUATION

The Master notes that the Trustees' List of Assets shows the Estate having an aggregate value in excess of $5.7 billion as of June 30, 1996. C.R. at 26. The Master correctly notes that the value includes adjusted Hawaii real estate values, previously reported by the Estate pursuant to prior order of this Court at 1965 values and now reported at current adjusted tax assessed values. The Master also correctly notes that the market value of the Estate's landholdings may be different from the adjusted tax assessed values and that the Estate is carrying its investments through Pauahi Holdings at "book value." For example, the Estate's interest in Goldman Sachs is carried at its cost (about $500 million) despite current press reports that it may now be worth $3 billion.

While comparatively modest losses and loss reserves are reported in detail, the Trustees have reported some of the Estate's significant investments at cost even though significant appreciation in value may have occurred. This reflects a conservative accounting posture consistent with GAAP. The Estate's gains will be reported when they are realized in a subsequent accounting year. Unfortunately for the incumbent Trustees, this means that their reports reflect losses and loss reserves arising out of past activities, often of prior boards, without showing gains that likely outstrip the performance of virtually all other portfolios in Honolulu.

Inclusion of estimates of the value of the Estate's many highly successful investments would make the pending accounts look better. Many have advised the Trustees that they should take the opportunity to advertise their successes. They choose not to do so in order that public offerings and other events concerning those investments not be affected by an insider's published estimates of value. The Trustees' circumspection in this regard is prudent but results in an under-reporting of the Estate's successes.

VI.ACCUMULATION OF INCOME

A. Introduction

Part VII of the Master's Consolidated Report concerns the issue of accumulated income and contains six of the Master's nineteen recommendations. The degree of the Master's apparent concern with accumulated income is disproportionate to the magnitude of the actual issue. The accumulated income exists unimpaired and is being held solely for the benefit of the Kamehameha Schools. There has been no misappropriation, misapplication or misuse of funds. The question is primarily one of documentation and will be resolved promptly by the preparation of special purpose financial statements for the use of the Court and its masters.

B. Explanation Concerning Segregation of Corpus and Revenue Accounts

In his second recommendation, the Master recommends that the Trustees "provide an explanation to the Court in their response to this Report why the prior order of the Court requiring segregation of the corpus account and the revenue account was not complied with." C.R. at 31. Accordingly, the Trustees offer the following explanation to the Court. Some of the history is relevant to other matters discussed in this Response and is included here for the sake of context and completeness. As will be seen, no prior order of the Court has been violated.

Richard S. Sasaki, master as to the Trustees' Eighty-first Annual Report (FY 1966) was critical of Trustees Midkiff, Murray, Richards, Lyman and Keppler. The Estate's assets at the time were reported to be about $217 million. About $4 million had been spent for the operations of the Kamehameha Schools. Mr. Sasaki was dissatisfied with the form of the Trustees' accounts, the bookkeeping system employed, the methods for valuation of Estate assets, the quality of investments, the degree and quality of planning, the rate of return, operating expenses and the quality of the Estate's due diligence.

Mr. Sasaki, however, recognized the unique nature of the Estate and his words concerning its income producing operations are insightful:

1. In a review of the operations of the income-producing activities of the Trustees, the nature of the organization must first be considered. Bishop Trust Estate, from the standpoint of its investment activities, is a business organization. Its prime objective is to maximize income out of the investment of its resources. It is a profit-making body, with profit objectives, just as any other business enterprise, whether operated under the corporate form, partnership, or sole proprietorship. The fact that the net earnings are directed for use for eleemosynary purposes should not make it less so. ⁷....
   
   
2. In the review process, the nature of the income-producing assets must also be considered. The trust has been heavily endowed with holdings in real estate by the testatrix with the specific authority to maintain such landholdings, even though this may not conform to the general laws governing the investment of trust corpus where specific direction to the contrary is not given on investment powers....
   
   
3. The management of the trust corpus of Bishop Trust Estate entails a somewhat different process from the ordinary trust even where such a trust holds real estate because Bishop Estate's landholdings require considerable management in producing income. The Trustees cannot enjoy the role of a passive investor as is the case of trustees managing investments in marketable securities....
   
   
4. It must be emphasized, therefore, that we are reviewing a business organization; a business organization with the wrong kind of legal entity -- the trust device, which is inherently unsuitable in operating an efficient business organization. ....

Report to the Attorney General On the Petition of the Trustees
For Approval of the Eighty-first Annual Report at 25-26 (emphasis added).

Among Mr. Sasaki's concerns was the treatment of accumulated income. He objected to the Trustees' treatment of recoveries of off-site development costs as income rather than corpus. He urged that "the Court should insist upon a program of the maintenance of corpus values." Id. at § 36.
He noted that the there had been four years of deficit operations and that the trend was worsening, saying "[t]he result of the deficiency in revenues for so many years has been the curtailment of Kamehameha School's enrollment and programs." Id. at § 39. He criticized the Trustees' low revenues from leasing activities and questioned whether a $1.3 million investment in stocks and bonds was "justified in light of the low returns derived from these investments." Id. at § 42.

He concluded with three questions: whether recoveries of development costs should continue to be credited to income rather than corpus, whether fixed assets could be paid for out of accumulated income and "Whether or not the Trustees should be required to segregate all accounts as between income and corpus and not only in the equity accounts as previously done." Id. at § 43

Upon this, the Attorney General recommended that recoveries of development costs be credited to income and said "The Trustees should be required to segregate accounts as between income and corpus and not only in equity accounts as previously done." Report of the Attorney General With Respect To The 81st Annual Account ..., filed herein on February 10, 1970, at 6.

In their Exceptions to the Attorney General's Report, the Trustees disputed the Attorney General's position concerning segregation of accounts. This Exception was item number 14 in their response.⁸ Exceptions To The Report Of The Attorney General On The 81st Report Of the Trustees, filed herein on June 2, 1970.

On July 21, 1970, a one page pre-hearing stipulation was filed in the First Circuit Court. It was signed on behalf of the Trustees and the Attorney General and was approved by the presiding judge. A true copy of the stipulation is attached hereto as Exhibit "A". It provides is relevant part as follows:

Pursuant to the informal conference had July 15, 1970 on the Exceptions of the Trustees to the report of the Attorney General on the 81st Account,

IT IS HEREBY STIPULATED:

1. That a satisfactory arrangement has been agreed upon between the Trustees and the Attorney General which will meet the requirements of the Attorney General in future accountings of the matters referred to in Exceptions 1, 2, 3, 4, 5, 6, 10, 11, 12 and 14.
   
   
2. That testimony be adduced relative to Exceptions 7, 8, 9 and 13.

The 1970 Stipulation was not a Court order and did not memorialize the terms of the "arrangement" between the Trustees and the Attorney General. While it was approved by Judge Fukushima, its function was merely to record an agreement between the Trustees and the Attorney General concerning which of the Trustees' Exceptions would require further hearing. The Trustees were entitled to a determination by the Court concerning each of their fourteen Exceptions. By the Stipulation, ten of them, including Exception No. 14 concerning the segregation of accounts between income and corpus, were withdrawn from hearing.

There is no Court Order concerning the undisclosed arrangement. The Order Approving the 81st Annual Account, a true copy of which is attached hereto as Exhibit "B", recites that the Attorney General recommended approval of the Account subject to the Stipulation. It orders that the Account be approved and allowed. Thus, the Court record concerning the disposition of Mr. Sasaki's concern about segregated accounting is, at best, murky. The Master's categorical statements concerning the matter are simply inaccurate.

For the next eighteen years, the Estate's financial statements segregated the income and corpus accounts. In 1988, however, the Estate's Controller requested advice from the Estate's General Counsel regarding the transfer of accumulated income to corpus. The Controller's inquiry arose out of concerns about the presentation of the Estate's financial reports to "corporate America."

As the Estate embarked upon its process of diversification and redeployment of the proceeds of forced sales under so-called "fee conversion" programs, it was asked for its financial reports by prospective lenders, credit agencies, investment partners and others, all of whom were accustomed to corporate balance sheets and financial reports. The form employed by the Estate may have been useful to the masters but it was confusing to persons unfamiliar with trust accounting. As Mr. Sasaki had observed in 1970, the "conglomeration" of trust and business accounting reflected the inherent problem of conducting the Estate's business in the forms customarily employed for trusts. Retained earnings, capital, equity, and similar nomenclature were familiar to corporate America. "Accumulated Income" was not.

The Controller advised General Counsel that the aggregation of accumulated income with corpus was permitted by GAAP. He asked whether trust law permitted the transfer.

The Office of General Counsel researched the question, gathering copies of prior court orders, masters' reports, relevant provisions of the Will of Bernice Pauahi Bishop, the opinion of the Court in Collins v. Hodgson, 36 Haw. 334 (1943), and other pertinent information.

General Counsel advised the Controller that accumulated income could be transferred to corpus. General Counsel based this conclusion in part on (i) a 1977 order of this Court authorizing commingled investment and reinvestment of accumulated income and corpus in income-producing property; (ii) the recommendation of the master of the 99th Account that long range expenditure of accumulated income be reflected in the Ten Year Plan; and (iii) the fact that the Will of Bernice Pauahi Bishop contemplates the use of both income and corpus to cover maintenance expenses at the Kamehameha Schools.

General Counsel's view was that since income and corpus may be commingled for investment and used for the same purpose of maintenance, it was not important that a separate income account be reflected on the Estate's financial reports. General Counsel recommended that the income so transferred to corpus be "earmarked" and noted that any uncertainties could be addressed to the Court in a petition for instructions.

It is clear that General Counsel was not aware of the unspecified arrangement between the Trustees and the Attorney General. The research file contains numerous documentary extracts and General Counsel's opinion to the Controller refers to many of them. The 1970 Stipulation and its uninformative reference to an off-record arrangement as to Exception 14 is not among the research materials.

In turn, the Controller reported to the Trustees that staff recommended reclassification of accumulated income to corpus. The staff report states in relevant part as follows:

Kamehameha Schools/Bernice P. Bishop Estate has maintained and reported its Fund Balance in two separate fund categories: Corpus and Accumulated Income.

The Corpus Account originally represented the initial appraised value of all the lands and other property inventoried upon the death of Bernice Pauahi Bishop. Over the years, net adjustments based on the State Tax Assessor's valuations were made periodically to the initial appraised value of the lands. These adjustments were recorded in the Corpus Fund and this action, in effect, destroyed the identity of the original Corpus....

The Accumulated Income Fund records the cumulative net income/expense after the cost of operating The Kamehameha Schools. This Fund represents the cumulative excess of operations that together with Corpus is available for the support and maintenance of the Kamehameha Schools.

In effect, both the Corpus and Accumulated Income Funds are wholly and solely restricted for the support of the Kamehameha Schools.

General Counsel's opinion (to be submitted separately) in support of the recommendation made in this report, indicates that terms of Pauahi's Will and Codicils allows the use of Corpus as well as the annual income for the maintenance and operations of the Kamehameha Schools. Discussions with Coopers & Lybrand, CPAs indicates that the proposed reclassification of Accumulated Income to Corpus does not violate generally accepted accounting principles.

Staff Report, June 30, 1988 (emphasis in the original).

The board of trustees approved the recommendation and the June 30, 1987 balance of accumulated income was reclassified for accounting purposes as Corpus as of July 1, 1987.

Thus, where the Estate's audited financial statements for FY 1987 included separate entries for Corpus ($477,872,269) and Accumulated Income ($65,629,805), the audited financial statements for FY 1988 contained a single new entry, "Kamehameha Schools/Bernice P. Bishop Estate equity" in the amount of $761,699,677. The accompanying restated entry for the prior year (FY 1987) was $543,502,074, which was the total of the previous year's separate entries for Corpus and Accumulated Income. Copies of the pages showing these entries are attached as Exhibits "C" and "D". The 1988 financial statements also contained an entry for the "Excess of income over cost of operating The Schools" in the amount of $11,123,200. This amount became accumulated income on the first day of the ensuing fiscal year.

Significantly, neither the next master nor the Attorney General complained of this change in format. If either were concerned about the segregation of income and corpus accounts, the 1988 financial reports which reported a combined "equity" rather than separate corpus and accumulated income figures, should have triggered some response. In all likelihood, the Attorney General in 1988 was as unaware of the 1970 "arrangement" as was the staff of the Estate, and the master did not find the presentation in the audited financials improper.

This is not to say that a separate record of accumulated income cannot be maintained nor to dispute that there may have been, in 1970, some agreed arrangement concerning the matter. But the incumbent Master's characterization of the Trustees's 1988 action as a 'unilateral alteration' suggests a degree of bad faith or wrongful intention that was simply not present. Eighteen years later, personnel had changed and memories had faded (including, apparently, the Attorney General's). A change in format was recommended to the Trustees and approved by them. The Estate's financial report now was more consistent with the format familiar to its lenders and business partners.

Thereafter, accumulated income again was transferred to corpus in 1992 and in subsequent years. In 1995, expenditures of more than $30 million in excess of revenues were funded out of the consolidated account, consistent with the Controller's 1988 recognition that "[i]n effect, both the Corpus and Accumulated Income Funds are wholly and solely restricted for the support of the Kamehameha Schools."

The accumulated income fund can be readily segregated. The funds exist and can be traced from one audited financial report to the next. The report for each year after 1988 contains an entry for the excess (or deficit) of revenue over expenses. The total of these amounts is the total of accumulated income after 1988.

In 1988, General Counsel recommended that the accumulated income be "earmarked." The word is not a term of art. The Controller and other staff members concerned with keeping the books considered that the annual report of excess revenue and the Ten Year Plans accomplished sufficient "earmarking."

The Master complains that this change was not affirmatively disclosed to the Court, was unauthorized, and undermined the ability of the Court to exercise its function properly. C.R. at 32 & 33. The action may have been mistaken but it was not duplicitous. Anyone reviewing the Estate's audited financial statements for the periods after 1988 could readily see that accumulated income was not separately reported in them. Four masters have reported on six accountings since 1988. None objected to the change.

C. Accounting For Accumulated Income

The Master's third and fourth recommendations are as follows:

Recommendation No. 3:

Accumulated Income Should Be Restored To The Revenue Account.
Your Master recommends that the Trustees be ordered to: (a) immediately cease and desist from continuing these practices; (b) restore to the revenue account all accumulated income which has been reclassified to corpus; and (c) provide a compliance report to your Master within 30 days from the date upon which the Court issues its order adopting this recommendation.

C.R. at 33.

Recommendation No. 4:

An Accounting Of Accumulated Income And Independent Verification Should Be Conducted.
Your Master recommends that the Trustees be ordered to provide an accounting to your Master within 60 days regarding the full extent of the accumulation of income by the Trust Estate and that such accounting be subject to independent review and verification by Arthur Andersen LLP.

C.R. at 35.

The Trustees will restore to the revenue account all accumulated income reclassified as corpus, will cease any further reclassification of accumulated income to corpus, and will provide the Master with the requested accounting and compliance report for review and verification by Arthur Andersen.

D. Disposition of Accumulated Income

The Master's fifth, sixth and seventh recommendations are as follows:

Recommendation No. 5:

Strategic Planning Should Incorporate Expenditure Of Accumulated Income.
Your Master recommends that the Court order the Trustees to undertake an appropriate strategic planning process under the supervision of the Court (as described in more detail in Part IX, Section A of this Report) which incorporates planning for the expenditure of the accumulated income.

C.R. at 40.

Recommendation No. 6:

No Future Reclassification Of Accumulated Income Should Be Permitted Without Prior Court Approval.
Your Master recommends that the Trustees be instructed that should they choose to rely upon the provisions of HRS Chapter 517D to reclassify accumulated or unexpended income to corpus in the future, that they shall do so only upon notice to the Attorney General as parens patriae of the Trust Estate and approval by the Court upon a proper petition for instruction.

C.R. at 43.

Recommendation No. 7:

The Appropriateness Of The Replacement Cost Reserve Should Be Determined By The Court.
Your Master recommends that the Trustees explain in their response to this Report why the Replacement Cost Reserve is not contrary to the terms of the Will and the Revised Uniform Principal and Income Act. Otherwise, should the Trustees desire to continue the practice of charging the revenue account for future additions to the Replacement Cost Reserve they should seek appropriate instructions from the Court.

C.R. at 44.

The appropriate disposition of accumulated income is an important issue for the long term interests of the Estate and the Master does not recommend that the accumulation should be liquidated. His emphasis, as in other matters, is on long range planning, and the Trustees have no objection to planning for the use of accumulated income. They do so regularly in the formulation of the Estate's Ten Year Plans.

As the Master observes, the Estate has not always generated sufficient income to meet the operating expenses of the Kamehameha Schools. There were times within recent memory when the Estate had trouble meeting payroll. The Trustees also are ever-mindful of the fate of the Estate of King Lunalilo. Had its trustees been permitted to preserve its corpus, many estimate the value of that estate would have surpassed the value of the Bernice Pauahi Bishop Estate. Instead, its value is reported to this Court in Equity No. 2414-A at less than $8 million.

Recognizing that preservation of corpus is vital if the Estate is to continue to serve its educational purposes in perpetuity, the Trustees have acted conservatively to assure that all maintenance can be funded out of income without resort to corpus. This has been accomplished through the establishment of reserves for maintenance, depreciation and replacement costs and by a concerted effort to restore corpus to replace value lost through forced sales incident to fee conversion.⁹

Accumulated income is a vital component of this process of preservation and restoration of corpus. It should go without saying that it would not be prudent for the Trustees to expend all revenues received every year. This, however, requires discussion of the opinion in Collins v. Hodgson, 36 Haw. 334 (1943).

E. Collins v. Hodgson: Accumulation May Be Inevitable

Collins v. Hodgson was an appeal by the Attorney General from an order concerning the right of the Bishop Estate trustees to use accumulated income to defray the cost of erecting new school buildings. In 1941, the trustees had petitioned for instructions whether to charge income or corpus for such construction costs. In response, the Attorney General first argued that the costs should be charged to income but later amended his pleadings to assert that the costs should be charged to corpus. The circuit judge agreed with the Attorney's General's first position and concluded that accumulated income could be used to pay the construction costs. The Attorney General appealed and the Supreme Court held that only corpus could be used to pay the construction costs of new buildings. That is all the opinion in Collins v. Hodgson really holds.

By way of dictum, the Court added, however:

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

The record before us does not disclose over what period or why the income has been in excess of the expenditures. Neither does it disclose facts from which it could be determined whether or not a continual increase in the surplus income is or may become inevitable. Our decision that under the terms of the will income as such cannot be used to defray the cost of buildings is not to be understood as having any reference to the power of the chancellor, on a proper bill and showing, to apply the doctrine of cy pres and authorize an inevitable surplus, if any, to be applied to some other use within the purview of that doctrine.

Collins v. Hodgson, 36 Haw. at 339-40 (emphasis added).

From this dictum hangs the view that the accumulation of income is a violation of the Will, notwithstanding the fact that the Supreme Court itself acknowledged that accumulation may be "inevitable."¹⁰

The Will of Bernice Pauahi Bishop is not as certain as the Supreme Court's remarks might suggest. Article Thirteen directs the Trustees to expend up to half of the corpus in the purchase of a school site and the erection and furnishing of buildings. As to the balance remaining, it provides:

I direct my trustees to invest the remainder of my estate in such manner as they may think best, and to expend the annual income in the maintenance of said schools; meaning thereby the salaries of teachers, the repairing of buildings and other incidental expenses; and to devote a portion of each year's income to the support and education of orphans, and others in indigent circumstances, giving the preference to Hawaiians of pure or part aboriginal blood; the proportion in which said annual income is to be divided among the various objects above mentioned to be determined solely by my said trustees, they to have full discretion.

Will of Bernice Pauahi Bishop, Article Thirteen (emphasis added).

The seventeenth paragraph of the First Codicil to the Will provides:

I give unto the trustees named in my will the most ample power to sell and dispose of any lands or other portions of my estate, and to exchange lands and otherwise dispose of the same; and to purchase land, and to take leases of land wherever they think it expedient, and generally to make such investments as they consider best; but I direct that my said trustees shall not purchase land for said schools if any lands come into their possession under my will which in their opinion may be suitable for such purpose; and I further direct that my said trustees shall not sell any real estate, cattle ranches, or other property, but to continue and manage the same, unless in their opinion a sale may be necessary for the establishment or maintenance of said schools, or for the best interest of my estate.

First Codicil to the Will of Bernice Pauahi Bishop, seventeenth paragraph (emphasis added).

With all respect to the dictum of the Supreme Court in Collins v. Hodgson, the foregoing provisions do not necessarily mandate the annual expenditure of all income received. Even if Article Thirteen of the Will is read as a direction to expend all of the annual income, the First Codicil, which amends the Will, empowers the Trustees to purchase land, "take leases" (and therefore pay rents), and to make investments. The First Codicil does not require that such purchases and investments be made with corpus or only upon sale of lands.

Consistent with the provisions of the First Codicil, this Court has determined that the Trustees have power to reinvest cash, including accumulated surplus income, in income producing property:

10. Power To Invest Cash in Income Producing Property. The Trustees have power and are authorized to invest and reinvest cash proceeds from the sale of corpus, and any accumulated cash surplus income, in income producing real property whenever they determine it is for the benefit of the Estate.

Findings of Fact, Conclusions of Law, And Order Approving Eighty-fifth Annual Report, entered herein on February 3, 1977, at 5.

Certainly, if accumulated income may be reinvested in income producing property, it does not have to be fully expended annually.

In 1985, George S. W. Hong, master on the Trustees' 99th Annual Report (FY 1984) devoted most of his report to the issue of accumulated income. Mr. Hong did not advocate a spending spree, however:

Recognizing that the immediate expenditure of the accumulated income merely for the purpose of spending may not be in the best interest of either the Schools or the Estate, your master recommends that the Trustees examine the future needs of the Schools and the non-campus activities and periodically prepare a long-range plan for the expenditure of accumulated income for the educational purposes set forth in the Will and from time to time amend such plan as may be appropriate under the circumstances. Such plan should be subject to periodic examination by this Court.

Report of the Master on the Petition Of the Trustees of the 99th Annual Report, filed herein on August 2, 1985, at 24 (emphasis added).

Upon this recommendation, the Court decreed:

The Trustees are directed that they shall continue to prepare, implement and from time to time amend and revise their Ten-Year Plan, incorporating therein long-range planning for the expenditure of accumulated income for the educational purposes consistent with said Will.

Findings of Fact, Conclusions of Law and Order Approving 99th Annual Report, entered herein on October 8, 1985, at 6.

The incumbent Master's conclusion that there is no satisfactory plan for the expenditure of the accumulated income derives from his dissatisfaction with the Trustees' strategic planning process and the fact that the Ten Year Plans do not refer specifically to accumulated income. Strategic planning is discussed below in Part and the Trustees' agreement to segregate income and corpus and to report accumulated income separately will result in changes to the format of the Ten Year Plans.

G. Establishment Of Reserves Is Permitted

That brings the discussion to the real substance of the matter: What reserves and corpus protections are permitted to the Trustees to protect the long term interests of the Kamehameha Schools Bernice Pauahi Bishop Estate?

This Court has previously determined that the Trustees may maintain a depreciation reserve:

6. Depreciation Or Amortization of Depreciable Assets of the Trust Estate. The Trustees are authorized to set up reserves for depreciation for all depreciable assets held or acquired by them, and for all depreciable improvements to Trust property. Such depreciation should be charged to income, and corpus should be replenished over the estimated useful life of the assets, as set forth in the recommendations of Coopers & Lybrand, Certified Public Accountants, its letter of advice of October 29, 1976 ....

Findings of Fact, Conclusions of Law, And Order Approving Eighty-fifth Annual Report, entered herein on February 3, 1977, at 4.

This determination is consistent with H.R.S. § § 557-13(a)(2) (the Revised Uniform Principal and Income Act ) which allows a charge against income for a reasonable depreciation allowance taken in accordance with GAAP.

The Master recognizes the effect of the statute but suggests that a replacement cost reserve established by the Trustees in 1990 cannot be charged against income. In support of this view, he quotes H.R.S. § 557-13(c)(2) which provides that extraordinary repairs and expenses incurred in making capital improvements are to be charged against principal (corpus). The Master misinterprets the section. Replacement costs are neither extraordinary repairs nor expenses for capital improvements. They are, instead, a form of depreciation reserve permitted by Section 557-13(a)(2). Indeed, Section 557-13(c)(2), which mandates that extraordinary repairs and capital improvements be paid out of corpus, also provides that "a trustee may establish an allowance for depreciation out of income to the extent permitted by subsection (a)(2) and by section 557-8."¹¹

Depreciation reserves and replacement reserves are nothing more than an accountant's recognition that things wear out and must be replaced. By charging an annual amount against income each year, a reserve has been established to provide for such costs when they arise. The Master says this has the effect of restricting the income available for expenditure. C.R. at 43. This is only partially true.

If the generation that uses the depreciating facility also spends the unrestricted income, it is burning the candle at both ends, at the cost of future generations. It has been noted that "[t]he basic policy of section 13 [of the Uniform Act, being H.R.S. § 557-13] is to allocate all trust expenses among the interests which receive the expense's particular benefit." Carl J. Sinder, Note, The Revised Uniform Principal and Income Act - Progress, But Not Perfection, U. Ill. L.F. 473, 492 (1963). This is exactly what the Trustees have endeavored to do by establishing reserves out of income for assets that are being used currently and will have to be repaired or replaced for the use of future generations. In a year in which maintenance and repair of facilities is funded from the reserve account, the annual income otherwise available for expenditure that year is not reduced by the costs so funded.

The Trustees' establishment of a replacement cost reserve is, therefore, both prudent and consistent with the directions of the Will and the opinions of the Supreme Court that both corpus and income may be used for the maintenance of the Kamehameha Schools. The opinion in Collins v. Hodgson, has it that income may not be used to defray the costs of erecting entirely new buildings. It says nothing about maintenance, repair and renovation of existing facilities and cannot be interpreted as precluding the establishment of a reserve for the replacement of existing facilities.¹²

H. Conclusion

In summary, there is considerably more to the issue of accumulated income than a 1970 pre-trial stipulation. A court order clarifying the matter would be helpful to all concerned, whether based upon a stipulation among the Trustees, the Master and the Attorney General, or entered after hearing of a special petition for instructions.

VII.UNIFORM PRUDENT INVESTOR ACT

A. Introduction

Part VIII of the Master's Consolidated Report relies heavily upon the Hawaii Uniform Prudent Investor Act , H.R.S. § Ch. 554C ("HUPIA"), which was enacted in 1997. The Master characterizes this as a codification of the Prudent Investor Rule. C.R. at 46. A "non-exclusive list of factors" identified by the Master as arising under the Prudent Investor Rule provides the outline upon which Part VIII is based. C.R. at. 48.

The Trustees believe this analysis of their performance is flawed by the mixture of HUPIA and its non-exclusive list of standards with numerous decisions of the Hawaii Court that antedate HUPIA by several years, including (in the order mentioned by the Master in Part VIII) Brown v. Brown, 22 Haw. 715 (1915); Bishop v. Kemp, 35 Haw. 1 (1939); Ahuna v. Department of Hawaiian Homelands, 64 Haw. 327, 640 P.2d 1161 (1982) amended, 64 Haw. 688; Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964); and Dowsett v. Hawaiian Trust Co., 47 Haw. 577, 393 P.2d 89 (1964) reh'g denied, 47 Haw. 628, 393 P.2d 648.

The following discussion will show in some detail that, prior to HUPIA, there were two so-called "prudent man" rules. One was applicable to dynastic trusts such as the Kamehameha Schools Bernice Pauahi Bishop Estate, which are designed to perpetuate substantial holdings in trust for as many years as the law allows (in the case of the Estate, in perpetuity). The other was appropriate to caretaker trusts, which are designed to serve the needs of specific beneficiaries, usually a surviving spouse and minor children, for a comparatively shorter period of time. The considerations driving a dynastic trust and those driving a caretaker trust are very different but courts, including the Hawaii Supreme Court, and commentators have not always recognized the distinction.

B. HUPIA and the Third Restatement

The Restatement (Third) of the Law on Trusts (the "Third Restatement"), from which HUPIA and its "prudent investor" rule is derived, was intended in part to resolve the conflict in rules and to establish a new standard. It is hardly appropriate to employ the "non-exclusive list of factors" enunciated in HUPIA in 1997 while quoting from earlier case law which the framers of HUPIA intended to clarify and, in some cases, supersede.

HUPIA became law on April 14, 1997. H.R.S. § 554C-11 is clear that the statute is entirely prospective and applies only to decisions or actions occurring after that date. The periods of the Master's Consolidated Report are from July 1, 1993 to June 30, 1996, and HUPIA is not applicable to these accounting periods.

HUPIA is not a mere codification of pre-existing common law. In fact, only a few elements of pre-existing statutory and case law were incorporated into HUPIA. Adding to the confusion is the fact that HUPIA repealed former H.R.S. § 406-22(a) which had been called the "Prudent Investment Rule". See Matter of Estate of Dwight, 67 Haw. 139, 144-45, 681 P.2d 563, 567 (1984) recon. denied, 67 Haw. 683, 744 P.2d 779; and Steiner v. Hawaiian Trust Co., 47 Haw. 548, 561, 393 P.2d 96 (1964).

HUPIA is not based on common law but on provisions of the Third Restatement , which was adopted and promulgated by the American Law Institute in 1990. The Reporter for the Third Restatement was Professor Edward C. Halbach, Jr. whom the Master acknowledges as one of his consultants. C.R. at 5. Professor Halbach has said of the Third Restatement: "It attempts to restate the common law of trust investment and also makes changes in Restatement Second sections that affect or are affected by new sections 227, 228 and 229, which constitute the prudent investor rule."

Edward C. Halbach, Redefining the "Prudent Investor Rule", 129 Tr. & Est. 14 (1990) (hereinafter cited as "Halbach"). In reply to a question as to how the new concept of the Third Restatement varies from the "prudent man" rule, Prof. Halbach said:

Some of the changes we have made in Restatement doctrine will not be brand new to some prudent man states. But the overall thrust is to restore the originally intended flexibility of the Harvard College dictum. Flexibility is needed not just for the widely varied objectives and circumstances of different trusteeships but also to adapt over time to changes in the operation of financial markets, in the investment products available and in the practices of fund managers, as well as in the theories and knowledge underlying those practices. Thus, we have sought both to modernize trust investment law and to restore its flexibility.

There are some rather clear-cut differences between the new rule and that of the prior Restatement, which was fairly typical of the prudent man rules of the various states. Other differences involve mainly changes in emphasis or rationale.

Illustrative of the latter is the principle of diversification, the trustee's general duty to diversify. The prudent investor rule recognizes the nature and important role of asset allocation, which was not mentioned in the earlier Restatement, and it is more flexible than the old rule in ways that reflect the underlying reasons for diversification. To convey a better understanding of the relationship between this duty and risk, the new book discusses the different types of risk involved in investing--especially "compensated" and "uncompensated" risk. The objective is to have the role and the nature of diversification better explained and understood. This all represents mainly a change of emphasis and rationale, with associated adjustments in application. Certainly there has been a duty to diversify under prior Restatements and in most prudent man jurisdictions.

Another example of changed emphasis is the effort to enhance understanding of expense problems in fiduciary investing, with greater attention to management and transaction costs and to reasons why. Between change of emphasis and change of direction is our revision of the duty of impartiality, calling for reasonable effort in most cases to protect purchasing power.

Illustrative of clear cut change is our quite different view of the propriety and role of delegation by trustees. Maybe even more fundamental, however, and probably our most important reversal of direction, was the elimination of arbitrary prohibitions categorizing investments in the abstract as "speculative," or as permissible or impermissible per se. Under the traditional rule in most states, venture capital would not be a permissible investment, and in many real estate would similarly be excluded as involving too much risk and difficulty of management. Subrules like these usually applied to trusts generally, and without allowing for the tremendous variety that exists in trusts and trusteeships. The prudent investor rule says than no investment or course of action is per se prohibited. Significant differences follow from stressing that investments are to be judged by their portfolio role and context.

Id. at § 14-15.

C. The Two "Prudent Man" Rules

The so-called "prudent man" rule derives from the landmark decision of the Massachusetts Court in Harvard College v. Amory, 26 Mass. (9 Pick.) 446 (1830), which considered the power of fiduciaries to invest in insurance and manufacturing stocks. In that case, the court discarded the English common law, which restricted fiduciary investments to government securities, and enunciated what became known as the "prudent man" rule governing the conduct of a trustee:

[H]e shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.

26 Mass. at 461.

As noted in Lawrence W. Friedman, The Dynastic Trust, 73 Yale L.J. 547 (1964):

The test laid down was carefully stated, for all its apparent vagueness. The "prudent investor" rule has been so often quoted, cited, and repeated, that the eye is apt to pass over it without noticing the precision of its phrasing. The ideal trustee must "observe how men of prudence, discretion and intelligence manage their own affairs." This presupposes a certain class of trustees: men of business ability, whose social and economic position allows them easily to observe how their peers manage large estates for themselves or others. The test was more appropriate to the professional than to the amateur trustee who assumed trusteeship out of friendship or blood ties with the settlor. The court also spoke of a "permanent disposition of funds." This might mean nothing more than the trustee's duty to avoid speculative investment; but in another sense "permanent disposition" implied investment for the long run. This phrasing was more appropriate to the dynastic than the caretaker trust.

73 Yale L.J. at 554.

For a variety of reasons, the prudent man rule, which was well-established in the United States at the turn of the century, went into eclipse in many jurisdictions for a number of years. At least one of the reasons was the paucity of dynastic trusts designed to last as long as legally possible. Dynastic trusts required administrative flexibility and it was such a dynastic trust that was considered in the Harvard College case.

At the opposite end of the spectrum is the caretaker trust, which is a short-term trust designed to serve the needs of limited group of beneficiaries for a relatively short period of time. The caretaker trust could tolerate only a very conservative and liquid portfolio. Since the caretaker trust was by far the more common form of trust, Harvard College, involving a dynastic trust, was perceived by many courts to be somewhat too expansive. As Professor Friedman puts it, "[most] states ..., lacking dynastic trusts in any significant numbers, lacking Boston's institution of professional trust-managers, and face to face with a wide, dangerous and complicated investment market, were not ready for Harvard College." Id. at § 561.

Thus, a different prudent man rule was enunciated in King v. Talbot, 40 N.Y. 76 (1869), a case involving a caretaker trust, the principal of which was to be paid to the decedent's children when they reached majority. While the New York court described a prudent man rule which superficially resembled the Massachusetts rule of Harvard College, it had key differences which, while suitable to caretaker trusts, were wholly unsuitable to the dynastic trust for which the original prudent man rule had been formulated. The court in the King case held that "the trustee is bound to employ such diligence and prudence ... as in general, prudent men of discretion and intelligence in such matters, employ in their own like affairs." Id. at § 85-86. The New York court saw that trustees had three basic investment duties: First, to place the money in a "state of security" ; second, to make it "productive of interest" ; and third, "to keep the fund, that it should always be subject to future recall for the benefit of the cestui que trust." Id. at § 88.

When the King court stressed that the income should be "without exposure to the uncertainties or fluctuations of adventures of any kind," it was saying, in effect, that the investment must be as utterly free of risk as it can possibly be. Thus emerged the beginnings of an alternative branch in American trust law, a counterpoint to the original "prudent man" rule but still calling itself the "prudent man" rule.

It is more accurately termed the "legal lists" rule. After King, courts began to narrow the rule laid down in Harvard College and legislatures began adopting lists of what were regarded as relatively risk-free investments to which fiduciaries would be restricted.

The differing legal approaches to trust investments are really different approaches to the regulation of risk and the risk of loss. Note, The Regulation of Risky Investments, 83 Harv. L. Rev. 603, 616 (1970) (hereinafter cited as "Investments"). There are several consequences to this. First, risk cannot be treated in isolation from the return in investment it contributes to a portfolio. There is a trade-off between risk and return and if each investment is evaluated solely from the point of view of risk of loss, the least risky investment will always be chosen. Perhaps because the law does not operate in the marketplace, the complementary concepts of risk and return are not commonly seen together from the bench. However, no prudent investor weighs one without the other and neither should the law. To do otherwise is to harm the trust beneficiary "either by being denied a worthwhile investment or by being exposed to the dangers of a poor one." Id. at § 618.

The risk factor most frequently overlooked is the inflation risk in any investment or portfolio. The danger to a dynastic trust today is less likely to be that the fiduciary will invest too aggressively than that the trustee will not invest aggressively enough to offset the effects of inflation. A failure to invest in such a manner as to offset the effects of inflation results in a radical diminution in corpus as inflation takes its yearly toll. The commentator in Investments notes the peculiar logic that this may entail:

The return on a portfolio means nothing unless it means the production and conservation of real, and not monetary, wealth. Accordingly, the risk of inflation and decline in purchasing power is at least as important as the risk of monetary loss. Inflation risk is the probability that, over the investment horizon of the portfolio, monetary inflation will decrease the real value of the portfolio. It is another type of uncertainty risk that current regulation fails to reflect.

... In overlooking possible inflationary conditions the law of trusts does not attach the same importance to risks of lessened purchasing power as it does to risks of monetary loss. Since both have the same economic impact trustees should have a legal duty to consider both risks, and the standard of prudence should be broadened to allow both to be anticipated.

Id. at § 622-624 (footnotes omitted).

Multiple editions of the treatise of Professor Scott, one of the leading commentators on trust law, also acted to inhibit development. As Professor Jeffrey N. Gordon observed in The Puzzling Persistence of the Constrained Prudent Man Rule, 62 N.Y.U. L. Rev. 52, 58 (1987), Scott was the leading commentator and the reporter of the First and Second Restatements. Most case law and commentaries quoted him. But his treatise had become moribund. "Scott's teachings on investment management by trustees have remained virtually unmodified over a fifty-year period." Id.

... Scott's rules and examples are more constraining, and less flexible, than Harvard College required. Perhaps initially useful, these rules and examples no longer conform to our best understanding of prudent investment strategy and thus unwisely restrict trustees. ... In a sense Scott has become "Scott," too authoritative to revise. Since the publications of the last editions of the Treatise and the second Restatement there has been an explosion of theoretical and empirical work by financial economists, leading to new conceptions of investor and market behavior. None of this progress is reflected in "Scott"; indeed, what has been learned contradicts much of what "Scott" states on investment management. ...

Three key decisions in the Treatise and the Restatement transformed the flexible standard of Harvard College into what has become the constrained Prudent Man Rule. First, Scott altered the Rule to require a more conservative benchmark of prudence than Harvard College. Instead of the prudence of persons seeking "permanent disposition of their funds," Scott prescribed the prudence of one seeking primarily the "preservation of the estate". An investment strategy designed to preserve principal will presumably be more cautious than one aimed at permanent disposition, which could include a buy-and-hold portfolio of common stocks at a higher level of risk and expected return. Moreover, in inflationary times, a mandate to preserve the estate becomes confounding; to preserve the estate in nominal terms may well defeat the testator's objective of transferring wealth to the next generation, but to preserve the estate in real terms requires investment that may risk the loss of principal.

Second, instead of an investment standard based on how prudent men conduct their own affairs, Scott prescribed the more constraining norm of "men who are safeguarding property for others." Thus, instead of the prudent man test, we have the prudent trustee test. The implication is that a trustee must use especially safe means to attain the desired level of investment safety, rather than ordinarily prudent means. So, making the debatable assumption that preservation of capital ought to be the trustee's primary goal, Scott tells us that a prudent trustee may not pursue this goal in ways acceptable to a prudent investor. Scott's dubious distinction confuses the setting of appropriately safe investment objectives with the process of investing. The confusion creates a special problem for a financial model like portfolio theory, in which investments (and investment techniques) designed to achieve greater safety may nevertheless appear risky viewed in isolation.

Third, and most serious, Scott, in separating "prudence" from "speculation," set hard and fast rules that now stymie the trustee's ability to adapt to prevailing circumstances in the financial markets. On the forbidden investment list are, for example, margin purchases of securities, "speculative" stock, discount bonds, securities in new and untried enterprises, and second mortgages. "Speculative stock" seems to refer to all companies except those "with regular earnings and paying regular dividends which may reasonably be expected to continue."

Id. at § 58-61 (footnotes omitted).

Professor Gordon's observation that Scott had become too authoritative to revise is borne out by the words of the Preface to the most recent (1987) edition of Professor Scott's treatise. "The Fourth Edition is a deliberately conservative revision of a monumental treatise written by a distinguished scholar and teacher." I Austin W. Scott & Wm. F. Frachter, The Law of Trusts, Introduction, at xxii (4th ed. 1987) (hereinafter cited as "Scott").

Frustration with the situation of a body of law that had not grown with the times gave impetus to the Third Restatement. Trust law had become bound up in rules and subrules, tending to drive trustees (especially trustees of dynastic trusts) in a direction which was at variance with what the marketplace regarded as good investment practice. The result was a legal revolution resulting in the Third Restatement, which enunciated the law of trusts not so much as it existed, but as the American Law Institute believed it should be. See Halbach at 21-22, Lyman W. Welch, How The Prudent Investor Rule May Affect Trustees, 130 Tr. & Est. 15 (1991) and Robert T. Willis, Prudent Investor Rule Gives Trustees New Guidelines, 19 Est. Plan. (1992).

D. Hawaii's Experience

The Supreme Court of Hawaii first specifically considered the standards by which a fiduciary's investments should be governed in the case of In Re Estate of Banning, 9 Haw. 453 (1894). The Court adopted the Harvard College standard, holding that a trustee's discretion must be accorded wide latitude. "The discretion confided in such matters to the trustee is one that is founded upon sound reasoning and conformity to established business principles ..." Id. at § 462 (citing Harvard College).

The Court held to the rule announced in Banning despite "much unpleasant criticism" and defended the rule as the law of many states. Guardianship of Parker, 14 Haw. 347, 351 (1902). It recognized that in some jurisdictions, "the [trustee's] discretion has been confined." Id. at § 352. But the Court adhered to the rule stated in Banning. See Brown v. Brown, 22 Haw. 715 (1915), fully restating and adopting the Harvard College prudent man rule.

Nonetheless, Hawaii became a "legal list" jurisdiction by act of the Legislature in 1933. See 1933 Haw. Sp. Sess. L. ch. 47. The Hawaii Court remarked that it was unable to comprehend the necessity for the legislation and noted that "even the legislature is powerless by subsequent enactment to vary any of the terms of a trust deed previously executed." Bishop v. Kemp, 35 Haw. 1, 8 (1939). In 1947, the 1933 Act was amended to adopt as statutory law the prudent man rule of Harvard College. See 1947 Haw. Sess. L. ch. 125.

In 1984, the Supreme Court of Hawaii decided Matter of the Estate of Dwight, which may be regarded as a classic failure of fiduciary due diligence. The trial court had found that First Hawaiian Bank, the successor trustee, invested trust assets in a decaying fifty-two year old building in a deteriorated and depressed area of Honolulu surrounded by bars and porno shops, which was designated for condemnation and urban renewal. The building was not in conformity with the applicable building codes and was termite infested. The successor trustee had made the investment on the strength of a short term lease to The Salvation Army. The successor trustee neglected to read the lease, which specifically disclosed some of the repair and damage problems, or to question the tenant about the condition of the building. The successor trustee "neither knew nor attempted to determine whether the building conformed to applicable building, health, safety and fire code requirements. The Trustee also did not secure any structural or termite inspections." 67 Haw. at 567, 681 P.2d at 143-44.

The Supreme Court observed:

In the absence of specific directions in the trust instrument concerning the investment of trust funds, our court has held that the trustee's duties to the beneficiaries are controlled by statute. Steiner v. Hawaiian Trust Co., 47 Haw. 548, 561-562, 393 P.2d 96, 105 (1964). The statute applicable in this case, Hawaii Revised Statutes (HRS) § 406-22(a) (1968), codified the generally accepted "prudent investment rule."

Id. at § 144-45, 681 P.2d at 567.

The statute which the Court called the "prudent investment rule" was former H.R.S. § 406-22(a), made applicable to trustees generally by the provisions of H.R.S. § 554-6. It provided for the exercise of:

... the judgment and care which, under the circumstances then prevailing, men of prudence, discretion, and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds and property considering both probable income and probable safety of capital.

This is a classic formulation of the Harvard College prudent man rule.
Section 406-22(a) was superseded in 1976 by the Uniform Probate Code, which brought with it a revised formulation of the prudent man rule, this time as H.R.S. § 560:7-302. H.R.S. § 560:7-302 provides that the trustee:

... shall observe the standards in dealing with the trust assets that would be observed by a prudent person dealing with the property of another, and if the trustees has special skills or is named trustee on the basis of representations of special skills or expertise, the trustee is under a duty to use those skills.

This is what Professor Gordon, quoted above, calls the "prudent trustee" rule and lays at the doorstep of Professor Scott's moribund analysis.

Then, in 1997, the Legislature enacted HUPIA. As shown above, HUPIA was designed to revise and restate the "prudent man" rule as the "prudent investor" rule. Section 560:7-302 is still on the books, however.

E. Summary

While HUPIA and its "non-exclusive list of factors" is a valuable tool for the future, it must be understood as an intentionally revolutionary restatement of the law of trusts. It was designed by its framers to make into law what, in their view, the courts and the commentators had failed to develop in the years since Harvard College v. Amory. As a legislative statement, HUPIA supersedes prior Hawaii case law which is inconsistent with it. At this time, there are no reported Hawaii decisions construing HUPIA or its non-exclusive list of factors. And, for the period of the three Accounts now under review, HUPIA was not the law and the law was a confusion of standards, including two "prudent man" rules and a "prudent trustee" rule. This is especially clear in the Steiner decision, discussed next.

F. Steiner v. Hawaiian Trust Co.

The Master refers to the decision in Steiner v. Hawaiian Trust Co., 47 Haw. 548, 393 P.2d 96 (1964) several times. C.R. at 49, 63-66 & 123. The factual situation of that case is important to understanding the tone of the Court's statements. Steiner is less about diversification than it is about a careless corporate fiduciary. The case involved three identical revocable personal trusts established in 1931 by former Supreme Court Chief Justice E. C. Peters and his wife for the benefit of their children. Hawaiian Trust Company was the trustee. Each trust was endowed with 100 shares of Hawaiian Pineapple Company stock. The Trustee was prohibited from making any change in investments without the written consent of Judge Peters. When Mrs. Peters died in 1944, more assets were added to the trusts and they were amended to make them irrevocable. The added assets included several shares in various plantations and in Hawaiian Trust, with the result that each trust was worth about $35,610, with 99% of the stock in plantations, and over 80% of the stock being in Hawaiian Pineapple Company. In 1951, Hawaiian Pineapple stopped paying dividends. In 1955, Hawaiian Trust began a program of diversification. Hawaiian Trust sold the plantation stocks and invested the proceeds in Hawaiian Trust's own common trust fund. It never obtained Judge Peter's consent. In 1956, Judge Peters removed Hawaiian Trust as trustee and appointed Ernest Steiner as successor trustee. Steiner sued Hawaiian Trust.

The Court found three breaches: Hawaiian Trust's sale of Judge Peters' Hawaiian Trust stock to the president of Hawaiian Trust; Hawaiian Trust's sale of stocks without Judge Peter's consent; and Hawaiian Trust's failure to diversify sooner by advising Judge Peters to sell the stocks of declining plantations.

The Court emphasized that Hawaiian Trust was "bound to use the higher degree of skill that it possessed as an expert professional fiduciary." Steiner, 47 Haw. at 562, 393 P.2d at 105. The Court relied heavily on the Restatement (Second) of Trusts (the "Second Restatement") and Professor Scott's treatise, both of which were quoted at length. The Court reviewed in detail the erratic history of Hawaiian Pineapple, its instability, unpredictability and varying performance. Id. at § 571. It noted that the chancellor was not so much concerned with the concentration in local plantation stocks as he was in the quality of the investments. Pepeekeo Sugar had a history of deficits, dividend omissions, losses, low yields and insecurity. Id. at § 573.

From this, it is clear that Steiner involved a caretaker trust (established by parents for their children), a corporate fiduciary that held itself out as an expert, and an egregious factual situation, including sale of trust assets in violation of the terms of the trust and a dilatory approach to disposition of stocks that suffered badly in the postwar economy. Although not mentioned in the reported opinion, it is common knowledge that the wartime and postwar economies devastated Hawaii's plantation system.

Significantly, the Court's legal analysis includes the view that the trustee was obliged:

... "to make such investments as a prudent man would make of his own property having primarily in view the preservation of the estate and the amount and regularity of the income to be derived. *** It involves three elements, namely care and skill and caution." 3 Scott, Trusts, § 227 (2d ed. 1956). This is nothing more than a statement of the statutory "prudent investment rule."

Id. at § 573.

The Court's quotation from Section 227 of Scott is significant. Scott's formulation is not the Harvard College v. Amory prudent man rule. Instead, it is a direct descendant of the narrower New York standard enunciated in King v. Talbot. Thus, the Hawaii Supreme Court's statement that Scott's formulation is "nothing more" than a statement of the Hawaii rule was entirely mistaken. Hawaii's statute was the broader rule of Harvard College and Scott's formulation, appropriate to a caretaker trust, was not a statement of the Hawaii statutory rule.

It is apparent from the opinion that the Court was unaware of the distinction between the two rules. Earlier in the same opinion, it had correctly concluded that the Hawaii statute, R.L.H. § 179-14(a) [which later became H.R.S. § 406-22(a)] was a codification of the prudent investment rule set forth in Harvard College. Steiner, 47 Haw. at 562, 393 P.2d at 105. The Court's conclusion eleven pages later that Scott's narrower formulation was an accurate reflection of Hawaii statutory law was therefore plainly mistaken.¹³

The Hawaii Court's failure to distinguish the Harvard College "prudent man" rule from the prudent man of King v. Talbot is also clear in Ahuna v. Department of Hawaiian Home Lands, 64 Haw. at 340, 640 P.2d at 1169, (1982), wherein the Court quotes Mainland authority which itself confuses the two standards.

Thus, the law of Hawaii has been a confusion of the two prudent man rules, with legislative dabbling in the "legal list" and "prudent trustee" rules as well. HUPIA's emergence in 1997 as the "new" rule for prudent investors may bring clarity to the situation. For purposes of the present accounts, however, the Master cannot apply HUPIA's standards retroactively nor can HUPIA's standards be considered as a mere codification of pre-existing law. HUPIA's standards are intentionally new. They reflect a conscious effort to effect a rapid evolution of the law of trusts. Moreover, given the confusion of the case law and statutes, it is hard to say what standard did apply during the period of FY 1994 through FY 1996.

G. Hawaii Chronology

The following chronology shows the evolution of Hawaii law from the Harvard "prudent man" rule to HUPIA's prudent investor rule:

1894	Banning: Harvard prudent man rule adopted by the Hawaii Court
1919	Brown v. Brown: Harvard prudent man rule confirmed by the Hawaii Court.
1933	Act 47: "Legal List" enacted.
1939	Bishop v. Kemp: Hawaii Court questions need for "Legal List."
1947	Act 125: "Legal List" repealed and Harvard prudent man rule enacted. [R.L.H. § § 179-14(a) and H.R.S. § 406-22(a)].
1964	Steiner: Hawaii Court's analysis confuses Harvard prudent man rule with King v. Talbot prudent man rule.
1976	Uniform Probate Code: "Prudent trustee" rule enacted (H.R.S. § 560:7-302) and Harvard prudent man rule [H.R.S. § 406-22(a)] repealed.
1982	Ahuna: Hawaii Court continues to confuse the two prudent man rules.
1997	Hawaii Uniform Prudent Investor Act (HUPIA) enacted.

H. Losses And Loss Reserves

The Master previously reported that the Estate had suffered more than $264 million in "combined losses and loss reserves" during FY 1994. The Trustees vehemently disputed the figure and the terminology. The Master now reports a revised calculation of about $135.5 million in losses, and explains the sources of the prior misstatement. C.R. at 56-58. Because this issue has attracted so much attention, further comment is necessary. The Master's conceded errors include:

a. Over $34 million previously reported as a loss or loss reserve was attributable not to the Estate but to an entity (SoCal) in which it made an investment. SoCal was a troubled savings bank. The Estate invested in it and the bank was turned around. It is now known as the Peoples Bank of California and has become a publicly traded entity. Not only was there no loss or loss reserve attributable to the Estate in FY 1994 for its SoCal investment but the investment has since proved itself handsomely profitable.

b. Almost $46 million previously reported as a loss or loss reserve proved to be an arithmetic error on the part of the Master or persons advising him.

c. Over $52 million previously reported as a loss or loss reserve for FY 1994 in fact arose in other years.

The $135 million figure now reported by the Master for FY 1994 is a combination of realized losses, equity losses and loss reserves established that year. As noted in the Trustees' First Response, loss reserves are a conservative and prudent accounting device. When circumstances arise which suggest that there is a potential impairment of value in an investment, which may be temporary or permanent, conservative practice is to establish loss reserves. An equity loss reflects the proportionate share of an investor's operating loss for that accounting period.

There also is a difference between a realized loss and a loss in value. A realized loss represents a permanent loss, as when an investment fails or is disposed of at less than what was paid for it. Valuation losses are experienced by investors every time the stock market dips or land values decline. Such losses are realized and become permanent only if the stock or the land is sold while its price is depressed.

The perception that the Estate "lost" $135 million in FY 1994 needs clarification. It fails to distinguish equity losses (operating losses) from reserves for potential losses, which may not occur if management is successful in rehabilitating the investment, as happened in the case of SoCal. It fails to recognize that operating losses may be offset in another year by operating income as an investment's fortunes improve. Most important, it leaves in the mind of many members of the Kamehameha ohana and the general public the mistaken idea that the Estate was poorer at the end of 1994 than it was at the beginning. To the extent that the Estate suffered losses in FY 1994, such losses were dwarfed by the Estate's reported gains.

The Master acknowledges this fact at page 58 of his Consolidated Report where he summarizes the Estate's financial statements, showing the various categories of gains and losses for each of the three years under review. The Master's table reveals the following significant facts: Equity losses amounted to only $18 million in FY 1994, $25.8 million in FY 1995, and $16.2 million in FY 1996. In those same years, the net gains on operating activities other than the sale of land were $65.2 million, $48.4 million and $71.4 million. Land sales in those same years added another $199.6 million, $83.1 million and $51.7 million. Even when the loss reserves are added to the calculations, the Master's table shows that the Estate enjoyed net increases in its assets in each of the three years, as follows: $192,815,000; $94,681,000; and $105,633,000. If the 1996 figures included the market value of various investments such as Goldman Sachs, the net increase would be substantially higher. (As discussed above in this Response, such investments are carried at their cost.) No fair minded person can conclude from these facts that the Estate is losing money or that land sales are covering losses.¹⁴

At page 76 of his Consolidated Report, the Master notes that Arthur Andersen:

... questions whether the Trust Estate is adequately exploiting the economic potential of its Kakaako land holdings through such planning. It also highlights a need for the Trust Estate to more effectively deal with the market forces and competitive factors which may adversely impact the Trust Estate's highest and best use development plans for Kakaako.

The Trustees consider that this question, perhaps more than any other, demonstrates the firm's lack of familiarity with Hawaii, existing economic conditions and the long term interests of the Kamehameha Schools Bernice Pauahi Bishop Estate.

Kakaako is the Estate's sleeping giant. Ten years ago, its redevelopment appeared certain. Government poured money into infrastructure and developers bulldozed entire blocks in anticipation of imminent highrise construction. Today, the bulldozed blocks are idle and Waterfront Plaza (Restaurant Row), one of the first developments in the new Kakaako, is about to be auctioned. The Estate is holding its land and biding its time. When the Hawaii economy revives and the Honolulu real estate market improves, the Estate's Kakaako holdings will benefit. For the time being, it is apparent to the Trustees, if not to others, that this is not a good time to master lease, develop or sell land in Kakaako.

J. Non-Hawaii Real Estate

The Master comments briefly concerning the Estate's non-Hawaii real estate. He observes correctly that several of the Estate's directly held real estate investments outside Hawaii did not begin that way. That is, prior boards made equity investments for the Estate "to minimize its risk exposure and provide for more predictable income flow." C.R. at 78. The previously troubled Mainland real estate market and other business considerations required the Trustees to step in and become owners in some cases. Prudent management and improvements in the Mainland real estate market have seen many of these troubled investments turn around and they are now valuable assets in their own right.
The balance of the Master's comments in this section concern documentation and targeted investing. The Trustees have acknowledged the value of greater documentation. Targeted investing is an aspect of strategic planning which is discussed below.

K. Hamakua Land Purchase

The Master's comments concerning the Estate's acquisition of approximately 30,000 acres of land on the Hamakua Coast of Hawaii do not present a complete picture of that transaction. C.R. at 81-82. While the Trustees have conceded that documentation practices can be improved upon, the Trustees submit that the purchase of the Hamakua properties is an example of their prudent and responsive administration of the Estate. The following discussion is presented to afford the Court a more balanced perspective.

The economic woes of the Hamakua Sugar Company are well known. Faced with foreclosure and bankruptcy, that company made efforts to save itself by offering to sell its lands. The Trustees were approached by the Company and offered a fraction of its properties for several millions of dollars. They declined the proposal.

Unable to meet its obligations, Hamakua Sugar went into bankruptcy in 1993. Its primary creditor was the Western Farm Credit Bank which held an $85 million first mortgage. The court authorized bulk sale of most of Hamakua Sugar's lands, approximately 30,000 acres. A public auction was scheduled for September 7, 1994. The bank let it be known that a pre-auction private sale might be considered at a price of about $35 million.

The property to be offered at auction comprised more than 600 separate lots covered by 273 tax parcel numbers. It included buildings, including a post office, homes and a commercial building, 50 miles of paved roads, several hundred miles of cane haul roads, water lines, bridges, ditches, pumps and reservoirs. 24,000 acres of the property was zoned for agriculture. Almost all of it had been used for growing sugar cane. The lands extended along 40 miles of coastline, from sea level to 2,700 feet.

Estate staff recognized and reported to the Trustees that the "Hamakua Coast provides some of the most productive growing conditions for timber/fiber production anywhere in the world." (Staff Report, Acquisition of Hamakua Sugar Lands, at 4.) Staff reported on an anticipated 21st century shortage of timber and fiber pulp for the Asian market. It noted that the Hawaii State Division of Forestry and Wildlife and the Department of Business, Economic Development and Tourism were promoting the forestry potential of the Hamakua Coast. Staff concluded that a "preliminary estimate of value" of the Hamakua lands was $15 million. Id. § Significantly, it based this estimate upon a review of prior land sales, the bulk sale aspect of the auction, continued pasture and agricultural use of large portions of the property with lease rents merely covering the real property taxes, and an assumption that management would be "passive" rather than "active" because of tax considerations. Staff specifically recognized that other investors who would directly acquire and manage the property for forestry operations "could afford to finance a higher initial purchase price that would be recovered through more substantial cash flows." Id. at § 5.

At their meeting on September 1, 1994, the Trustees instructed staff to gather more information and report back. The auction was then six days off. At the auction, Western Farm Credit Bank bid the property in at $20 million. That bid was subject to confirmation by the court on September 26, 1994. To reopen bidding, a 5% increase over the successful bid was required. Thus, the minimum bid at the confirmation hearing would be $21 million.

At their meeting on September 22, 1994, four days before the confirmation hearing, the Trustees heard an oral report from their staff concerning the property and, after deliberation, authorized staff to bid $21 million at the hearing. The Estate was the successful bidder and acquired the property for $21 million. Closing occurred on October 14, 1994.

All of the foregoing facts are reflected in contemporaneous Estate records.

At the meeting on September 22, 1994, staff presented oral reports and analyses of the proposed purchase. In its initial report wherein it recommended that the Estate bid $15 million while conceding that others could afford to go higher, staff had not considered the favorable interest rates available to the Estate and had made a number of other conservative assumptions about the Estate's use of the property. Subsequent review by the staff and discussion among the Trustees and staff on September 22 demonstrated that the staff's "preliminary estimate" was unnecessarily low.

The Trustees were also cognizant of the fact that, in 1994, Hamakua Sugar had surrendered its leaseholds of Estate lands and that Mauna Kea Agribusiness had done the same in 1993. Acquisition of Hamakua Sugar's fee titles gave the Estate a critical mass of prime Big Island properties to be converted from sugar agriculture to forestry operations.

Of the approximately 30,000 acres acquired from Hamakua Sugar, about 17,000 acres (together with other Estate lands) are now leased to PruTimber for forestry and about 7,500 acres are leased for other purposes. Another 4,470 acres of former Hamakua Sugar watershed lands are to be leased to the State of Hawaii in connection with the Lower Hamakua Ditch. When this is completed, over 99% of the lands acquired from Hamakua Sugar will be leased. In 2002, the Estate will begin to participate in percentage rents due from the first timber harvests.

The Hamakua land is a long-term investment in Hawaii. The Estate did not enter upon it with the intention of quick turnover and immediate profit. As a perpetual charitable trust, it can and should take the long view. With the purchase, the Estate controls some of the best forestry lands in the world, has consolidated its pre-existing holdings, and is positioned to benefit from the predicted worldwide shortage of pulp and timber. In this, the Trustees have honored the Hawaii land-based traditions of the Estate and have exercised the discretion granted them by Bernice Pauahi Bishop "to purchase land ... whenever they think it expedient." (Will, First Codicil, seventeenth paragraph)
While in retrospect, the documentation of the Trustees' decisions concerning Hamakua could have been more detailed, it is significant that the court-imposed deadlines were such that oral staff presentations and prompt Trustee action were required. Cumbersome procedures that might typically be required of a public agency are not conducive to the conduct of business in the "real world." An opportunity presented itself, the staff reported it to the Trustees, and the Trustees acted upon it.

L. Master's Request For Information

The Master states that there was an outstanding request by him for information concerning Hamakua. C.R. at 81. It should be noted that the Master's request was made on August 3, 1998, just four days before the Consolidated Report was filed.

The Estate has responded to numerous inquiries from the Master and Arthur Andersen. During the process of the financial and management audit, weekly meetings were held to assure the flow of information and the adequacy of responses. Arthur Andersen provided regularly updated schedules and lists of outstanding and new requests for information and documentation. The Master and the Trustees made every effort to avoid a repetition of the misunderstandings and miscommunications that occurred in connection with the First Report.

During the course of his review, the Master also requested specific information about various subjects referred to in his Consolidated Report. Responses have been made as quickly as counsel has obtained the information and, in some instances, the Master requested follow-up information. Hamakua is one of these. Estate Counsel replied to the Master's August 3 inquiry on August 24. The substance of that response appears above.

This cooperative process will continue as the Master undertakes his review of the Trustees' 112th Annual Account (FY 1997).

M. Kahala Mandarin

In the First Report, the Master questioned the Trustees' handling of the renegotiation of the lease underlying the former Kahala Hilton Hotel and requested supplemental information concerning the transaction. The Estate provided that information and the Master now reports that he is satisfied t