a whistle-blower program is a privatization approach, not unlike hiring a private company to run a prison. But for the S.E.C., it is law enforcement that is being privatized. Rather than being able to take aim at particularly worrisome corners of the securities markets, the program leaves the S.E.C. beholden to tippees. Moreover, if Congress believes whistle-blowers, rather than the agency, are doing the work, it will have yet another justification for placing tight limits on the agency’s budget.
Do check it out, and let me know your thoughts, either down below or thataway.
The SEC just announced that it would split the post of enforcement chief between two lawyers, both alumni of the US Attorney's Office at the SDNY. I've never heard of such an arrangement outside of the Roman Empire; why do it?
Conflict of interest. One of the enforcement directors worked closely with Mary Jo White at her New York firm; the other one can handle Debevoise cases until they age out of the problem. Which means that this does not need to be a permanent arrangment, and perhaps fittingly, the conflict enforcement chief plans on leaving reasonably soon.
But it is also a statement about how such problems come up more the closer you get to the top of an agency. Mary Jo White is hardly the first appointee to bring her favorite person at her law firm along for the ride. But special assistants and assistant deputies are easy to wall off; it used to be that there was only one enforcement director.
- Here's Bainbridge on the SEC's suit against Illinois: "Why do I call this a stunt? No fine. No relief for the affected bondholders. No benefits for Illinois pensioners, although I grant that that's largely beyond the SEC's jurisdiction. And no additional changes beyond what Illinois has already done."
- Ben Walsh is right, this dodgy hedge fund manager is "hilariously ostentatious." And no master criminal, either - he got really rich doing things that were really obviously fraudulent. At the very least the SEC can catch those guys.
- The NY soda ban injunction isn't really business law, but it is a good illustration of the arbitrary and capricious standard's downside, which can undo compromised, but potentially promising regulation, which in turn might be a byword for your average SEC rulemaking. As the New York judge observed:
- The simple reading of the Rule leads to ... uneven enforcement even within a particular City block, much less the City as a whole...The loopholes in this Rule effective defeat the stated purpose of the Rule. It is arbitrary and capricious because it applies to some but not all food establishments in the city, it excludes other beverages that have significantly higher concentrations of sugar sweeteners and/or calories on suspect grounds, and the loopholes inherent in the Rule, including but not limited to no limitations on refills, defeat and/or serve to gut the purpose of the Rule.
Ben Protess reports that the government is increasingly looking for guilty pleas in misconduct that occured after the financial crisis. But because some guilty pleas are company killers, they are getting them from foreign subsidiaries. It's a strange compromise between imposing responsibilility and avoiding economic disruption. Some thoughts:
- This is a total adaption of the government's foreign corruption enforcement strategy, which has invovlved obtaining guilty pleas from foreign subs for a while now. And that just shows how big a deal foreign corruption cases are right now. They are literally setting the template for the regulation of the rest of Wall Street wrongdoing.
- Company guilty pleas are strange things. They either mean nothing - corporate persons don't feel bad for being convicted, can't be put in jail, and absent alternative consequences, would you rather your closely held corporation paid a fine, or stood up in court and said "I did it"? Or they mean far too much - an auditor like Arthur Andersen could literally no longer audit after it was convicted of a crime.
- Which is why I think truly serious prosecution is all about individual responsibility. This middle ground isn't quite the get tough attitude that insistence on pleas from natural, rather than corporate, persons would be.
- This podcast of Joseph Grundfest on the SAC insider trading investigation is admirably clear.
- Should Goldman really be seeking restitution from Gupta? Here's their restitution memo opp, and here's Gupta's.
- And here's Frontline on the lack of criminal proseuctions in the wake of the financial crisis.
Matt Levine over at Dealbreaker suspects that the answer is yes:
The paradigmatic SEC investigation – “find an insider trader through phone records” – is about drilling down, not broadening out. It starts from a suggestive general pattern – “boy SAC makes a lot of money” – and looks for the one specific fact to nail somebody. The financial regulators you’d really want would start from specific facts and look for the general pattern. They’d spend years looking for broad problems with systems, not phone records to prove a single instance of wrongdoing by a single person. These SEC lawyers – the ones held up as models of SEC enforcement, the ones responsible for the SEC’s one post-crisis success story – should have been finding Bin Laden, not overseeing a financial system.
Kinnucan is the expert network operator who refused to wear a wire and was indicted for insider trading. He was just sentenced to four years in prison, and he did things that expert networks do:
He admitted to supplying customers with confidential data about companies including SanDisk and Flextronics. Prosecutors said Mr. Kinnucan had built a deep network of sources at public companies by paying them cash and providing them with illegal tips.
It does sound fishy, doesn't it? But that's kind of what expert networks do, as the Wall Street Journal has been saying for a while:
Generally speaking, expert-network firms link industry experts with hedge-fund managers and other professional traders for a fee.
Expert-networking firms started springing up in the early part of the last decade, after the SEC attempted to crack down on the practice of companies selectively disclosing information to analysts and other. Writes the WSJ’s Greg Zuckerman and Susan Pulliam in this 2010 story:
In 2000, the Securities and Exchange Commission attempted to make markets fairer by introducing rules barring companies from selectively disclosing material information to favored investors and analysts, a common practice during the 1990s technology bubble.
The SEC rule, Regulation Fair Disclosure, barred investor-relations professionals and other senior executives at public companies from selectively disclosing market-moving information to analysts and investors. The SEC said Reg FD would “bring all investors, regardless of the size of their holdings, into the information loop.”
But a back-door method was discovered to help big investors find an edge: companies offering to match “experts,” such as midlevel executives at various companies, with investors.
Indeed, the network experts continue to crop up in this continuing wave of insider-trading cases.
I'm not sure if these outfits are now doomed, but it must take some strong nerves to operate one these days. It's anecdotal, but my students at Wharton, fwiw, report turning to these networks quite a bit before coming for their MBAs.
It looks like the DC Circuit will say no, in a case of interest to those bemused by the massive number of deferred prosecution agreements signed by corporations in white collar crime/securities violation situations. Sometime those DPAs include corporate monitoring requirements. One enterprising reporter requested AIG's consent decree monitor reports after the firm went belly-up, hopeful that it would tell her something about the financial crisis:
AIG agreed to the final judgment in Washington federal district court in November 2004 with the SEC without admitting or denying the allegations, rooted in transactions between AIG and PNC Bank. The company agreed to give up $46.3 million in profit in the SEC civil action. DOJ entered a deferred prosecution agreement with AIG that same month in federal district court in Pennsylvania.
The terms of the deal with the SEC required AIG to hire an independent consultant to, among other things, keep tabs on the work of AIG's "transaction review committee." The committee was tasked with reviewing transactions that "involved heightened legal or regulatory risk because of the dangers of questionable accounting by counterparties," AIG lawyers said in court papers.
It would be interesting to know what that consultant thought about all of AIG's unhedged credit insurance activity, wouldn't it? But is it a judicial record? Even though the court never saw it? It sounds like the DC Circuit will not conclude that keeping the report in camera is akin to holding private trials. And more's the pity for those who want to know more about the collapse of AIG ... or the usefulness of corporate monitoring consent decrees.
One can go back and forth on the merits of the SEC's obsession with insider trading, but the Martoma SAC Capital case looks pretty damning. You don't want to prejudge. But it looks like:
a) an SAC analyst obtained inside information from a tipper breaching his fiduciary duty to his employer (who had hired him to do a study on a new drug)
b) the analyst must have known that the tipper was breaching his fiduciary duty (though he denies that he has done anything wrong).
c) the analyst, on the basis of the information, told Cohen to trade the stock.
d) Cohen did so.
That sounds like a slum dunk case that SAC Capital committed insider trading, if only a corporation (or partnership or whatever) could do so. The only question is whether Cohen himself (as opposed to his hedge fund) knew that the advice he was getting was based on inside information, right? The idea would be that he didn't ask his analyst what the basis was for his recommendation that he dump a centimillion dollar stake in a stock? Culpable intent is an O'Hagan requirement, as I (and Brian Carr) understand it. I like to defer to others when it comes to 10b-5, so if you have any advice in the comments, I'd be happy to hear it.
Below is the Times's nifty graphic on the other issues faced by SAC, if you haven't seen it.
As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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For most of us, poor Allen Stanford dropped off of our radars awhile ago. Even though he was accused of a $7 billion Ponzi-like scheme involving certificate of deposits in Antigua, he had the misfortune of being eclipsed by Bernie Madoff, who will go down in history as the biggest swindler in U.S. history since Carlo Ponzi. Stanford is a mere also-ran, who didn't have the attractive family, fancy and famous clientele, or New York presence to garner much press attention. Even his bizarre pre-trial antics didn't whip up much attention.
However, Stanford is set to be sentenced this week in Houston after having been convicted on multiple counts of fraud earlier this year. Peter Henning dissects the prosecution's request for a maximum sentence that would exceed Madoff's 150-year sentence. Madoff's sentence was interesting not only for its length and its symbolic value, but also for its being applied to a case in which the defendant quickly pled guilty and at least appeared to cooperate. Stanford isn't that easy to work with and has continued to protest his innocence.
As Peter notes, several white-collar cases in the post-Enron era have garnered lengthy sentences, reflecting the sense that wiping out individual's savings is akin to "economic homicide," worthy of murder-like punishments. I also wrote about this trend here (Enron)and here (Madoff), musing that our 401(k)s are now our castles, not our homes.
Anyway, if Stanford wants to be in the history books, he needs to hit 151.
Thanks to Erik Gerding for the opportunity to share some of my ideas on corporate criminal liability, Dodd-Frank, corporate influences on individual behavior and educating today's law students only three months into my new academic career. I appreciate the thoughtful and encouraging emails I received from many of you. I even received a request for an interview from the Wall Street Journal after a reporter read my two blog posts on Dodd-Frank conflicts minerals governance disclosures. We had a lengthy conversation and although I only had one quote, he did link to the Conglomerate posts and for that I am very grateful.
I plan to make this site required reading for my seminar students, and look forward to continuing to learn from you all.
Best wishes for the holiday season and new year.
Time Magazine’s “person of the year” is the “protestor.” Occupy Wall Street’s participants have generated discussion unprecedented in recent years about the role of corporations and their executives in society. The movement has influenced workers and unemployed alike around the world and has clearly shaped the political debate.
But how does a corporation really act? Doesn’t it act through its people? And do those people behave like the members of the homo economicus species acting rationally, selfishly for their greatest material advantage and without consideration about morality, ethics or other people? If so, can a corporation really have a conscience?
In her book Cultivating Conscience: How Good Laws Make Good People, Lynn Stout, a corporate and securities professor at UCLA School of Law argues that the homo economicus model does a poor job of predicting behavior within corporations. Stout takes aim at Oliver Wendell Holmes’ theory of the “bad man” (which forms the basis of homo economicus), Hobbes’ approach in Leviathan, John Stuart Mill’s theory of political economy, and those judges, law professors, regulators and policymakers who focus solely on the law and economics theory that material incentives are the only things that matter.
Citing hundreds of sociological studies that have been replicated around the world over the past fifty years, evolutionary biology, and experimental gaming theory, she concludes that people do not generally behave like the “rational maximizers” that ecomonic theory would predict. In fact other than the 1-3% of the population who are psychopaths, people are “prosocial, ” meaning that they sacrifice to follow ethical rules, or to help or avoid harming others (although interestingly in student studies, economics majors tended to be less prosocial than others).
She recommends a three-factor model for judges, regulators and legislators who want to shape human behavior:
“Unselfish prosocial behavior toward strangers, including unselfish compliance with legal and ethical rules, is triggered by social context, including especially:
(1) instructions from authority
(2) beliefs about others’ prosocial behavior; and
(3) the magnitude of the benefits to others.
Prosocial behavior declines, however, as the personal cost of acting prosocially increases.”
While she focuses on tort, contract and criminal law, her model and criticisms of the homo economicus model may be particularly helpful in the context of understanding corporate behavior. Corporations clearly influence how their people act. Professor Pamela Bucy, for example, argues that government should only be able to convict a corporation if it proves that the corporate ethos encouraged agents of the corporation to commit the criminal act. That corporate ethos results from individuals working together toward corporate goals.
Stout observes that an entire generation of business and political leaders has been taught that people only respond to material incentives, which leads to poor planning that can have devastating results by steering naturally prosocial people to toward unethical or illegal behavior. She warns against “rais[ing] the cost of conscience,” stating that “if we want people to be good, we must not tempt them to be bad.”
In her forthcoming article “Killing Conscience: The Unintended Behavioral Consequences of ‘Pay for Performance,’” she applies behavioral science to incentive based-pay. She points to the savings and loans crisis of the 80's, the recent teacher cheating scandals on standardized tests, Enron, Worldcom, the 2008 credit crisis, which stemmed in part from performance-based bonuses that tempted brokers to approve risky loans, and Bear Sterns and AIG executives who bet on risky derivatives. She disagrees with those who say that that those incentive plans were poorly designed, arguing instead that excessive reliance on even well designed ex-ante incentive plans can “snuff out” or suppress conscience and create “psycopathogenic” environments, and has done so as evidenced by “a disturbing outbreak of executive-driven corporate frauds, scandals and failures.” She further notes that the pay for performance movement has produced less than stellar improvement in the performance and profitability of most US companies.
She advocates instead for trust-based” compensation arrangements, which take into account the parties’ capacity for prosocial behavior rather than leading employees to believe that the employer rewards selfish behavior. This is especially true if that reward tempts employees to engage in fraudulent or opportunistic behavior if that is the only way to realistically achieve the performance metric.
Applying her three factor model looks like this: Does the company’s messaging tell employees that it doesn’t care about ethics? Is it rewarding other people to act in the same way? And is it signaling that there is nothing wrong with unethical behavior or that there are no victims? This theory fits in nicely with the Bucy corporate ethos paradigm described above.
Stout proposes modest, nonmaterial rewards such as greater job responsibilities, public recognition, and more reasonable cash awards based upon subjective, ex post evaluations on the employee’s performance, and cites studies indicating that most employees thrive and are more creative in environments that don’t focus on ex ante monetary incentives. She yearns for the pre 162(m) days when the tax code didn’t require corporations to tie executive pay over one million dollars to performance metrics.
Stout’s application of these behavioral science theories provide guidance that lawmakers and others may want to consider as they look at legislation to prevent or at least mitigate the next corporate scandal. She also provides food for thought for those in corporate America who want to change the dynamics and trust factors within their organizations, and by extension their employee base, shareholders and the general population.
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Massey Energy and Walmart made headlines last week for different reasons. Massey had the worst mining disaster in 40 years, killing 29 employees and entered into a nonprescution agreement with the Department of Justice. The DOJ has stated in the past that these agreements balance the interests of penalizing offending companies, compensating victims and stopping criminal conduct “without the loss of jobs, the loss of pensions, and other significant negative consequences to innocent parties who played no role in the criminal conduct, were unaware of it, or were unable to prevent it.”
Massey’s new owner Alpha Natural Resources, has agreed to pay $210 million dollars in fines to the government, compensation to the families of the deceased miners and for safety improvements (the latter may be tax-deductible). The government’s 972-page report concluded that the root cause was Massey’s “systematic, intentional and aggressive efforts” to conceal life threatening safety violations. The company maintained a doctored set of safety records for investigators, intimidated workers who complained of safety issues, warned miners when inspectors were coming (a crime), and had 370 violations. The mine had been shut down 48 times in the previous year and reopened once violations were fixed. 112 miners had had no basic safety training at all. Only one executive has been convicted of destroying documents and obstruction, and investigations on other executives are pending. However, the company itself has escaped prosecution for violations of the Mine Safety and Health Act, conspiracy or obstruction of justice. Perhaps new ownership swayed prosecutors and if Massey had its same owners, things would be different. But is this really justice? The miner’s families receiving the settlement certainly don’t think so.
Walmart announced in its 10-Q that based upon a compliance review and other sources (Dodd-Frank whistleblowers maybe?), it had informed both the SEC and DOJ that it was conducting a worldwide review of its practices to ensure that there were no violations of the Foreign Corrupt Practices Act (“FCPA”). Although no facts have come out in the Walmart case and I have no personal knowledge of the circumstances, let’s assume for the sake of this post that Walmart has a robust compliance program, which takes a risk based approach to training its two million employees in what they need to know (the greeter in Tulsa may not need in-depth training on bribery and corruption but the warehouse manager and office workers in Brazil and China do). Let’s also assume that Walmart can hire the best attorneys, investigators and consultants around, and based on their advice, chose to disclose to the government that they were conducting an internal investigation. Let’s further assume that the incidents are not widespread and may involve a few rogue managers around the world, who have chosen to ignore the training and the policies and a strong tone at the top.
As is common today, let’s also assume that depending on what they find, the company will do what every good “corporate citizen” does to avoid indictment --disclose all factual findings and underlying information of its internal investigation, waive the attorney client privilege and work product protection, fire employees, replace management, possibly cut off payment of legal fees for those under investigation, and actively participate in any government investigations of employees, competitors, agents and vendors.
Should this idealized version of Walmart be treated the same as Massey Energy? (For a great compilation of essays on the potential conflicts between the company and its employees, read Prosecutors in the Boardroom: Using Criminal Law to Regulate Corporate Conduct, edited by Anthony and Rachel Barkow). Should they both be charged and face trial or should they get deferred or nonprosecution agreements for cooperation? Do these NPAs and DPAs erode our sense of justice or should there be an additional alternative for companies that have done the right thing -- an affirmative defense?
A discussion of the history of corporate criminal liability would be too detailed for this post, but in its most simplistic form, ever since the 1909 case of New York Central & Hudson River Railroad Co v. United States, companies have endured strict liability for the criminal acts of employees who were acting within the scope of their employment and who were motivated in part by an intent to benefit the corporation. As case law has evolved, companies face this liability even if the employee flouted clear rules and mandates and the company has a state of the art compliance program and corporate culture. In reality, no matter how much money, time or effort a company spends to train and inculcate values into its employees, agents and vendors, there is no guarantee that their employees will neither intentionally nor unintentionally violate the law.
The DOJ has reiterated this 1909 standard in its policy documents. And because so few corporations go to trial and instead enter into DPAs or NPAs, we don’t know whether the compliance programs in place would have led to either the potential 400% increase or 95% decrease in fines and penalties under the Federal Sentencing Guidelines because judges aren’t making those determinations. The DPAs are now providing more information about corporate compliance reporting provisions, but again, even if a company already had all of those practices in place, and a rogue group of employees ignored them, the company faces the criminal liability. The Ethical Resource Center is preparing a report in celebration of the 20th Anniversary of the Sentencing Guidelines with recommendations for the U.S. Sentencing Commission, members of Congress, the DOJ and other enforcement agencies. They are excellent and timely, but they do not go far enough.
A Massey Energy should not receive the same treatment as my idealized model corporate citizen Walmart. Instead, I agree with Larry Thompson, formerly of the DOJ and now a general counsel and others who propose an affirmative defense for an effective compliance program- not simply as possible reduction in a fine or a DPA or NPA.
While the ideal standard would require prosecutors to prove that upper management was willfully blind or negligent regarding the conduct, this proposed standard may presume corporate involvement or condonation of wrongful conduct but allow the company to rebut this presumption with a defense.
In the past decade, companies drastically changed their antiharassment programs after the Supreme Court cases of Fargher and Ellerth allowed for an affirmative defense. The UK Bribery Act also allows for an affirmative defense for implementing “adequate procedures” with six principles of bribery prevention. Interestingly, they too are looking at instituting DPAs.
I would limit a proposed affirmative defense to when nonpolicymaking employees have committed misconduct contrary to law, policy or management instructions. If the company adopted or ratified the conduct and/or did not correct it, it could not avail itself of the defense. The company would have to prove by a preponderance of the evidence that: it has implemented a state of the art program approved and overseen by the board or a designated committee; clearly communicated the corporation’s intent to comply with the law and announced employee penalties for prohibited acts; met or exceeded industry standards and norms; is periodically audited and benchmarked by a third party and has made modifications if necessary; has financial incentives for lawful and penalties unlawful behavior; elevated the compliance officer to report directly to the board or a designated committee (a suggestion rejected in the 2010 amendments to the Sentencing Guidelines); has consistently applied anti-retaliation policies for whistleblowers; voluntarily reported wrongdoing to authorities when appropriate; and of course taken into account what the DOJ has required of offending companies and which is now becoming the standard. The court should have to rule on the defense pre-trial.
Instead of serving as vicarious or deputized prosecutors, under this proposed standard, a corporation’s cooperation with prosecutors will be based on factors more within the corporation's control,rather than the catch-22 they currently face where if employees are guilty, there is no defense. And if the employees are guilty, this would not preclude the government from prosecuting them, as they should.
Responsible corporations now spend significant sums on compliance programs and the reward is simply a reduction in a fine for conduct for which it is vicariously liable and which its policies strictly prohibited. A defense will promote earlier detection and remedying of the wrongdoing, reduce government expenditures, provide more assurance to investors and regulators, allow the government to focus on companies that don’t have effective compliance program, and most important provide incentives for companies to invest in more state of the art programs rather than a cosmetic, check the box initiative because the standard would be higher than what is currently Sentencing Guidelines.
Perhaps only a small number of companies may be able to prevail with this defense. Frankly, corporations won’t want to bear the risk of a trial, but they will at least have a better negotiating position with prosecutors. Moreover, companies that try in good faith to do the right thing won’t be lumped into the same categories as those who invest in the least expensive programs that may pass muster or worse, engage in clearly intentional criminal behavior. If companies have the certainty that there is a chance to use a defense, that will invariably lead to stronger programs that can truly detect and prevent criminal behavior.
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