Earn-out trends: continued

Back in April 2015, we discussed key questions to keep in mind when negotiating earn-outs, and looked at recent trends coming out of the American Bar Association’s 2014 Canadian Private Target M&A Deal Points Study (the 2014 ABA Study). As the ABA has now published its 2016 study (the 2016 ABA Study), we thought it may present a good opportunity to revisit the topic and look at some key earn-out trends.

General use of earn-outs

The 2016 ABA Study showed a decrease of earn-out clauses present in the transactions surveyed down to 17% from the 25% level in the 2014 ABA Study, and the 21% level in the American Bar Association’s 2012 Canadian Private Target M&A Deal Points Study.

Performance metrics

One of the most important steps in structuring an earn-out is determining and clearly defining the performance metrics to be used. Based on the 2016 ABA Study, it seems that financial metrics are becoming increasingly popular. Out of the earn-out clauses evaluated, 25% of them used top-line revenue as a metric and 38% used an earnings based metric, while only 19% (down from 53% in 2014) used some other form, which included non-financial metrics. While sellers will typically tend to prefer more clear cut and harder to manipulate metrics such as revenues, and purchasers often prefer an earnings-based metric (having valued the transaction based on earnings), there are some isolated instances (6% in the 2016 ABA Study) where the parties have structured the earn-out using both revenue and earnings metrics.

Time period

Earn-out periods between one and three years have consistently been the most common in terms of Canadian M&A transactions in recent years. The 2016 ABA Study is notable in that there were no transactions that used an earn-out period of four years or longer, compared to 20% in the 2014 ABA Study. It is possible that companies are finding that longer earn-out periods are unnecessarily delaying full integration of the business, or that sellers are unwilling to increase the long-term performance risk they take on, particularly as their impact and influence on the organization’s performance would typically be expected to decrease over time.

Acceleration clauses

One trend that is picking up steam is the inclusion of express acceleration provisions in earn out mechanisms, which are triggered upon the occurrence of certain events. As discussed in our previous post, an acceleration of the earn-out can be beneficial to the purchaser or the seller depending on the circumstances. The ability for a purchaser to “buy-out” an earn-out payment can provide for greater flexibility if the future of the company is different than what was predicted. This may be the reason for the sharp increase of earn-out transactions containing an express acceleration clause. While only 7% of transactions contained such a clause in the 2014 ABA Study, the 2016 ABA Study found that 31% of transactions had an express acceleration clause.

While the total number of earn-out clauses present in the transactions surveyed by the ABA decreased from its previous study, they still remain a useful tool to benefit both the purchaser and the seller, and should be carefully considered when completing a transaction.

The author would like to thank Simone Nash, articling student, for her assistance in preparing this legal update.

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Set up for success? Difficulties in M&A integration

In a previous post, we discussed the impact that deal team size can have on post transaction synergies. A recent report from PwC makes clear that pitfalls in the M&A process hardly disappear once the parties have determined the make-up of their deal team. Indeed, the report suggests that without early planning, rapid execution and long-term commitment to integration completion, it will be difficult for a merger or acquisition to achieve its goals and deliver value. In an era of growing workplace diversity where numerous industries are undergoing digital disruption, this can be easier said than done.

Transformational change

The question of post-deal integration has become all the more pressing due to the rise in transformational deals, meaning those that involve acquiring new markets, channels, products or operations in a way that is transformative to the fully integrated organization. 54% of Fortune 1000 survey respondents indicated the largest deal their company had completed in the previous 3 years was transformational, up from 29% of respondents in 2010.

This rise is explained by the consolidation that took place in many sectors of the economy during the global recession between 2007-2009, as well as the increasing impact of technology on everyday economic activities. As a result, companies have turned to deal making in order to obtain the capabilities needed to be competitive. However, in certain cases, this can require integrating markedly different work cultures and business models.

Strategy and execution risks are particularly acute in transformational deals, and this was borne out by the experience of M&A participants. For example, of the 78% of respondents who stated growth in market share was a very important objective for their deal, only 15% said this had been completely achieved. Further, access to new brands, products or technologies was cited as a very important deal objective by 72% of respondents, yet only 29% reported this was completely achieved. Interestingly, strategic success was more elusive for acquirers that had done over 8 deals (50%) than for companies that had done 3 deals or fewer (66%) since 2013.

Integration success leads to financial success

Companies reported that M&A transactions have had a favourable impact with respect to both profitability and cash flow, while also leading to notable progress in capturing revenue and cost synergies. According to PwC, in many cases, these positive financial outcomes can be attributed to the implementation of leading practices in M&A integration and value realization. Unsurprisingly, respondents suggested they had placed increased emphasis on certain key areas within 6 months of closing, namely leadership alignment, stakeholder communication and operating policy integration.

Companies have also turned their minds to integration at an earlier stage in the M&A process. In 2013, 44% of respondents indicated their integration team became involved at the due diligence stage, while the plurality of respondents (32%) now state the involvement begins at the deal screening stage. The earlier involvement of integration teams is another by-product of transformational deals, as executives and board members demand greater scrutiny and more careful planning before moving into new commercial spaces.

However, this earlier involvement is not enough to completely mitigate the difficulties posed by the integration of people, IT systems, go-to-market objectives, and geographies and legal entities. In particular, employee retention was highlighted as a challenge in the post-deal context, as respondents remarked upon a drop in morale and a lack of understanding of the company’s future direction. To this end, deploying a cross-functional team to engage each of these areas, or better yet, designing an Integration Management Office, can help companies clear these hurdles at the appropriate time. Ultimately, deals are more likely to prove successful under the supervision of dedicated leaders and personnel.

The author would like to thank Brian Peebles, Articling Student, for his assistance in preparing this legal update.

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Socially responsible investing: considerations for private companies

Certain consumers seeking out companies that have socially responsible products and services or that have a focus on environmental, social and corporate governance (ESG) is nothing new. Recently, however, evidence has emerged suggesting that investors, both retail and institutional, are increasingly taking these social factors into account when making decisions about how to allocate their investments.

Responsible investing

According to a recent study by the Responsible Investment Association, the Canadian market for responsible investments has grown by 49% over the past two years and has surpassed $1.5 trillion in assets under management. This suggests that Canadians are becoming more willing to support social causes not just through their consumption choices, but also through their investments.

While currently the majority of assets under management in the responsible investment segment are held in public companies, private companies can leverage this shift in consumer sentiment to increase their appeal to outside investors and potential acquirers who consider ethical or socially responsible factors when making investment decisions.

In the United States, there is evidence of this type of strategy already paying off for private companies. For instance, there are several venture capital firms who concentrate on investing in companies that have an ESG or ethical business focus. Most notably is DBL Partners (the DBL stands for double bottom line) which was an early-stage investor in both Tesla Motors and SolarCity. In Canada, change has been less significant and there are fewer institutional investors focussing on the ESG space. However, several Canadian investment advisors have added socially responsible investment funds to their rosters and some online brokerages now have the capacity to sort and filter stocks based on ESG factors.

The Canadian market

These trends provide two takeaways for private Canadian companies. First, companies that already have a focus on socially responsible products or practices should emphasize these attributes when considering a change of control transaction. Even if a potential acquiror does not have a specific focus on their ESG reputation, by highlighting its socially responsible credentials, a target may be able to extract a higher price from an acquiror.

Second, companies with a socially responsible focus should keep apprised of financing opportunities geared towards this niche. While private equity or venture capital funds with a specific focus on responsible investing may not be as prevalent in Canada as in the United States, the increased amount of interest in this area by Canadians suggests that such financing opportunities may be available in the near future. In the meantime, other financing tools such as equity crowdfunding or financial cooperatives may be attractive to socially responsible businesses.

The author would like to thank Mark Bissegger, Articling Student, for his assistance in preparing this legal update.

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Strong outlook for pharma and biotech M&A in 2017

While certain sectors experienced a shaky 2016 with respect to M&A activity, deal activity in the pharmaceutical and biotechnology industries held steady following record levels in 2015 and is expected to perform equally as well in 2017. In Prognosis positive: Pharma and biotech M&A outlook, a recent report by Mergermarket (the Report) on these industries, four experienced dealmakers outlined some of the key factors driving the optimistic outlook for the upcoming year and highlighted some of the deal trends that have emerged over the past few years in these industries.

Replacing declining revenues

According to the Report, the declining revenue levels of larger firms in the pharma market (largely brought about by the pricing practices and pressures of Medicare and other third-party providers as well as the expiration of patents of widely-used therapies and drugs) have resulted in a continual search by these companies for new and additional revenue streams. As most of these corporations tend to be highly capitalized with substantial amounts of cash on their balance sheets, they are often in a position to boost growth and revenues inorganically by acquiring and consolidating with smaller players in the market rather than fostering growth organically (and at a slower pace) through the implementation of in-house strategies. Additionally, there is a possibility that the new Trump administration may enact tax reform that permits the repatriation of overseas profits which would increase the funds available to pharma firms to pursue additional acquisitions. With an estimated US$98 billion in offshore cash held by global biopharma companies, such tax reform has the potential to have a significant impact on the number of deals pursued by these firms.

Another key to understanding the strong levels of deal activity in this sector is that irrespective of the performance of the economy as a whole, there is a critical and persistent demand for new drugs and therapies to treat illnesses and diseases. The demographics of North America, and the aging population in particular, will continue to fuel this high level of demand and, in the process, increase M&A levels among biopharma companies.

Continued focus on early-stage development companies

The Report also highlighted a recent shift in focus by acquirers to early stage companies. Approximately 19% of deals in 2016 involved companies with lead assets that had already received approval as compared to 49% five years earlier. Factors motivating firms to seek out acquisition opportunities with smaller, early stage players may be to ensure that there is less competition among bidders, lower valuations of the target (as compared to companies with advanced and well developed products), and the desire by the larger pharma companies to offer multiple drugs or treatment options for the same diseases. Smaller, early stage companies may also seek and encourage such buyers as part of a carefully planned exit strategy where their focus remains on developing products to a certain stage before selling it to an experienced player in the industry in order to avoid the difficult and costly exercise of building the infrastructure that is necessary to commercialize and market drugs and treatment therapies. This has led to a rising number of “option-to-acquire” deals between experienced pharma companies and early stage companies where the interested party purchases an option to acquire the target that is triggered upon the achievement of certain milestones by the early stage company.

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The Canada Infrastructure Bank: big plans for big projects

Last month’s federal budget reaffirmed the government’s plans to establish a new Canada Infrastructure Bank (the Infrastructure Bank) and vest it with the responsibility of spending at least $35 billion in infrastructure over 11 years. The Infrastructure Bank is intended to pool public funds with private investments for infrastructure projects. Along the way, the Infrastructure Bank will build up expertise in packaging, financing and managing projects, so as to attract institutional investors and investment funds.

The Infrastructure Bank goes hand in hand with Prime Minister Trudeau’s desire to attract investments into Canadian infrastructure projects. In the fall of 2016 Mr. Trudeau met with fund managers, including institutional investors and domestic pensions funds to promote the idea of investments in revenue generating public-private partnership (P3) projects.

As Ottawa attempts to woo private investments to Canada, the European market for P3 projects is getting crowded. For example, in the UK, one of the earliest jurisdictions to adopt the P3 model around 30 years ago, institutional investors and private funds are elbowing each other out for territory. Institutional investors are winning the fight and the increased competition is encroaching on the traditionally high returns from the safe infrastructure asset class.

A recent Mergermarker report explains that the large institutional investors have been battling with investment funds for the prized “core” infrastructure projects – those monopolistic transport, energy and environmental projects that provide secure long-term yields. Incidentally, “core” infrastructure projects are exactly the types of projects on offer under Mr. Trudeau’s direction. The Infrastructure Bank will be using loans, loan guarantees and equity investments to finance large transformative projects such as regional transit plans, transportation networks and electricity grid interconnections.

The overall appetite for infrastructure investment remains strong. It’s estimated that $57 trillion in new investment will be needed globally between 2013 to 2030. With this type of demand, many look forward to the establishment of the Infrastructure Bank.

Fortunately, the federal government states that it will propose legislation to establish the Infrastructure Bank soon and has set a public goal to have the Infrastructure Bank operational by late 2017.

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M&A update: Canadian federal budget 2017 tax measures

Yesterday, Budget 2017 was tabled by the Liberal government. While Budget 2016 contained many significant tax changes, Budget 2017 does not. Despite having indicated in its 2015 election platform and in Budget 2016 that the Liberal government intended to eliminate a number of perceived tax advantages it considered were benefitting wealthy Canadians and not the middle class, the Liberal government deferred dealing with those perceived tax advantages, but indicated that a paper would be delivered in the coming months outlining issues and providing proposed policy changes relating to tax planning strategies being used by private corporations that provide tax advantages that may be perceived to be unfair.

Below are a summary of the tax proposals in Budget 2017 that relate to M&A.

Investment fund mergers

Merger of switch corporations into mutual fund trusts

Currently, the Income Tax Act (Canada) (the Act) contains rules that allow for certain mergers of mutual funds on a tax-deferred basis. For example, a merger of two mutual fund trusts or a merger of a mutual fund corporation and a mutual fund trust fall within these rules. However, these rules do not currently allow for the tax-deferred reorganization of a mutual fund corporation into multiple mutual fund trusts. Such a reorganization may be relevant for switch corporations, which are mutual fund corporations with multiple classes of shares, where each class of shares represents a different investment fund.

Budget 2017 proposes to expand the mutual fund merger rules to allow a mutual fund corporation that is a switch corporation to reorganize into multiple mutual fund trusts on a tax-deferred basis. For this measure to apply, in respect of each class of shares of the mutual fund corporation that is or is part of an investment fund, all or substantially all of the assets allocable to that class need to be transferred to a mutual fund trust and the shareholders of that class must become unitholders of that mutual fund trust. This measure will apply to qualifying reorganizations that occur on or after March 22, 2017.

Segregated fund mergers

Segregated funds are life insurance policies that share many similar characteristics to mutual fund trusts; however, unlike mutual fund trusts, segregated funds cannot merge on a tax-deferred basis. Budget 2017 proposes to allow for the merger of segregated funds on a tax-deferred basis to provide consistency between the treatment of segregated funds and mutual fund trusts. It is also proposed that a segregated fund be able to carry over non-capital losses that arise in taxation years that begin after 2017 and apply the non-capital losses in computing its taxable income for taxation years that begin after 2017. The use of these losses will be restricted following mergers of segregated funds. These measures will apply to mergers of segregated funds after 2017 and to losses arising in taxation years that begin after 2017.

For further reading, please see our full report on tax measures regarding Budget 2017.

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New cybersecurity requirements for DFS-regulated entities

Deal Law Wire - Norton Rose FulbrightNew cybersecurity requirements for Department of Financial Services (DFS)-regulated entities took effect on March 1, 2017. The New York DFS created these requirements in response to recent or potential threats to sensitive electronic information, particularly financial information and private consumer information. EY’s report provides an overview of the new framework with implications for the affected entities. A main goal is to protect information systems of the affected entities and the non-public information stored in those systems.

The new cybersecurity requirements include indications for the below-noted areas. An annual statement certifying compliance with these requirements must be submitted to the Superintendent by February 15th. In the context of a M&A transaction, purchasers considering the acquisition of a DFS-regulated entity should conduct effective due diligence to ensure the target is in compliance with these new requirements.

Risk assessment

Each entity must periodically assess the risk to its information systems from a cybersecurity standpoint. This assessment must be in accordance with defined policies and is to inform the cybersecurity program and policies developed under the new requirements.

Cybersecurity program

Each entity must maintain a cybersecurity program that performs enumerated cybersecurity functions including the identification and detection of, protection against, response to, and recovery from cybersecurity events and risks, including an incident response plan. The entity must also manage access to its non-public information by maintaining user access privileges, having policies on data retention, monitoring access, providing training regarding access, and implementing encryption or encryption-like protection for non-public information held or transmitted by the entity, including over external networks. The entity must also ensure that its (or third-party) development of computer applications meet defined security-related standards. Further, the entity must perform penetration testing and vulnerability assessments on its cybersecurity program at a specified frequency and in accordance with the risks identified by its risk assessment.

Cybersecurity policies

Each entity must adopt a written policy or policies that address, as applicable, 14 enumerated items relating to information access management, security, data governance, business continuity and recovery, and risk assessment and response. Further, each entity must adopt written policies applicable to information systems and non-public information that are accessible to its third party service providers.

Chief Information Security Officer (CISO) and personnel

Each entity must designate a CISO who is responsible for managing and enforcing the cybersecurity program and policies. The CISO must prepare a written report to the entity’s board of directors. The entity must also have qualified cybersecurity personnel who are trained in addressing cybersecurity risks.

Notices to Superintendent and record keeping

In the event of a material cybersecurity event, the entity must notify the Superintendent within 72 hours.

Additionally, the entity must maintain records that support its annual certification of compliance with these requirements, as well as certain audit trails that can help support its normal operations and that can detect and respond to material cybersecurity events.

The author would like to thank Larissa Leong, Articling Student, for her assistance in preparing this legal update.

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Trends in U.S. post-deal litigation

As we reported in 2014, United States post-deal litigation became more of a rule than an exception in the early-to-mid 2010s, with over 95% of M&A transactions attracting litigation. In many cases, a single deal could result in multiple suits distributed across state jurisdictions. The majority of these actions were “disclosure-only”, aimed at prompting the target company to make additional disclosure (and generally resulting in large fees for plaintiffs’ counsel) and drew a great deal of criticism from lawmakers and jurists. However, changes may be on their way, led by the state of Delaware.

Delaware developments

In the last two years, a series of Delaware decisions has begun to curtail the post-deal litigation trend. In 2015, Corwin v. KKR Fin. Holdings LLC established the business judgment rule as the standard of review in post-closing damages litigation. The next year, re Trulia rejected a disclosure-only action that would not have resulted in substantial benefit to shareholders. Delaware courts have also recently begun enforcing forum selection clauses in deals in efforts to hamper multi-jurisdictional deal challenges.

A recent paper published by the University of Pennsylvania Law School (the Paper) evaluates the impact that these recent jurisprudential changes have had on the Delaware M&A litigation landscape. Notably, the authors discovered that the percentage of Delaware deals subject to post-closing actions halved between 2015 and 2016, declining to 32%. During the same period, the percentage of settlements rejected by the court rose from close to 0% to around 20% and median attorneys’ fees declined from $500,000 to $275,000. Furthermore, there is evidence that the changes in Delaware have affected the national rate of litigated deals, which declined from 93% to 84% between 2013 and 2014 and more substantially to 64% in 2016. The national decline may be partly attributed to the disappearance of multi-jurisdictional actions related to Delaware matters as a result of forum selection provisions.

Too much of a good thing?

The changes brought on by the Delaware decisions are not without their drawbacks. The authors of the Paper warn that over-zealous restrictions on post-deal litigation is likely to dissuade legitimate claims and thus allow target company boards to act without fear of reprisal. Furthermore, the authors stressed the importance of Delaware’s balancing act to remain the top destination for corporate residency. With other states such as Nevada and New York (in which a state court recently opted not to follow re Trulia) already competing for Delaware’s position, it could be risky to adopt overly defensive standards.

Creative adaptations

The authors of the Paper assert that creative counsel have found and will likely continue to find ways to adapt to the changes. Already, the authors noted a rise in motions for dismissal combined with “mootness” fees as an alternative to traditional challenges (whereby if the plaintiff can establish that an action has resulted in disclosure mooting the litigation, the parties can settle and the defendants generally pay a voluntary “mootness fee” to plaintiff’s counsel). Furthermore, more claims are being brought in federal court, which are outside the restrictions imposed by forum selection clauses. Finally, despite recent limitations on appraisal remedies in Delaware, these actions are more prevalent each year, filling the vacuum left by traditional challenges that have become no longer viable.

Canadian perspective

As we discussed in a previous article, while post-deal litigation has never been as prominent in Canada as it has south of the border, it does still occur. It would therefore benefit Canadian dealmakers to keep informed of the developing scenario in the United States, and in Delaware in particular, which is often looked to by Canadian courts regarding matters of emerging corporate law.

The author would like to thank Peter Charbonneau, Articling Student, for his assistance in preparing this legal update.

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M&A: the subsection 20(24) election

In a business acquisition transaction, it is not uncommon to find an assumption by the purchaser of the obligations of the vendor to deliver goods or perform services in the future for which the vendor has already received payment. In such a scenario, there are two possible outcomes from a tax perspective, as set out below:

No election made under subsection 20(24) of the Income Tax Act

Typically the purchaser would treat the assumed obligation as part of the consideration for the purchase of the business. Where no election is made, the purchaser would not be able to deduct expenses required to fulfill the obligations since the expenses would relate to the acquisition of a capital asset. The vendor would include in its income the payment it receives from its customers but no deduction would be allowed to the vendor since no expenses would have been incurred to fulfill the obligations.

Election made under subsection 20(24) of the Income Tax Act

In contrast, if consideration has been received by the purchaser for the assumption of obligations, an election under subsection 20(24) may be available. The tax burden associated with prepaid income amounts then shifts from the vendor to the purchaser.

In effect, the election allows the vendor to deduct the amount of consideration in respect of the assumed obligations from its income. Meanwhile, the purchaser must recognize that amount in its income but is allowed to deduct any expenses related to the performance of the vendor’s obligations.

When should the election be made?

The execution of an election pursuant to subsection 20(24) is often in the interests of the vendor. Whether making the election is in the purchaser’s interest is dependent upon the amount of the income inclusion, the period over which the deductions may be made and the amounts of those deductions.

Since the election can only be made if both parties agree, it is imperative that both sides determine whether the election is right for them and be prepared to negotiate should the other side disagree.

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The InterOil decision: robust and independent fairness opinion required

A recent decision of the Yukon Court of Appeal, InterOil Corporation v Mulacek, has potentially significant consequences for corporate governance practices in the context of plans of arrangement.

Fairness opinions in plans of arrangement

When a corporation proposes a plan of arrangement to its shareholders, it is generally considered a best practice of corporate governance to obtain a fairness opinion that assesses the financial fairness of the arrangement for affected shareholders. The fact that the directors sought expert financial advice evidences compliance with their fiduciary duties and, when applying for court approval, is an important factor in persuading the court that the plan is “fair and reasonable”.

InterOil Corporation v Mulacek: Yukon Supreme Court decision

The decision in InterOil Corporation v Mulacek suggests that unless the fairness opinion is thorough, balanced and independent, it may be of limited use as evidence that an arrangement is fair and reasonable.

At first instance, the chambers judge approved an arrangement involving the exchange of the shares of InterOil Corporation for shares of Exxon Mobil Corporation valued at $45 per share, plus a capped “contingent resource payment” (CRP). The judge reviewed InterOil’s board process and the fairness opinion obtained from its financial advisor. With respect to the fairness opinion, the judge found that it:

  • Lacked independence because the expert’s fee was contingent on the success of the arrangement;
  • Failed to disclose the details of the contingency fee;
  • Failed to address the value of the resource assets and the impact of the cap on the CRP so that shareholders could consider whether the arrangement reflected that value;
  • Failed to account for the CEO’s significant financial incentive for the arrangement to proceed; and
  • Was otherwise deficient because it failed to refer to specific documents or facts to indicate what the opinion was based on and lacked analysis of that information.

Despite these findings, the judge found the arrangement “fair and reasonable”. 80% of InterOil’s shareholders voted in favour of it and many of the details lacking in the fairness opinion were evident in the information circular.

InterOil Corporation v Mulacek: Yukon Court of Appeal decision

The Court of Appeal reversed this finding. It held that the shareholders were not in a position to make an informed choice as to the value they would be giving up and the value that they would be receiving. For the reasons outlined above, the fairness opinion was inadequate for that purpose.

In addition to the fairness opinion problems, other facts put the fairness of the arrangement in doubt: the CEO was in a position of conflict; the “independent” special committee likely was not independent; and the arrangement was not a “necessity”. Therefore, the inadequacy of the fairness opinion was not the only basis for the decision. However, the Court’s decision still serves to elevate the importance of a robust and independent fairness opinion, particularly where there may otherwise be some question whether the plan is “fair and reasonable”.

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