True sales: a refresher

Securitization remains an important tool for companies to realize value from future payment streams and raise financing, typically at a better cost of funds than the interest expense associated with a corporate loan or bond. While there are many different ways to structure a securitization transaction, it is of paramount importance to isolate the relevant cash-generating assets from the potential default and bankruptcy risk of the corporation. A typical transaction structure involves the sale of defined cash-generating assets (e.g., loans, accounts receivable) of a company to a bankruptcy-remote special purpose vehicle that issues securities to investors in order to raise funds for the company (the issuer).

True sales

The sale by the company must completely transfer the assets to the issuer (and remove those assets from the estate of the company) to be an effective “true sale”. A true sale provides the issuer’s creditors with assurances that in the event the company defaults or becomes bankrupt or insolvent its creditors will not have access to the assets sold to the issuer. Conversely, the company achieves present value monetization of future cash streams and optimal cost of funds for its financing needs. If improperly structured, a securitization transaction may be re-characterized by a court as a financing transaction.

Factors in true sale transactions

The leading case relating to the characterization of securitization transactions is the trial decision from Metropolitan Toronto Police Widows & Orphans Fund v Telus Communications (Widows & Orphans). In Widows & Orphans, the Ontario Superior Court held that, in addition to looking to the substance, and not merely the form, of the transaction and the intention of the parties, the factors considered by the courts in determining whether a transaction constitutes a true sale are:

  1. the transfer of ownership risk and the level of recourse;
  2. the ability to identify the assets sold;
  3. the ability to calculate the purchase price; and
  4. whether the return to the purchaser will be more than its initial investment and a calculated yield on such investment.

Additional factors to be considered in the case of a sale of receivables are:

  1. the right to retain surplus collections;
  2. a right of redemption;
  3. the responsibility for collection of the accounts receivables; and
  4. the ability of the vendor to extinguish the purchaser’s rights from sources other than the collection of the receivables.

More recently, in Coutinho & Ferrostaal GmbH v. Tracomex (Canada) Ltd., the British Columbia Supreme Court applied the factors set out in Widows & Orphans to a transaction involving steel rail. In this case the express language of the agreement indicated the transaction was a purchase and sale; there was no reference to loans, interest payments or security. Applying the Widows & Orphans principles, the Court looked to the “substance” or “true nature” of the transaction and found that it was a financing arrangement, upon consideration of the following factors:

  • written communications between the parties during the negotiation of the agreement proposed a “financing” transaction;
  • the “sale price” of the steel rail was considerably lower than the market value;
  • there was a right of repurchase at the vendor’s option, which was expected to be exercised and where the repurchase price seemed to be based on an interest calculation; and
  • the vendor continued to pay general liability insurance for the steel rail and agreed to reimburse the purchaser for storage cost if the right of repurchase was exercised.

Given that a number of the facts in the Coutinho case were consistent with a financing transaction, the decision seems to indicate a continuing reluctance of Canadian courts to re-characterize a sale of cashflow-generating assets as a secured financing when the transaction has been documented as a sale. The court, after weighing the factors, respected the form of the contract as an objective indication of the intention of the parties. Notwithstanding this approach of Canadian courts, any securitization involves a careful legal structuring based on application of the case law to the facts at hand, typically supported by a legal opinion.

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

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Governing law clauses: “without regard to conflict of law”

Contracting parties will typically consider a “governing law” provision, which identifies the proper law of a contract by express intention. A governing law provision applies to the substantive issues of the contract, provided that it is bona fide, legal and not contrary to public policy. Such provisions will identify the preferred jurisdiction of governing law of a contract (e.g., “the laws of Ontario”, “the federal laws of Canada”, etc.), clarifying the intention of the parties regardless of which court has jurisdiction over a dispute.

Oftentimes, the governing law provision will also include the phrase, “without regard to conflict of law principles”. But, what does this phrase mean? There are two primary reasons for the exclusion of the principles of conflict of laws in a governing law provision.

First, express exclusion of conflict of laws principles prohibits a future argument from either party that conflict of laws principles require a court to apply the laws of a jurisdiction other than the express jurisdiction of governing law. Second, the express exclusion of conflict of laws principles is useful in avoiding a renvoi – which is where a court will refer to the laws of a foreign jurisdiction in a matter involving a conflict of law. In some instances, a renvoi may result in the intention of the parties being lost. Exclusion of conflict of laws principles clarifies that the parties intend that the governing law expressly indicated in the contract is to apply.

The phrase “without regard to conflict of law principles” may be glossed over by a contracting party. Although, however cursory this phrase may appear to be, it is an important inclusion in a contract to avoid the imposition of the laws of another jurisdiction despite the intention of the contracting parties.

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Incoming legislation implements common reporting standards

On July 1, amendments to the Income Tax Act (Canada) implementing international common reporting standards (CRS) will come into force. The CRS regime is intended to facilitate the exchange of taxpayer information between governments. Financial institutions will be required to report financial information about individuals and entities not resident in Canada[1] to the Canada Revenue Agency (CRA), which will in turn share the information with the tax authorities in the individual or entity’s jurisdiction of residence.

Due diligence obligations

Under CRS, financial institutions in Canada will be required to conduct due diligence on all financial accounts they maintain that are in existence prior to July 1, 2017. Financial accounts are defined broadly under CRS and include not just bank accounts, but most types of investment accounts, most types of investments in investment funds, and certain insurance contracts.

Financial institutions must determine, based on information already in their possession, whether any of their account holders have certain indicia of residence in jurisdictions other than Canada. If such indicia are found, the financial institution is generally required to report information about the account to the CRA. The information that must be reported includes the value or balance of the account, and in many cases also includes the flow of funds into and out of the account. Financial institutions are also required to conduct due diligence on the holders of any accounts opened after June 30, 2017 by obtaining a self-certification from the account holder identifying the account holder’s jurisdiction of residence.

As a result of these rules, detailed information about the accounts of foreign investors who set up financial accounts in Canada will be reported to the CRA and to the tax authorities in the investors’ home jurisdictions.

Identification of controlling persons

Even if an account holder is a Canadian resident entity (such as a corporation, partnership, or a trust), the account holder may still be required to provide its financial institution with a list of its “controlling persons”, including their jurisdiction of residence.

Once a financial institution determines that an entity is a Canadian resident, it is required to obtain a self-certification from the account holder identifying whether it is a passive non-financial entity (Passive NFE). If the holder certifies itself as a Passive NFE, it must also identify its controlling persons and their jurisdiction of residence. For CRS purposes, controlling persons are any natural persons who exercise control of the entity. The legislation deems certain individuals to be controlling persons of trusts and other entities. In the case of corporations, the CRA’s published administrative policy identifies the controlling persons as any natural person who owns at least 25% of the shares of the corporation, or, if no such natural person exists, the directors and senior officers of the corporation.   If any of the controlling persons are non-residents of Canada, the financial institution must report the account and the non-resident controlling persons.

Passive NFEs are generally any entities other than financial institutions and active non-financial entities (Active NFEs). An entity will generally be an active NFE if interests in the entity, or its parent company, are traded on an established securities market or if less than 50% of the entity’s income is passive income. Generally, if an entity is not a private company (or controlled by a private company) and earns at least 50% of its income as passive income, it will generally be required to identify its controlling persons.

What does this mean for investors?

The compliance burden on most investors that acquire Canadian businesses will likely be quite small, involving no more than completing self-certifications. However, anyone looking to acquire a Canadian business should be aware that, as of July 1, 2017, their Canadian holdings may be reported to the CRA, and then to their local taxation authorities.

Canadian investors looking to acquire businesses in foreign jurisdictions aren’t in the clear either. Jurisdictions around the world are implementing similar CRS regimes. Canadians investing into foreign jurisdictions may soon finds their investments reported to foreign tax authorities and shared with the CRA.

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[1] Other than entities resident in the United States, which are dealt with under a similar regime commonly referred to as FATCA.

Trend report: increased M&A deal values across the Americas for Q1 2017

On April 25, Mergermarket released its Q1 2017 Regional Flash Reports describing the M&A climate, trends and developments throughout the Americas during the first quarter of 2017.

The Canada’s Trend Report indicates that Canadian M&A has remained strong with 111 deals in Q1 2017 worth US$ 35.8bn. This is a robust start for 2017 as compared to the 151 deals in Q1 2016 representing US $17.1bn, and is in line with the trend of higher valuations for fewer deals as seen across the globe. The top Canadian sector for Q1 2017 was Energy, Mining and Utilities (EMU) with 28 deals worth US$ 26.3bn.

Top sectors for other regions across the Americas were reported to be Pharma, Medical & Biotech (PMB), EMU and Consumer, with EMU as a whole being the top global sector.

The New England region reported 99 deals worth US$ 14.2bn in Q1 2017 representing a 15.1% increase in comparison to Q1 2016. The top sector in this region was PMB which saw a 12.5% increase in value compared to Q1 2016.

The Mid-Atlantic region saw 188 deals worth US$ 45bn in Q1 2017 representing an increase of 84% as compared to the first quarter in 2016. The top sector was EMU, which dominated the region with an increase of almost 27 times the value from Q1 2016.

The Southeast region saw 194 deals worth US$ 83.1bn in Q1 2017 representing an increase in value of 198.2% compared to Q1 2016 notwithstanding a decrease in the number of deals. The top sector for this region was Consumer with a deal value of US$ 60.9bn.

The Midwest region reported 247 deals with a value of US$ 42.7bn in Q1 2017 which represented a loss in value as compared to the record high seen in Q1 2015 of US$ 122.5bn. The top sector in this region was Consumer with 28 deals worth US$ 22.3bn.

The Southwest region reported 191 deals worth US$ 85.7bn in Q1 2017 representing an increase in value of 66.8% as compared to Q1 2016. EMU was the top sector dominating the region with a value of US$ 66.9bn representing a 125.2% increase compared to last year’s first quarter.

The West Coast region saw 255 deals worth US$ 33.7bn in Q1 2017 representing a decrease in value of 8.4% compared to Q1 2016. PMB was the top sector for the region with 30 deals worth US$ 14.9bn.

Latin America reported a decrease in deal value for Q1 2017 as compared the last year’s first quarter, with a value of US$ 13.2bn. The leading sector for this region was Consumer with 17 deals worth US$ 4.3bn.

Overall, Mergermarket’s Flash Reports have indicated a strong start for M&A in Q1 2017 with deal values on the rise for the majority of regions across the Americas.

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

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Mining resurgence in M&A: proceed with caution

Earlier this year, KPMG released its Mining M&A Newsletter for the second half of 2016. According to the report, deal volume as well as deal value increased in the second half of 2016 due to a large North American merger. In fact, deal value more than doubled from the first half of 2016 to the second. In addition, for the first time in two years, the number of deals completed for producing assets grew significantly, also doubling its first half 2016 numbers.

For Canadian deals, it was reported that deal volume rose 16% in 2016, while deal value remained essentially the same. Of note was that 2016 only saw one deal valued at over US$1 billion. This seems to indicate a trend towards a higher volume of deals as opposed to fewer larger deals.

While many may view these trends with optimism, potential acquirers must be cautious in the midst of regulatory uncertainty in overseas operations of Canadian-registered mining companies. As mentioned in our previous post regarding parent-subsidiary liability, the 2015 election campaign saw the Liberal Party making promises regarding corporate social responsibility abroad. In particular, it was suggested that the Liberal Government would take a stricter approach with Canadian mining companies.

Currently there is no Canadian law that directly regulates Canadian mining companies abroad. However, a Liberal Party representative was quoted as saying that he expected to see a plan for the creation of a mining ombudsperson “by March 2017”. Talks of creating an ombudsperson in the extractive sector began back in November 2016, although we have yet to see a plan put in place.

Nevertheless, it would be prudent for potential acquirers to assess the potential impact associated with stricter regulatory rules governing mining abroad, as well as mitigate risks by taking actions such as obtaining legal advice and engaging in additional due diligence.

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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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