Supreme Court Affirms Chancery Penalties for Litigation Misconduct

The Supreme Court’s recent affirmance of penalties imposed by the Delaware Court of Chancery for litigation misconduct is a useful tool for litigators of all stripes to brandish as an incentive for both their clients and opposing parties to comply with the rules of the road in connection with obligations to preserve evidence during discovery–and to tell the truth (Yes, some need reminders.)

In Shawe v. Elting, Del. Supr., No. 487, 2016 (Feb. 13, 2017), Delaware’s high court upheld a civil penalty of more than $7 million in legal fees and costs, imposed after a hearing which found that one of the parties in a hotly contested stockholder dispute, engaged in the following bad faith conduct:   (1) intentionally attempting to destroy information on a laptop after the court had entered an order requiring the production of that laptop for forensic discovery and after litigation hold notices were sent; (2) at a minimum recklessly failing to safeguard evidence on a cell phone which was regularly used to exchange text messages among relevant witnesses; and (3) by repeatedly lying in responses to interrogatories and in a deposition to conceal the details about deletion of information from a laptop.

The Chancery Court’s 100-plus page decision on the merits was highlighted on these pagesChancery’s decision imposing penalties was highlighted in this space also. The Supreme Court’s affirmance opinion on the merits was issued on the same day as the decision upholding penalties that is highlighted in this post.  The affirmance on the merits features a vigorous dissent that provides a thought-provoking contrasting analysis on the merits.  Several key takeaways from the Supreme Court’s decision upholding the penalty are featured in the following bullet points:

  • An important point made in upholding the penalty was that there was no requirement that a person succeed in his efforts to thwart the ability of an imposing party to prosecute the merits of the case in order for the court to have the power to impose penalties for discovery abuse or other litigation misconduct.
  • Even if the deleted emails were ultimately recovered, the attempt to delete emails or other data in violation of discovery obligations is a sufficient basis to impose penalties. The recovery of deleted emails does not negate the illicit intent and does not cleanse the bad faith.
  • Moreover, a party need not prove that deleted data was relevant in order for the court to impose penalties for its deletion.
  • A party in litigation has an affirmative duty to preserve potentially relevant evidence and a court may impose penalties on a party who fails to prevent destruction of that evidence.
  • Although a party is not obligated to preserve every email or shred of evidence, it must “preserve what it knows, or reasonably should know, is relevant to the action, is reasonably calculated to lead to the discovery of admissible evidence, is reasonably likely to be requested during discovery and/or is the subject of a pending discovery request.”
  • In order to impose sanctions, such as the shifting of legal fees, a court “need only find that a party had a duty to preserve evidence and breached that duty.”
  • The court described as “incredible” the testimony of the co-CEO that his niece dropped his iPhone in a “cup of Diet Coke,” and then without having a professional try to preserve the data, discarded it after his assistant, who had no expertise in forensic discovery, was unable to retrieve the data after allowing the phone to dry.
  • The court found that the penalty of over $7 million in attorneys’ fees and costs was a civil penalty, and because it was not regarded as a criminal sanction for perjury, the court rejected the arguments regarding due process.

Notably, this seemingly high dollar amount as a penalty for legal fees incurred in connection with failure to comply with discovery obligations, including the deletion of electronically stored data, is not unprecedented in Delaware.  See Genger v. TR Investors, LLC, 26 A.3d 180 (Del. 2011), which was highlighted on these pages.

Court Appoints Lead Counsel in Appraisal Case

Justin M. Forcier, an associate in the Delaware office of Eckert Seamans, prepared this overview.

This case provides guidance to any attorney who would seek an appointment as lead counsel. In re Appraisal of Rouse Props., 12609-VCS (Del. Ch. Dec. 8, 2016)

Background:  On July 6, 2016, Rouse Properties, Inc. (“Rouse”) merged with an affiliate of Brookfield Asset Management, Inc. (“Brookfield”) in an all-cash merger for $18.25 per share.  Following the merger, a group of beneficial owners of Rouse, representing 21% of the pre-merger outstanding stock (the “Minority Petitioners”), filed a complaint seeking appraisal.  In August 2016, a group of former investors who represented 75% of Rouse’s beneficial owners (the “Majority Petitioners”) filed a similar complaint seeking appraisal.  Both groups were represented by different counsel.

During communications between the two parties’ counsel, the Minority Petitioners made clear that, despite any consolidation, they intended to engage and call their own valuation witness and would be free to deviate from the Majority Petitioners’ litigation strategy if they chose to.  Also, the Minority Petitioners would only agree to compensate their counsel, even if the Majority Petitioners’ counsel was chosen as lead.  Counsel for the Majority Petitioners filed a motion for appointment of lead counsel (the “Motion”).

Analysis: In their opposition to the Motion, the Minority Petitioners argued that the court could not grant the Motion because forcing the Majority Petitioners’ counsel on them would deprive the Minority Petitioners the right to “fully participate” in the appraisal action pursuant to 8 Del. C. § 262(h).  They also opposed the Motion because appointment of the Majority Petitioners’ counsel would deprive them of the right to be represented by the counsel of their choice.  Finally, the Minority Petitioners argued that granting the Motion would create negative incentives which should be avoided because their counsel fully intended on carrying their fair share of the workload.

Court’s Holding: The court examined 8 Del. C. § 262(h) and determined that it did not preclude it from overriding an active petitioner’s choice of counsel.  Citing Merriam-Webster’s Dictionary, the court noted that the verb “participate” means to take part in or to share.  It then held that nothing in the court’s order would preclude the Minority Petitioners from “taking part in” the appraisal litigation because their interests are perfectly aligned with the Majority Petitioners.

Next, the court found that the Minority Petitioners’ interests would be protected even if the counsel that was appointed was not the one they would have preferred.  First, Section 262(k) requires that the court approve the dismissal of an appraisal proceeding against any stockholder.  Second, Section 262(j) incorporates common-fund principles to attorneys’ fees.  And third, any counsel appointed as lead would owe every member of the class fiduciary duties.

Finally, weighing the Hirt factors, the court found that the Majority Petitioners’ counsel was well-suited to serve as lead counsel.  The court held that the quality of the pleadings was not a factor that weighed heavier in either direction.  Second, the enthusiasm and vigor with which the case was prosecuted so far was neutral towards both the Majority Petitioners’ counsel and Minority Petitioners’ counsel.  Third, no conflict existed with either parties’ counsel.  However, the competence of the Majority Petitioners’ counsel was a factor that weighed in their favor because of their extensive track record.  Finally, the Majority Petitioners comprised of 75% of the ownership; and therefore, they had more at stake to incentivize active litigation.  Therefore, the court held that the Majority Petitioners’ counsel should be appointed lead.

Military Generals and Boards of Directors

The National Association of Corporate Directors is hosting a seminar later this week for retired, or nearly retired, generals in the U.S. armed services who aspire to be on a board of directors. The goal of the two-day seminar is to provide the basic information that one should know in order to be better prepared to become a director. I’m honored to be on a panel for this seminar with Delaware Supreme Court Justice Karen Valihura during which we will present a basic overview of fiduciary duties of board members and the related role of the Delaware courts in determining compliance with those duties.

Chancery Addresses Indemnification for Affirmative Claims of Directors

The Delaware Court of Chancery recently addressed an issue of importance to directors of companies as well as those interested in corporate litigation. In the case of Dore v. Sweports, Ltd., C.A. No. 10513-VCL (Del. Ch. Jan. 31, 2017), the court addressed situations where a director conceivably could be indemnified for fees incurred in pursuing an affirmative claim against the company as compared to the typical situation where indemnification is sought for reimbursement of fees incurred to defend a claim successfully. This opinion also provides an excellent overview of basic indemnification principles based on DGCL Section 145.

Background: The various lawsuits that gave rise to this indemnification action were based in large part on the attempts of the law firm of Sweports, Ltd. to collect legal fees.  One of the partners in the law firm was on the board of the company and also had to defend himself when the company filed counterclaims against the plaintiffs that were unsuccessful.  The lawyers who were seeking to collect their fees against the company ultimately commenced involuntary bankruptcy proceedings against the company.  The Delaware lawsuit was initiated after the lawyers for the company were largely successful in their lawsuits against the company to collect fees, and in defending claims against them made by the company.

Indemnification Principles

Section 145 of the Delaware General Corporation Law (DGCL) allows for indemnification in an action “other than by or in the right of the corporation.”  Section 145(b) provides for indemnification in an action “by or in the right of the corporation.”  Section 145(c) mandates that a Delaware corporation indemnify an individual who was sued by reason of the fact that the individual served as a director or officer if the individual was successful on the merits or otherwise in defending against the claim.  Although Section 145(c) only covers directors and officers, when a corporation has provided other authorized individuals with mandatory indemnification to the fullest extent of the law, then that right extends the mandatory indemnification contemplated by Section 145(c) to those individuals.

When assessing an indemnification claim, typically the first inquiry is whether the expense has been incurred in connection with a covered proceeding.  A covered proceeding is a civil, criminal, administrative or investigative action in which the individual seeking indemnification was a “party or threatened to be made a party by reason of the fact that the individual is or was a director, officer, employee or agent of the corporation.”  The corporation has the burden of proof when it has provided individuals with mandatory indemnification to the fullest extent of the law, to prove that an individual is not entitled to indemnification.

Typically, step two in the analysis after it is determined that a proceeding is covered, is to analyze whether the expenses incurred “were actually and reasonably incurred” in connection with the proceeding.  The court determined that only a small fraction of the expenses sought were actually incurred, and some of the expenses claimed were inflated.

The key aspect of this 58-page opinion of the Delaware Court of Chancery that makes it notable is that it addresses those situations in which an affirmative claim is indemnifiable, as compared with the more common claim for indemnification based on fees and expenses incurred to defend a claim brought against a director.

In this opinion, the Vice Chancellor explained that “it is conceivable that indemnification might be warranted for preemptive litigation involving personal claims that sought to negate a threatened breach of fiduciary duty claim . . ..”  The court explained that “. . . indemnification might be available if disposition of the personal claims would determine definitively whether the plaintiffs had breached their fiduciary duties.”  Typically, indemnification claims are not allowed for personal claims that are not brought “by reason of” the director’s duties, for example, in connection with an employment agreement that does not involve the exercise of judgment, discretion, or decision-making authority on behalf of the corporation.  The court referred to a prior Delaware decision in which indemnification was permitted for an intervenor where collateral estoppel might have barred a claim in a subsequent proceeding.

In this case, the plaintiffs chose to pursue their claims based on pure breach of contract theories untethered to their conduct as fiduciaries of Sweports.  Although they could have proceeded in a different manner, they only proceeded on a breach of contract theory.  The contract claims were personal to the plaintiffs in their capacity as lenders, creditors and guarantors – – which did not have a sufficient nexus implicating corporate duties.

The court did allow a portion of the fees and expenses incurred to defend against counterclaims which plaintiffs successfully defended, as well as related claims that were defensive in nature.  Finally, because the plaintiffs were only successful to a small degree in their claims seeking indemnification, the court only allowed a small percentage of the “fees on fees” that were incurred in connection with their effort in this case to collect fees.

Can Delaware Be Dethroned?

A symposium at UCLA Law School on Feb. 17 and 18 will bring together corporate law professors and corporate litigation practitioners from around the country to address the perennial issue regarding whether Delaware can maintain its dominance in the corporate law world. Professor Stephen Bainbridge has organized a formidable assemblage of panels, the members of which will present a paper related to the titular topic and entertain questions from the audience during this two-day invitation-only event. Yours truly is thrilled to be a moderator for one of the panels. The agenda with a list of panel members is available at this hyperlink. An announcement follows: image004

Court Addresses Whether Unclean Hands Bars Advancement

Justin M. Forcier, an associate in the Delaware office of Eckert Seamans, prepared this overview.

The Court of Chancery recently addressed whether unclean hands may be a recognized defense to advancement actions.  Hankinson v. Pike Holdings Inc., C.A. No. 12730-CB (Del. Ch. Nov. 15, 2016) (telephonic transcript ruling).

Background:  Plaintiff was a director and CEO of Pike Holdings Inc. (“Pike”).  Pike filed an action against Plaintiff as a result of a sale of Pike’s main operating subsidiary.  Pike’s bylaws contain provisions for the advancement of legal fees and expenses.  Pike refused to advance Plaintiff the money, because its board of directors found that he acted in bad faith with respect to the sale.

After Plaintiff filed this action, Pike submitted an in camera review of recordings of telephone conversations allegedly containing evidence that Plaintiff sought to overstate the amount of fees he had incurred.

Analysis: During its ruling on the motion for summary judgment, the court noted that two issues were before it: (1) whether Plaintiff was entitled to advancement under the bylaws; and (2) the implication of the recordings on Plaintiff’s advancement rights.  The court first addressed whether Plaintiff is entitled to any advancement pursuant to the bylaws because, as the court noted, if no advancement is due, the issue of the recordings becomes moot.

Court’s Holding: First, the court looked at the language in the bylaws, which in part stated that no advancement would be made by Pike to one of its officers (except by reason of the fact such officer is or was a director of the Corporation, than this provision would not apply) if clear and convincing facts exist that such officer acted in bad faith.

The court held that all five counts in California named Plaintiff by reason of the fact that he was a director during the sale; and therefore, he is entitled to advancement of fees.

However, the court held, a separate trial is need to resolve the issue raised in the recordings regarding bad faith.  The court stated that it was unclear whether it could even consider the recordings, because Plaintiff claimed that they were improperly obtained by Pike and subject to the attorney-client privilege.  The court did not specifically rule on this issue because further inquiry was needed and the facts were vigorously disputed.

Furthermore, assuming the recordings were admissible, the court stated that even further proceedings would be needed to determine if Plaintiff engaged in fraudulent conduct that would cause his advancement–potentially–to be denied entirely under the unclean hands doctrine.

Finally, the court declined to enjoin the California proceeding because to do so would be premature.

Chancery Issues Additional Advancement and Indemnification Rulings in Quiznos Restructuring

Alexandra D. Rogin, an Eckert Seamans associate, prepared this overview.

The Court of Chancery issued two opinions relating to a web of advancement and indemnification claims brought on behalf of multiple, separate plaintiffs: (1) Meyers v. Quiz-Dia LLC, C.A. No. 9878-VCL (Del. Ch. Jan. 9, 2017); and (2) Meyers v. Quiz-Dia LLC, C.A. No. 9878-VCL (Del. Ch. Jan. 10, 2017).  A previous blog post summarized the Chancery Court’s December 2, 2016 order to stay certain indemnification claims pending a determination as to arbitrability in the same case.

The January 9, 2017 Memorandum Opinion:

In the January 9, 2017 Memorandum Opinion, the Court concluded from an analysis of contractual drafting history that the plaintiffs were not entitled to advancement and indemnification.  This decision is important because it addresses the relatively rare instance in which the Court will consider extrinsic evidence.  Of cautionary note, draft agreements with attorney comments were discoverable under the circumstances.

Background: An in-depth overview of the background of this litigation can be found here.  The plaintiffs, previously affiliated with a non-party parent entity, Quiznos, brought suit asserting entitlement to advancement and indemnification from the defendant subsidiaries pursuant to multiple agreements.  The parties filed cross-motions for summary judgment regarding the question of whether the defendants assumed advancement and indemnification obligations.  The Court explained that the claims turned on whether the defendants assumed the obligations pursuant to a post-restructuring Assignment, Assumption, and Release Agreement (the “Assignment Agreement”).

Court’s Analysis: The Assignment Agreement was subject to New York law.  Under New York law, contracts should be construed in accordance with the parties’ intent.  To determine whether the parties intended for defendants to assume the obligations, the Court conducted an extensive analysis of the drafting history of the Assignment Agreement.

The Assignment Agreement was prepared during the restructuring negotiations and contained two separate deal points: (1) a release of any claims that the post-restructuring entities might have against the sell-side parties, and (2) the assumption and continuation of indemnification rights.  The parties drafted the Assignment Agreement late in the restructuring process after negotiating multiple contracts, including a principal restructuring agreement.

Because the Assignment Agreement was ambiguous as to which entities were to assume the obligations, the Court was permitted to consider extrinsic evidence regarding the parties’ intent.  Thus, the Court reviewed deposition testimony and considered the parties’ multiple agreements.  The Court reviewed draft versions of the agreements, including attorney comments, and it read the documents as a whole.

Conclusion: After considering drafting history, context provided by the multiple agreements, and deposition testimony, the Court held that the defendants did not assume the indemnification and advancement obligations. Therefore, the Court granted summary judgment in the defendants’ favor as to certain non-stayed claims left in the case.

 

The January 10, 2017 Memorandum Opinion:

Background: The Court’s January 10, 2017 Memorandum Opinion addressed a motion to vacate its November 30, 2016 order dismissing certain indemnification claims as premature pending related litigation in Colorado (the “Colorado Action”).  The plaintiffs had advancement claims pending simultaneously in the Delaware court.

Parties’ Arguments: The moving plaintiffs argued that because the Colorado Action had been dismissed, and the dismissal was affirmed by the appellate court, there was a final disposition in the Colorado Action.  Therefore, the plaintiffs argued that their indemnification claims became ripe in Delaware.

Court’s Analysis: The Court explained that although the federal appellate court affirmed dismissal in the Colorado Action, the deadline to petition the U.S. Supreme Court for a writ of certiorari does not pass until March 13, 2017.  As long as the decision in the Colorado Action is not final, outstanding Delaware advancement claims were ripe.  However, when the decision in the Colorado Action becomes final, the Delaware advancement claim will be moot, and the indemnification claims will become ripe.

The Court reiterated that advancement and indemnification are distinct legal concepts.  A claim for advancement is a summary proceeding, and ordinarily, the Court would not await developments in another jurisdiction before adjudicating an advancement claim.  However, in the present action, questions had been raised about the ability of the Court to rule on the plaintiffs’ advancement rights, as the plaintiffs did not produce detailed invoices in support of their claims until after the discovery cutoff.  The Court also pointed out that the plaintiffs were well-off and another plaintiff was funding their litigation efforts.  Additionally, the plaintiffs’ legal representation was not compromised by the lack of advancement to date.  Therefore, the Court determined that the plaintiffs would not suffer harm if it withheld a decision on advancement and indemnification until it was clear whether the Colorado Action would proceed to the Supreme Court.

Conclusion: Citing its inherent authority to control its own docket, the Court denied the plaintiffs’ motion to vacate.  The Court explained that whether the plaintiffs had a right to advancement or indemnification would soon become clear pending a final determination in the Colorado Action.  Therefore, the Court stayed further outstanding advancement and indemnification claims in the interim.

Delaware Supreme Court Finds that Implied Covenant of Good Faith and Fair Dealing Requires Reversal

This Delaware Supreme Court decision must be read by anyone who hopes to understand the nuances of the rarely successful claim for breach of the implied covenant of good faith and fair dealing, especially in the context of a limited partnership agreement which waives all fiduciary duties. In Dieckman v. Regency GP LP, No. 208, 2016 (Del. Supr., Jan. 20, 2017), the Delaware Supreme Court took the rare step of reversing the Court of Chancery, determining that the claims were supported by the implied covenant of good faith and fair dealing.

Background:  The court described the parties as being “identified by a host of confusing abbreviations.” The plaintiff was a limited partner/unitholder in a publicly-traded master limited partnership (“MLP”). The general partner proposed that the partnership be acquired through merger with another limited partnership in the MLP family. The seller and buyer were indirectly owned by the same entity, creating a conflict of interest. The relevant agreements created two safe harbors to address conflict resolution provisions in the partnership agreement. One was a “Special Approval” by an independent Conflicts Committee, and the other safe harbor was by means of an “Unaffiliated Unitholder Approval.”

Issues Presented: The plaintiff alleged that the general partner failed to satisfy the Special Approval safe harbor because the Conflicts’ Committee was itself conflicted. In addition, the complaint alleged that the safe harbor of the Unaffiliated Unitholder Approval was unavailable because of false and misleading statements in a proxy statement submitted to secure the approval.

Procedural Posture: The Court of Chancery held that the general partners’ satisfaction of the requirements of the safe harbor under the Unaffiliated Unitholder Approval required dismissal of the case. The Court of Chancery reasoned that because fiduciary duty principles were waived, they could not be used to impose disclosure obligations.

Analysis: The Supreme Court found that the Court of Chancery focused “too narrowly” on the disclosure requirements of the partnership agreement instead of focusing on the conflict resolution provisions.

The Supreme Court reasoned in essence that: “The implied covenant is well-suited to imply contractual terms that are so obvious – – like a requirement that the general partner not engage in misleading or deceptive conduct to obtain safe-harbor approvals – – that the drafter would not have need to include the conditions as express terms in the agreement.”

The Supreme Court gave hope to those who might have despaired based on recent decisions upholding the provisions of limited partnership agreements that waived fiduciary duties and past decisions that rejected the argument that the implied covenant of good faith and fair dealing was a basis to assert claims when conflicted transactions followed the safe harbor procedures outlined in the agreement.

In sum, the Supreme Court explained that even when all fiduciary duties are waived, the implied covenant of good faith and fair dealing cannot be waived. In addition, a second potential avenue for relief in an agreement that waived all fiduciary duties is the contra proferentem doctrine which especially applies to give effect to the “investors’ reasonable expectation in connection with ambiguities in publicly-traded limited partnership agreements.” See cases cited at footnote 18 and 19.

Several principles regarding the implied covenant are worth highlighting in bullet points. Although they are not new, their application to the facts of this case is noteworthy:

· The implied covenant applies “when the party asserting the implied covenant proves that the other party has acted arbitrarily or unreasonably, thereby frustrating the fruits of the bargain that the asserting party reasonably expected.” The implied covenant applies where the express terms of an agreement “can be reasonably read to imply certain other conditions, or leave a gap, that would prescribe certain conduct, because it is necessary to vindicate the apparent intentions and reasonable expectations of the parties.”

· The court reasoned that the express terms of the agreement did not address, one way or the other, whether the general partner could use false or misleading statements to enable it to reach the safe harbors.

· The Supreme Court held that “implied in the language” of the agreement’s conflict resolution provision is a requirement that the general partner “not act to undermine the protections afforded unitholders in the safe harbor process.”

· Specifically, the Supreme Court imposed, through the implied covenant, terms that the court determined were “easily implied because the parties must have intended them and have only failed to express them because they are too obvious to need expression.” Stated another way, “some aspects of the deal are so obvious to the participants that they never think, or see no need, to address them.” See footnotes 25 and 26.

Bottom Line: The Supreme Court reasoned that although the defendant was not required to provide a 165-page proxy statement to induce the unaffiliated unitholders to approve the transaction, in order to trigger the safe harbor, once it went beyond the minimal disclosure requirements, the implied covenant barred the general partner from making misleading statements.

Moreover: implicit in the express terms is that the Special Committee membership be genuinely comprised of qualified members and that deceptive conduct not be used to create the false appearance of an unaffiliated, independent Special Committee. There were substantial questions raised at the pleading stage regarding the true independence of the members of the Special Committee.

Advancement Denied Based on Issue Preclusion Doctrine

In a short order, the Delaware Supreme Court affirmed in Aleynikov v. The Goldman Sachs Group, Inc., No. 366, 2016 (Del. Supr., Jan. 20, 2017), the Court of Chancery’s decision, which was highlighted on these pages, denying advancement claims based on the decision of a federal court that had addressed the issue before it reached the Delaware court. Chancery upheld the decision of the Third Circuit Court of Appeals which denied a request for advancement and indemnification. Although the Delaware Court of Chancery decision persuasively explained why the decision of the Third Circuit was not an exemplary application of Delaware law, based on the doctrine of issue preclusion the Court of Chancery felt bound by the Third Circuit decision, and the Supreme Court upheld that holding.

In essence, the lesson to be learned from this case is that when important matters of Delaware law are involved, the safest approach is to file suit in Delaware. If a non-Delaware court makes a mistake in deciding an issue of Delaware law, it will be too late to ask a Delaware court to “fix the mistaken ruling” on Delaware law.  In retrospect, it seems quite likely that if the initial advancement claim in this case, based on Delaware law, were filed in Delaware as opposed to the U.S. District Court for the District of New Jersey, the outcome of this case might have been different.

Supreme Court Hears Argument on Impact of Decisions in Other Fora

The Delaware Supreme Court recently heard the appeal in a case involving the Lululemon company which addressed the impact of a decision in another forum on the ability of stockholder in a Delaware derivative suit to make the same or similar claims. Laborers’ District Council Construction Industry Pension Fund et al. v. Bensoussan et al., No. 358, 2016, oral argument held (Del. Jan.18, 2017). Frank Reynolds of Thomson Reuters pens an informative article on the recent oral argument in the case and provides a more detailed overview of the case. The Court of Chancery decision citation is:  Laborers’ Dist. Council Constr. Indus. Pension Fund v. Bensoussan, No. 11293, 2016 WL 3352088 (Del. Ch. June 14, 2016).

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