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Add comment September 14th, 2013

Auditor Reporting: What More Can Be Done?

Investors have more information than ever before about the accounting firms that audit public companies, but some say it is still not enough. In the aftermath of the financial crisis, investors are requesting more information about the firms and their audit work, so as to better assess the quality of the audits and related risks. These requests are getting the attention of both regulators and accounting firms. The Public Company Accounting Oversight Board has issued a Concept Release about changes to the auditor’s reporting model, and at least one major accounting firm has issued a public report about how it maintains and enhances the quality of its audits. To learn more, read our Special Report for a discussion of the information gap, the extent to which voluntary reporting can help close the gap, and what is needed to step up to the broader issues.

Add comment December 7th, 2011

Dodd-Frank Act Brings Far-Reaching Reforms in Governance

On July 15, 2010, Congress passed the Wall Street Reform and Consumer Protection Act (also known as the Dodd-Frank Act). This law represents the most sweeping reform of the banking industry since the 1930s. Its objective is to promote US financial stability. Its provisions are designed to improve the level of accountability and transparency in the financial system, protect American taxpayers from the cost of bailouts, and protect consumers from abusive financial services practices.

The reforms established by this law will have the most direct effects on companies in the financial services industry, but they will also affect directors and shareholders of US public companies (domestic registrants) in other industries subject to regulations to be established by the SEC. Here are a few highlights of the changes to come in corporate governance:

  • The SEC is now officially authorized to set rules that will allow shareholders to nominate directors for inclusion in their company’s proxy materials.
  • Smaller public companies will be exempted from the requirements for auditor attestation of internal control reporting under Section 404(b) of the Sarbanes-Oxley Act. The Act also directs the SEC to study ways to ease the 404(b) burden on companies with market capitalizations between $75 and $250 million.
  • Public companies will be required to have a non-binding “say-on-pay” vote at least once every three years, more often if the shareholders so elect. But smaller companies may be exempted under rules to be issued by the SEC.
  • Rules similar to the say-on-pay rules will cover golden parachutes for named executive officers. A say-on-pay vote will be required in conjunction with transactions on which a company seeks shareholder approval, including a merger, acquisition, or proposed sale of all or substantially all of the company’s assets.
  • National securities exchanges will further restrict discretionary broker voting. This means brokers won’t be able to vote in any contested elections of board members or on any executive compensation matters, unless they have specific instructions from the beneficial owners.
  • Institutional investors will be required to disclose their say-on-pay and say-on-golden parachute voting records at least annually unless otherwise directed by the SEC.
  • Independence requirements will apply to compensation committees of boards of directors, and these committees will be permitted to hire and oversee the work of attorneys, compensation consultants and other advisors.
  • All US public companies will need to make disclosures about pay-for-performance and comparisons of executive pay with pay for other employees. For example, companies will need to disclose the CEO’s annual compensation, the median annual compensation of all employees other than the CEO, and a ratio comparing the two compensation levels.
  • Companies will be required to develop and implement policies for disclosures and clawbacks of executive compensation for years when earnings were restated.
  • Boards of directors of certain companies will be required to establish risk committees. This requirement applies to non-bank financial companies supervised by the Federal Reserve and bank holding companies with assets of $10 billion or more.
  • All US public companies will be required to disclose in proxy materials whether any employee or director of the company is permitted to purchase financial instruments designed to hedge any decrease in the market value of the company’s equity securities that are granted as compensation or otherwise held by the employee or director. Examples of hedging instruments include prepaid variable forward contracts, equity swaps, collars and exchange funds
  • Covered financial institutions will need to make disclosures to appropriate regulators about the structures of their incentive-based compensation arrangements. The objective is to gauge whether the arrangements provide the recipients with excessive compensation, fees, or benefits that could lead to material financial loss for the company. This requirement applies to bank holding companies, registered broker-dealers, insured credit unions, investment advisors and other to-be-designated financial institutions.

The full text of the conference report is available here.

The Center for Financial and Accounting Literacy will report on other aspects of this important new law in its blog on Financial and Accounting Insights and on its website at www.fincenter.org.

Add comment July 15th, 2010

Court Ruling Probes PCAOB’s Accountability

The Public Company Accounting Oversight Board (PCAOB) emerged largely intact after a legal battle that challenged its very existence (Free Enterprise Fund et al. v. Public Company Accounting Oversight Board et al., Supreme Court, June 28, 2010). On the surface, this ruling appears to be good news for investors. But the ruling doesn’t fully address the matter of the PCAOB’s accountability and it opens the door for future changes by Congress.

The key points:

  • By a narrow 5-4 decision, the Supreme Court stopped short of declaring the entire Sarbanes-Oxley Act unconstitutional and ordering the PCAOB to stop work.
  • Instead, the Court carved out a seemingly minor organizational provision or “structural flaw” that it said could be addressed separately.
  • At issue is SOX’s “double-for-cause” rule. SOX established the PCAOB under the SEC’s oversight. As enacted, the law said PCAOB members could be removed only for good cause by the SEC, whose members in turn can be removed by the President of the United States only for cause, (such as neglect of duty or malfeasance).
  • The Court’s ruling removes the “double-for-cause” rule and gives the SEC the authority to remove PCAOB members at will.
  • The reasoning for the ruling is that SOX’s “double-for-cause” rule represents an unacceptable “diffusion of power.” The resulting “diffusion of accountability” runs counter to the guiding principle that the President should oversee the conduct of all who execute laws in this country.

Our observations and recommendations:

  • Investors should be relieved to see that both the PCAOB and SOX are still standing. The PCAOB is an important cornerstone of the SOX Act, a pivotal law passed by Congress following the Enron and WorldCom accounting scandals. The intent of the law is to provide greater investor protection through higher audit quality.
  • However, the Court’s carve-out oversimplifies the complex issues involved. It also opens the door for Congress to explore alternative or supplemental ways to remedy the structural flaw.
  • Although the system of checks and balances is good in government, there are also important practical considerations for a board like the PCAOB. The PCAOB board members are not government employees and the so-called flaw in SOX was put in place intentionally to insulate the highly paid technical experts who serve on the PCAOB from political pressures.
  • The nature of the PCAOB’s work demands some sort of practical expedient because: (a) it involves contentious matters and occasionally unpopular decisions, and (b) the preservation of audit quality demands high standards of technical expertise, objectivity, and neutrality – all of which can be difficult to govern through normal political processes.
  • The discussions also leave important issues unresolved. One key open issue regards the right of appeal for those who feel adversely and unfairly affected by the PCAOB’s work. The recent court case started when a Nevada accounting firm received a report critical of its auditing procedures and was informed the PCAOB planned to begin a formal investigation. Firms in this position should have suitable recourse.
  • There should also be suitable recourse for public companies that wish to protest increases in the mandatory fees imposed on them in an effort to provide an independent source of revenue for both the PCAOB and its accounting standard-setting counterpart, the Financial Accounting Standards Board. There are reports of fee increases of 30 and 40 percent over the past two years despite difficult economic conditions. For true accountability, companies and investors should be provided with clearer cost justifications.

The full text of the Supreme Court’s ruling is available at
http://www.supremecourt.gov/opinions/09pdf/08-861.pdf. The full docket is available
here.

Add comment July 8th, 2010

SEC Strikes the Right Tone on IFRS

Investors should be well-pleased with the SEC’s newly-approved list of factors to be considered before any decision is made about whether and how International Financial Reporting Standards (IFRS) might be incorporated into the financial reporting system for U.S. issuers.

Overall Approach

The SEC’s overall approach to IFRS decision-making was approved at an open meeting on February 24, 2010. Led by Chief Accountant Jim Kroeker, the Commission’s staff presented a carefully crafted work plan designed to protect the masses of U.S. investors who might need to learn a second accounting language, if the SEC were to permit the use of IFRS for domestic reporting. Among other things, the SEC’s plan calls for careful consideration of the following factors:

  • Sufficiency of development and consistency of application of IFRS.
  • Adequacy of investor understanding of IFRS.
  • Acceptability of the impact on issuers of all sizes, including the costs and timeframes needed to adapt accounting systems, corporate governance practices, and litigation considerations.
  • Desirability of the impact of a switch to IFRS on the entire U.S. regulatory environment, including other forms of reporting, such as tax reporting.
  • Readiness of all the various players in the financial reporting process, including regulators and enforcement agencies.
  • Sustainability of the accounting standard-setting processes in the U.S. and at a global level.

Investors’ Interests and Trust Are Key

Remarks by SEC Chairman Mary Schapiro and Commissioner Luis Aguilar indicate that investors’ interests and trust will be high on the list of key considerations before IFRS gets a green light for domestic U.S. reporting.

Chairman Schapiro noted that any such go-ahead would represent a significant undertaking. She cautioned that, “We must carefully consider and deliberate whether such a change is in the best interest of U.S. investors and markets.” Commissioner Luis Aguilar added that, “If we move forward with IFRS, it will be because we have determined that… U.S. investors can trust the numbers.”

The critical factors in Aguilar’s view include whether IFRS will provide investors with higher quality information than U.S. GAAP, whether IFRS can be as rigorously audited and enforced as U.S. GAAP, and whether the benefits to investors will justify the costs to preparers of financial statements. Stressing that it is too early to say whether U.S. financial reporting will move to IFRS, Aguilar said that the promise of a single set of globally accepted accounting standards is worth pursuing and that the SEC is committed to working toward a responsible, informed decision that is in the best interests of investors.

Well said, Chairman Schapiro and Commissioner Aguilar. The Center for Financial and Accounting Literacy applauds the SEC’s progressive yet practical approach to evaluating possible use of IFRS by U.S. issuers.

Add comment February 24th, 2010

SEC Helps Investors Weigh Governance and Risks in 2010

It took a financial crisis to teach regulators the value of intangibles seldom found in financial statements. But 2010 marks the start of a new decade, and investors can take comfort in the way the SEC is stepping up to the challenges with new proxy disclosure requirements that shine a brighter spotlight on governance practices and the role of directors in overseeing risks. This information has grown especially critical after investors suffered unexpected losses and faulted poorly-disclosed compensation practices and ineffective systems of risk management.

The SEC’s new reporting requirements take effect on February 28, 2010. Below are highlights of the newly required information and the expected benefits for investors:

  • Qualifications of directors and nominees. 2010 proxy statements will contain more complete descriptions of the experience, qualifications, attributes and skills of directors and nominees. This should help investors assess whether a particular nominee is an appropriate choice for a particular company.
  • Consideration of diversity in board nominations. Investors will also find a discussion of the factors taken into consideration by the nominating committee when evaluating the composition of the board taken as a group. Some companies may seek a mix of directors with different professional experience, education, and skills; others may seek a mix of races, genders and national origins. Whatever the factors involved, boards with diversity policies must explain how their company’s policy is implemented and how they evaluate its effectiveness.
  • Board leadership structure and role in risk oversight. The SEC is requiring companies to describe their leadership structures and their reasons for selecting these structures, as well as the role of the board of directors in the oversight of different kinds of risks, including credit, liquidity, and operational risks. This information should help investors evaluate whether the board is exercising appropriate oversight of risks and whether the company’s risk profile is consistent with their investment goals.
  • Compensation policies and their effect on risk-taking. Larger public companies will need to discuss their compensation policies and practices for all employees, if these policies or practices create risks that are reasonably likely to have a material adverse effect on the company. Despite the subjectivity involved in making these disclosures, the end result is likely to help investors by focusing their attention on any incentive structures that may be inconsistent with their investment goals.

The SEC’s desire to have these reporting requirements effective for the 2010 proxy season leaves companies little time to adjust their processes and controls. But, if properly implemented, the SEC’s new disclosures should provide investors with more solid information on which to base their voting decisions and a more solid footing on which to base their investment decisions.

For more information, see our special report on Changes in Proxy Rules: Will They Help or Hurt?

Add comment December 30th, 2009

SEC introduces investor.gov

The U.S. Securities and Exchange Commission has introduced a website packed with practical tools and advice for investors. The site tends to focus most heavily on the various types of investments available today and the types of investment professionals who provide related services. The content is quite comprehensive and convenient. Among other things, investor.gov provides:

A list of questions to ask before investing: http://investor.gov/ask-questions/

Links to timely investor alerts: http://investor.gov/investor-alerts/

Links to practical online tools and calculators including:

Links to investor education resources: http://investor.gov/investor-education-resources/     

A series of “Top Tips” including:

Sections on how to contact the SEC, with questions https://tts.sec.gov/acts-ics/do/question or complaints http://www.sec.gov/complaint/selectconduct.shtml.

 

 

Add comment October 23rd, 2009

SEC Strives for Investor-Friendly E-Proxies

Concerns about possible shareholder confusion have prompted the US Securities and Exchange Commission (SEC) to propose a number of changes designed to make the e-proxy process more investor-friendly. First adopted in 2007, the SEC’s “notice and access” model for furnishing proxy materials requires that issuers and other soliciting persons post their proxy materials on an Internet web site and also furnish notices of the materials’ availability to shareholders. Under the SEC’s rules, issuers are permitted to provide a full set of proxy materials in addition to the ones accessible via the web site. As a practical matter, though, many companies prefer to provide only a notice that refers investors to the web site because of the resulting cost savings. It is the use of this “notice-only” method that seems to be causing the confusion.

Murphy’s Law

As proof that even a long-overdue and seemingly win-win solution like e-proxies can have unintended consequences consistent with Murphy’s Law (“anything that can go wrong will go wrong”), early experiences indicate the following unexpected problems may have resulted from the use of the notice-only method for-e-proxies:

  • Statistics show that the shareholder response (meaning the percentage of shareholders who voted) was lower for issuers who chose the notice-only model, compared with those who distributed a full set of proxy materials. It is not clear at this time whether this is a coincidence or a matter of cause and effect.
  • There are also reports that some shareholders mistakenly attempted to indicate their voting instructions by returning a marked copy of the notice, rather than using the Internet site or requesting a paper copy of the proxy materials.

The SEC is requesting comments from shareholders on the prevalence of these problems.

Proposed remedies

As potential steps to address the problems described above, the SEC is proposing the following changes to the e-proxy process:

  1. The existing rules would be clarified to provide added flexibility in formatting and wording the notices that identify the matters to be acted upon at the shareholders’ meeting, (e.g., election of directors, ratification of auditors, or approval of a stock option plan). Current rules impose restrictions on the format and language, resulting in “boilerplate” language that may be confusing to shareholders. Even with the added flexibility, the intent remains the same. Issuers should “stick to the facts,” provide a clear and impartial identification of each matter up for a vote and describe each matter that is up for consideration, but they should not try to persuade shareholders how to vote on the matter.
  2. A new rule would permit issuers and soliciting shareholders to include supplemental explanatory materials with the notice. These materials would be permitted for purposes of explaining the procedures for receiving and reviewing the proxy materials and for casting one’s vote. Materials designed to persuade shareholders to vote in a particular manner, change the method of delivery, or explain the basis for sending only a notice to shareholders would not be permitted.
  3. The timeframe would be modified for delivering a notice to shareholders when a soliciting person other than the issuer relies on the notice-only option. The SEC’s proposal is that the soliciting shareholder would be required to file a preliminary proxy statement within 10 days after the issuer files its definitive proxy statement and to send the notice no later than the date on which it files its definitive proxy statement with the Commission. This timeline is expected to provide sufficient time for the soliciting person to prepare its proxy statement, respond to any staff comments, and then use the notice and access model.

In addition, the SEC’s Office of Investor Education and Advocacy, together with the Division of Corporation Finance, will be developing a program to educate and inform shareholders, especially individual shareholders, about the notice and access model. The program will include explanations of how shareholders can participate through this model and explain shareholders’ rights under the model.

Comments on the proposed rule changes are due by November 20, 2009. For helpful links and additional information about other SEC initiatives related to proxies, see www.fincenter.org/Proxy_Access.htm.

Add comment October 21st, 2009

SEC Focuses On Auditor Risks Following Madoff Fraud

Speaking at a Senate Banking Committee hearing on September 10, 2009, a senior-level SEC official said the Commission is paying “a lot more attention” to auditor risks following the Madoff fraud. The official is John Walsh, Acting Director of the SEC’s Office of Compliance Inspections and Examinations. His remarks were made in response to a question from Senator Jeff Merkley (D-OR) about lessons learned from an in-depth report by the SEC Inspector General on the SEC’s failure to uncover the fraud.

Auditor-related Red Flags

The Inspector General’s report identifies several auditor-related red flags, including:

  1. Reports that Madoff’s auditor was his brother or brother-in-law. (These reports raise concerns about the auditor’s independence or ability to conduct an unbiased, fair and impartial audit).
  2. Reports of Madoff’s excessive secrecy and refusals to allow investors to hire their own auditors to audit his books. (A large international investor was reportedly told that only Madoff’s brother is allowed to audit performance for reasons of secrecy.)
  3. Reports that the audit firm’s capabilities appeared inadequate to handle the billions of dollars that Madoff was managing for investors. The specifics included the audit firm’s relatively small size (three employees), the obscurity of its location (“New City, NY”), and its lack of visibility to those with industry expertise.

Despite these red flags, the SEC staff apparently did not take the time to examine the auditor’s work papers, and the Inspector General concluded that this was a mistake. If they had, the fraud would have been detected earlier. After Madoff confessed to running a Ponzi scheme, the SEC staff requested copies of the auditor’s work papers. Within hours of obtaining the work papers, they were able to determine that no audit work had been done.

Coming Reforms

SEC’s Walsh explained that, “This [auditor inadequacy] is one of the high risk factors that we are looking into to see if there are more problems lurking out there.” In addition, the SEC is adding more specialists and looking at other risk factors that can be identified by specialized industry expertise and analytical procedures. Examples related to the Madoff fraud might include the apparent misrepresentations of trading volume, unusually consistent and non-volatile returns, and the use of an unusual fee structure.

On balance, investors can be encouraged by the list of reforms that Congress and the SEC are putting in place after the Madoff swindle.

  • The SEC’s list of reforms is posted on its website.
  • Other upcoming reforms were described in the testimony of Walsh and Robert Khuzami, the SEC Director of the Division of Enforcement, at the Senate hearing.
  • The US Public Company accounting Oversight Board (PCAOB) has issued new rules. In January 2009 the PCAOB issued a release announcing that financial statements of non-public broker-dealers for fiscal years ending after December 31, 2008 must be certified by a registered public accounting firm. (Madoff’s auditor escaped PCAOB registration and inspections because, at the time of the Madoff swindle, auditors of non-public broker-dealers were not required to register with the PCAOB.)
  • In September 2009, Senator Charles Schumer (D-NY) issued a news release saying that he is drafting legislation that would allow the SEC to keep all of the fees it collects so it can afford to recruit and retain better-trained personnel.

Open Questions

At the top of the list of open questions is one posed by Senator Schumer at the end of the hearing. He asked, “Is a higher standard of criminality needed?”

Schumer posed the question following remarks by Harry Markopolos, the whistle-blower who sent the SEC a long list of red flags indicating that Madoff was likely running a Ponzi scheme. Markopolos’ testimony included this observation: “The law is the lowest form of acceptable behavior, but ethics are a higher standard that the SEC’s securities lawyers seem to ignore time and again.” As one example, Markopolos pointed to mutual fund market-timing. Another example might relate to violations by auditors of applicable ethical standards or codes of conduct.

According to the SEC’s enforcement release, Madoff’s auditor was not subjected to the required inspections in the US for auditors of non-public broker-dealers for years because he made false representations to the American Institute of CPAs (AICPA) about the firm’s involvement in issuing audit opinions. A peer review would have served as an effective safety net for the SEC staff. It is fair that the SEC should shoulder some of the blame for not uncovering the scandal sooner. But, as pointed out in a recent editorial in Investment News, the SEC was not alone is missing the Madoff debacle.

In the aftermath of what has described as “the biggest international swindle of all time,” Schumer’s question is a good one. Is it enough to encourage whistle-blowing to the SEC? Or should stiffer more direct criminal penalties apply to unethical conduct?

Another good question is, “Could better communications to investors help prevent another Madoff scandal?” Clearer communications about such matters as inspections might be a good starting point. It seems likely that some investors misunderstood the meaning of Madoff’s representations that his firm has just been inspected by the SEC. Some may have thought of this as some sort of seal of approval. Others may never have fully understood where to look for an AICPA peer review or what it means that a firm is (or is not) peer-reviewed.

Add comment September 15th, 2009

New Regulatory Era Will Bring Broader SEC Scrutiny

In the aftermath of what has been called “the most severe financial crisis since the Great Depression,” the US Treasury Department spent the summer of 2009 drafting volumes of proposed legislation. If enacted into law, the resulting reforms will have far-reaching effects. Most notably, investors will be armed with significantly more information, and companies will need to comply with extensive new reporting requirements particularly in areas related to risk and governance. Following a familiar pattern, the new regulatory system will rely heavily on the scrutiny of the US Securities and Exchange Commission (SEC).

Targeting Risks and Governance

As is often the case on Capitol Hill, it will take time to reach consensus on the final legislation. Some proposals may be dropped. But, considering the price paid in terms of massive job losses and decidedly unpopular government bailouts, lawmakers are likely to agree that “something” should be done to ensure future financial and economic stability.

The solution will need to include added reporting requirements, if it is to be responsive to the root causes of the credit crunch and ensuing financial crisis. Increasingly, with the benefit of hindsight, the nation’s best minds seem to agree that the causes of the crisis involve inadequate monitoring and regulation of risks and governance. Specifically:

  1. Certain types of risks were not well understood by either regulators or the investors who suffered losses as a result of the risks, and
  2. Some aspects of the current financial regulatory system may have spawned (or at least permitted) the kinds of corporate governance practices that encouraged unsafe risk-taking by big banks and other entities deemed “too big to fail.”

Areas of Broader SEC Scrutiny

Because of the focus on reporting of risks and governance, the proposed reforms call for a significant broadening of the SEC’s oversight of the following:

  • Compensation committees. The proposed Investor Protection Act of 2009 focuses on corporate governance practices related to executive compensation. It would require that all public companies include a non-binding shareholder vote on executive compensation as disclosed in the proxy for any annual meeting held after December 15, 2009. It would also mandate a separate vote on golden parachutes in the case of a merger or acquisition. The SEC will set the reporting requirements related to these votes. The Commission may also establish requirements for disclosures about the compensation committee’s independence, as well disclosures about how the company’s compensation policies relate to risk.
  • Credit rating agencies. Under another provision of the proposed Investor Protection Act of 2009, credit rating agencies would need to register with the SEC. The Commission would establish requirements for annual reports by these agencies, documentation of their rating policies and procedures, and disclosures about the risks they measure when rating a security, including use of special symbol to identify the risks associated with structured finance products.
  • Securitizers of asset-backed securities. Another provision of the Investor Protection Act of 2009 would expand the SEC’s authority to require loan-level disclosure for asset-backed securities in a standard format to enhance the ability of investors to perform their own due diligence. These requirements could conceivably be combined with the requirements for expanded use of XBRL reporting and a new taxonomy for interactive data related to the kinds of securitized loans that precipitated the recent credit crunch.
  • OTC derivative dealers and other major market participants. The proposed Over-the-Counter Derivatives Markets Act of 2009 would require central clearing of certain standardized OTC derivatives. Trading of these derivatives would be regulated by the SEC. The SEC and the Commodities Futures Trading Commission (CFTC) would oversee business conduct, reporting and record-keeping requirements for OTC derivative dealers and other major market participants.
  • Investment advisers. Several proposed laws focus on advisers, including (a) advisers to private funds, such as hedge, private equity, and venture capital funds, and (b) advisers who do not meet the legal definition of a broker or dealer. Under the proposed Private Fund Investment Advisers Act of 2009, private fund advisers will need to register with the SEC and comply with record-keeping, reporting and other requirements established by the SEC for purposes of monitoring and regulating risks in the market. Under the proposed Investor Protection Act of 2009, the SEC will establish consistent standards for broker-dealers and investment advisers. The Commission will also focus on added disclosure requirements for funds, (such as a summary prospectus), and governance practices, (such as compensation arrangements that encourage products and practices that are not in the investors’ best interest).

The Timetable for Reform

The timetable for finalization of the new laws is uncertain. The initial stages of regulatory reforms may appear to be moving slowly in part because the details can be mind-numbingly complex. But the Obama Administration is hoping the final laws will be available by the end of 2009.

Some Washington insiders caution that the economic recovery could slow the timetable by making the reforms seem less urgent. Recovery or no, there are still plenty of good reasons for enacting legislation to modernize outdated regulatory systems that have not kept pace with changes in the financial markets.

The Center commends the SEC for assigning a priority to regulatory reform initiatives and for taking a proactive leadership role in helping to shape the coming reforms. For more complete coverage of the draft legislation, see our special report on “New Era of Financial Regulation: How Will It Affect You?” at
www.fincenter.org/New_Regulatory_Era.htm.

Add comment September 9th, 2009

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