Understanding the Role of ESG and Stakeholder Governance Within the Framework of Fiduciary Duties

Martin Lipton is a founding partner of Wachtell, Lipton, Rosen & Katz, specializing in mergers and acquisitions and matters affecting corporate policy and strategy. This post is based on a Wachtell Lipton memorandum by Mr. Lipton, Adam O. EmmerichKevin S. SchwartzSabastian V. Niles and Anna M. D’Ginto. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders? (discussed on the Forum here), both by Lucian A. Bebchuk and Roberto Tallarita; Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock (discussed on the Forum here) by Leo E. Strine, Jr; and Stakeholder Capitalism in the Time of COVID (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.

Over the past decade, investors, companies, and commentators have increasingly accepted and adopted stakeholder governance as the way to pursue the proper purpose of the corporation and have embraced consideration of environmental, social and governance (ESG) issues in corporate decision-making toward that end. But an emerging movement opposed to any consideration, at all, of ESG factors threatens to erase the gains that have been made over the past ten years and revert to the outdated view that the purpose of a company is solely to maximize short-term shareholder profits.

This debate is playing out very publicly, with politicians at the highest levels of state and federal government publicly staking out positions on ESG and the extent to which it should (or should not) be considered by asset managers; through regulation and law; and in boardrooms across the country and around the world. At one extreme, critics of ESG are dismissing any consideration of the long-term impact of environmental or social risk on a company as “woke” capitalism, to be condemned, if not outlawed. (See Bloomberg, Populist House Republicans Picking a Fight With US Business Over ‘Woke Capitalism’ (Nov. 27, 2022).) At the same time, attacks from the other end of the spectrum condemn board consideration of ESG in a stakeholder governance model as insufficiently prescriptive. Yet neither view, attempting to politicize the role of companies and their boards, grapples adequately with the real meaning of ESG and stakeholder governance and the role of these concepts in the decision-making process of corporate boards and management.

ESG, properly understood, is not a monolithic concept, but rather refers to the panoply of risks and policies that a company must carefully balance in seeking to achieve long-term, sustainable value. To be sure, political action may be necessary to meaningfully confront climate change and other environmental and social challenges to the long-term success of the U.S. economy and global prosperity. But separate and apart from that political will — and all the debate that should properly surround it — it remains incumbent upon and entirely within the purview of each board of directors to look beyond short-term shareholder profits and seek sustainable long-term value creation, taking into account all stakeholders, including those implicated by ESG matters. With this in mind, we write to correct recent misinformation about stakeholder governance and ESG, and to explain how the consideration of ESG, properly understood, as well as other stakeholder factors, is entirely consistent with the fiduciary duties owed by the board and management to the company and to shareholders, and indeed required if board and management are to act prudently.


The Attack on Share Buybacks

Harry DeAngelo is Professor Emeritus of Finance and Business Economics & Kenneth King Stonier Chair in Business Administration at the University of Southern California Marshall School of Business. This post is based on his recent paper. Related research from the Program on Corporate Governance includes Short-Termism and Capital Flows by Jesse M. Fried and Charles C.Y. Wang (discussed on the Forum here); and Share Repurchases, Equity Issuances, and the Optimal Design of Executive Pay by Jesse M. Fried (discussed on the Forum here).

Corporate share buybacks are under attack, mainly from the political left (e.g., Senators Bernie Sanders, Chuck Schumer, and Elizabeth Warren and President Joe Biden), but also to some degree from the right (e.g., Senator Marco Rubio).  Critics decry the large sums distributed to shareholders via buybacks because that cash could have been used to fund greater investment and, especially, investment that would make workers better off.  They typically portray buybacks as an opportunistic way for managers to bolster their own pay by artificially inflating stock prices and EPS, leaving their firms starved for cash that could have funded larger investment outlays and provided higher wages and ancillary benefits for workers.  The proposed “remedy” is to impose higher taxes on buybacks, and possibly to allow a firm to repurchase its shares only if it makes investments that satisfy specific worker-friendly criteria (to be spelled out in federal legislation).


The Rise of Rule 10b5-1 Enforcement and How Companies Can Mitigate Risk of DOJ and SEC Actions

Jina Choi, Edward A. Imperatore, and Brian K. Kidd are Partners at Morrison & Foerster LLP. This post is based on their Morrison & Foerster memorandum. Related research from the Program on Corporate Governance includes Insider Trading Via the Corporation (discussed on the Forum here) by Jesse M. Fried. 

The U.S. Department of Justice (DOJ) and Securities and Exchange Commission (SEC) have recently intensified their scrutiny of insider trading under Rule 10b5-1 trading plans. The emerging trend of enforcement investigations and actions in this area shows that regulators and prosecutors are keen to hold executives accountable for insider trading. Companies and executives should adopt best practices to mitigate the risk that trading pursuant to a Rule 10b5-1 plan could result in an insider trading investigation.

Key Takeaways:

  • The SEC and DOJ are increasingly using data analytics to identify and initiate investigations of suspicious trading under Rule 10b5-1 plans, which are intended to shield companies and executives from insider trading allegations by letting them schedule transactions in advance;
  • Rule 10b5-1 plans, standing alone, cannot insulate corporate executives and employees from insider trading liability;
  • Insiders cannot possess material nonpublic information (MNPI) when they put a Rule 10b5-1 plan in place; otherwise, the plan will not serve as an affirmative defense to an allegation of insider trading;
  • The SEC has proposed amendments to the rules for Rule 10b5-1 plans, including a “cooling-off” period of at least 120 days between enacting the plan and when trading pursuant to the plan can begin;
  • The SEC’s view of information that constitutes MNPI may be expanding, and what is considered material will be assessed with hindsight; and
  • Companies should consider adopting the following for Rule 10b5-1 plans:
    • Institute a Cooling-off Period: Companies and executives should consider a “cooling-off” period between enacting the plan and when trades begin under the plan. Although no such restriction is currently in place, the SEC has proposed a period of at least 120 days, which would span an entire quarter, meaning that no trading could occur under a Rule 10b5-1 plan adopted in a particular quarter until after that quarter’s financial results are released. Adopting a cooling-off period designed to delay trading under a Rule 10b5-1 plan until after quarterly earnings are publicly announced can support an argument that the plan was created in good faith.
    • Ensure Robust Internal Controls: Companies should ensure that they have robust internal controls that are consistent with SEC rules and enforcement developments. They should look closely at their insider trading policy, enforcement of trading windows for enactment of Rule 10b5-1 plans, and review modifications to Rule 10b5-1 plans. Because the SEC has proposed heightened disclosure requirements for Rule 10b5-1 planned trades, companies may also want to prepare for possible disclosure of executive plans.
    • No Overlapping Plans: The SEC’s proposed rules prohibit “overlapping” Rule 10b5-1 trading plans. The SEC explained that, under the current rules, an insider can exploit Rule 10b5-1 plans by using them to establish multiple pre-existing hedged trading arrangements that temporally overlap and are timed to occur around dates on which the the issuer is likely to disclose earnings or other material information. An insider may decide later which trades to execute and which to cancel under the plans after the insider  becomes aware of MNPI but before the MNPI is made public. Under the proposed amendment, the affirmative defense would not be available for any trades by a trader who has established multiple overlapping trading arrangements for open market purchases or sales of the same class of securities. Companies should understand how directors and officers are using these plans and consider adopting a policy of prohibiting multiple overlapping plans.


Trends in E&S Proposals in the 2022 Proxy Season

Daniel Litowitz and Lara Aryani are Partners at Shearman & Sterling LLP. This post is based on a Shearman & Sterling piece by Mr. Litowitz, Ms. Aryani, George Casey, William Kim and Lucas Wherry and is part of the 20th Annual Corporate Governance Survey publication of Shearman & Sterling LLP. Related research from the Program on Corporate Governance includes Social Responsibility Resolutions (discussed on the Forum here) by Scott Hirst.


2022 has seen yet another record-setting proxy season,[1] with Russell 3000 companies fielding 813 shareholder proposals filed as of mid-July, 2022, representing approximately a 3% increase from 2021. Companies in the S&P 500 experienced a slightly higher year-over- year increase, receiving 642 proposals this season, representing a 5% increase from 2021. While the number of compensation-related proposals received by Russell 3000 companies remained generally consistent with 2021 and governance proposals decreased by approximately 15% in 2022, environmental and social (E&S)-related proposals continued their upward trend, with a record 471 E&S proposals submitted in 2022, a 15% increase over 2021. The number of E&S proposals continues to represent a majority of all shareholder proposals received by Russell 3000 companies, comprising 58% of proposals in 2022 compared to 51% in 2021.

Source: “Shareholder Voting Trends (2018-2022),” The Conference Board, https://www.conference-board.org/topics/shareholder-voting/trends-2022-brief-1-environmental-climate-proposals and https://www.conference-board.org/topics/shareholder-voting/trends-2022-brief-2-human-capital- management-socialproposals.

In 2022, there was a significant increase in the number of E&S proposals that were put to a vote in comparison with 2021 (from 47% to 59%). This was likely partly an effect of Staff Legal Bulletin No. 14L, issued by the Securities and Exchanges Commission (SEC) in July 2021, which made it harder for companies to exclude E&S proposals from proxy statements under the ordinary business exclusion pursuant to Rule 14a-8(i)(7) or the economic relevance exclusion pursuant to Rule 14a-8(i)(5).[2]


The Unicorn Puzzle

Rüdiger Fahlenbrach is Swiss Finance Institute professor at Ecole Polytechnique Fédérale de Lausanne (EPFL) College of Management. This post is based on a recent paper by Professor Fahlenbrach, Professor René M. Stulz, Daria Davydova, and Leandro Sanz.

Unicorns are private companies with pro forma valuations of at least $1 billion. In our paper “The Unicorn Puzzle,” recently posted on SSRN and available here, we investigate the puzzle of why controlling shareholders of certain startups find the unicorn status more valuable than being a public firm and the closely related question of why the number of unicorns increased so much recently. Our key findings are that unicorns differ from other VC-funded firms in that they rely more on organizational capital as well as network effects and the internet. Unicorn status enables startups to access new sources of capital. With this capital, they can invest more in organizational intangible assets with less expropriation risk than if they were public. As a result, they are more likely to capture the economies of scale that make their business model valuable.

We create a new unicorn database. Our sample consists of 639 U.S. unicorns. We have 427 active unicorns at the end of our sample period and observe 212 unicorn exits. Our sample covers all U.S. unicorns since the beginning of the 2000s until the end of the third quarter of 2021. We document the evolution of the number of unicorns and find that the number increases at an accelerating pace over our sample period. Even though 2021 has the highest number of unicorn exits, unicorn births outpace exits and the number of unicorns in existence increases in 2021. The increase is surprising because one would have expected the high valuations of 2021 to represent a unique opportunity for startups to enter public markets rather than seek to attain unicorn status.

Unicorns have reached a size that is much larger than the size of the typical IPO firm. To evaluate why founders find it valuable for their startups to stay private even though they have a much larger size than the typical IPO, we assess how the benefits and costs of being public may differ for unicorns from those of other startups. Since the unicorn phenomenon is a new phenomenon that did not exist before the 2000s, it has to be that either (1) the net benefit of being public (benefit minus cost of being public) became negative for many existing firms with private valuations of $1 billion or more, or (2) a new type of firms emerged for which the net benefit of being public is negative even at private valuations exceeding $1 billion. We show that both forces are at play. Funding has become increasingly available for firms with a valuation of at least $1 billion, which has decreased the funding and liquidity benefits of being public for these firms. In addition, a new type of firm that relies more on organizational capital and network effects has emerged. These firms are highly valuable if they succeed at capturing the benefits associated with the organizational capital and network effects that are central to their business plan, but they may not succeed in their efforts to build sufficient organizational capital and create network effects if they have to do so as public firms. These two effects constitute our proposed explanation for the unicorn phenomenon.


The corporate director’s guide to overseeing deals

Maria Castañón Moats is Leader, Paul DeNicola is Principal, and Colin Wittmer is Deals Leader at PricewaterhouseCoopers LLP. This post is based on their PwC memorandum.


The deal volume in 2021 reached levels not seen in recent years, a trend that continued into the first part of 2022. But since then, the markets have shifted.

With rising inflation rates, geopolitical uncertainty, continued supply chain interruptions, and a lingering pandemic, deal volume began to slow significantly as 2022 progressed.

A period of economic contraction will certainly influence transactions. This flows through inflationary, and borrowing rate pressure, real wage challenges, consumer spending variability, and other factors. The markets in 2022 still have an abundance of capital for both corporate and private equity (PE) to fund deals. As market volatility stifles IPO activity, alternative sources of capital (including from PE) become more appealing.

Some of the same forces creating market uncertainty also are driving dealmaking imperatives. Whether a company needs to transform its capabilities, supply chains, or go-to-market approach, the market is impatient and one of the fastest ways to accelerate transformation is through M&A.

Navigating this rapidly-evolving market presents a challenge for any business leader. But in any environment, a well-tailored deals strategy will open opportunities. And the current environment still poses a fiercely competitive deals marketplace as companies look to unlock value in new ways.

Overseeing deals and your company’s portfolio strategy

Having a focused deals strategy is critical to success. Along with organic growth through increased sales and new products and services, growth can also come through acquisitions, mergers, joint ventures, and other deals. What’s critical for the board is understanding the ins and outs of the deal, and how various transactions a company has done or wants to do are tied together in a portfolio strategy.


Linking Executive Compensation to ESG Performance

Merel Spierings is a Researcher for the ESG Center at The Conference Board. This post is based on her Conference Board memorandum, in partnership with ESG analytics firm ESGAUGE and compensation advisory firm Semler Brossy. Related research from the Program on Corporate Governance includes The Perils and Questionable Promise of ESG-Based Compensation (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; Paying for Long-Term Performance (discussed on the Forum here); Pay without Performance: The Unfulfilled Promise of Executive Compensation; and Executive Compensation as an Agency Problem, all by Lucian Bebchuk and Jesse M. Fried.


As companies address two fundamental and related shifts—the intensified focus on environmental,
social & governance (ESG) issues driven by investors, employees, consumers, business partners, ESG rating agencies, and regulators, [1] and the shift to a multistakeholder form of capitalism [2] —corporate boards are not only incorporating nonfinancial matters into discussions of company strategy and business plans, but also increasingly considering ESG performance measures in incentive plans. At the same time, there are concerns about the benefits of incorporating ESG measures into compensation, the risks of doing so (e.g., rewarding the wrong behaviors, setting inadequate targets, and creating guaranteed bonuses), and challenges in providing investors with what they view as sufficient transparency and specificity in ESG-based pay plans. These concerns have now been compounded by skepticism about whether ESG can actually drive financial performance for companies and investors alike. [3]

Insights for What’s Ahead

  • The vast majority of S&P 500 companies are now tying executive compensation to some form of ESG performance—growing from 66 percent in 2020 to 73 percent in 2021. The most significant increase was found in companies’ use of diversity, equity & inclusion (DEI) goals, rising from 35 percent in 2020 to 51 percent in 2021, as investors and other stakeholders continue to focus on diversity—making it a priority for companies as well. And as a result of the ever-growing attention to climate change, the share of S&P 500 companies that tied carbon footprint and emission reduction goals to executive pay also grew considerably, from 10 percent in 2020 to 19 percent in 2021.
  • Companies are embracing different approaches to factoring ESG into executive pay and are continuing to refine their ESG measures as they expand their reach. For example, some companies are moving from including ESG measures as part of the often-qualitative individual performance section of the annual incentive plan to incorporating ESG performance as a more quantitative modifier of the company’s overall financial performance rating, which is more aligned with investors’ preferences and expectations. Other companies are expanding the scope of those whose compensation is affected by ESG measures beyond the C-suite, reflecting that achieving ESG goals requires the collective effort of the employee base more widely.
  • Leading reasons companies are incorporating ESG measures into executive compensation, according to a poll of roundtable participants, are to signal that ESG is a priority, to respond to investor expectations, and to achieve ESG commitments the firm has made. While these are valid reasons, they also raise concerns. For example, some large institutional investors are skeptical about tying compensation to ESG measures, especially if there is not a strong business case for doing so and if the ESG goals are not sufficiently challenging or specific. Further, there are other less costly and disruptive ways of signaling ESG is a priority, including building ESG factors into professional development, succession, and promotion practices. Companies can also convey or achieve their commitment to ESG by enhancing disclosure on ESG performance.
  • Companies should consider using ESG operating goals for one to two years before including them in compensation. That allows time to see if those goals are truly relevant for the business, develop strong management and employee buy-in, and address any kinks in measurement methodology and reporting. It is especially important for companies to take time to validate and socialize ESG goals before rolling them out as part of compensation plans for a broader management or employee base.
  • It takes time to develop and compile reliable, meaningful data that can be used to measure and report actual performance against ESG goals. Companies can start by putting together a steering committee with representatives from various functions (e.g., compensation, finance, sustainability) who are engaged in the company’s strategy, and understand and have access to the data needed to measure and report on ESG performance.
  • Companies can link executive compensation to ESG successfully; however, they will need to go beyond simply “following the trend.” Actions companies will need to take include 1) identifying goals that are material, durable, and auditable, 2) assessing whether what the firm’s peers are doing in this area is instructive, 3) deciding whether to make performance measures absolute or relative to the market, and quantitative or qualitative, 4) determining the scope of those whose compensation is affected by ESG goals, 5) considering timing and assessing whether the ESG goal is appropriate for the annual or long-term incentive plan, 6) ensuring the type of metric reflects the firm’s corporate culture, 7) carefully considering the reaction of various stakeholder groups, and 8) reevaluating goals periodically to ensure that the ESG measures are still relevant and effective.
  • Companies will need to explain why including or adjusting ESG goals in compensation programs makes business sense and will “move the needle” on the firm’s performance and impact. Investors will want to understand how modifying the company’s compensation is necessary to achieve the firm’s financial, operating, and ESG goals—and whether the goals are sufficiently challenging to put compensation “at risk.” Those covered by the compensation programs will want to understand why a portion of their compensation is now linked to ESG goals. In some cases, the rationale may be obvious, such as when a company includes compliance-related goals in the wake of a widespread compliance failure. In other cases, boards and senior management will want to carefully consider whether they have a compelling narrative for adopting or adjusting such goals, especially as most companies say that including ESG measures in executive compensation is no more than “medium important” to their overall ESG efforts.
  • Measuring the full impact of including ESG performance goals in compensation is more challenging than measuring the impact of traditional operating or financial metrics. Companies should consider what they are trying to achieve by including ESG measures in compensation programs: is it to improve the firm’s ESG performance, to enhance its operating and financial performance, to signal that ESG (or a specific ESG metric) is a priority, to have a meaningful impact on society and the environment, or some combination of all four? If companies are actually seeking to have a broader impact on society and the environment, they may want to give serious consideration to how, if at all, they are incentivizing executives to work collaboratively with others in the industry and across the firm’s value chain—because making a measurable difference may require collective action.


The PCAOB Is Missing In Action on Climate Risk

Thomas L. Riesenberg is a Senior Regulatory Advisor at Ceres. This post is based on his Ceres piece.

Scores of U.S. and non-U.S. financial regulators have in recent years been addressing climate change through rulemakings, risk assessments, and other activities. But one actor has been absent – the Public Company Accounting Oversight Board.

The PCAOB (technically a nonprofit corporation, not a U.S. government agency) was created by the Sarbanes-Oxley Act to oversee the performance of public company audits and the auditing profession. Its five board members are appointed by the Securities and Exchange Commission. Last year, the SEC replaced all five Trump-era members, with SEC Chair Gary Gensler stating his hope that this would set the PCAOB “on a path to better protect investors by ensuring that public company audits are informative, accurate, and independent.”[1]

The PCAOB laid out that path in its PCAOB’s Draft Strategic Plan, issued in August of this year. [2] The draft plan sets forth the organization’s goals for 2022 through 2026, including the need to address many “emerging trends,” such as “new approaches to raising capital (including through special purpose acquisition companies), digital assets, the war for talent, and increased remote work at public companies, broker-dealers, and audit firms.” These trends, the Draft Plan stated, are “transforming auditing and financial statement preparation,” requiring the PCAOB to “anticipate and respond to developments in the audit profession” and moderniz[e] our standards to drive changes in auditing practices and enhance investor protection.”

No mention is made in the draft plan of any actions the PCAOB might take with respect to climate change. This is puzzling for several reasons, as Ceres, a sustainability nonprofit, explained in a comment letter submitted to the PCAOB. [3] Most significantly, a few months before the PCAOB issued its draft plan, the SEC published in March 2022 its proposed climate disclosure rule, and that rule would directly implicate the PCAOB’s work by requiring that independent third-parties, such as accounting firms registered with the PCAOB, provide assurance of certain SEC registrants’ reports of their greenhouse gas emissions. Given that potential requirement, the SEC’s proposing release includes references to the PCAOB more than a dozen times. For example, the SEC asked for comment on the question “[w]hat, if any, additional guidance or revisions” of the PCAOB standards might be needed if the proposed rule were adopted? Further, because the rule proposal would allow firms that are not PCAOBregistered accounting firms to perform this work, the SEC asked whether it should “direct the PCAOB to develop a separate registration process for service providers that are not otherwise registered?”[4]


Lessons from the Chancery Court Decision in P3 Health Group

Gail Weinstein is Senior Counsel, Steven J. Steinman and Brian T. Mangino are Partners at Fried, Frank, Harris, Shriver & Jacobson LLP. This post is based on a Fried Frank memorandum by Ms. Weinstein, Mr. Steinman, Mr. Mangino, Andrew J. Colosimo, Randi Lally, and Erica Jaffe and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes Are M&A Contract Clauses Value Relevant to Target and Bidder Shareholders? (discussed on the Forum here) by John C. Coates, Darius Palia, and Ge Wu; and The New Look of Deal Protection (discussed on the Forum here) by Fernán Restrepo and Guhan Subramanian.

In P3 Health Group, private equity firm Hudson Vegas Investments SVP LLC, which was the second-largest unitholder of P3 Health Group Holdings, LLC (the “Company”), challenged the Company’s de-SPAC merger. The Company’s sponsor, private equity firm Chicago Pacific Founders Fund, L.P., controlled the Company (a Delaware LLC) by virtue of its majority equity ownership, board designees, and contractual rights. Hudson claimed that the merger, which stripped it of $100 million of stock options and its contractual rights with respect to the Company and was effected over its objection, violated its contractual veto right over affiliated transactions.

The Delaware Court of Chancery recently issued five important decisions in the case (dated November 3, October 31, October 28, October 26, and September 12, 2022), rejecting dismissal of most of Hudson’s claims.

Background. Chicago Pacific provided the start-up capital for the Company and soon thereafter, Hudson invested $50 million in the Company. Soon thereafter, a de-SPAC merger was structured with Foresight Acquisition Corp. (a SPAC formed by an unaffiliated businessperson), which contemplated a three-way merger that included another Chicago Pacific portfolio company (known as “MyCare”). Hudson objected to the transaction. Chicago Pacific and the Company then restructured it to exclude MyCare (but allegedly contemplated including MyCare later in a follow-on transaction). Hudson unsuccessfully sued to enjoin the merger. Following the closing, Hudson asserted claims against Chicago Pacific and certain of its and the Company’s key managers and officers for their roles in arranging the merger. Hudson also added a claim that its initial investment in the Company was fraudulently induced. In a series of recent pleading-stage decisions, Vice Chancellor Laster rejected dismissal of most of the plaintiff’s claims.


Weekly Roundup: November 18-24, 2022

More from:

This roundup contains a collection of the posts published on the Forum during the week of November 18-24, 2022

Remarks by Commissioner Uyeda at the 2022 Cato Summit on Financial Regulation

SEC Releases Final Rules Regarding Clawback Policies for Public Issuers

Boards: Stepping Up as Stewards of Sustainability

Updating Annual Report Risk Factors

The Evolution of ESG Reports and the Role of Voluntary Standards

Bylaw Amendments, Shareholder Activism, and Flying Close to the Sun

Fifth Circuit Declines to Rehear Sweeping Decision That Hamstrings SEC’s Enforcement Program

Boardroom Racial Diversity: Evidence from the Black Lives Matter Protests

The Playing Field

EU’s New ESG Reporting Rules Will Apply to Many US Issuers

Universal Proxy Creates New Type of Proxy Fight

Review of Comments on SEC Climate Rulemaking

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