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The story of E.F. Hutton and what it can teach us

By Tamar Frankel

The following case is important to demonstrate a slippery slope situation, where people in an organization strart something which then deterriorates into wrongful behavior and ends in demolishing the organization altogether. This is the case of E.F. Hutton in the 1970s. I apologize for the length of the story but I believe it is sufficiently interesting and important.

© Mark Fagan and Tamar Frankel

This story of E.F. Hutton is a short version of a case study by Mark Fagan and Tamar Frankel. The background materials include Tamar’s book Trust and Honesty, America’ Business Culture at a Crossroad (2006). The case†raises issues for practicing lawyers and businesspersons. How could the failure of E.F.Hutton be avoided? What can we learn from this story?

The following ad represents E.F. Huttonís success in 1970s and 1980s. In a crowed restaurant an E.F. Hutton broker is dining with a customer. When the Hutton broker begins to speak the restaurant becomes silent and everyone turns toward the broker because: “When E.F. Hutton talks, people listen.” Everyone remembered this.

Huttonís revenues in 1980 were $1.1 billion and profits totaled $82 million. Hutton offered products across the financial services spectrum from stock trading to tax shelters to underwriting bond issues. The flagship product was retail brokerage services, employing 6000 brokers. From the founding of the company in 1904, buying and selling stocks and bonds for retail customers was the foundation of the company. Huttonís success in brokerage was a result of innovation, aggressive management and decentralized operations. With regard to innovations, in 1905, Hutton was the first west coast broker with a direct wire to New York, which enabled its customers to eliminate timing risks resulting from slow communications. Another example was that the company set up seasonal offices, Palm Beach and Miami, Florida in the winter and Saratoga, New York in the summer, to access its well-heeled customers. Management also realized that broad geographic coverage would leverage the firmís brand equity. Thus, Hutton acquired regional brokerage firms to build a national network. The founder, Edward Francis Hutton, was bold and aggressive. He saw the potential of Californiaís exploding growth at the beginning of the 20th century and had the courage to open up shop in this emerging market. From his first office in San Francisco Hutton rapidly expanded over the next several years opening offices in Los Angeles, Hollywood, Santa Monica, and San Diego. His aggressive tone became the firmís culture. Hutton died in 1962, but his legacy continued. The culture which he established was reinforced by Bob Fomon, who was Huttonís CEO from 1970 to 1986 and its chairman from 1977 to 1987. He too was forceful and directive in his management style. He supported the companyís hiring of aggressive salespeople for the brokerage business. The culture of the Hutton team was: when Hutton competed for business, it won. As described by the New York Times correspondent James Sterngold, Fomonís philosophy was that: “The world consisted of winners and losers in the Darwinian creed he adopted, and he would devote himself to winning at all costs.” This style was paying off. Institutional Investor magazine wrote “Hutton has surged into second place among US brokers- and very probably leads the pack when it comes to sheer aggressiveness.” Hutton adopted a decentralized management model. Brokers, not headquartersí managers, generated revenues. Their idea was to tap the entrepreneurial spirit of the brokers. Thus, the brokers defined the processes for managing their own business in ways to maximize profits. The decentralized model also allowed Hutton to attract successful brokers since individual deals could be cut with superstars without upsetting predetermined organizational boundaries. Don Sanders is a case in point. He was one of Huttonís most productive salesmen. He generated $2 to $3 million in commissions for the firm every year. To minimize the bureaucracy he faced, Hutton established for him a separate branch. This virtual branch allowed Hutton to cut a special profit-sharing deal with Sanders without changing the profit-sharing split for the rest of the brokers in the branch. Moreover, “[w]hen the designation ëN53,í the code for Sanderís Houston office, showed up on a document, no questions were asked. “Headquartersí role was to track performance.

While Fomon adopted a hands-off approach George Ball, president of the holding company, watched branch profitability with an eagle eye. According to Sterngold, Ball “had a prodigious appetite for the facts and details Fomon abhorred. A branch did not change a light bulb without his [Ballís] noticing.” On a monthly basis Ball ranked the branches for profitability, rewarding winners with gifts and chiding losers. Nonetheless, he was viewed favorably by the branch managers and brokers. He earned the brokersí unwavering support by treating them and their families personally and as the real heroes of the company and paying successful brokers more than industry average pay packages.

While Ball was very focused on the bottom line he did not examine the processes that generated the results. The organizational structure at headquarters mirrored the laissez-faire approach to branch management. Hearings held by the House Judiciary Committee Subcommittee on Crime which followed the companyís guilty plea revealed that this billion dollar company had no organization chart. “Its lack of that traditional management tool speaks Volumes about the way the firm was run. More than eighty years after its founding and with 17,000 employees, Hutton still operated as if it were an entrepreneurial enterprise.” Making money in the brokerage business from Huttonís founding until the 1970s was relatively easy. The firm earned commissions on each buy and sell transaction. The fees set by the stock exchanges enabled even the inefficient houses to profit. The secret to success was: grow the number and value of trades, keep expenses under reasonable control and watch the profits soar. That simple model underwent dramatic change in 1975 with the Securities Acts Amendments of 1975. Under this law the fixed brokerage fees, of 1% of the amount of the trade, was eliminated. The objective was to create competition in the brokerage sector and it worked. There appeared “no frills” brokers that charged reduced fees. For example, in 1979 E.F. Hutton charged a retail customer $85 to purchase 100 shares of IBM. The discount broker Charles Schwab charged one $40 for the same transaction. The transition to a competitive marketplace was not easy for Hutton. The companyís culture of special arrangements for key brokers and Bob Fomonís flamboyance did not lead the company to be a low-cost provider. In fact, to hire and retain aggressive brokers Hutton shared a larger portion of its commissions with its sales staff than most of its competitors. To maintain profits amid falling commission rates, greater competition and higher sales costs, branch offices looked to other income sources.

Cash management was identified as a particularly promising tool. A textbook lesson is that a firmís funds be “put to work” at all times; idle money is lost profits. Two particular techniques were often cited to maximize productivity of cash for corporations with wide-spread operations in the 1970s and 1980s. The first was to deposit customersí checks at local banks to speed the availability of funds. The second strategy was money mobilization: Bring excess cash balances into a central bank location(s) for disbursement or investment. A variant of the approach was to use the geographically dispersed banks to “play the float,” earning interest on checks that were still in the clearing process. As described in James Van Horneís Financial Management and Policy: “Taking advantage of inefficiencies in the checkclearing processes of the Federal Reserve System and of certain commercial banks as well as inefficiencies in the postal system, a firm may maximize the time the checks it writes remain outstanding.” For example, if a Hutton customer in Maine was due a check for $10,000, the firm could write the check on a bank in Arizona. The geographic separation of the banks lengthened the time for the check to clear. During this “travel” time, Hutton had the use of the funds, enabling the company to reduce its borrowing or earn interest. Of course, the companyís gain was a loss to the customer and the process incurred administrative costs for the banks. Concentration banking and money mobilization were and are legal although their benefits have been reduced with electronic banking. Three factors made playing the float particularly attractive to Hutton in the late 1970s and early 1980s. First, deregulation of the brokerage businesses and the subsequent competition from discount brokers such as Charles Schwab reduced Huttonís profits. Consequently the company sought new sources of income. Second, in the brokerage business large sums of money are received and disbursed, thus even small percentage gains could significantly improve the bottom line. Third, interest rates were at historically high levels during this time period. For example, the prime rate averaged 9 percent in 1978 and exceeded 20 percent in December 1980. Funds that could be invested rather than paid to customers were a further boost to otherwise sagging profits. The magnitude of the gain could be substantial. Increasing Huttonís daily cash balance by $10 million on an annual basis could lead to $1.8 million in interest income at the December 1980 interest rate level. In 1974, Hutton hired William Sullivan to help the company better manage its cash. Sullivan took his title, Money Mobilizer, literally and looked for ways to increase the value of Huttonís cash. In part as a result of a West Coast banker thanking Sullivan for leaving so much money in his bank, Sullivan realized that the cash concentration program was leaving excess funds at the branch banks. Moving the money to its central banks in Los Angeles and New York would enable the firm to earn interest on the otherwise unproductive funds. Next, Sullivan realized that he could use delays in the check clearing system to draw down twice the value of the funds in the account, earning more interest income for Hutton. For example, if a local branch deposited $100,000 per day, the branch could write a check for $200,000 and send it to Huttonís New York central bank. Because of the strong relationship between Hutton and its New York bank, Hutton was credited with the $200,000 immediately in New York. By the time the check cleared back in the branch bank another dayís deposit of $100,000 would cover the check. Thus, Hutton earned interest income on $200,000 during the time the check was being processed. Sullivan left Hutton in 1980 and was replaced by Thomas Morley. During the new Money Mobilizerís watch two new cash management techniques were adopted. First, Hutton overdrafted local bank accounts by large amounts. According to an internal investigation conducted by former Attorney General Griffin Bell, someone in the Alexandria, VA office inadvertently wrote a $9 million overdraft check rather than the intended $900,000 check. “When the overdraft went through without a complaint from the bank, the $9 million overdraft was repeated.” The second technique was “chaining” where Hutton branches would write checks greater than the funds they had in deposit and cover them with checks drawn from banks in other cities. Under this strategy the company had the use of the funds in both accounts until all the checks cleared providing Hutton with the equivalent of an interest free loan. The branches had a strong incentive to participate in these practices. Under the decentralized company philosophy, local managers shared directly in their branchesí profits. For branch managers this amounted to 10 percent of local net earnings. Thus, interest earnings of $124,000 for one month at a branch yielded $12,400 for the manager. A second reason to adopt the overdrafting approach was the “encouragement” from Ball at headquarters. Ball examined the branch financial performance and could see the positive financial impact of overdrafting. He wrote memos to the branches “praising branches with high profits from overdrafting and encouraged others to learn the process.” Perhaps the strongest selling point for the overdrafting scheme was that it worked. In 1980, Hutton reduced its working cash borrowing from $383 million to $192 million. The reduced interest expense was estimated to amount to one-third of the companyís profits. That year “Ball began a wholesale push for more interest income. Within a year a third of Huttonís branches were engaged in at least one of the two abusive practices . . . . Ball exhorted his troops to use overdrafting to boost their income, while leaving the precise method vague.” In 1981, an estimated 70 percent of profit earned by the retail sales area was from interest income. Ball and the branch managers most extensively involved in the overdrafting stated to internal auditors and the House Judiciary Committee that they thought they were using a generally accepted business practice.

The United States Office of the Comptroller of the Currency defines “check kiting” as “a method whereby a depositor . . . utilizes the time required for checks to clear to obtain an unauthorized loan without any interest charge.” The FBI definition is “a scheme which artificially inflates bank account balances, in accounts that are under common control, for the purposes of obtaining unauthorized use of bank funds, through the systematic exchanging or swapping of checks between these accounts, in a manner which is designed to misuse the float that exists in the banking system.” Check kiting is illegal in the United States and can be prosecuted under several bank fraud laws. The penalties include fines up to $1 million and 30 years in prison. Ned Chatt, the manager of the Genesee Country Bank in Batavia, New York, watched with delight as its newest customer, E.F. Hutton, deposited a steady steam of funds into its account during December 1981. On December 1 two checks totaling $334,000 were deposited. Two additional deposits on the 2nd raised the Hutton balance to $1.2 million. The next day a $2.6 million deposit boosted the Hutton account to $3.8 million. The account buildup continued on Friday when Hutton deposited a check for $8 million bringing the balance to almost $12 million. On Monday the deposits continued but three checks written on the bank also arrived, they totaled $11 million. The bank honored the checks but a bank auditor noticed that Genesee had paid $8 million before the Hutton deposits were cleared thought the Federal Reserve System. The Genesee officials realized that the magnitude of deposits were far greater than the banking requirements of Huttonís four-person Batavia office. They also realized that the checks being deposited were written by Hutton to Hutton drawn on two Pennsylvania banks. Genesee contacted the Pennsylvania banks and learned that Hutton had insufficient funds to cover the checks written. By Thursday December 10 Genesee refused to honor a Hutton check. The bouncing of Hutton checks continued on Friday and Monday. Further conversation between the banks revealed that Hutton was just moving money between the banks. On December 18 one of the Pennsylvania banks, United Penn Bank, contacted the Federal Deposit Insurance Corporation (FDIC) to investigate. Genesee reported its concerns to the New York State Banking Department. The FDIC investigator, Gerald Korn, in January 1982 wrote: “At first glance it could appear that Hutton was ëplaying the float,íÖbut further investigation revealed evidence of an apparent deliberate kiting operation almost ëtextbookí in form.” Huttonís immediate responses failed to defuse the problem. First, when the checks were bounced, the Hutton manager told Genesee that it would take its business elsewhere. The bank said: “fine.” Second, Hutton offered $5,000 to United Penn Bank to drop the matter, the bank refused. Within a few months, Huttonís New York leadership was involved in investigation. Fomon opted to retain Thomas Curnin of Cahill Gordon & Reindel to solve the problem, based on Curninís “reputation for being tough.” The Hutton strategy appeared at first to be “drag your feet.” The information requests submitted by Al Murray, the Pennsylvania prosecutor, went largely unanswered. When the prosecutor showed no signs of backing down Hutton dumped 7 million documents at Murrayís office. Murray had become convinced that Huttonís practices were “illegal, fraudulent, and criminal” in early 1984. On April 20 the government sent letters to the Hutton executives at the center of the probe stating: “This is to advise you that you are a target of a Federal Grand Jury investigation being conducted in the Middle District of Pennsylvania into possible violations of Federal law.” Fomon realized that the overdrafting issue was not going away. He attempted one last effort to solve the problem ñ he went to Washington and dined with William French Smith, the US Attorney General. When the meal was over, Fomon stated “I donít know if youíre aware but the U.S. attorney in the Middle District of Pennsylvania has been investigating our banking practices for two yearsÖOur lawyers have been having trouble with your lawyers. Will you look into it?” Smith was not happy about the request and never got involved. The discovery of a smoking gun in February 1985 changed the Hutton approach. A 1982 memo by Perry Bacon, a vice president responsible for several branches in the DC area, stated “Specifically, we will from time to time draw down not only deposits plus anticipated deposits, but also bogus deposits. I know of at least a dozen managers at Hutton ñ managers who along with Bill Sullivan and Tom Morley taught me the system ñ who do precisely the same thing.” Based on this memo, and the fact that it was not produced in response to prior requests, Curnin changed his strategy and began the plea bargaining process. On May 2, 1985 E.F. Hutton pled guilty to 2000 counts of mail and wire fraud. The financial community was shocked that a financial pillar had fallen. The press was shocked that only the firm, not individuals, were required to plead. In turn Congressmen “wrote a letter to the attorney general, demanding to know why he didnít hang everybody at Hutton by their toes.” The House Subcommittee on Crime took up the issue. Prosecutor Murray testified that the law around cash management was unclear. Further, many banks must have known that the practice was being used and accepted it as a cost of doing business. He concluded that it was the corporation not individuals that committed the crime. Beyond this he thought he would have a difficult time proving the case against individuals. The plea bargain allowed him to achieve his core objective ñ help stop fraudulent banking practices. As it turns out, Murray probably had greater impact because he pursed the corporation rather than a handful of individuals.

Hutton faced minimal short-term impact from the guilty plea. Huttonís stock price barely moved and senior management took steps to regain positive footing. One of the first actions was to conduct an internally sponsored investigation of the overdrafting affair to understand what went wrong and how to prevent it or similar problems in the future. Former Attorney General Griffin Bell was retained to conduct the investigation. Bellís investigators interviewed hundreds of Hutton employees as well as bank and regulatory officials. They also reviewed 40,000 pages of documentation. Bell concluded that Hutton had inadequate internal controls and a loose management structure that permitted employees to overdraft at will. The report directly blamed the CFO, Morley (the money mobilizer), general counsel, and three regional managers. At the branch level he found that six branch managers “participated in patterns of intentional overdrafting” that “were so excessive and egregious as to warrant sanctions.” A second step was to hire Robert Rittereiser, the chief administrative officer at Merrill Lynch, to improve Huttonís operations. Shortly after joining Hutton the Wall Street Journal ran a story headlined: Battered Broker: E.F. Hutton Appears Headed for Long Siege in Bank-Draft Scheme. Hiring Rittereiser was too little, too late. The board and Fomon were slow to act on the Bell report. Huttonís combative style was leading to more House hearings and keeping Hutton in a negative spotlight. The publicity led existing customers to rethink their relationships with Hutton. For example, the City of New York issued its largest financing ever in May 1985 and left Hutton out of the process. Rittereiser was also discovering that the Huttonís type of culture was playing out in other areas of the business. One of many revelations he learned was that Hutton had marketed tax-exempt securities with potentially misleading descriptions. In late 1986, Shearson and Hutton held merger discussions. The Shearson offer was in the $50 per share range. Huttonís Board demanded $55 and Shearson walked away. One year later after continued struggles Hutton agreed to an acquisition by Shearson for $29.25 per share.

The E.F. Hutton case touches on the foundation of our banking system. Crucial to our economy, banking has a fragile institutional structure. Banksí liabilities and assets are not matched in liquidity or level of risk. Deposits are paid on demand. Assets (loans to borrowers) are not. The risk posed by the assets (loans to borrowers) are borne by the bank and not passed on to the depositors. Further, the bank lends deposit money on the assumption that only a certain percentage of the depositors will demand their money back, or that the demanded deposits will be replenished by new depositors. This mismatch is the source of the bankís income that covers its expense. It is the spread between the interest paid to depositors (if any) and the interest paid on the assets. The two main risks to this structure are a “run” by all or more than anticipated depositors and reduced spread (by defaulted loans or other reasons). Runs on the banks have a long history, and are now treated by the federal government ñ the FDIC. Before the FDIC, both the banks and the States had organized their own support systems. “[A] National Credit Corporation, organized by bankers in the private sector, was created in October 1931 to extend loans to weakened banks. However, the corporation failed within a matter of weeks. Business leaders appealed to the federal government for assistance.” In response, the Hoover Administration recommended (1) creation of the Reconstruction Finance Corporation, which would make advances to troubled banks, and (2) making it easier for banks to borrow from the Federal Reserve. There were insurance programs in six states from 1829 to 1866. The first was established by New York in 1829. Others were adopted between 1831 and 1858. These programs generally “accomplished their purposes.” But they collapsed eventually mainly because of (1) “the emergence of the ëfree bankingí movement in the 1830s,” resulting in the establishment of “free banks” excluded from the insurance system, (2) “the establishment of the national bank system in 1863” and (3) the 1865 tax on state bank notes, resulting in state-chartered banks converting to national banks. Later, from 1908 to 1930, eight states operated state deposit insurance programs. These programs, adopted between 1907 and 1917, were also “generally unsuccessful,” failing during the depression of 1921. “By early 1930, all of the funds, including the Texas fund, which became insolvent after most of the participating banks withdrew, had ceased operations.” Banksí falling spread and lower income usually results from borrowersí defaults. But another form of loss of revenue is check kiting. A check kiting scheme operates as follows: The check kiter opens an account at Bank A with a nominal deposit. He then writes a check on that account for a large sum, such as $ 50,000. The check kiter then opens an account at Bank B and deposits the $ 50,000 check from Bank A in that account. At the time of deposit, the check is not supported by sufficient funds in the account at Bank A. However, Bank B, unaware of this fact, gives the check kiter immediate credit on his account at Bank B. During the several-day period that the check on Bank A is being processed for collection from that bank, the check kiter writes a $ 50,000 check on his account at Bank B and deposits it into his account at Bank A. At the time of the deposit of that check, Bank A gives the check kiter immediate credit on his account there, and on the basis of that grant of credit pays the original $50,000 check when it is presented for collection. By repeating this scheme, or some variation of it, the check kiter can use the $ 50,000 credit originally given by Bank B as an interest-free loan for an extended period of time. In effect, the check kiter can take advantage of the several-day period required for the transmittal, processing, and payment of checks from accounts in different banksÖUnlike “runs” on banks and borrowersí defaults, check kiting produces its most serious losses mainly during inflation time, such as the late 1970s and beginning of the 1980s. That is because check kiting constitutes free loans that pay no interest when interest rates are very high. In addition, check kiting defrauds the banking system because it involves at least two banks, and usually, as in the case of E.F. Hutton, many more. As compared to the failure of borrowers, the scheme is harder to spot until it becomes truly repetitious, and involves many banks. In addition, in the 1980s, banksí protection against check kiting was not foolproof. It could (and still can) be

practiced by a long-term customer such as E.F. Hutton, as well as by a new customer. In 1986 a commentator noted that [m]ost banks have taken precautionary measures by programming computers to alert them when there is a substantial volume of large transactions in a short period of time in any given account. This technique, however, is not failsafe. Banks that process a large number of checks may be unable to screen and check all of the accounts that the computer indicates are active. Furthermore, such shifts in balances may not, in reality, be due to a kite. In any event, these programs do not prevent kites. The Uniform Commercial Code requires a bank to act in “good faith.” Therefore, banks cannot arbitrarily refuse to honor a check drawn on another bank. Such a refusal may render a bank liable for the amount of the check. In the 1980s a bank could refuse to honor a check only for a very limited period, before the “midnight deadline ñ midnight on the banking day following receipt of the check ñ and [provided that the bank] has not settled for the item.” These two provisions were not fully effective because they were not consistently applied. In fact, “Hutton said, and officials confirmed, that its brokerage customers had not been hurt by the fraud. While acknowledging that the actions were illegal, Hutton’s chairman, Robert Fomon, said at a news conference in New York that the law was complex and little known. He also said that none of the employees involved apparently knew that the scheme was illegal or contrary to the firm’s policy.” In sum, check kiting was hard to spot and hard to prosecute. E.F. Hutton was sued by private parties on various violations of securities laws including a claim on its check kiting. The “plaintiffs allege[d] that a ëcheck-kitingí scheme to which defendant E.F. Hutton pled guilty to 2,000 counts of mail and wire fraud constitutes a ëpattern of racketeering activityÖDefendants argue[d] that the plaintiffs cannot show injury by these unrelated acts nor have plaintiffs alleged any injury. The Court [held] longer until it is honored. that the allegations on this check-kiting scheme are unrelated to the case at bar and do not constitute the predicate acts required for RICO allegations… Any amended complaints plaintiffs might choose to file, therefore, should not refer to the check-kiting scheme and should delete any claims under Section 1962(c) which allege that defendants are part of the enterprise.” In addition, E.F. Hutton was a registered broker-dealer as well as many of its employees. Such broker-dealers are subject to section 15 of the Securities Exchange Act of 1934. Part of the section provides that the Securities and Exchange Commission: by order, shall censure, place limitations on the activities, functions, or operations of, suspend for a period not exceeding twelve months, or revoke the registration of any broker or dealer if it finds . . . that [such order] is in the public interest and that such broker or dealer ÖñÖ (B) has been convicted within ten years preceding the filing of any application for registration or at any time thereafter of any felony or misdemeanor. Among these crimes are crimes involving activities in the conduct of the business of a broker and dealer that relates to securities laws violations, “larceny, theft, robbery, extortion, forgery, counterfeiting, fraudulent concealment, embezzlement, fraudulent conversion, or misappropriation of funds, or securities” and various species of fraud.

Discussion topics:

  1. What mechanisms can be put in place to allow sales persons to be aggressive and yet put barriers to crossing the line to illegality?
  2. What is the relationship, if any, between the structure of the organization (centralized, or decentralized) and compliance with the law? Could the directors or the CEO of Hutton have prevented the violations?
  3. Why was hiring Rittereiser too little, too late? What would have been different had Hutton acted immediately, and why?


  1. What are the duties of the directors and controlling persons of a broker dealer? 2. Were these duties violated in the case of Hutton? Did Hutton violate any duties as broker dealers under the securities acts? Should Huttonís brokerñdealer registration have been suspended or even revoked? Why was it not touched?

Public Policy

  1. How can regulation prevent a case such as the Hutton case from ever occurring again?
  2. Can the Securities and Exchange Commission or the National Association of Securities Dealers have prevented behavior of Hutton? Were there any “red flags” that the regulators could be discerned? What if the newspapers were alerted to its aggressive (not illegal) practices? What if the bank that suspected check kiting notified the newspapers instead of the regulators?

A decade later on May 2, 1985 Scott Pierce, President of E.F. Hutton & Co., pled guilty on behalf of the corporation to 2000 counts of wire and mail fraud associated with over-drafting checking accounts costing banks millions of dollars. With the guilty plea the company agreed to pay a fine of $2 million, compensate the government $750,000 for its investigation expenses, and make restitution to the banks that Hutton defrauded. The direct financial impact of the plea bargain was trivial for a billion dollar company; however, the loss of reputation for integrity within the financial community was so great the company never regained its own financial viability. In December 1987, the company was sold to Shearson in a fire sale for marginally more than book value.

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