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The Valuation of a Professional Practice in a Divorce Proceeding
A law practice has value even apart from its old couch, obsolete library, barely functioning IBM 386, accounts receivable, and whatever work is in progress. In addition to these assets, a practice may have goodwill, but the value of that goodwill may be the subject of much dispute. Nevertheless, in a divorce action, a court may find not only that a lawyer has goodwill but also that the lawyer's spouse must be compensated for that goodwill. Regrettably, the chance that a marriage will end in divorce is about 50 percent. Goodwill has various definitions, but the controlling definitions used in a divorce proceeding is found in the leading case on professional practice valuation - In re Marriage of Foster. 1
The standard for measuring the value of goodwill, however, is not clear. For other assets, the standard of value is their fair market value, which is defined in Code of Civil Procedure Section 1263.320(a) as the highest price on the date of valuation that would be agreed to by a seller willing to sell but under no particular or urgent necessity for doing so and a buyer that is ready, willing, and able to buy but under no particular necessity for doing so-and each party is dealing with the other with full knowledge of all the uses and purposes for which the property is reasonably adaptable and available. Family law cases, however, appear to have veered away from this definition, which is derived from eminent domain law. As the court noted in Foster:
The value of the community goodwill is not necessarily the specified amount of money that a willing buyer would pay for such goodwill. In view of the exigencies that are ordinarily attendant a marriage dissolution the amount obtainable in the marketplace might well be less than the true value of the goodwill. 2
The value of an attorney's goodwill - whether "true," "fair market," or some other standard is difficult to determine, but at least a commonsense test exists for fair market value.
Ever since the sale of law practices became legal in California in 1989, pricing information about law practices has been accumulating.
Before 1989, however, no California law practices were sold, so there was no available market data to arrive at a fair market value based on comparable sales. As a result, concepts of valuation that developed in the context of estate and gift taxation were applied to the valuation of professional practices in a marital dissolution. 3 Out of practical necessity - rather than superior accuracy these methods of determining the intrinsic value of a business became the norm in the valuation of professional practices. 4
The Loose Standards of Foster
In 1974 in Foster 5 which involved the valuation of a medical practice, the appellate court allowed the trial courts wide discretion to accept any legitimate method of valuation of a professional practice. The court said that any method of valuation "that measures its present value by taking into account some past result" is legitimate.
The appraiser who testified in Foster determined the value of the medical practice by taking three months of the doctor's gross income. According to Foster, the expert argued that "there is no definite method by which the value of goodwill can be determined and that it is 'always just somebody's opinion.'" 6 The Foster appraiser made it clear that he did not contend that the value of $27,000 that he assigned to the goodwill of the practice was what the seller would get if the practice were put on the market for sale. He did say that a hypothetical buyer would pay some price for goodwill, but he had no opinion about what that price would be.
The Foster appraiser also considered other methods. For example, the appraiser attempted to clarify how a practice may be valued using the excess earnings approach:[T]ake the net income for the year and subtract from that what a comparable [employee] would have as a salary in a comparable situation, and take that difference, and multiply that by a factor anywhere from...two to ten... You can take the net earnings of the business, one year's net earning of the business. You can take two years' net earnings of the business. You can take three years' net earnings of the business. You can take three months' charges to accounts receivable. You can take three months' receipts on accounts receivable. 7
The appellate court approved of the appraiser's methodology, declaring that a court is not restricted to market value and need not find evidence of "what a willing buyer would pay for the community goodwill." The Foster court indicated that the standard of value was not the fair market value but did not replace fair market value with another standard.
Another case, In re Marriage of Hewitson, 8 is also unhelpful, although the court did create a name - investment value - for the intangible and undefined interest in a business. In Hewitson, the court recognized the following possible methods of determining the investment value of closely held shares in an engineering company: 1) capitalization of earnings, 2) capitalization of dividends, and 3) book value or net asset value. 9 The decision criticizes the capitalization of dividends method in a footnote. Additionally, the court did not define "investment value" 10 except to say that the method must take into account the factors set forth in Revenue Ruling 5960. 11
(h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over the counter. Finally, the court found that the valuation of stock in closely held entities cannot be based on the price-to-earnings ratios of publicly held stock or use sales arising out of mergers because they were not comparable to open market sales of closely held corporate stock. 12 Without specific evidence of comparable transactions to provide the court, attorneys are likely to get a valuation, as the appraiser in Foster said, that is "just somebody's opinion." 13
Methods of Valuation
In In re Marriage of Sharp 14 the Fourth District Court of Appeal reestablished fair market value as the preferable standard, criticizing the trial court's use of "going concern" or "going business" value. 15 The court held that "going concern value...does not have the same...relevance as the fair market value concept." 16 The Sharp court neither cited nor discussed Hewitson, which the Second District Court of Appeal had issued only one month previously. Sharp also does not discuss investment value as an alternative to going concern value or fair market value. Thus, the districts appear to be divided on this issue. The California Supreme Court denied a petition for hearing in Sharp, and no petition was filed in Hewitson, leaving attorneys without clear guidance on the issue of which standard a court is most likely to uphold in a dissolution of marriage case. 17
In Foster, the leading case, the appraiser said he used both a multiple of earnings approach and the excess earnings approach. 18 These two approaches are regularly used today. The multiple of earnings approach is used not so much because it has sound theoretical underpinnings but because it is customarily used in the medical industry. According to an article in Family Law News, medical practices sell for three months' gross income, and therefore three months' gross earnings can be used as the value of a law practice's goodwill. 19
In the excess earnings method, the expert determines how much an attorney (preferably in the same field of practice) with similar experience earns. If published statistics are available, the appraiser may use them to determine reasonable compensation. Otherwise, the expert may obtain earnings information through interviews. The reasonable compensation of an average attorney is compared to the self-employed attorney's income. If the owner of the practice is earning more than the norm, the excess is attributable to goodwill. After compensating for a rate of return on the fixed assets, a capitalization rate is applied to the excess earnings to determine the value of the practice. 20
An article in the Journal of the American Academy of Matrimonial Lawyers criticizes the excess earnings approach for being not only speculative but also "simply a method of valuing future earnings. Future earnings are not marital property.' [This method] may produce unrealistic figures which overvalue the goodwill, when the professional spouse is required to pay tangible assets in exchange for intangible goodwill value." 21 Furthermore, Revenue Ruling 59-60 states, "The [excess earnings] approach should not be used if there is better evidence available from which the value of intangibles can be determined." 22 The excess earnings approach can impose hardship on attorneys who suffer economic loss after they have paid their spouses for the value of their practices. Whether the loss is caused by a change in the law, loss of a major client, loss of key personnel, an economic downturn, personal disability, or even death, attorneys will have paid for an asset that is no longer worth what they paid for it. For example, spouses of successful medical malpractice attorneys whose practices were valued in divorce prior to the enactment of the Medical Injury Compensation Reform Act may have received a substantial windfall. Errors can happen no matter what method is used, but it seems that this type of error is more likely when courts rely on past earnings to predict future performance.
Despite criticism, the excess earnings method has become the method of choice for valuing professional practices. The court in In re Marriage of Watts, 23 addressing the valuation of a surgeon's interest in a partnership, found that even if there is evidence that the professional practice cannot be sold, if excess earnings are found the court must determine there is a value to the practice. 24
Watts should not be read, however, to mean that every professional partnership has value. The court in In re Marriage of Slivka 25 found that there was no goodwill in the partnership interest in the Southern California Permanente group because the doctor was a Class 3 partner and was "most similar to an employee who has no ownership interest and is paid for services rendered." Also, in In re Marriage of Aufmuth, 26 in a case involving the valuation of a partnership interest in a law firm, the court found that a finding of no goodwill is appropriate in certain situations. The court found:[The] accountant called by [the] husband testified that, in his opinion, the law firm does not have a value beyond that expressed in the formula [in the stock purchase agreement]. At the time of trial, [the] husband was 31 years old and had been a member of the bar for only seven years. He had been a member of his law firm for just five years, and a shareholder for only two years. In view of his youth and comparative inexperience, the trial court could reasonably conclude that he had not contributed in any substantial way to whatever goodwill the law firm might possess. These factors support the court's determination that goodwill was not to be considered in evaluating his interest in the firm. 27
Even though Aufmuth, Slivka, and Sharp give some hope to attorneys, it is more likely than not that a court will find that there is goodwill and ignore fair market value. Many California courts and commentators contend that market value is irrelevant because, in fact, in a marital dissolution, the law practice is not going to be sold. Noted family law scholar Garrett Dailey comments:While [Revenue Ruling 59-60] offers guidance to the trial court in dissolution matters, there will seldom be an actual sale of the business or profession to a third party, and, if there is, it is seldom necessary to value the asset [because] the sales price determines the value. The problem in the dissolution setting is that a hypothetical sale is taking place without free market pressures. Therefore, it is necessary for the court to determine a hypothetical fair market value. To do so, it is often necessary to rely on the excess earnings method as there will seldom be a "better approach available." 28
Some courts have held that a premium should be added to the value of a professional practice. The court in Marriage of Winn held:One way to establish the market value is by reference to comparable sales of other practices.... This method has been criticized by the courts because a sale of goodwill to a third party is inherently different from a "sale" in a divorce proceeding. A buyer of a professional practice has no assurance that the seller's clients would continue their patronage of the practice and so he is not willing to pay to the seller a sum which represents the true value of the seller's goodwill. A sale of goodwill in a divorce proceedings, however, involves a conveyance of goodwill from the silent partner to the professional. The latter "sale," then, has no impact upon the earning potential of the practice and does not affect the value of the goodwill to the professional. 29
The idea that something that cannot be sold has value defies logic, and a finding that a business that will not be sold in a marital dissolution should have a premium place on it is preposterous.
Courts of other states have wrestled with the issue of valuation of professional goodwill and have maintained that fair market value is the standard in marital dissolution cases. In Hanson v. Hanson, the Missouri Supreme Court argued:Proof of the existence of goodwill is particularly troublesome in a professional context. This difficulty is a product of the fact that the reputation of the individual practitioner and the goodwill of his enterprise are often inextricably interwoven. Because of the difficulties inherent in separating the reputation of the professional from that of his enterprise, evidence that other professionals are willing to pay for goodwill when acquiring a practice is, in our view, the only acceptable evidence of the existence of goodwill. Thus, as a matter of proof, the existence of goodwill is shown only when there is evidence of a recent sale of a similarly situated professional practice, an offer to purchase such a practice or expert testimony and testimony of members of the subject profession as to the existence of goodwill in a similar practice in the relevant geographic and professional market. Absent such evidence, one can only speculate as to the existence of goodwill. 30
This is not the law in California, but it should be, not only because of the speculative nature of calculating goodwill but also because evidence of the market value now exists.
The Valuation Methods Are Changing
At the end of the 1980's, several important changes made the prevailing methods of determining the value of goodwill in a law practice unfair and outdated. In 1989, the Business and Professions Code and the Rules of Professional Conduct were amended to permit the sale of a law practice. 31 Market data relating to sales of practices is still limited, but competent testimony is available on what it costs to buy into a law partnership and what premiums are paid when one firm acquires another in a merger. 32
One of the historic justifications for not using fair market value as the standard is that nonprofessional spouses would be economically disadvantaged by not being compensated for the value of their professional spouses' practices. The courts assigned an intrinsic value to the professional practices, called it goodwill, and awarded the practice to the professional, offsetting it against an award to the family residence and other assets to the nonprofessional spouse. In most cases, this was a fiction used to give wives some economic security. But now there are more professional women in the workplace than ever before. There are more women attorneys, and there are more women owners of professional practices. Women's earning power, although still lagging, is on the increase. 33 Placing a high value on a law practice no longer necessarily benefits a woman in a marital dissolution.
With the 1989 changes in the Rules of Professional Conduct, it is reasonable to expect that courts will follow the intellectually more honest approach set forth in In re Marriage of Fortier. In reference to the valuation of a medical practice, the court criticized the nonprofessional spouse's appraiser, who applied the excess earnings approach and ignored the recent purchase of an interest in the practice by a new partner. The court noted:It must be recognized that the value of the goodwill must exist at the time off the dissolution. That value is separate and apart from the expectation of the spouses' future earnings. As we analyze the determination of the existent value of the goodwill applicable in dissolution of marriage actions, that value must be established without dependence upon the potential or continuing net income of the selling doctor. Certainly, where there is no showing of collusion or unfair dealing to the detriment of any interested party, the price paid [in another sale] can be said to be persuasive evidence of the value of the goodwill. 34
Judges should first consider evidence of recent sales of similar practices, a bona fide offer to purchase the practice, or relevant testimony that the practice can in fact be sold at all before applying the fair market value approach or other methods of valuation. But whatever methods are used, the court should first determine if the practice can be sold. If it cannot be sold, it has no goodwill and has no value beyond the firm's tangible assets.
It may be some time before California courts return to a fair market standard of valuation. Unmarried lawyers who are going into practice for themselves or who are already in practice should not consider getting marriage without first entering into a well drafted premarital agreement in which both sides are represented by counsel. The agreement should indicate that the legal practice is separate property and that any increase in the practice's value will be separate property. The agreement should also specify that the practice's accounts receivable, work in progress, capital account, and goodwill are all separate property.
Attorneys who are already married and do not have premarital agreements can at least preserve evidence of their firm's value at the date of marriage. They should preserve financial statements, tax returns, and billing data so that if they must have their practice valued at the date of marriage, the data will be available. Attorneys who are in a partnership should have an arm's-length buy-sell agreement to help establish the value of the partnership interest. 35 However, unless the professional's spouse subscribes to the agreement and is represented by independent counsel, and unless the buy-sell agreement states that it is controlling in the event of a marital dissolution, it will not be binding. 36
Attorneys who do not have a signed premarital agreement and are in the throes of a divorce can take steps to lessen the threat of a theoretical valuation of their practices. Although hard data is limited, more practitioners are buying and selling practices. Many different professionals may be called upon to provide evidence of value. They include law firm management consultants, business opportunities brokers, accountants, valuation experts, attorneys, and marketing consultants. The Internet and classified advertisements may have leads to comparable sales. Many managements professionals have the expertise and data to support values based on sales of these practices.
The standard of value for a law practice should be fair market value. Language in Foster indicates that evidence of what a willing buyer would pay for goodwill is not required; this language should be rejected. 37 Without fair market value as the foundation for the valuation of a law practice, the value will always be, as described in Foster, just somebody's opinion. This does not mean that courts should reject such methods of determining the intrinsic value of the practice as calculating excess earnings or the capitalization of earnings. These methods are simply attempts to determine the fair market value of a business. More important, intrinsic value has no meaning if the thing of supposed value cannot be sold. Intrinsic values should be used to check the validity of comparable sales and vice versa. Unless attorneys litigating the issue of a law firm's valuation present evidence of comparable transactions, courts will have to rely solely on intrinsic valuation methods. Until the law changes and unless attorneys have a valid and enforceable premarital agreement, they run the risk of paying a premium for their own law practices. 38
Peter M. Walzer is a Fellow of the American Academy of Matrimonial Lawyers who practices in Los Angeles and Ventura Counties, and Edward Poll is a nationally known law firm management consultant.1 In re Marriage of Foster, 42 Cal.App.3d 577, 117 Cal. Rptr 49 (1974). The Foster court defines goodwill as "the advantage...acquired by an establishment beyond the mere value of the capital stock, funds or property employed therein, in consequence of the general public patronage and encouragement which it receives from constant or habitual customers.... Goodwill is property of an intangible nature and is a thing of value." Id. at 581-82 (citing In re Lyons, 27 Cal. App. 293, 297 (1938); see also Piedmont Publishing Co. v. Rogers 193 Cal.App 2d 171 (1961).
2 Foster, 42 Cal. App 3d at 583.
3 See Rev. Rul. 59-60, 1959-1 C.B. 237.
4 Code Civ. Proc. § 1263.320(b): "The fair market value of property taken for which there is no relevant market is its value on the date of valuation as determined by any method of valuation that is just and equitable."
5 Foster, 42 Cal.App.3d 577.
6 Id. at 580 (quoting the expert).
7 Id. at 580.
8 In re Marriage of Hewitson, 142 Cal.App. 3d 874, 191 Cal. Rptr 392 (1983).
9 Id. at 888 (holding that Fam. Code § 2550, former Civ. Code § 4800(a), does not require the value of closely held shares to be determined by market value).
10 The International Glossary of Business Valuation Terms (2000) [hereinafter International Glossary] defines "investment value" as "[t]he value to a particular owner investor based on individual investment requirements and expectations."
11 Hewitson, 142 Cal. App. 3d 874 n.9 (quoting Rev. Rul. 59-60, 1959-1 C.B. 237). Rev Rul. 59-60, 1959-1 C.B. 237). Rev. Rul 59-60 lists factors for determining intrinsic value:
12 Hewitson, 142 Cal.App. 3d at 880 (citing in re Marriage of Lotz, 120 Cal.App. 3d 379, 174 Cal. Rptr 618(1981)). See also Stephen Adams, California Family Law Practice § G.67.1 (15th ed. 2000) [hereinafter Adams]. It seems possible that although a price earnings formula of a publicly held company might be based on factors not normally present in a closely held corporation, a qualified expert might be able to identify those different considerations and adjust the public formula accordingly.
13 In re Marriage of Foster, 42 Cal. App. 3d 577, 580, 117 Cal. Rptr. 49 (1974).
14 In re Marriage of Sharp, 143 Cal.App. 3d 714, 192 Cal. Rptr 97 (1983).
15 International Glossary, supra note 10, defines "going concern value" as "[t]he value of a business that is expected to continue to operate into the future. The intangible elements...result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place." Going concern value equals the overall value of the business, minus net asset value, and unlike goodwill, it does not involve excess earnings.
16 Sharp, 143 Cal.App. 3d at 719.
17 See Adams, supra note 12, at § G.67.9. Adams argues that Hewitson "appears to be the stronger of the two cases." On the other hand, Sharp is important because it reaffirms the standard of value as fair market value, as opposed to the vague investment value standard in Hewitson.
18 In re Marriage of Foster, 42 Cal.App. 3d 577, 117 Cal. Rptr. 49 (1974).
19 Mark Kohn, A Theoretical Basis for Using Three Practices, Family Law News, Spring 1995, at 5.
20 Rev. Rul. 68-609, 1967-1 C.B. 576, indicates that the excess earnings approach is calculated as follows: a percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period. The remainder, if any, is considered to be the amount of the average annual earnings from the tangible assets of the business for the period. This amount, capitalized at a percentage of 15 to 20 percent, is the value of the tangible assets of the business. But see Garrett Dailey, Attorney's Briefcase, in California Family Law (ver. 1999.3) [hereinafter Dailey], which argues for a smaller capitalization rate.
21 Helga White, Professional Goodwill: Is It a Settled Question or is There "Value" in Discussing It?, 15 J. Am. Academy of Matrimonial Lawyers 526-27 (1998) (quoting Mocnik v. Mocnik, 838 P.2d 500, 505 (Okla. 1992)).
22 Rev. Rul. 59-60, 1959-1 C.B. 237.
23 In re Marriage of Watts, 171 Cal.App. 3d 366, 217 Cal. Rptr 301 (1985).
24 Compare In re Marriage of Webb, 94 Cal.App. 3d 335, 156 Cal. Rptr 334 (1979) (appellate court affirmed a trial court that took wife's experts testimony that the value of the goodwill of Webb's business was $31,468 and balanced that with Webb's testimony that the goodwill of the business had no market value and found a value between the two of $16,000) with In re Marriage of Hargrave, 163 Cal. App. 3d 346, 209 Cal. Rptr 764 (1985) (disapproving of the Webb court's splitting the difference).
25 In re Marriage of Slivka, 183 Cal. App. 3d 159, 228 Cal. Rptr 76 (1986).
26 In re Marriage of Aufmuth, 289 Cal. App. 3d 446, 152 Cal. Rptr 668 (1979), disapproved on other grounds in In re Marriage of Lucas, 27 Cal. 3d 808 (1980). Aufmuth states that a finding of no goodwill is appropriate in certain situations.
27 Id. at 463. The court stated that the exclusion of goodwill in the buy-sell agreement was only one of the factors indicating that the employed spouse had not amassed any goodwill. See also In re Marriage of Nichols, 27 Cal. App 4th 661, 33 Cal. Rptr 2d 13 (1994). But note criticism of buy-sell agreements in In re Marriage of Fortier, 34 Cal. App. 3d 384, 388, 109 Cal. Rptr 915 (1973).
28 See Dailey, supra note 20 (quoting Rev. Rul 59-609, 1967.1 C.B. 576).
29 Marriage of Winn, 98 Cal. App. 3d 363, 367, 159 Cal. Rptr 554 (1979) (quoting Kennedy & Thomas, Putting a Value on Education and Professional Goodwill, 2 Family Law Advocate 3, 4 (1979) with approval). In consideration of goodwill, the court put a value on a horse slaughtering business with no sales value. The court in Haldeman v. Haldeman, 202 Cal. App 2d 498 (1962), found this concept valid in valuing a pharmacist's business.
30 Hanson v. Hanson, 738 S.W. 428, 435 (Mo. 1987). Texas, Florida, Illinois, and Pennsylvania adhere strictly to the standard of fair market value.
31 More than two dozen states allow the sale of law practices, and information on the market value of law practices is accumulating. See, e.g., Edward Poll, Tool Kit for Buying or Selling a Law Practice (1998).
32 In re Marriage of Hewitson, 142 Cal. App. 3d 874, 191 Cal. Rptr 392 (1983) (price paid in merger may not be competent evidence because the pressures are different from those in the open market).
33 Statistical Abstract of the United States (1989), tables nos. 323 and 672.
34 In re Marriage of Fortier, 34 Cal.App.3d 384, 388, 109 Cal. Rptr 915 (1973).
35 See In re Marriage of Rosan, 24 Cal.App.3d 885, 101 Cal. Rptr 295 (1972); In re Marriage of Aufmuth, 289 Cal. App. 3d 446, 152 Cal. Rptr 668 (1979), disapproved on other grounds in Marriage of Lucas, 27 Cal. 3d 808, 815, 166 Cal. Rptr 853 (1980); In re Marriage of Micalizio, 199 Cal.App. 3d 622, 245 Cal. Rptr 673 (1988) (buy-sell when interest was a minority interest). But see Marriage of Slater, 100 Cal. App. 3d 241, 160 Cal. Rptr 686 (1979) (the buy-sell was not binding, because it was not signed for the purpose of dissolution) and Marriage of Fenton, 134 Cal. App 3d 451, 184 Cal. Rptr. 597 (1982).
36 The practitioner cannot rely on In re Marriage of Aufmuth, 289 Cal. App. 3d 446, which considered the stock purchase agreement as one factor in finding there was no goodwill in new partner's interest.
37 In re Marriage of Foster, 42 Cal.App. 3d 577, 117 Cal. Rptr. 49 (1974). Judges are more likely to be receptive to this argument if evidence of market value is presented to the court. Los Angeles Superior Court Judge Richard E. Denner wrote, "If the goodwill cannot legally be transferred, it should not be valued. What should be valued is goodwill at market price. Formulas that are not used in actual sales are inappropriate." Richard E. Denner, Goodwill, Valuation and Economic Reality, Cal. Family L. Monthly, Nov. 1988, at 144. There is a long line of cases that hold that the value of goodwill is not necessarily what a willing buyer would pay for it. See, e.g., Marriage of Winn, 98 Cal. App. 3d 363, 159 Cal. Rptr 554 (1979); Marriage of Watts, 171 Cal. App. 3d 366 (1985); Marriage of Hargrave, 163 Cal. App. 3d 346, 209 Cal. Rptr 764 (1985).
38 Another inequity in the treatment of business owners in a marital dissolution is the problem of double dipping, in which the same funds are distributed through an order for spousal support and in the equalizing payment to compensate the nonowner spouse for an interest in the business. The owner spouse also may be obligated to pay child support. The argument that accounts receivable should be included in the business valuation because the same funds would be paid as child and spousal support was rejected in In re Marriage of Marx, 97 Cal. App. 3d 552, 159 Cal. Rptr. 1224 (1979). See Adams, supra note 12 , at § G.29.1.
To file for divorce, one spouse must have lived in California for the last six months, and the county where the action is filed for the last three months. Spouses who have lived in California for at least six months, but in different counties for at least three months can file in either county. These California residency requirements must be met in order for the court to have jurisdiction of the case.
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